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792851_1999.txt

792851_1999

1999

792851

ITEM 1 - BUSINESS THE COMPANY Mosler Inc. (the "Company" or "Mosler") is a major provider and servicer of security systems and product. The Company manufactures, markets, installs and services security systems and products used by financial institutions and other commercial and industrial entities. Founded in 1867, the Company's business historically was based on the manufacture and sale of vaults, safes and other physical security products. In recent years, the service of such products and the manufacture, marketing, installation and service of electronic security systems has become increasingly important to the Company. The Company estimates that during fiscal year 1999 approximately 54% of its gross profit was generated through the repair and service of security systems and products provided by the Company and others. The Company currently manufactures and sells electronic security systems, access control systems, CCTV systems, burglar alarms, currency handling equipment, drive-in banking systems, modular vaults, vault doors, security containers and safes. In 1967, the Company's predecessor in interest, the Mosler Safe Company, was acquired by American Standard Inc. In 1986, The Company was incorporated as a Delaware corporation by an investor group comprised of senior management of the Security Products Division of American Standard Inc. and affiliates of Kelso & Co., Inc. ("Kelso"). In July 1986, the Company acquired the assets and business of the Security Products Division, including the stock of The Mosler Safe Company, from American Standard Inc. for approximately $156 million. On May 23, 1990, the Company merged (the "Merger") with a corporation organized by Kelso Investment Associates IV, L.P. ("KIA IV"), a Delaware limited partnership, and an affiliate. In connection with the Merger and intermediate transactions, all of the shares of the Company's Class A Common Stock (the "Old Common Stock"), were exchanged, at the option of the holder, for either (i) $79 in cash plus .17 shares of the Company's Series D Preferred Stock (the "Cash and Preferred Stock Consideration") or (ii) 7.9 shares of Common stock and .17 shares of Series D Preferred Stock (the "Common and Preferred Stock Consideration"). Approximately 1,068,127 shares of Old Common Stock, representing 89.4% of the Old Common Stock outstanding prior to the Merger on a fully-diluted basis, were exchanged for the Cash and Preferred Stock Consideration and approximately 127,498 shares of Old Common Stock representing 10.6% of the Company's Old Common Stock outstanding prior to the Merger on fully-diluted basis, were exchanged for the Common and Preferred Stock Consideration. In the Merger, KIA IV and the affiliate purchased an aggregate of 1,400,000 shares of common stock. Also in connection with the Merger, the Company purchased from BancBoston Capital Inc. ("BancBoston") all shares of a previously outstanding series of preferred stock of the Company. All of the transactions described above are collectively referred to herein as the "1990 Transaction." Sources of funds for the 1990 Transaction included approximately $80 million from proceeds of borrowings under a Credit Agreement dated as of May 19, 1990 and approximately $14 million from KIA IV and its affiliate. In conjunction with the 1990 Transaction, Mosler solicited and obtained from the holders of its 12 1/2% Senior Subordinated Debentures due 1998 a consent to amend in certain respects the indenture relating to such Debentures including, but not limited to, increasing the interest rate from 12 1/2% to 13 5/8% for interest accruing after May 23, 1990. The 1990 Transaction resulted in an increase of the indebtedness of the Company from $83.3 million to $163.3 million. The 1990 Transaction was not considered by generally accepted accounting principles to result in a change of control of the Company due to the significant continuing interest of certain stockholders and this resulted in a decrease in the Company's Common stockholders' equity of $83.7 million. On July 29, 1993, the Company completed a refinancing transaction whereby it issued $115 million principal amount of 11% Series A Senior Notes due April 15, 2003. A portion of the net proceeds from the notes were deposited in trust to redeem all of the Company's 13 5/8% Senior Subordinated Debentures ($80 million) plus accrued and unpaid interest. On October 9, 1998, the Company acquired substantially all the assets and assumed substantially all the liabilities of the LeFebure Division of De La Rue Cash Systems, Inc. ("LeFebure") for approximately $39.2 million. Like Mosler, LeFebure specialized in the manufacture, distribution and service of security equipment. Unlike Mosler, the majority of LeFebure business was with financial institutions, with a minimal amount of business with other commercial and government entities. LeFebure's operating results are included in the Company's consolidated financial statements of operations beginning on October 9, 1998. As of the date hereof, affiliates of Kelso own approximately 62.5% of the common stock of the Company. The remaining common stock is owned by management, directors and employees of the Company (including shares held in the Company's 401(k) Savings Plan for their benefit, and the Company's ESOP). The Company's principal executive offices are located 8509 Berk Boulevard, Hamilton, Ohio 45015 and its telephone number is (513) 870-1900. BUSINESS GENERAL Mosler's broad array of security systems and products includes its proprietary COMSEC/Invisicom monitoring system, which incorporates multi-point alarm, CCTV monitoring, and access control and permits a customer with multiple branch locations to report security data to a central location without interfering with the customer's data processing network; the Autobanker drive-in banking system, which delivers transactions efficiently via pneumatic tubes; a microprocessor controlled currency handling system, which improves productivity through high speed counting, sorting, bill facing and counterfeit detection; and bullet resistant teller protection windows and counters. As part of its strategy to expand its electronic security business, Mosler continues to develop and service technologically sophisticated electronic security products. The Company built its reputation as a major provider and servicer of security systems and products by developing and marketing products to meet the demanding security requirements of commercial banks and other financial institutions. The Company believes that the technological expertise it has developed to meet the standards of financial institutions should provide it with competitive advantage as it continues to expand its sales in the commercial and industrial market. The Company's service business has been a reliable source of cash flow. Approximately 42% of the Company's service revenues are derived from service agreements for providing ongoing maintenance. Although the majority of the Company's service revenues are derived from servicing products provided by the Company, the Company's service organization is equipped to handle the products of other manufacturers. The Company's 1,594 person service and sales organization operates through approximately 65 offices located throughout the country. PRODUCTS The Company's two primary products are physical security and electronic security systems. The Company's operations can be divided into four general categories: service, electronic security systems, physical security products and international operations. The following table sets forth the Company's net sales from each of these four categories as a percentage of total net sales for each of the last three fiscal years: SERVICE The Company believes that the capabilities of its service organization significantly enhance the sale of its products. The Company services electronic security systems, remote drive-in systems and physical security products it produces, as well as products produced by other manufacturers. Service revenues accounted for approximately 45% of the Company's net sales for fiscal 1999. During fiscal 1999 service agreement sales increased $11.0 million. Time and material sales increased $12.3 million. The increases in revenue for service agreements and for time and material are due to the acquisition of LeFebure. Approximately 41.6% of the Company's service revenues for fiscal 1999 were generated by services performed under service agreements. The Company offers various maintenance plans, ranging from plans that provide service only during business hours to plans that provide service at any time. Service plans generally require advance payment of a specified service fee. The remaining service revenues were generated by individual customer service calls for which the customer was charged for labor and materials. The Company employs approximately 1300 field service personnel. A majority of the service personnel are located in the Company's 65 domestic offices. The Company maintains a fleet of 1271 service vehicles for use by its service personnel. To meet increased electronic security systems service requirements and accommodate changes in technology, the Company will be required to increase its servicing capability by continuing and expanding the practice of providing electronic security systems training to a substantial percentage of its existing field personnel, providing follow-up training sessions and recruiting new personnel with electronics systems experience. ELECTRONIC SECURITY SYSTEMS The Company engineers and manufactures electronic security systems for both financial institutions and commercial and industrial customers. The Company also engineers and manufactures drive-up banking systems for financial institutions. Sales of electronic security systems accounted for approximately 28% of the Company's net sales for the year ended June 25, 1999. The Company produces alarm and surveillance systems designed primarily for financial institutions and retail stores. A principal product in this area is the COMSEC security communications system. COMSEC is a central monitoring and control security system designed for use in a single building or a group of buildings anywhere in the United States. COMSEC utilizes two-way communications equipment to enable a console guard to monitor security and fire alarms, control access to remote areas, receive reports and initiate security checks and inquiries. A customer may purchase COMSEC on a modular basis, so that additional system functions and additional remote locations can be added to a COMSEC system at a later date. During fiscal 1996 the Company acquired a minority interest in PACOM DATA PTY. (PACOM) Ltd. of Sydney, Australia, a supplier of the Company. PACOM is a world leader in highly advanced security communications, networking and systems development. In 1998 PACOM was acquired by Bell Security Limited (Bell), Hertfordshire, Great Britain in a transaction through which 100% of PACOM's common shares were exchanged for common shares of Bell. After the transaction, Mosler held a 5% interest in Bell, 30% of which was sold in the fourth quarter of 1999, for a gain of approximately $1.1 million, leaving the Company with a 3.5% interest in Bell. Through a distribution arrangement with Toshiba, the Company also markets a line of currency handling equipment including a micro-processor controlled currency handling system which improves productivity through high speed counting, sorting, bill facing and counterfeit detection. Mosler also has a line of products which provide a higher level of security at both the entrance sites of facilities and also within the facilities. These products, which are sourced from outside suppliers, include automated security portals, turnstiles and metal detectors. The security portals and turnstiles can be integrated with the access control system to ensure only authorized personnel are allowed entry while also reducing requirements for guards. The security portals can also be integrated with metal detectors to provide screening for weapons without direct and continual involvement of a guard. The Company's electronic security systems are generally assembled by Company personnel from components manufactured by others, including circuit boards, data processing products and other components purchased both under general contracts and pursuant to specific purchase orders. On July 29, 1993, the Company purchased Security Control Systems, Inc. ("Linx") for $6.8 million plus the assumption of certain liabilities and obligations of Linx. Linx is a developer of micro-computer based access control systems with an installed base of approximately 250 systems. Linx has provided security services for the U.S. space program as well as various Fortune 500 companies, hospitals, financial institutions and correctional institutions. The Linx acquisition provided the Company with a greater presence in the commercial and industrial sector of the market for electronic security systems. PHYSICAL SECURITY PRODUCTS The Company engineers, purchases and manufactures modular vaults, vault doors, night depositories, safe-deposit boxes, drive-in windows and counter systems for financial institutions. The Company also provides drive-in and walk-up transaction systems for financial institutions, including equipment permitting sight-and-sound communications between tellers and customers and customer identification. The Company also engineers and manufactures money and record safes and insulated vault doors for financial institutions, United States government agencies and contractors and other commercial and industrial customers. Sales of physical security products accounted for approximately 24% of the Company's net sales for the year ended June 25, 1999. The Company closed its Hamilton, Ohio manufacturing facility on April 2, 1996. The plant closing is part of the Company's ongoing efforts intended to improve its competitive position in the industry. The product lines that had been manufactured at the Hamilton, Ohio plant were transferred to other Company facilities or built to the Company's specifications by other manufacturing companies. The plant closing and related shutdown expenses resulted in a pretax charge of approximately $3 million. The Company closed its Buffalo, New York manufacturing facility on August 1, 1997. The plant closing is part of the Company's ongoing efforts to improve cost efficiencies. The product lines that had been manufactured at the Buffalo, New York plant were transferred to another manufacturer who will build the product to the Company's specifications. The plant closing and related shut down expenses resulted in a pretax charge of approximately $.6 million. On January 31, 1999 the Company closed its leased Wayne, New Jersey facility and outsourced this production. In connection with this shut down, the Company took a one-time restructuring charge of approximately $1.8 million related primarily to severance and fixed asset write-offs. For additional information see Note 1 to the Consolidated Financial Statements. On August 23, 1999 the Company announced that the Mexico, Missouri location, a property acquired as part of the acquisition of the LeFebure Division (LeFebure) of De La Rue Cash Systems, Inc., will be closed. The Company plans to move certain of the production of the facility to other Mosler locations while outsourcing the remainder. Although final studies and estimates have not been completed, the Company expects to incur plant closing costs of approximately $2.0 million of which approximately $1.6 million will be allocated to the purchase price of LeFebure. The Company believes that it is the largest provider of Government Containers in the United States. Government Containers are secured file drawers, used by United States government agencies, including branches of the United States armed forces, to protect documents, weapons and other materials from espionage, theft and destruction. The Company also sells its Government Containers to government contractors. United States sales to government agencies and contractors accounted for approximately 2.6%, 4%, and 4.6% of the Company's net sales in fiscal years 1999, 1998 and 1997 respectively. Due to increased competition in the physical security product market and anticipated defense and federal government budget levels, the Company does not anticipate any significant future growth in sales to government agencies and contractors. The Company manufactures and purchases a variety of physical security products used by financial institutions, including vault doors, night depositories, safe-deposit boxes, drive-in windows, counter systems and safes. The Company also sells certain physical security products, like modular vaults, manufactured by others. The Company's counter systems for financial institutions include bank counters, check desks, coupon booths, under counter steel cabinets, currency storage equipment and a variety of protective devices constructed from bullet resistant material. The Company also manufactures and purchases a line of fire and burglary resistant products for commercial and industrial customers designed to protect currency, securities and records. The principal products in this line are money and record safes and insulated vault doors. These products are sold primarily to food and drug retail chain stores, educational institutions and insurance companies. The Company also manufactures a line of Dropository units, used by utilities, libraries, schools, insurance companies and governmental collection offices, designed to permit the payment of bills and the deposit of books and other packages during non-business hours. INTERNATIONAL The Company markets security products primarily to customers in Mexico, Canada, the Caribbean basin, South America and the Far East. The Company's international sales accounted for approximately 2.7% of the Company's total net sales for fiscal 1999. The Company maintains direct sales and service offices in Mexico, Canada and the Caribbean and a manufacturing facility for physical security products in Mexico. The Company has also entered into agreements with licensees in Indonesia and the Philippines pursuant to which the licensees are authorized to manufacture and sell certain of the Company's products in accordance with designs, specification and quality standards established by the Company in exchange for the payment of specified fees and royalties. The Company markets products in other international locations through independent dealers. Due to high transportation costs, the Company exports only a limited number of physical security products from its facilities in the United States. In July of 1998 the Company entered into a joint venture with three other companies for the purposes of distributing products for China. Although the company holds a minority position in the joint venture it has been approved to supply technical and management expertise. For financial information about the Company's international operations, see Note 15 to the Consolidated Financial Statements. PRINCIPAL MARKETS As a result of recent trends in the financial institutions market, the Company believes that sales of electronic security systems to financial institutions will show greater growth than sales of physical security products. Sales of electronic security systems are cost justified by a number of factors, including the need for greater security at remote locations, the desire for centralized monitoring and the reduction of personnel and other costs resulting from the implementation of improved technology. Sales of physical security products are primarily dependent upon branch openings and renovations. In addition, as a result of branch mergers and consolidations, the Company has experienced increased interest by merged banks in integrating existing security systems and implementing labor saving security systems. With respect to sales of physical products, the trend toward banking deregulation has resulted in the increased use of "limited branch" operations. In contrast to a full service operation, limited branches are smaller and require fewer physical security products. The Company estimates that the revenues generated from initial security product sales to a new limited branch and in connection with a branch renovation are approximately 25% and 50%, respectively, of the revenues generated from initial security product sales to a new full service branch. However, the first half of 1998 saw this trend reversing back towards full service branches, a move that has continued and has positively impacted the Company's sales and results of operations. In addition, the acquisition of LeFebure has enhanced Mosler's position in the financial institution market, since all of LeFebure's significant customers were banks. As part of its strategy to expand its presence in the commercial and industrial markets, the Company is attempting to expand sales of its electronic security systems (including access control systems) to commercial and industrial facilities for use in retail chain stores and office and other commercial buildings. The Company has installed integrated electronic security systems at American Honda, Oracle and United Healthcare and continues to provided electronic security systems to K-Mart and J.C. Penney retail chains. In 1998, the Company entered into a contract to supply an integrated access control system to the New York and New Jersey Port Authority, which will be completed in fiscal 2000. Mosler is pursuing the segment of the commercial and industrial electronic security market in which customers have a requirement for a high level of security. Included in this segment are technology firms, brokerage firms, retail chains with large stores, defense contractors, museums and universities. The Company expects access control and CCTV to be a major source of growth in the commercial and industrial electronic security business. With the exception of Government Containers, which are sold to a limited group of government agencies and contractors, sales of the Company's products and services are not dependent upon a single customer or a few customers. The Company provides products and services on a nationwide basis, and its business is not dependent on any particular geographic region. The Company's sales are not subject to significant seasonal variations. WARRANTY AND SERVICE The Company generally warrants its products for periods ranging up to one year against defective material and workmanship under normal use and service. The Company's obligations under such warranties are limited to repairing or replacing, free of charge, any defective parts. In negotiating specific sales contracts, the Company may increase or otherwise modify its standard warranties. COMPETITION The Company is subject to competition in the sale and service of physical security products and electronic security systems. Price and service are the principal methods of competition for physical security product sales in the financial institution market. The Company is one of the largest providers of physical security products for financial institutions. The Company's principal competitor in this market is Diebold, Inc., Canton, Ohio. The financial institutions market is also shared by a number of smaller regional and national manufacturers. The Company has experienced significantly greater competition in the commercial and industrial sector for its physical security products and electronic security systems than in the financial institution market. The Company believes that it is the largest provider of Government Containers in the U.S. The Company's principal competitor in the production of these Government Containers is Hamilton Products, Amelia, Ohio. Overly Co., located in Greensburg, PA, manufactures security vault doors for United States government agencies in competition with the Company. Competitors in this market must comply with government specifications applicable to each product. The Company competes with a number of major manufacturers in the commercial and industrial markets for integrated electronic security systems, including ADT Security Systems, Honeywell Inc. and Litton Industries, Inc. The principal methods of competition in this market are product design features (including customized applications), price and service. The Company focuses its marketing efforts for its electronic security systems on customers whose primary concern is security (as opposed to control of heating, ventilation and air-conditioning) and for whom a stand-alone proprietary system may be appropriate. In contrast, many of the Company's competitors emphasize systems controlling heating, ventilation and air-conditioning (with certain security features) or systems which are linked to a central alarm station. Many of the Company's competitors in this market have substantially greater financial resources than the Company and have developed reputations for system design capability. SOURCES OF SUPPLY The Company is not substantially dependent on any one supplier except that the Company purchases electronic locks for Government Containers from the only currently government approved supplier of these electronic locks. The Company believes its sources of supply for materials used in manufacturing and assembling its products are adequate for its needs. TRADEMARKS AND PATENTS The Company's principal trademark is the "Mosler" name. The Company has been doing business under the Mosler name since 1867 and has developed a reputation as a major supplier of quality security products. The Company also has a number of other trademarks, including the names "COMSEC," "Invisicom," "Autobanker," "Magna" and "Dropository". The Company holds patents for 30 security products, including certain remote transaction systems, vault doors, night depositories, locks and safe-deposit boxes. No patent or group of patents is, in the opinion of the Company's management, of material importance to its business. BACKLOG The Company's backlog of orders was approximately $39 million at June 25, 1999 compared with $40.6 million at June 27, 1998. The Company expects that substantially all of its backlog at June 25, 1999 will be shipped in the next 12 months. Except for certain long-term contracts, revenue from the sale of the Company's products, after provision for installation, is recognized when products to be installed for customer orders are shipped from the plants. GOVERNMENT CONTRACTS Approximately 2.6% of the Company's net sales in fiscal 1999 were made under contracts with United States government agencies or contractors. Most government contracts are subject to the provisions of the regulatory statutes applicable to government defense program contracts or subcontracts and contain standard terms, including provisions for price redetermination as well as termination for the convenience of the government. The Company's sales to United States government agencies and contractors are dependent upon the continued approval of its products by the GSA. The Company has been subject to governmental audits of costs under contracts with United States government agencies and contractors. RESEARCH AND DEVELOPMENT The Company conducts a research and development program for electronic security systems and physical security products. During fiscal 1999, the Company's research and development costs for electronic security systems and physical security products were $1.8 million and $.1 million, as compared to $1.2 million and $.1 million for such purposes in fiscal 1998. ENVIRONMENTAL REGULATION Certain of the Company's operations are subject to federal, state and local environmental laws and regulations. The Company believes that the Company is currently in material compliance with all environmental and pollution control laws applicable to the conduct of its business. EMPLOYEES At June 25, 1999, the Company employed 2,264 persons. Of this number 212 were employed in the manufacture of physical security products, 37 were employed in the manufacture of electronic security systems, 1,594 were employed in sales and service operations, 185 were employed in international operations and the remainder provided management, administrative and clerical support. Approximately 180 of the Company's employees are located outside the United States. ITEM 2 ITEM 2 PROPERTIES The Company owns safe, vault doors, safe-deposit box, drive-up window and other physical security equipment manufacturing facilities in Franklinville, New York; Farmington and Mexico, Missouri; and Mexico City, Mexico. The Farmington, Missouri and Mexico, Missouri plants were acquired from LeFebure. The Company announced the closing of the Mexico, Missouri facility on August, 23, 1999. The closing is scheduled to be completed no later than the end of the Company's third fiscal quarter in 2000. Certain of the production will be placed in other Company manufacturing facilities and the remainder will be outsourced. The Company closed its leased Wayne, New Jersey facility in January, 1999. A research and development facility for electronic security is leased in Northridge, California. Warehousing facilities for these products are maintained at the above locations. The Company's headquarters is located in Hamilton, Ohio, as is a training and educational center for the Service Division. The Company leases approximately 80 offices in various locations throughout the United States. These facilities are used for office, warehouse and servicing purposes. The lease terms range from one to seven years and many of the leases are renewable at the Company's option. The Company believes that its properties are suitable to its business and have productive capacities adequate for its anticipated needs. The Company leases and owns a fleet of 1271 service vehicles for use by its service representatives. The majority of the fleet is leased. The service vehicles consist of vans (approximately 62%), automobiles (approximately 1%), pick-ups and light duty trucks (approximately 34%), large installation trucks (approximately 1%) and trailers (approximately 2%). The Company replaces approximately one-third of the service vehicles each year. ITEM 3 ITEM 3 LEGAL PROCEEDINGS The Company is involved in routine litigation arising in the ordinary course of its business including claims against the Company involving alleged thefts from facilities in which the Company's security products were installed. The Company does not expect any of such actions to result in a finding that would have a material adverse effect on the Company's financial condition, results of operations, or cash flows. The Company is from time to time subject to lawsuits arising out of automobile accidents involving the Company's vehicles. The Company is also a party to various other actions arising out of the normal course of its business. The Company maintains liability insurance against risks arising out of the normal course of its business. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the quarter ended June 25, 1999. PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's equity securities are not traded in any market. As of September 7, 1999, there were 126 holders of the Company's Common Stock. No dividends have been paid on the Company's Common Stock in the last four fiscal years. The Company intends to utilize earnings to pay down debt and fund growth of its business and does not anticipate paying any cash dividends on its Common Stock. Under the various covenants in the Credit Agreement of October 9, 1998, as amended on September 15, 1999, between the Company and Fleet Bank as Administrative Agent and five other participating banks (the "Credit Agreement") the Company is limited in paying cash dividends on its Common Stock & Preferred Stock. ITEM 6 ITEM 6 SELECTED CONSOLIDATED FINANCIAL DATA - -------- (1) Includes costs for closing Hamilton, Ohio manufacturing plant of approximately $3.0 million in 1996, $581,000 in 1998 for the closing of the Buffalo, NY plant, and $1.8 million in 1999 for the closing of the Wayne, NJ plant. (2) Represents interest expense applicable to the 13 5/8% Debentures (including amortization of debt discount), the 11% Senior Notes due 2003, interest expense applicable to the indebtedness under the Credit Agreement, cost of interest rate protection agreements, miscellaneous interest expense and non-cash interest expense accrued on unpaid dividends applicable to the Company's preferred stock, all net of interest income. Includes amortization of debt discount and deferred debt issuance costs resulting from the acquisition of the Company from American Standard Inc. in 1986 and the 1990 Transaction. (3) Includes cumulative effect of a change in the method of accounting for service van inventories in 1997. (4) Includes dividends declared and paid on the Series C Preferred Stock, undeclared and unpaid dividends on the Series D Preferred Stock and amortization of discount on the Series D Preferred Stock. Excludes interest on accrued but unpaid dividends on the preferred stock. The Company has not paid any preferred dividends in cash since fiscal 1990. SELECTED CONSOLIDATED FINANCIAL DATA - -------- 5 Includes a reduction of $83.7 million attributable to the 1990 Transaction. RESULTS OF OPERATIONS The following table sets forth certain operating data of the Company for fiscal 1999, 1998 and 1997. The following table and discussion separates net sales and gross profit information for certain categories of the Company's products. * Does not include Buffalo plant closing cost of approximately $581,000 in 1998 or Wayne, NJ plant closing of approximately $1.8 million in 1999. ** Includes Buffalo restructuring cost of $581,000 and gain on termination of post retirement benefits $11.9 million in 1998 and Wayne, NJ restructuring cost of approximately $1.8 million in 1999. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS This document contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements include, without limitations, the Company's beliefs about trends in the Company's industries, and its views about the long-term future of these industries and the Company. The following factors, among others, could cause the Company's financial performance to differ materially from that expressed in such statements: (i) changes in consumer preferences resulting in a decline in the demand for product and service, (ii) the inability to reduce SG&A expenses as expected, (iii) an increase in the price of raw materials, (iv) political and/or economic instability in foreign countries where the Company has operations or has suppliers who supply the Company, (v) an unexpected increase in interest rates, (vi) a shift in strength of the overall U.S. economy thereby possibly reducing purchases, and, (vii) failure to remedy in a timely manner any Year 2000 issues that might arise. OVERVIEW The Company is a major provider and servicer of security systems and products to financial institutions. While consolidation within the banking industry has reduced the pace of bank branch construction and intensified competition among providers of security products, the Company believes that consolidation has and will benefit its business because it creates additional demand both for physical security products as merged branches are remodeled and for electronic security products and services as merged banks continue to integrate and upgrade their electronic security systems. Additionally, the Company believes that its broad product line and technologically sophisticated service and sales organization, combined with its nationwide presence, position it to continue to be a preferred supplier as financial institutions consolidate. Further, the acquisition of LeFebure has strengthened the Company's position in the physical financial security portion of its business. Historically, the Company has also generated significant revenues from the sale of Government Containers. Sales of Government Containers declined from fiscal 1988 to fiscal 1999 from $35.1 million to $7.8 million. The Company believes that the decline in these sales roughly parallels defense procurement spending. Although the Company does not expect the sale of Government Containers to be a source of revenue growth, the Company continues to take steps to make sales of Government Containers profitable at current sales levels. While the Company has begun to benefit from the recent improvement in banking industry profitability, management continues to pursue a strategy designed to reduce its dependence on the financial institution security market by increasing its focus on the commercial and industrial electronic security systems markets in order to expand its product line to include user-friendly products suited to the specific needs of commercial and industrial customers. In addition to pursuing its strategy of reducing its reliance on financial institutions, the Company continues to improve its cost position through plant closings, product line rationalization and manufacturing process improvements. FISCAL 1999 COMPARED WITH FISCAL 1998 NET SALES The Company's sales increased during fiscal 1999 by 33.4% to $301.7 million from $226.8 million in fiscal 1998. The increase in sales was due primarily to the acquisition of LeFebure. Increased shipments of Physical Security products (excluding Government) were $11.3 million and Electronic Security Systems increased $34.8 million. During the same period sales of Government products declined by $0.6 million and International declined $2.8 million. Service revenues increased in fiscal 1999 by $31.2 million to $135.5 million. The increase in service revenue is attributed to the increase in service contracts due to the LeFebure acquisition. Sales of Electronic Security Systems increased by 69.1% to $85.3 million from $50.5 million. This increase can be attributed to higher sales of COMSEC, Alarms, CCTV and Currency Handling products, as well as Access Control Systems, including approximately $9 million attributable to the Company's contract with the Port Authority of New York. Further, these increases are partially attributable to the acquisition of LeFebure. In September, 1997, the Company entered into an agreement with Triton Systems, Inc. to sell, install and service Triton's 9600 series ATM. As part of the agreement with Triton, the Company became the preferred service provider for Triton's installed base of ATMs. In addition one of the Company's largest financial institution customers merged with another financial institution which led to electronic conversion sales in the acquired branches. Sales of Physical Security products (excluding Government) increased by 21% to $65.6 million. This increase is attributed to increased sales of Vault Systems, Night Depositories, Drive In Systems, Financial Furniture and ATMs. Sales of Government products decreased by 7.1% to $7.8 million from $8.4 million. This decrease is attributed to a continued decline in defense procurement spending. Sales of the Company's International operations decreased 25.9% to $8.1 million. Sales declines were experienced in Export markets and in Mexico and Canada, and were only partially offset by a sales increase in Puerto Rico. GROSS PROFIT Gross profit increased by 26.6% to $65.0 million from $52.1 million in fiscal 1998, before plant closing costs. Gross profit as a percentage of sales decreased to 21.8% for fiscal 1999 from 23.0% for fiscal 1998. Gross profit from Service revenues increased during fiscal 1999 by 32.6% to $34.6 million from $26.8 million. Gross profit as a percentage of sales increased in fiscal 1999 to 26.1% from 25.7% in fiscal 1998. Gross profit from the sale of Electronic Security Systems increased by 70.2% to $14.8 million from $8.7 million. Gross profit as a percentage of sales increased to 17.4% from 17.3% in 1998. The increase in gross profit was due mainly to an increase in volume, due to the purchase of LeFebure.. Gross profit from the sale of Physical Security products (excluding Government) decreased by 6.3% to $11.8 million from $12.6 million in fiscal 1998. Gross profit as a percentage of sales decreased to 18.0% from 23.3% in fiscal 1998. The decrease in gross profit was due mainly to higher overhead variances, partially offset by increased volume. Gross Profit from the sale of Government products increased by 26.7% to $1.9 million from $1.5 million in fiscal 1998. Gross Profit as a percentage of sales increased to 24.6% from 18.0% in fiscal 1998. A decrease in product discounts and favorable product mix combined with lower variances and overhead costs resulted in this improvement. Gross profit from the Company's International operations decreased by 24.6% to $1.8 million from $2.4 million for fiscal 1998. Gross profit as a percentage of sales increased to 22.4% from 22.0% in fiscal 1998. The decline in gross profit is due to a decrease in sales volume in Export, Mexico, and Canada, with a decline in margins in Export and Puerto Rico. These were partially offset by a higher gross margin in Canada and increased sales in Puerto Rico. SELLING AND ADMINISTRATIVE EXPENSE Selling and administrative expenses increased by 65.9% to $55.6 million from $37.6 million in fiscal 1998. Selling and administrative expenses as a percentage of sales increased to 18.3% in fiscal 1999 from 16.6% in fiscal 1998. The increases in the percentage relates to transition costs associated with the acquisition of LeFebure. OPERATING INCOME The Company's operating income during fiscal 1999 decreased by 68.0% to $8.1 million from $25.6 million in fiscal 1998. Operating income as a percentage of sales decreased to 3.3% from 6.3% in fiscal 1998. Fiscal 1999 includes a charge of $1.8 million related to the closing of a plant and transition charges related to the acquisition of LeFebure of approximately $8.1 million. Included in operating income in fiscal 1998 was a gain on the termination of post-retirement benefits of $11.9 million, offset by a restructuring charge of $.6 million. NET INTEREST EXPENSE Net interest expense, including amortization of debt issuance costs, increased 24.3% to $25.8 million from $20.8 million in fiscal 1998. The increase relates to increased interest on a higher debt level under the Company's line of credit. The increased borrowings were used for the acquisition of LeFebure and for operating activities. NET LOSS BEFORE PREFERRED STOCK CHARGES Net loss before preferred stock charges decreased during fiscal 1999 to an $18.7 million loss from net income of $4.6 million in fiscal 1998. Included in the net loss of fiscal 1999 is a charge of approximately $8.1 million for transition costs related to the acquisition of LeFebure and plant closing costs of $1.8 million for Wayne, NJ. Included in the net income of fiscal 1998 is a one time favorable adjustment of $11.9 million due to discontinuance of the Company's medical and insurance benefit for retirees and an unfavorable adjustment of $.6 million for Buffalo, New York plant closing costs. INFLATION The Company believes that its business is affected by inflation to approximately the same extent as the national economy. Generally, the Company has been able to offset the inflationary impact of wages and other costs through a combination of improved productivity, cost reduction programs and price increases. The Company has had difficulty in effecting significant price increases because of the discounting practices of its competitors. PLANT CLOSINGS - FISCAL YEARS 1999, 1998, AND 1997 In August, 1999 the Company announced its decision to shut down the Mexico, Missouri facility. This facility was acquired from LeFebure as part of the October 9, 1998 purchase. Although final studies and estimates have not been completed, the Company expects restructuring costs of approximately $2 million. The majority of these costs will be recorded as an adjustment to the purchase price of LeFebure. In August of 1998 the Company announced it would shut down its leased Wayne, New Jersey Facility and outsource this production. In connection with this shut down, the Company took a restructuring charge of approximately $1.8 million related to severance and fixed asset write-offs. For additional information see Note 1 to the Consolidated Financial Statements. During the first quarter of fiscal 1998, the Company announced it would shut down its leased Buffalo, New York facility and outsource this production. The plant was closed on August 29, 1997. In connection with this shut down, the Company experienced one time plant closing costs of $.6 million related to severance, fixed asset write-offs, plant cleaning and repair. FISCAL 1998 COMPARED WITH FISCAL 1997 NET SALES The Company's sales increased during fiscal 1998 by 8.7% to $226.8 million from $208.6 million in fiscal 1997. The increase in sales was due primarily to improved shipments of Physical Security products (excluding Government) of $9.5 million, Electronic Security Systems of $11.1 million and International of $1.6 million. During the same period sales of Government products declined by $1.3 million. Remote Transaction Systems, produced in the Wayne, New Jersey, facility have historically been classified as Electronic Security Systems in the Company's Financial Statements. This product line is more appropriately classified as Physical Security Product, and therefore the Company has made a reclassification in the 1998 and 1997 financial statements to reflect this change. Service revenues declined in fiscal 1998 by $2.6 million to $104.3 million. Service Agreement revenue declined $.2 million, while Time and Material revenue declined $2.4 million. The decline in Time and Material revenue is a result of a refinement in the Company's method of recording certain revenues and costs formerly classified as Service and now allocated directly to product lines. Sales of Electronic Security Systems increased by 28.3% to $50.5 million from $39.3 million. This increase can be attributed to higher sales of COMSEC, Alarms, CCTV and Currency Handling products. Sales of Physical Security products (excluding Government) increased by 21.4% to $54.2 million. This increase is attributed to improved sales of Vault Systems, Night Depositories, Drive In Systems, Financial Furniture and ATMs. In September, 1997, the Company entered into an agreement with Triton Systems, Inc. to sell, install and service Triton's 9600 series ATM. As part of the agreement with Triton, the Company will also become the preferred service provider for Triton's installed base of ATMs. Sales of Government products decreased by 14.3% to $8.4 million from $9.8 million. This decrease is attributed to a continued decline in defense procurement spending as well as a decline in the number of large orders received in 1998 as compared to 1997. Sales of the Company's International operations increased by 17.2% to $10.9 million. Improved sales to the Mexico, Export and Puerto Rico markets were only partially offset by a sales decline in Canada. GROSS PROFIT Gross profit improved by 16.6% to $52.1 million from $44.7 million in fiscal 1997, before plant closing costs. Gross profit as a percentage of sales increased to 23.0% for fiscal 1998 from 21.4% for fiscal 1997. Gross profit from Service revenues increased during fiscal 1998 by 4.6% to $26.8 million from $25.7 million. Gross profit as a percentage of sales increased in fiscal 1998 to 25.7% from 24.0% in fiscal 1997. Gross profit from the sale of Electronic Security Systems increased by 34.6% to $8.7 million from $6.5 million. Gross profit as a percentage of sales increased to 17.3% from 15.6% in 1997. The increase in gross profit was due mainly to an increase in volume. Gross profit from the sale of Physical Security products (excluding Government) increased by 30.0% to $12.6 million from $9.7 million in fiscal 1997. Gross profit as a percentage of sales increased to 23.3% from 21.7% in fiscal 1997. The increase in gross profit was due mainly to an increase in volume with lower variances and overhead costs. Gross profit from the sale of Government products increased by 72.0% to $1.5 million from $.9 million in fiscal 1997. Gross profits as a percentage of sales increased to 18.0% from 9.0% in fiscal 1997. A decrease in product discounts and favorable product mix combined with lower variances and overhead costs resulted in this improvement. Gross profit from the Company's International operations increased by 23.1% to $2.4 million from $1.9 million for fiscal 1997. Gross profit as a percentage of sales increased to 22.0% from 20.9% in fiscal 1997. The improvement in gross profit resulted primarily from increased sales volume and favorable mix due to higher sales volumes in Mexico and Export where margins are higher. SELLING AND ADMINISTRATIVE EXPENSE Selling and administrative expenses decreased by 4.5% to $37.6 million from $39.4 million in fiscal 1997. Selling and administrative expenses as a percentage of sales decreased to 16.6% in fiscal 1998 from 18.9% in fiscal 1997. This decrease was a result of lower selling and Research and Development expenses. OPERATING INCOME The Company's operating income during fiscal 1998 increased by 341.4% to $25.6 million from $5.8 million in fiscal 1997 (before restructuring charges). Operating income as a percentage of sales increased to 6.3% from 2.8% in fiscal 1997. Included in operating income in fiscal 1998 was a gain on the termination of post-retirement benefits of $11.9 million, offset by a restructuring charge of $.6 million. NET INTEREST EXPENSE Net interest expense, including amortization of debt issuance costs, increased 10.0% to $20.8 million from $18.9 million in fiscal 1997 The increase relates to increased interest on funds borrowed under the Company's line of credit. The increased borrowings were used to finance operating activities. NET LOSS BEFORE PREFERRED STOCK CHARGES Net loss before preferred stock charges increased during fiscal 1998 to $4.6 million from a net loss of $5.7 million in fiscal 1997. Included in the net income of fiscal 1998 was a one time favorable adjustment of $11.9 million due to discontinuance of the Company's medical and insurance benefit for retirees and an unfavorable adjustment of $.6 million for Buffalo, New York plant closing costs. Included in the net loss of fiscal 1997 was a one time adjustment of $7.4 million for the cumulative effect of a change in accounting method relating to the capitalization of the service van inventory. LIQUIDITY AND CAPITAL RESOURCES As more fully described in Item I, the Company on October 9, 1998 acquired substantially all the assets and assumed substantially all the liabilities of the LeFebure division of De Le Rue Cash Systems Inc. and De La Rue Systems Americas Corporation. Coincident with the acquisition the Company entered into a Financing Agreement with a group of lenders, led by Fleet National Bank, to finance the acquisition and provide working capital for operations. Under the terms of the Financing Agreement, a Credit facility of $85 million was established. Effective September 15, 1999, this was increased to $90 million. The Company also agreed to certain financial covenants. The Company believes that this facility will provide adequate financial resources for its operations. Borrowing under the credit facility bears interest at LIBOR plus 2.65% or at the prime lending rate plus 1.625%. Cash used by operating activities was $8.7 million for fiscal 1999 compared to cash used of $3.4 million in fiscal 1998. The decrease was due to increased working capital requirements generated by increased revenue. The Company's unfinanced capital expenditures were $3.7 million for fiscal 1999 as compared to $1.5 million for fiscal 1998. Funds required for the Company's future capital expenditures will come from several sources, including operating cash flow, the Company's revolving credit facility and third-party financing to the extent permitted by the Company's debt instruments. The Company's operating plan for fiscal 2000 anticipates capital expenditures of $2.2 million. The Company currently makes cash contributions to the ESOP only to the extent necessary to fund the cash needs of the ESOP for payments to retired, terminated and deceased participants and for administrative expenses. The Company was in compliance with the financial covenants related to its line of credit and term loan . CONTINGENCIES The Internal Revenue Service (IRS) has conducted examinations of the Company's income tax returns for fiscal years 1988 through 1993 and has proposed various adjustments to increase taxable income. The Company has agreed to certain issues and has previously recorded a provision for additional income tax and interest. The IRS has issued deficiency notices on these issues related to 1) the allocation of the Company's purchase price of assets from American Standard and 2) the value of the Company's Series C preferred stock contributed to its ESOP. The Company allocated approximately $70 million of the purchase price of assets from American Standard to intangible assets which are being amortized over a period of generally 14 years. The IRS proposes to reduce this allocation to approximately $45 million and increase the amortization period to generally 17 years. In 1990 and 1993, the Company contributed to its ESOP, and claimed a tax deduction for, shares of Series C preferred stock having a value aggregating approximately $9.6 million. The IRS proposes to reduce this value to approximately $7.1 million. In September 1999, the Company agreed to settle these issues with the IRS. Under the terms of the settlement, the Company will pay additional taxes of approximately $576,000 along with related interest. The Company will also, for tax purposes, reduce the allocated value of its intangibles to $45 million and increase the amortization period to 17 years. The Company has recorded a provision for the additional tax and interest it expects to pay in the accompanying financial statements. Management believes that the payment of this additional tax and interest effectively resolves the matter. The Company is involved in an audit by the Department of Labor ("DOL") of its Employee Stock Ownership Plan. On June 23, 1995, the Department of Labor issued an audit letter claiming the Company's Employee Stock Ownership Plan engaged in a prohibited transaction. Essentially, the DOL alleges that Series C Preferred Stock contributed to the Plan was not a proper investment since it was neither stock nor a qualified equity as required by ERISA. The Company has responded to the claim and intends to pursue the matter vigorously as it believes the Series C Preferred Stock is stock and, therefore, constitutes a proper investment for the Plan. Various lawsuits and claims arising during the normal course of business are pending against the Company. In the opinion of management, the ultimate liability, if any, resulting from these matters will have no significant effect on the Company's consolidated financial position, results of operations or cash flows. NEW ACCOUNTING STANDARDS Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income" was issued in June 1997 and is effective for the Company's 1999 fiscal year. Reclassification of financial statements for earlier periods provided for comparative purposes was required. The statement requires that an enterprise classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of the balance sheet. Adoption of this new standard resulted in additional financial statement disclosures. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," was issued in June 1997 and is effective for the Company's 1999 fiscal year. In the initial year of application, comparative information for earlier years is to be restated. The statement requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Adoption of this new standard resulted in additional financial statement disclosures. SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits", was issued in February 1998 and is effective for the Company's 1999 fiscal year. Disclosures for earlier periods provided for comparative purposes was required. The statement revises employers' disclosures about pension and other post-retirement benefit plans. Adoption of this new standard resulted in additional financial statement disclosures. YEAR 2000 The Year 2000 problem is a result of computer programs being written using two digits (rather than four) to define the applicable year. Any of the Company's programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000, which would result in miscalculations or system failures. The Company's major computer systems consist of third-party software. The conclusion of the Company's research is that the latest existing releases of this software contain the necessary changes to correct any significant Year 2000 problems. As a matter of ongoing policy, in order to assure continuing contractual vendor support, the Company promptly installs and implements new releases of third-party software. To date, the Company has implemented third-party releases that it believes are Year 2000 compliant for substantially all of its software. The Company has spent approximately $1.6 million on these releases during 1999, which amounts were planned expenditures irrespective of any Year 2000 issues. The Company has tested and has further plans to test its software for compliance. Costs of addressing potential problems have not and are not currently expected to have a material adverse impact on the Company's financial position, results of operations or cash flows in future periods. The Company's compliance plan includes review of Year 2000 readiness of its major manufacturing equipment, products, suppliers, and customers. The Company has no Electronic Data Interchange (EDI) interfaces with either its customers or vendors. To date, the Company has not discovered any significant Year 2000 issues in these areas and does not anticipate any significant problems. Therefore, the Company has not developed specific contingency plans in preparation for the year 2000. As the Company continues to evaluate and test its readiness for the year 2000, the Company will assess whether there are any specific areas where a contingency plan could help alleviate possible adverse effects from the year 2000. If so, the Company will develop contingency plans in those areas prior to the end of 1999. Accordingly, the Company plans to devote the necessary resources to resolve all significant Year 2000 issues in a timely manner. The most likely Year 2000 problems that the Company may face appear to arise from the possible noncompliance of third parties. Possible difficulties could arise in receiving materials from suppliers or from failures in the operation of the Company's customers. The Company has documented and confirmed (in writing) Y2K compliance of the services and products provided to Mosler by our vendors. In addition, in the event that the Year 2000 would cause widespread loss of power or other utilities in areas where the Company, its suppliers or customers operate, the Company's business and operations could be disrupted. Such events could have a material adverse impact on the Company. ITEM 7A ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The principal market risk (i.e., the risk of loss arising from adverse changes in market rates and prices) to which the Company is exposed is interest rates on debt. At June 25, 1999, the carrying value of the Company's debt totaled $189 million. Approximately $74 million was at variable interest rates. For such floating rate debt, interest rate changes generally do not affect the fair market value but do impact earnings and cash flows, assuming other factors are held constant. Holding other variables constant (such as debt levels), the earnings and cash flows impact for the next year resulting from a one percentage point increase in interest rates on variable rate debt would be approximately $.7 million. The Company has limited its risk related to interest rate increases by purchasing an interest rate cap as discussed in Note 6 to the Consolidated Financial Statements. ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following are the directors and executive officers of the Company as of June 25, 1999. Mr. Rapoport was elected President and Chief Executive Officer in March 1995. Mr. Rapoport was formerly Vice President, Pitney Bowes International and Chairman, Pitney Bowes France since 1986. Mr. Bell was appointed Senior Vice President, Chief Financial Officer and Treasurer in October of 1997. Mr. Bell has been CEO and CFO of a number of companies in the restaurant and produce industry prior to joining Mosler and was formerly with Arthur Young & Company. Mr. Fogg joined the Company in September 1998 as Vice President, Installation and Service. From May 1997 through September 1998, Mr. Fogg was Regional General Manager for the Northeast Region for Securitylink from Ameritech, and prior thereto, he was Regional General Manager for the New York metropolitan area for ADT Security Systems, Inc., both providers of electronic security systems. Mr. Rabasca is currently Senior Vice President of Human Resources. Mr. Rabasca has held a variety of positions of increasing responsibility with Mosler since he joined Mosler in June of 1981. Mr. Watson joined Mosler in November 1997 as Senior Vice President of Sales and Marketing. Mr. Watson has held various positions with Sensormatic electronics corporation prior to joining Mosler. Ms. Meyers was elected General Counsel and Secretary of the Company in August 1998. She was Legal Counsel for Citizens Federal Bank, a federal savings bank, from December 1997 through August 1998, and prior thereto, she was Staff Vice President and Assistant General Counsel for American Premier Underwriters, Inc., a property and casualty insurer. Mr. Marquard is Chairman of the Board of Arkansas Best Corporation, primarily engaged, through its motor carrier subsidiaries, in less-than truckload shipments of general commodities, Chairman Emeritus of American Standard Inc., a producer of air conditioning systems, bathroom and kitchen fixtures, and fittings, and braking systems for heavy trucks and buses, and a Director of Kelso, an investment banking firm. He is also a Director of Earthshell Container Corp., Earle M. Jorgensen Company, and Treadco, Inc. Mr. Wall has been associated with Kelso since 1983, most recently as managing director. He is a director of AMF Bowling Inc., Consolidated Vision Group, Inc., Cygnus Publishing, Inc., IXL Enterprises, Inc., Mitchell Supreme Fuel company, Peebles, Inc., TransDigm Inc., 21st Century Newspaper, Inc. Mr. Young has been a member of the Board of Directors of the Company since 1988. Mr. Young has been President since 1973 and Chief Executive Officer since 1988 of Arkansas Best Corporation. He is also Director of Arkansas Best Corporation and First National Bank of Ft. Smith, Arkansas. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION The following table discloses compensation paid by the Company for fiscal years, 1999, 1998, and 1997 to its chief executive officer and other executive officers whose compensation was in excess of $100,000 for fiscal 1999. (1) Amounts listed as salary include premiums paid on health and life insurance polices. (2) Bonuses are paid to management employees based upon a percentage of each employee's salary range midpoint. Such percentage varies with the position of the employee in the Company. (3) The Company also provides certain incidental benefits, but the aggregate amount of such benefits does not exceed 10% of the total annual salary and bonus for the named individual. (4) Joined the Company in October 1997 as Chief Financial Officer. (5) Joined the Company as Senior Vice President, Service and Installation in September 1998. (6) Joined the Company as Senior Vice President, Sales and Marketing, in November 1997. STOCK OPTION PLAN On May 4, 1999, the Board of Directors adopted the Mosler Inc. Stock Incentive Plan ("the Plan"). The purpose of the Plan is to foster and promote the long-term financial success of the Company and its subsidiaries and materially increase stockholder value by (i) motivating superior performance by means of performance-related incentives, (ii) encouraging and providing for the acquisition of an ownership interest in the Company by officers and other key employees, and (iii) enabling the Company and its subsidiaries to attract and retain the services off an outstanding management team upon whose judgment, interest and special effort the successful conduct of its and their operations is largely dependent. The Plan requires that each employee selected for participation enter into a non competition and confidentiality agreement with the Company as a condition of participation. At the date hereof, there are 52 participants in the Plan. The Plan provides for awards to key employees through (i) percentage participation in a performance pool established with respect to a performance period or (ii) the grant of stock options to purchase shares of Common Stock. In the former case, the Company credits to the performance pool the aggregate amount of incentive compensation, if any, accrued with respect to a performance period in respect of actual performance against pre-established EBITDA (as defined in the Plan) objectives. The Board of Directors has established an initial three-year performance period which extends from June 28, 1998 to June 30, 2001, subject to the performance objective that EBITDA must be at least $24 million for each fiscal year of such period, with the performance pool credited annually with an amount equal to 15% of the amount, if any, by which EBITDA for each year in the performance period exceeds $24 million. The stock option portion of the Plan provides for the grant of stock options to key employees of the Company or its subsidiaries to purchase up to 300,000 shares of the Company's Common Stock at not less than 100% of the fair market value on the date of grant of shares covered by the options granted, with no option exercisable on or after the tenth anniversary of the date on which it is granted. Options awarded to a participant under the Plan shall be exercisable at such times and subject to such restrictions and conditions as specified in the applicable option agreement. The Board of Directors granted options on May 4, 1999 to purchase an aggregate of 200,000 shares at a purchase price per share of $2.40 per share, each designated an "incentive stock option" within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended. Prior to the adoption of the Mosler Inc. Stock Incentive Plan on May 4, 1999, the Company's stock option plan provided for the granting of options to purchase up to 160,000 shares of common stock. Options were granted with exercise prices and vesting schedules established by the Stock Option Committee of the Board of Directors, and expire ten years after grant. To date, the Company has granted options, with exercise prices of $10.00 per share, to purchase a total of 60,550 shares of common stock. FISCAL 1999 YEAR-END OPTIONS VALUES The following table provides information on the number of common shares underlying unexercised options held by the executive officers named on the Summary Compensation Table: Options are exercisable at $2.40 per share. The Company common stock has been appraised as of June 25, 1999 at $3.20 per share. BENEFIT PLANS Retirement Plan. The Company maintains a non-contributory defined benefit retirement plan (the "Retirement Plan") for salaried employees, including executive officers. The Retirement Plan provides retirement benefits based on credit years of service and average compensation, comprised solely of the Salary portion of Annual Compensation reported on the Summary Compensation Table, for the highest five consecutive calendar years of the final ten calendar years of employment. Service with American Standard Inc. is included in calculating credit years of service. On August 31, 1994, the Company froze the Retirement Plan. As a consequence, the accrual of the benefits for covered employee's ceased on that date and years of service after that date will not be included in calculating credit years of service. Benefits payable pursuant to the plan are reduced by Social Security Benefits and other benefits payable under the American Standard Inc. plans and the pension equivalent of monthly pension payments, subject to approval by the Administrative Committee of the Board of Directors in certain cases and, in the case of officers, the additional approval of the Board of Directors. As of August 31, 1994, the individuals named in the Summary Compensation Table have the following years of credited service for purposes of this plan: Michel Rapoport - 1 year. Employee Stock Ownership Plan. The ESOP is a noncontributory defined contribution stock bonus plan in which all of the Company's domestic employees not covered by a collective bargaining agreement are eligible. The ESOP primarily invests in the Company's Series C Preferred Stock and common stock. Company contributions are discretionary but will not exceed 15% of aggregate total compensation to participating employees. The Company has made contributions to the ESOP in shares of Series C Preferred Stock and in cash, and prior to the 1990 Transaction made contributions of Class "A" Common Stock. The ESOP received 225,000 shares of Common Stock as part of the 1990 Transaction and received shares of Series D Preferred Stock in connection with the 1990 Transaction. Contributions to the ESOP are allocated to individual accounts in proportion to the participant's compensation and vest over a seven-year period. No contributions were made to the ESOP by the Company on behalf of the named individuals included in the Summary Compensation Table. The Company currently makes cash contributions to the ESOP only to the extent necessary to fund the cash needs of the ESOP for payments to retired, terminated and deceased participants and for administrative expenses. The Company estimates that its cash purchases from ESOP will be approximately $3.7 million in fiscal 2000, in order to fund payments to retired, terminated and deceased employees. In fiscal 1993, the trustee of the ESOP elected to defer participant distributions in substantially equal annual payments over a period of five years in order to minimize cash contributions by the Company to the ESOP. Voting rights for share held by the ESOP are generally exercised by the Administrative Committee of the Board of Directors except with respect to certain major proposals, in which case the participants have the right to exercise voting rights. Savings Plan. The Company maintains a savings plan under Section 401(k) of the Internal Revenue Code of 1986 under which designated groups of non-union employees with one year of service, including all executive officers, may participate. Under the savings plan, a participant may contribute from 2% to 10% of compensation, which is eligible for 50% matching contributions from the Company. A participant may contribute over 6% but any excess will not be matched by the Company. Participants became vested in Company contributions to the extent of 20% after 3 year and thereafter at the rate of 20% per year. No amounts were deferred pursuant to the savings plan by the named individuals included in the Summary Compensation Table. EXECUTIVE SEVERANCE AGREEMENT The Company entered into an employment agreement on February 13, 1996 with Michel Rapoport, President and Chief Executive Officer of the Company as of March 15, 1996. Pursuant to the agreement as amended, if Mr. Rapoport's employment is terminated because of his death, disability, change in control of the Company or is terminated without cause, he will receive one year's salary, the annual bonus he would have been entitled to receive for the fiscal year in which his employment is terminated and the portion of the long term incentive compensation attributable to the period employed by the Company. DIRECTOR COMPENSATION The Company pays an annual retainer plus a per meeting fee to those directors who are not employees of the Company or Kelso. Currently, the Company pays an annual retainer of $15,000 plus $500 per day for each director's meeting attended. The Company also reimburses such persons for travel and incidental expenses incurred in connection with attending directors' meetings. Employees of the Company and Kelso do not receive any additional compensation for serving as director. The Compensation Committee of the Board of Directors (the "Committee") is composed of three independent, outside directors. The members of the Committee for fiscal 1999 were Messrs. Georgitsis, Marquard and Wall. The Committee had the overall responsibility of reviewing and recommending specific compensation levels for executive officers to the full Board of Directors. The Committee also receives and reports to the Board on Company programs for developing senior management personnel. Compensation decisions for fiscal 1999 followed the same pattern as fiscal 1998. The performance incentive compensation, which is paid out in the form of an annual cash bonus, was established by the Committee to provide a direct financial incentive to achieve corporate and operating goals. At the beginning of each fiscal year, the Committee establishes a target bonus for executive officers based on individual performance goals and on Company performance. ITEM 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table presents certain information concerning ownership of equity securities of the Company as of August 6, 1999 by (I) Directors, (ii) Executive Officers named in the Summary Compensation Table, (iii) all Directors and Executive Officers as a group and (iv) all persons known by the Company to beneficially own more than 5% of each class. * LESS THAN 1% (a) Beneficial ownership includes shares of common stock which may be acquired pursuant to currently exercisable options or options which become exercisable within sixty (60) days and includes shares of common stock held in the Employees Savings Plan. (b) Messrs. Schuchert, Nickell, Matelich and Wall may be deemed to share beneficial ownership of shares of Company common stock and Series D Preferred Stock owned of record by Kelso Investment Associates II, L.P., Kelso Mosler Partners, L.P., Kelso Investment Associates IV, L.P. and Kelso Equity Partners II, L.P. by virtue of their status as general partners of such partnerships. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by the Kelso affiliates. The address of Mr. Marquard is Eaglestone Farm, 6600 Walnut Grove Road, Carlisle, Kentucky, 40311. The address of Mr. Young is 1000 South 21st Street, Fort Smith, Arkansas 72901. The address of Mr. Wall and the Kelso entities is 320 Park Avenue, New York, New York 10022. The address of all other persons listed above is 8509 Berk Boulevard, Hamilton, Ohio 45015-2213. ITEM 13 ITEM 13 CERTAIN RELATIONSHIP AND RELATED TRANSACTIONS. From time to time the Company has had transactions with its directors, executive officers and principal shareholders. The Company believes that these transactions have been on terms no less favorable to the Company than could have been obtained from an unaffiliated third party. The Company has adopted a policy that all transactions with affiliates, including directors and shareholders owning more than 5% of the common stock, will be on terms no less favorable to the Company than could be obtained from an unaffiliated third party and must be approved by a majority of the disinterested independent directors. The Company is party to a management agreement with Kelso pursuant to which Kelso has been paid fees of $200,000 in each of the last three fiscal years. This continuing agreement was approved by all directors including the disinterested directors. PART IV ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: Page ---- 1. Financial Statements are included in pages -F23 2. Schedule II - Valuation and Qualifying Accounts 49 All other schedules have been omitted as they are not applicable, not required, or the information required thereby is set forth in the financial statements or the notes thereto. 3. Exhibits Description ----------- *** 3.1 Certificate of Incorporation, as amended of Mosler. * 3.2 By-laws of Mosler. *** 3.3 Certificate of Incorporation, as amended by Security Control Systems, Inc. *** 3.4 By-laws of Security Control Systems, Inc. *** 4 Indenture for 11% Series A Senior Notes due 2003 and 11% Senior Notes due 2003 dated as of July 29, 1993. **** 10.1 Credit Agreement September 1, 1995. *** 10.2 1990 Stock Option Plan. * 10.3 Employee Stock Ownership Plan, dated June 1, 1987. * 10.4 Amendment No. 1 to Employee Stock Ownership Plan, dated December 6, 1988. *** 10.5 Mosler Employee's Savings Plan and Trust, Amended and Restated through July 1, 1992. *** 10.6 Securities Purchase Agreement by and between each of the Common Shareholders of Security Control Systems, Inc., as Sellers and Mosler Inc. as Purchaser with Respect to the Acquisition of Security Control Systems, Inc. *** 10.9 Securities Purchase Agreement by and between El Dorado Ventures, a California Limited Partnership, and Mosler, Inc. as Purchaser with Respect to the Acquisition of Security Control Systems, Inc. dated July 21, 1993. ** 10.10 Agreement of Sale and Purchase, The Security Products Division of American Standard, Inc., including the Mosler Safe Company, a subsidiary of American Standard, Inc. * 10.11 Agreement Plan of Merger and Plan of Reorganization between Kelso Mosler Acquisition, Inc. and Mosler Inc. dated May 1, 1990. ***** 10.12 Asset Purchase Agreement, executed October 9, 1998 and dated as of September 30, 1998 by and among Mosler Inc., De La Rue Systems Americas Corporation and De La Rue Cash Systems Inc. ***** 10.13 Credit Agreement, dated October 9, 1998, among Mosler Inc. and the Lenders named therein. 21 Subsidiaries of the Registrant 27.0 Financial Data Schedule * Incorporated by reference to the exhibits to Securities Act of 1933 Form S-18 Registration No. 33-36426 ** Incorporated by reference to the exhibits to Securities Act of 1933 Form S-1 Registration No. 33-5184 *** Incorporated by reference to the exhibits to Securities Act of 1933 Form S-1 Registration No. 33-67908 **** Incorporated by reference to June 24, 1995 Form 10-K ***** Incorporated by reference to Form 8-K filed on October 22, 1998. (b) Reports on Form 8-K. No reports on Form 8-K were filed in the fourth quarter. SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. 1. THE REGISTRANT DID NOT SEND AN ANNUAL REPORT TO ITS SECURITY HOLDERS FOR FISCAL 1998. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES MOSLER INC. (In Thousands) (1) Represents amounts charged against the allowance net of recoveries. (2) Includes transfer of reserves from LeFebure in the amount of $398. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Mosler Inc. ----------- (Registrant) Date: October 1, 1999 By: /S/ Michel Rapoport - -------------------------------------------------------------------------------- Michel Rapoport President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: October 1, 1999 By: /S/ Michel Rapoport - -------------------------------------------------------------------------------- Michel Rapoport President and Chief Executive Officer (Principal Executive Officer) Date: October 1, 1999 By: /S/ Thomas J. Bell - -------------------------------------------------------------------------------- Thomas J. Bell Senior Vice President, Finance and Chief Financial Officer Date: October 1, 1999 By: /S/ William A. Marquard - -------------------------------------------------------------------------------- William A. Marquard Director Date: October 1, 1999 By: /S/ Thomas R. Wall IV - -------------------------------------------------------------------------------- Thomas R. Wall IV Director Date: October 1, 1999 By: /S/ Robert A. Young III - -------------------------------------------------------------------------------- Robert A. Young III Director MOSLER INC. - -------------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT The Board of Directors Mosler Inc. We have audited the accompanying consolidated balance sheets of Mosler Inc. as of June 25, 1999 and June 27, 1998 and the related consolidated statements of operations, common stockholders' deficiency and cash flows for each of the three years in the period ended June 25, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a) for the years ended June 25, 1999, June 27, 1998 and June 28, 1997. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the consolidated financial position of Mosler Inc. at June 25, 1999 and June 27, 1998 and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 25, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 5 to the consolidated financial statements, effective June 30, 1996, the Company changed its method of accounting for service van inventory. /S/ Deloitte & Touche LLP September 27, 1999 Cincinnati, Ohio MOSLER INC. CONSOLIDATED BALANCE SHEETS JUNE 25, 1999 AND JUNE 27, 1998 (In Thousands of Dollars Except Share Data) - -------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. MOSLER INC. CONSOLIDATED BALANCE SHEETS JUNE 25, 1999 AND JUNE 27, 1998 (In Thousands of Dollars Except Share Data) - -------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. MOSLER INC. CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED JUNE 25, 1999, JUNE 27, 1998 AND JUNE 28, 1997 (In Thousands of Dollars Except Share Data) - -------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements MOSLER INC. CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' DEFICIENCY YEARS ENDED JUNE 25, 1999, JUNE 27, 1998 AND JUNE 28, 1997 (IN THOUSANDS OF DOLLARS EXCEPT SHARE DATA) - -------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. MOSLER INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED JUNE 25, 1999, JUNE 27, 1998 AND JUNE 28, 1997 (IN THOUSANDS OF DOLLARS) - -------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. MOSLER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 25, 1999, JUNE 27, 1998 AND JUNE 28, 1997 - -------------------------------------------------------------------------------- 1. SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND PRINCIPLES OF CONSOLIDATION - The accompanying consolidated financial statements include the accounts of Mosler Inc. and its wholly-owned subsidiaries (the "Company"). All significant inter-company balances and transactions have been eliminated in consolidation. Kelso Investment Associates IV, L.P. ("Kelso") is the majority owner of the Company. The Company paid an affiliate of Kelso an annual management fee of $200,000 for each of the last three fiscal years in exchange for general corporate, financial and administrative advice. BUSINESS DESCRIPTION - The Company is a major provider and servicer of security systems and products. The Company manufactures, markets, installs and services security systems and products used by financial institutions and other commercial and industrial entities through its operations in Hamilton, Ohio, Franklinville, N.Y., Mexico, Missouri, Farmington, Missouri, and Mexico City, Mexico. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS - Assets and liabilities of the Company's foreign subsidiaries are translated at balance sheet date rates of exchange, and the statements of operations are translated at the average rates of exchange for the period. Translation adjustments are reflected as a separate component of common stockholders' deficiency. INVESTMENT SECURITIES - Investments in equity securities with readily determinable fair values, are accounted for at fair value. The Company's investment portfolio is classified as available-for-sale. INVENTORIES - The Company's inventories are stated at the lower cost (determined using the first-in, first-out method) or market. FACILITIES AND DEPRECIATION - Facilities are stated at cost, including interest incurred during construction which is not material during any of the period. Depreciation is provided on the straight-line method over the estimated useful lives of the respective assets as follows: Land improvements 20 years Buildings 20 to 40 years Machinery and equipment 4 to 15 years INTANGIBLES - Cost allocated to service agreements at the date of acquisition is carried at cost and is amortized over the 14 year estimated life of the contracts using the straight-line method. Goodwill is amortized on the straight-line method over periods of 5, 10, 15 and 40 years. The carrying value of service agreements and goodwill are evaluated periodically as events and circumstances indicate a possible inability to recover its carrying amount. Deferred debt issuance costs are amortized over the term of the related debt using the interest method. PRODUCT WARRANTY - The Company provides for estimated product warranty costs at the time of sale. REVENUE RECOGNITION - Except for certain long-term contracts, revenue from the sale of manufactured products, after provision for installation, is recognized when material to be installed for customer orders is shipped from the plants. Revenue on certain long-term contracts is recognized on the percentage-of-completion method. Service revenues are recognized on the straight-line method over the contractual period or as the services are performed. ADVERTISING - Advertising costs, included in selling and administrative expense, are charged to expense as incurred and totaled $1,291,000, $1,150,000 and $971,000 for the years ended June 25, 1999, June 27, 1998 and June 28, 1997, respectively. RESEARCH AND DEVELOPMENT - Research and development costs, included in selling and administrative expenses, are expensed as incurred and amounted to $1,900,000, $1,313,000 and $2,178,000 for the years ended June 25, 1999, June 27, 1998 and June 28, 1997, respectively. NET LOSS PER COMMON SHARE - Net loss per common share is computed by dividing net loss applicable to common stockholders by the weighted average number of common shares outstanding during the period. There is no difference in the calculation of basic and diluted net loss per common share. STOCK-BASED COMPENSATION - SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has elected to continue to account for such transactions under Accounting Principles Board Opinion ("APB") No. 25 "Accounting for Stock Issued to Employees" and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of grant over the exercise price. CASH FLOWS - For purposes of the consolidated statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. REPORTING PERIOD - The Company's fiscal year ends on the last Friday in June. During 1998 and 1997, the Company's fiscal year ended on the last Saturday in June. Fiscal years 1999, 1998 and 1997 each contained 52 weeks. RESTRUCTURING - In August 1998, the Company committed to shut down its leased Wayne, N.J. production facility. In connection with the shut down, the Company recorded a charge of approximately $1,824,000 in fiscal 1999 for certain exit costs related to severance of approximately $1,400,000 and fixed asset write-off of approximately $424,000. Approximately $1,800,000 has been incurred during fiscal 1999 for this shutdown. At June 25, 1999, $30,000 remains to be written-off. In July 1997, the Company shut down its leased Buffalo production facility. In connection with this shut down, the Company recorded a charge of approximately $581,000 in fiscal 1998 for certain exit costs related to severance and fixed asset write-offs. Substantially, all costs had been paid as of June 27, 1998. RECLASSIFICATION - Certain reclassifications have been made to the financial statements for prior years to conform to the current year classification. OTHER - SFAS No. 130, "Reporting Comprehensive Income," was issued in June 1997 and is effective for the Company's 1999 fiscal year. Reclassification of financial statements for earlier periods provided for comparative purposes was required. The statement requires that an enterprise classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings (deficit) and additional paid-in capital in the equity section of the balance sheet. Adoption of this new standard resulted in additional financial statement disclosures. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," was issued in June 1997 and is effective for the Company's 1999 fiscal year. In the initial year of application, comparative information for earlier years is to be restated. The statement requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Adoption of this new standard resulted in additional financial statement disclosures. SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," was issued in February 1998 and is effective for the Company's 1999 fiscal year. Disclosures for earlier periods provided for comparative purposes was required. The statement revises employers' disclosures about pension and other post-retirement benefit plans. Adoption of this new standard resulted in additional financial statement disclosures. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as subsequently amended, is effective for the Company's 2001 fiscal year. The statement revises the accounting for derivative instruments and requires, among other things, that all derivative instruments be recorded within the financial statements. The Company has not yet determined the impact of adopting this standard. 2. ACQUISITION On October 9, 1998, the Company acquired substantially all the assets and assumed substantially all the liabilities of the LeFebure Division of De La Rue Cash Systems Inc. ("LeFebure") for approximately $39 million. LeFebure specializes in the manufacture, distribution and service of security equipment for financial institutions. The acquisition of LeFebure has been accounted for by the purchase method of accounting. The cost of the acquisition has been allocated on the basis of the fair market value of assets acquired and liabilities assumed, resulting in goodwill of approximately $17 million which is being amortized over a period of 15 years. The final allocation of the purchase price of LeFebure will be determined once all valuations and studies have been finalized, which is expected within one year from the date of acquisition. LeFebure's operating results are included in the Company's consolidated statements of operations beginning on October 9, 1998. On August 23, 1999, as part of the Company's acquisition integration plan, management announced the shut down of LeFebure's Mexico, Missouri plant. The cost of this shut down, which will include fixed asset write-offs and severance costs, will be recorded as an adjustment to the purchase price once all studies have been completed and the affected employees have been notified. The unaudited consolidated results of operations for the year ended June 25, 1999 on a pro forma basis as though LeFebure had been acquired as of June 28, 1998 are as follows ($000's except per share amount): Net sales $337,092 Net loss $(24,109) Net loss per share $ (11.54) The pro forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the LeFebure acquisition been consummated as of the above date, nor are they indicative of future operating results. 3. SECURITIES Securities available for sale ($000): The fair value of securities is estimated based on quoted market prices. The Company realized a gain of $1,094,000 upon the sale of a portion of the securities during fiscal 1999. 4. ACCOUNTS RECEIVABLE Accounts receivable consists of the following: The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. At June 25, 1999 and June 27, 1998, accounts receivable from customers in the financial institutions industry were approximately 70% of total receivables. Progress payments are generally required and receivables generally are due within 30 days. Credit losses consistently have been within management's expectations. Unbilled amounts are due upon installation or acceptable completion of the contracts which normally does not extend beyond one year. 5. INVENTORIES The components of inventories are as follows: During the fourth quarter of fiscal 1997, the Company changed its method of accounting for service van inventory from immediately expensing the cost of inventory placed in its service van fleet to that of capitalizing such inventory and recording its usage through cost of sales. The cumulative effect of this change as of June 30, 1996 was to increase inventory and reduce net loss by $7,420,000 (net of reserve of $1,466,000), or $3.43 per share, for the year ended June 28, 1997. 6. LONG-TERM DEBT Long-term debt consists of the following: On October 9, 1998, and as subsequently amended, the Company established a credit facility, comprised of a $90 million revolving line of credit including a $10 million letter of credit sub-facility of the revolving line of credit (of which $3,410,000 was drawn upon at June 25, 1999). Borrowings under the credit facility bear interest at the prime lending rate plus 1.625% (9.375% at June 25, 1999) or the LIBOR rate plus 2.625% (7.80% at June 25, 1999). In conjunction with the credit facility, the Company pays a monthly commitment fee at a rate per annum equal to 0.5% on the average daily unused revolving credit commitment. The credit facility is secured by substantially all the assets of the Company. The Company has entered into an interest rate swap on approximately $35 million in order to manage its interest rate exposure. Under the terms of the swap, the Company pays a fixed rate of 4.99% and receives from the counterparty variable rate LIBOR. The terms permit quarterly settlements and expires on November 30, 2000. The swap is not secured by collateral; however, the Company believes the risk of default by the counterparty is minimal. The Company does not enter into derivative instruments for speculative purposes. On July 29, 1993, the Company completed a refinancing transaction whereby it issued $115 million principal amount of 11% Series A Senior Notes due April 15, 2003 (Notes). A portion of the net proceeds from the Notes were deposited in trust to redeem all of the Company's 13-5/8% Senior Subordinated Debentures ($80 million) plus accrued and unpaid interest. The Notes are senior unsecured obligations of the Company and rank pari passu with all other senior indebtedness of the Company. The terms of debt agreements covering the line of credit and the Notes provide, among other things, restrictions on the redemption of the Company's common and preferred stock, additional indebtedness, lease commitments and capital expenditures and provide that the Company meet certain financial covenants including maintaining a minimum fixed charge coverage ratio, interest expense coverage ratio, minimum turnover ratios, maximum ratio of total consolidated liabilities to consolidated tangible net worth and minimum earnings before interest, taxes, depreciation and amortization. The terms of the debt agreements prohibit the Company from declaring or paying dividends (other than dividends payable solely in shares of capital stock of the Company). The Company may repurchase capital stock distributed from the ESOP to terminated or retired employees in amounts not to exceed $4,500,000 in a twelve-month period, such twelve-month period being calculated from the last day of the month in which such purchase is made. Also, the Company may purchase capital stock from terminated or retired employees in amounts not to exceed $700,000 in any fiscal year. To the extent such purchases are less than $700,000, such difference may be carried over to subsequent years, but any such purchases may not exceed $1,000,000 in any fiscal year and in no event may such purchases be made before May 1, 2000. Additionally, the agreements prohibit the sale of certain assets, merger, or consolidation without the banking group's prior waiver of the related covenant. Capitalized lease obligations include long-term capital leases in the amount of $1,285,000 entered into during fiscal 1997 primarily for new computer software and telephone systems. The lease agreements provide for aggregate annual payments, including interest, payable monthly or quarterly, through June 2002. The Company's obligations under all capital leases carry an average interest rate of 9.0%. Annual contractual maturities of long-term debt and capital lease payments are as follows: AMOUNT (IN THOUSANDS) 2000 $ 414 2001 69 2002 62 2003 188,590 Given the variable nature of the Company's line of credit and considering comparable agency ratings for similar debt issuances, its carrying value is a reasonable estimate of its fair value. Based on market quotations, the fair value of the Company's 11% Series A Senior Notes was $97,750,000 at June 25, 1999 and $101,200,000 at June 27, 1998. The fair value of the Company's interest rate swap was not material at June 25, 1999. 7. PREFERRED STOCK The Company has authorized 2,000,000 shares of $.01 par value preferred stock. Of the 2,000,000 shares, 500,000 have been designated Series C adjustable rate cumulative preferred stock and 210,000 have been designated Series D increasing rate preferred stock as described in Notes 8 and 9. The remaining 1,290,000 shares may be issued with rights and preferences as may be determined by the Board of Directors of the Company. 8. SERIES D INCREASING RATE PREFERRED STOCK Series D increasing rate preferred stock consists of the following: The holders of the shares of Series D preferred stock are entitled to receive cumulative dividends semiannually at the rate of 17.5% per annum, increasing on July 1, 1999 to 19%, and on July 1, 2000 to 20.5%. Any dividend periods for which cash dividends are not paid due to the restrictions in the debt agreements described in Note 6 will accumulate and accrue additional dividends (at 17.50% for the year ended June 25, 1999) until the total is paid in full. For financial reporting purposes, such additional dividends are recorded as interest expense. Unpaid dividends, including the additional dividends, are classified as non-current since restrictions imposed by the debt agreements would prohibit payment within the next twelve months. Except in certain defined situations, the preferred stock is non-voting. Subject to limitations imposed by the debt agreements, the Series D preferred stock is redeemable at the option of the Company, in whole or in part at any time. The redemption price is $100 per share. The preferred stock is subject to mandatory redemption in full at $100 per share subject to any restrictions under debt agreements, on the occurrence of a change of control of the Company resulting in the Company's present largest stockholder owning less than 30% of the common stock of the Company. Holders of the Series D preferred stock, together with holders of the Series C preferred stock, will be entitled to a preference as to dividends and redemptions upon the liquidation of the Company. There are also certain restrictions against the (1) declaration or payment of dividends (other than dividends payable solely in capital stock) on capital stock other than the preferred stock or (2) the purchase, redemption, or retirement of any shares of the capital stock other than the preferred stock, as more fully described in Note 6. The carrying value of the Series D Preferred Stock represents the redemption value less unamortized discount. The discount is being amortized to produce a constant effective dividend cost of 20.5% on the carrying value. In connection with retirements and terminations, the Company from time to time repurchased shares of Series D preferred stock which had been issued to the ESOP. Changes in Series D Preferred Stock are as follows: 9. SERIES C ADJUSTABLE RATE CUMULATIVE PREFERRED STOCK The ESOP holds all outstanding shares of Series C preferred stock. The holders of the Series C preferred stock are entitled to cumulative dividends at an adjustable rate from the date of issue. The dividend rate (15.75% at June 25, 1999) is adjusted quarterly in accordance with a formula based on the prime rate. The dividends are payable annually on June 30 in cash, or at the option of the Company in shares of Series C preferred stock. Additional dividends on unpaid dividends accrue at the dividend rate and are recorded as interest expense. During 1999, the Company issued 69,641 shares of Series C preferred stock in payment of $6,491,000 of dividends and $458,000 of interest on unpaid dividends. During 1998, the Company issued 74,902 shares of Series C preferred stock in payment of $6,915,000 of dividends and $575,000 of interest on unpaid dividends. During 1997 the Company issued 62,210 shares of Series C preferred stock in payment of $5,785,000 of dividends and $436,000 of interest on unpaid dividends. The Series C preferred stock is redeemable at the option of the Company. The redemption price is $100 per share. In addition, participating employees of the ESOP who receive Series C preferred stock upon termination of service from the Company are entitled to have the stock redeemed by the Company. The Series C preferred stock is non-voting. Changes in Series C preferred stock are as follows: 10. REDEEMABLE COMMON STOCK Redeemable common stock represents the redemption value of common stock held by the ESOP or by retired or terminated employees as a result of distributions from the ESOP. The redemption value of common stock is determined annually by an independent appraisal. Changes in redeemable common stock are as follows: 11. INCOME TAXES Deferred income taxes reflect the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Significant components of the Company's deferred tax assets and liabilities are as follows: The components of income (loss) before income taxes and provision for income taxes are as follows: A reconciliation of the provision for income taxes with amounts determined by applying the U.S. statutory federal income tax rate of 35% to loss before income taxes is as follows: At June 25, 1999, the Company had unused U.S. net operating loss carry-forwards of $24,771,000 which expire in the years 2009 through 2013. No provision was made in 1999 for U.S. income taxes on the undistributed earnings of the foreign subsidiaries as it is the Company's intention to utilize the earnings in foreign operations for an indefinite period of time. 12. EMPLOYEE BENEFIT PLANS Defined benefit pension plans covering salaried employees generally provide benefits based on years of service and compensation during an employee's last years of employment. Plans covering hourly employees generally provide benefits of stated amounts for each year of service. All defined benefit pension plans are funded based on annual independent actuarial valuations. The Company adopted SFAS No. 132, "Employees' Disclosures about Pensions and Other Postretirement Benefits" on June 28, 1998. Accordingly, all historical disclosures have been restated to comply with current reporting formats. The following table sets forth the change in benefit obligation, change in plan assets, funded status, Consolidated Balance Sheet presentation, net periodic pension benefit cost and the relevant assumptions for the Company's defined benefit pension plans. The aggregate benefit obligation for plans with benefit obligations in excess of plan assets was $71 in 1999 and $8,257 in 1998. The fair value of plan assets for plans with benefit obligations in excess of plan assets was $69 in 1999 and $8,110 in 1998. Plan assets consist primarily of investments in common trust funds of a bank. Effective August 31, 1994, the Company froze pension benefits under its defined benefit pension plan covering salaried employees. Accordingly, no future accruals will be made for service subsequent to that date. The Company also sponsors several defined contribution plans. Contributions of $409,000 were made during 1999. No Company contributions were made to these plans for the years ending June 27, 1998 and June 28, 1997. On May 13, 1987, the Company's Board of Directors adopted the Mosler Employee Stock Ownership Plan (ESOP) effective July 2, 1986. The ESOP is a noncontributory defined contribution stock bonus plan in which all domestic employees not covered by a collective bargaining agreement of the Company are eligible. The ESOP invests in the Company's Series C and Series D preferred stock and common stock. Contributions are discretionary, but will not exceed 15% of aggregate total compensation to participating employees. Contributions to the ESOP are allocated to participants' accounts in proportion to the participant's compensation and vest over a seven-year period. No contributions were made for the years ending June 25, 1999, June 27, 1998 and June 28, 1997. Upon termination of service from the Company, participating employees of the ESOP are entitled to have capital stock allocated to their ESOP account redeemed by the Company. Under the credit agreement (see Note 6), the Company is permitted, within limitations, to repurchase the capital stock directly from the terminated or retired employees. During fiscal 1993, the trustees of the ESOP elected to make participant distributions in substantially annual equal payments over five years. During fiscal 1998, the Company notified its employees that the Company had terminated its health care and life insurance benefits for retired employees. In connection with this plan termination, the Company recorded a gain of $11,889,000 upon the reversal of its post-retirement benefit obligation. The Company has no obligation to fund these benefits in the future. Prior to 1998, the Company provided certain health care and life insurance benefits for retired employees. Entitlement to these benefits was contingent on years of service with the Company, age at retirement and collective bargaining agreements. Cost sharing provisions were also based on these same conditions. The post-retirement benefit cost for fiscal 1997 was $869,607, of which service cost, interest cost, and net amortization (including deferrals) were $521,706, $657,360 and ($309,459), respectively. During 1999, the Company's Board of Directors approved a deferred compensation plan for certain members of management under which compensation accrues based on the attainment of certain profitability and cash flow targets. During fiscal 1999, the Company accrued approximately $309,000 under the plan. 13. LEASES Minimum future rent payments approximating $11.3 million under commitments for non-cancelable operating leases with initial lease terms greater than one year as of June 25, 1999, principally for sales and service facilities, are payable $3.3 million, $2.5 million, $2.3 million, $1.7 million and $.9 million from fiscal 2000 through fiscal 2004, respectively, and $.6 thereafter. Rent expense was $7.7 million, $6.5 million and $6.9 million for the years ended June 25, 1999, June 27, 1998 and June 28, 1997, respectively. 14. STOCK OPTION PLAN The Company's 1990 Stock Option Plan, as amended, provides for the granting of options to purchase up to 160,000 shares of $.10 par value common stock. Options may be granted at an exercise price of $10 per share. The option generally become exercisable 50% three years after date of grant and 25% annually thereafter. Options generally expire at the end of ten years from the date of grant. During fiscal 1999, the Company's Board of Directors approved a new stock incentive plan (the "1999 Stock Incentive Plan"). The 1999 Stock Incentive Plan provides for the granting of options to purchase up to 300,000 shares of $.10 par value common stock. Options are granted at an exercise price not less than the fair market price of the common stock at the date of grant. The options become exercisable after 3 years. Options under the 1999 Stock Option Plan expire at the end of 10 years from the date of grant. A summary of the stock option transactions for the years ended June 25, 1999, June 27, 1998 and June 28, 1997 follows: At June 25, 1999, 114,200 shares of common stock are reserved for issuance under the 1990 Stock Option Plan and 100,000 are reserved for issuance under the 1999 Stock Incentive Plan. During fiscal 1997, the Company adopted the disclosure-only provisions of SFAS No. 123 and applies APB No. 25 and related Interpretations in accounting for its Stock Option Plan. Accordingly, no compensation cost has been recognized related to the Company's Stock Option Plan. Had compensation cost for the Company's Stock Option Plan been determined based on the fair value at the grant dates for awards consistent with the method of SFAS No. 123, the Company's net loss would have been increased (income decreased) by $88,000 for the year ended June 25, 1999 and $13,000 for the years ended June 27, 1998 and June 28, 1997. Net income (loss) per common share would not have been affected. Compensation expense reflected in these pro-forma disclosures is not indicative of future amounts when the SFAS No. 123 prescribed method will apply to all outstanding non-vested awards. The weighted-average fair value of options granted under the Stock Option Plan during 1999 and 1997 was $1.13 and $5.66, respectively. No options were granted in fiscal 1998. The fair value of each option granted is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average assumptions. Information regarding options outstanding at June 25, 1999 is as follows: 15. SEGMENT INFORMATION, FOREIGN OPERATIONS AND MAJOR CUSTOMERS The Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information", during fiscal 1999. Statement 131 requires companies to report information about the revenues derived from the enterprise's segments, about the geographical divisions in which the enterprise earns revenue and holds assets, and about major customers. The Corporate and Other segment includes international sales, certain financing and employee benefit costs, and other general corporate income and expense items. Corporate and Other assets primarily include investment securities, goodwill and facilities. Operating profit for Corporate and Other for 1998 includes an $11,889,000 gain related to the termination of certain post retirement benefits. Operations outside the United States accounted for approximately, 3% of net sales for the year ended June 25, 1999, 5% of net sales for the year ended June 27, 1998 and approximately 6% of net sales for the year ended June 28, 1997, respectively. Total assets outside the United States were approximately 3% of total assets at June 25, 1999 and June 27, 1998 and approximately 4% of net assets for the year ended June 28, 1997, respectively. Sales to United States government agencies and contractors amounted to approximately 3% of net sales for the year ended June 25, 1999 and 4% of net sales for each of the years ended June 27, 1998 and June 28, 1997. 16. STOCKHOLDER AGREEMENTS The Company has buy-sell agreements with its stockholders that (1) require an employee stockholder to sell to the Company and the Company to purchase from an employee stockholder all outstanding shares held by the stockholder in the event of termination for any reason, (2) restrict the transfer of common stock of the Company and (3) provide the Company and/or its remaining stockholders the right of first refusal in the event a bonafide offer from a third party is received by a stockholder. The provisions of these buy-sell agreements are modified in the event of an initial public offering of the Company's common stock, or on the occurrence of a change of control of the Company resulting in the Company's present largest stockholder owning less than 30% of the common stock of the Company. 17. SUPPLEMENTAL CASH FLOW DISCLOSURES During fiscal years 1999, 1998, and 1997, the Company issued shares of Series C preferred stock in payment of $6,491,000 $6,915,000, and $5,785,000 in dividends which were accrued on the Series C preferred stock, and recorded dividends of $3,342,000, $3,328,000, and $2,887,000 on shares of Series D preferred stock, respectively. 18. CONTINGENCIES The Internal Revenue Service (IRS) has conducted examinations of the Company's federal income tax returns for the fiscal years 1988 through 1993 and has proposed various adjustments to increase taxable income. The Company had agreed to certain issues and had paid all tax due with respect to those issues. Two issues remained unresolved, and the IRS has issued a notice of proposed adjustment on these issues. The issues related to 1) the allocation of the Company's purchase price of assets from American Standard and 2) the value of the Company's Series C preferred stock contributed to its ESOP. On September 8, 1999, the Company settled these issues with IRS and agreed to pay additional tax of approximately $576,000 plus related interest of approximately $575,000. These amounts have been accrued as of June 25, 1999. Various lawsuits and claims arising during the normal course of business are pending against the Company. In the opinion of management, the ultimate liability, if any, resulting from these matters will have no significant effect on the Company's consolidated financial position, results of operations or cash flows. * * * * * *

1025557_1999.txt

1025557_1999

1999

1025557

ITEM 1. BUSINESS. The statements which are not historical facts contained in this Annual Report for Focus Affiliates, Inc. ("FocusWireless.com," "Focus" or the "Company") are forward-looking statements that involve risks and uncertainties, including but not limited to those discussed below under "Risk Factors." Any of these and other risk factors could cause the Company's actual results to vary materially from anticipated results or other expectations expressed in its forward-looking statements. GENERAL The Company has been engaged since its formation in the wholesale distribution of wireless communications products. The Company has begun to transition its business to that of a business-to-business ("B2B") e-commerce provider of wireless communications products and services. The Company has adopted a new e-commerce strategy to exchange goods, services, and information online. The emphasis will be on the elimination of supply chain friction and reducing transaction costs while helping wireless service providers gain access to a broader range of customers and generating new revenue opportunities through emerging channels. The Company anticipates that new distribution channels may represent one of the faster growing segments of wireless subscriptions. Using its proprietary Web application, the Company intends to provide these new and emerging channels of wireless distribution with a turnkey, Internet-based business solution. The Company has built an e-commerce system that should provide meaningfully lower operational costs that may be shared with its customers, while its on-line order entry system is designed to significantly reduce errors associated with order taking. Focus' processes allow network operators to align themselves with name brand marketing companies that utilize Focus to completely manage this channel without conflicting with their current methods of distribution. Through its wholesale distribution activities and its October 1999 acquisition of Cellular Wholesalers, Inc. ("CWI"), the Company has developed a customer base of more than 3,000 wholesalers, network operators, agents, dealers and retailers in principally the domestic marketplace. The Company's objective is to capitalize on wireless communications opportunities in markets in which the Company believes it can achieve significant growth. The Company intends to implement its business structure by (i) strategically aligning with selected manufacturers and wireless service providers to provide value-added services within the supply chain of the wireless telecommunications industry and (ii) transitioning to a service-based Company offering a broad selection of mission-critical services and solutions related to distribution, including "just in time" delivery of wireless handsets and accessories, purchasing, selling, warehousing, picking, packing and shipping and value added services, including inventory management, marketing, kitting and customized packaging, private labeling, light assembly, accounts receivable management, end user support services and warranty servicing. Strategic initiatives include B2B e-fulfillment programs targeting two new fast-emerging wireless telecom distribution channels - mobile virtual network operators ("MVNO's") and e-retailers. Additional initiatives include operating a B2B wireless marketplace for the wireless telecom industry. Such activities would be designed to facilitate e-commerce between trading partners utilizing relationships and industry expertise. As part of its plan, the Company changed its name from Intellicell Corp. to Focus Affiliates, Inc. on September 29, 1999. In addition, the Company acquired Cellular Wholesalers, Inc. ("CWI") effective October 29, 1999 and The Wireless Group, Inc. ("TWG" or "SourceWireless.com") effective December 30, 1999. RECENT DEVELOPMENTS RECENT FINANCIAL PERFORMANCE The Company experienced an increase in net sales but incurred substantial operating losses in 1999. The losses, which have continued during the first quarter of 2000, are attributable to various factors, including an insufficient level of sales while it re-establishes a customer base that purchases wireless phones based on digital technology (as opposed to the former analog technology), the decision by Motorola, in November 1999, to curtail shipments to dealers, agents and retailers of wireless phones and related products, expenses related to the development of a Web site capable of e-commerce and to the legal, accounting, finance and other costs associated with the acquisition of CWI. These losses have had a material adverse effect on the Company's working capital and liquidity, and the Company will need to raise at least $3,000,000 in additional capital by May 2000 in order to continue its operations. The Company is seeking to raise capital in a private placement, but does not yet have commitments for any of this financing and there can be no assurance that it will be able to raise this capital on a timely basis or at all. See "Risk Factors - The Company Has An Immediate Need for Additional Capital" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." CWI PURCHASE PRICE ADJUSTMENT In March 2000, the Company entered into an agreement with the former shareholders of CWI (the "CWI Shareholders") pursuant to which the Company and the CWI Shareholders agreed that the total purchase price to be paid to the CWI Shareholders in connection with the Company's acquisition of CWI in October 1999 would be limited to the 2,250,000 shares of the Company's common stock previously delivered to the CWI Shareholders (the "Base Shares") and the $4,500,000 cash payment previously made to the CWI Shareholders. Accordingly, the $500,000 of potential additional consideration to be paid to the CWI Shareholders by the Company that had been escrowed was returned to the Company from the escrow. The Company and the CWI Shareholders further agreed that, subject to the Company obtaining additional equity capital of at least $3,900,000 on terms reasonably acceptable to the Company by April 22, 2000 (i) certain of the CWI Shareholders will contribute an aggregate of 1,300,000 Base Shares to the Company's capital for cancellation or retention as treasury stock, (ii) the Company will indemnify the CWI Shareholders for any legal expenses they incur should certain types of claims be brought against them by creditors of the Company and (iii) the Company and the CWI Shareholders will enter into limited mutual releases. BANK AGREEMENT As a condition of the Merger, in October 1999, the Company entered into a new revolving line of credit agreement ("Credit Agreement") that, in effect, increased its existing revolving line of credit with Banc of America Commercial Finance ("BancAmerica"). The Credit Agreement expires in October 2001, and provides for borrowings of up to a maximum of $20,000,000 based on a maximum of 85% of eligible receivables and the lesser of $7,500,000 or of up to 60% of eligible inventory, as defined. Borrowings under the agreement accrue interest at the prime rate plus 2.50% per annum. The credit facility is collateralized by substantially all of the assets of the Company. At April 11, 2000, $864,000 was outstanding under this facility. The Company is currently in violation of certain financial and other covenants of the facility and is negotiating with BancAmerica in an effort to secure BancAmerica's agreement to forbear from asserting any of its rights based on these violations. For further information regarding the Credit Agreement, see "Risk Factors - The Company is Not Currently in Compliance with the Covenants of its Senior and Subordinated Debt Obligations." WIRELESS COMMUNICATIONS INDUSTRY The wireless communications industry provides voice and data communications primarily through cellular telephone, personal communications services ("PCS"), personal communications networks, satellite, enhanced specialized mobile radio and paging services. Advances in system technology and equipment, the proliferation of manufacturers and the increased number of network operators have increased consumer acceptance and contributed to dramatic increases in worldwide demand for wireless communications equipment and services. The Company believes that the wireless communications industry should continue to grow due to economic growth, increased service availability and the lower cost of wireless service compared to conventional wired telephone systems. The Company also believes that the change from analog to digital technology should increase overall market growth and encourage consumers to purchase the next generation of wireless communications products. The wireless communications industry has historically provided telecommunications services primarily through analog technology. However, starting in late 1997, wireless carriers began to provide services built around digital technologies, which provide increased network capacity, more functionality, better voice quality and greater security/privacy than analog technologies. By the time digital technologies became commercially available, cellular systems in the United States had already been built to full capacity using analog technologies. Consequently, the first proponents of the new digital technologies in the United States were the PCS network operators, as they had not yet built costly infrastructures. These PCS providers now compete with incumbent cellular network operators in the United States, who have started to shift their subscribers toward digital coverage. As a result, the growth in the industry today is overwhelmingly derived from digital-based services. According to Dataquest, manufacturers of wireless handsets sold a record 162.9 million units worldwide in 1998, up 51% from the prior year, and digital mobile phones accounted for 84.6% of this total. The number of network operators in each market has increased as a result of deregulation within the wireless communications industry and the introduction of new technological applications such as PCS and satellite-based communications systems. Before the auctioning of the PCS spectrum in 1994, there were only two network operators per market. Today, there are as many as seven network operators in some metropolitan markets. In addition to the increased number of network operators, the proliferation of resellers in the market has intensified competition. The resulting price drop has caused network operators to offer enhanced services such as voicemail, text messaging, and caller ID in order to differentiate their services. In addition, the advent of single-rate plans has also served to increase usage. These plans have been extremely successful because they are easy for the consumer to understand and eliminate high roaming and long-distance fees. To increase market reach, network operators are forming strategic channel partnerships with MVNO's, national retailers, and e-retailers. As the variety of handset models expands, including third generation capabilities, the Company expects distribution flows to migrate from the agent/dealer network to these new channel partners. As a result, network operators may switch from in-house distribution to independent value-added distribution services to lower overall costs. In order to maintain their resources for marketing, sales and customer service, network operators are increasingly seeking to outsource their fulfillment and inventory management functions. Since price erosion may continue to threaten the profitability of network operators, it will become more and more necessary to offer better voice and data solutions, and to ensure that their networks and operations are efficiently managed. Quality outsourcing services are essential to the management of their business, and an Internet-based solution can offer unparalleled efficiency. This paradigm has created an opportunity for new channels of distribution, since one of the barriers to entry into reselling wireless services was the cost of handsets. As distribution of handsets migrates from the agent/dealer network, network operators need a solution for recruiting and supporting this new distribution channel. BUSINESS-TO-BUSINESS (B2B) e-COMMERCE AND ON-LINE AUCTION Business-to-business usage of the Internet is growing at an astounding pace as businesses realize the advantages of using e-commence and leveraging the Internet's ability to reach highly targeted audiences. It is estimated that B2B e-commerce will grow from $17.0 billion in 1998 to $327 billion in 2002. Of that amount, Forrester Research forecasts that the value of goods and services purchased through online business auctions will increase from $8.7 billion in 1998 to $52.6 billion in 2002. The B2B economy presents several opportunities for creating new revenue streams and reducing costs for participants. Vertical marketplaces (industry specific) and horizontal marketplaces (multiple industries) provide diverse revenue streams from advertising, auction-driven transactions, procurement for supply chains, fulfillment, and e-commerce transaction fees. The auction format has become increasingly popular as it enhances efficiency while maximizing the return for both buyers and sellers. Auctions help businesses improve operating efficiencies, reduce costs, and spur revenue by selling idle inventory and other assets at market prices. It is anticipated that Internet auction popularity will continue to increase due to the scale, reach, and real-time attributes afforded by the Internet. In addition to auctions, Internet marketplaces are providing single source points of purchase for buyers to locate, price, and purchase inventory requirements from multiple suppliers. Goldman Sachs Investment Research estimates that these marketplaces can reduce overall product costs from between 2% and 39%, depending on the commodity-like nature of the industry segment. The value proposition to distributors and manufacturers is reduced marketing costs, low barrier of entry for e-commerce applications, and access to a larger geographically dispersed customer base. Focus has adopted this new e-commerce paradigm to exchange goods, services, and information online with its trading partners. The emphasis is on channel management, thus eliminating supply chain friction and reducing transaction costs while helping wireless service providers gain access to a broader range of customers and generating new revenue opportunities through emerging channels. The benefits of B2B e-commerce to Focus may include: o Opening the market and integrating partners, suppliers and distribution channels. o Connecting Focus' new, expanded enterprise through a universal electronic medium, which in the wireless communications vertical market will be the SourceWireless.com marketplace. o Permitting the integration and alignment of technology, processes, and human performance with a continuously evolving strategic intent. The Company believes the wireless telecom industry is well positioned to utilize on-line auctions as auctions help to: o Maintain existing distribution channels: Network operators hold obsolete inventory of which they need to dispose. They will have the ability to dispose of this inventory into the marketplace without disrupting current distribution methods or price points. o Improve asset recovery value: Through dynamic pricing in a controlled distribution environment, network operators, manufacturers, distributors, and other suppliers can maximize the value of distressed and obsolete inventory by selling to the highest bidder. o Diversify customers' product offerings: Network operators, manufacturers and resellers can expand within the vertical domain by providing auctions for other equipment such as two-way radios, pagers, infrastructure components and test equipment. STRATEGY Historically a wholesale distributor of wireless products, Focus is transitioning its business to become a developer of B2B e-fulfillment and e-marketplace solutions for the wireless telecommunications industry. Leveraging its industry knowledge, distribution expertise, and customer base, the Company is seeking to market Internet-enabled commerce and e-fulfillment solutions for manufacturers, network operators, distributors, and other service providers throughout the United States. The Company has formed two strategic initiatives to capitalize on the opportunities presented by these emerging Internet trends. The first initiative is the Company's B2B e-fulfillment program which is designed to provide comprehensive, Internet-enabled facilitation programs for network operators, manufacturers, and other service providers. These services include end-to-end transaction management and the facilitation of product procurement, inventory risk management, handset programming, kitting, shipping and returned goods management. The Company is primarily focused on two new fast-emerging wireless telecom distribution channels - MVNO's and e-retailers. These new emerging distribution channels utilize their established customer bases by leveraging their brands with new bundled communication products and services such as long distance, local exchange service, Internet, home security, cable and cellular phone services. These channels may have marketing and supply agreements with Internet-service providers (ISP's), competitive local exchange carriers (CLEC's), e-retailers, utility companies, multi-level marketing groups, and Web portals. Focus intends to generate fee-based revenue by providing facilitation services to these new distribution channels. Some leading network operators are projecting these new channels to generate 10% to 25% of all new wireless subscribers beginning in 2001. The Company's second strategic initiative is to eventually operate one of the leading B2B wireless marketplaces for the wireless telecom industry through the Company's Web site, SourceWireless.com, acquired December 30,1999. Goldman Sachs defines an e-marketplace as "a Web Site where buyers and sellers come together to communicate, share ideas, advertise, bid in auctions, conduct transactions, and coordinate inventory and fulfillment." SourceWireless.com currently conducts online trading between buyers and sellers utilizing an auction and fixed-price catalog format, facilitates basic transactions, and provides an advertising medium for members - network operators, manufacturers, distributors, dealers and service providers - to leverage the broad reach and dynamic pricing benefits of SourceWireless.com to maximize value on excess and obsolete inventory. Distributors and manufacturers can further increase their visibility with a storefront solution to market their primary product lines. These storefronts allow participants to promote company branding, highlight product specials, and allow buyers to browse available product for purchase in the SourceWireless.com catalog. Wireless carriers and other large sellers can establish private marketplaces to make product available only to a targeted group of qualified buyers. This allows network operators to sell their excess and high-demand product to their qualified distribution channel of agents and resellers. Manufacturers can also limit buyers to only qualified distributors by utilizing a private marketplace without compromising current distribution channels. With B2B e-commerce spending forecasted at over $1.5 trillion by 2004 by Forresters Reseach, SourceWireless.com is positioned to be a part of the exploding trend of B2B e-commerce marketplaces in the fast growing wireless telecom sector. SourceWireless.com expects to earn revenue from auction commissions, advertising fees and other e-commerce transaction fees. Both of these strategic initiatives are expected to offer efficient sourcing methods, consultative sales techniques, and unique ordering processes not currently offered by existing competitors. Management feels the Company is positioned to offer a competitive value-added proposition to the wireless telecom industry and the specific customers it wishes to serve. PRODUCTS/SERVICES As a distributor, the Company currently offers a broad selection of wireless products purchased indirectly and directly from leading manufacturers. The Company's product offerings include a variety of hand-held and mobile cellular telephones featuring prominent brand names such as Ericsson, Motorola, Nokia, NEC, Audiovox and Samsung. The Company continually reviews and evaluates wireless products in determining the mix of products purchased for resale to customers and seeks to acquire distribution rights for products which the Company believes have the potential for significant market penetration. For the years ended December 31, 1997, 1998, and 1999, approximately, 92.0%, 92.3%, and 84.7%, respectively, of the Company's net sales were derived from sales of wireless telephones. A significant portion of the Company's sales were of Motorola, Ericsson and Nokia products. Motorola, Ericsson and Nokia handsets are not available to the Company directly from these manufacturers. Since the Company purchases these handsets from third parties, it does not obtain price protection, cooperative advertising and marketing allowances on such products. As part of its new strategic initiative, the Company's B2B e-fulfillment programs are designed to provide comprehensive, Internet-enabled facilitation programs for network operators, manufacturers, and other service providers. These services will include end-to-end transaction management and the facilitation of product procurement, inventory risk management, handset programming, kitting, shipping and returned goods management. In return for such services, the Company will seek to generate fees from the distribution channel or end-user. The Company is primarily focused on two new fast-emerging wireless telecom distribution channels: MVNO's and e-retailers. The Company's B2B marketplace, SourceWireless.com, seeks to provide prospective trading members with multiple ways to promote and sell their products and branding. Such ways include: Virtual StoreFronts are the cornerstone to the marketplace community for SourrceWireless.com. By bringing together large content providers such as manufacturers and distributors in one catalog marketplace, the Company offers buyers a convenient one-stop shop for locating and pricing wireless equipment from multiple suppliers. Much like shopping malls depend on anchor tenants to attract shoppers, these storefronts help drive traffic to the Company's site. The Company's storefront solutions allow manufacturers and distributors to promote their branding and available merchandise to members. The WirelessStore aggregates the available fixed-price merchandise from participating storefronts and lists them by specific category, or catalogs. The main page displays available product catalogs and featured sales items. Buyers can browse and purchase the available inventory by selecting an appropriate category and/or by searching for key words. The WirelessAuction provides an interactive on-line auction for equipment sellers to list equipment for sale to the highest bidder. Using a traditional auction method, bidders bid anonymously on listed items until the expiration of the auction close date established by the seller. If bidding fails to reach the reserve price, sellers do not sell the equipment. The WirelessAds area provides members with a free classified advertising section to post ads for equipment they wish to purchase or sell. This area is designed to increase membership, site visitation and the amount of time users spend on the site. SourceWireless.com also offers private marketplaces for large volume sellers whereby only select qualified buyers may bid on or purchase merchandise. This option is targeted to large national wireless carriers such as AT&T Wireless, PrimeCo, Arch Communications, and others who are concerned about the redistribution of their equipment. By restricting the buying market for these network operators, the Company can control the selling of this merchandise to a carrier's reseller channel, international buyers, or qualified brokers. Distributors can utilize private marketplaces to sell marked down inventory to the highest bidder or to transact directly with their preferred customer base. CUSTOMERS The Company has developed a customer base of more than 3,000 redistributors, network operators, agents, dealers and retailers. The Company believes that these categories of customers will continue to be important purchasers of the Company's products. As it moves forward with its new strategy, the Company intends to be a value-added service provider as it transitions to the B2B e-commerce and on-line auction businesses. Prospectively, it is anticipated that the Company's customer base may include a number of MVNOs, network operators, reseller and e-retailers. For the years ended December 31, 1997, 1998 and 1999, sales of cellular products to the Company's five largest customers accounted for approximately 36.2%, 28.6% and 21.5%, respectively, of the Company's net sales. For the year ended December 31, 1997, sales to Downtown Cellular and Brightpoint accounted for approximately 11.7% and 11.4%, respectively, of the Company's net sales. For the years ended December 31, 1998 and December 31, 1999, no single customer accounted for more than 10% of the Company's net sales. Brightpoint and CellStar are two of the Company's significant customers and suppliers, as well as being the Company's largest competitors. Failure or delay by these or other customers/suppliers in purchasing and/or supplying competitive products on favorable terms, or at all, would materially adversely affect the Company's sales, operating margins and ability to obtain and deliver products on a timely and competitive basis. See "Competition." The Company generally sells its products pursuant to customer purchase orders and ships product orders received by 4:00 P.M. local time the same day. Unless otherwise requested, substantially all of the Company's products are delivered within two days of receipt of customer orders by common carrier. Because orders are filled shortly after receipt, backlog is not material to the Company's business. The Company sells its products to customers in foreign markets, including Israel, Paraguay, Mexico, Peru, Brazil and Canada and to United States-based exporters of wireless products. For the years ended December 31, 1997, 1998 and 1999, sales of the Company's products to customers in foreign markets accounted for 17.6%, 8.0% and 9.1%, respectively, of the Company's net sales. SUPPLIERS The Company has established certain relationships with leading manufacturers and distributors of wireless products. The Company attempts to obtain adequate inventories of popular brand name products on favorable pricing terms. Inventory purchases are based on quality, price, service, customer demand, product availability and brand name recognition. Product manufacturers typically provide warranties, which the Company extends to its customers. The Company's primary suppliers of product have been other wholesale distributors. The supply of product from other wholesale distributors as compared to supplies from manufacturers is inconsistent, of higher cost, on less favorable terms and typically is without price protection and promotional allowances. The Company will continue to seek to establish additional supplier relationships with leading manufacturers of analog and digital cellular products. No assurance can be given that the Company will be able to establish such relationships. The Company has entered into non-exclusive arrangements with Audiovox, Motorola and Nokia pursuant to which the Company distributes wireless telephones and accessories to network operators, retailers and wholesalers. Such arrangements are terminable on short notice. The Company purchases products other than handsets from the above manufacturers and other distributors pursuant to purchase orders placed from time to time in the ordinary course of business. The Company believes that its relationships with its suppliers are satisfactory, although it is seeking to establish additional supplier relationships with selected manufacturers. The Company has recently experienced an inability to meet obligations due vendors and suppliers on a timely basis. As a result, the Company is presently on "credit hold" with many of its suppliers. For further information, see "Risk Factors - The Company Has An Immediate Need for Additional Capital" and "The Company Is Dependent On Its Principal Suppliers." The Company generally places orders to its suppliers on a daily basis. Purchase orders are typically filled within one to seven days and wireless products are shipped to the Company's warehouses by common carrier. For the years ended December 31, 1997, 1998 and 1999, the Company's four largest suppliers accounted for approximately 43.9%, 41.0% and 46.0%, respectively, of product purchases. For the year ended December 31, 1997, Brightpoint, Progressive Concepts, Inc. and Audiovox, accounted for approximately 11.9%, 11.8%, and 11.0%, respectively, of product purchases. For the year ended December 31, 1998, Sony, Audiovox and Brightpoint accounted for approximately 22.4%, 6.9%, and 6.5% respectively, of product purchases. For the year ended December 31, 1999, Audiovox, CellStar and Motorola accounted for approximately 16.8%, 13.4%, and 8.4% respectively, of product purchases. For these periods, none of the Company's other suppliers accounted for more than 10% of product purchases. Brightpoint and CellStar are two of the Company's primary competitors. Failure or delay by these or other suppliers in supplying competitive products on favorable terms, or at all, could materially adversely affect the Company's operating margins and the Company's ability to obtain and deliver products on a timely and competitive basis. See "Competition." SALES, MARKETING AND DISTRIBUTION The Company relies on direct mail catalog and its inside sales force to market its wholesale equipment to the traditional dealer customer base. During the first quarter of 2000, the Company implemented a beta version of a Web-based ordering system, allowing customers to place orders on the Internet from online catalogs. The Company anticipates a transition to online ordering by its customer base during 2000. The Company's e-fulfillment services have been developed by the Company's senior management team who are actively engaged in business development activities with leading network operators to jointly develop channel management opportunities. Leveraging key industry contacts, business process experience, and first-mover advantage, the Company has signed contracts with leading marketing companies engaging in wireless services subscriber marketing. These include Excel Communications, Encore Communications, and Wireless Assets. To promote the SourceWireless.com e-marketplace, the Company incorporates a broad-based strategy to reach the specific target market. The Company actively seeks content providers who wish to sell equipment, as well as industry management and owners who make purchasing decisions. In addition to leveraging relationships, the Company expects to utilize direct mail, telesales, networking, Internet banner ads, email broadcasts to targeted users, and print advertising in the industry's major magazines. The Company believes that product recognition by customers and consumers is an important factor in the marketing of the products sold by the Company. Accordingly, the Company promotes its product lines through advertising in trade publications and attendance at national and regional trade shows. The Company also solicits customers through direct mail, email, and telemarketing activities. The Company's manufacturers and dealers use a variety of methods to promote their products directly to consumers, including print and media advertising, which benefits the Company. ASSET MANAGEMENT ACCOUNTS RECEIVABLE For the years ended December 31, 1997, 1998 and 1999, approximately 93.6%, 86.5% and 90.3%, respectively, of the Company's sales were made on open account. The Company generally offers 30-day open account terms to its customers. As of December 31, 1997, 1998 and 1999, trade accounts receivable averaged 31.5, 28.3 and 39.2 days for sales made on open account, respectively. The Company experienced bad debt expense in 1999 of $351,000 (0.7% of 1999 sales), as compared to $108,000 in 1998 (0.4% of 1998 sales) and as compared to $3,627,000 for 1997 (4.4% of 1997 sales). The Company engages credit rating associations that provide credit rating information in connection with individual customer accounts, attempts to monitor its customers' creditworthiness and seeks to obtain advance payment or letters of credit from its foreign customers. All foreign sales are made in United States dollars. During 1999, due, in part, to nominal foreign sales, all credit insurance in force was not renewed. INVENTORY On average, the Company has historically turned inventory approximately 15.5 times per year. The Company takes physical inventory on a quarterly basis. On an annual basis, cumulative physical inventory adjustments have accounted for less than 1% of total purchases during the years ended December 31, 1997, 1998 and 1999. ACCOUNTS PAYABLE As of December 31, 1997, 1998 and 1999, trade accounts payable averaged 16.1, 16.1 and 51.0 days for purchases made on open account, respectively. At December 31, 1999 accounts payable totaled $12,298,000. The Company has recently experienced an inability to meet obligations due vendors and suppliers on a timely basis. As a result, the Company is presently on "credit hold" with many of its suppliers. For further information, see "Risk Factors - The Company Has An Immediate Need for Additional Capital" and "Risk Factors - The Company Is Dependent On Its Principal Suppliers." MANAGEMENT INFORMATION SYSTEMS The Company believes that inventory control and other information systems are important factors in providing customers with competitive prices and rapid delivery of a variety of products. Accordingly, the Company currently maintains financial, accounting and management controls for its operations through the use of a centralized accounting system and management information system. The Company has experienced and continues to experience reliability concerns with its accounting system as well as limitations with its proprietary order entry and fulfillment system. In order to replace the accounting system with a more reliable solution and expand the Web enabled services offered by the e-fulfillment and e-marketplace initiatives, the Company anticipates expending substantial capital on information technology requirements. Management is currently exploring various information technology solutions ranging in cost from $1,000,000 to $5,000,000 over the next twelve months. See below under "Risk Factors - The Company Plans to Replace its Information Technology Systems and Expand its Operations." COMPETITION The market for wireless communication products is characterized by intense price competition and significant price erosion over the life of a product. The Company's wholesale distribution business competes principally on the basis of price and product availability. The Company competes with numerous well-established wholesale distributors and manufacturers of wireless equipment, including the Company's customers and suppliers, as well as with providers of cellular services, most of which possess substantially greater financial, marketing, personnel and other resources than the Company and have established reputations for success in the distribution, sale and service of cellular products. A number of these competitors have the financial resources necessary to enable them to withstand substantial price competition and implement extensive advertising and promotional campaigns, both generally and in response to efforts by additional competitors to enter into new markets or introduce new products. The Company's e-fulfillment services compete mainly with established internal operations of the Company's target customers as well as other large wireless equipment distributors, including Brightpoint and CellStar. Both of these competitors are dynamic global companies and very diverse in their product and service offerings. Management believes that the ability for any one competitor to dominate a specific distribution channel in any one country may not be practical. Management believes that the Company's agility as a smaller vertical supplier can provide a distinct competitive advantage. The emergence of the B2B e-marketplace is relatively new, and consequently, to management's knowledge, there is no forefront provider of e-commerce marketplace services for the wireless industry. There are, however, a number of established industry specific marketplace sites offering e-commerce and auction solutions in other industries. VerticalNet.com, a publicly traded operator of industry vertical market hubs, operates 56 portals in a variety of industries including communications, environmental, foodservice/hospitality, healthcare, and metals. VerticalNet.com currently has two portals related to the wireless industry, WirelessDesignOnline.com, which is narrowly targeted to the RF engineers of wireless companies, and WirelessNetworksOnline.com, targeted to executives and buyers in wireless network operators. These sites are more advertising and information intensive, and do not offer product features or extensive e-commerce and auction services to their members. The Company also competes with other Web sites offering either auctions or product listing services. The Company has experienced and expects to continue to experience significant price competition in the sale of analog and digital wireless products. The Company believes this price competition is reflective of the lack of direct supplier relationships for high demand digital cellular product and the advent and customer acceptance of digital products. The primary suppliers of product and the primary customers of the Company have been other wholesale distributors. The supply of product from other wholesale distributors as compared to supplies from manufacturers is inconsistent, of higher cost, on less favorable terms and typically is without price protection and promotional allowances. The Company will continue to seek to establish additional supplier relationships with leading manufacturers of analog and digital cellular products. No assurance can be given that the Company will be able to establish such relationships. The Company expects its competitors to offer new and existing products and services at prices necessary to gain and retain market share. Certain of the Company's competitors have substantial financial resources, which enable them to withstand intense price competition or sustain a market downturn better than the Company. Furthermore, no assurance can be given that competitors of the Company (many of which are the Company's suppliers) will not develop enhanced services that the Company will not be able to match based on its industry expertise and financial position. Additionally, it is the Company's belief that the wide acceptance of the digital format has had a negative impact on the demand for analog cellular product. The Company has not secured a strategic relationship allowing it to access digital PCS products directly. Manufacturers currently in the digital PCS market have selected distributors and distribution channels other than the Company. As other manufacturers present their products to the digital market, they may compete directly with the Company, or enter into joint ventures or strategic relationships with the Company's competitors, in which case the Company's ability to access and sell such products could be reduced or eliminated. The Company's results of operations, net sales, profitability and financial condition have been and will continue to be adversely impacted until access to a consistent supply of digital products at commercially competitive rates is maintained at levels to sustain growth and profitability. The wireless distribution industry is characterized by low barriers to entry and the frequent introduction of new products. The industry is evolving, with value-added services becoming of increased importance to the market. This evolution is expected to increase entry barriers, as value added services require increased human resources, management information systems and equipment. The Company's ability to continue to compete successfully will be dependent on its ability to anticipate and respond both strategically and financially to various competitive factors affecting the industry, including new products and services, changes in consumer preferences, demographic trends, international, national, regional and local economic conditions particularly recessionary conditions adversely affecting consumer spending and discount pricing strategies and promotional activities by network operators. The markets for wireless communications products are characterized by rapidly changing technology and evolving industry standards, often resulting in product obsolescence or short product life cycles. Accordingly, the Company's success is dependent upon its ability to anticipate technological changes in the industry and to continually identify, obtain and successfully market new products that satisfy evolving industry and customer requirements. The use of alternative wireless technologies, including digital and satellite communications systems, will reduce demand for existing cellular products, increasing risk associated with the granting of credit and inventory obsolescence. Upon widespread commercial introduction, digital satellite communications systems and other new wireless technologies could materially change the types of products sold by the Company and its suppliers and result in further significant price competition. There can be no assurance that the Company will be able to continue to compete successfully, or will have the financial capability to sustain its business particularly as domestic cellular markets mature and the Company seeks to enter into new markets and market new products and services. The Company's current primary competitors include Brightpoint and CellStar. For the year ended December 31, 1999, the Company secured from the foregoing entities 18.2% of its product purchases. The occurrence of either increased price competition and/or the lack of supply of such products would have an adverse effect on the Company. EMPLOYEES At March 31, 2000, the Company had 69 employees, of which five are in executive positions, 16 are engaged in sales and marketing, 13 are engaged in warehouse operations and 35 engaged in accounting and administrative activities. There are no employees covered by a collective bargaining agreement. The Company believes that its relations with its employees are satisfactory. RISK FACTORS All statements other than statements of historical facts included in this report, including without limitation, statements under the captions "Business," "Risk Factors" and "Management's Discussion and Analysis" regarding the Company's financial position, business strategy and plans and objectives of management of the Company for future operations, constitute forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Cautionary statements describing important factors that could cause actual results to differ materially from the Company's expectations are disclosed hereunder and elsewhere in this report. All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by such cautionary statements. In addition to the other information in this Annual Report on Form 10-K, the following factors should be considered carefully in evaluating the Company's business and prospects: THE COMPANY HAS AN IMMEDIATE NEED FOR ADDITIONAL CAPITAL The Company has an immediate need for additional capital in order to continue its current operations and proceed with its business plan. The Company anticipates that it will need to secure financing in the amount of approximately $3,000,000 by May 2000 in order to prevent an immediate suspension of its current operations. In addition, the Company expects to require significant additional capital in order to develop its information technology capabilities and take the other steps necessary to position the Company as a competitive B2B e-fulfillment and e-marketplace solutions provider. If the Company is unable to raise additional capital, it may be forced to discontinue its current operations or delay the implementation of its business plan, either of which would have a material adverse effect on the Company. As described below under "The Company is Not Currently in Compliance with the Covenants of its Senior and Subordinated Debt Obligations," the Company is currently not able to draw down any further amounts under its $20,000,000 senior debt facility as a result of covenant noncompliance. The Company does not at this time have any other commitment from any third party to provide additional financing, and the Company may be unable to obtain financing on reasonable terms or at all. Furthermore, if the Company raises additional capital through the sale of equity, its shareholders will experience dilution. THE COMPANY IS NOT CURRENTLY IN COMPLIANCE WITH THE COVENANTS OF ITS SENIOR AND SUBORDINATED DEBT OBLIGATIONS The Company is not currently in compliance with the covenants of its $20,000,000 senior debt facility from BancAmerica, under which $864,000 was outstanding as of April 11, 2000. As a result, the Company is currently not able to draw down any further amounts under the facility. In addition, the Company is not currently in compliance with the covenants of its outstanding $1,000,000 subordinated note payable to Critical Capital L.P. ("Critical Capital") or its outstanding $1,200,000 subordinated note payable to American National Bank ("ANB"). The Company has obtained a one-time waiver of its noncompliance from ANB. The Company is seeking a similar waiver from Critical Capital and is negotiating with BancAmerica in an effort to secure BancAmerica's agreement to forbear from asserting any of its rights based on the Company's covenant violations. Critical Capital has indicated its intent to grant the Company a limited waiver with respect to its covenant defaults. However, Critical Capital has indicated that it will impose certain conditions with respect to this waiver and will limit the time for which this waiver is applicable. If either lender refuses to grant a waiver or forbearance, such lender could elect to declare all of the Company's indebtedness owing to such lender immediately due and payable, including accrued and unpaid interest, and, in the case of BancAmerica, could terminate its commitments with respect to funding obligations under the facility. In addition, such lender could proceed against the collateral securing the Company's indebtedness, which includes substantially all of the Company's assets. This would have a material adverse affect on the Company's current operations and future prospects. THE COMPANY IS HIGHLY LEVERAGED At April 11, 2000, the Company had outstanding $864,000 under its senior debt facility, approximately $2,200,000 in subordinated indebtedness and approximately $10,500,000 in trade payables. As a result of its high leverage, the Company is required to devote substantially all of its cash flow to debt service, and therefore is prevented from devoting substantial cash flow to its current operations or the development of the infrastructure necessary to proceed with its business plan. Further, the Company is currently unable to pay trade creditors in a timely fashion, which may damage the Company's relationships with these creditors, and, as a result, further impair the Company's ability to maintain its current operations or proceed with its business plan. THE COMPANY HAS RECENT AND ANTICIPATED CONTINUING LOSSES The Company has incurred operating losses for the years ended December 31, 1997, 1998 and 1999, and it anticipates that it will incur further losses throughout 2000. The Company's initiative to position itself as a competitive B2B e-fulfillment solutions provider will require the Company to make substantial up-front expenditures to develop its information technology capabilities and other infrastructure necessary to successfully compete in the B2B market. The Company expects to incur significant operating and capital expenditures and, as a result, will need to generate significant revenue to achieve and maintain profitability. There can be no assurance that the Company will generate sufficient revenue to achieve profitability. Even if the Company does achieve profitability, there can be no assurance that it can sustain or increase profitability in the future. If revenues grow slower than the Company anticipates, or if operating expenses exceed expectations or cannot be adjusted accordingly, the Company's business, results of operations and financial condition will be materially and adversely affected. THE COMPANY PLANS TO REPLACE ITS INFORMATION TECHNOLOGY SYSTEMS AND EXPAND ITS OPERATIONS The Company plans to achieve and maintain operating profitability by redeveloping its information technology systems and expanding its operations. The success of this plan will be largely dependent on the Company's ability to: o secure additional capital o execute its B2B e-fullfillment plan o maintain operating and gross margins o secure an adequate supply of competitive products o hire and retain skilled technology, marketing and other personnel o successfully manage growth by monitoring operations, controlling costs and maintaining effective management, inventory and credit controls o develop and maintain relationships with leading manufacturers, dealers, agents, network operators and sub-agents of wireless products The Company does not at this time have vendor support for its accounting system. In the unlikely event of a catastrophic failure of the main server for this system, it is possible that the Company would not be able to process accounting transactions on a timely basis. The Company believes that it should be able to eliminate this risk by switching accounting systems. Management estimates that it will need to invest from $1,000,000 to $5,000,000 in information technology infrastructure over the next 12 months to meet current back-office system requirements and expand its Web-centric technology to meet the needs of its planned business initiatives. The Company has limited experience in expansion efforts and there can be no assurance that its planned expansion will be successful. Further, if the Company fails to redevelop its information technology systems in a timely fashion, the Company's competitive position would be materially adversely affected. THE COMPANY RECENTLY ACQUIRED CELLULAR WHOLESALERS, INC. The Company recently acquired CWI, a privately owned wholesale distributor of wireless communications products. In connection with this acquisition: o CWI has generated unanticipated operating losses since the acquisition which have made it necessary for the Company to restructure its operations o the Company may be unable to successfully integrate CWI's operations with the Company's current operations o the conversion into common stock and warrants of the notes the Company issued in its $5,152,400 convertible debt financing has required the Company to issue a substantial number of shares of its common stock and will require the Company to issue a substantial number of additional shares upon exercise of the warrants o affiliates of CWI will continue to have significant transactions with it after the acquisition o due to the excess of the purchase price over the book value of CWI, the Company will amortize significant goodwill for accounting purposes against future reported earnings As described above under "Business - Recent Developments," the Company has entered into an agreement with the former shareholders of CWI (the "CWI Shareholders") pursuant to which the Company and the CWI Shareholders agreed that the total purchase price to be paid to the CWI Shareholders in connection with the Company's acquisition of CWI in October 1999 would be limited to the 2,250,000 shares of the Company's common stock previously delivered to the CWI Shareholders (the "Base Shares") and the $4,500,000 cash payment previously made to the CWI Shareholders. The Company and the CWI Shareholders further agreed that, subject to the Company obtaining additional equity capital of at least $3,900,000 by April 22, 2000 on terms reasonably acceptable to the Company, certain of the CWI Shareholders will contribute an aggregate of 1,300,000 Base Shares to the Company's capital for cancellation or retention as treasury stock. If the Company fails to obtain such additional equity capital within the required time period, it may adversely impact on the Company's ability to secure additional working capital in the future. THE COMPANY RECENTLY ACQUIRED SOURCEWIRELESS.COM The Company recently acquired SourceWireless.com, which operates an auction Web site for wireless communications products inventory. SourceWireless.com's limited operating history makes it difficult to evaluate its current prospects or accurately predict its future revenue or results of operations. Companies in early stages of development, particularly companies in new and rapidly evolving Internet industry segments, are generally more vulnerable to risks, uncertainties, expenses and difficulties than more established companies. The Web site auction business is new and evolving, and it is difficult to predict the size of the market, its future rate of growth, if any, or the level of prices the market will pay for related services. If markets develop more slowly than expected or become saturated with competitors, or the Company's services do not achieve or sustain market acceptance, the Company will be unlikely to be able to successfully operate this business. SourceWireless.com has generated only nominal revenue to date, and the Company expects it to incur operating losses for at least the next twelve months as the Company makes expenditures to develop its business, and there can be no assurance that SourceWireless.com will generate significant revenue in the future. THE COMPANY IS DEPENDENT ON ITS PRINCIPAL SUPPLIERS The Company is dependent on network operators, equipment manufacturers and distributors for all of its supply of cellular telephones and accessories. The Company relies on its suppliers to provide adequate inventories of popular brand name products on a timely basis and on favorable pricing terms. The Company generally does not maintain supply agreements. Instead, the Company purchases products under purchase orders on an on-going basis. The Company's suppliers may not continue to offer competitive products to the Company on favorable terms when the Company needs them. THE COMPANY FACES INTENSE COMPETITION FROM OTHER DISTRIBUTORS OF WIRELESS PRODUCTS The markets for wireless communications products are characterized by intense price competition and significant price erosion over the life of a product. The Company competes with numerous well-established wholesale distributors and manufacturers of wireless equipment, including the Company's customers and suppliers, as well as providers of wireless services. Many of the Company's competitors possess greater financial, marketing, personnel and other resources than the Company. Brightpoint and CellStar, historically two of the Company's principal suppliers, are also two of the Company's primary competitors. Some of the Company's competitors have the financial resources that allow them to withstand substantial price competition and implement extensive advertising and promotional programs. The wireless distribution industry is also characterized by low barriers to entry and frequent introduction of new products. The Company's ability to compete successfully will be largely dependent on its ability to enhance its current vendor relationships and anticipate and respond to various competitive factors affecting the industry, including: o new products o changes in consumer preferences o demographic trends o economic conditions, including recessions that decrease consumer spending o discount pricing and promotional strategies by network operators o consolidating trends in the industry o the challenges posed by new technologies There can be no assurance that the Company will be able to compete effectively, particularly as domestic wireless markets mature and it seeks to enter into new markets and market new products and services. THE COMPANY MAY HAVE LOSSES DUE TO BAD CREDIT The Company makes most of its sales by extending credit to customers, and the Company may be unable to collect payment from some of them. The Company has been required to write off significant accounts receivable balances in the past. The Company's accounts receivable, less an allowance for doubtful accounts of $1,000,000, were approximately $9,659,000 at December 31, 1999. Delays in collection or uncollectibility of accounts receivable could harm the Company's liquidity and working capital position. THE COMPANY MAY BE UNABLE TO ADJUST TO EVOLVING INDUSTRY STANDARDS AND RAPID TECHNOLOGICAL CHANGE The markets for wireless communications products are characterized by rapidly changing technology and evolving industry standards, often resulting in product obsolescence or short product life cycles. Accordingly, the Company's marketing strategy and ultimate success is dependent upon its ability to anticipate technological changes in the industry. Technology will probably play an even greater role going forward, as the Company implements its plan to focus on the B2B and Internet auction businesses. THE COMPANY MAY HAVE EXCESS OR OBSOLETE INVENTORY The Company acquires inventory in advance of product shipments. Because forecasting the desirable level of inventory is difficult, the Company may forecast incorrectly and stock excess inventory of particular products. Furthermore, the value of the Company's inventory may decrease due to price reductions by competitors, obsolescence due to technological change and product quality problems. The Company has in the past incurred significant declines in its inventory value and any future declines could have a material adverse effect on the Company's business. THERE ARE POSSIBLE MEDICAL RISKS ASSOCIATED WITH WIRELESS TELEPHONES Lawsuits have been filed against manufacturers of wireless telephones alleging possible medical risks, including brain cancer, associated with electromagnetic fields emitted by cellular telephones. Scientific research has not been conclusive on the effect of cellular telephones on humans. Future studies confirming health risks associated with cellular telephones could harm the Company's business. Furthermore, the perception of health risks could harm the Company's ability to sell wireless telephone products. As a distributor of wireless telephones, the Company could be subject to lawsuits filed by plaintiffs alleging health risks. The Company does not carry product liability insurance. THE COMPANY'S BUSINESS IS DEPENDENT ON ITS NEW MANAGEMENT TEAM The Company's future success depends to a significant extent on the continued services of its senior management, who have only recently joined the Company. Michael Hedge joined the Company as an executive vice president in February 1999 and became the Company's president and chief executive officer as well as a director in April 1999. John Swinehart, who had served as the Company's chief executive officer and a director since November 1998, became chairman of the board and chief operating officer in April 1999 and vice president of finance in March 2000. Other key officers and employees include Mark Fruehan, the Company's executive vice president of business development since May 1999, and Jim Krohn, the Company's chief financial officer since February 2000. The loss or interruption of the services of one or more of these individuals could have a material adverse effect on the Company's business and prospects. ITEM 2. ITEM 2. PROPERTIES In October 1999, the Company moved its executive offices to Lewisville, Texas. This facility provides 3,317 square feet of office space. The lease is for a five-year term beginning October 1999, and provides for an initial monthly rent of $5,805 with annual escalation based on the Consumer Price Index. At the end of the initial lease term, the Company has an option to extend the lease for a period of five years. In November 1998, CWI entered into an agreement to lease a 60,854 square foot facility located in Lincolnshire, Illinois. The Company assumed this lease in connection with its acquisition of CWI. The term of this lease is for a period of 10 years and two months commencing November 3, 1998 and ending December 31, 2008. The lease provides for the current monthly rent of $32,962.58 through December 31, 2001, with an increase in years four and seven (January 1, 2002 and January 1, 2005). At the end of the initial lease term, the Company may extend the lease for two successive periods of five years each. In September 1999, Focus entered into an agreement with Circle International, Inc. whereby Circle will provide warehousing and services to distribute cellular phones and accessories for Focus. This agreement is in effect until September 2002. Either party has the right to terminate the agreement upon at least ninety days written notice to the other party. Immediate termination can occur if either party becomes insolvent. Focus pays a monthly fee of $2,750.00 for 5,000 square feet of warehouse space. In addition, a fee is charged for each shipment filled, and Focus must pay for shipping supplies and transportation charges. By exceeding certain shipment levels, the Company may earn credits against rent payments. In February 1998, the Company leased a 33,000 square foot office and warehouse facility in Chatsworth, California. This facility provides 23,000 square feet of warehouse and 10,000 square feet of operations and office space. The lease is for a three-year term beginning February 1, 1998, and provides for an initial monthly rent of $18,495, with annual escalation based on the Consumer Price Index. In May 1998, the Company subleased approximately 11,000 square feet of the facility for the same remaining lease term as the underlying lease. On March 17, 2000, the Company substantially closed its operations within the Chatsworth facility. The Company will seek to sublease the property through the term of its lease obligation. The Company leased a 12,800 square foot facility in Miami, Florida. This facility was closed effective March 3, 2000 and the monthly rental obligation of $8,065 through December 2002 will be borne by the Company until a suitable sub-lease can be arranged. The Company believes that its existing facilities are adequate for its current and future requirements and that additional space will be available as needed to accommodate future expansion of its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On September 29, 1999, the Company held its Annual Meeting of Stockholders. At the meeting, the stockholders elected as directors Michael Hedge (with 6,854,453 affirmative votes and 35,400 withheld), Vinay Sharma (with 6,854,453 affirmative votes and 35,400 withheld), J. Sherman Henderson (with 6,854,453 affirmative votes and 35,400 withheld), John Swinehart (with 6,854,453 affirmative votes and 35,400 withheld), and Mark M. Laisure (with 6,854,435 affirmative votes and 35,400 withheld). The stockholders also approved the issuance of common stock to the stockholders of CWI (with 5,295,653 affirmative votes, 13,078 against, 5,935 abstaining and 1,575,187 broker non-votes). The stockholders also approved the change in the name of the Company to Focus Affiliates, Inc. (with 5,269,553 affirmative votes, 27,428 against, 21,035 abstaining and 1,571,837 broker non-votes). The stockholders also approved an amendment to the Company's certificate of incorporation to increase the number of shares of common stock authorized from 15,000,000 to 25,000,000 (with 5,239,773 affirmative votes, 67,108 against, 11,135 abstaining and 1,571,837 broker non-votes). The stockholders also approved an amendment the Company's 1998 Stock Option Plan to increase the number of shares of common stock issuable upon the exercise of options granted under the plan (with 5,178,713 affirmative votes, 122,218 against, 13,735 abstaining and 1,575,187 broker non-votes). The stockholders also ratified the appointment of Hollander, Lumer & Co. LLP as the independent auditors for the Company for the fiscal year ending December 31, 1999 (with 6,865,708 affirmative votes, 13,600 against and 10,545 abstaining). Hollander, Lumer & Co. LLP was subsequently replaced by Arthur Andersen LLP, effective January 3, 2000. See below under "ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure." PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has traded on the Nasdaq SmallCap Market ("Nasdaq") under the symbol "FONE" since the Company's initial public offering on December 18, 1996. The following table sets forth, for the period indicated, the high and low sales prices of the Company's Common Stock as reported by Nasdaq. Such quotations reflect inter-dealer bids, without retail mark-up, mark-down or commissions, and may not reflect actual transactions. On March 31, 2000, the closing price of the Common Stock on Nasdaq was $2.8125. As of March 31, 2000, there were approximately 196 holders of record of the Company's Common Stock. The Company believes that there are in excess of 500 beneficial owners of its Common Stock whose shares are held in "street name." DIVIDEND POLICY During the two most recent fiscal years, the Company has not paid any cash dividends on its Common Stock. The payment of cash dividends, if any, in the future is within the discretion of the Company's Board of Directors and will depend upon the Company's earnings, its capital requirements and financial condition and other relevant factors. The Board of Directors does not intend to declare any cash dividends in the foreseeable future, but instead intends to retain all earnings, if any, for use in the Company's business operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." RECENT SALES OF UNREGISTERED SECURITIES The Company did not make any unregistered sales of securities during the fourth quarter of the year ended December 31, 1999. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data for each of the five years in the period ended December 31, 1999 have been derived from the audited financial statement of the Company. The financial statements for the year ended December 31, 1995 were audited by Richard A. Eisner, LLP. The financial statements for the three years ended December 31, 1998 were audited by Hollander, Lumer & Co. LLP. The financial statements for the year ended December 31, 1999 were audited by Arthur Andersen LLP. The financial data set forth below at December 31, 1999 and 1998, and for each of the years in the three-year period ended December 31, 1999, have been derived from the audited financial statements of the Company and should be read in conjunction with the financial statements and notes there to commencing on page and "Item 8. Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company acquired CWI on October 29, 1999. The accompanying selected financial data reflects the historical operating results of CWI, including the results of operations of CWI since October 29, 1999. This acquisition affects the comparability of the respective prior year data. For information on the pro forma impact of the 1999 acquisition of CWI, see Note 4 to the Company's financial statements commencing at page of this report. STATEMENT OF OPERATIONS DATA: (In Thousands, Except Share and Per Share Data) BALANCE SHEET DATA: (In Thousands) - ----------------- (1) Includes pro forma adjustments for income taxes. (2) Based on pro forma net income and the weighted average number of shares of Common Stock outstanding. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following table sets forth, for the periods indicated, the percentage of net sales represented by certain items reflected in the Company's statement of operations. The statement of operations contained in the Company's financial statements and the following table include pro forma adjustment for income taxes. PERCENTAGES OF NET SALES: YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 Net sales were $46,498,000 in 1999 compared to $27,787,000 in 1998. The increase of $18,711,000 or 67.3% is a function of the inclusion of two months of net sales attributable to CWI and an increase in the volume of products sold. Volume gains were particularly strong during the third and fourth quarters of the year as the Company was able to obtain certain in-demand product from vendors which was not as readily available to the Company in 1998. Gross profit was increased by $871,000 or 53.2% from $1,635,000 or 5.9% of net sales in 1998 to $2,506,000 or 5.4% of net sales in 1999. The gross profit increase was in line with the year over year sales increase. Selling, general and administrative expenses increased by $3,516,000 or 84.4% from $4,167,000 or 15.0% of net sales in 1998 to $7,683,000 or 16.5% of net sales in 1999. The increase in selling, general and administrative expenses and the higher expense rate was attributable to non-capitalizable integration costs associated with the merger of CWI, severance costs to former management, and costs associated with the Company's effort to establish and develop its new B2B strategy. Interest expense increased from $204,000 in 1998 to $406,000 in 1999 as a result of additional borrowing necessary to finance the increased working capital requirement of the merger as well as the interest costs associated with the subordinated debt utilized to finance a portion of the merger. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 Net sales decreased from $81,401,000 in 1997 to $27,787,000 in 1998, a decrease of $53,614,000 or 65.9%. The primary reason for the decrease in sales was the Company's lack of product from suppliers of the newest generation digital products. The sales in 1997 were based on analog product which was more readily available compared to 1998's paradigm where digital product replaced analog's dominance and market share. In 1998, digital product was not readily available on a consistent basis to the Company. Even though the Company was able to obtain product from selected manufacturers and other distributors of digital product on a non-exclusive basis, it was only available in limited quantities. Gross profit decreased by $1,904,000, or 53.8%, from 1997 to 1998 and as a percentage of net sales increased from approximately 4.5% to approximately 5.9%, respectively, during these periods. The decrease in gross profit from 1997 to 1998 is in line with the decrease in sales. The increase in gross profits as percentage of sales is due to a somewhat more favorable mix of products offered by the Company in 1998 versus 1997. Selling, general and administrative expenses decreased by approximately $3,463,000 or 45.4%, from 1997 to 1998, but increased from 9.4% to 15.0%, as a percentage of net sales. The most significant items accounting for this decrease are decrease in personnel of $473,000 and decrease in bad debt expense for doubtful accounts receivable and doubtful notes receivable of $3,519,000. The decrease in payroll and payroll related costs for 1998 as compared to 1997 was primarily the result of having cost cutting measures initiated in 1998 by reducing the size of the Company's workforce to compensate for waning sales and lack of product. In 1997, the Company incurred non-recurring expenses totaling $1,300,000. Of this amount, $1,024,000 was incurred in connection with the audit of the Company's financial statements for the year ended December 31, 1996, consisting primarily of professional fees, including the fees of its prior auditor, fees of special counsel and a special auditor retained by the Company's Audit Committee. In December 1997, the Company terminated acquisition negotiations with Pacific Unplugged Communications, Inc. Such negotiations had been ongoing since a non-binding letter of intent was signed by the parties in August 1997. In connection with the proposed acquisition, the Company incurred and expensed, as non-recurring, $276,000 of professional and legal fees. Interest expense for 1997 and 1998 was $444,000 and $204,000, respectively. Interest expense is primarily attributable to borrowings under the Company's prior line-of-credit with Banc America, which during 1997, averaged $3,016,000 at an average interest rate of 10.25% per annum. At December 31, 1997, there was $3,402,000 of borrowing under this credit line. During 1998, the borrowings averaged $2,376,000 at an average interest rate of 7.1% per annum. For most of 1998, the Company was not in compliance with covenants of the Banc America line-of-credit, and several amendments to the line-of-credit agreement reduced the Company's ability to borrow funds for most of 1998. LIQUIDITY AND CAPITAL RESOURCES YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 Losses incurred in 1999, particularly during the fourth quarter of 1999, and additional working capital requirements associated with the merger of CWI have had a significant negative impact on working capital of the Company. As of December 31, 1999, the Company's working capital position was a deficit of $5,101,000. The Company's continuing losses in the first quarter of 2000 continue to severely restrict the Company's liquidity and have caused the Company to operate on restricted terms with certain vendors. Cash used in operating activities was $2,408,000 in 1999, as compared to cash provided by operating activities of $2,930,00 in 1998. The primary cause for the increase in cash used in operating activities for 1999 compared to 1998 was increased losses and additional working capital needs. In 1998, the Company was able to generate cash flow by reducing inventory and receivable levels by $4,510,000 and $2,467,000, respectively. In 1999, inventory levels (exclusive of acquired CWI balances) increased by $3,130,000, whereas receivables remained relatively flat between years. Excluding the impact of the Company's acquisitions in 1999, cash used in investing activities increased from $278,000 in 1998 to $976,000 in 1999. The cash paid for the CWI and TWG acquisitions was $5,122,000. Cash flows from financing activities increased to $10,639,000 in 1999 from a use of cash in financing activities of $2,290,000 in 1998. The increase was due to the financing of the CWI acquisition and additional borrowings on the revolving credit facility to finance increased working capital requirements as discussed above. During 1999 and the first quarter of 2000, the Company continued to incur significant losses, the continuation of which could have a materially adverse impact on its cash flow and liquidity. The Company is currently not in compliance with the covenants of its debt facility with BancAmerica, which restricts its ability to draw any further amounts under the facility. At April 11, 2000, there was $864,000 outstanding under this facility. In addition, the Company is not currently in compliance with the covenants of its outstanding $1,000,000 subordinated note payable to Critical Capital L.P. ("Critical Capital") or its outstanding $1,200,000 subordinated note payable to American National Bank ("ANB"). The Company has obtained a one-time waiver of its noncompliance from ANB. The Company is seeking a similar waiver from Critical Capital and is negotiating with BancAmerica in an effort to secure BancAmerica's agreement to forbear from asserting any of its rights based on the Company's covenant violations. Critical Capital has indicated its intent to grant the Company a limited waiver with respect to its covenant defaults. However, Critical Capital has indicated that it will impose certain conditions with respect to this waiver and will limit the time for which this waiver is applicable. If either lender refuses to grant a waiver or forbearance, such lender could elect to declare all of the Company's indebtedness owing to such lender immediately due and payable, including accrued and unpaid interest. See above under "Risk Factors - The Company is Not Currently in Compliance with the Covenants of its Senior and Subordinated Debt Obligations." Although the Company continues to have available credit through many of its vendors, there is no assurance that credit available to the Company will be sufficient to maintain the current level of its operations. In addition, the lack of borrowing capability further inhibits the Company's ability to finance new business initiatives including the relationships with network operators and manufacturers that would require additional working capital. As described above under "Risk Factors - The Company Has An Immediate Need for Additional Capital," the Company anticipates that it will need to secure approximately $3,000,000 in financing by May 2000 to prevent an immediate suspension of its current operations. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 At December 31, 1998, the Company had working capital of $2,490,000 compared to working capital of $3,596,000 at December 31, 1997. The decrease in working capital was primarily attributable to decreased accounts receivables from lower sales and lower inventory caused by a short supply of product offset by lower borrowings under the Company's former credit line. Net cash provided by (used in) operating activities was $2,930,000 in 1998, and ($5,374,000) in 1997. The increase in cash provided by operations for 1998 was primarily attributable to the reduced net loss, and decrease in accounts receivable and inventory. Net cash used in investing activities was $278,000 in 1998, versus cash provided by investing activities of $1,505,000 in 1997. The decrease in cash provided by investing activities was primarily attributable to proceeds from the collection of notes receivable in 1997. Net cash provided by (used in) financing activities was ($2,290,000) in 1998 and $3,869,000 in 1997. The decrease was primarily attributable to advances under the Company's line of credit in 1997 while in 1998, the Company repaid and terminated this line of credit with a portion of the proceeds from its private placement of convertible notes. In January 1997, the managing underwriter exercised an over-allotment option (the "Over-allotment Option") to purchase an additional 300,000 shares of common stock, resulting in net proceeds of $1,341,000. In November 1998, the Company consummated a private placement of convertible notes, resulting in net proceeds of $1,288,000 ($1,500,000 net of $212,000 offering costs). YEAR 2000 The Company completed its comprehensive review, testing, validation and implementation of all information technology ("IT") and non-IT systems before the end of 1999. This project included an evaluation of internally developed software, third-party software, technology hardware, third-party interfaces and assessments of third-party Year 2000 ("Y2K") compliance. During 1999, the Company incurred project costs of less than $25,000 relating to its Y2K remediation efforts. The majority of the cost incurred pertained to necessary technological hardware and software which were appropriately capitalized. Based on all system tests performed after January 1, 2000, the Company did not experience any material Y2K problem. The Company believes that all of its IT and non-IT systems are currently operating properly, and the Company does not anticipate any material or significant problem to arise in the future. SEASONALITY Sales of the Company's products are seasonal and are a function of consumer sales, with peak product shipments typically occurring in the third and fourth quarters. INFLATION Inflation has historically not had a material effect on the Company's operations. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company believes that its exposure to market risk related to changes in foreign exchange rates, interest rate fluctuations and trade accounts receivable is immaterial. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements appear in a separate section of this report as pages through following Part IV. The unaudited Quarterly Results of Operations are as follows (in thousands except per share data): ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On May 10, 1998, BDO Seidman, LLP, the accounting firm that audited the Company's financial statements at December 31, 1996 and 1997 and for the years ended December 31, 1996 and 1997, resigned as the Company's independent auditor. The report of BDO Seidman, LLP for the fiscal years ended December 31, 1996 and 1997 did not contain an adverse opinion or a disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles. During the audit period for the fiscal years ended December 31, 1996 and 1997, and during the interim period prior to BDO Seidman LLP's resignation, there were no disagreements on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of BDO Seidman, LLP would have caused it to make a reference to the subject matter of the disagreements in connection with its reports. The Company did not consult with BDO Seidman, LLP in relation to any financial statements or filings subsequent to May 10, 1998, including the Company's quarterly reports on Form 10-Q filed during 1998 and the Offering. BDO Seidman, LLP has disclaimed any association with such filings and Offering. Effective May 10, 1998, the Company engaged Hollander, Lumer & Co. LLP as its independent auditors to audit the Company's annual financial statements for the year ended December 31, 1998. During the Company's two most recent fiscal years, and the subsequent interim period prior to the engagement of Hollander, Lumer & Co. LLP, neither the Company nor any person acting on behalf of the Company consulted Hollander, Lumer & Co. LLP regarding (i) the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company's financial statements or (ii) any matters that were either the subject of a disagreement or a reportable event. On January 3, 2000, the Company engaged the accounting firm of Arthur Andersen LLP as the Company's independent accountants. The Company, on that same date, also informed Hollander, Lumer & Co., LLP of their dismissal effective January 3, 2000. The decision to change independent accountants was made upon the recommendation of the Audit Committee of the Company's Board of Directors. During the two most recent fiscal years ended December 31, 1998 and 1997, and interim periods subsequent to December 31, 1998, there were no disagreements with Hollander, Lumer & Co., LLP on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure. Hollander, Lumer & Co., LLP's report on the Company's financial statements for the past two fiscal years did not contain an adverse opinion or a disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. During the two most recent fiscal years and interim periods subsequent to December 31, 1998, there were no reportable events. The Company has requested that Hollander, Lumer & Co., LLP furnish it with a letter addressed to the SEC stating whether it agrees with the above statements. A copy of the letter, dated February 10, 2000, was filed as an exhibit to the Company's filing with the SEC on Form 8-K/A on February 11, 2000. During the two most recent fiscal years and interim periods subsequent to December 31, 1998 and prior to employing Arthur Andersen LLP, neither the Company nor anyone on its behalf consulted Arthur Andersen LLP regarding the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company's financial statements or any matter that was either the subject of a disagreement or a reportable event. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information regarding the executive officers and directors of the Company as of April 11, 2000: - ---------------------- (1) Member of the Audit Committee (2) Member of the committee administering grants to executive officers under the Company's stock option plans. Michael Hedge has served as President, Chief Executive Officer and as a director of the Company since April 1999. Prior to that, he served as the Company's Executive Vice President between January 1999 and April 1999. From 1987 to January 1999, Mr. Hedge was employed by CellStar Corporation, a leader in telecommunication products distribution ("CellStar"). He served in various roles at CellStar, including Vice President of U.S. Sales and Marketing and as a director. John Swinehart has served as a director of the Company since November 1998 and as Chief Executive Officer between November 1998 and April 1999. Mr. Swinehart assumed the role of Chairman of the Board and Chief Operating Officer in April 1999 and of Vice President of Finance in March 2000. Mr. Swinehart has also been serving as President and Chief Financial Officer of Biltmore Homes, a midwestern homebuilder and developer, since March 1996. From 1986 to March 1996, Mr. Swinehart served as Vice President of Allied Broadcast Equipment, an international broadcast-equipment distribution company. In 1980, Mr. Swinehart received his certified public accountant certificate. Jim Krohn joined the Company as Chief Financial Officer in late February 2000. Mr. Krohn's professional background includes more than 20 years experience in corporate finance, consulting and international banking. Prior to joining FocusWireless.com, Mr. Krohn was managing director of the Global Corporate Finance Group for Arthur Andersen in Dallas. Previously he served as a director of the Financial Advisory Services Group for Coopers & Lybrand; as a vice president in the Corporate Finance Department for Salomon Brothers Inc.; and a banking officer with RepublicBank Dallas N.A. Mr. Krohn is a Certified Public Accountant and earned Master of Business Administration and Bachelor of Business Administration degrees from the University of Texas at Austin. Mark Fruehan has served as Executive Vice President of New Business Development and Strategic Planning of the Company since May 1999. Prior to joining the Company, Mr. Fruehan was CellStar's Vice President of Global Service and U.S. Sales and Marketing from July 1996 to April 1999. From June 1991 to June 1996, Mr. Fruehan was National Sales Manager-America Region of Fujitsu Network Transmission Systems. Cary Maimon has served as Vice President-General Manager since October 1999 and as a director of the Company from October 1999 to January 2000. Prior to joining the Company, Mr. Maimon had served as Vice President-General Manager of CWI since 1996. From 1986 to 1993, he was employed by Cellular One-Chicago/Southwestern Bell Mobile Systems where he served in increasingly senior positions, including Vice President of Sales & Marketing. From 1994 to 1996, Mr. Maimon was the General Sales Manager of Mobile Media Paging, a national provider of paging services. Ronald Goldberg has been a director of the Company since October 1999. Mr. Goldberg was designated by the shareholders of CWI for appointment to the Board following the closing of the Company's acquisition of CWI. Mr. Goldberg was a founder of CWI and served as its president from 1987 until its acquisition by the Company. Prior to 1987, Mr. Goldberg was co-founder of Continental Mobile Telephone Company, a Chicago airtime reseller, and Continental Communications, which owned and operated as many as 23 retail stores. Alan M. Bluestine has been a director of the Company since February 2000. Mr. Bluestine is a Managing Director in the Investment Banking department at Sands Brothers & Co., Ltd., where he has been employed since May 1992. Prior to his employment at Sands Brothers, Mr. Bluestine worked in Arthur Andersen & Co.'s Financial Consulting Services Group, where he specialized in bankruptcy, troubled company consulting and litigation support. Mr. Bluestine holds a Bachelor of Science in Finance from Lehigh University and a Master of Business Administration degree from Columbia University's Graduate School of Business. J. Sherman Henderson has been a director of the Company since February 1998. Since 1993, Mr. Henderson has been President and CEO of UniDial Communications, a long-distance phone service reseller and full service distributor of telecommunications products and service founded by Mr. Henderson. Mark M. Laisure has been a director of the Company since November 1998. Since 1995, Mr. Laisure has been a Vice President of Shields & Company, an investment brokerage firm. In addition, Mr. Laisure has acted as a consultant to (a) Inktomi Corporation, a developer and marketer of network information and infrastructure applications, since June 1996, (b) Milcom, a technology development company which invests in new technology companies, since September 1997, (c) Stat Health Care, a provider of emergency room management services, since June 1991, and (d) Starstruck Records since August 1995. From 1994 to 1995, Mr. Laisure was a senior investment manager at Paine Webber. David Segneri has been a director of the Company since October 1999. Mr. Segneri was designated by the shareholders of CWI for appointment to the Board following the closing of the Company's acquisition of CWI. Mr. Segneri has been the owner and president of TeleCourier Communications, in Bloomington, Illinois since 1981. TeleCourier provides telecommunications services, such as cellular, paging, two-way radio, business telephone systems, and computer networks. Vinay Sharma has been a director of the Company since October 1996. Mr. Sharma has served as chief executive officer of Nu Auction.com since April 1999. Prior to that, Mr. Sharma was executive vice president and then president of Ravel Software Corp. ("Ravel") from 1998 to April 1999. Ravel filed for protection under Chapter 11 of the Federal Bankruptcy Act in August 1999. From 1992 to 1998, Mr. Sharma was a partner with the law firm Sharma & Herron. Mr. Sharma received his Masters in Business Administration in June 1974 and Juris Doctor degree in May 1982 from the University of California at Berkeley. Directors serve until the next annual meeting or until their successors are elected and qualified, or appointed. Officers are elected by and serve at the discretion of the Board of Directors. There are no family relationships among the officers or directors of the Company. ARRANGEMENTS AND UNDERSTANDINGS WITH DIRECTORS The Company agreed in connection with its initial public offering, until December 17, 1999, if so requested by Sands Brothers & Co., Ltd., the representative of the underwriters of the Company's initial public offering and the Company's financial advisor, to nominate and use its best efforts to elect a designee of Sands Brothers as a director or, at Sands Brothers' option, as a non-voting advisor to the Board. Sands Brothers exercised its right to designate Alan M. Bluestine, a managing director of Sands Brothers, as a non-voting advisor to the Company's Board of Directors on June 6, 1997. Sands Brothers subsequently exercised its option to designate a director, and Sands Brothers' designee, Mr. Bluestine, accepted his appointment to the Board in February 2000. In connection with a private placement of notes in November 1998 (the "Note Offering"), the Company agreed to appoint two persons designated by the investors in the Note Offering to the Company's Board of Directors. In November 1998, the Company appointed John Swinehart and Mark M. Laisure (the persons designated by the investors in the Note Offering) to the Board. SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and certain of its officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission"). Officers, directors and greater than 10% stockholders are required by the Commission's regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely upon a review of the copies of the forms furnished to the Company and the representations made by the reporting persons to the Company with respect to any required Form 5 filings, the Company believes that during the year ended December 31, 1999, its directors, officers and 10% stockholders complied with all filing requirements under Section 16(a) of the Exchange Act, with the exception of the following: Ben Neman three late filings reporting 26 transactions, Michael Hedge failed to file both a Form 3 and a Form 5, John Swinehart failed to file a Form 5, Mark Fruehan failed to file both a Form 3 and a Form 5, Cary Maimon failed to file both a Form 3 and a Form 5, Ronald Goldberg failed to file both a Form 3 and a Form 5, J. Sherman Henderson failed to file a Form 5 and David Kane failed to file a Form 5. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION EXECUTIVE COMPENSATION The following table sets forth the compensation for the years ended December 31, 1997, 1998 and 1999 paid by the Company to the two individuals who served as its chief executive officer during the year ended December 31, 1999 and the individuals who served as its Executive vice president of business development and chief financial officer, respectively, during the year ended December 31, 1999 (the "named executive officers"). No other executive officers received compensation exceeding $100,000 during the last fiscal year. - ---------------------- (1) The compensation described in this table does not include medical insurance, retirement benefits and other benefits received by the executive officers which are available generally to all employees of the Company and perquisites and other personal benefits received by these executive officers of the Company, the value of which does not exceed the lesser of $50,000 or 10% of the executive officer's cash compensation in the table. (2) Mr. Hedge joined the Company in January 1999 and became Chief Executive Officer in April 1999. (3) 100,000 of these options were granted on January 29, 1999 with an exercise price of $3.00 per share. 150,000 of these options were granted on November 18, 1999 with an exercise price of $4.125 per share. One-third of each group of these options vests at the end of each 12 months after the date of grant for such group. (4) Mr. Swinehart joined the Company in November 1998 and served in the capacity of Chief Executive Officer through April 1999. (5) The options have an exercise price of $1.00 per share. Of these options, 5/6 were immediately exercisable and 1/6 were to vest upon exercise of the warrants issued upon the conversion of the notes offered in the November 1998 private placement. These warrants were exercised in full in March 1999, making all of these options currently exercisable. (6) These options were granted on November 18, 1999, with an exercise price of $4.125 per share. One-third of these options vests at the end of each 12 months after the date of grant. (7) Mr. Fruehan joined the Company in May 1999. (8) 110,000 of these options were granted on May 1, 1999, with an exercise price of $3.00 per share. Of these 110,000 options, 10,000 vested on the ninety-first day of Mr. Fruehan's employment, which began on May 1, 1999, and the balance vest as to $100,000 of exercisable value (number of shares multiplied by cash exercise price) on each of December 31, 1999, December 31, 2000 and December 31, 2001, with any remaining options vesting on February 8, 2002. 50,000 of these options have an exercise price of $4.125 per share. Of these 50,000 options, one-third vest at the end of each 12 months after the date of grant, which was November 18, 1999. (9) Mr. Kane joined the Company in August 1998 and resigned in February 2000. (10) These options were granted on November 18, 1999, with an exercise price of $4.125 per share. One-third of these options vests at the end of each 12 months after the date of grant for such group. STOCK OPTION GRANTS AND EXERCISES IN 1999 The following table sets forth the grants of stock options to the named executive officers during 1999. - ---------------------- (1) Potential realizable values are computed by multiplying the number of shares of common stock subject to a given option by the closing market price on the date of grant for a share of common stock, assuming that the aggregate stock value derived from that calculation compounds at the annual 5% or 10% rate shown in the table for the entire five or ten-year term of the option and subtracting from that result the aggregate option exercise price. The 5% and 10% assumed annual rates of stock price appreciation are mandated by the rules of the Securities and Exchange Commission and do not represent the Company's estimate or projection of future common stock prices. (2) One-third of these options vests at the end of each 12 months after the date of grant. (3) One-third of these options vests at the end of each 12 months after the date of grant. (4) One-third of these options vests at the end of each 12 months after the date of grant. (5) Of these options, 10,000 vested on the ninety-first day of Mr. Fruehan's employment, which began on May 1, 1999, and the balance vest as to $100,000 of exercisable value (number of shares multiplied by cash exercise price) on each of December 31, 1999, December 31, 2000 and December 31, 2001, with any remaining options vesting on February 8, 2002. (6) One-third of these options vests at the end of each 12 months after the date of grant. (7) One-third of these options vests at the end of each 12 months after the date of grant. The following table sets forth information concerning the value of unexercised stock options held by the named executive officers as of December 31, 1999: - --------------------- (1) Based on the difference between the exercise price and the fair market value (the closing price of $4.875 reported by the Nasdaq SmallCap Market on December 31, 1999). DIRECTOR COMPENSATION Directors do not currently receive any cash compensation for serving on the Board of Directors. Directors are eligible to participate in the Company's stock option plans. During 1999, the Company did not grant options to any director for services rendered in that capacity. EMPLOYMENT AGREEMENTS WITH NAMED EXECUTIVE OFFICERS The Company entered into a three-year employment agreement with Michael Hedge, effective January 1999, for employment as Executive Vice President-General Manager. Under the agreement, Mr. Hedge will receive a salary of $150,000 per year. In addition, he received a $36,000 signing bonus and the Company agreed to loan him up to $500,400 to assist him in the exercise of stock options from his previous employer, with the loan to be repaid upon the earlier of the sale of these shares acquired or February 28, 2000. The Company loaned Mr. Hedge approximately $245,450 under this arrangement, and the entire amount was repaid by Mr. Hedge on December 29, 1999. In April 1999, Mr. Hedge became the President and Chief Executive Officer of the Company, with all of the other provisions of his employment agreement continuing in effect. The Company entered into a three-year employment agreement with Mark Fruehan, effective May 1, 1999, for employment as Executive Vice President of Strategic Planning and Business Development. Under the agreement, Mr. Fruehan will receive a salary of $135,000 per year. In addition, he received a $25,000 signing bonus and the Company agreed to loan him up to $50,000 to assist him in the exercise of stock options from his previous employer, with the loan to be repaid upon the earlier of the first sale of these shares acquired or April 30, 2000. The Company loaned Mr. Fruehan $50,369 under this arrangement, all of which remained outstanding as of April 11, 2000. The Company also agreed, subject to Board approval, to grant to Mr. Fruehan five-year incentive options to purchase 110,000 shares of the Company's common stock, under the Company's 1998 or 1996 Stock Option Plans. The Company agreed that the exercise price of these options would equal the fair market value of the Company's common stock on the date of grant. Of these options, 10,000 vested on the ninety-first day of Mr. Fruehan's employment, which began on May 1, 1999, and the balance vest as to $100,000 of exercisable value (number of shares multiplied by cash exercise price) on each of December 31, 1999, December 31, 2000 and December 31, 2001, with any remaining options vesting on February 8, 2002. The Company granted these options to Mr. Fruehan on May 1, 1999. The Company does not have any employment agreement with John Swinehart and did not have any employment agreement with David Kane. STOCK OPTION PLANS In October 1996, the Company adopted the 1996 Stock Option Plan, as amended (the "1996 Plan"), and in February 1998 the Company adopted the 1998 Stock Option Plan, as amended (the "1998 Plan"), pursuant to which 460,000 and 540,000 shares of common stock, respectively, were authorized for issuance upon the exercise of options designated as either (1) options intended to constitute incentive stock options under the Internal Revenue Code of 1986, as amended or (2) non-qualified options. Under the 1996 Plan and the 1998 Plan, incentive stock options may be granted to employees and officers of the Company. Non-qualified options may be granted to consultants, directors (whether or not they are employees), employees or officers of the Company. In July 1999, the Board approved an amendment to the 1998 Plan, to increase the number of shares of common stock which are authorized to be issued under the 1998 Plan from 540,000 to 1,040,000. The Company's shareholders subsequently approved this amendment in September 1999. REPRICING OF OPTIONS The following table sets forth certain information concerning the repricing of the options of any executive officer during the last ten fiscal years: COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION During the fiscal year ended December 31, 1999, the full Board of Directors decided all matters related to compensation, with the exception of the grant of options to executive officers under the Company's stock option plans. J. Sherman Henderson and Mark M. Laisure are the members of the committee administering these grants under the stock option plans. During 1999, two directors participated in deliberations on executive compensation while they also served as executive officers: Messrs. Swinehart and Hedge. There are no interlocks between the Company and other entities involving the Company's executive officers and directors who served as executive officers or board members of other entities. REPORT OF THE BOARD OF DIRECTORS ON EXECUTIVE COMPENSATION Nothwithstanding anything to the contrary set forth in any of the Company's previous or future filings under the Securities Act of 1933 or the Securities Exchange Act of 1934 that might incorporate this Annual Report on Form 10-K or future filings with the Securities and Exchange Commission, in whole or in part, the following report and the Performance Graph which follows will not be deemed to be incorporated by reference into any such filing. The following Report of the Board of Directors on Executive Compensation describes the compensation policies and rationale applicable to the Company's executive officers with respect to the compensation paid to such executive officers for the year ended December 31, 1999. The full Board of Directors decided all matters related to the compensation of the executive officers of the Company, except for grants of options to executive officers under the Company's stock option plans that were made after formation of a committee to oversee such grants. The current Board of Directors consists of Michael Hedge, John Swinehart, Alan M. Bluestine, Ronald Goldberg, J. Sherman Henderson, Mark M. Laisure, David Segneri and Vinay Sharma. Mr. Segneri became a director in October 1999 and Mr. Bluestine became a director in February 2000. Mr. Hedge serves as President and Chief Executive Officer of the Company. Mr. Swinehart serves as the Chief Operating Officer and Vice President of Finance of the Company. The Company entered into a three-year employment agreement with Michael Hedge, effective January 1999, for employment as Executive Vice President-General Manager for a period of three years. Under the agreement, Mr. Hedge will receive a salary of $150,000 per year. The Company also granted Mr. Hedge five year options to purchase 100,000 shares at an exercise price of $3.00 per share. In addition, he received a $36,000 signing bonus and the Company agreed to loan him up to $500,400 to assist him in the exercise of stock options from his previous employer, with the loan to be repaid upon the earlier of the sale of these shares acquired or February 28, 2000. The Company loaned Mr. Hedge approximately $245,450 under this arrangement, and the entire amount was repaid by Mr. Hedge on December 29, 1999. In April 1999, Mr. Hedge became the President and Chief Executive Officer of the Company, with all of the other provisions of his employment agreement continuing in effect. In November 1999, the Company granted Mr. Hedge five year options to purchase 150,000 shares at an exercise price of $4.125 per share, in consideration of Mr. Hedge's efforts in connection with the CWI acquisition. In 1999, the Company paid Mr. Swinehart (who served as Chief Executive Officer of the Company until April 1999) a salary of $73,684. In addition, the Company granted Mr. Swinehart five year options to purchase 50,000 shares at an exercise price of $4.125 per share, in consideration of Mr. Swinehart's efforts in connection with the CWI acquisition. Subject to existing contractual obligations, the base salaries of the Company's executives are fixed based on job responsibilities and a limited review of compensation practices for comparable positions at corporations which compete with the Company in its business or are of comparable size and scope of operations. The Board's decisions are based primarily on informal judgments reasonably believed to be in the best interests of the Company. Subject to existing contractual obligations, bonuses for the Company's executives are not determined through the use of specific criteria. Rather, the Board bases bonuses on the Company's overall performance, profitability, working capital management and other qualitative and quantitative measurements. In determining the amount of bonuses awarded, the Board considers the Company's net sales and profitability for the applicable period and each executive's contribution to the success of the Company. The Board believes that equity ownership by executive officers provides incentive to build stockholder value and aligns the interests of executive officers with the interests of stockholders. Upon the hiring of executive officers and other key employees, the Board will typically recommend stock option grants to those persons under the Company's stock option plans, subject to applicable vesting periods. Thereafter, the Board will consider awarding grants on a periodic basis. The Board of Directors believes that these additional grants will provide an incentive for executive officers to remain with the Company. Generally, options will be granted at the market price of the common stock on the date of grant and, consequently, will have value only if the price of the common stock increases over the exercise price. In determining the size of the periodic grants, the Board of Directors will consider various factors, including the amount of any prior option grants, the executive's or employee's performance during the current fiscal year and his or her expected contributions during the succeeding fiscal year. Section 162(m) of the Code, enacted in 1993, generally disallows a tax deduction to publicly held companies for compensation exceeding $1,000,000 paid to certain of the corporation's executive officers. However, compensation which qualifies as "performance-based" is excluded from the $1,000,000 limit if, among other requirements, the compensation is payable upon attainment of pre-established, objective performance goals under a plan approved by the stockholders. The compensation paid to the Company's executive officers for the year ended December 31, 1999 fiscal year did not exceed the $1,000,000 limit per officer, nor is it expected that the compensation to be paid to the Company's executive officers for 2000 will exceed that limit. Because it is very unlikely that the cash compensation payable to any of the Company's executive officers in the foreseeable future will approach the $1,000,000 limit, the Board has decided at this time not to take any action to limit or restructure the elements of cash compensation payable to the Company's executive officers. The Board will continue to monitor the compensation levels potentially payable under the Company's cash compensation programs, but intends to retain the flexibility necessary to provide total cash compensation in line with competitive practice, the Company's compensation philosophy and the Company's best interests. The foregoing report on executive compensation is provided by the Board of Directors: Michael Hedge, John Swinehart, Alan M. Bluestine, Ronald Goldberg, J. Sherman Henderson, Mark M. Laisure, David Segneri and Vinay Sharma. PERFORMANCE GRAPH The chart below sets forth a line graph comparing the performance of the Company's common stock against Nasdaq Market Index and the Media General Financial Service's Electronics Wholesale Index ("MG Group Index") for the period from December 18, 1996 (the date on which the market price of the Company's shares was first quoted by the Nasdaq SmallCap Market following the Company's initial public offering) through December 31, 1999. The indices assume that the value of an investment in the Company's common stock and each index was 100 on December 18, 1996 and that dividends, if any, were reinvested. [GRAPHIC OMITTED] ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information regarding the beneficial ownership of the Company's common stock as of March 31, 2000, by (i) each person who is known by the Company to own beneficially more than 5% of the Company's outstanding common stock; (ii) each named executive officer who continued to serve as an officer as of March 31, 2000; (iii) each of the Company's directors; and (iv) all executive officers and directors of the Company as a group. - ---------------------- * Less than one percent. (1) Unless otherwise indicated, the address of each stockholder is c/o the Company at 401 East Corporate Drive, Suite 220, Lewisville, Texas 75057. (2) Includes 217,000 shares of outstanding common stock, which are transferable to Meir Abramov (Vice President of the Company), upon the exercise of stock options granted to Mr. Abramov by Mr. Neman. Includes 8,000 shares issuable upon the exercise of currently exercisable stock options. Mr. Neman's address is 2180 Stradella Road, Los Angeles, California 90077. (3) Includes 200,000 shares issuable upon the exercise of currently exercisable stock options. Mr. Skjodt's address is 25 West 9th Street, Indianapolis, Indiana 96204. (4) Includes 30,333 shares issuable upon the exercise of currently exercisable warrants. Mr. Edwards' address is P.O. Box 219, Marshville, North Carolina 28103. (5) Consists of shares issuable upon the exercise of currently exercisable stock options. (6) Consists of shares issuable upon the exercise of currently exercisable stock options. (7) Consists of shares issuable upon the exercise of currently exercisable stock options. Mr. Bluestine's address is 90 Park Avenue, New York, New York 10016. (8) Pursuant to the terms of a Settlement Agreement dated as of March 8, 2000, among the Company, Intellicell Merger Sub, Inc., Ronald Goldberg, Philip Leavitt, Sherwin Geitner, Cary Maimon and Melvyn Cohen, Mr. Goldberg has agreed that 500,000 of his shares shall be cancelled by the Company if the Company raises $3,900,000 in equity funding by April 22, 2000. Mr. Goldberg's address is 600 Knightsbridge Pkwy., Lincolnshire, IL 60069. (9) Includes 100,000 shares issuable upon the exercise of currently exercisable stock options. Mr. Henderson's address is 9931 Corporate Campus Drive, Louisville, Kentucky 40223. (10) Consists of shares issuable upon the exercise of currently exercisable stock options. (11) Mr. Segneri's address is Tower Center, 520 N. Center, Bloomington, Illinois 61701. (12) Consists of shares issuable upon the exercise of currently exercisable stock options. (13) Pursuant to the terms of a Settlement Agreement dated as of March 8, 2000, among the Company, Intellicell Merger Sub, Inc., Ronald Goldberg, Philip Leavitt, Sherwin Geitner, Cary Maimon and Melvyn Cohen, Mr. Leavitt has agreed that 300,000 of his shares shall be cancelled by the Company if the Company raises $3,900,000 in equity funding by April 22, 2000. Mr. Leavitt's address is 600 Knightsbridge Pkwy., Lincolnshire, Illinois 60069. (14) Pursuant to the terms of a Settlement Agreement dated as of March 8, 2000, among the Company, Intellicell Merger Sub, Inc., Ronald Goldberg, Philip Leavitt, Sherwin Geitner, Cary Maimon and Melvyn Cohen, Mr. Geitner has agreed that 500,000 of his shares shall be cancelled by the Company if the Company raises $3,900,000 in equity funding by April 22, 2000. Mr. Geitner's address is 600 Knightsbridge Pkwy., Lincolnshire, Illinois 60069. (15) Includes 723,333 shares issuable upon the exercise of currently exercisable options and warrants. (16) Based on 10,746,040 shares of common stock outstanding on March 31, 2000. Shares issuable pursuant to currently exercisable stock options or warrants are added to the number of outstanding shares for the purpose of calculating each individual's percentage of ownership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In January 1999, the Company agreed to loan Michael Hedge up to $500,400 to assist him in the exercise of stock options from his previous employer, with the loan to be repaid upon the earlier of the sale of these shares acquired or February 28, 2000. The Company loaned Mr. Hedge approximately $245,450 under this arrangement, and the entire amount was repaid by Mr. Hedge on December 29, 1999. In May 1999, the Company agreed to loan Mark Fruehan up to $50,000 to assist him in the exercise of stock options from his previous employer, with the loan to be repaid upon the earlier of the first sale of these shares acquired or April 30, 2000. The Company loaned Mr. Fruehan $50,369 under this arrangement, all of which remained outstanding as of April 11, 2000. In April 1999, in connection with his termination from employment, the Company agreed to loan Stephen Jarrett, the Company's former Vice President of Business Development, $20,000 to assist him with taxes, and the Company deferred repayment of $10,000 that Mr. Jarrett owed the Company for expense advances. These amounts remained outstanding as of April 11, 2000. Digicell International Inc. ("Digicell"), a company controlled by two of Mr. Neman's cousins, is a customer and a supplier to the Company. For the year ended December 31, 1999, the Company sold to Digicell $1,454,000 and purchased from Digicell $172,000 of cellular products on terms no less favorable to the Company than could be obtained from an unaffiliated third party. As of December 31, 1999, the Company was owed $277,000 by Digicell. On March 17, 2000, the Company entered into a settlement agreement with Digicell pursuant to which, in discharge of the $197,881 net outstanding balance due from Digicell to the Company, Digicell paid the Company a lump sum payment of $60,000 and agreed to make eight additional payments in the amount of $5,000 per week for the following eight weeks. The Company forgave the remaining $97,881 owed by Digicell. On December 31, 1999, the Company was owed $300,000 by Continental Communications ("CMT"), a company owned by major shareholders of the Company, for product and services sold by CWI to CMT prior to the acquisition of CWI by the Company. $200,000 of this balance was paid subsequent to year end. In addition, the Company purchases product from CMT. For the year ended December 31, 1999, the Company purchased $40,000 of product from CMT. On December 31, 1999, the Company was owed $155,000 by Leavitt Communication ("Leavitt"), a company owned by a major shareholder, for product and services sold by CWI to Leavitt prior to the acquisition of CWI by the company. In addition, the Company purchases product from Leavitt. For the year ended December 31, 1999, the Company purchased $633,000 of product from Leavitt. On December 31, 1999, the Company owed $244,000 to Leavitt. In November 1999, the Company entered into a lease with a partnership that includes major shareholders. Rental expense was $66,000 in 1999. The lease calls for a monthly payment of approximately $33,000 through the year 2008. In November 1999, the Company subleased a portion of its Lincolnshire facility to both CMT and Leavitt for a total monthly payment of $11,600. In addition to the rent for the facility, the Company charges CMT and Leavitt a monthly management fee of $30,000, covering shared services for technology support, accounting and administrative activities. The total management fees received by the Company for the period October 31, 1999 through December 31, 1999 was approximately $60,000. The Company entered into a three-year employment agreement with Ben Neman, the Company's then Chairman of the Board, Chief Executive Officer and President, effective December 1996 (the "1996 Agreement"). Mr. Neman's compensation for 1997 was governed by such agreement, which agreement was superseded by a new three-year employment agreement in November 1998 (the "Neman Agreement"). Under the 1996 Agreement, Mr. Neman received an annual salary of $72,000 per year and such bonus as determined by the Board of Directors. In determining the salary and bonus for the Chief Executive Officer, the Board of Directors based its decisions upon the performance of the Company, as well as a review of the performance of the Chief Executive Officer. During 1998, the Company performed substantially below its performance during 1997, and the Board of Directors did not award any bonus to Mr. Neman for 1998. Mr. Neman did not participate in any decisions by the Board of Directors concerning his compensation. Pursuant to the Neman Agreement, Mr. Neman was to serve as the Chairman of the Board and President of the Company, but no longer serve as its Chief Executive Officer. Mr. Neman was to receive an annual salary of $72,000 and bonuses as determined by the Board. The term of the Neman Agreement was to expire in November 2001; provided, however, that the Neman Agreement could be terminated by the Company under certain circumstances. Upon a termination without cause as defined in the Neman Agreement, the Company would make a severance payment to Mr. Neman of $500,000. On April 21, 1999, the Company and Mr. Neman entered into an agreement pursuant to which Mr. Neman resigned as Chairman of the Board and President, and the parties terminated Mr. Neman's existing employment agreement. The Company paid Mr. Neman $250,000 upon signing of the termination agreement and agreed to pay him 24 monthly payments of $14,583.33 each, with the first payment commencing on May 1, 1999. The termination agreement also provides for some limitations on Mr. Neman's public sales of the balance of his shares of the Company's common stock. On October 2, 1999, the Company and Mr. Neman entered into a further agreement under which, in full discharge of its payment obligations under the April 21, 1999 agreement, the Company agreed to pay Mr. Neman 15 monthly payments of $14,585.33 each, with the first payment commencing on November 1, 1999. The Company and Mr. Neman further agreed that the unpaid balance of $109,320 owed to the Company by Cellular Specialists, a company controlled by Ben Neman's brother, would be discharged and the obligation assigned in full to Mr. Neman. Further, the Company and Mr. Neman agreed that Mr. Neman's options to purchase 12,000 shares of the Company's common stock at $5.50 per share had expired, and that Mr. Neman's brother's options to purchase 35,000 shares of the Company's common stock at $5.00 per share would be cancelled. Also on October 2, 1999, the Company and Mr. Neman's brother entered into an agreement reflecting the discharge of Cellular Specialist's unpaid balance and the cancellation of Mr. Neman's brother's options, as described above. In January 2000, the Company received a $416,500 loan from Carroll Edwards, a major shareholder. The loan bore simple interest at a rate of 8.0%. On March 31, 2000, the Company and Mr. Edwards entered into an agreement pursuant to which the entire loan (including all accrued and unpaid interest) was converted into shares of the Company's common stock at a price of $2.50 per share. PART IV ITEM. 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) The Financial Statements are filed as a part of this report as pages through following the signature page. (a)(2) Financial Statement Schedules Schedule II - Valuation and Qualifying accounts page All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (a)(3) Exhibits The following Exhibits are filed herewith pursuant to Rule 601 of Regulation of S-K and paragraph (c) of this Item 14.

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1081665_1999

1999

1081665

Item 1. Business. We are a major provider of broadband network solutions to business customers. We provide our data communications services using digital subscriber line, or DSL, technology and generally market those services directly through our own sales force. DSL technology allows our customers to access their corporate networks and the Internet through high-speed, "always on" connections over traditional copper telephone lines at speeds up to 7 megabits per second, substantially higher than common dial-up modems. We have branded our DSL service CopperNet, which we commercially launched in the northeast and mid- Atlantic regions of the United States in January 1999. We expect to commercially launch CopperNet in the southeastern and western regions of the United States in 2000. In seeking to solve the data communications needs of our business customers, we offer them network services, telecommunications products and equipment made by others and consulting services. Although nearly all of our revenue has historically been derived from our product sales and consulting services, we expect to continue to dedicate most of our financial and management resources to further developing our network services business. Through this business, which includes our CopperNet service offering, we provide MANs and WANs to our customers. We also manage and monitor our customers' networks. Through our product sales business, we sell telecommunications equipment that our customers use to build, maintain and secure their networks. Through our consulting services business, we design our customers' networks, install the related equipment and provide services to help them secure their networks. We currently offer our DSL-based networking solutions in the following nine northeast and mid-Atlantic cities and their surrounding markets: Baltimore, Boston, New York, Norfolk, Philadelphia, Pittsburgh, Richmond, Washington D.C. and Wilmington. On February 8, 2000, in connection with the announcement of a strategic summary operating agreement with SBC Telecom, Inc. and Telefonos de Mexico, S.A. de D.V. and a $150 million preferred stock investment by SBC Communications Inc. and Telmex Communications, LLC, we announced that we would be extending our network deployment into the southeastern and western regions of the United States. We refer to these SBC entities as SBC and these Telmex entities as Telmex. We, along with SBC and Telmex, have initially targeted deployment in the following 20 markets within these regions: Atlanta, Charlotte, Denver, Greensboro, Jacksonville, Louisville, Memphis, Miami, Minneapolis, Nashville, New Orleans, Orlando, Phoenix, Portland, Raleigh- Durham, Salt Lake City, Seattle, Tampa, Tucson and West Palm Beach. We intend to deploy our network in each of these markets in the second half of 2000. Since we began offering our DSL-based service we have made substantial progress in implementing our broadband network service platform. In April 1997, we entered into our first interconnection agreement with Bell Atlantic, which allowed us to use their copper telephone lines and to collocate our equipment in telephone company offices known as "central offices." Central offices serve as the central connection point for all copper telephone lines in a local area and form the basis for our network and a telephone company's network. As of December 31, 1999, we had installed our equipment in 362 central offices within our northeast and mid-Atlantic markets, and we expect to have installed our equipment in approximately 500 central offices by mid-2000, which will essentially complete our current plans for the roll-out of our network in these markets. We estimate that the central offices where we currently have installed our equipment serve approximately 85% of the business users in these areas. Upon the completion of our network deployment, we believe that the central offices where we have installed our equipment will serve approximately 95% of the business users in these areas. As of December 31, 1999, we had installed 2,910 lines in our northeast and mid-Atlantic regions. We expect to have installed our equipment in approximately 400 central offices in our new southeastern and western regions by the end of 2000 and in approximately 500 central offices by mid-2001. We have obtained competitive carrier certification in eight of the 17 southeastern and western states in which we expect to eventually offer services, and have applied for competitive carrier certification in the remaining nine states in which these markets are located. To date, we have signed interconnection agreements with BellSouth, U S WEST and GTE. Together, these three carriers serve as the traditional telephone companies in substantially all of our 20 target markets in the southeastern and western regions. We have designed our network to support our customers' changing data networking needs. Our network supports newer, evolving technologies designed to transmit both data and voice. Unlike traditional telecommunications networks, these newer technologies transmit data in small bundles, or packets, of information from multiple users over the same lines, and are referred to as packet-based technologies. These packet-based technologies generally allow for a more efficient use of a network. Our CopperNet service is compatible with Internet protocol, or IP, and packet-based communications systems such as asynchronous transfer mode, or ATM, and frame relay. This same architecture also supports the traditional technologies that carry most of today's voice telephone conversations. This network design allows us to offer businesses and their telecommuters cost-effective solutions for accessing the Internet, as well as other emerging applications and services of corporate networks, such as video and audio conferencing, application and Web hosting, multimedia and e- commerce. We create city-wide MANs and connect them to our private, leased, high-speed fiber optic network, or backbone. This network design enables us to provide our customers seamless connections to remote offices or employees in other locations, including other cities. Our network provides dedicated connections to our customers, enabling them to operate as if they were using their own private network. These virtual private networks, or VPNs, have capacity, speed, reliability and level of service designed to meet our customers' needs. Industry Overview We believe that a substantial business opportunity exists because of the concurrence of several factors. Growing Demand for High-Speed Data Communications and Networking Solutions. Many businesses and other organizations are finding it extremely expensive and time-consuming to manage the complex elements of their networks. Businesses are implementing internal networks using Internet technology, or intranets, and remote local area networks, or LANs, to enable employees to work from remote locations and from home, and to create private networks that connect corporate networks in multiple locations. Gartner Group estimates that the U.S. market for packet-based, VPN and Internet data services will grow from $3.4 billion in 1997 to $14.5 billion in 2003, a compounded annual growth rate of 34%. Business demand for Internet access, e-mail, video and audio services, web and application hosting and e-commerce is also increasing. This demand in turn drives the need for high-speed, high-capacity communications to support these applications. As businesses grow to take advantage of the extended power presented by their networks and the Internet, they will need extensive network management and security solutions designed to protect their internal data. International Data Corporation, or IDC, estimates that the U.S. market for network operations outsourcing services will more than double from $4.0 billion in 1997 to $9.1 billion in 2002, a compounded annual growth rate of 18%. High-speed data communications have become important to businesses in part due to the dramatic increase in Internet usage. According to IDC, the number of Internet users worldwide reached approximately 69 million in 1997 and is forecasted to grow to approximately 320 million by 2002. IDC also estimates that the value of goods and services sold worldwide through the Internet will increase from $12 billion in 1997 to over $400 billion in 2002. To remain competitive, businesses increasingly need high-speed connections to maintain complex Web sites, access critical business information and communicate more efficiently with employees, customers and business partners. Data communications is the fastest growing segment of the telecommunications industry. Gartner Group forecasts data traffic to grow over five times faster than voice traffic through 2002. Furthermore, Gartner Group projects an increase in the number of DSL lines in use from 3,000 in 1997, providing over $1.8 million in revenue, to over 7.1 million lines providing over $18 billion in revenue, in 2003, representing a 373% compounded annual growth rate in the number of lines and a 531% compounded annual growth rate in revenue. Increasing Network Congestion. The growing use of bandwidth-intensive applications is creating a number of challenges for the existing copper lines of the public telephone network, and for public data networks and private networks. These challenges affect the structure of the existing network and limit the ability of businesses to take full advantage of the benefits of new information technologies. Networks are becoming increasingly congested due to the rapid growth in data traffic and the imbalance in capacity between LANs and WANs. High-speed local access technologies such as DSL will be deployed to help solve the local access, or "last mile," bottleneck. The "last mile" is that part of the network that runs from an end-user's location to the first central office or nearest alternative service entry point into our network. Since the break-up of AT&T, substantially all data services have been configured with a local carrier, typically a regional Bell operating company like Bell Atlantic, providing the last mile local access, and a long distance carrier like AT&T, MCI WorldCom or Sprint providing the long distance portion. Although competition in the long distance market has evolved, stimulating technological development and causing price reductions, the local access markets have not similarly developed. As a result, the traditional local access market remains technologically behind the long distance market, with last mile access to major public networks like the Internet and data networks remaining either very slow or very expensive. In addition, expertise and networking solutions still will be needed to remedy bottlenecks, other than the last-mile bottlenecks that subsist throughout existing networks. Commercial Availability of Low-Cost DSL Technology. The full potential of Internet and remote LAN applications cannot be realized without removing the performance bottlenecks of the local telephone networks. DSL technology is designed to remove this performance bottleneck by increasing the data carrying capacity of copper telephone lines from the 56 kilobits per second speeds available with common dial-up modems and 128 kilobits per second speeds available on integrated services digital network, or ISDN, lines to DSL speeds of up to 7 megabits per second. Because DSL technology reuses existing copper telephone lines, DSL requires a lower initial fixed investment than that needed for existing alternative technologies, such as cable modems, fiber, wireless and satellite communications systems. As a result, after the build-out of a central office, subsequent investments in DSL technology for customers within the area served by that central office are directly related to the number of paying customers. Needs of Small- and Medium-Sized Businesses. A significant number of small- and medium-sized businesses have no practical alternative to low performance dial-up or ISDN lines and lack the financial resources to afford traditional high-cost alternatives, such as T-1 or T-3 lines. As a result, their employees suffer productivity limitations associated with slow transmission speeds. In addition, there is an increasing need by these businesses for integrated, value-added applications and services, such as web and application hosting or computer system back-up, that require an increasing amount of bandwidth capacity. Needs of Large Businesses to Improve Remote Worker Productivity. Many large companies are supporting increasing numbers of remote offices and workers as a means of dealing with transportation infrastructure constraints, skilled worker unavailability and other workplace issues. These companies face the challenge of finding a cost-effective way to make their remote workers as productive as those who have access to all of the high performance communications and networking resources available to workers located at corporate headquarters. A high-speed network solution that encompasses access to the corporate LAN, the corporate telephone system, the Internet, the corporate video conferencing system, customers, suppliers, and partners permits a substantial increase in remote office and worker productivity. Significant and Growing Demand for Network-Enabled Broadband Applications and Services. As applications become more advanced and necessary to conduct day-to- day business, we expect that the demand for broadband capacity will rise accordingly. Many companies lack the resources to develop, implement, manage and continually enhance their business' hosting and information technology applications needs. As a result, not only should the demand for bandwidth capacity rise, but there should be strong demand for outsourcing many of these applications so that companies are able to focus on their core competencies. Impact of the Telecommunications Act of 1996. The Telecommunications Act of 1996 (including its related regulations), which we refer to as the 1996 Telecom Act, allows competitive telecommunications companies like us to take advantage of traditional telephone companies' existing copper telephone line networks rather than constructing a competing infrastructure at significant cost. The 1996 Telecom Act requires traditional telephone companies: . to allow competitive telecommunications companies to lease copper lines on a line by line basis; . to permit competitive telecommunications companies to collocate their equipment, including DSL equipment, in traditional telephone companies' central offices, which enables competitive telecommunications companies to access end-users through existing telephone line connections; . to provide competitive telecommunications companies with the operations support services necessary for competitive telecommunications companies to compete; and . to permit competitive telecommunications companies to share access to and provide service over traditional telephone companies' existing copper telephone lines. The 1996 Telecom Act creates an incentive for some traditional telephone companies, including Bell Atlantic, to cooperate with competitive telecommunications companies because the incumbent carriers cannot provide long-distance service in the regions where they provide local exchange service until the FCC determines that the traditional telephone company has satisfied specific statutory criteria for opening its local markets to competition. Our Solution We provide a full range of broadband network solutions to allow businesses to outsource their Internet access, data transport, and other telecommunications or data communications needs effectively. We market our services both directly to businesses through our sales force and indirectly through other service providers. Our network services include: . High-speed, Last Mile Connectivity. CopperNet is designed to solve the last mile challenge using DSL technology to convert standard copper telephone lines into high-speed data connections. Our network is capable of delivering data at speeds ranging incrementally from 128 kilobits per second to 2 megabits per second symmetrically, where data travels at the same speed to and from the customer, and up to 7 megabits per second asymmetrically, where data travels faster to the customer than from the customer. The highest CopperNet speeds allow our customers to transfer data at rates faster than standard high-speed data connections, like T-1 lines and frame relay circuits. We provide packet-based connections like other DSL providers, but because many of today's existing networks use channelized technology, we also provide channelized connections, which we believe no other major DSL provider currently offers. Thus, CopperNet addresses both older channelized network requirements, like traditional voice telephone networks, and the packet-based communications better suited for newer, more efficient technologies such as ATM and frame relay, both of which transmit data at high-speed and can accommodate multiple types of media, including voice, video and data. In addition to ATM and frame relay, CopperNet can also accommodate other technologies based on IP, which is the set of standards that enables Internet communications. . Adaptable Network Design. The design of our network supports today's bandwidth-intensive business requirements, such as corporate networks, VPNs, office-to-office connectivity, telecommuting solutions, collaborative computing of users in different areas, Internet/intranet access, traditional voice, video conferencing, multimedia, e-mail, video and audio transmission, web and application hosting and e-commerce. We have designed our network so that we can individually configure a customer's features and speeds from our network operations center, eliminating the need for customers to upgrade their hardware or for us to visit their premises in order to enhance or upgrade services. . Metropolitan Area Network Solutions. We recognize that businesses with city-wide locations, as well as remote users who telecommute, need to communicate and share confidential information. We have constructed data communications networks that cover an entire city-wide, or metropolitan, area. These MANs provide high-capacity, secure, direct connections between remote locations and provide cost effective private network solutions to our customers with the capacity, speed, reliability and level of service that they require. . Wide Area Network Solutions. Many organizations have offices and employees in multiple cities. By linking our MANs, we have constructed a data communications network that covers an entire region in our northeast and mid-Atlantic regions. This WAN provides high-capacity, secure and reliable connections between geographically dispersed locations. Because our WAN customers, like our MAN customers, are served end-to-end on our CopperNet infrastructure, we are able to deliver a wide area, private network to our customers with the capacity, speed, reliability and level of service that they require. With our newly announced network expansion and through the definitive operating agreements we expect to sign with SBC and Telmex, we expect to be able to offer a significantly expanded WAN solution, over either our own or our partners' networks, to our customers. . Network-Enabled Broadband Communications and Services. We believe that providing high-speed access and data communications solutions will only be part of the solution we provide to our customers. Because our emphasis is on building customer relationships through our direct sales force and working with them to provide the best communications solutions, we believe that we will be able to identify further customer needs and effectively market and sell new solutions to meet these needs. For example, we currently provide remote online control, monitoring and management of our customers' networks. In addition, we develop and implement sophisticated network security solutions to protect our customers' networks and vital data, including VPNs, encryption and access authentication, risk assessment and audits, design consulting, security testing through attempted breaches of security and analysis of and response to breaches of security. In the future, we intend to offer additional services that may include e-commerce, voice-over technology (including IP, frame relay and ATM), web and application hosting, video conferencing and server back-up services. . SBC and Telmex Products and Services. Upon completion of a definitive sales agreement with SBC and Telmex, we expect to be able to offer our customers various SBC and Telmex data and voice telecommunications services, which we expect to bundle with our other product offerings, providing integrated communications solutions to our customers. Our Strategy Our goal is to be the premier provider of broadband network solutions in our traditional and future markets. To achieve our goal, and to take advantage of our market opportunity, we plan to implement a strategy consisting of the following principal elements: . Provide in-depth coverage in our traditional markets. Because DSL can only be provided to each individual end-user from the central office or alternative service entry point closest to that end-user, we must collocate our equipment in many central offices in order to provide a wide area of coverage of our markets. Thus, we have pursued a strategy of providing services in a substantial majority of the central offices in each of our target markets. Furthermore, our traditional focus on the northeast and mid-Atlantic regions has enabled us to deploy our network with speed and depth. We believe that our coverage within our traditional target markets is much deeper than that of other providers of DSL-based broadband access, enabling us to better serve our customers by providing them with access for substantially all of their end-users. . Expand our network coverage area. We have announced a significant expansion of our network coverage area, which we will begin building out in mid-2000. We expect to be able to initially deploy our network in all 20 southeastern and western markets in the second half of 2000. We believe that the skills, processes and certain other resources that we used to build out, provide service and obtain customers in our traditional nine markets are directly transferable to developing these additional 20 markets. We believe that by expanding our network coverage area, and through our planned relationships with SBC and Telmex, we will be able to offer our customers a seamless, integrated broadband communications solution throughout a significant portion of the United States. . Focus on small- and medium-sized business customers. We believe that many small- and medium-sized businesses currently do not have a cost- effective and integrated solution to their Internet access and data transport needs. Many small- and medium-sized businesses want to provide high-speed Internet access to their employees and connect multiple branch offices in the same city or multiple cities through MAN or WAN connections, but traditional data communications services are cost- prohibitive for these businesses. Because our CopperNet solution is more cost-effective than current solutions offered by traditional telephone companies, such as T-1 or ISDN connections, we intend to focus on this natural market for our services. In addition, we believe that our marketing approach enables us to provide these customers with a more effective and integrated solution to their data communications needs. . Focus on selected large enterprise customers. We believe that many large enterprise customers are unable to efficiently provide cost-effective high-speed access to their remote workers. Many large businesses have remote offices and workers that are not able to take advantage of the full array of communications and networking resources available to workers at the main office. Our extensive network coverage within our traditional markets allows us to provide service to most remote workers or office locations within those markets, and we expect to be able to provide a similar level of service in our southeastern and western markets by mid-2001. In addition, we believe that our planned expansion into an additional 20 markets and our planned relationships with SBC and Telmex will allow us to more effectively service large enterprise customers with employees in many geographic locations. . Enhance and expand our network to meet the broadest array of business requirements. Our network design and technology is designed to provide our customers with adaptable networking solutions that take advantage of many technologies. Our network supports a broad array of business requirements, such as corporate networks, VPNs, office-to-office connectivity, telecommuting solutions, collaborative computing of users in different areas, Internet/intranet access, video conferencing and multimedia, e-mail, video and audio transmission, web and application hosting and e-commerce. Our network provides solutions that can be adapted to meet the needs of our customers and integrate technological innovations as they are developed. . Expand network-enabled features and applications. We seek to have our network become a platform that facilitates the delivery of productivity- enhancing features and applications to businesses and their employees. We intend to either directly offer or jointly provide these services. We expect that our planned relationships with SBC and Telmex, along with Prodigy, an affiliate of both companies, will allow us to provide additional services, such as enhanced Internet services and local and long distance voice services, to our customers. One of our objectives in providing these enhanced features and applications is to strengthen customer loyalty and increase revenue per customer. . Provide superior customer care. We emphasize a comprehensive service solution for our customers by developing a complete project implementation plan for each installation and for the on-going maintenance of their service. This is to ensure that each customer receives the service for which it has contracted according to our service level agreements. We manage all aspects of our customers' connections to our network, including the design and installation of the end-user's connection, equipment configuration and network monitoring on a 24 hour a day, seven day a week basis. By providing our customers regular reports on the performance of their services, we are able to demonstrate to our customers our performance relative to our commitments and how customers may benefit by acquiring additional networking services from us. . Deliver our products and services through different types of marketing. We emphasize direct sales and marketing to small- and medium- sized businesses and to selected large enterprises. We also sell our services indirectly through our sales partners, including Internet service providers, or ISPs, long distance and local carriers and other networking service companies. Our sales force is supported by sales engineers who are trained, certified experts in all our vendor-partners' products and technologies, including Lucent Technologies, Inc. (through its acquisition of Ascend), Cisco Systems, Inc., and Paradyne Corporation. We intend to leverage our existing customer base through selling them additional products and services. Some of our sales partners include Verio, Inc., Intermedia Communications, Inc. and Comcast Telecommunications, Inc. In addition, we expect that our planned relationships with SBC and Telmex will offer us additional sales channels through which we expect to be able to distribute our products and services in both our traditional and future markets. . Capitalize on economics of DSL. DSL technology requires a lower initial fixed investment than that needed for existing alternative technologies because DSL uses existing copper telephone lines. Thus, we are able to offer businesses services comparable to traditional WAN technologies, like high-speed T-1 lines and frame relay circuits, at approximately 30% to 70% of the cost of such services. After we build out a central office, our subsequent investments in DSL technology for the customers within the area served by that central office are directly related to the number of paying customers, making a significant portion of our capital expenditures success-based. . Accelerate growth through strategic acquisitions or relationships. As part of our growth strategy, we intend to evaluate and consider opportunities to pursue strategic acquisitions, investments and relationships on an ongoing basis. We expect to focus our efforts on companies with complementary service capabilities, talented personnel with skills compatible with our business technologies that will permit us to enhance or expand our business and/or additional applications that will enable us to expand our network services. In addition, we may selectively acquire or partner with companies that permit us to increase our customer base. . Leverage our relationships with SBC and Telmex. We have executed a summary operating agreement, and we expect to enter into several definitive agreements, with SBC and Telmex that will govern our joint sales and marketing, network operations, systems integration and product development efforts. By closely aligning our network architecture and integrating our information systems with those of SBC and Telmex, we expect to create a national broadband network. This offers us a time-to- market advantage, as we anticipate that the combined networks will be deployed in more locations, with greater coverage, more quickly, and less expensively than if we were to build a nationwide network ourselves. We intend, working with SBC and Telmex, and possibly with other third parties, to provide DSL, certain other broadband services, and traditional voice services on a nationwide basis to business and residential customers. We intend to continue to market directly to our traditional customer base, but will also jointly market products and services with SBC and Telmex to both our traditional and non-traditional customers, such as Fortune 50 and residential customers. In addition, we believe that SBC could become a significant distribution channel for us as it fulfills its out-of-region strategy of offering data and communications services in additional markets. Our Service and Product Offerings Network Services CopperNet. In January 1999, we began commercially offering our CopperNet services. CopperNet uses DSL technology to provide high-speed continuously connected packet-based and channelized communications services. CopperNet connects business users to our MANs and WAN using ATM, frame relay and DSL technologies over traditional copper telephone lines. CopperNet customers are able to connect to our regional networks to obtain high-capacity, secure and reliable connections among geographically distant locations. Because our customers are served end-to-end on our CopperNet network, we are better able to deliver a true wide area VPN with the capacity, speed, reliability and level of service that they require. The chart below shows the service, speed, retail price (which includes equipment installed at the customer's location), range and performance of our CopperNet services, as of March 1, 2000: - -------- (1) In each case, the range from the central office is 18,000 feet. However, through our symmetrical CopperNet 128 application, there is no limitation on range. (2) "Kbps" means kilobits per second. "Mbps" means megabits per second. (3) Represents price per line. Wholesale and volume discount prices are available for network service providers. CopperNet Frame. CopperNet Frame provides seamless access to LANs and WANs using ATM and DSL technologies to deliver a flexible suite of frame relay services. The benefit to CopperNet Frame customers is the low cost and simplicity of use when contrasted against T-1 and ISDN services provided by traditional telephone companies and long distance carriers. CopperNet Internet. CopperNet Internet is a suite of Internet services and connectivity options designed specifically for business applications. Our customers choose their DSL connectivity speed, ranging from 128 Kbps to 2 Mbps, and we provide the necessary hardware, register our customers' chosen domain name and configure and maintain our customers' e-mail service. VPN Service. Our VPN service is a fully managed offering for organizations with a remote or mobile workforce that needs reliable and secure access to the corporate network. We provide a full service VPN solution that includes necessary hardware, software and communications services for a single monthly fee. VPOP Service. Our virtual point of presence, or VPOP, service provides network service providers access to our entire CopperNet network. With VPOP, a network service provider can offer services throughout the entire CopperNet network without additional investment in network communications infrastructure. This service offers wholesale customers the opportunity to sell DSL circuits in cities outside of the local service area in which they physically connect to the CopperNet network. Wholesale and volume discount prices are available for network service providers. ROC Services. We offer remote online control, or ROC, services to meet our customers' outsourced network requirements. From our network operations center in Sterling, Virginia, we continuously monitor the integrity of our customers' MANs and WANs, evaluate their network utilization, implement problem resolution systems, provide network health and status monitoring and other customized management solutions. We proactively monitor the performance of our customers' network devices and perform trouble resolution to address network problems, often before our customers' end-users become aware of them. SOC Services. We offer secure online control, or SOC, services to meet our customers' outsourced network security requirements. We provide proactive network monitoring, intrusion detection and management of these network security solutions on a 24 hour a day, seven day a week basis. We provide a variety of security solutions including barriers, or firewalls, between internal corporate networks and external networks like the Internet, VPN service, encryption and access authentication solutions for customers looking for the highest level of security on any network on which data is transported. Value-Added Products and Services. We offer an array of network and broadband enabled applications and features that take advantage of DSL's high-speed connectivity. These applications extend the capabilities of small- and medium- sized businesses and provide them access to expanded markets, resources, and functionality. Network Management Services. We provide our customers the opportunity to outsource network management services that are difficult or costly for them to manage internally. For example, we provide a single point of contact for vendor management/coordination, including vendors for equipment on the customers' premises, long distance carriers and traditional telephone companies, a help desk for network administrators, monitoring and coordinated maintenance of network services, analysis of network performance and capacity planning and network monitoring. We provide a wide variety of network management solutions customizable to any network configuration in order to meet our customers' unique network management requirements. We believe our strategy of providing these services will allow us to address a larger market opportunity than that represented by CopperNet alone. Consulting Services We provide professional consulting and network integration services to complement all of our network services. We also provide network design and integration, network management, staging, installation, maintenance and warranty services. Our consulting services include network security and professional services such as: . Risk assessments and audits. We work in conjunction with a customer's engineering staff to determine if a network's critical components work together, provide for overlapping network protection features and adequate firewall security at the perimeter of a network. We also determine whether an optimal defensive strategy exists and if it is adhered to. We assess the effectiveness of a customer's reporting and response mechanisms and determine vulnerabilities and other critical issues. . Network security architecture consulting. We provide expertise in designing, implementing, modifying and protecting data networks of all sizes. . Controlled security breaches. We will conduct organized security breaches with software tools and techniques designed to expose unauthorized information security breaches. These controlled penetrations are tailored to customer requirements. Following a security breach, our engineers will interpret the outcome and present results to both senior executives and lead engineers. We also take steps to ensure that knowledge gained from a controlled security breach is not lost during subsequent implementation and maintenance phases. Product Sales As part of our overall data communications solutions, we sell data communications products, including the network components and security components that our customers require in order to build, maintain and secure their networks. We primarily provide equipment manufactured by Lucent, Cisco and Paradyne. We do not manufacture any of this equipment ourselves. Our engineers select product solutions to improve our customers' operations and network efficiencies, and then help install and configure the equipment in our customers' networks. Customers As of December 31, 1999, we had more than 1,492 customers. AT&T accounted for 50.4% and 30.7%, and AstraZeneca PLC (formerly Zeneca Group PLC), accounted for 8.0% and 9.2%, of our revenue for the years ended December 31, 1998 and 1999, respectively. Network services, which includes our CopperNet service, represented 2.6% and 10.4% of our revenue for the years ended December 31, 1998 and 1999, respectively. Sales and Marketing We emphasize direct sales and marketing to small- and medium-sized businesses and to selected large enterprises. We also sell our services indirectly through our sales partners, including ISPs, long distance and local carriers and other networking services companies, and, subject to entering into definitive agreements with SBC and Telmex, we expect to sell indirectly through SBC, Telmex and Prodigy. Direct Sales. We market our full complement of products and services, including our network services, consulting services and product sales, through a sales force of 133 people at December 31, 1999. Our direct sales force is supported by sales engineers who also seek to sell our consulting services and network services. Our sales representatives focus on selling CopperNet connectivity to small- and medium-sized businesses and our account executives focus on selling CopperNet connectivity and consulting services and network services to medium- and large-sized businesses. We target businesses that have at least one of the following requirements: Internet connectivity, remote LAN access, traditional voice and data applications or MAN or WAN frame relay. We also generate lead referrals for our direct sales forces through telemarketing efforts. We intend to increase the size of our sales and technical support force to sell and support our services as we expand our business. By the end of 2000, we expect to have a sales force of approximately 400 people. We also seek to coordinate our direct sales and marketing efforts with our vendor partners, including Lucent, Cisco and Paradyne. Our direct sales process generally ranges from 30 to 60 days for small- and medium-sized businesses, which generally require simple connectivity and networking solutions. Larger businesses with more complex networking requirements often require customized solutions. The large business sales process may take up to six months and may involve: . a significant technical evaluation; . an initial trial rollout of our services; and . a commitment of capital and other resources by the customer. Indirect Sales. We sell our full complement of products and services, including our network services, consulting services and products, through network service providers, including ISPs, long distance and local carriers and other networking services companies. These providers combine one or more of our services with their own Internet, frame relay and voice services and resell those bundled services to their existing and new customers. We address these markets through sales and marketing personnel dedicated to this channel. We intend to augment our CopperNet sales through partnerships with other service providers which offer complementary services and can offer CopperNet as part of a complete business solution. We also leverage our equipment vendors' partnerships as sources for sales opportunities by offering joint technology seminars, implementing marketing campaigns and sharing cross-selling opportunities. SBC and Telmex Sales. In connection with our recently announced summary operating agreement with SBC and Telmex, we expect to enter into definitive operating agreements with SBC and Telmex covering several areas of our operations, including sales and marketing. We intend to continue to market directly to our traditional customer base, but will also jointly market products and services with SBC and Telmex to both our traditional and non- traditional customers, such as Fortune 50 and residential customers. In addition, we believe that SBC could become a significant distribution channel for us as it fulfills its out-of-region strategy of offering data and communications services in additional markets. Preferred Stock Issuance and SBC and Telmex Agreement On February 8, 2000, we announced strategic financing agreements with SBC and Telmex in which those companies agreed to purchase a total of $150 million, $75 million each, of our Series B preferred stock for $100 per share. On March 7, 2000, we issued 1,500,000 shares of our Series B preferred stock to SBC and Telmex. Our Series B preferred stock is non-voting and pays a 7.0% cumulative dividend, which can be satisfied with either additional stock or cash. Each share of Series B preferred stock is convertible at any time into 3.2258 shares of our common stock, or a total of 4,838,700 common shares. In conjunction with the financing agreements, we executed a summary operating agreement with both SBC and Telmex, and we intend to execute several definitive agreements with SBC and Telmex covering distinct operating areas in the first half of 2000. In connection with the financing agreements, we announced that we would be expanding our network into 20 additional markets in the southeastern and western regions of the United States. We will use the proceeds from the Series B preferred stock issuance to fund part of this expansion. Pursuant to the financing agreements, we granted to each of SBC and Telmex a right of first offer to purchase a percentage of any new securities we offer to sell to any third parties. That percentage is equal to the percentage ownership by each of SBC and Telmex in our common stock on a fully diluted basis prior to the sale of the stock subject to the right of first offer. In connection with the financing agreements, each of Jonathan P. Aust, our Chief Executive Officer, and Spectrum Equity Investors II, L.P., or Spectrum, granted each of SBC and Telmex a right of first offer to purchase any shares that either of the stockholders proposes to sell to any third party. The summary operating agreement is designed to align and integrate certain aspects of our, SBC's and Telmex's sales and marketing efforts, networks and operations, systems and new product development and collocation. We expect to execute definitive operating agreements which will further detail the scope and nature of the relationships among the parties in these various operational areas. The summary operating agreement is binding on the parties for one year. The summary operating agreement provides that the term of each definitive operating agreement will be five years from the date of execution, except that any of these agreements may be terminated by SBC or Telmex within specified periods if we are acquired by a third party or otherwise undergo a change in control. Other Key Strategic and Commercial Relationships In addition to our relationships with SBC and Telmex, we have entered into, are continuing to explore, and expect to enter into additional strategic and commercial relationships. We believe that these relationships are valuable because they provide additional marketing and distribution, network resources, technology and geographic expansion opportunities. In some cases, these relationships involve capital investment, product development or targeted numbers of new lines or customers. Lucent. Since 1995 we have sold data communications products and equipment made by Ascend (which recently became a wholly owned subsidiary of Lucent). Ascend has provided us with a capital lease facility and a credit facility for working capital. In addition, we are continuing to explore opportunities to participate in product development and the distribution of products and services for their network of sales partners. Cisco. In November 1999, we were awarded Cisco Powered Network, or CPN, certification. The CPN certification represents our next step towards introducing an enhanced business-class Internet access service that includes Cisco routers as the customer premises equipment. Paradyne. Since 1995 we have sold data communications products and equipment made by Paradyne. In addition, we are continuing to explore opportunities to participate in product development and the distribution of products and services for their network of sales partners. Turnstone. In December 1999, we entered into an agreement with Turnstone to use their cross-connect hardware systems in our collocated central offices. The agreement calls for Turnstone to be our exclusive loop management vendor. Verio. In August 1999, we were named as Verio's preferred provider of DSL service in Richmond, Virginia. Intermedia. In August 1999, we entered into a reseller agreement to sell frame relay services out of region. This allows us to expand our frame relay service via a network-to-network interface, or NNI, which provides nationwide frame relay coverage. Comcast. In May 1999, we entered into a master service agreement with Comcast to provide their business customers with CopperNet services across our northeast service territory. Customer Service Network service providers and communications managers at businesses typically have to assemble their digital communications networks using multiple vendors. This leads to additional work and cost for the customer as well as complex coordination issues. We work with each customer to develop project implementation plans. These plans include qualifying the customer for our service offerings, placing orders for connection facilities, coordinating the delivery of the connection, turn up and final installation. We emphasize a comprehensive service solution for our customers and provide our service according to a predetermined service level commitment with each customer. Our comprehensive solution includes: . Customer Line Installation. We work with each of our customers to establish all connection and configuration requirements to connect the customer's main location to our network. We order the copper telephone line for our customers, manage the installation process, test the copper telephone line once installed, assist our customers in configuring the equipment that terminates the copper telephone line, and monitor the copper telephone line from our network operations center. . End-User Line Installation. We order all end-user connections from the traditional telephone companies according to pre-determined technical line specifications. We manage the traditional telephone company's provisioning performance, test the installed line, and monitor the end- user line from our network operations center. . End-User Premises Wiring and Modem Configuration. We use both our own and contracted installation crews to install any required inside wiring at each end-user site. We rely on contracted crews to meet customers' demands at peak times. Our installation crews configure and install end- user equipment with information specific to each customer. . Network Monitoring. We monitor our network from our network operations center on a continuous end-to-end basis, which often enables us to correct potential network problems before service to a customer or end- user is affected. We also provide direct monitoring access of end-users to our network service providers and enterprise customers. . Customer Reporting. We communicate regularly with our customers about the status of their service. We provide web-based tools to allow individual network service providers and communications managers to monitor their end-users directly, to place orders for new end-users, to enter work orders on end-user lines and to communicate with us on an ongoing basis. . Customer Service and Technical Support. We provide service and technical support 24 hours a day, 7 days a week to all our customers. We serve as the sole contact for customers to whom we make direct sales. We also provide the second level of support for our indirect customers. We have developed and will continue to expand a database containing the questions we have addressed and the answers we have provided in response to past network issues. In this way, we are able to better respond to future customer questions. . Operating Support Systems. We have designed an integrated group of customized applications around our current and planned business processes. By customizing and integrating products from vendors such as Daleen Technologies, Inc. for billing, Eftia OSS Solutions Inc. for operating support systems and Hewlett-Packard Company for network management, we believe we have designed a system that will facilitate rapid service responsiveness and reduce the cost of customer support. Upon execution of definitive agreements with SBC and Telmex, we expect to upgrade our platform to provide integrated operating support systems. Network Structure and Technology Overview. We operate a series of MANs connected by our private, leased, high-speed fiber optic backbone. Our network employs a structure designed to deliver superior end-to-end capabilities, high-speed "last mile" connections and efficient data traffic management. Our technologically advanced network design has positioned us to deliver the high level of data communications services, including Internet access, VPNs, video conferencing and a broad array of multimedia services, increasingly demanded by businesses. We have planned for growth by ensuring that our network is scalable, flexible and secure. We intend to make seamless connections between our network and systems and those of SBC and Telmex in order to provide our customers with integrated national connectivity. . Scalable. Our adaptable, hierarchical network structure allows us to provide both channelized and packet-based services reliably and incrementally, which enables us to match investment with demand. As new CopperNet end-users are added to our network, our Traffic Management group monitors network utilization, and installs more equipment and network transmission circuits as necessary so that reliable performance is maintained for all users as our network grows. . Flexible. From our network operations center, we constantly monitor our network, the network service providers' networks and our customers' connections, and also perform network diagnostics and equipment surveillance, and initialize our end-users' connections. Because our network is centrally managed, we can identify and dynamically enhance network quality, service and performance and address network problems promptly, often without our end-users' becoming aware of the repairs. This capability also allows us to control costs associated with on-site network configuration and repair. . Secure. With dedicated, direct access to our private network, our end- users and businesses generally experience fewer network security risks than users of common dial-up modems, ISDN lines or dedicated access to the Internet because there is less risk of unauthorized access. Our network is designed to ensure secure availability of all internal applications and information for all end-users, whether they are within the corporate headquarters or telecommuting from remote locations. Our network provides a direct connection between discrete locations, which reduces the possibility of unauthorized access and allows our customers to safely perform their required tasks. Components. Our components are integrated into networks across local, metropolitan and wide areas that combine speed and balanced capacity in a manner designed to deliver a high performance networking experience for our customers. . Customer Endpoint. We currently offer channelized and packet-based DSL connections in our network. We provide our customers with a DSL modem as part of our complete service offering, the cost of which is included in the list price of the service. We configure and install these modems with the end-user's computer and network equipment along with any required on-site wiring needed to connect the modem and the telephone line. Under FCC policies, a customer also is free to obtain compatible modems from sources other than us. . Copper Telephone Lines. We lease copper telephone lines, known as unbundled network elements, which run from our network access points in central offices to the customer endpoint under terms specified in telecommunications regulations and our interconnection agreements. We have worked closely with Bell Atlantic to define specifications that provide for the quality of the copper telephone lines we receive, thereby ensuring the transmission speed of end-user connections. We expect to have the same working relationship with BellSouth and U S WEST. . Central Office Collocation Spaces. Through FCC and state telecommunications regulatory policies as well as our interconnection agreements, we secure collocation space in central offices from which we desire to offer CopperNet. These collocation spaces are designed to offer the same high reliability and availability standards as the telephone companies' other central office spaces. At present, our collocation spaces are either physical, SCOPE or virtual. With physical collocation, we install and maintain our equipment in central offices and have complete access to the space. With SCOPE collocation, we install and maintain our equipment in central offices, but our access to the space is non-exclusive. With virtual collocation, the telephone company installs and maintains the equipment on our behalf, but we have no access to the space. Approximately 98% of our central office collocations are physical or SCOPE, and we expect over time to eliminate virtual collocation. . Metropolitan Area Backbone. Our metropolitan area backbone is a private, leased, high-speed, fiber optic network that connects our network access points in central offices, node sites, and selected customer locations. To date, we have leased fiber optic circuits capable of speeds of up to 45 megabits per second from Bell Atlantic, Level 3 Communications and other providers for metropolitan area backbone services. We continue to review alternative providers in an effort to reduce costs. We do not have long-term lease agreements for these fiber optic circuits. . Node Sites. A node site is a physical location where we connect businesses and network service providers with our central offices within a particular MAN. The node site houses our equipment to switch and interconnect customer traffic to central offices within a region or across our entire network. Our node sites are housed in a secured facility in each of the nine metropolitan areas in which our network currently operates. . Wide Area Backbone. Our wide area backbone is a private, leased, high- speed, fiber optic network that interconnects our node sites in various metropolitan areas. To date, we have leased fiber optic circuits capable of speeds of up to 155 megabits per second from Level 3 Communications, Virginia Electric and Power Company and other providers. We do not have long-term lease agreements for these fiber optic circuits. We intend to upgrade our wide area backbone to higher capacities as necessary to deliver the quality of service that our customers demand. We continue to evaluate alternative providers of capacity in order to reduce costs. . Network Operations Center. We manage our network from our network operations center located in our corporate headquarters in Sterling, Virginia. We provide end-to-end network management to our customers using advanced network management tools on a 24 hour a day, seven day a week basis. This enhances our ability to address performance or connectivity issues before they affect the end-user experience. From our network operations center, we can monitor our network, including the equipment and circuits in our MANs and central offices, and our customers' networks, including individual end-user lines and DSL modems. Assuming execution of definitive agreements with SBC and Telmex, we expect to be able to monitor our customers' connections to the networks of SBC and Telmex in addition to our own network. Competition In each of our businesses, we face competition from many companies with significantly greater financial resources, well-established brand names and large, existing installed customer bases. We expect the level of competition to intensify in the future. Some of the competitive factors we face in each of our business segments include: . reliability of service; . diversity of product and service offerings; . breadth of network coverage; . price/performance; . network security; . infrastructure scaleability; . ease of access and use; . service bundling; . sales relationships; . customer support; . strategic relationships; and . operating experience. We believe that each potential customer presents a unique opportunity for competition and presents competitive challenges specific to that customer. The significance of the different competitive factors we face will vary with each customer depending on the needs of the particular customer and the particular competitor we face. For example, if we are competing for a customer against another provider of product sales and consulting services, we expect to compare favorably as to diversity of product and service offerings and operating experience, but perhaps less favorably as to brand recognition and financial resources. If we are competing for a customer against a traditional telephone company, we expect to compare favorably as to client support, transmission speed and price/performance, but perhaps less favorably as to operating experience, brand recognition and access to capital. If we are competing for a customer against another provider of DSL, we expect to compare favorably as to diversity of service offerings, sales relationships and operating experience, but perhaps less favorably as to the geographic breadth of network coverage. We expect to improve our competitive position relative to other DSL providers by expanding the geographic breadth of our network through opportunistic growth of our network and, in part, through strategic alliances like our new relationships with SBC and Telmex. We believe that our most direct competition for product sales and consulting services will come from Bell Atlantic's network integration services division and from other providers of network integration services like Tech Data Corporation. Historically, these companies have been our principal competitors. By focusing our business on broadband network solutions, we encounter a different set of competitors for our network services. We believe that our most direct competition for broadband network solutions will come from Bell Atlantic and other traditional telephone companies and carriers operating in our target markets. However, we also anticipate competition from service providers using other technologies. Bell Atlantic and Other Traditional Telephone Companies. Bell Atlantic and the other traditional telephone companies present in our target markets are conducting technical and/or market trials or have commenced commercial deployment of DSL-based services. We recognize that each traditional telephone company has the potential to quickly overcome many of the obstacles that we believe have delayed widespread deployment of DSL services by traditional telephone companies in the past. The traditional telephone companies currently represent and will in the future increasingly represent strong competition in all of our target markets. The traditional telephone companies have an established brand name, a large number of existing customers and a reputation for high quality in their service areas, possess sufficient capital to deploy DSL equipment rapidly, have their own copper lines and can bundle digital data services with their existing analog voice services to achieve economies of scale in serving customers. In the absence of strong oversight by the FCC and state telecommunications regulators, traditional telephone companies also have an economic incentive to benefit their own DSL retail operations by providing themselves with the copper telephone lines, collocation, support services and other essential DSL service inputs on more favorable terms than they provide these facilities and services to their DSL competitors, like us. These factors give the traditional telephone companies a potential competitive advantage compared with us. Accordingly, we may be unable to compete successfully against Bell Atlantic, BellSouth, U S WEST or the other traditional telephone companies, and any failure to do so would materially and adversely affect our business, operating results and financial condition. Other Major DSL Providers. Other competitive telecommunications companies plan to offer or have begun offering DSL-based access services in our targeted markets, and others are likely to do so in the future. Competitive telecommunications companies that provide DSL service include Covad Communications Group, Inc., Rhythms NetConnections, Inc. and NorthPoint Communications Group, Inc. Other Service Providers and Technologies. Many of our competitors are offering, or may soon offer, technologies and services that will compete with some or all of our high-speed DSL offerings. These technologies include T-1, ISDN, satellite, cable modems and analog modems and could be provided by the following: . Cable Modem Service Providers. Cable modem service providers, like MediaOne, Excite@Home, through its @Home service offering, and their cable partners, are offering or preparing to offer high-speed Internet access over fiber and cable networks to consumers. At Home, through its @Work service offering, has positioned itself to do the same for businesses. Where deployed, these networks provide local access services, in some cases at higher speeds than our CopperNet. They typically offer these services at lower prices than our services, in part by sharing the capacity available on their cable networks among multiple end users. . Traditional Long Distance Carriers. Many of the leading traditional long distance carriers, like AT&T, Sprint and MCI WorldCom, are expanding their capabilities to support high-speed, end-to-end networking services. Increasingly, their services include high-speed local access combined with MANs and WANs, and a full range of Internet services and applications. We expect them to offer combined data, voice and video services over these networks. These carriers have deployed large scale networks, have large numbers of existing business and residential customers and enjoy strong brand recognition, and, as a result, represent significant competition. For instance, they have extensive fiber networks in many metropolitan areas that primarily provide high- speed data and voice communications to large companies. They could deploy DSL services in combination with their current fiber networks. They also have interconnection agreements with many of the traditional telephone companies and have secured collocation spaces from which they could begin to offer competitive DSL services. . New Long Distance Carriers. New long distance carriers, such as Williams Communications, Qwest Communications International Inc. and Level 3 Communications, are building and managing high bandwidth, nationwide packet-based technology networks for the WAN. These same providers are acquiring or partnering with ISPs to offer services directly to business customers. These companies could extend their existing networks to include fiber optic networks within metropolitan areas and high-speed services using DSL technology, either alone, or in partnership with others. . Internet Service Providers. ISPs provide Internet access to business and residential customers. These companies generally provide Internet access over the traditional telephone company's networks at ISDN speeds or below. Some ISPs have begun offering DSL-based access using DSL services offered by the traditional telephone company or other DSL-based competitive telecommunications companies. Some Internet service providers such as Concentric Network Corporation, Earthlink, Inc., PSINet and Verio, Inc. have significant and even nationwide marketing presences and combine these with strategic or commercial alliances with DSL-based competitive telecommunications companies. . Wireless and Satellite Data Service Providers. Several new companies are emerging as wireless and satellite-based data service providers over a variety of frequency bands. Companies such as Teligent, Inc., Advanced Radio Telecom Corp. and WinStar Communications, Inc., hold point-to- point microwave licenses to provide fixed wireless services such as voice, data and videoconferencing. We also may face competition from satellite-based systems such as Motorola Satellite Systems, Inc., Hughes Space Communications, Globalstar Telecommunications Ltd. and others that are planning or are in the process of building global satellite networks that can be used to provide broadband voice and data services. Relationship with Bell Atlantic and Other Traditional Telephone Companies Our relationship with Bell Atlantic is critical to our current business. We depend on Bell Atlantic for collocation facilities, copper telephone lines, support services and some of the fiber optic transport that we use for CopperNet in our traditional markets. Our interconnection agreements with Bell Atlantic govern much of this critical relationship. We have signed interconnection agreements with Bell Atlantic in each of the states covering our initial target markets. These agreements cover a number of aspects, including: . the price and terms to lease access to Bell Atlantic's copper lines; . the special conditioning Bell Atlantic provides to enable the transmission of DSL signals on these lines; . the price and terms for collocation of our equipment in Bell Atlantic's central offices; . the price and terms to access Bell Atlantic's transport facilities; . the terms to access conduits and other rights of way Bell Atlantic has constructed for its own network facilities; . the operational support systems and interfaces that we use to place orders and trouble reports and monitor Bell Atlantic's response to our requests; . the dispute resolution process we and Bell Atlantic use to resolve disagreements relating to the terms of the interconnection agreement; and . the term of the interconnection agreement, its transferability to successors, its liability limits and other general aspects of our relationship with Bell Atlantic. Our interconnection agreements with Bell Atlantic for Delaware, Maryland, New Jersey, Pennsylvania, Virginia and Washington, D.C. terminate upon 90 days written notice by either party. We are presently negotiating new agreements with Bell Atlantic for these areas. We expect the new agreements to have a two- year term. Although we expect to arrive at new agreements, there is no assurance that they will provide us with the same or more favorable terms. Our interconnection agreements with Bell Atlantic for Massachusetts and New York expire in January 2001. We plan to initiate negotiations with Bell Atlantic to renew these agreements within the next several weeks. If an agreement expires, our service arrangements will continue without interruption under: . terms of a new agreement; . terms imposed by a state commission; . tariff terms generally applicable to competitive carriers and other carriers; or . if none of these are available, on a month-to-month basis under the terms of the expired agreement. Additionally, the FCC, state telecommunications regulators and the courts have authority to interpret our interconnection agreements and to resolve disputes in the event of a disagreement between us and Bell Atlantic. There can be no assurance that these bodies will not interpret the terms or prices of our interconnection agreements in ways that could adversely affect our business, operating results and financial condition. As we expand into other regions that are served by traditional telephone companies other than Bell Atlantic, we will need interconnection agreements with those incumbent carriers. We have entered into an interconnection agreement with BellSouth with an initial term that expires December 1, 2000. This agreement has been approved by the state public utility commissions in Alabama, Florida, Georgia, Kentucky, Louisiana and South Carolina. We plan to submit the agreement for approval to state public utility commissions in North Carolina and Tennessee as well. More recently, we have entered into an interconnection agreement with U S WEST covering the States of Arizona, Colorado, Iowa, Minnesota, New Mexico, Oregon, Utah and Washington. Each of the agreements must be approved by the public utility commission of the state to which it applies. We also have interconnection agreements with GTE (covering the States of Alabama, Florida, Kentucky, North Carolina, Oregon, Pennsylvania, South Carolina, Virginia and Washington) and with Sprint Corporation (covering New Jersey). Similar to our relationship with Bell Atlantic, we expect that our relationship with BellSouth and U S WEST and the services they provide to us will become critical to our business. As we expand our existing SBC and Telmex relationships through negotiation and execution of the definitive operating and related agreements, these relationships could become critical to our business. Government Regulation The following summary of regulatory developments and legislation describes material telecommunications regulations and legislation directly affecting our industry. The facilities and services that we obtain from Bell Atlantic and other traditional telephone companies in order to provide CopperNet are regulated extensively by the FCC and state telecommunications regulatory agencies. To a lesser extent, the FCC and state telecommunications regulators exercise direct regulatory control over the terms under which we provide CopperNet to the public. Municipalities also regulate limited aspects of our telecommunications business by imposing zoning requirements, permit or right-of-way procedures or fees, among other regulations. The FCC and state regulatory agencies generally have the authority to condition, modify, cancel, terminate or revoke operating authority for failure to comply with applicable laws, rules, regulations or policies. Fines or other penalties also may be imposed for such violations. We believe that we operate our business in compliance with applicable laws and regulations of the various jurisdictions in which we operate and that we possess the approvals necessary to conduct our current operations. However, we cannot assure you that regulators or third parties would not raise issues regarding our compliance or non-compliance with applicable laws and regulations. Federal Regulation. The 1996 Telecom Act substantially departs from prior legislation in the telecommunications industry by establishing competition as a national policy in all telecommunications markets. This legislation removes many state regulatory barriers to competition in telecommunications markets dominated by incumbent carriers and preempts, after notice and an opportunity to comment, laws restricting competition in those markets. Among other things, the 1996 Telecom Act also greatly expands the interconnection requirements applicable to traditional telephone companies. It requires the traditional telephone companies to: . provide collocation, which allows competitive telecommunications companies to install and maintain their own network termination equipment in telephone company central offices; . unbundle and provide access to components of their service networks to other providers of telecommunications services; . establish "wholesale" rates for the services they offer at retail to promote resale by competitive telecommunications companies; and . provide nondiscriminatory access to telephone poles, ducts, conduits and rights of way. Traditional telephone companies also are required by the 1996 Telecom Act to negotiate an interconnection agreement in good faith with carriers requesting any or all of the above arrangements. If a requesting carrier cannot reach an agreement within the prescribed time, either carrier may request binding arbitration by the state telecommunications regulatory agency. The FCC and state telecommunications regulators also are instructed by the 1996 Telecom Act to perform certain duties to implement the regulatory policy changes prescribed by the 1996 Telecom Act. The outcome of various ongoing proceedings to carry out these responsibilities, or judicial appeals of these proceedings, could materially affect our business, operating results and financial condition. In July 1997, the United States Court of Appeals for the Eighth Circuit overruled some of the rules initially adopted by the FCC to implement the 1996 Telecom Act, including rules: . providing the detailed standard that state telecommunication regulators must use in prescribing the price that traditional telephone companies charge for collocation and for the copper telephone lines and other network elements that competitive telecommunications companies must obtain from traditional telephone companies in order to provide service; and . giving competitive telecommunications companies the right to "pick-and- choose" interconnection provisions by requiring that a traditional telephone company enter into an interconnection agreement with the competitive telecommunications companies that combines provisions from a variety of interconnection agreements between that traditional telephone company and other competitive telecommunications companies. The FCC and others appealed this decision to the U.S. Supreme Court. In January 1999, the U.S. Supreme Court reversed much of the Eighth Circuit's decision, finding that the FCC has broad authority to interpret the 1996 Telecom Act and issue rules for its implementation, including authority to establish the methodology that state telecommunication regulators must use in setting the price that incumbent carriers charge competitive telecommunications companies for collocation, copper telephone lines and other network elements. The Supreme Court also reversed the Eighth Circuit's holding invalidating the FCC's "pick-and-choose" rule. However, the Supreme Court found that the FCC had violated the 1996 Telecom Act in defining the individual network elements incumbent carriers must make available to competitive telecommunications companies, and required the FCC to reconsider its delineation of these elements. It sent the matter back to the FCC with instructions to consider further the question of which parts of a traditional telephone company's network must be provided to competitors. The FCC released an order on November 5, 1999 that sought to follow the Supreme Court's instructions in delineating the particular network elements that traditional telephone companies must make available to competitors. The FCC's November decision reaffirms its earlier holding that traditional telephone companies must make available the particular inputs that we need in order to provide our CopperNet services (including, but not limited to, copper telephone lines, transmission facilities between local telephone company offices and various back-office support services). In addition, the FCC's November order requires, upon the request of competitive telecommunications companies like us, that traditional telephone companies provide competitive carriers with certain other inputs (such as "subloops" and in some cases packet switching) that may prove useful as we expand our CopperNet service, especially into more suburban areas. The Supreme Court's determination in its January 1999 order that the FCC rather than state telecommunications regulators has jurisdiction to determine pricing methodology also could be beneficial to us since the FCC has adopted a pricing standard that appears to be more beneficial to competitive telecommunications companies in some respects than the pricing standards that some state telecommunications regulators have employed. However, it remains unclear whether the particular pricing methodology prescribed by the FCC will go into effect because some parties have challenged the lawfulness of that methodology in the U.S. Court of Appeals for the Eighth Circuit, and that litigation is still pending. In an order released March 31, 1999, the FCC adopted new regulations that are designed to clarify the obligations of a traditional telephone company in providing space inside its offices to competitors like us so that they can access the telephone company's copper telephone lines and connect those lines to the competitor's electronic equipment located inside that telephone company office. Another rule adopted in that order is intended to help ensure that the customers of companies who provide services like CopperNet do not receive harmful interference from other users of the traditional telephone company network on which the service is provided. Several traditional telephone companies appealed the FCC order adopting these rules to the U.S. Court of Appeals for the District of Columbia Circuit, and on March 17, 2000, the Court vacated limited portions of the order on grounds that it contained certain definitions that are impermissibly broad. The Court remanded those aspects of the order to the FCC for further consideration. The FCC will be instituting proceedings to comply with the Court's mandate. The impact of the Court's decision on our company is unclear since we have no way to determine what action the FCC will take in response to the Court's mandate. An FCC order released on December 9, 1999 is designed to make it easier for companies like us to market high-speed data services like CopperNet to residential customers for accessing the Internet. Under this "line-sharing" order, traditional telephone companies are required to let a competitor use the same copper telephone line for providing the customer with data service that the telephone company uses for providing the same customer with local telephone service. At present, the traditional telephone companies provide residential customers with local phone service and high-speed Internet access service over a single phone line, but the traditional telephone companies require competitors like us to lease a separate phone line to provide high-speed Internet access to any residential customer when that customer obtains local phone service from the traditional local telephone company. The FCC's December 9, 1999 order requires that a traditional telephone company permit companies like us to provide high- speed Internet access service to a customer over the same line that the telephone company uses to provide local phone service to that customer. One goal of the order is to make it easier for companies like us to compete with the traditional local telephone companies in the residential high-speed Internet access market by permitting competitors to reduce significantly their costs to serve this market. However, it is not yet clear that the FCC's order will achieve its intended objective since the traditional local telephone companies have not yet put in place the policies and procedures necessary to implement the order. Moreover, some traditional telephone companies have appealed the order, and we have no way of determining whether the FCC's requirements will be affirmed. The FCC made another potentially favorable ruling for our industry in another recent case. That case involved the question of whether a telecommunications service like CopperNet that provides high-speed dedicated access to the Internet is an interstate service or an intrastate service. An interstate service must be provided subject to FCC regulatory controls, whereas an intrastate service must be provided subject to regulatory controls of the telecommunications regulatory agency of the state where the service is offered. In its decision, the FCC held that such services are jurisdictionally interstate and therefore must be provided on terms and conditions set by the FCC rather than state telecommunications regulators. This ruling is potentially advantageous to us because it reduces the number of telecommunications regulatory agencies that control the terms under which we provide CopperNet. It also is potentially advantageous because FCC regulatory controls in many respects are less burdensome than state regulatory controls. For example, the 1996 Telecom Act authorizes the FCC to forbear from regulating the terms under which carriers classified as "non-dominant" provide interstate telecommunications service. The FCC has exercised its forbearance authority by exempting non-dominant carriers like us from filing a tariff setting forth the terms under which they provide any interstate access service. Since we believe CopperNet is interstate special access, we provide the service to existing customers pursuant to contract rather than tariff. On May 8, 1997, in compliance with the requirements of the 1996 Telecom Act, the FCC released an order establishing a new federal universal service support fund, which provides subsidies to carriers that provide service to underserved individuals and customers in high-cost or low-income areas, and to companies that provide telecommunications services for schools and libraries and to rural health care providers. We are required to contribute to the universal service fund and are also required to contribute to state universal service funds. The new universal service rules are administered jointly by the FCC, the fund administrator, and state regulatory authorities, many of which are still in the process of establishing their administrative rules. We cannot determine the net revenue effect of these regulations at this time. On November 2, 1999, the FCC held that a statute requiring that traditional local telephone companies offer their retail services at a wholesale price to competitors like us does not apply when these telephone companies provide a discounted DSL service directed to ISPs. In that case, while competitors may purchase the traditional telephone companies' ISP-directed DSL offering on the same terms as the ISPs, the FCC ruled that competitors have no legal right to a wholesale discount off the price paid by ISPs. This ruling could adversely affect us if it gives ISPs an economic incentive to meet all of their DSL needs by subscribing to the traditional telephone companies' ISP-directed discounted DSL offerings rather than by subscribing to DSL services offered by competitors like us. In response to petitions by several traditional telephone companies requesting that the FCC substantially deregulate the retail price they charge for various types of telecommunications services, including high-speed data services like CopperNet, the FCC recently issued a decision that establishes a procedure by which traditional telephone companies may apply for certain pricing flexibility. We cannot yet determine the extent to which traditional telephone companies will use this procedure or the impact of any pricing flexibility that the FCC awards to any given company under this new procedure. The ultimate impact of the FCC's order also is uncertain because the order has been appealed to the U.S. Court of Appeals. If the FCC were to substantially eliminate price regulation of the high-speed data services that traditional telephone companies provide in competition with CopperNet, our business could be adversely affected. Late last December, the FCC approved Bell Atlantic's application for authority to provide long distance telephone service to customers in New York. The agency based its decision to grant this application on its finding that Bell Atlantic is providing services and facilities to competitors like us on terms that comply with the 1996 Telecom Act and the FCC's rules. The agency made this finding even though many Bell Atlantic competitors, including us, had urged the FCC to find that Bell Atlantic is not yet complying with these requirements. Although not certain, the FCC's finding that Bell Atlantic provides facilities and service to competitors in compliance with existing regulatory requirements could reduce Bell Atlantic's incentive to improve its provisioning of services and facilities to competitors. The FCC's December order approving Bell Atlantic's application to provide long distance telephone service in New York contains one feature that is designed to help ensure that Bell Atlantic provides competitors with facilities and services they need to provide advanced services like CopperNet on fair terms. More specifically, the order accepted Bell Atlantic's commitment to provide advanced services through an affiliate rather than through Bell Atlantic's New York telephone company and to provide advanced service competitors with facilities and services on the same terms that it provides such facilities and services to its advanced services affiliate. Even more recently, Bell Atlantic has told the FCC that, in return for FCC approval of Bell Atlantic's pending application for authority to merge with GTE, it would be willing to provide advanced services in all states through an advanced services affiliate subject to the same non-discriminatory treatment that it committed to as part of its application for authority to provide long distance telephone service in New York. It remains to be seen whether Bell Atlantic's provision of advanced services through an advanced services affiliate will help ensure that the Bell Atlantic telephone companies provide needed facilities and services to competitors on non-discriminatory terms. Apart from Bell Atlantic's voluntary offer to provide advanced services through an advanced services affiliate rather than through its telephone companies, the FCC has also proposed to permit all other traditional telephone companies to provide advanced services like CopperNet through separate affiliates on a deregulated basis. However, the agency has not yet implemented its proposal in this regard. Under the FCC's proposal, the affiliates would provide advanced services free of the requirements relating to interconnection, unbundling, resale and collocation imposed by the 1996 Telecom Act. In addition to regulatory policies set by the FCC, a variety of bills have been introduced in Congress that, if enacted, could affect competition in the advanced services market. Of most significance are several bills sponsored by key members of the House and Senate that would make it easier for the regional Bell operating companies to discriminate against their competitors in the advanced services market. It is unclear whether any of these bills will become law. State Regulation. While it is clear from the January 1999 Supreme Court decision that the FCC has broad authority to implement provisions in the 1996 Telecom Act that are intended to open all telecommunications markets to competition, state telecommunications regulators also have substantial authority in this area. For example, although the Supreme Court's decision validated the FCC's jurisdiction to prescribe the methodology traditional telephone companies must use in setting the price of copper telephone wires and other network elements, the FCC has exercised that jurisdiction by adopting a pricing standard and has given state regulators substantial authority to apply that standard in order to determine actual prices. Many states have set only temporary prices for some network elements that are critical to the provision of DSL services because they have not yet completed the regulatory proceedings necessary to determine permanent prices. Other states have begun proceedings to set new permanent prices based on more current data. The results of these proceedings will determine the price we pay for, and whether it is economically attractive for us to use, these network elements and services. The 1996 Telecom Act also gives state telecommunications regulators broad authority to approve or reject interconnection agreements that competitive telecommunications companies enter with traditional telephone companies and broad authority to resolve disputes that arise under these interconnection agreements. Under the 1996 Telecom Act, if we request, traditional telephone companies have a statutory duty to negotiate in good faith with us for agreements for interconnection and access to unbundled network elements. A separate agreement is signed for each of the states in which we operate. During these negotiations either the traditional telephone company or we may submit disputes to the state regulatory commissions for mediation and, after the expiration of the statutory negotiation period provided in the 1996 Telecom Act, we may submit outstanding disputes to the states for arbitration. The 1996 Telecom Act also allows state regulators to supplement FCC regulations as long as the state regulations are not inconsistent with FCC requirements. In addition, CopperNet may, as to some future customers, be classified as intrastate service subject to state regulation. All of the states in which we operate, or will operate, require some degree of state regulatory commission approval to provide certain intrastate services. We have obtained non-expiring state authorizations to provide intrastate services from the state regulatory agency in all states where we currently provide CopperNet service. We also have obtained non-expiring certificates to provide intrastate service in many of the states where we may provide CopperNet service in the future (Alabama, Colorado, Florida, Georgia, Iowa, Kentucky, South Carolina and Washington). Our applications for certificates to provide intrastate services are pending in several other states (Arizona, Connecticut, Louisiana, Minnesota, Nebraska, New Mexico, North Carolina, Oregon, Tennessee and Utah). In most states, intrastate tariffs are also required for various intrastate services, although non- dominant carriers like us are not typically subject to price or rate of return regulation for tariffed intrastate services. The statutes of three states where we provide CopperNet service--Delaware, New Jersey and New York--require that we obtain approval from the public utility commission in those states to issue new securities. It is possible that laws and regulations could be adopted that address other matters that affect our business. We are unable to predict what laws or regulations may be adopted in the future, to what extent existing laws and regulations may be found applicable to our business, or the impact such new or existing laws or regulations may have on our business. In addition, laws or regulations could be adopted in the future that may decrease the growth and expansion of the Internet's use, thereby decreasing demand for our services. Local Government Regulation. In certain instances, we may be required to obtain various permits and authorizations from municipalities in which we operate our own facilities. The extent to which such actions by local governments pose barriers to entry for competitive telecommunications companies that may be preempted by the FCC is the subject of litigation. Although our network consists primarily of unbundled network elements of the traditional telephone companies, in certain instances we may deploy our own facilities and therefore may need to obtain certain municipal permits or other authorizations. The actions of municipal governments in imposing conditions on the grant of permits or other authorizations or their failure to act in granting such permits or other authorizations could have a material adverse effect on our business, operating results and financial condition. Intellectual Property We regard our products, services and technology as proprietary and attempt to protect them with copyrights, trademarks, trade secret laws, restrictions on disclosure and other methods. There can be no assurance these methods will be sufficient to protect our technology and intellectual property. We also generally enter into confidentiality agreements with our employees and consultants, and generally control access to and distribution of our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our products, services or technology without authorization, or to develop similar technology independently. We own federal trademarks for the marks CuNet and COPPERNET for use with "communications services, namely, high-speed electronic data transmission services." We also have pending applications for the mark CU COPPERNET. We expect to seek registration of our copyrights in software and other intellectual property to the extent possible. There is no assurance that we will obtain any significant copyright protection for our systems that would protect our intellectual property from competition. Currently, we have not filed any patent applications. We intend to prepare applications and to seek patent protection for our systems and services to the extent possible. There is no assurance that we will obtain any patents or that any such patents would protect our intellectual property from competition that could seek to design around or invalidate such patents. In addition, effective patent, copyright, trademark and trade secret protection may be unavailable or limited in certain foreign countries, and the global nature of the Internet makes it virtually impossible to control the ultimate destination of our proprietary information. There can be no assurance that the steps we have taken will prevent misappropriation or infringement of our technology. In addition, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation of this type could result in substantial costs and diversion of resources and could have a material adverse effect on our business, operating results and financial condition. In addition, some of our information, including our competitive carrier status in individual states and our interconnection agreements, is a matter of public record and can be readily obtained by our competitors and potential competitors, possibly to our detriment. Employees As of December 31, 1999, we employed 383 individuals in engineering, sales, marketing, customer support and related activities and general and administrative functions. None of these employees is represented by a labor union, and we consider our relations with our employees to be satisfactory. We are not a party to any collective bargaining agreement. Our ability to achieve our financial and operational objectives depends in large part upon the continued service of our senior management and key technical, sales, marketing and managerial personnel, and our continuing ability to attract and retain highly qualified technical, sales, marketing and managerial personnel. Competition for qualified personnel is intense, particularly in software development, network engineering and product management, and we may be unable to identify, attract and retain such personnel in the future. Item 2. Item 2. Properties. Our headquarters are in Sterling, Virginia in facilities consisting of approximately 15,000 square feet under a lease that will expire in August 2001 and approximately 62,000 square feet under a lease that will expire in 2004. In addition, we have established branch offices in Wilmington, Delaware; Columbia and Monkton, Maryland; Boston and Woburn, Massachusetts; East Brunswick and Morristown, New Jersey; New York and Uniondale, New York; Malvern and Pittsburgh, Pennsylvania; and Richmond and Virginia Beach, Virginia. On October 27, 1999, we executed a lease for approximately 113,000 square feet in Herndon, Virginia. We have begun to move our headquarters to this location, and we expect to complete the move in May 2000. We also lease collocation space in central offices from Bell Atlantic where we operate or plan to operate under the terms of our interconnection agreements with Bell Atlantic and regulations imposed by state telecommunications regulators and the FCC. While the terms of these leases are perpetual, the productive use of our collocation facilities is subject to the terms of our interconnection agreements that have initial terms that expire in 2000 and 2001. We will increase our collocation space as we expand our network. Item 3. Item 3. Legal Proceedings. We are not currently involved in any legal proceedings that we believe could have a material adverse effect on our business, financial position, results of operations or cash flows. We are, however, subject to state telecommunications regulators, FCC and court decisions as they relate to the interpretation and implementation of the 1996 Telecom Act, the Federal Communications Act of 1934, as amended, various state telecommuni-cations statutes and regulations, the interpretation of competitive telecommunications company interconnection agreements in general and our interconnection agreements in particular. In some cases, we may be deemed to be bound by the results of ongoing proceedings of these bodies or the legal outcomes of other contested interconnection agreements that are similar to our agreements. The results of any of these proceedings could have a material adverse effect on our business, financial condition, results of operations and cash flows. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Inapplicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Stock Data. Our common stock trades on The Nasdaq Stock MarketSM under the symbol "NASC." As of March 15, 2000, there were 91 record holders and approximately 7,020 beneficial holders of our common stock. The following table sets forth, for the periods indicated, the high and low closing prices for our common stock: On March 23, 2000, the last reported sales price of our common stock on The Nasdaq Stock Market was $30.00. We have never paid cash dividends. It is our present policy to retain earnings to finance the growth and development of its business, and therefore we do not anticipate paying cash dividends on its common stock in the foreseeable future. Additional Investor Relations Information. All of our current required filings with the Securities and Exchange Commission, as well as press releases and other investor relations information, may be found at http://www.nas- corp.com on the Internet's world wide web. For those without Internet access, the same information may be obtained without charge by request to us addressed to: Investor Relations, Network Access Solutions Corporation, 100 Carpenter Drive, Suite 206, Sterling, VA 20164. Transfer Agent. Our transfer agent is American Stock Transfer & Trust Company, 40 Wall Street, New York, NY 10005, telephone (808) 937-5449. Annual Meeting. Our next Annual Meeting of Stockholders is scheduled to be held at 9:00 a.m. on Tuesday, June 6, 2000, at our new headquarters facility, located at Three Dulles Tech Center, 13650 Dulles Technology Drive, Herndon, Virginia. Use of Proceeds. In June 1999, we commenced and completed a firm commitment underwritten initial public offering of 7,500,000 shares of our common stock. The shares were registered with the Securities and Exchange Commission pursuant to a registration statement on Form S-1 (No. 333-74679), which was declared effective on June 3, 1999. After deducting underwriting discounts and commissions of $5.5 million and expenses of $1.8 million, we received net proceeds of $81.8 million. As of December 31, 1999, we have used approximately $37.3 million of these net proceeds. Of this amount, approximately $21.0 million was used to finance capital expenditures for central office installation and collocation fees, approximately $11.0 million was used to finance operating losses and approximately $4.1 million was used to finance capital expenditures for property and equipment. We have invested the remaining net proceeds from our initial public offering in short- and long-term investments in order to meet anticipated cash needs for future working capital. We invested our available cash principally in high-quality corporate issuers and in debt instruments of the U.S. Government and its agencies. Item 6. Item 6. Selected Financial and Other Data. We present below summary financial and other data for our company. The summary historical statement of operations and other data for each of the three years in the period ended December 31, 1999 have been derived from our audited financial statements that are included elsewhere in this Form 10-K. The statement of operations and other data for the year ended December 31, 1996 have been derived from audited financial statements that were included in our prior public filings. The summary balance sheet data as of December 31, 1998 and 1999 has been derived from our audited financial statements that are included elsewhere in this Form 10-K. The balance sheet data as of December 31, 1996 and 1997 has been derived from audited financial statements that were included in our prior public filings. PricewaterhouseCoopers LLP has audited the financial statements as of and for each of these years. The summary financial data as of and for the year ended December 31, 1995 have been derived from our unaudited financial statements that are not included in this Form 10- K. The unaudited financial statements include, in the opinion of our management, all adjustments, consisting of normal, recurring adjustments, necessary for a fair presentation of the information set forth. - -------- (1) EBITDA consists of net income (loss) excluding net interest, taxes, depreciation and amortization (including amortization of deferred compensation). EBITDA is provided because it is a measure of financial performance commonly used in the telecommunications industry. We have presented EBITDA to enhance your understanding of our operating results. You should not construe it as an alternative to operating income as an indicator of our operating performance or as an alternative to cash flows from operating activities as a measure of liquidity determined in accordance with generally accepted accounting principles. We may calculate EBITDA differently than other companies. For further information, see our financial statements and related notes elsewhere in this Form 10-K. - -------- (2) Excludes 11,014,379 shares of our common stock issuable upon exercise of stock options outstanding on December 31, 1999. Quarterly Results of Operations The following table presents our quarterly results of operations data and the components of net income (loss) for 1998 and 1999. In the opinion of management, this information has been prepared substantially on the same basis as the financial statements appearing elsewhere in this Form 10-K, and all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly the unaudited quarterly results when read in conjunction with our financial statements and related notes thereto appearing elsewhere in this Form 10-K. The operating results for any quarter are not necessarily indicative of the operating results for any future period. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis is provided to increase the understanding of, and should be read in conjunction with, the Financial Statements and Notes. Historical results and percentage relationships among any amounts in the Financial Statements are not necessarily indicative of trends in operating results for any future period. Overview We began operations in 1995 by selling data communications products made by others and providing consulting services for WANs. Shortly thereafter, we began offering a wide range of networking solutions for the data communications needs of businesses. We provide network integration services, where we design our customers' networks and sell and install related network equipment. We also manage our customers' networks, ensure the security of their networks and provide related professional services. From 1995 through 1998, our revenue was derived primarily from product sales and consulting services. Historically, we have primarily depended on AT&T and AstraZeneca for revenue from our product sales and consulting services operations. AT&T accounted for 30.7% and 50.4% of total revenue for the years ended December 31, 1999 and 1998, respectively, while AstraZeneca accounted for 8.0% and 9.2% of total revenue for the years ended December 31, 1999 and 1998, respectively. In 1996, we began to pursue deployment of a series of city-wide networks that enable DSL services. In February 1997, we began developing technical standards for delivery of DSL-based services within our target markets through a joint effort with Bell Atlantic. In April 1997, we entered into our first interconnection agreement with Bell Atlantic, which allowed us to use their copper telephone lines and to collocate our equipment in telephone company offices known as "central offices." Central offices serve as the central connection point for all copper telephone lines in a local area and form the basis for our network and a telephone company's network. We began CopperNet service trials in November 1997 and began commercially offering our CopperNet service in Philadelphia and Washington, D.C. in January 1999. We currently offer our DSL-based networking solutions in the following nine northeast and mid-Atlantic cities and their surrounding markets: Baltimore, Boston, New York, Norfolk, Philadelphia, Pittsburgh, Richmond, Washington D.C. and Wilmington. On February 8, 2000, in connection with the announcement of a $150 million Series B preferred stock investment by, and a strategic summary operating agreement with SBC and Telmex, we announced that we would be extending our network deployment into the southeastern and western regions of the United States. We, along with SBC and Telmex, have initially targeted deployment in the following 20 markets within these regions: Atlanta, Charlotte, Denver, Greensboro, Jacksonville, Louisville, Memphis, Miami, Minneapolis, Nashville, New Orleans, Orlando, Phoenix, Portland, Raleigh- Durham, Salt Lake City, Seattle, Tampa, Tucson and West Palm Beach. We intend to deploy our network in each of these markets in the second half of 2000. As of December 31, 1999, we had installed our equipment in 362 central offices within our northeast and mid-Atlantic markets, and we expect to have installed our equipment in approximately 500 central offices by mid-2000, which will essentially complete our current plans for the roll-out of our network in these markets. We estimate that the central offices where we currently have installed our equipment serve approximately 85% of the business users in these areas. Upon the completion of our network deployment, we believe that the central offices where we have installed our equipment will serve approximately 95% of the business users in these areas. As of December 31, 1999, we had installed 2,910 lines in our northeast and mid-Atlantic regions. We expect to have installed our equipment in approximately 400 central offices in our new southeastern and western regions by the end of 2000 and in approximately 500 central offices by mid-2001. We have obtained competitive carrier certification in eight of the 17 southeastern and western states in which we expect to eventually offer services, and have applied for competitive carrier certification in the remaining nine states in which these markets are located. To date, we have signed interconnection agreements with BellSouth, U S WEST and GTE. Together, these three carriers serve as the traditional telephone companies in substantially all of our 20 target markets in the southeastern and western regions. Since February 1997, we have invested increasing amounts in the development and deployment of our CopperNet service. We have funded the deployment of our CopperNet services through proceeds received from a preferred and common stock financing in August 1998, issuance of promissory notes that were converted into common stock during the three months ended June 30, 1999, capital lease financing, our initial public offering and the proceeds recently received from a sale of preferred stock to SBC and Telmex. We intend to increase our operating expenses and capital expenditures substantially in an effort to rapidly expand our equipment and human resource-related infrastructure and DSL- based network services. We expect to incur substantial operating losses, net losses and negative cash flow during the build-out of our network and our initial penetration of each new market we enter. Although in the short term we expect to derive the majority of our revenue from our product sales and related consulting services, we expect that over time revenue from network services, which includes our CopperNet services, will constitute the more significant portion of our total revenue. Revenue Revenue consists of: . Network services. We charge monthly service fees for access to our CopperNet local, metropolitan and wide area networks. We also provide a wide variety of network services to customers, including remote network management and monitoring, network security, dedicated private connections to our network, Internet access, e-commerce and other data applications. Some of these services are delivered to customers using resources from third-party providers under contract to us. . Consulting services. We bill our customers for network design and integration, on-site network management, staging, installation, maintenance and warranty services, network security and professional services based on time and materials for contracted services. In addition, we derive revenue from the maintenance and installation of equipment. Some of these services may be provided through third-party providers under contract to us. . Product sales. As part of our overall data communications solutions, we sell data communications products, including the network components and security components that our customers require in order to build, maintain and secure their networks. We sell, install and configure selected equipment from our manufacturing partners. Our engineers select product solutions to improve our customers' operations and network efficiencies. Our engineers refer to a standard network design that they seek to customize to fit the needs of each customer. Cost of Revenue Cost of revenue consists of: Network services. Our network service costs generally consist of non- employee-based charges such as: . CopperNet service fees. We pay a monthly service fee for each copper line and for each collocation arrangement, as well as usage fees for the support services we obtain from the traditional telephone companies we work with in order to serve our CopperNet customers. Sometimes, we must pay these companies to perform special work, such as preparing a telephone line to use DSL technology, when such work is required in order to serve a particular client. . Other access costs and levied line expense. We pay installation charges and monthly fees to competitive telecommunications companies or traditional telephone companies for other types of access, other than through our CopperNet network, which we provide to customers as part of our network services. . Backbone connectivity charges. We incur charges for our fiber optic network, or backbone, within a metropolitan area, typically from a competitive telecommunications company or a traditional telephone company, and for the backbone interconnecting our networks in different metropolitan areas from a long distance carrier. We pay these carriers a one-time installation and activation fee and a monthly service fee for these leased network connections. . Network operations expenses. We incur various recurring costs at our network operations center. These costs include data connections, engineering supplies and certain utility costs. . Equipment operating lease expenses. In the future, we may decide to enter into operating leases for some or all of the equipment we use in our network, including the DSL equipment we use in the traditional telephone company's central office locations and equipment installed on the customer's premises. Currently, we generally use capital leases to finance the acquisition of substantially all of this equipment, which we depreciate over a range of two to five years. Consulting services. Consulting services cost of revenue consists of charges for hardware maintenance, installation and certain contract services that we purchase from third parties. Product sales. We purchase equipment from various vendors whose technology and hardware solutions we recommend to our customers. We do not manufacture any of this equipment. Operating Expenses Selling, general and administrative expenses Our selling, general and administrative expenses include all employee-based charges, including field technicians, engineering support, customer service and technical support, information systems, billing and collections, general management and overhead and administrative functions. We expect that headcount in functional areas, such as sales, customer service and operations will increase significantly as we expand our network and as the number of customers increases. . Sales and marketing expenses. We distribute our products and services through direct and indirect sales efforts, agents and telemarketing. Our direct sales force focuses on selling CopperNet connectivity to small- and medium-sized businesses and consulting services and network services to medium- and large-sized businesses. We indirectly sell our full complement of products and services, including our network services, consulting services and products, through network service providers, including ISPs, long distance and local carriers and other networking services companies. Our sales and marketing expenses have increased, and will continue to increase, as we develop our CopperNet services. . General and administrative expenses. As we expand our network, we expect the number of employees located in specific markets to grow. Certain functions, such as customer service, network operations, finance, billing and administrative services, are likely to remain centralized in order to achieve economies of scale. We pay licensing fees for standard systems to support our business processes, such as billing systems. Amortization of deferred compensation on stock options We had outstanding stock options to purchase a total of 7,090,875 and 11,014,379 shares of common stock as of December 31, 1998 and 1999, respectively, at weighted average exercise prices of $0.09 and $1.73 per share, respectively. At December 31, 1999, all of these options were exercisable into restricted shares of our common stock that generally vest over a three- to four-year period. In certain instances, we determined the fair value of the underlying common stock on the date of grant was in excess of the exercise price of the options. As a result, we recorded deferred compensation of $3.7 million and $23.1 million for the years ended December 31, 1998 and 1999, respectively. We recorded this amount as a reduction to stockholders' equity that is amortized as a charge to operations over the vesting periods. For the years ended December 31, 1998 and 1999, we recognized $219,000 and $8.2 million of stock compensation expense, respectively, related to these options. On April 1, 1999, we entered into a stock option agreement that granted to one of our directors an option to purchase 250,000 shares of our common stock at an exercise price of $6.67 per share. On June 3, 1999, this director exercised this option. In addition, the agreement stipulated that this director will be issued an additional option to purchase 407,500 shares of common stock at an exercise price of $3.00 per share. These options immediately vested upon our initial public offering. As a result, we recognized approximately $3.5 million of compensation expense during the year ended December 31, 1999 related to these options. Depreciation and amortization Depreciation expense arising from our network and equipment purchases for our customers' premises will be significant and will increase as we deploy our network. Collocation fees, build-out costs, including one-time installation and activation fees, and other DSL-based equipment costs are capitalized and amortized over a range of two to five years. Interest Income (Expense), Net Interest income (expense), net, primarily consists of interest income from our cash and cash equivalents less interest expense associated with our debt and capital leases. As our capital expenditures increase, we anticipate that our interest expense associated with our capital leases will increase. Results of Operations The following tables present our results of operations data and the components of net income (loss) in dollars and as a percentage of our revenue. Year Ended December 31, 1999 Compared to Year Ended December 31, 1998 Revenue. We recognized $17.4 million in revenue for the year ended December 31, 1999, as compared to $11.6 million for the year ended December 31, 1998, an increase of $5.8 million. This increase was principally attributable to a $3.1 million increase in product sales, primarily from one of our largest customers, AT&T. Network services revenue increased by $1.5 million as a result of the introduction of our DSL-enabled network service offerings in early 1999. Consulting services increased by $1.2 million, which was attributable to increases in maintenance and consulting contracts. Cost of revenue. Cost of revenue was $17.8 million for the year ended December 31, 1999, as compared to $9.4 million for the year ended December 31, 1998, an increase of $8.4 million. The increase was principally attributable to growth in cost of network services of $4.8 million associated with expenses incurred to continue to develop and operate our CopperNet and other networking services and an increase in our product sales of $2.7 million. These were accompanied by a growth in cost related to additional consulting services of $932,000. Gross profit (loss). Gross loss was $401,000 and 2.3% of revenue for the year ended December 31, 1999, as compared to gross profit of $2.2 million and 18.9% of revenue for the year ended December 31, 1998, a decrease of $2.6 million. This loss was primarily a result of increased network services costs related to the continued expansion of our network. As a result of the expansion of our network, expenses have exceeded our revenue realized from our customer base. Selling, general and administrative expenses. Selling, general and administrative expenses were $27.7 million and 158.7% of revenue for the year ended December 31, 1999, as compared to $4.0 million and 34.5% of revenue for the year ended December 31, 1998, an increase of $23.7 million. This increase as a percentage of revenue was primarily due to increased staffing and other expenses incurred to develop, operate and sell our CopperNet network and other networking solutions. Amortization of deferred compensation on stock options. Amortization of deferred compensation was $8.2 million for the year ended December 31, 1999, as compared to $219,000 for the year ended December 31, 1998, an increase of $8.0 million. This increase is attributable to the increase in the unamortized deferred compensation from $3.5 million to $18.4 million as of December 31, 1998 and 1999, respectively, which is principally due to the granting of stock options to key employees, and the related amortization of this balance over the remaining vesting period for these options. Depreciation and amortization expense. Depreciation and amortization expense was $5.2 million and 29.8% of revenue for the year ended December 31, 1999, as compared to $130,000 and 1.1% of revenue for the year ended December 31, 1998, an increase of $5.1 million. This increase was primarily due to investments in our CopperNet network, computer equipment and software, office furnishings and leasehold improvements. Loss from operations. Our loss from operations was $41.4 million for the year ended December 31, 1999, as compared to $2.2 million for the year ended December 31, 1998, an increase of $39.2 million. The increased loss for the year ended December 31, 1999 was primarily due to increased staffing, amortization of deferred compensation and other operating expenses we incurred in connection with the expansion and support of our CopperNet network. Interest income (expense), net. For the year ended December 31, 1999, we recorded net interest income of $1.1 million, consisting of interest income of $2.1 million and interest expense of $(1.0) million. For the year ended December 31, 1998 we recorded net interest income of $64,000, consisting of interest income of $145,000 and interest expense of $(81,000). The increase in interest income was primarily attributable to interest earned from the net proceeds of $81.8 million from our initial public offering in June 1999. The increase in interest expense is primarily due to interest on notes payable and capital leases that commenced during 1999. Benefit for income taxes. We had a benefit for income taxes of $71,000 for the year ended December 31, 1999, as compared to a benefit of $28,000 for the year ended December 31, 1998. Net loss. For the foregoing reasons, our net loss was $40.3 million for the year ended December 31, 1999, as compared to a net loss of $2.1 million for the year ended December 31, 1998, an increase of $38.2 million. Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 Revenue. We recognized $11.6 million in revenue for the year ended December 31, 1998, as compared to $8.9 million for the year ended December 31, 1997, an increase of $2.7 million. Revenue increased as a result of a $1.8 million increase in product sales, primarily from one of our largest customers, AT&T, from an increase in consulting services of $0.6 million attributable to increases in maintenance and consulting contracts, and from growth in network services revenue of $0.3 million arising from the introduction of broader network service offerings in late 1997. Cost of revenue. Cost of revenue was $9.4 million for the year ended December 31, 1998, as compared to $7.4 million for the year ended December 31, 1997, an increase of $2.0 million. The increase was attributable to growth in cost related to an increase in product sales of $1.5 million, growth in cost related to additional consulting services of $0.5 million and from growth in the cost of network services of $39,000 attributable to expenses incurred to develop and operate our CopperNet and other networking services. Gross profit. Gross profit was $2.2 million and 18.9% of revenue for the year ended December 31, 1998, as compared to $1.5 million and 17.1% of revenue for the year ended December 31, 1997, an increase of $0.7 million. The increase in gross profit as a percentage of revenue was attributable to the costs associated with higher product sales and consulting services and the introduction of broader network service offerings in late 1997. Selling, general and administrative expenses. Selling, general and administrative expenses were $4.0 million and 34.5% of revenue for the year ended December 31, 1998, as compared to $1.4 million and 16.1% of revenue for the year ended December 31, 1997, an increase of $2.6 million. This increase as a percentage of revenue was primarily due to increased staffing and other expenses incurred to develop our CopperNet network and other networking solutions. Amortization of deferred compensation on stock options. Amortization of deferred compensation was $219,000 for the year ended December 31, 1998, which was primarily attributable to the granting of stock options to key employees and the amortization of the resulting deferred compensation over the remaining vesting period of these options. We had no amortization of deferred compensation for the year ended December 31, 1997. Depreciation and amortization expense. Depreciation and amortization expense was $130,000 and 1.1% of revenue for the year ended December 31, 1998, as compared to $12,000 and less than 1% of revenue for the year ended December 31, 1997, an increase of $118,000. This increase was primarily due to investments in computer equipment and software, office furnishings and leasehold improvements. Income (loss) from operations. Our loss from operations was $2.2 million for the year ended December 31, 1998, as compared to income from operations of $83,000 for the year ended December 31, 1997, a decrease of $2.3 million. The loss in 1998 was primarily due to increased staffing and other operating expenses we incurred in support of our CopperNet network and other networking solutions. Interest income (expense), net. For the year ended December 31, 1998, we recorded net interest income of $64,000, consisting of interest income of $145,000, which was primarily attributable to interest income earned from the proceeds of our issuance of $10.0 million of preferred and common stock in August 1998, interest expense of $81,000, compared to $5,000 of interest expense in 1997. The increase in interest expense is primarily due to interest on deferred compensation liabilities and notes payable. Provision (benefit) for income taxes. We had a benefit for income taxes of $28,000 for the year ended December 31, 1998, as compared to a provision for income taxes of $36,000 for the year ended December 31, 1997. Net income (loss). For the foregoing reasons, our net loss was $2.1 million for the year ended December 31, 1998, as compared to net income of $42,000 for the year ended December 31, 1997. Liquidity and Capital Resources Although we do not require significant capital expenditures for our product sales and consulting services segments, the development and expansion of our CopperNet network requires significant capital expenditures. The principal capital expenditures that we expect to incur during our CopperNet rollout include the procurement, design and construction of our collocation spaces and the deployment of DSL-based equipment in central offices and connection sites. Capital expenditures were $5.0 million and $55.3 million for the years ended 1998 and 1999, respectively. During the year 2000 and for future periods, we expect our capital expenditures to increase substantially primarily due to: . continued collocation construction in the Bell Atlantic and new collocation construction in the U S WEST and Bell South regions; . procurement of software systems; and . the purchase of telecommunications equipment for expansion of our network. Our capital expenditures will depend in part upon obtaining adequate demand for our services from our CopperNet customers. We anticipate capital expenditures during 2000 to range from $110.0 million to $125.0 million for the expansion of our network from 362 central offices at December 31, 1999 to approximately 900 central offices by the end of 2000. Initial Public Offering. The net proceeds from our initial public offering, completed in June 1999, were approximately $81.8 million. As of December 31, 1999, we have used approximately $37.3 million of these net proceeds. Of this amount, approximately $21.0 million was used to finance capital expenditures for central office installation and collocation fees, approximately $11.0 million was used to finance operating losses and approximately $4.1 million was used to finance capital expenditures for property and equipment. We expect to use approximately one half of the remaining net proceeds to finance operating losses that we expect to incur as we expand our customer base and network. We expect to use the remaining net proceeds from our initial public offering to finance additional capital expenditures for central office installation and collocation fees and to make payments under lease commitments and for general corporate purposes. Borrowings and Sale of Preferred Stock. In February 2000, we borrowed $15 million from each of SBC and Telmex until we received regulatory approvals for the issuance of our Series B preferred stock on March 7, 2000. The loans bore interest at a rate of prime plus 2% during the time they were outstanding, and we repaid both loans plus accrued interest in full upon consummation of the Series B preferred stock sale on March 7, 2000. The net proceeds from our sale of Series B preferred stock in March 2000 were approximately $149.0 million. Of this amount, approximately one half will be used to finance capital expenditures for central office installation and collocation fees, software systems, other capital equipment and certain operating costs related to expansion of our network into new regions beyond our original target markets. We expect to use the remaining net proceeds from our sale of Series B preferred stock to finance operating losses that we expect to incur as we expand our customer base and network, to make payments under lease commitments and for general corporate purposes. Following-On Offering. In December 1999, we filed a registration statement with the SEC to register shares of common stock for sale in an underwritten public offering. We currently expect to sell 4,800,177 shares in the public offering, subject to adjustment if additional stockholders decide to sell in the offering. In addition, we expect to grant to the underwriters the option to purchase up to an additional 750,000 shares from us to cover over- allotments. We expect to use the net proceeds from our sale of common stock to finance capital expenditures, to finance operating losses that we expect to incur as we expand our customer base and network, to finance any strategic acquisitions we decide to make and for general corporate purposes. Operating Activities. Net cash used in operating activities was $2.8 million in 1998 and $20.2 million in 1999. Net cash provided by operating activities was $805,000 in 1997. The increase in cash used in operating activities of $17.4 million from 1998 to 1999 was primarily the result of an increase in operating losses of $38.2 million attributable to the expansion of our network and the development of our CopperNet services, but also the result of increases in accounts receivable and other current assets. These increases were offset by increases in non-cash expenses for amortization of deferred compensation of $8.0 million and depreciation of $5.1 million accompanied by increases in accounts payable and accrued liabilities. The change in operating cash flow from 1997 to 1998 was primarily the result of operating losses attributable to the expansion of our historic business and the development of our CopperNet services, but also the result of an increase in accounts receivable accompanied by a decrease in accounts payable. Investing Activities. Net cash used in investing activities was $122,000 in 1997, $1.3 million in 1998 and $61.4 million in 1999. The increase in cash used for investing activities during 1999 of $60.1 million was primarily due to an increase in the deployment of equipment for our CopperNet services of $27.7 million and an increase in purchases of property and equipment of $6.3 million. These were accompanied by a net increase in the purchase of short-term investments of $24.6 million. The increase in cash used for investing activities during 1998 of $1.2 million was primarily due to an increase in the deployment of equipment for our CopperNet services of $641,000 accompanied by an increase in purchases of property and equipment of $394,000. Financing Activities. Net cash provided by financing activities was $9,000 in 1997, $9.0 million in 1998 and $94.3 million in 1999. The increase in cash provided by financing activities of $85.3 million during 1999 was primarily the result our initial public offering of $83.7 million partially offset by issuance costs paid of $1.9 million and borrowings on notes payable of $12.0 million. The increase in cash provided by financing activities of $9.0 million during 1998 was primarily the result of preferred and common stock financing of $9.9 million offset by the repurchase of common stock from existing shareholders of $1.9 million. Debt and Capital Lease Arrangements. We currently have debt and capital lease facilities available to us of approximately $125.0 million. Of this amount, Lucent (through its acquisition of Ascend) has provided us with a $95.0 million capital lease facility to fund acquisitions of certain Lucent equipment, under which $9.7 million was outstanding as of December 31, 1999. The terms of our capital leases range from three to four years. These leases require monthly lease payments and have an interest rate of 9.5%. Lucent has the right to withdraw or suspend further advances to us if our interconnection agreements with Bell Atlantic are not renewed or are terminated, or if certain key employees terminate their employment with us without competent replacement in the reasonable commercial judgment of Lucent. In addition, we have arrangements with other vendors that permit us to finance up to $25.0 million of equipment and other assets and $5.0 million of working capital. An aggregate of $23.8 million was outstanding under these arrangements as of December 31, 1999. Liquidity Requirements. We believe that our existing cash and cash equivalents, including the net proceeds of approximately $149.0 million we received from SBC and Telmex, existing equipment lease financings and anticipated future revenue generated from operations will be sufficient to complete the current planned build-out of our network in the northeast area mid-Atlantic regions and to begin expansion into the BellSouth and U S WEST territories during 2000 and to fund our operating losses, capital expenditures, lease payments and working capital requirements into the first quarter of 2001. Taking into account our estimated net proceeds from our contemplated offering, we believe that we will have sufficient financing to fund our operations into the third quarter of 2001. We expect our operating losses and capital expenditures to increase substantially primarily due to our network expansion into new markets. We expect that additional financing will be required for us to complete our planned network roll-out in the BellSouth & U S WEST regions. We may seek to finance such future operations through a combination of commercial bank borrowings, leasing, vendor financing or the private or public sale of equity or debt securities. If we were to leverage our business by incurring significant debt, we may be required to devote a substantial portion of our cash flow to service that indebtedness. This cash flow would otherwise be available to finance the deployment of our network. If we are forced to use our cash flow in this manner, we may be forced to delay the capital expenditures necessary to complete our network. Equity or debt financing may not be available to us on favorable terms or at all. Any delay in the deployment of our network could have a material adverse effect on our business. Our capital requirements may vary based upon the timing and success of our CopperNet roll-out, as a result of regulatory, technological and competitive developments or if: . demand for our services or cash flow from operations is more or less than expected; . our development plans or projections change or prove to be inaccurate; . we accelerate deployment of our network or otherwise alter the schedule or targets of our CopperNet roll-out plan; or . we engage in any strategic acquisitions or relationships. Impact of the Year 2000 Issue During 1999, we completed any required modifications to our critical systems and applications relating to year 2000 issues. We also completed our survey of our significant third-party service and product partners to assess our vulnerability if these companies were to fail to remediate their year 2000 issues. The responses received indicated that our third-party service and product partners were aware of the year 2000 issue and were implementing all necessary changes prior to the end of calendar year 1999. We also formulated contingency plans to ensure that business-critical processes were protected from disruption and will continue to function during and after the year 2000 and to ensure that our ability to produce an acceptable level of products and services is safeguarded in the event of failures of external systems and services. During 1999, we did not incur any material costs in connection with identifying, evaluating or remediating year 2000 issues. Our business and operations experienced no material adverse effects from the calendar change to the year 2000 or from the leap year that occurred in 2000, and we have not been notified of any disruptions to or failures in the systems of any of our suppliers. We will continue to monitor our information technology and non-information technology systems and those of third parties with whom we conduct business throughout the year 2000 to ensure that any latent year 2000 issues that may arise are addressed promptly. Although we do not anticipate any additional expenditures relating to year 2000 compliance, we cannot provide any assurance as to the magnitude of any future costs until significant time has passed. Recent Accounting Pronouncements In June 1999, the Financial Accounting Standards Board issued SFAS No. 137, which delays the effective date of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which will be effective for our fiscal year 2001. This statement establishes accounting and reporting standards requiring that every derivative instrument, including certain derivative instruments imbedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized in earnings unless specific hedge accounting criteria are met. We believe the adoption of SFAS No. 133 and SFAS No. 137 will not have a material impact on the financial statements. Forward-looking Statements Many statements made in this Form 10-K are forward-looking statements relating to future events and our future performance within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words "expects," "anticipates," "intends," "believes," or similar language. These forward-looking statements address, among other things: . our CopperNet deployment plans and strategies; . development and management of our business; . our planned relationships with SBC and Telmex; . our ability to attract, retain and motivate qualified personnel; . our ability to attract and retain customers; . the extent of acceptance of our services; . the market opportunity and trends in the markets for our services; . our ability to upgrade our technologies; . prices of telecommunication services; . the nature of regulatory requirements that apply to us; . our ability to obtain and maintain any required governmental authorizations; . our future capital expenditures and needs; . our ability to obtain and maintain financing on commercially reasonable terms; and . the extent and nature of competition. These statements may be found in this section, and in this Form 10-K generally. We have based these forward-looking statements on our current expectations and projections about future events based on information available to us on this date, and we assume no obligation to update any forward-looking statements. However, our actual results could differ materially from those anticipated in these forward-looking statements as a result of risks facing us or faulty assumptions on our part. These include, but are not limited to: . the nature of our ongoing relationship with Bell Atlantic; . our success in maintaining the continuity of our interconnection agreements; . our ability to keep pace with technological innovations within the telecommunications industry; . our ability to hire and retain key personnel; . our ability to protect our proprietary rights; . our ability to successfully market our services to current and new customers; . our ability to generate customer demand for our services in our target markets; . market pricing for our services and for competing services; . the extent of increasing competition; . our ability to acquire funds to expand our network; . the ability of our equipment and service suppliers to meet our needs; . trends in regulatory, legislative and judicial developments; and . our ability to manage growth of our operations. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Form 10-K may not occur. Item 7a. Item 7a. Quantitative and Qualitative Disclosures about Market Risk. We are exposed to certain financial market risks, the most predominant being fluctuations in interest rates. We monitor interest rate fluctuations as an integral part of our overall risk management program, which recognizes the unpredictability of financial markets and seeks to reduce the potentially adverse effect on our results of operations. We do not believe that we are currently exposed to material financial market risks. Item 8. Item 8. Financial Statements and Supplementary Data. Schedules not listed above have been omitted because they are not applicable or the information required to be set forth therein is included in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders Network Access Solutions Corporation: In our opinion, the accompanying balance sheets and the related statements of operations and other comprehensive income (loss), changes in stockholders' equity and cash flows present fairly, in all material respects, the financial position of Network Access Solutions Corporation (the Company) at December 31, 1998 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion expressed above. /s/ PricewaterhouseCoopers LLP McLean, Virginia March 7, 2000 NETWORK ACCESS SOLUTIONS CORPORATION BALANCE SHEETS The accompanying notes are an integral part of these financial statements. NETWORK ACCESS SOLUTIONS CORPORATION STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (LOSS) The accompanying notes are an integral part of these financial statements. NETWORK ACCESS SOLUTIONS CORPORATION STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For the years ended December 31, 1997, 1998 and 1999 The accompanying notes are an integral part of these financial statements. NETWORK ACCESS SOLUTIONS CORPORATION STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. NETWORK ACCESS SOLUTIONS CORPORATION NOTES TO FINANCIAL STATEMENTS 1. Business Network Access Solutions Corporation, or the Company, was originally incorporated in the Commonwealth of Virginia on December 19, 1994. On August 3, 1998, the Company reincorporated in the State of Delaware. Prior to the reincorporation, the Company had authorized 10,000 shares of common stock, of which 7,803 shares were issued and outstanding. As of August 3, 1998, the Company was recapitalized with authorized capital stock of 15,000,000 shares of common stock, $.001 par value per share and 10,000,000 shares of preferred stock, $.001 par value per share. On March 18, 1999, the Company increased the authorized common stock to 50,000,000 shares with a par value of $.001 per share. In conjunction with this reincorporation and recapitalization, the Company changed from a July 31 year-end to a calendar year-end. On March 18, 1999, the Company and its Board of Directors declared a two for one stock split, effected as a stock dividend, of its common stock. On May 7, 1999, the Company and its Board of Directors declared a 2.25 for one stock split, effected as a stock dividend, of its common stock. All share information has been retroactively adjusted for all periods presented to reflect the new capital structure and stock splits. The Company, which is a major provider of high-speed data communications services and related applications, provides network services, telecommunications products and equipment and consulting services to business customers. Through its CopperNet branded service, the Company offers its customers high-speed connectivity using Digital Subscriber Line (DSL) technology. The Company provides metropolitan area and wide area network services, manages and monitors its customers' networks, sells telecommunications equipment, designs networks for its customers, installs the equipment and provides related services. The Company currently offers its DSL- based networking solutions in the following nine cities and their surrounding markets: Baltimore, Boston, New York, Norfolk, Philadelphia, Pittsburgh, Richmond, Washington, D.C., and Wilmington. The Company also intends to expand its geographical coverage to the southeastern and western U.S. markets. 2. Summary of Significant Accounting Policies Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The estimates involve judgments with respect to, among other things, various future factors which are difficult to predict and are beyond the control of the Company. Therefore, actual amounts could differ from these estimates. Revenue Recognition The Company's revenue is derived from product sales, consulting services and network services. The Company recognizes revenue on the sale of its products when a valid purchase order is received, shipment occurs, collection is probable and no significant obligations remain related to the completion of installation and performance of support services. The Company provides consulting services, including network planning, design, and integration services, under time-and-material type contracts and recognizes revenue as services are performed and as costs are incurred. The Company provides network services, including DSL-based services, under monthly and fixed rate service contracts. Revenue on monthly contracts is recognized when services are performed. Revenue on fixed rate service contracts is recognized as costs are incurred over the related contract period, which generally does not exceed one year. Payments received in advance of providing services are recorded as deferred revenue until the period in which such services are provided. Revenue related to installation and activation fees are recognized to the extent of direct costs incurred. Any excess installation and activation fees over direct costs are deferred and amortized over the service contract. Such revenue is not expected to significantly exceed the direct costs. In certain situations, the Company will waive non-recurring installation and activation fees in order to obtain a sale. The Company will expense the related direct costs as incurred. Concentration of Credit Risk Financial instruments, which potentially subject the Company to concentrations of credit risk consist of cash and cash equivalents, short-term investments and accounts receivable. Cash and cash equivalents are held in a money market account at a national financial institution. Short-term investments consist of marketable securities, which are principally composed of debt securities with corporations and foreign governments. The Company has not experienced any losses on its cash and cash equivalents. The Company grants uncollateralized credit in the form of accounts receivable to its customers. As of December 31, 1999, AstraZeneca, PLC comprised 12% of accounts receivable. As of December 31, 1998, AT&T, Corp. (AT&T) comprised 47% of accounts receivable. The customers with concentrations of revenue greater than 10% of total revenue are as follows: Cash and Cash Equivalents The Company considers all highly liquid instruments purchased with an original maturity of three months or less to be cash equivalents. Restricted Cash Restricted cash is composed of amounts held in escrow to collateralize the Company's operating lease commitments for its new headquarters in Herndon, Virginia. Short-term Investments The Company's short-term investments consist of marketable securities that include bonds with maturities of less than two years. The marketable securities are classified as "available for sale" since management intends to hold the investments for an indefinite period and may sell the investments prior to their maturity. The investments are carried at aggregate fair value based generally on quoted market prices. Gains and losses are determined based on the specific identification method. Available-for-sale marketable securities that are reasonably expected by management to be sold within one year from the balance sheet date are classified as current assets. Inventory Inventories are stated at the lower of cost or market. Cost is determined using the weighted-average method. Inventories consist primarily of components, subassemblies and finished products held for sale. Property and Equipment Property and equipment consists of network costs associated with the development and implementation of the DSL networks, office and computer equipment, and furniture and fixtures. The costs associated with the DSL network under development are composed of collocation fees, equipment, equipment held under capital leases, and equipment installation. These assets are stated at cost. The Company leases certain of its equipment under capital lease agreements. The capital lease assets are stated at the lower of the present value of the net minimum lease payments or the fair value at the inception of the lease, and are depreciated over the shorter of the estimated useful life or the lease term. Depreciation of office and computer equipment and furniture and fixtures is computed using the straight-line method, generally over three to five years, based upon estimated useful lives, commencing when the assets are placed in service. The depreciation of the DSL network costs commences as individual network components are placed in service and are depreciated over two to five years. Expenditures for maintenance and repairs are expensed as incurred. When assets are retired or disposed, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is recognized in operations for the period. Income Taxes The Company accounts for income taxes by utilizing the liability method. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. The provision for income taxes consists of the Company's current provision (benefit) for federal and state income taxes and the change in net deferred tax assets and liabilities during the period. Fair Value Information The Company believes the carrying amount of certain of its financial instruments, which include cash equivalents, accounts payable, capital leases and notes payable, approximate fair value. Impairment of Long-Lived Assets The Company periodically evaluates the recoverability of its long-lived assets. This valuation consists of a comparison of the carrying value of the assets with the assets' expected future cash flow undiscounted and without interest costs. If the carrying value of an asset exceeds the expected future cash flows, an impairment exists. An impairment loss is measured by the amount by which the carrying value of the asset exceeds future discounted cash flows. No impairment losses have been recognized to date. Net Income (Loss) Per Share The Company presents basic and diluted net income (loss) per share. Basic net income (loss) per share is computed based on the weighted average number of outstanding shares of common stock. Diluted net income (loss) per share adjusts the weighted average for the potential dilution that could occur if stock options, warrants or other convertible securities were exercised or converted into common stock. Diluted loss per share for the year ended December 31, 1999, is the same as basic loss per share because the effects of such items were anti-dilutive. Stock-Based Compensation The Company measures compensation expense for its employee stock-based compensation using the intrinsic value method and provides pro forma disclosures of net loss as if the fair value method had been applied in measuring compensation expense. Under the intrinsic value method of accounting for stock-based compensation, when the exercise price of options granted to employees is less than the estimated fair value of the underlying stock on the date of grant, deferred compensation is recognized and is amortized to compensation expense over the applicable vesting period. Segment Reporting The Company has determined its reportable segments based on the Company's method of internal reporting, which disaggregates its business by product category. The Company's reportable segments are: network services, product sales and consulting services. The network services segment provides local, metropolitan and wide area data communications services to customers. This segment also provides a wide variety of other services to customers, including remote network management and monitoring, network security, virtual private networks, e-commerce and CopperNet, the Company's high-speed, continuously connected DSL access to telecommunications networks. The product sales segment provides sales of selected equipment from manufacturing partners. Engineers select product solutions based upon customized network designs to improve the customers' operations and network efficiencies. The consulting services segment provides nonrecurring service activation and installation, network integration, on site network management, network security consulting and professional services. In addition, the consulting services segment provides maintenance and installation of equipment, some of which may be provided through third party providers under contract. The Company's business is currently conducted principally in the eastern United States. There are no foreign operations. Recent Accounting Pronouncements In June 1999, the Financial Accounting Standards Board issued SFAS No. 137, which delays the effective date of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which will be effective for the Company's fiscal year 2001. This statement establishes accounting and reporting standards requiring that every derivative instrument, including certain derivative instruments imbedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized in earnings unless specific hedge accounting criteria are met. The Company believes the adoption of SFAS No. 133 and SFAS No. 137 will not have a material impact on the financial statements. 3. Initial and Secondary Public Offerings In June 1999, the Company completed an initial public offering (IPO) of 7,500,000 shares of common stock. Total proceeds to the Company were $81,853,900, net of underwriting discounts and commissions of approximately $5,500,000 and offering costs of $1,846,100. Concurrent with the IPO, $5,000,000 of the Company's Series A Mandatorily Redeemable Preferred Stock (Preferred Stock) was converted into 416,667 shares of common stock at $12.00 per share, the public offering price, with the remaining shares of Preferred Stock and all accrued dividends and accretion amounting to $1,238,096 cancelled without additional payment to the holders of those shares. In addition, $10,000,000 of the Company's 8% convertible notes (see Note 6) were converted into 833,334 shares of common stock at $12.00 per share, the public offering price. On December 22, 1999, the Company filed a registration statement on Form S-1 for the sale of shares of their common stock in a secondary public offering that has not been completed. In connection with the preparation and filing of this registration statement the Company incurred costs of $259,272, of which $59,272 has been paid as of December 31, 1999. These offering costs have been deferred on the balance sheet and will be offset against the proceeds and reported as a reduction to stockholders' equity when the secondary offering occurs. 4. Short-term Investments As of December 31, 1999, the Company had invested in marketable securities with original maturity dates exceeding 90 days. These marketable securities, which principally consist of debt securities with corporations and foreign governments, are due in one year or less and are considered "available for sale" and, as such, are stated at fair value. The aggregate amortized cost of these marketable securities was $24,627,853 at December 31, 1999. Given the rise in interest rates from the purchase date of these securities the Company has recorded an unrealized loss of $51,960 for the year ended December 31, 1999 to reduce the carrying value of these securities to fair value of $24,575,893 as of December 31, 1999. These net unrealized losses are reported as a part of accumulated other comprehensive income (loss). Realized gains or losses from the sale of marketable securities are based on the specific identification method. There were no gross realized gains and gross realized losses on sales of available for sale securities during the year ended December 31, 1999. 5. Property and Equipment Property and equipment consists of the following: The Company's network includes equipment under capital leases, equipment, installation, and collocation fees. Collocation fees represent nonrecurring fees paid to obtain central office space for location of certain equipment. When a new portion of the Company's network has been completed and made available for use, it is transferred from network development to network placed in service. As of December 31, 1998 and 1999, the recorded cost of the network equipment under capital leases was $1,513,138 and $22,939,012, respectively. Accumulated amortization for this equipment under capital leases was $20,739 and $2,998,446 as of December 31, 1998 and 1999, respectively. 6. Note Payable On October 16, 1998, the Company entered into a $10,000,000 line of credit agreement and a $30,000,000 equipment financing agreement (see Note 8) with Ascend Communications, Inc. (Ascend). Under the terms of the line of credit, the Company could draw on the line of credit in $1,000,000 increments up to a maximum of $5,000,000. The Company could draw the remaining $5,000,000, also in $1,000,000 increments, upon (i) completing the purchase or lease of equipment in excess of $15,000,000 from Ascend and (ii) demonstrating that at least 70% of such equipment is being used by the Company to generate revenue. The Company was required to make interest only payments at an annual rate of 8.25% on the amounts advanced for the first nine months from the date of the advance. For the next thirty-three months the Company was required to make principal and interest payments in accordance with a sixty-month amortization schedule using an interest rate of 8.25% for the first eighteen months at a rate equal to the prevailing high yield bond index for the next fifteen months. The remaining unpaid interest was due forty-two months after the related advance. The credit agreement required immediate repayment in the event of an initial public offering or debt offering in excess of $40,000,000 or a change in control, as defined. At December 31, 1998, $1,000,000 was outstanding under this agreement. On May 4, 1999, the Company amended its financing agreement with Ascend. The amendment reduced the line of credit available for working capital loans from $10,000,000 to $5,000,000 and relieved the Company's obligation to repay these loans upon the Company's IPO. As of December 31, 1999, the Company's total obligation under this agreement for working capital was $2,932,136. Principal payments due under this note payable as of December 31, 1999 are as follows: The Company had a $1,500,000 line of credit agreement with a bank which matured on November 30, 1998, was repaid and not renewed. Interest on outstanding borrowings accrued at the bank's prime rate of interest plus three- quarters of a percent (9.25% during 1998). On March 31, 1999, the Company entered into a financing agreement whereby certain holders of its preferred stock agreed to invest an additional $10,000,000 in the Company. Under the agreement, the Company received $5,000,000 on April 1, 1999 and an additional $5,000,000 on May 11, 1999 by issuing 8% convertible notes. Concurrent with the IPO, these notes, including principal and accrued interest, were converted into 833,334 shares of common stock. 7. Deferred Compensation Liability The Company has an unfunded deferred compensation plan for certain key executives. Under the plan, executives deferred a portion of their compensation by electing future payments in three equal installments in June 1999, December 1999 and June 2000. At December 31, 1998 and 1999, the deferred compensation liability was $500,000 and $166,667, respectively. Interest accrues on deferred amounts on a quarterly basis at a rate determined by management which is currently 6% based on the rate of interest for three-year Federal treasury notes. Accrued interest related to these amounts was $47,500 and $25,833 at December 31, 1998 and 1999, respectively. 8. Commitments and Contingencies Leases The Company leases or subleases office space in Maryland, Massachusetts, New York, Pennsylvania and Virginia and collocation space in central offices under the terms of the interconnection agreements with Bell Atlantic and other vendors. On October 27, 1999, the Company executed a lease for space in Herndon, Virginia. The Company entered into a Letter of Credit agreement, in the amount of $1,600,000 with a financial institution, that will serve as collateral for this lease. The Company has begun to move its headquarters to this location in phases beginning in March 2000 and expects to complete the move in May 2000. Commitments for minimum rental payments under noncancelable leases and subleases at December 31, 1999 are as follows: Rent expense for the years ended December 31, 1997, 1998 and 1999 was $80,103, $113,600 and $1,580,211, respectively. During 1998 and 1999, the Company entered into capital leases related to the acquisition of equipment for the development of the DSL network. Initially, the Company entered into a master lease agreement with Ascend to finance purchases of up to $30,000,000 through capital lease agreements. During 1999, this agreement was amended and increased to $95,000,000. In addition, the Company has an arrangement with Paradyne Corporation whereby the Company can finance DSL equipment purchases of up to $8,000,000 subject to vendor approval. During 1999, the Company entered into two sales leaseback transactions with a vendor totaling $530,000. The leaseback transactions were accounted for as capital leases. The present value of future minimum capital lease payments as of December 31, 1999, is as follows: Purchase commitments On November 24, 1998, the Company entered into an agreement with a software and service provider to support its DSL services. The Company's single largest shareholder is also a shareholder of this software and service provider. Under the terms of the agreement, software licensing and service fees were $1,023,700 which were payable through a $185,000 deposit which was made upon signing the agreement, $402,700 due upon project completion, and $436,000 payable within twenty-four months of project completion. Amounts not paid within 30 days of project completion accrue interest at a rate of 10%. The Company commenced implementing the software and support service in 1999. As of December 31, 1999, all fees under this agreement had been paid. Employment agreements The Company has entered into an employment agreement with certain of its executive officers. Each agreement has an initial term of four years, subject to earlier termination upon 30 days prior notice. These agreements are automatically extended for additional one year terms unless the Company or the employee elects to terminate the agreement within 30 days before the end of the current term. Under these agreements, these employees will receive an initial annual base salary that will be increased by at least 5% each year, based upon performance objectives set by the Board of Directors. The employees will also receive an annual bonus of up to 20% of the executives' then current salary. The bonus is payable in cash, stock or a combination of both at the election of the board of directors. 9. Income Taxes The provision (benefit) for income taxes consists of the following: Deferred tax assets consist of the following: As of December 31, 1999, a valuation allowance was established to reduce total deferred tax assets to an amount that management believes will more likely than not be realized, based on income taxes paid in the loss carry-back period net of refundable taxes. A reconciliation between income taxes from operations computed using the federal statutory income tax rate and the Company's effective tax rate is as follows (there are no material changes to the Company's effective tax rate for 1999): 10. Mandatorily Redeemable Preferred Stock and Stockholders' Equity Mandatorily Redeemable Preferred Stock On August 6, 1998, the Company issued 10,000,000 shares of Series A mandatorily redeemable preferred stock (Preferred Stock) and 22,050,000 shares of common stock for total proceeds of $10,004,900, excluding direct issuance costs of $55,798. The Company had allocated $5,074,042 and $4,875,060 of the net proceeds to the Preferred Stock and common stock, respectively, based on the Company's estimate of fair value of the Preferred Stock and common stock. Concurrently with the IPO, $5,000,000 of the Company's Series A Mandatorily Redeemable Preferred Stock (Preferred Stock) was converted into 416,667 shares of common stock at $12.00 per share, the public offering price, with the remaining shares of Preferred Stock and all accrued dividends and accretion, amounting to $1,238,096, cancelled without additional payment to the holders of those shares. The Preferred Stock activity is summarized as follows: Stock Repurchase On August 6, 1998, the Company repurchased 8,550,000 shares of common stock for $1,900,000 from certain founders of the Company. This treasury stock transaction was accounted for at cost. 11. Stock-Based Compensation On July 23, 1998, the Company adopted the 1998 Incentive Stock Plan (the "Plan"), under which incentive stock options, non-qualified stock options, stock appreciation rights, restricted or unrestricted stock awards, phantom stock, performance awards or any combination thereof may be granted to the Company's employees and certain other persons in accordance with the Plan. The Board of Directors, which administers the Plan, determines the number of options granted, the vesting period and the exercise price. The Board of Directors may terminate the Plan at any time. Options granted under the Plan are fully exercisable into restricted shares of the Company's common stock upon award and expire ten years after the date of grant. The restricted common stock generally vests over a three or four year period. Subsequent to exercise, unvested shares of restricted stock cannot be transferred while vested shares are subject to a right of first refusal by the Company to repurchase the shares at fair value. Upon voluntary termination, unvested shares of restricted stock can be repurchased by the Company at the lower of fair value or the exercise price. At December 31, 1998, 9,000,000 shares were reserved for issuance under the Plan. Effective November 1, 1999, the Company increased the number of shares of common stock reserved for issuance under the Plan to 13,250,000. On April 1, 1999, the Company entered into a stock option agreement, which granted a board of director member an option to purchase 250,000 shares of the Company's common stock at an exercise price of $6.67 per share. On June 3, 1999, the board member exercised the stock option by paying $1,667,500 to the Company. In addition, the agreement stipulated the board of director member was issued an additional option to purchase 407,500 shares of common stock at an exercise price of $3.00 per share and is unexercised as of December 31, 1999. These options immediately vested upon the Company's IPO. As a result, the Company recognized $3,504,375 of compensation expense during the year ended December 31, 1999. As of December 31, 1998 and 1999, a total of 7,090,875 and 11,014,379, respectively, of stock options which were immediately exercisable as of those dates had been granted at exercise prices ranging from $.09 to $32.00 per share. Stock option activity was as follows: In certain instances, the Company has determined the fair value of the underlying common stock on the date of grant was in excess of the exercise price of the options. As a result, the Company recorded deferred compensation of $3,681,750 and $23,092,080 for the years ended December 31, 1998 and 1999, respectively. This amount was recorded as a reduction to additional paid-in capital and is being amortized as a charge to operations over the vesting periods which range from three to four years of the underlying restricted common stock. The Company recognized stock compensation expense related to those options of $218,997, and $8,165,293 for the years ended December 31, 1998 and 1999, respectively. SFAS No. 123, Accounting for Stock-Based Compensation, encourages adoption of a fair value-based method for valuing the cost of stock-based compensation. However, it allows companies to continue to use the intrinsic value method for options granted to employees and disclose pro forma net loss and loss per share. Had compensation cost for the Company's stock-based compensation plans been determined consistent with SFAS No. 123, the Company's net loss and loss per share would have been as follows: The weighted-average fair value of options granted during the years ended December 31, 1998 and 1999 was approximately $1.04 and $7.23, respectively, based on the Black-Scholes option pricing model. Upon termination, unvested shares of restricted stock are repurchased by the Company at the lower of the exercise price or fair market value. The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants during the years ended December 31, 1998 and 1999: Dividend yield of 0%; expected volatility of 0% to 92%; risk-free interest rates of 5.21% to 6.48%; and expected term of 5 years. As of December 31, 1998 and 1999, the weighted average remaining contractual life of the options is 9.8 and 8.8 years, respectively. 12. Employee Benefit Plan On September 16, 1998, the Company adopted the Network Access Solution, Inc. 401(k) Profit Sharing Plan and Trust (the Plan). As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax-deferred salary deductions for eligible employees. Participants must be at least 21 years of age and may make voluntary contributions to the Plan of up to 15% of their compensation not to exceed the federally determined maximum allowable contribution. The Company is not obligated to make contributions or to match participant contributions. Participants incrementally vest in Company contributions on a straight-line basis over their first three years of employment. The Company did not make contributions to the Plan during 1998. During 1999 the Company contributed $403,726 to the Plan. 13. Segment Information In accordance with SFAS No. 131, the Company discloses certain segment information. The financial results of the Company's segments are presented on an accrual basis. The Company evaluates the performance of its segments and allocates resources to them based on gross profit. There are no intersegment revenues. The table below presents information about the reported gross profit (loss) of the Company's reportable segments for the years ended December 31, 1997, 1998 and 1999. Asset information is not reported for the product sales and consulting services segments, as this data is not considered by the Company in making its decisions regarding operating matters. - -------- (1) Adjustments that are made to the total of the segments gross profit in order to arrive at income (loss) before income taxes are as follows: 14. Subsequent Events On February 8, 2000, the Company announced a strategic financing agreement with SBC Communications, Inc. (SBC) and Telefonos de Mexico, S.A. de C.V. (Telmex), in which both companies agreed to purchase a total of $150 million ($75 million each), of the Company's convertible preferred stock for $100 per share. Due to the Company's need to obtain regulatory approvals, the Company was not able to consummate the preferred stock sale upon execution of the strategic financing agreement. In order to provide the Company with financing to begin its strategic plan, SBC and Telmex loaned the Company a total of $30 million ($15 million each) until it received the necessary regulatory approvals to complete the preferred stock sale. The loans bore interest at a rate of prime plus 2% during the time they were outstanding. Upon obtaining the regulatory approval, the Company exchanged the loans for preferred stock and received the remaining proceeds upon the consummation of the preferred stock sale on March 7, 2000, net of the principal and accrued interest on these interim borrowings. In conjunction with the financing agreement, the Company executed a summary operating agreement with both SBC and Telmex, and intends to execute several definitive agreements with SBC and Telmex covering distinct operating areas during April 2000. In connection with the financing agreement, the Company also announced that it would be expanding its network into 20 additional markets in the southeastern and western regions of the United States. The proceeds from the preferred stock issuance will, in part, fund this expansion. The convertible preferred stock is non-voting pays a 7.0% dividend, which can be satisfied with either additional stock or cash. Each $100.00 share of preferred stock is convertible at any time at the election of the holder into 3.2258 shares of the Company's common stock, or a total of 4,838,700 common shares. The preferred stock may be called by the Company for mandatory conversion into its common stock at any time between two and five years after the original issue date, provided the Company's stock is trading above $31.00 per share. On each anniversary of the issue date, beginning on the second anniversary and ending on the seventh anniversary, the holders of the preferred stock may request that the Company redeem the shares for a cash amount equal to $100 per share plus unpaid dividends. The Company may postpone such right until the following year for all but the seventh year if its common stock share price is below $31.00 for a specified period preceding the anniversary date. The Company has agreed to use 50% of the proceeds from the preferred stock to more closely align its network and business operations with the future network and business operations of both SBC and Telmex. If SBC and Telmex convert their preferred stock positions into the Company's common stock, SBC will own approximately 4.8% and Telmex will own approximately 4.5% of the Company's equity on a fully diluted basis. SBC and Telmex have the right to maintain their percentage equity ownership interests in the Company's common stock through a right of primary offer mechanism in the financing agreement. This right permits them to purchase, in any subsequent offering of the Company's stock by the Company, on the same terms and conditions as the stock is offered to third parties, an amount of stock that will allow them to maintain their respective percentage ownership interests. Through a separate agreement with the Company's present principal stockholders, Spectrum Equity Investors II, L.P. and Jonathan P. Aust, the Company's Chief Executive Officer, SBC and Telmex also have a right of first offer to purchase, in certain circumstances, any shares that these stockholders may wish to sell in the future. On March 1, 2000, the Company adopted an Employee Stock Purchase Plan (ESPP). A total of 500,000 shares of common stock are initially available for issuance under the ESPP. The ESPP, which is intended to qualify under Section 423 of the IRS Code, will be implemented by a series of overlapping offering periods of 12 months' duration, with new offering periods, other than the first offering period, commencing on January 1 and July 1 of each year. Participants may not accrue payroll deductions exceeding $10,000 during any offering period. The purchase price per share at which shares will be sold in an offering under the ESPP will be the lower of 85% of the fair market value of a share of the Company's common stock on the first day of an offering period or 85% of the fair market value of a share of the Company's common stock on the last day of an offering period. The fair market value of the Company's common stock on a given date will be equal to the closing price of the Company's common stock on such date on The Nasdaq Stock Market, as reported in The Wall Street Journal. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Network Access Solutions Corporation: Our audits of the financial statements referred to in our report dated March 7, 2000, appearing in this Form 10-K also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. /s/ PricewaterhouseCoopers LLP McLean, Virginia March 7, 2000 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS (in thousands) All other schedules are omitted because they are not required, are not applicable, or the information is included in the financial statements or notes thereto. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. Inapplicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The following table shows information about our directors and executive officers as of March 15, 2000: Jonathan P. Aust has been our Chief Executive Officer since founding Network Access Solutions, with his wife Longma, in December 1994. In August 1998, Mr. Aust also became our President and Chairman of the Board of Directors, and served as our President until February 2000. Mr. Aust was the National Account Manager for AT&T Paradyne responsible for the Federal Reserve System from October 1987 to December 1994. From June 1982 to October 1987, Mr. Aust held numerous engineer and sales positions at Paradyne Corporation, a manufacturer of data communications equipment. Nicholas J. Williams has been our President and Chief Operating Officer since joining us in February 2000. Prior to joining us, Mr. Williams served as Chief Executive Officer and a member of the Board of Directors from July 1998, and as President from April 1997, of Premisys Communications, Inc., a manufacturer of integrated multiple access communications servers, until its acquisition by Zhone Technologies, Inc. in November 1999. Mr. Williams also served as Chief Operating Officer of Premisys between April 1997 and July 1998. From 1993 until his move to Premisys, Mr. Williams was Vice President and General Manager, International, of Tellabs, Inc., a telecommunications company, where he contributed to the growth of multiple product lines, including the DXX and wireless products. Christopher J. Melnick was our Chief Operating Officer from July 1998 to February 2000 when he became our Senior Vice President, Sales Development and Marketing, and has been a Director since August 1998. Mr. Melnick was the Vice President and General Manager for the Southeast Region of Level 3 Communications from March 1998 to July 1998. Mr. Melnick was a Vice President of Sales for Worldcom, and formerly, MFS Telcom, from September 1995 to March 1998. From June 1994 to September 1995, Mr. Melnick was a member of sales management at MFS Telcom. Scott G. Yancey, Jr. has been our Chief Financial Officer since joining us in July 1998 and a Director since August 1998. Mr. Yancey was the Chief Financial Officer and General Manager of the data division of Cable & Wireless USA, a telecommunications service provider, from July 1982 to May 1998. John J. Hackett has been our Senior Vice President, Sales and Marketing since joining us in February 1999. Mr. Hackett was the Division President of MCI WorldCom and MFS Telcom from September 1993 to February 1999 responsible for Sales and Customer Support. Lester M. Lichter has been our Chief Information Officer since October 1999. Prior to joining us, Mr. Lichter was Executive Vice President and Chief Information Officer of Excel Communications from November 1997 to February 1999, where he was responsible for developing information services solutions to support the company's business development activities. Mr. Lichter was Chief Information Officer of Cable & Wireless USA from June 1996 to November 1997. Before joining Cable & Wireless USA, Mr. Lichter was Vice President and Chief Information Officer of AT&T's Business Communications Systems group from December 1993 to May 1996. Worth D. MacMurray has been our Vice President, Legal and Strategic Projects, since joining us in September, 1999. Prior to joining us, Mr. MacMurray served as Vice President, Legal & Administration from November 1998 to August 1999 at Landmark Systems Corporation, a performance management software company. Prior to joining Landmark, Mr. MacMurray served as Vice President and General Counsel of Intersolv, Inc., a software tools company, from October 1997 to October 1998. From February 1988 to September 1997, Mr. MacMurray served in various legal capacities for GTSI, an information technology reseller, including as General Counsel. Brian D. Roberts has been our Vice President for Engineering and Operations since August 1999. Prior to joining us, Mr. Roberts was Managing Partner for Network Solutions in the Mid-Atlantic Region for USWeb/CKS from February 1998 to August 1999. Mr. Roberts was Vice President for Engineering and Operations for ACSI Advanced Data Systems Division (now e.spire Communications, Inc.) from November 1997 to February 1999. Before joining ACSI, Mr. Roberts was Vice President for Operations and Data Services at MFS Communications (now MCI WorldCom) from August 1992 to April 1997. Brion B. Applegate has been a Director of Network Access Solutions since August 1998. Mr. Applegate is a co-founder and has been a Managing General Partner of Spectrum, a private equity fund, since March 1993. Mr. Applegate is a director of Tut Systems, Inc., a provider of broadband access services to multi-tenant buildings. Dennis R. Patrick has been a Director of Network Access Solutions since April 1999. Since February 2000, Mr. Patrick has been the President of AOL Wireless (a division of AOL Online, Inc.), a deliverer of AOL content and services to wireless devices. In addition, Mr. Patrick is and has been the President and Chief Executive Officer of Patrick Communications Inc. and Doeg Hill Ventures LLC since November 1997. Patrick Communications provides analysis of investment opportunities in the telecommunications and media industries to a select group of clients. Doeg Hill Ventures is a closely held venture capital enterprise focusing on early stage investments in the telecommunications industry. Mr. Patrick was the founder and Chief Executive Officer of Milliwave LP, a local exchange telephone company using digital radio frequencies to transmit data, from June 1995 to January 1997. Milliwave was acquired by Winstar Communications in January 1997, and Mr. Patrick served on the board of directors of the combined entity until September 1997. From February 1990 to December 1995, Mr. Patrick served as Chief Executive Officer of Time Warner Telecommunications, a division of Time Warner Entertainment. From November 1983 to August 1989, Mr. Patrick was a Commissioner and then Chairman of the FCC. Our executive officers are elected by our board of directors and serve at its discretion. There are no family relationships among our executive officers and directors. Our certificate of incorporation and bylaws provide for a classified board of directors consisting of three classes of directors, each serving three-year terms. As a result, a portion of our board of directors will be elected each year. Prior to consummation of our initial public offering on June 3, 1999, two of the nominees to the board were elected to a one-year term, two were elected to two-year terms and one was elected to a three-year term. Thereafter, directors will be elected for three-year terms. Messrs. Yancey and Melnick are Class I directors with terms expiring at the 2000 annual meeting of stockholders, Messrs. Applegate and Patrick are Class II directors, with terms expiring at the 2001 annual meeting of stockholders, and Mr. Aust is Class III director, with a term expiring at the 2002 annual meeting of stockholders. Board Committees Our board of directors established an audit committee in April 1999. The audit committee consists of Messrs. Applegate and Patrick. The responsibilities of the audit committee include: . recommending to our board of directors the independent public accountants to conduct the annual audit of our books and records; . reviewing the proposed scope of the audit; . approving the audit fees to be paid; . reviewing accounting and financial controls with the independent public accountants and our financial and accounting staff; and . reviewing and approving transactions between us and our directors, officers and affiliates. Our board of directors established a compensation committee in August 1998. The compensation committee consists of Messrs. Aust, Applegate and Patrick. The compensation committee determines the compensation of our executive officers and administers our stock plans and generally reviews our compensation plans to ensure that they meet our objectives. Mr. Aust does not participate in decisions regarding his own compensation. Compensation Committee Interlocks and Insider Participation During 1999, members of our compensation committee were Messrs. Aust and Applegate. None of our executive officers has served as a member of the compensation committee or other committee serving an equivalent function of any other entity, whose executive officers served as a director of or member of our compensation committee. Mr. Aust is our Chief Executive Officer. Mr. Applegate is the Managing General Partner of Spectrum, which is a holder of approximately 42.2% of our common stock. See "Related Transactions and Relationships" for a description of transactions between our company and Mr. Aust, and between our company and Spectrum. Directors' Compensation Our directors have received no compensation for serving as directors. We reimburse our directors for reasonable expenses they incur to attend board and committee meetings. Our non-employee directors are eligible to receive grants of options to acquire our common stock under our stock incentive plan. In April 1999, we granted an option to acquire 250,000 shares of our common stock at a price of $6.67 per share to Mr. Patrick. On June 3, 1999, Mr. Patrick received an option to purchase an additional 407,500 shares of common stock at an exercise price equal to $3.00 per share. Mr. Patrick exercised the option to acquire 250,000 shares of our common stock on June 3, 1999. The options granted to Mr. Patrick vested immediately upon the completion of our initial public offering on June 3, 1999. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934 requires our directors and officers, and persons who own more than 10% of a registered class of our equity securities, to file with the SEC reports concerning their beneficial ownership of our equity securities. Pursuant to Item 405 of Regulation S-K, we have an affirmative duty to provide disclosure of "insiders" who do not timely file such reports. To our knowledge, based solely on our review of the copies of such forms received by us from its directors, officers and greater than 10% beneficial owners, Messrs. MacMurray, Melnick, Yancey and Williams each filed on an untimely timely basis one report, each containing one transaction relating to common stock beneficially owned by them. Item 11. Item 11. Executive Compensation. Executive Compensation Summary Compensation Table. The following table summarizes the compensation paid to our chief executive officer and the three other executive officers whose total salary and bonus exceeded $100,000 during 1999, whom we identify as "named executive officers": - -------- (1) Includes amounts, if any, deferred by the named executive officer pursuant to our 401(k) plan. (2) Bonuses are based on corporate and individual performance. (3) Pursuant to SEC rules, perquisites not exceeding the lesser of $50,000 or 10% of a named executive officer's combined salary and bonus are not required to be reported. (4) Represents compensation for that portion of the year in which the officer commenced employment with us. Options Grants in 1999. The following table shows information about our grants of options to purchase our common stock made to the named executive officers during 1999: - -------- (1) All options were granted under our 1998 stock incentive plan. All options were incentive stock options that vest over time. Generally, these options vest in quarterly installments over 36 to 48 months. All of these options immediately vest in the event of a change in control of our company. If a majority of our stockholders elect to sell all or part of our company, then the option holder is required to sell an equivalent percentage of the shares underlying the option. (2) Based on options to purchase 4,720,100 shares of our common stock granted to employees in 1999. (3) Based on our initial public offering price, in accordance with SEC guidance on treatment of options granted prior to our initial public offering. (4) The options have ten-year terms, subject to earlier termination upon death, disability or termination of employment. (5) We recommend caution in interpreting the financial significance of the figures representing the potential realizable value of the stock options. They are calculated by multiplying the number of options granted by the difference between a future hypothetical stock price and the option exercise price and are shown pursuant to rules of the SEC. They assume the fair value of common stock appreciates 5% or 10% each year, compounded annually, for ten years (the term of each option). They are not intended to forecast possible future appreciation, if any, of our stock price or to establish a present value of options. Also, if appreciation does occur at the 5% or 10% per year rate, the amounts shown would not be realized by the recipients until the year 2009. Depending on inflation rates, these amounts may be worth significantly less in 2009, in real terms, than their value today. Aggregated Option Exercises in 1999 and Option Values at December 31, 1999. The following table sets forth information with respect to the named executive officers concerning the exercise of options during the year ended, and unexercised options held as of, December 31, 1999: - -------- (1) Represents the excess of the market value of the shares acquired upon exercise of such options over the exercise price of such options. (2) Represents the excess of the market value of the shares subject to such options over the exercise price of such options. No compensation intended to serve as incentive for performance to occur over a period longer than one year was paid pursuant to a long-term incentive plan during the last year to any of the named executive officers. Employment Arrangements. We have entered into employment agreements with each of the named executive officers. Each of these agreements has an initial term of four years, subject to earlier termination upon 30 days prior notice. The term of each agreement is automatically extended for additional one-year terms unless we or the executive elects to terminate the agreement within 30 days before the end of the current term. Under these agreements, these executives receive an initial annual base salary that will be increased by at least 5% each year, based upon performance objectives set by our board of directors. These executives also receive an annual bonus of up to 20% of the executive's then current salary. The bonus is payable in cash, stock or a combination of both at the election of our board of directors. The executives have received options to acquire shares of our common stock that vest in quarterly installments over either three or four years from the date of grant. The following table shows information about the current compensation arrangements we have with our named executive officers: The annual bonus and any salary increase for Mr. Aust are determined by our compensation committee on an annual basis, and Mr. Aust does not participate in decisions regarding his own compensation. If, during the term of one of these employment agreements, we terminate the executive's employment without cause or the executive terminates his employment for good reason, then the executive will be entitled to receive his base salary, bonus and all employee benefits for a period of one year from the date of the termination of employment. Under the terms of these agreements, these executives have agreed to preserve the confidentiality and the proprietary nature of all information relating to our business during the term of the agreement and after the agreement ends indefinitely. In addition, each of these executives has agreed to non-competition and non-solicitation provisions that will be in effect during the term of his agreement and for one year after the agreement ends. We require all of our employees to sign agreements that prohibit the employee from directly or indirectly competing with us while they are employed by us and generally for a period of one year thereafter. We require all of our employees to sign agreements that prohibit the disclosure of our confidential or proprietary information. 1998 Stock Incentive Plan. Our stock incentive plan authorizes the grant of: . stock options; . stock appreciation rights; . stock awards; . phantom stock; and . performance awards. The compensation committee of our board of directors administers our stock incentive plan. The committee has sole power and authority, consistent with the provisions of our stock incentive plan, to determine which eligible participants will receive awards, the form of the awards and the number of shares of our common stock covered by each award. The committee may impose terms, limits, restrictions and conditions upon awards, and may modify, amend, extend or renew awards, to accelerate or change the exercise timing of awards or to waive any restrictions or conditions to an award. The maximum number of shares available for issuance under our stock incentive plan is 13,250,000. As of March 15, 2000, we had 10,645,005 shares of common stock subject to outstanding options at a weighted average exercise price of $4.23 per share. Stock Options. Our stock incentive plan permits the granting of options to purchase shares of our common stock intended to qualify as incentive stock options under the Internal Revenue Code and stock options that do not qualify as incentive options. The option exercise price of each option will be determined by the committee. The term of each option will be fixed by the committee. The committee will determine at what time or times each option may be exercised and the period of time, if any, after retirement, death, disability or termination of employment during which options may be exercised. Stock Appreciation Rights. The committee may grant a right to receive a number of shares or, in the discretion of the committee, an amount in cash or a combination of shares and cash, based on the increase in the fair market value of the shares underlying the right during a stated period specified by the committee. Stock Awards. The committee may award shares of our common stock to participants at no cost or for a purchase price. These stock awards may be subject to restrictions or may be free from any restrictions under our stock incentive plan. The committee shall determine the applicable restrictions. The purchase price of the shares of our common stock will be determined by the committee. Phantom Stock. The committee may grant stock equivalent rights, or phantom stock, which entitle the recipient to receive credits that are ultimately payable in the form of cash, shares of our common stock or a combination of both. Phantom stock does not entitle the holder to any rights as a stockholder. Performance Awards. The committee may grant performance awards to participants entitling the participants to receive cash, shares of our common stock, or a combination of both, upon the achievement of performance goals and other conditions determined by the committee. The performance goals may be based on our operating income, or on one or more other business criteria selected by the committee. Employee Stock Purchase Plan. On March 1, 2000, we adopted an Employee Stock Purchase Plan, or ESPP. A total of 500,000 shares of common stock are initially reserved for issuance under the ESPP. The ESPP, which is intended to qualify under Section 423 of the IRS Code, will be implemented by a series of overlapping offering periods of 12 months' duration each. New offering periods, other than the first offering period, will commence on January 1 and July 1 of each year. Participants will not be permitted to accumulate payroll deductions that exceed $10,000 during any offering period. The purchase price per share at which shares will be sold in an offering under the ESPP will be the lower of 85% of the fair market value of a share of our common stock on the first day of an offering period or 85% of the fair market value of a share of our common stock on the last day of an offering period. The fair market value of our common stock on a given date will be equal to the closing price of our common stock on such date on the Nasdaq National Market, as reported in The Wall Street Journal. Implementation of the ESPP will require approval of a majority of our shareholders, a vote of whom will be taken at our scheduled June 6, 2000 annual meeting. The following performance graph shall not be deemed incorporated by reference by any general statement incorporating by reference this Form 10-K into any filing under the Securities Act of 1933 or under the Securities Exchange Act of 1934, except to the extent that we specifically incorporate this information by reference, and shall not otherwise be deemed filed under such Acts. PERFORMANCE GRAPH The following graph compares the annual percentage change in the cumulative total return on our common stock with the cumulative total return of the Nasdaq Composite Index and a Peer Index of companies with the same four-digit standard industrial classification (SIC) code as the Company (SIC Code 4813 -- Telephone Communications Except Radiotelephone) for the period commencing June 4, 1999 (the date of our initial public offering) and ending December 31, 1999. The stock price performance shown on the graph below assumes: (i) $100 invested on June 4, 1999 in our common stock and in the stocks of the companies comprising the Nasdaq Composite Index and the Peer Group Index; and (ii) immediate reinvestment of all dividends. This stock price performance is not necessarily indicative of future price performance. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The following shows the number and percentage of outstanding shares of our common stock that were owned as of March 15, 2000 by: . all persons known to us to beneficially own more that 5% of our common stock; . each director and named executive officer; and . all directors and executive officers as a group. An asterisk indicates ownership of less than 1%. As of March 15, 2000, there were 46,760,750 shares of our common stock outstanding. - -------- (1) The address of Messrs. Aust, Hackett, Melnick, Patrick and Yancey is 100 Carpenter Drive, Sterling, Virginia 20164. (2) The number of shares beneficially owned by each person includes outstanding shares of our common stock and shares of our common stock issuable upon conversion of our Series B preferred stock and exercise of stock options exercisable within 60 days of March 15, 2000. (3) Spectrum Equity Investors II, L.P. is under common control with SEA 1998 II, L.P., or SEA, and, therefore, beneficial ownership of the shares of our common stock owned by SEA is attributed to Spectrum Equity Investors. Mr. Applegate is a Managing General Partner of Spectrum Equity Investors and, therefore, beneficial ownership of the shares of our common stock owned by Spectrum Equity Investors is attributed to Mr. Applegate. (4) Includes 374,999 shares held by the Jonathan P. Aust Grantor Retained Annuity Trust, 5,962,660 shares held by Longma M. Aust, Mr. Aust's wife, and 375,001 shares held by the Longma M. Aust Grantor Retained Annuity Trust. (5) Includes shares issuable upon conversion of 750,000 shares of our Series B preferred stock. As reported in the Schedule 13-D dated March 8, 2000, filed by SBC Communications Inc. (6) Includes shares issuable upon conversion of 750,000 shares of our Series B preferred stock. As reported in the Schedule 13-G dated March 17, filed by Carlos Slim Helu, Telefonos de Mexico, S.A. de C.V., or Telmex Parent, is the beneficial owner of 2,777,773 shares. Of such 2,777,773 shares, Telmex Communications, LLC is the beneficial owner of 2,419,350 shares, which it has the right to acquire upon conversion of 750,000 shares of our Series B preferred stock owned by it. The shares beneficially owned by Telmex Parent are owned indirectly through Telmex Communications, L.L.C. and Inmobiliaria Aztlan, S.A. de C.V., each a wholly-owned subsidiary of Telmex Parent. Carso Global Telecom, S.A. de C.V. , or CGT, is the beneficial owner of the 2,777,773 shares. Each of Carlos Slim Helu, Carlos Slim Domit, Marco Antonio Slim Domit, Patrick Slim Domit, Maria Soumaya Slim Domit, Vanessa Paolo Slim Domit and Johanna Monique Slim Domit, which we collectively refer to as the Slim Family, as majority owners of CGT, are the beneficial owners of 2,777,773 shares, and has shared power to dispose of such shares. CGT may be deemed to control Telmex Parent through the regular voting shares of Telmex Parent that it owns directly, as well as through its interest in a trust, which we refer to as the Control Trust, that owns all of the outstanding Series AA shares of Telmex Parent, or AA Shares. The principal beneficiaries of the Control Trust are CGT, which owns a 45.0% economic and voting interest in the trust, SBC, which owns a 24.5% economic and voting interest in the trust, and France Telecom, which owns a 24.5% economic and voting interest in the trust. Under the terms of the Control Trust, the trustee must vote all shares held in the Control Trust as instructed by a simple majority of the members of a technical committee appointed by the trust's beneficiaries (except in the case of certain significant corporate matters). The Control Trust entitles CGT to appoint a majority of the members of such technical committee; therefore, CGT may be deemed to control the Control Trust. Through its ownership of all the outstanding AA Shares, the Control Trust owns a majority of Telmex Parent's outstanding regular voting equity securities. Therefore, through the Control Trust, CGT may be deemed to control Telmex Parent. All information presented in this footnote relating to Telmex Parent, Telmex Communications, LLC, Inmobiliaria Aztlan, S.A. de C.V., CGT and the Slim Family is based solely on the Schedule 13-G filed by Carlos Slim Helu. (7) Includes 712,502 shares issuable upon exercise of options to acquire our common stock. (8) Includes 1,282,500 shares issuable upon exercise of options to acquire our common stock. (9) Includes 407,500 shares issuable upon exercise of options to acquire our common stock. (10) Includes 337,500 shares issuable upon exercise of options to acquire our common stock. (11) Includes 2,796,251 shares issuable upon exercise of options to acquire our common stock that are held by Messrs. Hackett, Lichter, MacMurray, Melnick, Patrick, Roberts and Yancey. Item 13. Item 13. Certain Relationships and Related Transactions. In August 1998, we entered into a Series A Preferred Stock Purchase Agreement with Spectrum, FBR Technology Venture Partners, LLC, or FBR, and other investors and issued a total of 10,000,000 shares of mandatorily redeemable preferred stock and 22,050,000 shares of common stock in exchange for $10,004,900. Pursuant to this agreement, we issued to Spectrum and its affiliates 8,470,000 shares of our Series A preferred stock and 18,676,350 shares of our common stock in exchange for an aggregate purchase price of $8,474,150. As of March 15, 2000, Spectrum beneficially owned 42.2% of our common stock. Brion B. Applegate, a Managing General Partner of Spectrum, is a member of our board of directors. We also issued to FBR 1,500,000 shares of our Series A preferred stock and 3,307,500 shares of our common stock in exchange for an aggregate purchase price of $1,500,735. As of March 15, 2000, FBR owned 7.5% of our common stock. In March 1999, we entered into a note purchase agreement with Spectrum and FBR. Pursuant to this agreement, Spectrum purchased a convertible note in the principal amount of $4,250,000, and FBR purchased a convertible note in the principal amount of $750,000. The principal of and interest on the notes were converted into 416,667 shares of our common stock upon the closing of our initial public offering. Pursuant to our amended note purchase agreement, Spectrum purchased an additional convertible note in the principal amount of $4,250,000 and FBR purchased an additional convertible note in the principal amount of $750,000 on May 17, 1999. Those notes converted into an aggregate of 416,667 shares of our common stock upon the closing of the initial public offering on June 3, 1999. In March 1999, we amended our certificate of incorporation to modify the terms of our then outstanding Series A preferred stock. Upon completion of our initial public offering on June 3, 1999, 50% of our Series A redeemable preferred stock was cancelled and ceased to exist without compensation or recourse, and the remaining shares of Series A preferred stock were converted into 416,667 shares of our common stock. Following the sale of our Series A preferred stock in August 1998, we repurchased some of the shares of our common stock held by James A. Aust, Jonathan P. Aust, Longma M. Aust and Stephen C. Aust. We repurchased 1,350,000 shares of our common stock for an aggregate purchase price of $300,000 from James A. Aust. We repurchased 1,953,950 shares of our common stock for an aggregate purchase price of $434,211 from Jonathan P. Aust. We repurchased 3,986,051 shares of our common stock for an aggregate purchase price of $885,789 from Longma M. Aust. We repurchased 1,260,000 shares of our common stock for an aggregate purchase price of $280,000 from Stephen C. Aust. Jonathan P. Aust and Longma M. Aust are husband and wife. James A. Aust, Jonathan P. Aust and Stephen C. Aust are brothers. In March 1999, we issued an option to purchase 1,350,000 shares of our common stock at an exercise price of $0.09 per share to Mr. Hackett, our Vice President, Sales and Marketing. In August 1999, we issued options to purchase 125,000 shares of common stock at an exercise price of $5.12 to both Mr. MacMurray, our Vice President, Legal and Strategic Projects, and Mr. Roberts, our Vice President, Engineering and Operations. In October 1999, we issued an option to purchase 75,000 shares of our common stock at an exercise price of $12.62 to Mr. Lichter, our Chief Information Officer. We have also granted options to acquire shares of our common stock to Messrs. Patrick, James A. Aust and Melnick that are described under "Item 10 - -Directors and Executive Officers of the Registrant--Directors' Compensation" and "Management--Executive Compensation." We have entered into employment agreements with each of the named executive officers. For details of these agreements, see "Item 11 - - Executive Compensation." In November 1998, we entered into an agreement with a software and service provider to support its DSL services. Spectrum, our single largest shareholder, is also a shareholder of this software and service provider. Under the terms of the agreement, software licensing and service fees were $1,023,700 which were payable through a $185,000 deposit which was made upon signing the agreement, $402,700 due upon project completion, and $436,000 payable within twenty-four months of project completion. Amounts not paid within 30 days of project completion accrue interest at a rate of 10%. We commenced implementing the software and support service in 1999. As of December 31, 1999, all fees under this agreement had been paid. We believe that the transactions discussed above were made on terms no less favorable to us than would have been obtained from unaffiliated third parties. We have adopted a policy that requires all future transactions between us and our officers, directors and affiliates to be on terms no less favorable than could be obtained from unrelated third parties. These transactions must be approved by a majority of the disinterested members of our board of directors. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) Financial Statements See the Index included in Item 8 on Page 41 of this Form 10-K. (2) Financial Statement Schedules See the Index included in Item 8 on page 41 of this Form 10-K. (3) Exhibits - -------- /1 /Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 333-93455). /2 /Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 333-74679). /3 /Confidential portions omitted and supplied separately to the Securities and Exchange Commission. (b) Reports on Form 8-K None. (c) Exhibits See the list of Exhibits in Item 14(a)(3) beginning on Page 74 of this Form 10-K. (d) Financial Statement Schedules See the Index included in Item 8 on page 41 of this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Sterling, Commonwealth of Virginia. Network Access Solutions Corporation Dated: March 27, 2000 /s/ Jonathan P. Aust By: _________________________________ Jonathan P. Aust, Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. EXHIBIT INDEX - -------- /1 /Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 333-93455). /2 /Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 333-74679). /3 /Confidential portions omitted and supplied separately to the Securities and Exchange Commission.

920465_1999.txt

920465_1999

1999

920465

ITEM 1. BUSINESS. OVERVIEW La Jolla Pharmaceutical Company is a biopharmaceutical company focused on the research and development of highly specific therapeutics for the treatment of certain life-threatening antibody-mediated diseases. These diseases, including autoimmune conditions such as lupus and antibody-mediated stroke, are caused by abnormal B cell production of antibodies that attack healthy tissues. Current therapies for these autoimmune disorders address only symptoms of the disease, or nonspecifically suppress the normal operation of the immune system, which often results in severe, adverse side effects and hospitalization. Founded in 1989, the Company believes that its drug candidates, called Toleragens(R), will treat the underlying cause of many antibody-mediated diseases without these severe, adverse side effects. We are currently analyzing data from a Phase II/III clinical trial of our lupus drug candidate, LJP 394, and plan to meet with the FDA in the near future to discuss requirements for approval including the possibility of a Phase III trial. ANTIBODY-MEDIATED DISEASES The immune system is the major biological defense mechanism responsible for recognizing and fighting disease. The immune system identifies antigens, such as bacteria, viruses and other disease-causing substances, and seeks to rid the body of these antigens. There are two fundamental types of immune responses: cell-mediated and antibody-mediated. Cell-mediated immunity is primarily responsible for ridding the body of cells that have become infected. Antibody-mediated immunity is primarily responsible for eliminating circulating antigens. These immune responses are controlled by the activities of white blood cells called T cells and B cells. T cells provide cell-mediated immunity and regulate B cells. B cells produce antibodies that recognize and help to eliminate antigens. Each B cell produces antibodies against a specific structure on the antigen's surface called an epitope. The B cell is triggered to produce antibodies when the specific epitope is recognized by and binds to the antibody receptors on the surface of the B cell, and only when the B cell receives an appropriate signal from a T cell. When an epitope binds to the B cell with no corresponding T cell signal, the B cell may become "tolerized" and cease to produce antibodies. A properly functioning immune system distinguishes between foreign antigens and the body's healthy tissues. In a malfunctioning immune system, healthy tissue may trigger an immune response that causes B cells to produce disease-causing antibodies, resulting in antibody-mediated autoimmune disease. For example, B cells can produce disease-causing antibodies that are associated with the destruction of the kidneys in lupus and the wasting of muscles in myasthenia gravis. Other antibody-mediated disorders include antibody-mediated stroke, heart attack, deep vein thrombosis, recurrent fetal loss, as well as organ rejection in xenotransplantation, myasthenia gravis and Rh hemolytic disease of the newborn. Current therapies for antibody-mediated diseases have significant shortcomings, including severe side effects and a lack of specificity. Mild forms of antibody-mediated diseases are generally treated with drugs that address only the disease symptoms and fail to suppress disease progression, because such drugs do not control the production of disease-causing antibodies. Severe antibody-mediated diseases like lupus are treated with high levels of corticosteroids and immunosuppressive therapy (primarily anti-cancer drugs) which broadly suppress the normal function of the entire immune system. These therapies can leave patients susceptible to potentially life-threatening infections that may require hospitalization. Repeated dosing with corticosteroids may cause other serious conditions, including diabetes, hypertension, cataracts, osteonecrosis, and psychosis, which may limit the use of this therapy. The use of chemotherapy may lead to acute problems, including weight loss and nausea, and long-term adverse effects, including sterility and an increased risk of malignancies. LJP'S TOLERANCE TECHNOLOGY(R) PROGRAM Our Tolerance Technology program focuses on the discovery and development of proprietary therapeutics, called Toleragens, which target and suppress the production of specific disease-causing antibodies without affecting the protective functions of the immune system. The Company believes that its Toleragens will be able to treat the underlying causes of antibody-mediated diseases, and that its Tolerance Technology may be applied broadly wherever antibodies are involved in the disease process. Since the 1970s, hundreds of papers have been published describing animal studies and a Nobel Prize was awarded for research in B cell tolerance. The underlying science supporting the Company's Tolerance Technology is based on these discoveries as well as on our own patented research. Toleragens are composed of disease-specific epitopes and a carrier platform, which are proprietary chemical structures developed and synthesized by LJP. To mimic the unique epitopes on an antigen's surface, LJP identifies and synthesizes epitopes specific to particular antibody-mediated diseases and attaches or conjugates these epitopes to the carrier platform, which serves as a vehicle for presenting the epitopes to the antibody receptors on the targeted B cell. When the epitope binds to the antibody receptors on the B cell in the absence of a T cell signal, the B cell may become tolerized and cease to produce disease-causing antibodies. We believe that the Toleragen carrier platform, or a modification thereof, can be used with epitopes specific to various diseases to create therapeutics targeted at different antibody-mediated diseases. We design our Toleragens to bind selectively to disease-causing B cells without affecting the function of disease-fighting B cells. This process involves: (1) collecting and purifying the disease-causing antibodies from patients with the targeted disease; (2) generating and selecting an epitope that strongly binds to the purified antibodies; (3) modifying the epitope's structure to maximize its binding properties (optimization), and (4) linking the optimized epitope to the carrier platform. We believe this process enables us to create Toleragens that will preferentially tolerize and shut down B cells that generate antibodies with the highest binding affinity, and which are believed to be the most harmful. BUSINESS STRATEGY Our objective is to become the leading developer of highly specific therapeutics for the treatment of life-threatening, antibody-mediated diseases such as lupus, antibody-mediated stroke, heart attack, deep vein thrombosis, recurrent fetal loss, as well as organ rejection in xenotransplantation, myasthenia gravis and Rh hemolytic disease of the newborn. Our strategy includes the following key elements: Complete the Clinical Development of LJP 394. Our primary near-term goal is to complete development of LJP 394 to treat lupus. Following our analysis of the Phase II/III clinical trial of LJP 394, we plan to meet with the FDA to discuss their requirements for approval of the drug including the possible need for a Phase III clinical trial. Apply Tolerance Technology to Life-threatening Antibody-mediated Diseases. We are focusing on chronic, life-threatening diseases and conditions caused by antibodies, such as lupus, antibody-mediated thrombosis and organ rejection in xenotransplantation, for which there are no existing treatments or for which current therapeutics have significant limitations. We intend to use our Tolerance Technology to design therapeutics that specifically address other targeted antibody-mediated diseases without adversely affecting normal immune system function. Utilize Strategic Collaborations to Develop and Commercialize Product Candidates. We intend to seek appropriate collaborations with pharmaceutical companies to provide support for our research programs and for the clinical development and commercialization of other drug candidates. Expand Intellectual Property Leadership Position. We own 87 issued patents and have 52 pending patent applications covering our various technologies and drug candidates, including our Tolerance Technology, our lupus, antibody-mediated thrombosis, and xenotransplantation drug candidates, and our platform and linkage technologies for our Toleragens. We hope to broaden our position with future discoveries and additional patent filings. PRODUCTS UNDER DEVELOPMENT The Lupus Program Systemic lupus erythematosus is a life-threatening, antibody-mediated disease where disease-causing antibodies damage various tissues. According to recent statistics compiled by the Lupus Foundation of America, epidemiological studies and other sources, the number of lupus patients in the United States is estimated to be between 250,000 and 1,000,000, and approximately 16,000 new cases are diagnosed each year. Approximately nine out of 10 lupus patients are women, who usually develop the disease during their childbearing years. Lupus is characterized by a multitude of symptoms, including chronic kidney inflammation (which can lead to kidney failure), serious episodes of cardiac and central-nervous-system inflammation, as well as extreme fatigue, arthritis and rashes. Approximately 80% of all lupus patients will progress to serious symptoms. Approximately 50% of lupus patients have kidney disease. Antibodies to dsDNA can be detected in approximately 90% of untreated lupus patients. These antibodies are widely believed to cause kidney disease (nephritis), often resulting in morbidity and mortality in lupus patients. These antibodies are also associated with episodes of potentially life-threatening inflammation -- called "flares" -- that may occur more than once per year and usually require intensive-care hospitalization. Significant kidney destruction occurs during a flare. Lupus nephritis can lead to deterioration of kidney function and to end-stage kidney disease, requiring long-term renal dialysis or kidney transplantation to sustain the patient's life. Current treatments for lupus patients with kidney disease and other serious symptoms usually include repeated administration of corticosteroids, often at high levels that can have toxic effects when used as a chronic treatment regimen. Many patients with advanced disease are also treated with immunosuppressive therapy, including anti-cancer drugs that have a general suppressive effect on the immune system and may be carcinogenic. This immunosuppressive treatment leaves the patient vulnerable to serious infection and is a significant cause of morbidity and mortality. LJP has designed LJP 394 to suppress the production of antibodies to dsDNA in lupus patients without suppressing the normal function of the immune system. The design of LJP 394 is based upon scientific evidence of the role of antibodies to dsDNA in lupus. Published studies of lupus patients indicate that a rise in the level of antibodies to dsDNA may be predictive of flares in lupus patients with renal involvement, and that suppressing antibodies to dsDNA by treating with corticosteroids that non-specifically lower antibody levels prevents relapses in a majority of patients. In a mouse model of lupus nephritis that generates elevated levels of antibodies to dsDNA, administration of LJP 394 reduced the production of antibodies to dsDNA; reduced the number of antibody-forming cells; reduced kidney disease; and extended the life of the animals. We believe that our own and other studies provide evidence that inhibiting antibodies to dsDNA may provide an effective therapy for lupus nephritis. Certain studies of lupus patients indicate that antibodies to dsDNA with the highest binding affinity are associated with the most damage to the kidneys. We believe that our Tolerance Technology drug candidate preferentially targets these antibodies. Results of Clinical Trials Based on its preclinical findings, we filed an Investigational New Drug ("IND") application for LJP 394 with the FDA in August 1994. In a double-blind, placebo-controlled Phase I clinical trial conducted in December 1994, healthy volunteers received LJP 394 and displayed no significant drug-related adverse effects and no immune reaction to the drug. Our Phase II clinical trials included a single-dose trial; a repeat escalating-dose trial; and a dose-ranging trial. The single-dose clinical trial evaluated the safety of a single, 100 mg intravenous dose of LJP 394 in four female lupus patients by monitoring antibody levels, blood chemistry, vital signs and complement (inflammation-promoting proteins) levels for 28 days after dosing. LJP 394 was well tolerated by all four patients, with no drug-related adverse clinical symptoms and no clinically significant complement level changes. In addition, no clinically significant immune complex formation (inflammation-promoting accumulation of antibodies and antigens) was observed, indicating the absence of an adverse immune response to LJP 394. A transient reduction in dsDNA antibody levels was also observed. These results were presented at the American College of Rheumatology's Annual International Conference in October 1996. The repeat escalating-dose clinical trial involved two female patients, each receiving doses of 10, 10, 50, 50, 100 and 100 mg of LJP 394 at two-week intervals. After the 10-week dosing regimen, patients were followed for six weeks. LJP 394 was well tolerated with no drug-related adverse clinical symptoms, no clinically significant complement changes, and no significant immune complex formation. Six weeks after the last dose, the antibody levels in both patients remained suppressed below baseline levels. The dose-ranging trial evaluated 58 patients with mild lupus symptoms (53 females and five males). All patients were clinically stable and had dsDNA antibody levels exceeding those generally found in healthy individuals. The patients were organized into nine treatment groups at three dose levels (1 mg, 10 mg and 50 mg), and three frequencies (once per week, once every two weeks and once every four weeks). Patients were randomized to one of the nine treatment groups so that at each dose and frequency, four to seven patients received LJP 394 and one patient received a placebo. Patients in the weekly treatment groups showed a dose-response correlation between increasing doses of LJP 394 and reductions of levels of dsDNA antibodies. In patients treated weekly with 10 mg or 50 mg doses of LJP 394, antibodies to dsDNA were reduced by statistically significant levels and remained suppressed in certain patients for up to two months after the last dose. In the patient group treated weekly with 50 mg, the reductions in median levels of dsDNA antibodies were accompanied by increases in median levels of two important inflammation-related complement proteins, C3 and C4, which normally decrease during active lupus renal disease and increase with clinical improvement. These study data suggest that complement levels and antibody levels were normalizing in parallel. Throughout the dose-ranging trial, the drug was well tolerated with no clinically significant dose-related adverse reactions observed. Three patients experienced lupus flares, and three other patients were hospitalized as a result of transient adverse events that the treating clinicians believed were unrelated to the underlying disease or to LJP 394. Two of the patients with flares withdrew from the study, as did four patients who experienced exacerbations of lupus, and one patient who experienced herpes rash. However, no relationship was observed between the development of an adverse event and the dose or frequency of administration of LJP 394. In December 1996, we initiated a double-blind, placebo-controlled multicenter Phase II/III clinical trial of LJP 394. The purpose of the trial was to evaluate the safety of the drug and its potential to prevent renal flares, reduce disease severity and the need for immunosuppressive steroids/chemotherapy drugs and improve patients' quality of life. The trial enrolled over 200 patients and was conducted by LJP and Abbott Laboratories in North America and Europe in accordance with our joint development agreement with Abbott. In May 1999, an interim analysis indicated that the trial was unlikely to reach statistical significance for the primary endpoint, time to renal flare and it was decided to stop the study and evaluate the data. In September 1999, based on an initial analysis of mean summary data, LJP 394 appeared to have no clinical benefit, although it did lower mean antibody levels compared to placebo. There were no statistically significant serious safety issues, and clinical site investigators did not report that any thrombotic events were related to drug administration. Results of another Phase II dose-ranging study completed in 1999 showed that 50 mg per week had less effect than 100 mg per week, as measured by mean levels of antibodies to dsDNA. In September 1999, Abbott terminated the joint development agreement with LJP for LJP 394. Following additional analyses of the data in late November 1999, LJP announced encouraging results for LJP 394 from the Phase II/III clinical trial. These results were based on an analysis of the trial using a new blood test developed at LJP that appears to predict which patients would respond to drug treatment. In 1998, we developed this new blood assay and found that it predicted which patients in a previous Phase II trial responded to drug treatment. More than 80% of lupus patients evaluated in the Phase II/III trial tested positive in this blood assay. The new blood test measured the strength of the binding between LJP 394 and a patient's antibodies to double-stranded DNA (dsDNA). The responder group was defined as those patients whose antibodies to dsDNA exhibited a high affinity for LJP 394. Based on an analysis of all tested samples, time to renal flare for patients whose antibodies had high affinity for LJP 394 was increased in the drug-treated group when compared to the placebo-treated group in a statistically significant manner (p< 0.024). At 16 months, 14% of the drug-treated patients experienced a flare, compared to 35% in the placebo-treated group. The number of renal flares in the high-affinity patients treated with LJP 394 was less than half of the number of renal flares in high-affinity patients treated with placebo. In high-affinity patients tested, 30% or six out of 20 flares occurred in the drug treatment group, vs. 70% or 14 out of 20 flares in the placebo treated group (Fischer's Exact Test, p = 0.085). In addition, in the high-affinity population, placebo treated patients received three times as many treatments with high-dose corticosteroids or cyclophosphamide as drug-treated patients. Of the 32 times that patients with high-affinity antibodies for LJP 394 received high-dose corticosteroids or cyclophosphamide, 25% of the occurrences were in the drug-treated group versus 75% in the placebo-treated group. This result was statistically significant (Fischer's Exact Test, p < 0.001). In the Phase II/III study, mean levels of circulating antibodies to dsDNA in patients treated with LJP 394 were reduced by a statistically significant amount relative to placebo during drug treatment. Levels of an important complement protein, C3, improved when antibodies were reduced. In lupus patients, this inflammation-related protein decreases during active renal disease and increases with clinical improvement. The concurrent reduction of antibodies to dsDNA and increase in C3 complement levels is biologically consistent. This effect had been observed in a previous Phase II study of LJP 394 in 58 lupus patients. Results from the Phase II/III lupus study suggest ways to improve the clinical trial design of a Phase III trial. The Phase II/III trial design included periods during which patients received no drug for approximately two months (the "off" periods). When patients were on drug, mean levels of antibodies to dsDNA decreased. Unfortunately, mean levels of antibodies to dsDNA increased when patients were off drug. During the first four months, when patients were treated with 100 mg per week, there were approximately half as many flares in all patients treated with drug as compared to placebo. There were nine flares in the placebo-treated group and four in the drug-treated group. After the initial four-month induction period with doses of 100 mg per week, patients were treated with doses of only 50 mg per week during each of the three-month "on" periods for the duration of the study. A Phase II dose-ranging study that we completed in 1999 showed that 50 mg per week had less effect than 100 mg per week, as measured by mean levels of antibodies to dsDNA. We believe that eliminating the "off" periods and using 100 mg per week could increase the number of patients who respond. We believe that we have developed a blood test that can identify lupus patients who are most likely to respond to LJP 394 and are considering the use of this test to screen lupus patients for entry into a Phase III clinical trial. We have filed a patent application on this new blood assay. The clinical trial, and the development of LJP 394 in general, involve many risks and uncertainties, and there can be no assurance that any previous clinical results can be replicated in further clinical testing or that LJP 394 will be effective in inducing and sustaining antibody suppression; will prove to be clinically safe or effective; will receive required regulatory approvals, or if the FDA will require further clinical testing in addition to a Phase III clinical trial. If the continued development of LJP 394 produces negative or inconclusive results, our business and financial condition will be adversely affected and it may be difficult or impossible for LJP to survive. Antibody-Mediated Thrombosis, Including Stroke, Heart Attack, Deep Vein Thrombosis and Recurrent Fetal Loss Researchers believe that anticardiolipin antibodies promote arterial and venous blood clots, which can cause a variety of life-threatening medical problems. For example, blood clots that lodge in the brain may cause stroke and those that lodge in the legs may cause deep vein thrombosis. There are multiple conditions associated with these antibodies: antibody-mediated stroke, heart attack, deep vein thrombosis, recurrent fetal loss, and complications following cardiovascular surgery. Our program to develop a Toleragen to treat anticardiolipin antibodies targets stroke, myocardial infarction, deep vein thrombosis, recurrent fetal loss, and post-operative complications. These antibodies are associated with the formation of blood clots leading to multiple, recurring, and potentially life-threatening conditions. We estimate that there are about 2,000,000 patients in the United States and Europe with antibody-mediated thrombosis. Stroke is a leading cause of death in the United States. In 1996, there were approximately two million stroke patients in the United States, approximately 700,000 new episodes occurred, and in 1994, approximately 150,000 people died from stroke. This debilitating condition results from acute neurological injury caused by the blockage or rupture of blood vessels in the brain. Many of the blockages are caused by thromboses (blood clots), which many clinicians believe may be caused by a number of factors including a class of antibodies called anticardiolipin antibodies, which can be identified and measured by a clinical laboratory assay. It is estimated that about 10% of the strokes in the United States (affecting 100,000 to 200,000 patients) are caused by these antibodies. Antibody-mediated stroke is thought to occur in younger individuals and with greater frequency than non-antibody-mediated stroke. The cost of treatment for a survivor of a serious stroke is approximately $30,000 per year for life, to provide hospitalization and home nursing care. Anticardiolipin antibodies are also associated with recurrent fetal loss, a syndrome of repeated miscarriage. Published clinical reports estimate that many women with elevated anticardiolipin antibody levels experience multiple miscarriages, delayed fetal development or premature childbirth. Recent academic research suggests that elevated levels of anticardiolipin antibodies are also found in approximately 10 to 30% of patients with other clotting disorders, including myocardial infarction (heart attack), deep vein thrombosis and cardiac valve lesion, as well as in approximately 30% of lupus patients. In myocardial infarction, recent research suggests the relative risk of having a thrombotic event or death is twice as high in people with high anticardiolipin antibodies, and this risk is independent of other risk factors. In deep vein thrombosis, research indicates anticardiolipin antibody-positive patients have recurring deep vein thromboses twice as often as anticardiolipin antibody-negative patients. Current treatments for antibody-mediated thrombosis involve the use of chronic, potentially life-long anticoagulant therapy with drugs such as heparin or warfarin to prevent the formation of blood clots. Patients must be carefully monitored to minimize serious bleeding episodes that can occur because of the therapy. If patients are removed from anticoagulant therapy, they are at an increased risk of stroke or another thrombotic episode. Warfarin is not recommended in the treatment of recurrent fetal loss because it is toxic to the developing fetus. We believe that a Toleragen to treat this antibody-mediated thrombosis would be a major step forward in specifically targeting the cause of this clotting disorder, thereby avoiding the side effects of current therapy. Our research supports the finding that specific antibodies in antibody-mediated thrombosis enhance blood-clot formation by interfering with the natural breakdown of a blood component - Factor Va - that accelerates clotting. The target of these clot-promoting antibodies is a small region on a blood component called b2-glycoprotein I. To date, our scientists have shown that approximately 90% of patients studied with antibody-mediated thrombosis have antibodies that bind to this region. The identification of a disease target for antibody-mediated thrombosis has allowed us to begin building new drug candidates that bind to these antibodies with high affinity and are designed to tolerize, or shut down, the B cells that produce them. We have synthesized a family of candidate antibody-mediated thrombosis Toleragens for testing. We have also developed a mouse model of the disease, where the animals produce antibodies to b2-glycoprotein I and develop a clotting defect similar to that seen in patients with antibody-mediated thrombosis. In this animal model, several candidate molecules have been shown to reduce the production of pathogenic antibodies, a key step in the development of a drug to treat this disorder. Xenotransplantation Xenotransplantation, the use of animals as a source of donor organs for human transplantation, has become an area of great interest due to the worldwide shortage of human organs available for transplantation. According to the American Society of Transplant Physicians, approximately 100,000 patients in the United States are on waiting lists for organ transplants. More than 5,000 patients die annually, many of whom are too sick to qualify for waiting lists. A typical organ transplant can cost more than $100,000. Hyperacute rejection, or the immediate destruction of the transplanted animal organ by the recipient's antibodies, is a major barrier to xenotransplantation. Human antibodies recognize and bind to an epitope called alpha galactose found on the tissues of transplanted animal organs. This binding causes massive blood clots that block the blood supply to the transplanted organ, destroying it within minutes. We believe that a Toleragen that binds to B cells producing antibodies to alpha galactose may suppress antibody production and prevent or reduce antibody-mediated organ rejection in xenotransplantation. We also believe that such a Toleragen may provide benefit on a long-term basis by reducing the amount of immunosuppressive drugs needed to control the B cell production of antibodies to alpha galactose. In this disorder, the target of the pathogenic antibodies, alpha galactose, has already been identified. We have designed a Toleragen candidate intended to arrest the production of antibodies responsible for rejection of transplanted animal organs. In laboratory studies, this Toleragen inhibited the binding of both human and primate pathogenic antibodies. No measurable activation of complement proteins, which promote organ rejection, was observed during in vitro testing. In a placebo-controlled study in primates, our Toleragen reduced levels of antibodies associated with organ rejection and was well tolerated on a short-term basis. In mice receiving the experimental xenotransplantation drug, LJP 920, average levels of IgM and IgG alpha galactose antibodies associated with organ rejection remained near the pretreatment levels for three months, whereas antibody levels in the untreated group rose at least four-fold. Moreover, at the end of the study, the drug-treated mice had fewer B cells producing antibodies to alpha galactose than the control group. Other Antibody-Mediated Diseases We believe our Tolerance Technology may be applicable to additional diseases and conditions caused by the production of disease-causing antibodies, including myasthenia gravis and Rh hemolytic disease of the newborn. Myasthenia gravis is a form of muscular paralysis in which neuromuscular receptors are attacked by antibodies, which can lead to a wasting of muscles, progressive loss of strength and life-threatening respiratory arrest. This disease affected an estimated 20,000 people in the United States in 1994. Rh hemolytic disease of the newborn is a life-threatening fetal condition characterized by the hemolysis (destruction) of fetal red blood cells. This condition occurs in Rh-incompatible pregnancies in which maternal antibodies to Rh cross the placenta, bind to fetal red blood cells and cause their destruction. Each year approximately 500,000 women in the United States have Rh-incompatible pregnancies. LJP believes that a Toleragen that binds to the appropriate maternal B cells will suppress Rh antibody production, and that once the level of antibodies to Rh(+) red blood cells is reduced, the risk of life-threatening hemolysis will be reduced. COLLABORATIVE ARRANGEMENTS As part of our business strategy, we attempt to pursue collaborations with pharmaceutical companies in an effort to access their research, drug development, manufacturing, marketing and financial resources. In December 1996, we entered into a collaborative relationship with Abbott for worldwide development and commercialization of LJP 394. This agreement was terminated in September 1999 following the initial analysis of the Phase II/III lupus trial, and all rights to LJP 394 were returned to us. Concurrently with the formation of the collaborative relationship, Abbott had made an initial $4.0 million license payment to LJP and purchased 1,000,050 shares of our common stock for gross proceeds of $4.0 million. In September 1997 and October 1998, Abbott also purchased 831,152 and 1,538,402 shares of our common stock, respectively, for gross proceeds of $4.0 million on each purchase date. We incurred research and development costs for the development of LJP 394 of approximately $9.9 million in 1997, $8.6 million in 1998 and $4.7 million in 1999 under the collaborative agreement with Abbott. We intend to pursue collaborative arrangements with other pharmaceutical companies to assist in our research programs and the clinical development and commercialization of our drug candidates. There can be no assurance that we will be able to negotiate arrangements with any other collaborative partners on acceptable terms, if at all. Once a collaborative relationship is established, there can be no assurance that the collaborative partner will continue funding any particular program or will not pursue alternative technologies or develop alternative drug candidates, either individually or in collaboration with others, including our competitors, as a means for developing treatments for the diseases targeted by LJP. Furthermore, competing products, either developed by a collaborative partner or to which a collaborative partner has rights, may result in the withdrawal of support by the collaborative partner with respect to all or a portion of our technology. Failure to establish or maintain collaborative arrangements will require us to fund our own research and development activities, resulting in accelerated depletion of capital, and will require us to develop our own marketing capabilities for any drug candidate that may receive regulatory approval. The failure of any collaborative partner to continue funding any particular LJP program, or to commercialize successfully any product, could delay or halt the development or commercialization of any products involved in such program. As a result, failure to establish or maintain collaborative arrangements could hurt our business, financial condition and results of operations. MANUFACTURING We have constructed and are currently operating a pilot production facility for the manufacture of LJP 394 that is large enough to exceed anticipated research and clinical trial needs for LJP 394. Through internal development programs and external collaborations, we have made several improvements to the manufacturing process for LJP 394 that have reduced our costs and increased capacity. We have developed proprietary synthesis and conjugation technologies that are being used in the development of our other Toleragen candidates. We intend to further develop these technologies in order to increase our manufacturing efficiencies and apply our expertise to the development and manufacture of other potential products. However, our current facilities are not yet adequate for commercial production. In order to meet the supply of LJP 394 in bulk form for packaging and commercial resale, we will be required to invest substantial amounts of capital in the expansion of our facilities. The manufacture of our potential products for clinical trials and the manufacture of any resulting products for commercial purposes is subject to current Good Manufacturing Practices ("cGMP"), as defined by the FDA. We have never operated an FDA-approved manufacturing facility, and there can be no assurance that we will obtain the necessary approvals. We have limited manufacturing experience, and no assurance can be given that we will be able to make the transition to commercial production successfully. We may enter into arrangements with contract manufacturers to expand our own production capacity in order to meet requirements for our products, or to attempt to improve our manufacturing efficiency. If the we choose to contract for manufacturing services and encounter delays or difficulties in establishing relationships with manufacturers to produce, package and distribute finished products, clinical trials, market introduction and subsequent sales of such products would be adversely affected. Moreover, contract manufacturers must operate in compliance with the FDA's cGMP requirements. Our potential dependence upon others for the manufacture of LJP products may adversely affect our profit margins and our ability to develop and deliver such products on a timely and competitive basis. MARKETING AND SALES In order to commercialize any drug candidate approved by the FDA, we must either develop a marketing and sales force or enter into marketing arrangements with others. These arrangements may be exclusive or nonexclusive and may provide for marketing rights worldwide or in a specific market. We currently have no arrangements with others for the marketing of any of our drug candidates. There can be no assurance that we will be able to enter into any additional marketing agreements on favorable terms, if at all, or that any such agreements that we may enter into will result in payments to LJP. Under any co-promotion or other marketing and sales arrangements that we may enter into with other companies, any revenues that we may receive will be dependent on the efforts of others and there can be no assurance that such efforts will be successful. To the extent that we choose to attempt to develop our own marketing and sales capability, we will compete with other companies that currently have experienced and well-funded marketing and sales operations. Furthermore, there can be no assurance that LJP or any collaborative partner will be able to establish sales and distribution capabilities without undue delays or expenditures or gain market acceptance for any of our drug candidates. PATENTS AND PROPRIETARY TECHNOLOGIES The Company files patent applications in the United States and in foreign countries, as it deems appropriate, for protection of its proprietary technologies and drug candidates. We own 87 issued patents and have 58 pending patent applications covering various technologies and drug candidates, including our Tolerance Technology, our lupus and antibody-mediated stroke drug candidates, and our linkage technologies for our Toleragens. Our issued patents include: (1) four issued United States patents, one issued Australian patent, one granted Portuguese patent, one granted Norwegian patent, and one granted European patent which has been unbundled as thirteen European national patents concerning its lupus Toleragens (expiring in 2009, 2011, 2013, 2014, 2007, 2013, 2011 and 2011, respectively); (2) two issued United States patents, two issued Australian patents, one granted European patent which has been unbundled as fifteen European national patents, one granted Japanese patent, one granted Canadian patent, and one granted South Korean patent concerning its Tolerance Technology (expiring in 2010, 2014, 2008, 2014, 2012, 2012, 2012 and 2012, respectively); (3) four issued United States patents, three issued Australian patents one granted European patent which has been unbundled into 15 countries, and one issued Japanese patent concerning linkage technologies for its Toleragens (expiring in 2012, 2015, 2015, 2016, 2014, 2012, 2012, 2012, and 2012, respectively); and (4) one issued U.S. patent concerning its antibody-mediated stroke drug candidates (expiring in 2016). The Company has received a Notice of Allowance from the Canadian Patent Office for a patent application for its lupus Toleragens, a Notice of Allowance from the United States Patent and Trademark Office (USPTO) for a patent application for its Tolerance Technology, as well as a Notice of Allowance from the USPTO and a Notice of Allowance from the Australian Patent Office for patent applications for antibody-mediated stroke drug candidates. COMPETITION The biotechnology and pharmaceutical industries are subject to rapid technological change. Competition from domestic and foreign biotechnology companies, large pharmaceutical companies and other institutions is intense and expected to increase. A number of companies are pursuing the development of pharmaceuticals in our targeted areas. These include companies that are conducting clinical trials and preclinical studies for the treatment of lupus. In addition, there are many academic institutions, both public and private, engaged in activities relating to the research and development of therapeutics for autoimmune, inflammatory and other diseases. Most of these companies and institutions have substantially greater facilities, resources, research and development capabilities, regulatory compliance expertise, and manufacturing and marketing capabilities than LJP. In addition, other technologies may in the future be the basis of competitive products. There can be no assurance that our competitors will not develop or obtain regulatory approval for products more rapidly than LJP, or develop and market technologies and products that are more effective than those being developed by LJP or that would render our technology and proposed products obsolete or noncompetitive. We believe that our ability to compete successfully will depend upon our ability to attract and retain experienced scientists, develop patented or proprietary technologies and products, obtain regulatory approvals, manufacture and market products either alone or through third parties, and secure additional capital resources to fund anticipated net losses for at least the next several years. We expect that competition among products approved for marketing will be based in large part upon product safety, efficacy, reliability, availability, price and patent position. GOVERNMENT REGULATION Our research and development activities and the future manufacturing and marketing of any products developed by LJP are subject to significant regulation by numerous government authorities in the United States and other countries. In the United States, the Federal Food, Drug and Cosmetic Act and the Public Health Service Act govern the testing, manufacture, safety, efficacy, labeling, storage, record keeping, approval, advertising and promotion of any products we may develop. In addition to FDA regulations, we are subject to other federal, state and local regulations, such as the Occupational Safety and Health Act and the Environmental Protection Act, as well as regulations governing the handling, use and disposal of radioactive and other hazardous materials used in research activities. Product development and approval within this regulatory framework takes a number of years and involves the expenditure of substantial resources. In addition, this regulatory framework is subject to changes that may affect approval, delay an application or require additional expenditures. The steps required before a pharmaceutical compound may be marketed in the United States include (1) preclinical laboratory and animal testing; (2) submission to the FDA of an Investigational New Drug ("IND") application, which must become effective before clinical trials may commence; (3) adequate and well-controlled clinical trials to establish the safety and efficacy of the drug; (4) submission to the FDA of a New Drug Application ("NDA"); and (5) FDA approval of the NDA prior to any commercial sale or shipment of the drug. In addition to obtaining FDA approval for each product, each domestic drug manufacturing establishment must be registered with, and approved by, the FDA. Drug product manufacturing establishments located in California also must be licensed by the State of California in compliance with separate regulatory requirements. Preclinical testing includes laboratory evaluation of product chemistry and animal studies to assess the safety and efficacy of the product and its formulation. The results of preclinical testing are submitted to the FDA as part of an IND and, unless the FDA objects, the IND will become effective 30 days following its receipt by the FDA. Clinical trials involve administration of the drug to healthy volunteers or to patients diagnosed with the condition for which the drug is being tested under the supervision of a qualified clinical investigator. Clinical trials are conducted in accordance with protocols that detail the objectives of the study, the parameters to be used to monitor safety, and the efficacy criteria to be evaluated. Each protocol is submitted to the FDA as part of the IND. Each clinical trial is conducted under the auspices of an independent Institutional Review Board ("IRB"). The IRB will consider, among other matters, ethical factors, the safety of human subjects and the possible liability of the institution. Clinical trials are typically conducted in three sequential phases, but the phases may overlap. In Phase I, the initial introduction of the drug into healthy human subjects, the drug is tested for safety (adverse effects), dosage tolerance, metabolism, distribution, excretion and clinical pharmacology. Phase II involves trials in a limited patient population to (1) characterize the actions of the drug in targeted indications, (2) determine drug tolerance and optimal dosage and (3) identify possible adverse side effects and safety risks. When a compound is found to be effective and to have an acceptable safety profile in Phase II clinical trials, Phase III clinical trials are undertaken to further evaluate and confirm clinical efficacy and safety within an expanded patient population at multiple clinical trial sites. The FDA reviews both the clinical plans and the results of the trials and may discontinue the trials at any time if significant safety issues arise. The results of preclinical testing and clinical trials are submitted to the FDA in the form of an NDA or Product License Application for marketing approval. The testing and approval process is likely to require substantial time and effort and there can be no assurance that any approval will be granted on a timely basis, if at all. In addition, we will be required to obtain separate regulatory approval for each indicated use of a drug. The approval process is affected by a number of factors, including the severity of the disease, the availability of alternative treatments, and the risks and benefits demonstrated in clinical trials. Additional preclinical testing or clinical trials may be requested during the FDA review period and may delay marketing approval. After FDA approval for the initial indications, further clinical trials may be necessary to gain approval for the use of the product for additional indications. The FDA mandates that adverse effects be reported to the FDA and may also require post-marketing testing to monitor for adverse effects, which can involve significant expense. Among the conditions for FDA approval is the requirement that the prospective manufacturer's quality control and manufacturing procedures conform to the FDA's cGMP requirements. Domestic manufacturing facilities are subject to biennial FDA inspections and foreign manufacturing facilities are subject to periodic inspections by the FDA or foreign regulatory authorities. We are also subject to numerous and varying foreign regulatory requirements governing the design and conduct of clinical trials and marketing approval for pharmaceutical products to be marketed outside of the United States. The approval procedure varies among countries and can involve additional testing, and the time required to obtain approval may differ from that required to obtain FDA approval. The foreign regulatory approval process includes all of the risks associated with obtaining FDA approval, and approval by the FDA does not ensure approval by the health authorities of any other country. EMPLOYEES LJP currently has 53 full-time employees (including 11 Ph.D.s), 40 of whom are involved full-time in research, development and manufacturing scale-up activities. All of our management have had prior experience with pharmaceutical, biotechnology or medical product companies. We believe that we have been successful in attracting skilled and experienced scientific personnel, but competition for such personnel is intense and there can be no assurance that we will be able to attract and retain the individuals needed. None of our employees are covered by collective bargaining agreements and management considers relations with our employees to be good. CERTAIN RISK FACTORS In this section, all references to "we," "our," and "us," refer to La Jolla Pharmaceutical Company, a Delaware corporation. I. RISK FACTORS RELATED TO THE INDUSTRY IN WHICH WE OPERATE. Our success depends partially on healthcare reimbursement policies. The continuing efforts of government and healthcare insurance companies to reduce the costs of healthcare may negatively impact our business. For example, in certain foreign markets, pricing and profitability of prescription pharmaceuticals are subject to government control. In the United States, we expect that there will continue to be a number of federal and state proposals to implement similar government controls. In addition, increasing emphasis on managed care in the United States will continue to put pressure on pharmaceutical pricing. Cost control initiatives could decrease the revenue that we receive for any products we may develop and sell in the future and negatively impact our business. In addition, these cost control measures may impact our commercial partners and our ability to continue to work with these partners. Our business depends in part on the reimbursement policies of Medicare and healthcare companies. These policies can be unpredictable. Newly approved drugs may not be accepted for reimbursement by health insurers or Medicare. It is possible that these organizations will not offer coverage for our products. Government and other third-party payors increasingly attempt to contain healthcare costs by limiting both coverage and the level of reimbursement for new therapeutic products. If adequate coverage and reimbursement levels are not provided by government and other third-party payors for our products, the market acceptance of these products would be adversely affected. Our industry has numerous other companies that compete with LJP and we face rapid technological change from within our industry. The biotechnology and pharmaceutical industries are subject to rapid technological change. Competition from domestic and foreign biotechnology companies, large pharmaceutical companies and other institutions is intense and is expected to increase. A number of companies and institutions are pursuing the development of pharmaceuticals in our targeted areas. These include companies that are conducting clinical trials and preclinical studies for the treatment of lupus. Our competitors may develop or obtain regulatory approval for products more rapidly than we do, or develop and market technologies and products that are more effective than those being developed by us or that would render our technology and proposed products obsolete or noncompetitive. II. RISK FACTORS RELATING TO LA JOLLA PHARMACEUTICAL PARTICULARLY. Our drug candidates may not perform well in clinical trials and we may not be permitted to conduct further clinical trials. Without successful clinical trials, we will not be able to market or sell any products. We must demonstrate in clinical trials that LJP 394, our only drug candidate that has advanced to the clinical trial stage, is safe and effective for use before we apply for any regulatory approvals. We announced on May 12, 1999, that Abbott and the Company, in discussion with the FDA, elected to stop the enrollment and treatment of the more than 200 patients enrolled in the jointly conducted Phase II/III clinical trial of LJP 394 until the data could be validated and analyzed. This announcement was made following a planned interim analysis of the Phase II/III clinical trial in which an independent data monitoring committee reported lower than expected efficacy. No major safety concerns were observed, and patients receiving LJP 394 appeared to have a reduction in circulating antibodies to double-stranded DNA that are associated with lupus nephritis. In September 1999, Abbott and LJP terminated the collaborative agreement for the development of LJP 394. We are continuing to analyze the results of this clinical program and expect to complete this analysis by the end of the first quarter of 2000. Early analysis of these results seems to indicate that those patients who exhibited a certain trait (high antibody affinity for LJP 394) suffered fewer renal flares, the chosen endpoint for the Phase II/III clinical studies. A Phase II dose-ranging study of LJP 394 involving 75 lupus patients was recently completed, and we are currently analyzing the data from this study. We must understand the effects of LJP 394 on endpoints from these studies before deciding whether any further development is warranted. If LJP 394 is ultimately not found to be safe and effective, we would be unable to obtain regulatory approval for its commercialization. If that were to occur, there is no assurance that we would be able to develop an alternative drug candidate. Because LJP 394 is our only drug candidate that has advanced to clinical trials, our inability to commercialize it would have a material adverse effect on our business, financial condition and results of operation. Our products are in the early stage of development and the technology underlying our products is uncertain and unproven. All of our product development efforts are based on unproven technologies and therapeutic approaches that have not been widely tested or used. LJP 394 has not been proven to be effective in humans and its tolerance technology has been used only in our preclinical tests and clinical trials. Application of LJP 394's tolerance technology to antibody-mediated diseases other than lupus is in even earlier research stages. LJP 394 and our other potential drug candidates require significant additional research and development and are subject to significant risks. For example, potential products that appear to be promising at early stages of development may be ineffective or cause harmful side effects during preclinical testing or clinical trials, not receive necessary regulatory approvals, be difficult to manufacture, be uneconomical to produce, not be accepted by consumers, or be precluded from commercialization by the proprietary rights of others. We may not successfully complete development of LJP 394 or any other drug candidate or may not obtain required regulatory approvals. If introduced, LJP 394 or any other drug candidate may not generate sales. Even if proven effective, our products may never reach market. Potential products that appear to be promising at early stages of development may nevertheless fail to reach market or become profitable for reasons such as the following: - products may be ineffective or cause harmful side effects during preclinical testing or clinical trials, - products may fail to receive necessary regulatory approvals, - products may be difficult to manufacture, - products may be uneconomical to produce particularly if high dosages are required, and - products may fail to achieve market acceptance or be precluded from commercialization because of proprietary rights of third parties. There can be no assurance that our product development efforts with respect to LJP 394 or any other drug candidate will be successfully completed, that required regulatory approvals will be obtained, or that any product, if introduced, will be successfully marketed or achieve commercial acceptance. The technology underlying LJP 394 appears effective in humans. However, no therapeutic products have been developed to date that utilize this technology. There can be no assurance that LJP 394 will work as intended. Furthermore, clinical trials of LJP 394 may be viewed as a test of the Company's entire Tolerance Technology approach. If the data from these clinical trials indicate that LJP 394 is ineffective, the applicability of our Tolerance Technology to other antibody-mediated diseases will be highly uncertain. Therefore, there is significant risk that our therapeutic approaches will not prove to be successful, and there can be no assurance that our drug discovery technologies will result in any commercially successful products. We may need to establish collaborative agreements. We may seek to collaborate with pharmaceutical companies to access their research, drug development, manufacturing, marketing and financial resources. In December 1996, we entered into a collaborative agreement with Abbott. This agreement granted Abbott the exclusive right to market and sell LJP 394 throughout the world in exchange for royalties on sales, development financing, and milestone payments. Abbott's obligations to make payments to us and to conduct development activities were conditioned on the progress of clinical trials and the attainment of milestones related to regulatory approvals and sales levels. Following the May 1999 suspension of the jointly conducted Phase II/III clinical trial, Abbott and LJP terminated their collaborative agreement in September 1999. We may pursue collaborative arrangements with other pharmaceutical companies to assist in our research programs and the clinical development and commercialization of our other drug candidates. However, we may not be able to negotiate arrangements with any other collaborative partners on acceptable terms, if at all. Any additional collaborative relationships that we enter into may include conditions comparable to those in the Abbott agreement. Once a collaborative arrangement is established, the collaborative partner may not continue funding any particular program or may pursue alternative technologies or develop alternative drug candidates, either alone or with others, to develop treatments for the diseases we are targeting. Competing products, developed by a collaborative partner or to which a collaborative partner has rights, may result in the collaborative partner withdrawing support as to all or a portion of our technology. Without collaborative arrangements, we must fund our own research and development activities, accelerating the depletion of our capital and requiring us to develop our own marketing capabilities. Therefore, if we are unable to establish and maintain collaborative arrangements, we could experience a material adverse effect on our business, financial condition and results of operations. We will need additional funds to support operations and may need to reduce operations, sell stock or assets, or merge with another entity to continue operations. Our operations to date have consumed substantial capital resources, and we will continue to expend substantial and increasing amounts of capital for research, product development, preclinical testing and clinical trials of drug candidates, to establish commercial-scale manufacturing capabilities, and to market potential products. Our future capital requirements will depend on many factors, including: - continued scientific progress in our research and development programs and the size and complexity of these programs, - the scope and results of preclinical testing and clinical trials, - the time and costs involved in applying for regulatory approvals, - the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims, - competing technological and market developments, - our ability to establish and maintain collaborative research and development arrangements, and - the cost of manufacturing scale-up and effective commercialization activities and arrangements. We expect to incur substantial and increasing losses each year for at least the next several years as our clinical trial, research, development and manufacturing scale-up activities increase. We expect our existing capital resources (including the capital raised through the sale of stock that may be offered for resale under this prospectus) to be sufficient to fund our activities, as currently planned, for approximately the next 15 months. However, the amounts expended by the Company for various purposes may vary significantly, and it is possible that our cash requirements will exceed current projections and that we will therefore need additional financing sooner than currently expected. In the future, it is possible that we will not have adequate resources to support our business activities. We actively seek additional funding, including through collaborative arrangements and public and private financings. Our choice of financing alternatives may vary from time to time depending upon various factors, including the market price of our securities, conditions in the financial markets, and the interest of other entities in strategic transactions with LJP. There can be no assurance that additional financing will be available on acceptable terms, if at all, whether through collaborative arrangement, issuance of securities, or otherwise. If adequate funds are not available, we may be required to delay, scale back or eliminate one or more of our research and development programs or obtain funds through arrangements with collaborative partners or others that require us to relinquish rights to certain technologies or potential products. This could have a negative impact on our business. We have a history of losses and may not become profitable. We have incurred operating losses each year since our inception in 1989 and had an accumulated deficit of approximately $71.8 million as of December 31, 1999. Our losses are likely to exceed those experienced in prior years due to the termination of the Abbott collaborative relationship, unless we are successful in establishing additional collaborative relationships to help finance our research and development costs. To achieve profitability we must, among other things, complete the development of our products, obtain all necessary regulatory approvals and establish commercial manufacturing and marketing capabilities. We expect to incur significant losses each year for at least the next several years as our clinical trial, research, development and manufacturing scale-up activities increase. The amount of losses and the time required by us to reach sustained profitability are highly uncertain, and we do not expect to generate revenues from the sale of products, if any, for at least several years. We may never achieve product revenues or profitability. If LJP 394 fails in clinical trials, we will be unable to obtain FDA approval and will not be able to sell those products. In order to sell our products that are under development, we must first receive regulatory approval. To obtain those approvals, we must conduct clinical studies demonstrating that our products are safe and effective. If we cannot obtain FDA approval for LJP 394, currently our sole drug candidate, our business will be significantly impacted and our prospects for profitable sales will significantly decrease. Although LJP 394 appears promising, it may not be successful in future clinical trials. Our prior clinical study of LJP 394, in collaboration with Abbott, was halted, and any renewed clinical study may also be delayed or halted for various reasons, including: - the product is not effective, or physicians think that it is not effective, - patients experience severe side effects during treatment, - patients do not enroll in the study at the rate we expect, or - product supplies are not sufficient to treat the patients in the study. In addition, the FDA and foreign regulatory authorities have substantial discretion in the approval process. The FDA and foreign regulatory authorities may not agree that we have demonstrated that LJP 394 is safe and effective after we complete clinical trials. Even if the results of prior clinical trials are positive, the FDA may require us to design and conduct new Phase II and Phase III clinical trials, which will result in significant expense and delay. The FDA may require new clinical trials because of inconclusive results from earlier trials, a possible failure to conduct prior trials in complete adherence to FDA good clinical practice standards, and identification of new clinical trial endpoints. Our success depends significantly upon our ability to obtain patent protection for our therapeutic approach, LJP 394, and any other developed products. In addition, we will need to successfully preserve our trade secrets and operate without infringing on the rights of others. We own 87 issued Patents and 58 pending patent applications covering various technologies and drug candidates. However, there can be no assurance that any additional patents will be issued, or that the scope of any patent protection will be sufficient, or that any current or future issued patent will be held valid if subsequently challenged. There is a substantial backlog of biotechnology patent applications at the U.S. Patent and Trademark Office that may delay the review and issuance of any patents. The patent position of biotechnology firms like ours generally is highly uncertain and involves complex legal and factual questions, and no consistent policy has emerged regarding the breadth of claims covered in biotechnology patents or protection afforded by these patents. Presently, we have a number of patent applications pending in the United States relating to our technology, as well as foreign counterparts to some of our U.S. patent applications. We intend to continue to file applications as appropriate for patents covering both our products and processes. There can be no assurance that patents will be issued from any of these applications, or that the scope of any issued patents will protect our technology. Patent applications in the United States are kept secret until a patent is issued. As a result, we do not know if others, including competitors, have filed patent applications for technology covered by our pending applications, nor can we be certain that we were the first to invent or to file patent applications for our technologies. Competitors may have patents or patent applications pending that relate to compounds or processes that overlap or compete with our intellectual property. In particular, we are aware of one currently pending U.S. patent application that, if allowed, may contain claims covering subject matter that may compete or conflict with some of our patents and patent applications. Any conflict between our patents and patent applications, and patents or patent applications of third parties, could result in a significant reduction of the coverage of our existing patents or any future patents that may be issued. In addition, we may have to incur significant expenses in defending our patents. If the U.S. Patent Office or any foreign counterpart issues to a competitor patents containing competitive or conflicting claims, and if these claims are valid, there can be no assurance that we would be able to obtain licenses to these patents, that any licensing fees would be reasonable, or that we would be able to develop or obtain alternative technology. We also rely on unpatented intellectual property such as trade secrets and improvements, know-how, and continuing technological innovation. While we seek to protect these rights, it is possible that: (i) inventions relevant to our business will be developed by a person not bound by an LJP invention assignment agreement, (ii) binding LJP confidentiality agreements will be breached and we will not have adequate remedies for such a breach, or (iii) our trade secrets will otherwise become known or be independently discovered by competitors. We could incur substantial costs in defending suits brought against the Company by others for infringement of intellectual property rights or in prosecuting suits that we might bring against others to protect our intellectual property rights. We currently have only limited manufacturing capabilities. The manufacture of our potential products for clinical trials and the manufacture of any resulting products for commercial purposes are subject to certain FDA standards. While we are producing limited quantities of LJP 394 for clinical trials, our current facilities are not FDA approved for commercial production of our potential products. Substantial capital investment in the expansion and build-out of our manufacturing facilities will be required to enable manufacture of any products in commercial quantities. While we have initiated the process of obtaining FDA approval for our facilities, we have never operated an FDA-approved manufacturing facility and may not obtain necessary approvals. We have limited manufacturing experience, and we may be unable to successfully transition to commercial production. We may enter into arrangements with contract manufacturing companies to expand our own production capacity in order to meet requirements for our products, or to attempt to improve manufacturing efficiency. If we choose to contract for manufacturing services and encounter delays or difficulties in establishing relationships with manufacturers to produce, package and distribute our finished products, the clinical trials, market introduction and subsequent sales of these products would be adversely affected. If we become dependent on third parties for the manufacture of our products, our profit margins and our ability to develop and deliver products on a timely and competitive basis may be adversely affected. We lack experience in marketing products for commercial sale. In order to commercialize any drug candidate approved by the FDA, we must either develop a marketing and sales force or enter into marketing arrangements with others. We currently have no marketing arrangements with others, and there can be no assurance that we will be able to enter into any marketing agreements on favorable terms, or that any such agreements that will result in payments to LJP. To the extent that we enter into co-promotion or other marketing and sales arrangements with other companies, any revenues that we may receive will be dependent on the efforts of others. There can be no assurance that these efforts will be successful. If we attempt to develop our own marketing and sales capabilities, we will compete with other companies that have experienced and well-funded marketing and sales operations. Furthermore, if we attempt to establish sales and distribution capabilities, we may experience delays and expenditures and have difficulty in gaining market acceptance for our drug candidates. The use of LJP 394 and other potential products in clinical trials, and the sale of any approved products may expose us to liability claims resulting from the use of these products. We have not received marketing approval from the FDA for any drug candidates and we currently use LJP 394 only in clinical trials. The use and possible sale of LJP 394 and other potential products may expose us to legal liability and generate negative publicity. These claims might be made directly by consumers, pharmaceutical companies, or others. We maintain $10.0 million of product liability insurance for claims arising from the use of LJP products in clinical trials. However, coverage is becoming increasingly expensive, and there can be no assurance that we will be able to maintain insurance or that insurance can be acquired at a reasonable cost or in sufficient amounts to protect us against possible losses. Furthermore, it is possible that our financial resources would be insufficient to satisfy potential product liability claims. A successful product liability claim or series of claims brought could negatively impact our business and financial condition. Our research and development and operations depend in part on certain key employees and consultants. Losing these employees or consultants would negatively impact our product development and operations. We are highly dependent upon the principal members of our scientific and management staff, the loss of whose services would delay the achievement of our research and development objectives. Our anticipated growth and expansion into areas requiring additional expertise, such as clinical trials, government approvals, manufacturing, and marketing, is expected to place increased demands on our resources and require the addition of new management personnel as well as the development of additional expertise by existing management personnel. Retaining our current key employees and recruiting additional qualified scientific personnel to perform research and development work in the future will also be critical to our success. Because competition for experienced scientists among numerous pharmaceutical and biotechnology companies and research and academic institutions is intense, we may not be able to attract and retain these people. In addition, we rely upon consultants and advisors to assist us in formulating our research and development, clinical, regulatory and manufacturing strategies. All of our consultants and advisors are employed outside the Company and may have commitments or consulting or advisory contracts with other entities that may affect their ability to contribute to our business. It is possible that we may face environmental liabilities related to certain hazardous materials used in our operations. Due to the nature of our manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, emission, discharge, handling and disposal of certain materials and wastes. It is possible that we may have to incur significant costs to comply with environmental regulations as manufacturing is increased to commercial volumes. Our operations may be significantly impacted by current or future environmental laws, rules, regulations and policies or by any releases or discharges of hazardous materials. In our research activities, we utilize radioactive and other materials that could be hazardous to human health, safety, or the environment. These materials and various wastes resulting from their use are stored at our facility pending ultimate use and disposal. The risk of accidental injury or contamination from these materials cannot be eliminated. In the event of such an accident, we could be held liable for any resulting damages, and any such liability could exceed our resources. III. RISK FACTORS RELATED SPECIFICALLY TO OUR STOCK. Our common stock price has historically been very volatile. The market prices for securities of biotechnology and pharmaceutical companies, including ours, have historically been highly volatile, and the market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. Factors such as the following can have a negative effect on the market price of our securities: - announcements of technological innovations or new therapeutic products by LJP or others, - clinical trial results, - developments concerning agreements with collaborators, - government regulation, - developments in patent or other proprietary rights, - public concern as to the safety of drugs discovered or developed by LJP or others, - future sales of substantial amounts of our common stock by existing stockholders, and - comments by securities analysts and general market conditions. The realization of any of the risks described in these "Risk Factors" could have an adverse effect on the market price of our common stock. In the future, our stock may be removed from listing on the Nasdaq quotation system and may not qualify for listing on any stock exchange. Currently our securities are traded on the Nasdaq National Market. Nasdaq has certain continued listing requirements, including a minimum trading price. Previously, we have received notice from Nasdaq that our stock price fell below this minimum trading price. While we have since come back into compliance with this Nasdaq requirement, it is possible that we will fall out of compliance with this and/or other Nasdaq continued listing criteria at some point in the future. Failure to comply with any one of several Nasdaq requirements may cause our stock to be removed from listing on Nasdaq. Should this happen, we may not be able to secure listing on other exchanges or quotation systems. This would have a negative effect on the price and liquidity of our stock. Potential adverse effects of shares eligible for future sale. Sales of our common stock in the public market, or the perception that such sales could occur, could negatively impact the market price of our securities and impair our ability to complete equity financings. Certain anti-takeover plans and statutes may prevent hostile takeovers or prevent or delay the change in control within the Company. There are certain anti-takeover devices in place that may discourage or deter a potential acquirer from attempting to gain control of us. Certain provisions of the Delaware General Corporation Law may have the effect of deterring hostile takeovers or delaying or preventing changes in the control or management of us, including transactions in which stockholders might otherwise receive a premium for their shares over then-current market prices. We may also issue shares of preferred stock without stockholder approval and upon such terms as our Board of Directors may determine. The issuance of preferred stock could have the effect of making it more difficult for a third party to acquire a majority of our outstanding stock, and the holders of such preferred stock could have voting, dividend, liquidation and other rights superior to those of holders of the common stock. In 1998, we designated 75,000 shares of preferred stock as Series A Junior Participating Preferred Stock in connection with our Rights Plan. The Rights Plan could cause an unapproved takeover to be much more expensive to an acquirer, resulting in a strong incentive to negotiate with our Board of Directors. Our certificate of incorporation was recently amended to provide for a board of directors that is separated into three classes, with their respective terms in office staggered over three year periods. This has the effect of delaying a change in control of the board of directors without the cooperation of the incumbent board. In addition, our bylaws do not allow stockholders to call a special meeting of stockholders, require stockholders to give written notice of any proposal or director nomination to us within a certain period of time prior to the stockholder annual meeting, and establish certain qualifications for a person to be elected or appointed to the Board of Directors during the pendency of certain business combination transactions. Absence of dividends. The Company has not paid any cash dividends since its inception and does not anticipate paying any cash dividends in the foreseeable future. ITEM 2. ITEM 2. PROPERTIES. LJP leases two adjacent buildings in San Diego, California for a total of approximately 54,000 square feet. One building contains research and development labs and clinical manufacturing facilities, and the other contains general offices and our warehouse. Each building is subject to a lease, one that expires in 2001 and one that expires in 2004. Each lease includes an option to extend the term of the agreement for an additional five years and is subject to escalation clauses that provide for annual rent increases based on the U.S. Consumer Price Index. We believe that these facilities will be adequate to meet its needs for the near term. Over the longer term, management believes additional space can be secured at commercially reasonable rates. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is currently not a party to any material legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the three month period ended December 31, 1999. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers and key employees of the Company and their ages are set forth below. STEVEN B. ENGLE, Chairman of the Board and Chief Executive Officer, joined the Company in 1993 as Executive Vice President and Chief Operating Officer. He assumed the offices of President, Director and Secretary in 1994, and became Chief Executive Officer in 1995, and Chairman of the Board in 1997. From 1991 to 1993, Mr. Engle served as Vice President of Marketing and in other senior management positions while at Cygnus Inc., a publicly held company that develops drug-delivery systems for therapeutic drugs. From 1987 to 1991, he was Chief Executive Officer of Quantum Management Company, a privately held management consulting firm serving the pharmaceutical industry. From 1984 to 1987, he was Vice President of Marketing and Divisional General Manager for Micro Power Systems Inc., a privately held company that manufactures high technology products including medical devices. From 1979 to 1984, he was a management consultant at Strategic Decisions Group and SRI International where he advised pharmaceutical, high technology and other companies. Mr. Engle is the Chairman of BIOCOM, a regional trade association for the biotechnology and medical devices industries, and as a Director of CareLinc Corporation, a privately held developer of clinical information management systems. Mr. Engle holds an M.S.E.E. and a B.S.E.E. with a focus in biomedical engineering from the University of Texas. MATTHEW D. LINNIK, Ph.D., Executive Vice President of Research, joined the Company in 1998 as Director of Research and Development and became Vice President of Research in 1999. Prior to joining the Company, from 1989 to 1998, Dr. Linnik served as Senior Pharmacologist, Scientist, Research Scientist and Project Leader for Hoechst Marion Roussel, formerly Marion Merrell Dow and Marion Laboratories, a pharmaceutical company. From 1996 to 1998, he also served as Adjunct Associate Professor of Neurosurgery at the University of Cincinnati School of Medicine. From 1986 to 1988, he served as Postdoctoral Fellow, then Instructor, in the Departments of Neurology and Neurosurgery at Massachusetts General Hospital and Harvard Medical School. Dr. Linnik holds a B.A. in Physiology from Southern Illinois University and a Ph.D. in Physiology and Pharmacology from Southern Illinois University School of Medicine. ANDREW WISEMAN, Ph.D., Senior Director of Business Development, joined the Company in May 1989 as Director of Business Development and was one of the Company's original founders. Dr. Wiseman has also served as head of investor relations since 1994. From 1983 to 1989, Dr. Wiseman held several positions with Quidel Corporation, including Manager of Business Development, Project Manager in Diagnostic Research and Development and Senior Research Scientist. Dr. Wiseman was an Assistant Professor at the Medical Biology Institute and an Assistant Member at the Scripps Clinic and Research Foundation. He received a doctorate in Genetics from Duke University. PAUL JENN, Ph.D., Director of Operations, joined the Company in 1994 as Associate Director of Production & Process Development. In 1999 he was promoted to Director of Operations. Prior to joining the Company, from 1992 to 1994, Dr. Jenn was Director of Peptide Manufacturing at Telios Pharmaceuticals, Inc. a pharmaceutical company, and held several other positions. From 1988 to 1992, he served as Senior Research Associate at Mallinckrodt Specialty Chemicals, a specialty chemical company. From 1984 to 1988, Dr. Jenn served as a Research Scientist at International Minerals and Chemical Corp., a chemical company. From 1982 to 1984, he performed his Post-doctoral research at the Lawrence Berkeley Laboratory at the University of California at Berkley. Dr. Jenn holds a B.S. in Chemistry from Fu-Jen Catholic University, Taipei, Taiwan and a Ph.D. in Chemistry from New York State University at Buffalo. THEODORA REILLY, Director of Human Resources, joined the Company in 1998. Prior to joining the Company, from 1997 to 1998, Ms. Reilly was Director of Human Resources at ThermoLase Corporation, a public subsidiary of Thermo Electron Corporation, which developed laser-based systems for laser-based skin resurfacing. From 1994 to 1997, Ms. Reilly served as Director of Human Resources at Solectek Corporation, a privately held high tech manufacturer of wireless interconnectivity products. Ms. Reilly received a B.S. in Psychology from the Christian Bible College and Seminary, Independence, MO. GAIL A. SLOAN, Controller, joined the Company in 1996 as Assistant Controller. Prior to joining the Company, from 1993 to 1996, Ms. Sloan served as Assistant Controller at Affymax Research Institute, a drug discovery research company and a part of the Glaxo Wellcome Group. From 1985 to 1993, she progressed to the position of Audit Manager with Ernst & Young, LLP. Ms. Sloan holds a B.S. in Business Administration from California Polytechnic State University at San Luis Obispo and is a Certified Public Accountant. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock trades on the Nasdaq National Market under the symbol "LJPC." Set forth below are the high and low sales prices for the Company's Common Stock for each full quarterly period within the two most recent fiscal years. The Company has not paid dividends on its Common Stock and does not anticipate paying dividends in the foreseeable future. The number of record holders of the Company's Common Stock as of January 31, 2000 was approximately 3,800. On February 16, 2000, the Company sold 4,040,000 shares of its Common Stock to private investors for an aggregate price of $13.6 million. The sale was a privately negotiated sale to selected institutional investors and other accredited investors and the Company expects that it will file a resale registration statement for these shares on Form S-3 on or about February 28, 2000. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following Selected Financial Data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Since its inception in May 1989, LJP has devoted substantially all of its resources to the research and development of technology and potential drugs to treat antibody-mediated diseases. We have never generated any revenue from product sales and have relied upon private and public investors, revenue from collaborative agreements, equipment lease financings and interest income on invested cash balances for its working capital. We have been unprofitable since inception and we expect to incur substantial additional expenses and net operating losses for at least the next several years as we increase our clinical trial and manufacturing scale-up activities including the production of LJP 394 for clinical trials, and increase our research and development expenditures on additional drug candidates, and general and administrative expenditures to support increased clinical trial, research and development and manufacturing scale-up activities. Our activities to date are not as broad in depth or scope as the activities we must undertake in the future and our historical operations and the financial information included in this report are not necessarily indicative of our future operating results or financial condition. We expect that losses are likely to exceed those experienced in prior years due to the termination of the Abbott collaborative relationship in September 1999. In addition, we expect losses to fluctuate from quarter to quarter as a result of differences in the timing of expenses incurred. Some of these fluctuations may be significant. As of December 31, 1999, our accumulated deficit was approximately $71.8 million. Our business is subject to significant risks including, but not limited to, the risks inherent in research and development efforts, including clinical trials, uncertainties associated with both obtaining and enforcing patents and with the patent rights of others, the lengthy, expensive and uncertain process of seeking regulatory approvals, uncertainties regarding government reforms and of product pricing and reimbursement levels, technological change and competition, manufacturing uncertainties, our lack of marketing experience and the uncertainty of receiving future revenue from product sales or other sources such as collaborative relationships, future profitability and the need for additional financing. Even if our product candidates appear promising at an early stage of development, they may not reach the market for numerous reasons. Such reasons include the possibilities that the products will be ineffective or unsafe during clinical trials, will fail to receive necessary regulatory approvals, will be difficult to manufacture on a large scale, will be uneconomical to market or will be precluded from commercialization by proprietary rights of third parties. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 Revenue. We earned revenue of $4.7 million, $8.6 million, and $9.9 million for the years ended December 31, 1999, 1998 and 1997, respectively. In December 1996, we entered into a collaborative agreement with Abbott for the worldwide development and commercialization of LJP 394, our lupus drug candidate. All revenue in 1999, 1998 and 1997 was attributable to the funding from Abbott for the development of LJP 394. The collaborative agreement with Abbott granted Abbott the exclusive right to market and sell LJP 394 throughout the world in exchange for development funding, royalties on sales and milestone payments. Abbott's obligations to make payments to LJP and to conduct development activities were conditioned on the progress of clinical trials and the attainment of milestones related to regulatory approvals and sales levels. In May 1999, Abbott and LJP elected to stop the enrollment and treatment of the more than 200 patients enrolled in the jointly conducted Phase II/III clinical trial of LJP 394. In September 1999, Abbott and LJP terminated their agreement and all rights to LJP 394 were returned to us. There can be no assurance that we will realize any further revenue from any other collaborative arrangement. Research and Development Expenses. Our research and development expenses decreased to $11.7 million for the year ended December 31, 1999 from $14.6 million for the same period in 1998 and from $14.7 million for the same period in 1997. The decrease in research and development expense in 1999 from 1998 was primarily due to the decrease in expenses as a result of stopping our Phase II/III clinical trial for LJP 394. Research and development expenses for 1998 were comparable to those incurred in 1997. Although we experienced an increase in expenses in 1998 from 1997 due to the expansion of our research and development programs, these increases were offset by the decrease in expenses related to clinical trials that were paid directly by Abbott in 1998 and the timing of purchases for the production of LJP 394 for use in clinical trials. Our research and development expenses are expected to increase significantly in the future as clinical trial and manufacturing scale-up activities including the production of LJP 394 for clinical trials are increased, efforts to develop additional drug candidates are intensified, and other potential products progress into and through clinical trials. General and Administrative Expenses. Our general and administrative expenses of $2.9 million for the year ended December 31, 1999 decreased slightly from $3.1 million for the same period in 1998 and were comparable to $2.9 million for the same period in 1997. The slight decrease in general and administrative expense in 1999 compared to 1998 was due to the reduction in investor relations activities. Several factors contributed to the increase in general and administrative expense from 1997 to 1998, including expanded business development and investor relations activities. We expect general and administrative expenses to increase in the future to support increased clinical trial, manufacturing scale-up and research and development activities. Interest Income and Expense. Our interest income decreased to $0.8 million for the year ended December 31, 1999 from $1.2 million in 1998 and from $1.4 million in 1997. The decrease in interest income in 1999 from 1998 and 1997 was due to lower investment balances. Interest expense increased to $20,000 for the year ended December 31, 1999 from $6,000 in 1998 and decreased from $56,000 in 1997. The increase in interest expense in 1999 was due to our new capital lease obligations entered into in 1999. The decrease in interest expense from 1997 to 1998 was the result of decreases in our capital lease obligations. Net Operating Loss Carryforwards. At December 31, 1999, we had available net operating loss carryforwards and research tax credit carryforwards of approximately $68.8 million and $8.3 million, respectively, for federal income tax purposes, which will begin to expire in 2005 unless previously utilized. Because of "change in ownership" provisions of the Tax Reform Act of 1986, our net operating loss and tax credit carryforwards will be subject to an annual limitation regarding utilization against taxable income in future periods. We believe that such limitation will not have a material impact on the benefits that may arise out of our net operating loss and tax credit carryforwards. However, we cannot be certain that additional limitations arising from any future changes in ownership will not have a material impact on us. For more information concerning the provision for income taxes, see Note 8 of the Notes to Financial Statements. LIQUIDITY AND CAPITAL RESOURCES From inception through December 31, 1999, we have incurred a cumulative net loss of approximately $71.8 million and have financed our operations through private and public offerings of securities, revenues from collaborative agreements, capital and operating lease transactions, and interest income on invested cash balances. As of December 31, 1999, we have raised $83.7 million in net proceeds since inception from sales of equity securities. At December 31, 1999, we had $11.4 million in cash, cash equivalents and short-term investments, as compared to $23.4 million at December 31, 1998. Our working capital at December 31, 1999 was $10.7 million, as compared to $19.9 million at December 31, 1998. The decrease in cash, cash equivalents and short-term investments resulted from the decrease in funding received from Abbott for the development of LJP 394, the continued use of cash for operating activities, termination benefits paid for restructuring, patent expenditures and the purchase of property and equipment. We received $9.1 million in funding and proceeds of $3.8 million for the sale of 1,538,402 shares of our common stock to Abbott in 1998, as compared to $2.9 million in similar funding received in 1999. The decrease in payments received in 1999 was due to the stopping of the clinical trial for LJP 394 in May 1999 and the termination of our collaborative agreement with Abbott in September 1999. We invest our cash in corporate and United States Government-backed debt instruments. As of December 31, 1999, we had acquired an aggregate of $4.4 million in property and equipment, of which approximately $564,000 of total equipment costs is financed under capital lease obligations. In addition, we lease our office and laboratory facilities and certain equipment under operating leases. We have no material commitments for the acquisition of property and equipment. However, we anticipate increasing our investment in property and equipment in connection with the enhancement of our research and development and manufacturing facilities and capabilities. We intend to use our financial resources to fund clinical trials and manufacturing scale-up activities including the production of LJP 394 for clinical trials, research and development efforts, and for working capital and other general corporate purposes. The amounts actually expended for each purpose may vary significantly depending upon numerous factors, including the results of clinical trials, the analysis of the Phase II/III clinical trial data, the timing of regulatory applications and approvals, and technological developments. Expenditures also will depend upon the establishment and progression of collaborative arrangements and contract research as well as the availability of other financings. There can be no assurance that these funds will be available on acceptable terms, if at all. We anticipate that our existing capital along with the net proceeds of approximately $12.8 million received from the sale of 4,040,000 shares of our common stock to private investors in February 2000, and interest earned thereon, will be sufficient to fund our operations as currently planned into 2001. Our future capital requirements will depend on many factors, including continued scientific progress in our research and development programs, the size and complexity of these programs, the scope and results of clinical trials, the analysis of data from the Phase II/III clinical trial, the time and costs involved in applying for regulatory approvals, the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims, competing technological and market developments, ability to establish and maintain collaborative relationships, and the cost of manufacturing scale-up and effective commercialization activities and arrangements. We expect to incur significant net operating losses each year for at least the next several years as we expand our current research and development programs, including clinical trials and manufacturing scale-up activities, and increase our general and administrative expenses to support a larger, more complex organization. It is possible that our cash requirements will exceed current projections and that we will therefore need additional financing sooner than currently expected. We have no current means of generating cash flow from operations. Our lead drug candidate, LJP 394, will not generate revenues, if at all, until it has been proven safe and effective, has received regulatory approval and has been successfully commercialized, a process that is expected to take at least the next several years. Our other drug candidates are much less developed than LJP 394. There can be no assurance that our product development efforts with respect to LJP 394 or any other drug candidate will be successfully completed, that required regulatory approvals will be obtained, or that any product, if introduced, will be successfully marketed or achieve commercial acceptance. Accordingly, we must continue to rely upon outside sources of financing to meet our capital needs for the foreseeable future. We anticipate increasing expenditures on the clinical trials and manufacturing scale-up activities as well as the development of other drug candidates and, over time, our consumption of cash will necessitate tapping additional sources of financing. Furthermore, we have no internal sources of liquidity, and termination of the Abbott arrangement has had an adverse effect on our ability to generate sufficient cash to meet our needs. In February, we raised approximately $12.8 million in net proceeds from the sale of 4,040,000 shares of common stock to private investors. We will continue to seek capital through any appropriate means, including issuance of our securities and establishment of additional collaborative arrangements. However, there can be no assurance that additional financing will be available on acceptable terms and our negotiating position in capital-raising efforts may worsen as we continue to use existing resources. There is no assurance that we will be able to enter into further collaborative relationships. IMPACT OF YEAR 2000 In prior years, we discussed the nature and progress of our plans to become Year 2000 ready. In late 1999, we completed our remediation and testing of systems. As a result of those planning and implementation efforts, we experienced no significant disruptions in our mission critical information technology and non-information technology systems and we believe those systems successfully responded to the Year 2000 date change. We incurred approximately $95,000 during 1999 in connection with remediating systems. We are not aware of any material problems resulting from Year 2000 issues, either with our internal systems, or the products and services of third parties. We will continue to monitor our mission critical computer applications and those of our suppliers and vendors throughout the year 2000 to ensure that any latent Year 2000 matters that may arise are addressed promptly. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. We invest our excess cash in interest-bearing investment-grade securities that we hold for the duration of the term of the respective instrument. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that, while the investment-grade securities we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices or other market changes that affect market risk sensitive instruments. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements and supplementary data required by this item are at the end of this report beginning on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning our executive officers is included under the caption "Executive Officers" following Part I, Item 4 of this report. Other information for Item 10 is incorporated by reference from portions of our definitive proxy statement for the annual meeting of stockholders to be held on May 11, 2000 under the captions "Proposal 1 - Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 1999. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information for Item 11 is incorporated by reference from portions of our definitive proxy statement for the annual meeting of stockholders to be held on May 11, 2000 under the captions "Executive Compensation and Other Information," "Report of the Compensation Committee on Executive Compensation," "Compensation Committee Interlocks and Insider Participation," and "Stock Performance Graph," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 1999. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information for Item 12 is incorporated by reference from the portion of our definitive proxy statement for the annual meeting of stockholders to be held on May 11, 2000 entitled "Security Ownership of Certain Beneficial Owners and Management," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 1999. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Abbott owns approximately 3,369,000 shares of our common stock, representing more than 5% of our common stock and is considered a related party. Under our collaborative agreement with Abbott, in 1999, we recorded revenue of approximately $4.7 million from Abbott for the development of LJP 394, of which $2.9 million was received in cash in 1999 and $1.8 million was revenue recognized from previously deferred revenue. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this report: 3. Exhibits. - --------------- * This exhibit is a management contract or compensatory plan or arrangement. (1) Previously filed with the Company's Registration Statement on Form S-1 (No. 33-76480) as declared effective by the Securities and Exchange Commission on June 3, 1994. (2) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1994 and incorporated by reference herein. (3) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended March 31, 1995 and incorporated by reference herein. (4) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1995 and incorporated by reference herein. (5) Previously filed with the Company's annual report on Form 10-K for the fiscal year ended December 31, 1995 and incorporated by reference herein. (6) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996 and incorporated by reference herein. (7) Portions of the Exhibit 10.35 have been omitted and filed separately with the Securities and Exchange Commission pursuant to a request for confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934. (8) Previously filed with the Company's annual report on Form 10-K for the fiscal year ended December 31, 1996 and incorporated by reference herein. (9) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1997 and incorporated by reference herein. (10) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1998 and incorporated by reference herein. (11) Previously filed with the Company's Registration Statement on Form 8-A (No. 000-24274) as filed with the Securities and Exchange Commission on December 4, 1998. (12) Previously filed with the Company's annual report on Form 10-K for the fiscal year ended December 31, 1998 and incorporated by reference herein (13) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1999 and incorporated by reference herein. (14) Previously filed with the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1999 and incorporated by reference herein. (15) Filed herein. (b) Reports on Form 8-K: None. Report of Independent Auditors The Board of Directors and Stockholders La Jolla Pharmaceutical Company We have audited the accompanying balance sheets of La Jolla Pharmaceutical Company as of December 31, 1999 and 1998, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of La Jolla Pharmaceutical Company at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. ERNST & YOUNG LLP San Diego, California February 11, 2000 La Jolla Pharmaceutical Company Balance Sheets (In thousands, except share and per share data) See accompanying notes. La Jolla Pharmaceutical Company Statements of Operations (In thousands, except per share data) See accompanying notes. La Jolla Pharmaceutical Company Statements of Stockholders' Equity For the Years Ended December 31, 1997, 1998 and 1999 See accompanying notes. La Jolla Pharmaceutical Company Statements of Cash Flows (In thousands) See accompanying notes. La Jolla Pharmaceutical Company Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BUSINESS ACTIVITY La Jolla Pharmaceutical Company (the "Company") is a biopharmaceutical company focused on the research and development of highly specific therapeutics for the treatment of certain life-threatening antibody-mediated diseases. These diseases, including autoimmune conditions such as systemic lupus erythematosus ("lupus") and antibody-mediated stroke, are caused by abnormal B cell production of antibodies that attack healthy tissues. Current therapies for these autoimmune disorders target the symptoms of the disease or nonspecifically suppress the normal operation of the immune system, frequently resulting in severe, adverse side effects and hospitalization. The Company's drug candidates, called Toleragens(R), are designed to treat the underlying cause of many antibody-mediated diseases without these severe, adverse side effects. The Company's clinical drug candidate is known as LJP 394, a lupus treatment drug. All of the Company's revenues to date have been primarily derived from its former collaborative agreement with Abbott Laboratories ("Abbott"), a related party (See Note 2). As part of its planned business operations, the Company seeks to pursue collaborations with pharmaceutical companies in an effort to access their research, drug development, manufacturing and financial resources. Prior to generating product revenues, the Company must complete the development of its products, including several years of clinical testing, and receive regulatory approvals prior to selling these products commercially. There can be no assurance that the Company's product development efforts with respect to LJP 394 or any other drug candidate will be successfully completed, that required regulatory approvals will be obtained, or that any product, if introduced, will be successfully marketed or achieve commercial acceptance. In addition, there can be no assurance that the Company can successfully manufacture and market any such products at prices that would permit the Company to operate profitably. In May 1999, Abbott and the Company elected to stop enrollment and treatment of the more than 200 patients enrolled in the jointly conducted Phase II/III clinical trial of LJP 394. In September 1999, Abbott and the Company terminated their agreement and all rights to LJP 394 were returned to the Company. The Company actively seeks additional financing to fund its research and development efforts and commercialize its technologies. There is no assurance such financing will be available to the Company when required or that such financing would be available under favorable terms. The Company believes that patents and other proprietary rights are important to its business. The Company's policy is to file patent applications to protect technology, inventions and improvements to its inventions that are considered important to the development of its business. The patent positions of biotechnology firms, including the Company, are uncertain and involve complex legal and factual questions for which important legal principles are largely unresolved. There can be no assurance that any additional patents will be issued, or that the scope of any patent protection will be sufficient, or that any current or future issued patent will be held valid if subsequently challenged. La Jolla Pharmaceutical Company Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and disclosures made in the accompanying notes to the financial statements. Actual results could differ from those estimates. RECLASSIFICATION Certain amounts in the 1998 and 1997 financial statements have been reclassified to conform with the 1999 presentation. CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS Cash and cash equivalents consist of cash and highly liquid investments which include debt securities with remaining maturities when acquired of three months or less and are stated at market. Short-term investments mainly consist of debt securities with maturities greater than three months. Management has classified the Company's cash equivalents and short-term investments as available-for-sale securities in the accompanying financial statements. Available-for-sale securities are stated at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in interest income. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest income. CONCENTRATION OF RISK Cash, cash equivalents and short-term investments are financial instruments which potentially subject the Company to concentrations of credit risk. The Company deposits its cash in financial institutions. At times, such deposits may be in excess of insured limits. The Company invests its excess cash in United States Government securities and debt instruments of financial institutions and corporations with strong credit ratings. The Company has established guidelines relative to diversification of its cash investments and their maturities in an effort to maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates. To date, the Company has not experienced any impairment losses on its cash, cash equivalents and short-term investments. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 provides a comprehensive and consistent standard for the recognition and measurement of derivatives and hedging activities. SFAS 133 is effective January 1, 2001. The adoption of this statement is not expected to have a significant effect on the financial position or results of operations of the Company. La Jolla Pharmaceutical Company Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets (primarily five years). Leasehold improvements and equipment under capital leases are stated at cost and amortized on a straight-line basis over the shorter of the estimated useful life or the lease term. Property and equipment is comprised of the following (in thousands): IMPAIRMENT OF LONG-LIVED ASSETS The Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The Company also records the assets to be disposed of at the lower of their carrying amount or fair value less cost to sell. To date, the Company has not experienced any impairment losses on its long-lived assets used in operations. While the Company's current and historical operating and cash flow losses are indicators of impairment, the Company believes the future cash flows to be received support the carrying value of its long-lived assets and accordingly, the Company has not recognized any impairment losses as of December 31, 1999. PATENTS The Company has filed several patent applications with the United States Patent and Trademark Office and in foreign countries. Legal costs and expenses incurred in connection with pending patent applications have been deferred. Costs related to successful patent applications are amortized using the straight-line method over the lesser of the remaining useful life of the related technology or the remaining patent life, commencing on the date the patent is issued. Accumulated amortization at December 31, 1999 and 1998 was $166,000 and $120,000, respectively. Deferred costs related to patent applications are charged to operations at the time a determination is made not to pursue such applications. La Jolla Pharmaceutical Company Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) STOCK-BASED COMPENSATION As allowed under Statement of Financial Accounting Standard No. 123, "Accounting and Disclosure of Stock-Based Compensation" ("SFAS 123"), the Company has elected to continue to account for stock option grants in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations. Under APB 25, if the exercise price of the Company's employee and director stock options equals or exceeds the deemed fair value of the underlying stock on the date of grant, no compensation expense is recognized. When the exercise price of the employee or director stock options is less than the deemed fair value of the underlying stock on the grant date, the Company records deferred compensation for the difference and amortizes this amount to expense in accordance with FASB Interpretation No. 28 over the vesting period of the options. Options or stock awards issued to non-employees have been determined in accordance with SFAS 123 and EITF 96-18. Deferred charges for options granted to non-employees are periodically remeasured as the options vest. REVENUE RECOGNITION Revenue from collaborative agreements typically consists of ongoing research and development funding and milestone, royalty and other payments. Revenue from ongoing research and development funding is recorded as the expenses are incurred. Revenue from milestone, royalty and other payments will be recognized as earned. Payments received in advance under these agreements are recorded as deferred revenue until earned. The Company believes that the deferral of up-front fees received in connection with collaborative agreements would not have a material impact on the Company's financial statements as of December 31, 1999. NET LOSS PER SHARE Basic and diluted net loss per share is computed using the weighted-average number of common shares outstanding during the periods in accordance with Statement of Financial Accounting Standard No. 128, "Earnings per Share". As the Company has incurred a net loss for all three years presented, stock options and warrants are not included in the computation of net loss per share since their effect is anti-dilutive. COMPREHENSIVE LOSS Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income (Loss)" ("SFAS 130"), requires that all components of comprehensive income (loss), including net income (loss), be reported in the financial statements in the period in which they are recognized. Comprehensive income (loss) is defined as the change in equity during the period from transactions and other events and circumstances from non-owner sources. Net income (loss) and other comprehensive income (loss), including unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income (loss). The Company's comprehensive net loss and net loss are the same and therefore the adoption of SFAS 130 did not have an impact on the financial statements. La Jolla Pharmaceutical Company Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) SEGMENT INFORMATION On January 1, 1998, the Company adopted Statement of Financial Accounting Standard No. 131, "Segment Information" ("SFAS 131"). SFAS 131 redefines segments and requires companies to report financial and descriptive information about their operating segments. The Company has determined that it operates in one business segment. 2. COLLABORATIVE AGREEMENTS In December 1996, the Company entered into a collaborative agreement with Abbott, a diversified health-care company. Under this agreement, in exchange for an exclusive, worldwide license to market and sell LJP 394, Abbott agreed to pay an initial license fee of $4,000,000 upon signing, and agreed to fund the development of the Company's lupus drug candidate, LJP 394, in accordance with a mutually agreed upon budget, and to make certain payments to the Company upon the attainment of specific milestones, as well as royalty and sales incentive payments to the Company on sales of LJP 394. The Company retained worldwide manufacturing rights and ownership rights of all of its patents relating to the drug. Under a separate stock purchase agreement, Abbott also purchased common stock of the Company in December 1996, September 1997 and October 1998 for an aggregate purchase price of $4,000,000 on each date. Both Abbott and the Company had the right to terminate the collaborative agreement under certain circumstances. In September 1999, Abbott and the Company terminated this collaborative agreement and all rights to LJP 394 were returned to the Company following the May 1999 suspension of the jointly conducted Phase II/III clinical trial of LJP 394. Under the collaborative agreement with Abbott, the Company incurred research and development costs of approximately $4,690,000, $8,600,000 and $9,860,000 during the years ended December 31, 1999, 1998 and 1997, respectively, for the development of LJP 394. In 1999, the Company recorded revenue of $4,690,000 from Abbott for the development of LJP 394, of which $2,921,000 was received in cash in 1999 and $1,769,000 was revenue recognized from previously deferred revenue. In 1998, the Company received $9,077,000 from Abbott for the development of LJP 394, of which $8,600,000 was recorded as revenue. In 1997, the Company received $11,137,000 from Abbott for the development of LJP 394, of which $9,860,000 was recorded as revenue. 3. RESTRUCTURING CHARGES As a result of the termination of the Company's collaborative agreement with Abbott in September 1999, the Company restructured its operations in order to reduce expenses and to focus its resources on its remaining potential drug candidates. In September 1999, the Company recorded estimated restructuring charges of approximately $742,000. The restructuring was completed in December 1999 and actual charges recorded were approximately $640,000, which are included in both research and development and general and administrative expense, representing termination benefits paid to 38 employees. La Jolla Pharmaceutical Company Notes to Financial Statements 4. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The following is a summary of the estimated fair value of available-for-sale securities (in thousands): As of December 31, 1999 and 1998, the difference between cost and estimated fair value of available-for-sale securities was not significant. Included in cash and cash equivalents at December 31, 1999 and 1998 were $2,975,000 and $10,124,000, respectively, of securities classified as available-for-sale. As of December 31, 1999, available-for-sale securities of $9,969,000 mature in one year or less. 5. COMMITMENTS LEASES In July 1992, the Company entered into a non-cancellable operating lease for the rental of its office and research and development facilities, which expires in July 2004. The lease is subject to an escalation clause that provides for annual increases based on the Consumer Price Index. The lease also contains an option to extend the lease term for an additional five years and a one-time cancellation option effective any time after August 1, 1998 with the payment of certain penalties. The lease also contains a construction allowance in the amount of $1,434,000 for approved tenant improvements to the facility. In October 1996, the Company entered into a non-cancellable operating lease for the rental of office and research and development facilities, which expires in October 2001. The lease contains a provision for scheduled annual rent increases and an option to extend the lease term for an additional five years. The lease also contains a construction allowance in the amount of $168,000 for approved tenant improvements to the facility. The Company leases certain equipment under capital leases. The total amount of equipment financed under these capital leases as of December 31, 1999 was $564,000. The Company leases certain other equipment and leasehold improvements under operating leases. As of December 31, 1999, the total amount of equipment and leasehold improvements financed under these operating leases was $5,908,000. La Jolla Pharmaceutical Company Notes to Financial Statements 5. COMMITMENTS (CONTINUED) Annual future minimum lease payments as of December 31, 1999, which include $885,000 for the effect of exercising the facility operating lease cancellation option, are as follows (in thousands): Rent expense under all operating leases totaled $2,360,000, $2,179,000, and $1,853,000 for the years ended December 31, 1999, 1998 and 1997, respectively. Equipment acquired under capital leases included in property and equipment totaled $233,000 and $44,000 (net of accumulated amortization of $331,000 and $152,000) at December 31, 1999 and 1998, respectively. 6. STOCKHOLDERS' EQUITY PREFERRED STOCK As of December 31, 1999, the Company is authorized to issue 8,000,000 shares of preferred stock with a par value of $0.01 per share, in one or more series. The Board of Directors has designated 75,000 of preferred stock as nonredeemable Series A Junior Participating Preferred Stock ("Series A Preferred Stock"). In the event of liquidation, each share of Series A Preferred Stock is entitled to receive a preferential liquidation payment of $1,000 per share plus the amount of accrued unpaid dividends. The Series A Preferred Stock is subject to certain anti-dilution adjustments, and the holder of each share is entitled to 1,000 votes, subject to adjustments. Cumulative quarterly dividends of the greater of $0.25 or, subject to certain adjustments, 1,000 times any dividend declared on shares of common stock, are payable when, as and if declared by the Board of Directors, from funds legally available for this purpose. COMMON STOCK In May 1999, the Company increased the number of shares of common stock the Company is authorized to issue to 100,000,000 shares with a par value of $0.01 per share. La Jolla Pharmaceutical Company Notes to Financial Statements 6. STOCKHOLDERS' EQUITY (CONTINUED) WARRANTS In connection with the Company's initial public offering ("IPO") in June 1994, including the conversion of the principal and accrued interest on stockholder bridge notes, the Company issued 3,823,517 redeemable warrants. The redeemable warrant holders are entitled to purchase one-half of one share of common stock for each warrant at an exercise price of $3.00 per one-half share. In May 1999, the Company extended the expiration date of these warrants to June 3, 2000. The Company is entitled to redeem the warrants on not less than 30 days written notice at $0.05 per warrant if the average closing bid price of the common stock exceeds 150% of the then-effective warrant exercise price for one share of common stock, over a period of 20 consecutive trading days, ending within 15 days of the date of notice of redemption. At December 31, 1999, 3,822,617 redeemable warrants were outstanding to purchase 1,911,309 shares of common stock. The terms of the stockholder bridge notes also provided for the granting of additional warrants to the holders. Those additional warrants permit the holders to purchase 166,697 shares of common stock at $5.00 per share. In May 1999, the Company extended the expiration date of these warrants to June 3, 2000. At December 31, 1999, warrants to purchase 154,460 shares of common stock were outstanding. Also in connection with the IPO, the Underwriter was granted the option to purchase up to 260,000 additional shares of common stock and 260,000 redeemable warrants to purchase one-half of one share of common stock at an exercise price of $3.60 per one-half share. In May 1999, the Company extended the expiration date of the purchase option to June 3, 2000. At December 31, 1999, warrants to purchase 130,000 shares of common stock were outstanding. As of December 31, 1999, 4,237,077 warrants were outstanding and 2,195,769 shares of common stock are reserved for issuance upon exercise of warrants. STOCK OPTION PLANS In May 1989, the Company adopted the 1989 Stock Option Plan and the 1989 Nonstatutory Stock Option Plan (the "1989 Plan"), under which 904,000 shares of common stock have been authorized for issuance upon exercise of options granted by the Company. The 1989 Plan expired in 1999. In June 1994, the Company adopted the 1994 Stock Incentive Plan (the "1994 Plan"), under which 2,500,000 shares of common stock have been authorized for issuance upon exercise of options granted by the Company. The 1994 Plan provides for the grant of incentive and non-qualified stock options, as well as other stock-based awards, to employees, consultants and advisors of the Company with various vesting periods as determined by the compensation committee, as well as automatic fixed grants to non-employee directors of the Company. La Jolla Pharmaceutical Company Notes to Financial Statements 6. STOCKHOLDERS' EQUITY (CONTINUED) A summary of the Company's stock option activity and related data follows: La Jolla Pharmaceutical Company Notes to Financial Statements 6. STOCKHOLDERS' EQUITY (CONTINUED) Exercise prices and weighted-average remaining contractual lives for the options outstanding as of December 31, 1999 follow: At December 31, 1999, the Company has reserved 2,666,635 shares of common stock for future issuance under the 1989 and 1994 Plans. EMPLOYEE STOCK PURCHASE PLAN Effective August 1, 1995, the Company adopted the 1995 Employee Stock Purchase Plan (the "Purchase Plan") which was amended in July 1996. Under the amended Purchase Plan, a total of 300,000 shares of common stock are reserved for sale to full-time employees with six months of service. Employees may purchase common stock under the Purchase Plan every six months (up to but not exceeding 10% of each employee's earnings) over the offering period at 85% of the fair market value of the common stock at certain specified dates. The offering period may not exceed 24 months. For the year ended December 31, 1999, 78,202 shares of common stock had been issued under the Purchase Plan (43,191 shares for the year ended December 31, 1998). To date, 189,893 shares of common stock have been issued under the Purchase Plan and 110,107 shares of common stock are available for issuance. La Jolla Pharmaceutical Company Notes to Financial Statements 6. STOCKHOLDERS' EQUITY (CONTINUED) STOCK-BASED COMPENSATION Pro forma information regarding net loss and net loss per share is required by SFAS 123, which also requires that the information be determined as if the Company has accounted for its employee stock plans granted after December 31, 1994 under the fair value method of that statement. The fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1999, 1998 and 1997, respectively: risk-free interest rate of 6.8%, 4.8% and 5.5%; volatility factor of the expected market price of the Company's common stock of 1.09, 0.60 and 0.60; and a dividend yield of 0% and a weighted-average expected life of five years for all three years presented. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands except for net loss per share information): The effects of applying SFAS 123 for either recognizing compensation expense or providing pro forma disclosures are not likely to be representative of the effects on reported net loss for future years. STOCKHOLDER RIGHTS PLAN The Company has adopted a Stockholder Rights Plan (the "Rights Plan"). The Rights Plan provides for a dividend of one right (a "Right") to purchase fractions of shares of the Company's Series A Preferred Stock for each share of the Company's common stock. Under certain conditions involving an acquisition by any person or group of 15% or more of the common stock, the Rights permit the holders (other than the 15% holder) to purchase the Company's common stock at a 50% discount upon payment of an exercise price of $30 per Right. In addition, in the event of certain business combinations, the Rights permit the purchase of the common stock of an acquirer at a 50% discount. Under certain conditions, the Rights may be redeemed by the Board of Directors in whole, but not in part, at a price of $.001 per Right. La Jolla Pharmaceutical Company Notes to Financial Statements 6. STOCKHOLDERS' EQUITY (CONTINUED) The Rights have no voting privileges and are attached to and automatically trade with the Company's common stock. The Rights expire on December 2, 2008. 7. 401(k) PLAN The Company has established a 401(k) defined contribution retirement plan (the "401(k) Plan"), which was amended in July 1997, to cover all employees with six months of service. The 401(k) Plan provides for voluntary employee contributions up to 20% of annual compensation (as defined). The Company does not match employee contributions or otherwise contribute to the 401(k) Plan. 8. INCOME TAXES At December 31, 1999, the Company had federal and California income tax net operating loss carryforwards of approximately $68,789,000 and $8,297,000, respectively. The difference between the federal and California tax loss carryforwards is primarily attributable to the capitalization of research and development expenses for California income tax purposes and the 50% percent limitation on California loss carryforwards. The Company also had federal and California research tax credit carryforwards of $3,067,000 and $1,462,000, respectively. The federal net operating loss and tax credit carryforwards will begin to expire in 2005 unless previously utilized. A portion of the California net operating loss carryforwards totaling $1,272,000 expired in 1999, and will continue to expire in 2000. Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of the Company's net operating loss and credit carryforwards may be limited if a cumulative change in ownership of more than 50% occurs within a three-year period. Significant components of the Company's deferred tax assets are shown below (in thousands): A valuation allowance of $28,986,000 has been recognized to offset the deferred tax assets as realization of such assets is uncertain. La Jolla Pharmaceutical Company Notes to Financial Statements 9. SUBSEQUENT EVENT In February 2000, the Company issued 4,040,000 shares of common stock in a private placement to selected institutional investors and other accredited investors for gross proceeds of approximately $13,635,000. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LA JOLLA PHARMACEUTICAL COMPANY By: /s/ Steven B. Engle ------------------------------- February 24, 2000 Name: Steven B. Engle Title: Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. La Jolla Pharmaceutical Company Exhibit Index

109156_1999.txt

109156_1999

1999

109156

ITEM 1. BUSINESS GENERAL Zale Corporation and its wholly-owned subsidiaries (the "Company") is the largest specialty retailer of fine jewelry in North America. At July 31, 1999, the Company operated 1,333 retail jewelry stores located primarily in shopping malls throughout the United States, Canada and Puerto Rico. The Company operates under four brand names: Zales Jewelers(R), Gordon's Jewelers(R), Bailey Banks & Biddle Fine Jewelers(R), and Peoples Jewellers(R). Zales Jewelers provides traditional, moderately priced jewelry to a broad range of customers. Gordon's Jewelers offers contemporary merchandise targeted to regional preferences at somewhat higher price points than Zales Jewelers. Bailey Banks & Biddle Fine Jewelers operates upscale jewelry stores which are considered among the finest jewelry stores in their markets. Under the Zales Jewelers brand name, at July 31, 1999, the Company also operated 31 Zales Outlet stores in 17 states and offered online shopping at www.zales.com. The Company acquired substantially all of the assets of Peoples Jewellers Corporation, a Canadian company, effective May 23, 1999. Peoples Jewellers offers traditional moderately priced jewelry to customers across Canada. During the fiscal year ended July 31, 1999, the Company generated $1.4 billion of net sales. The Company believes it is well-positioned to compete in the approximately $41 billion, highly fragmented retail jewelry industry, leveraging its established brand names, economies of scale and geographic and demographic diversity. The Company enjoys significant brand name recognition as a result of its long-standing presence in the industry and its national and regional advertising campaigns. The Company believes that name recognition is an important advantage in jewelry retailing as products are generally unbranded and consumers must trust in a retailer's reliability and credibility. In addition, as the largest specialty retailer of fine jewelry in North America, the Company believes it realizes economies of scale in purchasing and distribution, real estate, advertising and administrative costs. The Company also believes that the geographic diversity of its retail distribution network through all 50 states and Canada and the demographic breadth of its target customer groups may serve to mitigate earnings volatility typically associated with local or regional conditions. The Company is incorporated in Delaware. Its principal executive offices are located at 901 W. Walnut Hill Lane, Irving, TX 75038-1003, its telephone number at that address is (972) 580-4000, and its internet address is www.zalecorp.com. BUSINESS INITIATIVES AND STRATEGY The Company has developed and implemented disciplined merchandising and marketing strategies to reestablish and promote its brand identities. Differentiated target customer segments have been emphasized for Zales, Gordon's, Bailey Banks & Biddle, and Peoples. Product assortments have been broadened to capitalize on year round gift giving: bridal, fashion and special occasions. Management has developed a key item strategy as the foundation for merchandising and marketing initiatives. Items have been identified from among the best selling products in the retail jewelry industry, such as tennis bracelets, diamond solitaires, diamond stud earrings, and bezel set style diamond pendants and earrings. The Company has ensured that these items are available in an appropriate variety of styles at a range of competitive price points. At the same time, the Company has adopted an aggressive approach to inventory management to keep key items in stock and inventories current. This goal is achieved through enhancements to the merchandise system which provides regular reporting to the Company's merchandise buyers on in-stock position and slow moving merchandise. The Company employs a consistent methodology which provides inventory turnover and profitability information to identify slow moving merchandise and determine appropriate merchandising actions on a timely basis. The Company's marketing efforts are product and event-focused. Television, radio, print advertising in nationally distributed newspapers and magazines, newspaper inserts, and direct mail advertising feature selected key items at a variety of price points. The Company has also broadened its marketing efforts beyond the Christmas season to tie in with other gift-giving holidays, such as Valentine's Day and Mother's Day. In addition, advertising and in-store promotions are synchronized with mall marketing efforts to take advantage of other periods of high mall traffic, such as Labor Day, which are typically not considered jewelry oriented holidays. The Company has recruited experienced buyers and has centralized purchasing for each brand to ensure consistency of quality and cost. In addition, the Company leverages its size to achieve better prices, payment terms, return privileges and cooperative advertising arrangements with its suppliers for certain products. The Company has enhanced its image as a provider of fine jewelry at competitive prices by establishing price points for merchandise that are perceived by customers as good values. Certain items are labeled "Brilliant Buys," "Premier Values" and "Bailey's Classic Values" in Zales and Peoples, Gordon's and Bailey Banks & Biddle stores, respectively. These items are prominently displayed along with their prices throughout the store, a practice that is uncommon in the U.S. jewelry retailing industry and one that the Company believes enhances its reputation for pricing integrity. Over the past five years, the Company has opened approximately 325 stores. Approximately 70 percent of the Company's stores have received significant upgrades or investments within the last five years. Typically, these stores experience revenue growth in future years that is significantly higher than other stores. The Company has taken steps to provide upgraded sales and product training company-wide through employee and manager training programs. Staffing plans are coordinated to schedule employees during peak periods. The Company's strategy is to continue to increase store productivity and profitability by: (i) focusing on the core categories of bridal, fashion and watches; (ii) using key item merchandise to drive volume; (iii) remodeling and renovating all existing stores; (iv) enhancing merchandising systems to assist buyer decision making; (v) executing tailored staffing and training programs for store personnel; (vi) focusing advertising on brand building and product distinction; and (vii) providing exclusive products to develop brand distinction. The Company plans to open approximately 165 new stores, principally under the brand names Zales, Zales Outlet and Bailey Banks & Biddle, for which it will incur approximately $40 million in capital expenditures during the combined fiscal years 2000 and 2001. The Company expects these stores to solidify the Company's core mall business by further penetrating markets where the Company is underrepresented. The Company targets premier regional mall locations throughout the country and selects sites based on a variety of well-defined demographic and store profitability characteristics. The Company has identified the specific malls for this planned expansion which satisfy the Company's real estate strategy. The Company also plans to refurbish, remodel or relocate approximately 200 stores at a cost of approximately $45 million during the same period. Over the past five years the Company has reduced selling, general and administrative expenses as a percent of sales principally by leveraging its fixed store and corporate operating expenses while increasing sales in its stores. Additionally, the Company has continued a focused effort to reduce selling, general and administrative expenses where appropriate by streamlining processes and leveraging technology where possible. Initiatives include: (i) improving the return on credit operations, including establishing a national credit card bank which has allowed greater flexibility in establishing finance charge rates to customers and has simplified the regulatory requirements under which the Company operates; (ii) outsourcing certain non-strategic functions, including certain aspects of management information systems operations, credit services, and the internal audit department among other areas; and (iii) streamlining corporate operations through review and improvement of current processes and application of new technology in areas such as merchandising, credit, store point of sale and financial systems. The Company continues to apply a disciplined approach to its credit policies, which are controlled centrally for all stores. See "Business -- Credit Operations." CURRENT YEAR EVENTS ACQUISITION OF PEOPLES JEWELLERS. Effective May 23, 1999, the Company acquired substantially all assets of Peoples Corporation, a privately owned chain consisting principally of 176 fine jewelry stores operating throughout Canada, for approximately $78 million cash and the assumption of certain liabilities. ZALE FUNDING TRUST SECURITIZATION. On July 15, 1999, the Company redeemed approximately $380.8 million, net of discount, aggregate principal amount of Receivables Backed Notes ("Receivables Notes") issued by Zale Funding Trust ("ZFT"), a limited purpose Delaware business trust wholly owned by Zale Delaware, Inc. ("ZDel"), and formed to finance customer accounts receivable. The Receivables Notes were redeemed with available cash and proceeds of advances under the Company's Revolving Credit Agreement and through the issuance of Variable Funding Notes ("Variable Notes") to a purchaser group under a new securitization facility in the initial aggregate principal amount of $250 million. The Variable Notes are part of a 364-day liquidity facility and are secured by a lien on customer accounts receivable. The Variable Notes currently bear interest at the market commercial paper rate plus a dealer fee of 0.05 percent. In addition, the Company pays a fee of 0.375 percent per annum on the funded portion of the facility and a commitment fee of 0.25 percent per annum on the unfunded portion. As of July 31, 1999, the entire $250 million facility is classified as a Short-term Borrowing since it matures within the next twelve months. As originally entered into, the facility required the Company to reduce the outstanding amount of the Variable Notes to $150 million no later than October 15, 1999. On September 15, 1999, the Company entered into an amendment to the new securitization facility to reduce the commitment of the original Variable Note purchaser group to $150 million and to add two new note purchaser groups having an aggregate commitment of $200 million, thereby increasing the total outstanding amount under the Variable Notes facility to $350 million on terms consistent with the original facility. Additionally the Company paid down the approximate $103 million balance under the Revolving Credit Agreement. The Company expects to refinance the Variable Notes on or before their maturity date with a new transaction or, with the consent of the note purchaser groups, to extend the maturity of the outstanding Variable Notes. STOCK REPURCHASE PLAN. During September 1999, the Board of Directors approved a stock repurchase program pursuant to which the Company, from time to time and at management's discretion, may purchase through fiscal year 2000, up to an aggregate of $50 million of the Company's common stock on the open market. In June 1999, the Company completed a $50 million repurchase program, which was authorized during August 1998. Under this program, the Company repurchased 1.7 million shares in fiscal 1999. DEFERRED COMPENSATION. During February 1999, 180,692 shares of restricted Common Stock were granted to certain key employees valued at $5.7 million as of the grant date. The shares will vest ratably on each of the anniversaries ranging from three to four years from the date of grant and are subject to restrictions on their sale or transfer. The total cost of restricted stock is amortized to income as compensation expense ratably over the vesting period and amounted to $0.7 million for the twelve months ended July 31, 1999. INDUSTRY The U.S. retail jewelry industry's sales were approximately $41 billion in 1998. Specialty jewelry stores (such as the Company) account for almost half of the industry, according to publicly available data. Historically, retail jewelry store sales have exhibited only limited effects of cyclicality. According to the U.S. Bureau of the Census, retail jewelry store sales have increased every year for the past 15 years with the exception of 1991 which included both the Persian Gulf War and the introduction of the luxury tax. Other significant segments of the industry include national chain department stores (such as J.C. Penney Company, Inc. and Sears, Roebuck and Co.), mass merchant discount stores (such as Wal-Mart Stores, Inc.), other general merchandise stores and apparel and accessory stores. The remainder of the retail jewelry industry is composed primarily of catalog and mail order houses, direct-selling establishments, TV home shopping (such as QVC, Inc.) and computer on-line shopping. The U.S. retail jewelry industry is highly fragmented with the 10 largest companies accounting for less than 25 percent of the market. The largest jewelry retailer is believed to be Wal-Mart Stores, Inc., followed by the Company. The Company is the largest specialty jewelry retail chain in North America, with approximately 3.4 percent of market share based on the United States Census Bureau estimate of 1998 U.S. Retail Jewelry and Watch Sales. Only two other specialty jewelry retailers had greater than 2 percent market share. OPERATIONS The Company operates principally under four brand names. The following table presents net sales, average sales per store and the number of stores for Zales, Gordon's, Bailey Banks & Biddle, and Peoples for the periods indicated. - --------------- (a) The Company acquired substantially all assets and certain operational liabilities of Peoples Jewellers Corporation effective May 23, 1999. See "Current Year Events -- Acquisition of Peoples Jewellers." (b) Other net sales: (i) includes sales from direct mail operations and (ii) includes sales from Diamond Park Fine Jewelers which was divested during fiscal year 1998. (c) Based on sales per store open a full twelve months during the respective year. Zales Jewelers Zales is positioned as the Company's national flagship and is a leading brand name in jewelry retailing in the United States. At July 31, 1999, Zales had 708 Zales stores in 50 states and Puerto Rico. Average store size is approximately 1,470 square feet, and the average selling price per unit sold is $260. Zales accounted for approximately 58 percent of the Company's sales in fiscal year 1999. Zales' merchandise selection is generally standardized across the nation and targeted at customers representing a cross-section of mainstream America. In fiscal year 1999, bridal merchandise represented 35 percent of merchandise sales, while fashion jewelry and watches comprised the remaining 65 percent. The bridal merchandise category consists of solitaire engagement rings, various bridal sets and diamond and gold anniversary bands. Fashion jewelry consists generally of diamond fashion rings, earrings, gold chains, watches and various other items. The Company believes that the prominence of diamond jewelry in its product selection fosters an image of quality and trust among consumers. While maintaining a strong focus on the bridal segment of the business, Zales is placing added emphasis on the non-bridal merchandise such as the fashion and gift-giving aspects of the business. Innovative product categories, including platinum engagement rings, and tanzanite fashion jewelry, have been added. The combination of Zales' national presence and centralized merchandise selection allows it to use television advertising across the nation as its primary advertising medium, supplemented by newspaper inserts and direct mail. Zales is in the direct fulfillment business through its direct mail operations and Internet web site. The direct fulfillment operations currently account for less than 2 percent of the Company's sales. Leveraging brand recognition and national advertising, Zales Outlet represents the Company's Outlet Mall format. At July 31, 1999, the Company operated 31 Zales Outlet stores in 17 states. The Company has begun expanding its Zales Outlet concept and plans to continue to grow it over the next several years. The merchandise assortment in a Zales Outlet Store includes a wide selection of today's most fashion-forward looks, including name brand watches and fashion items like tanzanite jewelry. Zales Outlet accounted for less than 2 percent of the Company's net sales in fiscal 1999. Gordon's Jewelers Gordon's is positioned as a major regional brand with an upgraded product offering. At July 31, 1999, Gordon's had 312 stores in 35 states and Puerto Rico. Average store size is approximately 1,400 square feet and the average selling price per unit sold is $314. Gordon's accounted for approximately 22 percent of the Company's net sales in fiscal year 1999. Gordon's distinguishes itself from Zales by providing a more upscale, contemporary product mix and tailoring a portion of store inventory to regional tastes. A portion of the merchandise sold by Gordon's stores overlaps the Zales product line. Regional radio broadcast campaigns that emphasize key items are utilized to complement printed inserts. Gordon's will continue to emphasize its new image to match its customer base and will further tailor key items to customers' regional preferences. Steps to upgrade Gordon's have included store remodeling, a more distinctive and fashion-oriented product assortment, improved displays, exclusive and value oriented merchandise and the application of more stringent credit-approval standards. Bailey Banks & Biddle Fine Jewelers Established in 1832, Bailey Banks & Biddle offers high-end merchandise, exclusive designs and a prestigious shopping environment for the upscale customer. The stores are among the pre-eminent stores in their markets and carry both exclusive and recognized designer merchandise selections to appeal to the more affluent customer. The Bailey Banks & Biddle merchandise assortment emphasizes the classic and traditional look and focuses on diamonds, precious stone and gold jewelry, as well as watches and giftware. At July 31, 1999, Bailey Banks & Biddle operated 106 upscale jewelry stores in 29 states. During fiscal 1999, the Company converted stores not under the Bailey Banks & Biddle name to that name. This change will enable Bailey Banks & Biddle to market and advertise on a national scale. The Company also utilizes the trade name Zell Bros.(R) for one store. The stores have an average selling price per unit sold of $651, an average store size of approximately 3,300 square feet and accounted for approximately 18 percent of the Company's net sales in fiscal year 1999. Bailey Banks & Biddle stores rely heavily on upscale direct-mail catalogs, enabling the stores to focus on specific products for specific customers. In fiscal year 1999, Bailey Banks & Biddle expanded its advertising reach with a repetitive presence in nationally distributed newspapers, such as the New York Times and The Wall Street Journal and high profile magazines such as Town & Country, Vanity Fair and Bon Appetit. Peoples Jewellers Effective May 23, 1999, the Company acquired substantially all assets and certain operational liabilities of Peoples Jewellers Corporation, a privately owned chain consisting principally of 176 fine jewelry stores operating throughout Canada under the Peoples and Mappins names. Peoples offers traditional jewelry and attracts the moderate customer segment in Canada. Peoples has the largest market share in Canada. Its closest specialty jewelry competitor has fewer than 40 locations. The Company believes that Peoples has a significant opportunity to improve store productivity by employing a focused merchandising strategy that offers the top 250 key items or "Brilliant Buys." Approximately 90 percent of this merchandise will overlap with Zales, allowing the Company to leverage its merchandising strength. The Company plans to execute an aggressive marketing strategy that includes many media channels and campaigns similar to those that Zales employs, including television advertising campaigns during key holiday periods. Beginning in late fiscal 2000 the Company expects to begin renovating existing Peoples' stores with an updated design, as well as targeting growth opportunities by identifying possible new store locations. STORE OPERATIONS The Company's stores are designed to create an attractive environment, maximize operating efficiencies and make shopping convenient and enjoyable. The Company pays careful attention to store layout, particularly in areas such as lighting, choice of materials and arrangement of display cases to maximize merchandise presentation. Promotional displays are changed periodically to provide variety, to reflect seasonal events or to complement a particular mall's promotions. Each of the Company's stores is led by a store manager who is responsible for certain store-level operations, including sales and some personnel matters. Non-sales administrative matters, including purchasing, credit operations and payroll are consolidated at the corporate level in an effort to maintain low operating costs at the store level. Each of the stores also offers standard warranties and return policies and provides extended warranty coverage which may be purchased at the customer's option. The Company has implemented inventory control systems, extensive security systems and loss prevention procedures to maintain low inventory losses. The Company screens employment applicants and provides all of its store personnel with training in loss prevention. Despite such precautions, the Company experiences losses from theft from time to time and maintains insurance to cover such losses. The Company believes it is important to provide knowledgeable and responsive customer service. The Company has implemented employee training programs, including training in sales techniques for new employees, on-the-job training and manager training for store managers. Under the banner of Zale Corporation University, the Company offers training to employees at every level of the organization, from store associate to buyer. PURCHASING AND INVENTORY The Company purchases substantially all of its merchandise in finished form from a network of established suppliers and manufacturers located primarily in the United States, Southeast Asia and Italy. All purchasing is done through buying offices at the corporate headquarters. The Company either purchases merchandise from its vendors or obtains merchandise on consignment. The Company had approximately $126.2 million and $146.8 million of consignment inventory on hand at July 31, 1999 and 1998, respectively. The Company historically has not engaged in any substantial amount of hedging activities with respect to merchandise held in inventory, since the Company has been able to adjust retail prices to reflect price fluctuations in the commodities that are used in the merchandise it sells. The Company is not subject to substantial currency fluctuations because most purchases are dollar denominated. During fiscal years 1999 and 1998, the Company purchased approximately 33 percent of its merchandise from its top five vendors, including more than 11 percent from its top vendor. CREDIT OPERATIONS The Company's private label credit card programs help facilitate the sale of merchandise to customers who wish to finance their purchases rather than use cash or other sources. Approximately 48 percent of the Company's net sales were generated by credit sales on the private label credit cards in fiscal year 1999. The Company has found that opening a credit account allows its sales personnel to build customer relationships that generate customer loyalty and facilitate repeat purchases as well as enhancing the Company's target marketing capability. Peoples outsources its proprietary credit program to a third party provider. In October 1997, the Company established a national credit card bank, Jewelers National Bank ("JNB" or the "Bank"), for the granting of credit under its private label credit cards. The creation of the national bank allows the Company greater flexibility in establishing rates charged to customers and simplifies regulatory requirements. Credit extension, customer service and collections for the private label accounts are performed by JNB in Tempe, Arizona, and Service Centers in Clearwater, Florida, San Marcos, Texas and San Juan, Puerto Rico. The Bank uses credit scoring to assess risk in extending credit to customers. The Bank has enhanced the timeliness of its approval process for new accounts, whereby customers can be approved rapidly at point of sale. The Bank offers a variety of credit marketing programs to facilitate sales, with an emphasis on flexible repayment terms. The Company currently has approximately 1.5 million customer names on file to which it directs promotional material. The Company uses many of these customer names in its target marketing programs. The Company focuses collection efforts on delinquent accounts in a rapid and disciplined manner. Collectors are trained with state of the art Computer Based Training programs, which are developed in-house. Collection accounts are scored on a behavioral model at monthly billing. This statistical analysis allows for optimum collection and follow-up on delinquent accounts. Based on the behavioral score, the account is put into priority queuing for letter and/or personal phone call follow-up. Early stage delinquencies are handled with an approach which is sensitive to customer goodwill. If accounts progress into delinquency, more assertive action is taken. The following table presents certain data concerning sales, credit sales and accounts receivable for the past three fiscal years, excluding Peoples and Diamond Park: - --------------- (a) In May 1999, the Company began operating under a new credit system. Under this system, billing cycles were changed and aging criteria are slightly different. Management believes that the characteristics of the accounts at July 31, 1999 are relatively consistent with previous years. Accounts are automatically charged off when no full scheduled payment is made for a period of seven consecutive billing cycles. Additionally, accounts are charged off if twelve contract payments are missed. INSURANCE AFFILIATES The Company, through Zale Indemnity Company, Zale Life Insurance Company and Jewel Re-Insurance Ltd., provides insurance and reinsurance facilities for various types of insurance coverage, which typically are marketed to the Company's private label credit card customers. Additionally, the Company promotes the sale of credit insurance products to customers who use the private label credit card program. In fiscal year 1999, over 48 percent of the Company's private label credit card purchasers purchased some form of credit insurance. The three companies, which are wholly owned subsidiaries of ZDel, are the insurers (either through direct written or reinsurance contracts) of the Company's customer credit insurance coverages. In addition to providing replacement property coverage for certain perils, such as theft, credit insurance coverage provides protection to the creditor and cardholder for losses associated with the disability, involuntary unemployment, leave of absence or death of the cardholder. Zale Life Insurance Company also provides group life insurance coverage for eligible employees of the Company. Zale Indemnity Company, in addition to writing direct credit insurance contracts, also has certain discontinued business that it continues to run off. Credit insurance operations are dependent on the Company's retail sales on its private label credit cards and are not significant on a stand-alone basis. EMPLOYEES As of July 31, 1999, the Company had approximately 12,000 employees, less than 1 percent of whom were represented by unions. The Company usually hires a limited number of temporary employees during each Christmas season. COMPETITION The retailing industry is highly competitive. The industry is fragmented, and the Company competes with a large number of independent regional and local jewelry retailers, as well as national jewelry chains. The Company also competes with other types of retailers who sell jewelry and gift items, such as department stores, catalog showrooms, discounters, direct mail suppliers, online retailers and television home shopping programs. Certain of the Company's competitors are non-specialty retailers which are larger and have greater financial resources than the Company. The malls where the Company's stores are located typically contain competing national chains, independent jewelry stores or department store jewelry departments. The Company believes that it is also competing for consumers' discretionary spending dollars and, therefore, competes with retailers who offer merchandise other than jewelry or giftware. Notwithstanding the national or regional reputation of its competition, the Company believes that it must compete on a mall-by-mall basis with other retailers of jewelry as well as with retailers of other types of discretionary items. Therefore, the Company competes primarily on the basis of reputation for high quality products, brand recognition, store location, distinctive and value-priced merchandise, personalized customer service and its ability to offer private label credit card programs to customers wishing to finance their purchases. The Company's success is also dependent on its ability to react to and create customer demand for specific merchandise categories. The Company holds no material patents, licenses, franchises or concessions; however, the established trademarks and trade names for stores and products in Zales, Gordon's, Bailey Banks & Biddle, and Peoples are important to the Company in maintaining its competitive position in the jewelry retailing industry. MANAGEMENT INFORMATION SYSTEMS The Company's information systems provide information necessary for: (i) management operating decisions; (ii) sales and margin management; (iii) inventory control; (iv) profitability monitoring by many measures (merchandise category, buyer, store); and (v) expense control programs. Data processing systems include point-of-sale reporting, purchase order management, receiving, merchandise planning and control, payroll, general ledger, credit card administration, and accounts payable. Bar code ticketing is used to ensure timely sales and margin data compilation and to provide for inventory control monitoring. Information is made available on-line to merchandising staff on a timely basis, thereby reducing the need for paper reports. The Company uses electronic data interchange ("EDI") with certain of its vendors to facilitate timely merchandise replenishment. The Company believes that the further use of EDI with its vendors will lower the administrative costs associated with invoice processing and settlement. The Company's information systems allow management to monitor and control the Company's operations, and to generate reports on a daily, monthly, quarterly and annual basis for each store and transaction. Senior management can therefore review and analyze activity by store, amount of sale, terms of sale or employees who made the sale. The Company entered into a five-year agreement during December 1996 with a third party for the management of the Company's mainframe processing operations, client server systems, LAN operations and desktop support. The Company believes that by outsourcing this portion of its management information systems it will be able to achieve additional efficiencies and allow the Company to focus its internal information technology efforts on developing new systems to enhance the performance of its core business. The Company has an operations services agreement for credit operations with a third-party servicer. The agreement, dated May 5, 1998, requires minimum annual payments based on credit activities. The Company has a commitment of approximately $15.2 million to be paid over the initial term of seven years. Additional annual payments will be paid based on credit volume for normal credit processing activities. The Company has historically upgraded, and expects to continue to upgrade, its information systems to improve operations and support future growth. The Company estimates it will make capital expenditures of approximately $21 million over the next two years for enhancements to its management information systems. A portion of these expenditures will assist the Company in maintaining Year 2000 compliant systems. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Year 2000." REGULATION The Company's operations are affected by numerous federal and state laws that impose disclosure and other requirements upon the origination, servicing and enforcement of credit accounts and limitations on the maximum amount of finance charges that may be charged by a credit provider. In addition to the Company's private label credit cards, credit to the Company's customers is provided primarily through bank cards such as Visa(R), MasterCard(R), and Discover(R), without recourse to the Company based upon a customer's failure to pay. Any change in the regulation of credit which would materially limit the availability of credit to the Company's traditional customer base could adversely affect the Company's results of operations or financial condition. The sale of insurance products by the Company is also highly regulated. State laws currently impose disclosure obligations with respect to the Company's sale of credit and other insurance. The Company's and its competitors' practices are also subject to review in the ordinary course of business by the Federal Trade Commission, and the Company's and other retail Companies credit cards are subject to regulation by the Office of the Comptroller of the Currency. See "Business -- Credit Operations." The Company believes that it is currently in material compliance with all applicable state and federal regulations. Merchandise in the retail jewelry industry is frequently sold at a discount to the "regular" or "original" price. A number of states in which the Company operates have regulations which require that retailers offering merchandise at discounted prices must offer the merchandise at regular or original prices for stated periods of time. Additionally, the Company is subject to certain truth-in-advertising and other various state and federal laws, including consumer protection regulations that regulate retailers generally and/or the promotion and sale of jewelry in particular. The Company undertakes to monitor changes in those laws and believes that it is in material compliance with all applicable federal and state laws with respect to such practices. CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements, including statements regarding, among other items, (i) the Company's implementation of its merchandising strategies, (ii) the extension or replacement of the Revolving Credit Agreement, (iii) a refinancing of the Variable Notes on or before their maturity date with a new transaction or, with the consent of the note purchaser groups, an extension of the maturity of the outstanding Variable Notes, (iv) expected capital expenditures to be made in the future, (v) expected significant upgrades to the Company's management information systems over the next several years, (vi) the addition of new locations through new store openings, (vii) the renovation and remodeling of the Company's existing store locations, (viii) the Company's efforts to reduce costs, (ix) the adequacy of the Company's sources of cash to finance its current and future operations, (x) the terms of renewal of the Company's store leases, (xi) resolution of litigation without material adverse effect on the Company and (xii) the expected impact of the "Year 2000" issue. This notice is intended to take advantage of the "safe harbor" provided by the Private Securities Litigation Reform Act of 1995 with respect to such forward-looking statements. These forward-looking statements involve a number of risks and uncertainties. Among others, factors that could cause actual results to differ materially are the following: development of trends in the general economy; competition in the fragmented retail jewelry business; the variability of quarterly results and seasonality of the retail business; the ability to improve productivity in existing stores and to increase comparable store sales; the availability of alternate sources of merchandise supply during the three month period leading up to the Christmas season; the dependence on key personnel who have been hired or retained by the Company; the changes in regulatory requirements which are applicable to the Company's business; management's decisions to pursue new distribution channels and strategies which may involve additional costs; and the risk factors listed herein and from time to time in the Company's Securities and Exchange Commission reports, including but not limited to, its Annual Reports on Form 10-K. ITEM 2. ITEM 2. PRINCIPAL PROPERTIES The Company leases a 430,000 square feet corporate headquarters facility, which extends through April 2008. The facility is located in Las Colinas, a planned business development in Irving, Texas, near the Dallas/ Fort Worth International Airport. During the fiscal year 1999, the Company sold a 120,000 square foot warehouse in Dallas, Texas, leasing back approximately 60,000 square feet of that warehouse. The Company leases a 32,000 square feet general office facility in Toronto, Ontario Canada for Peoples, which extends through April 2001. The Company leases a facility for the operations of JNB in Tempe, Arizona (24,200 square feet). The Company also leases three credit service centers located in Clearwater, Florida (30,000 square feet), San Juan, Puerto Rico (2,900 square feet) and one national collections center located in San Marcos, Texas (9,000 square feet). The Company rents most of its retail spaces under leases that generally range from five to ten years and may contain minimum rent escalations. Most of the store leases provide for the payment of base rentals plus real estate taxes, insurance, common area maintenance fees and merchants association dues, as well as percentage rents based on store gross sales. The following table indicates the expiration dates of the current terms of the Company's leases as of July 31, 1999 (executed lease agreements, including non-stores and unopened stores): Management believes substantially all of the store leases expiring in fiscal year 2000 that it wishes to renew (including leases which expired earlier and are on month-to-month extensions) will be renewed on terms not materially less favorable to the Company than the terms of the expiring leases. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in certain legal actions and claims arising in the ordinary course of business. The Company believes that such litigation and claims, both individually and in the aggregate, will be resolved without material effect on the Company's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the Company during the quarter ended July 31, 1999. EXECUTIVE OFFICERS OF THE REGISTRANT The following individuals serve as executive officers of the Company. Officers are elected by the Board of Directors annually, each to serve until their successor is elected and qualified, or until their earlier resignation, removal from office or death. The following is a brief description of the business experience of the executive officers of the Company for at least the past five years. Mr. Robert J. DiNicola relinquished his responsibilities as Chief Executive Officer to Beryl B. Raff, the Company's President and Chief Operating Officer on September 7, 1999. Mr. DiNicola continues to actively serve as Chairman of the Board of Directors. Mr. DiNicola had served as Chairman of the Board and Chief Executive Officer of the Company since April 18, 1994. For the three years prior to joining the Company, Mr. DiNicola was a senior executive officer of The Bon Marche Division of Federated Department Stores, Inc., having served as Chairman and Chief Executive Officer of that Division from 1992 to 1994 and as its President and Chief Operating Officer from 1991 to 1992. From 1989 to 1991, Mr. DiNicola was a Senior Vice President of Rich's Department Store Division of Federated. For 17 years, prior to joining the Federated organization, Mr. DiNicola was associated with Macy's, where he held various executive, management and merchandising positions, except for a one-year period during which he held a division officer position with The May Department Stores Company, Inc. Ms. Beryl B. Raff was appointed Chief Executive Officer and a member of the Company's Board of Directors on September 7, 1999 while retaining her position as President. From July 15, 1998 to September 7, 1999, Ms. Raff served as President and Chief Operating Officer. From July 1997 to July 1998, she served as Executive Vice President and Chief Operating Officer. From November 1994 to July 1997, she served as President of Zales. From March 1991 through October 1994, Ms. Raff served as Senior Vice President of Macy's East with responsibilities for its jewelry business in a 12 state region. From April 1988 to March 1991, Ms. Raff served as Group Vice President of Macy's South/Bullocks. Prior to 1988, Ms. Raff had 17 years of retailing and merchandising experience with the Emporium and Macy's department stores. Mr. Alan P. Shor was named Executive Vice President and Chief Operating Officer on September 15, 1999 while retaining his position as Secretary. From November 17, 1997 to September 15, 1999, Mr. Shor served as Executive Vice President, Chief Logistics Officer, Secretary and General Counsel (he relinquished the General Counsel position August 1, 1999). From May 1997 to November 1997, Mr. Shor served as Executive Vice President and Chief Administrative Officer, General Counsel and Secretary. From June 1995 to May 1997, Mr. Shor served as Senior Vice President, General Counsel and Secretary. For two years prior to joining the Company, Mr. Shor was the managing partner of the Washington, D.C. office of the Troutman Sanders law firm, whose principal office is based in Atlanta, Georgia. Mr. Shor, a member of Troutman Sanders since 1983, was a partner of the firm from 1990 to 1995. Ms. Sue E. Gove was appointed Executive Vice President and Chief Financial Officer on July 15, 1998. From December 1997 to July 1998, she served as Group Vice President and Chief Financial Officer. From January 1996 to December 1997, she served as Senior Vice President, Corporate Planning and Analysis. From September 1996 through June 1997, Ms. Gove also served as Senior Vice President and Treasurer, overseeing Investor Relations and the Treasury, Tax and Control functions. Ms. Gove joined the Company in 1980 and served in numerous assignments until her appointment to Vice President in 1989. Ms. Mary L. Forte was appointed Executive Vice President and Chief Administrative Officer on January 13, 1998. From July 1994 to January 1998, Ms. Forte served as President of Gordon's. From January 1994 to July 1994, Ms. Forte served as Senior Vice President of QVC -- Home Shopping Network. From July 1991 through January 1994, Ms. Forte served as Senior Vice President of the Bon Marche, Home Division of the Federated Department Store. From July 1989 to July 1991, Ms. Forte was Vice President of Rich's Department Store, Housewares Division. In addition to the above, Ms. Forte has an additional 13 years of retailing and merchandising experience with Macy's, The May Department Stores Company, Inc. and Federated Department Stores. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS' EQUITY The Common Stock is listed on the New York Stock Exchange ("NYSE") under the symbol ZLC. The following table sets forth the high and low sale prices for the Common Stock for each fiscal quarter during the two most recent fiscal years. As of September 3, 1999, the outstanding shares of Common Stock were held by approximately 1,126 holders of record. The Company has not paid dividends on the Common Stock since the initial issuance on July 30, 1993, and does not anticipate paying dividends on the Common Stock in the foreseeable future. In addition, the Company's Short-term Borrowings and Long-term Debt limit the Company's ability to pay dividends. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data is qualified in its entirety by the Consolidated Financial Statements of the Company (and the related Notes thereto) contained elsewhere in this Form 10-K and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations." The income statement and balance sheet data for each of the years ended July 31, 1999, 1998, 1997, 1996 and 1995, have been derived from the Company's audited Consolidated Financial Statements. - ------------------ (a) Unusual items consist of the gain on sale of Diamond Park Fine Jewelers of ($1.6 million) and a gain on sale of land of ($7.3 million) for the year ended July 31, 1998, and reorganization recoveries of ($4.5 million) for the year ended July 31, 1996. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS With respect to forward looking statements made in this Management's Discussion and Analysis of Financial Condition and Results of Operations see "Business -- Cautionary Notice Regarding Forward Looking Statements." RESULTS OF OPERATIONS The following table sets forth certain financial information from the Company's audited consolidated statements of operations expressed as a percentage of net sales and should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K. YEAR ENDED JULY 31, 1999 COMPARED TO YEAR ENDED JULY 31, 1998 Net Sales. Net Sales for the year ended July 31, 1999 increased by $115.2 million to $1.4 billion, a 8.8 percent increase compared to the previous year. Excluding sales from Diamond Park Fine Jewelers which was divested in fiscal year 1998, total sales for the year increased 10.9 percent. The sales increase primarily resulted from a 6.0 percent increase in sales from stores open for comparable periods, 64 new stores added during the year and two months of sales for Peoples which was acquired in May 1999. These factors were partially offset by 32 stores closed during the year. The Company believes that sales growth continues to be influenced by the execution of its merchandising, marketing and store operations strategies. Gross Margin. Gross Margin as a percentage of net sales was 48.4 percent for the year ended July 31, 1999 compared to 48.1 percent for the year ended July 31, 1998, an increase of 0.3 percent. This increase was principally due to more efficient purchasing, resulting in lower markdowns. The LIFO benefit was $0.7 million and $2.5 million for the years ended July 31, 1999 and 1998. Selling, General and Administrative Expenses. Selling, General and Administrative Expenses decreased to 35.2 percent of sales for the year ended July 31, 1999 from 36.2 percent for the year ended July 31, 1998, or 1.0 percent as a percentage of net sales. Store expenses as a percentage of sales decreased by 1.0 percent principally due to productivity improvements relating to the lowering of payroll costs as a percentage of sales. Net corporate expenses decreased by 0.2 percent of net sales. This decrease in expense was partially offset by Peoples, which had slightly higher store expenses as a percentage of sales. The selling, general and administrative expense reduction demonstrates the Company's ability to leverage its fixed store and corporate operating expenses while increasing sales in its stores. Earnings Before Interest, Taxes, Depreciation and Amortization Expense. Earnings Before Interest, Taxes, Depreciation and Amortization Expense were $189.4 million and $156.0 million for the years ended July 31, 1999 and 1998, respectively, an increase of 21.4 percent. Depreciation and Amortization Expense. Depreciation and Amortization Expense increased by $6.9 million, primarily as a result of the purchase of new assets, principally for new store openings, renovation and refurbishment and the acquisition of Peoples. Due to fresh start reporting, the Company wrote-off substantially all fixed assets of the Company effective July 31, 1993. As a result, depreciation and amortization relates to capital expenditures since July 31, 1993. Interest Expense, Net. Interest Expense, Net was $30.5 million and $32.0 million for the years ended July 31, 1999 and 1998, respectively. The decrease is a result of higher interest income from investments due to an increase in net monthly average cash and cash equivalents for fiscal year 1999 as compared to fiscal year 1998. Income Taxes. The income tax expense for the years ended July 31, 1999 and 1998 was $48.5 million and $41.4 million, respectively, reflecting an effective tax rate of 37.5 percent for both years. The Company will realize a cash benefit from utilization of tax net operating loss carryforwards ("NOL") (after annual limitations) against current and future tax liabilities. As of July 31, 1999, the Company had a remaining NOL (after limitations) of approximately $181 million. YEAR ENDED JULY 31, 1998 COMPARED TO YEAR ENDED JULY 31, 1997 Net Sales. Net Sales for the year ended July 31, 1998 increased by $60.0 million to $1.3 billion, a 4.8 percent increase compared to the previous year. The previous year included a full year of sales of the Company's Diamond Park Fine Jewelers stores, which the Company divested in the first and second quarters of fiscal year 1998. Excluding sales from Diamond Park Fine Jewelers, total sales for the year increased 14.2 percent. The sales increase primarily resulted from a 9.3 percent increase in sales from stores open for comparable periods and 89 new stores added during the year, which were partially offset by 29 stores closed during the year. The Company believes that the sales growth was influenced by enhanced merchandise assortments, successful product promotions and strong store level execution. Gross Margin. Gross Margin as a percentage of net sales was 48.1 percent for the year ended July 31, 1998 compared to 48.7 percent for the year ended July 31, 1997, a decrease of 0.6 percent. This decrease was primarily due to a shift in the mix to more diamond solitaire merchandise and the Company's planned competitive stance with regard to pricing in the current year. The LIFO (benefit)/provision was ($2.5) million and $3.7 million for the years ended July 31, 1998 and 1997. The benefit in fiscal 1998 is partially a result of a reduction in inventories during the current year. Selling, General and Administrative Expenses. Selling, General and Administrative Expenses decreased to 36.2 percent of sales for the year ended July 31, 1998 from 38.3 percent for the year ended July 31, 1997, or 2.1 percent as a percentage of net sales. Store expenses as a percentage of sales decreased by 1.9 percent principally due to productivity improvements and the divestiture of the Diamond Park Operations which had significantly higher payroll and rent costs as a percentage of sales. Corporate expenses decreased by 0.2 percent of net sales principally as a result of lower costs for payroll. The Selling, General and Administrative Expense reduction demonstrates the Company's ability to leverage its fixed store and corporate operating expenses while increasing sales in its stores. Earnings Before Interest, Taxes, Depreciation and Amortization Expense, and Unusual Items. Earnings Before Interest, Taxes, Depreciation and Amortization Expense, and Unusual Items were $156.0 million and $130.0 million for the years ended July 31, 1998 and 1997, respectively, an increase of 20.0 percent. Depreciation and Amortization Expense. Depreciation and Amortization Expense increased by $8.5 million, primarily as a result of the purchase of new assets, principally for new store openings, renovation and refurbishment. Due to fresh start reporting, the Company wrote-off substantially all fixed assets of the Company effective July 31, 1993. As a result, depreciation and amortization relates to capital expenditures since July 31, 1993. Unusual Items -- Gain on Sale of Diamond Park Fine Jewelers and Gain on Sale of Land. The Gain on Sale of Diamond Park Fine Jewelers was $1.6 million and the Gain on the Sale of Land was $7.3 million for fiscal 1998. Interest Expense, Net. Interest Expense, Net was $32.0 million and $36.1 million for the years ended July 31, 1998 and 1997, respectively. The decrease is a result of higher interest income from investments due to an increase in cash and cash equivalents. The increase in cash and cash equivalents is primarily due to an increase in net earnings and effective inventory management resulting in the leveraging of accounts payable and accrued liabilities. Income Taxes. The income tax expense for the years ended July 31, 1998 and 1997 was $41.4 million and $29.3 million, respectively, reflecting an effective tax rate of 37.5 percent and 36.7 percent, respectively. As a result of guidelines regarding accounting for income taxes of companies utilizing fresh-start reporting, the Company reports earnings on a fully-taxed basis even though it has not paid any significant income taxes through fiscal 1998. The Company expects to begin paying more significant income taxes in fiscal 1999. The Company will realize a cash benefit from utilization of tax net operating loss carryforwards ("NOL") (after annual limitations) against current and future tax liabilities. As of July 31, 1998, the Company had a remaining NOL (after limitations) of approximately $250.8 million. LIQUIDITY AND CAPITAL RESOURCES The Company's cash requirements consist principally of funding inventory and receivables growth, capital expenditures primarily for new store growth and renovations, upgrading its management information systems and debt service. As of July 31, 1999, the Company had cash and cash equivalents of $35.4 million, and $6.0 million of restricted cash. The retail jewelry business is highly seasonal, with a significant proportion of sales and operating income being generated in November and December of each year. Approximately 39.7 percent of the Company's annual sales were made during the three months ended January 31, 1999 and 1998, which includes the Christmas selling season. The Company's working capital requirements fluctuate during the year, increasing substantially during the fall season as a result of higher planned seasonal inventory levels. OPERATING ACTIVITIES Set forth below is certain summary information with respect to the Company's operations for the most recent eight fiscal quarters. Net cash provided by operating activities was $74.3 million, $112.8 million and $16.5 million for fiscal years 1999, 1998 and 1997 respectively. The net cash provided by operating activities decreased from the prior year principally due to the Company paying more taxes and to greater investment in inventory. In fiscal 1998, the net cash provided by operating activities resulted principally from an increase in net earnings and effective inventory management resulting in the leveraging of accounts payable and accrued liabilities. In fiscal 1997, net earnings, depreciation and amortization charges and the non-cash change in lieu of tax expense were offset by additional working capital needs for accounts receivable and inventory growth. Net cash used in investing activities was $154.3 million in fiscal 1999 principally related to the acquisition of Peoples, as well as expenditures for new store growth and expenditures for remodeling existing stores. Net cash provided by investing activities was $12.5 million in fiscal 1998, primarily related to proceeds from the sale of Diamond Park Fine Jewelers and proceeds from the sale of land offsetting capital expenditures for new store growth and existing store remodeling and refurbishment. Net cash used in investing activities was $49.1 million in fiscal 1997 principally related to capital expenditures for new store growth and existing store remodeling and refurbishment. Net cash used in financing activities was $57.8 million in fiscal 1999, principally related to the refinancing and reduction of the Zale Funding Trust Securitization and repurchase of the Company's common stock on the open market. Net cash provided by financing activities for fiscal 1998 and fiscal 1997 was $15.2 million and $46.8 million, respectively. In fiscal 1998, the net cash provided by financing activities resulted principally from the issuance of the Senior Notes and proceeds from exercise of stock options and warrants, offset by the repayment of the Revolving Credit Agreement and purchase of Treasury Stock. Net cash provided by financing activities for fiscal 1997 is primarily related to borrowings under the Revolving Credit Agreement. There has been an increase of approximately $93 million in owned merchandise inventories at July 31, 1999 compared to the balance at July 31, 1998. This increase resulted principally from new store growth, the acquisition of Peoples and a broader assortment of merchandise at Bailey Banks and Biddle. FINANCE ARRANGEMENTS - - On July 15, 1999, the Company redeemed approximately $380.8 million, net of discount, aggregate principal amount of Receivables Backed Notes ("Receivables Notes") issued by Zale Funding Trust ("ZFT"), a limited purpose Delaware business trust wholly owned by Zale Delaware, Inc. ("ZDel"), and formed to finance customer accounts receivable. The Receivables Notes were redeemed with available cash and proceeds of advances under the Company's Revolving Credit Agreement and through the issuance of Variable Funding Notes ("Variable Notes") to a purchaser group under a new securitization facility in the initial aggregate principal amount of $250 million. The Variable Notes are part of a 364-day liquidity facility and are secured by a lien on customer accounts receivable. The Variable Notes currently bear interest at the market commercial paper rate plus a dealer fee of 0.05 percent. In addition, the Company pays a fee of 0.375 percent per annum on the funded portion of the facility and a commitment fee of 0.25 percent per annum on the unfunded portion. As of July 31, 1999, the entire $250 million facility is classified as a Short-term Borrowing since it matures within the next twelve months. As originally entered into, the facility required the Company to reduce the outstanding amount of the Variable Notes to $150 million no later than October 15, 1999. On September 15, 1999, the Company entered into an amendment to the new securitization facility to reduce the commitment of the original Variable Note purchaser group to $150 million and to add two new note purchaser groups having an aggregate commitment of $200 million, thereby increasing the total outstanding amount under the Variable Notes facility to $350 million on terms consistent with the original facility. Additionally the Company paid down the approximate $103 million balance under the Revolving Credit Agreement. The Company expects to refinance the Variable Notes on or before their maturity date with a new transaction or, with the consent of the note purchaser groups, to extend the maturity of the outstanding Variable Notes. - - In order to support the Company's growth plans, the Company and ZDel (the "Borrowers") entered into a three year unsecured revolving credit agreement (the "Revolving Credit Agreement") with a group of banks on March 31, 1997. The Revolving Credit Agreement provides for revolving credit loans in an aggregate amount of up to $225.0 million, including a $30.0 million sublimit for letters of credit. The revolving credit loans bear interest at floating rates, currently, at the Borrowers' option of either (i) the Eurodollar Rate plus 1.25 percent or (ii) the higher of the annual rate of interest announced from time to time by the agent bank as its base rate or the Federal Funds Effective Rate plus 0.5 percent. The interest rate based on Eurodollar Rates and letter of credit commission rates can be reduced or increased based on certain future performance levels attained by the Borrowers. The Company pays a commitment fee of 0.25 percent per annum (subject to reduction or increase based on future performance) on the preceding month's unused Revolving Credit Agreement commitment. The Borrowers may repay the revolving credit loans at any time without penalty prior to the maturity date. The interest rates and commitment fee will also be reduced if the Company obtains an investment grade rating. The Revolving Credit Agreement may be extended by the Borrowers for one year upon obtaining appropriate consent. At July 31, 1999, approximately $103 million was outstanding under the Revolving Credit Agreement with a Eurodollar Rate of 6.4 percent. In addition, letters of credit in the amount of approximately $0.6 million were outstanding at July 31, 1999. The Company is currently in compliance with all of its covenant obligations under the Revolving Credit Agreement and the instruments governing its other indebtedness. The Company expects to enter into a new transaction to replace the Revolving Credit Agreement on or before the maturity date. - - In order to support the Company's longer term capital financing requirements, the Company issued $100 million of Senior Notes (the "Senior Notes") on September 23, 1997. These notes bear interest at 8 1/2 percent and are due in 2007. The Senior Notes are unsecured and are fully and unconditionally guaranteed by ZDel. The proceeds were utilized to repay indebtedness under the Company's Revolving Credit Agreement and for general corporate purposes. The indenture relating to the Senior Notes contains certain restrictive covenants including but not limited to limitations on indebtedness, limitations on dividends and other restricted payments (including repurchases of the Company's common stock), limitations on transactions with affiliates, limitations on liens and limitations on disposition of proceeds of asset sales, among others. CAPITAL GROWTH During the year ended July 31, 1999, the Company made approximately $60 million in capital expenditures, a portion of which was used to open 64 new stores. Under its continued growth strategy, the Company plans to open approximately 165 new stores for which it will incur approximately $40 million in capital expenditures during the combined fiscal years 2000 and 2001. These stores are expected to solidify the Company's core mall business by further penetrating markets where the Company is underrepresented. During the combined fiscal years 2000 and 2001, the Company anticipates spending approximately $45 million to remodel, relocate or refurbish approximately 200 additional stores. The Company also estimates it will make capital expenditures of approximately $21 million during the combined fiscal years 2000 and 2001 for enhancements to its management information systems. In total, the Company anticipates spending approximately $132 million on capital expenditures during the combined fiscal years 2000 and 2001. The Revolving Credit Agreement limits the Company's capital expenditures to $75 million for fiscal year 2000. OTHER ACTIVITIES AFFECTING LIQUIDITY - - Effective May 23, 1999, the Company acquired substantially all assets of Peoples Jewellers Corporation, a privately owned chain consisting principally of 176 fine jewelry stores operating throughout Canada, for approximately $78 million cash and the assumption of certain liabilities. - - During September 1999, the Board of Director's authorized a stock repurchase program pursuant to which the Company, from time to time and at management's discretion, may purchase up to an aggregate of $50 million of the Company's common stock on the open market through fiscal year 2000. In June 1999, the Company completed the $50 million repurchase plan authorized on August 25, 1998. - - The Company has an operations services agreement for credit operations with a third-party servicer. The agreement, dated May 5, 1998, requires minimum annual payments based on credit activities. The Company has a commitment of approximately $15.2 million to be paid over the initial term of seven years. Additional annual payments will be paid based on credit volume for normal credit processing activities. - - The Company has an operations services agreement for management information systems with a third-party servicer. The agreement, which began in December 1996, requires fixed payments totaling $34.4 million over a 60 month term and a variable amount based on usage. - - Future liquidity will be enhanced to the extent that the Company is able to realize the cash benefit from utilization of its NOL against current and future tax liabilities. The cash benefit realized in fiscal year 1999 was approximately $13 million. As of July 31, 1999, the Company had a NOL (after limitations) of approximately $181 million, which represents up to $72 million in future tax benefits. The utilization of this asset is subject to limitations. The most restrictive is the Internal Revenue Code Section 382 annual limitation. The NOL can be utilized through 2008. Management believes that operating cash flow, amounts available under the Revolving Credit Agreement, the extension or replacement of the Revolving Credit Agreement, the Variable Notes and a refinancing of the Variable Notes (or an extension of the maturity of the outstanding Variable Notes) should be sufficient to fund the Company's current operations, debt service and currently anticipated capital expenditure requirements for the foreseeable future. YEAR 2000 The Company's management has recognized the need to ensure, to the extent possible, that its operations and relationships with vendors and other third parties will not be adversely impacted by software processing errors arising from calculations using the year 2000 and beyond ("Year 2000"). Like those of many companies, a significant number of the Company's computer applications and systems required modification in order to render these systems Year 2000 compliant. The Company recognized that failure by the Company to timely resolve internal Year 2000 issues could result, in the worst case, in an inability of the Company to distribute its merchandise to its stores and to process its daily business for some period of time. However, Company management presently believes that scenario is unlikely based on the accomplishment of its Year 2000 remediation plan. Failure of one or more third party service providers on whom the Company relies to address Year 2000 issues could also result, in a worst case scenario, in some business interruption. However, to the extent possible, the Company has undertaken to ensure that its most critical vendors and service providers will be able to serve the Company without interruption. The lost revenues, if any, resulting from a worst case scenario such as those examples described above would depend on the time period in which the failure goes uncorrected and on how widespread the impact. Zale has used a combination of internal and external resources to assess and make the needed changes to its many different information technology ("IT") systems and personal computers, such as credit, point of sale, payroll, purchase ordering, merchandise distribution, management reporting, mainframe, and client/ server applications. In 1997 the Company launched a formal project using an industry standard process to address the Year 2000 problem. The process involved seven steps: 1) create awareness, 2) assess/inventory, 3) devise strategy/action plan, 4) replace/modify/outsource, 5) test/certify, 6) install and 7) provide post implementation support. The specialized software programs and hardware used throughout the corporation are now in the seventh phase of the process and will remain there until after the transition to Calendar Year 2000. Non-compliant programs and systems have been replaced, modified or outsourced, including credit processing, Store POS systems, inventory systems, distribution center systems, the EDI system, financial systems, HR systems, and Data Audit. The period from August 1, 1999 through December 31, 1999 will be used to perform additional testing, address exceptions and respond to issues, contingencies and/or third party concerns. Progress reports on the Year 2000 project are presented regularly to the Company's Board of Directors and senior management. With regard to non-IT systems, such as the General Office security systems, store security systems, environmental systems, and phone systems, the Company has remediated or replaced noncompliant systems. Since June 1998, the Company has sent approximately 3,500 inquiries to its vendors requesting compliance certification. The Company has collected responses to those inquiries. It continues to follow-up with those material vendors who either did not respond or whose response was insufficient. The Company has made and will continue to make site visits to critical vendors' facilities as appropriate. The Company outsources its MIS processing and credit processing and inquiry systems. These outsourcers have contractually committed to Year 2000 compliance, and the Company is monitoring their progress in that regard. The Company's primary delivery service has provided assurance that its systems will function correctly through the date change. The Company's payroll processing service provider has indicated that its major systems will operate with correct date logic for Year 2000. The Company's major benefits vendors and service providers have indicated they are or will be Year 2000 compliant, as have most of the Company's major merchandise vendors. Direct expenditures were approximately $1.7 million and internal costs were approximately $0.5 million, for a total cost of $2.2 million in expenditures associated with the Year 2000 in fiscal year 1998. Direct costs of $3.5 million and internal costs of $0.9 million, for a total cost of $4.4 million, were expended in fiscal year 1999. The Company has funded and will continue to fund these expenditures through its normal IT operations budget. As required by generally accepted accounting principles, these costs are expensed as incurred. The Company is currently addressing the financial needs associated with the Year 2000 for fiscal year 2000, which began August 1, 1999, and expects these costs to be approximately $0.75 million. The Company has had each of its departments develop basic contingency plans to restore material functions in the case of a Year 2000 failure. The contingency plans cover critical functions within each business location, including the stores, the General Office, the credit centers and third party service providers. The Company will continue to refine these plans, test them as possible, and make them more comprehensive as more information becomes available from testing and from third party suppliers. In addition, the Company's two processing outsourcers also have contingency plans for the Company's processing should their primary systems fail. Additionally, in the normal course of business, the Company has made capital investments in certain third party software and hardware systems to address the financial and operational needs of the business. These systems, which will improve the efficiencies and productivity of the replaced systems, have also been certified Year 2000 compliant by either the vendor or the Company. To date all of these capital projects were part of the Company's long-term strategic capital plan and their timing has not been accelerated as a result of the Year 2000 issue. Prior to the acquisition of its assets by the Company, Peoples had launched a Year 2000 compliance initiative that included replacement of its core merchandising, accounting and distribution systems, inspection and upgrades of POS devices, and validation of the Year 2000 compliance of its vendors, suppliers and service providers. That initiative has been continued by Zale, and its review indicates that Peoples will meet its Year 2000 goals in a timely manner. Testing and documentation will continue during the third calendar quarter to minimize any Year 2000 exposure. The fourth calendar quarter will be spent mitigating any material risks discovered during the third quarter. Management does not expect any Year 2000 issues within Peoples to be material to the Company. Although there can be no assurance that unanticipated events will not occur, or that the Company has identified all Year 2000 issues, it is management's belief that the Company has taken and continues to take adequate action to address Year 2000 issues. Management does not expect the financial impact of being Year 2000 compliant to be material to the Company's consolidated financial position, results of operations or cash flows. INFLATION In management's opinion, changes in net sales and net earnings that have resulted from inflation and changing prices have not been material during the periods presented. There is no assurance, however, that inflation will not materially affect the Company in the future. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risk from changes in interest rates which may adversely affect its financial position, results of operations and cash flows. In seeking to minimize the risks from interest rate fluctuations, the Company manages exposures through its regular operating and financing activities. The Company does not use financial instruments for trading or other speculative purposes and is not party to any leveraged financial instruments. The Company is exposed to interest rate risk primarily through its borrowing activities, which are described under "Short-term Borrowings" and "Long-term Debt" in the Notes to the Consolidated Financial Statements. The majority of the Company's borrowings are under variable rate arrangements. See "Short-term Borrowings" and "Long-term Debt" Notes to the Consolidated Financial Statements, which are incorporated herein by reference. The investments of the Company's insurance subsidiaries, primarily stocks and bonds in the amount of $27.7 million, approximate market value at July 31, 1999. Based on the Company's market risk sensitive instruments (including variable rate debt) outstanding at July 31, 1999, the Company has determined that there was no material market risk exposure to the Company's consolidated financial position, results of operations or cash flows as of such date. Due to its Canadian operations, the Company is exposed to market risk from currency exchange rate exposure which may adversely affect the Company's financial position, results of operations and cash flows. In seeking to minimize this risk, the Company manages exposures through its regular operating and financing activities. Based on the Company's market risk from currency exchange rate exposure at July 31, 1999, the Company believes that there was no material market risk exposure to the Company's consolidated financial position, results of operations or cash flows on such date. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following Consolidated Financial Statements of the Company and supplementary data are included as pages through at the end of this Annual Report on Form 10-K: ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III The information required to be included in Part III of this Annual Report on Form 10-K is incorporated by reference to the Company's Proxy Statement for the 1999 Annual Meeting of Stockholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as part of this report. 1. FINANCIAL STATEMENTS: The list of financial statements required by this item is set forth in Item 8. 2. INDEX TO FINANCIAL STATEMENT SCHEDULES All other financial statements and financial statement schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are not material or are not applicable and, therefore, have been omitted or are included in the consolidated financial statements or notes thereto. 3. EXHIBITS - --------------- (1) Previously filed as an exhibit to the registrant's Form 10-Q (No. 1-4129) for the quarterly period ended September 30, 1993, and incorporated herein by reference. (2) Incorporated by reference to the corresponding exhibit to the registrant's Registration Statement on Form S-1 (No. 33-73310) filed with the Commission on December 23, 1993, as amended. (3) Previously filed as an exhibit to the registrant's Form 10-K (No. 0-21526) for the fiscal year ended July 31, 1995, and incorporated herein by reference. (4) Previously filed as an exhibit to the registrant's Form 10-K (No. 0-21526) for the fiscal year ended July 31, 1996, and incorporated herein by reference. (5) Previously filed as an exhibit to the registrant's Form 10-Q for the quarterly period ended October 31, 1996, and incorporated herein by reference. (6) Previously filed as an exhibit to the registrant's Form 10-Q for the quarterly period ended January 31, 1997, and incorporated herein by reference. (7) Previously filed as an exhibit to the registrants' Form 10-K (No. 0-21526) for the fiscal year ended July 31, 1997, and incorporated herein by reference. (8) Incorporated by reference to Exhibit 4.1 to the registrant's Registration Statement on Form S-4 (No. 33-39473) filed with the Commission on November 4, 1997. (9) Previously filed as an exhibit to the registrant's Form 10-K (No. 1-04129) for the fiscal year ended July 31, 1998, and incorporated herein by reference. (10) Previously filed as an exhibit to the registrant's Form 10-Q for the quarterly period ended October 31, 1998, and incorporated herein by reference. (11) Filed herewith. * Management Contracts and Compensatory Plans. 4. REPORTS ON FORM 8-K 99 Press Release issued by the Company on June 3, 1999. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS MANAGEMENT'S REPORT To the Stockholders of Zale Corporation: The integrity and consistency of the consolidated financial statements of Zale Corporation (the "Company"), which were prepared in accordance with generally accepted accounting principles, are the responsibility of management and properly include some amounts that are based upon estimates and judgments. The Company maintains a system of internal accounting controls to provide reasonable assurance, at appropriate cost, that the Company's assets are protected and transactions are properly recorded. Additionally, the integrity of the financial accounting system is based on careful selection and training of qualified personnel, organizational arrangements which provide for appropriate division of responsibilities and communication of established written policies and procedures. The consolidated financial statements of the Company have been audited by Arthur Andersen LLP, independent public accountants. Their report expresses their opinion as to the fair presentation, in all material respects, of the financial statements and is based upon their independent audit conducted in accordance with generally accepted auditing standards. The Audit Committee, composed solely of outside directors, meets periodically with the independent public accountants and representatives of management to discuss auditing and financial reporting matters. In addition, the independent public accountants meet periodically with the Audit Committee without management representatives present and have free access to the Audit Committee at any time. The Audit Committee is responsible for recommending to the Board of Directors the engagement of the independent public accountants, which is subject to stockholder approval, and the general oversight review of management's discharge of its responsibilities with respect to the matters referred to above. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Zale Corporation: We have audited the accompanying consolidated balance sheets of Zale Corporation (a Delaware corporation) and subsidiaries as of July 31, 1999 and 1998, and the related consolidated statements of operations, cash flows, and stockholders' investment for each of the three years in the period ended July 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Zale Corporation and subsidiaries as of July 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended July 31, 1999, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Dallas, Texas September 1, 1999 (except with respect to the matter discussed in the Subsequent Event footnote, as to which the date is September 15, 1999) ZALE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Notes to the Consolidated Financial Statements. ZALE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS) ASSETS See Notes to the Consolidated Financial Statements. ZALE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) See Notes to the Consolidated Financial Statements. ZALE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' INVESTMENT (AMOUNTS IN THOUSANDS) See Notes to the Consolidated Financial Statements. ZALE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' INVESTMENT -- (CONTINUED) (AMOUNTS IN THOUSANDS) See Notes to the Consolidated Financial Statements. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES THE ACCOMPANYING CONSOLIDATED FINANCIAL STATEMENTS include the accounts of Zale Corporation and its wholly-owned subsidiaries (the "Company" or "Zale"). The Company consolidates substantially all its U.S. operations into Zale Delaware, Inc. ("ZDel"). ZDel is the parent company for several subsidiaries, including three that are engaged primarily in providing credit insurance to credit customers of the Company. The Company consolidates its Canadian retail operations (see Acquisition of Peoples Jewellers) into Zale International, Inc., which is a wholly owned subsidiary of Zale Corporation. All significant intercompany transactions have been eliminated. USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS includes cash on hand, deposits in banks and short-term marketable securities at varying interest rates with maturities of three months or less. The carrying amount approximates fair value because of the short maturity of those instruments. At July 31, 1999, $6.0 million was restricted primarily by the capital requirements of Jewelers National Bank ("JNB"), the Company's national credit card bank and consignment arrangements with certain vendors. CUSTOMER RECEIVABLES are classified as current assets, including amounts which are due after one year, in accordance with industry practices. The allowance for doubtful accounts was $76.5 million and $67.3 million at July 31, 1999 and 1998, respectively. Finance charge income and net earnings from credit insurance subsidiaries of $118.5 million, $113.3 million and $101.0 million for the years ended July 31, 1999, 1998 and 1997, respectively, has been reflected as a reduction of Selling, General and Administrative Expenses. Finance charge and insurance charge income are recorded pursuant to the calculation set forth in the Company's credit card agreements. MERCHANDISE INVENTORIES are stated at the lower of cost or market. Cost for U.S. inventories is determined primarily in accordance with the retail inventory method. Substantially all U.S. inventories represent finished goods which are valued using the last-in, first-out ("LIFO") method. Merchandise inventory of Peoples Jewellers are valued using the first-in, first-out ("FIFO") method determined using the cost method. LONG LIVED ASSETS. In fiscal year 1997, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," which establishes accounting standards for the impairment of long-lived assets and goodwill. Under the guidance of SFAS No. 121, intangibles and long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Any impairment would be recognized in operating results if a permanent reduction were to occur. DEPRECIATION AND AMORTIZATION are computed using the straight-line method over the estimated useful lives of the assets or remaining lease life. Estimated useful lives of the assets range from three to twenty years. Original cost and related accumulated depreciation or amortization are removed from the accounts in the year assets are retired. Gains or losses on dispositions of property and equipment are included in operations in the year of disposal. Computer software costs related to the development of major systems are capitalized as incurred and are amortized over their useful lives. EXCESS OF REVALUED NET ASSETS OVER STOCKHOLDERS' INVESTMENT is being amortized over fifteen years. Amortization was $5.9 million for each of the years ended July 31, 1999, 1998 and 1997. Accumulated amortization was $35.4 million and $29.5 million at July 31, 1999 and 1998, respectively. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) STORE PRE-OPENING COSTS are charged to results of operations when incurred. Store closing costs are estimated and recognized in the period in which the Company makes the decision that the store will close. Such costs include the present value of estimated future rentals net of anticipated sublease income, loss on retirement of property and equipment and other related occupancy costs. ADVERTISING EXPENSES are charged against operations when incurred. Cooperative advertising funds are received from certain merchandise vendors. Amounts charged against operations were $49.0 million, $45.8 million and $46.1 million for the years ended July 31, 1999, 1998 and 1997, respectively, net of amounts contributed by vendors to the Company. The amounts of prepaid advertising at July 31, 1999 and 1998 are $2.5 million and $4.4 million, respectively. RECLASSIFICATIONS. The classifications in use at July 31, 1999 have been applied to the financial statements for July 31, 1998 and 1997. FOREIGN CURRENCY. Translation adjustments result from translating foreign subsidiaries' financial statements into U.S. dollars. Balance sheet accounts are translated at exchange rates in effect at the balance sheet date. Income statement accounts are translated at average exchange rates during the year. Resulting translation adjustments are included as a component of Comprehensive Income in the Consolidated Statements of Stockholders' Investment. ACQUISITION OF PEOPLES JEWELLERS Effective May 23, 1999, the Company acquired substantially all assets of Peoples Jewellers Corporation, a privately owned chain consisting principally of 176 fine jewelry stores operating throughout Canada, for approximately $78 million cash, payment of approximately $18 million to pay down existing bank debt and the assumption of certain liabilities. The excess of the purchase price over the fair value of the net assets acquired of approximately $57.1 million is classified as goodwill, and is included in other assets in the accompanying balance sheet and is being amortized on a straight-line basis over twenty years. Assets acquired and liabilities assumed have been recorded at their estimated fair values, and are subject to adjustment when additional information concerning the alignment of operations is finalized. The acquisition described above was accounted for by the purchase method of accounting for business combinations. Accordingly, the accompanying consolidated statements of operations do not include any revenues or expenses related to the acquisition prior to May 23, 1999. The entire cost of the acquisition was funded through the Company's available cash. The following unaudited pro forma information presents a summary of our consolidated results of operations including Peoples Jewellers as if the acquisition was effective on August 1, 1997: The unaudited pro forma information does not purport to represent what the results of operations of the Company would actually have been if the aforementioned transaction had occurred on August 1, 1997, nor do they project the results of operations or financial position for any future periods or at any future date. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) MERCHANDISE INVENTORIES The Company's U.S. operations use the LIFO method of accounting for inventory, which results in a matching of current costs with current revenues. The LIFO (benefit)/provision was ($0.7) million, ($2.5) million and $3.7 million for the years ended July 31, 1999, July 31, 1998 and July 31, 1997, respectively. The estimated cost of replacing the Company's inventories exceeds its net LIFO cost by approximately $12.7 million and $13.4 million at July 31, 1999 and 1998, respectively. Inventories on a first-in, first-out ("FIFO") basis were $546.8 million and $491.9 million at July 31, 1999 and 1998, respectively. The Company also maintained consigned inventory at its retail locations of approximately $126.3 million and $146.8 million at July 31, 1999 and 1998, respectively. This consigned inventory and related contingent obligation are not reflected in the Company's financial statements. At the time consigned inventory is sold, the Company records the purchase liability in accounts payable and the related cost of merchandise in Cost of Sales. The Company's Canadian operations use the FIFO method of accounting for inventory. Inventory net of reserves was approximately $37.6 million and consigned inventory was approximately $5.4 million at July 31, 1999. PROPERTY AND EQUIPMENT The Company's property and equipment consists of the following: ACCOUNTS PAYABLE, ACCRUED LIABILITIES AND NON-CURRENT LIABILITIES The Company's accounts payable and accrued liabilities consist of the following: The Company's non-current liabilities consist principally of the accumulated obligation for postretirement benefits under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," loss reserves for insurance subsidiaries and reserves for tax contingencies. POSTRETIREMENT BENEFITS. In February 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 132 ("SFAS No. 132"), "Employers' Disclosures ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) about Pensions and Other Postretirement Benefits an amendment of FASB Statements No. 87, 88, and 106," which revises employers' disclosures about pensions and other postretirement benefit plans. The Company adopted the provisions of SFAS No. 132 for the year ended July 31, 1999. All prior year information has been restated in accordance with SFAS No. 132. The Company provides medical and dental insurance benefits for all eligible retirees and spouses with benefits to the latter continuing after the death of the retiree. Substantially all of the Company's full-time employees, who were hired on or before November 14, 1994, become eligible for those benefits upon reaching age 55 while working for the Company and having ten years continuous service. The medical and dental benefits are provided under two plans. The lifetime maximum on medical benefits is $500,000 up to the age of 65 and $50,000 thereafter. These benefits include deductibles, retiree contributions and co-insurance provisions that are assumed to grow with the health care cost trend rate. The costs of the postretirement benefits are recognized in the financial statements over an employee's active career on an accrual basis. The Company funds actual claims as they occur. Change in Benefit Obligation: The weighted average assumption of the discount rate is 7.75 percent and 7.0 percent as of July 31, 1999, and 1998 respectively. For measurement purposes, a 10.0 percent and 11.0 percent annual rate of increase in the per capita cost covered health care benefits was assumed for July 31, 1999 and July 31, 1998 respectively. The rate was assumed to decrease gradually to 6.0 percent for 2006 and remain at that level thereafter. Components of Net Periodic Benefit Cost: Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects: ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SHORT-TERM BORROWINGS The Company's Short-term Borrowings consist of the following: REVOLVING CREDIT AGREEMENT. In order to support the Company's growth plans, the Company and ZDel (the "Borrowers") entered into a three year unsecured revolving credit agreement (the "Revolving Credit Agreement") with a group of banks on March 31, 1997. The Revolving Credit Agreement provides for revolving credit loans in an aggregate amount of up to $225.0 million, including a $30.0 million sublimit for letters of credit. The revolving credit loans bear interest at floating rates, currently, at the Borrowers' option of either (i) the Eurodollar Rate plus 1.25 percent or (ii) the higher of the annual rate of interest announced from time to time by the agent bank as its base rate or the Federal Funds Effective Rate plus 0.5 percent. The interest rate based on Eurodollar Rates and letter of credit commission rates can be reduced or increased based on certain future performance levels attained by the Borrowers. The Company pays a commitment fee of 0.25 percent per annum (subject to reduction or increase based on future performance) on the preceding month's unused Revolving Credit Agreement commitment. The Borrowers may repay the revolving credit loans at any time without penalty prior to the maturity date. The interest rates and commitment fee will also be reduced if the Company obtains an investment grade rating. The Revolving Credit Agreement may be extended by the Borrowers for one year upon obtaining appropriate consent. At July 31, 1999, approximately $103 million was outstanding under the Revolving Credit Agreement with a Eurodollar Rate of 6.4 percent. In addition, letters of credit in the amount of approximately $0.6 million were outstanding at July 31, 1999. The Company is currently in compliance with all of its covenant obligations under the Revolving Credit Agreement and the instruments governing its other indebtedness. The Company expects to enter into a new transaction to replace the Revolving Credit Agreement on or before the maturity date. See Notes to Consolidated Financial Statements -- Subsequent Event. The Revolving Credit Agreement contains certain restrictive covenants, which, among other things, restricts within certain limits the Borrowers' ability to pay dividends and make other payments, incur additional indebtedness, make capital expenditures, engage in certain transactions with affiliates, incur liens, make investments and sell assets. The Revolving Credit Agreement also requires the Borrowers to maintain certain financial ratios and specified levels of net worth. ZALE FUNDING TRUST SECURITIZATION. On July 15, 1999, the Company redeemed approximately $380.8 million, net of discount, aggregate principal amount of Receivables Backed Notes ("Receivables Notes") issued by Zale Funding Trust ("ZFT"), a limited purpose Delaware business trust wholly owned by Zale Delaware, Inc. ("ZDel"), and formed to finance customer accounts receivable. The Receivables Notes were redeemed with available cash and proceeds of advances under the Company's Revolving Credit Agreement and through the issuance of Variable Funding Notes ("Variable Notes") to a purchaser group under a new securitization facility in the initial aggregate principal amount of $250 million. The Variable Notes are part of a 364-day liquidity facility and are secured by a lien on customer accounts receivable. The Variable Notes currently bear interest at the market commercial paper rate plus a dealer fee of 0.05 percent. In addition, the Company pays a fee of 0.375 percent per annum on the funded portion of the facility and a commitment fee of 0.25 percent per annum on the unfunded portion. As of July 31, 1999, the entire ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $250 million facility is classified as a Short-term Borrowing since it matures within the next twelve months. At that same time the effective borrowing rate was 5.6 percent. As originally entered into, the facility required the Company to reduce the outstanding amount of the Variable Notes to $150 million no later than October 15, 1999. The Company expects to refinance the Variable Notes on or before their maturity date with a new transaction or, with the consent of the note purchaser groups, to extend the maturity of the outstanding Variable Notes. See Notes to Consolidated Financial Statements -- Subsequent Event. Jewelers National Bank (the "Servicer"), a subsidiary of ZDel, is the servicing entity for the collection of the customer accounts receivable and its servicing obligations are guaranteed by ZDel. The Company has accounted for the Variable Notes as a secured borrowing in accordance with the provisions of SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." The ZFT Securitization imposes certain reporting obligations on the Company and limits ZFT's ability, among other things, to grant liens, incur certain indebtedness, or enter into other lines of business. Additionally, under certain conditions as defined, including among other things, failure to pay principal or interest when due, failure to cure a borrowing base deficiency and breach of any covenant that is not cured, the ZFT Securitization is subject to an early amortization whereby the ZFT Securitization may be declared due and payable immediately. The restricted cash balance shown on the Consolidated Balance Sheets as of July 31, 1999 and 1998 includes the restricted cash of ZFT of $1.2 million and $2.3 million as of July 31, 1999 and July 31, 1998 respectively, which is based on the relationship between the ZFT Securitization outstanding and gross accounts receivable as of July 31, 1999 and 1998. LONG-TERM DEBT The Company's long-term debt consists of the following: SENIOR NOTES. On September 23, 1997, the Company sold $100 million in aggregate principal amount of 8 1/2 percent Senior Notes (the "Senior Notes") due 2007 by means of an offering memorandum to qualified institutional buyers under Rule 144A promulgated under the Securities Act of 1933. All proceeds from the sale of the Senior Notes were used by the Company to repay outstanding indebtedness under its Revolving Credit Agreement and for general corporate purposes. The Senior Notes are unsecured and are fully and unconditionally guaranteed by ZDel. The Senior Notes are redeemable for cash at any time on or after October 1, 2002, at the option of the Company, in whole or in part, at redemption prices starting at 104.25 percent of the principal amount. The indenture relating to the Senior Notes contains certain restrictive covenants including, but not limited to, limitations on indebtedness, limitations on dividends and other restricted payments (including repurchases of the Company's common stock), limitation on transactions with affiliates, limitations on liens and limitations on disposition proceeds of asset sales, among others. Pursuant to a registration rights agreement relating to the Senior Notes, the Company has exchanged for the Senior Notes new notes of the Company registered with the Securities and Exchange Commission and with terms identical in all material respects to the Senior Notes. The Senior Notes are included in Long-term Debt on the accompanying balance sheet. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ZALE FUNDING TRUST SECURITIZATION. See Short-term Borrowings for description of Zale Funding Trust Securitization. LEASE COMMITMENTS The Company rents most of its retail space under leases that generally range from five to ten years and may contain base rent escalations. Lease incentives of approximately $4.3 million for reimbursement of certain leasehold improvement expenditures are being amortized against lease payments over the life of the lease. All existing real estate leases are treated as operating leases. Sublease rental income under noncancelable leases is not material. Rent expense is as follows: Contingent rentals paid to lessors of certain store facilities are determined principally on the basis of a percentage of sales in excess of contractual limits. Future minimum rent commitments as of July 31, 1999, for all noncancellable leases of ongoing operations were as follows: 2000 -- $91.2 million; 2001 -- $85.5 million; 2002 -- $78.7 million; 2003 -- $74.5 million; 2004 -- $70.6 million; thereafter -- $197.4 million; for a total of $597.9 million. INTEREST Interest expense for the years ended July 31, 1999, 1998 and 1997 was approximately $37.5 million, $37.2 million and $36.9 million, respectively. Interest income for the years ended July 31, 1999, 1998 and 1997 was $7.0 million, $5.2 million and $0.8 million, respectively. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INCOME TAXES Currently, the Company files a consolidated income tax return. The effective income tax rate varies from the federal statutory rate as follows: Pursuant to the guidance provided by the American Institute of Certified Public Accountants in Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), the Company adopted fresh-start reporting as of the close of business on July 31, 1993. In connection with the adoption of fresh-start reporting, the net book values of substantially all non-current assets existing at July 30, 1993 (the "Effective Date") were eliminated. As a consequence, SFAS No. 109, in conjunction with SOP 90-7, requires that any tax benefits realized for book purposes after the Effective Date, from the reduction of the valuation allowance existing as of the Effective Date be reported as an increase to additional paid-in capital rather than as a reduction in the tax provision in the Consolidated Statements of Operations. However, the Company will realize the cash benefit from utilization of its tax net operating loss ("NOL") against current and future tax liabilities. The cash benefit realized was approximately $13 million, $38 million and $25 million for the years ended July 31, 1999, 1998 and 1997, respectively. As of July 31, 1999, the Company has a NOL carryforward (after limitations) of approximately $181 million. A majority of the tax basis NOL carryforward, which will be available to offset future taxable income of the Company, was determined based upon the initial equity valuation of the Company as determined upon the Effective Date. The utilization of this asset is subject to limitations. The most restrictive is the Internal Revenue Code Section 382 annual limitation. The NOL carryforward can be utilized through 2008. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Deferred tax assets and liabilities are determined based on estimated future tax effects of the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates. Tax effects of temporary differences that give rise to significant components of the deferred tax assets and deferred tax liabilities at July 31, 1999 and 1998 are presented below. Pursuant to the requirements of SFAS No. 109, a valuation allowance must be provided when it is more likely than not that the deferred income tax asset will not be realized. The valuation reserve was approximately $15 million and $49 million as of July 31, 1999 and 1998, respectively. The Company believes that, as of July 31, 1999, a sufficient history of earnings has been established to make realization of an approximately $49 million deferred income tax asset more likely than not. The change in valuation allowance from July 31, 1998 to July 31, 1999 was approximately $34 million. CAPITAL STOCK COMMON STOCK. At July 31, 1999 and 1998, 70,000,000 shares of Common Stock, par value of $0.01 per share, were authorized, 39,261,005 shares and 38,061,538 shares, respectively, were issued, of which ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 35,982,708 shares and 36,400,047 shares, respectively, were outstanding. The Company held 3,278,297 and 1,661,491 treasury shares at July 31, 1999 and 1998, respectively. PREFERRED STOCK. At July 31, 1999 and 1998, 5,000,000 shares of Preferred Stock, par value of $0.01, were authorized. None are issued or outstanding. WARRANTS. During 1998, 1,945,420 Series A Warrants were exercised. The remaining 27,330 Series A Warrants expired July 30, 1998. Accordingly, at July 31, 1999 and July 31, 1998 there were no warrants outstanding. Each Series A Warrant entitled the holder to purchase one share of Zale common stock for $10.368 per share (subject to certain anti-dilution adjustments). TREASURY STOCK. During fiscal 1998 the Company repurchased approximately 1,364,971 shares at an aggregate cost of $40 million, related to a stock repurchase program authorized in February 1998. In June 1999, the Company completed a $50 million repurchase program, which was authorized during August 1998. Under this program, the Company repurchased 1,669,400 shares in fiscal 1999. During September 1999, the Board of Directors approved a stock repurchase program pursuant to which the Company, from time to time and at management's discretion, may purchase through fiscal year 2000, up to an aggregate of $50 million of common stock on the open market. INCENTIVE STOCK PLAN. As of July 31, 1999 the Company had two stock incentive plans. On July 30, 1993 the Company adopted an incentive stock option plan (the "Incentive Stock Plan") to enable the Company to attract, retain and motivate officers and key employees by providing for proprietary interest of such individuals in the Company. Stock awards to purchase an aggregate of 6,555,000 shares of common stock may be granted under the Incentive Stock Plan to eligible employees. The Incentive Stock Plan allows for the granting of restricted stock, stock options, stock bonuses and stock appreciation rights subject to the provisions of the Incentive Stock Plan. Restricted Stock granted under the Incentive Stock Plan vests ratably over a four year vesting period except for 103,846 shares granted which vest ratably over a three year period, and are non-transferable prior to vesting. Options granted under the Stock Option Plan (i) must be granted at an exercise price not less than the fair market value of the shares of common stock into which such options are exercisable, (ii) vest ratably over a four-year vesting period and (iii) expire ten years from the date of grant. The 1995 Outside Director Stock Option Plan, (the "Director Plan") authorizes the Company to grant common stock to non-employee directors at fair market value of the Company common stock on the date of grant. The options vest over a four year period and expire ten years from the date of grant. The maximum number of shares which may be granted under the Director Plan is 150,000 shares. During February 1999, 180,692 shares of restricted Common Stock were granted to certain key employees valued at $5.7 million as of the grant date. The shares will vest ratably on each of the anniversaries ranging from three to four years from the date of grant and are subject to restrictions on their sale or transfer. The total cost of restricted stock is amortized to income as compensation expense ratably over the vesting period and amounted to $0.7 million for the twelve month period ended July 31, 1999. Stock option transactions are summarized as follows: ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) As of July 31, 1999 and 1998, 918,448 and 1,155,257, respectively, of options outstanding were exercisable. In fiscal year 1997, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation." The Company accounts for the Stock Option Plan under APB Opinion No. 25, under which no compensation cost has been recognized. Had compensation cost for this plan been determined pursuant to the provisions of SFAS No. 123, the Company's pro-forma net earnings for fiscal years 1999, 1998 and 1997 would have been (amounts in thousands) $77,149, $67,002 and $48,587 respectively, resulting in diluted earnings per share of $2.10, $1.79 and $1.33, respectively. The fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model with the following weighted-average assumptions used for options granted in fiscal years 1999, 1998 and 1997 respectively: risk-free interest rate of 5.3 percent, 5.8 percent and 6.0 percent, expected dividend yield of zero, expected lives of 5 years, and expected volatility of 34.0 percent, 32.2 percent, and 35.8 percent. The weighted average fair value of options granted for fiscal years 1999, 1998 and 1997 is $17.34, $12.74 and $9.06, respectively. Because the SFAS No. 123 method of accounting has not been applied to options granted prior to August 1, 1996, the resulting pro forma compensation cost may not be representative of that to be expected in future years. EARNINGS PER COMMON SHARE Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the reporting period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Outstanding stock options, restricted stock and warrants issued by the Company represent the only dilutive effect reflected in diluted weighted average shares. For the years ended July 31, 1999, 1998 and 1997, there were antidilutive common stock equivalents of 593,000, 1,266,000 and 524,000, respectively. COMPREHENSIVE INCOME Effective August 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 establishes standards for the reporting and display of comprehensive ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as the change in equity during a period from transactions and other events, except those resulting from investments by and distributions to stockholders. The components of comprehensive income are reported in the consolidated statements of stockholders' investment. SEGMENTS The Company adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. The Company has one reportable segment given the similarities of economic characteristics and products offered between the operations represented by the Company's four brands. Revenues of international retail operations represent approximately 1.5 percent of the Company's revenues for fiscal 1999. Net property and equipment of international operations, represents approximately 8.0 percent of the Company's net property and equipment for fiscal 1999. The Company's international retail operations commenced with the acquisition of Peoples Jewellers effective May 23, 1999. UNUSUAL ITEM -- GAIN ON SALE OF DIAMOND PARK On September 3, 1997, the Company signed an agreement to sell Diamond Park Fine Jewelers (the "Diamond Park Sale"). Diamond Park Fine Jewelers, which managed leased fine jewelry departments in major department store chains including Marshall Field's, Dillard's, Mercantile and Parisian, had net sales of $125.3 million in fiscal year 1997. On October 6, 1997, the Company closed the Diamond Park Sale resulting in a gain of $1.6 million. The Company received $58.0 million in October 1997 and approximately $4.8 million was received in February 1998. UNUSUAL ITEM -- GAIN ON SALE OF LAND In fiscal 1998, the Company closed the sale of excess land surrounding the corporate headquarters facility for $12.9 million, resulting in a gain of $7.3 million. COMMITMENTS AND CONTINGENCIES The Company is involved in certain other legal actions and claims arising in the ordinary course of business. Management believes that such litigation and claims will be resolved without material effect on the Company's financial position or results of operations. The Company has an operations services agreement for management information systems with a third-party servicer. The agreement, which began in December 1996, requires fixed payments totaling $34.4 million over a 60 month term and a variable amount based on usage. The Company has an operations services agreement for credit operations with a third-party servicer. The agreement, dated May 5, 1998, requires minimum annual payments based on credit activities. The Company has a commitment of approximately $15.2 million to be paid over the initial term of seven years. Additional annual payments will be paid based on credit volume for normal credit processing activities. BENEFIT PLANS Defined Contribution Retirement Plan At July 31, 1999, the Company maintains The Zale Corporation Savings & Investment Plan. Substantially all employees who are at least age 21 are eligible to participate in the plan. Effective August 1, 1998, new employees are required to complete one year of continuous service with the Company to be eligible ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to participate in the plan. Each employee can contribute from one percent to fifteen percent of their annual salary. Under this plan, the Company matches one dollar in Zale stock for every dollar an employee contributes up to four percent of annual earnings, subject to Internal Revenue Service limitations. In order for an employee to be eligible for the Company match, the employee must have worked at least 1,000 hours during the plan year and be employed on the last day of the plan year. For matching contributions made through fiscal year 1998 an employee is 33.3 percent vested in the Zale stock after one year of service, 66.7 percent vested after two years of service and 100 percent vested after three years of service. Matching contributions subsequent to July 31, 1998, will immediately vest 100 percent. In order to be eligible for the contribution, employees must be employed by the Company at the time of the contribution. The Company's matching contributions were $1.3 million, $1.2 million and $1.2 million for fiscal years 1999, 1998 and 1997, respectively. The Company contributed 52,594 and 35,047 treasury shares to its 401(k) plan in fiscal year 1999 and 1998, respectively. Retirement Plan On September 14, 1995, the Boards of Directors of Zale and ZDel approved the preparation and implementation of the Zale Delaware, Inc. Supplemental Executive Retirement Plan (the "Plan"), which was executed on behalf of the Company February 23, 1996, to be effective as of September 15, 1995. The purpose of the Plan is to provide eligible executives with the opportunity to receive payments each year after retirement equal to a portion of their final average pay as defined. FINANCIAL INSTRUMENTS As cash and short-term cash investments, customer receivables, the revolving credit agreement, variable funding notes, trade payables and certain other short-term financial instruments are all short-term in nature, their carrying amount approximates fair value. Also, the carrying amount of the $99.6 million, net of discount, Senior Notes approximates fair value. The investments of the Company's insurance subsidiaries, primarily stocks and bonds in the amount of $27.7 million and $26.6 million, approximate market value at July 31, 1999 and July 31, 1998 respectively and are reflected in Other Assets on the Consolidated Balance Sheets. Investments are classified as available for sale and are carried at fair value. Changes in unrealized gains and losses are recorded directly to stockholders' investment. Net realized gains recognized for the years ended July 31, 1999, 1998 and 1997 were $1.6 million, $0.8 million, and $2.0 million, respectively. CONCENTRATIONS OF CREDIT RISK. Financial instruments which potentially subject the Company to significant concentrations of credit risk consist principally of cash investments and customer receivables. The Company maintains cash and cash equivalents, short and long-term investments and certain other financial instruments with various financial institutions. These financial institutions are located throughout the country. Concentrations of credit risk with respect to customer receivables are limited due to the Company's large number of customers and their dispersion across many regions. As of July 31, 1999 and 1998, the Company had no significant concentrations of credit risk. RELATED-PARTY TRANSACTIONS One of the Company's directors serves as a director of a company from which the Company purchased approximately $2.6 million and $3.1 million of jewelry merchandise during fiscal year 1999 and 1998, respectively. The Company believes the terms were equivalent to those of unrelated parties. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION The Company's payment obligations under the Senior Notes are guaranteed by ZDel (the "Guarantor Subsidiary"). Such guarantee is full and unconditional with respect to ZDel. ZFT, a limited purpose Delaware business trust wholly owned by ZDel which owns the customer accounts receivable of ZDel, is not a guarantor of the obligations under the Senior Notes. Separate financial statements of the Guarantor Subsidiary are not presented because the Company's management has determined that they would not be material to investors. The following supplemental financial information sets forth, on an unconsolidated basis, statements of operations, balance sheets, and statements of cash flow information for the Company ("Parent Company Only"), for the Guarantor Subsidiary and for the Company's other subsidiaries (the "Non-Guarantor Subsidiaries"). The supplemental financial information reflects the investments of the Company and the Guarantor Subsidiary in the Guarantor and Non-Guarantor Subsidiaries using the equity method of accounting. Certain reclassifications have been made to provide for uniform disclosure of all periods presented. These reclassifications are not material. ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS YEAR ENDED JULY 31, 1999 (AMOUNTS IN THOUSANDS) ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS YEAR ENDED JULY 31, 1998 (AMOUNTS IN THOUSANDS) ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS YEAR ENDED JULY 31, 1997 (AMOUNTS IN THOUSANDS) ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET JULY 31, 1999 (AMOUNTS IN THOUSANDS) ASSETS ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET JULY 31, 1998 (AMOUNTS IN THOUSANDS) ASSETS ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS YEAR ENDED JULY 31, 1999 (AMOUNTS IN THOUSANDS) ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS YEAR ENDED JULY 31, 1998 (AMOUNTS IN THOUSANDS) ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION -- (CONTINUED) SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS YEAR ENDED JULY 31, 1997 (AMOUNTS IN THOUSANDS) ZALE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUBSEQUENT EVENT As originally entered into, the facility required the Company to reduce the outstanding amount of the Variable Notes to $150 million no later than October 15, 1999. On September 15, 1999, the Company entered into an amendment to the new securitization facility to reduce the commitment of the original Variable Note purchaser group to $150 million and to add two new note purchaser groups having an aggregate commitment of $200 million, thereby increasing the total outstanding amount under the Variable Notes facility to $350 million on terms consistent with the original facility. Additionally the Company paid down the approximate $103 million balance under the Revolving Credit Agreement. The Company expects to refinance the Variable Notes on or before their maturity date with a new transaction or, with the consent of the note purchaser groups, to extend the maturity of the outstanding Variable Notes. See Notes to Consolidated Financial Statements -- Short-term Borrowings, Zale Funding Trust Securitization. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Unaudited quarterly results of operations for the years ended July 31, 1999 and 1998 were as follows (amounts in thousands except per share data): SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of the 30 day of September, 1999. ZALE CORPORATION By: /s/ ROBERT J. DINICOLA ---------------------------------- Robert J. DiNicola Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Zale Corporation: We have audited in accordance with generally accepted auditing standards, the financial statements of Zale Corporation (a Delaware corporation) and subsidiaries included in this Form 10-K, and have issued our report thereon dated September 1, 1999 (except with respect to the matter discussed in the Subsequent Event footnote, as to which the date is September 15, 1999). Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule II is the responsibility of the Company's management and is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Dallas, Texas, September 1, 1999 SCHEDULE II ZALE CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS - --------------- (1) Accounts written off, less recoveries and other adjustments. INDEX TO EXHIBITS - --------------- (1) Previously filed as an exhibit to the registrant's Form 10-Q (No. 1-4129) for the quarterly period ended September 30, 1993, and incorporated herein by reference. (2) Incorporated by reference to the corresponding exhibit to the registrant's Registration Statement on Form S-1 (No. 33-73310) filed with the Commission on December 23, 1993, as amended. (3) Previously filed as an exhibit to the registrant's Form 10-K (No. 0-21526) for the fiscal year ended July 31, 1995, and incorporated herein by reference. (4) Previously filed as an exhibit to the registrant's Form 10-K (No. 0-21526) for the fiscal year ended July 31, 1996, and incorporated herein by reference. (5) Previously filed as an exhibit to the registrant's Form 10-Q for the quarterly period ended October 31, 1996, and incorporated herein by reference. (6) Previously filed as an exhibit to the registrant's Form 10-Q for the quarterly period ended January 31, 1997, and incorporated herein by reference. (7) Previously filed as an exhibit to the registrants' Form 10-K (No. 0-21526) for the fiscal year ended July 31, 1997, and incorporated herein by reference. (8) Incorporated by reference to Exhibit 4.1 to the registrant's Registration Statement on Form S-4 (No. 33-39473) filed with the Commission on November 4, 1997. (9) Previously filed as an exhibit to the registrant's Form 10-K (No. 1-04129) for the fiscal year ended July 31, 1998, and incorporated herein by reference. (10) Previously filed as an exhibit to the registrant's Form 10-Q for the quarterly period ended October 31, 1998, and incorporated herein by reference. (11) Filed herewith. * Management Contracts and Compensatory Plans.

1074544_1999.txt

1074544_1999

1999

1074544

ITEM 1. BUSINESS -------- MERRILL LYNCH PREFERRED CAPITAL TRUST VI Merrill Lynch Preferred Capital Trust VI (the "Trust") is a statutory business trust formed under the Delaware Business Trust Act, as amended, pursuant to a declaration of trust and the filing of a certificate of trust with the Secretary of State on December 7, 1998. The Trust exists for the exclusive purposes of (i) issuing trust securities, consisting of Trust Originated Preferred Securities (the "TOPrS") and trust common securities (the "Trust Common Securities"), representing undivided beneficial ownership interests in the assets of the Trust, (ii) investing the gross proceeds of the trust securities in Partnership Preferred Securities (the "Partnership Preferred Securities") issued by Merrill Lynch Preferred Funding VI, L.P. (the "Partnership"), and (iii) engaging in only those other activities necessary or incidental thereto. None of such TOPrS, Trust Common Securities, or Partnership Preferred Securities were issued as of December 31, 1999. MERRILL LYNCH PREFERRED FUNDING VI, L.P. The Partnership is a limited partnership formed under the Delaware Revised Uniform Limited Partnership Act, as amended, pursuant to an agreement of limited partnership and the filing of a certificate of limited partnership with the Secretary of State on December 7, 1998. Merrill Lynch & Co., Inc. (the "Company") is the sole general partner of the Partnership. The Partnership is managed by the general partner and exists for the exclusive purposes of (i) issuing its partnership interests, consisting of the Company's general partner interest and the Partnership Preferred Securities, (ii) investing the proceeds thereof in certain eligible securities of the Company and wholly owned subsidiaries of the Company (the "Affiliate Investment Instruments") and certain eligible debt securities, and (iii) engaging in only those other activities necessary or incidental thereto. The Partnership has made no investment in Affiliate Investment Instruments as of December 31, 1999. The information set forth under the headings "Merrill Lynch Preferred Capital Trust VI", "Merrill Lynch Preferred Funding VI, L.P.", "Description of the Trust Preferred Securities", "Description of the Trust Guarantee", "Description of the Partnership Preferred Securities", "Description of the Partnership Guarantee", and "Use of Proceeds" in the Prospectus dated December 11, 1998, of the Trust and the Partnership is incorporated by reference herein. ITEM 2. ITEM 2. PROPERTIES ---------- Not Applicable. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- The Registrants know of no material legal proceedings involving the Trust, the Partnership or the assets of either of them. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- No matter was submitted to a vote of holders of any securities of the Trust or the Partnership during the fiscal year covered by this report. PART II ------- ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS --------------------------------------------------------------------- Not Applicable. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ----------------------- The financial statements included herein in response to ITEM 8. - Financial Statements and Supplementary Data are incorporated by reference in response to this item. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS ----------------------------------------------------------------------- OF OPERATIONS ------------- As of December 31, 1999, neither the Trust nor the Partnership had any assets or operations. In 1999 Merrill Lynch completed its efforts to address the Year 2000 issue (the "Y2K issue"). The Y2K issue was the result of a widespread programming technique that caused computer systems to identify a date based on the last two numbers of a year, with the assumption that the first two numbers of the year are "19." As a result, the year 2000 would be stored a "00," causing computers to incorrectly interpret the year as 1900. Left uncorrected, the Y2K issue may have caused serious failures in information technology systems and other systems. The Trust and the Partnership have no independent operations and are dependent upon Merrill Lynch. Merrill Lynch's efforts to address the Y2K issue are more fully discussed in the Merrill Lynch & Co., Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 1999, filed with the Securities and Exchange Commission. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK --------------------------------------------------------- As of December 31, 1999, neither the Trust nor the Partnership had any assets or operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- In response to this ITEM 8, the financial statements and notes thereto and the independent auditors' reports set forth on pages through are incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURES --------------------- None. PART III -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------- The Trustees of the Trust are as follows: Regular Trustee: Stanley Schaefer Property Trustee: The Chase Manhattan Bank Delaware Trustee: Chase Manhattan Bank Delaware Stanley Schaefer is Senior Director of Corporate Tax for the Company and has served in that capacity or another capacity with the Company for the last five years. Each Trustee has served since the Trust was organized on December 7, 1998. The Trustees serve at the pleasure of the Company, as the holder of the Trust Common Securities. The Partnership has no directors or executive officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ---------------------- Neither the Trust nor the Partnership has any executive officers. No employee of the Company receives any compensation for serving as a Regular Trustee or acting in any capacity for the Trust or the Partnership separate from his or her compensation as an employee of the Company. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -------------------------------------------------------------- Not Applicable. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- None. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K --------------------------------------------------------------- (a) Documents filed as part of this Report: 1. Financial Statements The contents of the financial statements are listed on page hereof, and the financial statements and accompanying independent auditors' reports appear on pages through. 2. Financial Statement Schedules None. 3. Exhibits 4.1 Certificate of Trust, dated December 3, 1998, of the Trust (incorporated by reference to Exhibit 4.1 to the Trust's Quarterly Report on From 10-Q for the period ended June 25, 1999 (File No. 1-7182-12) 4.2 Certificate of Limited Partnership, dated as of December 3, 1998, of the Partnership (incorporated by reference to Exhibit 4.2 to the Partnership's Quarterly Report on From 10-Q for the period ended June 25, 1999 (File No. 1-7182-11) 23* Consent of Deloitte & Touche LLP 24* Powers of Attorney 27* Financial Data Schedules. The Financial Data Schedules to be contained in Exhibit 27 are required to be submitted only in the Registrants' electronic filing of this Form 10-K by means of the EDGAR system. (b) Reports on Form 8-K None. ____________ * Filed herewith ----------------------------- ITEM 14(a)(1) FINANCIAL STATEMENTS PAGE - -------------------- ---- MERRILL LYNCH PREFERRED CAPITAL TRUST VI Balance Sheets, December 31, 1999 and December 25, 1998 Note to Balance Sheets Independent Auditors' Report MERRILL LYNCH PREFERRED FUNDING VI, L.P. Balance Sheets, December 31, 1999 and December 25, 1998 Note to Balance Sheets Independent Auditors' Report See Note to Balance Sheets MERRILL LYNCH PREFERRED CAPITAL TRUST VI NOTE TO BALANCE SHEETS DECEMBER 31, 1999 - -------------------------------------------------------------------------------- ORGANIZATION AND PURPOSE Merrill Lynch Preferred Capital Trust VI (the "Trust") is a statutory business trust formed on December 7, 1998 under the laws of the State of Delaware for the exclusive purposes of (i) issuing the Trust Originated Preferred Securities (the "Trust Preferred Securities") and the Trust Common Securities (together with the Trust Preferred Securities, the "Trust Securities") representing undivided beneficial ownership interests in the assets of the Trust, (ii) purchasing Partnership Preferred Securities (the "Partnership Preferred Securities") representing the limited partnership interests of Merrill Lynch Preferred Funding VI, L.P. (the "Partnership") with the proceeds from the sale of the Trust Securities, and (iii) engaging in only those other activities necessary or incidental thereto. The Trust has a perpetual existence, subject to certain termination events as provided in the Declaration of Trust under which it was formed. The Trust intends to issue and sell its Trust Preferred Securities in a public offering and to issue and sell its Trust Common Securities to Merrill Lynch & Co., Inc. (the "Company"). No Trust Securities have been issued as of December 31, 1999. The Partnership Preferred Securities will be redeemable for cash, at the option of the Partnership, in whole or in part, from time to time, after a certain date to be determined. Upon any redemption of the Partnership Preferred Securities, the Trust Preferred Securities will be redeemed, in whole or in part, as applicable. Holders of the Trust Preferred Securities will have limited voting rights and will not be entitled to vote to appoint, remove, or replace, or to increase or decrease the number of, Trustees, which voting rights are vested exclusively in the holder of the Trust Common Securities. The Company will be obligated to pay compensation to the underwriters of the offering of the Trust Preferred Securities. The Company will also pay all fees and expenses related to the organization and operations of the Trust (including any taxes, duties, assessments or governmental charges of whatever nature (other than withholding taxes) imposed by the United States or any other domestic taxing authority upon the Trust) and be responsible for all debts and other obligations of the Trust (other than the Trust Securities). The Company has agreed to indemnify the trustees and certain other persons. INDEPENDENT AUDITORS' REPORT To the Trustees of Merrill Lynch Preferred Capital Trust VI We have audited the accompanying balance sheets of Merrill Lynch Preferred Capital Trust VI (the "Trust") as of December 31, 1999 and December 25, 1998. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Trust at December 31, 1999 and December 25, 1998 in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP New York, New York March 28, 2000 See Note to Balance Sheets MERRILL LYNCH PREFERRED FUNDING VI, L.P. NOTE TO BALANCE SHEETS DECEMBER 31, 1999 - -------------------------------------------------------------------------------- ORGANIZATION AND PURPOSE Merrill Lynch Preferred Funding VI, L.P. (the "Partnership") is a limited partnership that was formed under the Delaware Revised Uniform Limited Partnership Act on December 7, 1998 for the exclusive purposes of purchasing certain eligible debt instruments of Merrill Lynch & Co., Inc. (the "Company") and wholly owned subsidiaries of the Company (the "Affiliate Investment Instruments") with the proceeds from the sale of Partnership Preferred Securities (the "Partnership Preferred Securities") to Merrill Lynch Preferred Capital Trust VI (the "Trust") and a capital contribution from the Company in exchange for the general partnership interest in the Partnership (collectively, the "Partnership Proceeds"). The Partnership Proceeds will be used initially to purchase debt instruments from the Company and a domestic wholly owned subsidiary of the Company, retaining 1% in unaffiliated debt securities. The Partnership shall have a perpetual existence subject to certain termination events. The Partnership Proceeds will be redeemable for cash, at the option of the Partnership, in whole or in part, from time to time, after a certain date to be determined. Except as provided in the Limited Partnership Agreement and Partnership Preferred Securities Guarantee Agreement, and as otherwise provided by law, the holders of the Partnership Preferred Securities will have no voting rights. The Company serves as the sole general partner of the Partnership. The Company, in its capacity as General Partner of the Partnership, has agreed to pay all fees and expenses related to the organization and operations of the Partnership (including any taxes, duties, assessments or government charges of whatever nature (other than withholding taxes) imposed by the United States or any other domestic taxing authority upon the Partnership) and the offering of the Partnership Preferred Securities and be responsible for all debts and other obligations of the Partnership (other than with respect to the Partnership Preferred Securities). The General Partner has agreed to indemnify certain officers and agents of the Partnership. INDEPENDENT AUDITORS' REPORT To the General Partner and Limited Partner of Merrill Lynch Preferred Funding VI, L.P. We have audited the accompanying balance sheets of Merrill Lynch Preferred Funding VI, L.P. (the "Partnership") as of December 31, 1999 and December 25, 1998. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Partnership at December 31, 1999 and December 25, 1998 in conformity with generally accepted accounting principle. /s/ Deloitte & Touche LLP New York, New York March 28, 2000 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized on the 29th day of March, 2000. MERRILL LYNCH PREFERRED CAPITAL TRUST VI* By: /s/ Stanley Schaefer -------------------------------------------------- Name: Stanley Schaefer Title: Regular Trustee MERRILL LYNCH PREFERRED FUNDING VI, L.P.* By: MERRILL LYNCH & CO., INC., as General Partner By: /s/ John C. Stomber -------------------------------------------------- Name: John C. Stomber Title: Senior Vice President and Treasurer, and as Attorney-in-Fact for a majority of the Board of Directors** - ------------ * There is no principal executive officer(s), principal financial officer, controller, principal accounting officer or board of directors of the Registrants. The Trustees of the Trust (which include the Regular Trustees, the Property Trustee and the Delaware Trustee) together exercise all powers and perform all functions with respect to the Trust. ** Pursuant to Powers of Attorney filed as Exhibit 24 hereto. EXHIBIT INDEX 4.1 Certificate of Trust dated as of December 3, 1998 of the Trust (incorporated by reference to Exhibit 4.1 to the Trust's Quarterly Report on From 10-Q for the period ended June 25, 1999 (File No. 1-7182-12) 4.2 Certificate of Limited Partnership dated as of December 3, 1998 of the Partnership (incorporated by reference to Exhibit 4.2 to the Partnership's Quarterly Report on From 10-Q for the period ended June 25, 1999 (File No.1-7182-11) 23* Consent of Deloitte & Touche LLP 24* Powers of Attorney 27* Financial Data Schedules. The Financial Data Schedules to be contained in Exhibit 27 are required to be submitted only in the Registrants'electronic filing of this Form 10-K by means of the EDGAR system. _____________________ * Filed herewith

1055349_1999.txt

1055349_1999

1999

1055349

Item 1. Business Omitted. Item 2. Item 2. Properties The Trust has acquired certain auto loan receivables from the Bank pursuant to a Sale and Servicing Agreement. The aggregate principal balance of the receivables, as of December 31, 1999, was $418,224,348.00. The Trust also holds a reserve account, pursuant to the Sale and Servicing Agreement. The principal balance of the reserve account, as of December 31, 1999, was $12,546,730.43. The aggregate balance of receivables that were 60 or more days past due, as of December 31, 1999, was $3,601,979.94, or 0.861% of the receivables by principal balance. The aggregate amount of principal charge-offs, net of recoveries, for the year ended December 31, 1999, was $3,292,718.93, or 0.5906% of the average aggregate outstanding principal balance of the receivables for that year. Item 3. Item 3. Legal Proceedings The Registrant knows of no material pending legal proceedings with respect to the Trust, the Trustee or The Bank. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of Certificateholders during the fiscal year covered by this report. Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholders Matters The registrant has no voting stock or class of common stock outstanding as of the date of this report. The beneficial interest in the Trust is represented by certificates of beneficial interest (the "Certificates"). The registrant is also the issuer of two outstanding classes of asset backed notes ("Notes"). To the knowledge of the registrant , the Certificates are traded in the over-the-counter market to a limited extent. As of December 31, 1999, all of the Certificates were registered in the name of CEDE and Co. The registrant understands that CEDE and Co. is the nominee for the Depository Trust Company ("DTC"). The registrant further understands that DTC has no knowledge of the actual beneficial owners of the Certificates held of record by CEDE & Co., and that DTC knows only the identity of the participants to those whose accounts such Certificates are credited, who may or may not be the beneficial owners of the Certificates. The records provided to the Trust by DTC indicate that as of December 31, 1999, the number of holders of record for each class of securities issued by the Trust were as follows: CLasses # of Holders --------- ------------------ A3 24 A4 18 Certificates 2 Item 6. Item 6. Selected Financial Data Omitted. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Omitted. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Not applicable. Item 8. Item 8. Financial Statements and Supplementary Data Omitted. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part III Item 10. Item 10. Directors and Executive Officers of the Registrant Omitted. Item 11. Item 11. Executive Compensation Omitted. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The records of DTC indicate that at December 31, 1999, there were 17 participants in the DTC system that held positions in a class of securities of the Trust equal to more than 5% of the total principal amount of a class of securities outstanding on that date: - ----------------------------------------------------------------------- Name & Address of Original % of Participant Certificate Class Principal Balance - ----------------------------------------------------------------------- Class A-3 Bank of New York 18,235,000 6.20% (The) 925 Patterson Plank Rd. Secaucus, NJ 07094 - ----------------------------------------------------------------------- Bankers Trust Company 24,420,000 8.31% C/O BT Services Tennessee Inc. 648 Grassmere Park Drive Nashville, TN 37211 - ----------------------------------------------------------------------- Bank One Trust 12,055,000 6.87% Company, N. A. 1900 Polaris Parkway 4th Floor New York, NY 10004 - ----------------------------------------------------------------------- Boston Safe Deposit 20,210,000 6.87% and Trust Company C/O Mellon Bank N.A. Three Mellon Bank Center Room 153-3015 Pittsburgh, PA - ----------------------------------------------------------------------- Chase Manhattan Bank 75,850,000 25.80% 4 New York Plaza 13th Floor New York, NY 10004 - ----------------------------------------------------------------------- Citibank, N.A. 19,000,000 6.46% P.O. Box 30576 Tampa, FL 33630-3576 - ----------------------------------------------------------------------- Investors Bank & 19,800,000 6.73% Trust/M.F. Custody 200 Clarendon Street 15th Fl Hancock Tower Boston, MA 02116 - ----------------------------------------------------------------------- - ----------------------------------------------------------------------- State Street Bank 56,785,000 19.31% and Trust Company 1776 Heritage Dr. Global Corporate Action Unit JAB 5NW No. Quincy, MA 02171 - ----------------------------------------------------------------------- Class A4 Bank of New York 25,940,000 10.54% (The) 925 Patterson Plank Rd. Secaucus, NJ 07094 - ----------------------------------------------------------------------- Bankers Trust Company 87,370,000 35.52% C/O BT Services Tennessee Inc. 648 Grassmere Park Drive Nashville, TN 37211 - ----------------------------------------------------------------------- Boston Safe Deposit 13,100,000 5.33% and Trust Company C/O Mellon Bank N.A. Three Mellon Bank Center Room 153-3015 Pittsburgh, PA - ----------------------------------------------------------------------- Chase Manhattan Bank 27,000,000 10.98% 4 New York Plaza 13th Floor New York, NY 10004 - ----------------------------------------------------------------------- Citibank, N.A. 17,750,000 7.22% P. O. Box 30576 Tampa, FL 33630-3576 - ----------------------------------------------------------------------- Northern Trust 21,500,000 8.47% Company (The) 801 S. Canal C-IN Chicago, IL 60607 - ----------------------------------------------------------------------- State Street Bank 29,755,000 12.10% and Trust Company 1776 Heritage Dr. Global Corporate Action Unit JAB 5NW No. Quincy, MA 02171 - ----------------------------------------------------------------------- Certificates Bank of New York 23,000,000 75.11% (The) 925 Patterson Plank Road Secaucus, NJ 07094 - ----------------------------------------------------------------------- Chase Manhattan Bank 7,620,000 24.89% 4 New York Plaza, 13th floor New York, NY 10004 - ----------------------------------------------------------------------- Item 13. Item 13. Certain Relationships and Related Transactions None. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports of Form 8-K (a) Exhibits. The following documents are filed as part of this Annual Report on Form 10-K. Exhibit Number Description --------------- ---------------- 23.1 Consent of Independent Accountants. 28.1 Annual Management Report on Internal Controls 28.2 Annual Servicer's Certificate pursuant to Section 4.10 of the Agreement. 28.3 Annual Independent Accountants' Servicing Reports pursuant to Section 4.11 of the Agreement. 28.4 Annual Issuer's Certificate of Compliance with the Indenture. (b) Reports on Form 8-K. The following reports were filed on Form 8-K in 1999: Date Items Reported Financial Statements - ------------ ---------------- ----------------------------- 2/4/1999 5, 7 Monthly report to certificateholders dated 1/15/1999 3/16/1999 5, 7 Monthly report to certificateholders dated 2/15/99 6/18/1999 5, 7 Monthly report to certificateholders dated 3/15/1999, 4/15/1999 and 5/17/1999 6/30/1999 5, 7 Monthly report to certificateholders dated 6/15/1999 7/30/1999 5, 7 Monthly report to certificateholders dated 7/15/1999 8/27/1999 5, 7 Monthly report to certificateholders dated 8/16/1999 9/30/1999 5, 7 Monthly report to certificateholders dated 9/15/1999 10/29/1999 5, 7 Monthly report to certificateholders dated 10/15/1999 11/30/1999 5, 7 Monthly report to certificateholders dated 11/15/1999 12/23/1999 5, 7 Monthly report to certificateholders dated 12/15/1999 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 29, 2000 Chase Manhattan Auto Owner Trust 1998-A by: Chase Manhattan Bank USA, National Association By: /s/ Patricia Garvey ----------------------------------- Name: Patricia Garvey Title: Vice President INDEX TO EXHIBITS Exhibit Number: Description: - --------------- ------------------------ 23.1 Consent of Independent Accountants 28.1 Annual Management Report on Internal Controls 28.2 Annual Servicer's Certificate pursuant to Section 4.10 of the Agreement 28.3 Annual Independent Accountant's Servicing Reports pursuant to Section 4.11 of the Agreement 28.4 Annual Issuer's Certificate of Compliance with the Indenture

1011976_1999.txt

1011976_1999

1999

1011976

ITEM 1 BUSINESS GENERAL Adams Outdoor Advertising Limited Partnership (the "Company") is the seventh largest owner and operator of outdoor advertising structures in the United States. Adams Outdoor Advertising, Inc. is the managing general partner of the Company. The Company provides outdoor advertising services to fourteen markets and surrounding areas in the Midwest, Southeast and mid-Atlantic states: Charlotte, NC; Charleston, SC; Orangeburg, SC; Florence, SC; Laurens, SC; Kalamazoo, MI; Lansing, MI; Jackson, MI; Lehigh Valley, PA; Northeast PA; Madison, WI; Minneapolis, MN; Norfolk, VA; and Peoria, IL. As of December 31, 1999, the Company operated, in the aggregate, 9,586 advertising displays, including 2,567 painted bulletins, 6,809 30-sheet posters, and 210 junior (8-sheet) posters. HISTORY The Company's business was founded in 1983 with the acquisition of Central Outdoor Advertising, which had offices in Lansing, Jackson and Kalamazoo, MI. Over the next five years, the Company pursued a strategy of geographic expansion into additional medium-sized markets, primarily through the acquisition of existing outdoor advertising businesses in selected Midwest, Southeast and mid-Atlantic markets. This geographic expansion strategy has enabled the Company to capitalize on the efficiencies, economies of scale and marketing opportunities associated with operating outdoor advertising businesses located in proximate or contiguous geographic markets to its primary markets. Since 1988, the Company's sales and growth in Operating Cash Flow (operating income plus depreciation, amortization and deferred compensation expense) have resulted from a concentration on rate and occupancy levels of existing inventory, construction of new displays, upgrading of displays in existing markets, acquisition of displays in existing markets, and new market acquisitions in South Carolina and Pennsylvania. INDUSTRY OVERVIEW Outdoor advertising is one of several major advertising media that includes television, radio, newspapers and magazines, among others. According to the Outdoor Advertising Association of America, Inc. ("OAAA"), an industry trade association, outdoor advertising in the United States generated total revenues of approximately $2.1 billion in 1999, an 11.4% decrease over 1998. Because of its repetitive impact and relatively low cost-per-thousand impressions (a commonly used media standard), outdoor advertising is attractive to both large national advertisers and smaller local and regional businesses. The principal outdoor advertising display is the billboard, of which there are three standardized formats: o PAINTED BULLETINS are generally 14 feet high and 48 feet wide (672 square feet) and consist of panels or a single sheet of vinyl that are hand painted at the facilities of the outdoor advertising company or computer painted in accordance with design specifications supplied by the advertiser. The panels or vinyl are then transported to the billboard site and mounted to the face of the display. On occasion, to attract more attention, some of the displays are designed to extend beyond the linear edges of the display face and may include three-dimensional embellishments for which the outdoor advertising company often receives additional revenue. Because of painted bulletins' greater impact and higher cost relative to other types of billboards, they are usually located near major highways, and space is usually sold to advertisers for periods of four to twelve months. o 30-SHEET POSTERS are generally 12 feet high by 25 feet wide (300 square feet) and are the most common type of billboard. Lithographed or silk-screened paper sheets that are supplied by the advertiser are pre-pasted and packaged in airtight bags by the outdoor advertising company and applied, like wallpaper, to the face of the display. The 30-sheet posters are concentrated on major traffic arteries and space is usually sold to advertisers for periods of one to twelve months. o JUNIOR (8-SHEET) POSTERS are usually 6 feet high by 12 feet wide (72 square feet). The displays are prepared and mounted in the same manner as 30-sheet posters. Most junior posters, because of their smaller size, are generally concentrated on city streets and are targeted at pedestrian traffic. Space on junior posters is usually sold to advertisers for periods of one to twelve months. Typically, billboards are mounted on structures that are owned by the outdoor advertising company and located on sites that are owned or leased by it or on which it has an easement. Leases of structure sites usually provide for a term of three to ten years depending on locale. A structure may contain one or more displays (generally two), each of which is referred to as a "face." A more recent addition to the various types of outdoor advertising displays is bus shelter displays and transit ads, which are located on the sides of buses. Bus shelter displays are usually enclosed within glassed, back-lit cases on two or more sides of a pedestrian shelter located at an urban bus stop. Transit displays are inserted into panels on the sides and back exteriors of buses. The advertisements appear on lithographed or silk-screened posters supplied in a single sheet by the advertiser. Transit displays and bus shelter displays generally are sold to advertisers for periods of one to twelve months. Advertisers usually contract for outdoor displays (and other media exposure) through advertising agencies, which are responsible for the artistic design and written content of the advertising as well as the choice of media and the planning and implementation of the overall campaign. Outdoor advertising companies pay commissions to the agencies for advertising contracts secured through such agencies. Advertising contracts are negotiated on the basis of the monthly rates that are published in the outdoor advertising company's "rate card." These rates, which are typically set annually during the first quarter of each year, are based on a particular display's exposure (or number of "impressions" delivered) in relation to the demographics of the particular market and its location within that market. The number of "impressions" delivered by a display (measured by the number of vehicles passing the site during a defined period and weighted to give effect to such factors as its proximity to other displays and the speed and viewing angle of approaching traffic) are determined by surveys that are verified by the Traffic Audit Bureau, an independent agency which is the outdoor advertising industry's equivalent of television's Arbitron ratings and which audits approximately 175,000 outdoor advertising sites annually. Advertisers purchase outdoor advertising for a variety of reasons. In the case of restaurants, motels, service stations and similar roadside businesses, the message reaches potential customers close to the point of sale and provides ready directional information. For advertisers seeking to build product brand name awareness, outdoor advertising is attractive because of its constant repetition and comparatively low cost per thousand impressions. According to the OAAA, the top ten categories of businesses ranked by outdoor advertising expenditures for 1999 were local services and amusements, retail establishments, public transportation/hotels and resorts, media and advertising, restaurants, automotive dealers and services, automotive accessories and equipment, insurance and real estate, financial and miscellaneous merchandise. BUSINESS STRATEGY The Company's strategy is to focus its operations on providing value-added outdoor advertising services to advertisers in medium-sized markets in which it is or could be the leading provider of such services. The Company believes that its focus on medium-sized markets allows it to achieve a dominant share of outdoor advertising revenues and display faces within those markets. The Company also believes that by educating current and potential customers on the effectiveness of the outdoor medium, it has a significant opportunity to gain a larger share of overall advertising expenditures. The Company's business strategy comprises the following elements: o Focus marketing efforts on local and regional advertisers in order to develop and maintain a diverse client base and to limit reliance on national advertising accounts. The Company believes that focusing on local and regional advertisers helps generate stable revenue growth and reduce its reliance on any single local economy or industry segment. In 1999, net revenues attributable to local and regional advertising accounted for 97.1% of total net revenues. o Take advantage of recent technological advances in computer and printing technology, which allow the Company to provide higher quality reproduction to its customers, thereby attracting new advertisers to the outdoor medium. o Raise potential customers' awareness of the reach, impact and value of outdoor advertising and convince customers to use outdoor advertising as an integral part of their advertising plan. o Continue to enhance sales, marketing and customer service capabilities. The Company's salespersons are paid pursuant to a performance-based compensation system and supervised by a local sales manager executing a coordinated marketing plan. o Increase revenues from existing display faces by developing programs that maximize advertising rates and optimize occupancy levels in each market. In addition, the Company also plans to continue to pursue new advertising categories, such as transit buses and passenger shelters, to further diversify the Company's revenue base. o Expand operations within the Company's markets through construction of new display faces and the upgrading of existing displays, placing an emphasis on painted bulletins, which generally command higher rates and longer contracts from advertisers. o Pursue strategic acquisitions of outdoor displays in existing and contiguous markets and capitalize on the efficiencies, economies of scale and significant opportunities for inter-market cross-selling that are associated with operating in proximate or contiguous geographic markets. The Company recognizes, and closely monitors, the needs of its customers and seeks to provide them with a quality advertising product at a lower cost than competitive media. The Company believes it has a reputation of providing excellent customer service and quality outdoor advertising space. As such, the Company is nationally recognized as a five star member (the highest ranking) of the OAAA, a distinction currently held by only 35 of the approximately 800 members of the OAAA. MARKETS The Company operates in eleven geographically diverse medium-sized markets that offer to local, regional and national advertisers significant areas of population to whom advertising may be targeted. In addition, the Company offers comprehensive outdoor advertising services, including local production facilities and local representation, in all of its markets except in the Minneapolis market. The following table sets forth information as of December 31, 1999 with respect to each of the Company's markets, including the ADI (as defined herein) rank of that market and the number of each display type operated by the Company in that market: (a) Indicates the market rank of the area of dominant influence ("ADI"), as determined by The Arbitron Company, within which the office is located. ADIs are ranked based on population, with the market having the largest population ranked first. ADI rank is the standard measure of market size used by the media industry. (b) The Jackson, MI market is included in the Lansing, MI ADI ranking. (c) The Lehigh Valley market is included in the Philadelphia ADI ranking. According to the U.S. Census Bureau, the Lehigh Valley market was the 86th largest metropolitan statistical area in the United States at December 31, 1990, the latest date for which such information is available. The following tables set forth information with respect to the net revenues, operating income and operating margins for the Company's displays in each of its markets for each of the past five years. Amounts presented for Northeast PA and South Carolina include results from their acquisition dates of November 8, 1996 and December 2, 1996, respectively, through December 31, 1999. NET REVENUES (a) The 1996 and 1995 figures for Jackson, MI are included with Lansing, MI. OPERATING INCOME (a) The 1996 and 1995 figures for Jackson, MI are included with Lansing, MI. OPERATING MARGIN (a) The 1996 and 1995 figures for Jackson, MI are included with Lansing, MI. SALES AND MARKETING The growth in the Company's revenues and Operating Cash Flow is primarily a result of its focus on the use of sales and marketing staff to increase the productivity of its inventory of displays while maintaining strict controls on its expenses. Historically, outdoor advertising companies have derived a significant portion of their revenues from large national advertisers, such as tobacco companies, auto manufacturers and distributors of alcoholic beverages. As tobacco industry advertising purchases have declined in recent years, some outdoor advertising companies have recently shifted their marketing focus to local and regional advertisers to replace these lost revenues. Nonetheless, large national advertisers continue to account for a significant percentage of outdoor advertising industry revenues. Despite this fact, the Company believes that sales to local and regional advertisers lend stability to its revenue stream by diversifying its customer base. The Company emphasizes sales to local and regional customers. In 1999, the Company generated approximately 97.1% of its net revenues from local and regional sales. The Company believes that the Company's local and regional focus enables it to capitalize on the growing use of outdoor media by advertisers that historically have relied on other media in marketing their products and services, such as consumer product companies, professional service firms, health care providers and financial institutions. The Company's sales and marketing strategy has been successful largely due to the efforts of its team of general managers in its markets. These general managers have an average of over 15 years of experience in the outdoor advertising industry and are responsible for implementing the Company's sales and marketing strategy. Each of the Company's markets has a team of account executives that is supported locally by a creative department, which provides innovative marketing ideas, generates art work and designs billboard advertising for potential customers' advertising campaigns. In addition, each market has a business development staff, which makes available comprehensive information about local market research, customer needs and advertising opportunities. This allows the Company to assess the impact and potential reach for a potential target customer's display in a given market. The sales and marketing departments focus on increasing revenues through developing new marketing programs for customers, educating both current and potential customers on the effectiveness of the outdoor advertising product relative to other advertising media and integrating this medium into a customer's marketing plan. The Company's sales personnel are compensated primarily on a commission basis which maximizes their incentive to perform. The following table illustrates the diversity of the Company's markets and customers by setting forth the percentage of the Company's gross revenues for 1999 attributable to each of the top ten advertising categories: 1999 REVENUES BY CATEGORY (PERCENT OF GROSS REVENUES) TOTAL ----- Auto/Boat/Motorcycle/Recreational............................... 10.2% Restaurants..................................................... 9.4 Telecommunications.............................................. 5.6 Amusement/Entertainment......................................... 5.1 Hotel/Motel..................................................... 4.0 Radio/Television/Cable.......................................... 4.0 Tobacco......................................................... 3.6 Hospitals/Healthcare Providers ................................. 3.4 Banking/Financial Institutions.................................. 2.9 Real Estate Agents/Brokers ..................................... 2.7 All Others...................................................... 49.1 ----- Total................................................ 100.0% ===== LOCAL MARKET OPERATIONS In each of its primary markets, the Company maintains a complete outdoor advertising operation including a sales office, a construction and maintenance facility, an art department equipped with state-of-the-art computer technology, a real estate unit and support staff. The Company conducts its outdoor advertising operations through these local offices, which is consistent with senior management's belief that an organization with decentralized sales and operations is more responsive to local market demand and provides greater incentives to employees. At the same time, the Company maintains consolidated accounting and financial controls, which allow it to monitor closely the operating and financial performance of each market. The general managers, who report directly to the Company's chief executive officer, are responsible for the day-to-day operations of their offices and are compensated based on the financial performance of their respective markets. In general, these local managers oversee market development, production and local sales. Each local office is responsible for locating and ultimately obtaining sites for the displays in its market. Each office has a leasing department, which maintains an extensive data base containing information on local property ownership, lease contract terms, zoning ordinances and permit requirements. The Company owns certain of the sites on which its displays are located and leases others. Site lease contracts vary in term but typically range from three to ten years with various termination and renewal provisions. As of and for the twelve months ended December 31, 1999, the Company had approximately 4,633 active site leases accounting for a total land lease expense of approximately $8.6 million, representing approximately 12.3% of net revenues. In each of its primary markets, the Company has construction and maintenance facilities, which facilitate the expeditious and economical construction and maintenance of displays and the painting and mounting of customers' advertisements. Typically, the Company uses vinyl skins for bulletins. The vinyl skins are reusable, thereby reducing the Company's production costs, and are easily transportable. Due to the geographic proximity of the Company's markets and the transportability of vinyl skins, the Company can shift production among markets to use its available capacity more effectively. The local offices also maintain fully equipped art departments to assist local customers in the development and production of creative, effective advertisements. COMPETITION The Company competes in each of its markets with other outdoor advertisers as well as other media, including broadcast and cable television, radio, newspaper and direct mail marketers. In competing with other media, outdoor advertising relies on its low cost-per-thousand impressions and its ability to repetitively reach a broad segment of the population in a specific market or geographic area within that market. In most of its markets, the Company encounters direct competition from other major outdoor media companies, including Outdoor Systems, Inc. and Whiteco, among others, each of which has a large national network and resources significantly greater than the Company's. The Company believes that its focus on local and regional advertisers and its position as the leading provider of full service outdoor advertising in each of its primary markets enable it to compete effectively with other outdoor media operators, as well as other media, both within those markets and in each respective region. The Company also competes with other outdoor advertising companies for sites on which to build new structures. GOVERNMENT REGULATION The outdoor advertising industry is subject to governmental regulation at the federal, state and local level. Federal law, principally the Highway Beautification Act of 1965, encourages states, by the threat of withholding federal appropriations for the construction and improvement of highways within such states, to implement legislation to control outdoor advertising structures located within 660 feet of or visible from interstates and primary highways, except in commercial or industrial areas, and to force the removal at the owner's expense and without any compensation of any nonconforming structures on such highways. The Highway Beautification Act and the various state statutes implementing it require the payment of just compensation whenever governmental authorities require legally erected and maintained structures to be removed from federally-aided highways. States and local jurisdictions have, in some cases, passed additional regulation on the construction, repair, upgrading, height, size and location of outdoor advertising structures adjacent to federally-aided highways and other thoroughfares. Such regulations, often in the form of municipal building, sign or zoning ordinances, specify standards for the height, size and location of outdoor advertising structures. In the event non-conforming advertising structures are damaged, including damage caused by natural events, such as windstorms and hurricanes, the Company may not be able to repair the structures. In some cases, the construction of new or relocation of existing structures is prohibited. Some jurisdictions also have restricted the ability to enlarge or upgrade existing structures, such as converting from wood to steel or from non-illuminated to illuminated structures. From time to time, governmental authorities order the removal of structures by the exercise of eminent domain or through various regulatory actions or other litigation. In such cases, the Company seeks compensation under appropriate procedures and thus far, the Company has been able to obtain satisfactory compensation for any of its structures removed at the direction of governmental authorities. However, compensation may not always be available in such circumstances. Some municipalities have attempted to regulate outdoor advertising by taxing revenues attributable to advertising structures, or by requiring the payment of annual permit fees based on factors such as the square footage of an outdoor advertising company's display faces, located in those municipalities. Other municipalities take into account lease payments received by lessors of property on which advertising structures are located in making property tax assessments. These taxes and fees can increase an outdoor advertising company's direct operating costs. Amortization legislation has also been adopted in some areas across the country, including Charlotte, NC, one of the Company's markets. Amortization only permits the owner of an outdoor advertising structure to operate its structure as a non-conforming use for a specified period of time, after which it must remove or otherwise conform its structure to the applicable regulations at its own cost without any compensation. Some jurisdictions require the removal of certain structures without any compensation if there is a change in use of the premises (e.g., construction on previously unimproved land). Amortization and such other regulations requiring the removal of structures without compensation currently are subject to vigorous litigation in the state and federal courts, which have reached differing conclusions as to their constitutionality. In 1988, the company reached an agreement with the city of Charlotte, NC that no boards will have to be removed for 5 years in settlement of the 1998 lawsuit with Charlotte, NC. In other localities in which the Company operates, outdoor advertising is subject to restrictive and, in some cases, prohibitive zoning regulations. Management expects federal, state, and local regulations to continue to be a significant factor in the operation of the Company's business In recent years, there have been efforts to restrict billboard advertising of certain products, including tobacco and alcohol. Congress has passed no legislation at the federal level except legislation requiring health hazard warnings similar to those on cigarette packages and print advertisements. In November 1998, the major U.S. tobacco companies (the "Tobacco Companies") reached an out of court settlement (the "Agreement") with 46 states, the District of Columbia, the Commonwealth of Puerto Rico and four other U.S. territories (the "Settling States"). The remaining four states had already reached similar settlements with the Tobacco Companies. The Agreement called for the removal of tobacco advertising from out-of-home media, including billboards, along with signs and placards in arenas, stadiums, shopping malls and video game arcades by April 23, 1999. Additionally, the Agreement provided that, at the Settling States' option, the Tobacco Companies must, at their expense, substitute for tobacco advertising alternative advertising which discourages youth smoking. That alternative advertising must remain in place for the duration of the Tobacco Companies' out-of-home media advertising contracts which existed as of the date of the Agreement. Although the extent of the future impact on operations is not known, the Company has been successful thus far in replacing tobacco advertising in its markets. The elimination of tobacco advertising as called for by the Agreement will cause a reduction in direct revenues from Tobacco Companies and may simultaneously increase the available space on the existing inventory of billboards in the outdoor advertising industry. Although the extent of the future impact on operations is not known, the Company has been successful thus far in replacing tobacco advertising in its Minneapolis market where settlement was reached prior to the Agreement. While this is positive, the Company can give no assurance that the further cutbacks in tobacco advertising during 1999 will not have an adverse effect on operations for 1999 or beyond. To date regulations applicable in the Company's markets have not materially affected its operations, and compliance with those regulations has not had a material impact on its costs. No assurance can be given, however, as to the effect of changes in those regulations or of new regulations that may be adopted in the future. EMPLOYEES As of December 31, 1999, the Company employed 334 persons, of whom approximately 116 were primarily engaged in sales and marketing, 147 were engaged in painting, posting, construction and maintenance of displays, and the balance were employed in financial, administrative and similar capacities. No employees are covered by a collective bargaining agreement except for five production shop workers in Peoria, IL covered by a collective bargaining agreement with the Brotherhood and Painters and Allied Trades that expires on December 31, 2000. Management considers its employee relations to be good. ITEM 2 ITEM 2 FACILITIES The Company's corporate office is located in Atlanta, GA. In addition, the Company has an office and complete production and maintenance facilities in each of Charlotte, NC; Charleston, SC; Orangeburg, SC; Florence, SC; Laurens, SC; Kalamazoo, MI; Lansing, MI; Jackson, MI; Lehigh Valley, PA; Northeast PA; Madison, WI; Norfolk, VA; and Peoria, IL. Additionally, the Company has a sales office in Minneapolis, MN. The Peoria and Minneapolis facilities are leased, and all other facilities are owned. The Company considers its facilities to be well maintained and adequate for its current and reasonably anticipated future needs. The Company owns approximately 141 parcels of real property that serve as the sites for its outdoor displays. The Company also has easements on approximately 147 parcels of real property on which it has outdoor displays. Additionally, the Company's displays are located on sites leased or licensed by the Company, typically for three to ten years with renewal options. ITEM 3 ITEM 3 LEGAL PROCEEDINGS The Company from time to time is involved in litigation in the ordinary course of business, including disputes involving advertising contracts, site leases, employment claims, construction matters, condemnation and amortization. The Company is also involved in routine administrative and judicial proceedings regarding permits and fees relating to outdoor advertising structures and compensation for condemnations. The Company is not a party to any lawsuit or proceeding which, in the opinion of management, is likely to have a material adverse effect on the Company. See "Business--Government Regulation." Information contained in this Annual Report, including, without limitation information in this Business section, may contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, which can be identified by the use of forward-looking terminology as "may," "will," "would," "expect," "anticipate," "estimate" or "continue" or the negative thereof or other variations thereon or comparable terminology. Certain factors, including, the Company's substantial leverage, regulation of outdoor advertising by federal, state and local governments, tobacco advertising patterns, competition and general economic conditions, could cause actual results to differ materially from those in such forward-looking statements. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Not Applicable. ITEM 6 ITEM 6 SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data, insofar as it relates to each of the years in the five-year period ended December 31, 1999, has been derived from the Company's financial information and should be read in conjunction with the audited financial statements, including the Company's balance sheets at December 31, 1999 and 1998 and the related statements of operations for each of the years in the three-year period ended December 31, 1999 and the notes thereto appearing elsewhere in this Form 10-K. The selected consolidated financial data should also be read in conjunction with the information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations." SELECTED CONSOLIDATED FINANCIAL DATA (DOLLARS IN THOUSANDS) (a) Deferred compensation expense represents accrued expenses under certain deferred compensation arrangements, including phantom stock and nonqualified retirement plan agreements with certain key management personnel. The phantom stock agreements in effect provide for the repurchase of the "phantom stock" in three equal annual payments after each executive's termination, death or disability, the sale of the Company, or the fifth anniversary of the agreement's execution. See "Executive Compensation--Agreements with Management--Incentive Compensation under Phantom Stock Agreements." (b) The following table sets forth the calculation of "Operating Cash Flow." Operating Cash Flow is not intended to represent net cash flow provided by operating activities as defined by generally accepted accounting principles and should not be considered as an alternative to net income as an indicator of the Company's operating performance or to net cash provided by operating, investing and financing activities as a measure of liquidity or ability to meet cash needs. The Company believes Operating Cash Flow is a measure commonly reported and widely used by analysts, investors and other interested parties in the media industry. Accordingly, this information has been disclosed herein to permit a more complete comparative analysis of the Company's operating performance relative to other companies in the media industry. However, the definition of Operating Cash Flow or of similarly defined terms may vary among companies and such differences should be noted in comparing the Company's operating performance relative to other companies. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." (c) Earnings consist of operating income plus fixed charges adjusted to exclude capitalized interest. The Company's fixed charges consist of interest expense plus amortization of deferred financing costs and the estimated interest portion of rents. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Company is the seventh largest owner and operator of outdoor advertising structures in the United States. The Company provides outdoor advertising services through fourteen facilities in the Midwest, southeast and mid-Atlantic states: Charlotte, NC; Charleston, SC; Orangeburg, SC; Florence, SC; Laurens, SC; Kalamazoo, MI; Lansing, MI; Jackson, MI; Lehigh Valley, PA; Northeast PA; Madison, WI; Minneapolis, MN; Norfolk, VA; and Peoria, IL. As of December 31, 1999, the Company operated 9,586 advertising displays, including 2,567 painted bulletins, 6,809 30-sheet posters, and 210 junior (8-sheet) posters. The Company's business was founded in 1983 with the acquisition of Central Outdoor Advertising, which had offices in Lansing, Jackson and Kalamazoo, MI. Over the next five years, the Company pursued a strategy of geographic expansion into additional medium-sized markets, primarily through the acquisition of existing outdoor advertising businesses in selected Midwest, Southeast and mid-Atlantic markets. This geographic expansion strategy has enabled the Company to capitalize on the efficiencies, economies of scale and marketing opportunities associated with operating outdoor advertising businesses located in proximate or contiguous geographic markets. As a result of its acquisition of outdoor advertising businesses from 1983 to 1988, the Company incurred substantial debt. Interest expense required to service such debt, together with depreciation and amortization, has contributed to historical marginal profits for the Company. Since 1991, the Company has continued to strengthen its market share through the construction and acquisition of displays in its existing markets, introduction of transit advertising in its Madison, WI market and acquisitions, in the last quarter of 1996, of operations in South Carolina and Pennsylvania. This expansion has been financed through internally generated cash flow and borrowings from the Company's $43 million credit facilities. The following table presents certain information from the Consolidated Statements of Operations as a percentage of net revenues for each of the three years in the three-year period ended December 31, 1999. YEARS ENDED DECEMBER 31, ------------------------ 1999 1998 1997 ---- ---- ---- Net revenues 100.0% 100.0% 100.0% Direct advertising expenses 49.2 49.7 50.8 Corporate general and administrative expenses 5.4 6.0 6.2 ---- ---- ---- Operating Cash Flow 45.4 44.3 43.0 Depreciation and amortization 10.2 12.2 14.2 Deferred compensation expense 3.6 6.7 1.6 ---- ---- ---- Operating income 31.6 25.4 27.2 Interest expense 19.6 22.3 25.5 Payments to partners 3.7 -- -- Other (income) expenses, net (1.0) .2 .1 Loss on disposals of property and equipment, net .5 .6 .2 Extraordinary loss on early extinguishment of debt .3 .5 -- ---- ---- ---- Net income 8.5% 1.8% 1.4% ==== ==== ==== The Company's revenues are a function of both the occupancy rate of the Company's outdoor advertising display inventory (the percentage of time that its displays contain paid-for advertisements) and the rates that the Company charges for use of its displays. The Company's business strategy includes the optimization of the mix of rate and occupancy of its display inventory in order to maximize revenues. Advertising rates for the Company's displays are based upon a variety of factors, including historical base rates, the time of year, and the occupancy rate of a particular market's display inventory. The following table presents the number of painted bulletins and 30-sheet poster displays operated by the Company and the average rates and occupancy levels with respect to such displays for the three years ended December 31, 1999. These figures do not include junior-posters and route town paints. YEARS ENDED DECEMBER 31, ----------------------- 1999 1998 1997 (2) ---- ---- ------- Number of Displays: Painted Bulletins 2,567 2,529 1,934 30-Sheet Posters 6,809 6,704 4,892 Average Rates: (1) Painted Bulletins $1,729 $1,583 $1,624 30-Sheet Posters $ 538 $ 489 $ 529 Average Occupancy: Painted Bulletins 75% 78% 73% 30-Sheet Posters 64% 69% 69% (1) Represents average rate per display per month (2) The figures for 1997 do not include the South Carolina market. The primary operating expenses incurred by the Company are advertising agency commissions, lease payments to property owners for use of the land on which the Company's displays are located, operational and administrative costs and sales expenses (primarily commissions). Of these expenses, advertising agency commissions, sales expenses, and certain operational and administrative costs are considered direct costs. Commissions are paid to advertising agencies that contract for the use of the Company's advertising displays on behalf of advertisers. These agency commissions are deducted from gross revenues to calculate net revenues. The Company currently maintains a phantom stock program under which certain executive management personnel and general managers have the ability to earn deferred compensation based upon the operating performance of the Company or, in the case of the general managers, their respective divisions. Annual accruals under the program are based upon exceeding a base level of operating profit. The Company believes that its phantom stock program provides its senior employees incentives to continue improving the operating performance of the Company. The Company's marketing strategy of servicing local and regional advertisers and reducing its dependence on national and tobacco advertising resulted in moderate increases in overall revenues during a time when national advertising dollars, primarily tobacco, were declining. The Company concentrates its marketing efforts on generating sales from local and regional advertisers in each of its markets, including those advertisers within industries and product categories that have not historically been traditional users of outdoor media. These potential advertisers include fast food restaurants, retailers, food stores, casinos, cellular and telecommunications companies, building supply retailers, radio stations, travel-related industries and medical care providers. This focus on local and regional advertisers has been critical to the Company's ability to control revenue fluctuations resulting from the variability and potential long-term decline of revenues attributable to the tobacco products industry, which represented 2.9% of the Company's net revenues in 1999, 10.3% in 1998, 10.5% in 1997, 12.5% in 1996 and 12.6% in 1995. Sales to local and regional advertisers accounted for 97.1% of the Company's net revenues in 1999. The Company's sales and marketing strategy has been successful largely due to its team of general managers in its markets. These key managers have an average of 15 years of industry experience. The Company also has integrated a business development department into each market, making available to each region's sales force comprehensive information about local market research, customer needs and advertising opportunities. The business development departments have given the Company's sales departments significantly improved information and tools to develop additional local and regional advertising customers, especially with many customers that have not historically advertised through the outdoor medium. Sales representatives have been able to use these additional resources to develop creative ideas for new customers and educate them about the cost effectiveness of outdoor advertising in attempting to reach their customers. The Company considers its emphasis on local and regional sales, the expertise and tenure of its managers and its marketing and customer service capabilities to be factors which enhance the productivity of its inventory of advertising displays. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1999 COMPARED WITH YEAR ENDED DECEMBER 31, 1998 Net revenues (gross revenues net of agency commissions) for 1999 of $68.0 million increased by 5.4% from $64.6 million for 1998. This increase resulted from higher advertising rates in certain markets and an increase in the number of displays sold. Direct advertising expenses for 1999 of $33.5 million increased by 4.4% from $32.1 million in 1998. The increase was attributable to direct costs associated with increased sales from new displays and an increase in sales commissions due to higher average rates. Corporate general and administrative expenses for 1999 of $3.7 million decreased by 6.2% from $3.9 million in 1998. This decrease was attributable to a couple of things in particular: the Company purchased an airplane in 1999, which eliminated the lease costs which were incurred for air travel during 1998. In addition, all costs associated with the new Company logo and identification project were incurred in 1998. Depreciation and amortization for 1999 of $6.9 million decreased by 12.0% from $7.9 million in 1998. Depreciation expense decreased as a result of the expiration of the depreciable life of certain assets during 1999. Deferred compensation expense for 1999 of $2.5 million decreased by 42.6% from $4.3 million in 1998 primarily due to the inclusion of the Chief Executive Officer in the Phantom Stock Plan to acquire his 3% interest in the company and the additional vesting of General Managers under the Phantom Stock Plan in 1998. Interest expense for 1999 of $13.4 million decreased 7.3% from $14.4 million in 1998. This decrease was attributable to a lower interest rate in 1999, as well as a lower outstanding loan balance. The Company's effective interest rate decreased to 10.0% for 1999 from 10.2% for 1998. Net income for 1999 increased to $5.8 million from $1.2 million in 1998 as a result of the items discussed above. Operating cash flow for 1999 of $30.9 million increased by 8.1% from $28.6 million in 1998. This increase was attributable to the aforementioned increase in net revenues coupled with only a modest increase in total operating expenses. YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31, 1997 Net revenues (gross revenues net of agency commissions) for 1998 of $64.6 million increased by 12.7% from $57.3 million for 1997. This increase resulted from higher advertising rates in certain markets and an increase in the number of displays sold. Direct advertising expenses for 1998 of $32.1 million increased by 10.3% from $29.1 million in 1997. The increase was attributable to direct costs associated with increased sales from new displays and an increase in sales commissions due to higher average rates. Corporate general and administrative expenses for 1998 of $3.9 million increased by 8.8% from $3.6 million in 1997. This increase was attributable to increased travel expenses and costs associated with the new Company logo and identification project. Depreciation and amortization for 1998 of $7.9 million decreased by 3.4% from $8.1 million in 1997. Depreciation expense decreased as a result of the expiration of the depreciable life of certain assets during 1998. Deferred compensation expense for 1998 of $4.3 million increased significantly from $901,000 in 1997 primarily due to the inclusion of the Chief Executive Officer in the Phantom Stock Plan to acquire his 3% interest in the company and the additional vesting of General Managers under the Phantom Stock Plan. Interest expense for 1998 of $14.4 million decreased 1.2% from $14.6 million in 1997. This decrease was attributable to a lower interest rate in 1998. The Company's effective interest rate decreased to 10.2% for 1998 from 10.4% for 1997. Net income for 1998 increased to $1.2 million from $791,000 in 1997 as a result of the items discussed above. Operating cash flow for 1998 of $28.6 million increased by 16.1% from $24.6 million in 1997. This increase was attributable to the aforementioned increase in net revenues coupled with only a modest increase in total operating expenses. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company's cash needs have arisen from operating expenses (primarily direct advertising expenses and corporate general and administrative expenses), debt service, capital expenditures and deferred compensation payments under phantom stock agreements. The Company's interest expense was $13.4 million in 1999, $14.4 million in 1998 and $14.6 million in 1997. The Company's primary sources of cash are net cash generated from operating activities and borrowings under its credit facility. The Company's net cash provided from operations decreased by 4.6% to $11.3 million for 1999, increased by 66.1% to $11.9 million for 1998 and decreased by 43.0% to $7.1 million for 1997. In 1996, the Company issued $105 million in aggregate principal amount of its 10-3/4% Senior Notes due 2006 (the "Senior Notes") and entered into a revolving credit facility, which was increased to $35 million in December 1996. As a result of such financings, borrowings for acquisitions in 1996 and for capital expenditures in 1997, the average outstanding indebtedness increased in 1996 and 1997. During 1997, the Company had interest expense of $14.6 million on average outstanding indebtedness of $135.3 million, resulting in an effective annual interest rate of 10.4%. During 1998, the Company had interest expense of $14.4 million on average outstanding indebtedness of $136.7 million, resulting in an effective annual interest rate of 10.2%. During 1999, the Company had interest expense of $13.4 million on average outstanding indebtedness of $127.6 million, resulting in an effective annual interest rate of 10.0%. Scheduled interest payments on the Senior Notes aggregate approximately $10.5 million per year. In November 1998, the senior unsecured credit facility was increased to $8 million. At December 31, 1999 nothing was outstanding under such facility. Substantially all of the assets of the Company are pledged to secure indebtedness of up to $35.0 million (of which approximately $21.3 million was outstanding as of December 31, 1999) under the revolving credit facility and, accordingly, the lenders thereunder will have a prior claim on those assets. Permitted borrowings under the revolving credit facility are subject to various conditions. In addition, the availability of borrowings are subject to compliance with certain financial covenants. The agreement governing the revolving credit facility contains a number of covenants that are more restrictive than those contained in the indenture, including covenants requiring the Company to maintain certain financial ratios that become more restrictive over time. Adverse operating results could cause noncompliance with one or more of these covenants, reducing the Company's borrowing availability, and, in certain circumstances, entitling the lenders to accelerate the maturity of outstanding borrowings. In November 1998 the senior unsecured credit facility was increased to $8 million. At December 31, 1999 and 1998, the Company was in compliance with all covenants. On March 31, 1998, the Company entered into an additional $3 million senior unsecured credit facility. In September 1998, the proceeds from the senior unsecured facility were used to purchase $4 million of the Company's Senior Notes on the open market at 105% of principal plus accrued interest. As a result of the redemption, the Company recognized an extraordinary loss of $330,000, which represented the redemption premium plus recognition of a proportionate share of the associated deferred financing fees. On June 30, 1999, the Company purchased $1,250,000 of its Senior Notes on the open market at 106% of principal plus accrued interest. During the third quarter of 1999, additional amounts of $2,000,000 and $75,000 were purchased at 105 3/4% and 105 1/2%, respectively. As a result of these redemptions, the Company recognized an extraordinary loss of $194,000, which represented the redemption premium plus recognition of a proportionate share of the associated deferred financing fees. The Company believes that net cash provided from operations and available credit under the revolving credit facility will be sufficient to meet its cash needs for its current operations, required debt payments, anticipated capital expenditures and the deferred compensation payments for the reasonably foreseeable future. The Company reduced its debt by $13.8 million in 1999, reduced its debt by $2.3 million in 1998 and increased its debt by $1.8 million in 1997. The Company also made capital expenditures, primarily for new billboard construction in existing markets, of $10.2 million in 1999, $10.1 million in 1998 and $7.6 million in 1997. The Company expects that its capital expenditures during 2000 will be approximately $11.0 million and will be primarily for new billboard construction and the upgrading of existing displays. The Company expects to finance such capital expenditures with cash flow provided by operating activities or borrowings under the revolving credit facilities. IMPACT OF INFLATION Though increases in operating costs could adversely affect the Company's operations, management does not believe that inflation has had a material effect on operating profit during the past several years. SEASONALITY Although revenues during the first and fourth quarters are slightly lower than the other quarters, management does not believe that seasonality has a significant impact on the operations or cash flow of the Company. FORWARD LOOKING STATEMENTS Information contained in this Form 10-K, including, without limitation in the foregoing Management's Discussion and Analysis of Financial Condition and Results of Operations may contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, which can be identified by the use of forward-looking terminology as "may," "will," "would," "expect," "anticipate," "estimate" or "continue" or the negative thereof or other variations thereon or comparable terminology. Certain factors, including the Company's substantial leverage, regulation of outdoor advertising by federal, state and local governments, tobacco advertising patterns, competition and general economic conditions, could cause actual results to differ materially from those in such forward-looking statements. YEAR 2000 COMPLIANCE OVERVIEW The "Year 2000 issue" had no effect on the Company. NEW ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement, which will be effective for the Company beginning January 1, 2001, establishes accounting and reporting standards requiring that every derivative instrument (including certain embedded in other contracts) be recorded in the balance sheet as either assets or liabilities measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The Company has not yet quantified the impact of adopting SFAS No. 133 and has not determined the timing or method of its adoption, however it is not expected that adoption will have a material impact on earnings. ITEM 7A ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risk from changes in interest rates. The information below summarizes the Company's market risk associated with its debt obligations as of December 31, 1999. The information presented below should be read in conjunction with Note 8 of the Notes to Consolidated Financial Statements. INTEREST RATE RISK The Company carries some floating rate debt and thus is exposed to the impact of interest rate changes. At December 31, 1999, indebtedness under its revolving credit facility, representing approximately 17.9% of the Company's long-term debt, bears interest at variable rates. Accordingly, the Company's net income and cash flow are affected by changes in interest rates. A 91 basis point move in interest rates (10% of the Company's weighted average interest rate) would have an immaterial impact on earnings and cashflow. Fluctuations in interest rates may also adversely affect the fair market value of the Company's fixed rate borrowings. The fair value of debt with a fixed interest rate will increase as interest rates fall and decrease as interest rates rise. The Company's fixed rate borrowings consist of $97.7 million of senior notes bearing interest at 10 3/4%. A 91 basis point move in interest rate would also have an immaterial effect on the fair value of the Company's fixed rate senior notes. ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information required by Item 9 was previously reported by the Company. Please see the Company's report on Form 8-K filed on September 15, 1998. PART III ITEM 10 ITEM 10 MANAGEMENT EXECUTIVE OFFICERS AND DIRECTORS The executive officers and directors of Adams Outdoor Advertising, Inc., the managing general partner of the Company, are as follows: STEPHEN ADAMS has been Chairman of Adams Outdoor Advertising, Inc. since its founding in 1983. Since the 1970's, Mr. Adams has served as chairman of privately owned banking, bottling, publishing, outdoor advertising, television and radio companies in which he held a controlling ownership interest. Mr. Adams is Chairman of the Board of Directors of Affinity Group, Inc., a membership-based marketing company. J. KEVIN GLEASON has served as the Chief Executive Officer of the Company and President of Adams Outdoor Advertising, Inc. since 1991. Mr. Gleason has seventeen years of experience in advertising, eleven of which have been dedicated to the outdoor advertising industry. Mr. Gleason has been with Adams Outdoor Advertising, Inc. since 1987, serving as General Manager of various local markets and then as Executive Vice President at the corporate level. Prior to joining Adams Outdoor Advertising, Inc., Mr. Gleason served as General Manager of Naegele Outdoor Advertising ( "Naegele ") of Southern California from 1985 to 1987. Mr. Gleason also currently serves as a Vice-Chairman of the Outdoor Advertising Association of America. ABE LEVINE has served as Chief Financial Officer of the Company and as Vice President of Adams Outdoor Advertising, Inc. since 1991. From 1988 to 1991, Mr. Levine worked as Controller of Adams Outdoor Advertising of Atlanta, Inc. Mr. Levine was employed by Gulf + Western Industries, Inc. from 1979 through 1987 in various senior accounting and financial positions, and by KPMG Peat Marwick from 1975 through 1979 in various auditing positions. GEORGE PRANSKY, PH.D. has been in private practice as co-director of Pransky and Associates in La Conner, Washington since 1988. He is a frequent consultant for government and private agencies and has been a contract faculty member for a number of educational institutions, including the University of Washington, the University of Oregon and Antioch College. Dr. Pransky has trained management groups in team building, stress elimination and management development for fifteen years. DAVID FRITH-SMITH has served as managing partner of Biller, Frith-Smith & Archibald, Certified Public Accountants, since 1988. Mr. Frith-Smith was a principal in Maidy and Lederman, Certified Public Accountants, from 1980 to 1984, and with Maidy Biller Frith-Smith & Brenner, Certified Public Accountants, from 1984 to 1988. Mr. Frith-Smith is a director of various private and non-profit corporations. ANDRIS A. BALTINS has been a member of the law firm of Kaplan, Strangis and Kaplan, P.A. since 1979. He is a director of Polaris Industries Inc., a manufacturer of snowmobiles, all-terrain vehicles, personal watercraft and related products. Mr. Baltins is also a director of various private and non-profit corporations. OTHER SIGNIFICANT MANAGEMENT PERSONNEL The following table sets forth certain information with respect to other significant management personnel: NAME AGE POSITION Jon Kane........................... 34 General Manager - Lansing, MI Jim Balestino...................... 35 General Manager - Jackson, MI Mike Peters........................ 37 General Manager - Kalamazoo, MI John Hayes......................... 46 General Manager - Lehigh Valley, and Northeast PA Michelle Kullmann.................. 31 General Manager - Madison, WI Gardner King....................... 47 General Manager - Norfolk, VA Barry M. Asmann.................... 42 General Manager - Charlotte, NC Robert J. Lord..................... 40 General Manager - Peoria, IL Robert A. Graiziger................ 46 General Manager - Minneapolis, MN Jerry Heinz........................ 57 General Manager - South Carolina JON KANE has been general manager of the Lansing, MI division since July 1997. He joined the Company in 1989 as an account executive in its Lehigh Valley, PA division. He also served as regional sales manager and poster sales manager for Lehigh and was later promoted to general manager of the Madison, WI division before being transferred to Lansing. JIM BALESTINO has served as General Manager of the Jackson, MI division since January 1999. He joined the Company in 1997 as the Sales Manager in its Florence, SC division. Mr. Balestino previously held the position of General Sales Manager with FKM Advertising in Youngstown, OH. In addition, he served as the Regional Account Manager and Market Development Manager from 1992 until 1995. He began his career in 1988 as a Real Estate/Account Executive for Penn Advertising in Altoona, PA. MIKE PETERS has been general manager of the Kalamazoo, MI division since October, 1996. He began his outdoor advertising career in 1985 as an account executive with Creative Displays in Lehigh Valley, PA. Mr. Peters stayed on as an account executive when Adams purchased Creative Displays and in 1989 was promoted to sales manager. He has thirteen years of experience in the outdoor advertising industry. JOHN HAYES has served as general manager of the Lehigh Valley, PA division from 1985 to 1991 and from 1994 to the present. He began his career in outdoor advertising in 1976 as an account executive with Creative Displays in the Lehigh Valley market, later becoming sales manager in 1979 and assistant manager in 1981. From 1991 to 1994, Mr. Hayes managed a paging business in the Lehigh Valley area. MICHELLE KULLMANN has been general manager of the Madison, Wisconsin division since June 1997. Michelle first started with Adams in 1991 as an account executive. In 1993 she was promoted to sales manager of Madison and held that position until her most recent promotion to General Manager. GARDNER KING has served as general manager of the Norfolk, VA division since January 1988. From 1980 through 1985, Mr. King was the founder and sole proprietor of an outdoor advertising company in Norfolk, VA, which he sold to Whiteco. After the expiration of his non-compete agreement with Whiteco, Mr. King joined the Company in 1988. Mr. King has 16 years of experience in the outdoor advertising industry. BARRY ASMANN has served as general manager of the Charlotte, NC division since January 1993 and prior thereto was sales manager in both the Charlotte, NC and Lehigh Valley, PA divisions. Mr. Asmann has 13 years of experience in the outdoor advertising industry, working in various markets throughout the country with the Company and Naegele. ROBERT LORD has served as general manager of the Peoria, IL division since December 1993. From February 1993 to December 1993, he served as the sales manager of the Company's Charlotte division and from 1989 to January 1993, he served as the sales manager of the Company's Peoria, IL division. Mr. Lord served as an account executive in the Peoria division from 1986 to 1989. ROBERT GRAIZIGER has served as general manager of the Minneapolis, MN division since 1988, when he sold an outdoor advertising company that he founded and operated in Minneapolis to the Company. Mr. Graiziger has been involved in the outdoor advertising business in various capacities since 1978. JERRY HEINZ has served as general manager of the South Carolina division since December 1996. He came to Adams Outdoor from Burkhart Advertising, Inc. Mr. Heinz joined Burkhart Advertising, Inc. in 1969 as an account executive. During the next 27 years, Mr. Heinz held the positions of sales manager, general manager and finally as President and CEO. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION The following table provides certain summary information concerning the compensation incurred by the Company for its Chief Executive Officer and each of the two other executive officers for the years ended December 31, 1999, 1998, and 1997. SUMMARY COMPENSATION TABLE (a) All amounts represent accruals under deferred phantom stock agreements. (b) Less than the lesser of (i) 10% of total annual salary and bonus and (ii) $50,000. (c) Amounts for 1999, 1998, and 1997 include contributions to the accounts of Messrs. Gleason and Levine under the Company's nonqualified retirement plan of $30,000 and $15,000, respectively. All other amounts represent Company contributions to the Company's 401(k) plan. (d) The Company entered into an employment agreement with Mr. Adams providing for a salary of $200,000 per year, adjusted for annual cost of living increases, and the reimbursement of business expenses. (e) Does not include reimbursement of company travel and entertainment expense advanced by Mr. Adams aggregating $105,298 in 1997. Nothing was reimbursed to Mr. Adams in 1998 or 1999. EMPLOYMENT AGREEMENT The Company and Stephen Adams entered into an employment agreement effective January 1, 1996. Under the employment agreement, Mr. Adams is employed as Chairman of Adams Outdoor Advertising, Inc. until December 31, 2001 at a base salary of $200,000 plus an annual cost of living increase. AGREEMENTS WITH MANAGEMENT--INCENTIVE COMPENSATION UNDER PHANTOM STOCK AGREEMENTS The Company has deferred phantom stock agreements with certain managers, including each general manager with respect to the performance of his respective market. The compensation is calculated using a multiple of the operating profit of the general manager's respective division for the fiscal year ending immediately prior to the determination date over the value of the division at the time of agreement. The agreements provide for three equal annual payments to the participants upon the determination date, which is defined as termination of employment, death, disability, sale of the Company or the fifth anniversary of the execution of the agreement. The Company incurred deferred compensation expense related to the phantom stock agreements of $2.5 million, $4.3 million and $901,000, respectively, for the years ended December 31, 1999, 1998, and 1997, respectively. As of December 31, 1999, the Company has accrued the following amounts of deferred compensation expense payable related to the phantom stock agreements: NAME AMOUNT ---- ------ (DOLLARS IN THOUSANDS) Kevin Gleason........................... $1,935 Abe Levine.............................. -- Others.................................. 1,860 ----- Total.................... $3,795 ====== If amounts accrued as of December 31, 1999 as deferred compensation payable related to the phantom stock agreements are paid as currently scheduled (assuming no executive terminations, deaths or disabilities), such payments will occur as follows: AGREEMENTS WITH MANAGEMENT INCENTIVE COMPENSATION UNDER NONQUALIFIED RETIREMENT PLAN The Company also maintains a deferred compensation plan for each of Messrs. Gleason, Levine and each of the area general managers. Under such plan, the Company contributes $30,000 per year to the retirement account of Mr. Gleason and $15,000 per year to the account of each of the other participants. In addition, Messrs. Gleason and Levine deferred a substantial portion of their 1999 and 1998 compensation into a similar plan. Deferred compensation payable as of December 31, 1999 related to the nonqualified retirement plans was approximately $3.2 million. 401(K) SAVINGS PLAN Company employees also participate in a deferred savings and profit sharing plan (the "401(k) Plan") qualified under Section 401(a) and 401(k) of the Internal Revenue Code (the "Code"). All employees over age 21 who have completed one year of service are eligible to participate in the 401(k) Plan. Eligible employees may contribute to the 401(k) Plan up to 10% of their salary subject to an annual maximum established under the Code, and the Company matches these employee contributions at a rate of 50% up to the first 6% of the employee's salary. Employees may make additional voluntary contributions. DIRECTOR COMPENSATION Following the refinancing, the Company pays directors who are not also employees (Messrs. Pransky, Frith-Smith and Baltins) director fees of $5,400 per quarter. ITEM 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS & MANAGEMENT PRINCIPAL SECURITY HOLDERS The table below sets forth, the beneficial ownership interests in the Company as of December 31, 1999. (a) Stephen Adams holds 100% of the issued and outstanding shares of Adams Outdoor Advertising, Inc., the managing general partner of the Company, and, accordingly, may control the affairs of the Issuers. (b) Stephen M. Adams, Mark C. Adams, Scott L. Adams and Kent R. Adams are sons of Stephen Adams. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS CERTAIN TRANSACTIONS Stephen Adams, J. Kevin Gleason and Abe Levine own 57%, 14% and 14%, respectively, of HSP Graphics ("HSP"), a printing company headquartered in Canada. The Company pays the salary and expenses of the HSP salesmen who operate in the Atlanta, GA area and HSP reimburses the Company for those expenses in cash and services. At December 31, 1999, 1998 and 1997, the Company had accounts receivable of $21,869, $114 and $227,991, respectively, outstanding from HSP. The Company expensed $11,000 and $84,000 for printing services provided during 1998, and 1997, respectively. Nothing was expensed in 1999 for these services. During 1998, the Company entered into a building lease with J. Kevin Gleason, an officer of the Company. The lease term is for 10 years and has been classified as an operating lease. Rent expense of approximately $52,000 related to this transaction has been included in direct advertising expense during the year ended December 31, 1998. The Company exercised its option to purchase the building in 1999. ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed (1) Financial statements (included under Item 8) (2) Financial statement schedules S-1 Independent Public Accountants' Reports on Schedule S-2 Schedule II - Valuation and Qualifying Accounts (3) Exhibits (b) Reports on Form 8-K The company filed no reports on form 8-K during the quarter ended December 31, 1997. (c) Exhibits Included in Item 14(a)(3) above. (d) Financial Statements Schedules Included in Item 14(a)(2) above. Financial Statement Schedules - Identify Signature Page - Power of Attorney Exhibit Index (Item 601, Reg. S-K) - Financial Data Schedules Item 601(b)(27) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To: Adams Outdoor Advertising Limited Partnership We have audited in accordance with auditing standards generally accepted in the United States, the consolidated balance sheets of Adams Outdoor Advertising Limited Partnership as of December 31, 1999 and 1998 and the related consolidated statements of operations, partners' equity (deficit), and cash flows for the years then ended, and have issued our report thereon dated February 25, 2000. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying Schedule II-Valuation and Qualifying Accounts is the responsibility of the company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen LLP Atlanta, GA February 25, 2000 INDEPENDENT AUDITORS' REPORT The Board of Directors Adams Outdoor Advertising Limited Partnership: Under date of March 18, 1998, we reported on the consolidated balance sheets of Adams Outdoor Advertising Limited Partnership as of December 31, 1997, and the related consolidated statements of operations, changes in partners' equity (deficit) and cash flows for each of the years in the two-year period ended December 31, 1997, as contained in the annual report on Form 10-K for the year 1998. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule as listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP Atlanta, Georgia March 18, 1998 ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (a) Write-offs, net of recoveries SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP By: Adams Outdoor Advertising, Inc., its general partner By: /s/ J. Kevin Gleason ------------------------------------------- J. Kevin Gleason PRESIDENT AND CHIEF EXECUTIVE OFFICER ADAMS OUTDOOR ADVERTISING, INC. By: /s/ J. Kevin Gleason ------------------------------------------- J. Kevin Gleason PRESIDENT AND CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. J. Kevin Gleason, pursuant to powers of attorney, executed by each of the officers and directors listed above whose name is marked by an "*" filed as an exhibit hereto to this Report, by signing his name hereto, does hereby sign and execute this report of Adams Outdoor Advertising, Inc. on behalf of each such officers and directors in the capacities in which the names of each appear. POWER OF ATTORNEY - ----------------- (FORM 10-K) KNOW ALL MEN BY THESE PRESENTS, that ADAMS OUTDOOR ADVERTISING, INC., a Minnesota corporation (the "Company"), and each of the undersigned directors of the Company, hereby constitutes and appoints J. Kevin Gleason and Abe Levine and each of them (with full power to each of them to act alone) its/his/her true and lawful attorney-in-fact and agent, for it/him/her and on its/him/her and in its/his/her name, place and stead, in any and all capacities to sign, execute, affix its/his/her seal thereto and file the Annual Report on Form 10-K of the Company and Adams Outdoor Advertising Limited Partnership for the year ended December 31, 1999 under the Securities Exchange Act of 1933, as amended, with any amendment or amendments thereto, with all exhibits and any and all documents required to be filed with respect thereto with any regulatory authority. There is hereby granted to said attorneys, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in respect of the foregoing as fully as it/he/she or itself/himself/herself might or could do if personally present, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, may lawfully do or cause to be done by virtue hereof. This Power of Attorney may be executed in any number of counterparts, each of which shall be an original, but all of which taken together shall constitute one and the same instrument and any of the undersigned directors may execute this Power of Attorney by signing any such counterpart. Adams Outdoor Advertising, Inc. has caused this Power of Attorney to be executed in its name by its Chief Executive Officer on the 29th day of March, 2000. ADAMS OUTDOOR ADVERTISING, INC. By /s/ J. Kevin Gleason ---------------------------- J. Kevin Gleason CHIEF EXECUTIVE OFFICER AND PRESIDENT The undersigned, directors of ADAMS OUTDOOR ADVERTISING, INC., have hereunto set their hands as of the 29th day of March, 2000. /s/ Stephen Adams /s/ J. Kevin Gleason - --------------------------- --------------------------- Stephen Adams J. Kevin Gleason /s/ David Frith-Smith /s/ George Pransky - --------------------------- --------------------------- David Frith-Smith George Pransky /s/ Andris A. Baltins - --------------------------- Andris A. Baltins D I R E C T O R S ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES Consolidated Financial Statements as of December 31, 1999, 1998, and 1997 Together With Auditors' Report ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999, 1998, AND 1997 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS FINANCIAL STATEMENTS Consolidated Balance Sheets--December 31, 1999 and 1998 Consolidated Statements of Operations for the Years Ended December 31, 1999, 1998, and 1997 Consolidated Statements of Changes in Partners' Equity (Deficit) for the Years Ended December 31, 1999, 1998, and 1997 Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998, and 1997 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - 2 - REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Adams Outdoor Advertising Limited Partnership: We have audited the accompanying consolidated balance sheets of ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP (a Minnesota limited partnership) AND SUBSIDIARIES as of December 31, 1999 and 1998 and the related consolidated statements of operations, changes in partners' equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of Adams Outdoor Advertising Limited Partnership and subsidiaries as of and for the year ended December 31, 1997 were audited by other auditors whose report dated March 18, 1998 expressed an unqualified opinion on those statements. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Adams Outdoor Advertising Limited Partnership and subsidiaries as of December 31, 1999 and 1998 and the results of their operations and their cash flows for the two years then ended in conformity with accounting principles generally accepted in the United States. Arthur Andersen LLP Atlanta, Georgia February 25, 2000 ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND 1998 The accompanying notes are an integral part of these consolidated balance sheets. ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 The accompanying notes are an integral part of these consolidated statements. ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERS' EQUITY (DEFICIT) FOR THE YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 LIMITED GENERAL PARTNERS' TOTAL PARTNERS' (DEFICIT) PARTNERS' DEFICIT EQUITY DEFICIT ------- ------ ------- BALANCE, DECEMBER 31, 1996 $(67,829,366) $ (615,112) $(68,444,478) Net income 0 791,357 791,357 Distributions 0 (1,933,107) (1,933,107) ------------ ----------- ------------ BALANCE, DECEMBER 31, 1997 (67,829,366) (1,756,862) (69,586,228) Net income 0 1,183,738 1,183,738 Distributions 0 (1,045,000) (1,045,000) ------------ ----------- ------------ BALANCE, DECEMBER 31, 1998 (67,829,366) (1,618,124) (69,447,490) Net income 0 5,780,743 5,780,743 Distributions 0 (1,499,782) (1,499,782) ------------ ----------- ------------ BALANCE, DECEMBER 31, 1999 $(67,829,366) $ 2,662,837 $(65,166,529) ============ =========== ============ The accompanying notes are an integral part of these consolidated statements. ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 The accompanying notes are an integral part of these consolidated statements. ADAMS OUTDOOR ADVERTISING LIMITED PARTNERSHIP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999, 1998, AND 1997 1. ORGANIZATION AND NATURE OF OPERATIONS Adams Outdoor Advertising Limited Partnership ("Adams" or the "Company" or the "Partnership") was organized under the Minnesota Uniform Limited Partnership Act on December 12, 1985 and will terminate on December 31, 2025 unless terminated sooner under the provisions of the partnership agreement. The Company was organized for the purpose of acquiring and operating businesses engaged in the outdoor advertising industry. The Company owns and operates outdoor advertising structures in 11 markets in the Midwest, Southeast, and Mid-Atlantic states. The managing general partner is Adams Outdoor Advertising, Inc. The partnership agreement was amended and restated on March 31, 1995 to convert and transfer 99% of the general partners' interest to the limited partners' interests. The partnership agreement was amended and restated on January 1, 1996 to, among other matters, eliminate classes of limited partner interests resulting in general partners' interests of .71% and limited partners' interests of 99.29%. The partnership agreement provides that losses will be allocated 100% to the general partners. Profits will be allocated to the general and limited partners in the same proportion, based on their aggregate interest in the Company, as they have received distributions of distributable cash (defined as annual cash gross receipts, less cash expenses and any amount set aside for reserves) for such calendar year. In the event there are profits in a calendar year in which no distribution of distributable cash has been made, profits will be allocated 100% to the general partners. In the event of a sale, refinancing, or dissolution of the Partnership, the proceeds available for distribution, after payment of all expenses and previously outstanding debt of the Partnership, will be distributed first to the partners up to an amount equal to the respective partner's adjusted aggregate interest in the Partnership. In May 1999, the Partnership's majority partner contributed his direct and indirect interests in the Company and Adams Outdoor Advertising, Inc. to a newly formed limited liability company, AOA Holding LLC ("AOA Holding"). Following the reorganization, AOA Holding and its 100%-owned subsidiary, AOA Capital Corp., issued $50 million of 10 3/8% senior notes due 2006. The net proceeds from the offering were used by AOA Holding to make a distribution to its sole member, to repay $13.5 million of indebtedness of the Company, and to make a $2.5 million payment to the minority limited partner. Amounts loaned to the Company are noninterest-bearing and are reflected as advances from AOA Holding LLC in the accompanying consolidated balance sheets. In connection with the reorganization, the partnership agreement was amended to provide that the limited partnership interest of AOA Holding LLC become a "priority" interest whereby all limited partner distributions (other than permitted tax distributions) will be made only to AOA Holding until the notes are paid in full. In recognition of the change in the partnership agreement, the Company paid to the minority limited partners approximately $2.5 million, which has been reflected as other expense in the accompanying statements of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The financial statements include the financial statements of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. USE OF ESTIMATES The Company's financial statements are prepared in accordance with generally accepted accounting principles, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH EQUIVALENTS The Company considers all short-term, highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. INVESTMENTS Investments consist primarily of corporate and U.S. government debt instruments and equity securities. Securities are classified in one of three categories: trading, available-for-sale, or held-to-maturity. Management of the Company determines the appropriate classification of its investments at the time of acquisition and reevaluates such determination at each balance sheet date. The Company has classified all securities purchased and held during 1999 and 1998 as trading securities, as they are intended to be sold in the near term. Trading securities are carried at fair value, with realized and unrealized gains and losses included in net income. INVENTORIES Inventories are valued at the lower of cost or market. Cost is determined using the first-in, first-out method. Market approximates net realizable value. PROPERTY, PLANT, AND EQUIPMENT Property, plant, and equipment are stated at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which are as follows: Buildings and equipment 5 to 32 years Outdoor advertising structures 12 to 15 years Vehicles, machinery and equipment, and office equipment 3 to 5 years INTANGIBLE ASSETS Intangible assets include financing costs, noncompete agreements, and goodwill. Goodwill is being amortized using the straight-line method over periods of 12 to 40 years. The remaining intangible assets are recorded at cost and are amortized using the straight-line method over the assets' estimated useful lives of two to five years for noncompete agreements and the terms of the related debt for financing costs. The Company periodically assesses the recoverability of intangible assets based on expected future cash flows. INCOME TAXES The Company is not considered a taxable entity for federal and state income tax purposes. Any taxable income or loss, tax credits, and certain other items are reported by the partners on their own tax returns in accordance with the partnership agreement. REVENUE RECOGNITION Revenues represent outdoor advertising services provided by the Company. The Company recognizes revenue when rendered, usually on a monthly basis in accordance with contract terms, as advertising services are provided. BARTER TRANSACTIONS Barter transactions, which represent the exchange of advertising for goods or services, are recorded at the estimated fair value of the advertising provided and the products or services received. Barter revenue is recognized when advertising services are rendered, and barter expense is recognized when the related products or services are received. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company's financial instruments consist primarily of cash and short-term investments, trade receivables, notes receivable, and accounts payable. In management's opinion, the carrying amounts of these financial instruments approximate their fair values at December 31, 1999 and 1998. NEW ACCOUNTING STANDARDS The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures About Segments of an Enterprise and Related Information." This statement establishes standards for the way enterprises report information about operating segments in annual financial statements and requires that enterprises report selected information about operating segments in interim financial statements. Adams operates in a single reportable segment in the outdoor advertising industry as defined by this statement. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement, which will be effective for the Company beginning January 1, 2001, establishes accounting and reporting standards requiring that every derivative instrument (including certain embedded in other contracts) be recorded on the balance sheet as either assets or liabilities measured at fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The Company has not yet quantified the impact of adopting SFAS No. 133 and has not determined the timing or method of its adoption; however, it is not expected that adoption will have a material impact on earnings. 3. RELATED-PARTY TRANSACTIONS Certain partners and employees of the general partner have ownership in HSP Graphics ("HSP"), a printing operation headquartered in Canada. The Company pays the salary and expenses of HSP employees, and HSP reimburses the Company for these expenses in cash or services. At December 31, 1999 and 1998, the Company had accounts receivable of $21,870 and $114, respectively, outstanding related to this arrangement with HSP. The Company expensed $0, $11,000, and $84,000 for printing services provided by HSP during 1999, 1998, and 1997, respectively. During 1998, the Company loaned $100,000 to an officer of the Company, which was repaid during 1999. This amount was included in other accounts receivable at December 31, 1998. During 1998, the Company entered into a building lease with an officer of the Company. The lease term is for ten years and has been classified as an operating lease. Rent expense of approximately $37,000 and $52,000 related to this transaction is included in direct advertising expense in 1999 and 1998, respectively. During 1999, the Company purchased this building from the officer of the Company for $461,000. During 1997, the Company entered an aircraft lease with a party related to the Company. The lease term was for seven years and was classified as an operating lease. At the beginning of 1999, the Company purchased an aircraft and was released from the lease agreement. Lease and operating expenses of approximately $549,000 and $466,000 related to this transaction have been included in corporate general and administrative expense during 1998 and 1997, respectively. During 1999, the Company purchased outdoor advertising displays from two related parties in Peoria for $100,000 in cash paid to each of the parties. 4. INVESTMENTS The carrying and estimated fair values of investment securities at December 31, 1999 and 1998 are summarized as follows: 5. PROPERTY, PLANT, AND EQUIPMENT Property, plant, and equipment consist of the following at December 31, 1999 and 1998: 1999 1998 ---- ---- Land $ 3,692,333 $ 2,398,489 Buildings and improvements 5,522,640 4,185,364 Outdoor advertising structures 104,600,078 100,950,797 Vehicles 3,947,917 3,436,538 Machinery and equipment 1,586,670 739,698 Office equipment 4,738,466 4,065,258 Construction in progress 1,446,410 1,459,417 ------------- ------------ 125,534,514 117,235,561 Less accumulated depreciation (69,008,631) (63,885,413) ------------- ------------ $ 56,525,883 $ 53,350,148 ============= ============ 6. INTANGIBLE ASSETS Intangible assets consist of the following at December 31, 1999 and 1998: 1999 1998 ---- ---- Goodwill $ 7,582,597 $ 7,582,597 Noncompete agreements 2,325,500 2,425,500 Financing costs 5,368,952 5,170,270 ------------ ----------- 15,277,049 15,178,367 Less accumulated amortization (7,373,168) (6,070,456) ------------ ----------- $ 7,903,881 $ 9,107,911 ============ =========== 7. ACCRUED EXPENSES AND OTHER LIABILITIES Accrued expenses and other liabilities consist of the following at December 31, 1999 and 1998: 1999 1998 ---- ---- Accrued insurance $ 376,677 $ 391,872 Accrued payroll 215,698 205,236 Other 2,768,905 1,986,501 ---------- ---------- $3,361,280 $2,583,609 ========== ========== 8. LONG-TERM DEBT Long-term debt at December 31, 1999 and 1998 consists of the following: 1999 1998 ---- ---- 10.75% senior notes due March 12, 2006 $ 97,675,000 $101,000,000 Revolving credit facilities due December 31, 2001 21,272,288 31,727,500 ------------ ------------ $118,947,288 $132,727,500 ============ ============ On March 12, 1996, the Company completed a refinancing (the "Refinancing") of its outstanding debt. Pursuant to the Refinancing, substantially all of the Partnership's existing debt was repaid, $105 million of 10.75% senior notes due 2006 (the "Senior Notes") were issued, and a credit agreement (the "Credit Agreement") was executed which provided for a revolving credit facility with total availability of $15 million. On December 2, 1996, the Credit Agreement was amended and restated to increase the availability on the revolving credit facility from $15 million to $35 million for a fee of $387,500. On March 31, 1998, the Company entered into an additional $3 million senior unsecured credit facility to increase the line of credit to $38 million. In September 1998, proceeds from the senior unsecured facility were used to purchase $4 million of the Company's Senior Notes on the open market at 105% of principal plus accrued interest. As a result of the redemption, the Company recognized an extraordinary loss of $329,778, which represented the redemption premium plus recognition of a proportionate share of the associated deferred financing fees. In November 1998, the senior unsecured credit facility was increased to $8 million. On June 30, 1999, the Company used proceeds from the $50 million of 10 3/8% senior notes due 2006 (see Note 1) to purchase $1.3 million of the Senior Notes on the open market for 105% of principal plus accrued interest. On August 10, 1999, the Company purchased an additional $2 million of the Senior Notes at 105% of principal plus accrued interest. As a result of these redemptions, the Company recognized an extraordinary loss of $194,125 which represents the redemption premium plus recognition of a proportionate share of the associated deferred financing fees. Borrowings under the Credit Agreement bear interest at a rate equal to, at the option of the Company, either (i) the base rate (which is defined as the higher of the prime rate or the federal funds rate plus .5% or (ii) LIBOR, in each case plus an applicable margin, as defined, determined by reference to the ratio of total debt to cash flow of the Company. At December 31, 1999 and 1998, the weighted-average interest rate was 9.1% and 8.8%, respectively, on outstanding borrowings. The obligations of the Company under the Credit Agreement are secured primarily by a first priority pledge of the stock of Adams Outdoor Advertising, Inc., the corporate general partner; a first priority pledge of the Company's interests; and a first priority lien on all the assets of the Company, with the exception of certain real estate assets which are subject to a negative pledge. The Credit Agreement contains, among other things, covenants restricting the ability of the Company to dispose of assets, make distributions to its partners, create liens, make capital expenditures, make certain investments or acquisitions, enter into transactions with affiliates, and otherwise restrict certain activities. The Credit Agreement also contains financial covenants related to minimum interest coverage, maximum leverage ratio, and a minimum fixed-charge coverage ratio. At December 31, 1999 and 1998, the Company was in compliance with all covenants. The 10.75% senior notes due 2006 were issued under an indenture dated March 12, 1996 (the "Indenture") among the Company and the trustee of the notes. The notes are senior unsecured obligations of the Company ranking pari passu in right of payment with all existing and future senior indebtedness of the Company and senior in right of payment to all existing and future subordinated indebtedness of the Company that by its terms is subordinated in right of payment to the notes. The notes are effectively subordinated to all secured indebtedness of the Company to the extent of the value of the assets securing such indebtedness. The notes mature on March 15, 2006 and bear interest at an annual rate of 10.75% from the date of issuance until maturity. Interest is payable semiannually in arrears on March 15 and September 15 to holders of record of the notes. The notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 15, 2001 at the following redemption prices (expressed as a percentage of principal amount), together, in each case, with accrued and unpaid interest to the redemption date, if redeemed during the 12-month period beginning on March 15 of each year, as listed below: Year: 2001 105.375% 2002 103.583 2003 101.792 2004 and thereafter 100.000 Also, up to 25% of the notes are redeemable at the option of the Company in the event of a public equity offering. The Indenture contains, among other things, covenants restricting the ability of the Company to incur additional indebtedness, make certain distributions, make certain investments, change the status of company subsidiaries, create liens, enter into transactions with affiliates, dispose of assets, enter into sale and leaseback transactions, make payments for consents, enter into any additional lines of business, and otherwise restrict certain activities. At December 31, 1999, the fair value of the Company's long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities was approximately $121.9 million. Annual minimum maturities of long-term debt based on amounts outstanding at December 31, 1999 are as follows: 2000 $ 0 2001 21,272,288 2002 0 2003 0 2004 0 Thereafter 97,675,000 ------------ $118,947,288 ============ 9. EMPLOYEE BENEFIT PLAN The Company has a 401(k) deferred savings and profit-sharing plan. Employees must be at least age 21 and must have completed one year of service to participate in the plan. Employees may contribute up to 10% of their salaries, and the Company matches employee contributions at the rate of 50%, up to 6% of the employee's salary. The Company's contributions to the plan were approximately $254,000, $240,000, and $188,000 in 1999, 1998, and 1997, respectively. 10. DEFERRED COMPENSATION BENEFITS PHANTOM STOCK AGREEMENTS The Company has deferred compensation benefits referred to as phantom stock agreements with certain management personnel. The compensation is calculated using a multiple of the operating profit of a division or the Company for the year ending immediately prior to the determination date over the base cost, which is the assigned value of the division or the Company, at the date of the agreement's execution. The agreements provide for three equal annual payments to the participants on the determination date, which is defined as termination, death, disability, the sale of the Company, or the fifth anniversary of the agreement's execution. The Company incurred deferred compensation expense related to these agreements of $2,261,909, $4,098,470, and $698,376 as of December 31, 1999, 1998, and 1997, respectively. NONQUALIFIED RETIREMENT PLANS The Company also maintains certain nonqualified retirement plans (the "Plans") to provide deferred compensation benefits for certain members of management. The Company has established trusts (the "Trusts") for contributions to provide sources of funds for liabilities under the Plans. The Trusts are revocable and constitute unfunded arrangements, as their assets are subject to the claims of the Company's creditors in the event of insolvency, until such time as the obligations have been paid to plan participants in accordance with the Plans. Earnings of the trusts are allocated proportionately to participant accounts. During the years ended December 31, 1999, 1998, and 1997, the Company recorded deferred compensation expense of $217,500, $217,501, and $202,500, respectively, to these plans. 11. COMMITMENTS AND CONTINGENCIES OPERATING LEASE COMMITMENTS The Company leases real estate to erect signs in commercial and industrial areas along traffic routes in cities or close to populated urban areas. The Partnership also leases certain vehicles used in its operations. These leases have terms ranging from one to ten years. Approximate future minimum lease payments under noncancelable operating leases with terms in excess of one year at December 31, 1999 are as follows: 2000 $ 5,651,047 2001 3,993,157 2002 3,413,405 2003 2,703,578 2004 2,377,857 Thereafter 16,588,579 ----------- $34,727,623 =========== Rent expense incurred under operating leases aggregated approximately $8,617,282, $7,315,000, and $7,735,000 for 1999, 1998, and 1997, respectively. ZONING REGULATIONS In 1988, the city of Charlotte, North Carolina, adopted a comprehensive sign ordinance prohibiting the construction of virtually all new, off-premise outdoor advertising signs within the city limits and mandating that all nonconforming signs either be brought into compliance or be removed by February 1, 1998 at the owner's expense without payment of compensation. Through March 1998, the Company had received a total of 307 notices of violation ("NOVs"). The Company does not anticipate receiving any additional NOVs at this time. In 1998, the Company filed a lawsuit in the Superior Court of Mecklenburg County, North Carolina, challenging the constitutionality of the Charlotte sign ordinance. In 1998, the case was settled, and approximately 160 of the billboards in question must be removed at the Company's expense by December 5, 2002. This will result in a material adverse impact on the gross revenues and cash flow attributable to the Charlotte market but, in the opinion of management, not on the financial condition of the Company as a whole. In other localities in which the Company operates, outdoor advertising is subject to restrictive and, in some cases, prohibitive zoning regulations. Management expects federal, state, and local regulations to continue to be a significant factor in the operation of the Company's business. LITIGATION The Company is a party to a number of lawsuits and claims which it is vigorously defending. Such matters arise out of the normal course of business and relate to government regulations and other issues. Certain of these actions seek damages in significant amounts. While the results of litigation cannot be predicted with certainty, management believes that based on the advice of company counsel, the final outcome of such litigation will not have a material adverse effect on the financial statements of the Company. CONCENTRATION OF RISKS Approximately 2.9%, 10.3%, and 10.5% of the Company's net revenues for the years ended December 31, 1999, 1998, and 1997, respectively, were attributable to the tobacco products industry. In November 1998, the major U.S. tobacco companies (the "Tobacco Companies") reached an out-of-court settlement (the "Agreement") with 46 states, the District of Columbia, the Commonwealth of Puerto Rico, and four other U.S. territories (the "Settling States"). The remaining four states had already reached similar settlements with the Tobacco Companies. The Agreement called for the removal of tobacco advertising from out-of-home media, including billboards, along with signs and placards in arenas, stadiums, shopping malls, and video game arcades by April 23, 1999. Additionally, the Agreement provided that, at the Settling States' option, the Tobacco Companies must, at their expense, substitute for tobacco advertising alternative advertising which discourages youth smoking. That alternative advertising must remain in place for the duration of the Tobacco Companies' out-of-home media advertising contracts which existed as of the date of the Agreement. Although the extent of the future impact on operations is not known, the Company has been successful thus far in replacing tobacco advertising in its markets. 12. SUPPLEMENTAL CASH FLOW INFORMATION The following summarizes supplemental cash paid and noncash activities for the years ended December 31, 1999, 1998, and 1997: 1999 1998 1997 ---- ---- ---- Supplemental disclosure of cash paid during the year for interest $13,241,685 $14,367,555 $13,639,516 ----------- ----------- ----------- 13. SUBSEQUENT EVENT On March 9, 2000, two indirect wholly-owned subsidiaries of the Partnership together acquired all of the outstanding stock of HSP, a company with which the Partnership has been doing business for a number of years (Note 3). The aggregate purchase price was $16,575,045. EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 27 Financial Data Schedules for Adams Outdoor Advertising, Inc. 27.1 Financial Data Schedules for Adams Outdoor Advertising Limited Partnership

827054_1999.txt

827054_1999

1999

827054

ITEM 1. BUSINESS Microchip Technology Incorporated, a Delaware corporation ("Microchip" or the "Company"), develops, manufactures and markets 8-bit microcontrollers, application-specific standard products (ASSPs) and related memory products for high-volume embedded control applications in the consumer, automotive, office automation, communications and industrial markets. The Company provides highly cost-effective embedded control products for a wide variety of applications and believes that its PIC(R) product family is a price/performance leader in the worldwide 8-bit microcontroller market. Microchip's embedded control products also offer the advantages of a small footprint and low voltage operation along with ease of development, enabling timely and cost-effective product integration by its customers. The Company's ASSP products include a variety of specialized integrated circuits, including its family of KEELOQ(R) security products. The Company's memory products are primarily comprised of Serial EEPROMs, which are used primarily to provide non-volatile memory storage in embedded control systems. Except as noted below, references to the Company include the Company and its subsidiaries. The Company's executive offices are located at 2355 West Chandler Boulevard, Chandler, Arizona 85224-6199 and its telephone number is (480) 786-7200. Risks and uncertainties that may affect the Company's future operating results are set forth throughout the following discussion of the Company's business. For further discussion on certain risk factors that may affect the Company's future operating results, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation," below. THIS REPORT CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND UNCERTAINTIES, INCLUDING STATEMENTS REGARDING THE COMPANY'S STRATEGY, FINANCIAL PERFORMANCE AND REVENUE SOURCES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS INCLUDING THOSE SET FORTH UNDER "ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND ELSEWHERE IN THIS REPORT. INDUSTRY BACKGROUND Competitive pressures require manufacturers to expand product functionality and provide differentiation while maintaining or reducing cost. To address these requirements, manufacturers use integrated circuit-based embedded control systems which provide an integrated solution for application-specific control requirements. Embedded control systems enable manufacturers to differentiate their products, replace less efficient electromechanical control devices, add product functionality and significantly reduce product costs. In addition, embedded control systems facilitate the emergence of complete new classes of products. Embedded control systems have been incorporated into thousands of products and subassemblies in a wide variety of markets worldwide, including automotive air bag systems, remote control devices, handheld tools, appliances, portable computers, cordless and cellular telephones, motor controls and security systems. Embedded control systems typically incorporate a microcontroller as the principal active, and sometimes sole, component. A microcontroller is a self-contained computer-on-a-chip consisting of a central processing unit, non-volatile program memory, RAM memory for data storage and various input/output functions. In addition to the microcontroller, a complete embedded control system incorporates application-specific software and may include specialized peripheral device controllers and external non-volatile memory components, such as EEPROMs, to store additional program software. The increasing demand for embedded control has made the market for microcontrollers one of the largest segments of the semiconductor logic market. Microcontrollers are currently available in 4-bit through 32-bit architectures. Although 4-bit microcontrollers are relatively inexpensive, typically costing under $1.00 each, they generally lack the minimum performance and features required by today's design engineers for product differentiation and are typically used only to produce basic functionality in products. While 16- and 32-bit architectures provide very high performance, they are prohibitively expensive for most high-volume embedded control applications, typically costing over $5.00 each. As a result, manufacturers of competitive, high-volume products have increasingly found 8-bit microcontrollers, that typically cost $1.00 to $8.00 each, to be the most cost-effective embedded control solution. For example, a typical new automobile may include one 32-bit microcontroller for engine control, three 16-bit microcontrollers for transmission control, audio systems and anti-lock braking, and up to 50 8-bit microcontrollers to provide other embedded control functions, such as door locking, automatic windows, sun roof, adjustable seats, electric mirrors, air bags, fuel pump, speedometer, and the security and climate control systems. Most microcontrollers available today are ROM-based and must be programmed by the semiconductor supplier during manufacturing, resulting in six-to-20 week lead times for delivery of such microcontrollers. In addition to delayed product introduction, these long lead times can result in potential inventory obsolescence and factory shutdowns when changes to the firmware are required. To address time-to-market constraints, some suppliers have made EPROM, EEPROM, or Flash Memory-based programmable microcontrollers available for prototyping and preproduction runs. However, these microcontrollers have been relatively expensive, and manufacturers have still been required to send program code to the semiconductor factory for ROM programming as product changes are made. As a result, the long lead times for production volume microcontrollers have not been significantly reduced by traditional approaches. PRODUCTS Microchip's strategic focus is on embedded control products, including microcontrollers, ASSPs, related memory products and application development systems. MICROCONTROLLERS Microchip offers a broad family of proprietary 8-bit microcontrollers under the PIC(R) name and has shipped approximately 850 million PIC(R) microcontrollers to customers worldwide since 1990. The Company's PIC(R) products are designed for applications requiring high performance and low cost. They feature a variety of memory configurations, low voltage and power, small footprint and ease of use. Microchip believes this product family is currently a price/performance leader in the 8-bit microcontroller marketplace. Microchip's performance results from an exclusive RISC-based architecture that provides significant speed advantages over the alternative 8-bit CISC architectures. In addition to providing up to 40 MHz performance, this architecture offers up to a 2:1 software compaction advantage, thereby significantly reducing software development time. RISC architectures also have the advantage of being more easily scaled to higher internal clock speeds in future products. Prices for Microchip's 8-bit microcontrollers range from approximately $.49 to $12.00 per unit. Microchip's original market focus was in the lowest cost segment of the 8-bit microcontroller marketplace. With its baseline 8-bit products, the Company built its current market position as the leading supplier of field programmable microcontrollers. Over the past four years, Microchip has introduced more than 100 new 8-bit microcontrollers targeted at the baseline, mid-range and high-end segments of the 8-bit microcontroller marketplace, as well as the lower end of the 16-bit microcontroller market. In addition, with its 8-pin, 8-bit microcontroller, introduced in the first quarter of fiscal 1997, the Company has also targeted a portion of the large 4-bit microcontroller marketplace. The Company believes that these additional segments represent a significant opportunity for future sales growth. Microchip has used its manufacturing experience and design and process technology to bring additional enhancements and manufacturing efficiencies to the development and production of its PIC(R) family of microcontroller products. This extensive experience base has enabled the Company to develop its advanced, low cost user programmability feature by incorporating non-volatile memory (EPROM, EEPROM and Flash Memory) into the microcontroller in addition to masked ROM program memory. DEVELOPMENT SYSTEMS The Company offers a comprehensive set of low cost and easy-to-learn application development tools. These tools enable system designers to quickly and easily program a PIC(R) microcontroller for specific applications and are a key factor for obtaining design wins. Microchip's family of development tools operates in the standard Windows environment on standard PC hardware. Entry-level systems, which include an assembler and programmer hardware, are priced at less than $200. A fully configured system, which also provides in-circuit emulation hardware, performance simulators and software debuggers, is priced at approximately $3,700. Customers moving from entry-level designs to those requiring real-time emulation are able to preserve their investment in software tools as they migrate to future PIC(R) devices since all the product families are assembly- and C- language compatible. Many independent companies also develop and market application development tools and systems which support Microchip's standard microcontroller product architecture. The Company believes that familiarity with and adoption of the Company's, and third-party, development systems by an increasing number of product designers will be an important factor in the future selection of Microchip's embedded control products. These development tools allow design engineers to develop thousands of application-specific products from Microchip's standard microcontrollers. Currently, there are more than 120 third-party tool suppliers worldwide whose products support the Company's proprietary microcontroller architecture. ASSPS (APPLICATION-SPECIFIC STANDARD PRODUCTS) Microchip's application-specific standard products are specialized products designed to perform specific end-user applications as opposed to the Company's other products which are more general purpose in nature. The Company's ASSP device families currently include the KEELOQ(R) family of secure data transmission products, as well as other specialized integrated circuit devices. KEELOQ(R) security products are designed for low cost, secure, uni-directional communications and verification purposes. Applications include automotive remote keyless entry systems, automotive immobilizer systems, automatic garage and gate openers and smart cards. MEMORY PRODUCTS Microchip's memory products consist primarily of Serial EEPROMs. The Company sells these devices primarily into the embedded control market and is one of the largest suppliers of such devices worldwide. EEPROM (electrically erasable programmable read only memory) products are used for non-volatile program and data storage in systems where such data must be modified frequently. Serial EEPROMs have a very low I/O pin requirement, permitting production of very small devices. As a result, Serial EEPROMs are widely used to supply non-volatile memory in space-sensitive applications such as portable computers, cellular and cordless telephones, pagers and remote control devices. Within this market, Microchip has emphasized providing Serial EEPROMs to customers that require features such as highly compact packaging, low operating voltage, reduced power consumption, extended data retention and high endurance. The Company addresses these requirements by offering products with extremely small package sizes and very low operating voltage for both read and write functions (1.8 volts in contrast with the industry standard of 3.3 volts), together with a wide operating voltage range (1.8 to 5.5 volts). High performance circuitry and microcode are also available to reduce power consumption when a device is not in use, while permitting immediate operating capability when required. The products also feature long data retention and high erase/write endurance. Microchip currently offers a complete Serial EEPROM family, which meets three principal industry bus interface standards and is available in most standard density, configuration and packaging alternatives. The Company's Smart Serials(TM) line of specialized Serial EEPROMs with user-configurable architecture and other advanced features targets applications such as cellular telephones and data communications. MANUFACTURING Microchip's ownership of its manufacturing resources is an important component of its business strategy, enabling it to maintain a high level of manufacturing control and to be one of the lowest cost producers in the embedded control industry. By owning its wafer fabrication and the majority of its test operations, and by employing proprietary statistical process control techniques, the Company has been able to achieve high production yields. Direct control over wafer fabrication also allows Microchip to shorten the Company's design and production cycles and to capture the manufacturing and a portion of the testing profit margin. Wafer fabrication and wafer test facilities are located in Chandler ("Fab 1") and Tempe ("Fab 2"), Arizona. Currently, the Company performs product test at its facilities in Kaohsiung, Taiwan and Chachoengsao, Thailand, located near Bangkok. During the fourth quarter of fiscal 1999, the Company ceased manufacturing five-inch wafers at Fab 1. Also, during the fourth quarter of fiscal 1999, the Company announced that it was phasing out test operations at its Kaohsiung, Taiwan facility over the first two quarters of fiscal 2000. The Company intends to shift the Kaohsiung test operations to its Thailand facility. See also "Item 2 ITEM 2. PROPERTIES The Company's current headquarters, research and development center and one of its U.S. wafer fabrication facilities are located in three buildings totaling approximately 242,000 square feet situated on a 77-acre parcel of land in Chandler, Arizona. A second U.S. manufacturing site consisting of a wafer fabrication facility, office and warehouse facilities and a development systems center, totaling approximately 253,000 square feet, is situated on a 22-acre parcel of land in Tempe, Arizona. The Company owns the Chandler and Tempe facilities. Company-owned final test facilities are located in Taiwan and Thailand. The Taiwan operations are housed in a three-story, 88,700 square foot building located in the Kaohsiung Export Processing Zone in Kaohsiung, Taiwan, Republic of China. The Taiwan building is owned by the Company's Taiwan subsidiary and is located on land that is leased to the Company pursuant to leases from the Taiwan government expiring in December 2002 and 2003. The Company will not renew these leases as the Company's Kaohsiung operations will be closed by the end of the second quarter of fiscal year 2000. The Company's Thailand final test and assembly operations are housed in a 150,000 square foot facility located in the Alphatechnopolis Industrial Park in Chachoengsao, Thailand, near Bangkok. An expansion of 50,000 square feet is presently under construction and is scheduled to be complete by the end of the third quarter of fiscal year 2000. This area will house additional test capacity and will also be available for incremental assembly capacity. The Thailand facility, owned by the Company's Thailand subsidiary, is situated on land to which the Company expects to acquire title by the end of fiscal 2000, in accordance with an agreement between the Company and the land owner. The Company leases space for 23 Technical Support Centers in major metropolitan areas in the United States, Europe and Asia. See "Item 1 - Business - Sales and Distribution," above. The Company's aggregate monthly rental payments for its leased facilities are approximately $128,000. The Company currently believes that its existing facilities, together with the additional capacity presently under construction in Thailand, will be adequate to meet its requirements for the next 12 months. THE FOREGOING STATEMENTS RELATED TO THE SCHEDULED COMPLETION OF THE EXPANSION OF THE CHACHOENGSAO FACILITY, ACQUISITION OF TITLE OF THE LAND ON WHICH THE CHACHOENGSAO FACILITY IS SITUATED AND THE ADEQUACY OF FACILITIES FOR THE NEXT 12 MONTHS ARE FORWARD LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: DELAYS IN CONSTRUCTION AND FACILITIZATION OF THE EXPANSION AREA AT THE CHACHOENGSAO FACILITY; THE AVAILABILITY OF EQUIPMENT AND OTHER SUPPLIES; SUPPLY DISRUPTION; LABOR UNREST; CHANGES IN PRODUCT MIX; THE CYCLICAL NATURE OF THE SEMICONDUCTOR INDUSTRY AND THE MARKETS ADDRESSED BY THE COMPANY'S PRODUCTS; DEMAND FOR THE COMPANY'S PRODUCTS; FLUCTUATIONS IN PRODUCTION YIELDS, PRODUCTION EFFICIENCIES AND OVERALL CAPACITY UTILIZATION; COMPETITIVE PRESSURES ON PRICES; POLITICAL INSTABILITY AND EXPROPRIATION; ECONOMIC CONDITIONS IN THAILAND; AND OTHER ECONOMIC CONDITIONS. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the ordinary course of its business, the Company is involved in a limited number of legal actions, both as plaintiff and defendant, and could incur uninsured liability in any one or more of them. Although the outcome of these actions is not presently determinable, the Company believes that the ultimate resolution of these matters will not have a material adverse effect on the Company's results of operations or financial conditions. Litigation relating to the semiconductor industry is not uncommon, and the Company is, and from time to time, has been, subject to such litigation. No assurances can be given with respect to the extent or outcome of any such litigation in the future. See "Item 1 --Business --Patents, Licenses and Trademarks," above. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's security holders during the fourth quarter of fiscal 1999. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the Nasdaq National Market under the symbol "MCHP." The Company's Common Stock has been quoted on the Nasdaq National Market since March 19, 1993. The following table sets forth the quarterly high and low closing prices of the Common Stock as reported by the Nasdaq National Market for the last two years: Fiscal 1999 High Low Fiscal 1998 High Low ----------- ---- --- ----------- ---- --- First Quarter $31.750 $20.813 First Quarter $36.25 $29.00 Second Quarter 33.375 18.313 Second Quarter 48.88 29.88 Third Quarter 39.188 18.375 Third Quarter 48.38 26.94 Fourth Quarter 40.875 27.125 Fourth Quarter 31.88 21.00 On May 17, 1999, the closing sale price for the Company's Common Stock was $43.0625 per share. As of such date, there were approximately 480 holders of record of the Company's Common Stock. This figure does not reflect beneficial ownership of shares held in nominee names. The Company has not paid cash dividends on its capital stock. The Company currently anticipates that it will retain all available funds for use in the operations of its business and therefore does not anticipate paying any cash dividends in the foreseeable future. The trading price of the Company's Common Stock has been, and in the future could be, subject to wide fluctuations in response to quarterly variations in operating results of the Company and other semiconductor companies, actual or anticipated announcements of technical innovations or new products by the Company or its competitors, changes in analysts' estimates of the Company's financial performance, general conditions in the semiconductor industry, worldwide economic and financial conditions and other events or factors. In addition, the stock market has experienced significant price and volume fluctuations which have particularly affected the market prices for many high technology companies and which often have been unrelated to the operating performance of such companies. These broad market fluctuations and other factors may adversely affect the market price of the Company's Common Stock. During fiscal 1999, the Company sold put options whereby the Company agreed to acquire Common Stock at various prices as part of its stock repurchase program. The issuance of stock put options was deemed exempt from registration under the Securities Act of 1933, as amended, in reliance on Section 4(2) of such Act. See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources, above, and Note 13 to the Consolidated Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data for the five-year period ended March 31, 1999 should be read in conjunction with the Company's Consolidated Financial Statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION During fiscal 1999, the global semiconductor industry was characterized by flat to negative sales growth, extremely low order visibility and declining inventory levels at customers and throughout the distribution channel. Over this period, Microchip's sales remained relatively flat overall, while the Company experienced moderate growth in its core 8-bit microcontroller product line and has continued to gain market share in that market. Microchip anticipates an industry-wide return to growth during calendar year 1999 and has taken a variety of measures to optimally position the Company for such an upturn. The Company has implemented two restructuring actions to position the Company for future cost effective growth. During the March 1999 quarter, the Company completed closure of its 5-inch wafer line which represented the Company's least flexible and least cost-effective production capacity. Eliminating the 5-inch production capacity reduces the Company's productive capacity by approximately 20%. The Company intends to replace this capacity with 6-inch and 8-inch wafer production over time. This action resulted in a restructuring charge of $7.5 million in the March 1999 quarter. The Company also decided to restructure its test operations over the next two quarters by closing its Kaohsiung facility and migrating its test capacity to its lower-cost, Thailand facility. See "Item 1 - Business - Manufacturing," above. This action resulted in a restructuring charge of $6.1 million in the March 1999 quarter. Additionally, as indicated in Note 2 to the Consolidated Financial Statements, under the terms of the acquisition of the Keeloq(R) technology, the Company made the final acquisition payment to the seller of $10.3 million, net of legal expenses of $1.1 million. Under the provision of FAS 121, Impairment of Assets, the Company has determined that $4.3 million of the final acquisition payment will be treated as purchased technology and amortized over the expected life of the revenue stream of the Keeloq(R) product. The balance of the payment, including the residual asset value capitalized as part of the initial payment, has been written off as part of the special charge made by the Company in the quarter ended March 31, 1999. The total charge associated with this matter was $7.6 million. Included in the special charge the Company has taken in the March 1999 quarter is $1.8 million related to two legal settlements associated with intellectual property matters and $0.4 million related to the restructuring of a portion of the Company sales infrastructure. During the quarter ended June 30, 1998, the Company recognized a special charge of $5.5 million which was comprised of three elements: a $3.3 million legal settlement with another company involving an intellectual property dispute; a $1.7 million write-off of products obsoleted by the introduction of newer products; and a $0.5 million charge associated with the restructuring of a portion of the Company's sales organization. THE FOREGOING STATEMENTS RELATING TO ANTICIPATED INDUSTRY-WIDE RETURN TO GROWTH, THE COMPANY'S POSITIONING FOR AN INDUSTRY-WIDE UPTURN AND RESTRUCTURING OF TEST OPERATIONS OVER THE NEXT TWO QUARTERS ARE FORWARD-LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: MARKET CONDITIONS IN THE SEMICONDUCTOR INDUSTRY AND DEMAND FOR THE COMPANY'S PRODUCTS; THE TIMING AND SUCCESS OF MANUFACTURING PROCESS TRANSITION; THE IMPACT OF COST REDUCTIONS AND THE POSSIBLE NEED FOR FURTHER COST REDUCTIONS; DELAY IN THE FACILITATION OF THE COMPANY'S IN-HOUSE ASSEMBLY AND TEST OPERATIONS; FLUCTUATIONS IN PRODUCTION YIELDS AND PRODUCTION EFFICIENCIES; OVERALL CAPACITY UTILIZATION; COST AND AVAILABILITY OF RAW MATERIALS; ABSORPTION OF FIXED COSTS, LABOR AND OTHER DIRECT MANUFACTURING COSTS; CHANGES IN PRODUCT MIX; AND OTHER ECONOMIC CONDITIONS. RESULTS OF OPERATIONS The following table sets forth certain operational data as a percentage of net sales for the years indicated: Year Ended March 31, 1999 1998 1997 ---- ---- ---- Net sales .................................. 100.0% 100.0% 100.0% Cost of sales .............................. 50.1% 50.3% 50.1% ----- ----- ----- Gross profit ............................... 49.9% 49.7% 49.9% Research and development ................... 10.0% 9.7% 9.6% Selling, general and administrative ........ 15.5% 17.0% 16.8% Special charges ............................ 7.1% 1.2% 2.2% ----- ----- ----- Operating income ........................... 17.3% 21.8% 21.3% ===== ===== ===== NET SALES Microchip's net sales of $406.5 million in fiscal 1999 increased by $9.6 million, or 2.4%, over fiscal 1998 and net sales of $396.9 million in fiscal 1998 increased by $62.6 million, or 18.7%, over fiscal 1997. The Company's family of 8-bit microcontrollers represents the largest component of Microchip's total net sales. Microcontrollers and associated application development systems accounted for 76%, 68% and 66% of total net sales in fiscal 1999, 1998 and 1997, respectively. A related component of the Company's product sales consists primarily of Serial EEPROM memories which accounted for 24%, 32% and 34% of net sales in fiscal 1999, 1998 and 1997, respectively. The Company's net sales in any given quarter are dependent upon a combination of orders received in that quarter for shipment in that quarter ("turns orders") and shipments from backlog. The Company has emphasized its ability to respond quickly to customer orders as part of its competitive strategy. This strategy, combined with current industry conditions, results in customers placing orders with short delivery schedules. The Company experienced increasing turns orders as a portion of the Company's business in fiscal 1999, as compared to the last two years, which reduced the Company's visibility of future net sales levels. Visibility improved at the end of fiscal 1999. Backlog for the first quarter of fiscal 2000 grew 28% from backlog for the previous fiscal quarter, which is the first quarter this has occurred in 12 quarters. However, because turns orders are difficult to predict, there can be no assurance that the combination of turns orders and shipments from backlog in any quarter will be sufficient to achieve growth in net sales. If the Company does not achieve a sufficient level of turns orders in a particular quarter, the Company's revenues and operating results would be adversely affected. The Company's overall average selling prices for its microcontroller products have remained relatively constant, while average selling prices of its memory products have declined over time. Over the last two fiscal years, the Company has experienced increased pricing pressure on its memory products, primarily due to the less proprietary nature of these products and increased competition. Over time, the Company expects to continue to experience increased pricing competition and declining prices for memory products. While average selling prices for microcontrollers have remained relatively constant, the Company has experienced, and expects to continue to experience, increasing pricing pressure in certain microcontroller product lines, due primarily to competitive conditions. There can be no assurance that average selling prices for the Company's microcontroller or other products can be maintained due to increased pricing pressure in the future. An increase in pricing pressure could adversely affect the Company's operating results. THE FOREGOING STATEMENTS REGARDING TURNS ORDERS, IMPROVED VISIBILITY, AVERAGE SELLING PRICES AND PRICING PRESSURES are FORWARD LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: THE LEVEL OF ORDERS THAT ARE RECEIVED AND CAN BE SHIPPED IN A QUARTER; INVENTORY MIX AND TIMING OF CUSTOMER ORDERS; COMPETITION AND COMPETITIVE PRESSURES ON PRICING AND PRODUCT AVAILABILITY; CUSTOMERS' INVENTORY LEVELS, ORDER PATTERNS AND SEASONALITY; THE CYCLICAL NATURE OF BOTH THE SEMICONDUCTOR INDUSTRY AND THE MARKETS ADDRESSED BY THE COMPANY'S PRODUCTS; MARKET ACCEPTANCE OF THE PRODUCTS OF BOTH THE COMPANY AND ITS CUSTOMERS; DEMAND FOR THE COMPANY'S PRODUCTS, FLUCTUATIONS IN PRODUCTION YIELDS, PRODUCTION EFFICIENCIES AND OVERALL CAPACITY UTILIZATION; CHANGES IN PRODUCT MIX; AND ABSORPTION OF FIXED COSTS, LABOR AND OTHER FIXED MANUFACTURING COSTS. Foreign sales represented 69%, 68% and 66% of net sales in fiscal 1999, 1998 and 1997, respectively. The Company's foreign sales have been predominantly in Asia and Europe which the Company attributes to the manufacturing strength in those areas for consumer, automotive, office automation, communications and industrial products. The majority of foreign sales are U.S. Dollar denominated. The Company has entered into and, from time to time, will enter into hedging transactions in order to minimize exposure to currency rate fluctuations. Although none of the countries in which the Company conducts significant foreign operations have had a highly inflationary economy in the last five years, there is no assurance that inflation rates or fluctuations in foreign currency rates in countries where the Company conducts operations will not adversely affect the Company's operating results in the future. ADDITIONAL FACTORS AFFECTING OPERATING RESULTS The Company believes that future growth in net sales of its 8-bit family of microcontroller products and related memory products will depend largely upon the Company's success in having its current and new products designed into high-volume customer applications. Design wins typically precede the Company's volume shipment of products for such applications by 15 months or more. The Company also believes that shipment levels of its proprietary application development systems are an indicator of potential future design wins and microcontroller sales. The Company continued to achieve a high volume of design wins and shipped increased numbers of application development systems in fiscal 1999 compared to previous fiscal years. There can be no assurance that any particular development system shipment will result in a product design win or that any particular design win will result in future product sales. The Company's operating results are affected by a wide variety of other factors that could adversely impact its net sales and profitability, many of which are beyond the Company's control. These factors include the Company's ability to design and introduce new products on a timely basis, market acceptance of products of both the Company and its customers, customer order patterns and seasonality, changes in product mix, whether the Company's customers buy from a distributor or directly from the Company, product performance and reliability, product obsolescence, the amount of any product returns, availability and utilization of manufacturing capacity, fluctuations in manufacturing yield, the availability and cost of raw materials, equipment and other supplies, the cyclical nature of the semiconductor industry and the markets addressed by the Company's products, technological changes, competition and competitive pressures on prices, and economic, political or other conditions in the United States, and other worldwide markets served by the Company. The Company's products are incorporated into a wide variety of consumer, automotive, office automation, communications and industrial products. A slowdown in demand for products which utilize the Company's products as a result of economic or other conditions in the worldwide markets served by the Company could adversely affect the Company's operating results. GROSS PROFIT The Company's gross profit was $202.9 million, $197.4 million and $166.9 million in fiscal 1999, 1998 and 1997, respectively. Gross profit as a percent of sales was 49.9%, 49.7% and 49.9% in fiscal 1999, 1998 and 1997, respectively. While the gross profit percentage in the last three fiscal years was relatively constant, the Company's performance was impacted by several factors including reduced 5-inch wafer production at Fab 1, increased pricing pressure on its non-volatile memory products, increased 8-inch wafer production and the Company's ongoing cost reduction programs. The Company is continuing the process of transitioning products to smaller geometries and to larger wafer sizes to reduce future manufacturing costs. Eight-inch wafer production commenced at the Tempe wafer fabrication facility in early fiscal 1998 and the Company continues transition products to its 0.7 micron process. The Company expects that 50% of its products will be produced on 8-inch wafers during fiscal 2000. The Company anticipates that its gross product margins will fluctuate over time, driven primarily by the product mix of 8-bit microcontroller products and related memory products, manufacturing yields, fixed cost absorption, wafer fab loading levels and competitive and economic conditions. During the quarter ended March 31, 1999, the Company completed the shut-down of its 5-inch wafer production line, primarily due to the higher cost and lower manufacturing flexibility of this production line as compared to the Company's 6-inch and 8-inch wafer capacity. This action will reduce the Company's production capacity by approximately 20%. The Company intends to replace this capacity with 6-inch and 8-inch wafer production over time. The Company also plans to restructure its test operations over the next two quarters, by closing its test facility in Kaohsiung and transferring this capacity to its more cost effective test facility in Thailand. In order to offset the adverse cost absorption effects related to the elimination of the 5-inch wafer production line, and the potential impact of conversion of its test capacity to its location in Thailand, the Company has instituted a series of cost reductions in all aspects of its business. There can be no assurance that these restructuring actions and cost reductions will sufficiently reduce fixed manufacturing costs to enable the Company to maintain gross profit margins. In addition, these restructuring actions could result in execution problems and manufacturing yield problems that could adversely impact the Company's gross profit. THE FOREGOING STATEMENTS RELATING TO ANTICIPATED GROSS PRODUCT MARGINS, 6-INCH AND 8-INCH WAFER PRODUCTION, THE TRANSITION TO HIGHER YIELDING MANUFACTURING PROCESSES, RESTRUCTURING OF TEST OPERATIONS, AND THE IMPACT OF COST REDUCTIONS ARE FORWARD-LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: FLUCTUATIONS IN PRODUCTION YIELDS, PRODUCTION EFFICIENCIES AND OVERALL CAPACITY UTILIZATION; COST AND AVAILABILITY OF RAW MATERIALS; ABSORPTION OF FIXED COSTS, LABOR AND OTHER DIRECT MANUFACTURING COSTS; THE TIMING AND SUCCESS OF MANUFACTURING PROCESS TRANSITION; DELAYS IN CONSTRUCTION AND FACILITIZATION OF THE EXPANSION AREA AT THE CHACHOENGSAO FACILITY; TIMING AND SUCCESS OF THE TRANSITION OF TEST OPERATIONS FROM TAIWAN TO THAILAND, DEMAND FOR THE COMPANY'S PRODUCTS; COMPETITION AND COMPETITIVE PRESSURE ON PRICING; THE IMPACT OF COST REDUCTIONS AND THE POSSIBLE NEED FOR FURTHER COST REDUCTIONS; CHANGES IN PRODUCT MIX; AND OTHER ECONOMIC CONDITIONS. In the quarter ended June 30, 1997, the Company changed its method of accounting for inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. The change did not have a material effect on the results of operations. The FIFO method is the predominant accounting method used in the semiconductor industry. Prior to this change, the Company's inventory costs did not differ significantly under the two methods. Prior period results of operations have not been restated for this change as the impact is not material. Currently all of Microchip's assembly operations, and a portion of its test requirements, are performed by third-party contractors. Reliance on third parties involves some reduction in the Company's level of control over these portions of its business. While the Company reviews the quality, delivery and cost performance of these third-party contractors, there can be no assurance that reliance on third-party contractors will not adversely impact results in future reporting periods if any third-party contractor is unable to maintain assembly and test yields and costs at approximately their current levels. Microchip intends to develop its own in-house assembly operations over the next fiscal year and will shift a portion of its assembly operations from third-party contractors to fill this capacity. The Company currently performs test operations at Company owned facilities in Taiwan and Thailand. THE FOREGOING STATEMENT RELATED TO THE COMPANY'S INTENTION TO DEVELOP IN-HOUSE ASSEMBLY OPERATIONS OVER THE NEXT 12 MONTHS IS A FORWARD-LOOKING STATEMENT. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: TIMING AND SUCCESS OF THE TRANSITION FROM THIRD PARTY ASSEMBLY SERVICES PROVIDERS TO COMPANY-OWNED ASSEMBLY OPERATIONS; DELAY IN THE FACILITATION OF THE COMPANY'S IN-HOUSE ASSEMBLY OPERATIONS; DIFFICULTIES IN THE TRANSITION OF THE ASSEMBLY FUNCTION FROM THIRD PARTIES TO THE COMPANY; SUPPLY DISRUPTION; LABOR UNREST; CHANGES IN PRODUCT MIX; COMPETITIVE PRESSURES ON PRICES; AND OTHER ECONOMIC CONDITIONS. The Company's reliance on facilities in Taiwan, Thailand, and other foreign countries, and maintenance of substantially all of its finished goods in inventory overseas, entails certain political and economic risks, including political instability and expropriation, supply disruption, currency controls and exchange fluctuations, as well as changes in tax laws, tariff and freight rates. To date, the Company has not experienced any significant interruptions in its foreign business operations. Nonetheless, the Company's business and operating results could be adversely affected if foreign operations or international air transportation were disrupted. RESEARCH AND DEVELOPMENT The Company is committed to continued investment in new and enhanced products, including its development systems software and in its design and manufacturing process technology, which are significant factors in maintaining the Company's competitive position. The dollar investment in research and development increased 6.3% in fiscal 1999 over fiscal 1998, and 19.6% in fiscal 1998 over fiscal 1997. The Company will continue to invest in research and development in the future, including an investment in process and product development. The Company's future operating results will depend to a significant extent on its ability to continue to develop and introduce new products on a timely basis which can compete effectively on the basis of price and performance and which address customer requirements. The success of new product introductions depends on various factors, including proper new product selection, timely completion and introduction of new product designs, development of support tools and collateral literature that make complex new products easy for engineers to understand and use and market acceptance of customers' end products. Because of the complexity of its products, the Company has experienced delays from time to time in completing development of new products. In addition, there can be no assurance that any new products will receive or maintain substantial market acceptance. If the Company were unable to design, develop and introduce competitive products on a timely basis, its future operating results would be adversely affected. The Company's future success will also depend upon its ability to develop and implement new design and process technologies. Semiconductor design and process technologies are subject to rapid technological change, requiring large expenditures for research and development. Other companies in the industry have experienced difficulty in effecting transitions to smaller geometry processes and to larger wafers and, consequently, have suffered reduced manufacturing yields or delays in product deliveries. The Company believes that its transition to smaller geometries and to larger wafers will be important for the Company to remain competitive, and operating results could be adversely affected if the transition is substantially delayed or inefficiently implemented. SELLING, GENERAL AND ADMINISTRATIVE The Company reduced its level of selling, general and administrative costs to $63.0 million in fiscal 1999 compared to $67.5 million in fiscal 1998. This reduction resulted from the Company's ongoing cost reduction programs. Selling, general and administrative costs in fiscal year 1998 increased by $11.3 million from selling, general and administrative costs in fiscal 1997. Selling, general and administrative costs represented 15.5%, 17.0% and 16.8% of sales in fiscal years 1999, 1998 and 1997, respectively. As the Company continues to invest in incremental worldwide sales and technical support resources to promote the Company's embedded control products, selling, general and administrative costs are expected to rise over time. OTHER INCOME (EXPENSE) Interest income in fiscal 1999 decreased from fiscal 1998 and 1997 as a result of lower invested cash balances. Interest expense in fiscal 1999 increased over fiscal 1998 due to increased borrowing levels associated with the Company's stock buyback programs. Other income represents numerous immaterial non-operating items. PROVISION FOR INCOME TAXES Provisions for income taxes reflect tax on foreign earnings and federal and state tax on U.S. earnings. The Company had an effective tax rate of 27.0%, 27.0% and 26.4% for the years ended March 31, 1999, 1998 and 1997, respectively, due primarily to lower tax rates at its foreign locations. The Company believes that its tax rate for the foreseeable future will be approximately 27%. THE FOREGOING STATEMENT REGARDING THE COMPANY'S ANTICIPATED FUTURE TAX RATE IS A FORWARD-LOOKING STATEMENT. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: CURRENT TAX LAWS AND REGULATIONS; TAXATION RATES IN GEOGRAPHIC REGIONS WHERE THE COMPANY HAS SIGNIFICANT OPERATIONS; AND CURRENT TAX HOLIDAYS AVAILABLE IN FOREIGN LOCATIONS. YEAR 2000 ISSUE The Year 2000 ("Y2K") issue is the result of various computer programs being written using two digits rather than four to define the year, thus potentially rendering them incapable of properly managing and manipulating data that includes 21st century dates. The potential for Y2K issues which could reasonably affect the Company could arise from any combination of: a) the Company's own internal information processing and embedded systems, b) external systems used by providers of critical goods or services to the Company, c) customer failures resulting from Y2K problems leading to reductions in demand from the customer, and d) Y2K issues arising within the products manufactured by the Company. THE COMPANY'S CURRENT STATE OF YEAR 2000 READINESS The Company has implemented a Y2K readiness program and has, as of March 31, 1999, taken substantial efforts to reasonably insure that its operations are not subject to substantial adverse Y2K-related impact. This program began in 1997 with a comprehensive documentation of potential sources of Y2K exposure which could reasonably impact the Company's business. This initial source identification phase has been completed. The subsequent step in the program has been to systematically analyze each identified potential source of Y2K exposure as to its likelihood of material effect on the Company's operations and the range of available remediation actions. In the case of identified systems internal to the Company, analysis generally involved performing physical tests which simulated performance of the systems with post-year 2000 dates. For potential sources of Y2K risk which are external to the Company, such as with the Company's external vendors and suppliers, the Company has typically relied upon written assurances of Y2K compliance from those various parties in lieu of physical testing by the Company's employees. To date, the Company has not identified any Y2K issues inherent in the products manufactured by the Company. The Company's products, for the most part, involve hardware integrated circuits which, at the time of sale to customers, have no inherent date sensitive features. The analysis phase of the Y2K readiness program has been substantially completed. The final phase of the Y2K readiness program involves the modification, replacement or elimination of systems identified in the prior analysis phase as being in need of remediation. To date, the Company has completed the remediation process for the majority of its identified internal systems, with the primary effort centered around the total replacement of information systems related to the Company's sales order process, planning, physical distribution and finance functions. The majority of this task was completed during the quarter ended September 30, 1998. As of March 31, 1999, the Company had received letters of Y2K compliance from approximately 93% of its key EXTERNAL vendors and suppliers and expects to secure documentation of compliance from the remainder of these key vendors and suppliers by September 30, 1999. COSTS TO ADDRESS THE YEAR 2000 ISSUE The total cost associated with required modifications to become Y2K compliant is not expected to be material to the Company's financial position. The amount expended through March 31, 1999 was approximately $14,000,000, primarily associated with the total replacement of the information systems related to the Company's sales order process, planning, physical distribution and finance functions which was completed during the quarter ended September 30, 1998. The Company had intended to replace such systems in the ordinary course of its business and the implementation was not substantially accelerated due to the Y2K issue. The Company believes that the cost of its Y2K readiness program, as well as currently anticipated costs to be incurred with respect to Y2K issues of third parties, will not exceed $18,000,000, inclusive of the costs described above. It is anticipated that all such expenditures will be funded from operating cash flows and absorbed as part of the Company's ongoing operations. MOST REASONABLY LIKELY WORST CASE SCENARIO(S) Having reasonably determined that the Company's own hardware and software systems will be substantially Y2K compliant and that its products inherently have no date code-related issues, management believes that the worst case scenarios would most likely involve massive, simultaneous Y2K-related disruptions from the Company's key external raw material suppliers and/or service providers. For these worst case scenarios to have maximum adverse impact on the Company, the vendors in question would either need to be sole-source providers or their peer companies, who would otherwise be potential second-source suppliers, would also need to undergo similar Y2K-related disruption. Examples on the material supplier side would include extended and substantial disruptions of the Company's key raw material suppliers of silicon wafers, leadframes, specialty chemicals and gasses. Examples on the service provider side would include extended, substantial disruptions of the Company's third-party semiconductor assembly firms, telecommunications and datacommunications services, airfreight and delivery services, or the worldwide banking system. Examples on the customer side would include Y2K problems encountered by such customer adversely impacting that customer's business and reducing the customer's purchases from the Company. The Company believes that such massive and simultaneous disruptions of the supply of basic goods and services due to Y2K-related issues are highly unlikely to occur. CONTINGENCY PLANS The Company has made no contingency plans for handling Y2K issues because it believes that the steps it has taken to assess its own hardware and software systems and those of its key vendors and suppliers are adequate to ensure minimal disruption to its business processes. In the event of random, unforeseen Y2K problems (such as the failure of specific pieces of process equipment, or the temporary inability of certain vendors to provide materials or services), the Company believes that these types of issues will most likely be able to be resolved in the normal course of business, including the potential use of alternate suppliers, in most cases. THE FOREGOING STATEMENTS RELATED TO MATERIALITY OF Y2K COSTS, THE COSTS TO ADDRESS Y2K ISSUES AND THE FUNDING AND ABSORPTION OF SUCH COSTS, WORST-CASE SCENARIO(S) AND CONTINGENCY PLANS ARE FORWARD LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: THE FAILURE TO CORRECTLY TIMELY IDENTIFY AND CORRECT Y2K PROBLEMS, EITHER BY THE COMPANY OR ITS KEY SUPPLIERS OR CUSTOMERS. EURO CONVERSION ISSUES The Company operates in the European Market and currently generates approximately 30% of its net sales from customers located in Europe. The Company's commercial headquarters in Europe are located in the United Kingdom, which is not currently one of the eleven member states of the European Union converting to a common currency. The Company currently conducts 96% of its business in Europe in U.S. Dollars and 2% of its business in Europe in Pounds Sterling. The balance of its net sales are conducted in currencies which will eventually be replaced by the Euro. The Company will be monitoring the potential commercial impact of converting a portion of its current business to the Euro, but does not expect any material impact to its business based on this transition. The Company does not currently anticipate any material impact to its business related to Euro matters from information technology, derivative transactions, tax issues and accounting software issues. LIQUIDITY AND CAPITAL RESOURCES The Company had $30.8 million in cash and cash equivalents at March 31, 1999, a decrease of $1.4 million from the March 31, 1998 balance. The Company has an unsecured line of credit with a syndicate of domestic banks totaling $90.0 million. Borrowings under the domestic line of credit as of March 31, 1999 were $25.0 million. The domestic line of credit requires the Company to achieve certain financial ratios and operating results. The Company was in compliance with these covenants at March 31, 1999. The Company also has an unsecured short term line of credit totaling $32.8 million with certain foreign banks. Borrowings under the foreign line of credit as of March 31, 1999 were $1.5 million. There are no covenants related to the foreign line of credit. At March 31, 1999, an aggregate of $96.3 million of these facilities was available, subject to financial covenants and ratios with which the Company was in compliance. The Company's ability to fully utilize these facilities is dependent on the Company remaining in compliance with such covenants and ratios. During the year ended March 31, 1999, the Company generated $102.6 million of cash from operating activities, a decrease of $33.9 million from the year ended March 31, 1998, and an increase of $25.1 million from the year ended March 31, 1997. The decrease in cash flow from operations during fiscal year 1999 was primarily due to reduced profitability, the impact of special charges, and the impact of changes in accounts payable, accrued expenses and accounts receivable. The Company's level of capital expenditures varies from time to time as a result of actual and anticipated business conditions. Capital expenditures in the years ended March 31, 1999, 1998 and 1997 were $39.6 million, $145.3 million and $79.0 million, respectively. Capital expenditures were primarily for the expansion of production capacity and the addition of research and development equipment in each of these periods. The Company currently intends to spend approximately $120.0 million during the next 12 months for additional capital equipment to increase capacity at its existing wafer fabrication facilities, to expand product test operations and to develop in-house assembly capability. The Company expects capital expenditures will be financed by cash flow from operations, available debt arrangements and other sources of financing. The Company believes that the capital expenditures anticipated to be incurred over the next 12 months will provide sufficient additional manufacturing capacity to meet its currently anticipated needs. THE FOREGOING STATEMENTS REGARDING THE ANTICIPATED LEVEL OF CAPITAL EXPENDITURES OVER THE NEXT 12 MONTHS AND THE FINANCING OF SUCH CAPITAL EXPENDITURES ARE FORWARD LOOKING STATEMENTS. ACTUAL CAPITAL EXPENDITURES COULD DIFFER MATERIALLY BECAUSE OF THE FOLLOWING FACTORS, AMONG OTHERS: THE CYCLICAL NATURE OF THE SEMICONDUCTOR INDUSTRY AND THE MARKETS ADDRESSED BY THE COMPANY'S PRODUCTS; MARKET ACCEPTANCE OF THE PRODUCTS OF BOTH THE COMPANY AND ITS CUSTOMERS; UTILIZATION OF CURRENT MANUFACTURING CAPACITY; DELAYS IN CONSTRUCTION AND FACILITIZATION OF THE EXPANSION AREA AT THE CHACHOENGSAO FACILITY; THE AVAILABILITY AND COST OF RAW MATERIALS, EQUIPMENT AND OTHER SUPPLIES; AND THE ECONOMIC, POLITICAL AND OTHER CONDITIONS IN THE MARKETS SERVED BY THE COMPANY. Net cash used in financing activities was $64.4 million and $2.1 million for the years ended March 31, 1999 and March 31, 1998, respectively. Net cash provided by financing activities was $13.4 million for the year ended March 31, 1997. Proceeds from sale of stock and put options were $16.0 million, $12.5 million and $59.5 million for the years ended March 31, 1999, 1998 and 1997, respectively. Payments on long term debt and capital lease obligations were $4.4 million, $6.1 million and $5.7 million for the years ended March 31, 1999, 1998 and 1997, respectively. Net proceeds from lines of credit were $3.5 million and $23.0 million for the years ended March 31, 1999 and 1998 respectively. Repayments on lines of credit were $21.0 million for the year ended March 31, 1997. Cash expended for the purchase of the Company's Common Stock was $79.5 million, $31.5 million and $19.5 million for the years ended March 31, 1999, 1998 and 1997, respectively. During the year ended March 31, 1999, the Company purchased 2,847,500 shares of Common Stock at an aggregate cost of $70,324,000 and had outstanding 700,000 put options at prices ranging from $22.30 to $28.81. The Company also has outstanding a net share settled forward contact. See Note 8 to "Consolidated Financial Statements." The net share settled forward contract could obligate the Company to purchase shares of the Company's Common Stock in the future if the price of the Company's Common Stock is below the strike price of the instruments. The Company expects from time to time to purchase shares of Common Stock in connection with its authorized stock purchase program. The Company will also have cash requirements associated with the restructuring activities described above. The Company believes that its existing sources of liquidity combined with cash generated from operations will be sufficient to meet the Company's currently anticipated cash requirements for at least the next 12 months. However, the semiconductor industry is capital intensive. In order to remain competitive, the Company must continue to make significant investments in capital equipment, for both production and research and development. The Company may seek additional equity or debt financing during the next 12 months for the capital expenditures required to maintain or expand the Company's wafer fabrication and product test facilities or other purposes. The timing and amount of any such capital requirements will depend on a number of factors, including demand for the Company's products, product mix, changes in industry conditions and competitive factors. There can be no assurance that such financing will be available on acceptable terms, and any additional equity financing could result in additional dilution to existing investors. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is set forth at "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources," above. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of the Company listed in the index appearing under Item 14(a)(1) hereof are filed as part of this Annual Report on Form 10-K. See also Index to Financial Statements on page hereof. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the Company's directors is incorporated herein by reference to the Company's proxy statement for the 1999 annual meeting of stockholders under the caption "Election of Directors." See Item I, Part I hereof under the caption "Executive Officers" for information with respect to the Company's executive officers. Information with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is incorporated herein by reference to the Company's proxy statement for the 1999 annual meeting of stockholders under the caption "Section16(a) Beneficial Ownership Reporting Compliance." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information with respect to executive compensation is incorporated herein by reference to the information under the caption "Executive Compensation" in the Company's proxy statement for the 1999 annual meeting of stockholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information with respect to security ownership of certain beneficial owners and management of the Company is incorporated herein by reference to the information under the caption "Security Ownership of Principal Stockholders, Directors and Executive Officers" in the Company's proxy statement for the 1999 annual meeting of stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Annual Report on Form 10-K: Page No. -------- (1) Financial Statements: Independent Auditors' Report Consolidated Balance Sheets as of March 31, 1999 and 1998 Consolidated Statements of Income for each of the years in the three-year period ended March 31, 1999 Consolidated Statements of Cash Flows for each of the years in the three-year period ended March 31, 1999 Consolidated Statements of Stockholders' Equity for each of the years in the three-year period ended March 31, 1999 Notes to Consolidated Financial Statements (2) Financial Statement Schedules - Applicable schedules have been omitted because information is included in the footnotes to the Financial Statements. (3) The Exhibits which are filed with this report or which are incorporated herein by reference are set forth in the Exhibit Index which appears on page E-1 hereof, which Exhibit Index is incorporated herein by this reference. (b) No current reports on Form 8-K were filed during the quarter ended March 31, 1999. (c) See Item 14(a)(3) above. (d) See "Index to Financial Statements" included under Item 8 to this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MICROCHIP TECHNOLOGY INCORPORATED (Registrant) By: /s/ Steve Sanghi ------------------------------------- Steve Sanghi President and Chief Executive Officer Date: May 17, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Name and Signature Title Date - ------------------ ----- ---- /s/ Steve Sanghi Director, President and May 17, 1999 - -------------------------- Chief Executive Officer Steve Sanghi - -------------------------- Albert J. Hugo-Martinez* Director May 17, 1999 - -------------------------- L. B. Day* Director May 17, 1999 - -------------------------- Matthew W. Chapman* Director May 17, 1999 /s/ C. Philip Chapman Vice President, Chief Financial May 17, 1999 - -------------------------- Officer and Secretary (Principal C. Philip Chapman Financial and Accounting Officer) *By: /s/ Steve Sanghi Individually and as Attorney-in-fact May 17, 1999 - -------------------------- Steve Sanghi Annual Report on Form 10-K Item 8, Item 14(a)(1) and (2), (c) and (d) --------------------------------- CONSOLIDATED FINANCIAL STATEMENTS EXHIBITS --------------------------------- YEAR ENDED MARCH 31, 1999 MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES CHANDLER, ARIZONA MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Number ----------- Independent Auditors' Report Consolidated Balance Sheets as of March 31, 1999 and 1998 Consolidated Statements of Income for each of the years in the three-year period ended March 31, 1999 Consolidated Statements of Cash Flows for each of the years in the three-year period ended March 31, 1999 Consolidated Statements of Stockholders' Equity for each of the years in the three-year period ended March 31, 1999 Notes to Consolidated Financial Statements i INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Microchip Technology Incorporated: We have audited the accompanying consolidated balance sheets of Microchip Technology Incorporated and subsidiaries as of March 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended March 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material aspects, the financial position of Microchip Technology Incorporated and subsidiaries as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 1999, in conformity with generally accepted accounting principles. Phoenix, Arizona April 20, 1999 MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands except share amounts) ASSETS March 31, March 31, 1999 1998 --------- --------- Cash and cash equivalents $ 30,826 $ 32,188 Accounts receivable, net 62,545 56,320 Inventories 67,975 66,293 Prepaid expenses 2,982 2,208 Deferred tax asset 37,129 35,778 Other current assets 1,958 1,802 --------- --------- Total current assets 203,415 194,589 Property, plant and equipment, net 293,663 325,892 Other assets 8,152 4,262 --------- --------- Total assets $ 505,230 $ 524,743 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Short-term lines of credit $ 1,509 $ 16,000 Accounts payable 28,489 36,049 Current maturities of long-term debt 1,403 2,196 Current maturities of capital lease obligations 413 2,206 Accrued liabilities 49,699 53,452 Deferred income on shipments to distributors 28,607 29,515 --------- --------- Total current liabilities 110,120 139,418 Long-term lines of credit 25,000 7,000 Long-term debt, less current maturities -- 1,420 Capital lease obligations, less current maturities -- 348 Long-term pension accrual -- 976 Deferred tax liability 11,313 8,273 Stockholders' equity: Preferred stock, $.001 par value; authorized 5,000,000 shares; no shares issued or outstanding -- -- Common stock, $.001 par value; authorized 100,000,000 shares; issued 53,881,342 and outstanding 51,232,157 shares at March 31, 1999; 54 54 issued 53,881,342 and outstanding 52,870,389 shares at March 31, 1998 Additional paid-in capital 161,242 176,865 Retained earnings 264,281 214,193 Less shares of common stock held in treasury at cost; 2,649,185 shares at March 31, 1999 and 1,010,953 at March 31, 1998 (66,780) (23,804) --------- --------- Net stockholders' equity 358,797 367,308 Total liabilities and stockholders' equity $ 505,230 $ 524,743 ========= ========= See accompanying notes to consolidated financial statements MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share amounts) Years Ended March 31, ------------------------------------- 1999 1998 1997 --------- --------- --------- Net sales $ 406,460 $ 396,894 $ 334,252 Cost of sales 203,574 199,538 167,330 --------- --------- --------- Gross profit 202,886 197,356 166,922 Operating expenses: Research and development 40,787 38,362 32,073 Selling, general and administrative 63,006 67,549 56,248 Special charges 28,937 5,000 7,544 --------- --------- --------- 132,730 110,911 95,865 Operating income 70,156 86,445 71,057 Other income (expense): Interest income 754 2,635 1,419 Interest expense (2,964) (1,130) (3,271) Other, net 665 217 288 --------- --------- --------- Income before income taxes 68,611 88,167 69,493 Income taxes 18,523 23,799 18,361 --------- --------- --------- Net income $ 50,088 $ 64,368 $ 51,132 ========= ========= ========= Basic net income per share $ 0.98 $ 1.21 $ 0.99 ========= ========= ========= Diluted net income per share $ 0.94 $ 1.14 $ 0.94 ========= ========= ========= Weighted average common shares outstanding 51,136 53,376 51,569 ========= ========= ========= Weighted average common and common equivalent shares outstanding 53,528 56,313 54,683 ========= ========= ========= See accompanying notes to consolidated financial statements MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See accompanying notes to consolidated financial statements MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIAIRES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY See accompanying notes to consolidated financial statements MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES NATURE OF BUSINESS Microchip develops, manufactures and markets field programmable 8-bit microcontrollers, application specific standard products ("ASSPs") and related specialty memory products for high-volume embedded control applications in the consumer, automotive, office automation, communications and industrial markets. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Microchip Technology Incorporated and its wholly owned subsidiaries ("Microchip" or the "Company"). All significant intercompany accounts and transactions have been eliminated in consolidation. CASH AND CASH EQUIVALENTS All highly liquid investments including marketable securities purchased with an original maturity of three months or less are considered to be cash equivalents. There were no marketable securities at March 31, 1999 and 1998. INVENTORIES Inventories are valued at the lower of cost or market using the first-in, first-out (FIFO) method. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Major renewals and improvements are capitalized, while maintenance and repairs are expensed when incurred. Depreciation is provided on a straight-line basis over the estimated useful lives of the related assets which range from three to twenty-five years. Assets acquired under capital lease arrangements have been recorded at the present value of the future minimum lease payments and are being amortized on a straight-line basis over the estimated useful life of the asset or the lease term, whichever is shorter. Amortization of this equipment is included in depreciation and amortization expense. FOREIGN CURRENCY TRANSLATION AND FORWARD CONTRACTS The Company's foreign subsidiaries are considered to be extensions of the U.S. company and any translation gains and losses related to these subsidiaries are included in income. As the U.S. Dollar is utilized as the functional currency, gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the subsidiaries' functional currency) are also included in income. Gains and losses associated with currency rate changes on forward contracts are recorded currently in income. REVENUE RECOGNITION Revenue from product sales to direct customers is recognized upon shipment. The Company defers recognition of net sales and profits on sales to distributors that have rights of return and price protection until the distributors have resold the products. INCOME TAXES Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. COMPUTATION OF NET INCOME PER SHARE In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 128, EARNINGS PER SHARE ("SFAS No. 128"). SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate restated, to conform to the SFAS No. 128 requirements. IMPAIRMENT OF LONG-LIVED ASSETS The Company records impairment losses on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. STOCK OPTION PLANS Prior to April 1, 1996, the Company accounted for its stock option plans in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations. As such, compensation expense would be recorded only if, on the date of grant, the current market price of the underlying stock exceeded the exercise price. On April 1, 1996, the Company adopted SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, ("SFAS No. 123") which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in fiscal 1996 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123. USE OF ESTIMATES The Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates. RECLASSIFICATIONS Certain 1998 and 1997 fiscal year balances have been reclassified to conform to the fiscal year 1999 presentation. 2. SPECIAL CHARGES LEGAL SETTLEMENT WITH LUCENT TECHNOLOGIES INC. On January 13, 1998, the Company finalized a settlement of its patent litigation with Lucent Technologies Inc. resulting in the Company recording a $5,000,000 special charge during the quarter ended December 31, 1997. Under the terms of the settlement, Microchip made a one-time cash payment to Lucent and issued to Lucent warrants to acquire 300,000 shares of Common Stock of the Company priced at $25.25 per share. The terms of the settlement also provide for the Company to make a contingent payment to Lucent if the Company's earnings per share performance for the three and one-half year period ending June 30, 2001 does not meet certain targeted levels. Based on the current estimate of earnings per share for the measurement period the Company has provided the appropriate reserve to meet this liability. It is currently anticipated that any additional contingent payment required under the terms of the settlement, in addition to the current reserve, would be expensed in the period the amount is determined. RESTRUCTURING CHARGES The Company has implemented two restructuring actions to position the Company for future cost effective growth. During the March 1999 quarter, the Company completed closure of its 5-inch wafer line which represented the Company's least flexible and least cost-effective production capacity. Eliminating the 5-inch production capacity reduces the Company's productive capacity by approximately 20%. The Company intends to replace this capacity with 6-inch and 8-inch wafer production over time. This action resulted in a restructuring charge of $7,561,000 in the March 1999 quarter. The Company also decided to restructure its test operations over the next two quarters by closing its Kaohsiung facility and migrating its test capacity to its lower-cost, Thailand facility. This action resulted in a restructuring charge of $6,089,000 in the March 1999 quarter. Included in the restructuring charges resulting from elimination of the 5-inch production capacity was $6,758,000 related to equipment that was written off, $310,000 related to employee severance costs and $493,000 related to other restructuring costs. Included in the restructuring charges resulting from the closure of the Kaohsiung facility was $5,579,000 related to employee severance costs and $510,000 related to other restructuring costs. Included in the special charge the Company recorded in the March 1999 quarter was $1,805,000 related to two legal settlements associated with intellectual property matters, and $350,000 related to restructure of a portion of the Company's sales infrastructure. During the quarter ended June 30, 1998, the Company recognized a special charge of $5,500,000 which was comprised of three elements: a $3,300,000 legal settlement with another company involving an intellectual property dispute; a $1,700,000 write-off of products obsoleted by the introduction of newer products; and a $500,000 charge associated with the restructuring of a portion of the Company's sales organization. During the quarter ended June 30, 1996, primarily in response to inventory correction activities at the Company's customers, the Company implemented a series of actions to reduce production capacity, curtail the growth of inventories and reduce operating expenses. These actions included delaying capital expansion plans and deferring capital spending, a 15% production cutback in wafer fabrication, a headcount reduction in early April 1996 representing approximately 3% of the Company's worldwide employees, and a two-week wafer fab shut down in early July 1996. As a result of these actions, the Company recorded a pre-tax special charge of $5,969,000 in the quarter ended June 30, 1996 to cover costs primarily related to idling part of the Company's 5-inch wafer fab capacity, paying continuing expenses during the wafer fabrication facility shutdown and paying severance costs associated with the April 1996 headcount reduction. ACQUISITIONS KEELOQ(R) HOPPING COde On November 17, 1995, the Company acquired the Keeloq(R) hopping code technology and patents developed by Nanoteq Ltd. of the Republic of South Africa, and the marketing rights related thereto (the "Keeloq Acquisition"). The Keeloq Acquisition was treated as an asset purchase for accounting purposes. The amount paid for the Keeloq Acquisition, including all related costs, was $12,948,000. The Company has written off a substantial portion of the purchase price that relates to in-process research and development costs, which is consistent with the Company's ongoing treatment of research and development costs, as well as all Keeloq Acquisition-related costs. The special charge associated with the Keeloq Acquisition was $11,448,000, with the balance treated as purchased technology and amortized on a straight line basis over five years. Under the terms of the Keeloq Acquisition, the Company agreed to a secondary payment which has been determined to be $10,250,000, net of legal expenses of $1,107,000. The Company has determined that $4,250,000 will be treated as purchased technology and amortized over the remaining expected life of the revenue stream of the Keeloq products. Under the provisions of SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG LIVED ASSETS AND FOR LONG LIVED ASSETS TO BE DISPOSED OF, the balance of the payment including the residual asset value capitalized as part of the initial payment has been written off as part of the special charge made by the Company in the quarter ended March 31, 1999. The total amount expensed as part of the special charge in the quarter ended March 31, 1999 was $7,632,000. ASIC TECHNICAL SOLUTIONS On June 25, 1996, the Company acquired ASIC Technical Solutions, Inc., a fabless provider of quick turn gate array devices (the "ASIC Acquisition"). The ASIC Acquisition was treated as a purchase for accounting purposes. The amount paid for the ASIC Acquisition and related costs was $1,750,000. As part of the ASIC Acquisition, the Company allocated a substantial portion of the purchase price to in-process research and development costs, which is consistent with the Company's on-going treatment of research and development costs. The total special charge associated with the ASIC Acquisition was $1,575,000, with the balance treated as purchased technology related to current products and amortized over five years. 3. CONTINGENCIES The Company is subject to lawsuits and other claims arising in the ordinary course of its business. In the Company's opinion, based on consultation with legal counsel, as of March 31, 1999, the effect of such matters will not have a material adverse effect on the Company's financial position. 4. ACCOUNTS RECEIVABLE Accounts receivable consists of the following (amounts in thousands): March 31, 1999 1998 ---- ---- Trade accounts receivable $64,335 $57,922 Other 570 790 ------- ------- 64,905 58,712 Less allowance for doubtful accounts 2,360 2,392 ------- ------- $62,545 $56,320 ======= ======= 5. INVENTORIES The components of inventories are as follows (amounts in thousands): March 31, 1999 1998 ---- ---- Raw materials $ 4,491 $ 5,795 Work in process 46,947 40,000 Finished goods 26,531 30,021 ------- ------- 77,969 75,816 Less allowance for inventory valuation 9,994 9,523 ------- ------- $67,975 $66,293 ======= ======= In the quarter ended June 30, 1997, the Company changed its method of accounting for inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. The change did not have a material effect on the results of operations. The FIFO method is the predominant accounting method used in the semiconductor industry. Prior to this change, the Company's inventory costs did not differ significantly under the two methods. Prior period results of operations have not been restated for this change as the impact is not material. 6. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following (amounts in thousands): March 31, 1999 1998 ---- ---- Land $ 11,545 $ 11,749 Building and building improvements 77,600 59,725 Machinery and equipment 365,947 322,624 Projects in process 41,143 82,528 -------- -------- 496,235 476,626 Less accumulated depreciation and amortization 202,572 150,734 -------- -------- $293,663 $325,892 ======== ======== 7. LONG-TERM DEBT Long-term debt consists of borrowings (denominated in U.S. Dollars) from three Taiwan financial institutions, secured by equipment financed thereby. Interest rates are at the Singapore Interbank Offering Rate (SIBOR) (5.125% at March 31, 1999) plus 0.75% and at the London Interbank Offering Rate (LIBOR) (5.125% at March 31, 1999) plus 0.75%. The weighted average interest rate on these borrowings was 5.875% at March 31, 1999. Payments, including interest, are due on a semi-annually basis. With the scheduled closure of the Kaohsiung testing facility and the transfer of the equipment secured by this financing to the Company's testing facility in Bangkok, Thailand, the balance of $1,403,000 remaining under the terms of this financing has been classified as a current liability. The Company has an unsecured line of credit with a syndicate of U.S. banks for up to $90,000,000, bearing interest at the LIBOR plus .325% expiring in October 2000. The Company had utilized $25,000,000 and $7,000,000 of this line of credit as of March 31, 1999 and 1998, respectively. The agreement between the Company and the syndicate of banks requires the Company to achieve certain financial ratios and operating results. The Company was in compliance with these covenants as of March 31, 1999. The Company has an additional unsecured line of credit with various Taiwan financial institutions for up to $32,814,000 (U.S. Dollar equivalent). These borrowings are predominantly denominated in U.S. Dollars, bearing interest at SIBOR plus 0.59% (average) and expiring on various dates through November, 1999. At March 31, 1999 and 1998 the Company had utilized $1,509,000 and $16,000,000, respectively, of this line of credit. 8. EMPLOYEE BENEFIT PLANS The Company maintains a contributory profit-sharing plan for a majority of its domestic employees meeting certain service requirements. The plan qualifies under Section 401(k) of the Internal Revenue Code, and allows employees to contribute up to 15% of their compensation, subject to maximum annual limitations prescribed by the Internal Revenue Service. Company contributions to the plan were at the discretion of the Board of Directors until January 1, 1997, when the employer match was revised to provide for a fixed and discretionary component. The Company shall make a matching contribution of up to 25% of the first 4% of the participant's eligible compensation and may award up to an additional 25% under the discretionary match. All matches are provided on a quarterly basis and require the participant to be an active employee at the end of each quarter. For the fiscal years ended March 31, 1999, 1998 and 1997, the Company contributions to the plan totaled $445,000, $525,000 and $452,000, respectively. The Company's Employee Stock Purchase Plan (the "Purchase Plan") allows eligible employees of the Company to purchase shares of Common Stock at semi-annual intervals through periodic payroll deductions. The purchase price per share, in general, will be 85% of the lower of the fair market value of the Common Stock on the participant's entry date into the offering period or 85% of the fair market value on the semi-annual purchase date. As of March 31, 1999, 101,710 shares were available for issuance under the Purchase Plan. Since the inception of the Purchase Plan, 3,306,000 shares of Common Stock have been reserved for issuance under the Purchase Plan. In April 1999, subject to stockholder approval, the Board reserved an additional 400,000 shares of Common Stock for issuance under the Purchase Plan. During fiscal 1995, a purchase plan was adopted for employees in non-U.S. locations. Such plan allows for the purchase price per share to be 100% of the lower of the fair market value of the Common Stock on the beginning or end of the semi-annual purchase plan period. Effective January 1, 1997, the Company adopted a non-qualified deferred compensation arrangement. This plan is unfunded and is maintained primarily for the purpose of providing deferred compensation for a select group of management as defined in ERISA Sections 201, 301 and 401. There are no Company matching contributions with respect to this plan. Substantially all employees in foreign locations are covered by a statutory pension plan. Contributions are accrued based on an actuarially determined percentage of compensation and are funded in amounts sufficient to meet statutory requirements. Pension expense amounted to $1,037,000, $1,202,000 and $1,316,000 for the years ended March 31, 1999, 1998 and 1997, respectively. The Company has a management incentive compensation plan which provides for bonus payments, based on a percentage of base salary, from an incentive pool created from operating profits of the Company, at the discretion of the Board of Directors. During the years ended March 31, 1999, 1998 and 1997, $2,220,000, $1,851,000 and $2,064,000 respectively, was charged against operations for this plan. The Company also has a plan which provides a cash bonus based on the operating profits of the Company for all employees, at the discretion of the Board of Directors. During the years ended March 31, 1999, 1998 and 1997, $607,000, $1,746,000 and $1,373,000, respectively, was charged against operations for this plan. 9. STOCK OPTION PLANS Under the Company's stock option plans (the "Plans"), key employees, non-employee directors and consultants may be granted incentive stock options or non-statutory stock options to purchase shares of Common Stock at a price not less than 100% of the fair value of the option shares on the grant date. Options granted under the Plans vest over the period determined by the Board of Directors at the date of grant, at periods ranging from one year to four years. At March 31, 1999, there were 3,940,780 shares available for grant under the Plans. In April 1999, the Board reserved an additional 1,500,000 shares of Common Stock for issuance under the 1997 Nonstatutory Stock Option Plan. The per share weighted-average fair value of stock options granted under the Plans for the years ended March 31, 1999, 1998 and 1997 was $10.31, $15.61 and $9.66, respectively, based on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: Years Ended March 31, 1999 1998 1997 ---- ---- ---- Expected life (years) 3.96 3.64 3.50 Risk-free interest rate 5.10% 5.75% 6.25% Volatility 68% 62% 60% Dividend yield 0% 0% 0% Under the Plans, 18,897,479 shares of Common Stock had been reserved for issuance since the inception of the Plans. The stock option activity is as follows: Options Outstanding Weighted Average Shares Exercise Price ------ -------------- Outstanding at March 31, 1996 6,547,307 $10.88 Granted 2,092,952 17.74 Exercised (1,314,977) 6.16 Canceled (967,610) 21.28 ---------- Outstanding at March 31, 1997 6,357,672 $12.50 Granted 1,631,821 27.80 Exercised (778,418) 7.72 Canceled (1,006,781) 25.99 ---------- Outstanding at March 31, 1998 6,204,294 $14.84 Granted 1,323,606 22.79 Exercised (944,349) 10.44 Canceled (344,574) 28.94 ---------- Outstanding at March 31, 1999 6,238,977 $16.83 ========== ====== The following table summarizes information about the stock options outstanding at March 31, 1999: At March 31, 1999 and 1998, the number of options exercisable was 2,506,115 and 2,625,827, respectively, and the weighted-average exercise price of those options was $10.46 and $8.94, respectively. On March 2, 1998, the Board of Directors of the Company approved an option exchange program for options priced in excess of $25.00. This program excluded executive officers, corporate officers and directors. Eligible employees who were issued stock options in this category could elect to keep their options to buy Common Stock at the original grant price or elect to exchange such options for options priced at $21.50 per share, the fair market value of the Company's Common Stock on March 9, 1998. If the employee elected to exchange the options for options priced at $21.50 per share, the vesting commencement date was extended by 90 days from the original vesting date. There were 534,522 shares exchanged under this option exchange program. For certain options granted, the Company recognized as compensation expense the excess of the deemed value for accounting purposes of the Common Stock issuable upon exercise of such options over the exercise price of such options. This deferred compensation expense is amortized ratably over the vesting period of each option. During the year ended March 31, 1997, the Company recorded compensation expense of $30,000. The Company received a tax benefit of $4,915,000, $5,332,000 and $5,742,000 for the years ended March 31, 1999, 1998 and 1997, respectively, from the exercise of non-qualified stock options and the disposition of stock acquired with incentive stock options or through the Purchase Plan. For financial reporting purposes, the tax effect of this deduction is accounted for as a credit to additional paid-in capital rather than as a reduction of income tax expense. The Company applies APB Opinion No. 25 in accounting for its various stock plans and, accordingly, no compensation cost has been recognized for the Plans or the Purchase Plan in the financial statements. Had the Company determined compensation cost in accordance with SFAS No. 123, the Company's net income per share would have been reduced to the pro forma amounts indicated below: Years Ended March 31, 1999 1998 1997 ------- ------- ------- Net income As reported $50,088 $64,368 $51,132 Pro forma 43,183 58,461 48,202 Basic net income As reported $ 0.98 $ 1.21 $ 0.99 per share Pro forma 0.84 1.10 0.93 Dilutednet income As reported $ 0.94 $ 1.14 $ 0.94 per share Pro forma 0.81 1.04 0.88 Pro forma net income reflects only options granted during the fiscal years ended March 31, 1999, 1998, 1997 and 1996. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in pro forma net income amounts presented above because compensation cost is reflected over the options' vesting period and compensation cost for options granted prior to April 1, 1995 is not considered. 10. LEASE COMMITMENTS The Company leases office space, transportation and other equipment under capital and operating leases which expire at various dates through September, 2007. The future minimum lease commitments under these leases are payable as follows (amounts in thousands): Year ended Capital Operating March 31, Leases Leases --------- ------ ------ 2000 $424 $1,432 2001 -- 1,130 2002 -- 925 2003 -- 777 2004 -- 564 Thereafter 1,278 ---- ------ Total minimum lease payments $424 $6,106 Less amount representing interest (at rates ranging from 6.7% to 8.5%) (11) ---- Present value of net minimum lease payments 413 ==== Rental expense under operating leases totaled $2,759,000, $2,811,000 and $2,644,000 for the years ended March 31, 1999, 1998 and 1997, respectively. 11. INCOME TAXES The provision for income taxes is as follows (amounts in thousands): Years Ended March 31, 1999 1998 1997 -------- -------- -------- Current expense: Federal $ 8,405 $ 22,575 $ 13,814 State 934 2,508 3,454 Foreign 7,495 8,139 4,093 -------- -------- -------- 16,834 33,222 21,361 -------- -------- -------- Deferred expense (benefit): Federal 1,413 (6,315) (1,322) State 157 (702) (331) Foreign 119 (2,406) (1,347) -------- -------- -------- 1,689 (9,423) (3,000) -------- -------- -------- $ 18,523 $ 23,799 $ 18,361 ======== ======== ======== The tax benefit associated with the exercise of employee stock options reduced taxes currently payable by $4,915,000, $5,332,000, and $5,742,000 for the years ended March 31, 1999, 1998 and 1997, respectively. These amounts were credited to additional paid in capital in each of the three fiscal years. The provision for income taxes differs from the amount computed by applying the statutory federal tax rate to income before income taxes. The sources and tax effects of the differences are as follows (amounts in thousands): Years Ended March 31, 1999 1998 1997 -------- -------- -------- Computed expected provision $24,014 $30,858 $24,323 State income taxes, net of federal benefit 1,289 1,630 2,245 Foreign sales corporation benefit (2,824) (3,707) (2,552) Foreign income taxed at lower than the federal rate (3,956) (4,982) (5,655) ------- ------- ------- $18,523 $23,799 $18,361 ======= ======= ======= Pretax income from foreign operations was $29,787,000, $39,554,000 and $32,172,000 for the years ended March 31, 1999, 1998 and 1997, respectively. Unremitted foreign earnings that are considered to be permanently invested outside the United States and on which no deferred taxes have been provided, amounted to approximately $177,661,000 at March 31, 1999. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows (amounts in thousands): March 31, 1999 1998 -------- -------- Deferred tax assets: Intercompany profit in inventory $ 15,474 $ 15,168 Deferred income on shipments to distributors 9,884 9,398 Inventory reserves 3,921 3,550 Accrued expenses and other 7,850 10,460 -------- -------- Gross deferred tax assets 37,129 38,576 -------- -------- Deferred tax liabilities: Property, plant and equipment, principally due to differences in depreciation (11,313) (11,071) -------- -------- Gross deferred tax liability (11,313) (11,071) -------- -------- Net deferred tax asset $ 25,816 $ 27,505 ======== ======== Management believes that the results of future operations will generate sufficient taxable income to realize the deferred tax assets. The Company has benefited from a partial tax holiday for its Taiwan manufacturing operations over the past several years. The Company is currently benefiting from a tax holiday for its Thailand manufacturing operations. The aggregate dollar benefits derived from these tax holidays approximated $5,121,000, $5,614,000, and $5,415,000 for the years ended March 31, 1999, 1998 and 1997, respectively. The benefit the tax holidays had on net income per share approximated $0.10, $0.10 and $0.10 for the years ended March 31, 1999, 1998 and 1997, respectively. The Company's tax holiday status in Taiwan expired in March 1997 and will partially expire in Thailand in September 2003. 12. ACCRUED LIABILITIES Accrued liabilities consists of the following (amounts in thousands): March 31, 1999 1998 ------- ------- Accrued salaries and wages $11,437 $ 7,468 Income taxes 5,654 22,396 Keeloq acquisition 10,250 -- Other accrued expenses 21,873 23,588 ------- ------- $49,214 $53,452 ======= ======= 13. STOCKHOLDERS' EQUITY STOCKHOLDER RIGHTS PLAN. On February 13, 1995, the Company's Board of Directors adopted a Stockholder Rights Plan (the "Plan"). Under the Plan, each share of the Company's Common Stock has one right which entitles the stockholder to buy 1/100th of a share of the Company's Series A Participating Preferred Stock. The rights have an exercise price of $66.67 and expire in February 2005. The rights become exercisable and transferable upon the occurrence of certain events. STOCK REPURCHASE ACTIVITY. In connection with a stock repurchase program, during the years ended March 31, 1999 and 1998, the Company purchased a total of 2,847,500 and 1,277,500 shares of the Company's Common Stock in open market activities at a total cost of $70,324,000 and $31,481,000 respectively. During the year ended March 31, 1999 the Company received 230,575 shares in conjunction with the net share settled forward contract. Also, in connection with a stock repurchase program, during fiscal 1999 and fiscal 1998 the Company sold put options for 600,000 shares and 700,000 shares of Common Stock, respectively. Pricing per share ranged from $22.30 to $27.50 in fiscal 1999 and from $29.50 to $38.81 in fiscal 1998. During fiscal 1999 and 1998, the Company purchased put options for 50,000 and 300,000 shares, respectively. The net proceeds from the sale and repurchase of these options, in the amount of $2,113,000 and $2,215,000 for fiscal 1999 and 1998 respectively has been credited to additional paid-in capital. During the year ended March 31, 1999 put options for 250,000 shares were purchased at the settlement dates at a total cost of $9,188,000. As of March 31, 1999, the Company had outstanding put options for 700,000 shares which have expiration dates ranging from July 29, 1999 to September 13, 1999 at prices ranging from $22.30 to $28.81 per share. During the year ended March 31, 1999, the Company completed two transactions in connection with the stock repurchase program. In April 1998 the Company completed a costless collar transaction for 500,000 calls priced at $25.95 and 665,000 puts priced at $25.19. The expiration date of the transaction was April 28, 1999, resulting in the Company receiving $4,660,000 which will be credited to additional paid in capital. Also in connection with the stock repurchase program, the Company completed a net share settled forward contract for 2,000,000 shares at an average price of $29.24. The expiration date of this transaction is May 2000 with quarterly interim settlement dates. The Company expects from time to time to purchase shares of Common Stock in connection with its authorized Common Stock repurchase plan. 14. GEOGRAPHIC INFORMATION The Company operates in one industry segment and engages primarily in the design, development, manufacture and marketing of semiconductor products. The Company sells its products to system manufacturers and distributors in a broad range of industries, performs on-going credit evaluations of its customers and generally requires no collateral. The Company's operations outside the United States consist of comprehensive product final test facilities in Taiwan and Thailand and sales offices in certain foreign countries. Domestic operations are responsible for the design, development and wafer fabrication of all products, as well as the coordination of production planning and shipping to meet worldwide customer commitments. The Taiwan and Thailand test facilities are reimbursed in relation to value added with respect to test operations and other functions performed, and certain foreign sales offices receive a commission on export sales within their territory. Accordingly, for financial statement purposes, it is not meaningful to segregate sales or operating profits for the test and foreign sales office operations. Identifiable assets by geographic area are as follows (amounts in thousands): March 31, 1999 1998 -------- -------- United States $284,496 $306,142 Taiwan 125,768 136,128 Thailand 66,532 57,374 Other 28,434 25,099 -------- -------- Total Assets $505,230 $524,743 ======== ======== Sales to unaffiliated customers located outside the United States, primarily in Asia and Europe, aggregated approximately 69%, 68% and 66% of consolidated net sales for the years ended March 31, 1999, 1998 and 1997, respectively. 15. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of cash equivalents approximates fair value because their maturity is less than three months. The carrying amount of accounts receivable, accounts payable and accrued liabilities approximates fair value due to the short term maturity of the amounts. The fair value of capital lease obligations, long-term debt and lines of credit approximate their carrying value as they are estimated by discounting the future cash flows at rates currently offered to the Company for similar debt instruments. The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to reduce its exposure to fluctuations in foreign exchange rates. These financial instruments include standby letters of credit and foreign currency forward contracts. When engaging in forward contracts, risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities values, interest rates and foreign exchange rates. At March 31, 1999 and 1998, the Company held contracts totaling $4,263,000 and $9,158,000, respectively, which were entered into and hedged the Company's foreign currency risk. The contracts matured May 4, 1999 and April 28, 1998. Unrealized gains and losses as of the balance sheet dates and realized gains and losses for the years ending March 31, 1999, 1998 and 1997 were not material. 16. NET INCOME PER SHARE The following table sets forth the computation of basic and diluted net income per share (in thousands except per share amounts): Years Ended March 31, 1999 1998 1997 ------- ------- ------- Net income $50,088 $64,368 $51,132 ======= ======= ======= Weighted average common shares outstanding 51,136 53,376 51,569 Dilutive effect of stock options 2,392 2,937 3,114 ------- ------- ------- Weighted average common and common equivalent shares outstanding 53,528 56,313 54,683 ======= ======= ======= Basic net income per share $ 0.98 $ 1.21 $ 0.99 ======= ======= ======= Diluted net income per share $ 0.94 $ 1.14 $ 0.94 ======= ======= ======= 17. QUARTERLY RESULTS (UNAUDITED) The following table presents the Company's selected unaudited quarterly operating results for eight quarters ended March 31, 1999. The Company believes that all necessary adjustments have been made to present fairly the related quarterly results (in thousands except per share amounts). 18. SUPPLEMENTAL FINANCIAL INFORMATION Cash paid for income taxes amounted to $27,875,000, $19,857,000 and $8,108,000 during the years ended March 31, 1999, 1998 and 1997, respectively. Cash paid for interest amounted to $2,688,000, $796,000 and $3,183,000 during the years ended March 31, 1999, 1998 and 1997, respectively. Included in the special charge for the year ended March 31, 1999 was a non-cash amount of $8,920,000, of which $1,700,000 pertained to the write off of products obsoleted by the introduction of newer products and $7,220,000 pertained to the write down of fixed assets due to the restructuring of wafer fabrication facilities. A summary of additions and deductions related to the allowances for accounts receivable and inventories for the years ended March 31, 1999, 1998 and 1997 follows: EXHIBIT INDEX Exhibit No. Description Page No. - ----------- ----------- -------- 3.1 Restated Certificate of Incorporation of Registrant [Incorporated by reference to Exhibit 3.1 to Registration Statement No. 33-70608] 3.1.1 Certificate of Amendment to Registrant's Restated Certificate of Incorporation [Incorporated by reference to Exhibit 3.3.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1994] 3.1.2 Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock of Registrant [Incorporated by reference to Exhibit No. 3.1.2 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1995] 3.1.3 Certificate of Amendment to Registrant's Restated Certificate of Incorporation [Incorporated by reference to Exhibit No. 1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995] 3.1.4 Certificate of Amendment to Registrant's Certificate of Incorporation [Incorporated by reference to Exhibit No. 3.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997] 3.2 Amended and Restated By-Laws of Registrant, as amended through August 10, 1998 [Incorporated by reference to Exhibit No. 3.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998] 4.1 Preferred Share Rights Agreement dated as of February 13, 1995 between Registrant and Bank One, Arizona, N.A., including the form of Rights Certificate and the Summary of Rights attached as exhibits thereto [Incorporated by reference to Exhibit No. 1 to Registrant's Registration Statement on Form 8-A as filed with the Securities and Exchange Commission as of February 14, 1995] 10.1 Form of Indemnification Agreement between Registrant and its directors and certain of its officers [Incorporated by reference to Exhibit No. 10.1 to Registration Statement No. 33-57960] 10.2 Land Lease Contract dated January 1, 1989 between Registrant's subsidiary and Kaohsiung Export Processing Zone Administration Summary (English Summary) [Incorporated by reference to Exhibit No. 10.10 to Registration Statement No. 33-57960] 10.3 Land Lease Contract dated September 1, 1992 between Registrant's subsidiary and Kaohsiung Export Processing Zone Administration Summary (English Summary) [Incorporated by reference to Exhibit No. 10.11 to Registration Statement No. 33-57960] 10.4 Amended and Restated 1989 Stock Option Plan [Incorporated by reference to Exhibit No. 10.14 to Registration Statement No. 33-57960] 10.5 1993 Stock Option Plan, as amended through April 25, 1997 [Incorporated by reference to Exhibit 10.11 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1997] E-1 EXHIBIT INDEX Exhibit No. Description Page No. - ----------- ----------- -------- 10.6 Form of Notice of Grant For 1993 Stock Option Plan, with Exhibit A thereto, Form of Stock Option Agreement; and Exhibit B thereto, Form of Stock Purchase Agreement [Incorporated by reference to Exhibit No. 10.6 Registration Statement No. 333-872] 10.7 Employee Stock Purchase Plan, as amended through April 25, 1997[Incorporated by reference to Exhibit 10.13 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1997] 10.8 Form of Stock Purchase Agreement for Employee Stock Purchase Plan [Incorporated by reference to Exhibit No. 10.2 to Registration Statement No. 333-872] 10.9 Form of Enrollment Form For Employee Stock Purchase Plan [Incorporated by reference to Exhibit No. 10.3 to Registration Statement No. 333-872] 10.10 Form of Change Form For Employee Stock Purchase Plan [Incorporated by reference to Exhibit No. 10.4 to Registration Statement No. 333-872] 10.11 Form of Executive Officer Severance Agreement [Incorporated by reference to Exhibit No. 10.7 to Registration Statement No. 333-872] 10.12 Credit Agreement dated as of October 28, 1997 among Registrant, the Banks named therein, Bank One, Arizona, NA as Administrative Agent and The First National Bank of Chicago, as Documentation Agent [Incorporated by reference to Exhibit No. 10.1 to Registrant's Quarterly Report on Form 10-Q for the Quarter Ended September 30, 1997] 10.13 Modification Agreement dated as of March 30, 1998 to the Credit Agreement dated as of October 28, 1997 among Registrant, the Banks named therein, Bank One, Arizona, NA, as Administrative Agent and The First National Bank of Chicago, as Documentation Agent [Incorporated by reference to Exhibit No. 10.13 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998] 10.14 Modification Agreement dated as of November 4, 1998 to the Credit Agreement dated as of October 28, 1997 among Registrant, the Banks named therein, Bank One, Arizona, NA, as Administrative Agent and The First National Bank of Chicago, as Documentation Agent [Incorporated by reference to Exhibit No. 3.2 toRegistrant's Quarterly Report on Form 10-Q for the Quarter Ended September 30, 1998] 10.15 Development Agreement dated as of August 29, 1997 by and between Registrant and the City of Chandler, Arizona [Incorporated by reference to Exhibit No. 10.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1997] 10.16 Development Agreement dated as of July 17, 1997 by and between Registrant and the City of Tempe, Arizona [Incorporated by reference to Exhibit No. 10.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1997] E-2 EXHIBIT INDEX Exhibit No. Description Page No. - ----------- ----------- -------- 10.17 1997 Nonstatutory Stock Option Plan [Incorporated by reference to Exhibit No. 10.16 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998] 10.18 Form of Notice of Grant For 1997 Nonstatutory Stock Option Plan, with Exhibit A thereto, Form of Stock Option Agreement [Incorporated by reference to Exhibit No. 10.17 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998] 10.19 International Employee Stock Purchase Plan as Amended Through April 25, 1997 [Incorporated by reference to Exhibit 10 to Registration Statement No. 333-40791] 18.1 Letter from KPMG Peat Marwick LLP re: Change in Accounting Principles [Incorporated by reference to Exhibit No. 18.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997] 21.1 Subsidiaries of Registrant [Incorporated by reference to Exhibit No. 21.1 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1996] 23.1 Consent of KPMG LLP 24.1 Power of Attorney Re: Microchip Technology Incorporated, the Registrant [Incorporated by reference to Exhibit No. 24.1 to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998] 27 Financial Data Schedule E-3

937971_1999.txt

937971_1999

1999

937971

ITEM 1. BUSINESS ACT Manufacturing, Inc. (ACT or We) is a leading provider of value-added electronics manufacturing services to original equipment manufacturers (OEMs) in the networking and telecommunications, computer and industrial and medical equipment markets. We provide OEMs with: . complex printed circuit board assembly, primarily utilizing advanced surface mount technology; . electro-mechanical sub-assembly; . total system assembly and integration; and . mechanical and molded cable and harness assembly. We target and have developed a particular expertise in serving emerging and established OEMs who require moderate volume production runs of complex, leading-edge commercial market applications. The multiple configurations and high printed circuit board densities that characterize these applications generally require technologically-advanced and flexible manufacturing as well as a high degree of other value-added services. As an integral part of our offerings to customers, we provide the following value-added services in all of our service offerings: . new product introduction services; . advanced manufacturing and test engineering; . flexible materials management; . comprehensive test services; . product diagnostics and repair; . product configuration; . packaging; . order fulfillment; and . distribution services. Since 1997, we have completed four acquisitions that have enabled us to strengthen our advanced engineering capabilities, expand our operations and geographic presence and diversify our customer base. Prior to 1997, we operated primarily in the northeastern United States. Through our acquisitions, we have added facilities in California, Georgia, Mississippi, Ireland and Mexico. Our July 1999 merger with CMC Industries, Inc. enabled us to significantly increase our scale of operations, expand our customer base and geographic presence, and strengthen our management and engineering resources. In addition, the acquisition of certain inventory and fixed assets of GSS/Array Technology, Inc. in October 1999 strengthened and expanded our California operations and considerably enhanced our advanced engineering capabilities, in particular those related to high-end radio frequency applications. We expect to continue to pursue select strategic acquisitions to enhance our growth, operations, geographic presence, engineering capabilities and service offerings. We have developed strong customer relationships with a wide range of companies in the networking and telecommunications and computer industries. Our customer base of over 100 customers includes large, established OEMs such as EMC Corporation, Motorola and Nortel Networks, and emerging providers of next-generation technology products such as Convergent Networks, Efficient Networks and Unisphere Solutions (formerly Redstone Communications). OEMs in the networking and telecommunications segment of the electronics industry represented approximately 66% of our net sales for fiscal 1999 while OEMs in the computer segment accounted for approximately 25% for the same period. These customers require our advanced engineering capabilities and other value- added services to manufacture technologically complex products, such as wireless and ADSL modems, Internet access switches, routers and mass storage systems . We establish close, long-term relationships with our customers by offering them a complete and flexible electronics manufacturing solution in order to accelerate their time-to-market and time-to-volume production. Recent and Pending Business and Asset Acquisitions On March 15, 2000, we entered into a Pre-Tender Agreement for the acquisition of GSS Array Technology Public Company Limited (GSS Thailand), a Thailand company publicly traded on the Stock Exchange of Thailand. Under the terms of the agreement, GSS Thailand would be delisted from the Stock Exchange of Thailand and we would then make a cash tender offer for all issued shares and outstanding options of GSS Thailand for approximately $93.0 million at the exchange rate in effect between the Thai Baht and the U.S. Dollar on March 15, 2000. We also have the option to make the cash tender offer prior to the delisting of GSS Thailand from the Stock Exchange of Thailand. Holders of approximately 23% of GSS Thailand's outstanding shares have agreed to tender their issued shares and outstanding options to ACT. We expect to close the acquisition in the third quarter of fiscal 2000, however, the acquisition is subject to various regulatory approvals and other closing conditions. We cannot assure you that these closing conditions will be satisfied and we therefore may not consummate this acquisition of GSS Thailand on a timely basis or at all. On October 12, 1999, we acquired certain inventory and fixed assets of GSS/Array Technology, Inc., located in San Jose, California, for approximately $12.9 million in cash and the assumption of $0.6 million in liabilities, which we financed primarily through our bank credit facility. The purchase of these assets did not constitute the acquisition of a business. GSS/Array Technology, Inc. was a subsidiary of GSS Thailand. We assumed on-going relationships with select GSS/Array domestic customers and hired select employees. On July 29, 1999, we completed our merger with CMC Industries, Inc. (CMC), a provider of electronics manufacturing services to OEMs in the telecommunications, computer and electronics industries. CMC operated manufacturing facilities in Santa Clara, California, Corinth, Mississippi and Hermosillo, Mexico. As a result of the merger, CMC became our wholly owned subsidiary. Under the terms of the merger agreement, each share of CMC common stock was exchanged for 0.5 of a share of our common stock and all CMC stock options were assumed by us. We issued approximately 3.9 million shares of common stock and reserved approximately 0.9 million shares of common stock for future issuance under CMC's 1990 Equity Incentive Plan, pursuant to the merger. The merger has been accounted for as a pooling of interests. The merger with CMC has provided us many benefits which enable us to compete more effectively in the electronics manufacturing services industry, including: . We gained the critical mass necessary to compete for the business of larger OEMs in the electronics industry. . We enhanced our customer diversity, reduced our reliance on specific major customers and enhanced our opportunity to sell additional value- added services to a larger customer base as a result of the lack of overlap between the ACT and CMC customer bases. . We expanded our geographic presence and broadened our range of cost and volume production capabilities through the addition of high volume, low cost manufacturing production facilities in Corinth, Mississippi and Hermosillo, Mexico and a moderate volume facility in Santa Clara, California. . We acquired significant managerial, sales and engineering resources which has facilitated the expansion of our manufacturing capacity and has strengthened our advanced engineering capabilities. . We acquired a procurement office in Taiwan as well as experienced purchasing personnel which has strengthened our component supply chains. Services We utilize a business unit or cell approach to provide value-added services to more effectively satisfy the needs of our customers. Within this environment, we assign dedicated equipment, personnel and systems to specific customers. Throughout the manufacturing organization, we use state-of-the-art production performance, statistical process control and quality reporting systems to provide accurate, timely and relevant management and customer information. Manufacturing of Electronic Assemblies We offer manufacturing capabilities for printed circuit board assembly, electro-mechanical sub-assembly, total system assembly and integration, and cable and harness assembly. Printed Circuit Board Assembly. Printed circuit boards are platforms on which integrated circuits and other electronic components are mounted. Semiconductor designs are complex and often require printed circuit boards with many layers of narrow, densely-spaced wiring. Rapid technological advances have occurred in the electronics industry in recent years that have increased the speed and performance of components, while reducing their size. These technological advances have caused printed circuit boards to become smaller with components more densely attached to the board. These technological advances have required increasingly advanced surface mount manufacturing technologies, in addition to traditional surface mount and pin- through-hole technology. In pin-through-hole production, components are attached by pins, also called leads, inserted through and soldered to plated holes in the printed circuit board. In traditional surface mount technology production, the leads on integrated circuits and other electronic components are soldered to the surface of the printed circuit board rather than inserted into holes. Surface mount technologies can accommodate a substantially higher number of leads in a given area than pin-through-hole production. As a result, surface mount technologies allow the printed circuit board to interconnect a greater density of integrated circuits. This density permits tighter component spacing and a reduction in the printed circuit board dimensions. Additionally, surface mount technologies allow components to be placed on both sides of the printed circuit board, thereby permitting even greater density. The substantially finer lead-to-lead spacing in surface mount technologies requires a manufacturing process far more exacting than the pin-through-hole interconnect products. An advanced surface mount technology called micro ball grid array (BGA) allows for even greater densities than traditional surface mount technology. The BGA assembly process uses small balls of solder, instead of leads that could bend and break, located directly underneath the part, to interconnect the component and circuit board. Because of their high number of leads, most complex or very large scale integrated circuits are configured for surface mount technologies production. We employ advanced surface mount technologies, primarily micro ball grid array, in our printed circuit board assembly operations in addition to traditional surface mount technologies. We also continue to support pin- through-hole technology and related semi-automated and manual placement processes for existing and new applications that require these technologies. We focus on low to moderate volume manufacturing of highly complex and sophisticated printed circuit board assemblies. We manufacture these complex assemblies on a batch basis and have developed expertise in quickly changing equipment set-up and manufacturing capabilities in order to respond to our customers' changing needs. We believe this capability provides our customers with optimal flexibility in product design, while allowing for rapid turnaround of new or highly complex but lower volume products. We also offer our customers high volume manufacturing alternatives. In our Hermosillo, Mexico and Corinth, Mississippi facilities, we currently manufacture larger volume, less complex printed circuit boards using a variety of surface mount technologies. As part of our comprehensive manufacturing process, we provide in-circuit, functional and stress environmental testing services for substantially all completed printed circuit board assemblies. In-circuit tests verify that: . the components have been attached properly; . the components meet functional standards; and . the electrical circuits have been completed properly. We perform these tests on industry standard testing equipment using proprietary software developed either by the customer or our test engineers. We also use specialized testing equipment designed and provided by the customer or developed by our engineers to perform customized functional tests designed to ensure that the printed circuit board assembly will perform its intended functions. In addition, since defective components normally fail after a relatively short period of use, we subject more complex printed circuit board assemblies to controlled environmental stresses, typically thermal or electrical stresses, based on customer requests. Electro-Mechanical Sub-Assembly and Total System Assembly and Integration. We integrate components, including our printed circuit board and cable and harness assemblies, into higher level sub-assemblies and total system assemblies. We maintain significant systems assembly capacity to meet the increasing demands of our customers for total system assemblies. In addition to product assemblies, we also provide the following services to customers seeking to integrate manufacturing and distribution services: . custom configuration; . documentation; . packaging; and . order fulfillment. Cable and Harness Assembly. We offer a wide range of cable and harness assembly services for molded and mechanical applications including: . custom manufactured ribbon assemblies; . multiconductor, co-axial and fiber optic cable assemblies; and . discrete wire harness assemblies. We use advanced and diverse manufacturing processes, in-line inspection and test and dedicated work cells to minimize work-in-process time and focus on process efficiencies and quality. We use both automated and semi-automated preparation and insertion equipment, as well as manual assembly techniques to accomplish the cable and harness assembly process. We test substantially all of our cable and harness assemblies using automated test equipment. Value-Added Services Outsourcing allows OEMs to take advantage of the manufacturing expertise, advanced technology, capital investments and overall cost benefits obtained by electronics manufacturing services providers. In addition, OEMs outsource their manufacturing strategies to accelerate their time-to-market and time-to- volume production, improve inventory management and purchasing power, and improve the overall quality of their products. In order for OEMs to fully achieve the benefits of outsourcing, they seek a comprehensive manufacturing solution. To meet the requirements of our OEM customers, we provide the following value-added services across the full range of our electronics manufacturing services: New Product Introduction Services. We work with potential and existing customers as early as possible in the new product development process to optimize their products' design for manufacturing. Our new product introduction services include design and layout, concurrent engineering, test development and prototype engineering. Our new product introduction services are designed to shorten customers' product development cycles by offering full design and development services that compliment the customers' in-house capabilities. We believe that our new product introduction capabilities result in close interaction with our customers and new business prospects which: . enhance responsiveness to customers; . enable us to stay at the forefront of technological innovations; and . strengthen our relationships with our existing and new customers. Advanced Manufacturing and Test Engineering. Our advanced manufacturing engineers work closely with a customer's product designers at the early design stage of a product. Our engineers: . evaluate the initial product design to identify potential manufacturing and testability issues; . review the layout of a board to determine if it has the optimal tool set- up and efficient component spacing and densities; and . participate in parts selection and materials utilization decisions. This early interaction with the customer optimizes product manufacturability, testability, and reliability. This participation also mitigates component availability issues which might arise during the manufacturing cycle. Our engineers also evaluate the ongoing manufacturing process and recommend improvements to reduce manufacturing costs or lead times, or to increase the quality of finished assemblies. Our engineering services help customers: . bring their products rapidly to the market; . meet the market's expectation for quality; and . take advantage of advances in manufacturing and testing technology and processes. Materials Management. We provide our customers optimal flexibility regarding their production delivery and product mix requirements. We directly purchase all or a substantial portion of the components necessary for our product assemblies. We procure components from vendors which meet our standards for timely delivery, high quality, cost-effectiveness, flexibility and compliance with customer specifications. To help control inventory investment, we generally order components only when we have a customer forecast, purchase order or commitment to purchase the completed assemblies. We use a materials requirements planning system to plan and procure materials. We use electronic data interchange systems to efficiently communicate with many of our vendors. We have recently begun using an Internet-based procurement tool and expect to realize cost savings and efficiencies by sourcing components via the Internet. Additionally, we use just-in-time inventory management techniques and manage our materials pipelines and vendor base to provide our customers flexibility to change their volume requirements within established frameworks. Product Diagnostics and Repair. As OEMs increasingly outsource their manufacturing needs and divest their internal manufacturing capabilities, they need electronics manufacturing services providers that offer product diagnostic and repair services. If a product purchased by an OEM's customer fails or breaks, an OEM that has outsourced its manufacturing is not likely to have the equipment, facilities or trained personnel available to identify and fix the problem. We use our engineering and test capabilities to provide product diagnostic and repair for assemblies we manufacture and, in some instances, for other products of our customers. We also offer our OEM customers revision control, lot tracking and materials management services for their product revisions, upgrades and repairs. Order Fulfillment and Distribution. To more rapidly respond to the market demands of our customers, we offer delivery programs and capabilities designed with the flexibility to ship products directly to an OEM's customers. Under these programs, we package products to the customer's specification with appropriate product documentation and manage the logistics of delivery. We work closely with our customers to identify and offer additional services in anticipation of future customer needs. Suppliers Our OEM customers need us to: . assure the short and long term supply of materials and components to manufacture their products; . negotiate low prices for these materials; . secure the highest quality and most reliable materials; . assure the on-time delivery of these materials; and . provide them with the flexibility to change their production requirements on short notice. To compete effectively in this business environment, we have developed a materials procurement strategy whereby we maintain strong, long-term relationships with a limited number of suppliers who conform to our high standards. We seek to work only with suppliers that consistently deliver the best technology and quality materials at the lowest total cost on the shortest and most flexible lead times. We consistently evaluate all of our suppliers' performances and provide them with suggestions for improving our relationships. When we do business with a supplier at our customer's direction, we closely monitor the supplier's performance and work with both the supplier and the customer to improve the supplier's performance when necessary. We believe this strategy enables us to provide optimal flexibility to our OEM customers and enables us to better satisfy their electronics manufacturing services needs. Our team of materials acquisition professionals is responsible for all materials procurement and planning. We have a strategic purchasing group that develops our worldwide materials and commodity procurement strategy. We have adopted a more direct supplier model that targets select high quality suppliers from a more distributor-oriented procurement model. This strategic group is responsible for understanding the needs of our customers and the commodity supply market, evaluating the overall quality of suppliers and negotiating and executing low cost commodity supply contracts with preferred suppliers. We also have a group that focuses on the day-to-day tactical execution of our materials procurement process to insure that material or component costs or shortages do not prevent us from providing optimal services to our customers. This group is responsible for proactively managing inventory programs, evaluating day-to-day supplier performance and co-ordinating customer plan production changes. We typically procure components when a purchase order or forecast is received from a customer. Due to our utilization of just-in-time inventory techniques, the timely availability of many components depends on our ability to both develop accurate forecasts of customer requirements and manage our materials supply chain. Given our direct component procurement strategy with quality suppliers, we rely on a single or limited number of suppliers for many proprietary and other components used in our assembly process. Although we have strong relationships with high quality suppliers, we do not have any long term supply agreements. Shortages of materials and components have occurred from time to time and will likely occur in the future despite our development of select long-term supplier relationships. In particular, we are currently experiencing a shortage in components such as tantalum and ceramic capacitors, flash memory and dynamic and static ram. We believe our direct procurement strategy and the division of responsibility within our materials procurement team enable us to better manage our supply chain in order to reduce the occurrence and minimize the effect on our customers of materials or component shortages. Customers and Markets We serve a wide range of customers from emerging growth companies to established multinational corporations in a variety of markets, including networking and telecommunications, computer and industrial and medical equipment. We currently provide services to over 100 customers worldwide. Customers in the networking and telecommunications segment of the electronics industry represented approximately 66% of our net sales for fiscal 1999 while OEMs in the computer segment accounted for approximately 25% for the same period. For fiscal 1999, our five largest customers accounted for approximately 52% of our net sales. For fiscal 1999, each of Nortel Networks (formerly Bay Networks and Aptis Communications) and S-3 Incorporated (formerly Diamond Multimedia) accounted for 10% or more of our net sales (15% and 13%, respectively). Customers representing 10% or more of our net sales in fiscal 1998 were Nortel Networks and Micron Electronics, each with approximately 12%, as compared to Nortel Networks with 17% of our net sales in fiscal 1997. The timing and level of orders from our customers varies substantially from period to period. The historic level of net sales we have received from a specific customer in one particular period is not necessarily indicative of net sales we may receive from that customer in any future period. While we focus on maintaining long term relationships with our customers, for various reasons, including consolidation in our customers' industries, we have in the past and will continue in the future to terminate or lose relationships with customers. Customers may also significantly reduce the level of business they do with us or delay the volume of manufacturing services they order from us. Significant or numerous terminations, reductions or delays in our customers' orders could negatively impact our operating results in future quarters. We continue to focus on expanding and diversifying our customer base to reduce dependence on any individual customer or market. In many cases, our customers utilize more than one electronics manufacturing services provider across their product lines. Our goal is to be the primary electronics manufacturing services provider for our customers. We seek to manufacture the high-value, leading-edge products of our customers and target OEMs that require moderate volume production. Our high volume, low cost facilities enable us to offer our customers a broad range of volume production and cost alternatives. We believe that we are advantageously positioned to be selected to provide manufacturing and value-added services for our customers' new product offerings due to our: . close interaction with the design engineering personnel of our customers at the product development stage; . prototype production experience; . advanced manufacturing and engineering capabilities, such as radio frequency capabilities; and . established and dependable materials pipeline. We generally warrant that our products will be free from defects in workmanship for twelve months. We also pass on to our customers any warranties provided by component manufacturers and material suppliers to the extent permitted under our arrangements with these parties. Our warranty provides that during the warranty period we will take action to repair or replace failed products. We test substantially all of our assemblies prior to shipment. In addition, our customers generally test or have tested final products on a sample basis prior to deployment in the field. Our warranty costs have not been material to date. Sales and Marketing We develop close, long term relationships with our customers by working with them throughout the development, manufacturing and distribution processes. Electronics manufacturing services providers generally face a long sales cycle and must perform satisfactorily on a trial basis prior to capturing significant orders from an OEM. As a result, we seek to develop these close relationships with customers during the initial product design and development stage. We then support our existing customer relationships through a comprehensive staff of program managers dedicated to individual customer accounts. We assign each customer a program manager who acts as the primary contact for the customer. Program managers are responsible for the development of the manufacturing relationship between our company and the customer and the assignment of our resources to meet the customer's requirements. We market our services primarily through a direct sales force, and to a lesser extent, through independent manufacturer's representatives in the United States, Canada and Europe. As we have grown, we have increasingly relied on and developed our direct selling organization as opposed to utilizing independent manufacturer representatives. We divide our direct sales organization into two operations groups. The strategic sales group focuses its selling efforts on major multinational accounts. The core sales group focuses on existing and new accounts within set geographic regions. We expect to continue to expand our direct sales organization and marketing efforts in response to increased customer opportunities in new geographic markets, our increased critical mass and our expanded customer base. Competition The electronics manufacturing services industry is highly competitive. We compete against numerous U.S. and foreign electronics manufacturing services providers with global operations, including Benchmark Electronics, Celestica, Flextronics, Jabil Circuit, Plexus, Sanmina, SCI and Solectron. We also face competition from a number of electronics manufacturing services providers that operate on a local or regional basis. In addition, current and prospective customers continually evaluate the merits of manufacturing products internally. Consolidation in the electronics manufacturing services industry results in a continually changing competitive landscape. The consolidation trend in the industry also results in larger and more geographically diverse competitors who have significant combined resources with which to compete against us. We believe that the principal competitive factors in the segments of the electronics manufacturing services industry in which we operate are: . geographic location and coverage; . flexibility in adapting to customers' needs; . manufacturing capability; . price; . service; . technology; . quality; . reliability; and . timeliness in delivering finished products. We believe that we have developed a particular strength relative to some of our major competitors in the manufacturing of complex, moderate volume, leading-edge products. Competition from existing or potential competitors could result in reduced prices, margins and market share which would significantly and negatively impact our operating results. Governmental Regulation Our operations are subject to certain federal, state and local regulatory requirements relating to environmental compliance and site cleanups, waste management and health and safety matters. In particular, we are subject to regulations promulgated by: . the Occupational Safety and Health Administration pertaining to health and safety in the workplace; . the Environmental Protection Agency pertaining to the use, storage, discharge and disposal of hazardous chemicals used in the manufacturing processes; and . corresponding state agencies. To date the costs of compliance and environmental remediation have not been material to us. Nevertheless, additional or modified requirements may be imposed in the future. If such additional or modified requirements are imposed on us, or if conditions requiring remediation were found to exist, we may be required to incur substantial additional expenditures. Employees At December 31, 1999, we had 2,816 permanent employees. To provide manufacturing flexibility for our customers, we utilize the services of temporary employees to meet short-term manufacturing capacity fluctuations. The only employees represented by a labor union are those employees in our Mexico operations. We have never experienced a labor stoppage or strike. We consider our relations with our employees to be good. ITEM 2. ITEM 2. PROPERTIES Our principal manufacturing facilities are located in ten facilities containing an aggregate of approximately 1.0 million square feet. Our significant facilities are as follows: We lease two of the Hudson facilities from Re-Act Realty Trust, a Massachusetts nominee trust, which is controlled by John A. Pino, our Chairman of the Board, President and Chief Executive Officer, and the beneficial interest of which is principally owned by Mr. Pino. Our manufacturing facility in Corinth, Mississippi is located on 64 acres of land. The facility and land are leased from the Industrial Development Board of Alcorn County, Mississippi under a lease which has options to renew until 2060. We also lease 20,000 square feet of warehouse space in Corinth, Mississippi, an international purchasing office in Taiwan and a sales and procurement office in Huntsville, Alabama. We have consolidated the equipment and assets we purchased from GSS/Array into our Santa Clara operations. Our Santa Clara facility's lease term expires in November 2000. We have signed a lease for a new 202,000 square foot facility in San Jose, California that is under construction. We plan to move our existing Santa Clara operations and the equipment and assets we purchased from GSS/Array to this new facility and expect to begin operations in this new facility in the fourth quarter of fiscal 2000. All of our manufacturing facilities have been certified to the ISO 9002 international quality standard except the Corinth, Mississippi facility which is certified to the ISO 9001 international quality standard and our newly leased facility in Marlborough, Massachusetts, which we occupied in January 2000. We expect that this facility will be certified in the near future. Our Massachusetts facilities contain 14 surface mount technology lines. We operate 16 surface mount technology lines at our Corinth, Mississippi facility; ten at Hermosillo, Mexico; nine at Santa Clara, California; three at Lawrenceville, Georgia; and two in the Dublin, Ireland facility. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On February 27, 1998, our company and several of our officers and directors were named as defendants in a purported securities class action lawsuit filed in the United States District Court for the District of Massachusetts. The plaintiffs amended the complaint on October 16, 1998. The plaintiffs purport to represent a class of all persons who purchased or otherwise acquired our common stock in the period from April 17, 1997 through March 31, 1998. The amended complaint alleges, among other things, that the defendants knowingly made misstatements to the investing public about the value of our inventory and the nature of our accounting practices. On December 15, 1998, we filed a motion to dismiss the case in its entirety based on the pleadings. Our motion to dismiss was granted without prejudice on May 27, 1999 and the case was closed by the court on June 1, 1999. On June 28, 1999, the plaintiffs filed a motion with the court seeking permission to file a second amended complaint. We opposed that motion. On July 13, 1999, the court denied the plaintiffs' motion to amend, noting "final judgment having entered in the case." On July 26, 1999, the plaintiffs filed a motion with the court asking the court to extend the 30-day period for filing an appeal of its ruling dismissing the case. We opposed that motion as well, and the court denied the motion on August 10, 1999. The plaintiffs have filed an appeal with the United States Court of Appeals for the First Circuit requesting that the Court of Appeals reverse each of the orders described above. The parties are currently briefing the issues before the Court of Appeals. We believe the claims asserted in this action, and the plaintiffs' pending appeal, are without merit and intend to continue to defend ourselves vigorously in this action. We further believe that this litigation will not have a material adverse effect on our business and results of operations, although we cannot assure you as to the ultimate outcome of these matters. In December 1993, CMC Industries retained the services of a consultant to assist in quantifying the potential exposure to CMC in connection with clean- up and related costs of a former manufacturing site. This site is commonly known as the ITT Telecommunications site in Milan, Tennessee. The consultant initially estimated that the cost to remove and dispose of the contaminated soil would be approximately $200,000. CMC subsequently entered into a voluntary agreement to investigate the site with the Tennessee Department of Environment and Conservation. In addition, CMC agreed to reimburse a tenant of the site $115,000 for expenditures previously incurred to investigate environmental conditions at the site. CMC recorded a total provision of $320,000 based on these estimates. In fiscal 1995, an environmental consultant estimated that the cost of a full study combined with short and long term remediation of the site may cost between $3.0 and $4.0 million. Subsequent environmental studies done in fiscal 1999 have estimated such costs as between $750,000 and $3.5 million. During CMC's fiscal 1996, the State of Tennessee's Department of Environment and Conservation named certain potentially responsible parties in relation to the former facility. CMC was not named as a potentially responsible party. However, Alcatel, Inc., a potentially responsible party named by the State of Tennessee's Department of Environment and Conversation and a former owner of CMC, sought indemnification from CMC under the purchase agreement by which CMC acquired the stock of one of the operators of the facility. To date, Alcatel has not filed any legal proceedings to enforce its indemnification claim. However, Alcatel could initiate such proceedings and other third parties could assert claims against us relating to remediation of the site. We have entered into an agreement with Alcatel pursuant to which the statute of limitations on its indemnification claim is tolled for a period of time. In the event any proceedings are initiated or any claim is made, we would defend ourselves vigorously but defense or resolution of this matter could negatively impact our financial position and results of operations. In connection with a fiscal 1996 staff reduction by CMC, a number of terminated employees subsequently claimed that CMC had engaged in age discrimination in their dismissal and sought damages of varying amounts. CMC defended the actual and threatened claims vigorously during fiscal 1998 incurring approximately $275,000 in legal costs over the course of the year. On August 6, 1998, a judgment was rendered in favor of one plaintiff, in the amount of $127,000 which CMC subsequently settled for $112,000. A second plaintiff's claim for $53,000 was filed and subsequently settled for $48,500. The EEOC negotiated with CMC to reach a monetary settlement for other potential claimants. Without admitting any liability, CMC entered into a Conciliation Agreement with the EEOC and agreed to pay approximately $500,000 to settle all such claims and limit future litigation costs. As a result of these events and the significant ongoing costs to defend these claims, in October 1998, CMC concluded that its interest would be best served to settle all such matters. CMC reserved $975,000 to resolve all such claims, which represented its best estimate of funds to ultimately be paid to such claimants. This charge was recorded in CMC's fiscal year ended July 31, 1998. On June 15, 1999, we received written notice from legal counsel for the Lemelson Medical, Education & Research Foundation, Limited Partnership alleging that we were infringing certain patents held by the Lemelson Foundation Partnership and offering to license such patents to us. We entered into a perpetual patent license agreement with the Lemelson Foundation Partnership in February 2000. From time to time, we are also subject to claims or litigation incidental to our business. We do not believe that any incidental claims or litigation will have a material adverse effect on our results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of the fiscal year ended December 31, 1999 to a vote of security holders of ACT, through the solicitation of proxies or otherwise. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock is quoted on the Nasdaq National Market under the symbol "ACTM." The following table sets forth the high and low bid information for the common stock as reported by Nasdaq for the periods indicated. On March 24, 2000, the closing price of our common stock on The Nasdaq National Market was $48.75 per share. As of March 24, 2000, there were approximately 132 holders of record of our common stock, which does not include stockholders for whom shares were held in a nominee or street name. We did not pay any cash dividends on our common stock during the periods shown above. We presently do not anticipate paying any cash dividends in the foreseeable future. We presently intend to retain future earnings, if any, to finance the expansion and growth of our business. Our bank credit facility prohibits the payment of cash dividends on our capital stock. See note 5 of notes to our consolidated financial statements. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The data set forth below has been restated to give retroactive effect to the merger of ACT Manufacturing, Inc. and CMC Industries, Inc. on July 29, 1999 which has been accounted for as a pooling of interests as described in note 1 to our consolidated financial statements. The selected consolidated financial data set forth below for the fiscal years ended December 31, 1999, 1998 and 1997 and the consolidated balance sheet data as of December 31, 1999 and 1998 are derived from our audited consolidated financial statements, which are included elsewhere in this Annual Report on Form 10-K. The selected consolidated financial data for the fiscal years ended December 31, 1996 and 1995 and the consolidated balance sheet data as of December 31, 1997, 1996 and 1995 are derived from the combination of our respective audited consolidated financial statements that are not included in this Annual Report on Form 10-K. You should read the data set forth below in conjunction with "Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This Annual Report on Form 10-K, including the following discussion, contains trend analysis and other forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements in this Annual Report on Form 10-K that are not statements of historical facts are forward-looking statements. These forward-looking statements are based on a number of assumptions and involve risks and uncertainties. Our actual results may differ materially from those indicated in such forward-looking statements as a result of the factors set forth elsewhere in this Annual Report on Form 10-K, including under "Year 2000 Readiness Disclosure Statement" and "Cautionary Statements." Overview We are a leading provider of value-added electronics manufacturing services to original equipment manufacturers (OEMs) in the networking and telecommunications, computer and industrial and medical equipment markets. We provide OEMs with complex printed circuit board assembly, primarily utilizing advanced surface mount technology, electro-mechanical sub-assembly, total system assembly and integration, and mechanical and molded cable and harness assembly. We target and have developed a particular expertise in serving emerging and established OEMs who require moderate volume production runs of complex, leading-edge commercial market applications. These applications are generally characterized by multiple configurations and high printed circuit board densities. As a result, they generally require technologically-advanced and flexible manufacturing as well as a high degree of other value-added services. As an integral part of our offerings to customers, we provide the following value-added services: new product introduction services, advanced manufacturing and test engineering, flexible materials management, comprehensive test services, product diagnostics and repair, packaging, order fulfillment and distribution services. We currently manufacture at ten facilities having an aggregate of approximately 1.0 million square feet. Of our leased manufacturing facilities, five of the facilities are located in Massachusetts and one facility is located in each of Santa Clara, California; Lawrenceville, Georgia; Corinth, Mississippi; and Dublin, Ireland. We also own a 4.4-acre tract of land and a 110,000 square foot manufacturing facility on that property in Hermosillo, Mexico. All of our manufacturing facilities have been certified to the ISO 9002 international quality standard, except our Corinth, Mississippi facility which has been certified to the ISO 9001 international quality standard. We commenced operations in a 126,000 square foot, newly leased facility in Massachusetts in the first quarter of 2000. This new facility has not been certified to the ISO 9001 or 9002 international quality standards, although we expect that it will be certified in the near future. We have signed a lease for a new 202,000 square foot facility in San Jose, California that is under construction. We plan to move our existing Santa Clara operations and the equipment and assets we purchased from GSS/Array to this new facility and expect to begin operations in this new facility in the fourth quarter of fiscal 2000. Our facilities contain 54 surface mount technology lines. We recognize revenue upon shipment to customers or otherwise, under certain contracts, when title to and reward of ownership pass to the customer. We generally do not obtain long-term purchase orders or commitments from our customers. Instead, we work closely with our customers to anticipate delivery dates and future volume of orders based on customer forecasts. The level and timing of orders placed by our customers vary due to: . customer attempts to manage inventory; . changes in the customer's manufacturing strategy; and . variation in demand for customer products due to, among other things, introduction of new products, product life cycles, competitive conditions or industry or general economic conditions. We may purchase components for product assemblies based on customer forecasts. Our policy is that customers are generally responsible for materials and associated acquisition costs in the event of a significant reduction, delay or cancellation of orders from the forecasted amounts. Recent and Pending Business and Asset Acquisitions On March 15, 2000, we entered into a Pre-Tender Agreement for the acquisition of GSS Array Technology Public Company Limited (GSS Thailand), a Thailand company publicly traded on the Stock Exchange of Thailand. Under the terms of the agreement, GSS Thailand would be delisted from the Stock Exchange of Thailand and we would then make a cash tender offer for all issued shares and outstanding options of GSS Thailand for approximately $93.0 million at the exchange rate in effect between the Thai Baht and the U.S. Dollar on March 15, 2000. We also have the option to make the cash tender offer prior to the delisting of GSS Thailand from the Stock Exchange of Thailand. Holders of approximately 23% of GSS Thailand's outstanding shares have agreed to tender their issued shares and outstanding options to ACT. We expect to close the acquisition in the third quarter of fiscal 2000, however, the acquisition is subject to various regulatory approvals and other closing conditions. We cannot assure you that these closing conditions will be satisfied, and we therefore may not consummate this acquisition of GSS Thailand on a timely basis or at all. On October 12, 1999, we acquired certain inventory and fixed assets of GSS/Array Technology, Inc., located in San Jose, California, for approximately $12.9 million in cash and the assumption of $0.6 million in liabilities, which we financed primarily from our bank credit facility. The purchase of these assets did not constitute the acquisition of a business. GSS/Array Technology, Inc. was a subsidiary of GSS Thailand. We have assumed on-going relationships with select GSS/Array domestic customers and hired select employees. See note 2 of notes to our consolidated financial statements. On July 29, 1999, we completed our merger with CMC Industries, Inc., a provider of electronics manufacturing services to OEMs in the telecommunications, computer and electronics industries. CMC operated manufacturing facilities in Santa Clara, California, Corinth, Mississippi and Hermosillo, Mexico. As a result of the merger, CMC became our wholly owned subsidiary. Under the terms of the merger agreement, each share of CMC common stock was exchanged for 0.5 of a share of our common stock and all CMC stock options were assumed by us. We issued approximately 3.9 million shares of common stock, and reserved approximately 0.9 million shares of common stock for future issuance under CMC's 1990 Equity Incentive Plan, pursuant to the merger. The merger has been accounted for as a pooling of interests. Accordingly, our consolidated financial statements for prior periods have been restated to include the operating results and financial position of CMC at the beginning of the earliest period presented. ACT prepares its consolidated financial statements on the basis of a fiscal year ending December 31 and CMC prepared its consolidated financial statements on the basis of a fiscal year ending July 31. The consolidated statements of operations, comprehensive income (loss) and cash flows for the years ended December 31, 1997 and 1998 (referred to as "fiscal" 1997 and 1998) reflect the results of operations, comprehensive income (loss) and cash flows for ACT for the years then ended combined with the results of operations and cash flows for CMC for the years ended July 31, 1997 and 1998. The consolidated balance sheet as of December 31, 1998 reflects the financial position of ACT as of that date combined with the financial position of CMC as of July 31, 1998. The consolidated statements of operations data, comprehensive income (loss) and the consolidated balance sheet data as of December 31, 1999 reflect the results of operations and financial position of ACT and CMC for the year then ended. As a result of ACT and CMC having different fiscal years, CMC's condensed consolidated results of operations and cash flows for the five-month period from August 1, 1998 through December 31, 1998 are reported separately in this Annual Report on Form 10-K. The consolidated financial statements have been adjusted to reflect the conforming of CMC's accounting policy with that of ACT's by expensing previously capitalized preoperating and start-up costs associated with CMC's Mexican manufacturing facility. The adjustment also gives effect to the tax deductibility of these expenses. See note 1 of notes to our consolidated financial statements. In June 1997, we acquired substantially all of the assets and liabilities of Electronic Systems International, located in Georgia, a provider of electronics manufacturing services to OEMs based primarily in the southeastern United States. We issued 186,100 shares of our common stock, valued at that time at approximately $5.1 million, to purchase the ESI business. In 1997, we also acquired Advanced Component Technologies Limited (formerly SignMax Limited), located in Dublin, Ireland, a provider of electronics manufacturing services primarily consisting of cable and harness assembly. We acquired this business for approximately $2.0 million in cash and assumed liabilities. We have since expanded our manufacturing facility in Ireland to include a printed circuit board operation utilizing primarily surface mount technology. The operating results of these acquired businesses are included from the dates of purchase in our consolidated statement of operations for the year ended December 31, 1997. See note 2 of notes to our consolidated financial statements. Results of Operations The following table sets forth certain consolidated statement of operations data as a percentage of net sales for each period indicated. The table and the discussion below should be read in conjunction with our consolidated financial statements and the related notes appearing elsewhere in this Annual Report on Form 10-K. We provide electronics manufacturing services to customers in the networking and telecommunications, computer and industrial and medical equipment markets. The percentage of net sales by market for fiscal 1999, 1998 and 1997 is as follows: Fiscal 1999 Compared to Fiscal 1998 Our net sales increased $103.8 million or 17.5% to $696.3 million in fiscal 1999 from $592.5 million for fiscal 1998. The increase was attributable to an expansion of business in our printed circuit board assembly service offering of $102.4 million, of which approximately $7.7 million resulted from the GSS/Array acquisition. Approximately $71.5 million of the net increase was from new customers and the remainder was due to increased business from existing customers. Net sales in the printed circuit board assembly service offering, including value-added services such as systems integration, test, repair and order fulfillment, as a percentage of net sales was approximately 95% and 94% in fiscal 1999 and 1998, respectively. Net sales in our cable and harness assembly service offering accounted for approximately 5% and 6% in fiscal 1999 and 1998, respectively. Gross profit increased $18.3 million or 50.6% to $54.4 million in fiscal 1999 compared to $36.1 million for fiscal 1998. Gross profit as a percentage of net sales, or gross margin, increased to 7.8% in fiscal 1999 from 6.1% in fiscal 1998. The increase was primarily attributable to growth in sales volume, an increase in sales with higher margins and an increase in absorption of overhead in our Mexican facility. Selling, general and administrative expenses increased $2.2 million or 7.9% to $29.5 million compared with $27.4 million for fiscal 1998. SG&A expenses as a percentage of net sales decreased to 4.2% from 4.6% in fiscal 1998. SG&A expenses increased primarily to support the larger revenue base and anticipated revenue growth. Merger costs of $5.6 million related to the July 29, 1999 merger with CMC Industries were recorded in fiscal 1999. These merger costs consisted primarily of investment banking, legal, accounting, printing, integration and other fees and expenses directly related to the merger. Operating income increased $10.5 million to $19.3 million, or 2.8% of net sales, compared with operating income of $8.8 million, or 1.5% of net sales, for fiscal 1998 as a result of the above factors. Interest and other expense, net increased $1.6 million to $5.3 million compared to $3.7 million for fiscal 1998. The increase was due to higher average working capital requirements resulting in higher average loan balances in fiscal 1999, higher interest rates during fiscal 1999 and interest on capital leases entered into in fiscal 1999. We recorded a provision for income taxes of $7.8 million and $2.0 million in fiscal 1999 and 1998, respectively. The effective income tax rate was 55.6% in fiscal 1999 and 39.8% in fiscal 1998. The increase in the fiscal 1999 effective income tax rate was primarily attributable to the effects of non- deductible merger costs. Fiscal 1998 Compared to Fiscal 1997 Our net sales increased $113.4 million or 23.7% to $592.5 million in fiscal 1998 from $479.1 million in fiscal 1997. The increase was attributed principally to an expansion of printed circuit board assembly business from existing and new customers. Customers representing 10% or more of our net sales in fiscal 1998 were Nortel Networks (12%) and Micron Electronics (12%) as compared to Nortel Networks (17%) in fiscal 1997. Net sales in the printed circuit board assembly product line, including system integration, test, repair and order fulfillment, as a percentage of net sales was approximately 94% in each of fiscal 1998 and fiscal 1997. Net sales in the cable and harness assembly product line accounted for approximately 6% of net sales in each of fiscal 1998 and fiscal 1997. Gross profit increased $11.2 million or 45.0% to $36.1 million in fiscal 1998 compared to $24.9 million in fiscal 1997. Gross margin increased to 6.1% in fiscal 1998 from 5.2% in fiscal 1997. Within fiscal 1998, gross margin was 5.0%, 5.7%, 6.9% and 7.0% in the first, second, third and fourth quarters. This sequential improvement was due primarily to the positive impact of our cost management programs and a favorable product mix offset in part by an increase in costs of materials as a percentage of cost of goods sold in our Mississippi operation. In addition, fiscal 1997 gross profit was impacted by a charge relating to an inventory shortfall identified at the end of fiscal 1997 of approximately $13.1 million which was included in cost of goods sold, and by the effect of a $989,000 write-off of certain inventory balances to cost of goods sold. Selling, general and administrative expenses increased $2.9 million or 11.7% to $27.4 million in fiscal 1998 from $24.5 million in fiscal 1997. SG&A expenses as a percentage of net sales decreased to 4.6% in fiscal 1998 from 5.1% in fiscal 1997. SG&A expenses in fiscal 1998 included a $1.3 million charge for defense and settlement of certain claims of age discrimination resulting from a September 1995 workforce reduction at CMC. Without admitting any liability, CMC agreed to enter into a Conciliation Agreement with the EEOC to settle claims related to this matter and limit future litigation costs. SG&A expenses in fiscal 1997 included a bad debt reserve of $1.7 million for terminated customers and $600,000 for costs of investigating the inventory shortfall. Although SG&A expenses decreased as a percentage of net sales, these expenses increased in absolute dollars in fiscal 1998 primarily due to our increase in net sales. Operating income increased $8.3 million to $8.8 million, or 1.5% of net sales, in fiscal 1998, compared with operating income of $420,000 in fiscal 1997 as a result of the previously discussed factors. Interest and other expense, net decreased $431,000 to $3.6 million for fiscal 1998 from $4.1 million for fiscal 1997. The decrease resulted principally from reduced average borrowings on our credit facilities and lower average interest rates in fiscal 1998 compared to fiscal 1997. We recorded a provision for income taxes of $2.0 million in fiscal 1998 compared to a benefit for income taxes of $1.2 million in fiscal 1997. The effective income tax rate was 39.8% in fiscal 1998 and 34.0% in fiscal 1997. The 1997 tax benefit was provided at 34% primarily due to the effects of non- deductible expenses and the differences in pre-tax income earned in various jurisdictions in which we do business. CMC Results of Operations for the Five Months Ended December 31, 1998 For the five months ended December 31, 1998, CMC generated gross profit of $2.7 million on total net sales of $122.4 million. The gross margin of 2.2% was lower than CMC's historical gross margin primarily because of the loss of two customers, Micron Electronics and Global Village Communications, offset by net sales to new customers and expanded business with existing customers at lower margins. Gross profit was also adversely affected by increases in manufacturing overhead costs incurred in anticipation of higher sales volumes and inefficiencies associated with the initiation of new manufacturing projects. The net loss for the five months ended December 31, 1998 of $2.1 million did not include any one time, non-recurring charges. Liquidity and Capital Resources We had working capital of $170.4 million at December 31, 1999 compared with $86.1 million at December 31, 1998. Operating activities used $48.9 million of cash in fiscal 1999 compared with cash provided by operations of $11.7 million in fiscal 1998. The primary use of cash by operating activities for fiscal 1999 was an increase in both inventory and accounts receivable, partially offset by an increase in accounts payable. Inventory increased $89.2 million to $171.8 million and accounts receivable increased $44.1 million to $153.4 million, while accounts payable increased $56.2 million to $153.8 million, as of December 31, 1999. These increases in inventory and accounts payable are the result of continued sequential quarterly revenue growth, purchasing strategies to prevent shortages of key components and reflect inventory requirements to support first quarter 2000 customer demand. The increase in accounts receivable is primarily due to sales revenue generated later in the fourth quarter of 1999 than in the fourth quarter of fiscal 1998. On July 29, 1999, we announced that we had executed an Amended and Restated Credit Agreement for a new $107.0 million Senior Secured Credit Facility with a group of banks led by The Chase Manhattan Bank as agent to replace our previous credit facilities with the banks. This new credit facility provides for a $7.0 million, five-year term loan and a $100.0 million five-year line of credit, both of which are secured by substantially all of our assets. At December 31, 1999, $41.3 million of the credit facility was utilized and an additional $58.7 million was available for use based upon the applicable borrowing base and the full term loan was utilized. At December 31, 1999, the interest rate on the $7.0 million term loan was 7.89%, the rate on $17.0 million of the line of credit was 6.76% and the rate on the remainder of the line of credit was 8.75%. The term loan amortizes at a rate of $1.0 million per year for the first year and $1.5 million per year for years two through five. We made $0.3 million in principal payments on the $7.0 million term loan in fiscal 1999. The credit facility also provides for borrowings up to an aggregate amount of $100.0 million, limited to a percentage of qualified accounts receivable and qualified inventory. Interest is payable monthly. For the term loan, we may choose an interest rate of either 2.5% above the prevailing London Interbank Offering Rate (LIBOR), or 0.5% above the prime rate as announced by the agent. For the revolving credit facility, we may choose an interest rate of either 2.25% above the prevailing LIBOR rate, or 0.25% above the prime rate as announced by the agent. In addition to certain other prohibited actions, the credit facility limits our capital expenditures and prohibits the payment of cash dividends on our common stock. The credit facility also requires us to maintain certain minimum fixed charge coverage ratios and maximum leverage ratios. We received net proceeds of $79.9 million from the sale of our common stock in fiscal 1999. On November 22, 1999, we sold 3,022,500 shares of our common stock in a public offering. Net proceeds of $73.3 million from this sale were principally used to reduce our indebtedness under our bank credit facility and for general corporate purposes. The remaining $6.6 million of net proceeds from the sale of our common stock were primarily the result of the exercise of employee stock options. We are a party to a $17.0 million interest rate swap in order to fix the interest rate on a portion of our outstanding borrowings under the bank credit facility. The swap agreement provides for payments by us at a fixed rate of interest of 6.76% and matures on October 19, 2001. The fair value of the interest rate swap at December 31, 1999 was approximately $(56,000) since the fixed rate of 6.76% was higher than the floating rate. The swap agreement was terminated on March 24, 2000. Capital expenditures of $6.7 million for fiscal 1999 were primarily for the acquisition of equipment related to operations. We lease a manufacturing facility and certain equipment and computer software used in our manufacturing operations under capital lease agreements that expire through 2003. During the first quarter of 1999, we refinanced approximately $2.6 million of our then existing operating leases and classified these leases as capital leases in the accompanying consolidated balance sheet for fiscal 1999. The effect of this refinancing on our results of operations will not differ materially from the previous lease financing arrangements. At December 31, 1999, we had equipment lease lines of approximately $13.0 million available for purchases of manufacturing equipment, computer hardware and software and furniture. We sold 575,000 shares of common stock of eOn Communications (formerly Cortelco), a related party, for net proceeds of approximately $6.4 million in the first quarter of 2000. The accounting for the gain on the sale of the eOn investment will be recorded in the fiscal 2000 financial statements. Our need for, cost of and access to funds are dependent in the long-term on our future operating results as well as conditions external to us. We may require additional capital to finance further acquisitions or other enhancements to or expansions of our manufacturing capacity. Although no assurance can be given that any additional financing will be available on terms satisfactory to us, we may seek additional funds from time to time through public or private debt or equity offerings, or through further bank borrowings or through equipment lease financing. We believe that our current sources of liquidity are adequate to support our anticipated liquidity needs for the next twelve months. Newly Issued Accounting Standards In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," amended in June 1999 and effective for fiscal years beginning after June 15, 2000. The new standard requires that all companies record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. Our management is currently assessing the impact of SFAS No. 133 on our consolidated financial statements. We will adopt this accounting standard on January 1, 2001, as required. Year 2000 Readiness Disclosure Statement We have not experienced any material disruption in our operations as a result of the Year 2000 issue, although it is possible that we could still experience such a disruption. We incurred approximately $500,000 in costs in assessing and correcting our internal hardware, software, equipment and embedded technology. We used our working capital and available lease lines to fund our Year 2000 project costs. Cautionary Statements The Private Securities Litigation Reform Act of 1995 (the Act) contains certain safe harbors regarding forward-looking statements. From time to time, information we provide or statements made by our employees may contain forward-looking information. Any statements in this Annual Report on Form 10-K that are not statements of historical fact are forward-looking statements. In some cases you can identify these statements by forward-looking words such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "should," "will," and "would" or other similar words. You should read statements that contain these words carefully because they discuss our future, expectations, contain projections of our future results of operations or of our financial position or state other forward-looking information. The following cautionary statements should be considered carefully in evaluating our business. The factors discussed in these cautionary statements, among other factors, provide examples of risks, uncertainties and events that could cause our actual results to differ materially from those contained in the forward-looking statements made in this Annual Report on Form 10-K and presented elsewhere by management from time to time. These cautionary statements are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the safe harbor provisions of the Act. Risks Related to Acquisitions We may not close the acquisition of GSS Thailand. The closing of the acquisition of GSS Thailand is subject to various closing conditions including, among other things: . the occurrence of all necessary government approvals, filings and registrations; . the shareholders of GSS Thailand voting in favor of the delisting of the ordinary shares from the Stock Exchange of Thailand and the transferability of the outstanding options to ACT, based on ACT's obligation to make the tender offer; . GSS Thailand obtaining a waiver from the Board of Investment relating to its factory premises at Ayudhaya; . no material breach of the Pre-Tender Offer Agreement before the launching of the tender offer; . no material adverse change in the business, condition (financial or otherwise) or results of operation of GSS Thailand and/or reduction in the value and/or assets of GSS Thailand (excluding changes occasioned by (i) events affecting the contract electronic manufacturing industry as a whole and (ii) fluctuations in the Baht/U.S. dollar exchange rate), prior to the launch of the tender offer by ACT; and . no proposal or offer for a tender offer for the shares of GSS Thailand which is publicly announced and, in the judgment of the board of directors of GSS Thailand, would result in a transaction more favorable to the shareholders than the ACT offer, which causes GSS Thailand's board to withdraw or adversely modify its recommendations to the shareholders and optionholders for the delisting of the shares and the acceptance of the tender offer. If the Stock Exchange of Thailand accepts the delisting application of GSS Thailand, we will be required to commence our tender offer for all issued shares and outstanding options of GSS Thailand at the price per share set forth in the Pre-Tender Agreement, and may not terminate our offer or lower the purchase price based on adverse developments in the business, condition or results of operations of GSS Thailand or otherwise. As part of the Pre-Tender Agreement, holders of approximately 23% of GSS Thailand's outstanding shares agreed to tender their shares and options in ACT's tender offer. However, we cannot assure you that these closing conditions will be satisfied or that we will consummate the acquisition of GSS Thailand on a timely basis or at all. Even if we consummate the GSS Thailand acquisition, we may not realize any of the anticipated benefits of the acquisition. Additional benefits from the merger with CMC Industries may not occur. We completed the merger with CMC Industries with the expectation that the merger would result in certain benefits, including: . the opportunity to generate revenue from new customers that require an electronics manufacturing services provider to have a minimum size and geographic coverage; . opportunities to increase revenues from our current customers by providing a lower cost alternative and a broader geographic presence; . operating efficiencies such as combined managerial, sales, marketing and technological expertise and personnel; and . other synergies due to the strategic fit and compatibility of the two companies, including their common equipment platforms and information systems. We may not realize all of the anticipated benefits of the merger. Integrating CMC's operations and personnel with our business has been and continues to be a complex and difficult process. Achieving the benefits of the merger will depend upon the successful integration of CMC's business in an efficient and timely manner. The integration of CMC with our operations could require additional costs and expenses as well as demands on management personnel. The diversion of the attention of our management and any difficulties encountered in the process of combining our companies could cause the disruption of, or a loss of momentum in, our activities. We may fail to make additional acquisitions and may not successfully integrate acquisitions we do make, which could impair our ability to compete and our operating results. In light of the consolidation trend in our industry, we intend to pursue selective acquisitions of additional electronics manufacturing services providers, facilities, assets or businesses. We may compete for acquisition opportunities with entities having significantly greater resources than us. As a result, we may not succeed in acquiring some or all of the companies, facilities, assets or businesses that we seek to acquire. Failure to consummate additional acquisitions may prevent us from accumulating sufficient critical mass required by customers in this consolidating industry. This failure could significantly impact our ability to effectively compete in our targeted markets and could negatively affect our results of operations. Moreover, acquisitions that we do complete may result in: . the potentially dilutive issuance of common stock or other equity instruments; . the incurrence of debt and amortization expenses related to goodwill and other intangible assets; or . the incurrence of significant costs and expenses. Acquisition transactions, including our pending acquisition of GSS Thailand, also involve numerous business risks, including: . difficulties in assimilating the acquired operations, technologies, personnel and products; . difficulties in managing geographically dispersed and international operations; . the diversion of management's attention from other business concerns; . the potential disruption of our business; and . the potential loss of key employees. Risks Related to Our Operations Our business may suffer if the networking and telecommunications segments of the electronics industry fail to grow and evolve. Our customer base has historically been concentrated in a limited number of segments within the electronics industry. Net sales to customers within the networking and telecommunications segments accounted for approximately 66% of our net sales in fiscal 1999, 58% in fiscal 1998, and 66% in fiscal 1997. Developments adverse to these industry segments could materially and negatively impact us. These industry segments, and the electronics industry as a whole, experience: . intense competition; . rapid technological changes resulting in short product life-cycles and consequent product obsolescence; . significant fluctuations in product demand; . economic cycles, including recessionary periods; and . consolidation. A recessionary period or other event leading to excess capacity affecting one or more segments of the electronics industry we serve would likely result in intensified price competition, reduced margins and a decrease in our net sales. The loss of major customers could adversely affect us. We depend on a small number of customers for a significant portion of our business. Our five largest customers accounted for approximately 52% of our net sales in fiscal 1999. For fiscal 1999, each of Nortel Networks (formerly Bay Networks and Aptis Communications) and S-3 Incorporated (formerly Diamond Multimedia) accounted for 10% or more of our net sales (15% and 13%, respectively). Customers representing 10% or more of our net sales in fiscal 1998 were Nortel Networks and Micron Electronics, each with approximately 12%, as compared to Nortel Networks with 17% of our net sales in fiscal 1997. The timing and level of orders from our customers varies substantially from period to period. The historic level of net sales we have received from a specific customer in one particular period is not necessarily indicative of net sales we may receive from that customer in any future period. Our results may depend on our ability to diversify our customer base and reduce our reliance on particular customers. Our major customers may not continue to purchase products and services from us at current levels or at all. In particular, we terminated our business with Ascend, which was acquired by Lucent Technologies, in the fourth quarter of fiscal 1999 and we experienced a significant decrease in sales to Micron in the third quarter of fiscal 1998. For various reasons, including consolidation in our customers' industries, we have in the past and will continue in the future to terminate or lose relationships with customers. We may not be able to expand our customer base to make up any sales shortfalls from our major customers so as to increase overall net sales. Because certain customers represent such a large part of our business, any of the following could negatively impact our business: . the loss of one or more major customers; . a significant reduction or delay in purchases from any major customer; . discontinuance by any major customer of the sale of products we manufacture; . a reduction in demand for the products of major customers that we manufacture; or . the inability or unwillingness of a major customer to pay for products and services on a timely basis or at all. Our customers do not enter into long-term purchase orders or commitments, and cancellations, reductions or delays in customer orders would adversely affect our profitability. The level and timing of orders placed by our customers vary due to: . customer attempts to manage inventory; . changes in the customers' manufacturing strategy, such as a decision by a customer to either diversify or consolidate the number of electronics manufacturing services providers used or to manufacture their products internally; and . variation in demand for customer products. We generally do not obtain long-term purchase orders or commitments from our customers. Instead, we work closely with our customers to anticipate delivery dates and future volume of orders based on customer forecasts. We rely on our estimates of anticipated future volumes when making commitments regarding: . the levels of business that we will seek and accept; . the timing of production schedules; . the purchase of materials; . the purchase or leasing of facilities and equipment; and . the levels and utilization of personnel and other resources. Customers may cancel, reduce or delay orders that were either previously made or anticipated for a variety of reasons. Significant or numerous terminations, reductions or delays in our customers' orders could negatively impact our operating results. We often purchase components for product assemblies based on customer forecasts, at times without a written customer commitment to pay for them. Our policy is that customers are generally responsible for materials and associated acquisition costs in the event of a significant reduction, delay or cancellation of orders from the forecasted amounts. A customer's unwillingness or inability to reimburse us for materials costs in the case of a significant variance from forecast could adversely affect our operating results. Increased competition may result in decreased demand or prices for our services. The electronics manufacturing services industry is highly competitive. We compete against numerous U.S. and foreign electronics manufacturing services providers with global operations, as well as those who operate on a local or regional basis. In addition, current and prospective customers continually evaluate the merits of manufacturing products internally. Consolidation in the electronics manufacturing services industry results in a continually changing competitive landscape. The consolidation trend in the industry also results in larger and more geographically diverse competitors who have significant combined resources with which to compete against us. Some of our competitors have substantially greater managerial, manufacturing, engineering, technical, financial, systems, sales and marketing resources than we do. These competitors may: . respond more quickly to new or emerging technologies; . have greater name recognition, critical mass and geographic and market presence; . be better able to take advantage of acquisition opportunities; . adapt more quickly to changes in customer requirements; and . devote greater resources to the development, promotion and sale of their services. We may be operating at a cost disadvantage compared to manufacturers who have greater direct buying power from component suppliers, distributors and raw material suppliers or who have lower cost structures. Our manufacturing processes are generally not subject to significant proprietary protection, and companies with greater resources or a greater geographic and market presence may enter our market or increase their competition with us. Increased competition from existing or potential competitors could result in price reductions, reduced margins or loss of market share. We may not be able to obtain raw materials or components for our assemblies on a timely basis or at all. We rely on a single or limited number of third-party suppliers for many proprietary and other components used in the assembly process. We do not have any long-term supply agreements. Shortages of materials and components have occurred from time to time and will likely occur in the future. In particular, we are currently experiencing a shortage in components such as tantalum and ceramic capacitors, flash memory, and dynamic and static ram. Raw materials or component shortages could result in shipping delays or increased prices which could adversely affect our ability to manufacture products for our customers on a timely basis or at acceptable cost. Moreover, the consolidation trend in our suppliers' industry results in changes in supply relationships and in the price, availability and quality of components and raw materials. Due to our utilization of just-in-time inventory techniques, the timely availability of many components is dependent on our ability to both develop accurate forecasts of customer requirements and manage the materials supply chain. If we fail to do either, our operating results may suffer. Operating in foreign countries exposes us to increased risks. We acquired in fiscal 1997, and then subsequently expanded in fiscal 1998, operations in Dublin, Ireland. As a result of our merger with CMC, we acquired operations in Hermosillo, Mexico and a procurement office in Taiwan. We may in the future expand into other international regions. We have limited experience in managing geographically dispersed operations and in operating in Europe, Mexico or Asia. We also purchase a significant number of components manufactured in foreign countries. Because of the scope of our international operations, we are subject to the following risks which could materially impact our results of operations: . economic or political instability; . transportation delays and interruptions; . foreign exchange rate fluctuations; . increased employee turnover and labor unrest; . longer payment cycles; . greater difficulty in collecting accounts receivable; . utilization of different systems and equipment; . difficulties in staffing and managing foreign personnel and diverse cultures; and . less developed infrastructures. In addition, changes in policies by the U.S. or foreign governments could negatively affect our operating results due to: . increased duties; . increased regulatory requirements; . higher taxation; . currency conversion limitations; . restrictions on the transfer of funds; . the imposition of or increase in tariffs; or . limitations on imports or exports. Also, we could be adversely affected if our host countries revise their current policies encouraging foreign investment or foreign trade. Our business could suffer if we lose the services of, or fail to attract, key personnel. Our future success largely depends upon the skills and efforts of John A. Pino, Chairman of the Board, President and Chief Executive Officer, our other key executives and our managerial, manufacturing, sales and technical employees. With the exception of Jack O'Rear, Vice President of Operations, and a small number of sales people, we have not entered into employment contracts or noncompetition agreements with any of our senior management or other key employees. We do not maintain or plan to acquire any key-man life insurance on any of our key personnel. The loss of services of any of our executives or other key personnel could negatively affect our business. Our continued growth will also require us to attract, motivate, train and retain additional skilled and experienced managerial, manufacturing, sales and technical personnel. We face intense competition for such personnel. We may not be able to attract, motivate and retain personnel with the skills and experience needed to successfully manage our business and operations. We may not be able to maintain our technological and manufacturing process expertise. The markets for our manufacturing services are characterized by rapidly changing technology and evolving process development. The continued success of our business will depend upon our ability to: . maintain and enhance our technological capabilities; . develop and market manufacturing services which meet changing customer needs; and . successfully anticipate or respond to technological changes in manufacturing processes on a cost-effective and timely basis. Although we believe that our operations utilize the assembly and testing technologies, equipment and processes currently required by our customers, we cannot be certain that we will develop capabilities required by our customers in the future. Also, the emergence of new technologies, industry standards or customer requirements may render our equipment, inventory or processes obsolete or noncompetitive. In addition, we may have to acquire new assembly and testing technologies and equipment to remain competitive. The acquisition and implementation of new technologies and equipment may require significant expense or capital investment. Our failure to anticipate and adapt to our customers' changing technological needs and requirements would have an adverse effect on our business. We may incur significant liabilities if we fail to comply with environmental regulations. We are subject to environmental regulations relating to the use, storage, discharge, site cleanup, and disposal of hazardous chemicals used in our manufacturing processes. If we fail to comply with present and future regulations, or are required to perform site remediation, we could be subject to future liabilities or the suspension of production. Present and future regulations may also: . restrict our ability to expand our facilities; . require us to acquire costly equipment; or . require us to incur other significant costs and expenses. Products we manufacture may contain design or manufacturing defects which could result in reduced demand for our services and liability claims against us. We manufacture products to our customers' specifications which are highly complex and may at times contain design or manufacturing errors or failures. Defects have been discovered in products we manufacture in the past and, despite our quality control and quality assurance efforts, defects may occur in the future. Defects in the products we manufacture, whether caused by a design, manufacturing or component failure or error, may result in delayed shipments to customers or reduced or cancelled customer orders. If these defects occur in large quantities or too frequently, our business reputation may also be impaired. In addition, these defects may result in liability claims against us. Risks Related to our Expansion Our operating results will depend on our ability to manage our growth. We have grown rapidly in recent years and we expect to continue to expand our operations. This growth has placed, and will continue to place, significant strain on our management, operations, technical, financial, systems, sales, marketing and other resources. For example, we identified a significant inventory shortfall occurring in the fourth quarter of fiscal 1997 that substantially adversely affected our operating results for that period. As a result of this shortfall, we reviewed and continue to review our security procedures and operating and financial controls. Based upon such review, we implemented enhanced security systems and inventory work-in-process tracking systems. These systems may not be adequate or have the intended results. We also implemented various cost management programs to enhance our profitability. These programs may not result in the anticipated cost savings, however. We will have to continue to invest in both our manufacturing infrastructure to expand capacity and our operational, financial, and management information systems. If we fail to manage our expected growth effectively, the quality of our services and products and our operating results could suffer significantly. Expansion of our operations may negatively impact our business. We may expand our operations by establishing or acquiring new manufacturing facilities or by expanding capacity in our current facilities. We may expand both in geographical areas in which we currently operate and in new geographical areas within the United States and internationally. We have recently begun operations in a new facility in Massachusetts and have signed a lease for a new facility in California which is currently under construction and which will enable us to consolidate and expand our operations. We expect to begin operations in this new California facility in the fourth quarter of fiscal 2000. We may not be able to find additional suitable facilities on a timely basis or on terms satisfactory to us. Expansion of operations involves numerous business risks, including: . the inability to successfully integrate additional facilities or capacity and to realize anticipated synergies, economies of scale or other value; . difficulties in the timing of expansions, including delays in the implementation of construction and manufacturing plans; . the diversion of management's attention from other business areas during the planning and implementation of expansions; . the strain placed on our operational, financial, management, technical and information systems and resources; . disruption in manufacturing operations; . the incurrence of significant costs and expenses; and . the inability to locate enough customers or employees to support the expansion. Our results of operations could be adversely affected if the revenues associated with new or expanded facilities are not sufficient to offset the increased expenditures associated with the expansions. We may fail to secure necessary additional financing. We have made and will continue to make substantial capital expenditures to expand our operations and remain competitive in the rapidly changing electronics manufacturing services industry. Our future success may depend on our ability to obtain additional financing and capital to support our continued growth and operations. We may seek to raise capital by: . issuing additional common stock or other equity instruments; . issuing debt securities; . obtaining additional lease financings; . increasing our lines of credit; or . obtaining off-balance sheet financing. We may not be able to obtain additional capital when we want or need it, and capital may not be available on satisfactory terms. If we issue additional equity securities or convertible debt to raise capital, it may be dilutive to your ownership interest. Furthermore, any additional capital may have terms and conditions that adversely affect our business, such as financial or operating covenants. Risks Related to our Common Stock We anticipate that our net sales and operating results will fluctuate which could affect the trading price of our common stock. Our net sales and operating results have fluctuated and may continue to fluctuate significantly from quarter to quarter. A substantial portion of our net sales in a given quarter may depend on obtaining and fulfilling orders for assemblies to be manufactured and shipped in the same quarter in which those orders are received. Further, a significant portion of our net sales in a given quarter may depend on assemblies configured, completed, packaged and shipped in the final weeks of such quarter. In addition to the variability resulting from the short-term nature of our customers' commitments, the following factors may contribute to such fluctuations: . fluctuations in demand for our services or the products we manufacture; . shipment delays; . interruptions in manufacturing caused by earthquakes or other natural disasters; . effectiveness in controlling manufacturing costs; . changes in cost and availability of labor and components; . inefficiencies in managing inventory and accounts receivable, including inventory obsolescence and write-offs; and . the levels at which we utilize our manufacturing capacity. Our operating expenses are based on anticipated revenue levels and a high percentage of our operating expenses are relatively fixed in the short term. As a result, any unanticipated shortfall in revenue in a quarter would likely adversely affect our operating results for that quarter. Also, changes in our product assembly mix may cause our margins to fluctuate which could negatively impact our results of operations for that period. Results of operations in any period should not be considered indicative of the results to be expected for any future period. It is likely that in one or more future periods our results of operations will fail to meet the expectations of securities analysts or investors, and the price of our common stock could decline significantly. We may incur costs and liability related to potential or pending litigation. On February 27, 1998, our company and several of our officers and directors were named as defendants in a purported securities class action lawsuit filed in the United States District Court for the District of Massachusetts. The plaintiffs amended the complaint on October 16, 1998. The plaintiffs purport to represent a class of all persons who purchased or otherwise acquired our common stock in the period from April 17, 1997 through March 31, 1998. The amended complaint alleges, among other things, that the defendants knowingly made misstatements to the investing public about the value of our inventory and the nature of our accounting practices. On December 15, 1998, we filed a motion to dismiss the case in its entirety based on the pleadings. Our motion to dismiss was granted without prejudice on May 27, 1999, and the case was closed by the court on June 1, 1999. On June 28, 1999, the plaintiffs filed a motion with the court seeking permission to file a second amended complaint. We opposed that motion. On July 13, 1999, the court denied the plaintiffs' motion to amend, noting "final judgment having entered in the case." On July 26, 1999, the plaintiffs filed a motion with the court asking the court to extend the 30-day period for filing an appeal of its ruling dismissing the case. We opposed that motion as well, and the court denied the motion on August 10, 1999. The plaintiffs have filed an appeal with the United States Court of Appeals for the First Circuit requesting that the Court of Appeals reverse each of the orders described above. The parties are currently briefing the issues before the Court of Appeals. We believe the claims asserted in this action and the plaintiffs' pending appeal are without merit and intend to continue to defend ourselves vigorously in this action. However, a material adverse judgment in such matter could cause our financial condition or operating results to suffer. In December 1993, CMC Industries retained the services of a consultant to assist in quantifying the potential exposure to CMC in connection with clean- up and related costs of a former manufacturing site. This site is commonly known as the ITT Telecommunications site in Milan, Tennessee. The consultant initially estimated that the cost to remove and dispose of the contaminated soil would be approximately $200,000. CMC subsequently entered into a voluntary agreement to investigate the site with the Tennessee Department of Environment and Conservation. In addition, CMC agreed to reimburse a tenant of the site $115,000 for expenditures previously incurred to investigate environmental conditions at the site. CMC recorded a total provision of $320,000 based on these estimates. In fiscal 1995, an environmental consultant estimated that the cost of a full study combined with short- and long-term remediation of the site may cost between $3.0 and $4.0 million. Subsequent environmental studies done in fiscal 1999 have estimated such costs as between $750,000 and $3.5 million. During CMC's fiscal 1996, the State of Tennessee's Department of Environment and Conservation named certain potentially responsible parties in relation to the former facility. CMC was not named as a potentially responsible party. However, Alcatel, Inc., a potentially responsible party named by the State of Tennessee's Department of Environment and Conservation and a former owner of CMC, sought indemnification from CMC under the purchase agreement by which CMC acquired the stock of one of the operators of the facility. To date, Alcatel has not filed any legal proceedings to enforce its indemnification claim. However, Alcatel could initiate such proceedings and other third parties could assert claims against us relating to remediation of the site. We have entered into an agreement with Alcatel pursuant to which the statute of limitations on its indemnification claim is tolled for a period of time. In the event any proceedings are initiated or any claim is made, we would defend ourselves vigorously but defense or resolution of this matter could negatively impact our financial position and results of operations. John A. Pino has significant influence over our company. John A. Pino, Chairman of the Board, President and Chief Executive Officer, and a number of trusts for his and his family's benefit, collectively beneficially owns approximately 31% of our common stock. As a result, Mr. Pino is able to exert significant influence over us through his ability to influence the election of directors and all other matters that require action by our stockholders. The voting power of Mr. Pino and these trusts could have the effect of preventing or delaying a change in control of our company, which Mr. Pino opposes even if our other stockholders believe it is in their best interests. The price of our common stock has been and may continue to be volatile. The trading price of our common stock has been and may continue to be volatile. From October 1, 1998 through March 24, 2000, our stock price has fluctuated between a low of $5.06 per share and a high of $49.31 per share. On March 24, 2000, the closing price for our common stock was $48.75. The price of our common stock may fluctuate significantly in response to a number of events and factors relating to our company, our competitors and the market for our services, many of which are beyond our control, such as: . quarterly variations in our operating results; . announcements of new technological innovations, equipment or service offerings by us or our competitors; . announcements of new products or enhancement by our customers; . changes in financial estimates and recommendations by securities analysts; and . news relating to trends in our markets. In addition, the stock market in general, and the market prices for technology companies in particular, have experienced extreme volatility that often has been unrelated to the operating performance of these companies. These broad market and industry fluctuations may adversely affect the market price of our common stock, regardless of our operating performance. Recently, when the market price of a stock has been volatile, holders of that stock have often instituted securities class action litigation against the company that issued the stock. We have been the subject of such a lawsuit. If any of our stockholders brought another securities class action lawsuit against us, we could incur substantial additional costs defending that lawsuit. The lawsuit could also divert the time and attention of our management and an adverse judgment could cause our financial condition or operating results to suffer. It may be difficult for a third party to acquire our company, and this could depress the trading price of our common stock. Massachusetts corporate law and our articles of organization and by-laws contain provisions that could have the effect of delaying, deferring or preventing a change in control of our company or our management. These provisions could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions: . authorize the issuance of "blank check" preferred stock, which is preferred stock that can be created and issued by our board of directors without prior stockholder approval, with rights senior to those of common stock; . provide for a staggered board of directors, so that it would take three successive annual meetings to replace all directors; . require unanimity for stockholder action by written consent; and . establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to changes in interest rates and foreign currency exchange primarily in our cash, debt and foreign currency transactions. We do not hold derivative financial instruments for trading or speculative purposes. We have a $107.0 million Senior Secured Credit Facility which bears interest at variable interest rates. We have a $17.0 million interest rate swap agreement which matures in October 2001 in order to reduce the impact of fluctuating interest rates on our credit facility. This swap agreement is classified as held for purposes other than trading. Under this swap agreement, we have agreed with the counterpart to pay fixed rate payments on a monthly basis, based upon an annual interest rate of 6.76%, in exchange for receiving variable rate payments on a monthly basis, calculated on an agreed-upon notional amount. Net interest payments or receipts from interest rate swaps are recorded as adjustments to interest expense in our condensed consolidated statements of operations. The swap agreement was terminated on March 24, 2000. Our exposure related to adverse movements in interest rates is primarily derived from the variable rate on the remainder of our credit facility. As of December 31, 1999, $17.0 million of the outstanding balance of $41.3 million under the credit facility was at a rate of 6.76% and the remainder of the credit facility was at an 8.75% interest rate. Based on the portion of this balance in excess of $17.0 million, an adverse change of one percent in the interest rate would cause a change in interest expense of approximately $243,000 on an annual basis. The foreign currencies to which we have exchange rate exposure are the Irish punt and the Mexican peso. International operations do not currently constitute a significant portion of our net sales or net assets. Therefore this exposure is not considered material to us. Based on a hypothetical ten percent adverse movement in interest rates and foreign currency exchange rates, the potential losses in future earnings, fair value of the risk-sensitive financial instruments and cash flows are immaterial. However, the actual effects of interest rates and foreign currency exchange rates may differ materially from the hypothetical analysis. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES The Company's Consolidated Financial Statements and the Independent Auditors' Reports thereon are presented in the following pages. The Consolidated Financial Statements filed in Item 8 are as follows: Independent Auditors' Report Report of Independent Accountants Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders ACT Manufacturing, Inc.: We have audited the consolidated balance sheets of ACT Manufacturing, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the consolidated financial statement schedule listed in the index at Item 14 (a)(2). These consolidated financial statements and consolidated financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedule based on our audits. The consolidated financial statements give retroactive effect to the merger of ACT Manufacturing, Inc. and CMC Industries, Inc., which has been accounted for as a pooling of interests as described in Note 1 to the consolidated financial statements. We did not audit the balance sheet of CMC Industries, Inc. as of July 31, 1998, or the related statements of income, stockholders' equity, and cash flows of CMC Industries, Inc. for each of the two years in the period ended July 31, 1998, which statements reflect total assets of $93,405,000 as of July 31, 1998, and total revenues of $301,955,000 and $214,485,000 for the years ended July 31, 1998 and 1997, respectively. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for CMC Industries, Inc. for 1998 and 1997, is based solely on the report of such other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ACT Manufacturing, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principals generally accepted in the United States of America. Also, in our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Deloitte & Touche LLP Boston, Massachusetts February 16, 2000, except as to Note 14 which is dated March 15, 2000 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of CMC Industries, Inc. In our opinion, the consolidated balance sheets and the related consolidated statements of income, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of CMC Industries, Inc. and its subsidiaries (not presented separately herein) at July 31, 1998, and the results of their operations and their cash flows for each of the two years in the period ended July 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers LLP - ------------------------------------------ PricewaterhouseCoopers LLP Memphis, Tennessee August 21, 1998, except as to Note 14, which is as of October 9, 1998 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of CMC Industries, Inc. In our opinion, the accompanying consolidated statements of operations, of changes in stockholders' equity and of cash flows of CMC Industries, Inc. and its subsidiaries (not presented separately herein) present fairly, in all material respects, their operations and their cash flows for the five months in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. As discussed in Note 1, CMC Industries, Inc. merged with Act Manufacturing, Inc. on July 29, 1999. The merger was accounted for as a pooling of interests. /s/ PricewaterhouseCoopers LLP ______ PricewaterhouseCoopers LLP Memphis, Tennessee June 21, 1999, except as to Note 13, which is as of July 29, 1999 ACT MANUFACTURING, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1999 and 1998 See notes to consolidated financial statements. ACT MANUFACTURING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 1999, 1998 and 1997 See notes to consolidated financial statements. ACT MANUFACTURING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1999, 1998 and 1997 See notes to consolidated financial statements. ACT MANUFACTURING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1999, 1998 and 1997 ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Nature of Business and Summary of Significant Accounting Policies Nature of Business--ACT Manufacturing, Inc. and Subsidiaries (the "Company" or "ACT") provide value-added electronics manufacturing services for original equipment manufacturers in the networking and telecommunications, computer and industrial and medical equipment markets. The Company provides original equipment manufacturers with complex printed circuit board assembly primarily utilizing advanced surface mount technology, electro-mechanical subassembly, total system assembly and integration, and mechanical and molded cable and harness assembly. Principles of Consolidation and Basis of Presentation--The consolidated financial statements include the accounts of ACT Manufacturing, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. On July 29, 1999 the Company completed a merger with CMC Industries, Inc. ("CMC") in which CMC became a wholly owned subsidiary of ACT Manufacturing, Inc. The merger has been accounted for as a pooling of interests, and accordingly, the Company's consolidated financial statements for prior periods have been restated to include the operating results, financial position and cash flows of CMC at the beginning of the earliest period presented. In connection with the pooling, ACT issued 0.5 of a share of ACT common stock for each outstanding share of CMC common stock. A total of 3.9 million shares of ACT common stock were issued in connection with the merger, and approximately 0.9 million shares of ACT common stock were reserved for the conversion of CMC's outstanding stock options. Approximately $5,601,000 in merger-related costs were charged to operations in the quarter ended September 30, 1999. ACT prepares its consolidated financial statements on the basis of a fiscal year ending December 31, and CMC prepared its consolidated financial statements on the basis of a fiscal year ending July 31. The consolidated statements of operations, comprehensive income (loss) and cash flows for the years ended December 31, 1998 and 1997 (herein referred to as "fiscal" 1998 and 1997) reflect the results of operations, comprehensive income (loss) and cash flows for ACT for the years then ended combined with CMC for the years ended July 31, 1998 and 1997, respectively. The consolidated balance sheet as of December 31, 1998 reflects the financial position of ACT as of that date combined with the financial position of CMC as of July 31, 1998. As a result of ACT and CMC having different fiscal years, CMC's condensed consolidated results of operations for the five-month period from August 1, 1998 through December 31, 1998 are reported separately. However, this condensed consolidated statement of operations data of CMC, presented below, for the period August 1, 1998 through December 31, 1998 does not reflect any adjustment to conform CMC's accounting policy with that of ACT's of expensing previously capitalized preoperating and start-up costs associated with CMC's Mexican manufacturing facility. The effect of such adjustment would be to reduce cost of goods sold by $100,000 and reduce net loss by $60,000. This adjustment also gives effect to the tax deductibility of these expenses. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Translation of Foreign Currency--The Company translates financial statements denominated in foreign currency by translating balance sheet accounts at the end of period exchange rate and statement of operations accounts at the average exchange rate for the period. Where the local currency is the functional currency, translation gains and losses are recorded as a separate component of stockholders' equity in accumulated other comprehensive income (loss) and transaction gains and losses are reflected in other income (loss) in determining net income. Where the U. S. dollar is the functional currency, all foreign currency gains and losses are included in determining net income. Use of Estimates--The preparation of the Company's consolidated financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates. Estimates include such items as reserves for accounts receivable and inventory, useful lives of other assets, goodwill, property and equipment, investment in related party and accrued liabilities. Actual results could differ from those estimates. Fair Value of Financial Instruments--Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures About Fair Value of Financial Instruments," requires disclosure of the fair value of certain financial instruments. The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value because of their short-term nature. The Company's bank debt, because it carries a variable interest rate, is stated at its approximate fair market value. Derivatives--The Company has entered into an interest rate swap that qualifies as a matched swap that is linked by designation with a balance sheet liability and has opposite interest rate characteristics of such balance sheet item. Matched interest rate swaps qualify for settlement accounting. Under settlement accounting, periodic net cash settlements under the swap agreement are recognized in income on an accrual basis. These settlements are offset against interest expense in the consolidated statements of operations. Revenue Recognition--Revenue is recognized upon shipment of the product or otherwise, under certain contracts, when title to and risks and reward of ownership pass to the customer. Cash and Cash Equivalents--The Company considers all highly liquid debt instruments purchased with original maturities of three months or less to be cash equivalents. Inventory--Inventory is stated at the lower of cost or market. Cost has been determined using the first-in, first-out ("FIFO") method for approximately 72% and 69% of the inventories at the end of fiscal 1999 and 1998, respectively, with the remaining balance determined using the last-in, first-out ("LIFO") method. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Property and Equipment--Purchased property and equipment is recorded at cost. Capital lease property and equipment is recorded at the lesser of cost or the present value of the minimum lease payments required. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the related assets (three to thirty years) and over the terms of the related leases (five years). Goodwill--Goodwill is being amortized on a straight-line basis over a period of ten to twenty years. Investment in Related Party--The carrying amount of the investment in preferred stock of a related party is based upon the present value of expected cash flows. See Note 11. Other Assets--Other assets include cash surrender value of officer's life insurance, prepaid pension expense and noncompete agreements. The noncompete agreements are being amortized over three to ten years. Warranty--The Company generally warrants that its hardware assemblies will be free from defects in workmanship for 12 months and passes on to the customer any warranties provided by component manufacturers and material suppliers to the extent permitted. Warranty costs have not been material to date. Income Taxes--The Company accounts for income taxes under SFAS No. 109, "Accounting for Income Taxes." This Statement requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the Company's consolidated financial statements or tax returns. Deferred tax liabilities and assets are determined based on the difference between the financial statement carrying amounts and tax bases of existing assets and liabilities, using enacted tax rates in effect in the years in which the differences are expected to reverse. Stock-Based Compensation--As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," the Company accounts for stock option grants using the intrinsic value method in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Net Income (Loss) Per Common Share--Basic net income (loss) per common share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted net income (loss) per common share reflects the potential dilution if common equivalent shares outstanding (common stock options and warrants) were exercised or converted into common stock unless the effects of such equivalent shares were antidilutive. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) A reconciliation of net income (loss) per common share and the weighted average shares used in the earnings per share ("EPS") calculations for fiscal years 1999, 1998 and 1997 is as follows (in thousands except per share amounts): Options and warrants to purchase 228,501, 757,296 and 1,328,774 shares of common stock were outstanding during fiscal 1999, 1998 and 1997, respectively, but were not included in the computation of diluted EPS because of either the net loss in fiscal 1997 or because the options' exercise prices were greater than the average market prices of the common stock, and therefore, their effect would be antidilutive. Supplemental Cash Flow Information--Selected cash payments and noncash activities for fiscal 1999, 1998 and 1997 were as follows (in thousands): Impairment of Long-Lived Assets--At each balance sheet date, the Company assesses whether there has been an impairment in the value of long-lived assets by determining whether projected undiscounted cash flows generated by the applicable asset exceeds its net book value as of the assessment date. At the end of fiscal 1999 and 1998, subject to changes in circumstances, there were no impairments of the Company's assets. Comprehensive Income (Loss)--The Company adopted SFAS No. 130, "Reporting Comprehensive Income" in fiscal 1998. SFAS No. 130 requires the reporting of comprehensive income (loss), which in the case of the Company, is the combination of reported net income, and the change in the cumulative translation adjustment and the change in the minimum pension liability, which is a component of stockholders' equity. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Recently Issued Financial Accounting Standard--In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," amended in June 1999 and effective for fiscal years beginning after June 15, 2000. The new standard requires that all companies record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. Management is currently assessing the impact of SFAS No. 133 on the consolidated financial statements of the Company. The Company will adopt this accounting standard on January 1, 2001, as required. 2. Acquisitions of Businesses and Assets Business Acquisitions Effective June 9, 1997, the Company acquired substantially all of the assets and liabilities of Electronics Systems International ("ESI") located in Georgia. ESI is an electronics manufacturing services provider to customers throughout the southeastern United States. Under the terms of the purchase agreement, the Company acquired assets and liabilities of ESI in exchange for 190,546 shares of the Company's common stock plus acquisition costs. In 1998 the Company cancelled 4,446 shares previously issued and held in escrow. The per share market value of the Company's common stock on the date of the purchase was $27.50. Effective June 10, 1997, the Company acquired substantially all of the outstanding stock of Advanced Component Technologies Limited (formerly SignMax Limited), a cable and harness manufacturing company based in Dublin, Ireland. Under the terms of the purchase agreement, approximately 82% of the outstanding common shares of Advanced Component Technologies Limited (formerly SignMax Limited) were acquired for cash of $1,000,000 plus acquisition costs. Effective June 27, 1997, the Company acquired all of the outstanding stock of SignMax America, LLC, which owned the remaining 18% of Advanced Component Technologies Limited (formerly SignMax Limited). Under the terms of the purchase agreement, 100% of the outstanding common shares were acquired for cash of $460,000 and the assumption of $575,000 in notes payable. The ESI and SignMax transactions were accounted for as purchases in accordance with APB Opinion No. 16, "Business Combinations," as follows (in thousands): The operating results of the ESI and SignMax acquired businesses from the dates of purchase are included in the Company's Consolidated Statement of Operations for fiscal 1997. The Consolidated Statement of Operations for fiscal 1998 includes a full year of operations of these acquired businesses. Pro forma information ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) has not been provided, as the operations of the acquired businesses were not material to the consolidated results of operations or financial position of the Company in fiscal 1997. The Company attributes the goodwill to the expected ability to expand sales in these new geographic markets, utilizing the acquired existing business infrastructure and geographic market presence as a basis for expansion. Accumulated amortization on these acquisitions amounted to approximately $1,082,000 and $640,000 at the end of fiscal 1999 and 1998, respectively. Asset Acquisition Effective October 12, 1999, the Company acquired certain inventory and fixed assets of GSS/Array Technology, Inc. located in San Jose, California, a subsidiary of GSS Array Technology Public Company Limited, a Thailand company. Under the terms of the purchase agreement, the Company assumed on going relationships with select GSS/Array domestic customers. The Company paid approximately $12,875,000 in cash and assumed $618,000 in liabilities in connection with this asset purchase. The fair value of the assets purchased was approximately $8,879,000. The Company recorded $4,614,000 as the excess of the asset purchase price over the fair value of assets purchased. The operating results following the Company's purchase of the selected GSS/Array assets from the date of purchase are included in the Company's Consolidated Statement of Operations for fiscal 1999. The Company attributes the goodwill to the expected future economic benefits the acquisition of these assets is expected to provide. Accumulated amortization on the acquisition of these assets amounted to approximately $96,000 in fiscal 1999. 3. Inventory Inventory consisted of the following at fiscal year end 1999 and 1998 (in thousands): The carrying value of inventory approximates replacement cost. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 4. Property and Equipment Property and equipment consisted of the following at fiscal year end 1999 and 1998 (in thousands): Included in property and equipment is a manufacturing facility and certain equipment held under capital leases with a net carrying value of $5,745,000 and $1,615,950 at the end of fiscal 1999 and 1998, respectively. The Company has capitalized interest in the amount of $40,000 and $171,000 at the end of fiscal 1999 and 1998, respectively, related to the construction- in-progress. 5. Indebtedness On July 29, 1999, the Company executed an Amended and Restated Credit Agreement for a new $107.0 million Senior Secured Credit Facility ("Credit Facility") with a group of banks led by The Chase Manhattan Bank as agent ("Agent") to replace the Company's previous credit facilities with the banks. This new Credit Facility provides for a $7.0 million, five-year Term Loan ("Term Loan") and a $100.0 million, five-year Line of Credit ("Revolving Credit Facility"), both of which are secured by substantially all of the assets of the Company. The Term Loan shall amortize at a rate of $1.0 million per year for the first year and $1.5 million per year for years two through five. The Revolving Credit Facility provides for borrowings up to an aggregate amount of $100.0 million, limited to a certain percentage of qualified accounts receivable and qualified inventory. Interest is payable monthly. For the Term Loan, the Company may choose an interest rate of either (i) 2.5% above the prevailing London Interbank Offering Rate ("LIBOR"), or (ii) 0.5% above the prime rate as announced by the Agent. For the Revolving Credit Facility, the Company may choose an interest rate of either (i) 2.25% above the prevailing LIBOR rate, or (ii) 0.25% above the prime rate as announced by the Agent. In addition to certain other prohibited actions, the Credit Facility limits capital expenditures by the Company and prohibits the payment of cash dividends on the Company's common stock. The Credit Facility requires the Company to maintain certain minimum fixed charge coverage ratios and maximum leverage ratios. Outstanding borrowings under the Credit Facility are secured primarily by the Company's accounts receivable, inventories, machinery and equipment. The interest rates on the Term Loan and the Credit Facility were 7.89% and 8.75%, respectively, at December 31, 1999. The balances outstanding under the Term Loan and the Credit Facility at December 31, 1999 were $6.8 million and $41.3 million, respectively, and $58.7 million was available for borrowing under the Credit Facility. Previously, the Company had a total credit facility at the end of fiscal 1998 of $90.0 million including a $55.0 million Senior Secured Credit Facility ("Senior Credit Facility") with a financial institution and a $35.0 million Loan and Security Agreement with another financial institution. The Company executed the $55.0 million Senior Credit Facility in fiscal 1998 to replace the $50.0 million Loan and Security Agreement then outstanding. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The Company entered into a $17.0 million interest rate swap agreement in fiscal 1998 simultaneous with the execution of the Senior Credit Facility. The swap agreement provides for payments by the Company at a fixed rate of interest of 6.76% and matures on October 19, 2001. The fair value of the interest rate swap at December 31, 1999 was approximately $(56,000) since the fixed rate of interest of 6.76% was higher than the floating rate. The aggregate annual maturities of long-term debt at the end of fiscal 1999 are as follows (in thousands): 6. Other Long-Term Liabilities Other long-term liabilities consisted of the following at fiscal year end 1999 and 1998 (in thousands): Noncompete Covenant--In 1993, the Company entered into an agreement with its former sole stockholder, which provides for monthly payments over a ten-year period, in return for a promise not to compete. The liability is recorded at the present value of the required future payments at an interest rate of 8%. Deferred Revenue--The Company received grants of $540,000 and $483,000 in fiscal 1999 and 1998, respectively, under an agreement with the Ireland Industrial Development Agency. These payments have been recorded as deferred revenue at the end of fiscal 1999 and 1998 since the Company will be required to return the grants if certain conditions, including employment levels, are not met by December 31, 2002. Facility and Equipment Leases--The Company leases a manufacturing facility and certain equipment and computer software used in its manufacturing operations under capital lease agreements that expire through 2003. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Other long-term liabilities at the end of fiscal 1999 are due as follows (in thousands): 7. Income Taxes The provisions (benefit) for income taxes for fiscal years 1999, 1998 and 1997 are as follows (in thousands): Deferred income tax assets (liabilities) are attributable to the following for fiscal years 1999 and 1998 (in thousands): The net deferred tax liability is classified as follows at the end of the fiscal years 1999 and 1998 (in thousands): ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) No valuation allowance is required as the deferred tax assets are expected to be fully realized. A reconciliation of the expected tax rate at the U.S. statutory rate to the effective tax rate for the fiscal years indicated is as follows: For state income tax purposes, the Company has utilized all net operating loss carryforwards as of fiscal year end 1999. 8. Capital Stock Stock Option Plans The Company has the 1995 Stock Plan, which provides for the grant of incentive and nonqualified stock options to purchase up to an aggregate of 2,250,000 shares. The Company has a 1995 Non-Employee Director Stock Option Plan that provides for the grant of options to purchase a maximum of 100,000 shares to nonemployee directors of the Company. The Company also has the 1993 Incentive Stock Option Plan under which options for up to 690,664 shares of common stock may be granted at an exercise price not less than fair market value at the date of grant. CMC's 1990 Equity Incentive Plan provides for the granting of options to purchase a maximum of 950,052 shares. Options granted under CMC's 1990 Equity Incentive Plan were converted to ACT options in conjunction with the pooling. Such activity is incorporated in the activity below. Stock option activity for the fiscal years indicated was as follows: ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The options generally vest over three- to five-year periods. The Company has reserved shares for future grants of common stock for issuance pursuant to the 1993 Incentive Stock Option Plan, 1995 Non-Employee Director Stock Option Plan, the 1995 Stock Plan and the 1990 Equity Incentive Plan for 450,800, 66,000, 1,012,600 and 209,400 shares, respectively. In January 1998 the Board of Directors approved a vote to reprice 516,500 employee stock options. The options were originally issued between March 1997 and October 1997 and had original grant prices ranging between $14.44 and $39.25. The grant price for these options was lowered to $13.94, which reflects the market value of the stock as of the reprice date. The repriced options continue to vest according to the original grant date. No compensation expense was required to be recorded in the Consolidated Statements of Operations. As described in Note 1, the Company uses the intrinsic value method to measure compensation expense associated with grants of stock options to employees. Had the Company used the fair value method to measure compensation for grants made after fiscal 1995, (including the repricing described above) pro forma net income (loss) and net income (loss) per share for fiscal years indicated would have been as follows (in thousands, except per share data): The fair value of options on their grant date was measured using the Black/Scholes option-pricing model. Key assumptions used to apply this pricing model for the fiscal years indicated are as follows: It should be noted that the option-pricing model used was designed to value readily tradable stock options with relatively short lives. The options granted to employees are not tradable and have contractual lives of up to ten years. However, management believes that the assumptions used to value the options and the model applied yield a reasonable estimate of the fair value of the grants made under the circumstances. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Private Placement In 1998, CMC issued 250,000 shares of stock to two members of the board of directors in a private placement. Proceeds from the issuance totaled $3,620,000. The purchase price equaled the fair market value of the stock issued. Capitalization On May 16, 1996, CMC issued 218,018 shares of common stock with detachable warrants that entitle the holders to purchase 84,481 shares of common stock at a price of $15.00 per share. The total proceeds for the shares and warrants issued were $2,464,000 and $44,000, respectively. Due to the Company meeting specified levels of financial performance, the warrants were called during fiscal 1997. Total proceeds from the exercise of the warrants were $1,267,000. Stock Purchase Plan On November 15, 1996, CMC's stockholders approved the Employee Stock Purchase Plan ("ESPP"). The ESPP allowed eligible employees the right to purchase common stock on a semi-annual basis at the lower of 85% of the market price at the beginning or end of each offering period. This plan was terminated as a result of the merger of ACT and CMC on July 29, 1999. Common Stock and Stock Option Plan Amendments On July 29, 1999, the Company's shareholders approved an amendment to the Restated Articles of Organization of ACT Manufacturing, Inc. to increase the number of authorized shares of the Company's common stock, $0.01 par value, from 30,000,000 to 50,000,000. Also on July 29, 1999, the Company's shareholders approved an amendment to the 1995 Stock Plan increasing the aggregate number of shares which may be issued from 1,250,000 to 2,250,000 shares. 9. Employee Benefit Plans Retirement Benefits In 1999, the Company adopted SFAS No. 132, "Employers' Disclosures about Pension and Other Postretirement Benefits." The provisions of SFAS No. 132 provide new disclosure requirements for pensions and other postretirement benefit plans, but do not change the measurement or recognition of these plans. SFAS 132 standardizes the disclosure requirements for pensions and other postretirment benefits to the extent practicable and requires additional information on the changes in benefit obligations and fair values of plan assets. CMC maintains a defined benefit pension plan (the "Pension Plan") which covers certain hourly employees at one plant. Retirement benefits under the Pension Plan are based on an employee's length of service and a benefit formula based on year of hire. The benefit formula does not include a provision for increases in further compensation levels. Contributions to the Pension Plan are primarily based on the projected unit actuarial cost method. The Pension Plan's assets consist principally of short-term U.S. government instruments and pooled fixed income, debt and equity investment funds with several financial institutions. Effective June 1, 1994, the Company terminated the future service payments for employees; accordingly, salary increase assumptions are not applicable. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The components of net periodic pension cost and related assumptions for fiscal years 1999, 1998 and 1997 were as follows (in thousands): The following table sets forth changes in the projected benefit obligation and changes in the value of Plan assets at fiscal year end (in thousands): Under SFAS No. 87, the portion of deferred gains and losses in excess of 10% of the projected benefit obligation is amortized as a component of net periodic pension cost. If amortization is required, the period used is the average remaining service period of active employees, which was approximately 12.39 years as of December 31, 1999. Savings Plans During fiscal 1994, the Company adopted a savings plan for its employees pursuant to Section 401(k) of the Internal Revenue Code. Substantially all employees are eligible to participate, and the plan allows a deferral ranging from a minimum of 1% to the maximum percentage of compensation permitted by law. Company ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) contributions to the plan are at the discretion of the Board of Directors. Contributions to the Plan were $0, $0 and $50,000, in fiscal 1999, 1998 and 1997, respectively. CMC had a profit sharing savings plan (the "Savings Plan") for employees of CMC. Under the terms of the Savings Plan, employees may contribute from 2% to 16% of compensation and an additional elective amount. Effective June 30, 1994, the Company terminated matching employee contributions. The Company may also elect to make an additional discretionary profit sharing contribution. Effective January 1, 1996, the Savings Plan eligibility requirements were amended to include all full-time employees with one hour of service. The Company recorded no contributions in fiscal 1999, 1998 and 1997. Medical Care and Disability Benefit Plans The Company is self-insured with respect to certain medical care and disability benefit plans for a percentage of its employees. The costs for such plans are charged against earnings in the period incurred. The liability for healthcare claims was $605,000 and $661,000 at fiscal year end 1999 and 1998 respectively, and the related expense incurred was $4,774,000, $4,265,000 and $4,897,000 for fiscal 1999, 1998 and 1997, respectively. The Company does not provide benefits under these plans to retired employees. 10. Major Customers and Operating Data Sales to Nortel Networks (formerly Bay Networks and Aptis Communication) and S-3 Corporation (formerly Diamond Multimedia) were 15% and 13%, respectively, of the Company's fiscal 1999 net sales. In fiscal 1998, sales to Nortel Networks and Micron Electronics were each approximately 12% of the Company's net sales. In fiscal 1997 Nortel Networks accounted for approximately 17% of the Company's net sales. All such sales relate to the printed circuit board assembly service offering of the Company's business. The Company operates as a single segment within the electronics manufacturing services industry. A summary of the net sales for the Company's principal service offerings for fiscal 1999, 1998 and 1997 are as follows (in thousands): 11. Transactions With Related Parties The Company leases certain facilities and equipment from a realty trust controlled by its principal stockholder under leases that expire in fiscal 2003. These commitments are included in Note 12. The Company pays all operating costs of the building. Total payments to the realty trust were approximately $388,000, $388,000 and $364,000 in fiscal 1999, 1998 and 1997, respectively. In fiscal 1993, the Company entered into a ten-year agreement with one of its directors for future consulting services. Payments under the agreement were approximately $302,000, $280,000 and $259,000 in fiscal 1999, 1998 and 1997, respectively. Future commitments under this agreement are approximately $326,000 in fiscal 2000, $352,000 in fiscal 2001, $380,000 in fiscal 2002 and $233,000 in fiscal 2003. The agreement expires in fiscal 2003. A noncompete agreement was also entered into with the same individual (see Notes 1 and 6). Payments under this agreement were $79,000, $73,000 and $68,000 in fiscal 1999, 1998 and 1997, respectively, with future payments totaling $279,000. All of these payments were charged to the statement of operations in the year they were incurred. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) In August 1993, CMC transferred certain assets and related liabilities associated with its telephone business to Cortelco Systems Holding Corporation ("Cortelco"). Under a manufacturing services agreement which expired in fiscal 1998, CMC provided manufacturing services to Cortelco on a turnkey basis with prices based on cost plus 8% for telephone products and cost plus 10% for telecommunications systems products. Included in net sales for fiscal 1999, 1998 and 1997 were sales to Cortelco totaling $25,221,000, $26,436,000 and $31,312,000, respectively. Total cost of sales for the same periods relating to these sales to Cortelco were $23,203,000, $24,321,000 and $28,807,000, respectively. CMC continues to provide services to Cortelco with prices negotiated on a per contract basis. In July of 1998, CMC converted certain accounts receivable from Cortelco totaling $2,000,000 into a note receivable. Under the terms of the note, Cortelco agrees to pay the balance over a three-year term with monthly payments of $50,000 plus interest. Interest accrues on the note at a rate of 9.0% per annum. CMC continues to provide credit for manufacturing services sold to Cortelco in the form of trade receivables. In connection with the August 1993 transfer of assets and related liabilities to Cortelco, CMC received preferred stock in Cortelco. The Cortelco preferred stock was non-voting, had a liquidation preference of $12.50 per share and entitled the Company to dividends which were non- cumulative until August 1995 and thereafter cumulative at $0.75 per share for each year in which Cortelco earned net income of $2.0 million or more. The Company could, subject to certain restrictions, require Cortelco to redeem the preferred stock, on a pro rata basis, over a five-year period beginning August 1999. The Company recorded the preferred stock at fair value, $5,884,000 in 1995, based on the discounted cash flow of the redemption requirements. The excess cost basis of the net assets over the fair value of the preferred shares received was recorded as a distribution of capital to CMC's stockholders. In March 1999, the Company consented to a restructuring of certain assets of Cortelco. In connection with this restructuring, Cortelco distributed common stock of Cortelco Systems, Inc. to its stockholders on a pro rata basis. Pursuant to this distribution, CMC received its pro rata share which was equal to 6,125,302 shares of common stock of Cortelco Systems. During the fourth quarter of 1999, Cortelco Systems effected a 1-for-10 reverse stock split. The Company's investment in Cortelco was 612,530 shares as a result of this stock split. Also in the fourth quarter of 1999, Cortelco Systems changed its corporate name to eOn Communications Corporation ("eOn") and filed a Form S-1 for the initial public offering of common stock. On February 4, 2000, eOn completed an initial public offering of its common stock and the Company sold 575,000 shares of common stock in eOn for approximately $6.4 million. The accounting for the gain on the sale of the eOn investment will be recorded in the fiscal 2000 financial statements. ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 12. Operating Lease Commitments The Company leases various plant and office equipment under noncancelable operating leases expiring through 2007. Rent expense in fiscal 1999, 1998 and 1997 was approximately $17,628,000, $14,276,000 and $9,361,000, respectively. The future minimum rental payments under these leases over the next five years are approximately as follows (in thousands): The Company has equipment lease lines of approximately $13.0 million available for purchases of manufacturing equipment, computer hardware and software and furniture. 13. Contingencies On June 15, 1999, we received written notice from legal counsel for the Lemelson Medical, Education & Research Foundation, Limited Partnership alleging that we were infringing certain patents held by the Lemelson Foundation Partnership and offering to license such patents to us. We entered into a perpetual patent license agreement with the Lemelson Foundation Partnership in February 2000. On February 27, 1998, the Company and several of the Company's officers and directors were named as defendants in a purported securities class action lawsuit filed in the United States District Court for the District of Massachusetts. The plaintiffs amended the complaint on October 16, 1998. The plaintiffs purport to represent a class of all persons who purchased or otherwise acquired our common stock in the period from April 17, 1997 through March 31, 1998. The amended complaint alleges, among other things, that the defendants knowingly made misstatements to the investing public about the value of the Company's inventory and the nature of its accounting practices. On December 15, 1998, the Company filed a motion to dismiss the case in its entirety based on the pleadings. The Company's motion to dismiss the purported securities class action lawsuit was granted without prejudice on May 27, 1999 and the case was closed by the court on June 1, 1999. On June 29, 1999, the plaintiffs filed a motion with the court seeking permission to file a second amended complaint. The Company opposed that motion. On July 13, 1999, the court denied the plaintiffs' motion to amend, noting "final judgment having entered in the case." On July 26, 1999, the plaintiffs filed a motion with the court asking the court to extend the 30-day period for filing an appeal of its ruling dismissing the case. The Company opposed that motion as well, and the court denied the motion on August 10, 1999. The plaintiffs have filed an appeal with the United States Court of Appeals for the First Circuit requesting that the Court of Appeals reverse each of the orders described above. The parties are currently briefing the issues before the Court of Appeals. The Company believes the claims asserted in this action, and the plaintiffs' pending appeal, are without merit and intends to continue to defend itself vigorously in this action. The Company further believes that this litigation will not have a material adverse effect on the Company's business and results of operations, although the Company cannot assure you as to the ultimate outcome of these matters. In December 1993, CMC Industries retained the services of a consultant to assist in quantifying the potential exposure to CMC in connection with clean- up and related costs of a former manufacturing site. This site is ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) commonly known as the ITT Telecommunications site in Milan, Tennessee. The consultant initially estimated that the cost to remove and dispose of the contaminated soil would be approximately $200,000. CMC subsequently entered into a voluntary agreement to investigate the site with the Tennessee Department of Environment and Conservation. In addition, CMC agreed to reimburse a tenant of the site $115,000 for expenditures previously incurred to investigate environmental conditions at the site. CMC recorded a total provision of $320,000 based on these estimates. In fiscal 1995, an environmental consultant estimated that the cost of a full study combined with short- and long-term remediation of the site may cost between $3.0 and $4.0 million. Subsequent environmental studies done in 1999 have estimated such costs as between $750,000 and $3.5 million. During CMC's fiscal 1996, the State of Tennessee's Department of Environment and Conservation named certain potentially responsible parties in relation to the former facility. CMC was not named as a potentially responsible party. However, Alcatel, Inc., a potentially responsible party named by the State of Tennessee's Department of Environment and Conversation and a former owner of CMC, sought indemnification from CMC under the purchase agreement by which CMC acquired the stock of one of the operators of the facility. To date, Alcatel has not filed any legal proceedings to enforce its indemnification claim. However, Alcatel could initiate such proceedings and other third parties could assert claims against us relating to remediation of the site. We have entered into an agreement with Alcatel pursuant to which the statute of limitations on its indemnification claim is tolled for a period of time. In the event any proceedings are initiated or any claims made, the Company would defend itself vigorously but defense or resolution of this matter could negatively impact the Company's financial position and results of operations. In connection with a fiscal 1996 staff reduction by CMC, a number of terminated employees subsequently claimed that CMC had engaged in age discrimination in their dismissal and sought damages of varying amounts. CMC defended the actual and threatened claims vigorously during fiscal 1998 incurring approximately $275,000 in legal costs over the course of the year. On August 6, 1998, a judgment was rendered in favor of one plaintiff, in the amount of $127,000 which CMC subsequently settled for $112,000. A second plaintiff's claim for $53,000 was filed and subsequently settled for $48,500. The Equal Employment Opportunity Commission ("EEOC") negotiated with CMC to reach a monetary settlement for other potential claimants. Without admitting any liability, CMC entered into a Conciliation Agreement with the EEOC and agreed to pay approximately $500,000 to settle all such claims and limit future litigation costs. As a result of these events and the significant ongoing costs to defend these claims, in October 1998, CMC concluded that its interest would be best served to settle all such matters. CMC reserved $975,000 to resolve all such claims, which represented its best estimate of funds to ultimately be paid to such claimants. This charge was recorded in CMC's fiscal year ended July 31, 1998. From time to time, the Company is also subject to claims or litigation incidental to its business. The Company does not believe that any incidental claims or litigation will have a material adverse effect on its results of operations. 14. Subsequent Event On March 15, 2000, the Company signed a pre-tender agreement (the "Agreement") to acquire GSS Array Technology Public Company Limited ("GSS Thailand"). As part of the Agreement, certain of GSS Thailand's principal shareholders have agreed to tender all their issued shares and outstanding options to the Company. GSS Thailand is a Thai-based contract electronics manufacturing company and is listed on the Stock Exchange of Thailand. The acquisition is subject to various closing conditions and is expected to close in the third quarter of fiscal 2000. Under the terms of the Agreement, GSS Thailand would be delisted from the Stock Exchange of Thailand and ACT would make a cash tender offer for all issued shares and outstanding options of GSS Thailand for ACT MANUFACTURING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) approximately $93.0 million in cash. Upon the closing of the acquisition, ACT would assume on-going relationships with GSS Thailand customers and will retain certain GSS Thailand management to support this additional operation. 15. Selected Quarterly Financial Data (unaudited): Summarized quarterly financial data are as follows (in thousands, except per share amounts): The Company's third quarter fiscal 1999 net loss includes $5,601,000 of non- tax deductible merger costs incurred in connection with the Company's merger with CMC. * * * * * ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III Anything herein to the contrary notwithstanding, in no event are the sections entitled "Stock Performance Graph" and "Compensation Committee and Stock Option Committee Report on Executive Compensation" to be incorporated by reference herein from the Company's definitive proxy statement for the Company's 2000 Annual Meeting of Stockholders which will be filed with the Commission within 120 days after the close of the fiscal year (the "Definitive Proxy Statement"). ITEM 10. ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT Certain information concerning the directors of the Company is incorporated by reference herein from the information contained under the heading "Election of Directors" in the Company's Definitive Proxy Statement. Certain information concerning directors and executive officers of the Company is incorporated by reference herein from the information contained under the heading "Occupations of Directors and Executive Officers" in the Company's Definitive Proxy Statement. The information concerning compliance with Section 16(a) of the Exchange Act required under this item is incorporated herein by reference from the information contained under the heading "Section 16 Reporting" in the Company's Definitive Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Certain information concerning executive compensation is incorporated by reference herein from the information contained under the heading "Compensation and Other Information Concerning Directors and Executive Officers" in the Company's Definitive Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Certain information concerning security ownership of certain beneficial owners and management is incorporated by reference herein from the information contained under the heading "Securities Ownership of Certain Beneficial Owners and Management" in the Company's Definitive Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Certain information concerning certain relationships and related transactions is incorporated by reference herein from the information contained under the heading "Certain Relationships and Related Transactions" in the Company's Definitive Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Index To Consolidated Financial Statements The following Consolidated Financial Statements of the Registrant are filed as part of this report: Independent Auditors' Report Report of Independent Accountants Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997. Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements (a)(2) Index to Consolidated Financial Statement Schedules The following Consolidated Financial Statement Schedule of the Registrant is filed as part of this report: Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the accompanying consolidated financial statements or Notes thereto. (a)(3) Index to Exhibits - -------- (1) Incorporated herein by reference to the exhibits to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (2) Incorporated herein by reference to the exhibits to the Company's Registration Statement on Form S-1 (File No. 33-89532), as amended. (3) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1996. (4) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1996. (5) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1998. (6) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1998. (7) Incorporated herein by reference to the exhibits to the Company's Registration Statement on Form S-8 (File No. 333-84231). (8) Incorporated herein by reference to the exhibits to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. (9) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1999. (10) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1999. (11) Incorporated herein by reference to the exhibits to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1999. * Filed herewith. (b) REPORTS ON FORM 8-K Not applicable. (c) EXHIBITS The Company hereby files as part of this Annual Report on Form 10-K the exhibits listed in Item 14(a)(3) above. Exhibits which are incorporated herein by reference can be inspected and copied at the public reference facilities maintained by the Commission, 450 Fifth Street, NW, Room 1024, Washington, D.C. and at the Commission's regional offices at 219 South Dearborn Street, Room 1204, Chicago, Illinois; 26 Federal Plaza, Room 1102, New York, New York and 5757 Wilshire Boulevard, Suite 1710, Los Angeles, California. Copies of such material can also be obtained from the Public Reference Section of the Commission, 450 Fifth Street, NW, Washington, D.C. 20549, at prescribed rates. (d) FINANCIAL STATEMENT SCHEDULES The Company hereby files as part of this Annual Report on Form 10-K the consolidated financial statement schedules listed in Item 14(a)(2) above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ACT Manufacturing, Inc. Date: March 28, 2000 /s/ John A. Pino By: _________________________________ John A. Pino President and Chief Executive Officer POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints John A. Pino and Jeffrey B. Lavin, jointly and severally, his attorney-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SCHEDULE II ACT MANUFACTURING, INC. Valuation and Qualifying Accounts and Reserves For the years ended December 31, 1999, 1998 and 1997 S-1

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1999

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ITEM 1. DESCRIPTION OF BUSINESS BACKGROUND Revlon, Inc. (and together with its subsidiaries, the "Company") conducts its business exclusively through its direct subsidiary, Revlon Consumer Products Corporation and its subsidiaries ("Products Corporation"). The Company manufactures, markets and sells an extensive array of cosmetics and skin care, fragrances and personal care products ("consumer products"). REVLON is one of the world's best known names in cosmetics and is a leading mass market cosmetics brand. The Company believes that its global brand name recognition, product quality and marketing experience have enabled it to create one of the strongest consumer brand franchises in the world, with products sold in approximately 175 countries and territories. The Company's products are marketed under such well-known brand names as REVLON, COLORSTAY, REVLON AGE DEFYING, ALMAY and ULTIMA II in cosmetics; MOON DROPS, ETERNA 27, ULTIMA II and JEANNE GATINEAU in skin care; CHARLIE and FIRE & ICE in fragrances; and FLEX, OUTRAGEOUS, MITCHUM, COLORSTAY, COLORSILK, JEAN NATE, PLUSBELLE, BOZZANO and COLORAMA in personal care products. To further strengthen its consumer brand franchises, the Company markets each core brand with a distinct and uniform global image, including packaging and advertising, while retaining the flexibility to tailor products to local and regional preferences. The Company was founded by Charles Revson, who revolutionized the cosmetics industry by introducing nail enamels matched to lipsticks in fashion colors over 65 years ago. Today, the Company has leading market positions in many of its principal product categories in the United States self-select distribution channel. The Company's leading market positions for its REVLON brand products include the number one positions in lip makeup and nail enamel (which the Company has occupied for the past 23 years), with the top three selling brands of lip makeup for 1999. The REVLON brand captured in 1996 and continued to hold in 1999 the number one position overall in color cosmetics (consisting of lip, eye and face makeup and nail enamel) in the United States self-select distribution channel, where its market share was 19.7% for 1999. The Company also has leading market positions in several product categories in certain markets outside of the United States, including in Argentina, Australia, Brazil, Canada, Mexico and South Africa. All United States market share and market position data herein for the Company's brands are based upon retail dollar sales, which are derived from A.C. Nielsen data. A.C. Nielsen measures retail sales volume of products sold in the United States self-select distribution channel. Such data represent A.C. Nielsen's estimates based upon data gathered by A.C. Nielsen from market samples and are therefore subject to some degree of variance. In the United States, the self-select distribution channel includes independent drug stores and chain drug stores (such as Walgreens, CVS, Eckerds, Rite Aid and Longs), mass volume retailers (such as Wal-Mart, Target Stores and Kmart) and supermarkets and combination supermarket/drug stores (such as Albertson's, Kroger and H.E. Butt). Internationally, the self-select distribution channel includes retailers such as Boots in the United Kingdom and Western Europe, Shoppers Drug Mart in Canada and Wal-Mart worldwide. The foregoing retailers, among others, sell the Company's products. RECENT DEVELOPMENTS On October 1, 1999 the Company announced that it had completed its review of strategic alternatives to maximize shareholder value and had decided to pursue the sale of its worldwide professional products line and its non-core Latin American brands Colorama, Juvena, Bozzano and Plusbelle. On March 30, 2000, the Company completed the disposition of its worldwide professional products line, including professional hair care products for use in and resale by professional salons, ethnic hair and personal care products, Natural Honey skin care and certain regional toiletries brands. Proceeds from the sale were $315 million in cash, (before adjustments), plus $10 million in contingent consideration based upon the business' future performance. A portion of the net proceeds of approximately $150.3 million was used to reduce the aggregate commitment under the Credit Agreement (as described below) and the balance will be available for general corporate purposes. On March 28, 2000, Products Corporation executed a definitive agreement for the sale of its non-core Plusbelle brand in Argentina for $46.5 million in cash. The closing of the sale, which is expected to occur during the second quarter, is subject to various conditions. A portion of the net proceeds of the sale will be used to reduce the aggregate commitment under the Credit Agreement and the balance will be available for general corporate purposes. The Company continues to pursue the sale of its non-core Colorama, Juvena and Bozzano brands in Brazil and is in discussions with prospective purchasers. If a transaction is consummated, a portion of the net proceeds will be applied to reduce the aggregate commitment under the Credit Agreement and the balance will be available for general corporate purposes. In the fourth quarter of 1998, the Company committed to a restructuring plan to realign and reduce personnel, exit excess leased real estate, realign and consolidate regional activities, reconfigure certain manufacturing operations and exit certain product lines. During 1999, the Company recorded a net charge of $20.5 million relating to such restructuring plan, principally for employee severance and other personnel benefits. Additionally, the Company adopted a plan to exit a non-core business as to which a charge of $1.6 million was recorded. During the fourth quarter of 1999, the Company continued to re-evaluate its organizational structure and implemented a new restructuring plan principally at its New York headquarters and New Jersey locations resulting in a charge of $18.1 million principally for employee severance. As part of this restructuring plan, the Company reduced personnel and consolidated excess real estate. In the fourth quarter of 1999, the Company also recorded a $22.0 million charge in connection with executive separation costs. The Company will continue to evaluate its organizational structure, which may result in additional restructuring charges in the future. BUSINESS OBJECTIVES AND STRATEGY The Company's objective is to become the most dynamic leader in global beauty and skin care by being the most trusted supplier to its customers and consumers, the most innovative in meeting their needs, and the first to market with these innovations. To achieve its objectives the Company's business strategy, which is intended to improve its operating performance, is: o to attract and retain the best people in the industry; o to build consistent global equities; o to gain unique insights into its consumer needs and to execute flawlessly against those needs; o to understand the needs of and to exceed the expectations of its trade partners; and o to operate at benchmark levels of efficiency in all aspects of its business. PRODUCTS The Company manufactures and markets a variety of products worldwide. The following table sets forth the Company's principal brands (a). (a) Brands relating to the Company's professional products line, ethnic products and Natural Honey products are not listed. (b) Trademark owned in certain markets outside the United States. Cosmetics and Skin Care. The Company sells a broad range of cosmetics and skin care products designed to fulfill specifically identified consumer needs, principally priced in the upper range of the self-select distribution channel, including lip makeup, nail color and nail care products, eye and face makeup and skin care products such as lotions, cleansers, creams, toners and moisturizers. Many of the Company's products incorporate patented, patent-pending or proprietary technology. The Company markets several different lines of REVLON lip makeup (which includes lipstick, lip gloss and liner). The Company's breakthrough COLORSTAY lipcolor, which uses patented transfer-resistant technology that provides long wear, is produced in approximately 50 shades. COLORSTAY Liquid Lip, a patented lip technology introduced in 1999, is produced in approximately 40 shades and builds on the strengths of the COLORSTAY foundation by offering long-wearing benefits in a new product form, which enhances comfort and shine. SUPER LUSTROUS lipstick is produced in approximately 70 shades. MOON DROPS, a moisturizing lipstick, is produced in approximately 50 shades. LINE & SHINE utilizes an innovative product form, combining lipliner and lip gloss in one package, and is produced in approximately 20 shades. MOISTURESTAY uses patent-pending technology to moisturize the lips even after the color wears off, and is produced in approximately 40 shades. The Company's nail color and nail care lines include enamels, cuticle preparations and enamel removers. The Company's flagship REVLON nail enamel is produced in approximately 85 shades and uses a patented formula that provides consumers with improved wear, application, shine and gloss in a toluene-free and formaldehyde-free formula. TOP SPEED nail enamel is produced in approximately 80 shades and contains a patented speed drying polymer formula, which sets in 60 seconds. REVLON has the number one position in nail enamel in the United States self-select distribution channel. The Company also sells CUTEX nail polish remover and nail care products in certain countries outside the United States. The Company sells face makeup, including foundation, powder, blush and concealers, under such REVLON brand names as REVLON AGE DEFYING, which is targeted for women in the over 35 age bracket; COLORSTAY, which uses patent-pending transfer-resistant technology that provides long wear and won't rub off benefits; and NEW COMPLEXION, for consumers in the 18 to 34 age bracket. The Company's eye makeup products include mascaras, eyeliners, eye shadows and brow color. COLORSTAY eyecolor, mascara and brow color, EVERYLASH mascara, SOFTSTROKE eyeliners and REVLON Wet/Dry eye shadows are targeted for women in the 18 to 49 age bracket. The Company's ALMAY brand consists of a complete line of hypo-allergenic, dermatologist-tested, fragrance-free cosmetics and skin care products targeted for consumers who want "a fresh, healthy, effortless look." ALMAY products include lip makeup, nail color, eye and face makeup and skin care products. In 1999, ALMAY expanded its flagship ONE COAT franchise to include ONE COAT MASCARA COLOR & CURL; other ONE COAT products include ONE COAT LIPCOLOR, ONE COAT NAIL COLOR, ONE COAT GEL EYE PENCIL and ONE COAT LIP SHINE. The Company also introduced Skin Stays Clean liquid and compact foundation makeup with its patented "clean pore complex." ALMAY expanded its STAY SMOOTH franchise beyond its ANTI-CHAP LIPLINER to STAY SMOOTH MASCARA, a defining mascara with a built in comb. The ALMAY AMAZING COLLECTION features long-wearing mascaras, foundations and lipcolor. The Company's STREETWEAR brand consists of a quality, value-priced line of nail enamels, mascaras, lip and eye liners, lip glosses and body accessories that are targeted for the young, beauty savvy consumer. The Company's premium priced cosmetics and skin care products are sold under the ULTIMA II brand name, which is the Company's flagship premium priced brand sold throughout the world. ULTIMA II'S products include lip makeup, eye and face makeup and skin care products including GLOWTION, a line of skin brighteners that combines skin care and color; FULL MOISTURE FOUNDATION and lipcolor, VITAL RADIANCE and CHR skin care products; the BEAUTIFUL NUTRIENT collection, a complete line of nourishing makeup that provides advanced nutrient protection against dryness; THE NAKEDS makeup, a trend-setting line of makeup emphasizing neutral colors; and WONDERWEAR. The WONDERWEAR collection includes a long-wearing foundation that uses patented technology, cheek and eyecolor products that use proprietary technology that provides long wear, and WONDERWEAR lipstick, which uses patented transfer-resistant technology. In the U.S. the Company has broadened the distribution of ULTIMA II into the self-select channel. The Company sells implements, which include nail and eye grooming tools such as clippers, scissors, files, tweezers and eye lash curlers. The Company's implements are sold individually and in sets under the REVLON brand name and are the number one brand in the United States self-select distribution channel. The Company also sells cosmetics in international markets under regional brand names including COLORAMA and JUVENA in Brazil. The Company's skin care products, including moisturizers, are sold under brand names, including ETERNA 27, MOON DROPS, REVLON RESULTS, ALMAY TIME-OFF REVITALIZER, CLEAR COMPLEXION and ULTIMA II VITAL RADIANCE. In addition, the Company sells skin care products in international markets under internationally recognized brand names and under various regional brands, including the Company's premium priced JEANNE GATINEAU. Fragrances. The Company sells a selection of moderately priced and premium priced fragrances, including perfumes, eau de toilettes and colognes. The Company's portfolio includes fragrances such as CHARLIE and CIARA and line extensions such as CHARLIE RED and CHARLIE WHITE. The Company's CHARLIE fragrance has been a market leader since the mid-1970's. In international markets, the Company distributes under license certain brands, including VERSACE and VAN GILS. Personal Care Products. The Company sells a broad line of personal care consumer products, which complements its core cosmetics lines and enables the Company to meet the consumer's broader beauty care needs. In the self-select distribution channel, the Company sells haircare, antiperspirant and other personal care products, including the FLEX, OUTRAGEOUS and AQUAMARINE haircare lines throughout the world and the COLORAMA, BOZZANO, PLUSBELLE and JUVENA brands outside the United States; the breakthrough, patented COLORSTAY, as well as COLORSILK, REVLON SHADINGS and FROST & GLOW hair coloring lines throughout most of the world; and the MITCHUM, LADY MITCHUM and HI & DRI antiperspirant brands throughout the world. The Company also markets hypo-allergenic personal care products, including sunscreens, moisturizers and antiperspirants, under the ALMAY brand. MARKETING Consumer Products. The Company markets extensive consumer product lines at a range of retail prices primarily through the self-select distribution channel and markets select premium lines through demonstrator-assisted channels, principally outside the U.S. Each line is distinctively positioned and is marketed globally with consistently recognizable logos, packaging and advertising designed to differentiate it from other brands. The Company's existing consumer product lines are carefully segmented, and new product lines are developed, to target specific consumer needs as measured by focus groups and other market research techniques. The Company uses print and television advertising and point-of-sale merchandising, including displays and samples. The Company's marketing emphasizes a uniform global image and product for its portfolio of core brands, including REVLON, COLORSTAY, REVLON AGE DEFYING, ALMAY, ULTIMA II, FLEX, CHARLIE, OUTRAGEOUS and MITCHUM. The Company coordinates advertising campaigns with in-store promotional and other marketing activities. The Company develops jointly with retailers carefully tailored advertising, point-of-purchase and other focused marketing programs. The Company uses network and spot television advertising, national cable advertising and print advertising in major general interest, women's fashion and women's service magazines, as well as coupons, magazine inserts and point-of-sale testers. The Company also uses cooperative advertising programs with some retailers, supported by Company-paid or Company-subsidized demonstrators, and coordinated in-store promotions and displays. The Company also has developed unique marketing materials such as the "Revlon Report," a glossy, color pamphlet distributed in magazines and on merchandising units, available in approximately 80 countries and approximately 20 languages, which highlights seasonal and other fashion and color trends, describes the Company's products that address those trends and contains coupons, rebate offers and other promotional material to encourage consumers to try the Company's products. Other marketing materials designed to introduce the Company's newest products to consumers and encourage trial and purchase include point-of-sale testers on the Company's display units that provide information about, and permit consumers to test, the Company's products, thereby achieving the benefits of an in-store demonstrator without the corresponding cost, magazine inserts containing samples of the Company's newest products, trial size products and "shade samplers," which are collections of trial size products in different shades. Additionally, the Company has its own website, which features current product and promotional information. NEW PRODUCT DEVELOPMENT AND RESEARCH AND DEVELOPMENT The Company believes that it is an industry leader in the development of innovative and technologically-advanced consumer products. The Company's marketing and research and development groups identify consumer needs and shifts in consumer preferences in order to develop new products, tailor line extensions and promotions and redesign or reformulate existing products to satisfy such needs or preferences. The Company's research and development group comprises departments specialized in the technologies critical to the Company's various product categories as well as an advanced technology department that promotes inter-departmental, cross-functional research on a wide range of technologies to develop new and innovative products. The Company independently develops substantially all of its new products. The Company also has entered into joint research projects with major universities and commercial laboratories to develop advanced technologies. The Company believes that its Edison, New Jersey facility is one of the most extensive cosmetics research and development facilities in the United States. The scientists at the Edison facility are responsible for all of the Company's new product research worldwide, performing research for new products, ideas, concepts and packaging. The Company also has satellite research facilities in Brazil and France. The research and development group at the Edison facility also performs extensive safety and quality tests on the Company's products, including toxicology, microbiology and package testing. Additionally, quality control testing is performed at each manufacturing facility. As of December 31, 1999, the Company employed approximately 200 people in its research and development activities, including specialists in pharmacology, toxicology, chemistry, microbiology, engineering, biology, dermatology and quality control. In 1999, 1998 and 1997, the Company spent approximately $32.9 million, $31.9 million and $29.7 million, respectively, on research and development activities. MANUFACTURING AND RELATED OPERATIONS AND RAW MATERIALS The Company manufactures REVLON brand color cosmetics, personal care products and fragrances and ULTIMA II cosmetics and skin treatment products for sale in the United States, Japan and most of the countries in Latin America and Southeast Asia at its Phoenix, Arizona facility and its Canadian facility. The Company manufactures ALMAY brand products for sale throughout the world at its Oxford, North Carolina facility. Implements for sale throughout the world are manufactured and/or assembled at the Company's Irvington, New Jersey facility. The Phoenix and Oxford facilities have been ISO-9002 certified. ISO-9002 certification is an internationally recognized standard for manufacturing facilities, which signifies that the manufacturing facility has achieved and maintains certain performance and quality commitment standards. The Company manufactures its entire line of consumer products (except implements) for sale in most of Europe at its Maesteg, South Wales facility. Production of cosmetics and personal care products also currently takes place at the Company's facilities in Canada, Venezuela, Mexico, New Zealand, Brazil, Argentina, France and South Africa. Production of color cosmetics for Japan and Mexico has been shifted primarily to the United States. The Maesteg facility has been certified by the British equivalent of ISO-9002. The globalization of the Company's core brands allows the Company to centralize production of some product categories for sale throughout the world within designated facilities and shift production of certain other product categories to more cost effective manufacturing sites to reduce production costs. Shifts of production may result in the closing of certain of the Company's manufacturing facilities, and the Company continually reviews its needs in this regard. In addition, as part of its efforts to continuously reduce costs, the Company attempts to ensure that a significant portion of its capital expenditures is devoted to improving operating efficiencies. The Company purchases raw materials and components throughout the world. The Company continuously pursues reductions in cost of goods through the global sourcing of raw materials and components from qualified vendors, utilizing its large purchasing capacity to maximize cost savings. The global sourcing of raw materials and components from accredited vendors also ensures the quality of the raw materials and components. The Company believes that alternate sources of raw materials and components exist and does not anticipate any significant shortages of, or difficulty in obtaining, such materials. The Company's improvements in manufacturing, sourcing and related operations have contributed to improved customer service, including an improvement in the percentage of timely order fulfillment from most of the Company's principal manufacturing facilities, and the timeliness and accuracy of new product and promotion deliveries. To promote the Company's understanding of and responsiveness to the needs of its retail customers, the Company has dedicated teams assigned to significant accounts, and has provided retail accounts with a designated customer service representative. As a result of these efforts, accompanied by stronger and more customer-focused management, the Company has developed strong relationships with its retailers. INFORMATION SYSTEMS As part of the Company's comprehensive business process enhancement program the Company's management information systems have been substantially upgraded to provide comprehensive order processing, production and accounting support for the Company's business, as well as to upgrade certain information technology to be Year 2000 compliant. In addition, the Company developed a comprehensive plan to address Year 2000 issues. The Year 2000 plan addressed three main areas: (a) information technology systems; (b) non-information technology systems (including factory equipment, building systems and other embedded systems); and (c) business partner readiness (including without limitation customers, inventory and non-inventory suppliers, service suppliers, banks, insurance companies and tax and other governmental agencies). Since January 1, 2000, the Company has not experienced any adverse consequences resulting from Year 2000 issues relative to its systems or business partners. The Company believes that incremental out-of-pocket costs of its Year 2000 program (which do not include costs incurred in connection with the Company's comprehensive business process enhancement program) were not material. These costs included the cost of third party consultants, remediation of existing computer software and replacement and remediation of embedded systems. DISTRIBUTION The Company's products are sold in approximately 175 countries and territories. The Company's worldwide sales force had approximately 1,000 people as of December 31, 1999 (which includes approximately 300 employees related to the professional products line which was sold in March 2000), including dedicated sales forces for cosmetics, skin care and fragrance products in the self-select distribution channel, for the demonstrator-assisted distribution channel, for personal care products distribution and, prior to the disposition of the worldwide professional products line, for salon distribution. In addition, the Company utilizes sales representatives and independent distributors to serve specialized markets and related distribution channels. United States. Net sales in the United States accounted for approximately 56.2% of the Company's 1999 net sales, a majority of which were made in the self-select distribution channel. The Company also sells a broad range of consumer products to United States Government military exchanges and commissaries. The Company licenses its trademarks to select manufacturers for products that the Company believes have the potential to extend the Company's brand names and image. As of December 31, 1999, 10 licenses were in effect relating to 15 product categories to be marketed in the self-select distribution channel. Pursuant to the licenses, the Company retains strict control over product design and development, product quality, advertising and use of its trademarks. These licensing arrangements offer opportunities for the Company to generate revenues and cash flow through earned royalties. International. Net sales outside the United States accounted for approximately 43.8% of the Company's 1999 net sales. The ten largest countries in terms of these sales, which include, among others, Spain, Brazil, the United Kingdom, Argentina, Australia, South Africa and Canada, accounted for approximately 31.9% of the Company's net sales in 1999. The Company is increasing distribution through the expanding self-select distribution channels outside the United States, such as drug stores/chemists, hypermarkets/mass volume retailers and variety stores, as these channels gain importance. The Company also distributes outside the United States through department stores and specialty stores such as perfumeries. At December 31, 1999, the Company actively sold its products through wholly owned subsidiaries established in 28 countries outside of the United States and through a large number of distributors and licensees elsewhere around the world. The Company continues to pursue strategies to establish its presence in new markets where the Company identifies opportunities for growth. In addition, the Company is building a franchise through local distributorships in northern and central Africa, where the Company intends to expand the distribution of its products by capitalizing on its market strengths in South Africa. CUSTOMERS The Company's principal customers include large mass volume retailers and chain drug stores, including such well known retailers as Wal-Mart, Target, Kmart, Walgreens, Rite Aid, CVS, Eckerds, Albertsons Drugs and Longs in the United States, Boots in the United Kingdom, Carrefour in Western Europe and Wal-Mart internationally. Wal-Mart and its affiliates worldwide accounted for approximately 13.1% of the Company's 1999 consolidated net sales. Although the loss of Wal-Mart as a customer could have an adverse effect on the Company, the Company believes that its relationship with Wal-Mart is satisfactory and the Company has no reason to believe that Wal-Mart will not continue as a customer. COMPETITION The consumer products business is characterized by vigorous competition throughout the world. Brand recognition, together with product quality, performance and price and the extent to which consumers are educated on product benefits, have a marked influence on consumers' choices among competing products and brands. Advertising, promotion, merchandising and packaging, and the timing of new product introductions and line extensions, also have a significant impact on buying decisions, and the structure and quality of the sales force affect product reception, in-store position, permanent display space and inventory levels in retail outlets. The Company competes in most of its product categories against a number of companies, a number of which have substantially greater resources than the Company. In addition to products sold in the self-select and demonstrator-assisted distribution channels, the Company's products also compete with similar products sold door-to-door or through mail order or telemarketing by representatives of direct sales companies. The Company's principal competitors include L'Oreal S.A., The Procter & Gamble Company, Unilever N.V. and Estee Lauder, Inc. SEASONALITY The Company's business is subject to certain seasonal fluctuations, with net sales in the second half of the year benefiting slightly from increased retailer purchases in the United States for the back-to-school and Christmas selling seasons. PATENTS, TRADEMARKS AND PROPRIETARY TECHNOLOGY The Company's major trademarks are registered in the United States and in many other countries, and the Company considers trademark protection to be very important to its business. Significant trademarks include REVLON, COLORSTAY, REVLON AGE DEFYING, STREETWEAR, FLEX, PLUSBELLE, CUTEX (outside the U.S.), MITCHUM, ETERNA 27, ULTIMA II, ALMAY, CHARLIE, JEAN NATE, REVLON RESULTS, COLORAMA, FIRE & ICE, MOON DROPS, SUPER LUSTROUS, WONDERWEAR and COLORSILK. The Company utilizes certain proprietary or patented technologies in the formulation or manufacture of a number of the Company's products, including COLORSTAY lipcolor and cosmetics, COLORSTAY hair color, classic REVLON nail enamel, TOP SPEED nail enamel, REVLON AGE DEFYING foundation and cosmetics, NEW COMPLEXION makeup, WONDERWEAR foundation, WONDERWEAR lipstick, ALMAY TIME-OFF skin care and makeup, ALMAY AMAZING cosmetics, ALMAY ONE COAT eye makeup and cosmetics, ULTIMA II VITAL RADIANCE skin care products and OUTRAGEOUS shampoo. The Company also protects certain of its packaging and component concepts through design patents. The Company considers its proprietary technology and patent protection to be important to its business. GOVERNMENT REGULATION The Company is subject to regulation by the Federal Trade Commission and the Food and Drug Administration (the "FDA") in the United States, as well as various other federal, state, local and foreign regulatory authorities. The Phoenix, Arizona and Oxford, North Carolina manufacturing facilities are registered with the FDA as drug manufacturing establishments, permitting the manufacture of cosmetics that contain over-the-counter drug ingredients such as sunscreens. Compliance with federal, state, local and foreign laws and regulations pertaining to discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and is not anticipated to have, a material effect upon the capital expenditures, earnings or competitive position of the Company. State and local regulations in the United States that are designed to protect consumers or the environment have an increasing influence on product claims, contents and packaging. INDUSTRY SEGMENTS, FOREIGN AND DOMESTIC OPERATIONS The Company operates in a single segment. Certain geographic, financial and other information of the Company is set forth in Note 19 of the Notes to Consolidated Financial Statements of the Company. EMPLOYEES As of December 31, 1999, the Company employed the equivalent of approximately 11,000 full-time persons (which includes approximately 1,900 employees related to the professional products line which was sold in March 2000). As of December 31, 1999, approximately 1,700 of such employees in the United States were covered by collective bargaining agreements, (which includes approximately 400 employees related to the professional products line). The Company believes that its employee relations are satisfactory. Although the Company has experienced minor work stoppages of limited duration in the past in the ordinary course of business, such work stoppages have not had a material effect on the Company's results of operations or financial condition. ITEM 2. ITEM 2. PROPERTIES The following table sets forth as of December 31, 1999 the Company's major manufacturing, research and warehouse/distribution facilities, all of which are owned except where otherwise noted. (a) Facility was transferred to the purchaser of the professional products line in March 2000. In addition to the facilities described above, additional facilities are owned and leased in various areas throughout the world, including the lease for the Company's executive offices in New York, New York (346,000 square feet, of which approximately 19,000 square feet were sublet to affiliates of the Company and approximately 78,000 square feet were sublet to unaffiliated third parties as of December 31, 1999). Management considers the Company's facilities to be well-maintained and satisfactory for the Company's operations, and believes that the Company's facilities provide sufficient capacity for its current and expected production requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various routine legal proceedings incident to the ordinary course of its business. The Company believes that the outcome of all pending legal proceedings in the aggregate is unlikely to have a material adverse effect on the business or consolidated financial condition of the Company. In October and November 1999 six purported class actions were filed by each of Thomas Comport, Boaz Spitz, Felix Ezeir and Amy Hoffman, Ted Parris, Jerry Krim and Dan Gavish individually and on behalf of others similarly situated to them, in the United States District Court for the Southern District of New York, against the Company and certain of its present and former officers and directors, alleging, among other things, violations of Rule 10b-5 under the Securities Exchange Act of 1934, as amended, through the alleged use of deceptive accounting practices during the period from October 29, 1997 through October 2, 1998, inclusive, in the Comport and Hoffman/Parris cases and October 30, 1997 through October 1, 1999, inclusive, in the Spitz, Ezeir, Krim and Gavish cases. Each of the actions seeks a declaration that it is properly brought as a class action, and unspecified damages, attorney fees and other costs. In January 2000, the court consolidated the six cases. The Company believes the allegations contained in these suits to be without merit and intends to vigorously defend against them. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MacAndrews & Forbes Holdings Inc. ("MacAndrews Holdings"), which is indirectly wholly owned by Ronald O. Perelman, through REV Holdings Inc. ("REV Holdings"), beneficially owns 11,250,000 shares of the Company's Class A Common Stock (representing 56.3% of the outstanding shares of Class A Common Stock) and all of the outstanding 31,250,000 shares of Class B Common Stock, which together represent approximately 83% of the outstanding shares of the Company's Common Stock and have approximately 97.4% of the combined voting power of the outstanding shares of the Company's Common Stock. The remaining 8,742,837 shares of Class A Common Stock outstanding at March 8, 2000 are owned by the public. As of March 8, 2000, there were 744 holders of record of Class A Common Stock. No dividends were declared or paid during 1999 or 1998. The terms of the Credit Agreement, the 8 5/8% Notes (as hereinafter defined), the 8 1/8% Notes (as hereinafter defined) and the 9% Notes (as hereinafter defined) currently restrict the ability of Products Corporation to pay dividends or make distributions to Revlon, Inc. See the Consolidated Financial Statements of the Company and the Notes thereto. The table below shows the Company's high and low quarterly stock prices for the years ended December 31, 1999 and 1998. 1999 QUARTERLY STOCK PRICES (1) ------------------------------------------------- 1ST 2ND 3RD 4TH QUARTER QUARTER QUARTER QUARTER ------- ------- ------- ------- High .................... $ 22 1/4 $ 32 $ 29 1/8 $ 12 Low ..................... 13 1/2 19 1/8 18 7 1/2 1998 QUARTERLY STOCK PRICES (1) ------------------------------------------------- 1ST 2ND 3RD 4TH QUARTER QUARTER QUARTER QUARTER ------- ------- ---------- ---------- High .................... $ 51 13/16 $ 56 1/16 $ 54 1/2 $ 27 13/16 Low ..................... 33 5/8 47 9/16 30 7/8 12 1/2 (1) Represents the closing price per share on the New York Stock Exchange (NYSE), which is the exchange on which shares of the Company's Class A Common Stock are listed. The Company's symbol is REV. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Consolidated Statements of Operations Data for each of the years in the five-year period ended December 31, 1999 and the Balance Sheet Data as of December 31, 1999, 1998, 1997 and 1996 are derived from the Consolidated Financial Statements of the Company, which have been audited by KPMG LLP, independent certified public accountants. The Balance Sheet Data as of December 31, 1995 is derived from unaudited consolidated financial statements, which have been restated to reflect the Company's former retail and outlet store business as discontinued operations. The Selected Consolidated Financial Data should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes to the Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations." (a) Includes business consolidation costs and other, net and executive separation costs of $40.2 million and $22.0 million, respectively. See Note 4 to the Consolidated Financial Statements. (b) Includes business consolidation costs and other, net aggregating $35.8 million. See Note 4 to the Consolidated Financial Statements. (c) Includes business consolidation costs and other, net, of $3.6 million. See Note 4 to the Consolidated Financial Statements. (d) Represents the weighted average number of common shares outstanding for the period. See Note 1 to the Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (DOLLARS IN MILLIONS) OVERVIEW The Company operates in a single segment and manufactures, markets and sells an extensive array of cosmetics and skin care, fragrances and personal care products, and, until the disposition of its professional products line in March 2000, had included professional products, which consisted of hair and nail care products principally for use in and resale by professional salons. In addition, the Company has a licensing group. RESULTS OF OPERATIONS The following table sets forth the Company's net sales for each of the last three years: YEAR ENDED DECEMBER 31, -------------------------------------------- 1999 1998 1997 -------- -------- -------- Net sales: United States ................ $ 1,046.2 $ 1,343.7 $ 1,304.9 International ................ 815.1 908.5 933.7 ---------- --------- ---------- $ 1,861.3 $ 2,252.2 $ 2,238.6 ========== ========== ========== The following table sets forth certain statements of operations data as a percentage of net sales for each of the last three years: YEAR ENDED DECEMBER 31, -------------------------------------------- 1999 1998 1997 ---- ---- ---- Cost of sales* ............ 36.9 % 34.0 % 33.2 % Gross profit .............. 63.1 66.0 66.8 Selling, general and administrative expenses ("SG&A")** ............. 72.4 59.0 57.1 Business consolidation costs and other, net ... 2.2 1.5 0.1 Operating (loss) income.... (11.4) 5.5 9.6 * 1998 includes $2.7 (0.1% of net sales) for charges related to business consolidation costs. ** 1999 includes $22.0 (1.2% of net sales) for charges related to executive separation costs. YEAR ENDED DECEMBER 31, 1999 COMPARED WITH YEAR ENDED DECEMBER 31, 1998 Net sales were $1,861.3 and $2,252.2 for 1999 and 1998, respectively, a decrease of $390.9, or 17.4% on a reported basis (a decrease of 14.9% on a constant U.S. dollar basis). United States. Net sales in the United States were $1,046.2 for 1999 compared with $1,343.7 for 1998, a decrease of $297.5, or 22.1%. Net sales for 1999 were adversely affected by lower than anticipated share growth, competitive activities and a reduction in the level of Company shipments to certain retailers to achieve such retailers' new lower inventory target levels. The reduction of retailers' target inventory levels will continue and is expected to adversely impact sales through the first half of 2000. New products in 1999 included EVERYLASH mascara, MOISTURESTAY SHEER LIP COLOR, REVLON AGE DEFYING compact makeup, WET/DRY EYE SHADOW, ALMAY STAY SMOOTH lip makeup and mascara, ALMAY Foundation with Skin Stays Clean attributes, products in the ALMAY ONE COAT collection, MITCHUM COOL DRY antiperspirant and COLORSTAY LIQUID LIP. International. Net sales outside the United States were $815.1 for 1999 compared with $908.5 for 1998, a decrease of $93.4, or 10.3%, on a reported basis (a decrease of 3.7% on a constant U.S. dollar basis). Net sales for 1999 on a constant U.S. dollar basis were affected by unfavorable economic conditions in certain markets outside the U.S., principally Brazil, which restrained consumer and trade demand, increased competitive activity and lower sales in certain markets, principally the United Kingdom and Canada. The decrease in net sales for 1999 on a reported basis also reflects the unfavorable effect on sales of a stronger U.S. dollar against certain foreign currencies, particularly the Brazilian real. Sales outside the United States are divided into three geographic regions. In Europe, which comprises Europe, the Middle East and Africa, net sales decreased by 9.2% on a reported basis to $369.5 for 1999 as compared with 1998 (a decrease of 4.3% on a constant U.S. dollar basis). In the Western Hemisphere, which comprises Canada, Mexico, Central America, South America and Puerto Rico, net sales decreased by 15.4% on a reported basis to $303.1 for 1999 as compared with 1998 (a decrease of 3.0% on a constant U.S. dollar basis). The Company's operations in Brazil are significant. In Brazil, net sales were $76.1 on a reported basis for 1999 compared with $122.5 for 1998, a decrease of $46.4, or 37.9% (a decrease of 3.1% on a constant U.S. dollar basis). On a reported basis, net sales in Brazil were adversely affected by the stronger U.S. dollar against the Brazilian real, unfavorable economic conditions and increased competitive activities. In the Far East, net sales decreased by 0.7% on a reported basis to $142.5 for 1999 as compared with 1998 (a decrease of 4.0% on a constant U.S. dollar basis). Net sales outside the United States, including, without limitation, in Brazil, may be adversely affected by generally weak economic conditions, political and economic uncertainties, including, without limitation, currency fluctuations and competitive activities in certain markets. Cost of sales As a percentage of net sales, cost of sales was 36.9% for 1999 compared with 34.0% for 1998. The increase in cost of sales as a percentage of net sales for 1999 compared with 1998 is due to changes in product mix, the effect of weaker local currencies on the cost of imported purchases by subsidiaries outside the U.S. and the effect of lower net sales. SG&A expenses As a percentage of net sales, SG&A expenses were 72.4% ($1,347.6) for 1999 compared with 59.0% ($1,328.8) for 1998. The increase in SG&A expenses as a percentage of net sales is due in large measure to the reduced levels of sales coupled with the Company's decision to maintain throughout the second half of 1999 brand support intended to drive consumer purchasing and facilitate the inventory reduction process by U.S. retailers referred to earlier. In addition, SG&A increased as a result of executive separation costs of $22.0, which were partially offset by savings from the Company's restructuring plan from 1998. Business consolidation costs and other, net In the fourth quarter of 1998, the Company committed to a restructuring plan to realign and reduce personnel, exit excess leased real estate, realign and consolidate regional activities, reconfigure certain manufacturing operations and exit certain product lines. During 1999, the Company continued to implement such restructuring plan for which it recorded a charge of $20.5 for employee severance and other personnel benefits, costs associated with the exit from leased facilities as well as other costs. Also in 1999, the Company consummated an exit from a non-core business, resulting in an additional charge of $1.6, which is included in business consolidation costs and other, net. During the fourth quarter of 1999, the Company continued to re-evaluate its organizational structure and implemented a new restructuring plan principally at its New York headquarters and New Jersey locations resulting in a charge of $18.1 principally for employee severance. As part of this new restructuring plan, the Company reduced personnel and consolidated excess real estate. As a result of the new restructuring plan, executive separation costs, and the elimination of open positions, the Company anticipates annual savings of between $45 and $50, beginning in 2000. Operating (loss) income As a result of the foregoing, operating (loss) for 1999 was $(212.6) compared to operating income of $124.6 for 1998. Other expenses/(income) Interest expense was $147.9 for 1999 compared with $137.9 for 1998. The increase in interest expense for 1999 as compared with 1998 is due to higher average outstanding debt and higher interest rates under the Credit Agreement, partially offset by lower interest rates as a result of the refinancings in 1998. Foreign currency (gains) losses, net, were $(0.5) for 1999 compared with $4.6 in 1998. Foreign currency losses, net for 1998 consisted primarily of losses in several markets in Latin America. Provision for income taxes The provision for income taxes was $9.1 for 1999 compared with $5.0 for 1998. Discontinued operations During 1998, the Company completed the disposition of its approximately 85% ownership interest in The Cosmetic Center, Inc. ("CCI") and, accordingly, the results of operations of CCI had been reported as discontinued operations along with the loss on disposal of such operations. YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31, 1997 NET SALES Net sales were $2,252.2 and $2,238.6 for 1998 and 1997, respectively, an increase of $13.6, or 0.6% (or 2.7% on a constant U.S. dollar basis). United States. Net sales in the United States were $1,343.7 for 1998 compared with $1,304.9 for 1997, an increase of $38.8, or 3.0%. The increase in net sales in 1998 reflects improvements in net sales of products in the Company's ALMAY and ULTIMA franchises and expansion of certain of the Company's professional product lines including an acquisition. For the first half of 1998, net sales for the Company's REVLON franchise increased as compared to the first half of 1997 as a result of continued consumer acceptance of new product offerings and general improvement in consumer demand for the Company's color cosmetics. Beginning in third quarter of 1998, such sales were adversely affected by a slowdown in the rate of growth in the mass market color cosmetics category and a leveling of market share. Additionally, net sales for 1998 were impacted by reduced purchases by some retailers, particularly chain drug stores, resulting from improved inventory management through systems upgrades and inventory reductions following several recent business combinations. REVLON brand color cosmetics continued as the number one brand in dollar market share in the U.S. self-select distribution channel. New product introductions (including, in 1998, certain products launched during 1997) generated incremental net sales in 1998, principally as a result of launches of TOP SPEED nail enamel, MOISTURESTAY lip makeup, products in the NEW COMPLEXION line, COLORSTAY shampoo, ALMAY STAY SMOOTH lip makeup, products in the ALMAY AMAZING collection, products in the ALMAY ONE COAT collection, products in the ULTIMA II BEAUTIFUL NUTRIENT and ULTIMA II FULL MOISTURE lipcolor lines and ULTIMA II GLOWTION skin brighteners. International. Net sales outside the United States were $908.5 for 1998 compared with $933.7 for 1997, a decrease of $25.2, or 2.7%, on a reported basis (an increase of 2.4% on a constant U.S. dollar basis). The increase in net sales for 1998 on a constant dollar basis reflects the benefits of increased distribution, including acquisitions, and successful new product introductions in several markets including MOISTURESTAY lip makeup and TOP SPEED nail enamel. The decrease in net sales for 1998 on a reported basis reflects the unfavorable effect on sales of a stronger U.S. dollar against most foreign currencies and unfavorable economic conditions in several international markets. These unfavorable economic conditions restrained consumer and trade demand outside the U.S., particularly in South America and the Far East, as well as Russia and other developing economies. Sales outside the United States are divided into three geographic regions. In Europe, which comprises Europe, the Middle East and Africa, net sales decreased by 2.6% on a reported basis to $406.9 for 1998 as compared with 1997 (an increase of 0.5% on a constant U.S. dollar basis). In the Western Hemisphere, which comprises Canada, Mexico, Central America, South America and Puerto Rico, net sales increased by 4.7% on a reported basis to $358.1 for 1998 as compared with 1997 (an increase of 9.5% on a constant U.S. dollar basis). The Company's operations in Brazil are significant. In Brazil, net sales were $122.5 on a reported basis for 1998 compared with $130.9 for 1997, a decrease of $8.4, or 6.4% (an increase of 0.5% on a constant U.S. dollar basis). On a reported basis, net sales in Brazil were adversely affected by the stronger U.S. dollar against the Brazilian real. In the Far East, net sales decreased by 17.5% on a reported basis to $143.5 for 1998 as compared with 1997 (a decrease of 7.4% on a constant U.S. dollar basis). Net sales outside the United States, including without limitation in Brazil, were adversely impacted by generally weak economic conditions, political and economic uncertainties, including without limitation currency fluctuations, and competitive activities in certain markets. Cost of sales As a percentage of net sales, cost of sales was 34.0% for 1998 compared with 33.2% for 1997. The increase in cost of sales as a percentage of net sales for 1998 compared with 1997 is due to changes in product mix, the effect of weaker local currencies on the cost of imported purchases, the effect of lower net sales in the second half of 1998 and the inclusion of $2.7 of other costs incurred to exit certain product lines outside the United States in connection with the restructuring charge in the fourth quarter of 1998. These factors were partially offset by the benefits of more efficient global production and purchasing. SG&A expenses As a percentage of net sales, SG&A expenses were 59.0% for 1998 compared with 57.1% for 1997. SG&A expenses other than advertising and consumer-directed promotion expenses, as a percentage of net sales, were 40.2% for 1998 compared with 39.3% for 1997. The increase in SG&A expenses other than advertising and consumer-directed promotion expenses as a percentage of net sales was due primarily to the effects of lower than expected sales. The Company's advertising and consumer-directed promotion expenditures were incurred to support existing product lines, new product launches and increased distribution. Advertising and consumer-directed promotion expenses as a percentage of net sales were 18.8%, or $422.9, for 1998 compared to 17.8%, or $397.4, for 1997. Business consolidation costs and other, net In the fourth quarter of 1998 the Company committed to a restructuring plan to realign and reduce personnel, exit excess leased real estate, realign and consolidate regional activities, reconfigure certain manufacturing operations and exit certain product lines. As a result, the Company recognized a net charge of $42.9 consisting of $26.6 of employee severance and termination benefits for 720 sales, marketing, administrative, factory and distribution employees worldwide, $14.9 of costs to exit excess leased real estate primarily in the United States and $2.7 of other costs described above in cost of sales, partially offset by a gain of $1.3 for the sale of a factory outside the United States. In the third quarter of 1998 the Company recognized a gain of approximately $7.1 for the sale of the wigs and hairpieces portion of its business in the United States. In 1997 the Company incurred business consolidation costs of $20.6 in connection with the implementation of its business strategy to rationalize factory operations. These costs primarily included severance for 415 factory and administrative employees and other costs related to the rationalization of certain factory and warehouse operations worldwide. Such costs were partially offset by an approximately $12.7 settlement of a claim and related gains of approximately $4.3 for the sales of certain factory operations outside the United States. Operating income As a result of the foregoing, operating income decreased by $90.3, or 42.0%, to $124.6 for 1998 from $214.9 for 1997. Other expenses/income Interest expense was $137.9 for 1998 compared with $133.7 for 1997. The increase in interest expense for 1998 as compared with 1997 is due to higher average outstanding borrowings partially offset by lower interest rates. Foreign currency losses, net, were $4.6 for 1998 compared to $6.4 for 1997. The foreign currency losses for 1998 consisted primarily of losses in several markets in Latin America. The losses in 1997 consisted primarily of losses in several markets in Europe and the Far East. Provision for income taxes The provision for income taxes was $5.0 and $9.3 for 1998 and 1997, respectively. The decrease was primarily attributable to lower taxable income outside the United States in 1998. Discontinued operations During 1998, the Company completed the disposition of its approximately 85% equity interest in CCI. In connection with such transaction, the Company recorded a loss on disposal of $47.7 during 1998. (Loss) income from discontinued operations was $(16.5) (excluding the $47.7 loss on disposal) and $0.7 for 1998 and 1997, respectively. The 1997 period includes a $6.0 non-recurring gain resulting from the merger of Prestige Fragrance & Cosmetics, Inc., then a wholly owned subsidiary of the Company, with and into CCI on April 25, 1997, partially offset by related business consolidation costs of $4.0. The 1998 period includes the Company's share of a non-recurring charge of $10.5 taken by CCI primarily related to inventory and severance. Extraordinary items The extraordinary loss of $51.7 in 1998 resulted primarily from the write-off of deferred financing costs and payment of call premiums associated with the redemption of Products Corporation's 9 3/8% Senior Notes due 2001 (the "Senior Notes") and Products Corporation's 10 1/2% Senior Subordinated Notes due 2003 (the "Senior Subordinated Notes"). The extraordinary loss in 1997 resulted from the write-off of deferred financing costs associated with the extinguishment of borrowings under the credit agreement in effect at that time prior to maturity with proceeds from the credit agreement, and costs of approximately $6.3 in connection with the redemption of Products Corporation's 10 7/8% Sinking Fund Debentures due 2010 (the "Sinking Fund Debentures"). FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Net cash (used for)/provided by operating activities was $(82.8), $(51.5) and $8.7 for 1999, 1998 and 1997, respectively. The increase in net cash used for operating activities for 1999 compared with 1998 was the result of operating losses and increased use of cash for business consolidation costs during 1999, partially offset by changes in working capital. The increase in net cash used for operating activities for 1998 compared with cash provided in 1997 resulted primarily from lower operating income and increased cash used for business consolidation costs in 1998. Net cash used for investing activities was $40.7, $91.0 and $84.3 for 1999, 1998 and 1997, respectively. Net cash used for investing activities in 1999 related principally to capital expenditures. Net cash used for investing activities for 1998 and 1997 includes cash paid in connection with acquisitions of businesses and capital expenditures, partially offset by the proceeds from the sale of the wigs and hairpieces portion of the Company's business in the United States in 1998 and from the sale of certain assets in 1998 and 1997. Net cash used for investing activities for 1999, 1998 and 1997 included capital expenditures of $42.3, $60.8 and $52.3, respectively, and in 1998 and 1997 $57.6 and $40.5, respectively, used for acquisitions. Net cash provided by financing activities was $118.5, $159.1 and $84.9 for 1999, 1998 and 1997, respectively. Net cash provided by financing activities for 1999 included cash drawn under the Credit Agreement, partially offset by repayments of borrowings under the Credit Agreement, redemption of the 9 1/2% Senior Notes due 1999 (the "1999 Notes") and repayments under Products Corporation's Japanese yen-denominated credit agreement (the "Yen Credit Agreement"). Net cash provided by financing activities for 1998 included proceeds from the issuance of Products Corporation's 9% Senior Notes due 2006 (the "9% Notes"), Products Corporation's 8 5/8% Senior Subordinated Notes due 2008 (the "8 5/8% Notes") and Products Corporation's 8 1/8% Senior Notes due 2006 (the "8 1/8% Notes") and cash drawn under the Credit Agreement, partially offset by the payment of fees and expenses related to the issuance of the 9% Notes, the 8 5/8% Notes and the 8 1/8% Notes, the redemption of the Senior Subordinated Notes and the Senior Notes, and the repayment of borrowings under the Yen Credit Agreement. Net cash provided by financing activities for 1997 included cash drawn under the credit agreement in effect at that time and the Credit Agreement, partially offset by the repayment of borrowings under the credit agreement in effect at that time, the payment of fees and expenses related to entering into the Credit Agreement, the repayment of borrowings under the Yen Credit Agreement and the redemption of Products Corporation's Sinking Fund Debentures. During 1998 and 1997, net cash used by discontinued operations was $17.3 and $3.4, respectively. In May 1997, Products Corporation entered into a credit agreement (as subsequently amended, the "Credit Agreement") with a syndicate of lenders, whose individual members change from time to time. Prior to the commitment reduction resulting from the sale of the professional products line (See "Subsequent Event" below) the Credit Agreement provided up to $723.0 and comprises five senior secured facilities: $198.0 in two term loan facilities (the "Term Loan Facilities"), a $300.0 multi-currency facility (the "Multi-Currency Facility"), a $175.0 revolving acquisition facility, which may also be used for general corporate purposes and which may be increased to $375.0 under certain circumstances with the consent of a majority of the lenders (the "Acquisition Facility"), and a $50.0 special standby letter of credit facility (the "Special LC Facility"). At December 31, 1999, the Company had approximately $198.0 outstanding under the Term Loan Facilities, $235.2 outstanding under the Multi-Currency Facility, $155.0 outstanding under the Acquisition Facility and $29.8 of issued but undrawn letters of credit under the Special LC Facility. The Credit Agreement contained financial covenants requiring Products Corporation to maintain minimum interest coverage and to limit its leverage ratio, among other things. As a result of the loss from continuing operations before taxes incurred by Products Corporation in the third quarter of 1999, the interest coverage and leverage ratios specified in the Credit Agreement were not achieved at September 30, 1999. The Credit Agreement was amended on November 10, 1999 to (i) eliminate the interest coverage ratio and leverage ratio covenants from the quarter ended September 30, 1999 through the year 2000 and to modify those covenants for the years 2001 and 2002; (ii) add a minimum EBITDA covenant for each quarter end during the year 2000; (iii) limit the amount that Products Corporation may spend for capital expenditures and investments including acquisitions; (iv) permit the sale of Products Corporation's worldwide professional products line and its non-core Latin American brands Colorama, Juvena, Bozzano and Plusbelle (the "Asset Sales"); (v) change the reduction of the aggregate commitment that is required upon consummation of any Asset Sale to an amount equal to 60% of the "Net Proceeds" (as defined in the Credit Agreement) from such Asset Sale as opposed to 100% of such Net Proceeds as provided under the Credit Agreement prior to the amendment; (vi) increase the "applicable margin" by 3/4 of 1% and (vii) permit the amendment of the Yen Credit Agreement described below. In March 2000, 60% of the Net Proceeds from the sale of its worldwide professional products line was applied to reduce the aggregate commitment under the Credit Agreement to $572.7 (See "Subsequent Event" below). In March 2000, the Credit Agreement was amended to eliminate the default upon the acceleration of or certain payment defaults under indebtedness of REV Holdings in excess of $0.5. A subsidiary of Products Corporation was the borrower under the Yen Credit Agreement, which had a principal balance of approximately (Yen)1.0 billion as of December 31, 1999 (approximately $9.9 U.S. dollar equivalent as of December 31, 1999) after giving effect to the payment of approximately (Yen)539 million (approximately $4.6 U.S. dollar equivalent) in March 1999. In November 1999, the borrower under the Yen Credit Agreement executed an amendment to the Yen Credit Agreement to eliminate the amortization payment due in March 2000 and to provide that the final maturity date of the Yen Credit Agreement will be the earlier of (i) the closing date of the sale of Products Corporation's professional products line and (ii) December 31, 2000. In March 2000, the outstanding balance under the Yen Credit Agreement was repaid in full in accordance with its terms. In November 1998, Products Corporation issued and sold $250.0 principal amount of 9% Notes, of which $200.0 was used to temporarily reduce borrowings under the Credit Agreement in anticipation of the redemption referred to below. On June 1, 1999, Products Corporation redeemed the $200.0 principal amount of 1999 Notes with borrowings from the Credit Agreement. Products Corporation borrows funds from its affiliates from time to time to supplement its working capital borrowings at interest rates more favorable to Products Corporation than interest rates under the Credit Agreement. No such borrowings were outstanding as of December 31, 1999. The Company's principal sources of funds are expected to be cash flow generated from operations (before interest) and borrowings under the Credit Agreement, other existing working capital lines and renewals thereof, as well as proceeds from the sale of one or more of the Company's non-core Latin American brands. The Credit Agreement, the 8 5/8% Notes, the 8 1/8% Notes and the 9% Notes contain certain provisions that by their terms limit Products Corporation's and/or its subsidiaries' ability to, among other things, incur additional debt. The Company's principal uses of funds are expected to be the payment of operating expenses, working capital and capital expenditure requirements, expenses in connection with the Company's restructuring referred to above and debt service payments. As required under the Credit Agreement, the Company used 60% of the Net Proceeds (as defined in the Credit Agreement) from the sale of its worldwide professional products line to reduce the aggregate commitment under the Credit Agreement. Additionally, the Company expects that it will receive cash proceeds from the sale of one or more of its non-core Latin American brands and that it will use 60% of the Net Proceeds, to reduce the aggregate commitment under the Credit Agreement. The Company estimates that capital expenditures for 2000 will be approximately $25, including upgrades to the Company's management information systems. The Company estimates that cash payments related to the restructuring plans referred to in Note 4 and executive separation costs will be approximately $35 in 2000. Pursuant to a tax sharing agreement, Revlon, Inc. may be required to make tax sharing payments to Mafco Holdings Inc. as if Revlon, Inc. were filing separate income tax returns, except that no payments are required by Revlon, Inc. if and to the extent that Products Corporation is prohibited under the Credit Agreement from making tax sharing payments to Revlon, Inc. The Credit Agreement prohibits Products Corporation from making any tax sharing payments other than in respect of state and local income taxes. Revlon, Inc. currently anticipates that, as a result of net operating tax losses and prohibitions under the Credit Agreement, no cash federal tax payments or cash payments in lieu of federal taxes pursuant to the tax sharing agreement will be required for 2000. Products Corporation enters into forward foreign exchange contracts and option contracts from time to time to hedge certain cash flows denominated in foreign currencies. There were no forward foreign exchange or option contracts outstanding at December 31, 1999. Products Corporation had forward foreign exchange contracts denominated in various currencies of approximately $197.5 (U.S. dollar equivalent) outstanding at December 31, 1998 and option contracts of approximately $51.0 at December 31, 1998. Such contracts are entered into to hedge transactions predominantly occurring within twelve months. If Products Corporation had terminated these contracts on December 31, 1998 no material gain or loss would have been realized. The Company expects that cash flows from operations and funds from currently available credit facilities and renewals of short-term borrowings will be sufficient to enable the Company to meet its anticipated cash requirements during 2000 on a consolidated basis, including for debt service. However, there can be no assurance that the combination of cash flow from operations, funds from existing credit facilities and renewals of short-term borrowings will be sufficient to meet the Company's cash requirements on a consolidated basis. If the Company is unable to satisfy such cash requirements, the Company could be required to adopt one or more alternatives, such as reducing or delaying capital expenditures, restructuring indebtedness, selling other assets or operations, or seeking capital contributions or loans from affiliates of the Company or issuing additional shares of capital stock of Revlon, Inc. Products Corporation has had discussions with an affiliate that is prepared to provide financial support to Products Corporation of up to $40 on appropriate terms through December 31, 2000. Revlon, Inc., as a holding company, will be dependent on the earnings and cash flow of, and dividends and distributions from, Products Corporation to pay its expenses and to pay any cash dividend or distribution on the Class A Common Stock that may be authorized by the Board of Directors of Revlon, Inc. There can be no assurance that any of such actions could be effected, that they would enable the Company to continue to satisfy its capital requirements or that they would be permitted under the terms of the Company's various debt instruments then in effect. The terms of the Credit Agreement, the 8 5/8% Notes, the 8 1/8% Notes and the 9% Notes generally restrict Products Corporation from paying dividends or making distributions, except that Products Corporation is permitted to pay dividends and make distributions to Revlon, Inc., among other things, to enable Revlon, Inc. to pay expenses incidental to being a public holding company, including, among other things, professional fees such as legal and accounting, regulatory fees such as Securities and Exchange Commission (the "Commission") filing fees and other miscellaneous expenses related to being a public holding company and to pay dividends or make distributions in certain circumstances to finance the purchase by Revlon, Inc. of its Class A Common Stock in connection with the delivery of such Class A Common Stock to grantees under the Revlon, Inc. Second Amended and Restated 1996 Stock Plan, provided that the aggregate amount of such dividends and distributions taken together with any purchases of Revlon, Inc. common stock on the open market to satisfy matching obligations under the excess savings plan may not exceed $6.0 per annum. EURO CONVERSION As part of the European Economic and Monetary Union, a single currency (the "Euro") will replace the national currencies of the principal European countries (other than the United Kingdom) in which the Company conducts business and manufacturing. The conversion rates between the Euro and the participating nations' currencies were fixed as of January 1, 1999, with the participating national currencies to be removed from circulation between January 1, 2002 and June 30, 2002 and replaced by Euro notes and coinage. During the transition period from January 1, 1999 through December 31, 2001, public and private entities as well as individuals may pay for goods and services using checks, drafts, or wire transfers denominated either in the Euro or the participating country's national currency. Under the regulations governing the transition to a single currency, there is a "no compulsion, no prohibition" rule which states that no one can be prevented from using the Euro after January 1, 2002 and no one is obliged to use the Euro before July 2002. In keeping with this rule, the Company expects to either continue using the national currencies or the Euro for invoicing or payments. Based upon the information currently available, the Company does not expect that the transition to the Euro will have a material adverse effect on the business or consolidated financial condition of the Company. FORWARD-LOOKING STATEMENTS This annual report on Form 10-K for the year ended December 31, 1999 as well as other public documents of the Company contains forward-looking statements that involve risks and uncertainties. The Company's actual results may differ materially from those discussed in such forward-looking statements. Such statements include, without limitation, the Company's expectations and estimates as to being the most trusted supplier, the most innovative and the first to market with innovations, attracting and retaining the best people in the industry, building consistent global equities, addressing consumer needs, exceeding trade partners' expectations, operating at benchmark levels of efficiency, becoming the most dynamic leader in global beauty and skin care, the introduction of new products and expansion into markets, future financial performance, the effect on sales of lower retailer inventory targets, the effect on sales of political and/or economic conditions and competitive activities in certain markets, the Company's estimate of restructuring activities, costs and benefits, cash flow from operations, capital expenditures, the Company's qualitative and quantitative estimates as to market risk sensitive instruments, the Company's expectations about the effects of the transition to the Euro, the availability of funds from currently available credit facilities, renewals of short-term borrowings, and capital contributions or loans from affiliates or the sale of assets or operations or additional shares of Revlon, Inc. and the Company's intent to pursue the sale of one or more of its non-core regional Latin American brands, that it will consummate such sales during the second quarter of 2000 and its expectation regarding the proceeds of such sales. Statements that are not historical facts, including statements about the Company's beliefs and expectations, are forward-looking statements. Forward-looking statements can be identified by, among other things, the use of forward-looking language, such as "believe," "expects," "may," "will," "should," "seeks," "plans," "scheduled to," "anticipates" or "intends" or the negative of those terms, or other variations of those terms or comparable language, or by discussions of strategy or intentions. Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update them. A number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. In addition to factors that may be described in the Company's filings with the Commission, including this filing, the following factors, among others, could cause the Company's actual results to differ materially from those expressed in any forward-looking statements made by the Company: (i) difficulties or delays in becoming the most trusted supplier, the most innovative and the first to market with innovations, attracting and retaining the best people in the industry, building consistent global equities, addressing consumer needs, exceeding trade partners' expectations, operating at benchmark levels of efficiency, becoming the most dynamic leader in global beauty and skin care, and in developing and introducing new products or failure of customers to accept new product offerings; (ii) changes in consumer preferences, including reduced consumer demand for the Company's color cosmetics and other current products; (iii) difficulties or delays in the Company's continued expansion into the self-select distribution channel and into certain markets and development of new markets; (iv) unanticipated costs or difficulties or delays in completing projects associated with the Company's strategy to improve operating efficiencies ; (v) the inability to secure capital contributions or loans from affiliates or sell assets or operations or additional shares of Revlon, Inc.; (vi) effects of and changes in political and/or economic conditions, including inflation and monetary conditions, and in trade, monetary, fiscal and tax policies in international markets, including but not limited to Brazil; (vii) actions by competitors, including business combinations, technological breakthroughs, new products offerings and marketing and promotional successes; (viii) combinations among significant customers or the loss, insolvency or failure to pay debts by a significant customer or customers; (ix) lower than expected sales as a result of difficulties or delays in achieving retailers' inventory target levels; (x) difficulties, delays or unanticipated costs or less than expected benefits resulting from the Company's restructuring activities; (xi) interest rate or foreign exchange rate changes affecting the Company and its market sensitive financial instruments; (xii) difficulties, delays or unanticipated costs associated with the transition to the Euro; and (xiii) difficulties or delays in pursuing the sale of one or more of its non-core Latin American brands, the inability to consummate such sales during the second quarter of 2000 or to secure the expected level of proceeds from such sales. EFFECT OF NEW ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of SFAS No. 133, an Amendment of SFAS No. 133," which has delayed the required implementation of SFAS No. 133 such that the Company must adopt this new standard no later than January 1, 2001. The effect of adopting the new standard by the Company has not yet been determined. The Company plans to adopt the new standard on January 1, 2001. INFLATION In general, costs are affected by inflation and the effects of inflation may be experienced by the Company in future periods. Management believes, however, that such effects have not been material to the Company during the past three years in the United States or foreign non-hyperinflationary countries. The Company operates in certain countries around the world, such as Brazil, Venezuela and Mexico, that have experienced hyperinflation in the past three years. The Company's operations in Brazil were accounted for as operating in a hyperinflationary economy until June 30, 1997. Effective July 1, 1997, Brazil was considered a non-hyperinflationary economy. The impact of accounting for Brazil as a non-hyperinflationary economy was not material to the Company's operating results. Effective January 1997, Mexico was considered a hyperinflationary economy for accounting purposes. Effective January 1, 1999, Mexico was considered a non-hyperinflationary economy. In hyperinflationary foreign countries, the Company attempts to mitigate the effects of inflation by increasing prices in line with inflation, where possible, and efficiently managing its working capital levels. SUBSEQUENT EVENT On March 30, 2000, the Company completed the disposition of its worldwide professional products line, including professional hair care for use in and resale by professional salons, ethnic hair and personal care products, Natural Honey skin care and certain regional toiletries brands, for $315 in cash, before adjustments, plus $10 in purchase price payable in the future, contingent upon the purchasers' achievement of certain rates of return on their investment. The disposition involved the sale of certain of the Company's subsidiaries throughout the world devoted to the professional products line, as well as assets dedicated exclusively or primarily to the lines being disposed. The worldwide professional products line was purchased by a company formed by CVC Capital Partners, the Colomer family and other investors, led by Carlos Colomer, a former manager of the line that was sold, following arms'-length negotiation of the terms of the purchase agreement therefor, including the determination of the amount of the consideration. The following unaudited summary pro forma financial information gives effect to the sale of the worldwide professional products line as of January 1, 1999 in the case of the pro forma statement of operations data and as of December 31, 1999 in the case of the pro forma balance sheet data. The pro forma information includes certain adjustments, such as reduced interest expense and a reduction in long-term debt as a result of the repayment of debt with $294.3 of the net proceeds from the disposition. The unaudited pro forma statement of operations data exclude the gain on the sale of the professional products line and eliminate costs incurred to date in connection with the sale since the gain and associated costs are non-recurring. The unaudited summary pro forma financial information is not necessarily indicative of the results of operations of the Company had the sale occurred at January 1, 1999, or financial position at December 31, 1999 had the sale occurred at that date, nor is it necessarily indicative of future results. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Sensitivity The Company has exposure to changing interest rates, primarily in the United States. The Company's policy is to manage interest rate risk through the use of a combination of fixed and floating rate debt. The Company from time to time makes use of derivative financial instruments to adjust its fixed and floating rate ratio. The table below provides information about the Company's indebtedness that is sensitive to changes in interest rates. The table presents cash flows with respect to principal on indebtedness and related weighted average interest rates by expected maturity dates. Weighted average variable rates are based on implied forward rates in the yield curve at December 31, 1999. The information is presented in U.S. dollar equivalents, which is the Company's reporting currency. Exchange Rate Sensitivity The Company manufactures and sells its products in a number of countries throughout the world and, as a result, is exposed to movements in foreign currency exchange rates. In addition, a portion of the Company's borrowings are denominated in foreign currencies, which are also subject to market risk associated with exchange rate movement. The Company from time to time hedges major net foreign currency cash exposures generally through foreign exchange forward and option contracts. The contracts are entered into with major financial institutions to minimize counterparty risk. These contracts generally have a duration of less than twelve months and are primarily against the U.S. dollar. In addition, the Company enters into foreign currency swaps to hedge intercompany financing transactions. The forward foreign exchange and option contracts entered into during 1999 expired by December 31, 1999. The Company does not hold or issue financial instruments for trading purposes. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Index on page of the Consolidated Financial Statements of the Company and the Notes thereto contained herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information concerning the Directors and executive officers of the Company. Each Director holds office until his successor is duly elected and qualified or until his resignation or removal, if earlier. NAME POSITION Ronald O. Perelman Chairman of the Board, Chairman of the Executive Committee of the Board and Director Jeffrey M. Nugent President, Chief Executive Officer and Director Frank J. Gehrmann Executive Vice President and Chief Financial Officer Wade H. Nichols III Executive Vice President and Chief Administrative Officer Donald G. Drapkin Director Meyer Feldberg Director Howard Gittis Director Morton L. Janklow Director Vernon E. Jordan Director Edward J. Landau Director Jerry W. Levin Director Linda Gosden Robinson Director Terry Semel Director Martha Stewart Director The name, age (as of March 8, 2000), principal occupation for the last five years and selected biographical information for each of the Directors and executive officers of the Company are set forth below. Mr. Perelman (57) has been Chairman of the Board of Directors of the Company and of the Company's wholly owned subsidiary Products Corporation since June 1998, Chairman of the Executive Committee of the Board of the Company and of Products Corporation since November 1995, and a Director of the Company and of Products Corporation since their respective formations in 1992. Mr. Perelman was Chairman of the Board of the Company and of Products Corporation from their respective formations in 1992 until November 1995. Mr. Perelman has been Chairman of the Board and Chief Executive Officer of Mafco Holdings Inc. ("Mafco Holdings" and, collectively with MacAndrews Holdings, "MacAndrews & Forbes") and MacAndrews Holdings and various of its affiliates since 1980. Mr. Perelman is also Chairman of the Executive Committee of the Board of Directors of M&F Worldwide Corp. ("M&F Worldwide") and is Chairman of the Board of Directors of Panavision Inc. ("Panavision"). Mr. Perelman is also a Director of the following corporations which file reports pursuant to the Securities Exchange Act of 1934, as amended (the "Exchange Act"): Golden State Bancorp Inc. ("Golden State"), Golden State Holdings Inc. ("Golden State Holdings"), M&F Worldwide, Panavision and REV Holdings. (On December 27, 1996, Marvel Entertainment Group, Inc. ("Marvel"), Marvel Holdings Inc. ("Marvel Holdings"), Marvel (Parent) Holdings Inc. ("Marvel Parent") and Marvel III Holdings Inc. ("Marvel III"), of which Mr. Perelman was a Director on such date, filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code.) Mr. Nugent (53) has been President and Chief Executive Officer of the Company and of Products Corporation since December 5, 1999. He has been a Director of the Company and of Products Corporation since February 14, 2000. He had been Worldwide President and Chief Executive Officer of Neutrogena Corporation from January 1995 until December 5, 1999. Prior to that, Mr. Nugent held various senior executive positions at Johnson & Johnson. Mr. Gehrmann (45) was elected as Executive Vice President and Chief Financial Officer of the Company and of Products Corporation in January 1998. From January 1997 until January 1998 he had been Vice President of the Company and of Products Corporation. Prior to January 1997 he served in various appointed senior executive positions for the Company and for Products Corporation, including Executive Vice President and Chief Financial Officer of Products Corporation's Operating Groups from August 1996 to January 1998, Executive Vice President and Chief Financial Officer of Products Corporation's Worldwide Consumer Products business from January 1995 to August 1996, and Executive Vice President and Chief Financial Officer of Products Corporation's Revlon North America unit from September 1993 to January 1994. From 1983 through September 1993, Mr. Gehrmann held positions of increasing responsibility in the financial organizations of Mennen Corporation and the Colgate-Palmolive Company, which acquired Mennen Corporation in 1992. Prior to 1983, Mr. Gehrmann served as a certified public accountant at the international auditing firm of Ernst & Young. Mr. Nichols (57) has been Executive Vice President and Chief Administrative Officer of the Company and of Products Corporation since January 1, 2000. He was Executive Vice President and General Counsel of the Company and of Products Corporation from January 1998 until December 31, 1999 and served as Senior Vice President and General Counsel of the Company and Products Corporation from their respective formations in 1992 until January 1998. Mr. Drapkin (52) has been a Director of the Company and of Products Corporation since their respective formations in 1992. He has been Vice Chairman of the Board of MacAndrews & Forbes and various of its affiliates since 1987. Mr. Drapkin was a partner in the law firm of Skadden, Arps, Slate, Meagher & Flom for more than five years prior to 1987. Mr. Drapkin is also a Director of the following corporations which file reports pursuant to the Exchange Act: Algos Pharmaceutical Corporation, Anthracite Capital, Inc., BlackRock Asset Investors, The Molson Companies Limited, Nexell Therapeutics Inc., Playboy Enterprises, Inc., Warnaco Group, Inc. and Weider Nutrition International, Inc. (On December 27, 1996, Marvel, Marvel Holdings, Marvel Parent and Marvel III, of which Mr. Drapkin was a Director on such date, filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code.) Professor Feldberg (57) has been a Director of the Company since February 1997. Professor Feldberg has been the Dean of Columbia Business School, New York City, for more than the past five years. Professor Feldberg is also a Director of the following corporations which file reports pursuant to the Exchange Act: Federated Department Stores, Inc., PRIMEDIA Inc. and Paine Webber Group, Inc. (28 directorships within such fund complex). Mr. Gittis (66) has been a Director of the Company and of Products Corporation since their respective formations in 1992. He has been Vice Chairman of the Board of MacAndrews & Forbes and various of its affiliates since 1985. Mr. Gittis is also a Director of the following corporations which file reports pursuant to the Exchange Act: Golden State, Golden State Holdings, Jones Apparel Group, Inc., Loral Space & Communications Ltd., M&F Worldwide, Panavision, REV Holdings and Sunbeam Corporation. Mr. Janklow (69) has been a Director of the Company since July 1997. He has been of counsel to Janklow, Newborn & Ashley and Senior Partner of Janklow & Nesbit Associates, a New York City-based literary agency, since 1989 and Chairman of the Board and Chief Executive Officer of Morton L. Janklow Associates, Inc., New York City since 1977. Mr. Janklow is also trustee of the Managed Accounts Services Portfolio Trust/Pace. Mr. Jordan (64) has been a Director of the Company since June 1996. Mr. Jordan has been a Managing Director of Lazard Freres & Co. LLC since January 2000. Since January 2000, Mr. Jordan has been Of Counsel at the Washington, D.C. law firm of Akin, Gump, Strauss, Hauer & Feld, LLP, and was a Senior Partner of such firm for more than five years prior thereto. He is also a Director of the following corporations which file reports pursuant to the Exchange Act: American Express Company, Callaway Golf Corporation, AMFM Inc., Dow Jones & Company, Inc., J.C. Penney Company, Inc., Ryder System, Inc., Sara Lee Corporation, Union Carbide Corporation and Xerox Corporation. He is also a trustee of Howard University. Mr. Landau (70) has been a Director of the Company since June 1996. Mr. Landau has been Of Counsel at the law firm of Wolf, Block, Schorr and Solis-Cohen LLP since February 1998, and was a Senior Partner of Lowenthal, Landau, Fischer & Bring, P.C., the predecessor to such firm, for more than five years prior to that date. Mr. Landau is also a Director of Offitbank Investment Fund, Inc., which files reports pursuant to the Exchange Act. Mr. Levin (55) was Chairman of the Board of the Company and of Products Corporation from November 1995 to June 1998 and has been a Director of the Company since its formation in 1992 and a Director of Products Corporation from its formation in 1992 to November 1998. Mr. Levin has been President and Chief Executive Officer and a Director of Sunbeam Corporation ("Sunbeam") since June 1998 and was elected Chairman of the Sunbeam Board in March 1999. He has served as Chairman and Chief Executive Officer of The Coleman Company, Inc. ("Coleman") since August 1998. Mr. Levin was Chairman and Chief Executive Officer of Company from 1997 to March 1998 and was Chairman of the Board and a Director of The Cosmetic Center, Inc. from April 1997 until December 1998. Mr. Levin was Chief Executive Officer of the Company and of Products Corporation from their respective formations in 1992 until 1997 and President of the Company and of Products Corporation from their respective formations in 1992 until November 1995. Mr. Levin has been Executive Vice President of MacAndrews Holdings since March 1989. For 15 years prior to joining MacAndrews Holdings, he held various senior executive positions with The Pillsbury Company. Mr. Levin is a Director of the following corporations which file reports pursuant to the Exchange Act: Ecolab, Inc., Sunbeam Corporation and U.S. Bancorp, Inc. Ms. Robinson (47) has been a Director of the Company since June 1996. Ms. Robinson has been Chairman of the Board and Chief Executive Officer of Robinson Lerer & Montgomery, LLC, a New York City strategic communications consulting firm, since May 1996. For more than five years prior thereto she was Chairman of the Board and Chief Executive Officer of Robinson Lerer Sawyer Miller Group, or its predecessors. Ms. Robinson is a trustee of Mt. Sinai Medical Center and Health System. Mr. Semel (57) has been a Director of the Company since June 1996. Mr. Semel has been Chairman of Windsor Media, Inc., Los Angeles, a diversified media company, since October 1999. He was Chairman of the Board and Co-Chief Executive Officer of the Warner Bros. Division of Time Warner Entertainment LP ("Warner Brothers"), Los Angeles, from March 1994 until October 1999 and of Warner Music Group, Los Angeles, from November 1995 until October 1999. For more than ten years prior to that he was President of Warner Brothers or its predecessor, Warner Bros. Inc. Mr. Semel is also a Director of Polo Ralph Lauren Corporation, which files reports pursuant to the Exchange Act. Ms. Stewart (58) has been a Director of the Company since June 1996. Ms. Stewart is the Chairman of the Board and Chief Executive Officer of Martha Stewart Living Omnimedia, Inc., New York City (formerly Martha Stewart Living Omnimedia, LLC, New York City). She has been an author, founder of the magazine Martha Stewart Living, creator of a syndicated television series, a syndicated newspaper column and a catalog company, and a lifestyle consultant and lecturer for more than the past five years. Ms. Stewart is a Director of Martha Stewart Living Omnimedia, Inc., which files reports pursuant to the Exchange Act. BOARD OF DIRECTORS AND ITS COMMITTEES The Board of Directors has an Executive Committee, an Audit Committee and a Compensation and Stock Plan Committee (the "Compensation Committee"). The Executive Committee consists of Messrs. Perelman, Gittis and Nugent. The Executive Committee may exercise all of the powers and authority of the Board, except as otherwise provided under the Delaware General Corporation Law. The Executive Committee also serves as the Company's nominating committee for Board membership. The Audit Committee, consisting of Mr. Landau, Professor Feldberg and Ms. Robinson, makes recommendations to the Board of Directors regarding the engagement of the Company's independent auditors for ratification by the Company's stockholders, reviews the plan, scope and results of the audit, and reviews with the auditors and management the Company's policies and procedures with respect to internal accounting and financial controls, changes in accounting policy and the scope of the non-audit services which may be performed by the Company's independent auditors, among other things. The Compensation Committee, currently consisting of Messrs. Gittis, Drapkin and Semel and Mr. Morton Janklow, who will not be standing for re-election as a director at the Annual Meeting, makes recommendations to the Board of Directors regarding compensation and incentive arrangements (including performance-based arrangements) for the Chief Executive Officer, other executive officers, officers and other key managerial employees of the Company. The Compensation Committee also considers and recommends awards pursuant to the Revlon, Inc. Second Amended and Restated 1996 Stock Plan, which was amended and restated as of December 17, 1996 and as of February 12, 1999 (the "Stock Plan"), and administers such plan. During 1999, the Board of Directors held six meetings and acted once by unanimous written consent, the Executive Committee acted four times by unanimous written consent, the Audit Committee held five meetings and the Compensation Committee held one meeting and acted nine times by unanimous written consent. During 1999, all Directors (other than Mr. Semel and Ms. Stewart) attended 75% or more of the meetings of the Board of Directors and of the Committees of which they were members. COMPENSATION OF DIRECTORS Directors who currently are not receiving compensation as officers or employees of the Company or any of its affiliates are paid an annual retainer fee of $25,000, payable in quarterly installments, and a fee of $1,000 for each meeting of the Board of Directors or any committee thereof they attend. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth information for the years indicated concerning the compensation awarded to, earned by or paid to the persons who served as Chief Executive Officer of the Company during 1999 and the four most highly paid executive officers, other than the Chief Executive Officers, who served as executive officers of the Company during 1999 (collectively, the "Named Executive Officers"), for services rendered in all capacities to the Company and its subsidiaries during such periods. SUMMARY COMPENSATION TABLE (a) The amounts shown in Annual Compensation for 1999, 1998 and 1997 reflect salary, bonus and other annual compensation (including perquisites and other personal benefits valued in excess of $50,000) and amounts reimbursed for payment of taxes awarded to, earned by or paid to the persons listed for services rendered to the Company and its subsidiaries. The Company has a bonus plan (the "Executive Bonus Plan") in which executives participate (including Mr. Nugent and Mr. Nichols (see "--Employment Agreements and Termination of Employment Arrangements")). The Executive Bonus Plan provides for payment of cash compensation upon the achievement of predetermined corporate and/or business unit and individual performance goals during the calendar year established pursuant to the Executive Bonus Plan or by the Compensation Committee. Mr. Gehrmann's compensation is reported for 1999 and 1998 only because he did not serve as an executive officer of the Company prior to 1998. Each of Messrs. Engelman's and Nugent's compensation is reported for 1999 only because neither served as a paid executive officer of the Company prior to 1999. (b) Mr. Nugent served as President and Chief Executive Officer of the Company effective December 5, 1999. The amount shown for Mr. Nugent under Salary for 1999 is comprised of $76,923 in salary and $83,333 earned by Mr. Nugent for consulting services provided by Mr. Nugent to the Company. Mr. Nugent did not receive a Bonus for 1999. The amount shown for Mr. Nugent under Other Annual Compensation for 1999 includes a payment of $36,382 in respect of gross ups for taxes on imputed income arising out of relocation expenses paid or reimbursed by the Company in 1999. The amount shown under All Other Compensation for 1999 reflects $38,743 in Company-paid relocation expenses. (c) Mr. Fellows served as President and Chief Executive Officer of the Company during 1999 until his resignation effective November 1999. The amount shown for Mr. Fellows under Bonus for 1999 is comprised of a special restructuring bonus of $1,685,000 paid to Mr. Fellows for 1999 upon achievement of business objectives set by the Compensation Committee. The amount shown for Mr. Fellows under Other Annual Compensation for 1999 includes $18,020 in respect of personal use of a Company-provided automobile and $17,145 in respect of Company-paid tax preparation expenses and payments in respect of gross ups for taxes on imputed income arising out of personal use of a Company-provided automobile and Company-provided air travel and for taxes on imputed income arising out of premiums paid or reimbursed by the Company in respect of life insurance. The amount shown under All Other Compensation for 1999 reflects $29,251 in respect of life insurance premiums, $4,800 in respect of matching contributions under the Revlon Employees' Savings, Profit Sharing and Investment Plan (the "401(k) Plan"), $15,000 in respect of matching contributions under the Revlon Excess Savings Plan for Key Employees (the "Excess Plan") and $1,800,000 payable pursuant to Mr. Fellows' separation agreement. The amount shown for Mr. Fellows under Other Annual Compensation for 1998 includes $18,020 in respect of personal use of a Company-provided automobile and $15,445 in respect of membership fees and related expenses for personal use of a health and country club and payments in respect of gross ups for taxes on imputed income arising out of personal use of a Company-provided automobile and Company-provided air travel and for taxes on imputed income arising out of premiums paid or reimbursed by the Company in respect of life insurance. The amount shown under All Other Compensation for 1998 reflects $13,381 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan and $15,000 in respect of matching contributions under the Excess Plan. The amounts shown under Other Annual Compensation for 1997 reflect payments in respect of gross ups for taxes on imputed income arising out of personal use of a Company-provided automobile and for taxes on imputed income arising out of premiums paid or reimbursed by the Company in respect of life insurance. The amount shown under All Other Compensation for 1997 reflects $11,117 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan and $15,000 in respect of matching contributions under the Excess Plan. (d) Ms. Dwyer served as Senior Vice President of the Company during 1999 and resigned effective January 3, 2000. The amount shown for Ms. Dwyer under Bonus for 1999 is comprised of a special restructuring bonus of $755,000 paid to Ms. Dwyer for 1999 upon achievement of business objectives set by the Compensation Committee. The amounts shown under Bonus for 1998 and 1997 include an additional payment of $300,000 in each year pursuant to her employment agreement in effect at the time. The amounts shown for Ms. Dwyer under Other Annual Compensation for 1999, 1998 and 1997 reflect payments in respect of gross ups for taxes on imputed income arising out of personal use of a Company-provided automobile and payments in respect of gross ups for taxes on imputed income arising out of premiums paid or reimbursed by the Company in respect of life insurance. The amount shown under All Other Compensation for 1999 reflects $1,810 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan, $14,694 in respect of matching contributions under the Excess Plan and $475,000 payable pursuant to Ms. Dwyer's separation agreement. The amount shown under All Other Compensation for 1998 reflects $1,785 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan and $15,000 in respect of matching contributions under the Excess Plan. The amount shown under All Other Compensation for 1997 reflects $2,720 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan and $10,857 in respect of matching contributions under the Excess Plan. (e) Mr. Engelman became an executive officer of the Company in November 1998 and served as Vice Chairman and Chief Administrative Officer of the Company during 1999 until his resignation effective December 31, 1999. The amount shown for Mr. Engelman under All Other Compensation for 1999 reflects $15,000 in respect of matching contributions under the Excess Plan and $525,000 payable pursuant to Mr. Engelman's separation agreement. (f) Mr. Gehrmann became an executive officer of the Company in January 1998. The amount shown for Mr. Gehrmann under Bonus for 1999 reflects the bonus amount payable to Mr. Gehrmann pursuant to his employment agreement. The amounts shown for Mr. Gehrmann under Other Annual Compensation for 1999 and 1998 reflects payments in respect of gross ups for taxes on imputed income arising out of personal use of a Company-provided automobile. The amount shown under All Other Compensation for 1999 reflects $4,800 in respect of matching contributions under the 401(k) Plan and $9,444 in respect of matching contributions under the Excess Plan. The amount shown under All Other Compensation for 1998 reflects $4,800 in respect of matching contributions under the 401(k) Plan and $12,497 in respect of matching contributions under the Excess Plan. (g) The amount shown for Mr. Nichols under Bonus for 1999 reflects the amount payable to Mr. Nichols under the Executive Bonus Plan, taking into account the guarantee by the Company of a minimum of 50% of targeted awards for 1999 (see "--Employment Agreements and Termination of Employment Arrangements"). The amount shown for Mr. Nichols under Bonus for 1997 were deferred pursuant to the Revlon Executive Deferred Compensation Plan (the "Deferred Compensation Plan") pursuant to which eligible executive employees who participate in the Executive Bonus Plan may elect to defer all or a portion of the bonus otherwise payable in respect of a calendar year. The amounts shown under Other Annual Compensation for 1999, 1998 and 1997 reflect payments in respect of gross ups for taxes on imputed income arising out of personal use of a Company-provided automobile and payments for taxes on imputed income arising out of premiums paid or reimbursed by the Company in respect of life insurance. The amount shown for Mr. Nichols under All Other Compensation for 1999 reflects $9,377 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan, $11,781 in respect of matching contributions under the Excess Plan and $11,844 in respect of above-market earnings on compensation deferred under the Deferred Compensation Plan for each year in which compensation was deferred that were earned but not paid or payable during 1999. The amount shown under All Other Compensation for 1998 reflects $9,990 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan, $10,463 in respect of matching contributions under the Excess Plan and $7,942 in respect of above-market earnings on compensation deferred under the Deferred Compensation Plan for each year in which compensation was deferred that were earned but not paid or payable during 1998. The amount shown under All Other Compensation for 1997 reflects $4,252 in respect of life insurance premiums, $4,800 in respect of matching contributions under the 401(k) Plan, $11,606 in respect of matching contributions under the Excess Plan and $2,431 in respect of above-market earnings on compensation deferred under the Deferred Compensation Plan for each year in which compensation was deferred that were earned but not paid or payable during 1997. OPTION GRANTS IN THE LAST FISCAL YEAR During 1999, the following grants of stock options were made pursuant to the Stock Plan to the executive officers named in the Summary Compensation Table: The grants made during 1999 under the Stock Plan to Messrs. Fellows, Engelman and Nichols and Ms. Dwyer were made on February 12, 1999, vested fully on the first anniversary of the grant date, and have an exercise price equal to the NYSE closing price per share of the Class A Common Stock on the grant date, as indicated in the table above. The options granted to Mr. Nichols in 1999 consist of non-qualified options having a term of 10 years. The options granted to Messrs. Fellows and Engelman in 1999 consist of non-qualified options that expire on December 31, 2002 and February 12, 2001, respectively, and the options granted to Ms. Dwyer in 1999 consist of non-qualified options that expired on January 3, 2000, pursuant to her termination agreement. (See "--Employment Agreements and Termination of Employment Arrangements"). The grants made during 1999 under the Stock Plan to Mr. Gehrmann were made on February 12, 1999 (with respect to an option to purchase 40,000 shares of the Company's Class A Common Stock that vested in full on the first anniversary of the grant date) and May 17, 1999 (with respect to an option to purchase 25,000 shares of the Company's Class A Common Stock that vests 25% each year beginning on the first anniversary of the grant date and will become 100% vested on the fourth anniversary of the grant date) and consist of non-qualified options having a term of 10 years with an exercise price equal to the NYSE closing price per share of the Class A Common Stock on the applicable grant date, as indicated in the table above. The grant made during 1999 under the Stock Plan to Mr. Nugent was made on December 5, 1999, has an exercise price equal to the NYSE closing price per share of the Class A Common Stock on the first business day after the grant date, as indicated in the table above, and will not vest as to any portion until the third anniversary of the date of grant and will thereupon become 100% vested, except that upon termination of employment by Mr. Nugent for "good reason" or by the Company other than for "cause" under his employment agreement, such options will vest with respect to 33 1/3% of the shares subject thereto if such termination is on or after the first and before the second anniversaries of such grant and with respect to 66 2/3% if such termination is on or after the second and before the third anniversaries of such grant. During 1999, the Company also granted an option to purchase 300,000 shares of the Company's Class A Common Stock pursuant to the Stock Plan to Mr. Perelman, the Chairman of the Board of Directors of the Company. The option vested in full on the grant date and has an exercise price of $15.00, the NYSE closing price per share of the Class A Common Stock on February 12, 1999, the date of the grant. (a) Grant Date Present Values were calculated using the Black-Scholes option pricing model. The model as applied used the grant dates of February 12, 1999 and May 17, 1999 with respect to the options granted on such dates and used the grant date of December 6, 1999 (the first business day after the date of grant) with respect to the option granted to Mr. Nugent on December 5, 1999. Stock option models require a prediction about the future movement of stock price. The following assumptions were made for purposes of calculating Grant Date Present Values: (i) a risk-free rate of return of 5.18% with respect to the options granted on February 12, 1999, 6.24% with respect to the options granted on May 17, 1999, and 5.75% with respect to the option granted to Mr. Nugent on December 5, 1999, which were the rates as of the applicable grant dates for the U.S. Treasury Zero Coupon Bond issues with a remaining term similar to the expected term of the options; (ii) stock price volatility of 68% based upon the volatility of the Company's stock price; (iii) a constant dividend rate of zero percent and (iv) that the options normally would be exercised on the final day of their seventh year after grant. No adjustments to the theoretical value were made to reflect the waiting period, if any, prior to vesting of the stock options or the transferability (or restrictions related thereto) of the stock options. The real value of the options in the table depends upon the actual performance of the Company's stock during the applicable period and upon when they are exercised. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES The following chart shows the number of stock options exercised during 1999 and the 1999 year-end value of the stock options held by the executive officers named in the Summary Compensation Table: (a) The market value of the underlying shares of Class A Common Stock at year end, calculated using $7 15/16, the December 31, 1999 NYSE closing price per share of Class A Common Stock, was less than the exercise price of all stock options listed in the table. The actual value, if any, an executive may realize upon exercise of a stock option depends upon the amount by which the market price of shares of Class A Common Stock exceeds the exercise price per share when the stock options are exercised. (b) Pursuant to Mr. Fellows' separation agreement effective November 1999, Mr. Fellows' 1998 option grant was cancelled; accordingly, the 1998 grant is not included in the option information in the above table for Mr. Fellows at fiscal year end. (c) The option information for Ms. Dwyer in the table above is correct as of December 31, 1999. Pursuant to Ms. Dwyer's separation agreement, effective January 3, 2000 unvested options were cancelled; accordingly, as of January 3, 2000 the number of securities underlying Ms. Dwyer's total outstanding options, all of which are exercisable, was 126,250. EMPLOYMENT AGREEMENTS AND TERMINATION OF EMPLOYMENT ARRANGEMENTS Each of Messrs. Nugent, Gehrmann and Nichols has a current executive employment agreement with the Company's wholly owned subsidiary, Products Corporation. Mr. Nugent's employment agreement, effective December 5, 1999, provides that he will serve as President and Chief Executive Officer at a base salary of not less than $1,000,000 for 1999 and 2000, not less than $1,150,000 for 2001 and not less than $1,300,000 for 2002, and that management recommend to the Compensation Committee that he be granted options to purchase 300,000 shares of Class A Common Stock on December 5, 1999 (which grant was made) and 100,000 shares of Class A Common Stock on each of December 5, 2000 and 2001. At any time on or after December 31, 2002, Products Corporation may terminate the term of Mr. Nugent's agreement by 24 months' prior notice of non-renewal. During any such period after notice of non-renewal Mr. Nugent would be deemed an employee at will and would be eligible for severance under the Executive Severance Policy. Mr. Gehrmann entered into an employment agreement with Products Corporation dated as of May 10, 1999, which provides that he will serve as Chief Financial Officer at a base salary of not less than $500,000 and that management will recommend to the Compensation Committee that he be granted options to purchase 40,000 shares of Class A Common Stock each year during the term of the agreement (unless and until a "triggering event" (as defined in the employment agreement) were to occur). At any time, Products Corporation may give written notice of non-extension of the term of Mr. Gehrmann's agreement such that the term would expire on the third anniversary of such notice. Mr. Nichols' employment agreement with Products Corporation was amended and restated as of May 10, 1999 and amended as of January 1, 2000 and provides that he will serve as chief administrative officer or another equivalent executive position through February 28, 2003 at a base salary of not less than $650,000 and that management will recommend to the Compensation Committee that he be granted options to purchase 40,000 shares of Class A Common Stock each year during the term of the agreement (unless and until a "triggering event" (as defined in the employment agreement) were to occur). Mr. Fellows resigned from his employment with the Company effective November 1, 1999 and entered into a termination agreement with Products Corporation dated as of February 16, 2000 (the "Fellows Agreement"), which provides that he receive a separation allowance of $5,400,000 payable over a period to expire December 31, 2002, which allowance would be reduced in each calendar year on account of any compensation earned from employment or consulting services during such calendar year by an amount equal to fifty percent of the gross amount of such compensation earned up to $1,000,000. Pursuant to the Fellows Agreement, the Company made a payment to Mr. Fellows for 1999 in the amount of $1,800,000 and will make a payment for 2000 in the amount of $900,000. Ms. Dwyer resigned from her employment with the Company effective January 3, 2000 and entered into a termination agreement with Products Corporation dated as of November 23, 1999 (the "Dwyer Agreement"), which provides that she receive a separation allowance of $1,900,000 payable over a period of twenty-four months, the unpaid portion of which allowance would be reduced on account of any compensation earned for employment or consulting services after the date of acceptance of subsequent employment, provided that Ms. Dwyer could, upon commencing subsequent employment, elect instead of such reduction to be paid a cash lump sum amount equal to 50% of the remaining allowance. Pursuant to the Dwyer Agreement, the Company made a payment to Ms. Dwyer for 1999 of $475,000. Mr. Engelman resigned from his employment with the Company effective December 31, 1999 and entered into a termination agreement with Products Corporation dated as of November 17, 1999 (the "Engelman Agreement"), which provides that he receive severance pay for twelve months at a base salary rate of $700,000, which pay would not be reduced by compensation earned for employment of consulting services during the severance period. Pursuant to the Engelman Agreement, the Company made a payment to Mr. Engelman for 1999 in the amount of $525,000. During 1999, in connection with the Company's review of strategic alternatives and in order to retain its executives during such process, the Company guaranteed a minimum of 50% of targeted awards payable under the Executive Bonus Plan for 1999, regardless of achievement of corporate and/or business unit objectives. Messrs. Nugent's and Nichols' employment agreements provide for participation in the Executive Bonus Plan. Mr. Nugent's agreement also provides that he will receive not less than $500,000 as a bonus for 2000 regardless of whether Executive Bonus Plan objectives are attained for such year. Mr. Gehrmann's agreement provides for a bonus for 1999 equal to 75% of base salary and for 2000 and thereafter a bonus of 75% of Mr. Gehrmann's 1999 base salary payable in bi-weekly installments in lieu of annual bonus payments. All of the employment agreements currently in effect provide for continuation of life insurance and executive medical insurance coverage in the event of permanent disability and participation in other executive benefit plans on a basis equivalent to senior executives of the Company generally. The agreements with Messrs. Nugent and Nichols provide for Company-paid supplemental term life insurance during employment in the amount of three times base salary, and all of the employment agreements currently in effect provide for Company-paid supplemental disability insurance. All of the employment agreements currently in effect provide for protection of Company confidential information and include a non-compete obligation. Mr. Gehrmann's agreement provides that in the event of termination of the term of the employment agreement by Mr. Gehrmann on 30 days' notice effective June 30, 2000 or for breach by the Company of a material provision of the employment agreement, failure of the Compensation Committee to adopt and implement the recommendations of management with respect to stock option grants, or following a "triggering event" (as defined in the employment agreement), Mr. Gehrmann would be entitled to continued base salary and bonus payments until the third anniversary of the date of termination (without reduction for compensation received by Mr. Gehrmann from other employment or consultancy) as well as continued participation in the Company's life insurance plan subject to a limit of two years and medical plans subject to the terms of such plans until the third anniversary of the date of termination or until Mr. Gehrmann were to become covered by like plans of another company. Mr. Nichols' agreement provides that in the event of termination of the term of the employment agreement by Mr. Nichols for breach by the Company of a material provision of the employment agreement, failure of the Compensation Committee to adopt and implement the recommendations of management with respect to stock option grants, or following a "triggering event" for "good reason" (as defined in the employment agreement), which event is not agreed to by Mr. Nichols, or by the Company (otherwise than for "cause", as defined in the employment agreement, or disability), Mr. Nichols would be entitled, at his election, to severance pursuant to the Executive Severance Policy (see "- Executive Severance Policy") (other than the six-month limit on lump sum payment provided for in the Executive Severance Policy, which provision would not apply to Mr. Nichols) or continued payments of base salary and bonus throughout the term and continued participation in the Company's life insurance plan subject to a limit of two years and medical plans subject to the terms of such plans throughout the term or until Mr. Nichols were covered by like plans of another company. Such payments to Mr. Nichols would only be reduced by compensation earned by Mr. Nichols from other employment or consultancy during such period if termination of employment were prior to a "triggering event" (as defined in the employment agreement). Mr. Nugent's agreement provides that in the event of termination of the term of the employment agreement by Mr. Nugent for breach by the Company of a material provision of the employment agreement or failure of the Compensation Committee to adopt and implement the recommendations of management with respect to stock option grants, or by the Company prior to December 31, 2002 (otherwise than for "cause" as defined in the employment agreement or disability), Mr. Nugent would be entitled, at his election, to severance pursuant to the Executive Severance Policy (see "-Executive Severance Policy") (other than the six-month limit on lump sum payment provided for in the Executive Severance Policy, which provision would not apply to Mr. Nugent) or continued payments of base salary through December 31, 2004 and continued participation in the Company's life insurance plan subject to a limit of two years and medical plans subject to the terms of such plans through December 31, 2004 or until Mr. Nugent were covered by like plans of another company, continued Company-paid supplemental term life insurance and continued Company-paid supplemental disability insurance. Such payments to Mr. Nugent would be reduced by any compensation earned by Mr. Nugent from other employment or consultancy during such period. In addition, the employment agreement with Mr. Nugent provides that if he remains employed by Products Corporation or its affiliates until age 62, then upon any subsequent retirement he will be entitled to a supplemental pension benefit in a sufficient amount so that his annual pension benefit from all qualified and non-qualified pension plans of Products Corporation and its affiliates (expressed as a straight life annuity) equals $500,000. If Mr. Nugent's employment were to terminate prior to September 30, 2000 then he would receive no supplemental pension benefit. If his employment were to terminate on or after September 30, 2000 and prior to September 30, 2001 then he would receive 11.1% of the amount otherwise payable pursuant to his agreement and thereafter an additional 11.1% would accrue as of each September 30th on which Mr. Nugent is still employed (but in no event more than would have been payable to Mr. Nugent under the foregoing provision had he retired at age 62). Mr. Nugent would not receive any supplemental pension benefit and would be required to reimburse the Company for any supplemental pension benefits received if he were to terminate his employment prior to January 1, 2003 other than for "good reason" (as defined in the employment agreement), or if he were to breach the agreement or be terminated by the Company for "cause" (as defined in the employment agreement). Mr. Nugent's employment agreement provides that he is entitled to a loan from Products Corporation of up to $500,000 for relocation expenses, which will be due and payable with interest at the applicable federal rate upon the earlier of the termination of his employment or five years from the initial loan. In addition, during the term of his employment agreement, Mr. Nugent will be entitled to additional compensation payable on a monthly basis equal to the amount actually paid by him in respect of interest and principal on a bank loan (the "Mortgage") of up to $1,500,000 obtained by Mr. Nugent to purchase a principal residence in the New York metropolitan area (the "Home Loan Payments"), plus a gross up for any taxes payable by Mr. Nugent as a result of such additional compensation. If Mr. Nugent terminates his employment for other than "good reason" or is terminated for "cause" (as such terms are defined in his employment agreement), then he shall be obligated to pay to Products Corporation an amount equal to the total amount of interest that would have been payable on the Home Loan Payments if the rate of interest on the Mortgage were the applicable federal rate in effect from time to time, plus the applicable tax gross up for such amounts. In addition, Mr. Nugent's employment agreement provides that he shall be entitled to a special bonus, payable on January 15 of the year next following the year in which his employment terminates, equal to the product of (A) $1,500,000 less the amount of Home Loan Payments made prior to the termination multiplied by (B) the following percentages: for termination in 2000, 0%; for termination in 2001, 20%; for termination in 2002, 40%; for termination in 2003, 60%; for termination in 2004, 80%; and for termination in 2005 or thereafter, 100%. Notwithstanding the above, if Mr. Nugent terminates his employment for other than "good reason" or is terminated for "cause" (as such terms are defined in his employment agreement), or if he breaches certain post-employment covenants, any bonus described above shall be forfeited or repaid by Mr. Nugent, as the case may be. EXECUTIVE SEVERANCE POLICY Products Corporation's Executive Severance Policy provides that upon termination of employment of eligible executive employees, including Mr. Nugent and the other Named Executive Officers (other than Ms. Dwyer and Messrs. Fellows and Engelman), other than voluntary resignation or termination by Products Corporation for good reason, in consideration for the execution of a release and confidentiality agreement and the Company's standard employee non-competition agreement, the eligible executive will be entitled to receive, in lieu of severance under any employment agreement then in effect or under Products Corporation's basic severance plan, a number of months of severance pay in semi-monthly installments based upon such executive's grade level and years of service reduced by the amount of any compensation from subsequent employment, unemployment compensation or statutory termination payments received by such executive during the severance period, and, in certain circumstances, by the actuarial value of enhanced pension benefits received by the executive, as well as continued participation in medical and certain other benefit plans for the severance period (or in lieu thereof, upon commencement of subsequent employment, a lump sum payment equal to the then present value of 50% of the amount of base salary then remaining payable through the balance of the severance period). Pursuant to the Executive Severance Policy, upon meeting the conditions set forth therein, Messrs. Gehrmann, Nugent and Nichols would be entitled to severance pay equal to two years of base salary at the rate in effect on the date of employment termination plus continued participation in the medical and dental plans for two years on the same terms as active employees. DEFINED BENEFIT PLANS The following table shows the estimated annual retirement benefits payable (as of December 31, 1999) at normal retirement age (65) to a person retiring with the indicated average compensation and years of credited service, on a straight life annuity basis, after Social Security offset, under the Revlon Employees' Retirement Plan (the "Retirement Plan"), including amounts attributable to the Pension Equalization Plan, each as described below. HIGHEST CONSECUTIVE FIVE-YEAR ESTIMATED ANNUAL STRAIGHT LIFE ANNUITY BENEFITS AT AVERAGE RETIREMENT WITH COMPENSATION INDICATED YEARS OF CREDITED SERVICE (a) DURING FINAL -------------------------------------------------------- TEN YEARS 15 20 25 30 35 - ------------ -------- -------- -------- -------- -------- $ 600,000 $151,701 $202,268 $252,835 $303,402 $303,402 700,000 177,701 236,935 296,168 355,402 355,402 800,000 203,701 271,601 339,502 407,402 407,402 900,000 229,701 306,268 382,835 459,402 459,402 1,000,000 255,701 340,935 426,168 500,000 500,000 1,100,000 281,701 375,601 469,502 500,000 500,000 1,200,000 307,701 410,268 500,000 500,000 500,000 1,300,000 333,701 444,935 500,000 500,000 500,000 1,400,000 359,701 479,601 500,000 500,000 500,000 1,500,000 385,701 500,000 500,000 500,000 500,000 2,000,000 500,000 500,000 500,000 500,000 500,000 2,500,000 500,000 500,000 500,000 500,000 500,000 (a) The normal form of benefit for the Retirement Plan and the Pension Equalization Plan is a straight life annuity. The Retirement Plan is intended to be a tax qualified defined benefit plan. Retirement Plan benefits are a function of service and final average compensation. The Retirement Plan is designed to provide an employee having 30 years of credited service with an annuity generally equal to 52% of final average compensation, less 50% of estimated individual Social Security benefits. Final average compensation is defined as average annual base salary and bonus (but not any part of bonuses in excess of 50% of base salary) during the five consecutive calendar years in which base salary and bonus (but not any part of bonuses in excess of 50% of base salary) were highest out of the last 10 years prior to retirement or earlier termination. Except as otherwise indicated, credited service includes all periods of employment with the Company or a subsidiary prior to retirement. The base salaries and bonuses of each of the Chief Executive Officer and the other Named Executive Officers are set forth in the Summary Compensation Table under columns entitled "Salary" and "Bonus," respectively. The Employee Retirement Income Security Act of 1974, as amended, places certain maximum limitations upon the annual benefit payable under all qualified plans of an employer to any one individual. In addition, the Omnibus Budget Reconciliation Act of 1993 limits the annual amount of compensation that can be considered in determining the level of benefits under qualified plans. The Pension Equalization Plan, as amended effective December 14, 1998, is a non-qualified benefit arrangement designed to provide for the payment by the Company of the difference, if any, between the amount of such maximum limitations and the annual benefit that would be payable under the Retirement Plan but for such limitations, up to a combined maximum annual straight life annuity benefit at age 65 under the Retirement Plan and the Pension Equalization Plan of $500,000. Benefits provided under the Pension Equalization Plan are conditioned on the participant's compliance with his or her non-competition agreement and on the participant not competing with Products Corporation for one year after termination of employment. The number of years of credited service under the Retirement Plan and the Pension Equalization Plan as of January 1, 2000 (rounded to full years) for Mr. Fellows is eleven years (which includes credit for prior service with Revlon Holdings Inc. ("Holdings")), for Ms. Dwyer is six years, for Mr. Engelman is one year, for Mr. Gehrmann is six years and for Mr. Nichols is 21 years (which includes credit for prior service with Holdings). Mr. Nugent had no years of credited service as of January 1, 2000. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth as of January 31, 2000 the number of shares of Common Stock beneficially owned, and the percent so owned, by (i) each person known to the Company to be the beneficial owner of more than 5% of the outstanding shares of Common Stock, (ii) each director of the Company, (iii) each of the Chief Executive Officers during 1999 and each of the other Named Executive Officers during 1999 and (iv) all directors and executive officers of the Company as a group. The number of shares owned are those beneficially owned, as determined under the rules of the Commission, and such information is not necessarily indicative of beneficial ownership for any other purpose. Under such rules, beneficial ownership includes any shares of Common Stock as to which a person has sole or shared voting power or investment power and any shares of Common Stock which the person has the right to acquire within 60 days through the exercise of any option, warrant or right, through conversion of any security or pursuant to the automatic termination of a power of attorney or revocation of a trust, discretionary account or similar arrangement. *Less than one percent. (1) Mr. Perelman through Mafco Holdings (which through REV Holdings) beneficially owns 11,250,000 shares of Class A Common Stock (representing approximately 56.3% of the outstanding shares of Class A Common Stock) and all of the outstanding 31,250,000 shares of Class B Common Stock, which together represent approximately 83.0% of the outstanding shares of Common Stock and has approximately 97.4% of the combined voting power of the outstanding shares of Common Stock. All of the shares of Common Stock owned by REV Holdings are pledged by REV Holdings to secure obligations, and shares of intermediate holding companies are or may from time to time be pledged to secure obligations of Mafco Holdings or its affiliates. Mr. Perelman also holds an option to acquire 300,000 shares, which option vested on February 12, 1999. The vested option to acquire 300,000 shares together with the Class A and Class B Common Stock owned by Mr. Perelman represents approximately 83.5% of the outstanding shares of Common Stock. (2) All of such shares are held by trusts for Mr. Drapkin's children and beneficial ownership is disclaimed. (3) Includes 3,000 shares held directly; 625 shares acquired pursuant to the Company matching under the 401(k) Plan; 1,242 shares that Ms. Dwyer has the right to receive pursuant to the Company matching under the Excess Plan; 31,250, 31,250, 18,750 and 45,000 shares which may be acquired under options which vested on January 9, 1998, January 9, 1999, January 8, 1999 and February 28, 1999, respectively. (4) Includes 10,000 shares owned jointly by Mr. Engelman's wife and 859 shares acquired pursuant to the Company matching under the Excess Plan. (5) Includes 8,000 shares held directly; 314 shares acquired pursuant to the Company matching under the 401(k) Plan; 1,372 shares that Mr. Fellows has the right to receive pursuant to the Company matching under the Excess Plan; 42,500, 42,500, 120,000 and 170,000 shares which may be acquired under options which vested on January 9, 1999, January 9, 2000, February 28, 1999 and February 12, 2000, respectively. (6) Includes 3,000 shares owned jointly by Mr. Gehrmann's wife; 578 shares acquired pursuant to the Company matching under the 401(k) Plan; 1,119 shares that Mr. Gehrmann has the right to receive pursuant to the Company matching under the Excess Plan; 2,500, 2,500, 2,500, 2,500, 3,000, 3,000, 3,000, 7,500, 7,500 and 40,000 shares which may be acquired under options which vested on February 28, 1997, February 28, 1998, February 28, 1999, February 28, 2000, January 9, 1998, January 9, 1999, January 9, 2000, January 8, 1999, January 8, 2000 and February 12, 2000, respectively. (7) Includes 25,000 shares held directly by Mr. Levin; 1,000 shares owned by Mr. Levin's daughter as to which beneficial ownership is disclaimed; 129 shares acquired pursuant to the Company matching under the 401(k) Plan; 360 shares that Mr. Levin has the right to receive pursuant to the Company matching under the Excess Plan; 42,500, 42,500, 42,500, 42,500, 42,500, 42,500 and 170,000 shares which may be acquired under options which vested on January 9, 1998, January 9, 1999, January 9, 2000, January 8, 1999, January 8, 2000, March 2, 1999 and February 28, 1999, respectively. (8) Includes 5,400 shares held directly; 568 shares acquired pursuant to the Company matching under the 401(k) Plan; 1,486 shares that Mr. Nichols has the right to receive pursuant to the Company matching under the Excess Plan; 7,500, 7,500, 7,500, 10,000, 10,000, 30,000 and 40,000 shares which may be acquired under options which vested on January 9, 1998, January 9, 1999, January 9, 2000, January 8, 1999, January 8, 2000, February 28, 1999 and February 12, 2000, respectively. (9) Includes 2,000 shares owned by Mr. Semel's children as to which beneficial ownership is disclaimed and 3,000 shares owned jointly by Mr. Semel's wife. (10) Includes 500 shares owned directly and 500 shares owned indirectly by the Martha Stewart Inc. Defined Benefit Pension Plan. (11) Includes only shares held by persons who were directors and executive officers of the Company as of January 31, 2000. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS MacAndrews & Forbes beneficially owns shares of Common Stock having approximately 97.4% of the combined voting power of the outstanding shares of Common Stock. As a result, MacAndrews & Forbes is able to elect the entire Board of Directors of the Company and control the vote on all matters submitted to a vote of the Company's stockholders. MacAndrews & Forbes is wholly owned by Ronald O. Perelman, who is Chairman of the Board of Directors of the Company. TRANSFER AGREEMENTS In June 1992, Revlon, Inc. and Products Corporation entered into an asset transfer agreement with Holdings and certain of its wholly owned subsidiaries (the "Asset Transfer Agreement"), and Revlon, Inc. and Products Corporation entered into a real property asset transfer agreement with Holdings (the "Real Property Transfer Agreement" and, together with the Asset Transfer Agreement, the "Transfer Agreements"), and pursuant to such agreements, on June 24, 1992 Holdings transferred assets to Products Corporation and Products Corporation assumed all the liabilities of Holdings, other than certain specifically excluded assets and liabilities (the liabilities excluded are referred to as the "Excluded Liabilities"). Certain consumer products lines sold in demonstrator assisted distribution channels considered not integral to the Company's business and which historically had not been profitable (the "Retained Brands") and certain of the assets and liabilities were retained by Holdings. Holdings agreed to indemnify Revlon, Inc. and Products Corporation against losses arising from the Excluded Liabilities, and Revlon, Inc. and Products Corporation agreed to indemnify Holdings against losses arising from the liabilities assumed by Products Corporation. The amount reimbursed by Holdings to Products Corporation for the Excluded Liabilities for 1999 was $0.5 million. OPERATING SERVICES AGREEMENT In June 1992, Revlon, Inc., Products Corporation and Holdings entered into an operating services agreement (as amended and restated, and as subsequently amended, the "Operating Services Agreement") pursuant to which Products Corporation has manufactured, marketed, distributed, warehoused and administered, including the collection of accounts receivable, the Retained Brands for Holdings. Pursuant to the Operating Services Agreement, Products Corporation was reimbursed an amount equal to all of its and Revlon, Inc.'s direct and indirect costs incurred in connection with furnishing such services, net of the amounts collected by Products Corporation with respect to the Retained Brands, payable quarterly. There were no amounts reimbursed by Holdings to Products Corporation for such direct and indirect costs for 1999. REIMBURSEMENT AGREEMENTS Revlon, Inc., Products Corporation and MacAndrews Holdings have entered into reimbursement agreements (the "Reimbursement Agreements") pursuant to which (i) MacAndrews Holdings is obligated to provide (directly or through affiliates) certain professional and administrative services, including employees, to Revlon, Inc. and its subsidiaries, including Products Corporation, and purchase services from third party providers, such as insurance and legal and accounting services, on behalf of Revlon, Inc. and its subsidiaries, including Products Corporation, to the extent requested by Products Corporation, and (ii) Products Corporation is obligated to provide certain professional and administrative services, including employees, to MacAndrews Holdings (and its affiliates) and purchase services from third party providers, such as insurance and legal and accounting services, on behalf of MacAndrews Holdings (and its affiliates) to the extent requested by MacAndrews Holdings, provided that in each case the performance of such services does not cause an unreasonable burden to MacAndrews Holdings or Products Corporation, as the case may be. The Company reimburses MacAndrews Holdings for the allocable costs of the services purchased for or provided to the Company and its subsidiaries and for reasonable out-of-pocket expenses incurred in connection with the provision of such services. MacAndrews Holdings (or such affiliates) reimburses the Company for the allocable costs of the services purchased for or provided to MacAndrews Holdings (or such affiliates) and for the reasonable out-of-pocket expenses incurred in connection with the purchase or provision of such services. The net amount reimbursed by MacAndrews Holdings to the Company for the services provided under the Reimbursement Agreements for 1999 was $0.5 million. Each of Revlon, Inc. and Products Corporation, on the one hand, and MacAndrews Holdings, on the other, has agreed to indemnify the other party for losses arising out of the provision of services by it under the Reimbursement Agreements other than losses resulting from its willful misconduct or gross negligence. The Reimbursement Agreements may be terminated by either party on 90 days' notice. The Company does not intend to request services under the Reimbursement Agreements unless their costs would be at least as favorable to the Company as could be obtained from unaffiliated third parties. TAX SHARING AGREEMENT Revlon, Inc., for federal income tax purposes, is included in the affiliated group of which Mafco Holdings is the common parent, and Revlon, Inc.'s federal taxable income and loss is included in such group's consolidated tax return filed by Mafco Holdings. Revlon, Inc. also may be included in certain state and local tax returns of Mafco Holdings or its subsidiaries. In June 1992, Holdings, Revlon, Inc. and certain of its subsidiaries, and Mafco Holdings entered into a tax sharing agreement (as subsequently amended, the "Tax Sharing Agreement"), pursuant to which Mafco Holdings has agreed to indemnify Revlon, Inc. against federal, state or local income tax liabilities of the consolidated or combined group of which Mafco Holdings (or a subsidiary of Mafco Holdings other than Revlon, Inc. or its subsidiaries) is the common parent for taxable periods beginning on or after January 1, 1992 during which Revlon, Inc. or a subsidiary of Revlon, Inc. is a member of such group. Pursuant to the Tax Sharing Agreement, for all taxable periods beginning on or after January 1, 1992, Revlon, Inc. will pay to Holdings amounts equal to the taxes that Revlon, Inc. would otherwise have to pay if it were to file separate federal, state or local income tax returns (including any amounts determined to be due as a result of a redetermination arising from an audit or otherwise of the consolidated or combined tax liability relating to any such period which is attributable to Revlon, Inc.), except that Revlon, Inc. will not be entitled to carry back any losses to taxable periods ending prior to January 1, 1992. No payments are required by Revlon, Inc. if and to the extent Products Corporation is prohibited under the Credit Agreement from making tax sharing payments to Revlon, Inc. The Credit Agreement prohibits Products Corporation from making such tax sharing payments other than in respect of state and local income taxes. Since the payments to be made under the Tax Sharing Agreement will be determined by the amount of taxes that Revlon, Inc. would otherwise have to pay if it were to file separate federal, state or local income tax returns, the Tax Sharing Agreement will benefit Mafco Holdings to the extent Mafco Holdings can offset the taxable income generated by Revlon, Inc. against losses and tax credits generated by Mafco Holdings and its other subsidiaries. There were no cash payments in respect of federal taxes made by Revlon, Inc. pursuant to the Tax Sharing Agreement for 1999. REGISTRATION RIGHTS AGREEMENT Prior to the consummation of the Company's initial public equity offering in 1996, Revlon, Inc. and Revlon Worldwide Corporation (subsequently merged into REV Holdings), the then direct parent of Revlon, Inc., entered into the Registration Rights Agreement pursuant to which REV Holdings and certain transferees of Revlon, Inc.'s Common Stock held by REV Holdings (the "Holders") have the right to require Revlon, Inc. to register all or part of the Class A Common Stock owned by such Holders and the Class A Common Stock issuable upon conversion of Revlon, Inc.'s Class B Common Stock owned by such Holders under the Securities Act of 1933, as amended (a "Demand Registration"); provided that Revlon, Inc. may postpone giving effect to a Demand Registration up to a period of 30 days if Revlon, Inc. believes such registration might have a material adverse effect on any plan or proposal by Revlon, Inc. with respect to any financing, acquisition, recapitalization, reorganization or other material transaction, or if Revlon, Inc. is in possession of material non-public information that, if publicly disclosed, could result in a material disruption of a major corporate development or transaction then pending or in progress or in other material adverse consequences to Revlon, Inc. In addition, the Holders have the right to participate in registrations by Revlon, Inc. of its Class A Common Stock (a "Piggyback Registration"). The Holders will pay all out-of-pocket expenses incurred in connection with any Demand Registration. Revlon, Inc. will pay any expenses incurred in connection with a Piggyback Registration, except for underwriting discounts, commissions and expenses attributable to the shares of Class A Common Stock sold by such Holders. OTHER Pursuant to a lease dated April 2, 1993 (the "Edison Lease"), Holdings leased to Products Corporation the Edison research and development facility for a term of up to 10 years with an annual rent of $1.4 million and certain shared operating expenses payable by Products Corporation which, together with the annual rent, were not to exceed $2.0 million per year. In August 1998, Holdings sold the Edison facility to an unrelated third party, which assumed substantially all liability for environmental claims and compliance costs relating to the Edison facility, and in connection with the sale Products Corporation terminated the Edison Lease and entered into a new lease with the new owner. Holdings agreed to indemnify Products Corporation to the extent rent under the new lease exceeds rent that would have been payable under the terminated Edison Lease had it not been terminated. The net amount reimbursed by Holdings to Products Corporation with respect to the Edison facility for 1999 was $0.2 million. During 1999, Products Corporation leased certain facilities to MacAndrews & Forbes or its affiliates pursuant to occupancy agreements and leases. These included space at Products Corporation's New York headquarters and at Products Corporation's offices in London. The rent paid to Products Corporation for 1999 was $1.1 million. Products Corporation's Credit Agreement is supported by, among other things, guarantees from Holdings and certain of its subsidiaries. The obligations under such guarantees are secured by, among other things, the capital stock and certain assets of certain subsidiaries of Holdings. Products Corporation borrows funds from its affiliates from time to time to supplement its working capital borrowings. No such borrowings were outstanding as of December 31, 1999. The interest rates for such borrowings are more favorable to Products Corporation than interest rates under the Credit Agreement and, for borrowings occurring prior to the execution of the Credit Agreement, the credit facilities in effect at the time of such borrowing. The amount of interest paid by Products Corporation for such borrowings for 1999 was $0.5 million. During 1998, the Company made advances of $0.25 million, $0.3 million and $0.4 million to Mr. Fellows, Ms. Dwyer, and Mr. Levin, respectively, which advances were repaid in 1999. During 1999, the Company made an advance of $0.4 million to Mr. Nugent. During 1999, a company that was an affiliate of the Company during part of 1999 assembled lipstick cases for Products Corporation. Products Corporation paid approximately $0.1 million for such services in 1999. During 1999, Products Corporation made payments of $0.1 million to a fitness center, an interest in which is owned by members of Mr. Drapkin's immediate family, for discounted health club dues for an executive health program of Products Corporation. The law firm of which Mr. Jordan is of counsel provided legal services to Revlon, Inc. and its subsidiaries during 1999, and it is anticipated that it will provide legal services to Revlon, Inc. and its subsidiaries during 2000. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) List of documents filed as part of this Report: (1) Consolidated Financial Statements and Independent Auditors' Report included herein: See Index on page (2) Financial Statement Schedule: See Index on page All other schedules are omitted as they are inapplicable or the required information is furnished in the Consolidated Financial Statements of the Company or the Notes thereto. (3) List of Exhibits: EXHIBIT NO. DESCRIPTION 3. CERTIFICATE OF INCORPORATION AND BY-LAWS. 3.1 Amended and Restated Certificate of Incorporation of Revlon, Inc. dated March 4, 1996. (Incorporated by reference to Exhibit 3.4 to the Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996 of Revlon, Inc.). 3.2 Amended and Restated By-Laws of Revlon, Inc. dated January 30, 1997. (Incorporated by reference to Exhibit 3.2 to the Annual Report on Form 10-K for the year ended December 31, 1996 of Revlon, Inc. (the "Revlon 1996 10-K")). 4. INSTRUMENTS DEFINING THE RIGHT OF SECURITY HOLDERS, INCLUDING INDENTURES. 4.1 Indenture, dated as of February 1, 1998, between Revlon Escrow and U.S. Bank Trust National Association (formerly known as First Trust National Association), as Trustee, relating to the 8 1/8% Senior Notes due 2006 (the "8 1/8% Senior Notes Indenture"). (Incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-1 of Products Corporation filed with the Commission on March 12, 1998, File No. 333-47875 (the "Products Corporation 1998 Form S-1")). 4.2 Indenture, dated as of February 1, 1998, between Revlon Escrow and U.S. Bank Trust National Association (formerly known as First Trust National Association), as Trustee, relating to the 8 5/8% Senior Notes Due 2006 (the "8 5/8% Senior Subordinated Notes Indenture"). (Incorporated by reference to Exhibit 4.3 to the Products Corporation 1998 Form S-1). 4.3 First Supplemental Indenture, dated April 1, 1998, among Products Corporation, Revlon Escrow, and the Trustee, amending the 8 1/8% Senior Notes Indenture. (Incorporated by reference to Exhibit 4.2 to the Products Corporation 1998 Form S-1). 4.4 First Supplemental Indenture, dated March 4, 1998, among Products Corporation, Revlon Escrow, and the Trustee, amending the 8 5/8% Senior Subordinated Notes Indenture. (Incorporated by reference to Exhibit 4.4 to the Products Corporation 1998 Form S-1). 4.5 Indenture, dated as of November 6, 1998, between Products Corporation and U.S. Bank Trust National Association, as Trustee, relating to Products Corporation's 9% Senior Notes due 2006. (Incorporated by reference to Exhibit 4.13 to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998 of Revlon, Inc. (the "Revlon 1998 Third Quarter Form 10-Q")). 4.6 Third Amended and Restated Credit Agreement dated as of June 30, 1997, between Pacific Finance & Development Corp. and the Long-Term Credit Bank of Japan, Ltd. (the "Yen Credit Agreement"). (Incorporated by reference to Exhibit 4.11 to the Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997 of Revlon, Inc.). 4.7 First Amendment to the Yen Credit Agreement dated as of December 10, 1998. (Incorporated by reference to Exhibit 4.8 to the Registration Statement on Form S-4 of Products Corporation filed with the Commission on December 18, 1998, File No. 33-69213 (the "Products Corporation 1998 S-4")). 4.8 Second Amendment to the Yen Credit Agreement dated as of November 12, 1999 by and among Pacific Finance & Development Corp. and General Electric Capital Corporation, assignee of the Long Term Credit Bank of Japan. (Incorporated by reference to Exhibit 4.13 to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999 of Revlon, Inc. (the "Revlon 1999 Third Quarter Form 10-Q")). 4.9 Amended and Restated Credit Agreement, dated as of May 30, 1997, among Products Corporation, The Chase Manhattan Bank, Citibank N.A., Lehman Commercial Paper Inc., Chase Securities Inc. and the lenders party thereto (the "Credit Agreement"). (Incorporated by reference to Exhibit 4.23 to Amendment No. 2 to the Registration Statement on Form S-1 of Revlon Worldwide (Parent) Corporation, filed with the Commission on June 26, 1997, File No. 33-23451). 4.10 First Amendment, dated as of January 29, 1998, to the Credit Agreement. (Incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K for the year ended December 31, 1997 of Revlon, Inc. (the "Revlon 1997 10-K")). 4.11 Second Amendment, dated as of November 6, 1998, to the Credit Agreement. (Incorporated by reference to Exhibit 4.12 to the Revlon 1998 Third Quarter Form 10-Q). 4.12 Third Amendment, dated as of December 23, 1998, to the Credit Agreement. (Incorporated by reference to Exhibit 4.12 to Amendment No. 1 to the Products Corporation 1998 Form S-4 filed with the Commission on January 22, 1999, File No. 33-69213). 4.13 Fourth Amendment, dated as of November 10, 1999, to the Credit Agreement. (Incorporated by reference to Exhibit 4.12 to the Revlon 1999 Third Quarter Form 10-Q). 10. MATERIAL CONTRACTS. 10.1 Asset Transfer Agreement, dated as of June 24, 1992, among Holdings, National Health Care Group, Inc., Charles of the Ritz Group Ltd., Products Corporation and Revlon, Inc. (Incorporated by reference to Exhibit 10.1 to Amendment No. 1 to the Revlon, Inc. Registration Statement on Form S-1 filed with the Commission on June 29, 1992, File No. 33-47100 (the "Revlon 1992 Amendment No. 1")). 10.2 Tax Sharing Agreement, dated as of June 24, 1992, among Mafco Holdings, Revlon, Inc., Products Corporation and certain subsidiaries of Products Corporation (the "Tax Sharing Agreement"). (Incorporated by reference to Exhibit 10.5 to the Revlon 1992 Amendment No. 1). 10.3 First Amendment, dated as of February 28, 1995, to the Tax Sharing Agreement. (Incorporated by reference to Exhibit 10.5 to the Annual Report on Form 10-K for the year ended December 31, 1994 of Products Corporation). 10.4 Second Amendment, dated as of January 1, 1997, to the Tax Sharing Agreement. (Incorporated by reference to Exhibit 10.7 to the Revlon 1996 10-K). 10.5 Second Amended and Restated Operating Services Agreement by and among Holdings, Revlon, Inc. and Products Corporation, dated as of January 1, 1996 (the "Operating Services Agreement"). (Incorporated by reference to Exhibit 10.8 to the Revlon 1996 10-K). 10.6 Amendment to the Operating Services Agreement, dated as of July 1, 1997. (Incorporated by reference to Exhibit 10.10 to the Revlon 1997 10-K). 10.7 Employment Agreement amended and restated as of the 10th day of May, 1999, effective as of January 1, 1998, between Products Corporation and Wade H. Nichols (the "Nichols Employment Agreement"). (Incorporated by reference to Exhibit 10.25 to the Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999 of Revlon, Inc.). *10.8 Amendment, as of January 1, 2000 to the Nichols Employment Agreement. *10.9 Employment Agreement dated as of May 10, 1999 between Products Corporation and Frank Gehrmann. *10.10 Employment Agreement dated as of November 2, 1999 between Products Corporation and Jeffrey M. Nugent. 10.11 Amended and Restated Revlon Pension Equalization Plan, amended and restated as of December 14, 1998. (Incorporated by reference to Exhibit 10.15 to the Annual Report on Form 10-K for year ended December 31, 1998 of Revlon, Inc.). 10.12 Executive Supplemental Medical Expense Plan Summary dated July 1991. (Incorporated by reference to Exhibit 10.18 to the Registration Statement on Form S-1 of Revlon, Inc. filed with the Commission on May 22, 1992, File No. 33-47100 (the "Revlon 1992 Form S-1")). 10.13 Description of Post Retirement Life Insurance Program for Key Executives. (Incorporated by reference to Exhibit 10.19 to the Revlon 1992 Form S-1). 10.14 Benefit Plans Assumption Agreement dated as of July 1, 1992, by and among Holdings, Revlon, Inc. and Products Corporation. (Incorporated by reference to Exhibit 10.25 to the Annual Report on Form 10-K for the year ended December 31, 1992 of Products Corporation). 10.15 Revlon Executive Bonus Plan effective January 1, 1997. (Incorporated by reference to Exhibit 10.20 to the Revlon 1996 10-K). 10.16 Revlon Amended and Restated Executive Deferred Compensation Plan dated as of August 6, 1999. (Incorporated by reference to Exhibit 10.27 to the Revlon 1999 Third Quarter Form 10-Q). 10.17 Revlon Executive Severance Policy effective January 1, 1996. (Incorporated by reference to Exhibit 10.23 to the Amendment No. 3 to the Registration Statement on Form S-1 of Revlon, Inc. filed with the Commission on February 5, 1996, File No. 33-9958). 10.18 Revlon, Inc. Second Amended and Restated 1996 Stock Plan (Amended and Restated as of February 12, 1999). (Incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-8 of Revlon, Inc. filed with the Commission on April 14, 1999, File No. 333-76267). *10.19 Purchase Agreement dated as of February 18, 2000 by and among Revlon, Inc., Revlon Consumer Products Corporation, REMEA 2 B.V., Revlon Europe, Middle East and Africa, Ltd., Revlon International Corporation, Europeenne de Produits de Beaute S.A., Deutsche Revlon GmbH & Co. K.G., Revlon Canada, Inc., Revlon de Argentina, S.A.I.C., Revlon South Africa (Proprietary) Limited, Revlon (Suisse) S.A., Revlon Overseas Corporation C.A., CEIL - Comercial, Exportadora, Industrial Ltda., Revlon Manufacturing Ltd., Revlon Belgium N.V., Revlon (Chile) S.A., Revlon (Hong Kong) Limited, Revlon, S.A., Revlon Nederland B.V., Revlon New Zealand Limited, European Beauty Products S.p.A. and Beauty Care Professional Products Luxembourg, S.a.r.l. 21. SUBSIDIARIES. *21.1 Subsidiaries of the Registrant. 23. Consents of Experts and Counsel. 23.1 Consent of KPMG LLP. 24. POWERS OF ATTORNEY. *24.1 Power of Attorney of Ronald O. Perelman. *24.2 Power of Attorney of Donald G. Drapkin. *24.3 Power of Attorney of Meyer Feldberg. *24.4 Power of Attorney of Howard Gittis. *24.5 Power of Attorney of Morton L. Janklow. *24.6 Power of Attorney of Vernon E. Jordan, Jr., Esq. *24.7 Power of Attorney of Edward J. Landau, Esq. *24.8 Power of Attorney of Jerry W. Levin. *24.9 Power of Attorney of Linda Gosden Robinson. *24.10 Power of Attorney of Terry Semel. *24.11 Power of Attorney of Martha Stewart. 27. Financial Data Schedule. - -------------------- * Filed herewith. (b) Reports on Form 8-K - None. REVLON, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE Page ---- Independent Auditors' Report...............................................F-2 AUDITED FINANCIAL STATEMENTS: Consolidated Balance Sheets as of December 31, 1999 and 1998.......................................F-3 Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 1999...................................F-4 Consolidated Statements of Stockholders' Deficiency and Comprehensive Loss for each of the years in the three-year period ended December 31, 1999....................F-5 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1999..........................................F-6 Notes to Consolidated Financial Statements.............................F-7 FINANCIAL STATEMENT SCHEDULE: Schedule II--Valuation and Qualifying Accounts........................F-32 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Revlon, Inc.: We have audited the accompanying consolidated balance sheets of Revlon, Inc. and its subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' deficiency and comprehensive loss and cash flows for each of the years in the three-year period ended December 31, 1999. In connection with our audits of the consolidated financial statements we have also audited the financial statement schedule as listed on the index on page. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Revlon, Inc. and its subsidiaries as of December 31, 1999 and 1998 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP New York, New York March 30, 2000 REVLON, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. REVLON, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. REVLON, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY AND COMPREHENSIVE LOSS (DOLLARS IN MILLIONS) - ------------------- (a) Represents net loss since June 24, 1992, the effective date of the transfer agreements referred to in Note 16. (b) Accumulated other comprehensive loss includes a revaluation of marketable securities of $3.8 and $3.0 for 1999 and 1998, respectively, currency translation adjustments of $59.4, $37.1 and $19.2 for 1999, 1998 and 1997, respectively, and adjustments for the minimum pension liability of $4.9, $32.5 and $4.5 for 1999, 1998 and 1997, respectively. (c) Represents changes in capital from the acquisition of the Bill Blass business (See Note 16). (d) Accumulated other comprehensive loss and comprehensive loss each include a reclassification adjustment of $2.2 for realized gains associated with the sale of certain assets outside the United States. See Accompanying Notes to Consolidated Financial Statements. REVLON, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) See Accompanying Notes to Consolidated Financial Statements. REVLON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) 1. SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION: Revlon, Inc. (and together with its subsidiaries, the "Company") conducts its business exclusively through its direct subsidiary, Revlon Consumer Products Corporation and its subsidiaries ("Products Corporation"). The Company manufactures and sells an extensive array of cosmetics and skin care, fragrances and personal care products, and professional products (products for use in and resale by professional salons). On March 30, 2000, the Company sold its worldwide professional products line (See Note 20 for further information). The Company's principal customers include large mass volume retailers and chain drug stores, as well as certain department stores and other specialty stores, such as perfumeries. The Company also sells consumer and professional products to United States military exchanges and commissaries and has a licensing group. Unless the context otherwise requires, all references to the Company mean Revlon, Inc. and its subsidiaries. Through December 31, 1999, Revlon, Inc. has essentially had no business operations of its own and its only material asset has been all of the outstanding capital stock of Products Corporation. As such, its net (loss) income has historically consisted predominantly of its equity in the net (loss) income of Products Corporation and in 1999, 1998 and 1997 included approximately $1.2, $1.5 and $1.2, respectively, in expenses incidental to being a public holding company. The Consolidated Financial Statements include the accounts of the Company and its subsidiaries after elimination of all material intercompany balances and transactions. Further, the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities, the disclosure of liabilities and the reporting of revenues and expenses to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates. The Company is an indirect majority owned subsidiary of MacAndrews & Forbes Holdings Inc. ("MacAndrews Holdings"), a corporation wholly owned indirectly through Mafco Holdings Inc. ("Mafco Holdings" and, together with MacAndrews Holdings, "MacAndrews & Forbes") by Ronald O. Perelman. Certain amounts in the prior year financial statements have been reclassified to conform with the current year's presentation. CASH AND CASH EQUIVALENTS: Cash equivalents (primarily investments in time deposits which have original maturities of three months or less) are carried at cost, which approximates fair value. INVENTORIES: Inventories are stated at the lower of cost or market value. Cost is principally determined by the first-in, first-out method. PROPERTY, PLANT AND EQUIPMENT AND OTHER ASSETS: Property, plant and equipment is recorded at cost and is depreciated on a straight-line basis over the estimated useful lives of such assets as follows: land improvements, 20 to 40 years; buildings and improvements, 5 to 50 years; machinery and equipment, 3 to 17 years; and office furniture and fixtures and capitalized software, 2 to 12 years. Leasehold improvements are amortized over their estimated useful lives or the terms of the leases, whichever is shorter. Repairs and maintenance are charged to operations as incurred, and expenditures for additions and improvements are capitalized. Included in other assets are permanent displays amounting to approximately $131.2 and $129.0 (net of amortization) as of December 31, 1999 and 1998, respectively, which are amortized over 3 to 5 years. In addition, the Company has included in other assets charges related to the issuance of its debt instruments amounting to approximately $21.0 and $23.6 (net of amortization) as of December 31, 1999 and 1998, respectively, which are amortized over the terms of the related debt instruments. INTANGIBLE ASSETS RELATED TO BUSINESSES ACQUIRED: Intangible assets related to businesses acquired principally represent goodwill, the majority of which is being amortized on a straight-line basis over 40 years. The Company evaluates, when circumstances warrant, the recoverability of its intangible assets on the basis of undiscounted cash flow projections. When impairment is indicated, the Company writes down recorded amounts of goodwill to the amount of estimated undiscounted cash flows. Accumulated amortization aggregated $128.0 and $115.6 at December 31, 1999 and 1998, respectively. REVENUE RECOGNITION: The Company recognizes net sales upon shipment of merchandise. Net sales comprise gross revenues less expected returns, trade discounts and customer allowances. Cost of sales is reduced for the estimated net realizable value of expected returns. INCOME TAXES: Income taxes are calculated using the liability method in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The Company is included in the affiliated group of which Mafco Holdings is the common parent, and the Company's federal taxable income and loss will be included in such group's consolidated tax return filed by Mafco Holdings. The Company also may be included in certain state and local tax returns of Mafco Holdings or its subsidiaries. For all periods presented, federal, state and local income taxes are provided as if the Company filed its own income tax returns. On June 24, 1992, Holdings (as hereinafter defined), the Company and certain of its subsidiaries and Mafco Holdings entered into a tax sharing agreement, which is described in Notes 13 and 16. PENSION AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS: The Company sponsors pension and other retirement plans in various forms covering substantially all employees who meet eligibility requirements. For plans in the United States, the minimum amount required pursuant to the Employee Retirement Income Security Act, as amended, is contributed annually. Various subsidiaries outside the United States have retirement plans under which funds are deposited with trustees or reserves are provided. The Company accounts for benefits such as severance, disability and health insurance provided to former employees prior to their retirement, if estimable, on a terminal basis in accordance with the provisions of SFAS No. 5, "Accounting for Contingencies," as amended by SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires companies to accrue for postemployment benefits when it is probable that a liability has been incurred and the amount of such liability can be reasonably estimated. RESEARCH AND DEVELOPMENT: Research and development expenditures are expensed as incurred. The amounts charged against earnings in 1999, 1998 and 1997 were $32.9, $31.9 and $29.7, respectively. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign operations are generally translated into United States dollars at the rates of exchange in effect at the balance sheet date. Income and expense items are generally translated at the weighted average exchange rates prevailing during each period presented. Gains and losses resulting from foreign currency transactions are included in the results of operations. Gains and losses resulting from translation of financial statements of foreign subsidiaries and branches operating in non-hyperinflationary economies are recorded as a component of accumulated other comprehensive loss. Foreign subsidiaries and branches operating in hyperinflationary economies translate nonmonetary assets and liabilities at historical rates and include translation adjustments in the results of operations. Effective January 1997 and for all of 1997 and 1998, the Company's operations in Mexico have been accounted for as operating in a hyperinflationary economy. Effective January 1, 1999, the Company's operations in Mexico have been accounted for as is required for a non-hyperinflationary economy. Effective July 1997, the Company's operations in Brazil have been accounted for as is required for a non-hyperinflationary economy. The impact of the changes in accounting for Brazil and Mexico was not material to the Company's operating results in 1997 and in 1999 for Mexico. SALE OF SUBSIDIARY STOCK: The Company recognizes gains and losses on sales of subsidiary stock in its Consolidated Statements of Operations. BASIC AND DILUTED (LOSS) INCOME PER COMMON SHARE AND CLASSES OF STOCK: The basic (loss) income per common share has been computed based upon the weighted average number of shares of common stock outstanding during each of the periods presented. Diluted (loss) income per common share has been computed based upon the weighted average number of shares of common stock outstanding and when appropriate the dilutive effect of stock options. The Company's outstanding stock options represent the only potential dilutive common stock outstanding. The amounts of (loss) income used in the calculations of diluted and basic (loss) income per common share were the same in each year presented. The number of shares used in the calculation of diluted (loss) income per common share for 1997 was greater than the number of shares used in the calculation of basic (loss) income per common share for that year by 412,878 shares to give effect to the dilutive effect of outstanding stock options. The number of shares used in the calculation of diluted (loss) income per common share for 1999 and 1998 does not include any incremental shares that would have been outstanding assuming the exercise of stock options because the effect of those incremental shares would have been antidilutive. The Class A Common Stock, par value $.01 per share (the "Class A Common Stock") and Class B Common Stock, par value $.01 per share (the "Class B Common Stock") (collectively with the Class A Common Stock, the "Common Stock") vote as a single class on all matters, except as otherwise required by law, with each share of Class A Common Stock entitling its holder to one vote and each share of the Class B Common Stock entitling its holder to ten votes. All of the shares of the Class B Common Stock are owned by REV Holdings Inc. ("REV Holdings"), an indirect wholly owned subsidiary of Mafco Holdings. Mafco Holdings beneficially owns shares of Common Stock having approximately 97.4% of the combined voting power of the outstanding shares of Common Stock. The holders of the Company's two classes of common stock are entitled to share equally in the earnings of the Company from dividends, when and if declared by the Board. Each outstanding share of Class B Common Stock is convertible into one share of Class A Common Stock. The Company designated 1,000 shares of Preferred Stock as the Series A Preferred Stock, of which 546 shares are outstanding and held by REV Holdings. The holder of Series A Preferred Stock is not entitled to receive any dividends. The Series A Preferred Stock is entitled to a liquidation preference of $100,000 per share before any distribution is made to the holders of Common Stock. The holder of the Series A Preferred Stock does not have any voting rights, except as required by law. The Series A Preferred Stock may be redeemed at any time by the Company, at its option, for $100,000 per share. However, the terms of Products Corporation's various debt agreements currently restrict Revlon, Inc.'s ability to effect such redemption by generally restricting the amount of dividends or distributions Products Corporation can pay to Revlon, Inc. STOCK-BASED COMPENSATION: SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to account for stock-based compensation plans using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretation. Accordingly, compensation cost for stock options issued to employees is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock (See Note 15). DERIVATIVE FINANCIAL INSTRUMENTS: Derivative financial instruments are utilized from time to time by the Company to reduce interest rate and foreign exchange risks. The Company maintains a control environment, which includes policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. The Company does not hold or issue derivative financial instruments for trading purposes. The differentials to be received or paid under interest rate contracts designated as hedges are recognized in income over the life of the contracts as adjustments to interest expense. Gains and losses on terminations of interest rate contracts designated as hedges are deferred and amortized into interest expense over the remaining life of the original contracts or until repayment of the hedged indebtedness. Unrealized gains and losses on outstanding contracts designated as hedges are not recognized. To qualify for hedge accounting, a contract must meet defined correlation and effectiveness criteria, be designated as a hedge and result in cash flows and financial statement effects that substantially offset those of the position being hedged. Derivative financial instruments that the Company temporarily continues to hold after the early termination of a hedged position, or that otherwise no longer qualify for hedge accounting, are marked-to-market, with gains and losses recognized in the Company's Statements of Operations after the termination or disqualification. Gains and losses on contracts designated to hedge identifiable foreign currency commitments are deferred and accounted for as part of the related foreign currency transaction. Transaction gains and losses have not been material. In June 1998, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of SFAS No. 133, an Amendment of SFAS No. 133," which has delayed the required implementation of SFAS No. 133 such that the Company must adopt this new standard no later than January 1, 2001. The effect of adopting the new standard by the Company has not yet been determined. The Company plans to adopt the new standard on January 1, 2001. ADVERTISING AND PROMOTION Costs associated with advertising and promotion are expensed in the year incurred. Advertising and promotion expenses were $411.8, $422.9 and $397.4 for 1999, 1998 and 1997, respectively. 2. DISCONTINUED OPERATIONS During 1998, the Company completed the disposition of its approximately 85% equity interest in The Cosmetic Center, Inc. (the "Cosmetic Center"), along with certain amounts due from Cosmetic Center to the Company for working capital and inventory, to a newly formed limited partnership controlled by an unrelated third party. The Company received a minority limited partnership interest in the limited partnership as consideration for the disposition. Based upon the Company's expectation that it would receive no future cash flows from the limited partnership, as well as other factors, the Company assigned no value to such interest. As a result, the Company recorded a loss on disposal of $47.7 during 1998. All prior periods were restated to reflect the results of operations of Cosmetic Center as discontinued operations. 3. EXTRAORDINARY ITEMS The extraordinary loss of $51.7 in 1998 resulted primarily from the write-off of deferred financing costs and payment of call premiums associated with the redemption of the Senior Notes (as hereinafter defined) and the Senior Subordinated Notes (as hereinafter defined). The extraordinary loss in 1997 resulted from the write-off in the second quarter of 1997 of deferred financing costs associated with the early extinguishment of borrowings under a prior credit agreement and costs of approximately $6.3 in connection with the redemption of Products Corporation's 10 7/8% Sinking Fund Debentures due 2010 (the "Sinking Fund Debentures"). The early extinguishment of borrowings under a prior credit agreement and the redemption of the Sinking Fund Debentures were financed by the proceeds from a new credit agreement, which became effective in May 1997 (the "Credit Agreement"). 4. BUSINESS CONSOLIDATION COSTS AND OTHER, NET In the fourth quarter of 1998, the Company committed to a restructuring plan to realign and reduce personnel, exit excess leased real estate, realign and consolidate regional activities, reconfigure certain manufacturing operations and exit certain product lines. During 1999, the Company continued to implement such restructuring for which it recorded a charge of $20.5 for employee severance and other personnel benefits, costs associated with the exit from leased facilities as well as other costs. Also in 1999, the Company consummated an exit from a non-core business, resulting in a charge of $1.6, which is included in the table below. Of the 720 and the 493 sales, marketing, administrative, factory and distribution employees worldwide for whom severance and other personnel benefits were included in the charges for the fourth quarter 1998 and during 1999, respectively, the Company had terminated 1,146 employees by December 31, 1999. During the fourth quarter of 1999, the Company continued to re-evaluate its organizational structure and implemented a new restructuring plan principally at its New York headquarters and New Jersey locations resulting in a charge of $18.1 principally for employee severance. As a part of this restructuring plan, the Company reduced personnel and consolidated excess leased real estate. Of the 208 sales, marketing and administrative employees for whom severance and other personnel benefits were included in the charge for the fourth quarter 1999, the Company had terminated 159 of these employees by December 31, 1999. In 1998 the Company recognized a gain of approximately $7.1 for the sale of the wigs and hairpieces portion of its business in the United States and included the amount in business consolidation costs and other, net. The cash and noncash elements of the restructuring charges recorded in 1999 approximate $38.8 and $1.4, respectively and in 1998 approximated $37.2 and $5.7, respectively. In 1997 the Company incurred business consolidation costs of $20.6 in connection with the implementation of its business strategy to rationalize factory operations. These costs primarily included severance for 415 factory and administrative employees and other costs related to the rationalization of certain factory and warehouse operations worldwide. Such costs were partially offset by an approximately $12.7 settlement of a claim and related gains of approximately $4.3 on the sales of certain factory operations outside the United States. As of December 31, 1998 and 1997 the Company had terminated 415 and 200 employees, respectively, relating to the 1997 charge. Details of the charges are as follows: As of December 31, 1999 and 1998, the unpaid balance of the business consolidation costs are included in accrued expenses and other in the Company's Consolidated Balance Sheets. 5. ACQUISITIONS In 1998 and 1997 the Company consummated acquisitions for a combined purchase price of $62.6 and $51.6 (excluding the acquisition of Cosmetic Center), respectively, with resulting goodwill of $63.7 and $35.8, respectively. These acquisitions were not significant to the Company's results of operations. There were no acquisitions made by the Company in 1999. 6. INVENTORIES 7. PREPAID EXPENSES AND OTHER 8. PROPERTY, PLANT AND EQUIPMENT, NET Depreciation expense for the years ended December 31, 1999, 1998 and 1997 was $45.9, $40.5 and $38.4, respectively. 9. ACCRUED EXPENSES AND OTHER 10. SHORT-TERM BORROWINGS Products Corporation maintained uncommitted short-term bank lines of credit, that may be borrowed against at any time at December 31, 1999 and 1998 aggregating approximately $65.6 and $88.3, respectively, of which approximately $37.6 and $27.9 were outstanding at December 31, 1999 and 1998, respectively. Interest rates on amounts borrowed under such short-term lines at December 31, 1999 and 1998 ranged from 3.1% to 6.8% and from 2.9% to 8.6%, respectively, excluding Latin American countries in which the Company had outstanding borrowings of approximately $8.3 and $3.5 at December 31, 1999 and 1998, respectively. Compensating balances at December 31, 1999 and 1998 were approximately $14.2 and $10.3, respectively. Interest rates on compensating balances at December 31, 1999 and 1998 ranged from 4.0% to 4.7% and 1.9% to 5.8%, respectively. 11. LONG-TERM DEBT DECEMBER 31, --------------------------- 1999 1998 ---------- ----------- Working capital lines (a).......................... $ 588.2 $ 272.2 Bank mortgage loan agreement due 2000 (b).......... 9.9 13.6 9 1/2% Senior Notes due 1999 (c)................... - 200.0 8 1/8% Senior Notes due 2006 (d)................... 249.4 249.3 9% Senior Notes due 2006 (e)....................... 250.0 250.0 8 5/8% Senior Subordinated Notes due 2008 (f)...... 649.8 649.8 Advances from Holdings (g)......................... 24.1 24.1 Notes payable due through 2004..................... 0.7 1.0 --------- -------- 1,772.1 1,660.0 Less current portion............................... (10.2) (6.0) --------- -------- $1,761.9 $1,654.0 ========= ======== (a) In May 1997, Products Corporation entered into the Credit Agreement with a syndicate of lenders, whose individual members change from time to time. The proceeds of loans made under the Credit Agreement were used to repay the loans outstanding under the credit agreement in effect at that time and to redeem the Sinking Fund Debentures. On November 10, 1999, the Credit Agreement was amended as described below. The Credit Agreement provides up to $723.0 at December 31, 1999 and consists of five senior secured facilities: $198.0 in two term loan facilities (the "Term Loan Facilities"), a $300.0 multi-currency facility (the "Multi-Currency Facility"), a $175.0 revolving acquisition facility, which may be increased to $375.0 under certain circumstances with the consent of a majority of the lenders (the "Acquisition Facility"), and a $50.0 special standby letter of credit facility (the "Special LC Facility" and together with the Term Loan Facilities, the Multi-Currency Facility and the Acquisition Facility, the "Credit Facilities"). The Multi-Currency Facility is available (i) to Products Corporation in revolving credit loans denominated in U.S. dollars (the "Revolving Credit Loans"), (ii) to Products Corporation in standby and commercial letters of credit denominated in U.S. dollars (the "Operating Letters of Credit") and (iii) to Products Corporation and certain of its international subsidiaries designated from time to time in revolving credit loans and bankers' acceptances denominated in U.S. dollars and other currencies (the "Local Loans"). At December 31, 1999 and 1998, Products Corporation had approximately $198.0 and $199.0, respectively, outstanding under the Term Loan Facilities, $235.2 and $9.7, respectively, outstanding under the Multi-Currency Facility, $155.0 and $63.5, respectively, outstanding under the Acquisition Facility and $29.8 and $29.0, respectively, of issued but undrawn letters of credit under the Special LC Facility. The Credit Facilities (other than loans in foreign currencies) bear interest as of December 31, 1999 at a rate equal to, at Products Corporation's option, either (A) the Alternate Base Rate plus 2.50% (or 3.50% for Local Loans); or (B) the Eurodollar Rate plus 3.50%. Loans in foreign currencies bear interest as of December 31, 1999 at a rate equal to the Eurocurrency Rate or, in the case of Local Loans, the local lender rate, in each case plus 3.50%. The applicable margin is reduced in the event Products Corporation attains certain leverage ratios. Products Corporation pays the lender a commitment fee as of December 31, 1999 of 1/2 of 1% of the unused portion of the Credit Facilities. Under the Multi-Currency Facility, the Company pays the lenders an administrative fee of 1/4% per annum on the aggregate principal amount of specified Local Loans. Products Corporation also paid certain facility and other fees to the lenders and agents upon closing of the Credit Agreement. Prior to its termination date, the commitments under the Credit Facilities will be reduced by: (i) the net proceeds in excess of $10.0 each year received during such year from sales of assets by Holdings (or certain of its subsidiaries), Products Corporation or any of its subsidiaries (and $25.0 in the aggregate during the term with respect to certain specified dispositions), subject to certain limited exceptions, (ii) certain proceeds from the sales of collateral security granted to the lenders, (iii) the net proceeds from the issuance by Products Corporation or any of its subsidiaries of certain additional debt, (iv) 50% of the excess cash flow of Products Corporation and its subsidiaries (unless certain leverage ratios are attained) and (v) certain scheduled reductions in the case of the Term Loan Facilities, which commenced on May 31, 1998 in the aggregate amount of $1.0 annually over the remaining life of the Credit Agreement, and in the case of the Acquisition Facility, which commenced on December 31, 1999 in the amount of $25.0 and, as of December 31, 1999, in the amounts of $60.0 during 2000, $90.0 during 2001 and $25.0 during 2002 (which reductions will be proportionately increased if the Acquisition Facility is increased). As described below, as a result of the reduction in commitment resulting from the sale of the Company's worldwide professional products line, the originally scheduled reductions in 2000 and 2001 have decreased. The Credit Agreement will terminate on May 30, 2002. The weighted average interest rates on the Term Loan Facilities, the Multi-Currency Facility and the Acquisition Facility were 9.9%, 8.1% and 9.8% at December 31, 1999, respectively, and 8.1%, 9.2% and 8.7% at December 31, 1998, respectively. The Credit Facilities, subject to certain exceptions and limitations, are supported by guarantees from Holdings and certain of its subsidiaries, Revlon, Inc., Products Corporation and the domestic subsidiaries of Products Corporation. The obligations of Products Corporation under the Credit Facilities and the obligations under the aforementioned guarantees are secured, subject to certain limitations, by (i) a mortgage on Products Corporation's Phoenix, Arizona facility; (ii) the capital stock of Products Corporation and its domestic subsidiaries, 66% of the capital stock of its first tier foreign subsidiaries and the capital stock of certain subsidiaries of Holdings; (iii) domestic intellectual property and certain other domestic intangibles of (x) Products Corporation and its domestic subsidiaries and (y) certain subsidiaries of Holdings; (iv) domestic inventory and accounts receivable of (x) Products Corporation and its domestic subsidiaries and (y) certain subsidiaries of Holdings; and (v) the assets of certain foreign subsidiary borrowers under the Multi-Currency Facility (to support their borrowings only). The Credit Agreement provides that the liens on the stock and personal property referred to above may be shared from time to time with specified types of other obligations incurred or guaranteed by Products Corporation, such as interest rate hedging obligations, working capital lines and a subsidiary of Products Corporation's yen-denominated credit agreement. The Credit Agreement contains various material restrictive covenants prohibiting Products Corporation from (i) incurring additional indebtedness or guarantees, with certain exceptions, (ii) making dividend, tax sharing and other payments or loans to Revlon, Inc. or other affiliates, with certain exceptions, including among others, permitting Products Corporation to pay dividends and make distributions to Revlon, Inc., among other things, to enable Revlon, Inc. to pay expenses incidental to being a public holding company, including, among other things, professional fees such as legal and accounting, regulatory fees such as Securities and Exchange Commission ("Commission") filing fees and other miscellaneous expenses related to being a public holding company, and to pay dividends or make distributions in certain circumstances to finance the purchase by Revlon, Inc. of its common stock in connection with the delivery of such common stock to grantees under any stock option plan, provided that the aggregate amount of such dividends and distributions taken together with any purchases of Revlon, Inc. common stock on the market to satisfy matching obligations under an excess savings plan may not exceed $6.0 per annum, (iii) creating liens or other encumbrances on their assets or revenues, granting negative pledges or selling or transferring any of their assets except in the ordinary course of business, all subject to certain limited exceptions, (iv) with certain exceptions, engaging in merger or acquisition transactions, (v) prepaying indebtedness, subject to certain limited exceptions, (vi) making investments, subject to certain limited exceptions, and as described below and (vii) entering into transactions with affiliates of Products Corporation other than upon terms no less favorable to Products Corporation or its subsidiaries than it would obtain in an arms'-length transaction. In addition to the foregoing, the Credit Agreement contains financial covenants requiring Products Corporation to maintain minimum interest coverage in 2001 and 2002, covenants that limit the leverage ratio of Products Corporation in 2001 and 2002, and covenants that limit the amount of capital expenditures. The events of default under the Credit Agreement include a Change of Control (as defined in the Credit Agreement) of Products Corporation, the acceleration of, or certain payment defaults under, indebtedness of REV Holdings in excess of $0.5 (which was eliminated by amendment in March 2000), and other customary events of default for such types of agreements. The Credit Agreement contained financial covenants requiring Products Corporation to maintain minimum interest coverage and to limit its leverage ratio, among other things. As a result of the loss from continuing operations before taxes incurred by Products Corporation in the third quarter of 1999, the interest coverage and leverage ratios specified in the Credit Agreement were not achieved at September 30, 1999. On November 10, 1999 the Credit Agreement was amended to (i) eliminate the interest coverage ratio and leverage ratio covenants from the quarter ended September 30, 1999 through the year 2000 and to modify those covenants for the years 2001 and 2002; (ii) add a minimum EBITDA covenant for each quarter end during the year 2000; (iii) limit the amount that Products Corporation may spend for capital expenditures and investments including acquisitions; (iv) permit the sale of Products Corporation's worldwide professional products line and its non-core Latin American brands Colorama, Juvena, Bozzano and Plusbelle (such sales, the "Asset Sales"); (v) change the reduction of the aggregate commitment that is required upon consummation of any Asset Sale to an amount equal to 60% of the Net Proceeds (as defined in the Credit Agreement) from such Asset Sale as opposed to 100% of such Net Proceeds as provided under the Credit Agreement prior to the amendment; (vi) increase the "applicable margin" by 3/4 of 1% and (vii) permit the amendment of a yen-denominated credit agreement (the "Yen Credit Agreement"). On March 30, 2000, approximately 60% of the $250.5 in Net Proceeds (as that term is defined in the Credit Agreement) from the sale of its worldwide professional products line was used to permanently reduce the aggregate commitment under the Credit Agreement to $572.7. As a result of such commitment reduction, as of March 30, 2000, the aggregate amount outstanding under the Term Loan Facilities was reduced by $79.8 to $118.2, and the aggregate commitments under the Acquisition Facility was reduced by $70.5 to $104.5. The scheduled reductions of the Acquisition Facility will also be reduced such that the total amount of such reductions is equal to the reduced aggregate Acquisition Facility commitment. The scheduled reductions of the Acquisition Facility changed from $60.0 to $35.8 during 2000, from $90.0 to $53.8 during 2001 and from $25.0 to $14.9 during 2002. (b) The Pacific Finance & Development Corp., a wholly owned subsidiary of Products Corporation, is the borrower under the Yen Credit Agreement, which had a principal balance of approximately (Yen)1.0 billion as of December 31, 1999 (approximately $9.9 U.S. dollar equivalent as of December 31, 1999) after giving effect to the payment of approximately (Yen)539 million (approximately $4.6 U.S. dollar equivalent) in March 1999. On November 12, 1999, the borrower under the Yen Credit Agreement executed an amendment to the Yen Credit Agreement to eliminate the amortization payment due in March 2000 and to provide that the final maturity date of the Yen Credit Agreement will be the earlier of (i) the closing date of the sale of Products Corporation's professional products line and (ii) December 31, 2000. The applicable interest rate at December 31, 1999 under the Yen Credit Agreement was the Euro-Yen rate plus 2.75%, which approximated 3.6%. The interest rate at December 31, 1998 was the Euro-Yen rate plus 2.75%, which approximated 3.5%. In March 2000, the outstanding balance under the Yen Credit Agreement was repaid in accordance with its terms. (c) During 1999 Products Corporation redeemed the 9 1/2% Senior Notes due 1999 (the "1999 Notes") with proceeds from the sale of the 9% Senior Notes due 2006 (the "9% Notes"). (d) The 8 1/8% Notes due 2006 (the "8 1/8% Notes") are senior unsecured obligations of Products Corporation and rank pari passu in right of payment with all existing and future Senior Debt (as defined in the indenture relating to the 8 1/8% Notes (the "8 1/8% Notes Indenture")) of Products Corporation, including the 1999 Notes until the maturity or earlier retirement thereof, the 9% Notes and the indebtedness under the Credit Agreement, and are senior to the 8 5/8% Notes and to all future subordinated indebtedness of Products Corporation. The 8 1/8% Notes are effectively subordinated to the outstanding indebtedness and other liabilities of Products Corporation's subsidiaries. Interest is payable on February 1 and August 1. The 8 1/8% Notes may be redeemed at the option of Products Corporation in whole or from time to time in part at any time on or after February 1, 2002 at the redemption prices set forth in the 8 1/8% Notes Indenture plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to February 1, 2001, Products Corporation may redeem up to 35% of the aggregate principal amount of the 8 1/8% Notes originally issued at a redemption price of 108 1/8% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date fixed for redemption, with, and to the extent Products Corporation receives, the net cash proceeds of one or more Public Equity Offerings (as defined in the 8 1/8% Notes Indenture), provided that at least $162.5 aggregate principal amount of the 8 1/8% Notes remains outstanding immediately after the occurrence of each such redemption. Upon a Change of Control (as defined in the 8 1/8% Notes Indenture), Products Corporation will have the option to redeem the 8 1/8% Notes in whole at a redemption price equal to the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of redemption plus the Applicable Premium (as defined in the 8 1/8% Notes Indenture) and, subject to certain conditions, each holder of the 8 1/8% Notes will have the right to require Products Corporation to repurchase all or a portion of such holder's 8 1/8% Notes at a price equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of repurchase. The 8 1/8% Notes Indenture contains covenants that, among other things, limit (i) the issuance of additional debt and redeemable stock by Products Corporation, (ii) the incurrence of liens, (iii) the issuance of debt and preferred stock by Products Corporation's subsidiaries, (iv) the payment of dividends on capital stock of Products Corporation and its subsidiaries and the redemption of capital stock of Products Corporation and certain subordinated obligations, (v) the sale of assets and subsidiary stock, (vi) transactions with affiliates and (vii) consolidations, mergers and transfers of all or substantially all Products Corporation's assets. The 8 1/8% Notes Indenture also prohibits certain restrictions on distributions from subsidiaries. All of these limitations and prohibitions, however, are subject to a number of important qualifications. (e) The 9% Notes are senior unsecured obligations of Products Corporation and rank pari passu in right of payment with all existing and future Senior Debt (as defined in the indenture relating to the 9% Notes (the "9% Notes Indenture")) of Products Corporation, including the 1999 Notes until the maturity or earlier retirement thereof, the 8 1/8% Notes and the indebtedness under the Credit Agreement, and are senior to the 8 5/8% Notes and to all future subordinated indebtedness of Products Corporation. The 9% Notes are effectively subordinated to outstanding indebtedness and other liabilities of Products Corporation's subsidiaries. Interest is payable on May 1 and November 1. The 9% Notes may be redeemed at the option of Products Corporation in whole or from time to time in part at any time on or after November 1, 2002 at the redemption prices set forth in the 9% Notes Indenture plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to November 1, 2001, Products Corporation may redeem up to 35% of the aggregate principal amount of the 9% Notes originally issued at a redemption price of 109% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date fixed for redemption, with, and to the extent Products Corporation receives, the net cash proceeds of one or more Public Equity Offerings (as defined in the 9% Notes Indenture), provided that at least $162.5 aggregate principal amount of the 9% Notes remains outstanding immediately after the occurrence of each such redemption. Upon a Change in Control (as defined in the 9% Notes Indenture), Products Corporation will have the option to redeem the 9% Notes in whole at a redemption price equal to the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of redemption plus the Applicable Premium (as defined in the 9% Notes Indenture) and, subject to certain conditions, each holder of the 9% Notes will have the right to require Products Corporation to repurchase all or a portion of such holder's 9% Notes at a price equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of repurchase. The 9% Notes Indenture contains covenants that, among other things, limit (i) the issuance of additional debt and redeemable stock by Products Corporation, (ii) the incurrence of liens, (iii) the issuance of debt and preferred stock by Products Corporation's subsidiaries, (iv) the payment of dividends on capital stock of Products Corporation and its subsidiaries and the redemption of capital stock of Products Corporation and certain subordinated obligations, (v) the sale of assets and subsidiary stock, (vi) transactions with affiliates and (vii) consolidations, mergers and transfers of all or substantially all Products Corporation's assets. The 9% Notes Indenture also prohibits certain restrictions on distributions from subsidiaries. All of these limitations and prohibitions, however, are subject to a number of important qualifications. (f) The 8 5/8% Notes due 2008 (the "8 5/8% Notes") are general unsecured obligations of Products Corporation and are (i) subordinate in right of payment to all existing and future Senior Debt (as defined in the indenture relating to the 8 5/8% Notes (the "8 5/8% Notes Indenture")) of Products Corporation, including the 1999 Notes until the maturity or earlier retirement thereof, the 9% Notes, the 8 1/8% Notes and the indebtedness under the Credit Agreement, (ii) pari passu in right of payment with all future senior subordinated debt, if any, of Products Corporation and (iii) senior in right of payment to all future subordinated debt, if any, of Products Corporation. The 8 5/8% Notes are effectively subordinated to the outstanding indebtedness and other liabilities of Products Corporation's subsidiaries. Interest is payable on February 1 and August 1. The 8 5/8% Notes may be redeemed at the option of Products Corporation in whole or from time to time in part at any time on or after February 1, 2003 at the redemption prices set forth in the 8 5/8% Notes Indenture plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to February 1, 2001, Products Corporation may redeem up to 35% of the aggregate principal amount of the 8 5/8% Notes originally issued at a redemption price of 108 5/8% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date fixed for redemption, with, and to the extent Products Corporation receives, the net cash proceeds of one or more Public Equity Offerings (as defined in the 8 5/8% Notes Indenture), provided that at least $422.5 aggregate principal amount of the 8 5/8% Notes remains outstanding immediately after the occurrence of each such redemption. Upon a Change of Control (as defined in the 8 5/8% Notes Indenture), Products Corporation will have the option to redeem the 8 5/8% Notes in whole at a redemption price equal to the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of redemption plus the Applicable Premium (as defined in the 8 5/8% Notes Indenture) and, subject to certain conditions, each holder of the 8 5/8% Notes will have the right to require Products Corporation to repurchase all or a portion of such holder's 8 5/8% Notes at a price equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of repurchase. The 8 5/8% Notes Indenture contains covenants that, among other things, limit (i) the issuance of additional debt and redeemable stock by Products Corporation, (ii) the incurrence of liens, (iii) the issuance of debt and preferred stock by Products Corporation's subsidiaries, (iv) the payment of dividends on capital stock of Products Corporation and its subsidiaries and the redemption of capital stock of Products Corporation, (v) the sale of assets and subsidiary stock, (vi) transactions with affiliates, (vii) consolidations, mergers and transfers of all or substantially all of Products Corporation's assets and (viii) the issuance of additional subordinated debt that is senior in right of payment to the 8 5/8% Notes. The 8 5/8% Notes Indenture also prohibits certain restrictions on distributions from subsidiaries. All of these limitations and prohibitions, however, are subject to a number of important qualifications. The 1999 Notes Indenture, the 8 1/8% Notes Indenture, the 8 5/8% Notes Indenture and the 9% Notes Indenture contain customary events of default for debt instruments of such type. (g) During 1992, Revlon Holdings Inc., the indirect parent of the Company ("Holdings"), made an advance of $25.0 to Products Corporation, evidenced by subordinated noninterest-bearing demand notes. The notes were subsequently adjusted by offsets and additional amounts loaned by Holdings to Products Corporation. In June 1997, Products Corporation borrowed from Holdings approximately $0.5, representing certain amounts received by Holdings from the sale of a brand and the inventory relating thereto. In 1998, approximately $6.8 due to Products Corporation from Holdings was offset against the notes payable to Holdings. At December 31, 1999 the balance of $24.1 is evidenced by noninterest-bearing promissory notes payable to Holdings that are subordinated to Products Corporation's obligations under the Credit Agreement. (h) Products Corporation borrows funds from its affiliates from time to time to supplement its working capital borrowings. No such borrowings were outstanding as of December 31, 1999 or 1998. The interest rates for such borrowings are more favorable to Products Corporation than interest rates under the Credit Agreement and, for borrowings occurring prior to the execution of the Credit Agreement, the credit facilities in effect at the time of such borrowing. The amount of interest paid by Products Corporation for such borrowings for 1999, 1998 and 1997 was $0.5, $0.8 and $0.6, respectively. The aggregate amounts of long-term debt maturities (at December 31, 1999), in the years 2000 through 2004 are $10.2, $67.5, $545.1, $0 and $0.1, respectively, and $1,149.2 thereafter. The Company expects that cash flows from operations and funds from currently available credit facilities and renewals of short-term borrowings will be sufficient to enable the Company to meet its anticipated cash requirements during 2000 on a consolidated basis, including for debt service. However, there can be no assurance that the combination of cash flow from operations, funds from existing credit facilities and renewals of short-term borrowings will be sufficient to meet the Company's cash requirements on a consolidated basis. If the Company is unable to satisfy such cash requirements, the Company could be required to adopt one or more alternatives, such as reducing or delaying capital expenditures, restructuring indebtedness, selling other assets or operations, or seeking capital contributions or loans from affiliates of the Company or issuing additional shares of capital stock of Revlon, Inc. Products Corporation has had discussions with an affiliate that is prepared to provide financial support to Products Corporation of up to $40 on appropriate terms through December 31, 2000. 12. FINANCIAL INSTRUMENTS As of December 31, 1997, Products Corporation was party to a series of interest rate swap agreements totaling a notional amount of $225.0 in which Products Corporation agreed to pay on such notional amount a variable interest rate equal to the six month LIBOR to its counterparties and the counterparties agreed to pay on such notional amounts fixed interest rates averaging approximately 6.03% per annum. Products Corporation entered into these agreements in 1993 and 1994 (and in the first quarter of 1996 extended a portion equal to a notional amount of $125.0 through December 2001) to convert the interest rate on $225.0 of fixed-rate indebtedness to a variable rate. Products Corporation terminated these agreements in January 1998 and realized a gain of approximately $1.6, which was recognized upon repayment of the hedged indebtedness and is included in the extraordinary item for the early extinguishment of debt. Certain other swap agreements were terminated in 1993 for a gain of $14.0 that was amortized over the original lives of the agreements through 1997. The amortization of the 1993 realized gain in 1997 was approximately $3.1. Products Corporation enters into forward foreign exchange contracts and option contracts from time to time to hedge certain cash flows denominated in foreign currencies. At December 31, 1998, Products Corporation had outstanding forward foreign exchange contracts denominated in various currencies of approximately $197.5 and outstanding option contracts of approximately $51.0. Such contracts are entered into to hedge transactions predominantly occurring within twelve months. If Products Corporation had terminated these contracts on December 31, 1998 or the contracts then outstanding on December 31, 1997, no material gain or loss would have been realized. There were no forward foreign exchange or option contracts outstanding on December 31, 1999. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same issues or on the current rates offered to the Company for debt of the same remaining maturities. The estimated fair value of long-term debt at December 31, 1999 and 1998 was approximately $444.2 and $63.1 less than the carrying values of $1,772.1 and $1,660.0, respectively. Because considerable judgment is required in interpreting market data to develop estimates of fair value, the estimates are not necessarily indicative of the amounts that could be realized or would be paid in a current market exchange. The effect of using different market assumptions or estimation methodologies may be material to the estimated fair value amounts. Products Corporation also maintains standby and trade letters of credit with certain banks for various corporate purposes under which Products Corporation is obligated, of which approximately $30.5 and $30.7 (including amounts available under credit agreements in effect at that time) were maintained at December 31, 1999 and 1998, respectively. Included in these amounts are $25.7 and $26.9, respectively, in standby letters of credit, which support Products Corporation's self-insurance programs. The estimated liability under such programs is accrued by Products Corporation. The carrying amounts of cash and cash equivalents, marketable securities, trade receivables, accounts payable and short-term borrowings approximate their fair values. 13. INCOME TAXES In June 1992, Holdings, Revlon, Inc. and certain of its subsidiaries, and Mafco Holdings entered into a tax sharing agreement (as subsequently amended, the "Tax Sharing Agreement"), pursuant to which Mafco Holdings has agreed to indemnify Revlon, Inc. against federal, state or local income tax liabilities of the consolidated or combined group of which Mafco Holdings (or a subsidiary of Mafco Holdings other than Revlon, Inc. or its subsidiaries) is the common parent for taxable periods beginning on or after January 1, 1992 during which Revlon, Inc. or a subsidiary of Revlon, Inc. is a member of such group. Pursuant to the Tax Sharing Agreement, for all taxable periods beginning on or after January 1, 1992, Revlon, Inc. will pay to Holdings amounts equal to the taxes that Revlon, Inc. would otherwise have to pay if it were to file separate federal, state or local income tax returns (including any amounts determined to be due as a result of a redetermination arising from an audit or otherwise of the consolidated or combined tax liability relating to any such period which is attributable to Revlon, Inc.), except that Revlon, Inc. will not be entitled to carry back any losses to taxable periods ended prior to January 1, 1992. No payments are required by Revlon, Inc. if and to the extent that Products Corporation is prohibited under the Credit Agreement from making tax sharing payments to Revlon, Inc. The Credit Agreement prohibits Products Corporation from making any tax sharing payments other than in respect of state and local income taxes. Since the payments to be made by Revlon, Inc. under the Tax Sharing Agreement will be determined by the amount of taxes that Revlon, Inc. would otherwise have to pay if it were to file separate federal, state or local income tax returns, the Tax Sharing Agreement will benefit Mafco Holdings to the extent Mafco Holdings can offset the taxable income generated by Revlon, Inc. against losses and tax credits generated by Mafco Holdings and its other subsidiaries. As a result of net operating tax losses and prohibitions under the Credit Agreement there were no federal tax payments or payments in lieu of taxes pursuant to the Tax Sharing Agreement for 1999, 1998 or 1997. The Company has a liability of $0.9 to Holdings in respect of federal taxes for 1997 under the Tax Sharing Agreement. Pursuant to the asset transfer agreement referred to in Note 16, Products Corporation assumed all tax liabilities of Holdings other than (i) certain income tax liabilities arising prior to January 1, 1992 to the extent such liabilities exceeded reserves on Holdings' books as of January 1, 1992 or were not of the nature reserved for and (ii) other tax liabilities to the extent such liabilities are related to the business and assets retained by Holdings. The Company's (loss) income from continuing operations before income taxes and the applicable provision (benefit) for income taxes are as follows: The effective tax rate on (loss) income from continuing operations before income taxes is reconciled to the applicable statutory federal income tax rate as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1999 and 1998 are presented below: In assessing the reliability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income for certain international markets and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of certain deductible differences existing at December 31, 1999. The valuation allowance increased by $60.8 and $102.9 during 1999 and 1998, respectively and decreased by $54.0 during 1997. During 1999, 1998, and 1997, certain of the Company's foreign subsidiaries used operating loss carryforwards to credit the current provision for income taxes by $8.8, $2.4, and $4.0, respectively. Certain other foreign operations generated losses during 1999, 1998 and 1997 for which the potential tax benefit was reduced by a valuation allowance. During 1998 and 1997, the Company used domestic operating loss carryforwards to credit the deferred provision for income taxes by $5.3 and $12.0, respectively. During 1997, the Company applied domestic operating loss carryforwards to credit the current provision for income taxes by $18.1. At December 31, 1999, the Company had tax loss carryforwards of approximately $975.1 that expire in future years as follows: 2000-$9.2; 2001-$19.9; 2002-$40.0; 2003-$22.1; 2004 and beyond-$699.5; unlimited-$184.4. The Company could receive the benefit of such tax loss carryforwards only to the extent it has taxable income during the carryforward periods in the applicable jurisdictions. In addition, based upon certain factors, including the amount and nature of gains or losses recognized by Mafco Holdings and its other subsidiaries included in the consolidated federal income tax return, the amount of net operating loss carryforwards attributable to Mafco Holdings and such other subsidiaries and the amounts of alternative minimum tax liability of Mafco Holdings and such other subsidiaries, pursuant to the terms of the Tax Sharing Agreement, all or a portion of the domestic operating loss carryforwards may not be available to the Company should the Company cease being a member of the Mafco Holdings consolidated federal income tax return. Appropriate United States and foreign income taxes have been accrued on foreign earnings that have been, or are expected to be remitted in the near future. Unremitted earnings of foreign subsidiaries which have been, or are currently intended to be, permanently reinvested in the future growth of the business aggregated approximately $13.3 at December 31, 1999, excluding those amounts which, if remitted in the near future, would not result in significant additional taxes under tax statutes currently in effect. 14. POSTRETIREMENT BENEFITS Pension: A substantial portion of the Company's employees in the United States are covered by defined benefit pension plans. The Company uses September 30 as its measurement date for plan obligations and assets. Other Postretirement Benefits: The Company also has sponsored an unfunded retiree benefit plan, which provides death benefits payable to beneficiaries of certain key employees and former employees. Participation in this plan is limited to participants enrolled as of December 31, 1993. The Company also administers a medical insurance plan on behalf of Holdings, the cost of which has been apportioned to Holdings. The Company uses September 30 as its measurement date for plan obligations. Information regarding the Company's significant pension and other postretirement plans at the dates indicated is as follows: The following weighted-average assumptions were used in accounting for the plans: The components of net periodic benefit cost for the plans are as follows: Where the accumulated benefit obligation exceeded the related fair value of plan assets, the projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the Company's pension plans are as follows: 15. STOCK COMPENSATION PLAN Since March 5, 1996, Revlon, Inc. has had a stock-based compensation plan as amended and restated as of February 12, 1999 (the "Plan"), which is described below. Revlon, Inc. applies APB Opinion No. 25 and its related interpretations in accounting for the Plan. Under APB Opinion No. 25, because the exercise price of Revlon, Inc.'s employee stock options equals the market price of the underlying stock on the date of grant, no compensation cost has been recognized. Had compensation cost for the Plan been determined consistent with SFAS No. 123, Revlon, Inc.'s net (loss) income and net (loss) income per diluted share of $(371.5) and $(7.25), respectively, for 1999, $(143.2) and $(2.80), respectively, for 1998, and $43.6 and $0.85, respectively, for 1997 would have been changed to the pro forma amounts of $(397.2) and $(7.75) for 1999, respectively, $(166.8) and $(3.25) for 1998, respectively, and $31.3 and $0.61, respectively, for 1997. The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model assuming no dividend yield, expected volatility of approximately 68% in 1999, 56% in 1998, and 39% in 1997; weighted average risk-free interest rate of 5.48% in 1999, 5.37% in 1998, and 6.54% in 1997; and a seven year expected average life for the Plan's options issued in 1999, 1998 and 1997. The effects of applying SFAS No. 123 in this pro forma disclosure are not necessarily indicative of future amounts. Under the Plan, Revlon, Inc. may grant options to its Revlon, Inc. employees for up to an aggregate of 7.0 million shares of Class A Common Stock. Non-qualified options granted under the Plan have a term of 10 years during which the holder can purchase shares of Class A Common Stock at an exercise price which must be not less than the market price on the date of the grant. Option grants vest over service periods that range from one to five years, except as disclosed below. Options granted in February 1999 with an original four year vesting term were modified in May 1999 to allow the options to become fully vested on the first anniversary date of the grant. During each of 1999, 1998 and 1997, the Company granted to Mr. Perelman, Chairman of the Board, options to purchase 300,000 shares of Class A Common Stock, which grants will vest in full on the fifth anniversary of the grant dates as to the 1998 and 1997 grants and which vested 100% on the date of grant as to the 1999 grant. At December 31, 1999, 1998 and 1997 there were 1,850,050, 403,950 and 98,450 options exercisable under the Plan, respectively. A summary of the status of the Plan as of December 31, 1999, 1998 and 1997 and changes during the years then ended is presented below: SHARES WEIGHTED AVERAGE (000) EXERCISE PRICE -------- ----------------- Outstanding at December 31, 1996..... 891.1 $24.37 Granted.............................. 1,485.5 32.64 Exercised............................ (12.1) 24.00 Forfeited............................ (85.1) 29.33 -------- Outstanding at December 31, 1997..... 2,279.4 29.57 Granted.............................. 1,707.8 36.65 Exercised............................ (55.9) 26.83 Forfeited............................ (166.8) 32.14 -------- Outstanding at December 31, 1998..... 3,764.5 32.71 Granted.............................. 2,456.7 16.89 Exercised............................ (5.8) 27.94 Forfeited............................ (444.2) 27.03 -------- Outstanding at December 31, 1999..... 5,771.2 26.42 ======== The weighted average fair value of options granted during 1999, 1998 and 1997 approximated $10.65, $22.26, and $16.42, respectively. The following table summarizes information about the Plan's options outstanding at December 31, 1999: 16. RELATED PARTY TRANSACTIONS TRANSFER AGREEMENTS In June 1992, Revlon, Inc. and Products Corporation entered into an asset transfer agreement with Holdings, which is an indirect parent of the Company and certain of its wholly owned subsidiaries (the "Asset Transfer Agreement"), and Revlon, Inc. and Products Corporation entered into a real property asset transfer agreement with Holdings (the "Real Property Transfer Agreement" and, together with the Asset Transfer Agreement, the "Transfer Agreements"), and pursuant to such agreements, on June 24, 1992 Holdings transferred assets to Products Corporation and Products Corporation assumed all the liabilities of Holdings, other than certain specifically excluded assets and liabilities (the liabilities excluded are referred to as the "Excluded Liabilities"). Certain consumer products lines sold in demonstrator-assisted distribution channels considered not integral to the Company's business and which historically had not been profitable (the "Retained Brands") and certain of the assets and liabilities were retained by Holdings. Holdings agreed to indemnify Revlon, Inc. and Products Corporation against losses arising from the Excluded Liabilities, and Revlon, Inc. and Products Corporation agreed to indemnify Holdings against losses arising from the liabilities assumed by Products Corporation. The amounts reimbursed by Holdings to Products Corporation for the Excluded Liabilities for 1999, 1998 and 1997 were $0.5, $0.6 and $0.4, respectively. Certain assets and liabilities relating to divested businesses were transferred to Products Corporation on the transfer date and any remaining balances as of December 31 of the applicable year have been reflected in the Company's Consolidated Balance Sheets as of such dates. At December 31, 1999 and 1998, the amounts reflected in the Company's Consolidated Balance Sheets aggregated a net liability of $23.6, of which $5.2 is included in accrued expenses and other and $18.4 is included in other long-term liabilities as of both dates. OPERATING SERVICES AGREEMENT In June 1992, Revlon, Inc., Products Corporation and Holdings entered into an operating services agreement (as amended and restated, and as subsequently amended, the "Operating Services Agreement") pursuant to which Products Corporation has manufactured, marketed, distributed, warehoused and administered, including the collection of accounts receivable, the Retained Brands for Holdings. Pursuant to the Operating Services Agreement, Products Corporation was reimbursed an amount equal to all of its and Revlon, Inc.'s direct and indirect costs incurred in connection with furnishing such services, net of the amounts collected by Products Corporation with respect to the Retained Brands, payable quarterly. The net amounts due from Holdings to Products Corporation for such direct and indirect costs plus a fee equal to 5% of the net sales of the Retained Brands for 1998 and 1997 were $0.9 (which amount was offset against certain notes payable to Holdings) and $1.7, respectively. REIMBURSEMENT AGREEMENTS Revlon, Inc., Products Corporation and MacAndrews Holdings have entered into reimbursement agreements (the "Reimbursement Agreements") pursuant to which (i) MacAndrews Holdings is obligated to provide (directly or through affiliates) certain professional and administrative services, including employees, to Revlon, Inc. and its subsidiaries, including Products Corporation, and purchase services from third party providers, such as insurance and legal and accounting services, on behalf of Revlon, Inc. and its subsidiaries, including Products Corporation, to the extent requested by Products Corporation, and (ii) Products Corporation is obligated to provide certain professional and administrative services, including employees, to MacAndrews Holdings (and its affiliates) and purchase services from third party providers, such as insurance and legal and accounting services, on behalf of MacAndrews Holdings (and its affiliates) to the extent requested by MacAndrews Holdings, provided that in each case the performance of such services does not cause an unreasonable burden to MacAndrews Holdings or Products Corporation, as the case may be. The Company reimburses MacAndrews Holdings for the allocable costs of the services purchased for or provided to the Company and its subsidiaries and for reasonable out-of-pocket expenses incurred in connection with the provision of such services. MacAndrews Holdings (or such affiliates) reimburses the Company for the allocable costs of the services purchased for or provided to MacAndrews Holdings (or such affiliates) and for the reasonable out-of-pocket expenses incurred in connection with the purchase or provision of such services. The net amounts reimbursed by MacAndrews Holdings to the Company for the services provided under the Reimbursement Agreements for 1999, 1998 and 1997 were $0.5, $3.1 ($0.2 of which was offset against certain notes payable to Holdings), and $4.0, respectively. Each of Revlon, Inc. and Products Corporation, on the one hand, and MacAndrews Holdings, on the other, has agreed to indemnify the other party for losses arising out of the provision of services by it under the Reimbursement Agreements other than losses resulting from its willful misconduct or gross negligence. The Reimbursement Agreements may be terminated by either party on 90 days' notice. The Company does not intend to request services under the Reimbursement Agreements unless their costs would be at least as favorable to the Company as could be obtained from unaffiliated third parties. TAX SHARING AGREEMENT Holdings, Revlon, Inc., Products Corporation and certain of its subsidiaries and Mafco Holdings are parties to the Tax Sharing Agreement, which is described in Note 13. Since payments to be made under the Tax Sharing Agreement will be determined by the amount of taxes that Revlon, Inc. would otherwise have to pay if it were to file separate federal, state or local income tax returns, the Tax Sharing Agreement will benefit Mafco Holdings to the extent Mafco Holdings can offset the taxable income generated by Revlon, Inc. against losses and tax credits generated by Mafco Holdings and its other subsidiaries. REGISTRATION RIGHTS AGREEMENT Prior to the consummation of the Company's initial public equity offering on March 5, 1996, Revlon, Inc. and Revlon Worldwide Corporation (subsequently merged into REV Holdings), the then direct parent of Revlon, Inc., entered into the Registration Rights Agreement pursuant to which REV Holdings and certain transferees of Revlon, Inc.'s Common Stock held by REV Holdings (the "Holders") have the right to require Revlon, Inc. to register all or part of the Class A Common Stock owned by such Holders and the Class A Common Stock issuable upon conversion of Revlon, Inc.'s Class B Common Stock owned by such Holders under the Securities Act of 1933, as amended (a "Demand Registration"); provided that Revlon, Inc. may postpone giving effect to a Demand Registration up to a period of 30 days if Revlon, Inc. believes such registration might have a material adverse effect on any plan or proposal by Revlon, Inc. with respect to any financing, acquisition, recapitalization, reorganization or other material transaction, or if Revlon, Inc. is in possession of material non-public information that, if publicly disclosed, could result in a material disruption of a major corporate development or transaction then pending or in progress or in other material adverse consequences to Revlon, Inc. In addition, the Holders have the right to participate in registrations by Revlon, Inc. of its Class A Common Stock (a "Piggyback Registration"). The Holders will pay all out-of-pocket expenses incurred in connection with any Demand Registration. Revlon, Inc. will pay any expenses incurred in connection with a Piggyback Registration, except for underwriting discounts, commissions and expenses attributable to the shares of Class A Common Stock sold by such Holders. OTHER Pursuant to a lease dated April 2, 1993 (the "Edison Lease"), Holdings leased to Products Corporation the Edison research and development facility for a term of up to 10 years with an annual rent of $1.4 and certain shared operating expenses payable by Products Corporation, which, together with the annual rent, were not to exceed $2.0 per year. Pursuant to an assumption agreement dated February 18, 1993, Holdings agreed to assume all costs and expenses of the ownership and operation of the Edison facility as of January 1, 1993, other than (i) the operating expenses for which Products Corporation was responsible under the Edison Lease and (ii) environmental claims and compliance costs relating to matters that occurred prior to January 1, 1993 up to an amount not to exceed $8.0 (the amount of such claims and costs for which Products Corporation is responsible, the "Environmental Limit"). In addition, pursuant to such assumption agreement, Products Corporation agreed to indemnify Holdings for environmental claims and compliance costs relating to matters that occurred prior to January 1, 1993 up to an amount not to exceed the Environmental Limit and Holdings agreed to indemnify Products Corporation for environmental claims and compliance costs relating to matters that occurred prior to January 1, 1993 in excess of the Environmental Limit and all such claims and costs relating to matters occurring on or after January 1, 1993. Pursuant to an occupancy agreement, during 1998 and 1997 Products Corporation rented from Holdings a portion of the administration building located at the Edison facility and space for a retail store of Products Corporation's now discontinued retail operation. Products Corporation provided certain administrative services, including accounting, for Holdings with respect to the Edison facility pursuant to which Products Corporation paid on behalf of Holdings costs associated with the Edison facility and was reimbursed by Holdings for such costs, less the amount owed by Products Corporation to Holdings pursuant to the Edison Lease and the occupancy agreement. In August 1998, Holdings sold the Edison facility to an unrelated third party, which assumed substantially all liability for environmental claims and compliance costs relating to the Edison facility, and in connection with the sale, Products Corporation terminated the Edison Lease and entered into a new lease with the new owner. Holdings agreed to indemnify Products Corporation to the extent rent under the new lease exceeds rent that would have been payable under the terminated Edison Lease had it not been terminated. The net amount reimbursed by Holdings to Products Corporation with respect to the Edison facility for 1999, 1998 and 1997 was $0.2, $0.5, and $0.7, respectively. During 1997, a subsidiary of Products Corporation sold an inactive subsidiary to a company that was its affiliate during 1997 and part of 1998 for approximately $1.0. Effective July 1, 1997, Holdings contributed to Products Corporation substantially all of the assets and liabilities of the Bill Blass business not already owned by Products Corporation. The contributed assets approximated the contributed liabilities and were accounted for at historical cost in a manner similar to that of a pooling of interests and, accordingly, prior period financial statements were restated as if the contribution took place prior to the beginning of the earliest period presented. On February 2, 1998, Revlon Escrow Corp., an affiliate of Products Corporation, issued and sold in a private placement $650.0 aggregate principal amount of 8 5/8% Notes and $250.0 aggregate principal amount of 8 1/8% Notes, with the net proceeds deposited into escrow. The proceeds from the sale of the 8 5/8% and 8 1/8% Notes were used to finance the redemption of Products Corporation's $555.0 aggregate principal amount of 10 1/2% Senior Subordinated Notes due 2003 (the "Senior Subordinated Notes") and $260.0 aggregate principal amount of 9 3/8% Senior Notes due 2001 (the "Senior Notes" and, together with the Senior Subordinated Notes, the "Old Notes"). Products Corporation delivered a redemption notice to the holders of the Senior Subordinated Notes for the redemption of the Senior Subordinated Notes on March 4, 1998, at which time Products Corporation assumed the obligations under the 8 5/8% Notes and the related indenture (the "8 5/8% Notes Assumption"), and to the holders of the Senior Notes for the redemption of the Senior Notes on April 1, 1998, at which time Products Corporation assumed the obligations under the 8 1/8% Notes and the related indenture (the "8 1/8% Notes Assumption" and, together with the 8 5/8% Notes Assumption, the "Assumption"). A nationally recognized investment banking firm rendered its written opinion that the Assumption, upon consummation of the redemptions of the Old Notes, and the subsequent release from escrow to Products Corporation of any remaining net proceeds from the sale of the 8 5/8% and 8 1/8% Notes are fair from a financial standpoint to Products Corporation under the 1999 Notes Indenture. Products Corporation leases certain facilities to MacAndrews & Forbes or its affiliates pursuant to occupancy agreements and leases. These included space at Products Corporation's New York headquarters and at Products Corporation's offices in London during 1999, 1998 and 1997 and in Hong Kong during 1997 and the first half of 1998. The rent paid to Products Corporation for 1999, 1998 and 1997 was $1.1, $2.9 and $3.8, respectively. Products Corporation's Credit Agreement is supported by, among other things, guarantees from Holdings and certain of its subsidiaries. The obligations under such guarantees are secured by, among other things, the capital stock and certain assets of certain subsidiaries of Holdings. During 1998, the Company made advances of $0.25, $0.3 and $0.4 to Mr. Fellows, Ms. Dwyer and Mr. Levin, respectively, which advances were repaid in 1999. During 1999, the Company made an advance of $0.4 to Mr. Nugent. During 1997, Products Corporation used an airplane owned by a corporation of which Messrs. Gittis and Drapkin were the sole stockholders, for which Products Corporation paid approximately $0.2 in 1997. During 1998 and 1997, Products Corporation purchased products from a company that was its affiliate during part of 1998 and all of 1997, for which it paid approximately $0.4 and $0.9, respectively. During 1997, Products Corporation provided licensing services to a company that was its affiliate during 1997 and part of 1998, for which Products Corporation was paid approximately $0.7 in 1997. In connection with the termination of the licensing arrangement and its agreement to provide consulting services during 1998, Products Corporation received payments of $2.0 in 1998 and an additional $1.0 in 1999. A company that was an affiliate of the Company during part of 1999, and during 1998 and 1997 assembled lipstick cases for Products Corporation. Products Corporation paid approximately $0.1, $1.1, and $0.9 for such services for 1999, 1998 and 1997, respectively. During 1999, Products Corporation made payments of $0.1 to a fitness center, an interest in which is owned by members of Mr. Drapkin's immediate family, for discounted health club dues for an executive health program of Products Corporation. 17. COMMITMENTS AND CONTINGENCIES The Company currently leases manufacturing, executive, including research and development, and sales facilities and various types of equipment under operating lease agreements. Rental expense was $42.8, $43.7 and $46.1 for the years ended December 31, 1999, 1998 and 1997, respectively. Minimum rental commitments under all noncancelable leases, including those pertaining to idled facilities, with remaining lease terms in excess of one year from December 31, 1999 aggregated $126.9; such commitments for each of the five years subsequent to December 31, 1999 are $31.2, $28.2, $25.1, $12.5 and $5.4, respectively. Such amounts exclude the minimum rentals to be received by the Company in the future under noncancelable subleases of $17.4. The Company and its subsidiaries are defendants in litigation and proceedings involving various matters. In the opinion of the Company's management, based upon advice of its counsel handling such litigation and proceedings, adverse outcomes, if any, will not result in a material effect on the Company's consolidated financial condition or results of operations. In October and November 1999 six purported class actions were filed by each of Thomas Comport, Boaz Spitz, Felix Ezeir and Amy Hoffman, Ted Parris, Jerry Krim and Dan Gavish individually and on behalf of others similarly situated to them, in the United States District Court for the Southern District of New York, against the Company and certain of its present and former officers and directors, alleging, among other things, violations of Rule 10b-5 under the Securities Exchange Act of 1934, as amended, through the alleged use of deceptive accounting practices during the period from October 29, 1997 through October 2, 1998, inclusive, in the Comport and Hoffman/Parris cases and October 30, 1997 through October 1, 1999, inclusive, in the Spitz, Ezeir, Krim and Gavish cases. Each of the actions seeks a declaration that it is properly brought as a class action, and unspecified damages, attorney fees and other costs. In January 2000, the court consolidated the six cases. The Company believes the allegations contained in these suits to be without merit and intends to vigorously defend against them. 18. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the unaudited quarterly results of operations: (a) Includes business consolidation costs of $8.2, $9.5, $4.4 and $18.1 in the first, second, third and fourth quarters, respectively. (See Note 4). Additionally the fourth quarter includes $22.0 of executive separation costs. (b) Includes a non-recurring gain of $7.1 in the third quarter and business consolidation costs of $42.9 in the fourth quarter (See Note 4). 19. GEOGRAPHIC INFORMATION The Company manages its business on the basis of one reportable operating segment. See Note 1 for a brief description of the Company's business. As of December 31, 1999, the Company had operations established in 28 countries outside of the United States and its products are sold throughout the world. The Company is exposed to the risk of changes in social, political and economic conditions inherent in foreign operations and the Company's results of operations and the value of its foreign assets are affected by fluctuations in foreign currency exchange rates. The Company's operations in Brazil have accounted for approximately 4.1%, 5.4% and 5.8% of the Company's net sales for 1999, 1998 and 1997, respectively. Net sales by geographic area are presented by attributing revenues from external customers on the basis of where the products are sold. During 1999, 1998 and 1997, Wal-Mart and its affiliates accounted for approximately 13.1%, 10.1% and 10.3% of the Company's consolidated net sales, respectively. Although the loss of Wal-Mart as a customer could have an adverse effect on the Company, the Company believes that its relationship with Wal-Mart is satisfactory and the Company has no reason to believe that Wal-Mart will not continue as a customer. GEOGRAPHIC AREAS: YEAR ENDED DECEMBER 31, --------------------------------------------- Net sales: 1999 1998 1997 --------- --------- --------- United States........... $ 1,046.2 $ 1,343.7 $ 1,304.9 International........... 815.1 908.5 933.7 --------- --------- --------- $ 1,861.3 $ 2,252.2 $ 2,238.6 ========= ========= ========= DECEMBER 31, ---------------------------------- Long-lived assets: 1999 1998 ------- ------ United States............. $ 611.3 $637.9 International............. 259.4 287.4 ------- ------ $ 870.7 $925.3 ======= ====== CLASSES OF SIMILAR PRODUCTS: YEAR ENDED DECEMBER 31, ----------------------- Net sales: 1999 1998 1997 --------- -------- -------- Cosmetics, skin care and fragrances.............. $ 1,001.8 $ 1,309.7 $1,319.6 Personal care and professional 859.5 942.5 919.0 --------- -------- -------- $ 1,861.3 $ 2,252.2 $2,238.6 ========= ======== ======== 20. SUBSEQUENT EVENT On March 30, 2000, the Company completed the disposition of its worldwide professional products line, including professional hair care for use in and resale by professional salons, ethnic hair and personal care products, Natural Honey skin care and certain regional toiletries brands, for $315 in cash, before adjustments, plus $10 in purchase price payable in the future, contingent upon the purchasers' achievement of certain rates of return on their investment. The disposition involved the sale of certain of the Company's subsidiaries throughout the world devoted to the professional products line, as well as assets dedicated exclusively or primarily to the lines being disposed. The worldwide professional products line was purchased by a company formed by CVC Capital Partners, the Colomer family and other investors, led by Carlos Colomer, a former manager of the line that was sold, following arms'-length negotiation of the terms of the purchase agreement therefor, including the determination of the amount of the consideration. SCHEDULE II REVLON, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (DOLLARS IN MILLIONS) - ----------------- Notes: (1) Doubtful accounts written off, less recoveries, reclassifications and foreign currency translation adjustments. (2) Discounts taken, reclassifications and foreign currency translation adjustments. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Revlon, Inc. (Registrant) By: /s/ Jeffrey M. Nugent By: /s/ Frank J. Gehrmann ------------------------- ------------------------------------- Jeffrey M. Nugent Frank J. Gehrmann President, Executive Vice Chief Executive Officer President and and Director Chief Financial Officer By: /s/ Laurence Winoker - ---------------------------------- Laurence Winoker Senior Vice President Corporate Controller and Treasurer Dated: March 30, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant on March 30, 2000 and in the capacities indicated. Signature Title - --------- ----- * Chairman of the Board and Director - ---------------------------------- (Ronald O. Perelman) * Director - ----------------------------------- (Howard Gittis) /s/ Jeffrey M. Nugent President, Chief Executive Officer - ----------------------------------- and Director (Jeffrey M. Nugent) * Director - ----------------------------------- (Donald G. Drapkin) * Director - ----------------------------------- (Meyer Feldberg) * Director - ----------------------------------- (Morton L. Janklow) * Director - ----------------------------------- (Vernon E. Jordan) * Director - ----------------------------------- (Edward J. Landau) * Director - ----------------------------------- (Jerry W. Levin) * Director - ----------------------------------- (Linda Gosden Robinson) * Director - ----------------------------------- (Terry Semel) * Director - ----------------------------------- (Martha Stewart) * Robert K. Kretzman, by signing his name hereto, does hereby sign this report on behalf of the directors of the registrant after whose typed names asterisks appear, pursuant to powers of attorney duly executed by such directors and filed with the Securities and Exchange Commission. By: /s/ Robert K. Kretzman Robert K. Kretzman Attorney-in-fact

83604_1999.txt

83604_1999

1999

83604

ITEM 1. BUSINESS Reynolds Metals Company (the "Registrant") was incorporated in 1928 under the laws of the State of Delaware. In this report, "Reynolds" and "the Company" mean the Registrant and its consolidated subsidiaries unless otherwise indicated. GENERAL NATURE OF OPERATIONS - -------------------- Reynolds is the world's third-largest aluminum producer and the world's leading aluminum foil producer. Reynolds serves customers in growing world markets including the alumina and primary aluminum, packaging and consumer, commercial construction, distribution, and automotive markets, with a wide variety of aluminum, plastic and other products. At December 31, 1999, Reynolds employed approximately 18,900 people. Reynolds has operations or interests in operations at more than 100 locations in 24 countries. Reynolds' world headquarters is in Richmond, Virginia. Reynolds' operations are organized into four market-based, global business units: Base Materials; Packaging and Consumer; Construction and Distribution; and Transportation. For a description of these units, see the discussion below under the heading "Global Business Units." For information about certain operations that are not considered part of a global business unit, see the discussion below under the heading "Other Operations." MERGER - ------ On August 18, 1999, Reynolds, Alcoa Inc. (Alcoa) and RLM Acquisition Corp., a wholly owned subsidiary of Alcoa, entered into an agreement and plan of merger. Under the merger agreement, each outstanding share of Reynolds common stock would be converted into 1.06 shares of Alcoa common stock and Reynolds would become wholly owned by Alcoa. On January 10, 2000, Alcoa announced that its Board of Directors had declared a two-for-one split of Alcoa's common stock to Alcoa shareholders of record on May 26, 2000. The stock split is subject to approval of Alcoa shareholders who must approve an amendment to Alcoa's articles to increase the authorized shares of common stock at Alcoa's annual meeting on May 12, 2000. If approved, the stock split would be distributed on June 9, 2000. Shares of Alcoa stock that are issued in the merger will be adjusted, as necessary, to reflect the stock split. The proposed merger, which was approved by Reynolds' stockholders at a special meeting held on February 11, 2000, is subject to customary closing conditions, including antitrust clearances. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 prohibits Alcoa and Reynolds from completing the merger until certain information has been furnished to the Antitrust Division of the Department of Justice and the Federal Trade Commission, and until certain waiting period requirements have been satisfied. Alcoa filed a Hart-Scott-Rodino Premerger Notification and Report Form on August 24, 1999 and Reynolds filed such a Form on August 30, 1999. On September 29, 1999, the Antitrust Division issued a request for additional information and documentary material (a "second request"). On February 11, 2000, both Reynolds and Alcoa announced that they believed that they were in substantial compliance with the second request. They also advised the Department of Justice that they would not close the merger before March 31, 2000, in order to provide the Department sufficient time to review the transaction. In Europe, certain regulations require that Alcoa file a premerger notification form with the Commission of the European Communities prior to consummation of the proposed merger. Alcoa filed such notification on November 18, 1999. This filing began an initial one-month review period in which the European Commission was required to determine whether there are sufficiently "serious doubts" about the proposed merger's compatibility with the common market to require a more complete review. The initial one-month period expired on December 20, 1999, whereupon the European Commission issued a determination that the proposed merger did require a more complete review. The European Commission must complete its investigation and make a final determination with respect to the proposed merger no later than May 10, 2000. Reynolds and Alcoa have also made filings under the competition laws of Canada, Australia and certain other countries where the companies have significant operations. Alcoa and Reynolds have been advised that the Canadian Competition Bureau has classified this merger as "very complex." Its review is expected to be completed no later than May 24, 2000. The Australian review process is also expected to be completed by the end of May 2000. The merger agreement contains certain restrictions on the conduct of Reynolds' business before completion of the merger. For example, Reynolds has agreed to operate its business only in the ordinary course, to refrain from taking certain corporate actions without the consent of Alcoa, and not to solicit alternative acquisition proposals. Reference is made to the copy of the merger agreement incorporated by reference herein as Exhibit 2. RESTRUCTURING - ------------- In early 1999, Reynolds finalized the sale of its Alloys can stock complex, which included a rolling mill, two reclamation plants and a coil coating facility, located in Alabama to Wise Alloys LLC, an affiliate of Wise Metals Co., Inc. Also in early 1999, Reynolds sold its aluminum extrusion plant in Irurzun, Spain, as well as its distribution operations for architectural systems located in Spain, to an affiliate of Alcoa. Reynolds sold its investment in a Canadian rolling mill and related assets to Hocan Inc., an affiliate of CORUS Group PLC, in early January 2000. Finalization of these transactions marks the substantial completion of Reynolds' portfolio review process. FINANCIAL INFORMATION REGARDING GLOBAL BUSINESS UNITS AND OPERATIONS BY GEOGRAPHIC LOCATION - ----------------------------------------------------------------------- Financial information for operations and assets attributable to Reynolds' global business units and information regarding its operations by geographic location are included in Note 12 to the consolidated financial statements in Item 8 of this report. GLOBAL BUSINESS UNITS BASE MATERIALS - -------------- Reynolds' base materials global business unit produces metallurgical alumina, alumina chemicals and primary aluminum. It also produces carbon products, principally for use in primary aluminum reduction plants. Aluminum is one of the most plentiful metals in the earth's crust. It is found chemically combined with other elements. Aluminum silicates are in almost every handful of clay, but aluminum is produced primarily from bauxite, an ore containing aluminum in the form of aluminum oxide, commonly referred to as alumina. Aluminum is made by extracting alumina from bauxite and then removing oxygen from the alumina through an electrolytic process known as "reduction." The result is molten primary aluminum, which is cast into various forms for shipment to fabricating plants. It takes about four tons of bauxite to make two tons of alumina, which in turn yield about a ton of primary aluminum. Reynolds refines bauxite into alumina at its Sherwin alumina plant near Corpus Christi, Texas. Reynolds also is entitled to a share of the production from two joint ventures in which it has interests, one located in Western Australia, known as the Worsley Joint Venture ("Worsley"), and the other located in Stade, Germany, known as Aluminium Oxid Stade ("Stade"). See Table 1 under this Item. In addition, Reynolds has a contract with a third party to purchase 120,000 metric tons of alumina in 2000. Worsley currently has the capacity to produce 1.88 million metric tons of alumina per year. Reynolds is entitled to 56% of the alumina produced by the joint venture. The Worsley refinery is currently being expanded to increase its annual capacity to 3.1 million metric tons. In addition to increasing capacity, the expansion project will further reduce operating costs and improve product quality. Construction is scheduled to be completed in the second quarter of 2000. Worsley has proven bauxite reserves sufficient to operate the plant at capacity for at least the next 35 years, even after taking into account the ongoing expansion of the refinery's annual capacity. Bauxite requirements for Reynolds' Sherwin alumina plant and Reynolds' share of the Stade joint venture are obtained from the following sources: AUSTRALIA Reynolds has a long-term purchase arrangement under which it may buy from a third party an aggregate of approximately 18,800,000 dry metric tons of Australian bauxite through 2021. BRAZIL Reynolds owns a 5% interest in Mineracao Rio Do Norte S.A. ("MRN"), which owns the Trombetas bauxite mining project in Brazil. Reynolds has agreed to purchase approximately 7,000,000 dry metric tons of Brazilian bauxite from the project for the period 2000 through 2019. Reynolds also maintains an interest in other, undeveloped bauxite deposits in Brazil. GUINEA Reynolds owns a 6% interest in Halco (Mining), Inc. Halco owns 51% and the Guinean government owns 49% of Compagnie des Bauxites de Guinee ("CBG"), which has the exclusive right through 2038 to develop and mine bauxite in a 10,000 square-mile area in northwestern Guinea. Reynolds has a bauxite purchase contract with CBG that will provide Reynolds with a minimum of approximately 6,050,000 dry metric tons of Guinean bauxite for the period 2000 through 2011. GUYANA Reynolds is a 50% partner with the Guyanese government in a bauxite mining project in the Berbice region of Guyana. Reynolds will buy approximately 2,000,000 dry metric tons of bauxite from the project in 2000. JAMAICA Reynolds has a purchase arrangement under which it will buy from a third party an aggregate of up to 3,600,000 dry metric tons of Jamaican bauxite for the period 2000 through 2001. OTHER Reynolds has an arrangement with the U.S. government under which it will buy at a negotiated price during 2000 approximately 600,000 long dry tons of Jamaican bauxite stored next to the Sherwin alumina plant. Reynolds' present sources of bauxite and alumina are more than adequate to meet the forecasted requirements of its primary aluminum production operations for the foreseeable future. Reynolds produces primary aluminum at three plants in the United States and one at Baie Comeau, Quebec, Canada. Reynolds is also entitled to a share of the primary aluminum produced at three joint ventures in which it participates: one in Quebec known as the Becancour joint venture ("Becancour"); one in Hamburg, Germany, known as Hamburg Aluminium-Werk GmbH ("Hamburg"); and the third in Ghana, known as Volta Aluminium Company Limited ("Ghana"). See Table 2 under this Item. Reynolds' primary aluminum products include unalloyed aluminum ingot; billet, which is used by extrusion plants; sheet ingot, which is supplied to rolling facilities; foundry ingot, which is the base material for cast products such as automotive wheels; and electrical redraw rod, which is used by the electrical cable industry. During 1999, 80% of Reynolds' primary aluminum products were sold externally to third parties; the remainder was purchased by other Reynolds business units. Production at Reynolds' primary aluminum plants can vary due to a number of factors, including changes in worldwide supply and demand. Reynolds currently has the annual capacity to produce 1,094,000 metric tons of primary aluminum, of which 47,000 metric tons are temporarily idled. During 1998, Reynolds restarted 162,000 metric tons of previously idled production capacity. Reynolds will monitor market conditions and its internal needs before proceeding with further restarts. In addition to the primary aluminum plants listed in Table 2, Reynolds has a 10% equity interest in the Aluminum Smelter Company of Nigeria ("ALSCON"). The smelter closed indefinitely in 1999 due to lack of working capital. The closing has no material effect on Reynolds' operations or financial position. Reynolds also has an 8% equity interest in C.V.G. Aluminio del Caroni, S.A. ("ALCASA"), which produces primary aluminum in Venezuela. Reynolds owns and operates two carbon products manufacturing facilities located in Lake Charles and Baton Rouge, Louisiana. These facilities have the capacity to produce 875,000 metric tons of calcined petroleum coke and 145,000 metric tons of carbon anodes annually. The anodes are produced principally for consumption at Reynolds' primary aluminum plant in Baie Comeau, Quebec. The calcined petroleum coke is used by Reynolds' wholly owned primary aluminum plants. Reynolds also sells calcined petroleum coke worldwide to the aluminum and titanium dioxide industries. Reynolds' base materials business also operates a commercial hazardous waste treatment facility in Gum Springs, Arkansas for the treatment of spent potliner resulting from Reynolds' and other producers' North American aluminum reduction operations. Regulations issued by the U.S. Environmental Protection Agency (the "EPA") require the treatment of spent potliner to prescribed standards prior to disposal. The Gum Springs facility has the capacity to treat 120,000 short tons of spent potliner annually and is currently operating at approximately 50% of capacity. In July 1998, the U. S. Court of Appeals for the District of Columbia struck down the treatment standards included in the then current EPA regulations. The EPA subsequently adopted temporary standards, which are expected to continue in effect until final standards are adopted. Reynolds has submitted permit applications to state and federal environmental authorities to allow it to operate the Gum Springs facility's landfill as a hazardous waste landfill. The applications were submitted as a result of the EPA's 1997 decision to classify treated spent potliner as a hazardous waste. ENERGY - ------ Reynolds consumes substantial amounts of energy in the aluminum production process. Refining alumina from bauxite requires high temperatures. The facilities where Reynolds refines alumina achieve these temperatures by burning natural gas or coal to produce direct heat or steam. Natural gas and coal for these facilities are purchased under long- and short-term contracts. See Table 1 under this Item. The electrolytic process for reducing alumina to primary aluminum requires large amounts of electricity. Reynolds generally expects to meet the energy requirements for its primary aluminum production for the foreseeable future under long-term contracts. Under these contracts, however, Reynolds may experience shortages of interruptible power from time to time at its Massena, New York plant and at the plant in Ghana in which Reynolds holds a joint- venture interest. The portion of power supplied to the Massena plant that is interruptible (approximately 15%) can be offset with power purchased from other sources at market rates. Production at Ghana is dependent on hydroelectric power. The Ghana plant is currently operating at reduced capacity due to drought conditions that have existed since 1994. See Table 2 under this Item. Bonneville Power Administration ("BPA") supplies electricity to Reynolds' smelters at Longview, Washington and Troutdale, Oregon. The current contract with BPA expires on September 30, 2001. BPA has proposed reducing the amount of power supplied to the smelters by one-third and pricing the power on a formula under which charges would vary with world aluminum prices. Assuming "average" world aluminum prices (with the basis for determining what is "average" yet to be settled), the rate charged to Reynolds for the period 2001-2006 would increase by 13% over what Reynolds currently pays. Reynolds would also have to find other sources for the balance of its power needs. The BPA proposal is subject to full consideration in a rate case, in which Reynolds can present arguments to improve the offered rate, and other parties can challenge both the quantity of power being provided to the Reynolds smelters and the rates at which it is to be provided. Reynolds expects to participate actively in the resolution of this issue and to continue assessing alternate power sources for the two smelters. NOTES TO TABLES 1, 2, and 3. (a) Ratings are estimates at the end of the period based on designed capacity and normal operating efficiencies and do not necessarily represent maximum possible production. (b) See "Energy" above. (c) The Sherwin plant currently purchases 50% of the natural gas required to operate the plant on a month-to-month basis. Beginning in June 2000, it is anticipated that all gas will be supplied under contracts of one year or longer. (d) Reynolds has a long-term agreement to purchase all of Sherwin's steam and a portion of its electricity from a third-party cogeneration facility beginning in June 2000. Worsley has a similar contract to purchase a portion of its steam and electricity which began in early 2000. (e) Reynolds is entitled to 56% of the production of Worsley and 50% of the production of Stade. Capacity and production figures reflect Reynolds' share. (f) Reynolds curtailed 121,000 metric tons of production capacity at its Troutdale primary aluminum plant in the second half of 1991 and restarted 74,000 metric tons of that capacity in 1998. Reynolds also curtailed an aggregate of 88,000 metric tons of primary aluminum production capacity at its Massena (41,000 metric tons) and Longview (47,000 metric tons) plants effective in 1993. All of the idled capacity at Massena and Longview was restarted during 1998. (g) The power contract terminates in 2013, subject to earlier termination by the supplier in 2003 if its federal license for its hydroelectric project is not renewed. (h) Reynolds is entitled to 50% of the production of Becancour, 33-1/3% of the production of Hamburg, and 10% of the production of Ghana. Capacity and production figures reflect Reynolds' share. Production at Ghana has been curtailed since September 1994 by drought. At December 31, 1998, Ghana was operating at 20% of capacity. Ghana began restarting a portion of its curtailed capacity in 1999. The plant is currently operating at approximately 80% of capacity. (i) Production is from the alumina production operations listed in Table 1. (j) Production is from the primary aluminum production operations listed in Table 2. PACKAGING AND CONSUMER - ---------------------- Reynolds' packaging and consumer global business unit provides a variety of foil, plastic and other products and related services to the packaging and consumer products markets. Reynolds is the world's leading aluminum foil producer and a major converter of plastic resins. Reynolds markets a diverse range of flexible packaging products including inner and outer wraps, pouches, specialty cartons, child-resistant blister backing, and plastic containers. Reynolds' customers include global marketers of food, confection, healthcare and tobacco products. Reynolds also serves the foodservice market (restaurants, delis, supermarket take- out, and fast-food and catering establishments) with over 1,000 foil, plastic and paper products including aluminum and plastic film, plastic containers and lids, foodservice bags, catering trays, sandwich bags and wraps, baking cups and trays. Reynolds also produces industrial plastic film (including Reynolon shrink film) and labels for shrink wrapping and tamper-evident packaging. Reynolds manufactures its packaging products at wholly owned facilities in the U.S., Brazil, Canada and Spain. See Table 4 under the heading "Packaging and Consumer." Reynolds also has an interest in foil operations in Colombia and Venezuela. The capacity of these manufacturing facilities depends on the variety and types of products manufactured. Reynolds' packaging and consumer global business unit also manufactures and markets an extensive line of foil, plastic and paper consumer products under the Reynolds brand name. Products include the well-known Reynolds Wrap Aluminum Foil, Reynolds Plastic Wrap, Reynolds Oven Bags, Reynolds Freezer Paper, Reynolds Cut-Rite Wax Paper, Reynolds Baker's Choice Bake Cups, Reynolds Hot Bags Foil Bags and Reynolds Wrappers Foil Sandwich Sheets. Reynolds' consumer products are distributed throughout the U.S., which is Reynolds' largest market for these products, and in more than 65 other countries. In April 1999, Reynolds launched a foodservice packaging and consumer products subsidiary, Reyco Ltda., in Sao Paulo, Brazil. Reyco produces foodservice packaging and consumer products under the Reynolds brand name. Through its Presto Products Company subsidiary, Reynolds is a supplier of private label consumer products. Presto produces a variety of plastic food wraps and bags (including trash bags and reclosable snack, sandwich, storage and freezer bags) that are sold under private labels. Reynolds' subsidiary, Southern Graphic Systems, Inc., produces rotogravure printing cylinders, color separations and flexographic plates used in Reynolds' packaging printing operations and for the consumer and industrial packaging industry. Southern Graphic's major customers, in addition to Reynolds, are other consumer products companies and converters, with a trend toward consumer products companies. Southern Graphic also provides graphics management services and manufactures printing accessories (bases and anilox rolls). In February 1999, Southern Graphic acquired London Graphics Inc., a Toronto, Ontario producer of flexographic separations and plates for the packaging industry in Canada. It has been integrated with Southern Graphic's Canadian operations. Southern Graphic also acquired the assets and/or businesses of four U.S. producers of flexographic separations and plates for the packaging industry in 1999. In addition, Southern Graphic, through its Mexican subsidiary, Southern Graphic Systems Mexico S. de R.L. de C. V., began providing onsite services to its customers at its new Mexico City, Mexico offices in late 1999. CONSTRUCTION AND DISTRIBUTION - ----------------------------- Reynolds' construction and distribution global business unit distributes aluminum, stainless steel and other specialty metal products under the names Reynolds Aluminum Supply Company ("RASCO") and RASCO Specialty Metals Inc. (in Canada). This business unit also produces and sells architectural products and systems. RASCO provides supply chain management services to North American metal fabricating customers requiring high-quality aluminum, stainless steel and other specialty metal products. During 1999, RASCO's sales (not including RASCO Specialty Metals Inc.) were 58% in aluminum products and 39% in stainless steel products. RASCO processes and distributes plate, sheet, extrusions, rod and bar products through 37 facilities across North America. RASCO provides metal processing services such as cutting to length, slitting, shearing, sawing and plasma burning. The metal processing services offered by RASCO allow it to provide customized products, delivered just-in-time to customers. RASCO's customers include fabricators and manufacturers in transportation, equipment, machinery and other markets. In 1999, RASCO acquired two metal distribution centers in the U.S. and five in Canada, and opened three new metal distribution centers in the U.S. and one in Mexico. Through its construction operations Reynolds produces Reynobond aluminum composite material that is sold worldwide for architectural and specialty applications. In 1999, Reynolds increased its capability to serve European and global demand for composite material with the substantial completion of an expansion of its plant in Merxheim, France. Reynolds' construction and distribution business unit also produces Reynolux painted aluminum sheet and profiled products; designs and markets architectural systems consisting of curtainwall, window and door units for residential and commercial applications; and produces and sells polymer- coated magnet wire for electrical transformers. TRANSPORTATION - -------------- Reynolds' transportation global business unit operates nine plants supplying a wide range of fabricated aluminum products to the transportation industry and has interests in two additional plants located in Canada and Venezuela. See Table 4 below under the heading "Transportation." Reynolds' principal products are wheels, heat exchanger tubing and automotive structures. Reynolds markets these products primarily in North America to the "Big Three" automobile manufacturers, with customers also in Europe and Venezuela. Reynolds produces forged and cast aluminum wheels in a variety of sizes, styles and finishes. In February 1999, Reynolds completed the start-up of a $32 million expansion of its forged aluminum wheel manufacturing facility in Lebanon, Virginia. The expansion doubled the plant's production capacity to 1.4 million wheels per year. Heat exchanger tubing products include extruded and drawn round tube, micro multivoid tube and oval tube made of aluminum and long-life alloys. These products are used in applications such as automotive air conditioning systems and radiators. Automotive structures include bumpers, car and truck door frames, convertible roof brackets, sunroof frames, antilock brake system housings, steering shafts and steering column brackets, among other items, for use in automobiles and truck and trailer systems. In mid-1999, Reynolds completed an equipment expansion at its Indiana extrusion facility to begin production of the industry's first high volume aluminum engine cradle. OTHER OPERATIONS Reynolds has certain operations that are not within a global business unit. These include, principally, its headquarters operations, as well as the following: BOHAI ALUMINIUM INDUSTRIES, LTD. - Reynolds owns a 32.48% interest in this aluminum foil and extrusion operation located in China. CAN MACHINERY - Reynolds operates a can machinery plant that manufactures can production machinery used by aluminum can manufacturers around the world. EUROPEAN EXTRUSION OPERATIONS - Reynolds' plants in Nachrodt, Germany and Harderwijk, Netherlands produce extruded aluminum products that are used internally by Reynolds' construction and distribution and transportation global business units. In addition, the plants manufacture products that are sold directly to third parties. The portion of these extrusion operations related to products sold directly to third parties is not included within Reynolds' global business units. LATAS DE ALUMINIO. S.A. ("Latasa") - Reynolds owns a 36.6% interest in this South American aluminum can operation. REAL ESTATE - Reynolds has real estate holdings consisting principally of undeveloped land and commercial buildings. UNITED ARAB CAN MANUFACTURING COMPANY, LTD. - Reynolds owns a 27.5% interest in this aluminum can operation located in Saudi Arabia. COMPETITION Competition in Reynolds' industries is based on price, quality and service. In the sale of its products, Reynolds competes primarily with (i) producers of alumina and primary aluminum and processors of reclaimed aluminum, (ii) producers of plastic products, (iii) producers of aluminum and non-aluminum packaging materials, (iv) metals service center companies engaged in the distribution of aluminum and other products and (v) fabricators of aluminum and non-aluminum automotive products. Reynolds competes with many companies around the world in the manufacture of primary aluminum products. In Europe, Reynolds' principal competitors are seven major multinational producers of extruded aluminum products and a number of smaller European producers of aluminum semifabricated products. Reynolds' consumer products operations compete primarily with a number of U.S. companies. North America is Reynolds' largest market for its flexible packaging products. Reynolds has a large number of competitors in this area, ranging from small, local businesses to large, national companies. Aluminum and related products compete with various products, including those made of iron, steel, copper, zinc, tin, titanium, lead, glass, wood, plastic, magnesium and paper. Plastic products compete with products made of glass, aluminum, steel, paper, wood and ceramics, among others. ENVIRONMENTAL COMPLIANCE Reynolds has spent and will spend substantial capital and operating amounts relating to ongoing compliance with environmental laws. The area of environmental management, including environmental controls, continues to be in a state of scientific, technological and regulatory evolution. Consequently, it is not possible for Reynolds to predict accurately the total expenditures necessary to meet all future environmental requirements. Reynolds expects, however, to add or modify environmental control facilities at a number of its worldwide locations to meet existing and certain anticipated regulatory requirements, including regulations to be implemented under the Clean Air Act Amendments of 1990 (the "Clean Air Act"). Based on information currently available, Reynolds estimates that compliance with the Clean Air Act's hazardous air pollutant standards would require in excess of $200 million of capital expenditures (including a portion of the expenditures at the Massena plant referred to below), primarily at its U.S. primary aluminum production plants. The ultimate effect of the Clean Air Act on such plants and on Reynolds' other operations (and the actual amount of any such capital expenditures) will depend on how the Clean Air Act is interpreted and implemented pursuant to regulations that are currently being developed and on such additional factors as the evolution of environmental control technologies and the economic viability of such operations at the time. Based on an August 1995 memorandum of understanding with the State of New York to resolve environmental issues at its Massena, New York primary aluminum production plant, Reynolds has undertaken a capital spending program (planned for completion in 2002) of an estimated $175 million to modernize the Massena plant and significantly reduce air emissions from the plant. Pursuant to the memorandum of understanding, Reynolds is accelerating certain expenditures believed necessary to achieve compliance with the Clean Air Act's Maximum Achievable Control Technology standards. Reynolds' capital expenditures for equipment designed for environmental control purposes were approximately $43 million in 1997, $80 million in 1998 and $48 million in 1999. The portion of such amounts expended in the United States was $41 million in 1997, $74 million in 1998 and $41 million in 1999. Reynolds estimates that annual capital expenditures for environmental control facilities will be approximately $24 million in 2000, $30 million in 2001 and $21 million in 2002. The majority of these estimated expenditures are associated with the capital spending program referred to above at the Massena plant. Future capital expenditures for environmental control facilities cannot be predicted with accuracy for the reasons cited above; however, it is reasonable to expect that environmental control standards will become increasingly stringent and that the expenditures necessary to comply with them could increase substantially. Reynolds has been identified as a potentially responsible party ("PRP") and is involved in remedial investigations and remedial actions under the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund") and similar state laws regarding the past disposal of wastes at approximately 40 sites in the United States. Such statutes may impose joint and several liability for the costs of such remedial investigations and actions on the entities that arranged for disposal of the wastes, the waste transporters that selected the disposal sites, and the owners and operators of such sites. Responsible parties (or any one of them) may be required to bear all of such costs regardless of fault, legality of the original disposal, or ownership of the disposal site. In addition, Reynolds is investigating possible environmental contamination, which may also require remedial action, at certain of its present and former U. S. manufacturing facilities. The following discussion provides information about the current status of two individually significant sites. MASSENA, NEW YORK SITE. In 1988, Reynolds discovered that soils in the area of the heat transfer medium system at Reynolds' primary aluminum production plant in Massena, New York were contaminated with polychlorinated biphenyls ("PCBs") and other contaminants. Remediation of the contaminated soils and other contaminated areas of the plant was substantially completed in 1998. Portions of the St. Lawrence River system adjacent to the plant are also contaminated with PCBs. Since 1989, Reynolds has been conducting investigations and studies of the river system under order from the EPA issued under Superfund. Reynolds is in the process of working with the EPA to better define the scope of the dredging program which is planned for 2001. Reynolds is also aware of a natural resource damage claim arising out of the discharge of PCBs and other contaminants into the river system that may be asserted by potential claimants, including federal, state and tribal natural resource trustees. TROUTDALE, OREGON SITE. In 1994, the EPA added Reynolds' Troutdale, Oregon primary aluminum production plant to the National Priorities List of Superfund sites. Reynolds is cooperating with the EPA and, under a September 1995 consent order, is working with the EPA in investigating potential environmental contamination at the Troutdale site and promoting more efficient cleanup at the site. At most of the Superfund sites referred to above where Reynolds has been identified as a PRP, Reynolds is one of many PRPs, and its share of the anticipated cleanup costs is expected to be small. With respect to certain other sites (not included in the 40 sites discussed above) where Reynolds has been identified as a PRP, Reynolds has either fully or substantially settled or resolved actions related to such sites at minimal cost or believes that it has no responsibility with regard to them. Reynolds has been notified that it may be a PRP at certain sites in addition to those already referred to in this paragraph. Reynolds' policy is to accrue remediation costs when it is probable that remedial efforts will be required and the related costs can be reasonably estimated. On a quarterly basis, Reynolds evaluates the status of all sites, develops or revises estimates of costs to satisfy known remediation requirements and adjusts its accruals accordingly. At December 31, 1999, the accrual for known remediation requirements was $162 million. This amount reflects management's best estimate of Reynolds' ultimate liability for such costs. Potential insurance recoveries are uncertain and therefore have not been considered. As a result of factors such as the developing nature of administrative standards promulgated under Superfund and other environmental laws; the unavailability of information regarding the condition of potential sites; the lack of standards and information for use in the apportionment of remedial responsibilities; the numerous choices and costs associated with diverse technologies that may be used in remedial actions at such sites; the availability of insurance coverage; the ability to recover indemnification or contribution from third parties; and the time periods over which eventual remediation may occur, estimated costs for future environmental compliance and remediation are necessarily imprecise. It is not possible to predict the amount or timing of future costs of environmental remediation that may subsequently be determined. Based on information currently available, it is management's opinion that such future costs are not likely to have a material adverse effect on Reynolds' competitive or financial position. However, such costs could be material to future quarterly or annual results of operations. See the discussion under "Environmental" in Item 7, and under Note 13 to the consolidated financial statements in Item 8 of this report regarding Reynolds' anticipated costs of environmental compliance. RESEARCH AND DEVELOPMENT Reynolds engages in a continuous program of basic and applied research and development to support its global business units. This program deals with new and improved materials, products, processes and related environmental compliance technologies. It includes development and expansion of products and markets that benefit from aluminum's light weight, strength, resistance to corrosion, ease of fabrication, high heat and electrical conductivity, recyclability and other properties. Materials and core competencies involving aluminum, ceramics, composites and various polymers and their processing, fabrication and applications are also included in the scope of Reynolds' research and development activities. Expenditures for Reynolds-sponsored research and development activities were approximately $25 million in 1999, $31 million in 1998, and $41 million in 1997. Reynolds owns numerous patents relating to its products and processes based predominantly on its in-house research and development activities. The patents owned by Reynolds, or under which it is licensed, generally concern particular products or manufacturing techniques. Reynolds' business is not, however, materially dependent on patents. EMPLOYEES At December 31, 1999, Reynolds had approximately 18,900 employees. In 1996, Reynolds entered into new six-year labor contracts with the United Steelworkers of America and the Aluminum, Brick and Glass Workers International Union. The contracts involve approximately 3,700 active employees. At the end of the fifth year, the economic provisions of the contracts will be reopened. If agreement cannot be reached, the economic provisions applicable to the sixth year will be submitted to arbitration. ITEM 2. ITEM 2. PROPERTIES Reynolds' products are produced at numerous domestic and foreign plants wholly or partly owned by Reynolds. The annual capacity of many of these plants depends upon the variety and type of products manufactured. For information on the location and general nature of certain of Reynolds' principal domestic and foreign properties, see Item 1 of this report. Table 4 lists as of February 25, 2000 Reynolds' wholly owned domestic and foreign operations and shows the domestic and foreign locations of operations in which Reynolds has interests. Facilities that are under construction or for other reasons have not begun production are not listed. The properties listed are held in fee except as otherwise indicated. Properties held other than in fee are not, individually or in the aggregate, material to Reynolds' operations and the arrangements under which such properties are held are not expected to limit their use. Reynolds believes that its facilities are suitable and adequate for its operations. With the exception of the Troutdale, Ghana and Nigerian primary aluminum production plants and the Arkansas spent potliner treatment facility, as explained in Item 1, there is no significant surplus or idle capacity at Reynolds' major manufacturing facilities. TABLE 4 WHOLLY OWNED OPERATIONS BASE MATERIALS ALUMINA: PRIMARY ALUMINUM: Corpus Christi, Texas Massena, New York Malakoff, Texas+ Troutdale, Oregon Longview, Washington CALCINED COKE: Baie Comeau, Quebec Baton Rouge, Louisiana Lake Charles, Louisiana SPENT POTLINER TREATMENT: Gum Springs, Arkansas CARBON ANODES: Lake Charles, Louisiana ELECTRICAL REDRAW ROD: Becancour, Quebec PACKAGING AND CONSUMER FOIL FEED STOCK: PACKAGING GRAPHICS AND IMAGE CARRIERS: Hot Springs, Arkansas Bridgeport, Connecticut* Atlanta, Georgia* PACKAGING AND CONSUMER PRODUCTS: LaGrange, Georgia* Beacon Falls, Connecticut Elgin, Illinois* Louisville, Kentucky (2) Clarksville, Indiana* Mt. Vernon, Kentucky Dayton, Kentucky* Sparks, Nevada* Louisville, Kentucky (2) Boyertown, Pennsylvania Newport, Kentucky* Downingtown, Pennsylvania West Monroe, Louisiana Lewiston, Utah Battle Creek, Michigan* Rutland, Vermont St. Louis, Missouri * Bellwood, Virginia Armonk, New York* Grottoes, Virginia Fulton, New York Richmond, Virginia Wilmington, North Carolina* South Boston, Virginia Exton, Pennsylvania* Appleton, Wisconsin (2) Dallas, Texas Little Chute, Wisconsin Richmond, Virginia (2)** Weyauwega, Wisconsin Mexico City, Mexico* Sao Paulo, Brazil* Brockville, Ontario* Rexdale, Ontario* Mississauga, Ontario (2)* Barcelona, Spain Toronto, Ontario* CONSTRUCTION AND DISTRIBUTION CONSTRUCTION: DISTRIBUTION: Eastman, Georgia Service Centers (U.S.) (27)** Ashland, Virginia (Canada) (5)** Merxheim, France (Mexico) (1)* Lelystadt, Netherlands Processing Centers (U.S.) (4)** Distribution Centers (Europe) (9)** (China) (1)* (U.S.) (1)* TRANSPORTATION HEAT EXCHANGERS: WHEELS: Louisville, Kentucky Lebanon, Virginia Wexford, Ireland Beloit, Wisconsin Ferrara, Italy STRUCTURES: Auburn, Indiana Maracay, Venezuela Nachrodt, Germany*** Harderwijk, Netherlands*** OTHER CAN MACHINERY AND SYSTEMS: RESEARCH AND DEVELOPMENT: Richmond, Virginia Muscle Shoals, Alabama Bauxite, Arkansas Corpus Christi, Texas Richmond, Virginia (2) OTHER OPERATIONS IN WHICH REYNOLDS HAS INTERESTS Argentina: Ghana: Aluminum cans Primary aluminum Australia: Guinea: Bauxite, alumina Bauxite, alumina Brazil: Guyana: Aluminum cans and ends, bauxite Bauxite Canada: Italy: Primary aluminum, electric power Reclamation generation, aluminum wheels Nigeria: Chile: Primary aluminum Aluminum cans Saudi Arabia: China: Aluminum cans Foil, extrusions Venezuela: Colombia: Primary aluminum, mill products, Mill products, extrusions, foil foil, aluminum wheels Egypt: Extrusions Germany: Alumina, primary aluminum ____________________________ * Leased. ** Richmond, Virginia Packaging Graphics and Image Carriers - 1 leased. European Distribution Centers - 5 leased. U.S. Service Centers - 17 leased. Canadian Service Centers - 3 leased. U.S. Processing Centers - 2 leased. *** These plants also produce extruded products for Reynolds' construction and distribution business unit. The plant in Harderwijk, Netherlands also manufactures heat exchangers and other extruded products. + This plant manufactures chemical grade alumina and does not manufacture alumina for use in the aluminum production process. The titles to Reynolds' various properties were not examined specifically for this report. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On August 11, 1999, eight class action complaints on behalf of stockholders of Reynolds were filed in the Delaware Court of Chancery against Reynolds and certain present and former members of its board of directors. These actions are styled Tozour Energy Systems Retirement Plan v. Sheehan, et al.; Lisa v. Reynolds Metals Company, et al.; Yassin v. Reynolds Metals Company, et al.; Weinfeld v. Sheehan, et al.; Bader & Yakaitis Profit Sharing Plan and Trust v. Sheehan, et al.; Rand v. Sheehan, et al.; Grill v. Sheehan, et al.; and Randolph Capital Management, Inc. v. Sheehan, et al. The complaints were filed after Alcoa announced its proposal to acquire Reynolds. The plaintiff in each action alleged, among other things, that the directors of Reynolds failed to negotiate with Alcoa before Alcoa's announcement; that they were breaching their fiduciary duties by failing to explore offers for the purchase of Reynolds or to engage in meaningful discussions with interested parties such as Alcoa; that they were attempting to entrench themselves in their positions at Reynolds through misuse of Reynolds' shareholder rights plan; and that they were attempting to deprive the plaintiffs of the true value of their investment in Reynolds. The plaintiff in each action sought injunctive relief requiring the directors of Reynolds to give due consideration to any proposed business combination, to resolve any conflicts in favor of Reynolds' public stockholders, and to refrain from consummating any business combination without conducting an auction or other process to obtain the highest possible price for Reynolds. The complaints also sought unspecified damages and awards of fees and costs. On February 11, 2000, Reynolds' stockholders approved the merger agreement between Reynolds and Alcoa. Counsel for the plaintiffs in the Lisa, Yassin, Weinfeld, Bader & Yakaitis Profit Sharing Plan and Trust, Rand and Grill actions recently informed the Delaware Court of Chancery that the plaintiffs in those actions intend to file promptly with the Court a notice dismissing such actions without prejudice. Various other suits, claims and actions are pending against Reynolds. In the opinion of Reynolds' management, after consultation with legal counsel, disposition of these proceedings, either individually or in the aggregate, will not have a material adverse effect on Reynolds' competitive or financial position. No assurance can be given, however, that the disposition of one or more of such suits, claims or actions in a particular reporting period will not be material in relation to the reported results for such period. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Registrant's security holders during the fourth quarter of 1999. A special meeting of Reynolds stockholders was held on February 11, 2000. The stockholders approved and adopted the Agreement and Plan of Merger, dated as of August 18, 1999, among Alcoa Inc., RLM Acquisition Corp. and Reynolds Metals Company, and approved the transactions contemplated thereby. At December 29, 1999, the record date for the special meeting, 63,463,257 shares of common stock were outstanding and entitled to vote. The number of votes cast for and against, and the number of abstentions, as applicable, were as set forth below. No other matter was voted upon at the meeting. Number of Votes Cast "For" 41,335,471 Number of Votes Cast "Against" 457,861 Number of Abstentions 5,609,245 ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Registrant are as follows: Name Age* Positions Held During Past Five Years - ---- ---- ------------------------------------- Jeremiah J. Sheehan 61 Chairman of the Board and Chief Executive Officer since October 1996. President and Chief Operating Officer 1994-1996. Director since 1994. Randolph N. Reynolds** 58 Vice Chairman and Executive Officer since October 1996. Vice Chairman 1994-1996. Director since 1984. William E. Leahey, Jr. 50 Executive Vice President and Chief Financial Officer since July 1998. Senior Vice President, Global Can, April 1997-1998. Vice President, Can Division 1993-1997. Thomas P. Christino 60 Senior Vice President, Global Packaging and Consumer Products, since April 1997. Vice President, Flexible Packaging Division 1993-1997. Donald T. Cowles 53 Senior Vice President, Global Construction and Distribution, since April 1997. Vice President and Reynolds Aluminum Supply Company Division General Manager August 1995-1997. Executive Vice President, Human Resources and External Affairs 1993-1995. Eugene M. Desvernine 58 Senior Vice President, Diversified Investments, since July 1999. Senior Vice President, Global Transportation, April 1997 - 1999. Vice President 1994-1997. Allen M. Earehart 57 Senior Vice President and Controller since July 1998. Vice President, Controller 1994-1998. D. Michael Jones 46 Senior Vice President and General Counsel since October 1996. Vice President, General Counsel and Secretary 1993-1996. John M. Lowrie 59 Senior Vice President and Executive Director - Enterprise Systems since January 1999. Vice President, Consumer Products 1988-1999. Paul Ratki 60 Senior Vice President, Global Metals and Carbon Products, since April 1997. Vice President, Metals Division 1994-1997. C. Stephen Thomas 60 Senior Vice President, Global Technology and Operational Services, since May 1997. Vice President, Mill Products Division 1992-1997. Donna C. Dabney 52 Secretary and Assistant General Counsel since October 1996. Associate General Counsel 1993-1996. Douglas M. Jerrold 49 Vice President, Tax Affairs, since April 1990. Ruth J. Mack 45 Vice President, Consumer Products, since April 1999. Executive Vice President, Sales and Marketing, Wampler Foods 1997-1999. Executive Vice President, Marketing and Sales, Just Born 1994-1997. Lou Anne J. Nabhan 45 Vice President, Corporate Communications, since January 1998. Director, Corporate Communications 1993-1998. F. Robert Newman 56 Vice President, Human Resources, since October 1995. Corporate Director, Human Resources 1993-1995. Edmund H. Polonitza 57 Vice President, Development and Strategic Planning, since January 1998. Corporate Director, Development and Strategic Planning 1987-1998. William G. Reynolds, Jr.** 60 Vice President, Government Relations and Public Affairs, since October 1980. John F. Rudin 54 Vice President, Chief Information Officer, since August 1995. Vice President since April 1995. Reynolds Aluminum Supply Company Division General Manager 1989-1995. Julian H. Taylor 56 Vice President, Treasurer, since April 1988. _______________ * As of February 25, 2000. ** Randolph N. Reynolds and William G. Reynolds, Jr. are brothers. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's Common Stock is listed on the New York Stock Exchange. At February 25, 2000, there were 7,161 holders of record of the Registrant's Common Stock. The high and low sales prices for shares of the Registrant's Common Stock as reported on the New York Stock Exchange Composite Transactions Tape and the dividends declared per share during the periods indicated are set forth below: On February 18, 2000, the Board of Directors declared a dividend of $.35 per share of Common Stock, payable April 3, 2000 to stockholders of record on March 3, 2000. RECENT SALES OF UNREGISTERED SECURITIES - --------------------------------------- Under the Registrant's Stock Plan for Outside Directors (the "Stock Plan"), each outside Director serving on the Registrant's Board of Directors on or after January 1, 1997 receives an annual grant of 225 shares of phantom stock of the Registrant, plus dividend equivalents based on the dividends that would have been paid on the phantom stock if the outside Director had actually owned shares of the Registrant's Common Stock. The annual grant is made in quarterly installments at the end of each calendar quarter. This rate is increased for each outside Director to 425 shares of phantom stock per year once the restrictions have expired on all 1,000 shares of restricted stock awarded to such outside Director under the Registrant's Restricted Stock Plan for Outside Directors. Payments under the Stock Plan will be made upon the outside Director's retirement, resignation or death in shares of Common Stock of the Registrant, with fractional shares paid in cash. Information regarding grants of phantom shares under the Stock Plan during the period January 1 - September 30, 1999 is included in the Registrant's Quarterly Reports on Form 10-Q for the quarters ended March 31, 1999, June 30, 1999 and September 30, 1999. On October 1, 1999, 112 phantom shares, in the aggregate, were granted to the Registrant's nine outside Directors, based on an average price of $59.437 per share. These phantom shares represent dividend equivalents paid on phantom shares previously granted under the Stock Plan. On December 31, 1999, 756 phantom shares, in the aggregate, were granted to the nine outside Directors, based on an average price of $76.531 per share. These phantom shares represent a quarterly installment of each outside Director's annual grant under the Stock Plan. During 1999, 3,233 phantom shares were granted under the Stock Plan. To the extent that these grants constitute sales of equity securities, the Registrant issued these phantom shares in reliance on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended, taking into account the nature of the Stock Plan, the number of outside Directors participating in the Stock Plan, the sophistication of the outside Directors and their access to the kind of information that a registration statement would provide. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - ----------------------------------------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with the consolidated financial statements, related notes and other sections of this report. In the tables, dollars are in millions, except per share and per pound amounts, and shipments are in thousands of metric tons. A metric ton is equivalent to 2,205 pounds. Management's Discussion and Analysis contains forecasts, projections, estimates, statements of management's plans, objectives and strategies for the Company and other forward-looking statements. Please refer to the "Risk Factors" section beginning on page 32 where we have summarized factors that could cause actual results to differ materially from those projected in a forward-looking statement or affect the extent to which a particular projection is realized. PROPOSED MERGER - --------------- On August 18, 1999, Reynolds, Alcoa Inc. (Alcoa) and RLM Acquisition Corp., a wholly owned subsidiary of Alcoa, entered into an agreement and plan of merger. Under the merger agreement, each outstanding share of Reynolds common stock would be converted into 1.06 shares of Alcoa common stock and Reynolds would become wholly owned by Alcoa. On January 10, 2000, Alcoa announced that its Board of Directors had declared a two-for-one split of Alcoa's common stock to Alcoa shareholders of record on May 26, 2000. The stock split is subject to approval of Alcoa shareholders who must approve an amendment to Alcoa's articles to increase the authorized shares of common stock at Alcoa's annual meeting on May 12, 2000. If approved, the stock split would be distributed on June 9, 2000. Shares of Alcoa stock that are issued in the merger will be adjusted, as necessary, to reflect the stock split. The proposed merger, which was approved by Reynolds' stockholders at a special meeting held on February 11, 2000, is subject to customary closing conditions, including antitrust clearances. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 prohibits Alcoa and Reynolds from completing the merger until certain information has been furnished to the Antitrust Division of the Department of Justice and the Federal Trade Commission, and until certain waiting period requirements have been satisfied. Alcoa filed a Hart-Scott-Rodino Premerger Notification and Report Form on August 24, 1999 and Reynolds filed such a Form on August 30, 1999. On September 29, 1999, the Antitrust Division issued a request for additional information and documentary material (a "second request"). On February 11, 2000, both Reynolds and Alcoa announced that they believed that they were in substantial compliance with the second request. They also advised the Department of Justice that they would not close the merger before March 31, 2000, in order to provide the Department sufficient time to review the transaction. In Europe, certain regulations require that Alcoa file a premerger notification form with the Commission of the European Communities prior to consummation of the proposed merger. Alcoa filed such notification on November 18, 1999. This filing began an initial one-month review period in which the European Commission was required to determine whether there are sufficiently "serious doubts" about the proposed merger's compatibility with the common market to require a more complete review. The initial one-month period expired on December 20, 1999, whereupon the European Commission issued a determination that the proposed merger did require a more complete review. The European Commission must complete its investigation and make a final determination with respect to the proposed merger no later than May 10, 2000. Reynolds and Alcoa have also made filings under the competition laws of Canada, Australia and certain other countries where the companies have significant operations. Alcoa and Reynolds have been advised that the Canadian Competition Bureau has classified this merger as "very complex." Its review is expected to be completed no later than May 24, 2000. The Australian review process is also expected to be completed by the end of May 2000. PROPOSED MERGER - continued - --------------- The merger agreement contains certain restrictions on the conduct of Reynolds' business before completion of the merger. For example, Reynolds has agreed to operate its business only in the ordinary course, to refrain from taking certain corporate actions without the consent of Alcoa, and not to solicit alternative acquisition proposals. In 1999, the Company recognized $19 million of merger-related expenses. Merger-related expenses are principally for investment banking and legal services and an increase in the expense accrual for a long-term compensation plan, which varies based principally on appreciation of the Company's stock price as compared to the S&P Basic Materials Index. The Company expects total merger-related expenses to be at least $35 million. Income before extraordinary loss and cumulative effect of accounting change includes after tax charges for: Our results increased (decreased) compared to the prior year due principally to the following (all amounts are pre-tax): RESULTS OF OPERATIONS - continued - --------------------- GLOBAL BUSINESS UNITS The Company is organized into four market-based, global business units. The four global business units and their principal products are as follows: . Base Materials - alumina, carbon products, primary aluminum ingot and billet, and electrical rod . Packaging and Consumer - aluminum and plastic packaging; foodservice and consumer products; printing products . Construction and Distribution - architectural construction products and the distribution of a wide variety of aluminum and stainless steel products . Transportation - aluminum wheels, heat exchangers and automotive structures The Base Materials global business unit consists principally of the following: Aluminum - -------- . Primary aluminum - Three plants in the U.S., one in Canada and partial interests in plants in Canada (50% owned), Germany (33-1/3% owned) and Ghana (10% owned). Our rated annual production capacity including our share of partial interests is 1,094,000 metric tons, of which 47,000 metric tons is temporarily idled (see below). . Electrical rod - One plant in Canada. Nonaluminum - ----------- . Alumina - One plant in the U.S. and partial interests in plants in Australia (56% owned) and Germany (50% owned). Our rated annual production capacity including our share of partial interests is 3,028,000 metric tons. Depending on operating rates of primary aluminum and alumina facilities, approximately 70% of alumina production is consumed within the Base Materials global business unit. . Carbon products - Two U.S. plants that produce calcined petroleum coke (one of which also produces carbon anodes) principally for use in primary aluminum facilities. Depending on operating rates of primary aluminum and carbon products facilities, approximately 45% of carbon products production is consumed within the Base Materials global business unit. The increase in customer aluminum shipments in 1999 and 1998 reflects strong demand for our value-added products (foundry, high purity and sheet ingot, billet and rod), which made up 75% of our primary aluminum shipments in 1999. Our available supply to meet customer needs has increased because we no longer need to supply downstream fabricating operations that have been sold. Our available supply also increased because of restarting idled capacity in 1998 (as discussed below). In addition to reflecting the changes in shipping volume, aluminum revenues were significantly affected by lower primary aluminum prices in 1999 and 1998. RESULTS OF OPERATIONS - continued - --------------------- GLOBAL BUSINESS UNITS - continued BASE MATERIALS - continued Nonaluminum revenues were lower in 1999 because of lower prices and shipping volume for carbon products. Alumina shipments were higher in 1998 because of significant improvements in production efficiencies and capacity utilization at our U.S. alumina plant. Nonaluminum revenues were flat in 1998 as lower prices for alumina and carbon products offset the effect of higher alumina shipments. The most significant factor affecting operating profit in 1999 and 1998 was lower prices for primary aluminum. Also contributing to the decline in 1998 were non-recurring restart costs at our primary aluminum plants, lower technical services income and lower alumina prices. We were able to offset most of the declines with improved capacity utilization, significant cost reductions, lower costs for certain raw materials, higher customer shipments and, in 1999, higher alumina prices. Results in all three years were negatively impacted by temporarily curtailed capacity at our U.S. primary aluminum plants. During 1998, we restarted 162,000 metric tons of previously idled capacity. We plan to monitor our internal needs and market conditions before finalizing the schedule to restart the remaining 47,000 metric tons at our Troutdale, Ore., plant. Bonneville Power Administration ("BPA") supplies electricity to our smelters at Longview, Washington and Troutdale, Oregon. The current contract with BPA expires on September 30, 2001. BPA has proposed reducing the amount of power supplied to the smelters by one-third and pricing the power on a formula under which charges would vary with world aluminum prices. Assuming "average" world aluminum prices (with the basis for determining what is "average" yet to be settled), the rate charged to Reynolds for the period 2001-2006 would increase by 13% over what we currently pay. We would also have to find other sources for the balance of our power needs. The BPA proposal is subject to full consideration in a rate case, in which we can present arguments to improve the offered rate, and other parties can challenge both the quantity of power being provided to the Reynolds smelters and the rates at which it is to be provided. We expect to participate actively in the resolution of this issue and to continue assessing alternate power sources for the two smelters. The outlook for this business unit in the first quarter of 2000 is very good. Aluminum and alumina prices are rebounding and demand is strong. The Packaging and Consumer global business unit consists principally of 17 packaging and consumer products plants in the U.S., one each in Canada, Spain and Brazil, and 23 graphics facilities located in the U.S., Canada and Mexico that produce graphics, printing cylinders and plates. Aluminum shipments and revenues increased in 1999 and 1998 because of strong demand for Reynolds Wrap aluminum foil and the introduction of new products. The volume effect on revenues in 1999 was partially offset by lower prices. In 1998, the gains from sales of Reynolds Wrap aluminum foil and new products were offset by lower sales of packaging products with the elimination of certain low-margin products. RESULTS OF OPERATIONS - continued - --------------------- GLOBAL BUSINESS UNITS - continued Packaging and Consumer - continued The increase in nonaluminum sales in 1999 resulted from higher sales of foodservice, graphics and plastic consumer products. The volume increase was partially offset by lower prices. Operating income increased in 1999 because of the higher sales volume and lower costs for conversion and aluminum raw materials. These benefits were mostly offset by lower prices and higher costs for other raw materials. Operating income increased in 1998 due to higher sales of consumer products, lower raw material costs and cost reduction programs. Higher product development and marketing costs for new consumer products introduced in 1998 partially offset these benefits. Looking forward, this business unit expects to enjoy sales growth from acquisitions completed in 1999, the benefits of expansions at plastic and printing plants, and new product introductions. The Construction and Distribution global business unit consists principally of 48 distribution centers in the U.S., Europe, Canada and Mexico and four manufacturing plants, two in the U.S. and two in Europe. The increase in aluminum shipments in 1999 and 1998 resulted from strong demand for distribution products. All of our major distribution products (plate, sheet and extrusions) benefited from market share growth in our major domestic markets. Construction products shipments were lower in 1999 after growing in 1998. Shipments in 1999 were adversely affected by weak market conditions in Germany, the China/Pacific Rim area and Latin America. Shipments were higher in 1998 because of our global expansion efforts and strong demand for aluminum composite material. The effect of the shipping volume increase on aluminum revenues in 1999 was totally offset by lower prices. The decline in prices reflected lower material costs. The increase in aluminum revenues in 1998 was the result of the shipping volume increase while prices remained relatively flat. Shipments of stainless steel distribution products increased 17% in 1999 (including the effect of acquisitions) and 8% in 1998. The effect of these volume increases on nonaluminum revenues was offset by lower prices, especially in 1998. Prices for these products, under pressure due to lower material costs resulting from global supply/demand imbalances, began to improve in late 1999. Operating income in 1999 and 1998 benefited from the higher shipping volumes. This was somewhat offset by lower capacity utilization in construction products plants resulting from weak business conditions in certain foreign markets. In 1998, we incurred higher marketing costs to expand construction products' global sales and distribution infrastructure to enhance customer service. Customers in our major distribution markets continue to experience a strong business climate, and our outlook for the first quarter of 2000 is strong. For construction products, we expect to see improvement as economies around the world improve. With the expansion of our Merxheim, France plant to produce aluminum composite material, we have improved our ability to meet European and global demand for Reynobond aluminum composite material from this plant and our U.S. plant. RESULTS OF OPERATIONS - continued - --------------------- GLOBAL BUSINESS UNITS - continued TRANSPORTATION The Transportation global business unit consists principally of the following: . Aluminum wheels - Two plants in the U.S., one in Italy, and partial interests in plants in Canada (75% owned) and Venezuela (41% owned). . Automotive extrusions - Two plants in the U.S. and one each in The Netherlands, Germany, Ireland and Venezuela. Shipments and revenues were higher in 1999 because of strong demand for cast and forged aluminum wheels. Our available supply increased due to improved capacity utilization and the completion of the expansion of our Virginia forged aluminum wheel plant in early 1999. The volume impact on revenues was partially offset by lower prices. Shipments and revenues in 1998 were negatively impacted by volume declines in bumpers and cast aluminum wheels. The decline in bumper shipments resulted from the completion of a contract in 1997 at our Indiana automotive structures plant. Cast aluminum wheel shipments were lower because of decreased demand related to a substantial number of mid-year wheel program conversions and a strike at a customer earlier in the year. The lower shipments of cast aluminum wheels in 1998 were somewhat offset by higher shipments of forged aluminum wheels from our Virginia plant. Revenues in 1998 also declined due to lower prices for wheels because of competition for new business. The increased losses in 1999 and 1998 were due to start-up costs relating to an engine cradle program at our Indiana automotive structures plant, higher conversion costs resulting from manufacturing difficulties in wheel operations and lower selling prices. Despite significant effort, this business unit was not able to return to profitability because of two major challenges. The first was in the forged wheels business. We built a new plant in Lebanon, Virginia that uses a new technology. We have now constructed two lines at the plant. In 1999, the capability of the plant fell short of the projections on which sales commitments had been made. In order to meet promised deliveries to customers - and in some instances to keep customer operations running - we incurred significantly higher costs. This situation has been improving, and our wheel business overall realized important year-over-year improvement in 1999. We expect the wheel business to become profitable in 2000. The second major challenge is in our structures operations. Together with General Motors, we have pioneered a new aluminum automotive component - the engine cradle. We underestimated the technological and operational requirements of producing this new product, and we have incurred significantly higher spending and resource allocation to meet promised deliveries. This situation is also improving, and we expect better results in 2000. Evaluating opportunities for strategic alliances in this business unit has been part of our plan for performance improvement. During 1999, we looked at a number of options and progressed to serious discussions. All of this activity, however, was suspended once our merger with Alcoa was announced. RESULTS OF OPERATIONS - continued - --------------------- GLOBAL BUSINESS UNITS - continued RESTRUCTURING No revenues or operating results are included in the Restructuring category in 1999. Prior to 1999, this category consisted of the following operations that have been sold: . U.S. recycling operations . aluminum extrusion facilities in Canada . European rolling mill operations . Illinois sheet and plate plant . North American aluminum beverage can operations . Alabama can stock complex . U.S. residential construction products business . aluminum reclamation plant in Virginia . aluminum extrusion plants in Virginia and Texas . coal properties in Kentucky . one-half of the Company's wholly owned interest in a rolling mill and related assets in Canada . aluminum powder and paste plant in Kentucky Customer revenues generated by these operations were $1.4 billion in 1998 and $2.7 billion in 1997. The decline in shipments and net sales in 1998 and 1997 was due to the sale of these operations. In 1998, the absence of operating income from sold operations was offset by the effect ($65 million) of ceasing depreciation on assets held for sale. For additional information concerning the Company's restructuring activities, see Notes 3 and 12 to the consolidated financial statements. OTHER This category consists principally of European extrusion operations and investments in Canada, China, Latin America and Saudi Arabia, and real estate. The increase in shipments and revenues in 1999 resulted from improved demand at European extrusion operations. Operating income was higher in 1999 because of improved operations in emerging markets and higher equity income in our Latin American can operations. The increased operating loss in 1998 was due to lower equity income in our Latin American can operations. In early 2000, we sold our remaining investment in a Canadian rolling mill and related assets that was included in this category. This transaction will not have a material impact on our operating results or financial position. GEOGRAPHIC AREA ANALYSIS The Company has worldwide operations in the U.S., Canada and other foreign areas including Europe and Australia. Certain of these consist of equity interests in entities, the revenues of which are not included in our consolidated revenues. In Australia, we participate in an unincorporated joint venture that mines bauxite and produces alumina. Revenues were negatively impacted in 1999 and 1998 due to lower primary aluminum prices and the Company's restructuring activities in 1998 and 1997. Revenues in Canada increased in 1999 as primary aluminum previously sold internally became available for customer shipments because we no longer need to supply downstream fabricating operations that have been sold. INTEREST EXPENSE Interest expense decreased in 1999 because of: . lower amounts of debt outstanding . lower average interest rates due to extinguishing higher cost debt . higher amounts of capitalized interest Interest expense decreased in 1998 because of lower amounts of debt outstanding. RESULTS OF OPERATIONS - continued - --------------------- TAXES ON INCOME The Company pays U.S. federal, state and foreign taxes based on the laws of the various jurisdictions in which it operates. The effective tax rates (see reconciliation in Note 11 to the consolidated financial statements) reflected in the income statement differ from the U.S. federal statutory rate principally because of the following: . foreign taxes at different rates . the effects of percentage depletion allowances . additionally in 1999 and 1998, credits and other tax benefits . additionally in 1997, the adverse effect of permanent basis differences on asset dispositions We have worldwide operations in many tax jurisdictions that generate deferred tax assets and/or liabilities. Deferred tax assets and liabilities have been netted by jurisdiction. This results in both a deferred tax asset and a deferred tax liability on the balance sheet. At December 31, 1999, we had $822 million of deferred tax assets that relate primarily to U.S. tax positions. The most significant portions of these assets relate to tax carryforward benefits and accrued costs for employee health care, environmental and restructuring costs. We expect to realize a major portion of these assets in the future through the reversal of temporary differences, principally depreciation. To the extent that these assets are not covered by reversals of depreciation, we expect the remainder to be realized through U.S. income earned in future periods. The Company has a strong history of sustainable earnings. However, even without considering projections of income, certain tax planning strategies (such as changing the method of valuing inventories from LIFO to FIFO and/or entering into sale-leaseback transactions) would generate sufficient taxable income to realize the portion of the deferred tax asset relating to U.S. operations. In addition, the majority of our U.S. tax carryforward benefits may be carried forward indefinitely. Based on our evaluation of these matters, we expect to realize these deferred tax assets. We are not aware of any events or uncertainties that could significantly affect our conclusions regarding realization. We reassess the realization of deferred tax assets quarterly and, if necessary, adjust the valuation allowance accordingly. ENVIRONMENTAL The Company is involved in remedial investigations and actions at various locations, including Environmental Protection Agency-designated Superfund sites where we and, in most cases, others have been designated as potentially responsible parties (PRPs). We accrue remediation costs when it becomes probable that such efforts will be required and the costs can be reasonably estimated. We evaluate the status of all significant existing or potential environmental issues quarterly, develop or revise cost estimates to satisfy known remediation requirements, and adjust the accrual accordingly. At December 31, 1999, the accrual was $162 million. The accrual reflects our best estimate of the ultimate liability for known remediation costs. Amounts accrued for two sites - our Massena, New York and Troutdale, Oregon primary aluminum plants - represent individually material portions of the accrual at December 31, 1999. For information about the current status of these two sites, see the discussion in Item 1 under "Environmental Compliance." At most of the other Superfund sites where the Company has been identified as a PRP, the Company is one of many PRPs, and our share of the anticipated cleanup costs is expected to be small. In estimating anticipated costs, we consider the extent of our involvement at each site, joint and several liability provisions under applicable law, and the likelihood of obtaining contribution from other PRPs. Potential insurance recoveries are uncertain and therefore have not been considered. Based on information currently available, we expect to make remediation expenditures relating to costs currently accrued over the next 15 to 20 years with the majority spent by the year 2005. We expect cash provided by operating activities to provide the funds for environmental capital, operating and remediation expenditures. RESULTS OF OPERATIONS - continued - --------------------- ENVIRONMENTAL - continued Annual capital expenditures for equipment designed for environmental control purposes averaged approximately $57 million over the past three years. Ongoing environmental operating costs for the same period averaged approximately $81 million per year. The Company expects operating expenditures for 2000 through 2002 to be approximately $80 million per year. We estimate annual capital expenditures for environmental control facilities will be approximately $24 million in 2000, $30 million in 2001 and $21 million in 2002. The majority of these expenditures are for the capital spending program referred to below at our primary aluminum plant in Massena, New York. Our spending on environmental compliance will be influenced by future environmental regulations, including those issued and to be issued under the Clean Air Act Amendments of 1990. We are spending an estimated $175 million at our primary aluminum plant in Massena, New York for new air emissions controls and a phased modernization of the plant's production lines. We expect to complete this project in the year 2002. We are accelerating certain expenditures believed necessary to achieve compliance with the Clean Air Act's proposed Maximum Achievable Control Technology standards. Based on current information, we estimate that compliance with the Clean Air Act's hazardous air pollutant standards will require in excess of $200 million of capital expenditures (including a portion of the expenditures at the New York plant previously discussed), principally at our U.S. primary aluminum plants. For additional information concerning environmental expenditures, see Note 13 to the consolidated financial statements. YEAR 2000 READINESS DISCLOSURE In 1999, we completed a formal program to address and resolve potential exposure associated with information and non-information technology systems arising from the Year 2000 issue. The Year 2000 issue results from computer programs and systems that rely on two digits rather than four to define the applicable year. Such systems may treat a date using "00" as the year 1900 rather than the year 2000. As a result, computer systems could fail to operate or make miscalculations, causing disruption of business operations. Our goal was that none of our critical business operations or computer processes that are shared with suppliers and customers would be substantially impaired by the advent of the year 2000. We accomplished this goal and experienced no business interruptions as a result of Year 2000 problems. The minor Year 2000 problems encountered (e.g., incorrect invoice dates) were solved in a timely manner. We do not anticipate the need for additional contingency planning. However, we will continue monitoring for Year 2000 issues beyond those already addressed and anticipate that any additional problems will be resolved using resources normally available to the Company. The total cost of our Year 2000 remediation project was approximately $22 million, which included labor, equipment and license costs. EURO CONVERSION On January 1, 1999, 11 of the 15 member countries of the European Union established fixed conversion rates between their former sovereign currencies and a common currency, the euro. The euro trades on currency exchanges and is available for non-cash transactions. Between January 1, 1999 and July 1, 2002, entities in the participating countries must convert all of their transactions denominated in the legacy currencies to the new euro currency. We expect to have our systems ready in time to process euro denominated transactions. We do not expect any material adverse effects from the euro conversion on our competitive or financial position or our ongoing results of operations. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- WORKING CAPITAL The decline in working capital was due in part to the sale of $128 million of accounts receivable under a non-recourse facility. We are able to operate with lower levels of working capital as a result of our restructuring activities. OPERATING ACTIVITIES We used the net cash provided by operating activities for the past three years primarily to fund capital investments. INVESTING ACTIVITIES The following table shows capital investments in the following categories: operational (replacement equipment, environmental control projects, etc.) and strategic (performance improvement, acquisitions and investments). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In the tables, dollars are in millions, except per share amounts. Certain amounts have been reclassified to conform to the 1999 presentation.) - ---------------------------------------------------------------------------- 1. ACCOUNTING POLICIES GENERAL The consolidated financial statements are prepared in conformity with generally accepted accounting principles. As a result, management makes estimates and assumptions that affect the following: . reported amounts of revenues and expenses during the reporting period . reported amounts of assets and liabilities at the date of the financial statements . disclosure of contingent liabilities at the date of the financial statements Actual results could differ from those estimates. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries after eliminating inter-company transactions, profits and losses. The Company accounts for investments in unincorporated joint ventures on an investment cost basis adjusted for the Company's share of the non-cash production charges of the operation. Unincorporated joint ventures are production facilities without marketing or sales activities. Products produced are distributed in kind and cash production costs are allocated to the joint venturers based upon their respective percentage interests in the facilities. Our operating results include our share of cash production costs and non-cash production charges (principally depreciation) as well as revenues from the ultimate sale by us of our share of the products. Investments in associated companies (20% - 50% owned) are carried at cost adjusted for the Company's equity in undistributed net income. REVENUE RECOGNITION Revenues are recognized when products are shipped and ownership risk and title pass to the customer. INVENTORIES Inventories are stated at the lower of cost or market. Inventory costs were determined by the last-in, first-out (LIFO); first-in, first-out (FIFO); and average-cost methods. LIFO method inventories were $171 million at the end of 1999 (1998 - $178 million). FIFO and average-cost method inventories were $348 million at the end of 1999 (1998 - $322 million). Inventories would increase by $233 million at the end of 1999 (1998 - $221 million) if the FIFO method were applied to LIFO method inventories. The favorable impact of the liquidation of certain LIFO layers that occurred as a result of the Company's divestitures ($184 million in 1998 and $58 million in 1997) is included in "Operational restructuring effects - net" in the Consolidated Statement of Income. Since inventories are sold at various stages of processing, there is no practical distinction between finished products, in-process products and other materials. Inventories are therefore presented as a single classification. DEPRECIATION AND AMORTIZATION The straight-line method is used to depreciate plant and equipment over their estimated useful lives (buildings and leasehold improvements - 10 to 40 years, machinery and equipment - 5 to 20 years). Improvements to leased properties are generally amortized over the shorter of the terms of the respective leases or the estimated useful life of the improvement. ENVIRONMENTAL EXPENDITURES Remediation costs are accrued when it is probable that such efforts will be required and the related costs can be reasonably estimated. 1. ACCOUNTING POLICIES - continued POSTEMPLOYMENT BENEFITS The expected cost of postemployment benefits is accrued when it becomes probable that such benefits will be paid. HEDGING Forward, futures, option and swap contracts are designated to manage market risks resulting from fluctuations in the aluminum, natural gas, foreign currency and debt markets. These instruments, which are not held for trading purposes, are effective in minimizing such risks by creating equal and offsetting exposures. Unrealized gains and losses are deferred and recorded as a component of the underlying hedged transaction when it occurs. Realized gains or losses from matured and terminated hedge contracts are recorded in other assets or liabilities until the underlying hedged transactions are consummated. Realized and unrealized gains or losses on hedge contracts relating to transactions that are subsequently not expected to occur are recognized in results currently. None of these instruments contains multiplier or leverage features. There is exposure to credit risk if the other parties to these instruments do not meet their obligations. Creditworthiness of the other parties is closely monitored, and they are expected to fulfill their obligations. Contracts used to manage risks in these markets are not material. CUMULATIVE EFFECT OF ACCOUNTING CHANGE In 1998, the Accounting Standards Executive Committee (AcSEC) of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 98-5, "Reporting on the Costs of Start-Up Activities." The SOP requires costs of start-up activities and organization costs to be expensed as incurred. The Company adopted the SOP in 1998 and recognized an after-tax charge for the cumulative effect of accounting change of $23 million. STATEMENT OF CASH FLOWS In preparing the Consolidated Statement of Cash Flows, all highly liquid, short-term investments purchased with an original maturity of three months or less are considered to be cash equivalents. STOCK OPTIONS Stock options are accounted for using the intrinsic value method. Compensation expense is not recognized because the exercise price of the stock options equals the market price of the underlying stock on the date of grant. ACCOUNTING FOR THE COSTS OF DEVELOPING OR OBTAINING INTERNAL-USE SOFTWARE In 1999, the Company adopted the AcSEC's Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." The SOP requires qualifying computer software costs incurred in connection with obtaining or developing software for internal use to be capitalized. In prior years, the Company capitalized costs of purchased software and expensed internal costs of developing software. The effect of adopting this SOP was not material to 1999 results. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In 1998, the FASB issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes new accounting and reporting standards for derivative instruments and hedging activities. The Company must adopt this statement by January 1, 2001. The Company has not determined the impact this statement will have on its financial position or results of operations. 2. PROPOSED MERGER On August 18, 1999, Reynolds, Alcoa Inc. (Alcoa) and RLM Acquisition Corp., a wholly owned subsidiary of Alcoa, entered into an agreement and plan of merger. Under the merger agreement, each outstanding share of Reynolds common stock would be converted into 1.06 shares of Alcoa common stock and Reynolds would become wholly owned by Alcoa. On January 10, 2000, Alcoa announced that its Board of Directors had declared a two-for-one split of Alcoa's common stock to Alcoa shareholders of record on May 26, 2000. The stock split is subject to approval of Alcoa shareholders who must approve an amendment to Alcoa's articles to increase the authorized shares of common stock at Alcoa's annual meeting on May 12, 2000. If approved, the stock split would be distributed on June 9, 2000. Shares of Alcoa stock that are issued in the merger will be adjusted, as necessary, to reflect the stock split. 2. PROPOSED MERGER - continued The proposed merger, which was approved by Reynolds' stockholders at a special meeting held on February 11, 2000, is subject to customary closing conditions, including antitrust clearances. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 prohibits Alcoa and Reynolds from completing the merger until certain information has been furnished to the Antitrust Division of the Department of Justice and the Federal Trade Commission, and until certain waiting period requirements have been satisfied. Alcoa filed a Hart-Scott-Rodino Premerger Notification and Report Form on August 24, 1999 and Reynolds filed such a Form on August 30, 1999. On September 29, 1999, the Antitrust Division issued a request for additional information and documentary material (a "second request"). On February 11, 2000, both Reynolds and Alcoa announced that they believed that they were in substantial compliance with the second request. They also advised the Department of Justice that they would not close the merger before March 31, 2000, in order to provide the Department sufficient time to review the transaction. In Europe, certain regulations require that Alcoa file a premerger notification form with the Commission of the European Communities prior to consummation of the proposed merger. Alcoa filed such notification on November 18, 1999. This filing began an initial one-month review period in which the European Commission was required to determine whether there are sufficiently "serious doubts" about the proposed merger's compatibility with the common market to require a more complete review. The initial one-month period expired on December 20, 1999, whereupon the European Commission issued a determination that the proposed merger did require a more complete review. The European Commission must complete its investigation and make a final determination with respect to the proposed merger no later than May 10, 2000. Reynolds and Alcoa have also made filings under the competition laws of Canada, Australia and certain other countries where the companies have significant operations. Alcoa and Reynolds have been advised that the Canadian Competition Bureau has classified this merger as "very complex." Its review is expected to be completed by May 24, 2000. The Australian review process is also expected to be completed by the end of May 2000. The merger agreement contains certain restrictions on the conduct of Reynolds' business before completion of the merger. For example, Reynolds has agreed to operate its business only in the ordinary course, to refrain from taking certain corporate actions without the consent of Alcoa, and not to solicit alternative acquisition proposals. In 1999, the Company recognized $19 million of merger-related expenses. Merger-related expenses are principally for investment banking and legal services and an increase in the expense accrual for a long-term compensation plan, which varies based principally on appreciation of the Company's stock price as compared to the S&P Basic Materials Index. The Company expects total merger-related expenses to be at least $35 million. 3. OPERATIONAL RESTRUCTURING In the first quarter of 1999, the final closing of the sale of the Company's Alabama can stock complex occurred. In 1998, the Company sold the following: . U.S. recycling operations . aluminum extrusion facilities in Canada . European rolling mill operations . Illinois sheet and plate plant . North American aluminum beverage can operations . Alabama can stock complex (with final closing in early 1999) 3. OPERATIONAL RESTRUCTURING - continued In 1997, the Company sold the following: . U.S. residential construction products business . aluminum reclamation plant in Virginia . aluminum extrusion plants in Virginia and Texas . coal properties in Kentucky . one-half of its wholly owned interest in a rolling mill and related assets in Canada . aluminum powder and paste plant in Kentucky Financial information for 1998 and 1997 relating to operations divested is reflected in the Restructuring category in Note 12. Customer revenues generated by these operations were $1.4 billion in 1998 and $2.7 billion in 1997. Depreciation expense in 1998 was reduced $65 million as a result of ceasing depreciation on assets held for sale relating to the divestitures. The favorable impact of the liquidation of certain LIFO layers that occurred as a result of the Company's divestitures ($184 million in 1998 and $58 million in 1997) is included in "Operational restructuring effects - net" in the Consolidated Statement of Income. The Company recognized the following operational restructuring charges: The charges for employee terminations recorded in 1998 and 1997 were principally for severance and related costs for approximately 2,000 salaried and hourly employees. The employees worked principally at domestic plants. Approximately 600 employees worked at corporate headquarters. Employees terminated in each period were 1,385 in 1998 and 498 in 1997. An analysis of the accrual for restructuring liabilities follows: Liabilities at December 31, 1999 relating to the Company's restructuring activities are expected to be substantially satisfied in 2000 with cash provided by operating activities. Liabilities relating to contractual postretirement obligations are reflected in postretirement benefits on the balance sheet and will be settled over numerous future years in conjunction with the Company's funding of its pension and other postretirement benefit obligations. The Company used proceeds from completed divestitures for debt repayments and repurchases of common stock (see Notes 4 and 9). Early in the first quarter of 2000, the Company sold its investment in a Canadian rolling mill and related assets. This transaction will not have a material impact on our operating results or financial position. 4. EXTRAORDINARY LOSS The Company had an extraordinary loss from debt extinguishments in 1998 of $63 million (net of income tax benefit of $39 million). The debt extinguished at a loss consisted of $500 million of medium-term notes and $79 million of 9% debentures. 5. EARNINGS PER SHARE The following reconciles income and average shares for the basic and diluted earnings per share computations for "Income before extraordinary loss and cumulative effect of accounting change." 6. UNINCORPORATED JOINT VENTURES AND ASSOCIATED COMPANIES The Company has interests in unincorporated joint ventures which produce alumina and primary aluminum. It also has interests in foreign-based associated companies which produce bauxite, alumina, primary aluminum, hydroelectric power and fabricated aluminum products. At December 31, the Company's investment in these activities consisted of the following: Property, plant and equipment and other assets for the unincorporated joint ventures in 1999 includes $359 million (1998 - $150 million) of construction in progress for the expansion of the Worsley Alumina Refinery joint venture. 7. PROPERTY, PLANT AND EQUIPMENT (AT COST) 8. FINANCING ARRANGEMENTS Long-term debt at December 31, 1999 matures as follows: 2000 $153 2001 569 2002 70 2003 58 2004 35 2005 - 2025 335 The medium-term notes and 9% debentures were issued under a shelf registration. The medium-term notes bear interest at an average fixed rate of 8.5% and have maturities ranging from 2000 to 2013. At December 31, 1999, $13 million of debt securities remained unissued under the shelf registration. In early 2000, the Company increased the amount of debt securities it can issue under the shelf registration to $163 million. A portion of this fixed-rate debt has been effectively converted to a variable rate through the use of a $100-million interest rate swap that matures in 2001. Under the swap, payments are received based on a fixed rate (6%) and made based on a variable rate (5.9% at December 31, 1999). The variable rate is based on the London Interbank Offer Rate (LIBOR). The differential to be paid or received as interest rates change is accrued and recognized as an adjustment of interest expense. The fair value of this agreement and its effect on interest expense was not material. The 6-5/8% amortizing notes were issued at a discount (99.48%) and have an effective interest rate of 6.7%. The notes require annual principal repayments of $57 million between 2000 and 2002. 8. FINANCING ARRANGEMENTS - continued Industrial and environmental control revenue bonds consist principally of variable-rate debt with interest rates averaging 4.8% at December 31, 1999. The variable rates are based on market interest rates. These bonds require principal repayments in lump sums periodically between 2000 and 2025. Letters of credit issued by banks support most of these bonds. The Company has classified $250 million of commercial paper as long-term debt because the Company intends to refinance the debt on a long-term basis and the commercial paper is supported by a $500 million long-term credit facility. The Company also has a $150 million long-term credit facility. These long-term credit facilities have variable interest rates (6.4% at December 31, 1999) and mature in 2001. The variable rates are based on LIBOR. The Company pays an annual commitment fee of .1% on the unused portion of these facilities. In addition to the long-term credit facilities, the Company has a short-term credit facility of $185 million that was unutilized and available at December 31, 1999. This credit facility has a variable interest rate that is based on LIBOR. The Company pays an annual commitment fee of .125% on the unused portion. Certain financing arrangements contain restrictions that primarily consist of requirements to maintain specified financial ratios. These restrictions do not inhibit operations or the use of fixed assets. At December 31, 1999, the Company exceeded all such requirements. The fair value of long-term debt was approximately equal to book value at the end of 1999 and 1998. The fair value was determined by using discounted cash flow analysis. Interest capitalized was $24 million during 1999 (1998 - $12 million, 1997 - $8 million). Interest rates on short-term borrowings are based on market rates. The weighted-average interest rates were: 9. STOCKHOLDERS' EQUITY PREFERRED STOCK The Company has 21,000,000 shares of preferred stock authorized. Two million shares have been designated Series A Junior Participating Preferred. COMMON STOCK The Company has 200,000,000 shares of common stock (without par value) authorized. The Company has authorization to repurchase up to 18 million shares of common stock of which approximately 11.3 million shares have been repurchased through December 31, 1999. (See the Consolidated Statement of Changes in Stockholders' Equity for additional share repurchase information.) Under the merger agreement with Alcoa, the Company has agreed to refrain from purchasing additional shares without the consent of Alcoa. (See Note 2.) 9. STOCKHOLDERS' EQUITY - continued STOCK OPTIONS The Company has a non-qualified stock option plan under which key employees may be granted stock options at a price equal to the fair market value at the date of grant. The stock options outstanding at December 31, 1999 vest in one year and are exercisable between one year and ten years from the date of grant. Upon a change in control of the Company, all outstanding options would become immediately exercisable. The range of exercise prices for the stock options outstanding at December 31, 1999 was $45 to $64 and their weighted-average remaining contractual life was 6 years. A summary of stock option activity and related information follows (options are in thousands): In addition to the above, 150,000 performance-based stock options expired in 1999. Pro forma net income and earnings per share have been prepared based on expensing (after tax) the estimated fair value of stock options granted during 1999, 1998 and 1997. The estimated fair value of the stock options was determined by using the Black-Scholes option-pricing model. The estimated fair values and the weighted-average assumptions used to estimate those values follow: 9. STOCKHOLDERS' EQUITY - continued STOCK OPTIONS - continued The Black-Scholes option-pricing model was not developed for use in valuing employee stock options. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, it requires the input of highly subjective assumptions including expectations of future dividends and stock price volatility. The assumptions are only used for making the required fair value estimate and should not be considered as indicators of future dividend policy or stock price appreciation. Because changes in the subjective input assumptions can materially affect the fair value estimate and because the employee stock options have characteristics significantly different from those of traded options, the use of the Black-Scholes option- pricing model may not provide a reliable single measure of the employee stock options' value. The pro forma information follows: SHAREHOLDER RIGHTS PLAN Under the shareholder rights plan each share of common stock has one right attached and the rights trade with the common stock. The rights are exercisable only if a person or group buys 15% or more of the Company's common stock, or announces a tender offer for 15% or more of the outstanding common stock. Each right will entitle a holder to buy one- hundredth of a share of the Company's Series A Junior Participating Preferred Stock at an exercise price of $300. If a person or group acquires 15% or more of the common stock of the Company, each right would permit its holder to buy common stock of the Company having a market value equal to two times the exercise price of the right. In addition, if at any time after the rights become exercisable, the Company is acquired in a merger, or if there is a sale or transfer of 50% or more of its assets or earning power, each right would permit its holder to buy common stock of the acquiring company having a market value equal to two times the exercise price of the right. The rights, which do not have voting privileges, expire in 2007. The Board of Directors may redeem the rights before expiration, under certain circumstances, for $0.01 per right. Until the rights become exercisable, they have no effect on earnings per share. These rights should not interfere with a business combination approved by the Board of Directors. However, they will cause substantial dilution to a person or group that attempts to acquire the Company without conditioning the offer on redemption of the rights or acquiring a substantial number of the rights. In connection with the merger agreement with Alcoa (see Note 2), the Company amended the shareholder rights plan to render the plan inapplicable to this transaction. 10. PENSIONS AND OTHER POSTRETIREMENT BENEFITS 10. PENSIONS AND OTHER POSTRETIREMENT BENEFITS - continued For measurement purposes, a 5.5% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2000. The rate was assumed to decrease gradually to 5.0% in 2002 and remain at that level thereafter. The assumed health care cost trend rate has a significant effect on the amounts reported. A one-percentage-point change in the assumed health care cost trend rate would have the following effects: 11. TAXES ON INCOME The significant components of the provision for income taxes were: The deferred tax provision includes domestic carryforward benefits of $11 million (1998 - $8 million, 1997 - $2 million). 11. TAXES ON INCOME - continued The effective income tax rate varied from the U.S. statutory rate as follows: Income taxed at other than the U.S. rate includes a 10% adverse effect in 1997 from basis differences on asset dispositions. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. At December 31, 1999, the Company had $822 million (1998 - $844 million) of deferred tax assets and $675 million (1998 - $694 million) of deferred tax liabilities that have been netted with respect to tax jurisdictions for presentation purposes. The significant components of these amounts were: The tax carryforward benefits can be carried forward indefinitely except for $68 million that will expire primarily between 2004 and 2014. A valuation reserve of $20 million relating to certain of these benefits has been recorded. Alternatives continue to be evaluated that may result in the ultimate realization of a portion of these reserved assets. Income taxes have not been provided on the undistributed earnings ($904 million) of foreign subsidiaries. The Company uses these earnings to finance foreign expansion, reduce foreign debt or support foreign operating requirements. The geographic components of income (loss) before income taxes, extraordinary loss and the cumulative effect of accounting change was as follows: 12. COMPANY OPERATIONS The Company is organized into four market-based, global business units. The global business units and their principal products are: . Base Materials - alumina, carbon products, primary aluminum ingot and billet, and electrical rod . Packaging and Consumer - aluminum and plastic packaging, foodservice and consumer products; printing products . Construction and Distribution - architectural construction products and the distribution of a wide variety of aluminum and stainless steel products . Transportation - aluminum wheels, heat exchangers and automotive structures The Restructuring category includes operations sold. (See Note 3 for a discussion of the Company's restructuring activities.) The Other category consists principally of European extrusion operations, investments in Canada, China, Latin America and Saudi Arabia and real estate. Part of the real estate, principally undeveloped land, is held for sale and is expected to be sold over the next few years. The carrying amount for these held-for-sale assets was $36 million at December 31, 1999. Expenses relating to holding these assets, principally real estate taxes, were approximately $1 million per year in each of the last three years. ACCOUNTING POLICIES Operating income for each global business unit is calculated as revenues plus equity income less cost of products sold, depreciation and the unit's selling, general and administrative expenses. The sales between units are made at market-related prices. Cost of products sold reflects current costs. Assets for each global business unit include: . receivables (including internal receivables from other units) . inventories (based on the FIFO method) . property, plant and equipment (excluding construction in progress) . investments in unincorporated joint ventures and associated companies . other assets directly associated with the unit's operations Current liabilities for each global business unit include: . trade payables . accrued compensation and related amounts . other current liabilities . internal liabilities from other units For the geographic presentation, revenues are attributed to specific countries based on the location of the operation generating the revenue. Long-lived assets consist of all noncurrent assets such as property, plant and equipment and investments in joint ventures and associated companies. 12. COMPANY OPERATIONS - continued Certain amounts for the years 1998 and 1997 have been reclassified to conform to the 1999 presentation. The principal reclassification was to move corporate amounts from the Other category to Reconciling Items. 12. COMPANY OPERATIONS - continued 12. COMPANY OPERATIONS - continued 12. COMPANY OPERATIONS - continued RECONCILING ITEMS Reconciling items consist of the following: The reconciling amounts for nonaluminum revenues, depreciation and amortization and capital investments relate to corporate activities. Inventory accounting adjustments include elimination of unrealized profits on sales between global business units and LIFO inventory adjustments. Construction in progress in 1999 includes $359 million (1998 - $150 million) related to the expansion of the Worsley Alumina Refinery joint venture in Australia. Research and development expenditures were $25 million in 1999 (1998 - $31 million, 1997 - $41 million). The majority of the Other Foreign category is comprised of European operations except that long-lived assets include $891 million in 1999 ($673 million in 1998 and $569 million in 1997) related to the Worsley Alumina Refinery joint venture located in Australia. 13. CONTINGENT LIABILITIES AND COMMITMENTS LEGAL Various suits, claims and actions are pending against the Company. In the opinion of management, after consultation with legal counsel, disposition of these suits, claims and actions, either individually or in the aggregate, are not expected to have a material adverse effect on the Company's competitive or financial position. No assurance can be given, however, that the disposition of one or more of such suits, claims or actions in a particular reporting period will not be material in relation to the reported results for such period. LEASES Certain items of property, plant and equipment are leased under long-term operating leases. Lease expense was $35 million in 1999 ($36 million in 1998 and $45 million in 1997). Lease commitments at December 31, 1999 were $57 million. Leases covering major items contain renewal and/or purchase options that may be exercised. ENVIRONMENTAL The Company is involved in various worldwide environmental improvement activities resulting from past operations, including designation as a potentially responsible party (PRP), with others, at various Environmental Protection Agency-designated Superfund sites. The Company has recorded estimated amounts (on an undiscounted basis), which are expected to be sufficient to satisfy anticipated costs of known remediation requirements including such costs relating to sold locations. An analysis of the accrual for environmental remediation costs follows: The balance of the accrual at December 31, 1999 is expected to be spent over the next 15 to 20 years with the majority to be spent by the year 2005. Estimated environmental remediation costs are developed after considering, among other things, the following: . currently available technological solutions . alternative cleanup methods . risk-based assessments of the contamination . estimated proportionate share of remediation costs (if applicable) The Company may also use external consultants and consider, when available, estimates by other PRPs and governmental agencies and information regarding the financial viability of other PRPs. Based on information currently available, the Company believes it is unlikely that it will incur substantial additional costs as a result of failure by other PRPs to satisfy their responsibilities for remediation costs. 13. CONTINGENT LIABILITIES AND COMMITMENTS - continued Estimated costs for future environmental compliance and remediation are necessarily imprecise because of factors such as: . continuing evolution of environmental laws and regulatory requirements . availability and application of technology . identification of presently unknown remediation requirements . cost allocations among PRPs Furthermore, it is not possible to predict the amount or timing of future costs of environmental remediation that may subsequently be determined. Based on information presently available, such future costs are not expected to have a material adverse effect on the Company's competitive or financial position. However, such costs could be material to results of operations in a future interim or annual reporting period. 14. CANADIAN REYNOLDS METALS COMPANY, LTD. AND REYNOLDS ALUMINUM COMPANY OF CANADA, LTD. Financial statements for Canadian Reynolds Metals Company, Ltd. and Reynolds Aluminum Company of Canada, Ltd. have been omitted because certain securities registered under the Securities Act of 1933, of which these wholly owned subsidiaries of Reynolds Metals Company (Reynolds) are obligors (thus subjecting them to reporting requirements under Section 13 or 15(d) of the Securities Exchange Act of 1934), are fully and unconditionally guaranteed by Reynolds. Financial information relating to these companies is presented herein in accordance with Staff Accounting Bulletin 53 as an addition to the notes to the consolidated financial statements of Reynolds Metals Company. Summarized financial information is as follows: 14. CANADIAN REYNOLDS METALS COMPANY, LTD. AND REYNOLDS ALUMINUM COMPANY OF CANADA, LTD. - continued Reynolds Aluminum Company of Canada, Ltd. - continued QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) (Millions, except per share amounts) REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS Stockholders and Board of Directors Reynolds Metals Company We have audited the accompanying consolidated balance sheets of Reynolds Metals Company as of December 31, 1999 and 1998, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Reynolds Metals Company at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for the costs of start-up activities in 1998. ERNST & YOUNG LLP Richmond, Virginia February 18, 2000 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information required by this item, see the information under the captions "Item 1. Election of Directors - Nominees" and "Certain Relationships" and "Stock Ownership Information - Section 16(a) Beneficial Ownership Reporting Compliance" in the Registrant's definitive proxy statement for its 2000 Annual Meeting of Stockholders. That information is incorporated in this report by reference. Information concerning executive officers of the Registrant is shown in Part I - Item 4A of this report. ITEM 11. EXECUTIVE COMPENSATION For information required by this item, see the information under the captions "Item 1. Election of Directors - Compensation of Directors" and "Executive Compensation" in the Registrant's definitive proxy statement for its 2000 Annual Meeting of Stockholders. That information (other than that appearing under the captions "Executive Compensation - Report of the Compensation Committee on Executive Compensation" and "Executive Compensation - Performance Graph") is incorporated in this report by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT For information required by this item, see the information under the caption "Stock Ownership Information - Holders of More Than 5%" and "Director and Executive Officer Stock Ownership" in the Registrant's definitive proxy statement for its 2000 Annual Meeting of Stockholders. That information is incorporated in this report by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information required by this item, see the information under the captions "Item 1. Election of Directors - Certain Relationships" and "Change in Control and Termination Arrangements" in the Registrant's definitive proxy statement for its 2000 Annual Meeting of Stockholders. That information is incorporated in this report by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The consolidated financial statements and exhibits listed below are filed as a part of this report. (1) Consolidated Financial Statements: Page ---- Consolidated statement of income - Years ended December 31, 1999, 1998 and 1997. 36 Consolidated balance sheet - December 31, 1999 and 1998. 37 Consolidated statement of cash flows - Years ended December 31, 1999, 1998 and 1997. 38 Consolidated statement of changes in stockholders' equity - Years ended December 31, 1999, 1998 and 1997. 39 Notes to consolidated financial statements. 40 Report of Ernst & Young LLP, Independent Auditors. 64 (2) Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts - Years Ended December 31, 1999, 1998 and 1997. 67 This report omits all other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission because they are not required, are inapplicable or the required information has otherwise been given. This report omits individual financial statements of Reynolds Metals Company because the restricted net assets (as defined in Accounting Series Release 302) of all subsidiaries included in the consolidated financial statements filed, in the aggregate, do not exceed 25% of the consolidated net assets shown in the consolidated balance sheet as of December 31, 1999. This report omits financial statements of all associated companies (20% to 50% owned) because no associated company is individually significant. Summarized financial information of all associated companies has been omitted because the associated companies in the aggregate are not significant. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (A) Allowance for deferred income taxes is charged to provision for taxes on income. (B) Deductions consist of the following: (C) Deductions were due to divestitures. (3) Exhibits * EXHIBIT 2 - Agreement and Plan of Merger among Alcoa Inc., RLM Acquisition Corp. and Reynolds Metals Company dated as of August 18, 1999. (File No. 001-01430, Form 8-K dated August 19, 1999, EXHIBIT 99.1) EXHIBIT 3.1 - Restated Certificate of Incorporation, as amended. * EXHIBIT 3.2 - By-laws, as amended. (File No. 001-01430, 1998 Form 10-K Report, EXHIBIT 3.2) EXHIBIT 4.1 - Restated Certificate of Incorporation. See EXHIBIT 3.1. * EXHIBIT 4.2 - By-laws. See EXHIBIT 3.2. * EXHIBIT 4.3 - Form of Common Stock Certificate. (Registration Statement No. 333-79203 on Form S-8, dated May 24, 1999, EXHIBIT 4.2) * EXHIBIT 4.4 - Indenture dated as of April 1, 1989 (the "Indenture") between Reynolds Metals Company and The Bank of New York, as Trustee, relating to Debt Securities. (File No. 001-01430, Form 10-Q Report for the Quarter ended March 31, 1989, EXHIBIT 4(c)) * EXHIBIT 4.5 - Amendment No. 1 dated as of November 1, 1991 to the Indenture. (File No. 001-01430, 1991 Form 10-K Report, EXHIBIT 4.4) * EXHIBIT 4.6 - Amended and Restated Rights Agreement dated as of March 8, 1999 (the "Rights Agreement") between Reynolds Metals Company and ChaseMellon Shareholder Services, L.L.C. (File No. 001-01430, Form 8-K Report dated March 8, 1999, EXHIBIT 4.1) * EXHIBIT 4.7 - First Amendment dated August 20, 1999 to the Rights Agreement. (File No. 001-01430, Form 8-A/A (Amendment No. 2 to Registration Statement on Form 8-A, pertaining to Preferred Stock Purchase Rights) dated August 19, 1999, EXHIBIT 1) * EXHIBIT 4.8 - Form of Fixed Rate Medium-Term Note. (Registration Statement No. 33-30882 on Form S-3, dated August 31, 1989, EXHIBIT 4.3) * EXHIBIT 4.9 - Form of Floating Rate Medium-Term Note. (Registration Statement No. 33-30882 on Form S-3, dated August 31, 1989, EXHIBIT 4.4) * EXHIBIT 4.10 - Form of Book-Entry Fixed Rate Medium-Term Note. (File No. 001-01430, 1991 Form 10-K Report, EXHIBIT 4.15) * EXHIBIT 4.11 - Form of Book-Entry Floating Rate Medium-Term Note. (File No. 001-01430, 1991 Form 10-K Report, EXHIBIT 4.16) * EXHIBIT 4.12 - Form of 9% Debenture due August 15, 2003. (File No. 001-01430, Form 8-K Report dated August 16, 1991, EXHIBIT 4(a)) _______________________ * Incorporated by reference. * EXHIBIT 4.13 - Articles of Continuance of Societe d'Aluminium Reynolds du Canada, Ltee/Reynolds Aluminum Company of Canada, Ltd. (formerly known as Canadian Reynolds Metals Company, Limited -- Societe Canadienne de Metaux Reynolds, Limitee) ("RACC"), as amended. (File No. 001-01430, 1995 Form 10-K Report, EXHIBIT 4.13) * EXHIBIT 4.14 - By-Laws of RACC, as amended. (File No. 001-01430, Form 10-Q Report for the Quarter ended March 31, 1997, EXHIBIT 4.14) * EXHIBIT 4.15 - Articles of Incorporation of Societe Canadienne de Metaux Reynolds, Ltee/Canadian Reynolds Metals Company, Ltd. ("CRM"), as amended. (File No. 001-01430, Form 10-Q Report for the Quarter ended September 30, 1997, EXHIBIT 4.15) * EXHIBIT 4.16 - By-Laws of CRM, as amended. (File No. 001-01430, Form 10-Q Report for the Quarter ended September 30, 1997, EXHIBIT 4.16) * EXHIBIT 4.17 - Indenture dated as of April 1, 1993 among RACC, Reynolds Metals Company and The Bank of New York, as Trustee. (File No. 001-01430, Form 8-K Report dated July 14, 1993, EXHIBIT 4(a)) * EXHIBIT 4.18 - First Supplemental Indenture, dated as of December 18, 1995 among RACC, Reynolds Metals Company, CRM and The Bank of New York, as Trustee. (File No. 001- 01430, 1995 Form 10-K Report, EXHIBIT 4.18) * EXHIBIT 4.19 - Form of 6-5/8% Guaranteed Amortizing Note due July 15, 2002. (File No. 001-01430, Form 8-K Report dated July 14, 1993, EXHIBIT 4(d)) EXHIBIT 9 - None. =* EXHIBIT 10.1 - Reynolds Metals Company 1987 Nonqualified Stock Option Plan. (Registration Statement No. 33-13822 on Form S-8, dated April 28, 1987, EXHIBIT 28.1) =* EXHIBIT 10.2 - Reynolds Metals Company 1992 Nonqualified Stock Option Plan. (Registration Statement No. 33-44400 on Form S-8, dated December 9, 1991, EXHIBIT 28.1) =* EXHIBIT 10.3 - Amendment and Restatement of Reynolds Metals Company Performance Incentive Plan, as adopted and executed May 21, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.3) =* EXHIBIT 10.4 - Amendment and Restatement of Supplemental Death Benefit Plan for Officers, as adopted and executed April 26, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.5) _______________________ * Incorporated by reference. = Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K. =* EXHIBIT 10.5 - Financial Counseling Assistance Plan for Officers. (File No. 001-01430, 1987 Form 10-K Report, EXHIBIT 10.11) =* EXHIBIT 10.6 - Management Incentive Deferral Plan. (File No. 001-01430, 1987 Form 10-K Report, EXHIBIT 10.12) =* EXHIBIT 10.7 - Amendment and Restatement of Deferred Compensation Plan for Outside Directors, as adopted and executed April 28, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.8) =* EXHIBIT 10.8 - Form of Indemnification Agreement for Directors and Officers. (File No. 001-01430, 1998 Form 10-K Report, EXHIBIT 10.9) =* EXHIBIT 10.9 - Form of Executive Severance Agreement, as amended, between Reynolds Metals Company and key executive personnel, including each of the individuals listed in Item 4A of this report. (File No. 001-01430, Form 10-Q Report for the Quarter ended September 30, 1999, EXHIBIT 10.9) =* EXHIBIT 10.10 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective May 20, 1988. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1988, EXHIBIT 19(a)) =* EXHIBIT 10.11 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective October 21, 1988. (File No. 001-01430, Form 10-Q Report for the Quarter ended September 30, 1988, EXHIBIT 19(a)) =* EXHIBIT 10.12 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective January 1, 1987. (File No. 001-01430, 1988 Form 10-K Report, EXHIBIT 10.22) =* EXHIBIT 10.13 - Form of Stock Option and Stock Appreciation Right Agreement, as approved February 16, 1990 by the Compensation Committee of the Company's Board of Directors. (File No. 001-01430, 1989 Form 10-K Report, EXHIBIT 10.24) =* EXHIBIT 10.14 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective January 18, 1991. (File No. 001-01430, 1990 Form 10-K Report, EXHIBIT 10.26) =* EXHIBIT 10.15 - Form of Stock Option Agreement, as approved April 22, 1992 by the Compensation Committee of the Company's Board of Directors. (File No. 001-01430, Form 10-Q Report for the Quarter ended March 31, 1992, EXHIBIT 28(a)) =* EXHIBIT 10.16 - Amendment and Restatement of Reynolds Metals Company Restricted Stock Plan for Outside Directors, as adopted and executed April 28, 1999 (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.17) _______________________ * Incorporated by reference. = Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K. =* EXHIBIT 10.17 - Amendment and Restatement of Reynolds Metals Company New Management Incentive Deferral Plan, as adopted and executed April 28, 1999 (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.18) =* EXHIBIT 10.18 - Amendment and Restatement of Reynolds Metals Company Salary Deferral Plan for Executives, as adopted and executed April 28, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.19) =* EXHIBIT 10.19 - Amendment and Restatement of Reynolds Metals Company Supplemental Long-Term Disability Plan for Executives, as adopted and executed April 26, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.20) =* EXHIBIT 10.20 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective August 19, 1994. (File No. 001-01430, Form 10-Q Report for the Quarter ended September 30, 1994, EXHIBIT 10.34) =* EXHIBIT 10.21 - Amendment to Reynolds Metals Company 1992 Nonqualified Stock Option Plan effective August 19, 1994. (File No. 001-01430, Form 10-Q Report for the Quarter ended September 30, 1994, EXHIBIT 10.35) =* EXHIBIT 10.22 - Form of Split Dollar Life Insurance Agreement (Trustee Owner, Trustee Pays Premiums). (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1995, EXHIBIT 10.34) =* EXHIBIT 10.23 - Form of Split Dollar Life Insurance Agreement (Trustee Owner, Employee Pays Premium). (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1995, EXHIBIT 10.35) =* EXHIBIT 10.24 - Form of Split Dollar Life Insurance Agreement (Employee Owner, Employee Pays Premium). (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1995, EXHIBIT 10.36) =* EXHIBIT 10.25 - Form of Split Dollar Life Insurance Agreement (Third Party Owner, Third Party Pays Premiums). (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1995, EXHIBIT 10.37) =* EXHIBIT 10.26 - Form of Split Dollar Life Insurance Agreement (Third Party Owner, Employee Pays Premiums). (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1995, EXHIBIT 10.38) =* EXHIBIT 10.27 - Amendment and Restatement of Reynolds Metals Company 1996 Nonqualified Stock Option Plan, as adopted and executed April 15, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.28) =* EXHIBIT 10.28 - Amendment to Reynolds Metals Company 1992 Nonqualified Stock Option Plan effective January 1, 1993. (Registration Statement No. 333-03947 on Form S-8, dated May 17, 1996, EXHIBIT 99) - ------------------ * Incorporated by reference. = Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K. =* EXHIBIT 10.29 - Form of Stock Option Agreement, as approved May 17, 1996 by the Compensation Committee of the Company's Board of Directors. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1996, EXHIBIT 10.41) =* EXHIBIT 10.30 - Form of Three Party Stock Option Agreement, as approved May 17, 1996 by the Compensation Committee of the Company's Board of Directors. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1996, EXHIBIT 10.42) =* EXHIBIT 10.31 - Reynolds Metals Company Supplemental Incentive Plan. (File No. 001-01430, 1996 Form 10-K Report, EXHIBIT 10.40) =* EXHIBIT 10.32 - Amendment and Restatement of Reynolds Metals Company Stock Plan for Outside Directors, as adopted and executed April 28, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.34) =* EXHIBIT 10.33 - Amendment and Restatement of Reynolds Metals Company Long-Term Performance Share Plan, as adopted and executed April 26, 1999. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.37) * EXHIBIT 10.34 - Asset Purchase Agreement by and among Ball Corporation, Ball Metal Beverage Container Corp. and Reynolds Metals Company dated as of April 22, 1998. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1998, EXHIBIT 2) =* EXHIBIT 10.35 - Reynolds Metals Company 1999 Nonqualified Stock Option Plan (Registration Statement No. 333-79203 on Form S-8, dated May 24, 1999, EXHIBIT 4.5) =* EXHIBIT 10.36 - Form of Stock Option Agreement, as approved May 21, 1999 by the Compensation Committee of the Company's Board of Directors. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.40) =* EXHIBIT 10.37 - Form of Three Party Stock Option Agreement, as approved May 21, 1999 by the Compensation Committee of the Company's Board of Directors. (File No. 001-01430, Form 10-Q Report for the Quarter ended June 30, 1999, EXHIBIT 10.41) EXHIBIT 11 - Omitted; see Item 8

820757_1999.txt

820757_1999

1999

820757

ITEM 1. BUSINESS. As of December 27, 1999, Chart House Enterprises, Inc. and its subsidiaries (the "Company") operated 51 restaurants, consisting of 49 Chart House restaurants, one Peohe's restaurant, and one Angelo and Maxie's steakhouse. The Company was incorporated in Delaware on July 25, 1985. In May, 1996, the Company sold its Islands restaurant operations and in October, 1998, the Company sold Solana Beach Baking Company, a wholesale bakery operated by the Company. The Angelo and Maxie's steakhouse concept was acquired in April, 1999. CONCEPTS/OPERATIONS Chart House operations commenced in 1961 with the opening of the first Chart House in Aspen, Colorado by a predecessor of the Company. Chart House restaurants are full-service, casual seafood dinner houses with a menu featuring fresh fish and seafood, as well as steaks, chicken and prime rib. Many of the Chart House restaurants feature an elaborate salad bar where the customer prepares his or her own salad and some Chart Houses have a seafood bar which offers various appetizers. The Company opened its Peohe's restaurant in January, 1988 in Coronado, California overlooking San Diego Bay and the San Diego city skyline. Although similar to the Company's Chart House restaurants in many respects, Peohe's opened under a different name in part to minimize confusion and competition with other nearby Chart House restaurants and also to provide Chart House management a suitable vehicle for experimentation and development of different menu items, restaurant design and operating concepts. Peohe's has a more extensive and higher priced menu, higher level of service and greater variety of cooking techniques than the typical Chart House restaurant. In April, 1999 the Company acquired the Angelo and Maxie's steakhouse in New York, New York. Unlike typical steakhouses, Angelo and Maxie's offers diners great steak, but serves up oversized portions at reasonable prices, all in a unique setting that's sophisticated, yet energetic, and fun. Angelo and Maxie's is a smoke-friendly establishment, and sells a revolving selection of premium cigars at the restaurant. The acquisition creates infinite expansion opportunities for the Company. The Company places great emphasis upon the location, exterior and interior design of each restaurant. Each restaurant is unique and designed to fit within and complement its surroundings. A significant remodeling program commenced in 1998. By the end of 1999, the Company had spent approximately $10 million renovating about half of the Company's restaurants. These remodels serve two purposes. First, the Company is investing in the structure of each building to maximize its longevity and ensure long term existence of the restaurant. Secondly, the image and concept are best reflected in the updated decor chosen for each location. Representative exteriors of Chart House restaurants range from the restored 1887 Victorian boathouse on Coronado Island in San Diego Bay, which will undergo renovations in 2000, to the modern three-tiered glass restaurant in Philadelphia overlooking the Delaware River, which was remodeled in 1999. With a few exceptions, the restaurants are freestanding buildings. In 1999, the annual revenue for each restaurant currently in operation for the whole of 1999 ranged from $1.5 million to $6.1 million, with an average annual sales per Chart House restaurant of $2.7 million. The average dinner check was approximately $36 per person. Angelo and Maxie's contributed $6.4 million in revenues since it's acquisition in April, 1999. The average dinner check was approximately $40 per person. Historically, the Company's business is seasonal in nature with revenues and net income for the first, second, and third quarters greater than in the fourth quarter. The operating hours are typically 5:00 p.m. to 11:00 p.m. A few selected restaurants are open for lunch and/or brunch. Alcoholic beverages are available at all locations. The sale of alcoholic beverages accounted for approximately 22% of the revenues generated during each of the past three years. OPERATIONS Each restaurant is managed by one general manager and between two and seven assistant managers, depending on the operating characteristics and size of the restaurant. On average, general managers possess approximately six years experience with the Company. Each general manager is required to comply with an extensive operations manual which contains procedures to ensure uniform operations, consistently high quality products and service, and proper accounting for restaurant operations. The general manager and his or her assistants are responsible for training restaurant employees under a training program managed by the Company's Director of Training. Assistant managers generally are required to participate in a comprehensive management development program that emphasizes the Company's operating strategies, procedures, and standards. The aim of this program is to provide each manager with the tools needed to thrive in progressive management assignments. The success of each concept relies on the continued involvement of regional Directors of Operations, regional Vice Presidents of Operations, and the President and Chief Executive Officer of the Company. There are currently six regional Directors of Operations, each of whom is responsible for five to eight restaurants in a given area. The regional Directors of Operations report to one of two regional Vice Presidents of Operations, who report directly to the President and Chief Executive Officer of the Company. Recently, the Company has hired a Vice President of Operations for the Angelo and Maxie's concept. As the number of Angelo and Maxie's restaurants grows, we anticipate employing a similar management structure for the concept. The involvement of operations management ranges from attracting quality management teams for the restaurants to routine visits to each location enforcing strict adherence to Company strategies, policies and standards of quality. EXPANSION STRATEGY The Company's long term strategies include expanding both the Chart House concept and the Angelo and Maxie's concept. This plan includes opening at least five Angelo and Maxie's and at least two Chart Houses in 2000, with comparable openings in the subsequent two to three years. The development will be concentrated in markets with attractive demographics which will support the Chart House concept and the Angelo and Maxie's concept. When identifying and developing restaurant sites, particular emphasis is placed on a potential site's physical location. Trade area demographics, traffic volume, visibility, and accessibility are all key performance indicators analyzed by management. Sales and profit projections are then prepared to determine whether the economics of investment are sound. The Company accords great importance to the selection of and coordination with the architect to ensure that the proposed restaurant structure fits the Company image. Executive management is involved extensively in each facet of the site selection process. The rate at which the Company can successfully achieve these expansion objectives is dependent upon the success of locating acceptable sites, negotiating acceptable lease or purchase terms, obtaining requisite governmental permits and approvals, supervising location construction, and recruitment and training of personnel. PROCUREMENT OF FOOD AND SUPPLIES The Company's ability to maintain consistent quality throughout its system depends in part upon its ability to acquire food products and related items from reliable sources in accordance with Company specifications. Suppliers are pre-approved by the Company and are required to adhere to strict product specifications to ensure that high quality food and beverage products are served in the restaurants. The Company negotiates directly with the major suppliers to obtain competitive prices and uses purchase agreements to stabilize the potentially volatile pricing associated with certain commodities. Management believes that adequate alternative sources of quality food and supplies are readily available. EMPLOYEES AND LABOR RELATIONS The Company employs approximately 3,400 persons, of whom approximately 60 are corporate personnel. Approximately 220 are restaurant management personnel and the remainder represent hourly restaurant personnel. None of the Company's employees are covered by a collective bargaining agreement. The Company has never experienced a work stoppage and considers its labor relations to be good. COMPETITION In general, the restaurant business is highly competitive and can be affected by competition created by similar restaurants in a geographic area, changes in the public's eating habits and preferences, and local and national economic conditions affecting consumer spending habits, population trends and traffic patterns. Key competitive factors in the industry are the quality and value of the food products offered, quality of service, cleanliness, name identification, restaurant locations, price and attractiveness of facilities. The Company's strategy is to differentiate itself from its competitors by continually upgrading its menu, updating the appearance of each restaurant through remodeling activities, and efficient and friendly service in a unique setting. MARKETING The Company has developed a coordinated marketing communications program. Efforts are concentrated on various local activities, print media, promotional campaigns and support for "ViewPoints", the Company's frequent diner rewards program. The Company recently hired a Vice President of Marketing to expand the marketing and promotion ventures. GOVERNMENT REGULATION Each of the Company's restaurants is subject to various federal, state and local laws, regulations and administrative practices affecting its business and must comply with provisions regulating, among other things, health and sanitation standards, equal employment, public accommodations for disabled patrons, minimum wages, worker safety and compensation and licensing for the sale of food and alcoholic beverages. Difficulties or failures in obtaining or maintaining required liquor licenses, or other required licenses, permits, or approvals, could delay or prevent the opening of new restaurants or adversely affect the operations of existing restaurants. Federal and state environmental regulations have not had a material effect on the Company's operations but more stringent and varied requirements of local governmental bodies with respect to zoning, land use and environmental factors could delay construction of new restaurants and add to their construction cost. The Company is also subject to the Fair Labor Standards Act, which governs such matters as minimum wages, overtime and other working conditions. A significant number of the Company's food service personnel are paid at rates related to federal and state minimum wage requirements and, accordingly, increases in the minimum wage or decreases in the allowable tip credit will increase the Company's labor cost. There can be no assurance that future legislation covering, among other matters, mandated health insurance, will not be enacted and subsequently have a significant effect on the Company. The Company believes it is operating in substantial compliance with applicable laws, regulations and administrative practices governing its operations. TRADEMARKS The original "Chart House" logo and trademark were registered with the United States Patent and Trademark Office (the "USPTO") in 1972 and 1977, respectively. The new corporate "Chart House" logo and trademark were registered with the USPTO in August 1997. The "Peohe's" logo and trademark were registered with the USPTO in 1988. Applications to register new trademarks in connection with "ViewPoints", the Company's new frequent dining program, "Angelo and Maxie's Steakhouse", and various marketing slogans are currently pending with the USPTO. The "Chart House" trademark and logo is licensed by the Company to the operator of one Chart House restaurant located in Honolulu, Hawaii. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information about the Executive Officers of the Company. All positions are with Chart House Enterprises, Inc. Executive Officers of the Company are appointed annually by the Board of Directors and serve at the Board's discretion. Thomas J. Walters was promoted to Chief Executive Officer in November 1998. He joined the Company as President and Chief Operating Officer and became a member of the Board of Directors in February 1998. From March 1995 until February 1998, Mr. Walters was President of Morton's of Chicago. He also previously held the positions at Morton's of Vice President of Operations and Regional Manager from March 1993 to March 1995. Prior to Mr. Walters' association with Morton's, he was Director of Food and Beverage with the Ritz- Carlton Hotel Corporation for six years. He has also held positions as Director of Food and Beverage for the La Costa Resort & Spa, and Director of Catering and Banquet for the Hyatt Hotels Corporation. William M. Sullivan was promoted to Executive Vice President and Chief Financial Officer in June 1999. He joined the Company as Vice President-- Finance and Controller in March 1998. From June 1995 until March 1998, Mr. Sullivan was the Chief Financial Officer for the mid-west area development group for Boston Chicken, Inc. Prior to June 1995, he held various financial positions with Boston Chicken, Inc. and McDonald's Corporation. Mr. Sullivan is a CPA. ITEM 2. ITEM 2. PROPERTIES. A majority of the restaurant properties used by the Company are subject to a lease agreement. The following table sets forth the number of restaurants owned, leased and operated pursuant to ground leases and the average remaining lease term (including renewal options) in years as of December 27, 1999. Restaurant sizes range from 4,600 to 15,800 square feet with an average of 8,350 square feet. Seating capacities range from 112 to 434 with an average of 267. The amount of rent paid to lessors and the methods of computing rent vary considerably from lease to lease. All of the Company's restaurant property leases provide for a minimum annual rent, and most leases require payment of additional rent based on sales volume at the particular location over specified minimum levels. All of the Company's assets, which includes properties held in fee, are pledged as collateral under the Revolving Credit and Term Loan Agreement, filed herewith. The Company's principal executive offices occupy approximately 13,200 square feet of leased office space in a building located in Chicago, Illinois. This lease expires in June, 2003. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company periodically is a defendant in cases incidental to its business activities. While any litigation or investigation has an element of uncertainty, the Company believes that the outcome of any of these matters will not have a materially adverse effect on its financial condition or operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information appearing under the caption "Common Stock Information" on page 29 of the Company's Annual Report to Stockholders for the year ended December 27, 1999 (the "Annual Report") is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The selected financial data for the Company and its subsidiaries on page 13 of the Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Financial Condition and Results of Operations appears on pages 8 through 12 of the Annual Report and is incorporated herein by reference. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company is exposed to market risk from changes in interest rates on debt and changes in commodity prices. The Company's net exposure to interest rate risk consists of its Revolving Credit and Term Loan Agreement that is benchmarked to the prime rate and the LIBOR rate, respectively. The impact on the Company's results of operations of a one-point interest rate change on the outstanding debt balance as of December 27, 1999 would be approximately $177,000 in incremental interest expense. The Company does not use derivative instruments to manage borrowing costs or reduce exposure to adverse fluctuations in the interest rate. The Company does not use derivative instruments for trading purposes. The Company purchases certain commodities such as beef, seafood, chicken, and cooking oil. These commodities are generally purchased based upon purchase agreements established with vendors. These purchase agreements may contain contractual features that fix the commodity price or define the price from an agreed upon formula. The Company does not use financial instruments to hedge commodity prices because these purchase arrangements help control the ultimate cost paid and any commodity price fluctuations are generally short term in nature. These disclosures contain forward-looking statements. Actual results may differ based upon general market conditions. ITEM 8. ITEM 8. FINANCIAL STATEMENTS. The consolidated financial statements of the Company and its subsidiaries appear on pages 14 through 16 of the Annual Report and are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Directors. The information appearing under the caption "Election of Directors" on pages 2-6 of the Company's Proxy Statement for its Annual Meeting of Stockholders to be held on May 15, 2000 (the "Proxy Statement") is incorporated herein by reference. Executive Officers. The information appearing under the caption "Executive Officers of the Company" included on page 5 in Item 1 of this Annual Report on Form 10-K is incorporated herein by reference. Compliance with Section 16(a) of the Exchange Act. The information appearing under the caption "Security Ownership of Management" on pages 12 and 13 of the Proxy Statement is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information appearing under the caption "Executive Compensation" commencing on page 6 of the Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing under the captions "Security Ownership of Certain Beneficial Owners" on pages 10-12 and "Security Ownership of Management" on pages 12 and 13 of the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing under the caption "Certain Relationships and Related Transactions" on page 10 of the Proxy Statement is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) Financial Statements: Included in Part II of this report are the following financial statements incorporated herein by reference to the following pages of the Annual Report. (2) Financial Statement Schedules: All schedules have been omitted since the information required to be submitted has been included in the consolidated financial statements or notes thereto or have been omitted as not applicable or not required. (3) Exhibits: - -------- (1) Filed as an exhibit to the Company's Registration Statement on Form S-1 dated August 27, 1987 or amendments thereto dated October 6, 1987 and October 14, 1987 (Registration No. 33-16795). (2) Filed as an exhibit to the Company's Registration Statement on Form S-1 dated July 20, 1989 or amendment thereto dated August 25, 1989 (Registration No. 33-30089). (3) Filed as an exhibit to Form 10-K for the fiscal year ended December 31, 1989. (4) Filed as an exhibit to Form 10-K for the fiscal year ended December 31, 1991. (5) Filed as an exhibit to Form 10-Q for the quarterly period ended April 1, 1996. (6) Filed as an exhibit to Form 10-Q for the quarterly period ended March 31, 1997. (7) Filed as Exhibit 2.1 to Amendment No. 4 to a Schedule 13D of Chart House Investors, LLC dated as of October 7, 1997. (8) Filed as an exhibit to Form 10-K for the fiscal year ended December 30, 1996. (9) Filed as an exhibit to Form 10-K for the fiscal year ended December 29, 1997. (10) Filed as an exhibit to Form S-8 dated December 14, 1998. (11) Filed as an exhibit to Form 10-K for the fiscal year ended December 28, 1998. (b) Reports on Form 8-K. A report on Form 8-K/A was filed by the Company on July 6, 1999. Item 7 was reported describing financial statements and pro forma financial information filed subsequent to the Angelo and Maxie's business combination. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Chart House Enterprises, Inc. Date: March 24, 2000 /s/ Thomas J. Walters By: _________________________________ Thomas J. Walters President and Chief Executive Officer; Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the dates indicated.

1099524_1999.txt

1099524_1999

1999

1099524

ITEM 1. Business. The trust fund (the "Trust") created pursuant to a Pooling and Servicing Agreement dated as of September 1, 1999 (the "Pooling and Servicing Agreement") among Bear Stearns Asset Backed Securities, Inc., a Delaware corporation, as depositor (the "Depositor"), EMC Mortgage Corporation, a Delaware corporation, as seller (in such capacity, the "seller") and as master servicer (in such capacity, the "Master Servicer"), and Bankers Trust Company of California, N.A., a national banking association, as trustee, (the "Trustee"). The Certificates will be issued pursuant to the Pooling and Servicing Agreement. The Bear Stearns Asset Backed Securities, Inc. Asset-Backed Certificates, Series 1999-2 (the "Certificates") will consist of: (a) the following fixed rate certificates (the "Fixed Rate Certificates"): Class AF-1 and Class AF-2 Certificates (collectively, the "Class A Fixed Rate Certificates"), Class MF-1 Certificates (the "Class MF-1 Certificates"), Class MF-2 Certificates (the "Class MF-2 Certificates" and together with the Class MF-1 Certificates, the "Mezzanine Fixed Rate Certificates"), Class BF Certificates (the "Class BF Certificates" and together with the Mezzanine Fixed Rate Certificates, the "Subordinated Offered Fixed Rate Certificates"); Class BF-IO Certificates (the "Class BF-IO Certificates"); and Class PF Certificates (the "Class PF Certificates"); (b) the following adjustable rate certificates (the "Adjustable Rate Certificates"): Class AV-1 and Class AV-2 Certificates (collectively, the "Class A Adjustable Rate Certificates" and, together with the Class A Fixed Rate Certificates, the "Class A Certificates"), Class MV-1 Certificates (the "Class MV-1 Certificates" and together with the Class MF-1 Certificates, the "Class M-1 Certificates"), Class MV-2 Certificates (the "Class MV-2 Certificates" and together with the Class MV-1 Certificates, the Mezzanine Adjustable Rate Certificates", the Class MV-2 Certificates together with the Class MF-2 Certificates, the "Class M-2 Certificates"); Class BV Certificates (the Class BV Certificates" and together with the Mezzanine Adjustable Rate Certificates, the "Subordinated Offered Adjustable Rate Certificates;" and together with the Class BF Certificates, the "Class B Certificates"); Class BV-IO Certificates (the "Class BV-IO Certificates" and together with the Class BF-IO Certificates, the "Class B-IO Certificates"); and Class PV Certificates (the "Class PV Certificates" and collectively with the Class PF Certificates, the "Class P Certificates"); and (c) Class R Certificates (the "Residual Certificates"). The Mezzanine Fixed Rate Certificates and the Mezzanine Adjustable Rate Certificates are referred to collectively as the "Mezzanine Certificates." The Subordinated Offered Fixed Rate Certificates and the Subordinated Offered Adjustable Rate Certificates are referred to collectively as the "Subordinate Offered Certificates." Information with respect to the business of the Trust would not be meaningful because the only "business" of the Trust is the collection on the Mortgage Loans and distribution of payments on the Certificates to Certificateholders. This information is accurately summarized in the Monthly Reports to Certificateholders, which are filed on Form 8-K. There is no additional relevant information to report in response to Item 101 of Regulation S-K. ITEM 2. ITEM 2. Properties. The Depositor owns no property. The Bear Stearns Asset Backed Securities, Inc. Asset-Backed Certificates, Series 1999-2, in the aggregate, represent the beneficial ownership in a Trust consisting primarily of the Mortgage Loans. The Trust will acquire title to real estate only upon default of the mortgagors under the Mortgage Loan. Therefore, this item is inapplicable. ITEM 3. ITEM 3. Legal Proceedings. None. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of Certificateholders during the fiscal year covered by this report. PART II ITEM 5. ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Bear Stearns Asset Backed Securities, Inc. Asset-Backed Certificates, Series 1999-2 represents, in the aggregate, the beneficial ownership in a trust fund consisting primarily of the Mortgage Certificates. The Certificates are owned by Certificateholders as trust beneficiaries. Strictly speaking, the Registrant has no "common equity," but for purposes of this Item only, the Registrant's Asset Backed Securities, Inc. Asset-Backed Certificates, Series 1999-2 are treated as "common equity." (a) Market Information. There is no established public trading market for Registrant's Certificates. Registrant believes the Certificates are traded primarily in intra-dealer markets and non-centralized inter-dealer markets. (b) Holders. The number of registered holders of all classes of Certificates on December 31, 1999 was: 10. (c) Dividends. Not applicable. The information regarding dividends required by sub-paragraph (c) of Item 201 of Regulation S-K is inapplicable because the Trust does not pay dividends. However, information as to distribution to Certificateholders is provided in the Monthly Reports to Certificateholders for each month of the fiscal year in which a distribution to Certificateholders was made. ITEM 6. ITEM 6. Selected Financial Data. Not Applicable. Because of the limited activities of the Trust, the Selected Financial Data required by Item 301 of Regulation S-K does not add relevant information to that provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Not Applicable. The information required by Item 303 of Regulation S-K is inapplicable because the Trust does not have management per se, but rather the Trust has a Trustee who causes the preparation of the Monthly Reports to Certificateholders. The information provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K, do not provide the relevant financial information regarding the financial status of the Trust. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. Monthly Remittance Statement to the Certificateholders dated as of October 25, 1999. Monthly Remittance Statement to the Certificateholders dated as of November 25, 1999. Monthly Remittance Statement to the Certificateholders dated as of December 27, 1999. Annual Statement of Compliance by the Master Servicer will be subsequently filed on Form 10-K/A after August 31, 2000. Independent Accountant's Report on Servicer's will be subsequently filed on Form 10-K/A after August 31, 2000. ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III ITEM 10. ITEM 10. Directors and Executive Officers of Registrant. Not Applicable. The Trust does not have officers or directors. Therefore, the information required by items 401 and 405 of Regulation S-K are inapplicable. ITEM 11. ITEM 11. Executive Compensation. Not Applicable. The Trust does not have officers or directors to whom compensation needs to be paid. Therefore, the information required by item 402 of regulation S-K is inapplicable. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. (a) Security ownership of certain beneficial owners. Under the Pooling and Servicing Agreement governing the Trust, the holders of the Certificates generally do not have the right to vote and are prohibited from taking part in management of the Trust. For purposes of this Item and Item 13 ITEM 13. Certain Relationships and Related Transactions. (a) Transactions with management and others. Registrant knows of no transaction or series of transactions during the fiscal year ended December 31, 1999, or any currently proposed transaction or series of transactions, in an amount exceeding $60,000 involving the Registrant in which the Certificateholders identified in Item 12(a) had or will have a direct or indirect material interest. There are no persons of the types described in Item 404(a)(1),(2) and (4) of Regulation S-K, however, the information required by Item 404(a)(3) of Regulation S-K is hereby incorporated by reference in Item 12 herein. (b) Certain business relationships. None. (c) Indebtedness of management. Not Applicable. The Trust does not have management consisting of any officers or directors. Therefore, the information required by item 404 of Regulation S-K is inapplicable. (d) Transactions with promoters. Not Applicable. The Trust does not use promoters. Therefore, the information required by item 404 of Regulation S-K is inapplicable. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following is a list of documents filed as part of this report: EXHIBITS Monthly Remittance Statement to the Certificateholders dated as of October 25, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. Monthly Remittance Statement to the Certificateholders dated as of November 25, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. Monthly Remittance Statement to the Certificateholders dated as of December 27, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. Annual Statement of Compliance by the Master Servicer will be subsequently filed on Form 10-K/A after August 31, 2000. Independent Accountant's Report on Servicer's will be subsequently filed on Form 10-K/A after August 31, 2000. (b) The following Reports on Form 8-K were filed during the last quarter of the period covered by this Report: Monthly Remittance Statement to the Certificateholders dated as of October 25, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. Monthly Remittance Statement to the Certificateholders dated as of November 25, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. Monthly Remittance Statement to the Certificateholders dated as of December 27, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. (c) The exhibits required to be filed by Registrant pursuant to Item 601 of Regulation S-K are listed above and in the Exhibit Index that immediately follows the signature page hereof. (d) Not Applicable. The Trust does not have any subsidiaries or affiliates. Therefore, no financial statements are filed with respect to subsidiaries or affiliates. Supplemental information to be furnished with reports filed pursuant to Section 15(d) by registrants which have not registered securities pursuant to Section 12 of the Act. No annual report, proxy statement, form of proxy or other soliciting material has been sent to Certificateholders, and the Registrant does not contemplate sending any such materials subsequent to the filing of this report. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: Bankers Trust Company of California, N.A. not in its individual capacity but solely as a duly authorized agent of the Registrant pursuant to the Pooling and Servicing Agreement, dated as of September 1, 1999. By: /s/Judy L. Gomez Judy L. Gomez Assistant Vice President Date: March 31, 2000 EXHIBIT INDEX Exhibit Document 1.1 Monthly Remittance Statement to the Certificateholders dated as of October 25, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. 1.2 Monthly Remittance Statement to the Certificateholders dated as of November 25, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. 1.3 Monthly Remittance Statement to the Certificateholders dated as of December 27, 1999, and filed with the Securities and Exchange Commission on Form 8-K on January 19, 2000. 1.4 The Pooling and Servicing Agreement of the Registrant dated as of September 1, 1999 (hereby incorporated herein by reference and filed as part of the Registrant's Current Report on Form 8-K as Exhibit 4.1, and filed with the Securities and Exchange Commission on October 27, 1999.

1037900_1999.txt

1037900_1999

1999

1037900

ITEM 1. BUSINESS THE COMPANY The Company is an operator of television stations located in middle to small markets, ranging generally from the 50th to the 150th largest DMAs in the United States. Since the Company's formation in March 1997, it has undergone rapid and significant growth. This growth has resulted primarily from a series of carefully selected acquisitions and dispositions of network-affiliated television stations and the implementation of the Company's business strategies. Since January 1998, the Company has grown from five stations to 13 stations, including satellite stations. History The Company was organized by its current management and Hicks Muse in 1997 with the goal of becoming a leading owner and operator of network-affiliated television stations, serving select middle-to-small markets (i.e., those DMAs ranked from approximately 50 to 150 by Nielsen). The following chart sets forth certain information regarding the Company's currently owned and operated broadcast stations (collectively, the Stations): The Company acquired WEYI, WTOV, WROC and KSBW (together, the Jupiter/Smith Stations) from Jupiter/Smith TV Holdings, L.P. (Jupiter/Smith) and Smith Broadcasting Partners, L.P. (SBP) for approximately $163.2 million. SBP is a partnership between Smith Broadcasting Group, Inc. (SBG), Sandy DiPasquale, John Purcell, and David Fitz. The majority owner of SBG is Robert Smith. These four individuals operated the Jupiter/Smith Stations from January 1996 until the sale to the Company on March 1, 1997. All four individuals continue as senior management of the Company. The Company acquired all of the outstanding stock of WJAC, Incorporated on October 1, 1997 for approximately $36.1 million including working capital of $1.4 million. WJAC, Incorporated owned and operated WJAC, the NBC affiliate for Johnstown, Pennsylvania. On April 1, 1998, the Company acquired 100% of the outstanding stock of Abilene Radio and Television Company (ARTC) for approximately $8.2 million. ARTC operated television stations KRBC and KACB, NBC affiliates for Abilene and San Angelo, Texas. In a series of transactions, the Company acquired certain assets from Hearst-Argyle Stations, Inc., (Hearst) through transactions structured as an exchange of assets (the Hearst Transaction). On February 3, 1998, the Company acquired WPTZ, WNNE, and a local marketing agreement (LMA) for WFFF from Sinclair Broadcast Group, Inc. for $72.0 million, with the intention of using these assets in the Hearst Transaction. WPTZ and WNNE are the NBC affiliates and WFFF is the FOX affiliate serving the Burlington, Vermont, and Plattsburgh, New York television market. On February 18, 1998, the Company agreed with Hearst to trade KSBW, the NBC affiliate for Salinas, California, WPTZ, and WNNE for WDTN, the ABC affiliate in Dayton, Ohio, WNAC, the FOX affiliate in Providence, Rhode Island, WNAC's interest in a Joint Marketing Programming Agreement with WPRI, the CBS affiliate in Providence, Rhode Island, and approximately $22.0 million in cash. On April 24, 1998, the Company completed a purchase of the non-license assets (all operating assets other than FCC licenses and other minor equipment) of WPTZ, WNNE, and WFFF for $70.0 million. WFFF was sold by the Company to a related party on April 24, 1998 (see Item 13 "Certain Relationships and Related Transactions"). Funds to complete this acquisition were provided by Hearst. The assets acquired were pledged to Hearst under the related loan agreement and the loan was repaid on July 3, 1998. Effective June 1, 1998, the Company received via contract rights the benefits of the operation of stations WDTN and WNAC and WNAC's joint operating agreement with WPRI. The Company recorded a book gain of approximately $17.5 million on the asset swap. On July 3, 1998 the Company consummated the Hearst transaction. On November 1, 1998, the Company acquired substantially all of the assets of KVLY, KFYR, KUMV, KMOT, and KQCD (the Meyer Stations) from Meyer Broadcasting for approximately $65.3 million. The Meyer Stations are all NBC affiliates serving Fargo, Bismarck, Williston, Minot, and Dickinson, North Dakota. On February 5, 1999, the Company acquired substantially all the assets of WUPW from Raycom Media, Inc. for approximately $74.4 million, including fees and expenses. WUPW, Channel 36, is the FOX-affiliated station serving Toledo, Ohio. On March 3, 1999, the Company, STC License Company, a subsidiary of the Company, and Nexstar Broadcasting of Rochester, Inc. (Nexstar) entered into an asset purchase agreement (the Rochester Agreement) pursuant to which the Company would sell to Nexstar the television broadcast license and operating assets of WROC, Rochester, New York for approximately $46.0 million subject to adjustment for certain customary proration amounts. On April 1, 1999, the Company completed the non-license sale of WROC assets to Nexstar for $43.0 million and entered into a Time Brokerage Agreement with Nexstar under which Nexstar programmed most of the available time of WROC and retained the revenues from the sale of advertising time through the license closing on December 23, 1999. The Company recognized a gain of $4.5 million from the transaction. THE STATIONS The markets in which the Company currently operates offer geographic diversity that reduces the impact on the Company of changes in respective market economies and provide favorable competitive operating environments. The Company believes that the Stations are well positioned to achieve long-term growth in audience share and revenue share because of: (i) the limited competition for viewers from other over-the-air television broadcasters in these markets; (ii) the strength of the Company's management; and (iii) the Stations' favorable and/or improving rankings within their DMAs. Management believes that the limited number of other television broadcast stations in these markets enables the Company to purchase syndicated programming at favorable rates. The following table summarizes additional information regarding each Station and its respective DMA. (1) BIA's Investing in Television 1999, 4th Edition (2) As of November 1999, Sunday through Saturday 6 a.m to 2 a.m. Nielsen Household Shares (3) Satellite stations are counted as one with the main station (4) Represents approximately 50% of the broadcast cash flow of WNAC and WPRI less certain adjustments (5) Includes KRBC and KACB MARKET PROFILES The following household trends for various stations in the market profiles are found in the Nielsen rating books for the time period 7:00 AM to 1:00 AM Monday through Sunday. Information included in the market overview is provided by BIA's Investing in Television 1999 4th Edition. WNAC/WPRI (Providence, Rhode-Island - New Bedford, Massachusetts) Market Overview. Providence, Rhode Island-New Bedford, Massachusetts is the 50th largest DMA in the United States, with a population of approximately 1,502,000 and approximately 565,000 television households. Cable penetration in the Providence-New Bedford market is estimated to be 78%. The Providence-New Bedford market experienced compound annual revenue growth of approximately 5.9% from 1992 through 1998, and BIA has projected this market to grow at a compound annual rate of 4.2% from 1998 through 2002. Average household income was approximately $43,000. The table below provides an overview of the competitive stations serving the Providence-New Bedford market. WDTN (Dayton, Ohio) Market Overview. Dayton, Ohio is the 56th largest DMA in the United States with a population of approximately 1,334,000 and approximately 508,000 television households. Cable penetration in the Dayton market is estimated to be 71%. The Dayton market experienced compound annual revenue growth of approximately 4.6% from 1992 through 1998, and BIA has projected this market to grow at a compound annual rate of 2.0% from 1998 through 2002. Average household income was approximately $43,000. The table below provides an overview of the competitive stations serving the Dayton market: WEYI (Flint-Saginaw-Bay City, Michigan) Market Overview. Flint-Saginaw-Bay City, Michigan is the 64th largest DMA in the United States, with a population of approximately 1,194,000 and approximately 446,000 television households. Cable penetration in the Flint-Saginaw-Bay City market is estimated to be 65%. The Flint-Saginaw-Bay City market experienced compound annual revenue growth of approximately 6.4% from 1992 through 1998, and BIA has projected this market to grow at a compound annual rate of 2.7% from 1998 through 2002. Average household income was approximately $37,000. The table below provides an overview of the competitive stations serving the Flint-Saginaw-Bay City market: WUPW (Toledo, Ohio) Market Overview. Toledo, Ohio is the 67th largest DMA in the United States, with a population of approximately 1,106,000 and approximately 412,000 television households. Cable penetration in the Toledo market is estimated to be 68%. The Toledo market experienced compound annual revenue growth of approximately 5.6% from 1992 through 1998, and BIA has projected this market to grow at a compound annual rate of 4.5% from 1998 through 2002. Average household income was approximately $42,000. The table below provides an overview of the competitive stations serving the Toledo market. WJAC (Johnstown-Altoona, Pennsylvania) Market Overview. Johnstown-Altoona, Pennsylvania is the 95th largest DMA in the United States, with a population of approximately 783,000 and approximately 294,000 television households. Cable penetration in the Johnstown-Altoona market is estimated to be 81%. The Johnstown-Altoona market experienced compound annual revenue growth of approximately 6.5% from 1992 through 1998, and BIA projects this market to grow at a compound annual rate of 5.6% from 1998 through 2002. Average household income was approximately $36,000. The table below provides an overview of the competitive stations serving the Johnstown-Altoona market. KVLY (Fargo-Valley City, North Dakota) Market Overview. Fargo-Valley City, North Dakota is the 119th largest DMA in the United States, with a population of approximately 584,000 and approximately 224,000 television households. Cable penetration in the Fargo-Valley City market is estimated to be 63%. The Fargo-Valley City market experienced compound annual revenue growth of approximately 6.2% from 1992 through 1998, and BIA projects this market to grow at a compound annual rate of 4.2% from 1998 through 2002. Average household income was approximately $36,000. The table below provides an overview of the competitive stations serving the Fargo-Valley City market. WTOV (Wheeling, West Virginia-Steubenville, Ohio) Market Overview. Wheeling, West Virginia-Steubenville, Ohio is the 140th largest DMA in the United States, with a population of approximately 404,000 and approximately 159,000 television households. Cable penetration in the Wheeling, West Virginia-Steubenville, Ohio market is estimated to be 78%. The Wheeling, West Virginia-Steubenville, Ohio market experienced compound annual revenue growth of approximately 6.2% from 1992 through 1998, and BIA projects this market to grow at a compound annual rate of 5.7% from 1998 through 2002. Average household income was approximately $33,000. The table below provides an overview of the competitive station serving the Wheeling, West Virginia-Steubenville, Ohio market: (1) In addition, WTOV and the CBS affiliate are secondary ABC affiliates. However, WTOV has the right of first refusal to carry ABC programming events. KFYR (Minot-Bismarck-Dickinson, North Dakota) Market Overview. Minot-Bismarck-Dickinson, North Dakota is the 152nd largest DMA in the United States, with a population of approximately 353,000 and approximately 136,000 television households. Cable penetration in the Minot-Bismarck-Dickinson market is estimated to be 63%. The Minot-Bismarck-Dickinson market experienced compound annual revenue growth of approximately 6.3% from 1992 through 1998, and BIA projects this market to grow at a compound annual rate of 4.0% from 1998 through 2002. Average household income was approximately $39,000. The table below provides an overview of the competitive stations serving the Minot-Bismarck-Dickinson market. KRBC (Abilene-Sweetwater, Texas) Market Overview. Abilene-Sweetwater, Texas is the 163rd largest DMA in the United States, with a population of approximately 304,000 and approximately 114,000 television households. Cable penetration in the Abilene-Sweetwater market is estimated to be 72%. The Abilene-Sweetwater market experienced compound annual revenue growth of approximately 6.3% from 1992 through 1998, and BIA projects this market to grow at a compound annual rate of 3.0% from 1998 through 2002. Average household income was approximately $32,000. The table below provides an overview of the competitive stations serving the Abilene-Sweetwater market: KACB (San Angelo, Texas) Market Overview. San Angelo, Texas is the 196th largest DMA in the United States, with a population of approximately 142,000 and approximately 51,000 television households. Cable penetration in the San Angelo market is estimated to be 77%. The San Angelo market experienced compound annual revenue growth of approximately 12.9% from 1992 through 1998, and BIA projects this market to grow at a compound annual rate of 4.7% from 1998 through 2002. Average household income was approximately $37,000. The table below provides an overview of the competitive stations serving the San Angelo market: BUSINESS STRATEGY The Company's business strategy is to acquire and operate television broadcast stations and maximize operating cash flow through both revenue growth and improved cost control. The Company believes that revenue growth and cost control may be achieved simultaneously, principally because many of the costs associated with operating a television station are fixed. Key components of the Company's business strategy include: Management. The Company believes that one of its most important assets is its experienced management team. The Stations' general managers are responsible for the day-to-day operations of their respective stations. The Company believes that the autonomy of its station management enables it to attract top quality managers capable of implementing an aggressive marketing strategy and reacting to competition in the local markets. As an incentive, a portion of each station general manager's compensation is based on the performance of the station for which he or she is responsible. Controlling Costs. The Company seeks to selectively reduce costs at newly acquired stations without adversely affecting growth. After acquiring a station, management implements a cost control strategy stressing the elimination of unnecessary costs, budgeting, accountability and disciplined credit and collection procedures. The Company's management believes that it can create an operating structure that will accommodate both revenue growth and cost reductions. Intensifying Sales Efforts. The Company implements an aggressive approach to sales and marketing designed to increase market revenue share. The Company's management believes that increases in revenue share are not necessarily dependent on increases in audience share. Building on Local News Franchises. The Company seeks to increase revenues by developing a highly-rated, well-differentiated local news product designed to build viewer loyalty and target specific demographic audiences that appeal to advertisers. Managing Program Selection. Each Station seeks to cost effectively purchase first-run and off-network syndicated programming to target specific demographic audiences. The Stations have been able to purchase syndicated programming at rates that Company's management believes are attractive, in part because of the limited competition for such programming in the Stations' DMAs. Positioning and Branding Stations. The Company seeks to increase revenues by developing and maintaining a unique, local "brand image" for each Station within its respective market with which viewers and advertisers can identify. This strategy integrates local news, programming, promotion, and sales efforts for each Station based on its market's demographics, competition, dynamics, and opportunities. Pursuing Selective Acquisitions. The Company actively seeks to acquire television stations that management believes can benefit from its business strategy. Targeted stations generally have one or more of the following characteristics: (i) attractive acquisition terms, which may include station-for-station exchanges; (ii) opportunities to implement effective cost controls; (iii) opportunities for increased advertising revenue; (iv) opportunities for increased audience share through improved newscasts and programming; (v) limited competition from other television broadcasters; and (vi) market locations that possess attractive projected growth in advertising revenues. The Company generally targets network-affiliated stations, which typically have established audiences for their news, sports and entertainment programming, located in DMAs generally ranked from 50 to 150. NETWORK AFFILIATIONS. Each of the Stations is affiliated with a major broadcast network pursuant to a long-term affiliation agreement. Each affiliation agreement generally provides the Station with the right to broadcast all programs transmitted by the network with which the Station is affiliated. In return, the network has the right to sell a substantial amount of the advertising time during its broadcasts in exchange, in the case of networks other than FOX, for a specified network compensation fee payable to the Station. These payments are negotiated on a station-by-station basis and are subject to increases or decreases by the network during the term of an affiliation agreement with provisions for advance notice and a right of termination by the Station in the event of a reduction. The agreements generally are long-term in nature, and contain customary renewal provisions, which generally provide for automatic renewal for successive terms, subject to either party's right to terminate the agreement at the end of any term upon proper notice. During 1999, each of the major networks publicly indicated that it is reviewing the economic and other terms under which it provides programming to network affiliates like the Stations. Proposed changes (which could be implemented during the term of pending affiliation agreements) that have been publicly discussed include: (i) reducing or eliminating the cash payments paid by networks to affiliates, (ii) reducing the period of exclusivity with respect to popular programming, (iii) reducing the amount of advertising time made available for sale by affiliates during network programming and (iv) requiring affiliates to share part of the costs of producing popular or special programming. In response to declining revenues, some networks have suggested that they may search for alternative methods of distribution for their programming, such as satellite and cable channels. Any of such changes could materially adversely affect the Company's asset values and operating margins. The following table summarizes the network affiliation agreements for the Stations, as well as for WPRI: (1) The Company is negotiating with FOX on renewal of the WNAC affiliation agreement. The contract remains in effect while negotiations proceed. ADVERTISING SALES General. Television station revenues are primarily derived from the sale of local and national advertising. Television stations compete for advertising revenues primarily with other broadcast television stations, radio stations, cable system operators and programmers, and newspapers serving the same market. All network-affiliated stations are required to carry spot advertising sold by their networks which reduces the amount of advertising spots available for sale by the Stations. The Stations directly sell all of the remaining advertising to be inserted in network programming and all of the advertising in non-network programming, retaining all of the revenues received from these sales. A national syndicated program distributor typically retains a portion of the available advertising time for programming it supplies in exchange for no fees or reduced fees charged to the stations for such programming. Advertisers wishing to reach a national audience usually purchase time directly from the networks, or advertise nationwide on an ad hoc basis. National advertisers who wish to reach a particular region or local audience often buy advertising time directly from local stations through national advertising sales representative firms. Local businesses purchase advertising time directly from the stations' local sales staffs. Advertising rates are based upon a program's popularity among the viewers that an advertiser wishes to target, the number of advertisers competing for the available time, the size and the demographic composition of the market served by the station, the availability of alternative advertising media in the market area, and the effectiveness of the stations' sales force. Advertising rates are also determined by a station's overall ability to attract viewers in its market area, as well as the station's ability to attract viewers among particular demographic groups that an advertiser may be targeting. Advertising revenues are positively affected by strong local economies, national and regional political election campaigns, and certain events such as the Olympic Games or the Super Bowl. Because television broadcast stations rely on advertising revenues, declines in advertising budgets, particularly in recessionary periods, adversely affect the broadcast industry, and as a result may contribute to a decrease in the revenues of broadcast television stations. Conversely, increases in advertising budgets targeting specific demographic groups are based upon superior coverage or the dominant competitive position of the Stations. The Company seeks to manage its advertising spot inventory efficiently to maximize advertising revenues and its return on programming costs. Local Sales. Local advertising time is sold by each Station's local sales staff who call upon advertising agencies and local businesses, which typically include car dealerships, retail stores and restaurants. Compared to revenues from national advertising accounts, revenues from local advertising generally are more stable and, due to a lower cost of sales, more profitable. The Company seeks to attract new advertisers to television, and to increase the amount of advertising time sold to existing local advertisers by relying on experienced local sales forces with strong community ties, producing news and other programming with local advertising appeal and sponsoring or co-promoting local events and activities. The Company places a strong emphasis on experience of its local sales staff and maintains an on-going training program for sales personnel. To increase accountability of the Stations' sales forces, management has implemented initiatives whereby sales managers are responsible for the effective management of commercial inventory using input from account executives who are responsible for preparing detailed reports and projections. National Sales. National advertising time is sold through national sales representative firms which call upon businesses, which typically include automobile manufacturers and dealer groups, telecommunications companies, fast food franchisers, and national retailers (some of which may advertise locally). Each Station has a manager assigned to work with the national sales representative to increase advertising expenditures with the Stations. INDUSTRY BACKGROUND General. Commercial television broadcasting began in the United States on a regular basis in the 1940s over a portion of the broadcast spectrum commonly known as the "VHF Band" (very-high frequency broadcast channels numbered 2 through 13). Television channels were later assigned by the FCC under additional broadcast spectrum commonly known as the "UHF Band" (ultra-high frequency broadcast channels numbered 14 through 83; channels 70 through 83 have since been reallocated to non-broadcast services). The license to operate a broadcast station is granted by the FCC, and due to spacing requirements and other considerations, the number of licenses allocated to any one market is limited. Although UHF and VHF stations compete in the same market, UHF stations historically have suffered a competitive disadvantage, in part because: (i) receivers of many households were originally designed only for VHF reception; (ii) UHF signals were more affected by terrain and other obstructions than VHF signals; and (iii) VHF stations were able to provide higher quality signals to a wider area. This historic disadvantage of UHF stations has gradually declined through: (a) carriage on cable system; (b) improvements in television receivers; (c) improvement in television transmitters; (d) wider use of all channel antennae; (e) increased availability of programming; and (f) the development of new networks such as FOX, UPN and the WB, which typically broadcast through UHF stations. All television stations throughout the United States are grouped into 211 generally recognized DMAs, which are ranked in size according to various formulae based upon actual or potential audience. Each DMA is defined as an exclusive geographic area consisting of all counties in which the home-market commercial stations receive the greatest percentage of total viewing hours. Television Networks. A majority of commercial television stations in the United States are affiliated with ABC, CBS, FOX, or NBC. The affiliation by a station with one of the four major networks has a significant impact on the composition of the station's programming, revenues, expenses, and operations. ABC, CBS, and NBC provide the majority of its affiliates' programming each day without charge in exchange for nearly all of the available advertising time in the programs supplied, and sells this advertising time, and retains the revenues. The affiliate receives compensation from the three networks and retains the revenue from time sold by the affiliate during breaks in and between network programs and in programming the affiliate produces or purchases from non-network sources. FOX has established an affiliation of independent stations which operates on a basis similar to ABC, CBS and NBC. However, the number of hours per week of programming supplied by FOX to its affiliates is significantly less than the number of hours supplied by ABC, CBS, and NBC, and the network compensation, if any, is normally less. As a result, FOX affiliates retain a significantly higher portion of the available inventory of broadcast time for their own use but must, however, purchase or produce a greater amount of their own programming, resulting in generally higher programming costs. In contrast to stations affiliated with major networks, an independent station supplies over-the-air programming through the acquisition of broadcast programs through syndication. This syndicated programming is generally acquired by the independent stations for cash and/or barter. Independent stations that acquire a program through syndication are usually given exclusive rights to show the program in the station's market for either a period of years or a number of episodes agreed upon between the independent station and the syndicator of the programming. Types of syndicated programs aired on the independent stations include feature films, popular series previously shown on network television, and series produced for direct distribution to television stations. During 1994, UPN and WB each established a network of independent stations that began broadcasting in January 1995 and operating on a basis similar to FOX. However, UPN and WB currently supply fewer hours of programming per week to their affiliates than any of the four major networks. As a result, UPN and WB affiliates retain a significantly higher portion of the available inventory of broadcast time for their own use than affiliates of any of the four major networks. Television Viewing Audience. Nielsen is a national audience measuring service that periodically publishes data on estimated audiences for television stations in various DMAs throughout the country. The estimates are expressed in terms of the percentage of the total potential audience in the DMA viewing a station, referred to as the station's "rating," and of the percentage of the audience actually watching the television station, referred to as the station's "share." This rating service provides such data on the basis of total television households and of selected demographic groupings in the media markets being measured. Nielsen uses one of two methods to measure the station's actual viewership. In larger DMAs, ratings are determined by a combination of meters connected directly to selected television sets, and periodic surveys of television viewing, while in smaller DMAs only periodic surveys are completed. During 1999, all of the DMAs in which the Company operated were survey markets except Providence, Rhode Island. COMPETITION Competition in the television industry exists on several levels, including competition for audience, advertisers, and programming (including local news). Competition is continually affected by technological change and innovation, fluctuation in the popularity of competing entertainment and communications media (including newspapers, magazine, internet, and direct mail), and governmental restrictions or actions by Congress and federal regulatory bodies. Any of these factors could have a material adverse effect on the Company's operations. Competition in the television broadcasting industry occurs primarily in individual DMAs. Generally, a television broadcast station in one DMA does not compete with television broadcast stations in other DMAs. Certain market competitors who are part of larger organizations have substantially greater financial, technical, and programming resources than the Company. Audience. Stations compete for audience share primarily on the basis of program popularity, which has a direct effect on advertising rates. A large amount of the Stations' prime time programming is supplied by the networks, and is therefore dependent upon the performance of such network programs in attracting viewers. Non-network time periods are programmed by the Station primarily with syndicated programs, and locally produced news. The development of methods of video transmission other than over-the-air broadcasting has significantly altered competition for audience share in the television industry. These other transmission methods can increase competition faced by a broadcast station by bringing into its market distant broadcasting signals not otherwise available to the station's audience, and by serving as a distribution system for programming that originates on the cable and satellite systems. Other sources of competition for audience include home entertainment systems (including video cassette recorder and playback systems, videodiscs and television game devices), multichannel multipoint distribution systems, and internet services. Stations face competition from high-powered direct broadcast satellite services that transmit programming directly to homes equipped with special receiving antennas or to cable television systems for transmission to their subscribers. Further advances in technology may increase competition for household audiences and advertisers. Video compression techniques, now under development for use with current cable channels and direct broadcast satellites, are expected to reduce the bandwidth required for television signal transmission. These compression techniques, as well as other technological developments, are applicable to all video delivery systems, including over-the-air broadcasting, and have the potential to provide vastly expanded programming to highly targeted audiences. Reduction in the cost of creating additional channel capacity could lower entry barriers for new channels and encourage the development of increasingly specialized "niche" programming. This ability to reach very defined audiences may alter the competitive dynamics for advertising expenditures. The Company is unable to predict the effect that technological changes will have on the broadcast television industry or the future results of the Company's operations. Advertising. Stations compete for advertising revenues, primarily with other broadcast television stations and, to a lesser extent, with radio stations, cable system operators and programmers, and newspapers serving the same market. Advertising revenues and advertising rates are based upon factors that include the size of the DMA in which the station operates, a program's popularity among the viewers that an advertiser wishes to attract, the number of advertisers competing for the available time, the demographic makeup of the DMA served by the station, the availability of alternative advertising media in the DMA, aggressive and knowledgeable sales forces and developments of projects, features and programs that tie advertiser messages to programming. Historically, cable operators generally have not sought to compete with over-the-air broadcast stations for a share of the local news audience in the size of the markets that the Company targets. To the extent they elect to do so, increased competition from cable operators for local news audiences could have a material adverse effect on the Company's advertising revenues. Cable operators have, however, started competing with the Stations by selling advertising spots on certain cable channels. Cable penetration in each of the Company's markets generally exceeds 60%. As cable-originated programming has emerged as a competitor for viewers of over-the-air broadcast television programming, the advertising share of cable networks has increased significantly, although no single cable programming network regularly attains audience levels amounting to more than a small fraction of any over-the-air programming. Notwithstanding such increases in cable viewership and advertising, over-the-air broadcasting remains the dominant distribution system for mass market television advertising. Programming. The Company competes for programming, which involves negotiating with national program distributors or syndicators that sell first-run and rerun packages of programming. The Stations compete for exclusive access to those programs against in-market broadcast station competitors for syndicated products. Cable systems generally do not compete with local stations for programming, although various national cable networks have become more active in acquiring programs that would have otherwise been offered to local television stations. In addition, a television station may acquire programming through barter arrangements. Under barter arrangements, which are becoming increasingly popular with both network affiliates and independents, a national program distributor can receive advertising time in exchange for the programming it supplies, with the station paying no fee or a reduced fee for such programming. FEDERAL REGULATION OF TELEVISION BROADCASTING General. The ownership, operation and sale of television stations are subject to the jurisdiction of the Federal Communications Commission (FCC) which acts under authority granted by the Communications Act of 1934, as amended (Communications Act). Among other things, the FCC assigns frequency bands for broadcasting; determines the particular frequencies, locations and operating power of stations; issues, renews, revokes and modifies station licenses; regulates equipment used by stations; adopts and implements regulations and policies that directly or indirectly affect the ownership and operation of stations; and has the power to impose penalties for violations of its rules or the Communications Act. The following is a brief summary of certain provisions of the Communications Act, the Telecommunications Act of 1996 (the Telecommunications Act) and specific FCC regulations and policies. Further information concerning the nature and extent of federal regulation of broadcast stations is found in the Communications Act, the Telecommunications Act, FCC rules and the public notices and rulings of the FCC. License Grant and Renewal. Television stations operate pursuant to broadcasting licenses that usually are granted by the FCC for a maximum permitted term of eight years. Television licenses are subject to renewal upon application to the FCC. Under the Communications Act, the FCC is required to grant a renewal application if it finds that (1) the station has served the public interest, convenience and necessity; (2) there have been no serious violations by the licensee of the Communications Act or the rules and regulations of the FCC; and (3) there have been no other violations by the licensee of the Communications Act or the rules and regulations of the FCC that, when taken together, would constitute a pattern of abuse. All of the Stations are presently operating under licenses with terms expiring as follows: April 1, 2007 (WNAC), August 1, 2007 (WJAC), October 1, 2005 (WEYI, WDTN, WTOV, WUPW), April 1, 2006 (KFYR, KMOT, KQCD, KUMV, KVLY) and August 1, 2006 (KRBC, KACB). WPRI's license expires April 1, 2007. There can be no assurance that any of the licenses of such stations will be renewed. Ownership Matters FCC Issues. On August 5, 1999, the FCC adopted changes in several of its broadcast ownership rules (collectively, the FCC Ownership Rules). These rule changes became effective on November 16, 1999; however, several petitions have been filed with the FCC seeking reconsideration of the new rules, so the rules may change. While the following discussion does not describe all of the ownership rules or rule changes, it attempts to summarize those rules that appear to be most relevant to the Company. The FCC relaxed its "television duopoly" rule, which barred any entity from having an attributable interest in more than one television station with overlapping service areas. Under the new rules, one entity may have attributable interests in two television stations in the same Nielsen Designated Market Area (DMA) provided that: (1) one of the two stations is not among the top four in audience share and (2) at least eight independently owned and operated commercial and noncommercial television stations will remain in the DMA if the proposed transaction is consummated. The new rules also permit common ownership of television stations in the same DMA where one of the stations to be commonly owned has failed, is failing or is unbuilt or where extraordinary public interest factors are present. In order to transfer ownership in two commonly owned television stations in the same DMA, it will be necessary to once again demonstrate compliance with the new rules. Lastly, the new rules authorize the common ownership of television stations with overlapping signal contours as long as the stations to be commonly owned are located in different DMAs. Similarly, the FCC relaxed its "one-to-a-market" rule, which restricts the common ownership of television and radio stations in the same market. One entity now may own up to two television stations and six radio stations or one television station and seven radio stations in the same market provided that (1) 20 independent media voices (including certain newspapers and a single cable system) will remain in the relevant market following consummation of the proposed transaction, and (2) the proposed combination is consistent with the television duopoly and local radio ownership rules. If fewer than 20 but more than 9 independent voices will remain in a market following a proposed transaction, and the proposed combination is otherwise consistent with the Commission's rules, a single entity may have attributable interests in up to two television stations and four radio stations. If these various "independent voices" tests are not met, a party generally may have an attributable interest in no more than one television station and one radio station in a market. The FCC made other changes to its rules that determine what constitutes "cognizable interest" in applying the FCC Ownership Rules (the Attribution Rules). Under the new Attribution Rules, a party will be deemed to have a cognizable interest in a television or radio station, cable system or daily newspaper that triggers the FCC's cross-ownership restrictions if (1) it is a non-passive investor and it owns 5% or more of the voting stock in the media outlet; (2) it is a passive investor (i.e., bank trust department, insurance company or mutual fund) and it owns 20% or more of the voting stock; or (3) its interests (which may be in the form of debt or equity (even if non-voting), or both) exceeds 33% of the total asset value of the media outlet and it either (i) supplies at least 15% of a station's weekly broadcast hours or (ii) has an attributable interest in another media outlet in the same market. The FCC also declared that local marketing agreements (LMAs) now will be attributable interests for purposes of the FCC Ownership Rules. The FCC will grandfather LMAs that were in effect prior to November 5, 1996, until it has completed the review of its attribution regulations in 2004. Parties may seek the permanent grandfathering of such an LMA, on a non-transferable basis, by demonstrating that the LMA is in the public interest and that it otherwise complies with FCC Rules. Finally, the FCC eliminated its "cross interest" policy, which had prohibited common ownership of a cognizable interest in one media outlet and a "meaningful" non-cognizable interest in another media outlet serving essentially the same market. It is difficult to assess how these changes in the FCC ownership restrictions will affect the Company's broadcast business. The recent changes to the FCC Ownership Rules may affect the Company's relationship with Smith Acquisition Company (SAC). The Company owns a substantial non-voting equity stake in SAC, which, together with a wholly owned subsidiary, owns WNAC-TV, Providence, Rhode Island, and WTOV-TV, Steubenville, Ohio. Under the new FCC Ownership Rules, the Company's formerly non-attributable interest in SAC has become attributable. Accordingly, the Company, and parties to the Company, must consider whether its other broadcast interests, when viewed in combination with those of SAC, are consistent with all relevant FCC Ownership Rules. The Company is in the process of conducting that review. To the extent the recent changes require the Company to modify its broadcast interests or ownership structure, the Company expects to act as necessary to remain in compliance with all relevant FCC Ownership Rules. With the changes in the FCC Ownership Rules, the Company no longer needs to maintain its waiver to own both KRBC-TV, Abilene, Texas, and KACB-TV, San Angelo, Texas, as the common ownership of these stations is now consistent with the Commission's Rules. On October 2, 1999, AMFM Inc. (AMFM) entered into an Agreement and Plan of Merger with Clear Channel Communications, Inc. (Clear Channel) and CCU Merger Sub, Inc. (Merger Sub), pursuant to which AMFM will be merged with and into Merger Sub and will become a wholly-owned subsidiary of Clear Channel (the AMFM Merger). Thomas O. Hicks, who is the Company's ultimate controlling shareholder, has an attributable interest in AMFM and currently is the Chairman and Chief Executive Officer of AMFM. AMFM and Clear Channel have announced that Mr. Hicks will serve as Vice Chairman of the combined entity. The Company is in the process of analyzing the impact of this AMFM Merger on the Company's operations and regulatory obligations. Alien Ownership. The Communications Act prohibits the issuance of broadcast licenses to, or the holding of a broadcast license by, any corporation of which more than 20% of the capital stock is beneficially or nominally owned or voted by non-U.S. citizens or their representatives or by a foreign government or a representative thereof, or by any corporation organized under the laws of a foreign country (collectively, Aliens). The Communications Act also authorizes the FCC, if the FCC determines that it would be in the public interest, to prohibit the issuance of a broadcast license to, or the holding of a broadcast license by, any corporation directly or indirectly controlled by any other corporation of which more than 25% of the capital stock is beneficially or nominally owned or voted by Aliens. The FCC has issued interpretations of existing law under which these restrictions in modified form apply to other forms of business organizations, including partnerships. The Company and its subsidiaries are domestic corporations, and the Company's ultimate controlling stockholder is a United States citizen. The Certificate of Incorporation of each of the Company and Sunrise contain limitations on Alien ownership and control that are substantially similar to those contained in the Communications Act. Pursuant to the Certificate of Incorporation, the Company, has the right to purchase any Alien-owned shares of the Company's capital stock at their fair market value to the extent necessary, in the judgment of the Board of Directors, to comply with the Alien ownership restrictions. Local Television/Cable Cross-Ownership Rule. While the Telecommunications Act eliminated a previous statutory prohibition against the common ownership of a television broadcast station and a cable system that serves the same local market, the Telecommunications Act left a similar FCC rule in place. The legislative history of the Act indicates that its repeal of the statutory ban should not prejudge the outcome of any FCC review of the rule. The FCC has pending a rulemaking proceeding in which it has solicited comment on retention of its proscription on television-cable cross-ownership. OTHER MATTERS Must-Carry Retransmission Consent. Pursuant to the Cable Act of 1992, television broadcasters are required to make triennial elections to exercise either "must-carry" or "retransmission consent" rights in connection with their carriage by cable systems in each broadcaster's local market. By electing must-carry rights, a broadcaster demands carriage on a specified channel on cable systems within its DMA, as defined by the Nielson 1997-98 DMA Market and Demographic Rank Report. These must-carry rights are not absolute, and their exercise is dependent on variables such as: (i) the number of activated channels on a cable system; (ii) the location and size of a cable system; and (iii) the amount of programming on a broadcast station that duplicates the programming of another broadcast station carried by the cable station. Alternatively, if a broadcaster chooses to exercise retransmission consent rights, it can prohibit cable systems from carrying its signal or grant the appropriate cable system the authority to retransmit the broadcast signal for a fee or other consideration. The most recent election date for must-carry or retransmission consent was October 1, 1999, such election to be effective for the three-year period from January 1, 2000 through December 31, 2002. The FCC currently is conducting a rulemaking proceeding to determine carriage requirements for digital broadcast television stations on cable systems during and following the transition from analog to digital broadcasting, including carriage requirements with respect to ancillary and supplementary services that may be provided by broadcast stations over their digital spectrum. SHVIA. On November 29, 1999, the President signed the Satellite Home Improvement Act (SHVIA). Among other things, SHVIA provides for a statutory copyright license to enable satellite carriers to retransmit local television broadcast stations into the stations' respective local markets. After May 27, 2000, satellite carriers will be prohibited from delivering a local signal into its local markets - so called "local-into-local" service - without the consent or must-carry election of such station, but stations will be obligated to engage in good faith retransmission consent negotiations with the carriers. SHVIA does not require satellite carriers to carry local stations, but provides that carriers that choose to do so must comply with certain mandatory signal carriage requirements by a date certain, as defined by the Act or as-yet to be drafted FCC regulations. Further, the Act authorizes satellite carriers to continue to provide certain network signals to unserved households, as defined in SHVIA and FCC rules, except that carriers may not provide more than two same-network stations to a household in a single day. Also, households that do not receive a signal of Grade A intensity from any of a particular network's affiliates may continue to receive distant station signals for that network until December 31, 2004, under certain conditions. The FCC has initiated several rule making proceedings, as required by SHVIA, to implement certain aspects of the act, such as standards for good faith retransmission consent negotiations, must-carry procedures, exclusivity protection for local stations against certain distant signals, and enforcement. Digital Television. The FCC has taken a number of steps to implement digital television service (DTV) (including high-definition television) in the United States. On February 17, 1998, the FCC adopted a final table of digital channel allotments and rules for the implementation of DTV. The table of digital allotments provides each existing television station licensee or permittee with a second broadcast channel to be used during the transition to DTV, conditioned upon the surrender of one of the channels at the end of the DTV transition period. Implementation of DTV will improve the technical quality of television. Furthermore, the implementing rules permit broadcasters to use their assigned digital spectrum flexibly to provide either standard or high definition video signals and additional services, including, for example, data transfer, subscription video, interactive materials, and audio signals subject to the requirement that they continue to provide at least one free, over the air television service. Conversion to DTV may reduce the geographic reach of the Company's stations or result in increased interference, with, in either case, a corresponding loss of population coverage. DTV implementation will impose additional costs on the Company, primarily due to the capital costs associated with construction of DTV facilities and increased operating costs both during and after the transition period. The FCC has adopted rules that require broadcasters to pay a fee of 5% of gross revenues received from ancillary or supplementary uses of the digital spectrum for which they receive subscription fees or compensation other than advertising revenues derived from free over-the-air broadcasting services. Pursuant to the FCC's rules, the Company's Stations filed DTV construction permit applications on or before the November 1, 1999 deadline. The Company plans to complete construction of DTV facilities by the May 1, 2002 deadline. The FCC has set a target date of 2006 for expiration of the transition period, subject to biennial reviews to evaluate the progress of DTV, including the rate of consumer acceptance. Management of the Company believes that its conversion to DTV will commence in 2000 for all of the Company's markets. Future capital expenditures by the Company will be compatible with the new technology requirements to the extent they are not constrained by financial debt covenants included in the Company's debt agreements. Presently, no Company Station is broadcasting in DTV format. PROGRAMMING AND OPERATION General. The Communications Act requires broadcasters to serve the "public interest." The FCC has relaxed or eliminated many of the more formalized procedures it had developed in the past to promote the broadcast of certain types of programming responsive to the needs of a station's community of license. FCC licensees continue to be required, however, to present programming that is responsive to community issues, and to maintain certain records demonstrating such responsiveness. Complaints from viewers concerning a station's programming often will be considered by the FCC when it evaluates renewal applications of a licensee, although such complaints may be filed at any time and generally may be considered by the FCC at any time. Stations also must pay regulatory and application fees, and follow various rules promulgated under the Communications Act that regulate, among other things, political advertising, sponsorship identifications, the advertisement of contests and lotteries, obscene and indecent broadcasts, and technical operations, including limits on radiofrequency radiation. In addition, pursuant to FCC rules which became effective on February 16, 1999, broadcast licensees will be required to disclose on a biennial basis information regarding the race, ethnic background and gender of persons with attributable positions or ownership interests in the licensee. Failure to observe these or other rules and policies can result in the imposition of various sanctions, including monetary forfeitures, or the grant of a "short" (i.e., less than the full) license renewal term or, for particularly egregious violations, the denial of a license renewal application or the revocation of a license. Children's Television Programming. Pursuant to legislation enacted in 1990, the amount of commercial matter broadcast during programming designated for children 12 years of age and under is limited to 12.0 minutes per hour on weekdays and 10.5 minutes per hour on weekends. In addition, television stations are required to broadcast a minimum of three hours per week of "core" children's educational programming, which, among other things, must have a significant purpose of servicing the educational and informational needs of children 16 years of age and under. A television station found not to have complied with the "core" programming requirements or the children's commercial limitations could face sanctions, including monetary fines and the possible non-renewal of its broadcasting license. The FCC has indicated its intent to enforce its children's television rules strictly. Television Violence. Pursuant to a directive in the Telecommunications Act, the broadcast and cable television industries have adopted, and the FCC has approved, a voluntary content ratings system which, when used in conjunction with V-Chip technology, would permit the blocking of programs with a common rating. The FCC has directed that all television receiver models with picture screens 13 inches or greater be equipped with V-Chip technology under a phased implementation beginning on July 1, 1999. The Company cannot predict how the implementation of the ratings system and V-Chip technology will affect the Company's business. Closed Captioning. Under rules which became effective January 1, 1998, programming distributors, including television stations, are generally responsible for compliance with an on-screen captioning requirement with respect to the vast majority of video programming. The rules divide programming into two groups: pre-rule programming (which is defined to be programming that was first published or exhibited on or before January 1, 1998 by any distribution method) and new programming (programming that was first published or exhibited after that date). Pre-rule programming is subject to no specific requirements until the first calendar quarter of 2003. In that quarter, 30% of all pre-rule programming actually aired is required to be captioned. In the first quarter of 2008, the percentage of pre-rule programming that must be captioned will rise to 75%. In the first calendar quarter of 2000, new programming that is not otherwise exempt from captioning requirements became subject to a series of increasing quarterly benchmarks, until January 1, 2006, when 100% of all new non-exempt programming is to be captioned. EEO. On January 20, 2000, the Commission approved new equal employment opportunity and outreach requirements that will apply to all broadcast licensees (and cable operators). Although the Commission has not yet released the text of these rules, the key elements are: (1) licensees will be required to implement a minority outreach program; (2) licensees with five or more full-time employees must place a report regarding their outreach efforts in their public inspection file annually, and, if they have more than 10 full-time employees, they must submit the last four years of these reports to the Commission at the halfway point and endpoint of their license terms, which will be subject to Commission review; (3) licensees with five or more full-time employees also must file with the Commission a "Statement of Compliance" with regard to their outreach efforts every two years; and (4) licensees with five or more full-time employees also must file annual employment reports, of the sort filed prior to 1998, which the Commission will use only to monitor minority employment. Proposed Changes. The United States Congress and the FCC have under consideration, and in the future may consider and adopt, new laws, regulations and policies regarding a wide variety of matters that could affect, directly or indirectly, the operation, ownership and profitability of the Company's broadcast stations, result in the loss of audience share and advertising revenues for the Stations, and affect the ability of the Company to acquire additional broadcast stations or finance such acquisitions. In addition to the changes and proposed changes noted above, such matters include, for example, spectrum use fees, political advertising rates, potential restrictions on the advertising of certain products (beer, wine and hard liquor, for example), and the rules and policies to be applied in enforcing the FCC's equal employment opportunity regulations. Other matters that could affect the Company's broadcast properties include technological innovations and developments generally affecting competition in the mass communications industry, such as radio and television direct broadcast satellite service, the continued establishment of wireless cable systems and low power television stations, digital television and radio technologies, and the advent of telephone company participation in the provision of video programming service. The Telecommunications Act eliminated the overall ban on the offering of video services by telephone companies and eliminated the prohibition on the ownership of cable television companies by telephone companies in their service areas (or vice versa) in certain circumstances. Telephone companies providing such video services will be regulated according to the transmission technology they use. The Telecommunications Act also permits telephone companies to hold an ownership interest in the programming carried over such systems. Although the Company cannot predict the effect of the removal of these barriers to telephone company participation in the video services industry, it may have the effect of increasing competition in the television broadcasting industry in which the Company operates. Other Considerations. The foregoing summary does not purport to be a complete discussion of all provisions of the Communications Act or other congressional acts or of the regulations and policies of the FCC. For further information, reference should be made to the Communications Act, other congressional acts, and regulations and public notices promulgated from time to time by the FCC. There are additional regulations and policies of the FCC and other federal agencies that govern political broadcasts, public affairs programming, equal opportunity employment and other matters affecting the Company's business and operations. EMPLOYEES As of December 31, 1999, the Company had approximately 623 full-time and 81 part-time employees. WEYI has a contract with United Auto Workers that expires on September 30, 2002 with respect to 42 employees. WTOV has a contract with AFTRA that expires January 29, 2002 and a contract with International Brotherhood of Electrical Workers (IBEW) that expires on November 30, 2000 with respect to 27 and 18 employees, respectively. WJAC has a contract with International Alliance of Theatrical Stage Employees that expires on September 30, 2002 with respect to 50 employees. WDTN has a contract with the IBEW that expires July 1, 2003 with respect to 52 employees. KFYR has a contract with IBEW that expires on September 9, 2003 with respect to 10 employees. No significant labor problems have been experienced by the Stations. The Company considers its overall labor relations to be good. However, there can be no assurance that the Company's collective bargaining agreements will be renewed in the future or that the Company will not experience a prolonged labor dispute, which could have a material adverse effect on the Company's business, financial condition, or results of operations. ENVIRONMENTAL REGULATION Prior to the Company's ownership or operation of its facilities, substances or wastes that are or might be considered hazardous under applicable environmental laws may have been generated, used, stored or disposed of at certain of those facilities. In addition, environmental conditions relating to the soil and groundwater at or under the Company's facilities may be affected by the proximity of nearby properties that have generated, used, stored, or disposed of hazardous substances. As a result, it is possible that the Company could become subject to environmental liabilities in the future in connection with these facilities under applicable environmental laws and regulations. Although the Company believes that it is in substantial compliance with such environmental requirements, and has not in the past been required to incur significant costs in connection therewith, there can be no assurance that the Company's costs to comply with such requirements will not increase in the future. The Company presently believes that none of its properties have any condition that is likely to have a material adverse effect on the Company's financial condition or results of operations. PENDING ACQUISITION On March 16, 1999, the Company and Sinclair Communications, Inc. (Sinclair) entered into a purchase agreement (the Sinclair Agreement). Pursuant to the Sinclair Agreement, the Company agreed to purchase from Sinclair: WICS, Channel 20, Springfield, Illinois; WICD, Channel 15, Champaign, Illinois; and KGAN, Channel 2, Cedar Rapids, Iowa for a total purchase price of $87.0 million, including working capital, fees and expenses. WICS and WICD are NBC affiliates and KGAN is a CBS affiliate. Closing of this purchase is subject to customary conditions, including review by the Department of Justice and the Federal Communications Commission (FCC). In April 1999, the Antitrust Division of the United States Department of Justice (DOJ) issued various requests for additional information under the Hart-Scott-Rodino Antitrust Improvement Act (HSR Act) in connection with the acquisition. The Company and Sinclair are in discussions with the DOJ regarding this transaction, and the waiting period under the HSR Act has been extended pending completion of these discussions. While the resolution of these discussions remains uncertain, it appears likely that, if the acquisition is consummated as contemplated under the Sinclair Agreement, the Company would be required by the DOJ to sell, or enter into a local marketing agreement with respect to, WICS and WICD substantially concurrently with the closing of the acquisition of those stations, if it occurs at all. Under the terms of the Sinclair Agreement, either the Company or Sinclair (to the extent they are not in breach) may terminate the Sinclair Agreement if the closing has not occurred on or prior to March 16, 2000. The Company is presently exploring a variety of alternatives, including possibly a sale of WICS and WICD, but cannot be sure of the terms on which this transaction will be completed, if at all. The Company has assigned the right to acquire the broadcast licenses and other license assets of the Sinclair Stations to SDF Television License Corp. (SDF), an entity separate from the Company, but owned by members of the Company's senior management team. On April 2, 1999, SDF filed applications seeking FCC consent to the assignment of the licenses of WICS, WICD and KGAN. The application has been accepted for filing, and no petitions to deny were filed by the May 13, 1999 deadline, although informal objections advocating denial of the applications may be filed up until the date that the FCC grants the applications. The application is still pending before the FCC, and accordingly, the Company cannot be sure when the application will be granted, if at all. ITEM 2. ITEM 2. PROPERTIES Each Station's real properties generally include main offices, studios and transmitter/antenna sites. The transmitter/antenna sites generally are located to provide maximum signal strength and market coverage. The Company generally considers its facilities and equipment to be suitable for its current operations, and generally in good condition. The Company does not anticipate any difficulties leasing or purchasing additional space. The Company continues to evaluate potential upgrades in its facilities and equipment. The principal executive offices of the Company are located at 720 2nd Avenue South, St. Petersburg, Florida 33701. The telephone number of the Company at that address is (727) 821-7900. The following table generally describes the Company's principal properties in each of the markets of operation: (1) Main office/studio and tower/antenna site are at the same location. (2) WNAC owns significant additional assets that are co-located at WPRI studio site in Providence, Rhode Island. (3) The North Dakota Stations are interconnected with a significant number of microwave towers. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Lawsuits and claims are filed against the Company from time to time in the ordinary course of business. Management believes that the outcome of any such pending matters will not materially affect the financial position or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS Not applicable PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no established public trading market for the Company's common stock, par value $0.01 per share (the Common Stock). All of the Company's Common Stock is held by Sunrise Television Corp. (Sunrise). The Company has never paid a cash dividend with respect to its Common Stock. The Company's Senior Credit Agreement generally prohibits the Company from paying dividends on its Common Stock. On February 24, 1997, the Company issued 1,000 shares of its Common Stock to Sunrise in a private transaction for a cash purchase price of $50.0 million in reliance on the exemption, set forth in Section 4(2) of the Securities Act of 1933, as amended (the Securities Act), from the registration requirement set forth in Section 5 of the Securities Act. On February 28, 1997, the Company sold 300,000 shares of its 14% Redeemable Preferred Stock Series A in a private placement in reliance on Section 4(2) of the Securities Act for a cash purchase price of $28.95 million, with an aggregate liquidation preference of $30.0 million, or $100 per share, in connection with the acquisition of the Jupiter/Smith Stations. These shares are entitled to quarterly dividends and accrue at a rate per annum of 14%. Prior to February 28, 2002, dividends may be paid in either additional whole shares of Redeemable Preferred Stock Series A or cash, at the Company's option, and only in cash following that date. On March 25, 1997, the Company sold $100.0 million aggregate principal amount of its 11% Senior Subordinated Notes due 2007 (the Notes) in reliance on Rule 144A of the Securities Act to Chase Securities, Inc., NationsBanc Capital Markets, Inc., and Schroder Wertheim & Co. as the initial purchasers. The Company paid discounts to the initial purchasers of 3% of the aggregate principal amount of the Notes sold. On February 5, 1999, the Company entered into a $90.0 million Redeemable Preferred Stock Series B bridge financing agreement (Preferred Agreement) with three purchasers, two of which are participants in the Senior Credit Agreement and sold $37.5 million of Redeemable Preferred Stock Series B to fund the WUPW purchase in a private transaction for cash in reliance on the exemption set forth in Section 4(2) of the Securities Act from the registration requirement set forth in Section 5 of the Securities Act. On August 5, 1999, the Company repaid all amounts outstanding under the Preferred Agreement, and the availability for selling additional preferred stock under the Preferred Agreement was cancelled. On December 30, 1999, the Company issued and sold 25,000 shares of its 14% Redeemable Preferred Stock Series B to Sunrise in a private transaction for an aggregate cash purchase price of $25.0 million in reliance on the exemption set forth in Section 4(2) of the Securities Act from the registration requirement set forth in Section 5 of the Securities Act. ITEM 6. ITEM 6. SELECTED HISTORICAL FINANCIAL DATA The following table sets forth the selected historical information of the Company as of the dates and for the periods indicated. Information for the Company for the two years ended December 31, 1999 and 1998 and the ten months ended December 31, 1997 was derived from the financial statements of the Company, which have been audited by Arthur Andersen, LLP and are included in Item 8 (excluding the consolidated balance sheet as of December 31, 1997, which was previously filed). Predecessor historical information for the two months ended February 28, 1997 and the year ended December 31, 1996 were derived from the audited financial statements of the Jupiter/Smith Stations which have been audited by Arthur Andersen, LLP and included in Item 8. Predecessor historical financial information for the year ended December 31, 1995, has been derived from the audited financials of the Jupiter/Smith Stations, which were audited by Arthur Andersen, LLP. Statement of Operations Data below station operating income, as well as Balance Sheet Data, for the Jupiter/Smith Stations for the year ended December 31, 1995 have not been presented because such information is not meaningful for the following reasons: (i) during such period the Stations were owned and/or operated by persons other than the Company and/or management; (ii) they were not owned or operated as a single unit for any such periods; and (iii) they were operated as part of larger units and therefore, allocations of corporate expenses, interest, and long term debt cannot be made to the Stations. NOTES TO SELECTED HISTORICAL FINANCIAL DATA (Dollars in thousands) (1) Financial statements for periods presented are at the various predecessor cost bases. (2) Financial information for the year ended December 31, 1996 and the two months ended February 28, 1997 refers to the period that the Jupiter/Smith Stations were owned by Jupiter and operated by SBP, an affiliate of Robert N. Smith. (3) Includes revenues resulting from the Joint Marketing Agreement between the Company and Clear Channel Communications (CCC) pursuant to which CCC operates both WNAC, which is owned by the Company and WPRI, which is owned by CCC. The Company and CCC share equally the cash flow from these stations subject to certain adjustments. (4) Includes amortization of program rights. (5) Represents book gain on the swap of television stations WPTZ, WNNE, and KSBW with Hearst-Argyle Stations, Inc. for television stations WDTN and WNAC and the interest of WNAC in the Joint Marketing Agreement with CCC. (6) Consists primarily of approximately $1.5 million of non-recurring revenues for consulting services provided during 1996 and $825 expenses incurred in cancelled debt offering in 1999. (7) Reflects dividend requirement and accretion on the Series A and Series B redeemable preferred stock. (8) Broadcast cash flow consists of operating income (loss) plus depreciation of property and equipment, amortization of intangible assets and other assets, amortization of program rights, and corporate expense minus payments on program rights. (9) Broadcast cash flow margin is broadcast cash flow divided by net revenues expressed as a percentage. (10) EBITDA is defined as broadcast cash flow less corporate expenses. (11) For purposes of this calculation, "earnings" consist of net loss applicable to common stock before income tax (benefit) and fixed charges. "Fixed charges" consist of interest expense, amortization of deferred financing costs, the component of rental expense believed by management to be representative of the interest factor thereon and preferred stock dividend requirements and related accretion. If the ratio is less than 1.0x, the deficiency is shown. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The operating revenues of the Stations are derived primarily from advertising revenues and, to a much lesser extent, compensation paid by the networks to the Stations for broadcasting network programming. The Stations' primary operating expenses are employee compensation and related benefits, news gathering costs, film and syndicated programming expenditures and promotional costs. A significant proportion of the operating expenses of the Stations are fixed. The Stations receive revenues from advertising sold for placement within and adjoining its local programming and network programming. Advertising is sold in time increments and is priced primarily on the basis of a program's popularity within the demographic group an advertiser desires to reach, as measured principally by audience surveys conducted in February, May and November of each year. The ratings of local television stations affiliated with a national television network can be affected by ratings of network programming. Advertising rates are affected by the number of advertisers competing for the available time, the size and demographic makeup of the markets served by the television station and the availability of alternative advertising media in the market areas. Advertising rates are highest during the most desirable viewing hours, generally during local news programming, access (the hour before prime time), early fringe (3:00 p.m. to 5:00 p.m.) and prime time. Most advertising contracts are short-term and generally run for only a few weeks. A majority of the revenues of the Stations are generated from local advertising, which is sold primarily by a Station's sales staff, and the remainder of the advertising revenues represents national advertising, which is sold by independent national advertising sales representatives. The Stations generally pay commissions to advertising agencies on local and national advertising, and on national advertising the Stations pay commissions to the national sales representatives operating under 9 agreements that provide for exclusive representation within the particular Station market. In 1999, local advertising comprised 62.0% of the Company's gross spot revenues (excluding political advertising), and national advertising comprised 38.0% of the Company's gross spot revenues (excluding political advertising). The gross spot broadcast revenues of the Stations are generally highest in the second and fourth quarters of each year, due in part to increases in consumer advertising in the spring and retail advertising in the period leading up to and including the holiday season. Advertising spending by political candidates is typically heaviest during the fourth quarter. In 1998, the Stations' advertising revenues benefited from local and congressional elections and the Winter Olympic Games on CBS. "Broadcast Cash Flow" is defined as operating income (loss) plus depreciation of property and equipment, amortization of intangible assets and other assets, amortization of program rights, and corporate expenses less payments for program rights. EBITDA is defined as Broadcast Cash Flow less corporate expenses. The Company has included Broadcast Cash Flow and EBITDA data because such data are commonly used as a measure of performance for broadcast companies and are used by investors to measure a company's ability to service debt. Broadcast Cash Flow and EBITDA are not, and should not be used as an indicator or alternative to operating income, net loss or cash flow as reflected in the accompanying financial statements, is not intended to represent funds available for debt service, dividends, reinvestment or other discretionary uses, is not a measure of financial performance under generally accepted accounting principles and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with generally accepted accounting principles. This Annual Report on Form 10-K contains forward-looking statements. All statements other than statements of historical facts included herein may constitute forward-looking statements. The Company has based these forward-looking statements on our current expectations and projections about future events. Although we believe that our assumptions made in connection with the forward-looking statements are reasonable, we cannot assure you that our assumptions and expectations will prove to have been correct. These forward-looking statements are subject to various risks, uncertainties and assumptions including increased competition, increased costs, changes in network compensation agreements, impact of future acquisitions and dispositions, loss or retirement of key members of management, inability to realize our acquisition strategy, increases in costs of borrowings, unavailability of additional debt and equity capital, adverse state or federal legislation or changes in Federal Communications Commissions policies, and changes in general economic conditions. Readers are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. HISTORICAL PERFORMANCE (ALL DOLLARS PRESENTED IN TABLES ARE SHOWN IN THOUSANDS) BROADCAST CASH FLOW The following table sets forth certain data for the three years ended December 31, 1999. NET REVENUES Set forth below are the principal types of television revenues that the Company has generated for the periods indicated and the percentage contribution of each to total revenues. (1) Represents approximately 50% of the broadcast cash flow of WNAC and WPRI less certain adjustments. RESULTS OF OPERATIONS Set forth below is a summary of the operations of the Company for the years indicated and their percentages of net revenues. YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 In the discussion comparing the years ended December 31, 1999 and 1998, WTOV, WEYI, and WJAC will be referred to as the Core Stations. The acquisition of television stations KVLY, KFYR, KUMV, KQCD, KMOT (the Meyer Stations), and KRBC, KACB and WUPW will be referred to as the Station Acquisitions. The KRBC and KACB acquisition closed on April 1, 1998, the Meyer Stations acquisition closed on November 1, 1998, and the WUPW acquisition closed on February 1, 1999. The Company continues to own all of the stations acquired in the Station Acquisitions. The acquisition of WPTZ and WNNE from Sinclair, and the transfer to Hearst-Argyle Television, Inc. (Hearst) of KSBW, WPTZ and WNNE in exchange for WDTN, WNAC and WNAC's interest in a Joint Marketing Agreement with WPRI, will be referred to as the Swap Transaction. The sale of the non-license assets of WROC, and the entering into of a time brokerage agreement, will be referred to as the WROC Sale. The following table details how the above transactions affected operating income. Core Stations A decrease of $1.1 million in net sales was the result of less political sales during 1999 compared to 1998. The remaining decrease in sales in 1999 was due to a decrease in General Motors advertising and market specific softness. A decrease of $0.2 million in selling, general and administrative expense is a result of decreased sales costs. An increase of $0.2 million in depreciation is attributable to the increased capital spending and the $0.3 million reduction in amortization is attributable to the write off of loan costs during 1998. Corporate expenses increased by $1.2 million due to higher salary costs, additional staff and related benefits, new office space and increased professional service costs. Interest Expense Interest expense increased by $4.3 million to $20.6 million for the year ended December 31, 1999 from $16.3 million for the year ended December 31, 1998. An increase of $5.3 million is due to higher outstanding balances on the Senior Loan Agreement and higher interest rates. A decrease of approximately $0.9 million was due to no 1999 comparable amounts outstanding under the Hearst-Argyle loan. Gain on Sale of WROC Gain on the sale of WROC was $4.5 million for the year ended December 31, 1999 with no amount for the year ended December 31, 1998. Expenses Incurred in Cancelled Debt Offering During the second quarter of 1999, the Company and Sunrise contemplated selling either debt securities of Sunrise or preferred stock of the Company in a private placement to fund the acquisition under the Sinclair Agreement and repay the outstanding amounts under the Preferred Agreement. Sunrise and the Company subsequently determined that they would attempt to fund the Sinclair Agreement through an additional borrowing under the Senior Credit Agreement and by an additional capital contribution by Sunrise. The year ended December 31, 1999 includes an $0.8 million charge for the cancelled offering. Income Tax Benefit Income tax benefit increased by $9.3 million to $7.5 million for the year ended December 31, 1999 from an expense of $1.8 million for the year ended December 31, 1998. This increase is mainly attributable to deferred tax assets being generated by the Company's net operating loss carryforwards. Redeemable Preferred Stock Dividends and Accretion Redeemable preferred stock dividends and accretion increased $2.3 million to $7.4 million for the year ended December 31, 1999 from $5.1 million for the year ended December 31, 1998. An increase of $1.6 million is a result of the initial issuance of the Series B preferred stock during 1999 and the remainder of the increase resulted from higher outstanding balances on the Series A preferred stock. Net Loss Applicable to Common Stock Net loss applicable to common stock increased by $13.6 million to $20.5 million for the year ended December 31, 1999 from a loss of $6.9 million for the period ended December 31, 1998 due to the reasons outlined above. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 In the discussion comparing the year ended December 31, 1998 to 1997, WTOV, WEYI and WROC will be referred to as the Core Stations. The effect of the acquisition of television stations WJAC, KRBC, KACB, and the Meyer Stations will be referred to as the Station Acquisitions. The WJAC acquisition closed on October 1, 1997, KRBC and KACB acquisition closed on April 1, 1998, and the Meyer acquisition closed on November 1, 1998. The net change resulting from the transactions with Sinclair and Hearst (acquisition of WDTN, WNAC and its joint operating agreement with WPRI, and the disposition of KSBW, WPTZ and WNNE) will be referred to as the Swap Transaction. The Jupiter/Smith Stations operations are presented on a pre- acquisition cost basis and are not comparable with the Company's operations for periods subsequent to March 1, 1997. The 1997 financial information is a combination of the Company financial statements of the ten months ended December 31, 1997, and the Jupiter/Smith Stations financial statements for the two months ended February 28, 1997. The following table details how the above transactions affected operating income. Core Stations. An increase of $2.3 million in net revenue is a result of political advertising revenue. An increase of $0.5 million in station operating expense is attributable to increased costs at WEYI and WROC for expanded spending on news. An increase of $0.4 million in selling, general and administrative expenses was a result of increased sales costs and promotion. An increase of $0.2 million in depreciation expense is attributable to increased capital expenditures and an increase of $0.2 million in amortization is attributable to the revaluation of assets at the time of purchase by the Company on March 1, 1997. Corporate expenses increased by $0.8 million related to higher salary costs, additional staff and related benefits. Operating Income. Operating income increased by $1.1 million or 154.5% to $1.7 million for the year ended December 31, 1998 from $0.6 million for the year ended December 31, 1997 due to the reasons outlined above. Interest Expense. Interest expense increased by $5.8 million to $16.3 million for the year ended December 31, 1998 from $10.5 million for the year ended December 31, 1997. An increase of $1.8 million is due to higher average outstanding balances of the Senior Subordinated Notes resulting from the issuance in March of 1997. An increase of $2.0 million is due to higher outstanding balances on the Senior Credit Agreement resulting from Station Acquisitions, an increase of $0.9 million is due to interest payable to Hearst on the purchase of WPTZ, WNNE, and WFFF and operations of the stations through closing on May 31, 1998, and an increase of $1.1 million resulting from the Swap Transactions. Income Tax. Income tax increased by $2.1 million to $1.8 million for the year ended December 31, 1998 from a benefit of $0.3 million for the year ended December 31, 1997. This increase is attributable to the acquisition of WJAC, KRBC, and KACB, and the related amortization of the step up in basis of their assets for purchase accounting offset by the gain on asset swap. Gain on Asset Swap. Gain on asset swap was $17.5 million for the year ended December 31, 1998 with no gain for the year ended December 31, 1997. $7.9 million of the gain is attributable to the non-license assets of KSBW, $1.6 million is attributable to the non-license assets of WPTZ and WNNE, and $8.0 million is attributable to the FCC licenses of KSBW, WPTZ, and WNNE. Extraordinary Item. Extraordinary charge for early retirement of debt was $2.9 million for the year ended December 31, 1998 with no extraordinary item for the period ended December 31, 1997. The charge consists of $2.4 million of write offs related to the unamortized costs incurred on the issuance of the former Bank Credit Agreement and $2.2 million of fees incurred on the issuance of the Senior Credit Agreement, net of $1.7 million of taxes. Redeemable Preferred Stock Dividends and Accretion. Redeemable preferred stock dividends and accretion increased by $1.3 million to $5.1 million for the year ended December 31, 1998 from $3.8 million for the period ended December 31, 1997. The increase is attributable to twelve months in 1998 versus ten months in 1997 and higher average outstanding balances during 1998. Net Loss Applicable to Common Stock. Net loss applicable to common stock decreased by $4.7 million to $6.9 million for the year ended December 31, 1998 from a loss of $11.6 million for the period ended December 31, 1997 due to the reasons outlined above. Liquidity and Capital Resources As of December 31, 1999, the Company had $3.9 million in cash balances and net working capital of approximately $4.1 million. The Company's primary sources of liquidity are cash provided by operations, availability under the Senior Credit Agreement and the equity contributions by Sunrise. Net cash flows provided by operating activities decreased by $7.8 million to $6.1 million for the year ended December 31, 1999 from $13.9 million for the year ended December 31, 1998. The Company made interest and film payments of $20.6 million and $6.4 million, respectively, during the year ended December 31, 1999 compared to $16.3 million and $5.7 million, respectively for the year ended December 31, 1998. Net cash flows used in investing activities decreased by $103.3 million to $34.0 million for the year ended December 31, 1999 from $137.3 million for the year ended December 31, 1998. In 1999, the Company purchased WUPW for approximately $74.5 million, spent $5.8 million on capital expenditures and generated $46.0 million for the sale of WROC. Net cash flows provided by financing activities decreased by $100.6 million to $26.5 million for the year ended December 31, 1999 from $127.1 million for the year ended December 31, 1998. In 1999, the Company received a capital contribution of $15.0 million from Sunrise, sold $61.4 million of redeemable preferred stock Series B, redeemed $37.5 million of redeemable preferred stock Series B, paid $1.2 million of dividends on redeemable preferred stock Series B and decreased borrowings under the Senior Credit Agreement by a net of $11.3 million. The Company's liquidity needs consist primarily of debt service requirements for the Senior Credit Agreement and the 11% Senior Subordinated Notes (Senior Subordinated Notes), working capital needs, the funding of capital expenditures and potential acquisitions. The Company may incur additional indebtedness in the future, subject to certain limitations contained in the Senior Credit Agreement and the Senior Subordinated Notes and intends to do so in order to fund future acquisitions as part of its business strategy. The Company has historically funded acquisitions through a combination of borrowings and the receipt of capital contributions from Sunrise. Principal and interest payments under the Senior Credit Agreement and the Senior Subordinated Notes will represent significant liquidity requirements for the Company in the future. Loans under the Senior Credit Agreement bear interest at floating rates based upon the interest rate option selected by the Company. The Senior Credit Agreement and the Senior Subordinated Notes limit the Company's ability to pay cash dividends prior to 2002. The Senior Credit Agreement and the Senior Subordinated Notes impose certain limitations on the ability of the Company and its subsidiaries to, among other things, pay dividends or make restricted payments, consummate certain asset sales, enter into transactions with affiliates, incur liens, impose restrictions on the ability of a subsidiary to pay dividends or make certain payments to Sunrise, merge or consolidate with any person or sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of the assets of the Company. In 1997, the Company completed a private placement of $100.0 million principal amount of its Senior Subordinated Notes, which subsequently were exchanged for registered Senior Subordinated Notes having substantially identical terms. Interest on the Senior Subordinated Notes is payable on March 15 and September 15 of each year. On July 2, 1998, the Company entered into a Senior Credit Agreement with various lenders which provides a $100.0 million Term Loan Facility and $65.0 million Revolving Credit Facility. The term loan facility is payable in quarterly installments commencing on September 30, 1999 and ending June 3, 2006. The revolving loan facility requires scheduled annual reductions of the commitment amount commencing on September 30, 2001. At December 31, 1999, the Company had outstanding $98.5 million on the term loan facility and $1.25 million under the revolving loan facility. The Senior Credit Agreement provides for first priority security interest in all of the tangible and intangible assets of the Company and its direct and indirect subsidiaries. Any loans under the Senior Credit Agreement are guaranteed by Sunrise and the Company's current direct and indirect and any future subsidiaries. The Senior Credit Agreement and the Senior Subordinated Notes contain certain financial operating maintenance covenants including a maximum consolidation leverage ratio (currently 7.0:1), a minimum consolidated fixed charge coverage ratio (currently 1.05:1), and a consolidated interest coverage ratio (currently 1.3:1). The Company is limited in the amount of annual payments that may be made for capital expenditures and corporate overheard. The operating covenants of the Senior Credit Agreement and the Senior Subordinated Notes include limitations on the ability of the Company to (i) incur additional indebtedness, other than certain permitted indebtedness; (ii) permit additional liens or encumbrances, other than certain permitted liens; (iii) make any investments in other persons, other than certain permitted investments; (iv) become obligated with respect to contingent obligations, other than certain permitted contingent obligations; and (v) make restricted payments (including dividends on its common stock). The operating covenants include restrictions on certain specified fundamental changes, such as mergers and asset sales, transactions with shareholders and affiliates and transactions outside the ordinary course of business as currently conducted, amendments or waivers of certain specified agreements and the issuance of guarantees or other credit enhancements. At December 31, 1999, the Company was in compliance with the financing and operating covenants of both the Senior Credit Agreement and the Senior Subordinated Notes. On March 1, 1997, the Company issued 300,000 shares of Redeemable Preferred Stock Series A with an aggregate liquidation preference of $30.0 million, or $100 per share, which are entitled to quarterly dividends that will accrue at a rate per annum of 14%. Prior to February 28, 2002, dividends may be paid in either additional whole shares of Redeemable Preferred Stock Series A or cash, at the Company's option, and only in cash following that date. The Senior Subordinated Notes and the Senior Credit Agreement prohibit the payment of cash dividends until May 31, 2002. On February 5, 1999, the Company entered into an agreement (the Preferred Agreement) to sell up to $90.0 million of Redeemable Preferred Stock Series B to finance acquisitions by the Company from time to time. An aggregate of $37.5 million of Redeemable Preferred Stock was sold on February 5, 1999 to finance the acquisition of WUPW ($35.0 million) and to fund an escrow account ($2.5 million) to pay dividends on such Redeemable Preferred Stock Series B. On August 5, 1999, the Company repaid all amounts outstanding under the Preferred Agreement by borrowing $21.0 million under the Senior Credit Agreement, receiving a $15.0 million capital contribution from Sunrise and using $1.5 million in available cash. The borrowing availability under the Preferred Agreement was cancelled. On December 30, 1999, the Company issued and sold to Sunrise 25,000 shares of Redeemable Preferred Stock Series B with an aggregate liquidation preference of $25.0 million. Each share is entitled to quarterly dividends that will accrue at a 14% rate per annum. The Company's Senior Credit Agreement and Senior Subordinated Notes prohibit the payment of cash dividends until May 31, 2002. The Certificates of Designation for the Redeemable Preferred Stock Series A and B contain covenants customary for comparable securities including covenants that restrict the ability of the Company and its subsidiaries to incur additional indebtedness, pay dividends and make certain other restricted payments, to merge or consolidate with any other person or to sell, assign, transfer, lease, convey, or otherwise dispose of all or substantially all of the assets of the Company. Such covenants are substantially identical to those covenants contained in the Senior Subordinated Notes. Based on the current level of operations, anticipated future internally generated growth, additional borrowings under the Senior Credit Agreement and additional equity contributions from Sunrise, the Company anticipates that it will have sufficient funds to meet its anticipated requirements for working capital, capital expenditures, interest payments, and have funds available for additional acquisitions. The Company's future operating performance and ability to service or refinance the Senior Subordinate Notes and to extend or refinance the Senior Credit Agreement and Redeemable Preferred Stock Series A and B will be subject to future economic conditions and to financial, business, and other factors, many of which are beyond the control of the Company. The ability of the Company to implement its business strategy, and to consummate future acquisitions will require additional debt and significant equity capital, and no assurance can be given as to whether, and on what terms, such additional debt and/or equity capital will be available, including additional equity contributions from Sunrise. The degree to which the Company is leveraged could have a significant effect on its results of operations. Credit and Interest Rate Risks The Company's financial instruments that constitute exposed credit risks consist primarily of cash equivalents and trade receivables. The Company's cash equivalents consist solely of high quality securities. Concentrations of credit risks with respect to receivables are somewhat limited due to the large number of customers and to their dispersion across the geographic areas served by the Stations. No single customer amounts to 10% of the Company's total outstanding receivables. The Company was exposed to minimal market risk related to interest rates as of December 31, 1999. The Company's Senior Subordinate Debt is fixed at 11% and is due and payable on March 15, 2007. On September 11, 1998, the Company entered into a three year interest rate swap agreement to reduce the impact of changing interest rates on $70.0 million of its variable rate borrowings under the Senior Credit Agreement. The base interest rate was fixed at 5.15% plus the applicable borrowing margin (currently 2.125%) for an overall borrowing rate of 7.275% at December 31, 1999. On February 9, 1999, the Company entered into a two-year interest rate swap agreement, which was extendable by either party for an additional two years, to reduce the impact of changing interest rates on $40.0 million of its floating rate borrowings from the Senior Credit Agreement. The interest rate was fixed at 5.06% plus applicable borrowing margin. Due to the issuance by the Company on December 30, 1999 of $25.0 million of Redeemable Preferred Stock Series B to Sunrise and the subsequent reduction in outstanding balances under the Senior Credit Agreement, the Company terminated the swap agreement, but simultaneously entered into a new swap agreement that fixed the interest rate on $25.0 million of its floating rate borrowings for 18 months at 5%, plus the applicable borrowing margin (currently 2.125%), for an overall borrowing rate of 7.125% at December 31, 1999. The variable interest rates on these interest rate swap contracts are based upon the three month London Interbank Offered Rate (LIBOR) and the measurement and settlement is performed quarterly. The quarterly settlements of this agreement will be recorded as an adjustment to interest expense and are not anticipated to have a material effect on the operations of the Company. The counter party to the new interest rate swap agreement is one of the lenders under the Senior Credit Agreement. Capital Expenditures Capital expenditures were $5.8 million and $5.6 million for the years ended December 31, 1999 and 1998, respectively. Maintenance capital expenditures for the Company are estimated to be approximately $6.0 million per year beginning in 2000. In addition, we anticipate that the adoption of digital television will require a minimum capital expenditure of approximately $1.5 to $2.5 million per station to develop facilities necessary for transmitting a digital signal with the initial expenditures beginning in 2000. Depreciation, Amortization and Interest Because the Company has incurred substantial indebtedness in the acquisition of stations, for which it will have significant debt service requirements, and because the Company will have significant non-cash charges relating to the depreciation and amortization expense of the property, equipment, and intangibles that were acquired in the multiple station acquisitions, the Company expects that it will report net losses for the foreseeable future. Inflation The Company believes that its business is affected by inflation to an extent no greater than other businesses are generally affected. Current Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. SFAS No. 133, as amended by SFAS No. 137, is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. Management has not determined what effect this statement will have on the Company's consolidated financial statements. Network Affiliation Agreements In July 1999, the FOX Network entered into an agreement with WNAC and WUPW which required these affiliates to buy prime time spots from the FOX network. The Company's agreements with Fox Network commenced on July 15, 1999 and will terminate on June 30, 2002. Finalization of WNAC's network agreement is pending. As a result of these agreements, the Company does not expect its operating income with respect to such stations to decrease by a significant amount. In July 1999, the ABC Network entered into an agreement with WDTN-TV which required that WDTN contribute approximately $0.3 million to the network in return for additional prime time spots. The agreement contains certain additional items related to children clearances, NFL inventory, the Soap Channel cable revenue sharing, entertainment, sports and news exclusivity. The agreement has a term of three years beginning August 1, 1999. As a result of this agreement, the Company does not expect its operating income with respect to WDTN to decrease by a significant amount. FCC Issues On August 5, 1999, the FCC adopted changes in several of its broadcast ownership rules (collectively, the FCC Ownership Rules). These rule changes became effective on November 16, 1999; however, several petitions have been filed with the FCC seeking reconsideration of the new rules, so the rules may change. While the following discussion does not describe all of the ownership rules or rule changes, it attempts to summarize those rules that appear to be most relevant to the Company. The FCC relaxed its "television duopoly" rule, which barred any entity from having an attributable interest in more than one television station with overlapping service areas. Under the new rules, one entity may have attributable interests in two television stations in the same Nielsen Designated Market Area (DMA) provided that: (1) one of the two stations is not among the top four in audience share and (2) at least eight independently owned and operated commercial and noncommercial television stations will remain in the DMA if the proposed transaction is consummated. The new rules also permit common ownership of television stations in the same DMA where one of the stations to be commonly owned has failed, is failing or is unbuilt or where extraordinary public interest factors are present. In order to transfer ownership in two commonly owned television stations in the same DMA, it will be necessary to once again demonstrate compliance with the new rules. Lastly, the new rules authorize the common ownership of television stations with overlapping signal contours as long as the stations to be commonly owned are located in different DMAs. Similarly, the FCC relaxed its "one-to-a-market" rule, which restricts the common ownership of television and radio stations in the same market. One entity now may own up to two television stations and six radio stations or one television station and seven radio stations in the same market provided that (1) 20 independent media voices (including certain newspapers and a single cable system) will remain in the relevant market following consummation of the proposed transaction, and (2) the proposed combination is consistent with the television duopoly and local radio ownership rules. If fewer than 20 but more than 9 independent voices will remain in a market following a proposed transaction, and the proposed combination is otherwise consistent with the Commission's rules, a single entity may have attributable interests in up to two television stations and four radio stations. If these various "independent voices" tests are not met, a party generally may have an attributable interest in no more than one television station and one radio station in a market. The FCC made other changes to its rules that determine what constitutes "cognizable interest" in applying the FCC Ownership Rules (the Attribution Rules). Under the new Attribution Rules, a party will be deemed to have a cognizable interest in a television or radio station, cable system or daily newspaper that triggers the FCC's cross-ownership restrictions if (1) it is a non-passive investor and it owns 5% or more of the voting stock in the media outlet; (2) it is a passive investor (i.e., bank trust department, insurance company or mutual fund) and it owns 20% or more of the voting stock; or (3) its interests (which may be in the form of debt or equity (even if non-voting), or both) exceeds 33% of the total asset value of the media outlet and it either (i) supplies at least 15% of a station's weekly broadcast hours or (ii) has an attributable interest in another media outlet in the same market. The FCC also declared that local marketing agreements (LMAs) now will be attributable interests for purposes of the FCC Ownership Rules. The FCC will grandfather LMAs that were in effect prior to November 5, 1996, until it has completed the review of its attribution regulations in 2004. Parties may seek the permanent grandfathering of such an LMA, on a non-transferable basis, by demonstrating that the LMA is in the public interest and that it otherwise complies with FCC Rules. Finally, the FCC eliminated its "cross interest" policy, which had prohibited common ownership of a cognizable interest in one media outlet and a "meaningful" non-cognizable interest in another media outlet serving essentially the same market. It is difficult to assess how these changes in the FCC ownership restrictions will affect the Company's broadcast business. The recent changes to the FCC Ownership Rules may effect the Company's relationship with Smith Acquisition Company (SAC). The Company owns a substantial non-voting equity stake in SAC, which, together with a wholly owned subsidiary, owns WNAC-TV, Providence, Rhode Island, and WTOV-TV, Steubenville, Ohio. Under the new FCC Ownership Rules, the Company's formerly non-attributable interest in SAC has become attributable. Accordingly, the Company, and parties to the Company, must consider whether its other broadcast interests, when viewed in combination with those of SAC, are consistent with all relevant FCC Ownership Rules. The Company is in the process of conducting that review. To the extent the recent changes require the Company to modify its broadcast interests or ownership structure, the Company expects to act as necessary to remain in compliance with all relevant FCC Ownership Rules. With the changes in the FCC Ownership Rules, the Company no longer needs to maintain its waiver to own both KRBC-TV, Abilene, Texas, and KACB-TV, San Angelo, Texas, as the common ownership of these stations is now consistent with the Commission's Rules. On October 2, 1999, AMFM Inc. (AMFM) entered into an Agreement and Plan of Merger with Clear Channel Communications, Inc. (Clear Channel) and CCU Merger Sub, Inc. (Merger Sub), pursuant to which AMFM will be merged with and into Merger Sub and will become a wholly-owned subsidiary of Clear Channel (the AMFM Merger). Thomas O. Hicks, who is the Company's ultimate controlling shareholder, has an attributable interest in AMFM and currently is the Chairman and Chief Executive Officer of AMFM. AMFM and Clear Channel have announced that Mr. Hicks will serve as Vice Chairman of the combined entity. The Company is in the process of analyzing the impact of this AMFM Merger on the Company's operations and regulatory obligations. YEAR 2000 COMPLIANCE The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures that may create an inability for the Stations to broadcast their daily programming and generate revenues. Since its inception, the Company has been replacing and enhancing its computer systems acquired in station acquisitions to gain significant operational efficiencies and, through these same efforts, year 2000 compliant equipment and applications have been installed. In October of 1998, Company management initiated a company-wide program to prepare the Company's operations for the year 2000. The Company's program consisted of two phases. The first phase was an assessment of the Company's systems with respect to year 2000 compliance and the formulation of an action plan. During the assessment phase, the Company reviewed individual applications, as well as the computer hardware and satellite delivery systems. The assessment included information technology ("IT") and non-information technology systems. A comprehensive review and inventory was completed in the first quarter of 1999. This phase involved an assessment of the readiness of third party vendors and suppliers. The Company issued year 2000 readiness questionnaires to vendors. However, responses to these inquiries were limited or qualified. The assessment of the Company's IT and non-IT systems, and an action plan for remediation was substantially completed by June 30, 1999. The second phase of the Company's program was the implementation and testing of the remediations required based upon the conclusions reached from the assessments completed during the first phase. It is difficult for the Company to estimate all costs incurred to date related specifically to remediating year 2000 issues, since the Company has been replacing and enhancing its computer systems in the ordinary course of business. Total expenditures at December 31, 1999 amount to less than $2.0 million for the replacement and enhancement of these systems. Estimated future costs of remediation, if any, are not considered material to the Company's financial position and results of operations. To date, the Company has not experienced any significant computer or system problems during the first months of the year 2000 and has not recorded any reserve for future liability related to year 2000 readiness. The preceding Year 2000 disclosure is designated a "Year 2000 Readiness Disclosure" under the Year 2000 Information and Readiness Disclosure Act. PRO FORMA BASIS The pro forma financial information presents the results of operations of the Stations owned by the Company at December 31, 1999. The following pro forma financial information is not indicative of the actual results that would have been achieved had each station been owned on January 1, 1998, nor is it indicative of future results of operations. Pro Forma Net Revenues. Set forth below are the principal types of pro forma television revenues that the Company has generated for the periods indicated and the percentage contribution of each to total revenues. Pro Forma Results of Operations Set forth below is a summary of the pro forma results of operations of the Company for the periods indicated and their percentages of net revenue. Pro Forma Broadcast Cash Flow and EBITDA: The following table sets forth a computation of pro forma Broadcast Cash Flow and EBITDA. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK On September 11, 1998, the Company entered into a three year interest rate swap agreement to reduce the impact of changing interest rates on $70.0 million of its variable rate borrowings under the Senior Credit Agreement. The base interest rate was fixed at 5.15% plus the applicable borrowing margin (currently 2.125%) for an overall borrowing rate of 7.275% at December 31, 1999. On February 9, 1999, the Company entered into a two-year interest rate swap agreement, which was extendable by either party for an additional two years, to reduce the impact of changing interest rates on $40.0 million of its floating rate borrowings from the Senior Credit Agreement. The interest rate was fixed at 5.06% plus applicable borrowing margin. Due to the issuance by the Company on December 30, 1999 of $25.0 million of Redeemable Preferred Stock Series B to Sunrise and the subsequent reduction in outstanding balances under the Senior Credit agreement, the Company was forced to terminate the swap agreement, but simultaneously entered into a new swap agreement that fixed the interest rate on $25.0 million of its floating rate borrowings for 18 months at 5% plus the applicable borrowing margin (currently 2.125%) for an overall borrowing rate of 7.125% at December 31, 1999. The variable interest rates on both contracts are based upon the three month LIBOR and the measurement and settlement is performed quarterly. The quarterly settlements of this agreement will be recorded as an adjustment to interest expense and are not anticipated to have a material effect on the consolidated financial statements of the Company. The counter party to this agreement is one of the lenders under the Senior Credit Agreement. PART III ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Certified Public Accountants To the Stockholder of STC Broadcasting, Inc.: We have audited the accompanying consolidated balance sheets of STC Broadcasting, Inc. and subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, stockholder's equity and cash flows for the years ended December 31, 1999 and 1998, and the ten months ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of STC Broadcasting, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for the years ended December 31, 1999 and 1998 and the ten months ended December 31, 1997, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Tampa, Florida February 18, 2000 STC BROADCASTING, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) See accompanying notes to consolidated financial statements. STC BROADCASTING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share amounts) See accompanying notes to consolidated financial statements. STC BROADCASTING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (Dollars in thousands) See accompanying notes to consolidated financial statements. STC BROADCASTING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) See accompanying notes to consolidated financial statements. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) 1. ORGANIZATION AND NATURE OF OPERATIONS: The accompanying financial statements present the consolidated financial statements of STC Broadcasting, Inc. and subsidiaries (the Company). STC Broadcasting, Inc. was incorporated on November 1, 1996, in the state of Delaware, commenced operations on March 1, 1997, and is a wholly owned subsidiary of Sunrise Television Corp. (Sunrise). All of the common stock of Sunrise is owned by Sunrise Television Partners, L.P., of which the managing general partner is Thomas O. Hicks, an affiliate of Hicks, Muse, Tate and Furst, Incorporated (Hicks Muse). The Company operates the following commercial television stations (the Stations) at December 31, 1999: Various subsidiaries hold the assets of the Stations. One subsidiary, Smith Acquisition Company (SAC) has a one percent equity interest controlled by Smith Broadcasting Group, Inc., (SBG). SBG is controlled by Robert N. Smith, the Chief Executive Officer and a Director of Sunrise and the Company. SBG's interest in SAC, which includes the assets of WTOV and WNAC, represents an insignificant portion of the Company. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Basis of Presentation The accompanying consolidated financial statements include the consolidated accounts of the Company. All material intercompany items and transactions have been eliminated. Reclassifications Certain reclassifications have been made to the 1998 and 1997 financial statements to conform to the current year's presentation. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less to be cash equivalents. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Concentration of Risk and Accounts Receivable The Company serves the markets shown in Note 1 and accordingly, the revenue potential of the Company is dependent on the economy in these markets. The Company monitors the collectibility of its accounts receivable through continuing credit evaluations. Credit risk is limited due to the large number of customers comprising the Company's customer base and their dispersion across different geographic areas. Total provision for losses on doubtful accounts amounted to approximately $403, $351 and $34 for the years ended December 31, 1999 and 1998, and the ten months ended December 31, 1997, respectively. Program Rights The Company has agreements with distributors for the rights to television programming over contract periods which generally run from one to four years. Each contract is recorded as an asset and liability when the license agreement is signed or committed to by the Company. Program rights and the corresponding obligation are classified as current or long-term based on the estimated usage and payment terms. The capitalized cost of program rights for one-time only programs is amortized on a straight-line basis over the period of the program rights agreements. The capitalized cost of program rights for multiple showing syndicated program material is amortized on an accelerated basis over the period of the program rights agreements. Program rights are reflected in the consolidated balance sheets at the lower of unamortized cost or estimated net realizable value. Estimated net realizable values are based upon management's expectation of future advertising revenues, net of sales commissions, to be generated by the program material. Payments of program rights liabilities are typically paid on a scheduled basis and are not affected by adjustments for amortization or estimated net realizable value. Program Barter and Trade Transactions The Company purchases certain programming, which includes advertising time of the syndicator during the airing of the programs. The estimated fair value of advertising revenue received in program barter transactions is recognized as revenue and a corresponding program cost when the airtime is used by the advertiser. The Company broadcasts certain customers' advertising in exchange for equipment, merchandise, or services. The estimated fair value of the equipment, merchandise or services received is recorded as deferred trade costs, the corresponding obligation to broadcast advertising is recorded as deferred trade revenues, resulting in a net current asset or net current liability. The deferred trade costs are expensed or capitalized as they are used, consumed or received. Deferred trade revenues are recognized as the related advertising is aired. The following table summarizes program barter revenue and trade revenue. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Property and Equipment Property and equipment of the Stations acquired were recorded at the estimate of fair value based upon independent appraisals, and property and equipment acquired subsequent thereto is recorded at cost. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the assets, as follows: Expenditures for maintenance and repairs are charged to operations as incurred, whereas expenditures for renewals and betterments are capitalized. The major classes of property and equipment are as follows: Intangible Assets Intangible assets consist principally of values assigned to the Federal Communications Commission (FCC) licenses and network affiliation agreements of the Stations. Intangible assets are being amortized on the straight-line basis over 15 years. Intangible assets consist of the following: Other Assets Other assets consist of values assigned to deferred financing and acquisition costs and the non-current portion of program rights. Deferred financing costs are amortized over the applicable loan period (seven or ten years) on a straight-line basis, and deferred acquisition and organization costs are amortized over a five year period on a straight-line basis. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Other assets consist of the following: Revenue Recognition The Company's primary source of revenue is the sale of television time to advertisers. Revenue is recorded when the advertisements are broadcast and are net of agency and national representative commissions. Joint Operating Agreement The Company has a Joint Marketing and Programming Agreement with Clear Channel Communications (CCC) under which CCC programs certain airtime, including news programming for WNAC and manages the sale of commercial air time on WNAC and WPRI, the CBS station in Providence, for an initial period of ten years commencing July 1, 1996. The Company and CCC each receive 50% of the broadcast cash flow generated by the two stations subject to certain adjustments, as defined. This amount is recorded by the Company in income from joint operating agreement in the accompanying consolidated statements of operations. Income Taxes Income taxes are provided using the liability method in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Long-Lived Assets Long-lived assets and identifiable intangibles are reviewed periodically for impairment if events or changes in circumstances indicate that the carrying amount should be addressed. The Company has determined that there has been no impairment in the carrying value of long-lived assets of the Stations, as of December 31, 1999 and 1998. Fair Value of Financial Instruments The book value of all financial instruments approximates their fair value as of December 31, 1999 and 1998. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period. Actual results could differ from those estimates. Basic and Diluted Net Loss per Common Share Net loss per common share is computed as net loss applicable to common stockholder divided by STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) the weighted average number of shares of common stock outstanding. Current Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133). SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. SFAS 133, as amended by SFAS No. 137, is effective for all fiscal years beginning after June 15, 2000. Management has not determined what effect this statement will have on the Company's consolidated financial statements. 3. ACQUISITIONS AND DISPOSALS: 1999 Transactions On February 5, 1999, the Company acquired substantially all of the assets related to WUPW from Raycom Media, Inc. for approximately $74,487. WUPW, Channel 36, is the UHF FOX-affiliated television station serving the Toledo, Ohio market. The accompanying consolidated financial statements reflect the acquisition under the purchase method of accounting and include the results of operations from February 5, 1999. The acquired assets and assumed liabilities were recorded at fair value as of the date of acquisition. The approximate purchase price was allocated as follows: The acquisition was funded with $40,000 of borrowing under the Senior Credit Agreement (see Note 6) and the sale of $35,000 Redeemable Preferred Stock Series B (see Note 7). On March 3, 1999, the Company, STC License Company, a subsidiary of the Company, and Nexstar Broadcasting of Rochester, Inc. (Nexstar) entered into an asset purchase agreement (the Rochester Agreement) to sell to Nexstar the television broadcast license and operating assets of WROC, Rochester New York for approximately $46,000 subject to adjustment for certain customary proration amounts. On April 1, 1999, the Company completed the non-license sale of WROC assets to Nexstar for $43,000 and entered into a Time Brokerage Agreement with Nexstar under which Nexstar programmed most of the available time of WROC and retained the revenues from the sale of advertising time through the license closing on December 23, 1999. The Company recognized a gain of $4,500 from the sale. The results of operations for the years ended December 31, 1999 and 1998, include operations of each station acquired from the respective date of acquisition and exclude operations after stations have been disposed. The following table summarizes the unaudited condensed consolidated pro forma results of operations for the years ended December 31, 1999 and 1998 assuming the WUPW acquisition and the WROC sale had occurred on January 1, 1998. The pro forma information above is presented in response to applicable accounting rules relating to business acquisitions and is not necessarily indicative of the actual results that would have been achieved had each of the Stations been acquired at the beginning of 1998, nor is it indicative of the future results of operations. 1998 Transactions On April 1, 1998, the Company acquired 100% of the outstanding stock of Abilene Radio and Television Company (ARTC) for approximately $8,172. ARTC operated television stations KRBC and KACB, NBC affiliates for Abilene and San Angelo, Texas. The accompanying consolidated financial statements reflect the acquisition under the purchase method of accounting and include the results of operations from April 1, 1998. The acquired assets and assumed liabilities were recorded at fair value as of the date of acquisition. The approximate purchase price was allocated as follows: The acquisition was funded by borrowings under the Credit Agreement (see Note 6). In a series of transactions, the Company acquired certain assets from Hearst-Argyle Stations, Inc., (Hearst) through transactions structured as an exchange of assets (the Hearst Transaction). On February 3, 1998, the Company agreed to acquire WPTZ, WNNE, and a local marketing agreement (LMA) for WFFF from Sinclair Broadcast Group, Inc. for $72,000, with the intention of using these assets in the Hearst Transaction. WPTZ and WNNE are the NBC affiliates and WFFF is the FOX affiliate serving the Burlington, Vermont and Plattsburgh, New York television market. On February 18, 1998, the Company agreed with Hearst to trade KSBW, the NBC affiliate in Salinas, California, WPTZ and WNNE for WDTN, the ABC affiliate in Dayton, Ohio, WNAC, the FOX affiliate in Providence, Rhode Island, WNAC's interest in a Joint Marketing Programming Agreement with WPRI, the CBS affiliate in Providence, Rhode Island, and approximately $22,000 in cash. On April 24, 1998, the Company completed a purchase of non-license assets (all operating assets other than FCC licenses and other minor equipment) of WPTZ, WNNE and WFFF for $70,000. WFFF was sold by the Company to a related party on April 24, 1998 (see Note 8). Under the purchase method of accounting, the accompanying financial statements reflect the results of operations of WPTZ and WNNE for the period April 24, 1998 to May 31, 1998. Funds to complete the acquisition of WPTZ, WNNE, and WFFF were provided by Hearst. The assets acquired were pledged to Hearst under the related loan agreement which was repaid on July 3, 1998, the date the transaction closed. On June 1, 1998, the Company contractually received the benefits of the operation of stations WDTN, and WNAC and WNAC's joint operating agreement with WPRI. The accompanying consolidated financial statements reflect the asset swap using the purchase method of accounting and include the STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) results of operations from June 1, 1998. The Company recorded a book gain of approximately $17,457 on the asset swap. The fair value of the WDTN and WNAC assets were allocated as follows: The asset swap was funded by borrowings of $72,500 under the Senior Credit Agreement, $10,400 of additional contributed capital from Sunrise and available cash. On November 1, 1998, the Company acquired substantially all of the assets of KVLY, KFYR, KUMV, KMOT, and KQCD (the Meyer Stations) from Meyer Broadcasting for approximately $65,259. The accompanying consolidated financial statements reflect the acquisition under the purchase method of accounting and include results of operations from November 1, 1998. The acquired assets and assumed liabilities were recorded at fair value as of the date of acquisition. The purchase price was allocated as follows: The acquisition was funded by $43,500 of borrowing under the Senior Credit Agreement, $22,800 of additional contributed capital from Sunrise and available cash on hand. 1997 Transactions On March 1, 1997 , the Company acquired substantially all of the assets of WEYI, WROC, KSBW, and WTOV (the Jupiter/Smith Stations) from Jupiter/Smith TV Holdings, L.P. and Smith Broadcasting Partners, L.P. for approximately $163,176. The accompanying consolidated financial statements reflect the acquisition under the purchase method of accounting. Accordingly, the acquired assets and assumed liabilities were recorded at fair value as of the date of acquisition. The purchase price was allocated as follows: The acquisition was funded by $90,800 in borrowings under the Credit Agreement and the sale of preferred and common stock in the approximate amount of $77,500. On October 1, 1997, the Company acquired 100% of the outstanding stock of WJAC, Incorporated (WJAC) for approximately $36,078. The accompanying consolidated financial statements reflect the acquisition under the purchase method of accounting. Accordingly, the acquired assets and assumed STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) liabilities were recorded at fair value as of the date of acquisition. The purchase price was allocated as follows: The acquisition was funded by $17,000 of borrowing under the Credit Agreement, $15,000 of additional contributed capital from Sunrise, and available cash on hand. 4. ACCRUED EXPENSES: Accrued expenses consist of the following: 5. OBLIGATIONS FOR PROGRAM RIGHTS: The aggregate scheduled maturities of program rights obligations subsequent to December 31, 1999 are as follows: 6. LONG-TERM DEBT: To finance the Jupiter/Smith acquisition described in Note 3, the Company entered into a Credit Agreement with Chase Manhattan Bank and NationsBank of Texas, N.A., (the Credit Agreement), as agents for borrowings up to $95,000. The Credit Agreement provided for: (i) a seven-year term loan facility in the amount of $60,000 (the Term Loan Facility); and (ii) a seven-year revolving credit facility in the amount of $35,000 (the Revolving Credit Facility) both expiring on February 27, 2004. On March 25, STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 1997, the Company completed a private placement of $100,000 principal amount of its 11% Senior Subordinated Notes due March 15, 2007. Proceeds from the sale were used to repay all outstanding borrowings under the Credit Agreement and the Term Loan Facility was cancelled. The remaining net proceeds were available for general working capital purposes. On September 26, 1997, the Company completed an exchange offer in which all the original notes were exchanged for registered 11% Senior Subordinated Notes (Senior Subordinated Notes) of the Company having substantially the identical terms. On July 2, 1998, the Company entered into an Amended and Restated Credit Agreement (the Senior Credit Agreement) with various lenders which provides a $100,000 term loan facility and $65,000 revolving credit facility. On July 3, 1998, the Company borrowed $72,500 from the Senior Credit Agreement to fund the amounts owed Hearst under the Hearst Transaction, retire outstanding amounts under the Credit Agreement, pay transaction fees and provide for working capital needs. The Company recorded a pretax extraordinary loss of $4,586 on the retirement of the Credit Agreement. The loss consisted of $2,422 of previously unamortized costs incurred on the Credit Agreement and $2,164 of financing fees paid to the lenders of the Senior Credit Agreement. The Senior Credit Agreement bears interest at an annual rate, at the Company's option, equal to the applicable borrowing rate plus the applicable margin as defined in the Senior Credit Agreement (9.375% at December 31, 1999), or the Eurodollar Rate plus the applicable margin as defined in the Senior Credit Agreement (8.305% at December 31, 1999). Interest rates may be reduced in the event the Company meets certain financial tests relating to consolidated leverage. The Senior Credit Agreement provides for first priority security interests in all of the tangible and intangible assets of the Company and its direct and indirect subsidiaries. In addition, the loans under the Senior Credit Agreement are guaranteed by Sunrise and the Company's current direct and indirect and any future subsidiaries. The Senior Credit Agreement and the Senior Subordinate Notes contain certain financial and operating maintenance covenants including a maximum consolidation leverage ratio (currently 7.0:1), a minimum consolidated fixed charge coverage ratio (currently 1.05:1), and a consolidated interest coverage ratio (currently 1.3:1). The Company is limited in the amount of annual payments that may be made for capital expenditures and corporate expenses. The operating covenants of the Senior Credit Agreement and the Senior Subordinate Notes include limitations on the ability of the Company to: (i) incur additional indebtedness, other than certain permitted indebtedness; (ii) permit additional liens or encumbrances, other than certain permitted liens; (iii) make any investments in other persons, other than certain permitted investments; (iv) become obligated with respect to contingent obligations, other than certain permitted contingent obligations; and (v) make restricted payments (including dividends on its common stock). The operating covenants also include restrictions on certain specified fundamental changes, such as mergers and asset sales, transactions with shareholders and affiliates and transactions outside the ordinary course of business as currently conducted, amendments or waivers of certain specified agreements and the issuance of guarantees or other credit enhancements. At December 31, 1999, the Company was in compliance with the financing and operating covenants of both the Senior Credit Agreement and the Senior Subordinate Notes. On September 11, 1998, the Company entered into a three year interest rate swap agreement to reduce the impact of changing interest rates on $70,000 of its variable rate borrowings under the Senior Credit Agreement. The base interest rate was fixed at 5.15% plus the applicable borrowing margin (currently 2.125%) for an overall borrowing rate of 7.275% at December 31, 1999. On February 9, 1999, the Company entered into a two year interest rate swap agreement, which was extendable by the other party for an additional two years, to reduce the impact of changing interest rates on $40,000 of its floating rate borrowings from the Senior Credit Agreement. The interest rate was fixed at 5.06% plus the applicable borrowing margin. Due to the issuance by the Company on December 30, 1999 of $25,000 of Redeemable Preferred Stock Series B to Sunrise and the subsequent reduction in outstanding balances under the Senior Credit agreement, the Company terminated the swap agreement, but simultaneously STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) entered into a new swap agreement that fixed the interest rate on $25,000 of its floating rate borrowings for 18 months at 5%, plus the applicable borrowing margin (currently 2.125%), an overall borrowing rate of 7.125% at December 31, 1999. The variable interest rates on these contracts are based upon the three month London Inter Bank Offered Rate (LIBOR) and the measurement and settlement is performed quarterly. The quarterly settlements of this agreement will be recorded as an adjustment to interest expense and are not anticipated to have a material effect on the consolidated financial statements of the Company. The counter party to the new interest rate swap agreement is one of the lenders under the Senior Credit Agreement. Interest on the Senior Subordinate Notes is payable semiannually on March 15 and September 15 of each year. The Senior Subordinate Notes will mature on March 15, 2007. Except as described below, the Company may not redeem the Senior Subordinate Notes prior to March 15, 2002. On and after such date, the Company may redeem the Senior Subordinate Notes, in whole or in part, together with accrued and unpaid interest, if any, to the redemption date. In addition, at any time on or prior to March 15, 2000, the Company may, subject to certain requirements, redeem up to 25% of the aggregate principal amount of the Senior Subordinate Notes with the net cash proceeds from one or more Public Equity Offerings at a redemption price equal to 111% of the principal amount thereof plus accrued and unpaid interest, if any, to the redemption date, provided that after any such redemption, at least 75% of the aggregate principal amount of the Senior Subordinate Notes originally issued remain outstanding immediately after each such redemption. The Senior Subordinate Notes will not be subject to any sinking fund requirements. Upon a change of control, as defined, the Company will have the option, at any time on or prior to March 15, 2002, to redeem the Senior Subordinate Notes, in whole but not in part, at a redemption price equal to 100% of the principal amount thereof, plus accrued and unpaid interest plus the applicable premium and if the Senior Subordinate Notes are not redeemed or if such change of control occurs after March 15, 2002, the Company will be required to offer to repurchase the Senior Subordinate Notes at a price equal to 101% of the principal amount thereof, together with accrued and unpaid interest, if any, to the repurchase date. The Senior Subordinate Notes are unsecured and subordinated in right of payment to all existing and future senior indebtedness of the Company. The Senior Subordinate Notes rank pari passu with any future senior subordinated indebtedness of the Company and will rank senior to all other subordinated indebtedness of the Company. The indenture under which the Senior Subordinate Notes were issued permits the Company to incur additional indebtedness, including senior indebtedness subject to certain limitations. Long-term debt consists of the following: STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The following table shows scheduled payments on long-term debt: The following table shows interest expense for the periods indicated: 7. REDEEMABLE PREFERRED STOCK: Redeemable Preferred Stock consisted of the following: Redeemable Preferred Stock dividend and accretion consisted of the following: STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Series A In connection with the Jupiter/Smith Stations acquisition, the Company issued 300,000 shares of Redeemable Preferred Stock Series A with an aggregate liquidation preference of $30,000, or $100 per share, which is entitled to quarterly dividends that will accrue at a rate per annum of 14%. Prior to February 28, 2002, dividends may be paid in either additional whole shares of Redeemable Preferred Stock Series A or cash, at the Company's option, and only in cash following that date. The Senior Subordinate Notes and the Senior Credit Agreement prohibit the payment of cash dividends until May 31, 2002. The Redeemable Preferred Stock Series A is subject to mandatory redemption (subject to contractual and other restrictions with respect thereto and to the legal availability of funds therefor) in whole on February 28, 2008, at a price equal to the then effective liquidation preference thereof, plus all accumulated and unpaid dividends to the date of redemption. Prior to February 28, 2008, the Company has various options on redemption of the Redeemable Preferred Stock Series A at various redemption prices exceeding the liquidation preference. The Company may, at its option, subject to certain conditions, including its ability to incur additional indebtedness under the Senior Subordinate Notes and the Senior Credit Agreement, on any scheduled dividend payment date, exchange the Redeemable Preferred Stock Series A, in whole but not in part, for the Company's 14% subordinated exchange debentures due 2008 (the Exchange Debentures). Holders of the Redeemable Preferred Stock Series A will be entitled to receive $1.00 principal amount of Exchange Debentures for each $1.00 in liquidation preference of Redeemable Preferred Stock Series A. Holders of the Redeemable Preferred Stock Series A have no voting rights, except as otherwise required by law; however, the holders of the Redeemable Preferred Stock Series A, voting together as a single class, shall have the right to elect the lesser of the two directors or 25% of the total number of directors constituting the Board of Directors of the Company upon the occurrence of certain events, including but not limited to, the failure by the Company on or after February 28, 2002, to pay cash dividends in full on the Redeemable Preferred Stock Series A for six or more quarterly dividend periods, the failure by the Company to discharge any mandatory redemption or repayment obligation with respect to the Redeemable Preferred Stock Series A, the breach or violation of one or more of the covenants contained in the Certificate of Designation, or the failure by the Company to repay at final stated maturity, or the acceleration of the final stated maturity of, certain indebtedness of the Company. The Certificate of Designation for the Redeemable Preferred Stock Series A and the indenture for the Exchange Debentures contain covenants customary for securities comparable to the Redeemable Preferred Stock Series A and the Exchange Debentures, including covenants that restrict the ability of the Company and its subsidiaries to incur additional indebtedness, pay dividends and make certain other restricted payments, to merge or consolidate with any other person or to sell, assign, transfer, lease, convey, or otherwise dispose of all or substantially all of the assets of the Company. Such covenants are substantially identical to those covenants contained in the Senior Subordinate Notes. Series B On February 5, 1999, the Company entered into a $90,000 Redeemable Preferred Stock Series B bridge financing agreement (the Preferred Agreement) with three purchasers, two of which are participants in the Senior Credit Agreement, and sold $35,000 or 35,000 shares of Redeemable Preferred Stock Series B to fund the WUPW purchase, and $2,500 or 2,500 shares to fund an escrow account to pay dividends on the stock. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) On August 5, 1999, the Company repaid all amounts outstanding under the Preferred Agreement by a borrowing of $21,000 under the Senior Credit Agreement, a $15,000 capital contribution from Sunrise, and $1,500 of available cash. The availability for selling additional preferred stock under the Preferred Agreement was cancelled. On December 30, 1999, the Company sold to Sunrise 25,000 shares of Redeemable Preferred Stock Series B with an aggregate liquidation preference of $25,000. Each share is entitled to quarterly dividends that will accrue at 14% rate per annum. The Company's Senior Credit Agreement and Senior Subordinated Notes prohibit the payment of cash dividends until May 31, 2002. The Redeemable Preferred Stock Series B is subject to mandatory redemption in whole on February 28, 2008 at a price equal to the then effective liquidation preference per share plus an amount in cash equal to all accumulated and unpaid dividends per share. Prior to February 28, 2008, the Company can redeem the Redeemable Preferred Stock Series B at the then effective liquidation preference per share plus an amount in cash equal to all accumulated and unpaid dividend per share. In the event of a Change of Control (as defined in the Certificate of Designation for the Redeemable Preferred Stock Series B), the Company must offer to purchase all outstanding shares at the then effective liquidation preference per share plus an amount in cash equal to all accumulated and unpaid dividends per share. With respect to dividends and distributions upon liquidation, winding-up and dissolution of the Company, the Redeemable Preferred Stock Series B ranks senior to all classes of common stock of the Company and the Redeemable Preferred Stock Series A of the Company. Holders of the Redeemable Preferred Stock Series B have no voting rights, except as otherwise required by law or as expressly provided in the Certificate of Designation for the Redeemable Preferred Stock Series B; however, the holders of the Redeemable Preferred Stock Series B, voting together as a single class, shall have the right to elect the lesser of two directors or 25% of the total number of directors constituting the Board of Directors of the Company upon the occurrence of certain events, including but not limited to, the failure by the Company on or after February 28, 2002, to pay cash dividends in full on the Redeemable Preferred Stock Series B for six or more quarterly dividend periods or the failure by the Company to discharge any mandatory redemption or repayment obligation with respect to the Redeemable Preferred Stock Series B or the breach or violation of one or more of the covenants contained in the Certificate of Designation or the failure by the Company to repay at final stated maturity, or the acceleration of the final stated maturity of, certain indebtedness of the Company. The Certificate of Designation for the Redeemable Preferred Stock Series B contains covenants customary for securities comparable to the Redeemable Preferred Stock Series B, including covenants that restrict the ability of the Company and its subsidiaries to incur additional indebtedness, pay dividends and make certain other restricted payments, to merge or consolidate with any other person or to sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of the assets of the Company. Such covenants are substantially identical to those covenants contained in the Senior Subordinated Notes. 8. TRANSACTIONS WITH AFFILIATES: On March 1, 1997, Sunrise and the Company entered into a ten-year agreement (the Monitoring and Oversight Agreement) with an affiliate of Hicks Muse (Hicks Muse Partners) pursuant to which Sunrise and the Company have agreed to pay Hicks Muse Partners an annual fee payable quarterly for oversight and monitoring services to the Company. The annual fee is adjustable on January 1, of each calendar year to an amount equal to 0.2% of the budgeted consolidated annual net revenues of the Company and its subsidiaries for the then-current fiscal year plus reimbursement of certain expenses. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The Monitoring and Oversight Agreement makes available the resources of Hicks Muse Partners concerning a variety of financial and operational matters. The Company does not believe that the services that have been, and will continue to be, provided to the Company by Hicks Muse Partners could otherwise be obtained by the Company without the addition of personnel or the engagement of outside professional advisors. In the Company's opinion, the fees provided for under the Monitoring and Oversight Agreement reasonably reflect the benefits received, and to be received, by Sunrise and the Company. Total payments related to this agreement amounted to approximately $233, $201 and $139 for the years ended December 31, 1999, 1998 and the ten months ended December 31, 1997, respectively. On March 1, 1997, Sunrise and the Company entered into a ten-year agreement (the Financial Advisory Agreement) pursuant to which Hicks Muse Partners received a financial advisory fee of 1.5% of the transaction value at the closing of the Jupiter/Smith acquisition as compensation for its services as financial advisor to the Company. Hicks Muse Partners is entitled to receive a fee equal to 1.5% of the "transaction value" for each "add-on transaction" in which the Company is involved. The term "transaction value" means the total value of the add-on transaction including, without limitation, the aggregate amount of the funds required to complete the add-on transaction (excluding any fees payable pursuant to the Financial Advisory Agreement), including the amount of any indebtedness, preferred stock or similar terms assumed (or remaining outstanding). The term "add-on transaction" means any future proposal for a tender offer, acquisition, sale, merger, exchange offer, recapitalization, restructuring or other similar transaction directly involving the Company or any of its subsidiaries, and any other person or entity. The Financial Advisory Agreement makes available the resources of Hicks Muse Partners concerning a variety of financial and operational matters. The Company does not believe that the services that have been, and will continue to be provided by Hicks Muse Partners could otherwise be obtained by the Company without the addition of personnel or the engagement of outside professional advisors. In the Company's opinion, the fees provided for under the Financial Advisory Agreement reasonably reflect the benefits received and to be received by the Company. Total fees paid under this agreement for the years ended December 31, 1999, 1998 and the ten month period ended December 31, 1997 were $1,764, $2,723 and $3,356, respectively, and were capitalized as cost of acquisition or netted against preferred stock. On March 1, 1997, affiliates of Hicks Muse purchased 250,000 shares of the Redeemable Preferred Stock Series A for a purchase price of approximately $24,100 (or 96.5% of the initial liquidation preference of such shares) and received in connection therewith warrants to purchase shares of common stock of Sunrise. The Hicks Muse affiliates, along with the other purchaser of the Redeemable Preferred Stock Series A and warrants, received certain registration rights with respect to the shares of common stock of Sunrise issuable upon exercise of the warrants. The Company has elected to participate in a Hicks Muse affiliate insurance program which covers vehicles, buildings, equipment, libel and slander, liability and earthquake damage. The Company pays actual invoice costs and no employee of Hicks Muse is compensated for these services other than through the above Monitoring and Oversight Agreement. Management believes the amounts paid are representative of the services provided. The Company has elected to participate in the Sunrise health, life, vision and dental program, long and short-term disability, travel accident and long-term care program. Management believes the amounts paid are representative of the services provided. A defined contribution 401(k) savings plan is provided to employees of the Company by Sunrise. Employees of the Company who have been employed for six months and who have attained the age of 21 years are generally eligible to participate. Certain employees represented by one union have elected not to participate in the Plan and have established their own plan. Total contributions by the STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Company to the defined contribution 401(k) savings plan were approximately $492, $341 and $135 for the years ended December 31, 1999 and 1998, and the ten months ended December 31, 1997, respectively. The Company has contracts with national representation firms to sell advertising time. During 1998, entities controlled by Hicks Muse acquired certain of these firms. In 1999, the Company entered into extensions of certain of these contracts in the normal course of business on terms and conditions which the Company considered representative of current market conditions. On April 24, 1998, the Company sold to Robert N. Smith the assets and certain rights and obligations related to WFFF for $500. The purchase price was secured by a note and liens on all of the assets sold and on July 23, 1998, the Company received full payment on the note. 9. PENSION PLAN: In October 1997, the Company approved the termination of two WJAC non-contributory, defined benefit pension plans (the Plans) covering principally all full-time salaried and hourly employees and certain part-time employees of WJAC. Effective December 31, 1997, the Company froze pension benefits at the current level and suspended future benefit accruals. The Company terminated the Plans during 1998. Final distribution to current and former employees and expenses related to the termination were paid out of the Plans' assets in 1998. 10. INCOME TAXES: STC Broadcasting, Inc. files a consolidated federal income tax return with all qualified subsidiaries. All nonqualifying subsidiaries file a separate federal income tax return. STC Broadcasting, Inc. and certain subsidiaries file separate state income tax returns. The provision (benefit) for income taxes consists of the following for the years ended December 31, 1999 and 1998 and the ten months ended December 31, 1997: Deferred taxes reflect the tax effect on temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Components of the Company's net deferred tax liability as of December 31, 1999 and 1998, are as follows: STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The Company has federal and state NOL carryforwards which expire from 2012 through 2019. During the years ended December 31, 1999 and 1998 and the ten months ended December 31, 1997, the Company created $1,509, $588, and $392, respectively, of valuation allowance to reserve for deferred tax assets resulting from nonqualifying subsidiaries' NOLs for the tax reporting period and for other deferred tax assets. During 1997, the Company created approximately $2,453 in valuation allowance to reserve for deferred tax assets created as a result of STC Broadcasting, Inc. and qualified subsidiaries' NOLs. This valuation allowance was reversed as a result of the WJAC acquisition and the reversal was charged against the intangible assets of WJAC in accordance with the provisions of SFAS No. 109 "Accounting for Income Taxes." The reconciliation of the income tax provision (benefit) based on the federal statutory income tax rate (34 percent) to the Company's income tax provision (benefit) is as follows for the years ended December 31, 1999 and 1998 and for the ten months ended December 31, 1997: 11. COMMITMENT AND CONTINGENCIES: Legal Proceedings The Company is subject to legal proceedings and claims in the normal course of business. In the opinion of management, after discussion with legal counsel, the amount of ultimate liability with respect to these actions will not materially affect the financial position or results of operations of the Company. Management Contracts On March 1, 1997, the Company entered into five-year employment agreements with four members of senior management for minimum base compensation of $250 and an annual bonus STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) based upon criteria established by the Board of Directors. If prior to the fourth anniversary of the executive officers employment date, the executive officer terminates his employment for good reason, as defined, or Sunrise or the Company terminate his employment for any reason other than for cause, as defined, then such executive officer shall be paid his salary and shall continue to be covered by certain employee benefit plans for 12 months or until the third anniversary of the employment date, whichever period is longer; provided, however, that continued coverage under any employee benefit plan of Sunrise or the Company shall terminate upon such executive officer becoming eligible for comparable benefits pursuant to new employment. In the event of a change of control (as defined in the employment agreements) prior to the fourth anniversary of the employment date, either Sunrise, the Company, or the executive officer may terminate the employment agreement concurrently with sale and receive the salary and benefits on the same terms described in the preceding sentence. Employees At December 31, 1999, the Company had 623 full time and 81 part time employees. The Company had 199 employees represented by six different union locals with these union contracts expiring as follows: two in 2000, three in 2002, and one in 2003. No significant labor problems have been experienced by the Stations. The Company considers its overall labor relations to be good, however, there can be no assurance that the Company's collective bargaining agreements will be renewed in the future or that the Company will not experience a prolonged labor dispute which could have a material adverse effect on the Company's business, financial position and/or results of operations. FCC Issues On August 5, 1999, the FCC adopted changes in several of its broadcast ownership rules (collectively, the FCC Ownership Rules). These rule changes became effective on November 16, 1999; however, several petitions have been filed with the FCC seeking reconsideration of the new rules, so the rules may change. While the following discussion does not describe all of the ownership rules or rule changes, it attempts to summarize those rules that appear to be most relevant to the Company. The FCC relaxed its "television duopoly" rule, which barred any entity from having an attributable interest in more than one television station with overlapping service areas. Under the new rules, one entity may have attributable interests in two television stations in the same Nielsen Designated Market Area (DMA) provided that: (1) one of the two stations is not among the top four in audience share and (2) at least eight independently owned and operated commercial and noncommercial television stations will remain in the DMA if the proposed transaction is consummated. The new rules also permit common ownership of television stations in the same DMA where one of the stations to be commonly owned has failed, is failing or is unbuilt or where extraordinary public interest factors are present. In order to transfer ownership in two commonly owned television stations in the same DMA, it will be necessary to once again demonstrate compliance with the new rules. Lastly, the new rules authorize the common ownership of television stations with overlapping signal contours as long as the stations to be commonly owned are located in different DMAs. Similarly, the FCC relaxed its "one-to-a-market" rule, which restricts the common ownership of television and radio stations in the same market. One entity now may own up to two television stations and six radio stations or one television station and seven radio stations in the same market provided that (1) 20 independent media voices (including certain newspapers and a single cable system) will remain in the relevant market following consummation of the proposed transaction, and (2) the proposed combination is consistent with the television duopoly and local radio ownership rules. If fewer than 20 but more than 9 independent voices will remain in a market following a proposed transaction, and the proposed combination is otherwise consistent with the FCC's rules, a single entity may have STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) attributable interests in up to two television stations and four radio stations. If these various "independent voices" tests are not met, a party generally may have an attributable interest in no more than one television station and one radio station in a market. The FCC made other changes to its rules that determine what constitutes "cognizable interest" in applying the FCC Ownership Rules (the Attribution Rules). Under the Attribution Rules, a party will be deemed to have a cognizable interest in a television or radio station, cable system or daily newspaper that triggers the FCC's cross-ownership restrictions if: (1) it is a non-passive investor and it owns 5% or more of the voting stock in the media outlet; (2) it is a passive investor (i.e., bank trust department, insurance company or mutual fund) and it owns 20% or more of the voting stock; or (3) its interests (which may be in the form of debt or equity (even if non-voting), or both) exceeds 33% of the total asset value of the media outlet and it either (i) supplies at least 15% of a station's weekly broadcast hours or (ii) has an attributable interest in another media outlet in the same market. The FCC also declared that local marketing agreements (LMAs) now will be attributable interests for purposes of the FCC Ownership Rules. The FCC will grandfather LMAs that were in effect prior to November 5, 1996, until it has completed the review of its attribution regulations in 2004. Parties may seek the permanent grandfathering of such an LMA, on a non-transferable basis, by demonstrating that the LMA is in the public interest and that it otherwise complies with FCC Rules. Finally, the FCC eliminated its "cross interest" policy, which had prohibited common ownership of a cognizable interest in one media outlet and a "meaningful" non-cognizable interest in another media outlet serving essentially the same market. The recent changes to the FCC Ownership Rules may effect the Company's relationship with Smith Acquisition Company (SAC). The Company owns a substantial non-voting equity stake in SAC, which, together with a wholly owned subsidiary, owns WNAC-TV, Providence, Rhode Island, and WTOV-TV, Steubenville, Ohio. Under the new FCC Ownership Rules, the Company's formerly non-attributable interest in SAC has become attributable. Accordingly, the Company, and parties to the Company, must consider whether its other broadcast interests, when viewed in combination with those of SAC, are consistent with all relevant FCC Ownership Rules. The Company is in the process of conducting that review. To the extent the recent changes require the Company to modify its broadcast interests or ownership structure, the Company expects to act as necessary to remain in compliance with all relevant FCC Ownership Rules. With the changes in the FCC Ownership Rules, the Company no longer needs to maintain its waiver to own both KRBC-TV, Abilene, Texas, and KACB-TV, San Angelo, Texas, as the common ownership of these stations is now consistent with the FCC's Rules. On October 2, 1999, AMFM Inc. (AMFM) entered into an Agreement and Plan of Merger with CCC and CCU Merger Sub, Inc. (Merger Sub), pursuant to which AMFM will be merged with and into Merger Sub and will become a wholly-owned subsidiary of CCC (the AMFM Merger). Thomas O. Hicks, who is the Company's ultimate controlling shareholder, has an attributable interest in AMFM and currently is the Chairman and Chief Executive Officer of AMFM. AMFM and CCC have announced that Mr. Hicks will serve as Vice Chairman of the combined entity. The Company is in the process of analyzing the impact of this AMFM Merger on the Company's operations and regulatory obligations. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Lease Commitments The Company leases certain tower and studio facilities, satellite sales and news offices and corporate offices. Total rental expense was approximately $421, $132 and $98 for the years ended December 31, 1999 and 1998, and the ten months ended December 31, 1997, respectively. At December 31, 1999, the total minimum annual rental commitments under non cancelable leases for studio, transmitter, satellite sales and news offices, and corporate offices excluding minor translator sites, are as follows: The lease on the WUPW transmitter site is a 99 year lease with an end date of December 2, 2089. The Company has an option to purchase the property on August 1, 2018 at fair market value. The above lease commitment disclosure includes the monthly payments, (presently $5 a month plus an annual 3% increase) through the option date. 13. CANCELLED PRIVATE PLACEMENT During 1999, the Company and Sunrise had plans to sell debt securities of Sunrise or preferred stock of the Company in a private placement to complete the Sinclair Agreement (see Note 15) and repay the outstanding amounts under the Preferred Agreement. Sunrise and the Company subsequently determined that they would attempt to fund the Sinclair Agreement through an additional borrowing under the Senior Credit Agreement and by an additional capital contribution by Sunrise. The results of operations for the year ended December 31, 1999 include a charge of $825 for expenses incurred in the cancelled private placement. 14. SEGMENT INFORMATION The Company has 11 reportable segments, two license corporations and a corporate office in accordance with SFAS 131, "Disclosures about Segments of an Enterprise and Related Information." These segments are television stations in designated market areas (DMA) as defined by A. C. Nielsen Company. The majority of each segments' revenues are broadcast related. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on operating income before interest income, interest expense, income taxes, nonrecurring gains and losses, and extraordinary items. The Company has no significant intersegment sales or transfers other than interest that is allocated to subsidiaries but not divisions. All segments have local distinct management separate from corporate management. Each management team is evaluated based upon the results of operations of their station. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The following tables set forth information by segments, aggregated with segments that have similar economic characteristics, and reconciles segment information to the consolidated financial statements. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (1) The extraordinary loss of early retirement of debt and tax provision and benefit were allocated entirely to the corporate office. (2) Interest expense is allocated to various subsidiaries, which own WJAC, KRBC, KACB, WTOV and WNAC. STC BROADCASTING, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 15. PENDING SINCLAIR ACQUISITIONS: On March 16, 1999, the Company and Sinclair Communications, Inc. (Sinclair) entered into a purchase agreement (the Sinclair Agreement). Pursuant to the Sinclair Agreement, the Company agreed to purchase from Sinclair: WICS, Channel 20, Springfield, Illinois; WICD, Channel 15, Champaign, Illinois; and KGAN, Channel 2, Cedar Rapids, Iowa for a total purchase price of $87.0 million, including working capital, fees and expenses. WICS and WICD are NBC affiliates and KGAN is a CBS affiliate. Closing of this purchase is subject to customary conditions, including review by the Department of Justice and the Federal Communications Commission (FCC). In April 1999, the Antitrust Division of the United States Department of Justice (DOJ) issued various requests for additional information under the Hart-Scott-Rodino Antitrust Improvement Act (HSR Act) in connection with the acquisition. The Company and Sinclair are in discussions with the DOJ regarding this transaction, and the waiting period under the HSR Act has been extended pending completion of these discussions. While the resolution of these discussions remains uncertain, it appears likely that, if the acquisition is consummated as contemplated under the Sinclair Agreement, the Company would be required by the DOJ to sell, or enter into a local marketing agreement with respect to, WICS and WICD substantially concurrently with the closing of the acquisition of those stations, if it occurs at all. Under the terms of the Sinclair Agreement, either the Company or Sinclair (to the extent they are not in breach) may terminate the Sinclair Agreement if the closing has not occurred on or prior to March 16, 2000. The Company is presently exploring a variety of alternatives, including possibly a sale of WICS and WICD, but cannot be sure of the terms on which this transaction will be completed, if at all. The Company has assigned the right to acquire the broadcast licenses and other license assets of the Sinclair Stations to SDF Television License Corp. (SDF), an entity separate from the Company, but owned by members of the Company's senior management team. On April 2, 1999, SDF filed applications seeking FCC consent to the assignment of the licenses of WICS, WICD and KGAN. The application has been accepted for filing, and no petitions to deny were filed by the May 13, 1999 deadline, although informal objections advocating denial of the applications may be filed up until the date that the FCC grants the applications. The application is still pending before the FCC, and accordingly, the Company cannot be sure when the application will be granted, if at all. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To Jupiter/Smith TV Holdings, L.P.: We have audited the accompanying combined statements of operations, partners' equity and cash flows of Smith Television of Michigan, L.P., Smith Television of Rochester, L.P., Smith Television - WTOV, L.P. and Smith Television of Salinas-Monterey, L.P., and their respective licensed subsidiaries, (collectively, the Partnerships) for the two months ended February 28, 1997, and the year ended December 31, 1996. These financial statements are the responsibility of the Partnerships' management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material respects, the results of the Partnerships' operations and cash flows for the two months ended February 28, 1997, and the year ended December 31, 1996, in conformity with generally accepted accounting principles. As discussed in Note 2, on March 1, 1997, Jupiter/Smith TV Holdings, LP. and Smith Broadcasting Partners, L.P. sold substantially all of the assets of the Partnerships to STC Broadcasting, Inc. and Smith Acquisition Company. Arthur Andersen, LLP Tampa, Florida February 18, 1998 SMITH TELEVISION OF MICHIGAN, L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P., AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. COMBINED STATEMENTS OF OPERATIONS See accompanying notes to combined financial statements. SMITH TELEVISION OF MICHIGAN, L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P., AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. COMBINED STATEMENTS OF PARTNERS' EQUITY See accompanying notes to combined financial statements. SMITH TELEVISION OF MICHIGAN, L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P., AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. COMBINED STATEMENTS OF CASH FLOWS See accompanying notes to combined financial statements. SMITH TELEVISION OF MICHIGAN, L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P., AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1996 AND FEBRUARY 28, 1997 1. ORGANIZATION AND NATURE OF OPERATIONS: The accompanying financial statements present the combined results of operations, partners' equity, and cash flows for the year ended December 31, 1996 and the two months ended February 28, 1997 of four limited partnerships: Smith Television of Michigan, L.P., Smith Television of Rochester, L.P., Smith Television - WTOV, L.P. and Smith Television of Salinas-Monterey, L.P., and their respective licensed subsidiaries, (collectively, the Partnerships). The Partnerships own the following commercial television stations: WEYI, Saginaw, Flint and Bay City, Michigan; WROC, Rochester, New York; WTOV, Wheeling, West Virginia and Steubenville, Ohio; and KSBW, Monterey-Salinas, California (collectively, the Stations). Stations WEYI, WTOV and KSBW are NBC affiliates and station WROC is a CBS affiliate. The Partnerships are controlled by Jupiter/Smith TV Holdings, L.P. (Jupiter/Smith) and Smith Broadcasting Partners, L.P. (SBP). Under the terms of the Partnerships' agreements, SBP is the managing general partner. Income and loss is generally allocated based on capital contribution percentages. The Partnerships were formed on December 13, 1995 and acquired the Stations in January 1996 for a total purchase price of approximately $105,400,000, including transaction fees and working capital. The combined financial statements reflect the acquisitions of the Stations under the purchase method of accounting. Accordingly, the acquired assets and liabilities were recorded at fair value as of the date of acquisition. The acquisition price of approximately $105,400,000 was allocated based upon appraised values resulting in approximately $27,600,000, $71,800,000 and $6,000,000 being assigned to property and equipment, intangibles (including deferred financing and organizational costs), and working capital, respectively. The transaction was funded by the Credit Agreement and partners' contributions. Management does not consider the results of operations of the Stations from January 1, 1996, to the dates the Stations were acquired to be significant. 2. SALE OF THE ASSETS OF THE PARTNERSHIPS: On March 1, 1997, Jupiter/Smith and SBP completed the sale of substantially all of the assets of the Partnerships to STC Broadcasting, Inc. (STC) and Smith Acquisition Company (SAC) for an aggregate sales price of approximately $157,000,000. In connection with the sale, STC and SAC will assume the Partnerships' television programming obligations, certain accounts payable and accrued liabilities, and certain other obligations relating to the operations of the Stations after the closing date. The Partnerships will retain all other liabilities of the Partnerships, including the Credit Agreement with Chase Manhattan Bank. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Basis of Presentation The accompanying financial statements include the combined accounts of the Partnerships. The Partnerships are combined because of common ownership, management and relationship of operations. All material items and transactions between the Partnerships have been eliminated. Cash and Cash Equivalents The Partnerships consider all highly liquid investments with a maturity of three months or less to be cash equivalents. SMITH TELEVISION OF MICHIGAN, L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P., AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. NOTES TO COMBINED FINANCIAL STATEMENTS - (CONTINUED) Concentration of Risk and Accounts Receivable The Partnerships serve the Saginaw, Flint and Bay City, Michigan; Rochester, New York; Wheeling, West Virginia and Steubenville, Ohio; and Monterey and Salinas, California, demographic areas. Accordingly, the revenue potential of the Partnerships is dependent on the economy in these diverse areas. The Partnerships monitor their accounts receivable through continuing credit evaluations. Historically, the Partnerships have not had significant uncollectible accounts. Program Rights The Partnerships have agreements with distributors for the rights to television programming over contract periods which generally run from one to four years. Each contract is recorded as an asset and liability when the license agreement is signed. The capitalized cost of program rights for one-time only programs is amortized on a straight-line basis over the period of the program rights agreements. The capitalized cost of program rights for multiple showing syndicated program material is amortized on an accelerated basis over the period of the program rights agreement. Program rights are reflected in the consolidated financial statements at the lower of unamortized cost or estimated net expectation of future advertising revenues net of sales commissions to be generated by the program material. Property and Equipment Property and equipment acquired in purchase transactions are recorded at the estimate of fair value based upon independent appraisals and property and equipment acquired subsequent thereto are recorded at cost. Property and equipment are depreciated using the straight-line method over the estimated useful lives of the assets, as follows: Expenditures for maintenance and repairs are charged to operations as incurred, whereas expenditures for renewals and betterments are capitalized. Intangible Assets Intangible assets consist principally of values assigned to the Federal Communications Commission (FCC) licenses and network affiliation agreements of the Stations. Intangible assets are being amortized on the straight-line basis primarily over 15 years. Revenue Recognition The Company's primary source of revenue is the sale of television time to advertisers. Revenue is recorded when the advertisements are broadcast. SMITH TELEVISION OF MICHIGAN L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P. AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. NOTES TO COMBINED FINANCIAL STATEMENTS - (CONTINUED) Impairment of Long-Lived Assets Long-lived assets and identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed. The Partnerships have determined there has been no impairment in the carrying value of long-lived assets of Stations as of December 31, 1996 or February 28, 1997. Deferred Charges Deferred charges are being amortized over the applicable loan period (84 month period) on a straight-line basis, and organization costs are being amortized over a 60-month period on a straight-line basis. Trade/Barter Transactions Trade/barter transactions involve the exchange of advertising time for products and/or services. Trade/barter transactions are recorded based on the fair market value of the products and/or services received. Revenue is recorded when advertising schedules air and expense is recognized when products and/or services are used or received. Income Taxes No income tax provision has been included in the financial statements since income or loss of the Partnerships is required to be reported by the partners on their respective income tax returns. Allocation of Partnerships' Loss The Partnerships' loss for the year ended December 31, 1996 and the two months ended February 28, 1997, is allocated as described by the Partnership Agreement. Supplemental Cash Flow Disclosures Cash paid for interest during 1996 was $5,974,847 and $0 for the two months ended February 28, 1997. In addition, the Partnerships acquired new contracts for television program obligations in the amount of $698,861 during 1996 and $0 for the two months ended February 28, 1997. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The preparation of financial statements in conformity with generally accepted accounting principles also requires management to make estimates and assumptions that affect the disclosures of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. SMITH TELEVISION OF MICHIGAN L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P. AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. NOTES TO COMBINED FINANCIAL STATEMENTS - (CONTINUED) 4. CREDIT AGREEMENT To finance the acquisitions described in Note 1 and to provide for future operating capital, the Partnerships entered into a Credit Agreement with Chase Manhattan Bank, N.A. (the Credit Agreement), as administrative agent for borrowings of up to $72,000,000. The borrowings are collateralized by all of the Partnerships' assets and outstanding Partnership interests. Under the Credit Agreement, the Partnerships have the option to maintain domestic and Eurodollar loans. Interest on borrowings under this agreement are at varying rates based, at the Partnerships' option, on the banks' prime rate or the London Interbank Offering Rate (LIBOR), plus a fixed percent, and are adjusted based upon the ratio of total debt to earnings before interest, taxes, depreciation, and amortization. The weighted average interest rate during 1996 and the two months ended February 28, 1997, was 9.08% and 8.9%, respectively. Additionally, commitment fees of 0.5% are payable quarterly. Under the existing Credit Agreement, the Partnerships agree to abide by restrictive covenants which place limitations upon payments of cash distributions, issuance of Partnership interest, investment transactions and the incurrence of additional obligations. In addition, the Partnerships must maintain specified levels of operating cash flow and comply with other financial covenants. Upon the sale of assets on February 28, 1997, the Credit Agreement was paid in full from the proceeds. 5. AFFILIATE TRANSACTIONS: The Partnerships pay SBP, the general partner of the Partnerships, to provide certain management services. The Partnerships recorded expense of $840,135 in 1996 and $146,000 for the two months ended February 28, 1997 for these services. Management believes these amounts are reasonable and representative of the services provided. The agreement terminates upon the sale of the Stations' assets. The Partnerships have elected to participate in an affiliate insurance program which covers automobiles, buildings, equipment, libel and slander, liability and earthquake damage. The Partnerships pay actual invoice costs and no employee of the affiliate or SBP is compensated for these services other than through the above management fee. Management believes the amounts paid are reasonable and representative of the services provided. The Partnerships have elected to participate in an affiliate health, life, vision and dental program, long and short term disability, travel accident and long-term care program. The Partnerships are charged the same costs as any other participating affiliate. No employee of the affiliate or SBP is compensated for these services other than through the above management fee. Management believes the amounts paid are reasonable and representative of the services provided. A defined contribution savings plan (401k) (the Plan) is provided to employees of the Partnerships by an affiliate. Employees of the Partnerships who have been employed for six months, who have attained the age of 21 years and who have completed 1,000 hours of service are generally eligible to participate. Certain employees represented by various unions have elected not to participate in the Plan SMITH TELEVISION OF MICHIGAN L.P. SMITH TELEVISION OF ROCHESTER, L.P. SMITH TELEVISION - WTOV, L.P. AND SMITH TELEVISION OF SALINAS-MONTEREY, L.P. NOTES TO COMBINED FINANCIAL STATEMENTS - (CONTINUED) or have established their own plans. Amounts contributed to the Plan by the Partnerships amounted to $131,429 in 1996 and $35,682 for the two months ended February 28, 1997. Management believes the costs incurred in connection with the above affiliate programs approximate the costs that would be incurred if the Partnerships procured such services on a stand-alone basis. OTHER INCOME: Other income for the periods indicated consisted of the following: During 1996, the Partnerships agreed to provide certain services to an unaffiliated national television network and agreed to potentially swap one of its Stations for one of the unaffiliated network's stations. The Partnerships have provided all services required by the network. The Partnerships received $1,500,000 for these services. 7. CONTINGENCIES: The Partnerships are subject to legal proceedings and claims in the ordinary course of business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial position or results of operations of the Partnerships. SCHEDULE II STC BROADCASTING, INC. AND SUBSIDIARIES TELEVISION STATIONS WEYI, WROC, WTOV AND KSBW VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) (1) Amounts represent allowance for doubtful account balances purchased in connection with the acquisition of certain television stations. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None to Report PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth information concerning the executive officers and directors of Sunrise and the Company as of March 1, 1999. ROBERT N. SMITH has served in the broadcast industry for 20 years and served as President of Sunrise and Chief Executive Officer and Director of Sunrise and the Company since their formation. Since 1985, Mr. Smith has served as President and majority stockholder of SBG, which owns, operates and manages seven television stations in addition to the Company's Stations, and has served as Chief Executive Officer of SBP, an affiliate of SBG. From 1983 to 1985, Mr. Smith served as an officer, director and part owner of Heritage Broadcasting Company, which was the licensee of WCTI-TV, New Bern, North Carolina. Mr. Smith first became involved with the television broadcast industry as an attorney in the Broadcast Bureau of the FCC from 1971 to 1974. Thereafter, Mr. Smith's career included substantial government service, including serving on the White House Staff in 1977 and as Assistant Director for Community Services Administration from 1977 to 1979, prior to returning full time to the broadcast industry in 1983. SANDY DIPASQUALE has served in the broadcast industry for 20 years and served as President of the Company and Executive Vice President and Chief Operating Officer of Sunrise since their formation. From January of 1996 through February of 1997, Mr. DiPasquale served as Chief Operating Officer of SBP and was responsible for the day-to-day operations and from November 1994 to January 1996 was associated with SBG. From 1989 to 1994, Mr. DiPasquale served as President, Chief Executive Officer and was a part owner of SD Communications, Inc., KBS, Limited Partnership and KBS, Inc., which were the owners of KWCH-TV, Wichita, Kansas, and its affiliated stations in Hays, Goodland and Dodge City, Kansas. From 1986 to 1988, Mr. DiPasquale served as President and General Manager and was a partner in WGRZ-TV, Buffalo, New York. Prior to such time, Mr. DiPasquale served in sales and management positions at various television broadcast stations in the Buffalo area. DAVID A. FITZ has served in the broadcast industry for 22 years and served as Senior Vice President and Chief Financial Officer of Sunrise and the Company since their formation. From January 1996 through February 1997, Mr. Fitz served as Chief Financial Officer of SBP and as an officer and director of each of the SBG affiliated companies. Mr. Fitz has held various positions with SBG affiliated companies since 1986. Prior to joining SBG, Mr. Fitz served for nine years as Executive Vice President and Chief Financial Officer of the Broadcast Division of Gulf Broadcast Company, which at that time owned six television and eight radio broadcast stations. Prior to that time, Mr. Fitz was a manager with KPMG Peat Marwick, which he joined in 1969. JOHN M. PURCELL has served in the broadcast industry for 37 years and served as Regional Vice President of Sunrise and the Company and as General Manager of WROC-TV, Rochester, New York, from March 1997 to April 1, 1999. From January 1996, through February 1997, Mr. Purcell served as Senior Vice President of SBP and General Manager of WROC-TV, Rochester, New York. From November 1994, to January 1996, Mr. Purcell was associated with SBG. From 1986 to September 1994, Mr. Purcell served as Vice President and General Manager of WHTM-TV, Harrisburg, Pennsylvania, an SBG-owned station. Prior to such time, Mr. Purcell served as President and General Manager of WGHP-TV, Greensboro, North Carolina, and as Vice President and Director of Sales of WTSP-TV, Tampa/St. Petersburg, Florida. JOHN R. MUSE has served as Chairman of the Board of Directors of the Company and Sunrise since its formation. Mr. Muse is Chief Operating Officer and Partner of Hicks, Muse, and co-founded the firm in 1989. At Hicks, Muse, Mr. Muse has been actively involved in originating, structuring, and monitoring Hicks Muse's investments. From 1984 to 1989, Mr. Muse headed the merchant/investment banking operations of Prudential Securities for the Southwestern region of the United States. From 1980 to 1984, Mr. Muse served as Senior Vice President and a Director of Schneider, Bernet & Hickman, Inc., in Dallas, and was responsible for that firm's investment banking activities. Mr. Muse serves as a director of Premier International Foods plc, Financlare Movlins de Champagne, Glass's Information Services, Arnold Palmer Gold Management Co., LIN Television, Media Capital Soc. Gestora de Participacoes Sociasi, S.A., G.H. Mumm & Cie, Champagne Perrier-Jouet, Premier International Foods plc, Hillsdown Holdings plc, Glass's Information Services, Regal Cinemas, Inc., and Suiza Food Corporation. Mr. Muse also serves on the Board of Directors for Goodwill Industries, SMU Edwin L. Cox School of Business, the UCLA Anderson School Board of Visitors and the Board of Trustees of St. Mark's School of Texas. MICHAEL J. LEVITT has served as a director of the Company and Sunrise since its formation. Mr. Levitt has been a partner of Hicks Muse since 1996, and is involved in originating, structuring, executing, and monitoring Hicks Muse's investments as well as building relationships with investment and commercial banking firms. Prior to joining Hicks Muse, Mr. Levitt served as a Managing Director and Deputy Head of Investment Banking with Smith Barney, Inc. from 1993 through 1995. He was also a member of the investment committee of Greenwich State Capital, the merchant banking arm of the Travelers Group. From 1986 through 1995, Mr. Levitt was a Managing Director with Morgan Stanley & Co. responsible for corporate finance, merger and acquisition and high yield activities with leveraged buyout firms and non-investment grade companies. Mr. Levitt serves as director of AMFM Corp., AMFMi Corp., Award.com Inc., El Sitio, Inc., G.H. Mumm/Perrier Jouet & Cie., Globix Corporation, iParty Corp., Ibero American Media Partners, L.P., International Home Foods, Inc., PeopleLink, Inc., RCN Corporation, RealPulse.com, Inc., StreetZebra.com, Inc. and Rhythms NetConnections, Inc. In addition, Mr. Levitt has been named interim Chief Executive Officer of AMFMi Corp. Mr. Levitt is the Chairman of the Make-A-Wish Foundation of Metro New York, a member of the Board of the Hope and Heroes Children's Cancer Fund, and a Trustee of the Elizabeth Morrow School. JOHN H. MASSEY has served as a director of the Company and Sunrise since its formation. Until August 2, 1996, Mr. Massey served as the Chairman of the Board and Chief Executive Officer of Life Partners Group, Inc., an insurance holding company, having assumed those offices in October 1994. Prior to joining Life Partners, he served, since 1992, as the Chairman of the Board of, and currently serves as a director of, FSW Holdings, Inc., a regional investment banking firm. Since 1986, Mr. Massey has served as a director of Gulf-California Broadcast Company, a private holding company, that was sold in May 1996. From 1986 to 1992, he also was President of Gulf-California Broadcast Company. From 1976 to 1986, Mr. Massey was President of Gulf Broadcast Company, which owned and operated 6 television stations and 11 radio stations in major markets in the United States. Mr. Massey currently serves as a director of AMFM Corp., Central Texas Bankshare Holdings, Inc., Hill Bank and Trust Co., Hill Bancshares Holdings, Inc., Bank of the Southwest of Dallas, Texas, Columbus State Bank, Columbine JDS Systems, Inc., and the Paragon Group, Inc. ERIC C. NEUMAN has served as a director of Sunrise and STC Broadcasting since May 1999. Mr. Neuman is Vice President and a director of LIN Television. Mr. Neuman resumed his position as an officer of Hicks Muse in April 1999 and currently serves as a Principal. Mr. Neuman was the Senior Vice President of Strategic Development for Chancellor from July 1998 to March 1999. From May 1993 to July 1, 1998, Mr. Neuman served as an officer of Hicks Muse. From 1985 to 1993 Mr. Neuman served as a Managing General Partner of Communications Partner, Ltd., a Dallas-based private investment firm specializing in media and communications businesses. All directors hold office for one year terms and until their successors are duly elected and qualified. The Board of Directors of the Company established an Executive Committee to which Messrs. Massey, Muse and Levitt have been appointed, and an Audit Committee and Compensation Committee to which Messrs. Levitt, Massey and Muse have been appointed. Directors of the Company are elected by Sunrise, the sole stockholder of the Company. Director Compensation Directors of Sunrise who are employees of Sunrise, STC Broadcasting or Hicks Muse serve without additional compensation. Independent directors receive an annual retainer of $12,000. These independent directors receive an additional $1,000 for each meeting of the Board of Directors and each committee meeting attended. Independent directors are reimbursed for any expenses incurred in connection with their attendance at such meetings. Currently, John H. Massey is Sunrise's only independent director. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the compensation paid by the Company to its Chief Executive Officer and each of its four most highly compensated executive officers. (1) Dollar value of premiums for life insurance reimbursed by the Company. (2) Represents amounts contributed by the Company to the Sunrise 401(k) Savings Plan. (3) Represents amount of deferred compensation included in employment letter. Employment Agreements On March 1, 1997, Sunrise and the Company entered into five-year employment agreements with Robert Smith, Sandy DiPasquale, David Fitz and John Purcell. Each employment agreement is subject to automatic successive one-year renewal terms that take effect unless notice of non-renewal is given by either party to the agreement at least 120 days prior to the expiration of the initial term or annual extension, as the case may be. The compensation provided Messrs. Smith, DiPasquale, Fitz and Purcell under their respective agreements includes minimum annual base salary of $250,000 each, subject to adjustment at the sole discretion of the Board of Directors of Sunrise, and an annual bonus based upon criteria to be established by the Board of Directors at the beginning of each fiscal year. These executives are entitled to participate in certain benefit plans. If prior to the fourth anniversary of the Employment Date, the executive officer terminates his employment for good reason (as defined) or Sunrise or the Company terminate his employment for any reason other than for cause (as defined), then such executive officer shall be paid his salary and shall continue to be covered by certain employee benefit plans for 12 months. In the event of a change of control (as defined in the agreements) prior to the fourth anniversary of the Employment Date, either Sunrise, the Company or the executive officer may terminate the employment agreement concurrently with sale and receive the salary and benefits on the same terms described in the preceding sentence. Mr. Smith's employment agreement requires him to devote his best efforts and such time, attention, knowledge and skill to the operation of the Stations as is necessary to manage and supervise the Stations and the Company. Mr. Fitz's employment agreement requires him to devote his best efforts and his working time, attention, knowledge and skill solely to the operation of the Stations; provided, however, that Mr. Fitz is permitted to devote reasonable time in advisory services and oversight duties in connection with Mr. Smith's investments in other business enterprises having an interest in or operating a television station within certain excluded markets in which Mr. Smith currently holds an interest in a television station (the Excluded Markets) and any acquisition or investment in up to three additional excluded stations (the Excluded Stations). Each employment agreement contains a noncompetition provision, which provides that during the term of each agreement and for a period of two years thereafter (or one year, if Hicks Muse or its affiliates cease to own any of the Stations) and during any period in which the executive officer is receiving severance payments pursuant to the employment agreement, such executive officer will not engage in the television broadcast business within the DMA of any Station. Mr. Smith's employment agreement permits him to invest in, become employed by or otherwise render services to or for (i) another business enterprise (other than the Company) having an interest in or operating a television station within the Excluded Markets and (ii) after an opportunity to acquire or invest shall have been presented to the Company and the Company shall have declined in writing to make such acquisition or investment, the Excluded Stations. 401(k) Savings Plan Effective as of March 1, 1997, the Company became a participating subsidiary in the Sunrise 401(k) Savings Plan (the Plan), which covers employees of the Company and subsidiaries who have attained the age of 21, and completed six months of service. An employee may contribute up to an aggregate of 15% of annual compensation to the Plan, subject to statutory limitations and top heavy limitations. The Company will match 100% of each employee's contribution up to 3% of employee compensation or $3,000 which ever is less. Contributions are allocated to each employee's individual account, which is intended to be invested in various funds according to the direction of the employee. All five highly compensated executive officers participate in the Plan. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Company has 1000 shares of Common Stock, $0.01 par value per share, issued and outstanding, all of which are owned by Sunrise, whose address is 720 2nd Avenue South, St. Petersburg, Florida 33701. All of the capital stock of Sunrise is owned by Sunrise Television Partners, L.P. (the Partnership) of which the ultimate managing partner is Thomas O. Hicks, an affiliate of Hicks Muse. Affiliates of Hicks Muse have purchased $25.0 million of the Company's Redeemable Preferred Stock Series A for a price of approximately $24.1 million (or 96.5% of the initial liquidation preferences of such shares) and received, in connection therewith, warrants to purchase shares of common stock of Sunrise. The Hicks Muse affiliates, along with the other purchasers of the Redeemable Preferred Stock Series A and warrants, received certain registration rights with respect to the shares of common stock of Sunrise issuable upon exercise of the warrants. Robert N. Smith (through SBG), Sandy DiPasquale, David A. Fitz and John M. Purcell own 100% of the Class B limited partnership interest in the Partnership, and together with others have invested $2.7 million in Class A interest of the Partnership. The return on the Class B ownership interest is based on the performance of Sunrise and the Company. Neither the Class A nor Class B interest owned by limited partners have any rights to participate in the management or control of the Partnership or its business. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS On March 1, 1997, Sunrise and the Company entered into a ten-year agreement (the Monitoring and Oversight Agreement) with an affiliate of Hicks Muse (Hicks Muse Partners) pursuant to which Sunrise and the Company have agreed to pay Hicks Muse Partners an annual fee payable quarterly for oversight and monitoring services to the Company. The annual fee is adjustable on January 1, of each calendar year to an amount equal to 0.2% of the budgeted consolidated annual net revenues of the Company and its subsidiaries for the then-current fiscal year plus reimbursement of certain expenses. The Monitoring and Oversight Agreement makes available the resources of Hicks Muse Partners concerning a variety of financial and operational matters. The Company does not believe that the services that have been, and will continue to be provided to the Company by Hicks Muse Partners could otherwise be obtained by the Company without the addition of personnel or the engagement of outside professional advisors. In the Company's opinion, the fees provided for under the Monitoring and Oversight Agreement reasonably reflect the benefits received, and to be received, by Sunrise and the Company. Total payments related to this agreement amount to $0.2 million, $0.2 million and $0.1 million for the years ended December 31, 1999 and 1998, and the ten months ended December 31, 1997, respectively. On March 1, 1997, Sunrise and the Company entered into a ten-year agreement (the Financial Advisory Agreement) pursuant to which Hicks Muse Partners received a financial advisory fee of 1.5% of the transaction value at the closing of the Jupiter/Smith acquisition as compensation for its services as financial advisor to the Company. Hicks Muse Partners is entitled to receive a fee equal to 1.5% of the "transaction value" for each "add-on transaction" in which the Company is involved. The term "transaction value" means the total value of the add-on transaction including, without limitation, the aggregate amount of the funds required to complete the add-on transaction (excluding any fees payable pursuant to the Financial Advisory Agreement), including the amount of any indebtedness, preferred stock or similar terms assumed (or remaining outstanding). The term "add-on transaction" means any future proposal for a tender offer, acquisition, sale, merger, exchange offer, recapitalization, restructuring or other similar transaction directly involving the Company or any of its subsidiaries, and any other person or entity. The Financial Advisory Agreement makes available the resources of Hicks Muse Partners concerning a variety of financial and operational matters. The Company does not believe that the services that have been, and will continue to be provided by Hicks Muse Partners could otherwise be obtained by the Company without the addition of personnel or the engagement of outside professional advisors. In the Company's opinion, the fees provided for under the Financial Advisory Agreement reasonably reflect the benefits received and to be received by the Company. Total fees paid under this agreement for the years ended December 31, 1999 and 1998, and the ten month period ended December 31, 1997 were $1.8 million, $2.7 million and $3.4 million, respectively, and were capitalized as cost of acquisition or netted against preferred stock. On March 1, 1997, affiliates of Hicks Muse purchased $25.0 million of the Redeemable Preferred Stock Series A for a purchase price of approximately $24.1 million (or 96.5% of the initial liquidation preference of such shares) and received in connection therewith warrants to purchase shares of common stock of Sunrise. The Hicks Muse affiliates, along with the other purchaser of the Redeemable Preferred Stock Series A and warrants, received certain registration rights with respect to the shares of common stock of Sunrise issuable upon exercise of the warrants. The Company has elected to participate in a Hicks Muse affiliate insurance program which covers vehicles, buildings, equipment, libel and slander, liability and earthquake damage. The Company pays actual invoice costs and no employee of Hicks Muse is compensated for these services other than through the above Monitoring and Oversight Agreement. Management believes the amounts paid are attractive and representative of the services provided. The Company has elected to participate in the Sunrise health, life, vision and dental program, long and short-term disability, travel accident and long-term care program. Management believes the amounts paid are attractive and representative of the services provided. A defined contribution 401(k) savings plan is provided to employees of the Company by Sunrise. Employees of the Company who have been employed for six months and who have attained the age of 21 years are generally eligible to participate. Certain employees represented by various unions have elected not to participate in the Plan or have established their own plans. Total contributions by the Company to defined contribution 401(k) savings plan were approximately $0.5 million, $0.3 million and $0.1 million for the years ended December 31, 1999 and 1998, and the ten months ended December 31, 1997, respectively. The Company has contracts with national representation firms to sell advertising time. During 1998, entities controlled by Hicks Muse acquired certain of these firms. In 1999, the Company entered into extensions of certain of these contracts in the normal course of business on terms and conditions which the Company considered attractive and representative of current market conditions. On April 24, 1998, the Company sold to Robert N. Smith, the Chief Executive Officer and a Director of Sunrise and the Company, the assets and certain rights and obligations related to WFFF for $0.5 million. The purchase price was secured by a note and liens on all of the assets sold and on July 23, 1998, the Company received full payment on the note. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements STC Broadcasting, Inc. Report of Independent Certified Public Accountants Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Operations for the years ended December 31, 1999 and 1998 and ten months ended December 31, 1997 Consolidated Statements of Stockholder's Equity for the years ended December 31, 1999 and 1998 and ten months ended December 31, 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1999 and 1998 and ten months ended December 31, 1997 Notes to Consolidated Financial Statements Smith Television of Michigan, L.P. Smith Television of Rochester, L.P. Smith Television - WTOV, L.P. Smith Television of Salinas-Monterey, L.P. Report of Independent Certified Public Accountants Combined Statements of Operations for the year ended December 31, 1996 and the two months ended February 28, 1997 Combined Statements of Partners' Equity for the year ended December 31, 1996 and the two months ended February 28, 1997 Combined Statements of Cash Flows for the year ended December 31,1996 and the two months ended February 28,1997 Notes to Combined Financial Statements a(2) Financial Statement Schedule Schedule II Valuation and Qualifying Accounts a(3) Exhibits 2.1 Asset Purchase Agreement by and between Elcom of Ohio, Inc., and STC Broadcasting, Inc. dated as of July 24, 1998. (1) 2.2 Asset Purchase Agreement by and among STC Broadcasting, Inc. and STC License Company and Nexstar Broadcasting of Rochester, Inc. dated March 3, 1999. (2) 2.3 Purchase Agreement by and among Sinclair Communications, Inc., and STC Broadcasting, Inc., dated March 16, 1999 (2) 3.1 Certificate of Designation of the Powers, Preferences and Relative Participating, optional and other special rights of Preferred Stock, Series B dated February 5, 1999. (2) 3.2 Certificate of Elimination with respect to the Preferred Stock, Series B of STC Broadcasting, Inc. dated December 28, 1999. (3) 3.3 Certificate of Designation of the Powers, Preferences and Relative Participating, Optical and Other Special Rights of Preferred Stock, Series B and Qualifications, Limitations and Restrictions thereof of STC Broadcasting, Inc. dated December 28, 1999. (3) 10.1 Securities Purchase Agreement by and among the Company and Chase Manhattan Corporation, Credit Suisse First Boston Corporation, and Salomon Brothers Holding Company, Inc. dated February 5, 1999 (2) 10.2 Fourth Amendment to the Amended and Restated Credit Agreement dated as of December 21, 1999. (3) 10.3 Preferred Stock Purchase Agreement dated December 30, 1999 by and between Sunrise Television Corp. and STC Broadcasting, Inc. (3) 10.4 Senior Subordinated Note Purchase Agreement by and among Sunrise Television Corp. and Hicks Muse, Tate & Furst Equity Fund III, L.P., HM3 Coinvestors, L.P. and Chase Equity Associates, L.P. dated December 30, 1999. (3) 10.5 Agreement between STC Broadcasting, Inc. and the International Brotherhood of Electrical Workers dated September 15, 1999 representing certain employees of television station KFYR in Bismarck, North Dakota. (4) 12 Statement of fixed charge ratio (4) 21.1 Subsidiaries of STC Broadcasting, Inc. (4) 27.2 Financial Data Schedule (4) (1) Incorporated by reference to the Form 10-Q of STC Broadcasting, Inc. for the period April 1, 1998 to June 30, 1998. (2) Incorporated by reference to the Form 10K of STC Broadcasting, Inc. for the year ended December 31, 1998. (3) Incorporated by reference to the Form 8K of STC Broadcasting, Inc. dated January 6, 2000. (4) Filed herewith. Reports on Form 8-K Nothing to report for period October 1, 1999 to December 31, 1999. The Company filed an 8K report on January 6, 2000 related to the license closing on the sale of WROC and the sale of $25.0 million of Redeemable Preferred Stock Series B. SIGNATURES Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of St. Petersburg, State of Florida, on the 1st day of March, 2000. STC Broadcasting, Inc. By: /s/ Robert N. Smith ------------------- Robert N. Smith Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant in the capacities and on the dates indicated: EXHIBIT INDEX (1) Incorporated by reference to the Form 10-Q of STC Broadcasting, Inc. for the period April 1, 1998 to June 30, 1998. (2) Incorporated by reference to the Form 10K of STC Broadcasting, Inc. for the year ended December 31, 1998. (3) Incorporated by reference to the Form 8K of STC Broadcasting, Inc. dated January 6, 2000. (4) Filed herewith.

1029267_1999.txt

1029267_1999

1999

1029267

ITEM 1. BUSINESS COMPANY OVERVIEW Freedom Securities Corporation is a holding company which together with its subsidiaries (collectively, the "Company" or "Freedom") is a full-service retail brokerage, investment banking and asset management firm. The Company provides a wide range of products and investment services including securities brokerage and trading services, investment banking and research, and asset management and other investment advisory services. The Company was formed in November 1996 to effect the acquisition (the "Acquisition") of Freedom Securities Holding Corporation and its subsidiaries (collectively, the "Predecessor Company") from John Hancock Mutual Life Insurance Company ("Hancock"). The Acquisition was financed through purchases of equity securities by approximately 350 employees of the Company including senior management and investment executives as well as by affiliates of Thomas H. Lee Company and SCP Private Equity Partners, L.P. and through borrowings under a credit facility. In April 1998, the Company completed its initial public offering of 7.4 million shares plus an over allotment of 1.1 million shares, including 4.2 million shares of common stock sold by the Company. Management believes that it can best serve the needs of its clients in various regions through separate, independently managed operating companies, while avoiding cost duplication by using shared clearing and support services. This approach enables the Company to capitalize on each organization's name recognition, historical areas of expertise and close community ties while lessening the Company's reliance on a single region's economy. The Company's four principal operating subsidiaries are described below: - Tucker Anthony Incorporated ("Tucker Anthony"), headquartered in Boston, is a brokerage and investment banking firm. Tucker Anthony's divisions include Tucker Anthony Cleary Gull ("Tucker Cleary"), an investment banking and institutional brokerage firm; Gibraltar Securities Co. ("Gibraltar"), a New Jersey-based brokerage and investment advisory firm acquired by the Company in the third quarter of 1999; and Tucker Anthony MidAtlantic Division ("TA MidAtlantic"), formerly Hopper Soliday & Co., Inc. ("Hopper Soliday"), a Pennsylvania-based municipal finance and underwriting brokerage firm acquired by the Company in the first quarter of 1999. - Sutro & Co. Incorporated ("Sutro"), headquartered in San Francisco, is a West Coast regional brokerage and investment banking firm. - Hill, Thompson, Magid & Co., Inc. ("Hill Thompson") is a New Jersey-based over-the-counter trading firm that the Company acquired in the fourth quarter of 1999. - Freedom Capital Management Corporation ("Freedom Capital") is a Boston-based asset management firm. The consolidated financial statements and other data included elsewhere in this report include the results of operations of the acquired companies from their respective dates of acquisition. Tucker Anthony, Sutro and Cleary Gull Investment Management Services, Inc. ("Cleary Gull IMS") clear their securities transactions on a fully disclosed basis through Wexford Clearing Services Corporation ("Wexford"), a guaranteed wholly-owned subsidiary of Prudential Securities Incorporated ("Prudential"). Hill Thompson clears all proprietary securities transactions on a self-clearing basis and substantially all customer transactions through Schroder & Co., Inc. on a fully disclosed basis. The Company employed 2,535 people at December 31, 1999. DESCRIPTION OF BUSINESS ACTIVITIES The Company's four main areas of business, described below, are its (1) full-service retail brokerage operations; (2) equity capital markets activities; (3) asset management business and (4) trading activities. Retail Operations In its retail operations, the Company focuses on maintaining and developing strong client relationships through a dedicated community focus while providing the breadth and quality of services and products offered by national brokerage firms. Tucker Anthony and Sutro provide their retail clients with a broad range of services delivered in a personalized, service-oriented manner. In addition to recommending and effecting transactions in securities, the Company makes available equity research reports prepared by Tucker Cleary, Sutro, and other research analysts and offers services such as financial and tax planning, and trust and estate advice to its retail clients. The Company believes that the personalized nature and range of services it provides to its clients is a key factor in the success of its retail brokerage businesses. The retail operations of Tucker Anthony and Sutro, conducted in 18 states and the District of Columbia, have together generated 54%, 51% and 57% of the Company's net revenues in 1999, 1998 and 1997, respectively, and have historically represented the Company's core business. A large portion of the Company's revenues is generated from commissions or fees earned as a broker or dealer for individual clients in the purchase and/or sale of equity securities, fixed income securities, mutual funds, insurance products, options and U.S. government and municipal securities. As of December 31, 1999, retail customers had approximately $43 billion of assets in over 238,000 brokerage accounts. Management believes that the experience of its 900 investment executives and their strong ties to their communities help differentiate the Company from its competitors and enable the Company to more effectively access and serve its clients. The Company's strategy of providing its investment executives with a high level of support and the flexibility to operate in an entrepreneurial manner has allowed the Company to recruit and retain highly effective, motivated investment executives, many of whom have significant tenure at their local branch offices. Management believes that Tucker Anthony and Sutro have been able to successfully recruit and retain investment executives for a number of reasons, including a corporate culture that rewards performance, encourages employee ownership, and provides advanced technology, competitive payouts, no discount sharing and a service-driven rather than a product-driven environment. The Company is currently beta testing its technology for on-line trading and plans to offer on-line trading capabilities to certain of its fee-based retail clients in the near future. The Company continues to enhance its commitment to customer service by providing its investment executives with upgraded account information systems and flexibility in determining fee schedules for certain services based upon the level of customer needs, and by providing an array of one-stop investment and financial planning services. The Company plans to continue to improve the profitability of its retail operations primarily by hiring additional experienced and highly productive investment executives who are attracted to the Company because of its entrepreneurial culture, high level of product offerings and technological support. Equity Capital Markets The Company's equity capital markets business consists of equity research, investment banking, institutional sales, trading and syndication services. Each of Tucker Cleary and Sutro has historically demonstrated strengths in offering various investment banking services, including merger and acquisition services, public offerings and private placements to clients. The respective research and investment banking departments of Tucker Cleary and Sutro target emerging and middle-market companies within the industries in which they specialize, such as consumer products, healthcare, financial services, distribution and logistics, internet and technology and business services. Within each of these industries, Tucker Cleary and Sutro have focused on various niches which each believes offers it the greatest opportunities. Each firm focuses its equity capital markets group on coordinating its research, institutional sales, corporate finance, trading and syndication functions. Management believes that its research will be a key factor in growing its equity capital markets activities. The Company's revenues from equity capital markets activities generated 13%, 20% and 14% of the Company's net revenues in 1999, 1998 and 1997, respectively. Tucker Cleary and Sutro execute securities transactions for institutional investors such as banks, mutual funds, insurance companies and pension and profit-sharing plans. These investors normally purchase and sell securities in large quantities, which transactions require specialized marketing and trading expertise. In order to service these institutional accounts, the Company has established a network of institutional offices located in New York, Boston, San Francisco, Los Angeles, Milwaukee, Chicago, Denver and Washington, D.C. Institutional transactions are executed by the Company acting as agent or principal. The Company permits discounts from its commission schedule to its institutional customers. The amount of such discounts can vary with the size of particular transactions and other factors. The Company believes that it receives a significant portion of its institutional brokerage commissions as a consequence of its research advice and services regarding specific corporations and industries, its principal transactions business and its investment banking activities. The Company's investment banking activities are performed by the corporate finance and syndicate departments of Tucker Cleary and Sutro. The corporate finance groups manage and underwrite public offerings of equity and, to a significantly lesser extent, debt securities, arrange private placements of equity and debt securities and provide financial advice in connection with mergers and acquisitions, divestitures and other corporate reorganizations and restructurings. The managed public equity offerings and merger and acquisition transactions of Tucker Cleary and Sutro are typically undertaken for emerging or middle-market companies in the consumer products, healthcare, financial services, distribution and logistics, technology and business services sectors or for companies located in each firm's respective geographic region. Historically, the Company's merger and acquisition advisory business has been a significant component of the Company's investment banking revenues. The Company believes that it has a well established merger and acquisition advisory business and plans to capitalize on this strength by further building upon the equity capital markets groups of Tucker Cleary and Sutro. The syndicate departments coordinate the distribution of managed and co-managed corporate securities offerings and accept invitations to participate in underwritings managed by other investment banking firms. The Company, through certain subsidiaries and employee incentive arrangements, has participated from time to time in the past and may participate from time to time in the future as an equity investor in connection with specific transactions. The Company intends to continue to increase its equity capital markets business by committing greater resources to and carefully focusing its research and investment banking coverage on geographical regions and industries which management believes offer the greatest opportunities. Management also believes that consolidations within the investment banking industry, as a whole, will offer enhanced opportunities for those firms which maintain their local and industry specific focus. Asset Management The Company provides investment advisory and portfolio management services to institutions, pension and endowment funds, money market funds, professional firms, individuals and trusts. The asset management business consists of Freedom Capital, Cleary Gull IMS and asset management business from Tucker Anthony and Sutro. As of December 31, 1999, total assets under management were over $11.0 billion. Asset management revenues in 1999 increased 42% over the prior year and have represented 12%, 11% and 9% of the Company's net revenues in 1999, 1998 and 1997, respectively. Freedom Capital, headquartered in Boston, was formed in 1930. Freedom Capital has developed a leading position in the management of public funds for local Massachusetts municipalities and agencies, has developed an increasing presence in certain sectors of the union pension fund market and has expanded its high net worth asset management business. As of December 31, 1999, Freedom Capital had $7.8 billion in assets under management of which $3.7 billion are in money market funds for which it acts as an investment advisor. As with other aspects of the Company's business, Freedom Capital is focused on service and client communication. To foster active and attentive management, Freedom Capital limits the number of client relationships of each portfolio manager. This policy is intended to provide each portfolio manager with the time necessary to foster ongoing client relationships and the opportunity to discuss portfolio strategies with the client. In addition, Freedom Capital provides its clients with economic commentary and investment letters on a regular basis. Cleary Gull IMS is an asset management firm based in Milwaukee and a wholly-owned subsidiary of the Company. Cleary Gull IMS provides primarily investment management services to institutional accounts and high net worth individuals and had almost $1.0 billion in assets under management at December 31, 1999. The Company acquired Cleary Gull Reiland & McDevitt Inc. ("Cleary Gull") in the second quarter of 1998. During 1999, the investment banking, equity research and institutional brokerage activities of Cleary Gull and Tucker Anthony were combined to form Tucker Cleary, a division of Tucker Anthony. The remaining business of Cleary Gull, now Cleary Gull IMS, is investment management services provided to institutional accounts and high net worth individuals. Freedom Trust Company, a New Hampshire chartered trust company and a subsidiary of Freedom Capital, commenced operations in early 1996 to provide clients the opportunity to place their assets in trust so that the Company may continue to provide asset management services to such trusts after the client's death. Freedom Trust Company had assets under custody of $576 million as of December 31, 1999. Trading and Other Broker-Dealer Activities Tucker Anthony, Sutro and Hill Thompson make markets, buying and selling as principal, in common stocks, convertible preferred stocks, warrants and other securities traded on Nasdaq or other over-the-counter ("OTC") markets. As of December 31, 1999, the Company made markets in equity securities of over 9,000 issuers compared to 535 issuers as of December 31, 1998. The increase in market making activity in 1999 from prior years is mainly due to the acquisition of Hill Thompson whose primary business is market making in Nasdaq Small Cap, OTC Bulletin Board and Pink Sheets stocks. The majority of Hill Thompson's trading represents dealer-to-dealer transactions with major wire houses, wholesale market makers, discount brokerages and internet trading firms as well as trading on a principal basis with mutual funds, banks, insurance companies and other financial service institutions. Tucker Anthony's and Sutro's market making activities are primarily in securities in which there is substantial continuing client interest and include securities which the Company has underwritten or on which it provides research reports. The Company also effects transactions in blocks of securities, usually with institutional investors and generally involving 10,000 or more shares of listed stocks. Such transactions are handled on an agency basis to the extent possible, although the Company may take a long or short position as principal to the extent that no buyer or seller is immediately available. By engaging in block positioning as a principal, the Company places a portion of its capital at risk to facilitate transactions for clients. The Company provides clients access to a range of fixed income products including municipal securities, U.S. government and agency securities, mortgage related securities including those issued through Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corp. ("FHLMC"), and corporate investment-grade and high-yield bonds. The Company takes positions on a principal basis in municipal, U.S. government, agency and corporate securities to facilitate transactions for its clients. Additionally, trading activities include the purchase of securities under agreements to resell at future dates (reverse repurchase agreements) and the sale of the same or similar securities under agreements to repurchase at future dates (repurchase agreements). The Company actively participates on a principal basis in the mortgage-backed securities markets through the purchase or sale of GNMA, FNMA, FHLMC, mortgage pass-through securities, collateralized mortgage obligations and other mortgage related securities in order to meet client needs. The Company finances the majority of its trading positions as part of its Wexford clearing arrangement, through overnight borrowings and through repurchase agreements. Revenues derived from principal trading in OTC markets and fixed income products were 9%, 7% and 8% of the Company's net revenues in 1999, 1998 and 1997, respectively. Tucker Anthony and Sutro are each municipal securities dealers in both the primary and secondary markets, buying and selling securities for their own accounts and for clients. The public finance departments of Tucker Anthony and Sutro provide financial consulting, advisory and underwriting services to municipalities and public service districts. These subsidiaries manage and underwrite offerings of municipal securities to finance the construction and maintenance of a broad range of public-related facilities, including healthcare, housing, education, public power, water and sewer, airports, highways and other infrastructure needs. Over the last several years, the public finance industry has generally experienced diminishing spreads. Nevertheless, both firms have experienced increased revenues in this sector by concentrating on regionally focused community projects. Tucker Anthony engages in the purchase and sale of convertible and equity securities to take advantage of market price differences. Tucker Anthony's arbitrage activities include both convertible and risk arbitrage. To the extent that purchase and sale transactions are not simultaneous, or the closing of a position is subject to a subsequent event such as the successful consummation of a corporate merger, Tucker Anthony places a portion of its capital at risk. Sutro does not engage in significant arbitrage activities. In 1999, arbitrage revenues represented less than three percent of the Company's net revenues. Tucker Anthony and Sutro hold memberships in the New York Stock Exchange, Inc. (the "NYSE") and in other major securities exchanges in the United States in order to provide services to their brokerage clients in the purchase and sale of listed securities. The Company's wholly-owned subsidiary, Freedom Specialist Inc., has a 25% interest in the profits and losses of a joint specialist account in which it participates with RPM Specialist Corp. and R. Adrian & Co., two other NYSE specialist firms. Specialists are responsible for executing transactions and maintaining a fair and orderly market in securities under NYSE rules and regulations. In this function, a specialist firm acts as an agent in executing orders entrusted to it and/or acts as a dealer on the opposite side of public orders in the security executed on the floor of the NYSE. As of December 31, 1999, the joint specialist account acted as a specialist in 36 equity issues. Stock settlement and clearing activities for the joint specialist account are provided by RPM Clearing Corporation. Securities transactions for clients are executed on either a cash or margin basis. In most margin transactions, credit is extended to a client through the Wexford clearing arrangement for the purchase of securities, using the securities purchased and/or other securities in the client's account as collateral for amounts loaned. The Company receives income from interest charged on such extensions of credit. The financing of margin purchases can be an important source of revenue to the Company, since the interest rate paid by the client on funds loaned through Wexford exceeds the Company's interest costs paid to Wexford for net customer debit balances. The amount of the Company's net interest income is affected not only by prevailing interest rates, but also by the volume of business conducted on a margin basis. Net interest income generated 5%, 6% and 6% of the Company's net revenues in 1999, 1998 and 1997, respectively. By permitting a client to purchase on margin, the Company takes the risk that the client will not perform its obligations under the margin loan to maintain adequate collateral in the event that market declines reduce the value of the collateral below the principal amount loaned. Amounts loaned are limited by margin regulations of the Board of Governors of the Federal Reserve System and other regulatory authorities and are subject to credit review and daily monitoring by Wexford, Tucker Anthony, Sutro and Cleary Gull IMS. STRATEGIC ACQUISITIONS During 1999, the Company continued its growth strategy by completing four acquisitions. Management believes these acquisitions strengthen and expand the Company's geographic and product offering base while reducing the Company's costs by leveraging its infrastructure. The 1999 acquisitions are summarized below. TA MidAtlantic (formerly Hopper Soliday) On January 19, 1999, the Company acquired certain assets and liabilities of Hopper Soliday, renamed TA MidAtlantic, and transferred them to Tucker Anthony. TA MidAtlantic is an investment and municipal banking operation founded in 1872 and based in Lancaster, Pennsylvania. The acquisition of TA MidAtlantic, which had 1998 revenues of approximately $20 million, enhanced the Company's investment and municipal finance business and provided greater penetration into markets in Pennsylvania. Charter Investment Group, Inc. On February 1, 1999, the Company, through its Sutro subsidiary, acquired the business and substantially all of the assets of Charter Investment Group, Inc. ("Charter"), a brokerage firm based in Portland, Oregon. Charter, which had 1998 revenues of approximately $7.5 million and approximately $900 million in brokerage accounts as of December 31, 1998, added 28 investment executives to the Company's West Coast retail operations and provided market penetration into Oregon. Gibraltar On September 1, 1999, the Company acquired Gibraltar, a regional brokerage and investment advisory services firm based in New Jersey, and merged it with Tucker Anthony. Gibraltar, which was formed in 1968, added more than 40,000 accounts to the Company's retail client base and had revenues of approximately $38 million in 1999, including results after its acquisition by the Company. Hill Thompson On October 29, 1999, the Company acquired The Hill Thompson Group, Ltd. ("Hill Thompson Group"), including its primary operating subsidiary, Hill Thompson, a New Jersey based OTC trading firm founded in 1932. Hill Thompson makes markets in almost 9,000 Nasdaq Small Cap, OTC Bulletin Board and Pink Sheets stocks and had revenues of approximately $44 million in 1999, including results after its acquisition by the Company. RELATIONSHIP WITH WEXFORD With the exception of Hill Thompson, the Company clears all securities transactions, and carries accounts for customers and its proprietary accounts, with Wexford. Wexford furnishes the Company with information necessary to run the Company's business, including commission runs, transaction summaries, data feeds for various reports including compliance and risk management, execution reports, trade confirmations and monthly account statements; cashiering functions and the handling of margin accounts. As a result of its arrangement with Wexford, the Company has achieved substantial savings in its clearing and related operations. Under the Wexford arrangement, management believes that the Company's cost of clearing its transactions is very competitive with the industry's costs. The Company pays a fixed fee per trade, subject to an aggregate annual minimum payment, for clearing trades through Wexford. The agreement between subsidiaries of the Company and Wexford has a fixed term of five years expiring in April 2001, with provisions for negotiated extensions. The Company has an uncommitted financing arrangement with Wexford pursuant to which the Company finances most of its customer accounts, broker-dealer balances and firm trading positions through Wexford. Although the customer accounts and such broker-dealer balances are not reflected on the Company's statements of financial condition, the Company has agreed to indemnify Wexford for losses it may sustain in connection with accounts of the Company's customers and therefore retains risk with respect thereto. The Company seeks to control the risks associated with these activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal guidelines. The Company and Wexford monitor required margin levels daily and, pursuant to such guidelines, require customers to deposit additional collateral or reduce securities positions when necessary. SEGMENT REPORTING The Company has two reportable segments: broker-dealer and asset management. The Company's broker-dealer segment includes its retail operations, investment banking, research, institutional sales and syndication service businesses as well as its OTC, fixed income and arbitrage trading activities. The asset management segment consists of Freedom Capital, Cleary Gull IMS and asset management business from Tucker Anthony and Sutro. For further information, see Note 18 of the audited financial statements contained in Item 8 of this report. EFFECTS OF INTEREST RATES The Company's business is affected by general economic conditions, including movements of interest rates. Interest rate movements may have direct effects. For example, the Company's inventory of fixed income securities may fluctuate as interest rates change, and the Company's interest income and interest expense may likewise change as interest rates change. However, interest rates have indirect effects on other aspects of the Company's business as well. As interest rates increase, the price of equity securities may decline, partially reflecting the increased competition posed by more attractive rates on fixed income securities and partially reflecting the fact that interest rate increases may tend to dampen economic activity by increasing the cost of capital for investment and expansion, thereby reducing corporate profits and the value of securities. As interest rates decline, securities may tend to rise in value. The impact of these changes may affect the Company's inventory of securities, which may change in value, and may also affect the profitability of the Company's investment banking activities. Retail commission revenue may also be affected by changes in interest rates and any resulting indirect impact on the value of securities. The Company's asset management revenues are derived from fees which are generally based on the market value of assets under management. Consequently, significant fluctuations in the values of securities, which can occur as a result of changes in interest rates or changes in other economic factors, may materially affect the amount of assets under management and thus the Company's revenues and profitability. COMPETITION All aspects of the Company's business and of the securities industry in general are highly competitive. The Company competes directly with national and regional full-service broker-dealers, and to a lesser extent with discount brokers and dealers, investment banking firms, investment advisors and certain commercial banks. Also, recent and pending legislative and regulatory initiatives intended to ease restrictions on the sale of securities by commercial banks are already beginning to increase competition from domestic and international banks. In addition, the Company competes indirectly for investment assets with insurance companies and others. In recent years the financial services industry has undergone significant consolidation as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. These mergers and acquisitions have further concentrated equity capital and other financial resources in the industry and increased competition. Many of the Company's competitors use their greater financial capital and scope of operations to offer their customers more product offerings, broader research capabilities, access to international markets, and other products and services not offered by the Company. Entities offering electronic and/or discount brokerage services are increasing competition in the securities industry. Competitors offering internet-based or other electronic brokerage services may have lower costs and offer their customers more attractive pricing than other service providers in the industry. The Company also anticipates that additional competition may arise from underwriters who will attempt to conduct offerings of securities for emerging and middle-market companies through new distribution channels such as the internet. Issuers may bypass financial intermediaries altogether and offer their shares directly to purchasers through the internet and other electronic channels. In addition, the Company faces competition for investment professionals. Although the Company strives to maintain strong relationships with its investment executives, the demand for investment executives has increased and employers in the industry are increasingly offering guaranteed contracts, upfront payments and increased compensation in an attempt to attract and retain qualified personnel. The Company believes that the principal competitive factors positively influencing the Company's business are: (1) the qualifications and experience of its professional staff; (2) its reputation in the marketplace; (3) its existing client relationships; (4) its ability to commit capital to client transactions; (5) the mix of market capabilities offered by the Company; and (6) the adequacy of its capital levels and its ability to raise additional capital. REGULATION The securities and commodities industry is one of the nation's most extensively regulated industries. Moreover, the regulations are subject to change at any time, which can affect competition in the industry, capital requirements and the Company's compliance costs. The SEC is responsible for carrying out the federal securities laws and serves as a supervisory body over all national securities exchanges and associations. In many respects, the regulation of broker-dealers has been delegated by the federal securities and commodities laws to self-regulatory organizations ("SROs"). These SROs include all the national securities and commodities exchanges, the National Association of Securities Dealers (the "NASD") and the Municipal Securities Rulemaking Board (the "MSRB"). Subject to review by the SEC and the Commodity Futures Trading Commission (the "CFTC"), these SROs adopt rules that govern the industry and conduct periodic examinations of the operations of certain subsidiaries of the Company. The NYSE has been designated as the primary regulator of certain of the Company's subsidiaries, including Tucker Anthony and Sutro. The NASD has been designated as the primary regulator of Hill Thompson. In addition, these subsidiaries are subject to regulation under the laws of the 50 states, the District of Columbia, Puerto Rico and certain foreign countries in which they are registered to conduct securities, investment banking, insurance or commodities business. Broker-dealers are subject to regulations which cover all aspects of the securities business, including sales methods, trade practices, use and safekeeping of customers' funds and securities, capital structure of securities firms, record-keeping and the conduct of directors, officers and employees. Violation of applicable regulations can result in the revocation of broker- dealer licenses, the imposition of censures or fines and the suspension or expulsion of a firm, its officers or employees. As registered broker-dealers or member firms of the NYSE or NASD, Tucker Anthony, Sutro, Cleary Gull IMS, Hill Thompson and Freedom Specialist Inc. are subject to certain net capital requirements set forth in Rule 15c3-1 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and NYSE Rule 325 ("the Net Capital Rules"). Freedom Distributors Corporation, a subsidiary of Freedom Capital, is also subject to Rule 15c3-1. The Net Capital Rules, which specify minimum net capital requirements for registered broker-dealers, are designed to measure the financial soundness and liquidity of broker-dealers. The Net Capital Rules also (1) require that broker-dealers notify the SEC, in writing, two business days prior to making withdrawals or other distributions of equity capital or lending money to certain related persons if those withdrawals would exceed, in any 30-day period, 30% of the broker-dealer's excess net capital, and that they provide such notice within two business days after any such withdrawal or loan that would exceed, in any 30-day period, 20% of the broker-dealer's excess net capital; (2) prohibit a broker-dealer from withdrawing or otherwise distributing equity capital or making related party loans if after such distribution or loan, the broker-dealer's net capital is less than 120% of its minimum net capital dollar amount or if the aggregate indebtedness of the broker-dealer's consolidated entities would exceed 1,000% of the broker-dealer's net capital and in certain other circumstances; and (3) provide that the SEC may, by order, prohibit withdrawals of capital from a broker-dealer for a period of up to 20 business days, if the withdrawals would exceed, in any 30-day period, 30% of the broker-dealer's excess net capital and if the SEC believes such withdrawals would be detrimental to the financial integrity of the firm or would unduly jeopardize the broker-dealer's ability to pay its customer claims or other liabilities. Under NYSE Rule 326, a broker-dealer that is a NYSE member is required to reduce its business if its net capital (after giving effect to scheduled maturities of subordinated indebtedness or other planned withdrawals of regulatory capital during the following six months) is less than either 125% of its minimum net capital dollar amount or 4% of aggregate debit items (or 6% of the funds required to be segregated pursuant to the Commodity Exchange Act) for fifteen consecutive days. NYSE Rule 326 also prohibits the expansion of a member's business if its net capital (after giving effect to scheduled maturities of subordinated indebtedness or other planned withdrawals of regulatory capital during the following six months) is less than either 150% of its minimum net capital dollar amount or 5% of aggregate debit items (or 7% of the funds required to be segregated pursuant to the Commodity Exchange Act) for fifteen consecutive days. For information concerning compliance by the Company's subsidiaries with the Net Capital Rules, see Note 12 of the audited financial statements included in Item 8 of this report. The Company also is subject to "Risk Assessment Rules" imposed by the SEC which require, among other things, that certain broker-dealers maintain and preserve certain information, describe risk management policies and procedures and report on the financial condition of certain affiliates whose financial and securities activities are reasonably likely to have a material impact on the financial and operational condition of the broker-dealers. Certain "Material Associated Persons" (as defined in the Risk Assessment Rules) of the broker-dealers and the activities conducted by such Material Associated Persons may also be subject to regulation by the SEC. In addition, the possibility exists that, on the basis of the information it obtains under the Risk Assessment Rules, the SEC could seek authority over the Company's unregulated subsidiaries either directly or through its existing authority over the Company's regulated subsidiaries. Tucker Anthony, Sutro, Cleary Gull IMS, Freedom Capital and other subsidiaries are registered with the SEC as investment advisors under the Investment Advisors Act of 1940 (the "Advisors Act") and are subject to the requirements of regulation pursuant to both the Advisors Act and certain state securities laws and regulations. Such requirements relate to, among other things, limitations on the ability of investment advisors to charge performance-based or non-refundable fees to clients, record-keeping and reporting requirements, disclosure requirements, limitations on principal transactions between an advisor or its affiliates and advisory clients, as well as general anti-fraud prohibitions. The state securities law requirements applicable to registered investment advisors are in certain cases more comprehensive than those imposed under federal securities laws. As registered investment advisors under the Advisors Act, Tucker Anthony, Sutro, Cleary Gull IMS, Freedom Capital and certain other subsidiaries of the Company are subject to regulations which cover various aspects of the Company's business, including compensation arrangements. Under the Advisors Act, every investment advisory agreement with the Company's clients must expressly provide that such contract may not be assigned by the investment advisor without the consent of the client. Under the Investment Company Act of 1940 (the "Investment Company Act"), every investment advisor's agreement with a registered investment company must provide for the agreement's automatic termination in the event it is assigned. Under both the Advisors Act and the Investment Company Act, an investment advisory agreement is deemed to have been assigned when there is a direct or indirect transfer of the agreement, including a direct assignment or a transfer of a "controlling block" of the firm's voting securities or, under certain circumstances, upon the transfer of a "controlling block" of the voting securities of its parent corporation. A transaction is not, however, an assignment under the Advisors Act or the Investment Company Act if it does not result in a change of actual control or management of the investment advisor. Any assignment of the Company's investment advisory agreements would require, as to any registered investment company client, the prior approval of a majority of its shareholders, and as to the Company's other clients, the prior consent of such clients to such assignments. The Company is also subject to the risk of losses as a result of employee errors, misconduct and fraud (including unauthorized transactions by traders) and failures in connection with the processing of securities transactions. In the fourth quarter of 1997, the Company determined that a former employee improperly valued securities positions of the Company over the first eleven months of 1997 in order to conceal trading losses of $2.6 million. The Company recognized these losses in its 1997 financial results and notified the SEC and the NYSE of this situation. The Company has conducted an internal review of the specific trading loss and the Company's reports and procedures relating thereto, and the Company has enhanced procedures where appropriate. The SEC is investigating this matter. The Company does not expect that the results of this investigation will have a material adverse effect on the Company's business, financial condition or operating results. ITEM 2. ITEM 2. PROPERTIES The principal executive offices of the Company are located at One Beacon Street, Boston, Massachusetts under a lease expiring in December 2005. The Company is currently leasing approximately 104,000 square feet at that location. Additionally, the Company has a number of offices in leased premises throughout the United States. The Company's primary operating subsidiaries hold leases for their principal offices as follows: - approximately 88,000 square feet (of which 18,000 square feet has been sublet) at One World Financial Center in New York expiring January 2005. - approximately 64,000 square feet (of which 8,000 square feet has been sublet) at 201 California Street, San Francisco, California expiring July 2003. - approximately 13,000 square feet at 15 Exchange Place, Jersey City, New Jersey expiring September 2007. The properties are shared by the Company's two reportable segments, except for the Jersey City property which is occupied by Hill Thompson and used solely by the Company's broker-dealer segment. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties to various civil actions and arbitrations incidental to its securities business. Some of these legal actions involve claims for substantial amounts. The defense of such legal proceedings may divert the attention of the Company's management, and the Company may incur significant legal expenses in defending such claims or litigation. While the ultimate outcome of these matters cannot be ascertained at this time, it is the opinion of management, after consultation with legal counsel, that the resolution of such suits will not have a material adverse effect on the Company's consolidated financial position or results of operation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth information regarding the executive officers of the Company as of March 21, 2000. The executive officers of the Company hold office until their successors are appointed and qualify. JOHN H. GOLDSMITH. Mr. Goldsmith joined the Company (previously the Predecessor Company) in 1988 and has served as Chairman, Director and Chief Executive Officer of the Company as well as CEO of Tucker Anthony since that time. Prior to joining the Company, Mr. Goldsmith served in various capacities at Prescott, Ball & Turben in Cleveland, Ohio, including as Managing Partner and Chief Executive Officer from 1978 to 1982 and as President and Chief Executive Officer from 1982 to 1988. Mr. Goldsmith worked in the institutional sales department of L.F. Rothschild from 1963 to 1971. KENNETH S. KLIPPER. Mr. Klipper, a CPA, was named Executive Vice President and Chief Financial Officer of the Company in January 2000. Prior to joining the Company, Mr. Klipper served in various capacities at Fidelity Investments from 1994 to 2000, including most recently as Chief Financial Officer for its two principal broker-dealer subsidiaries, Fidelity Brokerage Services, Inc. and National Financial Services Corp. Previously, Mr. Klipper was Managing Director and Controller of Wheat First Butcher Singer, Inc. from 1992 to 1994 and held various positions at KPMG Peat Marwick from 1981 to 1992. JOHN F. LUIKART. Mr. Luikart joined Sutro in 1988 as Executive Vice President and was responsible for directing all of the firm's capital markets activities. Mr. Luikart became President of Sutro in 1990. Mr. Luikart was appointed Chief Executive Officer of Sutro in October 1995 and subsequently elected to the Board of Directors of the Company in 1996. Mr. Luikart became Chairman of Sutro in October 1998. Prior to joining Sutro, Mr. Luikart served as General Partner and Executive Vice President at Prescott, Ball & Turben in Cleveland, Ohio. Mr. Luikart is a former Chairman of the NASD District Business Conduct Committee and is a member of the New York Stock Exchange Regional Firm Advisory Committee. KEVIN J. MCKAY. Mr. McKay joined the Company in 1994 and has served as General Counsel and Secretary since that time. Prior to joining the Company, Mr. McKay was General Counsel of Prudential Securities Incorporated from 1990 to 1994. Mr. McKay has over 20 years of experience in the legal and compliance field of the securities industry. Mr. McKay is a past President of the Compliance & Legal Division of the Securities Industry Association. DAVID P. PROKUPEK. Mr. Prokupek was appointed to the Company's Board of Directors in May 1998, following the acquisition of Cleary Gull. He joined Cleary Gull as Managing Director of the Investment Banking Department in 1992, was elected a director in 1994, was named Chief Executive Officer in 1996 and currently serves as President of Tucker Cleary and Chairman and CEO of Cleary Gull IMS. Prior to joining Cleary Gull, Mr. Prokupek was a Managing Director of American Asset Management, a New York-based investment counselor and merchant bank, and from 1987 to 1989 he was a member of Bankers Trust Company's Merchant Banking Group. MARK T. WHALEY. Mr. Whaley was appointed to the Company's Board of Directors in September 1999, following the acquisition of Gibraltar. Mr. Whaley joined Gibraltar in 1982, was elected Executive Vice President in 1996 and was promoted to President of Gibraltar in 1999. Mr. Whaley has more than 18 years of experience in the brokerage industry as a stockbroker, training manager and director of sales. ROBERT H. YEVICH. Mr. Yevich joined Tucker Anthony in 1985 and became National Sales Manager in 1988. Mr. Yevich was elected to the Board of Directors of the Company and promoted to President of Tucker Anthony in 1995. Mr.Yevich has more than 25 years of experience in the retail brokerage business as a stockbroker, branch manager and research associate. Prior to joining Tucker Anthony, Mr. Yevich served as branch manager with PaineWebber. PART II ITEM 5. ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Market Information The Company's common stock is listed on the NYSE under the symbol "FSI." The high and low sales prices per share of the Company's common stock by quarter since the Company's public offering in April 1998 were as follows: As of March 21, 2000, the closing sales price per share of the Company's common stock was $14 1/8. (b) Holders As of February 11, 2000, there were approximately 618 record holders of the Company's common stock, according to the records maintained by the Company's transfer agent. As of February 11, 2000, the Company estimates that there were over 6,000 beneficial owners of the Company's common stock. (c) Dividends Through December 31, 1999, cash dividends per common share declared and paid by the Company each quarter since its public offering in April 1998 were as follows: The timing and amount of future dividends will be determined by the Company's Board of Directors and will depend, among other factors, upon the Company's earnings, financial condition and cash requirements at the time such payment is considered. The Company has historically funded its quarterly dividend payments through dividends received from its subsidiaries whose ability to pay dividends is limited by the Net Capital Rules of various regulatory bodies. Additionally, the Company's dividend payments are restricted by its revolving credit agreement. See Notes 10 and 12 of the Company's audited financial statements in Item 8 of this report. (d) Unregistered Securities During the fourth quarter of 1999, the Company issued 1,233,405 shares of its common stock to the former owners of Hill Thompson Group to acquire their firm in a private placement transaction exempt under section 4(2) of the Securities Act. Additionally, the Company issued 4,645 shares of common stock during the 1999 fourth quarter in private placement transactions exempt under section 4(2) of the Securities Act to John Hancock Subsidiaries, Inc. pursuant to the Additional Share Agreement entered into in connection with the acquisition of the Company's subsidiaries from Hancock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------- (a) Based on the consolidated results of the Predecessor Company for the eleven months ended November 29, 1996 combined with the consolidated results of the Company for one month ended December 31, 1996. (b) Predecessor Company. (c) Certain amounts have been reclassified to conform with 1999 financial statement presentation. (d) Extraordinary item of $1.2 million after tax represents the write-off of capitalized debt costs as a result of the retirement of $77.5 million in debt following the Company's April 2, 1998 initial public offering. (e) EBITDA represents earnings before extraordinary item, acquisition interest expense, taxes, depreciation and amortization. EBITDA is a supplemental measure of operating results or cash flow from operations and is a widely accepted financial indicator of a Company's liquidity. It is not an alternative measure of operating results or cash flow from operations as determined in accordance with generally accepted accounting principles. (f) Return on average equity has been restated to conform with current year methodology. Return on average equity for 1998 is before extraordinary item. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS ENVIRONMENT The Company's retail securities brokerage activities, as well as its investment banking, asset management, institutional sales and trading and equity research services, are in highly competitive markets and subject to various risks including volatile trading markets and fluctuations in the volume of market activity. These markets are affected by general economic and market conditions, including fluctuations in interest rates, volume and price levels of securities, flows of investor funds into and out of mutual funds and pension plans and by factors that apply to particular industries such as technological advances and changes in the regulatory environment. Declining interest rates and an improving economic environment contributed to a significant increase in activity in the equity markets in the United States throughout 1997. The United States economy remained strong during 1998, with stable interest rates and low inflation. However, the financial markets experienced periods of heavy volatility during August and September 1998, resulting in a difficult operating environment for the third quarter, particularly in trading and investment banking activities. The year 1999 saw a continuation of positive monetary conditions and low inflation which continued to propel the United States equity markets. Financial market conditions remained favorable in 1999 despite some uncertainty over the direction of U.S. interest rates during the last three quarters of the year. The Company's financial results have been and may continue to be subject to fluctuations due to the changing economic environment. Consequently, the results of operations for a particular period may not be indicative of results to be expected for other periods. COMPANY DEVELOPMENTS During 1999, the Company continued its growth strategy which resulted in several new acquisitions summarized below. - In January 1999, the Company acquired certain assets and liabilities of Hopper Soliday & Co., Inc. ("Hopper Soliday"), renamed Tucker Anthony MidAtlantic Division ("TA MidAtlantic") and transferred them to Tucker Anthony. TA MidAtlantic is an investment and municipal banking operation based in Pennsylvania. - In February 1999, the Company, through its Sutro subsidiary, acquired the business and substantially all of the assets of Charter Investment Group, Inc. ("Charter"), a retail brokerage firm based in Oregon. - In September 1999, the Company acquired Gibraltar Securities Co. ("Gibraltar"), a regional brokerage and investment advisory service firm located in New Jersey which was merged with and operates as a division of Tucker Anthony. - In October 1999, the Company acquired The Hill Thompson Group, Ltd. ("Hill Thompson Group"), including its primary operating subsidiary Hill, Thompson, Magid & Co., Inc. ("Hill Thompson"), a New Jersey-based over-the-counter trading firm. During 1998, the Company undertook two key initiatives as highlighted below: - On April 2, 1998, the Company completed its initial public offering of 7.4 million shares plus an over-allotment of 1.1 million shares, including 4.2 million shares of common stock sold by the Company. The Company's public offering raised approximately $75.7 million for the Company, after deducting underwriting discounts, commissions and expenses. The Company used the proceeds and available cash to repay $77.5 million of debt. - In May 1998, the Company completed its acquisition of Cleary Gull Reiland & McDevitt Inc. ("Cleary Gull"), a privately held investment banking, institutional brokerage and investment advisory firm headquartered in Milwaukee, Wisconsin. During 1999, the investment banking, equity research and institutional brokerage activities of Cleary Gull and Tucker Anthony were combined to form Tucker Anthony Cleary Gull ("Tucker Cleary"), a division of Tucker Anthony. The remaining business of Cleary Gull, now Cleary Gull IMS, is primarily investment management services provided to institutional accounts and high net worth individuals. COMPONENTS OF REVENUES AND EXPENSES REVENUES. Commission revenues include retail and institutional commissions received by the Company as an agent in securities transactions, including all exchange listed, over-the-counter agency, mutual fund, insurance and annuity transactions. Principal transactions revenues include principal sales credits and dividends as well as gains and losses from the trading of securities by the Company. Investment banking revenues include selling concessions, underwriting fees and management fees received from the underwriting of corporate or municipal securities as well as fees earned from providing merger and acquisition and other financial advisory services. Asset management revenues include fees generated from providing investment advisory, portfolio management and custodial services to clients, as well as managed account fees and 12b-1 distribution fees. Other revenues primarily consist of retirement plan revenue, third party correspondent clearing fees and other transaction fees. Net interest income equals interest income less interest expense. Interest income primarily consists of interest earned on margin loans made to customers, securities purchased under agreements to resell and fixed income securities held in the Company's trading accounts. Interest expense includes interest paid under its Wexford financing arrangement and on bank borrowings, securities sold under agreements to repurchase, fixed asset financing and cash balances in customer accounts held by Wexford. EXPENSES. Compensation and benefits expense includes sales, trading and incentive compensation, which are primarily variable based on revenue production and/or business unit profit contribution, and salaries, payroll taxes and employee benefits which are relatively fixed in nature. Incentive compensation, including bonuses for eligible employees, is accrued proratably throughout the year based on actual or estimated annual amounts. Occupancy and equipment expense includes rent and operating expenses for facilities, expenditures for repairs and maintenance, and depreciation and amortization of furniture, fixtures and leasehold improvements. Communications expense includes charges for telecommunications, news and market data services. Brokerage and clearance expense includes the cost of securities clearance, floor brokerage and exchange fees. Promotional expense includes travel, entertainment and advertising. Other expenses include general and administrative expenses, such as professional services, litigation expenses, goodwill amortization, data processing and other miscellaneous expenses. Acquisition interest expense represents the interest expense incurred to fund acquisitions through borrowings under revolving credit agreements. RESULTS OF OPERATIONS The following table sets forth year-to-year increases (decreases) in the major revenue and expense categories (in thousands): - --------------- (a) Certain amounts have been reclassified to conform with 1999 financial statement presentation. (b) Net interest income is net of interest expense of $37,335 in 1999, $25,836 in 1998 and $22,428 in 1997. (c) Not meaningful. (d) Extraordinary item is related to the write-off of capitalized debt costs as a result of the retirement of $77.5 million in debt in conjunction with the Company's April 2, 1998 initial public offering. 1999 Compared to 1998 Net revenues were a record $553.3 million for 1999, up $112.9 million or 26% from $440.4 million in 1998. The Company's net revenue growth primarily stems from the expansion of its retail business combined with growth through new acquisitions. Net revenues increased $48.9 million in 1999 as a result of the acquisitions of Hopper Soliday, Charter, Gibraltar and Hill Thompson in 1999 and Cleary Gull in the second quarter of 1998 (collectively, the "acquired companies"). Net income for the year ended December 31, 1999 was $29.1 million, a 16% increase from $25.1 million a year ago and a 10% increase from 1998 net income before extraordinary item of $26.4 million. Earnings per common share (diluted) before extraordinary item were $1.39 compared with $1.34 for the year ended December 31, 1998. Commission revenues increased 28% or $49.2 million to $228.2 million in 1999 from $179.0 million in 1998. The current year increase is primarily due to higher average productivity from existing investment executives combined with production from new investment executives as a result of the Company's aggressive expansion of its retail business. Principal transactions revenues were $146.6 million in 1999, up $48.3 million or 49% when compared to $98.3 million in 1998. The revenue increase is primarily attributable to a significant rise in fixed income related revenues as well as higher over-the-counter and arbitrage trading revenues when compared with 1998 which was adversely affected by turbulent financial market conditions during the 1998 third quarter. Investment banking revenues were $72.9 million in 1999, down 11% from $82.3 million in 1998. Despite a significant improvement in municipal finance fees, investment banking revenues were down due to reduced equity underwriting activity and to the transitional effects of realigning much of the Company's equity capital market businesses. Asset management revenues rose 42% to $67.1 million in 1999 from $47.3 million in 1998, primarily due to increased revenues earned on assets under management. Assets under management grew to $11.0 billion at year end 1999 from $9.0 billion in 1998 as a result of both new money added to the funds and asset appreciation. Net interest income was $28.9 million in 1999, up $3.9 million or 16% from $25.0 million in 1998. The increase in net interest income was mainly due to higher average customer margin balances resulting from growth in the Company's retail businesses. Compensation and benefits expense was $362.2 million in 1999 compared to $286.1 million in 1998, an increase of $76.1 million or 27% of which $28.7 million was attributable to acquired companies. The remainder of the increase was due to higher production related compensation based on the Company's improved operating results and to costs of recruiting new investment executives. Compensation and benefits as a percentage of net revenues were 65% in both 1999 and 1998. Non-compensation related operating expenses were $142.3 million in 1999, an increase of $34.1 million or 31% when compared with $108.2 million in 1998. Included in 1999 operating expenses are costs from acquired companies of $15.5 million which were not included in 1998. Non-compensation related operating expenses as a percentage of net revenues was 26% for 1999 compared with 25% in 1998. Occupancy and equipment expense increased $5.0 million or 21% in 1999 primarily due to additional office space, expansion within the Company's retail business and $2.6 million of costs from acquired companies. Communications expense was $22.4 million in 1999 compared to $18.4 million in 1998, an increase of 22 % or $4.0 million of which $2.3 million stems from acquired companies with the remainder mostly related to new retail branches. Brokerage and clearance expense was $21.7 million in 1999, up $7.3 million or 50% (including $2.6 million from acquired companies) compared with $14.4 million in 1998 mainly reflecting additional execution clearing costs resulting from higher business volumes. Promotional expense increased $4.0 million or 28% (including $1.8 million from acquired companies) to $18.1 million in 1999 from $14.1 million a year ago due to increased spending on business development, advertising and travel. Other expenses, which include information systems, professional fees, data processing, printing, postage and license/registration fees, increased $13.8 million (including $6.2 million from acquired companies) to $51.6 million in 1999 from $37.8 million in 1998. This increase partly stems from investments in technology, increased professional fees associated with new hiring and additional goodwill amortization resulting from acquisitions. The Company's income tax provisions for 1999 and 1998 were $18.9 million and $18.2 million, respectively. The effective tax rate was 39% for 1999, down from 41% in 1998 reflecting an increase in income not subject to tax and a decrease in state taxes due to higher taxable income in states with lower tax rates. 1998 Compared to 1997 The Company achieved record net revenues in 1998 compared to 1997. Net revenues increased $63.6 million or 17% to $440.4 million in 1998 from $376.8 million in 1997 and, with the exception of principal transactions, reflected increases in all revenue categories. Net income before extraordinary item was $26.4 million for 1998, up $7.7 million or 41%, versus $18.7 million in 1997. Earnings per common share (diluted) before extraordinary item were $1.34 in 1998, compared to $1.27 in 1997. Earnings per common share in 1998 were significantly impacted by the increase in the number of shares outstanding following the Company's initial public offering. Commission revenues increased $21.8 million or 14% to $179.0 million in 1998 from $157.2 million in 1997, due to higher institutional sales as well as increased volume in the Company's retail businesses, resulting from increased average production per retail investment executive, a greater number of investment executives and penetration into new markets. The Company opened three new retail branches in 1998 and hired 105 new investment executives. Principal transactions revenues of $98.3 million in 1998 were essentially flat when compared to $98.0 million in 1997. Although fixed income related revenues rose 14% from 1997, this increase was offset by lower over-the-counter and arbitrage trading revenues. Arbitrage trading activities were adversely impacted by turbulent financial market conditions in the 1998 third quarter, but rebounded during the fourth quarter and were profitable for the year. Investment banking revenues increased $24.6 million or 43% to $82.3 million in 1998 from $57.7 million in 1997. The improvement in investment banking revenues resulted from higher public offering revenues during the first six months of the year, continued growth in merger and acquisition and advisory activities, and the inclusion of Cleary Gull for eight months in 1998. Asset management revenues grew $12.9 million or 38% to $47.3 million in 1998 from $34.4 million in 1997, and represented 11% of the Company's total net revenues versus 9% in 1997. This revenue increase reflected the overall growth in assets under management, which grew 38% to $9.0 billion at year end 1998 and resulted from both new money added to the funds as well as asset appreciation arising from equity market performance. Net interest income was $25.0 million in 1998, up $3.4 million or 16% from $21.6 million in 1997 primarily due to higher average customer margin balances. Acquisition interest expense decreased $4.6 million during 1998 reflecting the retirement of debt following the Company's public offering. Compensation and benefits expense increased $40.9 million or 17% to $286.1 million in 1998 from $245.2 million in 1997, primarily due to increased incentive and production-related compensation attributable to higher revenues and the inclusion of Cleary Gull in 1998. Compensation and benefits as a percentage of net revenues were 65% for both 1998 and 1997. Non-compensation related operating expenses increased an aggregate of $15.0 million or 16% to $108.2 million in 1998 from $93.2 million in 1997. The increase in 1998 included approximately $6.7 million of operating expenses for Cleary Gull which was not included in 1997. Non-compensation related operating expenses as a percentage of net revenues were 25% in both 1998 and 1997. Promotional expenses increased $3.7 million or 35% (including $1.2 million from Cleary Gull) to $14.1 million in 1998 from $10.4 million in 1997 due to increased spending on research conferences, advertising, business development and travel. Other expenses, which include professional fees, data processing, printing, postage and license/registration fees, increased $5.4 million or 16% (including $2.7 million from Cleary Gull) to $37.8 million in 1998 from $32.4 million in 1997. The Company's income tax provisions for 1998 and 1997 were $18.2 million and $13.7 million, respectively. The effective tax rate was 41% for 1998, down from 42% in 1997 reflecting an increase in income not subject to tax. LIQUIDITY AND CAPITAL RESOURCES The Company receives dividends, interest on loans and other payments from its subsidiaries, which are the Company's main sources of funds to pay expenses, service debt and pay dividends. Distributions and interest payments to the Company from its registered broker-dealer subsidiaries, the Company's primary sources of liquidity, are restricted as to amounts which may be paid by applicable law and regulations. The Net Capital Rules are the primary regulatory restrictions regarding capital resources. The Company's rights to participate in the assets of any subsidiary are also subject to prior claims of the subsidiary's creditors, including customers of the broker-dealer subsidiaries. The assets of the Company's primary operating subsidiaries are highly liquid with the majority of their assets consisting of securities inventories and collateralized receivables, both of which fluctuate depending on the levels of customer business. Collateralized receivables consist mainly of securities purchased under agreements to resell, which are secured by U.S. government and agency securities. The majority of the subsidiaries' assets are financed through Wexford, by securities sold under repurchase agreements and by securities sold, not yet purchased. The Company's principal source of short-term financing stems from its clearing arrangement with Wexford under which the Company can borrow on an uncommitted collateralized basis against its proprietary inventory positions. This financing generally is obtained from Wexford at rates based upon prevailing market conditions. The Company monitors overall liquidity by tracking the extent to which unencumbered marketable assets exceed short-term unsecured borrowings. Repurchase agreements are used primarily for customer accommodation purposes and to finance the Company's inventory positions in U.S. government and agency securities. These positions provide products and liquidity for customers and are not maintained for the Company's investment or market speculation. The level of activity fluctuates depending on customer and inventory needs; however, these fluctuations have not materially affected liquidity or capital resources. The Company monitors the collateral position and counterparty risk on these transactions daily. The subsidiaries' total assets and short-term liabilities and the individual components thereof may vary significantly from period to period because of changes relating to customer needs and economic and market conditions. The Company's total assets at December 31, 1999 and December 31, 1998 were $818.0 million and $606.3 million, respectively. The Company's operating activities generate cash resulting from net income earned during the period and fluctuations in its current assets and liabilities. The most significant fluctuations have resulted from changes in the level of customer activity and securities inventory changes resulting from proprietary arbitrage trading strategies dictated by prevailing market conditions and the effects of acquired companies. In addition to normal operating requirements, capital is required to satisfy financing and regulatory requirements. The Company's overall capital needs are continually reviewed to ensure that its capital base can appropriately support the anticipated capital needs of the subsidiaries. The excess regulatory net capital of the Company's broker-dealer subsidiaries may fluctuate throughout the year reflecting changes in inventory levels and/or composition, investment banking commitments and balance sheet components. For a description of the Company's net capital requirements, see Note 12 of the audited financial statements contained in Item 8 of this report. Management believes that existing capital, funds provided by operations, the credit arrangements with Wexford and funds available from a revolving credit agreement will be sufficient to finance the operating subsidiaries' ongoing businesses. In 1999, the Company financed acquisitions with cash, stock or a combination of both. Future acquisitions, if any, would likely be financed in the same manner. Funds available from a revolving credit agreement are expected to be sufficient to finance acquisitions in the near future. During 1999, the Company amended its $50 million revolving credit agreement (the "Credit Agreement") to increase the total commitments of participating banks to $100 million. At December 31, 1999, the Company had borrowings outstanding of $50 million, the proceeds of which were used to finance the acquisitions of Gibraltar and Hill Thompson Group. The Credit Agreement matures in November 2003 with all outstanding loans payable at that date. The Company maintains, through two subsidiaries, a fixed asset credit facility (the "Fixed Asset Facility") secured by certain of the Company's fixed assets. During 1999, the Company refinanced a portion of the Fixed Asset Facility and secured additional financing which was used to upgrade its computer systems. At December 31, 1999, the Company had borrowings outstanding under the Fixed Asset Facility of $11.3 million, of which $9.0 million is payable in monthly installments until December 2001 and $2.3 million is payable in monthly installments through June 2003. The Company has historically financed capital expenditures through internal cash generation and through the Fixed Asset Facility. For the years ended December 31, 1999, 1998 and 1997, the Company had capital expenditures of approximately $9.5 million, $5.1 million and $2.0 million, respectively, which were funded from operations. In September 1998, the Board of Directors approved a stock repurchase program that permits the Company's management to purchase at its discretion up to five percent of the Company's common stock outstanding or approximately one million shares. In April 1999, the Board of Directors authorized the purchase of an additional one million shares. To date, the Company has funded its stock repurchases from internal sources. During 1999, the Company's treasury stock activities consisted of repurchased shares of 1,777,763 at an average price of $15.60 per share. Included in the shares repurchased, but not part of the stock repurchase program are 494,748 shares acquired from SCP Private Equity Partners, L.P., one of the original equity investors in the Company, and 256,973 shares acquired in private transactions. As of March 21, 2000, the Company was authorized to repurchase an additional 906,758 shares under the repurchase program. CASH FLOWS For the year ended December 31, 1999, cash and cash equivalents increased $13.4 million. Funds generated from operating activities were $56.2 million including net income of $29.1 million and depreciation, amortization and other non-cash charges to net income of $24.5 million. During 1999, the Company invested cash of $62.0 million including $52.3 million for acquisitions and $9.5 million for fixed asset purchases and leasehold improvements. Cash provided by financing activities in 1999 amounted to $19.2 million comprised principally of $43.2 million in net proceeds from bank borrowings partially offset by $21.7 million in purchases of treasury stock and $3.8 million of dividend payments. RISK MANAGEMENT The Company's primary risk exposures are market risk (particularly equity price and interest rate risk) and credit risk. Market risk refers to the risk that a change in the level of equity prices, interest rates or other factors could result in trading losses. Credit risk refers to the risk that a counterparty to a transaction might fail to perform under its contractual commitment resulting in the Company incurring losses. Tucker Anthony's, Sutro's and Hill Thompson's risk management focuses on the trading of securities, extension of credit to counterparties and investment banking activities, as well as the extension of credit to retail and institutional customers. Tucker Anthony, Sutro and Hill Thompson monitor their market and credit risks daily though a number of control procedures designed to identify and evaluate the various risks to which they are exposed. Market Risk Tucker Anthony, Sutro and Hill Thompson may act as a principal to facilitate customer-related transactions in financial instruments which expose the firm to market risks. Tucker Anthony, Sutro and Hill Thompson may make markets in equity and debt securities and Tucker Anthony trades for its own account in arbitrage-related trading activities. Whether acting as principal to facilitate customer transactions or trading for their own account, Tucker Anthony, Sutro and Hill Thompson monitor market risk very closely. Managing market risk exposure includes: limiting firm commitments by position levels both long and short for every product that is traded; limiting the type of trade that can occur in each inventory account; and tactically employing certain hedging techniques that reduce the level of risk taken. Management believes that the risk management practices of Tucker Anthony, Sutro and Hill Thompson aid in managing the Company's market exposure. Tucker Anthony, Sutro and Hill Thompson manage daily risk exposure in their firm inventory accounts by requiring various levels of management review of these accounts. The primary purpose of risk management is to participate in the establishment of position limits, as well as to monitor both the buy and sell activity in the firm's trading accounts. Trading activities of Tucker Anthony, Sutro and Hill Thompson result in the creation of inventory positions. Position and exposure reports indicating positions by product or trader are prepared, distributed and reviewed each day. These reports enable Tucker Anthony, Sutro and Hill Thompson to control inventory levels, monitor daily trading results by product, as well as review inventory aging, pricing and concentration. The Company is exposed to changes in interest rates as a result of its borrowings under its Credit Agreement. The amount of the Company's long-term debt may vary as a result of future business requirements, market conditions and other factors. For a description of the terms of the Company's long term debt, see Note 10 of the audited financial statements contained in Item 8 of this report. Credit Risk Tucker Anthony and Sutro deal with counterparties or other broker-dealers in conducting business for their clients or for their own accounts. Financing extended to counterparties is provided against collateral through Wexford. The Company reviews counterparties to establish appropriate exposure levels on an account by account basis. Tucker Anthony and Sutro manage daily credit exposure by monitoring the level of collateral and creditworthiness of counterparties and their related trading limits. Tucker Anthony and Sutro, through Wexford, extend credit to retail customers. Amounts loaned are limited by the margin regulations of the Board of Governors of the Federal Reserve System and other regulatory authorities and are subject to credit review and daily monitoring by Wexford, Tucker Anthony and Sutro. Risks associated with investment banking activities are controlled through capital commitment committees within Tucker Anthony and Sutro. These commitment committees review every significant proposed investment banking transaction prior to its acceptance by Tucker Anthony or Sutro. These respective capital committees review major proposed transactions in order to determine the effect of such transactions on regulatory capital prior to their approval. Only after acceptance by the committee within each firm will that subsidiary's commitment to underwrite a specific security be extended to the investment banking client. Value at Risk Under Securities and Exchange Commission rules, the Company is required to disclose information about its exposure to market risk. As permitted by SEC rules, the Company used a statistical technique known as Value-at-Risk ("VaR") to estimate the potential daily earnings effect of adverse changes in fair value of its trading positions. VaR incorporates numerous variables that could impact the fair value of the Company's trading portfolio, including equity and interest rates, associated volatilities, as well as the correlation that exists among these variables. The Company calculated VaR using a variance/covariance model with confidence level of 95% over a one-day holding period. That is, the Company's VaR represents a potential one-day loss in value that would be exceeded less than 2.5% of the time if the portfolio were unchanged. Among the benefits, a VaR model permits the estimation of a portfolio's aggregate market risk exposure; incorporates a range of varied market risks in the calculation; reflects risk reduction due to portfolio diversification; and is comprehensive yet relatively easy to interpret. However, VaR risk measures should be interpreted in light of the methodology's limitations, which include the fact that past changes in market risk will not always accurately predict future changes in a portfolio's value; the model does not include all of a trading portfolio's market risk factors; and any published VaR results which reflect a point in time analysis (i.e., December 31, 1999 positions) do not fully capture the market risk of positions that may not be liquidated or hedged within one day. The Company is aware of these and other limitations and therefore views VaR as only one component in its risk management review process. The table below presents the Company's VaR results for each of the Company's primary risk exposures as well as on an aggregate basis and incorporates substantially all financial instruments generating market risk. Since VaR is based on historical data and changes in market risk factor returns, VaR should not be viewed as predictive of the Company's future financial performance or its ability to manage and monitor risk. Also, there can be no assurance that the Company's actual losses on a particular day will not exceed the VaR amounts indicated below. The Company's VaR results are as follows (in thousands): - --------------- * The diversification benefit represents the elimination of market risks which are present and are offsetting in both the interest rate VaR and the equity VaR. During 1999, the Company's VaR varied from a high of $1.2 million to a low of $0.7 million primarily due to an increase in financial instruments generating market risk as a result of current year acquisitions. IMPACT OF YEAR 2000 In prior years, the Company discussed the nature and progress of its plans to become Year 2000 ready. During 1999, the Company completed its remediation and testing of systems. As a result of those planning and implementation efforts, the Company did not experience any significant disruptions in mission critical information technology and non-information technology systems and believes those systems successfully responded to the Year 2000 change. Through December 31, 1999, the Company's costs related to Year 2000 were minimal and were funded out of working capital. The Company is not aware of any material problems resulting from Year 2000 issues, either with its products, its internal systems, or the products and services of third parties. The Company will continue to monitor its mission critical computer applications and those of its suppliers and vendors throughout the year 2000 to ensure that any unidentified Year 2000 matters that may arise are addressed promptly. ITEM 7a. ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is contained in "Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations" under the caption "Risk Management" and is incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF FREEDOM SECURITIES CORPORATION: We have audited the accompanying consolidated statements of financial condition of Freedom Securities Corporation (the "Company") as of December 31, 1999 and 1998 and the related consolidated statements of income, changes in stockholders' equity, and cash flows for the years ended December 31, 1999, 1998 and 1997. These financial statements are the responsibility of the management of the Company. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Freedom Securities Corporation at December 31, 1999 and 1998 and the consolidated results of its operations and its cash flows for the years ended December 31, 1999, 1998 and 1997 in conformity with accounting principles generally accepted in the United States. /s/ ERNST & YOUNG, LLP New York, New York January 24, 2000 FREEDOM SECURITIES CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 1999 AND 1998 (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) See Notes to Consolidated Financial Statements. FREEDOM SECURITIES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) See Notes to Consolidated Financial Statements. FREEDOM SECURITIES CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (AMOUNTS IN THOUSANDS) See Notes to Consolidated Financial Statements. FREEDOM SECURITIES CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) See Notes to Consolidated Financial Statements. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Freedom Securities Corporation is a holding company which together with its wholly-owned subsidiaries (collectively, the "Company") is a full-service retail brokerage, asset management and investment banking firm. The Company is engaged primarily in the retail and institutional brokerage business including corporate finance and underwriting services. The consolidated financial statements include the accounts of the Company including its primary operating subsidiaries: - Tucker Anthony Incorporated ("Tucker Anthony"), headquartered in Boston, is a brokerage and investment banking firm. Tucker Anthony's divisions include Tucker Anthony Cleary Gull ("Tucker Cleary"), an investment banking and institutional brokerage firm; Gibraltar Securities Co. ("Gibraltar"), a New Jersey-based brokerage and investment advisory firm acquired by the Company in the third quarter of 1999; and Tucker Anthony MidAtlantic Division ("TA MidAtlantic"), formerly Hopper Soliday & Co., Inc. ("Hopper Soliday"), a Pennsylvania-based municipal finance and underwriting brokerage firm acquired by the Company in the first quarter of 1999. - Sutro & Co. Incorporated ("Sutro"), headquartered in San Francisco, is a West Coast regional brokerage and investment banking firm. - Hill, Thompson, Magid & Co., Inc. ("Hill Thompson"), based in New Jersey, is an over-the-counter trading firm. - Freedom Capital Management Corporation ("Freedom Capital") is a Boston-based asset management firm. Tucker Anthony, Sutro and Cleary Gull Investment Management Services, Inc. ("Cleary Gull IMS") clear their securities transactions on a fully disclosed basis through Wexford Clearing Services Corporation ("Wexford"), a guaranteed wholly-owned subsidiary of Prudential Securities Incorporated ("Prudential"). Hill Thompson clears all proprietary securities transactions on a self-clearing basis and substantially all customer transactions through Schroder & Co. Inc. on a fully disclosed basis. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates. Certain prior period amounts have been reclassified to conform with the current period's financial statement presentation. Securities Securities transactions and related revenues and expenses are recorded on a trade date basis. Securities owned and securities sold, not yet purchased are stated at market value with related changes in unrealized appreciation or depreciation reflected in principal transactions revenues. Market value is generally based on listed market prices. If listed market prices are not available, fair value is determined based on other relevant factors, including broker or dealer price quotations. Securities sold, not yet purchased represent obligations to deliver specified securities at predetermined prices. The Company is obligated to acquire the securities sold short at prevailing market prices in the future to satisfy these obligations. Arbitrage positions included in securities owned and securities sold, not yet purchased result from buying or selling a security subject to exchange, conversion or reorganization and selling or buying the security or securities to be received upon FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) completion of the exchange, conversion or reorganization. The Company may from time to time enter into options and futures contracts. These contracts are valued at market with related changes in unrealized appreciation or depreciation reflected in principal transactions revenues. Investment Banking Investment banking revenues are recorded as follows: management fees as of the offering date, sales commissions on the trade date and underwriting fees at the time the underwriting is completed and the income is reasonably determinable. Asset Management Fees The Company earns fees for investment advisory and custodial services rendered to its clients. Fees are based on a percentage of the average market value of net assets managed, a percentage of quarter-end market value of assets managed or on a fee for account basis, depending on the type of client account. These fees are recorded as earned and billed monthly or quarterly. Fixed Assets Furniture and fixtures are depreciated on a straight-line basis over their estimated useful lives, generally three to ten years. Leasehold improvements are amortized on a straight-line basis over the lesser of the economic useful lives of the improvements or the terms of the respective leases. Fixed assets are stated at cost net of accumulated depreciation and amortization of $9.6 million and $7.7 million at December 31, 1999 and 1998, respectively. Intangibles Goodwill is stated at cost net of accumulated amortization and is amortized on a straight-line basis over fifteen years. The accumulated amortization of intangibles totaled $8.6 million and $4.7 million at December 31, 1999 and 1998, respectively. Stock Based Compensation The Company accounts for its stock-based compensation in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees" and, accordingly, recognizes no compensation expense related to stock option grants issued at fair market value. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," which encourages, but does not require, companies to recognize compensation expense for grants of stock and stock options based on the fair value of those instruments. The Company has elected, as permitted by SFAS No. 123, to adopt the disclosure requirement of SFAS No. 123 and to continue to account for stock-based compensation under APB Opinion No. 25. Income Taxes The Company accounts for income taxes using the asset and liability method required by SFAS No. 109, "Accounting for Income Taxes." Under this method, the Company recognizes taxes payable or refundable for the current year and deferred tax liabilities and assets based on temporary differences between the carrying amounts of assets and liabilities for book purposes versus tax purposes. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Cash Flows For purposes of reporting cash flows, the Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash flows for the years ended December 31, 1999 and 1998 are shown net of the effects of acquired companies (See Note 4). Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which establishes standards for the accounting and reporting of derivative instruments. This statement was originally effective for fiscal years beginning after June 15, 1999. However, in June 1999, the FASB issued SFAS No. 137, which delayed the effective date of SFAS No. 133 by one year. SFAS No. 133 is currently effective for fiscal years beginning after June 15, 2000. The Company does not expect the adoption of this statement to have a material impact on the Company's consolidated financial statements. 3. INITIAL PUBLIC OFFERING On April 2, 1998, the Company completed its initial public offering of 7.4 million shares plus an over-allotment of 1.1 million shares (the "Offering"), including 4.2 million shares of $.01 par value common stock sold by the Company. The Offering raised approximately $75.7 million for the Company after deducting underwriting discounts, commissions and expenses. The Company used the proceeds and available cash to repay $77.5 million of existing debt (See Note 10). Also, the Company wrote-off related debt issuance costs which resulted in an after-tax extraordinary item of $1.2 million in the consolidated statement of income for the year ended December 31, 1998. 4. ACQUISITIONS Hopper Soliday (renamed TA MidAtlantic) On January 19, 1999 the Company acquired certain assets and liabilities of Hopper Soliday, renamed TA MidAtlantic, and transferred them to Tucker Anthony. TA MidAtlantic is an investment and municipal banking operation based in Pennsylvania and its results are included in the consolidated financial statements from the date of acquisition. The purchase price was $9.0 million paid in cash and the acquisition was accounted for using the purchase method of accounting. The excess of the purchase price over the estimated fair value of net assets acquired, which was recorded as goodwill, was $1.5 million and is being amortized over 15 years using the straight-line method of amortization. In addition, the Company agreed to make certain incentive and retention payments with a total value of $2.0 million (the majority of which is subject to a three year vesting period). Charter On February 1, 1999 the Company, through its Sutro subsidiary, acquired the business and substantially all of the assets of Charter Investment Group, Inc. ("Charter"), a brokerage firm based in Portland, Oregon. The consolidated financial statements include the results of Charter from the date of acquisition and the acquisition was accounted for using the purchase method of accounting. The purchase price was $3.6 million which included 203,665 shares of the Company's common stock valued at $3.1 million and $0.5 million paid in cash. The excess of the purchase price over the estimated fair value of net assets acquired, which was recorded as goodwill, was $2.4 million and is being amortized over 15 years using the straight-line method of amortization. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Gibraltar On September 1, 1999, the Company acquired Gibraltar, a regional brokerage and investment advisory service firm based in New Jersey. The acquisition was accounted for using the purchase method of accounting and the consolidated financial statements include Gibraltar's results from the acquisition date. The purchase price was $40.6 million which included 1,380,626 shares of the Company's common stock, valued at $19.5 million, and $19.6 million in cash. In addition, stock options to purchase shares of Gibraltar capital stock were converted into options with a net value of $1.5 million to purchase shares of the Company's common stock. The excess of the purchase price over the estimated fair value of net assets acquired, which was recorded as goodwill, was $26.5 million and is being amortized over 15 years using the straight-line method of amortization. In addition, the Company agreed to make certain retention payments over a four year period with a total value of $6.75 million. Hill Thompson On October 29, 1999, the Company acquired The Hill Thompson Group, Ltd. ("Hill Thompson Group"), including its primary operating subsidiary Hill Thompson, a New Jersey-based over-the-counter trading firm. The acquisition was accounted for using the purchase method of accounting and the consolidated financial statements include the results of Hill Thompson Group from the date of acquisition. The purchase price was $47.3 million which includes 1,295,895 shares of the Company's common stock (of which 62,490 shares were issued subsequent to December 31, 1999) valued at $19.4 million and $27.9 million in cash (of which approximately $1.4 million was paid subsequent to December 31, 1999). The excess of the purchase price over the estimated fair value of net assets acquired, which was recorded as goodwill, was $25.7 million and is being amortized over 15 years using the straight-line method of amortization. Additionally, the Company agreed to issue 666,667 shares of the Company's common stock valued at $10 million to retain Hill Thompson employees. These shares will be issued over a four year period beginning one year from the date of the acquisition. Cleary Gull On May 1, 1998, the Company completed its acquisition of Cleary Gull Reiland & McDevitt Inc. ("Cleary Gull"), a privately held, investment banking, institutional brokerage and investment advisory firm headquartered in Milwaukee, Wisconsin. The acquisition was accounted for under the purchase method of accounting and the consolidated financial statements include the results of Cleary Gull's operations from the date of acquisition. The purchase price was $24.7 million which included 875,910 shares of the Company's common stock (a portion of which is subject to a four year vesting period) valued at $17.4 million and $4.6 million in cash. In addition, stock options to purchase shares of Cleary Gull capital stock with a value of $2.7 million were converted into options to purchase shares of the Company's common stock. The excess of the purchase price over the estimated fair value of net assets acquired, which was recorded as goodwill, was $12.5 million and is being amortized over 15 years using the straight-line method of amortization. The Company also granted options to Cleary Gull employees to purchase an additional 239,250 shares of the Company's common stock, subsequently canceled these options and re-issued options to purchase 242,910 shares with an exercise price of $13.00 per share. During 1999 the investment banking, equity research and institutional brokerage activities of Cleary Gull and Tucker Anthony were combined to form Tucker Cleary, a division of Tucker Anthony. The remaining business of Cleary Gull, now Cleary Gull IMS, is primarily investment management services provided to institutional accounts and high net worth individuals. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. RECEIVABLES FROM AND PAYABLES TO BROKERS AND DEALERS Included in the receivables from brokers and dealers are unsettled proprietary trades, cash on deposit with Hill Thompson's clearing broker and certain overnight funds with Prudential. Included in payables to brokers and dealers are the amounts due to Wexford for collateralized financing of proprietary positions and to the custodian of Freedom Capital's money market funds. The Company's principal source of short-term financing is provided by Wexford, from which the Company can borrow on an uncommitted basis against its proprietary inventory positions, subject to collateral maintenance requirements. The Company conducts business with brokers and dealers that are members of the major securities exchanges. The Company monitors the credit standing of such brokers and dealers, monitors the market value of collateral and requests additional collateral as deemed appropriate. Amounts receivable from and payable to brokers and dealers consist of the following (in thousands): 6. TRANSACTIONS WITH CUSTOMERS For transactions in which the Company, through Wexford, extends credit to customers, the Company seeks to control the risks associated with these activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal guidelines. The Company and Wexford monitor required margin levels daily and, pursuant to such guidelines, require customers to deposit additional collateral or reduce securities positions when necessary. The Company has agreed to indemnify Wexford for losses that it may sustain in connection with customer accounts introduced by the Company. At December 31, 1999 there were no amounts known to the Company to be indemnified to Wexford for these customer accounts. 7. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE Securities purchased under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing transactions, and are carried at amounts at which the securities will be subsequently resold or reacquired plus accrued interest. It is the Company's policy to take possession or control of securities purchased under agreements to resell. The Company is required to provide securities to counterparties in order to collateralize repurchase agreements. The Company minimizes credit risk associated with these activities by monitoring credit exposure and collateral values on a daily basis and requiring additional collateral to be deposited or returned when deemed appropriate. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 8. TRANSACTIONS WITH AFFILIATES Effective with the buyout of the Company from John Hancock Mutual Life Insurance Company ("Hancock"), the Company entered into management agreements with certain shareholders and agreed to pay annual management fees totaling $0.3 million. These agreements terminated in 1998 upon the initial public offering of the Company's common stock. The Company participated in group insurance arrangements through Hancock until June 30, 1997, when the Company obtained its own insurance arrangements. The Company paid to Hancock its allocable share of the cost of such insurance which amounted to $6.1 million for the six month period ended June 30, 1997. 9. SECURITIES Securities owned and securities sold, not yet purchased are recorded at market value and consist of the following (in thousands): 10. NOTES PAYABLE TO BANKS Included in notes payable to banks are the Company's borrowings for fixed asset financing of approximately $11.3 million and $16.7 million at December 31, 1999 and 1998, respectively. Of the total borrowings, $9.0 million bears interest at 8.02% annually and is payable in equal monthly installments through December 2001. During 1999, the Company refinanced a portion of its debt outstanding under its Fixed Asset Facility. As a result, the remainder of the fixed asset borrowings outstanding of $2.3 million bears interest at 5.00% annually and is payable in equal monthly installments through June 2003. These notes are collateralized by furniture, fixtures and leasehold improvements. During 1999, the Company amended its $50 million revolving credit agreement (the "Credit Agreement") to increase total commitments of participating banks to $100 million. At December 31, 1999, the Company had borrowings outstanding of $50 million, the proceeds of which were used to finance the acquisitions of Gibraltar and Hill Thompson Group. These borrowings are at interest rates ranging from 1% to 1.45% above the federal funds rate. In addition, the Company must pay a commitment fee of 0.20% on the unused available credit. The Credit Agreement matures in November 2003 with all outstanding notes payable at that date. The Company must comply with certain financial covenants under the Credit Agreement and was in compliance with such covenants at December 31, 1999. The Credit Agreement also restricts dividend FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) payments that can be made by the Company. In accordance with provisions of the Credit Agreement, several of the Company's subsidiaries have executed agreements to guarantee the borrowings of the Company to the benefit of participating banks. Prior to August 1998, the Company maintained a revolving credit agreement with certain participating banks and at December 31, 1997 had $80 million in borrowings outstanding. On April 7, 1998, the $77.5 million balance then outstanding under this revolving credit agreement was repaid in full with the Company's net proceeds from the Offering and available cash. The aggregate amount of principal repayment requirements on notes payable at December 31, 1999 is as follows by year (in thousands): 11. INCOME TAXES The components of income tax expense (benefit) are (in thousands): The effective income tax rate differs from the amount computed by applying the Federal statutory income tax rate as follows (in thousands): FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The temporary differences which created deferred tax assets and liabilities are as follows (in thousands): The Company has determined that a valuation allowance for the deferred tax asset is not required since it is likely that the deferred tax asset will be realized primarily through future reversals of existing taxable temporary differences. 12. NET CAPITAL REQUIREMENTS Certain subsidiaries of the Company are subject to the net capital requirements of the New York Stock Exchange, Inc. ("Exchange") and the Uniform Net Capital requirements of the Securities and Exchange Commission ("Commission") under Rule 15c3-1. The Exchange and the Commission requirements also provide that equity capital may not be withdrawn or cash dividends paid if certain minimum net capital requirements are not met. The Company's principal regulated subsidiaries are discussed below. Tucker Anthony is a registered broker and dealer. At December 31, 1999, Tucker Anthony had net capital of approximately $18.2 million which was $17.2 million in excess of the $1.0 million amount required to be maintained at that date. Sutro is a registered broker and dealer. At December 31, 1999, Sutro had net capital of approximately $11.9 million which was $10.9 million in excess of the $1.0 million amount required to be maintained at that date. Cleary Gull IMS is a registered broker and dealer. At December 31, 1999, Cleary Gull IMS had net capital of approximately $0.4 million which was $0.3 million in excess of the $0.1 million amount required to be maintained at that date. Hill Thompson is a registered broker and dealer. At December 31, 1999, Hill Thompson had net capital of approximately $20.9 million which was $19.9 million in excess of the $1.0 million amount required to be maintained at that date. In addition, at December 31, 1999, Hill Thompson had $0.2 million in cash segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the reserve formula requirements of Rule 15c3-3. Freedom Trust Company ("FTC") is a subsidiary of Freedom Capital and is a limited purpose trust company. Pursuant to state regulations, FTC is required to meet and maintain certain capital ratios and minimums. At December 31, 1999, FTC's regulatory capital, as defined, was $1.3 million and FTC was in compliance with all such requirements. Under the clearing arrangement with Wexford, Tucker Anthony, Sutro and Cleary Gull IMS are required to maintain certain minimum levels of net capital and comply with other financial ratio requirements. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1999, Tucker Anthony, Sutro and Cleary Gull IMS were in compliance with all such requirements. 13. COMMITMENTS AND CONTINGENCIES The Company leases office space and various types of equipment under noncancelable leases generally varying from one to ten years, with certain renewal options for like terms. Occupancy and equipment expense includes net rentals of $21.2 million, $18.3 million and $15.9 million for the years ended December 31, 1999, 1998 and 1997, respectively. At December 31, 1999, the Company's future minimum rental commitments based upon original terms (including escalation provisions) under noncancelable leases which have an initial or remaining term of one year or more are as follows (in thousands): The Company is a defendant or co-defendant in legal actions primarily relating to its broker-dealer activities. It is the opinion of management, after consultation with legal counsel, that the resolution of these legal actions will not have a material adverse effect on the consolidated financial position or results of operations of the Company. The Company has outstanding underwriting agreements and when-issued contracts which commit it to purchase securities at specified future dates and prices. The Company presells such issues to manage risk exposure related to these off-balance sheet commitments. Transactions which were open at December 31, 1999 have subsequently settled and had no material effect on the consolidated statements of income and financial condition. 14. BENEFITS Certain subsidiaries of the Company have 401(k) and qualified profit-sharing plans which cover substantially all of their full-time employees. The plans include employee contributions and matching contributions by the Company subject to certain limitations. In addition, a subsidiary may contribute additional amounts to its plans, at its discretion, based upon its profits for the year. The aggregate contributions to these plans for the years ended December 31, 1999, 1998 and 1997 were $5.3 million, $5.0 million and $7.1 million, respectively. Freedom Capital has a noncontributory defined benefit pension plan covering substantially all of its employees. Effective August 1, 1997, the plan was amended to provide that no new pension benefits would accrue and no new participants would be admitted after August 1, 1997. Amounts related to the plan are not material to the consolidated financial statements. Compensation costs recognized for common stock and stock options issued to employees during 1999, 1998 and 1997 were $0.2 million, $0.6 million and $1.4 million, respectively. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 15. FINANCIAL INSTRUMENTS Substantially all of the Company's financial instruments are carried at fair value or amounts approximating fair value. Assets, including cash and cash equivalents, securities owned, securities purchased under agreements to resell and certain receivables are carried at fair value or contracted amounts which approximate fair value. Similarly, liabilities including securities sold, not yet purchased, securities sold under agreements to repurchase and certain payables are carried at fair value or contracted amounts approximating fair value. The fair value of the fixed asset financing, estimated using the Company's incremental borrowing rate, approximated its carrying value at December 31, 1999 and 1998. The carrying value of the Company's debt under the Credit Agreement at December 31, 1999 approximated its fair value. In the normal course of business, the Company may enter into transactions in financial instruments to manage its exposure to market risks. At December 31, 1999 and 1998, the Company had equity options outstanding approximating $13.2 million and $11.3 million, respectively (notional amounts). The notional amounts are not reflected on the consolidated statements of financial condition and are indicative only of the volume of activity at December 31, 1999 and 1998. They do not represent amounts subject to market risks, and in many cases, limit the Company's overall exposure to market losses by hedging other on-balance sheet and off-balance sheet transactions. The volume of activity in these contracts was not significant during the years ended December 31, 1999, 1998 and 1997. 16. EARNINGS PER COMMON SHARE The Company computes its earnings per share in accordance with SFAS No. 128, "Earnings Per Share." The following table sets forth the computation for basic and diluted earnings per share (in thousands, except per share amounts): - --------------- (a) Options to purchase 50,625 shares and 239,553 shares of the Company's common stock were outstanding at December 31, 1999 and 1998, respectively, but were not included in the computation of diluted earnings per share. Also excluded from the computation were 738,428 shares of restricted stock that were not vested at December 31, 1999. The inclusion of such options and restricted stock would have had an antidilutive effect on the diluted earnings per share calculation because the options' exercise prices and restricted stock prices were greater than the average market price of the Company's common shares for 1999 and 1998. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 17. INCENTIVE PLANS The Company has adopted a number of compensation plans to attract, retain and motivate officers and other key employees to compensate them for their contributions to growth and profits of the Company and to encourage employee stock ownership. Stock Option and Restricted Stock Plans The Company has three plans under which officers and other key employees can be granted stock options, stock appreciation rights, restricted stock and long-term performance awards at the fair market value of the stock on the date of the grant or on such terms as the administrators, a committee of non-employee directors, may select. Some of the options are currently exercisable and others vest in the future if certain individual and Company performance-based goals are met. The options expire within approximately seven to ten years from the date of the grant. The activity during the years ended December 31, 1997, 1998 and 1999 is set forth below: During 1999, the Company granted 764,973 shares of restricted stock, primarily for employee retention programs in connection with the acquisitions of Hopper Soliday and Hill Thompson Group, and 6,545 of these shares were forfeited. The remaining shares granted vest mainly over the next three to four years. The following table summarizes information about stock options outstanding at December 31,1999: FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company accounts for stock option grants in accordance with APB Opinion No. 25. Pro forma information regarding net income and earnings per share is required under SFAS No. 123 and has been determined as if the Company had accounted for all 1999, 1998 and 1997 stock option grants based on the fair value method. The pro forma information presented below is not representative of the effect stock options will have on pro forma net income or earnings per share for future years. The pro forma information for the years ended 1999, 1998 and 1997 was as follows (in thousands, except per share amounts): The fair value of each option granted during the years ended December 31, 1999, 1998 and 1997 is the estimated present value at grant date. The fair value of 1999 and 1998 options was estimated using the Black-Scholes option pricing model whereby the expected volatility for 1999 was based on the Company's weekly historical stock prices and for 1998 on the average volatilities of similar companies. The fair value of 1997 options was estimated using the minimum value model. The following weighted-average assumptions were used for 1999, 1998 and 1997, respectively: - dividend yield of 1.6%, 1.4% and 0.8%, respectively - expected life of 6, 8 and 6 years, respectively - risk free interest rate of 6.8%, 5.1% and 5.4%, respectively - expected volatility of 28.7% and 56.2%, respectively The weighted-average fair value of options granted during 1999, 1998 and 1997 whose exercise price equals the fair market value of the Company's stock on grant date was $5.82, $7.47 and $1.30, respectively. The weighted-average fair value of options granted during 1999, 1998 and 1997 whose exercise price is less than the fair market value of the Company's stock on grant date was $3.80, $7.71 and $4.37, respectively. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the "ESPP") allows eligible employees to invest from 1% to 10% of their compensation to purchase shares of the Company's common stock at a price equal to 85% of its fair market value. The Company reserved 500,000 shares for purchase by employees under the ESPP and 293,732 shares were purchased through December 31, 1999. 18. SEGMENT REPORTING DATA In 1998, the Company adopted SFAS 131, "Disclosures about Segments of an Enterprise and Related Information." The Company has two reportable segments: broker-dealer and asset management. The Company's broker-dealer segment includes the retail operations, equity capital markets and trading businesses of Tucker Anthony, Sutro and Hill Thompson since they generally offer similar products and services and are subject to uniform regulatory requirements. The Company offers its broker-dealer clients a wide range of products and services, including retail brokerage, investment banking, institutional sales and fixed income products. The asset management segment includes Freedom Capital, Cleary Gull IMS and asset management business from Tucker Anthony and Sutro. The Company offers its asset management clients investment FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) advisory, portfolio management and custodial services. Substantially all of the Company's business is transacted in the United States. The following table presents information about reported segments (amounts in thousands): - --------------- (a) Other reflects the activities of the Company's holding companies. Income (loss) before income taxes principally includes amortization of goodwill and acquisition interest expense. Total assets primarily consist of goodwill and deferred taxes of Freedom Securities Corporation. FREEDOM SECURITIES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 19. QUARTERLY INFORMATION (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED): - --------------- (a) Certain amounts have been reclassified to conform with 1999 financial statement presentation. (b) Prices represent the range of sales per share on the New York Stock Exchange since the Company's public offering on April 2, 1998. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required in Item 10 will be contained in the Company's proxy statement to be filed pursuant to Regulation 14A within 120 days after the close of the fiscal year for which this Report is filed and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required in Item 11 will be contained in the Company's proxy statement to be filed pursuant to Regulation 14A within 120 days after the close of the fiscal year for which this Report is filed and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required in Item 12 will be contained in the Company's proxy statement to be filed pursuant to Regulation 14A within 120 days after the close of the fiscal year for which this Report is filed and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required in Item 13 will be contained in the Company's proxy statement to be filed pursuant to Regulation 14A within 120 days after the close of the fiscal year for which this Report is filed and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements A listing of all financial statements filed as part of this Annual Report on Form 10-K is included in Item 8. (2) Financial Statement Schedules All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (3) Exhibits The exhibits listed on the accompanying Index to Exhibits below are filed as part of this Annual Report on Form 10-K. (b) (1) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. /s/ JOHN H. GOLDSMITH ------------------------------------ JOHN H. GOLDSMITH CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND DIRECTOR Date: March 24, 2000 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 24th day of March, 2000. EXHIBIT INDEX - --------------- + Incorporated by reference to the Company's registration statement on Form S-1 (File No. 333-44938) ++ Incorporated by reference to the Company's registration statement on Form S-1 (File No. 333-62857) +++ Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 Schedules and exhibits to certain exhibits to this Form 10-K have been omitted, which schedules shall be furnished to the Commission upon request.

356130_1999.txt

356130_1999

1999

356130

ITEM 1. BUSINESS. - ------- --------- GENERAL - ------- EMC Insurance Group Inc. is an insurance holding company incorporated in Iowa in 1974. EMC Insurance Group Inc. is approximately 72 percent owned by Employers Mutual Casualty Company (Employers Mutual), a multiple-line property and casualty insurance company organized as an Iowa mutual insurance company in 1911 that is licensed in all 50 states and the District of Columbia. The term "Company" is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries and an affiliate (including the Company), are referred to as the "EMC Insurance Companies." The Company conducts its insurance business through two business segments as follows: ............................... : : : EMC INSURANCE GROUP INC. : :.............................: : Property and : Casualty Insurance : Reinsurance ......................:................................ : : : : Illinois EMCASCO Insurance Company (Illinois EMCASCO) EMC Dakota Fire Insurance Company (Dakota Fire) Reinsurance Farm and City Insurance Company (Farm and City) Company EMCASCO Insurance Company (EMCASCO) : : EMC Underwriters, LLC. Illinois EMCASCO was formed in Illinois in 1976, Dakota Fire was formed in North Dakota in 1957 and EMCASCO was formed in Iowa in 1958 for the purpose of writing property and casualty insurance. Farm and City was formed in Iowa in 1962 to write nonstandard risk automobile insurance and was purchased by the Company in 1984. These companies are licensed to write insurance in a total of 35 states and are participants in a pooling agreement with Employers Mutual (see "Property and Casualty Insurance - Pooling Agreement"). The reinsurance subsidiary was formed in 1981 to assume reinsurance business from Employers Mutual. The company assumes a portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts, and is licensed to do business in nine states. The Company's excess and surplus lines insurance agency, EMC Underwriters, LLC., was acquired in 1985. The company was formed in Iowa in 1975 as a broker for excess and surplus lines insurance. Effective December 31, 1998, the excess and surplus lines insurance agency was converted to a limited liability company and the ownership was contributed to EMCASCO. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS - --------------------------------------------- For information concerning the Company's revenues, operating income and identifiable assets attributable to each of its industry segments over the past three years, see note 8 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. PROPERTY AND CASUALTY INSURANCE - ------------------------------- POOLING AGREEMENT The four property and casualty insurance subsidiaries of the Company and two subsidiaries and an affiliate of Employers Mutual (Union Insurance Company of Providence, EMC Property & Casualty Company and Hamilton Mutual Insurance Company) are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. Operations of the pool give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all companies in the pool. Effective January 1, 1998, Farm and City, a subsidiary of the Company that writes nonstandard risk automobile insurance business, became a participant in the pooling agreement. Farm and City assumes a 1.5 percent participation in the pool, which increased the Company's aggregate participation in the pool from 22 percent in 1997 to 23.5 percent in 1998 and 1999. In connection with this change in the pooling agreement, the Company's liabilities increased $6,224,586 and invested assets increased $5,569,567. The Company reimbursed Employers Mutual $726,509 for expenses that were incurred to generate the additional business assumed by the Company and Employers Mutual paid the Company $71,490 in interest income as the actual cash transfer did not occur until March 25, 1998. Effective January 1, 1997, Hamilton Mutual Insurance Company (Hamilton Mutual) became a participant in the pooling agreement. In connection with this change in the pooling agreement, the Company's liabilities increased $6,393,063 and invested assets increased $5,674,458. The Company reimbursed Employers Mutual $794,074 for expenses incurred to generate the additional business assumed by the Company and Employers Mutual paid the Company $75,469 in interest income as the actual cash transfer did not occur until March 24, 1997. PRINCIPAL PRODUCTS The Company's property and casualty insurance subsidiaries and the other parties to the pooling agreement underwrite both commercial and personal lines of insurance. The following table sets forth the aggregate direct written premiums of all parties to the pooling agreement for the three years ended December 31, 1999. The pooling agreement is continuous, but may be amended or terminated at the end of any calendar year as to any one or more parties. Percent Percent Percent of of of Line of Business 1999 total 1998 total 1997 total - ---------------- ---- ----- ---- ----- ---- ----- (Dollars in thousands) Commercial Lines: Automobile ............ $157,095 20.8% $131,317 18.9% $118,624 18.2% Property .............. 118,939 15.8 115,815 16.6 110,637 17.0 Workers' compensation 126,285 16.7 117,120 16.8 115,117 17.6 Liability ............. 122,528 16.2 115,377 16.6 110,647 16.9 Other ................. 16,615 2.2 15,418 2.2 15,139 2.3 -------- ----- -------- ----- -------- ----- Total commercial lines 541,462 71.7 495,047 71.1 470,164 72.0 -------- ----- -------- ----- -------- ----- Personal Lines: Automobile ............ 138,168 18.3 130,693 18.8 119,580 18.3 Property .............. 73,380 9.7 68,365 9.8 61,569 9.4 Liability ............. 2,280 0.3 2,134 0.3 2,026 0.3 Other ................. 51 - 52 - 51 - -------- ----- -------- ----- -------- ----- Total personal lines 213,879 28.3 201,244 28.9 183,226 28.0 -------- ----- -------- ----- -------- ----- Total ............ $755,341 100.0% $696,291 100.0% $653,390 100.0% ======== ===== ======== ===== ======== ===== MARKETING Marketing of insurance by the parties to the pooling agreement, excluding the nonstandard risk automobile insurance sold by Farm and City, is conducted through 18 offices located throughout the United States and approximately 3,200 independent agencies. These offices allow the Company to respond quickly to changes in local market conditions. Each office employs underwriting, claims, marketing and risk improvement representatives, as well as field auditors and branch administrative technicians. The offices are supported by Employers Mutual technicians and specialists. Systems are in place to monitor the underwriting results of each office and to maintain guidelines and policies consistent with the underwriting and marketing environment in each region. Farm and City specializes in insuring private passenger automobile risks that are found to be unacceptable in the standard automobile insurance market. Farm and City is licensed in a six state area that includes Iowa, Kansas, Missouri, Nebraska, North Dakota and South Dakota. Private passenger automobile policies are solicited through the American Agency System using approximately 1,100 independent agencies. The following table sets forth the geographic distribution of the aggregate direct written premiums of all parties to the pooling agreement for the three years ended December 31, 1999. 1999 1998 1997 ------ ------ ------ Alabama ............................ 3.7% 3.7% 3.6% Arizona ............................ 3.7 3.7 3.7 Illinois ........................... 4.8 5.2 5.3 Iowa ............................... 18.1 19.3 19.0 Kansas ............................. 7.8 7.8 8.3 Michigan ........................... 3.7 3.6 4.1 Minnesota .......................... 3.6 3.8 3.8 Nebraska ........................... 6.9 7.1 7.2 North Carolina ..................... 2.9 3.2 3.3 North Dakota ....................... 3.2 3.1 2.4 Ohio ............................... 2.3 2.3 3.2 Texas .............................. 4.9 4.4 4.4 Wisconsin .......................... 4.3 4.4 4.4 Other * ............................ 30.1 28.4 27.3 ----- ----- ----- 100.0% 100.0% 100.0% ===== ===== ===== * Includes all other jurisdictions, none of which accounted for more than 3%. COMPETITION The property and casualty insurance business is highly competitive. The Company's property and casualty insurance subsidiaries and the other pool members compete in the United States insurance market with numerous insurers, many of which have greater financial resources. Competition in the types of insurance in which the property and casualty insurance subsidiaries are engaged is based on many factors, including the perceived overall financial strength of the insurer, premiums charged, contract terms and conditions, services offered, speed of claim payments, reputation and experience. In this competitive environment, insureds have tended to favor large, financially strong insurers and the Company faces the risk that insureds may become more selective and may seek larger and/or more highly rated insurers. BEST'S RATING A.M. Best rates insurance companies based on their relative financial strength and ability to meet their contractual obligations. The "A" (Excellent) rating assigned to the Company's property and casualty insurance subsidiaries and the other pool members is based on the pool members' 1998 operating results and financial condition as of December 31, 1998. A.M. Best reevaluates its ratings from time to time (normally on an annual basis) and there can be no assurance that the Company's property and casualty insurance subsidiaries and the other pool members will maintain their current rating in the future. Management believes that a Best's rating of "A" (Excellent) or better is important to the Company's business since many insureds require that companies with which they insure be so rated. Best's publications indicate that these ratings are assigned to companies which A.M. Best believes have achieved excellent overall performance and have a strong ability to meet their obligations over a long period of time. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors. REINSURANCE CEDED The parties to the pooling agreement cede insurance in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. The pool participants also purchase catastrophe reinsurance to cover multiple losses arising from a single event. During 1999 and 1998, the pool participants purchased aggregate property catastrophe excess of loss reinsurance to cover losses arising from multiple catastrophes. Due to substantial changes in both the terms and the cost of the coverage, this reinsurance protection has not been renewed for year 2000. If this reinsurance protection had not been in place in 1999 the Company would have reported $3,524,000 of additional operating losses, net of the premium cost savings. All major reinsurance treaties, with the exception of the pooling agreement and a boiler treaty, are on an "excess of loss" basis whereby the reinsurer agrees to reimburse the primary insurer for covered losses in excess of a predetermined amount, up to a stated limit. The boiler treaty provides for 100 percent reinsurance of the pool's direct boiler coverage written. Facultative reinsurance from approved domestic markets, which provides reinsurance on an individual risk basis and requires specific agreement of the reinsurer as to the limits of coverage provided, is purchased when coverage by an insured is required in excess of treaty capacity or where a high-risk type policy could expose the treaty reinsurance programs. Each type of reinsurance coverage is purchased in layers, and each layer may have a separate retention level. Retention levels are adjusted according to reinsurance market conditions and the surplus position of EMC Insurance Companies. The intercompany pooling arrangement aids efficient buying of reinsurance since it allows for higher retention levels and correspondingly decreased dependence on the reinsurance marketplace. A summary of the reinsurance treaties benefiting the parties to the pooling agreement as of December 31, 1999 is presented below. Retention amounts reflect the accumulated retentions of all layers within a treaty. Type of Reinsurance Treaty Retention Limits -------------------------- ----------- -------------------------- Property per risk ........... $ 2,000,000 100 percent of $18,000,000 Property catastrophe ........ $11,550,000 95 percent of $51,000,000 Aggregate property catastrophe excess ........ $21,225,000 100 percent of $37,500,000 Casualty .................... $ 2,000,000 100 percent of $38,000,000 Workers' Compensation excess $ - $20,000,000 excess of $40,000,000 Umbrella .................... $ 1,400,000* 100 percent of $ 8,600,000 Fidelity and Surety ......... $ 750,000 100 percent of $ 4,250,000 Surety excess .............. $ 1,450,000 100 percent of $10,550,000 Boiler ...................... $ 0 100 percent of $50,000,000 * An annual aggregate deductible of $3,600,000 must be reached before the reinsurers may be petitioned. Although reinsurance does not discharge the original insurer from its primary liability to its policyholders, it is the practice of insurers for accounting purposes to treat reinsured risks as risks of the reinsurer since the primary insurer would only reassume liability in those situations where the reinsurer is unable to meet the obligations it assumed under the reinsurance agreements. The ability to collect reinsurance is subject to the solvency of the reinsurers. The major participants in the pool members' reinsurance programs as of December 31, 1999 are presented below. The percentages represent the reinsurers' share of the total reinsurance protection under all coverages. Each type of coverage is purchased in layers, and an individual reinsurer may participate in more than one coverage and at various layers within these coverages. The property per risk, property catastrophe and casualty reinsurance programs are handled by a reinsurance intermediary (broker). The reinsurance of those programs is syndicated to approximately 50 domestic and foreign reinsurers. In formulating reinsurance programs, Employers Mutual is selective in its choice of reinsurers. Employers Mutual selects reinsurers on the basis of financial stability and long-term relationships, as well as price of the coverage. Reinsurers are generally required to have a Best's rating of "A-" or higher and policyholders' surplus of $50,000,000 ($100,000,000 for casualty reinsurance). Percent of total 1999 Property per risk, property catastrophe reinsurance Best's and casualty coverages: protection rating - --------------------------------------- ----------- ------ Underwriters at Lloyd's of London .................... 20.6% A Transatlantic Reinsurance Company .................... 8.9 A++ Zurich Reinsurance (North America), Inc .............. 6.5 A+ NAC Reinsurance Corporation .......................... 6.2 A+ X.L. Mid Ocean Reinsurance Company, Ltd .............. 5.6 (1) AXA Reassurance ...................................... 5.1 A+ Continental Casualty Company ......................... 3.9 A Aggregate property catastrophe excess coverage: - ----------------------------------------------- Munich Reinsurance Company (UK) ...................... 49.5 (1) Underwriters at Lloyd's of London .................... 33.4 A Workers' compensation excess coverage: - -------------------------------------- First Allmerica Financial Life Insurance Company ..... 50.0 A Trenwick America Reinsurance Corporation ............. 50.0 A+ Umbrella coverage: - ------------------ General Reinsurance Corporation ...................... 100.0 A++ Fidelity and surety coverages: - ------------------------------ SCOR Reinsurance Company ............................. 42.0 A+ GE Reinsurance Corporation ........................... 20.0 A Signet Star Reinsurance Company ...................... 20.0 A Partner Reinsurance Company of the U.S. .............. 18.0 A Boiler coverage: - ---------------- Hartford Steam Boiler Inspection and Insurance Company 100.0 A+ (1) Not rated. Premiums ceded under the pool members' reinsurance programs by all pool members and by the Company's property and casualty insurance subsidiaries for the year ended December 31, 1999 are presented below. Each type of reinsurance coverage is purchased in layers, and an individual reinsurer may participate in more than one coverage and at various layers within the coverages. Since each layer of each coverage is priced separately, with the lower layers being more expensive than the upper layers, a reinsurer's overall participation in a reinsurance program does not necessarily correspond to the amount of premiums it receives. Premiums ceded by ------------------------ Property and casualty All pool insurance Reinsurer members subsidiaries - --------- ----------- ------------ General Reinsurance Corporation..................... $ 4,338,094 $ 1,019,452 Hartford Steam Boiler Inspection & Insurance Company 2,267,667 532,902 NAC Reinsurance Corporation ........................ 1,322,065 310,685 SCOR Reinsurance Company ........................... 902,154 212,006 Transatlantic Reinsurance Company .................. 874,276 205,455 Munchener Ruckversicherungs ........................ 758,796 178,317 Continental Casualty Company........................ 724,654 170,294 Signet Star Reinsurance Company .................... 720,956 169,425 Renaissance Reinsurance Company .................... 680,400 159,894 AXA Reassurance .................................... 649,503 152,633 Other Reinsurers ................................... 8,179,443 1,922,169 ----------- ------------ Total ............................................ $21,418,008 $ 5,033,232 =========== ============ The parties to the pooling agreement also cede reinsurance on both a voluntary and a mandatory basis to state and national organizations in connection with various workers' compensation and assigned risk programs and to private organizations established to handle large risks. Premiums ceded by all pool members and by the Company's property and casualty insurance subsidiaries for the year ended December 31, 1999 are presented below. Premiums ceded by ------------------------ Property and casualty All pool insurance Reinsurer members subsidiaries - --------- ----------- ------------ Wisconsin Compensation Rating Bureau ............... $ 3,737,058 $ 878,209 National Workers' Compensation Reinsurance Pool .... 3,015,899 708,736 North Carolina Reinsurance Facility ................ 1,153,243 271,012 North Carolina Insurance Underwriting Association .. 754,400 177,284 Mutual Reinsurance Bureau .......................... 495,270 116,388 Other Reinsurers ................................... 365,255 85,835 ----------- ------------ $ 9,521,125 $ 2,237,464 =========== ============ For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries and Reinsurance Subsidiary - Reinsurance Ceded." REINSURANCE ASSUMED The parties to the pooling agreement also assume insurance from involuntary pools and associations in conjunction with direct business written in various states. Through its participation in the pooling agreement, the Company assumes insurance business from the North Carolina Reinsurance Facility (NCRF), which is a state run assigned risk program. Prior to 1998 the Company had not recognized its share of certain surcharges reported by the NCRF. During the fourth quarter of 1998, the Company received clarification regarding such amounts and recorded its share of these cumulative surcharges. As a result, the consolidated financial statements for the year ended December 31, 1998 reflect assumed premium income of $542,656 and assumed loss recoveries of $661,818 related to prior years. Beginning in 1999, these surcharges are being recorded on a quarterly basis. RELATIONSHIP BETWEEN NET PREMIUMS WRITTEN AND SURPLUS The amount of insurance a property and casualty insurance company writes under industry standards is a multiple of its surplus calculated in accordance with statutory accounting practices. Generally, a ratio of 3 to 1 or less is considered satisfactory by regulatory authorities. The ratios of the pool members for the past three years are as follows: Year ended December 31, ------------------------------ 1999 1998 1997 ---- ---- ---- Employers Mutual .................... .86 .82 .80 EMCASCO ............................. 2.03 1.66 1.62 Illinois EMCASCO .................... 2.18 1.87 1.68 Dakota Fire ......................... 2.17 1.79 1.59 Farm and City ....................... 2.04 2.15 1.60 EMC Property & Casualty Company ..... .80 .65 1.08 Union Insurance Company of Providence .79 .75 .72 Hamilton Mutual ..................... 1.69 1.41 1.17 OUTSTANDING LOSSES AND SETTLEMENT EXPENSES The property and casualty insurance subsidiaries' reserve information is included in the property and casualty loss reserve development for 1999. See "Property and Casualty Insurance Subsidiaries and Reinsurance Subsidiary - Outstanding Losses and Settlement Expenses." REINSURANCE - ----------- The reinsurance subsidiary is a property and casualty treaty reinsurer with a concentration in property lines. The reinsurance subsidiary assumes a quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary assumes its quota share portion of all premiums and related losses and settlement expenses of this business, subject to a maximum loss per event. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, or any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual. Operations of the quota share agreement give rise to intercompany balances with Employers Mutual, which are settled on a quarterly basis. Effective January 1, 1997, the reinsurance subsidiary's quota share participation was increased from 95 percent to 100 percent and the maximum loss per event assumed by the reinsurance subsidiary was increased from $1,000,000 to $1,500,000. In connection with the change in the quota share percentage, the Company's liabilities increased $3,173,647 and invested assets increased $3,066,705. The Company reimbursed Employers Mutual $106,942 for expenses that were incurred to generate the additional business assumed by the Company. PRINCIPAL PRODUCTS The reinsurance subsidiary assumes both pro rata and excess of loss reinsurance from Employers Mutual. The following table sets forth the assumed written premiums of the reinsurance subsidiary for the three years ended December 31, 1999. The amounts reported in the Company's financial statements for the year 1997 reflect an adjustment of $354,735 related to the change in the quota share percentage. This adjustment was made to offset the income statement effect that resulted from the increase in the reinsurance subsidiary's reserve for unearned premiums on January 1, 1997 in connection with this transaction. Percent Percent Percent of of of Line of Business 1999 total 1998 total 1997 total - ---------------- ------- ----- ------- ----- ------- ----- (Dollars in thousands) Pro rata reinsurance: Property and Casualty .. $12,642 29.0% $15,105 38.7% $ 8,985 26.2% Property ............... 7,461 17.1 2,601 6.7 6,546 19.0 Crop ................... 4,727 10.8 3,967 10.2 3,101 9.0 Casualty ............... 4,771 11.0 3,919 10.0 2,879 8.4 Marine/aviation ........ 2,289 5.3 1,424 3.6 1,866 5.4 Other .................. 261 0.6 1,661 4.2 2,116 6.2 ------- ----- ------- ----- ------- ----- Total pro rata reinsurance 32,151 73.8 28,677 73.4 25,493 74.2 ------- ----- ------- ----- ------- ----- Excess per risk reinsurance: Property ............... 2,298 5.3 2,099 5.4 2,110 6.2 Casualty ............... 1,979 4.6 2,104 5.4 1,595 4.6 Other .................. 754 1.7 868 2.2 647 1.9 ------- ----- ------- ----- ------- ----- Total excess per risk reinsurance ...... 5,031 11.6 5,071 13.0 4,352 12.7 ------- ----- ------- ----- ------- ----- Excess catastrophe/ aggregate reinsurance: Property ............... 5,674 13.0 4,744 12.1 4,293 12.5 Crop ................... 330 0.8 284 0.7 252 0.8 Marine/aviation ........ 20 - 38 0.1 8 - Other .................. 341 0.8 260 0.7 (62) (0.2) ------- ----- ------- ----- ------- ----- Total excess catastrophe/ aggregate reinsurance 6,365 14.6 5,326 13.6 4,491 13.1 ------- ----- ------- ----- ------- ----- Total excess reinsurance 11,396 26.2 10,397 26.6 8,843 25.8 ------- ----- ------- ----- ------- ----- $43,547 100.0% $39,074 100.0% $34,336 100.0% ======= ===== ======= ===== ======= ===== MARKETING Over the last several years Employers Mutual has emphasized writing excess of loss reinsurance business and has worked to increase its participation on existing contracts that had favorable terms. Employers Mutual strives to be flexible in the types of reinsurance products it offers, but generally limits its writings to direct reinsurance business rather than providing retrocessional covers. During the last three years there has been a trend in the reinsurance marketplace for "across the board" participation on excess of loss reinsurance contracts. As a result, reinsurance companies must be willing to participate in all coverages and on all layers offered under a specific contract in order to be considered a viable reinsurer. COMPETITION The reinsurance marketplace is very competitive; however, recent worldwide catastrophe losses may help ease rate adequacy concerns. Employers Mutual competes in the global reinsurance market with numerous reinsurers, many of which have greater financial resources. In this competitive environment, reinsurance brokers have tended to favor large, financially strong reinsurers who are able to provide "mega" line capacity for all lines of business. Employers Mutual is addressing this issue by accepting a larger share of coverage on desirable programs and strengthening its relationships with reinsurance intermediaries. REINSURANCE CEDED For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries and Reinsurance Subsidiary - Reinsurance Ceded." BEST'S RATING The most recent Best's Property Casualty Key Rating Guide gives the reinsurance subsidiary a "B++" (Very Good) policyholders' rating. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors. OUTSTANDING LOSSES AND SETTLEMENT EXPENSES The reinsurance subsidiary's reserve information is included in the property and casualty loss reserve development for 1999. See "Property and Casualty Insurance Subsidiaries and Reinsurance Subsidiary - Outstanding Losses and Settlement Expenses." PROPERTY AND CASUALTY INSURANCE SUBSIDIARIES AND REINSURANCE SUBSIDIARY - ----------------------------------------------------------------------- Employers Mutual provides various services to all of its subsidiaries. Such services include data processing, claims, financial, actuarial, auditing, marketing and underwriting. Costs of these services are allocated to the subsidiaries outside the pooling agreement based upon a number of criteria, including usage and number of transactions. Costs not allocated to these subsidiaries are charged to the pool and each pool participant shares in the total cost in proportion to its participation percentage. STATUTORY COMBINED RATIOS The following table sets forth the Company's insurance subsidiaries' statutory combined ratios and the property and casualty insurance industry averages for the five years ended December 31, 1999. The combined ratios below are the sum of the following: the loss ratio, calculated by dividing losses and settlement expenses incurred by net premiums earned, and the expense ratio, calculated by dividing underwriting expenses incurred by net premiums written and policyholder dividends by net premiums earned. Generally, if the combined ratio is below 100 percent, a company has an underwriting profit; if it is above 100 percent, a company has an underwriting loss. Year ended December 31, -------------------------------------- 1999 1998 1997 1996 1995 ------ ------ ------ ------ ------ Property and casualty insurance Loss ratio ................... 83.6% 83.5% 74.3% 70.5% 67.3% Expense ratio ................ 32.0 33.3 32.8 34.3 32.6 ------ ------ ------ ------ ------ Combined ratio ............. 115.6% 116.8% 107.1% 104.8% 99.9% ====== ====== ====== ====== ====== Reinsurance Loss ratio ................... 83.1% 75.4% 68.4% 68.7% 66.3% Expense ratio ................ 30.6 31.1 34.1 31.5 32.3 ------ ------ ------ ------ ------ Combined ratio ............. 113.7% 106.5% 102.5% 100.2% 98.6% ====== ====== ====== ====== ====== Total insurance operations Loss ratio ................... 83.5% 81.9% 73.1% 70.0% 67.1% Expense ratio ................ 31.7 32.9 33.1 33.6 32.5 ------ ------ ------ ------ ------ Combined ratio ............. 115.2% 114.8% 106.2% 103.6% 99.6% ====== ====== ====== ====== ====== Property and casualty insurance industry averages (1) Loss ratio ................... 78.3% 76.3% 72.8% 78.3% 78.9% Expense ratio ................ 29.2 29.4 28.8 27.5 26.1 ------ ------ ------ ------ ------ Combined ratio ............. 107.5% 105.7% 101.6% 105.8% 105.0% ====== ====== ====== ====== ====== (1) As reported by A.M. Best Company. The ratio for 1999 is an estimate; the actual combined ratio is not currently available. REINSURANCE CEDED The following table presents amounts due to the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums as of December 31, 1999: Amount Percent Best's recoverable of total rating ----------- -------- ------ Wisconsin Compensation Rating Bureau .. $ 3,470,126 28.0% (1) National Workers' Compensation Reinsurance Pool .................... 1,813,296 14.6 (1) General Reinsurance Corporation ....... 796,609 6.4 A++ Hartford Fire Insurance Company ....... 636,935 5.1 A+ Minnesota Workers'Comp Reins Assoc .... 574,790 4.6 (2) PMA Reinsurance Corporation ........... 502,545 4.1 A+ American Re-Insurance Company ......... 472,057 3.8 A++ Mutual Reinsurance Bureau (MRB)........ 449,830 3.6 (3) GE Reinsurance Corporation ............ 345,542 2.8 A AXA Reinsurance Corporation ........... 290,479 2.3 A+ Other Reinsurers ...................... 3,057,720 24.7 ----------- -------- Total ........................... $12,409,929(4) 100.0% =========== ======== (1) Amounts recoverable reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to these organizations by Employers Mutual in connection with its role as "service carrier." Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of the business to these organizations. Credit risk associated with these amounts is minimal as all companies participating in these organizations are responsible for the liabilities of such organizations on a pro rata basis. (2) Not rated. (3) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this underwriting organization by Employers Mutual. MRB is composed of Employers Mutual and five other nonaffiliated mutual insurance companies. Each of the six members cede primarily property insurance to MRB and assume equal proportionate shares of this business. Each member benefits from the increased capacity provided by MRB. MRB is backed by the financial strength of the six member companies. All of the members of MRB were assigned an "A-" (Excellent) or better rating by A.M. Best. (4) The total amount recoverable at December 31, 1999 represented $868,550 in paid losses and settlement expenses, $10,260,815 in unpaid losses and settlement expenses and $1,280,564 in unearned premiums. The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred for the three years ended December 31, 1999 is presented below. Year ended December 31, ---------------------------------------- 1999 1998 1997 ------------ ------------ ------------ Premiums written: Direct ........................ $228,588,440 $213,134,588 $175,350,677 Assumed from nonaffiliates .... 781,225 1,888,951 1,219,564 Assumed from affiliates ....... 221,051,986 204,964,038 178,624,357 Ceded to nonaffiliates ........ (7,270,696) (5,808,352) (5,615,772) Ceded to affiliates ........... (228,588,440) (213,249,508) (164,978,055) ------------ ------------ ------------ Net premiums written ........ $214,562,515 $200,929,717 $184,600,771 ============ ============ ============ Premiums earned: Direct ........................ $223,593,165 $202,514,027 $169,304,584 Assumed from nonaffiliates .... 873,710 1,969,067 1,403,778 Assumed from affiliates ....... 217,416,300 197,166,272 171,514,339 Ceded to nonaffiliates ........ (7,191,869) (5,801,680) (5,937,679) Ceded to affiliates ........... (223,593,165) (201,603,281) (159,066,776) ------------ ------------ ------------ Net premiums earned ......... $211,098,141 $194,244,405 $177,218,246 ============ ============ ============ Losses and settlement expenses incurred: Direct ........................ $183,031,797 $171,209,604 $126,922,536 Assumed from nonaffiliates .... 429,244 1,298,167 926,403 Assumed from affiliates ....... 182,375,574 171,681,607 122,827,934 Ceded to nonaffiliates ........ (5,928,570) (7,395,934) (3,364,737) Ceded to affiliates ........... (183,031,797) (178,917,350) (117,458,832) ------------ ------------ ------------ Net losses and settlement expenses incurred ......... $176,876,248 $157,876,094 $129,853,304 ============ ============ ============ OUTSTANDING LOSSES AND SETTLEMENT EXPENSES The Company maintains reserves for losses and settlement expenses with respect to both reported and unreported claims. The amount of reserves for reported claims is primarily based upon a case-by-case evaluation of the specific type of claim, knowledge of the circumstances surrounding each claim and the policy provisions relating to the type of loss. Reserves on assumed business are the amounts reported by the ceding company. The amount of reserves for unreported claims is determined on the basis of statistical information for each line of insurance with respect to the probable number and nature of claims arising from occurrences which have not yet been reported. Established reserves are closely monitored and are frequently recomputed using a variety of formulas and statistical techniques for analyzing actual claim costs, frequency data and other economic and social factors. The Company does not discount reserves. Inflation is implicitly provided for in the reserving function through analysis of cost trends, reviews of historical reserving results and projections of future economic conditions. Large ($100,000 and over) incurred and reported gross reserves are reviewed regularly for adequacy. In addition, long-term and lifetime medical claims are periodically reviewed for cost trends and the applicable reserves are appropriately revised. Loss reserves are estimates at a given time of what the insurer expects to pay on incurred losses, based on facts and circumstances then known. During the loss settlement period, which may be many years, additional facts regarding individual claims become known, and accordingly, it often becomes necessary to refine and adjust the estimates of liability on a claim. Settlement expense reserves are intended to cover the ultimate cost of investigating claims and defending lawsuits arising from claims. These reserves are established each year based on previous years experience to project the ultimate cost of settlement expenses. To the extent that adjustments are required to be made in the amount of loss reserves each year, settlement expense reserves are correspondingly revised. Changes in reserves for losses and settlement expenses are reflected in the operating results of the year such changes are recorded. Despite the inherent uncertainties of estimating insurance company loss and settlement expense reserves, management believes that the Company's reserves are being calculated in accordance with sound actuarial practices and, based upon current information, that the Company's reserves for losses and settlement expenses at December 31, 1999 are adequate. The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the property and casualty insurance subsidiaries and the reinsurance subsidiary. Amounts presented are on a net basis, with a reconciliation of beginning and ending reserves to the gross amounts presented in the consolidated financial statements. Year ended December 31, ---------------------------------------- 1999 1998 1997 ------------ ------------ ------------ Gross reserves at beginning of year $245,610,323 $217,777,942 $202,502,986 Ceded reserves at beginning of year (15,563,600) (13,030,150) (13,796,769) ------------ ------------ ------------ Net reserves at beginning of year, before adjustments ............... 230,046,723 204,747,792 188,706,217 Adjustment to beginning reserves due to change in pooling agreement ........................ - 3,600,220 3,795,453 Adjustment to beginning reserves due to change in quota share percentage ....................... - - 2,726,913 ------------ ------------ ------------ Net reserves at beginning of year, after adjustments ................ 230,046,723 208,348,012 195,228,583 ------------ ------------ ------------ Incurred losses and settlement expenses: - ---------------------- Provision for insured events of the current year ............ 182,609,687 168,953,309 137,300,762 Decrease in provision for insured events of prior years .. (5,733,439) (11,077,215) (7,447,458) ------------ ------------ ------------ Total incurred losses and settlement expenses ...... 176,876,248 157,876,094 129,853,304 ------------ ------------ ------------ Payments: - --------- Losses and settlement expenses attributable to insured events of the current year ............ 72,970,531 73,228,354 57,649,830 Losses and settlement expenses attributable to insured events of prior years ................. 77,699,231 62,949,029 62,684,265 ------------ ------------ ------------ Total payments ............. 150,669,762 136,177,383 120,334,095 ------------ ------------ ------------ Net reserves at end of year ........ 256,253,209 230,046,723 204,747,792 Ceded reserves at end of year ...... 10,260,815 15,563,600 13,030,150 ------------ ------------ ------------ Gross reserves at end of year ...... $266,514,024 $245,610,323 $217,777,942 ============ ============ ============ The following table shows the calendar year development of loss and settlement expense reserves of the property and casualty insurance subsidiaries and the reinsurance subsidiary. Amounts presented are on a net basis with, beginning in 1992, (i) a reconciliation of the net loss and settlement expense reserves, to the gross amounts presented in the consolidated financial statements and (ii) disclosure of the gross re-estimated loss and settlement expense reserves and the related re-estimated reinsurance receivables. Reflected in this table is (1) the increase in the property and casualty insurance subsidiaries' collective participation in the pool from 17 percent to 22 percent in 1992, (2) the change in the pooling agreement whereby effective January 1, 1993 the voluntary reinsurance business written by Employers Mutual is no longer subject to cession to the pool members, (3) the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement in 1993, (4) the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool at December 31, 1993, (5) the reinsurance subsidiary's commutation of all outstanding reinsurance balances ceded to Employers Mutual under catastrophe and aggregate excess of loss reinsurance treaties related to accident years 1991 through 1993 in 1994, and (6) the increase in the reinsurance subsidiary's quota share assumption of Employers Mutual's assumed reinsurance business from 95 percent to 100 percent in 1997. The table has been restated to reflect the addition of Hamilton Mutual to the pooling agreement effective January 1, 1997 and the addition of Farm and City to the pooling agreement effective January 1, 1998. In evaluating the table, it should be noted that each cumulative redundancy (deficiency) amount includes the effects of all changes in reserves for prior periods. Conditions and trends that have affected development of the liability in the past, such as a time lag in the reporting of assumed reinsurance business, the high rate of inflation associated with medical services and supplies and the reform measures implemented by several states to control administrative costs for workers' compensation insurance, may not necessarily occur in the future. Accordingly, it may not be appropriate to project future development of reserves based on this table. During the last three years the Company has experienced favorable development in the provision for insured events of prior years. The majority of the favorable development has come from the property and casualty insurance subsidiaries. Favorable development has also been experienced in the reinsurance subsidiary, but to a lesser degree. The Company has historically experienced favorable development in its reserves and current reserving practices have not been relaxed; however, the amount of favorable development experienced is expected to fluctuate from year to year. Asbestos and Environmental Claims The Company has exposure to asbestos and environmental related claims associated with the insurance business written by the parties to the pooling agreement and the reinsurance business assumed from Employers Mutual by the reinsurance subsidiary. Estimating loss and settlement expense reserves for asbestos and environmental claims are very difficult due to the many uncertainties surrounding these types of claims. These uncertainties exist because the assignment of responsibility varies widely by state and claims often emerge long after the policy has expired, which makes assignment of damages to the appropriate party and to the time period covered by a particular policy difficult. In establishing reserves for these types of claims, management monitors the relevant facts concerning each claim, the current status of the legal environment, the social and political conditions and the claim history and trends within the Company and the industry. Based upon current facts, management believes the reserves established for asbestos and environmental related claims at December 31, 1999 are adequate. Although future changes in the legal and political environment may result in adjustments to these reserves, management believes any adjustments will not have a material impact on the financial condition or results of operations of the Company. The following table presents asbestos and environmental related losses and settlement expenses incurred and reserves outstanding for the Company: Year ended December 31, -------------------------------- 1999 1998 1997 ---------- ---------- ---------- Losses and settlement expenses incurred: Asbestos: Property and casualty insurance ......... $ 125,687 $ 34,287 $ 25,246 Reinsurance ............................. (25,971) - 394,524 ---------- ---------- ---------- 99,716 34,287 419,770 ---------- ---------- ---------- Environmental: Property and casualty insurance ......... 11,227 18,288 25,615 Reinsurance ............................. 223,996 - 374,822 ---------- ---------- ---------- 235,223 18,288 400,437 Total loss and settlement expenses ---------- ---------- ---------- incurred .......................... $ 334,939 $ 52,575 $ 820,207 ========== ========== ========== Loss and settlement expense reserves: Asbestos: Property and Casualty insurance ......... $ 259,148 $ 186,840 $ 170,302 Reinsurance ............................. 753,481 793,624 805,429 ---------- ---------- ---------- 1,012,629 980,464 975,731 ---------- ---------- ---------- Environmental: Property and casualty insurance ......... 724,662 885,578 864,043 Reinsurance ............................. 710,520 506,056 572,961 ---------- ---------- ---------- 1,435,182 1,391,634 1,437,004 Total loss and settlement expense ---------- ---------- ---------- reserves .......................... $2,447,811 $2,372,098 $2,412,735 ========== ========== ========== INVESTMENTS - ----------- Securities classified as held-to-maturity are purchased with the intent and ability to be held to maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the financial statements. All other securities have been classified as securities available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as accumulated other comprehensive income in stockholders' equity, net of deferred income taxes. At December 31, 1999, approximately 71 percent of the Company's bonds were invested in government or government agency issued securities. A variety of maturities are maintained in the Company's portfolio to assure adequate liquidity. The maturity structure of bond investments is also established by the relative attractiveness of yields on short, intermediate and long-term bonds. The Company does not invest in any high-yield debt investments (commonly referred to as junk bonds). During the second and third quarters of 1999, the Company sold approximately $55,000,000 of investments in tax-exempt fixed maturity securities and reinvested the proceeds into taxable fixed maturity securities that pay a higher interest rate. This change in asset allocation was implemented to increase the Company's after-tax rate of return on its investment portfolio in response to the recent deterioration in the Company's underwriting results and the expectation that underwriting results will not improve significantly in the near future. The Company's equity investment holdings include common stock and preferred stock. During 1998 the Company liquidated its common stock mutual fund portfolio and reinvested the proceeds in individual stock issues that are being managed on a tax-aware basis. Investments of the Company's insurance subsidiaries are subject to the insurance laws of the state of their incorporation. These laws prescribe the kind, quality and concentration of investments that may be made by insurance companies. In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages. The Company believes it is in compliance with these laws. The investments of EMC Insurance Group Inc. and its subsidiaries are supervised by investment committees of each entity's respective board of directors. The investment portfolios are managed by an internal staff that is composed of employees of Employers Mutual. Investment expenses are based on actual expenses incurred plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total invested assets and number of investment transactions. The following table shows the composition of the Company's investment portfolio (at amortized cost), by type of security, as of December 31, 1999 and 1998. In the Company's consolidated financial statements, securities held-to-maturity are carried at amortized cost; securities available-for-sale are carried at fair value. Year ended December 31, -------------------------------------------- 1999 1998 --------------------- --------------------- Amortized Amortized cost Percent cost Percent ------------ ------- ------------ ------- Securities held-to-maturity: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. $109,055,239 24.8% $140,041,154 33.0% Mortgage-backed securities 18,148,921 4.1 24,885,036 5.8 ------------ ------- ------------ ------- Total securities held- to-maturity ............ 127,204,160 28.9 164,926,190 38.8 ------------ ------- ------------ ------- Securities available-for-sale: Fixed maturity securities: U.S. treasury securities and obligations of U.S. government corporations and agencies ............. 4,419,411 1.0 3,491,259 0.8 Obligations of states and political subdivisions ... 96,077,294 21.9 155,138,275 36.5 Mortgage-backed securities ............... 49,440,943 11.2 - - Debt securities issued by foreign governments ...... 6,479,135 1.5 - - Public utilities ........... 8,890,108 2.0 7,304,015 1.7 Corporate securities ....... 98,413,442 22.4 42,181,578 9.9 ------------ ------- ------------ ------- Total fixed maturity securities ............. 263,720,333 60.0 208,115,127 48.9 ------------ ------- ------------ ------- Equity securities: Common stock ............... 25,853,745 5.9 26,782,547 6.3 Non-redeemable preferred stocks ................... 2,640,886 0.6 3,145,886 0.7 ------------ ------- ------------ ------- Total equity securities .. 28,494,631 6.5 29,928,433 7.0 ------------ ------- ------------ ------- Total securities available-for-sale ..... 292,214,964 66.5 238,043,560 55.9 ------------ ------- ------------ ------- Short-term investments ......... 20,164,210 4.6 22,660,011 5.3 ------------ ------- ------------ ------- Total investments ........ $439,583,334 100.0% $425,629,761 100.0% ============ ======= ============ ======= Fixed maturity securities held by the Company generally have an investment quality rating of "A" or better by independent rating agencies. The following table shows the composition of the Company's fixed maturity securities, by rating, as of December 31, 1999. Securities Securities held-to-maturity available-for-sale (at amortized cost) (at fair value) --------------------- --------------------- Amount Percent Amount Percent ------------ ------- ------------ ------- Rating(1) AAA ..................... $127,204,160 100.0% $108,712,161 42.5% AA ...................... - - 56,705,280 22.1 A ....................... - - 86,180,793 33.6 BAA ..................... - - 4,583,195 1.8 ------------ ------- ------------ ------- Total fixed maturities $127,204,160 100.0% $256,181,429 100.0% ============ ======= ============ ======= (1) Ratings for preferred stocks and fixed maturity securities with initial maturities greater than one year are assigned by Moody's Investor's Services, Inc. Moody's rating process seeks to evaluate the quality of a security by examining the factors that affect returns to investors. Moody's ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity exists. The quantitative factors include debt coverage, sales and income growth, cash flows and liquidity ratios. Qualitative factors include management quality, access to capital markets and the quality of earnings and balance sheet items. Ratings for securities with initial maturities less than one year are based on an evaluation of the underlying assets or the credit rating of the issuer's parent company. The amortized cost and estimated fair value of fixed maturity securities at December 31, 1999, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Estimated Amortized fair cost value ------------ ------------ Securities held-to-maturity: Due in one year or less ................... $ 4,498,477 $ 4,562,505 Due after one year through five years ..... 32,067,841 33,088,104 Due after five years through ten years .... 63,257,577 62,077,061 Due after ten years ....................... 9,231,344 8,592,680 Mortgage-backed securities ................ 18,148,921 18,358,715 ------------ ------------ Totals .................................. $127,204,160 $126,679,065 ============ ============ Securities available-for-sale: Due in one year or less ................... $ 1,753,344 $ 1,756,937 Due after one year through five years ..... 25,307,861 25,259,693 Due after five years through ten years .... 54,694,520 53,277,920 Due after ten years ....................... 132,523,665 126,452,673 Mortgage-backed securities ................ 49,440,943 49,434,206 ------------ ------------ Totals .................................. $263,720,333 $256,181,429 ============ ============ The mortgage-backed securities shown in the above table include $52,661,313 of securities issued by government corporations and agencies and $14,928,551 of collateralized mortgage obligations (CMOs). CMOs are securities backed by mortgages on real estate, which come due at various times. The Company has attempted to minimize the prepayment risks associated with mortgage-backed securities by not investing in "principal only" and "interest only" CMOs. The CMOs that the Company has invested in are designed to reduce the risk of prepayment by providing predictable principal payment schedules within a designated range of prepayments. Investment yields may vary from those anticipated due to changes in prepayment patterns of the underlying collateral. Investment results of the Company for the periods indicated are shown in the following table: Year ended December 31, ---------------------------------------- 1999 1998 1997 ------------ ------------ ------------ Average invested assets (1) ........ $432,606,548 $412,682,091 $386,852,093 Investment income (2) .............. $ 25,760,561 $ 24,859,063 $ 23,780,303 Average yield ...................... 5.96% 6.02% 6.15% Realized investment gains (3) ...... $ 276,673 $ 5,901,049 $ 4,100,006 (1) Average of the aggregate invested amounts (amortized cost) at the beginning and end of the year. (2) Investment income is net of investment expenses and does not include realized gains or income tax provisions. (3) The amount for 1999 reflects realized gains of $1,589,953 resulting from the disposal of tax-exempt fixed maturity securities. The proceeds from the disposal of these tax-exempt fixed maturity securities were reinvested in taxable fixed maturity securities that pay a higher interest rate. This change in asset allocation was implemented to increase the Company's after- tax rate of return on its investment portfolio. The amount for 1998 reflects realized gains of $7,585,293 resulting from the liquidation of the Company's common stock mutual fund portfolio. The proceeds from the disposal of the common stock mutual fund portfolio were reinvested in individual stock issues that are being managed on a tax-aware basis. The amount for 1997 reflects a capital gains distribution of $4,010,683 related to the Company's common stock mutual fund portfolio. EMPLOYEES - --------- EMC Insurance Group Inc. has no employees of its own, although approximately 15 employees of Employers Mutual perform administrative duties on a part-time basis. Otherwise, the Company's business activities are conducted by employees of Employers Mutual and one of the property and casualty insurance subsidiaries, which have 1,980 and 68 employees, respectively. The property and casualty insurance subsidiaries share the costs charged to the pooling agreement in accordance with their pool participation percentages. See "Property and Casualty Insurance - Pooling Agreement." REGULATION - ---------- The Company's insurance subsidiaries are subject to extensive regulation and supervision by their home states, as well as those in which they do business. The purpose of such regulation and supervision is primarily to provide safeguards for policyholders rather than to protect the interests of stockholders. The insurance laws of the various states establish regulatory agencies with broad administrative powers, including the power to grant or revoke operating licenses and to regulate trade practices, investments, premium rates, deposits of securities, the form and content of financial statements and insurance policies, accounting practices and the maintenance of specified reserves and capital for the protection of policyholders. Premium rate regulation varies greatly among jurisdictions and lines of insurance. In most states in which the Company's subsidiaries write insurance, premium rates for their lines of insurance are subject to either prior approval or limited review upon implementation. States require rates for property and casualty insurance that are adequate, not excessive, and not unfairly discriminatory. The Company's insurance subsidiaries are required to file detailed annual reports with the appropriate regulatory agency in each state where they do business based on applicable statutory regulations, which differ from generally accepted accounting principles. Their businesses and accounts are subject to examination by such agencies at any time. Since EMC Insurance Group Inc. and Employers Mutual are domiciled in Iowa, the State of Iowa exercises principal regulatory supervision, and Iowa law requires periodic examination. The Company's insurance subsidiaries are subject to examination by state insurance departments on a periodic basis, as applicable law requires. State laws governing insurance holding companies also impose standards on certain transactions with related companies, which include, among other requirements, that all transactions be fair and reasonable and that an insurer's surplus as regards policyholders be reasonable and adequate in relation to its liabilities. Under Iowa law, dividends or distributions made by registered insurers are restricted in amount and may be subject to approval from the Iowa Commissioner of Insurance. "Extraordinary" dividends or distributions are subject to prior approval and are defined as dividends or distributions made within a 12 month period which exceed the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis. Both Illinois and North Dakota impose restrictions, which are similar to those of Iowa, on the payment of dividends and distributions. At December 31, 1999, $11,505,996 was available for distribution in 2000 to the Company without prior approval. See note 6 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. The National Association of Insurance Commissioners (NAIC) utilizes a risk-based capital model to help state regulators assess the capital adequacy of insurance companies and identify property/casualty insurers that are in (or are perceived as approaching) financial difficulty by establishing minimum capital needs based on the risks applicable to the operations of the individual insurer. The risk-based capital requirements for property and casualty insurance companies measure three major areas of risk: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. At December 31, 1999, each of the Company's insurance subsidiaries ratio of total adjusted capital to risk-based capital is well in excess of the minimum level required. ITEM 2. ITEM 2. PROPERTIES. - ------- ----------- The Company does not own any real property. Lease costs of the Company's office facilities in Oak Brook, Illinois, and Bismarck, North Dakota, which total approximately $293,000 and $300,000 annually, are included as expenses under the pooling agreement. Expenses of office facilities owned and leased by Employers Mutual are borne by the parties to the pooling agreement, less the rent received from the space used and paid for by non-insurance subsidiaries and outside tenants. See "Property and Casualty Insurance - Pooling Agreement" under Item 1 of this Form 10-K. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. - ------- ------------------ The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have reserves that are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. - ------- ---------------------------------------------------- None. PART II ------- ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED - ------- ------------------------------------------------- STOCKHOLDER MATTERS. -------------------- The "Stockholder Information" section from the Company's Annual Report to Stockholders for the year ended December 31, 1999, which is included as Exhibit 13(d) to this Form 10-K, is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - ------- ------------------------ The "Selected Consolidated Financial Data" section from the Company's Annual Report to Stockholders for the year ended December 31, 1999, which is included as Exhibit 13(a) to this Form 10-K, is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------- --------------------------------------------------------------- RESULTS OF OPERATIONS. ---------------------- The "Management's Discussion and Analysis of Financial Condition and Results of Operations" section from the Company's Annual Report to Stockholders for the year ended December 31, 1999, which is included as Exhibit 13(b) to this Form 10-K, is incorporated herein by reference. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. - -------- ----------------------------------------------------------- The information under the caption "Market Risk" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section from the Company's Annual Report to Stockholders for the year ended December 31, 1999, which is included as Exhibit 13(b) to this Form 10-K, is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------- -------------------------------------------- The consolidated financial statements from the Company's Annual Report to Stockholders for the year ended December 31, 1999, which is included as Exhibit 13(c) to this Form 10-K, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON - ------- ------------------------------------------------ ACCOUNTING AND FINANCIAL DISCLOSURE. ------------------------------------ None. PART III -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - -------- --------------------------------------------------- See the information under the caption "Election of Directors" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 2000, which information is incorporated herein by reference. The following sets forth information regarding all executive officers of the Company. NAME AGE POSITION Bruce G. Kelley 46 President and Chief Executive Officer of the Company and of Employers Mutual since 1992 and Treasurer of both organizations since 1996. He was elected President of the Company and Employers Mutual in 1991. Mr. Kelley was Executive Vice President of the Company and Employers Mutual from 1989 to 1991. He has been employed by Employers Mutual since 1985. Fred A. Schiek 65 Executive Vice President and Chief Operating Officer of the Company and of Employers Mutual since 1992. He was Vice President of Employers Mutual from 1983 until 1992. He has been employed by Employers Mutual since 1959. John D. Isenhart 62 Senior Vice President of the Company since 1997 and of Employers Mutual since 1992. He has been employed by Employers Mutual since 1963. Margaret A. Ball 61 Senior Vice President of the Company since 1998 and of Employers Mutual since 1997. She was Vice President of the Company from 1995 until 1998. She has been employed by Employers Mutual since 1971. Ronald W. Jean 51 Senior Vice President of the Company and Employers Mutual since 1997. He was Vice President of the Company from 1985 until 1997. He has been employed by Employers Mutual since 1979. Raymond W. Davis 54 Senior Vice President of the Company and Employers Mutual since 1998. He was Vice President of the Company from 1985 until 1998. He has been employed by Employers Mutual since 1979. Donald D. Klemme 54 Senior Vice President and Secretary of the Company since 1998. Senior Vice President of Employers Mutual since 1998. He was Vice President and Secretary of the Company from 1996 until 1998. He has been employed by Employers Mutual since 1972. David O. Narigon 47 Senior Vice President of the Company and of Employers Mutual since 1998. He was Vice President of the Company from 1989 until 1998. He has been employed by Employers Mutual since 1983. Mark E. Reese 42 Vice President of the Company and Employers Mutual since 1996 and Chief Financial Officer of the Company and Employers Mutual since 1997. He has been employed by Employers Mutual since 1984. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. - -------- ----------------------- See the information under the caption "Compensation of Management" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 2000, which information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - -------- --------------------------------------------------------------- See the information under the captions "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 2000, which information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - -------- ----------------------------------------------- See the information under the caption "Certain Relationships and Related Transactions" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 2000, which information is incorporated herein by reference. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - -------- ----------------------------------------------------------------- (a) List of Financial Statements and Schedules. Page ---- 1. Financial Statements Independent Auditors' Report ................................ 15* Consolidated Balance Sheets, December 31, 1999 and 1998 ..... 16* Consolidated Statements of Income for the Years ended December 31, 1999, 1998 and 1997 ......................... 17* Consolidated Statements of Comprehensive Income for the Years ended December 31, 1999, 1998 and 1997 ............. 17* Consolidated Statements of Stockholders' Equity for the Years ended December 31, 1999, 1998 and 1997 ............. 18* Consolidated Statements of Cash Flows for the Years ended December 31, 1999, 1998 and 1997 ......................... 19* Notes to Consolidated Financial Statements .................. 21-40* Form 10-K 2. Schedules Page ---- Independent Auditors' Report on Schedules ................... 30 Schedule I - Summary of Investments ....................... 31 Schedule II - Condensed Financial Information of Registrant 32 Schedule III - Supplementary Insurance Information .......... 35 Schedule IV - Reinsurance .................................. 36 Schedule VI - Supplemental Information Concerning Property-Casualty Insurance Operations ..... 37 All other schedules have been omitted for the reason that the items required by such schedules are not present in the consolidated financial statements, are covered in the notes to the consolidated financial statements or are not significant in amount. * Refers to the respective page of the financial information insert of EMC Insurance Group Inc.'s 1999 Annual Report to Stockholders. The Consolidated Financial Statements and Independent Auditors' Report, which are included as Exhibit 13(c), are incorporated by reference. With the exception of the portions of such Annual Report specifically incorporated by reference in this Item and Items 5, 6, 7 and 8, such Annual Report shall not be deemed filed as part of this Form 10-K or otherwise subject to the liabilities of Section 18 of the Securities Exchange Act of 1934. 3. Management contracts and compensatory plan arrangements Exhibit 10(b). 1999 Senior Executive Compensation Bonus Program. Exhibit 10(d). 1982 Employers Mutual Casualty Company Incentive Stock Option Plan, as amended. Exhibit 10(e). Deferred Bonus Compensation Plans. Exhibit 10(f). EMC Reinsurance Company Executive Bonus Program. Exhibit 10(h). Employers Mutual Casualty Company Excess Retirement Benefit Agreement. Exhibit 10(i). Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. Exhibit 10(j). 1993 Employers Mutual Casualty Company Incentive Stock Option Plan, as amended. Exhibit 10(k). Employers Mutual Casualty Company Non-Employee Director Stock Option Plan. Exhibit 10(l). Employers Mutual Casualty Company Supplemental Executive Retirement Plan. (b) Reports on Form 8-K. None (c) Exhibits. 3. Articles of incorporation and bylaws: (a) Articles of Incorporation of the Company, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) (b) Bylaws of the Company, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) 10. Material contracts. (a) Quota Share Reinsurance Contract between Employers Mutual Casualty Company and EMC Reinsurance Company. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1997.) (b) 1999 Senior Executive Compensation Bonus Program. (c) EMC Insurance Companies reinsurance pooling agreements between Employers Mutual Casualty Company and certain of its affiliated companies, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) (d) 1982 Employers Mutual Casualty Company Incentive Stock Option Plan, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) (e) Deferred Bonus Compensation Plans. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) (f) EMC Reinsurance Company Executive Bonus Program. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) (g) EMC Insurance Group Inc. Amended and Restated Dividend Reinvestment and Common Stock Purchase Plan. (Incorporated by reference to Registration No. 33-34499.) (h) Employers Mutual Casualty Company Excess Retirement Benefit Agreement. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1998.) (i) Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. (Incorporated by reference to Registration No. 33-49335.) (j) 1993 Employers Mutual Casualty Company Incentive Stock Option Plan. (Incorporated by reference to Registration Nos.33-49337 and 333-45279.) (k) Employers Mutual Casualty Company Non-Employee Director Stock Option Plan. (Incorporated by reference to Registration No. 33-49339.) (l) Employers Mutual Casualty Company Supplemental Executive Retirement Plan. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1995.) 13. Annual Report to Security Holders. (a) Selected Financial Data from the Company's 1999 Annual Report to Stockholders. (b) Management's Discussion and Analysis of Financial Condition and Results of Operations from the Company's 1999 Annual Report to Stockholders. (c) Consolidated Financial Statements from the Company's 1999 Annual Report to Stockholders. (d) Stockholder Information from the Company's 1999 Annual Report to Stockholders. 21. Subsidiaries of the Registrant. 23. Consent of KPMG LLP with respect to Forms S-8 (Registration Nos. 2-93738, 33-49335, 33-49337, 33-49339 and (333-45279) and Form S-3 (Registration No. 33-34499). 24. Power of Attorney. (d) Financial statements required by Regulation S-X which are excluded from the Annual Report to Stockholders by Rule 14a-3(b)(1). None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 28, 2000. EMC INSURANCE GROUP INC. /s/ Bruce G. Kelley ------------------------ Bruce G. Kelley President, Treasurer and Chief Executive Officer /s/ Mark E. Reese ------------------------ Mark E. Reese Vice President - Chief Financial Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 28, 2000. /s/ Mark E. Reese ------------------------ George C. Carpenter III* Director /s/ Mark E. Reese ------------------------ E. H. Creese* Director /s/ Mark E. Reese ------------------------ David J. Fisher* Director /s/ Bruce G. Kelley ------------------------ Bruce G. Kelley Director /s/ Mark E. Reese ------------------------ George W. Kochheiser* Chairman of the Board /s/ Mark E. Reese ------------------------ Raymond A. Michel* Director /s/ Mark E. Reese ------------------------ Fredrick A. Schiek* Director * by power of attorney INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors and Stockholders EMC Insurance Group Inc.: Under date of February 24, 2000, we reported on the consolidated balance sheets of EMC Insurance Group Inc. and Subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1999, as contained in Part II, Item 8 of Form 10-K for the year 1999. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules listed in Part IV, Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Des Moines, Iowa February 24, 2000 EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule I - Summary of Investments - Other Than Investments in Related Parties December 31, 1999 Amount at which shown Fair in the Type of investment Cost value balance sheet ------------------ ------------ ------------ ------------- Securities held-to-maturity: Fixed maturities: United States Government and government agencies and authorities .............. $109,055,239 $108,320,350 $109,055,239 Mortgage-backed securities ..... 18,148,921 18,358,715 18,148,921 ------------ ------------ ------------ Total fixed maturity securities 127,204,160 126,679,065 127,204,160 ------------ ------------ ------------ Securities available-for-sale: Fixed maturities: United States Government and government agencies and authorities .............. 4,419,411 4,361,084 4,361,084 States, municipalities and political subdivisions ....... 96,077,294 93,213,764 93,213,764 Mortgage-backed securities ..... 49,440,943 49,434,206 49,434,206 Debt securities issued by foreign governments .......... 6,479,135 6,569,030 6,569,030 Public utilities ............... 8,890,108 8,837,456 8,837,456 Corporate securities ........... 98,413,442 93,765,889 93,765,889 ------------ ------------ ------------ Total fixed maturity securities 263,720,333 256,181,429 256,181,429 ------------ ------------ ------------ Equity securities: Common stocks .................. 25,853,745 29,803,765 29,803,765 Non-redeemable preferred stocks 2,640,886 2,604,507 2,604,507 ------------ ------------ ------------ Total equity securities ...... 28,494,631 32,408,272 32,408,272 ------------ ------------ ------------ Short-term investments ............. 20,164,210 20,164,210 20,164,210 ------------ ------------ ------------ Total investments ...... $439,583,334 $435,432,976 $435,958,071 ============ ============ ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule II - Condensed Financial Information of Registrant Condensed Balance Sheets December 31, -------------------------- 1999 1998 ------------ ------------ ASSETS - ------ Investment in common stock of subsidiaries (equity method) .................. $138,167,388 $157,416,941 Fixed maturity investments: Securities held-to-maturity, at amortized cost 1,999,431 3,999,138 Securities available-for-sale, at market value 1,467,525 - Short-term investments .......................... 337,525 2,552,944 Cash ............................................ 5,008 62,448 Accrued investment income ....................... 78,409 50,417 Income taxes recoverable ........................ 12,000 - Accounts receivable ............................. 2,568 216 Deferred tax asset .............................. 6,252 3,850 ------------ ------------ Total assets ............................... $142,076,106 $164,085,954 ============ ============ LIABILITIES - ----------- Accounts payable ................................ $ 127,548 $ 128,245 Income taxes payable ............................ - 18,000 Indebtedness to related party ................... 32,281 1,869 ------------ ------------ Total liabilities .......................... 159,829 148,114 ------------ ------------ STOCKHOLDERS' EQUITY - -------------------- Common stock, $1 par value, authorized 20,000,000 shares; issued and outstanding, 11,265,232 shares in 1999 and 11,496,389 shares in 1998 ......... 11,265,232 11,496,389 Additional paid-in capital ...................... 65,333,686 67,822,412 Accumulated other comprehensive (loss) income ... (3,625,263) 8,079,371 Retained earnings ............................... 68,942,622 76,539,668 ------------ ------------ Total stockholders' equity ................. 141,916,277 163,937,840 ------------ ------------ Total liabilities and stockholders' equity $142,076,106 $164,085,954 ============ ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Condensed Statements of Income Years ended December 31, ------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Equity in undistributed (loss) earnings of subsidiaries ..................... $(7,577,404) $ 1,685,244 $ 9,377,037 Dividends received from subsidiaries .. 6,800,055 4,275,035 3,750,032 Investment income ..................... 364,042 463,889 445,816 Other income .......................... 52 - - ----------- ----------- ----------- (413,255) 6,424,168 13,572,885 Operating expenses .................... 390,894 387,056 313,762 ----------- ----------- ----------- (Loss) income from operations before income tax (benefit) expense ..... (804,149) 6,037,112 13,259,123 Income tax (benefit) expense .......... (164) 24,247 42,556 ----------- ----------- ----------- Net (loss) income ....... $ (803,985) $ 6,012,865 $13,216,567 =========== =========== =========== Condensed Statements of Comprehensive Income Years ended December 31, ------------------------------------- 1999 1998 1997 ------------ ----------- ----------- Net (loss) income ..................... $ (803,985) $ 6,012,865 $13,216,567 ------------ ----------- ----------- Other Comprehensive Income: Unrealized holding (losses) gains arising during the period, net of deferred income tax (benefit) expense ........................... (11,527,264) 4,264,242 6,399,757 Reclassification adjustment for gains included in net (loss) income, net of income tax expense ............. (177,370) (3,871,963) (2,704,732) ------------ ----------- ----------- Other comprehensive (loss) income (11,704,634) 392,279 3,695,025 ------------ ----------- ----------- Total comprehensive (loss) income $(12,508,619) $ 6,405,144 $16,911,592 ============ =========== =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Condensed Statements of Cash Flows Years ended December 31, ------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Net cash provided by operating activities ................ $ 6,740,085 $ 4,015,569 $ 3,702,567 ----------- ----------- ----------- Cash flows from investing activities: Purchases of fixed maturity securities held-to-maturity ....... - - (3,999,340) Disposals of fixed maturity securities held-to-maturity ....... 2,000,000 2,500,000 2,000,000 Purchases of fixed maturity securities available-for-sale ..... (1,500,000) - - Net sales (purchases) of short-term investments ...................... 2,215,419 (1,643,245) 1,413,904 ----------- ----------- ----------- Net cash provided by (used in) investing activities ........... 2,715,419 856,755 (585,436) ----------- ----------- ----------- Cash flows from financing activities: Issuance of common stock ........... 278,794 823,927 1,019,919 Dividends paid to stockholders ..... (6,793,061) (5,637,687) (4,314,083) Repurchase of common stock ......... (2,998,677) - - ----------- ----------- ----------- Net cash used in financing activities ..................... (9,512,944) (4,813,760) (3,294,164) ----------- ----------- ----------- Net (decrease) increase in cash ....... (57,440) 58,564 (177,033) Cash at beginning of year ............. 62,448 3,884 180,917 ----------- ----------- ----------- Cash at end of year ................... $ 5,008 $ 62,448 $ 3,884 =========== =========== =========== Income taxes paid ..................... $ 31,952 $ 50,229 $ 40,000 Interest paid ......................... $ 285 $ - $ - EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule III - Supplementary Insurance Information For Years Ended December 31, 1999, 1998 and 1997 Deferred Losses and policy settlement acquisition expense Unearned Segment costs reserves premiums ------- ----------- ------------ ----------- Year ended December 31, 1999: Property and casualty insurance $11,992,874 $194,872,984 $57,598,773 Reinsurance ................... 1,626,318 71,641,040 7,392,356 Parent company ................ - - - ----------- ------------ ----------- Consolidated ............. $13,619,192 $266,514,024 $64,991,129 =========== ============ =========== Year ended December 31, 1998: Property and casualty insurance $10,666,188 $182,529,015 $53,785,443 Reinsurance ................... 1,689,294 63,081,308 7,678,608 Parent company ................ - - - ----------- ------------ ----------- Consolidated ............. $12,355,482 $245,610,323 $61,464,051 =========== ============ =========== Year ended December 31, 1997: Property and casualty insurance $ 8,949,126 $159,403,277 $47,532,320 Reinsurance ................... 1,611,531 58,374,665 7,325,143 Parent company ................ - - - ----------- ------------ ----------- Consolidated ............. $10,560,657 $217,777,942 $54,857,463 =========== ============ =========== Losses and Net settlement Premium investment expenses Segment revenue income incurred ------------ ----------- ------------ Year ended December 31, 1999: Property and casualty insurance $167,265,093 $18,282,642 $140,481,323 Reinsurance ................... 43,833,048 7,113,877 36,394,925 Parent company ................ - 364,042 - ------------ ----------- ------------ Consolidated ............. $211,098,141 $25,760,561 $176,876,248 ============ =========== ============ Year ended December 31, 1998: Property and casualty insurance $155,523,486 $17,635,076 $128,666,666 Reinsurance ................... 38,720,919 6,760,098 29,209,428 Parent company ................ - 463,889 - ------------ ----------- ------------ Consolidated ............. $194,244,405 $24,859,063 $157,876,094 ============ =========== ============ Year ended December 31, 1997: Property and casualty insurance $143,112,560 $16,719,458 $106,547,480 Reinsurance ................... 34,105,686 6,615,029 23,305,824 Parent company ................ - 445,816 - ------------ ----------- ------------ Consolidated ............. $177,218,246 $23,780,303 $129,853,304 ============ =========== ============ Amortization of deferred policy Other acquisition underwriting Premiums Segment costs expenses written ------- ----------- ----------- ------------ Year ended December 31, 1999: Property and casualty insurance $38,374,266 $13,698,660 $171,015,719 Reinsurance ................... 9,682,652 3,767,162 43,546,796 Parent company ................ - - - ----------- ----------- ------------ Consolidated ............. $48,056,918 $17,465,822 $214,562,515 =========== =========== ============ Year ended December 31, 1998: Property and casualty insurance $35,754,919 $13,829,886 $161,855,333 Reinsurance ................... 8,907,722 3,186,535 39,074,384 Parent company ................ - - - ----------- ----------- ------------ Consolidated ............. $44,662,641 $17,016,421 $200,929,717 =========== =========== ============ Year ended December 31, 1997: Property and casualty insurance $27,688,763 $16,557,572 $149,909,925 Reinsurance ................... 8,253,329 3,498,497 34,690,846 Parent company ................ - - - ----------- ----------- ------------ Consolidated ............. $35,942,092 $20,056,069 $184,600,771 =========== =========== ============ (1) The amount for 1998 reflects an adjustment of ($3,600,220) related to the 1998 change in the property and casualty insurance subsidiaries' pooling agreement. This adjustment was made to offset the income statement effect that resulted from the $3,600,220 increase in reserves for losses and settlement expenses on January 1, 1998 related to this transaction. The 1997 amount reflects an adjustment of ($3,795,453) related to the 1997 change in the property and casualty insurance subsidiaries' pooling agreement and ($2,726,913) related to the change in the reinsurance subsidiary's quota share percentage. These adjustments were made to offset the income statement effect that resulted from the $6,522,366 increase in reserves for losses and settlement expenses on January 1, 1997 related to these transactions. The index to exhibits in the electronic format indicates the exhibits are included in the direct transmission. The circulated document contains the page numbers of the exhibits. EMC Insurance Group Inc. and Subsidiaries Index to Exhibits Exhibit number Item ------ ---- 10(b) 1999 Senior Executive Compensation Included in Bonus Program. direct transmission 13(a) Selected Financial Data. Included in direct transmission 13(b) Management's Discussion and Analysis of Financial Condition and Results Included in of Operations. direct transmission 13(c) Consolidated Financial Statements. Included in direct transmission 13(d) Stockholder Information. Included in direct transmission 21 Subsidiaries of the Registrant. Included in direct transmission 23 Consent of KPMG LLP with respect to Included in Forms S-8 and Form S-3. direct transmission 24 Power of Attorney. Included in direct transmission

51644_1999.txt

51644_1999

1999

51644

Item 1. Business -------- The Interpublic Group of Companies, Inc. was incorporated in Delaware in September 1930 under the name of McCann-Erickson Incorporated as the successor to the advertising agency businesses founded in 1902 by A.W. Erickson and in 1911 by Harrison K. McCann. It has operated under the Interpublic name since January 1961. As used in this Annual Report, the "Registrant" or "Interpublic" refers to The Interpublic Group of Companies, Inc. while the "Company" refers to Interpublic and its subsidiaries. The advertising agency business is the primary business of the Company. This business is conducted throughout the world primarily through two advertising agency systems, McCann-Erickson WorldGroup and The Lowe Group, plus a number of standalone local agencies. Interpublic also carries on an independent media buying business through its ownership of Initiative Media Worldwide and its affiliates, as well as a separate relationship (direct) marketing business through its ownership of DraftWorldwide, a global public relations capability through International Public Relations, an internet and business consultancy through its Zentropy Partners, and a multi-national sports and event marketing organization, Octagon. The Company also offers advertising agency services through association arrangements with local agencies in various parts of the world. Other activities conducted by the Company within the area of "marketing communications" include brand equity and corporate identity services, management consulting, healthcare marketing, market research, sales promotion, internet services, sales meetings and events, multicultural advertising and promotion, and other related specialized marketing and communications services. The principal functions of an advertising agency are to plan and create advertising programs for its clients and to place advertising in various media such as television, cinema, radio, magazines, newspapers, direct mail, outdoor and interactive electronic media. The planning function involves analysis of the market for the particular product or service, evaluation of alternative methods of distribution and choice of the appropriate media to reach the desired market most efficiently. The advertising agency develops a communications strategy and then creates an advertising program, within the limits imposed by the client's advertising budget, and places orders for space or time with the media that have been selected. The principal advertising agency subsidiaries of Interpublic operating within the United States directly or through subsidiaries and the locations of their respective corporate headquarters are: Campbell-Ewald Company............ Detroit (Warren), Michigan Campbell Mithun Esty LLC.......... Minneapolis, Minnesota Dailey & Associates, Inc.......... Los Angeles, California DraftWorldwide, Inc............... Chicago, Illinois Hill, Holliday, Connors, Cosmopulos, Inc................. Boston, Massachusetts International Public Relations. Inc. New York, New York, and London, England Lowe Lintas & Partners.......... New York, New York McCann-Erickson USA, Inc.......... New York, New York Zentropy Partners, Inc............ Cambridge, Massachusetts In addition to domestic operations, the Company provides services for clients whose business is international in scope as well as for clients whose business is restricted to a single country or a small number of countries. It has offices in Canada as well as in one or more cities in each of the following countries: EUROPE, AFRICA AND THE MIDDLE EAST ---------------------------------- Austria Germany Morocco Slovakia Azerbaijan Greece Namibia Slovenia Bahrain Hungary Netherlands South Africa Belgium Israel Nigeria Spain Bulgaria Ireland Norway Sweden Cameroon Italy Oman Switzerland Croatia Ivory Coast Pakistan Tunisia Czech Republic Jordan Poland Turkey Denmark Kazakhstan Portugal Ukraine Egypt Kenya Qatar United Arab Emirates Estonia Kuwait Romania United Kingdom Finland Lebanon Russia Uzbekistan France Mauritius Saudi Arabia Zambia Senegal Zimbabwe LATIN AMERICA AND THE CARIBBEAN ------------------------------- Argentina Colombia Guatemala Peru Barbados Costa Rica Honduras Puerto Rico Bermuda Dominican Republic Jamaica Trinidad Brazil Ecuador Mexico Uruguay Chile El Salvador Panama Venezuela ASIA AND THE PACIFIC -------------------- Australia Korea Philippines Taiwan Hong Kong Malaysia Singapore Thailand India Nepal Sri Lanka Vietnam Indonesia New Zealand South Korea Japan People's Republic of China Operations in the foregoing countries are carried on by one or more operating companies, at least one of which is either wholly owned by Interpublic or a subsidiary or is a company in which Interpublic or a subsidiary owns a 51% interest or more, except in Malawi and Nepal, where Interpublic or a subsidiary holds a minority interest. The Company also offers services in Albania, Aruba, the Bahamas, Belize, Bolivia, Cambodia, Gabon, Ghana, Grand Cayman, Guadeloupe, Guam, Guyana, Haiti, Reunion, Ivory Coast, Martinique, Nicaragua, Nigeria, Paraguay, Surinam, Uganda and Zaire through association arrangements with local agencies operating in those countries. For information concerning revenues and long-lived assets on a geographical basis for each of the last three years, reference is made to Note 12: Geographic Areas of the Notes to the Consolidated Financial Statements in the Company's Annual Report to Stockholders for the year ended December 31, 1999, which Note is hereby incorporated by reference. Developments in 1999 - -------------------- The Company completed a number of acquisitions within the United States and abroad in 1999. See Note 4 to the Consolidated Financial Statements incorporated by reference in this Report on Form 10-K for a discussion of acquisitions. Income from Commissions and Fees - -------------------------------- The Company generates income from planning, creating and placing advertising in various media and from planning and executing other communications or marketing programs. Historically, the commission customary in the industry was 15% of the gross charge ("billings") for advertising space or time; more recently lower commissions have been negotiated, but often with additional incentives for better performance. For example, an incentive component is frequently included in arrangements with clients based on improvements in an advertised brand's awareness or image, or increases in a client's sales or market share of the products or services being advertised. Under commission arrangements, media bill the Company at their gross rates. The Company bills these amounts to its clients, remits the net charges to the media and retains the balance as its commission. Some clients, however, prefer to compensate the Company on a fee basis, under which the Company bills its client for the net charges billed by the media plus an agreed-upon fee. These fees usually are calculated to reflect the Company's salary costs and out-of-pocket expenses incurred on the client's behalf, plus proportional overhead and a profit mark-up. Normally, the Company, like other agencies, is primarily responsible for paying the media with respect to firm contracts for advertising time or space. This is a problem only if the client is unable to pay the Company because of insolvency or bankruptcy. The Company makes serious efforts to reduce the risk from a client's insolvency, including (1) carrying out credit clearances, (2) requiring in some cases payment of media in advance, or (3) agreeing with the media that the Company will be solely liable to pay the media only after the client has paid the Company for the media charges. The Company also receives commissions from clients for planning and supervising work done by outside contractors in the physical preparation of finished print advertisements and the production of television and radio commercials and other forms of advertising. This commission is customarily 17.65% of the outside contractor's net charge, which is the same as 15% of the outside contractor's total charges including commission. With the expansion of negotiated fees, the terms on which outstanding contractors' charges are billed are subject to wide variations and even include in some instances the elimination of commissions entirely provided that there are adequate negotiated fees. The Company also derives income in many other ways, including the planning and placement in media of advertising produced by unrelated advertising agencies; the maintenance of specialized media placement facilities; the creation and publication of brochures, billboards, point of sale materials and direct marketing pieces for clients; the planning and carrying out of specialized marketing research; developments/public relations campaigns, managing special events at which clients' products are featured; and designing and carrying out interactive programs for special uses. The five clients of the Company that made the largest contribution in 1999 to income from commissions and fees accounted individually for 1.8% to 8.0% of such income and in the aggregate accounted for over approximately 18% of such income. Twenty clients of the Company accounted for approximately 28% of such income. Based on income from commissions and fees, the three largest clients of the Company are General Motors Corporation, Nestle and Unilever. General Motors Corporation first became a client of one of the Company's agencies in 1916 in the United States. Predecessors of several of the Lintas agencies have supplied advertising services to Unilever since 1893. The client relationship with Nestle began in 1940 in Argentina. While the loss of the entire business of one of the Company's three largest clients might have a material adverse effect upon the business of the Company, the Company believes that it is very unlikely that the entire business of any of these clients would be lost at the same time, because it represents several different brands or divisions of each of these clients in a number of geographical markets - in each case through more than one of the Company's agency systems. Representation of a client rarely means that the Company handles advertising for all brands or product lines of the client in all geographical locations. Any client may transfer its business from an advertising agency within the Company to a competing agency, and a client may reduce its advertising budget at any time. The Company's agencies in many instances have written contracts with their clients. As is customary in the industry, these contracts provide for termination by either party on relatively short notice, usually 90 days but sometimes shorter or longer. In 1999, however, 23% of income from commissions and fees was derived from clients that had been associated with one or more of the Company's agencies or their predecessors for 20 or more years. Personnel - --------- As of January 1, 2000, the Company employed approximately 38,600 persons, of whom nearly 16,200 were employed in the United States. Because of the personal service character of the marketing communications business, the quality of personnel is of crucial importance to continuing success. There is keen competition for qualified employees. Interpublic considers its employee relations to be satisfactory. The Company has an active program for training personnel. The program includes meetings and seminars throughout the world. It also involves training personnel in its offices in New York and in its larger offices worldwide. Competition and Other Factors - ----------------------------- The advertising agency and other marketing communications businesses are highly competitive. The Company's agencies and media services must compete with other agencies and with other providers of creative or media services which are not themselves advertising agencies, in order to maintain existing client relationships and to obtain new clients. Competition in the advertising agency business depends to a large extent on the client's perception of the quality of an agency's "creative product". An agency's ability to serve clients, particularly large international clients, on a broad geographic basis is also an important competitive consideration. On the other hand, because an agency's principal asset is its people, freedom of entry into the business is almost unlimited and quite small agencies are, on occasion, able to take all or some portion of a client's account from a much larger competitor. Moreover, increasing size bring some limitations to an agency's potential for securing new business, because many clients prefer not to be represented by an agency that represents a competitor. Also, clients frequently wish to have different products represented by different agencies. The fact that the Company owns two separate worldwide agency systems and interests in other advertising agencies gives it additional competitive opportunities. The advertising and marketing communications businesses is subject to government regulation, both domestic and foreign. There has been an increasing tendency in the United States on the part of advertisers to resort to the courts, industry and self-regulatory bodies to challenge comparative advertising on the grounds that the advertising is false and deceptive. Through the years, there has been a continuing expansion of specific rules, prohibitions, media restrictions, labeling disclosures and warning requirements with respect to the advertising for certain products. Representatives within state governments and the federal government as well as foreign governments continue to initiate proposals to ban the advertising of specific products and to impose taxes on or deny deductions for advertising which, if successful, may have an adverse effect on advertising expenditures. Some countries are relaxing commercial restrictions as part of their efforts to attract foreign investment. However, with respect to other nations, the international operations of the Company still remain exposed to certain risks which affect foreign operations of all kinds, such as local legislation, monetary devaluation, exchange control restrictions and unstable political conditions. In addition, international advertising agencies are still subject to ownership restrictions in certain countries because they are considered an integral factor in the communications process. Statement Regarding Forward Looking Disclosure - ---------------------------------------------- Certain sections of this report, including "Business", "Competition and Other Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contain forward looking statements concerning future events and developments that involve risks and uncertainties, including those associated with the effect of national and regional economic conditions, the ability of the Company to attract new clients and retain existing clients, the financial success of clients of the Company, other developments of clients of the Company, and developments from changes in the regulatory and legal environment for advertising agencies around the world. Item 2. Item 2. Properties ---------- Most of the operations of the Company are conducted in leased premises, and its physical property consists primarily of leasehold improvements, furniture, fixtures and equipment. These facilities are located in various cities in which the Company does business throughout the world. However, subsidiaries of the Company own office buildings in Louisville, Kentucky; Blair, Nebraska; Warren, Michigan; Frankfurt, Germany; Sao Paulo, Brazil; Lima, Peru; Mexico City, Mexico; Santiago, Chile; and Brussels, Belgium and own office condominiums in Buenos Aires, Argentina; Bogota, Colombia; Manila, the Philippines; in England, subsidiaries of the Company own office buildings in London, Manchester, Birmingham and Stoke-on-Trent. The Company's ownership of the office building in Frankfurt is subject to three mortgages which became effective on or about February 1993. These mortgages terminate at different dates, with the last to expire in February 2003. Reference is made to Note 10: Long-Term Debt, of the Notes to the Consolidated Financial Statements in the Company's Annual Report to Stockholders for the year ended December 31, 1999, which Note is hereby incorporated by reference. Item 3. Item 3. Legal Proceedings ----------------- Neither the Company nor any of its subsidiaries are subject to any pending material legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- Not applicable. Executive Officers of the Registrant - ------------------------------------ There follows the information disclosed in accordance with Item 401 of Regulation S-K of the Securities and Exchange Commission (the "Commission") as required by Item 10 of Form 10-K with respect to executive officers of the Registrant. Name Age Office - ---- --- ------ Philip H. Geier, Jr.(1) 65 Chairman of the Board, President and Chief Executive Officer Sean F. Orr(1) 45 Executive Vice President, Chief Financial Officer Nicholas J. Camera 53 Senior Vice President, General Counsel and Secretary John J. Dooner, Jr.(1) 51 Chairman and Chief Executive Officer of McCann-Erickson WorldGroup C. Kent Kroeber 61 Senior Vice President-Human Resources Barry R. Linsky 58 Senior Vice President-Planning and Business Development Frank B. Lowe(1) 58 Chairman of the Board and Chief Executive Officer of Lowe Lintas & Partners Frederick Molz 43 Vice President and Controller Thomas J. Volpe 64 Senior Vice President-Financial Operations - ---------- [FN] (1) Also a Director There is no family relationship among any of the executive officers. The employment histories for the past five years of Messrs. Geier, Dooner, Lowe and Orr are incorporated by reference to the Proxy Statement for Interpublic's 2000 Annual Meeting of Stockholders. Mr. Camera joined Interpublic in May, 1993. He was elected Vice President, Assistant General Counsel and Assistant Secretary in June, 1994, Vice President, General Counsel and Secretary in December, 1995, and Senior Vice President, General Counsel and Secretary in February, 2000. Mr. Kroeber joined Interpublic in January, 1966 as Manager of Compensation and Training. He was elected Vice President in 1970 and Senior Vice President in May, 1980. Mr. Linsky joined Interpublic in January, 1991 when he was elected Senior Vice President-Planning and Business Development. Prior to that time, he was Executive Vice President, Account Management of Lowe & Partners, Inc. Mr. Linsky was elected to that position in July, 1980, when the corporation was known as The Marschalk Company and was a subsidiary of Interpublic. Mr. Molz was elected Vice President and Controller of Interpublic effective January, 1999. He joined Interpublic in August, 1982, and his most recent position was Senior Vice President-Financial Operations of Ammirati Puris Lintas Worldwide, a subsidiary of Interpublic, since April, 1994. He also held previous positions in the Interpublic Controller's Department and Tax Department. Mr. Volpe joined Interpublic in March, 1986. He was appointed Senior Vice President-Financial Operations in March, 1986. He served as Treasurer from January 1, 1987 through May 17, 1988 and the Treasurer's office continues to report to him. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder ----------------------------------------------------------------- Matters ------- The response to this Item is incorporated: (i) by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1999. See the heading: Results by Quarter (Unaudited), and Note 2: Stockholders' Equity, of the Notes to the Consolidated Financial Statements and information under the heading Transfer Agent and Registrar for Common Stock; (ii) on October 5, 1999, a subsidiary of the Registrant acquired 100% of the capital stock of a company in consideration for which Registrant paid $2,960,612.88 in cash and issued 24,330 shares of Interpublic Stock to the shareholders of the acquired company. The shares of Interpublic Stock had a market value of $985,365.00 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (iii) on October 26, 1999, a subsidiary of the Registrant acquired 100% of the capital stock of a company in consideration for which Registrant paid $1,508,780.00 in cash and issued 17,412 shares of Interpublic Stock to the shareholders of the acquired company. The shares of Interpublic Stock were valued at $682,332.75 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (iv) on October 29, 1999, the Registrant issued a total of 63,990 shares of Interpublic Stock and paid $7,048,233.75 to shareholders of a foreign company as installment payments of the purchase price of the capital stock of the foreign company. The Interpublic stock issued had a market value of (pound)1,412,500 (U.S.$2,353,225) on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (v) on October 29, 1999, the Registrant issued an aggregate of 16,243 shares of Interpublic Stock and paid $416,687.55 in cash to the two former stockholders of a company which was acquired in the fourth quarter of 1998. This represented a deferred payment of the purchase price. The shares of Interpublic Stock were valued at $625,050.57 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; (vi) on November 8, 1999, a subsidiary of the Registrant acquired substantially all of the assets and assumed substantially all the liabilities of a domestic company in consideration for which the registrant paid $19,230,657.25 in cash and issued a total of 1,019,831 shares of the registrant's common stock par value $.10 per share ("Interpublic Stock") to the security holders of the company. The shares of Interpublic Stock had a market value of $39,317,646.53 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; (vii) on November 9, 1999, a subsidiary of the Registrant acquired 100% of the capital stock of a domestic company in consideration for which the Registrant paid $1,900,000 in cash and issued a total of 200,131 shares of Interpublic Stock to the security holders of the company. The shares of Interpublic Stock had a market value of $7,600,000 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; (viii) on November 12, 1999, the Registrant paid U.S. $8,130,000 in cash and issued a total of 210,948 shares of Interpublic Stock to shareholders of a foreign company as an installment payment of the purchase price for 100% of the capital stock of a foreign company acquired in the first quarter of 1998. The Interpublic stock issued had a market value of (pound)5,000,000 (U.S. $8,250,700) on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (ix) on November 24, 1999, the Registrant issued a total of 178,763 shares of Interpublic Stock to shareholders of a foreign company in full payment of the purchase price for 100% of the capital stock of the foreign company. The Interpublic stock issued had a market value of (pound)4,350,000 (U.S. $7,074,536) on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (x) on December 10, 1999, a subsidiary of the Registrant acquired 100% of the issued and outstanding shares of a company in consideration for which the Registrant paid $1,000,000 in cash and issued 31,764 shares of Interpublic Stock to the acquired company's shareholders. The shares of Interpublic Stock had a market value of $1,500,000 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; (xi) on December 14, 1999, the Registrant paid U.S. $4,481,636.20 in cash and issued a total of 31,838 shares of Interpublic Stock to shareholders of a foreign company in full payment of the purchase price for 51% of the capital stock of the foreign company. The Interpublic stock issued had a market value of DM 2,900,000 (U.S. $1,505,633) on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (xii) on December 16, 1999, the Registrant paid U.S. $11,416,000 in cash and issued a total of 237,279 shares of Interpublic Stock to shareholders of a foreign company in full payment of the purchase price for 100% of the capital stock of the foreign company. The Interpublic stock issued had a market value of (pound)7,080,000 (U.S. $11,338,903) on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (xiii) on December 17, 1999, the Registrant paid U.S. $1,302,000 in cash and issued a total of 3,321 shares of Interpublic Stock to shareholders of a foreign company in full payment of the purchase price for 60% of the capital stock of the foreign company. The Interpublic stock issued had a market value of Mexican Pesos 1,505,900 (U.S. $159,776) on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (xiv) on December 20, 1999, the Registrant acquired 100% of the capital stock of a domestic company in consideration for which the Registrant paid $4,915,500 in cash and issued a total of 31,773 shares of Interpublic Stock to the security holders of the company. The shares of Interpublic Stock had a market value of $1,638,500 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; (xv) on December 23, 1999, a subsidiary of the Registrant acquired 60% of the capital stock of a foreign company in consideration for which Registrant paid $867,900 in cash and issued without registration 13,770 shares of the Common Stock, $.10 par value of Registrant (the "Interpublic Stock") to the shareholders of the acquired company. The shares of Interpublic Stock had a market value of $710,100 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act of 1933, as amended, (the "Securities Act"); (xvi) on December 23, 1999, the Registrant acquired 100% of the capital stock of three related companies, in consideration for which Registrant paid $7,309,292 in cash and issued 53,927 shares of Interpublic Stock to the shareholders of the acquired company. The shares of Interpublic Stock were valued at $2,696,350 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (xvii) on December 30, 1999, the Registrant acquired 100% of the capital stock of a company in consideration for which Registrant paid $4,065,501.13 in cash and issued 9,658 shares of Interpublic Stock to the shareholders of the acquired company. The shares of Interpublic Stock were valued at $536,622.63 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act; (xviii)on October 13, 1999, a subsidiary of the Registrant acquired 100% of the capital stock of a domestic company in consideration for which Registrant paid $2,025,000 in cash and issued 17,159 shares of the Common Stock, $.10 par value, of Registrant (the "Interpublic Stock") to the shareholders of the acquired company. The shares of Interpublic Stock were valued at $674,992.16 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; (xix) on December 7, 1999, IPG acquired all of the common stock of a company in exchange for which Interpublic issued to the former stockholders of the company 357,833 shares of Interpublic Stock with a value on the date of issuance of $15,000,000. The shares of Interpublic Stock were issued by the Registrant without registration in reliance on Section 4(2) under the Securities Act, based on the sophistication of the acquired company's former stockholders; and (xx) on December 1, 1999, a subsidiary of the Registrant acquired 100% of the capital stock of a foreign company in consideration for which Registrant issued 5,158,122 shares of the Common Stock, $.10 par value of Registrant (the "Interpublic Stock") to the shareholders of the acquired company. The shares of Interpublic Stock had a market value of U.S. $239,853,000 on the date of issuance. The shares of Interpublic Stock were issued by the Registrant without registration in an "offshore transaction" and solely to "non-U.S. persons" in reliance on Rule 903(b)(3) of Regulation S under the Securities Act of 1933, as amended (the "Securities Act"). Item 6. Item 6. Selected Financial Data ----------------------- The response to this Item is incorporated by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1999 under the heading Selected Financial Data for Five Years. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations --------------------- The response to this Item is incorporated by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1999 under the heading Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk ---------------------------------------------------------- The response to this Item is incorporated by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1999 under the heading Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 8. Item 8. Financial Statements and Supplementary Data ------------------------------------------- The response to this Item is incorporated in part by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1999 under the headings Financial Statements and Notes to the Consolidated Financial Statements. Reference is also made to the Financial Statement Schedule listed under Item 14(a) of this Report on Form 10-K. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- The information required by this Item is incorporated by reference to the Registrant's Proxy Statement for its 2000 Annual Meeting of Stockholders (the "Proxy Statement"), to be filed not later than 120 days after the end of the 1999 calendar year, except for the description of Interpublic's Executive Officers which appears in Part I of this Report on Form 10-K under the heading "Executive Officers of the Registrant". Item 11. Item 11. Executive Compensation ---------------------- The information required by this Item is incorporated by reference to the Proxy Statement. Such incorporation by reference shall not be deemed to incorporate specifically by reference the information referred to in Item 402(a)(8) of Regulation S-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- The information required by this Item is incorporated by reference to the Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions ---------------------------------------------- The information required by this Item is incorporated by reference to the Proxy Statement. Such incorporation by reference shall not be deemed to incorporate specifically by reference the information referred to in Item 402(a)(8) of Regulation S-K. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K --------------------------------------------------------------- (a) Listed below are all financial statements, financial statement schedules and exhibits filed as part of this Report on Form 10-K. 1. Financial Statements: See the Index to Financial Statements on page. 2. Financial Statement Schedule: See the Index to Financial Statement Schedule on page. 3. Exhibits: (Numbers used are the numbers assigned in Item 601 of Regulation S-K and the EDGAR Filer Manual. An additional copy of this exhibit index immediately precedes the exhibits filed with this Report on Form 10-K and the exhibits transmitted to the Commission as part of the electronic filing of the Report.) Exhibit No. Description - ------------ ----------- 3 (i) The Restated Certificate of Incorporation of the Registrant, as amended is incorporated by reference to its Report on Form 10-Q for the quarter ended June 30, 1999. See Commission file number 1-6686. (ii) The By-Laws of the Registrant, amended as of February 19, 1991, are incorporated by reference to its Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. 4 Instruments Defining the Rights of Security Holders. (i) Indenture, dated as of September 16, 1997 between Interpublic and The Bank of New York is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended September 30, 1998. See Commission file number 1-6686. (ii) The Preferred Share Purchase Rights Plan as adopted on July 18, 1989 is incorporated by reference to Registrant's Registration Statement on Form 8-A dated August 1, 1989 (No. 00017904) and, as amended, by reference to Registrant's Registration Statement on Form 8 dated October 3, 1989 (No. 00106686). 10 Material Contracts. (a) Purchase Agreement, dated September 10, 1997, among The Interpublic Group of Companies, Inc. ("Interpublic"), Morgan Stanley & Co., Incorporated, Goldman Sachs and Co. and SBC Warburg Dillon Read Inc. is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended September 30, 1999. See Commission file number 1-6686. (b) Employment, Consultancy and other Compensatory Arrangements with Management. Employment and Consultancy Agreements and any amendments or supplements thereto and other compensatory arrangements filed with the Registrant's Reports on Form 10-K for the years ended December 31, 1980 through December 31, 1998 inclusive, or filed with the Registrant's Reports on Form 10-Q for the periods ended March 31, 1999, June 30, 1999 and September 30, 1999 are incorporated by reference in this Report on Form 10-K. See Commission file number 1-6686. Listed below are agreements or amendments to agreements between the Registrant and its executive officers which remain in effect on and after the date hereof or were executed during the year ended December 31, 1999 and thereafter, unless previously submitted, which are filed as exhibits to this Report on Form 10-K. (i) Sean F. Orr ----------- (a) Employment Agreement dated as of April 27, 1999 between Interpublic and Sean F. Orr. (b) Executive Special Benefit Agreement dated as of May 1, 1999 between Interpublic and Sean F. Orr. (c) Executive Severance Agreement dated as of April 27, 1999 between Interpublic and Sean F. Orr. (ii) Eugene P. Beard --------------- (a) Executive Special Benefit Agreement dated as of March 13, 2000 between Interpublic and Eugene P. Beard. (b) Letter Agreement dated as of January 17, 2000 between Interpublic and Eugene P. Beard. (iii) Martin F. Puris --------------- (a) Termination Letter dated as of November 1, 1999 between Interpublic and Martin F. Puris. (c) Executive Compensation Plans. (i) Trust Agreement, dated as of June 1, 1990 between Interpublic, Lintas Campbell-Ewald Company, McCann-Erickson USA, Inc., McCann-Erickson Marketing, Inc., Lintas, Inc. and Chemical Bank, as Trustee, is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. (ii) The Stock Option Plan (1988) and the Achievement Stock Award Plan of the Registrant are incorporated by reference to Appendices C and D of the Prospectus dated May 4, 1989 forming part of its Registration Statement on Form S-8 (No. 33-28143). (iii) The Management Incentive Compensation Plan of the Registrant is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1995. See Commission file number 1-6686. (iv) The 1986 Stock Incentive Plan of the Registrant is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. See Commission file number 1-6686. (v) The 1986 United Kingdom Stock Option Plan of the Registrant is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (vi) The Employee Stock Purchase Plan (1985) of the Registrant, as amended, is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. See Commission file number 1-6686. (vii) The Long-Term Performance Incentive Plan of the Registrant is incorporated by reference to Appendix A of the Prospectus dated December 12, 1988 forming part of its Registration Statement on Form S-8 (No. 33-25555). (viii) Resolution of the Board of Directors adopted on February 16, 1993, amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ix) Resolution of the Board of Directors adopted on May 16, 1989 amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Report on Form 10-K for the year ended December 31, 1989. See Commission file number 1-6686. (x) The 1996 Stock Incentive Plan of the Registrant is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1996. See Commission file number 1-6686. (xi) The 1997 Performance Incentive Plan of the Registrant is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1997. See Commission file number 1-6686. (d) Loan Agreements. (i) Amendment dated August 31, 1999 to the Credit Agreement dated as of June 25, 1996 between Interpublic and The Chase Manhattan Bank (formerly known as Chemical Bank). (ii) Other Loan and Guaranty Agreements filed with the Registrant's Annual Report on Form 10-K for the years ended December 31, 1988 and December 31, 1986 are incorporated by reference in this Report on Form 10-K. Other Credit Agreements, amendments to various Credit Agreements, Supplemental Agreements, Termination Agreements, Loan Agreements, Note Purchase Agreements, Guarantees and Intercreditor Agreements filed with the Registrant's Report on Form 10-K for the years ended December 31, 1989 through December 31, 1998, inclusive and filed with Registrant's Reports on Form 10-Q for the periods ended March 31, 1999, June 30, 1999 and September 30, 1999 are incorporated by reference into this Report on Form 10-K. See Commission file number 1-6686. (e) Leases. Material leases of premises are incorporated by reference to the Registrant's Annual Report on Form 10-K for the years ended December 31, 1980 and December 31, 1988. See Commission file number 1-6686. (f) Acquisition Agreement for Purchase of Real Estate. Acquisition Agreement (in German) between Treuhandelsgesellschaft Aktiengesellschaft & Co. Grundbesitz OHG and McCann-Erickson Deutschland GmbH & Co. Management Property KG ("McCann-Erickson Deutschland") and the English translation of the Acquisition Agreement are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (g) Mortgage Agreements and Encumbrances. (i) Summaries in German and English of Mortgage Agreements between McCann-Erickson Deutschland and Frankfurter Hypothekenbank Aktiengesellschaft ("Frankfurter Hypothekenbank"), Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Frankfurter Hypothekenbank, Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Hypothekenbank are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. See Commission file number 1-6686. Summaries in German and English of Mortgage Agreement, between McCann-Erickson Deutschland and Frankfurter Sparkasse and Mortgage Agreement, dated January 7, 1993, between McCann-Erickson Deutschland and Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ii) Summaries in German and English of Documents creating Encumbrances in favor of Frankfurter Hypothekenbank and Frankfurter Sparkasse in connection with the aforementioned Mortgage Agreements, Encumbrance, dated January 15, 1993, in favor of Frankfurter Hypothekenbank, and Encumbrance, dated January 15, 1993, in favor of Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (iii) Loan Agreement (in English and German), dated January 29, 1993 between Lintas Deutschland GmbH and McCann-Erickson Deutschland is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. 11 Computation of Earnings Per Share. 13 This Exhibit includes: (a) those portions of the Annual Report to Stockholders for the year ended December 31, 1999 which are included therein under the following headings: Financial Highlights; Vice-Chairman's Report of Management; Management's Discussion and Analysis of Financial Condition and Results of Operations; Consolidated Balance Sheet; Consolidated Statement of Income; Consolidated Statement of Cash Flows; Consolidated Statement of Stockholders' Equity and Comprehensive Income; Notes to Consolidated Financial Statements (the aforementioned Consolidated Financial Statements together with the Notes to Consolidated Financial Statements hereinafter shall be referred to as the "Consolidated Financial Statements"); Report of Independent Accountants; Selected Financial Data for Five Years; Results by Quarter (Unaudited); and Stockholders Information. 21 Subsidiaries of the Registrant. 23 Consent of Independent Accountants: PricewaterhouseCoopers LLP Consent of Independent Auditors: Ernst & Young Consent of Independent Auditors: Ernst & Young LLP 24 Power of Attorney to sign Form 10-K and resolution of Board of Directors re Power of Attorney. 27 Financial Data Schedules. 99 The Company filed the following reports on Form 8-K during the quarter ended December 31, 1999: (i) Agreement and Plan of Merger, dated as of December 20, 1999, between The Interpublic Group of Companies, Inc. and NFO Worldwide, Inc., is incorporated by reference to Exhibit 2.1 of the Registrant's Form 8-K dated December 20, 1999. (ii) Stock Option Agreement, dated as of December 20, 1999, between The Interpublic Group of Companies, Inc. and NFO Worldwide, Inc., is incorporated by reference to Exhibit 2.2 of the Registrant's Form 8-K dated December 20, 1999. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. THE INTERPUBLIC GROUP OF COMPANIES, INC. (Registrant) March 21,2000 BY: Philip H. Geier, Jr. -------------------- Philip H. Geier, Jr. Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Name Title Date ---- ----- ---- /s/ Philip H. Geier, Jr. Chairman of the Board, March 21, 2000 - ------------------------ President and Chief Executive Philip H. Geier, Jr. Officer (Principal Executive Officer) /s/ Sean F. Orr Executive Vice President March 21, 2000 - ------------------------ Chief Financial Officer Sean F. Orr (Principal Financial Officer) and Director /s/ Frank J. Borelli Director March 21, 2000 - ------------------------ Frank J. Borelli /s/ Reginald K. Brack Director March 21, 2000 - ------------------------ Reginald K. Brack /s/ Jill M. Considine Director March 21, 2000 - ------------------------ Jill M. Considine /s/ John J. Dooner, Jr. Director March 21, 2000 ------------------------ John J. Dooner, Jr. /s/ Frank B. Lowe Director March 21, 2000 - ------------------------- Frank B. Lowe /s/ Michael A. Miles Director March 21, 2000 - ------------------------- Michael A. Miles /s/ Frederick Molz Vice President and March 21, 2000 - ------------------------- Controller (Principal Frederick Molz Accounting Officer) /s/ Leif H. Olsen Director March 21, 2000 - ------------------------- Leif H. Olsen /s/ Allen Questrom Director March 21, 2000 - ------------------------- Allen Questrom /s/ J. Phillip Samper Director March 21, 2000 - ------------------------- J. Phillip Samper By: /s/ Nicholas J. Camera ---------------------- Nicholas J. Camera The Financial Statements appearing under the headings: Financial Highlights, Vice-Chairman's Report of Management; Management's Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements, Notes to Consolidated Financial Statements, Report of Independent Accountants, Selected Financial Data for Five Years and Results by Quarter (Unaudited), accompanying the Annual Report to Stockholders for the year ended December 31, 1999, together with the report thereon of PricewaterhouseCoopers LLP dated February 22, 2000 are incorporated by reference in this report on Form 10-K. With the exception of the aforementioned information and the information incorporated in Items 5, 6 and 7, no other data appearing in the Annual Report to Stockholders for the year ended December 31, 1999 is deemed to be filed as part of this report on Form 10-K. The following financial statement schedule should be read in conjunction with the financial statements in such Annual Report to Stockholders for the year ended December 31, 1999. Financial statement schedules not included in this report on Form 10-K have been omitted because they are not applicable or the required information is shown in the financial statements or the notes thereto. Separate financial statements for the companies which are 50% or less owned and accounted for by the equity method have been omitted because, considered in the aggregate as a single subsidiary, they do not constitute a significant subsidiary. INDEX TO FINANCIAL STATEMENT SCHEDULE Page Report of Independent Accountants on Financial Statement Schedule Financial Statement Schedule Required to be filed by Item 8 of this form: VIII Valuation and Qualifying Accounts REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors and Stockholders of The Interpublic Group of Companies, Inc. Our audits of the consolidated financial statements referred to in our report dated February 22, 2000 appearing in the 1999 Annual Report to Stockholders of The Interpublic Group of Companies, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule listed in Item 14 (a)(2) of this Form 10-K. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PricewaterhouseCoopers LLP New York, New York February 22, 2000 SCHEDULE VIII THE INTERPUBLIC GROUP OF COMPANIES, INC. AND ITS SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1999, 1998 and 1997 ================================================================================ (Dollars in thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F - -------------------------------------------------------------------------------- Additions --------- Charged Balance at Charged to to Other Balance Beginning Costs & Accounts- Deductions- at End Description of Period Expenses Describe Describe of Period - -------------------------------------------------------------------------------- Allowance for Doubtful Accounts - deducted from Receivables in the Consolidated Balance Sheet: 1999 $53,093 $21,271 $5,148(5) $(22,780)(3) $57,841 2,934(1) (1,215)(2) (610)(4) 1998 $44,110 $18,362 $6,471(1) $(15,247)(3) $53,093 2,111(5) (3,310)(4) 596(2) 1997 $37,049 $16,753 $2,256(1) $ (2,553)(2) $44,110 848(5) (7,869)(3) (2,374)(4) - ---------------------- [FN] (1) Allowance for doubtful accounts of acquired and newly consolidated companies. (2) Foreign currency translation adjustment. (3) Principally amounts written off. (4) Reversal of previously recorded allowances on accounts receivable. (5) Miscellaneous. INDEX TO DOCUMENTS Exhibit No. Description - ------------ ----------- 3 (i) The Restated Certificate of Incorporation of the Registrant, as amended is incorporated by reference to its Report on Form 10-Q for the quarter ended June 30, 1999. See Commission file number 1-6686. (ii) The By-Laws of the Registrant, amended as of February 19, 1991, are incorporated by reference to its Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. 4 Instruments Defining the Rights of Security Holders. (i) Indenture, dated as of September 16, 1997 between Interpublic and The Bank of New York is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended September 30, 1998. See Commission file number 1-6686. (ii) The Preferred Share Purchase Rights Plan as adopted on July 18, 1989 is incorporated by reference to Registrant's Registration Statement on Form 8-A dated August 1, 1989 (No. 00017904) and, as amended, by reference to Registrant's Registration Statement on Form 8 dated October 3, 1989 (No. 00106686). 10 Material Contracts. (a) Purchase Agreement, dated September 10, 1997, among The Interpublic Group of Companies, Inc. ("Interpublic"), Morgan Stanley & Co., Incorporated, Goldman Sachs and Co. and SBC Warburg Dillon Read Inc. is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended September 30, 1999. See Commission file number 1-6686. (b) Employment, Consultancy and other Compensatory Arrangements with Management. Employment and Consultancy Agreements and any amendments or supplements thereto and other compensatory arrangements filed with the Registrant's Reports on Form 10-K for the years ended December 31, 1980 through December 31, 1998 inclusive, or filed with the Registrant's Reports on Form 10-Q for the periods ended March 31, 1999, June 30, 1999 and September 30, 1999 are incorporated by reference in this Report on Form 10-K. See Commission file number 1-6686. Listed below are agreements or amendments to agreements between the Registrant and its executive officers which remain in effect on and after the date hereof or were executed during the year ended December 31, 1999 and thereafter, unless previously submitted, which are filed as exhibits to this Report on Form 10-K. (i) Sean F. Orr ----------- (a) Employment Agreement dated as of April 27, 1999 between Interpublic and Sean F. Orr. (b) Executive Special Benefit Agreement dated as of May 1, 1999 between Interpublic and Sean F. Orr. (c) Executive Severance Agreement dated as of April 27, 1999 between Interpublic and Sean F. Orr. (ii) Eugene P. Beard --------------- (a) Executive Special Benefit Agreement dated as of March 13, 2000 between Interpublic and Eugene P. Beard. (b) Letter Agreement dated as of January 17, 2000 between Interpublic and Eugene P. Beard. (iii) Martin F. Puris --------------- (a) Termination Letter dated as of November 1, 1999 between Interpublic and Martin F. Puris. (c) Executive Compensation Plans. (i) Trust Agreement, dated as of June 1, 1990 between Interpublic, Lintas Campbell-Ewald Company, McCann-Erickson USA, Inc., McCann-Erickson Marketing, Inc., Lintas, Inc. and Chemical Bank, as Trustee, is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. (ii) The Stock Option Plan (1988) and the Achievement Stock Award Plan of the Registrant are incorporated by reference to Appendices C and D of the Prospectus dated May 4, 1989 forming part of its Registration Statement on Form S-8 (No. 33-28143). (iii) The Management Incentive Compensation Plan of the Registrant is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1995. See Commission file number 1-6686. (iv) The 1986 Stock Incentive Plan of the Registrant is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. See Commission file number 1-6686. (v) The 1986 United Kingdom Stock Option Plan of the Registrant is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (vi) The Employee Stock Purchase Plan (1985) of the Registrant, as amended, is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. See Commission file number 1-6686. (vii) The Long-Term Performance Incentive Plan of the Registrant is incorporated by reference to Appendix A of the Prospectus dated December 12, 1988 forming part of its Registration Statement on Form S-8 (No. 33-25555). (viii) Resolution of the Board of Directors adopted on February 16, 1993, amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ix) Resolution of the Board of Directors adopted on May 16, 1989 amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Report on Form 10-K for the year ended December 31, 1989. See Commission file number 1-6686. (x) The 1996 Stock Incentive Plan of the Registrant is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1996. See Commission file number 1-6686. (xi) The 1997 Performance Incentive Plan of the Registrant is incorporated by reference to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1997. See Commission file number 1-6686. (d) Loan Agreements. (i) Amendment dated August 31, 1999 to the Credit Agreement dated as of June 25, 1996 between Interpublic and The Chase Manhattan Bank (formerly known as Chemical Bank). (ii) Other Loan and Guaranty Agreements filed with the Registrant's Annual Report on Form 10-K for the years ended December 31, 1988 and December 31, 1986 are incorporated by reference in this Report on Form 10-K. Other Credit Agreements, amendments to various Credit Agreements, Supplemental Agreements, Termination Agreements, Loan Agreements, Note Purchase Agreements, Guarantees and Intercreditor Agreements filed with the Registrant's Report on Form 10-K for the years ended December 31, 1989 through December 31, 1998, inclusive and filed with Registrant's Reports on Form 10-Q for the periods ended March 31, 1999, June 30, 1999 and September 30, 1999 are incorporated by reference into this Report on Form 10-K. See Commission file number 1-6686. (e) Leases. Material leases of premises are incorporated by reference to the Registrant's Annual Report on Form 10-K for the years ended December 31, 1980 and December 31, 1988. See Commission file number 1-6686. (f) Acquisition Agreement for Purchase of Real Estate. Acquisition Agreement (in German) between Treuhandelsgesellschaft Aktiengesellschaft & Co. Grundbesitz OHG and McCann-Erickson Deutschland GmbH & Co. Management Property KG ("McCann-Erickson Deutschland") and the English translation of the Acquisition Agreement are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (g) Mortgage Agreements and Encumbrances. (i) Summaries in German and English of Mortgage Agreements between McCann-Erickson Deutschland and Frankfurter Hypothekenbank Aktiengesellschaft ("Frankfurter Hypothekenbank"), Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Frankfurter Hypothekenbank, Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Hypothekenbank are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. See Commission file number 1-6686. Summaries in German and English of Mortgage Agreement, between McCann-Erickson Deutschland and Frankfurter Sparkasse and Mortgage Agreement, dated January 7, 1993, between McCann-Erickson Deutschland and Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ii) Summaries in German and English of Documents creating Encumbrances in favor of Frankfurter Hypothekenbank and Frankfurter Sparkasse in connection with the aforementioned Mortgage Agreements, Encumbrance, dated January 15, 1993, in favor of Frankfurter Hypothekenbank, and Encumbrance, dated January 15, 1993, in favor of Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (iii) Loan Agreement (in English and German), dated January 29, 1993 between Lintas Deutschland GmbH and McCann-Erickson Deutschland is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. 11 Computation of Earnings Per Share. 13 This Exhibit includes: (a) those portions of the Annual Report to Stockholders for the year ended December 31, 1999 which are included therein under the following headings: Financial Highlights; Vice-Chairman's Report of Management; Management's Discussion and Analysis of Financial Condition and Results of Operations; Consolidated Balance Sheet; Consolidated Statement of Income; Consolidated Statement of Cash Flows; Consolidated Statement of Stockholders' Equity and Comprehensive Income; Notes to Consolidated Financial Statements (the aforementioned Consolidated Financial Statements together with the Notes to Consolidated Financial Statements hereinafter shall be referred to as the "Consolidated Financial Statements"); Report of Independent Accountants; Selected Financial Data for Five Years; Results by Quarter (Unaudited); and Stockholders Information. 21 Subsidiaries of the Registrant. 23 Consent of Independent Accountants: PricewaterhouseCoopers LLP Consent of Independent Auditors: Ernst & Young Consent of Independent Auditors: Ernst & Young LLP 24 Power of Attorney to sign Form 10-K and resolution of Board of Directors re Power of Attorney. 27 Financial Data Schedules. 99 The Company filed the following reports on Form 8-K during the quarter ended December 31, 1999: (i) Agreement and Plan of Merger, dated as of December 20, 1999, between The Interpublic Group of Companies, Inc. and NFO Worldwide, Inc., is incorporated by reference to Exhibit 2.1 of the Registrant's Form 8-K dated December 20, 1999. (ii) Stock Option Agreement, dated as of December 20, 1999, between The Interpublic Group of Companies, Inc. and NFO Worldwide, Inc., is incorporated by reference to Exhibit 2.2 of the Registrant's Form 8-K dated December 20, 1999.

1065869_1999.txt

1065869_1999

1999

1065869

Item 1 - Business All statements contained herein that are not statements of historical fact constitute "Forward-Looking Statements" within the meaning of Section 21E of the Securities Exchange Act. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that could cause the actual results of the Company to be materially different from historical results or from any future results expressed or implied by such forward-looking statements. Readers are urged to consider statements that include the terms "believe", "belief", "expects", "plans", "anticipates", "intends" or the like to be uncertain and forward-looking. Forward-looking statements also include projections of financial performance, statements regarding management's plans and objectives and statements concerning any assumptions relating to the foregoing. We are a leading provider of broadband local access communication services to businesses and consumers. Our services include high-speed, "always on" connections to the Internet and to private networks. We also offer a growing suite of network features and applications including Internet services that bring added value to our service offerings. We use multiple Digital Subscriber Line (DSL) technologies to provide data transfer rates ranging from 128 kbps to 7.1 Mbps delivering data to the user and from 128 kbps to 1.5 Mbps receiving data from the user. Accordingly, we believe that our peak network transfer rates to and from the user are higher than those of other national DSL service providers. For customers that subscribe at the 7.1 Mbps rate, our network provides data speeds to the user up to 125 times the speed of the fastest dial- up modem and over 55 times the speed of integrated services digital network (ISDN) lines. We believe that our Internet Protocol (IP)-over-DSL network capability is unique compared to other national DSL service providers because it allows us to provide a broader range of IP internetworking capabilities in a simpler, more cost-effective way than those offered by traditional networking alternatives. Our customers include Internet service providers (ISPs), telecommunications carriers and broadband communication services resellers, which we refer to as broadband service providers. We also sell to businesses or enterprises that are not otherwise served by our broadband service provider customers. Internet service providers and broadband communication services resellers typically purchase our services in order to provide high-speed Internet access to their business and consumer end users. Telecommunications carriers typically purchase our services for resale to their Internet service provider affiliates and business customers. Enterprise customers typically purchase our services indirectly from our telecommunications carriers or directly from us to provide employees, branch offices and other affiliates with high-speed remote access to the enterprise's local and wide area networks. We believe we have one of the nation's largest DSL networks with over 1,200 built or operational collocation sites in incumbent carrier central offices providing access to approximately 30 million homes and businesses as of December 31, 1999. As of December 31, 1999, we had approximately 12,500 DSL lines in service and were providing service to approximately 1,500 broadband service providers and businesses. Our broadband service provider customers include MCI WorldCom, AT&T, Qwest, Level 3 Communications, Williams Communications, Intermedia Communications, UUNET, Microsoft Network, Flashcom, PSINet, SAVVIS Communications, CAIS Internet, Telocity, Phoenix Networks, Digital Island/Sandpiper Networks and iPhysicianNet. Our enterprise customers include Cisco, Ford Motor Company and SGI, among others. We believe our higher data transfer rates, combined with our network features and applications, allow us to record the highest average revenue per installed line per month among national DSL service providers. From our inception in February 1997 through September 30, 1999 our average revenue per installed line was approximately $131 per month. As of December 31, 1999, we offered our services in 38 markets and 67 of the largest metropolitan statistical areas (MSAs) in the United States, of which there are 314 total. We expect to complete the initial build-out of our network by the end of 2000. At that time we anticipate that our services will be offered in 70 markets and 108 MSAs, and our network will pass a total of 51 million homes and businesses, representing approximately 45% of U.S. homes and 50% of U.S. businesses. In addition to our high speed access services, we plan to offer an increasing variety of network features and applications such as voice-over-DSL. We believe these new services are important to increase our revenue. First, these services expand the size of our addressable market by enhancing and enabling new broadband services, such as video streaming, that cannot be practically achieved with narrowband communications connections. Second, certain of these services require higher speed connections that may result in higher average revenue per installed line per month for us. Third, some of these services may contain additional network features and applications that may provide us with additional recurring monthly revenue from our communication services resellers and business customers. To further our goal of offering network features and applications, we expect to continue to enter into business arrangements and trials with broadband service providers, such as our arrangements with Digital Island/Sandpiper Networks, as well as telecommunications carriers, such as our arrangements with MCI WorldCom and Level 3 Communications, and leading networking equipment providers such as our arrangements with Cisco. We intend to continue to explore expansion of our DSL network both in the United States and internationally. In October 1999 we invested $5.3 million in OCI Communications Inc., the parent company of Optel Communications Corporation, a competitive local exchange carrier in Canada. This investment was made in connection with our establishing a joint venture company, Rhythms Canada, with Optel in January 2000. Rhythms Canada is expected to develop a Canadian DSL network and offer dedicated high-speed DSL services to enterprise customers and telecommunications carriers throughout Canada. Market Opportunity Growing demand for broadband local access communications services Demand for broadband local access communication services is growing at a rapid rate as the use of the Internet, intranets and extranets increases. Industry experts believe that by 2003, 55% of all enterprises in the United States and 71% of all home-based businesses in the United States will be on- line. To remain competitive, small and medium-sized businesses increasingly need high-speed Internet connections to maintain complex web sites, access critical business information, communicate more effectively with employees, customers and business partners, and participate in the rapidly growing e-commerce market. According to industry analysts, Internet commerce revenue in the United States will reach $556 billion by 2002. Today, business spending for connecting remote workers, branch or affiliate offices and corporate headquarters to each other and to customers, suppliers and partners either through the Internet or private networks is large and growing. Much of that growth will be driven by enterprises seeking to find a cost effective way to make their remote workers, offices and affiliates as productive as those who have access to all of the high performance communications and networking resources available to workers located at the corporate headquarters. Today, a record number of households use the Internet for e-mail, information, entertainment and shopping. Increasingly, consumers are demanding high-speed remote access connections. According to industry analysts, the number of U.S. residential subscribers to high-speed Internet access services should grow to 3.3 million by the end of 2000, and 16.6 million by 2004, up from 1.4 million at the end of 1999. Rapid adoption of new applications and services that are enhanced or enabled by broadband access is expected to further fuel the growth in broadband local access communication services. Collaboration services, such as video conferencing, are expected to grow rapidly, as are video and audio streaming services. Industry experts project that revenues from video services will increase from $469 million in 1998 to approximately $1.6 billion in 2002. Broadcast programming and on-line shopping are expected to grow dramatically in the consumer market. The trend toward convergence of voice, data and video services over a single, broadband, multimedia Internet Protocol network should further fuel the demand for broadband local access communication services. Historically, telecommunications service providers offered multiple, single purpose networks to deliver a range of voice and data services. Increasingly, small businesses and consumers will be able to purchase a full range of local and long distance voice services and features, Internet access services and video services over a single, cost-effective, high-speed DSL connection. Communications industry researchers project that by 2005, almost 25 million lines of voice-over-DSL will be deployed worldwide - with about one third of these lines being deployed in North America. DSL is a cost-effective technology for broadband local access communication services We believe that traditional network alternatives are inadequate and costly as compared to DSL. Only a fraction of buildings in the United States are currently connected to high-speed fiber networks - typically large buildings in metropolitan areas, or clusters of buildings in regional campus parks. Consequently, the vast majority of connections to the Internet or private data networks are through slow, dial-up modems connected to the traditional circuit switched public telephone system. The data carrying capacity of the fastest commercially available dial-up modem is only 56 kbps, and the capacity of another alternative, ISDN, is only 128 kbps. DSL technology dramatically increases the data, voice and video carrying capacity of standard copper telephone lines. Our peak data transfer rates range as high as 7.1 Mbps which is up to 125 times the speed of the fastest dial-up modem and over 55 times the speed of ISDN lines. We anticipate that continued advances in semiconductor technology will continue to increase peak data transfer rates, and that equipment prices will decline as DSL technology continues to be broadly deployed. DSL services are generally favorably priced relative to other available alternatives, and can be less complex to order, install and maintain. Traditional T1 frame relay and private line services are considerably more costly than a DSL service, as are heavily used ISDN services that are priced based on usage. Consumer class DSL services generally are priced competitively with cable modem services. Because DSL technology uses existing copper telephone lines, a broad network deployment can be implemented rapidly and requires a lower initial fixed investment than some existing alternative technologies, such as fiber, cable modems, wireless data and satellite data communications systems. A significant portion of the cost of building a DSL network is directly related to the demand of paying subscribers, resulting in a success-based deployment of capital. Packet-based networks often are more efficient than traditional point-to-point networks, and allow end users to connect to any location that can be assigned an Internet Protocol address. Traditional point-to-point networks, including the traditional telephone networks and private line networks, are less efficient because they require a dedicated connection between two locations. Packet-based networks allow multiple users to share connections between locations. Favorable regulatory environment exists for new broadband local access communication providers The 1996 Telecommunications Act allows competitive carriers to leverage the existing incumbent carrier infrastructure, as opposed to building a competing infrastructure at significant cost. The 1996 Telecommunications Act was designed to create an incentive for incumbent local exchange carriers that were formerly part of the Bell system to cooperate with competitive carriers. These incumbent local exchange carriers cannot provide long distance service until regulators determine that the incumbent local exchange carrier has met a "checklist" test showing that it is meeting the Act's requirements in opening its network and markets to competition. The 1996 Telecommunications Act requires traditional telephone companies, among other things: . to allow competitive telecommunications companies to lease copper telephone wires on a line-by-line basis; . to provide central office space for the competitive telecommunications companies' DSL and other equipment used to connect to the leased copper telephone wires; . to lease access on their central office fiber backbone to link the competitive telecommunications companies' equipment; and . to allow competitive telecommunications companies to use their operational support systems to place orders and access their databases. The FCC, in interpreting the 1996 Telecommunications Act, has emphasized the need for competition-driven innovation in the deployment of advanced telecommunications services, such as DSL services. Our Competitive Strengths We offer an attractive value proposition compared to alternative local access communications services For end users that subscribe at the 7.1 Mbps rate, our network provides transfer speeds over 55 times the speed of ISDN lines at monthly rates similar to or lower than those for heavily used ISDN lines, and over four times the speed of T1 private lines and frame relay circuits at a substantially lower price. Because we use dedicated connections from each end user to the network of our broadband service providers and business customers, end users can receive dependable data transfer rates and reduce the risk of unauthorized access. Unlike dial-up modems and ISDN lines, the DSL solution is "always on," and provides 24 hour continuous connection. Users are not required to dial-up to connect to the Internet or their local area network for each use. In addition, our DSL network has been designed to allow us, for certain customers and services, to proactively and continuously monitor our network to the end user's DSL modem or router, eliminating the need for the end user to initiate a report of network malfunctions, as is the case with dial-up modems or ISDN lines. Our network has been designed to be flexible and easily upgradeable to support new network features and applications Our network has been designed from the outset to be flexible and upgradeable to support new network features and applications. Because our network utilizes multiple technology platforms, we can provide higher end user speeds than other national providers, a broad range of IP internetworking capabilities in addition to traditional virtual point-to-point connectivity and various types of network traffic, including data, voice and video. The quality and characteristics of each end user's copper telephone wire are different. Because we use a variety of technologies we are able to select a solution that provides the highest speed available for each end user. As a result, as of December 31, 1999, users on our network were capable of receiving average data transfer rates of nearly 1.9 Mbps. Our network supports traditional transmission protocols such as Asynchronous Transfer Mode and frame relay, as well as the rapidly growing IP transmission protocol. Our IP over DSL network capability allows us to provide a broad range of IP internetworking capabilities in a simpler, more cost-effective manner compared to traditional protocols. For example, our network can give each user simultaneous access to the Internet and private networks using a single connection, the ability to take advantage of distributed content caching services in an internetworked environment, and the ability to add other emerging IP services such as voice-over-IP using their existing connection. Our network has also been designed to support multiple types of network traffic, starting with data and expanding to voice applications, including a variety of voice-over-DSL technologies, and video applications, including conferencing and streaming. Our network can also be easily upgraded, as it has been designed to incorporate new applications and features, thereby avoiding costly and time consuming network upgrades. We have leveraged our early mover advantage to rapidly expand our dense, national network and grow our number of lines in service We were among the first to widely roll out national DSL services, offering commercial services in our first market in April 1998. This early start enabled us to rapidly expand our network to our targeted markets and develop early relationships with customers requiring a dense, national footprint. Because our initial network footprint in each market or MSA is extensive in coverage, we typically are able to make our services available to at least 70% of our customers' end user homes and businesses. We have been able to establish customer relationships with recognized leaders in the networking industry We currently have strategic and/or customer relationships with many of the major interexchange carriers and fiber backbone providers including MCI WorldCom, AT&T, Qwest, Level 3 Communications, and Williams Communications. We also have customer relationships with many of the leading national business and consumer ISPs, including UUNET, Microsoft Network, PSINet, SAVVIS, Flashcom, Telocity and Phoenix Networks. MCI WorldCom has designated us as their preferred provider in its alternative carrier access provisioning system for DSL services in certain circumstances. MCI WorldCom and Qwest together have committed to purchase an aggregate 200,000 lines over a seven year period subject to penalties for failure to reach target commitments. Under the terms of our strategic partnership with Cisco, Cisco has agreed to jointly market and sell our networking solutions to its customer base in conjunction with our telecommunications carrier customers and engage in joint development projects with us, including voice-over-DSL and video streaming applications. Our management team has extensive experience Our senior management team has extensive experience in developing next generation networking businesses, including: . Catherine Hapka, Chairman of the Board and Chief Executive Officer (former Executive Vice President, Markets at U S WEST Communications, Inc. and founder, President and Chief Operating Officer, !NTERPRISE Networking Services U S WEST's data networking business), . Steve Stringer, President and Chief Operating Officer (former Global Chief Operating Officer, GE Capital IT Solutions), . Scott Chandler, Chief Financial Officer (former President and CEO, C- COR.net), . Richard H. Johnston, Chief Sales Officer (former Executive Vice President of Sales, GE Capital IT Solutions), . Rand Kennedy, Senior Vice President Networks (former Principal Network Architect, CompuServe Incorporated), . B.P. Rick Adams Jr., Chief Marketing Officer (former Group Vice President, Marketing, MicroAge, Inc.) and . Michael S. Lanier, Chief Information Officer (former President of Technology Extension Corporation, L.L.C.) Our Business Strategy Our goal is to become the leading national service provider of high performance networking solutions for broadband service providers and businesses. We intend to implement the following strategies to achieve our goal: Complete our dense, national network build-out in our target markets and MSAs As of December 31, 1999, we offered service in 38 markets and 67 of the largest MSAs in the United States. When our initial network build-out is completed, which we expect to be by the end of 2000, our services will be offered in 70 markets and 108 MSAs, and our network will pass a total of 51 million homes and businesses, representing approximately 45% of homes and 50% of businesses in the United States. Network installation on this scale requires significant time and resources. Therefore, we believe our progress to date provides us a significant time-to- market advantage over our present and future competitors. We have gained significant build-out experience, which we believe will streamline our further expansion both in the United States and select international markets. In addition to our planned footprint covering 108 of the largest MSAs, our initial footprint in each market is dense, and covers a substantial majority of the central offices in each market that we enter. This is important, since our Internet service provider customers, telecommunications carrier and broadband communication services reseller customers desire to market their services broadly in each market. Enterprise customers also require a dense footprint in order to provide all employees remote access to the corporate network irrespective of where they reside. Typically, our initial footprint in each market serves a minimum of 70% of our target market. When sufficient demand materializes in those central offices that were not a part of our original plan, we intend to expand our build-out to include that central office. Maintain and build our sales and marketing relationships with leading broadband service provider customers We principally target Internet service providers, telecommunications carriers and other broadband communications services resellers that can offer their end user customers cost and performance advantages for Internet access or private networks using our services. Our objectives in using these channels of distribution is to increase our volume and reduce our costs by serving multiple resellers and leveraging their selling efforts. We currently serve the large business market through our relationships with MCI WorldCom, AT&T and Qwest. We have fielded a direct applications and technical support force to support our partners' solutions-based selling effort in these large enterprises. In addition, as part of our alliance with Cisco, Cisco has agreed to jointly market and sell our services to large businesses on our behalf and on behalf of our telecommunications carrier customers. We believe our investment in a direct applications and technical support force will lead to a higher success rate for our telecommunications carrier customers, and a preference for our services. We primarily serve the small and medium business market through a number of national and regional Internet service providers, including the affiliates of our major telecommunications carrier customers. Currently, we have distribution relationships with many of the major national Internet service providers including UUNET, AT&T Internet Services (AIS), Qwest Internet Services, PSINet, Intermedia Communications and SAVVIS Communications, and a growing number of regional Internet service providers. In the future, we intend to continue to build the number of relationships we have with these Internet service providers. We also market our broadband communications services to small and medium businesses through our telemarketing and telesales division in markets where we do not have Internet service providers reselling our services. In markets where we have such Internet service provider relationships, we use our telemarketing and telesales division to generate leads on behalf of our broadband service providers. We expect to continue to build relationships with the growing number of new broadband communication service resellers who wish to resell our services as part of their Internet-based or content services, such as our relationship with iPhysicianNet. In December 1999, we announced the availability of a consumer Internet access service. Our consumer service is offered through Internet service providers such as Flashcom, Telocity, DSLnetworks and Phoenix Networks. We plan to add additional Internet service provider relationships in the future. Expand the number of network features and applications we offer We seek to have our network support multiple features and applications that are enhanced and enabled by our broadband local access communications network. Our objective is to offer multiple features and applications to our customers that increase the value of our offering to their end users, thereby increasing the number of subscribers on our network and the revenue we receive for each network user. Network features and applications under development include voice- over-DSL and frame relay over DSL. In pursuing this objective, we intend to continue to collaborate with leading industry broadband application service providers such as Digital Island/Sandpiper Networks, as well as telecommunications carrier customers such as MCI WorldCom, and leading networking equipment and software providers such as Cisco and Microsoft to build our portfolio of network features and applications. For example, in June 1999, MCI WorldCom and we, in conjunction with Cisco and Jetstream Communications, successfully demonstrated multiple toll quality voice and high-speed data communications over a single copper line utilizing DSL technology. In addition, we are testing frame relay over DSL services with MCI WorldCom and Intermedia Communications, and we are currently participating in Microsoft's Windows Media Division's Broadband Jumpstart program to hold trials of streaming media video technology. Lead the industry in customer service and build a reputation for being a desirable business partner As part of our strategy to provide a high level of customer satisfaction to obtain and retain customers and accelerate the adoption of our services, we intend to continue to enhance our efforts to provide superior service and customer care. Accordingly, we have developed a systematic approach to fully integrate our operations with our broadband service provider customers' operations to support functions such as order qualification, order entry, customer service, installation, service assurance and billing. In addition, we have invested and will continue to invest significant resources in process improvement and fully automated customer support systems. Our Network Operations Center is available to support our customers 24 hours a day, seven days a week. For certain customers and services, we will guarantee high quality service by providing carrier-class networking solutions including end-to-end proactive network monitoring and management through our Network Operations Center, as well as a full range of service level agreements. In addition, our network offers multiple security features, and has been designed so that we can scale and expand our network to meet demand. Capitalize on new regulatory developments to advance our business The Federal Communications Commission (FCC) mandated "line sharing" in a November 1999 decision that became effective in mid 2000. Some details of implementation of this mandate may be reconsidered by the FCC. Line sharing requires existing incumbent local exchange carriers to permit competitive local exchange carriers to add data services existing copper telephone lines to provide services to the end-user. The Minnesota Public Utility Commission ordered line sharing as a matter of state law in December 1999. The California Public Utility Commission also ordered implementation of the FCC's order on line sharing and called for a shorter implementation time frame in February 2000. In February 2000, we successfully installed our first line sharing customer in Minnesota. Line sharing, where available, will allow us to provide our asymmetric DSL service on the same existing copper telephone lines as the existing incumbent local exchange carrier user to provide its voice service. Until the FCC's line sharing decision, we were required in every case to provision our asymmetric DSL services over a separate copper telephone wire from that used by the incumbent to provide its voice services to the same customer, which required the installation of an additional copper telephone wire to the customer's location. Most, if not all, of the traditional telephone companies provide their own asymmetric DSL services on the same line as existing voice services. We believe line sharing is an extremely important opportunity for us to enhance customer service and reduce cost. First, line sharing should significantly reduce the time it takes incumbent local exchange carriers to make their copper telephone wires available for our use. Second, line sharing should significantly reduce the one time installation cost in those cases where we do not need to send a technician to the customer site to install the service. Third, the monthly recurring charge we pay to the incumbent local exchange carrier for the use of the copper telephone wire should decline since the incumbent local exchange carrier does not incur a separate monthly charge for the use of the copper telephone line for its own DSL service. Evaluate and selectively pursue attractive international markets In the future, we intend to replicate our network build-out, customer acquisition and operational knowledge in selected, attractive international market. In January 2000, we created a 50% owned joint venture with Optel Communications Corporation, known as Rhythms Canada. Rhythms Canada is expected to develop a Canadian DSL network and offer dedicated high-speed DSL services to enterprise customers and telecommunications carriers throughout Canada. We will continue to evaluate the merits of entering other international markets, as well as the best way for us to enter into optimal business entry structure for each market. Strategic Partnerships MCI WorldCom In March 1999, we started a strategic partnership with MCI WorldCom in which MCI WorldCom invested $30.0 million in us. . Providing DSL services to MCI WorldCom. We have been designated MCI WorldCom's first choice in its alternative carrier access provisioning system for DSL services in areas where we deploy our network for all new DSL services, except for services to certain subsidiaries and in locations where MCI WorldCom deploys its own DSL equipment. In addition, MCI WorldCom has committed to sell a minimum of 100,000 business quality DSL lines, subject to penalties for failure to reach target commitments. MCI WorldCom will have 60 months to place orders for these lines, starting on the date when we have 1,250 collocations in commercial service in at least 29 metropolitan statistical areas. As part of our agreement, we must provide specified service levels and have available capacity. . Obtaining network services from MCI WorldCom. We have designated MCI WorldCom as our preferred provider of network services, including metropolitan area network services and long-haul backbone services. MCI WorldCom has a right of first refusal to provide all of these services to us at market competitive terms. . Collaboration. We are jointly developing voice and data applications over a single DSL connection. For instance, in June 1999, MCI WorldCom and we, in conjunction with Cisco and Jetstream Communications, successfully demonstrated toll quality voice and high-speed data communications over a single copper line utilizing DSL technology. We have also formed a working group with MCI WorldCom to develop and implement the systems and procedures necessary to jointly deploy DSL service nationwide. We will collaborate with MCI WorldCom in selecting technologies and vendors to support our network deployments. Microsoft In March 1999, we entered into a strategic partnership with Microsoft, in which Microsoft invested $30.0 million in us. We are working with Microsoft to trial a multiple feature consumer offering in Boston including high-speed Internet access, Internet services, Microsoft Network connectivity and streaming media. In conjunction with this trial, we are currently participating in Microsoft's Windows Media Division's Broadband Jumpstart program to hold trials of streaming media video technology. Qwest In April 1999, we entered into a customer relationship with Qwest, in which Qwest invested $15.0 million in us. Pursuant to this relationship, among other things, Qwest has committed to purchase from us performance class DSL services for sale to its customers. In return, we have agreed to use Qwest's network and application hosting services in certain situations. The combined DSL line commitment from Qwest and MCI WorldCom totals 200,000 lines over several years. Cisco In October 1998, we entered into a strategic partnership with Cisco, in which Cisco agreed to work jointly with us to sell our services to its customers including providing compensation to its sales representatives for selling our services. In addition, Cisco has committed to a joint marketing program with us to increase our market recognition among businesses and consumers. We have also contracted with Cisco to manage and upgrade its remote access program for 8,500 teleworkers nationwide. Our Service Offerings We offer our customers solutions that address many of their broadband access networking needs. Our local connection services use a variety of DSL technologies to deliver high-speed, "always on" local access. We also aggregate traffic within metropolitan areas and route or switch the traffic to our broadband service provider customers, or to a corporate network within the same metropolitan area or another metropolitan area using our inter-network connections. In addition to local connections and metropolitan and wide area inter-network connections, we offer a growing suite of network features and applications that bring additional value-added services to our customers. Local connection services Our local connection services connect individual users or multiple users on a local area network through our metropolitan network to our national network, the Internet or a telecommunications carrier network using DSL technology over traditional telephone lines. Our network is capable of data transfer rates ranging from 128 kbps to 7.1 Mbps. Unlike dial-up modems and ISDN lines, our DSL solution is "always on"; it does not require users to dial-up to connect to the Internet or their local area network for each use. We place DSL equipment both at the customer premises a residence or business and in the central office that services that specific customer premises. There are typically many incumbent carrier central offices in each metropolitan area. We connect the DSL equipment in each central office to one of our Metro Service Centers so that we can route or switch network traffic to either a local destination, a national destination, or the Internet. For our local connection services, the speed and effectiveness of the DSL connection will vary based on a number of factors, including the distance of the end user from the central office and the condition of the copper telephone line that connects the end user to the central office. The specific number of potential users who will qualify for higher speeds will vary by central office and will be affected by line quality. In the future, we intend to examine adding additional high-speed local access technologies to our offering as they are developed, including emerging wireless technologies. The chart below compares the performance and range of our local connection services as of December 31, 1999. Speed to Speed From Range* Technology** End User End User (feet) ------------ -------- -------- ------ 144 kbps 144 kbps*** 50,000 IDSL**** 256 kbps 256 kbps 18,000 SDSL**** 384 kbps 384 kbps 15,000 RADSL 512 kbps 512 kbps 14,000 RADSL 768 kbps 768 kbps 12,000 RADSL 1 Mbps 1 Mbps 12,000 RADSL 1.5 Mbps 1.5 Mbps 8,000 SDSL**** 3 Mbps 1 Mbps 10,700 RADSL 5 Mbps 1 Mbps 9,000 RADSL 7.1 Mbps 1.1 Mbps 7,800 RADSL ___________ * Estimated maximum distance from the central office to the end user. ** The technologies listed below are more fully described in "DSL Technologies" below. *** May be 128 kbps under some circumstances. **** Cannot be used with line-sharing. We offer three classes of broadband local access communication services, all of which are available up to 50,000 feet from the central office which serves the end user: Select Links. Our Select Links offer is available in the following range of speeds: 128 kbps x 128 kbps, 256 kbps x 256 kbps, 384 kbps x 384 kbps, 512 kbps x 512 kbps, 768 kbps x 768 kbps, 1 Mbps x 1 Mbps and 1.5 Mbps x 1.5 Mbps. We plan to make this service available soon in a range of additional speeds, including 3 Mbps x 1 Mbps, 5 Mbps x 1 Mbps and 7.1 Mbps x 1.1 Mbps. Our Select Links services are sold through Internet service providers, telecommunications carrier customers and broadband communication services resellers, and are primarily used by small and medium businesses for high-speed Internet access. Basic installation for our Select Links offering includes our standard inside wiring service, installation and basic configuration of the fully featured DSL router and service activation. Installation charges consist of a one-time charge and may be discounted for large volume commitments, long term end user contracts, and promotions. Complete Links. Our Complete Links service offers a fully managed Internet Protocol (IP) over DSL service, which is available in all of our symmetric and asymmetric speeds. Our Complete Links services are sold though Internet service providers, broadband communications services resellers, and our internal sales and marketing division, called the Channel Development Organization, in those markets which are not otherwise served by our Internet service provider customers. Our Complete Links services are primarily used by small and medium businesses for high-speed Internet access, and enterprises for telework and branch office connectivity. We offer a premium installation for our Complete Links offering that includes our standard inside wiring service, installation and basic configuration of the fully featured DSL router or modem, end-to-end service activation and management, maintenance and support of the DSL router or modem. Installation charges consist of a one-time charge and may be discounted for large volume commitments and/or long term end user contracts and promotions. Consumer Links. Our Consumer Links services are available at the following speeds: 144 kbps x 144 kbps, 208 kbps x 208 kbps, 384 kbps x 272 kbps, 408 kbps x 384 kbps, 768 kbps x 408 kbps, 1. Mbps x 408 kbps, 3 Mbps x 1 Mbps and 7.1 Mbps x 1.1 Mbps. Our Consumer Links services are sold though Internet service providers and broadband communications services resellers, and are primarily used for Internet access. Basic installation for our Consumer Links offering includes our standard inside wiring service, installation and configuration of a basic DSL modem, and service activation. We also offer our premium installation option. Prices for our broadband local access services vary depending upon the performance level of the service. For example, a 144 kbps service is our lowest priced service and our 7.1 Mbps is our highest priced service. Metropolitan area and wide area inter-network connection services For our broadband service provider and business customers, we offer two high-speed connection services both within and among metropolitan areas. Metropolitan LAN. Our metropolitan area inter-network connection service allows us to aggregate traffic from each of the central offices within a metropolitan area to an Internet service provider, telecommunications services carrier, broadband communications services reseller or an enterprise customer site within that same metropolitan area. We offer our Metropolitan LAN services in two speeds. Our 1.544 Mbps service (DS-1) is suitable for small broadband service providers and business customers, and is available in both asynchronous transfer mode and Internet protocols. Our 45 Mbps service (DS-3) is intended for large broadband service providers, and business customers, and is available in two protocols-asynchronous transfer mode and Internet protocol. In addition to monthly service charges, we impose nonrecurring order setup charges for inter- network connection services. U.S. LAN. Our wide area inter-network connection service currently operates between each of the metropolitan areas in which we provide service, and allows our Internet service provider customers the ability to quickly and cost- effectively offer services in new markets, and our enterprise customers the ability to connect affiliate offices and teleworkers nationwide. Our monthly service charge varies depending on the number of local access connections and the data transfer rate required by the customer. Network features and applications We intend to continue to add further network features and applications to add additional value to our offering. We believe our strategy to provide additional network features and applications will increase our revenue by expanding the size of our addressable market, increasing the speeds required by our customers and allowing us to receive additional recurring monthly revenue from certain of our customers. The features and applications that our network currently offers or enables are listed below: . Internet Services. We bundle high-speed DSL-based local access with Internet access services for small and medium business customers in markets that are not otherwise served by our broadband service provider customers. Our basic Internet services include Internet access using our Complete Links services, e-mail accounts and IP addresses. Optional features include domain name transfer and registration, Web hosting services, collocation services and virtual private network over DSL capability. These services are provided in cooperation with Epoch Internet. . Service Selection. We have implemented a service selection feature within our network that enables end users to access multiple destinations, including the corporate local area network, the corporate telephone system, the Internet, customers, suppliers and partners, using the same DSL access line. This feature alleviates the corporate network from servicing Internet traffic to a teleworker. . Dynamic Host Configuration Protocol Functionality. This feature relieves network administrators from the burden of notifying each teleworker of network configuration changes. The use of this protocol ensures that once teleworkers start up their computers, the customer's server automatically downloads all of his or her network configuration parameters. . Collocation Services. We have announced plans to offer certain broadband application service providers the ability to collocate their equipment in our network. Collocation allows these providers to take advantage of our distributed, fully routed IP network by placing their caching and hosting equipment in our markets in order to seamlessly and cost-effectively extend their network optimization services to their customers' end users using our broadband communications access services. . Virtual Private Network (VPN) over DSL. This service uses the public Internet backbone or our private data networks in conjunction with our high-speed DSL access connections, to create a channel for sharing information and applications within a closed user group in different locations. Our private VPN service is available for remote or branch offices that require high-speed interoffice connectivity across multiple locations and for teleworkers and other remote users who want secure access to their corporate network and the Internet from home. . Voice over IP. Utilizing the IP over DSL capability of our network, we enable or support our customers' implementation of voice over DSL services through the addition of customer premises equipment and software. This feature allows our business customers to extend the functionality of the corporate telephone system directly into a teleworker's home. Benefits to our business customers include increased worker productivity, reduced second line expenses for voice service and the ability to aggregate and control long distance charges. . Streaming. Our network supports streaming media services. For certain customers and services, we provide guaranteed data transfer rates through service level agreements. For example, we are working with iBEAM Broadcasting Corporation to provide a business-class video streaming service. In addition, we are currently participating in Microsoft's Windows Media Division's Broadband Jumpstart program to hold trials of streaming media video technology for consumers. In the future, we plan to continue to expand our network features and applications by working closely with leading broadband applications service providers, networking equipment companies, and our telecommunications carrier customers. Future development efforts include frame relay-over-DSL. Our expected development of voice-over-DSL will allow our broadband service provider customers to provide a full range of local and long distance voice services in addition to high-speed Internet and private networking services to their end user customers over a single DSL connection. We are currently conducting trials for a voice-over-DSL service with MCI WorldCom and Intermedia. If we develop frame relay-over-DSL, it would allow our telecommunications carrier customers to replace expensive, low-speed, local access frame relay connections currently purchased from the incumbent local exchange carrier with affordable, high-speed DSL connections that utilize the frame relay protocol. We are currently conducting frame relay-over-DSL trials with MCI WorldCom and other telecommunications carriers. Customers, sales and marketing We offer our services to broadband service providers and businesses not otherwise served by our broadband service providers. As of December 31, 1999, we were providing services to approximately 1,500 broadband service providers and business customers, and had approximately 12,500 DSL lines in service. The following is a list of selected Internet service provider, telecommunications carrier and enterprise customers: Select Internet Service Provider Select Telecommunications Select Enterprise Customers Carriers Customers UUNET MCI WorldCom Cisco Microsoft Network AT&T Ford Motor Company PSINet Qwest QUALCOMM Digex Level 3 Communications SGI SAVVIS Williams Communications CAIS Internet Intermedia Communications Flashcom Telocity Phoenix Networks DSLnetworks Internet service providers Our business-focused Internet service provider customers resell our services, typically to small and medium businesses, and our consumer-focused Internet service providers, including Telocity, Flashcom and Microsoft Network, resell our services to consumers. We offer our business-focused Internet service providers our Select Links services or our Complete Links services, and our consumer-focused Internet service providers our Consumer Links services. We also offer our Internet service provider customers our metropolitan area and wide area inter-network connection services. Our Internet service provider customers can then combine our services with their own services to offer a total solution to their customers. Telecommunications carrier customers A key element of our strategy is to enter into relationships with leading telecommunications carriers, including interexchange carriers and competitive telecommunications carriers in order that they may resell our services to their customers. For example, we have entered into commercial agreements with each of MCI WorldCom, AT&T, Qwest, Level 3 Communications, Williams Communications and Intermedia providing for the resale of our services, primarily to their carrier, Internet service provider, broadband communication services resellers, enterprise and small business customers. In order to advance our telecommunications carrier customers' sales effort to enterprises, and develop preference for the Rhythms solution, we have fielded a carrier applications and technical support force to support our customers' solutions-based selling efforts. We reinforce our applications and technical support force through our alliance with Cisco. Cisco has agreed to assist us and certain of our telecommunications carrier customers in marketing and selling our broadband local access communications services. We supplement our carrier applications and technical support efforts by offering sales support services that may include training, joint proposal development, lead generation, joint participation in national and regional customer events and seminars, and press announcements. Additionally, we support our carrier customers' efforts through dedicated support teams and complete operations integration including qualifying potential end users for our service, ordering connections, installing equipment on the customer premises, turning up the service, monitoring the network and invoicing our carrier customer on a single bill. Broadband communications services resellers An emerging component of our strategy is to enter into relationships with broadband communications services resellers that include firms with existing Web-based customer relationships that wish to resell broadband applications and access services to their customers. It also includes a number of emerging integrators of broadband communications infrastructure and applications services to serve a specialized or vertical market need. For example, in January 2000 we entered into a relationship with iPhysicianNet to provide its physician customers with Web-based multimedia and fully IP internetworked broadband local access services. We believe that this channel will enable us to penetrate our target markets more rapidly. Channel development organization In markets where we do not have established indirect channels, we market our services directly to business customers through our Channel Development Organization. Our Channel Development Organization seeks to sell Internet access, telework and remote branch connectivity solutions to small and medium sized businesses, through direct marketing and consultative selling over the phone. As of December 31, 1999, we had roughly 150 persons dedicated to this effort. Our contracts are typically one to two years in length, and we receive an average revenue per line per month that is higher than what we receive through our broadband service provider channels. Once we have established indirect channels in a market, our Channel Development Organization will provide direct marketing, lead generation and telesales support services for our customers. Customer support We supplement certain of our Internet service providers' and broadband communication services resellers' sales efforts by offering sales tools and marketing programs that may include market development funds, promotions and incentives, launch programs, sales collateral, joint participation in national and regional customer events and training. Through our Channel Development Organization, we will also provide direct marketing, lead generation and telesales support services. We support our customers through sales and marketing personnel dedicated to each type of channel and to each of our largest broadband service provider customers. Additionally, we support our broadband service provider customers through complete operational integration including qualifying potential end users for service, ordering connections, installing equipment on the customer premises, turning up the service, monitoring the network and invoicing the customer on a single bill. Our agreements with our broadband service providers vary widely. Generally, our agreements have a one to three year term, and are based on negotiated prices that decline with increasing levels of volume achievement. Certain of our broadband service provider customers have committed to sell specified quantities of DSL lines, subject to penalties for failure to reach these target commitments. In many cases, our broadband service providers have selected one or two, and perhaps as many as three, DSL service providers as suppliers in each market. Our goal is to be selected as the preferred supplier or one of the preferred suppliers by broadband service providers in each metropolitan area where we operate. When we are selected as a preferred supplier within a given market, we may enter into nonstandard joint marketing arrangements to promote our DSL services. We may also offer additional price discounts in return for our selection as a preferred supplier with first right of refusal on orders. See "Risk Factors - We depend on third parties for the marketing and sales of our network services." Brand campaign In December 1999 we launched a two-phase national brand development campaign, including television, print, radio and online advertisements. The first phase consists of television and national print advertising, and is intended to build awareness for our brand and educate the market about our broadband service offering and differentiate our services. The second phase, which focuses on product messaging, will run in local newspapers and drive-time radio in 30 major metropolitan markets, and is designed to generate demand for our broadband services. Customer Service, Operations and Support Systems We offer our broadband service provider and business customers a one-stop broadband service solution including network implementation, customer service, technical support and ongoing network monitoring and billing. For major broadband service providers and businesses, we establish dedicated teams to work with the account to develop and implement a complete, fully automated operations integration plan in order to ensure that our service implementation, maintenance and billing proceeds smoothly. Network implementation Working with a broadband service provider or business customer we connect our customer's premises and their end users to our network by ordering telephone lines from the incumbent local exchange carrier or a competitive telecommunications company, connecting our customer's premises and end users to our network, testing the connections, configuring our customers' end users' endpoints, connecting to our customers' routers or switches and monitoring the connections from our Network Operations Center. We are implementing fully automated, Web-based, service qualification and order entry tools using standard industry interfaces. For large customers, we develop and implement a personalized, fully automated, private extranet site for service qualification and order entry. Orders can be placed individually, in real time through our Web site, or in bulk through our customers' private extranet sites. We are installing systems to ensure that our customers' orders automatically flow through to the incumbent local exchange carriers' order entry systems. In October 1999, we announced our selection of NightFire SupplierExpress from NightFire Software to automate our process for pre- ordering, ordering and provisioning unbundled local loops from the incumbent local exchange carrier. We outsource field service personnel and, to a more limited extent, use our own field service personnel to perform any necessary inside wiring, install and configure the endpoint and, if required, install a network interface card and configure the end user's PC or laptop. Currently, we offer two types of installation service. Our basic installation service includes a standard inside wiring service, endpoint installation and configuration, and line test. Our premium installation service also includes installing one network interface card in the end user's computer, configuring one computer and a complete end-to-end service test. Customer service, technical support, and network monitoring Our Network Operations Center in Denver provides network surveillance through standard Simple Network Management Protocol tools for all equipment in our network. Because we have complete end-to-end visibility of our network, we are able to proactively detect and correct the majority of our customers' maintenance problems remotely for certain customers and services. Our goal is to proactively detect and repair 90% of our customer's maintenance problems before our customers become aware of a problem. Customer-initiated maintenance and repair requests are managed and resolved primarily through our customer advocacy team in our Network Operations Center. We provide support to our customers 24 hours a day, seven days a week. Our broadband service provider and business customers typically serve as the initial contact for service and technical support while we provide the second level of support. We utilize a trouble ticket management system to communicate customer maintenance problems from the customer advocacy team to our Network Operations Center engineers and the field service engineers. Because our Network Operations Center is fully staffed 24 hours a day, seven days a week, we believe our ability to provide superior proactive maintenance is significantly enhanced. Billing Customer bills are currently issued on a monthly basis through an internal billing system. In the future, we expect our billing system to electronically interface with our customers and support a broad array of billing options. Our Customer Service Center manages customer billing inquiries. In the future, billing inquiries will also be supported through our Web-based interfaces. In November 1999 we announced our intention to utilize Portal Software's Infranet customer management and billing software. Operational Support Systems We are implementing what we believe to be industry leading operational support systems for DSL broadband access services. We are installing complete flow through order management and provisioning systems with system-to-system interfaces. These systems will allow us to scale our business rapidly because they will eliminate many manual processes such as order taking and verification, line ordering, receipt and testing, network path configuration, equipment configuration and billing. Our system architecture is designed to enable rapid order fulfillment and reduce the cost of customer support. We use a set of standard, off-the-shelf systems to support our business processes. All business functions, including sales, ordering, provisioning, maintenance and repair, billing, accounting and decision support use a single database management system from Oracle. Complete systems integration is accomplished through the use of Vitria middleware to ensure rapid scaling of all business functions and uninterrupted growth. Network Architecture The network design features that we believe are important to our customers are: Carrier-class network management Our network is designed to be carrier-class throughout. For example, it has been designed with redundant network electronics and transmission paths. We have the ability to electronically view our entire network including the DSL modem located at the end user's premise from our Network Operations Center in Denver. Because we proactively monitor and manage the network at all times for certain customers and services, we can identify and address network problems quickly. In addition, for those customers that choose our Internet Protocol-over-DSL capability, we are able to monitor and manage Internet Protocol applications all the way to the end user location. Scaleable network performance We anticipate significant volume on our network over time. Accordingly, we have designed our network for scalability and consistently high performance as network usage grows. Our local access network is designed so that each line in service is a dedicated connection, and as such, does not contend for bandwidth or capacity with other users as they are added to the network. Our metropolitan and wide area inter-networking services have been designed to support a wide array of service level agreements that guarantee specific levels of network performance to our broadband service provider and business customers. We believe that our network is unique in that we support Internet Protocol routing as well as Asynchronous Transfer Mode switching equipment in our network. IP networks allow our customers' end users to easily access thousands of Internet or private network destinations without the need to establish physical permanent virtual connections for each destination, creating a much less complex, cost-effective, easily scalable network for our customers and their end users. Our network support systems are also scaleable. We use industry standard, off-the-shelf software to support network provisioning, installation, testing, monitoring and trouble management. We have implemented and are continually enhancing these systems using Web-based, distributed client-server systems architecture. This approach will allow us to grow our customer support and network management capabilities as customer demand increases. Network security Non-dedicated access, such as dial-up modem or ISDN lines, or dedicated access to the public Internet, represents security risks for business networks. These security risks are mitigated through the use of virtual private network technologies such as authentication, tunneling, encryption and through the use of permanent virtual circuits that define a logical dedicated connection between the end user and the corporate network. Our network enables businesses to fully employ these virtual private network technologies by using their own equipment at the edges of our network, or optionally purchasing virtual private networking services from us. For our IP-over-DSL network implementation, we have added several layers of security for our customers including Multi-Protocol Label Switching (MPLS), policy routing, network segmentation by customer and the implementation of access control at the end user's DSL router. Multiple network features and applications capability Our network has been designed from the outset to be flexible and upgradeable to support new network features and applications. Because our network utilizes multiple technology platforms, we can provide higher end user speeds than other national providers, a broad range of IP internetworking capabilities in addition to traditional virtual point-to-point connectivity, and various types of network traffic starting with data, but expanding to voice and video as well. Our use of multiple technology platforms, also allows us to leverage the research and development capabilities of several different equipment manufacturers to provide a growing number of network features and applications in our offering. Because the quality and characteristics of each end user's telephone wire is different, we are able to select a technology solution that provides the highest speed available for each end user. As of December 31, 1999, users on our network were capable of receiving average data transfer rates of 1.9 Mbps. Our network supports traditional transmission protocols such as Asynchronous Transfer Mode and Frame Relay, as well as the rapidly growing IP transmission protocol. Our IP-over-DSL network capability allows us to provide a broad range of IP internetworking capabilities in a simpler, more cost-effective manner than by using more traditional protocols. For example, our network can give each user simultaneous access to the Internet and private networks using a single connection, the ability to take advantage of distributed content caching services in an internetworked environment and the ability to add other emerging IP services such as voice over IP using their existing connection. Our network has also been designed to support multiple types of network traffic, starting with data but expanding to voice applications, such as voice over DSL and video applications such as conferencing and streaming. Our network is also easily upgradeable in that it has been designed to incorporate new applications and features with customer premises equipment and software alone, avoiding costly, time consuming network upgrades. Our network is an overlay network; we place our network electronics on an already existing physical network that we lease from existing transport services providers local access telephone wires from incumbent local exchange carriers, metropolitan fiber from incumbent local exchange carriers or competitive telecommunications carriers and long-distance backbone fiber from long distance (interexchange) carriers. The primary components of our network are customer endpoint devices, local transport, our connection points, high-speed metropolitan area network, our Metro Service Centers, our backbone and our Network Operations Center. Customer endpoint devices Depending upon the wishes of our broadband service provider customer, we will either include the end user endpoint device the DSL modem or router as part of our complete service offering, or buy our DSL endpoints from our suppliers for resale to our service provider for use by their end users. For our business customers, we always include the end user endpoint device as part of our complete service offering. We configure and install these modems on the end user's premises along with any basic on-site wiring needed to connect the modem to the copper telephone line leased from the incumbent carrier. Although we generally deploy central office based DSL multiplexing equipment from multiple vendors in each of our central offices, currently, almost all of the DSL modems and central office-based DSL multiplexing equipment we use for a single connection over a copper telephone line must come from the same vendor since there are no existing interoperability standards for the equipment used in our higher speed services. Local transport Our local transport connects customer endpoint devices to our network using a DSL-capable copper telephone wire leased by us from the incumbent local exchange carrier under terms specified in our interconnection agreements and/or the terms and conditions set by the state public utility commissions. In some cases, DSL-capable lines result from removing certain devices from voice grade lines to allow the lines to carry digital signals; at times involving an additional one-time or monthly charge relative to voice grade lines. For private line access, the transport is leased copper or fiber trunks provided by the incumbent local exchange carrier or a competitive telecommunications carrier. Connection points Through our interconnection agreements with the incumbent local exchange carriers, we secure collocation space in central offices serving the area where we intend to offer our services. In each of these connection points, we connect our end users' DSL endpoint equipped copper telephone lines to our DSL multiplexing equipment (DSLAMs) to provide high-speed DSL signals to them. Each of our connection points is designed to offer the same high reliability and availability standards as the incumbent carrier's own central office equipment. We expect to place our equipment in certain of the central offices in any metropolitan area that we enter. As of December 31, 1999, we had connection points in over 1,200 central offices. Although we expect that many connection points will be physically located within the central office, we have placed and will continue to place our connection points in locations immediately adjacent to central offices, when collocation space within the central office is not available. High-Speed Metropolitan Area Network In each of our targeted metropolitan area markets, we operate a private metropolitan area network. The network consists of high-speed Asynchronous Transfer Mode communications circuits that we lease from competitive carriers or incumbent local exchange carriers to connect our connection points to the Metro Service Center. The metropolitan area network operates at 45 Mbps (DS-3) today, and can be upgraded to 155 Mbps (OC-3) and 622 Mbps (OC-12) in the future. We lease a substantial portion of this capacity from MCI WorldCom, as described in "Strategic Partnerships." Metro Service Centers The Metro Service Center is a physical point of presence within a metropolitan area where local access traffic is aggregated from the connection points over our high-speed metropolitan area network. Although we generally expect to have one Metro Service Center in each of our targeted metropolitan areas, in larger metropolitan areas, we may have two. The Metro Service Center houses our Asynchronous Transfer Mode switches and Internet Protocol routers. We design our Metro Service Centers for high availability including battery backup power, redundant equipment and active network monitoring. Backbone Our backbone interconnects our Metro Service Centers so that communications traffic can be transported among different metropolitan areas. We currently lease frame relay backbone and Asynchronous Transfer Mode backbone capacity from a number of long distance carriers. We have almost completed upgrading our nationwide network to two protocols Asynchronous Transfer Mode and Internet Protocol. Network Operations Center Our entire network is managed from the Network Operations Center located in Denver. From this center, we provide end-to-end network monitoring and management, 24 hours a day, seven days a week, using advanced network management tools. This enhances our ability to address performance or connection issues before they affect our end user's experience. From the Network Operations Center, we monitor the equipment and circuits in each Metro Service Center, each metropolitan area network, each connection point, and each of the individual end user lines and endpoints. A second Network Operations Center is under construction. Please see "Risk Factors - system failure or breach of network security could cause delays or interruptions of service to our customers." We are pursuing a program of ongoing network development. Our engineering efforts focus on the design and development of new technologies and services to increase the speed, efficiency, reliability and security of our network and to enable network features and applications developed by us or by third parties. Please see "Risk Factors - We may be unable to effectively expand our network services and provide high performance to a substantial number of end users." DSL Technologies We utilize various DSL equipment and technologies from different vendors. The various DSL technologies allow us to offer a range of connection speeds and value-added network features and applications. Actual speeds that can be provided over a particular line are a function of the distance from the end user or local area network to the central office and the quality of the copper telephone line. The basic features and the market positioning of our primary DSL technologies include: Rate adaptive digital subscriber line (RADSL) RADSL technology allows each end user or local area network to utilize the full digital capability of the underlying telephone line. Speeds reach up to 7.1 Mbps downstream and up to 1.1 Mbps upstream if the end user or local area network is within 7,800 feet from the central office. We use this technology for end users or local area networks needing very high access speeds. Our target customers for RADSL connections consist of small and medium businesses and branch offices of large businesses needing T-1 (1.5 Mbps) or higher speeds. We believe that these businesses often find the cost of dedicated private line or frame relay services to be prohibitive. Our RADSL connection competes favorably on a price and performance basis relative to traditional fractional T-1 and frame relay services. Our RADSL service also provides the highest speed of any of our DSL services for bandwidth intensive applications, and is necessary to support line sharing, which we believe will offer us significant customer service and cost advantages when implemented. Symmetric digital subscriber line (SDSL) Our SDSL technology allows end users and local area network to achieve up to 1.5 Mbps speeds both downstream and upstream. Depending on the quality of the copper telephone line, 1.5 Mbps can typically be achieved if the end user or local area network is within 8,000 feet, or approximately 1.5 miles, from the central office. Integrated digital subscriber line (IDSL) IDSL technology allows us to reach all end users or local area networks within a central office serving area within 50,000 feet of the end user or local area network distance from the central office. Our IDSL service operates at up to 144 kbps in each direction. This service can use existing integrated services digital network (ISDN) equipment at the end user site, and is targeted at the integrated services digital network (ISDN) replacement market. For information intensive users, we believe that IDSL compares favorably with integrated services digital network (ISDN) on a price/performance basis when the monthly flat rate IDSL charge is compared with the per minute integrated services digital network (ISDN) charge and because IDSL, as an "always on" service is not subject to the inconvenience of ISDN's dial-up characteristics. We also offer IDSL to end users that have lines that do not consist of continuous copper, such as digital line carrier equipped lines that are partially copper and partially fiber. Competition The markets for broadband service provider and business broadband access services are extremely intense. We face competition from many competitors with significantly greater financial resources, well-established brand names and large, existing installed customer bases. Moreover, we expect the level of competition to intensify in the future. We expect significant competition from: Incumbent Local Exchange Carriers. All of the largest incumbent local exchange carriers in our target markets have begun offering DSL services or have announced their intention to provide DSL services in the near term. As a result, the incumbent local exchange carriers represent strong competition in all of our markets, and we expect this competition to intensify. The incumbent local exchange carriers have well-established brand names and reputations, for high quality service in their regions, possess sufficient capital to deploy a DSL network rapidly and own the central offices and copper telephone wires. Importantly, they can offer both digital data services and their existing voice services over a single line to achieve a lower cost per line per month than we can until line sharing is widely implemented. Certain of the incumbent local exchange carriers have priced their consumer DSL services as low as $19-$29 per line per month, placing very high pricing pressure on our Consumer Links services. Traditional Interexchange Carriers. Many of the leading traditional interexchange carriers, such as AT&T, MCI WorldCom and Sprint, are rapidly expanding their networks to include high-speed, local access services, and/or acquiring other companies with high-speed local access capabilities, including cable modem (such as AT&T's acquisition of TCI and its pending acquisition of MediaOne, both of which can offer cable modem service). They also have interconnection agreements with the incumbent local exchange carriers and may have secured collocation spaces from which they may have begun to offer competitive DSL services. When combined with their extensive, existing metropolitan and wide area networks, and full range of Internet and private networking services, they are able to provide their customers with a complete broadband communications offer capable of voice, data and video solutions. Because these competitors have significantly greater financial resources, enjoy strong brand recognition, and have large, existing business and consumer franchises, they represent significant competition. Newer Interexchange Carriers. The newer interexchange carriers, such as Williams Communications, Qwest and Level 3 Communications, are building and managing high bandwidth, packet-based metropolitan and wide area networks nationwide. Additionally, they are constructing large hosting centers in major metropolitan areas and partnering with broadband applications services providers to provide a full range of broadband communications services to their Internet service providers, telecommunications carriers, broadband communications services resellers, and in some cases their business and consumer customers. Some carriers also have interconnection agreements with the incumbent local exchange carriers and have secured collocation spaces from which they could begin to offer competitive DSL services. Because they could extend their existing fiber networks to include high-speed, local access services using DSL, either alone, or in partnership with others, they represent a significant competitive threat. Cable Modem Service Providers. Cable modem service providers, like Excite@Home, AT&T (through its acquisition of TCI and pending acquisitions of MediaOne) and AOL, and their cable partners, are offering high-speed Internet access over hybrid fiber coaxial cable networks to consumers, and increasingly, businesses. Similar networks are being deployed in some areas by the electric power company, by itself or in partnership with other service providers. Where deployed, these networks provide Internet access services similar to our services, and in some cases at higher speeds. In certain cases cable modem services are priced lower than our services, partly because operators share the bandwidth available on their cable networks among multiple end users. Wireless and Satellite Data Service Providers. Wireless and satellite data service providers are developing wireless and satellite-based Internet and private network connectivity. We may face competition from terrestrial wireless services, including two Gigahertz (Ghz) and 28 Ghz wireless cable systems (Multi-channel Multipoint Distribution System (MMDS) and Local Multipoint Distribution System (LMDS)), and 18 Ghz and 39 Ghz point-to-point microwave systems. For example, the FCC has recently revised its rules to permit ITFS and MMDS licensees to use their systems to offer two-way services, including high- speed data, rather than solely to provide one-way video services. Many ITFS and MMDS providers are teaming with wireless data technology companies, or on their own planning to offer wireless data services. The FCC also recently auctioned spectrum for LMDS services in all markets, and later this year will auction spectrum in the 700 MHz range, currently being used for television channels 60- 69. This spectrum is expected to be used for wireless cable and telephony services, including high-speed digital services, to both businesses and individual consumers. In addition, companies such as Teligent, Advanced Radio Telecom and WinStar Communications hold point-to-point microwave licenses to provide fixed wireless services such as voice, data and video conferencing. We also may face increasing competition from satellite-based systems. Motorola Satellite Systems, Inc., Hughes Space Communications (a subsidiary of General Motors Corporation), Teledesic LLC, and others have filed applications with the FCC for global satellite networks which can be used to provide broadband voice and data services, and in some cases have begun providing such services. The FCC has authorized several of these applicants to operate their proposed networks, and some are providing commercial service. Internet Service Providers. Internet service providers provide Internet access to residential and business customers. These companies generally provide such Internet access, on a dial-up basis, over the incumbent carriers' circuit switched networks at integrated services digital network (ISDN) speeds (either 64 kbps or 128 kbps) or below. However, some Internet service providers have begun offering DSL-based access using their own DSL services such as HarvardNet and InterAccess, or DSL services offered by the incumbent local exchange carrier or other DSL-based competitive local exchange carriers. Because certain large, national Internet service providers, such as Verio and Concentric, have made investments in our competitors, and entered into joint marketing arrangements nationwide, it is difficult for us to recruit these Internet service partners as customers, and as a result, they represent important competitors. Online Service Providers. Online service providers include companies such as AOL, and the Microsoft Network (MSN) that provide, over the Internet and on proprietary online services and networks, content and applications ranging from news and sports to consumer video conferencing. These services are designed for broad consumer access over telecommunications-based transmission media, which enable the provision of digital services to the significant number of consumers who have personal computers with modems. In addition, they provide Internet connectivity, ease-of-use and consistency of environment. Many of these online service providers have developed their own access networks for modem connections. If these online service providers were to extend their access networks to include DSL or other high-speed service technologies, they would become competitors of ours. Competitive Local Exchange Carriers. Certain competitive carriers, including Covad Communications Group and NorthPoint Communications, offer DSL-based broadband access services using a business strategy similar to ours. In addition, regional competitive carriers, including HarvardNet, Network Access Solutions Corp., Blue Star, and DSL.net, offer DSL-based access services that compete with the services we offer. Other voice competitive local exchange carriers, such as NEXTLINK Communications, Allegiance Communications and MGC Communications, have also announced that they have or will deploy DSL-based. Conditions attached to the merger between SBC and Ameritech may make entry and operation in affected regions easier for our competitors. The 1996 Telecommunications Act specifically grants competitive carriers the right to negotiate interconnection agreements with incumbent carriers, including interconnection agreements that may be identical in all respects to our agreements. Many of these competitors are offering, or may soon offer, technologies and services that will directly compete with some or all of our service offerings. Such technologies include integrated services digital network (ISDN), DSL, wireless and satellite data and cable modems. Please see "Risk Factors: The market in which we operate is highly competitive, and we may not be able to compete effectively, especially against established industry competitors with significantly greater financial resources, for more details about this risk." Some of the competitive factors we face include: . transmission speed, . reliability of service, . breadth of service availability, . price/performance, . network security, . ease of access, installation and use, . content bundling, . customer support, . brand recognition, . operating experience, . ability to scale, . capital availability and . exclusive contracts. Interconnection Agreements With Incumbent Carriers Interconnection agreements with incumbent carriers are critical to our business. These agreements cover a number of aspects of our relationships with incumbent carriers, including: . the prices we pay to lease and the access we have to the incumbent carrier's copper lines; . the removal by the incumbent carrier of equipment or electronics from lines to enable these lines to transmit DSL signals; . the price and terms for collocation of our equipment in the incumbent carrier central offices; . the price we pay and the access we have to the incumbent carrier's transport facilities; . the ability we have to access conduits and other rights-of-way the incumbent carrier uses to construct its own network facilities; . the operational support systems and interfaces that we can use to place orders and report and monitor the incumbent carrier's response to our requests; . the dispute resolution process we use with the incumbent carrier to resolve disagreements on the terms of the interconnection contract; and . the term of the interconnection agreement, its transferability to successors, its liability limits and other general aspects of our relationship with the incumbent carrier. We have signed interconnection agreements with seven different major incumbent carriers covering 24 states and the District of Columbia. In many cases, incumbent carriers do not agree to the provisions in interconnection agreements that we request, and we have not consistently prevailed in obtaining all of the provisions we desire. We may be unable to continue to sign interconnection agreements with incumbent carriers. If we are unable to enter into, or experience delay in obtaining, interconnection agreements, this inability or delay may materially and adversely affect our business and financial prospects. The Telecommunications Act also requires the incumbent carriers to permit competitive carriers to adopt previously signed interconnection agreements, in whole or in part, in some circumstances. Our interconnection agreements have a maximum term of three years, requiring us to renegotiate the existing terms in the future. We may be unable to extend our existing interconnection agreements or renegotiate new agreements on favorable or any terms. In addition, our interconnection agreements are subject to state commission, Federal Communications Commission and judicial oversight. These bodies may modify the terms or prices of our interconnection agreements in ways that would adversely affect our business and financial prospects. Government Regulation A significant portion of the services that we offer, particularly through our wholly owned subsidiaries, Rhythms Links Inc., formerly ACI Corp., and Rhythms Links Inc.-Virginia, formerly ACI Corp.-Virginia, may be subject to regulation at the federal, state and/or local levels. Future federal or state regulations and legislation may be less favorable to us than current regulation and legislation and therefore have a material and adverse impact on our business and financial prospects. In addition, we may expend significant financial and managerial resources to participate in proceedings setting rules at either the federal or state level, without achieving a favorable result. Federal legislation and regulation The 1996 Telecommunications Act, enacted on February 8, 1996, substantially departs from prior legislation in the telecommunications industry by establishing local exchange competition as a national policy. This act removes state regulatory barriers to competition and preempts laws restricting competition in the local exchange market. The 1996 Telecommunications Act in some sections is self-executing, but in addition, the Federal Communications Commission issues regulations that identify specific requirements upon which we and our competitors rely in implementing the changes it prescribes. The outcome of these various ongoing Federal Communications Commission rulemaking proceedings or judicial appeals of such proceedings could materially affect our business and financial prospects. The 1996 Telecommunications Act, and the Federal Communications Commission's initial rules interpreting such act, encourage increased local competition. A federal appeals court for the Eighth Circuit reviewed some of the initial rules, and overruled some of its provisions, including some rules on pricing and nondiscrimination. In January, 1999, the United States Supreme Court reversed elements of the Eighth Circuit's ruling, finding that the Federal Communications Commission has broad authority to interpret the 1996 Telecommunications Act and issue rules for its implementation, specifically including authority over pricing methodology. The Supreme Court upheld the Federal Communications Commission's orders to the incumbent carriers to combine unbundled elements for competitors, and to allow competitors to pick and choose among provisions in existing interconnection agreements. The Supreme Court also found that the Federal Communications Commission's interpretation of the rules for establishing unbundled elements was not consistent with the 1996 Telecommunications Act, and required the Federal Communications Commission to reconsider its delineation of unbundled elements. The Federal Communications Commission's replacement decision on unbundled elements reaffirmed the right of CLECs like Rhythms to obtain access to the necessary unbundled elements in the incumbent network. This decision remains subject to reconsideration appeal. In November, 1998, the Federal Communications Commission ruled that DSL services provided as dedicated access services in connection with interstate services such as Internet access are interstate services subject to the Federal Communications Commission's jurisdiction. In November, 1999 the Federal Communications Commission, upon further reconsideration, reiterated this decision. On March 24, 2000, the D.C. Circuit vacated the Federal Communications Commissions order with respect to dial-up Internet traffic, without addressing the jurisdictional nature of DSL services. In addition, in the Spring of 1998, four of the regional Bell Operating Companies petitioned the Federal Communications Commission, and they and others have initiated legislative efforts since then, to be relieved of certain regulatory requirements in connection with their own DSL services, including obligations to unbundle DSL loops, but not the obligation to unbundle the loops we purchase for our DSL services, and to resell DSL services. In October 1998, the Federal Communications Commission ruled that DSL services are telecommunications services subject to the requirements of the 1996 Telecommunications Act to unbundle such services and offer them for resale. In October 1998, the Federal Communications Commission also issued a Notice of Proposed Rulemaking indicating its intention to clarify expanded rights of competitive carriers for collocation, access to copper loops, and various other issues of consequence to competitive carriers deploying DSL services. The Federal Communications Commission also indicated its intention to allow incumbent carriers to create separate affiliates for their DSL businesses that would have to operate as competitive carriers and would be permitted to operate free of the resale and unbundling obligations of the 1996 Telecommunications Act. The final outcome of these decisions, originally scheduled to be announced on January 28, 1999, had been postponed by the Federal Communications Commission while it considered the impact of the Supreme Court's ruling on the 1996 Telecommunications Act. On March 31, 1999, the Federal Communications Commission issued a decision on collocation issues that was generally favorable to the competitive carriers. This decision was appealed to the D.C. Circuit by U S WEST and GTE. On March 17,2000, the D.C. Circuit vacated and remanded certain aspects of the Commission's decision. The Commission decision on remand could impact the terms and conditions governing our ability to collocate. In the same decision the Federal Communications Commission established further proceedings to consider issues related to unbundled network elements. In December of 1999, the Federal Communications Commission determined that by June of 2000, incumbents must allow data carriers to provide service over the same line that the incumbent provides its own voice services otherwise known as "line sharing". These decisions are subject to reconsideration and appeal. In addition, state commission determination of the prices for these new elements could significantly impact our business interest. State regulation Some of our services, particularly those of our subsidiaries, Rhythms Links Inc. and Rhythms Links Inc.-Virginia, may be classified as intrastate services subject to state regulation. All of the states where we operate, or will operate, require some degree of state regulatory commission approval to provide certain intrastate services. In most states, intrastate tariffs are also required for various intrastate services, although we are not typically subject to price or rate of return regulation for tariffed intrastate services. Actions by state public utility commissions could cause us to incur substantial legal and administrative expenses. Under the 1996 Telecommunications Act, if we so request, incumbent carriers have a statutory duty to negotiate in good faith with us for agreements for interconnection and access to unbundled network elements. These negotiations are conducted on a region-wide basis, and individual agreements are then signed for each of the states in the region for which we have made a request. We have signed interconnection agreements with SBC Communications, Bell Atlantic, BellSouth, GTE, Pacific Bell, U S WEST and Cincinnati Bell. We have signed an interconnection agreement with Cincinnati Bell for Ohio and Kentucky. We have signed agreements with SBC Communications for Illinois, Michigan, Indiana, Ohio, Wisconsin (formerly Ameritech) and California (formerly Pacific Bell). We have signed agreements with Bell Atlantic for the District of Columbia, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Virginia, Connecticut, Delaware, New Hampshire and Rhode Island. We are currently negotiating an agreement for West Virginia. We have signed agreements with BellSouth for Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee. We have signed agreements with GTE for California, Florida, North Carolina, Washington and Texas and are currently completing agreements for Ohio, Oregon and Virginia. We have signed agreements with U S WEST for Arizona, Colorado, Minnesota, Oregon, Washington, Iowa, Nebraska, New Mexico, North Dakota, Montana, and Utah. In addition, we have signed an arbitrated agreement with SBC for Texas, and are currently negotiating for Kansas and Missouri and with Sprint for Florida, Minnesota, Nevada, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee and Virginia and with the Southern New England Telephone Company for Connecticut. These interconnection agreements may not be on terms that are entirely satisfactory to us. During these negotiations, either the incumbent carrier or we may submit disputes to the state regulatory commissions for mediation and, after the expiration of the statutory negotiation period set forth in the 1996 Telecommunications Act, we may submit outstanding disputes to the states for arbitration. We arbitrated with SBC Communications Inc. in Texas the terms of our interconnection agreement with Southwestern Bell for Texas. On November 30, 1999 the Texas Public Utilities Commission Arbitrators issued an Award deciding most issues in favor of Rhythms' positions, and ordered the parties to conclude the negotiations by adopting language consistent with the Award. On February 7, 2000, the full Commission approved the interconnection agreement proposed by the Parties implementing the Arbitrator's Award, and rejected requests by SBC for rehearing of the Arbitrator's Award. This Order remains subject to additional requests for rehearing or appeal. Under the 1996 Telecommunications Act, states have begun and, in a number of cases, completed regulatory proceedings to determine the pricing of unbundled network elements and services, and the results of these proceedings will determine the price we pay for, and whether it is economically attractive for us to use, these elements and services. We are subject to requirements in some states to obtain prior approval for, or notify the state commission of, any transfers of control, sales of assets, corporate reorganizations, issuances of stock or debt instruments and related transactions. Although we believe such authorizations could be obtained, there can be no assurance that the state commissions would grant us authority to complete any transactions. Local government regulation Should we in the future decide to operate our own transport facilities over public rights-of-way, we may be required to obtain various permits and authorizations from municipalities in which we operate such facilities. Some municipalities may seek to impose similar requirements on users of transmission facilities, even though they do not own such facilities. If municipal governments impose conditions on granting permits or other authorizations or if they fail to act in granting such permits or other authorizations, our business could be adversely affected. Employees As of December 31, 1999, we had approximately 1,250 employees. We believe that our future success will depend in part on our continued ability to attract, hire and retain qualified personnel. Competition for such personnel is intense, and we may be unable to identify, attract and retain such personnel in the future. None of our employees are represented by a labor union or are the subject of a collective bargaining agreement. We have never experienced a work stoppage and believe that our employee relations are good. Risk Factors In addition to the other information contained herein, you should carefully consider the following risk factors in evaluating our company. We cannot predict our success because we have a short operating history We formed our company in February 1997, and we have a short operating history for you to review in evaluating our business. We have limited historical financial and operating data upon which you can evaluate our business and prospects. We entered into our first interconnection agreement with an incumbent carrier in July 1997 and began to offer commercial services in our first market in April 1998. We have limited commercial operations and have recognized limited revenue since our inception. In addition, our senior management team and our other employees have worked together at our company for only a short period of time. Because our market is new and evolving, we cannot predict its future growth or ultimate size, and we may be unable to compete effectively The market for broadband local access DSL communication services using copper telephone lines is in the early stages of development. Since this market is new and evolving and because our current and future competitors are likely to introduce competing services, we cannot accurately predict the rate at which this market will grow, if at all, or whether new or increased competition will result in market saturation. Various providers of broadband local access DSL communication services are testing products from various suppliers for various applications. Certain critical issues concerning commercial use of DSL for Internet and private network access, including security, reliability, ease and cost of access and quality of service, remain unresolved and may impact the growth of these services. If the markets for our services fail to develop, grow more slowly than anticipated or become saturated with competitors, these events could materially and adversely affect our business, prospects, operating results and financial condition. Our success will depend on the development of this new and rapidly evolving market and our ability to compete effectively in this market. To address these risks, we must, among other things: . rapidly expand the geographic coverage of our network services; . raise additional capital; . enter into interconnection agreements and working arrangements with additional incumbent carriers, substantially all of which we expect to be our competitors; . deploy an effective network infrastructure; . attract and retain customers; . successfully develop and maintain relationships and activities with our broadband service providers, including MCI WorldCom, Microsoft, Qwest, Level 3 Communications and Cisco; . continue to attract, retain and motivate qualified personnel; . accurately assess potential markets and effectively respond to competitive developments; . continue to develop and integrate our operational support system and other back office systems; . obtain any required governmental authorizations; . comply with evolving governmental regulatory requirements; . increase awareness of our services; . rapidly scale our operations and the systems that support those operations; . continue to upgrade our technologies; and . effectively manage our expanding operations. We may not be successful in addressing these and other risks, and our failure to address risks would materially and adversely affect our business, prospects, operating results and financial condition. Our substantial debt creates financial and operating risk We are highly leveraged, and we intend to seek additional debt funding in the future. As of December 31, 1999, we had approximately $506.1 million of outstanding debt. We are not generating sufficient revenue to fund our operations or to repay our debt. Our substantial leverage poses the risks that: . we may be unable to pay dividends on our preferred stock or to repay our debt, due to one or more events discussed in "Risk Factors;" . we may be unable to obtain additional financing; . we must dedicate a substantial portion of our cash flow from operations to servicing our debt once our debt requires us to make cash interest payments, and any remaining cash flow may not be adequate to fund our planned operations; and . we may be more vulnerable during economic downturns, less able to withstand competitive pressures and less flexible in responding to changing business and economic conditions. We will need significant additional funds, which we may not be able to obtain The expansion and development of our business will require significant additional capital. We intend to seek substantial additional financing in the future to fund the growth of our operations, including funding the significant capital expenditures and working capital requirements necessary for us to provide service in our targeted markets. We believe that our current capital resources, will be sufficient to fund our aggregate capital expenditures and working capital requirements, including operating losses, through approximately December 2001. Although we expect that our initial build-out will be complete by this date, we anticipate that we will continue building our network beyond our initial build-out plans and will need significant additional capital, whether or not our estimate on how long current capital resources will last is accurate. In addition, our actual funding requirements may differ materially if our assumptions underlying this estimate turn out to be incorrect. Therefore, you should consider our estimate in light of the following facts: . we have no meaningful history of operations or revenues; . our estimated funding requirements do not reflect any contingency amounts and may increase, perhaps substantially, if we are unable to generate revenues in the amount and within the time frame we expect or if we have unexpected cost increases; and . we face many challenges and risks, including those discussed elsewhere in Risk Factors. We may be unable to obtain any future equity or debt financing on acceptable terms or at all. Recently the financial markets have experienced extreme price fluctuations. A market downturn or general market uncertainty may adversely affect our ability to secure additional financing. The indentures that govern the 1998 senior discount notes, the 1999 senior notes and the 2000 senior notes restrict our ability to obtain additional debt financing. Any future borrowing instruments, such as credit facilities and lease agreements, are likely to contain similar or more restrictive covenants and could require us to pledge assets as security for the borrowings. If we are unable to obtain additional capital or are required to obtain it on terms less satisfactory than what we desire, we will need to delay deployment of our network services or take other actions that could adversely affect our business, prospects, operating results and financial condition. If we are unable to generate sufficient cash flow or obtain funds necessary to meet required payments of our debt, then we will be in default on our debt instruments. To date, our cash flow from operations has been insufficient to cover our expenses and capital needs. For more details about our financial condition, please see Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations- Liquidity and Capital Resources. We may be unable to satisfy, or may be adversely constrained by, the covenants in our debt securities The indentures governing our 1998 senior discount notes, our 1999 senior notes and our 2000 senior notes impose significant restrictions on how we can conduct our business. For example, the restrictions prohibit or limit our ability to make dividend payments, incur additional debt and engage in certain business activities. The restrictions may materially and adversely affect our ability to finance future operations or capital needs or conduct additional business activities. Any future senior debt that we may incur will likely impose additional restrictions on us. If we fail to comply with any existing or future restrictions, we could default under the terms of the applicable debt and be unable to meet our debt obligations. If we default, the holders of the applicable debt could demand that we repay the debt, including interest, immediately. We may be unable to make the required payments or raise sufficient funds from alternative sources to make the payments. Even if additional financing is available in the event that we default, it may not be on acceptable terms. We cannot predict our success because our business model is unproven We have not validated our business model and strategy in the market. We believe that the combination of our unproven business model and the highly competitive and fast changing market in which we compete makes it impossible to predict the extent to which our network services will achieve market acceptance and our overall success. To be successful, we must develop and market network services that are widely accepted at profitable prices. We may never be able to deploy our network as planned, achieve significant market acceptance, favorable operating results or profitability or generate sufficient cash flow to repay our debt. Of the approximately 12,500 lines that are in service, we installed approximately 60% to only five customers, with approximately 40% of these total lines to Cisco. None of our large business customers, with the exception of Cisco, has rolled out our services broadly to its employees and none of our broadband service provider customers have rolled out our services broadly to their end-users, and we cannot be certain when or if these rollouts will occur. We will not receive significant revenue from our large customers unless these rollouts occur. Any continued or ongoing failure for any reason of large customers to roll out our services, failure to validate our business model in the market, including failure to build-out our network, achieve widespread market acceptance or sustain desired pricing would materially and adversely affect our business, prospects, operating results and financial condition. We expect our losses to continue We have incurred losses and experienced negative operating cash flow for each month since our formation. As of December 31, 1999, we had an accumulated deficit of approximately $257.6 million. We intend to rapidly and substantially increase our expenditures and operating expenses in an effort to expand our network services. We expect to have annual interest and amortization expense relating to our 1998 senior discount notes, our 1999 senior notes and our 2000 senior notes of approximately $89.0 million in 2000 and increasing to $123.0 million in 2003. In addition, we may incur more debt in the future. In addition, dividends of approximately $126.0 million will accrue on the Series E preferred stock through February 2005. No cash dividends are payable on the Series E preferred stock until 2005, and at our option such dividends may continue to accrue as liquidation preference. Dividends on the 6 3/4% Series F preferred stock are cumulative from the date of issuance in an annual amount of approximately $16.9 million. As a result of these factors, we expect to incur substantial operating and net losses and negative operating cash flow for the foreseeable future. We will need to obtain additional financing to pay our expenses and to make payments on our debt. We cannot give you any assurance about whether or when we will have sufficient revenues to satisfy our funding requirements or pay our debt service and preferred stock obligations. Our operating results in one or more future periods are likely to fluctuate significantly and may fail to meet or exceed the expectations of securities analysts or investors Our annual and quarterly operating results are likely to fluctuate significantly in the future due to numerous factors, many of which are outside of our control. These factors include: . the rate of customer acquisition and turnover; . the prices our customers are willing to pay which may decline due to competitive factors; . the amount and timing of expenditures relating to the expansion of our services and infrastructure; . the timing and availability of incumbent carrier central office collocation facilities and transport facilities; . our ability to effectively develop and market network features and applications; . the mix of our services that our customers purchase at different prices; . our ability to scale our business to meet the demands of our customers; . our ability to control our corporate overhead while rapidly growing our business; . the success of our relationships with our partners and distributors, including MCI WorldCom, Microsoft, Qwest and Cisco; . our ability to deploy our network on a timely basis; . introduction of new services or technologies by our competitors; . price competition; . the ability of our equipment and service suppliers to meet our needs; . regulatory developments, including interpretations of the 1996 Telecommunications Act; . technical difficulties or network downtime; . the success of our strategic alliances; . the condition of the telecommunication and network service industries and . general economic conditions. Because of these factors, our operating results in one or more future periods could fail to meet or exceed the expectations of securities analysts or investors. In that event, any trading price of our common stock would likely decline. We depend on third parties for the marketing and sales of our services We rely significantly on indirect sales channels for the marketing and sales of our services. We will seek to continue to establish and maintain relationships with numerous broadband service providers in order to gain access to end-users. Our agreements to date with these broadband service providers are non-exclusive, and we anticipate that future agreements will also be on a non- exclusive basis, allowing these broadband service providers to sell services offered by our competitors. These agreements are generally short term, and can be cancelled by these broadband service providers without significant financial consequence. We cannot control how these broadband service providers perform and cannot be certain that their performance will be satisfactory to us or our customers. Many of these companies have similar arrangements with our competitors and also compete directly with us. If the number of customers we obtain through indirect sales channels is significantly lower than our forecast for any reason, or if these broadband service providers with which we have contracted are unsuccessful in competing in their own intensely competitive markets, these events would have a material and adverse effect on our business, prospects, operating results and financial condition. If forecasted sales for services sold directly to our business customers for a particular period are not realized in that period due to the lengthy sales cycle of our services, our operating results for that period will be harmed The sales cycle of our network services can be very lengthy, particularly for large businesses. Our sales cycle for large businesses typically lasts at least six months. During this lengthy sales cycle, we will incur significant expenses in advance of the receipt of revenues. If sales that we forecast for a particular period do not occur because of our lengthy sales cycle, this event could materially and adversely affect our business, prospects, operating results and financial condition, during that period. We depend on incumbent carriers for collocation and transmission facilities We must use copper telephone lines controlled by the incumbent carriers to provide DSL connections to customers. We also depend on the incumbent carriers for collocation and for a substantial portion of the transmission facilities we use to connect our equipment in incumbent carrier central offices to our Metro Service Centers. In addition, we depend on the incumbent carriers to test and maintain the quality of the copper telephone lines that we use. In many cases, we may be unable to obtain access to collocation and transmission facilities from the incumbent carriers, or to gain access at acceptable rates, terms and conditions, including timeliness. We have experienced, and expect to experience in the future, lengthy periods between our request for and the actual provision of the collocation space and copper telephone lines. An inability to obtain or maintain adequate and timely access to collocation space or transmission facilities on acceptable terms and conditions from incumbent carriers could have a material and adverse effect on our business, prospects, operating results and financial condition. Because we compete with incumbent carriers in our markets, they may be reluctant to cooperate with us. The incumbent carriers may experience, or claim to experience, a shortage of collocation space or transmission capacity. If this occurs, we may not have alternate means of connecting our DSL equipment with the copper telephone lines or connecting our equipment in central offices to Metro Service Centers. We have experienced rejections of some of our collocation applications on the grounds that no space is available. We may receive additional rejections in the future. The number of other competitive local exchange carriers that request collocation space will also affect the availability of collocation space and transmission capacity. If we are unable to obtain physical collocation space or transmission capacity from our targeted incumbent carriers, we may face delays, additional costs or an inability to provide services in certain locations. Where we use virtual collocation in our network, it reduces our control over our equipment, and therefore may reduce the level of quality and service we provide to our customers. Delays in obtaining access to collocation space and copper telephone lines or the rejection of our applications for collocation could result in delays in, and increased expenses associated with, the rollout of our services, which in turn could have a material and adverse effect on our business, prospects, operating results and financial condition. We are unable to control the terms and conditions under which we gain access to incumbent carrier collocation and transmission facilities We cannot control the terms under which we collocate our equipment, connect to copper telephone lines or gain the use of an incumbent carrier's transmission facilities. State tariffs, state public utility commissions, the Federal Communications Commission and interconnection agreements with the incumbent carriers determine the price, terms and conditions under which collocation space is made available, and they make these administrative determinations in ongoing hearings. Interconnection agreements and state public utility commissions also determine the terms and conditions of access to copper telephone lines and other components of an incumbent carrier's network. We may be unable to negotiate or enter into interconnection agreements on acceptable terms or at all. In addition, we cannot be sure that incumbent carriers will abide by their obligations under those agreements. Delays in obtaining interconnection agreements would delay our entry into certain markets. In addition, disputes may arise between us and the incumbent carriers with respect to interconnection agreements, and we may be unable to resolve disputes in our favor. If we are unable to enter into, or experience a delay in obtaining, interconnection agreements, this inability or delay could adversely affect our business, prospects, operating results and financial condition. Further, the interconnection agreements are generally short term, and we may be unable to renew the interconnection agreements on acceptable terms or at all. The state commissions, the Federal Communications Commission and the courts oversee, in varying degrees, interconnection arrangements as well as the terms and conditions under which we gain access to incumbent carrier copper telephone lines and transmission facilities. These government entities may modify the terms or prices of our interconnection agreements and our access to incumbent carrier copper telephone lines and transmission facilities in ways that would be adverse to our business. The Federal Communications Commission and state regulatory commissions establish the rates for DSL-capable copper telephone lines as well as other rates, terms and conditions of our dealings with the incumbent carriers in ongoing public hearings. Participation in these hearings will involve significant management time and expense. Incumbent carriers may from time to time propose new rates, and the outcomes of hearings and rulings could have a material and adverse effect on our business, prospects, operating results and financial condition. The market in which we operate is highly competitive, and we may not be able to compete effectively, especially against established industry competitors with significantly greater financial resources We will face competition from many competitors with significantly greater financial resources, well-established brand names and large, existing installed customer bases. We expect the level of competition to intensify in the future. We expect significant competition from incumbent local exchange carriers, traditional and new interexchange carriers, other DSL providers, cable modem service providers, Internet service providers, wireless and satellite data service providers and other competitive carriers. Incumbent local exchange carriers have existing metropolitan area networks and circuit-switched local access networks. In addition, most incumbent local exchange carriers are establishing their own Internet service provider businesses and are in some stage of market trials and retail sales of DSL-based access services. Incumbent local exchange carriers are aggressively marketing these services to their residential customers at attractive prices. We believe that incumbent local exchange carriers have the potential to quickly overcome many of the issues that have delayed widespread deployment of DSL services in the past. It is possible that present or future competitors may reduce prices for competitive services, perhaps drastically. In addition, we may experience substantial customer turnover in the future. Many providers of telecommunications and networking services experience high rates of customer turnover. Many of the leading traditional long distance carriers, including AT&T Corporation, MCI WorldCom and Sprint, are expanding their capabilities to support high-speed, end-to-end networking services. The newer long distance carriers, including Williams, Level 3 Communications, Inc. and Qwest, are building and managing high bandwidth, nationwide packet networks and partnering with Internet service providers to offer services directly to the public. Cable modem service providers, like Excite@Home Networks, are offering or preparing to offer high-speed Internet access over hybrid fiber networks to consumers, and @Work has positioned itself to do the same for businesses. Several new companies are emerging as wireless, including satellite-based, data service providers. Internet service providers, including some with significant and even nationwide presences, provide Internet access to residential and business customers, generally over the incumbent carriers' circuit switched networks, although some offer competitive DSL-based access. Certain competitive carriers, including Covad Communications Group, Inc. and NorthPoint Communications, Inc., offer competitive DSL-based access services, and, like us, have attracted strategic equity investors, marketing allies and product development partners. Others are likely to do the same in the future. In addition, regional Internet service providers and competitive carriers, including HarvardNet, Inc., Network Access Solutions Corp. and DSL.net, Inc. offer competitive DSL-based services that compete with the services we offer. As a result of increasing competition for our services, we are experiencing substantial price competition, particularly with respect to sales generated through our indirect sales channels. Many of these competitors are offering, or may soon offer, technologies and services that will directly compete with some or all of our service offerings. Some of the technologies used by these competitors for local access connections include ISDN, DSL, wireless data and cable modems. Some of the competitive factors in our markets include transmission speed, reliability of service, breadth of service availability, price, network security, ease of access and use, content bundling, customer support, brand recognition, operating experience, capital availability and exclusive contracts. We believe that we compare unfavorably with many of our competitors with regard to, among other things, brand recognition, existing relationships with end users, available pricing discounts, central office access, capital availability and exclusive contracts. Substantially all of our competitors and potential competitors have substantially greater resources than us. We may not be able to compete effectively in our target markets. Our failure to compete effectively would have a material and adverse effect on our business, prospects, operating results and financial condition. For more details about our competitors, please see Item 1 -Business - Competition. Our network services may not achieve significant market acceptance because our prices are often higher than those charged for competing services Our prices are in some cases higher than those that our competitors charge for some of their services. Prices for digital communications services have fallen historically, and we expect prices in the industry in general, and for the services we offer now and plan to offer in the future, to continue to fall. We may be required to reduce prices periodically to respond to competition and to generate increased sales volume. Our prices may not permit our network services to gain a desirable level of commercial acceptance, and we may be unable to sustain any current or future pricing levels. Due to these factors, we cannot accurately forecast our revenues or the rate at which we will add new customers. Our services are subject to government regulation, and changes in current or future laws or regulations could restrict the way we operate our business A significant portion of the services that we offer through our subsidiaries is subject to regulation at the federal, state and/or local levels. Future federal or state regulations and legislation may be less favorable to us than current regulation and legislation and therefore have an adverse impact on our business, prospects, operating results and financial condition. In addition, we may expend significant financial and managerial resources to participate in rule-setting proceedings at either the federal or state level, without achieving a favorable result. In particular, we believe that incumbent carriers will work aggressively to modify or restrict the operation of many provisions of the 1996 Telecommunications Act. We expect incumbent carriers will pursue litigation in courts, institute administrative proceedings with the Federal Communications Commission and other regulatory agencies and lobby the United States Congress, all in an effort to affect laws and regulations in a manner favorable to the incumbent carriers and against the interest of competitive carriers such as us. If the incumbent carriers succeed in any of their efforts, if these laws and regulations change or if the administrative implementation of laws develops in an adverse manner, these events could have a material and adverse effect on our business, prospects, operating results and financial condition. For more details about our regulatory situation, please see Item 1 - Business - Government Regulation. Our failure to manage growth could adversely affect us We have rapidly and significantly expanded our operations. We anticipate further significant expansion of our operations and the systems supporting those operations in an effort to achieve our network rollout and deployment objectives. Our expansion to date has strained our management, financial controls, operations systems, personnel and other resources. Any future rapid expansion would increase these strains. If our marketing strategy is successful, we may experience difficulties responding to customer demand for services and technical support in a timely manner and in accordance with their expectations. As a result, rapid growth of our business would make it difficult to implement successfully our strategy to provide superior customer service. To manage any growth of our operations, we must: . improve existing and implement new operational, financial and management information controls, operational support systems, reporting systems and procedures; . hire, train and manage additional qualified personnel; . expand and upgrade our core technologies; and . effectively manage multiple relationships with our customers, suppliers and other third parties. We may not be able to install operational support systems or management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations. Failure to manage our future growth effectively could adversely affect the expansion of our customer base and service offerings. Any failure to successfully address these issues could materially and adversely affect our business, prospects, operating results and financial condition. Failure to effectively develop and market network features and applications could limit our revenue growth Our business model relies on network features and applications to increase our revenues. We have only recently begun to develop these network features and applications. In order to be successful, we must develop and effectively market network features and applications that are widely accepted, at profitable prices. We cannot assure you that we will be able to do so. Our failure to develop and market these features and applications could materially and adversely affect our business, prospects, operating results and financial condition. The telecommunications industry is undergoing rapid technological change, and new technologies may be superior to the technology we use The telecommunications industry is subject to rapid and significant technological changes, such as continuing developments in DSL technology and alternative technologies for providing high-speed data communications. We cannot predict the effect of technological changes on our business. We will rely in part on third parties, including certain of our competitors and potential competitors, for the development of and access to communications and networking technology. We expect that new products and technologies applicable to our market will emerge. New products and technologies may be superior to and/or render obsolete the products and technologies that we currently use. Our future success will depend, in part, on our ability to anticipate and adapt to technological changes and evolving industry standards. We may be unable to obtain access to new technology on acceptable terms or at all, and we may be unable to adapt to new technologies and offer services in a competitive manner. Our joint development projects with Cisco and MCI WorldCom and our strategic arrangement with Microsoft may not produce useful technologies or services for us. Further, new technologies and products may not be compatible with our technologies and business plan. In addition, many of the products and technologies that we intend to use in our network services are relatively new and unproven and may be unreliable. We may be unable to effectively expand our network services and provide high performance to a substantial number of end users Due to the limited deployment of our network services, we cannot guarantee that our network will be able to connect and manage a substantial number of end users at high transmission speeds. We may be unable to scale our network to service a substantial number of end users while achieving high performance. Further, our network may be unable to achieve and maintain competitive digital transmission speeds. While digital transmission speeds of up to 7.1 Mbps are possible on certain portions of our network, that speed is not available over a majority of our network. Actual transmission speeds on our network will depend on a variety of factors and many of these factors are beyond our control, including the type of DSL technology deployed, the distance an end user is located from a central office, the quality of the telephone lines, the presence of interfering transmissions on nearby lines and other factors. As a result, we may not be able to achieve and maintain digital transmission speeds that are attractive in the market. Our services may suffer or be unavailable because the copper telephone lines we require may be unavailable or in poor condition Our ability to provide DSL-based services to potential customers depends on the quality, physical condition, availability and maintenance of copper telephone lines within the control of the incumbent carriers. We believe that the current condition of copper telephone lines in many cases will be inadequate to permit us to fully implement our network services. In addition, the incumbent carriers may not maintain the copper telephone lines in a condition that will allow us to implement our network effectively. The copper telephone lines may not be of sufficient quality or the incumbent carriers may claim they are not of sufficient quality to allow us to fully implement or operate our network services. Further, some telephone services employ technologies other than copper lines, and DSL might not be available over these telephone lines. Our success depends on our retention of certain key personnel and on the performance of those personnel Our success depends on the performance of our officers and key employees, especially our Chief Executive Officer and our President and Chief Operating Officer. Members of our senior management team have worked together for only a short period of time. We do not have "key person" life insurance policies on any of our employees nor do we have employment agreements for fixed terms with any of our employees. Any of our employees, including any member of our senior management team, may terminate his or her employment with us at any time. Given our early stage of development, we depend on our ability to retain and motivate high quality personnel, especially our management. Our future success also depends on our continuing ability to identify, hire, train and retain highly qualified technical, sales, marketing and customer service personnel. Moreover, the industry in which we compete has a high level of employee mobility and aggressive recruiting of skilled personnel. We may be unable to continue to employ our key personnel or to attract and retain qualified personnel in the future. We face intense competition for qualified personnel, particularly in software development, network engineering and product management. For more details about our officers and key employees, please see Item 1 - Business - Employees. We depend on third parties for equipment, installation and provision of field service We currently plan to purchase all of our equipment from many vendors and outsource the majority of the installation and field service of our networks to third parties. Our reliance on third party vendors involves a number of risks, including the absence of guaranteed capacity and reduced control over delivery schedules, quality assurance, production yields and costs. If any of our suppliers reduces or interrupts its supply, or if any significant installer or field service provider interrupts its service to us, this reduction or interruption could disrupt our business. Although multiple manufacturers currently produce or are developing equipment that will meet our current and anticipated requirements, our suppliers may be unable to manufacture and deliver the amount of equipment we order, or the available supply may be insufficient to meet our demand. Currently, almost all of the DSL modem and DSL multiplexing equipment we use for a single connection over a copper telephone line must come from the same vendor since there are no existing interoperability standards for the equipment used in our higher speed services. If our suppliers or licensors enter into competition with us, or if our competitors enter into exclusive or restrictive arrangements with the suppliers or licensors, then these events may materially and adversely affect the availability and pricing of the equipment we purchase and the technology we license. A system failure or breach of network security could cause delays or interruptions of service to our customers Our operations depend on our ability to avoid damages from fires, earthquakes, floods, power losses, excessive sustained or peak user demand, telecommunications failures, network software flaws, transmission cable cuts and similar events. A natural disaster or other unanticipated problem at our owned or leased facilities could interrupt our services. Additionally, if an incumbent carrier, competitive carrier or other service provider fails to provide the communications capacity we require, as a result of a natural disaster, operational disruption or any other reason, then this failure could interrupt our services. Despite the implementation of security measures, our network may be vulnerable to unauthorized access, computer viruses and other disruptive problems. Corporate networks and Internet service providers have in the past experienced, and may in the future experience, interruptions in service as a result of accidental or intentional actions of Internet users, current and former employees and others. Unauthorized access could also potentially jeopardize the security of confidential information stored in the computer systems of our customers, which might cause us to be liable to our customers, and also might deter potential customers. Eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to our customers and our customers' end users. Interference or claims of interference could delay our rollout or harm our services All transport technologies deployed on copper telephone lines have the potential to interfere with, or to be interfered with by, other transport technologies on the copper telephone lines. We believe that our DSL technologies, like other transport technologies, do not interfere with existing voice services. We believe that a workable plan that takes into account all technologies could be implemented in a scalable way across all incumbent carriers using existing plant engineering principles. There are several initiatives underway to establish national standards and principles for the deployment of DSL technologies. We believe that our technologies can be deployed consistently with these evolving standards. Nevertheless, incumbent carriers may claim that the potential for interference permits them to restrict or delay our deployment of DSL services. Interference could degrade the performance of our services or make us unable to provide service on selected lines. The procedures to resolve interference issues between competitive carriers and incumbent carriers are still being developed, and these procedures may not be effective. We may be unable to successfully negotiate interference resolution procedures with incumbent carriers. Moreover, incumbent carriers may make claims regarding interference or unilaterally take action to resolve interference issues to the detriment of our services. State or federal regulators could also institute responsive actions. Interference, or claims of interference, if widespread, would adversely affect our speed of deployment, reputation, brand image, service quality and customer satisfaction and retention. We depend on third parties for fiber optic transport facilities We depend on the availability of fiber optic transmission facilities from third parties to connect our equipment within and between metropolitan areas. These third party fiber optic carriers include long distance carriers, incumbent carriers and other competitive carriers. Many of these entities are, or may become, our competitors. This approach includes a number of risks. For instance, we may be unable to negotiate and renew favorable supply agreements. Further, we depend on the timeliness of these companies to process our orders for customers who seek to use our services. We have in the past experienced supply problems with certain of our fiber optic suppliers, and they may not be able to meet our needs on a timely basis in the future. Moreover, the fiber optic transport providers whose networks we lease may be unable to obtain or maintain permits and rights-of-way necessary to develop and operate existing and future networks. Uncertain federal and state tax and other surcharges on our services may increase our payment obligations Telecommunications providers pay a variety of surcharges and fees on their gross revenues from interstate and intrastate services. The division of our services between interstate and intrastate services is a matter of interpretation, and in the future the Federal Communications Commission or relevant state commission authorities may contest this division. A change in the characterization of the jurisdiction of our services could cause our payment obligations to increase. In addition, pursuant to periodic revisions by state and federal regulators of the applicable surcharges, we may be subject to increases in the surcharges and fees currently paid. Our intellectual property protection may be inadequate to protect our proprietary rights, and we may be subject to infringement claims We rely on a combination of licenses, confidentiality agreements and other contracts to establish and protect our technology and other intellectual property rights. We have applied for trademarks and servicemarks on certain terms and symbols that we believe are important for our business. We currently have no patents or patent applications pending. The steps we have taken may be inadequate to protect our technology or other intellectual property. Moreover, our competitors may independently develop technologies that are substantially equivalent or superior to ours. Third parties may assert infringement claims against us and, in the event of an unfavorable ruling on any claim, we may be unable to obtain a license or similar agreement to use technology we rely upon to conduct our business. We also rely on unpatented trade secrets and know-how to maintain our competitive positions, which we seek to protect, in part, by confidentiality agreements with employees, consultants and others. However, these agreements may be breached or terminated, and we may not have adequate remedies for any breach. In addition, our competitors may otherwise learn or discover our trade secrets. Our management personnel were previously employees of other telecommunications companies. In many cases, these individuals are conducting activities for us in areas similar to those in which they were involved prior to joining us. As a result, we or our employees could be subject to allegations of violation of trade secrets and other similar claims. Risks associated with potential general economic downturn In the last few years the general health of the economy, particularly the economy of California where we have conducted a significant portion of our operations to date, has been relatively strong and growing, a consequence of which has been increasing capital spending by individuals and growing companies to keep pace with rapid technological advances. To the extent the general economic health of the United States or of California declines from recent historically high levels, or to the extent individuals or companies fear a decline is imminent, these individuals and companies may reduce expenditures such as those for our services. Any decline or concern about an imminent decline could delay decisions among certain of our customers to roll out our services or could delay decisions by prospective customers to make initial evaluations of our services. Any delays would have a material and adverse effect on our business, prospects, operating results and financial condition. We expect our stock price to be volatile The trading price of our common stock has been and is likely to continue to be highly volatile. Our stock price could fluctuate widely in response to many factors, including the following: . our historical and anticipated quarterly and annual operating results; . announcements of new products or services by us or our competitors or new competing technologies; . the addition or loss of business or service provider customers; . variations between our actual results and analyst and investor expectations; . investor perceptions of our company and comparable public companies; . conditions or trends in the telecommunications industry, including regulatory developments; . announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments; . additions or departures of key personnel; . future equity or debt offerings or our announcements of such offerings; and . general market and economic conditions. In addition, in recent years the stock market in general, and the Nasdaq National Market and the market for Internet and technology companies in particular, have experienced extreme price and volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. These market and industry factors may materially and adversely affect our stock price, regardless of our operating performance. We have not paid and do not intend to pay dividends We have not paid any dividends on our common stock, and we do not intend to pay cash dividends on our common stock in the foreseeable future. Our current financing documents contain provisions which restrict our ability to pay dividends. Anti-takeover provisions could negatively impact our stockholders Our Board of Directors has adopted a stockholder rights plan. Our stockholder rights plan would cause substantial dilution to any person or group that attempts to acquire our company on terms not approved in advance by our Board of Directors. In addition, some of the provisions that may be included in our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition at a premium price. These provisions include: . authorizing the issuance of "blank check" preferred stock; . providing for a classified Board of Directors with staggered, three-year terms; . eliminating the ability of stockholders to call a special meeting of stockholders; . limiting the removal of directors by the stockholders to removal for cause; and . requiring a super-majority stockholder vote to effect certain amendments. In addition, certain provisions of the Delaware General Corporation Law and our stockholder rights plan may deter someone from acquiring or merging with us, including a transaction that results in stockholders receiving a premium over the market price for the shares of common stock held by them. Section 203 of the Delaware General Corporation Law also imposes certain restrictions on mergers and other business combinations between us and any holder of more than 15% and less than 85% of our common stock. The indentures governing our 1998 senior discount notes, 1999 senior notes and 2000 senior notes require us to offer to repurchase all such notes for 101% of their principal amount or accreted value, as the case may be, plus any accrued interest and liquidated damages, within 30 days after a change of control. We might not have sufficient funds available at the time of any change of control to make any required payment, as well as any payment that may be required pursuant to any other outstanding indebtedness at the time, including our indebtedness to equipment financing lenders, or outstanding preferred stock. These covenants may also deter third parties from entering into a change of control transaction with us. The price of our common stock may decline due to shares eligible for future sale Sales of substantial amounts of common stock in the public market following this offering, or the appearance that a large number of shares is available for sale, could adversely affect the market price for the common stock. In addition to the adverse effect a price decline could have on holders of common stock, that decline would likely impede our ability to raise capital through the issuance of additional shares of common stock or other equity securities. Item 2 Item 2 - Properties Our headquarters are located in facilities consisting of approximately 80, 000 square feet in Englewood, Colorado, which we occupy under a lease that expires in January 2004. This lease may be extended. We also lease space for network equipment installations and business offices in a number of other locations. Item 3 Item 3 - Legal Proceedings In December 1998, we instituted an arbitration proceeding, before the Public Utility Commission of Texas, with Southwestern Bell Telephone Company regarding the terms of interconnection with Southwestern Bell in Texas. On November 30, 1999 the Texas Public Utilities Commission Arbitrators issued an award deciding most issues in favor of our positions, and ordered the parties to conclude the negotiations by adopting language consistent with the award. On February 7, 2000 the full Commission approved the interconnection agreement proposed by the parties implementing the arbitrator's award, and rejected requests by SBC for rehearing of the arbitrator's award. This order remains subject to additional requests for rehearing or appeal. In addition, on March 12, 1999, our subsidiary Rhythms Links Inc. filed a complaint with the Oregon Public Utilities Commission against U S WEST requesting that the Oregon Public Utilities Commission determine that U S WEST permit collocation by Rhythms Links in several central offices in which U S WEST claimed that it had no space available. U S WEST agreed to permit Rhythms Links collocation in the disputed central offices just before hearings were scheduled to begin in June 1999. On February 18, 1999, we filed a complaint for declaratory relief in San Diego County Superior Court, North County against Thomas R. Lafleur. Mr. Lafleur is a former employee of the Company. After he left, he was sent a check for the repurchase or buy-back of his unvested shares. Mr. Lafleur refused to cash this check. The declaratory relief action is to determine that his shares were unvested and thus properly repurchased. We have since amended our complaint to allege additional causes of action, including fraud, breach of contract, and interference with prospective economic advantage. On or about March 26, 1999, Mr. Lafleur filed an answer to the complaint and also filed a cross-complaint against us. The cross-complaint has been amended a number of times and seeks compensatory and punitive damages. We intend to defend vigorously against the claims asserted in the current cross-complaint. We are currently accounting for these 438,115 shares as treasury stock. We are aware of the filing of a legal action by i2 Technologies, Inc. in the United States District Court in the Northern District of Texas on January 7, 2000 challenging our use of the name "Rhythms" on various grounds and alleging that our use of that name infringes certain trademarks owned by i2 Technologies. We deny that it infringes any legitimate trademark rights of i2 Technologies, in part on the grounds that we have priority in the Rhythms name with respect to the goods and services provided by us and that our use of those marks is not likely to cause confusion among the consumers of our services, and the services provided by i2 Technologies, respectively. We intend to vigorously defend the continued use of our name in the manner in which we have used it in the past and our interests in the name "Rhythms". In addition, we are subject to state commission, Federal Communications Commission and court decisions as they relate to the interpretation and implementation of the 1996 Telecommunications Act, the interpretation of competitive carrier interconnection agreements in general and our interconnection agreements in particular. In some cases, we may be deemed to be bound by the results of ongoing proceedings of these bodies. We therefore may participate in proceedings before these regulatory agencies or judicial bodies that affect, and allow us to advance, our business plans. Item 4 Item 4 - Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the quarter ended December 31, 1999. PART II Item 5 Item 5 - Market for Registrant's Common Equity and Related Stockholder Matters. The Company's common stock is traded on the Nasdaq National Market under the symbol "RTHM." As of March 15, 2000, there were approximately 329 shareholders of record of the Company's common stock, par value $.001 per share. The common stock began trading on the Nasdaq National Market on April 7, 1999, the date of our initial public offering. Prior to April 7, 1999, there was no public market for our common stock. The following table sets forth, for the period indicated, the high and low closing daily bid prices for our common stock as quoted by the Nasdaq National Market. - -------------------------------------------------------------------------------- Year Ended December 31, 1999: High Low ---- ---- - -------------------------------------------------------------------------------- Second Quarter (from April 7, 1999 through June 30, 1999) $93.13 $45.25 - -------------------------------------------------------------------------------- Third Quarter................................................68.94 30.00 - -------------------------------------------------------------------------------- Fourth Quarter...............................................45.50 26.69 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Dividend Policy We have not paid dividends on our common stock and currently intend to continue this policy in order to retain earnings for use in our business. In addition, the terms of the indentures governing our 1998 senior discount notes, 1999 senior notes and 2000 notes contain restrictions on our ability to pay dividends or other distributions. Sales of Unregistered Securities Since our incorporation in February 1997, we have issued and sold unregistered securities as follows (adjusted for subsequent stock splits): (1) An aggregate of 2,161,764 shares of common stock was issued in private placements in February through June 1997 to Enterprise Partners in connection with our initial funding. The consideration received for such shares was $901. (2) An aggregate of 6,140,000 shares of Series A preferred stock (which were converted into 14, 736,000 shares of common stock) was issued in a private placement in July 1997 to Brentwood Venture Capital, Enterprise Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and certain other purchasers pursuant to a Series A Preferred Stock Purchase Agreement. The consideration received for such shares was $6,138,500. (3) An aggregate of 6,350,000 shares of Series A preferred stock (which were converted into 15,240,000 shares of common stock) was issued in a private placement in December 1997 to Brentwood Venture Capital, Enterprise Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and certain other purchasers pursuant to a Series A Preferred Stock Purchase Agreement and a Subsequent Closing Purchase Agreement. The consideration received for such shares was $6,350,000. (4) An aggregate of 365,094 shares of Series A preferred stock (which were converted into 876,226 shares of common stock) was issued in a private placement in February 1998 to Catherine Hapka in connection with the Series A Preferred Stock Purchase Agreement, the Subsequent Closing Purchase Agreement and an employment agreement between us and Ms. Hapka. The consideration received for such shares was $292,075. (5) An aggregate of 4,044,943 shares of Series B preferred stock (which were converted into 9,707,863 shares of common stock) was issued in a private placement in March 1998 to Brentwood Venture Capital, Enterprise Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and Enron Communications Group, Inc. The consideration received for such shares was $18,000,000. (6) In May 1998, we issued 290,000 units consisting of 13 1/2% senior discount notes due 2008 and warrants to purchase an aggregate of 4,732,800 shares of common stock with exercise prices of $0.004 per share to Merrill Lynch & Co. and Donaldson, Lufkin & Jenrette Securities Corporation, as initial purchasers, for resale to qualified institutional buyers. Merrill Lynch & Co. and Donaldson, Lufkin & Jenrette Securities Corporation received commissions of $5,262,920 for acting as initial purchasers in connection with this transaction. Effective November 20, 1998, we completed an exchange offer of the 13 1/2% senior discount notes that allowed for registration of such notes under the Securities Act of 19333, as amended. Of the original issue notes, $289.0 million were tendered for exchange. (7) In May 1998, we issued to Sun Financial Group, Inc., now GATX Capital Corporation, a warrant to purchase 574,380 shares of common stock with an exercise price of $1.85 per share in connection with an equipment lease financing. (8) In March 1999, we issued to MCI WorldCom Venture Fund, Inc. and to Microsoft Corporation 3,731,410 and 3,731,409 shares of Series C preferred stock, respectively, and issued to each of them a warrant to purchase 720,000 shares of common stock for an aggregate purchase price of $60.0 million. (9) In April 1999, we issued to Qwest 932,836 shares and 441,176 shares of Series C and Series D preferred stock, respectively, and warrants to purchase 180,000 shares of common stock for an aggregate purchase price of $15.0 million. (10) Effective April 12, 1999, we completed an initial public offering of our common stock. A total of 10,781,250 common shares were issued at $21.00 per share for aggregate proceeds of approximately $210.1 million after payment of underwriting fees and related issue costs. Upon completion of the offering, all classes of preferred stock automatically converted to common stock, resulting in an additional 51,076,051 shares of common stock being issued leaving no shares of preferred stock issued and outstanding. (11) Effective August 17, 1999, we completed a secondary public offering of our common stock in a transaction that allowed certain holders of warrants issued in connection with the 13 1/2% senior discount notes to exercise those warrants and sell the resulting common stock at $29.00 per share. In connection with the secondary offering, the underwriters of the offering were allowed to purchase 594,279 shares of common stock from us for $29.00 per share. The sale of these shares was completed on September 14, 1999 for aggregate proceeds of $16.4 million, net of underwriting discount. (12) In February 2000, we issued $300.0 million aggregate principal amount of 14% senior notes due 2010 for net proceeds of approximately $291.3 million. The notes are redeemable at our option, in whole or in part, at any time after February 15, 2005, at predetermined redemption prices, together with any accrued and unpaid interest through the date of redemption. Upon a change of control, each holder of the senior notes may require us to purchase the notes at 101% of the principal amount thereof, plus any accrued and unpaid interest to the date of purchase. The 2000 senior notes contain restrictive covenants, including limitations on future indebtedness, restricted payments, transactions with affiliates, liens, sale of stock of subsidiaries, entering new lines of business, dividends, mergers and transfer of assets. (13) In February and March 2000, we issued 3,000,000 shares of 6 3/4% Series F cumulative convertible preferred stock in a private placement. Net proceeds were approximately $291.0 million. Each share of Series F preferred stock is convertible into 2.35 shares of common stock at any time at a conversion price of $42.56 per share, subject to adjustment. Holders of Series F preferred stock are entitled to dividends on a cumulative basis at an annual rate of 6 3/4%, payable quarterly in cash. The preferred stock is redeemable at our option, in whole or in part, at any time after March 6, 2003, at predetermined redemption prices, together with any accrued and unpaid dividends through the date of redemption. Upon a change of control, each holder of the preferred shares may require us to purchase any or all of the shares at 100% of the liquidation preference, plus any accrued and unpaid dividends to the date of purchase. The Series F preferred stock is subject to mandatory redemption on March 3, 2012. (14) In March 2000, we sold $250.0 million of 8 1/4% Series E convertible preferred stock to Hicks, Muse, Tate & Furst Inc. (Hicks Muse). Each share of Series E preferred stock is convertible into shares of common stock at any time at a conversion price of $37.50 per share, subject to adjustment. In addition, we issued Hicks Muse warrants to purchase 1,875,000 shares of common stock at an exercise price of $45.00 per share, exercisable for three years; 1,875,000 shares of common stock at an exercise price of $50.00 per share, exercisable for five years; and 1,875,000 shares of common stock at an exercise price of $55.00 per share, exercisable for seven years. (15) From August 1997 through December 31, 1999, we granted stock options to purchase an aggregate of 17,407,722 shares of common stock to employees and consultants with aggregate exercise prices ranging from $0.21 to $56.94 per share pursuant to our stock option plan. As of December 31, 1999, 8,592,013 shares of common stock have been issued upon exercise of options. No underwriters were used in connection with these sales and issuances except for the issuance of the senior discount notes and related warrants in (6) above, issuances of common stock in our public and secondary offerings in (11) and (12) above and issuance of senior notes in (12) above and issuances of preferred stock in (13) above. The sales and issuances of these securities except for those in (6), (11) and (12) above were exempt from registration under the Securities Act pursuant to Rule 701 promulgated thereunder on the basis that these securities were offered and sold either pursuant to a written compensatory benefit plan or pursuant to written contracts relating to consideration, as provided by Rule 701, or pursuant to Section 4 (2) thereof on the basis that the transactions did not involve a public offering. The sales and issuance in (6), (12), (13) and (14) above were exempt from registration under the Securities Act pursuant to Section 4 (2) and, in connection with the resale by the initial purchasers of the securities described in (6) above, Rule 144A thereunder. Use of Proceeds We have and continue to use aggregate net proceeds from our initial public offering as follows: . to fund the expenditures incurred in the continuing deployment of network services in our existing markets, as well as our planned rollout in additional markets; . for expenses associated with the continued development of our sales and marketing activities; . to fund the addition of subscribers or end-users; . to fund operating losses; . to pay our debt obligations; and . for general corporate purposes. We have also invested them in short-term, investment grade securities to the extent permitted by the covenants governing the notes and our existing senior discount notes and our existing debt and any statistical asset tests imposed by the Investment Company Act of 1940. The actual amounts we spend have varied and will vary significantly depending upon a number of factors, including future revenue growth, if any, capital expenditures, the amount of cash generated by our operations and other factors, many of which are beyond our control. Additionally, we may modify the number, selection and timing of our entry with respect to any or all of our targeted markets. Accordingly, our management has and will retain broad discretion in the allocation of the net proceeds. Item 6 Item 6 - Selected Financial Data The following table sets forth the Selected Consolidated Financial Data for the Company for the periods from inception on February 27, 1997 to December 31, 1997 and for the years ended December 31, 1998, and 1999, and is based on the audited Consolidated Financial Statements of the Company and its subsidiaries. Such data should be read in conjunction with the Company's Consolidated Financial Statements and the notes thereto incorporated into this report in Item 8 and Management's Discussion and Analysis of Financial Condition and Results of Operations. _____________ (1) EBITDA consists of the net loss excluding net interest, depreciation and amortization of capital assets, deferred business acquisition costs and deferred compensation expense. EBITDA is presented to enhance an understanding of our operating results and is not intended to represent cash flow or results of operations in accordance with generally accepted accounting principles for the period indicated and may be calculated differently than EBITDA for other companies. (2) Adjusted EBITDA reflects EBITDA excluding total operating lease expenses to GATX Capital Corporation (GATX) and Cisco Systems Capital Corporation (Cisco). No amounts were incurred to GATX and Cisco for operating leases in 1997. Total operating expenses for the year ended December 31, 1998 include $1.6 million of operating lease expense to GATX. Total operating expenses for the year ended December 31, 1999 include $21.6 million of operating lease expense to GATX and Cisco. Item 7 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations All statements contained within the Management's Discussion and Analysis of Financial Condition and Results of Operations that are not statements of historical fact constitute "Forward-Looking Statements" within the meaning of Section 21E of the Securities Exchange Act. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that could cause the actual results of the Company to be materially different from historical results or from any future results expressed or implied by such forward-looking statements. Readers are urged to consider statements that include the terms "believe", "belief", "expects", "plans", "anticipates", "intends" or the like to be uncertain and forward-looking. Forward-looking statements also include projections of financial performance, statements regarding management's plans and objectives and statements concerning any assumptions relating to the foregoing. Certain important factors regarding the Company's business, operations and competitive environment, which may cause actual results to vary materially from these forward-looking statements, are discussed above under the caption "Risk Factors" Overview We are a leading service provider of broadband local access communication services to businesses and consumers. We began offering commercial services in the United States in April 1998. As of December 31, 1999, we offered our services in 38 markets and 67 of the largest of the 314 Metropolitan Statistical Areas (MSAs) in the U.S., and our national DSL network passed 30 million homes and businesses. We intend to continue our network rollout into an additional 32 markets and 41 MSAs by the end of 2000. Since our inception in February 1997, our primary activities have consisted of: . obtaining required governmental authorizations; . negotiating and executing interconnection agreements with incumbent carriers; . entering into strategic alliances; . identifying collocation space and locations for our connection points, Metro Service Centers and business offices; . acquiring and deploying equipment and facilities; . launching service trials; . hiring management and other personnel; . raising capital; . forming a joint venture company, Rhythms Canada, to develop a Canadian DSL network; . adding end user subscribers to our network; . conducting various marketing and sales activities; . launching a national brand campaign; . creating and expanding relationships with broadband service providers; . implementing process improvement and quality programs; and . developing and integrating our operations support system and other back office systems. During 1999, we continued the development of our business operations as follows: . entered 28 new markets for a total of 38 markets at December 31, 1999; . added 1,025 central office locations for a total of 1,225 central offices at December 31, 1999; . added 12,000 DSL lines for a total of 12,500 DSL lines at December 31, 1999; and . increased headcount by 1,090 employees for a total of approximately 1,250 employees at December 31, 1999. We have incurred operating losses, net losses and negative operating cash flow for each month since our formation. As of December 31, 1999, we had an accumulated deficit of $257.6 million. We intend to substantially increase our capital expenditures and operating expenses in an effort to rapidly expand our network infrastructure, network features and applications, and add end user subscribers. We expect to incur substantial operating losses, net losses and negative cash flow during our network build and initial penetration of each new market we enter. These losses are expected to continue for at least the next several years. Factors Affecting Operations Revenue The following factors affect our revenue: . Service Offerings. We derive a majority of our operating revenue from broadband local connection services, metropolitan area inter-network connection services and installation. For broadband local connection services, we bill our customers a flat rate, monthly recurring charge based on the data transfer speeds selected by the end user. We also bill our broadband local connection services customers for nonrecurring service activation and installation charges on each line. For our metropolitan area internetwork connection services, we bill fixed, monthly recurring charges and nonrecurring charges to each customer for the high-speed connection between our Metro Service Center and the customer's router or switch. To encourage potential customers to adopt our services, we sometimes offer reduced metropolitan area internetwork connection service prices for an initial period of time. In some situations, we reduce the nonrecurring service activation and installation charges on our broadband local connection services for customers who sign long-term contracts of greater than 12 months. We expect that, as a result of competitive forces and our evolving service offerings, our prices will decline over time. We expect that the mix of services our customers purchase from us will change from time to time and that a mix more heavily weighted toward the lower priced services would reduce the average revenue per end-user subscriber. . Number and Penetration of Target Markets. The total number of markets in which we choose to provide our service offerings, as well as the penetration within each market, will affect our revenues. We base our target market assessment on the number of local area networks in each market, which we believe is the best indication of data-intensive business density and potential customers for our service offerings. For each target market, we expect to collocate in the appropriate number of incumbent local exchange carrier (ILEC) central offices to cover 70% of the total market opportunity within the metropolitan area. . Turnover. To date, our customer turnover has been minimal. We expect this to increase in the future as competition intensifies. Network and Service Costs Our network and service costs are generally composed of the following: . End-User Subscriber Installation Charges. In each market, we require a number of field service technicians to perform installation services at end-user locations. We currently outsource most of this function. . Customer Premise Equipment. We provide a DSL modem or router for use at the end user's location. We purchase this equipment from various DSL equipment providers. . Monthly Recurring and Nonrecurring Line and Service Charges. We pay ILECs a one-time installation and activation fee and a monthly service fee for each copper telephone line. . Metropolitan Area Network Transport Charges. We incur monthly recurring and nonrecurring charges for transport between our connection points and our Metro Service Centers. These charges are typically for DS-3 services from a competitive local exchange carrier (CLEC) or ILEC. These charges also include metropolitan area internetwork connections to our network. . Network Facilities Operating Expenses. We incur various monthly recurring costs at our connection points and Metro Service Centers. These costs include facility rent and utility costs. . Wide Area Network Connection Charges. We pay interexchange carriers a one-time installation and activation fee and a monthly service fee for leasing wide area network connections over a frame relay or Asynchronous Transfer Mode (ATM) network. . Equipment Operating Lease Expenses. We currently take advantage of short-term operating leases to finance the acquisition of substantially all of our network equipment, including DSL multiplexers, ATM switches and routers. . Line Repair and Support Costs. Similar to other telecommunication providers, we estimate that a small percentage of our lines may require repair or support. These costs will consist of field dispatch labor and a portion of our Network Operations Center costs. Selling, Marketing, General and Administrative Our selling, marketing, general and administrative expenses include customer service and technical support, information systems, billing and collections, general management and overhead, and administrative functions. Headcount in functional areas, such as customer service, engineering and operations, will increase as we expand our network, and add new customers and end-user subscribers. . Selling and Marketing Costs. Our sales and marketing efforts focus on attracting and retaining broadband service providers and business customers, adding end-users to our network, and building and maintaining our brand. . General and Administrative Costs. As we expand our network, we expect the number of employees located in specific markets to grow. We also use outside contractors, in addition to our own employees, for certain activities. Certain functions, such as network operations, information systems, marketing, quality, national sales management, finance, billing and site planning, are likely to remain centralized in order to achieve economies of scale. Depreciation and Amortization Depreciation expense arises from the capitalization of our equipment and furniture. Collocation fees are capitalized and amortized over an estimated useful life of ten years. Results of Operations 1999 Compared to 1998 Revenue We recorded $11.1 million in revenue in 1999 compared to $0.5 million in revenue in 1998. Revenue consisted of net monthly recurring service fees of $7.5 million in 1999 compared to $0.3 million in 1998. Nonrecurring net installation revenue totaled $3.5 million for 1999 compared to $0.2 million in 1998. We recorded late fees of $0.1 million in 1999 compared to none in 1998. The substantial increase in revenue in 1999 is a result of our increased sales and marketing efforts and continued network deployment as more fully detailed above. Each new market we enter provides us with an additional revenue opportunity, but also higher costs until we have an established customer base in the market. Network and Service Costs Our network and service costs for 1999 were $68.2 million compared to $4.7 million in 1998. The significant increase in network and service costs in 1999 is a result of our continued network deployment as more fully detailed above. Selling, Marketing, General and Administrative Our selling, marketing, general and administrative expenses were $110.9 million in 1999, compared to $22.4 million for the same period one year ago. This increase reflects our continued growth in staffing levels, sales and marketing efforts, and legal expenses associated with the development and launch of new markets as more fully detailed above. Depreciation and Amortization Depreciation and amortization in 1999 was $12.6 million, a significant increase over the $1.1 million recorded in 1998. This increase reflects the rapid expansion of our network, as discussed above, and includes amortization of collocation fees and depreciation on operating equipment as we begin service in each new location. We expect depreciation and amortization to continue to increase in the future as we continue to expand our network. During the first and second quarters of 1999, we entered into strategic arrangements with Microsoft Corp. and Qwest Communications International Inc. In addition to their investments in our company totaling $45.0 million, the strategic arrangements provide for certain other business relationships. Combined, these business relationships along with certain warrant issuances are valued at $23.2 million and we have capitalized these costs as deferred assets. These assets are being amortized over three- and five-year periods. Accordingly, during 1999 we recorded $4.8 million in amortization for deferred business acquisition costs that have no corresponding amortization in the prior year. Deferred compensation expense increased to $3.7 million in 1999 as compared to $0.7 million for the same period one year ago and reflects the granting of stock options to our employees and officers with per share exercise prices below the per share fair values of our common stock at the dates of grant. We are amortizing the deferred compensation over the vesting period of the applicable options. Net Interest Income and Expense During 1999, we recorded interest income of $22.7 million, compared to $5.8 million in 1998. The increase between years resulted primarily from a substantial increase in invested cash balances. As of December 31, 1999, we had unrestricted cash and investments totaling $340.3 million, compared to unrestricted cash and investments of $136.8 million at December 31, 1998. The increase during 1999 resulted from a variety of financing activities, including: . issuing Series C and Series D preferred stock and warrants for cash proceeds totaling $75.0 million in March and April 1999; . issuing common stock upon our initial public offering in April 1999 for net cash proceeds of $210.1 million; . issuing 12 3/4% senior debt in April 1999 for net cash proceeds of $314.5 million; . executing additional equipment lease lines of $100.0 million; . issuing common stock upon our secondary public offering in September 1999 for net cash proceeds of $16.4 million. Interest expense and amortized debt discount and issue costs increased significantly to $52.5 million in 1999 as compared to $13.8 million in 1998. This increase primarily resulted from the senior notes we issued in April 1999. Income Taxes We generated net operating loss carryforwards of $2.1 million, $21.2 million, and $186.9 million in 1997, 1998, and 1999, respectively. We expect significant consolidated losses for the foreseeable future that will generate additional net operating loss carryforwards. However, our ability to use net operating losses may be subject to annual limitations. In addition, income taxes may be payable during this time due to operating income in certain tax jurisdictions. In the future, if we achieve operating profits and the net operating losses have been exhausted or have expired, we may incur significant tax expense. We continue to be in a net operating loss tax position through December 31, 1999; consequently, we have not recorded a provision for income taxes for periods through December 31, 1999. 1998 Compared to Period From February 27, 1997, (Inception) to December 31, 1997 Revenue We did not offer commercial services in 1997 and, as a result, did not record any revenue in 1997. During 1998, we continued the development of our business operations, commencing service in the San Diego market in April; the San Francisco, Oakland/East Bay and San Jose markets in July; the Los Angeles and Orange County markets in September and the Chicago market in October. We recorded revenue of $0.5 million during this period, which was primarily from DSL service and installation charges, net of discounts given to customers. Network and Service Costs Since we did not offer commercial services in 1997, we did not record any network or service costs in 1997. In 1998, we recorded network and service costs of $4.7 million. We expect network and service costs to increase significantly in future periods as we expand our network into additional markets. Selling, Marketing, General and Administrative From inception through December 31, 1997, selling, marketing, general and administrative expenses were $2.3 million and consisted primarily of salaries and legal and consulting fees incurred to establish a management team and develop our business. In 1998, we recorded selling, marketing, general and administrative expenses of $22.4 million. This increase is attributable to growth in staffing levels, increased marketing efforts coinciding with the launch of commercial services and increased legal fees associated with the development of additional markets. Depreciation and Amortization Depreciation from network equipment was minimal since substantially all of this equipment was leased. Depreciation and amortization was $1,000 for the period from inception through December 31, 1997, and was $1.1 million in 1998. The increase was due to the commencement of our operations in 1998. Other Income and Expense Other income and expense consists primarily of interest income from our cash and short-term investments and interest expense associated with our debt. From inception through December 31, 1997, net interest income was $0.1 million, which was primarily attributable to the interest income earned from the proceeds raised in our Series A preferred stock financing. In 1998, we recorded net interest expense of $8.0 million, consisting of interest income of $5.8 million generated from invested cash balances, offset by $13.8 million in interest expense. The increase in the interest expense is substantially due to the accretion of interest on the senior discount notes issued in May 1998. Income Taxes We generated net operating loss carryforwards of $2.1 million from inception to December 31, 1997, and $21.2 million during 1998. We expect significant consolidated losses for the foreseeable future which will generate additional net operating loss carryforwards. However, our ability to use net operating losses may be subject to annual limitations. In addition, income taxes may be payable during this time due to operating income in certain tax jurisdictions ons. In the future, if we achieve operating profits and the net operating losses have been exhausted or have expired, we may incur significant tax expense. We recognized no provision for taxes because we operated at a loss throughout 1997 and 1998. Liquidity and Capital Resources We have substantial indebtedness and debt service obligations. As of December 31, 1999, we had $506.1 million of total indebtedness. In addition, the development and expansion of our business requires significant capital expenditures. These capital expenditures primarily include network build costs such as the procurement, design and construction of our connection points and one or two Metro Service Center locations in each market, as well as other costs that support our network design. The number of targeted central offices in each market varies, as does the average capital cost to build our connection points in such market. Capital expenditures, including payments for collocation fees, were $193.3 million in 1999. We expect our capital expenditures to be higher in future periods, arising primarily from payments of collocation fees and the purchase of infrastructure equipment necessary for the development and expansion of our network. Through December 31, 1999, we have financed our operations and network primarily through: . private placements of equity totaling $105.8 million, net; executing equipment lease lines totaling $126.5 million; . issuing 13 1/2% senior discount notes in May 1998 for $144.0 million in netproceeds; . issuing common stock in April 1999 in our initial public offering for $210.1 million in net proceeds; . issuing 12 3/4% senior notes in April 1999 for $314.5 million in . net proceeds; . issuing common stock in September 1999 in a secondary public offering for $16.4 million in net proceeds Subsequent to December 31, 1999, we have: . increased equipment lease lines by an aggregate of $75 million; . issued 14% senior notes in February 2000 for $291.3 million in net proceeds; and . issued 6 3/4% Series F cumulative convertible preferred stock in February and March 2000 for $291.0 million in net proceeds. . issued $250 million of Series E convertible preferred stock to Hicks Muse in a privately negotiated transaction in March 2000; Refer to Note 10 of the accompanying consolidated financial statements for terms and descriptions of these transactions. The indentures for the 1998 senior discount notes and the 1999 and 2000 senior notes contain covenants that limit our ability to: . pay dividends on, redeem or repurchase our capital stock; . incur additional debt; . make investments; . consolidate, merge or transfer all or substantially all of our assets; and . make dividend or other payments to us by our restricted subsidiaries. As of December 31, 1999, we had $436.5 million in cash and investments and we had an accumulated deficit of $257.6 million. Of this cash, $96.2 million is restricted in accordance with the terms of the 1999 senior notes. In 1999, the net cash used in our operating activities was $153.8 million. This cash was used for a variety of operating purposes, including salaries, consulting and legal expenses, network operations and overhead expenses. Our net cash used for investing activities in 1999 was $471.4 million and was used primarily for purchases of short-term investments and equipment and payments of collocation fees. Net cash provided by financing activities in 1999 was $652.1 million and primarily came from the issuance of equity and senior notes as described above. In 1998, the net cash used in our operating activities was $19.0 million. This cash was used for a variety of operating purposes, including salaries, consulting and legal expenses, network operations and overhead expenses. Our net cash used for investing activities in 1998 was $139.0 million and was used primarily for purchases of short-term investments and equipment and payments of collocation fees. Net cash provided by financing activities in 1998 was $169.2 million and primarily came from the issuance of the senior discount notes and from the issuance of preferred stock. Since inception through December 31, 1997, the net cash used in our operating activities was $1.6 million. The net cash used for operations was primarily due to working capital requirements and net losses, partially offset by increases in accounts payable and accrued expenses. Our net cash used for investing activities for the period ended December 31, 1997 was $1.3 million. This cash was used for purchases of equipment and collocation fees. Net cash provided by financing activities for the period ended December 31, 1997 was $13.1 million and primarily came from the issuance of preferred stock and proceeds from bank borrowings. Our capital requirements may vary based upon the timing and success of our rollout and as a result of regulatory, technological and competitive developments, or if: . demand for our services or our anticipated cash flow from operations is less or more than expected; . our development plans or projections change or prove to be inaccurate; . we engage in any acquisitions; or . we accelerate deployment of our network services or otherwise alter the schedule or targets of our rollout plan. We believe that our cash and investment balances as of December 31, 1999, together with the proceeds of the events subsequent to December 31, 1999, and anticipated future revenue generated from operations, will be sufficient to fund our operating losses, capital expenditures, lease payments and interest payments through approximately December 2001. We expect our operating losses and capital expenditures to increase substantially in the near-term, primarily due to our network expansion. We expect that significant additional financing will be required in the future. We may attempt to raise financing through some combination of commercial bank borrowings, leasing, vendor financings, or the private or public sale of equity or debt securities. Future equity or debt financings may not be available to us at all or, if available, may not be on favorable terms. If we are unable to obtain financing in the future, we will continue the expansion of our operations on a reduced scale based on our existing capital resources. Impact of the Year 2000 Issue Many computer programs have been written using two digits rather than four to define the applicable year. This posed a problem at the end of the century because these computer programs might recognize a date using "00" as the year 1900 rather than the year 2000. This, in turn, could have resulted in major system failures or miscalculations, and was generally referred to as the "Year 2000 issue." We formulated and, to a large extent, effected a plan to address our Year 2000 issues. We are not currently aware of any Year 2000 compliance problems relating to our systems that would have a material adverse effect on our business, financial condition and operating results. In response to the Year 2000 issue we implemented changes to our existing information technology systems through a combination of modifications and upgrades to Year 2000 compliant software. We evaluated our non-information technology systems and believe these systems are Year 2000 compliant. We incurred minimal costs associated with identifying and addressing Year 2000 compliance. The Year 2000 issue did not have a material adverse effect on our business, financial condition or operating results. However, despite all our efforts to date toward ensuring Year 2000 compliance, latent issues may still surface in the future. Item 8 Item 8 - Financial Statements and Supplementary Data The financial statements required pursuant to this item are included in Item 14 of this Form-10K and are presented beginning on page. Item 9 Item 9 - Change in and Disagreements with Accountants Not applicable. Item 10 Item 10 - Directors and Executive Officers of the Company The information required by this item concerning the Company's directors, is incorporated by reference to the information set forth in the Company's proxy statement (2000 Proxy Statement) for the 2000 annual meeting of stockholders to be filed with the SEC within 120 days after the end of the Company's fiscal year ended December 31, 1999 Item 11 Item 11 - Executive Compensation The information required by this item regarding executive compensation is incorporated by reference to the information set forth in the Company's 2000 Proxy Statement. Item 12 Item 12 - Security Ownership of Certain Beneficial Owners and Management The information required by this item regarding security ownership of certain beneficial owners and management is incorporated by reference to the information set forth in the Company's 2000 Proxy Statement. Item 13 Item 13 - Certain Relationships and Related Transactions The information required by this item regarding certain relationships and related transactions is incorporated by reference to the information set forth in the Company's 2000 Proxy Statement. Item 14 Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K Financial Statements: Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Operations and Comprehensive Income for the period from February 27, 1997, (Inception) through December 31, 1997 and the years ended December 31, 1998 and 1999 Consolidated Statements of Stockholders' Equity for the period from February 27, 1997, (Inception) through December 31, 1997 and the years ended December 31, 1998 and 1999 Consolidated Statements of Cash Flows for the period from February 27, 1997, (Inception), through December 31, 1997 and the years ended December 31, 1998 and 1999 Financial Statement Schedules: Report of Independent Accountants On Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts All other schedules have been omitted because the information is not required or is included in the consolidated financial statements Exhibits: 3.1** Restated Certificate of Incorporation of the Company. 3.2** Certificate of Designation of Series 1 Junior Participating Preferred Stock of Company. 3.3** Restated Bylaws of the Company. 3.4 Certificate of Designation of 6 3/4% Series F Convertible Preferred Stock. 3.5 Certificate of Designation of 8.25% Series E Convertible Preferred Stock. 4.1** Form of Certificate of common stock. 4.2* Indenture, dated as of May 5, 1998, by and between the Company and State Street Bank and Trust Company of California, N.A., as trustee, including form of the Company's 13 1/2% Senior Discount Notes due 2008, Series A and form of Company's 13 1/2% Senior Discount Notes due 2008, Series B. 4.3* Warrant Agreement, dated as of May 5, 1998, by and between the Company and State Street Bank and Trust Company of California, N.A. 4.4* Warrant Registration Rights Agreement, dated as of May 5, 1998, by and among the Company and Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated, and Donaldson, Lufkin & Jenrette Securities Corporation. 4.5** Warrant to Purchase Shares of Common Stock, dated May 19, 1998, by and between the Company and Sun Financial Group, Inc. 4.6** Common Stock Purchase Warrant, dated March 3, 1999, by and between the Company and MCI WorldCom Venture Fund, Inc. 4.7** Common Stock Purchase Warrant, dated March 16, 1999, by and between the Company and Microsoft Corporation. 4.8** Warrant to Purchase Shares of Common Stock, dated March 31, 1999, by and between Company and GATX Capital Corporation. 4.9** Warrant Purchase Agreement, dated as of April 6, 1999, by and between Company and MCI WorldCom Venture Fund, Inc. 4.10** Common Stock Purchase Warrant, dated April 6, 1999, by and among Company and MCI WorldCom Venture Fund, Inc. 4.11** Common Stock Purchase Warrant, dated April 6, 1999, by and among the Company and U.S. Telesource, Inc. 4.12** Common Stock Purchase Warrant, dated April 5, 1999, by and among Company and Cisco Systems Capital Corporation. 4.13** Rights Agreement, dated April 2, 1999, by and among Company and American Securities Transfer & Trust, Inc. 4.14*** Indenture, dated as of April 23, 1999, by and between the Company and State Street Bank and Trust Company of California, N.A., as trustee, including form of the Company's 12 3/4% Senior Notes due 2009, Series A and form of the Company's 12 3/4% Senior Notes due 2009, Series B 4.15*** Notes Registration Rights Agreement, dated as of April 23, 1999, by and among the Company and Merrill Lynch & Co., Merrill Lynch, Pierce Fenner & Smith Incorporated, Salomon Smith Barney Inc. and Chase Securities Inc. 4.16*** Pledge and Escrow Agreement, dated as of April 23, 1999, from the Company as Pledgor to State Street Bank and Trust Company of California, N.A., as trustee. 4.17**** Amendment No. 1 to Warrant Agreement, dated as of August , 1999 between the Company and State Street Bank and Trust Company of California, N.A. 4.18 Indenture, dated February 23, 2000. by and between the Company and State Street Bank and Trust Company of California, N.A., as trustee, including form of the Company's 14% Senior Notes due 2010, Series A and form of the Company's 14$ Senior Notes due 2010, Series B. 4.19 Notes Registration Rights Agreement, dated as of February 23, 2000, among the Company, Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner and Smith Incorporated, and Salomon Smith Barney Inc., Chase Securities Inc., and Credit Suisse First Boston. 4.20 Registration Rights Agreement, dated March 3, 2000, by and among the Company and Merrill Lynch, Pierce, Fenner and Smith Incorporated and Salomon Smith Barney Inc. 4.21 Registration Rights Agreement, dated March 16, 2000, by and among the Company and the entities listed on Schedule I thereto. 9.1* Voting Trust Agreement, dated as of May 5, 1998, by and among Sprout Capital VII, L.P., Donaldson Lufkin & Jenrette Securities Corporation, and First Union Trust Company, National Association, as trustee. 9.2* Voting Trust Agreement, dated as of March 12, 1998, by and between Enron Communications Group, Inc. and the Company, as trustee. 10.1* Series A Preferred Stock Purchase Agreement, dated July 3, 1997, by and among the Company and the Investors listed on Schedule A thereto. 10.2* Subsequent Closing Purchase Agreement, dated December 23, 1997, by and among the Company and the Investors listed on Schedule A thereto. 10.3* Series B Preferred Stock Purchase Agreement, dated March 12, 1998, by and among the Company and the Investors listed on Schedule A thereto. 10.4** Enterprise Services Solution Agreement between Cisco Systems, Inc. and the Company, dated December 3, 1998 10.5** Series C Preferred Stock Purchase Agreement, dated March 3, 1999, by and among the Company and MCI WorldCom Venture Fund, Inc. 10.6** Amended and Restated Investors' Rights Agreement, dated March 3, 1999, by and among the Company and the Investors listed on Schedule A thereto. 10.7** Agreement, dated March 3, 1999, by and between the Company and MCI WorldCom, Inc. 10.8** Series C Preferred Stock and Warrant Purchase Agreement, dated March 16, 1999, by and among the Company and Microsoft Corporation. 10.9** Amended and Restated Investors' Rights Agreement, dated March 16, 1999, by and among the Company and the Investors listed on Schedule A thereto. 10.10** Distribution Agreement, dated March 16, 1999, by and among the Company and Microsoft Corporation. 10.11* Master Lease Agreement No. 1642 and Addendum thereto, each dated November 19, 1997, and Second Addendum thereto, dated as of May 19, 1998, between the Company and Sun Financial Group, Inc. 10.12** Business Lease (Single Tenant) between the Company and BR Venture, LLC dated September 1998. 10.13* Employment Agreement between the Company and Catherine M. Hapka, dated June 10, 1997. 10.14* 1997 Stock Option/Stock Issuance Plan. 10.15** 1999 Stock Incentive Plan. 10.16** 1999 Employee Stock Purchase Plan. 10.17* Form of Indemnification Agreement between the Company and each of its directors. 10.18* Form of Indemnification Agreement between the Company and each of its officers. 10.19* QuickStart Loan and Security Agreement, dated October 29, 1997, between the Company and Silicon Valley Bank. 10.20** Third Addendum, dated March 31, 1999, to Master Lease Agreement, dated November 19, 1997, by and among Company and GATX Capital Corporation 10.21** Master Lease Agreement, dated March 31, 1999, by and among Company and GATX Capital Corporation. 10.22** First Addendum, dated March 31, 1999, to Master Lease Agreement, dated March 31, 1999, by and among Company and GATX Capital Corporation. 10.23** Amendment No. 1, dated April 6, 1999, to Framework Agreement, dated March 3, 1999, by and among the Company and MCI WorldCom, Inc. 10.24** Series C Preferred Stock and Warrant Purchase Agreement, dated April 6, 1999, by and among the Company and U.S Telesource, Inc. 10.25** Series D Preferred Stock Purchase Agreement, dated April 6, 1999, by and among the Company and the Investors listed on Schedule A thereto. 10.26** Amended and Restated Investors' Rights Agreement, dated April 6, 1999, by and among the Company and the Investors listed on Schedule A thereto. 10.27** Lease Agreement, dated April 5, 1999, by and among the Company and Cisco Systems Capital Corporation. 10.28*** Amendment No. 2, dated May 10, 1999, to Framework Agreement, dated March 3, 1999, by and among the Company and MCI WorldCom, Inc. 10.29**** Employment Agreement with Steve Stringer. 10.30**** Employment Agreement with Michael Lanier. 10.31 *****Master Lease Agreement, dated July 30, 1999, by and between the Company and GATX Capital Corporation 10.32 ****** ACI Plus Service Agreement, dated April 6, 1999, by and between the Company and Qwest Communications Corporation. 10.33 Joint Venture Agreement, dated January 1, 2000, by and between the Company, Rhtyms Links, Inc. and Optel Communications Corporation. 10.34 Preferred Stock and Warrant Purchase Agreement, dated February 6, 2000 by and between the Company and the Purchasers listed on Schedule I thereto. 10.35 Purchase Agreement, dated February 16, 2000, by and between the Company and the Initial Purchasers listed on Schedule I thereto. 10.36 Purchase Agreement, dated February 28, 2000 by and between the Company and Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated and Salomon Smith Barney Inc. 10.37 Employment Agreement with David J. Shimp. 10.38 Employment Agreement with Scott C. Chandler. 21.1** Subsidiaries of the Company. 23.1 Consent of PricewaterhouseCoopers 24.1 Powers of Attorney (included on signature page). 99.3**** Plus Service Agreement, dated April 6, 1999, by and between the Company and Qwest Communications Corporation. * Previously filed with the Commission as an exhibit to the registration statement on Form S-4 (File No. 333-59393) and incorporated herein by reference. II-6 **Previously filed with the Commission as an exhibit to the registration statement on Form S-1 (File No. 333-72409) and incorporated herein by reference. *** Previously filed with the Commission as an exhibit to the registration statement on Form S-4 (File No. 333-82637) and incorporated herein by reference. ****Previously filed with the Commission as an exhibit to the registration statement on Form S-1 (File No. 333-82867) and incorporated herein by reference. *****Previously filed with the Commission as an exhibit to Form 10-Q filed November 11, 1999 and incorporated herein by reference. ******Previously filed with the Commission as an exhibit to Form 10-Q filed August 11, 1999 and incorporated herein by reference. Reports on Form 8-K 1. The Company filed no current reports on Form 8-K in the fourth quarter ended December 31, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the securities exchange act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. RHYTHMS NETCONNECTIONS INC. Date: March 29, 2000 By: /s/ Scott C. Chandler ------------------------------------- Scott C. Chandler, Chief Financial Officer (Principal Financial and Accounting Officer) Know all men by these presents, that each person whose signature appears below constitutes and appoints Catherine M. Hapka or Scott C. Chandler, his or her attorney-in-fact, with power of substitution in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that the attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 29, 2000 By: /s/ Catherine M. Hapka ------------------------------------- Catherine M. Hapka, Chairman and Chief Executive Officer Date: March 29, 2000 By: /s/ Steve Stringer ------------------------------------- Steve Stringer, President and Chief Operating Officer Date: March 29, 2000 By: /s/ Scott C. Chandler ------------------------------------- Scott C. Chandler, Chief Financial Officer Date: March 29, 2000 By: /s/ Kevin R. Compton ------------------------------------- Kevin R. Compton Director Date: March 29, 2000 By: /s/ Susan Mayer ------------------------------------- Susan Mayer, Director Date: March 29, 2000 By: /s/ William R. Stensrud ------------------------------------- William R. Stensrud, Director Date: March 29, 2000 By: /s/ John L. Walecka --------------------------- John L. Walecka, Director Date: March 29, 2000 By: /s/ Edward J. Zander ---------------------------- Edward J. Zander, Director ----------------------------- RHYTHMS NETCONNECTIONS INC. Contents Report of Independent Accountants............................................F-1 Financial Statements: Consolidated Balance Sheets..........................................F-2 Consolidated Statements of Operations................................F-3 Consolidated Statements of Cash Flows................................F-4 Consolidated Statements of Stockholders' Equity......................F-5 Notes to Consolidated Financial Statements...........................F-7 Report of Independent Accountants To the Board of Directors and Stockholders of Rhythms NetConnections Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, of cash flows, and of stockholders' equity present fairly, in all material respects, the financial position of Rhythms NetConnections Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for the period from February 27, 1997, (Inception) through December 31, 1997, and for each of the two years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP February 29, 2000, except for Note 10, as to which the date is March 16, 2000 RHYTHMS NETCONNECTIONS INC. CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts) The accompanying notes are an integral part of these consolidated financial statements. RHYTHMS NETCONNECTIONS INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (In thousands, except share and per share amounts) The accompanying notes are an integral part of these consolidated financial statements. RHYTHMS NETCONNECTIONS INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) The accompanying notes are an integral part of these consolidated financial statements. RHYTHMS NETCONNECTIONS INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (In thousands, except share amounts) The accompanying notes are an integral part of these consolidated financial statements. RHYTHMS NETCONNECTIONS INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (In thousands, except share amounts) The accompanying notes are an integral part of these consolidated financial statements. RHYTHMS NETCONNECTIONS INC. Notes to Consolidated Financial Statements 1. THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Operations Rhythms NetConnections Inc. (the Company), a Delaware corporation, was organized under the name Accelerated Connections Inc. effective February 27, 1997. The Company's name was changed to Rhythms NetConnections Inc. as of August 15, 1997. The Company is in the business of providing broadband local access communication services to businesses and consumers. The Company's services include high-speed "always on" connections to the Internet and to private networks. The Company began offering commercial services in the U.S. in April 1998. The Company's ultimate success depends upon, among other factors, rapidly expanding the geographic coverage of its network services; entering into interconnection agreements with ILECs, some of which are competitors or potential competitors of the Company; deploying network infrastructure; attracting and retaining customers; accurately assessing potential markets; continuing to develop and integrate its operational support system and other back office systems; obtaining any required governmental authorizations; responding to competitive developments; continuing to attract, retain and motivate qualified personnel; and continuing to upgrade its technologies and commercialize its network services incorporating such technologies. There can be no assurance that the Company will be successful in addressing these matters and failure to do so could have a material adverse effect on the Company's business, prospects, operating results and financial condition. As the Company continues the development of its business, it will seek additional sources of financing to fund its development. If unsuccessful in obtaining such financing, the Company will continue expansion of its operations on a reduced scale based on its existing capital resources. Principles of Consolidation and Basis of Presentation The accompanying consolidated financial statements include the transactions and balances of Rhythms NetConnections Inc. and its wholly owned subsidiaries Rhythms Links Inc. and Rhythms Links Inc. - Virginia (since February 1998). All significant intercompany balances and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates and assumptions. Revenue Recognition Revenue consists of recurring fees for monthly DSL service, and nonrecurring fees for equipment and installation. Customer contracts are renewable and range from one to three years in duration with payments due on a monthly basis. Monthly recurring service revenue is recorded in the month the services are rendered. Revenue for installations is recognized to the extent of installation costs in the month incurred. Costs in excess of revenue related to installation services are deferred and amortized to network and service costs on a straight- line basis over the term of the customer contracts. Cash and Cash Equivalents Cash and cash equivalents include cash on hand, money market funds, certificates of deposit, obligations of the U.S. government and its agencies and commercial paper with a maturity of three months or less at the time of purchase. Included in accounts payable are outstanding checks in excess of cash balances of $8.5 million at December 31, 1999. Short-Term Investments Short-term investments consist of obligations of the U.S. government and its agencies and commercial paper that have a maturity between 91 days and one year from the date of purchase. Management determines the appropriate classification of marketable debt and equity securities at the time of purchase. Restricted Cash Restricted cash is made up of a portfolio of U.S. government securities purchased to secure payment of the first six scheduled interest payments on the 1999 senior notes. Fair Value of Financial Instruments The carrying amounts reported in the balance sheets for cash and cash equivalents, short-term investments, accounts receivable, and accounts payable approximate fair value because of the immediate or short-term maturity of these financial instruments. The carrying amounts reported for long-term debt other than the 12 3/4% senior notes and 13 1/2% senior discount notes approximate fair value based upon management's best estimates of what interest rates would be available for the same or similar instruments. The senior notes are publicly traded securities. The combined quoted fair market value and the combined carrying amount of the senior notes at December 31, 1999 are $471.9 million and $505.7 million, respectively. Investment in OCI Communications Inc. On October 29, 1999, the Company completed a strategic investment in OCI Communications Inc. (OCI), a provider of telecommunications services in Canada. In exchange for a $5.3 million cash investment, the Company received warrants convertible into 763,680 shares of Class B non-voting stock in OCI. These warrants were converted in December 1999. As part of this investment, the Company received various rights, including the ability to appoint a representative to OCI's Board of Directors, among others. This investment is classified as an available-for-sale security and is carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. As part of this strategic relationship, in January 2000, the Company formed a joint venture with OCI to offer DSL-based services in selected Canadian markets. See Note 10. Inventory Inventory consists of communications equipment that will be installed at customer locations. Inventory is accounted for using the first-in, first-out method at the lower of cost or market. Equipment and Furniture Equipment and furniture consists of purchased equipment, furniture, computer software, and leasehold improvements. Equipment and furniture is recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally three to seven years or the lease term, if shorter. When equipment and furniture are retired, sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and gains and losses resulting from such transactions are reflected in operations. Collocation Fees Collocation fees represent nonrecurring fees paid to secure central office space for location of certain Company equipment. The fees are amortized over their estimated useful lives of ten years. Impairment of Long-Lived Assets The Company investigates potential impairments of its long-lived assets on an exception basis when evidence exists that events or changes in circumstances may have made recovery of an asset's carrying value unlikely. An impairment loss is recognized when the sum of the expected undiscounted future net cash flows is less than the carrying amount of the asset. No such losses have been identified. Concentrations of Credit Risk Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash equivalents and short-term investments. Cash in excess of operating requirements is conservatively invested in money market funds, certificates of deposit with high quality financial institutions, obligations of the U.S. government and its agencies, and commercial paper rated A-1, P-1 to minimize risk. At December 31, 1998 and 1999, accounts receivable balances from two significant customers were 22.4% and 33.2%, respectively, of the total net accounts receivable balance and 50.4% and 40.8%, respectively, of revenues. Ongoing credit evaluations of customers' financial condition are performed and, generally, no collateral is required. The Company maintains an allowance for potential credit losses and such losses, in the aggregate, have not exceeded management's expectations. At December 31, 1998 and 1999, the allowance for doubtful accounts was $50,000 and $0.4 million, respectively. The Company's customer base is widespread geographically. Advertising Costs Advertising costs are expensed as incurred. Approximately $0.7 million and $6.9 million of advertising costs were incurred in 1998 and 1999,respectively. No such material amounts were incurred in 1997. Income Taxes The Company provides for income taxes utilizing the liability method. Under the liability method, current income tax expense or benefit represents income taxes expected to be payable or refundable for the current period. Deferred income tax assets and liabilities are established for both the impact of differences between the financial reporting bases and tax bases of assets and liabilities and for the expected future tax benefit to be derived from tax credits and tax loss carryforwards. Deferred income tax expense or benefit represents the change during the reporting period in the net deferred income tax assets and liabilities. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Net Loss Per Share Basic earnings per share (EPS) is calculated by dividing the income or loss available to common stockholders by the weighted average number of common shares outstanding for the period without consideration for common stock equivalents. Diluted EPS is computed by dividing the income or loss available to common stockholders by the weighted average number of common shares outstanding for the period in addition to the weighted average number of common stock equivalents outstanding for the period. Shares subject to repurchase by the Company are considered common stock equivalents for purposes of this calculation. Shares issuable upon conversion of the Series A and Series B preferred stock, upon the exercise of outstanding stock options and warrants and shares issued subject to repurchase by the Company totaling 36,653,940 and 52,958,513, at December 31, 1997 and 1998, respectively, have been excluded from the computation since their effect would be antidilutive. Shares issuable upon conversion of the exercise of outstanding stock options and warrants and shares issued subject to repurchase by the Company totaling 6,897,060 at December 31, 1999 have been excluded from the computation since their effect would be antidilutive. Stock Options and Stock Purchase Warrants Accounting Principles Board Opinion 25, "Accounting for Stock Issued to Employees," is applied in accounting for all employee stock option and stock purchase warrant arrangements. Compensation cost is recognized for all stock options and stock purchase warrants granted to employees when the exercise price is less than the market price of the underlying common stock on the date of grant. Statement of Financial Accounting Standards No. 123 (SFAS No. 123), "Accounting for Stock-Based Compensation" requires pro forma disclosures regarding earnings (loss) as if compensation cost for stock options and stock purchase warrants had been determined in accordance with the fair value based method prescribed in SFAS No.123. Estimates of the fair market value are made for each stock option and stock purchase warrant at the date of grant by the use of the Black-Scholes option pricing model. New Accounting Pronouncements In December 1999, the SEC issued Staff Accounting Bulletin No. 101 (SAB No. 101), "Revenue Recognition in Financial Statements." SAB 101 provides specific guidance, among other things, as to the recognition of revenue related to up- front non-refundable fees and services charges received in connection with a contractual arrangement. The Company will adopt SAB No. 101 as required in 2000. The Company is in the process of evaluating the impact on its consolidated financial statements. In June 1998, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued. This statement establishes accounting and reporting standards for derivative instruments and for hedging activities. The Company will adopt SFAS No. 133 as required in 2001. The Company expects that adoption will have no impact on the consolidated financial statements. Reclassifications Certain balances in the 1997 and 1998 financial statements have been reclassified to conform to the 1999 presentation. The reclassifications had no effect on financial condition, results of operations or cash flows. 2. SHORT-TERM INVESTMENTS The Company's marketable debt securities are classified as held-to-maturity and carried at amortized cost, which approximates fair value. Short-term investments consist of the following: -------------------------------------------------------------------- December 31, ------------------------ (In thousands) 1998 1999 -------------------------------------------------------------------- Short-term investments: Commercial paper $ 33,170 $ 75,902 U.S. government securities 82,327 216,106 -------------------------------------------------------------------- $ 115,497 $ 292,008 -------------------------------------------------------------------- 3. COMPOSITION OF CERTAIN BALANCE SHEET COMPONENTS 4. DEBT Outstanding debt consists of the following: (a) Cash proceeds from the issuance of the 1999 senior notes were approximately $314.5 million of which approximately $113.2 million was used to purchase a portfolio of U.S. government securities to secure payment of the first six scheduled interest payments on the 1999 senior notes. These senior notes are unsecured obligations of the Company and mature on April 15, 2009. The notes are redeemable at the Company's option, in whole or in part, at any time after April 15, 2004, at predetermined redemption prices, together with any accrued and unpaid interest through the date of redemption. Upon a change of control, each holder of the senior notes may require the Company to purchase the notes at 101% of the principal amount thereof, plus any accrued and unpaid interest to the date of purchase. The 1999 senior notes contain restrictive covenants, including limitations on future indebtedness, restricted payments, transactions with affiliates, liens, sale of stock of subsidiaries, entering new lines of business, dividends, mergers and transfers of assets. (b) The sale of the 1998 senior discount notes included warrants to purchase 4,732,800 shares of common stock at an exercise price of $0.004 per share. The notes were issued at a discount and cash proceeds from the issuance of the notes and warrants were $150.4 million. The value ascribed to the warrants of $6.6 million resulted in additional debt discount. The debt issue costs are being amortized to interest expense using the effective interest method over the period that the notes are outstanding. The notes will accrete in value through May 15, 2003, at a rate of 13 1/2% per annum, compounded semi-annually; no cash interest will be payable prior to that date. Upon a change in control or upon certain asset sales, the Company must offer to repurchase all or a portion of the outstanding notes. In addition, the Company has the option to repurchase the notes upon payment of a premium of accreted value at that point in time. The notes contain restrictive covenants including limitations on future indebtedness, restricted payments, transactions with affiliates, liens, sale of stock of subsidiaries, dividends, mergers and transfers of assets. Effective November 20, 1998, the Company completed an exchange offer of the 13 1/2% senior discount notes that allowed for registration of such notes under the Securities Act of 1933, as amended. Of the original issue notes, $289.0 million were tendered for exchange. The registered notes have substantially the same terms and conditions as the unregistered notes, except that the registered notes are not subject to the restrictions on resale or transfer that applied to the unregistered notes. Effective September 17, 1999, the Company completed an exchange offer of the 12 3/4% senior discount notes that allowed for registration of such notes under the Securities Act of 1933, as amended. The original issue notes of $325.0 million were tendered for exchange. The registered notes have substantially the same terms and conditions as the unregistered notes, except that the registered notes are not subject to the restrictions on resale or transfer that applied to the unregistered notes. Future maturities of outstanding debt are $0.3 million in 2000, $0.1 million in 2001, none in 2002, none in 2003, none in 2004, and $615.0 million thereafter. 5. STOCKHOLDERS' EQUITY The Company was initially capitalized in February 1997 with common stock. On July 3, 1997, the Company issued 12,280,000 shares of its Series A preferred stock to new and existing investors for an aggregate purchase price of $12.3 million, which converted into 29,472,000 shares of common stock upon the closing of the initial public offering of the Company's common stock as discussed below. In addition, 210,000 shares of Series A preferred stock was sold to certain investors for an aggregate purchase price of $0.2 million, which converted into 504,000 shares of common stock upon the closing of the initial public offering of the Company's common stock as discussed below. The Company also issued 365,094 shares of Series A preferred stock at a purchase price of $0.80 per share which converted into 876,226 shares of common stock upon the closing of the initial public offering of the Company's common stock in April 1999 as discussed below. On March 12, 1998, the Company issued 4,044,943 shares of its Series B preferred stock to new and existing investors at a price of $4.45 per share. The Company received proceeds totaling $18.0 million, which converted into 9,707,863 shares of common stock upon the closing of the initial public offering of the Company's common stock in April 1999 as discussed below. In March 1999, the Company issued 3,731,410 shares of Series C preferred stock to MCI WorldCom's investment fund for an aggregate purchase price of $30.0 million, which converted into 4,477,692 shares of common stock upon the closing of the initial public offering of the Company's common stock in April 1999 as discussed below. The terms of the transaction also provide for the Company and MCI WorldCom to enter into various business relationships, including MCI WorldCom's commitment to sell 100,000 of the Company's DSL lines over a period of five years, subject to penalties for failure to reach target commitments. This transaction included certain warrants as discussed in Note 6. In March 1999, the Company issued 3,731,409 shares of Series C preferred stock to Microsoft for an aggregate purchase price of $30.0 million, which converted into 4,477,691 shares of common stock upon the closing of the initial public offering of the Company's common stock in April 1999 as discussed below. The terms of the transaction also provide for the Company and Microsoft to enter into various business relationships. In connection with these business relationships, the Company capitalized $10.0 million in business acquisition costs that is being amortized to operating expense over a three-year period. This transaction included certain warrants as discussed in Note 6. In April 1999, the Company issued 932,836 shares of Series C preferred stock to Qwest, which converted into 1,119,403 shares of common stock upon the closing of the initial public offering of the Company's common stock in April 1999, as discussed below. Also included was 441,176 shares of Series D preferred stock, which converted into 441,176 shares of common stock upon the closing of the initial public offering of the Company's common stock. The aggregate purchase price for these transactions was $15.0 million. In accordance with provisions of the agreement underlying this investment, the Company and Qwest have entered into certain business relationships. In connection with this business relationship, the Company capitalized $11.1 million in business acquisition costs that is being amortized to operating expense over a five-year period. This transaction included certain warrants as discussed in Note 6. Effective April 12, 1999, the Company completed an initial public offering of its common stock. A total of 10,781,250 common shares were issued at $21.00 per share; net proceeds to the Company were approximately $210.1 million after payment of underwriting fees and related issue costs. Upon completion of the offering, all classes of preferred stock automatically converted to common stock, resulting in an additional 51,076,051 shares of common stock being issued leaving no shares of preferred stock issued and outstanding. Effective August 17, 1999, the Company completed a secondary public offering of its common stock in a transaction that allowed certain holders of warrants issued in connection with the 13 1/2% senior discount notes to exercise those warrants and sell the resulting common stock at $29.00 per share. A total of 3,961,862 shares were issued in the transaction; the company received no proceeds from the sale of these shares. In connection with the secondary offering, the underwriters of the offering were allowed to purchase 594,279 shares of common stock from the Company for $29.00 per share. The sale of these shares was completed on September 14, 1999 and the Company received proceeds of $16.4 million, net of underwriting discount. Effective November 4, 1998, the Company completed a two-for-one split of its common stock. Effective March 19, 1999, the Company completed a six-for-five split of its common stock. The accompanying consolidated financial statements have been restated for all periods presented to reflect the stock splits. 6. STOCK OPTIONS AND WARRANTS The Company has established the 1999 Stock Incentive Plan (the 1999 Plan) as the successor equity incentive program to the 1997 Option/Stock Issuance Plan (the 1997 Plan). The 1999 Plan provides for the grant of options to employees, directors and outside consultants for purchase of up to an aggregate of 17,173,530 shares of common stock. All outstanding options under the 1997 Plan were incorporated into the 1999 Plan, and no further options grants may be made under the 1997 Plan. Options granted under the 1997 Plan are immediately exercisable and expire within ten years after the date of grant. Shares acquired upon exercise are subject to repurchase by the Company ratably over a four-year period from the date of grant, at the option of the Company and at the exercise price. Options granted under the 1999 Plan are exercisable ratably over a four-year period from date of grant and expire within ten years of the date of the grant. The 1999 Plan provides for both incentive option and non-statutory option grants and for accelerated vesting in the event of a 50% or more change in control of the Company. The 1999 Plan activity is as follows: The following summarizes the outstanding and exercisable options under the 1999 Plan at December 31, 1999: During 1997, 1998, and 1999, options were granted to employees at less than fair value on the date of grant, resulting in $1.5 million, $4.9 million, and $11.4 million, respectively, of deferred compensation recorded as a reduction of stockholders' equity. These amounts are being amortized as a charge to deferred compensation expense over the vesting periods of the applicable options; such amortization totaled $0.2 million, $0.7 million, and $3.7 million for the periods ended December 31, 1997, 1998, and 1999, respectively. An option to purchase 365,094 shares of Series A preferred stock at $0.80 per share was granted to an employee during 1997. The Company recorded $73,000 in compensation expense during 1997 related to this grant. Had compensation expense for the Company's 1999 Plan and the preferred stock option been determined based on the fair value method of accounting for stock- based compensation, the Company's net loss and net loss per share for the periods ended December 31, 1997, 1998, and 1999 would have been increased by $11,000, $60,000, and $10.8 million and $0.01, $0.02, and $0.20 per share, respectively. For purposes of determining this compensation expense, the fair value of each option grant is estimated on the grant date using the Black- Scholes option pricing model with the following weighted average assumptions used for grants during the periods ended December 31, 1997, 1998, and 1999, respectively: no dividend yield; risk-free interest rates of 5.3%, 4.9%, and 5.5%, respectively; expected volatility of nil for pre-initial public offering grants; and 50% for post initial public offering grants and expected term of four years for common options and six months for the preferred option. The following summarizes the issued, outstanding, and exercised warrants at December 31, 1999: In August 1999, after a "net exercise" of the warrants associated with the 13 1/2% senior discount notes, 3,961,862 of these shares were sold and an additional 740,111 shares were sold by the selling stockholders in November 1999. The Company received no proceeds from these sales. The remaining warrants have an expiration date of May 15, 2008. The warrants may be required to be repurchased by the Company for cash upon the occurrence of a repurchase event, such as a consolidation, merger, or sale of assets to another entity, as defined in the provisions of the Warrant Agreement, at a price to be determined by an independent financial expert selected by the Company. In the event a repurchase event occurs, the difference between the repurchase price and the carrying value of the warrants would be charged to equity. During May 1998, the Company entered into a 36-month lease line that provides for $24.5 million in equipment on an operating lease basis. In connection with this lease agreement, the Company issued 574,380 warrants to purchase common stock at a price of $1.85 per share, exercisable immediately. In March 1999, the Company entered into additional 36-month lease lines for an aggregate of up to $24.0 million in lease financing. In connection with these March 1999 leases, the Company issued warrants to purchase an aggregate of 45,498 shares of common stock at a price of $10.55 per share. These warrants are immediately exercisable. In April 1999, the Company entered into an agreement for up to $20.0 million in equipment lease financing and issued a warrant to purchase up to 75,000 shares of common stock at an exercise price per share of $10.55. This warrant is immediately exercisable. In July 1999, the Company entered into an additional 36-month lease line for an aggregate of up to $26.0 million in lease financing to be used for equipment. In connection with this July 1999 lease, the Company issued a warrant to purchase 10,000 shares of common stock at a price of $50.00 per share. This warrant is immediately exercisable. 7. INCOME TAXES As of December 31, 1999, the Company had net operating loss carryforwards of approximately $210.2 million, which are available to offset future taxable income through 2019 for federal tax, a portion of which will be subject to the limitations of Internal Revenue Code Section 382 relating to changes in ownership of the Company. The deferred tax asset arising from the loss carryforwards has been fully offset by a valuation allowance since the utilization is uncertain. The valuation allowance increased by approximately $1.0 million, $13.9 million, and $84.0 million during 1997, 1998, and 1999, respectively, primarily as a result of the losses in each of these periods. Components of deferred income taxes are as follows: --------------------------------------------------------------------- (In thousands) 1998 1999 --------------------------------------------------------------------- Deferred tax assets: Net operating loss carryforwards $ 14,724 $ 85,028 Original issue discount and other 178 13,885 --------------------------------------------------------------------- Gross deferred tax asset 14,902 98,913 Valuation allowance (14,902) (98,913) --------------------------------------------------------------------- Net deferred income taxes $ - $ - --------------------------------------------------------------------- The provision for (benefit from) income taxes reconciles to the statutory federal tax rate as follows: -------------------------------------------------------------------------- 1997 1998 1999 -------------------------------------------------------------------------- Statutory federal tax rate (34.0%) (34.0%) (35.0%) State income tax, net of federal benefit (5.4%) (5.4%) (5.3%) Other (including non-deductible items) (1.8%) 0.9% 1.7% Deferred tax asset valuation allowance 41.2% 38.5 38.6% -------------------------------------------------------------------------- -% -% -% -------------------------------------------------------------------------- 8. RELATED PARTY TRANSACTIONS The Company's in-house legal counsel is also a partner in a law firm used externally by the Company. During 1998 and 1999, the Company incurred legal fees and expenses of approximately $1.3 million and $2.4 million, respectively, to the external firm in addition to the salary paid to the in-house counsel. At December 31, 1999, the Company had a balance payable of approximately $0.7 million to this entity. Two members of the Company's Board of Directors serve as directors to a company that supplies equipment to the Company. The total purchases during 1998 and 1999 from the equipment supplier were approximately $13.0 million and $54.0 million, respectively. At December 31, 1999, the Company had a balance payable of approximately $0.4 million to this entity. One member of the Company's Board of Directors serves as President of MCI WorldCom Venture Fund and a Senior Vice President of MCI WorldCom. In March 1999, the Company entered into a strategic arrangement with MCI WorldCom. No revenue was received from MCI WorldCom in 1999 under this arrangement. 9. COMMITMENTS AND CONTINGENCIES The Company leases office space and certain office equipment, telecommunications equipment, network equipment and furniture under non-cancelable operating lease agreements. The leases range in term from 24 months to 60 months and, in certain instances, provide for options to extend. Rent expense under the operating leases for 1997, 1998, and 1999 totaled $46,000, $2.0 million, and $21.0 million, respectively. Future minimum rental payments under the leases are $41.1 million in 2000, $40.6 million in 2001, $25.2 million in 2002, $3.5 million in 2003, $1.8 million in 2004, and $58,000 thereafter. On February 18, 1999, the Company filed a complaint for declaratory relief in San Diego County Superior Court, North County against Thomas R. Lafleur. Mr. Lafleur is a former employee of the Company. After he left, he was sent a check for the repurchase or buy-back of his unvested shares. Mr. Lafleur refused to cash this check. The declaratory relief action is to determine that his shares were unvested and thus properly repurchased. The Company has since amended its complaint to allege additional causes of action, including fraud, breach of contract, and interference with prospective economic advantage. On or about March 26, 1999, Mr. Lafleur filed an answer to the complaint and also filed a cross-complaint against the Company. The cross-complaint has been amended a number of times and seeks compensatory and punitive damages. The Company intends to defend vigorously against the claims asserted in the current cross-complaint. The Company is currently accounting for these 438,115 shares as treasury stock. The Company is aware of the filing of a legal action by i2 Technologies, Inc. in the United States District Court in the Northern District of Texas on January 7, 2000, challenging its use of the name "Rhythms" on various grounds and alleging that its use of that name infringes certain trademarks owned by i2 Technologies. The Company denies that it infringes any legitimate trademark rights of i2 Technologies, in part on the grounds that the Company has priority in the Rhythms name with respect to the goods and services provided by it and that its use of those marks is not likely to cause confusion among the consumers of our services and the services provided by i2 Technologies, respectively. The Company intends to vigorously defend the continued use of its name in the manner in which we have used it in the past and the Company's interests in the name "Rhythms." In addition, the Company is subject to state commission, Federal Communications Commission and court decisions as they relate to the interpretation and implementation of the 1996 Telecommunications Act, the interpretation of competitive carrier interconnection agreements in general and our interconnection agreements in particular. In some cases, the Company may be deemed to be bound by the results of ongoing proceedings of these bodies. The Company therefore, may participate in proceedings before these regulatory agencies or judicial bodies that affect, and allow it to advance, its business plans. 10. SUBSEQUENT EVENTS In January 2000, the Company formed a joint venture with OCI to offer DSL-based services in selected Canadian markets. The Company and OCI each received 100,000 shares of Class A voting stock. OCI also purchased 10,000,000 shares of Series A preferred shares with a redemption amount of US $1.00 per share for $10.0 million. The Series A preferred shares have no voting or conversion rights, but will earn dividends at a rate of six percent per annum payable only upon redemption. To the extent the joint venture is unable to receive sufficient financing through third parties, the Company and OCI shall be obligated to provide additional capital contributions through installments. In January and February 2000, the Company entered into an additional 36-month lease line for an aggregate of up to $50.0 million in lease financing with GATX Capital Corporation to be used for network equipment. In February 2000, the Company entered into an additional 36-month lease line for $25.0 million in lease financing with Cisco Systems Capital Corporation to be used for network equipment. In February 2000, the Company issued $300.0 million aggregate principal amount of 14% senior notes due 2010. Net proceeds of approximately $291.3 million were raised. These senior notes are general unsecured obligations of the Company and mature on February 15, 2010. The notes are redeemable at the Company's option, in whole or in part, at any time after February 15, 2005, at predetermined redemption prices, together with any accrued and unpaid interest through the date of redemption. Upon a change of control, each holder of the senior notes may require the Company to purchase the notes at 101% of the principal amount thereof, plus any accrued and unpaid interest to the date of purchase. The 2000 senior notes contain restrictive covenants, including limitations on future indebtedness, restricted payments, transactions with affiliates, liens, sale of stock of subsidiaries, entering new lines of business, dividends, mergers and transfer of assets. In February and March 2000, the Company issued 3,000,000 shares of 6 3/4% Series F cumulative convertible preferred stock in a private placement. Net proceeds were approximately $291.0 million. Each share of Series F preferred stock is convertible into 2.35 shares of common stock at any time at a conversion price of $42.56 per share, subject to adjustment. Holders of Series F preferred stock are entitled to dividends on a cumulative basis at an annual rate of 6 3/4%, payable quarterly in cash. The preferred stock is redeemable at the Company's option, in whole or in part, at any time after March 6, 2003, at predetermined redemption prices, together with any accrued and unpaid dividends through the date of redemption. Upon a change of control, each holder of the preferred shares may require the Company to purchase any or all of the shares at 100% of the liquidation preference, plus any accrued and unpaid dividends to the date of purchase. The Series F preferred stock is subject to mandatory redemption on March 3, 2012. In March 2000, the Company sold $250.0 million of 8 1/4% Series E convertible preferred stock to Hicks, Muse, Tate & Furst Inc. (Hicks Muse). Each share of Series E preferred stock is convertible into shares of common stock at any time at a conversion price of $37.50 per share, subject to adjustment. In addition, the Company issued Hicks Muse warrants to purchase 1,875,000 shares of common stock at an exercise price of $45.00 per share, exercisable for three years; 1,875,000 shares of common stock at an exercise price of $50.00 per share, exercisable for five years; and 1,875,000 shares of common stock at an exercise price of $55.00 per share, exercisable for seven years. As part of the Hicks Muse agreement, holders of Series E preferred stock affiliated with Hicks Muse have the right to appoint one representative to the Company's Board of Directors provided that they continue to hold 40% of the Series E preferred stock purchased by them or the underlying common stock or any combination thereof. In addition, holders of the Company's Series E preferred stock are be entitled to vote on all matters upon which the Company's common stockholders can vote. 11. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following table sets forth certain unaudited consolidated statement of income data for each of the Company's last eight quarters. This data has been derived from unaudited consolidated financial statements that have been prepared on the same basis as the annual audited consolidated financial statements and, in the opinion of the Company, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of such information. These unaudited quarterly results should be read in conjunction with the consolidated financial statements and notes. The consolidated results of operations for any quarter are not necessarily indicative of the results for any future period. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Rhythms NetConnections Inc. Our audits of the consolidated financial statements referred to in our report dated February 29, 2000, except for Note 10, as to which the date is March 16, 2000 included in this Annual Report on Form 10-K also included an audit of the financial statement schedule listed in the index in Item 14 of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PricewaterhouseCoopers LLP Denver, Colorado February 29, 2000 SCHEDULE II Valuation and Qualifying Accounts (in thousands)

780117_1999.txt

780117_1999

1999

780117

ITEM 1. BUSINESS. GENERAL Quebecor World (USA) Inc. ("Quebecor World" or the "Company"), formerly known as World Color Press, Inc. ("World Color"), is a wholly owned subsidiary of Quebecor Printing (USA) Holdings Inc. and an indirect wholly owned subsidiary of Quebecor Printing Inc. ("QPI"). On July 12, 1999, World Color entered into an Agreement and Plan of Merger with QPI and its indirect wholly owned subsidiary, Printing Acquisition Inc. ("Acquisition Inc."). On July 16, 1999, QPI, through Acquisition Inc., commenced a tender offer (the "Offer") to acquire up to 23,500,000 shares of World Color common stock at a price of $35.69 per share. On August 20, 1999, QPI acquired, through Acquisition Inc., 19,179,495, or approximately 50.4%, of World Color's outstanding shares of common stock (the "Change in Control"). On October 8, 1999, World Color and Acquisition Inc. completed a merger (the "Merger") of World Color with and into Acquisition Inc., with World Color as the surviving corporation, following receipt of approval from the Company's stockholders. The capital structure of the surviving corporation is 3,000 authorized shares of common stock, par value $1.00 per share. As of March 15, 2000 there were 10 shares outstanding. The surviving corporation is known as Quebecor World (USA) Inc. As a result of the Merger, we became an indirect wholly owned subsidiary of QPI. The remaining outstanding shares of the common stock of World Color (other than shares purchased by Acquisition Inc. in the Offer) were converted into the right to receive 1.2685 subordinate voting shares of QPI and $8.18 in cash per share. In addition, each of World Color's 6% Convertible Senior Subordinated Notes due 2007, outstanding at the Merger, became convertible into the number of QPI subordinate voting shares and cash that would have been received had the convertible note been converted immediately prior to October 8, 1999. DUE TO CERTAIN COVENANTS IN ITS REGISTERED DEBT SECURITIES, QUEBECOR WORLD IS REQUIRED TO CONTINUE TO MAKE REPORTS UNDER SECTION 13 AND 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 (THE "EXCHANGE ACT"). THIS ANNUAL REPORT SPEAKS TO THE OPERATIONS OF THE FORMER WORLD COLOR PRESS, INC. AND SUBSIDIARIES AND EXCLUDES THE OTHER OPERATIONS OF QPI OF WHICH IT IS NOW AFFILIATED. QUEBECOR PRINTING INC. GENERAL QPI, a diversified global commercial printing company, is the largest commercial printer in Canada and Europe and one of the largest in the United States and South America. Its 1999 revenues reached $5.0 billion, including approximately $1.0 billion contributed by the Company since its acquisition by QPI. QPI offers its customers state-of-the-art web offset, gravure and sheet fed printing capabilities, plus related value-added printing services in product categories including magazines, retail circulars, books, catalogs, directories, specialty printing and direct mail, and digital and other value-added services. QPI is a market leader in most of its product categories. QPI believes that the diversity of its customer base, geographic coverage and product segments reduces its reliance on any single product line or market. QPI's strategy for growth focuses on increasing its geographic coverage and expanding its product segments and services across its network of facilities. QPI services these markets and offers its products through a network of 160 printing and related services facilities capable of servicing virtually all major markets in the United States, Canada, France, Germany, Austria, United Kingdom, Spain, Sweden, Finland, Mexico, India, Chile, Argentina, Peru and Colombia. As of March 1, 2000, QPI employed over 40,000 people. QUEBECOR WORLD (USA) INC. GENERAL We are an industry leader in the management and distribution of print and digital information. Prior to the acquisition by QPI, we were the second largest diversified commercial printer in the United States, providing digital pre-media, press, binding, distribution and multi-media services to customers in the commercial, magazine, catalog, direct mail, book and directory markets. Founded in 1903, we currently operate 54 facilities with a network of sales offices nationwide. Through selective acquisitions and internal expansion, we have strategically positioned ourselves as a full-service provider of high technology solutions for our customers' imaging, print and distribution needs. We operate in one business segment--printing services, which is comprised of six separate sectors including commercial, magazines, catalogs, direct mail, books and directories. We completed five acquisitions in fiscal year 1999: Great Western Publishing (December 1998), a commercial retail insert printer; Infiniti Graphics (January), a commercial printer; Universal Press Graphics (March), a commercial printer which also provided us with an entry into the packaging sector; Downey Printing (April), a printer of specialty directories; and Metroweb (June), a publication and commercial printer. Substantially all sales are made to customers through our employees based upon customer specification. A significant amount of our sales are made pursuant to term contracts with our customers, with the remainder being made on an order-by-order basis. As a result, we have a significant backlog of orders. No customer accounted for more than 5% of our net sales in 1999. In our opinion, the loss, at substantially the same time, of all of the business provided by any one of our largest customers could have an adverse effect upon us. MARKET SECTORS COMMERCIAL We are a premier printer of virtually all of the different kinds of printed materials used by businesses to promote their goods and services to businesses, investors and consumers. We print high quality specialty products such as annual reports and automobile and travel brochures. We are also a leading printer of product brochures, bill stuffers, informational marketing materials and other advertising supplements. We also print freestanding inserts and retail inserts for established national and regional retailers and are the second largest offset printer of retail advertising inserts in the United States. We are an industry leader in three highly specialized areas: (1) complex personalized direct response materials; (2) unique and intricate consumer-involvement promotional materials such as scratch-off game pieces; and (3) airline guides and hotel directories. With a broad range of specialized equipment and focused attention to customer service, we provide commercial customers with format flexibility, high-speed production and the ability to print high quality commercial products from start to finish at one full-service source. MAGAZINES We are a leading printer of consumer magazines in the United States. The publication customer base includes some of the largest and most established consumer magazine publishers in a diverse range of market categories. The popularity of these magazines makes them less susceptible to cyclical downturns in advertising spending, which we believe provides us with a significant advantage over our competitors whose customers may be more susceptible to these downturns. A majority of our magazine printing is performed under contracts with remaining terms of between one and nine years, the largest of which are with customers with whom the Company has had relationships for, on average, more than 20 years. We have extended a majority of these contracts beyond the initial expiration dates and intend to continue this practice when economically practicable. CATALOGS We are a leading printer for the U.S. catalog market. We currently print many of the most well known catalog titles. In addition, our business-to-business catalog printing work spans a broad range of industries including the computer, home and office furniture, office products and industrial safety products industries. DIRECT MAIL We print direct mail materials such as booklets, inserts, bill stuffers and other advertisements. In addition, we provide direct marketers with direct imaging, personalization and other lettershop services. We believe that we are the only direct mail printer capable of providing complex personalization for both short and long-run projects. BOOKS We print mass-market rack size books as well as hardcover books for the consumer, education and reference markets. We service many of the largest U.S. publishers. DIRECTORIES We print four-color white-page and yellow-page directories for Pacific Bell and certain other independent directory publishers. CURRENT SERVICES DIGITAL AND PRE-MEDIA SERVICES We are a leader in the transition from conventional pre-media services to an all-digital workflow, providing a complete spectrum of film and digital preparation services, from traditional paste-up and color separations to state-of-the-art, all-digital pre-media services, as well as digital imaging and digital archiving. Our specialized digital and pre-media facilities, which are strategically located close to and, in certain cases, onsite at customer's facilities, provide our customers high quality, 24-hour preparatory services linked directly to our various printing facilities. In addition, our computer systems enable us to exchange images and textual material electronically, directly between our facilities and our customers' business locations. The integrated pre-media operations provide us with competitive advantages over traditional pre-media shops that are not able to provide the same level of integrated services. Our digital group also provides multi-media services such as the transformation of customers' existing printed and digital material into interactive media such as user-friendly information kiosk systems, Internet web sites, corporate intranets, CD-ROMs and computer laptop sales presentations. Our digital services group has provided a natural opportunity for cross-selling efforts by offering integrated pre-media and multi-media services to print customers who may have historically used third-party suppliers for their pre-media and multi-media needs. PRESS AND BINDING SERVICES We believe that we provide our customers with access to state-of-the-art technology in all phases of the printing and binding process, including, among others, wide-web presses, computerized quality information systems, computer-to-plate and digital processing systems, high speed binding and personalization capabilities and robotic material handling. Wide-web press technology, which only a small number of well-capitalized printers are able to justify, generates a significant cost savings on longer press runs. Computerized quality information systems provide us and our customers with instant analysis of the quality of the printing, thereby enabling us to improve our performance and plan preventive maintenance of our equipment more effectively. Computer-to-plate and digital processing technologies eliminate the use of film, which significantly reduces costs and production time and enables customers to extend their production deadlines. Our personalization capabilities allow customers to include different content, whether advertising or editorial or both, within different copies of their product depending upon the geographic, demographic and subscriber specifications of their readers. We operate web and sheet fed offset, rotogravure and flexographic presses. We believe that the variety and capabilities of our presses and other production equipment allows us to meet the broad range of our customers' printing needs and be the full service provider demanded by the market. This capacity provides us with a competitive advantage over smaller printers who are unable to meet this demand. DISTRIBUTION AND LOGISTICS We believe that our sophisticated mailing and distribution capabilities are among the best in the industry. We maintain a network of strategic regional locations as well as a central facility in the Chicago, Illinois area from which we provide customers important access to our nationwide services. Nearly all of our printing facilities dedicated to servicing our magazine, catalog and direct mail customers are strategically located in the mid-region of the country. We believe that the size of these printing plants and their central location and close proximity to each other provide us with a significant advantage in distribution capabilities, enabling us to distribute a greater volume of product than our competitors to a wider target market at a lower cost. We also operate facilities on the west and east coasts which serve more regionalized needs. We use computerized cost studies to examine the benefits of pooled and palletized mailing for our customers to develop an efficient and cost effective distribution plan designed to enable the customer's product to reach consumers at narrowly specified delivery times. Our mail capabilities extend from state-of-the-art mail list processing technology through entry point optimization, load planning, consolidation, carrier management, mail tracking and customer reporting. COMPETITION Although we are one of the largest diversified commercial printers in the United States, the industry is highly competitive in most product categories and geographic regions. Competition is largely based on price, quality, range of services offered, distribution capabilities, customer service, availability of printing time on appropriate equipment and state-of-the-art technology. We compete for commercial business not only with large national printers, but also with smaller regional printers. In certain circumstances, due primarily to factors such as freight rates and customer preference for local services, printers with better access to certain regions of the country may have a competitive advantage in such a region. The printing industry is experiencing excess capacity. Further, the industries that we serve have been subject to consolidation efforts, leading to a smaller number of potential customers who exercise increased pricing leverage over the industry. Primarily as a result of this excess capacity and customer consolidation, there has been, and we believe will continue to be, downward pricing pressure and increased competition in the printing industry. We continue to evaluate solutions to address the challenges and opportunities presented to us by the increased use of e-commerce and reliance on communication through electronic media, including the Internet, in the conduct of our business, both with our customers and suppliers. We are being called upon to address our customers' use of electronic media throughout their business spectrums, from the delegation of their print requirements through the production and distribution of their product. We have continued to move to an all digital environment in our pre-media service offerings to allow our customers to produce, manage and redeploy their media assets by electronic means. We are also developing electronic transaction technology that will enable us to use electronic tools in aggregating and transacting our supply side purchases. Sales volume in general has been positively affected by increased advertising pages, including those related to Internet/New Media companies. We expect this trend to continue through 2000 and beyond. SEASONALITY The operations of our business are seasonal with approximately two-thirds of historical operating income recognized in the second half of the fiscal year, primarily due to the higher number of magazine pages, new product launches and back-to-school and holiday catalog promotions. RAW MATERIALS The primary raw materials required in a printing operation are ink and paper. We supply all of the ink and a substantial amount of the paper used in the printing process. Our net sales include sales to certain customers of paper that we purchase. We provide warehouse space for both ourselves and customer supplied paper. The price of paper is volatile over time and may cause significant swings in net sales and cost of sales. We generally are able to pass on increases in the cost of paper to our customers, while declines in paper costs result in lower prices to our customers. In 1998, paper prices declined from previous years and availability was plentiful for most grades of paper. In the first three quarters of 1999, paper prices in general continued to decline moderately. In the fourth quarter of 1999, paper prices started to recover and were relatively flat compared to the same period in 1998. We expect the trend of increasing paper prices to continue throughout 2000. We believe we have adequate allocations with our paper suppliers to meet our customers' needs. Our contracts with our customers generally provide for price adjustments to reflect price changes for other materials, wages and outside services. Our materials management program capitalizes on our purchasing power in order to minimize materials costs while optimizing inventory management. We are not dependent upon any one source for our paper or ink. We believe that an adequate supply of ink is available. Given the volume of our purchases, we are generally able to obtain quality paper, ink and other materials at competitive prices. Our strong commercial relationships with a relatively small number of suppliers allow us to negotiate favorable price discounts and achieve more assured sourcing of high quality paper that meets our specifications. ENVIRONMENTAL COMPLIANCE We are subject to regulation under various and changing federal, state and local laws relating to the environment and to employee safety and health. These environmental regulations relate to the generation, storage, transportation, disposal and emission into the environment of various substances. Permits are required for operation of our business (particularly air emission permits), and these permits are subject to renewal, modification and, in certain circumstances, revocation. We believe that we are in substantial compliance with such laws and permitting requirements. We are also subject to regulation under various and changing federal, state and local laws which allow regulatory authorities to compel (or to seek reimbursement for) clean-up of environmental contamination at our own sites and at facilities where our waste is or has been disposed. We have procedural controls and personnel dedicated to compliance with all applicable environmental laws. We estimate that capital expenditures in 2000 required to comply with federal, state and local provisions for environmental controls, as well as expenditures for our share of costs for environmental clean-up, if any, will not be material and will not have a material adverse effect on us. We expect to incur ongoing capital and operating costs to maintain compliance with applicable environmental laws, which costs we do not expect to be, in the aggregate, material. RESEARCH AND DEVELOPMENT Suppliers of equipment and materials used by companies such as us perform most of the research and development related to the printing industry. Accordingly, our expenses and capital investments for research and development are not material. We do, however, dedicate significant resources to improving our operating efficiencies and the services we provide to our customers. In an effort to realize increased efficiencies in our printing processes, we have made significant investments in state-of-the-art equipment, including new press and binding technology, digital photography, computer-to-plate and digital processing technology and real-time product quality monitoring systems. EMPLOYEES As of March 1, 2000, we had over 16,000 employees, approximately 17% of who were represented by unions under several different labor contracts, which expire at various times from April 2000 through August 2005. As of March 1, 2000, approximately 600 of such unionized employees, in one facility, were covered under a contract, the term of which has been automatically extended by its terms and currently is under negotiation. Under the terms of the contract during the period of extension either party may give the other party 21 calendar days written notice terminating the contract. ITEM 2. ITEM 2. PROPERTIES. Our corporate office is currently located in leased facilities in Greenwich, Connecticut. Production facilities are located throughout the United States, as set forth below. We believe our facilities provide adequate productive capacity for our needs. Summary information regarding our facilities as of March 1, 2000 is set forth as follows: In addition, we maintain an extensive network of sales offices located throughout the United States, as well as additional warehouse space. We believe that none of our leases are material to our operations and that such leases were entered into on market terms. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. We do not believe that there are any pending legal proceedings, which, if adversely determined, could have a material adverse effect on our financial condition or results of operations, taken as a whole. There were no material pending legal proceedings that were terminated in the fourth quarter of the fiscal year ended December 31, 1999. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On October 8, 1999, World Color held a Special Meeting of Stockholders. At the meeting, the stockholders voted on the Merger of World Color and Acquisition Inc. A total of 32,588,921 and 5,447,381 shares were voted and unvoted, respectively. The following table sets forth certain information with respect to such stockholder vote. No other matters were submitted for stockholder vote during the fourth quarter of 1999. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. MARKET PRICE RANGE OF COMMON STOCK Until the effective time of the Merger on October 8, 1999, World Color's common stock was listed on the New York Stock Exchange under the symbol: WRC. In connection with the Merger, the remaining outstanding shares of the common stock of World Color were converted into 1.2685 subordinate voting shares of QPI and $8.18 in cash per share. The following table sets forth the range of the high and low sales prices of the common stock of World Color as quoted on the New York Stock Exchange for 1998 and 1999*. We did not pay dividends during 1998 or 1999. - ------------------------ * October 8, 1999, the day of the Merger, was the final day of public trading for the common stock of World Color. Following the Merger, there is no established public trading market for our Common Stock, par value $1.00 per share. There was one holder of such Common Stock at March 15, 2000, which was an affiliate of the Company. DIVIDEND POLICY We do not expect to declare or pay cash dividends on the Common Stock at any time in the foreseeable future. The decision whether to apply legally available funds to the payment of dividends on the Common Stock will be made by our Board of Directors from time to time in the exercise of its prudent business judgment, taking into account, among other things, our results of operations and financial condition and any then existing or proposed commitments for our use of available funds. We are restricted by the terms of certain of our outstanding debt and financing agreements from paying cash dividends on our Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data for the five fiscal years ended December 31, 1999 have been derived from the Company's audited consolidated financial statements. The data presented below should be read in conjunction with, and is qualified in its entirety by reference to, the Company's consolidated financial statements and the notes thereto appearing elsewhere in this report. - ------------------------ (1) In 1999, the Company changed its fiscal year end to December 31, 1999 from the last Sunday in December. The change resulted in a 369-day period rather than a 52-week period. This change was not material to the Company's results of operations. The fiscal years prior to 1999 each represent the 52 or 53 week period ending on the last Sunday in December. Fiscal year 1995 consisted of 53 weeks. Fiscal years 1996, 1997 and 1998 each consisted of 52 weeks. (2) In 1999, the Company recognized merger related charges of $313,845. See Note 4 to the consolidated financial statements for further details. (3) In 1999, the Company recognized restructuring and other special charges of $74,807 to eliminate redundant and less efficient capacity resulting from its ongoing acquisition strategy. See Note 8 to the consolidated financial statements for further details. (4) Operating income in 1995 was reduced by $40,900 of a nonrecurring streamlining charge. This charge reflects the Company's strategy in 1995 to realign certain business operations. The major components of this realignment plan were to close a facility and to consolidate certain digital prepress operations and functions. (5) In 1999, the Company recognized extraordinary charges of $11,992, net of tax, for the early extinguishment of certain debt instruments. See Note 9 to the consolidated financial statements for further details. (6) The Company adopted Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities," in the first quarter of 1999 which resulted in a charge of $10,513, net of tax. See Note 2 to the consolidated financial statements for further details. (7) 1998 capital expenditures are net of proceeds of approximately $88,500 from the sale and leaseback of certain equipment. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. (Dollars in thousands, except per share data) GENERAL We are a diversified commercial printer serving customers in the commercial, magazine, catalog, direct mail, book and directory markets. We operate in one business segment--the management and distribution of print and digital information. Our revenues are derived primarily from the sale of services and materials to our customers, including digital and pre-media services, press and binding services and distribution and logistics services. On July 12, 1999, we entered into an Agreement and Plan of Merger with Quebecor Printing Inc. ("QPI") and its indirect wholly owned subsidiary, Printing Acquisition Inc. ("Acquisition Inc."), which provided for the acquisition of World Color (the "Merger"). On July 16, 1999, QPI, through Acquisition Inc., commenced a tender offer to acquire up to 23,500,000 shares of our common stock at a price of $35.69 per share. On August 20, 1999, QPI acquired, through Acquisition Inc., 19,179,495, or approximately 50.4%, of our outstanding shares. On October 8, 1999, World Color and Acquisition Inc. completed the Merger following receipt of approval from our stockholders. As a result, World Color became an indirect wholly owned subsidiary of QPI and at that time was renamed Quebecor World (USA) Inc. The remaining outstanding shares of our common stock (other than shares purchased by QPI in the tender offer) were converted into the right to receive 1.2685 subordinate voting shares of QPI and $8.18 in cash per share. In addition, each 6% Convertible Senior Subordinated Note due 2007, outstanding at the Merger, became convertible into the number of QPI subordinate voting shares and cash that would have been received had the convertible note been converted immediately prior to October 8, 1999. Our new capital structure consists of 3,000 authorized shares of common stock, par value $1.00 per share. At December 31, 1999, 10 common shares were outstanding. In connection with the Merger, we incurred $169,301 of non-recurring costs in the third quarter of 1999. These costs included: the cancellation and settlement by Acquisition Inc. of all vested and unvested options, bonuses, severance, legal and attorney fees, and other fees specifically related to the Merger. In addition, our outstanding restricted stock became fully vested in connection with the Merger. The costs related to the Merger are included in selling, general and administrative expenses in our 1999 consolidated statement of operations. The majority of these costs were paid during 1999. In connection with the Merger, we have developed an integration strategy for the combined entities that requires the redeployment and/or disposal of assets and the shutdown or relocation of certain of our plant locations and sales offices. This revised strategic initiative resulted in a charge to our 1999 cost of sales and selling, general and administrative expenses of $134,668 and $9,876, respectively. The charge was primarily composed of $40,011 for the writedown of fixed assets to reflect fair market value, $32,303 for severance and related costs to shut down certain plant locations and sales offices, $19,672 for the disposal and other related costs of inventories and $34,100 to reflect other operational changes in the business as a result of the Merger. At December 31, 1999, all such assets have been adjusted to reflect the appropriate value and we expect to proceed with the closure of the facilities and related employee terminations in 2000. The expected cash expenditures for the above charges are approximately $14,000, the majority of which is severance related and will be paid in 2000. As a result of the Merger integration plan, we anticipate incurring additional charges, primarily in 2000, of approximately $26,000. There continues to be significant pricing pressure on all printers, including us. Our net sales include sales to certain customers of paper we purchased. The price of paper, our primary raw material, is volatile over time and may cause significant swings in net sales and cost of sales. We generally are able to pass on increases in the cost of paper to our customers, while declines in paper costs result in lower prices to our customers. In 1998, paper prices declined from previous years and availability was plentiful for most grades of paper. In the first three quarters of 1999, paper prices in general continued to decline moderately. In the fourth quarter of 1999, paper prices started to recover and were relatively flat compared to the same period in 1998. We expect the trend of increasing paper prices to continue throughout 2000. Our contracts with our customers generally provide for price adjustments to reflect price changes for other materials, wages and outside services. ACQUISITIONS In fiscal year 1999, we acquired five businesses serving customers in the commercial, retail, publication and directory markets for an aggregate purchase price of approximately $203,000, including assumed indebtedness. In 1998, we acquired four businesses serving customers in the commercial, direct mail and book markets for an aggregate purchase price of approximately $200,000. In 1997, we acquired two businesses serving the book and short-run publications markets for an aggregate purchase price of approximately $194,000. These companies have been included in results of operations since their respective acquisition dates and the acquisitions were accounted for as purchases. RESULTS OF OPERATIONS Historically our fiscal years have represented the 52 or 53 week period ending on the last Sunday in December. Fiscal 1997 and 1998 were 52-week years. In 1999, we changed our fiscal year end to December 31, 1999 in order to conform with the fiscal year end of QPI. The change in the fiscal year did not have a material effect on our results of operations. YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 27, 1998 Net sales increased $196,010 or 8.3% to $2,552,895 in 1999 from $2,356,885 in 1998. The increase was due to the inclusion of both a full year of results from the acquisitions in 1998 and results from the acquisitions in 1999, higher paper volume and improved sales in our base business. Gross profit decreased $99,624 or 23.2% to $329,471 in 1999 from $429,095 in 1998, due primarily to the fourth quarter charges related to the Merger as described above, partially offset by the inclusion of the 1998 and 1999 acquisitions and improved operating efficiencies in our base business. Excluding the effect of the Merger related costs, gross profit margin remained flat at 18.2% in 1999 and 1998, respectively, due to the increased sales resulting from higher paper volume, offset by synergies resulting from the integration of the acquired businesses. Selling, general and administrative expenses, including expenses related to the Merger of $179,177 and restructuring and other special charges of $74,807, increased $266,675 to $481,537 in 1999 from $214,862 in 1998. Excluding the non-recurring Merger and restructuring charges, the 1999 increase of $12,691 or 5.9% to $227,553 was due primarily to the acquisitions in 1999 and 1998, including the related additional amortization expense for goodwill, partially offset by benefits derived from cost saving initiatives. In 1999, we recorded restructuring and other special charges of $74,807, or $44,297 net of tax, to eliminate redundant and less efficient capacity resulting from our ongoing acquisition strategy. The restructuring and other special charges included the costs to exit and consolidate certain facilities and sales offices, write down impaired assets and eliminate certain administrative positions. These charges, consisting primarily of $26,615 for the writedown of equipment and $44,566 to reserve for certain lease costs, resulted from changes in our strategic growth objectives and were primarily determined based on independent appraisals. As of year end 1999, we have closed the affected facilities and sales offices and terminated the related employees. Fixed assets have been adjusted to reflect their appropriate values. In 1999, we paid approximately $5,000 related to these charges. The remaining costs, primarily lease payments, will extend through 2008. The aggregate effect of all restructuring and other special charges was originally estimated to be in the range of $125,000 to $175,000 for the closure of facilities, write down of assets and elimination of administrative positions. The Merger significantly altered this estimate and as of the fourth quarter of 1999, we have completed this restructuring initiative. Interest expense and securitization fees increased $15,277 or 17.2% to $103,866 in 1999 from $88,589 in 1998. The increase was due to higher average borrowings incurred to fund acquisitions, capital expenditures and working capital requirements, offset by a lower average cost of funds. The effective tax rate, primarily composed of the combined federal and state statutory rates, was approximately 22.0% for 1999 and 41.4% for 1998. Full year 1999's rate was impacted by costs related to the Merger, some of which were nondeductible, as well as restructuring and other special charges. YEAR ENDED DECEMBER 27, 1998 COMPARED TO YEAR ENDED DECEMBER 28, 1997 Net sales increased $375,660 or 19.0% to $2,356,885 in 1998 from $1,981,225 in 1997. The increase was due to the inclusion of both a full year of results from the acquisitions in 1997 and results from the acquisitions in 1998, higher paper prices and volume and improved sales in our base business. Gross profit increased $61,808 or 16.8% to $429,095 in 1998 from $367,287 in 1997, due primarily to the inclusion of the 1997 and 1998 acquisitions and improved operating efficiencies in our base business. Gross profit margin decreased to 18.2% in 1998 from 18.5% in 1997 due to increased sales resulting from higher paper prices and volume, slightly offset by the benefits of certain cost reduction initiatives and other synergies resulting from the integration of the acquired businesses. Selling, general and administrative expenses increased $26,174 or 13.9% to $214,862 in 1998 from $188,688 in 1997. The increase was due to the 1997 and 1998 acquisitions, including the related additional amortization expense for goodwill, offset by benefits derived from cost saving initiatives and a decrease in the 1998 provision for bad debts. The 1997 provision for bad debts was higher than usual because of bad debts related to a customer that entered into bankruptcy. Interest expense and securitization fees increased $8,550 or 10.7% to $88,589 in 1998 from $80,039 in 1997. The increase was due to higher average borrowings incurred to fund acquisitions, capital expenditures and working capital requirements, offset by a lower average cost of funds. The 1998 and 1997 amounts included $11,888 and $5,133, respectively, of fees resulting from the asset securitization agreement entered into in June 1997. The effective tax rate, primarily composed of the combined federal and state statutory rates, was approximately 41.4% for 1998 and 42.0% for 1997. LIQUIDITY AND CAPITAL RESOURCES In November 1998, we issued Senior Subordinated Notes in the aggregate principal amount of $300,000 for net proceeds of approximately $291,700. Interest on the notes is payable semi-annually at the annual rate of 8.375%. Principal payments on the notes are not required prior to maturity on November 15, 2008. We used a portion of the net proceeds to repay certain indebtedness incurred under the Second Amended and Restated Credit Agreement dated June 6, 1996, as amended ("1996 Credit Agreement"). The remaining net proceeds were invested in money market securities through December 27, 1998. In the beginning of fiscal year 1999, we used the remaining net proceeds to redeem all of our then outstanding 9.125% Senior Subordinated Notes due 2003 (the "Notes") in an aggregate principal amount of $150,000. The Notes were redeemed for approximately $160,800, including the redemption premium of $6,840 and accrued interest. This early extinguishment of debt generated an extraordinary charge of $5,946, net of taxes of $4,132, for the redemption premium and write-off of deferred financing costs. The Notes were included in current maturities of long-term debt at December 27, 1998. On February 22, 1999, we issued Senior Subordinated Notes in the aggregate principal amount of $300,000, receiving net proceeds of approximately $294,000. Interest on the notes is payable semi-annually at the annual rate of 7.75%. The notes do not have required principal payments prior to maturity on February 15, 2009. The net proceeds from the notes issuance were used to repay certain indebtedness under the 1996 Credit Agreement. In connection with the issuance of these notes, we amended our 1996 Credit Agreement resulting in, among other modifications, a $95,000 permanent reduction in borrowings and commitments under the 1996 Credit Agreement. As a result, aggregate total commitments decreased from $920,000 to $825,000. The amendment and related permanent reduction in total borrowings and commitments resulted in a substantial modification of the terms under the 1996 Credit Agreement. Accordingly, we recognized an extraordinary charge for the early extinguishment of debt of $6,046, net of taxes of $4,201, in the first quarter of 1999. As described below, all amounts outstanding under the 1996 Credit Agreement were repaid in connection with the Merger. At December 31, 1999, there were no available commitments under the 1996 Credit Agreement. In August 1999, certain wholly owned subsidiaries of QPI provided us with $511,500, which was borrowed on our behalf from subsidiaries' external long-term credit facilities. We used these funds to pay certain Merger expenses and repay $491,600 in outstanding debt incurred under the 1996 Credit Agreement. Our resulting indebtedness has an interest rate of LIBOR plus 2% per annum, adjusted quarterly. In 1999, the interest rate ranged from 7.23% to 8.07%. Payment is not required prior to January 1, 2001. On August 20, 1999, we entered into a credit agreement with a third party lender with a maximum commitment of $100,000. Interest is payable at a variable floating rate based on LIBOR or prime rate. We do not owe any amounts under this credit agreement at December 31, 1999. As part of the Merger expenses discussed above, we recognized a non-cash charge of $67,474 for the cancellation and settlement by Acquisition Inc. of all vested and unvested options. Of this amount, $40,868 was paid directly by Acquisition Inc. to the option holders on our behalf and $26,606 was paid in stock of QPI upon consummation of the Merger. In addition, we received $51,299 from Acquisition Inc. to pay certain other Merger expenses. These amounts will not be repaid and are, therefore, included in stockholders' equity in the December 31, 1999 consolidated balance sheet. In July and October 1998, we entered into agreements for the sale and leaseback of certain printing equipment for which we received approximately $88,500 of proceeds. The equipment used for the sale and leaseback transaction was primarily composed of 1998 capital expenditures. The lease expires in July 2010 and has been classified as an operating lease. The proceeds were used to repay certain indebtedness incurred under the 1996 Credit Agreement. In August 1998, the Board of Directors authorized the repurchase of up to 1,800,000 shares of our common stock. The repurchase of shares commenced in August 1998 and continued through mid 1999. Shares were repurchased primarily to satisfy commitments under certain employee benefit plans. From the inception of the plan through mid-1999, we repurchased 1,750,153 shares at a weighted average cost of $26.02 and reissued 466,255 shares. In connection with the Merger, the share repurchase plan was terminated and the treasury stock was retired. In October 1997, we issued 4,600,000 shares of our common stock, receiving net proceeds of approximately $127,600. Concurrent with the stock offering, we issued $151,800 aggregate principal amount of Convertible Senior Subordinated Notes, receiving net proceeds of approximately $147,900. Interest on the convertible notes is payable semi-annually at the annual rate of 6%. The convertible notes have no required principal payments prior to maturity on October 1, 2007. Prior to the Merger, the convertible notes in the aggregate were convertible into 3,660,477 shares of our common stock at $41.47 per share, subject to adjustment upon the occurrence of certain events. Subsequent to the Merger, each note is convertible into the number of QPI subordinated shares and cash that would have been received had the convertible note been converted immediately prior to October 8, 1999. Certain convertible notes were redeemed by the holders in 1999, reducing our liability to approximately $144,000 at December 31, 1999. While we have the option to redeem the notes subsequent to October 4, 2000, we do not intend to do so. Therefore, the notes are classified as long-term in the consolidated balance sheets. In June 1997, we entered into an agreement to sell, on a revolving basis for a period of up to five years, certain of our accounts receivable to a wholly-owned subsidiary, which entered into an agreement to transfer, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable to a maximum of $204,000. Subsequent to the Merger, this asset securitization program was cancelled. We entered into a new agreement which was aligned with QPI's existing program and has substantially the same terms and conditions as our previous agreement. In 1997, we received the proceeds from the sale of $200,000 of accounts receivable. Accordingly, accounts receivable has been reduced by $200,000 at December 31, 1999 and December 27, 1998. Fees associated with the asset securitization vary based on commercial paper rates plus a margin, providing a lower effective rate than that available from our traditional funding sources. Working capital was $291,068 at December 31, 1999 and $239,428 at December 27, 1998, increasing $51,640 or 21.6% primarily due to the 1999 acquisitions and the repayment of the 1996 Credit Agreement in 1999, a portion of which was included in current maturities of long-term debt in 1998. Cash flow from operations was primarily used to fund working capital requirements, capital expenditures and acquisitions. Capital expenditures totaled $140,005 and $95,533 in 1999 and 1998, respectively. These capital expenditures reflect the purchase of additional press and bindery equipment which increased our capacity and are part of our ongoing program to maintain modern, efficient plants and continually increase productivity. At December 31, 1999, we had net operating loss carryforwards from business acquisitions for federal income tax purposes of $1,762 available to reduce future taxable income, expiring from 2007 to 2010. We also had federal tax credits of $4,162 expiring primarily from 2000 to 2002 and state tax credits of $3,894 expiring from 2001 to 2013. In addition, we had alternative minimum tax carryover credits of $29,631 which do not expire and may be applied against regular tax in the future, in the event that the regular tax expense exceeds the alternative minimum tax. Concentrations of credit risk with respect to accounts receivable are limited due to our diverse operations and large customer base. As of December 31, 1999, we had no significant concentrations of credit risk. In the normal course of business, we are exposed to changes in interest rates. However, we manage this exposure by having a balanced variety of debt maturities as well as a combination of fixed and variable rate obligations. In addition, in 1998, we entered into interest rate cap and swap agreements in order to further reduce the exposure on our variable rate obligations. The interest rate cap agreements expired in 1999. As allowed under the interest rate swap agreements, these agreements were cancelled in the third quarter of 1999 by the respective counterparties. These agreements did not have a material impact on the consolidated financial statements for the periods presented. As of December 31, 1999 we are not party to any such agreements. We do not hold or issue any derivative financial instruments for trading purposes. We believe that our liquidity, capital resources and cash flows from operations are sufficient to fund planned capital expenditures, working capital requirements and interest and principal payments for the foreseeable future. RECENT ACCOUNTING PRONOUNCEMENTS In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This SOP requires certain costs related to computer software developed or obtained for internal use to be expensed or capitalized depending on the stage of development and the nature of the costs. We adopted this SOP in the first quarter of fiscal year 1999. The adoption of SOP 98-1 did not have a material effect on our consolidated financial statements. In April 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of Start-Up Activities," which requires costs of start-up activities and organization costs to be expensed as incurred. We adopted this SOP in the first quarter of fiscal year 1999, which resulted in a charge of $10,513, net of taxes of $7,305, for the non-recurring write-off of deferred start-up costs. The adoption of this SOP did not have a material effect on our operating income on a continuing basis. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement requires companies to recognize all derivatives as either assets or liabilities and measure those instruments at fair value. We would account for gains or losses resulting from changes in the values of those derivatives depending on the use of the derivative and whether it qualifies for hedge accounting. In June 1999, the Financial Accounting Standards Board issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133," to delay the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. Therefore, we plan to adopt this statement in the first quarter of fiscal year 2001. We do not expect the adoption of SFAS No. 133 to have a material impact on our consolidated financial statements. SEASONALITY The operations of our business are seasonal with approximately two-thirds of historical operating income recognized in the second half of the fiscal year, primarily due to the higher number of magazine pages, new product launches and back-to-school and holiday catalog promotions. YEAR 2000 We did not experience any material adverse impact with regard to software or hardware failure or malfunction as a result of the year 2000 transition. The costs incurred to date related to the year 2000 efforts have not been material, nor are they expected to be material in 2000. We will continue to monitor our systems throughout the first quarter of 2000. FORWARD-LOOKING STATEMENTS Except for historical information contained herein, the statements in this document are forward-looking and made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve known and unknown risks and uncertainties, which may cause our actual results in future periods to differ materially from forecasted results. Those risks include, among others, changes in customers' demand for our products, changes in raw material and equipment costs and availability, seasonal changes in customer orders, pricing actions by our competitors and general changes in economic condition. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. For quantitative and qualitative disclosures about market risk, see the notes to the consolidated financial statements (Note 9) referenced in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of the Company on pages through hereof and the related schedule thereto set forth on page S-1 hereof are incorporated hereto by reference. The supplementary quarterly data set forth in Note 18 on page hereof is incorporated hereto by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. EXECUTIVE OFFICERS The table below sets forth certain information regarding the current executive officers and Directors of the Company as of March 1, 2000. MARC L. REISCH has been the Chairman of the Board of Directors, President and Chief Executive Officer of the Company since October 1999. Prior to that, Mr. Reisch had served as President of World Color since November 1998. Prior to holding that position, Mr. Reisch held the position of Vice Chairman, Group President since January 1998. Mr. Reisch held the position of Group President, Sales and Chief Operating Officer from August 1996 until January 1998 and the position of Executive Vice President, Chief Operating and Financial Officer from June 1996 until August 1996. Mr. Reisch held the position of Executive Vice President, Chief Operating and Financial Officer and Treasurer from July 1995 until June 1996. Prior to holding that position, Mr. Reisch was Executive Vice President, Chief Financial Officer and Treasurer since October 1993. Mr. Reisch has been a director of the Company since March 1996. KENNETH BACON has been Vice President, Taxes since January 1998. Prior to holding that position, Mr. Bacon held the position of Tax Director for the Company, since joining the Company in June 1996. Prior to joining the Company, Mr. Bacon was a Senior Tax Manager at Coopers & Lybrand LLP. JEROME V. BROFFT has been Senior Vice President, Purchasing since October 1995. Prior to holding that position, Mr. Brofft held the position of Vice President, Purchasing and Logistics from February 1995 until October 1995 and the position of Vice President, Purchasing from May 1992 until February 1995. PAUL B. CAROUSSO has been Vice President, Controller since December 1998. Prior to holding that position, Mr. Carousso was Vice President, Assistant Controller from July 1998. Mr. Carousso held the position of Assistant Controller from July 1996 until July 1998 and the position of Manager, Financial Reporting from October 1994 until July 1996. Prior to joining the Company, Mr. Carousso was an auditor with Ernst & Young LLP. DAVID R. COATES has served as director since October 1999. Mr. Coates is retired as a partner of KPMG, where he was employed until June 1993. Currently, Mr. Coates provides business advisory services and serves as director of Green Mountain Power Corporation. MARK A. D'SOUZA has been an officer of the Company since August 1999. Mr. D'Souza has also served as Vice President, Treasurer of Quebecor Printing Inc. since November 1998. From September 1997 to November 1998, Mr. D'Souza was Treasurer of Quebecor Printing Inc. From March 1995 to September 1997 he was Director, Finance of Societe Generale de Financement du Quebec and from July 1989 to March 1995, Mr. D'Souza held several positions in Corporate Finance at the Royal Bank of Canada and Union Bank of Switzerland. Mr. D'Souza is a Canadian citizen. MARCELLO A. DE GIORGIS has been director of the Company since October 1999. Mr. DeGiorgis is currently the sole proprietor of Berkshire International Business Consulting. Mr. DeGiorgis also serves as director of Quebecor Printing Inc. KEVIN P. HAYDEN has been Vice President, Operations of the Company since February 1998. Prior thereto, Mr. Hayden was Director, Operations of the Company's Northeast Graphics Inc. subsidiary from November 1997. Prior to holding that position, Mr. Hayden served as Director, Planning since joining the Company in July 1994. MARIE D. HLAVATY has been Vice President, General Counsel and Secretary of the Company since November 1999. Prior to holding that position, Ms. Hlavaty was Vice President, Deputy General Counsel and Assistant Secretary from March 1998. Ms. Hlavaty held the position of Vice President, Assistant General Counsel from October 1996 to March 1998 and the position of Assistant General Counsel from August 1995 to October 1996. Prior thereto, Ms. Hlavaty was Associate Counsel since joining the Company in February 1994. HEIDI J. NOLTE has been Senior Vice President, Chief Information Officer of the Company since July 1997. Prior to holding that position, Ms. Nolte was Vice President, Chief Information Officer since joining the Company in September 1994. Prior to joining World Color, Ms. Nolte was Senior Director, MIS at U.S. Surgical where she had been employed since 1979. CHRISTIAN M. PAUPE has been an officer and director of the Company since August 1999. Mr. Paupe has also served as Executive Vice President and Chief Financial Officer of Quebecor Printing Inc., since January 1999. In April 1999, Mr. Paupe was appointed as Executive Vice President, Chief Administrative Officer and Chief Financial Officer of Quebecor Printing Inc. Prior thereto, Mr. Paupe held the position of Senior Executive Vice President and Director of Levesque Beaubien Geoffrion Inc. (investment dealer) from 1997 until January 1999. Prior thereto, Mr. Paupe was a Senior Vice President of Southam Inc. (newspaper publisher) from 1995 to 1997. From 1993 to 1995, Mr. Paupe was Vice President, Corporate Finance of Bell Canada International Inc. (cable and telecommunications). Mr. Paupe is a Swiss and Canadian citizen. MICHEL P. SALBAING has been Senior Vice President, Chief Financial Officer since August 1999 and a director since October 1999. Prior to holding that position, Mr. Salbaing held the position of Chief Executive Officer, Quebecor Printing Europe since April 1998. From June 1996 to April 1998, Mr. Salbaing held the position of Chief Financial Officer of Quebecor Printing Inc. Prior thereto, Mr. Salbaing was Chief Financial Officer of Societe Generale de Financement du Quebec. Mr. Salbaing is a United States, French and Canadian citizen. DIRECTOR'S FEES Each director who is not an employee of the Company receives an annual board retainer of $7,500 as well as $1,000 attendance fee per meeting. Directors who are also employees of the Company receive no remuneration for serving as directors. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The following table sets forth the cash compensation awarded in fiscal years 1997, 1998 and 1999, paid to or earned by (i) all individuals serving as a Chief Executive Officer during the last completed fiscal year, (ii) our four most highly paid executive officers other than Chief Executive Officer who were serving as executive officers at the end of the last completed fiscal year, and (iii) two additional individuals who would have been covered under (ii) but for the fact that he/she was not serving as an executive officer at the end of the last fiscal year. - ------------------------ (1) Mr. Burton was employed by the Company until October 1999. (2) Ms. Adams was employed by the Company until December 1999. (3) Mr. Salbaing commenced employment as of August 1999. Accordingly, compensation shown reflects amounts paid after that date. (4) Mr. Lewis was employed by the Company until August 1999. (5) Mr. Lillie was employed by the Company until August 1999. (6) On April 6, 1999, the Company granted Mr. Burton 40,000 Restricted Shares. In addition, Mr. Reisch, Ms. Adams, Mr. Lewis and Mr. Lillie were granted 30,000 Restricted Shares, 20,000 Restricted Shares, 15,000 Restricted Shares and 7,500 Restricted Shares, respectively. The fair market value of World Color's common stock on such date was $21.19 per share. Under the Company's Restricted Stock Plan, shares vested over a five year period. Pursuant to the Merger Agreement, the Board of Directors of World Color (or, if appropriate, the committee administering the Restricted Stock Plan) adopted resolutions and took such actions as required to provide that any restrictions imposed pursuant to the Restricted Stock Plan on any shares of common stock of World Color (such shares, "Restricted Stock") would (subject to the consummation of the Offer) lapse and each share of Restricted Stock would be entitled to receive $35.69 per share. All such shares were subsequently tendered into the Offer. (7) On May 28, 1998, the Company granted Mr. Burton, Mr. Reisch and Ms. Adams 40,000 shares of Restricted Stock, 25,000 shares of Restricted Stock and 25,000 shares of Restricted Stock, respectively. The fair market value of the Company's common stock on such date was $30.063 per share. On November 16, 1998, the Company granted Mr. Burton and Mr. Reisch an additional 25,000 shares of Restricted Stock and 20,000 shares of Restricted Stock, respectively. The fair market value of the Company's common stock on such date was $30.50 per share. Under the Company's 1998 Restricted Stock Plan, shares vested over a five-year period. Any of such shares outstanding at the time of the Offer were tendered into the Offer. (8) Messrs. Burton, Reisch, Brofft, Lewis and Lillie and Ms. Adams and Nolte received certain amounts provided for under their respective Change in Control/Retention and Severance Agreements in connection with the Change in Control. Mr. Burton's amount includes the amount due to him under the Third Amended and Restated Supplemental Retirement Plan. OPTION GRANTS IN 1999 INDIVIDUAL GRANTS - ------------------------ (1) Had these options not been settled in connection with the consummation of the Offer in August 1999, the options would have vested in 20% annual increments over a period of five years from the date of grant, subject to accelerated vesting in the event of termination of employment upon death, permanent disability or a permitted retirement and upon a change in control of World Color. The options were exercisable for ten years from the date of the grant, with certain exceptions, including, without limitation, in the case of the termination of the option holder's employment with World Color. Under certain circumstances, the option holder had the right to resell option shares and World Color had the right to repurchase a specified percentage of options and option shares. (2) The fair market value as of the dates of grant, February 3, 1999, in the case of Mr. Burton's grant of 875,000 options and May 5, 1999 in the case of all other grants to the named executive officers, has been calculated using the Black-Scholes method using assumptions about stock price volatility, dividend yield and future interest rates. The assumptions used in calculating the grant date values are set forth in the following table: For each grant, the assumed expected life of the options was ten years, and the assumed dividend yield of the option was zero. The fair market value as of the grant dates set forth in the table are only theoretical values and may not accurately determine fair market value. The actual value, if any, that was realized by each individual depended on the market price of the common stock on the date of exercise/settlement. AGGREGATE OPTION EXERCISES IN FISCAL 1999 AND FISCAL YEAR END OPTION VALUES - ------------------------ (1) Mr. Burton exercised these options in April 1999. (2) Pursuant to the Merger Agreement, the Board of Directors of World Color (or, if appropriate, the committee administering the Stock Option Plans) adopted such resolutions or took such other actions as required to effect the following: adjust the terms of all outstanding employee or director stock options to purchase common shares and any related stock appreciation rights ("Company Stock Options") granted under any stock option or stock purchase plan, program or arrangement of World Color (the "Stock Plans"), to provide that, subject to certain exceptions, at the consummation of the Offer, each Company Stock Option outstanding immediately prior to the consummation of the Offer be cancelled in exchange for (A) a cash payment from the surviving corporation to be made promptly following the consummation of the Offer (subject to any applicable withholding taxes) equal in value to (1) the product of (x) the total number of shares of World Color common stock subject to such Company Stock Option (the "Option Shares"), multiplied by (y) $22.00, multiplied by (z) the excess of $35.69 over the exercise price per share of World Color common stock subject to such Company Stock Option, divided by (2) $35.69, and (B) a number of shares of QPI common stock to be issued promptly following the effective time of the Merger equal to (1) the product of (x) the number of Option Shares, multiplied by (y) 0.6311, multiplied by (z) the excess of $35.69 over the exercise price per share of World Color common stock subject to such Company Stock Option, divided by (2) $35.69. The calculation of the amounts described in (A) and (B) may also be expressed with the following formulas: (A) = (Options Shares) X ($22.00) X ($35.69-Exercise Price)/$35.69 (B) = (Options Shares) X (.6311) X ($35.69-Exercise Price)/$35.69 The Stock Plans and any other plan, program or arrangement providing for the issuance or grant of any other interest in respect of the capital stock of World Color or any subsidiary terminated as of the effective time of the Merger. (3) As of December 31, 1999, all options had been settled in connection with the Merger and none were outstanding. COMPENSATION UNDER RETIREMENT PLANS PENSION PLAN BENEFITS The retirement plan of the Company in which the named executive officers, among others, participate is named the World Color Press Cash Balance Plan (the "Cash Balance Plan"), and provides for the determination of a participant's accrued benefit on a cash balance formula. Although the Cash Balance Plan is a defined benefit pension plan, each participant is credited with a hypothetical individual account in order to better describe his or her benefit. A participant's cash balance account is credited each month with an amount equal to 4% (on an annualized basis) of the participant's annual base wages plus monthly interest at an annual rate equal to the interest on one-year U.S. Treasury securities. A participant in the Cash Balance Plan becomes fully vested in his/her accrued benefit after the completion of five years of service. Benefits under the Cash Balance Plan are limited to the extent required by provisions of the Internal Revenue Code of 1986, as amended (the "Code") and the Employee Retirement Income Security Act of 1974, as amended. If payment of actual retirement benefits is limited by such provisions, an amount equal to any reduction in retirement benefits will be paid as a supplemental benefit under World Color's unfunded Supplemental Executive Retirement Plan, as amended. The following table sets forth the estimated combined annual retirement benefits under the Cash Balance Plan and the Supplemental Executive Retirement Plan (exclusive of Social Security payments) payable on a straight single life annuity basis to each of Messrs. Reisch and Brofft and Ms. Nolte assuming continued service until age 65 and current compensation levels remain unchanged. PENSION TABLE In connection with their departure from the Company, none of Ms. Adams or Messrs. Lillie or Lewis, participate in the Cash Balance Plan and the Supplemental Executive Retirement Plan. Mr. Salbaing does not participate in the Cash Balance Plan or the Supplemental Executive Retirement Plan. AGREEMENTS WITH NAMED EXECUTIVE OFFICERS The terms of employment for Mr. Reisch as the President and Chief Executive Officer of Quebecor World North America, contemplate that he will be paid an annual salary of $600,000 to be reviewed annually; he will participate in the Quebecor Printing Inc. short-term incentive plan; he will be entitled to receive stock option grants under the Quebecor Printing Inc. Executive Stock Option Plan; and that he will receive all benefits to which other senior executives of Quebecor Printing Inc. are entitled to receive. Mr. Reisch is also entitled to receive severance benefits in case of termination of employment pursuant to his employment arrangement with QPI and that certain Retention and Severance Agreement entered into between Mr. Reisch and the Company in August 1999 (the "Retention and Severance Agreement"). The Retention and Severance Agreement and condition of the special one-time option grants by Quebecor Printing Inc. to Mr. Reisch include non-competition/non-solicitation covenants restricting Mr. Reisch's ability to own, manage, operate, join, control or participate in the ownership, management, operation or control of any "competing business," with certain exceptions or solicit customers or employees. Such restrictions are to be effective during Mr. Reisch's employment and for a period of up to 18 months after termination of his employment. Each of Ms. Nolte and Ms. Hlavaty and Messrs. Bacon, Brofft, Carousso and Hayden are party to Retention and Severance Agreements with the Company providing for the payment of retention bonuses and in the case of a termination of employment by the Company without cause or by the employee for good reason (as such terms are defined in the respective agreements), the payment of severance benefits including continuation of coverage and participation in employee welfare and fringe benefit plans or programs until the earlier of the first anniversary of termination or the date on which the respective employee becomes re-employed and receives comparable benefits. Pursuant to their respective Retention and Severance Agreements, each of Ms. Nolte and Ms. Hlavaty and each of Messrs. Brofft, Carousso and Hayden are subject to non-competition/non-solicitation covenants, which provide that for one year from the earlier of August 20, 2000 or the date of termination of employment, the respective employee shall not directly or indirectly, own, manage, operate, join, control or participate in the ownership, management, operation or control of any "competing business," with certain exceptions, or solicit customers or employees. Under these agreements, the employees receive a full gross-up for all excise taxes and related costs in connection with any payments deemed "excess parachute payments." COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Compensation Committee for the Company during 1999 until the Change in Control was comprised of Messrs. Gerald Armstrong and Scott Stuart, Dr. Mark Griffin and Ms. Patrice Daniels. Until the acquisition by QPI, World Color paid fees to Kohlberg Kravis Roberts & Co. L.P. ("KKR") of $750,000 per year for management consulting and financial advisory services. Mr. Stuart, a former director and member of the Compensation Committee, is a member of the limited liability company which is a general partner of KKR and is a general partner of KKR Associates. Mr. Alexander Navab, Jr., a former director of World Color, is an Executive of KKR and a limited partner of KKR Associates. CIBC, Inc., an affiliate of CIBC Oppenheimer Corp., was a lender under the Company's credit facility and CIBC Oppenheimer Corp. was a co-lead manager in the Company's November 1998 issuance of $300.0 million of its 8 3/8% Senior Subordinated Notes due 2008 and a co-manager in the Company's February 1999 issuance of $300.0 million of its 7 3/4% Senior Subordinated Notes due 2009. Ms. Daniels, who is a former director and member of the Compensation Committee, is a managing director of CIBC Oppenheimer Corp. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth information regarding the beneficial ownership of the Common Stock of Quebecor World as of March 1, 2000, including beneficial ownership by (i) each stockholder of Quebecor World who owns more than 5% of the outstanding shares of Quebecor World Common Stock, (ii) each director of Quebecor World, (iii) the Chief Executive Officer of Quebecor World, (iv) Quebecor World's four highest paid executive officers (exclusive of the Chief Executive Officer) and (v) all directors and executive officers of Quebecor World as a group. Except otherwise noted, the persons named in the table below have sole voting and investment power with respect to all shares of Quebecor World common stock shown as beneficially owned by them. - ------------------------ (1) For purposes of this table, "beneficial ownership" includes any shares that a person has the right to acquire within 60 days of March 1, 2000. For purposes of computing the percentage of outstanding shares of Quebecor World Common Stock held by each person or group of persons named above on a given date, any security which this person(s) has the right to acquire within 60 days after March 1, 2000 is deemed to be outstanding for purposes of computing the percentage ownership of this person, but is not deemed to be outstanding in computing the percentage ownership of any other person. (2) Quebecor Printing Inc. indirectly owns all of the issued and outstanding shares of its subsidiary, Quebecor Printing (USA) Holdings Inc. The address for Quebecor Printing (USA) Holdings Inc. is 300 Delaware Ave., Suite 900, Wilmington, DE 19801. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Until the acquisition by QPI, World Color paid fees to KKR of $750,000 per year for management consulting and financial advisory services. In August 1999, World Color paid KKR fees of $17,997,000 for consulting services related to the acquisition by QPI. We believe these fees were no less favorable than those which could be obtained for comparable services from unaffiliated third parties. Members of the limited liability company which is the general partner of KKR and employees of KKR who also served as directors of World Color did not receive additional compensation for service in such capacity, other than customary directors' fees. Mr. Scott Stuart was a director of World Color until August 1999 and is a member of the limited liability company which is the general partner of KKR and a general partner of KKR Associates. Mr. Alexander Navab, Jr. was a director of World Color until August 1999 and is an executive of KKR and a limited partner of KKR Associates. CIBC, Inc., an affiliate of CIBC Oppenheimer Corp., was a lender under World Color's credit facility and CIBC Oppenheimer Corp. was a co-lead manager in World Color's November 1998 issuance of $300.0 million of its 8 3/8% Senior Subordinated Notes due 2008 and a co-manager in World Color's February 1999 issuance of $300.0 million of its 7 3/4% Senior Subordinated Notes due 2009. Ms. Patrice Daniels was a director of World Color and is a managing director of CIBC Oppenheimer Corp. On November 5, 1997, World Color loaned $100,000 to each of Messrs. Lewis, Lillie and Quinlan, each of whom were executive officers of World Color, to enable each of such persons to purchase World Color's common stock in the open market. Each such loan bore interest at the rate of 7.0% per annum in 1999. In connection with the Change of Control of World Color, these loans were forgiven in accordance with the applicable Change in Control agreements between World Color and such individuals. On April 26, 1999, World Color loaned $100,000 to each of Messrs. Lewis, Lillie, Quinlan, Carousso and Ms. Hlavaty. Each of Messrs. Lewis, Lillie, Quinlan and Carousso were executive officers for purposes of Section 16 of the Securities Exchange Act of 1934 at such time. These loans were made to enable such persons to purchase World Color's common stock in the open market. Each of such loans bore interest at the rate of 7.0% per annum in 1999. In connection with the Change in Control in August 1999 such loans were repaid by these individuals and in accordance with the applicable requirements of Section 16(b) of the Securities Exchange Act of 1934 the profit with respect to such shares purchased was disgorged, as applicable. In connection with World Color's common stock repurchase program and in an effort to provide for an orderly disposition of options held since at least 1991 and expiring over the next two to three years, World Color repurchased from Messrs. Armstrong and Burton shares issued upon the exercise of certain stock options. Specifically, World Color repurchased 31,603 shares and 180,782 shares from Messrs. Armstrong and Burton, respectively, on April 6, 1999 at the fair market value of $21.00 per share. In 1999, certain wholly owned subsidiaries of QPI provided Company with $511.5 million, which was borrowed on the Company's behalf from the subsidiaries' external long-term credit facilities. The resulting indebtedness has an interest rate of LIBOR plus 2% per annum, adjusted quarterly. The interest rate was 8.07% at December 31, 1999. Payment is not required prior to January 1, 2001. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." As part of the Merger costs, the Company recognized a non-cash charge of $67.5 million for the cancellation and settlement by Acquisition Inc. of all vested and unvested options. Of this amount, $40.9 million was paid directly by Acquisition Inc. to the option holders on behalf of the Company and $26.6 million was paid in stock of QPI upon consummation of the Merger. In addition, Acquisition Inc. contributed $51.3 million to the Company to pay certain other Merger costs. These amounts will not be repaid and are, therefore, included in stockholders' equity in the 1999 consolidated balance sheet. At December 31, 1999, the Company had amounts payable to a wholly owned subsidiary of QPI of approximately $5.1 million for the purchase of raw materials. In addition, the Company sold land for $4.0 million to a wholly owned subsidiary of QPI. The Company subsequently leased this property from the subsidiary for a lease term through 2004. The Company believes that any past or present transactions with its affiliates have been at prices and on terms no less favorable to the Company than transactions with independent third parties. The Company may enter into transactions with its affiliates in the future. However, the Company intends to enter into such transactions only at prices and on terms no less favorable to the Company than transactions with independent third parties. In addition, the Company's debt instruments generally prohibit the Company from entering into any such affiliate transaction on other than arm's length terms. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: (i) Consolidated Financial Statements--See accompanying Index to Consolidated Financial Statements and Financial Statement Schedule on (ii) Financial Statement Schedule: Schedule II, Valuation and Qualifying Accounts, as set forth on page S-1 of this report. All other schedules have been omitted because they are inapplicable or are not required or the information is included elsewhere in the financial statements or notes thereto. (iii) Exhibits: - ------------------------ (b) Reports on Form 8-K The registrant filed a Current Report on Form 8-K dated October 8, 1999, with respect to the merger with an indirect wholly owned subsidiary of Quebecor Printing Inc. The items reported in such Current Report were Item 2 (Acquisition or Disposition of Assets) and Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated on March 30, 2000. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE All other schedules for which provision is made in the applicable regulations of the Securities and Exchange Commission are omitted because they are not required under the related instructions or are not applicable or the required information is shown in the financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Quebecor World (USA) Inc.: We have audited the accompanying consolidated balance sheets of Quebecor World (USA) Inc. and subsidiaries as of December 31, 1999 and December 27, 1998, and related consolidated statements of operations, stockholders' equity and cash flows for each of the three years then ended. Our audits also included the financial statement schedule listed in the Index at Item 14. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Quebecor World (USA) Inc. and subsidiaries at December 31, 1999 and December 27, 1998, and the results of their operations and their cash flows for each of the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 2 to the consolidated financial statements, in 1999 Quebecor World (USA) Inc. changed its method of accounting for deferred start-up costs to conform with Statement of Position 98-5. DELOITTE & TOUCHE LLP New York, New York January 24, 2000 QUEBECOR WORLD (USA) INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND DECEMBER 27, 1998 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. QUEBECOR WORLD (USA) INC. CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (IN THOUSANDS) See notes to consolidated financial statements. QUEBECOR WORLD (USA) INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (IN THOUSANDS) See notes to consolidated financial statements. QUEBECOR WORLD (USA) INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (IN THOUSANDS) See notes to consolidated financial statements. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1. ORGANIZATION Quebecor World (USA) Inc., formerly known as World Color Press, Inc., (along with its subsidiaries the "Company" or "World") specializes in the production and distribution of data for customers in the commercial, magazine, catalog, direct mail, book and directory markets. On July 12, 1999, the Company entered into an Agreement and Plan of Merger with Quebecor Printing Inc. ("QPI") and its indirect wholly owned subsidiary, Printing Acquisition Inc. ("Acquisition Inc."), which provided for the acquisition of the Company (the "Merger"). On July 16, 1999, QPI, through Acquisition Inc., commenced a tender offer to acquire up to 23,500,000 shares of the Company's common stock at a price of $35.69 per share. On August 20, 1999, QPI acquired, through Acquisition Inc., 19,179,495, or approximately 50.4%, of the Company's outstanding shares. On October 8, 1999, the Company and Acquisition Inc. completed the Merger following receipt of approval from the Company's stockholders. As a result, the Company became an indirect wholly owned subsidiary of QPI and at that time was renamed Quebecor World (USA) Inc. The remaining outstanding shares of World's common stock (other than shares purchased by QPI in the tender offer) were converted into the right to receive 1.2685 subordinate voting shares of QPI and $8.18 in cash per share. In addition, each 6% Convertible Senior Subordinated Note due 2007, outstanding at the Merger, became convertible into the number of QPI subordinate voting shares and cash that would have been received had the convertible note been converted immediately prior to October 8, 1999. In connection with the Merger, all of the Company's then outstanding common stock, treasury stock and additional paid-in capital was recapitalized into 10 common shares, par value $1.00 per share. All shares are held by a wholly owned subsidiary of QPI. Under the Company's new capital structure, 3,000 common shares, par value $1.00, were authorized. No preferred shares were authorized. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION--The consolidated financial statements include the accounts of Quebecor World (USA) Inc. and its subsidiaries. Intercompany transactions have been eliminated. CASH AND CASH EQUIVALENTS--Cash equivalents consist of highly liquid instruments with original maturities of three months or less. ACCOUNTING PERIOD--In 1999, the Company changed its fiscal year end from the last Sunday in December to December 31, 1999 to conform to QPI's fiscal year end. This change resulted in a 369-day period rather than a 52-week period under the previous policy. The change in fiscal year did not have a material effect on the Company's results of operations. The Company's fiscal year in 1998 and 1997 was the 52-week period ending on the last Sunday in December. CONSOLIDATED STATEMENTS OF CASH FLOWS--During 1999, 1998 and 1997, the Company borrowed and repaid $1,860,706, $599,100 and $563,200, respectively, pursuant to the terms of credit agreements. See also Note 9. Such amounts have been reflected as net in the consolidated statements of cash flows because of the short-term nature of the borrowings. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Cash paid for interest by the Company during the years 1999, 1998 and 1997 was $101,141, $82,392 and $75,738, respectively, net of capitalized interest of $1,919, $2,374 and $941, respectively. Cash paid for taxes during the years 1999, 1998 and 1997 was $19,162, $35,145 and $28,266, respectively. REVENUE RECOGNITION--In accordance with trade practice, sales are recognized by the Company on the basis of production and service activity at the pro rata billing value of work completed. INVENTORIES--The Company's raw materials of paper and ink and the related raw material component of work-in-process are valued at the lower of cost, as determined using the first-in, first-out method, or market. The remainder of the work-in-process is valued at the pro rata billing value of work completed. DEPRECIATION AND AMORTIZATION--Property, plant and equipment is stated at cost. Depreciation is recorded principally on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on the straight-line method over the lesser of the useful life of the improvement or the lease term. Estimated useful lives used in computing depreciation and amortization expense are 3 to 15 years for machinery and equipment and 15 to 40 years for buildings and leasehold improvements. GOODWILL--Goodwill is amortized using the straight-line method primarily over 35 years. Amortization of goodwill for the years 1999, 1998 and 1997 was $24,093, $20,008 and $16,424, respectively, and is included in selling, general and administrative expenses. Accumulated amortization of goodwill was $95,329 and $71,236 as of year end 1999 and 1998, respectively. RECLASSIFICATIONS--Certain reclassifications have been made to prior years' amounts to conform with the current year presentation. USE OF ESTIMATES--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. INTEREST RATE SWAP AGREEMENTS--The Company enters into interest rate swap agreements from time to time to reduce exposures to market risks resulting from fluctuations in interest rates. The Company does not hold or issue any derivative financial instruments for trading purposes. Gains and losses on interest rate agreements are recognized through income and offset the transactions which they are intended to hedge. RECENT ACCOUNTING PRONOUNCEMENTS--In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components in the financial statements. The Company adopted this statement in the first quarter of fiscal year 1998. The adoption of SFAS No. 130 did not have a material effect on the Company's consolidated financial statements. In June 1997, the Financial Accounting Standards Board also issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) reporting information on operating segments in the financial statements. The Company adopted this statement for the fiscal year ended 1998. In accordance with this standard, the Company has determined that, while it offers services to a diverse group of customers in different industries, the Company itself operates in one business segment, the management and distribution of print and digital information. In accordance with the management approach prescribed in the statement, there are no discernable operating segments that management evaluates separately on a regular basis. In addition, no customer accounted for more than 5% of the Company's net sales in 1999. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This SOP requires certain costs related to computer software developed or obtained for internal use to be expensed or capitalized depending on the stage of development and the nature of the costs. The Company adopted this SOP in the first quarter of fiscal year 1999. The adoption of SOP 98-1 did not have material effect on the Company's consolidated financial statements. In April 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of Start-Up Activities," which requires costs of start-up activities and organization costs to be expensed as incurred. The Company adopted this SOP in the first quarter of fiscal year 1999, which resulted in a charge of $10,513, net of taxes of $7,305, as the cumulative effect of a change in accounting principle for the non-recurring write-off of deferred start-up costs. The adoption of this SOP did not have a material effect on operating income on a continuing basis . In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement requires companies to recognize all derivatives as either assets or liabilities and measure those instruments at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. In June 1999, the Financial Accounting Standards Board issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133," to delay the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. Therefore, the Company plans to adopt SFAS No. 133 in the first quarter of fiscal year 2001. The Company does not expect the adoption of SFAS No. 133 to have a material impact on its consolidated financial statements. 3. BUSINESS ACQUISITIONS In fiscal year 1999, the Company acquired five businesses serving customers in the commercial, retail and directory markets for an aggregate purchase price of approximately $203,000, including assumed indebtedness. In 1998, the Company acquired four businesses serving customers in the commercial, direct mail and book markets for an aggregate purchase price of approximately $200,000. In 1997, the Company acquired two businesses serving the book and short-run publication markets for an aggregate purchase price of approximately $194,000. These acquisitions were accounted for as purchases and the consolidated financial statements include the results of their operations from the respective acquisition dates. These acquisitions have not had a material effect on the Company's results of operations. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 4. MERGER RELATED COSTS The Company incurred $169,301 of non-recurring Merger related costs in 1999. These costs included: the cancellation and settlement by Acquisition Inc. of all vested and unvested options, bonuses, severance, legal and attorney fees, and other fees specifically related to the Merger. In addition, the Company's outstanding restricted stock became fully vested in connection with the Merger. The Merger related costs are included in selling, general and administrative expenses in the Company's 1999 consolidated statement of operations. The majority of these costs were paid in 1999. In connection with the Merger, the Company has developed an integration strategy for the combined entities that requires the redeployment and/or disposal of assets and the shutdown or relocation of certain of the Company's plant locations and sales offices. This revised strategic initiative resulted in a charge to the Company's 1999 cost of sales and selling, general and administrative expenses of $134,668 and $9,876, respectively. The charge was primarily composed of $40,011 for the writedown of fixed assets to reflect the fair market value, $32,303 for severance and related costs to shut down certain plant locations and sales offices, $19,672 for the disposal and other related costs of inventories and $34,100 to reflect other operational changes in the business as a result of the Merger. At December 31, 1999, all such assets have been adjusted to reflect the appropriate value and the Company expects to proceed with the closure of the facilities and related employee terminations in 2000. The expected cash expenditures for the above charges are approximately $14,000, the majority of which is severance related and will be paid in 2000. As a result of the Merger integration plan, the Company anticipates incurring additional charges, primarily in 2000, of approximately $26,000. 5. INVENTORIES QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 6. PROPERTY, PLANT AND EQUIPMENT Depreciation expense related to property, plant and equipment was $131,206, $120,250 and $114,819 for the years 1999, 1998 and 1997, respectively. 7. ACCRUED EXPENSES 8. RESTRUCTURING AND OTHER SPECIAL CHARGES In 1999, the Company recorded restructuring and other special charges of $74,807, or $44,297 net of tax, to eliminate redundant and less efficient capacity resulting from its ongoing acquisition strategy. The restructuring and other special charges included the costs to exit and consolidate certain facilities and sales offices, write down impaired assets and eliminate certain administrative positions. These charges, consisting primarily of $26,615 for the writedown of equipment and $44,566 to reserve for certain lease costs, resulted from changes in the Company's strategic growth objectives and were primarily determined based on independent appraisals. The Company has closed the affected facilities and sales offices and terminated related employees. Fixed assets have been adjusted to reflect their appropriate values. In 1999, the Company paid approximately $5,000 related to these charges. The remaining costs, primarily lease payments, will extend through 2008. The Company does not expect to incur additional expenses related to this restructuring initiative. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 9. LONG-TERM DEBT 7.75% SENIOR SUBORDINATED NOTES--On February 22, 1999, the Company issued Senior Subordinated Notes in the aggregate principal amount of $300,000, receiving net proceeds of approximately $294,000. Interest on the notes is payable semi-annually at the annual rate of 7.75%. The notes do not have required principal payments prior to maturity on February 15, 2009. The net proceeds from the notes issuance were utilized to repay certain indebtedness under the Credit Agreement, as defined below. The fair value of the notes was approximately $287,000 at December 31, 1999 based on quoted market prices. 8.375% SENIOR SUBORDINATED NOTES--On November 20, 1998, the Company issued Senior Subordinated Notes in the aggregate principal amount of $300,000, receiving net proceeds of approximately $291,700. Interest on the Senior Subordinated Notes is payable semi-annually at the annual rate of 8.375%. The notes do not have required principal payments prior to maturity on November 15, 2008. The Company utilized the net proceeds from the issuance of these notes to repay revolving loan commitments incurred under the Credit Agreement and to redeem all of its outstanding 9.125% Senior Subordinated Notes. The fair value of the notes was approximately $299,000 and $300,000 at December 31, 1999 and December 27, 1998, respectively, based on quoted market prices. CONVERTIBLE SENIOR SUBORDINATED NOTES--On October 8, 1997, the Company issued $151,800 aggregate principal amount of Convertible Senior Subordinated Notes (the "Convertible Notes"), receiving net proceeds of approximately $147,900. Interest on the Convertible Notes is payable semi-annually at the annual rate of 6.00%. The Convertible Notes have no required principal payments prior to maturity on October 1, 2007. The Convertible Notes are convertible at the option of the holder at any time and at the option of the Company, at specified prices, subsequent to October 4, 2000. As discussed in Note 1, on October 8, 1999, each 6% Convertible Note due 2007 became convertible into the number of QPI subordinate voting shares and cash that would have been received had the Convertible Note been converted immediately prior to October 8, 1999. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 9. LONG-TERM DEBT (CONTINUED) The face value of the Convertible Notes was reduced to approximately $144,000 during 1999, due to the redemption of the notes by the holders. The Company does not intend to exercise its option to redeem the Convertible Notes in 2000, therefore the Convertible Notes are classified as long-term in the consolidated balance sheet. The fair value of the notes was approximately $146,000 and $149,000 at December 31, 1999 and December 27, 1998, respectively, based on quoted market prices. 9.125% SENIOR SUBORDINATED NOTES--On May 10, 1993, the Company issued Senior Subordinated Notes in the aggregate principal amount of $150,000. Interest on the Senior Subordinated Notes was payable semi-annually at the annual rate of 9.125%. The notes did not have required principal payments prior to maturity on March 15, 2003. On December 28, 1998, the Company used proceeds from its November 1998 debt issuance to redeem all of its outstanding 9.125% Senior Subordinated Notes due 2003 in an aggregate principal amount of $150,000. The notes were redeemed for approximately $160,800, including the redemption premium of $6,840 and accrued interest. This early extinguishment of debt generated an extraordinary charge of $5,946, net of taxes of $4,132, for the redemption premium and write-off of deferred financing costs. The 9.125% Senior Subordinated Notes were classified as current maturities of long-term debt in the December 27, 1998 consolidated balance sheet. BORROWINGS UNDER CREDIT AGREEMENTS--On February 22, 1999 concurrent with the 7.75% Senior Subordinated Notes issuance, the Second Amended and Restated Credit Agreement dated as of June 6, 1996, as amended (the "Credit Agreement"), was amended resulting in, among other modifications, a $95,000 permanent reduction in borrowings and commitments under the Credit Agreement. As a result, aggregate total commitments decreased from $920,000 to $825,000. The amendment and related permanent reduction in total borrowings and commitments resulted in a substantial modification of the terms under the Credit Agreement. Accordingly, the Company recognized an extraordinary charge for the early extinguishment of debt of $6,046, net of taxes of $4,201, for the write-off of deferred financing costs. Subsequent to the Merger, the Company repaid all of its outstanding debt incurred under the Credit Agreement. At December 31, 1999, there were no available commitments under the Credit Agreement. On August 20, 1999, the Company entered into a credit agreement with a third party lender with a maximum total commitment of $100,000. Interest is payable at a variable floating rate based on LIBOR or prime rate. At December 31, 1999, the Company did not owe any amounts under this agreement. NOTES BORROWED ON THE COMPANY'S BEHALF--In 1999, certain wholly owned subsidiaries of QPI provided the Company with $511,500, which was borrowed on the Company's behalf from subsidiaries' external long-term credit facilities. The Company used these funds to pay certain Merger expenses and repay $491,600 in outstanding debt incurred under the Credit Agreement. The borrowings bear interest at rates based on LIBOR plus 2% per annum, adjusted quarterly. Interest on the borrowings ranged from 7.23% to 8.07% in 1999. Payment is not required prior to January 1, 2001. In 1999, the Company incurred $14,374 of interest expense, of which $2,305 was included in payables to related parties on the consolidated balance sheet at December 31, 1999. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 9. LONG-TERM DEBT (CONTINUED) The fair value of these notes was approximately $511,600 at December 31, 1999, based upon the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair value of the Company's remaining debt approximated its carrying value, based upon the Company's current incremental borrowing rates for similar types of borrowing arrangements. Aggregate annual maturities of long-term debt subsequent to December 31, 1999 are as follows: 10. ASSET SECURITIZATION On June 30, 1997, the Company entered into an agreement to sell, on a revolving basis for a period of up to five years, certain of its accounts receivable to a wholly-owned subsidiary, which entered into an agreement to transfer, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable to a maximum of $204,000. Subsequent to the Merger, this asset securitization program was cancelled. The Company entered into a new agreement which was aligned with QPI's existing program and has substantially the same terms and conditions as World's previous agreement. At December 31, 1999 and December 27, 1998, accounts receivable was reduced by $200,000 for amounts sold. Fees arising from the securitization transaction of $11,456, $11,888 and $5,133 are included in interest expense and securitization fees in the consolidated statements of operations for the years ended December 31, 1999, December 27, 1998 and December 28, 1997, respectively. These fees vary based on commercial paper rates plus a margin. The Company maintains an allowance for doubtful accounts based on the expected collectibility of all accounts receivable, including receivables sold. 11. LEASES OPERATING LEASES--The Company leases certain equipment, warehouse facilities and office space under noncancellable operating leases which expire over the next 11 years. Most of these operating leases provide the Company with the option, after the initial lease term, either to purchase the equipment or renew its lease based upon the fair value of the property at the option date. In 2000, the Company entered into an agreement to lease real property from a wholly owned subsidiary of QPI. The lease, which expires in December 2004, has been classified as an operating lease. The lease payments of $360 per year have been included in the minimum rental payments table. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 11. LEASES (CONTINUED) In 1998, the Company entered into interest rate swap agreements to exchange floating rate for fixed interest payments. The agreements effectively converted a notional principal amount of $75,000 variable rate, quarterly operating lease payments into fixed. As allowable under the agreements, the respective counterparties cancelled the agreements in September 1999. These agreements did not have a material impact on the consolidated financial statements for the periods presented. SALE AND LEASEBACK OF EQUIPMENT--In 1998, the Company entered into agreements for the sale and leaseback of certain printing equipment for which it received approximately $88,500 of proceeds. The lease, which expires in July 2010, has been classified as an operating lease. The proceeds were utilized to repay revolving loan commitments incurred under the Credit Agreement. Future minimum rental payments required under noncancellable leases at December 31, 1999 were as follows: Rental expense for operating leases was $57,154, $49,697 and $44,703 for the years 1999, 1998 and 1997, respectively. Assets recorded under capital leases amounted to $1,567, net of accumulated amortization of $357, at the end of 1998. 12. INCOME TAXES The provision (benefit) for income taxes is summarized as follows: QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 12. INCOME TAXES (CONTINUED) The tax effects of significant items comprising the Company's net deferred tax liability as of December 31, 1999 and December 27, 1998 are as follows: The 1999 and 1998 amounts above include a valuation allowance of $3,007 and $5,095, respectively, relating to a capital loss carryforward that potentially may not be realized for tax purposes and for the limitations of certain state net operating loss carryforwards. The following table reconciles the difference between the U.S. federal statutory tax rates and the rates used by the Company in the determination of net income: QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 12. INCOME TAXES (CONTINUED) At December 31, 1999, the Company had net operating loss carryforwards from business acquisitions for federal income tax purposes of $1,762 available to reduce future taxable income, expiring from 2007 to 2010. The Company also had federal tax credits of $4,162 expiring primarily from 2000 to 2002 and state tax credits of $3,894 expiring from 2001 to 2013. In addition, the Company had alternative minimum tax carryover credits of $29,631 which do not expire and may be applied against regular tax in the future, in the event that the regular tax expense exceeds the alternative minimum tax. 13. EMPLOYEE BENEFIT PLANS PENSION PLANS--The Company has defined benefit pension plans in effect which cover certain employees who meet minimum eligibility requirements. The Company contributes annually amounts sufficient to satisfy the government's minimum standards. Net periodic pension cost is determined based upon years of service and compensation levels, using the projected unit credit method. Prior year service costs and unrecognized gains and losses are amortized over the estimated future service periods of active employees in the respective plan. POSTRETIREMENT PLANS--The Company provides postretirement medical benefits to eligible employees. The Company's postretirement health care plans are unfunded. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 13. EMPLOYEE BENEFIT PLANS (CONTINUED) The following table provides a reconciliation of the changes in the plans' benefit obligations and fair value of plan assets for the fiscal years ended December 31, 1999 and December 27, 1998 and a statement of the funded status as of December 31, 1999 and December 27, 1998: The unrecognized net transition asset is being amortized over the average expected future service periods of employees. Plan assets consist principally of common stocks and U.S. government and corporate QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 13. EMPLOYEE BENEFIT PLANS (CONTINUED) obligations. The plans' assets included common stock of the Company totaling $8,934 at December 27, 1998. The following table provides the amounts recognized in the consolidated balance sheets as of December 31, 1999 and December 27, 1998: The following table provides the components of net periodic benefit cost for the fiscal years ended December 31, 1999 and December 27, 1998: The weighted average assumptions used in the measurement of the Company's benefit obligation are as follows: At December 31, 1999, the Company had only one pension plan with an accumulated benefit obligation in excess of plan assets of $1,731. At December 27, 1998, accumulated benefit obligations exceeded plan assets for all pension plans. The market value of plan assets was used to calculate the expected return on plan assets. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 5% at the end of 1998 and 1999, and is expected to remain constant at that rate for future QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 13. EMPLOYEE BENEFIT PLANS (CONTINUED) periods. A one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1999 by $3,395 and the annual postretirement benefit expense by approximately $290. A one percentage point decrease in the assumed health care cost trend rate would decrease the accumulated postretirement benefit obligation as of December 31, 1999 by $3,093 and the annual postretirement benefit expense by approximately $255. Certain union employees of the Company participate in multiemployer plans. Amounts charged to benefit expense relating to the multiemployer plans for 1999, 1998 and 1997 totaled $3,850, $3,685 and $3,352, respectively. In addition, the Company has various deferred savings and profit sharing plans for certain employees who meet eligibility requirements. Amounts charged to benefit expense related to these plans for 1999,1998 and 1997 totaled $3,891, $2,993 and $1,977, respectively. 14. STOCK-BASED COMPENSATION PLANS STOCK OPTION PLANS--Prior to the Merger, the Company had stock option plans that permitted the Stock Option Committee to grant up to an aggregate of 7,750,000 options to purchase shares of the Company's common stock to certain key employees of the Company. Options granted under the plans generally vested ratably over a five-year period. Vested options were exercised up to ten years from the date of grant. Subsequent to the Merger, the Company's stock option plan was terminated and no options were granted. Information related to the Company's stock option plans is presented below. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 14. STOCK-BASED COMPENSATION PLANS (CONTINUED) As discussed in Note 4, the Company canceled and settled all vested and unvested options at the time of the Merger. The Company recognized $67,474 compensation expense related to the cancellation and settlement of the outstanding stock options. As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," prior to 1999, the Company had not recorded compensation expense for stock options granted to employees. Therefore, the Company has determined the pro forma net income for fiscal years 1998 and 1997, had compensation expense been recorded for options granted during those years under the applicable fair value method described in the statement. For options granted during 1998 and 1997, the fair value at the date of grant was estimated using the Black-Scholes option pricing model. Under the Black-Scholes model, a volatility factor of .281 and .310 was used for 1998 and 1997, respectively. The following weighted average assumptions were used in calculating the fair value of the options granted in 1998 and 1997, respectively: risk-free interest rates of 5.13% and 6.33%; an assumed dividend yield of zero; and an expected life of the options of ten years. For purposes of the pro forma disclosures, the estimated fair value of the options granted is amortized to compensation expense over the options' vesting period. The Company's pro forma information is as follows: RESTRICTED STOCK--Restricted shares of the Company's stock were issued in 1999 and 1998 to certain key employees under a restricted stock plan. The stock vested ratably over five years and was contingent upon employment. The market value of the stock at the time of grant was recorded as unamortized restricted stock compensation in stockholders' equity and was amortized to expense over the five year vesting period. In 1999 and 1998, the Company issued 202,500 and 135,000 restricted shares of common stock at a weighted average price of $21.19 and $30.21 per share, respectively. As discussed in Note 4, all of the Company's restricted stock became fully vested at the time of the Merger. Unamortized restricted stock compensation at the time of the Merger of $7,306 was recognized in selling, general and administrative expenses as part of the Merger related expenses in 1999. 15. TREASURY STOCK In August 1998, the Board of Directors authorized the repurchase of up to 1,800,000 shares of the Company's common stock. The repurchase of shares commenced in August 1998 in the open market at prevailing market prices or in negotiated transactions, depending on market conditions. The shares were repurchased to satisfy commitments under certain employee benefit plans. When treasury shares were reissued, the Company used the weighted average cost method and the excess of repurchase cost over QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 15. TREASURY STOCK (CONTINUED) reissuance price was treated as a reduction of retained earnings. In 1999, the Company repurchased 1,263,652 shares of common stock at a weighted average cost of $24.18 per share. Since the inception of the plan in 1998, the Company had repurchased 1,750,153 shares at a weighted average cost of $26.02 and reissued 466,255 shares. The Company terminated the share purchase plan in 1999 and the treasury stock was retired as a result of the Merger. 16. RELATED PARTY TRANSACTIONS As part of the Merger expenses discussed in Note 4, the Company recognized a non-cash charge of $67,474 for the cancellation and settlement by Acquisition Inc. of all vested and unvested options. Of this amount, $40,868 was paid directly by Acquisition Inc. to the option holders on behalf of the Company and $26,606 was paid in stock of QPI upon consummation of the Merger. In addition, Acquisition Inc. contributed $51,299 to the Company to pay certain other Merger expenses. These amounts will not be repaid and are, therefore, included in stockholders' equity in the 1999 consolidated balance sheet. At December 31, 1999, the Company had amounts payable to a wholly owned subsidiary of QPI of approximately $5,075 for the purchase of raw materials. This payable, along with the interest payable discussed in Note 9, is included in short-term payables to related parties in the consolidated balance sheet at December 31, 1999. In 1999, the Company sold land for $4,000 to a wholly owned subsidiary of QPI. The Company subsequently entered into a lease agreement for the land with this subsidiary for a lease term through 2004. The Company paid $17,997 for consulting services related to the Merger provided by Kohlberg Kravis Roberts & Co. L.P. These fees are included in the Merger related costs discussed in Note 4. The Company has incurred expenses of $750 in each of the fiscal years ending 1999, 1998 and 1997 for management services provided by affiliated companies prior to the Merger. 17. COMMITMENTS AND CONTINGENT LIABILITIES The Company is subject to legal proceedings and other claims arising in the ordinary course of operations. In the opinion of management, ultimate resolution of proceedings currently pending will not have a material effect on the results of operations or financial position of the Company. QUEBECOR WORLD (USA) INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1999, DECEMBER 27, 1998 AND DECEMBER 28, 1997 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 18. UNAUDITED QUARTERLY FINANCIAL INFORMATION SCHEDULE II QUEBECOR WORLD (USA) INC. VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) - ------------------------ (1) Write-offs of receivables, net of recoveries. (2) Balance of acquired companies at acquisition date. S-1

849145_1999.txt

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1999

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ITEM 1. DESCRIPTION OF BUSINESS. OVERVIEW I-Link Incorporated (the "Company") is an integrated voice and data communications company focused on simplifying the delivery of "Unified Communication." Unified Communication is the integration of traditional telecommunications with new data IP (Internet Protocol) communications systems with the effect of simplifying communications, increasing communication capabilities and lowering overall communication costs. Unified Communication platforms integrate telecommunication, mobile communication, paging, voice-over-IP (VoIP) and Internet technologies. Through its wholly owned subsidiaries I-Link Communications, Inc., and I-Link Systems, Inc., the Company provides enhanced telecommunications services on a wholesale and retail basis. Through its wholly-owned subsidiaries MiBridge, Inc., and ViaNet Technologies Ltd., the Company undertakes the research and development of new telecommunications services, products, and technologies, and the licensing of certain of these products and technologies to other telecommunications companies. I-Link is a leader in the delivery of unified communications as a result of six core technology offerings: I-Link's Intranet, Softswitch Plus-TM-, GateLink-TM-, V-Link-TM-, Indavo-TM-, and I-Link TalkFree-TM-. CORE TECHNOLOGIES I-Link's Intranet I-Link's real-time IP communications network ("RTIP Network") consists of a nationwide, dedicated network of leased telecommunications lines and equipment augmented by IP software developed by I-Link. The RTIP Network is an IP-based network like the Internet; however, it is dedicated for use only by I-Link and its customers - an INTRANET. The RTIP Network provides the platform for the enhanced service applications developed by I-Link and other third-party applications developers who partner with I-Link. The RTIP Network is composed of an IP backbone that ties together local loop dial-up and broadband connections via major hubs strategically located in major metropolitan areas throughout the United States. Through proxies, the RTIP Network is able to integrate SS7, Wireless, Public Switch Telephone Networks (PSTN), the Internet, and next generation network protocols such as SIP, MGCP, and H323 into one interoperable platform. The architecture and technological approach used by the RTIP Network has resulted in cost and capability breakthroughs unattainable through traditional circuit switch telecommunications networks, while maintaining the high voice-quality and reliability associated with traditional circuit switch networks. A more detailed description of the RTIP Network is included below. Softswitch Plus-TM- Softswitch Plus-TM- is the operating system that ties together all of I-Link's core services that are available both to end users and third-party applications developers. Much like a PC's operating system integrates hardware elements such as disk drives, monitors, network interface cards, memory, and other computer elements, Softswitch Plus-TM- integrates communication elements such as connection services, voice recognition, interactive voice response (IVR) services, text-to-speech services, unified messaging, conference call services, operation support systems (OSS) and other application servers and communication elements created by I-Link and/or other third-party applications developers. These software components are called "media servers" and the software layer that ties these together is called a "softswitch." I-Link's Softswitch Plus-TM- greatly simplifies new application development as well as reduces infrastructure costs. GateLink-TM- GateLink-TM- is a powerful set of developer tools that serves as the mechanism for creating new applications, user services and solutions that can be hosted within the I-Link RTIP Network. Companies determined to build real time communication services are faced with many challenges, such as developing the solution, building the network in which the solution will operate, defining the OSS system to properly provision and bill for the new services. GateLink-TM- greatly simplifies this process by confining it to developing the application. Once the application is developed it can be certified by I-Link and then deployed within the RTIP Network. V-Link-TM- V-Link-TM-, one of the applications hosted within the RTIP Network, is a powerful suite of basic and enhanced telecommunications services created by I-Link to meet the communication needs of the residential, SOHO (small office/home office) and SME (small-to-medium enterprise) consumer. V-Link-TM- services include: - ENHANCED LOCAL OR LONG DISTANCE SERVICE. Long distance calls can be made at significantly lower costs. - SINGLE NUMBER SERVICE. Set up to ring a subscriber's office phone, home office phone, cellular phone (or any phone number the subscriber specifies) and pager simultaneously so that he may be reached wherever he is, and without the caller having to try multiple numbers or know his party's current location. - CALL SCREENING/CALL WHISPER. The subscriber can hear the name of the person calling before deciding to accept the call or send it to voice mail. If the subscriber receives a new call while already engaged in a call, the name of the new caller is "whispered" to the subscriber in a manner that is inaudible to the other call participant. - CALLER HOLD. The subscriber can put a caller on hold, with music on hold. - CONFERENCE CALLING. Provides the ability to conference in up to 9 people at one time. - PORTABLE FAX. The subscriber receives a fax to his Single Number Service, he is notified that there is a fax in his mailbox, and he can choose to route the fax to any fax machine, or to his e-mail through a fax-to-e-mail gateway. - VOICE MAIL. Enables callers to leave recorded messages that can be retrieved, saved, forwarded, etc. Subscribers access their V-Link-TM- service through an assigned local and/or toll-free (800) number (that also can become a single, convenient telephone number through which others call and fax the subscriber). Once inside the V-Link-TM- enhanced communications environment, all of the subscriber's communications functions are handled over the I-Link RTIP Network, with its associated benefits and capabilities -- irrespective of where the call is originated. For example, long distance calls are routed primarily through the RTIP Network, and secondarily through the traditional public switched telephone network where needed to ensure full geographic coverage. In addition to long distance calling capability, entering the V-Link-TM- communications environment allows a multitude of enhanced capabilities to the user without the need of any special equipment by the user. Once the communications session is established by logging-in to V-Link-TM- from any telephone, a subscriber has the ability to perform any number of multiple operations within the session (multiple long distance calls, call screening, voice mail, fax, conference calling, etc.). The Indavo-TM- Line Capacity Expansion Device Through its wholly-owned subsidiary ViaNet Technologies, Ltd., the Company has developed Indavo-TM- (referred to by the Company as "C-4" during its development stage), a revolutionary device that from a single standard telephone line that can simultaneously (1) create the capacity of multiple lines that can carry on simultaneous calls and other communications functions ("multiplexing"), (2) provide the inter-office/home functionality of a PBX, and (3) maintain a persistent Internet connection. In other words, through a single standard telephone wire and line, the customer and his or her family members or business associates can, from multiple phones, fax machines, and computers within the customer's home or business premises, simultaneously carry on multiple independent or conference telephone calls, receive or send faxes as if on one or more dedicated fax lines, and maintain a persistent Internet connection, without any sacrifice of quality or functionality. Indavo-TM- provides the capacity of up to 24 lines using the existing telephone wires connected to the customer's home or office. With the Indavo-TM- device connected to a single standard telephone line within the customer's home or business office, the customer obtains the following benefits: MULTIPLEXING. Multiple independent telephone calls and fax send/receive calls can be simultaneously carried on from multiple phones and fax machines within the customer's home or business office, with no degradation of quality. VIRTUAL PBX FUNCTIONALITY. The functionality of a PBX system, normally obtainable through the acquisition of a costly equipment and software system, is achieved over the existing telephones within the customer's home or office. These include inter-home/office call conferencing, call forwarding, etc. PERSISTENT V-LINK-TM- CONNECTION. Through Indavo, the customer is always connected to the V-Link enhanced services environment and can fully utilize all of the services provided by V-Link (and additional enhancements) without the need to dial into the V-Link service. PERSISTENT INTERNET CONNECTION. Through Indavo, the customer is able to maintain a persistent connection to the Internet, usually obtainable only through the purchase by the customer and on-site installation of specialized equipment (a router). Because it obviates the need for the customer to purchase multiple telephone lines, a PBX system, and routing equipment, Indavo-TM- provides both substantial cost savings and increased functionality to the customer. It is anticipated that a larger capacity version of the Indavo-TM- device will be marketed to traditional telecommunications carriers to provide a low-cost and more functional alternative to the costly and functionally-limited switches now required within their infrastructure. Indavo-TM- is now in full production and distribution. I-Link TalkFree-TM- In late 1999, I-Link developed and deployed I-Link TalkFree-TM-, a unique web-based service that powerfully promotes I-Link's products and services by utilizing spare network capacity to permit prospective customers to experience a long distance call over the I-Link Network at no cost. I-Link TalkFree-TM- works as follows: a visitor to the I-Link or a partner web page clicks on the I-Link TalkFree-TM- icon and then enters his or her phone number and the long distance number they want to call. In a few seconds, the call is generated automatically via the caller's phone. In March 2000, approximately four weeks after I-Link TalkFree-TM- was introduced, I-Link announced that the number of I-Link TalkFree-TM- calls placed had exceeded one million. Not only has I-Link TalkFree-TM- quickly proven to be a powerful tool for promoting I-Link's products and services, it has generated substantial interest from other companies who want to use I-Link TalkFree-TM- as an advertising tool for their own products and services. The Company intends to continue to use I-Link TalkFree-TM- as a promotional tool for its own products and services, and to aggressively market it to other companies both inside and outside the telecommunications industry as a promotional tool. I-LINK'S RTIP NETWORK I-Link's communications services, as well as applications and services developed by certified third-party developers, are carried over the RTIP Network. The RTIP Network is a packet-based network established by I-Link and composed of an IP backbone that integrates local loop dial-up and broadband connections via eleven multiple routing facilities or "Hubs" strategically established in large metropolitan areas nationwide. Each of these Hubs is comprised of off-the-shelf hardware elements and I-Link's proprietary software. Figure 1 shows an architectural view of a RTIP Hub. [GRAPH] I-Link's technology enables the user to employ its existing telephone, fax machine, pager or modem to achieve high-quality communications with other conventional communications equipment, while exploiting the capabilities of IP technology. The RTIP Network is comprised of leased and dedicated lines carrying telecommunications transmissions converted into a data format (TCP/IP). Network access points ("gateways") comprised of sophisticated communications equipment and proprietary software, which I-Link calls Communication Engines-TM-, are used to integrate I-Link's Intranet with the traditional telecommunications network. The Communication Engine, including the software and firmware, represents I-Link's patent-pending technology. Through the Communication Engines, the RTIP Network receives traffic from the public switched telephone network as a TDM stream (time division multiplexing) and converts it to IP (internet/intranet protocol) data packets. The data is converted from the PCM (pulse code modulation) format standard, which is the traditional telephony standard, to an I-Link proprietary coding. The I-Link proprietary coding can distinguish among and handle voice, fax and modem communications differently. Voice is compressed using a voice coder or codec, fax and modem traffic are demodulated/modulated. The data can then be stored (such as recording a message), altered (as in changing a fax call from 14400 BPS to 9600 BPS) or redistributed to multiple recipients (as in the case of conferencing). I-Link's gateways are flexible such that the RTIP Network can readily integrate with other carriers' protocols and infrastructure. Accordingly, I-Link is also capable of leveraging the access infrastructure of other carriers, resellers, and Internet service providers (ISP's) and wholesaling its enhanced services to these providers and their customers while avoiding the need to build additional access infrastructure. Unlike the traditional telecommunication network, the RTIP Network uses TCP/IP as its communication protocol. This is the same protocol used by the Internet for computer-to-computer communication. I-Link utilizes TCP/IP because of the potential for interoperability between diverse technologies. This protocol provides the potential for the RTIP Network to integrate fax, voice, e-mail, websites, video conferencing, speech recognition servers, intelligent call processing servers, Internet Information servers, and other technologies in an efficient way. Not all of these technologies are currently implemented within the RTIP Network. However, because communication is being carried over a TCP/IP protocol these solutions can be integrated into I-Link's offerings at a fraction of the cost of traditional telecommunication implementations. The advantage of communication via the TCP/IP protocol is that it allows for efficient integration of many enhanced information services as noted above. I-Link doesn't need to build all of the services that are presented to the user; it can easily integrate additional services because the communication protocol offers interoperability between all types of conventional communication equipment. The other advantage to TCP/IP is that the cost of integration is substantially less as a result of network design. New services, enhancements and updates can be enabled at a central location and linked automatically to a subscriber's packet of services, thus eliminating the costs and time restrictions of installing the enhancement at each physical facility. The result of these benefits is lower cost with greater capabilities. Cost Advantages The cost advantages realized from the creation and deployment of enhanced services over the RTIP Network are two-fold: (a) lower transmission costs, and (b) lower capital infrastructure costs. Lower transmission costs result from the inherent maximization of capacity in an IP-based "packet-switch" architecture (like the Internet and I-Link's RTIP Network) as opposed to traditional "circuit-switch" telecommunication architecture. A packet-switch network converts the information being carried (such as a voice call) into a series of data packets and is able to fill the entire capacity of the network with these data packets simultaneously during transmission, while a traditional circuit-switch network processes a single call at a time. Simply put, an IP-based packet-switch network makes more efficient use of its fixed-cost capacity than does a traditional circuit-switch network. The benefit to capital infrastructure costs can be seen by recognizing that a traditional enhanced service platform (a "platform" is the equipment and software required to provide a particular service to customers)--a conference calling platform for example- must be purchased and installed by the communications provider to work alongside a traditional telecommunications switch (a "switch" is a large, sophisticated piece of telecommunications equipment through which calls are routed, and that has a given capacity of calls that can simultaneously be handled). The traditional switch, unable to process anything but low-level signals, must pass an incoming call for conferencing (in our example) to a special conference call switch for processing. These types of special switches are highly expensive, costing providers several hundreds of thousands of dollars each. Because the transmission within the RTIP Network has been converted to an IP signal, the given enhanced service (conference calling in our example) occurs within a software-defined network handled through standard personal computers, rather than a hardware- or equipment-defined network requiring special and redundant, costly telecommunications switches for each enhanced service offered. Thus, I-Link is able to provide the given service at a fraction of the cost of a traditional communication services provider, because it is able to avoid the capital expense of acquiring, installing and servicing an array of special switches. Lower costs in both the cost of transmission and the capital infrastructure to provide the services, results in lower costs to the customer. Flexible Integration In addition to the conference calling service discussed above, consider a provider that offers many combined services. In a traditional telecommunications network, each service - voicemail, fax mail, conference calling, single number, etc. - must be processed through one or more separate, non-integrated switches, with the customer being assigned a separate number for each service: "call this number to send me a fax, . . . call this number for my voice mail, . . . call this number for my conference call," etc. Again, because I-Link's services are provided in an IP environment and a software-defined network, all of these services can be easily integrated through one switch and function utilizing one customer number. I-Link's IP environment also provides for the easy integration of additional new services as they are developed and introduced. Because of the expanded capabilities and capacity of the RTIP Network, I-Link's goal is to "resell" its core technologies as many times as possible. I-Link has developed a service model for marketing these core technologies to other telecommunications service providers and application developers on a wholesale basis as well as to the residential/SOHO/SME market. DISTRIBUTION CHANNELS Wholesale The wholesale distribution channel intends to leverage I-Link established network and services to distribute to it's own customer base. Such wholesale channels use (or lease from I-Link) it's own sales, billing, customer care and collection. The wholesale channel consists of two types of partners: Application developers and their customers and Service providers: Third-Party Application Developers I-Link provides application-hosting services to other third-party applications developers and their respective customers on a wholesale basis. Third-party developers who create new applications and solutions with GateLink-TM- are able to host these services within I-Link's RTIP Network. These hosted services are then made available to the third-party developers' channels of distribution and customers. The Company will negotiate where possible to be able to offer these third-party applications to I-link's service provider channel, and I-Link's Master Agent channel. Using I-Link and the RTIP Network to host new applications greatly simplifies and expedites getting new services to market. Service Providers I-Link intends to sell its enhanced services on a wholesale basis to other service providers, such as CLECs (Competitive Local Exchange Carriers), ILECs (Independent Local Exchange Carriers), ISPs (Internet Service Providers), and other alternate service providers. These telecommunications service providers can bundle V-link-TM- and other third-party developed services by connecting to the RTIP Network through one of I-Link's major hubs located strategically throughout the United States. Master Agent Channel I-Link sells its enhanced services and other I-Link hosted services to residential/SOHO/SME users on a retail basis through independent master agents. Master Agents are paid on a commission basis, and are enabled with Internet e-commerce tools to simplify order entry, provisioning and fulfillment. I-Link's call center is responsible for customer support. Network Marketing Channel Prior to February 15, 2000 and as of December 31, 1999 the Company's telecommunication and marketing service revenues were primarily dependent upon the sales efforts of independent representatives (IRs) functioning within a Network Marketing channel of distribution which targets residential and small businesses in the United States. These revenue sources depended directly upon the efforts of IRs. IRs personally solicited potential individual and business customers via one to one sales presentations wherein customers sign order forms for I-Link telecommunication products and services (telecommunication service revenues). Growth in revenue for both telecommunications and marketing services required an increase in the productivity of IRs and/or growth in the total number of IRs. On February 15, 2000 the Company signed a strategic marketing and channel agreement with Big Planet, a wholly owned subsidiary of Nu Skin Enterprises, Inc. Under terms of the agreement, I-Link's independent network marketing sales force (the IR's) transitioned to Big Planet, and Big Planet was granted the exclusive worldwide rights to market and sell I-Link's products and services through the Network Marketing (sometimes referred to as "Multi-Level") sales channel to residential and small business users. Other I-Link sales channels into the residential, small business, and other markets are unaffected by the agreement with Big Planet. The result of the agreement with Big Planet is that the Network Marketing channel became part of I-Link's wholesale client Big Planet.. HISTORY I-Link began its research and development activities in 1995. In 1997, the Company began providing telecommunications products and services over the traditional public switched telephone network and began the creation of the I-Link Network through the deployment of its IP technology. Also in 1997, the Company launched it's direct-sales marketing company, I-Link Worldwide, LLC, to market its products and services to the residential and small business markets. In August 1997, the Company acquired MiBridge, Inc. ("MiBridge"), a New Jersey-based communications technology company engaged in the design, development, integration and marketing of a range of software telecommunication products that support multimedia communications over the public switched telephone network (PSTN), local area networks (LAN) and the Internet. Historically, MiBridge has concentrated its development efforts on compression systems such as voice and fax over IP. MiBridge has developed patent-pending technologies that combine sophisticated compression capabilities with IP telephony technology. The acquisition of MiBridge permitted I-Link to accelerate the development and deployment of its own IP technology and add strength and depth to its research and development team, and provides I-Link with the opportunity to generate income and develop industry alliances through the strategic licensing of its technologies to other leading companies within the industry, such as Lucent Technologies, Nortel, IDP, Brooktrout, Analogic and others. In late 1997 the Company formed ViaNet Technologies, Ltd., headquartered in Tel Aviv, Israel, to undertake advanced research and development of the Indavo-TM- line capacity expansion device. In 2000 the Company transitioned its I-Link Worldwide multi-level marketing sales program to Big Planet, Inc. (a subsidiary of Nu Skin Enterprises, Inc.). While maintaining its other existing traditional sales agent channels for retail sales of products and services, the transition of the multi-level marketing sales channel to Big Planet has allowed the Company to focus its efforts on the expansion of the RTIP Network and the development and deployment of new enhanced services and products. COMPETITION The market for business communications services is extremely competitive. I-Link believes that its ability to compete in this market successfully will depend upon a number of factors, including the pricing policies of competitors and suppliers; the capacity, reliability, availability and security of the RTIP Network infrastructure; market presence and channel development; the timing of introductions of new products and services into the marketplace; ease of access to and navigation of the Internet or other such IP networks; I-Link's ability in the future to support existing and emerging industry standards; I-Link's ability to balance network demand with the fixed expenses associated with network capacity; and industry and general economic trends. While I-Link believes there is currently no competitor in the North American market providing the same capabilities in the same manner as I-Link offers using the RTIP Network, there are many companies that offer communications services, and therefore compete with I-Link at some level. These range from large telecommunications companies and carriers such as AT&T, MCI, Sprint, LDDS/WorldCom, Excel, Level3 and Qwest, to other VoIP carriers such as iBasis, ITXC, smaller, regional resellers of telephone line access, and to companies providing Internet telephony. These companies, as well as others, including manufacturers of hardware and software used in the business communications industry, have announced plans to develop future products and services that are likely to compete with those of I-Link on a more direct basis. These entities may be far better capitalized than I-Link and control significant market shares in their respective industry segments. In addition, there may be other businesses that are attempting to introduce products similar to I-Link's for the transmission of business information over the Internet. There is no assurance that I-Link will be able to successfully compete with these market participants. GOVERNMENT REGULATION GENERAL. Traditionally, the Federal Communications Commission (the "FCC") has sought to encourage the development of enhanced services as well as Internet-based services by keeping such activities free of unnecessary regulation and government influence. Specifically in the area of telecommunications policy and the use of the Internet, the FCC has refused to regulate most online information services under the rules that apply to telephone companies. This approach is consistent with the passage of the Telecommunications Act of 1996 ("1996 Act"), which expresses a Congressional intent "to preserve the vibrant and competitive free market that presently exists for the Internet and other interactive computer services, unfettered by Federal or State regulation." FEDERAL. Since 1980, the FCC has refrained from regulating value-added networks ("VANs"), software or computer equipment that offer customers the ability to transport data over telecommunications facilities. By definition, VAN operators purchase transmission facilities from "facilities-based" carriers and resell them packaged with packet transmission and protocol conversion services. Under current rules, such operators are excluded from regulation that applies to "telecommunications carriers" under Title II of the Communications Act. In the wake of the 1996 Act, however, the FCC is revisiting many of its past decisions and could impose common carrier regulation on some of the transport and resold telecommunications facilities used to provide telecommunications services as a part of an enhanced or information service package. The FCC also may conclude that I-Link's protocol conversions, computer processing and interaction with customer-supplied information are insufficient to afford the Company the benefits of the "enhanced service" classification, and thereby may seek to regulate some of the Company's operations as common carrier/telecommunications services. The FCC could conclude that such decisions are within its statutory discretion, especially with respect to voice services. In December 1999, for example, the FCC found that it had regulatory authority over incumbent local exchange carrier advanced services. In addition, there is a pending inquiry at the FCC to determine whether the IP telephony services and networks should be made available to persons with disabilities and must comply with the FCC rules for persons with disabilities. I-Link has been moving its customers off the facilities of existing long distance carriers, and has increased its reliance on a proprietary Internet protocol network involving the provision of information services, which the Company believes would be sufficient to exempt it from common carrier regulation under current rules. Historically, the FCC has not regulated companies that provide the software and hardware for Internet telephony, or other Internet data functions, as common carriers or telecommunications service providers. Moreover, in May 1997 the FCC concluded that information and enhanced service providers are not required to contribute to federal universal service funding mechanisms, a decision it reaffirmed in April of 1998 in a report to Congress. Notwithstanding the current state of the rules, the FCC's potential jurisdiction over the Internet is broad because the Internet relies on wire and radio communications facilities and services over which the FCC has long-standing authority. The FCC's framework for "enhanced services" confirms that the FCC has authority to regulate computer-enriched services, but provides that carrier-type regulation would not serve the public interest. Only recently has this general deregulatory approach been questioned within the industry. In March 1996, for instance, America's Carriers Telecommunications Association ("ACTA"), a trade association primarily comprised of small and medium-size interexchange carriers, filed a petition with the FCC asking that the FCC regulate Internet and Internet Protocol ("IP") telephony. ACTA argued that providers of software that enables real-time voice communications over the Internet should be treated as common carriers and subject to the regulatory requirements of Title II of the Communications Act. The FCC sought comment on the request and has not yet issued its decision. Congress directed the FCC to submit a report by April 10, 1998, describing how its classification of information and telecommunications services is affecting contributions to universal service charge funds. In this report, the FCC reiterated its conclusions that information services, and Internet access services, in particular, are not subject to telecommunications service regulation or universal service contribution requirements. The FCC did, however, indicate its belief that certain gateway-based IP telephony services may be the functional equivalent to a telecommunications service. The FCC deferred a definitive resolution of this issue until it could examine a specific case of phone-to-phone IP telephony. U.S. Senators from several states with large rural areas have expressed concern that migration of voice services to the Internet could erode the contribution base for universal service subsidies. There will likely be continuing pressure from those Senators to classify Internet telephony as a telecommunications service, rather than an information service, so that it can be subjected to a regulatory assessment for universal service contributions. On April 5, 1999, US West filed a "Petition for Expedited Declaratory Ruling" with the FCC in which US West seeks to have interexchange carriers ("IXCs") that provide phone-to-phone IP telephony declared telecommunications service providers whose services are subject to access charges. The Petition claims principally that because there is no net protocol conversion in the message as sent and received and IXCs hold themselves out to provide voice telephony, IP telephony does not qualify as an enhanced service under FCC rules. The Commission is expected to issue a Public Notice to receive comments from interested persons prior to issuing a ruling. We cannot predict with certainty what the Commission will rule or when. If US West is successful in this petition, the FCC could rule that IP telephony service providers are obligated to pay interstate access charges to local telephone companies for originating and terminating interstate calls. Any FCC determination that Internet-based service providers should be subject to some level of Title II regulation could affect the manner in which I-Link operates, to the extent it uses the Internet to provide facsimile or voice capabilities, as well as create costs of complying with federal common carrier requirements. With the passage of the 1996 Act, the precise dividing line or overlap between "telecommunications" and "information" services as applied to Internet-based service providers is uncertain. Consequently, I-Link's activities may be subject to evolving rules as the FCC addresses novel questions presented by the increased use of the Internet to offer services that appear functionally similar to traditionally-regulated telecommunications services. At this time, it is impossible to determine what effect, if any, such regulations may have on the future operation of the Company. STATE. While states generally have declined to regulate enhanced services, their ability to regulate the provision of intrastate enhanced services remains uncertain. The FCC originally intended to preempt state regulation of enhanced service providers, but intervening case law has cast doubt on the earlier decision. Moreover, some states have continued to regulate particular aspects of enhanced services in limited circumstances, e.g., to the extent they are provided by incumbent local exchange carriers. Whether the states within which I-Link makes its Intranet services capabilities available will seek to regulate I-Link's activities as a telecommunications carrier will depend largely on whether the states determine that there is a need for or other public benefits of such regulation. For example, the staff of the Nebraska Public Service Commission recently concluded that an Internet telephony gateway service operated by a Nebraska Internet Service Provider was required to obtain state authority to operate as a telecommunications carrier. The FCC has authority to preempt state regulation that impedes competition; it has not, however, had occasion to consider this or similar decisions. On February 25, 1999, the FCC issued an order and notice of proposed rulemaking holding that dial-up telephone traffic directed to the Internet should be treated as interstate in nature for purposes of determining regulatory jurisdiction. This order, however, was vacated and remanded by the United States Court of Appeals for the District of Columbia Circuit. According to the court, the FCC had failed to use reasoned decision-making in making its jurisdictional determination. It is unclear how the FCC will rule on remand, and thus what impact the subsequent decision will have on I-Link's Internet based services. The notice of proposed rulemaking is considering how local telecommunications carriers should compensate each other for jointly carrying calls to the Internet. The outcome of this proceeding could affect the charges I-Link pays to local carriers for the carriage of traffic routed to I-Link. DELIVERY OF SERVICES OVER EXISTING SWITCHED TELECOMMUNICATIONS NETWORKS A portion of I-Link's communications services are delivered over existing switched telecommunications networks through I-Link Communications, Inc., a long distance telecommunications carrier that provides long distance service to all states of the United States. Access to the switched telephone network is a necessary component of the RTIP Network to ensure full geographic coverage of the RTIP Network in lesser-populated geographic areas that are not serviced by one of the RTIP Network's Hubs. I-Link Communications, Inc. currently maintains traditional switch facilities in Dallas, Los Angeles, Phoenix, and Salt Lake City. ITEM 2. ITEM 2. DESCRIPTION OF PROPERTY. The Company leases approximately 45,300 square feet of space for its offices and other facilities in Draper, Utah pursuant to commercial leases with original terms of five to seven years. These leases expire between 2003 and 2005 subject to the Company's right to extend for an additional five years. The initial base rent is approximately $44,000 per month. I-Link has delivered $107,000 in certificates of deposit to the landlord as a security deposit under the leases. I-Link also leases several other spaces to house its Communication Engines throughout the United States. Such spaces vary in size and are rented on a month-to-month basis. ILC currently leases and occupies approximately 3,600 square feet of office space in Phoenix, Arizona, pursuant to a commercial lease dated March 18, 1996. The lease term is four years and two months commencing March 18, 1996 beginning with a base rent of $3,598 per month and escalating to $4,498 per month at the end of the lease. ILC also currently leases and occupies approximately 5,100 square feet of office space in Salt Lake City, Utah, pursuant to a commercial lease dated July 1, 1996. The lease term is five years commencing July 1, 1996 beginning with a base rent of $5,313 per month and escalating to $5,843 per month at the end of the lease. MiBridge rents 3,662 square feet of office space in Eatontown, New Jersey under a five-year lease effective December 1, 1997 at a cost of $5,187 per month. The lease may be cancelled at the end of the third year under certain conditions. ViaNet Technologies leases approximately 1,400 square feet of office space in Tel Aviv, Israel at a cost of $2,200 per month. The lease expires in February 2002. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. On February 25, 2000, JNC Opportunity Fund, Ltd. ("JNC"), the sole holder of the Company's Series F preferred shares, filed suit against the Company in U.S. District Court in New York seeking to require the Company to redeem for cash its remaining Series F preferred shares. The controversy arose as a result of the failure of the Company's shareholders at a special shareholders' meeting held February 11, 2000, to approve the further conversion of Series F preferred shares at a conversion price below the market price for the Company's common shares as calculated on the original date of issuance of the Series F preferred shares ("below-market conversions"). The terms of the Series F preferred shares require shareholder approval for below-market conversions where any such further conversions would cause the aggregate number of common shares obtained upon below-market conversions of the Series F preferred shares to attain or exceed 20% of the total number of common shares outstanding on the original date of issuance of the Series F Preferred shares. At the February 11, 2000 Special Shareholders' Meeting, approximately 64% of the total votes cast were voted by Winter Harbor, LLC, the Company's largest equity holder, who voted against such approval. On March 10, 2000 the Company and JNC entered into a settlement and release agreement. Pursuant to the settlement, the Company agreed to issue 531,968 shares of the Company's common stock immediately, representing conversion of all remaining Series F shares outstanding at a conversion price equal to the market price of the Company's common shares on the original date of issuance of the Series F preferred shares. These settlement shares are subject to certain provisions restricting the amount that can be sold by JNC on any given trading day, and prohibiting any short sales of the Company's stock either directly or indirectly by JNC. In full settlement of all other claims for cash redemption of the Series F preferred shares, the Company also agreed to issue an additional 790,000 registered shares (increasing at an annual rate of 8.25 percent from February 1, 2000 until issued) (the "Additional Shares") of the Company's common stock (subject to the same sale restrictions) upon shareholder approval. As part of the settlement agreement, Winter Harbor, LLC agreed to vote all of its shares in favor of such approval. The Company will proceed immediately to hold a special shareholders meeting to request approval of the issuance of the additional 790,000 common shares. In addition to the "Additional Shares", the Company would be subject to other penalties to be paid in common shares (the "Late Shares") in the event the common shares are not issued by May 24, 2000. Further, if the Company fails to deliver any of the above shares by May 24, 2000, the Company must issue additional Late Shares ("Additional Late Shares") equal to the number of the Late Shares times a fraction the numerator of which equals the number of days from May 24, 2000 to the actual date of issuance of such undelivered shares and the denominator of which is 30. In the event that the common shares are not issued by May 24, 2000 (or June 28, 2000 in the event the Company has received from the SEC a registration comment letter related to the registration of such shares prior to May 24, 2000), upon written notice from JNC, the Company would be required to pay JNC (in lieu of delivering the shares) the amount determined by multiplying (x) the higher of the average closing share price of the common stock for the ten trading day period ending on the deadline (May 24 or June 28, 2000 as applicable) or the notice date by (y) the number of undelivered shares. The Company is involved in litigation relating to claims arising out of its operations in the normal course of business, none of which is expected, individually or in the aggregate, to have a material adverse affect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted during the fourth quarter of the fiscal year ended December 31, 1999, to a vote of the Company's security holders. PART II ITEM 5. ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. PRICE RANGE OF COMMON STOCK The Company's common stock is traded on The Nasdaq Small-Cap Market ("Nasdaq") tier of The Nasdaq Stock Market, Inc. under the symbol "ILNK." Although the Common Stock is currently listed for quotation on Nasdaq, there can be no assurance given that the Company will be able to continue to satisfy the requirements for maintaining quotation of such securities on Nasdaq or that such quotation will otherwise continue. The Company has no current plans to apply for listing of any preferred shares, warrants or any of its other securities for quotation on Nasdaq. The following table sets forth for the period indicated the high and low bid prices for the Common stock as quoted on Nasdaq under the symbol "ILNK" based on interdealer bid quotations, without retail markup, markdown, commissions or adjustments and may not represent actual transactions: On April 10, 2000, the closing price for a share of common stock was $8.63. DIVIDEND POLICY The Company must be current on dividends for it's Series C, F and M preferred stock in order to pay any dividends to common stock holders. Preferred stock dividends in the amount of $351,868 and $489 were paid in 1999 and 1998, respectively, in common stock (non-cash) on the converted shares of Series F redeemable preferred stock. Dividends on Series F redeemable preferred stock will continue to be paid in common stock as the holders convert their preferred stock into common stock. As of December 31, 1999, dividends in arrears (undeclared) on Series C, F, and M preferred stock were $543,408, $186,000 and $2,973,877, respectively. On February 22, 2000 the Company's Board of Director set a record date for payment of accrued dividends on Class (Series) C preferred stock of $563,781 to stockholders of record on February 22, 2000, to be paid in shares (approximately 125,400) of the Company's common stock (the "Dividend Shares") within ten business days of the date the Dividend Shares become subject to an effective registration statement (anticipated in mid 2000) under the Securities Act of 1933, as amended. The Company has not paid and does not anticipate that it will pay dividends on its common stock in the foreseeable future. SHAREHOLDERS As of April 10, 2000, the Company had approximately 615 stockholders of common stock of record and approximately 18,070 beneficial owners. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected consolidated financial data of the Company for each of the past five years including the period ended December 31, 1999, are derived from the audited financial statements and notes thereto of the Company, certain of which are included herein. The selected consolidated financial data should be read in conjunction with "Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. FORWARD-LOOKING INFORMATION THIS REPORT CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS AND INFORMATION RELATING TO THE COMPANY THAT ARE BASED ON THE BELIEFS OF MANAGEMENT AS WELL AS ASSUMPTIONS MADE BY AND INFORMATION CURRENTLY AVAILABLE TO MANAGEMENT. WHEN USED IN THIS DOCUMENT, THE WORDS "ANTICIPATE," "BELIEVE," "ESTIMATE," "EXPECT," AND "INTENDED" AND SIMILAR EXPRESSIONS, AS THEY RELATE TO THE COMPANY OR ITS MANAGEMENT, ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS REFLECT THE CURRENT VIEW OF THE COMPANY RESPECTING FUTURE EVENTS AND ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES AS NOTED BELOW. SHOULD ONE OR MORE OF THESE RISKS OR UNCERTAINTIES MATERIALIZE, OR SHOULD UNDERLYING ASSUMPTIONS PROVE INCORRECT, ACTUAL RESULTS MAY VARY MATERIALLY FROM THOSE DESCRIBED HEREIN AS ANTICIPATED, BELIEVED, ESTIMATED, EXPECTED OR INTENDED. Although the Company believes that its expectations are based on reasonable assumptions, it can give no assurance that its expectations will be achieved. Among many factors that could cause actual results to differ materially from the forward looking statements herein include, without limitation, the following: the Company's ability to finance and manage expected rapid growth; the impact of competitive services and pricing; the Company's ongoing relationship with its long distance carriers and vendors; dependence upon key personnel; subscriber attrition; the adoption of new, or changes in, accounting policies; litigation; federal and state governmental regulation of the long distance telecommunications and internet industries; the Company's ability to maintain, operate and upgrade its information systems network; the Company's success in deploying its Communication Engine network in internet telephony; the existence of demand for and acceptance of the Company's products and services (including but not limited to V-Link and Indavo); as well as other risks referenced from time to time in the Company's filings with the SEC. The Company undertakes no obligation and does not intend to update, revise or otherwise publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. RESULTS OF OPERATIONS Operating results for 1999, 1998 and 1997 are not comparable due to changes in the operations of the Company. In January 1997 the Company acquired I-Link Communications (formerly Family Telecommunications, Inc. and referred to herein as "ILC") and in August 1997 the Company acquired MiBridge, Inc. In 1997, the Company launched operations of a network marketing program through I-Link Worldwide, L.L.C., to market its products. In March 1998, the Company made the decision to dispose of the operations of the subsidiaries of the Company operating in the healthcare industry in order to concentrate on its telecommunications and technology sectors. Accordingly, the healthcare operation during the three years ended December 31, 1999 has been reported as discontinued operations. Therefore, results of continuing operations for the Company 1997 to 1999 include the following subsidiaries for the indicated time period: - I-Link Communications Inc. (January 1997 to December 1999) - I-Link Systems Inc. (January 1997 to December 1999) - I-Link Worldwide, L.L.C. (June 1997 to December 1999) - MiBridge Inc. (August 1997 to December 1999) - ViaNet Technologies, Inc. (December 1997 to December 1999) Prior to February 15, 2000 and as of December 31, 1999, the Company's telecommunication and marketing service revenues were primarily dependent upon the sales efforts of independent representatives (IRs) functioning within a Network Marketing channel of distribution which targeted residential users and small businesses in the United States. These revenue sources depended directly upon the efforts of IRs. IRs personally solicited potential residential and business customers via one to one sales presentations wherein customers sign order forms for I-Link telecommunication products and services (telecommunication service revenues). An individual could also become an IR upon entering into a standard written independent sales representative agreement with the Company and paying a fee of either $50 or $295 based on options elected for promotional and presentation materials (included in market service revenues). The initial term of the agreement was for twelve months and could be renewed on a yearly basis thereafter. IRs received commissions based upon sales of I-Link products and services to customers who became I-Link subscribers. Commissions ranged from 2% to 46% based upon the product sold or services utilized and the IR's seniority within the Network Marketing plan. An additional commission from $210 to $370 could be earned by the IR based upon the IR's initial signing up of another IR and that new IR signing up users of I-Link products or services. Growth in revenue for both telecommunications and marketing services required an increase in the productivity of IRs and/or growth in the total number of IRs. There could be no assurance that the productivity or number of IRs would be sustained at then current levels or increased in the future. The Company had approximately 14,000, 12,700 and 12,600 IRs as of December 31, 1999, 1998 and 1997, respectively. On February 15, 2000 the Company signed a strategic marketing and channel agreement with Big Planet, a wholly owned subsidiary of Nu Skin Enterprises, Inc. Under terms of the agreement, I-Link's independent network marketing sales force (the IR's) transitioned to Big Planet, and Big Planet was granted the exclusive worldwide rights to market and sell I-Link's products and services through the Network Marketing (sometimes referred to as "Multi-Level") sales channel to residential and small business users. Other I-Link sales channels into the residential, small business, and other markets are unaffected by the agreement with Big Planet. The impact on the results of operations will be a termination of marketing service revenues and marketing service costs effective February 15, 2000. Additionally, telecommunication service revenues will initially decrease as the Company sells its services to the same subscribers but through Big Planet at wholesale prices which will initially reduce telecommunication services revenues by approximately 40%. The reduction in telecommunications service revenues will also be partially offset by a reduction in commissions paid to IRs related to telecommunication services revenues, which accounted for approximately 13% of telecommunication network expense in 1999. However the Company believes the revenue reduction will be temporary and believes that this affiliation with Big Planet will have a positive strategic and overall long-term financial impact to the Company by increasing revenues, reducing expenses and increasing profit margins through new customer subscriptions to current and future I-link products and decreasing channel management expenses in the short and long term. The Company anticipates the future increase in revenues to be related to leveraging the larger consolidated sales force of IRs in Big Planet. However, there can be no assurance that this agreement will result in increased sales, decreased costs or increased profitability of the Company. YEAR ENDED DECEMBER 31, 1999 COMPARED TO THE YEAR ENDED DECEMBER 31, 1998 REVENUES Net operating revenue of the Company in 1999 and 1998 included three primary sources of revenue which were: (1) telecommunications service; (2) marketing services which began in June 1997 (and terminated in February 2000 - see "Results of Operations" above) and includes revenues from the Network Marketing channel, including revenues from independent representatives for promotional and presentation materials and national conference registration fees; and (3) technology licensing and development revenues which began in August 1997 upon the acquisition of MiBridge, Inc. which develops and licenses communications software that supports multimedia communications over the public switched and local area networks and the Internet. Telecommunication service revenues increased $6,805,336 to $26,440,017 in 1999 as compared to $19,634,681 in 1998. The increase was primarily due to an increase of $9,192,135 from growth in telecommunication sales by the network marketing channel (started in June 1997). This increase was partially offset by a decrease of $2,386,799 in revenues from other channels of distribution as the Company continues to refocus the resources of the Company to concentrate on those channels of distribution of its products which have higher profit margins. The increase in revenues is primarily due a 38% increase in usage, which was offset by an 11% decrease in revenue per minute. Telecommunication service revenues may be significantly different in 2000 due to the agreement with Big Planet as discussed in greater detail previously in "Results of Operations". Marketing service revenues decreased $875,433 to $3,672,988 in 1999 as compared to $4,548,421 in 1998. The decrease was primarily due to a reduction of new IR sign ups resulting in a decrease of $1,937,634 in revenues from promotional and presentational materials and national conventions. This decrease was offset by increased revenues from product sales of $1,062,201 primarily from Web Centre sales, which began in 1999. As the Company transitioned this network marketing channel to Big Planet in February 2000, marketing service revenues will cease in February 2000. Technology licensing and development revenues increased $1,040,386 to $2,506,701 as compared to $1,466,315 in 1998. The increase was primarily due to increasing acceptance of the Company's core technologies in the market place. This source of revenue began with the acquisition of MiBridge, Inc. in August 1997. The Company has decided to direct a greater portion of the MiBridge resources into commercial product research and development rather than external technology licensing and development. However, revenues from existing contracts in the first quarter of 2000 will approximate all of 1999 revenues. Accordingly, it is anticipated that technology licensing and development revenues will increase approximately 50% in year 2000 as compared to 1999 revenues. OPERATING COSTS AND EXPENSES Telecommunications network expenses increased $1,274,015 to $20,373,209 in 1999 as compared to $19,099,194 in 1998. The increase is related to the costs of continuing development and deployment of the Company's communication network and expenses related to the telecommunication service revenue. Moreover, the deployment of the Company's Communication Engines in 1999 and better pricing from underlying carriers have allowed telecommunications revenues to grow at a rate significantly higher than the related telecommunication network expenses. Marketing services costs decreased $450,724 to $5,400,149 in 1999 as compared to $5,850,873 in 1998. These costs directly relate to the Company's marketing services revenue that began late in the second quarter of 1997 and include commissions and the costs of providing promotional and presentation materials and ongoing administrative support of the Network Marketing channel. As the Company transferred this network marketing channel to Big Planet in February 2000, marketing service costs will cease after February 2000. Selling, general and administrative expenses increased $1,865,574 to $12,428,956 in 1999 as compared to $10,563,382 in 1998. The increase was primarily due to (1) payroll related to an increased number of employees and (2) increased rent and travel costs related to the increased number of employees. The provision for doubtful accounts increased $542,455 to $3,703,076 in 1999 as compared to $3,160,621 in 1998. The increase is related directly to the growth in telecommunication service revenues, and increased bad debts from receivables in the channels which the Company decided to terminate in order to refocus the resources of the Company on those channels of distribution of its products which had higher profit margins. Depreciation and amortization increased $1,290,465 to $5,482,639 in 1999 as compared to $4,192,174 in 1998. The increase is primarily associated with increasing expenditures related to continued and increasing expansion of the I-Link Network. In the first quarter of 1999, the Company recorded a write-down of capitalized software costs of $1,847,288. In early 1998 the Company contracted with an outside consulting company to develop a billing and operations information system. The Company continually evaluated the functionality and progress of the in-process system development. The Company's management and its Board of Directors concluded that the new system would not significantly enhance the Company's existing billing and information systems or meet its ultimate needs and accordingly did not justify paying additional contracted expenses of approximately $1,000,000. Accordingly, effect March 31, 1999, the Company recorded a write-down on the in-process system development of $1,847,288. Research and development increased $207,625 to $2,636,741 in 1999 as compared to $2,429,116 in 1998. The increase is associated with the Company's increased commitment to continuing telecommunication network research and development efforts. The increase is primarily associated with increased research and development occurring in the Company's Israeli subsidiary, ViaNet Technologies. OTHER INCOME (EXPENSE) Interest expense decreased $3,318,277 to $5,086,141 in 1999 as compared to $8,404,418 in 1998. The decrease is primarily due to the a decrease of $4,013,095 from the accretion of debt discounts (non-cash) related to certain warrants granted in connection with $7,768,000 in loans to the Company during 1998 as compared to warrants granted in connection with $8,000,000 in loans in 1999. An increase in interest expense in 1999 of approximately $694,818 on loans outstanding and an increase in capital leases offset this decrease. Interest and other income decreased $91,083 to $179,205 in 1999 as compared to $270,288 in 1998. The decrease was primarily due to interest earned in 1998 on deposits with the Company's primary provider of long-distance telecommunications capacity, which did not recur in 1999 as the deposits were refunded. YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997 REVENUES Net operating revenue of the Company in 1998 and 1997 included three primary sources of revenue which were: (1) telecommunications service; (2) marketing services which began in June 1997 and includes revenues from the Network Marketing channel, including revenues from independent representatives for promotional and presentation materials and national conference registration fees; and (3) technology licensing and development revenues which began in August 1997 upon the acquisition of MiBridge, Inc. which develops and licenses communications software that supports multimedia communications over the public switched and local area networks and the Internet. Telecommunication service revenues increased $8,553,674 to $19,634,681 in 1998 as compared to $11,081,007 in 1997. The increase was primarily due to an increase of $13,830,000 from growth in the network marketing channel (started in June 1997). This increase was partially offset by a decrease of $5,275,000 in revenues from other channels of distribution as the Company determined that it would refocus the resources of the Company to concentrate on those channels of distribution of its products which had higher profit margins and accordingly terminated certain relationships. The increase in revenues is primarily due to increased usage, as the average rate per minute did not change significantly from 1997 to 1998. Marketing service revenues increased $1,911,090 to $4,548,421 in 1998 as compared to $2,637,331 in 1997. As this marketing channel began in June 1997, the increase was primarily due to twelve months of revenue in 1998 as compared to approximately seven months in 1997. Marketing service costs were greater than marketing service revenues for the year as this channel of revenue continued to expand. Technology licensing and development revenues increased $1,119,440 to $1,466,315 as compared to $346,875 in 1997. The increase was primarily due to increasing acceptance of the Company's products in the market place and as this source of revenue began with the acquisition of MiBridge, Inc. in August 1997, there are twelve months of revenue in 1998 as compared to approximately five months in 1997. OPERATING COSTS AND EXPENSES Telecommunications network expenses increased $4,464,195 to $19,099,194 in 1998 as compared to $14,634,999 in 1997. The increase is related to the costs of continuing development and deployment of the Company's communication network and expenses related to the telecommunication service revenue. Moreover, the deployment of the Company's Communication Engines in 1998 and better pricing from the Company's underlying carriers have allowed telecommunications revenues to grow at a rate significantly faster than the related telecommunication network expenses. Marketing services costs increased $1,556,859 to $5,850,873 in 1998 as compared to $4,294,014 in 1997. These costs directly relate to the Company's marketing services revenue that began late in the second quarter of 1997 and include commissions and the costs of providing promotional and presentation materials and ongoing administrative support of the Network Marketing channel. Selling, general and administrative expenses decreased $1,385,186 to $10,563,382 in 1998 as compared to $11,948,568 in 1997. The decrease was primarily due to (1) decreased legal fees associated with warrants granted to the Company's outside general counsel in 1997 valued at $1,400,000 compared to $450,000 in 1998 and (2) the write off of certain intangible assets and losses on disposal of certain assets totaling $1,212,000 in 1997 which did not recur in 1998. These decreases were offset by general increases in corporate expenses, associated with growth of Company operations, such as salaries and wages. The provision for doubtful accounts increased $1,775,621 to $3,160,621 in 1998 as compared to $1,385,000 in 1997. The increase is related directly to the growth in telecommunication service revenues, and increased bad debts from receivables in the channels which the Company decided to terminate in order to refocus the resources of the Company on those channels of distribution of its products which had higher profit margins. Depreciation and amortization increased $1,642,892 to $4,192,174 in 1998 as compared to $2,549,282 in 1997. The increase is primarily due to an approximate $600,000 increase in amortization related to the intangible assets acquired in the acquisition of MiBridge in August 1997 (twelve months of amortization in 1998 as compared to five months in 1997) and approximately $887,000 related to increased amortization of acquisition costs incurred in June 1997 with the release from escrow of shares of common stock associated with the acquisition of I-Link Worldwide Inc. Depreciation expense also increased due to the continued acquisition of other equipment. Acquired in-process research and development was $4,235,830 in 1997. This amount was related to the acquisition of MiBridge in 1997. There was no such acquisition in 1998. This expense related to the specific acquisition of MiBridge in 1997 and as such is not of a recurring nature other than as may occur if the Company were to acquire other similar entities in the future. Research and development increased $1,550,534 to $2,429,116 in 1998 as compared to $878,582 in 1997. The increase is associated with the Company's increased commitment to continuing telecommunication network research and development efforts. Approximately $700,000 of the increase is associated with the research and development occurring in the Company's Israeli subsidiary, ViaNet Technologies, which was formed in 1998. OTHER INCOME (EXPENSE) Interest expense increased $5,381,799 to $8,404,418 in 1998 as compared to $3,022,619 in 1997. The increase is primarily due to the an increase of approximately $5,040,000 from the accretion of debt discounts (non-cash) related to certain warrants granted in connection with $7,768,000 in loans to the Company during 1998 as compared to warrants granted in connection with $5,000,000 in loans in 1997. In addition there was an increase in interest expense of approximately $670,000 on loans to the Company outstanding in 1998 as compared to 1997. The increases above were offset by $320,000 (non-cash) of interest expense in 1997 associated with the issuance of convertible notes issued at a discount in 1996 that did not recur in 1998. Interest and other income increased $54,299 to $270,288 in 1998 as compared to $215,989 in 1997. The increase was primarily due to interest earned in 1998 on deposits with the Company's primary provider of long-distance telecommunications capacity. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents as of December 31, 1999 were $2,950,730, short-term certificates of deposit were $53,500 and the working capital deficit was $1,318,640. Cash used by operating activities during 1999 was $10,381,925 as compared to $16,825,719 in 1998 and $12,008,526 in 1997. The decrease in cash used by operating activities in 1999 compared to 1998 was primarily due to a decrease in the net loss of the Company and timing of accounts receivable collections and accounts payable payments. The increase in 1998 compared to 1997 was primarily due to an increase in operating losses as the Company continued to develop its network infrastructure and product base. Net cash used by investing activities in 1999 was $1,585,299 as compared to $1,602,974 in 1998 and $1,387,526 in 1997. The decrease in cash used by investing activities in 1999 as compared to 1998 was primarily attributable to (1) a decrease in purchases of furniture, fixtures and equipment of $1,210,241 which was offset by a decrease in cash received in connection with maturing of restricted certificates of deposits of $923,566 and (2) a decrease in investing activities of discontinued operations of $260,000. The net increase in cash used by investing activities in 1998 as compared to 1997 was primarily due to (1) an increase in purchases of furniture, fixtures and equipment of $1,309,332 which was partially offset by increased funds received from matured certificates of deposit of $1,291,715 and (2) receipt in 1998 of $310,000 in proceeds from sales of assets in its discontinued operation. In 1997 the Company received $514,886 from the acquisition of ILC and MiBridge which did not recur in 1998. Financing activities in 1999 provided net cash of $13,594,301 as compared to $18,069,765 in 1998 and $10,623,680 in 1997. Cash provided in 1999 included $8,200,000 from long-term debt, $7,116,408 net proceeds from the sale of preferred stock and $5,000 from the exercise of stock options and warrants. During 1999, the Company repaid $1,727,107 of long-term debt and capital lease obligations. Cash provided in 1998 included $9,430,582 from issuance of preferred stock (net of offering costs), $11,009,712 in proceeds from loans to the Company, and $684,943 from exercise of stock options and warrants. Long term-debt and capital lease payments of $2,885,007 offset these sources of cash. Cash provided in 1997 included $5,000,000 in long-term debt, which was subsequently exchanged for equity, $6,618,888 of net proceeds from the sale of preferred stock and $137,933 from the exercise of warrants and options. During 1997 the Company repaid $1,079,585 of long-term debt and capital lease obligations. The Company incurred a net loss from continuing operations of $24,159,288 for the year ended December 31, 1999, and as of December 31, 1999 had an accumulated deficit of $109,953,971 and negative working capital of $1,318,640. The Company anticipates that revenues generated from its continuing operations will not be sufficient during 2000 and beyond to fund ongoing operations, the continued expansion of its private telecommunications network facilities, Indavo development and manufacturing, and anticipated growth in subscriber base. The Company has entered into additional financing arrangements as described below in order to obtain the additional funds required for its continuing operations in 2000. CURRENT POSITION/FUTURE REQUIREMENTS During 2000, the Company plans to use available cash to fund the development and marketing of I-Link products and services. The Company anticipates that revenues from all sources of continuing operations will grow in 2000 and will increasingly contribute to meeting the cash requirements of the Company. The Company anticipates increased cash flow in 2000 primarily from the following sources: - - During 1999 and the first quarter of 2000 the Company deployed its Communication Engines in an additional four metropolitan areas in the United States (San Francisco, New York, Washington D.C. and Atlanta) and anticipates continued deployments during the remainder of 2000 to continue the build out of the Company's IP Telephony network. The anticipated effect of this expansion is additional revenues and increased profit margins for telecommunications services in the future. - Anticipated revenues from its Gatelink product offering commencing in the second quarter of 2000. - Anticipated revenues from marketing of its Indavo (formerly referred to as C4) product which sales are anticipated to begin in the second quarter of 2000. - The affiliation with Big Planet effective February 15, 2000 is anticipated to have a positive overall financial impact in the long-term to the Company by increasing revenues, reducing expenses and increasing profit margins. - Increased revenues from technology licensing and development, which revenues in the first quarter of 2000 approximated the total revenues in 1999. - During the first quarter of 2000, the Company has received approximately $3,000,000 from exercises of common stock options and warrants. Depending primarily on the common stock price in the remainder of 2000, the Company could receive more cash from continued exercises. The Company's business plan of continued market penetration and deployment of I-Link products and services will require financial resources at increasingly higher levels than those experienced in 1999. In order to provide for capital expenditure and working capital needs, the Company entered into the following three agreements in 2000: - On April 13, 2000, Winter Harbor, LLC, agreed to provide I-Link with a line of credit of up to an aggregate amount of $15,000,000. This commitment expires on the earlier of April 12, 2001 or the date I-Link has received net cash proceeds of not less than $15,000,000 pursuant to one or more additional financings or technology sales, as well as licensing or consulting agreements outside the normal and historical course of business. The $15,000,000 aggregate commitment will be reduced by the $1,300,000 (plus accrued interest at 8% per annum) advanced to I-Link in the first quarter of 2000 by Winter Harbor, interest accruing on any other advances under such commitment, as well as any net cash proceeds received by I-Link in the future from additional financings or technology sales as well as licensing or consulting agreements outside the normal and historical course of business. Any amounts outstanding under the loan will be due and payable no later than April 12, 2001. As part of this agreement, I-Link has agreed to use its best effort to consummate as soon as possible one or more additional financings, technology sales or licensing or consulting agreements and to repay amounts outstanding under the loan with any net cash proceeds received by it from any such transaction. The loan from Winter Harbor will bear interest at 12.5% per annum, be secured by substantially all of the assets of I-Link and may be converted into common stock of I-Link, at the option of Winter Harbor, at a fixed conversion price of $8.625 per share. If I-Link has not terminated the commitment and repaid all amounts outstanding thereunder by May 15, 2000, it will issue to Winter Harbor up to 750,000 warrants to purchase I-Link common stock, with the actual number of warrants issued to be equal to the product of 750,000 times a fraction, the numerator of which equals the sum of the outstanding commitment and unpaid balance under the loan on such date and the denominator of which is 15,000,000. The warrants will be exercisable at a fixed strike price of $8.625 per share and expire in five years. - On February 25, 2000, the Company obtained leasing arrangements for certain network equipment up to $5,000,000 dollars. - The due date of the Company's existing obligation to Winter Harbor in the amount of $7,768,000 and accrued interest $1,345,801 as of December 31, 1999, which was due April 15, 2000, was extended to April 15, 2001. While the Company believes that the aforementioned sources of funds will be sufficient to fund operations in 2000, the Company anticipates that additional funds will be necessary from public or private financing markets to successfully integrate and finance the planned expansion of the business communications services, product development and manufacturing, and to discharge the financial obligations of the Company. The availability of such capital sources will depend on prevailing market conditions, interest rates, and financial position and results of operations of the Company. There can be no assurance that such financing will be available, that the Company will receive any additional proceeds from the exercise of outstanding options and warrants or that the Company will not be required to arrange for additional debt, equity or other type of financing. OTHER ITEMS The Company has reviewed all other recently issued, but not yet adopted, accounting standards in order to determine their effects, if any, on the results of operations or financial position of the Company. Based on that review, the Company believes that none of these pronouncements will have a significant effect on current financial condition or results of operations. IMPACT OF YEAR 2000 I-Link's Year 2000 ("Y2K") program is designed to minimize the possibility of serious Y2K interruptions. Possible worst case scenarios include the interruption of significant parts of I-Link's business as a result of critical telecommunication networks and/or information systems failure. Any such interruption may have a material adverse impact on future results. In as much as the Company has not suffered any significant Y2K disruption as of this date, the Company does not believe its non-IT or IT systems were or will be significantly affected by Y2K. Much of the remediation efforts involved readily available, simple upgrades to hardware and software components, or relatively minor changes to the Company's in-house developed systems. Total cost of all remediation was approximately $100,000. Use of the Company's internal resources did not significantly delay any other systems development efforts. The Company believes that reliance on other telecommunications providers represent the Company's greatest Y2K exposure and is the primary third-party relationship that is critical to the Company's on-going operations. While the Company has its own communications network to carry much of its traffic, the Company's network is dependent upon significant third-party carriers (such as Sprint) and all local exchange carriers (LECs), such as U.S. West and PacBell. These entities originate and terminate local and long-distance caller traffic which accesses the Company's communications network or services areas not covered by I-Link's network. I-Link's carriers appear to have been Y2K compliant such that I-Link did not suffer any business interruptions on January 1, 2000. However, should any of I-Link's carriers suffer any interruptions related to Y2K subsequent to January 1, 2000, the Company would not be able to deliver its services which would have a substantial negative impact on the Company and its results of operations, liquidity, and financial position. ITEM 8. ITEM 8. FINANCIAL STATEMENTS. See Consolidated Financial Statements beginning on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 10. ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT. - --------- As of April 1, 2000, the Board of Directors has four members. The Company's Articles of Incorporation provide that the Board of Directors is divided into three classes and that each director shall serve a term of three years. The term of office of Mr. Keenan, the sole Class I Director, will expire at the annual meeting of shareholders in 2002. The term of office of Mr. Toh, the Class II Director, will expire at the 2000 annual meeting of shareholders, and the term of office of Mr. Edwards and Mr. Bradford, the Class III Directors, will expire at the annual meeting of shareholders in 2001. Mr. Keenan serves as the designee of Winter Harbor, and Winter Harbor has the right to designate one additional member of the Board of Directors pursuant to the Company's financing arrangements with Winter Harbor. Under terms of the agreement between the Company and Big Planet, Inc., Big Planet has the right to designate one board member; however, that member has not yet been designated by Big Planet. Biographical information with respect to the present executive officers, directors, and key employees of the Company are set forth below. There are no family relationships between any present executive officers and directors except that John W. Edwards and Robert W. Edwards, the Company's Vice President of Network Operations, are brothers. JOHN W. EDWARDS, Chairman of the Board, President and Chief Executive Officer of the Company. Mr. Edwards was selected to fill a vacancy on the Board of Directors as a Class III director in June 1996. He was elected Chairman of the Board in August 1997. Mr. Edwards serves as the Chief Executive Officer of I-Link and, from September 30, 1996 through December 1999, served as the President and Chief Executive Officer of the Company. Mr. Edwards served as President and a director of Coresoft, Inc., a software company developing object-oriented computer solutions for small businesses from September 1995 to April 1996. During the period August 1988 through July 1995, Mr. Edwards served in a number of executive positions with Novell, Inc., a software company providing networking software, including Executive Vice President of Strategic Marketing, Executive Vice President of the Appware and Desktop Systems Groups and Vice President of Marketing of the NetWare Systems Group. Mr. Edwards was involved in the development of the NetWare 386 product line. Until May 1996, he was a visiting faculty member at the Marriott School of Management at Brigham Young University. Mr. Edwards received a B.S. degree in Computer Science from Brigham Young University. Mr. Edwards was re-elected to the Board of Directors as a Class III Director at the 1997 Annual Meeting. DROR NAHUMI, President of the Company. Mr. Nahumi was appointed President of the Company in December 1999. Mr. Nahumi was President of MiBridge Inc., a communications software company, when the Company acquired MiBridge in June 1997. Mr. Nahumi served as Senior VP of Engineering for the Company from June 1997 until his appointment as President. Prior to founding MiBridge, Mr. Nahumi was working for AT&T Bell Labs, where he represented AT&T in voice, data and cellular standards competitions. The speech-coding algorithm Mr. Nahumi designed for the cellular standard was chosen for deployment in the CDMA cellular network in North America. Mr. Nahumi was also a senior telecommunications engineer for ECI Telecom and other telecom R&D centers in Israel. DAVID E. HARDY, Sr. VP, Secretary and General Counsel of the Company. Mr. Hardy has served as General Counsel to the Company since October 1996, and was appointed Secretary of the Company in December 1996. In November 1999, Mr. Hardy became an employee of I-Link and in January 2000 was named Sr. VP. He is a founding partner of the law firm of Hardy & Allen, in Salt Lake City. From February 1993 to April 1995, Mr. Hardy served as Senior Vice President and General Counsel of Megahertz Corporation, a publicly held manufacturer of data communication products. Prior to his association with Megahertz Corporation, Mr. Hardy was a senior partner of the law firm of Allen, Hardy, Rasmussen & Christensen that was founded in 1982. Mr. Hardy holds a Bachelor of Arts degree from the University of Utah and a Juris Doctor degree from the University of Utah School of Law. JOHN M. AMES, CPA, Sr. VP, Chief Operating Officer and acting Chief Financial Officer. Mr. Ames joined I-Link as Vice President of Operations in September of 1998 and in August 1999, was promoted to SR. VP, Chief Operating Officer and acting Chief Financial Officer. Between April 1997 and August 1998, Mr. Ames organized, developed and sold Time Key L.C., a company specializing in Time and Labor Management software and consulting. From June 1996 until April 1997, he was the Vice President and Chief Financial Officer of Neurex (now Elan Pharmaceutical), a Menlo Park, California based public biotech company. From August 1993 until June 1996, Mr. Ames managed various information services, finance and cost accounting, strategic partnering, international tax, risk management and human resource functions as the Director of Corporate Services at TheraTech (now Watson Pharmaceutical), a public California bay area based pharmaceutical company. From April 1992 through August 1993, he was responsible for overseeing U.S. sites information services activities as the Corporate Director of Information Services with Otsuka Pharmaceutical, a large privately owned Japanese conglomerate. Prior to joining Otsuka, Mr. Ames spent over eight years with KPMG Peat Marwick as an auditor and consultant in the High Technology practice. He is a graduate from Brigham Young University with both a Bachelors and Masters (MAcc) degree in accounting with emphasis in accounting information systems and management consulting. MARK S. HEWITT, VICE PRESIDENT OF BUSINESS DEVELOPMENT. Mr. Hewitt joined I-Link in March 1999. Mr. Hewitt directs I-Link's strategic business and product development. Mr. Hewitt has 24 years experience in developing technologies and strategies for the telecommunications industry. Prior to joining I-Link, Mr. Hewitt was Senior Director of Engineering and Product Development with Frontier Communications. He has also served as a council member and chairman of the public utility board in Fairbanks, Alaska. ALEX RADULOVIC, VICE PRESIDENT OF TECHNOLOGY. Mr. Radulovic has considerable Internet and telecommunications development experience. Previously, he was a consultant to IBM for a wide range of AIX Communications projects and was also a development engineer for Novell's NetWare 386-network operating system. Mr. Radulovic is a co-developer of I-Link's patent-pending technology. HENRY Y.L. TOH, Director of the Company. The Board of Directors elected Mr. Toh as a Class II Director and as Vice Chairman of the Board of Directors in March 1992. Mr. Toh was elected President of the Company in May 1993, Acting Chief Financial Officer in September 1995 and Chairman of the Board in May 1996, and served as such through September 1996. He was appointed Assistant Secretary of the Company in May 1997. Mr. Toh is a Director of Four M. Mr. Toh served as a senior tax manager in international taxation and mergers and acquisitions with KPMG Peat Marwick from March 1980 to February 17, 1992. He is a graduate of Rice University. THOMAS A. KEENAN, Director of the Company. Mr. Keenan was appointed to serve as a Class I Director on September 1, 1998. Mr. Keenan was elected to fill this board seat pursuant to the right of Winter Harbor to designate up to two board members under the Stockholder Agreement dated September 30, 1997 between Winter Harbor and I-Link. Mr. Keenan is the principal of Wolfeboro Holdings, an investment fund based in Wellesley, Massachusetts. Mr. Keenan received a Juris Doctor degree from the University of Michigan Law School, and from September 1994 to August 1996 was employed by McKinsey & Company, an international management-consulting firm DAVID R. BRADFORD, Director of the Company. The Board of Directors elected Mr. Bradford as a Class III Director in January 1999. Mr. Bradford is senior vice-president and general counsel for Novell, Inc. Prior to joining Novell, Inc., he served as western region legal counsel for Prime Computer and spent several years as an associate attorney for Irsfeld, Irsfeld and Younger and as the general manager for Businessland in Los Angeles. Mr. Bradford is past chairman of the board of the Business Software Alliance, the leading business software trade association representing Microsoft, Novell, Adobe and Autodesk, among others. Mr. Bradford also serves on the board of directors of Pervasive Software, Altius Heath, Found.com, SportsNuts.com and Utah Valley State College. Mr. Bradford received his law degree from Brigham Young University and a master's degree in business administration from Pepperdine University. JOSEPH A. COHEN, Director of the Company. Mr. Cohen was appointed a Class II Director of the Company in September 1996 as the designee of Commonwealth Associates. He is President of Leslie Group, Inc., a diversified company with holdings primarily in the music, film, home video and other entertainment-oriented businesses. He is also a Founder and President of Leslie/Linton Entertainment Inc., a merchant banking company that provides investment funds and assists in raising capital and debt for companies. Mr. Cohen also serves as President of Pickwick Communications, Inc., an independent music publishing company. From 1977 to 1986, Mr. Cohen served as Executive Vice President of the National Association of Recording Merchandisers, Inc. and Founder and Executive Vice President of Video Software Dealers Association, Inc., trade associations representing all segments of the recorded music and home video industries, respectively. Mr. Cohen resigned as of April 1, 2000 for personal reasons. Each officer of the Company is chosen by the Board of Directors and holds his or her office until his or her successor shall have been duly chosen and qualified or until his or her death or until he or she shall resign or be removed as provided by the Bylaws. Mr. Bradford, Mr. Keenan and Mr. Cohen are non-employee independent directors of the Company as of December 31, 1999 There are no material proceedings to which any director, officer or affiliate of the Company, any owner of record or beneficial owner of more than five percent of any class of voting securities of the Company, or any associate of any such director, officer, affiliate of the Company or security holder is a party adverse to the Company or any of its subsidiaries or has a material interest adverse to the Company or any of its subsidiaries. COMMITTEES OF THE BOARD OF DIRECTORS The Committees of the Board of Directors were as follows prior to the resignation of Joseph A. Cohen on April 1, 2000. The effect of his resignation on committee assignments has not yet been determined. AUDIT COMMITTEE. The Company's audit committee (the "Audit Committee") is responsible for making recommendations to the Board of Directors concerning the selection and engagement of the Company's independent certified public accountants and for reviewing the scope of the annual audit, audit fees, and results of the audit. The Audit Committee also reviews and discusses with management and the Board of Directors such matters as accounting policies and internal accounting controls, and procedures for preparation of financial statements. Its membership is currently comprised of Joseph A. Cohen (chairman), David R. Bradford and Thomas A. Keenan. The Audit Committee held three meetings during the last fiscal year. COMPENSATION COMMITTEE. The Company's compensation committee (the "Compensation Committee") approves the compensation for executive employees of the Company. Its membership is currently comprised of David R. Bradford (chairman), Joseph Cohen and Thomas A. Keenan. The Compensation Committee held six meetings during the last fiscal year. FINANCE COMMITTEE. The Company's finance committee (the "Finance Committee") is responsible for reviewing and evaluating financing, strategic business development and acquisition opportunities. Its membership is currently comprised of Thomas A. Keenan (chairman), Joseph A. Cohen and John Edwards. The Finance Committee held twelve meetings during the last fiscal year. The Company has no nominating committee or any committee serving a similar function. SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership of equity securities of the Company with the Securities and Exchange Commission ("SEC"). Officers, directors, and greater than ten percent shareholders are required by the SEC regulation to furnish the Company with copies of all Section 16(a) forms that they file. Based solely upon a review of Forms 3 and Forms 4 furnished to the Company pursuant to Rule 16a-3 under the Exchange Act during its most recent fiscal year and Forms 5 with respect to its most recent fiscal year, the Company believes that all such forms required to be filed pursuant to Section 16(a) of the Exchange Act were timely filed, as necessary, by the officers, directors, and security holders required to file the same during the fiscal year ended December 31, 1999, except that one report was filed late by the following persons, due in part to a filing error by the Company: Henry Toh, Joseph Cohen, David Bradford, John Edwards, Thomas Keenan. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the aggregate cash compensation paid for services rendered to the Company during the last three years by each person serving as the Company's Chief Executive Officer during the last year and the Company's five most highly compensated executive officers serving as such at the end of the year ended December 31, 1999, whose compensation was in excess of $100,000. (1) Mr. Edwards began his employment with I-Link in April 1996 and was appointed President and CEO as of September 30, 1996; Mr. Edwards' annual salary was $96,000 in 1997 until August, when it was increased to an annual salary of $150,000. In November 1997 Mr. Edwards voluntarily reduced his annual salary to $35,000, for the balance of 1997 and until the Company's financial restraints are reduced. See "-- Employment Agreements." Mr. Edwards was paid at an annual rate of $125,000 commencing January 1, 1998. Mr. Edward's salary was increased to $200,000 effective May 1997, however the salary increase accrued but was not paid from May 1997 to April 1999 when the Company began to pay his salary at the rate of $225,000 The deferred salary will not be paid until the Company has generated sufficient cash resources to enable the increase to be paid without creating an undue burden on the Company's cash resources. Accordingly as of December 31, 1999, the accrued but unpaid salary to Mr. Edwards was $141,875. In the first quarter of 2000, $70,938 of the deferred salary was paid to Mr. Edwards. (2) Mr. Nahumi began his employment with I-Link in June 1997 when the Company acquired MiBridge of which Mr. Nahumi was the President. Mr. Nahumi was appointed president of I-Link in December 1999. Mr. Nahumi's annual salary during 1997 was $80,000; 1998 was $100,000; 1999 was $110,000 which salary was then increased to $200,000 per year when Mr. Nahumi was appointed President. See "-- Employment Agreements." (3) Mr. Hardy became an employee of I-Link on November 1, 1999. Commencing October 1996 and continuing, Mr. Hardy serves as Secretary and General Counsel to the Company. Mr. Hardy's annual consulting fee during the first four months of 1997 was $125,000. Mr. Hardy's consulting fee was increased to $175,000 per year effective May 1997, however the salary increase was deferred until September 1999, when the Company began to pay his salary at the rate of $175,000. The deferred salary will not be paid until the Company has generated sufficient cash resources to enable the increase to be paid without creating an undue burden on the Company's cash resources. During 1999, Mr. Hardy was paid $23,685 of his deferred salary resulting in accrued but unpaid salary to Mr. Hardy of $74,857 at December 31, 1999. In the first quarter of 2000, $48,709 of the deferred salary was paid to Mr. Hardy. (4) Mr. Ames began his employment in September 1998; his annual salary during 1998 was $120,000. See "--Employment Agreements." In September 1999, Mr. Ames salary was increased to $165,000 per year. (5) Mr. Radulovic began his employment with I-Link in February 1996; his annual salary during 1997 was $90,000. Mr. Radulovic's salary was increased to $150,000 effective November 1998 and again to $200,000 in October 1999. See "--Employment Agreements." (6) Mr. Hewitt began his employment with I-Link in March 1999 at an annual salary of $200,000 per year. See "--Employment Agreements." OPTION/SAR GRANTS IN LAST FISCAL YEAR (1999) The following table sets forth certain information with respect to the options granted during the year ended December 31, 1999, for the persons named in the Summary Compensation Table (the "Named Executive Officers"): - -------------------- (1) On December 13, 1998, the Board of Directors authorized the repricing of all outstanding options of Mr. Edwards (options to purchase 1,800,000 shares of common stock) and Mr. Hardy (options to purchase 800,000 shares of common stock) as part of a general repricing of all outstanding options held by current employees, directors and consultants of the Company. The original exercise prices of between $7.00 and $4.88 were reduced to $3.90. Using the Black Scholes option pricing model the incremental fair value of the repriced options over the original options was approximately $351,000 and $151,000 for Mr. Edwards and Mr. Hardy, respectively. (2) Determined using the Black Scholes option pricing model. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES The following table sets forth certain information with respect to options exercised during 1999 by the Named Executive Officers and with respect to unexercised options held by such persons at the end of 1999. - ----------------- (1) The calculations of the value of unexercised options are based on the difference between the closing bid price on Nasdaq of the common stock on December 31, 1999, and the exercise price of each option, multiplied by the number of shares covered by the option. Value ascribed to unexercised options at December 31, 1999 was minimal as the exercise price exceeded the closing bid price at December 31, 1999 for the majority of options. DIRECTOR COMPENSATION During 1997, Directors of the Company then serving received options to purchase 10,000 shares of common stock on the first business day of January at an exercise price equal to the fair market value of the common stock on the date of grant. Effective February 6, 1997 and the first business day of January of each year thereafter, each Director then serving will receive options, to purchase 10,000 shares (20,000 shares effective January 1, 1998) of common stock and, for each committee on which the Director serves, options to purchase 5,000 shares of common stock. The exercise price of such options shall be equal to the fair market value of the common stock on the date of grant. The Directors are also eligible to receive options under the Company's stock option plans at the discretion of the Board of Directors. In addition to the above options, Mr. Cohen received options to purchase 64,000 shares of common stock upon his appointment to the Board. On August 29, 1997, Mr. Cohen was also granted 150,000 options to purchase common stock, 50,000 of such options vested upon closing of the Winter Harbor equity investment in October 1997, 50,000 will vest when the Company reaches the break even point, and the balance will vest at such time as the Company has attained $50 million in annual sales. All options expire 10 years from the date of grant. EMPLOYMENT AGREEMENTS On September 9, 1999, I-Link entered into a three-year employment agreement with John W. Edwards, Chief Executive Officer and Director of the Company. Pursuant to the terms of the employment agreement, Mr. Edwards is employed as the Chief Executive Officer and a Director of I-Link, and is required to devote substantially all of his working time to the business and affairs of I-Link. Mr. Edwards is entitled under his employment agreement to receive compensation at the rate of $225,000 per year and is entitled to a profitability bonus at the discretion of the I-Link Board of Directors and to participate in fringe benefits of the Company as are generally provided to executive officers. In addition, Mr. Edwards was granted an option to purchase 200,000 shares of common stock of the Company at an exercise price of $3.56 per share based on the market price at the date of grant. Of such options, 33,340 vested immediately and 16,666 vest and become exercisable on the first calendar day of each quarter beginning October 1, 1999. In the event of termination by I-Link or in the event of a violation of a material provision of the agreement by I-Link which is unremedied for thirty (30) days and after written notice or in the event of a "change in control" (as defined in the agreement), Mr. Edwards is entitled to receive, as liquidated damages or severance pay, an amount equal to the Monthly Compensation (as defined in the agreement) for the remaining term of the agreement or two years whichever is shorter and all options shall thereupon be fully vested and immediately exercisable. The agreement contains non-competition and confidentiality provisions. On January 3, 2000, I Link entered into a three-year agreement with Dror Nahumi, President of the Company. Mr. Nahumi is required to devote substantially all of his working time to the business and affairs of I-Link. Mr. Nahumi is entitled under his employment agreement to receive compensation at the rate of $200,000 per year and is entitled to a profitability bonus at the discretion of the I-Link Board of Directors and to participate in fringe benefits of the Company as are generally provided to executive officers. In addition, Mr. Nahumi was granted an option to purchase 1,000,000 shares of common stock of the Company at an exercise price of $2.75 per share based on the market price at the date of grant. Of such options, 83,333 vested immediately and 83,333 vest and become exercisable on the first calendar day of each quarter beginning October 1, 1999. Mr. Nahumi was also granted an option to purchase 750,000 shares of common stock as performance-vested options. Vesting of 125,000 of the performance options are to occur when the daily closing stock price attains or exceeds each of the following levels for more than 20 consecutive trading days: $10, $12, $14, $16, $18, $20. In the event of a "change in control" (as defined in the agreement), the Company shall not accelerate vesting of the options, except in the event of a change of control pursuant to which the Company's stock is exchanged for the stock of another entity and the options are not rolled-over or otherwise exchanged for similar options of such entity (with like terms and conditions). The agreement contains non-competition and confidentiality provisions. On January 3, 2000, I-Link entered into three-year employment agreements with John M. Ames as Senior Vice President, Chief Operating Officer and Acting Chief Financial Officer, David E. Hardy as Senior Vice President and General Counsel, and Alex Radulovic as Vice President Technology. Pursuant to the terms of the employment agreements, each of the three individuals is required to devote substantially all of his working time to the business and affairs of I-Link. Mr. Ames, Hardy and Radulovic are entitled under his employment agreement to receive compensation at the rate of $165,000, $200,000 and $200,000 per year, respectively, and are entitled to a profitability bonus at the discretion of the I-Link Board of Directors and to participate in fringe benefits of the Company as are generally provided to executive officers. In addition, Mr. Ames, Hardy and Radulovic were granted an option to purchase 300,000, 100,000 and 400,000, respectively, shares of common stock of the Company at an exercise price of $2.75 per share based on the market price at the date of grant. Of such options, 25,000, 8,333 and 33,333, respectively, vested immediately and the same amounts vest and become exercisable on the first calendar day of each quarter beginning October 1, 1999. In the event of termination by I-Link or in the event of a violation of a material provision of the agreement by I-Link which is unremedied for thirty (30) days and after written notice or in the event of a "change in control" (as defined in the agreement), all are entitled to receive, as liquidated damages or severance pay, an amount equal to the Monthly Compensation (as defined in the agreement) for twelve months and all options shall thereupon be fully vested and immediately exercisable. The agreement contains non-competition and confidentiality provisions. In March 1999, I-Link entered into a two-year employment agreement with Mark S. Hewitt, Vice President of Business Development. Pursuant to the terms of the employment contract, Mr. Hewitt is required to devote all his time to the business and affairs of the Company except vacations, illness or incapacity. Mr. Hewitt is entitled under his employment agreement to receive compensation at the rate of $200,000 per year and a bonus commensurate with his performance and that of I-Link. In addition, Mr. Hewitt is entitled to options to purchase 250,000 shares of common stock at an exercise price of $2.50 per share based on the market price at the date of grant. Of such options 31,250 vested immediately and the same amount vest and become exercisable on the first calendar day of each quarter beginning April 1, 1999. In the event of termination by I-Link without cause, Mr. Hewitt is entitled to receive, as severance pay, a lump sum equal to his monthly compensation for twelve months and all options shall thereupon be fully vested and immediately exercisable. In the event of a "change of control" (as defined in the agreement) all of Mr. Hewitt's then unvested options shall vest. The agreement contains non-competition and confidentiality provisions. CONSULTING AGREEMENTS In September 1996, Joseph A. Cohen, a director, and the Company entered into a consulting agreement in the amount of $4,000 per month for a 36-month period. Mr. Cohen provided services including business management and financial consulting services. The consulting agreement was terminated effective March 1, 1999 and all unpaid balances ($78,000) were settled by the grant to Mr. Cohen of 100,000 options to purchase the Company's common stock at an exercise price of $3.00 per share and the additional obligation of the Company to pay Mr. Cohen an aggregate of $50,000 in installments beginning at such time as the Company reports positive cash flow of at least $150,000 in a fiscal quarter. All of Mr. Cohen's options expire 10 years from the date of grant. REPRICING OF STOCK OPTIONS AND WARRANTS On December 13, 1998, the Board of Directors approved a repricing of all options to purchase common stock with exercise prices above $3.90 held by current employees, directors and consultants of the Company. As a result, the exercise price on options to purchase 6,475,000 shares of common stock was reduced to $3.90. The options had original exercise prices of between $4.375 and $9.938. All other terms of the various option agreements remained the same. The closing price of the Company's common stock on December 13, 1998 was $2.56. DIRECTOR STOCK OPTION PLAN The Company's Director Stock Option Plan (the "DSOP") authorizes the grant of stock options to directors of the Company. Options granted under the DSOP are non-qualified stock options exercisable at a price equal to the fair market value per share of common stock on the date of any such grant. Options granted under the DSOP are exercisable not less than six (6) months or more than ten (10) years after the date of grant. As of December 31, 1999, options for the purchase of 8,169 shares of common stock at prices ranging from $.875 to $3.875 per share were outstanding. As of December 31, 1999, options to purchase 15,228 shares of common stock have been exercised. In connection with adoption of the 1995 Director Plans (as hereinafter defined) the Board of Directors authorized the termination of future grants of options under the DSOP; however, outstanding options granted under the DSOP will continue to be governed by the terms thereof until exercise or expiration of such options. 1995 DIRECTOR STOCK OPTION PLAN In October 1995, the stockholders of the Company approved adoption of the Company's 1995 Director Stock Option and Appreciation Rights Plan, which plan provides for the issuance of incentive options, non-qualified options and stock appreciation rights (the "1995 Director Plan"). The 1995 Director Plan provides for automatic and discretionary grants of stock options which qualify as incentive stock options (the "Incentive Options") under Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), as well as options which do not so qualify (the "Non-Qualified Options") to be issued to directors. In addition, stock appreciation rights (the "SARs") may be granted in conjunction with the grant of Incentive Options and Non-Qualified Options. No SARs have been granted to date. The 1995 Director Plan provides for the grant of Incentive Options, Non-Qualified Options and SARs to purchase up to 250,000 shares of common stock (subject to adjustment in the event of stock dividends, stock splits and other similar events). To the extent that an Incentive Option or Non-Qualified Option is not exercised within the period of exercisability specified therein, it will expire as to the then-unexercised portion. If any Incentive Option, Non-Qualified Option or SAR terminates prior to exercise thereof and during the duration of the 1995 Director Plan, the shares of common stock as to which such option or right was not exercised will become available under the 1995 Director Plan for the grant of additional options or rights to any eligible employees. The shares of common stock subject to the 1995 Director Plan may be made available from either authorized but unissued shares, treasury shares, or both. The 1995 Director Plan also provides for the grant of Non-Qualified Options on a non-discretionary basis pursuant to the following formula: each member of the Board of Directors then serving shall receive a Non-Qualified Option to purchase 10,000 shares of common stock at an exercise price equal to the fair market value per share of the common stock on that date. Pursuant to such formula, directors received options to purchase 10,000 shares of common stock as of October 17, 1995, options to purchase 10,000 shares of common stock on January 2, 1996, and will receive options to purchase 10,000 shares of common stock on the first business day of each January. The number of shares granted to each Board member was increased to 20,000 in 1998. In addition, the Board member will receive 5,000 options for each committee membership. Each option is immediately exercisable for a period of ten years from the date of grant. The Company has 190,000 shares of common stock reserved for issuance under the 1995 Director Plan. As of December 31, 1999, options exercisable to purchase 170,000 shares of common stock at prices ranging from $1.00 to $1.25 per share are outstanding under the 1995 Director Plan. As of December 31, 1999, options to purchase 60,000 shares have been exercised under the 1995 Director Plan. 1995 EMPLOYEE STOCK OPTION PLAN In October 1995, the stockholders of the Company approved adoption of the Company's 1995 Employee Stock Option and Appreciation Rights Plan (the "1995 Employee Plan"), which plan provides for the issuance of Incentive Options, Non-Qualified Options and SARs. Directors of the Company are not eligible to participate in the 1995 Employee Plan. The 1995 Employee Plan provides for the grant of stock options which qualify as Incentive Stock Options under Section 422 of the Code, to be issued to officers who are employees and other employees, as well as Non-Qualified Options to be issued to officers, employees and consultants. In addition, SARs may be granted in conjunction with the grant of Incentive Options and Non-Qualified Options. No SARs have been granted to date. The 1995 Employee Plan provides for the grant of Incentive Options, Non-Qualified Options and SARs of up to 400,000 shares of common stock (subject to adjustment in the event of stock dividends, stock splits and other similar events). To the extent that an Incentive Option or Non-Qualified Option is not exercised within the period of exercisability specified therein, it will expire as to the then-unexercised portion. If any Incentive Option, Non-Qualified Option or SAR terminates prior to exercise thereof and during the duration of the 1995 Employee Plan, the shares of common stock as to which such option or right was not exercised will become available under the 1995 Employee Plan for the grant of additional options or rights to any eligible employee. The shares of common stock subject to the 1995 Employee Plan may be made available from either authorized but unissued shares, treasury shares, or both. The Company has 400,000 shares of common stock reserved for issuance under the 1995 Employee Plan. As of December 31, 1999, options to purchase 280,333 shares of common stock with exercise prices of $1.125 to $3.90 per share have been granted under the 1995 Employee Plan. As of December 31, 1999, 25,000 options have been exercised under the 1995 Employee Plan. 1997 RECRUITMENT STOCK OPTION PLAN In October 1997, the stockholders of the Company approved adoption of the Company's 1997 Recruitment Stock Option and Appreciation Rights Plan, which plan provides for the issuance of incentive options, non-qualified options and SAR's (the "1997 Plan"). The 1997 Plan provides for automatic and discretionary grants of stock options, which qualify as incentive stock options (the "Incentive Options") under Section 422 of the Code, as well as options which do not so qualify (the "Non-Qualified Options"). In addition, stock appreciation rights (the "SARs") may be granted in conjunction with the grant of Incentive Options and Non-Qualified Options. No SARs have been granted to date. The 1997 Plan provides for the grant of Incentive Options, Non-Qualified Options and SARs to purchase up to 4,400,000 shares of common stock (subject to adjustment in the event of stock dividends, stock splits and other similar events). The price at which shares of common stock covered by the option can be purchased is determined by the Company's Board of Directors; however, in all instances the exercise price is never less than the fair market value of the Company's common stock on the date the option is granted. To the extent that an Incentive Option or Non-Qualified Option is not exercised within the period of exercisability specified therein, it will expire as to the then unexercised portion. If any Incentive Option, Non-Qualified Option or SAR terminates prior to exercise thereof and during the duration of the 1997 Plan, the shares of common stock as to which such option or right was not exercised will become available under the 1997 Plan for the grant of additional options or rights. The shares of common stock subject to the 1997 Plan may be made available from either authorized but unissued shares, treasury shares, or both. As of December 31, 1999, options to purchase 2,916,876 shares of common stock, with exercise prices of $2.125 to $4.91 per share have been granted under the 1997 Plan. As of December 31, 1999, no options have been exercised under the 1997 Plan. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table shows, as of April 10, 2000, all directors, executive officers, and, to the best of the Company's knowledge, all other parties the Company knows to be beneficial owners of more than 5% of the common stock, or beneficial owners of a sufficient number of shares of Series C preferred stock, Series F redeemable preferred stock, Series M redeemable preferred stock or Series N preferred stock to be converted into at least 5% of the common stock. As of April 10, 2000, there were issued and outstanding the following: 26,727,108 shares of common stock, 16,686 shares of Series C preferred stock, 4,400 shares of Series M Redeemable preferred stock and 15,284 shares of Series N preferred stock. - ---------------- * Indicates less than one percent. 1 Unless noted, all of such shares of common stock are owned of record by each person or entity named as beneficial owner and such person or entity has sole voting and dispositive power with respect to the shares of common stock owned by each of them. All addresses are c/o I-Link Incorporated unless otherwise indicated. 2 As to each person or entity named as beneficial owners, such person's or entity's percentage of ownership is determined by assuming that any options or convertible securities held by such person or entity which are exercisable or convertible within 60 days from the date hereof have been exercised or converted, as the case may be. 3 Includes 1,000 shares of common stock and 358,333 shares of common stock issuable pursuant to options. 4 Includes 461,500 shares of common stock issuable pursuant to options and 72,000 shares of common stock issuable to the Leslie Group, Inc. upon conversion of 3,000 shares of Series C preferred stock held of record by Leslie Group, Inc., of which Mr. Cohen is President. 5 Represents shares of common stock issuable pursuant to options and warrants. 6 Includes 99,167 shares of common stock subject to options, 51,079 shares of common stock issuable upon conversion of 142 shares of Series N preferred stock and 70,000 shares of common stock held of record by members of Mr. Keenan's immediate family. Mr. Keenan serves on the Board of Directors as the designee of Winter Harbor. Mr. Keenan's wife is the beneficiary of a trust which owns non-voting stock in the corporate general partner of First Media, L.P., the parent of Winter Harbor. For further information about Winter Harbor, see "Transactions with Winter Harbor, L.L.C.; Series M and N preferred stock." Neither Mr. Keenan nor his wife has dispositive power or voting control over the securities of I-Link held by Winter Harbor; Mr. Keenan disclaims beneficial ownership of the securities held by Winter Harbor. See also footnote 10 below. 7 Represent 500,000 shares of common stock subject to options and 738,458 shares of common stock owned. 8 Represent 516,669 shares of common stock subject to options and 106,850 shares of common stock owned. 9 Represents shares of common stock issuable pursuant to options. Does not include shares held of record by Four M International, Ltd., of which Mr. Toh is a director. Mr. Toh disclaims any beneficial ownership of such shares. 10 Includes 7,593,360 shares of common stock issuable upon conversion of Series M Redeemable preferred stock, 5,181,295 shares of common stock issuable upon conversion of Series N Convertible preferred stock, 5,057,893 shares of common stock issuable upon conversion of Series M redeemable preferred stock which may be issued on conversion of promissory notes held by the named stockholder, and 28,540,000 shares of common stock issuable upon exercise of warrants. In addition, I-Link includes herein 5,000,000 shares of common stock issuable upon exercise of warrants which the named stockholder will be entitled to receive should it convert its promissory notes to common stock. Winter Harbor is owned by First Media, L.P., a private media and communications company that is a private investment principally of Richard E. Marriott and his family. I-Link's general counsel, David E. Hardy, is a brother of Ralph W. Hardy, Jr. who is general counsel and a minority equity holder in Winter Harbor. David E. Hardy has no ownership in or association with Winter Harbor. Thomas A. Keenan's wife has an interest in First Media, L.P. (see footnote 6 above). 11 Represents 916,308 shares of common stock issued, 5,158,394 shares of common stock which may be obtained pursuant to options and warrants exercisable within 60 days of the date hereof, 51,079 shares of common stock into which 142 share of Series N preferred stock are convertible and 72,000 shares of common stock into which 3,000 shares of Series C preferred stock are convertible. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Company's management was informed that Winter Harbor had purchased an ownership interest in Tenfold Corporation, a consulting company that the Company contracted with to develop a new internal information system. In March 1999, Winter Harbor, LLC transferred ownership of the investment to First Media TF Holdings, LLC, an affiliate of Winter Harbor, LLC. First Media TF Holdings, LLC beneficially owns 10.6% of Tenfold's common stock. The Company's referral to Tenfold did not come through Winter Harbor, and Winter Harbor played no part in the negotiation of such consulting arrangement. In the first quarter of 1999, the Company's management and its Board of Directors concluded that the new system would not significantly enhance the Company's existing billing and information systems or meet its ultimate needs and accordingly did not justify paying additional contracted expenses of approximately $1,000,000. Accordingly the Company recorded a write-down on the in-process system development of $1,847,288. See Item 11 hereof for descriptions of the terms of employment and consulting agreements between the Company and certain officers, directors and other related parties. TRANSACTIONS WITH WINTER HARBOR, L.L.C.; SERIES M AND N PREFERRED STOCK Winter Harbor, L.L.C. ("Winter Harbor") is owned by First Media, L.P., a private media and communications company which is a private investment principally of Richard E. Marriott and his family. The Company's general counsel, David E. Hardy, is a brother of Ralph W. Hardy, Jr. who is general counsel and a minority equity holder in Winter Harbor. David E. Hardy has no ownership or association with Winter Harbor. As a result of this relationship, as well as personal relationships of David E. Hardy with the principals of Winter Harbor, discussions were initiated which led to Winter Harbor's investments in the Company, which are summarized below. On June 5, 1997, the Company entered into a term loan agreement ("Loan Agreement") and promissory note ("Note") with Winter Harbor pursuant to which Winter Harbor agreed to loan to the Company the principal sum of $2,000,000 (the "Loan") for capital expenditures and working capital purposes. As further consideration for Winter Harbor's commitment to make the Loan, the Company granted to Winter Harbor a warrant ("Loan Warrant") to purchase up to 500,000 shares of common stock at an exercise price of $4.97 per share, subject to adjustment, pursuant to the terms of a Warrant Agreement between the parties. The Loan Warrant expires on March 11, 2002, and contains demand and piggyback registration rights and customary anti-dilution terms. The maturity date of the Note was October 15, 1998; however, the Loan Agreement anticipated an equity investment in the Company by Winter Harbor (the "Investment"). Upon closing of the Investment, all principal and accrued interest then due under the Note was credited toward payment of Winter Harbor's purchase price for the Investment and the Note was cancelled. The loan from Winter Harbor had an interest rate of prime plus 2%. In addition to the stated interest rate, the Company recognized the debt discount attributable to the warrants as interest expense over the life of the loan (maturity date was October 15, 1998). The Company expended significant time and effort pursuing various financing alternatives and determined that the Winter Harbor proposal was the best alternative available to the Company. On August 18, 1997, the Company and Winter Harbor amended their agreement pursuant to which the Company borrowed an additional $3,000,000 bringing the total principal amount due under the Note to $5,000,000, and issued additional warrants to purchase an additional 300,000 shares at an exercise price of $6.38 per warrant to Winter Harbor in connection therewith. The Company and Winter Harbor executed a Sales Purchase Agreement, dated as of September 30, 1997, and closed on October 10, 1997, pursuant to which Winter Harbor invested $12,100,000 in a new series of the Company's convertible preferred stock (the "Series M redeemable preferred stock"). Winter Harbor purchased approximately 2,545 shares of Series M redeemable preferred stock (convertible into 2,545,000 shares of common stock) for aggregate cash consideration of approximately $7,000,000 (equivalent to $2.75 per share of common stock). The agreement with Winter Harbor provided for purchase of approximately 1,855 additional shares of Series M redeemable preferred stock (convertible into 1,855,000 shares of common stock). Such additional shares of Series M redeemable preferred stock were paid for by exchanging the $5,000,000 outstanding principal balance plus approximately $100,000 accrued interest due under the Note. As additional consideration for its equity financing commitments, Winter Harbor was issued additional warrants by the Company to acquire (a) 2,500,000 shares of common stock at an exercise price of $2.75 per share (the "Series A Warrants"), (b) 2,500,000 shares of common stock at an exercise price of $4.00 per share (the "Series B Warrants") and (c) 5,000,000 shares of common stock at an exercise price of $4.69 per share (the "Series C Warrants"). The respective exercise prices for the Series A Warrants, the Series B Warrants and the Series C Warrants (collectively, the "Investment Warrants"), shall be subject to adjustment. The Series A Warrants will be exercisable at any time for thirty months from the date of issuance, and the Series B Warrants and Series C Warrants will be exercisable at any time for sixty months from the date of issuance. All of the Investment Warrants (i) have demand registration rights and anti-dilution rights and (ii) contain cashless exercise provisions. The Series M redeemable preferred stock is entitled to receive cumulative dividends in the amount of 10% per annum before any other Series of preferred or common stock receives any dividends. Thereafter, the Series M redeemable preferred stock will participate with the common stock in the issuance of any dividends on a per share basis. Moreover, the Series M redeemable preferred stock will have the right to veto the payment of dividends on any other class of stock, except for cumulative dividends which accrue pursuant to the terms of the Series C preferred stock outstanding prior to the Winter Harbor investment. The Series M redeemable preferred stock is convertible at any time prior to the fifth anniversary of its issuance, at the sole option of Winter Harbor, into shares of common stock on a one thousand-for-one basis; provided, however, that the Series M redeemable preferred stock shall be automatically converted to common stock on the fifth anniversary of its issuance at no cost to Winter Harbor. The conversion price shall be, in the case of discretionary conversion, $2.75 (subsequently reset to $2.033) per share of common stock, or, in the case of automatic conversion, the lesser of $2.033 per share or 50% of the average closing bid price of the common stock for the ten trading days immediately preceding the fifth anniversary of issuance. The basis for discretionary conversion, or the conversion price for automatic conversion, shall be adjusted upon the occurrence of certain events, including without limitation, issuance of stock dividends, recapitalization of the Company, or the issuance of stock by the Company at less than the fair market value thereof. Upon completion of the Winter Harbor Investment, the Company included in its earnings per share calculation a (non-cash) preferred stock dividend in the fourth quarter of 1997 in the amount of $88,533,450. This amount was calculated as the difference between the exercise or conversion price per common share per the agreement as compared to the market price of the common stock on the date of the closing, plus the value of the warrants issuable in connection with the Investment. During 1998, the Company obtained an aggregate of $7.768 million in new interim debt financing from Winter Harbor, L.L.C. As consideration for Winter Harbor's commitment to make the loan, the Company agreed to issue 6,740,000 warrants to purchase common stock of the Company at exercise prices ranging from $5.50 to $7.22 based upon 110% of the closing price of the common stock on the day loan funds were advanced. The warrants have exercise periods of 7.5 years from issuance. The Company also agreed to extend the exercise period on all warrants previously issued to Winter Harbor (10,800,000) to seven and one-half years. Pursuant to the terms of the loan agreement with Winter Harbor, the initial borrowings of $5,768,000 were payable upon demand by Winter Harbor no earlier than May 15, 1998, and were collateralized by essentially all of the assets of the Company's subsidiaries. As the loan was not repaid by May 15, 1998, the total loan, including additional borrowings of $2,000,000 obtained in the second quarter, continues on a demand basis with interest accruing at prime plus four percent. On April 15, 1999, Winter Harbor agreed that it would not demand payment under the notes prior to April 15, 2000 and in April 2000 agreed to extend the due date of the principal and accrued interest to April 15, 2001. Additionally, Winter Harbor has the right at any time until the loan is repaid to elect to exchange the unpaid balance of the loan into additional shares of the Company's Series M redeemable preferred stock and receive an additional 5,000,000 warrants to purchase common stock of the Company at an exercise price of $2.033 per share. During 1998, the Company recorded $7,274,000 as a discount against the new $7,768,000 debt representing the relative fair value attributed to the new warrants, the change of the exercise period on prior warrants and the equity instruments associated with the assumed conversion of the debt into equity. The debt discount was amortized over the original terms of the respective borrowings. The exercise prices of the above warrants issued or issuable to Winter Harbor varied at the time of their respective issuance, however, all are subject to adjustment downward to equal the market price of common stock in the event the common stock market price is below the original exercise price at the time of exercise, subject to an exercise price lower limit of the lesser of the original exercise price or $2.75 per share. The exercise price of all Winter Harbor warrants has been reset to $2.033 as of December 31, 1999 and continue to be subject to downward adjustment per the agreement. On January 15, 1999, I-Link formalized an agreement with Winter Harbor for additional financing. The financing arrangement consists of an $8,000,000 bridge loan facility and a $3,000,000 standby letter of credit to secure additional capital leases of equipment and telephone lines relative to the expansion of the Company's telecommunications network. As of December 31, 1999, the Company had borrowed the full amount available on the Bridge Loan and lease facility. The bridge loan and accrued interest were exchanged for Series N preferred stock in July 1999. As additional consideration for making the loan, the Company granted warrants to purchase common stock to Winter Harbor. Initially, Winter Harbor receives one warrant for every $10 borrowed from Winter Harbor including the standby letter of credit. The warrants have a 7.5 year exercise period with an exercise price of the lower of (a) $2.78 (reset to $2.033 as of December 31, 1999), (b) the average trading price for any 20 day period subsequent to the issuance of the warrants, (c) the price at which new shares of common stock or common stock equivalents are issued, or (d) the exercise price of any new options, warrants, preferred stock or other convertible security. The exercise price is subject to a $1.25 floor. On April 14, 1999, the shareholders voted to approve a plan of financing which includes issuing 10 warrants for each $10 borrowed under the Bridge Loan and standby letter of credit. The Company did not repay the loan before April 26, 1999 and granted Winter Harbor warrants to purchase 11,000,000 shares of common stock. During 1999 and 1998, the Company recorded $2,956,283 and $1,032,634, respectively, as a discount against the $8.0 million Bridge Loan representing the relative fair value attributed to the bridge loan warrants and line of credit. The debt discount was amortized over the term of the Bridge Loan, or leases as applicable. During 1999 and 1998, $3,360,771 and $128,059, respectively, of debt discount was amortized. On April 15, 1999, the Company entered into a financing agreement with Winter Harbor. Winter Harbor loaned the Company up to $4 million under a note due September 30, 1999. In July 1999 this loan and accrued interest was exchanged for Series N preferred stock as discussed below. On July 23, 1999 the Company completed its offering of 20,000 shares of Series N preferred stock. The offering was fully subscribed through cash subscriptions and the Company exercising its right to exchange notes payable to Winter Harbor of $8.0 million and $4.0 million plus accrued interest. In total the Company exchanged $12,718,914 in debt and accrued interest. Winter Harbor purchased 14,404 (in cash and exchange of debt and interest) of the 20,000 shares of Series N stock. The Series N conversion price was initially set at $2.78, but may be reset to the lowest of: (1) 110% of the average trading price for any 20 day period following the date that Series N preferred stock is first issued; (2) the price at which any new common stock or common stock equivalent is issued; (3) the price at which common stock is issued upon the exercise or conversion of any new options, warrants, preferred stock or other convertible security; (4) the conversion price of any Series F preferred stock converted after the date that Series N preferred stock is first issued; and (5) a conversion price floor of $1.25. On April 13, 2000, Winter Harbor, LLC, agreed to provide I-Link with a line of credit to meet its minimum financing needs of up to an aggregate amount of $15,000,000. This commitment expires on the earlier of April 12, 2001 or the date I-Link has received net cash proceeds of not less than $15,000,000 pursuant to one or more additional financings or technology sales as well as licensing or consulting agreements outside the normal and historical course of business. The $15,000,000 aggregate commitment will be reduced by the $1,300,000 (plus interest at 8% per annum) advanced to I-Link in the first quarter of 2000 by Winter Harbor, interest accruing on any other advances under such commitment, as well as any net cash proceeds received by I-Link in the future from additional financings or technology sales as well as licensing or consulting agreements outside the normal and historical course of business. Any amounts outstanding under the loan will be due and payable no later than April 12, 2001 (see- "Current Position/Future Requirements'). MIBRIDGE ACQUISITION; SERIES D PREFERRED STOCK On August 12, 1997 the Company entered into an agreement with MiBridge, Inc., a New Jersey corporation ("MiBridge") and Mr. Dror Nahumi, the principal shareholder of MiBridge, pursuant to which the Company acquired all of the issued and outstanding stock of MiBridge (the "MiBridge Acquisition"). The MiBridge Acquisition subsequently closed on September 2, 1997. MiBridge is the owner of patent-pending audio-conferencing technology and is a leader in creating speech-encoding and compression algorithms designed to produce superior audio quality and lower delay over low-band networks. The Company agreed to pay the stockholders of MiBridge (the "MiBridge Stockholders") consideration consisting of (i) an aggregate $2,000,000 in cash, payable in quarterly installments over two years, and (ii) an aggregate 1,000 shares of a series of the Company's convertible preferred stock (the "Series D preferred stock"). The 1,000 shares of Series D preferred stock are convertible at the option of the MiBridge Stockholders, at any time during the nine months following the closing of the MiBridge Acquisition, into such number of shares of common stock as shall equal the sum of $6,250,000 divided by $9.25 (the "Series D Conversion Price"), which price was the closing bid price of the Company's common stock on June 5, 1997 (the date that the first letter agreement relating to the transaction was executed) or the average closing bid price for the five trading days immediately preceding the date the Company receives notice of conversion whichever is lower. As of December 31, 1999, all shares of the Series D preferred stock had been converted into common stock and all amounts payable in cash had been paid. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following financial statements and those financial statement schedules required by Item 8 hereof are filed as part of this report: 1. Financial Statements: Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997 Consolidated Statement of Changes in Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements 2. Financial Statement Schedule: Report of Independent Accountants Schedule II - Valuation and Qualifying Accounts All other schedules are omitted because of the absence of conditions under which they are required or because the required information is presented in the Financial Statements or Notes thereto. (b) The Company did not file any reports on Form 8-K during the fourth quarter of 1999. (c) The following exhibits are filed as part of this Registration Statement: - --------------- * Indicates a management contract or compensatory plan or arrangement required to be filed. 1 Filed herewith. 2 Incorporated by reference to the Company's Current Report on Form 8-K, dated February 23, 1996, file number 0-17973. 3 Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1995, file number 0-17973. 4 Incorporated by reference to the Company's Current Report on Form 8-K, dated February 23, 1996, file number 0-17973. 5 Incorporated by reference to the Company's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996, file number 0-17973. 6 Incorporated by reference to the Company's Current Report on Form 8-K, dated January 13, 1997, file number 0-17973. 7 Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1996, file number 0-17973. 8 Incorporated by reference to the Company's Registration Statement on Form SB-2, file number 333-17861. 9 Incorporated by reference to the Company's Current Report on Form 8-K, dated June 5, 1997, file number 0-17973. 10 Incorporated by reference to the Company's Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2, file number 333-17861. 11 Incorporated by reference to the Company's Current Report on Form 8-K, dated September 30, 1997, file number 0-17973. 12 Incorporated by reference to the Company's Pre-Effective Amendment No. 3 to Registration Statement on Form SB-2, file number 333-17861. 13 Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997, file number 0-17973. 14 Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1998, file number 0-17973. 15 Incorporated by reference to the Company's Registration Statement on Form S-1 filed September 3, 1998, file number 333-62833. 16 Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1998, file number 0-17973. 17 Incorporated by reference to the Company's Current Report on Form 8-K filed on March 23, 1999, file number 0-17973. 18 Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998, file number 0-17973 19 Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1999, file number 0-17973. SIGNATURES In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized. I-LINK INCORPORATED (Registrant) Dated: April 13, 2000 By: /s/ John W. Edwards ------------------------------------------- John W. Edwards, Chairman of the Board, and Chief Executive Officer In accordance with Section 13 of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. FINANCIAL STATEMENTS & SUPPLEMENTAL SCHEDULES REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of I-Link Incorporated and Subsidiaries: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in stockholders' equity (deficit), and cash flows present fairly, in all materials respects, the financial position of I-Link Incorporated and its subsidiaries (the "Company") as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Salt Lake City, Utah April 13, 2000 I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1999 AND 1998 The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 Continued The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT), CONTINUED FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT), CONTINUED FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 Continued The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 The accompanying notes are an integral part of these consolidated financial statements I-LINK INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------ NOTE 1 - DESCRIPTION OF BUSINESS, PRINCIPLES OF CONSOLIDATION AND LIQUIDITY The consolidated financial statements include the accounts of I-Link Incorporated and its subsidiaries (the "Company"). The Company's principal operation is the development, sale and delivery of enhanced communications products and services utilizing its own private intranet and both owned and leased network switching and transmission facilities. The Company provides unique communications solutions through its use of proprietary technologies. Telecommunications services are marketed primarily through master agent and wholesale distributor arrangements. Historically, these services were marketed primarily through independent representatives to subscribers throughout the United States (see Note 17). The Company's telecommunication services operations began primarily with the first quarter of 1997 acquisition of I-Link Communications, Inc., an FCC licensed long-distance carrier (see Note 10). During the second quarter of 1997, the Company formed a new wholly owned subsidiary, I-Link Worldwide, L.L.C., through which it launched a network marketing channel to market its telecommunications services and products. In February 2000, the Company entered into a wholesale marketing arrangement with and transitioned the representatives in the network marketing channel to Big Planet (see Note 17). Through its wholly owned subsidiaries, MiBridge, Inc. (MiBridge) and ViaNet Technologies, Ltd. (ViaNet), the Company develops and licenses communications products and software that support multimedia communications (voice, fax and audio) over the public switched network, local area networks and the Internet. MiBridge was acquired during the third quarter of 1997 (see Note 10). The Company formed ViaNet in the fourth quarter of 1997. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company incurred a net loss from continuing operations of $24,159,288 for the year ended December 31, 1999, and as of December 31, 1999 had an accumulated deficit of $109,953,971 and negative working capital of $1,318,640. The Company anticipates that revenues generated from its continuing operations will not be sufficient during 2000 to fund ongoing operations, the continued expansion of its private telecommunications network facilities, Indavo development and manufacturing, and anticipated growth in subscriber base. The Company has entered into additional financing arrangements and proposes to issue additional stock as described below in order to obtain the additional funds required for its continuing operations in 2000. In order to provide for working capital needs, on April 13, 2000, Winter Harbor entered into a binding commitment to provide funding to the Company of up to $15 million pursuant to a revolving line of credit. Funds borrowed under the line of credit (including interest accruing at the rate of 12.5% per annum) are due April 12, 2001 (see Note 17). While the Company believes that the aforementioned sources of funds will be sufficient to fund operations into 2001, the Company anticipates that additional funds will be necessary from public or private financing markets to successfully integrate and finance the planned expansion of the business communications services, product development and manufacturing, and to discharge the financial obligations of the Company. The availability of such capital sources will depend on prevailing market conditions, interest rates, and financial position and results of operations of the Company. There can be no assurance that such financing will be available, that the Company will receive any proceeds from the exercise of outstanding options and warrants or that the Company will not be required to arrange for additional debt, equity or other type of financing. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents primarily with financial institutions in Utah, California, Arizona, New Jersey and Florida, which at times, may exceed federally insured limits. The Company has not experienced any losses on such accounts. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED ALLOWANCE FOR DOUBTFUL ACCOUNTS The Company evaluates the collectibility of its receivables at least quarterly, based upon various factors including the financial condition and payment history of major customers, an overall review of collections experience on other accounts and economic factors or events expected to affect the Company's future collections experience. FURNITURE, FIXTURES, EQUIPMENT AND SOFTWARE Furniture, fixtures, equipment and software are stated at cost. Depreciation is calculated using the straight-line method over the following estimated useful lives: Betterments and renewals that extend the life of the assets are capitalized; other repairs and maintenance charges are expensed as incurred. The cost and related accumulated depreciation applicable to assets retired are removed from the accounts and the gain or loss on disposition is recognized in operations. The Company regularly evaluates whether events or circumstances have occurred that indicate the carrying value of its furniture, fixtures, equipment and software may not be recoverable. When factors indicate the asset may not be recoverable, the Company compares the related undiscounted future net cash flows to the carrying value of the asset to determine if an impairment exists. If the expected future net cash flows are less than the carrying value, impairment is recognized based on the fair value of the asset. During 1999, the Company wrote off $1,847,288 in unrecoverable capitalized software costs (see Note 6). There were no such write-offs in 1998 or 1997. INTANGIBLE ASSETS The Company regularly evaluates whether events or circumstances have occurred that indicate the carrying value of its intangible assets may not be recoverable. When factors indicate the asset may not be recoverable, the Company compares the related undiscounted future net cash flows to the carrying value of the asset to determine if impairment exists. If the expected future net cash flows are less than carrying value, impairment is recognized based on the fair value of the asset. During 1997, the Company wrote off $860,305 in unrecoverable intangible assets. The write off is included in selling, general and administrative expense. There were no such write-offs for 1999 and 1998. Amortization of intangible assets is calculated using the straight-line method over the following periods: REVENUE RECOGNITION Long-distance and enhanced service revenue is recognized as service is provided to subscribers. Marketing services revenues from the network marketing channel primarily include revenues recognized from independent representatives ("IRs") for promotional and presentation materials and national conference registration fees. IRs enter into a standard written independent sales representative agreement with the Company and pay a fee of either $50 or $295 based on selected options for sales and marketing materials and on-going administrative support. Revenue from the sale of promotional and presentation materials (included in Marketing services revenue) is recognized at the time the materials are shipped. The portion of the sign-up fee, including a normal profit margin, relating to on-going administrative support is deferred and recognized over twelve months (the initial term of the IR agreement). Marketing services revenues are presented net of estimated refunds on returns of network marketing materials (see Note 17). NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED During the second quarter of 1999, the Company began offering its WebCentre product to IRs in the network marketing channel. WebCentre is a personalized web page that can be used for business promotion and back-office support. Each user pays a set-up fee of between $395 - $495, plus a monthly recurring charge of $15.95. Revenue relating to the set-up fee is partially recognized at the time the WebCentre product is made available to the user. The portion of the set-up fee, plus a normal profit margin, relating to ongoing support of the WebCentre is deferred over the estimated life of the IR agreement. Revenue related to the monthly recurring charge is recognized in the month the services are provided (see Note 17). In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements, which provides guidance on the recognition, presentation, and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosure related to revenue recognition policies. Though the Company is currently evaluating the impact (if any) of SAB 101, the Company does not presently believe it will have a material effect on the financial position or result of operations of the Company. Revenue from the sale of software licensing is recognized when the product has been shipped, a noncancellable agreement is in force, the license fee is fixed or determinable, acceptance has occurred and collectibility is reasonably assured. Maintenance and support revenues are recognized ratably over the term of the related agreements, which in most cases is one year. Revenues on long-term development projects are recognized under the percentage of completion method of accounting and are based upon costs incurred on the project, compared to estimated total costs related to the contract. COMPUTER SOFTWARE COSTS Effective January 1, 1999, the Company adopted Statement of Position No. 98-1 (SOP 98-1), "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use". In accordance with SOP 98-1, the Company capitalizes qualified costs associated with developing computer software for internal use. Previously these costs were recognized as a current expense. The impact of applying this standard was not material to the 1999 consolidated financial position or results of operations of the Company. Purchased computer software for internal use is capitalized and amortized over the expected useful life, usually three years. CONCENTRATIONS OF CREDIT RISK The Company's telecommunications subscribers are primarily residential subscribers and are not concentrated in any specific geographic region of the United States. INCOME TAXES The Company records deferred taxes in accordance with Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." The statement requires recognition of deferred tax assets and liabilities for temporary differences between the tax bases of assets and liabilities and the amounts at which they are carried in the financial statements, based upon the enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. SEGMENT REPORTING In 1998, the Company adopted SFAS 131, "Disclosures about Segments of an Enterprise and Related Information". SFAS 131 supersedes SFAS 14, "Financial Reporting for Segments of a Business Enterprise", replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company's reportable segments. SFAS 131 also requires disclosures about products and services, geographic areas and major customers. The adoption of SFAS 131 did not affect results of operations or financial position, but did affect the disclosure of segment information (see Note 15). NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECLASSIFICATIONS Certain balances in the December 31, 1998 and 1997 financial statements have been reclassified to conform to current year presentation. These changes had no effect on previously reported net loss, total assets, liabilities or stockholders' equity. NOTE 3 - NET LOSS PER SHARE Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. Options, warrants, convertible preferred stock and convertible debt are included in the calculation of diluted earnings per share, except when their effect would be anti-dilutive. As the Company had a net loss from continuing operations for 1999, 1998 and 1997, basic and diluted loss per share are the same. During 1999 and 1998, holders of the Series F redeemable preferred stock converted 750 and 2 of those preferred shares, respectively. Accordingly, they were paid stock dividends of 165,220 and 240 shares, respectively, of common stock on the converted shares. As the conversion prices of the Series E, F, M and N preferred stock at issuance were less than the market price of the Company's common stock, the Company recognized deemed preferred stock dividends at issuance, which increases the loss attributable to common shareholders in the calculation of basic and diluted net loss per common share. The deemed dividends are implied only and do not represent future obligations to pay a dividend. The deemed preferred stock dividends on the Series N preferred stock were calculated as the difference between the conversion price per common share per the Series N agreement and the market price of the common stock on the date the proceeds from the offering were received and/or the debt was exchanged. The deemed preferred stock dividends on Series E and Series F convertible cumulative redeemable preferred stock equal the sum of the difference between the conversion price per common share per the agreements and the market price of the common stock as of the date the agreements were finalized and the difference between the fair value of the Series F redeemable preferred stock issued and the carrying value of the Series E stock at the date of redemption. The deemed preferred stock dividend on Series M convertible cumulative redeemable preferred stock is calculated as the difference between the conversion price per common share per the agreement and the market price of the common stock as of the date the agreement was finalized, plus the fair value of the warrants issuable in connection with the preferred stock investment. NOTE 3 - NET LOSS PER SHARE, CONTINUED Potential common shares that were not included in the computation of diluted EPS because they would have been anti-dilutive are as follows as of December 31: As of December 31, 1999, Winter Harbor, the sole holder of Series M redeemable preferred stock, held warrants, exercisable at any time, for the purchase of up to 28,540,000 shares of common stock. In addition, should Winter Harbor elect to exchange its $7.768 million in promissory notes into additional shares of Series M redeemable preferred stock, it is entitled to receive additional warrants to purchase 5,000,000 shares of common stock. The exercise prices of all of such warrants varied at the time of their respective issuance, however, all are subject to adjustment downward to equal the price at which new shares of common stock are issued or to equal the market price of common stock in the event the common stock market price is below the original exercise price at the time of exercise. The current exercise price of all Winter Harbor warrants is $2.033. NOTE 4 - DISCONTINUED OPERATIONS On March 23, 1998, the Company's Board of Directors approved a plan to dispose of the Company's medical services businesses in order to focus its efforts on the sale of telecommunication services and technology licensing. The Company has sold essentially all of the fixed assets, with the proceeds being used to satisfy outstanding obligations of the medical services subsidiaries. During 1998, the Company received $310,000 from the sale of assets from the medical services subsidiaries. In January 1999, the Company sold additional assets for $15,000 and a note receivable of $35,000. In March 2000, the Company sold the remaining assets and settled the outstanding liabilities of the China operations and received net proceeds of $150,000. The Company continues to collect on the outstanding receivables from the discontinued operations and will use the proceeds to settle the remaining obligations of the discontinued entities. As of December 31, 1999, there are no revenue generating activities remaining from the medical services operations. On-going administrative costs include fees associated with collecting outstanding accounts receivable and oversight of the final close out procedures. These anticipated costs have been accrued for as part of the expected ultimate loss on disposal. The Company recorded an additional loss from discontinued operations in 1999 in the amount of $500,000. The Company has experienced unexpected delays in disposing of the remaining non-operating assets, including certain assets located in China. Additionally, the Company's best estimate of proceeds from the remaining assets is expected to be less than originally estimated by management. As the remaining asset disposals have not occurred as expected, during 1999 the Company revised its best estimate of the ultimate loss on disposal and related on-going administrative costs and accordingly recorded the additional estimated loss of $500,000. The results of the medical services operations have been classified as discontinued operations for all periods presented in the Consolidated Statements of Operations. The assets and liabilities of the discontinued operations have been classified in the Consolidated Balance Sheets as "Net assets or Net Liabilities - discontinued operations". Discontinued operations have also been segregated for all periods presented in the Consolidated Statements of Cash Flows. NOTE 4 - DISCONTINUED OPERATIONS, CONTINUED Net assets (liabilities) of the Company's discontinued operations (excluding intercompany balances, which have been eliminated against the net equity of the discontinued operations) are as follows: Revenues of the discontinued operations were $337,268, $1,445,376 and $2,309,099 for 1999, 1998 and 1997, respectively. The net assets (liabilities) of the discontinued operations as of December 31, 1999 are shown as current in the consolidated balance sheet as it is anticipated the remaining assets and liabilities of the medical services businesses will be sold or settled during 2000. NOTE 5 - CERTIFICATES OF DEPOSIT - RESTRICTED As of December 31, 1999, the Company has $129,636 in restricted certificates of deposit (CDs). The CDs collateralize certain facilities lease agreements. All of the CDs are held in escrow and bear interest, which is paid to the Company. During 1999, restricted CDs totaling $412,649 were released to the Company in accordance with the lease agreements. Of the remaining CDs held in escrow, $53,500 will be released to the Company during 2000 and are classified as a current asset in the consolidated balance sheet. NOTE 6 - FURNITURE, FIXTURES, EQUIPMENT AND SOFTWARE CONTINUING OPERATIONS Furniture, fixtures, equipment and software relating to continuing operations consisted of the following at December 31: Included in telecommunications network equipment are $3,907,312 and $1,730,215 in assets acquired under capital lease at December 31, 1999 and 1998, respectively. Accumulated amortization on these leased assets was $1,671,657 and $538,954 at December 31, 1999 and 1998, respectively. During 1998, the Company contracted with an outside consulting firm to develop a billing and operations information system and capitalized as a component of furniture, fixture, equipment and software $2,284,574 in costs (including amounts in accounts payable at December 31, 1998 of $437,286) associated with this in-process system development. The Company continually evaluated the functionality and progress of the in-process system development. In May 1999, the Company's management and its Board of Directors concluded that the new system would not significantly enhance the Company's existing billing and information systems, would not meet its ultimate needs and had no alternative future use and accordingly did not justify paying additional billed and contracted expenses of approximately $1,000,000. Negotiations to discontinue work under the contract were concluded in May 1999, with the consulting company forgoing any future payments on the project while retaining amounts paid to date of $1,847,288. Accordingly, the Company recorded, effective March 31, 1999, a write-down of capitalized software costs on the in-process system development of $1,847,288. DISCONTINUED OPERATIONS Furniture, fixtures and equipment relating to discontinued operations consisted of the following at December 31: NOTE 7 - INTANGIBLE ASSETS Intangible assets consisted of the following at December 31: NOTE 8 - LONG-TERM DEBT CONTINUING OPERATIONS Long-term debt relating to continuing operations, the carrying value of which approximates market, consists of the following at December 31: During 1998, the Company obtained an aggregate of $7,768,000 in new interim debt financing from Winter Harbor, L.L.C. As consideration for Winter Harbor's commitment to make the loan, the Company agreed to issue 6,740,000 warrants to purchase common stock of the Company at exercise prices ranging from $5.50 to $7.22 (subsequently reset to $2.033) based upon 110% of the closing price of the common stock on the day loan funds were advanced. The warrants have exercise periods of 7.5 years from issuance. The Company also agreed to extend the exercise period on all warrants previously issued to Winter Harbor (10,800,000) to seven and one-half years. Pursuant to the terms of the loan agreement with Winter Harbor, the initial borrowings of $5,768,000 were payable upon demand by Winter Harbor no earlier than May 15, 1998, and were collateralized by essentially all of the assets of the Company's subsidiaries. As the loan was not repaid by May 15, 1998, the total loan, including additional borrowings of $2,000,000 obtained in the second quarter, continued on a demand basis with interest accruing at prime plus four percent. On April 15, 1999, Winter Harbor agreed that it would not demand payment under the notes prior to April 15, 2000 and in April 2000 agreed to extend the due date of the principal and accrued interest to April 15, 2001. Additionally, Winter Harbor has the right at any time until the loan is repaid to elect to convert the unpaid balance of the loan into additional shares of the Company's Series M redeemable preferred stock and receive an additional 5,000,000 warrants to purchase common stock of the Company at an exercise price of $2.033 per share. During 1998, the Company recorded $7,274,000 as a discount against the $7,768,000 Winter Harbor debt representing the relative fair value attributed to the warrants, the change of the exercise period on prior warrants and the equity instruments associated with the assumed conversion of the debt into equity. The debt discount was amortized over the original terms of the respective borrowings. Accrued and unpaid interest on the $7,768,000 Winter Harbor debt is included in long-term liabilities on the consolidated balance sheet and totaled $1,345,801 and $414,000 at December 31, 1999 and 1998, respectively. NOTE 8 - LONG-TERM DEBT, CONTINUED On January 15, 1999, I-Link finalized an agreement that had been negotiated in November 1998 with Winter Harbor for additional financing. The financing arrangement consisted of an $8,000,000 bridge loan facility (Bridge Loan) and a $3,000,000 standby letter of credit to secure additional capital leases of equipment and telephone lines relative to the expansion of the Company's telecommunications network. As of December 31, 1998, the amount borrowed under the Bridge Loan was $3,841,712. During 1999, the Company made additional borrowings under the Bridge Loan totaling $4,158,288. Amounts outstanding under the Bridge Loan were originally due on October 31, 1999. In July 1999, the Company exercised its right to exchange the $8,000,000 in outstanding notes payable along with accrued interest for Series N preferred stock (see Note 13). As additional consideration for making the $8,000,000 Bridge Loan and $3,000,000 standby letter of credit, the Company granted warrants to purchase common stock to Winter Harbor. Initially, Winter Harbor received one warrant for every $10 borrowed from Winter Harbor. On April 14, 1999, the shareholders voted to approve a plan of financing which included issuing 10 warrants for each $10 borrowed under the Bridge Loan and standby letter of credit if the Company did not repay the bridge loan on April 26, 1999. As the loan was not repaid by April 26, 1999, the number of warrants increased in total to 10 warrants for every $10 borrowed. The warrants have a 7.5 year exercise period with an exercise price of the lower of (a) $2.78, (b) the average trading price for any 20 day period subsequent to the issuance of the warrants, (c) the price at which new shares of common stock or common stock equivalents are issued, or (d) the exercise price of any new options, warrants, preferred stock or other convertible security. As of December 31, 1999, the exercise price is $2.033 and is subject to a $1.25 floor. The Company has recorded $3,253,196 (of which $2,220,563 was recorded in 1999) as a discount against borrowings on the $8,000,000 Bridge Loan representing the relative fair value attributed to the Bridge Loan warrants. The debt discount was being amortized over the term of the Bridge Loan. As the $8,000,000 loan was exchanged for Series N preferred stock in 1999, the debt discount has been fully amortized. In addition, the Company recorded $735,720 as debt issuance costs related to obligations under certain capital leases guaranteed by the Winter Harbor letter of credit representing the fair value of the warrants associated with the letter of credit warrants. The debt issuance costs are being amortized over the term of the lease agreements. On April 15, 1999, the Company entered into a new financing agreement with Winter Harbor. Winter Harbor agreed to loan to the Company up to $4 million under a note originally due September 30, 1999. In July 1999, the Company exercised its right to exchange the loan for Series N preferred Stock. On June 6, 1997, the Company entered into a term loan agreement and promissory note with Winter Harbor pursuant to which Winter Harbor agreed to loan to the Company the principal sum of $2,000,000 for capital expenditure and working capital purposes. As further consideration for Winter Harbor's commitment to make the loan, the Company granted to Winter Harbor a warrant to purchase up to 500,000 shares of common stock of the Company at a purchase price of $4.97 (subsequently reset to $2.033) per share, subject to adjustment, pursuant to the terms of a warrant agreement between the parties. The loan warrant expires on March 11, 2002, and contains demand and piggyback registration rights and customary anti-dilution terms. In August 1997, the Company amended the existing note allowing for additional borrowings of up to $3,000,000, for an aggregate borrowing of $5,000,000. The incremental borrowings under this amendment had a maturity date of February 15, 1998. The Company issued 300,000 warrants at the then current market price (originally $6.38 per share, but subsequently reset to $2.033) in connection with the additional borrowings. All other provisions of the additional borrowings are the same as the note discussed above. The entire amount of these two loans ($5.0 million) was exchanged for Series M redeemable preferred stock on October 10, 1997 (see Note 13). A portion of the proceeds received was allocated based upon the relative fair value of the warrants issued in connection with these loans and reflected as a debt discount of $2,371,575, which was amortized to expense in 1997. NOTE 8 - LONG-TERM DEBT, CONTINUED DISCONTINUED OPERATIONS The note payable relating to discontinued operations, the carrying value of which approximates market, consists of a note payable to a finance company totaling $241,661 at December 31, 1999 and 1998. The note bears interest at 15% with quarterly principal and interest payments beginning April 1, 2000. The note is collateralized by the accounts receivable and general assets of the discontinued operations. NOTE 9 - COMMITMENTS UNDER LONG-TERM LEASES The Company leases a variety of equipment, fiber optics and facilities used in its operations. The majority of these lease agreements are with three creditors. During 1998, Winter Harbor obtained on behalf of the Company a letter of credit totaling $3,000,000 to guarantee payment on a new lease agreement providing for equipment purchases of up to $3,000,000. As of December 31, 1999 and 1998, the Company had acquired $3,000,000 and $1,144,066 in assets under this lease, respectively. Agreements classified as operating leases have terms ranging from one to six years. The Company's rental expense for operating leases was approximately $3,270,000, $2,900,000 and $2,850,000 for 1999, 1998 and 1997, respectively. Future minimum rental payments required under non-cancelable capital and operating leases with initial or remaining terms in excess of one year consist of the following at December 31, 1999: In January 1999, the Company entered into an agreement with a national carrier to lease local access spans. The three-year agreement includes minimum usage commitments of $1,512,000 during the first year and $2,160,000 in the second and third years. If the Company were to terminate the agreement early, it would be required to pay 25 percent of any remaining second and third year minimum monthly usage requirements. NOTE 10 - ACQUISITION OF SUBSIDIARIES FAMILY TELECOMMUNICATIONS INCORPORATED On January 13, 1997, pursuant to the terms of a Share Exchange Agreement, the Company acquired 100% of the outstanding stock of Family Telecommunications Incorporated (FTI), a Utah corporation, from the stockholders of FTI, namely Robert W. Edwards, Jr. and Jerald L. Nelson. John W. Edwards, a Director and Chief Executive Officer of the Company, and Robert W. Edwards, Jr., the principal shareholder of FTI, are brothers. The consideration ($2,415,000) for the transaction consisted of an aggregate of 400,000 shares of the Company's common stock. NOTE 10 - ACQUISITION OF SUBSIDIARIES, CONTINUED The acquisition has been accounted for using the purchase method of accounting. FTI is a FCC licensed long-distance carrier and provider of telecommunications services. FTI has been renamed "I-Link Communications, Inc." The net purchase price was allocated to the tangible net liabilities of $135,000 (based on their fair market value) with the excess acquisition cost over fair value of assets acquired of $2,550,000 allocated to intangible assets. The intangible assets are being amortized over periods ranging between three and ten years. The fair values of assets acquired and liabilities assumed in conjunction with this acquisition were as follows: MIBRIDGE, INC. In 1997, the Company completed its acquisition of 100% of the outstanding stock of MiBridge, Inc. (MiBridge). The consideration ($8,250,000) for the transaction consisted of: (1) an aggregate of 1,000 shares of Series D preferred stock, which preferred stock is convertible into such a number of common shares as shall equal the sum of $6,250,000 divided by the lower of $9.25 or the average closing bid price of the Company's common stock for the five consecutive trading days immediately preceding the conversion date and (2) a note payable in the amount of $2,000,000 payable in cash in quarterly installments over two years. The acquisition was accounted for using the purchase method of accounting. MiBridge is the owner of patent and patent-pending audio-conferencing technology. The acquisition cost of $8,250,000 (representing the fair value of the common stock into which the 1,000 shares of Series D preferred stock can be converted and the $2,000,000 note payable) was allocated, based on their estimated fair values, to tangible net assets ($552,760) acquired technology ($1,450,000), acquired in-process research and development ($4,235,830), employment contracts for the assembled workforce ($606,000) and excess acquisition cost over fair value of net assets acquired ($1,405,410). These assets are being amortized over three years, with the exception of the excess acquisition cost over fair value of net assets acquired which is being amortized over five years. Acquired in-process research and development was expensed upon acquisition, as the research and development had not reached the requirements for technological feasibility at the closing date. The fair value of assets acquired in conjunction with this acquisition were as follows: NOTE 11 - INCOME TAXES The Company recognized no income tax benefit from its losses in 1999, 1998 and 1997. The reported benefit from income taxes varies from the amount that would be provided by applying the statutory U.S. Federal income tax rate to the loss from continuing operations before taxes for the following reasons: At December 31, 1999, the Company had net operating loss carryforwards for both federal and state income tax purposes of approximately $58,600,000. The net operating loss carryforwards will expire between 2006 and 2020 if not used to reduce future taxable income. The components of the deferred tax asset and liability as of December 31, 1999 and 1998 are as follows: The valuation allowance at December 31, 1999 and 1998 has been provided to reduce the total deferred tax assets to the amount which is considered more likely than not to be realized, primarily because the Company has not generated taxable income from its business communications services. The change in the valuation allowance is due primarily to the increase in net operating loss carryforwards. It is at least reasonably possible that a change in the valuation allowance may occur in the near term. NOTE 12 - LEGAL PROCEEDINGS On February 25, 2000, JNC Opportunity Fund, Ltd. ("JNC"), the sole holder of the Company's Series F preferred shares, filed suit against the Company in U.S. District Court in New York seeking to require the Company to redeem for cash its remaining Series F preferred shares. The controversy arose as a result of the failure of the Company's shareholders at a special shareholders' meeting held February 11, 2000, to approve the further conversion of Series F preferred shares at a conversion price below the market price for the Company's common shares as calculated on the original date of issuance of the Series F preferred shares ("below-market conversions"). The terms of the Series F preferred shares require shareholder approval for below-market conversions where any such further conversions would cause the aggregate number of common shares obtained upon below-market conversions of the Series F preferred shares to attain or exceed 20% of the total number of common shares outstanding on the original date of issuance of the Series F Preferred shares. At the February 11, 2000 Special Shareholders' Meeting, approximately 64% of the total votes cast were voted by Winter Harbor, LLC, the Company's largest equity holder, who voted against such approval. On March 10, 2000 the Company and JNC entered into a settlement and release agreement. Pursuant the settlement, the Company agreed to issue 531,968 shares of the company's common stock immediately, representing conversion of all remaining Series F shares outstanding at a conversion price equal to the market price of the Company's common shares on the original date of issuance of the Series F preferred shares. These settlement shares are subject to certain provisions restricting the amount that can be sold by JNC on any given trading day, and prohibiting any short sales of the Company's stock either directly or indirectly by JNC. In full settlement of all other claims for cash redemption of the Series F preferred shares, the Company also agreed to issue an additional 790,000 registered shares (increasing at 8.25 percent from February 1, 2000 until issued) (the "Additional Shares") of the Company's common stock (subject to the same sale restrictions) upon shareholder approval. As part of the settlement agreement, Winter Harbor, LLC agreed to vote all of its shares in favor of such approval. The Company will proceed immediately to hold a special shareholders meeting to request approval of the issuance of the additional 790,000 common shares. In addition to the "Additional Shares", the Company would be subject to other penalties to be paid in common shares (the "Late Shares") in the event the common shares are not issued by May 24, 2000. Further, if the Company fails to deliver any of the above shares by May 24, 2000, the Company must issue additional Late Shares ("Additional Late Shares") equal to the number of the Late Shares times a fraction the numerator of which equals the number of days from May 24, 2000 to the actual date of issuance of such undelivered shares and the denominator of which is 30. In the event that the common shares are not issued by May 23, 2000 (or June 28, 2000 in the event the Company has received a registration comment letter related to the registration of such shares prior to May 24, 2000), upon written notice from JNC, the Company would be required to pay JNC (in lieu of delivering the shares) the amount determined by multiplying the higher of the average closing share price of the common stock for the ten trading day period ending on the deadline (May 24 or June 28, 2000 as applicable) or the notice date by the number of undelivered shares. The Company is also involved in litigation relating to claims arising out of its operations in the normal course of business, none of which is expected, individually or in the aggregate, to have a material adverse affect on the Company. NOTE 13 - STOCKHOLDERS' EQUITY PREFERRED STOCK The Company's Articles of Incorporation provide for up to 240,000 shares of preferred stock as Series C Convertible Cumulative preferred stock (the "Series C preferred stock"). The Series C preferred stock has a par value of $10 per share and holders are entitled to receive cumulative preferential dividends equal to 8% per annum of the liquidation preference per share of $60.00. Unless previously redeemed, the Series C preferred stock is convertible into 24 shares of the Company's common stock ("Conversion Shares") at the option of the holder (subject to certain anti-dilution adjustments). The Series C preferred stock is redeemable at any time prior to September 6, 2000, at the option of the Company at a redemption price equal to $60 per share plus accrued and unpaid dividends, provided (i) the Conversion Shares are covered by an effective registration statement; and (ii) during the immediately preceding thirty (30) consecutive trading days ending within fifteen (15) days of the date of the notice of redemption, the closing bid price of the Company's common stock is not less than $8.00 per share. The Series C preferred stock is redeemable at any time after September 6, 2000, at the option of the Company at a NOTE 13 - STOCKHOLDERS' EQUITY, CONTINUED redemption price equal to $90 plus accrued and unpaid dividends, provided the Conversion Shares are covered by an effective registration statement or the Conversion Shares are otherwise exempt from registration. During the years ending December 31, 1999 and 1998, 10,374 and 70,908 shares, respectively, of Series C preferred stock were converted into common shares. At December 31, 1999 and 1998, 33,677 and 44,051 Series C preferred shares were outstanding. In August 1997, the Company completed its acquisition of MiBridge. As partial consideration for 100 percent of the outstanding stock of MiBridge, the Company agreed to issue 1,000 shares of Series D preferred stock to the prior owners of MiBridge. The Series D preferred shares were issued in October 1997. During the years ending December 31, 1998 and 1997, 567 and 433 shares, respectively, of Series D preferred stock were converted into a total of 1,092,174 shares of common stock and as of December 31, 1999 and 1998 there were no Series D preferred shares outstanding. On October 10, 1997, the Company closed an agreement with Winter Harbor pursuant to which Winter Harbor invested $12,100,000 in a new series of the Company's convertible preferred stock. Winter Harbor purchased approximately 2,545 shares of Series M redeemable Preferred Stock, originally convertible into approximately 2,545,000 shares of common stock, for an aggregate cash consideration of approximately $7,000,000 (equivalent to $2.75 per share of common stock). The agreement with Winter Harbor also provided for the purchase of approximately 1,855 additional shares of Series M redeemable preferred stock, originally convertible into approximately 1,855,000 shares of common stock. Such additional shares of Series M redeemable preferred stock were paid for by Winter Harbor exchanging $5,000,000 in outstanding notes payable and accrued interest of approximately $100,000. As additional consideration for its equity investment in Series M redeemable preferred stock, Winter Harbor was issued additional warrants by the Company to acquire 10,000,000 shares of common stock. The exercise price on each of the warrants has subsequently been reset to $2.033 (see Note 3). All of the warrants have demand registration rights and anti-dilution rights and contain cashless exercise provisions. The Series M redeemable preferred stock is entitled to receive cumulative dividends in the amount of 10% per annum before any other Series of preferred (other than Series F) or common stock receives any dividends. Thereafter, the Series M redeemable preferred stock participates with the common stock in the issuance of any dividends on a per share basis. The Series M redeemable preferred stock will have the right to veto the payment of dividends on any other class of stock. The Series M redeemable preferred stock is convertible at any time prior to the fifth anniversary of its issuance, at the sole option of Winter Harbor, and automatically converts at that date if not converted previously. If automatically converted on the fifth anniversary, the conversion price will be the lower of the reset conversion price of $2.033 per share or 50% of the average closing bid price of the common stock for the ten trading days immediately preceding the conversion date. The basis for discretionary conversion, or the conversion price for automatic conversion, shall be adjusted upon the occurrence of certain events, including without limitation, issuance of stock dividends, recapitalization of the Company or the issuance of stock by the Company at less than the fair market value thereof. During December 31, 1999, the conversion price of the Series M redeemable preferred stock was reduced to $2.033 as a result of shares of Series F preferred shares being converted at that price. The Series M redeemable preferred stock will vote with the common stock on an as-converted basis on all matters which are submitted to a vote of the stockholders, except as may otherwise be provided by law or by the Company's Articles of Incorporation or By-Laws; provided, however, that the Series M redeemable preferred stockholders will have the right to appoint two members of the Company's board of directors. Furthermore, the Series M redeemable preferred stockholders shall have the right to be redeemed at fair market value in the event of a change of control of the Company, shall have preemptive rights to purchase securities sold by the Company, and shall have the right to preclude the Company from engaging in a variety of business matters without the concurrence of Winter Harbor, including without limitation: mergers, acquisitions and disposition of corporate assets and businesses, hiring or discharging key employees and auditors, transactions with affiliates, commitments in excess of $500,000, the adoption or settlement of employee benefit plans and filing for protection from creditors. As of December 31, 1999, all 4,400 shares of the Company's Series M redeemable preferred stock remain issued and outstanding. Because the above redemption provisions are not entirely within the control of the Company, the Series M redeemable preferred stock is presented as a separate line item above stockholders' deficit. NOTE 13 - STOCKHOLDERS' EQUITY, CONTINUED On July 9, 1998 the Company obtained a $10 million equity investment, net of $530,000 in closing costs, from JNC Opportunity Fund Ltd. ("JNC"). Under the original terms of the equity investment, JNC purchased 1,000 shares of the Company's newly created 5% Series E convertible preferred stock, which were convertible into the Company's common shares at a conversion price of the lesser of 110% of the market price of the Company's publicly traded common shares as of the date of closing, and 90% of a moving average market price at the time of conversion. In addition, JNC obtained a warrant to purchase 250,000 shares of the Company's common stock at an exercise price of $5.873 (equal to 120% of the market price of the Company's publicly traded common shares as of the date of closing). On July 28, 1998, the terms of the JNC equity investment were amended to provide a floor to the conversion price, and to effect the amendment the Company created a 5% Series F convertible preferred stock for which the Series E preferred shares originally issued to JNC were exchanged one for one. Pursuant to the amendment, the Series F preferred shares were originally convertible into common shares at a conversion price of the lesser of $4.00 per common share or 87% of the moving average market price of the Company's common shares at the time of conversion, subject to a $2.50 floor. The Series F preferred shares provide for adjustments in the initial conversion price and as of December 31, 1998 the conversion price had been adjusted to the lesser of $3.76 or 81% of a moving average market price of the Company's common shares at the time of conversion. In the event the market price remains below $2.50 for five consecutive trading days, the floor will be re-set to the lower rate, provided, however, that the floor shall not be less than $1.25. As of December 31, 1999, the floor had been reset to $2.033. JNC also received an additional warrant to purchase 100,000 shares of the Company's common stock at an exercise price of $4.00 per common share. The Series F preferred shares were convertable at any time, or would be automatically converted at the end of three years, and were subject to specific provisions that would prevent any issuance of I-Link common stock at a discount if and to the extent that such shares would equal or exceed in the aggregate 20 percent of the number of common shares outstanding on July 9, 1998, absent shareholder approval as contemplated by the Nasdaq Stock Market Non-Quantitative Designation Criteria. JNC may not convert shares of Series F redeemable preferred stock (or receive related dividends in common stock) to the extent that the number of shares of common stock beneficially owned by it and its affiliates after such conversion or dividend payment would exceed 4.999% of the issued and outstanding shares following such conversion. This limitation applies to the number of shares of common stock held at any one time and does not prevent JNC from converting some of its shares of Series F redeemable preferred stock, selling the common stock received, then, subject to the aforementioned limitation, converting additional shares of Series F redeemable preferred stock. The 4.999% limitation may be waived by JNC upon 75 days notice to the Company. See "Note 12 - Legal Proceeding" for additional information relating to the Series F preferred stock and settlement with JNC. In certain instances, including a change in control of the Company in excess of 33% and if the Company's common stock is not listed on NASDAQ or a subsequent market or is suspended for more than three non-consecutive trading days, the holders of the Series F preferred stock may require that the Company redeem their Series F preferred stock. Because these redemption provisions are not entirely within the control of the Company, the Series F preferred stock is presented as a separate line item above stockholders' deficit as of December 31, 1999. In addition, the Company issued warrants to purchase 75,000 shares of the Company's common stock at a price of $4.89 per share to two individuals as a brokerage fee in connection with the JNC equity investment. During 1999 and 1998, JNC converted 750 and two shares of Series F redeemable preferred stock into 3,518,051 and 10,004 shares of common stock, respectively. In addition, during 1999 and 1998, JNC was paid a stock dividend of 165,220 and 240 shares of common stock on the converted shares. As of December 31, 1999, 248 shares of Series F redeemable preferred stock remain issued and outstanding. On July 23, 1999, the Company completed its offering of 20,000 shares of Series N preferred stock. The offering was fully subscribed through cash subscriptions and the Company exercising its rights to exchange notes payable to Winter Harbor of $8.0 million and $4.0 million, plus accrued interest. In total the Company received $7,281,086 in cash (before expenses of $486,679) and exchanged $12,718,914 in debt and accrued interest. The Series N conversion price was initially set at $2.78, but may be adjusted to the lowest of: (1) 110% of the average trading price for any 20 day period following the date that Series N preferred stock is first issued; (2) the price at which any new common stock or common stock equivalent is issued; NOTE 13 - STOCKHOLDERS' EQUITY, CONTINUED (3) the price at which common stock is issued upon the exercise or conversion of any new options, warrants, preferred stock or other convertible security; (4) the conversion price of the Series F preferred; and (5) a conversion price floor of $1.25. The Series N preferred stock votes with the common stock on an as converted basis and is senior to all other preferred stock of the Company, except that the Series N preferred stock will in all rights be equal in seniority to the already outstanding Series F preferred stock. Dividends will be paid on an as converted basis equal to common stock dividends. During 1999, holders of the Series N preferred stock converted 3,685 of those shares into 1,413,369 shares of common stock at conversion prices ranging between $2.78 and $2.033. As the conversion price of the Series N preferred stock at issuance was less than the market price, the Company recognized a $6,978,417 deemed preferred stock dividend in the third quarter of 1999. On April 14, 1999, the shareholders approved an amendment to the Articles of Incorporation increasing the authorized common stock from 75,000,000 shares to 150,000,000 shares. At December 31, 1999, 9,486,500 of the 10,000,000 shares of preferred stock authorized remain undesignated and unissued. Dividends in arrears at December 31, 1999 were $543,408, $179,456 and $2,973,877 for Series C, F and M preferred stock, respectively. NOTE 14 - STOCK-BASED COMPENSATION PLANS At December 31, 1999, the Company has several stock-based compensation plans, which are described below. The Company applies APB Opinion No. 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed option plans. On December 13, 1998, the Board of Directors approved a repricing of all options to purchase common stock with exercise prices above $3.90 held by current employees, directors and consultants of the Company. As a result, the exercise price on options to purchase 6,475,000 shares of Common Stock were reduced to $3.90. The options had original exercise prices of between $4.375 and $9.938. All other terms of the various option agreements remained the same. The closing price of the Company's common stock on December 13, 1998 was $2.56. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under the plans and based on the incremental fair value associated with the repricing of options consistent with the method outlined by SFAS 123, "Accounting for Stock-Based Compensation", the Company's net loss and loss per share would have been increased to the pro forma amounts indicated as follows: The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions: expected volatility of 97%, 103% and 100% in 1999, 1998, and 1997, respectively, risk free rates ranging from 4.35% to 6.08%, 4.26% to 5.67% and 6.02% to 6.88% in 1999, 1998, and 1997, respectively, expected lives of 3 years for each year, and dividend yield of zero for each year. NOTE 14 - STOCK-BASED COMPENSATION PLANS, CONTINUED The following table summarizes information about fixed stock options and warrants outstanding at December 31, 1999. 1997 RECRUITMENT STOCK OPTION PLAN In October 1997, the shareholders of the Company approved the adoption of the 1997 Recruitment Stock Option Plan which provides for the issuance of incentive stock options, non-qualified stock options and stock appreciation rights (SARs) up to an aggregate of 4,400,000 shares of common stock (subject to adjustment in the event of stock dividends, stock splits, and other similar events). The price at which shares of common stock covered by the option can be purchased is determined by the Company's Board of Directors; however, in all instances the exercise price is never less than the fair market value of the Company's common stock on the date the option is granted. As of December 31, 1999, there were incentive stock options to purchase 1,602,709 shares of the Company's common stock and non-qualified stock options to purchase 1,314,167 shares of the Company's common stock outstanding. The outstanding options vest over three years at exercise prices of $2.125 to $4.91 per share. Options issued under the plan must be exercised within ten years of grant and can only be exercised while the option holder is an employee of the Company. The Company has not awarded any SARs under the plan. During 1999 and 1998, options to purchase 126,042 and 228,500 shares of common stock, respectively, were forfeited or expired. DIRECTOR STOCK OPTION PLAN The Company's Director Stock Option Plan authorizes the grant of stock options to directors of the Company. Options granted under the Plan are non-qualified stock options exercisable at a price equal to the fair market value per share of common stock on the date of any such grant. Options granted under the Plan are exercisable not less than six months or more than ten years after the date of grant. NOTE 14 - STOCK-BASED COMPENSATION PLANS, CONTINUED As of December 31, 1999, options for the purchase of 8,169 shares of common stock at prices ranging from $0.875 to $3.875 per share were outstanding, all of which are exercisable. In connection with the adoption of the 1995 Director Plan, the Board of Directors authorized the termination of future grants of options under the plan; however, outstanding options granted under the plan will continue to be governed by the terms thereof until exercise or expiration of such options. 1995 DIRECTOR STOCK OPTION AND APPRECIATION RIGHTS PLAN The 1995 Director Stock Option and Appreciation Rights Plan (the "1995 Director Plan") provides for the issuance of incentive options, non-qualified options and stock appreciation rights to directors of the Company. The 1995 Director Plan provides for the grant of incentive options, non-qualified options, and SARs to purchase up to 250,000 shares of common stock (subject to adjustment in the event of stock dividends, stock splits, and other similar events). The 1995 Director Plan also provides for the grant of non-qualified options on a discretionary basis to each member of the Board of Directors then serving to purchase 10,000 shares of common stock at an exercise price equal to the fair market value per share of the common stock on that date. The number of shares granted to each Board member was increased to 20,000 in 1998. In addition, the Board member will receive 5,000 options for each committee membership. Each option is immediately exercisable for a period of ten years from the date of grant. The Company has 190,000 shares of common stock reserved for issuance under the 1995 Director Plan. The Company granted 105,000 options to purchase common shares under this plan in 1997. As of December 31, 1999, options to purchase 170,000 shares of common stock at prices ranging from $1.00 to $1.25 per share are outstanding and exercisable. There were 20,000 options exercised under this plan during 1997 and 40,000 options exercised during 1996. No options were granted or exercised under this plan in 1998 or 1999. 1995 EMPLOYEE STOCK OPTION AND APPRECIATION RIGHTS PLAN The 1995 Employee Stock Option and Appreciation Rights Plan (the "1995 Employee Plan") provides for the issuance of incentive options, non-qualified options, and SARs. Directors of the Company are not eligible to participate in the 1995 Employee Plan. The 1995 Employee Plan provides for the grant of stock options which qualify as incentive stock options under Section 422 of the Internal Revenue Code, to be issued to officers who are employees and other employees, as well as non-qualified options to be issued to officers, employees and consultants. In addition, SARs may be granted in conjunction with the grant of incentive options and non-qualified options. The 1995 Employee Plan provides for the grant of incentive options, non-qualified options and SARs of up to 400,000 shares of common stock (subject to adjustment in the event of stock dividends, stock splits, and other similar events). To the extent that an incentive option or non-qualified option is not exercised within the period of exercisability specified therein, it will expire as to the then unexercisable portion. If any incentive option, non-qualified option or SAR terminates prior to exercise thereof and during the duration of the 1995 Employee Plan, the shares of common stock as to which such option or right was not exercised will become available under the 1995 Employee Plan for the grant of additional options or rights to any eligible employee. The shares of common stock subject to the 1995 Employee Plan may be made available from either authorized but unissued shares, treasury shares or both. The Company has 400,000 shares of common stock reserved for issuance under the 1995 Employee Plan. As of December 31, 1999, options to purchase 280,333 shares of common stock with exercise prices ranging from $1.125 to $3.90 are outstanding under the 1995 Employee Plan. During 1999 and 1998, options to purchase 45,834 and 23,833 shares of common stock were forfeited or expired and during 1997, options to purchase 25,000 shares of common stock were exercised. OTHER WARRANTS AND OPTIONS Pursuant to the terms of a Financial Consulting Agreement dated as of November 3, 1994 between the Company and JW Charles Financial Services, Inc., the Company issued a common stock purchase warrant (the "JWC Warrant") covering 250,000 (331,126 as adjusted) shares of common stock to JW Charles Financial Services as partial consideration for its rendering financial consulting services to the Company. The warrant is exercisable at a price of $1.51 per share and expires on November 3, 2001. During 1998, warrants to purchase 165,563 shares of common stock were exercised. NOTE 14 - STOCK-BASED COMPENSATION PLANS, CONTINUED In April 1996, the Company approved the issuance of 1,000,000 options to John Edwards at an option price of $7.00 per share (repriced to $3.90 on December 13, 1998) as part of his employment agreement. The options vest over a three-year period and expire in 2006. On July 1, 1996, the Company approved the issuance of options to purchase 1,500,000 and 500,000 shares of common stock to Clay Wilkes and Alex Radulovic respectively as part of their employment agreements. Each option has an exercise price of $7.00 per share, vesting in 25% increments in the event that the average closing bid price of a share of the Company's common stock for five consecutive trading days exceeds $10, $15, $20 and $25, respectively. Each option becomes exercisable (to the extent vested) on June 30, 1997, vests in its entirety on June 30, 2001 and lapses on June 30, 2002. As of December 31, 1999, 500,000 of the options had vested. In August 1996, Commonwealth Associates, the Placement Agent for the Company's offering of Series C preferred stock and 8% Convertible Notes, designated Joseph Cohen as its nominee for election to the Board of Directors. The Company issued options to purchase 64,000 shares of common stock to Mr. Cohen, exercisable at the fair market value of the common stock on September 30, 1996 of $5.25 (repriced to $3.90 on December 31, 1998). All options were vested and exercisable as of December 31, 1999 and expire in September 2006. In September 1996, the Company closed a private placement offering of Series C preferred stock. As a result of this transaction, the Company issued warrants to purchase 750,000 shares of common stock at an exercise price of $2.50 per share as compensation to the Placement Agent. These warrants expire on August 20, 2001. During 1999, 1998 and 1997, warrants to purchase 73,050, 46,477 and 34,923 shares of common stock were exercised, respectively. John Edwards agreed to amend his employment contract on August 21, 1996, which reduced his salary. In consideration of the salary reduction, the Company granted him options, which vested immediately, to purchase 250,000 shares of common stock. The options have a term of 10 years and an exercise price of $4.875 per share (repriced to $3.90 on December 13, 1998) which was based on the closing price of the stock at grant date. In October 1996 the Company agreed to issue options to purchase 250,000 shares of common stock each to William Flury and Karl Ryser Jr. pursuant to their employment agreements. The options were issued at $4.41 (repriced to $3.90 on December 13, 1998) based on the closing price of the stock at grant date. The options vest quarterly over a three-year period and expire in 2006. As of December 31, 1999, 41,670 options had been forfeited. During 1996, the Company issued 120,000 warrants to non-employees at $4.00 per share. The warrants expired in 1999. During 1997, the Company issued options to purchase 1,210,000 share of common stock (210,000 of which were issued under the 1997 recruitment stock option plan) to consultants at exercise prices ranging from $4.875 to $8.438 (repriced to $3.90 on December 13, 1998), which was based on the closing price of the stock at the grant date. The fair value of the options issued was recorded as deferred compensation of $4,757,134 to be amortized over the expected period the services were to be provided. As a result of the repricing, the Company recorded additional deferred compensation expense totaling $262,200 (of which $44,364 and $196,733 was expensed in 1999 and 1998, respectively), representing the incremental fair value of the repriced options over the original options. During 1999, 1998 and 1997, $852,714, $1,157,901 and $2,467,369, respectively, of the deferred compensation was amortized to expense. During 1999 and 1998, options to purchase 16,669 and 60,000, respectively, shares of common stock expired. The remaining options must be exercised within ten years of the grant date. During 1997, the Company issued non-qualified options to purchase 2,295,000 shares of common stock to certain executive employees at exercise prices ranging from $4.875 to $5.188 (repriced to $3.90 on December 13, 1998), which was based on the closing price of the stock at the grant date. The options must be exercised within ten years of the grant date. During 1999, options to purchase 66,670 shares of common stock were forfeited. During 1998, the Company issued non-qualified options to purchase 935,000 shares of common stock to certain executive employees at exercise prices ranging from $2.563 to $3.125, which price was based on the closing price of the stock at the grant date. The options must be exercised within ten years of the grant date. During 1999, options to purchase 58,333 shares of common stock were forfeited. NOTE 14 - STOCK-BASED COMPENSATION PLANS, CONTINUED During 1999, the Company issued non-qualified options to purchase 655,000 shares of common stock to certain executive employees at exercise prices ranging from $2.50 to $3.563, which price was based on the closing price of the stock at the grant date. The options must be exercised within ten years of the grant date. During 1999, the Company issued options to purchase 200,000 share of common stock to consultants at an exercise price ranging from $3.00 which was based on the closing price of the stock at the grant date. The fair value of the options issued was recorded as deferred compensation of $300,000 to be amortized over the expected period the services were to be provided. During 1999 $162,500 of the deferred compensation was amortized to expense. NOTE 15 - SEGMENT OF BUSINESS REPORTING In 1998, the Company adopted SFAS 131. The prior year's segment information has been restated to present the Company's three reportable segments as follows: - - Telecommunications services - includes long-distance toll services and enhanced calling features such as V-Link. The telecommunications services products are marketed primarily to residential and small business customers. - - Marketing services - includes training and promotional materials to independent sales representatives (IRs) in the network marketing sales channel and WebCentre set-up and monthly recurring fees. Additionally, revenues are generated from registration fees paid by IRs to attend regional and national sales conferences (see Note 17). - - Technology licensing and development - provides research and development to enhance the Company's product and technology offerings. Products developed by this segment include V-Link, C4, and other proprietary technology. The Company licenses certain developed technology to third party users, such as Lucent, Brooktrout and others. There are no intersegment revenues. The Company's business is conducted principally in the U.S.; foreign operations are not material. The table below presents information about net loss and segment assets used by the Company as of and for the year ended December 31: NOTE 15 - SEGMENT OF BUSINESS REPORTING, CONTINUED NOTE 15 - SEGMENT OF BUSINESS REPORTING, CONTINUED The following table reconciles reportable segment information to the consolidated financial statements of the Company: NOTE 16 - COMMITMENTS EMPLOYMENT AND CONSULTING AGREEMENTS The Company has entered into employment and consulting agreements with a consultant and eight employees, primarily executive officers and management personnel. These agreements generally continue over the entire term unless terminated by the employee or consultant of the Company, and provide for salary continuation for a specified number of months. Certain of the agreements provide additional rights, including the vesting of unvested stock options in the event a change of control of the Company occurs or termination of the contract without cause. The agreements contain non-competition and confidentiality provisions. As of December 31, 1999, if the contracts were to be terminated by the Company, the Company's liability for salary continuation would be approximately $1,450,000. PURCHASE COMMITMENTS The Company has commitments to purchase long-distance telecommunications capacity on lines from a national provider in order to provide long-distance telecommunications services to the Company's customers who reside in areas not yet serviced by the Company's dedicated telecommunications network. The Company's minimum monthly commitment is approximately $550,000. The agreement is effective through May 2000. Failure to achieve the minimum will require shortfall payments by the Company equal to 50% of the remaining monthly minimum usage amounts. In January 1999, the Company entered into an agreement with a national carrier to lease local access spans. The three-year agreement includes minimum usage commitments of $1,512,000 during the first year and $2,160,000 in the second and third years. If the Company were to terminate the agreement early, it would be required to pay 25 percent of any remaining second and third year minimum monthly usage requirements. In December 1999, the Company entered into an agreement with a national carrier to provide long-distance capacity in order to provide long-distance telecommunications services to the Company's customers who reside in areas not yet serviced by the Company's dedicated telecommunications network. The eighteen-month agreement includes minimum monthly usage commitments of $250,000 beginning in the sixth month of the agreement. Either party may terminate the agreement with 90 days notice. NOTE 17 - SUBSEQUENT EVENTS LINE OF CREDIT WITH WINTER HARBOR On April 13, 2000, Winter Harbor, LLC, agreed to provide I-Link with a line of credit of up to an aggregate amount of $15,000,000. This commitment expires on the earlier of April 12, 2001 or the date I-Link has received net cash proceeds of not less than $15,000,000 pursuant to one or more additional financings or technology sales, as well as licensing or consulting agreements outside the normal and historical course of business. The $15,000,000 aggregate commitment will be reduced by the $1,300,000 (plus accrued interest at 8% per annum) advanced to I-Link in the first quarter of 2000 by Winter Harbor, interest accruing on any other advances under such commitment, as well as any net cash proceeds received by I-Link in the future from additional financings or technology sales as well as licensing or consulting agreements outside the normal and historical course of business. Any amounts outstanding under the loan will be due and payable no later than April 12, 2001. As part of this agreement, I-Link has agreed to use its best effort to consummate as soon as possible one or more additional financings, technology sales or licensing or consulting agreements and to repay amounts outstanding under the loan with any net cash proceeds received by it from any such transaction. The loan from Winter Harbor will bear interest at 12.5% per annum, be secured by substantially all of the assets of I-Link and may be converted into common stock of I-Link, at the option of Winter Harbor, at a fixed conversion price of $8.625 per share. If I-Link has not terminated the commitment and repaid all amounts outstanding thereunder by May 15, 2000, it will issue to Winter Harbor up to 750,000 warrants to purchase I-Link common stock, with the actual number of warrants issued to be equal to the product of 750,000 times a fraction, the numerator of which equals the sum of the outstanding commitment and unpaid balance under the loan on such date and the denominator of which is 15,000,000. The warrants will be exercisable at a fixed strike price of $8.625 per share and expire in five years NOTE 17 -SUBSEQUENT EVENTS, CONTINUED STRATEGIC MARKETING AND CHANNEL AGREEMENT WITH BIG PLANET On February 15, 2000 the Company signed a strategic marketing and channel agreement with Big Planet, a wholly owned subsidiary of Nu Skin Enterprises, Inc. Under terms of the agreement, I-Link's independent network marketing sales force (the IR's) transitioned to Big Planet, and Big Planet was granted the exclusive worldwide rights to market and sell I-Link's products and services through the Network Marketing (sometimes referred to as "Multi-Level") sales channel to residential and small business users. Other I-Link sales channels into the residential, small business, and other markets are unaffected by the agreement with Big Planet. The impact on the results of operations will be a termination of marketing service revenues and marketing service costs effective February 15, 2000. Additionally, telecommunication service revenues will initially decrease as the Company sells its services to the same subscribers but through Big Planet at wholesale prices which will initially reduce telecommunication services revenues by approximately 40%. The reduction in telecommunications service revenues will also be partially offset by a reduction in commissions paid to IRs related to telecommunication services revenues, which accounted for approximately 13% of telecommunication network expense in 1999. However the Company believes the revenue reduction will be temporary and believes that this affliiation with Big Planet will have a positive strategic and overall long-term financial impact to the Company by increasing revenues, reducing expenses and increasing profit margins through new customer subscriptions to current and future I-link products and decreasing channel management expenses in the short and long term. The Company anticipates the future increase in revenues to be related to leveraging the larger consolidated sales force of IRs in Big Planet. However, there can be no assurance that this agreement will result in increased sales, decreased costs or increased profitability of the Company. WHOLESALE SERVICE PROVIDER AND DISTRIBUTION AGREEMENT On February 15, 2000 the Company entered into a wholesale service provider and distribution agreement with Big Planet, a wholly owned subsidiary of NuSkin Enterprises, Inc. Under the terms of the agreement, Big Planet will integrate the Company's independent network marketing representatives into the Big Planet sales force. In addition, Big Planet will acquire and provide the Company's products and services directly to I-Link's existing customers which were acquired through the I-Link network marketing channel. Big Planet will pay the Company a wholesale fee for products and services used by its customers. As a result, the Company anticipates that initially, its revenues from telecommunications revenue will decrease as a result from this change from retail to wholesale billing. Other existing I-Link customers will be retained and serviced by the Company. There will also be a decrease in costs associated with the customers transitioned to Big Planet as the Company will no longer have to pay commissions to IR's on the sale of telecommunications products and will be reimbursed by Big Planet for certain costs associated with servicing those customers. Also, after February 15, 2000 the Company will no longer receive revenues from the sale of network marketing products such as WebCentre and IR kits and will no longer incur the costs associated with maintaining that marketing channel. The Company believes this agreement with Big Planet will have a positive strategic and financial impact to the Company by increasing future revenues, reducing channel management and operating expenses and increasing profit margins through new customer subscriptions generated from the I-Link Worldwide LLC and Big Planet combined sales force. LEASE FACILITY In March 2000, the Company entered into a new lease facility with Cisco Systems Capital providing for equipment purchases of up to $5,000,000. The equipment will be used in expanding the Company's IP network. The lease agreement requires monthly payments over the three-year term. OTHER ITEMS During January and February 2000, the Company issued approximately 4,670,000 options to purchase the Company's common stock at exercise prices based on the closing price of the stock at the grant date. Of the options granted, 2,550,000 were to executives of the Company and as such 2,050,000 are subject to shareholder approval at the next annual meeting. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors and Stockholders of I-Link Incorporated and Subsidiaries: In our opinion, the accompanying financial statement schedule is fairly stated in all material respects in relation to the basic financial statements, taken as a whole, of I-Link Incorporated and subsidiaries for the years ended December 31, 1999, 1998 and 1997, which are covered by our report dated April 13, 2000. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. This information is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements. PricewaterhouseCoopers LLP Salt Lake City, Utah April 13, 2000 S-1 I-LINK INCORPORATED AND SUBSIDIARIES SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS - ---------------------- (a) For the allowance for doubtful accounts represents amounts written off as uncollectible and recoveries of previously reserved amounts. S-2

722573_1999.txt

722573_1999

1999

722573

Item 1. Business General Maxicare Health Plans, Inc., a Delaware corporation ("MHP"), is a holding company which owns various operating subsidiaries, primarily in the field of managed health care. MHP and its subsidiaries (the "Company") operate health plans in California, Indiana and Louisiana and have a combined enrollment of approximately 466,600 as of December 31, 1999. In addition to the HMO subsidiaries, MHP owns and operates Maxicare Life and Health Insurance Company ("MLH") and HealthAmerica Corporation. Through these subsidiaries, the Company offers an array of employee benefit packages, including group HMO, Medicaid and Medicare HMO, preferred provider organization ("PPO"), point of service ("POS"), group life and accidental death and dismemberment insurance, administrative services only programs, wellness programs and other services and products. Through its HMO operations the Company arranges for the delivery of comprehensive health care services to its members for a predetermined, prepaid fee. The Company generally provides these services by contracting on a prospective basis with physician groups for a fixed fee per member per month regardless of the extent and nature of services provided to members, and with hospitals and other providers under a variety of fee arrangements. The Company believes that an HMO offers certain advantages over traditional indemnity health insurance: To the member, an HMO offers comprehensive and coordinated health care programs, including preventive services, with predictable out-of-pocket expense and generally without requiring claims forms. To the employer, an HMO offers an opportunity to improve the breadth and quality of health benefit programs available to employees and their families without a significant increase in cost or administrative burdens. To health care providers, such as physician groups and hospitals, an HMO provides a more predictable revenue source. The Company's executive offices are located at 1149 South Broadway Street, Los Angeles, California 90015, and its telephone number is (213) 765-2000. Company Operations In December 1997, the Company began a restructuring of the Company's operations and businesses with a view towards enhancing and focusing on the Company's operations in California and Indiana which have generated substantially all of the membership growth in recent years. As a result of assessing various strategic alternatives, the Company concluded that the divestiture of the Company's operations in Wisconsin, Illinois and the Carolinas through either a sale or closure of these operations was in its best interest as the Company was unable to predict a return to profitability for these health plans in a reasonable time frame. On September 30, 1998, the Company completed the sale of its Wisconsin health plan which had approximately 4,700 commercial members and approximately 10,200 Medicaid members. On October 16, 1998, the Company completed the sale of its Illinois health plan which had approximately 22,600 commercial members. In addition, on September 30, 1998, the Company announced it would cease providing health care coverage in North and South Carolina beyond March 1999 for all commercial health care lines of business, including its commercial health maintenance organization, preferred provider organization and point of service product lines. The Company's membership for its operations in California, Indiana and Louisiana has decreased from approximately 489,100 members at December 31, 1998 to approximately 466,600 members at December 31, 1999. This decrease of 22,500 members is primarily a result of 1) a decrease in Medicaid membership of 24,600 due to the Company not participating in the Medicaid program in the central region of Indiana and in the San Bernardino and Riverside Counties of California as of December 31, 1999 compared to the prior period, 2) a decrease in commercial membership of 3,900 members related to pricing discipline, offset in part by 3) a 6,000 member increase in Medicare membership. The Company's total membership for its continuing operations follows: Overview of Managed Health Care Services Commercial HMO. The Company owns and operates HMOs. An HMO is an organization that arranges for health care services to its members. For these services, the members' employers pay a predetermined premium fee that does not vary with the nature or extent of health care services provided to the member, and the member may pay a relatively small copayment for certain services. The fixed payment distinguishes HMOs from conventional indemnity health insurance plans that contain customary coinsurance and deductible features and also require the submission of claim forms. An HMO receives a fixed amount from its contracted employer groups for its members regardless of the nature and extent of health care services provided, and as a result, has an incentive to keep its members healthy and to manage its costs through measures such as the monitoring of hospital admissions and the review of specialist referrals by primary care physicians. The HMO's goal is to combine the delivery of and access to quality health care services with effective management controls in order to make the most cost-effective use of health care resources. Although HMOs have been operating in the United States for over half of a century, their popularity began increasing in the 1970s in response to rapidly escalating health care costs and enactment of the Federal Health Maintenance Organization Act of 1973, a federal statute designed to promote the establishment and growth of HMOs (see "Item 1. Business - Government Regulation"). The four basic organizational models utilized by HMOs are the staff, group, independent practice association and network models. The distinguishing feature between models is the HMO's relationship with its physicians. In the staff model, the HMO employs the physicians directly at an HMO facility and compensates the physicians by salary and other incentive plans. In the group model, the HMO contracts with a multi-specialty physician group in which the physicians practice together as a group and provide services primarily for HMO members. The physician group receives a fixed monthly fee, known as capitation, for each HMO member, regardless of the nature and amount of services provided to the member. Under the independent practice association ("IPA") model, the HMO generally contracts on a capitated basis or discounted fee for service basis through a physicians' association or other legal entity, which in turn contracts directly with individual physicians. These physicians provide care in their own offices. Under the network model of organization, the HMO contracts with numerous community multi-specialty physician groups, IPAs, hospitals, individual physicians and other health care providers. The physician groups are paid primarily on a capitated basis, as in the group model, but medical care is usually provided in the physician's own facilities. The Company's HMOs generally utilize network, group and IPA models. In addition to these models, the Company's HMOs also contract directly with individual physicians and physician practices. Under these direct contracts, physicians are predominately reimbursed in accordance with an agreed upon fee schedule for actual health care services rendered to members. PPO. The Company offers PPO products which include certain attributes of managed care; however, a PPO is similar to conventional indemnity health insurance in that it provides a member with the unrestricted flexibility to choose a physician or other health care provider. In a PPO, the member is encouraged, through benefit design that includes cost sharing and other incentives, to use participating health care providers which have contracted with the PPO to provide services at discounted rates. In the event a member elects not to use a participating health care provider, the member may be required to pay a higher coinsurance plus a portion of the provider's fees as in a conventional indemnity plan. The Company's PPO products are generally marketed in conjunction with the Company's HMO products. The Company's PPO business began in Indiana in the fourth quarter of 1989 and has expanded to California and Louisiana. The PPO line of business comprised approximately 1% of the Company's total enrollment at December 31, 1999. POS. The Company also offers a point of service ("POS") product which is designed for the large employer who is promoting single carrier consolidation and employee transition from PPO or indemnity product into managed care programs. This product combines the elements of an HMO with the elements of a conventional indemnity health insurance product by permitting members to participate in managed care but allowing them to choose, at the time services are required, to use providers not participating in the managed care network. Deductibles and copayments generally increase the out-of-pocket costs to the member if a non-participating provider is utilized. The POS line of business comprised approximately 1% of the Company's total enrollment at December 31, 1999. Specialty Managed Care and Other Insurance Services. In addition to its commercial HMO operations, the Company offers a range of specialty managed care and other insurance services. The Company offers a number of pharmacy programs including benefit design, formulary management, claims processing and mail order services for employers and their employees. Through MLH, the Company offers group life and accidental death and dismemberment insurance products. Medicaid. Medicaid is a state-operated program which utilizes both state and federal funding to provide health care services to qualified low-income residents. A Medicaid managed care initiative developed by a state must be approved by the federal government's Health Care Financing Administration ("HCFA"). HCFA requires that Medicaid managed care plans meet federal standards and cost no more than ninety-five percent (95%) of the amount that would have been spent on a comparable fee for service basis. Under the contract with a state, the Company receives a fixed monthly payment for which it is required to provide managed health care services to a member. Medicaid beneficiaries do not pay any premiums, deductibles or copayments. Since January 1995, the Indiana HMO has provided HMO services to Medicaid recipients in the northern and southern regions of Indiana. The State of Indiana has awarded the Indiana HMO new two year contracts for the northern and southern regions commencing January 1, 1999. Effective January 1997 the Indiana HMO entered into a two year contract with the State of Indiana to provide HMO services to Medicaid recipients in the central region of Indiana. This contract was renewed by the State of Indiana for the 2000 year. As of December 31, 1999 the Medicaid program comprised approximately 61,700 members of the Indiana HMO's total enrollment. The Medicaid membership in the northern, and southern regions as of December 31, 1999 approximated 45,400 members and 16,300 members, respectively. The Indiana HMO did not have any membership in the central region as of December 31, 1999; however, effective March 2000 the Indiana HMO had enrolled approximately 1,100 members. In 1996 the State of California began implementation of a new mandatory Medicaid managed care program which resulted in a publicly-sponsored health plan being established in Los Angeles County to serve the Medicaid population ("L.A. Care Health Plan"). L.A. Care Health Plan and Foundation Health (the commercial health plan) have both contracted with the State of California for this new managed care program. The California HMO has contracted for a three year term with L.A. Care Health Plan to provide HMO services under this program through April 2000. This program, which was designed in part as a replacement to the Medicaid fee for service and managed care programs in Los Angeles County, became operational during 1997. Effective January 1998 Medi-Cal beneficiaries with a mandatory enrollment code within certain aid categories were required to choose between the two authorized health plans. Those beneficiaries who made no choice were assigned to either L.A. Care Health Plan or Foundation Health. Beneficiaries assigned to L.A. Care Health Plan in turn were allocated among its subcontracting health plans including the Company's California HMO during this phase-in period. This new program has been fully implemented as of the fourth quarter of 1998. As of December 31, 1999 the Los Angeles County Medicaid program comprised approximately 89,000 members of the California HMO's total enrollment. Although the Company cannot be certain at this point in time of the effects from the ongoing operation of this program, it believes the California HMO will be awarded a new three year contract by L.A. Care Health Plan effective May 1, 2000 and the Los Angeles County Medicaid membership of the California HMO will remain relatively consistent in 2000 with the current membership level. Effective July 1, 1997 the California HMO signed an agreement with Molina Medical Centers ("MMC") which assigned MMC's Medi-Cal contracts for the provision of services in San Bernardino and Riverside Counties (the "San Bernardino/Riverside Contract") and Sacramento County (the "Sacramento Contract") with the State of California to Maxicare. The California HMO entered into an agreement with MMC as a provider in those service areas effective July 1, 1997. As of December 31, 1998, the San Bernardino/Riverside Contract comprised approximately 11,100 members and the Sacramento Contract comprised approximately 20,000 members. The State of California fully implemented in 1999 a new mandatory managed care program in the San Bernardino and Riverside Counties. Under this new program, the State of California has contracted on a multi-year basis with MMC as the commercial health plan and a publicly-sponsored health plan to provide HMO services to Medicaid recipients. This new program was designed in part as a replacement to the Medicaid fee for service and managed care programs in San Bernardino and Riverside Counties and upon transition to this new program the San Bernardino/Riverside Contract assigned to the Company was effectively discontinued upon the completion of the transition process. Effective September 30, 1999 the transition process was completed, and accordingly, the California HMO ceased to service Medicaid members in San Bernardino and Riverside Counties. The California HMO arranged for the provision of services under the Sacramento Contract through the contract expiration date of December 31, 1998. The State of California solicited bids for a two-year contract period commencing January 1, 1999 for Sacramento County and the California HMO was successful in securing an award for a new two-year contract. The California HMO has arrangements with MMC and other providers for the provision of health care services in Sacramento County. As of December 31, 1999 the Sacramento Contract comprised approximately 19,700 members of the California HMO's total membership. Medicare. The Company has entered into federally sponsored one year Medicare+Choice contracts to provide prepaid healthcare services to Medicare beneficiaries in California, Indiana and Louisiana. The programs, known as MAX 65 plus, provide Medicare recipients basic benefits defined by HCFA and preventive services not available under traditional fee for service Medicare for little or no out-of-pocket expense. MAX 65 plus pays all coinsurance and deductible amounts the recipient would have paid under standard Medicare coverage. The Company's Louisiana HMO contract for the provision of prepaid health care services through the MAX 65 plus program became operational in October 1999. The MAX 65 plus programs comprised approximately 4% of the Company's total enrollment as of December 31, 1999. (See "Item 1. Business - Government Regulation"). Health Care Services In exchange for a predetermined monthly payment, an HMO member is entitled to receive a broad range of health care services. Various state and federal regulations require an HMO to offer its members physician and hospital services and adult and pediatric preventive care, and permit an HMO to offer certain supplemental services such as dental care and prescription drug services at additional cost. The Company's members generally receive the following range of health care services: Primary Care Physician Services - medical care provided by primary care physicians (typically family practitioners, general internists and pediatricians). Such care generally includes periodic physical examinations, well-baby care and other preventive health services, as well as the treatment of illnesses not requiring referral to a specialist. Specialist Physician Services - medical care provided by specialist physicians on referral from the responsible primary care physicians. The most commonly used specialist physicians include obstetrician-gynecologists, cardiologists, surgeons and radiologists. Hospital Services - inpatient and outpatient hospital care including room and board, diagnostic tests, and medical and surgical procedures. Diagnostic Laboratory Services - inpatient and outpatient laboratory tests. Diagnostic and Therapeutic Radiology Services - X-ray and nuclear medicine services, including CT scans, MRI and therapeutic radiological procedures. Prescription Drug Services - outpatient prescription drugs for commercial, Medicaid and Medicare HMO members and certain over-the-counter drugs for Medicaid members. Other Services - other related health care services such as ambulance, durable medical supplies and equipment, family planning and infertility services and health education (including prenatal nutritional counseling, weight-loss and stop-smoking programs). Additional optional services available to HMO members may include inpatient psychiatric care, hearing aids, dental care, vision care, infertility services and chiropractic care. Delivery of Health Care Services The Company's HMOs arrange for the delivery of health care services to their members by contracting with physicians, either directly or through IPAs and medical groups, hospitals and other health care providers or contracting entity. The Company's HMOs typically pay to the IPA, medical group, hospital or other contracting entity a fixed monthly capitation fee for each member assigned to the contracting entity. The amount of the monthly capitation fee does not vary with the nature or extent of services utilized. The physicians employed by or contracting with the IPA, medical group or other contracting entity provide professional services to members, including providing or arranging for laboratory services and X-rays. Members select a primary care physician to serve as their personal physician from a listing of contracting physicians or groups. This physician will oversee their medical care and refer them to a specialist when medically necessary. In order to attract new members and retain existing members, the Company's HMOs must retain a network of quality physicians and groups and continue to develop agreements with new physician groups. The Company's HMOs contract for hospital services directly with various hospitals under a variety of arrangements, including fee-for-service, discounted fee-for-service, per diem and capitation. The Company's HMOs also contract through capitation arrangements with IPAs, medical groups or other contracting entities for the provision of hospital services in addition to capitated physician services. Except in emergency situations, a member's hospitalization must be approved in advance by the utilization review committee of the member's physician group and/or the Company's HMOs and must take place in hospitals contracted with the Company's HMOs. When HMO members encounter emergency situations requiring medical care by physicians or hospitals that are not contracted with the Company's HMOs or are out of area, the Company's HMOs generally assume financial responsibility for the cost of medically necessary care. The Company's HMOs arrange for the delivery of health care services to their members primarily through a capitated network. As of January 1999 and January 2000 approximately 87% and 80%, respectively, of the members of the Company's continuing HMOs receive their health care services through a capitated provider arrangement for both physician and hospital services. The Company's HMOs perform various assessment and oversight activities with respect to health care providers contracted under capitation arrangements. These activities include assessments regarding member access to health care services, quality of service and care provided to the members, administrative and financial management expertise of the providers, and provider stability and solvency. The Indiana HMO has an exclusive capitated contract arrangement with Managed Health Services, Inc. through December 31, 2000 in the northern and southern regions for the provision of health care services to approximately 61,700 Medicaid members who represent 13.2% of the Company's total membership as of December 31, 1999 and 33.7% of the Indiana HMO's total membership at December 31, 1999. The Indiana HMO has a multi-year capitated contract arrangement with Indiana ProHealth Network, Inc. for the provision of physician and hospital services to approximately 21,300 commercial members and 2,500 Medicare members which in the aggregate represents 5.1% of the Company's total membership as of December 31, 1999 and 13.6% of the Indiana HMO's total membership as of December 31, 1999. The California HMO has a multi-year capitated contract arrangement with Chauduri Medical Corporation for the provision of physician services to approximately 24,000 commercial members, 1,100 Medicare members and 4,100 Medicaid members which in the aggregate represents 6.3% of the Company's total membership as of December 31, 1999 and 10.5% of the California HMO's total membership at December 31, 1999. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations"). Quality Assurance As required by federal and state law, the Company evaluates the quality and appropriateness of the medical care delivered to its members by its independently contracted providers. When considering whether to contract with a provider, the HMO evaluates the quality of the physician or group's medical facilities, professional qualifications and the capacity to accommodate membership demands. Among the means used to gauge the quality and appropriateness of care are: the performance of periodic medical care evaluation studies, the analysis of monthly utilization of certain services, the performance of periodic member satisfaction studies and the review and response to member and physician grievances. The Company compiles a variety of statistical information concerning the utilization of various services, including emergency room care, outpatient care, out-of-area services, hospital services and physician visits. Under-utilization as well as over-utilization is closely evaluated in an effort to monitor the quality of care provided to the Company's members by participating physicians and physician groups. The Company's HMOs have member services departments which deal directly with members concerning their health care questions, comments, concerns and/or grievances. The Company conducts annual surveys among members concerning their level of satisfaction with the services they receive. Management reviews any problems that are raised by members concerning the delivery of medical care and receives periodic reports summarizing member grievances. The National Committee for Quality Assurance ("NCQA") is an independent, non-profit organization that reviews and accredits HMOs. NCQA performs an evaluation of an HMO's operations with respect to standards established for quality assurance, preventive health services, utilization management, reporting, members' rights, as well as other factors. HMOs that comply with NCQA's review requirements and quality standards receive NCQA accreditation. After an NCQA review is completed, NCQA will issue one of four designations. These are (i) accreditation for three years; (ii) accreditation for one year; (iii) provisional accreditation for twelve to eighteen months to correct certain matters with a follow-up review to determine qualification for accreditation; and (iv) not accredited. In February 1999, the Company's Indiana HMO was awarded a one year accreditation. In February 2000, the Indiana HMO underwent a re-review by NCQA, the results of which are not expected to be released until the second quarter of 2000. The California HMO is scheduled for an initial accreditation review in March 2000. The Louisiana HMO is also in the process of preparing for NCQA accreditation. Premium Structure and Cost Control The Company generally sets its membership fees, or premiums, for employees and their dependents pursuant to a community rating system, thereby charging the same premium per class of subscriber within a geographic area for like services; however, groups which meet certain enrollment requirements are charged premiums which may take into account prior cost experience and/or adjustments to community rating (see "Item 1. Business - Government Regulation"). The Company manages health care costs primarily through contractual arrangements with health care providers who share the risk of certain health care costs. The Company's HMOs arrange for health care services primarily through capitation arrangements. Under capitation contracts, the HMO pays the IPA, medical group or hospital a fixed amount per member per month to cover the payment of all or most medical services regardless of utilization, thereby transferring the risk of certain health care costs to the provider organization. For the year ended December 31, 1998 and 1999 approximately 87% and 80%, respectively, of the members of the Company's continuing HMOs received their health care services through a capitated provider arrangement for both physician and hospital services. For the year ended December 31, 1998 and 1999 physician and hospital capitation for the Company's continuing HMOs represented approximately 76% and 73%, respectively of the total corresponding health care costs. During 1999 the Company assumed increased risk for hospital services that were previously provided through capitated arrangements. A primary factor contributing to this shift in risk was the assumption by the California HMO of hospital services risk formerly capitated with MedPartners Provider Network, Inc. (see "Item 1. Business - Risks and Cautionary Statements - MedPartners Provider Network, Inc."). The focus for cost-efficient use of medical and hospital services in the Company's HMOs is the primary care physician or group who provide services and manage utilization of services by directing or approving hospitalization and referrals to specialists and other providers. In order to manage costs in situations where the Company assumes the financial responsibility for specialist referrals and hospital utilization, the Company may provide additional incentives to health care providers for the medically appropriate, yet efficient utilization of these services. In addition to directing the Company's health care providers toward capitation arrangements, the Company has a variety of programs and procedures in place to encourage appropriate utilization. These programs and procedures are intended to address the utilization of inpatient services, outpatient services and referral services which: (i) verify the medical necessity of inpatient nonemergency treatment or surgery, (ii) establish whether services are appropriately performed in an inpatient setting or could be done on an outpatient basis; and (iii) determine the appropriate length of stay for inpatient services, which may involve concurrent review, discharge planning and/or retrospective review. In addition, the Company monitors the administration, costs and utilization of its pharmacy plan, incorporating such features as drug formularies. The Company's outpatient prescription drug formulary is developed, monitored and updated by the Company's National Pharmacy and Therapeutics Committee. This Committee is comprised of the Company's Medical Directors for the health plans, the Vice President of Pharmacy Services and other representatives. The formulary is designed to serve as a guideline in promoting cost-effective, quality drug therapy for the Company's members. For further information, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Item 8. Financial Statements and Supplementary Data-Consolidated Statements of Operations" included herein. Marketing The Company markets its commercial product to employers or other groups through direct selling efforts and through contacts with insurance brokers and consultants. Commercial members typically join the Company's HMOs through an employer, who pays all or most of the monthly premium. In many instances, employers offer employees a choice of indemnity health insurance coverage or coverage with PPOs and HMOs such as those operated by the Company. The Company's PPO and HMO agreements with employers are generally for a term of 12 months, and automatically renew unless a termination notice is given. Once the Company's relationship with the employer is established, marketing efforts are then focused on the employees of these employers. During an annual "open enrollment period", employees may select their desired health care coverage. The primary annual open enrollment period occurs in the month of January. As of January 31, 2000, approximately 60% of the Company's commercial members had selected their desired health care coverage for the ensuing annual period. The Company's commercial membership is widely diverse, with no commercial employer group comprising 10% or more of the Company's total commercial enrollment with the exception of the State of Indiana employer group which has approximately 10.9% of the Company's commercial members as of December 31, 1999. The Company's 10 largest employer groups acccounted for approximately 33.1% of the Company's commercial members as of December 31, 1999. The Company's HMOs were offered by approximately 1,230 commercial employer groups as of December 31, 1999. The Company believes that attracting employers is only the first step toward increasing enrollment at each of its HMOs. Ultimately, the Company's ability to retain and increase membership will depend upon how users of the health care system assess its benefit package, rates, quality of service, financial condition and responsiveness to user demands. The Company markets its Medicare programs to employer groups with retiree groups and to eligible individuals through direct solicitation and cooperative advertising with participating medical groups. The Company markets its Medicaid programs pursuant to guidelines established by the various states. Medicaid and Medicare beneficiaries may disenroll at any time for any reason. The disenrollment may be effective as early as the first of the month following the date the notification is received. Management Information Systems All of the Company's HMOs are currently linked through a network of data lines to the corporate data center, allowing the Company to prepare and distribute management, accounting and health care services reports (including eligibility, billing, capitation, claims information and utilization reports) on an ongoing basis. System generated reports contain budgeted and actual monthly cost and utilization statistics relating to physician initiated services and hospitalization. Hospital utilization management reports, which are available on a daily basis, are further analyzed by the type of service, days paid, and actual and average length and cost of stay by type of admission. The Company's systems also support efficient transfer of information with providers and employer groups. The Company is currently in the process of a comprehensive evaluation of its information technology, data retrieval and management information systems with a view towards enhancing and upgrading its systems capabilities and improving operating efficiencies. The Company has undergone a Year 2000 readiness program to upgrade and test its systems in preparation for the year 2000 and to assess Year 2000 issues relative to its computing information systems and related business processes. The Company did not experience any disruption to its computing information systems effective with the year 2000 and through March 24, 2000. There can be no assurance, however, that the Company will not experience Year 2000 disruptions or operational issues including those as a result of the Company's vendors and customers.(See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Information - Year 2000"). The corporate data center is located in Los Angeles. Competition Both the health care industry as a whole and the managed care industry in particular are increasingly competitive in all markets. HMOs operating in this highly competitive industry are subject to significant market- place changes from business consolidations, new and emerging strategic alliances, consumer initiatives and legislative reform. The Company competes in its regional markets for employers and members with other HMOs, indemnity health insurers and PPOs as well as employers who elect to self-insure. In addition, the Company competes with other HMOs and PPOs for quality health care providers including physician groups, specialists and hospitals. Many of these competitors are significantly larger and/or have greater financial resources than the Company. The level of competition varies from area to area depending on the variety and relative market share of indemnity insurance, HMO, POS and PPO health care services offered. The Company also faces competition from hospitals and other health care providers who have combined and formed their own networks to contract directly with employer groups and other prospective customers for the delivery of health care services. California, the largest market in which the Company operates, is served by a significant number of HMOs and is one of the most heavily penetrated markets by HMOs in the United States. Competition for members and market share in the Company's markets has resulted in an increase in price competition and a corresponding increase in the difficulty of maintaining margins and market share. The Company believes that the principal competitive factors in the managed health care industry are health care costs to members and employers, the quality and accessibility of contracted providers, the variety of health care coverage options offered and the quality of service to employers, members and providers. Competition may result in pressure to reduce premium rates or limit the growth potential of HMOs in a particular market. Employers, for example, are increasingly cost sensitive in selecting health care coverage for their employees, resulting in market pressures for the Company to keep its rates competitive. In addition to the above, the Company has recently faced increased competition from health care providers offering not only HMO services but PPO, POS and other health care services as well. In an effort to remain competitive, the Company offers a variety of health care services, including PPO and POS and is actively exploring offering more cost effective benefit plans and other services; however, due to competitive pressures it has become increasingly difficult to maintain profitable margins amongst certain blocks of business and/or geographic areas. In 1999, the Company's lack of market share and inability to improve margins necessitated its withdrawal from the commercial line of business in Sacramento. Competition may also be affected by mergers and acquisitions in the managed care and general health care industries as companies and health care providers seek to expand their operating territories, gain economies of scale and increase market share. Many of the Company's markets, and the California market, in particular, have recently experienced a number of mergers and acquisitions among health care providers and/or managed care organizations. A significant number of the Company's principal competitors have substantially larger membership and/or greater financial resources than the Company. Government Regulation The federal government and each of the states in which the Company conducts its business have adopted laws and regulations that govern the business activities of the Company to varying degrees. The most important laws affecting the Company are the Federal Health Maintenance Organization Act of 1973, as amended (the "HMO Act"), and the regulations thereunder promulgated by the Secretary of Health and Human Services, and the various state regulations mandating compliance with certain net worth and other financial tests. All of the Company's HMOs are federally qualified under the HMO Act. Under federal regulations, services to members must be provided substantially on a fixed prepaid monthly basis, without regard to the actual level of utilization of services. Premiums established by HMOs may vary from employer to employer through composite rate factors and special treatment of certain broad classes of members, including geographical location ("community rating"). Prospective experience rating of accounts (i.e., setting premiums for a group account based on that group's past use of health care services) is also permitted under federal regulations in certain circumstances. Pre-existing condition exclusions are prohibited under the HMO Act. From time to time, modifications to the HMO Act have been considered by Congress. The Company is unable to predict what, if any, modifications to the HMO Act will be passed into law or what effect, if any, such legislation would have upon the operations, profitability or business prospects of the Company. Among other areas regulated by federal and state law, although not necessarily by each state, are the scope of benefits available to members, the manner in which premiums are structured, procedures for the review of quality assurance, enrollment requirements, the relationship between the HMO and its health care providers, procedures for resolving grievances, licensure, expansion of service area, financial condition, grounds for termination or non-renewal and patient rights. The HMOs are subject to periodic review and or audit by the federal and state licensing authorities regulating them. A number of jurisdictions in which the Company's HMOs operate have enacted small group insurance and rating reforms which generally limit the ability of insurers and HMOs to use risk selection as a method of controlling costs for small group business. These laws may generally limit or eliminate use of pre-existing conditions exclusions, experience rating and industry class rating and may limit the amount of rate increases from year to year. All of the Company's HMOs are licensed by pertinent state authorities and are subject to extensive state regulations which require periodic financial reports and compliance with minimum equity, capital, deposit and/or reserve requirements. These and other requirements limit the ability of the HMO subsidiaries to transfer funds to MHP. The Company has implemented administrative services agreements which provide for MHP to furnish various management, financial, legal, computer and telecommunication services to the HMOs pursuant to the terms of the agreement with each HMO. The California HMO is subject to state regulation principally by the California Department of Corporations under the Knox-Keene Act. In 1999, California enacted a law transferring jurisdiction of the Knox-Keene Act to a new agency, the Department of Managed Care, which is anticipated to become effective no later than July 1, 2000. MLH and the Company's Indiana and Louisiana HMOs are subject to regulation under state insurance holding company regulations. Such insurance holding company laws and regulations generally require registration with the state Department of Insurance and the filing of certain reports describing capital structure, ownership, financial condition, certain intercompany transactions and general business activities. Certain state insurance holding company laws and regulations require prior regulatory approval of, or in certain circumstances, prior notice of, certain transactions between the regulated companies and their affiliates. The Company's HMOs have Medicare risk contracts which are subject to regulation by HCFA, a branch of the United States Department of Health and Human Services. HCFA has the right to audit HMOs operating under Medicare risk contracts to determine compliance with contract terms, regulations and laws governing the use of federal funds and to monitor the quality of care being rendered to the HMO's enrollees. HCFA also has the right to terminate the Company's Medicare contracts if the Company fails to meet established compliance standards. The Company's HMOs which have Medicaid contracts are subject to both federal and state regulation regarding services to be provided to Medicaid enrollees, payment for those services and other requirements of the Medicaid program. All of the Company's HMOs have commercial contracts with the Federal Employees Health Benefit Plan ("FEHBP"). These contracts are subject to extensive regulation including complex rules relating to the premium rates charged. The FEHBP has the authority to retroactively audit the premium rates and seek adjustments thereto in accordance with specified guidelines. In 1997 the Health Insurance Portability and Accountability Act of 1996 ("HIIPA") was enacted. HIIPA, among other things, requires the guaranteed issuance and renewability of health coverage for certain individuals and small groups, guaranteed renewability for large and small groups and certain individuals, limits pre-existing condition exclusions, limits the grounds for terminating coverage, provides for a demonstration project for medical savings accounts and imposes significant new regulations and penalties designed to prevent health care fraud and abuse. In 1997 the Balanced Budget Act (the "Budget Act") was enacted which, among other things, replaced the Medicare risk contract program with the Medicare+Choice program. The legislation modified the method of federal reimbursement and the requirements for organizations participating in the Medicare+Choice program. The federal reimbursement methodology for determining premiums paid by HCFA was revised to adopt a risk adjusted payment methodology based upon a blend of national and local health care cost factors. HCFA will be implementing payment under the risk adjusted payment methodology effective January 1, 2000 and payment under this methodology will be phased in over a five year period. The legislation includes a provision for a minimum increase of 2% annually in health plan Medicare reimbursement for the next five years. The legislation further provides for expedited licensure of provider-sponsored Medicare plans, a repeal in 1999 of the rule requiring health plans to have one commercial member for each Medicare or Medicaid member, and added program requirements related to provider contracting, quality assurance, utilization management, grievances and appeals. This legislation could have the effect of increasing competition in the Medicare market and increasing the Company's cost of administering its Medicare plans. Government regulation of health care coverage products and services is a changing area of law that varies from jurisdiction to jurisdiction. Changes in applicable laws and regulations are continually being considered and the interpretations of existing laws and rules may also change from time to time. Regulatory agencies generally have broad discretion in promulgating regulations and in interpreting and enforcing laws and rules. The Company is unable to predict what regulatory changes may occur or what may be the impact on the Company of any particular change. In addition, the issue of health care reform on both a state and federal level continues to undergo discussion and examination within both the public and private sectors. Although the concept of managed care appears to be an integral part of many proposals, the Company cannot determine the effect, if any, these proposals or other reforms, if enacted, may have on the business or operations of the Company. The Company believes that it would benefit from legislative proposals encouraging the use of managed health care; however, there can be no assurance that the enactment of any such regulatory or legislative change would not materially and adversely affect the Company's financial position, results of operations, or cash flows. Although the Company intends to maintain its continuing HMOs' federal qualifications, state licenses, Medicare and Medicaid contracts, there can be no assurance that it can do so. The Company believes that it is currently in compliance in all material respects with the various federal and state regulations and contractual requirements applicable to its continuing operations (see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations"). Business Risks and Cautionary Statements The Company is faced with various risks and uncertainties to its operations which include a variety of factors that may have a material effect on its operating results. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Information"). Health Care Costs - The Company's results of operations are significantly impacted by the Company's ability to estimate and manage future health care costs over the related premium period. Many factors may adversely impact the Company's ability to estimate and manage future health care costs including increased utilization, high dollar claims, inflation, catastrophic events, epidemics, new mandated benefits, new technologies and health care practices, and inability to secure cost effective provider compensation arrangements. Pharmaceutical Costs - Prescription drug costs continue to rise at a rate in excess of most other health care services. Although the Company has implemented strategies to mitigate this cost trend there can be no assurance that the Company will be able to effectively manage this increasing trend or successfully recoup the increasing costs thereof. Claims Reserves - The Company's claims reserves are estimates of incurred health care costs based upon various assumptions and environmental factors. Given the inherent variability of such estimates, the actual development of such reserves could be materially different from amounts provided. Health Care Provider Network - The Company's marketability and profitability is dependent, in large part, upon its ability to attract and contract on a cost effective basis with hospitals, medical groups, physicians and other provider contracting entities. The Company contracts with providers and other provider contracting entities primarily through capitation arrangements. The inability of contracted provider entities to properly manage costs under capitation arrangements can result in financial instability and insolvency of such providers resulting in the termination of their relationship with the Company, and subject the Company to possible liability of unpaid claims. In addition, the potential loss of capitation arrangements subjects the Company to increased financial risk related to health care costs. Competition and Marketing - The Company operates in an environment where many of its competitors enjoy greater market share and greater capital resources. Competitive pressures have in the past and may continue to adversely affect the Company's ability to retain or increase its customer base, limit its pricing flexibility, and maintain or improve operating margins. Concentration of Business - The Company's Medicaid and Medicare lines of business are subject to the Company's ongoing ability to secure contracts with the respective contracting entities. In addition, the governmental programs are subject to extensive federal and state regulation. The Company's Medicaid and Medicare premium revenues represented approximately 28.5% and 12.9%, respectively, of the Company's total premium revenues for 1999. A failure to retain one or more of the largest governmental contracts could have a material adverse effect on the Company's business and operations. Management Information Systems - The Company's business operations are significantly dependent on the functionality and effectiveness of its management information systems. The Company is presently assessing various alternative initiatives regarding the implementation of significant system enhancements and/or conversions including internet-based systems. Any significant problems resulting from the implementation of such initiatives and/or conversions could result in a material adverse impact on the Company's business processes, customer and provider relationships, results of operations and financial condition. Administrative and Management Structure - An element of the Company's business strategy is to ensure its operations maintain an efficient administrative cost structure. However, the implementation of various business strategies such as the introduction of new products, geographic and/or service area expansion, information system enhancements and improved workflow processes involve operational challenges and the risk of unanticipated costs and related impact to the Company's workforce. Governmental Regulation; Federal and State Legislation - The health care industry is subject to extensive regulation, including, but not limited to requirements related to licensing, policy benefits design, member disclosure and enrollment, cash reserves, net worth and restrictions on dividending. In addition, the Company is subject to various reviews and audits regarding compliance with applicable laws and regulations. Future changes related to pending legislation or regulation could have a material adverse impact on the Company's business. Litigation - The Company is subject to various legal actions, including claims disputes with providers, breach of contract actions, and other matters primarily related to contractual arrangements of the Company. An adverse determination in one or more of these litigations could have a material adverse effect on the Company's business and operations (see "Item 3. Legal Proceedings"). MedPartners Provider Network, Inc. - The Company's California HMO had a multi-year capitated contract arrangement with MedPartners Provider Network, Inc. ("MPN"), a wholly owned subsidiary of Caremark Rx, Inc., formerly know as Medpartners, Inc. ("MedPartners"), that as of June 30, 1999 provided health care services to approximately 29,700 commercial members, 1,800 Medicare members and 3,500 Medicaid members. In November 1998, MedPartners announced its intention to divest its physician groups and physician practice management business which includes the operations of MPN. On March 11, 1999 the California Department of Corporations (the "DOC") appointed a conservator to manage the operations of MPN; and the conservator, on behalf of MPN, filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court (the "Bankruptcy Court") for the Central District of California (the "DOC Actions"). In connection with MPN's Chapter 11 filing, certain non-contracted providers of MPN have asserted that the health plans contracting through MPN remain liable for any unpaid obligations of MPN related to the provision of covered health care services to the members of the respective health plans. Under an amended and restated settlement agreement among the DOC, MPN and MedPartners (the "Global Settlement"), MedPartners agreed to fund, subject to the satisfaction of certain conditions and funding commitment limitations, MPN's liabilities to its providers and liabilities of MedPartners' affiliated medical groups. The Global Settlement provided for the sale of MedPartners California physician practice groups (the "California Operations"). As of mid August 1999, MedPartners had completed the sales of its California Operations. In connection with the sale of certain of the California Operations, the Company's California HMO and other California HMOs have been asked to collectively loan $12 million for the benefit of the purchaser (the "Plan Loan") to assure that the purchaser has adequate working capital and that continuity of care can be maintained. If consented to, the California HMO's share of the Plan Loan would be approximately $500,000 and would depend on an acceptable agreement being reached on the terms and conditions for the Plan Loan by and among the California HMOs, Medpartners and the purchaser. The terms and provisions of the Plan Loan are subject to negotiations among the parties to the Plan Loan and have not been finalized. The Company has not yet determined if the California HMO will participate in such proposed Plan Loan. Effective June 1, 1999 the California HMO assumed the financial risk for hospital services provided to its members assigned to MPN. MPN has filed a plan of reorganization with the Bankruptcy Court on November 5, 1999 (the "Proposed Plan"). The Proposed Plan has not been approved by MPN's creditors or the Bankruptcy Court. The Company cannot state what adverse effect, if any, the Proposed Plan will have on the Global Settlement. Neither the effect of the DOC Actions, the Global Settlement, the Proposed Plan nor the Company's potential business and financial risks associated with its contractual arrangement with MPN is known at this point in time; however, the effect of these risks could have a material adverse effect on the Company's operations, financial position, results of operations and cash flows. History The Company's HMO business originated in California in 1973. The Company began multi-state operations in June 1982 by purchasing 100% of CNA Health Plans, Inc. As part of its expansion strategy, the Company acquired all of the stock of HealthCare USA Inc. ("HealthCare") and HealthAmerica Corporation ("HealthAmerica") in the fourth quarter of 1986. At that time, HealthCare owned or managed HMOs in three states and HealthAmerica owned or managed HMOs in 17 states, including 11 states not previously served by the Company. As a result of these acquisitions, which were highly leveraged, and adverse industry conditions, the Company's financial condition deteriorated significantly culminating in MHP and forty-seven affiliated entities filing for protection under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in March and April of 1989. Under the Bankruptcy Code, substantially all pre-petition liabilities, contingencies and other contractual obligations were discharged upon emergence from Chapter 11 on December 5, 1990, the "Effective Date" of the plan of reorganization (the "Reorganization Plan"). Pursuant to the Reorganization Plan, the Company made distributions of cash, Senior Notes and Common Stock to holders of allowed claims and interests under the Reorganization Plan. On January 13, 1998 the United States Bankruptcy Court entered an order closing all of the jointly administered bankruptcy cases of the Company, with the exception of the Penn Health Corporation bankruptcy case, having determined that the Reorganization Plan had been consummated. The Company believes the resolution of the Penn Health Corporation bankruptcy case and certain other matters relating to the Reorganization Plan will not adversely impact the Company's ongoing business and operations. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and "Item 8. Financial Statements and Supplementary Data - Note 9 to the Company's Consolidated Financial Statements"). Shareholder Rights Plan On February 24, 1998, the Board of Directors of the Company (the "Board") adopted a Shareholder Rights Plan (the "Rights Plan") designed to assure that in the event of an unsolicited or hostile attempt to acquire the Company, the Board would have the opportunity to consider and implement a course of action which would best maximize shareholder value. Additionally, on February 24, 1998, the Board declared a dividend distribution of one preferred share purchase right (a "Right") for each outstanding share of Common Stock. The dividend is payable to the stockholders of record on March 16, 1998, and with respect to Common Stock issued thereafter, until the Distribution Date (as defined below) and, in certain circumstances, with respect to Common Stock issued after the Distribution Date. Each Right shall entitle the holder thereof to purchase 1/500th of a share of the Company's Series B Preferred Stock (the "Series B Preferred") for $45.00 (the "Exercise Price"). Each 1/500th Series B Preferred share (the "Preferred Fraction") shall be entitled to one vote in all matters being voted on by the holders of Common Stock and shall also be entitled to a liquidation preference of $0.20. The Rights will initially be attached to the Company's Common Stock and will not be exercisable until a shareholder or group of shareholders acting together, without the approval of the Board, announce their intent to become a 15% or more owner in the Company's Common Stock. At that time, certificates evidencing the Rights shall be distributed to shareholders (the "Distribution Date"), the Rights shall detach from the Common Stock and shall become exercisable. When such buyer acquires 15% or more of the Company's Common Stock, all Rights holders, except the non-approved buyer, will be entitled to acquire an amount of the Preferred Fraction at a rate equal to twice the Exercise Price divided by the then market price of the Common Stock. In addition, if the Company is acquired in a non-approved merger, after such an acquisition, all Rights holders, except the aforementioned 15% or more buyer, will be entitled to acquire stock in the surviving corporation at a 50% discount in accordance with the Rights Plan. The Rights shall attach to all common shares held by the Company's shareholders of record as of the close of business on March 16, 1998. Shares of Common Stock that are newly-issued after that date will also carry Rights until the Rights become detached from the Common Stock. The rights will expire on February 23, 2008. The Company may redeem the Rights for $.01 each at any time before a non-approved buyer acquires 15% or more of the Company's Common Stock. Heartland Advisors, Inc. ("Heartland") was the beneficial owner of approximately 18.5% of the Company's Common Stock as of the date the Rights Plan was adopted and was "grandfathered" with respect to their existing position, including allowance for certain small incremental additions thereto. As of December 31, 1999, Heartland was the beneficial owner of 19.8% of the Company's Common Stock. In addition, in 1999 the Board waived the implementation of the Rights Plan in connection with Snyder Capital Management, L.P.'s ("SCMLP") acquiring beneficial ownership of up to 20% of the Company's Common Stock. As of December 31, 1999, SCMLP was the beneficial owner of 19.5% of the Company's Common Stock (see "Item 12. Security Ownership of Certain Beneficial Owners and Management"). Consent Solicitation and Related Matters On March 19, 1998, Paul R. Dupee, Jr. ("Mr. Dupee") and certain other entities holding in the aggregate approximately 5% of the Company's outstanding shares began an action to solicit written consents of shareholders of the Company by filing preliminary consent material with the Securities and Exchange Commission (the "SEC"), and issuing a press release (the "Dupee Consent Solicitation"). The Dupee Consent Solicitation proposed to enact the following proposals (the "Dupee Proposals"): (i) to repeal any amendments to the Company's Bylaws adopted by the Board since February 1, 1998; (ii) to amend Article III, Section 2 of the Company's Bylaws through the addition of ten new directors, thereby increasing the number of directors eligible to serve on the Board to 17, and to confirm that the existing Bylaw provisions of Article II, Section 14 were not applicable to the Dupee Consent Solicitation; and (iii) to fill the new directorships created by the increase in the authorized number of directors with the ten nominees proposed by Mr. Dupee, including Mr. Dupee and Mr. Robert M. Davies. At the same time, Mr. Dupee filed litigations against the Company in Federal court and against the Company and its directors in State court (the "Dupee Litigations"). In response to the Dupee Consent Solicitation, the Board filed an opposition preliminary consent solicitation with the SEC, filed answers and counterclaims in the Dupee Litigations, and, in March 1998 amended certain provisions of the Bylaws (the "March Bylaw Amendments"). The effect of the March Bylaw Amendments was to make the adoption of the Dupee Proposals more difficult. When the March Bylaw Amendments were added, the Board also amended Mr. Ratican's employment agreement and the Company's Supplemental Executive Retirement Plan. (See "Item 11. Executive Compensation - Ratican Employment Agreements and Supplemental Executive Retirement Plan"). Prior to either the Company or Mr. Dupee sending definitive consent solicitation material to the shareholders, Mr. Dupee and certain entities affiliated with the Dupee Consent Solicitation (the "Dupee Group"), entered into a settlement agreement with the Company dated May 8, 1998 (the "Settlement Agreement") pursuant to which Mr. Dupee terminated the Dupee Consent Solicitation. In accordance with the Settlement Agreement, the Board authorized an increase in the number of directors to serve on the Board from seven to nine. The three vacancies (one existed prior to the increase by the Board) were filled by Messrs. Paul R. Dupee, Jr., Robert M. Davies and Elwood I. Kleaver, Jr. In addition, Mr. Dupee became a member of the Company's Executive Committee which was expanded to four members. Messrs. Dupee and Kleaver were classified as Class II directors and as Nominees for the 1998 Annual Meeting of Shareholders. Mr. Davies has been classified as a Class I director with a term which will expire in 2000. In addition, the members of the Dupee Group agreed not to initiate or support any written consent or other shareholder solicitations for a special meeting prior to the 1999 Annual Meeting of Shareholders. Pursuant to the Settlement Agreement, the Company scheduled the 1998 Annual Meeting of Shareholders for July 30, 1998 and agreed to hold the 1999 Annual Meeting of Shareholders no later than June 30, 1999 (the "Termination Date"). Under the Settlement Agreement, the Dupee Litigations have been dismissed with prejudice, provided, that such dismissals shall not preclude a claim arising from any action or failure to take any action on and after May 8, 1998 by the Company, the Board, Mr. Dupee, or any other current or future shareholder of the Company. Pursuant to the Settlement Agreement, the Company agreed not to take certain actions with respect to the issuance of its voting securities prior to the Termination Date. The Company's 1998 Annual Meeting of Shareholders was held on July 30, 1998 at which the Company's shareholders approved by ballot and by proxy all five proposals provided for in the Settlement Agreement, including the election of three new Directors, Ms. Florence F. Courtright, Mr. Paul R. Dupee, Jr. and Mr. Elwood I. Kleaver, Jr. to serve until the year 2001 Annual Meeting of Shareholders. The Company's shareholders also approved an amendment to the Rights Plan to eliminate the "dead hand" (continuing Directors) provision of the Rights Plan and agreed to the reimbursement for an aggregate of $444,135 representing certain expenses incurred by Mr. Dupee and others in connection with the Dupee Consent Solicitation. The Company's shareholders also adopted certain amendments to the Company's Certificate of Incorporation and Bylaws which were agreed to in the Settlement Agreement. Employees As of December 31, 1999 the Company employed approximately 500 full-time employees. None of the Company's employees are represented by a labor union or covered by a collective bargaining arrangement. The Company believes its employee relations are good. Directors and Executive Officers of the Registrant The directors and executive officers of the Company at December 31, 1999 were as follows: Name Age Position Paul R. Dupee, Jr. 56 Chairman of the Board of Directors, Chief Executive Officer Richard A. Link 45 Chief Operating Officer, Chief Financial Officer, Executive Vice President - Finance and Administration Alan D. Bloom 53 Senior Vice President, Secretary and General Counsel Patricia A. Fitzpatrick 48 Treasurer Warren D. Foon 43 Vice President, General Manager - Maxicare California Kenneth D. Kubisty 34 Acting Vice President, General Manager - Maxicare Indiana Sanford N. Lewis 56 Vice President - Administrative Services George H. Bigelow 57 Director Claude S. Brinegar 73 Director Florence F. Courtright 68 Director Robert M. Davies 49 Director Thomas W. Field, Jr. 66 Director Elwood I. Kleaver, Jr. 57 Director Charles E. Lewis, M.D. 71 Director Simon J. Whitmey 53 Director Paul R. Dupee, Jr. was appointed Chairman of the Board of Directors in June 1999 and Chief Executive Officer of the Company in August 1999. For more than five years prior hereto, Mr. Dupee has been a private investor. He has served as a Director of the Lynton Group, Inc. since 1996 and has been Chairman since 1998. From 1986 through 1996, Mr. Dupee was Director and Vice Chairman of the Boston Celtics Limited Partnership, which owns the National Basketball Association team, the Boston Celtics. Mr. Dupee has been a director of the Company since May 1998. Richard A. Link was appointed Chief Operating Officer in August 1999 in addition to his appointment as Chief Financial Officer, Executive Vice President - Finance and Administration of the Company in December 1997. Mr. Link served as Chief Accounting Officer and Senior Vice President - Accounting of the Company from September 1988 to December 1997. He has a Bachelor's degree in Business Administration from the University of Southern California and is a certified public accountant. Alan D. Bloom has been Senior Vice President, Secretary and General Counsel to the Company since July 1987. Mr. Bloom joined the Company as General Counsel in 1981. Mr. Bloom received a Bachelor's degree in Biology from the University of Chicago, a Master of Public Health from the University of Michigan, and a J.D. degree from American University. Patricia A. Fitzpatrick has served as Treasurer of the Company since July 1998. Previously, Ms. Fitzpatrick served as Assistant Treasurer of the Company from July 1988 to July 1998. Ms. Fitzpatrick received a Bachelor of Science Degree in Management from Pepperdine University. Warren D. Foon was appointed Vice President, General Manager of the California HMO in May 1995. Mr. Foon was Vice President - Plan Operations of the Company from March 1989 through April 1995 and Vice President - National Provider Relations from October 1986 through February 1989. Mr. Foon received a Doctor of Pharmacy and a Masters in Public Administration from the University of Southern California and a Bachelor of Arts in Biology from the University of California at Los Angeles. Kenneth D. Kubisty was appointed Acting Vice President, General Manager of Maxicare Indiana, Inc. in November 1999. Mr. Kubisty served as Director of Governmental Programs and Provider Relations from April 1998 through October 1999. Prior to joining Maxicare, Mr. Kubisty served as a provider services manager for Managed Care Solutions, Inc. from March 1997 through March 1998 and served as a policy analyst for the state of Indiana's Medicaid managed care program from June 1996 through March 1997. Prior to June 1996 Mr. Kubisty pursued undergraduate and graduate studies and received a Master of Health Administration degree from Indiana University and a Bachelor of Arts in Health Management from the Governors State University. Sanford N. Lewis was appointed Vice President - Administrative Services of the Company in February 1996. He was Associate Vice President - Underwriting from July 1993 to January 1996 and prior to that National Director Data Control. Mr. Lewis has been with the Company since 1987. George H. Bigelow has been a managing member of Americana Group, LLC, a real estate investment advisor since January 1998. Previously, he was the President, Chief Operating Officer and Director of Americana Hotels and Realty Corporation, a publicly traded real estate investment trust located in Boston, Massachusetts, from 1986 to 1998 and he became Chief Financial Officer in March 1997. Mr. Bigelow has been a director of the Company since June 1999. Claude S. Brinegar is the retired Vice Chairman of the board of directors and Chief Financial Officer of Unocal Corporation. Prior to his retirement Mr. Brinegar had been with Unocal for 39 years. Mr. Brinegar is currently a member of the board of directors of CSX Corporation and served on the board of directors of Conrail, Inc. from 1990 to 1998. Mr. Brinegar has been a director of the Company since June 1991. Florence F. Courtright has been a private investor for more than the last five years. She is a founding Limited Partner of Bainco International Investors, l.p. and a Trustee of Loyola Marymount University. Further, Ms. Courtright is the former co-owner of the Beverly Wilshire Hotel. Ms. Courtright has been a director of the Company since November 1993. Robert M. Davies has been Managing Director of The Menai Group LLC, a merchant banking firm since April 1998. Mr. Davies was the Vice President of Wexford Capital Corporation, an investment manager to several private investment funds, from 1994 to March 1997. From September 1993 to May 1994 he was Managing Director of Steinhardt Enterprises, Inc., an investment company, and from 1987 to August 1993 he was Executive Vice President of The Hallwood Group Incorporated, a merchant banking firm. Mr. Davies is a Director and Chairman of Oakhurst Company, Inc., a Director of its majority-owned subsidiary, Steel City Products, Inc. and a Director of Industrial Acoustics Company, Inc. Mr. Davies has been a director of the Company since May 1998. Thomas W. Field, Jr. has been President of Field & Associates, a management consulting firm, since October 1989. Mr. Field served as Chairman of the Board of ABCO Markets from December 1991 through January 1996. ABCO Markets is in the grocery business. Mr. Field also holds directorships at Campbell Soup Company and Stater Bros. Markets. Mr. Field has been a director of the Company since April 1992. Elwood I. Kleaver, Jr. served as Interim Chief Operating Officer of the Company from April 1999 through July 1999. He has been a private investor and self-employed health care consultant specializing in turnaround situations. He also serves as the President and Director of Alcohol Detection Services LLC ("ADS"), a start-up biotech company, and is a Director of Independent Care and Harmony Health Plan, HMOs specializing in care to the chronically disabled and Medicaid beneficiaries, respectively. In 1995, Mr. Kleaver became an officer and Director of Early Detection, Inc. ("EDI"), a start-up biotech company which in 1998 underwent liquidation under Chapter 128 of the Wisconsin law. ADS is the successor of the operations formerly operated by EDI. From January 1993 through January 1995, Mr. Kleaver was President and Director of CareNetwork, a Wisconsin based HMO. Mr. Kleaver has been a director of the Company since May 1998. Charles E. Lewis has been a Professor of Medicine, Public Health and Nursing at the University of California at Los Angeles, since 1970. As of July 1993, he was appointed Director of the Center of Health Promotion and Disease Prevention. He is a member of the Institute of Medicine, National Academy of Sciences and is a graduate of the Harvard Medical School and of the University of Cincinnati School of Public Health where he received a Doctorate of Science degree. Dr. Lewis is a Regent of the American College of Physicians and a member of the Board of Commissioners of the Joint Commission on Accreditation of Health Care Organizations. Dr. Lewis has been a director of the Company since August 1983. Simon J. Whitmey has served as President and Chief Executive Officer of Acralight, Inc., a privately owned California corporation (and a California licensed contractor) that manufactures and installs glazing systems since 1995. Mr. Whitmey was self-employed as a real estate developer from 1992 to 1995. Mr. Whitmey has been a director of the Company since June 1999. The Board of Directors (the "Board") is classified into Class I, Class II and Class III directors. Class I directors include Dr. Lewis, Mr. Brinegar and Mr. Davies and they will serve until the 2000 annual meeting of stockholders and until their successors are duly qualified and elected. Class II directors include Ms. Courtright, Mr. Dupee and Mr. Kleaver and they will serve until the 2001 annual meeting of stockholders and until their successors are duly qualified and elected. Class III directors include Mr. Bigelow, Mr. Field and Mr. Whitmey and they will serve until the 2002 annual meeting of stockholders and until their successors are duly qualified and elected. Officers are elected annually and serve at the pleasure of the Board, subject to all rights, if any, under certain contracts of employment (see "Item 11. Executive Compensation"). Item 2. Item 2. Properties The Company's operating facilities are held through leaseholds. At December 31, 1999, the Company leased approximately 212,000 square feet at 13 locations with an aggregate current monthly rental expense of approximately $174,000. These leases have remaining terms of up to 4 years. The Company's leased properties include administrative locations for its HMOs and corporate facilities and other miscellaneous facilities. In June 1994, and effective as of that date, the Company entered into a lease with a term of 72 months for new office space in Los Angeles for its corporate and California HMO operations. Effective June 1999, the Company amended the lease agreement with a 36 month term through May 2002. (the "1999 Amended Lease"). The 1999 Amended Lease is for approximately 83,000 square feet with a monthly rental expense of approximately $81,000 excluding the Company's percentage share of all increases in the landlord's operating cost of the building. Item 3. Item 3. Legal Proceedings a. ALPHA HEALTH SYSTEMS, INC. AND CALIFORNIA FAMILY CARE SERVICES, INC. 1. Arbitration Proceedings On or about November 20, 1998 California Family Care Services, Inc.,("Cal") and Alpha Health Systems, Inc. ("Alpha") each filed a separate Demand For Arbitration (collectively, the "First Demands") with the American Arbitration Association ("AAA") in Los Angeles, California, seeking arbitration of a breach of contract dispute with Maxicare, a California corporation ("California Plan"), the Company's California subsidiary. At the time the First Demands were filed with the AAA, Cal and Alpha were participating providers in the California Plan's Los Angeles County Medi-Cal program pursuant to their Medi-Cal provider contracts with the California Plan ("Provider Agreement"). In the First Demands Cal and Alpha contended that the California Plan: (a) overcharged them for stop loss coverage and administrative fees; (b) miscalculated capitation payments paid to them for the month of May 1997; (c) failed to submit adequate documentation for pharmacy charges; and (d) caused them to lose revenue because of administrative delays in credentialing physicians and performing physician site evaluations and because the California Plan failed to offer them as health care providers to the California Plan's commercial members ("Allegations"). Cal and Alpha also requested in the First Demands that the arbitrators determine whether, by reason of the Allegations, the California Plan breached the covenant of good faith and fair dealing or statutes and regulations to which the California Plan is subject. In the First Demands compensatory damages were claimed in the approximate amounts of $3.9 million and $4.2 million, for Cal and Alpha respectively, and pre and post arbitration award interest and attorneys' fees were also sought. In January 1998 the California Plan filed a motion to dismiss each of the arbitration proceedings on the grounds that the First Demands were untimely under the arbitration provisions contained in Cal and Alpha's respective provider contracts with the California Plan. In August 1999 the California Plan terminated its separate Provider Agreements with Cal and Alpha as a result of their material breaches of the agreements. In December 1999, Cal and Alpha each served a pre- arbitration notice of dispute ("Dispute Notices") and demands for indemnification ("Indemnification Demands") on the California Plan. In the Dispute Notices Cal and Alpha notified the California Plan of disputes involving, among other things, (i) overcharges in administrative fees; (ii) the failure to pay capitation increases; (iii) the cancellation of the Provider Agreements without cause and in bad faith resulting in lost revenue; (iv) a loss of revenue due to a refusal to grow Alpha's lives base in conformity to other networks; (v) the termination of the Provider Agreements in bad faith and without cause, resulting in costs of rebuilding the network to pre-termination size; and (vi) indemnification for damages for which Cal and Alpha may be liable, alleged to be the result of the California Plan's purported breaches and wrongful cancellation of the Provider Agreements. In the Dispute Notices Cal and Alpha claim unpaid capitation, lost revenue and other damages in the respective amounts of $80 million and $76 million. In the Indemnification Demands Cal and Alpha seek indemnification for the same items identified in the Dispute Notices. In January 2000 the California Plan responded to the Dispute Notices and the Indemnification Demands and denied all of the allegations set forth in the Dispute Notices and Indemnification Demands. The California Plan also denied that it is obligated, liable, or indebted to Cal or Alpha in any amount on account of the issues, matters, or claims purported to be set forth in the Dispute Notices. By ruling dated January 24, 2000 the arbitrator in the Cal arbitration granted the California Plan's motion to dismiss the arbitration initiated by the filing of the Cal First Demand with prejudice ("Dismissal Ruling"). On or about March 17, 2000, the California Plan received a demand for arbitration dated March 12, 2000, asserting a claim based on the Cal Dispute Notice By ruling dated January 31, 2000 the Alpha arbitrator denied the California Plan's motion to dismiss the arbitration initiated by the filing of the Alpha First Demand. Following the arbitrator's ruling the California Plan filed its answer and counterclaims in the Alpha arbitration. Alpha has objected to the California Plan's answer and counterclaims contending they are untimely and that the California Plan's counterclaims were filed without the consent of the arbitrator. Alpha has also requested that the arbitrator give it leave to amend and update Alpha's First Demand to assert the claims identified in Alpha's Dispute Notice. The California Plan asserts that its answer was timely, the filing of its counter claims proper, and that Alpha's request to amend the Demand is inconsistent with the arbitration provision in the Provider Contract. 2. State Court Proceedings On December 3, 1998, Cal and Alpha filed a complaint in the Superior Court for Los Angeles County ("Superior Court") that named the California Plan as a defendant and asserted breach of contract, breach of the covenant of good faith and fair dealing, fraud, intentional interference with prospective economic advantage and negligence. No damages were specified in the complaint. (Case No. B.C. 201751). On January 25, 1999, the Superior Court granted the California Plan's motion to compel arbitration of the claims asserted in the complaint and ordered arbitration of such claims. The California Plan believes that at least certain of the breach of contract claims asserted in the complaint overlap with the claims asserted in First Demands. To the extent the breach of contract claims are encompassed in the dismissed Cal First Demand, such claims are barred by the Dismissal Ruling. On August 5, 1999, Cal and Alpha filed a complaint with the Superior Court that named Mr. Warren Foon and Mr. Walter Gray, two of the California Plan's officers, as defendants, and asserted claims for conversion and interference with contract. On March 13, 2000 the Superior Court granted the California Plan's motion to stay the action and to compel arbitration of the claims asserted in the complaint on the ground that the claims were claims against the California Plan and directed that such claims be adjudicated through arbitration with the California Plan. The Company believes that all of the claims asserted by Cal and Alpha in the arbitration proceedings and the State Court proceedings are without merit, intends vigorously to contest the claims in the arbitration proceedings and believes it will prevail in the arbitrations. Notwithstanding the foregoing, if there is an adverse determination in any material aspect of the arbitrations, such determination could have a material adverse effect on the Company. b. CALIFORNIA MEDICAL ASSOCIATION On July 15, 1999, the California Medical Association, a California nonprofit corporation ("CMA"), commenced an action in San Diego County Superior Court against seven California HMOs and the Company (the "Defendants"), entitled: "California Medical Association, California nonprofit corporation, Plaintiff, v. Aetna U.S. Healthcare, Blue Cross of California, Blue Shield of California, Healthnet, Maxicare Health Plans, Inc., Pacificare of California, Prudential Healthcare, United Health Care of California, Inc., and DOES 1-100, Defendants" (the "Action")(Case No. 732614). The Defendants have entered into a joint defense agreement among themselves which, among other things, permits the sharing of crucial information relating to the defense of the Action on an attorney-client privileged basis. The Defendants' joint demurrer to the first amended complaint was sustained by the Court pursuant to an order entered on January 7, 2000. On January 24, 2000 the CMA filed its second amended complaint in the Action asserting a quantum meruit claim against the Defendants ("Second Amended Complaint"). Pursuant to a stipulation the Company's California subsidiary, Maxicare, a California corporation ("California Plan"), was added as a named defendant and the Company was dismissed from the Action. In the Second Amended Complaint, the CMA purporting to sue as the assignee of certain physicians and physician medical groups, has asserted a claim for quantum meruit against the Defendants, to recover payment for medical services that were not paid by the purported intermediaries with which the physicians contracted. In the Action CMA seeks recovery from the Defendants even though the Defendants have paid the intermediaries and certain of the physicians' contracts with the purported intermediaries require that they only seek payment from the intermediaries. The CMA seeks approximately $270,000 in damages from the California Plan. The Defendants, including the California Plan, have filed a joint demurrer to the Second Amended Complaint seeking dismissal of the complaint. The hearing on the joint demurrer is scheduled for April 7, 2000. The Company believes that the Action is without merit, intends to contest the Action vigorously and believes it will prevail in the Action. Notwithstanding the foregoing, while the Company does not believe that an adverse determination in the Action in and of itself will have a material adverse effect on the Company, if a subsequent adverse appellate decision were to ensue and a multiplicity of similar claims from physicians and other providers were subsequently asserted against the California Plan, such claims could have a material adverse effect on the Company. c. MANAGED HEALTH SERVICES On June 30, 1999, Maxicare Indiana, Inc. ("Maxicare Indiana"), a wholly- owned subsidiary of Maxicare Health Plans, Inc., received a "Written Notice of Dispute" from Coordinated Care Corporation of Indiana, Inc. d.b.a. Managed Health Services ("MHS") concerning a capitated contract arrangement between MHS and Maxicare Indiana, effective as of July 1, 1998, in which MHS agreed to administer Maxicare Indiana's Medicaid program for the Southern Region of Indiana (the "MHS Contract"). Thereafter, on August 31, 1999, MHS filed a Complaint in Marion Superior Court No. 11 in Indianapolis, Indiana against Maxicare Indiana under Cause No. 49D11 9908 CP001241 (the "Complaint"). In the Complaint, MHS alleged that Maxicare Indiana misrepresented certain facts upon which MHS relied when negotiating the MHS Contract. MHS also alleged that Maxicare Indiana acted in bad faith in negotiating the MHS Contract. MHS amended the Complaint on or about September 24, 1999, to include a demand of approximately $6 million in contractual damages, as well as punitive damages and rescission of the MHS Contract. MHS and Maxicare Indiana have entered into a settlement that fully resolves the claims at issue in MHS' Written Notice of Dispute and the Complaint. The settlement between MHS and Maxicare Indiana is comprised of an Amendment to the MHS Contract (the "Amendment") and a full Release Agreement (the "Release"). Pursuant to the Amendment, MHS specifically acknowledges and affirms that MHS will remain a party to the MHS Contract until the expiration of the regular term on December 31, 2000. The Amendment also calls for some slight modifications to the capitation payment terms, which will not have a material adverse effect on Maxicare Indiana. Under the Release between MHS and Maxicare Indiana the parties have completely released each other from all claims and liabilities arising from the factual and legal claims made in MHS' Written Notice of Dispute and the Complaint. The Release also states that the parties acknowledge that Maxicare Indiana admits no liability for the claims raised in MHS' Written Notice of Dispute and the Complaint, and that settlement was reached for the sole purpose of avoiding the time and expense associated with further litigation. As required under the release, MHS has stipulated to dismissal of the MHS Complaint, with prejudice. Accordingly, the Company will no longer be reporting on this matter. d. OTHER LITIGATION The Company is a defendant in a number of other lawsuits arising in the ordinary course from its operations, including cases in which the plaintiffs assert claims against the Company or third parties that assert breach of contract, indemnity or contribution claims against the Company for malpractice, negligence, bad faith in the failure to pay claims on a timely basis or denial of coverage seeking compensatory, fraud and, in certain instances, punitive damages in an indeterminate amount which may be material and/or seeking other forms of equitable relief. The Company does not believe that the ultimate determination of these cases will either individually or in the aggregate have a material, adverse effect on the Company's business or operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders during the three months ended December 31, 1999. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) Market Information The Company's Common Stock trades on The Nasdaq Stock Market ("Nasdaq") under the trading symbol MAXI. The following table sets forth the high and low sale prices per share on Nasdaq. The quotations are interdealer prices without retail mark-ups, markdowns, or commissions, and may not represent actual transactions. Common Stock Sale Price --------------- High Low ------ ------ 1998 First Quarter $13.13 $ 7.00 Second Quarter $12.63 $ 6.00 Third Quarter $ 8.81 $ 2.63 Fourth Quarter $ 6.81 $ 2.75 1999 First Quarter $ 7.00 $ 3.81 Second Quarter $ 5.88 $ 3.75 Third Quarter $ 6.00 $ 4.25 Fourth Quarter $ 4.88 $ 2.31 (b) Holders There were 17,150 holders of record of the Company's Common Stock as of December 31, 1999. (c) Dividends The Company has not paid any cash dividends on its Common Stock and has no current intention of doing so in the foreseeable future (see "Item 8. - - Financial Statements and Supplementary Data - Note 5 to the Company's Consolidated Financial Statements") Notes to Selected Financial Data The selected financial data should be read in conjunction with "Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The year ended December 31, 1999 compared to the year ended December 31, 1998 The Company reported a net loss of $12.3 million for the year ended December 31, 1999 which included a $3.0 million charge for loss contracts related to the Carolinas commercial line of business, a $5.5 million charge for management settlement costs and $4.1 million of other income from a litigation settlement, compared to a net loss of $27.5 million for 1998 which included a $12.5 million charge for loss contracts and divestiture costs related to health plans identified for disposition, a $2.0 million charge for litigation and a $2.0 million charge for provider insolvency/impairment related to certain of the Company's capitated provider arrangements. Net loss per common share was $.68 for 1999 compared to a net loss per common share of $1.54 for 1998. In 1999, the Company completed its restructuring program to exit unprofitable markets by asset sales or plan closings and concentrate on its continuing health care businesses in California, Indiana and Louisiana (the "continuing operations"). As of December 31, 1999, the continuing operations accounted for commercial membership of approximately 279,400 members, Medicaid membership of approximately 170,300 members and Medicare membership of approximately 16,900 members. The Company is presently undergoing a strategic assessment which includes a variety of initiatives to improve the Company's market position, strengthen its medical management, claims payment administration and other critical business processes. In addition, the Company is presently assessing various alternative initiatives regarding the implementation of significant system enhancements and/or conversions including internet- based systems. The execution of this restructuring program may be dependent upon the Company's ability to secure additional capital financing and may result in restructuring costs to be incurred upon implementation. Premium revenues for the year ended December 31, 1999 decreased by $22.2 million to $705.0 million, a decrease of 3.1% as compared to 1998. This decrease was a result of a $77.1 million decrease in premium revenues related to the Company's discontinued operations which have been fully divested as of September 30, 1999 offset in part by a $54.9 million increase in premium revenues related to the Company's continuing operations. Commercial premiums for the year ended December 31, 1999 decreased $53.1 million to $412.5 million as compared to $465.6 million for 1998. The Company's commercial premiums for its continuing operations increased by $12.7 million to $412.0 million for 1999 as compared to $399.3 million for 1998 primarily due to premium rate increases offset in part by a decrease in membership. The Company's commercial membership for its continuing operations of 279,400 members as of December 31, 1999 decreased by 3,900 members as compared to the prior year period primarily as a result of pricing discipline. The average commercial premium revenue per member per month ("PMPM") increased 6.5% as compared to 1998. Medicaid premiums for the year ended December 31, 1999 decreased $3.3 million to $201.2 million as compared to $204.5 million for 1998. The Company's Medicaid premiums for its continuing operations increased by $8.0 million primarily as a result of premium rate increases in California and Indiana. As of December 31, 1999 the California and Indiana health plans had 108,600 and 61,700 Medicaid members, respectively as compared to 125,400 and 69,500 Medicaid members, respectively as of December 31, 1998. The decline in California is primarily attributable to the California health plan not having ongoing participation in the new managed care program in San Bernardino and Riverside counties which was fully implemented and transitioned effective September 30, 1999. The decline in Indiana is primarily attributable to the Indiana health plan not participating in the central region after January 1999 due to the loss of its capitated network provider. Effective March 2000 the Indiana health plan had restructured its provider network in the central region and had commenced enrollment of members. The average Medicaid premium PMPM for the continuing operations increased by 4.3%, primarily due to premium rate increases in California and Indiana. Medicare premiums for the year ended December 31, 1999 increased $34.1 million to $91.3 million as compared to 1998 as a result of premium rate increases and membership growth in both the California and Indiana health plans and the start up of Medicare operations in the Company's Louisiana health plan. As of December 31, 1999 the California, Indiana and Louisiana health plans had 10,500, 5,800 and 600 Medicare members, respectively, representing an increase in membership of 6,000 from 1998 primarily as a result of growth in California. The average Medicare premium PMPM increased by 5.7% due to premium rate increases in both California and Indiana and due to greater membership growth in California, which has a higher average Medicare premium PMPM as compared to that of Indiana. Investment income for the year ended December 31, 1999 decreased by $1.6 million to $3.8 million as compared to 1998 due to lower cash and investment balances as well as lower investment yields. Health care expenses for the year ended December 31, 1999 were $652.3 million as compared to $684.4 million for 1998. This decrease of $32.1 million was primarily due to the decrease in health care expenses associated with the divestitures of the Company's Illinois, Wisconsin and Carolinas health plans offset in part by an increase to health care expenses as a result of growth in the continuing operations and an increase to pharmacy costs. Although prescription drug costs are expected to continue to rise, the Company continues to implement strategies to mitigate this trend through benefit design changes and enhanced procedures and controls to promote cost effective use of prescription drug benefits. Included in health care expenses for the year ended December 31, 1999 was a $6.0 million charge recorded in the fourth quarter to increase health care claims reserves. Marketing, general and administrative ("M,G&A") expenses for the year ended December 31, 1999 increased $2.9 million to $64.0 million as compared to $61.1 million for 1998. M,G&A expenses for the year ended December 31, 1998 excluded approximately $3.7 million of maintenance and divestiture costs which were applied against the reserve for loss contracts and divestiture costs. Including the $3.7 million of maintenance costs, M,G&A expenses were 9.1% and 8.9% of premium revenues for the year ended December 31,1999 and 1998, respectively. For the year ended December 31, 1999, the Company reported a provision for income taxes of $55,000 and an offsetting income tax benefit of $55,000 due to the Company increasing its deferred tax asset. For the year ended December 31, 1998, the Company reported a provision for income taxes of $106,000 and an offsetting income tax benefit of $106,000 due to the Company increasing its deferred tax asset. (See "Item 8. Financial Statements and Supplementary Data - Note 7 to the Company's Consolidated Financial Statements"). The year ended December 31, 1998 compared to the year ended December 31, 1997 The Company reported a net loss of $27.5 million for the year ended December 31, 1998 after recording charges of $16.5 million related to loss contracts and divestiture costs, litigation and provider insolvency/impairment costs. This compares to a net loss of $25.1 million for 1997 which included charges of $9.0 million related to litigation and management restructuring costs. In December 1997, the Company began a comprehensive restructuring of the Company's operations and businesses with a view towards enhancing and focusing on the Company's operations which have generated substantially all of the membership growth in recent years. As a result of assessing various strategic alternatives, the Company concluded that the divestiture of the Company's operations in Illinois, the Carolinas and Wisconsin through either a sale or closure of these operations was in its best interest as the Company was unable to predict a return to profitability for these health plans in a reasonable time frame. Additionally, the Company initiated the restructuring of its commercial and Medicaid provider network arrangements in Southern Indiana to improve the operating margins in this region. Accordingly, the Company recorded in the second quarter of 1998 a $10.0 million charge for anticipated continuing losses primarily related to contracts in Illinois and the Carolinas for which the anticipated future health care costs and associated maintenance costs exceed the related premiums, and certain other costs associated with the divestiture of these health plans. On September 30, 1998, the Company completed the sale of its Wisconsin health plan which had approximately 4,700 commercial members and approximately 10,200 Medicaid members. On October 16, 1998, the Company completed the sale of its Illinois health plan which had approximately 22,600 commercial members. In addition, on September 30, 1998, the Company announced it would cease offering in North and South Carolina, all commercial health care lines of business, including its commercial health maintenance organization, preferred provider organization and point of service product lines. The Company's Carolinas health plans ceased providing commercial and Medicaid health care coverage as of March 31, 1999 and September 30, 1999, respectively. The Company's reported loss of $27.5 million for 1998 was, among other factors, significantly impacted by the specific operations targeted in the Company's restructuring plan which was implemented in 1998. The significant factors contributing to the loss of $27.5 million were the following: 1) $22.3 million of losses associated with the Wisconsin, Illinois and Carolinas health plans, 2) $7.3 million of losses associated with the Southern Indiana Medicaid line of business (the provider network arrangement has been restructured effective July 1998 from a fee for service network to a capitated risk arrangement,, 3) $3.8 million of losses associated with the commercial line of business in Southern Indiana (as of January 1, 1999 the Indiana health plan is no longer providing health care coverage to the member base which generated these losses; accordingly, the Company has mitigated its ongoing financial risk in this marketplace), 4) $2.0 million provider insolvency/impairment charge, and 5) $1.2 million of costs associated with a shareholder action. In the aggregate these aforementioned factors accounted for approximately $36.6 million in losses for the year ended December 31, 1998 which were in part offset by other operating results of the Company. Premium revenues for the year ended December 31, 1998 increased by $69.1 million to $727.2 million, an increase of 10.5% as compared to 1997. The Company's premium revenues for its continuing operations increased by $93.8 million as a result of premium rate increases and enrollment growth in the commercial, Medicaid and Medicare lines of business primarily generated by the California and Indiana health plans. Commercial premiums for the year ended December 31, 1998 increased $8.0 million to $465.6 million as compared to $457.6 million for 1997. The Company's commercial premiums for its continuing operations increased by $28.9 million to $399.1 million for 1998 as compared to $370.2 million for 1997 primarily due to a 5.5% membership increase. The Company's commercial membership for its continuing operations of 283,300 members as of December 31, 1998 increased by 10,600 members as a result of increases in California, Indiana and Louisiana. The average commercial premium revenue per member per month ("PMPM") increased 2.2% as compared to 1997. Medicaid premiums for the year ended December 31, 1998 increased $44.6 million to $204.5 million as compared to $159.9 million for 1997. The Company's Medicaid premiums for its continuing operations increased by $48.4 million as a result of premium rate increases in Los Angeles County and Sacramento and a 37.2% membership increase. As of December 31, 1998 the California and Indiana health plans had 125,400 and 69,500 members, respectively, representing an increase in membership of 30,200 from 1997 primarily as a result of the growth in Los Angeles County. The average Medicaid premium PMPM for the continuing operations decreased by 2.0% due to the greater membership growth in Los Angeles County which has a lower premium PMPM as compared to that of Indiana and other California counties. Medicare premiums for the year ended December 31, 1998 increased $16.5 million to $57.1 million as compared to 1997 as a result of premium rate increases and membership growth in both the California and Indiana health plans. As of December 31, 1998 the California and Indiana health plans had 6,200 and 4,700 members, respectively, representing an increase in membership of 3,000 from 1997 primarily as a result of growth in California. The average Medicare PMPM increased by 4.9% due to premium rate increases in both California and Indiana and due to greater membership growth in California, which has a higher average Medicare premium PMPM as compared to that of Indiana. Investment income for the year ended December 31, 1998 decreased by $2.1 million to $5.4 million as compared to 1997 due to lower cash and investment balances as well as lower investment yields. Health care expenses for the year ended December 31, 1998 were $684.4 million as compared to $630.9 million for 1997. This increase in health care expenses was in part a result of growth in all continuing operations lines of business and an increase in pharmacy costs reduced by approximately $8.3 million of health care costs applied against the reserve for loss contracts and divestiture costs established in 1998. Although prescription drug costs are expected to continue to rise, this trend was somewhat mitigated by enhanced procedures and controls implemented from June 1998 through September 1998 to promote cost effective use of prescription drug benefits. Marketing, general and administrative ("M,G&A") expenses for the year ended December 31, 1998 increased $5.3 million to $61.1 million as compared to $55.8 million for 1997. M,G&A expenses for 1998, including approximately $1.2 million of costs recorded in the second quarter of 1998 related to a shareholder action and excluding approximately $3.7 million of maintenance and divestiture costs applied against the reserve for loss contracts and divestiture costs, were 8.4% of premium revenues as compared to 8.5% of premium revenues for 1997. For the year ended December 31, 1998, the Company recorded $16.5 million of charges composed of 1) a $12.5 million charge for loss contracts and divestiture costs related to the discontinued health plans, 2) a $2.0 million litigation charge substantially related to the Company's former Illinois health plan and 3) a $2.0 million charge for provider insolvency/impairment related to certain of the Company's capitated provider arrangements including the arrangement with MedPartners Provider Network, Inc. (see "Item 1. Business - Business Risks and Cautionary Statements - MedPartners Provider Network, Inc."). For the year ended December 31, 1997, the Company recorded $9.0 million of charges composed of 1) a $6.0 million litigation charge as a result of a ruling by the Commonwealth of Pennsylvania Board of Claims denying the Company recovery on its receivable of $5.0 million due the Company from the Pennsylvania Department of Public Welfare and 2) a $3.0 million management restructuring charge for termination expenses primarily related to the settlement of certain obligations pursuant to the former chief financial officer's employment agreement. For the year ended December 31, 1998, the Company reported a provision for income taxes of $106,000 and an offsetting income tax benefit of $106,000 due to the Company increasing its deferred tax asset. For the year ended December 31, 1997, the Company reported a provision for income taxes of $61,000 and an offsetting income tax benefit of $61,000 due to the Company increasing its deferred tax asset. (See "Item 8. Financial Statements and Supplementary Data - Note 7 to the Company's Consolidated Financial Statements"). Liquidity and Capital Resources Cash provided by operations for the year ended December 31, 1999 was $5.7 million as compared to cash used for operations of $39.6 million for the year ended December 31, 1998. This improvement in cash flow is primarily attributable to the reduced net loss for 1999, a reduction in 1999 in premium receivables and an increase in estimated claims and other health care costs payable. The $4.1 million increase in 1999 in estimated claims and other health care costs payable is largely attributable to an increase to the California HMO's claims reserve as a result of the health plan assuming financial risk for hospital services for members assigned to MPN (see "Item 1. Business - Business Risks and Cautionary Statements - - MedPartners Provider Network, Inc.") partially offset by the payment in 1999 of the claims payable related to the Company's divested Wisconsin, Illinois and Carolinas health plans. All of MHP's operating subsidiaries are direct subsidiaries of MHP. The operating HMOs and MLH currently pay monthly fees to MHP pursuant to administrative services agreements for various management, financial, legal, computer and telecommunications services. The Company's HMOs are federally qualified and are licensed in the states where they operate. MLH is licensed in 35 states as of December 31, 1999 including the states in which the Company's HMOs operate. The Company's HMOs and MLH are subject to state regulations which require compliance with certain statutory deposit, dividend distribution and net worth requirements. To the extent the operating HMOs and MLH must comply with these regulations, they may not have the financial flexibility to transfer funds to MHP. MHP's proportionate share of net assets (after inter-company eliminations) which, at December 31, 1999 may not be transferred to MHP by subsidiaries in the form of loans, advances or cash dividends without the consent of a third party is referred to as "Restricted Net Assets". Restricted Net Assets of these operating subsidiaries were $29.9 million at December 31, 1999, with deposit requirements and limitations imposed by state regulations on the distribution of dividends representing $6.4 million and $7.6 million of the Restricted Net Assets, respectively, and net worth requirements in excess of deposit requirements and dividend limitations representing the remaining $15.9 million. In addition to the $.8 million in cash, cash equivalents and marketable securities held by MHP, approximately $.8 million in funds held by operating subsidiaries could be considered available for transfer to MHP at December 31, 1999 (collectively, the "Available Cash"). MHP made $8.3 million and $22.5 million in capital contributions in 1999 and 1998, respectively, to ensure that the operating subsidiaries had adequate statutory net worth as of December 31, 1999 and 1998. Additionally, MHP received $10.7 million and $11.7 million in dividends from its operating subsidiaries in 1999 and 1998, respectively. In March 2000 the Indiana HMO obtained approval from the Indiana Department of Insurance to dividend $1.5 million to MHP; accordingly, these funds were distributed to MHP in March 2000 and as a result have supplemented the liquidity position of MHP. (See "Item 8. Financial Statements and Supplementary Data" and "Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - Schedule I"). In September and October 1998, MHP completed the sale of its Wisconsin and Illinois health plans. Under the terms of the respective stock sales agreements, MHP retained certain assets and liabilities of the health plans (including premium receivables and estimated claims payable) which related to the operations of the health plans prior to October 1, 1998. In September 1998, the Company announced it would cease offering in North and South Carolina commercial health care coverage beyond March 1999. The Company ceased commercial and Medicaid health care coverage in the Carolinas as of March 31, 1999 and September 30, 1999, respectively. As of December 31, 1999 the Company's estimated claims payable related to the Wisconsin, Illinois and Carolinas health plans (the "divested health plans") aggregated approximately $.2 million. As of December 31, 1999 the divested health plans had cash and cash equivalents and marketable securities of approximately $40,000 and restricted investments of $1.1 million. The restricted investment balances of $.8 million and $.3 million are on deposit with the North Carolina Department of Insurance and South Carolina Department of Insurance, respectively. Subsequent to December 31, 1999 the North Carolina Department of Insurance released $.3 million of the $.8 million restricted investment and the South Carolina Department of Insurance released the entire $.3 million restricted investment. The Company believes the cash resources of the divested health plans and the Available Cash will be adequate to fund the payment of the estimated claims payable balance as of December 31, 1999 of the divested health plans. Although the Company believes it currently has sufficient resources to fund ongoing operations and obligations and remain in compliance with statutory financial requirements for its California, Indiana and Louisiana HMOs and MLH, the lack of liquidity and available cash poses operational risk. Continuing losses and/or unforeseen cash requirements in the future could leave the Company without sufficient resources to fund its operations. In response to the need to secure additional capital resources, the Company is exploring various financing alternatives including raising debt or equity capital or other source of financing to provide it with additional working capital. However, the Company cannot state with any degree of certainty at this time whether it could obtain such source of financing, and if available, whether such financing would be at terms and conditions acceptable to the Company. In the event the Company is unable to obtain such financing, the Company's liquidity and capital resources may be insufficient to fund the operational requirements of MHP and the Company and the ability of the Company to maintain compliance with statutory financial requirements for its California, Indiana and Louisiana HMOs and MLH. Forward Looking Information General - This Annual Report on Form 10-K contains and incorporates by reference forward looking statements within the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Reference is made in particular to the discussions set forth under "Item 1. Business" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations". Such statements are based on certain assumptions and current expectations that involve a number of risks and uncertainties, many of which are beyond the Company's control. These risks and uncertainties include limitations on premium levels, greater than anticipated increases in healthcare expenses, loss of contracts with providers and other contracting entities, insolvency of providers and other contracting entities, benefit mandates, variances in anticipated enrollment as a result of competition or other factors, changes to the laws or funding of Medicare and Medicaid programs, and increased regulatory requirements for dividending, minimum capital, reserve and other financial solvency requirements. The effects of the aforementioned risks and uncertainties could have a material adverse impact on the liquidity and capital resources of MHP and the Company. These statements are forward looking and actual results could differ materially from those projected in the forward looking statements, which statements involve risks and uncertainties. In addition, past financial performance is not necessarily a reliable indicator of future performance and investors should not use historical performance to anticipate results or future period trends. Shareholders are also directed to disclosures in this and other documents filed by the Company with the SEC. Business Strategy - The Company's business strategy includes strengthening its position in the markets it serves by: marketing an expanded range of managed care products and services, providing superior service to the Company's members and employer groups, enhancing long-term relationships and arrangements with health care providers, and selectively targeting geographic areas within a state for expansion through increased penetration or development of new areas. The Company continually evaluates opportunities to expand its business as well as evaluates the investment in these businesses. Year 2000 - The Company has undergone a Year 2000 readiness program to upgrade and test its systems in preparation for the year 2000 and to assess Year 2000 issues relative to its computing information systems and related business processes. As a result of the assessment process, necessary changes and/or augmentations to the Company's systems were made including selected systems being retired and replaced with packaged software from large vendors that is Year 2000 compliant. The total estimated cost of the program incurred since 1997 through December 31, 1999 was approximately $1.5 million and projected future costs of the program are estimated to be minimal. As of December 31, 1999, the Company's core legacy systems were complete as to testing and confirmation as Year 2000 compliant. The Company did not experience any disruption to its computing information systems effective with the year 2000 and through March 24, 2000. There can be no assurance, however, that the Company will not experience Year 2000 disruptions or operational issues including those as a result of the Company's vendors and customers. The Company continues to keep business process contingency plans in place in the event a significant Year 2000 matter should occur. Item 7a. Item 7a. Quantitative and Qualitative Disclosures About Market Risk As of December 31, 1999, the Company has approximately $78.9 million in cash and cash equivalents, marketable securities and restricted investments. Marketable securities of $1.7 million are classified as available-for-sale investments and restricted investments of $8.1 million is classified as held-to-maturity investments. These investments are primarily in fixed income, investment grade securities. The Company's investment policies emphasize return of principal and liquidity and are focused on fixed returns that limit volatility and risk of principal. Because of the Company's investment policies, the primary market risk associated with the Company's portfolio is interest rate risk. As of December 31, 1999, the Company did not have any outstanding bank borrowings or debt obligations. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Maxicare Health Plans, Inc. We have audited the accompanying consolidated balance sheets of Maxicare Health Plans, Inc. as of December 31, 1999 and 1998, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the information with respect to the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Maxicare Health Plans, Inc. at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Los Angeles, California March 24, 2000 MAXICARE HEALTH PLANS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BUSINESS DESCRIPTION Maxicare Health Plans, Inc., a Delaware corporation ("MHP"), is a holding company which owns various subsidiaries, primarily health maintenance organizations ("HMOs"). MHP conducts ongoing HMO operations in California, Indiana and Louisiana (see Note 9). All of MHP's HMOs are federally qualified by the United States Department of Health and Human Services and are generally regulated by the Department of Insurance of the state in which they are domiciled (except the California HMO, which is regulated by the California Department of Corporations). Maxicare Life and Health Insurance Company ("MLH"), a licensed insurance company and wholly-owned subsidiary of MHP, operates preferred provider organizations ("PPOs") in California, Indiana and Louisiana which constitute approximately 1% of the consolidated enrollment of MHP and subsidiaries (the "Company") at December 31, 1999. In addition, MLH writes policies for group life and accidental death and dismemberment insurance; however, these lines of business make up less than 1% of the Company's revenues for the year ended December 31, 1999. NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Segment Information The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 131 "Disclosures about Segments of an Enterprise and Related Information." Management evaluates and assesses the Company's operations as a single segment; accordingly, the Company has not included the additional disclosures required by SFAS No. 131. Use of Estimates The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates. Cash and Cash Equivalents The Company considers all highly liquid investments that are both readily convertible into known amounts of cash and mature within 90 days from their date of purchase to be cash equivalents. Cash and cash equivalents consist of the following at December 31: 1999 1998 (Amounts in thousands) -------- -------- Cash.............................. $ 13,557 $ 4,768 Certificates of deposit........... 2,571 3,717 Commercial paper.................. 22,134 9,632 Money market funds................ 28,712 20,421 Repurchase agreements............. 149 1,985 U.S. Government obligations....... 1,994 7,984 -------- -------- $ 69,117 $ 48,507 ======== ======== Investments Realized gains and losses and unrealized losses judged to be other than temporary with respect to available-for-sale and held-to-maturity securities are included in the determination of net income. The cost of securities sold is based on the specific identification method. Fair values of marketable securities are based on published or quoted market prices. The Company has designated its marketable securities included in current assets as available-for-sale. Such securities have been recorded at fair value, and unrealized holding gains and losses, net of related tax effects, are reported as accumulated other comprehensive income (loss) in the Consolidated Statements of Changes in Shareholders' Equity until realized. The Company's restricted investments consist of securities restricted to specific purposes as required by various governmental regulations. These securities have been designated as held-to-maturity as the Company has the intent and the ability to hold them to maturity. These securities are stated at amortized cost. During 1999, the Company sold available-for-sale marketable securities having a book value of $3.0 million, realizing a net gain of approximately $2,500. During 1998, the Company sold available-for-sale marketable securities having a book value of $15.5 million, realizing a net gain of approximately $43,000. During 1997, the Company sold marketable available-for-sale securities having a book value of $15.9 million, realizing a net gain of approximately $178,000. The following is a summary of investments at December 31(gross unrealized gains and losses are immaterial): The contractual maturities of investments at December 31, 1999 were as follows: Estimated Amortized Fair (Amounts in thousands) Cost Value --------- --------- Available-for-sale: Due in one year or less................ $ 1,322 $ 1,321 Due after one year through five years.. 390 381 ------- ------- $ 1,712 $ 1,702 ======== ======== Held-to-maturity: Due in one year or less................ $ 7,029 $ 7,002 Due after one year through five years.. 1,046 1,029 ------- -------- $ 8,075 $ 8,031 ======= ======== Accounts Receivable Accounts receivable consisted of the following at December 31: 1999 1998 (Amounts in thousands) ------- ------- Premiums receivable.................... $22,368 $35,020 Allowance for retroactive billing adjustments.................. (1,892) (5,481) ------- ------- Premiums receivable, net............... 20,476 29,539 Other.................................. 7,736 7,048 ------- ------- Accounts receivable, net............... $28,212 $36,587 ======= ======= Property and Equipment Property and equipment are recorded at cost and include assets acquired through capital leases and improvements that significantly add to the productive capacity or extend the useful lives of the assets. Costs of maintenance and repairs are charged to expense as incurred. Depreciation for financial reporting purposes is provided on the straight-line method over the estimated useful lives of the assets. The costs of major remodeling and improvements are capitalized as leasehold improvements. Leasehold improvements are amortized using the straight-line method over the shorter of the remaining term of the applicable lease or the life of the asset. Intangible Assets Intangible assets consist primarily of purchased computer software and are amortized using the straight-line method over five years. Accumulated amortization of intangible assets at December 31, 1999 and 1998 is $2.3 million and $2.1 million, respectively. Revenue Recognition Premiums are recorded as revenue in the month for which enrollees are entitled to health care services. Premiums collected in advance are deferred. A portion of premiums is subject to possible retroactive adjustment. Provision has been made for estimated retroactive adjustments to the extent the probable outcome of such adjustments can be determined. Any other revenues are recognized as services are rendered. Health Care Expense Recognition The cost of health care services is expensed in the period the Company is obligated to provide such services. The Company's HMOs arrange for the provision of health care services primarily through capitation arrangements and to a lesser degree shared risk arrangements. Under capitation contracts, the HMO pays the health care provider or providers a fixed amount per member per month to cover the payment of all or most physician and hospital services regardless of utilization. Under shared risk arrangements where the Company retains the financial responsibility for specialist referrals, hospital utilization, pharmacy and other health care costs, the Company establishes an accrual for estimated claims payable including claims reported as of the balance sheet date and estimated (based upon utilization trends and projections of historical developments) costs of health care services rendered but not reported. Estimated claims payable are continually monitored and reviewed and, as settlements are made or accruals adjusted, differences are reflected in current operations. Insurance The Company is self-insured for medical malpractice claims, and risks on certain medical and hospital claims incurred by members covered by the HMOs or MLH. MLH and Health Care Assurance Company Limited, a wholly owned subsidiary of MHP, provide various reinsurance and medical malpractice coverage to the affiliated HMOs of the Company. Premium Deficiencies Estimated future health care costs and maintenance expenses under a group of contracts in excess of estimated future premiums and reinsurance recoveries on those contracts are recorded as a loss when determinable. As of December 31, 1998 the Company reserved for premium deficiencies through March 31, 1999 related to the commercial line of business for the North Carolina and South Carolina HMOs (see Note 9). No other premium deficiencies existed at December 31, 1998 and 1999. Net Income Per Common Share Basic earnings per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding, after giving effect to stock options with an exercise price less than the average market price for the period. The following is a reconciliation of the numerators and denominators used in the calculation of basic and diluted earnings per share for each period presented in the financial statements: Concentrations of Credit Risk Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of investments in marketable securities and premiums receivable. The Company's investments in marketable securities are managed by internal investment managers within the guidelines established by the board of directors, which, as a matter of policy, limit the amounts which may be invested in any one issuer. Concentrations of credit risk with respect to premiums receivable are limited due to the large number of employer groups comprising the Company's customer base. As of December 31, 1999 management believes that the Company had no significant concentrations of credit risk. NOTE 3 - LITIGATION Two former Medi-Cal provider groups of the California HMO have asserted various claims against the California HMO alleging breaches of their former provider contracts including improper termination of the contracts and are seeking substantial monetary damages. Although the Company cannot estimate the range of possible damages, an adverse determination on one or more of the claims could have a material adverse effect on the Company's consolidated financial position, results of operations and cash flows. The Company believes that the claims asserted by the former provider groups are without merit, intends to vigorously contest the claims and believes it will prevail in the actions. The Company is involved in other litigations arising in the normal course of business, which, in the opinion of management, will not have a material adverse effect on the Company's consolidated financial position, results of operations and cash flows. NOTE 4 - COMMITMENTS AND CONTINGENCIES Leases The Company has operating leases, some of which provide for initial free rent and all of which provide for subsequent rent increases. Rental expense is recognized on a straight-line basis with rental expense of $1.8 million, $2.5 million and $2.3 million reported for the years ended December 31, 1999, 1998 and 1997, respectively. Assets held under capital leases at December 31, 1999 and 1998 of $1,323,000 and $469,000, respectively, (net of $1,229,000 and $850,000 , respectively, of accumulated amortization) are comprised primarily of equipment leases. Amortization expense for capital leases is included in depreciation expense. Future minimum lease commitments for noncancelable leases at December 31, 1999 were as follows: Operating Capitalized Leases Leases (Amounts in thousands) --------- ----------- 2000.......................... $ 2,162 $ 461 2001.......................... 2,462 391 2002.......................... 1,328 385 2003.......................... 340 288 2004 . . . . . . . . . . . . . 178 9 Total minimum ------ ------ obligations................. $ 6,470 1,534 ====== Amount representing interest . 250 Less current obligations................ 351 Long-term ------ obligations................. $933 ====== NOTE 5 - CAPITAL STOCK On March 9, 1992 the shareholders voted to amend MHP's current Restated Certificate of Incorporation to increase the authorized Capital Stock of the Company from 18.0 million shares to 45.0 million shares through: (i) an increase in the amount of authorized Common Stock of the Company, par value $.01, from 18.0 million shares to 40.0 million shares, and (ii) the authorization of 5.0 million shares of Preferred Stock, par value $.01, of which 2.5 million shares were designated the Series A Stock. Preferred Stock In the first quarter of 1992 MHP issued 2,400,000 shares of Series A Cumulative Convertible Preferred Stock (the "Series A Stock") and redeemed certain Senior Notes issued in conjunction with the Company's joint plan of reorganization, as modified (the "Reorganization Plan"). In the first quarter of 1995, the Company redeemed all of the remaining 2.29 million outstanding shares of the Series A Stock of which 2.27 million shares were converted into 6.25 million shares of Common Stock and the remaining .02 million shares were redeemed for cash. Common Stock The Company is authorized to issue 40.0 million shares of $.01 par value Common Stock. Under the Reorganization Plan 10.0 million shares of the Company's Common Stock were issued for the benefit of holders of allowed claims, interest and equity claims. An additional 6.6 million shares were issued upon the conversion of Series A Stock in 1994 and 1995, and .4 million shares were issued in connection with the exercise of warrants issued pursuant to the Reorganization Plan. As of December 31, 1998 approximately 17.9 million shares of the Company's Common Stock were outstanding. The Certificate of Incorporation of the Company prohibits the issuance of certain non-voting equity securities as required by the United States Bankruptcy Code. Shareholder Rights Plan On February 24, 1998, the Board of Directors of MHP (the "Board") adopted a Shareholder Rights Plan (the "Rights Plan") designed to assure that in the event of an unsolicited or hostile attempt to acquire the Company, the Board would have the opportunity to consider and implement a course of action which would best maximize shareholder value. Additionally, on February 24, 1998, the Board declared a dividend distribution of one preferred share purchase right (a "Right") for each outstanding share of Common Stock. The dividend is payable to the stockholders of record on March 16, 1998, and with respect to Common Stock issued thereafter, until the Distribution Date (as defined below) and, in certain circumstances, with respect to Common Stock issued after the Distribution Date. Each Right shall entitle the holder thereof to purchase 1/500th of a share of the Company's Series B Preferred Stock (the "Series B Preferred") for $45.00 (the "Exercise Price"). Each 1/500th Series B Preferred (the "Preferred Fraction") share shall be entitled to one vote in all matters being voted on by the holders of Common Stock and shall also be entitled to a liquidation preference of $0.20. The Rights will initially be attached to the Company's Common Stock and will not be exercisable until a shareholder or group of shareholders acting together, without the approval of the Board, announce their intent to become a 15% or more owner in the Company's Common Stock. At that time, certificates evidencing the Rights shall be distributed to shareholders (the "Distribution Date"), the Rights shall detach from the Common Stock and shall become exercisable. When such buyer acquires 15% or more of the Company's Common Stock, all Rights holders, except the non-approved buyer, will be entitled to acquire an amount of the Preferred Fraction at a rate equal to twice the Exercise Price divided by the then market price of the Common Stock. In addition, if the Company is acquired in a non-approved merger, after such an acquisition, all Rights holders, except the aforementioned 15% or more buyer, will be entitled to acquire stock in the surviving corporation at a 50% discount in accordance with the Rights Plan. The Rights shall attach to all common shares held by the Company's shareholders of record as of the close of business on March 16, 1998. Shares of Common Stock that are newly-issued after that date will also carry Rights until the Rights become detached from the Common Stock. The rights will expire on February 23, 2008. The Company may redeem the Rights for $.01 each at any time before a non-approved buyer acquires 15% or more of the Company's Common Stock. Any current holder that has previously advised the Company of owning an amount in excess of 15% of the Company's Common Stock as of the date hereof has been "grandfathered" with respect to their current position, including allowance for certain small incremental additions thereto. Stock Option Plans Pursuant to the Reorganization Plan, Mr. Peter J. Ratican, formerly Chief Executive Officer and President, and Mr. Eugene L. Froelich, formerly Chief Financial Officer and Executive Vice President - Finance and Administration ("Senior Management") each received stock options, which are all currently exercisable and which expire on December 5, 2000, to purchase up to 277,778 shares of Common Stock at a price of $6.54 per option share. As of January 1, 1992, the Company entered into employment agreements with Senior Management. Under the terms of these employment agreements, each member of Senior Management received a grant of stock options on February 25, 1992, to purchase up to 150,000 shares of Common Stock at a price of $8.00 per option share; both Mr. Ratican and Mr. Froelich exercised these options in February 1997. In December 1990, the Company approved the 1990 Stock Option Plan (the "1990 Plan"). Under the terms of the 1990 Plan, as amended, the Company may issue up to an aggregate of 1,000,000 nonqualified stock options to directors, officers and other employees. In July 1995, the Company approved the 1995 Stock Option Plan (the "1995 Plan"). Under the terms of the 1995 Plan, the Company may issue up to an aggregate of 1,000,000 nonqualified or incentive stock options to directors, officers and other employees. In June 1999, the Company approved the 1999 Stock Option Plan (the "1999 Plan"). Under the terms of the 1999 Plan, the Company may issue up to an aggregate of 750,000 nonqualified or incentive stock options to directors, officers and other employees. Under the 1990 Plan, the 1995 Plan and the 1999 Plan, stock options granted to date have been nonqualified stock options which expire no later than 10 years from the date of grant and vest in equal installments on the first, second and third anniversaries from the date of grant. Stock options granted to date under the 1990 Plan, the 1995 Plan and the 1999 Plan have been at an exercise price equal to the fair market value of the stock at the date of grant. In July 1996, the Company approved the Outside Directors 1996 Formula Stock Option Plan (the "Formula Plan"). Under the terms of the Formula Plan, the Company may issue up to an aggregate of 125,000 nonqualified stock options to directors who are not employees or officers of the Company (the "Outside Directors"). On the date the Formula Plan was adopted, each Outside Director received a grant of stock options to purchase 5,000 shares of Common Stock. Commencing January 2, 1997, and each January 2nd thereafter, each Outside Director then serving on the Board shall receive a grant of stock options to purchase 5,000 shares of Common Stock. Options granted under the Formula Plan are at an exercise price equal to the fair market value of the stock at the date of grant, vest six months from the date of grant and expire 10 years from the date of grant. In July 1996, the Company approved the Senior Executives 1996 Stock Option Plan (the "Senior Executives Plan"). Under the terms of the Senior Executives Plan, the Company may issue up to an aggregate of 700,000 nonqualified stock options to Mr. Ratican and Mr. Froelich (the "Senior Executives" and individually the "Senior Executive"). On the date the Senior Executives Plan was adopted, each Senior Executive received a grant of stock options to purchase 70,000 shares of Common Stock. Commencing January 1, 1997, and each January 1st thereafter through and including January 1, 2000, each Senior Executive then employed by the Company shall receive a grant of stock options to purchase 70,000 shares of Common Stock. Mr. Froelich's continuing participation in the Senior Executives Plan ceased when his employment with the Company was terminated in December 1997. Mr. Ratican's continuing participation in the Senior Executives Plan ceased when his employment with the Company terminated effective June 30, 1999. Options granted under the Senior Executives Plan are at an exercise price equal to the fair market value of the stock at the date of grant, vest immediately and expire 10 years from the date of grant. A summary of the Company's stock option activity, and related information for the years ended December 31 follows: The following table summarizes information about stock options outstanding at December 31, 1999: The Company has elected to follow APB Opinion No. 25 and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123 requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB Opinion No. 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Pro forma information regarding net income (loss) and earnings (loss) per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1999, 1998 and 1997, respectively: volatility factors of the expected market price of the Company's common stock of .53, .49, and .43; a weighted-average expected life of the options of 5.0 years; risk-free interest rates of 5.7%, 5.2%, and 6.0% and dividend yield of 0%. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. Pro forma disclosures required by SFAS No. 123 include the effects of all stock option awards granted by the Company from January 1, 1995 through December 31, 1999. During the initial phase-in period, the effects of applying this Statement for generating pro forma disclosures are not likely to be representative of the effects on pro forma net income for future years, for example, because options may vest over several years and additional awards generally are made each year. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information is as follows for the years ended December 31 (in thousands except for earnings per share information): 1999 1998 1997 -------- -------- -------- Pro forma net loss $(13,996) $(29,046) $(28,047) Pro forma loss per common share: Basic $ (.78) $ (1.62) $ (1.57) Diluted $ (.78) $ (1.62) $ (1.57) Restricted Stock On February 27, 1995 the Board approved Restricted Stock Grant Agreements awarding 65,000 shares of Restricted Stock each to Mr. Ratican and Mr. Froelich (individually the "Executive"). Mr. Froelich's Restricted Stock vested upon the termination of his employment with the Company on December 11, 1997. Mr. Ratican's Restricted Stock vested on February 27, 1998 upon the expiration of the three-year vesting period. The Company has measured the total compensation cost of the Restricted Stock awards as the excess of the quoted market price of similar but unrestricted shares of stock at the award date, subject to certain adjustments, over the purchase price, if any, of the Restricted Stock. The quoted market price of shares of the Company's Common Stock at the date of grant was $16.125, and the Restricted Stock was awarded to the Executives at no cost. The total compensation cost of the Restricted Stock grants recognized through December 31, 1998 was $1,764,000. NOTE 6 - NOTES RECEIVABLE FROM SHAREHOLDERS On February 18, 1997 the Company entered into recourse loan agreements with Peter J. Ratican and Eugene L. Froelich the Chief Executive Officer and Chief Financial Officer of the Company, respectively (collectively the "Executives" and individually the "Executive"), whereby the Company loaned to each Executive $2,229,028 in connection with the exercise of certain stock options granted to the Executives on February 25, 1992 (individually the "1997 Ratican Note" and the "1997 Froelich Note", respectively). The 1997 Ratican Note and the 1997 Froelich Note are evidenced by a secured Promissory Note which provides for interest compounding monthly at the one year London Interbank Offered Rate plus 50 basis points in effect from time to time and subject to certain adjustments in the event the Company enters into a transaction to borrow funds. The interest rate in effect as of February 18, 1997 and for all of 1997 was 6.25%, the interest rate in effect for 1998 was 6.44% and the interest rate in effect for 1999 was 5.60%. All principal and accrued interest is due at the maturity date of April 1, 2001 or upon an event of default; provided however, that if Executive shall sell any shares of the Company's Common Stock serving as security under the loan agreement, the Executive shall pay a pro rata share of the proceeds to the Company to be applied against any outstanding principal and accrued interest balances of such Executive as of such date. In connection with the Ratican Settlement Agreement (see Note 9), as of April 24, 1999, the 1997 Ratican Note and related loan documents were amended extending the term from April 1, 2001 to June 30, 2003 (the Restated 1997 Ratican Note). The Restated 1997 Ratican Note provides that on the maturity date, in lieu of payment of the original principal balance and all accrued interest thereon (the "Maturity Balance"), Ratican may fully satisfy his obligations under the Restated 1997 Ratican Note through the payment to the Company for payment to the applicable state and Federal tax authorities the applicable minimum state and federal withholding amounts and FICA taxes due from Mr.Ratican resulting from the reduction of the Maturity Balance to zero. The principal and accrued interest of notes receivable from shareholders at December 31, 1999 and 1998 has been reflected as a reduction of shareholders' equity. NOTE 7 - INCOME TAXES The benefit for income taxes for the year ended December 31 consisted of the following: 1999 1998 1997 (Amounts in thousands) ------- ------- ------- Current: Federal...................... $ $ (12) State........................ 55 $ 106 73 ------- ------- ------- 55 106 61 ------- ------- ------- Deferred: Federal...................... State........................ (55) (106 (61) ------- ------- ------- (55) (106) (61) ------- ------- ------- Benefit for income taxes....... $ -- $ -- $ -- ======= ======= ======= The federal and state deferred tax liabilities (assets) are comprised of the following at December 31: 1999 1998 (Amounts in thousands) --------- --------- Current deferred tax assets: Loss carryforwards............... $ $(5,082) ======== ========= Non-current deferred tax assets: Loss carryforwards............... $(137,638) $(110,496) Depreciation..................... (1,319) (1,528) Other............................ (5,249) (4,504) --------- --------- Gross deferred tax assets........ (144,206) (116,528) --------- --------- Deferred tax assets valuation allowance............ 125,984 103,443 --------- --------- Deferred tax assets.............. $ (18,222) $ (13,085) ========= ========= The differences between the benefit for income taxes at the federal statutory rate of 34% and that shown in the Consolidated Statements of Operations are summarized as follows for the years ended December 31: 1999 1998 1997 (Amounts in thousands) ------- ------- ------- Tax provision (benefit) at statutory rate................. $(4,170) $(9,362) $(8,528) State income taxes.................. 55 106 73 Exercise of nonqualified stock options........................... (1,755) Anticipation of future benefit of NOLs.............................. (55) (106) (61) Limitation on current-year tax benefit due to unrealized NOL carryforwards..................... 4,170 9,362 10,271 ------- ------- ------- Benefit for income taxes............ $ -- $ -- $ -- ======= ======= ======= The Company's net operating loss (NOL) carryforwards increased due to a $7.0 million NOL for tax purposes incurred in 1999. At December 31, 1999, the Company had NOL carryforwards for federal tax purposes expiring as follows (amounts are in millions): Year of Expiration NOL 2003 $ 166.2 2004 92.7 2005 9.3 2006 2.5 2007 1.5 2012 35.9 2018 92.4 2019 7.0 ------- Total NOL carryforwards $ 407.5 ======= On December 5, 1990 (the "Effective Date") the Company emerged from protection under Chapter 11 pursuant to the Company's joint plan of reorganization, as modified (the "Reorganization Plan"). Upon the Effective Date of the Reorganization Plan, the Company experienced a "change of ownership" pursuant to applicable provisions of the Internal Revenue Code (the "IRC"). As a result of the ownership change, the Company's pre-change NOL carryforwards of approximately $325 million are subject to limitation under provisions of Section 382 of the IRC. From the Effective Date through December 31, 1995 the Company has recognized for financial statement reporting purposes an annual limitation for its NOLs of approximately $6.3 million per year. In 1996, the Company determined its annual limitation for its pre-change NOLs is $9.2 million per year or an aggregate amount of $139 million over the carryover period. The Company also determined during 1996 that $182 million of additional limitation is available for income tax return purposes under other provisions of Section 382 of the IRC. Accordingly, the Company believes approximately $321 million of the total pre-change NOLs of $325 million will be available for utilization for federal income tax return purposes over the carryover period. In the event the current limitation amount is not fully utilized, the Company is allowed to carryover such amount to subsequent years during the carryover period. From December 5, 1990 through December 31, 1999 the Company has utilized approximately $55 million of the pre-change NOLs for federal income tax return purposes and has recognized approximately $105 million of pre-change NOLs for financial statement reporting purposes. The Company is unable to quantify to what extent, if any, the Company may be able to fully utilize its remaining pre-change NOLs prior to their expiration. Should the Company experience a second "change of ownership", the limitation under Section 382 of the IRC on NOLs would be recalculated. SFAS No. 109 "Accounting for Income Taxes" requires that the tax benefit of such NOLs be recorded as an asset to the extent that management assesses the utilization of such NOLs to be more likely than not. Management has estimated, based on the Company's recent history of operating results and its expectations for the future and available tax planning strategies, that future taxable income of the Company will more likely than not be sufficient to utilize a minimum of approximately $45 million of NOLs. Accordingly, the Company has recognized an aggregate deferred tax asset of $18.2 million as of December 31, 1999 related to anticipated future utilization of NOLs. NOTE 8 - EMPLOYEE BENEFIT PLANS The Company adopted the Maxicare Health Plans, Inc. Savings Incentive Plan (the "Savings Plan") in January 1985. The Savings Plan is a defined contribution 401(k) profit sharing plan covering employees of the Company who have satisfied the eligibility requirements. The primary eligibility requirement is that an employee must have completed one year of eligible service. The cost of the Savings Plan is shared by the participants and the Company. Eligible employees may defer from 1% to 15% of base compensation on a before-tax basis in accordance with Section 401(k) of the IRC. The Savings Plan calls for the Company to match up to 3% of total compensation, not to exceed the employee's contribution. The Company's contributions were approximately $380,000, $390,000 and $400,000 for the years ended December 31, 1999, 1998 and 1997, respectively. Effective January 1, 1997 the Company adopted the Maxicare Health Plans, Inc. Supplemental Executive Retirement Plan (the "SERP") which covers key executives as selected by the Board. Benefits are based on years of service and average compensation in the last three years of employment. Compensation expense recognized in connection with the SERP was $282,000 $284,000 and $984,000 for the years ended December 31, 1999, 1998 and 1997. Of the compensation expense recognized in 1999, $500,000 related to the immediate recognition of the discounted present value of vested retirement benefits for the Company's former Chief Executive Officer which was included in the management settlement charge recorded in 1999 (see Note 9). Of the compensation expense recognized in 1997, $700,000 related to the immediate recognition of the discounted present value of vested retirement benefits for the Company's former Chief Financial Officer and an additional former executive which was included in the management settlement charge recorded in 1997 (see Note 9). NOTE 9 - LOSS CONTRACTS, DIVESTITURE COSTS, LITIGATION, MANAGEMENT SETTLEMENT AND OTHER CHARGES In the first quarter of 1999, the Company incurred charges of $3.0 million for loss contracts associated with the Company's commercial healthcare operations in North and South Carolina. The Company has ceased offering commercial health care coverage in the Carolinas health plans as of March 31, 1999. In addition, the Company recorded in the first quarter of 1999 a $5.5 million management settlement charge related to a settlement with the Company's Chief Executive Officer, Peter J. Ratican pursuant to which Mr. Ratican agreed to retire as President and CEO of the Company and agreed not to seek re-election to the Board of Directors. The charge primarily relates to an allowance for the forgiveness of approximately $2.7 million of notes receivable, including accrued interest, due the Company from Mr. Ratican and the accrual of other settlement costs related to a consulting agreement and other benefits. Under the settlement agreement, a promissory note from Mr. Ratican to the Company in the principal amount of $2.2 million and accrued interest thereon will be forgiven on June 30, 2003 upon certain conditions being satisfied. The Company has made the determination that it is probable these conditions will be satisfied and the note forgiven; accordingly, the Company has recorded the charge associated with the forgiveness of the note receivable in the current period. In December 1997, the Company began a restructuring of the Company's operations and businesses with a view towards enhancing and focusing on the Company's operations in California and Indiana which have generated substantially all of the membership growth in recent years. As a result of assessing various strategic alternatives, the Company concluded that the divestiture of the Company's operations in Illinois, the Carolinas and Wisconsin through either a sale or closure of these operations was in its best interest as the Company was unable to predict a return to profitability for these health plans in a reasonable time frame. Accordingly, the Company recorded in the second quarter of 1998 a $10.0 million charge for anticipated continuing losses primarily related to contracts in Illinois and the Carolinas for which the anticipated future health care costs and associated maintenance costs exceed the related premiums, and certain other costs associated with the divestiture of these health plans. In the fourth quarter of 1998 the Company recorded a $6.5 million charge composed of 1) a $2.5 million increase to the reserve for loss contracts and divestiture costs related to the divestiture of the Carolina's commercial line of business extending beyond December 1998 through March 1999 and higher than anticipated costs in the non-continuing health plans, 2) a $2.0 million charge for litigation substantially related to the Company's former Illinois health plan and 3) a $2.0 million charge for provider insolvency/impairment related to certain of the Company's capitated provider arrangements. For the year ended December 31, 1998, the Company applied against the $12.5 million reserve for loss contracts and divestiture costs approximately $8.3 million of health care costs and $3.7 million of associated maintenance and divestiture costs which exceeded the related premiums. On September 30, 1998, the Company completed the sale of its Wisconsin health plan which had approximately 4,700 commercial members and approximately 10,200 Medicaid members. On October 16, 1998, the Company completed the sale of its Illinois health plan which had approximately 22,600 commercial members. In addition, on September 30, 1998, the Company announced it would cease offering in North and South Carolina, all commercial health care lines of business, including its commercial health maintenance organization, preferred provider organization and point of service product lines. The Company's Carolinas health plans did not provide commercial health care coverage beyond March 1999. In the fourth quarter of 1997 the Company recorded a $3.0 million management settlement charge for termination expenses primarily related to the settlement of certain obligations pursuant to the employment agreement of Eugene L. Froelich, the Company's former Chief Financial Officer. In March 1997 the Company received a ruling from the Commonwealth of Pennsylvania Board of Claims (the "Claims Board") denying the Company any recovery on its claims against the Pennsylvania Department of Public Welfare (the "DPW") in connection with the operation of a Medicaid managed care program from 1986 through 1989 by Penn Health Corporation, a subsidiary of the Company. Accordingly, the Company recorded in the first quarter of 1997 a $6.0 million non-cash litigation charge to fully reserve for the recorded estimate of $5.0 million due the Company from the DPW and related litigation costs. On April 24, 1997, the Company filed an appeal with the Commonwealth of Pennsylvania Commonwealth Court seeking to overturn the Claims Board's order and to award the Company damages. DPW filed a cross-appeal, appealing the portion of the Claims Board's order imposing liability upon the DPW for breach of contract. In addition, the Company pursued claims against certain providers who participated in the Medicaid programs for breach of the Company's Reorganization Plan in the United States Bankruptcy Court in California. The Company has reached a settlement with the DPW regarding the Company's claims against the DPW (the "DPW Settlement"). A settlement was also reached by the Company of the Company's claims in the Bankruptcy Court against certain providers (the "Provider Settlement"). The DPW Settlement and the Provider Settlement (collectively, the "Global Settlement") provide for the dismissal of the pending litigation against the settling parties and for DPW's payment to the Company of $4.7 million (including approximately $300,000 held in escrow for the Company's benefit), plus accrued interest thereon. On March 26, 1999, the United States Bankruptcy Court approved the Global Settlement and the Company's agreement with the Creditors' Committee to pay $400,000 to the Penn Health bankruptcy estate for distribution to creditors pursuant to the Reorganization Plan. Pursuant to the DPW Settlement, the $300,000 held in escrow was released to the Company and payment of an additional $4.5 million (inclusive of accrued interest) was made to the Company in early May 1999. From these settlement funds the Company funded $400,000 to the Penn Health bankruptcy estate resulting in the recognition of $4.1 million in other income recorded in the first quarter of 1999. Quarterly Results of Operations (Unaudited) The following is a tabulation of the quarterly results of operations for the years ended December 31, 1999 and 1998: Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures None. PART III Item 10. Item 10. Directors, Executive Officers, Promoters and Control Persons of the Registrant The information set forth in the table, the notes thereto and the paragraphs thereunder, in Part I, Item 1. of this Form 10-K under the caption "Directors and Executive Officers of the Registrant" is incorporated herein by reference. Compliance with Section 16(A) of the Securities Exchange Act of 1934 Based upon its review of such reports received by it and written representations of reporting persons, the Company believes that, its executive officers and directors filed all required reports on a timely basis. Item 11. Item 11. Executive Compensation Shown below is information concerning the annual and long-term compensation for services in all capacities to the Company for the years ended December 31, 1999, 1998 and 1997, of those persons who were, at December 31, 1999 (i) the chief executive officer, (ii) the other four most highly compensated executive officers of the Company or (iii) would have been among the four most highly compensated executive officers of the Company had they held such title at December 31, 1999 (collectively the "Named Officers"): (1) This bonus was payable pursuant to the Reorganization Plan and was paid from funds held by the Disbursing Agent in a segregated account and were not paid out of the Company's available cash. (2) This amount was paid pursuant to Mr. Link's employment agreement. (3) These amounts represent contributions made by the Company on behalf of the Named Officer under the Company's 401(k) Savings Incentive Plan. (4) In connection with Mr. Dupee's appointment as Chief Executive Officer and the services to be performed thereunder, the Company agreed to the payment of Mr. Dupee's reasonable business expenses including his living expenses in Los Angeles which approximated $169,000 in 1999. (5) Mr. Link served as Senior Vice President - Accounting and Chief Accounting Officer until December 11, 1997 when he was named Executive Vice President - Finance and Administration and Chief Financial Officer. In August 1999 Mr. Link was given the additional position of Chief Operating Officer. (6) Mr. Ratican resigned his position as Chairman of the Board of Directors, President and Chief Executive Officer of the Company effective June 30, 1999. On that date he also resigned as a director of the Company. (7) Ms. Perry resigned her position with the Company effective November 1999. Option Grants Shown below is further information on grants of stock options pursuant to the Senior Executives Plan, the 1990 Plan, the 1995 Plan and the 1999 Plan during the year ended December 31, 1999, to the Named Officers which are reflected in the Summary Compensation Table. (1) The option exercise price is subject to adjustment in the event of a stock split or dividend, recapitalization or certain other events. (2) The actual value, if any, the Named Officer may realize will depend on the excess of the stock price over the exercise price on the date the option is exercised, so that there is no assurance the value realized by the Named Officer will be at or near the value estimated. This amount is net of the option exercise price. (3) Options were automatically granted under the Senior Executives Plan as of January 1, 1999 and vest upon date of grant. Option Exercises and Fiscal Year-End Values No stock options were exercised by Named Officers in 1999. Shown below is information with respect to the unexercised options to purchase the Company's Common Stock granted in fiscal 1999 and prior years under employment agreements, the 1990 Plan, the 1995 Plan, the 1999 Plan and the Senior Executives Plan to the Named Officers and held by them at December 31, 1999. (1) Based on the closing price on the NASDAQ-NMS on that date ($2.875), net of the option exercise price. Ratican Employment Agreements The Company entered into a new five-year employment agreement with Peter J. Ratican (the "Executive") as of April 1, 1996, and as amended on February 11, 1997 (the "Ratican Employment Agreement"). The Ratican Employment Agreement superseded a five-year employment agreement entered into with Executive as of January 1, 1992, and as amended on February 27, 1995. The Ratican Employment Agreement provided for an annual base compensation of $500,000 for Executive, subject to increases and bonuses, as may be determined by the Board based on annual reviews. The Ratican Employment Agreement provided that upon the termination of Executive by (i) the Company for reasons other than death, incapacity, or "Cause" or (ii) voluntary termination for "Good Reason" ((i) and (ii) collectively defined as "Without Cause"), Executive would be entitled to receive (a) a payment equal to the balance of the Executive's annual base salary which would have been paid over the remainder of the term of the Ratican Employment Agreement; (b) an additional one year's annual base salary; (c) payment of any performance bonus amounts which would have otherwise been payable over the remainder of the term of the Ratican Employment Agreement; (d) immediate vesting of all stock options; and (e) the continuation of the right to participate in any profit sharing, bonus, stock option, pension, life, health and accident insurance, or other employee benefit plans including a car allowance through March 31, 2001. "Cause" was defined as: (i) the willful or habitual failure to perform requested duties commensurate with his employment without good cause; (ii) the willful engaging in misconduct or inaction materially injurious to the Company; or (iii) the conviction of a felony or of a crime involving moral turpitude, dishonesty or theft. "Good Reason" was defined as the voluntary termination by Executive, as a result of the occurrence, without Executive's express written consent, of a substantial, material and adverse change in conditions of employment imposed by the Company; including but not limited to: (a) the assignment by the Company of any duties materially inconsistent with, or the diminution of, Executive's positions, titles, offices, duties and responsibilities with the Company, or any removal or any failure to re-elect Executive to, any titles, offices or positions held by Executive hereunder, including membership on the Board; or (b) a reduction by the Company in Executive's base salary or any other compensation or benefit provided for herein; provided, however, that the occurrence of any of the foregoing would not constitute "Good Reason" to the extent that such occurrence is part of a change in benefits, compensation, policies or practices that affect substantially all of the employees of the Company; or (c) a change or relocation of Executive's place of employment, without his written consent, other than within thirty (30) miles of such location; or (d) the failure of the Company to obtain the explicit assumption in writing of its obligation under the Ratican Employment Agreement by any successor entity. In the event of a "Change of Control" of the Company, Executive was entitled to elect to terminate the Ratican Employment Agreement within 120 days after such "Change of Control" (the "Change of Control Period") in which case the Executive would have been entitled to receive a payment equal to 2.99 times Executive's average annualized compensation from all sources from and relating to the Company, which was includable in Executive's gross income (including the value of unexercised options) for the most recent five taxable years ending with and including the calendar year in which the "Change of Control" occurs, (the "Change of Control Payment"). Under the Ratican Employment Agreement, a "Change of Control" was defined as: (i) any transaction or occurrence which results in the Company ceasing to be publicly owned with at least 300 stockholders; (ii) any person or group becoming beneficial owner of more than 40% of the combined voting power of the Company's outstanding securities; (iii) "Continuing Directors", defined as directors as of April 1, 1996 or any subsequent director nominated by a vote of a majority of the Continuing Directors then in office, ceasing to be a majority of the Board; (iv) the merger or consolidation of the Company with or into any other non-affiliated entity whereby the Company's equity security holders, immediately prior to such transaction, own less than 60% of the equity; or (v) the sale or transfer of all or substantially all of the Company's assets. In the event of death or incapacity prior to June 30, 1999, the Executive or his estate shall receive the equivalent of 90 days base salary and, in the case of incapacity, the continuation of health and disability benefits. The Ratican Employment Agreement also provided that in the event Executive did not receive an offer for a new employment agreement containing terms at least as favorable as those contained in the existing Ratican Employment Agreement before the expiration of such Ratican Employment Agreement, Executive would have been entitled to receive a payment equal to one year's base salary under the terminating agreement. Under the Ratican Employment Agreement, Executive was entitled to receive an annual performance bonus, which is based on the Company's annual pre-tax earnings, before extraordinary items, over $10 million (the "Performance Bonus"). The Performance Bonus could not exceed $2,000,000 for any year and was to be in an amount equal to 2% of the pre-tax earnings in excess of $10 million, 2 1/2% of pre-tax earnings in excess of $15 million and 3% of pre-tax earnings in excess of $20 million. In addition, upon the sale of the Company, a sale of substantially all of its assets or a merger where the Company shareholders cease to own a majority of the outstanding voting capital stock (a "Sale"), Executive would have been entitled to a sale bonus which is based on a percentage of the excess sale value of the Company over an initial value of $147 million in an amount equal to 1% of the sale value in excess of $147 million, 1 1/2% of the sale value in excess of $197 million, 2% of the sale value in excess of $247 million and 2 1/2% of the sale value in excess of $347 million (the "Sale Bonus"). Executive would have been entitled to a Sale Bonus if a Sale occurs during the term of the Ratican Employment Agreement or thereafter if a definitive agreement with respect to a Sale, which is consummated, is entered into within 90 days after the termination of the Ratican Employment Agreement Without Cause. Effective March 28, 1998, the Board approved an amendment to the Ratican Employment Agreement to clarify that the Change of Control Payment in the Ratican Employment Agreement would also be payable if Executive was terminated Without Cause, died or became disabled during the 120 day period within which he is able to voluntarily terminate the Ratican Employment Agreement after a Change of Control. This amendment did not affect the amount payable under the Ratican Employment Agreement in connection with a Change of Control Payment. The purpose of this amendment was to ensure that Executive would not feel that he would be required to terminate the Ratican Employment Agreement immediately upon a Change of Control for fear of losing his rights. The Ratican Employment Agreement was also amended at that time to revise the Sale Bonus provision to provide that after a Change of Control a Sale Bonus would be payable in the event a Sale occurs: (i) within one year if Executive terminates voluntarily or (ii) through the end of the Ratican Employment Agreement if it is terminated Without Cause. The amount of the Sale Bonus payable to Executive under the Ratican Employment Agreement was not amended. The purpose of this amendment was to reflect Executive's contribution to increasing the value of the Company during his tenure as Chief Executive Officer and President by extending the time period in which the Sale Bonus was to be payable to Executive. In addition, Executive would be entitled to a Sale Bonus if after a Change of Control a definitive agreement with respect to a Sale, which is consummated, was entered into (a) within one year if Executive elects to terminate the Ratican Employment Agreement as a result of the Change of Control or the Ratican Employment Agreement terminates during the Change of Control Period as a result of Executive's death or incapacity or (b) on or before March 31, 2001 if the Ratican Employment Agreement is terminated Without Cause after a Change of Control. If any payment under the Ratican Employment Agreement, either alone or together with other amounts which Executive has the right to receive from the Company, (the "Affected Payment") would have constituted an "excess parachute payment" (as defined in the Internal Revenue Code), then Executive would have been entitled to receive an additional cash payment (the "Additional Payment") which, when added to the Affected Payment provides a net benefit to the Executive, after payment of the excise tax imposed by Section 4999 of the Internal Revenue Code and penalties and interest thereon, and payment of any federal, state and local income taxes and penalties and interest thereon attributable to such Additional Payment, equal to the Affected Payment before such Additional Payment. In connection with its approval of the Settlement Agreement with Mr. Dupee and certain other shareholders in May 1998, the Board on May 8, 1998 amended the Ratican Employment Agreement and the 1997 Link Employment Agreement, discussed below, to clarify that although the New Directors were elected to the Board by a majority of the "Continuing Directors" as such term is defined in such employment agreements, they would not be considered "Continuing Directors" for the purposes of determining whether a "Change of Control" had occurred under such employment agreements. As a result of the 1998 Amendment to the Ratican Employment Agreement, the election of a shareholder slate at the Annual Meeting which did not contain two Board nominees would trigger the "Change of Control" provisions to the Ratican Employment Agreement. Ratican Settlement and Consulting Agreements On April 16, 1999, the Company and Peter J. Ratican ("Ratican"), entered into a Settlement Agreement dated April 16, 1999 (the "Ratican Settlement Agreement") pursuant to which Ratican agreed to resign as Chairman of the Board, CEO and President of the Company. In order to ensure an orderly transition, the Company and Ratican agreed that such resignations would become effective on June 30, 1999 (the "Termination Date"). In addition, Ratican agreed not to stand for reelection to the Board when his term expired at the Annual Meeting. The Ratican Settlement Agreement, which was negotiated between Ratican and representatives of the Board over a two month period, outlines the terms of the agreements between Ratican and the Company, including the amendment to Ratican's Employment Agreement and certain other existing agreements and the terms of a new consulting agreement (the "Related Agreements"). The Ratican Settlement Agreement also provided that Ratican and the Company exchange releases. On April 24, 1999 (the "Effective Date") the Ratican Settlement Agreement and each of the Related Agreements became effective. In connection with the Ratican Settlement Agreement, Ratican and the Company entered into Amendment No. 4 ("Amendment No. 4") dated April 16, 1999 to the Ratican Employment Agreement, which became effective as of the Effective Date, pursuant to which Ratican and the Company agreed; (i) to shorten the termination date of the Ratican Employment Agreement from April 1, 2001 to the Termination Date; (ii) that Ratican would no longer be entitled to future or potential Performance Bonuses, Sale Bonuses, severance pay upon the expiration of the term of the Ratican Employment Agreement, or stock option grants under the terms of the Ratican Employment Agreement; (iii) that during the period from the Effective Date through the Termination Date, Ratican's powers and duties would be limited to those powers and duties designated by the Executive Committee of the Board (the "Executive Committee"); and (iv) the termination of Ratican's employment pursuant to Amendment No. 4 on the Termination Date and the election of the New Directors at the Annual Meeting would not trigger any Change of Control Payment to Ratican. Pursuant to the Ratican Settlement Agreement, Ratican and the Company have entered into a four year non-exclusive consulting agreement commencing July 1, 1999 (the "Commencement Date") at an annual consulting fee of $500,000 (the "Consulting Fee") and the provision by the Company to Ratican of certain health and other benefits comparable to those currently being received by Ratican under the Ratican Employment Agreement (the "Ratican Consulting Agreement"). The Ratican Consulting Agreement provides that Ratican's consulting services shall not interfere with his other business activities and he will be free to engage in such other business activities as he desires; provided, however, he shall be prohibited from rendering services to an HMO competitor of the Company in California, Indiana or Louisiana during the first year of the Ratican Consulting Agreement. After the Commencement Date, the Ratican Consulting Agreement may be terminated voluntarily by Ratican or for "Cause", as defined in the Consulting Agreement, by the Company in which case no further payments would be due Ratican thereunder. In the event of a termination of the Consulting Agreement after the Commencement Date as a result of Ratican's death or incapacity, Ratican or his estate would receive the Consulting Fee due for the remainder of the four year term. The Ratican Consulting Agreement provides for indemnification by the Company to Ratican under appropriate circumstances and the advancement of legal fees and expenses for indemnification actions and in the event of a dispute thereunder subject to certain requirements. If the Company, after notice and time to cure, fails to pay the Ratican Consulting Fee and is determined to be in breach of the Ratican Consulting Agreement (a "Company Default"), (i) Ratican may terminate the Ratican Consulting Agreement, declare the remaining balance due thereunder immediately payable and receive the discounted value thereof; (ii) the Amended Note (as defined below) will become non-recourse; and (iii) Ratican will continue to accrue benefits under the SERP (as defined below) through June 30, 2003. In connection with the Ratican Settlement Agreement, as of the Effective Date adjustments were also made to Ratican's outstanding option agreements. Ratican's Senior Executive Stock Option Agreement (the "1996 Option Agreement") with respect to options granted under the 1996 Senior Executives Option Plan (the "1996 Option Plan") was amended so that: (i) the term of the options granted thereunder (the "1996 Plan Options") was shortened to January 1, 2005 (the "Option Term"); (ii) the exercise price of the options granted on July 26, 1996, January 1, 1997 and January 1, 1998 was reduced from $14.75, $22.25 and 10.88, respectively, to $7.2875 or $1.875 over the average closing trading price of the Company's common stock for April 19, 1999 through April 23, 1999 or $5.412 per share and (iii) the 1996 Plan Options would remain exercisable through the Option Term, notwithstanding the termination of Ratican's employment with the Company or the termination of the Ratican Consulting Agreement. In addition, as of the Effective Date, the Company and Ratican entered into Amendment No. 2 dated April 16, 1999 to the 1989 Option Agreement pursuant to which the 1989 Option Agreement was amended to extend Ratican's ability to exercise the options granted thereunder (the "1989 Options") until December 5, 2000 (the original option term of the 1989 Options under the 1989 Option Agreement), notwithstanding the termination of Ratican's employment with the Company on the Termination Date. In connection with the Ratican Settlement Agreement, as of the Effective Date, the terms of the SERP and Ratican's promissory note to the Company dated February 17, 1997 were also amended, see "Supplemental Executive Retirement Plan" below and "Item 13.

1095651_1999.txt

1095651_1999

1999

1095651

ITEM 1. BUSINESS EXPLANATORY NOTE FOR PURPOSES OF THE "SAFE HARBOR PROVISIONS" OF SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED Except for historical information contained herein, this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Forward-looking statements are included with respect to, among other things, the Company's current business plan, business strategy and portfolio management. The Company's actual results or outcomes may differ materially from those anticipated. Important factors that the Company believes might cause such differences are discussed in the cautionary statements presented under the caption "Factors That May Affect the Company's Business Strategy" in Item 1 of this Form 10-K or otherwise accompany the forward-looking statements contained in this Form 10-K. In assessing forward-looking statements contained herein, readers are urged to read carefully all cautionary statements contained in this Form 10-K. OVERVIEW Starwood Financial Inc. (the "Company") is the leading publicly traded finance company focused on the commercial real estate industry. The Company, which is taxed as a real estate investment trust, provides structured mortgage, mezzanine and lease financing through its origination, acquisition and servicing platform. The Company's mission is to maximize risk-adjusted returns on equity by providing innovative and value-added financing solutions to private and corporate owners of commercial properties in major metropolitan markets nationwide. The Company's primary product lines include: - STRUCTURED FINANCE. The Company provides senior and subordinated loans from $20 million to $100 million to borrowers controlling institutional quality real estate. These loans may be either fixed or floating rate and are structured to meet the specific financing needs of the borrowers, including the acquisition, financing, repositioning or construction of large, high-quality real estate. The Company offers borrowers a wide range of structured finance options, including first mortgages, second mortgages, partnership secured loans, participating debt and interim/bridge facilities. - PORTFOLIO FINANCE. The Company provides funding to regional and national borrowers who own multiple properties in a geographically diverse portfolio. Loans are cross-collateralized to give borrowers the benefit of all available collateral and underwritten to recognize inherent portfolio diversification. Property types include multifamily, suburban office, all-suite, extended stay and limited service hotels and other property types where individual property values are less than $20 million on average. Loan terms are structured to meet the specific requirements of the borrower and range in size from $25 million to $150 million. - CORPORATE LENDING. The Company provides senior and subordinated debt capital to corporations engaged in real estate or real estate-related businesses. Loans may be either secured or unsecured and range in size from $20 million to $100 million. - LOAN ACQUISITION. The Company acquires whole loans and loan participations which present attractive risk-reward opportunities. Loans are generally acquired at a discount to the principal balance outstanding and may be acquired with financing provided by the seller. Loan acquisitions range from $5 million to $100 million and are collateralized by all major property types. - CREDIT TENANT LEASING. The Company provides capital to owners and borrowers who control properties leased to single creditworthy tenants. The Company's net leased facilities are generally subject to long-term leases with rated corporate credit tenants, and provide for all expenses at the property to be paid by the tenant on a triple net lease basis. Credit tenant transactions range in size from $20 million to $200 million. - SERVICING. Through its Starwood Asset Services division, the Company provides rated servicing to third-party, institutional loan portfolios, as well as to the Company's own portfolio. As more fully discussed in Note 4 to the Company's Consolidated Financial Statements, the Company began its business in 1993 through private investment funds formed to capitalize on inefficiencies in the real estate finance market. In March 1998, these funds contributed their approximately $1.1 billion of assets to the Company's predecessor, Starwood Financial Trust, in exchange for a controlling interest in that company. Since that time, the Company has grown by originating new lending and leasing transactions, as well as through corporate acquisitions. Specifically, in September 1998, the Company acquired the loan origination and servicing business of a major insurance company, and in December 1998, the Company acquired the mortgage and mezzanine loan portfolio of its largest private competitor. Additionally, in November 1999, the Company acquired TriNet Corporate Realty Trust, Inc., the largest publicly traded company specializing in the net leasing of corporate office and industrial facilities. The TriNet transaction was structured as a stock-for-stock merger of TriNet with a subsidiary of the Company. We refer to TriNet throughout this document as the "Leasing Subsidiary." Concurrent with the TriNet transaction, the Company also acquired its external advisor in exchange for shares of Common Stock and converted its organizational form to a Maryland corporation. As part of the conversion to a Maryland corporation, the Company replaced its dual class common share structure with a single class of Common Stock. The Company's Common Stock began trading on the New York Stock Exchange on November 4, 1999. Prior to this date, the Company's common shares were traded on the American Stock Exchange. INVESTMENT STRATEGY The Company's investment strategy targets specific sectors of the real estate credit markets in which it believes it can deliver value-added, flexible financial solutions to its customers, thereby differentiating its financial products from those offered by other capital providers. The Company has implemented its investment strategy by: - Focusing on the origination of large, highly structured mortgage, mezzanine and lease financings where customers require flexible financial solutions, and avoiding commodity businesses in which there is significant direct competition from other providers of capital. - Developing direct relationships with borrowers and corporate tenants as opposed to sourcing transactions through intermediaries. - Adding value beyond simply providing capital by offering borrowers and corporate tenants specific lending expertise, flexibility, speed, certainty and continuing relationships beyond the closing of a particular financing transaction. - Taking advantage of market anomalies in the real estate financing markets when the Company believes credit is mispriced by other providers of capital, such as the spread between lease yields and the yields on corporate tenants' underlying credit obligations. The Company intends to continue to emphasize a mix of portfolio financing transactions to create asset diversification and single-asset financings for properties with strong, long-term positioning. The Company's credit process will continue to focus on: - Building diversification by asset type, property type, obligor, loan/lease maturity and geography. - Financing high-quality commercial real estate assets in major metropolitan markets. - Underwriting assets using conservative assumptions regarding collateral value and future property performance. - Requiring adequate cash flow coverage on its investments. - Stress testing potential investments for adverse economic and real estate market conditions. In June 1999, the Company announced its intention to dispose of approximately $200 million of non-core properties held at the Leasing Subsidiary which generally have short-term lease rollover risk or other characteristics inconsistent with the Company's structured finance focus. Since that time, the Leasing Subsidiary has sold or entered into agreements to sell $146.8 million of assets. As of December 31, 1999, based on current carrying values, the Company's business consists of the following product lines: PRODUCT LINE: EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC The Company seeks to maintain an investment portfolio which is diversified by asset type, underlying property type and geography. As of December 31, 1999, based on current carrying values, the Company's total investment portfolio has the following characteristics: EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC FINANCING STRATEGY The Company has access to a wide range of debt and equity capital resources to finance its investment and growth strategies. At December 31, 1999, the Company had approximately $1.8 billion of tangible book equity capital and a total market capitalization of approximately $4 billion. The Company believes that its size, diversification, investor sponsorship and track record are competitive advantages in obtaining attractive financing for its businesses. The Company seeks to maximize risk-adjusted returns on equity and financial flexibility by opportunistically accessing a variety of public and private debt and equity capital sources, including: - A match-funded, securitized debt program now in process. - A combined $1.5 billion available under its revolving credit facilities (both secured and unsecured). - Long-term, unsecured corporate debt. - Public and private common and preferred equity. The Company's business model is premised on significantly lower leverage than many other commercial finance companies. In this regard, the Company seeks to: - Target a maximum consolidated debt/book equity ratio of 1.5x to 2.0x. - Maintain a minimum tangible equity base of $1.5 to $2.0 billion. - Maintain conservative credit statistics. - Match fund assets and liabilities. A more detailed discussion of the Company's current capital resources is provided in Item 7 - -"Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources". BUSINESS REAL ESTATE LENDING: The Company provides structured mortgage, mezzanine and corporate financing to leading commercial real estate owners through its origination and acquisition platform. Set forth below is information regarding the Company's primary real estate lending product lines as of December 31, 1999: As more fully discussed in Note 3 to the Company's Consolidated Financial Statements, the Company continually monitors borrower performance and completes a detailed loan-by-loan formal credit review on a quarterly basis. After having originated or acquired over $3 billion of lending transactions, neither the Company nor its private investment fund predecessors have experienced any actual losses on their loan investments. Further, based on current reviews of its portfolio, management is not aware of any factors relating to specific loans which indicate that such losses may be experienced in the forseeable future. While no losses are currently expected, the Company has considered it prudent to establish a policy of providing reserves for potential losses in the current portfolio which may result in the future. Accordingly, since the quarter ended June 30, 1998, management has reflected quarterly provisions for possible credit losses in its operating results. SUMMARY OF INTEREST CHARACTERISTICS As more fully discussed in Item 7 - -"Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources" as well as "--Interest Rate Risks", the Company utilizes certain interest rate risk management techniques, including both asset/liability matching and certain other hedging techniques, in order to mitigate the Company's exposure to interest rate risks. As of December 31, 1999, the Company's Lending Business portfolio has the following interest characteristics: SUMMARY OF PREPAYMENT TERMS The Company is exposed to risks of prepayment on its loan assets, and generally seeks to protect itself from such risk by structuring its loans with prepayment restrictions and/or penalties. As of December 31, 1999, the Companys Lending Business portfolio has the following prepayment term characteristics: SUMMARY OF LOAN MATURITIES As of December 31, 1999, the Company's Lending Business portfolio has the following maturity term characteristics: STRUCTURED FINANCE The Company provides custom-tailored senior and subordinated loans from $20 million to $100 million to borrowers controlling institutional quality real estate. These loans may be either fixed or floating rate and are structured to meet the specific financing needs of the borrowers, including financing related to the acquisition, refinancing, repositioning or construction of large, high-quality real estate. The Company offers borrowers a wide range of structured finance options, including first mortgages, second mortgages, partnership secured loans, participating debt and interim/bridge facilities. As of December 31, 1999, the Company's structured finance investments have the following characteristics: - ---------------------------------------- (1) Where Current Carrying Value is less than Initial Carrying Value, difference represents contractual amortization, partial prepayment of loan principal, or amortization of acquired premiums, discounts or deferred loan fees. (2) Estimated accounting yield represents the stated rate on the loan as adjusted for the amortization of loan fee revenue and any direct loan costs or acquisition premiums or discounts using the effective interest method over the term of the loan. Such estimate is not adjusted for the effects of expected early repayments of loans subject to prepayment penalties or the effects of possible additional contingent interest on loan participation features included under certain of the Company's loan investments. (3) Weighted average ratio of current loan carrying value to underlying collateral value using third-party collateral appraisal (where applicable) or the Company's internal valuation (where no appraisal available). PORTFOLIO FINANCE The Company provides funding to regional and national borrowers who own multiple properties in a geographically diverse portfolio. Loans are cross-collateralized to give borrowers the benefit of all available collateral and underwritten to recognize inherent diversification. Property types include multifamily, suburban office, all-suite, extended stay and limited service hotels and other property types where individual property values are less than $20 million on average. Loan terms are structured to meet the specific requirements of the borrower and range in size from $25 million to $150 million. As of December 31, 1999, the Company's portfolio finance investments have the following characteristics: - ---------------------------------------- (1) Where Current Carrying Value is less than Initial Carrying Value, difference represents contractual amortization, partial prepayment of loan principal, or amortization of acquired premiums, discounts or deferred loan fees. (2) Estimated accounting yield represents the stated rate on the loan as adjusted for the amortization of loan fee revenue and any direct loan costs or acquisition premiums or discounts using the effective interest method over the term of the loan. Such estimate is not adjusted for the effects of expected early repayments of loans subject to prepayment penalties or the effects of possible additional contingent interest on loan participation features included under certain of the Company's loan investments. (3) Weighted average ratio of current loan carrying value in underlying collateral value using third-party collateral appraisal (where applicable) or the Company's internal collateral valuation (where no appraisal available). CORPORATE LENDING The Company provides senior and subordinated debt capital to corporations engaged in real estate or real estate-related businesses. Loans may be either secured or unsecured and range in size from $20 million to $100 million. Corporate loans may be either cash flow-oriented or asset-based. As of December 31, 1999, the Company's corporate lending investments have the following characteristics: - ---------------------------------------- (1) Where Current Carrying Value is less than Initial Carrying Value, difference represents contractual amortization, partial prepayment of loan principal, or amortization of acquired premiums, discounts or deferred loan fees. (2) Estimated accounting yield represents the stated rate on the loan as adjusted for the amortization of loan fee revenue and any direct loan costs or acquisition premiums or discounts using the effective interest method over the term of the loan. Such estimate is not adjusted for the effects of expected early repayments of loans subject to prepayment penalties or the effects of possible additional contingent interest on loan participation features included under certain of the Company's loan investments. (3) Weighted average ratio of current loan carrying value to underlying collateral value using third-party collateral appraisal (where applicable) or the Company's internal collateral valuation (where no appraisal available). LOAN ACQUISITION The Company acquires whole loans and loan participations which may be performing, non-performing or sub-performing and which the Company believes represent attractive risk-reward opportunities. Loans are generally acquired at a discount to the principal balance outstanding and may be acquired with financing provided by the seller. The Company restructures many of these loans to performing status on terms favorable to the Company. In other cases, the Company negotiates a payoff at a price above the Company's basis in the loan. Loan acquisitions range from $5 million to $100 million and are collateralized by all major property types. For accounting purposes, these loans are initially reflected at the Company's acquisition cost which represents the outstanding balance net of the acquisition discount or premium. The Company amortizes such discounts or premiums as an adjustment to increase or decrease the yield, respectively, realized on these loans using the effective interest method. As such, differences between carrying value and principle balances outstanding do not represent embedded losses or gains as the Company generally plans to hold such loans to maturity or negotiate a favorable restructuring of a discount loan. As of December 31, 1999, the Company's loan acquisition investments have the following characteristics: - ---------------------------------------- (1) Where Current Carrying Value is less than Initial Carrying Value, difference represents contractual amortization, partial prepayment of loan principal, or amortization of acquired premiums, discounts or deferred loan fees. (2) Estimated accounting yield represents the stated rate on the loan as adjusted for the amortization of loan fee revenue and any direct loan costs or acquisition premiums or discounts using the effective interest method over the term of the loan. Such estimate is not adjusted for the effects of expected early repayments of loans subject to prepayment penalties or the effects of possible additional contingent interest on loan participation features included under certain of the Company's loan investments. (3) Weighted average ratio of current loan carrying value to underlying collateral value using third-party collateral appraisal (where applicable) or the Company's internal collateral valuation (where no appraisal available). LOAN SERVICING Through its Starwood Asset Services division, the Company provides loan servicing to third-party institutional owners of loan portfolios, as well as to the Company's own asset base. Starwood Asset Services is currently rated "above average" by Standard & Poor's as a master servicer. The Company's servicing business focuses on maximizing risk-adjusted investment returns through active, ongoing asset management with particular focus on risk management, asset financing strategies and opportunistic responsiveness to changing borrower/tenant needs. In September 1998, a subsidiary of the Company acquired the loan origination and servicing business of Phoenix Realty Services, Inc., a subsidiary of Phoenix Home Life Insurance Company, for $2.0 million. This acquisition not only expanded the Company's ability to service its own loans, but provided a platform for third-party servicing and additional borrower relationships which may result in investment opportunities in the future. CREDIT TENANT LEASING: The Company, directly and through its Leasing Subsidiary, provides capital to corporate owners of real estate facilities. Net leased facilities are generally subject to long-term leases to rated corporate credit tenants, and typically provide for all expenses at the property to be paid by the tenant on a triple net lease basis. Credit tenant lease ("CTL") transactions generally range in size from $20 million to $200 million. The Company pursues the origination of credit tenant lease transactions by structuring purchase/ leasebacks and by acquiring facilities subject to existing long-term net leases. In a typical purchase/ leaseback transaction, the Company purchases a corporation's property and leases it back to that corporation subject to a long-term net lease. This structure allows the corporate real estate user to reinvest the proceeds from the sale of its real estate into its core business while the Company capitalizes on its structured financing expertise. The Company generally intends to hold its net leased assets for long-term investment. However, subject to certain tax restrictions, the Company may dispose of an asset if it deems the disposition to be in the best interest of the stockholders and may either reinvest the disposition proceeds, use the proceeds to reduce debt, or distribute the proceeds to stockholders. The Company's CTL investments primarily represent a diversified portfolio of strategic office and industrial facilities subject to net lease agreements with creditworthy corporate tenants. The Company generally seeks high-quality, general-purpose real estate with residual values that represent a discount to current market values and replacement cost. Under a typical net lease agreement, the tenant agrees to pay a base monthly operating lease payment and all property operating expenses (including taxes, maintenance and insurance) are the responsibility of the tenant. The Company generally seeks corporate tenants with the following characteristics: - Established companies with stable core businesses or market leaders in rapidly growing industries. - Investment-grade credit strength or appropriate credit enhancements if tenant credit strength is not sufficient. - Commitment to the facility as an important asset to their on-going businesses. As of December 31, 1999, the Company had more than 160 corporate tenants operating in more than 10 industries, including aerospace, automotive, finance, healthcare, hotel, technology and telecommunications. These tenants represent well-recognized national and international companies, such as AlliedSignal, Federal Express, IBM, Lucent, Microsoft, Nike, Hilton and Nokia. As of December 31, 1999, the Company's CTL portfolio has the following tenant credit characteristics: EXPLANATORY NOTES: - ------------------------------ (1) A tenant's credit rating is considered "Investment Grade" if it has a published credit rating of Baa3/BBB- or above by one or more of the four national rating agencies. (2) Reflects annualized monthly base lease rates in effect on December 31, 1999. PORTFOLIO AND ASSET MANAGEMENT STRATEGY. The Company believes that diligent management of the CTL portfolio is an essential component of its long-term strategy. There are several ways to optimize the performance and maximize the value of net leases. The Company monitors its portfolio for changes that could affect the performance of the markets, tenants and industries in which it has invested. As part of this monitoring, the Company's asset management group reviews market, tenant and industry data and frequently inspects its properties. In addition, the Company attempts to develop strong relationships with its large corporate tenants, which provide a source of information concerning the tenants' real estate needs. These relationships allow the Company to be proactive in obtaining early lease renewals and in conducting early marketing of assets where the tenant has decided not to renew. The Company will seek to find a new tenant prior to the expiration of the existing lease. As of December 31, 1999, the Company owned 148 office and industrial properties principally subject to net leases to more than 160 tenants, comprising 18.5 million square feet in 25 states. The Company also has a portfolio of 17 hotels under a long-term master lease with a single tenant. Information regarding the Company's CTL properties as of December 31, 1999 is set forth below: EXPLANATORY NOTE: - ---------------------------------- (1) Reflects annualized monthly base lease rates in effect on December 31, 1999. As of December 31, 1999, the Company's portfolio of lease expirations on its CTL assets are as follows: EXPLANATORY NOTE: - ------------------------------ (1) Reflects annualized monthly base lease rates in effect on December 31, 1999. POLICIES WITH RESPECT TO OTHER ACTIVITIES At all times, the Company intends to make investments in a manner consistent with the requirements of the Code for the Company to qualify as a REIT unless, because of changing circumstances or changes in the Code (or in Treasury Regulations), the Company's Board of Directors, with the consent of the holders of a majority of the outstanding voting shares, determines that it is no longer in the best interests of the Company to qualify as a REIT. INVESTMENT RESTRICTIONS OR LIMITATIONS The Company does not have any prescribed allocation among investments or product lines. Instead, the Company focuses on corporate and real estate credit underwriting to develop an in-depth analysis of the risk/reward ratios in determining the pricing and advisability of each particular transaction. The Company believes that it is not, and intends to conduct its operations so as not to become, regulated as an investment company under the Investment Company Act. The Investment Company Act generally exempts entities that are "primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate" (collectively, "Qualifying Interests"). The Company intends to rely on current interpretations by the staff of the Securities and Exchange Commission in an effort to qualify for this exemption. To comply with the exemption, the Company, among other things, must maintain at least 55% of its assets in Qualifying Interests and also may be required to maintain an additional 25% in Qualifying Interests or other real estate-related assets. Generally, the Company's senior mortgages and certain of its subordinated mortgages constitute Qualifying Interests. The Company is restricted from making certain types of investments which may limit its flexibility in implementing its investment policy. Specifically, without the amendment, termination or waiver of provisions of certain non-competition agreements between Starwood Capital Group, L.L.C. and Starwood Hotels & Resorts Worldwide, Inc. the Company is prohibited from: (i) making investments in loans collateralized by hotel assets where it is anticipated that the underlying equity will be acquired by the debtholder within one year from the acquisition of such debt; (ii) acquiring equity interests in hotels (other than acquisitions of warrants, equity participations or similar rights incidental to a debt investment by the Company or that are acquired as a result of the exercise of remedies in respect to a loan in which the Company has an interest); or (iii) selling or contributing to or acquiring any interests in Starwood Hotels & Resorts Worldwide, Inc., including debt positions or equity interests obtained by the Company under, pursuant to or by reason of the Company's ownership of debt positions. Subject to the limitations on ownership of certain types of assets and the gross income tests imposed by the Federal Tax Code, the Company also may invest in the securities of other REITs, other entities engaged in real estate activities or other issuers, including for the purpose of exercising control over such entities. COMPETITION The Company is engaged in a competitive business. In originating and acquiring assets, the Company competes with public and private companies, including other finance companies, mortgage banks, pension funds, savings and loan associations, insurance companies, institutional investors, investment banking firms and other lenders and industry participants, as well as individual investors. Existing industry participants and potential new entrants compete with the Company for the available supply of investments suitable for origination or acquisition, as well as for debt and equity capital. Certain of the Company's competitors are larger than the Company, have longer operating histories, may have access to greater capital and other resources, may have management personnel with more experience than the officers of the Company, and may have other advantages over the Company in conducting certain businesses and providing certain services. REGULATION The operations of the Company are subject, in certain instances, to supervision and regulation by state and federal governmental authorities and may be subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which, among other things: (i) regulate credit granting activities; (ii) establish maximum interest rates, finance charges and other charges; (iii) require disclosures to customers; (iv) govern secured transactions; and (v) set collection, foreclosure, repossession and claims-handling procedures and other trade practices. Although most states do not regulate commercial finance, certain states impose limitations on interest rates and other charges and on certain collection practices and creditor remedies and require licensing of lenders and financiers and adequate disclosure of certain contract terms. The Company is also required to comply with certain provisions of the Equal Credit Opportunity Act that are applicable to commercial loans. In the judgment of management, existing statutes and regulations have not had a material adverse effect on the business conducted by the Company. However, it is not possible to forecast the nature of future legislation, regulations, judicial decisions, orders or interpretations, nor their impact upon the future business, financial condition or results of operations or prospects of the Company. The Company has elected and expects to continue to make an election to be taxed as a REIT under Section 856 through 860 of the Code. As a REIT, the Company generally will not be subject to federal income tax if it distributes at least 95% of its taxable income for each year to its shareholders. REITs are also subject to a number of organizational and operational requirements in order to elect and maintain REIT status. These requirements include specific share ownership tests and assets and gross income composition tests. If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate tax rates. Even if the Company qualifies for taxation as a REIT, the Company may be subject to state and local income taxes and to federal income tax and excise tax on its undistributed income. Although the Company did not qualify as a REIT for its fiscal years 1993 through 1997, it received a written agreement from the IRS confirming that the Company was eligible to make an election under Section 856(c)(1) of the Code to be taxed as a REIT for its taxable years beginning January 1, 1998. FACTORS THAT MAY AFFECT THE COMPANY'S BUSINESS STRATEGY The implementation of the Company's business strategy and investment policies are subject to certain risks, including the effect of economic and other conditions on property values, the general illiquidity of real estate investments, the risks of borrower and tenant defaults, in risks resulting from delays in enforcing remedies or in gaining control over the real estate collateral following a default, risks that the properties collateralizing debt instruments held by the Company or properties which are owned by the Company will not generate revenues sufficient to meet operating expenses and to pay scheduled debt service, the risk that prepayment restrictions may be insufficient to deter prepayments, the existence of junior mortgages that may affect the Company's rights, the effect of competition from properties owned by others, liability associated with uninsurable losses and unknown environmental liabilities. ENVIRONMENTAL MATTERS Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner of real estate (including, in certain circumstances, a secured lender that succeeds to ownership or control of a property) may become liable for the costs of removal or remediation of certain hazardous or toxic substances at, on, under or in its property. Those laws typically impose cleanup responsibility and liability without regard to whether the owner or control party knew of or was responsible for the release or presence of such hazardous or toxic substances. The costs of investigation, remediation or removal of those substances may be substantial. The owner or control party of a site may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from a site. Certain environmental laws also impose liability in connection with the handling of or exposure to asbestos-containing materials, pursuant to which third parties may seek recovery from owners of real properties for personal injuries associated with asbestos-containing materials. Absent succeeding to ownership or control of real property, a secured lender is not likely to be subject to any of these forms of environmental liability. The Company is not currently aware of any environmental issues which could materially affect the Company. EMPLOYEES As of March 15, 2000, the Company had 111 employees and believes its relationships with its employees to be good. The Company's employees are not represented by a collective bargaining agreement. ITEM 2. ITEM 2. PROPERTIES The Company's principal executive and administrative offices are located at 1114 Avenue of the Americas New York, NY 10036, 27th floor. Its telephone number, general facsimile number and e-mail address are (212) 930-9400, (212) 930-9494 and starwoodfinancial.com, respectively. The lease for the Company's primary corporate office space expires in February 2010. The Company believes that this office space is suitable for its operations for the foreseeable future. The Company also maintains super-regional offices in San Francisco, California, Hartford, Connecticut, and Atlanta, Georgia, as well as regional offices in Dallas, Texas, Denver, Colorado and New Orleans, Louisiana. See Item 1 - -"Credit Tenant Leasing" for a discussion of real estate facilities held by the Company and its Leasing Subsidiary for investment purposes and Item 8 - -"Schedule III--Real Estate and Accumulated Depreciation" for a detailed listing of such properties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material litigation or legal proceedings, or to the best of its knowledge, any threatened litigation or legal proceedings, which, in the opinion of management, individually or in the aggregate, would have a material adverse effect on its results of operations or financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On November 3, 1999, the Company held a special meeting of shareholders to vote on the following proposals: 1. To approve the acquisition of TriNet through the merger of TriNet with a subsidiary of the Company, with TriNet surviving the merger as a subsidiary of the Company. 2. To approve the acquisition of 100% of the ownership interests in the Company's external advisor, Starwood Financial Advisors L.L.C., through a merger and a contribution of interests by the owners of the external advisor. 3. To approve the merger of the Company into a newly-formed corporation in order to change its form of organization from a Maryland real estate investment trust to a Maryland corporation and eliminate its dual class common share structure. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S EQUITY AND RELATED SHARE MATTERS In November 1999, the Company eliminated its dual class share structure by exchanging its outstanding class A and class B shares for shares of a single class of Common Stock. The Company's Common Stock began trading on the New York Stock Exchange ("NYSE") under the symbol "SFI" on November 4, 1999. Prior to November 4, 1999, the class A shares were traded on the American Stock Exchange under the symbol "APT," and there was no established trading market for the class B shares. The high and low sales prices per share of Common Stock (or class A shares for periods prior to November 4, 1999) are set forth below for the periods indicated. EXPLANATORY NOTE: - ------------------------------ (1) As adjusted for a one-for-six reverse stock split effective June 19, 1998. On March 15, 2000, the closing sale price of the Common Stock as reported by the NYSE was $17.19. The Company had approximately 1,203 holders of record of Common Stock as of March 15, 2000. On June 12, 1998, the Frank Russell Company announced that the Company would be included in the Russell 1000 and Russell 3000 equity indices. The Company believes that index funds who were required to mirror the Russell indices' performance purchased a large number of the Company's class A shares in the public float. As a result of those purchases, and the limited availability of the shares in the public float at that time, the "market" price for the class A shares dramatically increased shortly after the June 12 announcement. From the time of the Company's inclusion in the Russell indices through the announcement that the Company had agreed to acquire TriNet, the reported stock price of the Company was highly volatile and trading volume relatively low due to the very limited number of shares available for trading at that time. At December 31, 1999, the Company had four series of preferred stock outstanding: Series A Preferred Stock (which currently pays dividends at the rate of 9.50% per annum), 9.375% Series B Preferred Stock, 9.20% Series C Preferred Stock and 8.00% Series D Preferred Stock. Each of the Series B, C, D preferred stock was issued in connection with the TriNet acquisition and is publicly traded. On January 4, 5 and 6, 1999 the Company issued 37,776, 1,512 and 8,945 class A shares, respectively, upon exercise of stock options issued to employees of the Company's external advisor. On March 15, 1999, the Company issued 15,000 class A shares upon exercise of stock options issued to an employee of the Company's external advisor. The exercise price of the options was $15.00 per share. As required by the Company's charter as in effect at that time, in connection with those option exercises, 31,616 class B shares were issued to the holders of the class B shares at par value. The Board of Directors approved, and the Company has implemented, a stock repurchase program under which the Company is authorized to repurchase up to 5.0 million shares of its Common Stock from time to time, primarily using proceeds from the disposition of assets and excess cash flow from operations, but also using borrowings under its credit facilities if the Company determines that it is advantageous to do so. As of December 31, 1999, the Company had repurchased approximately 2.3 million shares at an aggregate cost of approximately $40.4 million. DIVIDENDS The Company's management expects that any taxable income remaining after the distribution of preferred dividends and the regular quarterly or other dividends will be distributed annually to the holders of the Common Stock on or prior to the date of the first regular quarterly divided payment date of the following taxable year. The dividend policy with respect to the Common Stock is subject to revision by the Board of Directors. All distributions in excess of dividends on preferred stock or those required for the Company to maintain its REIT status will be made by the Company at the sole discretion of the Board of Directors and will depend on the taxable earnings of the Company, the financial condition of the Company, and such other factors as the Board of Directors deems relevant. The Board of Directors has not established any minimum distribution level. In order to maintain its qualifications as a REIT, the Company intends to make regular quarterly dividends to its shareholders that, on an annual basis, will represent at least 95% of its taxable income (which may not necessarily equal net income as calculated in accordance with generally accepted accounting principles), determined without regard to the deduction for dividends paid and excluding any net capital gains. Holders of Common Stock will be entitled to receive distributions if, as and when the Board of Directors authorizes and declares distributions. However, rights to distributions may be subordinated to the rights of holders of preferred stock, when preferred stock is issued and outstanding. In any liquidation, dissolution or winding up of the Company each outstanding share of Common Stock will entitle its holder to a proportionate share of the assets that remain after the Company pays its liabilities and any preferential distributions owed to preferred stockholders. The following table sets forth the dividends paid or declared by the Company on its Common Stock (or class A shares for periods prior to November 4, 1999): EXPLANATORY NOTES: - ------------------------------ (1) A portion of this quarterly dividend (approximately $0.29 per share) was treated as income to shareholders of record in 1998, and the remainder was treated as 1999 income. (2) A portion of this quarterly dividend (approximately $0.47 per share) was treated as income to stockholders of record in 1999, and the remainder will be treated as 2000 income. In November 1999, the Company declared and paid a dividend of a total of one million shares of Common Stock pro rata to all holders of record of Common Stock as of the close of business on November 3, 1999. The Company also declared dividends aggregating $20.9 million for the Series A preferred stock, which was outstanding for the entire year ended December 31, 1999. In addition, the Company also declared dividends of $1.2 million, $0.7 million and $2.0 million on its Series B, C and D preferred stock, respectively, for the year ended December 31, 1999. The amounts for the Series B, C and D preferred stock represent only fourth quarter dividends which were payable by the Company as a result of its acquisition of TriNet. There are no dividend arrearages on any of the series of preferred stock currently outstanding. Further, it declared and paid dividends aggregating $0.2 million per quarter to the holders of class B shares in connection with the March 31, June 30 and September 30 quarterly dividends to the holders of the class A shares. As previously described, the former class A and class B shares were converted into shares of Common Stock on November 4, 1999. The Company did not declare any dividends for the period from November 19, 1993 through the quarter ended March 31, 1998, representing its partial first quarter of operations after the completion of the Recapitalization Transactions. Distributions to shareholders will generally be taxable as ordinary income, although a portion of such dividends may be designated by the Company as capital gain or may constitute a tax-free return of capital. The Company annually furnishes to each of its shareholders a statement setting forth the distributions paid during the preceding year and their characterization as ordinary income, capital gain or return of capital. The Company intends to continue to declare quarterly distributions on its Common Stock. No assurance, however, can be given as to the amounts or timing of future distributions, as such distributions are subject to the Company's earnings, financial condition, capital requirements, and such other factors as the Company's Board of Directors deems relevant. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial data on a consolidated historical basis for the Company. However, prior to the recapitalization of the Company in March 1998, discussed more fully in Note 4 to the Company's Consolidated Financial Statements (the "Recapitalization Transactions"), the Company did not have substantial capital resources or operations. Prior to the Recapitalization Transactions, the Company's structured finance operations were conducted by two investment partnerships affiliated with Starwood Capital Group, L.L.C., which contributed substantially all their structured finance assets to the Company in the Recapitalization Transactions in exchange for cash and shares of the Company. Further, on November 4, 1999, as more fully discussed in Note 4 to the Company's Consolidated Financial Statements, the Company acquired TriNet, which substantially increased the size of the Company's operations, and also acquired its external advisor. Operating results for the year ended December 31, 1999 reflect only the effects of these transactions subsequent to their consummation. Accordingly, the historical balance sheet information as of and prior to December 31, 1998, as well as the results of operations for the Company for all periods reflected below, do not reflect the current operations of the Company as a well capitalized, internally-managed finance company operating in the commercial real estate industry. For these reasons, the Company believes that the information contained in the following tables relating to the 1995 through 1997 periods is not indicative of the Company's current business and should be read in conjunction with the discussions set forth in Item 7 Item 7 - -"Management's Discussion and Analysis of Financial Condition and Results of Operations." EXPLANATORY NOTES: - ------------------------------ (1) Historical stock option expense represents the option value of approximately 2.5 million fully-vested options to acquire class A shares which were issued to the Company's external advisor upon consummation of the March 18, 1998 capitalization of the Company. A portion of those options were then regranted to employees of the advisor subject to vesting periods which were typically three years from the date of grant. The remainder of those options were regranted on a fully-vested basis to an affiliate of Starwood Capital Group L.L.C., which then further regranted those options to certain of its employees subject to vesting restrictions. (2) As more fully discussed in Note 4 to the Company's Consolidated Financial Statements, this amount represents a non-recurring charge of approximately $94.5 million relating to the acquisition of the Company's external advisor. (3) Historical minority interest for the Company for fiscal 1998, 1997 and 1996 represents a minority interest in APMT Limited Partnership which was converted into class A shares on March 18, 1998, the date the partnership was liquidated and terminated. Minority interests in fiscal 1999 also reflects minority interests in certain of the Leasing Subsidiary's consolidated ventures. (4) Earnings per common share excludes 1% of net income allocable to the Company's class B shares prior to November 4, 1999. These class B shares were exchanged for Common Stock in connection with the TriNet acquisition and other related transactions on November 4, 1999. As a result, the Company now has a single class of Common Stock outstanding. (5) Management generally considers funds from operations, or FFO, to be one measure of the financial performance which provides a relevant basis for comparison among REITs. FFO is presented to assist investors in analyzing the performance of REITs. In 1995, the National Association of Real Estate Investment Trusts, or NAREIT, established new guidelines clarifying its definition of FFO and requested that REITs adopt this new definition beginning in 1996. FFO, as defined by NAREIT, is income (loss) before minority interest (determined in accordance with generally accepted accounting principles), excluding gains (losses) from debt restructuring and sales of property, plus real estate-related depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures. FFO does not represent cash generated from operating activities in accordance with generally accepted accounting principles and is not necessarily indicative of cash available to fund cash needs. FFO should not be considered an alternative to net income as an indication of financial performance nor an alternative to cash flows from operating, investing, and financing activities as measures of liquidity. (6) Because of certain non-cash or non-recurring items included in income for generally accepted accounting purposes, which are not adjusted for or eliminated under the NAREIT definition of FFO, FFO may differ from actual cash available for distribution to shareholders. These items include amortization of premiums or discounts on loan investments, provisions for possible credit losses, gains from sales of assets, deferred interest arising from differences between loan accrual and payment rates, non-cash rental revenues and capital expenditures. Accordingly, FFO is not necessarily indicative of cash available to fund cash needs or to pay dividends to shareholders. (7) Adjusted earnings represent GAAP net income before depreciation and amortization and, for the year ended December 31, 1999, exclude the non-recurring cost incurred in acquiring the Company's external advisor (see Note 4 to the Company's Consolidated Financial Statements). (8) Combined fixed charges are comprised of interest expense, capitalized interest, amortization of loan costs and preferred stock dividend requirements. (9) As adjusted for one-for-six reverse stock split effected by the Company on June 19, 1998. (10) The Company generally declares common and preferred dividends in the month subsequent to the end of the quarter. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL As more fully discussed in Note 4 to the Company's Consolidated Financial Statements, on March 18, 1998, the Company completed the Recapitalization Transactions which, among other things, substantially recapitalized the Company and modified its investment policy. Effective June 18, 1998, the Company (which was organized under California law) changed its domicile to Maryland by merging with a newly-formed subsidiary organized under Maryland law, and issued new shares of the subsidiary to the Company's shareholders in exchange for their shares in the Company. Concurrently, the Company consummated a one-for-six reverse stock split. Immediately prior to the consummation of the Recapitalization Transactions, the Company's assets primarily consisted of approximately $11.0 million in short-term, liquid real estate investments, cash and cash equivalents. On December 15, 1998, the Company sold $220.0 million of preferred shares and warrants to purchase class A shares to a group of investors affiliated with Lazard Freres. Concurrent with the sale of the preferred shares and warrants, the Company purchased $280.3 million in real estate loans and participation interests from a group of investors also affiliated with Lazard Freres. These transactions are referred to collectively as the "Lazard Transaction." As more fully discussed in Note 4 to the Company's Consolidated Financial Statements, on November 3, 1999, the Company's shareholders approved a series of transactions including: (i) the acquisition of TriNet; (ii) the acquisition of the Company's external advisor; and (iii) the reorganization of the Company from a trust to a corporation and the exchange of the class A and class B shares for Common Stock. Pursuant to the TriNet acquisition, TriNet merged with and into a subsidiary of the Company, with TriNet surviving as a wholly-owned subsidiary of the Company. In the acquisition, each share of common stock of TriNet was converted into 1.15 shares of Common Stock. Each share of TriNet Series A, Series B and Series C Cumulative Redeemable Preferred Stock was converted into a share of Series B, Series C or Series D (respectively) Cumulative Redeemable Preferred Stock of the Company. The Company's preferred stock issued to the former TriNet preferred stockholders has substantially the same terms as the TriNet preferred stock, except that the new Series B, C, and D preferred stock have additional voting rights not associated with the TriNet preferred stock. The Company's Series A Preferred Stock remained outstanding with the same rights and preferences as existed prior to the TriNet acquisition. As a consequence of the acquisition of its external advisor, the Company is now self-advised and will no longer pay external advisory fees. The transactions described above and other related transactions have materially impacted the historical operations of the Company and will continue to impact the Company's future operations. Accordingly, the reported historical financial information for periods prior to these transactions is not believed to be fully indicative of the Company's future operating results or financial condition. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 During fiscal year 1999, total revenue increased by approximately $136.7 million over total revenue for fiscal year 1998. This increase is a result of the interest generated by the loans and other investments contributed in the Recapitalization Transactions, as well as approximately $663.4 million of other loan investments newly-originated or acquired by the Company during 1999, an additional $46.4 million funded under existing loan commitments, and approximately $26.8 million in operating lease income generated from net lease assets acquired in the TriNet acquisition. The increase was partially offset by principal repayments of approximately $561.9 million made to the Company during fiscal year 1999. Included in other income for fiscal year 1999 is a fee associated with the repayment of a construction loan of approximately $1.9 million, yield maintenance payments of approximately $8.1 million resulting from the repayment of three loans, and approximately $1.0 million in additional revenue from certain cash flow participation features on five of the Company's loan investments. The Company's total costs and expenses during fiscal 1999 increased by approximately $157.7 million compared to fiscal 1998. These increases were generally the result of the increased scope of the Company's operations as a result of the Recapitalization Transactions, costs associated with additional lending operations, the TriNet acquisition and the acquisition of the Company's external advisor. The Company's interest expense increased by $46.5 million as a result of higher interest rates and higher average borrowings by the Company on its credit facilities and other term loans, the proceeds of which were used to fund additional loan origination and acquisition activities. Further, interest expense includes interest incurred by the Leasing Subsidiary subsequent to its acquisition. Property operating costs represent unreimbursed property operating expenses incurred by the Leasing Subsidiary subsequent to its acquisition. All costs of this kind were borne directly by the tenant on the Company's pre-existing credit tenant leasing portfolio. Depreciation and amortization increased as a result of a full year's depreciation on the Company's pre-existing credit tenant leasing portfolio, which it acquired in the Recapitalization Transactions, as well as depreciation on the Leasing Subsidiary's net leased assets subsequent to its acquisition. General and administrative costs increased by approximately $3.7 million as a result of additional costs incurred subsequent to the acquisition of the Company's external advisor, as well as additional administrative expenses associated with the Leasing Subsidiary subsequent to its acquisition. Base advisory fees increased by approximately $5.3 million as a result of fees being incurred from June 16, 1999 through year end in the prior year and through November 4, 1999 in fiscal 1999. Further, as a result of the Company's expanded operations, incentive fees paid under the prior advisory contract increased from $2.3 million in 1998 to $5.4 million in 1999. Subsequent to the acquisition of the Company's external advisor, the Company is now internally-managed and no further advisory fees will be incurred. The Company's charge for provision for possible credit losses increased by approximately $2.0 million as a result of expanded lending operations as well as additional seasoning of the Company's existing lending portfolio. As more fully discussed in Note 5 to the Company's Consolidated Financial Statements, the Company has not realized any actual losses on any of its loan investments to date. Stock compensation expense declined by approximately $5.6 million as a result of the non-recurring charge relating to the original grant of stock options to the Company's external advisor in fiscal 1998 concurrently with the consummation of the Recapitalization Transactions. Finally, as more fully discussed in Note 4 to the Company's Consolidated Financial Statements, included in fiscal 1999 costs and expenses is a non-recurring charge of approximately $94.5 million relating to the acquisition of the Company's external advisor. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 During fiscal year 1998, total revenue increased by approximately $126.2 million over total revenue for fiscal year 1997. This increase is a result of the interest generated by the loans and other investments contributed in the Recapitalization Transactions, as well as approximately $1.0 billion of other loan investments newly-originated or acquired by the Company during 1998, and an additional $16.5 million funded under existing loan commitments. The increase was partially offset by principal repayments of approximately $103.9 million made to the Company during fiscal year 1998. Included in other income for fiscal year 1998 are fees associated with the repayment of two first mortgage loans aggregating approximately $1.2 million, a gain of approximately $0.9 million resulting from the repayment of a $2.8 million loan participation which had been acquired at a discount, and approximately $0.6 million in additional revenue from certain cash flow participation features on two of the Company's loan investments. In 1997, a gain of approximately $1.0 million was recognized in other income on the early repayment of a loan acquired at a discount. The increase in the Company's total costs and expenses during fiscal year 1998 compared to fiscal year 1997 is primarily due to increased interest expense on the Company's borrowings used to fund its asset growth as well as the expense associated with the issuance to the Advisor of options to acquire approximately 2.5 million of the Company's class A shares (see Note 11 to the Company's Consolidated Financial Statements). Additionally, general and administrative costs associated with the implementation of the Company's business plan and advisory fee expenses increased the Company's total costs and expenses during fiscal 1998. The Company believes that because of the significant expansion of the scope of its operations following the Recapitalization Transactions which occurred on March 18, 1998, prior periods are not necessarily indicative of the Company's future operating results or financial condition. LIQUIDITY AND CAPITAL RESOURCES The Company requires capital to fund its investment origination and acquisition activities and operating expenses. The Company's capital sources include cash flow from operations, borrowings under lines of credit, additional term borrowings, long-term financing secured by the Company's assets, unsecured financing and the issuance of common, convertible and/or preferred equity securities. As a result of the Recapitalization Transactions, the Lazard Transaction, the TriNet acquisition, the acquisition of the Company's external advisor, and other transactions completed by the Company, the Company has significant access to capital resources to fund its existing business plan, which includes the expansion of its real estate lending and credit tenant leasing businesses. Further, the Company may acquire other businesses or assets using its capital stock, cash or a combination thereof. The distribution requirements under the REIT provisions of the Code restrict the Company's ability to retain earnings and thereby replenish capital committed to its operations. However, the Company believes that its significant capital resources and access to financing will provide it with financial flexibility and market responsiveness at levels sufficient to meet current and anticipated capital requirements, including expected new lending and leasing transactions. The Company's ability to meet its long-term (i.e., beyond one year) liquidity requirements is subject to the renewal of its credit lines and/or obtaining other sources of financing, including issuing additional debt or equity from time to time. Any decision by the Company's lenders and investors to enter into such transactions with the Company will depend upon a number of factors, such as compliance with the terms of its existing credit arrangements, the Company's financial performance, industry or market trends, the general availability of and rates applicable to financing transactions, such lenders' and investors' resources and policies concerning the terms under which they make such capital commitments and the relative attractiveness of alternative investment or lending opportunities. Based on its monthly interest and other expenses, monthly cash receipts, existing investment commitments and funding plans, the Company believes that its existing sources of funds will be adequate to purposes of meeting its short- and long-term liquidity needs. Material increases in monthly interest expense or material decreases in monthly cash receipts would negatively impact the Company's liquidity. On the other hand, material decreases in monthly interest expense would positively affect the Company's liquidity. As more fully discussed in Note 7 to the Company's consolidated financial statements, at December 31, 1999, the Company had existing fixed-rate borrowings of approximately $153.6 million secured by real estate under operating leases which mature in 2009, an aggregate of approximately $254.3 million in LIBOR-based, variable-rate loans secured by various senior and subordinate mortgage investments which mature in fiscal 2000, fixed-rate corporate debt obligations aggregating approximately $353.6 million which mature between 2001 and 2017, and other variable- and fixed-rate secured debt obligations aggregating approximately $151.6 million which mature at various dates through 2010. In addition, the Company has entered into LIBOR-based secured revolving credit facilities of $675.0 and $500.0 million which expire in fiscal 2001 and 2000 respectively. (Subsequent to December 31, 1999, the Company extended the maturity of its $500.0 million facility to 2002). As of December 31, 1999, the Company had drawn approximately $593.0 million and $170.0 million under these facilities. Availability under these facilities is based on collateral provided under a borrowing base calculation. In addition, the Leasing Subsidiary has an agreement with a group of 13 banks led by Bank of America, N.A. which provides it with a $350.0 million unsecured revolving credit facility. This facility matures on May 31, 2001 and has a one-year extension period at the Company's option. Interest incurred on the facility is LIBOR-based with a margin dependent on the Company's credit ratings. Facility fees under the credit facility are also tied to its credit ratings. All of the available commitment under the facility may be borrowed for general corporate and working capital needs of the Leasing Subsidiary, as well as for investments. Under the terms of this facility, the Leasing Subsidiary is generally permitted to make cash distributions to the Company in an amount equal to 85% of cash flow from operations in any rolling four-quarter period. The facility requires interest-only payments until maturity, at which time outstanding borrowings are due and payable. As of December 31, 1999, the Company had $186.7 million drawn and $163.3 million available under this facility. The Company has entered into LIBOR interest rate caps struck at 9.00%, 7.50% and 7.50% in notional amounts of $300.0 million, $40.4 million and $38.3 million, respectively, which expire in March 2001, January 2001 and June 2001, respectively. At December 31, 1999, the fair value appreciation of the Company's interest rate caps was $2.2 million. The Company has originated or acquired certain assets using proceeds from LIBOR-based borrowings. In connection with such borrowings, the Company entered into approximately $205.2 million of interest rate swaps to effectively fix the interest rate on such obligations. In addition, in connection with the TriNet acquisition, the Company acquired an interest rate swap which, together with certain existing interest rate cap agreements, effectively fix the interest rate on $75.0 million of the Leasing Subsidiary's LIBOR-based borrowings at 5.58% plus the applicable margin through December 1, 2004. Management expects that it will have aggregate LIBOR based borrowings at the Leasing Subsidiary in excess of the notional amount for the duration of the swap. The actual borrowing cost to the Company with respect to indebtedness covered by the swap will depend upon the applicable margin over LIBOR for such indebtedness, which will be determined by the terms of the relevant debt instruments. At December 31, 1999, the fair value appreciation of the Company's interest rate swaps was $3.4 million. The Company is currently pursuing or has consummated certain anticipated long-term fixed-rate borrowings and had entered into certain derivative instruments based on U.S. Treasury securities to hedge the potential effects of interest rate movements on these transactions. Under these agreements, the Company would generally receive additional cash flow at settlement if interest rates rise and pay cash if interest rates fall. The effects of such receipts or payments will be deferred and amortized over the term of the specific related fixed-rate borrowings. During the year ended December 31, 1999, the Company settled an aggregate notional amount of approximately $63.0 million that was outstanding under such agreements, resulting in a receipt of approximately $0.6 million to be amortized over the term of the anticipated borrowing. During the year ended December 31, 1999, the Company refinanced its $125.0 million term loan maturing March 15, 1999 with a $155.4 million term loan maturing March 5, 2009. The new term loan bears interest at 7.44% per annum, payable monthly, and amortizes over an approximately 22-year schedule. The new term loan represented one of the forecasted transactions for which the Company had previously entered into U.S. Treasury-based hedging transactions. The net $3.4 million cost of the settlement of such hedges has been deferred and will be amortized as an increase to the effective financing costs of the new term loan over its 10-year term. In the event that, in the opinion of management, it is no longer probable that the remaining forecasted transactions will occur under terms substantially equivalent to those projected, the Company will cease recognizing such transactions as hedges and immediately recognize related gains or losses based on actual settlement or estimated settlement value. No such gains or losses have been recognized by the company. STOCK REPURCHASE PROGRAM: The Board of Directors approved, and the Company has implemented, a stock repurchase program under which the Company is authorized to repurchase up to 5.0 million shares of its Common Stock from time to time, primarily using proceeds from the disposition of assets and excess cash flow from operations, but also using borrowings under its credit facilities if the Company determines that it is advantageous to do so. As of December 31, 1999, the Company had repurchased approximately 2.3 million shares, at an aggregate cost of approximately $40.4 million. YEAR 2000 The statements in the following section include Year 2000 readiness disclosure within the meaning of the Year 2000 Information and Readiness Disclosure Act. The Company intends such statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and is including this statement for purposes of complying with these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Although the Company believes that the expectations reflected in such forward-looking statements are based on reasonable assumptions, the Company's actual costs progress and expenses with respect to its plan to address Year 2000 issues could differ materially from those set forth in the forward-looking statements. Factors which could have a material adverse effect on the Company's results and progress include, but are not limited to , changes in the expense of or delays, in: the identification and upgrade or replacement by the Company of computer systems that do not relate to information technology but include embedded technology; and the Year 2000 compliance of vendors (including vendors of the Company's computer information systems) or third-party service providers (including the Company's primary bank and payroll processor). These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. The term "Year 2000 issue" is a general term used to describe various problems that may result from the improper processing by computer systems of dates after 1999. These problems could results in a system failure or miscalculations causing disruptions of operations. The term "Year 2000 compliant" is used in this discussion to mean that the system or device in question will perform its essential functions in the Year 2000 without significant operational problems. PARENT: The Company implemented a plan in 1999 to assess, test and correct, to the extent necessary, potential Year 2000 issues. Additionally, the Company assessed the potential impacts from outside parties and developed contingency plans for business interruptions after the date rollover. The costs involved in performing this internally managed plan were not significant to the Company's financial position or results of operations in 1998 and 1999. Since January 1, 2000, the Company has not experienced any material adverse impacts due to the Year 2000 issue. While the primary risk to the Company with respect to the Year 2000 issue continues to be the inability of external parties to provide services in a timely and accurate manner, to date, the Company is not aware of any such disruption. As a result, the Company does not expect any remaining Year 2000 risk to have a material adverse impact to the Company. LEASING SUBSIDIARY: The Leasing Subsidiary recognized that the Year 2000 may result in risk and implemented a plan in 1998 to prepare for potential Year 2000 issues. The Leasing Subsidiary's efforts to address potential Year 2000 issues were focused in the following four areas: (i) reviewing and taking any necessary steps to correct the Leasing Subsidiary's computer information systems (i.e., software applications and hardware platforms); (ii) evaluating and making any necessary modifications to other computer systems that do not relate to information technology but include embedded technology at its properties, such as security, heating, ventilation, and air conditioning, elevator, fire and safety systems; (iii) communicating with certain significant third-party service providers to determine whether there will be any interruption in their systems that could affect the Leasing Subsidiary; and (iv) developing contingency plans for business interruptions after the date rollover. The Leasing Subsidiary's Year 2000 compliance program is substantially complete. The cost involved in performing this internally managed plan were not significant to the Leasing Subsidiary's financial position or results of operations. The Leasing Subsidiary expects that a substantial portion of these costs will be passed back to tenants through recoveries of operating expense and that the remaining costs of addressing the Year 2000 issues will be funded through operating cash flows. Since the date rollover on January 1, 2000, the Leasing Subsidiary has not experienced any material adverse impact due to the Year 2000 issue. While the primary risk to the Leasing Subsidiary, with respect to the Year 2000 issue, is the ability of certain third party service providers to continue to provide services in a timely and accurate manner, to date, the Leasing Subsidiary is not aware of any such disruption. While the Leasing Subsidiary's efforts to address its Year 2000 issues may involve additional costs, the Leasing Subsidiary believes, based on available information, that these costs will not have a material adverse effect on its business, financial condition or results of operations. NEW ACCOUNTING STANDARDS In June 1997, the FASB issued Statement No. 131, "Disclosure about Segments of an Enterprise and Related Information" ("SFAS No. 131") effective for financial statements issued for periods beginning after December 15, 1997. SFAS No. 131 requires disclosures about segments of an enterprise and related information regarding the different types of business activities in which an enterprise engages and the different economic environments in which it operates. The Company adopted the requirements of this pronouncement in its financial statements beginning with its reporting for fiscal 1999. As of December 31, 1999, the Company is currently segmented between its lending and credit tenant lease businesses. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). On June 23, 1999 the FASB voted to defer the effectiveness of SFAS 133 for one year. SFAS 133 is now effective for fiscal years beginning after June 15, 2000, but earlier application is permitted as of the beginning of any fiscal quarter subsequent to June 15, 1998. SFAS No. 133 establishes accounting and reporting standards for derivative financial instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as: (i) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment; (ii) a hedge of the exposure to variable cash flows of a forecasted transaction; or (iii) in certain circumstances a hedge of a foreign currency exposure. The Company currently plans to adopt this pronouncement as required effective January 1, 2001. The adoption of SFAS 133 is not expected to have a material financial impact on the financial position or results of operations of the Company. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISKS Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. In pursuing its business plan, the primary market risk to which the Company is exposed is interest rate risk. Consistent with its election to qualify as a REIT, the Company has implemented an interest rate risk management policy based on match funding, with the objective that floating-rate assets be primarily financed by floating-rate liabilities and fixed-rate assets be primarily financed by fixed-rate liabilities. The Company's operating results will depend in part on the difference between the interest and related income earned on its assets and the interest expense incurred in connection with its interest-bearing liabilities. Competition from other providers of real estate financing may lead to a decrease in the interest rate earned on the Company's interest-bearing assets, which the Company may not be able to offset by obtaining lower interest costs on its borrowings. Changes in the general level of interest rates prevailing in the financial markets may affect the spread between the Company's interest-earning assets and interest-bearing liabilities. Any significant compression of the spreads between interest-earning assets and interest-bearing liabilities could have a material adverse effect on the Company. In addition, an increase in interest rates could, among other things, reduce the value of the Company's interest-bearing assets and its ability to realize gains from the sale of such assets, and a decrease in interest rates could reduce the average life of the Company's interest-earning assets. A substantial portion of the Company's loan investments are subject to significant prepayment protection in the form of lock-outs, yield maintenance provisions or other prepayment premiums which provide substantial yield protection to the Company. Those assets generally not subject to prepayment penalties include: (i) variable-rate loans based on LIBOR, originated or acquired at par, which would not result in any gain or loss upon repayment; and (ii) discount loans and loan participations acquired at discounts to face values, which would result in gains upon repayment. Further, while the Company generally seeks to enter into loan investments which provide for substantial prepayment protection, in the event of declining interest rates, the Company could receive such prepayments and may not be able to reinvest such proceeds at favorable returns. Such prepayments could have an adverse effect on the spreads between interest-earning assets and interest-bearing liabilities. While the Company has not experienced any significant credit losses, in the event of a significant rising interest rate environment and/or economic downturn, defaults could increase and result in credit losses to the Company which adversely affect its liquidity and operating results. Further, such delinquencies or defaults could have an adverse effect on the spreads between interest-earning assets and interest-bearing liabilities. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political conditions, and other factors beyond the control of the Company. As more fully discussed in Note 9 to the Company's Consolidated Financial Statements, the Company employs match funding-based hedging strategies to limit the effects of changes in interest rates on its operations, including engaging in interest rate caps, floors, swaps, futures and other interest rate-related derivative contracts. These strategies are specifically designed to reduce the Company's exposure, on specific transactions or on a portfolio basis, to changes in cash flows as a result of interest rate movements in the market. The Company does not enter into derivative contracts for speculative purposes nor as a hedge against changes in credit risk of its borrowers or of the Company itself. Each interest rate cap or floor agreement is a legal contract between the Company and a third party (the "counterparty"). When the Company purchases a cap or floor contract, the Company makes an up-front payment to the counterparty and the counterparty agrees to make payments to the Company in the future should the reference rate (typically one- or three-month LIBOR) rise above (cap agreements) or fall below (floor agreements) the "strike" rate specified in the contract. Each contract has a notional face amount. Should the reference rate rise above the contractual strike rate in a cap, the Company will earn cap income. Should the reference rate fall below the contractual strike rate in a floor, the Company will earn floor income. Payments on an annualized basis will equal the contractual notional face amount multiplied by the difference between actual reference rate and the contracted strike rate. The cost of the up-front payment is amortized over the term of the contract. Interest rate swaps are agreements in which a series of interest rate flows are exchanged over a prescribed period. The notional amount on which swaps are based is not exchanged. In general, the Company's swaps are "pay fixed" swaps involving the exchange of floating-rate interest payments from the counterparty for fixed interest payments from the Company. Interest rate futures are contracts, generally settled in cash, in which the seller agrees to deliver on a specified future date the cash equivalent of the difference between the specified price or yield indicated in the contract and the value of that of the specified instrument (e.g., U.S. Treasury securities) upon settlement. The Company generally uses such instruments to hedge forecasted fixed-rate borrowings. Under these agreements, the Company will generally receive additional cash flow at settlement if interest rates rise and pay cash if interest rates fall. The effects of such receipts or payments will be deferred and amortized over the term of the specific related fixed-rate borrowings. In the event that, in the opinion of management, it is no longer probable that a forecasted transaction will occur under terms substantially equivalent to those projected, the Company will cease recognizing such transactions as hedges and immediately recognize related gains or losses based on actual settlement or estimated settlement value. No such gains or losses have been recognized by the Company. While a REIT may freely utilize the types of derivative instruments discussed above to hedge interest rate risk on its liabilities, the use of derivatives for other purposes, including hedging asset-related risks such as credit, prepayment or interest rate exposure on the Company's loan assets, could generate income which is not qualified income for purposes of maintaining REIT status. As a consequence, the Company may only engage in such instruments to hedge such risks on a limited basis. There can be no assurance that the Company's profitability will not be adversely affected during any period as a result of changing interest rates. In addition, hedging transactions using derivative instruments involve certain additional risks such as counterparty credit risk, legal enforceability of hedging contracts and the risk that unanticipated and significant changes in interest rates will cause a significant loss of basis in the contract. With regard to loss of basis in a hedging contract, indices upon which contracts are based may be more or less variable than the indices upon which the hedged assets or liabilities are based, thereby making the hedge less effective. The counterparties to these contractual arrangements are major financial institutions with which the Company and its affiliates may also have other financial relationships. The Company is potentially exposed to credit loss in the event of nonperformance by these counterparties. However, because of their high credit ratings, the Company does not anticipate that any of the counterparties will fail to meet their obligations. There can be no assurance that the Company will be able to adequately protect against the foregoing risks and that the Company will ultimately realize an economic benefit from any hedging contract it enters into which exceeds the related costs incurred in connection with engaging in such hedges. The following table quantifies the potential changes in net investment income and net fair value of financial instruments should interest rates increase or decrease 200 basis points, assuming no change in the shape of the yield curve (i.e., relative interest rates). Net investment income is calculated as revenue from loans and other lending investments and operating leases (as of December 31, 1999), less related interest expense and property operating costs, for the year ended December 31, 1999, on a pro forma basis for the TriNet acquisition. Net fair value of financial instruments is calculated as the sum of the value of off-balance sheet instruments and the present value of cash in-flows generated from interest-earning assets, less cash out-flows in respect of interest-bearing liabilities as of December 31, 1999. The cash flows associated with the Company's assets are calculated based on management's best estimate of expected payments for each loan based on loan characteristics such as loan-to-value ratio, interest rate, credit history, prepayment penalty, term and property type. Most of the Company's loans are protected from prepayment as a result of prepayment penalties and contractual terms which prohibit prepayments during specified periods. However, for those loans where prepayments are not currently precluded by contract, declines in interest rates may increase prepayment speeds. The base interest rate scenario assumes interest rates as of December 31, 1999. Actual results could differ significantly from those estimated in the table. ESTIMATED PERCENTAGE CHANGE IN EXPLANATORY NOTE: - ------------------------------ (1) Amounts exclude fair values of non-financial investments, primarily assets under long-term operating leases and preferred limited partnership interests. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of nine owned companies or joint ventures accounted for under the equity method have been omitted because the Company's proportionate share of the income from continuing operations before income taxes is less than 20% of the respective consolidated amount and the investments in and advances to each company are less than 20% of consolidated total assets. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Starwood Financial Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Starwood Financial Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP New York, NY March 6, 2000 STARWOOD FINANCIAL INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) - -------------------------- * RECLASSIFIED TO CONFORM TO 1999 PRESENTATION The accompanying notes are an integral part of the financial statements. STARWOOD FINANCIAL INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) - ------------------------ * RECLASSIFIED TO CONFORM TO 1999 PRESENTATION. (1) Net income per basic common share excludes 1% of net income allocable to the Company's class B shares prior to November 4, 1999. These shares were exchanged for Common Stock in connection with the TriNet acquisition and related transactions on November 4, 1999. As a result, the Company now has a single class of Common Stock outstanding. (2) As adjusted for one-for-six reverse stock split effective June 19, 1998. The accompanying notes are an integral part of the financial statements. STARWOOD FINANCIAL INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (IN THOUSANDS) EXPLANATORY NOTE: - ------------------------------ * RECLASSIFIED TO CONFORM TO 1999 PRESENTATION. (1) As adjusted for one-for-six reverse stock split effective June 19, 1998. The accompanying notes are an integral part of the financial statements. STARWOOD FINANCIAL INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) - ------------------------------ * RECLASSIFIED TO CONFORM TO 1999 PRESENTATION. The accompanying notes are an integral part of the financial statements. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--ORGANIZATION AND BUSINESS ORGANIZATION--Starwood Financial Inc.(1) (the "Company") began its business in 1993 through private investment funds (collectively, the "Starwood Investors") formed to capitalize on inefficiencies in the real estate finance market. In March 1998, these funds contributed their approximately $1.1 billion of assets to the Company's predecessor, Starwood Financial Trust, in exchange for a controlling interest in that company. Since that time, the Company has grown by originating new lending and leasing transactions, as well as through corporate acquisitions. Specifically, in September 1998, the Company acquired the loan origination and servicing business of a major insurance company, and in December 1998, the Company acquired the mortgage and mezzanine loan portfolio of its largest private competitor. Additionally, in November 1999, the Company acquired TriNet Corporate Realty Trust, Inc. ("TriNet"), the largest publicly traded company specializing in the net leasing of corporate office and industrial facilities. The TriNet acquisition was structured as a stock-for-stock merger of TriNet with a subsidiary of the Company. Concurrent with the TriNet acquisition, the Company also acquired its external advisor (the "Advisor Transaction") in exchange for shares of common stock, $0.001 par value, of the Company (the "Common Stock"), and converted its organizational form to a Maryland corporation (the "Incorporation Merger"). As part of the conversion to a Maryland corporation, the Company replaced its dual class common share structure with a single class of Common Stock. The Company's Common Stock began trading on the New York Stock Exchange under the symbol "SFI" in November 1999. During 1993 through 1997, the Company did not qualify as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). However, pursuant to a closing agreement with the Internal Revenue Service (the "IRS") obtained in March 1998, the Company was eligible and elected to be taxed as a REIT for the taxable year beginning January 1, 1998. BUSINESS--The Company believes it is the largest publicly traded finance company in the United States focused on the commercial real estate industry. The Company, which is taxed as a real estate investment trust, provides structured mortgage, mezzanine and lease financing through its origination, acquisition and servicing platform. The Company's investment strategy targets specific sectors of the real estate credit markets in which it can deliver value-added, flexible financial solutions to its customers, thereby differentiating its financial products from those offered by other capital providers. The Company has implemented its investment strategy by: (i) focusing on the origination of large, highly structured mortgage, mezzanine and lease financings where customers require flexible financial solutions, and avoiding commodity businesses in which there is significant direct competition from other providers of capital; (ii) developing direct relationships with borrowers and corporate tenants as opposed to sourcing transactions through intermediaries; (iii) adding value beyond simply providing capital by offering borrowers and corporate tenants specific lending expertise, flexibility, speed, certainty and continuing relationships beyond the closing of a particular financing transaction; and (iv) taking advantage of market anomalies in the real estate financing markets when the Company believes credit is mispriced by other providers of capital such as the spread between lease yields and the yields on corporate tenants' underlying credit obligations. The Company intends to continue to emphasize a mix of portfolio financing transactions to create built-in diversification and single-asset financings for properties with strong, long-term positioning. EXPLANATORY NOTE: - ------------------------------ (1) As more fully discussed in Note 4, on November 4, 1999, the Company changed its form and became a corporation under Maryland law and changed its name from Starwood Financial Trust to Starwood Financial Inc. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2--BASIS OF PRESENTATION The accompanying audited Consolidated Financial Statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). The Consolidated Financial Statements include the accounts of the Company, its qualified REIT subsidiaries, and its majority-owned and controlled partnership. Certain third-party mortgage servicing operations are conducted through Starwood Operating, Inc. ("Starwood Operating"), a taxable corporation which is not consolidated with the Company for financial reporting or income tax purposes. The Company owns all of the preferred stock and a 95% economic interest in Starwood Operating, which is accounted for under the equity method for financial reporting purposes. In addition, the Company has an investment in TriNet Management Operating Company, Inc. ("TMOC"), a taxable noncontrolled subsidiary of the Company, which is also accounted for under the equity method. Further, certain other investments in partnerships or joint ventures which the Company does not control are also accounted for under the equity method. All significant intercompany balances and transactions have been eliminated in consolidation. NOTE 3--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES LOANS AND OTHER LENDING INVESTMENTS, NET--As described in Note 5 "Loans and Other Lending Investments," includes the following investments: senior mortgages, subordinate mortgages, partnership loans/ unsecured notes, loan participations and other lending investments. In general, management considers its investments in this category as held-to-maturity and, accordingly, reflects such items at amortized historical cost. REAL ESTATE AND DEPRECIATION--Real estate is generally recorded at cost. Certain improvements and replacements are capitalized when they extend the useful life, increase capacity or improve the efficiency of the asset. Repairs and maintenance items are expensed as incurred. The Company capitalizes interest costs incurred during the land development or construction period on qualified development projects including investments in joint ventures accounted for under the equity method. Depreciation is computed using the straight line method of cost recovery over estimated useful lives of 40.0 years for buildings, seven years for furniture and equipment, the shorter of the remaining lease term or expected life for tenant improvements, and the remaining life of the building for building improvements. Real estate assets to be disposed of are reported at the lower of their carrying amount or fair value less cost to sell. The Company also periodically reviews long-lived assets to be held and used for an impairment in value whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. In management's opinion, real estate assets to be held and used are not carried at amounts in excess of their estimated recoverable amounts. CASH AND CASH EQUIVALENTS--Cash and cash equivalents include cash held in banks or invested in money market funds with original maturity terms of less than 90 days. NON-CASH ACTIVITY--During the year ended December 31, 1998, the Company had significant non-cash activity including: (i) conversion of units in APMT Limited Partnership (shown as "minority interest" in the consolidated financial statements) to class A shares of the Company (see Note 4); (ii) issuance of options to Starwood Financial Advisors, L.L.C. (the "Advisor") to acquire class A shares of the Company (see Note 11); and (iii) issuance of new class A shares in exchange for a portion of the acquisition of loans and related investments as part of the Recapitalization Transactions (see Note 4). STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The cash portion of the Recapitalization Transactions is summarized as follows (in thousands): During 1999, the Company acquired TriNet (see Note 4). The following is a summary of the effects of this transaction on the Company's consolidated financial position (in thousands): MARKETABLE SECURITIES--The Company has certain investments in marketable securities such as those issued by the Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), and Federal Home Loan Mortgage Corporation (FHLMC). Although the Company generally intends to hold such investments for long-term investment purposes, it may, from time to time, sell any of its investments in these securities as part of its management of liquidity. Accordingly, the Company considers such investments as "available-for-sale" and reflects such investments at fair market value with changes in fair market value reflected as a component of shareholders equity. REPURCHASE AGREEMENTS--The Company may enter into sales of securities or loans under agreements to repurchase the same security or loan. The amounts borrowed under repurchase agreements are carried on the balance sheet as part of debt obligations at the amount advanced plus accrued interest. Interest incurred on the repurchase agreements is reported as interest expense. REVENUE RECOGNITION--The Company's revenue recognition policies are as follows: LOANS AND OTHER LENDING INVESTMENTS: The Company generally intends to hold all of its loans and other lending investments to maturity. Accordingly, it reflects all of these investments at amortized cost less allowance for loan losses, acquisition premiums or discounts, deferred loan fees and undisbursed loan funds. The Company may acquire loans at either premiums or discounts based on the credit characteristics of such loans. These premiums or discounts are recognized as yield adjustments over the lives of the related loans. If loans that were acquired at a premium or discount are prepaid, the Company immediately STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) recognizes the unamortized premium or discount as a decrease or increase in the prepayment gain or loss, respectively. Loan origination or exit fees, as well as direct loan origination costs, are also deferred and recognized over the lives of the related loans as a yield adjustment. Interest income is recognized using the effective interest method applied on a loan-by-loan basis. Certain of the Company's loans provide for accrual of interest at specified rates which differ from current payment terms. Interest is recognized on such loans at the accrual rate subject to management's determination that accrued interest and outstanding principal are ultimately collectible, based on the underlying collateral and operations of the borrower. Prepayment penalties or yield maintenance payments from borrowers are recognized as additional income when received. Certain of the Company's loan investments provide for additional interest based on the borrower's operating cash flow or appreciation of the underlying collateral. Such amounts are considered contingent interest and are reflected as income only upon certainty of collection. LEASING INVESTMENTS: Operating lease revenue is recognized on the straight-line method of accounting from the later of the date of the origination of the lease or the date of acquisition of the facility subject to existing leases. Accordingly, contractual lease payment increases are recognized evenly over the term of the lease. The difference between lease revenue recognized under this method and actual cash receipts is recorded as a deferred rent receivable on the balance sheet. PROVISION FOR POSSIBLE CREDIT LOSSES--The Company's accounting policies require that an allowance for estimated credit losses be maintained at a level that management, based upon an evaluation of known and inherent risks in the portfolio, considers adequate to provide for possible credit losses. Specific valuation allowances are established for impaired loans in the amount by which the carrying value, before allowance for estimated losses, exceeds the fair value of collateral less disposition costs on an individual loan basis. Management considers a loan to be impaired when, based upon current information and events, it believes that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement on a timely basis. Management measures these impaired loans at the fair value of the loans' underlying collateral less estimated disposition costs. Impaired loans may be left on accrual status during the period the Company is pursuing repayment of the loan, however, these loans are placed on non-accrual status at such time that the loans either: (i) become 90 days delinquent; or (ii) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the impairment. While on non-accrual status, interest income is recognized only upon actual receipt. Impairment losses are recognized as direct write-downs of the related loan with a corresponding charge to the provision for possible credit losses. Charge-offs occur when loans, or a portion thereof, are considered uncollectible and of such little value that further pursuit of collection is not warranted. Management's periodic evaluation of the allowance for possible credit losses is based upon an analysis of the portfolio, historical and industry loss experience, economic conditions and trends, collateral values and quality and other relevant factors. INCOME TAXES--The Company did not qualify as a REIT from 1993 through 1997; however, it did not incur any material tax liabilities as a result of its operations. See Note 10 to the consolidated financial statements for more information. As confirmed in a closing agreement with the IRS obtained in March 1998, the Company was eligible and elected to be taxed as a REIT for its tax year beginning January 1, 1998. As a REIT, the Company will be subject to federal income taxation at corporate rates on its REIT taxable income; however, the STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Company is allowed a deduction for the amount of dividends paid to its stockholders, thereby subjecting the distributed net income of the Company to taxation at the shareholder level only. Starwood Operating and TMOC are not consolidated for federal income tax purposes and are taxed as corporations. For financial reporting purposes, current and deferred taxes are provided for in the portion of earnings recognized by the Company with respect to its interest in Starwood Operating and TMOC. NET INCOME ALLOCABLE TO COMMON SHARES--Net income allocable to common shares excludes 1% of net income allocable to the class B shares prior to November 4, 1999. The class A and class B shares were exchanged for Common Stock in connection with the TriNet acquisition, as more fully described in Note 4. EARNINGS (LOSS) PER COMMON SHARES--In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS No. 128") effective for periods ending after December 15, 1997. SFAS No. 128 simplifies the standard for computing earnings per share and makes them comparable with international earnings per share standards. The statement replaces primary earnings per share with basic earnings per share ("Basic EPS") and fully-diluted earnings per share with diluted earnings per share ("Diluted EPS"). USE OF ESTIMATES--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. NEW ACCOUNTING STANDARDS--In June 1997, the FASB issued Statement No. 131, "Disclosure about Segments of an Enterprise and Related Information" ("SFAS No. 131") effective for financial statements issued for periods beginning after December 15, 1997. SFAS No. 131 requires disclosures about segments of an enterprise and related information regarding the different types of business activities in which an enterprise engages and the different economic environments in which it operates. The Company adopted the requirements of this pronouncement in its financial statements beginning with its reporting for fiscal 1999. As of December 31, 1999, the Company is currently segmented between its lending and credit tenant lease businesses. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). On June 23, 1999 the FASB voted to defer the effectiveness of SFAS 133 for one year. SFAS 133 is now effective for fiscal years beginning after June 15, 2000, but earlier application is permitted as of the beginning of any fiscal quarter subsequent to June 15, 1998. SFAS No. 13 establishes accounting and reporting standards for derivative financial instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments as fair value. If certain conditions are met, a derivative may be specifically designated as: (i) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment; (ii) a hedge of the exposure to variable cash flows of a forecasted transaction; or (iii) in certain circumstances a hedge of a foreign currency exposure. The Company currently plans to adopt this pronouncement as required effective January 1, 2001. The adoption of SFAS 133 is not expected to have a material financial impact on the financial position or results of operations of the Company. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--CAPITAL TRANSACTIONS TRANSACTIONS WITH AFFILIATES--In November 1993, the Company was notified that SAHI, Inc. (one of the Starwood Investors) had acquired all of the Company's 212,500 outstanding class B shares. Subsequent to the acquisition of the class B shares, SAHI Partners (another Starwood Investor) purchased the class B shares from SAHI, Inc. and accumulated 40,683 class A shares, or 9.60% of the total class A shares then outstanding. On March 15, 1994, the Company announced that it had entered into an agreement with SAHI Partners and SAHI, Inc. for the sale of a warrant for the right to purchase 833,333 class A shares at a price of $6.00 per share (the "Class A Warrant") and 416,667 class B shares at a price of $0.06 per share (the "Class B Warrant"). SAHI Partners and SAHI, Inc. purchased the warrants for $101,000, which amount was applied against the purchase price for the initial class A and class B shares purchased pursuant to the warrants. On March 28, 1996, the Class A Warrant was assigned to Starwood Mezzanine Investors, L.P. ("Starwood Mezzanine"). On September 26, 1996, the Company became sole general partner of APMT Limited Partnership by contributing $400,000 in cash in exchange for an 8.05% interest in that partnership. Starwood Mezzanine became the 91.95% limited partner by contributing to the partnership its entire interest in the participation certificates in a mortgage note relating to the Warwick Hotel, valued by the Company at approximately $4.6 million as of September 30, 1996. Starwood Mezzanine's interest in the partnership was evidenced by units, which were convertible into cash, class A shares or a combination of both pursuant to an exchange rights agreement. As described below, the units were converted to class A shares in the first quarter of 1998. On January 22, 1997, Starwood Mezzanine exercised its rights under the Class A Warrant to acquire 833,333 class A shares. After its exercise of the Class A Warrant, Starwood Mezzanine beneficially owned 833,333 class A shares and 761,491 units. In addition, SAHI, Inc. exercised its rights under the Class B Warrant to acquire 416,667 class B shares. After its exercise of the Class B Warrant, SAHI Inc. beneficially owned 1,009,911 class B shares and 40,683 class A shares. Upon exercise of the Class A and Class B Warrants, SAHI Partners, SAHI, Inc. and Starwood Mezzanine jointly owned 69.46% of the outstanding class A shares and, with the voting interest of the class B shares, controlled 79.64% of the voting interests of the Company. The Company increased its capital by approximately $5.0 million, and the resulting funds were used to purchase qualified short-term government securities. During the quarter ended March 31, 1998, the Company consummated certain transactions and entered into agreements which significantly recapitalized and expanded the capital resources of the Company as well as modified future operations, including those described herein below in "Recapitalization Transactions" and "Advisor Transaction". RECAPITALIZATION TRANSACTIONS--As more fully discussed above, pursuant to a series of transactions beginning in March 1994 and including the exercise of the Class A and Class B Warrants in January 1997, the Starwood Investors acquired joint ownership of 69.46% and 100% of the outstanding class A shares and class B shares of the Company, respectively, through which they controlled approximately 79.64% of the voting interests in the Company as of December 31, 1997. Prior to the consummation of these transactions (collectively, the "Recapitalization Transactions"), Starwood Mezzanine also owned 761,491 units which represented the remaining 91.95% of APMT Limited Partnership not held by the Company. Those units were convertible into cash, an additional 761,491 class A shares of the Company, or a combination of the two, as determined by the Company. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--CAPITAL TRANSACTIONS (CONTINUED) On March 18, 1998, each outstanding unit held by Starwood Mezzanine was exchanged for one class A share of the Company and, concurrently, the partnership was liquidated through a distribution of its net assets to the Company, its then sole partner. Simultaneously, Starwood Mezzanine contributed various real estate loan investments to the Company in exchange for 9,191,333 class A shares and $25.5 million in cash, as adjusted. Starwood Opportunity Fund IV, L.P., one of the Starwood Investors ("SOF IV"), contributed real estate loans and related investments, $17.9 million in cash and certain letters of intent in exchange for 41,179,133 class A shares of the Company and a cash payment of $324.3 million. Concurrently, the holders of the class B shares who were affiliates of the Starwood Investors acquired 25,565,979 additional class B shares sufficient to maintain existing voting preferences pursuant to the Company's Amended and Restated Declaration of Trust. Immediately after these transactions, the Starwood Investors owned approximately 99.27% of the outstanding class A shares of the Company and 100% of the class B shares. Assets acquired from Starwood Mezzanine have been reflected using step acquisition accounting at predecessor basis adjusted to fair value to the extent of post-transaction third-party ownership. Assets acquired from SOF IV have been reflected at their fair market value. ADVISORY AGREEMENT--In connection with the Recapitalization Transactions, the Company and the Advisor, an affiliate of the Starwood Investors, entered into an Advisory Agreement (the "Advisory Agreement") pursuant to which the Advisor managed the affairs of the Company, subject to the Company's purpose and investment policy, the investment restrictions and the directives of the Board of Directors. The services provided by the Advisor included the following: (i) identifying investment opportunities for the Company; (ii) advising the Company with respect to and effecting acquisitions and dispositions of the Company's investments; (iii) monitoring, managing and servicing the Company's loan portfolio; and (iv) arranging debt financing for the Company. The Advisor was prohibited from acting in a manner inconsistent with the express direction of the Board of Directors, and reported to the Board of Directors and the officers of the Company with respect to its activities. The Company paid the Advisor a quarterly base management fee of 0.3125% (1.25% per annum) of the "Book Equity Value" of the Company determined as of the last day of each quarter but estimated and paid in advance subject to recomputation. "Book Equity Value" was generally defined as the excess of the book value of the assets of the Company over all liabilities of the Company. In addition, the Company paid the Advisor a quarterly incentive fee of 5.00% of the Company's "Adjusted Net Income" during each quarter that the Adjusted Net Income for such quarter (restated and annualized as a rate of return on the Company's Book Equity Value for such quarter) equaled or exceeded the "Benchmark BB Rate." "Adjusted Net Income" was generally defined as the Company's gross income less the Company's expenses for the applicable quarter (including the base fee for such quarter but not the incentive fee for such quarter). In calculating both Book Equity Value and Adjusted Net Income, real estate-related depreciation and amortization (other than amortization of financing costs and other prepaid expenses to the extent such costs and prepaid expenses have previously been booked as an asset of the Company) were not deducted. The Advisor was also reimbursed for certain expenses it incured on behalf of the Company. Because payment of both the base fee and the incentive fee commenced 90 days after the consummation of the Recapitalization Transactions, fees were recognized ratably over the period from March 18, STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--CAPITAL TRANSACTIONS (CONTINUED) 1998 through December 31, 1998. The operating results of the Company for such period were greater than they would have been had the advisory fee not been deferred. The Advisory Agreement had an initial term of three years subject to automatic renewal for one-year periods unless the Company had been liquidated or a Termination Event (as defined in the Advisory Agreement and which generally included violations of the Advisory Agreement by the Advisor, a bankruptcy event of the Advisor or the imposition of a material liability on the Company as a result of the Advisor's bad faith, willful misconduct, gross negligence or reckless disregard of duties) had occurred and was continuing. In addition, the Advisor could have terminated the Advisory Agreement on 60 days' written notice to the Company and the Company could have terminated the Advisory Agreement upon 60 days' written notice if a Termination Event had occurred or if the decision to terminate were based on affirmative vote of the holders of two thirds or more of the voting shares of the Company at the time outstanding. Prior to the transactions described below through which, among other things, the Company became self-advised, the Company was dependent on the services of the Advisor and its officers and employees for the successful execution of its business strategy. 1999 TRANSACTIONS--On November 3, 1999, consistent with previously announced terms, the Company's shareholders approved a series of transactions including: (i) the acquisition, through a merger, of TriNet; (ii) the acquisition, through a merger and a contribution of interests, of 100% of the ownership interests in the Advisor; and (iii) the change in form, through a merger, of the Company's organization into a Maryland corporation. TriNet stockholders also approved the TriNet acquisition on November 3, 1999. These transactions were consummated on November 4, 1999. As part of these transactions, the Company also changed its name to Starwood Financial Inc. and replaced its dual class common share structure with a single class of Common Stock. TRINET ACQUISITION--TriNet merged with and into a subsidiary of the Company, with TriNet surviving as a wholly-owned subsidiary of the Company (the "Leasing Subsidiary"). In the TriNet acquisition, each share of TriNet common stock was converted into 1.15 shares of Common Stock, resulting in an aggregate issuance of 28.9 million shares of Common Stock. Each share of TriNet Series A, Series B and Series C Cumulative Redeemable Preferred Stock was converted into a share of Series B, Series C or Series D (respectively) Cumulative Redeemable Preferred Stock of the Company. The Company's preferred stock issued to the former TriNet preferred stockholders has substantially the same terms as the TriNet preferred stock, except that the new Series B, C, and D preferred stock has additional voting rights not associated with the TriNet preferred stock. The holders of the Company's Series A Preferred Stock will retain the same rights and preferences as existed prior to the TriNet acquisition. The TriNet acquisition was accounted for as a purchase. Because the Company's stock prior to the transaction was largely held by the Starwood Investors, and, as a result, the stock was not widely traded relative to the amount of shares outstanding, the pro forma financial information presented below was prepared utilizing a stock price of $28.14 per TriNet share, which was the average stock price of TriNet during the five-day period before and after the TriNet acquisition was agreed to and announced. ADVISOR TRANSACTION--Contemporaneously with the consummation of the TriNet acquisition, the Company acquired 100% of the interests in the Advisor in exchange for total consideration of four million shares of Common Stock. For accounting purposes, the Advisor Transaction was not considered the STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--CAPITAL TRANSACTIONS (CONTINUED) acquisition of a "business" in applying Accounting Principles Board Opinion No. 16, "Business Combinations" and, therefore, the market value of the Common Stock issued in excess of the fair value of the net tangible assets acquired of approximately $94.5 million has been charged to operating income as a one-time item in the fourth quarter of 1999, rather than capitalized as goodwill. INCORPORATION MERGER--Prior to the consummation of the TriNet acquisition and the Advisor Transaction, the Company changed its form from a Maryland trust to a Maryland corporation in the Incorporation Merger, which technically involved a merger of the Company with a wholly-owned subsidiary formed solely to effect such merger. In the Incorporation Merger, the class B shares were converted into shares of Common Stock on a 49-for-one basis (the same ratio at which class B shares were previously convertible into class A shares), and the class A shares were converted into shares of Common Stock on a one-for-one basis. As a result, the Company no longer has multiple classes of common shares. The Incorporation Merger was treated as a transfer of assets and liabilities under common control. Accordingly, the assets and liabilities transferred from Starwood Financial Trust to Starwood Financial Inc. were reflected at their predecessor basis and no gain or loss was recognized. The Company declared and paid a special dividend of one million shares of its Common Stock payable pro rata to all holders of record of its Common Stock following completion of the Incorporation Merger, but prior to the effective time of the TriNet acquisition and the Advisor Transaction. PRO FORMA INFORMATION--The summary unaudited pro forma consolidated statement of operations for the years ended December 31, 1999 and 1998 are presented as if the following transactions, consummated in November 1999, had occurred on January 1, 1998: (i) the TriNet acquisition; (ii) the Advisor Transaction; and (iii) the borrowing necessary to consummate the aforementioned transactions, and as if the following transactions consummated in March 1998, had occurred on January 1, 1998: (i) the Recapitalization Transactions; (ii) the exchange of each outstanding unit in the APMT Limited Partnership held by holders other than the Company for one class A share; (iii) the liquidation and termination of the partnership; and (iv) the borrowings necessary to consummate the aforementioned transactions. The unaudited pro forma information is based upon the historical consolidated results of operations of the Company and TriNet for the years ended December 31, 1999 and 1998, after giving effect to the events described above. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--CAPITAL TRANSACTIONS (CONTINUED) PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) Investments and dispositions are assumed to have taken place as of January 1, 1998; however, loan originations and acquisitions are not reflected in these pro forma numbers until the actual origination or acquisition date by the Company. The pro forma information above excludes the charge of approximately $94.5 million taken by the Company in fiscal 1999 to reflect the costs incurred in acquiring the Advisor as such charge is non-recurring. The pro forma information also excludes certain non-recurring historical charges recorded by TriNet of $3.4 million in 1999 for a provision for a real estate write-down and $3.0 million in 1998 for a special charge for an expected reduction in TriNet's investment activity. General and administrative costs represent estimated expense levels as an internally-managed Company. The pro forma financial information is not necessarily indicative of what the consolidated results of operations of the Company would have been as of and for the periods indicated, nor does it purport to represent the results of operations for future periods. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5--LOANS AND OTHER LENDING INVESTMENTS The following is a summary description of the Company's loans and other lending investments (in thousands): EXPLANATORY NOTES: - ---------------------------------- * RECLASSIFIED TO CONFORM TO 1999 PRESENTATION. (1) Substantially all variable-rate loans are based on 30-day LIBOR and reprice monthly. (2) The loans require fixed payments of principal and interest resulting in partial principal amortization over the term of the loan with the remaining principal due at maturity. In addition, one of the loans permits additional annual prepayments of principal of up to $1.3 million without penalty at the borrower's option. (3) Under some of these loans, the lender receives additional payments representing additional interest from participation in available cash flow from operations of the property and the proceeds, in excess of a base amount, arising from a sale or refinancing of the property. (4) As of December 31, 1999 and 1998, the unfunded committment amount on one of the Company's construction loans, included in subordinated mortgages, was $16.2 million and $36.7 million, respectively. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5--LOANS AND OTHER LENDING INVESTMENTS During the years ended December 31, 1999 and 1998, respectively, the Company and its affiliated ventures originated or acquired an aggregate of approximately $663.4 million and $1.0 billion in loans and other lending investments, funded $46.4 million and $16.5 million under existing loan commitments and received principal repayments of $561.9 million and $103.9 million. The Company has reflected additional provisions for possible credit losses of approximately $4.8 million and $2.8 million in its results of operations during the years ended December 31, 1999 and 1998. No provisions were reflected in year ended December 31, 1997 as the Company had no significant lending operations prior to the Recapitalization Transactions. There was no other activity in the Company's reserve balances during this period. These provisions represent portfolio reserves based on management's evaluation of general market conditions, the Company's and industry loss experience, likelihood of delinquencies or defaults and the underlying collateral. No direct impairment reserves on specific loans were considered necessary. Management may transfer reserves between general and specific reserves as considered necessary. NOTE 6--REAL ESTATE SUBJECT TO OPERATING LEASES The Company's investments in real estate subject to operating leases, at cost, were as follows: The Company's net lease facilities are leased to tenants with initial term expiration dates from 2000 to 2020. Future rentals under non-cancelable operating leases, excluding tenant reimbursements of expenses in effect at December 31, 1999, are approximately as follows (in thousands): Under certain leases, the Company receives additional participating rent to the extent gross revenues of the tenant exceed a base amount. The Company earned $0.5 million and $0.6 million of such additional participating rent in the years ended December 31, 1999 and 1998, respectively. At December 31, 1999, the Company had investments in five joint ventures: (i) TriNet Sunnyvale Partners L.P. ("Sunnyvale") whose external partners are John D. O'Donnell, Trustee, John W. Hopkins, STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6--REAL ESTATE SUBJECT TO OPERATING LEASES (CONTINUED) and Donald S. Grant; (ii) Corporate Technology Associates LLC ("CTC I") whose external member is Corporate Technology Centre Partners LLC; (iii) Sierra Land Ventures ("Sierra"), whose external joint venture partner is Sierra-LC Land, Ltd.; (iv) Corporate Technology Centre Associates II LLC ("CTC II") whose external joint venture member is Corporate Technology Centre Partners II LLC; and (v) TriNet Milpitas Associates, LLC ("Milpitas") whose external member is The Prudential Insurance Company of America, for the purpose of operating, acquiring and in certain cases, developing properties. Effective November 22, 1999, the joint venture partners, who are affiliates of Whitehall Street Real Estate Limted Partnership, IX and The Goldman Sachs Group L.P. (the "Whitehall Group") in W9/TriNet Poydras, LLC ("Poydras") elected to exercise their right under the parntership agreement, which was accelerated as a result of the TriNet acqusition, to exchange all of their membership units for 350,746 shares of Common Stock of the Company and a $767,000 distribution of available cash. As a consequence, Poydras is now wholly owned and is reflected on a consolidated basis in these financial statements. At December 31, 1999, the ventures comprised 22 net leased facilities totaling 1.5 million square feet, four properties under development totaling 312,400 square feet and 40.4 acres of land held for sale and development. The Company's combined investment, including advances, in these joint ventures at December 31, 1999 was $84.8 million. In the aggregate, the joint ventures had total assets of $332.8 million, total liabilities of $251.9 million, and net income of $0.5 million. The Company accounts for these investments under the equity method because the Company's joint venture partners have certain participating rights which limit the Company's control. The Company's investments in and advances to unconsolidated joint ventures, its percentage ownership interests, its respective income and the Company's pro rata share of its ventures' third party debt as of December 31, 1999 are presented below (in thousands): At December 31, 1999, the Company was the guarantor for 50% of CTC I's $63.8 million construction loan. Additionally, if the Company agrees with its joint venture partner to commence the development of phase II of the project, it will have additional commitments to fund further development costs. The amount of these additional commitments are estimated to be $11.1 million. This amount will vary depending upon the amount of senior third party financing obtained. Currently, the limited partners of the Sunnyvale partnership have the option to convert their partnership interest into cash; however, the Company may elect to deliver 297,728 shares of Common Stock in lieu of cash. Additionally, commencing in February 2002, subject to acceleration under certain circumstances, partnership units held by certain partners of Milpitas may be converted into 984,476 shares of Common Stock. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7--DEBT OBLIGATIONS As of December 31, 1999, the Company has debt obligations under various arrangements with financial institutions as follows (in thousands): EXPLANATORY NOTES: - ---------------------------------- (1) Subsequent to year end, the Company extended the term of its $500.0 million facility to August 2002 and increased pricing under the facility to LIBOR + 1.50% to 1.75%. (2) Based on a 12-month LIBOR contract currently at 5.317%, repricing in May 2000. (3) Other mortgage loans mature at various dates through 2010. (4) Subject to mandatory tender on March 31, 2003, to either the Dealer or the Leasing Subsidiary. The initial coupon of 6.75% applies to first five-year term through the mandatory tender date. If tendered to the Dealer, the notes must be remarketed. The rates reset upon remarketing. (5) These obligations were assumed as part of the TriNet acquisition. As part of the accounting for the purchase, these fixed rate obligations were considered to have stated interest rates which were below the then prevailing market rates at which the Leasing Subsidiary could issue new debt obligations and, accordingly, the Company ascribed a market discount to each obligation. Such discounts will be amortized as an adjustment to interest expense using the effective interest method over the related term of the obligations. As adjusted, the effective annual interest rates on these obligations were 8.81%, 8.75%, 9.51% and 9.04%, for the 6.75% Dealer Remarketable Securities, 7.30% Notes, 7.70% Notes and 7.95% Notes, respectively. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7--DEBT OBLIGATIONS (CONTINUED) Availability of amounts under the secured revolving credit facilities are based on percentage borrowing base calculations. Except as indicated above, all debt obligations are based on 30-day LIBOR and reprice monthly. Certain of the Leasing Subsidiary's debt obligations contain financial covenants pertaining to the subsidiary. Such obligations also establish restrictions on certain inter-company transactions between the Leasing Subsidiary and other Company affiliates. Further, such obligations also provide for a limit on distributions from the Leasing Subsidiary at 85% of cash flow from operations on a rolling four-quarter basis. Subsequent to year end, the Company closed a new unsecured revolving credit facility. The facility is led by a major commercial bank, which has committed $50.0 million of the facility amount and intends to upsize the facility to $100.0 million through syndication. The new facility has a two-year primary term and a one-year extension at the Company's option, and bears interest at LIBOR plus 2.00% to 2.25%, depending upon certain conditions. In addition, subsequent to year end, the Company extended the term of its existing $500.0 million secured credit facility. The Company extended the original August 2000 maturity date to August 2002, through a one-year extension to the facility's draw period and an additional one-year "term out" period during which outstanding principal amortizes 25% per quarter. In connection with the extension, the Company and the facility lender also expanded the range of assets that the lender would accept as collateral under the facility. In exchange for the extension and expansion, the Company agreed to increase the facility's interest rate from LIBOR plus 1.25% to 1.50%, to a revised rate of LIBOR plus 1.50% to 1.75%, depending upon certain conditions. Future maturities of outstanding long-term debt, as adjusted for the subsequent term extension of the Company's $500.0 million secured credit facility discussed above, is as follows (in thousands): NOTE 8--STOCKHOLDERS' EQUITY Prior to November 4, 1999, the Company was authorized to issue 105.0 million shares, representing 70.0 million class A shares and 35.0 million class B shares, with a par value of $1.00 and $0.01 per share, respectively. Class B shares were required to be issued by the Company in an amount equal to one half of the number of class A shares outstanding. Class A and class B shares were each entitled to one vote per share with respect to the election of directors and other matters. Pursuant to the Declaration of Trust, the class B shares were convertible at the option of the class B shareholders into class A shares on the basis of STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 8--STOCKHOLDERS' EQUITY (CONTINUED) 49 class B shares for one class A share. However, the holder of class B shares had agreed with the Company that it would not convert the class B shares into class A shares without the approval of a majority of directors that were not affiliated with such holder. All distributions of cash were made 99% to the holders of class A shares and 1% to the holders of class B shares. On December 15, 1998, for an aggregate purchase price of $220.0 million, the Company issued 4.4 million Series A Preferred Shares and warrants to acquire 6.1 million class A shares, as adjusted for dilution, at $35.00 per share. The warrants are exercisable on or after December 15, 1999 at a price of $35.00 per share and expire on December 15, 2005. The proceeds were allocated between the two securities issued based on estimated relative fair values. As more fully described in Note 4, the Company consummated a series of transactions on November 4, 1999, in which its class A and class B shares were exchanged into a single class of Common Stock. The Company's charter now provides for the issuance of up to 200.0 million shares of Common Stock, par value $0.001 per share, and 30.0 million shares of preferred stock. As part of these transactions, the Company adopted articles supplementary creating four series of preferred stock designated as 9.5% Series A Cumulative Redeemable Preferred Stock, consisting of 4.4 million shares, 9.375% Series B Cumulative Redeemable Preferred Stock, consisting of 2.3 million shares, 9.20% Series C Cumulative Redeemable Preferred Stock, consisting of 1.5 million shares, and 8.0% Series D Cumulative Redeemable Preferred Stock, consisting of 4.6 million shares. The Series B, C and D Cumulative Redeemable Preferred Stock were issued in the TriNet acquisition in exchange for similar issuances of TriNet stock then outstanding. The Series A, B, C and D Cumulative Redeemable Preferred Stock are redeemable without premium at the option of the Company at their respective liquidation preferences beginning on December 15, 2003, June 15, 2001, August 15, 2001 and October 8, 2002, respectively. STOCK REPURCHASE PROGRAM: The Board of Directors approved, and the Company has implemented, a stock repurchase program under which the Company is authorized to repurchase up to 5.0 million shares of its Common Stock from time to time, primarily using proceeds from the disposition of assets and excess cash flow from operations, but also using borrowings under its credit facilities if the Company determines that it is advantageous to do so. As of December 31, 1999, the Company had repurchased approximately 2.3 million shares, at an aggregate cost of approximately $40.4 million. NOTE 9--RISK MANAGEMENT AND USE OF FINANCIAL INSTRUMENTS RISK MANAGEMENT--In the normal course of its on-going business operations, the Company encounters economic risk. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or different bases, than its interest-earning assets. Credit risk is the risk of default on the Company's loan assets that results from a property's, borrower's or tenant's inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of loans, securities available for sale and purchased mortgage servicing rights due to changes in interest rates or other market factors, including the rate of prepayments of principal and the value of the collateral underlying loans and the valuation of real estate held by the Company. USE OF DERIVATIVE FINANCIAL INSTRUMENTS--The Company's use of derivative financial instruments is primarily limited to the utilization of interest rate agreements or other instruments to manage interest rate risk exposure. The principal objective of such arrangements is to minimize the risks and/or costs associated STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9--RISK MANAGEMENT AND USE OF FINANCIAL INSTRUMENTS (CONTINUED) with the Company's operating and financial structure as well as to hedge specific anticipated transactions. The counterparties to these contractual arrangements are major financial institutions with which the Company and its affiliates may also have other financial relationships. The Company is potentially exposed to credit loss in the event of nonperformance by these counterparties. However, because of their high credit ratings, the Company does not anticipate that any of the counterparties will fail to meet their obligations. Prior to the Recapitalization Transactions, the Company did not significantly utilize derivative financial instruments. The Company has entered into LIBOR interest rate caps struck at 9.00%, 7.50% and 7.50% in notional amounts of $300.0 million, $40.4 million and $38.3 million, respectively, which expire in March 2001, January 2001 and June 2001, respectively. At December 31, 1999, the fair value appreciation of the Company's interest rate caps was $2.2 million. The Company has entered into approximately $205.2 million of interest rate swaps to effectively fix the interest rate on a portion of the Company's floating-rate term loan obligations. In addition, in connection with the TriNet acquisition, the Company acquired an interest rate swap agreement which, together with certain existing interest rate cap agreements, effectively fix the interest rate on $75.0 million of the Leasing Subsidiary's LIBOR-based borrowings at 5.58% plus the applicable margin through December 1, 2004. Management expects that it will have aggregate LIBOR-based borrowings at the Leasing Subsidiary in excess of the notional amount for the duration of the swap. The actual borrowing cost to the Company with respect to indebtedness covered by the swap will depend upon the applicable margin over LIBOR for such indebtedness, which will be determined by the terms of the relevant debt instruments. At December 31, 1999, the fair value appreciation of the Company's interest rate swaps was $3.4 million. The Company is currently pursuing or recently consummated certain anticipated long-term fixed rate borrowings and had entered into certain derivative instruments based on U.S. Treasury securities to hedge the potential effects of interest rate movements on these transactions. Under these agreements, the Company would generally receive additional cash flow at settlement if interest rates rise and pay cash if interest rates fall. The effects of such receipts or payments will be deferred and amortized over the term of the specific related fixed-rate borrowings. During the year ended December 31, 1999, the Company settled an aggregate notional amount of approximately $63.0 million that was outstanding under such agreements, resulting in a receipt of approximately $0.6 million to be amortized over the term of the anticipated borrowing. During the year ended December 31, 1999, the Company refinanced its $125.0 million term loan maturing March 15, 1999 with a $155.4 million term loan maturing March 5, 2009. The new term loan bears interest at 7.44% per annum, payable monthly, and amortizes over an approximately 22-year schedule. The new term loan represented one of the forecasted transactions for which the Company had previously entered into U.S. Treasury-based hedging transactions. The net $3.4 million cost of the settlement of the related interest rate hedges has been deferred and will be amortized as an increase to the effective financing cost of the new term loan over its effective 10-year term. In the event that, in the opinion of management, it is no longer probable that the remaining forecasted transaction will occur under terms substantially equivalent to those projected, the Company will cease recognizing such transactions as hedges and immediately recognize related gains or losses based on STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9--RISK MANAGEMENT AND USE OF FINANCIAL INSTRUMENTS (CONTINUED) actual settlement or estimated settlement value of the underlying derivative contract. No such gains or losses have been recognized by the Company. CREDIT RISK CONCENTRATIONS--Concentrations of credit risks arise when a number of borrowers or tenants related to the Company's investments are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations, including those to the Company, to be similarly affected by changes in economic conditions. The Company regularly monitors various segments of its portfolio to assess potential concentrations of credit risks. Management believes the current credit risk portfolio is reasonably well diversified and does not contain any unusual concentration of credit risks. Substantially all of the Company's real estate subject to operating leases (including those held by joint ventures), loans and other lending investments are collateralized by properties located in the United States, with significant concentrations (i.e., greater than 10%) as of December 31, 1999 in California (26.4%) and Texas (11.8%). As of December 31, 1999, the Company's investments also contain significant concentrations in the following asset/collateral types: office (52%), hotel/resorts (12%), retail (8%) and industrial (8%). The Company underwrites the credit of prospective borrowers and tenants and often requires them to provide some form of credit support such as corporate guarantees or letters of credit. Although the Company's loans and other lending investments and net lease assets are geographically diverse and the borrowers and tenants operate in a variety of industries, to the extent the Company has a significant concentration of interest or operating lease revenues from any single borrower or tenant, the inability of that borrower or tenant to make its payment could have an adverse effect on the Company. As of December 31, 1999, the Company's five largest borrowers or tenants collectively accounted for approximately 15.0% of the Company's annualized interest and operating lease revenue. NOTE 10--INCOME TAXES Although originally formed to qualify as a REIT under the Code for the purpose of making and acquiring various types of mortgage and other loans, during 1993 through 1997, the Company failed to qualify as a REIT. As confirmed by a closing agreement with the Internal Revenue Service (the "IRS") obtained in March 1998, the Company was eligible and elected to be taxed as a REIT for the tax years commencing on January 1, 1998. The Company did not incur any material tax liabilities as a result of its operations during such years. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and income tax purposes, as well as operating loss and tax credit carry forwards. A valuation allowance is recorded if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred income tax asset will not be realized. Given the limited nature of the Company's operations and assets and liabilities from 1993 through 1997, the only deferred tax assets are net operating loss carry forwards ("NOL's") of approximately $4.0 million, which arose during such periods. Since the Company has elected to be treated as a REIT for its tax years beginning January 1, 1998, the NOL's have expired unutilized. Accordingly, no net deferred tax asset value, after consideration of a 100% valuation allowance, has been reflected in these financial statements as of December 31, 1999 and 1998 nor a net tax provision for any of the fiscal years ended December 31, 1999, 1998 or 1997. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--STOCK OPTION PLANS AND EMPLOYEE BENEFITS The Company's 1996 Long-Term Incentive Plan (the "Plan") is designed to provide incentive compensation for officers, other key employees and directors of the Company. The Plan provides for awards of stock options and restricted stock and other performance awards. The maximum number of shares of Common Stock available for awards under the Plan is 9% of the outstanding shares of Common Stock, calculated on a fully diluted basis, from time to time; provided that, the number of shares of Common Stock reserved for grants of options designated as incentive stock options is 4.9 million, subject to certain antidilution provisions in the Plan. All awards under the Plan, other than automatic awards to non-employee directors, are at the discretion of the Board or a committee of the Board. At December 31, 1999, a total of approximately 7.7 million shares of Common Stock were available for awards under the Plan, of which options to purchase approximately 3.9 million shares of Common Stock were outstanding. Concurrently with the Recapitalization Transactions, the Company issued approximately 2.5 million fully vested (as adjusted) and immediately exercisable options to purchase class A shares at $15.00 per share to the Advisor with a term of ten years. The Advisor granted a portion of these options to its employees and the remainder allocated to an affiliate. In general, the grants to the Advisor's employees provided for scheduled vesting over a predefined service period of three to five years and in some cases provided for accelerated vesting based on a change in control of the Advisor or completion of certain liquidity transactions. These options expire concurrently with the original option grant to the Advisor. Upon consummation of the Advisor Transaction these individuals became employees of the Company. In connection with the TriNet acquisition, outstanding options to purchase TriNet stock under TriNet's stock option plans were converted into options to purchase shares of Common Stock on substantially the same terms, except that both the exercise price and number of shares issuable upon exercise of the TriNtet options were adjusted to give effect to the merger exchange ratio of 1.15 shares of Common Stock for each share of TriNet common stock. In addition, options held by the directors of TriNet and certain executive officers became fully vested as a result of the transaction. The TriNet directors received a number of options of the Company to purchase Common Stock on a fully vested basis on substantially the same terms as the TriNet options, in each case giving effect to the 1.15 exchange ratio for their options. Also, as a result of the TriNet acquisition, TriNet terminated its dividend equivalent rights program. The program called for immediate vesting and cash redemption of all dividend equivalent rights upon a change of control of 50% or more of the voting common stock. Concurrent with the TriNet acquisition, all dividend equivalent rights were vested and amounts due to former TriNet employees of approximately $8.3 million were paid by the Company. Such payments were included as part of the purchase price paid by the Company to acquire TriNet for financial reporting purposes. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--STOCK OPTION PLANS AND EMPLOYEE BENEFITS (CONTINUED) Changes in options outstanding during each of fiscal 1997, 1998 and 1999 are as follows: EXPLANATORY NOTE: - ------------------------ (1) Represents the reclassification of stock options originally granted to the Advisor and regranted to its employees who became employees of the Company upon consummation of the Advisor Transaction (see Note 4). STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--STOCK OPTION PLANS AND EMPLOYEE BENEFITS (CONTINUED) The following table summarizes information concerning outstanding and exercisable options as of December 31, 1999: EXPLANATORY NOTE: - ------------------------------ (1) Includes approximately 764,000 options which were granted, on a fully exercisable basis, in connection with the Recapitalization Transactions to Starwood Capital Group, and were subsequently regranted by that entity to its employees subject to vesting requirements. As a result of those vesting requirements less than 2,000 of these options are currently exercisable by the beneficial owners. In the event that these employees forfeit such options they revert to Starwood Capital Group, who may regrant them at its discretion. The Company has elected to use the intrinsic method for accounting for options issued to employees or directors, as allowed under Statement of Financial Accounting Standards No. 123 "Accounting for Stock Based Compensation" ("SFAS 123") and, accordingly, recognizes no compensation charge in connection with these options to the extent that the options exercise price equals or exceeds the quoted price of the Company's common shares at the date of grant or measurement date. In connection with the Advisor Transaction, as part of the computation of the one-time charge to earnings, the Company calculated a deferred compensation charge of approximately $5.1 million. This deferred charge represents the difference of the closing sales price of the shares of Common Stock on the date of the Advisor Transaction of $20.25 over the strike price of the options of $15.00 for the unvested portion of the options granted to former employees of the Advisor who are now employees of the Company. This deferred charge will be amortized over the related remaining vesting terms to the individual employees as additional compensation expense. In connection with the original grant of options to the Advisor, the Company utilized the option value method as required by SFAS 123 to account for the initial grant of options to the Advisor. An independent financial advisory firm estimated the value of these options at date of grant to be approximately $2.40 per share using a Black-Scholes valuation model. In the absence of comparable historical market information STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--STOCK OPTION PLANS AND EMPLOYEE BENEFITS (CONTINUED) for the Company, the advisory firm utilized assumptions consistent with activity of a comparable peer group of companies including an estimated option life of five years, a 27.5% volatility rate and an estimated annual dividend rate of 8.5%. The resulting charge to earnings was calculated as the number of options allocated to the Advisor multiplied by the estimated value at consummation. A charge of approximately $6.0 million has been reflected in the Company's first quarter 1998 financial results for this original grant. Had the Company's compensation costs been determined using the fair value method of accounting for stock options issued under the Plan to employees and directors prescribed by SFAS 123, the Company's net income and earnings per share for the fiscal year ended December 31, 1999 would have been reduced on a pro forma basis by approximately $141,000, which would not have significantly impacted earnings per share. As the Company had no employees prior to the consummation of the Advisor Transaction, no pro forma adjustment is necessary to reflect in the results of operations for fiscal 1998 and 1997 as if the option value were utilized. For the above SFAS 123 calculation, the Company utilized the following assumptions; a 33.63% volatility rate (derived from a group of comparable companies), a risk free rate of 5.91% and an estimated annual dividend rate of 11.85%. Future charges may be taken to the extent of additional option grants, which are at the discretion of the Board of Directors. Effective November 4, 1999, the Company implemented a savings and retirement plan (the "401 (k) Plan"), which is a voluntary, defined contribution plan. All employees are eligible to participate in the 401 (k) Plan following completion of six months of continuous service with the Company. Each participant may contribute on a pretax basis between 2% and 15% of such participant's compensation. At the discretion of the Board of Directors, the Company may make matching contributions on the participant's behalf up to 50% of the first 10% of the participant's annual contribution. The Company made contributions of approximately $0.02 million to the 401 (k) Plan for the year ended December 31, 1999. NOTE 12--EARNINGS PER SHARE Prior to November 4, 1999, basic EPS was computed based on the income allocable to class A shares (net income reduced by accrued dividends on preferred shares and by 1% allocated to class B shares) divided by the weighted average number of class A shares outstanding during the period. Diluted EPS was based on the net earnings allocable to class A shares plus dividends on class B shares which were convertible into class A shares, divided by the weighted average number of class A shares and dilutive potential class A shares that were outstanding during the period. Dilutive potential class A shares included the class B shares, which were convertible into class A shares at a rate of 49 class B shares for one class A share, and potentially dilutive options to purchase class A shares issued to the Advisor and the Company's directors and warrants to acquire class A shares. As more fully described in Note 4, in the Incorporation Merger, the class B shares were converted into shares of Common Stock on a 49-for-one basis (the same ratio at which class B shares were previously convertible into class A shares), and the class A shares were converted into shares of Common Stock on a one-for-one basis. As a result, the Company no longer has multiple classes of common shares. Basic and STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12--EARNINGS PER SHARE (CONTINUED) diluted earnings per share are based upon the following weighted average shares outstanding during the years ended December 31, 1999, 1998 and 1997, respectively. As previously indicated, effective June 19, 1998, the Company consummated a one-for-six reverse stock split for its shares. Historical earnings per share have been retroactively restated to reflect the reverse split for comparative purposes. NOTE 13--COMPREHENSIVE INCOME In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive Income" ("SFAS No. 130") effective for fiscal years beginning after December 15, 1997. The statement changes the reporting of certain items currently reported as changes in the shareholders equity section of the balance sheet and establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS No. 130 requires that all components of comprehensive income shall be reported in the financial statements in the period in which they are recognized. Furthermore, a total amount for comprehensive income shall be displayed in the financial statement where the components of other comprehensive income are reported. The Company was not previously required to present comprehensive income or its components under generally accepted accounting principles. The Company has adopted this standard effective January 1, 1998. Total comprehensive income (loss) was $38.7 million, $59.9 million and $(0.2) million for the years ended December 31, 1999, 1998 and 1997 respectively. The primary component of comprehensive income other than net income was the change in value of certain investments in marketable securities classified as available-for-sale. NOTE 14--DIVIDENDS In order to maintain its election to qualify as a real estate investment trust, the Company must distribute, at a minimum, an amount equal to 95% of its taxable income and must distribute 100% of its taxable income to avoid paying corporate federal income taxes. Accordingly, the Company anticipates it will distribute all of its taxable income to its shareholders. Because taxable income differs from cash flow from operations due to non-cash revenues or expenses, in certain circumstances, the Company may be required to borrow to make sufficient dividend payments to meet this anticipated dividend threshold. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 14--DIVIDENDS (CONTINUED) On November 4, 1999, the class A shares were converted into shares of Common Stock on a one-for-one basis. Total dividends declared by the Company aggregated $116.1 million, or $1.86 per common share, for the year ended December 31, 1999. On November 29, 1999, the Company declared a dividend of approximately $48.4 million, or $0.57 per common share applicable to the fourth quarter and payable to shareholders of record on December 31, 1999. For the year ended December 31, 1999, total dividends declared by the Company aggregated $59.7 million, or $1.14 per common share. The Company also declared dividends aggregating $20.9 million, $1.2 million, $0.7 million, and $2.0 million, respectively, on its Series A, B, C and D preferred stock, respectively, for the year ended December 31, 1999. The Series B, C, and D preferred stock was issued in connection with the TriNet acquisition and the amounts above represent only fourth quarter dividends. There are no dividend arrearages on any of the preferred shares currently outstanding. Further, it declared and paid dividends aggregating $0.2 million per quarter to the holders of the class B shares in connection with the March 31, June 30, and September 30 quarterly dividends to the holders of the class A shares. In November 1999, the Company declared and paid a dividend of a total of one million shares of Common Stock pro rata to all holders of record of Common Stock as of the close of business on November 3, 1999. The Series A preferred stock has a liquidation preference of $50.00 per share, carry an initial dividend yield of 9.50% per annum. The dividend rate on the preferred shares will increase to 9.75% on December 15, 2005, to 10.00% on December 15, 2006 and to 10.25% on December 15, 2007 and thereafter. Dividends on the Series A preferred shares are payable quarterly in arrears and are cumulative. Holders of shares of the Series B preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative preferential cash dividends at the rate of 9.375% per annum of the $25.00 liquidation preference, equivalent to a fixed annual rate of $2.34 per share. Dividends are cumulative from the date of original issue and are payable quarterly in arrears on or before the 15th day of each March, June, September and December or, if not a business day, the next succeeding business day. Any dividend payable on the Series B preferred stock for any partial dividend period will be computed on the basis of a 360-day year consisting of twelve 30-day months. Dividends will be payable to holders of record as of the close of business on the first day of the calendar month in which the applicable dividend payment date falls or on another date designated by the Board of Directors of the Company for the payment of dividends that is not more than 30 nor less than 10 days prior to the dividend payment date. Holders of shares of the Series C preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative preferential cash dividends at the rate of 9.20% of the $25.00 liquidation preference per year, equivalent to a fixed annual rate of $2.30 per share. Holders of shares of the Series D preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative preferential cash dividends at the rate of 8.00% of the $25.00 liquidation preference per year, equivalent to a fixed annual rate of $2.00 per share. The exact amount of future quarterly dividends to common shareholders will be determined by the Board of Directors based on the Company's actual and expected operations for the fiscal year and the Company's overall liquidity position. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 15--FAIR VALUES OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures About Fair Value of Financial Instruments" ("SFAS 107"), requires the disclosure of the estimated fair values of financial instruments. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Quoted market prices, if available, are utilized as estimates of the fair values of financial instruments. Because no quoted market prices exist for a significant part of the Company's financial instruments, the fair values of such instruments have been derived based on management's assumptions, the amount and timing of future cash flows and estimated discount rates. The estimation methods for individual classifications of financial instruments are described more fully below. Different assumptions could significantly affect these estimates. Accordingly, the net realizable values could be materially different from the estimates presented below. The provisions of SFAS 107 do not require the disclosure of the fair value of non-financial instruments, including intangible assets or the Company's real estate assets under operating leases. In addition, the estimates are only indicative of the value of individual financial instruments and should not be considered an indication of the fair value of the Company as an operating business. SHORT-TERM FINANCIAL INSTRUMENTS--The carrying values of short-term financial instruments including cash and cash equivalents and short-term investments approximate the fair values of these instruments. These financial instruments generally expose the Company to limited credit risk and have no stated maturities, or have an average maturity of less than 90 days and carry interest rates which approximate market. LOANS AND OTHER LENDING INVESTMENTS--For the Company's interests in loans and other lending investments, the fair values were estimated by discounting the future contractual cash flows (excluding participation interests in the sale or refinancing proceeds of the underlying collateral) using estimated current market rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities. MARKETABLE SECURITIES--Securities held for investment, securities available for sale, loans held for sale, trading account instruments, long-term debt and trust preferred securities traded actively in the secondary market have been valued using quoted market prices. OTHER FINANCIAL INSTRUMENTS--The carrying value of other financial instruments including, restricted cash, accrued interest receivable, accounts payable, accrued expenses and other liabilities approximate the fair values of the instruments. DEBT OBLIGATIONS--A substantial portion of the Company's existing debt obligations bear interest at fixed margins over LIBOR. Such margins or spreads may be higher or lower than those at which the Company could currently replace the related financing arrangements. Other obligations of the Company bear interest at fixed rates, which may differ from prevailing market interest rates. As a result, the fair values of the Company's debt obligations were estimated by discounting current debt balances from December 31, 1999 or 1998 to maturity using estimated current market rates at which the Company could enter into similar financing arrangements. INTEREST RATE PROTECTION AGREEMENTS--The fair value of interest rate protection agreements such as interest rate caps, floors, collars and swaps used for hedging purposes (see Note 9) is the estimated amount the Company would receive or pay to terminate these agreements at the reporting date, taking into account current interest rates and current creditworthiness of the respective counterparties. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 15--FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED) The book and fair values of financial instruments as of December 31, 1999 and 1998 were (in thousands): NOTE 16--SEGMENT REPORTING Statement of Financial Accounting Standard No. 131 ("SFAS 131") establishes standards for the way the public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected financial information about operating segments in interim financial reports issued to stockholders. The Company has two reportable segments: Real Estate Lending and Credit Tenant Leasing. The Company does not have substantial foreign operations. The accounting policies of the segments are the same as those described in Note 3. The Company has no single customer that accounts for 10% or more of revenues (see Note 9 for other information regarding concentrations of credit risk). STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16--SEGMENT REPORTING (CONTINUED) The Company evaluates performance based on the following financial measures for each segment: EXPLANATORY NOTES: - ------------------------------ (1) Includes the Company's pre-existing Credit Tenant Leasing investments acquired in the Recapitalization Transactions since March 18, 1998 and the Credit Tenant Leasing business acquired in the TriNet acquisition since November 4, 1999. (2) Corporate and Other represents all corporate-level items, including, general and administrative expenses and any intercompany eliminations necessary to reconcile to the consolidated Company totals. This caption also includes the Company's servicing business, which is not considered a material separate segment. In addition, as more fully discussed in Note 4, Corporate and Other for the year ended December 31, 1999 includes a non-recurring charge of approximately $94.5 million relating to the Advisor Transaction. (3) Total revenues represents all revenues earned during the period from the assets in each segment. Revenue from the Real Estate Lending Business primarily represents interest income and revenue from the Credit Tenant Leasing business primarily represents operating lease income. (4) Total operating and interest expense represents provision for possible credit losses for the Real Estate Lending business and property operating costs (including real estate taxes) for the Credit Tenant Leasing business. Interest expense, general and administrative, advisory fees and stock option compensation expense is included in Corporate and Other for all periods. Depreciation and amortization of $10,340, $4,287 and $0 in 1999, 1998 and 1997, respectively, are included in the amounts presented above. (5) Net operating income before minority interests represents total revenues, as defined in note (B) above, less total operating and interest expense, as defined in note (C) above, for each period. (6) Long-lived assets is comprised of Loans and Other Lending Investments, net and Real Estate Subject to Operating Leases, net, for each respective segment. STARWOOD FINANCIAL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 17--SUBSEQUENT EVENTS On January 31, 2000, the Company closed a new unsecured revolving credit facility. The facility is led by a major commercial bank, which has committed $50.0 of the facility amount and intends to increase the facility to $100.0 million through syndication. The new facility has a two-year primary term and one-year extension at the Company's option, and bears interest at LIBOR plus 2.00% to 2.25%, depending upon certain conditions. As more fully discussed in Note 7, on February 4, 2000, the Company extended the term, modified the interest rate and certain other provisions on its existing $500.0 million secured credit facility. NOTE 18--QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following table sets forth the selected quarterly financial data for the Company (in thousands, except for per share amounts). EXPLANATORY NOTES: - ------------------------------ (1) As more fully discussed in Note 4, the quarter ended December 31, 1999 includes a non-recurring charge of approximately $94.5 million relating to the Advisor Transaction. Excluding such charge, net income for the quarter would have been approximately $44.0 million and net income per common share for the quarter would have been $0.49. (2) On November 4, 1999, through the Incorporation Merger, the class B shares were effectively converted into shares of Common Stock on a 49-for-one basis and the class A shares were converted into shares of Common Stock on a one-for-one basis. (3) As adjusted for one-for-six reverse stock split effective June 19, 1998. STARWOOD FINANCIAL INC. SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (DOLLARS IN THOUSANDS) EXPLANATORY NOTE: - ------------------------------ (1) See Note 5 to the Company's 1999 Consolidated Financial Statements. STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) STARWOOD FINANCIAL INC. NOTES TO SCHEDULE III DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) 1. RECONCILIATION OF REAL ESTATE: The following table reconciles Real Estate from January 1, 1997 to December 31, 1999: 2. RECONCILIATION OF ACCUMULATED DEPRECIATION: The following table reconciles Accumulated Depreciation from January 1, 1997 to December 31, 1999: STARWOOD FINANCIAL INC. SCHEDULE IV--MORTGAGE LOANS ON REAL ESTATE AS OF DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Portions of the Company's definitive proxy statement for the 2000 annual meeting of shareholders to be filed within 120 days after the close of the Company's fiscal year are incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Portions of the Company's definitive proxy statement for the 2000 annual meeting of shareholders to be filed within 120 days after the close of the Company's fiscal year are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Portions of the Company's definitive proxy statement for the 2000 annual meeting of shareholders to be filed within 120 days after the close of the Company's fiscal year are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Portions of the Company's definitive proxy statement for the 2000 annual meeting of the shareholders to be filed within 120 days after the close of the Company's fiscal year are incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) and (d). Financial statements and schedules--see Index to Financial Statements and Schedules included in Item 8. (b) Reports on Form 8-K. None. (c) Exhibits--see index on following page. INDEX TO EXHIBITS EXPLANATORY NOTES: - ------------------------ * Incorporated by reference from the Company's Registration Statement on Form S-4 filed on May 12, 1998. ** Incorporated by reference from the Company's Annual Report on Form 10- K for the year ended December 31, 1997 filed on April 2, 1998. *** Incorporated by reference from the Company's Form 8-K filed on December 23, 1998. **** Incorporated by reference to the Company's Current Report on Form 8-K filed on June 22, 1999. ***** Incorporated by reference to the Company's Registration Statement on Form S-4 filed on August 25, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following person on behalf of the registrant and in the capacities and on the dates indicated.

1005286_1999.txt

1005286_1999

1999

1005286

ITEM 1. BUSINESS Except for the historical information contained herein, the matters discussed in this report are forward-looking statements that involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Potential risks and uncertainties include, without limitation, those mentioned in this Report and, in particular, the factors described in Item 7 under "Additional Factors That May Affect Future Results." GENERAL Landec Corporation and its subsidiaries ("Landec" or the "Company") design, develop, manufacture and sell temperature-activated and other specialty polymer products for a variety of food products, agricultural products, specialty industrial and medical applications. This proprietary polymer technology is the foundation, and a key differentiating advantage, upon which the Company has built its business. Landec's Food Products Technology business, operated through its wholly owned subsidiary Apio, combines Landec's proprietary food packaging technology with the capabilities of a large national food supplier and value-added produce processor. This combination was consummated in December 1999 when the Company acquired Apio, Inc. and certain related entities (collectively "Apio"). The Company's Agricultural Seed Technology business, operated through its wholly owned subsidiary Intellicoat Corporation ("Intellicoat"), combines Landec's proprietary seed coating technology with the unique direct marketing, telephone sales and e-commerce distribution capabilities of Fielder's Choice Direct ("Fielder's Choice"). In September 1997, Intellicoat acquired Fielder's Choice, a direct marketer of hybrid seed corn. In addition to its two core businesses, the Company also operates a Technology Licensing/Research and Development Business which licenses products outside of Landec's core businesses to industry leaders such as Alcon Laboratories, Inc. ("Alcon") and Hitachi Chemicals. It also engages in research and development activities with companies such as ConvaTec, a division of Bristol Myers Squibb. To support the polymer manufacturing needs of the core businesses, Landec has developed and acquired lab scale and pilot plant capabilities in Menlo Park, California and scale-up and commercial manufacturing capabilities at its Dock Resins Corporation subsidiary ("Dock Resins") in Linden, New Jersey. In April 1997, Landec acquired Dock Resins, a manufacturer and marketer of specialty acrylic and other polymers. In addition to providing manufacturing capabilities, Dock Resins sells industrial specialty products under the Doresco-TM- trademark which are used by more than 300 customers throughout the United States in the coatings, printing inks, laminating and adhesives markets. The Company's core polymer products are based on its patented proprietary Intelimer-registered Tradmark- polymers, which differ from other polymers in that they can be customized to abruptly change their physical characteristics when heated or cooled through a pre-set temperature switch. For instance, Intelimer polymers can change within the space of one or two DEG. Celsius from a slick, non-adhesive state to a highly tacky, adhesive state; from an impermeable state to a highly permeable state; or from a solid state to a viscous state. These abrupt changes are repeatedly reversible and can be tailored by Landec to occur at specific temperatures, thereby offering substantial competitive advantages in the Company's target markets. Historically, the Company had managed its operations in three business segments - Food Products Technology, Agricultural Seed Technology and Industrial High Performance Materials. However, in conjunction with the acquisition of Apio on December 2, 1999, the Company is now focusing on two vertically integrated core businesses - Food Products Technology and Agricultural Seed Technology. Although not a core business, the Company continues to pursue, mostly with partners, opportunities both domestically and internationally with its industrial products focusing primarily on catalysts, resins, formulated products and adhesives. The principal products and services offered by the Company in its two core businesses - Food Products Technology and Agricultural Seed Technology - and in the technology licensing and research and development are described below. Financial information concerning the industry segments for which the Company reported its operations during fiscal years 1997 through 1999 is summarized in Note 13 to the Consolidated Financial Statements. The Company was incorporated in California on October 31, 1986. The Company completed its initial public offering in 1996 and is listed on the Nasdaq National Market under the symbol "LNDC." TECHNOLOGY OVERVIEW Polymers are important and versatile materials found in many of the products of modern life. Certain polymers, such as cellulose and natural rubber, occur in nature. Man-made polymers include nylon fibers used in carpeting and clothing, coatings used in paints and finishes, plastics such as polyethylene, and elastomers used in automobile tires and latex gloves. Historically, synthetic polymers have been designed and developed primarily for improved mechanical and thermal properties, such as strength and the ability to withstand high temperatures. Improvements in these and other properties and the ease of manufacturing of synthetic polymers have allowed these materials to replace wood, metal and natural fibers in many applications over the last 40 years. More recently, scientists have focused their efforts on identifying and developing sophisticated polymers with novel properties for a variety of commercial applications. Landec's Intelimer polymers are a proprietary class of synthetic polymeric materials that respond to temperature changes in a controllable, predictable way. Typically, polymers gradually change in adhesion, permeability and viscosity over broad temperature ranges. Landec's Intelimer materials, in contrast, can be designed to exhibit abrupt changes in permeability, adhesion and/or viscosity over temperature ranges as narrow as 1DEG.C to 2DEG.C. These changes can be designed to occur at relatively low temperatures (0DEG.C to 100DEG.C) that are relatively easy to maintain in industrial and commercial environments. FIGURE 1 illustrates the effect of temperature on Intelimer materials as compared to typical polymers. [GRAPHIC] Landec's proprietary polymer technology is based on the structure and phase behavior of Intelimer materials. The abrupt thermal transitions of specific Intelimer materials are achieved through the use of chemically precise hydrocarbon side chains that are attached to a polymer backbone. Below a pre-determined switch temperature, the polymer's side chains align through weak hydrophobic interactions resulting in a crystalline structure. When this side chain crystallizable polymer is heated to, or above, this switch temperature, these interactions are disrupted and the polymer is transformed into an amorphous, viscous state. Because this transformation involves a physical and not a chemical change, this process is repeatedly reversible. Landec can set the polymer switch temperature anywhere between 0DEG.C to 100DEG.C by varying the length of the side chains. The reversible transitions between crystalline and amorphous states are illustrated in FIGURE 2 below. [GRAPHIC] Side chain crystallizable polymers were first discovered by academic researchers in the mid-1950's. These polymers were initially considered to be merely of scientific curiosity from a polymer physics perspective, and, to the Company's knowledge, no significant commercial applications were pursued. In the mid-1980's, Dr. Ray Stewart, the Company's founder, became interested in the idea of using the temperature-activated permeability properties of these polymers to deliver various materials such as drugs and pesticides. After forming Landec in 1986, Dr. Stewart subsequently discovered broader utility for these polymers. After several years of basic research, commercial development efforts began in the early 1990's, resulting in initial products in mid-1994. Landec's Intelimer materials are generally synthesized from long chain acrylic monomers that are derived primarily from natural materials such as soybean and corn oils, and are highly purifiable and designed to be manufactured economically through known polymerization processes. Intelimer materials can be made into many different forms, including films, coatings, microcapsules and discreet forms. DESCRIPTION OF CORE BUSINESS The Company participates in two core segments- Food Products Technology and Agricultural Seed Technology. Outside of these two core segments, Landec will license technology and conduct on going research and development through its Technology Licensing/Research & Development Business. [GRAPH] FOOD PRODUCTS TECHNOLOGY BUSINESS Landec began marketing in late 1995 its proprietary Intelimer-based breathable membranes for use in the fresh-cut produce packaging market, the fastest growing segment in the food market. Landec's unique technology enabled Landec's customers to enter into and develop new businesses in this fresh-cut produce market (also known as the "value-added" market). In December 1999, Landec acquired Apio, Landec's largest customer in the Food Products Technology business and one of the nation's leading marketers and packers of produce and specialty packaged fresh-cut vegetables. With approximately $158 million in revenue in 1998, Apio provides year-round access to produce, utilizes state-of-the-art fresh-cut produce processing technology and distributes to 9 of the top 10 U.S. retail chains and major club stores. Landec's proprietary Intelimer-based packaging business has been combined with Apio into a wholly owned subsidiary which retains the Apio, Inc. name. This vertical integration within the Food Products Technology business places Landec in the unique position of providing the fresh-cut and whole produce market with both technology and access to larger end users/customers. INTELLIPAC-TM- BREATHABLE MEMBRANES Certain types of fresh-cut produce can spoil or discolor rapidly when packaged in conventional packaging materials and are therefore limited in their ability to be distributed broadly to markets. The Company's Intellipac breathable membranes facilitate the packaging of fresh-cut produce. Fresh-cut produce is pre-washed, cut and packaged in a form that is ready to use by the consumer and is thus typically sold at premium price levels. According to the Produce Marketing Association, in 1998, the total U.S. fresh produce market exceeded $100 billion. Of this, U.S. retail sales of fresh-cut produce grew almost 20 percent to an estimated $7 billion. The Company believes that the growth of this market has been driven by consumer demand and the willingness to pay for convenience, labor savings and uniform quality relative to produce prepared at the point of sale. The International Fresh Cut Produce Associates estimates that by 2003, U.S. retail sales of fresh-cut produce could be as much as $19 billion. Although fresh-cut produce companies have had success in the salad market, the industry has been slow to diversify into other fresh-cut vegetables or fruits due to limitations in film materials used to package the fresh-cut produce. After harvesting, vegetables and fruits continue to respire, consuming oxygen and releasing carbon dioxide. Too much or too little oxygen can result in premature spoilage and decay and promote the growth of contaminants and microorganisms that jeopardize inherent food safety. Conventional packaging films used today, such as polyethylene and polypropylene, can be made with modest permeability to oxygen and carbon dioxide, but often do not provide the optimal atmosphere for the produce packaged. Shortcomings of currently used materials have not significantly hindered the growth in the fresh-cut salad market because lettuce, unlike many vegetables and fruits, has low respiration requirements. The respiration rate of fresh-cut produce varies from vegetable to vegetable and from fruit to fruit. The challenge facing the industry is to develop packaging for the high respiring, high value and shelf life sensitive fresh-cut vegetable and fruit markets. The Company believes that today's conventional packaging films face numerous challenges in adapting to meet the diversification of pre-cut vegetables and fruits evolving in the industry without compromising shelf life and produce quality. To mirror the growth experienced in the fresh-cut salad market, the markets for high respiring vegetables and fruits such as broccoli, cauliflower, berries and stone fruit (peaches, apricots, nectarines) will require a more versatile and sophisticated packaging solution such as the Company's Intellipac breathable membranes. The respiration rate of fresh-cut produce also varies with temperature. As temperature increases, fresh-cut produce generally respires at a higher rate, which speeds up the aging process, resulting in shortened shelf life and increased potential for decay, spoilage, loss of texture and dehydration. As fresh-cut produce is transported from the processing plant through the refrigerated distribution chain to foodservice locations or retail stores, and finally to the ultimate consumer, temperatures can fluctuate significantly. Therefore, temperature control is a constant challenge in preserving the quality of fresh-cut produce -- a challenge few current packaging films can fulfill. The Company believes that its temperature-responsive Intellipac technology will respond well to the challenges of the fresh-cut distribution process. Using its Intelimer technology, Landec has developed Intellipac breathable membranes that it believes address many of the shortcomings of conventional materials. A membrane is applied over a small cutout section or an aperture of a flexible film bag. This highly permeable "window" acts as the mechanism to transmit the majority of the gas transmission properties required for the entire package. These membranes are designed to provide three principal benefits: - HIGH PERMEABILITY. Landec's Intellipac breathable membranes are designed to permit transmission of oxygen and carbon dioxide at 300 times the rate of conventional packaging films. The Company believes that these higher permeability levels will facilitate the packaging diversity required to market many types of fresh-cut produce. - ABILITY TO ADJUSTABLY SELECT OXYGEN AND CARBON DIOXIDE. Conventional packaging films diffuse gas transfer in and out of packages at an equal rate or fixed ratio of 1.0. Intellipac packages can be tailored with carbon dioxide to oxygen transfer ratios ranging from 1.0 to 12.0 and selectively transmit oxygen and carbon dioxide at optimum rates to sustain the quality and shelf life of produce. - TEMPERATURE RESPONSIVENESS. Landec has developed breathable membranes that can be designed to increase or decrease in permeability in response to environmental temperature changes. The Company has developed packaging that responds to higher oxygen requirements at elevated temperatures but is also reversible, and returns to its original state as temperatures decline. Landec believes that growth of the overall produce market will be driven by the increasing demand for the convenience of fresh-cut produce. This demand will in turn require packaging that facilitates the quality and shelf life of produce transported to fresh-cut processors in bulk and pallet quantities. The Company believes that in the future its Intellipac breathable membranes will be useful for packaging a diverse variety of fresh-cut produce products. Potential opportunities for using Landec's technology outside of the fresh-cut produce market exist in cut flowers and in other food products. Landec is working with leaders in the fresh-cut food service, club store and retail grocery markets. The Company believes it will have growth opportunities for the next several years through new customers and products in the United States, expansion of its existing customer relationships, and through export and shipments of specialty packaged foods. Landec manufactures its Intellipac breathable membranes with selected qualified contract manufacturers and markets and sells Intellipac breathable membranes directly to food processors. APIO, INC. In December 1999, Landec completed the acquisition of Apio and certain related entities. Landec paid $23.9 million in cash and Landec Common Stock for Apio. An additional $16.75 million in future payments over the next five years may be paid, $10.0 million of which is based on Apio achieving certain performance milestones. Apio had revenue of approximately $158 million in 1998, has realized a compounded annual growth in revenues of over 19% between 1996 and 1998 and is profitable. Based in Guadalupe, California, Apio consists of two major businesses - -- traditional whole produce harvesting, packing and marketing and specialty packaged fresh-cut value-added processed products that are pre-cut, washed and packaged in Landec's Intellipac packaging. The traditional produce business includes harvesting, packing, cooling and marketing of vegetables and fruits on a contract basis for growers in California's Santa Maria, San Joaquin and Imperial Valleys and in Arizona and Mexico. Apio currently has approximately 18,000 acres under contract, including access to approximately 20 percent of the farmable land in the Santa Maria Valley. The fresh-cut value-added processing business, developed within the last 4 years, sources a variety of fresh-cut vegetables to 9 of the top 10 retail grocery chains representing over 3,000 retail stores and to over 500 club stores. During 1998, Apio shipped more than 21 million cartons of produce to some 700 customers including leading supermarket retailers, wholesalers, food service suppliers and club stores throughout the United States and internationally, primarily in Asia. There are four major distinguishing characteristics of Apio that provide it a competitive advantage in the Food Products Technology market: - Apio has structured its business as a full service provider of vegetables, fruits, and fresh-cut value-added produce. As retail and club store chains consolidate, Apio is well positioned as a single source of a broad range of products. - Apio is unique in that it takes on less farming risk than its competitors. Apio reduces its farming risk by not taking ownership of farmland, and instead, will contract with growers for produce and charge for services that include packing, cooling, shipping and marketing. In many cases, Apio does not take title to the produce but receives a margin for services rendered. The year-round sourcing of produce is a key component to both the traditional produce business as well as the fresh-cut value-added processing business. - Apio strategically invested in the rapidly growing fresh-cut value-added business. Apio's new 35,000 square foot value-added plant operates during the peak seasons two 10-hour shifts per day, seven days a week. Apio has one of the very few temperature controlled value-added processing plants in the U.S. Ninety percent of Apio's value-added products utilize Landec's proprietary Intellipac membrane technology. Apio is also focused on developing its "Eat Smart" brand name for all of its fresh-cut value-added products. - Apio is uniquely positioned to benefit from the growth in export sales to Asia and Europe over the next decade with its export business, CalEx. Through CalEx, Apio is currently one of the largest U.S. exporters of broccoli to Asia. AGRICULTURAL SEED TECHNOLOGY BUSINESS Landec formed its Intellicoat subsidiary in 1995. Intellicoat's strategy is to build a vertically integrated seed technology company based on Intellicoat's proprietary seed coating technology and its direct marketing, telephonic sales and electronic commerce capabilities. INTELLICOAT SEED COATINGS Landec has developed and, through Intellicoat, is conducting field trials of its Intellicoat seed coatings, an Intelimer-based agricultural material designed to control seed germination timing, increase crop yields and extend the crop planting windows. These coatings are initially being applied to corn, soybean, cotton and canola seeds. According to the U.S. Agricultural Statistics Board, the total planted acreage in 1998 in North America for corn, soybean, cotton and canola seed exceeded 77.6 million, 77.2 million, 14.6 million and 1.1 million, respectively. Currently, farmers are required to predict the proper time to plant seeds. If the seeds are planted too early, they may rot or suffer chilling injury due to the absorption of water at cold soil temperatures. If they are planted too late, the growing season may end prior to the crop reaching full maturity. In either case, the resulting crop yields are sub-optimal. Moreover, the planting window can be fairly brief, requiring the farmer to focus almost exclusively on planting during this time. Seeds also germinate at different times due to variations in absorption of water, thus providing for variations in the growth rate of the crops. The Company's Intellicoat seed coating prevents planted seeds from absorbing water when the ground temperature is below the coating's pre-set switch. Intellicoat seed coatings are designed to enable coated seeds to be planted early without risk of chilling damage caused by the absorption of water at cold soil temperatures. As spring advances and soil temperatures rise to the pre-determined switch temperature, the polymer's permeability increases and the coated seeds absorb water and begin to germinate. The Company believes that Intellicoat seed coatings provide the following advantages: more flexible timing for planting, avoidance of chilling injury, uniform germination and crop growth, and protection against harmful fungi. As a result, the Company believes that Intellicoat seed coatings offer the potential for significant improvements in crop yields. Based on the success of fiscal year 1999's field trials, the Company will be selectively marketing its inbred corn seed coating products beginning in fiscal year 2000 through regional and national seed companies in the United States. This application is targeted to approximately 640,000 acres of farmland in ten states. In addition, Intellicoat seed coatings are being tested with numerous collaborators for the relay cropping of wheat and soybean. Relay cropping of wheat and soybeans will allow farmers to plant and harvest two crops during the year on the same acre of land, providing significant financial benefit for the farmer. Intellicoat plans to expand its testing of the relay cropping system in the spring of 2000 and assuming expanded field trials are successful, expects to commercially launch the technology in the spring of 2001. This application is targeted to approximately 10 million acres of farmland in six states. Future crops under consideration include cotton, canola, sugar beets and other vegetables. FIELDER'S CHOICE DIRECT (THE DIRECT MARKETING, TELEPHONIC SALES AND E-COMMERCE COMPANY) In September 1997, Intellicoat completed the acquisition of Fielder's Choice, a direct marketer of hybrid seed corn to farmers. Landec paid approximately $3.6 million in cash and direct acquisition costs and $5.2 million in Landec Common Stock for the Company. Terms of the agreement include additional consideration in the form of a cash earn-out based on future performance. Fielder's Choice had sales of approximately $13.3 million and $15.2 million in the twelve months ended October 31, 1998 and October 31, 1999, respectively. Based in Monticello, Indiana, Fielder's Choice offers a comprehensive line of corn hybrids to more than 16,000 producer seed customers in over forty states through direct marketing programs. The success of Fielder's Choice comes, in part, from its expertise in selling directly to the farmer producer, bypassing the traditional and costly farmer-dealer system. The Company believes that this direct channel of distribution provides a 35% cost advantage to its farmer producers. In order to support its direct marketing programs, Fielder's Choice has developed proprietary direct marketing, telephonic sales and e-commerce information technology, called "The Farmer First System", that enables state-of-the-art methods for communicating with a broad array of farmers. This proprietary direct marketing information technology includes a current database of over 60,000 farmers. In August 1999, the Company launched the seed industry's first comprehensive e-commerce website. This new website furthers the Company's ability to provide a high level of consultation to Fielder's Choice customers, backed by a six day a week call center capability that enables the Company to use the internet as a natural extension of its direct marketing strategy. The acquisition of Fielder's Choice was strategic in providing a cost-effective vehicle for Intellicoat seed coating products when they are ready for commercial production. The Company believes that the combination of a direct channel of distribution, telephonic and electronic commerce capabilities will enable Intellicoat to more quickly achieve meaningful market penetration. TECHNOLOGY LICENSING/RESEARCH & DEVELOPMENT BUSINESSES The Company believes its technology has commercial potential in a wide range of industrial, consumer and medical applications beyond those identified in its core businesses. In order to exploit these opportunities, the Company has entered into licensing and collaborative corporate agreements for product development and/or distribution in certain fields. INDUSTRIAL MATERIALS AND ADHESIVES Landec's industrial products development strategy is to focus on catalysts, resins, fully-formulated products and adhesives in the polymer materials market. During the product development stage, the Company identifies corporate partners to support the ongoing development and testing of these products, with the ultimate goal of licensing the applications at the appropriate time. INTELIMER POLYMER SYSTEMS. The Company is developing catalysts, curative, and curing agent systems based on its Intelimer technology for use in one-package thermoset products. These systems can incorporate catalysts, curatives and curing agents in a unique polymer envelope that prevents interaction by these agents with the resin when the polymer envelope is in its impermeable state. This characteristic allows all components of the thermoset product to be pre-mixed and stored at room temperature, and provides longer shelf life. Landec's unique polymer envelope system can be designed with a pre-set opening temperature switch to correspond with elevated temperatures used during standard manufacturing processes. When the thermoset system is exposed to the pre-set switch temperature, the Intelimer polymer abruptly changes to its permeable state, exposing the catalyst to the resin and initiating the curing process. In addition, the Intelimer polymer can be designed to change state over a predetermined temperature range in order to achieve a desired reaction time. Thermoset catalyst systems can eliminate the need for costly on-site mixing equipment and because thermosets can be pre-mixed by the manufacturer, will minimize sub-optimal product performance due to incorrect component mixing ratios. Furthermore, since the thermosets will not cure until exposed to elevated temperatures, pot life should be extended, resulting in significantly reduced waste and labor expense. The Company believes that the ability to control reaction time also provides advantages over existing thermoset systems and can enhance the throughput of targeted manufacturing customers. Landec received the R&D 100 Award from R&D Magazine for its Intelimer Polymer Systems product line in 1997 in recognition of the unique capabilities of this technology. Certain Intelimer Polymer Systems products are in field trials with some large industrial companies, which, if approved, will be ready for commercial introduction during the next year. AEROMARK-TM- 80. Landec announced in December 1998, the introduction of its first fully-formulated product, Aeromark 80, using the Company's proprietary Intelimer catalyst technology. Aeromark 80 and other related products under development are targeted to the rapidly growing prototyping/design market estimated to exceed $100 million a year in sales. Landec's initial focus is with large volume users such as major automakers and aerospace manufacturers. Landec has been testing materials with several large European automotive companies and is currently scaling manufacturing at a contract manufacturing site in Switzerland. DOCK RESINS. In April 1997, Landec completed the acquisition of Dock Resins, a privately-held manufacturer and marketer of specialty acrylic and other polymers based in Linden, New Jersey. Landec paid approximately $13.7 million in cash, a promissory note and direct acquisition costs and $2.1 million in Landec Common Stock to acquire Dock Resins. The acquisition of Dock Resins was strategic in providing the Company with immediate access to large-scale polymer manufacturing as well as a built-in customer base and national distribution network. Dock Resins has a track record of growth in revenues and earnings and a strong management team under the leadership of Dock Resins' Chief Executive Officer, Dr. A. Wayne Tamarelli. Dock Resins also sells products under the Doresco trademark which are used by more than 300 customers throughout the United States and other countries in the coatings, printing inks, laminating and adhesives markets. Dock Resins is a leading supplier of proprietary polymers including acrylic, methacrylic, alkyd, polyester, urethane and polyamide polymers to film converters engaged in hot stamping, decorative wood grain, automotive interiors, holograms, and metal foil applications. Dock Resins also supplies products to a number of other markets such as graphic arts, automotive refinishing, construction, pressure-sensitive adhesives, paper coatings, caulks, concrete curing compounds and sealers. Dock Resins had sales of approximately $15.4 million and $14.0 million in the twelve months ended October 31, 1998 and October 31, 1999, respectively. HITACHI CHEMICAL. The Company entered into two separate collaborations with Hitachi Chemical ("Hitachi") in the areas of industrial adhesives and Intelimer Polymer Systems. On October 1, 1994, the Company entered into a non-exclusive license agreement for seven years with Hitachi in the industrial adhesives area. The agreement provides Hitachi with a non-exclusive license to manufacture and sell products using Landec's Intelimer materials in certain Asian countries. Landec received up-front license fees upon signing the agreement and is entitled to future royalties based on net sales by Hitachi of the licensed products. Any fees paid to the Company are non-refundable. On August 10, 1995, the Company entered into the second collaboration with Hitachi in the Intelimer Polymer Systems area. The agreement provided Hitachi with an exclusive license to use and sell Landec's Intelimer Polymer Systems in industrial latent curing products in certain Asian countries. Landec is entitled to be the exclusive supplier of Intelimer Polymer Systems to Hitachi for at least seven years after commercialization. Landec received an up-front license payment upon signing this agreement and research and development funding over three years and is entitled to receive future royalties based on net sales by Hitachi of the licensed products. Any fees paid to the Company are non-refundable. This agreement has been converted to a non-exclusive agreement except for one application field. NITTA CORPORATION. On March 14, 1995, the Company entered into a license agreement with Nitta Corporation ("Nitta") in the industrial adhesives area. The agreement provides Nitta with a co-exclusive license to manufacture and sell products using Landec's Intelimer materials in certain Asian countries. Landec received up-front license fees upon signing the agreement and is entitled to future royalties based on net sales by Nitta of the licensed products. Any fees paid to the Company are non-refundable. This agreement is terminable at Nitta's option. Nitta and the Company entered into an additional exclusive license arrangement in February 1996 covering Landec's medical adhesives technology for use in Asia. The Company received up-front license fees upon execution of the agreement and research and development payments and is entitled to receive future royalties under this agreement. Any fees paid to the Company are non-refundable. Nitta and the Company also entered into another worldwide exclusive agreement on January 1, 1998 in the area of industrial adhesives specific to one field of electronic polishing adhesives. The Company received research and development payments as a part of this agreement. MEDICAL APPLICATIONS PORT-TM- OPHTHALMIC DEVICES. Landec developed the PORT (Punctal Occluder for the Retention of Tears) ophthalmic device initially to address a common, yet poorly diagnosed condition known as dry eye that is estimated to affect 30 million Americans annually. The device consists of a physician-applied applicator containing solid Intelimer material that transforms into a flowable, viscous state when heated slightly above body temperature. After inserting the Intelimer material into the lacrimal drainage duct, it quickly solidifies into a form-fitting, solid plug. Occlusion of the lacrimal drainage duct allows the patient to retain tear fluid and thereby provides relief and therapy to the dry eye patient. The PORT product is currently in human clinical trials. Landec and its partner, Alcon, a wholly-owned subsidiary of Nestle S.A., believe that PORT plugs will have additional ophthalmic applications beyond the dry eye market. This would include applications for people who cannot wear contact lenses due to limited tear fluid retention and patients receiving therapeutic drugs via eye drops that require longer retention in the eye. In December 1997, Landec licensed the rights to worldwide manufacturing, marketing and distribution of its PORT ophthalmic device to Alcon. Under the terms of the transaction, Landec received an up-front cash payment of $500,000, a $1 million milestone payment in November 1998, research and development funding and will receive ongoing royalties of 12.5% on product sales of each PORT device over an approximately 15-year period. In September 1999, Alcon submitted a 510K application to the FDA seeking approval to commercially sell the PORT device. Landec will continue to provide development support on a contract basis through the FDA approval process and product launch. CONVATEC. On October 11, 1999, the Company entered into a joint development agreement with ConvaTec, a division of Bristol Myers Squibb, under which Landec will develop adhesive film products for selected ConvaTec medical products. Landec is receiving support funding for this program. Upon completion of this agreement, the companies have the option to consider a license and supply agreement where Landec would supply materials to ConvaTec for use in specific medical devices. SALES AND MARKETING Each of the Company's core businesses are supported by dedicated sales and marketing resources. The Company intends to develop its internal sales capacity as more products progress toward commercialization and as business volume expands geographically. FOOD PRODUCTS TECHNOLOGY BUSINESS In the Intellipac breathable membrane business, there are a limited number of suppliers of fresh-cut produce, most of whom are located in the western United States. The Company currently has a small internal sales force targeted at this concentrated marketplace. Apio has over 22 sales people, located in central California and throughout the U.S., supporting both the traditional produce marketing business and the specialty packaged value-added produce business. AGRICULTURAL SEED TECHNOLOGY BUSINESS In preparation for the first launch of coated inbred corn seed products in fiscal year 2000, the Intellicoat seed coating business has identified a small internal sales force to target a very focused group of seed customers. For future coated seed products that are sold directly to farmers, the Company will utilize over 35 direct seed sales consultants located in Monticello, Indiana. These consultants also support Fielder's Choice in its direct marketing of corn seed. Customer contacts are made based on direct responses and inquiries from customers. OTHER Dock Resins sales are carried out through a small direct sales group and network of existing manufacturers' representatives and distributed through public warehouses. Sales are supported by internal sales and technical service resources at Dock Resins. Intelimer Polymer Systems sales are made through a small, technically oriented, internal sales organization in the U.S. and in Europe through Akzo Nobel and Aero Consultants Ltd. A.G., international distributors. MANUFACTURING Landec intends to control the manufacturing of its own products whenever possible, as it believes that there is considerable manufacturing margin opportunity in its products. In addition, the Company believes that know-how and trade secrets can be better maintained by Landec retaining manufacturing capability in-house. POLYMER MANUFACTURING - DOCK RESINS CORPORATION Dock Resins has manufacturing facilities that are flexible and adaptable to a wide range of processes. Its capabilities include various polymerization processes, grafting, dispersing, blending, pilot plant scale-ups and general synthesis. The Company has increased the capacity of these facilities in 1998 and 1999. Dock Resins' policy is to be a leader in safety, health and environmental protection. In 1998 and 1999, Dock Resins passed a voluntary comprehensive health and safety evaluation by the United States Occupational Safety and Health Administration (OSHA). As a result, OSHA awarded recognition to Dock Resins as a Merit Site in 1998 and a Star Site in 1999 in OSHA's Voluntary Protection Program. FOOD PRODUCTS TECHNOLOGY BUSINESS The manufacturing process for the Company's initial Intellipac breathable membrane products is comprised of polymer manufacturing, membrane coating and label conversion. The Company currently has the majority of its Intellipac breathable membrane products manufactured by selected outside contract manufacturers. Landec has recently scaled up a significant portion of label conversion manufacturing in Menlo Park to meet the increasing product demand and provide additional developmental capabilities. Apio processes all of its fresh-cut value-added products in a 35,000 square foot, state-of-the-art processing facility located in Guadalupe, California. The Company is currently running two shifts per day, seven days a week, and utilizes contract laborers from a third party contact labor supplier. Cooling of produce is done through third parties and Apio Cooling, a separate company of which Apio has a 60% ownership interest and is the general partner. AGRICULTURAL SEED TECHNOLOGY BUSINESS The Company is currently in the process of scaling up the manufacturing coating process in Menlo Park, California to support the launch of its inbred corn product and extend field trials of its wheat/soybean relay product. Fielder's Choice purchases its hybrid seed corn from an established producer under an exclusive purchase agreement. GENERAL. Many of the raw materials used in manufacturing certain of the Company's products are currently purchased from a single source, including certain monomers used to synthesize Intelimer polymers and substrate materials for the Company's breathable membrane products. In addition, virtually all of the hybrid corn varieties sold by Fielder's Choice are purchased from a single source. Upon manufacturing scale-up and as hybrid corn sales increase, the Company may enter into alternative supply arrangements. Although to date the Company has not experienced difficulty acquiring materials for the manufacture of its products nor has Fielder's Choice experienced difficulty in acquiring hybrid corn varieties, no assurance can be given that interruptions in supplies will not occur in the future, that the Company will be able to obtain substitute vendors, or that the Company will be able to procure comparable materials or hybrid corn varieties at similar prices and terms within a reasonable time. Any such interruption of supply could have a material adverse effect on the Company's ability to manufacture and distribute its products and, consequently, could materially and adversely affect the Company's business, operating results and financial condition. Landec has historically relied on the guidance of Good Manufacturing Practices ("GMP") in developing standardized research and manufacturing processes and procedures. Having entered into licensing agreements for the PORT device, the Company is no longer required to adhere to GMPs. The Company desires to maintain an externally audited quality system and has achieved ISO 9001 registration for the Menlo Park research and development site in fiscal year 1999. Such registration is required in order for the Company to sell product to certain potential customers, primarily in Europe. RESEARCH AND DEVELOPMENT Landec is focusing its research and development resources on both existing and new applications of its Intelimer technology. Expenditures for research and development in fiscal year 1999 were $5.8 million, compared with $5.7 million in fiscal year 1998. Fiscal year 1998 expenditures for research and development increased 24% from fiscal year 1997 expenditures of $4.6 million. In fiscal year 1999, research and development expenditures funded by corporate partners were $770,000, compared with $1.4 million in fiscal year 1998 and $863,000 in fiscal year 1997. The Company may continue to seek funds for applied materials research programs from U.S. government agencies as well as from commercial entities. The Company anticipates that it will continue to have significant research and development expenditures in order to maintain its competitive position with a continuing flow of innovative, high-quality products and services. As of October 31, 1999, Landec had 29 employees engaged in research and development (and a total of eight Ph.D.s in the Company) with experience in polymer and analytical chemistry, product application, product formulation, mechanical and chemical engineering. COMPETITION The Company operates in highly competitive and rapidly evolving fields, and new developments are expected to continue at a rapid pace. Competition from large food packaging and agricultural companies is expected to be intense. In addition, the nature of the Company's collaborative arrangements and its technology licensing business may result in its corporate partners and licensees becoming competitors of the Company. Many of these competitors have substantially greater financial and technical resources and production and marketing capabilities than the Company, and many have substantially greater experience in conducting field trials, obtaining regulatory approvals and manufacturing and marketing commercial products. There can be no assurance that these competitors will not succeed in developing alternative technologies and products that are more effective, easier to use or less expensive than those which have been or are being developed by the Company or that would render the Company's technology and products obsolete and non-competitive. PATENTS AND PROPRIETARY RIGHTS The Company's success depends in large part on its ability to obtain patents, maintain trade secret protection and operate without infringing on the proprietary rights of third parties. The Company has been granted eleven U.S. patents with expiration dates ranging from 2006 to 2015 and has filed applications for additional U.S. patents, as well as certain corresponding patent applications outside the United States, relating to the Company's technology. The Company's issued patents include claims relating to compositions, devices and use of a class of temperature sensitive polymers that exhibit distinctive properties of permeability, adhesion and viscosity. There can be no assurance that any of the pending patent applications will be approved, that the Company will develop additional proprietary products that are patentable, that any patents issued to the Company will provide the Company with competitive advantages or will not be challenged by any third parties or that the patents of others will not prevent the commercialization of products incorporating the Company's technology. Furthermore, there can be no assurance that others will not independently develop similar products, duplicate any of the Company's products or design around the Company's patents. Any of the foregoing results could have a material adverse effect on the Company's business, operating results and financial condition. The commercial success of the Company will also depend, in part, on its ability to avoid infringing patents issued to others. The Company has received, and may in the future receive, from third parties, including some of its competitors, notices claiming that it is infringing third party patents or other proprietary rights. If the Company were determined to be infringing any third-party patent, the Company could be required to pay damages, alter its products or processes, obtain licenses or cease certain activities. In addition, if patents are issued to others which contain claims that compete or conflict with those of the Company and such competing or conflicting claims are ultimately determined to be valid, the Company may be required to pay damages, to obtain licenses to these patents, to develop or obtain alternative technology or to cease using such technology. If the Company is required to obtain any licenses, there can be no assurance that the Company will be able to do so on commercially favorable terms, if at all. The Company's failure to obtain a license to any technology that it may require to commercialize its products could have a material adverse impact on the Company's business, operating results and financial condition. Litigation, which could result in substantial costs to the Company, may also be necessary to enforce any patents issued or licensed to the Company or to determine the scope and validity of third-party proprietary rights. If competitors of the Company prepare and file patent applications in the United States that claim technology also claimed by the Company, the Company may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office to determine priority of invention, which could result in substantial cost to and diversion of effort by the Company, even if the eventual outcome is favorable to the Company. Any such litigation or interference proceeding, regardless of outcome, could be expensive and time consuming and could subject the Company to significant liabilities to third parties, require disputed rights to be licensed from third parties or require the Company to cease using such technology and consequently, could have a material adverse effect on the Company's business, operating results and financial condition. In addition to patent protection, the Company also relies on trade secrets, proprietary know-how and technological advances which the Company seeks to protect, in part, by confidentiality agreements with its collaborators, employees and consultants. There can be no assurance that these agreements will not be breached, that the Company will have adequate remedies for any breach, or that the Company's trade secrets and proprietary know-how will not otherwise become known or be independently discovered by others. GOVERNMENT REGULATIONS The Company's products and operations are subject to substantial regulation in the United States and foreign countries. FOOD PRODUCTS TECHNOLOGY BUSINESS The Company's food packaging products are subject to regulation under the Food, Drug and Cosmetic Act ("FDC Act"). Under the FDC Act any substance that when used as intended may reasonably be expected to become, directly or indirectly, a component or otherwise affect the characteristics of any food may be regulated as a food additive unless the substance is generally recognized as safe. Food additives may be substances added directly to food, such as preservatives, or substances that could indirectly become a component of food, such as waxes, adhesives and packaging materials. A food additive, whether direct or indirect, must be covered by a specific food additive regulation issued by the FDA. The Company believes its Intellipac breathable membrane products are not subject to regulation as food additives because these products are not expected to become a component of food under their expected conditions of use. If the FDA were to determine that the Company's Intellipac breathable membrane products are food additives, the Company may be required to submit a food additive petition. The food additive petition process is lengthy, expensive and uncertain. A determination by the FDA that a food additive petition is necessary would have a material adverse effect on the Company's business, operating results and financial condition. The Company's agricultural operations are subject to a variety of environmental laws including the Food Quality Protection Act of 1966, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Federal Insecticide, Fungicide and Rodenticide Act and the Comprehensive Environmental Response, Compensation and Liability Act. Compliance with these laws and related regulations is an ongoing process. Environmental concerns are, however, inherent in most agricultural operations, including those conducted by the Company, and there can be no assurance that the cost of compliance with environmental laws and regulations will not be material. Moreover, it is possible that future developments, such as increasingly strict environmental laws and enforcement policies thereunder, and further restrictions on the use of manufacturing chemicals could result in increased compliance costs. As a result of the Apio acquisition, the Company is subject to USDA rules and regulations concerning the safety of the food products handled and sold by Apio, and the facilities in which they are packed and processed. Failure to comply with the applicable regulatory requirements can, among other things, result in fines, injunctions, civil penalties, suspensions or withdrawal of regulatory approvals, product recalls, product seizures, including cessation of manufacturing and sales, operating restrictions and criminal prosecution. AGRICULTURAL SEED TECHNOLOGY BUSINESS The Company's agricultural products are subject to regulations of the United States Department of Agriculture ("USDA") and the EPA. The Company believes its current Intellicoat seed coatings are not pesticides as defined in the Federal Insecticide, Fungicide and Rodenticide Act ("FIFRA") and are not subject to pesticide regulation requirements. The process of meeting pesticide registration requirements is lengthy, expensive and uncertain, and may require additional studies by the Company. There can be no assurance that future products will not be regulated as pesticides. In addition, the Company believes that its Intellicoat seed coatings will not become a component of the agricultural products which are produced from the seeds to which the coatings are applied and therefore are not subject to regulation by the FDA as a food additive. While the Company believes that it will be able to obtain approval from such agencies to distribute its products, there can be no assurance that the Company will obtain necessary approvals without substantial expense or delay, if at all. POLYMER MANUFACTURE The Company's manufacture of polymers is subject to regulation by the EPA under the Toxic Substances Control Act ("TSCA"). Pursuant to TSCA, manufacturers of new chemical substances are required to provide a Pre-Manufacturing Notice ("PMN") prior to manufacturing the new chemical substance. After review of the PMN, the EPA may require more extensive testing to establish the safety of the chemical, or limit or prohibit the manufacture or use of the chemical. To date, PMNs submitted by the Company have been approved by the EPA without any additional testing requirements or limitation on manufacturing or use. In addition, the ongoing manufacture of Dock Resins' existing product line is subject to state and federal environmental and safety regulations. No assurance can be given that the EPA will grant similar approval for future PMNs submitted by the Company. OTHER The Company and its products under development may also be subject to other federal, state and local laws, regulations and recommendations. Although Landec believes that it will be able to comply with all applicable regulations regarding the manufacture and sale of its products and polymer materials, such regulations are always subject to change and depend heavily on administrative interpretations and the country in which the products are sold. There can be no assurance that future changes in regulations or interpretations made by the FDA, EPA or other regulatory bodies, with possible retroactive effect, relating to such matters as safe working conditions, laboratory and manufacturing practices, environmental controls, fire hazard control, and disposal of hazardous or potentially hazardous substances will not adversely affect the Company's business. There can also be no assurance that the Company will not be required to incur significant costs to comply with such laws and regulations in the future, or that such laws or regulations will not have a material adverse effect upon the Company's ability to do business. Furthermore, the introduction of the Company's products in foreign markets may require obtaining foreign regulatory clearances. There can be no assurance that the Company will be able to obtain regulatory clearances for its products in such foreign markets. EMPLOYEES As of October 31, 1999, Landec had 173 full-time employees, of whom 64 were dedicated to research, development, manufacturing, quality control and regulatory affairs and 109 were dedicated to sales, marketing and administrative activities. As of December 31, 1999, with the inclusion of Apio, Landec had 316 full-time employees. Landec intends to recruit additional personnel in connection with the development, manufacturing and marketing of its products. None of Landec's employees is represented by a union, and Landec believes relationships with its employees are good. ITEM 2. ITEM 2. PROPERTIES The Company has offices in Menlo Park, California, Linden, New Jersey and Monticello, Indiana. During fiscal year 1999, the Landec operations located in Menlo Park, California expanded its warehouse and manufacturing space by 6,000 square feet to support the manufacturing efforts of the Intellipac breathable membrane business. Apio, which was acquired in December 1999, has facilities in Guadalupe and Reedley, California. These properties are described below: (1) Lease contains one two-year renewal option. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is currently not a party to any material legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of the Company's fiscal year ending October 31, 1999. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock is traded on the Nasdaq National Market under the symbol "LNDC". The following table sets forth for each period indicated the high and low sales prices for the Common Stock as reported on the Nasdaq National Market. There were approximately 136 holders of record of 15,922,331 shares of outstanding Common Stock as of January 7, 2000. Since holders are listed under their brokerage firm's names, the actual number of shareholders is higher. The Company has not paid any dividends on the Common Stock since its inception. The Company presently intends to retain all future earnings, if any, for its business and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. In connection with the sale of Series D Preferred Stock in July 1993, the Company issued warrants to purchase 186,349 shares of Common Stock at an exercise price of $4.31 per share for $5,357 in cash. In a cashless exercise during fiscal year 1998, 46,587 shares were issued in exchange for the warrants. In October 1998, certain directors and officers of the Company purchased 200,425 shares of Common Stock for between $3.75 and $3.94 per share for $776,000. Pursuant to a Series A Preferred Stock Purchase Agreement (the "Purchase Agreement") dated November 19, 1999, by and among the Company and Frederick Frank, the Company completed a financing that raised approximately $10.0 million through a private placement of its Series A-1 Preferred Stock and Series A-2 Preferred Stock (the "Preferred Stock"). Pursuant to the Purchase Agreement, the Company issued 166,667 shares of Preferred stock of the Company at $60.00 per share (representing 1,666,670 shares of Common Stock on a converted basis). In connection with the Company's acquisition of Apio on December 2, 1999, the prior owners of Apio received 2.5 million shares of Common Stock. As compensation for services rendered by Lehman Brothers Inc. in connection with the closing of the Apio acquisition, the Company issued 62,500 shares of Common Stock to Lehman Brothers, Inc. at $6.25 per share. The issuance of securities in this Item 5 was deemed to be exempt from registration under the Securities Act of 1933, as amended (the "Act"), in reliance on Section 4(2) of the Act as a transaction by an issuer not involving any public offering. The recipients of the securities in such transaction represented their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the securities issued in such transaction. The recipients were given adequate access to information about the Company. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The information set forth below is not necessarily indicative of the results of future operations and should be read in conjunction with the information contained in Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Company's Consolidated Financial Statements contained in Item 8 of this report. Except for the historical information contained herein, the matters discussed in this report are forward-looking statements that involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Potential risks and uncertainties include, without limitation, those mentioned in this report and, in particular, the factors described below under "Additional Factors That May Affect Future Results". OVERVIEW Since its inception in October 1986, the Company has been primarily engaged in the research and development of its Intelimer technology and related products. The Company has launched four product lines from this core development QuickCast-TM- splints and casts, in April 1994, which was subsequently sold to Bissell Healthcare Corporation in August 1997; Intellipac breathable membranes for the fresh-cut produce packaging market, in September 1995; Intelimer Polymer Systems for the industrial specialties market in June 1997; and Intellicoat coated inbred corn seeds in the Fall of 1999. On December 2, 1999, the Company acquired Apio, Inc and certain related entities ("Apio"). Apio is a leading marketer and packer of produce and specialty packaged fresh-cut vegetables. See "Business - Description of Core Business: Food Products Technology Business - Apio, Inc. During fiscal years 1997 through 1999, the Company managed its operations in three business segments - Food Products Technology, Agricultural Seed Technology and Industrial High Performance Materials. With the acquisition of Apio, the Company will be focusing on two vertically integrated core businesses - Food Products Technology and Agricultural Seed Technology. The Food Products Technology segment combines the Company's Intellipac breathable membrane technology with Apio's fresh-cut produce business. The Agricultural Seed Technology segment integrates the Intellicoat seed coating technology with Fielder's Choice's direct marketing, telephonic sales and e-commerce distribution capabilities. The Company also operates a Technology Licensing/Research and Development business which develops products to be licensed outside of the Company's core businesses. Dock Resins, the Company's polymer manufacturer supports the needs of these core businesses and manufactures products for the specialty polymer industry and Intelimer Polymer Systems customers. The Company has been unprofitable during each fiscal year since its inception. From inception through October 31, 1999, the Company's accumulated deficit was $45.5 million. The Company may incur additional losses in the future. The amount of future net profits, if any, is highly uncertain and there can be no assurance that the Company will be able to reach or sustain profitability for an entire fiscal year. RESULTS OF OPERATIONS The Company's results of operations reflect only the continuing operations of the Company and do not include the results of the discontinued QuickCast operation. FISCAL YEAR ENDED OCTOBER 31, 1999 COMPARED TO FISCAL YEAR ENDED OCTOBER 31, 1998 Total revenues were $35.4 million for fiscal year 1999 compared to $33.5 million for fiscal year 1998. Revenues from product sales increased to $33.9 million in fiscal year 1999 from $31.7 million in fiscal year 1998 primarily due to increased product sales from Fielder's Choice and Intellipac breathable membrane products which increased from $13.3 million and $2.9 million, respectively, in fiscal year 1998 to $15.2 million and $4.5 million, respectively, during fiscal year 1999. The increase in Fielder's Choice revenues was primarily due to increased per unit sales prices, and the increase in Intellipac breathable membrane revenues was primarily due to the introduction of various new products and increased volumes for existing products. These increases were partially offset by a decrease in Dock Resins product sales from $15.4 million during fiscal year 1998 to $14.0 million during fiscal year 1999. This decrease is a result of the overall weakness in the chemical industry during fiscal year 1999. Revenues from research and development funding were $770,000 for fiscal year 1999 compared to $1.4 million for fiscal year 1998. The decrease in research and development revenues was primarily due to the completion of research and development arrangements with Hitachi Chemical and Nitta Corporation in fiscal year 1998. Revenues from license fees during fiscal year 1999 were $750,000 compared to $500,000 during fiscal year 1998. The increase in revenues from license fees was due to a payment received from Alcon in fiscal year 1999 upon meeting a certain milestone related to the licensing agreement for the PORT ophthalmic devices. With the acquisition of Apio, the Company expects future revenues to be significantly higher. Cost of product sales consists of material, labor and overhead. Cost of product sales was $21.5 million for fiscal year 1999 compared to $20.3 million for fiscal year 1998. Cost of product sales as a percentage of product sales decreased to 63% in fiscal year 1999 from 64% in fiscal year 1998. The decrease in the cost of product sales as a percentage of product sales in fiscal year 1998 as compared to fiscal year 1999 was primarily the result of higher average selling prices of Fielder's Choice products, partially offset by start-up costs associated with establishing a new manufacturing facility in Menlo Park for Intellipac breathable membrane products. The Company anticipates future cost of product sales, in absolute dollars, to be significantly higher due to the acquisition of Apio. Cost of product sales as a percentage of product sales is expected to increase due to Apio's current mix of products having lower percentage margins than Landec's other businesses. However, gross margins in absolute dollars are expected to significantly increase due to Apio's high sales volume. Research and development expenses were $5.8 million for fiscal year 1999 compared to $5.7 million for fiscal year 1998. The Company's research and development expenses consist primarily of expenses involved in product development process scale-up, patent activities related to the Company's side chain crystallizable polymer technology, and research and development expenses related to Dock Resins products. The increase in research and development expenses in fiscal year 1999 compared to fiscal year 1998 was primarily due to increased development costs for the Company's Intellicoat seed coating products, partially offset by a reduction in costs in the Industrial High Performance Materials area. In future periods, the Company expects that spending for research and development will continue to increase in absolute dollars, although it will decrease significantly as a percentage of total revenues due to the acquisition of Apio. Selling, general and administrative expenses were $11.2 million for fiscal year 1999 compared to $10.8 million for fiscal year 1998, an increase of 4%. Selling, general and administrative expenses consist primarily of sales and marketing expenses associated with the Company's product sales, business development expenses, and staff and administrative expenses. Specifically, sales and marketing expenses increased to $6.2 million for fiscal year 1999, from $5.9 million for fiscal year 1998. Beginning fiscal year 2000, total selling, general and administrative spending is expected to increase significantly, due to the acquisition of Apio, although as a percentage of total revenues it is expected to decrease. Net interest income was $264,000 for fiscal year 1999 compared to $600,000 for fiscal year 1998. The decrease during fiscal year 1999 as compared to fiscal year 1998 was due principally to less cash being available for investing. FISCAL YEAR ENDED OCTOBER 31, 1998 COMPARED TO FISCAL YEAR ENDED OCTOBER 31, 1997 Total revenues were $33.5 million for fiscal year 1998 compared to $9.5 million for fiscal year 1997. Revenues from product sales increased to $31.7 million in fiscal year 1998 from $8.7 million in fiscal year 1997 due primarily to $13.3 million of product sales from Fielder's Choice, which was acquired in September 1997; and an increase of $8.0 million of product sales from Dock Resins, which was acquired in April 1997. Also contributing to the increase were Intellipac breathable membrane product sales which increased from $1.2 million in fiscal year 1997 to $2.9 million in fiscal year 1998, due primarily to an increase in unit sales and the introduction of several new products. Revenues from research and development funding were $1.4 million for fiscal year 1998 compared to $863,000 for fiscal year 1997. The increase in research and development revenues was primarily due to the agreement with Alcon for the funding of the PORT program. Revenues from license fees during fiscal year 1998 were $500,000 compared to none during fiscal year 1997. The increase in license fees revenue was due to a payment in the first quarter of fiscal year 1998 under the PORT license agreement with Alcon. Cost of product sales consists of material, labor and overhead. Cost of product sales was $20.3 million for fiscal year 1998 compared to $6.2 million for fiscal year 1997. Cost of product sales as a percentage of product sales decreased to 64% in fiscal year 1998 from 72% in fiscal year 1997. The decrease in the cost of product sales as a percentage of product sales in fiscal year 1998 as compared to fiscal year 1997 was primarily the result of higher margins resulting from product sales of Fielder's Choice and Dock Resins products. Research and development expenses were $5.7 million for fiscal year 1998 compared to $4.6 million for fiscal year 1997, an increase of 24%. The increase in research and development expenses in fiscal year 1998 compared to fiscal year 1997 was primarily due to increased development costs for the Company's Intellipac and Intellicoat seed coating products and a full year of development costs related to Dock Resins products. Selling, general and administrative expenses were $10.8 million for fiscal year 1998 compared to $4.7 million for fiscal year 1997, an increase of 130%. Selling, general and administrative expenses increased primarily as a result of an entire year of expenses and amortization of goodwill for Dock Resins and Fielder's Choice, which were acquired during fiscal year 1997. Specifically, sales and marketing expenses increased to $5.9 million for fiscal year 1998, from $1.8 million for fiscal year 1997. Net interest income was $600,000 for fiscal year 1998 compared to $1.4 million for fiscal year 1997. The decrease during fiscal year 1998 as compared to fiscal year 1997 was due principally to less cash being available for investing. LIQUIDITY AND CAPITAL RESOURCES As of October 31, 1999 the Company had cash, cash equivalents and short-term investments of $3.2 million, a net decrease of $7.0 million from $10.2 million as of October 31, 1998. This decrease was primarily due to cash used in operations of $3.6 million and the purchase of $3.7 million of property, plant and equipment partially offset by cash provided by financing activities of approximately $710,000 from primarily the sale of Common Stock and repayment of notes receivable from shareholders. The cash used in operations was primarily comprised of planned purchases of Fielder's Choice corn seed inventory to support the fiscal year 2000 growing season and deferred expenses associated with the Apio acquisition which were recorded to other current assets. The majority of the Company's $3.7 million of property and equipment expenditures during fiscal year 1999 was incurred for building improvement and equipment upgrade expenditures at Dock Resins to expand capacity, and purchasing quality assurance equipment to support the development of Intellipac and Intellicoat products. Subsequent to fiscal year end, and as a result of raising $10 million upon the sale of Preferred Stock and securing a new $11.25 million term debt agreement to acquire Apio, Inc., the Company's cash balance increased to over $8 million. In addition, Apio entered into a new $12 million line of credit agreement with Bank of America. The term debt and line of credit agreements ("loan agreements") contain restrictive covenants which require Apio to meet certain financial tests, including minimum levels of EBITDA, minimum fixed charge coverage ratio, minimum current ratio, minimum adjusted net worth and maximum leverage ratios. These requirements and ratios generally become more restrictive over time. The loan agreement, through restricted payment covenants, limits the ability of Apio to make cash payments to Landec, until the outstanding balance is reduced to an amount specified in the loan agreement. In addition to the cash raised during the acquisition of Apio Inc., the Company is currently in the process of establishing a credit facility to be used to fund the expansion of the manufacturing capabilities of Intellicoat seed coating products. The Company believes that with these new facilities, along with existing cash and cash equivalents will be sufficient to finance operational and capital requirements for the foreseeable future. The Company may, however, raise additional funds during the next twelve months through an equity financing. If such financing does occur it will have a dilutive effect on current shareholders. The Company's future capital requirements will depend on numerous factors, including the progress of its research and development programs; the development of commercial scale manufacturing capabilities; the development of marketing, sales and distribution capabilities; the ability of the Company to maintain existing collaborative and licensing arrangements and establish and maintain new collaborative and licensing arrangements; the timing and amount, if any, of payments received under licensing and research and development agreements; the costs involved in preparing, filing, prosecuting, defending and enforcing intellectual property rights; the ability to comply with regulatory requirements; the emergence of competitive technology and market forces; the effectiveness of product commercialization activities and arrangements; the seasonal needs to fund growing costs to ensure adequate and consistent supply of produce; and other factors. If the Company's currently available funds, together with the internally generated cash flow from operations, are not sufficient to satisfy its financing needs, the Company would be required to seek additional funding through other arrangements with collaborative partners, bank borrowings and public or private sales of its securities. There can be no assurance that additional funds, if required, will be available to the Company on favorable terms if at all. ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS The Company desires to take advantage of the "Safe Harbor" provisions of the Private Securities Litigation Reform Act of 1995 and of Section 21E and Rule 3b-6 under the Securities Exchange Act of 1934. Specifically, the Company wishes to alert readers that the following important factors, as well as other factors including, without limitation, those described elsewhere in this report, could in the future affect, and in the past have affected, the Company's actual results and could cause the Company's results for future periods to differ materially from those expressed in any forward-looking statements made by or on behalf of the Company. The Company assumes no obligation to update such forward-looking statements. HISTORY OF OPERATING LOSSES AND ACCUMULATED DEFICIT. The Company has incurred net losses in each fiscal year since its inception, including a net loss of $2.8 million for fiscal year 1999. The Company's accumulated deficit as of October 31, 1999 totaled $45.5 million. The Company may incur additional losses in the future. The amount of future net profits, if any, is highly uncertain and there can be no assurance that the Company will be able to reach or sustain profitability for an entire fiscal year. THE COMPANY'S SUBSTANTIAL INDEBTEDNESS COULD LIMIT ITS FINANCIAL AND OPERATING FLEXIBILITY AND SUBJECT IT TO OTHER RISKS. Upon the closing of the Apio acquisition, the Company's total debt, including current maturities and capital lease obligations, increased to approximately $22 million and the total debt to equity ratio was approximately 40%. This level of indebtedness could have significant consequences because: - a substantial portion of the Company's net cash flow from operations must be dedicated to debt service and will not be available for other purposes; - the Company's ability to obtain additional debt financing in the future for working capital, capital expenditures or acquisitions may be limited; and - the Company's level of indebtedness may limit its flexibility in reacting to changes in the industry and economic conditions generally. The Company's ability to service its indebtedness will depend on its future performance, which will be affected by prevailing economic conditions and financial, business and other factors, some of which are beyond the Company's control. If the Company were unable to service its debt, it would be forced to pursue one or more alternative strategies such as selling assets, restructuring or refinancing its indebtedness or seeking additional equity capital, which might not be successful and which could substantially dilute the ownership interest of existing shareholders. In addition, Apio is subject to various financial and operating covenants under its term debt and line of credit facilities (the "loan agreement"), including minimum levels of EBITDA, minimum fixed charge coverage ratio, minimum current ratio, minimum adjusted net worth and maximum leverage ratios. These requirements and ratios generally become more restrictive over time. The loan agreement limits the ability of Apio to make cash payments to Landec until the outstanding balance is reduced to an amount specified in the loan agreement. The Company has pledged substantially all of Apio's assets to secure its bank debt. The Company's failure to comply with the obligations under the loan agreement, including maintenance of financial ratios, could result in an event of default, which, if not cured or waived, would permit acceleration of the indebtedness due under the loan agreement. Any such violations of its obligations under the loan agreement could have a material adverse effect on the Company's business, results of operations and financial condition. QUARTERLY FLUCTUATIONS IN OPERATING RESULTS. In the past, the Company's results of operations have varied significantly from quarter to quarter and such fluctuations are expected to continue in the future. Historically, the Company's corn seed distributor, Fielder's Choice, has been the primary source of these fluctuations, as its revenues and profits are concentrated over a few months during the spring planting season (generally during the Company's second quarter). In addition, Apio can be heavily affected by seasonal and weather factors which could impact quarterly results. The Company's earnings in its Food Products Technology business will be sensitive to price fluctuations in the fresh vegetables and fruits markets. Excess supplies can cause intense price competition. Other factors affecting the Company's food and/or agricultural operations include the seasonality of its supplies, the ability to process produce during critical harvest periods, the timing and effects of ripening, the degree of perishability, the effectiveness of worldwide distribution systems, the terms of various federal and state marketing orders, total worldwide industry volumes, the seasonality of consumer demand, foreign currency fluctuations, foreign importation restrictions and foreign political risks. As a result of these and other factors, the Company expects to continue to experience fluctuations in quarterly operating results, and there can be no assurance that the Company will be able to reach or sustain profitability for an entire fiscal year. UNCERTAINTY RELATING TO INTEGRATION OF APIO AND OTHER NEW BUSINESS ACQUISITIONS. The Company's acquisition of Apio involves the integration of Apio's operations into the Company. The integration will require the dedication of management resources in order to achieve the anticipated operating efficiencies of the acquisition. No assurance can be given that difficulties encountered in integrating the operations of Apio into the Company will be overcome or that the benefits expected from such integration will be realized. The difficulties in combining Apio and the Company's operations are exacerbated by the necessity of coordinating geographically separate organizations, integrating personnel with disparate business backgrounds and combining different corporate cultures. The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of the combined company's business. Difficulties encountered or additional costs incurred in connection with the acquisition and the integration of the operations of Apio and the Company could have a material adverse effect on the business, results of operations and financial condition of the Company. The successful integration of other new business acquisitions may require substantial effort from the Company's management. The diversion of the attention of management and any difficulties encountered in the transition process could have a material adverse effect on the Company's ability to realize the anticipated benefits of the acquisitions. The successful combination of new businesses also requires coordination of research and development activities, manufacturing, and sales and marketing efforts. In addition, the process of combining organizations could cause the interruption of, or a loss of momentum in, the Company's activities. There can be no assurance that the Company will be able to retain key management, technical, sales and customer support personnel, or that the Company will realize the anticipated benefits of the acquisitions, and the failure to do so would have a material adverse effect on the Company's business, results of operations and financial condition. EARLY COMMERCIALIZATION OF CERTAIN PRODUCTS; DEPENDENCE ON NEW PRODUCTS AND TECHNOLOGIES; UNCERTAINTY OF MARKET ACCEPTANCE. The Company is in the early stage of product commercialization of certain Intellipac breathable membrane, Intellicoat seed coating and Intelimer polymer systems products and many of its potential products are in development. The Company believes that its future growth will depend in large part on its ability to develop and market new products in its target markets and in new markets. In particular, the Company expects that its ability to compete effectively with existing food products, agricultural, industrial and medical companies will depend substantially on successfully developing, commercializing, achieving market acceptance of and reducing the cost of producing the Company's products. In addition, commercial applications of the Company's temperature switch polymer technology are relatively new and evolving. There can be no assurance that the Company will be able to successfully develop, commercialize, achieve market acceptance of or reduce the costs of producing the Company's new products, or that the Company's competitors will not develop competing technologies that are less expensive or otherwise superior to those of the Company. There can be no assurance that the Company will be able to develop and introduce new products and technologies in a timely manner or that new products and technologies will gain market acceptance. The failure to develop and successfully market new products would have a material adverse effect on the Company's business, results of operations and financial condition. The success of the Company in generating significant sales of its products will depend in part on the ability of the Company and its partners and licensees to achieve market acceptance of the Company's new products and technology. The extent to which, and rate at which, market acceptance and penetration are achieved by the Company's current and future products are a function of many variables including, but not limited to, price, safety, efficacy, reliability, conversion costs and marketing and sales efforts, as well as general economic conditions affecting purchasing patterns. There can be no assurance that markets for the Company's new products will develop or that the Company's new products and technology will be accepted and adopted. The failure of the Company's new products to achieve market acceptance would have a material adverse effect on the Company's business, results of operations and financial condition. COMPETITION AND TECHNOLOGICAL CHANGE. The Company operates in highly competitive and rapidly evolving fields, and new developments are expected to continue at a rapid pace. Competition from large food products, agricultural, industrial and medical companies is expected to be intense. In addition, the nature of the Company's collaborative arrangements may result in its corporate partners and licensees becoming competitors of the Company. Many of these competitors have substantially greater financial and technical resources and production and marketing capabilities than the Company, and may have substantially greater experience in conducting clinical and field trials, obtaining regulatory approvals and manufacturing and marketing commercial products. There can be no assurance that these competitors will not succeed in developing alternative technologies and products that are more effective, easier to use or less expensive than those which have been or are being developed by the Company or that would render the Company's technology and products obsolete and non-competitive. LIMITED MANUFACTURING EXPERIENCE; DEPENDENCE ON THIRD PARTIES. The Company's success is dependent in part upon its ability to manufacture its products in commercial quantities in compliance with regulatory requirements and at acceptable costs. There can be no assurance that the Company will be able to achieve this. Although the Company believes Dock Resins will provide Landec with practical knowledge in the scale-up of Intelimer polymer products, production in commercial-scale quantities may involve technical challenges for the Company. The Company anticipates that a portion of the Company's products will be manufactured in the Linden, New Jersey facility acquired in the purchase of Dock Resins. The Company's reliance on this facility involves a number of potential risks, including the unavailability of, or interruption in access to, certain process technologies and reduced control over delivery schedules, and low manufacturing yields and high manufacturing costs. The Company may also need to consider seeking collaborative arrangements with other companies to manufacture certain of its products. If the Company becomes dependent upon third parties for the manufacture of its products, then the Company's profit margins and its ability to develop and deliver such products on a timely basis may be adversely affected. Moreover, there can be no assurance that such parties will adequately perform and any failures by third parties may impair the Company's ability to deliver products on a timely basis, impair the Company's competitive position, or may delay the submission of products for regulatory approval. In late fiscal 1999, in an effort to reduce reliance on third party manufacturers, the Company began the set up of a manufacturing operation at its facility in Menlo Park, California, for the production of Intellipac breathable membrane products. There can be no assurance that the Company can successfully operate a manufacturing operation at acceptable costs, with acceptable yields, and retain adequately trained personnel. The occurrence of any of these factors could have a material adverse effect on the Company's business, results of operations and financial condition. DEPENDENCE ON SINGLE SOURCE SUPPLIERS. Many of the raw materials used in manufacturing certain of the Company's products are currently purchased from a single source, including certain monomers used to synthesize Intelimer polymers and substrate materials for the Company's breathable membrane products. In addition, virtually all of the hybrid corn varieties sold by Fielder's Choice are purchased from a single source. Upon manufacturing scale-up and as hybrid corn sales increase, the Company may enter into alternative supply arrangements. Although to date the Company has not experienced difficulty acquiring materials for the manufacture of its products nor has Fielder's Choice experienced difficulty in acquiring hybrid corn varieties, no assurance can be given that interruptions in supplies will not occur in the future, that the Company will be able to obtain substitute vendors, or that the Company will be able to procure comparable materials or hybrid corn varieties at similar prices and terms within a reasonable time. Any such interruption of supply could have a material adverse effect on the Company's ability to manufacture and distribute its products and, consequently, could materially and adversely affect the Company's business, results of operations and financial condition. PATENTS AND PROPRIETARY RIGHTS. The Company's success depends in large part on its ability to obtain patents, maintain trade secret protection and operate without infringing on the proprietary rights of third parties. There can be no assurance that any pending patent applications will be approved, that the Company will develop additional proprietary products that are patentable, that any patents issued to the Company will provide the Company with competitive advantages or will not be challenged by any third parties or that the patents of others will not prevent the commercialization of products incorporating the Company's technology. Furthermore, there can be no assurance that others will not independently develop similar products, duplicate any of the Company's products or design around the Company's patents. The Company has received, and may in the future receive, from third parties, including some of its competitors, notices claiming that it is infringing third party patents or other proprietary rights. If the Company were determined to be infringing any third-party patent, the Company could be required to pay damages, alter its products or processes, obtain licenses or cease certain activities. If the Company is required to obtain any licenses, there can be no assurance that the Company will be able to do so on commercially favorable terms, if at all. Litigation, which could result in substantial costs to and diversion of effort by the Company, may also be necessary to enforce any patents issued or licensed to the Company or to determine the scope and validity of third-party proprietary rights. Any such litigation or interference proceeding, regardless of outcome, could be expensive and time consuming and could subject the Company to significant liabilities to third parties, require disputed rights to be licensed from third parties or require the Company to cease using such technology and, consequently, could have a material adverse effect on the Company's business, results of operations and financial condition. See "Business - Patents and Proprietary Rights" in Item 1. ENVIRONMENTAL REGULATIONS. Federal, state and local regulations impose various environmental controls on the use, storage, discharge or disposal of toxic, volatile or otherwise hazardous chemicals and gases used in certain manufacturing processes, including those utilized by Dock Resins. As a result of historic off-site disposal practices, Dock Resins was recently involved in two actions seeking to compel the generators of hazardous waste to remediate hazardous waste sites. Dock Resins has been informed by its counsel that it was a DE MINIMIS generator to these sites, and these actions have been settled without the payment of any material amount by the Company. In addition, the New Jersey Industrial Site Recovery Act ("ISRA") requires an investigation and remediation of any industrial establishment, like Dock Resins, which changes ownership. This statute was activated by the Company's acquisition of Dock Resins. Dock Resins has completed its investigation of the site, delineated the limited areas of concern on the site, and completed the bulk of the active remediation required under the statute. The costs associated with this effort are being borne by the former owner of Dock Resins, and counsel has advised Dock Resins and the Company that funds of the former owner required by ISRA to be set aside for this effort are sufficient to pay for the successful completion of remedial activities at the site. In most cases, the Company believes its liability will be limited to sharing clean-up or other remedial costs with other potentially responsible parties. Any failure by the Company to control the use of, or to restrict adequately the discharge of, hazardous substances under present or future regulations could subject it to substantial liability or could cause its manufacturing operations to be suspended and could have a material adverse effect on the Company's business, operating results and financial condition. There can be no assurance that changes in environmental regulations will not impose the need for additional capital equipment or other requirements. The Company's agricultural operations are subject to a variety of environmental laws including the Food Quality Protection Act of 1966, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Federal Insecticide, Fungicide and Rodenticide Act and the Comprehensive Environmental Response, Compensation and Liability Act. Compliance with these laws and related regulations is an ongoing process. Environmental concerns are, however, inherent in most agricultural operations, including those conducted by the Company, and there can be no assurance that the cost of compliance with environmental laws and regulations will not be material. Moreover, it is possible that future developments, such as increasingly strict environmental laws and enforcement policies thereunder, and further restrictions on the use of manufacturing chemicals could result in increased compliance costs. ADVERSE GROWING CONDITIONS. The Company's Food Products and Agricultural Seed Technology businesses are subject to weather conditions that affect commodity prices, crop yields, and decisions by growers regarding crops to be planted. Crop diseases and severe conditions, particularly weather conditions such as floods, droughts, frosts, windstorms and hurricanes may adversely affect the supply of vegetables and fruits used in the Company's business, reduce the sales volumes and increase the unit production costs. Because a significant portion of the costs are fixed and contracted in advance of each operating year, volume declines due to production interruptions or other factors could result in increases in unit production costs which could result in substantial losses and weaken the Company's financial condition. If the supply of any of the Company's products is adversely affected by the adverse conditions, there can be no assurance that the Company will be able to obtain sufficient supplies from alternative sources. LIMITED SALES AND MARKETING EXPERIENCE. The Company has only limited experience marketing and selling its Intelimer polymer products. While Dock Resins will provide consultation and in some cases direct marketing support for Landec's Intelimer polymer products, establishing sufficient marketing and sales capability will require significant resources. The Company intends to distribute certain of its products through its corporate partners and other distributors and to sell certain other products through a direct sales force. There can be no assurance that the Company will be able to recruit and retain skilled sales management, direct salespersons or distributors, or that the Company's sales and marketing efforts will be successful. To the extent that the Company has entered into or will enter into distribution or other collaborative arrangements for the sale of its products, the Company will be dependent on the efforts of third parties. There can be no assurance that such sales and marketing efforts will be successful and any failure in such efforts could have a material adverse effect on the Company's business, operating results and financial condition. DEPENDENCE ON COLLABORATIVE PARTNERS AND LICENSEES. For certain of its current and future products, the Company's strategy for development, clinical and field testing, manufacture, commercialization and marketing includes entering into various collaborations with corporate partners, licensees and others. The Company is dependent on its corporate partners to develop, test, manufacture and/or market certain of its products. Although the Company believes that its partners in these collaborations have an economic motivation to succeed in performing their contractual responsibilities, the amount and timing of resources to be devoted to these activities are not within the control of the Company. There can be no assurance that such partners will perform their obligations as expected or that the Company will derive any additional revenue from such arrangements. There can be no assurance that the Company's partners will pay any additional option or license fees to the Company or that they will develop, market or pay any royalty fees related to products under the agreements. Moreover, certain of the collaborative agreements provide that they may be terminated at the discretion of the corporate partner, and certain of the collaborative agreements provide for termination under certain other circumstances. In addition, there can be no assurance as to the amount of royalties, if any, on future sales of QuickCast and PORT products as the Company no longer has control over the sales of such products since the sale of QuickCast and the license of the PORT product lines. There can be no assurance that the Company's partners will not pursue existing or alternative technologies in preference to the Company's technology. Furthermore, there can be no assurance that the Company will be able to negotiate additional collaborative arrangements in the future on acceptable terms, if at all, or that such collaborative arrangements will be successful. GOVERNMENT REGULATION. The Company's products and operations are subject to governmental regulation in the United States and foreign countries. The manufacture of the Company's products is subject to periodic inspection by regulatory authorities. There can be no assurance that the Company will be able to obtain necessary regulatory approvals on a timely basis or at all. Delays in receipt of or failure to receive such approvals or loss of previously received approvals would have a material adverse effect on the Company's business, financial condition and results of operations. Although Landec has no reason to believe that it will not be able to comply with all applicable regulations regarding the manufacture and sale of its products and polymer materials, such regulations are always subject to change and depend heavily on administrative interpretations and the country in which the products are sold. There can be no assurance that future changes in regulations or interpretations relating to such matters as safe working conditions, laboratory and manufacturing practices, environmental controls, and disposal of hazardous or potentially hazardous substances will not adversely affect the Company's business. There can be no assurance that the Company will not be required to incur significant costs to comply with such laws and regulations in the future, or that such laws or regulations will not have a material adverse effect on the Company's business, operating results and financial condition. As a result of the Apio acquisition, the Company is subject to USDA rules and regulations concerning the safety of the food products handled and sold by Apio, and the facilities in which they are packed and processed. Failure to comply with the applicable regulatory requirements can, among other things, result in fines, injunctions, civil penalties, suspensions or withdrawal of regulatory approvals, product recalls, product seizures, including cessation of manufacturing and sales, operating restrictions and criminal prosecution. See "Business - Governmental Regulations" in Item 1. INTERNATIONAL OPERATIONS AND SALES. In fiscal years 1999 and 1998, approximately 2.3% of the Company's total revenues were derived from product sales to and collaborative agreements with international customers. The Company expects that with the acquisition of Apio and its export business, international revenues will become an important component of its total revenues. A number of risks are inherent in international transactions. International sales and operations may be limited or disrupted by the regulatory approval process, government controls, export license requirements, political instability, price controls, trade restrictions, changes in tariffs or difficulties in staffing and managing international operations. Foreign regulatory agencies have or may establish product standards different from those in the United States, and any inability to obtain foreign regulatory approvals on a timely basis could have a material adverse effect on the Company's international business and its financial condition and results of operations. While the Company's foreign sales are currently priced in dollars, fluctuations in currency exchange rates, such as those recently experienced in many Asian countries which comprise a part of the territories of certain of the Company's collaborative partners and Apio's export business, may reduce the demand for the Company's products by increasing the price of the Company's products in the currency of the countries to which the products are sold. There can be no assurance that regulatory, geopolitical and other factors will not adversely impact the Company's operations in the future or require the Company to modify its current business practices. CUSTOMER CONCENTRATION. For the fiscal year 1999, sales to the Company's top five customers accounted for approximately 28% of the Company's product sales with the top customer accounting for 10% of the Company's product sales. The Company expects that for the foreseeable future a limited number of customers may continue to account for a substantial portion of its net revenues. The Company may experience changes in the composition of its customer base, as Apio, Dock Resins and Fielder's Choice have experienced in the past. The Company does not have long-term purchase agreements with any of its customers. The reduction, delay or cancellation of orders from one or more major customers for any reason or the loss of one or more of such major customers could materially and adversely affect the Company's business, operating results and financial condition. In addition, since certain products manufactured in the Linden, New Jersey facility or processed by Apio at its Guadalupe, California facility are often sole sourced to its customers, the Company's operating results could be adversely affected if one or more of its major customers were to develop other sources of supply. There can be no assurance that the Company's current customers will continue to place orders, that orders by existing customers will not be canceled or will continue at the levels of previous periods or that the Company will be able to obtain orders from new customers. PRODUCT LIABILITY EXPOSURE AND AVAILABILITY OF INSURANCE. The testing, manufacturing, marketing, and sale of the products being developed by the Company involve an inherent risk of allegations of product liability. While no product liability claims have been made against the Company to date, if any such claims were made and adverse judgments obtained, they could have a material adverse effect on the Company's business, operating results and financial condition. Although the Company has taken and intends to continue to take what it believes are appropriate precautions to minimize exposure to product liability claims, there can be no assurance that it will avoid significant liability. The Company currently maintains medical and non-medical product liability insurance with limits in the amount of $4.0 million per occurrence and $5.0 million in the annual aggregate. In addition, Apio has product liability insurance with limits in the amount of $41.0 million per occurrence and $42.0 million in the annual aggregate. There can be no assurance that such coverage is adequate or will continue to be available at an acceptable cost, if at all. A product liability claim, product recall or other claim with respect to uninsured liabilities or in excess of insured liabilities could have a material adverse effect on the Company's business, operating results and financial condition. POSSIBLE VOLATILITY OF STOCK PRICE. Factors such as announcements of technological innovations, the attainment of (or failure to attain) milestones in the commercialization of the Company's technology, new products, new patents or changes in existing patents, the acquisition of new businesses or the sale or disposal of a part of the Company's businesses, or development of new collaborative arrangements by the Company, its competitors or other parties, as well as government regulations, investor perception of the Company, fluctuations in the Company's operating results and general market conditions in the industry may cause the market price of the Company's Common Stock to fluctuate significantly. In addition, the stock market in general has recently experienced extreme price and volume fluctuations, which have particularly affected the market prices of technology companies and which have been unrelated to the operating performance of such companies. These broad fluctuations may adversely affect the market price of the Company's Common Stock. FINANCIAL AND ACCOUNTING CHANGES. In order to address certain deficiencies in Apio's management information systems and accounting systems, Apio has restructured its financial and accounting department, including hiring a chief financial officer and a new controller, and retained consultants who have worked with Apio to improve accounting processes and procedures. Apio management believes that such changes will improve its managing of operations, including delivering complete and accurate financial statements to Landec's corporate offices in a more timely manner. However, the Company can give no assurances that it will be able to effect such changes in the management information systems and accounting systems in a timely manner or that any delay will not have a material adverse effect on our business, financial condition and results of operations. INTRODUCTION OF THE EURO. On January 1, 1999, certain member states of the European Economic Community fixed their respective currencies to a new currency, commonly known as the "Euro". During the three years beginning on January 1, 1999, business in these countries will be conducted both in the existing national currency, as well as the Euro. Companies operating in or conducting business in these countries will need to ensure that their financial and other software systems are capable of processing transactions and properly handling the existing currencies and the Euro. Based on the current level of direct European business conducted by the Company, and also because the Company expects that any transactions in Europe in the near future will be priced in U.S. dollars, the Company does not expect that introduction and use of the Euro will materially affect the Company's business. The Company will continue to evaluate the impact over time of the introduction of the Euro. However, if the Company encounters unexpected opportunities or difficulties in Europe, the Company's business could be adversely affected, including the inability to bill customers and to pay suppliers for transactions denominated in the Euro and the inability to properly record transactions denominated in the Euro in the Company's financial statements. IMPACT OF YEAR 2000. The Year 2000 issue concerns the potential inability of computer applications, other information technology systems, and certain software-based "embedded" control systems to recognize and process properly, date-sensitive information in the Year 2000 and beyond. The Company could suffer material adverse impacts on its operations and financial results if the applications and systems used by the Company, or by third parties with whom the Company does business, do not accurately or adequately process or manage dates or other information as a result of the Year 2000 issue. The Company has certain key relationships with customers, vendors and outside service providers. The Company is primarily relying upon the voluntary disclosures from third parties for this review of their Year 2000 readiness. Failure by the Company's key customers, vendors and outside service providers to adequately address the Year 2000 issue could have a material adverse impact on the Company's operations and financial results. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14 of Part IV of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT This information required by this item is contained in the Registrant's definitive proxy statement which the Registrant will file with the Commission no later than February 28, 2000 (120 days after the Registrant's fiscal year end covered by this Report) and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This information required by this item is contained in the Registrant's definitive proxy statement which the Registrant will file with the Commission no later than February 28, 2000 (120 days after the Registrant's fiscal year end covered by this Report) and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information required by this item is contained in the Registrant's definitive proxy statement which the Registrant will file with the Commission no later than February 28, 2000 (120 days after the Registrant's fiscal year end covered by this Report) and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information required by this item is contained in the Registrant's definitive proxy statement which the Registrant will file with the Commission no later than February 28, 2000 (120 days after the Registrant's fiscal year end covered by this Report) and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS Board of Directors and Shareholders Landec Corporation We have audited the accompanying consolidated balance sheets of Landec Corporation as of October 31, 1999 and 1998, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended October 31, 1999. Our audits also included the financial statement schedule listed in the index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Landec Corporation at October 31, 1999 and 1998 and the consolidated results of its operations and its cash flows for each of the three years in the period ended October 31, 1999 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ERNST & YOUNG LLP San Francisco, California December 6, 1999 LANDEC CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) SEE ACCOMPANYING NOTES. LANDEC CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) SEE ACCOMPANYING NOTES. LANDEC CORPORATION CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) SEE ACCOMPANYING NOTES. LANDEC CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) SEE ACCOMPANYING NOTES. LANDEC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION Landec Corporation and its subsidiaries (the "Company") design, develop, manufacture, and sell temperature-activated and other specialty polymer products for a variety of food product, agricultural products, specialty industrial and medical applications. In addition, the Company markets and distributes hybrid corn seed to producer customers. BASIS OF CONSOLIDATION The consolidated financial statements comprise the accounts of Landec Corporation and its wholly owned subsidiaries, Intellicoat Corporation ("Intellicoat") and Dock Resins Corporation ("Dock Resins"). All intercompany transactions and balances have been eliminated. CONCENTRATIONS OF CREDIT RISK Cash, cash equivalents and short-term investments are financial instruments which potentially subject the Company to concentrations of risk. Corporate policy limits, among other things, the amount of credit exposure to any one issuer and to any one type of investment, other than securities issued or guaranteed by the U.S. government. CASH, CASH EQUIVALENTS AND INVESTMENTS The Company records all highly liquid securities with three months or less from date of purchase to maturity as cash equivalents. Management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. As of October 31, 1999 and 1998, the Company's debt securities are carried at fair value and classified as available-for-sale, as the Company may not hold these securities until maturity in order to take advantage of market conditions. Unrealized gains and losses are reported as a component of shareholders' equity and were immaterial for all years presented. The cost of debt securities is adjusted for amortization of premiums and discounts to maturity. This amortization is included in interest income. Realized gains and losses on the sale of available-for-sale securities are also included in interest income and were immaterial for fiscal year 1999. The cost of securities sold is based on the specific identification method. INVENTORIES Inventories are stated at the lower of cost (using the first-in, first-out method) or market. As of October 31, 1999 and 1998 inventories consisted of (in thousands): 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) DEFERRED ADVERTISING The Company defers certain costs related to direct-response advertising of its hybrid corn seeds. Such costs are amortized over periods (less than one year) that correspond to the estimated revenue stream of the advertising activity. Advertising expenditures that are not direct-response advertisements are expensed as incurred. The advertising expense for fiscal years 1999 and 1998 was $1,272,000 and $1,165,000, respectively. The advertising expense for fiscal year 1997 was zero as the Company acquired Fielder's Choice in September, 1997. RECEIVABLE FROM RELATED PARTIES In October 1998, the Company loaned an officer of Intellicoat $500,000 in cash in exchange for a promissory note. Interest accrued at 7.50% per annum, compounded annually. On July 31, 1999 the balance of principal and accrued interest were offset by an earn-out provision related to the acquisition of Fielder's Choice by the Company. The resulting principal balance of $138,000 plus interest, if any, is due and payable on July 31, 2000. The $138,000 note has been included in other current assets at October 31, 1999. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Expenditures for major improvements are capitalized while repairs and maintenance are charged to expense. Depreciation is expensed on a straight-line basis over the estimated useful lives of the respective assets, generally twenty to thirty-one years for buildings and improvements and three to ten years for furniture, computers, machinery and equipment. Leasehold improvements are amortized over the lesser of the economic life of the improvement or the life of the lease on a straight-line basis. INTANGIBLE ASSETS Intangible assets represent the excess of acquisition costs over the estimated fair value of net assets acquired and consist of covenants not to compete, customer bases, work forces in place, trademarks, developed technology and goodwill. These assets are amortized on a straight-line basis over periods ranging from five to twenty years based on their estimated useful lives. DEFERRED REVENUE Cash received in advance of services performed or shipment of products, primarily hybrid corn seed, are recognized as a liability and recorded as deferred revenue. At October 31, 1999 approximately $2.1 million has been recognized as a liability for advances on future hybrid corn seed shipments. PER SHARE INFORMATION In 1997, the Financial Accounting Standards Board issued Statement No. 128, "Earnings Per Share" (SFAS No. 128). SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. Due to the Company's net loss in all periods presented, net loss per share includes only weighted average shares outstanding. All earnings per share amounts for all periods have been presented in accordance with SFAS No. 128 requirements. 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) REVENUE RECOGNITION Revenues related to research contracts are recognized ratably over the related funding periods for each contract, which is generally as research is performed. Revenues related to license agreements with noncancelable, nonrefundable terms and no significant future obligations are recognized upon inception of the agreements. Product sales are recognized upon shipment. RESEARCH AND DEVELOPMENT EXPENSES Costs related to both research contracts and Company-funded research is included in research and development expenses. Costs to fulfill research contracts generally approximate cost. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company accounts for its stock option plans and its employee stock purchase plans in accordance with the provisions of the Accounting Principles Board Opinion No. 25 (APB 25) "Accounting for Stock Issued to Employees." USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. IMPAIRMENT OF LONG LIVED ASSETS The Company has adopted SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of". The Company records impairment losses on long-lived assets used in operations or expected to be disposed when events and circumstances indicate that the assets are less than the carrying amounts of those assets. No such event and circumstances have occurred. 2. BUSINESS ACQUISITIONS On April 18, 1997, the Company acquired Dock Resins Corporation ("Dock Resins") a privately-held manufacturer and marketer of specialty acrylics and other polymers located in Linden, New Jersey for $15.8 million, comprised of $13.7 million in cash, a secured promissory note paid in January 1998 and direct acquisition costs along with 396,039 shares of common stock valued at $2.1 million. A payable of $9.5 million was recorded as of the acquisition date to recognize the promissory note and other liabilities related to the acquisition. A marketable investment of $8.8 million was set aside as security for payment of the promissory note, and subsequently used to pay off the promissory note in January 1998. In addition, $1.5 million of the cash consideration and all of the equity consideration was set aside in escrow to cover future costs associated with obligations under the representations and warranties made by the shareholder of Dock Resins in connection with the acquisition. During fiscal year 1998 $460,000 was drawn down from the escrow account to pay for obligations under the agreement. No amounts were drawn from the account during fiscal years 1999 and 1997. The escrow account expires on April 18, 2002. Management determined the portion of the purchase price allocable to in-process research and development based on the assessment of the technology and the effort required to complete the technology and sought advice from an independent appraiser with respect to the value of the in-process research and development. This assessment resulted in a $3.0 million charge during fiscal year 1997 as required under generally accepted accounting principles. Such in-process technology was determined to have no alternative future uses. The acquisition was accounted for using the purchase method. 2. BUSINESS ACQUISITIONS (CONTINUED) On September 30, 1997, Intellicoat acquired Williams & Sun, Inc. d/b/a Fielder's Choice Hybrids ("Fielder's Choice") a privately-held direct marketer of hybrid seed corn, located in Monticello, Indiana for $8.8 million, comprised of $3.6 million in cash and direct acquisition costs along with 1,425,648 shares of common stock valued at approximately $5.2 million. Terms of the agreement include additional consideration up to $2.4 million in the form of a cash earn-out based on the future performance of the Fielder's Choice business. During fiscal years 1999 and 1998, earn-out payments were made in the amount of $393,000 and $390,000, respectively. The acquisition was accounted for using the purchase method. 3. DISCONTINUED OPERATIONS In fiscal year 1997, the Company entered into an agreement with Bissell Healthcare Corporation ("Bissell") to sell substantially all of the net assets of QuickCast for $950,000 in cash plus royalties on future sales through August 28, 2007. As a result, the operations of the QuickCast product line for fiscal year 1997 has been classified as discontinued in the consolidated statements of operations. During fiscal years 1999 and 1998, the Company recognized $12,000 and $20,000 respectively, of royalties income related to this agreement. 4. COLLABORATIVE AGREEMENTS To facilitate the commercialization of its products, the Company has established a number of strategic alliances in which the Company receives license payments, research and development funding and/or future royalties in exchange for certain technology or marketing rights. HITACHI CHEMICAL. The Company entered into two separate collaborations with Hitachi Chemical ("Hitachi") in the areas of industrial adhesives and Intelimer Polymer Systems. On October 1, 1994, the Company entered into a non-exclusive license agreement for seven years with Hitachi in the industrial adhesives area. The agreement provides Hitachi with a non-exclusive license to manufacture and sell products using Landec's Intelimer materials in certain Asian countries. Landec received up-front license fees upon signing the agreement and is entitled to future royalties based on net sales by Hitachi of the licensed products. Any fees paid to the Company are non-refundable. On August 10, 1995, the Company entered into the second collaboration with Hitachi in the Intelimer Polymer Systems area. The agreement provided Hitachi with an exclusive license to use and sell Landec's Intelimer Polymer Systems in industrial latent curing products in certain Asian countries. Landec is entitled to be the exclusive supplier of Intelimer Polymer Systems to Hitachi for at least seven years after commercialization. Landec received an up-front license payment upon signing this agreement and research and development funding over three years and is entitled to receive future royalties based on net sales by Hitachi of the licensed products. Any fees paid to the Company are non-refundable. This agreement has been converted to a non-exclusive agreement except for one application field. In conjunction with this agreement, Hitachi purchased Series E Preferred Stock for $1.5 million which converted to common stock upon the Company's initial public offering. NITTA CORPORATION. On March 14, 1995, the Company entered into a license agreement with Nitta Corporation ("Nitta") in the industrial adhesives area. The agreement provides Nitta with a co-exclusive license to manufacture and sell products using Landec's Intelimer materials in certain Asian countries. Landec received up-front license fees upon signing the agreement and is entitled to future royalties based on net sales by Nitta of the licensed products. Any fees paid to the Company are non-refundable. This agreement is terminable at Nitta's option. Nitta and the Company entered into an additional exclusive license arrangement in February 1996 covering Landec's medical adhesives technology for use in Asia. The Company received up-front license fees upon execution of the agreement and research and development payments and is entitled to receive future royalties under this agreement. Any fees paid to the Company are non-refundable. Nitta and the Company also entered into another worldwide exclusive agreement on January 1, 1998 in the area of industrial adhesives specific to one field of electronic polishing adhesives. The Company received research and development payments as a part of this agreement. 4. COLLABORATIVE AGREEMENTS (CONTINUED) ALCON. In December 1997, Landec licensed the rights to worldwide manufacturing, marketing and distribution of its PORT ophthalmic device to Alcon. Under the terms of the transaction, Landec received an up-front cash payment, a $1 million milestone payment in November 1998, research and development funding and will receive ongoing royalties of 12.5% on product sales of each PORT device over an approximately 15-year period. In September 1999, Alcon submitted a 510K application to the FDA seeking approval to commercially sell the PORT device. Landec will continue to provide development support on a contract basis through the FDA approval process and product launch. CONVATEC. On October 11, 1999, the Company entered into a joint development agreement ConvaTec, a division of Bristol Myers Squibb, under which Landec will develop adhesive film products for selected ConvaTec medical products. Landec is receiving support funding for this program. Upon completion of this agreement, the companies have the option to consider a supply agreement where Landec would supply materials to ConvaTec of use in specific medical devices. 5. AVAILABLE-FOR-SALE SECURITIES There were no available-for-sale securities as of October 31, 1999. The following is a summary of available-for-sale securities as of October 31, 1998 (in thousands): 6. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands): Depreciation expense for fiscal years 1999, 1998 and 1997 was $986,000, $844,000, and $603,000, respectively. 7. INTANGIBLE ASSETS Intangible assets consist of the following (in thousands): Amortization expense for fiscal years 1999, 1998, and 1997 was $1,142,000, $1,120,000, and $335,000, respectively. 8. WARRANTS In connection with the sale of Series D preferred stock in July 1993, the Company issued warrants to purchase 186,349 shares of common stock at an exercise price of $4.31 per share for $5,357 in cash. In a cashless exercise during fiscal year 1998, 46,587 shares were issued in exchange for the warrants. 9. SHAREHOLDERS' EQUITY COMMON STOCK, STOCK PURCHASE PLANS AND STOCK OPTION PLANS In October 1998, certain directors and officers of the Company purchased 200,425 shares of common stock for between $3.75 and $3.94 per share for $776,000. At October 31, 1998, certain directors and officers of the Company were obligated to the Company for $291,000 relating to this issuance. This amount was recorded to shareholders' equity at October 31, 1998. The outstanding balances were paid in full by December 1998. The Company has 4,507,144 common shares reserved for future issuance under Landec Corporation stock option plans and employee stock purchase plans. The Company terminated its 1988 Stock Option Plan during fiscal year 1998 and canceled all stock options available for grant. The 1995 Directors' Stock Option Plan (the "Directors' Plan") provides that each person who becomes a nonemployee director of the Company, who has not received a previous grant, shall be granted a nonstatutory stock option to purchase 20,000 shares of common stock on the date on which the optionee first becomes a nonemployee director of the Company. Thereafter, on the date of each annual meeting of the shareholders each non-employee director shall be granted an additional option to purchase 10,000 shares of common stock if, on such date, he or she shall have served on the Company's Board of Directors for at least six months prior to the date of such annual meeting. The exercise price of the options is the fair market value of the Company's common stock on the date the options are granted. The Directors' Plan, as amended in 1998, authorizes the issuance of 400,000 shares under the plan. Options granted under this plan are exerciseable and vest upon grant. All directors' stock option grants outstanding on December 4, 1997 with an exercise price greater than $6.75, were repriced to $6.75 per share, the fair market value of the Company's common stock on April 15, 1998, the date of the annual shareholders' meeting. 9. SHAREHOLDERS' EQUITY (CONTINUED) The 1996 Non-Executive Stock Option Plan authorizes the Board of Directors to grant non-qualified stock options to employees and outside consultants who are not officers or directors of the Company. The exercise price of the options will be equal to the fair market value of the Company's common stock on the date the options are granted. As amended in 1999, 1,500,000 shares are authorized to be issued under this plan. Options are exercisable upon vesting and generally vest ratably over four years and are subject to repurchase if exercised before being vested. In November 1996, the Company's Board of Directors approved the 1996 Stock Option Plan. Under this plan, the Board of Directors of Landec may grant stock purchase rights, incentive stock options or non-statutory stock options to Landec executives. The exercise price of the stock purchase rights, incentive stock options and non-statutory stock options may be no less than 100% of the fair market value of Landec's common stock on the date the options are granted. The plan, as amended, authorizes the issuance of 1,500,000 shares of Landec common stock under the plan. Options are exercisable upon vesting and generally vest ratably over four years and are subject to repurchase if exercised before being vested. In January 1997, the company effected an option repricing program to allow non-officer employees and outside consultants who were issued options under the 1988 Stock Option Plan at an exercise price above $14.50 per share to exchange their out-of-money stock options for the same number of options at a more favorable exercise price. Under this repricing program, one new option could be obtained for every option cancelled. The exercise price of the new option was based on the fair market value of the Company's common stock on the date the old options were exchanged. The new options vest ratably over four years (commencing one year from January 7, 1997, the repricing date) and are subject to repurchase if exercised before being vested. As a result of this repricing program, options to purchase 58,250 shares were repriced. In January 1998, the Company effected another option repricing program to allow employees, directors and officers who were issued options under the 1988 Stock Option Plan, 1996 Non-Executive Stock Option Plan and 1996 Stock Option Plan at an exercise price above $5.00 per share to exchange their out-of-money stock options for the same number of options at a more favorable exercise price. The officers and directors repricing was approved at the April 15, 1998 shareholders' meeting. Under this repricing program, one new option could be obtained for every option cancelled. The exercise price of the new option was based on the higher of fair market value of the Company's common stock on the date the old options were exchanged, or $5.00 per share. The new options vest ratably over four years (commencing December 4, 1997, the repricing date) and are subject to repurchase if exercised before being vested. As a result of this repricing program and the repricing of the options issued under the 1995 Directors' Plan, options to purchase 753,100 shares were repriced. 9. SHAREHOLDERS' EQUITY (CONTINUED) Activity under all Landec Stock Option Plans is as follows: At October 31, 1999, 1998 and 1997, options to purchase 1,494,662, 1,101,387 and 902,135 of Landec's common stock were vested, respectively. No options have been exercised prior to being vested. For options granted through October 31, 1999, the Company recognized an aggregate of $451,000 as deferred compensation for the excess of the deemed value for accounting purposes of the common stock not issueable on exercise of such options over the aggregate exercise price of such options. The deferred compensation expense is being amortized ratably over the vesting period of the options. Total deferred compensation expense recognized in the Company's financial statements for stock-option awards under APB 25 for fiscal years 1999, 1998 and 1997 was $86,000, $112,000 and $113,000, respectively. 9. SHAREHOLDERS' EQUITY (CONTINUED) The following tables summarize information about Landec options outstanding and exerciseable at October 31, 1999. EMPLOYEE STOCK PURCHASE PLAN. The Company has an employee stock purchase plan which permits eligible employees to purchase common stock, which may not exceed 10% of an employee's compensation, at a price equal to the lower of 85% of the fair market value of the Company's common stock at the beginning of the offering period or on the purchase date. As of October 31, 1999, 175,860 shares have been issued under the Purchase Plan. INTELLICOAT STOCK PLAN. Under the 1996 Intellicoat Stock Plan, the Board of Directors of Intellicoat may grant stock purchase rights, incentive stock options or non-statutory stock options to employees and outside consultants. The exercise price of the stock purchase rights, incentive stock options and non-statutory stock options may be no less than 85%, 100% and 85%, respectively, of the fair market value of Intellicoat's common stock as determined by Intellicoat's Board of Directors. Two million shares are authorized to be issued under this plan. Options are exercisable upon vesting and generally vest ratably over four years and are subject to repurchase if exercised before being vested. 9. SHAREHOLDERS' EQUITY (CONTINUED) The following table summarizes activity under the Intellicoat Stock Option Plan. At October 31, 1999 options to purchase 986,897 shares with an average exercise price of $0.14 per share of Intellicoat's common stock were vested. For the options outstanding at October 31, 1999, 1,033,000 shares were granted with an exercise price of $0.10, 292,775 shares were granted with an exercise price of $0.20 and 197,000 were granted with an exercise price of $1.00. As of October 31, 1999, the Company has 1,999,466 common shares reserved for future issuance under the Intellicoat Corporation stock option plan. PRO FORMA INFORMATION. The Company has elected to follow APB 25 in accounting for its employee stock option because, as discussed below, the alternative fair value accounting provided for under SFAS 123 required the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, no compensation expense is recognized in the Company's financial statements unless the exercise price of the Company's employee stock options is less than the market price of the underlying stock on the date of grant. Pro forma information regarding net loss and net loss per share has been determined as if the Company had accounted for the Landec stock option plans and employee stock purchase plan under the fair value method and the Intellicoat Stock Plan under the minimum value method prescribed by SFAS No. 123. The fair value of options granted in fiscal years 1999, 1998 and 1997 reported below has been estimated at the date of grant using a Black-Scholes options pricing model with the following weighted average assumptions: The assumptions used for the Landec stock options for the expected life, the risk-free interest rate and the dividend yield are the same assumptions used to determine the fair value of the Intellicoat options granted in fiscal year 1999, 1998 and 1997. The volatility for the Intellicoat options is assumed to be zero since Intellicoat stock is not publicly traded. 9. SHAREHOLDERS' EQUITY (CONTINUED) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company's options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of its options. The weighted average estimated fair value of Landec employee stock options granted at grant date market prices during fiscal years 1999, 1998 and 1997 was $1.71, $1.67 and $2.50 per share, respectively. The weighted average exercise price of employee stock options granted at grant date market prices during fiscal year 1999, 1998 and 1997 was $4.78, $5.86 and $7.00 per share, respectively. No stock options were granted above grant date market prices during fiscal year 1999. The weighted average estimated fair value of Landec employee stock options granted above grant date market prices during fiscal years 1998 and 1997 was $7.84 and $3.05 per share, respectively. The weighted average exercise price of employee stock options granted above grant date market prices during fiscal year 1998 and 1997 was $5.00 and $12.00 per share, respectively. The weighted average estimated fair value of shares granted under the Landec Stock Purchase Plan during fiscal years 1999, 1998 and 1997 was $1.42, $1.57 and $2.26 per share, respectively. The weighted average estimated fair value of shares granted under the Intellicoat Stock Purchase Plan during fiscal years 1999, 1998 and 1997 was $0.30, $0.03 and $0.02 per share, respectively. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands, except per share amounts): The effects on pro forma disclosures of applying SFAS No. 123 are not likely to be representative of the effects on pro forma disclosures of future years. 10. DEBT In December 1997, Dock Resins entered into a loan and security agreement which provides for a long-term loan and a short-term revolving line of credit with a bank. Both the long-term loan and the short-term revolving line of credit are collateralized by a security interest in substantially all of the assets of Dock Resins. The Company pays interest on its long-term debt at an 8.19% fixed rate. From time to time the Company enters into equipment financing agreements when interest rates and payment terms are favorable. At October 31, 1999 and 1998, the Company had approximately $84,000 and $61,000, respectively, of equipment loans outstanding. LONG-TERM DEBT Long-term debt consists of the following (in thousands): 10. DEBT (CONTINUED) Maturities of long-term debt are as follows (in thousands): The long-term loan limits Dock Resins' dividend payments and contains various financial covenants including minimum working capital levels, net worth and debt service ratio. For the year ended October 31, 1999 and 1998, the Company paid interest on the long-term debt of $217,000 and $35,000, respectively. In fiscal year 1999, $141,000 was capitalized as the amount related to financing for capital expenditures. No interest was capitalized during fiscal year 1998. Management believes the fair value of its debt approximates carrying value. SHORT-TERM DEBT The short-term revolving line of credit allows for borrowings of up to $1,250,000. The interest rate on the revolving line of credit is principally charged at the LIBOR rate plus 1.75%. The revolving line of credit expires on January 31, 2000, and contains certain restrictive covenants which, among other things, require Dock Resins to maintain minimum levels of net working capital and tangible net worth. No amounts were outstanding on the revolving line of credit at October 31, 1999. 11. INCOME TAXES The Company's provision for income taxes of $54,000 for the year ended October 31, 1999 is attributable to state taxes. As of October 31, 1999, the Company had net operating loss carryforwards of approximately $27.8 million for federal income tax purposes. The Company also had federal research and development tax credit carryforwards of approximately $1.0 million. The net operating loss carryforwards will expire at various dates beginning in 2002 through 2014, if not utilized. Utilization of the net operating losses and credit carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986. The annual limitation may result in the expiration of net operating losses and credits before utilization. Significant components of the Company's deferred tax assets are as follows (in thousands): Due to the Company's absence of earning history, the net deferred tax asset has been fully offset by a valuation allowance. The valuation allowance decreased by $100,000 during the fiscal year ended October 31, 1998. 12. COMMITMENTS LEASES The Company leases office and laboratory space and certain equipment. Rent expense for the fiscal years ended October 31, 1999, 1998, and 1997 was approximately $522,000, $481,000, and $392,000 respectively. Future minimum lease obligations as of October 31, 1999 under all leases are as follows (in thousands): OTHER Under the terms of the acquisition of Dock Resins (see Note 2), the former shareholder of Dock Resins has indemnified the Company with regard to expenditures subsequent to the acquisition for certain environmental matters relating to circumstances existing at the time of the acquisition. To cover any such cost, an escrow for $1.5 million in cash and all of the equity consideration was set aside. During fiscal year 1998, $460,000 was drawn down from the escrow account to pay for environmental expenses incurred by Dock Resins, that had been indemnified by the former shareholder of Dock Resins in the purchase agreement. During fiscal years 1999 and 1997 no costs associated with the pre-acquisition environmental matters were incurred. 13. BUSINESS SEGMENT REPORTING During the years presented, the Company reported its operations in three business segments: the Food Products Technology segment, the Agricultural Seed Technology segment and the Industrial High Performance Materials segment. The Food Products Technology segment manufactures and sells film packages applied with the Intellipac breathable membrane to the fresh-cut produce industry. The Agricultural Seed Technology segment markets and distributes hybrid seed corn to the farming industry and is developing seed coatings using the Company's proprietary Intelimer polymers. The Industrial High Performance Materials segment manufactures and sells specialty acrylics and polymers to the coating, laminating, adhesive and printing industries. Corporate and Other amounts include corporate operating costs and net interest income. Assets classified as corporate and other amounts consist primarily of cash and marketable securities. 13. BUSINESS SEGMENT REPORTING (CONTINUED) Operations by Business Segment (in thousands): During fiscal years 1999, 1998 and 1997, an industrial high performance materials customer accounted for 10%, 13% and 25% of the Company's total revenue, respectively. This was the only customer with revenues individually representing 10% or more of total revenue. Export product sales were approximately $828,000, $863,000, and $421,000 in the years ended October 31, 1999, 1998 and 1997, respectively. 14. SUBSEQUENT EVENTS On December 2, 1999, the Company acquired Apio, Inc. and certain related entities, of Guadalupe, California, one of the nation's leading marketers and packers of produce and specialty packaged fresh-cut vegetables with annual sales of approximately $158 million. Upon closing, Landec paid $23.9 million in cash and stock, before expenses, for Apio, which will operate as a wholly owned subsidiary of Landec. Additional terms of the agreement include up to $16.75 million in future payments over five years, with $10.0 million of that amount based on Apio achieving certain performance milestones. The transaction was accounted for as a purchase. 14. SUBSEQUENT EVENTS (CONTINUED) To fund the transaction, Landec issued 2.5 million shares of common stock to the prior owners of Apio. Apio replaced a portion of its existing bank debt with a $11.25 million term note and entered into a new $12 million line of credit agreement with the Bank of America. Existing debt of $3.7 million was assumed in the transaction. In a separate transaction, Landec has sold $10 million of convertible preferred stock (convertible into 1,666,670 shares of Common Stock) to a private, long-term, investor at a $6.00 per share equivalent price. Under the terms of these transactions, Landec has agreed to effect the registration of approximately 2.5 million shares of Landec common stock by March 31, 2000. LANDEC CORPORATION VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) (b) No reports on Form 8-K were filed by the Company during the period August 1, 1999 to October 31, 1999. (c) Index of Exhibits 2.1(6) Stock Purchase Agreement by and among the Registrant, Dock Resins Corporation and A. Wayne Tamarelli dated as of April 18, 1997. 2.2(7) Agreement and Plan of Reorganization by and among the Registrant, Intellicoat Corporation, Williams & Sun, Inc. (d/b/a Fielder's Choice Hybrids) and Michael L. Williams dated as of August 20, 1997. 2.3(11) Form of Agreement and Plan Merger and Purchase Agreement by and among the Registrant, Apio, Inc. and related companies and each of the respective shareholders dated as of November 29, 1999. 3.1(1) Amended and Restated Bylaws of Registrant. 3.2(2) Ninth Amended and Restated Articles of Incorporation of Registrant. 3.3+ Certificate of Determination of Series A Preferred Stock 4.1(12) Series A Preferred Stock Purchase Agreement between the Registrant and Frederick Frank, dated as of November 19, 1999. 10.1(3) Form of Indemnification Agreement. 10.3(4)* 1995 Employee Stock Purchase Plan, as amended, and form of Subscription Agreement. 10.4(4)* 1995 Directors' Stock Option Plan, as amended, and form of Option Agreement. 10.6(3) Industrial Real Estate Lease dated March 1, 1993 between the Registrant and Wayne R. Brown & Bibbits Brown, Trustees of the Wayne R. Brown & Bibbits Brown Living Trust dated December 30, 1987. 10.14(4)* Consulting Agreement dated May 1, 1996 between the Registrant and Richard Dulude. 10.15(4)* 1996 Intellicoat Stock Option Plan and form of Option Agreement. 10.16(4)* 1996 Non-Executive Stock Option Plan and form of Option Agreement. 10.17(5)* 1996 Stock Option Plan and form of Option Agreement. 10.18(8) Asset Purchase Agreement between Bissell Healthcare Corporation and the Registrant, dated as of August 28, 1997. 10.19(8) Technology License Agreement between Bissell Healthcare Corporation and the Registrant, dated as of August 28, 1997. 10.20(8) Supply Agreement between Bissell Healthcare Corporation and the Registrant, dated as of August 28, 1997. 10.21(9)* Employment Agreement between the Registrant and A. Wayne Tamarelli dated as of April 18, 1997. 10.22(10) Form of Common Stock Purchase Agreement for certain officers and directors for restricted stock purchase. 10.23(10) Loan agreement between Registrant and Michael Williams dated October 1, 1998. 10.24+ Employment agreement between the Registrant and Nicholas Tompkins dated as of November 29, 1999. 10.25+ Stock Option Agreement between the Registrant and Nicholas Tompkins dated as of November 29, 1999. 10.26+ 1999 Apio, Inc. Stock Option Plan and form of Option Agreement. 10.27+ Loan agreement between Apio, Inc. and the Bank of America dated as of November 29, 1999. 21.1 Subsidiaries of the Registrant. 23.1+ Consent of Independent Auditors. 24.1+ Power of Attorney. See page 58. 27.1+ Financial Data Schedule - ------------------- (1) Incorporated by reference to Exhibit 3.4 filed with Registrant's Registration Statement on Form S-1 (File No. 33-80723) declared effective on February 12, 1996. (2) Incorporated by reference to Exhibit 3.5 filed with Registrant's Registration Statement on Form S-1 (File No. 33-80723) declared effective on February 12, 1996. (3) Incorporated by reference to the identically numbered exhibits filed with the Registrant's Registration Statement on Form S-1 (File No. 33-80723) declared effective on February 12, 1996. (4) Incorporated by reference to the identically numbered exhibits filed with the Registrant's Form 10-K filed for the year ended October 31, 1996. (5) Incorporated by reference to the identically numbered exhibits filed with the Registrant's Form 10-Q filed for the quarter ended April 30, 1997. (6) Incorporated by reference to Exhibit 2.1 filed with the Registrant's Form 8-K dated April 18, 1997. (7) Incorporated by reference to Exhibit 2.1 filed with the Registrant's Form 10-Q for the quarter ended July 31, 1997. (8) Incorporated by reference to the identically numbered exhibits filed with the Registrant's Form 8-K dated August 28, 1997. (9) Incorporated by reference to Exhibit C to Exhibit 2.1 filed with the Registrant's Form 8-K dated April 18, 1997. (10) Incorporated by reference to identically numbered exhibits filed with the Registrant's Form 10-K filed for the year ended October 31, 1998. (11) Incorporated by reference to the Exhibit 2.1 filed with the Registrant's Form 8-K dated December 2, 1999. (12) Incorporated by reference to identically numbered exhibits filed with the Registrant's Form 8-K dated December 2, 1999. * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this report pursuant to item 14(c) of Form 10-K. + Filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Menlo Park, State of California, on January 26, 2000. LANDEC CORPORATION By: /s/ Gregory S. Skinner ------------------------------------ Gregory S. Skinner Vice President of Finance and Chief Financial Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, THAT EACH PERSON WHOSE SIGNATURE APPEARS BELOW HEREBY CONSTITUTES AND APPOINTS GARY T. STEELE AND GREGORY S. SKINNER, AND EACH OF THEM, AS HIS ATTORNEY-IN-FACT, WITH FULL POWER OF SUBSTITUTION, FOR HIM IN ANY AND ALL CAPACITIES, TO SIGN ANY AND ALL AMENDMENTS TO THIS REPORT ON FORM 10-K, AND TO FILE THE SAME, WITH EXHIBITS THERETO AND OTHER DOCUMENTS IN CONNECTION THEREWITH, WITH THE SECURITIES AND EXCHANGE COMMISSION, HEREBY RATIFYING AND CONFIRMING OUR SIGNATURES AS THEY MAY BE SIGNED BY OUR SAID ATTORNEY TO ANY AND ALL AMENDMENTS TO SAID REPORT ON FORM 10-K. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed by the following persons in the capacities and on the dates indicated: EXHIBIT INDEX EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- 3.3 Certificate of Determination of Series A Preferred Stock 10.24 Employment agreement between the Registrant and Nicholas Tompkins dated as of November 29, 1999. 10.25 Stock Option Agreement between the Registrant and Nicholas Tompkins dated as of 10.25 November 29, 1999. 10.26 1999 Apio, Inc. Stock Option Plan and form of Option Agreement. 10.27 Loan agreement between Apio, Inc. and the Bank of America dated as of November 29, 1999. 23.1 Consent of Independent Auditors 24.1 Power of Attorney. See page 58. 27.1 Financial Data Schedule

1004985_1999.txt

1004985_1999

1999

1004985

ITEM 1. BUSINESS. Earthgrains Overview - -------------------- The Earthgrains Company (the "Company") is an international manufacturer, distributor and consumer marketer of packaged fresh bread and baked goods and refrigerated dough products. The Company began operations in 1925 with one bakery. In 1982, Anheuser-Busch Companies, Inc. ("AB") acquired the Company (then a publicly-traded company known as Campbell-Taggart, Inc.). The Company again became an independent, publicly-traded company on March 26, 1996 when Anheuser-Busch distributed 100% of the shares of the Company to its shareholders in a spin-off. The Company's common stock began trading on the New York Stock Exchange on March 27, 1996 under its present name and the symbol "EGR." The Company's operations are divided into two principal businesses: Bakery Products and Refrigerated Dough Products. The Company's Bakery Products business manufactures and distributes fresh- baked goods such as baked breads, buns, rolls, bagels, cookies, snack cakes and other sweet goods in the United States and fresh-baked sliced bread, buns, rolls, bagels, snack cakes and other sweet goods in Spain and Portugal. The Company's Refrigerated Dough Products business manufactures many different refrigerated dough products in the United States including biscuits, dinner rolls, sweet rolls, danishes, cookie dough, crescent rolls, breadsticks, cinnamon rolls, pizza crust and pie crusts, as well as shelf-stable toaster pastries. The Company's Refrigerated Dough Products business also manufactures and sells refrigerated dough products in Europe, primarily in France and Germany, and makes packaged rolled dough, which is used to prepare foods such as quiches, tarts and pies. BAKERY PRODUCTS Overview - -------- The Company operates fresh packaged-bread and bakery-products businesses in the United States and Europe. The Company offers a wide range of products in the popular, premium and superpremium segments of the market. It sells primarily to retail grocers and other food outlets, and also serves leading food service and fast food customers with products. The products are delivered to customers' outlets primarily by way of a Company owned direct store delivery route system. In accordance with the fresh-baked goods industry practice, the Company accepts fresh-baked goods that have not been sold by retailers by a prescribed freshness date, and operates retail thrift stores that sell certain returned products. U.S. Bakery Products - -------------------- The Company's U.S. Bakery Products division operates 39 direct store-delivery bakeries and 4 Diversified Products bakeries that supply the entire system with specialized products. U.S. Bakery Products division markets its white and wheat breads, buns, rolls and other bakery products under leading brand names in 7 regions across 28 states, primarily in the southern half of the United States, and across the country to food-service and fast-food customers such as Burger King(R), Pizza Hut(R), Waffle House(R) and Jack in the Box(R). The markets serving these 7 regions include 39 bakeries and 21 sales zones. The Company's 4 Diversified Products bakeries make products including hearth breads, shelf-stable bagels, croissants, breadsticks, frozen dough products and snack cakes, which are distributed to all 7 regions and nationally to food service customers. The fresh-baked goods are sold primarily on a wholesale basis through a variety of distribution systems, including approximately 3500 Company-owned direct store delivery routes, to grocers, restaurants, and institutions in areas generally within a 300 mile radius of the producing bakery. The Company operates approximately 275 retail thrift stores that sell certain returned products. U.S. Bakery Products is an industry leader in the use of information technology for category management and scan based trading. The division is also active in industry consolidation, making six acquisitions and entering into three major retailer supply agreements in the last three years. European Bakery Products - ------------------------ The Company's European Bakery Products division markets more than 240 branded products through almost 1,100 direct store delivery routes in Spain, the Canary Islands and Portugal. The European Bakery Products subsidiary, Bimbo, S.A., operates 10 bakeries in Spain and one in northern Portugal. The division is the leading producer of fresh-baked sliced bread, buns and rolls in Spain and the second largest producer of sliced bread in Portugal. European Bakery Products also produces and markets snack cakes and other sweet goods. In March 1999, the Company acquired Reposteria Martinez Group, the branded market leader in the retail sweet-good segments of cake and morning goods. Bimbo, S.A. also operates a separate store-brand bread and bun business, Pimad, S.A., a subsidiary that uses a separate manufacturing and distribution system. REFRIGERATED DOUGH PRODUCTS Overview - -------- The Company operates refrigerated dough businesses in the United States and Europe, and offers a wide variety of dough products that are convenienced packaged for in-home preparation and bake-off by the ultimate consumer. These products are sold primarily to retail grocers by both Company salespeople and food brokers, and are delivered to retailers' central warehouses. The Company also co-packs product for other branded food manufacturers. U.S. Refrigerated Dough Products - -------------------------------- The Company's U.S. Refrigerated Dough Products division is one of only two manufacturers of canned refrigerated dough in the United States. The Company is the only manufacturer of store-brand (private label) canned refrigerated dough and one of the largest store-brand toaster pastry producers in the United States. The Company's Refrigerated Dough Products include biscuits, specialty biscuits, dinner rolls, crescent rolls, cinnamon rolls, cookie dough, breadsticks, pizza crust and pie crusts. U.S. Refrigerated Dough Products markets its products nationwide under more than 100 store brands. The division also sells products under the Company's brand name, Merico, and under a licensed brand name. The products are sold in grocery retailers' refrigerated sections. European Refrigerated Dough Products - ------------------------------------ The Company's European Refrigerated Dough Products subsidiary, EuroDough, S.A.R.L., is based in France, operates 3 plants, and produces branded products under the Croustipate and HappyRoll brand names, as well as store-brand products. The Company also has a contract-packaging arrangement to manufacture products for The Pillsbury Company. The product lines include canned, rolled, block and frozen dough in France and much of western Europe. The Company is the only manufacturer of canned refrigerated dough in Europe. European Refrigerated Dough Products has recently expanded distribution of its products to Spain and Portugal. Last year's acquisition of Chevalier Servant, S.A. increased the Company's production capacity and added new production capabilities including packaged yeast-leavened pizza dough. Competition - ----------- GENERALLY The Company's ability to sell its products depends on its ability to attain store shelf space in relation to competing brands and other food products. Future growth for the Company will depend on the Company's ability to continue streamlining and reducing operating costs, maintaining effective cost control programs, improving branded product mix, taking advantage of industry consolidation opportunities, developing successful new products, maintaining effective pricing and promotion of its products, and providing superior customer service. Effective investment in capital and technology will play an important role in achieving these goals. The fresh-baked, refrigerated, and frozen dough product lines also compete with other alternative foods. BAKERY PRODUCTS The packaged bakery products business is highly competitive. There is intense price, product, and service competition with respect to all of the Company's products. Competition is based on product quality, price, brand loyalty, effective promotional activities, and the ability to identify and satisfy emerging consumer preferences. Customer service, including frequency of deliveries and maintenance of fully stocked shelves, also is an important competitive factor and is central to the competition for retail shelf space among fresh-baked goods manufacturers. Certain market areas of the fresh baked-goods business continue to exhibit lower margins due to regional differences in price levels, product mix, and input costs. The Company competes with other national and regional wholesale bakeries, large grocery chains that have vertically integrated or in- store bakeries, small retail bakeries, and many producers of alternative foods. The identities and number of competitors vary from market to market. The Company's leading competitors in the fresh-baked goods business include Interstate Bakeries Corporation, Flowers Industries Inc., Bestfoods, and Specialty Foods Corporation. The Company's leading competitor in Spain manufactures products under the brand name PANRICO, but the Company experiences competition from small regional bakeries in Spain as well. REFRIGERATED DOUGH PRODUCTS In the refrigerated dough product business in the U.S., the Company competes primarily with The Pillsbury Company, which produces branded products with which the Company's store brand products compete. In addition, the Company's other major competitors in the refrigerated and toaster pastry business include the Kellogg Company and Nabisco, Inc. In Europe, the Company is the only manufacturer of canned refrigerated dough in Europe. However, the Company competes with Nestle Inc., Danone and some small regional manufacturers of rolled, block and frozen dough products. Raw Materials - ------------- The products manufactured by both of the Company's business segments require a large volume of various agricultural products, including wheat for flours, soybean oil for shortening, and corn for high fructose corn syrup. Agricultural commodities represented 22-25% of the Company's cost of products sold for the 1999 fiscal year. The Company fulfills its commodities requirements through purchases from various sources, including futures contracts, options, contractual arrangements, and spot purchases on the open market. The commodity markets have experienced, and may continue to experience, significant price volatility. The price and supply of raw materials will be determined by, among other factors, the level of crop production, weather conditions, export demand, government regulations, and legislation affecting agriculture. The Company believes that adequate supplies of agricultural products are available at the present time, but cannot predict future availability or prices of such products and materials. Brand Names and Trademarks - -------------------------- GENERALLY The Company regards consumer recognition of and loyalty to its brand names and trademarks as being extremely important to its long-term success. The Company believes that its registered and common law trademarks are instrumental to its ability to create demand for and to market its products. There are currently no pending challenges to the use or registration of any of the Company's significant trademarks. BAKERY PRODUCTS The Company sells bakery products in the popular, premium and superpremium segments. The U.S. Bakery Products division's brand names in the popular segment for breads, buns and rolls are Colonial, Rainbo, Heiner's, Kern's, Sunbeam(R), Waldensian Heritage and Bost's. IronKids is a brand of special-recipe white bread for chidren. In the premium segment, products include premium wheat and variety breads under the Grant's Farm(R), Smith's, and Country Recipe brand names. Superpremium specialty breads, bagels and other bakery products are sold under the brand names Earth Grains, San Luis Sourdough and Cooper's Mill. Break Cake is the brand name for snack cakes and other sweet goods. The division sells products in the United States under the licensed brands Sunbeam(R), Roman Meal(R), Country Hearth(R) and Sun Maid(R). The Company owns several federally registered trademarks, including Rainbo, IronKids, and Earth Grains. In addition, pursuant to a license agreement with Anheuser Busch Companies Inc., the Company has the right to use the federally registered trademark Grant's Farm. The European Bakery Products division's popular segment products include white breads, buns and rolls under the Bimbo brand name. Silueta is the brand name for premium wheat and variety breads. Superpremium specialty breads and bagels are sold under the Semilla de Oro and Mr. Bagel brand names respectively, and snack cakes and sweet goods are manufactured and sold under brand names including Martinez, Madame Brioche and Bimbo Cao. REFRIGERATED DOUGH PRODUCTS In addition to manufacturing and selling refrigerated dough products under many different store brands, the U.S. Refrigerated Dough Products division sells its products under the Company's Merico brand name and the licensed Sun Maid(R) brand name. The European Refrigerated Dough Products division sells canned and rolled dough under various store brands as well as under the CroustiPate and HappyRoll brand names. Seasonality - ----------- The Company does experience minimal seasonal fluctuation in demand. Typically, sales of bakery products are seasonally stronger in the first and second quarters of the Company's fiscal year and sales of refrigerated dough products are seasonally stronger in the third quarter of the Company's fiscal year. Backlog - ------- The Company's relationship with its customers and its manufacturing and inventory practices do not provide for the traditional backlog associated with some manufacturing entities and no backlog data is regularly prepared or used by management. Research and Development - ------------------------ The Company actively works to develop new products and to improve existing products. The dollar amounts expended by the Company during each of the past three fiscal years on such development activities are not considered to be material relative to the Company's overall business and operations. Environmental Matters - --------------------- The operations of the Company are subject to various Federal, state, and local laws and regulations with respect to environmental matters. Additional information regarding such matters is provided in Item 3 of this report. Employees - --------- As of March 30, 1999, the Company employed approximately 19,400 persons, of which approximately 15,500 were based in the U.S. Approximately 60% of the Company's domestic employees are subject to approximately 200 union contracts. The Company believes its labor relations to be satisfactory. Business Segment and Geographic Information - ------------------------------------------- The percentage of net sales attributable to the Company's business segments for fiscal year 1999 was 84.8% for Bakery Products and 15.2% for Refrigerated Dough Products. In addition to the information provided in Items 1 and 2 in this Form 10-K, further information regarding the Company's business segments and geographic information is contained in Notes 14 and 15 on pages 37 and 38 of the Company's Annual Report to Shareholders for fiscal year 1999, and is hereby incorporated by reference. Year 2000 - --------- Information regarding the Year 2000's possible effects on the Company is hereby incorporated by reference to pages 22 and 23 of the Company's Annual Report to Shareholders for fiscal year 1999. ITEM 2. ITEM 2. PROPERTIES. Domestically, the Company operates 45 manufacturing facilities in 17 states. The Company's European subsidiaries own and operate 10 bakeries in Spain, 1 bakery in Portugal and 3 refrigerated dough manufacturing plants in France. The Company's domestic bakeries operate at approximately 80% of capacity. The Company owns all of its manufacturing facilities, except for the facility in Ft. Payne, Alabama and both manufacturing facilities in San Luis Obispo, California, which are subject to leases. The Ft. Payne facility is subject to two leases which expire in 2010 and 2016; both leases give the Company an option to purchase the property. The leases for the San Luis Obispo facilities expire in 2000 (with an option to renew the lease for 5 more years) and 2008 and both leases give the Company an option to purchase the property. The Company also operates approximately 275 retail thrift stores and maintains approximately 475 distribution centers, the majority of which are leased. In addition, the Company owns its corporate headquarters and a research and development facility in St. Louis, Missouri. The Company leases space in St. Louis, Missouri for its Financial Shared Services Center under a lease that will expire in 2004 (with an option to renew for 5 more years). The Company leases its Spanish corporate headquarters in Barcelona, Spain. The Company maintains approximately 7,000 motor vehicles used principally in the sales and distribution of its products. The Company's Worldwide Bakery Products facilities and the products produced at each are as follows: U.S. BAKERY PRODUCTS PLANTS PRODUCTS - ------ -------- Albuquerque, New Mexico Bread & Buns Atlanta, Georgia Bread & Buns Birmingham, Alabama Bread & Buns Chattanooga, Tennessee Bread & Buns Dallas, Texas Bread & Buns Denver, Colorado Bread & Buns Des Moines, Iowa Bread & Buns Dothan, Alabama Bread & Buns El Paso, Texas Bread & Buns Fresno, California Bread & Buns Grand Junction, Colorado Bread & Buns Harlingen, Texas Bread & Buns Houston, Texas Bread & Buns Huntington, West Virginia Bread & Buns Huntsville, Alabama Bread & Buns Hutchinson, Kansas Buns Johnson City, Tennessee Bread & Buns Knoxville, Tennessee Buns London, Kentucky Bread & Buns Louisville, Kentucky Bread & Buns Lubbock, Texas Bread & Buns Memphis, Tennessee Bread & Buns Meridian, Mississippi Bread & Buns Mobile, Alabama Bread & Buns Nashville, Tennessee Bread & Buns Oakland, California Bread, Buns & English Muffins Oklahoma City, Oklahoma Bread & Buns Orangeburg, South Carolina Bread & Buns Owensboro, Kentucky Bread & Buns Phoenix, Arizona Bread & Buns Sacramento, California Bread & Buns San Antonio, Texas Bread & Buns San Luis Obispo, California (2) Bread & Buns Springfield, Missouri Bread & Buns Stockton, California Bread, Buns & Sweet Goods Tucson, Arizona Bread & Buns Valdese, North Carolina Bread, Buns & Sweet Goods Wichita, Kansas Bread & Buns DIVERSIFIED PRODUCTS PLANTS PRODUCTS - ------ -------- Albuquerque, New Mexico Bagels Ft. Payne, Alabama Bread, Buns, Sweet Goods & Bagels Paris, Texas Bread, Buns, Sweet Goods & Frozen Dough Rome, Georgia Cookies EUROPEAN BAKERY PRODUCTS PLANTS PRODUCTS - ------ -------- Albergaria-a-Velha, Portugal Bread Almansa, Spain Bread & Buns Antequera, Spain Bread & Buns Azuqueca, Spain Bread Briviesca, Spain Sweet Goods Canary Islands, Spain Bread & Buns El Espinar, Spain Sweet Goods Granollers, Spain Bread, Buns & Sweet Goods Madrid (Las Mercedes), Spain Bread, Buns & Sweet Goods Palma, Spain Bread & Buns Solares, Spain Bread & Buns The Company's Worldwide Refrigerated Dough Products facilities and the products produced at each are as follows: U.S. REFRIGERATED DOUGH PRODUCTS PLANTS PRODUCTS - ------ -------- Carrollton, Texas Refrigerated Dough Forest Park, Georgia Refrigerated Dough & Toaster Pastries EUROPEAN REFRIGERATED DOUGH PRODUCTS PLANTS PRODUCTS - ------ -------- Lievin, France Refrigerated & Frozen Dough Valence, France Refrigerated Dough Vittel, France Refrigerated Dough The Company believes that its facilities are well maintained, suitable, and adequate for its immediate needs. Additional space is available if needed to accommodate expansion. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. As a manufacturer and marketer of food items, the Company's operations are subject to regulation by various government agencies, including the United States Food and Drug Administration. Under various statutes and regulations, such agencies prescribe requirements and establish standards for quality, purity, and labeling. Under the Nutrition and Labeling Act of 1990, as amended, food manufacturers are required to disclose nutritional information on their labels in a uniform manner. The finding of a failure to comply with one or more regulatory requirements can result in a variety of sanctions, including monetary fines or compulsory withdrawal of products from store shelves. The Company may also be required to comply with state and local laws regulating food handling and storage. The operations of Earthgrains, like those of similar businesses, are subject to various Federal, state, and local laws and regulations with respect to environmental matters, including air and water quality, underground fuel storage tanks, and other regulations intended to protect public health and the environment. Earthgrains has received notices from the U.S. Environmental Protection Agency that it has been identified as a potentially responsible party ("PRP") with respect to certain locations under the Comprehensive Environmental Response, Compensation and Liability Act and may be required to share in the cost of cleanup with respect to two sites. While it is difficult to quantify with certainty the financial impact of actions related to environmental matters, based on the information currently available, it is management's opinion that the ultimate liability arising from such matters, taking into account established liability accruals, should not have a material effect on Earthgrains' financial results, financial position, or cash flows from operations. The Company is involved in certain legal proceedings arising in the normal course of business. Although it is impossible to predict the outcome of any legal proceeding and the Company cannot estimate the range of the ultimate liability, if any, relating to these proceedings, the Company believes that it has meritorious defenses to the claims pending against it in such proceedings and that the outcome of such proceedings should not, individually or in the aggregate, have a material adverse effect on the results of operations or financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of the security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the 1999 fiscal year. EXECUTIVE OFFICERS OF THE REGISTRANT BARRY H. BERACHA (age 57) presently is Chief Executive Officer and Chairman of the Board of Directors of the Company, positions he has held since September 1993. From 1976 through March 1996, he was a Vice President and Group Executive of Anheuser-Busch Companies, Inc. ("AB"), and during that time served in various positions for various AB subsidiaries. In addition, he currently serves as a member of the board of directors of the Pepsi Bottling Group, a position he has held since April 1999. JOHN W. ISELIN, JR. (age 46) presently is the Company's President, Worldwide Bakery Products, a position he has held since March 1999. He served as Executive Vice President (U.S. Bakery Products) of the Company, from May 1994 through February 1999. From January 1994 through April 1994, he served as President and Chief Operating Officer of the Company's refrigerated dough operations. Mr. Iselin served as Executive Vice President and Chief Financial Officer for Eagle Snacks, Inc. (a subsidiary of AB) from January 1992 through December 1993. XAVIER ARGENTE (age 39) presently is the Company's Executive Vice President--European Bakery Operations, a position he has held since March 1999. He served as Executive Vice President (Bimbo) from December 1995 through February 1999. From June 1995 through December 1995, he was Vice General Manager of Operations. From 1990 through June 1995, he was the Commercial Director of Marketing, Sales and Distribution of Bimbo Operations. WILLIAM H. OPDYKE (age 55) presently is the Company's President, Worldwide Refrigerated Dough Products, Technology and Purchasing, a position he has held since March 1999. He served as Executive Vice President (Refrigerated Dough Products), from June 1995 through February 1999. He previously served as Executive Vice President--Operations (U.S. Bakery Products) of the Company from May 1994 to June 1995. From November 1993 until May 1994, Mr. Opdyke served as Executive Vice President--Corporate Quality for Eagle Snacks, Inc., and between November 1990 and November 1993 he was Executive Vice President--Sales and Marketing for Eagle Snacks, Inc. LARRY G. BERGNER (age 47) presently is the Vice President--Technology and Purchasing of the Company. He has held the Vice-President--Technology position since December 1995 and has held the Purchasing position since December 1997. He served as Vice President of Engineering and Management Information Systems of the Company from September 1995 until December 1995. He served as Vice President of Engineering of the Company from February 1994 until September 1995. Prior to that appointment, he served as Manager of Project Management and Construction for AB from 1984 through February 1994. TODD A. BROWN (age 51) presently is the Company's Vice President-- Operations & Administration (U.S. Refrigerated Dough Products), a position he has held since September 1995. From January 1995 through September 1995, Mr. Brown was the Company's Vice President of Quality & Technology. From April 1993 through December 1993 he was the Company's Vice President of Quality. He was Vice President of Quality of Metal Container Corporation (a subsidiary of AB). BARRY M. HORNER (age 50) presently is the Company's President, U.S. Bakery Products, a position he has held since March 1999. He served as Vice President (Bakery Operations) from June 1996 through February 1999. Mr. Horner served as Executive Vice President of Sales and Distribution of the Company's domestic baking operations from May 1994 until June 1996. From December 1993 until May 1994 he served as Executive Vice President of the Western Region (U.S. Bakery Products), and from May 1989 to December 1993 he served as Vice President and General Manager of the Company's Earth Grains (Diversified Products - U.S. Bakery Products) division. MARK H. KRIEGER (age 45) presently is the Company's Vice President and Chief Financial Officer, positions he has held since January 1994. He was Vice President of Corporate Planning from 1986 to December 1993. TIMOTHY J. MITCHELL (age 39) presently is the Company's Vice President--Sales and Customer Service (U.S. Refrigerated Dough Products), a position he has held since March 1996. From December 1994 until March 1996 he served as Regional Vice President of Eagle Snacks, Inc., a subsidiary of AB. From January 1994 until December 1994 he served as President of Screaming Eagle, Inc., a Chicago-based distributor of Eagle Snacks. He served as Director, Sales Administration of Eagle Snacks, Inc. from September 1982 until January 1994. JOSEPH M. NOELKER (age 50) presently is the Vice President, General Counsel, and Corporate Secretary of the Company, positions he has held since March 1996. Mr. Noelker served as Associate General Counsel of AB from January 1987 until March 1996. LARRY PEARSON (age 53) presently is the Company's Vice President-- Diversified Products (U.S. Bakery Products), a position he has held since July 1994. He served as Vice President--Marketing of Earthgrains Baking Companies, Inc. from 1986 until 1994. BRYAN A. TORCIVIA (age 39) presently is the Company's Vice President--Corporate Planning and Development, a position he has held since January 1994. From January 1992 to December 1993, he served as Executive Assistant to the Chief Executive Officer of the Company. Prior to that he served in the Planning and Finance Department of Metal Container Corporation (a subsidiary of AB) from 1989 to January 1992. MARTHA S. UHLHORN (age 44) presently is the Company's Vice President--Electronic Commerce and Category Management (U.S. Bakery Products), a position she has held since March 1999. She was Vice President--ECR and Sales Technology (U.S. Bakery Products) from 1999 through February 1999. Prior to that, Ms. Uhlhorn spent 16 years in the packaging industry with Metal Container Corporation and Continental Can Companies. EDWARD J. WIZEMAN (age 57) presently is the Company's Vice President--Human Resources, a position he has held since January 1994. Mr. Wizeman also served as Director of Human Resources (Operations) of AB from May 1991 to December 1993 and as Director of Human Resources of Metal Container Corporation (a subsidiary of AB) from 1986 to May 1991. OTHER SIGNIFICANT OFFICERS VIRGIL REHKEMPER (age 40) presently is Vice President and Controller of the Company, positions he has held since April 1997. Prior to that he served as Controller of the Company from April 1995 until 1997 and from 1990 to March 1995 he was Manager, Financial and Operational Audit of AB. MICHAEL SALAMONE (age 40) presently is Vice President and Treasurer of the Company, positions he has held since September 1996. From 1991 until 1993 he served as Assistant Treasurer of Pet Incorporated and as Vice President and Treasurer from 1993 until 1995. Prior to that, he held several positions in Corporate Finance at AB from 1983 until 1991. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this Item is hereby incorporated by reference to a portion of page 43 of the Company's Annual Report to Shareholders for fiscal year 1999 and page 6 of the Company's Proxy Statement for the Annual Meeting of Shareholders on July 16, 1999. The issuance of shares to non-employee directors discussed on page 6 in the Company's Proxy Statement was exempt from registration and constituted a private placement under the Securities Act of 1933. As of May 28, 1999, the Company had approximately 17,600 shareholders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is hereby incorporated by reference to page 40 of the Company's Annual Report to Shareholders for fiscal year 1999. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATIONS The information required by this Item is hereby incorporated by reference to pages 18-23 of the Company's Annual Report to Shareholders for fiscal year 1999. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is hereby incorporated by reference to pages 24-39 of the Company's Annual Report to Shareholders for fiscal year 1999. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with PricewaterhouseCoopers LLP, the Company's independent accountants, on accounting principles or practices or financial statement disclosures. The Company has not changed its independent accountants during the two most recent fiscal years, nor since the end of the most recent fiscal year. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item with respect to Directors is hereby incorporated by reference to pages 3-5 and 20 of the Company's Proxy Statement for the Annual Meeting of Shareholders on July 16, 1999. The information required by this Item with respect to Executive Officers is presented in this Form 10-K immediately following the response to Item 4. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is hereby incorporated by reference to page 5 and pages 12 through 18 of the Company's Proxy Statement for the Annual Meeting of Shareholders on July 16, 1999. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is hereby incorporated by reference to pages 2 and 7 of the Company's Proxy Statement for the Annual Meeting of Shareholders on July 16, 1999. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There are no reportable relationships or related transactions under Item 13. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT: 2. FINANCIAL STATEMENT SCHEDULES Financial Statement Schedules are omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto. 3. EXHIBITS 3.1 -- Amended and Restated Certificate of Incorporation of The Earthgrains Company (dated February 26, 1996) (incorporated by reference to Exhibit 3.1 to Form 10-K for the fiscal year ended March 25, 1997). 3.2 -- Certificate of Amendment of the Amended and Restated Certificate of Incorporation of The Earthgrains Company (filed November 17, 1998). 3.3 -- By-Laws of The Earthgrains Company (amended and restated as of February 22, 1996) (incorporated by reference to Exhibit 3.2 to Form 10-K for the fiscal year ended March 25, 1997). 4.1 -- Form of Rights Agreement dated as of February 22, 1996 between the Company and Boatmen's Trust Company, as Rights Agent (incorporated by reference to Exhibit 4.1 to Form 10-K for the fiscal year ended March 25, 1997). 10.1 -- The Earthgrains Company 1996 Stock Incentive Plan (As Amended April 11, 1996, March 21, 1997, May 30, 1997 and April 29, 1999; Restated to reflect two 2-for-1 Stock Splits on July 28, 1997and July 20, 1998). 10.2 -- The Earthgrains Company Non-Employee Directors Deferred Fee Plan effective October 6, 1998. 10.3 -- Amendment No. 1 to The Earthgrains Company Employee Stock Ownership Plan dated June 30, 1996 (amendment no. 1 also restated the Plan) (incorporated by reference to Exhibit 10.3 to Form 10-K for the fiscal year ended March 25, 1997). 10.4 -- Amendment No. 2 to The Earthgrains Company Employee Stock Ownership/401(k) Plan dated July 1, 1996 (incorporated by reference to Exhibit 10.4 to Form 10-K for the fiscal year ended March 31, 1998). 10.5 -- The Earthgrains Company Employee Stock Ownership/ 401(k) Plan Trust Agreement (Dated July 1, 1996) (incorporated by reference to Exhibit 10.4 to Form 10-K for the fiscal year ended March 25, 1997). 10.6 -- The Earthgrains Company Exceptional Performance Plan (Effective as of March 26, 1997) (incorporated by reference to Exhibit 10.5 to Form 10-K for the fiscal year ended March 25, 1997). 10.7 -- The Earthgrains Company Excess Benefit Plan (Effective October 1, 1993) (incorporated by reference to Exhibit 10.6 to Form 10 filed February 28, 1996). 10.8 -- The Earthgrains Company Supplemental Executive Retirement Plan (Effective April 1, 1996) (incorporated by reference to Exhibit 10.7 to Form 10 filed February 28, 1996). 10.9 -- The Earthgrains Company 401(k) Restoration Plan (Effective April 1, 1996) (incorporated by reference to Exhibit 10.8 to Form 10 filed February 28, 1996). 10.10 -- The Earthgrains Company Executive Deferred Compensation Plan (Effective March 27, 1996) (incorporated by reference to Exhibit 10.9 to Form 10 filed February 28, 1996). 10.11 -- License Agreement with Anheuser-Busch Companies, Inc. (incorporated by reference to Exhibit 10.1 to Form 10-Q for the period ended March 26, 1996). 10.12 -- Form of Second Amended and Restated Credit Agreement (Effective as of October 3, 1997) among the Registrant, the Bank of America National Trust and Savings Association, as Administrative Agent and Letter of Credit Issuing Lender, and the other financial institutions party thereto (incorporated by reference to Exhibit 10.12 to Form 10-K for the fiscal year ended March 31, 1998). 10.13 -- Form of First Amendment to the Second Amended and Restated Credit Agreement (dated as of February 2, 1999) among the Registrant, various financial institutions, and Bank of America National Trust and Savings Association, as Administrative Agent. 10.14 -- Employment Agreement between the Company and Barry H. Beracha (incorporated by reference to Exhibit 10.14 to Form 10-K for the fiscal year ended March 25, 1997). 10.15 -- Senior Executive Agreement between the Company and Mr. Argente (Dated October 23, 1996)(incorporated by reference to Exhibit 10.16 to Form 10-K for the fiscal year ended March 25, 1997). 13. -- Pages 17 through 41 and a portion of page 43 of the Company's Annual Report to Shareholders for fiscal year 1999, a copy of which is furnished for the information of the Commission. Portions of the Annual Report not incorporated herein by reference are not deemed "filed" with the Commission. 21. -- Subsidiaries of the Company. 23.1 -- Consent of independent accountants. 23.2 -- Consent of independent accountants. 27. -- Financial Data Schedules. [FN] _____________________ Management contract or compensatory plan or arrangement required to be filed pursuant to Item 14(a)(3) of Form 10-K. (b) REPORTS ON FORM 8-K There were no reports filed on Form 8-K during the fourth quarter of fiscal year 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE EARTHGRAINS COMPANY (Registrant) By: BARRY H. BERACHA ------------------------------------ Barry H. Beracha Chairman of the Board and Chief Executive Officer Date: June 25, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

354199_1999.txt

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ITEM 1. BUSINESS 1.1 General UniHolding Corporation ("UniHolding") is a Delaware corporation organized in 1987. UniHolding is a holding company. At May 31, 1999, pursuant to a February 25, 1999 reorganization further described below (the "Reorganization"), its principal asset is a non-controlling 38% interest in Unilabs Group Limited, a British Virgin Islands corporation ("UGL"), and itself a holding company. Prior to the Reorganization, UniHolding owned 100% of UGL. UGL is the majority shareholder of Unilabs SA, a Switzerland corporation ("ULSA"), which supplies clinical testing services in several European countries (the "Diagnostic Laboratory Division"), and, until the spin-off made in February 1998, UGL was also the sole shareholder of Global Unilabs Clinical Trials Limited, a British Virgin Islands corporation ("GUCT") supplying clinical trials testing for the pharmaceutical industry (the "Clinical Trials Division"). At May 31, 1999, UniHolding's only source of income is through its 38% ownership interest in UGL. Effective February 25, 1999, UGL reached an agreement with a major shareholder of UniHolding, Unilabs Holdings SA, a Panama corporation ("Holdings") whereby Holdings received approximately 2.3 million newly issued shares of common stock of UGL in exchange for its UniHolding shares of common stock on a one-for-one basis. At the same time, UGL reached agreements with certain other non-US shareholders whereby such shareholders also received newly issued shares of common stock of UGL in exchange for their approximate 0.4 million UniHolding shares of common stock on the same one for one basis. Accordingly, effective February 25, 1999, UGL had gained control of UniHolding. Further, during the period from February 25 to May 31, 1999, UGL reached agreements with certain other non-U.S. shareholders of UniHolding, whereby such shareholders also received newly issued shares of common stock of UGL in exchange for their approximately 0.6 million UniHolding shares of common stock also on the same one-for-one basis. In addition, also during the same period, a further aggregate of approximately 0.8 million UniHolding shares were acquired by UGL for a consideration consisting of approximately 14,000 ULSA bearer shares of common stock. As a result, as of May 31, 1999, UGL owned approximately 74% of UniHolding, while UniHolding owned approximately 38% of UGL. While it did not take any part in these transactions, the UniHolding Board of Directors acknowledged the new situation and entered into discussions with the board of UGL, with a view to primarily safeguard the interests of the remaining UniHolding shareholders. The UniHolding Board of Directors was informed by UGL that the primary purpose of the UGL Reorganization was for the non-U.S. shareholders to own their equity in UGL directly through a private corporation instead of holding shares of a publicly quoted U.S. corporation. However, as a consequence of the Reorganization, at May 31, 1999, the remaining UniHolding shareholders had suffered a dilution of their equity in UGL, and the UniHolding Board of Directors expressed their strong wish to eliminate such dilution. As a result of their discussions, the two boards came to an agreement on September 3, 1999, whereby UniHolding transferred to UGL 30,000 shares of UGL common stock, and UGL transferred to UniHolding UGL's entire shareholding of UniHolding common stock. Pursuant to this agreement, as of September 3, 1999, UGL did not own any UniHolding shares, while UniHolding owns a balance of approximately 2.0 million shares of UGL common stock, or approximately 37% of UGL's equity. The remaining UniHolding shareholders, who owned approximately 37 % of the outstanding UniHolding stock before the Reorganization, own 100% of the outstanding UniHolding stock after the Reorganization and the September 3, 1999, transaction. Accordingly, their indirect equity interest in UGL is not less than it was before the Reorganization. Until February 27, 1998, UGL had a wholly owned subsidiary, GUCT, which is the majority shareholder of TBL Holdings, Inc., a Delaware corporation ("TBLH" formerly known as UCT International, Inc.). TBLH supplies clinical testing services dedicated to the pharmaceutical industry in the United States and in Europe. GUCT was spun off to UniHolding's shareholders on February 27, 1998, while UGL had retained ownership of $20 million in non-voting, non- convertible, redeemable preferred stock of GUCT in exchange for previously existing inter-company debt, which GUCT stock was valued at $12,164 at May 31, 1998. As a result of the GUCT spin-off, UniHolding presently does not have any significant operations in the U.S. As of December 30, 1998, GUCT and UGL became parties to an agreement (the "DLJ Phoenix Agreement") with certain subsidiaries of a first-class third party investment bank, DLJ Phoenix, regarding the operating subsidiaries of TBLH. During the second half of calendar 1998, GUCT and UGL were informed that TBLH's operating subsidiaries were in need of substantial new capital to continue and satisfactorily develop their clinical trials operations, and that GUCT was unable to obtain the necessary funding. As a result of discussions held by GUCT with various potential partners throughout 1998, an agreement was reached whereby DLJ Phoenix agreed to invest $7.5 million in TBLH's subsidiaries, provided, among other conditions, that (1) DLJ Phoenix would have total management control over the business, and (2) GUCT or UGL would invest $2.5 million. As GUCT had no funds available for such a transaction, UGL agreed to fund such additional investment, essentially with a view to protect its own original investment in GUCT, in which UGL continued to own approximately $20 million of non-voting and non-convertible preferred stock, as described above. UGL and GUCT agreed that this additional financing of GUCT by UGL was structured such that GUCT owns the shares newly issued by TBLH's subsidiaries, and UGL owns additional non-voting, non-convertible, redeemable preferred stock of GUCT with a face value equal to the amount of the additional investment, $2.5 million plus $0.5 million of extra funding. The terms of the additional preferred stock include conditions that will enable UGL to share the upside potential, if any, of GUCT's investment. The DLJ Phoenix Agreement further provided that, if the operating subsidiaries met certain business targets by June 30, 1999, an additional investment of $4.5 million and $1.5 million, respectively, would be made in the second half of calendar 1999 by DLJ Phoenix and GUCT and/or UGL, respectively. On July 22, 1999, GUCT and UGL were informed that one of such business targets would not be met and that the additional investment in the form provided by the DLJ Phoenix Agreement would not be made. Instead, another form of financing was proposed and all of TBLH, GUCT and UGL declined to participate. Subsequently, GUCT and UGL were informed that DLJ Phoenix had decided not to provide additional financial support to TBLH's subsidiaries, and had decided to look for alternative solutions including a sale of operations or a liquidation. Accordingly, UGL's management has performed a careful review of the value of the GUCT preferred stock held as of May 31, 1999, considering the situation described above. As a result of such review, UGL's management has concluded that there was a permanent impairment in the value of GUCT, and that it was therefore necessary to record a $15.2 million write-down in the aggregate value of the GUCT preferred stock, now carried at a net amount of $0 in the accompanying balance sheet as of May 31, 1999. For the same reason, UGL has recorded a provision of $0.5 million as of May 31, 1999, on an account receivable from one of TBLH's subsidiaries. Since its inception in 1987, ULSA's Swiss operations have grown into the largest clinical laboratory group in Switzerland, with a network of laboratories which provide a full spectrum of clinical laboratory tests that are used in the diagnosis, monitoring and treatment of diseases and illnesses. ULSA also owns majority interests in Italian and Spanish clinical laboratory operations, as well as interests in Russian and Turkish laboratories. Until its disposition during fiscal 1998, ULSA also provided laboratory testing services in the United Kingdom through Unilabs Group (UK) Limited ("UGUK"). As part of UniHolding's plan to maximize shareholder values, UGL made an initial public offering on the Swiss Exchange of ULSA's then newly issued and existing shares, which closed on April 24, 1997. The offering comprised the issuance by ULSA to the public of a further 20% of its equity, and the sale by UGL of a portion of its holding in ULSA, thereby diluting UGL's holding in ULSA to 60% post-initial public offering. The shares of ULSA have been listed on the Swiss Exchange since April 25, 1997. As of May 31, 1999, UGL owned a controlling interest of approximately 48% in ULSA. In connection with the ULSA initial public offering, UGL has agreed to significant restrictions regarding the possible sale or listing of its investment in ULSA until April 25, 2002. On January 29, 1998, ULSA signed an agreement ("the UGUK Agreement") relating to the sale of its subsidiary UGUK to FHP Holdings Limited, a Bahamas corporation, and Focused Healthcare (Jersey) Limited, a Jersey, Channel Islands corporation ("FHL"), a group of investors led by a British businessman, Mr. Andrew Baker. Mr. Baker is the former Chairman and Chief Executive Officer of Unilab Corporation, a Delaware corporation, and currently is a Director of Medical Diagnostic Management, Inc. ("MDM"), a U.S. corporation, of which UniHolding holds redeemable preferred stock convertible into common stock under certain terms and circumstances. Such investment in MDM has been fully provided for by UniHolding. The UGUK sale consideration was agreed upon at SFr. 19.4 million (approximately $13.2 million), paid as SFr. 1.9 million (approximately $1.3 million) in cash, and SFr. 17.5 million (approximately $11.9 million) against issuance of non-voting preferred stock of FHL, redeemable within three years, carrying certain dividend and liquidation preferences. ULSA has the ability, through two non-executive directors whom it nominates on the board of FHL, to veto certain actions of FHL if such actions would have the effect of jeopardizing realization of ULSA's investment in FHL preferred stock (such as a merger, sale or liquidation). ULSA has not retained any management control over UGUK, of which Mr. Baker is Chairman and Managing Director. The transfer of the UGUK shares and other consequences of the closing of the UGUK Agreement had to be delayed until May 1998 because of unexpected difficulties in completing the necessary documentation and local filings. However, ULSA effectively transferred control of UGUK to FHL as of June 1, 1997, and therefore ceased consolidating UGUK as of that date. As of May 31, 1998, ULSA's investment in FHL preferred stock was carried at a value of $10,617, after the recording of a $1,190 write-down, reflecting ULSA's appraisal of the uncertainty as to the timing and possibility of recovery of its investment in FHL. ULSA was informed by FHL that certain discussions were taking place with a third party, with a view to merge UGUK with, or sell UGUK to, this third party. ULSA indicated that it would not veto a transaction which would enable it to recover the full amount of the FHL preferred stock currently recorded on ULSA's books, of SFr. 15.6 million (approximately $10.4 million). On October 1, 1999, ULSA closed on an agreement with FHL regarding the disposal of the non- voting, redeemable preferred shares of that company. As of that date, FHL merged its UK laboratory subsidiary into another laboratory owned by Advanced Pathology Services Ltd., England. In connection therewith, ULSA sold its FHL preferred shares against an immediate cash payment of 3.0 million pounds ($4.8 million), with the balance being essentially constituted of notes due within 4 years payable by Advanced Pathology Services. On December 21, 1999, ULSA closed on an agreement with Advanced Pathology Services Ltd., England, regarding the disposal of Unilabs International (UK) Ltd., a subsidiary engaged in the marketing of pathology services in the Middle East. The sale consideration was agreed at 0.5 million pounds ($0.9 million), in the form of a note payable on December 21, 2003. During the year ended May 31, 1998, ULSA acquired from third parties 100% of the equity of Institut Bio- Analytique Medical SA, a Geneva company, together with related companies, and Laboratoire Medical Pierre-Alain Gras SA, a Geneva company, at an aggregate cost of $25.3 million. During the year ended May 31, 1999, ULSA acquired 55% of Gespower (Belgium) SA, a Belgian corporation specializing in computer services to the health care industry at a cost of SFr. 2.6 million (approximately $1.7 million). Summarized financial information regarding each of ULSA's business segments is presented in the notes to UniHolding's consolidated financial statements included in this Annual Report on Form 10-K and is not reported herein. 1.2 The Clinical Testing Industry in Europe Clinical laboratory tests are used by both general practitioners and specialists and other health care providers to diagnose, monitor and treat illnesses, diseases and other medical conditions through the detection of substances or abnormalities in blood, urine or other body fluids and tissue samples. Clinical laboratory tests are primarily performed in hospitals, physician-owned laboratories and independent laboratories. The European clinical testing industry differs from the United States industry as it is characterized by fragmentation and substantial cultural, social, ethical and regulatory differences from country to country. Overall, the European clinical testing volume is estimated to be at least $20 billion annually. There are at least 12,000 active, independent clinical laboratory companies in Europe. ULSA presently operates its laboratory interests in Switzerland, Italy, Spain, Russia and Turkey. The Swiss market is an approximately $1.2 billion a year industry, for a population of approximately 7 million people. Currently, ULSA estimates that physician-owned laboratories represent approximately 50% of the Swiss clinical testing market, with hospitals (private and public) representing 30%, while private clinical laboratories, including ULSA and its subsidiaries, represent the remaining 20% of the market. ULSA estimates that the Italian market for clinical testing services is approximately $3.2 billion. In Italy, where physicians are prohibited from performing clinical laboratory tests, tests performed by hospitals and private laboratories represent approximately 75% and 25% of the total volume, respectively. There are presently approximately 2,000 private laboratories in Italy. The Italian health care sector is undergoing radical changes, including revisions of Social Security reimbursement practices. ULSA has entered the Italian market based on the growth potential in the market for private laboratories, and on the potential for managing public hospitals' laboratories. The clinical laboratory testing market in Spain is currently estimated at $1.6 billion and comprises approximately 1,000 private laboratories, the vast majority of which are very limited in size. Spain is experiencing rapid growth in its private health insurance market forcing price containment and consolidation in the industry. Currently, ULSA estimates that private laboratories represent approximately 25% of the Spanish clinical testing market, with hospitals (private and public) representing the remaining 75%. Due to ULSA's network of laboratories in Spain, management believes the operations are well situated to take advantage of the changing marketplace. In Russia, ULSA presently does not intend to pursue opportunities that may be offered by the general market. It presently caters only to a niche market comprising a particular segment of patients who can afford to pay for services that they would not receive in laboratories of public hospitals. There presently is no reliable data available as to the size of such market segment. In Turkey, the market comprises a large number of private laboratories, the majority of which focus on a limited range of routine analysis. The private sector is expanding rapidly and investment in this sector is strongly supported by the government. There are a number of initiatives to improve the general quality of testing which will lead to concentrations in the sector. In ULSA's view, the European clinical testing services market will continue to grow based on a number of factors. These include (i) rising health care expenditures resulting from an aging population, rising standards of living and the availability of both new and improved treatments for diseases and other medical conditions, (ii) increasing emphasis placed by health care providers on preventive care and the early detection of diseases, (iii) increasing occupational testing by insurance companies and large public and private employers, (iv) increasing testing for substance abuse, sexually transmitted diseases and AIDS, (v) increasing numbers and types of clinical tests resulting from an expanding base of scientific, technical and medical knowledge and (vi) expanding development of highly automated laboratory testing equipment, leading to increasing laboratory operating efficiencies. 1.3 Current Operations UniHolding presently does not have any operations other than its non-controlling holding in UGL. Prior to completing the spin-off of the Clinical Trials Division of UGL on February 27, 1998, UGL had two business segments: its core clinical laboratory business (the Diagnostic Laboratory Division), and the clinical trials testing business (the Clinical Trials Division). However, as discussed elsewhere, UniHolding spun off the Clinical Trials Division to the UniHolding's shareholders as of February 27, 1998. As European clinical laboratories are perceived as proximity services, a successful service requires personal interaction and on-site facilities capable of quality testing. However, these laboratories need to be supervised, networked and centrally supported to fulfill their role and survive economically in the changing marketplace. On a local level, laboratory operations must be appropriately located in the cities near hospitals, patients and physicians. Whereas, on a national level, the operations must be complemented with access to specialized entities which can produce high-level resources, whether human, scientific or technical to enhance the service and productivity of each of the operations. ULSA operates in Switzerland, Italy, Spain, Russia and Turkey, within a competitive environment. ULSA believes it is the largest independent clinical laboratory group in Switzerland and plans to capitalize on its experience, knowledge, and solid growth to maintain its market leadership. ULSA's laboratory operations offer a wide range of tests and deliver quality services typically within 24 hours through the use of highly advanced testing equipment, thorough procedures and its advanced proprietary data processing systems. ULSA centralizes the development and maintenance of such data processing systems and the scientific control and monitoring in each country to enhance its overall services and profitability. ULSA also allows each laboratory to have a local commercial autonomy, while in the aggregate the laboratories are supervised, coordinated and centrally supported in order to provide for greater administrative and management efficiencies. ULSA expects to further develop its market leadership and achieve further growth in the private health care sector through volume increases, market share gain and improvement in its test mix, while also continuing to optimize its operations to achieve maximum efficiencies. Increasing pressure for cost containment and improved quality of health care are leading to consolidation in the highly fragmented European markets where clinical testing is performed by private laboratories. Similar pressures are leading health care providers in both the public and private sector to contract with private laboratories in order to achieve lower costs, greater efficiency and better quality care. ULSA's size, economies of scale and experience in acquiring and integrating new operations furnishes it with a clear competitive advantage. ULSA believes that its experience in operating a network of laboratories of varying sizes in diverse geographic regions, its automated testing equipment and its sophisticated data processing (relating to both medical tests and financial data) and communication systems make it a credible partner for large-scale health care providers. ULSA is already leading the industry in this growth area, having signed several contracts with large public and private hospitals to manage and operate the hospitals' laboratory and provide other necessary clinical testing through its own laboratories. During fiscal 1998, ULSA began operating an agreement with a group of hospitals of the Zurich area where it created a central laboratory and emergency laboratories. ULSA intends to pursue other such contracts with large health care providers in various countries. The Italian and Spanish markets offer similar opportunities for growth due to changes in governmental policies and funding which will be monitored and pursued to increase the customer bases in those countries if such opportunities meet ULSA's criteria. In a rapidly evolving industry that is subject to concentration, technological innovation and political changes, ULSA believes it is uniquely positioned to take advantage of the opportunities for expansion and acquisitions that are being created in the European clinical laboratory industry. Services Through its network of laboratories, ULSA offers a comprehensive range of clinical tests to its clients, performing routine tests (tests which its laboratories perform every day, irrespective of the discipline or complexity of the test), as well as non-routine and specialized tests, for physicians, hospitals, clinics, other health care providers and employers. The laboratories make extensive use of automated testing equipment and data processing systems. Examples of the broad range of clinical tests offered include (i) the testing of blood, urine and other body fluids for the presence or absence of a specific disease or medical condition; (ii) the cultivation, identification and treatment of bacterial diseases in connection with the testing for general infections and tropical parasites; (iii) the detection of viral diseases through the study of the effects of viral infections on blood serum (including the testing for hepatitis, many sexually transmitted and tropical diseases, AIDS and German measles); (iv) pathological testing to detect abnormalities that are associated with disease in the composition, form or structure of tissue; and (v) the examination of cells (e.g., PAP smear) under a microscope to detect abnormalities in composition, form or structure which are associated with disease. In addition to testing for diseases, routine tests are often performed in connection with the preparation of patient profiles that include basic chemical and hematological screening information, such as sugar, urea, cholesterol, blood count and coagulation levels. Examples of esoteric tests include tests for antibodies, vitamins and metals, among other substances. Most of ULSA's laboratories process specimens on a continuous flow basis, which means that specimens arrive from clients or from collection stations throughout the day and are processed as soon as possible, most within 24 hours. All test results are scanned by computer to identify results that are not within the standard ranges. Any such results are verified by a second testing. Final test results are further reviewed by a physician, to check for abnormalities. If, at any time in the course of the testing process, an imminently life-threatening result is found, the referring physician is contacted immediately. Results are delivered securely by mail or courier service or by telefax, telephone or electronic transmission as instructed by the client. ULSA also offers specialized testing in histopathology and cytology in certain dedicated laboratories. Clients, Sales, Marketing and Client Service ULSA's sales strategy is tailored to the requirements of the various cultural preferences of its clients and patients and the local markets in which it operates. Each of the laboratories generally operates under its own name with its own local reference. ULSA was careful not to disturb the valuable existing commercial structures upon acquiring each laboratory. It respects the cultural diversity and aims to improve and enhance the image of the existing business rather than promote a group or network concept. The Swiss laboratories direct their marketing efforts to physicians, hospital laboratories and hospital administrators. No advertising may be made directly to patients. Their clients are primarily physicians, who, in fiscal years 1997, 1998 and 1999, accounted for more than 90% of its consolidated net revenues and the remaining portion of revenues were derived from hospitals, clinics, referrals from other laboratories and other clients. No single client represents more than 2% of ULSA's revenues. ULSA's Swiss laboratories primarily provide services to clients whose patients are covered by the private health insurance sector. The Italian laboratories primarily serve those medical doctors consulting in the Turin region, as well as providing occupational medical testing to large industrial companies. No advertising may be made directly to patients. The laboratories have earned a first class reputation in the Turin area and cater primarily to those patients who can afford the quality services offered by a private diagnosis center and by a private laboratory as the patients know that, in most cases, they will receive limited reimbursement or no reimbursement from their insurance. This private market is estimated to represent a maximum of only 25% of the total market presently. ULSA's Spanish subsidiary, United Laboratories Espana SA ("ULSP"), caters primarily to privately insured patients, capitalizing on the strong growth experienced in recent years by the private mutual health insurance sector, especially in the more developed urban areas such as Madrid and Barcelona. ULSP is approved by all the major health insurers in Spain, which have become its major clients. In addition, ULSP provides services to fully private patients and to hospitals and clinics, where in certain cases ULSP manages the on-site emergency laboratory. ULSP further undertakes certain clinical trials for pharmaceutical firms and occupational health testing for employee health check- up programs. No advertising may be made directly to patients; however, being on the approved list of health insurers is a strong marketing point for patients as this ensures that laboratory costs will be reimbursed. ULSA's joint venture operation in Moscow, Unimed laboratories, caters primarily to private clients. Currently, its clients are diplomats and their families, representatives of foreign firms in Moscow as well as Russian private citizens. Many patients are covered by private or State insurance companies. Currently, a majority of Unimed's clients are being treated in Medincenter's polyclinic, UGL's joint venture partner in Moscow and all tests ordered by Medincenter's clinicians are solely to be performed by Unimed laboratories. The marketing is oriented towards expanding the client base to embassies and companies, as well as other private and public medical providers in Moscow. In Turkey, ULSA provides a high quality service to private patients, some of them being covered by private insurance companies. The marketing is aimed at capturing a larger market share among young, well-educated doctors in Istanbul. Until December 1999, as described above, ULSA also provided test referral services to overseas clients, primarily in the Middle East and Ireland, to mostly public or private hospitals. In December 1999, such referral business was sold to Advanced Pathology Services Limited. Government and Industry Regulation The Swiss clinical testing industry is currently subject to limited government regulation. In Switzerland, prices are regulated by the Office Federal des Assurances Sociales ("OFAS"), which publishes detailed maximum price lists for all types of clinical testing that are applicable to private laboratories and on which such laboratories base their billing. As a result of price reductions imposed by OFAS since 1994, including the latest one, whereby effective October 1, 1997, OFAS decided to further reduce by 10% the prices of the 50 most frequent tests, ULSA's laboratories have experienced an overall average price reduction of less than 5% per year in fiscal 1997, 1998 and 1999, which, owing to ULSA's clientele mix, compares favorably with the loss in revenue experienced by other Swiss private laboratories. Physician-owned laboratories, which represent approximately 50% of the Swiss clinical testing market, are permitted to invoice customers at prices based on cantonal guidelines, which now typically approximate 20% to 30% higher than the published OFAS prices. While such cantonal prices have not been affected by the OFAS price change, discussions are currently being held in a number of cantons between Medical Associations, health authorities and health care insurance federations to adjust cantonal price lists to the OFAS price list, although the timing of such adjustments, if any, are uncertain. In addition, the current OFAS price list requires all clinical testing laboratories to participate satisfactorily in specified quality control programs. Laboratories which fail to maintain adequate quality standards are subject to a 25% price reduction. In Switzerland, new clinical testing laboratories must be inspected to receive certification to perform testing. In addition, new laboratories must be authorized by the government of the canton in which the laboratory is located. Swiss regulations also require that all laboratory supervisors be Swiss citizens. Yet, there are currently no ongoing verification or inspection processes. In addition, Switzerland regulates the disposal of radioactive waste and has adopted a law with respect to infectious waste disposal. ULSA believes its procedures are sufficient to protect its employees and to comply with Swiss law. ULSA's management does not believe these regulations will have a material effect on its ability to operate its business. However, ULSA cannot predict the potential effect of any future regulations that may be imposed on its operations. In Italy, where physicians are prohibited from performing clinical laboratory tests, tests performed by hospitals and private laboratories represent approximately 75% and 25% of the total volume, respectively. Expected changes in laboratory regulations will likely allow private laboratories to cover a greater geographical area, since, for example, restrictions on the transportation of blood are being abolished. Both trends are expected to lead to a needed consolidation among Italy's almost 2,000 private laboratories. While the reforms have been long-awaited and necessary because of the growing inability of the public sector to serve patients in an acceptable manner at acceptable costs, the timing of these reforms has been delayed by political instability through the recent years. However, it now appears that the reform is beginning to take place, albeit slowly. The reforms should also increase the potential for private companies to manage laboratories of public hospitals, a segment ULSA will be interested and well positioned to develop. In Spain, like Italy, physicians are prohibited from performing clinical laboratory tests so tests are performed by hospitals and private laboratories. The Spanish health care sector is also undergoing fundamental changes, such as the rapid growth of private health insurers and the need to revise the Social Security system. Pricing in the private laboratory sector is set freely by laboratories, except for private insurers, which issue their own price lists. In addition to exerting downwards pressure or containment on test prices, private insurers have raised quality requirements in order to reduce the number of approved laboratories capable of providing reliable testing. As a result, the private sector is undergoing a growing consolidation. In addition to price and quality, the ability to offer a national service through a network of laboratories is an important competitive advantage of ULSA's subsidiaries. In Russia, a laboratory has to be registered and licensed with the relevant authorities. Special approvals are required for specific types of activities or tests. There is no current pricing restriction that would affect ULSA's joint venture. In Turkey, there is a requirement for the laboratory to employ a qualified laboratory scientist with an appropriate diploma. There is also a minimum price list for clinical tests and medical services. The price list is issued and revised twice a year by the Medical Chamber of Turkey. Competition The Swiss clinical testing industry is highly fragmented, with approximately 150 independent private laboratories. Competition is based primarily on the accuracy, reliability and timeliness of results, variety and quality of service, and price. ULSA currently competes effectively in all of its markets, although certain of its local competitors are larger in particular localities and may be willing to devote greater resources in such localities. ULSA is the largest provider of clinical testing services in all of Switzerland. ULSA believes its size, economies of scale and experience in acquiring and integrating new operations give it competitive advantages in the marketplace. ULSA believes its Italian and Spanish laboratories are the leading private laboratories in their operating regions. It is estimated that the Italian laboratories compete with approximately 10 local laboratories, while the Spanish laboratories compete with approximately 50 local competitors in each city of operations. In Russia, there is little competition for ULSA's joint venture at present. Several private medical clinics have their own laboratory but with a limited range of tests to offer. There are several scientific institutes performing specialized clinical tests in Moscow but usually they are difficult to access and with a slow response time. In Turkey, there are several hundreds of small laboratories performing a limited range of routine tests and only few providing a range of assays comparable to what ULSA can offer. The public sector is generally poorly regarded in terms of quality and speed. Quality Assurance ULSA considers the accuracy and reliability of its testing services to be of paramount importance. ULSA has established its own comprehensive and rigorous quality control program. This program includes control testing, regular review of test data by laboratory technicians and medical personnel and repetitive testing for abnormal results. Each laboratory is supervised by a medical director, who is a physician and who is assisted in most cases by a technical director and other qualified medical professionals. A primary role of laboratory professionals is to ensure the accuracy of test results. Each laboratory is equipped with sophisticated testing equipment, which is routinely checked in accordance with a regular maintenance program. In 1995, ULSA applied to the Swiss Federal Accreditation Service for accreditation of all its Swiss laboratories under the European Standard EN 45001 ("General criteria for the operation of testing laboratories"). Accreditation is awarded based on an external audit of the laboratory's ability to provide testing services of a high quality, certifying the laboratory's competence and its compliance with international standards and good laboratory practices. The process comprises two stages: first, laboratories assess themselves against the EN 45001 standards, indicating compliance with or exemption from such standards; and second, an on-site assessment is conducted by the accrediting body to verify the laboratory's claims. Once accredited, laboratories are subject to periodic re-inspection. The accreditation process is progressing according to schedule, and several ULSA laboratories have now received their accreditation, a process which continued in calendar years 1999 and 2000. As part of its quality plan, ULSA also participates in industry proficiency testing programs as required by the new OFAS regulations. Such programs generally require ULSA's laboratories to perform tests, the results of which are already known, enabling verification of the accuracy of ULSA's test procedures. These programs are conducted by groups such as the Swiss Center for Clinical Testing Quality Control or the German Clinical Chemistry Association and other industry organizations. To date, ULSA has met all the requirements for accuracy in all such programs in which it has participated. The Italian and Spanish laboratories adhere to the same strict quality control procedures as instituted throughout the laboratory group. Regular quality control tests are performed under the supervision of the scientific directors. Accreditation is awarded by local authorities based on an external audit of each laboratory's ability to provide testing services of a high quality certifying the laboratory's competence and its compliance with international standards and good laboratory practices. These standards cover a set of defined conditions used throughout laboratories and covering all aspects of an investigation, including specimen collection and reporting. In Russia, quality assurance under foreign management is of importance to all patients. For this reason, it is an essential component of ULSA's joint venture strategy to emphasize quality assurance and to seek international accreditation as soon as practicable. In Turkey, there are some efforts to promote quality assurance, which effort is driven in particular by private medical insurance companies. Information technology services and Year 2000 remediation ULSA considers it critical to use state-of-the-art information systems to process its laboratory tests and related results. All ULSA's laboratories use computer software packages specifically tailored to the needs of their local market, which are comprehensive laboratory information and management software, generally running on IBM AS/400 or UNIX-based computers. Such systems handle all stages of a clinical sample laboratory processing : - Operational Planning and Monitoring : generating bar-coded labels and work schedules; supporting bi- directional connections to laboratory instrumentation; providing process monitoring, interactive entry, automated controls and computer-assisted test validation through on-screen consultation and reports. - Data Retrieval and Reporting : downloading test requests and retrieving test results, on-line. - Test Prescription : transmission of test prescription to the reference laboratory, avoiding duplication of specimen collection and test data entry between laboratories - Request Validation and Control. - Transmission of Results : routing and dispatching, videotext access, secure electronic fax service and downloading to the prescriber's computer or hospital ward stations. - Administrative Management : handling test and result archiving, inventory management and operational statistics. - Marketing : enabling easy client monitoring and provides such marketing tools as mail merging and videotext services. - Financial Control : invoicing, debtors accounting and receivables collection management. ULSA believes that the efficient and secure handling of information by a clinical laboratory is a critical factor in providing proper client service and in achieving success over the competition. Therefore, ULSA places a high degree of priority on the appropriate evolution of its management information systems, and is investing considerable amounts of money each year in this area. ULSA is currently contemplating engaging into the regular sale of its computerized systems to third parties. Most of ULSA's laboratories were faced with "Year 2000" remediation issues. Many computer programs were written with a two digit date field and if these programs were not made Year 2000 compliant, they would have been unable to correctly process date information on or after the Year 2000. While these issues impacted all of ULSA's data processing systems to some extent, they were most significant in connection with patient-related computer programs. Moreover, remediation efforts go beyond ULSA's internal computer systems and required coordination with clients, suppliers and other third parties to assure that their systems and related interfaces were compliant. Given the different computer systems operated by ULSA's business units, the type and extent of the Year 2000 issues and the cost of remediation varied significantly among ULSA's laboratories. Failure to achieve timely remediation of computer systems that process client information and transactions, and of all other systems with embedded technologies that are critical to ULSA's operations, would have had a material adverse effect on ULSA's business, operations and financial results. In response to the Year 2000 concerns, ULSA created a Year 2000 Task Force to coordinate and monitor the laboratories' progress in their Year 2000 remediation efforts. The Task Force reports directly to ULSA's executive management, provides regular progress reports to executive management, and regularly meets with executive management to discuss its reports. ULSA's initial plans called for all critical systems to be renovated and compliance testing underway by the end of calendar 1998. As of November 15, 1999, ULSA estimated that approximately 95 to 98% of its critical systems had been renovated and compliance testing underway, and that the balance would be renovated by December 1, 1999. As ULSA uses many computerized laboratory machinery manufactured, provided and maintained by third-party vendors, it requested each of those vendors to provide ULSA with appropriate certification that the machinery was Year 2000 compliant. Such certification has now been received. Acceptance testing was finalized with time frames differing by laboratory unit. Completion of any third party interface testing was dependent upon those third parties completing their own internal remediation. ULSA could have been adversely affected to the extent third parties with which it interfaces did not properly address their Year 2000 issues. As of the date hereof, UniHolding has not been made aware of any Year 2000 compliance related problems impacting ULSA, subsequent to the commencement of operations in calendar 2000. In fiscal 1998, ULSA spent approximately $0.5 million on its Year 2000 remediation efforts. ULSA anticipated expenditures for Year 2000 remediation efforts and testing in the range of approximately $0.6 million to $1.0 million in fiscal 1999, out of which approximately $0.6 million were spent in the nine months ended February 28, 1999, and $0.2 million in the 3 months ended May 31, 1999. Further, ULSA anticipates expenditures for Year 2000 remediation efforts and testing of approximately $0.2 million in fiscal 2000. Approximately $0.5 million were spent for computer equipment that was not compliant and had to be replaced, and substantially all of the balance of expenditures made are related to internal payroll and external consultants. All Year 2000 expenditures of ULSA are expensed as incurred. As of the date hereof, UniHolding has not received from ULSA any information that would substantially modify UniHolding's assessment of the costs associated with Year 2000 compliance. Employees As of May 31, 1999, ULSA employed approximately 770 people, as computed on a full-time equivalent basis. ULSA has never experienced any work stoppages, slow-downs, or other material labor problems and believes its relations with its employees are satisfactory. Seasonality ULSA, like most clinical laboratory companies, is affected by certain seasonal trends. Testing volumes tend to be lower during the holiday seasons, which vary throughout the year according to the cultural and regional influences. Therefore, ULSA's, UGL's and therefore UniHolding's results for a particular quarter may not be indicative of results in future quarters. ITEM 2. ITEM 2. PROPERTIES UniHolding and UGL do not own or rent any property. ULSA owns or leases property as described below. All of ULSA's laboratory facilities have been improved and adapted for the sole purpose of providing clinical testing services. Accordingly, the facilities are suitable and adequate and utilized solely for such services. Following are the descriptions of each regional facility. Switzerland ULSA leases laboratory space and other service sites and facilities at various locations at market rates. ULSA's executive management is located in Geneva, Switzerland. Its principal laboratories are located in Geneva (30,000 square feet), Bern (7,500 square feet), Zurich (5,000 square feet) and St. Gallen (27,500 square feet), and regional or specialized laboratories are located in Baden, Bern, Lausanne, Neuchatel, and Montreux. ULSA believes that such laboratory spaces, service sites and facilities are fully suitable and adequate for its business. The leases expire at various dates through May 31, 2001. Upon expiration of any lease, ULSA could find alternative space at competitive market rates and relocate its operations. Italy Italian operations occupy two floors of a building located in the heart of Turin. The total surface area is 6,500 square feet, out of which 5,000 square feet are owned, and 1,500 square feet are leased under a long-term lease. ULSA believes that such laboratory space and facilities are fully suitable and adequate for its business. Spain ULSP's executive management is located in Madrid, Spain. ULSP leases laboratory space and other service sites and facilities at various locations at market rates. Its principal laboratories are located in Madrid (10,000 square feet) and Barcelona, while regional laboratories are located in Valencia and Murcia. ULSP believes that such laboratory spaces, service sites and facilities are fully suitable and adequate for its business. Upon expiration of any lease, ULSP could find alternative space at competitive market rates and relocate its operations. Russia In Moscow, ULSA's joint venture is located on the 3rd floor of the Medincenter building. Unimed leases a surface area of approximately 6,500 square feet from Medincenter. Turkey In Istanbul, the laboratory leases a surface area of 2,500 square feet on the second floor of a modern office building. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the normal course of business, ULSA, UGL and UniHolding may be a party to various litigation. As of May 31, 1999, none of them was a party to any litigation which management believes may have a material impact on its financial position and results of operations. Because of circumstances related to UniHolding's previous involvement in the apparel industry, prior to 1994, UniHolding may benefit from the outcome of certain pending litigation where it is not a defendant, as described below. Such legal proceedings have been ongoing for several years and UniHolding is presently unable to determine the likely amount of any future award in UniHolding's favor. Given the uncertainty of the outcome and the high costs of continuing such litigation, UniHolding and UGL have agreed subsequent to May 31, 1999, that any proceeds deriving from such litigation will be for UGL's benefit, provided that UGL undertakes to pay the relevant legal costs. In 1990 and 1991, UniHolding was the majority shareholder of Americanino Capital Corporation, a Delaware corporation ("ACC") which held interests in the Italian apparel goods industry. In 1993, UniHolding divested itself of such interest as the business did not meet UniHolding's expectations. It therefore concluded an Asset Purchase Agreement and a Sharing Agreement (the "ACC Sale Agreement") with Linford Enterprises Inc., a British Virgin Islands corporation ("Linford") for an aggregate consideration consisting, among other things, of $50,000 in cash and approximately 80% of the value of the net appreciation of the shares of ACC arising from any subsequent sale by Linford of all or a portion of such shares of ACC. In addition, the ACC Sale Agreement provided that ACC would use its best efforts to pursue legal action against certain parties involved in the purchase by ACC of the various Italian apparel businesses, based on certain management actions and misrepresentations made to ACC and others at the time of such purchase. UGL is thus entitled to 80% of the net recovery (less legal fees and costs), limited to the amount of approximately $15 million, of any settlement or successful resolution of the arbitration (now dismissed) and the litigation (still pending) instituted by ACC and described below. In February 1993, ACC instituted arbitration proceedings before an Arbitral Tribunal of three qualified arbitrators (the "Arbitral Tribunal"), under the auspices of the International Court of Arbitration, against Mr. Eugenio Schiena, Mr. Raffaele Palma, Mr. Tonino Manzali, FIBRA S.p.A., GEFAPI S.r.l., "S.G.F." SOCIETE GENERALE COMMERCIALE ET FINANCIERE S.A., PARIBAS FINANZIARIA S.p.A., BANQUE PARIBAS (Milan, Italy), and BANQUE PARIBAS (Paris, France) (hereinafter collectively referred to as the "Defendants") for misrepresentations and fraudulent conduct in the negotiation, consummation and performance under an agreement by and between the above mentioned parties. From 1994 through 1996, nothing of substance was debated on the merits, as certain Defendants contested the competence of the Arbitral Tribunal. In 1996, ACC agreed to withdraw its claim against BANQUE PARIBAS (Italy), and BANQUE PARIBAS (France). PARIBAS FINANZIARIA continued to contest the competence of the Arbitral Tribunal over itself. A decision on jurisdiction was rendered by the Arbitral Tribunal on September 10, 1997, primarily stating that FIBRA and PARIBAS FINANZIARIA were not subject to the Arbitral Tribunal's jurisdiction. As a result of such decision, the parties subject to the Arbitral Tribunal's jurisdiction then remained : Mr. Eugenio Schiena, Mr. Raffaele Palma, Mr. Tonino Manzali, GEFAPI S.r.l., and "S.G.F." SOCIETE GENERALE COMMERCIALE ET FINANCIERE S.A. (a holding company member of the PARIBAS group of companies). Hearings of the parties and of witnesses presented by ACC were held in December 1997 and February 1998. A final brief on the merits was filed by ACC on June 30, 1998. The Defendants filed their final briefs on September 30, 1998. Oral pleadings took place on December 3, 1998. The award on the merits was rendered on October 18, 1999, and the sentence dismissed all of ACC's claims. ACC advised UniHolding of the Arbitral Award in December 1999 and a copy of the Award was furnished at the end of January 2000. ACC had previously informed UniHolding that, independently from the arbitration, it filed suit against BANQUE PARIBAS (France), BANQUE PARIBAS (Suisse) and BANQUE PARIBAS (Milan) before the Commercial Court of Paris (France), which suit is currently in its initial phase of depositing evidence. The Arbitral Tribunal expressly observed that its decision does not address, or affect, the claims now pending against the Banque Paribas units for breaches of their obligations to their client, ACC. Any possible proceeds from this suit would flow to UGL following the same formula and limitations as described above in regard to the arbitration. While, to the best of UniHolding's knowledge, the Claimant appears to have a legitimate claim, there can be no assurance that any award will be rendered in ACC's favor and thus benefit UGL. Any estimate of recovery is still subject to many factors beyond UGL's control. Realization of any amount is entirely dependent upon a favorable award and the collection thereof, if any, from the Defendants. UGL's management will continuously monitor the progress of the Paris suit and related proceedings. In connection with its prior involvement in the Italian apparel goods industry, UniHolding had guaranteed certain bank loans, and had, as security, received from third parties notes totaling Lit. 7.6 billion in favor of UniHolding, secured by mortgages on buildings owned by an Italian corporation (the "CORA Buildings"). Such receivable had a carrying value of $0.8 million as of May 31, 1999. Because the principals who had underwritten the notes have defaulted on their commitment to compensate UniHolding for the execution of the guarantees, UniHolding has instituted legal proceedings in Italy to foreclose upon the CORA Buildings. UniHolding has begun selling the CORA Buildings as market conditions permit; however, UniHolding cannot determine when such proceedings will be completed, nor when any final sale will take place. The management of UniHolding believes the proceeds from the sale of the CORA Buildings will be sufficient to cover the present carrying value of the notes receivable. Also in relation to the same facts and circumstances, on April 6, 1995, UniHolding presented a Complaint, a Memorandum of Law in Support of a Motion for a Writ or Order of Attachment and an Affidavit in Support of Motion for Attachment with an Order to Show Cause to the United States District Court in Newark, New Jersey against Tonino Manzali, Alessandra Sichirollo, Claudio Barozzi, Frederica Sichirollo, Marco Martinolli, Giuseppe Mortellaro, Giampaolo Pattarello, Giorgio Pezzolato, Brigida Russo and Anna Zinetti (known as the "Manzali Group"), who are all shareholders of record of UniHolding, and were directly or indirectly Defendants in the aforementioned arbitration proceedings. UniHolding presented therewith the Motion for Attachment against two of the above shareholders, Tonino Manzali and Alessandra Sichirollo, who have taken the necessary steps to dissipate some of their assets (their UniHolding shares) during the pendency of the arbitration proceeding. On April 17, 1995, the Court awarded and ordered the Attachment against Defendants Manzali and Sichirollo. On February 13, 1996, the Court placed the attachment proceeding on its suspense docket until such time as the parties re-open the proceedings for good cause shown for the entry of any stipulation or order, or for any other purpose required to obtain a final determination of the litigation. In view of the dismissal of all claims in the ACC arbitration, and in view of other claims and potential claims against the Defendants, counsel for UniHolding is now evaluating the appropriate procedure in this case. On March 22, 1996, upon notice of a request for transfer of additional shares of the Manzali Group held in the name of Antonio Sichirollo, UniHolding filed an adverse claim with its transfer agent estopping the further transfer of such shares. Since such time, UniHolding has proceeded with an attachment claim in the State of Colorado based on the same facts and circumstances as the attachment claim made in the United States District Court of New Jersey. On July 26, 1996, the Colorado Court placed the proceeding on its suspense docket until such time as the parties re-open the proceedings for good cause shown or entry of any order or for any other purpose required to obtain final determination of the litigation. As in the New Jersey case, UniHolding counsel is now evaluating the appropriate procedure in the Colorado case. In April 1999, two shareholders with significant holdings filed a Complaint in the Delaware Court of Chancery seeking a court order to direct UniHolding to permit the plaintiffs to inspect UniHolding's books and records. The plaintiffs alleged that the purpose in seeking to inspect UniHolding's books and records was to communicate with other stockholders and to investigate alleged corporate mismanagement and waste. UniHolding's Answer and Defenses to the Complaint, filed on June 3, 1999, asserted as Affirmative Defenses that the plaintiffs have demanded inspection of materials beyond the scope of the inspection permitted under the applicable Delaware law and that certain of such materials are not in UniHolding's possession or control and/or already in plaintiffs' possession and control. As additional Affirmative Defenses UniHolding asserted that the plaintiffs have not been damaged by any of UniHolding's actions, that UniHolding has sought shareholder approval for all corporate actions when such approval was required and that UniHolding was not engaged in any corporate waste or mismanagement. The Complaint was amended on July 19, 1999 as a result of the withdrawal of one of the plaintiffs from the action. On January 12, 2000, the Complaint was further amended to add another plaintiff and to state claims of breaches of fiduciary duties by directors and further asserting corporate waste and mismanagement. UniHolding intends to vigorously contest all substantive allegations contained in the Complaint as amended. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were presented to the shareholders for a vote in the quarter ended May 31, 1999. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS Until September 17, 1999, the UniHolding Common Stock was traded on the National Association of Securities Dealers Automated Quotation System Small Cap Market ("NASDAQ/Small Cap") under the symbol UHLD. As of that date, NASDAQ delisted the UniHolding Common Stock because UniHolding had failed to file its annual report on Form 10- K within the prescribed deadline. UniHolding intends to look for a listing on the OTC Bulletin Board as soon as it becomes current in its public filings. The following table sets forth the high and low ask and bid prices for UniHolding's common stock by fiscal quarters, as reported by NASDAQ for the preceding two years through May 1999. The prices represent prices between dealers, without retail mark-up, mark-down or commission and may not reflect actual transactions. Year ended May 31, 1999 Quarter Ended High Low August 31, 1998 $6.75 $3.50 November 30, 1998 $6.00 $3.125 February 28, 1999 $4.75 $3.00 May 31, 1999 $4.75 $1.00 Year ended May 31, 1998 Quarter Ended High Low August 31, 1997 $9.50 $3.50 November 30, 1997 $10.00 $4.50 February 28, 1998 $8.50 $5.50 May 31, 1998 $7.50 $4.50 The last closing sale price on September 13, 1999 (the last day of an actual trade before the date of the Company's delisting from Nasdaq Small Cap) was $3.675. As of November 15, 1999, the number of holders of record of the UniHolding Common Stock was approximately 400. Other than in connection with the spin-off of the GUCT shares as of February 27, 1998, UniHolding has not paid, and does not for the foreseeable future expect to pay, dividends with respect to the UniHolding Common Stock. Recent Sales of Unregistered Securities None ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Historical Selected Financial Information The following table presents selected historical consolidated financial data of UniHolding for each of the three years in the period ended May 31, 1999, which have been derived from financial statements appearing elsewhere herein that have been audited by independent auditors, and from the financial statements of UniHolding for the years ended May 31, 1995 and 1996 (not appearing herein). The data has been retroactively adjusted to reflect the spin-off of UGL's former Clinical Trials Division as of February 28, 1998. The data should be read in conjunction with consolidated financial statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations", which are included elsewhere herein (in thousands, except per share data): 1. Restated to reflect the results of operations and net assets of the Clinical Trials Division as a discontinued operation. On February 27, 1998, UniHolding completed the spin-off of the Clinical Trials Division. See Note 1 of Notes to Financial Statements. 2. For the year ended May 31, 1999, represents the consolidated results of operations for the nine months period ended February 28, 1999 of UniHolding, including its then wholly owned subsidiary UGL, and UniHolding's share of UGL's net income for the period February 25, 1999 to May 31, 1999. 3. Includes UniHolding's share of UGL's $15,710 impairment write-down of UGL's investment in GUCT redeemable preferred stock recorded in the fourth quarter of fiscal 1999. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations for the Three Years Ended May 31, 1999 Twelve months ended May 31, 1999 compared with the twelve months ended May 31, Pursuant to the reorganization of ownership (the "Reorganization") that occurred effective February 25, 1999, whereby UniHolding ceased to have management control over UGL, UniHolding stopped consolidating the results of UGL and ULSA on a full consolidation basis, and started consolidating on an equity basis as of that date. Accordingly, consolidated revenue and expenses of UniHolding reflect nine months of UGL's consolidated revenue and expenses, and UniHolding's proportionate share of UGL's earnings for the three months ended May 31, 1999. The complete consolidated financial statements of UGL have been included in the Form 10-K, and a separate discussion of financial condition and results of operations of UGL has been included as a separate section of this item. At May 31, 1999, UniHolding's only source of income is through its 38% ownership interest in UGL. Consolidated revenue was $72.0 million for the twelve months ended May 31, 1999, representing a decrease of $11.6 million (including the effect of the change in the US dollar exchange rate of $1.0 million) from the comparable prior year period, as restated for the spin-off of the clinical trials operations. Such decline is due to the effects of consolidating only 9 months of UGL's revenue in the current year as a result of the Reorganization, as opposed to the full consolidation in the prior year. Operating income for the twelve months ended May 31, 1999, was $6.0 million, versus $8.4 million in the comparable prior year period excluding the non-recurring charge of $1,190 and as restated for the spin-off of clinical trials operations. Again, such decrease of $2.4 million was primarily due to the effects of the Reorganization. During the twelve months ended May 31, 1999, UniHolding itself did not have any outstanding borrowings. The interest expense reflected in UniHolding's statement of operations for the twelve months ended May 31, 1999 relates to interest expense incurred by UGL and its subsidiaries for the period until the Reorganization. Interest expense, net, increased $1.3 million to $1.5 million during the twelve months ended May 31, 1999, as compared to the prior year, primarily due to higher average borrowing levels resulting from the Swiss acquisitions completed during fiscal 1998 and due to the UK debt incurred as a result of the acquisition of the UK building. With effect from February 25, 1999, UniHolding recorded its proportionate share of UGL's consolidated loss, which did not exist in the prior year. As further described below, during the last quarter of fiscal 1999, UGL recorded a $15.7 million charge to reflect management's current assessment of the collectability of the GUCT preferred shares. Sales of part of the investment held by UGL in ULSA resulted in a gain of $0.3 million versus a gain of $6.0 million in the comparable prior year period. Other income of $0.3 million for the twelve months ended May 31, 1999 comprises $0.4 million of rental income from the period Bewlay House was owned and leased to its tenants by UGL through the date of Bewlay House's disposal and approximately $0.4 million relating to the reversal of the provision established in fiscal 1998 relating to the expected loss on disposal of certain information technology equipment, as ULSA management determined such equipment can now be used by ULSA in current operations. Offsetting these gains were foreign exchange losses of approximately $0.5 million. Other expense of $1.2 million for the twelve months ended May 31, 1998, consists primarily of $0.4 million of Swiss withholding taxes, $0.5 million relating to the expected loss on disposal of certain information technology equipment, which were reversed in the fourth quarter of fiscal 1999 as described above, and $0.2 million of foreign exchange losses. Provision for income taxes on continuing operations in the twelve months ended May 31, 1999, was $2.7 million, as compared to $4.6 million in the prior year comparable period, primarily due to the effects of the Reorganization and also as a result of $1.2 million of US income taxes relating to dividends paid to UniHolding in 1998 by subsidiaries, which were not repeated in 1999. Minority interests in income of continuing operations in the twelve months ended May 31, 1999, were $1.9 million as compared to $2.5 million in the prior year comparable period. The decrease was effected by the Reorganization, which more than offset the impact of the increased profitability of ULSA combined with a decrease in the percentage of equity in ULSA owned by UGL, and certain income not subject to minority interest in the prior year. Significant equity investee - Unilabs Group Limited - Twelve months ended May 31, 1999 compared with the twelve months ended May 31, 1998 Consolidated revenue was $98.6 million for the twelve months ended May 31, 1999, representing an increase of $15.1 million (including the effect of the change in the US dollar exchange rate of $1.0 million) from the comparable prior year period, as restated for the spin-off of the clinical trials operations. Revenue generated by the Swiss operations for the twelve months was up by 17% in local currency as a result of (i) a 2.4% increase in sales of the existing laboratories and (ii) the contribution made by the new operations acquired during fiscal 1998. The Spanish operations increased revenues during the twelve month period to $8.5 million, as compared to $6.7 million in the comparable prior year period representing a 24% increase in local currency. Operating income for the twelve months ended May 31, 1999, excluding the non-recurring impairment charge of $15,710 was $13.4 million, versus $9.0 million in the comparable prior year period, excluding the non-recurring charge of $1,190 and as restated for the spin-off of clinical trials operations. Such increase of $4.4 million was primarily due to the Swiss operations, which increased operating income by $2.4 million, plus the net change in other operating income items as described immediately below. Other income of $.5 million for the twelve months ended May 31, 1999 comprised $0.4 million of rental income from the period Bewlay House was owned and leased to its tenants by UGL through the date of Bewlay House's disposal and approximately $0.4 million relating to contingencies relating to the sale of Unilabs Group UK Limited ("UGUK") established in fiscal 1998, which were subsequently not required and were reversed during the fourth quarter of fiscal 1999 concurrent with the completion of the sale of Bewlay House and related contingencies. Also during the last quarter of fiscal 1999, UGL reversed approximately $0.4 million of the provision established in fiscal 1998 relating to the expected loss on disposal of certain information technology equipment, as ULSA management determined such equipment can now be used by ULSA in current operations. Offsetting these gains were foreign exchange losses of approximately $0.8 million. Other expense of $1.0 million for the twelve months ended May 31, 1998, consisted primarily of $0.4 million of Swiss withholding taxes, $0.5 million relating to the expected loss on disposal of certain information technology equipment, which were subsequently reversed in 1999, as described above, offset in part by the gain on disposal of UGUK of $0.1 million. Interest expense, net, increased $1.8 million to $2.0 million during the twelve months ended May 31, 1999, as compared to the prior year, primarily due to higher average borrowing levels resulting from the Swiss acquisitions completed during fiscal 1998 and due to the UK debt incurred as a result of the acquisition of the UK building. Gains on sale of part of the investment held by UGL in ULSA resulted in income of $3.8 million versus $6.0 million in the comparable prior year period. During the fourth quarter of fiscal 1999, UGL recorded an impairment write-down of $15,710 relating to its investment in and advances to GUCT and its affiliates. Such write-down arose due to a lack of available financing for the operating companies in which GUCT has an ownership interest. As a result of such lack of available financing, GUCT and UGL were informed that the controlling shareholders of the operating companies had decided to look for alternative solutions including a sale of operations or a liquidation. Accordingly, UGL's management performed a careful review of the value of the GUCT preferred stock held as of May 31, 1999, considering the situation described above. As a result of such review, UGL's management concluded that there was a permanent impairment in the value of GUCT and related advances, and that it was therefore necessary to record a 100% write-down of the aggregate value of the GUCT preferred stock and advances to GUCT affiliates at May 31, 1999, now carried at a net amount of $0.0 million in UGL's financial statements as of May 31, 1999. Provision for income taxes in the twelve months ended May 31, 1999, was $4.0 million, as compared to $2.6 million in the prior year comparable period, which increase is primarily a result of a decrease in the earnings in the 0% tax jurisdictions in which UGL operates, primarily the British Virgin Islands. Minority interests in income of continuing operations in the twelve months ended May 31, 1999, were $4.7 million as compared to $2.5 million in the prior year comparable period, essentially due to the increased profitability of ULSA combined with a decrease in the percentage of equity in ULSA owned by UGL, and certain income not subject to minority interest in the prior year. Twelve months ended May 31, 1998 compared with the twelve months ended May 31, UniHolding's results of operations for the year ended May 31, 1998, include the operations of UGL's core business (the "Diagnostic Laboratory Division"). As a result of UniHolding's decision to spin off the Clinical Trials Division to UniHolding's shareholders, which was completed on February 27, 1998, the loss of the respective subsidiaries has been shown separately in the accompanying statement of operations for the year ended May 31, 1998, and the consolidated net asset value of the Clinical Trials Division has been shown as a separate item in the balance sheet as of May 31, 1997. Certain amounts in prior periods financial statements have been reclassified to conform with the current presentation. Consolidated revenue was $83.5 million for the year ended May 31, 1998, representing a decrease of $9.1 million from the comparable prior year period as restated to reflect the spin-off of the Clinical Trials Division. The decrease was primarily due to the sale of the UK operations of the Diagnostic Laboratory Division, which in fiscal 1997 had revenues of approximately $21.3 million. Such decrease was however partially compensated by organic growth and an acquisition in Switzerland. Revenue generated by the Swiss operations for the year, as expressed in local currency, increased by 5% as a result of an increase in specimen volume and test mix, all excluding the effect of newly-acquired operations which contributed to an increase in revenues of approximately 22%. Spanish operations increased revenues to $6.7 million, representing a 13% increase in local currency. Operating income for the year ended May 31, 1998, excluding the non-recurring impairment charge of $1,190 relating to management's expectation as to the timing and recovery of its investment in the preferred stock of FHL received in connection with the sale of UK operations, was $8.4 million, compared to an operating loss of $20.8 million in the comparable prior year period. The prior year losses were largely attributable to write-downs of goodwill in UK subsidiaries, a write-down in the carrying value of the UK property, and to an adjustment of accumulated amortization of goodwill. Excluding the effect of such items, the operating income generated by the Diagnostic Laboratory Division decreased by a net amount of $2.5 million versus the comparable prior year period. The major contributing operating factors providing such variance in operating income principally were due to a slightly lower contribution from our Swiss operations resulting from the continued growth, expanded marketing and accelerated computer developments. Those higher costs were largely offset by the positive contribution generated by newly acquired laboratories. Spanish operations showed slightly lower operating income, as continued price pressure in Spain kept operating margins low. Further, new operations in emerging markets like Turkey and Russia showed low margins during their first year of operation. Other expense of $1.2 million for the twelve months ended May 31, 1998, consists primarily of $0.4 million of Swiss withholding taxes, $0.5 million relating to the expected loss on disposal of certain information technology equipment, which were reversed in the fourth quarter of fiscal 1999, as described above and $0.2 million of foreign exchange losses. Gains on sale of part of the investment held by UGL in ULSA resulted in income of $6.0 million versus $16.2 million in the comparable prior year period. Interest expense, net, decreased $2.7 million during the year ended May 31, 1998, as compared to the prior year period, primarily due to lower average borrowing levels resulting from the initial public offering of our Swiss subsidiary in April 1997, the sale of the UK operations, and slightly lower interest rates in Switzerland. Provision for income taxes was $4.6 million, as compared to $0.8 million in the prior year period, then a low charge primarily linked to the fiscal 1997 write-downs. Minority interests in income of continuing operations in the year ended May 31, 1998, were $2.5 million as compared to $0.4 million in the prior year period. The 1998 increase resulted primarily from an increased percentage of minority interests in net income as a result of the Swiss subsidiary's initial public offering in April 1997, and from the sale of the UK operations. The prior year figure resulted primarily from the attribution to minority interests of the write-downs and write-offs made during the year ended May 31, 1997. In connection with the sale of its UK operations, UGL recorded during the year ended May 31, 1998, a net gain of $0.1 million, net of minority interests, resulting from the reversal of a cumulative translation adjustment and other adjustments relating to the UK operations of $1.5 million, offset by costs of disposal of $1.4. While they are no longer part of UniHolding's consolidated revenues, revenues of the Clinical Trials Division were $9.0 million for the period through February 27, 1998, being the date of the spin-off of such division, representing an increase of $2.0 million from the prior full year period ended May 31, 1997. The results for the Clinical Trials Division for the same period were a loss of $2.8 million, compared to a loss for the full year period ended May 31, 1997 of $3.03 million. Liquidity and Capital Resources Net cash provided by operating activities for the twelve months ended May 31, 1999 amounted to $6.5 million, a decrease of $4.7 million from the prior year period primarily due to the lower net income for the period and reduced cash inflows from operating assets and liabilities offset by an increase in the aggregate non-cash income items. Net cash provided by operating activities for the year ended May 31, 1998 amounted to $11.2 million, an improvement of $0.3 million from the prior year. Net cash used in financing activities for the twelve months ended May 31, 1999 was $0.0 million, a change of $21.8 million from the prior year period, due to the accounting effects of the Reorganization. Net cash provided by financing activities for the year ended May 31, 1998 was $21.8 million, primarily due to cash proceeds of new long-term debt arrangements made in connection with the acquisition of new operations in Switzerland, offset by a dividend paid by ULSA to all its shareholders ($3.7 million), and by cash used to purchase UniHolding's treasury stock ($1.7 million). During 1998 UniHolding acquired approximately 0.8 million shares of treasury stock in exchange for satisfaction of debt due from Unilabs Holdings SA in the approximate amount of $5.1 million. Net cash provided by investing activities for the twelve months ended May 31, 1999 was $0.6 million, compared to net cash used of $25.2 million in the prior year comparable period. Again, the change is primarily due to the accounting effects of the Reorganization. Net cash used in investing activities for the year ended May 31, 1998 was $25.2 million, compared to $2.0 million provided in the prior year period. The change is primarily due to capital expenditures incurred in connection with the expansion of laboratory operations in Switzerland. The effect of changing from the consolidation to the equity method of accounting for UniHolding's investment in UGL was to decrease net cash flows by approximately $16.4 million. As of November 15, 1999, UniHolding's bank facility provide for a total of approximately $0.5 million. As of December 15, 1999, UniHolding had approximately $0.3 million of availability under its credit facility. UniHolding believes that the liquidity provided to ULSA and UGL by the cash flow from operations, the existing cash balances and the borrowing arrangements described above will be sufficient to meet UGL's capital requirements including anticipated operating expenses arising from UGL's expansion into several new markets, as well as debt repayments. On July 23, 1996, UniHolding issued 333,333 new shares of its common stock to a U.S. institutional investor at $15.00 per share. Significant equity investee - Unilabs Group Limited - Liquidity and capital resources Net cash provided by operating activities for the twelve months ended May 31, 1999 amounted to $9.9 million, a decrease of $3.3 million from the prior year primarily due to a decrease in income from continuing operations and increased outflows from working capital items, offset in part by increased non-cash income items in the 1999 period. Net cash provided by operating activities for the year ended May 31, 1998 amounted to $13.2 million, an improvement of $0.9 million from the prior year. Net cash used in financing activities for the twelve months ended May 31, 1999 was $9.0 million, a change of $30.8 million from the prior year, due to repayment of long term debt in the current year and to lower proceeds from new long term debt as compared to the prior year. Net cash provided by financing activities for the year ended May 31, 1998 was $21.8 million, primarily due to cash proceeds of new long-term debt arrangements made in connection with the acquisition of new operations in Switzerland, offset by a dividend paid by ULSA to all its shareholders ($3.7 million), and by cash used to purchase UniHolding's treasury stock ($1.7 million). Net cash used in investing activities for the twelve months ended May 31, 1999 was $4.0 million, compared to $27.2 million in the prior year. The change was primarily due to lower payments for acquisition of shares in subsidiaries and property, plant and equipment and lower advances to affiliates, offset by proceeds of $12.4 primarily related to the sale of the UK building. Net cash used in investing activities for the year ended May 31, 1998 was $27.2 million, as compared to $5.6 million provided in the prior year, primarily resulting from an increased proceeds from the sale of ULSA shares and lower payments for purchases of businesses in 1997. As of December 15, 1999, UGL's bank facilities provide for a total of approximately $45 million. As of December 15, 1999, UGL had approximately $14 million of availability under its credit facilities. UGL believes that the liquidity provided to ULSA and UGL by the cash flow from operations, the existing cash balances and the borrowing arrangements described above will be sufficient to meet UGL's capital requirements including anticipated operating expenses arising from UGL's expansion into several new markets, as well as debt repayments. During the year ended May 31, 1997, UGL sold an aggregate of 94,000 shares (or 39.2% on a fully-diluted basis) of ULSA's common stock to financial institutions and to the public for a total consideration of SFr. 62.7 million (approximately $44.5 million) through an initial public offering of ULSA's newly-issued and existing shares. As of April 24, 1997, such initial public offering closed. Such offering, which was made at the price of SFr. 675 per share, comprised the issuance by ULSA to the public of a further 20% of its equity, and the sale by UGL of a portion of its holding in ULSA, thereby diluting UGL's holding in ULSA to approximately 60% post-initial public offering. The shares of ULSA are listed on the Swiss Exchange since April 25, 1997. The proceeds were used to reduce existing bank debt in the amount of approximately SFr. 17.5 million (approximately $12.5 million), and the balance was being used principally for acquisitions and financing the development of the then Clinical Trials Division. In addition to the above described matters, ULSA has outstanding obligations and commitments under capital leases, which mature over the next five to ten years. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 The preceding "Business" and Management's Discussion and Analysis contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent UniHolding's expectations or beliefs concerning UGL's operations, economic performance and financial condition, including, in particular, forward-looking statements regarding UniHolding's expectation of future performance following implementation of its new business strategy. Such statements are subject to various risks and uncertainties. Accordingly, UniHolding hereby identifies the following important factors that could cause UGL's and UniHolding's actual financial results to differ materially from those projected, forecast, estimated, or budgeted by UniHolding in such forward-looking statements. UniHolding undertakes no obligation to revise or update forward-looking statements to reflect changes in assumptions, the occurrence of unanticipated events, or changes to projections over time. (a) Heightened competition, including the intensification of price competition. (b) Impact of changes in tests and payer mix. (c) Adverse actions by governmental or other third-party payers, including unilateral reduction of fee schedules payable to ULSA. (d) Failure to obtain new customers, retain existing customers or reduction in tests ordered or specimens submitted by existing customers. (e) Adverse results in significant litigation matters, if any. (f) Denial of certification or licensure of any of ULSA's clinical laboratories by governmental agencies. (g) Adverse publicity and news coverage about ULSA or the clinical laboratory industry. (h) Inability to carry out marketing and sales plans. (i) Inability to successfully integrate the operations of or fully realize costs savings expected from the consolidation of certain operations and the elimination of duplicative expenses or risk that declining revenues or increases in other expenses will offset such savings. (j) Ability of ULSA to attract and retain experienced and qualified personnel. (k) Changes in interest rates causing an increase in ULSA's effective borrowing rate, and changes in exchange rates causing variances in consolidated income and expenses reported in dollars. (l) The effect of ULSA's effort to improve account profitability by selectively repricing or discontinuing business which perform below ULSA expectations. Other Information ULSA 's operating results will continue to be affected by the volume, mix and timing of test orders received during a period and by conditions in the industry (including pricing regulations) and in the economies in which UGL and ULSA operate, such as recessionary periods, political instability, and fluctuations in interest or currency exchange rates. ULSA further experiences both increases and decreases in its volume of testing due to seasonality shifts. All laboratories experience a slow down during the holiday seasons, primarily in summer. This may lead to quarterly information for ULSA and therefore UniHolding, which is not indicative of the trend of ULSA and UniHolding's businesses. Inflation was not a material factor in either revenue or operating expenses during the years presented, and is not expected to be in the current year. IMPACT OF YEAR 2000 Most of ULSA's laboratories were faced with "Year 2000" remediation issues. Many computer programs were written with a two digit date field and if these programs were not made Year 2000 compliant, they would have been unable to correctly process date information on or after the Year 2000. While these issues impacted all of ULSA's data processing systems to some extent, they were most significant in connection with patient-related computer programs. Moreover, remediation efforts go beyond ULSA's internal computer systems and required coordination with clients, suppliers and other third parties to assure that their systems and related interfaces were compliant. Given the different computer systems operated by ULSA's business units, the type and extent of the Year 2000 issues and the cost of remediation varied significantly among ULSA's laboratories. Failure to achieve timely remediation of computer systems that process client information and transactions, and of all other systems with embedded technologies that are critical to ULSA's operations, would have had a material adverse effect on ULSA's business, operations and financial results. In response to the Year 2000 concerns, ULSA created a Year 2000 Task Force to coordinate and monitor the laboratories' progress in their Year 2000 remediation efforts. The Task Force reports directly to ULSA's executive management, provides regular progress reports to executive management, and regularly meets with executive management to discuss its reports. ULSA's initial plans called for all critical systems to be renovated and compliance testing underway by the end of calendar 1998. As of November 15, 1999, ULSA estimated that approximately 95 to 98% of its critical systems had been renovated and compliance testing underway, and that the balance would be renovated by December 1, 1999. As ULSA uses many computerized laboratory machinery manufactured, provided and maintained by third-party vendors, it requested each of those vendors to provide ULSA with appropriate certification that the machinery was Year 2000 compliant. Such certification has now been received. Acceptance testing was finalized with time frames differing by laboratory unit. Completion of any third party interface testing was dependent upon those third parties completing their own internal remediation. ULSA could have been adversely affected to the extent third parties with which it interfaces did not properly address their Year 2000 issues. As of the date hereof, UniHolding has not been made aware of any Year 2000 compliance related problems impacting ULSA, subsequent to the commencement of operations in calendar 2000. In fiscal 1998, ULSA spent approximately $0.5 million on its Year 2000 remediation efforts. ULSA anticipated expenditures for Year 2000 remediation efforts and testing in the range of approximately $0.6 million to $1.0 million in fiscal 1999, out of which approximately $0.6 million were spent in the nine months ended February 28, 1999, and $0.2 million in the 3 months ended May 31, 1999. Further, ULSA anticipates expenditures for Year 2000 remediation efforts and testing of approximately $0.2 million in fiscal 2000. Approximately $0.5 million were spent for computer equipment that was not compliant and had to be replaced, and substantially all of the balance of expenditures made are related to internal payroll and external consultants. All Year 2000 expenditures of ULSA are expensed as incurred. As of the date hereof, UniHolding has not received from ULSA any information that would substantially modify UniHolding's assessment of the costs associated with Year 2000 compliance. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Number Reports of Independent Auditors..........................................II-F-2 UniHolding Corporation and Subsidiaries Consolidated Balance Sheets as of May 31, 1999, and 1998..............................II-F-3 UniHolding Corporation and Subsidiaries Consolidated Statements of Operations for the Years Ended May 31, 1999, 1998 and 1997..............................................II-F-5 UniHolding Corporation and Subsidiaries Consolidated Statements of Stockholders' Equity for the Years Ended May 31, 1999, 1998 and 1997..............................................II-F-6 UniHolding Corporation and Subsidiaries Consolidated Statements of Cash Flows for the Years Ended May 31, 1999, 1998 and 1997..............................................II-F-8 UniHolding Corporation and Subsidiaries Notes to Consolidated Financial Statements for the Years Ended May 31, 1999, 1998 and 1997........................................II-F-10 ATAG ERNST & YOUNG 6, rue d'Italie Telephone: ++41 22 318 06 18 P.O. Box 3270 Telefax: ++41 22 312 01 70 CH-1211 Geneva 3 Switzerland REPORT OF INDEPENDENT AUDITORS to the Board of Directors and Shareholders of UNIHOLDING CORPORATION, Delaware, USA We have audited the accompanying consolidated balance sheets of UniHolding Corporation and subsidiaries (the "Company") as of May 31, 1999 and 1998 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended May 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of UniHolding Corporation and subsidiaries at May 31, 1999 and 1998 and the consolidated results of their operations and their cash flows for each of the three years in the period ended May 31, 1999, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Geneva, Switzerland, December 17, 1999 ATAG ERNST & YOUNG /s/ C. PICCI /s/S. REID ----------------- -------------- C. Picci S. Reid ATAG ERNST & YOUNG SA: offices in Basel, Aarau, Berne/Thun, Bienne, Brig, Chur, Fribourg, Geneva, Kreuzlingen, Lausanne, Lucerne, Neuchatel/La Chaux-de-Fonds, St. Gallen/Buchs, Sion, Solothurn, Winterthur, Zurich Member of the Swiss Chamber of Auditors UNIHOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) May 31 ASSETS 1999 1998 CURRENT ASSETS: Cash and cash equivalents 227 $9,186 Accounts receivable, net of allowance for doubtful accounts of $444 in 1999 and $2,940 in 1998 104 19,464 Due from related companies - 1,587 Due from Unilabs Group Limited 919 - Inventories - 1,849 Prepaid expenses - 3,090 Other current assets 9 411 ---------- ---------- Total current assets 1,259 35,587 ---------- ---------- NON-CURRENT ASSETS: Long-term notes receivable 818 818 Intangible assets, net - 44,344 Property, plant and equipment, net - 8,828 Investment in Unilabs Group Limited 48,658 - Investment in equity affiliates - 481 Long-term investments - 22,781 Other assets, net - 132 ---------- ---------- Total non-current assets 49,476 77,384 ---------- ---------- $50,736 $112,971 ======= ========== See notes to financial statements UNIHOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) May 31 LIABILITIES AND STOCKHOLDERS' EQUITY 1999 1998 CURRENT LIABILITIES: Bank overdrafts - $4,010 Current portion of lease payable - 809 Payable to related parties 362 100 Trade payables 527 6,911 Accrued liabilities - 6,018 Current portion of long-term debt - 5,727 Taxes payable 6,155 6,459 Deferred taxes - 769 ---------- ---------- Total current liabilities 7,044 30,803 ---------- ---------- NON-CURRENT LIABILITIES: Lease payable - 725 Long-term debt - 29,544 Taxes payable - 74 Deferred taxes - 179 ---------- ---------- Total non-current liabilities - 30,522 ---------- ---------- Total liabilities 7,044 61,325 ---------- ---------- MINORITY INTERESTS - 9,440 ---------- ---------- COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Common stock, $0.01 par value; Voting; authorized 18,000,000 shares; issued 7,926,120 and 7,627,736 at May 31, 1999 and 1998, respectively 79 76 Non-Voting; authorized 2,000,000 shares; issued and outstanding 0 and 298,384 at May 31, 1999 and 1998, respectively - 3 Additional paid-in capital 49,832 49,832 Accumulated other comprehensive loss (1,792) (2,074) Retained earnings 6,333 7,623 ---------- ---------- 54,452 55,460 Less - cost of 1,237,865 (including 349,101 deemed treasury shares)and 1,602,569 shares of Common Stock held in treasury at May 31, 1999 and May 31, 1998, respectively (see Note 2) (10,760) (13,254) --------- ---------- Total stockholders' equity 43,692 42,206 --------- ---------- $50,736 $112,971 ========= ========= See notes to financial statements UNIHOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share data) See notes to financial statements UNIHOLDING CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands) (continued) UNIHOLDING CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands) (continued) See notes to financial statements UNIHOLDING CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (continued) UNIHOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (continued) See notes to financial statements UNIHOLDING CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Monetary amounts in 000's, except per share data) 1.Description of the Company and Basis of Presentation UniHolding Corporation ("UniHolding") is a holding company which, pursuant to a reorganization (the "Reorganization") further described below, owns as of May 31, 1999, a 38% interest in Unilabs Group Limited, a British Virgin Islands corporation ("UGL"), itself a holding company. Prior to the Reorganization, which took effect on February 25, 1999, UniHolding owned 100% of UGL. UGL is the majority shareholder of Unilabs SA, a Switzerland corporation ("ULSA"), which supplies clinical testing services in several European countries (the "Diagnostic Laboratory Division"), and, until the spin-off made in February 1998, UGL was also the sole shareholder of Global Unilabs Clinical Trials Limited, a British Virgin Islands corporation ("GUCT") supplying clinical trials testing for the pharmaceutical industry (the "Clinical Trials Division"). At May 31, 1999, UniHolding has no operations other than its indirect investment in ULSA. Accordingly, the accompanying financial statements reflect the full consolidation of UGL and its subsidiaries up to February 25, 1999. Subsequent to February 25, 1999, the financial statements reflect UniHolding's cost of investment in UGL, plus UniHolding's equity in undistributed earnings or losses of UGL and its subsidiaries since that date. UniHolding acquired control of UGL and its subsidiaries in March 1994, when it acquired from Unilabs Holdings SA, a Panama corporation ("Holdings"), 60% of the equity of UGL. UGL then had as principal operating subsidiaries ULSA and Unilabs Group (UK) Limited, a United Kingdom corporation ("UGUK"). As of June 30, 1995, UGL acquired from Unilab Corporation, a Delaware corporation ("Unilab") the remaining outstanding common stock of UGL for a total consideration of $30,000. The consideration was paid $13,000 in cash, $2,000 through the assumption of a debt from Unilab to a subsidiary, and $15,000 in the form of a one-year, interest-bearing promissory note. The excess of the purchase price over the fair value of the assets acquired, $3,301, was allocated to goodwill. The $15,000 promissory note, together with accrued but unpaid interest of $750 converted as of December 31, 1996, into 1,394,963 newly-issued shares of Common Stock of UniHolding and was accounted for by UniHolding as an additional investment in UGL of $15,750. The Reorganization Until February 25, 1999, UGL was a wholly-owned subsidiary of UniHolding. Effective February 25, 1999, UGL reached an agreement with Holdings, then a major shareholder of UniHolding, whereby Holdings received approximately 2.3 million newly issued shares of common stock of UGL in exchange for its UniHolding shares of common stock on a one-for-one basis. At the same time, UGL reached agreements with certain other non-US shareholders whereby such shareholders also received newly issued shares of common stock of UGL in exchange for their approximate 0.4 million UniHolding shares of common stock on the same one for one basis. Accordingly, effective February 25, 1999, UGL had gained control of UniHolding. Further, during the period from February 25 to May 31, 1999, UGL reached agreements with certain other non-U.S. shareholders of UniHolding, whereby such shareholders also received newly issued shares of common stock of UGL in exchange for their approximately 0.6 million UniHolding shares of common stock, also on the same one-for-one basis. In addition, also during the same period, a further aggregate of approximately 0.8 million UniHolding shares was acquired by UGL for a consideration consisting of approximately 14,000 bearer shares of ULSA common stock. As a result, as of May 31, 1999, UGL owned approximately 74% of UniHolding, while UniHolding owned approximately 38% of UGL. As more fully described in Note 12, UGL subsequently exchanged its shares of UniHolding common stock for 30,000 shares of UGL common stock held by UniHolding. Acquisitions and disposals prior to the Reorganization Clinical Trials Spin-off As of February 27, 1998, UniHolding spun off its wholly owned investment in the common stock of GUCT to UniHolding's shareholders. In connection therewith, UGL received $20,000 in non-voting, non-convertible, redeemable preferred stock of GUCT in exchange for previously existing inter-company debt. The redeemable preferred stock held by UGL is entitled to non-cumulative dividends in the form of additional redeemable preferred stock for a period of five years, and to cash dividends thereafter. The preferred stock is redeemable at GUCT's option at any time during the first five years at a redemption price equal to its then face value. At the time of the spin-off of GUCT's common stock to UniHolding's shareholders, UGL's net investment in GUCT amounted to $12,164 being the aggregate of $9,000 of common stock, plus advances of $10,979, less accumulated losses incurred of $7,815. UGL valued the $20,000 of GUCT preferred shares received at this net investment value, which valuation reflected the uncertainty as to the timing and the possibility of recovery of the investment. Accordingly, at May 31, 1998, the GUCT preferred stock was carried at a value of $12,164 and is included under 'Long-term investments' in the accompanying 1998 balance sheet. Revenues of the Clinical Trials Division were $9,000 for the period through February 27, 1998, being the date of the spin-off of such division and $7,000 and $4,400 for the years ended May 31, 1998 and 1997, respectively. During the fourth quarter of fiscal 1999, UGL recorded an impairment write-down of $15,710 relating to its investment in GUCT. Such write-down arose due to a lack of available financing for the operating companies in which GUCT has an ownership interest. As a result of such lack of available financing, GUCT and UGL were informed that the controlling shareholders of the operating companies had decided to look for alternative solutions including a sale of operations or a liquidation. Accordingly, UGL's management performed a careful review of the value of the GUCT preferred stock held as of May 31, 1999, considering the situation described above. As a result of such review, UGL's management concluded that there was a permanent impairment in the value of GUCT, and that it was therefore necessary to record a 100% write-down of the aggregate value of the GUCT preferred stock at May 31, 1999. Other Acquisitions and Disposals During the year ended May 31, 1998, ULSA acquired from third parties 100% of the equity of Institut Bio-Analytique Medical SA, a Geneva company, and related companies and 100% of the equity of Laboratoire Medical Pierre-Alain Gras SA, a Geneva company, at an aggregate cost of $25,260. Those acquisitions were accounted for as purchases and the excess of the assets contributed over the fair value of the assets acquired, $20,042, was allocated to goodwill and is being amortized by ULSA over a period of 20 years. Also during the year ended May 31, 1998, ULSA sold UGUK to a third party for $13,119, consisting of a $1,312 payment in cash and the balance in non-voting, redeemable preferred shares of the purchaser, Focused Healthcare (Jersey) Ltd. ("FHL"), a Jersey investment company. FHL is controlled by a former director of Unilab Corporation, who is also affiliated to Health Strategies Limited, a Jersey Channel Island corporation ("HSL") with which ULSA entered into certain other agreements during prior periods not presented herein. The agreement with FHL called for a disposal price equal to the net book value of UGUK at May 31, 1997. After reversal of cumulative translation and other adjustments of $1,550 related to UGUK, reduced by legal and other costs related to the disposal of $1,434, ULSA recorded a net gain on disposal of $116. Subsequently however, ULSA recorded a write-down of approximately $1,190, which reflects ULSA's appraisal of the uncertainty as to the timing and the possibility of recovery of its investment in FHL. Such amount of preferred shares was therefore carried at a value of $10,617 as of May 31, 1998, and is included under "Long-Term investments" in the accompanying 1998 balance sheet. ULSA has been informed by FHL that certain discussions are currently taking place with a third party, with a view to merge UGUK with, or sell UGUK to, this third party. ULSA has indicated that it will not veto a transaction which will enable it to recover the full amount of the FHL preferred stock currently recorded on ULSA's books, of SFr. 15,600 (approximately $10,300). See Note 12. In connection with the sale of UGUK, ULSA agreed to purchase from the latter the London building which housed most of UGUK's operations ("Bewlay House"), through its subsidiary Placelite Ltd. On July 8, 1998, ULSA completed this transaction and acquired a 999-year leasehold in Bewlay House for a purchase price of $12,322. On February 25, 1999, ULSA closed on definitive agreements to sell the building to a third party for cash consideration of approximately $12,000, net of all related costs and expenses. No significant gain or loss, other than resulting from currency changes, was made as compared to the carrying value of the building. 2. Significant Accounting Policies Principles of Consolidation The consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles and include the accounts of UniHolding and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Investments in significant 20 to 50%-owned affiliates or in which UniHolding otherwise exercises significant influence are accounted for by the equity method of accounting, whereby the investment is carried at cost of acquisition, plus the proportionate equity in undistributed earnings or losses since acquisition. As a result of UniHolding's decrease in ownership of UGL, the method used to account for the investment in UGL has changed from the consolidation method to the equity method. Valuation allowances are provided where management determines that the investment or equity in earnings is not realizable. As of May 31, 1999, UGL owns approximately 5 million shares of UniHolding common stock and UniHolding owns 2 million shares of UGL common stock. UniHolding has utilized the treasury stock method in accounting for this reciprocal shareholding between itself and UGL. The shares deemed treasury stock represents the ownership interest UniHolding has in itself through its investment in UGL. The Company's policy as regards the accounting treatment of gains or losses arising from the issuance by any of the Company's former subsidiaries, of such former subsidiaries stock, was to record such gain or loss presently in income. Such aggregate gain or loss was classified in the income statement classification "Gain on sale of subsidiary shares". Use of estimates The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from these estimates. Inventories Inventories, which consist principally of purchased clinical laboratory supplies, are valued at the lower of cost (first-in, first-out method) or market. Revenue Recognition Revenue from performing laboratory testing services is recognized at the time service is provided and is based on the amount billed or billable. Property and Equipment Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the related assets, which range from 3 to 33 years. Property and equipment includes items acquired under finance leases, which are capitalized, and the related equipment is amortized over its useful life. Leasehold properties are depreciated over the lease period, which may range from 1 to 10 years and leasehold improvements are depreciated using the straight-line method over the remaining term of the related lease or their useful life, whichever is shorter. Purchased data processing software costs which is considered to have a useful life of over one year is amortized over periods not exceeding 5 years. Goodwill Goodwill represents the excess of cost over the fair value of net tangible and identifiable intangible assets acquired and is amortized using the straight-line method. Goodwill is evaluated periodically based on undiscounted expected future cash flows and adjusted if necessary, if events and circumstances indicate that a permanent decline in value below the current unamortized historical cost has occurred. During the year ended May 31, 1997, ULSA revised its estimate of the useful life of existing goodwill from 40 to 20 years. The net effect of such change was a charge of $3,025 (or $0.43 per share), which is included in the income statement classification "Amortization of intangible assets". Other Intangible Assets Customer lists are recorded at cost and amortized utilizing the straight-line method over periods determined by the relative circumstances but not exceeding 15 years. The value of the customer lists is reviewed and evaluated periodically by management and adjusted, if necessary, if events and circumstances indicate that a permanent decline in value below the current unamortized historical cost has occurred. Income Taxes UniHolding accounts for income taxes utilizing the liability method requiring the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the basis of assets and liabilities for financial reporting purposes and tax purposes. UniHolding provided income taxes on the earnings of foreign subsidiaries to the extent they were taxable or expected to be remitted. Any dividend received from subsidiaries by UniHolding, through UGL, would be subject to the withholding taxes at a maximum rate of 35%, which UniHolding could not recover, but may be creditable against U.S. Federal income tax. Foreign Currency Translation UniHolding's principal operations, including its current investment in UGL, are located in Switzerland and various other countries. As a result, a significant part of net assets, revenues and expenses are denominated in the currency of those countries, while UniHolding presents its consolidated financial statements in US dollars. Assets and liabilities denominated in foreign currencies are translated at the exchange rates in effect at the balance sheet date. Revenues and expenses denominated in foreign currencies are translated at the weighted average exchange rates for the period. Net gains and losses arising upon translation of local currency financial statements to US dollars are accumulated in a separate component of Stockholders' Equity, the Cumulative Translation Adjustment account. Foreign Currency Transactions Gains and losses resulting from foreign currency transactions and changes in foreign currency positions are included in income or expense currently. Other income includes exchange losses of $528, $206, and $248 in fiscal 1999, 1998 and 1997, respectively. Income (Loss) Per Common Share Effective December 1997, UniHolding adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"), which changes the method used to compute earnings per share. This Statement specifies the computation, presentation and disclosure requirements for earnings per share ("EPS") for entities with publicly held common stock. SFAS 128 replaces the presentation of primary EPS with a presentation of basic EPS, and for entities with a complex capital structure requires the additional presentation of diluted EPS on the face of the income statement. Basic EPS is computed by dividing net income available to common stockholders by the weighted average number of shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS, except that the denominator is increased to include the number of additional common shares that would have been outstanding if any dilutive potential common shares had been issued. The adoption of this standard did not impact UniHolding's reported EPS, as no dilutive securities were outstanding during the periods presented, because all outstanding options were and are out of the money. Accordingly, for the years ended May 31, 1999, 1998 and 1997 income or loss per common share was computed by dividing net income or net loss by the weighted average number of voting and non-voting shares outstanding during the year. Cash and Cash Equivalents UniHolding considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Fair Value of Financial Instruments The carrying amount reported in the consolidated balance sheets for cash and cash equivalents, accounts receivable and accounts payable approximates fair value because of the immediate or short-term maturity of these financial instruments. The carrying amount reported for outstanding bank indebtedness approximates fair value because the debt is generally at a variable rate that reprices frequently. UniHolding believes that its non-bank indebtedness approximates fair value based on current yields for debt instruments of similar quality and terms. Concentration of credit risk UniHolding maintains cash and cash equivalents, and investment securities with various financial institutions. UniHolding limits its concentration of these financial instruments with any one institution, and periodically reviews the credit standings of these institutions. ULSA has a large and diverse customer base, thereby minimizing the credit risk of any one customer to accounts receivable amounts. In addition, whenever applicable, each ULSA business unit performs ongoing credit evaluations of their customers' financial condition. Stock Based Compensation Plans Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS 123"), establishes accounting and reporting standards for stock based employee compensation plans. As permitted by the standard, UniHolding continues to account for such arrangements under APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations. Accordingly, adoption of the standard has not affected UniHolding's results of operations or financial position. See Note 6. 3.Property, Plant and Equipment, net, and Intangible Assets Property, plant and equipment, net consists of the following: May 31, 1999 May 31, Land and buildings - $942 Long-term leasehold and improvements - 9,007 Furniture and fittings - 3,213 Laboratory and office equipment - 20,544 Capitalized data processing software - 1,862 ---------- ---------- - $35,568 Less: Accumulated depreciation - (26,740) ---------- ---------- $ - $8,828 Amounts charged to expense for depreciation of tangible assets, including assets under capital lease, was $2,152, $3,071, and $10,923 in the years ended May 31, 1999, 1998 and 1997, respectively. During the year ended May 31, 1997, as a result of its decision to sell a building used by its UK operations, ULSA reconsidered the carrying value of such building, and recorded a one-time charge of $5,805 (the equivalent of pound 4,000) to adjust such carrying value to its then currently estimated market value. The net amount of capitalized data processing software is $0 and $106 as of May 31, 1999 and 1998 respectively. The amount of assets under capital leases is $0 ($0 net of accumulated depreciation) and $4,476 ($1,725 net of accumulated depreciation) as of May 31, 1999 and 1998 respectively. Intangible assets consist of: May 31, 1999 May 31, 1998 - Goodwill - $50,577 Customer lists - 6,938 Other - 694 ---------- ---------- - 58,209 Less : Accumulated amortization - (13,865) ---------- ---------- $ - $44,344 Amortization of intangible assets was $2,388, $2,638, and $29,089 in the years ended May 31, 1999, 1998 and 1997. During the year ended May 31, 1997, ULSA revised its estimate of the useful life of existing goodwill from 40 to 20 years. The net effect of such change was a charge before tax effect of $3,025 (or $0.43 per share). Further, during the year ended May 31, 1997, management performed its periodic evaluation of ULSA's goodwill, based on undiscounted expected future cash flows. As a result thereof, in view of unexpected delays in returning UK operations to a level of profitability meeting management's criteria, and in view of the then present and estimated future profitability of such operations, ULSA recorded a charge before tax effect of $23,722 (or $3.38 per share) to adjust such goodwill. 4.Long Term Debt Long term debt consists of the following: May 31, 1999 May 31, 1998 Senior secured debt : ULSA Credit Facilities - $34,644 Other debt - 627 Capital leases, net of interest - 1,534 component ---------- ---------- - $36,805 Less: current portion (6,536) ---------- ---------- - $30,269 Senior Secured Debt Senior secured debt consisted of credit facilities granted by banks in Swiss francs to UGL and its subsidiaries. Such debt was secured by a pledge of the common stock of substantially all of ULSA's subsidiaries, and contained covenants of a customary nature, including restriction of the use of $2,740 of cash and cash equivalents only for future acquisitions or capital expenditures. Interest on long term debt was generally at market rates plus a margin, and depended upon actual utilization of the facilities and the maturity of the debt instruments. At May 31, 1998, the effective average interest rate was approximately 3.25% per annum. Subsequent to May 31, 1999, UniHolding obtained a $500 credit facility from a financial institution. Such credit facility will be utilized to fund the ongoing general and administrative expenses of UniHolding and is secured by a pledge of 320,000 UGL shares of common stock. In connection with the disposal of the UK operation by ULSA, all of the debt related to that operation was disposed of. See Note 1 regarding disposal of UK operations 5.Income Taxes Deferred income tax assets and liabilities are provided for temporary differences between financial statement income and the amounts currently taxable in the jurisdictions in which operations are taxed. Income (loss) before income taxes and minority interests of domestic and foreign corporations is as follows: Years ended May 31 1999 1998 1997 Domestic ($878) $2,149 $(3,052) Foreign 4,358 10,811 (6,045) ----------- ----------- ----------- Total $3,480 $12,960 ($9,097) The provision (benefit) for income taxes is as follows : Years ended May 31 1999 1998 1997 Current: Foreign $1,746 $3,037 $864 U.S. 1,155 2,000 3,000 Deferred: Foreign (179) (452) (3,050) -------- ----------- ----------- Total $2,722 $4,585 $814 ======== =========== =========== Deferred taxes are provided principally in relation to temporary differences in the amortization of intangibles and to different book and tax rates of depreciation of tangible assets. The deferred tax assets and liabilities as of May 31, 1999, are as follows : Assets Liabilities Operating loss carryforwards $1,023 Investment in UGL 16,608 - --------- --------- 17,631 - Valuation allowance (17,631) - -------- --------- - - Management of the Company has determined, based on UniHolding's history of operating earnings and its expected income, that operating income will not more likely than not be sufficient to utilize this deferred tax asset and accordingly has provided for it in full. The deferred tax assets and liabilities as of May 31, 1998, are as follows: Assets Liabilities Depreciation of tangible assets $ - $33 Amortization of intangibles - 303 Operating loss carry forwards 1,328 - 1,328 336 Valuation allowance (1,171) - -------- --------- $157 $336 ===== ==== A reconciliation between the actual income tax expense (benefit) and income taxes computed by applying the US Federal income tax rate of 34% to earnings before taxes and minority interests is as follows (in thousands) : Years ended May 31 1999 1998 1997 ==== ==== ==== Computed income taxes at rate of 34% $1,183 $4,406 ($3,093) Impact of difference between statutory and US tax rates (328) (2,028) (3,799) Non-deductible goodwill 729 US income taxes on dividends and interest paid to UniHolding from subsidiaries - 1,200 Withholding tax on dividend from ULSA to UGL - 769 - Penalties and interest on US tax liability 1,155 800 - US income taxes on deemed dividends relating to sales of subsidiary shares - 3,000 Effect of change in accounting estimates relating to write-down in carrying value UK building - - (1,916) Effect of change in accounting estimates relating to change in amortization period of goodwill - (510) Effect of adjustment of carrying value of goodwill in subsidiary 4,383 Change in valuation reserves on deferred tax assets (148) (697) 2,441 Other 131 135 308 ---------- ---------- -------- 2,722 $4,585 $814 ======== ========== ======= Certain of UniHolding's former subsidiaries incurred losses, which could be used to offset their taxable income for up to seven years after incurring the losses, depending on the applicable tax legislation. Total net operating loss carry forwards of such former subsidiaries amounted to approximately $6,400. Management reviewed the probability of realization of the tax benefits that may have arisen from these losses being carried forward. Based on the estimated realization, UniHolding reserved for the tax benefits in all cases where it had not been satisfied that it was more likely than not that the benefits would be realized. Therefore, UniHolding recognized deferred tax assets of $157 at May 31, 1998. The major portion of such underlying net operating loss carry forwards was expected to expire starting in 2004. At May 31, 1998, taxes were not provided on approximately $8,400 of accumulated foreign unremitted earnings because those earnings were expected to remain invested indefinitely and accordingly, no U.S. taxes were provided on such unremitted earnings. It was not practical to estimate the amount of additional tax that might be payable if such accumulated earnings were remitted. Additionally, if such accumulated earnings were remitted, certain countries impose withholding taxes that, subject to certain limitations, are available for use as a tax credit against any Federal income tax liability arising from such remittance. At May 31, 1999, no deferred income taxes were provided on approximately $3,129 of accumulated foreign unrequited earnings, due to the fact US tax credits for foreign taxes paid on the remitted undistributed earnings would more than offset any US tax liability from the remittance of such undistributed earnings. 6. Stockholders' Equity Treasury Stock During the period June 1, 1998 to February 25, 1999 UniHolding, through its then subsidiary UGL, acquired 422,071 shares of UniHolding at a cost of approximately $2,600. During the year ended May 31, 1998, UniHolding, and its then subsidiary UGL, acquired 1,309,419 shares of UniHolding common stock at a cost of approximately $9,200. Approximately $5,100 of this total was obtained through forgiveness of amounts owed by its principal shareholder. Of the remaining $4,100, $2,400 was attributable to purchases from its principal shareholder and $1,700 to purchases from third parties. During the year ended May 31, 1997, UGL acquired 125,150 of UniHolding common stock on the market for $913. Stock Options As of June 28, 1994, UniHolding's Board of Directors adopted a Stock Option Plan whereby options can be granted to directors, key officers or management personnel of UniHolding or any of its subsidiaries or affiliates by the Administrator of the Plan, acting in agreement with the Board. 500,000 shares of UniHolding's common stock can be so reserved each year for issuance pursuant to the Plan, as amended. Options are granted with an exercise price at no less than 100% of the fair market value of UniHolding's common stock on the date of the grant. Options vest 18 months after the date of grant, and shares subscribed by Option grantees cannot be sold prior to two years from the date of grant. The Plan will expire on June 28, 2004. Accordingly, UniHolding will be able to grant 3.0 million options in addition to those already granted. On August 17, 1995, a total of 131,250 options were granted. These options are all exercisable on or after February 17, 1997, at $22 per share for 31,250 options and at $24 per share for 100,000 options, and expire on June 28, 2004. During the year ended May 31, 1998, 31,250 options priced at $22 per share were forfeited. None of the remaining options have been exercised to date. On July 9, 1996, a total of 304,642 additional options were granted. These options are all exercisable on or after January 9, 1998, at $16 per share, and expire on June 28, 2004. None of the options have been exercised to date. On August 25, 1997, a total of 304,642 additional options were granted. These options are all exercisable on or after February 25, 1999, at $10 per share, and expire on June 28, 2004. None of the options have been exercised to date. The following tables summarize information about options outstanding at May 31, 1999: Outstanding Options ------------------------------------------------------- Weighted-Average Range of Exercise Shares Outstanding Remaining Contractual Weighted-Average Prices at May 31, 1999 Life Exercise Price $24.00 100,000 5.08 $24.00 $16.00 304,642 5.08 $16.00 $10.00 304,642 5.08 $10.00 ----------- 709,284 5.08 $14.55 =========== Options Exercisable ----------------------------------------------------------------- Range of Exercise Shares Exercisable at Weighted-Average Prices May 31, 1999 Exercise Price - ----------------- --------------------- ---------------- $24.00 100,000 $24.00 $16.00 304,642 $16.00 $10.00 304,642 $10.00 -------- 709,284 $14.55 ======== All options outstanding as of May 31, 1999, expire on June 28, 2004. Pro forma information: Pro forma information regarding net loss and loss per share is required by SFAS 123. This information is required to be determined as if UniHolding had accounted for its employee stock options granted subsequent to May 31, 1995, under the fair value method of that statement. The fair value of these options was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighted-average assumptions applied to all years: risk-free interest rate of 6.00 percent, dividend yield of 0.00 percent, volatility factors of the expected market price of UniHolding's common stock of 0.157 and a weighted average expected life of the options of 8 years. The weighted average fair value of options was $3.99 for options granted in 1997. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the option's vesting period. Pro-forma net income (loss) for 1999, 1998 and 1997 would be $1,257, $2,121 and ($15,010); pro forma basis and diluted earnings (loss) per common share would be $0.20, $0.28 and ($2.14), respectively. At May 31, 1999, 709,284 vested options are outstanding. All of these options vested during the years ended May 31, 1997, 1998 and 1999. Capital Stock of Former Subsidiary and Initial Public Offering by Former Subsidiary During the year ended May 31, 1997, ULSA acquired 3,750 bearer shares (or 1.9%) of its own common stock from unaffiliated investors in ULSA for a total consideration of SFr. 2,010 ($1,550), all of which was paid during the period. In February 1997, ULSA acquired 10,000 bearer shares (or 5.0%) of its own common stock from UniHolding's then controlling shareholder, Unilabs Holdings SA, for a total consideration of SFr. 6,500 ($5,000), which was paid through a partial set-off of advances previously made. In March, ULSA acquired a further 10,000 bearer shares (or 5.0%) of its own common stock from Holdings, for a total consideration of SFr. 6,500 ($5,000), which was paid through a partial set-off of advances previously made. The excess of the purchase price over the predecessor cost ($3,329) was debited to paid-in capital. According to the related purchase contracts, the purchase price was subject to an adjustment whereby UGL and Holdings would share on an equal basis any difference between the purchase price initially set and the price per share on the first day of trading of the ULSA shares on the Swiss Exchange after the ULSA initial public offering discussed below. Based upon the last price paid on April 25, 1997 (the first day of trading of the ULSA shares on the Swiss Exchange), of SFr. 705 per new ULSA bearer share, an amount of SFr. 550 became due by UGL to Holdings and was paid through a partial set-off of advances previously made. During the year ended May 31, 1997, in conformity with UniHolding's plans to maximize shareholder values, UGL organized an initial public offering of ULSA's newly-issued and existing shares. In anticipation thereof, UGL sold an aggregate of 30,000 shares (or 15.0% of ULSA's then equity) of ULSA's common stock to three financial institutions for a total consideration of SFr. 19,500 (approximately $15,000). As a result of this series of transactions, UGL owned approximately 84% of ULSA as of March 31, 1997. As of April 24, 1997, the initial public offering closed. The offering was made at the price of SFr. 675 per bearer share. The offering comprised the issuance by ULSA to the public of a further 20% of its equity, and the sale by UGL of a portion of its holding in ULSA, thereby diluting UGL's equity holding in ULSA to 60% post-initial public offering. The shares of ULSA have been listed on the Swiss Exchange since April 25, 1997. UGL recorded an aggregate gain of $16,164 from the sales of ULSA stock during the year ended May 31, 1997. During the year ended May 31, 1998, UGL purchased 3,260 shares of ULSA stock and sold 18,150 shares of ULSA stock, either on the market, or in private transactions at prices substantially equal to market and recorded an aggregate gain from such sales of $6,007. During the year ended May 31, 1999, UGL and ULSA purchased 28,840 shares of ULSA stock, and sold 34,756 shares of ULSA stock, either on the market, or in private transactions at prices substantially equal to market. Aggregate gains from sales made prior to the Reorganization on February 25, 1999 was $328. 7. Related Party Transactions Advances to and from related companies bear an interest rate based on the 3 months LIBOR plus 2% per annum. These advances are unsecured. During the year ended May 31, 1997, ULSA entered into a management services contract with a company in which the Chairman of UniHolding's Board of Directors is a director. Under this contract, a subsidiary of UGL paid SFr. 720 ($610 at the then average exchange rate), SFr. 720 ($492 at the then average exchange rate) and SFr. 835 ($581 at the then average exchange rate) during the years ended May 31, 1997, 1998 and 1999. During the years ended May 31, 1997, 1998, and 1999, a subsidiary of ULSA paid SFr. 720 ($610 at the then average exchange rate), SFr.720 ($492 at the then average exchange rate), and SFr. 835 ($581 at the then average exchange rate) for consultancy services to a company affiliated with a Director of UniHolding. 8. Retained Earnings Retained earnings of UGL's Swiss subsidiaries are partially restricted by law as to distribution. Restricted amounts (including temporary restrictions) were approximately $20,557 and $17,997 at May 31, 1999 and 1998. 9. Retirement plans All of ULSA's employees participate in the pension or retirement plans legally required in their place of work. All of such plans are defined contribution plans. Under all such plans, which are administered by third parties, contributions are made by the employees and by ULSA. This contribution is expensed in the period that the cost is incurred. Total benefit plans expenses was approximately $1,128, $1,247, and $1,336 for the years ended May 31, 1999, 1998 and 1997 respectively. ULSA does not maintain any plans for other post-employment or post-retirement employee benefits. 10. Commitments and Contingencies Operating lease expenses, which relate to the rental of buildings, office furniture and equipment of UGL's subsidiaries, were approximately $3,027, $3,984, and $3,220 for the years ended May 31, 1999, 1998 and 1997 respectively. Certain key officers of ULSA have employment agreements that provide for aggregate annual salaries of approximately $1,500 and which include non-competition clauses. In the event that ULSA invokes such clauses after termination of the employment agreements, ULSA may be obligated, under certain circumstances, to compensate these individuals for differences in salary between the compensation paid to them by ULSA on the date of the expiration of the employment agreements and their new annual salaries. In connection with the initial public offering of ULSA's bearer shares on April 25, 1997, UniHolding, UGL, ULSA, as well as certain of their direct and indirect shareholders, have agreed for a certain period of time to respect certain restrictions regarding the transfer and listing of ULSA's shares held by them and the maintenance of the existing shareholder control. The restrictions are summarized as follows: (a) no sale or other transfer of ULSA's bearer shares and/or registered shares until April 25, 1999, without the prior written consent of the lead manager of the initial public offering; (b) no listing of ULSA's registered shares on any securities exchange for a period of five years from April 25, 1997; and (c) maintenance of existing majority ownership and effective control of ULSA until April 25, 1999. In the normal conduct of their business, UniHolding, UGL and ULSA may be a party to certain litigation. As of May 31, 1999, ULSA is a party to a litigation in connection with a clinical test. While the proceedings are still at an early stage, in the opinion of management and as confirmed by legal counsel, the resolution of this matter should have no material effect, if any, on the financial position or results of operations of ULSA, UGL or UniHolding. 11. Investment in Equity Affiliates Pursuant to the Reorganization as described in Note 1, at May 31, 1999, UniHolding owned a non-controlling 38% interest in UGL, which it accounts for using the equity method of accounting. A summary of consolidated financial information of UGL as of, and for the year ended, May 31, 1999, is as follows: Balance Sheet Total current assets 33,089 ------ Investments 10,775 Cost of investment in UniHolding 36,741 Intangible assets 43,905 Other long-term assets 7,714 ------ Total long-term assets 99,135 ------- Total assets 132,224 ======= Short-term borrowings $10,201 Other current liabilities 14,908 ------ Total current liabilities 25,109 ------ Long-term borrowings 30,560 Other long-term liabilities 236 ------ Total long-term liabilities 30,796 ------ Minority interests 12,168 Statement of Income Revenues $98,619 Operating loss (2,270) Loss from operations (503) Net loss (9,247) 12. Subsequent Events On September 3, 1999, pursuant to separate board of director resolutions of the UniHolding and UGL board of directors, which resulted from discussions between the boards of directors of UniHolding and UGL, UniHolding transferred to UGL 30,000 shares of UGL common stock, and UGL transferred to UniHolding its entire shareholding of UniHolding common stock. Pursuant to this agreement, as of September 3, 1999, UGL did not own any UniHolding shares, while UniHolding owns a balance of approximately 2.0 million shares of UGL common stock, or approximately 37% of UGL's equity. The remaining UniHolding shareholders, who owned approximately 37% of the outstanding UniHolding stock before the Reorganization, own 100% of the outstanding UniHolding stock after the Reorganization and the September 3, 1999, transaction. Accordingly, their indirect equity interest in UGL is not less than it was before the Reorganization. On October 1, 1999, ULSA closed on an agreement with FHL regarding the disposal of the non-voting, redeemable preferred shares of that company. As of that date, FHL merged its UK laboratory subsidiary into another laboratory owned by Advanced Pathology Services Ltd., England. In connection therewith, ULSA sold its FHL preferred shares against an immediate cash payment of (pound)3,000 ($4,800), with the balance being essentially constituted of notes due within 4 years payable by Advanced Pathology Services. On December 21, 1999, ULSA closed on an agreement with Advanced Pathology Services Ltd., England, regarding the disposal of Unilabs International (UK) Ltd., a subsidiary engaged in the marketing of pathology services in the Middle East. The sale consideration was agreed at (pound)538 ($860), in the form of a note payable on December 21, 2003. 13. Supplemental Disclosures of Cash Flow Information (in thousands) Years ended May 31 1999 1998 1997 Cash paid during the year for: Interest 1,426 $1,039 $2,003 Income taxes 1,460 2,179 2,129 Capital lease obligations of $465, $955 and $1,904 were incurred during the years ended May 31, 1999, 1998 and 1997, respectively. 14. Quarterly Financial Data (unaudited) Summarized unaudited quarterly financial data for the years ended May 31, 1999 and 1998 is as follows (in thousands, except per share data)(note that discontinued operations have been reclassified): Year ended May 31, 1999 First Second Third Fourth Quarter Quarter Quarter Quarter (a) (b),(c) Revenue $20,542 $26,942 $24,469 - Operating income (loss) 764 3,757 1,431 1 Net income (loss) (86) 961 1,001 (3,166) Per share data : Net income (loss) ($0.01) $0.16 $0.02 ($0.48) Price range: High $6.75 $6.00 $4.75 $4.75 Low $3.50 $3.125 $3.00 $1.00 a. As per the amendment to Form 10-Q filed concurrently with UniHolding's Annual Report on Form 10-K for the year ended May 31, 1999. b. Pursuant to the Reorganization, effective February 25, 1999, UniHolding ceased consolidating the results of UGL and ULSA on a full consolidation basis and instead has applied equity accounting to its investment in UGL. Accordingly, the results for the fourth quarter reflect only UniHolding's revenues and expenses, and UniHolding's share of net loss from UGL of $1,255. c. Includes tax charge of $1,155 relating to late filing penalties and interest on UniHolding US income tax obligations. Year ended May 31, 1998 Earnings per share are computed independently for each of the quarters presented. Therefore, the sum of the quarterly earnings per share for a year does not equal the total computed for the year due to stock transactions that occurred during the periods. 15.Segment Information UniHolding adopted SFAS No. 131 'Disclosures about Segments of an Enterprise and Related Information' as of May 31, 1999. SFAS No. 131 requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. Prior years' presentations are restated to conform to current year presentations. UniHolding, through its indirect investment in ULSA (a supplier of clinical testing services in several European countries), has identified the following business segments based on their country location, which each operate in the filed of clinical laboratory services: Switzerland, the United Kingdom, Spain, and "All Other". During the year ended May 31, 1997, UniHolding performed testing in relation to clinical trials for the pharmaceutical industry and therefore distinguished its Diagnostic Laboratory Division from its Clinical Trials Division. As of February 27, 1998, the Clinical Trials Division was spun off to UniHolding's shareholders. Information related to UniHolding's reportable segments is shown below. Year Ended May 31 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS DIRECTORS, EXECUTIVE OFFICERS AND KEY MANAGEMENT PERSONNEL The following table sets forth certain information as of September 6, 1999, regarding the directors, executive officers and key management personnel of UniHolding and its subsidiaries. Directors and Executive Officers of UniHolding Name Age Position Edgard Zwirn 53 Chairman of The Board and Director, Chief Executive Officer and member of Audit Committee Alessandra van Gemerden 27 Director Tobias Fenster 53 Director, Chief Executive Officer - Spanish Operations Daniel Regolatti 68 Director and member of Audit Committee Pierre-Alain Blum 53 Director and member of Audit Committee Bruno Adam 50 Chief Financial Officer and Secretary Key Executive and Managerial Officers of Subsidiaries Name Age Position Blaise Mentha 40 Chief Executive Officer - Swiss Operations Eric Wavre 47 Executive Vice President, Treasurer and Chief Administrative Officer Miguel Payro 35 Executive Vice President, Head of Financial Planning and Business Development, Head of Investor Relations Edgard Zwirn has been Chairman and a member of UniHolding's board of directors since April 28, 1994. Edgard Zwirn was appointed as Chief Executive Officer of UniHolding on April 26, 1994. Edgard Zwirn has been the Chairman of the board of directors of Unilabs Holdings SA (a Panama corporation, "Holdings", which is UGL's largest shareholder) since 1993, ULSA since 1989, UGL since inception in October 1993, UIL, GUCT and TBLH since their respective inception in 1996. He has been Chairman of the board, President and Chief Executive Officer of Unilabs Holdings SA (a Swiss corporation which is the parent company of Holdings, "Swiss Holdings") since 1987. He has been President of UGL since October of 1993. Edgard Zwirn has been a member of Unilab Corporation's board of directors from November 1993 to June 1995 after having served as a member of the board of directors of the predecessor of Unilab Corporation from its formation in November 1988 until November 1993. Edgard Zwirn has also been Chairman of the board of directors of several UK subsidiaries of UGL, including UGUK, until their disposal in fiscal 1998. He currently is a non-executive director of Focused Health (Jersey) Limited, a company which acquired the former UK operations of ULSA. Alessandra van Gemerden has been a member of UniHolding's board of directors since July 1996. She holds degrees in Management and Psychology and has had prior experience in public relations and management of investment portfolios. Alessandra van Gemerden was a Director of UGUK from April 30, 1996, until fiscal 1998, and a Director of UIL, GUCT and TBLH since their respective inception in 1996. Ms. van Gemerden holds directorships in various non-U.S. corporations involved in the asset management business. Tobias Fenster has been a member of UniHolding's board of directors since July 1996. He holds degrees in Industrial Engineering and Business Administration from Stanford University. His previous work experience includes consulting services with Booz Allen & Hamilton and management of closely-held enterprises in the wood industry and in the computer distribution industry. Tobias Fenster currently is Chef Executive Officer of ULSP. Mr. Fenster was a Director of UGUK from April 30, 1996, until fiscal 1998, and a Director of UIL, GUCT and TBLH since their respective inception in 1996. Mr. Fenster is Mr. Zwirn's brother-in-law. Daniel Regolatti has been a member of UniHolding's board of directors and of the Audit Committee since October 1996. From 1957 to 1992, Mr. Regolatti held various positions with the Nestle group of companies, including his last position as Director of Finance at the Nestle world headquarters. He is currently an independent consultant in management and finance. Mr. Regolatti is a director of Julius Baer Holding and Bank Julius Baer, Zurich. He currently also is a director of ULSA. Mr. Regolatti is a Member of the International Council for the Verwaltungs und Privat-Bank, Vaduz, Liechtenstein and a Member of the Advisory Council for the MBA Program of the University of Rochester N.Y./Berne, Switzerland. Pierre-Alain Blum has been a member of UniHolding's board of directors and of the Audit Committee since October 1996. Mr. Blum was the founder of the EBEL Swiss watch manufacturing group in 1970. He left EBEL in 1996. He currently is an independent consultant in management. Mr. Blum is a director of several companies in various countries. He currently also is a director of ULSA. Bruno Adam was a member of UniHolding's board of directors from April 1994 to October 1996. Mr. Adam has been the Chief Financial Officer of UniHolding since May 1994. Mr. Adam has been Chief Financial Officer of ULSA from 1988 to 1993, and again since 1997, and a Director of UGL from November of 1993 to July 1996. Mr. Adam was appointed as a director of TBLH (now a subsidiary of GUCT) in September 1998. Mr. Adam was appointed Secretary of the UniHolding's board of directors in July 1999. Eric Wavre was appointed Executive Vice President and Chief Financial and Administrative Officer-European Affairs of UniHolding as of June 1, 1995. Mr. Wavre has been Executive Vice President and Chief Financial and Administrative Officer of UGL from January 1994 to July 1996. He was a Director of UGL from April 1994 to July 1996. Blaise Mentha was appointed Chief Executive Officer Swiss Operations of ULSA as of October 1, 1998. From February 1998 to September 1998, he was Chief Operating Officer, Swiss Operations, French-speaking Region. Prior to his appointment by ULSA, Mr. Mentha was since 1987 a self-employed consultant active in the health care industry. Mr. Mentha also was a director of several companies engaged in this business. From 1993 to January 1998, Mr. Mentha served as executive vice president of a Swiss laboratory group acquired by ULSA during the 1998 fiscal year. Miguel Payro has been a Vice President and financial controller of ULSA since 1994. From October 1996 to October 1997, he also served Chief Financial Officer of UCT and of the South Europe Region. Section 16(a) Beneficial Reporting Compliance Based solely upon UniHolding's review of the Forms 3 and 4, and any amendments thereto, furnished to it during its most recent fiscal year and the written representations from each of the persons or entities required to file such forms, no person was required to file a Form 5 except UGL, which failed to file timely Forms 4 for the acquisitions of common stock reported elsewhere herein. See Item 1, Business and Item 13, Certain Relationships And Transactions With Related Persons and Consolidated Statements of Stockholders' Equity. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION During the year ended May 31, 1999, each Director of UniHolding received a compensation of $10,000 for his/her services to UniHolding in such capacity. During the prior years, no such compensation was paid. The following table sets forth the annual and long-term compensation paid or accrued by UniHolding for services rendered in all capacities to UniHolding and its subsidiaries during the last three years of those persons who were at May 31, 1999, (i) the Chief Executive Officer of UniHolding and (ii) the other three executive officers of UniHolding, UGL and ULSA whose total annual salary and bonus for the year ended May 31, 1998 exceeded $100,000. (1) Until May of 1999 and the date hereof, UniHolding did not compensate any of its Directors or Executive Officers, except for a flat fee of $10,000 paid to each UniHolding Director. All Directors and Executive Officers are compensated by UGL subsidiaries. (2) Mr. Zwirn is not an employee of UniHolding, UGL or ULSA. Since the fiscal year 1994 Mr. Edgard Zwirn is compensated by ULSA through a management consulting agreement with a company in which Mr. Zwirn is a director. Such agreement currently provides for a management fee of SFr. 996,000 annually (approximately $693,000 in fiscal 1999). Mr. Zwirn disclaims having personally received any of the aforementioned management fee except approximately SFr. 450,000 (approximately $313,000). (3) UniHolding has granted such Options to such individuals on July 9, 1996, and August 22, 1997. (4) Mr. Paul Hokfelt resigned from all of his duties with UniHolding and UGL as of January 31, 1998, to become the full-time President and Chief Executive Officer of TBLH, an entity in which GUCT has an ownership interest. In connection with such resignation, he received a severance payment included in the above amount. (5) Mr. Blaise Mentha was appointed by ULSA as of February 1, 1998. Pension Benefits Other than Mr. Edgard Zwirn, who is employed by a consulting company through a management contract, all of the named executive officers have retirement benefits pursuant to mandatory provisions of Swiss law. Under the Swiss system, amounts ranging from 9% to 15% of each employee's compensation, depending on age and sex, is deducted by the employer and paid to the social security system and to such employee's account in a fund managed by an independent insurance company, while the employer contributes like amounts. In addition to the legally required plans, UGL offers to its executive officers and other employees supplemental retirement programs, based upon a defined contribution system. During the year ended May 31, 1998, UGL's contribution to the supplemental retirement programs of the named executive officers averaged approximately $30,000 for each. Upon termination of employment contracts, the total employer contribution may be transferred to new pension plans. Relative to its executive officers, UGL has no other pension or retirement liability and has no unfunded liability. Employment Agreements Mr. Bruno Adam's employment agreement does not contain any special clause other than a notice period of 12 months by either party, with or without cause. His agreement does not contain any provisions of mandatory bonus or additional compensation based upon performance or results. Mr. Eric Wavre's employment agreement does not contain any special clause other than a notice period of 6 months by either party, with or without cause. His agreement does not contain any provisions of mandatory bonus or additional compensation based upon performance or results. Mr. Blaise Mentha's employment agreement does not contain any special clause other than a notice period of 6 months by either party, with or without cause. His agreement does not contain any provisions of mandatory bonus or additional compensation based upon performance or results. The board of directors of ULSA determines all executive compensation, and may award bonuses or incentive pay to employees at their discretion. During the years ended May 31, 1999, 1998 and 1997 respectively, a subsidiary of ULSA made payments of SFr. 835,000 (approximately $581,000), SFr. 720,000 (approximately $492,000) and SFr. 720,000 (then approximately $610,000) for consultancy services to a company which may be deemed to be affiliated with Mr. Enrico Gherardi, a Director of UniHolding who resigned as of May 31, 1999, and with Ms. Alessandra Van Gemerden a Director of UniHolding. Stock Options UniHolding amended its Stock Option Plan dated June 28, 1994 whereby options may be granted to directors, key officers or management personnel of UniHolding or any of its subsidiaries or affiliates. The aggregate number of shares available for issuance under such Plan is 500,000 shares of UniHolding's common stock each year. The Administrator, acting in agreement with a majority of the board of directors, determines the number of shares which shall be subject to each Option, the time or times when such Option(s) shall be granted, the exercise date(s) of such Option(s), and the exercise price of each option, but not less than 100% of the fair market value of the common stock on the date of granting such Option. This Plan will expire as of June 28, 2004. On August 17, 1995, UniHolding implemented its amended Stock Option Plan with the grant of options for 163,750 shares of common stock to certain of its personnel. The options so granted are exercisable beginning in February 1997. None of these options have been exercised to date. On July 9, 1996, a total of 357,142 additional options were granted. These options are all exercisable beginning in January 1998. None of these options have been exercised to date. On August 22, 1997, a total of 352,142 additional options were granted. These options are all exercisable beginning in February 1999. None of these options have been exercised to date. No options were granted by UniHolding to its executive officers named in the Summary Compensation Table for the years ended May 31, 1998, and May 31,1999. The aggregate number of options granted to date by UniHolding to the above named persons are as follows: The options granted in fiscal year 1995 have become exercisable on February 17, 1997, while those issued in fiscal year 1996 have become exercisable on January 9, 1998 and those issued in fiscal year 1997 have become exercisable on February 22, 1999. None of the options granted are in the money. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND DIRECTORS As of February 15, 2000, there were issued 7,926,120 shares of Voting Common Stock, the only class of voting securities of UniHolding, including 298,384 shares of Non-voting Common Stock which converted to Voting Common Stock upon sale to UGL by their previous owner. Each share of Voting Common Stock entitles its holder to one vote, with the exception of 5,856,272 shares of Voting Common Stock held in treasury by UniHolding. There are accordingly 2,069,848 shares of Voting Common Stock presently with voting rights. The following table sets forth, as of February 15, 2000, the name and address of each person known to UniHolding to be the beneficial owner of more than 5% of the Voting Common Stock, the total number of shares of Voting Common Stock owned by each such person and the percentage of the class owned by each such person. Except as otherwise noted, each such person has full voting and investment power with respect to the shares so owned. (1) Percent of Class is calculated by dividing the number of currently issued and outstanding shares held by such beneficial owner by the total number of currently issued and outstanding shares of UniHolding. (2) Grace Brothers, Ltd. ("Grace Brothers") purchased from Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") a subparticipation interest in a 100% participation interest in the Unilab Note purchased by DLJ from Unilab Corporation (the "Grace Brothers Subparticipation Interest"). The Unilab Note converted as of January 1, 1997 into 1,394,963 shares of UniHolding Common Stock. Grace Brothers obtained beneficial ownership of 464,987 shares of UniHolding Common Stock by means of the Grace Brothers Subparticipation Interest. (3) BankAmerica purchased from DLJ a subparticipation interest in a 100% participation interest in the Unilab Note purchased by DLJ from Unilab Corporation (the "BankAmerica Subparticipation Interest"). The Unilab Note converted as of January 1, 1997 into 1,394,963 shares of UniHolding Common Stock. BankAmerica obtained beneficial ownership of 232,494 shares of UniHolding Common Stock by means of the BankAmerica Subparticipation Interest. (4) Morgan Stanley holds 408,988 shares that were acquired pursuant to the Morgan Stanley Agreement, including 75,655 that were acquired pursuant to antidilution rights related to the conversion of the Unilab Note. In addition, as per Schedule 13 G/A filed May 7, 1999, Morgan Stanley held as market maker 19,321 shares of UniHolding Common Stock. Pursuant to the terms of a Stock Purchase Agreement, dated June 30, 1995, by and between UniHolding and UGL, UniHolding acquired 20% of the common stock of UGL in exchange for the Unilab Note in the principal amount of $15,000,000 and certain other consideration. The principal amount of the Unilab Note was due as of June 30, 1996. Pursuant to the terms of the Unilab Note, the Unilab Note was converted as of January 1, 1997 into 1,394,963 shares of UniHolding Common Stock. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND TRANSACTIONS WITH RELATED PERSONS The following sets forth certain relationships among beneficial shareholders, executive officers and directors of UniHolding, in particular, the relationship between Mr. Zwirn and Mr. Adam as executive officers and directors of UniHolding, of Unilabs Holdings SA, a Swiss corporation ("Swiss Holdings"), and of Unilabs Holdings SA, a Panamanian corporation ("Holdings"). The acquisition of March 31, 1994, whereby UniHolding acquired 60% of UGL and 100% of UCLE from Holdings with an option to purchase Holdings' majority interests in its Italian and Spanish operating subsidiaries is considered a related party transaction. Pursuant to the Acquisition Agreement, Holdings assigned to UniHolding its rights and obligations under the Stockholders' Agreement with Unilab Corporation concerning UGL. In connection with the acquisition of 40% of UGL from Unilab Corporation on June 30, 1995, such Stockholders' Agreement was terminated. During fiscal 1994, UGL acquired some of the minority interests in ULSA from Holdings through an offset of receivables from Holdings (aggregating approximately $10 million) against payables to Holdings. UGL thereafter owned 86% of ULSA. On June 22, 1994, the board of directors of UniHolding determined that it would be in the best interest of UniHolding to accelerate the payment of the $18 million Promissory note (the "Note") to Holdings with shares of UniHolding's common stock in lieu of cash. The terms of the Note required payment of principal and interest (accruing at 5% per annum), in cash or shares, over five years with the first installment being due March 31, 1995. Holdings accepted early payment of the Note in shares of UniHolding's common stock in lieu of cash. Further, Holdings agreed that such payment would be calculated on the basis of $5.50 per share (prior to the reverse split of UniHolding's common stock). Accordingly, UniHolding issued 3,310,455 (prior to the reverse split of UniHolding's common stock) shares of common stock valued at $5.50 per share (unadjusted) to Holdings (equivalent to the principal and accrued interest of $18,207,500 as of June 22, 1994) in consideration for the cancellation of the Note. During the year ended May 31, 1995, UniHolding acquired from Holdings (a) 186 additional shares of ULSA for a consideration of $1,800,000 paid in cash, and (b) the Italian and Spanish laboratory operations for a consideration of $7,342,000 represented by two promissory notes subsequently offset against advances. ULSA previously entered into a Cooperation Agreement dated March 25, 1992 with Holdings covering (i) the use of the Unilabs logo and provision of financial and market research advisory services to ULSA ("General Services") and (ii) mergers and acquisitions advisory services. The agreement, which expired on May 31, 1996, provided for an annual general services fee of $238,000 payable by ULSA. The Cooperation Agreement was assigned to and assumed by UniHolding pursuant to the Acquisition Agreement. Holdings also billed ULSA an additional $355,000 for general and administrative expenses and $282,000 as a finder's fee in relation to an acquisition during fiscal year 1994. UniHolding also billed Holdings $387,000 relating to laboratory management and consulting services in fiscal 1994. The management fees paid to Holdings by UniHolding provided for, among other things, the services of Mr. Bruno Adam up to May 31, 1994. In December 1993, UniHolding extended a loan of approximately $2.9 million to Holdings bearing interest at an annual rate of 3.375% which was subsequently canceled by UniHolding on March 31, 1994, in partial consideration for the acquisition of the European clinical testing companies. Edgard Zwirn, as CEO of UniHolding, is compensated for his services through and pursuant to a management consulting agreement between a subsidiary of ULSA and a company in which he is a director. The agreement required in the year ended May 31, 1999, an annual payment of SFr 835,000 (approximately $581,000). During the year ended May 31, 1995, UniHolding entered into a management services contract with a company which may be deemed to be affiliated with Mr. Enrico Gherardi, a Director of UniHolding who resigned on May 31, 1999. UniHolding paid SFr. 600,000 (then approximately $470,000) under this contract during the year ended May 31, 1995. As of May 31, 1995, the contract was terminated. During the years ended May 31, 1999, 1998, 1997 and 1996 respectively, a subsidiary of ULSA made payments of SFr. 835,000 (approximately $581,000), SFr. 720,000 (then approximately $492,000), SFr. 720,000 (then approximately $610,000) and SFr. 600,000 (then approximately $500,000) for consultancy services to a company which may be deemed to be affiliated with Mr. Enrico Gherardi and with Ms. Alessandra Van Gemerden, a Director of UniHolding. During the year ended May 31, 1996, UniHolding acquired 155,000 shares of UniHolding's common stock from Holdings for $2,900,000, the then market value of such shares which was less than the cost of such shares to Holdings. UniHolding also purchased 13,000 shares of UniHolding's common stock for $217,000. As of May 31, 1998, shareholders and affiliates of Holdings transferred 841,698 shares of UniHolding's common stock to UniHolding in full and final settlement of Holding's debt to UniHolding (approximately $5,050,000). In addition, during 1998 UniHolding purchased 266,848 shares of UniHolding common stock from Holdings for approximately $2,400,000. During the year ended May 31, 1997, UGL acquired 20,000 bearer shares of ULSA's common stock from Holdings for SFr. 13.5 million (approximately $9.6 million), the fair market value of such shares which approximated the cost of such shares to Holdings. Half of such shares were resold by UGL to third party investors prior to ULSA's initial public offering at a value which was higher than the price paid by UGL to Holdings. The other half of such shares were resold by UGL in ULSA's initial public offering at a value which was higher than the price paid by UGL. According to the related purchase contracts, the purchase price was subject to an adjustment whereby UGL and Holdings would share on an equal basis any difference between the purchase price initially set and the price per share on the first day of trading of the ULSA shares on the Swiss Exchange after the ULSA initial public offering discussed below. Based upon the last price paid on April 25, 1997 (the first day of trading of the ULSA shares on the Swiss Exchange) of SFr. 705 per new ULSA bearer share, an amount (included in the above mentioned value) of SFr. 550,000 (approximately $390,000) became due by UGL to Holdings and was paid through a partial set-off of advances previously made. During the year ended May 31, 1999, UGL acquired approximately 2.3 million shares of UniHolding from Holdings in exchange for UGL shares on a one-for-one basis. See Item 1, Business. Following are entities affiliated with UniHolding, UGL and ULSA: Holdings. Swiss Holdings owns 100% of Holdings. Edgard Zwirn is Chairman. Swiss Holdings. Edgard Zwirn is Chairman of the board of directors of Swiss Holdings and, together with certain members of his immediate family, he owns 23.3% of the voting and equity interests in Swiss Holdings. Bruno Adam is Executive Vice President of Swiss Holdings. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND SCHEDULES: 1. Financial Statements - See Index to Financial Statements at ITEM 8 2. Financial Statement Schedule EXHIBITS: The information required pursuant to Item 601 of Regulation S-K is incorporated by reference to the Exhibit Index of this Report REPORTS ON FORM 8-K: 1. Current Report on Form 8-K dated March 12, 1999 Reporting on Item 2 EXHIBIT INDEX Exhibit No. Description 2.1 Share Purchase Agreement between Unilabs Management Company, Ltd. as Seller, and EIBA "Eidgenoessische Bank" Beteiligungs und Finanzgesellschaft as Purchaser, dated January 17, 1997 (1) 2.2 Share Purchase Agreement between Unilabs Group Limited and Unilabs Management Company Ltd. and Banque Cantonale de Geneve, dated February 6, 1997 (1) 2.3 Share Purchase Agreement between Unilabs Group Limited and KK Trust AG., dated February 17, 1997 (1) 2.4 Share Purchase Agreement between Unilabs Group Limited and Unilabs Holdings SA, dated February 18, 1997(2) 2.5 Share Purchase Agreement between Unilabs Group Limited and Unilabs Holdings SA, dated March 13, 1997(2) 2.6 Underwriting Agreement between Unilabs SA and Union Bank of Switzerland, dated April 24, 1997(2) 2.7 Master Combination Agreement by and among NDA Clinical Trials Services, Inc. ("NDA"), certain NDA stockholders and Global Unilabs Clinical Trials, Ltd., dated as of January 31, 1997 (3) 2.8 Stock Purchase Agreement, dated as of July 23, 1996, between Morgan Stanley & Co., Incorporated and UniHolding Corporation (4) 2.9 Agreement by and among Unilabs Group Limited, Health Strategies Limited and Medical Diagnostic Management, Inc., dated as of May 23, 1997(2) 3.1 Amended Certificate of Incorporation of UniHolding Corporation (5) 3.2 Bylaws of UniHolding Corporation(2) 10.1 Memorandum of Agreement between Health Strategies Ltd. and Unilabs Group Ltd. (6) 10.2 Amended Stock Option Plan (6) 10.3 Lock-Up Agreement between Edgard Zwirn, Unilabs Holdings SA, UniHolding Corp., Unilabs Group Ltd., Unilabs SA and Union Bank of Switzerland, dated April 14, 1997(2) 16 Letter from Richard A. Eisner & Company, LLP, dated June 16, 1997 (7) 21 Subsidiaries of Registrant 27 Financial Data Schedule 99 Financial Statements Unilabs Group Limited - --------------- (1) Incorporated by reference to Current Report on Form 8-K dated February 20, 1997. (2) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year ended May 31, 1997. (3) Incorporated by reference to Current Report on Form 8-K dated January 31, 1997. (4) Incorporated by reference to Quarterly Report on Form 10-Q for the period ended August 31, 1996 (5) Incorporated by reference to Quarterly Report on Form 10-Q for the period ended November 30, 1996. (6) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year ended May 31, 1996 . (7) Incorporated by reference to Amended Current Report on Form 8-K/A dated May 30, 1997 SIGNATURES Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UniHolding Corporation Date: 2-15-00 By: /s/ Bruno Adam ----------------------------- Bruno Adam Treasurer/CFO Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By: /s/ Edgard Zwirn Date: 2-15-00 Edgard Zwirn CEO and Director By: /s/ Bruno Adam Date: 2-15-00 Bruno Adam CFO and Secretary By: /s/ Alessandra Van Gemerden Date: 2-15-00 Alessandra Van Gemerden Director By: /s/ Tobias Fenster Date: 2-15-00 Tobias Fenster Director By: /s/ Daniel Regolatti Date: 2-15-00 Daniel Regolatti Director By: /s/ Pierre-Alain Blum Date: 2-15-00 Pierre-Alain Blum Director

890093_1999.txt

890093_1999

1999

890093

ITEM 1. BUSINESS Forward-Looking Statements Information included in this Report on Form 10-K may constitute forward-looking statements that involve a number of risks and uncertainties. From time to time, information provided by the company or statements made by its employees may contain other forward-looking statements. Factors that could cause actual results to differ materially from the forward-looking statements include but are not limited to: Bankruptcy Court actions or proceedings related to the bankruptcy, general economic conditions including inflation, consumer debt levels, trade restrictions and interest rate fluctuations; competitive factors including pricing pressures, technological developments and products offered by competitors; inventory risks due to changes in market demand or the Company's business strategies; and changes in effective tax rates. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date made. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. General On February 14, 1997, the Company (which prior to such date was incorporated in Delaware under the name "Sports & Recreation, Inc.") was merged into a wholly owned subsidiary organized under Florida law. The purpose of such merger was to change the corporate domicile of the Company from Delaware to Florida. Also on February 14, 1997, the Company changed its corporate name from Sports & Recreation, Inc. to JumboSports Inc. JumboSports is a specialty retailer of quality name brand sporting equipment, athletic footwear and apparel, operating 42 big-box sporting goods superstores in 33 markets and 18 states. The Company began fiscal 1998 with 59 stores. In May 1998, the Company announced the closing of two stores and in August 1998, the Company opened two new stores. In January 1999, an additional 17 stores were identified to be closed during the first half of fiscal 1999. The Company's business strategy is to offer its customers the best overall value in sporting goods through a wide assortment of quality name brand merchandise, superior customer service and competitive prices. The Company's stores average approximately 48,000 gross square feet. JumboSports has located stores in Standard Metropolitan Statistical Areas with populations as small as 200,000 and as large as 3,000,000. As of January 29, 1999, the Company employed approximately 2,300 people. None of the Company's associates are covered by collective bargaining agreements. The Company believes that its relationships with its associates are good. The Company's merchandising strategy is to offer both breadth and depth of selection in quality name brand sporting goods in each of its product categories. Each store offers approximately 70,000 stock keeping units ("SKUs") across 23 major departments and over 200 subdepartments. The Company's target customer ranges from the frequent sports enthusiast to the casual sporting goods customer. The sporting goods retail business is seasonal in nature with the fourth quarter (Christmas selling season) representing approximately 28% of sales for a JumboSports store that is open for the entire year. The average maturity and geographic dispersion of the Company's store base may impact this percentage in the future. The Company operates in one business segment. See Item 6, Selected Financial Data, for financial information. Chapter 11 On December 27, 1998 (the "Petition Date"), after experiencing a poor holiday season and with increased pressure being applied by the Company's lenders and suppliers, JumboSports Inc. and certain of its subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Middle District of Florida (the "Bankruptcy Court"). These related proceedings are being jointly administered under the caption "In re.: JumboSports Inc., d/b/a Vacations Travel, f/k/a Sports & Recreation, Inc., and f/d/b/a/ Sports Unlimited, Guide Series, Inc. and Property Holdings Company I" Case Nos. 98-22545-8C1, 98-22546-8C1 and 98-22547-8C1, pursuant to an order of the Bankruptcy Court. The following subsidiaries were not included in the bankruptcy filings: Nationwide Team Sales, Inc., Retail Process Management, Inc., Sports & Recreation, Inc., Sports & Recreation Holdings of PA, Inc. and Construction Resolution, Inc. The bankruptcy petitions were filed in order to preserve cash and permit the Company an opportunity to reorganize while working to restructure its indebtedness. Pursuant to the Senior-Secured Super Priority Debtor-In-Possession Loan and Security Agreement (the "DIP facility") dated February 12, 1999, among JumboSports Inc., as Borrower, various financial institutions, as Lenders, Foothill Capital Corporation, as Agent and Congress Financial Corporation (Southern), as Co-Agent, the lenders have agreed to provide up to $110 million in post-petition financing to the Company. As a result of the Chapter 11 filings, absent approval of the Bankruptcy Court, the Company is prohibited from paying, and creditors are prohibited from attempting to collect claims or debts arising pre-petition. The consummation of a plan of reorganization is the principal objective of the Company's Chapter 11 cases. The plan of reorganization will set forth the means for satisfying claims, including the liabilities subject to compromise, and interests in the Company and its debtor subsidiaries. The consummation of a plan of reorganization for the Company and its debtor subsidiaries will require approval of the Bankruptcy Court. The Company expects to propose a plan of reorganization for itself and the other filing subsidiaries. The Bankruptcy Court has granted the Company's request to extend its exclusive right to file a plan of reorganization through June 1, 1999. The Company intends to request a further extension of the exclusivity period while management works on implementing new operating strategies that are intended to improve operating performance. There can be no assurance that the Bankruptcy Court will grant such further extension or that management's new strategies will produce the desired results. After the expiration of the exclusivity period, creditors of the Company have the right to propose their own plans of reorganization. A plan of reorganization, among other things, may result in material dilution or elimination of the equity of existing stockholders as a result of the issuance of equity to creditors or new investors. At this time, it is not possible to predict the outcome of the Chapter 11 filing, in general, or its effects on the business of the Company or on the interests of creditors or stockholders. The Company's independent accountants have issued a report expressing doubt about the Company's ability to continue as a going concern. See the Consolidated Financial Statements of the Company beginning on page. The Company does not plan to hold annual stockholder meetings during the pendency of its Chapter 11 case. Store Closings Since January 31, 1997, when the Company operated 85 stores, two new stores have opened and 45 stores have closed. The remaining 42 open stores are cash contributors and have generally been profitable. The financial performance of these remaining stores will be reviewed on a continuing basis and additional stores may be closed, with the approval of the Bankruptcy Court, if such closings are warranted. When a store is closed, the inventory is liquidated and the proceeds are used to pay down the Company's revolving credit line. If the store is owned in fee, the real estate is marketed. The proceeds from the sale of the real estate was used to further reduce debt, and consequently future debt service requirements and interest expense. If the store is leased, the lease is marketed during the stores' going out of business period and any proceeds from the sale of the lease are used to reduce debt. If no market exists for the lease, the lease is rejected to minimize cash obligations on the Company. New Management On April 13, 1999, with the support of the official committees of bondholders and unsecured creditors, the Bankruptcy Court approved the appointment of Alfred F. Fasola, Jr. as Chief Executive Officer and Michael J. Worrall as President, replacing Jack E. Bush. Mr. Bush will continue to serve as Chairman of the Board. Both Mr. Fasola and Mr. Worrall have years of experience in challenging turnaround situations and extensive knowledge of the retail sporting goods industry. Along with B. Robert Floum, Chief Operating Officer, the new management team is expected to implement major new initiatives as part of the Company's reorganization efforts. Industry and Competition While JumboSports' competition differs by market, management generally classifies its competition within one of the following categories: TRADITIONAL AND SPECIALTY SPORTING GOODS RETAILERS. This category includes traditional sporting goods chains (e.g., Dunham's, MC Sports), specialty sports stores (e.g., Foot Locker, Just for Feet, Champs) and local sporting goods retailers (e.g., local independent stores, pro shops). These stores typically range in size from the small 1,000 square foot pro shops to the larger 20,000 square foot traditional sporting goods chains and footwear retailers. The traditional and specialty sporting goods retailers are primarily located in regional malls, strip shopping centers, local country clubs and resorts. The traditional chains and local sporting goods stores typically carry a varied assortment of merchandise; however, the size of their stores limits the breadth and depth of selection. The specialty stores and pro shops often carry a wide assortment of one specific product category, such as athletic shoes, fishing gear, golf or tennis equipment. MASS MERCHANDISERS. This category includes discount stores (e.g., Wal-Mart, Kmart, Target) and department stores (e.g., Sears, J.C. Penney). These stores range in size from approximately 50,000 to 200,000 square feet and are primarily located in regional malls and strip shopping centers in markets across the country. Sporting goods merchandise and apparel represent only a portion of the total merchandise sales in these stores and generally reflect a more limited selection with fewer high quality name brands. BIG-BOX SPORTING GOODS CHAINS. This category includes the "category killer" sporting goods retailers (e.g. The Sports Authority, Oshman's Superstores, Gart Sports) more directly comparable to JumboSports. The big-box stores range in size from 35,000 to 100,000 square feet and offer a selection of sporting goods merchandise and apparel of 40,000 to 70,000 SKUs. These stores compete on selection and depth of high quality merchandise and on the basis of price; certain operators are able to attract higher-end brands not carried by other competitive channels of distribution. The Company believes that although its sales are impacted by retailers in all three of the categories referred to above, the most significant competition comes from the big-box sporting goods retailers. Of the Company's stores, approximately six do not presently face competition from such big-box sporting goods retailers. Management expects it will continue to face additional competition in its markets from big-box stores over the next few years. The Company purchases merchandise from over 1,000 vendors. In fiscal 1998, the 100 highest volume vendors represented over 70% of total merchandise purchased. Nike, Inc., the Company's largest vendor, accounted for 8.7% of total merchandise purchased. The Company does not maintain any long-term or exclusive commitments or arrangements to purchase from any vendor. The Company is one of the largest customers for many of its vendors. Environmental Compliance with federal, state and local environmental laws and regulations has not had, and is not expected to have, a material effect on the capital expenditures, earnings and competitive position of the Company. ITEM 2. ITEM 2. PROPERTIES. As of January 29, 1999, the Company operated 59 retail stores of which 17 are scheduled to close in April 1999. These 17 closing stores operate in 12 states (1 in Arizona, 1 in Colorado, 4 in Florida, 1 in Georgia, 1 in Iowa, 1 in Illinois, 1 in Indiana, 1 in Louisiana, 1 in North Carolina, 1 in Ohio, 3 in Tennessee and 1 in Virginia). The remaining 42 stores operate in 18 states (2 in Alabama, 1 in Arkansas, 2 in Colorado, 1 in Delaware, 7 in Florida, 1 in Iowa, 1 in Kansas, 3 in Kentucky, 4 in Louisiana, 1 in Mississippi, 2 in Nebraska, 1 in Nevada, 3 in North Carolina, 3 in Oklahoma, 3 in South Carolina, 2 in Tennessee, 3 in Texas and 2 in Virginia) and its Corporate Headquarters are located in Tampa, Florida. The Company owns the beneficial interest in 24 stores and leases the other 18 of its remaining 42 retail stores. The primary lease terms are for 10 to 20 years, with options to renew ranging from two to four additional five-year terms. Two of the leases are treated for accounting purposes as capital leases. Additionally, as of January 29, 1999, the Company had sixteen properties held for sale and twelve leases on stores closed or scheduled to be closed. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is from time to time involved in routine litigation incidental to the conduct of its business. The Company believes that no such currently pending routine litigation to which it is a party will have a material adverse effect on its financial condition or results of operations. On Sunday, December 27, 1998, JumboSports Inc. and certain of its subsidiaries filed for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Middle District of Florida. These related proceedings are being jointly administered under the caption "In re.: JumboSports Inc., d/b/a/ Vacations Travel, f/k/a Sports & Recreation, Inc., and f/d/b/a Sports Unlimited, Guide Series, Inc. and Property Holdings Company I", Case Nos 98-22545-8C1, 98-22546-8C1 and 98-22547-8C1. The following subsidiaries were not included in the bankruptcy filings: Nationwide Team Sales, Inc., Retail Process Management, Inc., Sports & Recreation, Inc., Sports & Recreation Holdings of PA, Inc. and Construction Resolution, Inc. In connection with the Bankruptcy filing, all pre-petition actions against the Company have been stayed. A complaint was filed on March 23, 1999, in the Bankruptcy Court, "LaSalle National Bank, Trustee for JP Morgan Commercial Mortgage Finance Corporation Pass-through Certificate Series 1997-C5, acting by and through AMRESCO Management, Inc., its Special Servicer v. JumboSports Inc., which alleges that JumboSports did not have the right to terminate certain Trusts of which JumboSports was the sole beneficiary and sole settlor. The Trusts held bare legal title to real estate ("the Property") and pledged the Property as security for loans. The plaintiff is seeking a judicial declaration that the Property in question is not property of JumboSports, the Debtor's estate, and that the Plaintiff may proceed against the Property as if it were not property of the Debtor's estate. The Plaintiff further seeks a judicial declaration that the Trusts are separate legal entities, that the Trusts have not been terminated, that the termination is not valid, that there is no right to terminate the Trusts except in accordance with applicable Delaware law, the Trust Agreements, and the relevant loan documents and that there has been no transfer of the Property to the Debtor. Management is currently unable to predict the outcome of this case or the impact of an adverse ruling on its reorganization efforts. The Company expects to file its written responses and any claim for affirmative relief by April 30, 1999. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. On December 28, 1998, the New York Stock Exchange suspended trading in the Company's Common Stock and on February 22, 1999, the SEC delisted the Company's Common Stock. Subsequent to December 28, 1998, the Company's Common Stock has been traded on the "OTC Bulletin Board" under the symbol "JSIBQ". Prior to December 28, 1998, the Company's Common Stock was traded on the New York Stock Exchange under the symbol "JSI" and prior to February 20, 1997, the stock was traded under the symbol "WON". The following table reflects the range of high and low selling prices of the Company's Common Stock by quarter over the past two fiscal years. Fiscal 1997 High Low ----------- ---- ---- First Quarter 6.750 4.375 Second Quarter 4.875 2.750 Third Quarter 4.063 3.000 Fourth Quarter 3.250 1.000 Fiscal 1998 High Low ------------ ---- ---- First Quarter 2.063 1.250 Second Quarter 1.750 0.938 Third Quarter 1.063 0.250 Fourth Quarter 0.500 0.020 The Company did not pay any dividends during the last two fiscal years (see Management's Discussion & Analysis - Liquidity and Capital Resources regarding dividend prohibitions). The approximate number of stockholders of record as of January 29, 1999 was 422, and as of that date, the Company estimates that there were approximately 7,128 beneficial owners holding stock in nominee or "street" name. In connection with their respective employment agreements, and pursuant to the terms thereof, during fiscal year 1996 the Company loaned $166,667, $137,500 and $30,250 to each of Messrs. Bebis (former Chairman, President and Chief Executive Officer), Springer and Henning, respectively, to assist them with the purchase of non-registered shares of the Company's Common Stock. Mr. Bebis resigned in December 1997, and as part of his termination agreement the Company agreed to file a registration statement in order to register his shares. In lieu of incurring the expense of registering Mr. Bebis' shares, the Company accepted the shares, valued at the closing price 90 days after Mr. Bebis' date of termination, plus cash in satisfaction of the outstanding loan balance. The shares were then canceled. On February 17, 1998 the Company re-priced all options outstanding at January 30, 1998 for active employees to an exercise price of $1.8125, the market closing price on that date. The number of options this impacted was 876,221 with previous market valued prices ranging from $3.44 to $26.08. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AND SELECTED OPERATING DATA) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General The notes to the consolidated financial statements are an integral part of Management's Discussion and Analysis of Financial Condition and Results of Operation. This Management's Discussion and Analysis contains forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting certain future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements. These factors include, but are not limited to, product demand and market acceptance risks, the effect of economic conditions generally, the impact of competition, commercialization and technological difficulties and the condition of the retail and sporting goods industries. On December 27, 1998, JumboSports Inc. and certain of its subsidiaries filed petitions for reorganization under Chapter 11 of the United States Bankruptcy Code and are presently operating as debtors-in-possession subject to the jurisdiction of the Untied States Bankruptcy Court for the Middle District of Florida. For further discussion of Chapter 11 proceedings, see Item 1 "Chapter 11" and Note 1 to the consolidated financial statements. Results of Operations The following table sets forth certain data as a percentage of sales for the periods indicated: In the second fiscal quarter of fiscal 1998, the Company recorded a $15.2 million charge (4.2% of sales) for the loss on disposition of assets and closed store expenses. The components are as follows (in millions): Loss on disposition of assets and closed store expenses: Loss on disposition of real estate $ 8.6 Loss on disposals of closed store fixtures and equipment 2.9 Closed store expenses 3.7 ----- Total $15.2 ===== The $8.6 million loss on disposition of real estate represents the loss on sale of 16 properties comprised of closed stores and excess parcels. The $2.9 million loss on disposal of closed store fixtures relates to the excess loss on the disposition of the 28 stores closed since 1997. Both the loss on real estate and loss on closed store fixtures did not result in cash payments. The $3.7 million charge for closed store expenses relates primarily to the loss on inventory and expenses of two closed stores which closed during the second quarter of 1998, located in the Texas cities of San Antonio and El Paso. The balance relates to additional charges for prior closed store lease and severance reserves. These charges may result in future cash payments. As a result of the Chapter 11 filings, the Company has recorded the following reorganizational charges (in millions): Loss on disposition of real estate $24.4 Loss on disposals of closed store fixtures and equipment 6.4 Closed store expenses 8.9 Lease rejection damages 9.1 Restructuring charges 7.8 Retention and severance pay 1.8 ----- Total $58.4 ===== The $24.4 million loss on disposition of real estate represents the write-down to net realizable value of the eight closing store properties held in fee, the write-off of leasehold improvements on the 9 closing store properties held under lease and certain other capitalized and deferred costs. The $6.4 million loss on disposals of closed stores fixtures and equipment represents the write-down to net realizable value of fixtures and equipment of the 17 closing stores. Both the loss on the real estate and the loss on the fixtures and equipment will not result in cash payments. The $8.9 million charge for closed store expenses relates primarily to the loss on inventory ($7.0 million) and the expenses to be incurred in the 17 closing stores during the going out of business sales ($1.9 million). The $7.8 million restructuring charges include legal and professional fees incurred or paid prior to the petition date, the write-off of loan costs previously incurred in connection with the Company's pre-petition working capital facility, certain capitalized inventory costs, and uncollectible receivables from vendors. Certain leases on equipment and real estate will be rejected or modified in connection with the Company's efforts to reorganize. The $9.1 million of lease rejection damages is the Company's current estimate of expected loss associated with the rejection of these leases. A $1.8 million charge was recorded to recognize certain retention payments and severance pay in connection with the Company's initiatives. Of the $58.4 million, $2.0 million was paid in cash in FY 1998, and up to an additional $4.5 million may result in future cash payments. The remainder of the charges is non-cash. The following represents reserve amounts created by the $58.4 million of reorganization items (in millions): Loss on disposition of real estate $ 0.6 Closed store expenses 8.9 Restructuring charges 2.5 Retention and severance pay 1.3 ----- Total $13.3 ===== In the third and fourth quarters of fiscal 1997, the Company recorded non-recurring charges related to store closings, excess and slow moving inventory, severance, outdated technology and the write-off of debt costs in connection with the Company's revolving line of credit. The components are as follows (in millions): Cost of Sales: Mark-down of slow moving and excess inventory $17.9 Additional shrinkage 9.5 Write-down for inventory liquidation of closing stores 17.6 ----- 45.0 Non-recurring and other charges: Charges related to store closings 40.0 Other charges 4.0 ----- 44.0 Interest: Write-off of deferred debt costs 5.3 ----- Total $94.3 ===== The markdown of excess inventory of $17.9 million was taken to correctly state the value of merchandise at the lower of cost or market. The primary cause for this charge was due to problems experienced in athletic footwear and apparel; both categories were impacted by distribution problems, overly aggressive purchasing and soft sales. The Company took physical inventories in each of its stores at year-end. Throughout the year, management had estimated shrinkage at 2.2% of sales. This estimate was based on the prior year's actual shrinkage of 2.8% and the industry average of 1.5%. The year-end physical inventories resulted in a total shrinkage of 4.0% or approximately 1.8% above the accrual. The additional shrinkage is believed to be primarily attributable to implementation issues in connection with the new merchandising systems and problems encountered with the Company's new distribution facility. In February 1997, the Company changed its inventory distribution method and inventory systems. The Company transitioned the majority of merchandise flow from direct delivery to stores, to a third-party managed cross dock facility. The initial start-up of the cross dock facility caused significant product delays. Because of these delays, the Company experienced lost inventory, poor sales and overstocks, resulting in higher shrinkage and increased markdowns to alleviate seasonal and fashion oriented inventory levels. In October 1997, the Company terminated its relationship with the third-party distribution manager and returned to a merchandise flow direct to the Company's stores. By fiscal year end, inventory levels returned to normal, and the Company expects gross margins to return to historical levels in fiscal 1998. The Company installed new financial and inventory systems to enhance inventory control information and support the existing and future corporate infrastructure. As with any new system, conversion issues arose, but the issues were timely corrected. The new systems gave the Company real-time information to manage and control inventory levels. Many of the aforementioned causes have been addressed and management is focused on reducing and controlling shrinkage during fiscal 1998. Additionally, the Company will be taking physical inventories throughout the year to better estimate the proper shrinkage accrual. The Company recorded the inventory write-down of $17.6 million for store closings inventory liquidation based on the net realizable value of liquidating inventory at 26 stores anticipated to close from January 1998 through May 1998. The establishment of the aforementioned reserves did not result in additional cash payments in fiscal 1997. The $40.0 million of charges related to store closings represent the establishment of reserves of $29.1 million for the write-down of closed stores' property and equipment to net realizable value, $6.7 million for expenses attributable to the closing stores and $4.2 million for lease reserves at closing locations. The establishment of these reserves did not result in additional cash payments in fiscal 1997, but resulted in payments of $7.5 million in fiscal 1998. Other charges of $4.0 million are for severance agreements attributable to the administrative and management workforce reductions in January 1998, the establishment of reserves for outdated information communications technology and other miscellaneous charges. Cash payments of $0.5 million were made in fiscal 1997 and $2.5 million of cash payments were made in fiscal 1998. The Company accelerated the write-off of deferred debt costs in connection with the renegotiation of the Company's credit facility in the amount of $5.3 million. The deferred debt costs were loan fees and legal costs associated with the Company's former $185.0 million revolving credit facility which was revised on January 30, 1998, and subsequently refinanced. The write-off of deferred debt costs were for cash payments of $3.0 million in fiscal 1997, $1.0 million in non-cash payments and an additional $1.3 million for cash payments to be made in fiscal 1998. The following represents reserve accounts created by the $55.0 million in charges recorded in 1996, the $94.3 million in charges recorded in 1997 and the $15.2 million in charges in 1998 are as follows (in thousands): Fiscal 1998 Compared with Fiscal 1997 The Company began fiscal 1998 with 59 stores; two stores were closed in the second fiscal quarter and two stores opened in the third fiscal quarter. The Company ended the fiscal year with 59 stores. During the fourth fiscal quarter, the Company announced the closing of 17 stores. These 17 stores will run going out of business sales and close in late April, 1999. Sales for fiscal 1998 decreased 31.4% to $362.4 million compared with sales of $528.6 million in the prior year. The majority of the sales decline is due to fewer stores in operation. Same store sales decreased by 12.4% for the fiscal year. Same store sales were adversely affected by the following: 1. Poor sales trends were experienced throughout the retail sporting goods industry as a result of the lack of new exciting product, unfavorable weather conditions, changing consumer preferences and lower average price points caused by heavy discounting. 2. Apparel sales on a same store basis were off 23.8%, with the biggest declines occurring in licensed apparel and outerwear. License apparel is driven by a number of factors including team uniform changes, the location of league champions and professional sports labor disputes. The NBA lockout, for example, has adversely impacted sales of NBA licensed product. Outerwear sales are driven by weather conditions. An unseasonably warm fall adversely affected sales and led to heavy discounting. 3. Footwear sales were down 20.9% due to a general decline in the athletic footwear category industry wide. Heavy discounting by the footwear specialty retailers also contributed to the Company's sales declines. Due to the Company's weakened financial condition, the Company could not take advantage of manufacturer close-out merchandise which fueled the sales by the specialty stores and the better capitalized big-box competitors. 4. Tennis and golf continued poor sales trends as reported by most retailers. The Company's golf offering is limited to mostly entry-level brands and its own controlled label. Famous names such as Ping, Taylor Made and Cobra are not made available to the Company by manufacturers. Gross profit for the year was $80.1 million, or 22.1% of sales as compared to $75.1 million or 14.2% of sales in the prior year. This year's gross profit percentage reflects a 0.85% inventory shrinkage whereas last year's inventory shrinkage totaled 4.0% of sales. In the prior year, the Company recorded a $45 million inventory write down, or 8.5% of sales, related to slow moving athletic footwear and apparel, excess shrinkage and the inventory liquidation of closing stores. Selling, general and administrative expenses for the fiscal year were $78.9 million, or 21.8% of sales, compared to $112.5 million, or 21.3% of sales, in the prior year. The increase as a percentage of sales was due to lower sales volume leverage on general and administrative expenses and certain operational expenses. Store payroll expense improved 110 basis points versus last year and advertising expense was 34 basis points less than last year. During the third quarter of the fiscal year, the Company recorded $1.0 million of income for the settlement of legal proceedings. Due to the size and nature of this settlement, the amount has been separately stated on the Company's financial statements. In the second quarter of fiscal 1998, the Company recorded a $15.2 million charge for the loss on disposition of assets and closed store expenses. The components are as follows (in millions): Loss on disposition of assets and closed store expenses: Loss on disposition of real estate $ 8.6 Loss on disposals of closed store fixtures and equipment 2.9 Closed store expenses 3.7 ----- Total $15.2 ===== The $8.6 million loss on disposition of real estate represents the loss on sale of 16 properties comprised of closed stores and excess parcels. The $2.9 million loss on disposal of closed store fixtures relates to the excess loss on the disposition of the 28 stores closed since 1997. Both the loss on real estate and loss on closed store fixtures did not result in cash payments. The $3.7 million charge for closed store expenses relates primarily to the loss on inventory and expenses of two closed stores which closed during the second quarter of 1998, located in the Texas cities of San Antonio and El Paso. The balance relates to additional charges for prior closed store lease and severance reserves. These charges may result in future cash payments. Loss from operations was $13.0 million, or 3.6% of sales in fiscal 1998 as compared to loss from operations of $80.4 million or 15.2% of sales in fiscal 1997. The loss in the current year is primarily attributable to the $15.2 million charge taken in the second quarter. The loss in the prior year is primarily attributable to $89.0 million in charges taken in the third and fourth quarters. Interest expense for fiscal 1998 was $22.4 million, or 6.2% of sales compared to $30.4 million, or 5.8% of sales for the prior fiscal year. The decrease in interest expense relates primarily to a reduction in average debt outstanding due to the liquidation of closed store inventory and the sale of closed store and excess real estate. Average interest rates in fiscal 1998 were up 20 basis points over the prior year. No interest on the convertible subordinated notes was accrued after the petition date. Reorganization items represent charges incurred by the Company as part of its Chapter 11 reorganization. The components are as follows (in millions): Loss on disposition of real estate $24.4 Loss on disposals of closed store fixtures and equipment 6.4 Closed store expenses 8.9 Lease rejection damages 9.1 Restructuring charges 7.8 Retention and severance pay 1.8 ----- Total $58.4 ===== The $24.4 million loss on disposition of real estate represents the write-down to net realizable value of the eight closing store properties held in fee, the write-off of leasehold improvements on the 9 closing store properties held under lease and certain other capitalized and deferred costs. The $6.4 million loss on disposals of closed stores fixtures and equipment represents the write-down to net realizable value of fixtures and equipment of the 17 closing stores. Both the loss on the real estate and the loss on the fixtures and equipment will not result in cash payments. The $8.9 million charge for closed store expenses relates primarily to the loss on inventory ($7.0 million) and the expenses to be incurred in the 17 closing stores during the going out of business sales ($1.9 million). The $7.8 million restructuring charges include legal and professional fees incurred or paid prior to the petition date, the write-off of loan costs previously incurred in connection with the Company's pre-petition working capital facility, certain capitalized inventory costs, and uncollectible receivables from vendors. Certain leases on equipment and real estate will be rejected or modified in connection with the Company's efforts to reorganize. The $9.1 million of lease rejection damages is the Company's current estimate of expected loss associated with the rejection of these leases. A $1.8 million charge was recorded to recognize certain retention payments and severance pay in connection with the Company's initiatives. Of the $58.4 million, $2.0 million was paid in cash in FY 1998, and up to an additional $4.5 million may result in future cash payments. The remainder of the charges is non-cash. For fiscal 1998 the Company recorded a $163 thousand tax benefit related to certain tax carrybacks. In fiscal 1997 the Company recorded a $483 thousand tax expense as a result of writing off a deferred tax asset that had been recorded in the prior year. In the current fiscal year, the Company posted a net loss of $93.5 million, or 25.8% or sales, compared to a net loss of $111.3 million, or 21.1% of sales in the prior fiscal year. The net loss for the current year is primarily attributable to the $15.2 million loss recorded on disposition of assets, closed stores expenses and non-recurring charges and the $58.4 million in reorganization items. In the prior year, the net loss was attributable to the $94.3 million of charges for store closings, inventory write-downs and other charges. As part of its Chapter 11 reorganization efforts, management is developing a plan to reorganize and return the Company to profitability. Seventeen unprofitable stores have been closed and expenses reduced accordingly. Sales continue to present the biggest opportunity for management. Proper in-stock levels as well as better presentation of merchandise are believed to be key components to improving sales. Additionally, associates will be trained on improving their customer service skills and sales productivity. The Company believes that the sale of real estate that is held for sale will reduce debt and interest expense, although the precise amount that will be available to reduce debt will depend upon the interpretation and enforceability of contractual provisions in various mortgages. Prior to Petition Date, the Company negotiated prepayment premiums of approximately 5% on certain parcels of real estate which were subject to mortgages containing similar contractual provisions. An adverse judicial determination finding the contractual formula to be enforceable would cause the Company to reassess its real estate marketing program. Fiscal 1997 Compared with Fiscal 1996 During fiscal 1997, the Company announced the closing of 26 stores in 13 states as compared to opening five new stores with no store closings in fiscal 1996. The Company operated 85 stores for three fiscal quarters and 77 stores for one fiscal quarter, ending fiscal 1997 with 77 operating stores. Sales for fiscal 1997 decreased 15.3% to $528.6 million compared with sales of $624.0 million in the prior year. Same store sales decreased by 14.3% for fiscal 1997. While these same store sales were unfavorable, management believes they are not truly comparable because sales in the prior year were bolstered by the 1996 inventory clearance sale the Company started in June 1996 and continued through November 1996 and the additional five days of sales in fiscal 1996, fiscal 1996 being a 52 week and five day period. Sales below cost incurred during the inventory clearance sale were $32.8 million which represents 5.3% of the prior years sales and the additional five days sales totaled $3.5 million. Adjusting same store sales in the prior year for the below cost clearance sale and the five additional days of sales in fiscal 1996, results in a comparable sales decrease of 8.8%. Sales have been adversely impacted by the following: 1. New merchandise management systems, installed at the beginning of the fiscal year, caused significant disruptions in merchandise flow due to problems encountered in receiving and making product ready to sell at the store level; 2. Operational problems with the Company's distribution center during the first eight months of the year caused substantial delays in the flow of merchandise creating out of stock conditions for basic merchandise and late arrivals of seasonal merchandise; 3. Certain merchandise categories were further affected. Outerwear sales were lower due to less clearance sales than in the prior year. Fitness was lower due to fewer new "informercial"-driven product introductions. The footwear category was affected due to the declining in-line skate business and general softness in the athletic footwear industry; 4. Sales were generally soft throughout the sporting goods retail segment, partially as a result of comparisons against last year's Olympic merchandise sales and last year's increased foot traffic due to the Olympics; and 5. Competition continued to increase. Thirty-four additional stores this year were affected by new big-box competitors which have opened since the beginning of the prior year. Gross profit for fiscal 1997 was $75.1 million, or 14.2% of sales, as compared to $119.0 million, or 19.1% of sales in fiscal 1996. The Company incurred a $45.0 million inventory write-down charge, or 8.5% of sales related primarily to slow moving athletic footwear and apparel, excess shrinkage and the inventory liquidation in connection with the closing of 26 stores. In the prior year, the Company took a charge of $32.4 million, or 5.2% of sales, to recognize the loss on outdated and discontinued product. The remaining decrease was attributable to higher buying and occupancy costs as a percentage of sales. Selling, general and administrative expenses for the fiscal year were $112.5 million, or 21.3% of sales, compared to $124.9 million, or 20.0% of sales, in the prior year. The increase as a percentage of sales was due to lower sales volume leverage on fixed costs and certain higher operating costs. Payroll expense as a percentage of sales was up 29 basis points due to the in-store problems encountered by the introduction of the new merchandise information systems as well as problems experienced in the implementation of the new distribution center; also a higher average wage resulted from the "ripple-effect" of the minimum wage increase and a generally tighter labor market. Advertising expense as a percentage of sales was up 121 basis points, due to additional expenditures for radio and television advertising, newspaper advertising and the multi-paged advertising books in connection with the corporate name change. In addition to the $45.0 million inventory charge, the Company incurred $43.0 million of non-recurring charges, or 8.1% of sales, in the current year's third and fourth fiscal quarters for charges as discussed above. In the second quarter of the prior year, the Company recorded a $22.6 million charge, or 3.7% of sales for the disposition of and impairment of underperforming assets, for certain loss contingencies and other charges. Loss from operations in fiscal 1997 was $80.4 million or (15.2)% of sales, compared to a loss from operations of $28.5 million, or (4.6)% of sales in fiscal 1996. The loss in the current year was primarily attributable to $89.0 million in charges taken in the third and fourth quarters. The loss in the prior year was primarily attributable to the $55.0 million in charges taken in the second fiscal quarter. Interest expense for fiscal 1997 was $30.4 million, or 5.8% of sales, compared to $19.9 million, or 3.2% of sales for the prior fiscal year. This increase in interest expense was the result of the following: 1. Average debt increased due to refinancing the $58.0 million off balance sheet Tax Retention Operating Lease facility into the revolving credit facility and higher average inventory levels; 2. The re-negotiated existing credit facility called for borrowings at LIBOR plus 2% (beginning May 29, 1996) and 3.0% (beginning December 15, 1997) contributing to an overall 81 basis point increase in average interest rates; and 3. The accelerated write-off of $5.3 million in deferred financing costs in connection with the re-negotiation of the Company's existing credit facility. The Company had $100 million of interest rate collars which impacted interest expense by $15 thousand and $48 thousand, in fiscal 1996 and fiscal 1997, respectively. The Company recorded an income tax expense of $0.5 million in fiscal 1997, the result of writing off the deferred tax asset recorded in the prior year. In fiscal 1996, the Company recorded an income tax benefit of $17.9 million with an effective tax rate of 36.9%. In fiscal 1997, the Company posted a net loss of $111.3 million, or (21.1)% of sales, compared to a net loss of $30.5 million, or (4.9)% of sales for the prior fiscal year. The net loss for the fiscal year was primarily attributable to the $94.3 million of charges for store closings, inventory write-downs and other charges incurred in the third and fourth fiscal quarters with no federal income tax benefit, resulting in the full amount as a charge after tax. In the prior year, the net loss was attributable to the $55.0 million charge for inventory, non-recurring and other items incurred in the second quarter of the prior year reduced by a federal income tax benefit, resulting in a net charge after tax of $34.6 million. Liquidity and Capital Resources The Company's primary capital requirements have been to support capital investment for the opening of new stores, to purchase inventory for new stores, to meet seasonal working capital needs, and to retire indebtedness. The Company's working capital needs have been funded through a combination of external financing (including long-term debt and proceeds from the Company's IPO in 1992, proceeds from the issuance of 4 1/4% Convertible Subordinated Notes in 1993, proceeds from a two million share stock offering in 1994 and mortgage proceeds in 1996 and 1997), internally generated funds and credit terms from vendors. Historically, the Company's working capital needs peak in the fourth quarter. During fiscal 1998, the Company completed the sale of 30 properties totaling $77.1 million. Proceeds were used to reduce bank debt and retire mortgage loans. During fiscal 1997, the Company sold seven properties totaling $5.1 million. Proceeds were used to reduce bank debt. At end of fiscal 1998, the Company had 16 properties with an estimated value of $54.0 million held for sale. Eight of the 16 properties worth an estimated $26.8 million, were under contract or letter of intent to be sold. With the filing of the bankruptcy these sales were subject to Bankruptcy Court approval. Two of these contracts have been approved and one of the two sales has closed. The proceeds from the sale was used to reduce the DIP facility term loans consequently lowing future interest expense and debt service requirements. Sales of the remaining properties, if approved by Bankruptcy Court, will be used to reduce the DIP facility term loans and mortgage debt (assuming the non-enforceability of the yield maintenance provision and pre-payment penalties in certain of the mortgages secured by such properties). Operating activities in fiscal 1998 provided cash of $28.4 million compared to a cash use of $34.5 million in fiscal 1997. An orderly reduction in inventory levels in open stores plus the liquidation of inventory in the 18 stores (net) that closed during fiscal 1998 provided the majority of the cash. In fiscal 1997, excess merchandise purchases resulting from implementation issues with the Company's new merchandising system and third party distribution facility caused unplanned inventory increases and a high use of cash. Net cash of $71.1 million was provided by investing activities during fiscal 1998 compared to a net cash use of $6.0 million in fiscal 1997. Cash proceeds from the sale of property in fiscal 1998 were $77.1 million compared to $5.1 million in fiscal 1997. Cash used in financing activities was $76.0 million in fiscal 1998 compared to $35.9 million of cash provided by financing activities in fiscal 1997. In fiscal 1998 the Company repaid debt from the sale of property and the liquidation of inventory. In fiscal 1997 the Company borrowed on its working capital facility to finance inventory increases. As of January 29, 1999, the Company had $67.1 million of long-term mortgage obligations, $98.9 million of borrowings under its revolving line of credit and $18.5 million of borrowings on its term loan. Both the revolving line of credit and the term loan are components of the Company's $150 million credit facility which was completed on July 24, 1998. On December 27, 1998 the Company and certain of its subsidiaries filed petitions for reorganization under Chapter 11 of the Bankruptcy Code. Thereafter, no additional amounts were drawn under the credit facility agreement. Temporary usage of cash collateral was permitted by the Bankruptcy Court through February 12, 1999. On February 11, 1999, the Company and its lenders agreed to a $110 million Senior Secured Super Priority Debtor-In-Possession Loan and Security Agreement (the "DIP facility"). The DIP facility contains customary events of default and a number of covenants, including restrictions on liens and sales of assets, prohibition on dividends and certain changes in control. There are two financial covenants. As of April 30, 1999, the Company was in compliance with all the DIP facility covenants. The DIP facility bears interest on revolving loans at the Company's option, at the Reference Rate plus 0.5% or at LIBOR plus 2.75%. Also as of January 29, 1999, the Company had $137.4 million of liabilities subject to compromise. These liabilities relate to debt incurred or existing prior to the petition date and are subject to settlement under terms of a plan of reorganization. The inventory liquidation of 17 stores during the first quarter of fiscal 1999 and the proceeds from the sale of property held for sale are expected to provide cash for the repayment of secured debt. This repayment should materially reduce the Company's interest expense in future periods. The Company is not accruing interest on its $74.5 million of convertible subordinated notes during the pendency of its Chapter 11 case. Year 2000 Compliance Introduction The "Year 2000 Problem" arose because many existing computer programs use only the last two digits to refer to a year. Therefore, these computer programs do not properly recognize a year that begins with "20" instead of the familiar "19." If not corrected, many computer applications could fail or create erroneous results. The problems created by using abbreviated dates appear in hardware, operating systems and other software programs. The Company's Year 2000 ("Y2K") compliance project is intended to determine the readiness of the Company's business for the Year 2000. The Company defines Y2K "compliance" to mean that the computer code will process all defined future dates properly and give accurate results. Description of Areas of Impact and Risk The Company has identified three areas where the Y2K problem creates risk to the Company. These areas are: a) internal Information Technology ("IT") systems; b) non-IT systems with embedded chip technology; and c) system capabilities of third party businesses with relationships with the Company, including product suppliers, service providers (such as credit card processors, telephone, power, security systems, payroll processing) and other businesses whose failure to be Y2K compliant could have a material adverse effect on the Company's business, financial condition or results of operations. Plan to Address Year 2000 Compliance In the spring of 1997, the Company developed a plan to address Y2K readiness issues. The plan included the identification of IT and non-IT systems for compliance, the readiness of the components and modification or replacement of the components. Testing will be completed on each area before implementation. Finally, contingency plans to address potential risks that the Y2K compliance project will not address need to be developed. State of Readiness IT Systems - In the spring of 1997, the Company replaced all of its application software from IBM, Microsoft and JDA Software Group (JDA). With the implementation of one programming update from JDA, JumboSports will complete its Y2K compliance in key financial, information and operating systems. The application of the JDA update will require thorough testing of every application at JumboSports. This testing is scheduled to be completed before October 1999, with the applications implemented during October 1999. Non-IT Systems - The Company has also reviewed its non-IT systems for Y2K compliance. Areas for modification have be identified and are in process for completion in late 1999. Third-Party Business - The Company has obtained from service vendors written statements of Y2K compliance and readiness. For critical vendors, if the Company does not receive a written statement of compliance, the Company will pursue alternative means of obtaining Y2K readiness information, through the review of publicly available information published by such third parties. Cost of Project The overall cost of the Company's Y2K compliance effort has and is not expected to be material to the company's consolidated financial position, results of operations or cash flows. Contingency Plans and Risks The Company believes that its approach to Y2K readiness is sound, but it is possible that some business components are not identified, or that the testing process does not result in analysis and remediation of all source code. The Company's contingency plan will address alternative providers and processes to deal with business interruptions that may be caused by internal system or third party providers failure to be Y2K compliant. The failure to correct a material Y2K problem could result in an interruption in, or failure of, certain business activities or operations. Such failure could materially and adversely affect the Company's results of operations, liquidity and financial condition. In addition, the Company's operating results could be materially adversely affected if it were to be held responsible for the failure of products sold by the Company to be Y2K ready despite the Company's disclaimer of product warranties. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company does not believe there is material market risk. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information called for by this item is set forth as an exhibit to this Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Directors as of April 29, 1999 are as follows: Executive officers are appointed by the Board of Directors and serve at the pleasure of the Board. Executive Officers as of April 29, 1999 are as follows: Based solely on a review of Forms 3 and 4 and amendments thereto furnished to the Company pursuant to Rule 16(a)-3(e) during fiscal year 1998 and Form 5 and amendments thereto furnished to the Company with respect to fiscal year 1998 and any written representation otherwise furnished to the Company, the Company believes that SEC filing requirements applicable to its Directors and officers with respect to the Company's fiscal year ended January 29, 1999, have been fulfilled and that all such filings were made on a timely basis. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Directors Fees Directors of the Company each received, upon their first appointment to the Board, a one-time option grant to purchase 10,000 shares of the Company's Common Stock at the fair market value of the Common Stock on the date of grant. In addition, for so long as the Director were to remain a member of the Board, such director would receive annual compensation in the form of option grants to purchase 1,000 shares of the Company's Common Stock at the fair market value of the Common Stock on the day preceding each Annual Meeting of Stockholders. These options were to vest and become exercisable on the first anniversary of the date of grant, provided the Director then remained a member of the Board. This incentive compensation has not been approved by the Bankruptcy Court. In addition, each of said Directors is paid an annual fee of $16,000 and $1,500 for attendance, in person or by telephone, at each Board meeting, plus certain expense reimbursements and allowances. The Bankruptcy Court has approved this compensation. Executive Compensation Summary Compensation Table The following table sets forth, for the years ended January 29, 1999, January 30, 1998 and January 31, 1997, the cash compensation paid by the Company, as well as other compensation paid or accrued for these years to those persons who were at January 29, 1999, the Company's Chief Executive Officer and the other four most highly compensated officers of the Company ("Named Officers"). See discussion under Employment Contracts for additional information. Option Grants In Last Fiscal Year The following table contains information concerning the grant of stock options under the Company's Stock Incentive Plans to the Named Officers during the last fiscal year. These stock options may be subject to modification or elimination as part of the reorganization proceedings. Aggregated Option Exercises In Last Fiscal Year And Fiscal Year End Option Values None Compensation Committee Interlocks and Insider Participation During the fiscal year ended January 29, 1999, Messrs. Compton and Morris served on the Compensation Committee. Neither of them are or were formerly officers of the Company, and there were no interlocks between them or any of the Company's executive officers. Employment Contracts On April 13, 1999, the Bankruptcy Court approved the appointment of Alfred F. Fasola, Jr. as Chief Executive Officer of the Company and Michael J. Worrall as President. Mr. Fasola is to be paid a base annual compensation of $174,000 and is entitled to a performance bonus based upon sustained break-even performance by the Company as defined and to be agreed upon by the Board of Directors (with Bankruptcy Court approval). Mr. Worrall is to paid a base annual compensation of $250,000 and is entitled to a performance bonus to be determined on the same basis as Mr. Fasola. Both Mr. Fasola and Mr. Worrall will be entitled to a success fee upon the sale, reorganization or liquidation of the Company on terms to be agreed upon by the Board of Directors to the extent that such compensation is approved by the Bankruptcy Court. On February 23, 1999 and April 22, 1999, the Bankruptcy Court entered orders approving certain compensation arrangements between the Company and Jack E. Bush, who was on the Petition Date the Company's Chairman, Chief Executive Officer and President, and Raymond P. Springer, who was on the Petition Date the Company's Executive Vice President and Chief Financial Officer. As a result of these orders Messrs. Bush and Springer were authorized to receive (a) regular salary payments and benefits from the Petition Date through April 13, 1999; (b) prorated daily compensation and benefits for up to an additional 45 days; and (c) one year's salary in the form of a lump sum severance payment plus continued insurance coverage for one year. Messrs. Bush and Springer each received a retention bonus equal to six months' base compensation before the Petition Date. The employment agreements of Mr. Floum and Mr. Gold each terminate on the latest of (a) the effective date of a plan of reorganization, (b) dismissal of the Chapter 11 proceedings or (c) December 31, 1999 ("agreement termination date"). Both Mr. Floum and Mr. Gold each received a lump sum retention bonus on December 23, 1998 equal to six months of their respective base compensation. Each employment agreement provides that the retention bonus be refunded to the Company if the respective executive voluntarily terminates his employment prior to the earlier of (a) December 31, 1999, (b) the effective date of a plan of reorganization, (c) the date his employment is involuntarily terminated, or (d) the cessation of retail business operations, Chapter 7 conversion or dismissal of the Chapter 11 case. Additionally, each executive is eligible for a success bonus equal to six months of their respective base compensation payable on the effective date of a plan of reorganization, provided that (a) he remains in the employment of the Company as of the effective date of a plan of reorganization, (b) the plan is a non-liquidating plan, and (c) the plan is supported by majority vote of the official committees. Each executive is also eligible for severance pay of one year's annual base compensation, so long as he does not voluntarily terminate his employment prior to the agreement termination date. Mr. Henning's employment agreement calls for a retention bonus equal to three months' base compensation to be paid on the earlier of (a) the effective date of a plan of reorganization or (b) December 31, 1999, provided he remains in the employ of the Company. Mr. Henning is also eligible for a success bonus equal to three month's base compensation payable on the effective date of a plan of reorganization. The agreement further provides that Mr. Henning is eligible for salary continuation payable every two weeks until alternative permanent employment is accepted, not to exceed twelve months, should his employment be involuntarily terminated by the Company. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. To the best knowledge of the Company based on information filed with the Securities and Exchange Commission and information provided directly to the Company by the persons and entities named below, the following table sets forth the beneficial ownership of the Company's Common Stock, as of March 25, 1999 (unless otherwise noted), by each holder of more than 5% of the Company's Common Stock and by each Director and executive officer of the Company and by the Directors and executive officers as a group. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. In connection with their respective employment agreements, and pursuant to the terms thereof, during fiscal year 1996 the Company loaned $166,667, $137,500 and $30,250 to each of Messrs. Bebis (former Chairman, President and Chief Executive Officer), Springer and Henning, respectively, to assist them with the purchase of non-registered shares of the Company's Common Stock. In lieu of incurring the expense of registering Mr. Bebis' shares as provided in his termination agreement, the Company accepted the shares, valued at the closing price 90 days after Mr. Bebis' date of termination, plus cash in satisfaction of the outstanding loan balance. As of January 29, 1999, each of the outstanding loans had been repaid in full. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Annual Report on Form 10-K: (1) Financial Statements Page Reports of Independent Accountants......................................F-1 Consolidated Balance Sheets.............................................F-3 Consolidated Statements of Operations...................................F-4 Consolidated Statements of Stockholders' Equity.........................F-5 Consolidated Statements of Cash Flows...................................F-6 Notes to the Consolidated Financial Statements..........................F-7 (2) All schedules have been included as an Exhibit or the information is included elsewhere in the financial statements or notes thereto incorporated by reference in Item 8 of this Annual Report on Form 10-K. (3) Exhibits - See Exhibit Index on page 26 and 27. (b) Reports on Form 8-K: On December 27, 1998, JumboSports Inc., a Florida corporation, and its subsidiaries Guide Series, Inc. and Property Holdings Company I filed Voluntary Petitions for Relief (Case Nos.98-22545-8C1, 98-22546-8C1 and 98-22547-8C1, respectively) under Chapter 11 of Title 11 of the United States in United States Bankruptcy Court for the Middle District of Florida, Tampa Division reported on Form 8-K on January 14, 1999. EXHIBIT INDEX Exhibit Number Description Financial Statements - see index on page 25. Financial Statement Schedules - see index on page 25. 3.1 Articles of Incorporation of JumboSports Inc. Incorporated by reference to the exhibits included in the Company's Annual Report on Form 10-K/A filed on November 16,1998. 3.2 Bylaws of JumboSports Inc. Incorporated by reference to the exhibits included in the Company's Annual Report on Form 10-K/A filed on March 12, 1998. 4.1 Specimen Common Stock Certificate. Incorporated by reference to the exhibits included in the Company's Annual Report on Form 10-K/A filed on November 16,1998. 4.2 Specimen of Debt Security. Incorporated by reference to the exhibits included in the Company's Annual Report on Form 10-K/A filed on November 16,1998. 4.3 Indenture between JumboSports Inc. and Barnett Banks Trust Company, National Association, as Trustee. Incorporated by reference to exhibits included in the Company's Annual Report on Form 10-K/A for the fiscal year ended January 30, 1994. 4.4 Supplemental Indenture Agreement, dated February 14, 1997, between JumboSports Inc. and The Bank of New York. Incorporated by reference to the exhibits included in the Company's Form 8-B filed on June 11, 1997. 4.5 Rights Agreement, dated June 12, 1996, between JumboSports Inc. and ChaseMellon Shareholder Services, LLC. Incorporated by reference to the exhibits included in the Company's Form 8-A filed on June 20, 1996. 4.6 Rights Certificate. Incorporated by reference to the exhibits included in the Company's Form 8-A filed on June 20, 1996. 10.1 1989 Stock Incentive Plan, as amended through June 23, 1994. Incorporated by reference to exhibits included in the Company's Annual Report on Form 10-K for the fiscal year ended January 29, 1995. 10.2 Amendment to 1989 Stock Incentive Plan. Incorporated by reference to the exhibits included in the Company's Form S-8 Registration Statement filed on January 28, 1998 (Registration No. 333-45041). 10.3 1996 Stock Incentive Plan. Incorporated by reference to the exhibits included in the Company's Form 8-B filed June 11, 1997. 10.6 Officers' Medical Reimbursement Plan. Incorporated by reference to exhibits included in the Company's Registration Statement on Form S-1 (Registration Statement No. 33-50098). 10.7 Amended and Restated Credit Agreement, dated as of May 28, 1997, among JumboSports, each of the subsidiaries of JumboSports, Barnett Bank, N.A., NationsBank, N.A., and each of the Lenders (as defined in the Amended and Restated Credit Agreement). 10.8 Form of Stock Option Agreement pursuant to the 1989 Stock Incentive Plan for options granted to employees. Incorporated by reference to the exhibits included in the Company's Annual Report on Form 10-K/A filed on November 16,1998. 10.9 Form of Stock Option Agreement pursuant to the 1996 Stock Incentive Plan for options granted to Directors. Incorporated by reference to the exhibits included in the Company's Annual Report on Form 10-K/A filed on November 16,1998. 10.10 Employee Stock Purchase Plan, as amended through November 14, 1994. Incorporated by reference to exhibits included in the Company's Annual Report on Form 10-K for the fiscal year ended January 29, 1995. 10.11 Amendment Agreement, dated January 30, 1998, among JumboSports Inc., Barnett Bank, N.A., NationsBank, N.A., and each of the lenders (as defined in the Amendment Agreement). Incorporated by reference to exhibits included in the Company's Form 8-K filed on February 10, 1998. 10.12 Loan and Security Agreement, dated July 24, 1998, among JumboSports, Inc. and Foothill Capital Corporation, Paragon Capital LLC, Congress Financial Corporation, Foothill Partners III, L.P. and each of the lenders (as defined in the Amendment Agreement). Incorporated by reference to exhibits included in the Company's Form 8-K on August 27, 1998. EXHIBIT INDEX 10.13 Senior Secured, Super-Priority Debtor-In-Possession Loan and Security Agreement, dated February 12, 1999, among JumboSports Inc. and Foothill Capital Corporation, Congress Financial Corporation and each of the lenders (as defined in the Agreement). 10.14 Amended and Restated Employment Agreement dated as of March 16, 1999 between the Company and Jack E. Bush. 10.15 Amended and Restated Employment Agreement dated as of March 16, 1999 between the Company and B. Robert Floum. 10.16 Amended and Restated Employment Agreement dated as of March 16, 1999 between the Company and Raymond P. Springer. 10.17 Amended and Restated Employment Agreement dated as of March 16, 1999 between the Company and Barry Gold. 10.18 Amended and Restated Employment Agreement dated as of March 16, 1999 between the Company and Michael Henning. 12 Computation of Ratio of Earnings to Fixed Charges. 21 List of Subsidiaries. Incorporated by reference to exhibits included in the Company's Annual Report on Form 10-K for the fiscal year ended January 28, 1996. 23. Consent of PricewaterhouseCoopers LLP 27 Financial Data Schedule (Edgar filing-only). 99 Schedule II - Valuation and Qualifying Accounts. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on April 29, 1999. JumboSports Inc. (Registrant) By: /s/ ALFRED F. FASOLA JR. Alfred F. Fasola, Jr., Chief Executive Officer (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated above. By: /s/ ALFRED F. FASOLA, JR. Alfred F. Fasola, Jr., Chief Executive Officer (Principal Executive Officer) By: /s/ MICHAEL J. WORRALL Michael J. Worrall, President By: /s/ JEROME A. KOLLAR Jerome A. Kollar, Chief Financial Officer By: /s/ JACK E. BUSH Jack E. Bush, Chairman of the Board of Directors By: /s/ HAROLD F. COMPTON Harold F. Compton, Director By: /s/ R. DON MORRIS R. Don Morris, Director By: /s/ SAMUEL NORTHROP, JR. Samuel Northrop, Jr., Director By: /s/ RONALD L. VAUGHN Ronald L. Vaughn, Director REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors and Stockholders of JumboSports Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of JumboSports Inc. and its subsidiaries (the "Company") at January 29, 1999, and January 30, 1998, and the results of their operations and their cash flows for each of the three years in the period ended January 29, 1999, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, on December 27, 1998, JumboSports Inc. and certain of its subsidiaries filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code, thereby raising substantial doubt about its ability to continue as a going concern. The Company has not filed a plan of reorganization with the Bankruptcy Court. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of the petitions for reorganization. PRICEWATERHOUSECOOPERS LLP Tampa, Florida April 23, 1999 JUMBOSPORTS INC. (DEBTOR-IN-POSSESSION) CONSOLIDATED BALANCE SHEETS (IN THOUSANDS EXCEPT FOR SHARE AND PER SHARE DATA) See Notes To The Consolidated Financial Statements. JUMBOSPORTS INC. (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT FOR PER SHARE DATA) See Notes To The Consolidated Financial Statements. JUMBOSPORTS INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY (IN THOUSANDS EXCEPT FOR SHARE DATA) See Notes To The Consolidated Financial Statements. JUMBOSPORTS INC. DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See Notes To The Consolidated Financial Statements. JUMBOSPORTS INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS EXCEPT FOR SHARE, PER SHARE DATA AND AS OTHERWISE NOTED) Note 1 - Summary of Significant Accounting Policies CHAPTER 11 On December 27, 1998 (the "Petition Date"), after experiencing a poor holiday season and with increased pressure being applied by the Company's lenders and suppliers, JumboSports Inc. and certain of its subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Middle District of Florida (the "Bankruptcy Court"). These related proceedings are being jointly administered under the caption "In re.: JumboSports Inc., d/b/a Vacations Travel, f/k/a Sports & Recreation, Inc., and f/d/b/a/ Sports Unlimited, Guide Series, Inc. and Property Holdings Company I" Case Nos. 98-22545-8C1, 98-22546-8C1 and 98-22547-8C1, pursuant to an order of the Bankruptcy Court. The following subsidiaries were not included in the bankruptcy filings and are not material to the Company's consolidated financial statements: Nationwide Team Sales, Inc., Retail Process Management, Inc., Sports & Recreation, Inc., Sports & Recreation Holdings of PA, Inc. and Construction Resolution, Inc. The bankruptcy petitions were filed in order to preserve cash and permit the Company an opportunity to reorganize while working to restructure its indebtedness. Pursuant to the Senior-Secured Super Priority Debtor-In-Possession Loan and Security Agreement (the "DIP facility") dated February 12, 1999, among JumboSports Inc., as Borrower, various financial institutions, as Lenders, Foothill Capital Corporation, as Agent and Congress Financial Corporation (Southern), as Co-Agent, the lenders have agreed to provide up to $110 million in post-petition financing to the Company. As a result of the Chapter 11 filings, absent approval of the Bankruptcy Court, the Company is prohibited from paying, and creditors are prohibited from attempting to collect claims or debts arising pre-petition. The consummation of a plan of reorganization is the principal objective of the Company's Chapter 11 cases. The plan of reorganization will set forth the means for satisfying claims, including the liabilities subject to compromise, and interests in the Company and its debtor subsidiaries. The consummation of a plan of reorganization for the Company and its debtor subsidiaries will require approval of the Bankruptcy Court. The Company expects to propose a plan of reorganization for itself and the other filing subsidiaries. The Bankruptcy Court has granted the Company's request to extend its exclusive right to file a plan of reorganization through June 1, 1999. The Company intends to request a further extension of the exclusivity period while management works on implementing new operating strategies that are intended to improve operating performance. There can be no assurance that the Bankruptcy Court will grant such further extension or that management's new strategies will produce the desired results. After the expiration of the exclusivity period, creditors of the Company have the right to propose their own plans of reorganization. A plan of reorganization, among other things, may result in material dilution or elimination of the equity of existing stockholders as a result of the issuance of equity to creditors or new investors. At this time, it is not possible to predict the outcome of the Chapter 11 filing, in general, or its effects on the business of the Company or on the interests of creditors or stockholders. The Company's independent accountants have issued a report expressing doubt about the Company's ability to continue as a going concern. See the Consolidated Financial Statements of the Company beginning on page. The Company does not plan to hold annual stockholder meetings during the pendency of its Chapter 11 case. The accompanying financial statements have been prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. However, as a result of the Chapter 11 filing and circumstances relating to this event, including the Company's leveraged financial structure and losses from operations, such realization of assets and liquidation of liabilities is subject to substantial doubt. While under the protection of Chapter 11, the Company may sell or otherwise dispose of assets, and liquidate or settle liabilities, for amounts other than those reflected in the financial statements. Further, a plan of reorganization could materially change the amounts reported in the financial statements, which do not give effect to all adjustments of the carrying value of assets or liabilities that might be necessary as a consequence of a plan of reorganization. The appropriateness of using the going concern basis is dependent upon, among other things, confirmation of a plan of reorganization, future profitable operations, the ability to comply with the terms of the DIP facility and the ability to generate sufficient cash from operations to meet obligations. LEGAL PROCEEDINGS The Company is from time to time involved in routine litigation incidental to the conduct of its business. The Company believes that no such currently pending routine litigation to which it is a party will have a material adverse effect on its financial condition or results of operations. On Sunday, December 27, 1998, JumboSports Inc. and certain of its subsidiaries filed for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Middle District of Florida. These related proceedings are being jointly administered under the caption "In re.: JumboSports Inc., d/b/a/ Vacations Travel, f/k/a Sports & Recreation, Inc., and f/d/b/a Sports Unlimited, Guide Series, Inc. and Property Holdings Company I", Case Nos 98-22545-8C1, 98-22546-8C1 and 98-22547-8C1. The following subsidiaries were not included in the bankruptcy filings: Nationwide Team Sales, Inc., Retail Process Management, Inc., Sports & Recreation, Inc., Sports & Recreation Holdings of PA, Inc. and Construction Resolution, Inc. In connection with the Bankruptcy filing, all pre-petition actions against the Company have been stayed. A complaint was filed on March 23, 1999, in the Bankruptcy Court, "LaSalle National Bank, Trustee for JP Morgan Commercial Mortgage Finance Corporation Pass-through Certificate Series 1997-C5, acting by and through AMRESCO Management, Inc., its Special Servicer" v. JumboSports Inc., which alleges that JumboSports did not have the right to terminate certain Trusts of which JumboSports was the sole beneficiary and sole settlor. The Trusts held bare legal title to real estate ("the Property") and pledged the Property as security for loans. The plaintiff is seeking a judicial declaration that the Property in question is not property of JumboSports, the Debtor's estate, and that the Plaintiff may proceed against the Property as if it were not property of the Debtor's estate. The Plaintiff further seeks a judicial declaration that the Trusts are separate legal entities, that the Trusts have not been terminated, that the termination is not valid, that there is no right to terminate the Trusts except in accordance with applicable Delaware law, the Trust Agreements, and the relevant loan documents and that there has been no transfer of the Property to the Debtor. Management is currently unable to predict the outcome of this case or the impact of an adverse ruling on its reorganization efforts. The Company expects to file its written responses and any claim for affirmative relief by April 30, 1999. ORGANIZATION On January 31, 1997, JumboSports Inc. and its subsidiaries (the "Company"), previously Sports & Recreation, Inc., operated 85 retail sporting goods outlets in 29 states. In fiscal 1997 the Company announced the closings of 26 stores. On January 31, 1998, the Company operated 59 stores in 23 states. In fiscal 1998 the Company opened two new stores and announced the closing of 19 stores. On January 30, 1999, the Company will operate 42 stores in 18 states. PERIODS PRESENTED In fiscal 1996, the Company changed to utilizing a 52 or 53 week fiscal year ending on the Friday closest to the end of January, as compared to a 52 or 53 week fiscal year ending on the Sunday closest to the end of January. This change in fiscal year caused fiscal year 1996 to be a 52 week and five day period. The financial statements presented are for the 52 week and five day period ended January 31, 1997 ("fiscal 1996"), for the 52 week period ended January 30, 1998 ("fiscal 1997") and for the 52 week period ended January 29, 1999 ("fiscal 1998"). PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of JumboSports Inc. and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. BASIS OF ACCOUNTING The use of estimates is inherent in the preparation of financial statements in accordance with generally accepted accounting principles. Actual results can differ from these estimates. CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. INVENTORIES Inventories are stated at the lower of first-in, first-out (FIFO) cost or market for fiscal 1996 and for fiscal 1997 at the lower of cost (computed using the FIFO retail method) or market. The Company believes that the FIFO retail method provides improved information for the operation of its business in a manner consistent with the method used widely in the retail industry. The cumulative effect of the change to the FIFO retail method was immaterial. Proforma effects of the change for prior periods is not determinable. The Company considers cost to include the direct cost of merchandise, plus internal costs associated with merchandise procurement, storage, handling, and distribution. Selling, general and administrative costs capitalized into ending inventory were $4,128 and $4,237 in fiscal 1997 and fiscal 1998, respectively. PROPERTY AND EQUIPMENT Property is recorded at cost and includes interest on funds borrowed to finance construction. Capitalized interest was approximately $135, $221 and $37 in fiscal 1996, fiscal 1997 and fiscal 1998, respectively. Depreciation and amortization are provided using the straight-line method over the estimated useful service lives of the related assets. Costs and related accumulated depreciation on assets retired or disposed of are removed from the accounts and any gains or losses resulting therefrom are credited or charged to operations. INCOME TAXES The Company provides for federal and state income taxes currently payable as well as for those deferred because of timing differences between reporting income and expenses for financial statement purposes and income and expenses for tax purposes. Work Opportunity Tax credits were recorded as a reduction of income taxes. The Company uses the provisions of Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes". SFAS 109 requires an asset and liability approach in accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company's differences relate primarily to the difference in carrying values of certain assets and liabilities for book and tax reporting and the deferred income tax asset resulting from the Company's non-recurring restructuring charges. Under SFAS 109, the effective rate on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. ADVERTISING COSTS Advertising costs are expensed the first time advertising takes place. Included in selling, general and administrative expenses for fiscal 1996, fiscal 1997 and fiscal 1998 are $13,309, $17,498 and $10,778 respectively, of advertising expenses. DEFERRED LOAN CHARGES Deferred loan charges represent fees paid in connection with the acquisition of certain of the Company's debt. These charges are being amortized using the interest method over the term of the related debt. Net deferred loan costs were $2,217, $3,140 and $2,234 in fiscal 1996, fiscal 1997 and fiscal 1998, respectively. IMPAIRMENT OF ASSETS SFAS 121, "Accounting for Impairment of Long-Lived Assets to be Disposed of", requires that long-lived assets and certain intangibles to be held and used by the Company be reviewed for impairment. In conducting its review, management considers, among other things, its current and expected operating cash flows together with a judgment as to the fair value the Company could receive upon sale of its investment. Based on this review, the Company recorded a $5.2 million pre-tax charge as part of the $22.6 million charge it took in the second quarter of fiscal 1996. In fiscal 1997 and 1998 the Company recorded charges of $21.2 million and $8.6 million, respectively, for the write-down to net realizable values for closing stores. Although, the Company adopted SFAS 121 in fiscal 1996, the Company did not realize an impairment of long-lived assets until the second quarter of fiscal 1996 because of the corporate philosophy change from rapid expansion and growth to individual store profitability and contribution measurements. The change in philosophy came about due to a management change during February 1996. New management changed the focus concentrating on building infrastructure in order to support successful and profitable store expansion. To accomplish this, third party consulting groups were retained to build a real estate site selection model projecting revenues based on the Company's customer base and demographics for the existing and future store sites. With the developed model's information, the Company used the revenue projections to determine if the potential future sites under development at the time, would meet the Company's minimum return on investment. This allowed the Company to segregate the assets to be held and used, and to be disposed of. The analysis completed during the second fiscal quarter of 1996 showed that the impairment was for sites that were not opened and charges pertaining to SFAS 121 were recognized accordingly. The Company has completed the analysis on a periodic basis, and has made determinations to close stores and impair the assets relating to those stores, as evidenced in fiscal 1997. COST IN EXCESS OF FAIR VALUE OF NET ASSETS ACQUIRED Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over a 40 year period. Accumulated amortization was $2,862 and $3,204 as of January 30, 1998, and January 29, 1999, respectively. FAIR VALUES OF FINANCIAL INSTRUMENTS The carrying value of the Company's cash, receivables, accounts payable, revolving credit agreement, and long term debt approximate their fair values. The fair value of the convertible subordinated notes was approximately $31,000 and $4,900 on January 30, 1998, and January 29, 1999, respectively, based upon current market rates. TOTAL INTEREST EXPENSE AND RISK MANAGEMENT INSTRUMENTS Total interest expense incurred was $29,092, $30,928 and $24,790 for fiscal 1996, fiscal 1997 and fiscal 1998, respectively. The Company, in connection with its revolving credit facility, had entered into $100,000 of interest rate collar agreements. These agreements qualify for hedge accounting and are amortized to interest expense. The $100 million of interest rate collars impacted interest expense by $15, $48 and $8 in fiscal 1996, fiscal 1997 and fiscal 1998, respectively. Interest not accrued on the Senior Subordinated Notes from the Petition Date to January 29, 1999 was $265. The Company's $100 million of interest rate collar agreements expired by June 1998. EARNINGS PER COMMON SHARE Earnings per common shares is calculated in accordance with SFAS No. 128, "Earnings Per Share," and is based on the weighted average number of common shares outstanding during each year as follows: Weighted Average Year Shares Outstanding --------------------------------------------------- Fiscal 1996 19,984,993 Fiscal 1997 20,363,299 Fiscal 1998 20,404,857 ACCOUNTING PRONOUNCEMENTS In 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income", which is effective for periods ending after December 15, 1998. This statement establishes standards for computing and presenting income which includes translation adjustments. In 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which is also effective for periods ending after December 15, 1998. This statement establishes additional disclosure requirements for business segments. In 1998 the FASB issued SFAS No. 133 "Derivative Financial Instruments and Hedging Activities", which is effective for periods ending after June 15, 1999. This statement establishes standards for disclosing and valuing off balance sheet risk instruments. None of the above statements are applicable to the Company in the current reporting period. Note 2 - Property and Equipment Note 3 - Revolving Credit Agreement On July 24, 1998, the Company entered into a new five-year, $150,000 secured revolving loan and term loan agreement ("the Loan facility"). Proceeds of the loans were used to retire the existing $180 million secured revolving credit facility that was scheduled to mature on May 31, 1999, and to fund on-going working capital requirements. During the term of the Loan facility, the Company is restricted from making any distribution or declaring or paying any dividends (in cash or other property, other than capital stock) on, or purchasing, acquiring, redeeming or retiring any of the Company's capital stock, of any class, whether now or hereafter outstanding; provided however, that the Company is permitted to redeem shares of its capital stock in an amount not to exceed $200 thousand in the aggregate. Other restrictions include limitations on additional indebtedness, disposals of assets, change of control, investments and capital expenditures. There are no financial performance covenants. The term loans consist of a Tranche A and a Tranche B. The Tranche A term loan was initially funded at $20.5 million and the Tranche B term loan was initially funded at $10.2. Interest on the Tranche A term loan accrues at the Reference Rate (the variable rate of interest most recently announced by Norwest Bank Minnesota, N.A. as it "base rate") plus 1.50%. Interest on the Tranche B term loan accrues at 12.5%. Total principal installments of $511 are to be paid monthly commencing with October 1, 1998, and continuing on the first day of each succeeding month. The Company is required to prepay the term loans with the Net Proceeds from the sale of the Real Property Collateral pursuant to a prescribed allocation as set forth in the loan agreement. All prepayments of principal are applied ratably to principal installments in order of their maturity. Due to prepayments, future principal installment obligations have been satisfied through October 1, 2000. Availability under the Tranche A advances is limited to the lower of $125 million less Tranche A term loans and an amount based on a predetermined formula which includes a provision for up to 80% of eligible accounts and approximately 70% of eligible inventory. Interest accrues on Tranche A advances, at the Company's option, based upon the Reference Rate plus .50% (8.0% at January 29, 1999) or the Eurodollar Rate (LIBOR or other Eurodollar rates selected by Agent) plus 250 basis points. Anytime that no Tranche A availability exists, Tranche B advances may be requested by the Company. Availability on Tranche B advances is limited to the lesser of $15 million and an amount based on a predetermined formula which includes a provision for approximately 10% of eligible inventory. Interest accrues on Tranche B advances at the Reference Rate plus 3.0%. The Loan facility also includes a letter of credit subfacility. Commitments under the letter of credit subfacility are limited to the lesser of $10 million or availability under the revolving line of credit (Tranche A and Tranche B). At January 29, 1999, outstanding commitments under the letter of credit subfacility were $1.4 million. The Agreement also contains a provision for early termination, at the option of the Company, with a payment of an early termination premium to the lender. On December 27, 1998, the Company filed a petition for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court. Thereafter, no additional amounts were drawn under the Loan facility. On January 8, 1999, the Bankruptcy Court entered a Preliminary Order Granting Debtor's Emergency Motion for Authority to Use Cash Collateral effective as of December 28, 1998. At a hearing on January 21, 1999, the Company announced to the Court an agreement had been reached between the Company and its secured lenders for debtor-in-possession financing ("the DIP facility") and that a motion to seek approval of such financing would soon be filed with the Court. The Company was then granted authority to continue the use of cash collateral subject to certain restrictions through February 12, 1999, when it was anticipated that the motion seeking approval of the DIP financing would be heard in court. At January 30, 1998, the Company had a $180 million secured revolving credit facility which matured on May 31, 1999. During the term of this agreement, the Company was restricted from declaring or paying any cash dividends, making any other distributions on account of any class of its stock (other than stock splits or stock dividends) or redeeming, purchasing, retiring or otherwise acquiring directly or indirectly any shares of its stock, except for fractional shares in connection with stock splits or stock dividends and shares issued to employees to exercise outstanding options. Interest on this borrowing accrued, at the Company's option, based upon the lender's prime rate plus 200 basis points (10.50% at January 30, 1998) or LIBOR plus 300 basis points (8.62% at January 30, 1998). Interest on advances under the prime rate was payable quarterly in arrears. Interest on LIBOR rate advances was fixed and, at the Company's option, was payable in arrears on 30, 60 or 90 day periods. The revolving credit facility was collateralized by real and personal property. The availability under the revolving credit facility was the lower of $180,000 or the borrowing base. The borrowing base was a calculation based upon eligible assets: real estate, inventories and equipment. At January 30, 1998, the Company had $174,037 outstanding and $920 available under this agreement. In conjunction with the revolving credit facility, the Company also entered into a letter of credit sub-facility. Commitments under the letter of credit are limited to the lesser of $10 million or the availability under the revolving line of credit. At January 30, 1998, outstanding commitments under the letter of credit facility were $1.0 million. In conjunction with the revolving credit facility, the Company has entered into $100 million of interest rate collar agreements. These agreements hedge interest rate fluctuations by setting floor rates and ceiling rates on a notional amount of $100 million. The Company has $50 million of agreements with floor rates of 5.23% and ceiling rates of 8.00% and $50 million of agreements with floor rates of 5.75% and ceiling rates of 7.50%. These agreements terminated on various dates in calendar year 1998. Note 4 - Long-Term Debt Excluding liabilities subject to compromise, future minimum payments under the mortgage obligations during the fiscal years subsequent to January 29, 1999, are as follows: 1999 $ 6,870 2000 6,870 2001 6,870 2002 6,870 2003 6,870 Thereafter 88,238 ------- Total 122,588 Less amount representing interest 54,471 ------- Present value of future minimum lease payments 68,117 Less current maturities 893 ------- Total long-term debt $67,224 ======= Note 5 - Subordinated Debt During fiscal 1993, the Company issued $74,750 in convertible subordinated notes with interest at 4.25%. The notes require semi-annual interest payments beginning May 1, 1994, through November 1, 2000, the date of maturity. The notes are convertible into common stock of the Company at any time on or before November 1, 2000, unless previously redeemed, at a conversion price of $25.50 per share, subject to adjustment in certain events. The notes are subordinated to all secured indebtedness and parri passu with all unsecured indebtedness and have been reclassified as liabilities subject to compromise (see Note 6). Note 6 - Liabilities Subject to Compromise Liabilities subject to compromise are subject to future adjustments on Bankruptcy Court actions and further developments with respect to disputed claims. Liabilities subject to compromise are as follows: Convertible subordinated notes plus accrued interest $ 75,253 Accounts payable 37,268 Rejected leases and other miscellaneous claims 12,044 Obligations under capital leases 6,602 Accrued expenses 6,262 Deferred liabilities 2,204 -------- Total $139,633 ======== Liabilities subject to compromise under reorganization proceedings include substantially all unsecured debt as of the petition date. Pursuant to the provision of the Bankruptcy Code, payment of these liabilities may not be made except pursuant to a plan of reorganization or Bankruptcy Court order while the Company continues to operate as debtors in possession. The Company has recorded an estimated liability for certain leases and contracts that have either been rejected or the Company anticipates rejecting. Note 7 - Commitments and Contingencies TAX RETENTION OPERATING LEASE On May 10, 1995, the Company entered into a Tax Retention Operating Lease Agreement (the "TROL"), whereby an owner trust was formed for the sole purpose of acquiring and/or constructing properties which will later be leased to the Company as retail store locations. The TROL had an original aggregate facility commitment of $70,000. However, effective October 10, 1995, the aggregate facility commitment under the TROL agreement was increased to $85,000. Interim rental payments were due under the agreement for the properties opened within the first two years from the date of the TROL's inception, based upon a blended interest rate being (i) the greater of the NationsBank prime rate or the Federal Funds rate, plus 50 basis points, or (ii) the appropriate Eurodollar Rate plus a variable margin (112.5 to 150 basis points) determined based upon certain financial ratios of the Company. On June 4, 1996, the TROL was refinanced and $58,058, the utilized commitment, was incorporated into the Company's revolving credit facility. Accordingly, this transaction has been excluded from the accompanying Consolidated Statement of Cash Flows for fiscal 1996. In fiscal 1996, the Company utilized the TROL facility for new store construction on three of the five stores opened. The total commitment utilized through June 6, 1996, was $58,058. The purpose of the TROL was to provide off-balance sheet financing of new store site and development costs at attractive rates. OTHER OPERATING LEASES The Company has leases on 30 store facilities (18 opened stores and 12 closing stores), corporate office facilities and two warehouses with unrelated parties. These leases have terms ranging from five to 20 years, with options to renew ranging from two to four additional five-year terms. Additionally, certain store leases provide for contingent rent computed as a percentage of sales in excess of a specified amount. Contingent rent of $104, $81 and $34 was incurred for fiscal 1996, fiscal 1997 and fiscal 1998, respectively. In addition to the facility leases, the Company has entered into various leases for store fixtures, transportation equipment and data processing equipment under operating lease agreements with terms ranging from three to five years. Rent expense under all operating lease agreements including the TROL for each of the fiscal periods presented is as follows: 1996 $ 14,136 1997 12,935 1998 12,478 Excluding leases rejected or identified to be rejected, future minimum lease payments under non-cancelable operating lease agreements during the fiscal years subsequent to January 29, 1999, are as follows: 1999 $ 9,436 2000 7,104 2001 6,094 2002 5,597 2003 4,880 Thereafter 35,025 --------- Total $ 68,136 ========= NEW STORE CONSTRUCTION The Company had previously utilized one construction agent as general contractor for substantially all of its new store facilities. The agent worked solely for the Company. Current and future construction is subject to a competitive bidding process. Note 8 - Income Taxes Income tax expense (benefit) consists of the following: The following is a schedule of the significant net deferred income tax assets and liabilities as January 30, 1998 and January 29, 1999: At January 29, 1999, the Company had tax net operating loss ("NOL") carryforwards of $158,656 for federal income tax purposes and $185,016 for state income tax purposes. The federal NOL will expire, if unused, in years 2011, 2012 and 2013 and the state NOL's will expire, if unused, in the years 2001 through 2018. For the year ending January 29, 1999, the Company recorded a valuation allowance of $77,027 to offset the deferred tax assets in excess of the deferred tax liabilities. The Company's income tax expense differed from the statutory federal rate of 34%, as follows: Note 9 - Employee Benefit Plans The Company's qualified profit sharing and 401(k) savings plan (the "Plan") covers all employees meeting certain eligibility requirements. The Plan permits each participant to reduce his or her taxable compensation basis by up to 15% and have the amount of such reduction contributed to the Plan. The Company makes a matching contribution of 50% of the first 6% of compensation deferred by each participant. In addition, in any year, the Company may contribute to the Plan additional amounts determined by the Company's Board of Directors at its sole discretion. Salary reduction contributions are immediately vested in full; matching and discretionary contributions begin to vest after the participant's first year of service and become fully vested after the participants fourth year of service. During fiscal 1996, 1997 and 1998, expense under the Plan was approximately $62, $64 and $145, respectively. The Company's Employee Stock Purchase Plan ("ESPP") allows employees meeting certain eligibility requirements to purchase Company stock at a 15% discount from the fair market value of the stock price. The plan was terminated by the Company in the fourth quarter of fiscal 1998. The Company's key employee non-qualified deferred compensation plan allows the employee to defer compensation and earn interest at a rate of 10% annually. Interest expense for fiscal 1997 was $23. The plan was terminated by the Company in the first quarter of fiscal 1998. Note 10 - Loss on Disposition of Assets, Closed Stores Expenses and Other Charges In the second quarter of fiscal 1996 the Company recorded one-time charges of $55.0 million. The components are as follows (in millions): Cost of Sales: Inventory write-down for shrink and obsolete and slow moving merchandise $32.4 ----- Non-recurring and other charges: Disposition of and impairment of underperforming assets 11.4 Charges for certain loss contingencies 3.0 Other charges 8.2 ----- 22.6 ----- Total $55.0 ===== The inventory write-down for obsolete and slow moving merchandise and excess shrinkage of $32.4 million was comprised of a $24.3 million charge for the write-down of inventory below cost and an additional $8.1 million charge for merchandise inventory shrinkage. The Company recorded the inventory write-down to correctly state the value of discontinued, obsolete and slow moving inventory at a net realizable market value. The inventory for which these reserves were established was sold during fiscal 1996. Throughout the year, the Company accrued inventory shrinkage at 1.1% of sales based on prior years' experience. The excess shrinkage recorded at year-end is believed to be attributable to the inventory clearance sales and the fact that the Company had taken its first SKU level inventory. The establishment of these reserves did not result in additional cash payments. The $11.4 million charge for impairment of underperforming assets was attributable to the write-off of undesirable retail sites and impairment of other sites of $5.2 million and the write-off of assets as the result of organizational changes of $6.2 million. The write-off of committed retail sites was for new store projects that were deemed undesirable. The sites were deemed committed based on proforma operating income projections. The operating income projections revealed sites which, in the opinion of new management, would not achieve or maintain the Company's minimum requirements for return on investment. The charge for impairment of other sites was for nearly-completed retail sites that were also deemed undesirable based on proforma operating income projections. The impairment was determined based on the net realizable sale value of the sites. The establishment of these reserves did not result in additional cash payments. Charges for certain loss contingencies relate to the October 1996 submission of settlement with no admission of liability to the court by the Company and the plaintiffs in two pending class action suits. The class action suits asserted claims under the federal securities laws and alleged the Company artificially inflated the price of its common stock during the class period, July 14, 1994 through March 13, 1995. By the terms of the settlement, a class was certified by the court and prorata payments in the total amount of $6.3 million were made to the class members submitting claims. Of this amount, $2.9 million was funded by the Company and the remainder funded by the Company's insurance carrier. Other charges were attributable to costs incurred for severance and related charges of $1.8 million, employee benefit program charges of $4.3 million and other charges of $2.1 million. Cash payments of $0.9 million were paid in fiscal 1996 and an additional $0.9 million of cash payments will be made in future periods. In the third and fourth quarters of fiscal 1997, the Company recorded non-recurring charges of $94.3 million related to store closings, excess and slow moving inventory, severance, outdated technology and the write-off of debt costs in connection with the Company's revolving line of credit. The components are as follows (in millions): Cost of Sales: Mark-down of slow moving and excess inventory $ 17.9 Additional shrinkage 9.5 Write-down for inventory liquidation of closing stores 17.6 ------ 45.0 Non-recurring and other charges: Charges related to store closings 40.0 Other charges 4.0 ------ 44.0 Interest: Write-off of deferred debt costs 5.3 ------ Total $ 94.3 ====== The markdown of excess inventory of $17.9 million was taken to correctly state the value of merchandise at the lower of cost or market. The primary cause for this charge was due to problems experienced in athletic footwear and apparel; both categories were impacted by distribution problems, overly aggressive purchasing and soft sales. The Company took physical inventories in each of its stores at year-end. Throughout the year, management had estimated shrinkage at 2.2% of sales. This estimate was based on the prior year's actual shrinkage of 2.8% and the industry average of 1.5%. The year-end physical inventories resulted in a total shrinkage of 4.0% or approximately 1.8% above the accrual. The additional shrinkage is believed to be primarily attributable to implementation issues in connection with the new merchandising systems and problems encountered with the new distribution facility. In February 1997, the Company changed the inventory distribution method and inventory systems. The Company transitioned the majority of merchandise flow from direct delivery to stores, to a third party managed cross dock facility. The initial start-up of the cross dock facility caused significant product delays. Because of these delays, the Company experienced lost inventory, poor sales and overstocks, resulting in higher shrinkage and increased markdowns to alleviate seasonal and fashion oriented inventory levels. In October 1997, the Company terminated its relationship with the third-party distribution manager and returned to a merchandise flow direct to the Company's stores. By fiscal year end, inventory levels returned to normal, and the Company expects gross margins to return to historical levels in 1998. The Company installed new financial and inventory systems from JDA Software Group (JDA). The systems were installed to enhance inventory control information and support the existing and future corporate infrastructure. As with any new system, conversion issues arose, but the issues were timely corrected. The new systems gave the Company real-time information to manage and control inventory levels. Many of the aforementioned causes have been addressed and management is focused on reducing and controlling shrinkage during fiscal 1998. Additionally, the Company will be taking physical inventories throughout the year to better estimate the proper shrinkage accrual. The Company recorded the inventory write-down of $17.6 million for store closings inventory liquidation based on the net realizable value of liquidating inventory at 26 stores anticipated to close from January 1998 through May 1998. The establishment of the aforementioned reserves did not result in additional cash payments in fiscal 1997. The $40.0 million of charges related to store closings represent the establishment of reserves of $29.1 million for the write-down of closed stores property and equipment to net realizable value, $6.7 million for expenses attributable to the closing stores and $4.2 million for lease reserves at closing locations. The establishment of these reserves did not result in additional cash payments in fiscal 1997, but resulted in payments of $7.5 million in fiscal 1998. Other charges of $4.0 million are for severance agreements attributable to the administrative and management workforce reductions in January 1998 the establishment of reserves for outdated information communications technology and other miscellaneous charges. Cash payments of $0.5 million were made in fiscal 1997 and $2.5 million of cash payments were made in fiscal 1998. The Company accelerated the write-off of deferred debt costs in connection with the renegotiation of the Company's credit facility in the amount of $5.3 million. The deferred debt costs were loan fees and legal costs associated with the Company's former $185.0 million revolving credit facility which was revised on January 30, 1998, and subsequently refinanced. The write-off of deferred debt costs were for cash payments of $3.0 million in fiscal 1997, $1.0 million in non-cash payments and an additional $1.3 million for cash payments to be made in fiscal 1998. In the second quarter of fiscal 1998, the Company recorded a $15.2 million charge for the loss on disposition of assets and closed store expenses. The components are as follows (in millions): Loss on disposition of assets and closed store expenses: Loss on disposition of real estate $ 8.6 Loss on disposals of closed store fixtures and equipment 2.9 Closed store expenses 3.7 ----- Total $15.2 ===== The $8.6 million loss on disposition of real estate represents the loss on sale of 16 properties comprised of closed stores and excess parcels. The $2.9 million loss on disposal of closed store fixtures relates to the excess loss on the disposition of the 28 stores closed since 1997. Both the loss on real estate and loss on closed store fixtures did not result in cash payments. The $3.7 million charge for closed store expenses relates primarily to the loss on inventory and expenses of two closed stores which closed during the second quarter of 1998, located in the Texas cities of San Antonio and El Paso. The balance relates to additional charges for prior closed store lease and severance reserves. These charges may result in future cash payments. The following represents reserve accounts created by the $55.0 million in charges recorded in 1996 and the $94.3 million in charges recorded in 1997 and the $15.2 million in charges in 1998 (in thousands): Note 11 - Reorganization Items As a result of the Chapter 11 filings, the Company has recorded the following reorganizational charges (in millions): Loss on disposition of real estate $24.4 Loss on disposals of closed store fixtures and equipment 6.4 Closed store expenses 8.9 Lease rejection damages 9.1 Restructuring charges 7.8 Retention and severance pay 1.8 ----- Total $58.4 ===== The $24.4 million loss on disposition of real estate represents the write-down to net realizable value of the 8 closing store properties held in fee, the write-off of leasehold improvements on the 9 closing store properties held under lease and certain other capitalized and deferred costs. The $6.4 million loss on disposals of closed stores fixtures and equipment represents the write-down to net realizable value of fixtures and equipment of the 17 closing stores. Both the loss on the real estate and the loss on the fixtures and equipment will not result in cash payments. The $8.9 million charge for closed store expenses relates primarily to the loss on inventory ($7.0 million) and the expenses to be incurred in the 17 closing stores during the going out of business sales ($1.9 million). The $7.8 million restructuring charges include legal and professional fees incurred or paid prior to the petition date, the write-off of loan costs previously incurred in connection with the Company's pre-petition working capital facility, certain capitalized inventory costs, and uncollectible receivables from vendors. Certain leases on equipment and real estate will be rejected or modified in connection with the Company's efforts to reorganize. The $9.1 million of lease rejection damages is the Company's current estimate of expected loss associated with the rejection of these leases. A $1.8 million charge was recorded to recognize certain retention payments and severance pay in connection with the Company's initiatives. Of the $58.4 million, $2.0 million was paid in cash in FY 1998, and up to an additional $4.5 million may result in future cash payments. The remainder of the charges is non-cash. The following represents reserve amounts created by the $58.4 million of reorganization items (in millions): Loss on disposition of real estate $ 0.6 Closed store expenses 8.9 Restructuring charges 2.5 Retention and severance pay 1.3 ----- Total $13.3 ===== Note 12 - Stockholders' Equity The Company's Stock Option Plan was established on September 14, 1989 (the "1989 Plan"). The 1989 Plan provides that options be granted to certain key employees and directors at exercise prices equal to not less than 50% of fair market value on the date the option is granted. In June 1997, the stockholders of the Company approved an amendment to the 1989 Plan increasing the number of shares that may be issued thereunder as 1,000,000 shares. All options granted to date have been at fair market value on the date of the grant. Prior to Fiscal 1996, options granted to key employees generally became exerciseable after one year in 25% increments per year and expire 10 years from the date of grant. Options granted to key employees in Fiscal 1996 and forward generally become excerciseable at 40% after two years and 20% per year thereafter and expire 10 years from the date of grant. Options granted to directors generally become fully exerciseable after one year and expire 10 years from the date of grant. The Company has reserved 3,212,212 shares for distribution under the 1989 Plan. Options to purchase 968,347 shares were granted to key employees and directors thereunder as of January 29, 1999. In March of 1996, the Company adopted an additional stock incentive plan, the 1996 Stock Incentive Plan, for issuance of stock options to Company employees who are not subject to the reporting requirements of Section 16 under the Exchange Act (the "1996 Plan"). One million shares are reserved for issuance under the 1996 Plan, and options to purchase a total of 781,450 shares were granted to employees thereunder, as of January 29, 1999. Vesting provisions are similar under both the 1989 Plan and the 1996 Plan. All options granted to date have been at fair market value on the date of the grant. Options granted to employees generally become exerciseable after one year in 25% increments per year and expire 10 years from the date of grant. Effective January 30, 1998, the Company adopted SFAS No. 128, "Earnings Per Share," which established new standards for computing and presenting EPS. Upon adoption, the Company restated its EPS for 1996 to conform with SFAS No. 128. The computations under SFAS No. 128 are summarized below: A summary of stock option activity related to the 1989 and 1996 Plans is as follows: The following table further summarizes information about the 1989 and 1996 Plans: In October 1995, the Financial Accounting Standards Board issued Financial Accounts Standard No.123, "Accounting for Stock Based Compensation" ("SFAS 123") which is effective for fiscal years beginning after December 15, 1995. As permitted by SFAS 123, the Company has elected to continue to account for its stock based plans under APB No. 25, "Accounting for Stock Issued to Employees". If the Company had elected to recognize compensation expense for stock options based on the fair value at grant date, consistent with the method prescribed by SFAS 123, net income and earnings per share would have been reduced to the proforma amounts shown below: The proforma amounts were determined using the Black-Scholes Valuation Model with the following key assumptions: (i) a discount rate of 7.0%, 5.6% and 5.1% for 1996, 1997 and 1998, respectively; (ii) a volatility factor initially based on the average trading price for the prior 18 months; (iii) no dividend yield; and (iv) an average expected option life of four years. On February 17, 1998 the Company re-priced all options outstanding at January 30, 1998 for active employees to an exercise price of $1.8125, the market closing price on that date. The number of options this impacted was 876,221 with previous market value grant prices ranging from $3.44 to $26.08. In 1997, 680,000 options were canceled for executive officers (Mr. Bebis and Mr. Wittman) who terminated their employment with the Company. The balance of the options canceled in 1997 were for other employees who terminated service with the Company. The grants in fiscal 1997, were primarily to Mr. Bush, 200,000 options, and Mr. Floum, 200,000 options. The balance of option grants were to incoming management personnel. In conjunction with a change in management in fiscal 1996, 236,500 outstanding options with exercise prices ranging from $11.67 to $29.33 were canceled and reissued at the then market value of $5 per share. The options vest immediately and expire 5 years from the date of grant. Additionally, 300,000 options were issued with an exercise price of $4.38, the market value on the date of grant. The options vest 40% on the second anniversary of the date of the grant and 20% each year thereafter and expire 10 years after the date of grant. In addition to the above option activity and as result of the February 1996 management change, options were canceled and reissued to new management. Note 13 -Subsequent Events On February 11, 1999, the Bankruptcy Court granted a motion for authority to obtain debtor-in-possession financing. Proceeds from the 18 month DIP facility are being used to finance the on-going working capital needs of the Company, to pay fees and expenses incurred in connection with the DIP facility agreement, to pay all amounts due under the pre-petition credit agreement, to replace the letter of credits issued and outstanding thereunder, and to pay certain other costs and bankruptcy related claims and charges as allowed by the Bankruptcy Court. During the term of the DIP facility agreement, the Company is restricted from making any distribution or declaring or paying any dividends (in cash or other property, other than capital stock) on, or purchasing, acquiring, redeeming or retiring any of the Company's capital stock, of any class, whether now or hereafter outstanding. Other restrictions include limitations on additional indebtedness, disposal of assets, change of control, capital expenditures and investments; provided, however, that the Company may make loans to its subsidiaries, Nationwide Team Sales, Inc. in an aggregate amount not to exceed $1.25 million. Additionally, the Company agreed to achieve certain levels of earnings before interest, taxes, depreciation, amortization and restructuring charges ("EBITDAR") on a cumulative quarterly basis beginning with the first quarter of fiscal 1999 and each succeeding quarter thereafter through the end of fiscal 1999 and on a rolling 12 months basis thereafter through the duration of the agreement. The DIP facility provides for a term loan of $25 million and a revolving loan credit facility of $85 million including a $10 million letter of credit subfacility. The term loan consists of a Tranche A and a Tranche B. Tranche A was initially funded at $9.7 million with a total commitment of $10 million. The Tranche B term loan was initially funded at $15 million. Interest on the Tranche A term loan accrues at the Reference Rate plus 1.75%. Interest on the Tranche B term loan accrues at 12.75%. Total principal installments of $417 thousand are to be paid monthly commencing with August 1, 1999 and continuing on the first day of each succeeding month. The Company is required to prepay the term loans with the net proceeds from the sale of Real Property Collateral pursuant to a prescribed allocation in the loan agreement. All prepayments of principal will be ratably applied to principal installments in the inverse order of maturity. Availability under the revolving loan credit facility is limited to the lesser of $85 million or amounts based on a predetermined formula which includes a provision for up to 80% of Eligible Accounts and approximately 74.5% of Eligible Inventory. Commitments under the letter of credit subfacility are limited to the lesser of $10 million or availability under the revolving line of credit. The Company incurred approximately $1.3 million in fees in connection with the new DIP facility agreement. Interest on the term loans and revolving advances and fees on the letters of credit are payable monthly in arrears. The Agreement also contains a provision for early termination, at the option of the Company, with a payment of an early termination premium to the lenders if exit financing is provided by a third party. Note 14 - Quarterly Financial Information (Unaudited) Summarized quarterly financial data for fiscal 1998 and fiscal 1997 is as follows:

1060455_1999.txt

1060455_1999

1999

1060455

ITEM 1 BUSINESS - ---------------- Killbuck Bancshares, Inc. (the "Company") was incorporated under the laws of the State of Ohio on November 29, 1991 at the direction of management of the Killbuck Savings Bank Company (the "Bank,") for the purpose of becoming a bank holding company by acquiring all of the outstanding shares of the Bank. In November, 1992, the Company became the sole shareholder of the Bank. The Bank carries on business under the name "The Killbuck Savings Bank Company." The principal office of the Company is located at 165 N. Main Street, Killbuck, Ohio. The Killbuck Savings Bank Company was established under the banking laws of the State of Ohio in November in 1900. The Bank is headquartered in Killbuck, Ohio, which is located in the northeast portion of Ohio, in the County of Holmes. Holmes County has a population of approximately 35,000. The Bank provides a wide range of retail banking services to individuals and small to medium-sized businesses. These services include various deposit products, business and personal loans, credit cards, residential mortgage loans, home equity loans, and other consumer oriented financial services including IRA accounts, safe deposit and night depository facilities. The Bank also has automatic teller machines located at all locations providing 24 hour banking service to our customers. The Bank belongs to MAC, a national ATM network with thousands of locations nationwide. Neither the Company nor the Bank have any foreign operations, assets, investments or deposits. The Company has one wholly-owned subsidiary, The Killbuck Savings Bank Company. The Bank has seven full service offices, with five in Holmes County, one in Knox County and one in Tuscarawas County. The new full service branch facility in Sugarcreek, Ohio in Tuscarawas County opened in February, 2000. On November 21, 1998 the merger of Commercial and Savings Bank Company of Danville, Ohio with and into The Killbuck Savings Bank Company, with Killbuck Savings Bank being the surviving bank was completed using the purchase method of accounting. Commercial and Savings Bank Company had total assets of approximately $15.6 million on the date of the merger and operated out of one location in Danville, Ohio in Knox County. On April 13, 1998, the Board of Directors authorized an increase in the authorized common shares from 200,000 to 1,000,000 shares and also authorized a 5 for 1 stock split of common stock to shareholders of record on May 1, 1998. The Company, through its subsidiary, The Killbuck Savings Bank Company, conducts the business of a commercial banking organization. At December 31, 1999, the Company and its subsidiary had consolidated total assets of $243,149,880, and consolidated total equity of $28,916,718. The capital of the Company consists of 1,000,000 authorized shares of capital stock, no par value of which 705,331 shares were outstanding at December 31, 1999 to 975 shareholders. The Bank is a state banking Company. The Bank is regulated by the Ohio Division of Financial Institutions ("ODFI") and its deposits are insured by the Federal Deposit Insurance Corporation to the extent permitted by law and, as a subsidiary of the Company, is regulated by the Federal Reserve Board. EMPLOYEES - --------- As of December 31, 1999, the Bank had 80 full-time and 25 part-time employees. The Company had no employees. The Bank provides a number of benefits for its full-time employees, including health and life insurance, pension, workers' compensation, social security, paid vacations, and numerous bank services. No employees are union participants or subject to a collective bargaining agreement. COMPETITION - ----------- The commercial banking business in the market areas served by the Bank is very competitive. The Company and the Bank are in competition with commercial banks located in their own service areas. Some competitors of the Company and the Bank are substantially larger than the Bank. In addition to local bank competition, the Bank competes with larger commercial banks located in metropolitan areas, savings banks, savings and loan associations, credit unions, finance companies and other financial institutions for loans and deposits. There are six financial institutions operating in Holmes County. As of June 30, 1999 (the most recent date for which information is available) the Commercial and Savings Bank, Millersburg had the largest market share with $214 million in total deposits as of such date, representing a market share of 46.74%. The Bank had the second largest market share with deposits of $177 million as of such date, representing a market share of 38.56%. Commercial and Savings Bank had total assets as of December 31, 1999, of $326 million compared to the Bank's total assets of $243 million as of such date. CERTAIN REGULATORY CONSIDERATIONS - --------------------------------- The following is a summary of certain statutes and regulations affecting the Company and its subsidiary. This summary is qualified in its entirety by such statutes and regulations. THE COMPANY - ----------- The Company is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, ("BHC Act") and as such is subject to regulation by the Federal Reserve Board. A bank holding company is required to file with the Federal Reserve Board quarterly reports and other information regarding its business operations and those of its subsidiaries. A bank holding company and its subsidiary banks are also subject to examination by the Federal Reserve Board. The BHC Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before acquiring substantially all the assets of any bank or bank holding company or ownership or control of any voting shares of any bank or bank holding company, if, after such acquisition, it would own or control, directly or indirectly, more than five percent (5%) of the voting shares of such bank or bank holding company. In approving acquisitions by bank holding companies of companies engaged in banking-related activities, the Federal Reserve Board considers whether the performance of any such activity by a subsidiary of the holding company reasonably can be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, which outweigh possible adverse effects, such as over concentration of resources, decrease of competition, conflicts of interest, or unsound banking practices. Bank holding companies are restricted in, and subject to, limitations regarding transactions with subsidiaries and other affiliates. In addition, bank holding companies and their subsidiaries are prohibited from engaging in certain "tie in" arrangements in connection with any extensions of credit, leases, sales of property, or furnishing of services. THE COMPANY SUBSIDIARY - ---------------------- The Company operates a single bank, namely, The Killbuck Savings Bank Company. As an Ohio state chartered commercial bank, the Bank is supervised and regulated by the ODFI, and subject to laws and regulations applicable to Ohio banks. CAPITAL - ------- The Federal Reserve Board, ODFI, and FDIC require banks and holding companies to maintain minimum capital ratios. The Federal Reserve Board adopted final "risk-adjusted" capital guidelines for bank holding companies. The guidelines became fully implemented as of December 31, 1992. The ODFI and FDIC have adopted substantially similar risk-based capital guidelines. These ratios involve a mathematical process of assigning various risk weights to different classes of assets, then evaluating the sum of the risk-weighted balance sheet structure against the Company's capital base. The rules set the minimum guidelines for the ratio of capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) at 8%. At least half of the total capital is to be composed of common equity, retained earnings, and a limited amount of perpetual preferred stock less certain goodwill items ("Tier 1 Capital"). The remainder may consist of a limited amount of subordinated debt, other preferred stock, or a limited amount of loan loss reserves. In addition, the federal banking regulatory agencies have adopted leverage capital guidelines for banks and bank holding companies. Under these guidelines, banks and bank holding companies must maintain a minimum ratio of three percent (3%) Tier 1 Capital (as defined for purposes of the year-end 1992 risk-based capital guidelines) to total assets. The Federal Reserve Board has indicated, however, that banking organizations that are experiencing or anticipating significant growth, are expected to maintain capital ratios well in excess of the minimum levels. Regulatory authorities may increase such minimum requirements for all banks and bank holding companies or for specified banks or bank holding companies. Increases in the minimum required ratios could adversely affect the Company and the Bank, including their ability to pay dividends. At December 31, 1999, the Company's respective total and Tier 1 risk-based capital ratios and leverage ratios exceeded the minimum regulatory requirements. See Note 16 in the audited consolidated financial statements included in the Annual Report and incorporated herein by reference in the report as Exhibit 13. ADDITIONAL REGULATION - --------------------- The Bank is also subject to federal regulation as to such matters as required reserves, limitation as to the nature and amount of its loans and investments, regulatory approval of any merger or consolidation, issuance or retirement of their own securities, limitations upon the payment of dividends and other aspects of banking operations. In addition, the activities and operations of the Bank are subject to a number of additional detailed, complex and sometimes overlapping laws and regulations. These include state usury and consumer credit laws, state laws relating to fiduciaries, the Federal Truth-in-Lending Act and Regulation Z, the Federal Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the Truth in Savings Act, the Community Reinvestment Act, anti-redlining legislation and antitrust laws. DIVIDEND REGULATION - ------------------- The ability of the Company to obtain funds for the payment of dividends and for other cash requirements is largely dependent on the amount of dividends which may be declared by the Bank. Generally, the Bank may not declare a dividend, without the approval of the ODFI, if the total of dividends declared in a calendar year exceeds the total of its net profits for that year combined with its retained profits of the preceding two years. GOVERNMENT POLICIES AND LEGISLATION - ------------------------------------ The policies of regulatory authorities, including the ODFI, Federal Reserve Board, FDIC and the Depository Institutions Deregulation Committee, have had a significant effect on the operating results of commercial banks in the past and are expected to do so in the future. An important function of the Federal Reserve System is to regulate aggregate national credit and money supply through such means as open market dealings in securities, establishment of the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. Policies of these agencies may be influenced by many factors, including inflation, unemployment, short-term and long-term changes in the international trade balance and fiscal policies of the United States government. FINANCIAL SERVICES MODERNIZATION ACT OF 1999 - -------------------------------------------- On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act (better known as the Financial Services Modernization Act of 1999) which will, effective March 11, 2000, permit bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized under the Federal Deposit Insurance Corporation Act of 1991 prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. The Financial Services Modernization Act defines "financial in nature" to include: securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. In addition, a financial holding company may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company has a Community Reinvestment Act rating of satisfactory or better. The specific effects of the enactment of the Financial Services Modernization Act on the banking industry in general and on the Company and the Bank in particular have yet to be determined due to the fact that the Financial Services Modernization Act was only recently adopted. The United States Congress has periodically considered and adopted legislation, such as the Gramm-Leach-Bliley Act, which has resulted in further deregulation of both banks and other financial institutions, including mutual funds, securities brokerage firms and investment banking firms. No assurance can be given as to whether any additional legislation will be adopted or as to the effect such legislation would have on the business of the Bank or the Company DEPOSIT INSURANCE - ----------------- The Federal Deposit Insurance Company Improvement Act of 1991 ("FDICIA") was enacted in 1991. Among other things, FDICIA, requires federal bank regulatory authorities to take "prompt corrective action" with respect to banks that do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The amount each institution pays for FDIC deposit insurance coverage is determined in accordance with a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their level of capital and supervisory evaluation. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered substantial supervisory concerns pay the highest premium. Because the Bank is presently "well capitalized" it pays the minimum deposit insurance premiums. The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital. Management of the Company is not aware of any activity or condition that could result in termination of the deposit insurance of the Bank. PROPOSED LEGISLATION - -------------------- There have been proposed a number of legislative and regulatory proposals designed to strengthen the federal deposit insurance system and to improve the overall financial stability of the U.S. banking system. It is impossible to predict whether or in what form these proposals may be adopted in the future, and if adopted, what their effect would be on the Company or Bank. MONETARY POLICIES - ----------------- The earnings of the Company are dependent upon the earnings of its wholly-owned subsidiary bank. The earnings of the subsidiary bank are affected by the policies of regulatory authorities, including the Ohio Division of Financial Institutions, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation. The policies and regulations of the regulatory agencies have had and will continue to have a significant effect on deposits, loans and investment growth, as well as the rate of interest earned and paid, and therefore will affect the earnings of the subsidiary bank and the Company in the future, although the degree of such impact cannot accurately be predicted. SECURITIES LAWS AND COMPLIANCE - ------------------------------ As of June 30, 1998, the Company's common stock was registered with the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934, as amended ("1934 Act"). This registration requires ongoing compliance with the 1934 Act and its periodic filing requirements as well as a wide range of Federal and State securities laws. These requirements include, but are not limited to, the filing of annual, quarterly and other reports with the SEC, certain requirements as to the solicitation of proxies from shareholders as well as other proxy rules, and compliance with the reporting requirements and "short-swing" profit rules imposed by section 16 of the 1934 Act. ITEM 2 ITEM 2 DESCRIPTION OF PROPERTY - ------------------------------- PROPERTIES The Company owns no real property but utilizes the main office of the Bank. The Company's and the Bank's executive offices are located at 165 North Main Street, Killbuck, Ohio. The Company pays no rent or other form of consideration for the use of this facility. All offices are owned by the Bank. The Bank has five offices located in Holmes County (1), one in Knox County (2), and one in Tuscarawas County (3). The new full service branch facility in Sugarcreek, Ohio opened in February, 2000. The Bank's total investment in office property and equipment was $6.8 million with a net book value $3.9 million at December 31, 1999. The offices are at the following locations. Main Office: (1) Berlin Branch (1) Mt. Hope Branch (1) 165 North Main Street 4853 East Main Street 8115 State Rt. 241 Killbuck, Ohio 44637 Berlin Ohio 44610 Mt. Hope, Ohio 44660 Millersburg North Branch (1) Millersburg South Branch (1) Danville Branch (2) 181 N. Washington Street 1642 S. Washington Street 701 S. Market Street Millersburg, Ohio 44654 Millersburg, Ohio 44654 Danville, Ohio 43014 Sugarcreek Branch (3) 1035 W. Main Street Sugarcreek, Ohio 44681 ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ------------------------- Neither the Bank nor the Company is involved in any material legal proceedings. The Bank, from time to time, is a party to litigation which arises in the ordinary course of business, such as claims to enforce liens, claims involving the origination and servicing of loans, and other issues related to the business of the Bank. In the opinion of management the resolution of any such issues would not have a material adverse impact on the financial position, results of operation, or liquidity of the Bank or the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS - --------------------------------------------------------- No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDERS MATTERS - ---------------------------------------------------------------------------- As of December 31, 1999, the Company had 975 shareholders of record who collectively held 705,331 of the 1,000,000 authorized shares of the Company's no par value stock. There is no established public trading market for the Company's common stock and the shares of the Company are not listed on any exchange. Sale price information is based on information reported to the Company by individual buyers and sellers of the Company stock. The following table summarizes the high and low prices and dividend information for 1999 and 1998, adjusted for the five for one stock split on May 1, 1998. Cash dividends are paid on a semi-annual basis. Cash Dividends Quarter Ended High Low Paid - ------------------ -------- --------- --------- 1999 March 31 $92.88 $92.03 N/A June 30 94.47 93.48 .60 September 30 94.87 93.62 N/A December 31 96.33 96.12 .65 1998 March 31 69.50 69.50 N/A June 30 Unknown Unknown .50 September 30 82.63 82.63 N/A December 31 90.56 85.31 .55 The Company has paid regular semi-annual cash dividends since it became a bank holding company in 1992, and assuming the ability to do so, it is anticipated that the Company will continue to declare regular semi-annual cash dividends. For information on dividends per share, net income per share and ratio of dividends to net income per share see the Selected Financial Data of the Annual Report to Shareholders of Killbuck Bancshares, Inc. for the year ended December 31, 1999, included in this report as Exhibit 13 and is incorporated herein by reference. The ability of the Company to pay dividends will depend on the earnings of its subsidiary bank and its financial condition, as well as other factors such as market conditions, interest rates and regulatory requirements. Therefore, no assurances may be given as to the continuation of the Company's ability to pay dividends or maintain its present level of earnings. For a discussion on subsidiary dividends see Note 15 to the audited Consolidated Financial Statements of the Annual Report to Shareholders of Killbuck Bancshares, Inc. for the year ended December 31, 1999, included in this report as Exhibit 13 and is incorporated herein by reference. The common stock of the Company is not subject to any redemption provisions or restrictions on alienability. The common stock is entitled to share pro rata in dividends and in distributions in the event of dissolution or liquidation. There are no options, warrants, privileges or other rights with respect to Company stock at the present time, nor are any such rights proposed to be issued. ITEM 6 ITEM 6 SELECTED FINANCIAL DATA - ------------------------------ Selected Financial Data of the Annual Report to Shareholders Of Killbuck Bancshares, Inc. for the year ended December 31, 1999, included in this report as Exhibit 13, is incorporated herein by reference. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ---------------------------------------------------------------------- RESULTS OF OPERATIONS - --------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations of the Annual Report to Shareholders of Killbuck Bancshares, Inc. for the year ended December 31, 1999, included in this report as Exhibit 13, is incorporated herein by reference. Additional statistical information noted below is provided pursuant to Guide 3, Statistical Disclosure by Bank Holding Companies. Investment Portfolio Book Value of Investments Book values of investment securities at December 31 are as follows (in thousands): December 31, ------------------------------------- 1999 1998 1997 --------- --------- --------- Securities available for sale: U.S. Treasury securities $ 3,000 $ 9,372 $ 9,802 Obligations of U.S. Government Agencies and Corporations 38,150 28,755 24,233 Equity securities 1,161 1,101 1,044 --------- --------- --------- Total available for sale 42,311 39,228 35,079 --------- --------- --------- Securities held to maturity: Obligations of States and Political subdivisions 32,797 25,909 23,298 Corporate securities 1,628 1,640 100 --------- --------- --------- Total held to maturity 34,425 27,549 23,398 --------- --------- --------- Total $ 76,736 $ 66,777 $ 58,477 ========= ========= ========= MATURITY SCHEDULE OF INVESTMENTS The following table presents the investment portfolio, the weighted average yield and maturities at December 31, 1999 (dollars in thousands): (1) The weighted average yield has been computed using the historical amortized cost for available for sale securities. (2) Equity securities which have no stated maturity, are comprised of common stock of the Federal Home Loan Bank, Federal Reserve Bank and the Independent State Bank of Ohio. (3) Weighted average yields on nontaxable obligations have been computed based on actual yield stated on the security. Excluding holdings of U.S. Treasury and other agencies and corporations of the U.S. Government, there were no investments in securities of any one issuer that exceeded 10% of the Bank's shareholder equity at December 31, 1999. TYPES OF LOANS The following table presents the composition of the loan portfolio and the percentage of loans by type as follows (dollars in thousands): The largest category of loans comprising the Bank's loan portfolio is residential real estate loans. These loans are primarily single family residential real estate loans secured by a first mortgage on the dwelling. The risks associated with these loans are primarily the risk of default in repayment and inadequate collateral. The second largest loan segment of the Bank's loan portfolio is the commercial and other category. The loans comprising this category represent loans to business interest, located primarily within the Bank's defined market areas, with no significant industry concentration. Commercial loans include both secured and unsecured loans. The risks associated with these loans are principally the risk in default of the repayment of principal resulting from economic problems of the commercial customer, economic downturn effecting the market in general and in the case of secured loans inadequate collateral. Consumer and credit card loans comprise the next largest area of the Bank's loan portfolio. These loans include consumer installment, including automobile loans as well as personal and credit card loans. The risks inherent in these loans include the risk of default in principal repayment and in the case of secured loans, the risk of inadequate collateral. Real estate commercial loans represent the next largest category and include development loans as well as investment commercial real estate loans. These loans have risks which include the risk of default in the repayment of principal and inadequate collateral as well as the risk of cash flow interruption due to, in the case of rental real estate, the inability to obtain or collect adequate rental rates. MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST RATE The following table presents maturity distribution and interest rate sensitivity of real estate - commercial, real estate - construction and commercial and other loans at December 31, 1999 (dollars in thousands): After 1 Year Within Within 1 Year 5 Years After 5 Years Total -------- ------------ ------------- -------- Real estate - commercial $ 274 $ 1,541 $ 21,903 $ 23,718 Real estate - construction 1,397 - - 1,397 Commercial and other 19,700 13,262 4,805 37,767 -------- ---------- ---------- -------- $ 21,371 $ 14,803 $ 26,708 $ 62,882 ======== ========== ========== ======== Fixed interest rates $ 5,942 $ 7,174 $ 1,770 $ 14,886 Variable interest rates 15,429 7,629 24,938 47,996 -------- ---------- ---------- -------- $ 21,371 $ 14,803 $ 26,708 $ 62,882 ======== ========== ========== ======== RISK ELEMENTS Loans are subject to ongoing periodic monitoring by management and the board of directors. A loan is classified as nonaccrual when, in the opinion of management, there are doubts about collectability of interest and principal. At the time the accrual of interest is discontinued, future income is recognized only when cash is received. Renegotiated loans are those loans which terms have been renegotiated to provide a reduction or deferral of principal or interest as a result of the deterioration of the borrower. At December 31, 1999 the majority (85.95%) of the non accrual loans is comprised of three loans. One is a commercial loan for $110,000 and the other two are commercial real estate loans for $85,303 and $51,359 respectively. The commercial loan is secured by a certificate of deposit for $50,000 and residential real estate with approximately $185,000 worth of equity. The two commercial real estate loans are secured by commercial real estate appraised for $110,000 and $65,000 respectively. The following table presents information concerning nonperforming assets including nonaccrual loans, loans 90 days or more past due, renegotiated loans, other real estate and repossessed assets at December 31, (dollars in thousands). The amount of interest income that would have been recognized had the loans performed in accordance with their original terms was approximately $19,969 and the amount of interest income that was recognized was $-0- for the year ended December 31, 1999. There are no loans as of December 31, 1999, other than those disclosed above as either nonperforming or impaired, where known information about the borrower caused management to have serious doubts about the borrower's ability to comply with their contractual repayment obligations. There are no concentration of loans to borrowers engaged in similar activities which exceed 10% of total loans that management is aware of. Based upon the ongoing quarterly review and assessment of credit quality, management is not aware of any trends or uncertainties related to any accounts which might have a material adverse effect on future earnings, liquidity or capital resources. There are no other interest bearing assets that would be subject to disclosure as either nonperforming or impaired if such interest bearing assets were loans. LOAN LOSS EXPERIENCE Management makes periodic provisions to the allowance for loan losses to maintain the allowance at an acceptable level commensurate with the credit risks inherent in the loan portfolio. There can be no assurances, however, that additional provisions will not be required in future periods. The following table presents a summary of loan losses by loan type and changes in the allowance for loan losses for the years ended December 31, (dollars in thousands): The Bank reviews the adequacy of its allowance for loan losses on a quarterly basis. In determining the adequacy of its allowance account the Bank makes general allocations based upon loan categories, nonaccrual, past due and classified loans. After general allocations, the Bank makes specific allocations for individual credits. Any remaining balance is determined to be unallocated. The Bank has determined that the reserve is adequate as of December 31, 1999, based upon its analysis and experience. However, there can be no assurance that the current allowance for loan losses will be adequate to absorb all future loan losses. The following table presents management's estimate of the allocation of the allowance for loan losses among the loan categories, although the entire allowance balance is available to absorb any actual charge-offs that may occur, along with the percentage of loans in each category to total loans for the years ended December 31 (dollars in thousands): ITEM 7A ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Bank's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Because of the nature of the Bank's operations, the Bank is not subject to currency exchange or commodity price risk and, since the Bank has no trading portfolio, it is not subject to trading risk. Currently, the Bank has equity securities that represent only 1.51% of its investment portfolio and, therefore, equity price risk is not significant. The Bank's loan portfolio, concentrated primarily within the surrounding market area, is subject to risks associated with the local economy. Since all of the interest earning assets and interest bearing liabilities are located at the Bank, all of the interest rate risk lies at the Bank level. As a result, all significant interest rate risk management procedures are performed at the Bank level. The Bank actively manages interest rate sensitivity and asset/liability products through an asset/liability management committee. The principle purposes of asset-liability management are to maximize current net interest income while minimizing the risk to future earnings of negative fluctuations in net interest margin and to insure adequate liquidity exists to meet operational needs. In an effort to reduce interest rate risk and protect itself from the negative effects or rapid or prolonged changes in interest rates, the Bank has instituted certain asset and liability management measures, including underwriting long-term fixed rate loans that are saleable in the secondary market, offering longer term deposit products and diversifying the loan portfolio into shorter term consumer and commercial business loans. In addition, since the mid-1980's, the Bank has originated adjustable-rate loans and as of December 31, 1999, they comprised approximately 62% of the total loan portfolio. One of the principal functions of the Company's asset/liability management program is to monitor the level to which the balance sheet is subject to interest rate risk. The goal of this program is to manage the relationship between interest-earning assets and interest-bearing liabilities to minimize the fluctuations in the net interest spread and achieve consistent growth in net interest income during periods of changing interest rates. Interest rate sensitivity is measured as the difference between the volume of assets and liabilities that are subject to repricing in a future period of time. These differences are known as interest sensitivity gaps. The Bank utilizes gap management as the primary means of measuring interest rate risk. Gap analysis identifies and quantifies the Bank's exposure or vulnerability to changes in interest rates in relationship to the Bank's interest rate sensitivity position. A rate sensitive asset or liability is one which is capable of being repriced (i.e., the interest rate can be adjusted or principal can be reinvested) within a specified period of time. Subtracting total rate sensitive liabilities (RSL) from total rate sensitive assets (RSA) within specified time horizons nets the Bank's gap positions. These gaps reflect the Bank's exposure to changes in market interest rates, as discussed below. Because many of the Bank's deposit liabilities are capable of being immediately repriced, the Bank offers variable rate loan products in order to help maintain a proper balance in its ability to reprice various interest bearing assets and liabilities. Furthermore, the Bank's deposit rates are not tied to an external index. As a result, although changing market interest rates impact repricing, the Bank has retained much of its control over repricing. The Bank conducts the rate sensitivity analysis through the use of a simulation model which also monitors earnings at risk by projecting earnings of the Bank based upon an economic forecast of the most likely interest rate movement. The model also calculates earnings of the Bank based upon what are estimated to be the largest foreseeable rate increase and the largest foreseeable rate decrease. Such analysis translates interest rate movements and the Bank's rate sensitivity position into dollar amounts by which earnings may fluctuate as a result of rate changes. A 2% immediate increase in interest rates would increase earnings by 1.56% and a 2% immediate decrease in interest rates would decrease earnings by 1.54%. The data included in the table that follows indicates that the Bank is liability sensitive within one year. Generally, a liability sensitive gap indicates that declining interest rates could positively affect net interest income as expense of liabilities would decrease more rapidly than interest income would decline. Conversely, rising rates could negatively affect net interest income as income from assets would increase less rapidly than deposit costs. During times of rising interest rates, an asset sensitive gap could positively affect net interest income as rates would be increased on a larger volume of assets as compared to deposits. As a result, interest income would increase more rapidly than interest expense. An asset sensitive gap could negatively affect net interest income in an environment of decreasing interest rates as a greater amount of interest bearing assets could be repricing at lower rates. Although rate sensitivity analysis enables the Bank to minimize interest rate risk, the magnitude of rate increases or decreases on assets versus liabilities may not correlate directly. As a result, fluctuations in interest spreads can occur even when repricing capabilities are perfectly matched. It is the policy of the Bank to generally maintain a gap ratio within a range that is plus 20 percent to minus 10 percent of total assets for the time horizon of one year. When Management believes that interest rates will increase it can take actions to increase the RSA/RSL ratios. When Management believes interest rates will decline, it can take actions to decrease the RSA/RSL ratio. During 1999, in order to adjust its interest rate sensitivity, the Bank's focus was on spreading out the maturities of time deposits within the one year time frame while continuing to make variable rate loans. The above strategy was implemented to better position the Bank for rate changes in either direction. The Bank's asset/liability management focus for 2000 will include improving the Bank's rate sensitivity gap. As noted above, at December 31, 1999 the Bank was liability sensitive, however, the cumulative rate sensitivity gap was such that the Bank's earnings and capital should not be materially affected by the repricing of assets and liabilities due to increases or decreases in interest rates in 2000. Changes in market interest rates can also affect the Bank's liquidity position through the impact rate changes may have on the market value of the Bank's investment portfolio. Rapid increases in market rates can negatively impact the market values of investment securities. As securities values decline it becomes more difficult to sell investments to meet liquidity demands without incurring a loss. The Bank can address this by increasing liquid funds which may be utilized to meet unexpected liquidity needs when a decline occurs in the value of securities. The following table presents the Bank's interest rate sensitivity gap position as of December 31, 1999 (dollars in thousands): ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATE - -------------------------------------------------- The report of independent auditors and consolidated financial statements included in the Annual Report to shareholders of Killbuck Bancshares, Inc. for the year ended December 31, 1999, included in this report as Exhibit 13, are incorporated herein by reference. ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTS ON ACCOUNTING AND FINANCIAL - ----------------------------------------------------------------------------- DISCLOSURE - ---------- None PART III ITEM 10 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT - ------------------------------------------------------ The following table lists the Non-Director, Executive Officers of the Company and its subsidiary, Killbuck Savings Bank Company, and certain other information with respect to each individual, as of December 31, 1999. The information required by this item with respect to Directors and other executive officers of the Company and its subsidiary, Killbuck Savings Bank Company, is incorporated herein by reference to the information under the heading "Election of Directors and Information with Respect to Directors and Officers" in the Proxy Statement of the Company. The information required regarding disclosure of any known late filings or failure by an insider to file a report required by Section 16(a) of the Securities Exchange Act is incorporated herein by reference to the information under the heading "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Proxy Statement of the Company. Name Age All Positions with Company and Bank - ---------------- ----- --------------------------------------------- Craig A. Lawhead 42 Vice president and treasurer of Company since 1992; Executive vice president of bank since 1990. John D. Boley 39 Vice president and secretary of Company since 1992; Senior vice president and cashier of Bank since 1990. Executive officers of the Company and Bank reside in or near Killbuck, Ohio and all of the executive officers have been with the Company and Bank the past five years. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION - ------------------------------ Information required by this item is incorporated herein by reference to the information under the heading "Executive Compensation and Other Information" in the Proxy Statement of the Company. ITEM 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ---------------------------------------------------------------------- Information required by this item is incorporated herein by reference to the information under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement of the Company. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------ Information required by this item is incorporated herein by reference to the information under the heading "Certain Relationships and Related Transactions" in the Proxy Statement of the Company and in Note 5 of the Notes to Consolidated Financial statements included in the Annual Report to Shareholders for the year ended December 31, 1999, included in this report as Exhibit 13, and incorporated herein by reference. PART IV ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8 - --------------------------------------------------------------------- Financial Statements and Schedules ---------------------------------- The following consolidated financial statements of Killbuck Bancshares, Inc. and subsidiary, included in the Annual Report to Shareholders for the year ended December 31, 1999, are incorporated by reference in item 8.: Report of Independent Auditors' Consolidated Balance Sheet at December 31, 1999 and 1998 Consolidated Statement of Income for the Years ended December 31, 1999, 1998 and 1997 Consolidated Statement of Changes in Shareholders' Equity for the Years ended December 31, 1999, 1998 and 1997 Consolidated Statement of Cash Flows for the Years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements Schedules are omitted because they are inapplicable, not required, or the information is included in the consolidated financial statements or notes thereto. Reports on Form 8-K ------------------- No reports on Form 8-K were filed during the fourth quarter of 1999. Exhibits -------- The following exhibits are filed herewith and/or are incorporated herein by reference. Exhibit Number Description - ------- ----------------------------------------------------------------------- 3(i) Certificate and Articles of Incorporation of Killbuck Bancshares, Inc.* 3(ii) Code of regulations of Killbuck Bancshares, Inc.* 10 Agreement and plan of reorganization with Commercial and Savings Bank Company* 12 Statement regarding computation of ratios. 13 Portions of the 1999 Annual Report to Shareholders 22 Subsidiary of the Holding Company.* 24 Consent of S.R. Snodgrass, A.C. 27 Financial Data Schedule (electronic filing only) 99 Proxy statement dated March 13, 2000 for the Annual Shareholders meeting to be held April 10, 2000.** *Incorporated by reference to an identically numbered exhibit to the Form 10 (File No. 000-24147) filed with SEC on April 30, 1998 and subsequently amended on July 8, 1998 and July 31, 1998. **Except for the portions of the proxy expressly incorporated by reference, the proxy is furnished solely for the information of the commission and is not deemed "filed" as part hereof. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Killbuck Bancshares, Inc. ------------------------- (Registrant) By: /s/ Luther E. Proper ------------------------ Luther E. Proper President and Chief Executive Officer/Director (Duly authorized representative) Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Description Date - ------------------------ ------------------- -------------- /s/ Luther E. Proper President, Chief Executive March 13, 2000 - ------------------------ Officer and Director Luther E. Proper /s/ John W. Baker Director March 13, 2000 - ------------------------ John W. Baker /s/ Robert D. Bell Director March 13, 2000 - ------------------------ Robert D. Bell /s/ Ted Bratton Director March 13, 2000 - ------------------------ Ted Bratton /s/ Richard L. Fowler Director March 13, 2000 - ------------------------ Richard L. Fowler /s/ Thomas D. Gindlesberger Director March 13, 2000 - ------------------------ Thomas D. Gindlesberger /s/ Allan R. Mast Director March 13, 2000 - ------------------------ Allan R. Mast /s/ Dean J. Mullet Director March 13, 2000 - ------------------------ Dean J. Mullet /s/ Kenneth F. Taylor Director March 13, 2000 - ------------------------ Kenneth F. Taylor /s/ Michael S. Yoder Director March 13, 2000 - ------------------------ Michael S. Yoder

65770_1999.txt

65770_1999

1999

65770

ITEM 1. DESCRIPTION OF BUSINESS OVERVIEW Microvision, Inc. ("Microvision" or the "Company"), incorporated in 1993, develops information display and related technologies that allow electronically generated images and information to be projected to a viewer's eye. The Company has developed prototype Retinal Scanning Display ("RSD") technology devices including portable color and monochrome versions and a full color table-top version, and is currently refining and developing its RSD technology for defense and commercial applications. The Company expects to commercialize its technology through the development of products and as a supplier of personal display technology to original equipment manufacturers ("OEMs"). The Company believes the RSD technology will be useful in a variety of applications, including portable communications and visual simulation for defense, medical, industrial and entertainment that include applications requiring the superimposing of images on the user's field of vision. The Company expects that its RSD technology will allow for the production of highly miniaturized, lightweight, battery-operated displays that can be held or worn comfortably. The Company's scanning technology may also be applied to the capturing of images in such products as digital cameras or bar code readers. The Company may expend funds in evaluating and developing solutions for possible future products involving this application. The Company's RSD technology includes certain proprietary technology developed by the Company, certain technology licensed from other companies and the Virtual Retinal Display-TM- (VRD-TM-) technology licensed from the University of Washington ("see Intellectual Property and Proprietary Rights"). Information displays are the primary medium through which text and images generated by computers and other electronic systems are delivered to end-users. For decades, the cathode ray tube ("CRT") and, more recently, flat panel displays have been the dominant display devices. In recent years, as the computer and electronics industries have made substantial advances in miniaturization, manufacturers have sought lightweight, low power, cost effective displays to develop more portable products. The Company's RSD technology is fundamentally different from previously commercialized display technologies. RSD technology creates a high resolution, full motion image by scanning a low power beam of colored light to "paint" rows of pixels on the viewer's eye. In certain applications, the image appears in the viewer's field of vision as if the viewer were only an arm's length away from a high quality video screen. The RSD technology can also be used to superimpose an image on the viewer's field of vision, enabling the viewer to see data or images in the context of his or her natural surroundings. In each case, a high resolution, bright image is created. The Company's objective is to be a leading provider of personal display products and imaging technology in a broad range of professional and consumer applications. The Company intends to achieve this objective and to generate revenues through a combination of the following activities: the licensing of technology to OEMs of products to a variety of markets; the provision of engineering services associated with cooperative development arrangements and research contracts; and the manufacture and sale of high-performance personal display products to professional users, directly or through joint ventures. The Company is in discussions with systems and equipment manufacturers in the defense and aerospace, wireless communications, medical, industrial, and commercial and consumer electronics industries to develop or co-develop products that the Company believes to be the most commercially viable. During the fourth quarter of 1999, the Company sold engineering prototypes of a commercial RSD product. The Company plans to sell additional units of this prototype RSD during the first half of 2000. The Company plans to introduce a production version of the prototype RSD in 2001. Sales of production version RSD's may not occur, however, until substantially later, if at all. The Company's existing prototypes have demonstrated the technological feasibility of the RSD technology and the Company's ability to miniaturize certain of its key components. The Company has completed the development of a mechanical resonant scanner ("MRS") that the Company believes represents a breakthrough in the miniaturization of scanning devices. The Company believes that the MRS will permit high quality displays using smaller components produced at lower cost than is possible with current alternative technologies. Additional work is in progress to achieve full color capability in miniaturized RSD devices, to expand the "exit pupil" of the RSD system (which defines the range within which the viewer's eye can move and continue to see the image) and to design products for specific applications. Fundamental to the Company's technology development strategy is the development of standardized modules for each of the key components of an RSD system. These standardized modules can then be used in various combinations to create a small number of technology platforms. Each platform provides the basis for an entire family of products that in turn might be used in a wide array of applications in various market segments. CONSIDERATIONS RELATING TO THE COMPANY'S BUSINESS WE CANNOT BE CERTAIN THAT THE RSD TECHNOLOGY OR PRODUCTS INCORPORATING THIS TECHNOLOGY WILL ACHIEVE MARKET ACCEPTANCE. IF THE RSD TECHNOLOGY DOES NOT ACHIEVE MARKET ACCEPTANCE, OUR REVENUES MAY NOT GROW. Our success will depend in part on the commercial acceptance of the RSD technology. The RSD technology may not be accepted by manufacturers who use display technologies in their products or by consumers of these products. To be accepted, the RSD technology must meet the expectations of our potential customers in the defense, medical, industrial, and consumer markets. If our technology fails to achieve market acceptance, we may not be able to continue to develop the RSD technology. OUR LACK OF THE FINANCIAL AND TECHNICAL RESOURCES RELATIVE TO OUR COMPETITORS MAY REDUCE OUR REVENUES, POTENTIAL PROFITS, AND OVERALL MARKET SHARE. Our products and the RSD technology will compete with established manufacturers of miniaturized cathode ray tube and flat panel display devices, many of which have substantially greater financial, technical and other resources than us and many of which are also developing miniature displays. Because of their greater resources, our competitors may develop products or technologies that are superior to our own. The introduction of superior competing products or technologies could result in reduced revenues, lower margins or loss of market share, any of which could reduce the value of our business. WE MAY NOT BE ABLE TO KEEP UP WITH RAPID TECHNOLOGICAL CHANGE AND OUR FINANCIAL RESULTS MAY SUFFER. The electronic information display industry has been characterized by rapidly changing technology, accelerated product obsolescence, and continuously evolving industry standards. Our success will depend upon our ability to further develop the RSD technology and to introduce new products and features on a cost effective basis in a timely manner to meet evolving customer requirements and compete effectively with competitors' product advances. We may not succeed in these efforts because of: - - delays in product development; - - lack of market acceptance for our products; or - - lack of funds to invest in development. The occurrence of any of the above factors could result in decreased revenues and market share. IF WE CANNOT EXPAND OUR MANUFACTURING CAPABILITY, WE WILL NOT ACHIEVE COMMERCIAL SUCCESS. We currently lack the capability to manufacture products in commercial quantities. Our success depends in part on our ability to provide our components and future products in commercial quantities at competitive prices. Accordingly, we will be required to obtain access, through business partners or contract manufacturers, to manufacturing capacity and processes for the commercial production of our expected future products. We cannot be certain that we will successfully obtain access to sufficient manufacturing resources. Future manufacturing limitations of our suppliers could result in a limitation on the number of products incorporating the RSD technology that can be produced. IF WE CANNOT MANUFACTURE PRODUCTS AT COMPETITIVE PRICES, OUR FINANCIAL RESULTS WILL BE ADVERSELY AFFECTED. To date, we have produced only prototype products for research, development, and demonstration purposes. The cost per unit for these prototypes currently exceeds the level at which we could expect to profitably resell such products to customers. If we cannot lower our cost of production, we may face: - - loss of profitability and loss of competitiveness for our products; and - - increased demands on our financial resources, possibly requiring additional equity and/or debt financings to sustain our business operations. OUR PRODUCTS MAY BE SUBJECT TO FUTURE HEALTH AND SAFETY REGULATION THAT COULD INCREASE OUR DEVELOPMENT AND PRODUCTION COSTS. Products incorporating RSD technology could become subject to new health and safety regulations that would reduce our ability to commercialize the RSD technology. Compliance with any such new regulations would likely increase our cost to develop and produce products using the RSD technology and adversely affect our financial results. IF WE EXPERIENCE DELAYS OR FAILURES IN DEVELOPING AND PRODUCING COMMERCIALLY VIABLE PRODUCTS, WE MAY HAVE LOWER REVENUES. Although we have developed prototype products incorporating the RSD technology, we must undertake additional research, development and testing before we are able to produce products for commercial sale. In addition, product development delays or the inability to enter into relationships with potential product development partners may delay the introduction of, or prevent us from introducing, commercial products. IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR PATENTS AND OTHER PROPRIETARY TECHNOLOGY, WE MAY BE UNABLE TO COMPETE WITH OTHER COMPANIES. Our success will depend in part on our ability and the ability of the University of Washington (the University) and our other licensors to maintain the proprietary nature of the RSD and related technologies. Although our licensors have patented various aspects of the RSD technology and we continue to file our own patent applications covering RSD features and related technologies, we cannot be certain as to the degree of protection offered by these patents or as to the likelihood that patents will be issued from the pending patent applications. Moreover, these patents may have limited commercial value or may lack sufficient breadth to protect adequately the aspects of our technology to which the patents relate. We cannot be certain that our competitors, many of which have substantially greater resources than us and have made substantial investments in competing technologies, will not apply for and obtain patents that will prevent, limit or interfere with our ability to make and sell our products. We also rely on unpatented proprietary technology. Third parties could develop the same or similar technology or otherwise obtain access to our proprietary technology. We cannot be certain that we will be able to adequately protect our trade secrets, know-how or other proprietary information or to prevent the unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. WE COULD FACE LAWSUITS RELATED TO OUR USE OF THE RSD TECHNOLOGY. THESE SUITS COULD BE COSTLY, TIME CONSUMING AND REDUCE OUR REVENUES. We are aware of several patents held by third parties that relate to certain aspects of retinal scanning devices. These patents could be used as a basis to challenge the validity of the University's patents, to limit the scope of the University's patent rights, or to limit the University's ability to obtain additional or broader patent rights. A successful challenge to the validity of the University's patents could limit our ability to commercialize the RSD technology and, consequently, materially reduce our revenues. Moreover, we cannot be certain that patent holders or other third parties will not claim infringement by us or by the University with respect to current and future technology. Because U.S. patent applications are held and examined in secrecy, it is also possible that presently pending U.S. applications will eventually be issued with claims that will be infringed by our products or the RSD technology. The defense and prosecution of a patent suit would be costly and time-consuming, even if the outcome were ultimately favorable to us. An adverse outcome in the defense of a patent suit could subject us to significant cost, require others and us to cease selling products that incorporate RSD technology, or to cease licensing the RSD technology, or to require disputed rights to be licensed from third parties. Such licenses would increase our cost or may not be available at all. Moreover, if claims of infringement are asserted against our future co-development partners or customers, those partners or customers may seek indemnification from us for damages or expenses they incur. IF WE LOSE THE EXCLUSIVE USE OF THE VRD TECHNOLOGY, OUR BUSINESS OPERATIONS AND PROSPECTS WOULD BE ADVERSELY AFFECTED. We acquired the exclusive rights to the VRD technology under an exclusive license agreement ("License Agreement") with the University. If the University were to violate the terms of the License Agreement by providing the VRD technology to another company, our business, operations, and prospects would be adversely affected. In addition, we could lose the exclusivity under the License Agreement if we fail to challenge within the time limit claims that other companies are using the VRD technology in violation of our License Agreement. WE NEED TO COLLABORATE WITH THIRD PARTIES TO BE ABLE TO SUCCESSFULLY DEVELOP PRODUCTS FOR SALE. Our strategy for developing, testing, manufacturing and commercializing the RSD technology and products incorporating the RSD technology includes entering into cooperative development, sales and marketing arrangements with corporate partners, original equipment manufacturers, and other third parties. We cannot be certain that we will be able to negotiate arrangements on acceptable terms, if at all, or that these arrangements will be successful in yielding commercially viable products. If we cannot establish these arrangements, we would require additional working capital to undertake such activities on our own and would require extensive manufacturing, sales and marketing expertise that we do not currently possess and that may be difficult to obtain. In addition, we could encounter significant delays in introducing the RSD technology or find that the development, manufacture or sale of products incorporating the RSD technology would not be feasible. To the extent that we enter into cooperative development, sales and marketing or other joint venture arrangements, our revenues will depend upon the efforts of third parties. We cannot be certain that any such arrangements will be successful. OUR REVENUES ARE HIGHLY SENSITIVE TO DEVELOPMENTS IN THE DEFENSE AND AEROSPACE INDUSTRIES. Our revenues to date have been derived principally from product development research relating to defense applications of the RSD technology. We believe that development programs and sales of potential products in this market will represent a significant portion of our future revenues. Developments that adversely affect the defense sector, including delays in government funding and a general economic downturn, could cause our revenues to decline substantially. WE MAY REQUIRE ADDITIONAL CAPITAL TO CONTINUE IMPLEMENTING OUR BUSINESS PLAN. THIS MAY LESSEN THE VALUE OF CURRENT STOCKHOLDERS' SHARES. We believe that our current cash and investment securities balances will satisfy our budgeted capital and operating requirements for at least the next 12 months, based on our current operating plan. However, we may need additional funds in order to, among other requirements: - - further develop RSD technology, - - add manufacturing capacity, - - add to our sales and marketing staff, - - develop and protect our intellectual property rights, or - - fund long-term business development opportunities. We cannot be certain that we will be able to obtain financing when needed or that we will be able to obtain financing on satisfactory terms, if at all. If additional funds are raised through the issuance of equity, convertible debt or similar securities, current shareholders will experience dilution and the securities issued to the new investors may have rights or preferences senior to those of the shareholders of common stock. Moreover, if adequate funds were not available to satisfy our short-term or long-term financial needs, we would be required to limit our operations significantly. LOSS OF ANY OF OUR KEY PERSONNEL COULD HAVE A NEGATIVE EFFECT ON THE OPERATION OF OUR BUSINESS. Our success depends on our officers and other key personnel and on the ability to attract and retain qualified new personnel. Achievement of our business objectives will require substantial additional expertise in the areas of sales and marketing, engineering and product development, and manufacturing. Competition for qualified personnel in these fields is intense, and the inability to attract and retain additional highly skilled personnel, or the loss of key personnel, could reduce our revenues and adversely affect our business. WE HAVE A HISTORY OF OPERATING LOSSES AND EXPECT TO INCUR SIGNIFICANT LOSSES IN THE FUTURE. We have had substantial losses since our inception and our operating losses may increase in the future. Accordingly, we cannot assure you that we will ever become or remain profitable. - - As of December 31, 1999, we had an accumulated deficit of $39.5 million. - - We incurred net losses of $7.1 million from inception through 1995, $3.5 million in 1996, $4.9 million in 1997, $7.3 million in 1998 and $16.7 million in 1999. Our revenues to date have been generated from development contracts. We do not expect to generate significant revenues from product sales in the near future. The likelihood of our success must be considered in light of the expenses, difficulties, and delays frequently encountered by companies formed to develop and market new technologies. In particular, our operations to date have focused primarily on research and development of the RSD technology and development of prototypes, and we have developed marketing capabilities only during the past two years. We are unable to accurately estimate future revenues and operating expenses based upon historical performance. We cannot be certain that we will succeed in obtaining additional development contracts or that we will be able to obtain customer orders for products incorporating the RSD technology. In light of these factors, we expect to continue to incur substantial losses and negative cash flow at least through 2001 and possibly thereafter. We cannot be certain that we will become profitable or achieve positive cash flow at any time in the future. A SUBSTANTIAL NUMBER OF OUR SHARES MAY BE SOLD INTO THE MARKET IN THE NEAR FUTURE, WHICH COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO DROP SIGNIFICANTLY. As of March 15, 2000, we had outstanding: - - 10,650,460 shares of common stock; - - options under our option plans to purchase an aggregate of 2,350,495 shares of common stock; - - privately placed warrants and options to purchase 786,313 shares of common stock. Almost all of our outstanding shares of common stock may be sold without substantial restrictions. Sales in the public market of substantial amounts of common stock, including sales of common stock issuable upon exercises of stock options or warrants, could depress prevailing market prices for our common stock. Even the perception that such sales could occur may adversely impact the market price for our stock. A decrease in market price would decrease the value of an investment in our common stock. OUR QUARTERLY PERFORMANCE MAY VARY SUBSTANTIALLY AND THIS VARIANCE MAY DECREASE OUR STOCK PRICE. Our revenues to date have been generated from a limited number of development contracts with U.S. government entities and commercial partners. Our quarterly operating results may vary significantly based on: - - reductions or delays in funding of development programs involving new information display technologies by the U.S. government or our current or prospective commercial partners; or - - the status of particular development programs and the timing of performance under specific development agreements. In one or more future quarters, our results of operations may fall below the expectations of securities analysts and investors and the trading price of our common stock may decline as a consequence. OUR STOCK PRICE MAY BE VOLATILE AND THIS VOLATILITY COULD ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK. The stock market is subject to price and volume fluctuations that particularly affect the market prices of stock of small capitalization, high technology companies. The trading price of our common stock could be subject to significant fluctuations in response to, among other factors: - - variations in quarterly operating results; - - changes in analysts' estimates; - - announcements of technological innovations by our competitors; - - general conditions in the information display and electronics industries; and - - general economic conditions. Frequent changes in the market price of our common stock will affect the day-to-day value of an investment in our common stock. WE MAY INVEST OUR CAPITAL IN WAYS THAT DO NOT RESULT IN A FAVORABLE RETURN. THIS COULD LOWER OUR STOCK PRICE. Our management has broad discretion to invest our capital in ways in which our stockholders may not agree. The failure of our management to invest our capital effectively could result in lower returns than expected. This could lower the value of our stock. IT MAY BE DIFFICULT FOR A THIRD PARTY TO ACQUIRE THE COMPANY AND THIS COULD DEPRESS OUR STOCK PRICE. Certain provisions of Washington law and our amended and restated articles of incorporation and bylaws contain provisions that create burdens and delays when someone attempts to purchase our company. As a result, these provisions could limit the price that investors are willing to pay for our stock. These provisions: - - authorize our board of directors, without further shareholder approval, to issue preferred stock that has rights superior to those of the common stock. Potential purchasers may pay less for our company because the preferred stockholders may use their rights to take value from the Company; and - - provide that written demand of at least 25% of the outstanding capital shares is required to call a special meeting of the shareholders, which may be needed to approve the sale of the Company. The delay that this creates could deter a potential purchaser. INDUSTRY BACKGROUND The popularity of personal computing, electronic communication, television and video products has created a worldwide market for display technologies. Information displays are the primary medium through which text and images generated by computer and other electronic systems are delivered to end-users. While early computer systems were designed and used for tasks that involved little interaction between the user and the computer, today's graphical and multimedia information and computing environments require systems that devote most of their resources to generating and updating visual displays. The market for display technologies has also been stimulated by the increasing popularity of portable pagers and cellular phones; interest in simulated environments and augmented vision systems; and the recognition that improved means of connecting people and machines can increase productivity and enhance the enjoyment of electronic entertainment and learning experiences. For decades, the CRT has been the dominant display device. A CRT creates an image by scanning a beam of electrons across a phosphor-coated screen, causing the phosphors to emit visible light. The beam is generated by an electron gun and is passed through a deflection system that scans the beam rapidly left to right and top to bottom. A magnetic lens focuses the beam to create a small moving dot on the phosphor screen. It is these rapidly moving spots of light ("pixels") that "paint" the image on the surface of the viewing screen. The next generation of imaging technology, flat panel displays, is now in widespread use in portable computers, calculators, and other personal display devices. The flat panel display can consist of hundreds of thousands of pixels, each of which is formed by a single transistor acting on a crystalline material. In recent years, as the computer and electronics industries have made substantial advances in miniaturization, manufacturers have sought lightweight, low power, cost effective displays to enable the development of more portable products. Flat panel technologies have made meaningful advances in these areas, and liquid crystal flat panel displays are now commonly used for laptop computers and other electronic products. Both technologies, however, pose difficult engineering and fabrication problems for more highly miniaturized products, because of inherent constraints in size, weight and power consumption. In addition, both CRT and flat panel displays often become dim and difficult to see in outdoor or other settings where the ambient light is stronger than the light emitted from the screen and display mobility is limited by size. The Company believes that, as display technologies attempt to keep pace with miniaturization and other advances in information delivery systems, conventional CRT and flat panel technologies will no longer be able to provide the full range of performance characteristics, including high resolution, high level of brightness and low power consumption, required for state-of-the-art information systems. MICROVISION'S RETINAL SCANNING DISPLAY TECHNOLOGY The Company's RSD technology is fundamentally different from previously commercialized display technologies. RSD systems create an image on the retina like a miniaturized video projector focused on the "projection screen" at the back of the viewer's eye. By continuously scanning a low power beam of colored light to "scan" rows of pixels to the retina of the viewer's eye, the RSD technology creates a high resolution, full motion image. The light that is directed to the retina is much the same as light that is reflected to the retina from our natural environment. The drive electronics of the RSD technology acquire and process signals from the image or data source to control and synchronize the color mix and placement. Color pixels are generated by modulated light sources, from which the intensity of each of the red, green and blue lights is varied to generate a complete palette of colors and shades. Optical elements direct the beam of light through the pupil of the viewer's eye to create an image on the retina. The pixels are arranged on the retina by a horizontal scanner that rapidly sweeps the light beam to place the pixels into a row, and a vertical scanner that moves the light beam downward where successive rows of pixels are drawn. This process is continued until an entire field of rows has been placed and a full image appears to the user. STRATEGY The Company's objective is to be a leading provider of personal display and imaging technology in a broad range of professional and consumer applications. Key elements of the Company's strategy to achieve this objective include: I. Strategic Partnering to Extend Marketing and Technical Reach The Company's key technologies have applications in several markets and products. The Company has contracted with and will continue to pursue strategic partners who will provide resources and services that would take substantial time and additional cost to the Company to obtain without these partners. Strategic partners will be selected to provide support on the specific requirements of markets and products. Examples of activities that will benefit from strategic partnering are: CUSTOM DESIGN, MANUFACTURE AND SALE OF HIGH PERFORMANCE PRODUCTS. The Company anticipates providing high performance products to professional end-users in markets with lower product volume requirements. The Company expects that end-users in this category will include professionals in the defense, public safety, industrial process control and health care industries. The Company believes that, because the unit volume requirements for such end users are generally lower, demand for such products may be more predictable and the risks associated with production and inventory more easily managed. Depending upon the circumstances, the Company may manufacture these products using standard component suppliers and contract manufacturers as required, may license to OEMs, or may seek to form one or more joint ventures to manufacture the products. SALE OF COMPONENTS OR "ENGINES" OF SCANNING TECHNOLOGY. Certain potential applications of the RSD technology, such as pagers or cellular phones, could require integration of the RSD technology with other unrelated technologies. In markets requiring volume production of personal display components or subsystems that can be integrated with non-display components, the Company may provide components, subsystems and systems design technology to OEMs under licensing agreements. LICENSING OF PROPRIETARY TECHNOLOGY TO OEMS FOR VOLUME MANUFACTURE OF PRODUCTS. The Company believes that in consumer markets the ability of personal display products to compete effectively is largely driven by the ability to price aggressively for maximum market penetration. Significant economies of scale in volume purchasing, manufacturing and distribution are important factors in driving costs down to achieve pricing objectives and profitability. The Company's strategy will be to seek both initial license fees from such arrangements as well as ongoing per unit royalties. The Company expects that such relationships generally will involve a period of co-development during which engineering and marketing professionals from OEMs would work with the Company's technical staff to specify, design and develop a product appropriate to the targeted market and application. The Company would charge fees to such OEMs to compensate for the costs of the engineering effort incurred to such development projects. The nature of the relationships with such OEMs may vary from partner to partner depending on the proposed specifications for the RSD, the product to be developed, and the OEM's design, manufacturing and distribution capabilities. The Company believes that by limiting its own direct manufacturing investment for consumer products, it will reduce the capital requirements and risks inherent in taking the RSD technology to the consumer market. II. Platform Model to Leverage Core Technologies The Company is developing fundamental components of scanning technology that will be incorporated into modular "engines" that, in turn, will be integrated to create product offerings. Many of these product offerings will share engines and subsystems. Product offerings can be customized by utilizing interchangeable components. The Company has currently defined the following key product offerings for further development: - - High Performance - - Compact Wearable - - Microdisplay - - Projection - - Image Capture III. Development of an Intellectual Property Portfolio The Company believes that it can enhance its competitive position by reducing the cost and improving the performance of its RSD technology and by expanding its portfolio of intellectual property and proprietary rights. A key part of the Company's technology development strategy includes developing and protecting (i) concepts relating to the function, design and application of the RSD system; (ii) component technologies and integration techniques essential to the commercialization of the RSD technology and that are expected to reduce the cost and improve the performance of the system; and (iii) component technologies and integration techniques that reduce technical requirements and accelerate the pace of commercial development. The Company is continuing to develop a portfolio of patented technologies and proprietary processes and techniques that relate directly to the functionality and to the commercial viability of the RSD technology. See "- Technology Development" and "- Intellectual Property and Proprietary Rights." APPLICATIONS, MARKETS AND PRODUCTS The Company has identified a variety of potential applications for its RSD technology, including the following: AUGMENTED VISION. Augmented vision applications superimpose high contrast, monochromatic or color images and information on the user's view of the surrounding environment as a means of enhancing the safety, precision or speed of the user's performance of tasks. For example, a head-worn display could superimpose critical patient information such as vital signs, EKG traces, reference materials, X-rays or MRI images in a surgeon's field of vision. For military applications, troops could be equipped with eyeglasses that display high definition imagery that could be viewed without blocking normal vision and could assist in threat detection, reconnaissance and other activities. SIMULATION AND ENTERTAINMENT DISPLAYS. Manufacturers of interactive media products have recognized that the visual experience offered by simulation is enhanced by high resolution, three-dimensional displays projected over a wide field of vision. Although simulated environments traditionally have been used as a training tool for professional use, they are becoming increasingly popular as a means of entertainment, particularly in computer games. HAND-HELD PERSONAL COMMUNICATIONS DEVICES. Manufacturers of wireless and cellular communications devices have identified the need for products that incorporate personal display units for viewing electronic mail, fax and graphic images on highly miniaturized devices. Existing display technologies have had difficulty satisfying this demand fully because of the requirements that such devices be highly miniaturized, full format, relatively low cost, and offer high resolution and brightness without requiring high levels of battery power. The Company expects that the range of potential products in this category may include displays for cellular phones, pagers, or personal digital assistants that display electronic mail messages, faxes, or other information as a bright, sharp image. The Company has targeted various market segments for these potential applications, including defense and public safety, health care, business, industrial and consumer electronics. The following table identifies product development opportunities within each of these markets. The Company will target early adopters of the RSD technology who, even at an earlier stage of development, would achieve significant productivity or performance gains and associated cost savings. The Company believes that military, healthcare, and industrial users will value the ability of personal RSD based displays to superimpose high contrast images on the user's natural field of vision. Similarly, users of wireless devices, who have a need to receive critical or timely data through electronic mail, Internet or facsimile transmission, are expected to value the performance characteristics that RSD systems are expected to deliver. PROTOTYPES The Company has developed several prototypes to demonstrate the feasibility of the RSD technology. These prototypes are not commercial products or applications but rather are demonstration models of the technology. The first prototype developed was a table-top model, which received output from a personal computer and generated a full color image. The second and third prototypes are portable devices. For demonstration purposes, they also connect to a personal computer. The projection optics of the portable prototypes is packaged together with the vertical and horizontal scanners. One demonstrator is monochromatic and fits in an attache case, which also houses the electronics that receive and condition the signal. The second demonstrator is a full color model with the electronics that receive and condition the signal being housed in a separate case, which is the size of an airline carry-on bag. In 1999, the Company continued to develop prototypes, for Company use and for customers, that demonstrated higher resolution, greater brightness, smaller size and lower power consumption. The following four prototypes were delivered: an SVGA (480,000 pixels) color helmet-mounted RSD; a high luminance, SXGA (approximately 1,300,000 pixels) green monochrome helmet-mounted RSD; a high-luminance, SXGA full color head-worn RSD; and a battery powered, head-wearable red monochrome RSD. Currently under development is a "very high resolution" green monochrome system. TECHNOLOGY DEVELOPMENT The Company's existing prototypes have demonstrated the technical feasibility of the RSD system and the Company's ability to miniaturize certain of its key components. Additional work is in progress to achieve advances necessary for large-scale application, full-color capability in highly miniaturized versions and design of new architectures for specific applications. Research and development expenses for the fiscal years ended December 31, 1999, 1998 and 1997 were $10,232,700, $3,305,600 and $2,593,900, respectively. Substantially all of the Company's revenue to date has been derived from performance on development contracts to further develop the RSD technology to meet customer specifications. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." DRIVE ELECTRONICS. The Company has identified four areas where additional development of the drive electronics is necessary. The first involves further miniaturization using integrated circuits and advanced packaging techniques. To date, the Company has identified no technological barriers to the further miniaturization of the drive electronics. The second area involves refining the timing and nature of the signals driving the photon sources and scanners to improve display quality. The third area is the development of drive circuitry for light-sources. The fourth area of development relates to achieving and improving compatibility of the drive electronics with existing and emerging video standards. The Company's existing prototypes are compatible with current North American video format standards and the output from most personal computers. In 2000, the Company intends to further develop the RSD technology to conform to a broader range of interface standards, including existing higher resolution standards. PHOTON SOURCES. The photon source creates the light beam that paints the image on the retina. In a full color RSD system, red, green and blue photon sources are modulated and mixed to generate the desired color and brightness. Low power solid state lasers, laser diodes and light-emitting diodes ("LEDs") are suitable photon generators for the RSD system. Blue and green solid state lasers are currently available but are useful only for RSD applications where cost and size are not critical. Miniaturized visible laser diodes are currently available only in red, although a number of other companies are developing blue laser diodes in anticipation of high volume consumer electronics applications. Miniaturized LEDs are less expensive than laser diodes. The Company expects these LEDs will provide sufficient brightness for certain applications, however, the Company still expects to use laser diodes for augmented vision applications that require maximum brightness. The Company intends to rely on other companies independent work or to contract with other companies to complete development of the materials and processes necessary to produce specific configurations of green and blue LEDs and laser diodes. An important milestone was achieved in 1998 when the Company demonstrated custom green and blue LEDs as potential light sources for certain low power, low cost applications. During 1999, the Company entered into a strategic partnership alliance with Cree, Inc., a developer and manufacturer of green and blue LED's for mass markets to further the development of green and blue LED's to meet the Company's expected requirement. SCANNING. A pair of scanners, one horizontal and one vertical, is used to direct the light beam that creates the image on the retina. In laser printers and bar code readers, a spinning or oscillating mirror is used to scan a light beam, but these polygonal mechanical scanners are typically too large and too slow for use in miniaturized display applications. To solve this problem, the Company uses its proprietary horizontal scan, mechanical resonance scanner ("MRS"). In operation, the MRS resembles a very small tuning fork with a mirrored surface. It is tuned to resonate at the exact scanning frequency needed to generate the display, with very little power being needed to keep it oscillating. Directing the light beam at the vibrating mirror causes the light beam to scan rapidly back and forth horizontally. A second vibrating mirror is used to direct the pixels vertically down the retina. The Company believes that its MRS and its vertical scanner counterpart may have significant commercial value independent of RSD applications. Continued development of the scanning subsystem for RSD devices will be required in order to allow scanning capability for current standard video formats, including high definition television, as well as new digital video standards. Existing designs for scanner and scanner electronics may prove ineffective at higher resolutions and may need to be replaced with alternative scanning methods. In 1998, the Company demonstrated highly miniaturized smaller "micro-electro-mechanical system (MEMS) versions of both horizontal and vertical scanner systems. In 1999, the MEMS development resources were augmented substantially with additional specialized staff, an on-site clean room facility, and access to advanced fabrication and testing facilities at the University. With the availability of both MRS and MEMS scanning systems, the Company has achieved important flexibility from the standpoint of developing optimal architectures for key resolution targets including SVGA resolution. OPTICS. For applications where the RSD device is to be worn, it is desirable to have an exit pupil (the range within which the viewer's eye can move and continue to see the image) of 10 to 15 millimeters. The Company has developed an optic design that expands the exit pupil up to 15 millimeters. Additional design and engineering of this expanded exit pupil is required to develop commercial applications. In 1999, Company engineers refined optics designs for both monocular (one-eye) and biocular (two-eye) prototypes. A full "binocular" system, which incorporated two separate video channels (one for each eye), was also developed to provide the user with full stereoscopic viewing of 3-dimensional imagery. The Company's ongoing optics development is directed at the creation of optical systems that exhibit lower distortion, are ligher weight, and more cost-effective to manufacture. UNIVERSITY OF WASHINGTON LICENSE AGREEMENT The VRD technology comprises a substantial part of the Company's RSD technology. The VRD technology was originally developed at the University of Washington's Human Interface Technology Lab (the "HIT Lab") by a team of technicians and engineers. In 1993, the Company acquired the exclusive rights to the VRD technology and associated intellectual property from the University pursuant to the License Agreement. The scope of the license covers all possible commercial uses of the VRD technology worldwide, including the right to grant sublicenses. The license expires upon the expiration of the last of the University's patents that relate to the VRD, unless sooner terminated by the Company or the University. In granting the license, the University retained limited, non-commercial rights with respect to the VRD technology, including the right to use the technology for non-commercial research and for instructional purposes, and the right to comply with applicable laws regarding the non-exclusive use of the technology by the United States government. The University also has the right to consent to the Company 's sublicensing arrangements and to the prosecution and settlement by the Company of infringement disputes. In addition, the University retains the right to publish information regarding the VRD technology for academic purposes. The Company could lose the exclusivity under the License Agreement if the Company fails to respond to any infringement action relating to the VRD technology within 90 days of learning of such claim. In the event of the termination of the Company's exclusivity, the Company would lose its rights to grant sublicenses and would no longer have the first right to take action against any alleged infringement. In addition, each of the Company and the University has the right to terminate the License Agreement in the event that the other party fails to cure a material breach within 30 days of written notice. The Company may terminate the License Agreement at any time by serving 90 days prior written notice on the University. In the event of any termination of the License Agreement, the license granted to the Company would terminate. Under the terms of the License Agreement, the Company agreed to pay a non-refundable fee of $5,133,500 (the "License Fee") and to issue to the University shares of the Company's common stock. In addition, the University is entitled to receive certain ongoing royalties. The Company also entered into a research agreement with the University ("Research Agreement") to further develop the VRD technology. In August 1997, the Company made the final payment due under the Research Agreement, which resulted in the Company having paid in full the License Fee due under the License Agreement. (see "Intellectual Property and Proprietary Rights"). INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS In 1993, the Company acquired the exclusive rights to the VRD technology under the License Agreement with the University of Washington. See " - University of Washington License Agreement." Additional development of the VRD technology took place at the HIT Lab pursuant to the Research Agreement. The University has received thirteen patents on the VRD technology including the MRS and has an additional nineteen U.S. patent applications pending in the United States and in certain foreign countries, all of the rights to which have been exclusively licensed to the Company. The Company's ability to compete effectively in the information display market will depend, in part, on the ability of the Company, the University and other licensors to maintain the proprietary nature of the VRD technology or other technologies, including claims related to the ability to superimpose images on the user's field of view, a VRD using optical fibers; an expanded exit pupils; and the MRS. During 1998, the Company entered into a license agreement with a third party whereby the Company acquired the exclusive license to certain intellectual property related to the design and fabrication of a microminiature scanner using semiconductor fabrication techniques. The licensor has received six patents and has eight patent applications pending pertaining to use in the Company's field of use. The Company also generates intellectual property as a result of its ongoing performance on development contracts and as a result of the Company's internal research and development activities. The Company has filed sixteen patent applications in its own name resulting from these activities. The inventions covered by such applications generally relate to component miniaturization, specific implementation of various system components and design elements to facilitate mass production. The Company considers protection of these key enabling technologies and components to be a fundamental aspect of its strategy to penetrate diverse markets with unique products. As such, it intends to continue to develop its portfolio of proprietary and patented technologies at the system, component, and process levels. The Company also relies on unpatented proprietary technology. To protect its rights in these areas, the Company requires all employees, and where appropriate, contractors, consultants, advisors and collaborators to enter into confidentiality and noncompetition agreements. There can be no assurance, however, that these agreements will provide meaningful protection for the Company's trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. The Company has registered, with the United States Patent and Trademark Offices, the mark "Microvision" with its associated "tri-curve" logo. The Company filed for registration of the marks "Virtual Retinal Display" and "VRD" in the United States Patent and Trademark Office. These marks were examined and entered into the opposition phase, where an opposition was filed against the VRD mark. The Company believes the opposition filing is without merit and that the Company should prevail in the proceedings. Regardless of the outcome, the Company believes that it will be entitled to continue to use the terms "Virtual Retinal Display" and "VRD." HUMAN FACTORS, ERGONOMICS AND SAFETY As part of its research and development activities, the Company conducts ongoing research as to the cognitive, physiological and ergonomic factors that must be addressed by products incorporating RSD technologies and the safety of RSD technology, including such issues as the maximum permissible laser exposure limits established by American National Standards Institute ("ANSI"). Researchers from the HIT Lab have concluded that laser exposure to the retina under normal operating conditions would be below the calculated maximum permissible exposure level set by ANSI. COMPETITION The information display industry is highly competitive. The Company's products and the RSD technology will compete with established manufacturers of miniaturized CRT and flat panel display devices, including companies such as Sony Corporation and Texas Instruments Incorporated, most of which have substantially greater financial, technical and other resources than the Company and many of which are developing alternative miniature display technologies. The Company also will compete with other developers of miniaturized display devices. There can be no assurance that the Company's competitors will not succeed in developing information display technologies and products that could render the RSD technology or the Company's proposed products commercially infeasible or technologically obsolete. The electronic information display industry has been characterized by rapid and significant technological advances. There can be no assurance that the RSD technology or the Company's proposed products will remain competitive with such advances or that the Company will have sufficient funds to invest in new technologies products or processes. Although the Company believes that its RSD technology and proposed display products could deliver images of a quality and resolution substantially better than those of commercially available miniaturized LCD and CRT-based display products, there is no assurance that manufacturers of LCDs and CRTs will not develop further improvements of screen display technology that would eliminate or diminish the anticipated advantages of the Company's proposed products. OTHER TECHNOLOGY INVESTMENT The Company intends to pursue the acquisition and development of other imaging and display technologies as opportunities arise. In March 1994, the Company entered into a second exclusive license agreement with the University to acquire certain imaging technology unrelated to the RSD technology. This technology involves the projection of data and images onto the inside of a dome that is placed over the viewer's head. This imaging technology is referred to as HALO. The HALO license agreement requires the Company to make payments to the University upon filing a patent application and the issuance of a patent. See Note 7 of Notes to the Financial Statements. EMPLOYEES As of March 15, 2000, the Company has 117 employees and 14 contractors. The Company's employees are not subject to any collective bargaining agreements and management regards its relations with employees to be good. ITEM 2. ITEM 2. DESCRIPTION OF PROPERTY The Company currently leases approximately 67,400 square feet of combined use office and laboratory space as its headquarters facility in Bothell, Washington. The Company also has a commitment to lease between 25,000 and 34,000 additional square feet at this facility during the fourth and fifth years of the seven-year lease. See ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to, nor is its property subject to, any material pending legal proceeding. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS. The Company's Common Stock trades on the Nasdaq National Market under the symbol "MVIS." As of March 15, 2000, there were 212 holders of record and approximately 7,000 beneficial holders of 10,650,460 shares of Common Stock. The Company has never declared or paid cash dividends on the Common Stock. The Company currently anticipates that it will retain all future earnings to fund the operation of its business and does not anticipate paying dividends on the Common Stock in the foreseeable future. The Company's Common Stock began trading publicly on August 27, 1996. The quarterly high and low sales prices of the Company's Common Stock for each full quarterly period in the last two fiscal years and the year to date as reported by the Nasdaq National Market are as follows: On March 15, 2000, the last sale price for the Common Stock was $54.00. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA A summary of selected financial data as of and for the five years ended December 31, 1999 is set forth below: SELECTED FINANCIAL DATA (in thousands, except per share data) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company commenced operations in May 1993 to develop and commercialize technology for displaying images and information onto the retina of the eye. In 1993, the Company acquired an exclusive license to the Virtual Retinal Display technology from the University of Washington and entered into a research agreement with the University of Washington to further develop the VRD technology. The Company has continued to develop the VRD technology as part of its broader research and development efforts relating to the RSD technology. Since the completion of its initial public offering in August 1996, the Company has established and equipped its own in-house laboratory for the continuing development of the RSD technology and has transferred the research and development work on the VRD technology from the HIT Lab to the Company. The Company has incurred substantial losses since its inception and expects to continue to incur significant operating losses over the next several years. The Company currently has several prototype versions of the RSD including monochromatic and color portable units and a full color table-top model. The Company expects to continue funding prototype and demonstration versions of products incorporating the RSD technology at least throughout 2000. Future revenues, profits and cash flow and the Company's ability to achieve its strategic objectives as described herein will depend on a number of factors including acceptance of the RSD technology by various industries and OEMs, market acceptance of products incorporating the RSD technology and the technical performance of such products. See "Description of Business - Considerations Related to the Company's Business." RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998. CONTRACT REVENUE. Contract revenue decreased by approximately $171,000 or 2% to $6.9 million in 1999 from $7.1 million in 1998. The decrease resulted from a lower level of development contract business in 1999 than that performed in 1998 on contracts entered into in both 1999 and 1998. Delays in booking development contracts and increases in certain development project budgets contributed to the decline in revenue. During 1999, the Company went through a reorganization of its Research and Product Development Department to more directly focus its technical capabilities on product development and production. Because the Company recognizes revenue on a percentage of completion basis, the resulting loss of direct labor hours worked on development contracts resulted in lower revenue generation in 1999. Revenue in 1999 includes revenue for which precontract costs were recognized in 1998. To date, substantially all of the Company's revenue has been generated from development contracts. The Company's customers have included both the United States government and commercial enterprises, which accounted for approximately 82% and 18%, respectively, of total revenue during 1999 and 83% and 17%, respectively, of total revenue during 1998. The Company expects its sources of revenue to fluctuate from year to year. During 1999, the Company entered into several development contracts with both commercial and government entities for further development of the RSD technology for meeting specific customer applications. In the commercial business area, the Company entered into a multi-year product development and licensing agreement with Carl Zeiss Inc. to develop a range of products in ophthalmic diagnostics and surgical visualization. In the defense business area, the Company entered into a $4.2 million contract with the U.S. Army's Aircrew Integrated Systems Program Office to further advance the form and functional development of the helmet-mounted display. In March 1999, the Company entered into a $750,000 SBIR Phase II Contract with U.S. Army's Aviation Applied Technology Directorate (AATD) for the design of an advanced helmet-mounted display and imaging system to be used in the Virtual Cockpit Optimization Program (VCOP). In September 1999, the Company entered into a $1.5 million follow-on SBIR Phase III contract with the AATD to continue development of the VCOP advanced head-worn display. COST OF REVENUE. Cost of revenue includes both the direct and indirect costs of performing on development contracts. Direct costs include labor, materials and other costs incurred directly in the performance of specific projects. Indirect costs include labor and other costs associated with operating the Research and Product Development Department and building the technical capabilities of the Company. The cost of revenue is determined both by the level of direct costs incurred on development contracts and by the level of indirect costs incurred in managing and building the technical capabilities and capacity of the Company. The cost of revenue can fluctuate substantially from period to period depending on the level of both the direct costs incurred in the performance of projects and the level of indirect costs incurred. Cost of revenue decreased by approximately $1.5 million or 23% to $4.9 million in 1999 from $6.4 million in 1998. The decrease resulted from a decrease in the direct costs associated with the Company's performance on development contracts in 1999 from that in 1998. The lower level of expense in 1999 as compared to 1998 also resulted from a higher level of investment made by the Company in developing its technologies through work performed on its own internal research and development projects, resulted in greater overhead absorption by such research and development projects. The Company expects that the cost of revenue on an absolute dollar basis will increase in the future. This increase likely will result from additional development contract work that the Company expects to perform and the commensurate growth in the Company's personnel and technical capacity required for performance on such contracts. The cost of facilities is expected to increase as a result of the Company's relocation of its headquarters to larger facilities in April 1999. See -- "Liquidity and Capital Resources." As a percentage of contract revenue, the Company expects the cost of revenue to decline over time as the Company realizes economies of scale associated with an anticipated higher level of development contract business and as the Company's expenditures incurred to increase its technical capabilities and capacity become less as a percentage of a higher level of revenues. RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense consists of compensation and related support costs of employees and contractors engaged in internal research and development activities; payments made for laboratory operations, outside laboratory development and processing work; fees and expenses related to patent applications, prosecution and protection; and other expenses incurred in support of the Company's ongoing internal research and development activities. Included in research and development expenses are costs incurred in acquiring and maintaining licenses of technology from other companies and options or other rights to acquire or use intellectual property, either related to the Company's RSD technology or other technologies. To date, the Company has expensed all research and development costs. Research and development expense increased by approximately $6.9 million or 210% to $10.2 million in 1999 from $3.3 million in 1998. The increase reflects continued implementation of the Company's operating plan, which calls for building its technical staff and supporting activities to further develop the Company's technology; establishing and equipping its own in-house laboratories; and developing intellectual property related to the Company's business. In May 1999, the Company entered into a $2.6 million one year development contract with Cree, Inc. (Cree) to accelerate development of semi-conductor light-emitting diodes and laser diodes for application in the Company's proposed display and imaging products. The increase in research and development costs includes costs associated with the work performed by Cree pursuant to the development agreement. In addition, during 1999, costs of $452,000 related to the acquisition of an exclusive license were expensed by the Company. See -- "Liquidity and Capital Resources" and -- "Note 8 of Notes to Financial Statements." The Company believes that a substantial level of continuing research and development expense will be required to commercialize the RSD technology and to develop products incorporating the RSD technology. Accordingly, the Company anticipates that it will continue to commit substantial resources to research and development, including hiring additional technical and support personnel and expanding and equipping its in-house laboratories, and that these costs will continue to increase in future periods. MARKETING, GENERAL AND ADMINISTRATIVE EXPENSE. Marketing, general and administrative expenses include compensation and support costs for the Company's sales, marketing, management and administrative staff and their related activities, and for other general and administrative costs, including legal and accounting costs, costs of consultants and professionals, and other expenses. Marketing, general and administrative expenses increased by approximately $2.5 million or 52% to $7.4 million in 1999 from $4.9 million in 1998. The increase includes increased aggregate compensation and associated support costs for employees and contractors, including those employed at December 31, 1998 and those hired subsequent to that date, in sales and marketing and in management and administrative areas. The Company expects marketing, general and administrative expenses to increase substantially in future periods as the Company adds to its sales and marketing staff, makes additional investments in sales and marketing activities to support commercialization of its RSD technology and development of anticipated products, and as it increases the level of corporate and administrative activity. INTEREST INCOME AND EXPENSE. Interest income increased by approximately $856,000 to $1.2 million in 1999 from $307,000 in 1998. This increase resulted from higher average cash and investment securities balances in 1999, as a result of the financing activities of the Company, from the average cash and investment securities balances in 1998. Interest expense increased by approximately $91,000 or 111% to $172,000 in 1999 from $81,000 in 1998. This increase resulted from interest related to assignment of certain accounts receivable under the Company's accounts receivable assignment facility, to increased interest expense on capital lease obligations and to interest on long term debt entered into during 1999. PREFERRED STOCK DIVIDENDS. The Company paid a cash dividend of $73,400 to the holder of its Series B Convertible Preferred Stock in connection with the redemption of its convertible preferred stock and issuance of Common Stock. In October 1999, the Company amended the option to purchase convertible preferred stock to extend the expiration date to June 30, 2000. This extension was accounted for as a preferred stock dividend with a fair market value $154,400. Additionally, during 1999, the Company recorded a charge of $1,754,000 attributable to the beneficial conversion feature of convertible preferred stock issued in 1999. See Note 7 of Notes to Financial Statements. INCOME TAXES. No provision for income taxes has been recorded because the Company has experienced net losses from inception through December 31, 1999. At December 31, 1999, the Company had net operating loss carry-forwards of approximately $34.2 million for federal income tax reporting purposes. The net operating losses will expire beginning in 2005 if not previously utilized. In certain circumstances, as specified in the Internal Revenue Code, a 50% or more ownership change by certain combinations of the Company's shareholders during any three-year period would result in a limitation on the Company's ability to utilize its net operating loss carry-forwards. The Company has determined that such a change of ownership occurred during 1995 and that annual utilization of loss carry-forwards generated through the period of that change will be limited to approximately $761,000. An additional change of ownership occurred in 1996; however, the amount of the annual limitation is not material. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 CONTRACT REVENUE. Contract revenue increased by approximately $5.4 million to $7. 1 million in 1998 from $1.7 million in 1997. The increase resulted from a higher level of development contract business in 1998 over that performed in 1997 on contracts entered into in both 1998 and 1997. The Company's customers include both the United States government and various commercial enterprises, representing approximately 83% and 17%, respectively, of total revenue during 1998, and 37% and 63%, respectively, of total revenue during 1997. The Company expects its sources of revenue to fluctuate from year to year. See Note 2 of Notes to the Financial Statements. During 1998, the Company entered into several development contracts with both commercial and government entities for further development of the RSD technology directed toward meeting specific customer applications. In the commercial business area in 1998, the Company entered into a contract with the Wallace-Kettering Neuroscience Institute to collaborate on the design and manufacture of an advanced head-wearable display for use in neurosurgery. The display, which will provide "see-through" readability using the Company's RSD technology, is designed to allow surgeons to conveniently view anatomical images and other information during surgery. Also during 1998, the Company and Saab AB, in collaboration with Ericsson Saab Avionics AB, agreed to extend and broaden the company's commercial development program to develop the next generation high-resolution, helmet-mounted display technology for use in advanced aircraft display systems. During 1998 the Company delivered its second helmet-mounted display to Saab AB and Ericsson Saab Avionics AB. The full-color, high-resolution system was designed to deliver unprecedented image fidelity for fighter pilots. In the defense business area in 1998, the Company entered into a $1 million contract with the U.S. Army's Battle Command Battle Lab to build a head-worn display with the objective of replacing the desktop monitor at a workstation within its tactical operations center. The prototype will be a lightweight, dual eye (biocular) head-worn device with full color and high resolution. During 1998, the Company received a Phase II Small Business Innovation Research (SBIR) contract for the development of a high fidelity head-wearable display for use in flight simulators for training military pilots. The $1.1 million contract combines contributions from the Department of Defense, and Saab Ericsson Avionics, the Company's commercial partner, in the project. In June, the Company received a $583,000 Phase II SBIR from the U.S. Air Force to develop a wide field of view head-wearable display system using the Company's RSD technology. The display is designed to allow Command Control, Communications, Computers and Intelligence personnel to view large amounts of mission and situation critical data through a lightweight eyewear display system, resembling glasses. Also in 1998, the Company announced that it had entered into a contract to develop a lightweight, head-wearable display for the U.S. Navy. The RSD enabled display, which features daylight "see-through" readability, would be used on Navy vessels to provide enhanced user interface to complex on-board information systems. COST OF REVENUE. Cost of revenue includes both the direct and indirect costs of performing on revenue contracts as well as the additional staff and related support costs associated with building the Company's technical capabilities in preparation for performing additional contracts expected to be entered into by the Company in 1999 and thereafter. Cost of revenue also includes amounts invested by the Company in research and development activities undertaken in conjunction with work performed in fulfillment of development contracts. Cost of revenue increased by approximately $4.6 million to $6.4 million in 1998 from $1.8 million in 1997. The increase includes increases in both the direct and indirect costs incurred in the performance of development contracts resulting from a higher level of development contract business as well as a higher level of expenses incurred for staff, and related support costs associated with building the Company's technical capabilities and capacity to perform on expected future development contracts. The higher level of expense in 1998 over 1997 also reflects a higher level of investment made by the Company in developing its technology through work performed on development contracts, in addition to costs incurred on its own internal research and development projects. See "--Research and Development Expense." The Company expects that the cost of revenue on a dollar basis will increase in the future. This increase likely will result from additional development contact work that the Company will be performing and the commensurate growth in the Company's personnel and technical capacity. The cost of facilities is also expected to increase as a result of the Company's relocation of its headquarters to larger facilities in April 1999. See "--Liquidity and Capital Resources." As a percentage of contract revenue, the Company expects that the cost of revenue will decline over time as the Company realizes economies of scale associated with a higher level of development contract business and as the Company's expenditures incurred to increase its technical capabilities and capacity become less as a percentage of a higher level of revenues. RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense consists of compensation and related support costs of employees and contractors engaged in internal research and development activities; payments made for lab operations, outside development and processing work; payments made under the Research Agreement in 1997 and prior years; fees and expenses related to patent applications and patent prosecution; and other expenses incurred in support of the Company's on-going internal research and development activities. Included in research and development expenses are costs incurred in acquiring and maintaining licenses of technology from other companies, options or other rights to acquire or use intellectual property, either related to the Company's RSD technology or otherwise. To date, the Company has expensed all research and development costs. See Note 2 of Notes to the Financial Statements. Research and development expenses increased by approximately $700,000 to $3.3 million in 1998 from $2.6 million in 1997. In 1997 the Company made payments totaling $962,500 to the University of Washington pursuant to the Research Agreement. With the final payment on the Research Agreement having been made in 1997, no such payments to the University of Washington were required or made in 1998. The balance of the expenses of approximately $3.3 million and $1.6 million in 1998 and 1997 respectively, were incurred directly by the Company to further develop the RSD technology and to build the Company's research and product development capabilities through the addition of staff and equipment and related supporting costs. In addition, during 1998, the Company acquired an exclusive license on patents and other intellectual property related to the design and manufacture of a microminiature silicon scanner using microelectromechanical technology. The costs and expenses related to this acquisition are included in research and development expense in 1998. The increase in research and development expenses of approximately $700,000 in 1998 over 1997 reflects continued implementation of the Company's operating plan, which calls for building its technical staff and supporting activities to further develop the Company's technology; establishing and equipping its own laboratories; and developing or acquiring intellectual property related to the Company's business. The Company believes that a substantial level of continuing research and development expense will be required to further commercialize the RSD technology and to develop products incorporating the RSD technology. Accordingly, the Company anticipates that it will continue to commit substantial resources to research and development, including hiring additional technical and support personnel, and that these costs will continue to increase in future periods. MARKETING, GENERAL AND ADMINISTRATIVE EXPENSE. Marketing, general and administrative expenses include compensation and support costs for the Company's sales, marketing, management and administrative staff and their related activities, and for other general and administrative costs, including legal and accounting costs, costs of consultants and professionals and other expenses. Marketing, general and administrative expenses increased by approximately $1.8 million to $4.9 million in 1998 from $3.1million in 1997. The increase includes increased aggregate compensation and associated support costs for employees and contractors, including those employed at December 31, 1997 and those hired subsequent to that date, in sales and marketing and in executive and administrative areas. The Company expects marketing, general and administrative expenses to increase substantially in future periods as the Company adds to its sales and marketing staff, makes additional investments in sales and marketing activities to support commercialization of its RSD technology and development of anticipated products and as it increases the level of corporate and administrative activity. OTHER INCOME. Other income of $222,500 in 1997 resulted from the reduction of an accrued liability for litigation upon settlement of the matter at a lesser amount than the established reserve. INTEREST INCOME AND EXPENSE. Interest income decreased by $307,700 to $307,100 in 1998 from $614,800 in 1997. This decrease resulted from lower average cash and investment balances in 1998, representing the remaining net proceeds received by the Company from its initial public offering in August 1996. Interest expense increased by $78,200 to $81,600 in 1998 from $3,400 in 1997. This increase resulted from interest related to assignments of certain accounts receivable under the Company's accounts receivables assignment facility and increased interest expense related to capital lease obligations entered into in 1998 and 1997. LIQUIDITY AND CAPITAL RESOURCES The Company has funded its operations to date primarily through the sale of common stock and convertible preferred stock and, to a lesser extent, contract revenue. At December 31, 1999 the Company had $32.2 million in cash, cash equivalents and investment security balances. Cash used in operating activities totaled approximately $16.6 million in 1999 compared to $6.1 million in 1998. Cash used in operating activities for each period resulted primarily from the net loss for the period. Cash used in investing activities totaled approximately $32.1 million in 1999 compared to cash provided by investing activities of $3.1 million 1998. The increase in cash used in investing activities resulted primarily from increases in the purchase of investment securities and property and equipment. The Company used cash for capital expenditures of approximately $2.1 million in 1999 compared to approximately $696,000 in 1998. Historically, capital expenditures have been used to make leasehold improvements to leased office space and to purchase computer hardware and software, laboratory equipment and furniture and fixtures to support the Company's growth. Capital expenditures are expected to continue to increase significantly as the Company expands its operations. The Company currently has no material commitments for capital expenditures. Cash provided by financing activities totaled approximately $49.2 million in 1999 compared to $197,000 in 1998. The increase in cash provided by financing activities resulted primarily from increases in the net proceeds from the issuance of common and convertible preferred stock. See Note 7 of Notes to Financial Statement. SUBSEQUENT EVENT. In March 2000, the Company obtained a commitment from Cree and General Electric Pension Trust to purchase in a private placement 500,000 shares of common stock for a total of $25.0 million. Terms of the transaction include a provision that could result in a one time issuance of up to 55,556 additional shares if the market price of the Company's common stock on the date of effectiveness of the registration statement is less than the market price of the common stock used in the initial sale The Company's future expenditures and capital requirements will depend on numerous factors, including the progress of its research and development program, the progress in commercialization activities and arrangements, the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights, competing technological and market developments and the ability of the Company to establish cooperative development, joint venture and licensing arrangements. In order to maintain its exclusive rights under the Company's license agreement with the University of Washington, the Company is obligated to make royalty payments to the University of Washington with respect to the VRD technology. If the Company is successful in establishing OEM co-development and joint venture arrangements, the Company's expects its partners to fund certain non-recurring engineering costs for technology development and/or for product development. Nevertheless, the Company expects its cash requirements to increase significantly each year as it expands its activities and operations with the objective of commercializing the RSD technology and other technologies. The Company believes that its cash, cash equivalent, and investment securities balances totaling $32.2 million, will satisfy its budgeted cash requirements for at least the next 12 months based on the Company's current operating plan. Actual expenses, however, may exceed the amounts budgeted therefor and the Company may require additional capital earlier to further the development of its technology, for expenses associated with product development, and to respond to competitive pressures or to meet unanticipated development difficulties. In addition, the Company's operating plan calls for the addition of sales, marketing, technical and other staff and the purchase of additional laboratory and production equipment. The operating plan also provides for the development of strategic relationships with systems and equipment manufacturers that may require additional investments by the Company. There can be no assurance that additional financing will be available to the Company or that, if available, it will be available on terms acceptable to the Company on a timely basis. If adequate funds are not available to satisfy either short-term or long-term capital requirements, the Company may be required to limit its operations substantially. The Company's capital requirements will depend on many factors, including, but not limited to, the rate at which the Company can, directly or through arrangements with OEMs, introduce products incorporating the RSD technology and the market acceptance and competitive position of such products. Year 2000 During the first eleven weeks of calendar 2000, the Company did not encounter any disruption to its business operations due to Year 2000 issues in its internal systems. The Company is continuing to monitor both its internal systems and transactions with customers and suppliers for any indication of Year 2000 related problems. As of December 31, 1999, the incremental cost related to the Company's Year 2000 readiness programs with respect to internal IT and non-IT systems and third party providers was immaterial. With its Year 2000 readiness program essentially complete, the Company does not anticipate incurring any further costs. This estimate, however, does not include costs related to the potential failure of key suppliers to timely address or correct their Year 2000 issues, potential costs related to any customer or other product liability claims or the costs of internal software and hardware replaced in the ordinary course of business. All estimates are based on currently known circumstances and various assumptions regarding future events, and actual costs could differ materially from the estimates. The Company believes that it has no obligation for any costs incurred by its customers to address Year 2000 issues. The Company has not received any notifications from customers of problems associated with Year 2000 in their systems. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Substantially all of the Company's cash equivalents and investment securities are at fixed interest rates and, as such, the fair value of these instruments is affected by changes in market interest rates. As of December 31, 1999, all of the Company's cash equivalents and investment securities mature within one year. Accordingly, the Company believes that the market risk arising from its holdings of these financial instruments is immaterial. However, in the future the Company may invest in securities with maturities of more than one year, which may carry greater interest rate risk. Presently, all of the Company's development contract payments are made in U.S. dollars and, consequently, the Company believes it has no foreign currency exchange rate risk. However, in the future the Company may enter into development contracts in foreign currencies, which may subject the Company to foreign exchange rate risk. The Company does not have any derivative instruments and does not presently engage in hedging transactions. ITEM 8. ITEM 8. FINANCIAL STATEMENTS REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Microvision, Inc. In our opinion, the accompanying balance sheet and the related statements of operations, of shareholders' equity, of comprehensive loss and of cash flows present fairly, in all material respects, the financial position of Microvision, Inc. at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Seattle, Washington March 20, 2000 MICROVISION, INC. BALANCE SHEET - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. STATEMENT OF OPERATIONS - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. STATEMENT OF SHAREHOLDERS' EQUITY - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. STATEMENT OF SHAREHOLDERS' EQUITY (CONTINUED) - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. STATEMENT OF COMPREHENSIVE LOSS - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. STATEMENT OF CASH FLOWS - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. STATEMENT OF CASH FLOWS (CONTINUED) - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- 1. THE COMPANY Microvision, Inc. (the Company), a Washington corporation, was established to develop, manufacture and market Retinal Scanning Display (RSD) technology, which projects images directly onto the retina. The Company has entered into contracts with commercial and U.S. government customers to develop applications using the RSD technology. As part of these contracts, the Company has produced and delivered several demonstrator units. The Company is working to commercialize the RSD technology for potential defense, healthcare, industrial and consumer applications. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH, CASH EQUIVALENTS AND INVESTMENT SECURITIES The Company considers all investments that mature within 90 days of the date of purchase to be cash equivalents. Short-term investment securities are primarily debt securities. The Company has classified its entire investment portfolio as available-for-sale. Available-for-sale securities are stated at fair value with unrealized gains and losses included in other comprehensive income. Dividend and interest income are recognized when earned. Realized gains and losses are included in other income. The cost of securities sold is based on the specific identification method. RESTRICTED CASH The current portion of restricted investments represents investments available for sale held as collateral for a letter of credit issued to Cree, Inc. ("Cree") to secure payment on a development contract. The long-term portion of restricted investments represents investments available for sale pledged as collateral for letters of credit issued in connection with a lease agreement for the new corporate headquarters. Most of the balance is required to be maintained for the term of the lease. LONG TERM INVESTMENT In December 1999, the Company purchased 389,766 shares in Gemfire Corporation (Gemfire) a privately held corporation. Gemfire is a developer of components for display applications using diode lasers. The Company accounts for the investment in Gemfire using the cost method. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated over the estimated useful lives of the assets (three to five years) using the straight-line method. Leasehold improvements are depreciated over the shorter of their estimated useful life or the lease term. REVENUE RECOGNITION Revenue has primarily been generated from contracts for further development of the RSD technology and to produce prototypes for commercial enterprises and for the United States government. Revenue on such contracts is recorded using the percentage-of-completion method measured on a cost incurred basis. Losses, if any, are recognized in full as soon as identified. Changes in contract performance, contract conditions, and estimated profitability, including those arising from contract penalty provision, and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in revenue when their realization is assured. CONCENTRATION OF CREDIT RISK AND SALES TO MAJOR CUSTOMERS Financial instruments that potentially subject the Company to concentrations of credit risk are primarily, cash equivalents, investments, and accounts receivable. The Company typically does not require collateral from its customers. The Company has a cash investment policy that generally restricts investments to ensure preservation of principal and maintenance of liquidity. The Company's customers include the United States government and commercial enterprises, representing approximately 82% and 18%, respectively, of total revenue during 1999. These customers represented 83% and 17%, respectively, of total revenue during 1998 and 37% and 63% respectively of the total revenue during 1997. Three commercial enterprises represented 16%, 17% and 63% of total revenues during 1999, 1998 and 1997, respectively. INCOME TAXES The Company provides for income taxes under the principles of Statement of Financial Accounting Standards No. 109 (SFAS 109), which requires that provision be made for taxes currently due and for the expected future tax effects of temporary differences between book and tax bases of assets and liabilities and for loss and credit carry forwards. NET LOSS PER SHARE Basic net loss per share is calculated on the basis of the weighted-average number of common shares outstanding during the periods. Net loss per share assuming dilution is calculated on the basis of the weighted-average number of common shares outstanding MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- and the dilutive effect of all potential common stock equivalents and convertible securities. Net loss per share assuming dilution for the years ended December 31, 1999, 1998 and 1997 is equal to basic net loss per share since the effect of common stock equivalents outstanding during the periods, including convertible preferred stock, options and warrants computed using the treasury stock method, is anti-dilutive. RESEARCH AND DEVELOPMENT Research and development costs are expensed as incurred. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company's financial instruments include cash and cash equivalents, investment securities, accounts receivable, accounts payable, accrued liabilities, long-term debt, and capital lease obligations. Except for capital leases and long-term debt, the carrying amounts of financial instruments approximates fair value due to their short maturities. The carrying amount of capital leases and long-term debt at December 31, 1999 and 1998 was not materially different from the fair value based on rates available for similar types of arrangements. LONG-LIVED ASSETS The Company periodically evaluates the recoverability of its long-lived assets based on expected undiscounted cash flows and recognizes impairment of the carrying value of long-lived assets, if any, based on the fair value of such assets. STOCK-BASED COMPENSATION The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" and related interpretations, and complies with the disclosure provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation." The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force 96-18. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- NEW ACCOUNTING PRONOUNCEMENTS In June 1998, The Financial Accounting Standards Board ("FASB") issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities." The statement requires the recognition of all derivatives as either assets or liabilities in the balance sheet and the measurement of those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the planned use of the derivative and the resulting designation. Because the Company does not currently hold any derivative instruments and does not engage in hedging activities, the impact of the adoption of SFAS No. 133 is not currently expected to have a material impact on financial position, results of operations or cash flows. The Company will be required to implement SFAS No. 133 in the first quarter of fiscal 2001. In December 1999 the Securities and Exchange Commission ("SEC") issued SEC Staff Accounting Bulletin No. 101 ("SAB 101"). This pronouncement summarizes certain of the SEC's views on applying generally accepted accounting principles to revenue recognition. The Company is required to adopt SAB 101 for the year ending December 31, 2000 and does not expect the adoption of SAB 101 to have a material impact on its results of operations, financial position or cash flows. 3. INVESTMENTS AVAILABLE FOR SALE The following table summarizes the composition of the Company's available sale investments, which includes current and noncurrent restricted investments of $650,000 and 1,100,000 respectively at December 31, 1999. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 4. ACCRUED LIABILITIES Accrued liabilities consist of the following: 5. PROPERTY AND EQUIPMENT, NET Property and equipment consist of the following: 6. REVENUE AND RECEIVABLES Cost and estimated earnings in excess of billings on uncompleted contracts comprises amounts of revenue recognized on contracts that the Company has not yet billed to a customer because the amounts were not contractually billable at December 31, 1999 and 1998. In 1998, the Company established a non-recourse receivables purchasing facility (the "Facility") with a financial institution. The Facility allowed the Company to assign accounts receivable to the financial institution on a non-recourse basis for cash up to a maximum amount of $2,500,000. The Facility, which carried an administration fee and an interest discount, expired on September 24, 1999. As of December 31, 1998, approximately MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- $696,800 of receivables were assigned under the Facility and were recorded by the Company as a reduction of trade accounts receivable. During 1999 and 1998, the Company recorded fees and interest expense of $63,500 and $44,900 respectively under the Facility. 7. SHAREHOLDERS' EQUITY PREFERRED STOCK In January 1999, the Company raised $5,000,000 (before issuance costs) from the sale of 5,000 shares of Series B-1 convertible preferred stock to a private investor in a private placement. The preferred stock was immediately convertible into common stock at a rate of $12.50 in preferred stock per common share and carried a cumulative dividend of 4% per annum, payable in cash or additional convertible preferred stock at the election of the Company. The investor also acquired an option to purchase an additional 1,600 shares of Series B-2 convertible preferred stock at an exercise price of $16.00 per share with a six-month maturity and an option to purchase an additional 1,920 shares of Series B-3 convertible preferred stock at an exercise price of $19.20 per share with a nine-month maturity from the closing date of the transaction. In May 1999, the Company redeemed the Series B-1 convertible preferred stock and issued 400,000 shares of Common Stock. In addition, the Company paid a cash dividend of $73,400 to the investor at the time of the redemption. In July 1999, the investor exercised the option to purchase 1,600 shares of Series B-2 Convertible Preferred Stock for $1,600,000 (before issuance costs). The preferred stock is immediately convertible at a rate of $16.00 of preferred stock per common share. Unless converted sooner at the election of the investor, the convertible preferred stock will automatically convert into 100,000 shares of common stock at the end of its five-year term. The Series B-2 Convertible Preferred Stock is subject to mandatory redemption at the election of the preferred shareholder upon certain liquidation events (as defined). The convertible preferred stock carries a cumulative dividend of 4% per annum, payable in cash or additional convertible preferred stock at the election of the Company. Due to the mandatory redemption feature noted above, the carrying value of the Series B-2 convertible preferred stock is classified as temporary equity. The conversion prices of the Series B-1 and Series B-2 convertible preferred stock were less than the closing prices of the Company's common stock on the dates of commitment to purchase the preferred stock. This beneficial conversion feature was valued at $1,754,000. This "discount" is treated as a preferred stock dividend and recorded to accumulated deficit over the period between the date of sale and the date on which the preferred stock first becomes convertible. Because the preferred stock was immediately convertible, the entire value of the beneficial conversion feature was recorded as a dividend in 1999. In October 1999, the Company amended the option to purchase 1,920 shares of the Series B-3 Convertible preferred stock to extend of the expiration date of the MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- option to June 30, 2000. In consideration of the extension, the holder waived the right to receive dividends on the outstanding Series B-2 convertible preferred stock. The terms of the option were also amended to an option to purchase 100,000 shares of common stock at a conversion price of $19.20. The amendment was accounted for a preferred stock dividend with a fair market value of $154,400. COMMON STOCK In April 1999, the Company raised $6,000,000 (before issuance costs) from the sale of 440,893 shares of common stock to a private investor in a private placement. The investor also acquired two warrants to purchase additional common stock, one with a five-year term and the other with a one-year term. In May 1999, the Company raised $4,500,000 (before issuance costs) from the sale of 268,600 shares of common stock to Cree in a private placement. Concurrently with the sale of the stock, the Company entered into a one year $2.6 million development contract with Cree to accelerate development of semi-conductor light-emitting diodes and laser diodes for application with the Company's proposed display and imaging products. The agreement calls for payment of the $2.6 million cost of the project in four equal quarterly payments, the first of which was made concurrently with the signing of the agreement. The Company has pledged investments of $650,000 as of December 31, 1999 as security for a letter of credit, which will be used to fund the remaining payment under the agreement. WARRANTS In June 1999, the Company received $1,078,900 (before issuance costs) from the exercise of 49,950 warrants to purchase units, consisting of one share of common stock and one warrant to purchase common stock, and from the exercise of the underlying common stock purchase warrants, which resulted in the issuance by the Company of a total of 99,900 shares of common stock. In July 1999, the Company raised $27.0 million from the exercise of 2,253,430 publicly traded redeemable common stock purchase warrants and issuance of 2,253,430 shares of common stock. The remaining 20,496 warrants were redeemed for $5,100 in accordance with the terms of the Warrant Agreement. The Company has delisted the warrants from trading on the Nasdaq National Market. In December 1999, the Company raised $1.9 million from the exercise of 87,887 warrants to purchase units consisting of one share of common stock and one warrant to purchase common stock and from the exercise of the underlying common stock purchase warrants, which resulted in the issuance by the Company of a total of 175,774 shares of common stock. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- The following summarizes activity with respect to warrants during the three years ended December 31, 1999: OPTIONS During 1993, the Company adopted the 1993 Stock Option Plan (the 1993 Plan), which provides for granting incentive stock options (ISOs) and nonqualified options (NSOs) to employees, directors, officers, and certain nonemployees of the Company as determined by the Board of Directors, or its designated committee (Plan Administrator), for the purchase of up to a total of 228,938 shares of the Company's authorized but unissued common stock. The date of grant, option price, vesting period and other terms specific to options granted under such plan were determined by the Plan Administrator. In September 1995, an additional 625,000 shares were reserved for issuance under the 1993 Plan. The Company expects to terminate the 1993 Plan effective immediately following the issuance of the shares of common stock subject to the outstanding grants thereunder. During 1994, the Company adopted the 1994 Combined Incentive and Nonqualified Stock Option Plan (the 1994 Plan), which provides for the granting of ISOs and NSOs to employees, directors, officers, and certain nonemployees of the Company as determined by the Plan Administrator for the purchase of common shares not to exceed a total of 435,000 of the Company's authorized but unissued shares of common stock. The date of grant, option price, vesting terms and other terms specific to options granted under such plan were determined by the Plan Administrator. The 1994 Plan was terminated in 1999 following the final issuance of the shares of common stock for outstanding grants. During 1996, the Company adopted the 1996 Stock Option Plan (the 1996 Plan) and the 1996 Independent Director Stock Plan (the Independent Directors Plan). The 1996 Plan, MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- as amended, provides for granting ISOs and NSOs to employees, officers and agents of the Company as determined by the Plan Administrator, for the purchase of up to 3,000,000 shares of the Company's authorized but unissued common stock. The terms and conditions of any options granted, including date of grant, the exercise price and vesting period are to be determined by the Plan Administrator. The Independent Directors Plan provides for granting up to a total of 75,000 shares of common stock to nonemployee directors of the Company. Stock options issued under the 1993 Plan vest over three years and expire five years after the date of vesting. Stock options issued under the 1996 Plan vest over three to four years and typically expire after ten years. Stock issued under the Independent Director Plan vests upon the earlier of the day prior to the next regular Annual Shareholders Meeting, or one year. In 1999 and 1998, the three officers of the Company exercised a total of 57,750 and 43,000 stock options respectively in exchange for full recourse notes totaling $270,200 and $78,900 respectively. These notes bear interest at 4.64% to 6.20% per annum. Each note is payable in full upon the earliest of (1) a fixed date ranging from January 31, 2001 to December 31, 2004 depending on the option; (2) the sale of all of the shares acquired with the note; or (3) within 90 days of the officer's termination of employment. Each note is also payable on a pro rata basis upon the partial sale of shares acquired with the note. The notes are included in shareholders' equity on the balance sheet. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- The following table summarizes activity with respect to options for the three years ended December 31, 1999: MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- The following table summarizes information about stock options outstanding and exercisable at December 31, 1999: Deferred compensation of $5,300 and $785,000 was recorded during 1998 and 1997 respectively for stock options granted to employees at an exercise prices below fair market value. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Had compensation cost for the Plans been determined based upon the fair value at the grant date for awards under the Plans consistent with the methodology prescribed under SFAS 123, the Company's net loss and net loss per share would have been increased to the pro forma amounts indicated below: The fair value of the options granted was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1999, 1998 and 1997, respectively: dividend yield of zero percent for all years; expected volatility of 83%, 60%, and 60% for all years; risk-free interest rates of 5.50%, 5.11%, and 6.09%; assumed forfeiture rate of 5% for all years; and expected lives 5 years, 5 years and 4 years. 8. COMMITMENTS AND CONTINGENCIES AGREEMENTS WITH UNIVERSITY OF WASHINGTON In October 1993, the Company entered into a Research Agreement and an Exclusive License Agreement (License Agreement) with the University of Washington (UW). The License Agreement grants the Company the rights to certain intellectual property, including the technology being developed under the Research Agreement, whereby the Company has an exclusive, royalty-bearing license to make, use and sell or sublicense the licensed technology. In consideration for the license, the Company agreed to pay a one-time nonrefundable license issue fee of $5,133,500. Payments under the Research Agreement were credited to the license fee. In addition to the nonrefundable fee, which has been paid in full, the Company is required to pay certain ongoing royalties. In 1999, 1998 and 1997 these royalties were not material. The Research Agreement provided for the Company to pay $5,133,500 to fund agreed-upon VRD research and development activities to be carried out by the UW. The research funding was required to be paid in sixteen quarterly installments of $320,800 and was payable at the beginning of each quarter. During 1997, the Company made its final payments under the Research Agreement. Total payments made for 1997 and 1996 were $962,500 and $1,283,400, respectively. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Beginning in 2000, the Company is required to pay UW a nonrefundable license maintenance fee of $10,000 per quarter, to be credited against royalties due. In March 1994, the Company entered into an Exclusive License Agreement (HALO Agreement) with UW. The HALO Agreement grants the Company the right to receive certain technical information relating to HALO Display technology and an exclusive right to market the technical information for the purpose of commercial exploitation to unaffiliated entities. Under the agreement, the Company is obligated to pay to UW $75,000 and 31,250 common shares upon filing of the first patent and $100,000 and 62,500 common shares upon issuance of the first patent application. In 1999, the UW filed a patent application under the HALO Agreement. An obligation of $452,000 based on the value of the common stock was recorded as an accrued liability and an expense in 1999. A patent has not yet been issued. LITIGATION The Company is subject to various claims and pending or threatened lawsuits in the normal course of business. Management believes that the outcome of any such lawsuits would not have a material adverse effect on the Company's financial position, results of operations or cash flows. 9 LEASE COMMITMENTS AND DEBT The Company leases its office space and certain equipment under noncancelable capital and operating leases with initial or remaining terms in excess of one year. The Company entered into a new facility lease that commenced in April 1999. This lease includes an extension provision and rent escalation provisions over the term of the lease. Rent expense is recognized on a straight-line basis over the lease term. The Company entered into a loan agreement with the lessor of the Company's new corporate headquarters to finance $420,000 in tenant improvements. The loan carries a fixed interest rate of 10% and is repayable over the term of the lease and is secured by a letter of credit. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Future minimum rental commitments under capital and operating leases for years ending December 31 are as follows: The capital leases are collateralized by the related assets financed and by security deposits held by the lessors under the lease agreements. The cost and accumulated depreciation of equipment under capital leases was $245,700 and $208,300, respectively, at December 31, 1999, and $506,100 and $82,600 respectively, at December 31, 1998. Rent expense was $1,007,700, $294,000 and $147,100 for 1999, 1998 and 1997, respectively. 10. INCOME TAXES A provision for income taxes has not been recorded for 1999, 1998 or 1997 due to taxable losses incurred during such periods. A valuation allowance has been recorded for deferred tax assets because realization is primarily dependent on generating sufficient taxable income prior to expiration of net operating loss carry-forwards. At December 31, 1999, the Company has net operating loss carry-forwards of approximately $34.2 million for federal income tax reporting purposes. The net operating losses will expire beginning in 2005 if not previously utilized. In certain circumstances, as specified in the Internal Revenue Code, a 50% or more ownership change by certain combinations of the Company's stockholders during any three-year period would result in limitations on the Company's ability to utilize its net operating loss carry-forwards. The Company has determined that such a change occurred during 1995 and the annual utilization of loss carry-forwards generated through the period of that change will be limited to approximately $761,000. An additional change occurred in 1996; however, the amount of the annual limitation is not material. MICROVISION, INC. NOTES TO FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Deferred tax assets are summarized as follows: The difference between the zero provisions for income taxes in 1999, 1998 and 1997 and the expected amounts determined by applying the federal statutory rate to losses before income taxes results primarily from increases in the valuation allowance. Certain net operating losses arise from the deductibility for tax purposes of compensation under nonqualified stock options equal to the difference between the fair value of the stock on the date of exercise and the exercise price of the options. For financial reporting purposes, the tax effect of this deduction when recognized will be accounted for as a credit to shareholders' equity. 11. RETIREMENT SAVINGS PLAN On January 1, 1998 the Company established a retirement savings plan (the Plan) that qualifies under Internal Revenue Code Section 401(k). The plan covers all qualified employees. Contributions to this plan by the Company are made at the discretion of the Board of Directors. The Company did not contribute to the Plan in 1999 or 1998. In February 2000, the Board of Directors approved a plan amendment to match 50% of employee contributions to the Plan up to 6% of the employee's compensation, starting on April 1, 2000. 12. SUBSEQUENT EVENT (UNAUDITED) In March 2000, the Company obtained a commitment from two investors to purchase in a private placement 500,000 shares of common stock for a total of $25.0 million. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no changes in or disagreements with accountants in accounting or financial disclosure matters during the Company's fiscal years ended December 31, 1999 and 1998. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors and executive officers is incorporated by reference to the section entitled "Election of Directors" in the Microvision, Inc., definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with the next Annual Meeting of Shareholders to be held on June 22, 2000 (the "Proxy Statement"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the Proxy Statement under the heading "Executive Compensation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the Proxy Statement under the heading "Security Ownership of Certain Beneficial Owners and Management." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the Proxy Statement under the heading "Certain Transactions." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a) Documents filed as part of the report: (1) Financial Statements Balance Sheet as of December 31, 1999 and 1998 Statement of Operations for the years ended December 31, 1999, 1998 and 1997 Statement of Shareholders' Equity for the years ended December 31, 1999, 1998 and 1997 Statement of Comprehensive Loss for the years ended December 31, 1999, 1998 and 1997 Statement of Cash Flows for the years ended December 31, 1999, 1998 and 1997 (2) Financial Statement Schedules None. (3) Exhibits 3.1 Amended and Restated Articles of Incorporation of Microvision, Inc., as filed on August 14, 1996 with the Secretary of State of the State of Washington(1) 3.1.1 Articles of Amendment of Articles of Incorporation Containing the Statement of Rights and Preferences of the Series B Convertible Preferred Stock of Microvision, Inc., dated January 13, 1999(2) 3.2 Amended and Restated Bylaws of Microvision, Inc.(3) 4.1 Form of specimen certificate for Common Stock(1) 4.3 Form of specimen certificate for the Series B-2 Stock(5) 4.4 Form of specimen certificate for the Series B-3 Stock(5) 4.5 Microvision, Inc. Series 1 Stock Purchase Warrant, dated April 1, 1999 issued to Capital Ventures International(6) 4.6 Microvision, Inc. Series 2 Stock Purchase Warrant, dated April 1, 1999 issued to Capital Ventures International(6) 10.1 Assignment of License and Other Rights between The University of Washington and the Washington Technology Center and the H. Group, dated July 25, 1993(1) 10.2 Project II Research Agreement between The University of Washington and the Washington Technology Center and Microvision, Inc., dated October 28, 1993(1)+ 10.3 Exclusive License Agreement between The University of Washington and Microvision, Inc., dated October 28, 1993(1)+ 10.4 Employment Agreement between Microvision, Inc., and Richard F. Rutkowski, effective October 1, 1997(5) 10.5 Employment Agreement between Microvision, Inc., and Stephen R. Willey, effective October 1, 1998(6) 10.6 1993 Stock Option Plan(1) 10.7 1996 Stock Option Plan, as amended(4) 10.8 1996 Independent Director Stock Plan, as amended(5) 10.9 Exclusive License Agreement between the University of Washington and Microvision, Inc. dated March 3, 1994(1) 10.10 Form of Executive Stock Loan Agreement(3) 10.11 Employment Agreement between Microvision, Inc., and Richard A. Raisig, effective October 1, 1997(5) 10.12 Lease between S/I Northcreek II, LLC and Microvision, Inc., dated October 27, 1998(5) 10.12.1 Lease Amendment No. 1 to Lease between S/I Northcreek II, LLC and Microvision Inc., dated July 12, 1999 10.12.2 Lease Amendment No. 2 to Lease between S/I Northcreek II, LLC and Microvision, Inc., dated February 14, 2000 10.13 Series B Convertible Preferred Stock Purchase Agreement, dated as of January 14, 1999, between Microvision, Inc. and Margaret Elardi(5) 10.13.1 First Amendment to Series B Convertible Preferred Stock Purchase Agreement, dated October 14, 1999 23 Consent of PricewaterhouseCoopers LLP 27 Financial Data Schedule - ----------------------------- (1) Incorporated by reference to the Company's Form SB-2 Registration Statement, Registration No. 333-5276-LA. (2) Incorporated by reference to the Company's Current Report on Form 8-K filed on January 28, 1999. (3) Incorporated by reference to the Company's Form 10-QSB for the quarterly period ended June 30, 1998. (4) Incorporated by reference to the Company's Form 10-QSB for the quarterly period ended September 30, 1998. (5) Incorporated by reference to the Company's Annual Report on form 10-K for the year ended December 31, 1997, Registration No. 0-21221. (6) Incorporated by reference to the Company's Annual Report on form 10-K for the year ended December 31, 1998. + Subject to confidential treatment. (b) REPORTS ON FORM 8-K. Microvision filed no reports on Form 8-K during the last quarter of the fiscal year ended December 31, 1999. SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MICROVISION, INC. Date: March 28, 2000 By RICHARD F. RUTKOWSKI --------------------------------------- Richard F. Rutkowski President and Chief Executive Officer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the following capacities on March 28, 2000. SIGNATURE TITLE RICHARD F. RUTKOWSKI Chief Executive Officer, President and Director - ----------------------- (Principal Executive Officer) Richard F. Rutkowski STEPHEN R. WILLEY Executive Vice President and Director - ----------------------- Stephen R. Willey RICHARD A. RAISIG Chief Financial Officer and Vice President, - ----------------------- Operations and Director (Principal Financial Richard A. Raisig Officer) JEFF WILSON Chief Accounting Officer - ----------------------- (Principal Accounting Officer) Jeff Wilson JACOB BROUWER Director - ----------------------- Jacob Brouwer RICHARD A. COWELL Director - ----------------------- Richard A. Cowell MARGARET ELARDI Director - ----------------------- Margaret Elardi WALTER J. LACK Director - ----------------------- Walter J. Lack WILLIAM A. OWENS Director - ----------------------- William A. Owens ROBERT A. RATLIFFE Director - ----------------------- Robert A. Ratliffe DENNIS J. REIMER Director - ----------------------- DENNIS J. REIMER EXHIBIT INDEX The following documents are filed herewith or have been included as exhibits to previous filings with the Securities and Exchange Commission and are incorporated by reference as indicated below. 3.1 Amended and Restated Articles of Incorporation of Microvision, Inc., as filed on August 14, 1996 with the Secretary of State of the State of Washington(1) 3.1.1 Articles of Amendment of Articles of Incorporation Containing the Statement of Rights and Preferences of the Series B Convertible Preferred Stock of Microvision, Inc., dated January 13, 1999(6) 3.2 Amended and Restated Bylaws of Microvision, Inc.(3) 4.1 Form of specimen certificate for Common Stock(1) 4.3 Form of specimen certificate for the Series B-2 Stock(5) 4.4 Form of specimen certificate for the Series B-3 Stock(5) 4.5 Microvision, Inc. Series 1 Stock Purchase Warrant, dated April 1, 1999 issued to Capital Ventures International(6) 4.6 Microvision, Inc. Series 2 Stock Purchase Warrant, dated April 1, 1999 issued to Capital Ventures International(6) 10.1 Assignment of License and Other Rights between The University of Washington and the Washington Technology Center and the H. Group, dated July 25, 1993(1) 10.2 Project II Research Agreement between The University of Washington and the Washington Technology Center and Microvision, Inc., dated October 28, 1993(1)+ 10.3 Exclusive License Agreement between The University of Washington and Microvision, Inc., dated October 28, 1993(1)+ 10.4 Employment Agreement between Microvision, Inc., and Richard F. Rutkowski, effective October 1, 1997(5) 10.5 Employment Agreement between Microvision, Inc., and Stephen R. Willey, effective October 1, 1998(6) 10.6 1993 Stock Option Plan(1) 10.7 1996 Stock Option Plan, as amended(4) 10.8 1996 Independent Director Stock Plan, as amended(5) 10.9 Exclusive License Agreement between the University of Washington and Microvision, Inc. dated March 3, 1994(1) 10.10 Form of Executive Stock Loan Agreement(3) 10.11 Employment Agreement between Microvision, Inc., and Richard A. Raisig, effective October 1, 1997(5) 10.12 Lease between S/I Northcreek II, LLC and Microvision, Inc., dated October 27, 1998(5) 10.12.1 Lease Amendment No. 1 to Lease between S/I Northcreek II, LLC and Microvision Inc., dated July 12, 1999 10.12.2 Lease Amendment No. 2 to Lease between S/I Northcreek II, LLC and Microvision, Inc., dated February 14, 2000 10.13 Series B Convertible Preferred Stock Purchase Agreement, dated as of January 14, 1999, between Microvision, Inc. and Margaret Elardi(5) 10.13.1 First Amendment to Series B Convertible Preferred Stock Purchase Agreement 23 Consent of PricewaterhouseCoopers LLP 27 Financial Data Schedule - ----------------------------- (1) Incorporated by reference to the Company's Form SB-2 Registration Statement, Registration No. 333-5276-LA. (2) Incorporated by reference to the Company's Current Report on Form 8-K filed on January 28, 1999. (3) Incorporated by reference to the Company's Form 10-QSB for the quarterly period ended June 30, 1998. (4) Incorporated by reference to the Company's Form 10-QSB for the quarterly period ended September 30, 1998. (5) Incorporated by reference to the Company's Annual Report on form 10-K for the year ended December 31, 1997, Registration No. 0-21221. (6) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. + Subject to confidential treatment.

1086472_1999.txt

1086472_1999

1999

1086472

ITEM 1. BUSINESS General Description of Business We began our operations in January 1996, launched our first Net2Phone product in August 1996, and were incorporated in Delaware as a separate subsidiary of IDT in October 1997. We are a leading provider of services enabling users to make high-quality, low-cost telephone calls over the Internet. This service is commonly referred to as Internet telephony. Our Internet telephony services enable our customers to call individuals and businesses worldwide using their personal computers or traditional telephones. We are leveraging our Internet telephony expertise to integrate real-time voice communication capabilities into the Web. We currently offer Web-based Internet telephony services, which enable customers to make calls and send faxes over the Internet using their personal computers, and basic Internet telephony services, which enable customers to make calls using traditional telephones and fax machines. We have developed a sophisticated PC2Phone software application that enables the use of our Web-based Internet telephony services. We distribute this software free of charge through the Internet and through agreements to include our software with products sold by our strategic partners. In January 1999, Netscape agreed to integrate our PC2Phone software on an exclusive basis into future versions of Netscape's Internet browser released during the term of our agreement, including the Netscape Communicator products. Netscape also agreed to include a Net2Phone icon on the Netscape Navigator Personal Toolbar. In addition, we have entered into an agreement with ICQ, a subsidiary of America Online, to provide Internet telephony services to users of ICQ's instant messaging service. ICQ will integrate some of our Internet telephony software into ICQ's Instant Messenger software on an exclusive basis, allowing ICQ users to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls. We will also co-brand a pre-paid phone-to-phone calling card with ICQ, allowing users to place calls from the United States and 19 other countries to virtually anywhere in the world. In addition, we have entered into strategic marketing and distribution relationships with leading Internet companies, including Yahoo!, Go2Net, InfoSpace.com, Snap.com, Excite, and ZDNet. We have also entered into arrangements with leading computer equipment and software companies, such as IBM, Compaq and Packard Bell-NEC Europe to include our software with their products. We promote our services through direct sales and marketing and through international resellers who buy minutes of use from us in bulk, and resell them to customers in their respective countries. Our software is currently available in ten languages (English, Spanish, Japanese, French, Dutch, Portuguese, Italian, German, Swedish and Chinese). We intend to make our software available in additional languages as we expand our international customer base and distribution channels. As of July 31, 1999, we served over 325,000 active customers who made an average of approximately 60 minutes of calls per month and handled over 20 million minutes of use per month. Our net loss increased from approximately $500,000 in fiscal 1996, $1.7 million in fiscal 1997 and $3.5 million in fiscal 1998 to $24.7 million in fiscal 1999. Our total assets increased from $916,000 at July 31, 1997 and $7.0 million at July 31, 1998 to $50.8 million at July 31, 1999. Our revenue has grown substantially, increasing from approximately $2.7 million in fiscal 1997 to approximately $12.0 million in fiscal 1998. Our revenue for fiscal 1999 was approximately $33.3 million. We registered 6,210,000 shares of our common stock on a Form S-1 registration statement, which became effective of July 29, 1999. We received net proceeds of approximately $85.3 million from the sale of the 6,210,000 shares at the initial public offering price of $15.00 per share on August 3, 1999. The managing underwriters for this offering were Hambrecht & Quist LLC, BT Alex. Brown Incorporated and Bear. Stearns & Co. Inc. On November 4, 1999, we filed a registration statement with the Securities and Exchange Commission (Registration No. 333-90317) for the sale of 6,300,000 shares of common stock. Of the 6,300,000 shares to be sold in the offering, 3,400,000 shares are being sold by us. The remaining 2,600,000 shares are being sold by selling stockholders, including IDT, which will be selling 2,200,000 shares. The underwriters have also been granted an option for a period of 30 days to purchase up to 945,000 additional shares of common stock from other selling stockholders to cover over-allotments, if any. Industry Segments We only report in one industry segment. See "Notes to Financial Statements - -- Note 3." Description of Business The Internet is experiencing unprecedented growth as a global medium for communications and commerce. International Data Corporation estimates that the number of Internet users worldwide will grow from approximately 142 million at the end of 1998 to 399 million by the end of 2002. These users are increasingly using the Internet as a communications medium. A study by E-Marketer, a market research firm, estimated that 9.4 billion e-mail messages are delivered daily. Instant text communication through online "chat" rooms is also gaining widespread acceptance. Online commerce is also becoming widely accepted as a means of doing business. According to International Data Corporation, Internet users worldwide purchased more than $50 billion of goods and services in 1998. International Data Corporation projects that commerce over the Internet will grow to approximately $1.3 trillion in 2003. Emergence of Internet Telephony TeleGeography, a market research firm, estimates that the international long distance market will grow to $79 billion in 2001, with consumers and businesses making an estimated 143 billion minutes of international long distance calls. Despite the large size of this market and the number of minutes of calls made, traditional international long distance calls are still relatively expensive for the consumer. The primary reason for this expense is tariffs set by foreign governments and carriers that are passed on to consumers in the form of higher long distance rates. Internet telephony has emerged as a low cost alternative to traditional long distance calls. International Data Corporation projects that the Internet telephony market will grow rapidly to over $23.4 billion in 2003, from approximately $1.1 billion in 1998. Internet telephone calls are less expensive than traditional international long distance calls primarily because these calls are carried over the Internet or our network and therefore bypass a significant portion of international long distance tariffs. The technology by which Internet phone calls are made is also more cost-effective than the technology by which traditional long distance calls are made. We use a technology called "packet-switching" to break voice and fax calls into discrete data packets, route them over the Internet or our network and reassemble them into their original form for delivery to the recipient. Traditional international long distance calls, in contrast, are made using a technology called "circuit switching" which carries these calls over international voice telephone networks. These networks are typically owned by governments or carriers who charge a tariff for their use. Circuit switching requires a dedicated connection between the caller and the recipient that must remain open for the duration of the call. As a result, circuit-switching technology is inherently less efficient than packet-switching technology which allows data packets representing multiple conversations to be carried over the same line. This greater efficiency creates network cost savings that can be passed on to the consumer in the form of lower long distance rates. Integration of Voice into the Web We believe that Internet telephony offers significant benefits to consumers and businesses over and above international long distance cost savings. The technologies that enable Internet telephony can be applied to integrate live voice capabilities into the Web. We believe that this integration can enhance the potential for the Internet to become the preferred medium for both communications and commerce. For example, the integration of voice into the Web would supplement existing text-based modes of Internet communication such as e- mail and online chat by adding a live, secure, low-cost or free voice alternative. We believe that this will be attractive both to consumers and businesses. In addition, voice-enabling the Web would give Internet shoppers the ability to speak directly with customer service representatives of online retailers in order to ask questions and alleviate concerns about online security. This may increase the probability that a sale is made and may give online retailers a key competitive advantage by providing them with opportunities to sell higher margin and additional products to these customers. Voice-enabling a commercial Web site may also give online retailers the ability to provide more responsive customer support and service. Integrating live voice capabilities into the Web would also enable Internet companies to offer enhanced communications services, such as providing Internet users with a central source for retrieving voicemail, e-mail, faxes and pages. We believe this would allow these companies to attract more users to their sites and to increase the amount of time these users spend on their sites. This increased usage will allow these Internet companies to attract advertisers and secure higher advertising rates, thereby increasing revenue. Limitations of Existing Internet Telephony Solutions The growth of Internet telephony has been limited to date due to poor sound quality attributable to technological issues such as delays in packet transmission and network capacity limitations. However, recent improvements in packet-switching technology, new software algorithms and improved hardware have substantially reduced delays in packet transmissions. In addition, the use of private networks to transmit calls as an alternative to the public Internet is helping to alleviate network capacity constraints. Finally, the emergence of new, lower cost Internet access technologies, such as high-speed modems, are addressing local Internet access issues. Several large long distance carriers, including AT&T and Sprint, have announced Internet telephony service offerings. However, many of these service offerings have not been deployed on a large scale. Many also require users to purchase other telecommunications services or allow only domestic calling. Smaller Internet telephony service providers also offer low-cost Internet telephony services from personal computers to telephones and from telephones to telephones. These services, however, are available only in limited geographic areas and require payment by credit card which may preclude many international customers from signing up for these services. We also believe that existing Internet telephony service providers rely upon technologies and systems that lack large-scale billing, network management and monitoring systems, and customer service capabilities required for the integration of voice communication into the Web. In addition, many companies currently provide Internet telephony software and services that allow Internet telephone calls to be made between personal computers. However, most of these companies require both the initiator and the recipient of the call to have the same software installed on their personal computers and to be online at the same time. The Net2Phone Solution We deliver high-quality Internet telephony services and voice-enabling Web applications to consumers and businesses. Our solution provides the following benefits to our customers: . Low Cost. Our PC2Phone software is distributed free of charge, and our services allow our customers to make telephone calls often at a fraction of the cost of traditional long distance service. Because international long distance calls routed over the Internet bypass the international settlement process, we are able to charge lower rates than traditional long distance carriers. . High Voice Quality. We offer high voice quality through our proprietary packet-switching technologies, which reduce packet loss and delay, route packets efficiently and perform quality enhancing functions, such as echo cancellation. We intend to continue to enhance the voice quality of our services as our customer base and business grow. . Ease of Use and Access. Our services are designed to be convenient and easy to access from anywhere in the world. To make a call using our Web- based services, a customer need only install our free software on a sound- enabled personal computer, register and be connected to the Internet. No additional telephone lines or special equipment are required. Our Phone2Phone service is also easy to use and requires a customer only to register and dial a toll-free or local access number from any telephone or fax machine. . Voice-Enabled Online Retailing. Our services enable users anywhere in the world to speak with sales or customer service representatives of online retailers and other Web-based businesses while visiting their Web sites. This provides customers an opportunity to ask questions of and to provide credit card information directly to a customer service representative if they are concerned about Internet security, thereby increasing the likelihood of consummating an online sale. In addition, our services allow our customers outside of the United States and Canada to access telephone numbers that might otherwise be inaccessible to them through their local carriers. For example, users of our services in other countries may call United States or Canadian toll-free numbers (i.e., telephone numbers with 800, 877 or 888 prefixes), which are not otherwise available to them, at no charge. The ability to communicate with international customers in this manner provides United States and Canadian-based online retailers and other Web-based businesses with cost effective access to an expansive international customer base. . Reliable Service. Our network is reliable because of its technologically advanced design. This design allows us to expand our network and add capacity by adding switches to the existing network. Our system also provides seamless service and high-quality voice transmission through our ability to reroute packets if problems arise. We believe that our ability to provide reliable service is essential to voice-enable the Web. . Ease of Payment and Online Account Access. Once registered, our customers are able to make unlimited toll-free calls. In addition, they can make toll calls by opening a prepaid account using credit cards, wire transfers or checks payable in United States dollars. Acceptance of payment in multiple forms enables international customers who may not necessarily have credit cards to use our services. Our customers can access their accounts via the Internet in order to view their call history and account balances, and to increase their prepaid amounts. . Customer Support. We offer live customer support 24 hours a day, seven days a week in multiple languages. Our customer support center can be accessed from anywhere in the world at no charge either by calling our toll-free number, where available, or by using our Web-based Internet telephony service. Our integrated customer billing software and call management system provide our customer support staff with immediate access to user accounts, calling patterns and billing history to help us provide better, more responsive customer support. Strategy Our mission is to become the premier Web-based communications enabler. We intend to leverage our leadership position in the Internet telephony market to make our communications services readily available worldwide on the Internet and to develop and market online commerce and related products. Our strategy includes the following key elements: . Drive Usage through Resellers and Strategic Partners. We promote our services through direct sales and marketing and through relationships with international resellers and leading Internet hardware, software and content companies. We intend to build on these relationships and to add more partners and resellers to drive usage of our Internet telephony services. We also intend to partner with large telecommunications companies to enable them to offer our Internet telephony services under their brand. . Pursue Multiple Sources of Revenue. In addition to our minutes-based revenue, we intend to pursue new Web-based revenue opportunities from banner and audio advertising, as well as sponsorship opportunities on our PC2Phone software user interface and our EZSurf.com Web site. We also intend to explore the availability of revenue-sharing opportunities with online retailers. . Enhance Brand Recognition. We have established strong brand identity in the Internet telephony market in large part due to the high-quality of our services and our marketing efforts. We have entered into advertising relationships with leading Web companies such as Netscape, ICQ, Go2Net InfoSpace.com, Yahoo! and Excite in order to promote our services. We intend to continue to implement aggressive advertising and sales campaigns to increase brand awareness. In addition, we intend to enhance our brand recognition by cooperatively marketing our Internet telephony services with leading computer hardware and software companies and Internet services providers. . Make Our Software Readily Available Worldwide. We have entered into strategic distribution relationships with leading computer equipment and software companies to expand the availability of our software. For example, our software will be embedded into future versions of Netscape's Internet browser and a Net2Phone icon will be prominently positioned next to AOL's Instant Messenger icon on the Netscape Navigator Personal Tool Bar. In addition, customized versions of some of our Internet telephony services will be integrated into ICQ's instant messaging software and distributed by ICQ. Our software is included with IBM's Internet services and may be pre- loaded on computers sold by Compaq internationally. We intend to build upon these relationships and enter into new distribution relationships with other leading companies in order to enhance the distribution of our software worldwide. . Expand and Enhance Products and Services. We have committed significant resources to expand our network, enhance our existing product and service offerings and to develop and market additional products and services in order to continue to provide customers with high-quality Internet telephony services. For example, we plan to introduce new products and services, including: . PC2PC, which will allow high-quality Internet telephony from one personal computer to another; . Phone2PC, which will allow calls from a traditional telephone to a personal computer; . voice-enabled chat, which will allow two participants in an online chat room discussion to establish direct voice communication with each other while maintaining anonymity; . unified messaging services, which will include voice, fax and electronic messaging with multiple points of access, including the Web and conventional telephones; . online commerce applications, which will provide customer service representatives of online retailers with real-time access to a caller's profile and enable them to "push" specific content onto a caller's personal computer screen in order to better assist the caller in answering their inquiries; . customer payment applications, which will allow customers to pay for online commerce transactions by debiting their Net2Phone account; and . video conferencing between two or more personal computer users over the Internet. Strategic Relationships We have entered into strategic distribution, integration and advertising relationships with leading Internet and computer hardware and software companies. These relationships typically include arrangements under which we share with our strategic partners a portion of the revenue they bring to us. We believe that these relationships are important because they provide incentive to our partners and allow us to leverage the strong brand names and distribution channels of these companies to market our products and services. Our strategic partners include: Netscape Netscape has agreed to embed our PC2Phone software on an exclusive basis in future versions of Netscape's Internet browser released during the term of our agreement, including the Netscape Communicator products. Netscape also has agreed to: . place a Net2Phone icon on the Netscape Navigator Personal Toolbar immediately to the right of the AOL Instant Messenger icon, which will allow Netscape users to use our Web-based Internet telephony services from anywhere on the Web simply by clicking on our icon; . integrate our services into, and display our services on, the Netscape Netcenter site, including Netscape's Contacts section and Address Book section, which will allow Netscape users to make calls using our services simply by clicking on a displayed telephone number; and . include the software for our Web-based Internet telephony services in Netscape's suite of online plug-in software and Netscape Smart Update programs (both domestically and when available internationally) for downloading by Netscape users from centralized locations on Netscape's Web site. We also have the right to place a specified number of banner and other advertisements on Web pages of our choice on Netscape's domestic and international Web sites. The two-year term of our exclusive agreement with Netscape commences with the beta release of the next version of Netscape's Internet browser. This next version of Netscape's Internet browser has not yet been released, and our agreement with Netscape does not provide for a date by which it will be released. Accordingly, we would not expect any potential PC2Phone revenue related to our agreement with Netscape until their product is released. ICQ In July 1999, we entered into an exclusive, four-year distribution and marketing agreement with ICQ, a subsidiary of America Online. Under this agreement, ICQ has agreed to: . co-brand and promote our phone-to-phone Internet telephony services in the United States and in 19 other countries; . integrate customized versions of some of our Internet telephony services on an exclusive basis into ICQ's instant messaging software to allow ICQ customers to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls; . share revenue from some advertisements and sponsorships sold by ICQ within Internet-telephony-related areas within ICQ's instant messaging software; and . promote our services on some of ICQ's Web sites. All of our Internet telephony services that ICQ promotes under our agreement will be co-branded under both of our labels. Although our agreement with ICQ does not provide for definitive launch dates, we believe the phone-to-phone services will be launched in the United States later this year and internationally by early 2000. We also believe that the PC-based Internet telephony services will be launched in mid-2000. Go2Net In October 1999, we entered into an exclusive three-year distribution and marketing agreement with Go2Net, a network of branded, technology-and community- driven Web sites. Under this agreement, Go2Net has agreed to integrate co- branded versions of our Internet telephony products and services into the Go2Net Network. In addition, together with Go2Net and CommTouch Software Ltd., a provider of email solutions, we will create a unified communication and messaging platform on the Go2Net Network that will enable users to send and receive voice mail, faxes, email and telephone calls over the Internet. In addition, in the event Go2Net provides start pages or customized portal offerings for third parties distributed through set-top devices, cellular phones, personal digital assistants (also known as PDAs) and similar devices, we have the exclusive option to incorporate our services into such offerings to the extent Go2Net has the right to include Internet telephony services in such offerings. InfoSpace.com In March 1999, we entered into an agreement with Infospace.com, a leading Internet infrastructure company. Under this agreement, for a period of 30 months, one or more textual or graphical links to our www.net2phone.com Web site will be displayed on all then existing and future versions of Infospace.com's Web sites and its affiliate network sites, including Netscape's Netcenter Web site, the Microsoft Network, the GO Network and Xoom.com. In addition, our software is integrated into InfoSpace.com's network of white and yellow page directory services. In August 1999, we amended our agreement with InfoSpace.com under which InfoSpace.com will place on its affiliate network sites and, on an exclusive basis, on its own Web site, for a period of two years, advertisements, promotions, links, banners, logos and integrated access to our PC2Phone service and, upon release, our new unified messaging service. Priceline.com In November 1999, we entered into a memorandum of understanding and a co- marketing agreement with priceline.com, an Internet commerce service that allows users to name their own price to purchase goods and services over the Internet. Under the terms of our memorandum of understanding, we expect to offer our international and domestic Phone2Phone services as a premier provider through priceline.com, enabling priceline.com customers to name their own price to purchase blocks of minutes of our Phone2Phone services. It is expected that our Phone2Phone services will be offered for sale through priceline.com in the following manner: . domestic time blocks, where customers can name their own price for blocks of domestic long distance Phone2Phone minutes; . international time blocks, where customers can name their own price for blocks of international long distance Phone2Phone minutes to a specified country; . priceline.com's "Call Anywhere" program, where customers can name their own price for blocks of Phone2Phone minutes that can be used to call multiple designated locations; the actual amount of time purchased will vary per location. We also expect to work with priceline.com to develop an offer-by-phone service which will enable consumers to make offers to purchase Phone2Phone services from us on a per-call basis. Under the terms of the co-marketing agreement, we will participate in a co-marketing program with priceline.com through December 31, 1999. Yahoo! and Excite In 1998, we signed an agreement with Yahoo!, which was recently renewed through 2000. Our Web-based Internet telephony service is integrated into the Yahoo! People Search online telephone directory. As a result of this integration, an Internet user who performs a search on Yahoo! People Search can, after installing our software, simply click on a displayed telephone number to initiate a call to that number. Under this agreement, we also have the right to have our banner advertising appear when an Internet user performs a word- or category-search for "Internet Telephony" or related phrases on Yahoo! Additionally, our PC2Phone service is integrated into the Yahoo! Yellow Pages online directory. Our Web-based Internet telephony software is also integrated into Excite's Web sites in its International Network, which includes the United Kingdom, Germany, France, Japan, Italy, Australia, Sweden and the Netherlands. As a result, an Internet user in any of these countries will be able to click on any telephone number that appears on any page on these sites to initiate a call to that number using our PC2Phone service. In addition, our services will be prominently featured within the Excite International Network via advertising and promotion on various channels, including each member's homepage, business, technology/computer and travel channels, as well as the localized versions of My Excite, What's New/What's Cool and Mail Excite. We are negotiating with Excite to have our services integrated into Excite's United States Web sites as well. Other Strategic Relationships We also have entered into other important strategic relationships with other leading Internet and computer hardware and software companies, including: . Compaq. Our software is featured as a download from a special Compaq Web site accessible directly from the Compaq-branded keyboard, may be pre- installed on Compaq-branded computers distributed internationally and may be included with their other products. . Snap.com. Promotions for our services and a link to our Web site will be prominently displayed on the Snap.com Web site, and we are their preferred provider of PC-to-phone services. . ZDNet. We are the preferred provider of Internet telephony services for ZDNet and our Web-based Internet telephony service will be integrated throughout the ZDNet Web site. . WebHosting.com, 9Net Avenue, and Advanced Internet Technologies. Web hosting companies webhosting.com, 9Net Avenue, and Advanced Internet Technologies will resell our Click2Talk and Click2CallMe services to their clients. . AT&T. We have entered into an agreement with AT&T to be the exclusive provider of PC-to-phone service on the AT&T WorldNet Beta Site for a period of 90 days through January 15, 2000. Under the terms of the agreement, we will also provide 200 minutes of free calling time for calls that terminate in the United States to one AT&T WorldNet Beta Site member per household who has not previously used our PC-to-phone service. . Sprint. Sprint is testing our Internet telephony technology and international network for international consumer long distance calls to Asia through a service called Sprint Callternatives. As part of this test, we provide dedicated customer service, 24 hours a day, seven days a week to assist customer inquiries in multiple languages, including Mandarin, Cantonese and Korean. In addition, our advanced billing technology allows users of this service to view their telephone accounts in real time from our Web site. Products and Services Our services enable our customers to make low-cost, high-quality phone calls over the Internet using their personal computers or traditional telephones. Our principal current product and service offerings are described in the table below. Sales, Marketing and Distribution We distribute our software through the Internet, strategic partnerships and international resellers. In addition, our software will be embedded into future versions of Netscape's browser, which, according to International Data Corporation, was used by 41.5% of all consumer Internet users in mid-1998. Additionally, our software will be distributed into future versions of ICQ's Instant Messenger software. Customers can also download our software at no charge from our Web site and through links on other Web sites, including Yahoo!'s People Search and Lands' End's home page. We also distribute our software through strategic relationships with leading Internet and computer hardware and software companies, including IBM, Compaq and Packard Bell-NEC Europe. Our software is included with our partners' products and services and distributed domestically and internationally. We expect to distribute over 20 million units of our software in 1999 as a result of these and other distribution arrangements. We have also entered into agreements with three Web hosting companies, WebHosting.com, 9Net Avenue and Advanced Internet Technologies, under which they will resell our Click2Talk and Click2CallMe services to their customers. We promote our services through online and Internet-based advertising venues and traditional print advertising in domestic and international publications. We will also be advertising our services on the NBC television network. Another way we sell our services internationally is by entering into exclusive agreements with resellers in other countries. We sell these resellers bulk amounts of minutes of use of our products and services to be resold in the resellers' respective countries. For example, in Asia, we have agreements with Daewoo and Naray Mobile Telecom in South Korea and Marubeni in Japan. In Europe and the Middle East, we have agreements with CAPCOM in Spain and Dot.LB in Lebanon, among others. To facilitate distribution and attract users in foreign countries, we have developed our software in ten languages (English, Spanish, Japanese, French, Dutch, Portuguese, Italian, German, Swedish and Chinese) and intend to increase the number of languages as our distribution broadens. Customer Service As part of our goal to attract and retain customers, we offer free live customer support in multiple languages. We employ approximately 101 customer service representatives, who offer customer support to our users 24 hours a day, seven days a week. These services can be reached from anywhere in the world at no cost using either our toll-free number, where available, or our Web-based Internet telephony services. The customer support staff provides technical assistance, as well as general service assistance, for all of our products and services. We also offer customer support via e-mail and fax. Our integrated customer billing software and call management system provide our customer support staff with immediate access to user accounts, calling patterns and billing history, thereby enhancing the quality of service provided to our customers. In addition, our international resellers typically provide their own front-line customer support. Technology PC2Phone Software Our PC2Phone software is simple to install and to use and has won various industry awards. The installation process is wrapped in the industry-standard "Install Shield" product. During installation, the Net2Phone "wizard" verifies that the user's microphone and speakers are properly set for Internet telephony. The installation also has a service registration process that allows the customer to quickly register for paid time with the product. Our software has several buttons and drop down headings to enable customization. These buttons allow the user to change specific properties, access and modify customer account information, program and use speed dialing and verify rates. Our PC2Phone software has gone through fourteen releases, each improving upon our Internet telephony capabilities. The software is a Windows-compliant, 32-bit application written in a high-level PC language. The code is extendible allowing us to easily add new functionality, yet is relatively compact. The newest version of our software can record and play sound files allowing us to deliver voice-mail services and can interface with third party PC mail software applications such as Eudora and Microsoft Outlook. We expect this to be released in beta form by November 30, 1999 and commercially by December 31, 1999. We also have developed a software development kit allowing other companies to quickly and easily integrate their products with our PC2Phone software. For example, our services have been successfully integrated with Quicknet's line of sound cards and telephone interface cards. This integration enables Internet telephony service to be deployed through inexpensive equipment currently used throughout the world. Call Management System To maintain our leadership position in the Internet telephony market, we believe that reliable and flexible billing, information management, monitoring and control systems are critical. Accordingly, we have invested substantial resources to develop and implement our sophisticated real-time call management information system. Key elements of this system include: . Customer Provisioning. The system provides automated online customer registration and customer registration through call centers and resellers. It also provides online credit card authorization and batch billing capabilities that streamline customer registration. A special remote access application program allows other people access to our database, enabling sophisticated partners to remotely service customers through our system, and to tie our system directly to their own business systems. This remote capability includes remote account management and continuous real-time call detail and billing information. Additionally, the system makes customer account records readily available to call center representatives in the event of customer billing problems. . Customer Access. Our system allows customers to independently access their billing records online without the need to contact customer service representatives. . Fraud Control. Fraud detection and prevention features include caller authentication, prevention of multiple simultaneous calls using the same account, pin code verification and call duration timers. We also generate reports on suspicious calling patterns to detect caller registration fraud. We routinely scan for fraudulent content before credit card purchases are allowed. . Network Security. Firewalls are employed to prevent attacks on our network. We use sophisticated techniques to safeguard sensitive database information. In addition, we encrypt call requests and portions of the call to prevent "network sniffers" from unauthorized access to data. . Call Routing. The network management system identifies and routes calls to the most efficiently priced carrier. The system also automatically routes calls around links or servers that are experiencing problems, have failed or have been manually taken out of service for maintenance or upgrades. This system provides remote administration facilities for maintaining routing tables and system monitoring. . Monitoring. The management system provides for real-time monitoring of all call information. We are able to track potential problems such as too many short calls on a server or a low percentage of call completions. The system also provides remote management that allows partners to monitor and manage their own accounts. . Reliability. We maintain two separate network operations centers in Hackensack and Lakewood, New Jersey. These facilities house redundant equipment and have the ability to track calls simultaneously. This redundant system gives our network a high degree of reliability, enabling each network operations center to serve as a back-up to the other. . Detailed Call Records. The management software maintains detailed records for each call, including the account number of the caller, the caller's phone number, access number used, the point at which the call enters and exits our network, the account owner, the calling party, the server/service phone number, the number of the called party, a running account balance, and rate and billing information, including surcharges. The Net2Phone Network Through an agreement with IDT, we lease capacity on an Internet network comprised of leased high-speed fiber optic lines connecting eight major cities across the United States, and lease high-speed fiber optic lines connecting smaller cities to the network. We have a right to use network capacity leased by IDT. The network backbone uses state-of-the-art hardware including Cisco Series 7000 routers and Nortel Passport switches. Our high-speed backbone connects traffic at four major public Internet exchange points and is also facilitated by a growing number of private peering or exchange points with other networks. Through peering arrangements, we exchange Internet traffic with 25 other Internet backbone providers at these points. We operate IDT's network, one of the largest Internet access networks, providing local dial-up access through 36 locations. Our Internet network also includes more than 700 additional network access locations owned by local and regional Internet service providers. In addition, we entered into an agreement with AT&T Global Network Services, under which AT&T will provide us with managed IP networking services and collocation services, enabling us to extend the international reach of our Internet telephony services over AT&T's global network to 17 countries, with a dozen other countries under consideration for future expansion. AT&T will also provide collocation services for our servers at AT&T's Local Interface Gateway locations (or points of presence) in those countries. We are able to provide service in areas where we do not have dial-up equipment by utilizing call-forwarding technology to expand our coverage areas by increasing the total number of local access numbers. We have been closing down multiple network access points in a number of states in order to consolidate our equipment into central "Super Point of Presence" locations. For example, one Super Point of Presence in New Jersey can supply local access for the entire state of New Jersey. We seek to retain flexibility by utilizing dynamic call routing alternatives. This approach is intended to enable us to take advantage of the rapidly evolving Internet market in order to provide low-cost service to our customers. Accordingly, our network employs an "Open Shortest Path First" protocol that promotes efficient routing of traffic. Additionally, we have placed redundant hardware for reliability in high traffic areas to minimize loss of data packets. Each network data exchange point employs hardware to direct network traffic and a minimum of two dedicated leased data lines to increase reliability. We manage our network hardware remotely. It is compatible with a variety of local network systems around the world. We believe our Internet telephony network can currently support approximately 5,000 simultaneous calls. We believe our systems are scalable to 10 times their current capacity through the purchase and installation of certain additional hardware. To date, the highest number of simultaneous calls serviced by our network was 1,975 simultaneous calls made on September 15, 1999. The Network Operations Center Our Network Operations Center, located in Hackensack, New Jersey, currently employs a staff of 34 people. There are two groups that work within the network operations center, the network analysis group and the Internet telephony monitoring group. Both groups have 24 hours a day, seven days a week coverage to quickly respond to any issues. The network analysis group works around-the-clock monitoring network issues, handling customer requests, repairing outages and solving security problems. Our monitoring group oversees a nationwide real-time network analysis map, which notifies our staff of network errors. They also use software we developed to monitor our hardware around the world. This group can dynamically turn on or turn off equipment and re-route Internet telephony traffic, as necessary. Customers We have a diverse, global customer base. As of July 31, 1999, approximately 69% of our customers were based outside of the United States. As of July 31, 1999, we served over 325,000 active customers who had used our services during the preceding three months. In addition, as of October 10, 1999, we had installed the Click2Talk service on approximately 176 commercial Web sites. Competition Long Distance Market The long distance telephony market and, in particular, the Internet telephony market, is highly competitive. There are several large and numerous small competitors, and we expect to face continuing competition based on price and service offerings from existing competitors and new market entrants in the future. The principal competitive factors in the market include price, quality of service, breadth of geographic presence, customer service, reliability, network capacity and the availability of enhanced communications services. Our competitors include AT&T, MCI WorldCom and Sprint in the United States and foreign telecommunications carriers. Many of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we have. As a result, certain of these competitors may be able to adopt more aggressive pricing policies, which could hinder our ability to market our Internet telephony services. One of our key competitive advantages is the ability to route calls through Internet service providers, which allows us to bypass the international settlement process and realize substantial savings compared to traditional telephone service. Any change in the regulation of an Internet service provider could force us to increase prices and offer rates that are comparable to traditional telephone call providers. Web-Based Internet Telephony Services As consumers and telecommunications companies have grown to understand the benefits that may be obtained from transmitting voice over the Internet, a substantial number of companies have emerged to provide voice over the Internet. In addition, companies currently in related markets have begun to provide voice over the Internet services or adapt their products to enable voice over the Internet services. These related companies may potentially migrate into the Internet telephony market as direct competitors. . Internet Telephony Service Providers. During the past several years, a number of companies have introduced services that make Internet telephony services available to businesses and consumers. In addition to us, AT&T Jens (a Japanese affiliate of AT&T), deltathree.com (a subsidiary of RSL Communications), I-Link, iBasis (formerly known as VIP Calling), ICG Communications, IPVoice.com, ITXC and OzEmail (which was acquired by MCI WorldCom) provide a range of voice over the Internet services. These companies offer PC-to-phone or phone-to-phone services that are similar to the services we offer. Some, such as AT&T Jens and OzEmail, offer these services within limited geographic areas. Additionally, a number of companies have recently introduced Web-based voice-mail services and voice-chat services to Internet users. . Software/Hardware Providers. Many companies produce software and other computer equipment that may be installed on a user's computer to permit voice communications over the Internet. These products generally require each user to have compatible software and hardware equipment and rely on the public Internet for the transmission of traffic, which often results in reduced quality of communications. Representative companies include VocalTec, Netspeak and e-Net. We believe VocalTec's software and hardware are unable to handle large numbers of simultaneous calls. Netspeak focuses on delivering solutions targeted at traditional call centers that require significant customization. . Telecommunications Companies. A number of telecommunications companies, including AT&T, Deutsche Telekom, MCI WorldCom and Qwest, currently maintain, or plan to maintain, packet-switched networks to route the voice traffic of other telecommunications companies. These companies, which tend to be large entities with substantial resources, generally have large budgets available for research and development and therefore may enhance the quality and acceptance of the transmission of voice over the Internet. However, many of these companies are new to the Internet telephony market, and therefore may not build brand recognition among consumers for these services. These companies also may not have the range of product and service offerings that are necessary to independently provide a broad set of voice-enabled Web services. AT&T, for example, has attempted to enter the market but has focused its effort on the cable market and it is unclear if it will continue to pursue voice over the Web. Qwest has taken steps to enter the market by building a high capacity network in the United States. In addition, Qwest has also entered into a three-year strategic alliance with Netscape to provide one-stop access to Internet services including long distance calling, e-mail, voice mail, faxes, Internet access and conference calls. . Network Hardware Manufacturers. Several of the world's major providers of telecommunications equipment, such as Alcatel, Cisco, Lucent, Northern Telecom and Dialogic (which was acquired by Intel) have developed or plan to develop network equipment that may be used in connection with the provision of voice over the Web services, including routers, servers and related hardware and software. By developing this equipment, these manufacturers may exert substantial influence over the technology that is used in connection with transmission of voice over the Web and may develop products that facilitate the quality and timely roll-out of these networks. However, these companies are dependent upon the operators of Internet telephony networks to purchase and install their equipment into their networks. They are also dependent upon the developers of hardware and software to market their systems to end users. Cisco currently manufactures Internet telephony equipment for low to medium scale networking, but does not manufacture high-end Internet telephony equipment for large networks. However, Cisco recently acquired two companies that produce devices to help Internet service providers transition voice and data traffic to packet networks while maintaining traditional phone usage and network equipment. Lucent has recently co- developed with VocalTec a set of industry standards that have been adopted by major competitors and is currently marketing Internet telephony hardware, including servers that allow the transmission of calls and faxes over the Internet. Lucent also offers related support products, such as billing centers and "Internet call centers," which allow Internet access and conversation with a customer support agent on a single line. . Voice-Enabled Online Commerce Providers. Several providers have begun to apply Internet telephony technologies in connection with e-commerce transactions. These providers compete with services of ours such as Click2Talk by integrating voice communications into commercial Web sites. These competitors include USA Global Link, which introduced its Instant Call service in 1998, a system that permits voice communications between a customer on the Web and customer service representatives. In addition, AT&T's Inter@active Communications is a group of services that integrates voice into the Web, including AT&T Chat'N Talk, a voice- enabled chat service, and Click2Dial Conferencing Services, which initiates and manages conference calls. These services may emerge as significant competitors to our current and planned offerings. Research and Development Strategic Research and Development At our primary research and development center in Lakewood, New Jersey, we currently employ 17 engineers, whose specialties include software, hardware, switching, Internet security, voice compression, engineering real-time online transactions, billing, and network and call management. This staff is devoted to the improvement and enhancement of our existing product and service offerings, as well as to the development of new products and services. Current research and development activities include the following: . development of unified messaging services, PC2PC and Phone2PC products and voice-enabled chat; . enhancements to our customer billing software and call management system to increase the capacity of these systems; . improvements to our Internet telephony hardware to increase capacity; and . modifications to our PC2Phone software to increase functionality. Our future success will depend, in part, on our ability to improve existing technology and develop new products and services that incorporate leading technology. We incurred $473,000, $481,000 and $757,000 in product development expenses during fiscal 1997, fiscal 1998 and fiscal 1999, respectively. Management Information Systems Research and Development Our management information systems development team, located in Hackensack, New Jersey, has eleven programmers and a development manager dedicated to traditional management information systems development and upgrades. The group supports back-office accounting and reporting software, customer service support software and database support. The development schedule is primarily focused on a detailed list of upgrades that have been identified and prioritized by a team manager. The database architecture is managed by a senior developer in our Lakewood laboratory who was responsible for similar database functions at AT&T's WorldNet division. Web Research and Development The majority of our Web research and development is done by a separate Web development group located in our headquarters in Hackensack. The group of nine consists of five developers, two programmers, one graphics designer and one development manager. The team is responsible for our multiple language Web site, the EZSurf.com Web site and specialized Web interfaces, including the integration of our PC2Phone client software into Netscape's Internet browser. Regulation Regulation of Internet Telephony The use of the Internet to provide telephone service is a recent market development. Currently, the Federal Communications Commission is considering whether to impose surcharges or additional regulations upon certain providers of Internet telephony. On April 10, 1998, the FCC issued its report to Congress concerning the implementation of the universal service provisions of the Telecommunications Act. In the report, the FCC indicated that it would examine the question of whether certain forms of phone-to-phone Internet telephony are information services or telecommunications services. The FCC noted that it did not have, as of the date of the report, an adequate record on which to make a definitive pronouncement, but that the record suggested that certain forms of phone-to-phone Internet telephony appear to have the same functionality as non-Internet telecommunications services and lack the characteristics that would render them information services. If the FCC were to determine that certain services are subject to FCC regulation as telecommunications services, the FCC may require providers of Internet telephony services to make universal service contributions, pay access charges or be subject to traditional common carrier regulation. It is also possible that PC-to-phone and phone-to-phone services may be regulated by the FCC differently. In addition, the FCC sets the access charges on traditional telephony traffic and if it reduces these access charges, the cost of traditional long distance telephone calls will probably be lowered, thereby decreasing our competitive pricing advantage. Changes in the legal and regulatory environment relating to the Internet connectivity market, including regulatory changes which affect telecommunications costs or that may increase the likelihood of competition from the regional Bell operating companies or other telecommunications companies, could increase our costs of providing service. For example, the FCC recently has determined that subscriber calls to Internet service providers should be classified for jurisdictional purposes as interstate calls. This determination could affect a telephone carrier's costs for provision of service to these providers by eliminating the payment of reciprocal compensation to carriers terminating calls to these providers. The FCC has pending a proceeding to encourage the development of cost-based compensation mechanisms for the termination of calls to Internet service providers. Meanwhile, state agencies will determine whether carriers receive reciprocal compensation for these calls. If new compensation mechanisms increase the costs to carriers of terminating calls to Internet service providers or if states eliminate reciprocal compensation payments, the affected carriers could increase the price of service to Internet service providers to compensate, which could raise the cost of Internet access to consumers. In addition, although the FCC to date has determined that providers of Internet services should not be required to pay interstate access charges, this decision may be reconsidered in the future. This decision could occur if the FCC determines that the services provided are basic interstate telecommunications services and no longer subject to the exemption from access charges that are currently enjoyed by providers of enhanced services. Access charges are assessed by local telephone companies to long-distance companies for the use of the local telephone network to originate and terminate long-distance calls, generally on a per minute basis. The FCC has stated publicly that it would be inclined to hold the provision of phone-to-phone Internet protocol telephony to be a basic telecommunications service and therefore subject to access charges and universal service contribution requirements. In a Notice of Inquiry released September 29, 1999, the FCC again asked for comment on the regulatory status of Internet telephony. Specifically, the FCC asks commenters to address whether Internet telephony service generally, and phone-to-phone service in particular, may be regulated as a basic telecommunications service. If the Commission concludes that any or all Internet telephony should be regulated as basic communications service, it eventually could require that Internet telephony providers must contribute to universal service funds and pay access charges to local telephone companies. The imposition of access charges or universal service contributions would substantially increase our costs of serving dial-up customers. To our knowledge, there are currently no domestic and few foreign laws or regulations that prohibit voice communications over the Internet. State public utility commissions may retain jurisdiction to regulate the provision of intrastate Internet telephony services. A number of countries that currently prohibit competition in the provision of voice telephony have also prohibited Internet telephony. Other countries permit but regulate Internet telephony. If Congress, the FCC, state regulatory agencies or foreign governments begin to regulate Internet telephony, such regulation may materially adversely affect our business, financial condition or results of operations. In addition, access to our services may also be limited in foreign countries where laws and regulations otherwise do not prohibit voice communication over the Internet. For example, access to our PC2Phone service was recently blocked in certain countries in Asia and the Middle East by government- controlled telecommunications companies. These actions prevented our customers originating PC2Phone calls in these countries. We have experienced similar actions in the past in other countries. In each case, we were able to negotiate agreements to continue to provide our services in these countries. We intend to do the same in these countries as well, but no assurances can be given that we will be successful in these negotiations. We have resumed service to our customers in these countries by providing alternative means of access to our service, which may also be blocked by the government-controlled telecommunications companies. Furthermore, one of our competitors, iBasis, has recently disclosed that it has received a letter from the Israel Minister of Communications requesting that it cease and desist terminating international calls over the Internet in Israel. Regulation of the Internet Congress has recently adopted legislation that regulates certain aspects of the Internet, including online content, user privacy, taxation, access charges, liability for third-party activities and jurisdiction. In addition, a number of initiatives pending in Congress and state legislatures would prohibit or restrict advertising or sale of certain products and services on the Internet, which may have the effect of raising the cost of doing business on the Internet generally. The European Union has also enacted several directives relating to the Internet, one of which addresses online commerce. In addition, federal, state, local and foreign governmental organizations are considering other legislative and regulatory proposals that would regulate the Internet. Increased regulation of the Internet may decrease its growth, which may negatively impact the cost of doing business via the Internet or otherwise materially adversely affect our business, results of operations and financial condition. The Federal Trade Commission has proposed regulations regarding the collection and use of personal identifying information obtained from individuals when accessing Web sites, with particular emphasis on access by minors. These regulations may include requirements that companies establish certain procedures to disclose and notify users of privacy and security policies, obtain consent from users for certain collection and use of information and to provide users with the ability to access, correct and delete personal information stored by the company. These regulations may also include enforcement and redress provisions. There can be no assurance that we will adopt policies that conform with any regulations adopted by the FTC. Moreover, even in the absence of those regulations, the FTC has begun investigations into the privacy practices of companies that collect information on the Internet. One investigation resulted in a consent decree pursuant to which an Internet company agreed to establish programs to implement the principles noted above. We may become subject to a similar investigation, or the FTC's regulatory and enforcement efforts may adversely affect the ability to collect demographic and personal information from users, which could have an adverse effect on our ability to provide highly targeted opportunities for advertisers and electronic commerce marketers. Any of these developments would materially adversely affect our business, results of operations and financial condition. The European Union has adopted a directive that imposes restrictions on the collection and use of personal data. Under the directive, citizens of the European Union are guaranteed rights to access their data, rights to know where the data originated, rights to have inaccurate data rectified, rights to recourse in the event of unlawful processing and rights to withhold permission to use their data for direct marketing. The directive could, among other things, affect United States companies that collect information over the Internet from individuals in European Union member countries, and may impose restrictions that are more stringent than current Internet privacy standards in the United States. In particular, companies with offices located in European Union countries will not be allowed to send personal information to countries that do not maintain adequate standards of privacy. The directive does not, however, define what standards of privacy are adequate. As a result, the directive may adversely affect the activities of entities such as us that engage in data collection from users in European Union member countries. Intellectual Property Our performance and ability to compete are dependent to a significant degree on our proprietary and licensed technology. We rely on a combination of patent, copyright, trademark and trade secret laws and contractual restrictions to establish and protect our technology. All key employees have signed confidentiality agreements and we intend to require each newly hired employee to execute a confidentiality agreement. These agreements provide that confidential information developed by or with an employee or consultant, or disclosed to such person during his or her relationship with us, may not be disclosed to any third party except in certain specified circumstances. These agreements also require our employees to assign their rights to any inventions to us. The steps taken by us may not, however, be adequate to prevent the misappropriation of our proprietary rights or technology. In addition, our competitors may independently develop technologies that are substantially equivalent or superior to our technology. We do not currently have any issued patents or registered copyrights. We own the registered service mark for three of the marks used in our business and have applications pending to register 29 other service marks used in our business. There can be no assurance that we will be able to secure significant protection for all our service marks. Competitors of ours or others could adopt product or service marks similar to our marks, or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customer confusion. We have not taken steps to file applications in foreign countries to obtain protection of our trademarks, except for our recent filing of a Community Trademark application for registration of the "Net2Phone" mark, which covers certain European countries, and an application for the "Net2Phone" mark in Australia, Ecuador and Venezuela. To the extent trademark rights are acquired through registration in countries outside the United States, we may not be able to protect our marks or assure that we are not infringing other parties' marks in those countries. Moreover, although we have taken some steps to commence the registration of "net2phone" as a domain name with the various international registries, we cannot assure you that this will be accomplished. We have been assigned the rights to patent applications claiming a number of the technologies underlying our products and services. Our two United States utility patent applications have been rejected, but we are continuing to pursue patent protection for the claimed subject material. There can be no assurance that the applications will result in the issuance of patents or that, if issued, such patents would adequately protect us against competitive technology or that they would be held valid and enforceable against a challenge. In addition, it is possible that our competitors may be able to design around any such patents. Also, our competitors may obtain patents that we would need to license or circumvent in order to make, use, sell or offer for sale the technology. We have received correspondence from a company, NetPhone Inc., claiming that our use of the mark "Net2Phone" in connection with Internet telephony services infringes that company's "NetPhone" registered trademark and requesting that we cease and desist from using the "Net2Phone" mark. We responded by denying any infringement. No legal proceedings have been commenced against us with respect to this matter. This entity currently operates a Web site at www.netphone.com. There can be no assurance that the existence of this entity's claim, its business and Web site will not materially adversely affect our business. AT&T, who may have rights in the terms "Click2Dial," Click2Whisper" and "Click2Interact," has filed with the United States Patent and Trademark Office a request to extend its time limit for opposing the registration of our "Click2Talk" mark. AT&T could oppose registration of our "Click2Talk" mark or take other action aimed at restricting us from using this mark. We have negotiated an agreement with AT&T by which AT&T will agree not to file the opposition if we consent to the registration of one of AT&T's marks. There can be no assurance that any agreement, or the exact terms thereof, will be signed until one is in place. We are also aware of several other parties that use marks that are the same or similar to marks that we use, though in some instances, to the best of our knowledge, these parties are not in the same business as we are. There can be no assurance that the companies that notified us or other companies with marks similar to our marks will not bring suit to prevent us from using the "Net2Phone" mark or other marks. Defending or losing any litigation relating to intellectual property rights could materially adversely affect our business, results of operations and financial condition. In addition, a company known as ITM, Inc. operates a Web site at www.net2phone.net without our permission or authorization, and in violation of the agency agreement ITM entered into with us for the distribution of the Net2Phone software with certain ITM software. ITM had also taken steps to secure registration and ownership of the "Net2Phone" mark in France. We have reached an agreement with ITM by which ITM agreed to assign the French trademark application that it filed to us, as well as execute and deliver to us a Registrant Name Change Agreement to transfer the domain name net2phone.net to us. This document has been submitted to Network Solutions Inc. and we expect that Network Solutions will soon process the transfer. Because the French trademark application has been assigned to us, we have withdrawn the trademark opposition proceeding that we commenced against ITM. We are taking steps to secure our rights in Ecuador and in Venezuela against two parties that are attempting to register the "Net2Phone" mark or a confusingly similar mark in these countries. We believe that we do not infringe upon the patent rights of any third party. The only third party that has asserted a patent infringement claim against us is TechSearch for what it alleges is a patent directed to Web sites. TechSearch has asked for a one time licensing fee. Our initial investigation has led us to believe that we do not infringe and /or the patent is invalid. If we do not accept the offer for a license and we are sued, we may incur substantial legal fees in defending the suit and may be enjoined from using our Web site if it is found to be infringing. If we do agree to the licensing fee, it may detract from our ability to support other projects. It is possible, however, that other patent infringement claims might be asserted successfully against us in the future. Our ability to make, use, sell or offer for sale our products and services depends on our freedom to operate. That is, we must ensure that we do not infringe upon the patents of others or have licensed all such rights. We have not requested or obtained an opinion from our outside counsel as to whether our products and services infringe upon the patent rights of any third parties. We are aware that patents have recently been granted to others based on fundamental technologies in the Internet telephony area. In addition, we are aware of at least one other patent application involving potentially similar technologies to our own which if issued could materially adversely affect our business. Because patent applications in the Unites States are not publicly disclosed until issued, other applications may have been filed which, if issued as patents, could relate to our services and products. However, foreign patent applications do publish before issuance. We are aware of several such publications that relate to Internet telephony. One such published application claims as an inventor a previous consultant to IDT and has been assigned to another company. Issuance of a patent or patents from this application could materially adversely affect our ability to operate. A party making an infringement claim could secure a substantial monetary award or obtain injunctive relief which could effectively block our ability to provide services or products in the United States or abroad. If any of these risks materialize, we could be forced to suspend operations, to pay significant amounts to defend our rights, and a substantial amount of the attention of our management may be diverted from our ongoing business, each of which could materially adversely affect our ability to operate. We rely on a variety of technology, primarily software, that we license from third parties. Most of this technology was purchased or licensed on our behalf by IDT. Continued use of this technology by us may require that we purchase new or additional licenses from third parties or obtain consents from third parties to assign the applicable licenses from IDT. There can be no assurances that we can obtain those third party licenses needed for our business or that the third party technology licenses that we do have will continue to be available to us on commercially reasonable terms or at all. The loss or inability to maintain or obtain upgrades to any of these technology licenses could result in delays or breakdowns in our ability to continue developing and providing our products and services or to enhance and upgrade our products and services. Employees As of October 1, 1999, we had approximately 333 full-time employees, including approximately 146 in technical support and customer service, 84 in sales and marketing, 24 in management and finance, 30 in operations, and 49 in research and development. Our employees are not represented by any union, and we consider our employee relations to be good. We have never experienced a work stoppage. Revenues and Assets by Geographic Area For the year ended July 31, 1999, 62% of our revenue was derived from international customers and 38% from customers in the United States. All our long-lived assets are located in the United States. We face certain risks inherent in doing business on an international basis, including: . changing regulatory requirements, which vary widely from country to country; . action by foreign governments or foreign telecommunications companies to limit access to our services; . increased bad debt and subscription fraud; . legal uncertainty regarding liability, tariffs and other trade barriers; . political instability; and . potentially adverse tax consequences. ITEM 2. ITEM 2. PROPERTIES Our primary facilities consist of approximately 15,445 square feet, which comprise our headquarters, executive offices and customer service and technical support centers, and are located in two buildings in Hackensack, New Jersey leased from corporations that are owned and controlled by Howard S. Jonas. Mr. Jonas is one of our directors, a director of IDT and the controlling stockholder of IDT. These leases expire at the end of February 2002 and require us to make annual rental payments of $186,144. We also sublease space for some of our computer equipment in Piscataway, New Jersey from IDT, which leases this space from a company also owned and controlled by Mr. Jonas. This lease runs for a three-year term, beginning in May 1999, with monthly rent of $8,400. In addition, we lease office space in Lakewood, New Jersey for our research and development center. Pursuant to this lease, which expires at the end of August 2001, we are required to make annual rental payments of $48,125. ITEM 3. ITEM 3. LEGAL PROCEEDINGS We are not currently a party to any material legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year ended July 31, 1999, the following items were submitted for the approval of our security holders: . On June 25, 1999, our security holders, by written consent, adopted an amendment to our certificate of incorporation that increased our authorized capital stock to 200,000,000 shares of common stock, 37,042,089 shares of Class A stock and 10,000,000 shares of preferred stock and effected a three-for-one stock split for our common and Class A stock. Our security holders also voted to increase the number of shares of common stock available under our 1999 Stock Option and Incentive Plan by 6,000,000. These resolutions were voted in favor of by a majority of our security holders. . On July 13, 1999, a majority of our security holders voted by written consent to adopt an amendment to Article Fourth Section (e)(11) of our certificate of incorporation, clarifying the automatic conversion provision of our Series A convertible preferred stock. PART II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market Information Our common stock has traded on the Nasdaq National Market under the symbol NTOP since July 29, 1999. The following table sets forth the per share range of high and low closing sales prices of our common stock for the periods indicated: On November 2, 1999, the last reported sale price for our common stock on the Nasdaq National Market was $51.50 per share. The market price for our stock is highly volatile and fluctuates in response to a wide variety of factors. If our stock price remains volatile, we may become subject to securities litigation, which is expensive and could divert our resources. Holders As of November 2, 1999, we had approximately 79 holders of record of our common stock. This does not reflect persons or entities who hold their stock in nominee or "street" name through various brokerage firms. Dividend Policy We have not paid any dividends in the past and do not intend to pay cash dividends on our capital stock for the foreseeable future. Instead, we intend to retain all earnings for use in the operation and expansion of our business. Recent Sales of Unregistered Securities In October 1997, in connection with our initial organization, IDT Corporation purchased 27,864,000 shares of our common stock for nominal consideration. This transaction was exempt from registration under Section 4(2) of the Securities Act, as amended. In January 1998, pursuant to the terms of his employment agreement with IDT Corporation, Mr. Clifford M. Sobel purchased 3,096,000 shares of our common stock for $100,000. This transaction was exempt from registration under Section 4(2) of the Securities Act of 1933. In May 1999, we issued and sold an aggregate of 3,140,000 shares of Series A convertible preferred stock at $10.00 per share, which were converted into 9,420,000 shares of our common stock in August 1999 at the closing of our initial public offering. In connection with this transaction, we also issued warrants to purchase up to 180,000 shares of our class A stock (of which 44,248 were exercised prior to the closing of our initial public offering with the remaining warrants having terminated at the closing of our initial public offering) to several investors for an aggregate of $31,400,000, pursuant to Series A Subscription Agreements, dated as of May 13, 1999. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. We also issued a warrant to purchase up to 92,400 shares of our common stock to the placement agent as partial consideration for its services. This warrant was exercised in its entirety prior to the closing of our initial public offering. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. In May 1999, we issued options to purchase 5,040,000 shares pursuant to our 1999 Stock Option and Incentive Plan, and issued 1,420,218 shares of common stock upon exercise of some of these options. In July 1999, we issued options to purchase an additional sum of 920,000 shares under the Plan to our President. In July 1999, we issued options to purchase an additional 2,851,500 shares under the plan, and issued 50,000 shares of common stock upon exercise of some of these options. Since July 1999, we have granted options to purchase an aggregate of 183,250 shares of our common stock. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. In July 1999, in connection with our distribution and marketing agreement with ICQ, we issued a warrant to America Online, enabling it to acquire shares of common stock representing up to 3% of our outstanding capital on a fully- diluted basis. This transaction was exempt from registration under Section 4(2) of the Securities Act of 1933. Use of Proceeds On July 29, 1999, we offered 6,210,000 shares of our common stock in an initial public offering. These shares were registered with the Securities and Exchange Commission on a registration statement on Form S-1 (file number 333-78713), which became effective on July 29, 1999. We received net proceeds of approximately $85.3 million from the sale of the 6,210,000 shares at the initial public offering price of $15.00 per share after deducting underwriting commissions and discounts and expenses of approximately $1.5 million. The managing underwriters for our initial public offering were Hambrecht & Quist LLC, BT Alex. Brown Incorporated and Bear. Stearns & Co. Inc. $7.0 million of the net proceeds from our initial public offering was used to repay a portion of the $14.0 million note payable to IDT. $3.5 million was used to pay ICQ, a subsidiary of America Online, in connection with our distribution and marketing agreement. As of the date of this report, we have not made any other specific allocations with respect to the proceeds. We expect to use the balance of the net proceeds of our initial public offering for: . developing and maintaining strategic Internet relationships; . advertising and promotion; . research and development; . upgrading and expanding our network; and . general corporate purposes, including working capital. Pending any use, the net proceeds of our offering have been invested in short-term, interest-bearing securities. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with our financial statements and related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our financial statements and notes thereto. The historical financial information included in this report does not necessarily reflect what our financial condition and results of operations would have been had we been operated as an independent entity during the periods presented. Overview We began our operations in January 1996, launched our first Net2Phone product in August 1996, and were established as a separate subsidiary of IDT in October 1997. We have incurred net operating losses since inception and expect to incur additional losses for the foreseeable future, primarily as a result of increased sales and marketing efforts. As of July 31, 1999, we had an accumulated deficit of approximately $30.5 million. We recognized significant charges relating to non-cash executive compensation expense in the fourth quarter of 1999 and will recognize additional significant charges on an ongoing basis, in connection with the grants of options to purchase shares of our common stock in May and July 1999. With respect to these options, we recognized a charge of approximately $17.9 million in the fourth quarter of fiscal 1999, and will recognize charges of approximately $11.8 million during fiscal 2000, approximately $11.8 million during fiscal 2001 and approximately $8.3 million during fiscal 2002. In May 1999, we issued 3,140,000 shares of Series A convertible preferred stock which were converted into 9,420,000 shares of Class A stock at $3.33 per share at the time of our initial public offering. The Series A convertible preferred stock contains beneficial conversion features. The total value of the beneficial conversion features is approximately $75 million. For accounting purposes, the value of the beneficial conversion features was limited to the amount of proceeds allocated to the Series A convertible preferred stock. We recorded a reduction in net income available to common stockholders in the quarter ended July 31, 1999 of approximately $29.2 million. In connection with the issuance of the Series A convertible preferred stock, we issued warrants to purchase up to 272,400 shares of common stock at an exercise price of $3.33 per share. The fair value of warrants on the date of issuance was $2.1 million. These warrants were exercised to purchase an aggregate of 136,648 shares of common stock at the time of our initial public offering. The fair value of the warrants was recorded as an increase to additional paid in capital and a decrease to the carrying value of the Series A convertible preferred stock. The decrease in the carrying value of the Series A convertible preferred stock will be accreted, with a corresponding reduction of additional paid-in capital, over the period to the initial redemption date in May 2006. At the closing of our initial public offering in August 1999, the balance of the unamortized discount was recorded as a reduction of the amount of income available for common shareholders. In connection with our distribution and marketing agreement with ICQ, we issued a warrant to America Online to purchase up to 3% of our outstanding capital stock on a fully-diluted basis. This warrant will vest in 1% increments upon the achievement of each of three incremental thresholds of revenue generated under the agreement during the first four years that the warrant is outstanding. The per share exercise price under the warrant will be equal to the lesser of $12.00 per share or $450 million divided by the number of our fully- diluted shares on the initial exercise date. If one or more of the revenue thresholds set forth in the warrant are achieved, we will recognize additional non-cash charges in an amount equal to the value of the warrant, as determined at the time that these thresholds are met. We offered 6,210,000 shares of our common stock in an initial public offering, which became effective of July 29, 1999. On August 3, 1999 we received net proceeds of approximately $85.3 million from the sale of the 6,210,000 shares at the initial public offering price of $15.00 per share. The managing underwriters for this offering were Hambrecht & Quist LLC, BT Alex. Brown Incorporated and Bear. Stearns & Co. Inc. On November 4, 1999, we filed a registration statement with the Securities and Exchange Commission for the sale of 6,300,000 shares of common stock. Of the 6,000,000 shares to be sold in the offering, 3,400,000 shares are being sold by us. The remaining 2,600,000 shares are being sold by selling stockholders, including IDT, which will be selling 2,200,000 shares. The underwriters have also been granted an option for a period of 30 days to purchase up to 945,000 additional shares of common stock from other selling stockholders to cover over- allotments, if any. Sources of Revenue During fiscal 1999, approximately 59.3% of our revenue was derived from per-minute charges we billed to our customers on a prepaid basis to use our PC2Phone service, and approximately 31.0% of our revenue was derived from per-minute charges we billed to our customers and our international resellers on a prepaid basis to use our Phone2Phone service. The remainder of our revenue was derived from the sale of Internet telephony gateways, technology licensing and for services we provide to IDT and other carriers. In the future, in order to diversify and enhance our revenue sources, we plan to introduce a variety of value-added services and Internet commerce solutions. In addition, we plan to sell Web-based advertising to leverage our customer reach. To date, these additional products and services have provided no revenue and we do not anticipate material revenue from these additional products and services through at least December 1999. Approximately 90.3% of our revenue in fiscal 1999 was generated from per-minute charges we charge our customers on a prepaid basis to use our PC2Phone and Phone2Phone services. During fiscal 1999, approximately 62% of our revenue was derived from customers based outside of the United States. As of July 31, 1999, we served over 325,000 active customers who spent an average of approximately 60 minutes per month placing calls over the Internet. We recognize revenue as our customers utilize the balances in their prepaid accounts by placing calls. As such, we have deferred revenue for all unutilized balances in our customers' accounts. The remaining 9.7% of our revenue, which is derived from the sale of Internet telephony gateways, technology licensing and from services provided to IDT and other carriers, is recognized upon installation of the equipment and performance of the services. Cost Structure Our costs and expenses include: . direct cost of revenue, excluding depreciation; . selling and marketing; . general and administrative; and . depreciation. Direct Cost of Revenue Direct cost of revenue consists primarily of network costs associated with carrying our customers' traffic on our network and leased networks, and routing their calls through a local telephone company to reach their final destination. These costs exclude depreciation and include: . amounts paid to other carriers to terminate traffic on a per-minute basis; . the cost of leased routers and access servers; . telecommunications costs, including the cost of local telephone lines to carry subscriber calls to our network; . the costs associated with leased lines connecting our network directly to the Internet or to our operations centers and connecting our operations centers to the Internet; and . Internet backbone costs, which are the amounts we pay to Internet service providers for capacity. We expect our direct cost of revenue to increase in absolute terms over time to support our growing customer base. While some of these costs are fixed, other costs vary on a per minute basis. Therefore, there may be some volatility in our direct cost of revenue as a percentage of revenue, particularly as we expand our network. We try to terminate calls on our own network whenever possible. When we cannot terminate calls on our network, we terminate calls on the network of other suppliers, primarily IDT. We expect to continue to utilize this process. We also expect the percentage of our traffic that we terminate with IDT will decline in the future as we expand our own network. Selling and Marketing. Selling and marketing includes the expenses associated with acquiring customers, including commissions paid to our sales personnel, advertising costs, referral fees and amounts paid to our strategic partners in connection with revenue-sharing arrangements. We expect selling and marketing expenses to increase over time as we aggressively market our products and services. Historically, selling and marketing expenses have been a relatively variable cost and are expected to increase both in terms of absolute dollars and as a percentage of revenue as our revenue grows. We expect to spend significant capital to build brand recognition. Most of our sales and marketing expenses will go toward securing significant and strategic relationships with a variety of Internet companies. We have strategic alliances with Netscape, ICQ, InfoSpace.com, Yahoo! and Excite and intend to continue to pursue relationships with other companies. General and Administrative. General and administrative expenses consist of the salaries of our employees and associated benefits, and the cost of insurance, travel, entertainment, rent and utilities. A large portion of our general and administrative expenses include operations and customer support. These include the expenses associated with customer service and technical support, and consist primarily of the salaries and employment costs of the employees responsible for those efforts. We expect operations and customer support expenses to increase over time to support new and existing customers. We expect general and administrative costs to increase to support our growth, particularly as we establish a larger organization to implement our business plan. We include our research and development costs, comprised primarily of payroll expenses for our technical team of engineers and developers, in general and administrative expenses. We plan to incur additional costs for research and development, though they are not expected to increase as a percentage of revenue. Over time, we expect these relatively fixed general and administrative expenses to decrease as a percentage of revenue. Depreciation and Amortization. Depreciation and amortization primarily relates to our hardware infrastructure. We depreciate our network equipment over its estimated five-year useful life using the straight-line method. We plan to acquire a domestic high capacity network to provide additional capacity to handle the expected increase in customer traffic as our business grows. In addition, we will be adding more network hardware as traffic volumes justify. We expect depreciation to increase in absolute terms as we expand our network to support new and acquired customers, but to decrease as a percentage of total revenue. We have also entered into a strategic agreement with Netscape, part of which includes the purchase of software and trademark licenses. We expect to amortize the costs relating to the software and trademark licenses acquired from Netscape over the two-year term of the agreement. Dependence on IDT. Historically, we have been dependent on IDT for working capital, its telecommunications network and for various services. In connection with establishing ourselves as an independent operating entity, we recently contracted with IDT for telecommunications services and administrative support. We believe that the terms of our agreements with IDT are no less favorable than those we would have obtained from unaffiliated third parties. Results of Operations The following table sets forth certain items in our statement of operations as a percentage of total revenue for the periods indicated: Comparison of Fiscal Years Ended July 31, 1999 and 1998 Revenue. Revenue increased approximately 177% from approximately $12.0 million in fiscal 1998 to approximately $33.3 million for fiscal 1999. Of total revenue for fiscal 1999, PC2Phone generated approximately $19.7 million and Phone2Phone generated approximately $10.3 million. The increase in revenue was primarily due to an increase in minutes of use resulting from additional marketing of our products and services. Specifically, revenue from PC2Phone services increased approximately 148% from approximately $8.0 million for fiscal 1998 to approximately $19.7 million in revenue for fiscal 1999. Revenue from Phone2Phone increased approximately 408% from approximately $2.0 million for fiscal 1998 to approximately $10.3 million for fiscal 1999. We anticipate that revenue from PC2Phone and Phone2Phone will increase in absolute terms as our products become more widely distributed. However, as a percentage of revenue, we expect revenue from these products to decline over the next several years as we begin to market additional products and services and pursue additional sources of revenue. We also recognized revenue of approximately $2.0 million in fiscal 1998 and $3.2 million in fiscal 1999, from the sale of Internet telephone gateways, technology licensing and for services we provided to IDT and other carriers, which is included in "Other Revenue." Direct Cost of Revenue, Excluding Depreciation and Amortization. Total direct cost of revenue, excluding depreciation and amortization, increased by 160% from $6.8 million for fiscal 1998 to approximately $17.8 million for fiscal 1999. As a percentage of total revenue, these costs decreased from approximately 57.0% for fiscal 1998 to approximately 53.6% for fiscal 1999. This decrease is primarily attributable to improved efficiencies in terminating traffic and utilization of network assets. Over time, we expect direct cost of revenue to decline on a per-minute basis as international competition among carriers intensifies, resulting in lower prices from our suppliers, and as we leverage our position as a large provider of services and expand our own network. As a percentage of revenue, we expect direct cost of revenue to increase as a result of a decline in per-minute charges to customers. We expect to continue to utilize IDT's international and domestic networks at the current fair market value rates for termination. We also expect to incur additional costs in connection with the growth of our business, especially in connection with increasing our own network capacity to handle increased traffic volumes. Selling and Marketing. Selling and marketing expenses increased approximately 206% from approximately $2.9 million for fiscal 1998 to approximately $8.8 million for fiscal 1999. As a percentage of total revenue, these costs increased from approximately 24.1% for fiscal 1998 to approximately 26.5% for fiscal 1999. This increase primarily reflects the increased marketing and advertising expenses associated with the agreements established with Netscape, ICQ, InfoSpace.com, Yahoo!, Excite and other strategic partners. We expect to continue to increase significantly our advertising and marketing expenditures to build additional brand recognition, and to enhance the distribution of our products and services. General and Administrative. General and administrative expenses increased approximately 113% from approximately $5.1 million for fiscal 1998 to approximately $10.8 million for fiscal 1999. As a percentage of total revenue, these costs decreased from approximately 42.4% for fiscal 1998 to approximately 32.6% for fiscal 1999. This decrease primarily reflects the efficiencies we have begun to realize from leveraging our sales and support infrastructure. We believe that general and administrative expenses will continue to decline as a percentage of total revenue as a result of greater economies of scale and additional efficiencies. In absolute terms, we expect these expenses to continue to increase as we incur additional costs in product development and costs associated with hiring additional personnel and adding new office space. Moreover, in absolute terms, our research and development expenses will increase as we hire the additional engineers necessary to continue the development of new products and services. However, these research and development expenses are not expected to significantly increase as a percentage of our total revenue. Depreciation and Amortization. Depreciation and amortization increased approximately 219% from approximately $727,000 for fiscal 1998 to approximately $2.3 million for fiscal 1999. As a percentage of total revenue, these costs remained constant in fiscal 1998 and fiscal 1999. This increase is primarily attributable to the increase in capital expenditures for the deployment of network equipment both domestically and internationally to manage increased call volumes. Depreciation will continue to increase as we build out our network and amortize intangibles such as our licenses and trademark rights acquired under agreements with strategic partners, including Netscape. Compensation Charge from the Issuance of Stock Options. We recognized $17.9 million of non-cash compensation expense in fiscal 1999 as a result of option grants made in May 1999 and July 1999. As a percentage of total revenue, the compensation charge from issuance of stock options was 53.9% in fiscal 1999. No compensation charge from the issuance of stock options was recognized in fiscal 1998. Loss from Operations. Loss from operations was approximately $3.5 million for fiscal 1998 as compared to loss from operations of approximately $24.5 million for fiscal 1999. Excluding the non-cash compensation charge described above, our loss from operations for fiscal 1999 would have been $6.5 million. This change is due to the substantial increase in both selling and marketing expenses as well as general and administrative expenses we incurred as we expanded our distribution relationships, corporate infrastructure and human resources. We anticipate continued and increasing losses as we pursue our growth strategy. Comparison of Fiscal Years Ended July 31, 1998 and 1997 Revenue. Revenue increased approximately 353% from approximately $2.7 million for fiscal 1997 to approximately $12.0 million for fiscal 1998. The increase in revenue was primarily due to an increase in minutes of use resulting from increased marketing of our Internet telephony products and services. Of total revenue for the year ended July 31, 1998, PC2Phone generated approximately $8.0 million in revenue and Phone2Phone generated approximately $2.0 million. The increase in revenue was primarily due to an increase in minutes of use due to the marketing of our Internet telephony products and services. Specifically, revenue from PC2Phone services increased approximately 266% from approximately $2.2 million in revenue for fiscal 1997 to approximately $8.0 million in revenue for fiscal 1998. We realized significant revenue for the first time from our Phone2Phone services for fiscal 1998, as well as recorded revenue of approximately $1.5 million from the sale of equipment. In addition, we recognized revenue from amounts charged to IDT including monitoring the network operations center for IDT's Internet customers, of approximately $297,000 and $498,000, respectively, for fiscal 1997 and 1998. We do not expect to realize significant revenue from the sale of equipment in the future. Direct Cost of Revenue, Excluding Depreciation and Amortization. Total cost of revenue, excluding depreciation and amortization increased by approximately 341% from approximately $1.6 million for fiscal 1997 to approximately $6.8 million for fiscal 1998. As a percentage of total revenue, these costs decreased from approximately 58.6% for fiscal 1997 to approximately 57.0% for fiscal 1998. This decrease is primarily attributable to the impact of the higher margin equipment sold in the first half of fiscal 1998. Since we do not expect to realize significant revenue from the sale of equipment in the future, our direct costs will reflect our ability to terminate our traffic worldwide cost- effectively through our own network relationships or via those of IDT, our primary supplier. As a percentage of revenue we anticipate direct costs to remain approximately the same as our network expansion efforts mitigate potential pricing pressures. Selling and Marketing. Selling and marketing expenses increased by a factor of 37 from approximately $77,000 for fiscal 1997 to approximately $2.9 million for fiscal 1998. As a percentage of total revenue, these costs increased from approximately 2.9% for fiscal 1997 to approximately 24.1% for fiscal 1998. This increase primarily reflects the increased marketing and advertising expenses associated with the agreements established with Yahoo!, Excite and other strategic partners. We expect to continue to increase significantly our advertising and marketing expenditures to build additional brand recognition, and to enhance the distribution of our products and services. General and Administrative. General and administrative expenses increased approximately 96% from approximately $2.6 million for fiscal 1997 to approximately $5.1 million for fiscal 1998. As a percentage of total revenue, these costs decreased from approximately 98.0% for fiscal 1997 to approximately 42.4% for fiscal 1998. This decrease primarily reflects the efficiencies we have begun to realize from leveraging our sales and support infrastructure. We expect to continue to see further efficiencies and greater economies of scale, so that general and administrative expenses will continue to decline as a percentage of total revenue. In absolute terms, we expect these expenses to continue to increase as we incur additional costs associated with developing new products, hiring of additional personnel and adding new office space. Depreciation and Amortization. Depreciation and amortization increased from approximately $121,000 for fiscal 1997 to approximately $727,000 for fiscal 1998. As a percentage of total revenue, these costs increased from 4.5% in fiscal 1997 to 6.1% in fiscal 1998. This increase is primarily attributable to the increase in capital expenditures for the deployment of communications equipment both domestically and internationally to manage increased customer volume. Loss from Operations. Loss from operations was approximately $1.7 million for fiscal 1997 as compared to approximately $3.5 million for fiscal 1998. The increased losses reflect the substantial increase in marketing and general and administrative costs we incurred as we expanded our corporate infrastructure and resources to gain additional market share for our products and services. Quarterly Results of Operations The following table sets forth certain quarterly financial data for the eight quarters ended July 31, 1999. This quarterly information is unaudited, has been prepared on the same basis as the annual financial statements, and, in our opinion, reflects all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the information for periods presented. Operating results for any quarter are not necessarily indicative of results for any future period. We have experienced growth in revenue in each quarter since inception, reflecting greater acceptance and usage of our products and services by our expanded customer base. We expect our revenue to grow over time as minutes of use increase. However, we may experience declines in average revenue per minute due to competitive pressures, promotions and marketing initiatives, increased commissions paid to our international resellers and increased amounts paid to our strategic partners under existing and future revenue-sharing arrangements. We have experienced growth in total revenue in each quarter since inception. Our Phone2Phone revenue has increased in each quarter since inception and, over the last three quarters, has also increased as a percentage of our total revenue. This growth is primarily a result of expanded network coverage to create an increased number of access points, for our customers, enhanced service offerings, lower prices and increased selling and marketing efforts to promote our Phone2Phone services. Our PC2Phone revenue has also increased in each quarter since inception. Growth of PC2Phone revenue in future periods depends, in part, upon the additional distribution of our PC2Phone service through the integration of our PC2Phone software in the next versions of ICQ's instant messaging software and Netscape's Internet browser. We currently anticipate that the next version of ICQ's instant messaging software that incorporates our PC2Phone software will be released in mid-2000. The next version of Netscape's Internet browser that incorporates our PC2Phone Software has not yet been released, and, similar to our agreement with ICQ, our agreement with Netscape does not provide for a date by which the next version will be released. Any PC2Phone revenue we would expect to receive as a result of our agreements with ICQ and Netscape would not actually be received by us until their respective products become generally available. Further, any delay by our strategic partners in releasing the next version of their respective products could delay the associated PC2Phone revenue we could expect to receive from these sources. In addition, other factors could delay our growth of PC2Phone revenue. These factors may include regulatory or other actions by foreign regulatory agencies or government-controlled telecommunications companies or Year 2000-related problems in foreign countries that would prevent our international customers from accessing our PC2Phone service. For example, access to our PC2Phone services was recently blocked in certain countries in Asia and the Middle East by government-controlled telecommunications companies. These blockages have caused service interruptions that may cause us to earn as much as $250,000 less in PC2Phone revenue in the first quarter of fiscal 2000. While we have resumed service in each of these countries, there can be no assurance that there will not be future interruptions in these and other foreign countries or that we will be able to return to the level of service we had in each of these countries prior to any interruptions. Because we derive revenue from more than one source, we have experienced volatility in our direct cost of revenue. Specifically, our direct cost of revenue in the first two quarters of fiscal 1998 was low as a percentage of total revenue due to sales of equipment in these quarters. Because these sales were on a non-recurring basis, we realized a significant, albeit temporary, reduced direct cost of revenue for these two quarters. In the second half of fiscal 1998, we increased our advertising expenditures as we began marketing our Phone2Phone service. Revenue from our Phone2Phone service grew from approximately 5.0% of total revenue in the first half of the year to approximately 26.0% of total revenue in the latter half. We experienced start-up costs for Phone2Phone that increased our direct cost of revenue for those two quarters. However, we have been able to reduce direct cost of revenue for our Phone2Phone product as we expanded our network in fiscal 1999, which resulted in lower direct cost of revenue. In the most recent quarter, direct cost of revenue as a percentage of revenue accounted for approximately 54.0% as compared to approximately 80.4% in the quarter ended July 31, 1998. Our increased sales and marketing expenses reflect the relationships we have with various online strategic partners with whom we advertise our PC2Phone and Phone2Phone services. We expect to continue to increase significantly our advertising and marketing expenditures to build additional recognition of our products and services. As a result of our limited operating history and the emerging nature of the markets in which we compete, we are unable to accurately forecast our revenue and direct cost of revenue as they may be impacted by a variety of factors. These factors include the level of use of the Internet as a communications medium, seasonal trends, capacity constraints, the amount and timing of our capital expenditures, introduction of new services by us or our competitors, price competition, technical difficulties or system downtime, and the development of regulatory restrictions. Liquidity and Capital Resources Since inception in January 1996, we have financed our operations through advances from IDT. In May 1999, we received $29.9 million in net proceeds from the sale of our Series A convertible preferred stock and warrants. We applied a portion of the net proceeds from this sale to repay $8.0 million of the $22.0 million of advances from IDT that were outstanding as of April 30, 1999. The remaining $14.0 million due to IDT was converted into a promissory note in May 1999. Our operating activities generated negative cash flow of approximately $3.7 million in fiscal 1998 compared to negative cash flow of approximately $2.3 million in fiscal 1999. Cash used in investing activities was approximately $5.2 million in fiscal 1998 and approximately $19.5 million in fiscal 1999. Our use of cash in investing activities was principally for the purchase of telecommunications and Internet equipment and for the purchase of a trademark in fiscal 1999. In August 1999, we completed the initial public offering of 6,210,000 shares of our common stock, for which we received approximately $85.3 million in net proceeds. From these proceeds, we repaid $7.0 million of the principal amount of the $14.0 million note due to IDT. We had approximately $99.6 million in cash and cash equivalents, as of July 31, 1999, after giving effect to our initial public offering and the exercise of stock options at the time of the closing of the initial public offering. Our future capital requirements will depend on numerous factors, including market acceptance of our services, brand promotions, the amount of resources we devote to the development of our current and future products, and the expansion of our sales force and marketing our services. We may experience a substantial increase in our capital expenditures and lease arrangements consistent with the growth in our operations and staffing. Additionally, we will evaluate possible investments in businesses, products and technologies. We believe that our current cash balances, expected cash flow from our operations will be sufficient to meet our working capital and capital expenditure needs for at least the next 24 months. However, there can be no assurance that we will have sufficient capital to finance potential acquisitions or other growth oriented activities, and may issue additional equity securities, incur debt or obtain other financing. Warrant Issued to America Online In connection with our distribution and marketing agreement with ICQ, we issued a warrant to America Online to purchase up to 3% of our outstanding capital stock on a fully-diluted basis. This warrant will vest in 1% increments upon the achievement of each of three incremental thresholds of revenue generated under the agreement during the first four years that the warrant is outstanding. The per share exercise price under the warrant will be equal to the lesser of $12.00 per share or $450 million divided by the number of our fully- diluted shares on the initial exercise date. For example, if the first revenue threshold was reached, AOL would be permitted to purchase 1% of 57,766,647 shares, calculated as the sum of: . 11,672,616 shares of our outstanding common stock; . 36,524,250 shares of our common stock issuable upon conversion of our Class A stock; and . 9,569,781 shares of our common stock reserved for issuance upon exercise of stock options that are outstanding or reserved for issuance under our 1999 Stock Option and Incentive Plan. Thus, AOL would be permitted to purchase a total of 1,834,999 shares of common stock. The per share exercise price of the AOL warrant would be $7.36 per share, which is $450 million divided by the 57,766,647 fully-diluted shares outstanding. Year 2000 Systems Costs Computer systems, software packages, and microprocessor-dependent equipment may cease to function or generate erroneous data on or after January 1, 2000. The problem affects those systems or products that are programmed to accept a two-digit code in date code fields. For example, computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. To correctly identify the Year 2000, and therefore be "Year 2000 compliant," a four-digit date code field is required. We have conducted a comprehensive review of the computer hardware and software that we use in order to ensure that our computer-related applications are Year 2000 compliant. This review commenced when we were operated as a division of IDT, at which time IDT provided services in connection with this review. Our cost of addressing the Year 2000 issue is not expected to be material to our operations or financial position. However, the consequences of an incomplete or untimely resolution of the Year 2000 issue could be expected to have a material adverse effect upon our financial results. In the absence of such a resolution, our ability to route traffic in a cost effective manner, to deliver our services, to properly obtain payment for these services, and/or to maintain accurate records of our business and operations, could be substantially impaired until this issue is remedied. We may become liable for substantial damages in the event that, as a result of the Year 2000 issue, we fail to deliver any services that we have contracted to provide. Also, our name and reputation may be harmed if our services are disrupted due to Year 2000 problems. Our plan to ensure Year 2000 compliance consists of the following phases: . conducting a comprehensive inventory of internal systems; . assessing and prioritizing any required remediation; . repairing or, if appropriate, replacing any non-compliant systems; . testing all remediated systems for Year 2000 compliance; and . developing contingency plans that may be employed in the event that any systems used by us is unexpectedly affected by a previously unanticipated Year 2000 problem. We have substantially completed each of these phases, and believe that our internal systems are Year 2000 compliant. We are conducting an external review of our customers and suppliers, and any other third parties with whom we do business, to determine their vulnerability to Year 2000 problems and any potential impact on us. These parties include our equipment and systems providers. In particular, we may experience problems to the extent that telecommunications carriers whose networks connect with ours are not Year 2000 compliant. Our ability to determine the ability of these third parties to address issues relating to the Year 2000 problem is limited. To the extent that a limited number of carriers experience disruptions in service due to the Year 2000 issue, we believe that we will be able to obtain service from alternate carriers. However, our ability to provide certain services to customers in selected geographic locations may be limited. There can be no assurance that such problems will not have a material adverse effect on our business, reputation or operating results. In addition, computer systems and software products in foreign countries may not be as prepared for Year 2000 problems as computer systems and software products in the United States. Because a majority of our revenue is derived from customers located outside the United States, the failure of computer systems and software products in any foreign countries as a result of Year 2000 problems could block access to our services in those countries, which may adversely affect our customer base and revenue. We are also in the process of developing contingency plans with regard to potential or unforeseen Year 2000 problems. We believe that, in the event that one or more of our systems, or the systems of third parties with which we do business, is impaired due to unanticipated Year 2000 issues, our contingency plans will enable us to temporarily conduct operations on a temporarily modified basis until the impaired system or systems is remediated. There can be no assurances that our suppliers and customers will achieve full year 2000 compliance before the end of 1999 or that we will develop or implement effective contingency plans on a timely basis. A failure of our computer systems or the failure of our suppliers or customers to effectively upgrade their software and systems for transition to the Year 2000 could have a material adverse effect on our business, financial conditions and results of operations. Most of our internal systems were developed after developers became aware of Year 2000 problems. To date, we have not incurred material expenses in connection with the remediation of Year 2000 related issues. We do not expect to incur significant costs in connection with Year 2000 related issues. However, our actual costs may be significant if we discover that any major portion of our internal systems requires unforeseen remediation. We expense costs associated with Year 2000 remediation when they are incurred. Effects of Inflation Due to relatively low levels of inflation over the last several years, inflation has not had a material effect on our results of operations. RISK FACTORS In addition to the other information in this report, the following factors should be carefully considered in evaluating our business and prospects. Risks Related to Our Financial Condition and Our Business Our limited operating history makes evaluating our business difficult. IDT formed us as a subsidiary in October 1997. Prior to that, we conducted business as a division of IDT. Therefore, we have only a limited operating history with which you may evaluate our business. You must consider the numerous risks and uncertainties an early stage company like ours faces in the new and rapidly evolving market for Internet-related services. These risks include our ability to: . increase awareness of our brand and continue to build user loyalty; . maintain our current, and develop new, strategic relationships; . respond effectively to competitive pressures; and . continue to develop and upgrade our network and technology. If we are unsuccessful in addressing these risks, sales of our products and services, as well as our ability to maintain or increase our customer base, will be substantially diminished. We have never been profitable and expect our losses to continue for the foreseeable future. We have never been profitable on an annual basis. We had an accumulated deficit of approximately $30.5 million as of July 31, 1999. We expect to continue to incur operating losses for the foreseeable future. Our operating and marketing expenses have continuously increased since inception and we expect them to continue to increase significantly during the next several years. Accordingly, we will need to generate significant revenue to achieve profitability. We may not be able to do so. Even if we do achieve profitability, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or annual basis in the future. In addition, we expect to recognize significant additional charges relating to non-cash compensation in connection with options that we granted in May, July and October 1999. We recognized a charge of approximately $17.9 million in the fourth quarter of fiscal 1999 arising from these options, and will recognize charges of approximately $11.8 million during fiscal 2000, approximately $11.8 million during fiscal 2001 and approximately $8.3 million during fiscal 2002. We intend to pursue new streams of revenue, which we have not attempted to generate before and which may not be profitable. In the future, we intend to pursue revenue from new Web-based opportunities, such as banner and audio advertising, as well as from sponsorship opportunities on our user interface and our EZSurf.com Internet shopping directory. We also intend to explore the availability of revenue-sharing opportunities. We have not attempted to generate this type of revenue before. We intend to devote significant capital and resources to create these new revenue streams and we cannot ensure that these investments will be profitable. We may have difficulties managing our expanding operations, which may reduce our chances of achieving profitability. Our future performance will depend, in part, on our ability to manage our growth effectively. To that end, we will have to undertake the following tasks, among others: . develop our operating, administrative, financial and accounting systems and controls; . improve coordination among our engineering, accounting, finance, marketing and operations personnel; . enhance our management information systems capabilities; and . hire and train additional qualified personnel. If we cannot accomplish these tasks, our chances of achieving profitability may be diminished. If we fail to establish and maintain strategic relationships our ability to meet analyst expectations and our sales would suffer. We currently have strategic relationships with Netscape, ICQ, Go2Net, InfoSpace.com, Yahoo!, Excite and others. We depend on these relationships to: . distribute our products to potential customers; . increase usage of our services; . build brand awareness; and . cooperatively market our products and services. We believe that our success depends, in part, on our ability to develop and maintain strategic relationships with leading Internet companies and computer hardware and software companies, as well as key marketing distribution partners. In cases where our products and services are integrated into our strategic partners' product and service offerings, our ability to meet analyst expectations and our sales depend upon a timely release of these offerings. If any of our strategic relationships are discontinued or if the release of these partners' offerings that integrate our products and services are delayed, sales of our products and services and our ability to maintain or increase our customer base may be substantially diminished. Further, our agreements with ICQ and Netscape do not provide for a date by which the next version of their respective products which incorporate our PC2Phone software will be released. Any delay by any of our strategic partners in releasing the next version of their respective products could delay the associated PC2Phone revenue we could expect to receive from these sources. If we hire a reseller who fails to market our products and services effectively or who provides poor customer service, our reputation will suffer and we could lose customers. If we hire a reseller who fails to market our products and services effectively, we could lose market share. Additionally, if a reseller provides poor customer service, we could lose brand equity. Therefore, we must maintain and hire additional resellers throughout the world that are capable of providing high-quality sales and service efforts. If we lose a reseller in a key market, or if a current or future reseller fails to adequately provide customer support, our reputation will suffer and sales of our products and services and our customer base will be substantially diminished. Competition could reduce our market share and decrease our revenue. The market for our services has been extremely competitive. Many companies offer products and services like ours, and many of these companies have a substantial presence in this market. In addition, many of these companies are larger than we are and have substantially greater financial, distribution and marketing resources than we do. We therefore may not be able to compete successfully in this market. If we do not succeed in competing with these companies, we will lose customers and our revenue will be substantially reduced. Our competitors include the following: . Internet Telephony Service Providers. Internet telephony service providers such as AT&T Jens (a Japanese affiliate of AT&T), deltathree.com (a subsidiary of RSL Communications), I-Link, iBasis (formerly known as VIP Calling), ICG Communications, IPVoice.com, ITXC and OzEmail (which was acquired by MCI WorldCom) route voice traffic over the Internet. . Software/Hardware Providers. Companies such as VocalTec, Netspeak and e- Net produce software and other computer equipment that may be installed on a user's computer to permit voice communications over the Internet. . Telecommunications Companies. A number of telecommunications companies, including AT&T, Deutsche Telekom, MCI WorldCom and Qwest, currently maintain, or plan to maintain, packet-switched networks to route the voice traffic of other telecommunications companies. . Network Hardware Manufacturers. A number of large telecommunications providers and equipment manufacturers, including Alcatel, Cisco, Lucent, Northern Telecom and Dialogic (which was acquired by Intel), have announced that they intend to offer products similar to ours. We expect these products to allow live voice communications over the Internet between parties using a personal computer and a telephone and between two parties using telephones. Cisco Systems has also taken additional steps by recently acquiring companies that produce devices that help Internet service providers carry voice over the Internet while maintaining traditional phone usage and infrastructure. . Voice-Enabled Online Commerce Providers. Several companies, including USA Global Link and AT&T's Inter@active Communications, have begun to apply Internet telephony technologies in connection with online commerce transactions. These providers compete with services of ours such as Click2Talk by integrating voice communications into commercial Web sites. Pricing pressures may lessen our competitive pricing advantage. Our success is based on our ability to provide discounted domestic and international long distance services by taking advantage of cost savings achieved by carrying voice traffic over the Internet, as compared to carrying calls over long distance networks, such as those owned by AT&T, Sprint and MCI WorldCom. In recent years, the price of long distance calls has fallen. In response, we have lowered the price of our service offerings. For example, AT&T, Sprint and MCI WorldCom have adopted recent pricing plans in which the rates that they charge for U.S. domestic long distance calls are not always substantially higher than the rates that we charge for our U.S. domestic service. The price of long distance calls may decline to a point where we no longer have a price advantage over these traditional long distance services. Alternatively, other providers of long distance services may begin to offer unlimited or nearly unlimited use of some of their services for an attractive monthly rate. We would then have to rely on factors other than price to differentiate our product and service offerings, which we may not be able to do. We may not be able to compete with providers that can bundle long distance services with other offerings. Our competitors may be able to bundle services and products that we do not offer together with long distance or Internet telephony services. These services could include wireless communications, voice and data services, Internet access and cable television. This form of bundling would put us at a competitive disadvantage if these providers can combine a variety of service offerings at a single attractive price. In addition, some of the telecommunications and other companies that compete with us may be able to provide customers with lower communications costs or other incentives with their services, reducing the overall cost of their communications packages, and significantly increasing pricing pressures on our services. This form of competition could significantly reduce our revenues. We may not be able to hire and retain the personnel we need to sustain our business. We depend on the continued services of our executive officers and other key personnel. We have an employment agreement with only two of our executive officers, Clifford M. Sobel, our Chairman, and Jonathan Fram, our President. We need to attract and retain other highly-skilled technical and managerial personnel for whom there is intense competition. If we are unable to attract and retain qualified technical and managerial personnel, we may never achieve profitability. If our customers do not perceive our service to be effective or of high quality, our brand and name recognition would suffer. We believe that establishing and maintaining a brand and name recognition is critical for attracting and expanding our targeted client base. We also believe that the importance of reputation and name recognition will increase as competition in our market increases. Promotion and enhancement of our name will depend on the effectiveness of our marketing and advertising efforts and on our success in continuing to provide high-quality products and services, neither of which can be assured. If our customers do not perceive our service to be effective or of high quality, our brand and name recognition would suffer. We depend on our international operations, which subject us to unpredictable regulatory and political situations. As of July 31, 1999, approximately 69% of our customers were based outside of the United States, generating approximately 62% of our revenue during fiscal 1999. A significant component of our strategy is to continue to expand internationally. We cannot assure you that we will be successful in expanding into additional international markets. In addition to the uncertainty regarding our ability to generate revenue from foreign operations and expand our international presence, there are certain risks inherent in doing business on an international basis, including: . changing regulatory requirements, which vary widely from country to country; . action by foreign governments or foreign telecommunications companies to limit access to our services; . increased bad debt and subscription fraud; . legal uncertainty regarding liability, tariffs and other trade barriers; . political instability; and . potentially adverse tax consequences. We cannot assure you that one or more of these factors will not materially adversely affect the growth of our business or our customer base. All of the telephone calls made by our customers are connected through local telephone companies and, at least in part, through leased networks that may become unavailable. We are not a local telephone company or a registered local exchange carrier. Our network covers only portions of the United States. Accordingly, we must route parts of some domestic and all international calls made by our customers over leased transmission facilities. In addition, because our network does not extend to homes or businesses, we must route calls through a local telephone company to reach our network and, ultimately, to reach their final destinations. In many of the foreign jurisdictions in which we conduct or plan to conduct business, the primary provider of significant intra-national transmission facilities is the national telephone company. Accordingly, we may have to lease transmission capacity at artificially high rates from a monopolistic provider and, consequently, we may not be able to generate a profit on those calls. In addition, national telephone companies may not be required by law to lease necessary transmission lines to us or, if applicable law requires national telephone companies to lease transmission facilities to us, we may encounter delays in negotiating leases and interconnection agreements and commencing operations. Additionally, disputes may result with respect to pricing terms and billing. In the United States, the providers of local telephone service are generally the incumbent local telephone companies, including the regional Bell operating companies. The permitted pricing of local transmission facilities that we lease in the United States is subject to uncertainties. The Federal Communications Commission has issued an order requiring incumbent local telephone companies to price those facilities at total element long-run incremental cost, and the United States Supreme Court recently upheld the FCC's jurisdiction to set a pricing standard for local transmission facilities provided to competitors. However, the incumbent local telephone companies can be expected to bring additional legal challenges to the FCC's total element long-run incremental cost standard and, if they succeed, the result may be to increase the cost of incumbent local transmission facilities obtained by us. Our success depends on our ability to handle a large number of simultaneous calls, which our systems may not be able to accommodate. We expect the volume of simultaneous calls to increase significantly as we expand our operations. Our network hardware and software may not be able to accommodate this additional volume. If we fail to maintain an appropriate level of operating performance, or if our service is disrupted, our reputation could be hurt and we could lose customers. Because we are unable to predict the volume of usage and our capacity needs, we may be forced to enter into disadvantageous contracts that would reduce our operating margins. In order to ensure that we are able to handle additional usage, we have agreed to pay IDT a one-time fee of approximately $6.0 million for a 20-year right to use part of a new high capacity network that is under construction. This network has been pledged by IDT to its lenders under a credit facility. We may have to enter into additional long-term agreements for leased capacity. To the extent that we overestimate our call volume, we may be obligated to pay for more transmission capacity than we actually use, resulting in costs without corresponding revenue. Conversely, if we underestimate our capacity needs, we may be required to obtain additional transmission capacity through more expensive means that may not be available. We may not be able to obtain sufficient funds to grow our business. We intend to continue to grow our business. Due to our limited operating history and the nature of our industry, our future capital needs are difficult to predict. Therefore, we may require additional capital to fund any of the following: . unanticipated opportunities; . strategic alliances; . potential acquisitions; . changing business conditions; and . unanticipated competitive pressures. Obtaining additional financing will be subject to a number of factors, including market conditions, our operating performance and investor sentiment. These factors may make the timing, amount, terms and conditions of additional financings unattractive to us. If we are unable to raise additional capital, our growth could be impeded. Any damage to or failure of our systems or operations could result in reductions in, or terminations of, our services. Our success depends on our ability to provide efficient and uninterrupted, high-quality services. Our systems and operations are vulnerable to damage or interruption from natural disasters, power loss, telecommunication failures, physical or electronic break-ins, sabotage, intentional acts of vandalism and similar events that may be or may not be beyond our control. The occurrence of any or all of these events could hurt our reputation and cause us to lose customers. Unauthorized use of our intellectual property by third parties may damage our brand. We regard our copyrights, service marks, trademarks, trade secrets and other intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, customers, partners and others to protect our intellectual property rights. Despite our precautions, it may be possible for third parties to obtain and use our intellectual property without authorization. Furthermore, the laws of some foreign countries may not protect intellectual property rights to the same extent as do the laws of the United States. It may be difficult for us to enforce certain of our intellectual property rights against third parties who may have acquired intellectual property rights by filing unauthorized applications in foreign countries to register the marks that we use because of their familiarity with our worldwide operations. Since Internet related industries such as ours are exposed to the intellectual property laws of numerous foreign countries and trademark rights are territorial, there is uncertainty in the enforceability and scope of protection of our intellectual property. The unauthorized use of our intellectual property by third parties may damage our brand. Defending against intellectual property infringement claims could be expensive and could disrupt our business. We cannot be certain that our products and services do not or will not infringe upon valid patents, trademarks, copyrights or other intellectual property rights held or claimed by third parties. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others in the ordinary course of our business. We may incur substantial expenses in defending against these third-party infringement claims, regardless of their merit. Successful infringement claims against us may result in substantial monetary liability or may materially disrupt the conduct of our business. Year 2000 problems may disrupt our operations. Many computer systems and software products are coded to understand only dates that have two digits for the relevant year. These systems and products need upgrading to accept four digit entries in order to distinguish 21st century dates from 20th century dates. Without upgrading, many computer applications could fail or create erroneous results beginning in the year 2000. The Year 2000 problems of companies on the Internet generally could affect our systems or operations. In addition, computer systems and software products in foreign countries may not be as prepared for the Year 2000 problems as computer systems and software products in the United States. Because a majority of our revenue is derived from customers located outside the United States, the failure of computer systems and software products in any foreign countries as a result of the Year 2000 problems could block access to our services in those countries, which may adversely affect our customer base and revenue. Risks Related to Our Relationship with IDT We have contracted with IDT for various services and for the use of its telecommunications network, which contracts we may not be able to renew when they expire. In May 1999, we entered into agreements with IDT under which IDT will continue to provide administrative and telecommunication services to us. These agreements have an initial term of one year, and at the end of the initial term and each year thereafter, will automatically renew for additional one year periods unless one party has given the other party prior termination notice. When these agreements expire, we will need to extend them, engage other entities to perform these services or perform these services ourselves. In addition, after the initial term, these agreements are terminable by either party upon prior written notice. We cannot assure you that IDT will not terminate these agreements or continue to provide these services after the initial term of the agreements. As a result, we may have to purchase these services from third parties or devote resources to handle these functions internally, which may cost us more than we paid IDT for the same services. In addition, IDT has provided us in the past with working capital to fund our operations, and IDT is not under any obligation, under these agreements or otherwise, to do so in the future. We may experience conflicts of interest with IDT, which may not be resolved in our favor. Three members of our board of directors are officers and/or directors of IDT. One of these directors, Howard S. Jonas, is the Chairman and Chief Executive Officer of IDT and IDT's controlling shareholder. Additionally, one of our directors, James R. Mellor, was a director of IDT until June 1999. Clifford M. Sobel, our Chairman, has an option to transfer his interest in us to IDT in exchange for an option to purchase 875,000 shares of IDT common stock at a purchase price of $6.50 per share. In addition, certain of our executive officers, directors and employees hold shares of IDT common stock and options to acquire shares of IDT common stock. These individuals may have conflicts of interest with respect to certain decisions involving business opportunities and similar matters that may arise in the ordinary course of our business or the business of IDT. If conflicts arise with IDT, we expect to resolve those conflicts on a case-by-case basis, and in the manner required by applicable law and customary business practices, subject to our agreement with IDT to resolve disputes involving $5.0 million or less through mandatory, binding arbitration. Conflicts, if any, could be resolved in a manner adverse to us and our stockholders, which could harm our business. Through its ownership of our stock, IDT effectively controls our company and may exert influence contrary to the interests of other stockholders. IDT currently owns approximately 56.2% of our outstanding capital stock. Because IDT owns Class A stock, which entitles the holder to two votes per share, IDT controls 64.0% of our voting power. Therefore, IDT will have the power to determine the election of our directors, the appointment of new management and the approval of any other action requiring the approval of our stockholders, including any amendments to our certificate of incorporation and mergers or sales of our company or of all of our assets. In addition, without the consent of IDT, we could be prevented from entering into certain transactions that could be beneficial to us. Third parties could be discouraged from making a tender offer or bid to acquire us because of IDT's stockholdings and voting rights. IDT's ownership will increase if Clifford M. Sobel exercises his option to transfer his shares of our stock to IDT in exchange for an option to purchase shares of IDT. IDT has pledged its shares of our stock to secure a credit facility, which shares may be transferred to a third party that would effectively control us if IDT defaults on its obligations. The shares owned by IDT are pledged as collateral to secure an IDT credit facility. The lenders under the credit facility have agreed to permit IDT to transfer our shares free and clear of any liens as and when IDT seeks to transfer shares of our stock. Such transferability will cease if IDT's ownership of our capital stock drops below 50% of the number of shares which it owned 72 hours after the consummation of our initial public offering. If IDT defaults in its obligations under the credit facility, then a third party could acquire the voting rights with respect to the pledged stock and become party to our intercompany agreements. We cannot assume that a third party would maintain good relations with us or maintain or renew our agreements with IDT. Risks Related to Our Industry If the Internet does not continue to grow as a medium for voice communications, our business will suffer. The technology that allows voice communications over the Internet is still in its early stages of development. Historically, the sound quality of Internet calls was poor. As the industry has grown, sound quality has improved, but the technology requires additional refinement. Additionally, the Internet's capacity constraints may impede the acceptance of Internet telephony. Callers could experience delays, errors in transmissions or other interruptions in service. Making telephone calls over the Internet must also be accepted as an alternative to traditional telephone service. Because the Internet telephony market is new and evolving, predicting the size of this market and its growth rate is difficult. If our market fails to develop, then we will be unable to grow our customer base and our opportunity for profitability will be harmed. Our business will not grow without increased use of the Internet. The use of the Internet as a commercial marketplace is at an early stage of development. Demand and market acceptance for recently introduced products and services over the Internet are still uncertain. We cannot predict whether customers will be willing to shift their traditional activities online. The Internet may not prove to be a viable commercial marketplace for a number of reasons, including: . concerns about security; . Internet congestion; . inconsistent service; and . lack of cost-effective, high-speed access. If the use of the Internet as a commercial marketplace does not continue to grow, we may not be able to grow our customer base, which may prevent us from achieving profitability. Governmental regulations regarding the Internet may be passed, which could impede our business. The legal and regulatory environment that pertains to the Internet is uncertain and is changing rapidly as use of the Internet increases. For example, in the United States, the Federal Communications Commission is considering whether to impose surcharges or additional regulations upon certain providers of Internet telephony. In addition, regulatory treatment of Internet telephony outside the United States varies from country to country. For example, access to our PC2Phone services was recently blocked in India, Pakistan and Lebanon by government- controlled telecommunications companies. These blockages have caused service interruptions that may cause us to earn as much as $250,000 less in PC2Phone revenue in the first quarter of fiscal 2000. There can be no assurance that there will not be future interruptions in these and other foreign countries or that we will be able to return to the level of service we had in each of these countries prior to any interruptions. In addition, one of our competitors, iBasis, recently disclosed that it had received a letter from the Israeli Minister of Communications requesting that it cease and desist terminating international calls over the Internet in Israel. These actions and other similar actions in foreign countries may adversely affect our continuing ability to offer services in these and other countries, causing us to lose customers and revenue. New regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet, which could adversely effect our customer base and our revenue. The growth of the Internet may also be significantly slowed. This could delay growth in demand for our products and services and limit the growth of our revenue. In addition to new regulations being adopted, existing laws may be applied to the Internet. New and existing laws may cover issues that include: . sales and other taxes; . access charges; . user privacy; . pricing controls; . characteristics and quality of products and services; . consumer protection; . contributions to the universal service fund, an FCC-administered fund for the support of local telephone service in rural and high cost areas; . cross-border commerce; . copyright, trademark and patent infringement; and . other claims based on the nature and content of Internet materials. Our risk management practices may not be sufficient to protect us from unauthorized transactions or thefts of services. We may be the victim of fraud or theft of service. From time to time, callers have obtained our services without rendering payment by unlawfully using our access numbers and personal identification numbers. We attempt to manage these theft and fraud risks through our internal controls and our monitoring and blocking systems. If these efforts are not successful, the theft of our services may cause our revenue to decline significantly. Risks Related to our Stock Our stock price has been, and is likely to continue to be, highly volatile and could drop unexpectedly. Since trading commenced in July 1999, the trading price of our common stock has been highly volatile and may continue to be volatile in response to the following factors: . quarterly variations in our operating results; . announcements of technical innovations, new products or services by us or our competitors; . investor perception of us, the Internet telephony market or the Internet in general; . changes in financial estimates by securities analysts; and . general economic and market conditions. The stocks of many Internet-related companies have experienced significant fluctuations in trading price and volume. Often these fluctuations have been unrelated to operating performance. Declines in the market price of our common stock could also materially adversely affect employee morale and retention, our access to capital and other aspects of our business. If our stock price remains volatile, we may become subject to securities litigation, which is expensive and could divert our resources. In the past, following periods of market volatility in the price of a company's securities, security holders have instituted class action litigation. Many companies in our industry have been subject to this type of litigation. If the market value of our stock experiences adverse fluctuations, and we become involved in this type of litigation, regardless of the outcome, we could incur substantial legal costs and our management's attention could be diverted, causing our business to suffer. The sale of a substantial number of shares of our common stock may affect our stock price. The market price of our common stock could decline as a result of sales of substantial amounts of common stock in the public market or the perception that substantial sales could occur. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Our certificate of incorporation, our bylaws and Delaware law make it difficult for a third party to acquire us, despite the possible benefit to our stockholders. Provisions of our certificate of incorporation, our bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. For example, our certificate of incorporation provides for a classified board of directors, meaning that only approximately one-third of our directors will be subject to re-election at each annual stockholder meeting. Moreover, our certificate of incorporation creates a class of stock with super-voting rights. The holders of Class A stock are entitled to two votes per share while the holders of common stock are entitled to one vote per share. Except as otherwise required by law or as described below, the holders of Class A stock and common stock will vote together as a single class on all matters presented to the stockholders for their vote or approval, including the election of directors. The holders of Class A stock may have the ability to elect all of our directors and to effect or prevent certain corporate transactions. These provisions could discourage takeover attempts and could materially adversely affect the price of our stock. Item 7A. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Securities and Exchange Commission's rule related to market risk disclosure requires that we describe and quantify our potential losses from market risk sensitive instruments attributable to reasonably possible market changes. Market risk sensitive instruments include all financial or commodity instruments and other financial instruments (such as investments and debt) that are sensitive to future changes in interest rates, currency exchange rates, commodity prices or other market factors. We are not exposed to market risks from changes in foreign currency exchange rates or commodity prices. We do not hold derivative financial instruments nor do we hold securities for trading or speculative purposes. We are exposed to changes in interest rates primarily from our investments in cash equivalents. Under our current policies, we do not use interest rate derivative instruments to manage our exposure to interest rate changes. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements appear in Item 14 of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following persons are our executive officers and directors: Clifford M. Sobel has been Chairman of the board of directors since May 1999, served as our President from October 1997 to July 1999 and served as our Chief Executive Officer from October 1997 to January 1999. Since 1994, Mr. Sobel has been Chairman and Chief Executive Officer of SJJ Investment Corp., which has invested in Internet, cable, real estate and cosmetics companies. Prior to this, Mr. Sobel founded several companies in the design and manufacturing of retail interiors and themed environments, including DVMI and its subsidiary, Bon-Art International, and Bauchet International. These companies were sold in 1994, in transactions in which Bear, Stearns & Co. Inc. served as financial advisor. Mr. Sobel has testified before Congress on foreign trade issues and, by Presidential appointment, served on the Holocaust Memorial Council in Washington, D.C. Howard S. Balter has been a director since October 1997, our Chief Executive Officer since January 1999, and our Vice Chairman of the board of directors since May 1999. Mr. Balter also served as our Treasurer from October 1997 to July 1999. Prior to his employment with us, Mr. Balter was IDT's Chief Operating Officer from 1993 to 1998 and Chief Financial Officer from 1993 to 1995. Mr. Balter was a director of IDT from December 1995 to January 1999 and Vice Chairman of IDT's board from 1996 to 1999. From 1985 to 1993, Mr. Balter operated his own real estate development firm. Jonathan Fram became our President in July 1999. Prior to his employment with us, Mr. Fram was General Manager of Bloomberg L.P.'s New Media Group from 1996 to 1999, where he was responsible for Bloomberg's Internet strategy. Mr. Fram was employed as General Manager of Bloomberg's Television and Radio Group from 1991 to 1996. From 1989 to 1991, Mr. Fram served as the Chief Executive Officer of FNN:PRO--Institutional Research Network, Inc. Mr. Fram was also employed by both Bear Stearns & Co. and Paine Webber, Inc. as a securities analyst, and worked for IBM as a computer design engineer. David Greenblatt has been our Chief Operating Officer since January 1999. Between January 1998 and January 1999, Mr. Greenblatt served as IDT's Vice President of Networks, during which time he was primarily responsible for the operations of Net2Phone. Prior to his employment with IDT in January 1998, Mr. Greenblatt was Senior Vice President of Research and Development for Nextwave Communications from 1996 to 1997. From January 1984 to August 1996, Mr. Greenblatt was a principal of Financial Technologies, Inc., where he managed the process of software conversion for large and medium-sized businesses. From January 1980 to December 1984, Mr. Greenblatt was an information technologies consultant for various money center banks. From 1970 to 1980, Mr. Greenblatt has lectured in the areas of Computer Science and Mathematics at Queens College, New York University, Hunter College and Pace University. Ilan M. Slasky has been our Chief Financial Officer since January 1999. Prior to his employment with us, Mr. Slasky was IDT's Executive Vice President of Finance from December 1997 to January 1999, IDT's director of carrier services from November 1996 to July 1997 and IDT's Director of Finance from May 1996 to November 1996. From 1991 to 1996, Mr. Slasky worked for Merrill Lynch in various areas of finance, including risk management, fixed income trading and equity derivatives. H. Jeff Goldberg has been our Chief Technology Officer since January 1999. From January 1996 to January 1999, Mr. Goldberg was our Director of Technology and a consultant to IDT. Mr. Goldberg was an independent software consultant from 1985 to 1995, Vice President of Software and a member of the board of directors at Charles River Data Systems in Massachusetts from 1979 to 1985 and a developer of multimedia communications software at AT&T Bell Laboratories from 1977 to 1979. Mr. Goldberg is a founding member of the UNIX standards committee. Jonathan Reich has been our Executive Vice President--Marketing and Corporate Development since January 1999. Prior to his employment with us, Mr. Reich was IDT's Senior Vice President of Advertising, Marketing and Business Development in charge of strategic relationships for both us and IDT from June 1997 to December 1998 and IDT's director of advertising from January 1995 to November 1997. From 1992 to 1993, Mr. Reich worked for Sanford Bernstein & Co. as an associate analyst. Prior to this, Mr. Reich was an internal consultant for Morgan Stanley & Co. Martin Rothberg has been our Executive Vice President--Strategic Sales since January 1999 and a key employee since June 1997. Prior to his employment with us, Mr. Rothberg was IDT's Director of International Sales from September 1996 to June 1997 and IDT's Director of Domestic Sales from June 1995 to September 1996. Jonathan Rand has been our Executive Vice President--International Sales since January 1999, Treasurer since July 1999 and a key employee since January 1998. Prior to joining us, Mr. Rand was a member of IDT's senior management from 1992 to January 1999, including service as Senior Vice President--International Sales and Senior Vice President--Finance. Additionally, Mr. Rand is a co-founder and director of the International Internet Association. Prior to joining IDT, Mr. Rand operated his own magazine publishing business from 1986 to 1992 and was employed by Procter & Gamble from 1985 to 1986 in Brand Management. Howard S. Jonas was appointed a director in October 1997. Mr. Jonas founded IDT in August 1990 and has served as Chairman of the Board and Treasurer since its inception and as Chief Executive Officer since December 1991. Additionally, he served as President of IDT from December 1991 through September 1996. Mr. Jonas is also the founder and has been President of Jonas Publishing Corp., a publisher of trade directories, since its inception in 1979. James A. Courter was appointed a director in May 1999. Mr. Courter has been President of IDT since October 1996 and a director of IDT since March 1996. Mr. Courter has been a senior partner in the New Jersey law firm of Courter, Kobert, Laufer & Cohen, P.C. since 1972. He was also a partner in the Washington, D.C. law firm of Verner, Liipfert, Bernhard, McPherson & Hand from January 1994 to September 1996. From 1991 to 1994, Mr. Courter was chairman of the President's Defense Base Closure and Realignment Commission. Mr. Courter was a member of the United States House of Representatives for 12 years, retiring in January 1991. Mr. Courter also serves on the board of directors of Envirogen and The Berkeley School. Gary E. Rieschel was appointed a director in June 1999. Mr. Rieschel is the Executive Managing Director of SOFTBANK Technology Ventures, which he joined in January 1996. Mr. Rieschel has extensive overseas experience, having spent over four years in Tokyo as General Manager of Sequent Computer Systems' Asian operations. He serves as a Director for several SOFTBANK Technology Ventures' portfolio companies and is a member of SOFTBANK Corporation's Global Executive Board. James R. Mellor was appointed a director in June 1999. Mr. Mellor served as a director of IDT between August 1997 and June 1999. Since 1981, Mr. Mellor worked for General Dynamics Corporation, a developer of nuclear submarines, surface combatant ships and combat systems. From 1994 until 1997, Mr. Mellor served as Chairman and Chief Executive Officer of General Dynamics, and from 1993 to 1994, he served as President and Chief Operating Officer of General Dynamics. Before joining General Dynamics, Mr. Mellor served as President and Chief Operating Officer of AM International, Inc. now Multigraphics, Inc. Before that time, Mr. Mellor spent 18 years with Litton Industries in a variety of engineering and management positions, including Executive Vice President in charge of Litton's Defense Group from 1973 to 1997. Jesse P. King was appointed a director in July 1999. Mr. King has served as the Operation Manager for the Rockefeller Foundation's Next Generation Leadership Program and the Philanthropy Workshop since January of 1996. Before joining The Rockefeller Foundation, Mr. King worked as the Senior Program Director and Human Resource Director for the Colorado Outward Bound School from 1990 to 1996. Additionally, Mr. King worked as a Project Director and Consultant for the Children's Defense Fund and the Black Community Crusade for Children from February 1994 to 1995. Martin J. Yudkovitz was appointed a director in September 1999. Mr. Yudkovitz has been President of NBC Interactive Media since December 1995. Mr. Yudkovitz is responsible for developing NBC's new media strategy and managing NBC's interactive operations. From December 1993 to December 1995, Mr. Yudkovitz served as Senior Vice President of NBC Multimedia, and in addition was appointed Senior Vice President of Strategic Development of NBC in March 1993. He has also served as General Counsel and Vice President for Business Affairs of CNBC. Mr. Yudkovitz joined NBC in 1984. Mr. Yudkovitz is a director of iVillage, Inc. and Talk City, Inc., as well as a member of the board of managers of Snap! LLC. Daniel H. Schulman was appointed a director in September 1999. Mr. Schulman has been the President, Chief Operating Officer and a director of priceline.com since July 1999. From December 1998 to July 1999, Mr. Schulman was President of the AT&T Consumer Markets Division of AT&T Corp., a telecommunications services company, and was appointed to the AT&T Operations Group, the company's most senior executive body. From March 1997 to November 1998, Mr. Schulman was President of AT&T WorldNet Service. From December 1995 to February 1997, he was Vice President, Business Services Marketing of the AT&T Business Markets Division, and from May 1994 to November 1995, Mr. Schulman was Small Business Marketing Vice President of the AT&T Business Markets Division. Mr. Schulman also serves as director of iVillage, the Global Internet Project and several charitable organizations, including INROADS and Teach for America. Michael Fischberger was appointed a director in September 1999. Mr. Fischberger has served as Senior Vice President of Domestic Telecommunications and Internet services at IDT since 1993. In this capacity, he helped build IDT's Internet business, guiding the development of IDT's sales, technical support, customer service and nationwide backbone. Mr. Fischberger currently supervises IDT's domestic products and services, which includes domestic long distance services, Internet access, calling cards and corporate services. Prior to July 1999, Mr. Fischberger managed our Phone2Phone sales, customer service and anti- fraud departments. Harry C. McPherson, Jr. was appointed a director in October 1999. Mr McPherson has been a partner in the law firm of Verner, Liipfert, Bernhard, McPherson and Hand, Chartered, since 1969. Mr. McPherson has been the President of the Economic Club of Washington since 1992. In 1993, Mr. McPherson was a member of the Defense Base Closure and Realignment Commission. From 1988 to 1992, Mr. McPherson was the Vice Chairman of the United States International Cultural and Trade Center Commission. From 1983 to 1988, Mr. McPherson was President of the Federal City Council, Washington, D.C. In 1979, Mr. McPherson was a member of the President's Commission on the Accident at Three Mile Island. From 1965 to 1969, Mr. McPherson was Counsel and then Special Counsel to the President of the United States. From 1964 to 1965, Mr. McPherson was Assistant Secretary of State for Educational and Cultural Affairs. From 1963 to 1964, Mr. McPherson was Deputy Under Secretary of the Army for International Affairs. Board of Directors and Committees of the Board Our certificate of incorporation, as amended and restated, provides that the number of members of our board of directors shall be not less than five and not more than 11. The number of directors is currently 11. Our board of directors has been divided into three classes, and each class will be kept as nearly equal in number as possible. At each annual meeting of stockholders, the successors to the class of directors whose term expires at that time will be elected to hold office for a term of three years and until their respective successors are elected and qualified. All of the officers identified above serve at the discretion of our board of directors. IDT and Clifford M. Sobel, our Chairman, have agreed to vote all of their shares in favor of the election of a director nominated by SOFTBANK Technology Ventures IV and a director nominated by either GE Capital Equity Investments or NBC, in each case for as long as either entity holds a majority of the shares of Series A convertible preferred stock originally purchased by them or the shares into which they are convertible. Gary E. Rieschel was nominated to our board by SOFTBANK. Martin J. Yudkovitz was nominated to our board by GE and NBC. On October 29, 1999 Stephen A. Oxman resigned from our board of directors. On the same date, Mr. McPherson was appointed to our board of directors to replace him. We have established an audit committee, a compensation committee and a technology committee. The members of the compensation committee are Mr. Mellor, Mr. King and Mr. Rieschel. Mr. Mellor is currently the only member of the audit committee. Mr. Balter is the initial member of the technology committee. The audit committee oversees the retention, performance and compensation of the independent public accountants, and the establishment and oversight of such systems of internal accounting and auditing control as it deems appropriate. The compensation committee reviews and approves the compensation of our executive officers, including payment of salaries, bonuses and incentive compensation, determines our compensation policies and programs, and administers our stock option plans. The technology committee reviews and evaluates current technology as it relates to our business. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Exchange Act requires the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in beneficial ownership of Common Stock and other equity securities of the Company. Directors, officers and greater than 10% stockholders are required by Securities and Exchange Commission regulations to furnish the Company with all Section 16(a) forms they file. None of the Company's directors, officers or greater than 10% stockholders were subject to the reporting requirements of Section 16(a) until the consummation of the initial public offering on July 29, 1999. To the Company's knowledge, based solely upon review of the copies of such reports furnished to the Company, all of the Company's directors, officers and greater than 10% stockholders have complied with the applicable Section 16(a) reporting requirements, except for America Online and SOFTBANK, who failed to file on a timely basis. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth information relating to the compensation paid to our Chief Executive Officer and the four other individuals who served as our executive officers at the end of fiscal 1999 who earned the most cash compensation for services rendered on our behalf. The salary and bonus information in this table includes amounts paid by IDT for services rendered to us during fiscal 1999, in that all of these officers were compensated by IDT, and not by us directly, until January 1999. All of the named executive officers listed below were compensated by IDT until January 1999. Summary Compensation Table - ---------------- (1) Mr. Balter became our Chief Executive Officer in January 1999. Compensation information for fiscal 1999 excludes compensation paid during the period in which Mr. Balter served as IDT's Chief Operating Officer and Vice Chairman. (2) Mr. Rand joined Net2Phone in January 1998. Compensation information for fiscal 1998 excludes compensation paid during the period in which Mr. Rand rendered services primarily to IDT. Option Grants During Fiscal 1999 The following table describes the options to acquire shares of our common stock that were granted to our executive officers in fiscal 1999: - ---------------- (1) Assumes that the fair market value of each grant on the date of each grant was equal to the initial public offering price of $15.00 per share. The following table describes the options to acquire shares of common stock of IDT granted to the individuals named in the summary compensation table during fiscal 1999: Value of Net2Phone Options at Year End The following table describes the value of Net2Phone options exercised in fiscal 1999 and the value of unexercised options held by the individuals named in the summary compensation table at July 31, 1999. ___________ (1) All of the exercised options described in this table were exercised on May 17, 1999, before our initial public offering. The amounts in this table assume that the fair market value of our common stock on that date was $11.00 per share, the estimated mid-point of the offering price range of our common stock set forth in the amendment to the registration statement relating to our initial public offering, which was filed on June 28, 1999. (2) The closing price of Net2Phone's common stock on July 30, 1999, as reported on the Nasdaq National Market, was $27.375 per share. Value of IDT Options at Year End The following table describes the value of IDT options exercised in fiscal 1999 and the value of unexercised options held by the individuals named in the summary compensation table at July 31, 1999: __________ (1) The closing price of IDT's common stock on July 30, 1999, as reported on the Nasdaq National Market, was $19.75 per share. Compensation of Directors Under our 1999 Stock Option and Incentive Plan, we granted options to purchase 10,000 shares of our common stock to each of our non-employee directors, other than to our non-employee directors who serve as officers or employees of IDT, at the time of our initial public offering, or at the time they joined the board. See "1999 Stock Incentive Plan." In May 1999, we granted options to purchase 120,000 shares of our common stock to each of James A. Courter and Michael Fischberger, who are currently members of our board, for $3.33 per share. We intend to reimburse the reasonable expenses incurred by our board members in attending board and committee meetings. Employment Agreements Clifford M. Sobel, our Chairman, is employed pursuant to an employment agreement that was entered into in May 1997 and amended in May 1999. The agreement commenced in September 1997 and will expire in September 2000, and will automatically be extended though September 2001 unless either we or Mr. Sobel notifies the other that the extension will not take effect. Mr. Sobel receives an annual base salary of $100,000. In January 1998, in connection with an option set forth in his employment agreement, Mr. Sobel purchased 10% of our common stock for $100,000. Mr. Sobel's employment agreement provides him with an option to transfer his interest in us to IDT in exchange for an option from IDT to purchase 875,000 registered shares of IDT common stock at a purchase price of $6.50 per share. This option is exercisable at any time from September 15, 1999 through September 15, 2000, so long as he is employed by us as of September 15, 1999 and owns and holds all of the stock he received, other than shares that he transferred to a trust for the benefit of his offspring. Mr. Sobel is prohibited by an agreement with the underwriters from exercising this option until January 25, 2000. On July 2, 1999, we signed a three-year employment agreement with Jonathan Fram, our President. After its initial term, which ends on June 30, 2002, our agreement with Mr. Fram may be renewed annually. We will pay Mr. Fram an annual base salary of $350,000 and he is entitled to receive an annual bonus calculated on the basis of our gross revenue, which bonus could be up to $100,000. Additionally, we granted Mr. Fram options to purchase 920,000 shares of our common stock under our 1999 Stock Option and Incentive Plan. Of these options, 460,000 were granted at an exercise price of $3.33, 153,333 of which are vested and exercisable. The options to purchase the remaining 460,000 shares have an exercise price of $11.00. Other than those options already vested, the remaining 766,667 options will vest in three equal annual installments, commencing on July 20, 2000. An option to purchase an additional 100,000 shares of our common stock was granted to Mr. Fram on July 28, 1999. This option is immediately exercisable and has an exercise price equal to the initial public offering price of our common stock of $15.00 per share. These options will vest immediately if we terminate Mr. Fram's employment without cause, if Mr. Fram terminates his employment for good reason, or if the options of any other employee are accelerated upon a change of control of our company. At present, none of the other named executive officers or key employees is party to an employment agreement with us. 1999 Stock Incentive Plan Our 1999 Stock Option and Incentive Plan was adopted in April 1999. Under the plan, our officers, directors, key employees and consultants, together with those of IDT and its subsidiaries, are eligible to receive awards of stock options, stock appreciation rights, limited stock appreciation rights and restricted stock. Options granted under the plan may be incentive stock options or nonqualified stock options. Stock appreciation rights and limited stock appreciation rights may be granted simultaneously with the grant of an option or, in the case of nonqualified stock options, at any time during its term. Restricted stock may be granted in addition to or in lieu of any other award made under the plan. A total of 11,040,000 shares of common stock have been authorized to date for issuance under the plan, 5,040,000 of which were granted in May 1999, and 1,420,218 of which have been exercised. 1,321,500 of these options were granted to officers, directors and employees of IDT. These options have a weighted average exercise price of $3.33 per share. In connection with loans granted to several grantees under the plan to exercise a portion of these options, 23,382 outstanding options were cancelled. Additional options to purchase 7,000 shares were cancelled in connection with the termination of the employment of five grantees. In July 1999, we granted options to purchase an additional 920,000 shares of our common stock to Jonathan Fram, our President. We granted options to purchase approximately 2,503,500 additional shares of our common stock on July 28, 1999 that have an exercise price equal to the initial public offering price of our common stock of $15.00. 307,000 of these options were granted to officers, directors and employees of IDT. In addition, we also granted on July 28, 1999 additional options to purchase 168,000 shares of our common stock to employees that have an exercise price of $3.33 per share. In October 1999, we granted options to purchase 183,250 shares of our common stock that have an exercise price of $55.25 per share. None of these options were granted to officers, directors or employees of IDT. The 1999 Stock Option and Incentive Plan is administered by the compensation committee of our board. Subject to the provisions of the plan, the board of directors or the compensation committee will determine the type of award, when and to whom awards will be granted, the number of shares covered by each award and the terms and kind of consideration payable with respect to awards. The board of directors or the compensation committee may interpret the plan and may at any time adopt the rules and regulations for the plan as it deems advisable. In determining the persons to whom awards shall be granted and the number of shares covered by each award, the board of directors or the compensation committee may take into account the duties of the respective persons, their present and potential contribution to our success and other relevant factors. Stock Options. An option may be granted on the terms and conditions as the board of directors or the compensation committee may approve, and generally may be exercised for a period of up to ten years from the date of grant. Generally, incentive stock options will be granted with an exercise price equal to the fair market value on the date of grant. Additional limitations will apply to incentive stock options granted to a grantee that beneficially holds 10% or more of our voting stock. The board of directors or compensation committee may authorize loans to individuals to finance their exercise of vested options. See "Certain Transactions--Officer Loans." Options granted under the 1999 Stock Option and Incentive Plan will become exercisable at those times and under the conditions determined by the board of directors or the compensation committee. To date, the options that have been granted to our executive officers will generally vest automatically in the event that there is a change of control of our company, if we are merged into another company or if any of these individuals are employed by a subsidiary of our company that is sold to another company. The 1999 Stock Option and Incentive Plan provides for automatic option grants to eligible non-employee directors. Options to purchase 10,000 shares of common stock have been granted to each eligible non-employee director and options to purchase 10,000 shares of common stock will be granted to each new eligible non-employee director upon the director's initial election to the board. In addition, options to purchase 10,000 shares of common stock are granted annually to each eligible non-employee director on the anniversary date of his or her election to the board. Each of these options will have an exercise price equal to the fair market value of a share of common stock on the date of grant. All options granted to non-employee directors will be immediately exercisable. All options held by non-employee directors, to the extent not exercised, expire on the earliest of: . the tenth anniversary of the date of grant; . one year following the optionee's termination of directorship other than for cause; and . three months following the optionee's termination of directorship for cause. Stock Appreciation Rights and Limited Stock Appreciation Rights. The 1999 Stock Option and Incentive Plan also permits the board of directors or the compensation committee to grant stock appreciation rights and/or limited stock appreciation rights with respect to all or any portion of the shares of common stock covered by options. Generally, stock appreciation rights and limited stock appreciation rights may be exercised only at that time as the related option is exercisable. Upon exercise of a stock appreciation right, a grantee will receive for each share for which an stock appreciation right is exercised, an amount in cash or common stock, as determined by the board of directors or the compensation committee, equal to the excess of the fair market value of a share of common stock on the date the stock appreciation right is exercised over the exercise price per share of the option to which the stock appreciation right relates. Limited stock appreciation rights may be exercised only during the 90 days following a change in control, or a merger or similar transaction, involving Net2Phone. Upon exercise of a limited stock appreciation right, a grantee will receive, for each share for which a limited stock appreciation rights is exercised, an amount in cash equal to the excess of the highest fair market value of a share of our common stock during the 90-day period ending on the date of the limited stock appreciation rights is exercised, or an amount equal to the highest price per share paid for shares of our common stock in connection with a merger or a change of control of Net2Phone, whichever is greater, over the exercise price per share of the option to which the limited stock appreciation rights relates. In no event, however, may the holder of a limited stock appreciation right granted in connection with an incentive stock option receive an amount in excess of the maximum amount that will enable the option to continue to qualify as an incentive stock option. Restricted Stock. The 1999 Stock Option and Incentive Plan also provides for the granting of restricted stock awards, which are awards of common stock that may not be disposed of, except by will or the laws of descent and distribution, for a period of time determined by the compensation committee or the board of directors. The board or the compensation committee may also impose other conditions and restrictions on the shares as it deems appropriate, including the satisfaction of performance criteria. All restrictions affecting the awarded shares will lapse in the event of a merger or similar transaction involving Net2Phone. The board may amend or terminate the 1999 Stock Option and Incentive Plan. However, as required by any law, regulation or stock exchange rule, no change shall be effective without the approval of our stockholders. In addition, no change may adversely affect an award previously granted, except with the written consent of the grantee. No awards may be granted under the 1999 Stock Option and Incentive Plan after the tenth anniversary of its initial adoption. Options and Awards Under the 1999 Stock Option and Incentive Plan. We cannot now determine the number of options or awards to be granted in the future under the 1999 Stock Option and Incentive Plan to officers, directors and employees. Compensation Committee Interlocks and Insider Participation. Our compensation committee was established in June 1999. The committee's members are James R. Mellor, who served as a director of IDT and a member of its compensation committee before joining our board, and Jesse P. King. Prior to May 1999, compensation decisions relating to our executive officers, key employees and other senior personnel were generally made by IDT, which owned 90% of our outstanding capital stock until that time. Howard S. Jonas, James A. Courter, Hal Brecher and Joyce J. Mason, each of whom are executive officers of IDT, served as directors of Net2Phone during fiscal 1999. Howard S. Balter, our Chief Executive Officer and director, served as a Chief Operating Officer, Vice Chairman and as a director of IDT until January 1999. 401(k) Plan We established a plan in October 1999 under Section 401(k) of the Internal Revenue Code for the benefit of our employees. Our executive officers are permitted to participate on the same basis as our other employees. However, we do not intend to match the contributions that our executive officers make to the plan. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information with respect to the beneficial ownership of our outstanding common stock as of November 2, 1999 by: . each person who is the beneficial owner of more than 5% of our capital stock; . each of our directors; . each of our named executive officers in the summary compensation table; and . all of our named executive officers and directors as a group. Except as otherwise indicated, all of the shares indicated in the table are shares of common stock. _________ * Less than one percent. (1) Percentage of beneficial ownership is based on 11,672,616 shares of common stock and 36,524,250 shares of Class A stock outstanding at November 2, 1999. All percentage calculations assume that all shares of Class A stock have been converted into shares of common stock. (2) All of the shares held by IDT are Class A stock. IDT has pledged its shares as collateral to secure a credit facility. The lenders under the credit facility have agreed to release IDT's shares from collateral to permit IDT to transfer our shares free and clear of any liens as and when IDT seeks to transfer our shares. Such transferability will cease if IDT's ownership of our capital stock drops below 50% of the capital stock owned by IDT 72 hours after the closing of our initial public offering. Unless IDT defaults in its obligations under the pledge agreement, it has the voting rights with respect to the pledged stock. (3) Howard S. Jonas, together with a number of entities formed for the benefit of charities and members of his family, owns shares of IDT's capital stock that enable him to vote more than 50% of IDT's capital stock. Mr. Jonas is also the Chairman and Chief Executive Officer of IDT. As a result, he may be deemed to be the beneficial owner of the shares of our capital stock owned by IDT. Mr. Jonas disclaims beneficial ownership of these shares. (4) James A. Courter, one of our directors, is the President, Vice Chairman and a director of IDT. As a result, in addition to the 36,000 shares of our common stock that he holds directly, he may be deemed to be the beneficial owner of the shares of our capital stock owned by IDT. Mr. Courter disclaims beneficial ownership of these additional shares. (5) Includes 4,415,400 shares of Class A stock held by SOFTBANK Technology Ventures IV, L.P. and 84,600 shares of Class A stock held by SOFTBANK Technology Advisors Fund L.P. (6) Gary E. Rieschel is the Executive Managing Director of SOFTBANK Technology Ventures and, as a result, he may exercise the power to vote and to dispose of the shares held by SOFTBANK. Includes 10,000 shares issuable upon exercise of presently exercisable stock options. (7) 2,250,000 of these shares are shares of Class A stock and 500,000 shares are shares of common stock. (8) Includes 1,950,000 and 300,000 shares of Class A stock held by GE Capital Equity Investments, Inc. and Snap! LLC, respectively. Also includes 155,833 and 216,500 shares of common stock held by GE Capital Equity Investments, Inc. and NBC, respectively, and 5,248 shares of common stock held by Snap. GE Capital Equity Investments, Inc. and NBC are subsidiaries of General Electric Company. Snap is primarily owned by NBC and CNET, Inc., and NBC appoints a majority of the Board of Managers of Snap. (9) Includes 10,000 shares of common stock issuable upon exercise of presently vested options held by Martin J. Yudkovitz, over which NBC has the power to direct the disposition pursuant to a nominee agreement. Mr. Yudkovitz disclaims beneficial ownership of these shares. (10) Includes 360,000 shares held of record by a trust for the benefit of Mr. Balter's family members, of which Mr. Balter and his spouse are the trustees. Also includes an aggregate of 138,000 shares held of record by trusts for the benefit of the family members of Messrs. Greenblatt, Slasky and Rothberg, for which Mr. Balter acts as trustee. Also includes 67,050 shares issuable upon exercise of presently exercisable stock options. (11) Includes 54,000 shares held of record by a trust for the benefit of Mr. Greenblatt's family members, of which Mr. Balter is the trustee. Also includes 30,000 shares issuable upon exercise of presently exercisable stock options. (12) Includes 72,000 shares held of record by a trust for the benefit of Mr. Goldberg's family members, of which Mr. Goldberg's spouse is the trustee. Also includes 30,000 shares issuable upon exercise of presently exercisable stock options. (13) Includes 54,000 shares held of record by a trust for the benefit of Mr. Rothberg's family members, of which Mr. Balter serves as the trustee. (14) Includes 22,500 shares held of record by a trust for the benefit of Mr. Rand's family members. (15) All of these shares are shares of common stock issuable upon exercise of presently exercisable options. (16) All of these shares are shares of common stock. (17) Includes the shares of Class A stock held by IDT and SOFTBANK. Also includes an aggregate of 522,883 shares issuable upon exercise of presently exercisable stock options. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS We believe that all of the transactions set forth below were made on an arms-length basis. All future transactions between us and our officers, directors, principal stockholders and affiliates will be approved by a majority of the board of directors, including a majority of the outside directors, and will continue to be on terms no less favorable to us than could be obtained from unaffiliated third parties. Relationship with IDT IDT currently owns approximately 56.2% of our capital stock. IDT owns Class A stock that has twice the voting power of our common stock. Therefore, IDT controls 64.0% of our vote. Since inception, we have received various services from IDT, including administration (accounting, human resources, legal), customer support, telecommunications and joint marketing. IDT has also provided us with the services of a number of its executives and employees. In consideration for these services, IDT has historically allocated a portion of its overhead costs related to those services to us. We believe that the amounts allocated to us have been no greater than the expenses we would have incurred if we obtained those services on our own or from unaffiliated third parties. Prior to the execution of the agreements with IDT described below, none of these services had been provided to us pursuant to any written agreement. We entered into a suite of agreements with IDT in May 1999, including an assignment agreement, a separation agreement, an IDT services agreement, a Net2Phone services agreement, a tax sharing and indemnification agreement, a joint marketing agreement and an Internet/telecommunications agreement. Assignment Agreement In connection with this agreement, IDT assigned to us certain proprietary products, information, patent applications, trademarks and related intellectual property rights used in connection with our business. IDT also licensed to us certain proprietary business information that relates to our business. We licensed back to IDT certain software that IDT will use in connection with its business. IDT Services Agreement In connection with this agreement, IDT will continue to provide us with various administrative services, including general accounting services, payroll and benefits administration and customer support. . General Accounting Services. IDT will provide us with accounts payable services and general ledger services. IDT will charge us cost plus 20% for these services. This portion of the IDT services agreement may be cancelled by either party on 30-days prior written notice and may be renewed by mutual agreement of the parties. . Payroll and Benefits Administration. IDT will administer our payroll. Until we terminate this agreement or establish our own benefit plan for our employees, our employees will continue to be covered under IDT's health insurance policies. We will pay IDT for administering our payroll and benefits plans at IDT's cost plus 20%. Additionally, we will reimburse IDT for the employer's cost of health insurance attributable to each of our employees participating in IDT's group health insurance plan and for any other direct costs attributable to our employees' participation in IDT's benefit plans. . Customer Support. IDT has agreed to provide customer support services to our customers on a cost-plus 20% basis. In the event we request additional services from IDT and IDT agrees to provide those services, we will enter into an addendum to the IDT Services Agreement covering those services. We will negotiate in good faith any fees payable to IDT for those additional services. Net2Phone Services Agreement In connection with this agreement, we will support IDT's prepaid calling card platform. Our services under this agreement include technical support for the platform, ordering lines to handle calls, managing the debit card database and monitoring the network, 24 hours per day, seven days per week. We will provide these services at the greater of cost-plus 20% and $.0025 per minute of IDT usage of the prepaid calling card platform. In addition, IDT will reimburse us for all of our direct costs in connection with the acquisition, maintenance or support of any and all additional or replacement equipment needed for the prepaid calling card platform. The Net2Phone services agreement has an initial term of one year, which automatically renews for subsequent one-year periods unless one party gives the other 30-days prior written notice. In addition, following the initial term, the Net2Phone services agreement may be terminated at any time at either party's option upon 30-days prior written notice. If IDT requests services in addition to those described in the Net2Phone services agreement and we agree to provide those services, we will enter into an addendum to the Net2Phone services agreement covering those services. We will negotiate in good faith any fees payable to us for those additional services. Tax Sharing and Indemnification Agreement In connection with this agreement, IDT and Net2Phone will share certain past tax liabilities and benefits, including: . the allocation and payment of taxes for periods during which we and our subsidiaries, if any, were included in the same consolidated group with IDT for federal income tax purposes, and are, or were, included in the same consolidated, combined or unitary returns for state, local or foreign tax purposes; . the allocation of responsibility for the filing of tax returns; . the conduct of tax audits and the handling of tax controversies; and . various related matters. For periods during which we and our subsidiaries, if any, were or are included in IDT's consolidated federal income tax returns or state, local or foreign consolidated, combined, or unitary tax returns, we are required to pay an amount of tax equal to the amount we would have paid had we and our subsidiaries, if any, had filed a tax return as a separate affiliated group of corporations filing a consolidated federal income tax return or state, local or foreign consolidated, combined, or unitary tax returns. We are responsible for our own separate tax liabilities that are not determined on a consolidated or combined basis with IDT. As a result of leaving the IDT consolidated group, certain tax attributes of the IDT group attributable to our operations, such as net operating loss carryforwards, may be allocated to us. The tax sharing and indemnification agreement obligates us, where permitted by law, to elect to carry any post- deconsolidation losses forward, rather than to carry back such losses to tax years when we were included in the IDT consolidated or combined returns. We were included in IDT's consolidated group for federal income tax purposes from our incorporation in October 1997 until May 1999 when we concluded the sale of our Series A convertible preferred stock. Each corporation that is a member of a consolidated group during any portion of the group's tax year is jointly and severally liable for the federal income tax liability of the group for that year. While the tax sharing and indemnification agreement allocates tax liabilities between us and IDT during the period on or prior to the date of this report, in which we are included in IDT's consolidated group, we could be liable in the event federal tax liability allocated to IDT is incurred, but not paid, by IDT or any other member of IDT's consolidated group for IDT's tax years that include such periods. In such event, we would be entitled to seek indemnification from IDT pursuant to the tax sharing and indemnification agreement. Joint Marketing Agreement In connection with this agreement, we agreed to: . continue to offer links to the other's Web site; . cross-sell one another's products, including through their promotional materials and customer services representatives; and . undertake additional promotions as to which the parties shall agree from time to time. IDT will pay to us a fee of $8.00 for each of our customers who becomes a new customer of IDT as a result of our referral. We will pay IDT a fee of $8.00 for each customer of IDT who becomes a new customer of ours as a result of an IDT referral. However, in either case, these fees will be payable only with respect to any new customer who incurs and pays $50.00 or more in charges. The joint marketing agreement has an initial term of one year, which automatically renews for subsequent one-year periods unless one party gives the other party 60-days prior written notice. In addition, following the initial term, the joint marketing agreement may be terminated at any time at either party's option upon 60-days prior written notice. Internet/Telecommunications Agreement IDT has granted us an indefeasible right to use portions of its current high-speed network. We have the right to terminate our right to use portions of the existing network to the extent that the existing network is replaced, the underlying leases expire or at anytime with IDT's consent. We are obligated to reimburse IDT for all termination or cancellation charges which it incurs. We have agreed to pay IDT $60,000 per month for the right to use those portions of its existing network. This amount will be reduced as IDT terminates its right to use portions of the existing network at our request. IDT also granted us an indefeasible right to use portions of a new DS3 Network, which it will have the right to use for 20 years. This grant will be effective as construction of this new network is completed and delivered to IDT. This network has been pledged by IDT to the lenders under a credit facility. We have agreed to pay IDT an installation fee of $600,000 for this network, which we will pay as each portion of the new network is delivered. We also will reimburse IDT for the one-time fee of approximately $6.0 million payable in monthly installments over a five-year period, with interest of 9% per annum. We will reimburse IDT for all of maintenance and upgrade costs incurred by IDT with respect to those portions of the network that we use. IDT has also granted us a right to use IDT's equipment and other assets at its backbone points of presence and its network operations center for a two-year period. We will pay IDT an aggregate of $1.2 million for this right over the two-year period. At the end of the two-year period, we have the right to purchase any of this equipment then owned by IDT at fair market value. We must pay for all repairs, maintenance and upgrades of equipment and other facilities we use pursuant to this agreement. IDT also has agreed to enter into transit relationship agreements with us giving us access substantially identical to IDT's at five different core locations for a period of one year commencing May 1999. Following the initial term, the transit relationship agreements may be terminated at any time at either party's option upon 60-days prior written notice. IDT retains primary control over the equipment covered by this agreement but may require assistance from us in gaining Internet access. We have agreed to assist in facilitating access for a one-year period commencing May 1999. For each month during the effectiveness of the agreement, IDT will pay us: . $1.00 for each of IDT's dial-up Internet customers; . for each dedicated-line Internet customer, the lesser of $100.00 or 20% of the fee IDT charges; and . 25% of all fees charged by IDT for installation of dedicated lines. Following the initial one year term, this agreement automatically renews for one-year periods unless one party gives the other 60-days prior written notice of termination. Separation Agreement The separation agreement with IDT provides for the following: . Releases. This agreement provides for mutual general releases between us and IDT for alleged liability to the date of the agreement, with certain limited exceptions, including liability specifically excluded by any of the other agreements between us and IDT, and liability for unpaid amounts for products or services or refunds owing on products or services due on a value-received basis for work done by one party at the request or on behalf of the other. . Indemnification by Net2Phone. We have agreed to indemnify IDT and each of IDT's directors, officers and employees from all liabilities relating to, arising out of or resulting from our failure or the failure of any other person to pay, perform or otherwise promptly discharge any of our liabilities in accordance with their respective terms, and any breach by us of the agreements between us and IDT. . Indemnification by IDT. IDT has agreed to indemnify us and each of our directors, officers and employees from all liabilities relating to, arising out of or resulting from the failure of IDT or any other person to pay, perform or otherwise promptly discharge any liabilities of IDT other than our liabilities, and any breach by IDT of the agreements between us and IDT. . Dispute Resolution. We will attempt to resolve disputes by referring controversial matters to senior management (or other mutually agreed upon) representatives of the parties. If these efforts are not successful, either party may submit the dispute to mandatory, binding arbitration. This agreement contains procedures that are intended to expedite dispute resolution, including the selection of an arbitrator and certain limitations on discovery. In the event that any dispute may be in excess of $5.0 million, or in the event that an arbitration award in excess of $5.0 million is issued, either party may submit the dispute to a court of competent jurisdiction. If the parties disagree that the amount in controversy is in excess of $5.0 million, the parties are required to submit the disagreement to arbitration. . Noncompetition; Certain Business Transactions. For a period of 36 months commencing May 1999, IDT may not directly or indirectly, engage in the provision of or developmental efforts related to Internet telephony services and voice enabling Web applications anywhere in the world or become a stockholder, partner or owner of any entity that is engaged in such business anywhere in the world. However, subject to our approval, which may not be unreasonably withheld, IDT may acquire a passive interest of up to 20% in such entity so long as IDT does not assist that entity in developing an Internet telephony business or otherwise engaging in our business. Neither we nor IDT will have any duty to communicate or offer any corporate opportunity to the other party and may pursue or acquire any such opportunity for itself or direct such opportunity to any other person. Amounts Payable to IDT Since inception, IDT has provided the funds to finance our operations in the form of advances (approximately $22.0 million as of April 30, 1999, of which we repaid $8.0 million in May 1999 and $7.0 million in August 1999). These advances have been converted into a note that is payable in 60 monthly installments of principal and interest. The balance of the note is payable in 60 monthly installments of principal and interest at a rate of 9% per annum. In addition, as of July 31, 1999, we also owed IDT approximately $3.7 million under the suite of agreements we entered to in May 1999. Relationship with Other Investors Series A Subscription Agreements Pursuant to Series A Subscription Agreements, dated as of May 13, 1999, SOFTBANK Technology Ventures IV, GE Capital Equity Investments, America Online, Access Technology Partners, Hambrecht & Quist and its affiliates and BT Alex. Brown and its affiliates, purchased from us, in the aggregate, 3,140,000 shares of Series A convertible preferred stock and warrants to purchase up to 180,000 shares of our common stock, of which warrants to purchase 44,248 shares of our common stock were exercised prior to the closing of our initial public offering. The remaining warrants to purchase 135,752 shares of our common stock terminated at the closing of our initial public offering. Additionally, a warrant to purchase 92,400 shares of our common stock was issued to Hambrecht & Quist as part of its fee as placement agent with respect to the sale of our Series A convertible preferred stock, which warrants were exercised prior to the closing of our initial public offering. In connection with the subscription agreements, we also entered into a registration rights agreement and a stockholders agreement, each of which is described below. Registration Rights Agreement The Series A investors acquired the following registration rights: . one demand for registration at any time after January 28, 1999. This demand registration right may be made by one or more holders of the Series A convertible preferred stock that own at least 50% of the shares of Class A stock into which the Series A convertible preferred stock converts. If our board of directors determines in good faith that the demand registration would be materially detrimental to us, we are entitled to postpone the filing of the registration statement otherwise required to be prepared and filed by us for a reasonable period of time, not to exceed 90 days; . piggyback registration rights if we propose to register any securities under the Securities Act in connection with any offering of our securities other than a registration statement on Form S-8 or Form S-4, subject to quantity limitations determined by underwriters if the offering involves an underwriting; and . two demand registrations at any time after we become eligible to register our securities on Form S-3 (or any successor form). Holders that beneficially own at least 20% of the shares of Class A stock into which the Series A convertible preferred stock converts may make these demands. We agreed to pay all reasonable expenses incurred in connection with any registration, filing or qualification pursuant to the Registration Rights Agreement. We also agreed, to the extent permitted by law, to indemnify the Series A investors against some liabilities in connection with the offering of the shares, including liabilities arising under the Securities Act. Stockholders Agreement IDT and Clifford M. Sobel, our Chairman, agreed to vote all of their shares in favor of the election of a director nominated by SOFTBANK Technology Ventures IV and a director nominated by GE Capital Equity Investments or NBC, in each case for as long as either entity holds a majority of the shares of Series A convertible preferred stock originally purchased by them or the shares into which they are convertible. In addition, each Series A convertible investor agreed to a lock up with respect to their shares until January 25, 2000. The Series A investors, IDT and Mr. Sobel also agreed not to transfer any of their shares to any of our competitors for a period of 36 months beginning in May 1999, and thereafter only subject to our right of first refusal. However, the stockholders agreement does permit transfers between Series A investors. Agreements with America Online and Subsidiaries Netscape We signed a series of related agreements with Netscape, a subsidiary of America Online, on January 31, 1999, allowing us to embed our software and services in future versions of Netscape's Internet browsers. The two-year term of our exclusive arrangement with Netscape commences with the beta release of the next version of Netscape's Internet browser, which we believe will occur later this year. In addition, our services will be displayed on the Netscape Netcenter site and bundled with Netscape's suite of software and software updates. We also have a right to place advertisements on Netscape's Web site. In exchange, we will pay Netscape one-time licensing fees, a percentage of revenue generated by calls provided through our co-branded service and a percentage of advertising revenue generated by a co-branded Web page. Netscape's parent company, America Online, beneficially owns approximately 5.0% of our capital stock. ICQ In July 1999, we entered into an exclusive, four-year distribution and marketing agreement with ICQ, a subsidiary of America Online. ICQ provides software that enables Internet users to contact other users on a real-time basis, and to determine whether other individuals are on-line. ICQ's software also enables Internet users to chat, send messages and files and to play Internet-based games with one another. We believe that this agreement will enable us to attract a substantial number of ICQ's users to utilize our services, which will enhance our revenue, customer base and market share. Under this agreement, ICQ has agreed to: . co-brand and promote our phone-to-phone Internet telephony services in the United States and in 19 other countries; . embed customized versions of our software on an exclusive basis to allow ICQ customers to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls; . share revenue from advertisements and sponsorships sold by ICQ on our software that is embedded in ICQ's instant messaging software; and . promote our services on some of ICQ's Web sites. We have agreed to: . pay ICQ a fee of $7.5 million, $4.0 million of which was paid at signing, and the remaining $3.5 million was paid in September 1999; . pay ICQ a share of minutes-based revenue generated through the ICQ service and award ICQ a performance bonus on the basis of the total revenue derived under the agreement; and . promote ICQ on our Web sites. ICQ has the right to terminate the exclusivity granted to us as to a particular service under the agreement under certain circumstances, including if: . the price for the service or the scope of the service offered by us to retail customers through any other distribution channel is more favorable than the corresponding service offered by Net2Phone through the ICQ service; . mutually agreed upon third party reviewers determine that the service offered by us is not competitive as to per minute rates and quality with similar services offered by a competitor of Net2Phone; or . our service is not prepared for launch in a particular country by the applicable cut-off date specified in the agreement. In addition, ICQ has the right to terminate the entire agreement under certain circumstances, including if: . two or more of our services are not competitive with those of our competitors in terms of price, and the scope and quality of service; or . if more than one of our services is not fully prepared for launch by the specified cut-off dates. If at any time after July 14, 2001, ICQ or America Online enters into a strategic relationship with any major national or international telecommunications provider for the distribution of telecommunications services using America Online and its affiliates, and if ICQ terminates the agreement and the telecommunications provider does not agree to offer all of our services that are offered under the agreement on terms comparable to those in the agreement, then ICQ will be required to pay us a termination fee of up to $60.0 million. The amount of the termination fee, if any, will depend on whether the telecommunications provider offers any of our services and the aggregate transaction revenues represented by our services that will not be offered. In connection with our distribution and marketing agreement with ICQ, we issued a warrant to America Online to purchase up to 3% of our outstanding capital stock on a fully-diluted basis. This warrant will vest in 1% increments upon the achievement of each of three incremental thresholds of revenue generated under the agreement during the first four years that the warrant is outstanding. The per share exercise price under the warrant will be equal to the lesser of $12.00 per share or $450 million divided by the number of our fully- diluted shares on the initial exercise date. The warrant may be exercised for a period of five years from the date of issuance. The warrant grants to America Online demand registration rights enabling America Online to cause us to effect two registrations and piggy-back registration rights that can be used in connection with future registrations. In addition, America Online will have the right to require us to file up to two additional registration statements relating to the shares issuable upon exercise of the warrant at such time as we shall become eligible to register these shares on Form S-3 under the Securities Act of 1933. Agreements with NBC and Snap We signed an agreement with NBC on June 25, 1999 to purchase $1.5 million in television advertising time on the NBC television network. We also have the right to purchase additional spots to be telecast prior to June 30, 2000. Additionally, on May 18, 1999, we signed a non-binding letter of intent with NBC Multimedia, an affiliate of NBC. This letter of intent contemplates a one-year agreement whereby we will pay NBC Multimedia $280,000 in exchange for the integration of our services into the NBC.com and NBC Interactive Neighborhood Web sites. NBC is a wholly-owned indirect subsidiary of the General Electric Company Group, which beneficially owns approximately 5.5% of our capital stock. On May 17, 1999, we entered into an agreement with Snap. Snap, an Internet portal service of NBC and CNET, will strategically display links to our Web site and services on its Snap.com Web site. In addition, we are their preferred provider of PC-to-phone services during the two-year term of this agreement. Snap also will deliver a preset minimum number of impressions on its site and has agreed to give us the right to a certain amount of online advertising, subject to certain conditions. In exchange, we agreed to pay Snap a one-time fee, a percentage of revenue generated through their site and bonus payments for customers delivered by Snap after meeting certain quotas. NBC, a wholly-owned indirect subsidiary of General Electric Company, together with CNET, is the primary owner of Snap. Agreements with Priceline.com In November 1999, we entered into a memorandum of understanding with priceline.com, an Internet commerce service that allows users to name their own price to purchase goods and services over the Internet. The term of our memorandum of understanding is for a period of three years. Daniel H, Schulman, the President, Chief Operating Officer and a director of priceline.com, is a member of our board of directors. Under the terms of our memorandum of understanding, we expect to offer our international and domestic Phone2Phone services as a premier provider through priceline.com, enabling priceline.com customers to name their own price to purchase blocks of minutes of our Phone2Phone services. It is expected that our Phone2Phone services will be offered for sale through priceline.com in the following manner: . domestic time blocks, where customers can name their own price for blocks of domestic long distance Phone2Phone minutes; . international time blocks, where customers can name their own price for blocks of international long distance Phone2Phone minutes to a specified country; . priceline.com's "Call Anywhere" program, where customers can name their own price for blocks of Phone2Phone minutes that can be used to call multiple designated locations; the actual amount of time purchased will vary per location. We also expect to work with priceline.com to develop an offer-by-phone service which will enable consumers to make offers to purchase Phone2Phone services from us on a per-call basis. Under the terms of the co-marketing agreement, we will participate in a co-marketing program with priceline.com through December 31, 1999. Under the terms of the memorandum of understanding, we expect to pay priceline.com the aggregate sum of $17,000,000 in increasing installment payments over a three year period. Under the terms of the co-marketing agreement, we will pay priceline.com the aggregate sum of at least $1,450,000. Facility Leases We have entered into leases for the use of our Hackensack facilities with corporations that are owned and controlled by Howard S. Jonas, a member of our board of directors and a director of IDT. Additionally, Mr. Jonas, together with a number of entities formed for the benefit of charities and members of his family, owns shares of IDT's capital stock that enable him to vote more than 50% of IDT'S capital stock. As a result, he may be deemed to be the beneficial owner of the shares of Net2Phone capital stock owned by IDT. The two Hackensack leases run for three-year terms, beginning on March 1, 1999 with monthly rent of $5,600 for 294-298 State Street and $9,912 for 171-173 Main Street. We have also entered into a sublease with IDT for our Piscataway facility, which is leased by IDT from a corporation owned and controlled by Mr. Jonas. The Piscataway sublease runs for a three-year term, beginning in May 1999, with monthly rent of $8,400. Officer Loans In May 1999, Howard S. Balter, Ilan M. Slasky, David Greenblatt, Martin Rothberg, H. Jeff Goldberg, Jonathan Reich, and Jonathan Rand, each of whom is an executive officer, borrowed $1,447,240, $352,800, $352,800, $352,800, $352,800, $98,000 and $44,100, respectively, from us. All of the proceeds of these loans were used to purchase shares of our common stock upon the exercise of stock options. The loans bear interest at the rate of 7.0% per annum, and will mature in May 2001. As a condition to receiving these loans, these officers surrendered their right to exercise 8,862, 2,160, 2,160, 2,160, 2,160, 600 and 270 immediately exercisable options, respectively. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements. The Financial Statements filed as part of this Annual Report on Form 10-K are identified in the Index to Consolidated Financial Statements on page hereto. (a) (2) Financial Statement Schedules. Financial Statement Schedules have been omitted because the information required to be set forth therein is not applicable or is shown on the financial statements or notes thereto. (a) (3) Exhibits. The following exhibits are filed herewith or are incorporated by reference to exhibits previously filed with the Commission. ________________________ ** Incorporated by reference from our registration statement on Form S-1 (Registration No. 333-59751). # Confidential treatment granted as to parts of this document. (b) Reports on Form 8-K. During Fiscal 1999 we have not filed any reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: November 4, 1999 Net2Phone, Inc. By /s/ Howard S. Balter -------------------------------------- Howard S. Balter Chief Executive Officer Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on this 4th day of November, 1999. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Net2Phone, Inc. We have audited the accompanying balance sheets of Net2Phone, Inc. (the "Company") as of July 31, 1999 and 1998, and the related statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended July 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company at July 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended July 31, 1999, in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG LLP New York, New York September 22, 1999 See accompanying notes. See accompanying notes Net2Phone, Inc. STATEMENTS OF OPERATIONS - ---------------- * Excludes depreciation and amortization. See accompanying notes. Net2Phone, Inc. Statements of Stockholders' Equity (Deficit) Years ended July 31, 1999, 1998 and 1997 Net2Phone, Inc. Statements of Cash Flows See accompanying notes Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS July 31, 1999 1. Description of Business and Basis of Presentation The accompanying financial statements reflect the historical financial information of Net2Phone, Inc. (the ''Company''), a majority owned subsidiary of IDT Corporation (''IDT''), incorporated in October 1997, to operate and develop its Internet telephony business. Prior to such time, the Company's business was conducted as a division of IDT. The incorporation of Net2Phone, Inc. as a subsidiary of IDT was accounted for similar to a recapitalization. All earnings per share calculations assume that such shares were outstanding for all prior periods. The Company's statements of operations include allocations of certain costs and expenses from IDT (Note 6). Although such allocations are not necessarily indicative of the costs that would have been incurred if the Company operated as an unaffiliated entity, management believes that the allocation methods are reasonable. 2. Pro Forma Balance Sheet On August 3, 1999, the Company completed an initial public offering of 6,210,000 shares of common stock at an initial public offering price of $15.00 per share, resulting in net proceeds of approximately $85.3 million (the ''IPO''). The accompanying Pro Forma balance sheet gives effect to the following as if they occurred on July 31, 1999: . the sale of 6,210,000 shares of common stock in the IPO; . the application of $7.0 million of the net proceeds from the IPO to pay a portion of the note payable to IDT; . the conversion of 517,839 shares of Class A stock to common stock; . the exercise of options to purchase 75,000 shares of common stock at a price of $3.33 per share and options to purchase 50,000 shares of common stock at $15.00 per share; and . the conversion of 3,140,000 shares of Series A convertible preferred stock into 9,420,000 shares of Class A stock. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates. Revenue Recognition Internet telephony service revenue is recognized as service is provided. Revenue derived from equipment sales and from services provided to IDT is recognized upon installation of the equipment and performance of the services, respectively (See Note 6). Pre-payments for communications services are deferred and recognized as revenue as the communications services are provided. 3. Summary of Significant Accounting Policies The sale of equipment with software necessary to provide the Company's services is within the scope of the American Institute of Certified Public Accountants' Statement of Position 97-2, Software Revenue Recognition. Revenue on such sales is recognized when such products are delivered, collection of payments are assured and there are no significant future obligations. Direct Cost of Revenue Direct cost of revenue consists primarily of telecommunication costs, connectivity costs, and the cost of equipment sold to customers. Direct cost of revenue excludes depreciation and amortization. Property and Equipment Equipment and furniture and fixtures are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets of five years. Computer software is amortized using the straight-line method over the shorter of five years or the term of the related agreement. Advertising Costs The Company expenses the costs of advertising as incurred. Typically the Company purchases banner advertising on other companies' web sites pursuant to contracts which have one to three year terms and may include the guarantee of (i) a minimum number of impressions, (ii) the number of times that an advertisement appears in pages displayed to users of the web site, or (iii) a minimum amount of revenue that will be recognized by the Company from customers directed to the Company's Web site as a direct result of the advertisement. The Company recognizes expense with respect to such advertising ratably over the period in which the advertisement is displayed. In addition, some agreements require additional payments as additional impressions are delivered. Such payments are expensed when the impressions are delivered. In one case, the Company entered into an agreement with no specified term of years. In this case, the Company amortizes as expense the lessor of (i) the number of impressions to date/minimum guaranteed impressions, or (ii) revenue to date/minimum guaranteed revenue as a percentage of the total payments (See Note 9). For the years ended July 31, 1999, 1998, and 1997, advertising expense totaled approximately $6,590,000, $1,962,000, and $6,000, respectively. Software Development Costs Costs for the internal development of new software products and substantial enhancements to existing software products are expensed as incurred until technological feasibility has been established, at which time any additional costs would be capitalized. As the Company has completed its software development concurrently with the establishment of technological feasibility, it has commenced capitalizing these costs. Software development costs are the Company's only research and development expenditures. For the years ended July 31, 1999, 1998 and 1997, research and development costs totaled approximately $757,000, $481,000 and $473,000, respectively. Capitalized Internal Use Software Costs The Company capitalizes certain costs incurred in connection with developing or obtaining internal use software. These costs consist of payments made to third parties and the salaries of employees working on such software development. At July 31, 1999 and 1998, the Company has capitalized $4,065,000, and $2,198,000, respectively, of internal use software costs as computer software. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents are carried at cost which approximates market value. Trademark Costs associated with obtaining the right to use trademarks owned by third parties are capitalized and amortized on a straight-line basis over the term of the trademark. Income Taxes The Company accounts for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities. Stock Based Compensation The Company accounts for stock options issued to employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (''APB 25''). Compensation expense for stock options issued to employees is measured as the excess of the quoted market price of the Company's stock at the date of grant over amount an employee must pay to acquire the stock. Stock options issued to employees of IDT are accounted for in accordance with Financial Accounting Standards Board Statement (''SFAS'') No. 123, Accounting for Stock-Based Compensation. Compensation expense for stock options issued to employees of IDT is measured based on the fair value of the stock options on the grant date estimated using the Black-Scholes option pricing model. The Company applies the disclosure-only provisions of SFAS No. 123 with respect to stock options issued to the Company's employees. In March 1999, the Financial Accounting Standards Board issued an exposure draft of an interpretation on APB 25 containing proposed rules designed to clarify its application. The proposed rules included in the exposure draft are expected to be formally issued prior to December 31, 1999 and become effective at the time they are issued. The proposed rules would generally be applicable to events that occur after December 15, 1998. Consequently, if the exposure draft is enacted in the form currently proposed, the new rules would apply to all stock options granted by the Company in fiscal 1999. Earnings (Loss) Per Share Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to common shares by the weighted average of common shares outstanding during the period. Diluted earnings (loss) per share adjusts basic earnings (loss) per share for the effects of convertible securities, stock options and other potentially dilutive financial instruments, only in the periods in which such effect is dilutive. There were no dilutive securities in any of the periods presented herein. Current Vulnerability Due to Certain Concentrations Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, and trade receivables. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base. Management regularly monitors the creditworthiness of its domestic and international customers and believes that it has adequately provided for any exposure to potential credit losses. Long-Lived Assets In accordance with SFAS No. 121, Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to be Disposed Of, the Company reviews the impairment of long-lived assets and certain identifiable intangibles whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The analysis of the recoverability utilizes undiscounted cash flows. The measurement of the loss, if any, will be calculated as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Segment Disclosures SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, was issued in June 1997. This statement requires use of the "management approach" model for segment reporting. The management approach model is based on the way a company's management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregate a company. As the Company operates in one segment, the adoption of the statement in fiscal 1999 did not have any impact on its financial statements. 4. Property and Equipment Property and equipment consists of the following: 5. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share: The following securities have been excluded from the dilutive per share computation as they are antidilutive: The following table sets forth the computation of pro forma basic and diluted loss per common share for the year ended July 31, 1999, assuming conversion of the redeemable preferred shares to shares of common stock on their date of issuance. 6. Related Party Transactions In May 1999, the Company and IDT entered into a separation agreement whereby the transactions and agreements necessary to govern the relationship between the two companies necessary to effect their separation were determined. In accordance with such agreement, it was determined that amounts paid by IDT in excess of $22 million would be deemed to be capital contributions. In May 1999, the Company and IDT entered into an Internet/telecommunications agreement whereby the Company has agreed to pay IDT up to $110,000 per month for connectivity, the use of certain computer software and equipment owned or leased by IDT and to provide a platform for IDT's Internet services for a monthly per customer charge. In connection with such agreement, IDT has also granted the Company an indefeasible right, for a period of 20 years, to use a certain telecommunications network as it is completed and delivered for up to approximately $6.0 million. In May 1999, the Company and IDT entered into two one-year services agreements whereby the Company agreed to pay IDT for certain administrative, customer support and other services that IDT provides to it at the cost of such services plus 20%. Also, in conjunction with such agreements, the Company has agreed to provide IDT with certain support services for the cost of such services plus 20%. The agreement is effective for a period of two years. In May 1999, the Company and IDT entered into a joint marketing agreement whereby the companies have agreed to jointly advertise and market their products. The agreement continues for a term of one year and is automatically renewable for an additional one year unless terminated by either party. In conjunction with such agreement, a commission will be earned by each company for new customers generated by the other company as a result of such programs. In May 1999, the Company and IDT entered into an assignment agreement whereby IDT assigned all of its rights in certain trademarks, patents and proprietary products and information to the Company. These assets were contributed at IDT's historical cost which was $0. The accompanying financial statements for periods prior to the signing of the aforementioned agreements include charges by IDT to the Company for the aforementioned services. Such charges were based principally upon the Company's allocable portion of IDT's costs for such services. The ratios used to allocate these costs were the Company's total payroll and the Company's total revenue to IDT's total payroll and revenue, depending on the type of services provided. The allocated costs approximate the amounts that would have been charged under the inter-company agreements if they had been in effect during such periods. For the years ended July 31, 1999, 1998, and 1997, the Company recognized revenue for services provided to IDT of approximately $2,578,000, $498,000, and $297,000, respectively. At July 31, 1999 and 1998, the due to IDT balance represents the net amounts owed to IDT as a result of the aforementioned agreements and financing. No interest was charged on the Company's advances from IDT. The average balance owed to IDT during the years ended July 31, 1999 and 1998, were $14,775,000 and $7,388,000, respectively. On May 12, 1999, the Company converted a portion of its liability to IDT into a $14,000,000 promissory note. Such promissory note accrues interest at a rate of 9% per annum and is payable in 60 equal monthly installments of principal and interest. Notwithstanding the foregoing, $7,000,000 in principal was repaid in August 1999 with the proceeds of the IPO. The activity in the intercompany account with IDT was as follows: 7. Income Taxes The Company will file a consolidated Federal income tax return with IDT through May 13, 1999 and has entered into a tax sharing agreement with IDT. Pursuant to such tax sharing agreement, the Company would, while included in the IDT consolidated tax return, be reimbursed for the use of its tax losses to the extent IDT realizes a tax reduction from the use of such tax losses. In May 1999 IDT's ownership interest in the Company fell below 80% and as a result the Company will no longer be a part of the IDT consolidated Federal tax group. Significant components of the Company's deferred tax assets and liabilities consists of the following: The net deferred tax assets have been fully offset by a valuation allowance due to the uncertainty of the realization of the assets. At July 31, 1999, the Company had net operating loss carryforwards for federal income tax purposes of approximately $8.0 million expiring in years through 2019 and for state income tax purposes of approximately $16 million expiring in years through 2006. These net operating loss carryforwards may be limited to future taxable earnings of the Company. 8. Stockholders' Equity (Deficit) Initial Public Offering On August 3, 1999, the Company completed an initial public offering of 6,210,000 shares of common stock at an initial public offering price of $15.00 per share, resulting in net proceeds of approximately $85.3 million. Series A Stock On May 13, 1999, the Company designated 3,150,000 shares of its preferred stock as Series A ("Series A Stock") and sold 3,140,000 of such shares to unrelated third parties in a private placement transaction for aggregate gross proceeds of $31,400,000. The Series A Stock entitled its holders to a non-cumulative dividend of 8% per annum on the original issue price. Each share of Series A Stock was convertible into three shares of Class A stock at the option of the holder, subject to certain adjustments, as defined. The Series A Stock was redeemable at the option of the holder, beginning May 2006, over a period of 3 years. The Series A Stock contained beneficial conversion features. The total value of the beneficial conversion feature approximated $75 million. For accounting purposes the value of the beneficial conversion features was limited to the amount of proceeds allocated to the Series A Stock. The Company recorded an increase in net loss available to common stockholders on the date of issuance of the Series A Stock in the amount of approximately $29.2 million. In connection with the sale of Series A Stock, the Company granted warrants to purchase 272,400 shares of common stock at an exercise price of $3.33 per share, subject to certain adjustments as defined, from the date of issuance through May 13, 2004 to the Series A Stock investors and placement agent. The warrants contained a provision whereby they were automatically terminated upon a merger or sale of the Company or an initial public offering of the Company's stock. In July 1999, 136,648 warrants were exercised. The unexercised warrants expired unexercised upon the Company's IPO in August 1999. The fair value of the warrants on the date of issuance was $2.1 million. This was computed using the Black Scholes model with the following assumptions: the fair value of the common stock equal to $11.00 per share, the risk free interest rate of 4.79%, volatility factor of 84%, an expected life of 6 months, and a dividend yield of 0%. The fair value of the warrants was recorded as an increase to additional paid-in capital and a decrease to the carrying value of the Series A Stock. The decrease in the carrying value of the Series A Stock was accreted with a reduction of additional paid-in capital over the period to the initial redemption date in May 2006. In connection with the Company's IPO, the Series A convertible preferred stock was converted into Class A stock. In August 1999 upon the consummation of the IPO the balance of the unamortized discount was recorded as a reduction of the amount of income available for common shareholders. Stock Options In April 1999, the Company adopted a stock option and incentive plan (the "Plan"). Pursuant to the Plan, the Company's officers, employees and non- employee directors, as well as those of IDT, are eligible to receive awards of incentives and non-qualified stock options, stock appreciation rights, limited stock appreciation rights and restricted stock. In the fourth quarter of fiscal 1999, the Company granted options to purchase 8,821,500 shares of common stock at exercise prices ranging from $3.33 to $15.00 per share to employees of the Company and employees of IDT. The options generally vest over periods up to four years and expire ten years from the date of grant. In connection with the exercise of such options, the Company extended $3,149,900 of recourse loans to employees. In order to obtain the loans, optionees agreed to the cancellation of 23,382 outstanding options. Deferred compensation resulting from the issuance of the stock options of approximately $49.8 million is being charged to expense over the vesting period of the stock options as follows: fiscal 1999, $17.9 million; fiscal 2000, $11.8 million; fiscal 2001, $11.8 million; and fiscal 2002, $8.3 million. A summary of stock option activity under the Company's stock option plan is as follows: The following table summarizes the status of the stock options outstanding and exercisable at July 31, 1999: The weighted average fair value of options granted was $9.99 for the year ended July 31, 1999. Pro forma information regarding net loss and loss per share has been determined as if the Company had accounted for employee stock options under the fair value method. The fair value of the stock options was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions for vested and non-vested options: The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics that are significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. For the year ended July 31, 1999, pro forma net loss available to common stockholders and pro forma net loss per common share amounted to approximately $66,050,383 and $2.11, respectively. Stock Split and Class A Stock On June 25, 1999, the Company effectuated a three-for-one stock split. The financial statements give retroactive effect to the stock split. In addition, the Company designated 15,000,000 shares of its capital stock as Class A stock. The holders of Class A stock are identical to those of common stock except for voting and conversion rights and restrictions on transferability. The Class A stock is entitled to two votes per share. 9. Commitments On February 8, 1998, the Company entered into an agreement with an Internet company to develop a link between its Internet site and that of the Company and advertise Company products on such site. The agreement is effective for fifteen months upon the completion of the link and automatically extends for an additional one year unless terminated by either party. Pursuant to such agreement, the Company has made payments of $3.3 million through July 31, 1999 for the design, development, installation and implementation of the link as well as the placement of Company advertisements on the Internet company's site, of which $750,000 attributable to the establishment of such link was deferred and is being amortized over the term of the agreement and $2.4 million attributable to monthly payments for advertising and the maintenance of the link was expensed monthly as incurred. As of July 31, 1999, the Company was required to make an additional payment of $150,000 in fiscal 1999 and pay certain future commissions, as defined, based upon revenue earned and usage of the link. On August 4, 1998, the Company entered into an agreement with an Internet company to advertise Company products on the Internet company's site. The agreement is effective as of October 1, 1998, the launch date of the link, and extends indefinitely until the Internet company fully provides all advertising impressions guaranteed under the agreement. Pursuant to such agreement, the Company has made payments of $646,000 through July 31, 1999 for Company advertisements on such site. The Company is required to make additional payments of $975,000 in fiscal 2000, and $167,000 in fiscal 2001 and pay certain future commissions, as defined, based upon revenue earned and usage of the link. Under this agreement the Company records expenses equal to the lesser of (i) the number of impressions to date/minimum guaranteed impressions, or (ii) revenue to date/minimum guaranteed revenue as a percentage of the total payments. On February 19, 1999, the Company entered into an agreement under which an international computer company is to provide connections to its global network. These connections will allow worldwide transport of the Company's IP traffic. The agreement is effective for 63 months upon availability of the connections. Pursuant to such agreement, the Company has made payments of $1 million through July 31, 1999 which have been reflected on the balance sheets as prepaid contract deposits. As of July 31, 1999, the Company is required to make an additional payment of $1 million when the connections are available and pay fees for additional connections and usage. The $2 million of prepayments will be amortized over the term of the agreement beginning at the time the connections are available for use. On January 31, 1999, the Company entered into a series of agreements with a third party. The agreements call for the bundling of the Company's Internet telephony products with the third party's Internet browser, the purchase of software from the third party and the use of the third party's trademark. The agreements require the Company to pay the third party (i) $5,000,000 for the use of the trademark, (ii) $8,000,000 for the purchase of software and (iii) commissions on revenues generated from customers that the Company obtains from the bundling of products. Through July 31, 1999, the Company had paid $1.5 million for the right to use the trademark and $8 million for certain software. The Company has capitalized the costs of the right to use the trademark and the software costs and will amortize them over the term of the bundling agreement, which expires two years after the release of the bundled product. The Company has distribution agreements under which it has agreed to pay its agents commissions for obtaining new Internet telephony customers. The agreements require commissions upon activation of the customers. In May 1997, the Company entered into a three year employment agreement with one of its officers. Under the terms of such agreement, which was amended in May 1999, the Company agreed to, among other things, provide such officer with an annual salary of $100,000 and the right to purchase a 10% interest in the Company for $100,000, which was the fair market value of the Company at that time. Such right, which includes an anti-dilutive provision mandating that the officer's ownership interest cannot be diluted below 8% of the total outstanding shares upon consummation of an initial public offering of the Company's common stock, was exercised during fiscal 1998. Such agreement is automatically renewable on an annual basis after its initial three year term unless terminated by either party. In March 1999, the Company entered into two lease agreements with companies which are owned by the Chairman, Chief Executive Officer and Treasurer of IDT. Pursuant to such lease agreements, the Company is required to make equal monthly rental payments aggregating $558,000 to such companies through February 2002. The Company entered into an agreement with Snap, an Internet portal service of NBC and CNET, on May 17, 1999. Snap will display links to the Company's Web site and services on its Snap.com Web site. In addition, the Company is Snap's preferred provider of PC-to-phone services during the two-year term of this agreement. Snap also will deliver a preset minimum number of impressions on its site and agreed to give the Company the right to advertise on its Snap.com Web site, subject to certain conditions. In exchange, the Company agreed to pay Snap a one-time fee, a percentage of revenue generated through their site and bonus payments for customers delivered by Snap of $2,000,000 after meeting certain quotas. The Company will amortize the up front payment over the term of the agreement. The Company signed an agreement with NBC on June 25, 1999 to purchase $1.5 million in television advertising on the NBC television network. The Company also has the right to purchase additional spots to be telecast prior to June 30, 2000. The cost of the advertising will be expensed as the spots are shown. On July 15, 1999, the Company entered into a four-year distribution and marketing agreement with ICQ, a subsidiary of America Online. Under this agreement, ICQ has agreed to co-brand and promote the Company's Internet telephony services in the U.S. and in 19 other countries, embed customized versions of the Company's software to allow ICQ customers to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls, share revenue from advertisements and sponsorships sold by ICQ on the Company's software that is embedded in ICQ's Instant Messenger software, and promote the Company's services on some of ICQ's Web sites. The Company agreed to pay ICQ a fee of $7.5 million, $4.0 million of which was paid at signing, and the remainder of which was paid in September 1999. The Company also agreed to pay ICQ a share of minutes-based revenue generated through ICQ and to award ICQ a performance bonus on the basis of the total revenue derived under the agreement, and to promote ICQ on the Company's Web sites. In connection with the Company's distribution and marketing agreement with ICQ, the Company issued a warrant to America Online to purchase up to 3% of the Company's outstanding capital stock on a fully-diluted basis. This warrant will vest in 1% increments upon the achievement of each of three incremental thresholds of revenue generated under the agreement during the first four years that the warrant is outstanding. The per share exercise price under the warrant will be equal to the lesser of 80% of the price per share in the Company's initial public offering, or $450 million dividend by the number of the Company's fully-diluted shares on the initial exercise date. The warrant may be exercised for a period of five years from the date of issuance. On July 2, 1999 the Company signed a three-year employment agreement with its new President. After the initial term, the agreement may be renewed annually. The Company will pay its President an annual base salary of $350,000 and he is entitled to receive an annual bonus calculated on the basis of the Company's gross revenue, which bonus could be up to $100,000. The Company granted its President options to purchase 920,000 shares of its common stock under its 1999 Stock Option and Incentive Plan. Of these options, 460,000 were granted at an exercise price of $3.33 per share, 153,333 of which are vested and exercisable. The options to purchase the remaining 460,000 shares were granted at $11.00 per share. Other than those options which are vested, the remaining 766,667 options will vest in three equal annual installments, commencing on July 20, 2000. The Company recorded compensation in connection with the issuance of the options with an exercise price less than the fair market value of the stock over the vesting period. 10. Customer and Geographical Area Revenues from customers outside the United States represented approximately 44%, 72%, and 62% of total revenues during the years ended July 31, 1997, 1998 and 1999, respectively. During the year ended July 31, 1998, revenues derived from equipment sales to a customer in Korea represented approximately 14% of total revenue. No single geographic area accounted for more than 10% of total revenue during the years ended July 31, 1999 and 1997. No customer accounted for more than 10% of revenue during the years ended July 31, 1999 and 1997.

1094093_1999.txt

1094093_1999

1999

1094093

ITEM 1. BUSINESS - ------- -------- GENERAL - ------- COMPANY - ------- Carolina Power & Light Company (the Company), whose principal executive offices are located at 411 Fayetteville Street, Raleigh, North Carolina is a full service energy provider formed under the laws of North Carolina in 1926 and is an exempt holding company as defined by the Public Utility Holding Company Act of 1935. The Company is primarily engaged in the generation, transmission, distribution and sale of electricity in portions of North and South Carolina, and the transmission, distribution and sale of natural gas in portions of North Carolina. The Company provides these and other services through its business segments: electric, natural gas and other. The electric segment generates, transmits, distributes and sells electricity to 56 of the 100 counties in North Carolina, and 14 counties in northeastern South Carolina. The territory served is an area of 33,667 square miles, including a substantial portion of the coastal plain of North Carolina extending to the Atlantic coast between the Pamlico River and the South Carolina border, the lower Piedmont section of North Carolina, an area in northeastern South Carolina and an area in western North Carolina in an around the city of Asheville. The estimated total population of the territory served is approximately 4.2 million. At December 31, 1999, the electric segment was providing electric services, retail and wholesale, to 1.2 million customers. The electric segment is subject to the rules and regulations of the Federal Energy Regulatory Commission (FERC), the North Carolina Utilities Commission (NCUC) and the Public Service Commission of South Carolina (SCPSC). The natural gas segment transmits, distributes and sells gas to approximately 167,000 thousand customers in 110 towns and cities and four municipal gas distribution systems. The area served includes substantial portions of south-central and eastern North Carolina. The natural gas segment also purchases and transports natural gas under long-term contracts with Transcontinental Gas Pipe Line Corporation (Transco), Columbia Gas Transmission Corporation (Columbia) and several major oil and gas producers. Natural gas operations are subject to the rules and regulations of the NCUC. The other segment primarily includes telecommunication services, energy management services, propane and miscellaneous non-regulated activities. These services are primarily provided through two of the Company's subsidiaries, Strategic Resource Solutions Corp. (SRS) and Interpath Communications, Inc. (Interpath). SRS specializes in facilities and energy management software, systems and services for educational, commercial, industrial and governmental markets nationwide. Interpath is a telecommunications company primarily engaged in providing comprehensive network services. The Company holds franchises to the extent necessary to operate its regulated electric and natural gas operations in the municipalities and other areas it serves. SIGNIFICANT TRANSACTIONS - ------------------------ On July 15, 1999, the Company completed the acquisition of North Carolina Natural Gas Corporation (NCNG), now operating as a wholly owned subsidiary. Each outstanding share of NCNG common stock was converted into the right to receive 0.8054 shares of Company common stock, resulting in the issuance of approximately 8.3 million shares. The acquisition was accounted for as a purchase and, accordingly, the operating results of NCNG have been included in the Company's consolidated financial statements since the date of acquisition. See PART II, ITEM 7, "Other Matters." The Company, Florida Progress Corporation (FPC), a Florida corporation, and CP&L Energy, Inc. (CP&L Energy), a North Carolina corporation and wholly owned subsidiary of the Company formerly known as CP&L Holdings, Inc. entered into an Amended and Restated Agreement and Plan of Share Exchange dated as of August 22, 1999, amended and restated as of March 3, 2000 (the "Amended Agreement"). The transaction is expected to be completed in the fall of 2000. See PART II, ITEM 7, "Other Matters." The Company is in the process of converting to a holding company structure, in which the Company would become a subsidiary of a newly formed holding company. The holding company structure will allow for greater organizational flexibility, and will provide the ability to conduct financing activities at the holding company level. See PART II, ITEM 7, "Other Matters." FINANCIAL INFORMATION - --------------------- During 1999, the Company's operating revenues totaled $3.4 billion of which $3.1 billion was related to the electric segment, $98.9 million to the natural gas segment and $119.9 million to the other segment. During 1999, 34% of electric revenues were derived from residential sales, 22% from commercial sales, 22% from industrial sales, 13% from wholesale sales and 9% from other sources. Of such operating revenues, approximately 67% were derived from North Carolina retail customers, 13% from South Carolina retail customers, 13% from North Carolina wholesale customers, less than 0.5% from South Carolina wholesale customers and 7% from sales to other utilities and other customers. For the revenues related to the natural gas segment, 50% of the revenues were derived from industrial sales while the remaining sales were evenly distributed among residential, commercial, electric utilities and wholesale customers, all in North Carolina. The operating revenues for the other segment primarily include revenues of two of the Company's subsidiaries, SRS and Interpath. For additional information see PART II, ITEM 7, "Results of Operations" and PART II, ITEM 8, "Note 5." BUSINESS ACTIVITIES - ------------------- GENERATING CAPABILITY - --------------------- 1. FACILITIES. At December 31, 1999, the Company had a total system installed generating capability (including the North Carolina Eastern Municipal Power Agency's (Power Agency) share) of 10,128 megawatts (MW), with generating capacity provided primarily from the installed generating facilities listed in the table below. The remainder of the Company's generating capacity is composed of 53 coal, hydro and combustion turbine units ranging in size from a 2.5 MW hydro unit to a 78 MW coal-fired unit. Pursuant to certain agreements with the Company, Power Agency has acquired undivided ownership interests of 18.33% in Brunswick Unit Nos. 1 and 2, 12.94% in Roxboro Unit No. 4 and 16.17% in Harris Unit No. 1 and Mayo Unit No. 1. Of the total system installed generating capability of 10,128 MW, 53% is coal, 31% is nuclear, 2% is hydro and 14% is fired by other fuels including No. 2 oil, natural gas and propane. 2. MAINTENANCE OF PROPERTIES. The Company maintains all of its properties in good operating condition in accordance with sound management practices. The average life expectancy for ratemaking and accounting purposes of the Company's generating facilities (excluding combustion turbine units and hydro units) is approximately 40 years from the date of commercial operation. 3. GENERATION ADDITIONS SCHEDULE The Company's energy and load forecasts were revised in December 1999. Over the next ten years, system internal sales growth is forecasted to average approximately 2.8% per year and annual growth in system internal peak demand is projected to average approximately 2.8%. The Company's generation additions schedule provides for the addition of approximately 2,872 MW of combustion turbine capacity and 2,406 MW of combined cycle capacity over the period 2000 to 2009 in order to meet the needs of its growing customer base and increase its ability to participate in the wholesale power market. The Company may alter its long-term plans based on changes in load forecasts, market conditions, and other factors. In addition, see PART I, ITEM 1 "Interconnections with Other Systems" and PART I, ITEM 1, "Competition" for discussion of the Company's long-term purchase power contracts. On August 18, 1998 the Company filed with the NCUC an application for a Certificate of Public Convenience and Necessity to construct an additional 177 MW of combustion turbine capacity adjacent to the Company's Lee Steam Electric Plant in Wayne County, North Carolina and a second 160 MW combustion turbine unit at the Company's Asheville Steam Electric Plant in Buncombe County, North Carolina. The Wayne County Turbine is in addition to the 500 MW of combustion turbine capacity for which the Company received a Certificate of Public Convenience and Necessity on March 21, 1996. These units will primarily be used during periods of summer and winter peak demands. By order issued December 17, 1998, the NCUC granted the Company a Certificate to construct both units. Construction of the combustion turbines began during the first quarter of 1999. Commercial operation was anticipated to begin in June 2000 for both units; however, the Asheville combustion turbine became operational in February 2000, three months ahead of schedule. On March 19, 1999, the Company filed with the NCUC an application for a Certificate of Public Convenience and Necessity to construct 1600 MW of combustion turbine generating capacity between two sites, one in Rowan County and a site in Richmond County. The NCUC granted the certificate on November 11, 1999. Construction of the combustion turbine in Rowan county began November 15, 1999 and the construction of the combustion turbine in Richmond county began February 1, 2000. During 1999, the Company invested approximately $47.5 million in new generating plant facilities. 4. PEAK DEMAND. An instantaneous system peak demand record of 10,948 MW was reached on August 11, 1999. At the time of this peak demand, the Company's capacity margin, based on installed capacity (less unavailable capacity) and scheduled firm purchases and sales, was approximately 5.22%. Total system peak demand increased for 1997 by 2.2%, for 1998 by 5.0% and for 1999 by 4.0% as compared with the preceding year. The Company currently projects that system peak demand will increase at an average annual growth rate of approximately 2.8% over the next ten years. The year-to-year change in actual peak demand is influenced by the specific weather conditions during those years and may not exhibit a consistent pattern. Total system load factors, expressed as the ratio of the average load supplied to the peak load demand, were 60.6% for 1997, 60.1% for 1998, and 58.2% for 1999. The Company forecasts capacity margins of 10.5% over anticipated system peak load for 2000 and 10.6% for 2001. This forecast assumes normal weather conditions in each year consistent with long-term experience, and is based upon the rated Maximum Dependable Capacity of generating units in commercial operation and scheduled firm purchases of power. However, some of the generating units included in arriving at these capacity margins may be unavailable as a result of scheduled and unplanned outages. INTERCONNECTIONS WITH OTHER SYSTEMS - ----------------------------------- 1. INTERCONNECTIONS. The Company also has major interconnections with the Tennessee Valley Authority (TVA), Appalachian Power Company (APCO), Virginia Power, South Carolina Electric and Gas Company (SCE&G), South Carolina Public Service Authority (SCPSA) and Yadkin, Inc. (Yadkin). In addition, the Company, on occasion, will reserve daily to hourly transmission on Duke Energy's (Duke) system under the transmission tariff in order to accommodate the peak demand in the western control area. 2. INTERCHANGE AND POWER PURCHASE/SALE AGREEMENTS. ----------------------------------------------- a) The Company has interchange agreements with APCO, SCE&G, SCPSA, TVA, Virginia Power and Yadkin which provide for the purchase and sale of power for hourly, daily, weekly, monthly or longer periods. In addition to the interchange agreements, the Company has executed individual purchase agreements and sales agreements with more than 100 companies beyond the Virginia-Carolinas Subregion described in paragraph 2b below. Purchases and sales under these agreements may be made due to economic or reliability considerations. In June 1999, the Company terminated Schedule G to the Interchange Agreement between the Company and Duke. Schedule G provided for the wheeling of electricity between the Company's eastern area and its western area. On December 31, 1999, the Company terminated the Standby Concurrent Exchange Agreement (Standby Agreement) between the Company and Duke. The Standby Agreement provided for the simultaneous exchange of up to 70 MW of electricity during periods of scheduled maintenance or breakdown. On December 31, 1996, pursuant to the Federal Energy Regulatory Commission (FERC) Order 888, which directs that no bundled economy energy coordination transactions occur after December 31, 1996, the Company submitted to the FERC a compliance filing to unbundle transmission charges from rate schedules that are applicable to the power sales agreements between the Company and others. See PART I, ITEM 1, "Competition," for further discussion of the FERC Order 888. b) The Virginia-Carolinas Subregion of the Southeastern Electric Reliability Council is principally made up of the Company, Duke, Nantahala Power & Light Company, SCE&G, SCPSA, Virginia Power, Southeastern Power Administration and Yadkin. Electric service reliability is promoted by arrangements among the members of electric reliability organizations at the subregional level. 3. LONG-TERM PURCHASE POWER CONTRACTS. ----------------------------------- a) From July 1993 through June 1999, Duke provided 400 MW of firm capacity to the Company's system. The Company terminated this contract in 1999. Purchases under this agreement, including transmission use charges, totaled $33.8 million in 1999. b) The Company has an agreement, which has been approved by the FERC, with APCO and Indiana Michigan Power Company (Indiana Michigan), operating subsidiaries of American Electric Power Company, to upgrade transmission interconnections in the Company's western and eastern service areas and purchase 250 MW of generating capacity from Indiana Michigan's Rockport Unit No. 2 through 2009. Upgrades to the transmission interconnections in the Company's western and eastern service area were completed in 1992 and 1998, respectively. The estimated minimum annual payment for power purchases under the agreement is approximately $31 million, representing capital-related capacity costs. In 1999, purchases under this agreement, including transmission use charges, totaled $59.5 million. c) In 1996, the Company agreed with Cogentrix of North Carolina, Inc. and Cogentrix Eastern Carolina Corporation (collectively referred to as Cogentrix) to amend electric power purchase agreements related to five plants owned by Cogentrix. The amendments, which became effective on September 26, 1996, permit the Company to dispatch the output of the five plants. In return, the Company gave up its right to purchase two of the five plants in 1997. As a result of the amendments, the Company expects to realize energy cost savings through the expiration of the agreement in 2002. d) In December 1998, the Company entered into an agreement to purchase all of the output of a combustion turbine project to be built, owned, and operated by Broad River Energy, LLC, in Cherokee County, South Carolina. The project is scheduled to be in service on or before June 1, 2001 and is expected to have a net dependable capacity of approximately 500 MW. The agreement is for an initial period of 15 years, with an option for the Company to extend the agreement for two additional five-year terms. During the term of the agreement, the Company will have full rights to the output of the project as well as control over the scheduling of the units. 4. POWER AGENCY. Pursuant to the terms of a 1981 Power Coordination Agreement, as amended, between the Company and Power Agency, the Company is obligated to purchase a percentage of Power Agency's ownership capacity of, and energy from, the Harris Plant through 2007. The estimated minimum annual payments for these purchases, which reflect capital-related capacity costs, total approximately $26 million. Purchases under this agreement totaled $36.5 million in 1999. COMPETITION - ----------- 1. GENERAL. In recent years, the electric utility industry has experienced a substantial increase in competition at the wholesale level, caused by changes in federal law and regulatory policy. Several states have also decided to restructure aspects of retail electric service. The issue of retail restructuring and competition is being reviewed by a number of states and bills have been introduced in Congress that seek to introduce such restructuring in all states. Allowing increased competition in the generation and sale of electric power will require resolution of many complex issues. One of the major issues to be resolved is who will pay for stranded costs. Stranded costs are those costs and investments made by utilities in order to meet their statutory obligation to provide electric service, but which could not be recovered through the market price for electricity following industry restructuring. The amount of such stranded costs that the Company might experience would depend on the timing of, and the extent to which, direct competition is introduced, and the then-existing market price of energy. If electric utilities were no longer subject to cost-based regulation and it were not possible to recover stranded costs, the financial position and results of operations of the Company could be adversely affected. 2. WHOLESALE COMPETITION. Since passage of the National Energy Act of 1992 (Energy Act), competition in the wholesale electric utility industry has significantly increased due to a greater participation by traditional electricity suppliers, wholesale power marketers and brokers, and due to the trading of energy futures contracts on various commodities exchanges. This increased competition could affect the Company's load forecasts, plans for power supply and wholesale energy sales and related revenues. The impact could vary depending on the extent to which additional generation is built to compete in the wholesale market, new opportunities are created for the Company to expand its wholesale load, or current wholesale customers elect to purchase from other suppliers after existing contracts expire. To assist in the development of wholesale competition, the FERC, in 1996, issued standards for wholesale wheeling of electric power through its rules on open access transmission and stranded costs and on information systems and standards of conduct (Orders 888 and 889). The rules require all transmitting utilities to have on file an open access transmission tariff, which contains provisions for the recovery of stranded costs and numerous other provisions that could affect the sale of electric energy at the wholesale level. The Company filed its open access transmission tariff with the FERC in mid-1996. Shortly thereafter, Power Agency and other entities filed protests challenging numerous aspects of the Company's tariff and requesting that an evidentiary proceeding be held. The FERC set the matter for hearing and set a discovery and procedural schedule. In July 1997, the Company filed an offer of settlement in this matter. The administrative law judge certified the offer to the full FERC in September 1997. The offer is pending before the FERC. The Company cannot predict the outcome of this matter. On December 20, 1999, the FERC issued a rule on Regional Transmission Organizations (RTO) that sets forth four minimum characteristics and eight functions for transmission entities, including independent system operators and transmission companies, to become FERC-approved RTOs. The rule states that public utilities that own, operate or control interstate transmission facilities must file by October 15, 2000, either a proposal to participate in an RTO or an alternative filing describing efforts and plans to participate in an RTO. The Company plans to participate in an RTO and anticipates complying with this filing requirement. 3. RETAIL COMPETITION. The Energy Act prohibits the FERC from ordering retail wheeling - transmitting power on behalf of another producer to an individual retail customer. Several states have changed their laws and regulations to allow full retail competition. Other states are considering changes to allow retail competition. These changes and proposals have taken differing forms and included disparate elements. The Company believes changes in existing laws in both North and South Carolina would be required to permit competition in the Company's retail jurisdictions. 4. NORTH CAROLINA ACTIVITIES. In April 1997, the North Carolina General Assembly approved legislation establishing a 23-member study commission to evaluate the future of electric service in the state. During 1998, the study commission met and held public hearings around the state. The study commission also retained consultants to conduct analyses and studies concerning various restructuring issues, including stranded costs, state and local tax implications and electric rate comparisons. In June 1998, the study commission issued an interim report to the 1998 North Carolina General Assembly, summarizing the numerous fact-finding and educational activities and analytical projects the study commission had initiated or completed. That report offered no judgments or recommendations. In May 1999, the North Carolina General Assembly approved legislation that expanded the study commission from 23 to 29 members. All 29 study commission members were appointed by August 1999. The study commission conducted several meetings during August through November to discuss the reports regarding deregulation issues prepared by the Research Triangle Institute at the request of the study commission. During those meetings, several entities, including the Company and Duke, presented proposals for addressing the nearly $6 billion debt of North Carolina's Municipal Power Agencies. The study commission resumed meeting in January 2000. On March 8, 2000, the commission co-chairs presented draft recommendations regarding electric industry restructuring to the full study commission for its consideration in preparing its report to the North Carolina General Assembly. Key recommendations in the draft include (i) electric retail competition should begin in North Carolina no later than June 30, 2006; (ii) recovery of utilities' stranded costs should not be extended beyond June 30, 2006; and (iii) the generation and distribution of assets of the municipal power agencies (including Power Agency) should be sold no later than June 30, 2002, and the funds from those sales should be used to pay off a portion of the municipal power agencies' debt. The draft recommendations also address issues related to the legislative timetable, consumer protection measures, environmental concerns, tax laws, and transmission and distribution. Implicit in recommendation is a rate freeze through the year 2006. Initial comments on the draft recommendations were due on March 10, 2000. The Company and other interested parties submitted comments. The draft recommendations will serve as a starting point for preparation of the study commission's report addressing industry restructuring in the State of North Carolina. The recommendations and related issues will be debated and discussed at future study commission meetings. The commission is expected to make a final report to the North Carolina General Assembly in the spring of 2000. The Company cannot predict the outcome of this matter. 5. SOUTH CAROLINA ACTIVITIES. The 1999 session of the South Carolina General Assembly adjourned in June 1999 without approving any legislation regarding electric industry restructuring. On October 29, 1998, the South Carolina Senate Judiciary Committee appointed a 13-member task force to study the restructuring issue and make a report to the Senate. The task force was subsequently expanded to 18 members, including the Company. The task force, including its various committees, has conducted several meetings to receive input from various experts and interested parties and to discuss issues related to restructuring. The House Public Utility Subcommittee is expected to continue considering the electric industry restructuring bills that were introduced in 1999, and the Senate task force is expected to continue to consider the issue of restructuring during the South Carolina General Assembly's 2000 legislative session. The Company cannot predict the outcome of these matters. 6. FEDERAL ACTIVITIES. During 1999, over 20 bills were introduced in Congress regarding electric industry restructuring. A draft bill passed the House Commerce Subcommittee on October 27, 1999. This bill will proceed to full Commerce Committee consideration in the first quarter of 2000 where it is expected to be changed significantly. The Company cannot predict the outcome of this matter. 7. COMPANY ACTIVITIES. The developments described above have created changing markets for energy. As a strategy for competing in these changing markets, the Company is becoming a total energy provider in the region by providing a full array of energy-related services to its current customers and expanding its market reach. The Company took a major step towards implementing this strategy, by entering into the Amended Agreement with FPC. In December 1998, the Company entered into an agreement to purchase all of the output of a combustion turbine project to be built, owned and operated by Broad River Energy, LLC (BRE), in Cherokee County, South Carolina. In conjunction with this agreement, the Company agreed to provide bridge financing to BRE under a Financing Term Sheet. This financing will be used by BRE to (i) make payments to Duke Energy in connection with certain electrical interconnection agreements, (ii) purchase two generator step up transformers and (iii) acquire land for the Broad River Energy Center Project. Under the terms of this agreement, the Company agreed to loan BRE up to $20.5 million that will be due on July 1, 2000. In addition, in August of 1999 the Company agreed to loan Broad River Investors, LLC up to $84.5 million that will be due on July 1, 2000 to finance the purchase of the combustion turbines for the project. Interest on each of the loans is calculated based on the London Inter-Bank Offer Rate, LIBOR, plus a spread of 1%. In August 1999, the Company signed a five-year agreement with Municipal Electric Authority of Georgia (MEAG) pursuant to which MEAG will receive the full output of a 160 MW combustion turbine owned and operated by Monroe Power Company, a wholly owned subsidiary of the Company. Headquartered in Atlanta, Georgia, MEAG represents 48 municipal electric utilities in Georgia and is part owner of four generating facilities and the Georgia Integrated Transmission System. In August 1999, the Company signed an off-system wholesale peaking power sales agreement with Santee Cooper. The Company will provide up to 150 MW of additional peaking power for a one-year term from June 2001 to May 2002, to help meet the increasing demand in Santee Cooper's fast-growing service area. In October 1999, the Company and the Albemarle-Pamlico Economic Development Corporation (APEC) announced their intention to build an 850-mile natural gas transmission and distribution system to 14 currently unserved counties in eastern North Carolina. The Company will operate both the transmission and distribution systems and APEC will help ensure that the new facilities are built in the most advantageous locations to promote development of the economic base in the region. In conjunction with this proposal, the Company and APEC filed a joint request with the NCUC for $186 million of a $200 million state bond package established for clean water and natural gas infrastructure. If granted, these funds will be used to pay for the portion of the project that likely could not be recovered from future gas customers through rates. The Company plans to invest an additional $11.5 million, thus bringing the total cost of the project to $197.5 million. As proposed, the project is scheduled to be developed in phases through 2003. The NCUC has established a procedural schedule with hearings regarding the first phase of the project to be conducted in April 2000. An order is expected mid-2000. The Company cannot predict the outcome of this matter. In December 1999, the Company announced plans to build a 30-inch natural gas pipeline in North Carolina that will extend approximately 82 miles from Williams Energy's Transcontinental interstate pipeline in Iredell County to Richmond County. The pipeline will provide gas for the Company's planned new power plant in Richmond County and is scheduled to be completed during the spring of 2001. The pipeline is expected to cost approximately $100 million and will accommodate extension of natural gas service to future Company power plants and normal load growth on NCNG's system. This pipeline plan replaces a plan for a 175-mile pipeline, the Palmetto Pipeline that the Company and Southern Natural Gas Company, a subsidiary of El Paso Energy, had been assessing. As a regulated entity, the Company is subject to the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS-71). Accordingly, the Company records certain assets and liabilities resulting from the effects of the ratemaking process, which would not be recorded under generally accepted accounting principles for unregulated entities. The Company's ability to continue to meet the criteria for application of SFAS-71 may be affected in the future by competitive forces and restructuring in the electric utility industry. In the event that SFAS-71 no longer applied to a separable portion of the Company's operations, related regulatory assets and liabilities would be eliminated unless an appropriate regulatory recovery mechanism is provided. Additionally, these factors could result in an impairment of electric utility plant assets as determined pursuant to Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." CAPITAL REQUIREMENTS - -------------------- CAPITAL REQUIREMENTS. During 1999, the Company expended approximately $862 million for capital requirements. Estimated capital requirements for 2000 through 2002 primarily reflect construction expenditures to add generation, transmission and distribution facilities, as well as upgrade existing facilities. Those capital requirements are reflected in the following table (in millions): The table includes expenditures of approximately $311 million expected to be incurred at fossil-fueled electric generating facilities to comply with the Clean Air Act. In addition, the Company has total projected cash requirements of approximately $565 million over the years 2000 through 2002 relating to expenditures in other areas such as affordable housing investments and merchant generation. These projections are periodically reviewed and may change significantly. FINANCING REQUIREMENTS - ---------------------- 1. FINANCING REQUIREMENTS. The proceeds from the issuance of commercial paper and/or internally generated funds financed the retirement of long-term debt totaling $113 million in 1999. In addition, the issuance of $500 million extendible notes in October 1999, financed the retirement of $100 million of extendible commercial notes and reduced the outstanding commercial paper balance. External funding requirements, which do not include early redemptions of long-term debt, redemption of preferred stock or issuances in conjunction with acquisitions, are expected to approximate $490 million, $580 million and $640 million in 2000, 2001 and 2002, respectively. These funds will be required for construction, mandatory retirements of long-term debt and general corporate purposes. The amount and timing of future sales of Company securities will depend upon market conditions and the specific needs of the Company. The Company may from time to time sell securities beyond the amount needed to meet capital requirements in order to allow for the early redemption of long-term debt, the redemption of preferred stock, the reduction of short-term debt or for other general corporate purposes. 2. SEC FILINGS. i) The Company has on file with the Securities and Exchange Commission (SEC) a shelf registration statement (File No. 333-69237) under which first mortgage bonds, senior notes and other debt securities are available for issuance by the Company. As of December 31, 1999, the Company had $600 million available under this shelf registration. ii) The Company has on file with the SEC a shelf registration statement (File No. 33-5134) enabling the Company to issue up to $180 million of Serial Preferred Stock. 3. ISSUANCES OF BONDS, PREFERRED STOCK AND DEBENTURES. --------------------------------------------------- External financings during 1999 included: i) The issuance on March 5, 1999 of $400 million principal amount of Senior Notes, 5.95% Series due on March 1, 2009. The net proceeds were used to reduce the outstanding balance of commercial paper and for other general corporate purposes. ii) In October 1999, the Company issued $500 million of unsecured Extendible Notes with a final maturity of October 28, 2009, and an initial reset period from October 28, 1999 to July 28, 2000 at an interest rate to be reset and payable on a monthly basis at a rate equal to the one month LIBOR plus a spread of 0.33%. The net proceeds from this issuance were used to reduce commercial paper borrowings and other short-term indebtedness. 4. REDEMPTIONS/RETIREMENTS OF BONDS, PREFERRED STOCK AND DEBENTURES. ---------------------------------------------------------------- Redemptions and retirements during 1999 included: i) The retirement on July 1, 1999 of $50 million principal amount of First Mortgage Bonds, Medium Term Notes, 7.15% Series B, which matured on that date. ii) The redemption on August 9, 1999 of $25 million principal amount of, 9.21% Debentures Series C, due November 15, 2011 on behalf of NCNG. iii) The redemption on August 13, 1999 of $30 million principal amount of, 7.15% Debentures Series, due November 15, 2015 on behalf of NCNG. 5. CREDIT FACILITIES. As of December 31, 1999, the Company's revolving credit facilities totaled $750 million, all of which are long-term agreements. The Company is required to pay minimal annual commitment fees to maintain its credit facilities. Consistent with management's intent to maintain its commercial paper, pollution control revenue refunding bonds (pollution control bonds) and other short-term indebtedness on a long-term basis, and as supported by its long-term revolving credit facilities, the Company included in long-term debt commercial paper, pollution control bonds and other short-term indebtedness outstanding of approximately $363 million, $56 million and $331 million, respectively, as of December 31, 1999. Commercial paper and pollution control bonds outstanding of approximately $488 million and $56 million, respectively, were reclassified as long-term debt as of December 31, 1998. See PART II, ITEM 8, "Consolidated Financial Statements and Supplementary Data," Note 6, for a more detailed discussion of the Company's revolving credit facilities. 6. COMMERCIAL NOTES. In September 1999, the Company established a $150 million extendible commercial notes program. As of December 31, 1999, there were no extendible commercial notes outstanding. 7. CREDIT RATINGS. The Company's access to outside capital depends on its ability to maintain its credit ratings. The Company's credit ratings are as follows: The following is a summary of the meanings of the ratings shown above and the relative rank of the Company's rating within each agency's classification system. Duff and Phelps' top four bond ratings (AAA, AA, A and BBB) are considered "investment grade." Debt that is rated "A" is considered upper grade securities which possess adequate protection factors but risk factors that are more variable in periods of economic stress. Duff and Phelps may use a plus (+) or minus (-) sign to designate the relative position of a credit within the rating category. Moody's top four bond ratings (Aaa, Aa, A and Baa) are generally considered "investment grade." Obligations that are rated "A" possess many favorable investment attributes and are considered as upper medium grade obligations. Factors giving security to principal and interest are considered adequate but elements may be present which suggest a susceptibility to impairment sometime in the future. A numerical modifier ranks the security within the category with a "2" indicating the mid-range. Standard & Poor's top four bond ratings (AAA, AA, A and BBB) are considered "investment grade." Debt rated "A" has a strong capacity to pay interest and repay principal although it is somewhat more susceptible to the adverse effects of changes in economic conditions than debt in higher rated categories. Standard & Poor's may use a plus (+) or minus (-) sign after ratings to designate the relative position of a credit within the rating category. Duff and Phelps' top three commercial paper ratings (D-1, D-2 and D-3) are generally considered "investment grade." Issuers rated "D-1" have a very high certainty of timely payment, liquidity factors are excellent and risk factors are minor. Moody's top three commercial paper ratings (P-1, P-2 and P-3) are generally considered "investment grade." Issuers rated "P-1" have a superior ability for repayment of senior short-term debt obligations and repayment ability is often evidenced by a conservative structure, broad margins in earnings coverage of fixed financial charges and well established access to a range of financial markets and assured sources of alternate liquidity. Standard & Poor's commercial paper ratings are a current assessment of the likelihood of timely payment of debt having an original maturity less than 365 days. The top three Standard & Poor's commercial paper ratings (A-1, A-2 and A-3) are considered "investment grade." Issues rated "A-1" indicate that the degree of safety regarding timely payment is either overwhelming or very strong. Those issues determined to possess overwhelming safety are denoted with a plus (+) sign designation. RETAIL RATE MATTERS - ------------------- 1. GENERAL. The Company is subject to regulation in North Carolina by the NCUC and in South Carolina by the SCPSC with respect to, among other things, rates and service for electric energy sold at retail, retail service territory and issuances of securities. The Company is also subject to regulation in North Carolina by the NCUC with respect to rates and service for the transmission, distribution, and sale of natural gas in portions of North Carolina. 2. ELECTRIC RETAIL RATES. The rates of return granted to the Company in its most recent general rate cases are as follows: 3. NATURAL GAS RATES. On October 27, 1995, the NCUC issued its Order granting a general rate increase amounting to $4.2 million in annual revenues effective November 1, 1995. The Commission's Order approved, in all material respects, the Stipulation of Settlement reached among NCNG, the NCUC Public Staff, which represents the using and consuming public, the Carolina Utility Customers Association, Inc. (CUCA) and other intervenors in the rate case. The Order provides for a rate of return on net investment of 10.09% but, pursuant to the Stipulation of Settlement, did not state separately the rate of return on common equity nor the capital structure used to calculate revenue requirements. 4. OTHER RETAIL RATE MATTERS. Pursuant to authorizations from the NCUC and the SCPSC, the Company began to accelerate the amortization of certain regulatory assets over a three-year period beginning January 1997 and expiring December 1999. The accelerated amortization of these regulatory assets resulted in additional depreciation and amortization expenses of approximately $68 million in each year of the three-year period. In 1996, the NCUC also authorized the Company to defer operation and maintenance expenses of approximately $40 million associated with Hurricane Fran, with amortization over a 40-month period, which expired December 1999. In late 1998 and early 1999, the Company filed, and the respective commissions subsequently approved, proposals in the North and South Carolina retail jurisdictions to accelerate cost recovery of its nuclear generating assets beginning January 1, 2000 and continuing through 2004. The accelerated cost recovery begins immediately after the 1999 expiration of the accelerated amortization of certain regulatory assets, which began in January 1997. Pursuant to the orders, the Company's depreciation expense for nuclear generating assets will increase by a minimum of $106 million up to a maximum of $150 million per year. Recovering the costs of the nuclear generating assets on an accelerated basis will better position the Company for the uncertainties associated with potential restructuring of the electric utility industry. In conjunction with the acquisition, the Company and NCNG signed a joint stipulation agreement with the Public Staff of the NCUC in which the Company agreed to cap base retail electric rates, exclusive of fuel costs, with limited exceptions, through December 2004, and NCNG agreed to cap margin rates for gas sales and transportation services, with limited exceptions, through November 1, 2003. Management is of the opinion that this agreement will not have a material effect on the consolidated results of operations or financial position of the Company. 5. INTEGRATED RESOURCE PLANNING. Integrated resource planning is a process that systematically compares all reasonably available resources, both demand-side and supply-side, in order to develop that mix of resources that allows a utility to meet customer demand in a cost-effective manner, giving due regard to system reliability, safety and the environment. In the past, utilities were required to file their Integrated Resource Plans (IRP) with the NCUC and the SCPSC once every three years. The Company regularly reviews its IRP in light of changing conditions and evaluates the impact these changes have on its resource plans, including purchases and other resource options. During 1998, the NCUC and SCPSC substantially altered their IRP rules. Both the NCUC and SCPSC reduced the amount of information that must be included in the Company's IRP. The NCUC also eliminated the triennial IRP and now requires an annual filing. 6. FUEL COST RECOVERY. ------------------ a) In the North Carolina retail jurisdiction, the NCUC establishes base fuel costs in general rate cases and holds hearings annually to determine whether a rider should be added to base fuel rates to reflect increases or decreases in the cost of fuel and the fuel cost component of purchased power as well as changes in the fuel cost component of sales to other utilities. The NCUC considers the changes in the Company's cost of fuel during a historic test period ending March 31 of each year and corrects any past over- or under-recovery. On June 3, 1999, the Company filed its 1999 fuel cost recovery application. The NCUC issued a final order approving the Company's proposed billing fuel factor of 1.057 cents/kWh on September 9, 1999. This new factor became effective on September 15, 1999. On October 8, 1999, CUCA appealed the Commission's decision. b) In the South Carolina retail jurisdiction, fuel rates are set by the SCPSC. At the fuel hearings, any past over- or under-recovery of fuel costs is taken into account in establishing the new rate. The Company's fuel hearing was held on March 24, 1999 and by order issued April 1, 1999, the SCPSC approved the Company's proposed continuation of the existing fuel factor of 1.122 cents/kWh. 7. AVOIDED COST PROCEEDINGS. In 1998, the NCUC opened Docket No. E-100, Sub 81 for its biennial proceeding to establish the avoided cost rates for all electric utilities in North Carolina. Avoided cost rates are intended to reflect the costs that utilities are able to "avoid" by purchasing power from qualifying facilities. The Company's initial filing in this docket was made on November 6, 1998. Intervenor comments on the utilities' filings were filed January 15, 1999, and a hearing for non-expert public witnesses was held on February 2, 1999. By order issued July 16, 1999, the NCUC approved the Company's proposed avoided cost rates. WHOLESALE RATE MATTERS - ---------------------- The Company is subject to regulation by the FERC with respect to rates for transmission and sale of electric energy at wholesale, the interconnection of facilities in interstate commerce (other than interconnections for use in the event of certain emergency situations), the licensing and operation of hydroelectric projects and, to the extent the FERC determines, accounting policies and practices. The Company and its wholesale customers last agreed to a general increase in wholesale rates in 1988; however, wholesale rates have been adjusted since that time through contractual negotiations. ENVIRONMENTAL MATTERS - --------------------- 1. GENERAL. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes and other environmental matters, the Company is subject to regulation by various federal, state and local authorities. The Company considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations and believes it has all necessary permits to conduct such operations. Environmental laws and regulations constantly evolve and the ultimate costs of compliance cannot always be accurately estimated. The capital costs associated with compliance with pollution control laws and regulations at the Company's existing fossil facilities that the Company expects to incur from 2000 through 2002 are included in the estimates under PART I, ITEM 1, "Capital Requirements." 2. CLEAN AIR LEGISLATION. The 1990 amendments to the Clean Air Act require substantial reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fueled electric generating plants. The Clean Air Act required the Company to meet more stringent provisions effective January 1, 2000. The Company will meet the sulfur dioxide emissions requirements by maintaining sufficient sulfur dioxide emission allowances. Installation of additional equipment was necessary to reduce nitrogen oxide emissions. Increased operation and maintenance costs, including emission allowance expense, installation of additional equipment and increased fuel costs are not expected to be material to the consolidated financial position or results of operations of the Company. The EPA has been conducting an enforcement initiative related to a number of coal-fired utility power plants in an effort to determine whether modifications at those facilities were subject to New Source Review requirements or New Source Performance Standards under the Clean Air Act. The Company has recently been asked to provide information to the EPA as part of this initiative and has cooperated in providing the requested information. The EPA has initiated enforcement actions which may have potentially significant penalties against other companies that have been subject to this initiative. The Company cannot predict the outcome of this matter. On October 27, 1998, the EPA published a final rule addressing the issue of regional transport of ozone. This rule is commonly known as the NOx SIP call. The EPA's rule requires 22 states, including North and South Carolina, to further reduce nitrogen oxide emissions in order to attain a pre-set state NOx emission level by May 2003. The EPA's rule also suggests to the states that these additional nitrogen oxide emission reductions be obtained from the utility sector. The Company is evaluating necessary measures to comply with the rule and estimates its related capital expenditures through 2003 could be approximately $327 million, a portion of which is reflected in the "Capital Requirements" discussion under PART II, ITEM 7, "Liquidity and Capital Resources." Increased operation and maintenance costs relating to the NOx SIP call are not expected to be material to the Company's results of operations. The Company and the states of North and South Carolina have been participating in litigation challenging the NOx SIP call. On March 3, 2000, a three-judge panel of the District of Columbia Circuit Court of Appeals upheld the EPA's NOx SIP call. Further appeals are being considered. The Company cannot predict the outcome of this matter. The EPA published a final rule approving certain petitions under the Clean Air Act that requires certain sources to make reductions in nitrogen oxide emissions by 2003. The Company's fossil-fueled electric generating plants in North Carolina are included in these petitions. The Company and other states are participating in litigation challenging the EPA's actions. The Company cannot predict the outcome of this matter. 3. SUPERFUND. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA), authorize the EPA to require the clean up of hazardous waste sites. This statute imposes retroactive joint and several liability. Some states, including North and South Carolina, have similar types of legislation. There are presently several sites with respect to which the Company has been notified by the EPA or the State of North Carolina of its potential liability, as described below in greater detail. Various organic materials associated with the production of manufactured gas, generally referred to as coal tar, are regulated under various federal and state laws. There are several manufactured gas plant (MGP) sites to which both the electric utility and the gas utility have some connection. In this regard, the electric utility and the gas utility, along with others, are participating in a cooperative effort with the North Carolina Department of Environment and Natural Resources, Division of Waste Management (DWM), which has established a uniform framework to address MGP sites. The investigation and remediation of specific MGP sites will be addressed pursuant to one or more Administrative Orders on Consent (AOC) between the DWM and the potentially responsible party or parties. Both the electric utility and the gas utility have signed AOCs to investigate certain sites. Both the electric utility and the gas utility continue to identify parties connected to individual MGP sites, and to determine their relationships to other parties at those sites and the degree to which the Company will undertake efforts with others at individual sites. The Company does not expect the costs associated with these sites to be material to the consolidated financial position or results of operations of the Company. The Company is periodically notified by regulators such as the North Carolina Department of Environment and Natural Resources, the South Carolina Department of Health and Environmental Control, and the U.S. Environmental Protection Agency (EPA) of its involvement or potential involvement in sites, other than MGP sites, that may require investigation and/or remediation. Although the Company may incur costs at these sites about which it has been notified, based upon current status of these sites, the Company does not expect those costs to be material to the consolidated financial position or results of operations of the Company. 4. OTHER ENVIRONMENTAL MATTERS. The Company has filed claims with its general liability insurance carriers to recover costs arising out of actual or potential environmental liabilities. Some claims have been settled, and others are still being pursued. The Company cannot predict the outcome of these matters. NUCLEAR MATTERS - --------------- 1. GENERAL. Under the Atomic Energy Act of 1954 and the Energy Reorganization Act of 1974, as amended, operation of nuclear plants is intensively regulated by the Nuclear Regulatory Commission (NRC), which has broad power to impose nuclear safety and security requirements. In the event of noncompliance, the NRC has the authority to impose fines, set license conditions, or shut down a nuclear unit, or some combination of these, depending upon its assessment of the severity of the situation, until compliance is achieved. The electric utility industry in general has experienced challenges in a number of areas relating to the operation of nuclear plants, including: substantially increased capital outlays for modifications; the effects of inflation upon the cost of operations; increased costs related to compliance with changing regulatory requirements; renewed emphasis on achieving excellence in all phases of operations; unscheduled outages; outage durations; and uncertainties regarding disposal facilities for low-level radioactive waste and storage facilities for spent nuclear fuel. See paragraphs below. The Company experiences these challenges to varying degrees. Capital expenditures for modifications at the Company's nuclear units, excluding Power Agency's ownership interests, during 2000, 2001 and 2002 are expected to total approximately $41 million, $80 million and $29 million, respectively (including AFUDC). 2. SPENT FUEL AND OTHER HIGH-LEVEL RADIOACTIVE WASTE. The Nuclear Waste Policy Act of 1982 (Nuclear Waste Act) provides the framework for development by the federal government of interim storage and permanent disposal facilities for high-level radioactive waste materials. The Nuclear Waste Act promotes increased usage of interim storage of spent nuclear fuel at existing nuclear plants. The Company will continue to maximize the use of spent fuel storage capability within its own facilities for as long as feasible. As of December 31, 1999, sufficient on-site spent nuclear fuel storage capability is available for the full-core discharge of Brunswick Unit No. 1 through 2001, Brunswick Unit No. 2 through 2000, Robinson Unit No. 2 through 2000 and Harris through 2002 assuming normal operating and refueling schedules. The spent fuel storage facilities at the Brunswick and Robinson Units along with the Harris Plant spent fuel storage facilities are sufficient to provide storage space for spent fuel generated by all of the Company's nuclear generating units through the expiration of their current operating licenses, provided that currently idle storage space at the Harris Plant can be activated. On December 23, 1998, the Company submitted a license amendment application to the NRC requesting approval to activate and begin using the additional spent fuel storage at the Harris Plant. The Company is maintaining full-core discharge capability for the Brunswick Units and Robinson Unit No. 2 by transferring spent nuclear fuel by rail to the Harris Plant. As a contingency to the shipment by rail of spent nuclear fuel, during April 1989, the Company filed an application with the NRC for the issuance of a license to construct and operate an independent spent fuel storage facility for the dry storage of spent nuclear fuel at the Brunswick Plant. At the Company's request, the NRC suspended review of the Company's license application based on the success of the Company's shipping efforts. The NRC will resume review of the license upon notification by the Company of its desire to continue the application process. Subsequent to the expiration of the licenses, dry storage may be necessary in conjunction with the decommissioning of the units. Pursuant to the Nuclear Waste Act, the Company, through a joint agreement with the U.S. Department of Energy (DOE) and the Electric Power Research Institute, has built a demonstration facility at the Robinson Plant that allows for the dry storage of 56 spent nuclear fuel assemblies. The Company cannot predict the outcome of these matters. As required under the Nuclear Waste Policy Act of 1982, the Company entered into a contract with the U.S. Department of Energy (DOE) under which the DOE agreed to begin taking spent nuclear fuel by no later than January 31, 1998. All similarly situated utilities were required to sign the same standard contract. In April 1995, the DOE issued a final interpretation that it did not have an unconditional obligation to take spent nuclear fuel by January 31, 1998. In Indiana & Michigan Power v. DOE, the U.S. Court of Appeals vacated the DOE's final interpretation and ruled that the DOE had an unconditional obligation to begin taking spent nuclear fuel. The Court did not specify a remedy because the DOE was not yet in default. After the DOE failed to comply with the decision in Indiana & Michigan Power v. DOE, a group of utilities (including the Company) petitioned the U.S. Court of Appeals in Northern States Power (NSP) v. DOE, seeking an order requiring the DOE to begin taking spent nuclear fuel by January 31, 1998. The DOE took the position that their delay was unavoidable, and the DOE was excused from performance under the terms and conditions of the contract. The Court of Appeals issued an order that precluded the DOE from treating the delay as an unavoidable delay. However, the Court of Appeals did not order the DOE to begin taking spent nuclear fuel, stating that the utilities had a potentially adequate remedy by filing a claim for damages under the contract. After the DOE failed to begin taking spent nuclear fuel by January 31, 1998, a group of utilities (including the Company) filed a motion with the U.S. Court of Appeals to enforce the mandate in NSP v. DOE. Specifically, the utilities asked the Court to permit the utilities to escrow their waste fee payments, to order the DOE not to use the waste fund to pay damages to the utilities, and to order the DOE to establish a schedule for disposal of spent nuclear fuel. The Court denied this motion based primarily on the grounds that a review of the matter was premature and that some of the requested remedies fell outside of the mandate in NSP v. DOE. Subsequently, a number of utilities each filed an action for damages in the Court of Claims and before the Court of Appeals. The Company is in the process of evaluating whether it should file a similar action for damages. In NSP v. United States, the United States Court of Claims decided that NSP must pursue its administrative remedies instead of filing an action in the Court of Claims. NSP has filed an interlocutory appeal to the U.S. Court of Appeals based on NSP's position that the Court of Claims has jurisdiction to decide the matter. A group of utilities (including the Company) has submitted an amicus brief in support of NSP's position. The Company also continues to monitor legislation that has been introduced in Congress which might provide some limited relief. The Company cannot predict the outcome of this matter. With certain modifications and additional approval by the NRC, the Company's spent nuclear fuel storage facilities will be sufficient to provide storage space for spent fuel generated on the Company's system through the expiration of the current operating licenses for all of the Company's nuclear generating units. Subsequent to the expiration of these licenses, dry storage may be necessary. The Company has initiated the process of obtaining the additional NRC approval. 3. LOW-LEVEL RADIOACTIVE WASTE. Disposal costs for low-level radioactive waste that result from normal operation of nuclear units have increased significantly in recent years and are expected to continue to rise. Pursuant to the Low-Level Radioactive Waste Policy Act of 1980, as amended in 1985, each state is responsible for disposal of low-level waste generated in that state. States that do not have existing sites may join in regional compacts. The States of North and South Carolina were participants in the Southeast Regional Compact and disposed of waste at a disposal site in South Carolina along with other members of the compact. Effective July 1, 1995, South Carolina withdrew from the Southeast regional compact and excluded North Carolina waste generators from the existing disposal site in South Carolina. As a result, the State of North Carolina does not have access to a low-level radioactive waste disposal facility. The North Carolina Low-Level Radioactive Waste Management Authority, which is responsible for siting and operating a new low-level radioactive waste disposal facility for the Southeast regional compact, has submitted a license application for the site it selected in Wake County, North Carolina to the North Carolina Division of Radiation Protection. In December 1997, the Southeast Regional Compact Commission suspended funding for the proposed low-level radioactive waste facility in Wake County. The future funding for this project remains uncertain. Although the Company does not control the future availability of low-level waste disposal facilities, the cost of waste disposal or the development process, it supports the development of new facilities and is committed to a timely and cost-effective solution to low-level waste disposal. The Company's nuclear plants in North Carolina are currently storing low-level waste on site and are developing additional storage capacity to accommodate future needs. The Company's nuclear plant in South Carolina has access to the existing disposal site in South Carolina. Although the Company cannot predict the outcome of this matter, it does not expect the cost of providing additional on-site storage capacity for low-level radioactive waste to be material to the consolidated financial position or results of operations of the Company. 4. DECOMMISSIONING. ---------------- a) Pursuant to an NRC rule, licensees of nuclear facilities are required to submit decommissioning funding plans to the NRC for approval to provide reasonable assurance that the licensee will have the financial ability to implement its decommissioning plan for each facility. The rule requires licensees to do one of the following: prepay at least an NRC-prescribed minimum amount immediately; set up an external sinking fund for accumulation of at least that minimum amount over the operating life of the facility; or provide a surety to guarantee financial performance in the event of the licensee's financial inability to perform actual decommissioning. On July 26, 1990, the Company submitted its decommissioning funding plans to the NRC. In June 1991, the Company began depositing funds into an external trust as a vehicle to achieve such decommissioning funding. In the Company's retail jurisdictions, provisions for nuclear decommissioning costs are approved by the NCUC and the SCPSC and are based on site-specific estimates that included the costs for removal of all radioactive and other structures at the site. In the wholesale jurisdiction, the provisions for nuclear decommissioning costs are based on amounts agreed upon in applicable rate agreements. Decommissioning cost provisions, which are included in depreciation and amortization expense, were $33.3 million, $33.3 million, and $33.2 million in 1999, 1998, and 1997, respectively. Accumulated decommissioning costs, which are included in accumulated depreciation, were $568.0 million and $496.3 million at December 31, 1999 and 1998, respectively. These costs include amounts retained internally and amounts funded in an external decommissioning trust. The balance of the nuclear decommissioning trust was $379.9 million and $310.7 million at December 31, 1999 and 1998, respectively. Trust earnings increase the trust balance with a corresponding increase in the accumulated decommissioning balance. These balances are adjusted for net unrealized gains and losses related to changes in the fair value of trust assets. Based on the site-specific estimates discussed below, and using an assumed after-tax earnings rate of 7.75% and an assumed cost escalation rate of 4%, current levels of rate recovery for nuclear decommissioning costs are adequate to provide for decommissioning of the Company's nuclear facilities. b) The Company's most recent site-specific estimates of decommissioning costs were developed in 1998, using 1998 cost factors, and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site, with such removal occurring shortly after operating license expiration. See paragraph 5 below for expiration dates of operating licenses. These estimates, in 1998 dollars, are $279.8 million for Robinson Unit No. 2, $299.3 million for Brunswick Unit No. 1, $298.5 million for Brunswick Unit No. 2, and $328.1 million for the Harris Plant. The estimates are subject to change based on a variety of factors including, but not limited to, cost escalation, changes in technology applicable to nuclear decommissioning and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to Power Agency, which holds an undivided ownership interest in the Brunswick and Harris nuclear generating facilities. To the extent of its ownership interests, Power Agency is responsible for satisfying the NRC's financial assurance requirements for decommissioning costs. See PART I, ITEM 1, "Generating Capability," paragraph 1. c) The Financial Accounting Standards Board is proceeding with its project regarding accounting practices related to obligations associated with the retirement of long-lived assets, and an exposure draft of a proposed accounting standard was issued during the first quarter of 2000. It is uncertain what effects it may ultimately have on the Company's accounting for nuclear decommissioning and other retirement costs. 5. OPERATING LICENSES. Facility Operating Licenses, issued by the NRC, for the Company's nuclear units allow for a full 40 years of operation. Expiration dates for these licenses are set forth in the following table. Facility Operating License Facility Expiration Date -------- --------------- Robinson Unit No. 2 July 31, 2010 Brunswick Unit No. 1 September 8, 2016 Brunswick Unit No. 2 December 27, 2014 Harris Plant October 24, 2026 6. OTHER NUCLEAR MATTERS --------------------- a) In 1991, the NRC issued a final rule on nuclear plant maintenance that became effective on July 10, 1996. In general terms, the new maintenance rule prescribes the establishment of performance criteria for each safety system based on the significance of that system. The rule also requires monitoring of safety system performance against the established acceptance criteria, and provides that remedial action be taken when performance falls below the established criteria. In March 1998, the Company's Maintenance Rule Program was found acceptable by the NRC during baseline inspections. b) Degradation of tubing internal to steam generators in pressurized water reactor power plants due to intergranular stress corrosion cracking has been an on-going industry phenomenon. The Company has determined that the steam generators at the Harris Plant are subject to degradation and plans to replace the steam generators in 2001. The steam generators at the Robinson plant were replaced in 1984 and are expected to perform until the plant's operating license expires. The Company does not expect the costs associated with replacing the steam generators at the Harris Plant to be material to the consolidated financial position or results of operations of the Company. c) The Company is insured against public liability for a nuclear incident up to $9.7 billion per occurrence, which is the maximum limit on public liability claims pursuant to the Price-Anderson Act. In the event that public liability claims from an insured nuclear incident exceed $200 million, the Company would be subject to a pro rata assessment of up to $83.9 million, plus a 5% surcharge, for each reactor owned for each incident. Payment of such assessment would be made over time as necessary to limit the payment in any one year to no more than $10 million per reactor owned. Power Agency would be responsible for its ownership share of the assessment on jointly owned nuclear units. For a more detailed discussion of nuclear liability insurance, see PART II, ITEM 8, "Consolidated Financial Statements and Supplementary Data," Note 16b. FUEL - ---- 1. SOURCES OF GENERATION. Total system generation (including Power Agency's share) by primary energy source, along with purchased power, for the years 1996 through 2000 is set forth below: 1996 1997 1998 1999 2000 ---- ---- ---- ---- ---- (estimated) Fossil 45% 46% 47% 48% 48% Nuclear 41 43 42 42 41 Purchased Power 12 10 9 8 8 Hydro 2 1 1 1 1 Combustion Turbine -- -- 1 1 2 2. COAL. The Company has intermediate and long-term agreements from which it expects to receive approximately 80% of its coal burn requirements in 2000. These agreements have expiration dates ranging from 2000 to 2006. All of the coal that the Company is currently purchasing under intermediate and long-term agreements is considered to be low sulfur coal by industry standards. Recent amendments to the Clean Air Act may result in increases in the price of low sulfur coal. See PART I, ITEM 1, "Environmental Matters," paragraph 2. The average cost (including transportation costs) to the Company of coal delivered for 1999 was $41.98 per ton. 3. OIL. The Company uses No. 2 oil primarily for its combustion turbine units, which are used for emergency backup and peaking purposes, and for boiler start-up and flame stabilization. The Company has a No. 2 oil supply contract for its normal requirements. In the event base-load capacity is unavailable during periods of high demand, the Company may increase the use of its combustion turbine units, thereby increasing No. 2 oil consumption. The Company intends to meet any additional requirements for No. 2 oil through additional contract purchases or purchases in the spot market. There can be no assurance that adequate supplies of No. 2 oil will be available to meet the Company's requirements. To reduce the Company's vulnerability to the lack of No. 2 oil availability, twelve combustion turbine units with a total generating capacity of 766 MW can also burn natural gas. Over the last five years, No. 2 oil, natural gas and propane accounted for 2.89% of the Company's total burned fuel cost. In 1999, No. 2 oil, natural gas and propane accounted for 4.37% of the Company's total burned fuel cost. The availability and cost of fuel oil could be adversely affected by energy legislation enacted by Congress, disruption of oil or gas supplies, labor unrest and the production, pricing and embargo policies of foreign countries. 4. NUCLEAR. The nuclear fuel cycle requires the mining and milling of uranium ore to provide uranium oxide concentrate (U3O8), the conversion of U3O8 to uranium hexafluoride (UF6), and the enrichment of the UF6 and the fabrication of the enriched uranium into fuel assemblies. Existing uranium contracts are expected to supply the necessary nuclear fuel to operate all of the Company's nuclear generating facilities through 2001. The Company expects to meet its future U3O8 requirements from inventory on hand and amounts received under contract. Although the Company cannot predict the future availability of uranium and nuclear fuel services, the Company does not currently expect to have difficulty obtaining U3O8 and the services necessary for its conversion, enrichment and fabrication into nuclear fuel. For a discussion of the Company's plans with respect to spent fuel storage, see PART I, ITEM 1, "Nuclear Matters." 5. DOE ENRICHMENT FACILITIES DECONTAMINATION AND DECOMMISSIONING (D&D) FUND. Under Title XI of the Energy Policy Act of 1992, Public Law 102-486, Congress established a decontamination and decommissioning (D&D) fund for the DOE's gaseous diffusion enrichment plants. Contributions to this fund are being made by U.S. domestic utilities which have purchased enrichment services from DOE since it began sales to non-Department of Defense customers. Each utility's share of the contributions is based on that utility's past purchases of services as a percentage of all purchases of services by U.S. utilities. Total annual contributions are capped at $150 million per year with an overall cap of $2.25 billion over 15 years both indexed to inflation. The Company has paid approximately $40 million in D&D fees through 1999, and expects to pay a cumulative total of approximately $82 million over the 15 year period ending September 30, 2007 (excluding Power Agency's ownership share). The Company is recovering these costs as a component of fuel cost. During March 1997, the Company, along with other entities, filed an administrative claim with the DOE, and a Complaint against the DOE in the United States Court of Federal Claims, seeking a refund of part of the price paid by the Company for enrichment services purchased from the DOE. It is the Company's position that the contract price it paid to the DOE for uranium purchases included the cost of D&D, and that the DOE's collection of additional D&D fees pursuant to the Energy Act resulted in an overpayment of fees by the Company. In addition, the claim requested the elimination of future D&D fund assessments. It was the Company's position that the D&D assessments constitute a breach of contract, a taking of vested contract rights, a violation of property rights, illegal exaction and a violation of the Fifth Amendment of the United States Constitution. The Company's action was stayed pending the outcome of a similar case, Yankee Atomic Electric Company (Yankee Atomic) v. United States (33 Fed.Cl. 580 (Cl.Ct. 1995)), in which the United States Court of Claims found that a portion of the D&D assessments made against Yankee Atomic were unlawful. The government appealed that case to the District of Columbia Circuit Court of Appeals, which subsequently overturned the favorable Court of Claims decision. After the Circuit Court of Appeals refused to rehear the matter, Yankee Atomic filed a petition for a certiorari to seek a review by the United States Supreme Court, which was denied. During February 1999, the Company amended its complaint for various reasons, and the government subsequently filed a motion to dismiss. The total refund demanded in the Company's amended complaint through the date of the complaint filing (including Power Agency's ownership share) is approximately $39 million. The Company cannot predict the outcome of this matter. 6. PURCHASED POWER. The Company purchased 4,730,657 MWh in 1999, 5,336,867 MWh in 1998, and 5,886,722 MWh in 1997 or approximately 8%, 9%, and 10%, respectively, of its system energy requirements (including Power Agency) and had available 1,489 MW in 1999, 1,438 MW in 1998, and 1,839 MW in 1997 of firm purchased capacity under contract at the time of peak load. The Company may acquire purchased power capacity in the future to accommodate a portion of its system load needs. NATURAL GAS SUPPLY - ------------------ During 1999, the Company purchased 7,647,462 dekatherms (dt) of natural gas under its firm sales contracts on the pipeline/utility. It purchased 20,023,674 dt in the spot market or from other nontraditional sources, including long-term contracts with producers or national gas marketers. The Company also transported 6,961,187 dt of customer-owned gas in 1999. The outlook for natural gas supplies in the Company's service area remains favorable and the Company has many sources of gas available on a firm basis. Nationally, gas supplies are adequate and no supply curtailments are anticipated. The following table summarizes the supply sources which are under contract or otherwise available to the Company as of December 31, 1999. (a) Quantities are shown in dekatherms (dt) (one dt equals 1,000,000 Btu or one Mcf at Btu/cu. ft.). (b) Firm Transportation (FT) contracts are for pipeline capacity only. The Company is responsible for acquiring its own gas supplies to be transported on a firm basis under the FT contracts. Gas supplies are available under the Transco Firm Sales (FS) Agreement, other long-term agreements (See f below), multi-month term agreements or agreements of one month or less for supplies purchased in the spot market. (c) Washington Storage volumes may be withdrawn to the extent that the basic contract gas from Transco or other suppliers is unavailable on any day or if the Company elects to take such gas instead of other supplies. Service has continued subsequent to contract expiration under provisions of Transco's FERC tariff. FERC approval of abandonment would be required to terminate service. (d) Winter months only (November through March). (e) Provides for a lower daily deliverability volume in the summer period (April through October). (f) Contracts are for gas supply only - no pipeline capacity is included. Supplies purchased from these suppliers flow on the Company's FT contracts with Transco (See b above). (g) Transco salt dome storage capacity allocated to customers of Transco FS sales service by mandate of FERC order 636. Transco schedules injections and withdrawals of gas from Eminence storage capacity under agency agreements with the Company and the other FS sales service customers. (h) Deliverability of Company's transmission pipeline capacity to distribute supplies withdrawn from storage at the Company's LNG plant under normal operating conditions. DIVERSIFIED BUSINESSES - ---------------------- In 1999, the Company formed Monroe Power Company (Monroe), a wholly owned subsidiary. Monroe is a North Carolina corporation, authorized to do business in Georgia where it owns and operates a combustion turbine, which became operational in December 1999. In 1999, the Company completed the sale of Parke, a division of SRS that performed lighting retrofit services. In 1998, the Company formed Powerhouse Square, LLC, to facilitate the renovation of several historic buildings in North Carolina. OTHER MATTERS - ------------- 1. SAFETY INSPECTION REPORTS. In April 1990, the FERC sent a letter to the Company providing comments on its review of the Company's Fifth (1987) Independent Consultant's Safety Inspection Report, which is required every five years under the FERC Regulation 18 CFR Part 12, for the Walters Hydroelectric Project and requested the Company to undertake certain supplemental analyses and investigations regarding the stability of the dam under extreme and improbable loading conditions. In November 1994, the Company submitted the independent consultant's report to the FERC regarding the stability of the dam at the Walters Project. The independent consultant concluded that the Walters dam has adequate structural stability and reserve capacity to resist both usual and unusual loading conditions without failure and that structural remediation is neither warranted nor recommended. In February 1997, the Company received a letter from the FERC pertaining to the Company's inspection report filed in November 1994. The FERC submitted comments on the inspection report and requested that further analysis be conducted. The Company filed a response in April 1997. In its response, the Company agreed with some of the FERC's comments and took exception to others. In November 1998, the Company received a letter from the FERC pertaining to the Company's April 1997 letter. The Company filed a response in December 1998, which provided information on a plan to further investigate the dam abutments and which addresses FERC's revised dynamic evaluation criteria. Depending on the outcome of these matters, the Company could be required to undertake efforts to enhance the stability of the dams. The cost and need for such efforts have not been determined. The Company cannot predict the outcome of this matter. Similar letters were sent by the FERC during May 1990 with respect to the Company's Blewett and Tillery Hydroelectric Plants. The matters raised in the May 1990 letters from the FERC are still under investigation. Depending on the outcome of these matters, the Company could be required to undertake efforts to enhance the stability of the dams. The cost and need for such efforts have not been determined. The Company filed the Seventh (1998) Part 12 Report for the Tillery Hydroelectric Plant in November 1998 in accordance with a request from the FERC. The Tillery report does not indicate any deficiencies that would endanger the integrity of the dam. The consultant's Seventh Part 12 Report regarding the Blewett Hydroelectric Plant has been developed but, as requested by the FERC, has not been filed. The FERC is developing comments on earlier filings from the Company and has indicated that additional investigation and analyses may be required. The Company has agreed to await the comments from the FERC and incorporate the consultant's responses into the Seventh Part 12 Report. A review of the draft of the Seventh Part 12 Report for Blewett reveals that the consultant did not identify any critical dam safety deficiencies. The Company cannot predict the outcome of this matter. 2. MARSHALL HYDROELECTRIC PROJECT. In November 1991, the FERC notified the Company that the 5 MW Marshall Hydroelectric Project is no longer exempt from 18 CFR Part 12, Subpart C and D, dam safety regulations and that the plant's regulatory jurisdiction was being transferred from the NCUC to the FERC. This change resulted from updated dambreak flood studies which identified the potential impact on new downstream development, thus indicating the need to reclassify the project from a low hazard to a high hazard classification. In accordance with the change in regulatory jurisdiction, the Company developed an emergency action plan which meets the FERC guidelines and engaged its independent consultant to perform a safety inspection. In April 1992 the inspection report was submitted to the FERC for approval. In March 1995 the Company received comments on the inspection report from the FERC. As a result of these comments, and a meeting with the FERC officials, the Company was requested to perform further analyses and submit its findings to the FERC. The Company subsequently submitted the first phase of the requested analyses to the FERC in September 1995. Depending on the outcome of the FERC's review, the Company could be required to undertake efforts to enhance the stability of the Marshall dam and/or powerhouse. The cost and need for such efforts have not been determined. The Company cannot predict the outcome of this matter. 3. TAX REFUND DISPUTE. In April 1994, the Company filed a Complaint against the U.S. Government in the United States District Court for the Eastern District of North Carolina in Raleigh, North Carolina (Civil Action No. 5:94-CV-313-BR3) seeking a refund of approximately $188 million representing tax and interest related to depreciation deductions the Internal Revenue Service (IRS) previously disallowed for the years 1986 and 1987 on the Company's Harris Plant. The Company maintains that under applicable laws and regulations the Harris Plant was ready and available for operation in 1986. The IRS has previously denied some of the depreciation deductions on the Company's tax returns for the years in question on the ground that in its view the plant was not placed in service until 1987. During December 1995, the jury returned a verdict in favor of the U.S. Government. The Company has filed an appeal of the jury's verdict. The Company cannot predict the outcome of this matter. 4. YEAR 2000. The Company's critical systems, devices and applications successfully made the transition to the Year 2000. It is possible, however, that the Company, its vendors, distributors, suppliers or customers may encounter future Year 2000-related problems. If this should occur, we do not expect to experience any material adverse effects on our business, financial condition or results of operations. As of January 31, 2000, the Company had incurred and expensed approximately $18 million related to the inventory, assessment and remediation of non-compliant systems, equipment and applications. The Company does not expect additional costs related to the Year 2000 Project to be material to the consolidated financial position or results of operations of the Company. EMPLOYEES - --------- At December 31, 1999, the Company had 7,752 full-time employees. The Company has a noncontributory defined benefit retirement plan for substantially all full-time employees and an employee stock purchase plan among other employee benefits. The Company also provides contributory postretirement benefits, including certain health care and life insurance benefits, for substantially all retired employees. (a) Represents maximum dependable capacity of installed generating units plus other resources, including firm purchases. For 1999, total system capability during the summer was higher by 800 MW for term purchase contracts in place at time of summer peak. (b) Net of the Company's purchases from Power Agency. (c) Represents Power Agency's share of the energy supplied from the four generating facilities that are jointly owned. *Statistics reflect natural gas operations since the acquisition of NCNG by the Company. ITEM 2. ITEM 2. PROPERTIES - ------- ---------- In addition to the major generating facilities listed in PART I, ITEM 1, "Generating Capability," the Company also operates the following plants: Plant Location ----- -------- 1. Walters North Carolina 2. Marshall North Carolina 3. Tillery North Carolina 4. Blewett North Carolina 5. Weatherspoon North Carolina 6. Morehead North Carolina The Company's sixteen power plants represent a flexible mix of fossil, nuclear and hydroelectric resources in addition to combustion turbines, with a total generating capacity (including Power Agency's share) of 10,128 megawatts (MW). The Company's strategic geographic location facilitates purchases and sales of power with many other electric utilities, allowing the Company to serve its customers more economically and reliably. Major industries in the Company's service area include textiles, chemicals, metals, paper, food, rubber and plastics, wood products, and electronic machinery and equipment. The Company, through Monroe, a wholly owned subsidiary, owns and operates a combustion turbine in Georgia. The full output of 160 MW is received by MEAG, which represents 48 municipal electric utilities located in Georgia. At December 31, 1999, the Company had 5,585 pole miles of transmission lines including 292 miles of 500 kilovolt (kV) lines and 2,857 miles of 230 kV lines, and distribution lines of approximately 44,294 pole miles of overhead lines and approximately 13,842 miles of underground lines. Distribution and transmission substations in service had a transformer capacity of approximately 34,654 kilovolt-ampere (kVA) in 2,028 transformers. Distribution line transformers numbered 436,334 with an aggregate 18,599,000 kVA capacity. Power Agency has acquired undivided ownership interests of 18.33% in Brunswick Unit Nos. 1 and 2, 12.94% in Roxboro Unit No. 4 and 16.17% in Harris Unit No. 1 and Mayo Unit No. 1. Otherwise, the Company has good and marketable title to its principal plants and important units, subject to the lien of its Mortgage and Deed of Trust, with minor exceptions, restrictions, and reservations in conveyances, as well as minor defects of the nature ordinarily found in properties of similar character and magnitude. The Company also owns certain easements over private property on which transmission and distribution lines are located. The Company owns and operates a liquefied natural gas storage plant which provides 120,000 dekatherms (dt) per day to the Company's peak-day delivery capability. The Company owns approximately 1,128 miles of transmission pipelines of two to 16 inches in diameter which connect its distribution systems with the Texas-to-New York transmission system of Transco and the southern end of Columbia's transmission system. Transco delivers gas to the Company at various points conveniently located with respect to the Company's distribution area. Columbia delivers gas to one delivery point near the North Carolina - Virginia border. Gas is distributed by the Company through 2,865 miles of distribution mains. These transmission pipelines and distribution mains are located primarily on rights-of-way held under easement, license or permit on lands owned by others. The Company believes that all of its facilities are suitable, adequate, well-maintained and in good operating condition. Plant Accounts (including nuclear fuel) - During the period January 1, 1995 through December 31, 1999, there were $2,614,194,099 additions to the Company's electric utility plant accounts, $762,069,536 retirements and ($11,995,118) transfers and adjustments resulting in net additions of $1,840,129,445 to the electric utility plant. These net additions represent an increase of approximately 18.89%. During 1999, the Company acquired North Carolina Natural Gas Corporation resulting in a December 31, 1999 gas utility balance of $354,772,562. ITEM 3 ITEM 3 LEGAL PROCEEDINGS - ------- ----------------- Legal and regulatory proceedings are included in the discussion of the Company's business in PART I, ITEM 1 and incorporated by reference herein. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- --------------------------------------------------- (a) A special shareholder meeting was held on October 20, 1999. (b) The meeting was held to approve the Agreement and Plan of Share Exchange between the Company and CP&L Energy, Inc. (c) The total votes were as follows: Total Shareholder Accounts Voting 39,010 Total Votes Cast 123,640,874 *percentages represent portion of total available votes not total votes cast. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS 1. The Company's Common Stock is listed on the New York and Pacific Stock Exchanges. The high and low sales prices per share, as reported as composite transactions in The Wall Street Journal, and dividends declared per share are as follows: The December 31 closing price of the Company's Common Stock was $47 1/16 in 1998 and $30 7/16 in 1999. As of February 29, 2000, the Company had 66,791 holders of record of Common Stock. 2. Installment Payment of Consideration for Acquisition of Parke Industries, Incorporated: a) Securities Delivered. On February 5, 1999, and on February 11, 2000, 10,418 and 14,294 shares, respectively, of the Company's Common Shares were delivered to a former shareholder of Parke Industries, Incorporated (Parke) pursuant to an asset purchase agreement, dated January 30, 1998, by and between SRS and Parke. The asset purchase agreement provides that on each of the first three anniversaries of the closing of the above transaction, SRS is obligated to deliver Parke additional common shares having a market value of $450,000. The Common Shares delivered by SRS were acquired in market transactions and do not represent newly issued shares of the Company. b) Underwriters and Other Purchases. No underwriters were used in connection with this issuance of Common Shares. The Common Shares were received by one individual. c) Consideration. The consideration for the Common Shares was the delivery of certain assets of Parke. d) Exemption from Registration Claimed. The Common Shares described in this Item were issued on the basis of an exemption from registration under Section 4(2) of the Securities Act of 1933. The Common Shares were received by one individual and are subject to restrictions on resale appropriate for private placement. Appropriate disclosure was made to the recipient of the Common Shares. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA - ------- ------------------------------------ The selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS - --------------------- FOR 1999 AS COMPARED TO 1998 AND 1998 AS COMPARED TO 1997 In this section, earnings and the factors affecting them are discussed. The discussion begins with a general overview, then separately discusses earnings by business segment. In 1999, earnings available for common shareholders of Carolina Power & Light Company (the Company) were $379.3 million, a 4.3% decrease from $396.3 million in 1998. Earnings per share decreased from $2.75 per share in 1998 to $2.56 per share in 1999. Earnings were negatively affected by a decline in electric sales to industrial customers, a decline in electric revenues due to increased utilization of the real-time pricing tariff, and the effects of Hurricanes Dennis and Floyd. Continued customer growth and the addition of North Carolina Natural Gas Corporation (NCNG) positively affected earnings available for common shareholders. The Company issued common stock in connection with the acquisition of NCNG, which resulted in a dilution of earnings per common share. In 1998, earnings available for common shareholders were $396.3 million, a 3.7% increase from $382.3 million in 1997. Earnings per share increased from $2.66 per share in 1997 to $2.75 per share in 1998. Contributing to the increase were continued growth in the Company's service area in the commercial and residential sectors as well as a more favorable cooling season. Earnings were negatively affected by increased losses at two of the Company's subsidiaries, Interpath Communications, Inc. and Strategic Resource Solutions Corp. ELECTRIC - -------- The electric segment is primarily engaged in the generation, transmission, distribution and sale of electricity in portions of North and South Carolina. The territory served includes a substantial portion of the coastal plain of North Carolina extending to the Atlantic coast between the Pamlico River and the South Carolina border, the lower Piedmont section of North Carolina, an area in northeastern South Carolina and an area in western North Carolina in and around the city of Asheville. Electric revenue fluctuations as compared to the prior year are due to the following factors (in millions): *CUSTOMER GROWTH/CHANGES IN USAGE PATTERNS EXCLUDES INDUSTRIAL CUSTOMERS. The increase in the customer growth/changes in usage patterns component of revenue for both comparison periods reflects continued growth in the number of customers served by the Company. While residential and commercial sales increased in both periods, industrial sales have decreased resulting from a decline in the chemical and textile industries. For the 1999 comparison period, the price-related decrease is due to increased utilization of the real-time pricing tariff. The price-related decrease for the 1998 comparison period is attributable to changes in the Power Coordination Agreement between the Company and North Carolina Electric Membership Corporation (NCEMC), as well as decreases in the fuel cost component of revenue. The decrease in the weather component for 1999 reflects overall milder-than- normal weather conditions. The weather component and sales to North Carolina Eastern Municipal Power Agency (Power Agency) increased during 1998 due to a more favorable summer cooling season. The change in fuel expense for 1999 primarily reflects changes in the Company's generation mix. For 1998, the increase is attributable to a 5.3% increase in generation. For the 1999 comparison period, purchased power decreased due to the expiration in mid-1999 of the Company's long-term purchase power agreement with Duke Energy. The decrease in 1998 is attributable to a 9.4% reduction in kilowatt hours (kWh) purchased, which was partially offset by an increase in the average cost per kWh. In 1999, other operation and maintenance expense was negatively affected by $28.6 million of storm restoration expenses incurred as a result of Hurricanes Dennis and Floyd. The current year was also negatively affected by an increase in general and administrative expenses. For 1998, a decrease in the general and administrative expenses portion of other operation and maintenance expense was partially offset by expenses related to Hurricane Bonnie. Harris Plant deferred cost, net, decreased in 1998 due to the completion, in late 1997, of the amortization of the Harris Plant phase-in costs related to the North Carolina retail jurisdiction. NATURAL GAS - ----------- On July 15, 1999, the Company completed its acquisition of NCNG, now a wholly owned subsidiary. See "NCNG Acquisition" discussion under PART II, ITEM 7, "Other Matters." NCNG, headquartered in North Carolina, is a natural gas distribution utility. NCNG sells and transports natural gas to residential, commercial, industrial and electric power generation customers. NCNG provides natural gas, propane and related services to approximately 178,000 customers in 110 towns and cities and to four municipal gas distribution systems in south-central and eastern North Carolina. Much of that area is also part of the Company's electric service franchise. The ability to offer natural gas to customers is a priority for the Company as part of its strategy to become a total energy provider while securing fuel supplies for planned gas-fired electric generation. The results of NCNG are included in the Company's financial results since the date of the acquisition. Natural gas revenues for the six-month period totaled $98.9 million, while gas purchased for resale totaled $67.5 million and other operation and maintenance expenses totaled $13.8 million. NCNG's operations contributed $6.8 million of operating income. OTHER - ----- The other segment primarily includes the financial results of two of the Company's subsidiaries, Strategic Resource Solutions Corp. (SRS) and Interpath Communications, Inc. (Interpath), which are included in the caption Diversified businesses on the Consolidated Statements of Income. SRS, a wholly owned subsidiary, specializes in facilities and energy management software, systems and services for educational, commercial, industrial and governmental markets nationwide. SRS's operating losses were $9.9 million in 1999, down from a $34.7 million loss in 1998. Revenues for SRS in 1999 increased $27.8 million or 61% as compared to the prior year. Of this increase, unaffiliated revenues represented $25.2 million. This growth is primarily attributable to large performance contracts in the education and federal markets. Also contributing to the growth are strong sales in commercial and industrial building automation and HVAC controls. Even with this growth in revenues, operating expenses remained relatively flat in 1999 as compared to 1998 due to cost-cutting measures. Interpath, a wholly owned subsidiary, is an application service provider offering a full range of managed application services, Internet protocol-based applications and Internet consulting to businesses. Revenues for Interpath increased dramatically during 1999 to $73.2 million as compared to $37.6 million in 1998 and $3.8 million in 1997. Of these amounts, unaffiliated revenues represented $45.2 million, $15.7 million and $3.8 million in 1999, 1998 and 1997, respectively. This increase is primarily due to an increase in Interpath's customer base. Operating expenses increased significantly for all years due to the growth and business expansion of Interpath. This expansion contributed to Interpath's operating losses of $44.8 million and $15.3 million in 1999 and 1998, respectively. In 1997, prior to the acquisition of Capitol Information Services, Inc., Interpath's operating income was $1.1 million. Other Income (Expense) - ---------------------- In 1997, interest income included $11 million related to an income tax refund. For 1999, other, net was negatively affected by a $4.1 million loss incurred on the sale of SRS's lighting division. The $21.1 million change in other, net for 1998 included a $6.0 million non-recurring charge related to an investment write-off by SRS and various other items, none of which are individually significant. Income Taxes - ------------ In general, income taxes fluctuate with changes in the Company's income before income taxes. In addition, 1997 income tax expense was negatively affected by tax provision adjustments of $10 million recorded in 1997 for potential audit issues related to the in-service date of the Harris Plant. Preferred Stock Dividend Requirements - ------------------------------------- The decrease in the preferred stock dividend requirements for 1998 is the result of the redemption of two preferred stock series in July 1997. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- Cash Flow and Financing - ----------------------- The net cash requirements of the Company arise primarily from operational needs and support for investing activities, including replacement or expansion of existing facilities, construction to comply with pollution control laws and regulations and investments in diversified businesses. The Company has on file with the Securities and Exchange Commission (SEC) a shelf registration statement under which first mortgage bonds, senior notes and other debt securities are available for issuance by the Company. As of December 31, 1999, the Company had $600 million available under this shelf registration. The Company can also issue up to $180 million of additional preferred stock under a shelf registration statement on file with the SEC. The Company's ability to issue first mortgage bonds and preferred stock is subject to earnings and other tests as stated in certain provisions of its mortgage, as supplemented, and charter. The Company has the ability to issue an additional $4.5 billion in first mortgage bonds and an additional 18 million shares of preferred stock at an assumed price of $100 per share and a $7.40 annual dividend rate. The Company also has 10 million authorized preference stock shares available for issuance that are not subject to an earnings test. As of December 31, 1999, the Company's revolving credit facilities totaled $750 million, all of which are long-term agreements supporting its commercial paper borrowings and other short-term indebtedness. The Company is required to pay minimal annual commitment fees to maintain its credit facilities. Consistent with management's intent to maintain its commercial paper and other short-term indebtedness on a long-term basis, and as supported by its long-term revolving credit facilities, the Company included in long-term debt commercial paper and other short-term indebtedness of $750 million and $488 million at December 31, 1999 and 1998, respectively. In September 1999, the Company established a $150 million extendible commercial notes program. As of December 31, 1999, there were no extendible commercial notes outstanding. The proceeds from the issuance of commercial paper related to the credit facilities mentioned above and/or internally generated funds financed the retirement of long-term debt totaling $113 million in 1999. In addition, the issuance of $500 million extendible notes in October 1999, financed the retirement of $100 million of extendible commercial notes and reduced the outstanding commercial paper balance. External funding requirements, which do not include early redemption of long-term debt, redemption of preferred stock or issuances in conjunction with acquisitions, are expected to approximate $490 million, $580 million and $640 million in 2000, 2001 and 2002, respectively. These funds will be required for construction, mandatory retirements of long-term debt and general corporate purposes. The Company's access to outside capital depends on its ability to maintain its credit ratings. The Company's debt ratings are as follows: The amount and timing of future sales of Company securities will depend on market conditions and the specific needs of the Company. The Company may from time to time sell securities beyond the amount needed to meet capital requirements in order to allow for the early redemption of long-term debt, the redemption of preferred stock, the reduction of short-term debt or for other general corporate purposes. In addition to the above, an anticipated issuance of common stock and debt is discussed in the "Florida Progress Corporation" discussion under PART II, ITEM 7, "Other Matters." Capital Requirements - -------------------- Estimated capital requirements for 2000 through 2002 primarily reflect construction expenditures to add generation, transmission and distribution facilities, as well as to upgrade existing facilities. Those capital requirements are reflected in the following table (in millions): The table includes expenditures of approximately $311 million expected to be incurred at fossil-fueled electric generating facilities to comply with the Clean Air Act. In addition, the Company has total projected cash requirements of approximately $565 million for the years 2000 through 2002 relating to expenditures in other areas such as affordable housing investments and merchant generation plants. These projections are periodically reviewed and may change significantly. During 1999, the Company had two long-term agreements for the purchase of power and related transmission services from other utilities. The first agreement provides for the purchase of 250 megawatts of capacity through 2009 from Indiana Michigan Power Company's Rockport Unit No. 2 (Rockport). The second agreement, which expired mid-1999, was with Duke Energy for the purchase of 400 megawatts of firm capacity. The estimated minimum annual payment for power purchases under the Rockport agreement is approximately $31 million, representing capital-related capacity costs. In 1999, total purchases (including transmission use charges) under the Rockport and Duke Energy agreements amounted to $59.5 million and $33.8 million, respectively. In addition, pursuant to the terms of the 1981 Power Coordination Agreement, as amended, between the Company and Power Agency, the Company is obligated to purchase a percentage of Power Agency's ownership capacity of, and energy from, the Harris Plant through 2007. The estimated minimum annual payments for these purchases, representing capital- related capacity costs, total approximately $26 million. Purchases under the agreement with Power Agency totaled $36.5 million in 1999. OTHER MATTERS - ------------- Florida Progress Corporation - ---------------------------- The Company, Florida Progress Corporation (FPC), a Florida corporation, and CP&L Energy, Inc. (CP&L Energy), a North Carolina corporation and wholly owned subsidiary of the Company, formerly known as CP&L Holdings, Inc. entered into an Amended and Restated Agreement and Plan of Share Exchange dated as of August 22, 1999, amended and restated as of March 3, 2000 (the "Amended Agreement"). Under the terms of the Agreement, all outstanding shares of common stock, no par value, of FPC common stock would be acquired by CP&L Energy in a statutory share exchange with an approximate value of $5.3 billion. Each share of FPC common stock, at the election of the holder, will be exchanged for (i) $54.00 in cash and one contingent value obligation (CVO), or (ii) the number of shares of common stock, no par value, of CP&L Energy equal to the ratio determined by dividing $54.00 by the average of the closing sale price per share of CP&L Energy common stock (Final Stock Price) as reported on the New York Stock Exchange composite tape for the twenty consecutive trading days ending with the fifth trading day immediately preceding the closing date for the exchange, and one CVO or (iii) a combination of cash and CP&L Energy common stock, and one CVO; provided, however, that shareholder elections shall be subject to allocation and proration to achieve a mix of the aggregate exchange consideration that is 65% cash and 35% common stock. The number of shares of CP&L Energy common stock that will be issued as stock consideration will vary if the Final Stock Price is within a range of $37.13 to $45.39, but not outside that range. Thus, the maximum number of shares of CP&L Energy common stock into which one share of FPC common stock could be exchanged would be 1.4543, and the minimum would be 1.1897. In addition, FPC shareholders will receive one contingent value obligation for each share of FPC stock owned. Each contingent value obligation will represent the right to receive contingent payments that may be made by CP&L Energy based on certain cash flows that may be derived from future operations of four synthetic fuel plants currently owned by FPC. In conjunction with this proposed share exchange, CP&L Energy plans to issue debt to fund the cash portion of the exchange. The transaction has been approved by the Boards of Directors of FPC, the Company and CP&L Energy. Consummation of the exchange is subject to the satisfaction or waiver of certain closing conditions including, among others, the approval by the shareholders of FPC and the approval of the issuance of CP&L Energy common stock in the exchange by the shareholders of the Company or CP&L Energy; the approval or regulatory review by the Federal Energy Regulatory Commission (FERC), the SEC, the Nuclear Regulatory Commission (NRC), the North Carolina Utilities Commission (NCUC), and certain other federal and state regulatory bodies; the expiration or early termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; and other customary closing conditions. In addition, FPC's obligation to consummate the exchange is conditioned upon the Final Stock Price being not less than $30.00. Both the Company and FPC have agreed to certain undertakings and limitations regarding the conduct of their respective businesses prior to the closing of the transaction. The transaction is expected to be completed in the fall of 2000. Either party may terminate the Agreement under certain circumstances, including if the exchange has not been consummated on or before December 31, 2000; provided that if certain conditions have not been satisfied on December 31, 2000, but all other conditions have been satisfied or waived then such date shall be June 30, 2001. In the event that FPC or the Company terminate the Agreement in certain limited circumstances, FPC would be required to pay the Company a termination fee of $150 million, plus the Company's reasonable out-of-pocket expenses which are not to exceed $25 million in the aggregate. On January 31, 2000, applications were filed with the NRC seeking approval of the change in control of FPC that will result from the share exchange. On February 3, 2000, CP&L Energy filed an application with the NCUC for authorization of the share exchange with FPC and the issuance of common stock in connection with the transaction. On February 3, 2000, CP&L Energy and FPC filed a joint application with the FERC requesting approval of the share exchange. The Company cannot predict the outcome of these matters. On March 14, 2000, CP&L Energy and FPC filed an application with the SEC requesting approval of the share exchange under the Public Utility Holding Company Act. NCNG Acquisition - ---------------- On July 15, 1999, the Company completed the previously announced acquisition of NCNG for an aggregate purchase price of approximately $364 million. Each outstanding share of NCNG common stock was converted into the right to receive 0.8054 shares of Company common stock, resulting in the issuance of approximately 8.3 million shares. The acquisition has been accounted for as a purchase and, accordingly, the operating results of NCNG have been included in the Company's consolidated financial statements since the date of acquisition. The excess of the aggregate purchase price over the fair value of net assets acquired, approximately $240 million, has been recorded as goodwill of the acquired business and is being amortized primarily over a period of 40 years. NCNG, operating as a wholly owned subsidiary of the Company, is engaged in the transmission and distribution of natural gas. These gas services are provided under regulated rates to approximately 178,000 customers in eastern and south-central North Carolina. In conjunction with the acquisition, the Company and NCNG signed a joint stipulation agreement with the Public Staff of the NCUC in which the Company agreed to cap base retail electric rates, exclusive of fuel costs, with limited exceptions, through December 2004, and NCNG agreed to cap margin rates for gas sales and transportation services, with limited exceptions, through November 1, 2003. Management is of the opinion that this agreement will not have a material effect on the consolidated results of operations or financial position of the Company. Diversified Businesses - ---------------------- In addition to Interpath and SRS, whose results were previously discussed, the following subsidiaries represent diversified businesses of the Company. In 1999, the Company formed Monroe Power Company (Monroe), a wholly owned subsidiary. Monroe is a North Carolina corporation, authorized to do business in Georgia where it owns and operates a combustion turbine, which became operational in December 1999. In 1998, the Company formed Powerhouse Square, LLC, to facilitate the renovation of several historic buildings in North Carolina. Retail Rate Matters - ------------------- In late 1998 and early 1999, the Company filed, and the respective commissions subsequently approved, proposals in the North and South Carolina retail jurisdictions to accelerate cost recovery of its nuclear generating assets beginning January 1, 2000, and continuing through 2004. The accelerated cost recovery began immediately after the 1999 expiration of the accelerated amortization of certain regulatory assets, which began in January 1997. Pursuant to the orders, the Company's depreciation expense for nuclear generating assets will increase by a minimum of $106 million to a maximum of $150 million per year. Recovering the costs of the nuclear generating assets on an accelerated basis will better position the Company for the uncertainties associated with potential restructuring of the electric utility industry. Environmental - ------------- The Company is subject to federal, state and local regulations addressing air and water quality, hazardous and solid waste management and other environmental matters. Various organic materials associated with the production of manufactured gas, generally referred to as coal tar, are regulated under federal and state laws. There are several manufactured gas plant (MGP) sites to which both the electric utility and the gas utility have some connection. In this regard, the electric utility and the gas utility, along with others, are participating in a cooperative effort with the North Carolina Department of Environment and Natural Resources, Division of Waste Management (DWM). The DWM has established a uniform framework to address MGP sites. The investigation and remediation of specific MGP sites will be addressed pursuant to one or more Administrative Orders on Consent (AOC) between the DWM and the potentially responsible party or parties. Both the electric utility and the gas utility have signed AOCs to investigate certain sites at which investigation includes the completion of interim remedial measures where appropriate and anticipate signing AOCs to remediate sites as well. Both the electric utility and the gas utility continue to identify parties connected to individual MGP sites, and to determine their relative relationship to other parties at those sites and the degree to which they will undertake efforts with others at individual sites. The Company does not expect the costs associated with these sites to be material to the consolidated financial position or results of operations of the Company. The Company is periodically notified by regulators such as the North Carolina Department of Environment and Natural Resources, the South Carolina Department of Health and Environmental Control, and the U.S. Environmental Protection Agency (EPA) of its involvement or potential involvement in sites, other than MGP sites, that may require investigation and/or remediation. Although the Company may incur costs at the sites about which it has been notified, based upon the current status of these sites, the Company does not expect those costs to be material to the consolidated financial position or results of operations of the Company. The EPA has been conducting an enforcement initiative related to a number of coal-fired utility power plants in an effort to determine whether modifications at those facilities were subject to New Source Review requirements or New Source Performance Standards under the Clean Air Act. The Company has recently been asked to provide information to the EPA as part of this initiative and has cooperated in providing the requested information. The EPA has initiated enforcement actions which may have potentially significant penalties against other companies that have been subject to this initiative. The Company cannot predict the outcome of this matter. The 1990 amendments to the Clean Air Act require substantial reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fueled electric generating plants. The Clean Air Act required the Company to meet more stringent provisions effective January 1, 2000. The Company will meet the sulfur dioxide emissions requirements by maintaining sufficient sulfur dioxide emission allowances. Installation of additional equipment was necessary to reduce nitrogen oxide emissions. Increased operation and maintenance costs, including emission allowance expense, installation of additional equipment and increased fuel costs are not expected to be material to the consolidated financial position or results of operations of the Company. On October 27, 1998, the EPA published a final rule addressing the issue of regional transport of ozone. This rule is commonly known as the NOx SIP call. The EPA's rule requires 22 states, including North and South Carolina, to further reduce nitrogen oxide emissions in order to attain a pre-set state NOx emission level by May 2003. The EPA's rule also suggests to the states that these additional nitrogen oxide emission reductions be obtained from the utility sector. The Company is evaluating necessary measures to comply with the rule and estimates its related capital expenditures through 2003 could be approximately $327 million, a portion of which is reflected in the "Capital Requirements" discussion under PART II, ITEM 7, "Liquidity and Capital Resources." Increased operation and maintenance costs relating to the NOx SIP call are not expected to be material to the Company's results of operations. The Company and the states of North and South Carolina have been participating in litigation challenging the NOx SIP call. On March 3, 2000, a three-judge panel of the District of Columbia Circuit Court of Appeals upheld the EPA's NOx SIP call. Further appeals are being considered. The Company cannot predict the outcome of this matter. The EPA published a final rule approving petitions under section 126 of the Clean Air Act that requires certain sources to make reductions in nitrogen oxide emissions by 2003. The Company's fossil-fueled electric generating plants are included in these petitions. The Company and other states are participating in litigation challenging the EPA's actions. The Company cannot predict the outcome of this matter. Nuclear - ------- In the Company's retail jurisdictions, provisions for nuclear decommissioning costs are approved by the NCUC and the Public Service Commission of South Carolina (SCPSC) and are based on site-specific estimates that include the costs for removal of all radioactive and other structures at the site. In the wholesale jurisdiction, the provisions for nuclear decommissioning costs are based on amounts agreed upon in applicable rate agreements. Based on the site-specific estimates discussed below, and using an assumed after-tax earnings rate of 7.75% and an assumed cost escalation rate of 4%, current levels of rate recovery for nuclear decommissioning costs are adequate to provide for decommissioning of the Company's nuclear facilities. The Company's most recent site-specific estimates of decommissioning costs were developed in 1998, using 1998 cost factors, and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site, with such removal occurring shortly after operating license expiration. These estimates, in 1998 dollars, are $279.8 million for Robinson Unit No. 2, $299.3 million for Brunswick Unit No. 1, $298.5 million for Brunswick Unit No. 2 and $328.1 million for the Harris Plant. The estimates are subject to change based on a variety of factors including, but not limited to, cost escalation, changes in technology applicable to nuclear decommissioning and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to Power Agency, which holds an undivided ownership interest in the Brunswick and Harris nuclear generating facilities. Operating licenses for the Company's nuclear units expire in the year 2010 for Robinson Unit No. 2, 2016 for Brunswick Unit No. 1, 2014 for Brunswick Unit No. 2 and 2026 for the Harris Plant. The Financial Accounting Standards Board (FASB) is proceeding with its project regarding accounting practices related to obligations associated with the retirement of long-lived assets, and an exposure draft of a proposed accounting standard was issued during the first quarter of 2000. It is uncertain what effects it may ultimately have on the Company's accounting for nuclear decommissioning and other retirement costs. As required under the Nuclear Waste Policy Act of 1982, the Company entered into a contract with the U.S. Department of Energy (DOE) under which the DOE agreed to begin taking spent nuclear fuel by no later than January 31, 1998. All similarly situated utilities were required to sign the same standard contract. In April 1995, the DOE issued a final interpretation that it did not have an unconditional obligation to take spent nuclear fuel by January 31, 1998. In Indiana & Michigan Power v. DOE, the Court of Appeals vacated the DOE's final interpretation and ruled that the DOE had an unconditional obligation to begin taking spent nuclear fuel. The Court did not specify a remedy because the DOE was not yet in default. After the DOE failed to comply with the decision in Indiana & Michigan Power v. DOE, a group of utilities (including the Company) petitioned the Court of Appeals in Northern States Power (NSP) v. DOE, seeking an order requiring the DOE to begin taking spent nuclear fuel by January 31, 1998. The DOE took the position that their delay was unavoidable, and the DOE was excused from performance under the terms and conditions of the contract. The Court of Appeals issued an order which precluded the DOE from treating the delay as an unavoidable delay. However, the Court of Appeals did not order the DOE to begin taking spent nuclear fuel, stating that the utilities had a potentially adequate remedy by filing a claim for damages under the contract. After the DOE failed to begin taking spent nuclear fuel by January 31, 1998, a group of utilities (including the Company) filed a motion with the Court of Appeals to enforce the mandate in NSP v. DOE. Specifically, the utilities asked the Court to permit the utilities to escrow their waste fee payments, to order the DOE not to use the waste fund to pay damages to the utilities, and to order the DOE to establish a schedule for disposal of spent nuclear fuel. The Court denied this motion based primarily on the grounds that a review of the matter was premature and that some of the requested remedies fell outside of the mandate in NSP v. DOE. Subsequently, a number of utilities each filed an action for damages in the Court of Claims and before the Court of Appeals. The Company is in the process of evaluating whether it should file a similar action for damages. In NSP v. U.S., the Court of Claims decided that NSP must pursue its administrative remedies instead of filing an action in the Court of Claims. NSP has filed an interlocutory appeal to the Court of Appeals based on NSP's position that the Court of Claims has jurisdiction to decide the matter. A group of utilities (including the Company) has submitted an amicus brief in support of NSP's position. The Company also continues to monitor legislation that has been introduced in Congress which might provide some limited relief. The Company cannot predict the outcome of this matter. With certain modifications and additional approval by the NRC, the Company's spent nuclear fuel storage facilities will be sufficient to provide storage space for spent fuel generated on the Company's system through the expiration of the current operating licenses for all of the Company's nuclear generating units. Subsequent to the expiration of these licenses, dry storage may be necessary. The Company has initiated the process of obtaining the additional NRC approval. Competition - ----------- GENERAL - ------- In recent years, the electric utility industry has experienced a substantial increase in competition at the wholesale level, caused by changes in federal law and regulatory policy. Several states have also decided to restructure aspects of retail electric service. The issue of retail restructuring and competition is being reviewed by a number of states and bills have been introduced in Congress that seek to introduce such restructuring in all states. Allowing increased competition in the generation and sale of electric power will require resolution of many complex issues. One of the major issues to be resolved is who will pay for stranded costs. Stranded costs are those costs and investments made by utilities in order to meet their statutory obligation to provide electric service, but which could not be recovered through the market price for electricity following industry restructuring. The amount of such stranded costs that the Company might experience would depend on the timing of, and the extent to which, direct competition is introduced, and the then-existing market price of energy. If electric utilities were no longer subject to cost-based regulation and it were not possible to recover stranded costs, the financial position and results of operations of the Company could be adversely affected. WHOLESALE COMPETITION - --------------------- Since passage of the National Energy Act of 1992 (Energy Act), competition in the wholesale electric utility industry has significantly increased due to a greater participation by traditional electricity suppliers, wholesale power marketers and brokers, and due to the trading of energy futures contracts on various commodities exchanges. This increased competition could affect the Company's load forecasts, plans for power supply and wholesale energy sales and related revenues. The impact could vary depending on the extent to which additional generation is built to compete in the wholesale market, new opportunities are created for the Company to expand its wholesale load, or current wholesale customers elect to purchase from other suppliers after existing contracts expire. To assist in the development of wholesale competition, the FERC, in 1996, issued standards for wholesale wheeling of electric power through its rules on open access transmission and stranded costs and on information systems and standards of conduct (Orders 888 and 889). The rules require all transmitting utilities to have on file an open access transmission tariff, which contains provisions for the recovery of stranded costs and numerous other provisions that could affect the sale of electric energy at the wholesale level. The Company filed its open access transmission tariff with the FERC in mid-1996. Shortly thereafter, Power Agency and other entities filed protests challenging numerous aspects of the Company's tariff and requesting that an evidentiary proceeding be held. The FERC set the matter for hearing and set a discovery and procedural schedule. In July 1997, the Company filed an offer of settlement in this matter. The administrative law judge certified the offer to the full FERC in September 1997. The offer is pending before the FERC. The Company cannot predict the outcome of this matter. On December 20, 1999, the FERC issued a rule on Regional Transmission Organizations (RTO) that sets forth four minimum characteristics and eight functions for transmission entities, including independent system operators and transmission companies, to become FERC-approved RTOs. The rule states that public utilities that own, operate or control interstate transmission facilities must file by October 15, 2000, either a proposal to participate in an RTO or an alternative filing describing efforts and plans to participate in an RTO. The Company plans to participate in an RTO and anticipates complying with this filing requirement. RETAIL COMPETITION - ------------------ The Energy Act prohibits the FERC from ordering retail wheeling - transmitting power on behalf of another producer to an individual retail customer. Several states have changed their laws and regulations to allow full retail competition. Other states are considering changes to allow retail competition. These changes and proposals have taken differing forms and included disparate elements. The Company believes changes in existing laws in both North and South Carolina would be required to permit competition in the Company's retail jurisdictions. NORTH CAROLINA ACTIVITIES - ------------------------- In April 1997, the North Carolina General Assembly approved legislation establishing a 23-member study commission to evaluate the future of electric service in the state. During 1998, the study commission met and held public hearings around the state. The study commission also retained consultants to conduct analyses and studies concerning various restructuring issues, including stranded costs, state and local tax implications and electric rate comparisons. In June 1998, the study commission issued an interim report to the 1998 North Carolina General Assembly, summarizing the numerous fact-finding and educational activities and analytical projects the study commission had initiated or completed. That report offered no judgments or recommendations. In May 1999, the North Carolina General Assembly approved legislation that expanded the study commission from 23 to 29 members. All 29 study commission members were appointed by August 1999. The study commission conducted several meetings during August through November to discuss the reports regarding deregulation issues prepared by the Research Triangle Institute at the request of the study commission. During those meetings, several entities, including the Company and Duke Energy, presented proposals for addressing the nearly $6 billion debt of North Carolina's Municipal Power Agencies. The study commission resumed meeting in January 2000. On March 8, 2000, the commission co-chairs presented draft recommendations regarding electric industry restructuring to the full study commission for its consideration in preparing its report to the North Carolina General Assembly. Key recommendations in the draft include (i) electric retail competition should begin in North Carolina no later than June 30, 2006; (ii) recovery of utilities' stranded costs should not be extended beyond June 30, 2006; and (iii) the generation and distribution of assets of the municipal power agencies (including Power Agency) should be sold no later than June 30, 2002, and the funds from those sales should be used to pay off a portion of the municipal power agencies' debt. The draft recommendations also address issues related to the legislative timetable, consumer protection measures, environmental concerns, tax laws, and transmission and distribution. Implicit in recommendation is a rate freeze through the year 2006. Initial comments on the draft recommendations were due on March 10, 2000. The Company and other interested parties submitted comments. The draft recommendations will serve as a starting point for preparation of the study commission's report addressing industry restructuring in the State of North Carolina. The recommendations and related issues will be debated and discussed at future study commission meetings. The commission is expected to make a final report to the North Carolina General Assembly in the spring of 2000. The Company cannot predict the outcome of this matter. SOUTH CAROLINA ACTIVITIES - ------------------------- The 1999 session of the South Carolina General Assembly adjourned in June 1999 without approving any legislation regarding electric industry restructuring. On October 29, 1998, the South Carolina Senate Judiciary Committee appointed a 13-member task force to study the restructuring issue and make a report to the Senate. The task force was subsequently expanded to 18 members, including the Company. The task force, including its various committees, has conducted several meetings to receive input from experts and interested parties and to discuss issues related to restructuring. The House Public Utility Subcommittee is expected to continue considering the electric industry restructuring bills that were introduced in 1999, and the Senate task force is expected to continue to consider the issue of restructuring during the South Carolina General Assembly's 2000 legislative session. The Company cannot predict the outcome of these matters. FEDERAL ACTIVITIES - ------------------ During 1999, over 20 bills were introduced in Congress regarding electric industry restructuring. A draft bill passed the House Commerce Subcommittee on October 27, 1999. This bill will proceed to full Commerce Committee consideration in the first quarter of 2000 where it is expected to be changed significantly. The Company cannot predict the outcome of this matter. COMPANY ACTIVITIES - ------------------ In December 1998, the Company entered into an agreement to purchase all of the output of a combustion turbine project to be built, owned and operated by Broad River Energy, LLC (BRE), in Cherokee County, South Carolina. In conjunction with this agreement, the Company agreed to provide bridge financing to BRE under a Financing Term Sheet. This financing will be used by BRE to (i) make payments to Duke Energy in connection with certain electrical interconnection agreements, (ii) purchase two generator step up transformers and (iii) acquire land for the Broad River Energy Center Project. Under the terms of this agreement, the Company agreed to loan BRE up to $20.5 million that will be due on July 1, 2000. In addition, in August 1999 the Company agreed to loan Broad River Investors, LLC up to $84.5 million that will be due on July 1, 2000 to finance the purchase of the combustion turbines for the project. Interest on each of the loans is calculated based on the London Inter-Bank Offer Rate, LIBOR, plus a spread of 1%. In August 1999, the Company signed a five-year agreement with Municipal Electric Authority of Georgia (MEAG) pursuant to which MEAG will receive the full output of a 160 MW combustion turbine owned and operated by Monroe Power Company, a wholly owned subsidiary of the Company. Headquartered in Atlanta, MEAG represents 48 municipal electric utilities in Georgia and is part owner of four generating facilities and the Georgia Integrated Transmission System. In August 1999, the Company signed an off-system wholesale peaking power sales agreement with Santee Cooper. The Company will provide up to 150 MW of additional peaking power for a one-year term from June 2001 to May 2002, to help meet the increasing demand in Santee Cooper's fast-growing service area. In October 1999, the Company and the Albemarle-Pamlico Economic Development Corporation (APEC) announced their intention to build an 850-mile natural gas transmission and distribution system to 14 currently unserved counties in eastern North Carolina. The Company will operate both the transmission and distribution systems and APEC will help ensure that the new facilities are built in the most advantageous locations to promote development of the economic base in the region. In conjunction with this proposal, the Company and APEC filed a joint request with the NCUC for $186 million of a $200 million state bond package established for clean water and natural gas infrastructure. If granted, these funds will be used to pay for the portion of the project that likely could not be recovered from future gas customers through rates. The Company plans to invest an additional $11.5 million, thus bringing the total cost of the project to $197.5 million. As proposed, the project is scheduled to be developed in phases through 2003. The NCUC has established a procedural schedule with hearings regarding the first phase of the project to be conducted in April 2000. An order is expected mid-2000. The Company cannot predict the outcome of this matter. In December 1999, the Company announced plans to build a 30-inch natural gas pipeline in North Carolina that will extend approximately 82 miles from Williams Energy's Transcontinental interstate pipeline in Iredell County to Richmond County. The pipeline will provide gas for the Company's planned new power plant in Richmond County and is scheduled to be completed during the spring of 2001. The pipeline is expected to cost approximately $100 million and will accommodate extension of natural gas service to future Company power plants. This pipeline replaces a plan for a 175-mile pipeline, the Palmetto Pipeline, that the Company and Southern Natural Gas Company, a subsidiary of El Paso Energy, had been assessing. As a regulated entity, the Company is subject to the provisions of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." Accordingly, the Company records certain assets and liabilities resulting from the effects of the ratemaking process, which would not be recorded under generally accepted accounting principles for unregulated entities. The Company's ability to continue to meet the criteria for application of SFAS No. 71 may be affected in the future by competitive forces and restructuring in the electric utility industry. In the event that SFAS No. 71 no longer applied to a separable portion of the Company's operations, related regulatory assets and liabilities would be eliminated unless an appropriate regulatory recovery mechanism is provided. Additionally, these factors could result in an impairment of electric utility plant assets as determined pursuant to SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." Transition to Holding Company Structure - --------------------------------------- The Company is in the process of converting to a holding company structure, in which the Company would become a subsidiary of a newly formed holding company. This conversion will offer certain advantages as the Company continues to confront the rapidly changing environment facing electric utilities. The holding company structure would allow greater organizational flexibility, including a clearer separation of regulated businesses from each other and from unregulated businesses such as energy services, telecommunications and electric generation projects for wholesale markets. The ability to conduct financing activities at the holding company level without the need for state regulatory approvals will enable the Company to satisfy financing needs more quickly and efficiently. The Company's shareholders approved the contemplated holding company structure on October 20, 1999. The necessary approvals from various regulatory authorities are expected by the end of the first quarter of 2000. Upon conversion to a holding company structure, each share of the Company's common stock will automatically be exchanged for one share of common stock of the new holding company. On September 15, 1999, the Company filed an application with the NRC for consent to indirectly transfer control of its nuclear plant operating licenses to the newly formed holding company. This application was approved on December 31, 1999. On October 15, 1999, the Company filed an application with the NCUC to approve the transfer of ownership of the Company, Interpath and NCNG to the newly formed holding company. The Company cannot predict the outcome of this proceeding. On October 18, 1999, the Company filed an application with the SEC for approval which allows the holding company to acquire voting securities resulting in control over the Company and NCNG. The Company cannot predict the outcome of this matter. On October 20, 1999, the Company filed an application with the SCPSC to approve the transfer of the Company and Interpath to the newly formed holding company. The SCPSC issued an order approving the application on March 6, 2000. On October 25, 1999, the Company filed an application with the FERC for approval of the proposed reorganization of the Company related to the establishment of the new holding company. This application was approved on December 23, 1999. Year 2000 - --------- The Company's critical systems, devices and applications successfully made the transition to the Year 2000. It is possible, however, that the Company, its vendors, distributors, suppliers or customers may encounter future Year 2000-related problems. If this should occur, we do not expect to experience any material adverse effects on our business, financial condition or consolidated results of operations. As of January 31, 2000, the Company had incurred and expensed approximately $18 million related to the inventory, assessment and remediation of non-compliant systems, equipment and applications. The Company does not expect additional costs related to the Year 2000 Project to be material to the consolidated financial position or consolidated results of operations of the Company. New Accounting Standard - ----------------------- The FASB has delayed the effective date for SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The delay, published as SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," changes the effective date to fiscal years beginning after June 15, 2000. The Company expects to determine any effects of SFAS No. 133 by mid-2000. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - -------- ---------------------------------------------------------- The Company is exposed to certain market risks that are inherent in the Company's financial instruments, which arise from transactions entered into in the normal course of business. The Company's primary exposures are changes in interest rates with respect to its long-term debt and commercial paper, and fluctuations in the return on marketable securities with respect to its nuclear decommissioning trust funds. These financial instruments are held for purposes other than trading. The risks discussed below do not include the price risks associated with nonfinancial instrument transactions and positions associated with the Company's operations, such as sales commitments and inventory. INTEREST RATE RISK The Company manages its interest rate risks through use of a combination of fixed and variable rate debt. Variable rate debt has rates that adjust in periods ranging from daily to monthly. Interest rate derivative instruments may be used to adjust interest rate exposures and to protect against adverse movements in rates. The table below presents principal cash flows and related weighted-average interest rates, by maturity date, for the Company's long-term debt, commercial paper and other short-term indebtedness at December 31, 1999, including current portions. In conjunction with the issuance of $400 million principal amount of Senior Notes on March 5, 1999, the Company settled its interest rate lock, receiving approximately $9.7 million which will reduce interest expense over the 10-year debt term. The fixed and variable rate debt principal cash flows reflected in the table above are substantially the same as reported at December 31, 1998 for post-1999 debt, except for the issuance of $400 million principal amount of Senior Notes, 5.95% Series due March 1, 2009. Commercial paper outstanding at December 31, 1998 was approximately $488 million. There were no extendible notes outstanding at December 31, 1998. MARKETABLE SECURITIES RETURN RISK: The Company maintains trust funds, as required by the Nuclear Regulatory Commission, to fund certain costs of decommissioning. These funds are primarily invested in stocks, bonds and cash equivalents, which are exposed to price fluctuations in equity markets and to changes in interest rates. At December 31, 1999 and 1998, the fair values of these funds were approximately $380 million and $311 million, respectively. The Company actively monitors its portfolio by benchmarking the performance of its investments against certain indices and by maintaining, and periodically reviewing, target allocation percentages for various asset classes. The accounting for nuclear decommissioning recognizes the costs as recovered through the Company's regulated electric rates and; therefore, fluctuations in trust fund marketable security returns do not affect the earnings of the Company. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- -------------------------------------------------------- The following consolidated financial statements, supplementary data and consolidated financial statement schedules are included herein: All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Consolidated Financial Statements or the accompanying Notes to the Consolidated Financial Statements. INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF CAROLINA POWER & LIGHT COMPANY: We have audited the accompanying consolidated balance sheets and schedules of capitalization of Carolina Power & Light Company and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ DELOITTE & TOUCHE LLP Raleigh, North Carolina February 8, 2000, except for Note 2, as to which the date is March 3, 2000. Noncash Activities - ------------------ In July 1999, the Company purchased all outstanding shares of North Carolina Natural Gas Corporation (NCNG). In conjunction with the purchase of NCNG, the Company issued approximately $360 million in common stock. SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Basis of Presentation a. Organization Carolina Power & Light Company (the Company) is a public service corporation primarily engaged in the generation, transmission, distribution and sale of electricity in portions of North and South Carolina and the transmission, distribution and sale of natural gas in portions of North Carolina. b. Basis of Presentation The consolidated financial statements are prepared in accordance with generally accepted accounting principles. The accounting records of the Company are maintained in accordance with uniform systems of accounts prescribed by the Federal Energy Regulatory Commission (FERC), the North Carolina Utilities Commission (NCUC) and the Public Service Commission of South Carolina (SCPSC). Certain amounts for 1998 and 1997 have been reclassified to conform to the 1999 presentation, with no effect on previously reported net income or common stock equity. 2. Florida Progress Corporation The Company, Florida Progress Corporation (FPC), a Florida corporation, and CP&L Energy, Inc. (CP&L Energy), a North Carolina corporation and wholly owned subsidiary of the Company, formerly known as CP&L Holdings, Inc. entered into an Amended and Restated Agreement and Plan of Share Exchange dated as of August 22, 1999, amended and restated as of March 3, 2000 (the "Amended Agreement"). Under the terms of the Agreement, all outstanding shares of common stock, no par value, of FPC common stock would be acquired by CP&L Energy in a statutory share exchange with an approximate value of $5.3 billion. Each share of FPC common stock, at the election of the holder, will be exchanged for (i) $54.00 in cash and one contingent value obligation (CVO), or (ii) the number of shares of common stock, no par value, of CP&L Energy equal to the ratio determined by dividing $54.00 by the average of the closing sale price per share of CP&L Energy common stock (Final Stock Price) as reported on the New York Stock Exchange composite tape for the twenty consecutive trading days ending with the fifth trading day immediately preceding the closing date for the exchange, and one CVO or (iii) a combination of cash and CP&L Energy common stock, and one CVO; provided, however, that shareholder elections shall be subject to allocation and proration to achieve a mix of the aggregate exchange consideration that is 65% cash and 35% common stock. The number of shares of CP&L Energy common stock that will be issued as stock consideration will vary if the Final Stock Price is within a range of $37.13 to $45.39, but not outside that range. Thus, the maximum number of shares of CP&L Energy common stock into which one share of FPC common stock could be exchanged would be 1.4543, and the minimum would be 1.1897. In addition, FPC shareholders will receive one contingent value obligation for each share of FPC stock owned. Each contingent value obligation will represent the right to receive contingent payments that may be made by CP&L Energy based on certain cash flows that may be derived from future operations of four synthetic fuel plants currently owned by FPC. In conjunction with this proposed share exchange, CP&L Energy plans to issue debt to fund the cash portion of the exchange. The transaction has been approved by the Boards of Directors of FPC, the Company and CP&L Energy. Consummation of the exchange is subject to the satisfaction or waiver of certain closing conditions including, among others, the approval by the shareholders of FPC and the approval of the issuance of CP&L Energy common stock in the exchange by the shareholders of the Company or CP&L Energy; the approval or regulatory review by the Federal Energy Regulatory Commission (FERC), the SEC, the Nuclear Regulatory Commission (NRC), the North Carolina Utilities Commission (NCUC), and certain other federal and state regulatory bodies; the expiration or early termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; and other customary closing conditions. In addition, FPC's obligation to consummate the exchange is conditioned upon the Final Stock Price being not less than $30.00. Both the Company and FPC have agreed to certain undertakings and limitations regarding the conduct of their respective businesses prior to the closing of the transaction. The transaction is expected to be completed in the fall of 2000. Either party may terminate the Agreement under certain circumstances, including if the exchange has not been consummated on or before December 31, 2000; provided that if certain conditions have not been satisfied on December 31, 2000, but all other conditions have been satisfied or waived then such date shall be June 30, 2001. In the event that FPC or the Company terminate the Agreement in certain limited circumstances, FPC would be required to pay the Company a termination fee of $150 million, plus the Company's reasonable out-of-pocket expenses which are not to exceed $25 million in the aggregate. On January 31, 2000, applications were filed with the NRC seeking approval of the change in control of FPC that will result from the share exchange. On February 3, 2000, CP&L Energy filed an application with the NCUC for authorization of the share exchange with FPC and the issuance of common stock in connection with the transaction. On February 3, 2000, CP&L Energy and FPC filed a joint application with the FERC requesting approval of the share exchange. The Company cannot predict the outcome of these matters. 3. Summary of Significant Accounting Policies a. Principles of Consolidation The consolidated financial statements include the activities of the Company and its majority-owned subsidiaries. These subsidiaries have invested in areas such as natural gas transmission and distribution, communications technology, energy-management services and merchant generation plants. Significant intercompany balances and transactions have been eliminated in consolidation except as permitted by Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation," which provides that profits on intercompany sales to regulated affiliates are not eliminated if the sales price is reasonable and the future recovery of the sales price through the rate-making process is probable. b. Use of Estimates and Assumptions In preparing financial statements that conform with generally accepted accounting principles, management must make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and amounts of revenues and expenses reflected during the reporting period. Actual results could differ from those estimates. c. Utility Plant The cost of additions, including betterments and replacements of units of property, is charged to utility plant. Maintenance and repairs of property, and replacements and renewals of items determined to be less than units of property, are charged to maintenance expense. The cost of units of property replaced, renewed or retired, plus removal or disposal costs, less salvage, is charged to accumulated depreciation. Generally, electric utility plant other than nuclear fuel is subject to the lien of the Company's mortgage. Gas utility plant is not currently subject to the lien of the Company's mortgage. The balances of utility plant in service at December 31 are listed below (in thousands), with a range of depreciable lives for each: 1999 1998 ----------- ----------- Electric Production plant (7-33 years) $6,413,121 $6,295,252 Transmission plant (30-75 years) 1,018,114 986,609 Distribution plant (12-50 years) 2,676,881 2,469,613 General plant and other (8-75 years) 525,707 529,164 ----------- ----------- Total electric utility plant $10,633,823 $10,280,638 Gas plant (10-40 years) 354,773 - ----------- ----------- Utility plant in service $10,988,596 $10,280,638 =========== =========== As prescribed in regulatory uniform systems of accounts, an allowance for the cost of borrowed and equity funds used to finance utility plant construction (AFUDC) is charged to the cost of plant. Regulatory authorities consider AFUDC an appropriate charge for inclusion in the Company's utility rates to customers over the service life of the property. The equity funds portion of AFUDC is credited to other income and the borrowed funds portion is credited to interest charges. The composite AFUDC rate for electric utility plant was 6.4% in 1999 and 5.6% in both 1998 and 1997. The composite AFUDC rate for gas utility plant was 10.09% in 1999. d. Diversified Business Property The following is a summary of diversified business property (in thousands): 1999 1998 --------- --------- Property, plant and equipment $ 195,892 $27,422 Construction work in progress 65,848 43,619 Accumulated depreciation (21,758) (5,027) --------- --------- Diversified business property, net $ 239,982 $66,014 ========= ========= Diversified business property is stated at cost. Depreciation is computed on a straight-line basis using estimated useful lives of the assets, ranging from 3 to 20 years. e. Depreciation and Amortization For financial reporting purposes, depreciation of utility plant other than nuclear fuel is computed on the straight-line method based on the estimated remaining useful life of the property, adjusted for estimated net salvage. Depreciation provisions, including decommissioning costs (see Note 3f), as a percent of average depreciable property other than nuclear fuel, were approximately 3.9% in 1999, 1998 and 1997. Depreciation provisions totaled $409.6 million, $394.4 million and $382.1 million in 1999, 1998 and 1997, respectively. Depreciation and amortization expense also includes amortization of deferred operation and maintenance expenses associated with Hurricane Fran, which struck significant portions of the Company's service territory in September 1996. In 1996, the NCUC authorized the Company to defer these expenses (approximately $40 million) with amortization over a 40-month period, which expired in December 1999. Pursuant to authorizations from the NCUC and the SCPSC, the Company accelerated the amortization of certain regulatory assets over a three-year period beginning January 1997 and expiring December 1999. The accelerated amortization of these regulatory assets resulted in additional depreciation and amortization expenses of approximately $68 million in each year of the three-year period. Depreciation and amortization expense also includes amortization of plant abandonment costs (see Note 9c). Amortization of nuclear fuel costs, including disposal costs associated with obligations to the U.S. Department of Energy (DOE), is computed primarily on the unit-of-production method and charged to fuel expense. Costs related to obligations to the DOE for the decommissioning and decontamination of enrichment facilities are also charged to fuel expense. Goodwill, the excess of purchase price over fair value of net assets of businesses acquired, is being amortized on a straight-line basis over periods ranging from 10 to 40 years. Accumulated amortization was $11.5 million and $4.7 million at December 31, 1999 and 1998, respectively. f. Nuclear Decommissioning In the Company's retail jurisdictions, provisions for nuclear decommissioning costs are approved by the NCUC and the SCPSC and are based on site-specific estimates that include the costs for removal of all radioactive and other structures at the site. In the wholesale jurisdiction, the provisions for nuclear decommissioning costs are based on amounts agreed upon in applicable rate agreements. Decommissioning cost provisions, which are included in depreciation and amortization expense, were $33.3 million in 1999 and 1998 and $33.2 million in 1997. Accumulated decommissioning costs, which are included in accumulated depreciation, were $568.0 million and $496.3 million at December 31, 1999 and 1998, respectively. These costs include amounts retained internally and amounts funded in an external decommissioning trust. The balance of the nuclear decommissioning trust was $379.9 million and $310.7 million at December 31, 1999 and 1998, respectively. Trust earnings increase the trust balance with a corresponding increase in the accumulated decommissioning balance. These balances are adjusted for net unrealized gains and losses related to changes in the fair value of trust assets. Based on the site-specific estimates discussed below, and using an assumed after-tax earnings rate of 7.75% and an assumed cost escalation rate of 4%, current levels of rate recovery for nuclear decommissioning costs are adequate to provide for decommissioning of the Company's nuclear facilities. The Company's most recent site-specific estimates of decommissioning costs were developed in 1998, using 1998 cost factors, and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site, with such removal occurring shortly after operating license expiration. These estimates, in 1998 dollars, are $279.8 million for Robinson Unit No. 2, $299.3 million for Brunswick Unit No. 1, $298.5 million for Brunswick Unit No. 2 and $328.1 million for the Harris Plant. The estimates are subject to change based on a variety of factors including, but not limited to, cost escalation, changes in technology applicable to nuclear decommissioning and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to North Carolina Eastern Municipal Power Agency (Power Agency), which holds an undivided ownership interest in the Brunswick and Harris nuclear generating facilities. Operating licenses for the Company's nuclear units expire in the year 2010 for Robinson Unit No. 2, 2016 for Brunswick Unit No. 1, 2014 for Brunswick Unit No. 2 and 2026 for the Harris Plant. The Financial Accounting Standards Board (FASB) is proceeding with its project regarding accounting practices related to obligations associated with the retirement of long-lived assets, and an exposure draft of a proposed accounting standard was issued during the first quarter of 2000. It is uncertain what effects it may ultimately have on the Company's accounting for nuclear decommissioning and other retirement costs. g. Other Policies The Company recognizes utility revenues as service is rendered to customers. Fuel expense includes fuel costs or recoveries that are deferred through fuel clauses established by the Company's regulators. These clauses allow the Company to recover fuel costs and the fuel component of purchased power costs through the fuel component of customer rates. The Company is also allowed to recover the costs of gas purchased for resale through customer rates. Other property and investments are stated principally at cost. The Company maintains an allowance for doubtful accounts receivable, which totaled approximately $16.8 million and $14.2 million at December 31, 1999 and 1998, respectively. Inventory, which includes fuel, materials and supplies, and gas in storage, is carried at average cost. Long-term debt premiums, discounts and issuance expenses are amortized over the life of the related debt using the straight-line method. Any expenses or call premiums associated with the reacquisition of debt obligations are amortized over the remaining life of the original debt using the straight-line method, except that the balance existing at December 31, 1996 was amortized on a three-year accelerated basis (see Note 9a). The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. h. New Accounting Standard The FASB has delayed the effective date for SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The delay, published as SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," changes the effective date to fiscal years beginning after June 15, 2000. The Company expects to determine any effects of SFAS No. 133 by mid-2000. 4. NCNG Acquisition On July 15, 1999, the Company completed the acquisition of North Carolina Natural Gas Corporation (NCNG) for an aggregate purchase price of approximately $364 million. Each outstanding share of NCNG common stock was converted into the right to receive 0.8054 shares of Company common stock, resulting in the issuance of approximately 8.3 million shares. The acquisition has been accounted for as a purchase and, accordingly, the operating results of NCNG have been included in the Company's consolidated financial statements since the date of acquisition. The excess of the aggregate purchase price over the fair value of net assets acquired, approximately $240 million, has been recorded as goodwill of the acquired business and is being amortized primarily over a period of 40 years. NCNG, operating as a wholly owned subsidiary of the Company, is engaged in the transmission and distribution of natural gas. These gas services are provided under regulated rates to approximately 178,000 customers in eastern and south central North Carolina. In conjunction with the acquisition, the Company and NCNG signed a joint stipulation agreement with the Public Staff of the NCUC in which the Company agreed to cap base retail electric rates, exclusive of fuel costs, with limited exceptions, through December 2004, and NCNG agreed to cap margin rates for gas sales and transportation services, with limited exceptions, through November 1, 2003. Management is of the opinion that this agreement will not have a material effect on the consolidated results of operations or financial position of the Company. The acquisition of NCNG was not deemed significant to the Company's consolidated results of operations; therefore, proforma financial information has been omitted. 5. Financial Information by Business Segment The Company provides services through the following business segments: electric, natural gas and other. The electric segment generates, transmits, distributes and sells electric energy in North and South Carolina. Electric operations are subject to the rules and regulations of the FERC, the NCUC and the SCPSC. The natural gas segment transmits, distributes and sells gas in portions of North Carolina. Gas operations are subject to the rules and regulations of the NCUC. The other segments primarily include telecommunication services, energy management services, propane and miscellaneous non-regulated activities. For reportable segments presented in the accompanying table, segment earnings (losses) before taxes include intersegment sales accounted for at prices representative of unaffiliated party transactions. RECONCILIATION OF FINANCIAL INFORMATION BY BUSINESS SEGMENT TO CONSOLIDATED FINANCIAL STATEMENTS: DEPRECIATION AND AMORTIZATION (in thousands) Adjustments to depreciation and amortization and interest expense consist of expenses related to the other segments that are included in diversified business operating expenses on a consolidated basis. 6. Revolving Credit Facilities As of December 31, 1999, the Company's revolving credit facilities totaled $750 million, all of which are long-term agreements. The Company is required to pay minimal annual commitment fees to maintain its credit facilities. Consistent with management's intent to maintain its commercial paper, pollution control revenue refunding bonds (pollution control bonds) and other short-term indebtedness on a long-term basis, and as supported by its long-term revolving credit facilities, the Company included in long-term debt commercial paper, pollution control bonds, and other short-term indebtedness outstanding of approximately $363 million, $56 million and $331 million, respectively, as of December 31, 1999. Commercial paper and pollution control bonds outstanding of approximately $488 million and $56 million, respectively, were reclassified as long-term debt as of December 31, 1998. For commercial paper, pollution control bonds and other short-term indebtedness, weighted-average interest rates were 6.07%, 3.32% and 5.88%, respectively, at December 31, 1999. The weighted-average interest rates for commercial paper and pollution control bonds were 5.22% and 3.67%, respectively, as of December 31, 1998. 7. Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents, commercial paper and extendible notes approximate fair value due to the short maturities of these instruments. At December 31, 1999 and 1998, there were miscellaneous investments with carrying amounts of approximately $60 million and $66 million, respectively, included in miscellaneous other property and investments. The carrying amount of these investments approximates fair value due to the short maturity of certain instruments and certain instruments are presented at fair value. The carrying amount of the Company's long-term debt was $2.54 billion and $2.20 billion at December 31, 1999 and 1998, respectively. The estimated fair value of this debt, as obtained from quoted market prices for the same or similar issues, was $2.47 billion and $2.31 billion at December 31, 1999 and 1998, respectively. External funds have been established, as required by the NRC, as a mechanism to fund certain costs of nuclear decommissioning (see Note 3f). These nuclear decommissioning trust funds are invested in stocks, bonds and cash equivalents. Nuclear decommissioning trust funds are presented at amounts that approximate fair value. Fair value is obtained from quoted market prices for the same or similar investments. 8. Capitalization As of December 31, 1999, the Company had 21,594,424 shares of authorized but unissued common stock reserved and available for issuance, primarily to satisfy the requirements of the Company's stock plans. The Company intends, however, to meet the requirements of these stock plans with issued and outstanding shares presently held by the Trustee of the Stock Purchase-Savings Plan or with open market purchases of common stock shares, as appropriate. During 1999, the Company issued stock in conjunction with the NCNG acquisition as discussed in Note 4. In addition, CP&L Energy's Board of Directors has authorized the issuance of shares in conjunction with the planned share exchange with FPC (see Note 2). The Company's mortgage, as supplemented, and charter contain provisions limiting the use of retained earnings for the payment of dividends under certain circumstances. As of December 31, 1999, there were no significant restrictions on the use of retained earnings. As of December 31, 1999, long-term debt maturities for the years 2000, 2002, 2003 and 2004 amounted to $197 million, $100 million, $7 million and $300 million, respectively, excluding commercial paper, pollution control bonds and other short-term indebtedness reclassified as long-term debt. There are no long-term debt maturities in 2001. 9. Regulatory Matters a. Regulatory Assets As a regulated entity, the Company is subject to the provisions of SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." See Note 16c for additional discussion of SFAS No. 71. Accordingly, the Company records certain assets resulting from the effects of the ratemaking process, which would not be recorded under generally accepted accounting principles for unregulated entities. At December 31, 1999 and 1998, the balances of the Company's regulatory assets were as follows (in thousands): * ALL OR CERTAIN PORTIONS OF THESE REGULATORY ASSETS HAVE BEEN SUBJECT TO ACCELERATED AMORTIZATION (SEE NOTE 3E). b. Retail Rate Matters In late 1998 and early 1999, the Company filed, and the respective commissions subsequently approved, proposals in the North and South Carolina retail jurisdictions to accelerate cost recovery of its nuclear generating assets beginning January 1, 2000, and continuing through 2004. The accelerated cost recovery began immediately after the 1999 expiration of the accelerated amortization of certain regulatory assets (see Note 3e). Pursuant to the orders, the Company's depreciation expense for nuclear generating assets will increase by a minimum of $106 million to a maximum of $150 million per year. Recovering the costs of the nuclear generating assets on an accelerated basis will better position the Company for the uncertainties associated with potential restructuring of the electric utility industry. In conjunction with the acquisition with NCNG, the Company signed a joint stipulation agreement with the Public Staff of the NCUC in which the Company agreed to cap base retail electric rates and margin rates for gas sales and transportation services (see Note 4). c. Plant-Related Deferred Costs In the 1988 rate orders, the Company was ordered to remove from rate base and treat as abandoned plant certain costs related to the Harris Plant. Abandoned plant amortization related to the 1988 rate orders was completed in 1998 for the wholesale and North Carolina retail jurisdictions and in 1999 for the South Carolina retail jurisdiction. Amortization of plant abandonment costs is included in depreciation and amortization expense and totaled $15.0 million, $24.2 million and $30.8 million in 1999, 1998 and 1997, respectively. The unamortized balances of plant abandonment costs are reported at the present value of future recoveries of these costs. The associated accretion of the present value was $0.6 million, $1.7 million and $3.5 million in 1999, 1998 and 1997, respectively, and is reported in other, net. 10. Risk Management Activities and Derivatives Transactions The Company uses a variety of instruments, including swaps, options and forward contracts, to manage exposure to fluctuations in commodity prices and interest rates. Such instruments contain credit risk if the counterparty fails to perform under the contract. The Company minimizes such risk by performing credit reviews using, among other things, publicly available credit ratings of such counterparties. Potential nonperformance by counterparties is not expected to have a material effect on the consolidated financial position or consolidated results of operations of the Company. a. Commodity Instruments - Non-Trading At December 31, 1999, the Company held several forward contracts that reduced the exposure to market fluctuations relative to the price and delivery of electricity products. Selling electricity forward contracts can reduce price risk on the Company's available but unsold generation. These contracts provide for physical delivery of the related commodity, and the financial effects of such contracts are recorded in the month of settlement. The Company from time to time enters into electricity option contracts to ensure a reliable source of capacity to meet its customers' electricity requirements or to limit risk associated with electricity prices. It is management's intent to take or make physical delivery under such contracts. Premiums paid or received are deferred and charged to income during the option period. The Company's maximum exposure associated with purchased options is limited to premiums paid. Option sales are made only if the Company can, with reasonable certainty, make physical delivery from Company-owned resources. b. Commodity Instruments - Trading The Company from time to time engages in the trading of electricity commodity instruments and, therefore, experiences net open positions. The Company manages open positions with strict policies which limit its exposure to market risk and require daily reporting to management of potential financial exposures. When such instruments are entered into for trading purposes, the instruments are carried on the balance sheet at fair value, with changes in fair value recognized in earnings. Net losses related to trading electricity commodity instruments were not material during 1999 and 1998, and there was no trading activity in 1997. c. Other Financial Instruments The Company may from time to time enter into derivative instruments to hedge interest rate risk or equity securities risk. At December 31, 1998, the Company had an outstanding interest rate lock with a fair value asset position of approximately $1 million. The interest rate lock was settled during 1999 in conjunction with the issuance of long-term debt, and the Company received approximately $9.7 million, which will reduce interest expense over the 10-year debt term. 11. Stock-Based Compensation Plans a. Employee Stock Ownership Plan The Company sponsors the Stock Purchase-Savings Plan (SPSP) for which substantially all full-time employees and certain part-time employees are eligible. The SPSP, which has Company matching and incentive goal features, encourages systematic savings by employees and provides a method of acquiring Company common stock and other diverse investments. The SPSP, as amended in 1989, is an Employee Stock Ownership Plan (ESOP) that can enter into acquisition loans to acquire Company common stock to satisfy SPSP common share needs. Qualification as an ESOP did not change the level of benefits received by employees under the SPSP. Common stock acquired with the proceeds of an ESOP loan is held by the SPSP Trustee in a suspense account. The common stock is released from the suspense account and made available for allocation to participants as the ESOP loan is repaid. Such allocations are used to partially meet common stock needs related to Company matching and incentive contributions and/or reinvested dividends. All or a portion of the dividends paid on ESOP suspense shares and on ESOP shares allocated to participants may be used to repay ESOP acquisition loans. To the extent used to repay such loans, the dividends are deductible for income tax purposes. There were 6,365,364 and 6,953,612 ESOP suspense shares at December 31, 1999 and 1998, respectively, with a fair value of $193.7 million and $327.3 million, respectively. ESOP shares allocated to plan participants totaled 12,966,269 and 12,416,040 at December 31, 1999 and 1998, respectively. The Company's matching and incentive goal compensation cost under the SPSP is determined based on matching percentages and incentive goal attainment as defined in the plan. Such compensation cost is allocated to participants' accounts in the form of Company common stock, with the number of shares determined by dividing compensation cost by the common stock market value. The Company currently meets common stock share needs with open market purchases and with shares released from the ESOP suspense account. Total matching and incentive compensation cost recorded in 1999, 1998 and 1997 was approximately $17.3 million, $15.3 million and $13.4 million, respectively, substantially all of which was met with shares released from the suspense account. The Company has a long-term note receivable from the SPSP Trustee related to the purchase of common stock from the Company in 1989. The balance of the note receivable from the SPSP Trustee is included in the determination of unearned ESOP common stock, which reduces common stock equity. ESOP shares that have not been committed to be released to participants' accounts are not considered outstanding for the determination of earnings per common share. Interest income on the note receivable and dividends on unallocated ESOP shares are not recognized for financial statement purposes. b. Other Stock-Based Compensation Plans The Company has compensation plans for officers and key employees of the Company that are stock-based in whole or in part. The two primary active stock-based compensation programs are the Performance Share Sub-Plan (PSSP) and the Restricted Stock Awards program (RSA), both of which were established pursuant to the Company's 1997 Equity Incentive Plan. Under the terms of the PSSP, officers and key employees of the Company are granted performance shares that vest over a three-year consecutive period. Each performance share has a value that is equal to, and changes with, the value of a share of the Company's common stock, and dividend equivalents are accrued on, and reinvested in, the performance shares. For grant years prior to 1999, the sole performance measure under the PSSP is the Company's total shareholder return as compared to that of a peer group of utilities. Beginning in the 1999 grant year, the Company added an additional performance measure, earnings before interest, income taxes, depreciation and amortization, which is also compared to a peer group of utilities. Compensation expense is recognized over the vesting period based on the expected ultimate cash payout. Compensation expense is reduced by any forfeitures. The RSA, which began in 1998, allows the Company to grant shares of restricted common stock to key employees of the Company. The restricted shares vest on a graded vesting schedule over a minimum of three years. Compensation expense, which is based on the fair value of common stock at the grant date, is recognized over the applicable vesting period, with corresponding increases in common stock equity. Compensation expense is reduced by any forfeitures. Restricted shares are not included as shares outstanding in the basic earnings per share calculation until the shares are no longer forfeitable. Changes in restricted stock shares outstanding were: The total amount expensed for other stock-based compensation plans was $2.2 million, $1.3 million and $4.3 million in 1999, 1998 and 1997, respectively. 12. Postretirement Benefit Plans The Company has a noncontributory defined benefit retirement (pension) plan for substantially all full-time employees. The components of net periodic pension cost are (in thousands): Prior service costs and benefits are amortized on a straight-line basis over the average remaining service period of active participants. Actuarial gains and losses in excess of 10% of the greater of the pension obligation or the market-related value of assets are amortized over the average remaining service period of active participants. Reconciliations of the changes in the plan's benefit obligations and the plan's funded status are (in thousands): 1999 1998 --------- --------- Pension obligation Pension obligation at January 1 $ 678,210 $ 598,160 Interest cost 46,846 45,877 Service cost 20,467 18,357 Benefit payments (41,585) (25,466) Actuarial loss (gain) (50,120) 77,785 Plan amendments 5,546 (36,503) Acquisition of NCNG 28,760 -- --------- --------- Pension obligation at December 31 $ 688,124 $ 678,210 Fair value of plan assets at December 31 947,143 830,213 --------- --------- Funded status $ 259,019 $ 152,003 Unrecognized transition obligation 582 688 Unrecognized prior service benefit (18,175) (25,429) Unrecognized actuarial gain (245,343) (145,657) --------- --------- Accrued pension obligation at December 31 $ (3,917) $ (18,395) ========= ========= Reconciliations of the fair value of pension plan assets are (in thousands): 1999 1998 ---------- --------- Fair value of plan assets at January 1 $ 830,213 $ 768,297 Actual return on plan assets 127,167 87,382 Benefit payments (41,585) (25,466) Acquisition of NCNG 31,348 - ---------- --------- Fair value of plan assets at December 31 $ 947,143 $ 830,213 ========= ========= The weighted-average discount rate used to measure the pension obligation was 7.5% in 1999 and 7.0% in 1998. The assumed rate of increase in future compensation used to measure the pension obligation was 4.20% in 1999, 1998 and 1997. The expected long-term rate of return on pension plan assets used in determining the net periodic pension cost was 9.25% in 1999, 1998 and 1997. In addition to pension benefits, the Company provides contributory postretirement benefits (OPEB), including certain health care and life insurance benefits, for substantially all retired employees. The components of net periodic OPEB cost are (in thousands): 1999 1998 1997 -------- -------- -------- Actual return on plan assets $ (5,931) $ (3,877) $ (4,628) Variance from expected return, Deferred 2,553 785 2,186 -------- -------- -------- Expected return on plan assets $ (3,378) $ (3,092) $ (2,442) Service cost 7,936 7,182 7,988 Interest cost 13,914 13,402 11,065 Amortization of transition obligation 5,760 5,641 5,889 Amortization of actuarial gain (1) (549) -- -------- -------- -------- Net periodic OPEB cost $ 24,231 $ 22,584 $ 22,500 ======== ======== ======== Actuarial gains and losses in excess of 10% of the greater of the OPEB obligation or the market-related value of assets are amortized over the average remaining service period of active participants. Reconciliations of the changes in the plan's benefit obligations and the plan's funded status are (in thousands): 1999 1998 --------- --------- OPEB obligation OPEB obligation at January 1 $ 196,846 $ 181,324 Interest cost 13,914 13,402 Service cost 7,936 7,182 Benefit payments (5,769) (4,774) Actuarial loss (gain) (7,307) 3,428 Plan amendment 1,062 (3,716) Acquisition of NCNG 6,806 -- --------- --------- OPEB obligation at December 31 $ 213,488 $ 196,846 Fair value of plan assets at December 31 43,235 37,304 --------- --------- Funded status $(170,253) $(159,542) Unrecognized transition obligation 76,593 78,978 Unrecognized prior service cost 1,062 -- Unrecognized actuarial gain (17,261) (7,314) --------- --------- Accrued OPEB obligation at December 31 $(109,859) $ (87,878) ========= ========= Reconciliations of the fair value of OPEB plan assets are (in thousands): 1999 1998 --------- --------- Fair value of plan assets at January 1 $37,304 $33,427 Actual return on plan assets 5,931 3,877 --------- --------- Fair value of plan assets at December 31 $43,235 $37,304 ========= ========= The assumptions used to measure the OPEB obligation are: 1999 1998 --------- --------- Weighted-average discount rate 7.50% 7.00% Initial medical cost trend rate for pre-Medicare benefits 7.50% 6.60% Initial medical cost trend rate for post-Medicare benefits 7.25% 6.40% Ultimate medical cost trend rate 5.00% 4.50% Year ultimate medical cost trend rate is achieved 2006 2006 The expected long-term rate of return on plan assets used in determining the net periodic OPEB cost was 9.25% in 1999, 1998 and 1997. The medical cost trend rates were assumed to decrease gradually from the initial rates to the ultimate rates. Assuming a 1% increase in the medical cost trend rates, the aggregate of the service and interest cost components of the net periodic OPEB cost for 1999 would increase by $4.0 million, and the OPEB obligation at December 31, 1999, would increase by $29.3 million. Assuming a 1% decrease in the medical cost trend rates, the aggregate of the service and interest cost components of the net periodic OPEB cost for 1999 would decrease by $3.1 million and the OPEB obligation at December 31, 1999, would decrease by $23.6 million. During 1999, the Company completed the acquisition of NCNG (see Note 4). NCNG's pension and OPEB liabilities, assets and net periodic costs are reflected in the above information as appropriate. Effective January 1, 2000, NCNG's benefit plans were merged with those of the Company. 13. Earnings Per Common Share Restricted stock awards and contingently issuable shares had a dilutive effect on earnings per share for 1999 and increased the weighted-average number of common shares outstanding for dilutive purposes by 290,474, 250,660 and 11,893 for 1999, 1998 and 1997, respectively. The weighted-average number of common shares outstanding for dilutive purposes was 148.6 million, 144.2 million and 143.7 million for 1999, 1998 and 1997, respectively. 14. Income Taxes Deferred income taxes are provided for temporary differences between book and tax bases of assets and liabilities. Investment tax credits related to operating income are amortized over the service life of the related property. Net accumulated deferred income tax liabilities at December 31 are (in thousands): 1999 1998 ---------- ---------- Accelerated depreciation and property cost differences $1,583,610 $1,632,119 Deferred costs, net 70,478 66,757 Miscellaneous other temporary differences, net 26,403 10,885 ---------- ---------- Net accumulated deferred income tax liability $1,680,491 $1,709,761 ========== ========== Total deferred income tax liabilities were $2.20 billion and $2.21 billion at December 31, 1999 and 1998, respectively. Total deferred income tax assets were $519 million and $501 million at December 31, 1999 and 1998, respectively. The net of deferred income tax liabilities and deferred income tax assets is included on the Consolidated Balance Sheets under the captions other current liabilities and accumulated deferred income taxes. Reconciliations of the Company's effective income tax rate to the statutory federal income tax rate are: 1999 1998 1997 ---- ---- ---- Effective income tax rate 40.3% 39.2% 37.5% State income taxes, net of federal income tax benefit (4.6) (4.7) (4.9) Investment tax credit amortization 1.6 1.5 1.7 Other differences, net (2.3) (1.0) 0.7 ---- ---- ---- Statutory federal income tax rate 35.0% 35.0% 35.0% ==== ==== ==== The provisions for income tax expense are comprised of (in thousands): 1999 1998 1997 --------- --------- --------- Income tax expense (credit) Current - federal $ 253,140 $ 254,400 $ 258,050 state 48,075 51,817 56,747 Deferred - federal (30,011) (34,842) (61,384) state (2,484) (3,675) (9,465) Investment tax credit (10,299) (10,206) (10,232) --------- --------- --------- Total income tax expense $ 258,421 $ 257,494 $ 233,716 ========= ========= ========= 15. Joint Ownership of Generating Facilities Power Agency holds undivided ownership interests in certain generating facilities of the Company. The Company and Power Agency are entitled to shares of the generating capability and output of each unit equal to their respective ownership interests. Each also pays its ownership share of additional construction costs, fuel inventory purchases and operating expenses. The Company's share of expenses for the jointly owned units is included in the appropriate expense category. The Company's ownership interest in the jointly owned generating facilities is listed below with related information as of December 31, 1999 (dollars in thousands): In the table above, plant investment and accumulated depreciation, which includes accumulated nuclear decommissioning, are not reduced by the regulatory disallowances related to the Harris Plant. 16. Commitments and Contingencies a. Purchased Power Pursuant to the terms of the 1981 Power Coordination Agreement, as amended, between the Company and Power Agency, the Company is obligated to purchase a percentage of Power Agency's ownership capacity of, and energy from, the Harris Plant. In 1993, the Company and Power Agency entered into an agreement to restructure portions of their contracts covering power supplies and interests in jointly owned units. Under the terms of the 1993 agreement, the Company increased the amount of capacity and energy purchased from Power Agency's ownership interest in the Harris Plant, and the buyback period was extended six years through 2007. The estimated minimum annual payments for these purchases, which reflect capital-related capacity costs, total approximately $26 million. These contractual purchases, including purchases from the Mayo Plant that ended in 1997, totaled $36.5 million, $34.4 million and $36.2 million for 1999, 1998 and 1997, respectively. In 1987, the NCUC ordered the Company to reflect the recovery of the capacity portion of these costs on a levelized basis over the original 15-year buyback period, thereby deferring for future recovery the difference between such costs and amounts collected through rates. In 1988, the SCPSC ordered similar treatment, but with a 10-year levelization period. At December 31, 1999 and 1998, the Company had deferred purchased capacity costs, including carrying costs accrued on the deferred balances, of $56.1 million and $60.0 million, respectively. Increased purchases (which are not being deferred for future recovery) resulting from the 1993 agreement with Power Agency were approximately $23 million, $19 million and $17 million for 1999, 1998 and 1997, respectively. During 1999, the Company had two long-term agreements for the purchase of power and related transmission services from other utilities. The first agreement provides for the purchase of 250 megawatts of capacity through 2009 from Indiana Michigan Power Company's Rockport Unit No. 2 (Rockport). The second agreement, which expired mid-1999, was with Duke Energy for the purchase of 400 megawatts of firm capacity. The estimated minimum annual payment for power purchases under the Rockport agreement is approximately $31 million, representing capital-related capacity costs. Total purchases (including transmission use charges) under the Rockport agreement amounted to $59.5 million, $59.3 million and $61.9 million for 1999, 1998 and 1997, respectively. Total purchases (including transmission use charges) under the agreement with Duke Energy amounted to $33.8 million, $75.5 million and $69.5 million for 1999, 1998 and 1997, respectively. b. Insurance The Company is a member of Nuclear Electric Insurance Limited (NEIL), which provides primary and excess insurance coverage against property damage to members' nuclear generating facilities. Under the primary program, the Company is insured for $500 million at each of its nuclear plants. In addition to primary coverage, NEIL also provides decontamination, premature decommissioning and excess property insurance with limits of $1.4 billion on the Brunswick Plant, $2 billion on the Harris Plant and $800 million on the Robinson Plant. Insurance coverage against incremental costs of replacement power resulting from prolonged accidental outages at nuclear generating units is also provided through membership in NEIL. The Company is insured thereunder, following a twelve week deductible period, for 52 weeks in weekly amounts of $1.95 million at Brunswick Unit No. 1, $1.93 million at Brunswick Unit No. 2, $2.0 million at the Harris Plant and $1.7 million at Robinson Unit No. 2. An additional 104 weeks of coverage is provided at 80% of the above weekly amounts. For the current policy period, the Company is subject to retrospective premium assessments of up to approximately $12.5 million with respect to the primary coverage, $13.7 million with respect to the decontamination, decommissioning and excess property coverage and $5.0 million for the incremental replacement power costs coverage in the event covered expenses at insured facilities exceed premiums, reserves, reinsurance and other NEIL resources. These resources as of December 31, 1999 totaled approximately $5.0 billion. Pursuant to regulations of the NRC, the Company's property damage insurance policies provide that all proceeds from such insurance be applied, first, to place the plant in a safe and stable condition after an accident and, second, to decontamination costs, before any proceeds can be used for decommissioning, plant repair or restoration. The Company is responsible to the extent losses may exceed limits of the coverage described above. Power Agency would be responsible for its ownership share of such losses and for certain retrospective premium assessments on jointly owned nuclear units. The Company is insured against public liability for a nuclear incident up to $9.7 billion per occurrence, which is the maximum limit on public liability claims pursuant to the Price-Anderson Act. In the event that public liability claims from an insured nuclear incident exceed $200 million, the Company would be subject to a pro rata assessment of up to $83.9 million, plus a 5% surcharge, for each reactor owned for each incident. Payment of such assessment would be made over time as necessary to limit the payment in any one year to no more than $10 million per reactor owned. Power Agency would be responsible for its ownership share of the assessment on jointly owned nuclear units. c. Applicability of SFAS No. 71 The Company's ability to continue to meet the criteria for application of SFAS No. 71 (see Note 9a) may be affected in the future by competitive forces and restructuring in the electric utility industry. In the event that SFAS No. 71 no longer applied to a separable portion of the Company's operations, related regulatory assets and liabilities would be eliminated unless an appropriate regulatory recovery mechanism is provided. Additionally, these factors could result in an impairment of electric utility plant assets as determined pursuant to SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." d. Claims and Uncertainties 1. The Company is subject to federal, state and local regulations addressing air and water quality, hazardous and solid waste management and other environmental matters. Various organic materials associated with the production of manufactured gas, generally referred to as coal tar, are regulated under federal and state laws. There are several manufactured gas plant (MGP) sites to which both the electric utility and the gas utility have some connection. In this regard, both the electric utility and the gas utility, along with others, are participating in a cooperative effort with the North Carolina Department of Environment and Natural Resources, Division of Waste Management (DWM). The DWM has established a uniform framework to address MGP sites. The investigation and remediation of specific MGP sites will be addressed pursuant to one or more Administrative Orders on Consent (AOC) between the DWM and the potentially responsible party or parties. Both the electric utility and the gas utility have signed AOCs to investigate certain sites at which investigation includes the completion of interim remedial measures where appropriate and anticipate signing AOCs to remediate sites as well. Both the electric utility and the gas utility continue to identify parties connected to individual MGP sites, and to determine their relative relationship to other parties at those sites and the degree to which they will undertake efforts with others at individual sites. The Company does not expect the costs associated with these sites to be material to the financial position or consolidated results of operations of the Company. The Company is periodically notified by regulators such as the North Carolina Department of Environment and Natural Resources, the South Carolina Department of Health and Environmental Control, and the U.S. Environmental Protection Agency (EPA) of its involvement or potential involvement in sites, other than MGP sites, that may require investigation and/or remediation. Although the Company may incur costs at the sites about which it has been notified, based upon the current status of these sites, the Company does not expect those costs to be material to the consolidated financial position or results of operations of the Company. The EPA has been conducting an enforcement initiative related to a number of coal-fired utility power plants in an effort to determine whether modifications at those facilities were subject to New Source Review requirements or New Source Performance Standards under the Clean Air Act. The Company has recently been asked to provide information to the EPA as part of this initiative and has cooperated in providing the requested information. The EPA has initiated enforcement actions, which may have potentially significant penalties against other companies that have been subject to this initiative. The Company cannot predict the outcome of this matter. The EPA published a final rule approving petitions under section 126 of the Clean Air Act which requires certain sources to make reductions in nitrogen oxide emissions by 2003. The Company's fossil-fueled electric generating plants are included in these petitions. The Company and other states are participating in litigation challenging the EPA's action. The Company cannot predict the outcome of this matter. 2. As required under the Nuclear Waste Policy Act of 1982, the Company entered into a contract with the DOE under which the DOE agreed to begin taking spent nuclear fuel by no later than January 31, 1998. All similarly situated utilities were required to sign the same standard contract. In April 1995, the DOE issued a final interpretation that it did not have an unconditional obligation to take spent nuclear fuel by January 31, 1998. In Indiana & Michigan Power v. DOE, the Court of Appeals vacated the DOE's final interpretation and ruled that the DOE had an unconditional obligation to begin taking spent nuclear fuel. The Court did not specify a remedy because the DOE was not yet in default. After the DOE failed to comply with the decision in Indiana & Michigan Power v. DOE, a group of utilities (including the Company) petitioned the Court of Appeals in Northern States Power (NSP) v. DOE, seeking an order requiring the DOE to begin taking spent nuclear fuel by January 31, 1998. The DOE took the position that their delay was unavoidable, and the DOE was excused from performance under the terms and conditions of the contract. The Court of Appeals issued an order which precluded the DOE from treating the delay as an unavoidable delay. However, the Court of Appeals did not order the DOE to begin taking spent nuclear fuel, stating that the utilities had a potentially adequate remedy by filing a claim for damages under the contract. After the DOE failed to begin taking spent nuclear fuel by January 31, 1998, a group of utilities (including the Company) filed a motion with the Court of Appeals to enforce the mandate in NSP v. DOE. Specifically, the utilities asked the Court to permit the utilities to escrow their waste fee payments, to order the DOE not to use the waste fund to pay damages to the utilities, and to order the DOE to establish a schedule for disposal of spent nuclear fuel. The Court denied this motion based primarily on the grounds that a review of the matter was premature, and that some of the requested remedies fell outside of the mandate in NSP v. DOE. Subsequently, a number of utilities each filed an action for damages in the Court of Claims and before the Court of Appeals. The Company is in the process of evaluating whether it should file a similar action for damages. In NSP v. U.S., the Court of Claims decided that NSP must pursue its administrative remedies instead of filing an action in the Court of Claims. NSP has filed an interlocutory appeal to the Court of Appeals based on NSP's position that the Court of Claims has jurisdiction to decide the matter. A group of utilities (including the Company) has submitted an amicus brief in support of NSP's position. The Company also continues to monitor legislation that has been introduced in Congress which might provide some limited relief. The Company cannot predict the outcome of this matter. With certain modifications and additional approval by the NRC, the Company's spent nuclear fuel storage facilities will be sufficient to provide storage space for spent fuel generated on the Company's system through the expiration of the current operating licenses for all of the Company's nuclear generating units. Subsequent to the expiration of these licenses, dry storage may be necessary. The Company has initiated the process of obtaining the additional NRC approval. 3. In the opinion of management, liabilities, if any, arising under other pending claims would not have a material effect on the financial position and consolidated results of operations of the Company. CAROLINA POWER & LIGHT COMPANY SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS Year Ended December 31, 1999 CAROLINA POWER & LIGHT COMPANY SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS Year Ended December 31, 1998 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NONE PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT a) Information on the Company's directors is set forth in the Company's 2000 definitive proxy statement dated March 31, 2000, and incorporated by reference herein. b) Information on the Company's executive officers is set forth in PART I and incorporated by reference herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information on executive compensation is set forth in the Company's 2000 definitive proxy statement dated March 31, 2000, and incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT a) The Company knows of no person who is a beneficial owner of more than five (5%) percent of any class of the Company's voting securities except for Capital Research and Management Company, 333 South Hope Street, Los Angeles, CA 90071, which as of December 31, 1999, owned 9,450,000 shares of common stock (5.9% of class) as investment advisor and manager of The American Funds Group of Mutual Funds. b) Information on security ownership of the Company's management is set forth in the Company's 2000 definitive proxy statement dated March 31, 2000, and incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information on certain relationships and related transactions is set forth in the Company's 2000 definitive proxy statement dated March 31, 2000, and incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. a) The following documents are filed as part of the report: 1. Consolidated Financial Statements Filed: See ITEM 8 - Consolidated Financial Statements and Supplementary Data. 2. Consolidated Financial Statement Schedules Filed: See ITEM 8 - Consolidated Financial Statements and Supplementary Data 3. Exhibits Filed: See EXHIBIT INDEX b) Reports on Form 8-K filed during or with respect to the last quarter of 1999 and the portion of the first quarter of 2000 prior to the filing of this Form 10-K: 1. Current Report on Form 8-K dated October 25, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CAROLINA POWER & LIGHT COMPANY ------------------------------ Date: 3/24/00 (Registrant) ------- By: /s/Robert B. McGehee -------------------- Executive Vice President and Interim Chief Financial Officer By: /s/Larry M. Smith --------------------- Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION *2(a) Agreement and Plan of Merger By and Among Carolina Power & Light Company, North Carolina Natural Gas Corporation and Carolina Acquisition Corporation, dated as of November 10, 1998 (filed as Exhibit No. 2(b) to Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998, File No. 1-3382.) *2(b) Agreement and Plan of Merger by and among Carolina Power & Light Company, North Carolina Natural Gas Corporation and Carolina Acquisition Corporation, Dated as of November 10, 1998, as Amended and Restated as of April 22, 1999 (filed as Exhibit 2 to Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999, File No. 1-3382). *2(c) Agreement and Plan of Exchange, dated as of August 22, 1999, by and among Carolina Power & Light Company, Florida Progress Corporation and CP&L Holdings, Inc. (filed as Exhibit 2.1 to Current Report on Form 8-K dated August 22, 1999, File No. 1-3382). *2(4) Amended and Restated Agreement and Plan of Exchange, by and among Carolina Power & Light Company, Florida Progress Corporation and CP&L Energy, Inc., dated as of August 22, 1999, amended and restated as of March 3, 2000 (filed as Annex A to Joint Preliminary Proxy Statement of Carolina Power & Light Company and Florida Progress Corporation dated March 6, 2000, File No. 1-03382). *3a(1) Restated Charter of Carolina Power & Light Company, as amended May 10, 1996 (filed as Exhibit No. 3(i) to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1995, File No. 1-3382). *3a(2) Restated Charter of Carolina Power & Light Company as amended on May 10, 1996 (filed as Exhibit 3(i) to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997, File No. 1-3382). *3b(1) By-Laws of Carolina Power & Light Company, as amended May 10, 1996 (filed as Exhibit No. 3(ii) to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1995, File No. 1-3382). *3b(2) By-Laws of Carolina Power & Light Company, as amended on September 18, 1996 (filed as Exhibit 3(ii) to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997, File No.1-3382). *3b(3) By-Laws of Carolina Power & Light Company, as amended on March 17, 1999 (filed as Exhibit No. 3b(3) to Annual Report on Form 10-K for the fiscal year ended December 31, 1998, File No. 1-3382). *4a(1) Resolution of Board of Directors, dated December 8, 1954, authorizing the issuance of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $4.20 Series (filed as Exhibit 3(c), File No. 33-25560). *4a(2) Resolution of Board of Directors, dated January 17, 1967, authorizing the issuance of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $5.44 Series (filed as Exhibit 3(d), File No. 33-25560). *4a(3) Statement of Classification of Shares dated January 13, 1971, relating to the authorization of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $7.95 Series (filed as Exhibit 3(f), File No. 33-25560). *4a(4) Statement of Classification of Shares dated September 7, 1972, relating to the authorization of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $7.72 Series (filed as Exhibit 3(g), File No. 33-25560). *4b Mortgage and Deed of Trust dated as of May 1, 1940 between the Company and The Bank of New York (formerly, Irving Trust Company) and Frederick G. Herbst (Douglas J. MacInnes, Successor), Trustees and the First through Fifth Supplemental Indentures thereto (Exhibit 2(b), File No. 2-64189); and the Sixth through Sixty-sixth Supplemental Indentures (Exhibit 2(b)-5, File No. 2-16210; Exhibit 2(b)-6, File No. 2-16210; Exhibit 4(b)-8, File No. 2-19118; Exhibit 4(b)-2, File No. 2-22439; Exhibit 4(b)-2, File No. 2-24624; Exhibit 2(c), File No. 2-27297; Exhibit 2(c), File No. 2-30172; Exhibit 2(c), File No. 2-35694; Exhibit 2(c), File No. 2-37505; Exhibit 2(c), File No. 2-39002; Exhibit 2(c), File No. 2-41738; Exhibit 2(c), File No. 2-43439; Exhibit 2(c), File No. 2-47751; Exhibit 2(c), File No. 2-49347; Exhibit 2(c), File No. 2-53113; Exhibit 2(d), File No. 2-53113; Exhibit 2(c), File No. 2-59511; Exhibit 2(c), File No. 2-61611; Exhibit 2(d), File No. 2-64189; Exhibit 2(c), File No. 2-65514; Exhibits 2(c) and 2(d), File No. 2-66851; Exhibits 4(b)-1, 4(b)-2, and 4(b)-3, File No. 2-81299; Exhibits 4(c)-1 through 4(c)-8, File No. 2-95505; Exhibits 4(b) through 4(h), File No. 33-25560; Exhibits 4(b) and 4(c), File No. 33-33431; Exhibits 4(b) and 4(c), File No. 33-38298; Exhibits 4(h) and 4(I), File No. 33-42869; Exhibits 4(e)-(g), File No. 33-48607; Exhibits 4(e) and 4(f), File No. 33-55060; Exhibits 4(e) and 4(f), File No. 33-60014; Exhibits 4(a) and 4(b) to Post-Effective Amendment No. 1, File No. 33-38349; Exhibit 4(e), File No. 33-50597; Exhibit 4(e) and 4(f), File No. 33-57835; Exhibit to Current Report on Form 8-K dated August 28, 1997, File No. 1-3382; Form of Carolina Power & Light Company First Mortgage Bond, 6.80% Series Due August 15, 2007 filed as Exhibit 4 to Form 10-Q for the period ended September 30, 1998, File No. 1-3382; Exhibit 4(b), File No. 333-69237; and Exhibit 4(c), File No. 1-03382.) *4c(1) Indenture, dated as of March 1, 1995, between the Company and Bankers Trust Company, as Trustee, with respect to Unsecured Subordinated Debt Securities (filed as Exhibit No. 4(c) to Current Report on Form 8-K dated April 13, 1995, File No. 1-3382). *4c(2) Resolutions adopted by the Executive Committee of the Board of Directors at a meeting held on April 13, 1995, establishing the terms of the 8.55% Quarterly Income Capital Securities (Series A Subordinated Deferrable Interest Debentures) (filed as Exhibit 4(b) to Current Report on Form 8-K dated April 13, 1995, File No. 1-3382). *4d Indenture (for Senior Notes), dated as of March 1, 1999 between Carolina Power & Light Company and The Bank of New York, as Trustee, and the First Supplemental Senior Note Indenture thereto, (filed as Exhibits No. 4(a) and 4(b) to Current Report on Form 8-K dated March 19, 1999, File No. 1-03382). *4(e) Indenture (For Debt Securities), dated as of October 28, 1999 between Carolina Power & Light Company and The Chase Manhattan Bank, as Trustee (filed as Exhibit 4(a) to Current Report on Form 8-K dated November 5, 1999, File No. 1-03382). *10a(1) Purchase, Construction and Ownership Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency, amending letter dated February 18, 1982, and amendment dated February 24, 1982 (filed as Exhibit 10(a), File No. 33-25560). *10a(2) Operating and Fuel Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency, amending letters dated August 21, 1981 and December 15, 1981, and amendment dated February 24, 1982 (filed as Exhibit 10(b), File No. 33-25560). *10a(3) Power Coordination Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency and amending letter dated January 29, 1982 (filed as Exhibit 10(c), File No. 33-25560). *10a(4) Amendment dated December 16, 1982 to Purchase, Construction and Ownership Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Eastern Municipal Power Agency (filed as Exhibit 10(d), File No. 33-25560). *10a(5) Agreement Regarding New Resources and Interim Capacity between Carolina Power & Light Company and North Carolina Eastern Municipal Power Agency dated October 13, 1987 (filed as Exhibit 10(e), File No. 33-25560). *10a(6) Power Coordination Agreement - 1987A between North Carolina Eastern Municipal Power Agency and Carolina Power & Light Company for Contract Power From New Resources Period 1987-1993 dated October 13, 1987 (filed as Exhibit 10(f), File No. 33-25560). + *10b(1) Directors Deferred Compensation Plan effective January 1, 1982 as amended (filed as Exhibit 10(g), File No. 33-25560). + *10b(2) Supplemental Executive Retirement Plan effective January 1, 1984 (filed as Exhibit 10(h), File No. 33-25560). + *10b(3) Retirement Plan for Outside Directors (filed as Exhibit 10(i), File No. 33-25560). + *10b(4) Executive Deferred Compensation Plan effective May 1, 1982 as amended (filed as Exhibit 10(j), File No. 33-25560). + *10b(5) Key Management Deferred Compensation Plan (filed as Exhibit 10(k), File No. 33-25560). + *10b(6) Resolutions of the Board of Directors, dated March 15, 1989, amending the Key Management Deferred Compensation Plan (filed as Exhibit 10(a), File No. 33-48607). +*10b(7) Resolutions of the Board of Directors dated May 8, 1991, amending the Directors Deferred Compensation Plan (filed as Exhibit 10(b), File No. 33-48607). +*10b(8) Resolutions of the Board of Directors dated May 8, 1991, amending the Executive Deferred Compensation Plan (filed as Exhibit 10(c), File No. 33-48607). +*10b(9) 1997 Equity Incentive Plan, approved by the Company's shareholders May 7, 1997, effective as of January 1, 1997 (filed as Appendix A to the Company's 1997 Proxy Statement, File No. 1-03382). +*10b(10) Performance Share Sub-Plan of the 1997 Equity Incentive Plan, adopted by the Personnel, Executive Development and Compensation Committee of the Board of Directors, March 19, 1997, subject to shareholder approval of the 1997 Equity Incentive Plan, which was obtained on May 7, 1997, (filed as Exhibit 10(b), File No. 1-03382). +*10b(11) Resolutions of Board of Directors dated July 9, 1997, amending the Deferred Compensation Plan for Key Management Employees of Carolina Power & Light Company. +*10b(12) Resolutions of Board of Directors dated July 9, 1997, amending the Supplemental Executive Retirement Plan of Carolina Power & Light Company. +*10b(13) Amended Management Incentive Compensation Program of Carolina Power & Light Company, as amended December 10, 1997. +*10b(14) Carolina Power & Light Company Restoration Retirement Plan, effective January 1, 1998. +*10b(15) Carolina Power & Light Company Non-Employee Director Stock Unit Plan, effective January 1, 1998. +*10b(16) Carolina Power & Light Company Restricted Stock Agreement, as approved January 7, 1998, pursuant to the Company's 1997 Equity Incentive Plan (filed as Exhibit No. 10 to Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1998, File No. 1-3382.) +*10b(17) Resolutions of Board of Directors dated July 17, 1998, amending the Supplemental Executive Retirement Plan of Carolina Power & Light Company, effective January 1, 1999, (filed as Exhibit No. 10(a) to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998, File No. 1-3382.) +*10b(18) Amended Management Incentive Compensation Plan of Carolina Power & Light Company, effective January 1, 1999, as amended by the Organization and Compensation Committee of the Board of Directors on July 17, 1998, (filed as Exhibit No. 10(b) to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998, File No. 1-3382.) +*10b(19) Supplemental Senior Executive Retirement Plan of Carolina Power & Light Company, as amended January 1, 1999 (filed as Exhibit No. 10b(19) to Annual Report on Form 10-K for the fiscal year ended December 31, 1998, File No. 1-3382). +*10b(20) Carolina Power & Light Company Restoration Retirement Plan, as amended January 1, 1999 (filed as Exhibit No. 10b(20) to Annual Report on Form 10-K for the fiscal year ended December 31, 1998, File No. 1-3382). +10b(21) Performance Share Sub-Plan of the 1997 Equity Incentive Plan, as Revised and Restated March 17, 1999. +10b(22) Amended Management Incentive Compensation Plan of Carolina Power & Light Company, as amended January 1, 2000. +*10b(23) Carolina Power & Light Company Management Deferred Compensation Plan, adopted as of January 1, 2000, (filed as Exhibit 4 to Form S-8 dated October 25, 1999, File No. 333-89685). +10b(24) Amended and Restated Supplemental Senior Executive Retirement Plan of Carolina Power & Light Company, effective January 1, 1984, as last amended March 15, 2000. +*10b(25) Employment Agreement dated September 1, 1992, by and between the Company and William Cavanaugh III (filed as Exhibit 10b, File No. 1-03382). +*10b(26) Employment Agreement dated April 1, 1993, by and between the Company and William S. Orser (filed as Exhibit 10b, File No. 1-03382). +*10b(27) Employment Arrangement dated September 27, 1994 by and between the Company and Glenn E. Harder (filed as Exhibit 10b, File No. 1-03382). +*10b(28) Personal Services Agreement dated September 18, 1996, by and between the Company and Sherwood H. Smith, Jr. (filed as Exhibit 10b, File No.1-03382). +*10b(29) Employment Agreement dated June 2, 1997, by and between the Company and Robert B. McGehee (filed as Exhibit 10b, File No. 1-03382). +*10b(30) Employment Agreement dated September 24, 1997, by and between the Company and John E. Manczak (filed as Exhibit 10b, File No. 1-03382). +*10b(31) Employment Agreement dated August 3, 1998, by and between the Company and Tom D. Kilgore (filed as Exhibit 10b(27) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998, File No. 1-3382). +10b(32) Agreement dated April 27, 1999 between the Company and Sherwood H. Smith, Jr. +10b(33) Employment Agreement dated July 15, 1999 by and between North Carolina Natural Gas Corporation and Calvin B. Wells. +10b(34) Employment Arrangement dated August 5, 1999 by and between the Company and Larry M. Smith. 12 Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends Combined and Ratio of Earnings to Fixed Charges. 21 Subsidiaries of Carolina Power & Light Company 23(a) Consent of Deloitte & Touche LLP. 27 Financial Data Schedule *Incorporated herein by reference as indicated. +Management contract or compensation plan or arrangement required to be filed as an exhibit to this report pursuant to Item 14 (c) of Form 10-K. EXHIBIT 10B(21) EXHIBIT A TO 1997 EQUITY INCENTIVE PLAN PERFORMANCE SHARE SUB-PLAN -------------------------- (As Revised and Restated March 17, 1999) This Performance Share Sub-Plan ("Sub-Plan") sets forth the rules and regulations adopted by the Committee for issuance of Performance Share Awards under Section 10 of the 1997 Equity Incentive Plan ("Plan"). Capitalized terms used in this Sub-Plan that are not defined herein shall have the meaning given in the Plan. In the event of any conflict between this Sub-Plan and the Plan, the terms and conditions of the Plan shall control. No Award Agreement shall be required for participation in this Sub-Plan. SECTION 1. DEFINITIONS When used in this Sub-Plan, the following terms shall have the meanings as set forth below, and are in addition to the definitions set forth in the Plan. 1.1 "Account" means the account used to record and track the number of Performance Shares granted to each Participant as provided in Section 2.4. 1.2 "Award" as used in this Sub-Plan means each aggregate award of Performance Shares as provided in Section 2.2. 1.3 "EBITDA" means earnings before interest, taxes, depreciation, and amortization as determined from time to time by the Committee. 1.4 "EBITDA Growth" means the percentage increase (if any) in EBITDA for any Year, as compared to the previous Year as determined from time to time by the Committee. 1.5 "Peer Group" means the utilities included in the Standard & Poors Utility (Electric Power Companies) Index. 1.6 "Performance Period" for purposes of this Sub-Plan means three consecutive Years beginning with the Year in which an Award is granted. 1.7 "Performance Schedule" means Attachment 1 to this Sub-Plan, which sets forth the Performance Measures applicable to this Sub-Plan. 1.8 "Performance Share" for purposes of this Sub-Plan means each unit of an Award granted to a Participant, the value of which is equal to the value of Company Stock as hereinafter provided. 1.9 "Retire" or "Retirement" means termination of employment on or after: (a) becoming 65 years old with at least 5 years of service; (b) becoming 55 years old with at least 15 years of service; or (c) achieving at least 35 years of service, regardless of age. 1.10 "Salary" means the regular base rate of compensation payable by the Company to a Participant on an annual basis as of the date an Award is Granted. Salary does not include bonuses, if any, or incentive compensation, if any. Such compensation shall not be reduced by any deferrals made under any other plans or programs maintained by the Company. 1.11 "Total Shareholder Return" means the total percentage return realized by the owner of a share of stock during a relevant Year or any part thereof. Total Shareholder Return is equal to the appreciation or depreciation in value of the stock (which is equal to the closing value of the stock on the last trading day of the relevant period minus the closing value of the stock on the last trading day of the preceding Year) plus the dividends declared during the relevant period, divided by the closing value of the stock on the last trading day of the preceding Year. Closing values for the stock on the dates given above shall be those published in the Wall Street Journal. 1.12 "Year" means a calendar year. SECTION 2. SUB-PLAN PARTICIPATION AND AWARDS 2.1 Participant Selection. Participants under this Sub-Plan shall be selected by the Committee in its sole discretion as provided in Section 4.2 of the Plan. 2.2 Awards. Subject to any adjustments to be made under Section 2.5, the Compensation Committee may, in its sole discretion, grant Awards to some or all of the Participants in the form of a specific number of Performance Shares. The total value of any Award shall not exceed the following limitations, based on the Participant's Salary on the date that the Award is granted: ----------------------------------- --------------------- Participant Award Limitation ----------------------------------- --------------------- President/CEO 75% of Salary ----------------------------------- --------------------- Group Executives 50% of Salary ----------------------------------- --------------------- Department Heads and Key Managers* Level I 30% of Salary Level II 25% of Salary Level III 20% of Salary ----------------------------------- --------------------- *Levels shall be determined in the sole discretion of the Committee 2.3 Award Valuation at Grant. In calculating the limitations set forth in Section 2.2, the value of each Performance Share shall be equal to the closing price of a share of Stock on the last trading day before the Award is granted, as published in the Wall Street Journal. Each Award is deemed to be granted on the day that it is approved by the Committee. 2.4 Accounting and Adjustment of Awards. The number of Performance Shares awarded to a Participant shall be recorded in a separate Account for each Participant. The number of Performance Shares recorded in a Participant's Account shall be adjusted to reflect any splits or other adjustments in the Stock. If any cash dividends are paid on the Stock, the number of Performance Shares in each Participant's Account shall be increased by a number equal to (i) the dividend multiplied times the number of Performance Shares in each Participant's Account, divided by (ii) the closing price of a share of Stock on the payment date of the dividend, as published in the Wall Street Journal. 2.5 Performance Schedule and Calculation of Awards. Each Award shall become vested on January 1 immediately following the end of the applicable Performance Period, subject to adjustment in accordance with the following procedure. (a) One half of the Award shall be adjusted as follows: (i) The Total Shareholder Return for the Company shall be determined for each Year during the Performance Period, and shall then be averaged (the "Company TSR"). (ii) The average Total Shareholder Return for all Peer Group utilities shall be determined for each Year during the Performance Period, and shall then be averaged ( the "Peer Group TSR"). (iii) The Peer Group TSR for the Performance Period shall be subtracted from the Company TSR for the Performance Period. The remainder shall then be used to determine the number of vested Performance Shares using the Performance Schedule, based on one half of the number of Performance Shares in the Participant's Account. (b) The other half of the Award shall be adjusted as follows: (i) The EBITDA Growth for the Company shall be determined for each Year during the Performance Period, and shall then be averaged (the Company EBITDA Growth"). (ii) The average EBITDA Growth for all Peer Group utilities shall be determined for each Year during the Performance period, and shall be averaged (the Peer Group EBITDA Growth"). (iii) The Peer Group EBITDA Growth for the Performance Period shall be subtracted from the Company EBITDAGrowth for the Performance Period. The remainder shall then be used to determine the number of vested Performance Shares using the Performance Schedule, based on one half of the number of Performance Shares in the Participant's Account. (c) The total number of vested Performance Shares payable to the Participant shall be the sum of the amounts determined in accordance with subsections (a) and (b) above. (d) The Performance Measures and the Performance Schedule will not change during any Performance Period with regard to any Awards that have already been granted. The Committee reserves the right to modify or adjust the Performance Measures and/or the Performance Schedule in the Committee's sole discretion with regard to future grants. 2.6 Payment Options. Except as provided in Section 3, Awards shall be paid after expiration of the Performance Period. The Company will pay in cash to each Participant the aggregate value of vested Performance Shares, which shall be determined in accordance with Section 2.7. Payment shall be made as follows: (a) 100% on or about April 1 of the Year immediately following expiration of the Performance Period; or (b) in accordance with an alternative payment election made by Participant substantially in the form attached hereto as Attachment 2, provided that such election is executed by the Participant and returned to the Vice President, Human Resources Department no later than the end of the first Year of the Performance Period. Once made, this election is irrevocable. 2.7 Valuation of Performance Shares. For the purposes of payment of under Section 2.6, the aggregate value of vested Performance Shares shall be equal to the total number of vested Performance Shares in the Participant's Account (after any applicable adjustments under Section 2.5) multiplied times the closing price of the Stock on the last trading day before payment of the Award, as published in the Wall Street Journal. SECTION 3. EARLY VESTING AND FORFEITURE 3.1 Retirement, Death, Disability, Divestiture or Change in Control. If prior to expiration of the Performance Period the Participant Retires, dies or becomes disabled, or in the event of a Divestiture or a Change in Control during a Performance Period, the Participant's Award shall immediately become vested, and the aggregate value of the Award shall be paid in cash after being adjusted accordance with the following procedure. (a) One half of the Award shall be adjusted as follows: (i) The Total Shareholder Return for the Company shall be determined for each Year or partial Year, and a weighted average Total Shareholder Return for the Company shall be calculated for the period between the first day of the Performance Period and the date the Participant Retires, dies or becomes Disabled, or the date of the Divestiture, or the date that the Change in Control becomes effective (the "Prorated Company TSR"). (ii) The average Total Shareholder Return for all Peer Group utilities shall be determined for each Year or partial Year, and a weighted average Total Shareholder Return shall be calculated for the period between the first day of the Performance Period and the date the Participant Retires, dies or becomes Disabled, or the date of the Divestiture, or the date that the Change in Control becomes effective ( the "Prorated Peer Group TSR"). (iii) The Prorated Peer Group TSR for the Performance Period shall be subtracted from the Prorated Company TSR for the Performance Period. The remainder shall then be used to determine the vested Performance Shares using the Performance Schedule, based on one half of the number of Performance Shares in the Participant's Account. (b) The other half of the Award shall be adjusted as follows: (i) The EBITDA Growth for the Company shall be determined for each Year or partial Year, and a weighted average EBITDA Growth for the Company shall be calculated for the period between the first day of the Performance Period and the end of the calendar quarter immediately preceding the date that the Participant Retires, dies or becomes Disabled, or end of the calendar quarter immediately preceding the date of the Divestiture, or the date that the Change in Control becomes effective (the "Prorated Company EBITDA Growth"). (ii) The average EBITDA Growth for all Peer Group utilities shall be determined for each Year or partial Year, and a weighted average EBITDA Growth shall be calculated for the period between the first day of the Performance Period and the end of the calendar quarter immediately preceding the date the Participant Retires, dies or becomes Disabled, or the end of the calendar quarter immediately preceding the date of the Divestiture, or the date that the Change in Control becomes effective ( the "Prorated Peer Group EBITDA Growth"). (iii) The Prorated Peer Group EBITDA Growth for the Performance Period shall be subtracted from the Prorated Company EBITDA Growth for the Performance Period. The remainder shall then be used to determine the vested Performance Shares using the Performance Schedule, based on one half of the number of Performance Shares in the Participant's Account. (c) The total number of vested Performance Shares payable to the Participant shall be the sum of the amounts determined in accordance with subsections (a) and (b) above. (d) If the Participant Retires, the Award shall be paid in accordance with the Participant's election as provided in Section 2.6. If the Participant dies or becomes disabled, or in the event of a Divestiture or Change in Control, payment shall be made in cash within a reasonable time after the Participant dies or becomes Disabled, or within a reasonable time after the Divestiture or Change in Control becomes effective, notwithstanding any election under Section 2.6. Payment upon death shall be made to the Participant's Designated Beneficiary. The aggregate value of the vested Performance Shares shall be determined in accordance with section 3.2. 3.2 Valuation of Performance Shares. For the purposes of payment under Section 3.1, the aggregate value of vested Performance Shares shall be equal to the number of vested Performance Shares in the Participant's Account (after any applicable adjustments under Section 3.1) multiplied times the closing price of the Stock on the date that the Participant Retires, dies or becomes Disabled, or on the date of the Divestiture or Change in Control (as applicable), as published in the Wall Street Journal. 3.3 Termination of Employment. In the event that a Participant's employment with the Company terminates for any reason other than Retirement, death or Disability, any Award made to the Participant which has not vested as provided in Section 2 shall be forfeited. Any vested Awards shall be paid within a reasonable time after termination, notwithstanding any election to defer the payment of any Award under Section 2.6. 4. NON-ASSIGNABILITY OF AWARDS The Awards and any right to receive payment under the Plan and this Sub-Plan may not be anticipated, alienated, pledged, encumbered, or subject to any charge or legal process, and if any attempt is made to do so, or a Participant becomes bankrupt, then in the sole discretion of the Committee, any Award made to the Participant which has not vested as provided in Sections 2 and 3 shall be forfeited. 5. AMENDMENT AND TERMINATION This Sub-Plan shall be subject to amendment, suspension, or termination as provided in the Plan. ATTACHMENT 1 ------------ PERFORMANCE SCHEDULE -------------------- PERFORMANCE SHARE CALCULATION(1) -------------------------------- The following table shall be used to adjust one half of the Participant's Award in accordance with Section 2.5(a) or Section 3.1(a) of the Plan: IF THE COMPANY TSR(2) MINUS THEN THE 50% OF THE VESTED THE PEER GROUP TSR(2) IS: PERFORMANCE SHARE AWARD SHALL BE MULTIPLIED BY: 5% or better 2.00 4.0 - 4.99 1.75 3.0 - 3.99 1.50 2.0 - 2.99 1.25 1.0 - 1.99 1.00 (0.99) - 0.99 .50 (1.0) - (1.99) .25 (2.0) or less 0.00 The following table shall be used to adjust one half of the Participant's Award in accordance with Section 2.5(b) or Section 3.1(b) of the Plan: IF THE COMPANY EBITDA GROWTH(2) MINUS THEN THE 50% OF THE VESTED THE PEER GROUP EBITDA GROWTH(2) IS: PERFORMANCE SHARE AWARD SHALL BE MULTIPLIED BY: 5% or better 2.00 4.0 - 4.99 1.75 3.0 - 3.99 1.50 2.0 - 2.99 1.25 1.0 - 1.99 1.00 0.00 - 0.99 .50 Less than 0 0 (1) The number of Performance Shares as calculated above shall be paid in accordance with the provisions of Section 2.5 and 2.6 of the Sub-Plan. (2) For purposes of Section 3, the Prorated Company TSR and EBITDA Growth and Prorated Peer Group TSR and EBITDA Growth shall be used, and the number of Performance Shares as calculated above shall be paid in accordance with the provisions of Section 3.1 of the Sub-Plan. ATTACHMENT 2 ------------ PERFORMANCE SHARE SUB-PLAN 199_ DEFERRAL ELECTION FORM As an employee of Carolina Power & Light Company ("Company"), and a participant in the Performance Share Sub-Plan of the 1997 Equity Incentive Plan ("Sub-Plan"), I hereby elect to defer payment of my Award otherwise payable to me by the Company and attributable to services to be performed by me during the Performance Period beginning on January __, 199__. This election shall apply to [CHECK ONE]: [ ] 100% of the Award [ ] 50% of the Award [ ] 75% of the Award [ ] 25% of the Award Upon vesting, I understand that my Award shall continue be recorded in my Account as Performance Shares as described in the Sub-Plan and adjusted to reflect the payment and reinvesting of the Company's common stock dividends over the deferral period, until paid in full. I hereby elect to defer receipt (or commencement of receipt) of my Award until the date specified below, or as soon as practical thereafter [CHECK ONE]: [ ] a specific date certain at least 5 years from expiration of the Performance Period: 4 / 1 / * --------------------- (month/day/year) [ ] the April 1 following the date of retirement [ ] the April 1 following the first anniversary of my date of retirement * Notwithstanding my election above, if I elect a date certain distribution and I retire before that date certain, I understand that the Company will commence distribution of my account no later than the April 1 following the first anniversary of the date of retirement, or as soon as practical thereafter, even though said date is earlier than 5 years from expiration of the Performance Period. I hereby elect to be paid as described in the Sub-Plan in the form of [CHECK ONE]: [ ] a single payment [ ] annual payments commencing on the date set forth above and payable on the anniversary date thereof over: [ ] a two year period [ ] a three year period [ ] a four year period [ ] a five year period I understand that I will receive "earnings" on those deferred amounts when they are paid to me. I understand that the election made as indicated herein is irrevocable and that all deferral elections are subject to the provisions of the Sub-Plan, including provisions that may affect timing of distributions. I understand and acknowledge that my interests herein and my rights to receive distribution of the deferred amounts may not be anticipated, alienated, sold, transferred, assigned, pledged, encumbered, or subjected to any charge or legal process, and if any attempt is made to do so, or I become bankrupt, my interest may be terminated by the Committee, which, in his sole discretion. I further understand that nothing in the Sub-Plan shall be interpreted or construed to require the Company in any manner to fund any obligation to me, or to my beneficiary(ies) in the event of my death. - ------------------------------- ----------------------------------- (Signature) (Date) - ------------------------------- ----------------------------------- (Print Name) (Company Location) Received: Agent of Chief Executive Officer - ------------------------------- ----------------------------------- (Signature) (Date) EXHIBIT 10B(22) AMENDED MANAGEMENT INCENTIVE COMPENSATION PLAN OF CAROLINA POWER & LIGHT COMPANY AS AMENDED JANUARY 1, 2000 ii ARTICLE I --------- PURPOSE ------- The purpose of the Management Incentive Compensation Plan (the "Plan") of Carolina Power & Light Company (the "Sponsor") is to promote the financial interest of the Sponsor and its Affiliated Companies, including its growth, by (i) attracting and retaining executive officers and other management-level employees who can have a significant positive impact on the success of the Sponsor and its Affiliated Companies; (ii) motivating such personnel to help the Sponsor and its Affiliated Companies achieve annual incentive, performance and safety goals; (iii) motivating such personnel to improve their own as well as their business unit/work group's performance through the effective implementation of human resource strategic initiatives; and (iv) providing annual cash incentive compensation opportunities that are competitive with those of other major corporations. The Sponsor amends the Plan effective January 1, 2000. ARTICLE II ---------- DEFINITIONS ----------- The following definitions are applicable to the Plan: 1. "Award": The benefit payable to a Participant hereunder, consisting of a Corporate Component and a Noncorporate Component. 2. "Affiliated Company" shall mean any corporation or other entity that is required to be aggregated with the Sponsor pursuant to Sections 414(b), (c), (m), or (o) of the Internal Revenue Code of 1986, as amended (the "Code"), but only to the extent required. 3. "Company": Carolina Power & Light Company, a North Carolina corporation, or any successor to it in the ownership of substantially all of its assets and each Affiliated Company that, with the consent of the Compensation Committee, adopts the Plan and is included in Exhibit B, as in effect from time to time. 4. "Compensation Committee": The Organization and Compensation Committee of the Board of Directors of the Sponsor. 5. "Corporate Factor": The factor determined by the Compensation Committee to be utilized in calculating the Corporate Component of an Award pursuant to Article V, Section 3.a. hereof, which can range from 0 to 1.5. 6. "Corporate Component": That portion of an Award based upon the overall performance of the Sponsor, as determined in Article V, Section 3.a. hereof. 7. "Date of Retirement": The first day of the calendar month immediately following the Participant's Retirement. 8. "EBITDA": The earnings of the Sponsor before interest, taxes, depreciation, and amortization as determined from time to time by the Compensation Committee. 9. "EBITDA Growth": The percentage increase (if any) in EBITDA of the Sponsor for any Year, as compared to the previous Year as determined from time to time by the Compensation Committee. 10. "Noncorporate Component": That portion of an Award based upon the level of attainment of a Company, business unit/group, departmental, and individual Performance Measures, as provided in Article V, Section 3 .b. hereof, which can range from 0 to 1.5. 11. "Participant": An employee of any Company who is selected pursuant to Article IV hereof to be eligible to receive an Award under the Plan. 12. "Peer Group": The utilities included in the Standard & Poors Utility (Electric Power Companies) Index. 13. "Performance Measure": A goal or goals established for measuring the performance of a Company, business unit/group, department, or individual used for the purpose of computing the Noncorporate Component of an Award for a Participant. 14. "Performance Unit": A unit or credit, linked to the value of the Sponsor's Common Stock under the terms set forth in Article VI hereof. 15. "Plan": The Management Incentive Compensation Plan of Carolina Power & Light Company as contained herein, and as it may be amended from time to time. 16. "Retirement": A Participant's termination of employment with a Company after having met at least one of the following requirements: at least age 65 with 5+ years of service, at least age 55 with 15+ years of service, or 35+ years of service regardless of age. 17. "Salary": The compensation paid by a Company to a Participant in a relevant Year, consisting of regular or base compensation, such compensation being understood not to include bonuses, if any, or incentive compensation, if any. Provided, that such compensation shall not be reduced by any cash deferrals of said compensation made under any other plans or programs maintained by such Company. 18. "Section 16 Participants": Those Participants who are subject to the provisions of Section 16 of the Securities Exchange Act of 1934, as amended (the "1934 Act"). Individuals who are subject to Section 16 of the 1934 Act include, without limitation, directors and certain officers of the Sponsor, and any individual who beneficially owns more than ten percent of a class of the Sponsor's equity securities registered under Section 12 of the 1934 Act. 19. "Senior Management Committee": The Senior Management Committee of the Sponsor. 20. "Target Award Opportunity": The target for an Award under this Plan as set forth in Section 2 of Article V hereof. 21. "Year": A calendar year. ARTICLE III ----------- ADMINISTRATION -------------- The Plan shall be administered by the Chief Executive Officer of the Sponsor. Except as otherwise provided herein, the Chief Executive Officer of the Sponsor shall have sole and complete authority to (i) select the Participants; (ii) establish and adjust (either before or during the relevant Year) a Participant's Performance Measures, their relative percentage weight, and the performance criteria necessary for attainment of various performance levels; (iii) approve Awards; (iv) establish from time to time regulations for the administration of the Plan; and (v) interpret the Plan and make all determinations deemed necessary or advisable for the administration of the Plan, all subject to its express provisions. Notwithstanding the foregoing, with respect to Participants who are at or above the Department Head level in any Company, the performance criteria and Awards shall be subject to the specific approval of the Compensation Committee. In addition, the Compensation Committee shall have the sole authority to determine the total payout under the Plan up to a maximum of three percent (3%) of the Sponsor's after-tax income for a relevant Year. A majority of the Compensation Committee shall constitute a quorum, and the acts of a majority of the members present at any meeting at which a quorum is present, or acts approved in writing by a majority of the members of the Committee without a meeting, shall be the acts of such Committee. ARTICLE IV PARTICIPATION ------------- The Chief Executive Officer of the Sponsor shall select from time to time the Participants in the Plan for each Year from those employees of each Company who, in his opinion, have the capacity for contributing in a substantial measure to the successful performance of the Company that Year. No employee shall at any time have a right to be selected as a Participant in the Plan for any Year nor, having been selected as a Participant for one Year, have the right to be selected as a Participant in any other Year. ARTICLE V --------- AWARDS ------ 1. Eligibility. In order for any Participant to be eligible to receive an Award, two conditions must be met. First, a contribution must be earned by one or more groups of employees under the Employee Stock Incentive Plan feature of the Sponsor's Stock Purchase-Savings Plan. Second, the Sponsor must also meet minimum threshold performance levels for return on common equity, EBITDA Growth, and other measures for the relevant Year as may be established by the Compensation Committee. Threshold performance for return on common equity and EBITDA Growth is the weighted average of a Peer Group of utilities, averaged over the most recent three-year period. To satisfy threshold performance, the Sponsor must be above the three-year average with respect to return on common equity and EBITDA Growth. 2. Target Award Opportunities. The following table sets forth Target Award Opportunities, expressed as a percentage of Salary, for various levels of participation in the Plan: ------------------------------------------ ------------------------------- Participation Target Award 0pportunities ------------------------------------------ ------------------------------- Chief Executive Officer of Sponsor 60% ------------------------------------------ ------------------------------- Chief Operating Officer of Sponsor 60% ------------------------------------------ ------------------------------- Executive Vice Presidents of Sponsor 40% ------------------------------------------ ------------------------------- ------------------------------------------ ------------------------------- Senior Vice Presidents of Sponsor 35% ------------------------------------------ ------------------------------- Department Heads (or equivalent) 25% ------------------------------------------ ------------------------------- Other Participants: Key Managers 20% Other Managers 15% ------------------------------------------ ------------------------------- The Target Award Opportunity for the Chief Executive Officer of the Sponsor shall be 60%; however, the Compensation Committee of the Board shall be authorized to change that amount from year to year, or to award an amount of compensation based on other considerations, in its complete discretion. 3. Award Components. Awards under the Plan to which Participants are eligible consist of the sum of a Corporate Component and a Noncorporate Component. The portion of the Target Award Opportunities attributable to the Corporate Component and Noncorporate Component, respectively, for various levels of participation, is set forth in the following table: - ---------------------------------------------- ---------------- --------------- Participants Corporate Noncorporate Component Component - ---------------------------------------------- ---------------- --------------- Chief Executive Officer of Sponsor 100% - - ---------------------------------------------- ---------------- --------------- Chief Operating Officer of Sponsor 100% - - ---------------------------------------------- ---------------- --------------- Executive Vice Presidents of Sponsor 75% 25% - ---------------------------------------------- ---------------- --------------- Senior Vice Presidents of Sponsor 75% 25% - ---------------------------------------------- ---------------- --------------- Department Heads (or equivalent) 50% 50% - ---------------------------------------------- ---------------- --------------- Other Participants 50% 50% - ---------------------------------------------- ---------------- --------------- a. Corporate Component. The Corporate Component of an Award is based upon the overall performance of the Sponsor. In the event the conditions set forth in Section 1 of Article V are met and the Compensation Committee, in its discretion, determines an appropriate Corporate Factor, that Corporate Factor shall be multiplied by the portion of a Participant's Target Award Opportunity attributable to the Corporate Component in order to determine the percentage of such Participant's Salary which will comprise the Corporate Component of his or her Award. Notwithstanding the foregoing, if the second condition set forth in Section 1 of Article V is not fully met, the Compensation Committee may nevertheless in its discretion determine an appropriate Corporate Factor and grant a Corporate Component of an Award to the Participants. b. Noncorporate Component. The Noncorporate Component of an Award for a Participant is based upon the level of attainment of Company, business unit/group, departmental and individual Performance Measures. Performance Measures for each Participant and their relative weight are determined pursuant to authority granted in Article III hereof. (i) Performance Levels. There are three levels of performance related to each of a Participant's Performance Measures: outstanding, target, and threshold. The specific performance criteria for each level of a Participant's Performance Measures shall be set forth in writing prior to the beginning of an applicable Year, or within thirty (30) days after a Participant first becomes eligible to participate in the Plan, and shall be determined pursuant to authority granted in Article III hereof. The payout percentages to be applied to each Participant's Target Award Opportunity are as follows: Performance Level Payout Percentage ----------------- ----------------- Outstanding 150% Target 100% Threshold 50% Payout percentages shall be adjusted for performance between the designated performance levels, provided, however, that performance which falls below the "Threshold" performance level results in a payout percentage of zero unless the Chief Executive Officer of Sponsor directs otherwise. (ii) Determination of Noncorporate Component. In order to determine a Participant's Noncorporate Component, if any, for a particular Year, the Chief Executive Officer of Sponsor initially shall determine the appropriate payout percentage for each of such Participant's Performance Measures. Thereafter, each payout percentage is multiplied by the percentage weight assigned to each such Performance Measure and the results added together. That aggregate amount is multiplied by the Participant's Target Award Opportunity for the Noncorporate Award Component for the respective Year and the result is multiplied by the Participant's Salary. (iii) Change of Job Status. Participants who change organizations during a Year will have their Noncorporate Component prorated based upon the Performance Measures achieved in each organization and the length of time served in each organization. In the discretion of the Chief Executive Officer of Sponsor, employees may become Participants during a Year based on promotions and may receive an Award prorated based on the length of time served in the qualifying job and the Performance Measures achieved while in the qualifying job. 4. New Participants. Any Award that is earned during the Year of selection shall be pro rated based on the length of time served in the qualifying job. 5. Reduction of Award Amount. In the event of documented performance deficiencies of a Participant during a Year, the Chief Executive Officer of Sponsor, in his discretion, may reduce the Award payable to such Participant for such Year. 6. Example. Attached as Exhibit A and incorporated by reference is an example of the process by which an Award is granted hereunder. Said exhibit is intended solely as an example and in no way modifies the provisions of this Article V. ARTICLE VI DISTRIBUTION AND DEFERRAL OF AWARDS ----------------------------------- 1. Distribution of Awards. Unless a Participant elects to defer an award pursuant to the remaining provisions of this Article VI, awards under the Plan earned during any Year shall be paid in cash in the succeeding Year, normally no later than March 15 of such succeeding Year. 2. Deferral Election. A Participant may elect to defer the Plan Award he or she has earned for any Year by completing and submitting to the Vice President, Human Resources, a deferral election form by the later of (1) November 30 of the Year in which the Award is earned or (2) the thirtieth (30th) day after first becoming eligible to participate in the deferral election provisions of the Plan; provided, however, that for the 1995 Plan Year, deferral elections shall be made by no later than November 30, 1995. Such election shall apply to the Participant's Award, if any, otherwise to be paid as soon as practicable after the Year during which it was earned. A Participant's deferral election may apply to 100%, 75%, 50%, or 25% of the Plan Award; provided, however, that in no event shall the amount deferred be less than $1,000. The election to defer shall be irrevocable as to the Award earned during the particular Year. 3. Period of Deferral. At the time of a Participant's deferral election, a Participant must also select a distribution date. Subject to Section 6, the distribution date may be: (a) any date that is at least five (5) years subsequent to the date the Plan Award would otherwise be payable, but not later than the second anniversary of the Participant's Date of Retirement; or (b) any date that is within two years following the Participant's Date of Retirement. Subject to Section 6, a Participant may extend the distribution date for one or more additional Year(s) by making a new deferral election at least one (1) year before the previously selected distribution date occurs; provided, however, that in no event shall the subsequent distribution date be a date that is more than two years beyond the Participant's Date of Retirement. 4. Performance Units. All Awards which are deferred under the Plan shall be recorded in the form of Performance Units. Each Performance Unit is generally equivalent to a share of the Sponsor's Common Stock. In converting the cash award to Performance Units, the number of Performance Units granted shall be determined by dividing the amount of the Award by 85% of the average value of the opening and closing price of a share of the Sponsor's Common Stock on the last trading day of the month preceding the date of the Award. The Performance Units attributable to the 15% discount from the average value of the Sponsor's Common Stock shall be referred to as the "Incentive Performance Units." The Incentive Performance Units and any adjustments or earnings attributable to those Performance Units shall be forfeited by the Participant if he or she terminates employment either voluntarily or involuntarily other than for death or retirement prior to five years from March 15 of the Year in which payment would have been made if the Award had not been deferred. 5. Plan Accounts. A Plan Deferral Account will be established on behalf of each Participant, and the number of Performance Units awarded to a Participant shall be recorded in each Participant's Plan Deferral Account as of the first of the month coincident with or next following the month in which a deferral becomes effective. The number of Performance Units recorded in a Participant's Plan Deferral Account shall be adjusted to reflect any splits or other adjustments in the Sponsor's Common Stock, the payment of any cash dividends paid on the Sponsor's Common Stock and the payment of Awards under this Plan to the Participant. To the extent that any cash dividends have been paid on the Sponsor's Common Stock, the number of Performance Units shall be adjusted to reflect the number of Performance Units that would have been acquired if the same dividend had been paid on the number of Performance Units recorded in the Participant's Plan Deferral Account on the dividend record date. For purposes of determining the number of Performance Units acquired with such dividend, the average of the opening and closing price of the Sponsor's Common Stock on the payment date of the Sponsor's Common Stock dividend shall be used. Each Participant shall receive an annual statement of the balance of his Plan Deferral Account, which shall include the Incentive Performance Units and associated earnings and adjustments that are subject to being forfeited as provided above. 6. Payment of Deferred Plan Awards. Subject to Section 4 related to forfeiture of Incentive Performance Units, Deferred Plan Awards shall be paid in cash by each Company beginning no later than the next April 1 following the distribution date or the deferred distribution date specified by the Participant in accordance with Section 3. To convert the Performance Units in a Participant's Plan Deferral Account to a cash payment amount, Performance Units shall be multiplied by the average of the opening and closing price of the Sponsor's Common Stock on the last trading day preceding the payment of the Deferred Plan Award. Except as otherwise provided below, deferred amounts will be paid either in a single lump-sum payment or in up to five (5) annual payments. In the event that a Participant elects to receive the deferred Plan Award in equal annual payments, the amount of the Award to be received in each year shall be determined as follows: (a) To determine the amount of the initial annual payment, the number of Performance Units in the Participant's Plan Deferral Account will be divided by the total number of annual payments to be received, and the result will be multiplied by the average of the opening and closing price of the Sponsor's Common Stock on the last trading day preceding the due date of the initial payment. (b) To determine the amount of each successive annual payment, the Plan Deferral Account balance will be divided by the number of annual payments remaining, and the result will be multiplied by the average of the opening and closing price of the Sponsor's Common Stock on the last trading day preceding the due date of the annual payment. 7. Termination of Employment/Effect on Deferral Election. If the employment of a Participant terminates prior to the last day of a Year for which a Plan Award is determined, then any deferral election made with respect to such Plan Award for such Year shall not become effective and any Plan Award to which the Participant is otherwise entitled shall be paid as soon as practicable after the end of the Year during which it was earned, in accordance with paragraph 1 of this Article VI. 8. Termination of Employment/Acceleration of Deferral. Notwithstanding the foregoing, if a Participant terminates employment by reason other than death or Retirement, full payment of all amounts due to the Participant shall be accelerated and paid on the first day of the month following the date of termination. Incentive Performance Units shall be subject to forfeiture as provided in Section 4. 9. Financial Hardship Payments. In the event of a severe financial hardship occasioned by an emergency, including, but not limited to, illness, disability or personal injury sustained by the Participant or a member of the Participant's immediate family, a Participant may apply to receive a distribution earlier than initially elected. The Chief Executive Officer of Sponsor or his designee may, in his sole discretion, either approve or deny the request. The determination made by the Chief Executive Officer of Sponsor will be final and binding on all parties. If the request is granted, the payments will be accelerated only to the extent reasonably necessary to alleviate the financial hardship. Incentive Performance Units shall not be subject to early distribution under this Section 9 until five years from March 15 of the Year in which payment would have been made if the Award had not been deferred. 10. Death of a Participant. If the death of a Participant occurs before a full distribution of the Participant's Plan Deferral Account is made, payment shall be made to the beneficiary designated by the Participant to receive such amounts in accordance with the schedule specified in the Participant's Deferral Election form. Said payment shall be made as soon as practical following notification that death has occurred. In the absence of any such designation, payment shall be made to the personal representative, executor or administrator of the Participant's estate. 11. Non-Assignability of Interests. The interests herein and the right to receive distributions under this Article VI may not be anticipated, alienated, sold, transferred, assigned, pledged, encumbered, or subjected to any charge or legal process, and if any attempt is made to do so, or a Participant becomes bankrupt, the interests of the Participant under this Article VI may be terminated by the Chief Executive Officer of Sponsor, which, in his sole discretion, may cause the same to be held or applied for the benefit of one or more of the dependents of such Participant or make any other disposition of such interests that he deems appropriate. 12. Unfunded Deferrals. Nothing in this Plan, including this Article VI, shall be interpreted or construed to require the Sponsor or any Company in any manner to fund any obligation to the Participants, terminated Participants or beneficiaries hereunder. Nothing contained in this Plan nor any action taken hereunder shall create, or be construed to create, a trust of any kind, or a fiduciary relationship between the Sponsor or any Company and the Participants, terminated Participants, beneficiaries, or any other persons. Any funds which may be accumulated in order to meet any obligation under this Plan shall for all purposes continue to be a part of the general assets of the Sponsor or Company; provided, however, that the Sponsor or Company may establish a trust to hold funds intended to provide benefits hereunder to the extent the assets of such trust become subject to the claims of the general creditors of the Sponsor or Company in the event of bankruptcy or insolvency of the Sponsor or Company. To the extent that any Participant, terminated Participant, or beneficiary acquires a right to receive payments from the Sponsor or Company under this Plan, such rights shall be no greater than the rights of any unsecured general creditor of the Sponsor or Company. ARTICLE VII ----------- TERMINATION OF EMPLOYMENT ------------------------- A Participant must be actively employed by a Company on the next January 1 immediately following the Year for which a Plan Award is earned in order to be entitled to payment of the full amount of any Award for that Year. In the event the active employment of a Participant shall terminate or be terminated for any reason before the next January 1 immediately following the Year for which a Plan Award is earned, such Participant shall receive his or her Award for the year, if any, in an amount that the Chief Executive Officer of the Sponsor deems appropriate. ARTICLE VIII ------------ MISCELLANEOUS ------------- 1. Assignments and Transfers. The rights and interests of a Participant under the Plan may not be assigned, encumbered or transferred except, in the event of the death of a Participant, by will or the laws of descent and distribution. 2. Employee Rights Under the Plan. No Company employee or other person shall have any claim or right to be granted an Award under the Plan or any other incentive bonus or similar plan of the Sponsor or any Company. Neither the Plan, participation in the Plan nor any action taken thereunder shall be construed as giving any employee any right to be retained in the employ of the Sponsor or any Company. 3. Withholding. The Sponsor or Company (as applicable) shall have the right to deduct from all amounts paid in cash any taxes required by law to be withheld with respect to such cash payments. 4. Amendment or Termination. The Compensation Committee may in its sole discretion amend suspend or terminate the Plan or any portion thereof at any time. 5. Governing Law. This Plan shall be construed and governed in accordance with the laws of the state of North Carolina. 6. Effective Date. This Plan, as amended, shall be effective as of January 1, 1999. 7. Entire Agreement. This document (including the exhibit attached hereto and any future amendments to said exhibit that may be made by the Chief Executive Officer of the Sponsor) sets forth the entire Plan. EXHIBIT A (to be supplied) EXHIBIT B North Carolina Natural Gas Company DESIGNATION OF BENEFICIARY MANAGEMENT INCENTIVE COMPENSATION PLAN OF CAROLINA POWER & LIGHT COMPANY As provided in the MANAGEMENT INCENTIVE COMPENSATION PLAN of Carolina Power & Light Company, I hereby designate the following person as my beneficiary in the event of my death before a full distribution of my Deferral Account is made. PRIMARY BENEFICIARY: ------------------------------- ------------------------------- ------------------------------- CONTINGENT BENEFICIARY: ------------------------------- ------------------------------- ------------------------------- Any and all prior designations of one or more beneficiaries by me under the MANAGEMENT INCENTIVE COMPENSATION PLAN of Carolina Power & Light Company are hereby revoked and superseded by this designation. I understand that the primary and contingent beneficiaries named above may be changed or revoked by me at any time by filing a new designation in writing with the Sponsor's Human Resources Department. DATE:__________________ SIGNATURE OF PARTICIPANT:_________________________________ The Participant named above executed this document in our presence on the date set forth above WITNESS: WITNESS: ------------------------ -------------------------- EXHIBIT 10B(24) AMENDED AND RESTATED SUPPLEMENTAL SENIOR EXECUTIVE RETIREMENT PLAN OF CAROLINA POWER & LIGHT COMPANY Effective January 1, 1984 (As last amended effective March 15, 2000) ARTICLE I - STATEMENT OF PURPOSE ARTICLE II - DEFINITIONS Terms 2.01 Affiliated Companies 2.02 Assumed Deferred Vested Pension Benefit 2.03 Assumed Early Retirement Pension Benefit 2.04 Assumed Normal Retirement Pension Benefit 2.05 Board 2.06 Committee 2.07 Company 2.08 Designated Beneficiary 2.09 Early Retirement Date 2.10 Eligible Spouse 2.11 Final Average Salary 2.12 Normal Retirement Date 2.13 Participant 2.14 Pension 2.15 Plan 2.16 Retirement Plan 2.17 Salary 2.18 Service 2.19 Severance Date 2.20 Social Security Benefit 2.21 Spouse's Pension 2.22 Target Early Retirement Benefit 2.23 Target Normal Retirement Benefit 2.24 Target Pre-Retirement Death Benefit 2.25 Target Severance Benefit 2.26 ARTICLE III - ELIGIBILITY AND PARTICIPATION Eligibility 3.01 Date of Participation 3.02 Duration of Participation 3.03 ARTICLE IV - RETIREMENT BENEFITS Normal Retirement Benefit 4.01 Early Retirement Benefit 4.02 Surviving Spouse Benefit 4.03 Re-employment of Retired Participant 4.04 ARTICLE V - PRE-RETIREMENT DEATH BENEFITS Eligibility 5.01 Amount 5.02 Alternative Benefit 5.03 Commencement and Duration 5.04 ARTICLE VI - SEVERANCE BENEFITS Eligibility 6.01 Amount 6.02 Commencement and Duration 6.03 Surviving Spouse Benefit 6.04 ARTICLE VII - ADMINISTRATION Committee 7.01 Voting 7.02 Records 7.03 Liability 7.04 Expenses 7.05 ARTICLE VIII - AMENDMENT AND TERMINATION ARTICLE IX - MISCELLANEOUS Non-Alienation of Benefits 9.01 No Trust Created 9.02 No Employment Agreement 9.03 Binding Effect 9.04 Suicide 9.05 Claims for Benefits 9.06 Entire Plan 9.07 ARTICLE X - CONSTRUCTION Governing Law 10.01 Gender 10.02 Headings, etc. 10.03 Action 10.04 ARTICLE I ---------- STATEMENT OF PURPOSE -------------------- This Plan is designed and implemented for the purpose of enhancing the earnings and growth of Carolina Power & Light Company (the "Sponsor") by providing to the limited group of senior management employees largely responsible for such earnings and long-term growth deferred compensation in the form of supplemental retirement income benefits, thereby increasing the incentive of such key senior management employees to make the Sponsor and its Affiliated Companies more profitable. The benefits are normally payable to Participants upon retirement or death. The terms of the benefits operate in conjunction with the Participant's benefits payable under the Sponsor's Supplemental Retirement Plan and are designed to supplement such Supplemental Retirement Plan benefits and provide the Participant with additional financial security upon retirement or death. The Plan is intended to constitute an unfunded retirement plan for a select group of management or highly compensated employees within the meaning of Title I of the Employee Retirement Income Security Act of 1974, as amended. The Sponsor hereby restates and amends the Plan effective March 15, 2000. ARTICLE II ---------- DEFINITIONS ----------- 2.01 Terms - Unless otherwise clearly required by the context, the terms used herein shall have the following meaning. Capitalized terms that are not defined below shall have the meaning ascribed to them in the Retirement Plan. 2.02 Affiliated Company shall mean any corporation or other entity that is required to be aggregated with the Sponsor pursuant to Section 414(b), (c), (m), or (o) of the Internal Revenue Code of 1996, as amended (the "Code"), but only to the extent required. 2.03 Assumed Deferred Vested Pension Benefit shall mean the monthly benefit of the deferred vested Pension to commence on his Normal Retirement Date payable in the form of an annuity to which a separated Participant would be entitled under the Retirement Plan, calculated with the following assumptions based on such Participant's marital status at the time benefits hereunder commence: (a) In the case of a Participant with an Eligible Spouse, in the form of a 50% Qualified Joint and Survivor Annuity as provided in the Retirement Plan. (b) In the case of a Participant without an Eligible Spouse, in the form of a Single Life Annuity as provided in the Retirement Plan. (c) Without regard to any other benefit payment option under the Retirement Plan. 2.04 Assumed Early Retirement Pension Benefit shall mean the monthly benefit of the normal retirement Pension payable in the form of an annuity to which a Participant would be entitled under the Retirement Plan at his Normal Retirement Date, based upon his projected years of Service at his Normal Retirement Date and upon his Final Average Salary as of his Early Retirement Date, and calculated with the following assumptions based upon his marital status at the time benefits hereunder commence: (a) In the case of a Participant with an Eligible Spouse, in the form of a 50% Qualified Joint and Survivor Annuity as provided in the Retirement Plan. (b) In the case of a Participant without an Eligible Spouse, in the form of a Single Life Annuity as provided in the Retirement Plan. (c) Without regard to any other benefit payment option under the Retirement Plan. 2.05 Assumed Normal Retirement Pension Benefit shall mean the monthly benefit of the normal retirement Pension payable in the form of an annuity to which a Participant would be entitled under the Retirement Plan if he retired at his Normal Retirement Date, calculated with the following assumptions based on his marital status at the time benefits hereunder commence: (a) In the case of a Participant with an Eligible Spouse, in the form of a 50% Qualified Joint and Survivor Annuity as provided in the Retirement Plan. (b) In the case of a Participant without an Eligible Spouse, in the form of a Single Life Annuity as provided in the Retirement Plan. (c) Without regard to any other benefit payment option under the Retirement Plan. 2.06 Board shall mean the Board of Directors of Sponsor. 2.07 Committee shall mean the Committee on Organization and Compensation of the Board. 2.08 Company shall mean Carolina Power & Light Company or any successor to it in the ownership of substantially all of its assets, and each Affiliated Company that, with the consent of the Board adopts the Plan and is included in Appendix A, as in effect from time to time. Appendix A shall set forth any limitations imposed on employees of Affiliated Companies that adopt the Plan, including limitations on "Service," notwithstanding any provision of the Plan to the contrary. 2.09 Designated Beneficiary shall mean one or more beneficiaries as designated by a Participant in writing delivered to the Committee. In the event no such written designation is made by a Participant or if such beneficiary shall not be living or in existence at the time for commencement of payment to any Designated Beneficiary under the Plan, the Participant shall be deemed to have designated his estate as such beneficiary. 2.10 Early Retirement Date shall mean the date on which a Participant who qualifies for the early retirement benefit of Section 4.02 hereof retires from the employ of the Company and its affiliated entities. 2.11 Eligible Spouse shall mean the spouse of a Participant who, under the laws of the State where the marriage was contracted, is deemed married to that Participant on the date on which the payments from this Plan are to begin to the Participant, except that for purposes of Articles V and VI hereof, Eligible Spouse shall mean a person who is married to a Participant for a period of at least one year prior to his death. 2.12 Final Average Salary shall mean a Participant's average monthly Salary (as defined in Section 2.18 hereof) during the 36 completed calendar months of highest compensation within the 120-month period immediately preceding the earliest to occur of the Participant's death, Severance Date, Early Retirement Date, or Normal Retirement Date, whichever is applicable. Provided, however, if a Participant becomes entitled to a benefit hereunder while under a period of long-term disability under the Sponsor's Group Insurance Plan, Final Average Salary shall be determined for the 12 calendar months immediately preceding the commencement of such period of long-term disability. Provided, further, in determining average monthly Salary (i) annual bonuses and other similar payments shall be deemed received in twelve (12) equal payments beginning with the eleventh preceding month and ending with the month in which actual payment is made, and (ii) amounts of compensation deferred under any deferred compensation plan or arrangement shall be deemed received in the months such payments would have been received assuming no deferral had occurred. For years of Service granted under the terms of a written employment agreement as provided under Section 2.19, Salary during each such month is deemed to be zero dollars ($0.00) for purposes of calculating Final Average Salary. 2.13 Normal Retirement Date shall mean the first day of the calendar month coinciding with or next following the Participant's 65th birthday. 2.14 Participant shall mean an employee of the Company who is eligible and is participating in this Plan in accordance with Article III hereof. 2.15 Pension shall mean a level monthly annuity which is payable under the Retirement Plan as of the Benefit Commencement Date if the Participant elected an annuity form of benefit. 2.16 Plan shall mean the "Supplemental Senior Executive Retirement Plan of Carolina Power & Light Company" as contained herein and as it may be amended from time to time hereafter. 2.17 Retirement Plan shall mean the "Supplemental Retirement Plan of Carolina Power & Light Company" (as amended effective January 1, 1999) as it may be amended from time to time hereafter. 2.18 Salary shall mean the sum of: (1) The annual base compensation paid by the Company to a Participant, and (2) annual cash awards made under incentive compensation programs excluding, however, any payment made under the Sponsor's Long-Term Compensation Program or the Sponsor's 1997 Equity Incentive Plan, and (3) amounts of annual compensation deferred under any deferred compensation plan or arrangement (including, without limitation, the "Executive Deferred Compensation Plan," the "Deferred Compensation Plan for Key Management Employees of Carolina Power & Light Company," the "Carolina Power & Light Company Management Deferred Compensation Plan" effective January 1, 2000, and the "Stock Purchase - Savings Plan of Carolina Power & Light Company") and which, but for the deferral, would have been reflected in Internal Revenue Service Form W-2. 2.19 Service shall have the same meaning as "Eligibility Service," determined as provided in Sections 2.02 and 3.01 of the Retirement Plan, plus any additional years of service that may be granted to the Participant in connection with this Plan under the terms of a written employment agreement (or any amendment thereto) entered into between the Company and the Participant . 2.20 Severance Date shall mean the earlier of: (a) The date a Participant leaves the employ of the Company and all affiliated entities other than on account of his death, a period of long-term disability under the Company's Group Insurance Plan, or retirement at either his Early Retirement Date or upon or after his Normal Retirement Date, or (b) The first anniversary of the date on which a Participant is first absent from the service of the Sponsor and all Affiliated Companies, with or without pay, other than on account of his death, a period of long-term disability under the Company's Group Insurance Plan, or his retirement at either his Early Retirement Date or upon or after his Normal Retirement Date. If a Participant shall leave the employ of the Company and all Affiliated Companies under circumstances described in (b) and shall during such absence (and before the first anniversary of commencement of said absence) quit or be discharged, his Severance Date shall be the date he quits or is discharged. 2.21 Social Security Benefit means the monthly amount of benefit which a Participant is or would be entitled to receive at age 65 as a primary insurance amount under the federal Social Security Act, as amended, whether or not he applies for such benefit, and even though he may lose part or all of such benefit through delay in applying for it, by making application prior to age 65 for a reduced benefit, by entering into covered employment, or for any other reason. The amount of such Social Security Benefit to which the Participant is or would be entitled shall be estimated by the Committee for the purposes of this Plan as of the January 1 of the year in which his Severance Date or retirement occurs on the following basis: (a) For a Participant entitled to a normal retirement benefit, on the basis of the federal Social Security Act as in effect on the January 1 coincident with or next preceding his Normal Retirement Date (regardless of any retroactive changes made by legislation enacted after said January 1); (b) For a Participant entitled to an early retirement benefit, on the basis of the federal Social Security Act as in effect on the January 1 coincident with or next preceding his Early Retirement Date (regardless of any retroactive change made by legislation enacted after said January 1), assuming that his employment, and Salary in effect at his Early Retirement Date, continued to age 65; or (c) For a Participant entitled to a severance benefit, on the basis of the federal Social Security Act as in effect on the January 1 coincident with or next preceding his Severance Date (regardless of any retroactive change made by legislation enacted after said January 1), assuming that his employment, and Salary in effect at his Severance Date, continued to age 65. For purposes of the calculations required under paragraphs (a) and (b) above, if a Participant is disabled under a period of long-term disability under the Company's Group Insurance Plan, said Social Security Benefit shall be calculated as if his Salary in effect at the commencement of such period of long-term disability continued to age 65. 2.22 Spouse's Pension shall mean the actual monthly benefit payable to an Eligible Spouse under the Retirement Plan, assuming the Eligible Spouse elected a 50% Joint and Survivor Annuity form of benefit. 2.23 Target Early Retirement Benefit shall mean an amount equal to a Participant's Final Average Salary determined at his Early Retirement Date multiplied by four percent (4%) for each projected year of Service at his Normal Retirement Date up to a maximum of sixty-two percent (62%). 2.24 Target Normal Retirement Benefit shall mean an amount equal to a Participant's Final Average Salary determined at his Normal Retirement Date multiplied by four percent (4%) for each projected year of Service at his Normal Retirement Date up to a maximum of sixty-two percent (62%). 2.25 Target Pre-Retirement Death Benefit shall mean an amount equal to a deceased Participant's Final Average Salary determined at his death multiplied by four percent (4%) for each year of Service at his death up to a maximum of sixty-two percent (62%). 2.26 Target Severance Benefit shall mean an amount equal to a Participant's Final Average Salary determined at his Severance Date multiplied by four percent (4%) for each year of Service at his Severance Date up to a maximum of sixty-two percent (62%). ARTICLE III ----------- ELIGIBILITY AND PARTICIPATION ----------------------------- 3.01 Eligibility. Any executive employee of a Company who has served on the Senior Management Committee of the Sponsor and who has been a Senior Vice President or above for a minimum period of three (3) years and who has at least ten (10) years of Service shall be eligible to participate in this Plan. 3.02 Date of Participation. Each executive who is eligible to become a Participant under Section 3.01 shall become a Participant on the first day of the month following the month in which he is first eligible to participate. 3.03 Duration of Participation. Each executive who becomes a Participant shall continue to be a Participant until the termination of his employment with the Company or, if later, the date he is no longer entitled to benefits under this Plan. ARTICLE IV ---------- RETIREMENT BENEFITS ------------------- 4.01 Normal Retirement Benefit. (a) Eligibility. A Participant whose employment with the Company terminates on or after his Normal Retirement Date shall be eligible for the normal retirement benefit described in this Section 4.01. (b) Amount and Form. The monthly payment hereunder shall be in the form of a Single Life Annuity if the Participant has no Eligible Spouse and in the form of a 50% Qualified Joint and Survivor Annuity if the Participant has an Eligible Spouse. The eligible Participant's normal retirement benefit shall be a monthly amount equal to his Target Normal Retirement Benefit reduced by the sum of (1) his Assumed Normal Retirement Pension Benefit and (2) his Social Security Benefit. (c) Commencement and Duration. Monthly normal retirement benefit payments shall commence at the same time as the eligible Participant's normal retirement Pension payable from the Retirement Plan and shall continue in monthly installments thereafter ending with a payment for the month in which such eligible Participant's death occurs, unless the benefit is being paid in the form of a Qualified Joint and Survivor Annuity, in which case the survivor benefit shall be paid to the Eligible Spouse, if living, for his or her life. If at the time of commencement of payment such eligible Participant does not have an Eligible Spouse the monthly benefit payments shall be guaranteed for one hundred twenty (120) monthly payments with any such guaranteed payments remaining at such Participant's death payable to his Designated Beneficiary. 4.02 Early Retirement Benefit. (a) Eligibility. Upon recommendation of the Chief Executive Officer of the Company and approval of the Committee, a Participant whose employment with the Company terminates upon or after his attainment of age fifty-five (55) with at least fifteen (15) years of Service (except for purposes of calculating benefits payable under Article V. PRE-RETIREMENT DEATH BENEFITS and Article VI. SEVERANCE BENEFITS, as applicable) but prior to his Normal Retirement Date, shall be eligible for the early retirement benefit described in this Section 4.02. (b) Amount and Form. The monthly payment hereunder shall be in the form of a Single Life Annuity if the Participant has no Eligible Spouse and in the form of a 50% Qualified Joint and Survivor Annuity if the Participant has an Eligible Spouse. The eligible Participant's early retirement benefit shall be a monthly amount equal to his Target Early Retirement Benefit reduced by the sum of (1) his Assumed Early Retirement Pension Benefit and (2) his Social Security Benefit; provided, however, such benefit will be reduced, where applicable, by the following: (i) The amount of 2.5% for each year that such benefit is received prior to his Normal Retirement Date, and (ii) If such eligible Participant's projected years of Service at his Normal Retirement Date are less than fifteen (15), his Target Early Retirement Benefit and his Assumed Early Retirement Pension Benefit shall be calculated based upon his actual years of Service at his Early Retirement Date rather than upon his projected years of Service at his Normal Retirement Date. (c) Commencement and Duration. Monthly early retirement benefit payments shall commence on the first day of the month following the Participant's attainment of age 65, provided, such Participant may make written application to the Committee to have payments commence on the first day of any month following his Early Retirement Date and the decision of the Committee, based upon its sole and absolute discretion, to allow such early commencement of payment shall be final. After commencement of payment, said early retirement benefit payments shall continue in monthly installments thereafter ending with a payment for the month in which such eligible Participant's death occurs, unless the benefit is being paid in the form of a Qualified Joint and Survivor Annuity, in which case the survivor benefit shall be paid to the Eligible Spouse, if living, for his or her life. If at the time of commencement of payment such eligible Participant does not have an Eligible Spouse, the monthly benefit payments shall be guaranteed for one hundred twenty (120) monthly payments with any such guaranteed payments remaining at such Participant's death payable to his Designated Beneficiary. 4.03 Surviving Spouse Benefit. The surviving Eligible Spouse of a Participant who is receiving a Qualified Joint and Survivor Benefit as a normal retirement benefit or as an early retirement benefit shall be eligible for the surviving spouse benefit upon the death of the Participant for the duration of the Eligible Spouse's life. 4.04 Re-employment of Retired Participant. A retired Participant receiving or eligible to receive the retirement benefits described in Sections 4.01 and 4.02 hereof who is re-employed by a Company shall be ineligible to again participate in this Plan. ARTICLE V PRE-RETIREMENT DEATH BENEFITS 5.01 Eligibility. A Participant's surviving Eligible Spouse shall be eligible for the pre-retirement death benefit as described in this Article V if such Participant dies while in the employ of the Company with 10 or more years of Service. 5.02 Amount. Such surviving Eligible Spouse shall be entitled to a monthly pre-retirement death benefit payable in the form of an annuity in an amount equal to the difference, if any, between (a) forty percent (40%) of the Target Pre-Retirement Death Benefit and (b) the Spouse's Pension. 5.03 Alternative Benefit. If greater than the monthly benefit of Section 5.02 hereof, the surviving Eligible Spouse of a Participant who dies while in the employ of the Company after attaining age fifty-five (55) with ten (10) years of Service shall be entitled to a monthly pre-retirement death benefit equal to fifty percent (50%) of the early retirement benefit the Participant would have been entitled to receive under Section 4.02 hereof (calculated using both reductions, where applicable, in subsections 4.02(b)(i) and 4.02(b)(ii)) as if he had retired immediately prior to his death with the recommendation of the Chief Executive Officer and approval of the Committee. 5.04 Commencement and Duration. The surviving Eligible Spouse's monthly pre-retirement death benefit payments shall commence in the month following the Participant's death and shall be paid in monthly installments thereafter ending with a payment for the month in which such surviving Eligible Spouse's death occurs. ARTICLE VI SEVERANCE BENEFITS 6.01 Eligibility. Upon his termination of employment with the Company at his Severance Date, a Participant who has completed ten (10) or more years of Service shall be eligible for one of the severance benefits described in this Article VI. 6.02 Amount. (a) If at his Severance Date such eligible Participant is not entitled to a deferred vested Pension pursuant to Section 5.03 of the Retirement Plan or an early retirement Pension pursuant to Section 5.02 of the Retirement Plan, his severance benefit shall be a monthly amount equal to his Target Severance Benefit reduced by his Social Security Benefit. (b) If at his Severance Date such eligible Participant is entitled to a deferred vested Pension pursuant to Section 5.03 of the Retirement Plan, his severance benefit shall be a monthly amount equal to his Target Severance Benefit reduced by the sum of (1) his Assumed Deferred Vested Pension Benefit and (2) his Social Security Benefit. (c) If at his Severance Date such eligible Participant is entitled to an early retirement Pension pursuant to Section 5.02 of the Retirement Plan, his severance benefit shall be a monthly amount equal to his Target Severance Benefit reduced by the sum of (1) his Assumed Early Retirement Pension Benefit and (2) his Social Security Benefit; provided, however, such Assumed Early Retirement Pension Benefit shall be calculated based upon his actual years of Service at his Severance Date rather than upon his projected years of Service at his Normal Retirement Date. 6.03 Commencement and Duration. Monthly severance benefit payments shall commence on the eligible Participant's Normal Retirement Date and shall continue in monthly installments thereafter ending with a payment for the month in which such eligible Participant's death occurs. 6.04 Surviving Spouse Benefit. (a) Eligibility. The surviving Eligible Spouse of a Participant who is receiving or who dies after attaining age fifty-five (55) entitled to receive a severance benefit hereunder shall be eligible for the surviving spouse benefit described in this Section 6.04. (b) Amount. Such surviving Eligible Spouse shall be entitled to a monthly surviving spouse benefit in an amount equal to fifty percent (50%) of the severance benefit which the deceased Participant was receiving or entitled to receive at his Normal Retirement Date under either Section 6.02(a) or 6.02(b) hereof on the day before his death. (c) Commencement and Duration. The monthly surviving spouse benefit payment shall commence in the month following the Participant's death and shall be paid in monthly installments thereafter ending with a payment for the month in which such surviving Eligible Spouse's death occurs. ARTICLE VII ------------ ADMINISTRATION -------------- 7.01 Committee. This Plan shall be administered by the Committee. The Committee shall have all powers necessary to enable it to carry out its duties in the administration of the Plan. Not in limitation, but in application of the foregoing, the Committee shall have the duty and power to determine all questions that may arise hereunder as to the status and rights of Participants in the Plan. 7.02 Voting. The Committee shall act by a majority of the number then constituting the Committee, and such action may be taken either by vote at a meeting or in writing without a meeting. 7.03 Records. The Committee shall keep a complete record of all its proceedings and all data relating to the administration of the Plan. The Committee shall select one of its members as a Chairman. The Committee shall appoint a Secretary to keep minutes of its meetings and the Secretary may or may not be a member of the Committee. The Committee shall make such rules and regulations for the conduct of its business as it shall deem advisable. 7.04 Liability. To the extent permitted by law, no member of the Committee shall be liable to any person for any action taken or omitted in connection with the interpretation and administration of this Plan unless attributable to his own gross negligence or willful misconduct. The Sponsor shall indemnify the members of the Committee against any and all claims, losses, damages, expenses, including counsel fees, incurred by them, and any liability, including any amounts paid in settlement with their approval, arising from their action or failure to act, except when the same is judicially determined to be attributable to their gross negligence or willful misconduct. 7.05 Expenses. The cost of payments from this Plan and the expenses of administering the Plan shall be borne by each Company with respect to its own employees. ARTICLE VIII ------------ AMENDMENT AND TERMINATION ------------------------- The Sponsor reserves the right, at any time or from time to time, by action of its Board , to modify or amend in whole or in part any or all provisions of the Plan. In addition, the Sponsor reserves the right by action of its Board to terminate the Plan in whole or in part. Provided, however, any such modification, amendment or termination shall not reduce benefits accrued at such time nor increase vesting requirements with respect to such accrued benefits. ARTICLE IX ---------- MISCELLANEOUS ------------- 9.01 Non-Alienation of Benefits. No right or benefit under the Plan shall be subject to anticipation, alienation, sale, assignment, pledge, encumbrance, or charge, and any attempt to anticipate, alienate, sell, assign, pledge, encumber, or charge any right or benefit under the Plan shall be void. No right or benefit hereunder shall in any manner be liable for or subject to the debts, contracts, liabilities or torts of the person entitled to such benefits. If the Participant or Eligible Spouse shall become bankrupt, or attempt to anticipate, alienate, sell, assign, pledge, encumber, or charge any right hereunder, then such right or benefit shall, in the discretion of the Committee, cease and terminate, and in such event, the Committee may hold or apply the same or any part thereof for the benefit of the Participant or his spouse, children, or other dependents, or any of them, in such manner and in such amounts and proportions as the Committee may deem proper. 9.02 No Trust Created. The obligations of the Sponsor and each Company to make payments hereunder shall constitute a liability of the Sponsor and each Company, as the case may be, to a Participant. Such payments shall be made from the general funds of the Sponsor or a Company, and the Sponsor or a Company shall not be required to establish or maintain any special or separate fund, or purchase or acquire life insurance on a Participant's life, or otherwise to segregate assets to assure that such payment shall be made, and neither a Participant nor Eligible Spouse shall have any interest in any particular asset of the Sponsor or a Company by reason of its obligations hereunder. Nothing contained in the Plan shall create or be construed as creating a trust of any kind or any other fiduciary relationship between the Sponsor, a Company and a Participant or any other person. 9.03 No Employment Agreement. Neither the execution of this Plan nor any action taken by the Sponsor or a Company pursuant to this Plan shall be held or construed to confer on a Participant any legal right to be continued as an employee of the Sponsor or a Company in an executive position or in any other capacity whatsoever. This Plan shall not be deemed to constitute a contract of employment between the Sponsor or a Company and a Participant, nor shall any provision herein restrict the right of any Participant to terminate his employment with the Sponsor or a Company. 9.04 Binding Effect. Obligations incurred by the Sponsor or a Company pursuant to this Plan shall be binding upon and inure to the benefit of the Sponsor or a Company, its successors and assigns, and the Participant or his Eligible Spouse. 9.05 Suicide. No benefit shall be payable under the Plan to a Participant or Eligible Spouse where such Participant dies as a result of suicide within two (2) years of his commencement of participation herein. 9.06 Claims for Benefits. Each Participant or Eligible Spouse must claim any benefit to which he is entitled under this Plan by a written notification to the Committee. If a claim is denied, it must be denied within a reasonable period of time, and be contained in a written notice stating the following: A. The specific reason for the denial. B. Specific reference to the Plan provision on which the denial is based. C. Description of additional information necessary for the claimant to present his claim, if any, and an explanation of why such material is necessary. D. An explanation of the Plan's claims review procedure. The claimant will have 60 days to request a review of the denial by the Committee, which will provide a full and fair review. The request for review must be in writing delivered to the Committee. The claimant may review pertinent documents, and he may submit issues and comments in writing. The decision by the Committee with respect to the review must be given within 60 days after receipt of the request, unless special circumstances require an extension (such as for a hearing). In no event shall the decision be delayed beyond 120 days after receipt of the request for review. The decision shall be written in a manner calculated to be understood by the claimant, and it shall include specific reasons and refer to specific Plan provisions as to its effect. 9.07 Entire Plan. This document and any amendments contain all the terms and provisions of the Plan and shall constitute the entire Plan, any other alleged terms or provisions being of no effect. ARTICLE X ---------- CONSTRUCTION ------------ 10.01 Governing Law. This Plan shall be construed and governed in accordance with the laws of the State of North Carolina, to the extent not preempted by Federal Law. 10.02 Gender. The masculine gender, where appearing in the Plan, shall be deemed to include the feminine gender, and the singular may include the plural, unless the context clearly indicates to the contrary. 10.03 Headings, etc. The cover page of this Plan, the Table of Contents and all headings used in this Plan are for convenience of reference only and are not part of the substance of this Plan. 10.04 Action. Any action under this Plan required or permitted by the Sponsor shall be by action of its Board or its duly authorized designee. APPENDIX A ---------- North Carolina Natural Gas Company ("NCNG"); provided that for all purposes of the Plan, Service for an employee of NCNG on December 31, 1999 (as defined in Section 2.19) shall include employment only with NCNG (or another adopting Company) on or after January 1, 2000; and further provided that the accrued benefit calculated under Sections 2.03, 2.04 and 2.05 shall not include the "Accrued Benefit" under Supplement A, Paragraph A-2 of the Retirement Plan, attributable to the NCNG Employees Pension Plan. EXHIBIT 10B(32) April 27, 1999 Mr. Sherwood H. Smith, Jr. 408 Drummond Drive Raleigh, NC 27609 Dear Sherwood: This letter will confirm the discussion we have recently had concerning your upcoming retirement as Chairman of the Board of Directors of Carolina Power & Light Company. Your current Agreement with the Company anticipates that you will not serve as Chairman after the May 1999 Annual Meeting, and your current term as a Director expires at that meeting. We have agreed that you will accept a nomination at the May 1999 meeting to be a Director in Class II and to serve a one-year term expiring in 2000. We also anticipate that at the Board meeting in May you will be elected to the honorary position of Chairman Emeritus. The Agreement states that you will continue to provide various services to the Company through September 30, 1999. We also appreciate your commitment to be available to continue to provide these types of services to the Company after September 30, 1999. These additional services will be as requested by, and performed under the general direction of, CP&L's Chief Executive Officer, as agreed to by you. The compensation for such services will be as approved by the Chief Executive Officer. In addition, you will receive the standard compensation for service as an outside Director after September 30, 1999, until your term as Director expires. (The non-compete provisions of your Agreement will, of course, continue.) The Company will continue to provide the services and benefits described in your Agreement, including a home alarm and security service, a company network telephone, and facsimile equipment at your residence, and a car telephone. The Company will also provide you with its standard car allowance for three years following the expiration of the Agreement (through September 30, 2002). Finally, as noted in the Agreement, the Company will also continue to provide office and secretarial support. We are currently arranging accommodations in One Hannover Square with the intent of relocating your office in June. These services and appropriate office accommodations will be supplied until you attain the age of 80. After such time, if services or accommodations of any kind might be appropriate, the matter will be determined at that time by the Chief Executive Officer. I look forward to having you continue on the Board of Directors for another year. Very truly yours, /s/William Cavanaugh III William Cavanaugh III Agreed: /s/Sherwood H. Smith, Jr. ------------------------- Sherwood H. Smith, Jr. EXHIBIT 10B(33) EMPLOYMENT AGREEMENT BETWEEN NORTH CAROLINA NATURAL GAS CORPORATION AND CALVIN B. WELLS JULY 15, 1999 EMPLOYMENT AGREEMENT -------------------- EMPLOYMENT AGREEMENT ("Agreement"), dated as of the July 15, 1999, between North Carolina Natural Gas Corporation ("NCNG" or "Company"), a Delaware Corporation headquartered in Fayetteville, North Carolina and a subsidiary of Carolina Power & Light Company ("CP&L"), and Calvin B. Wells ("Wells"). RECITALS --------- 1. On or around July 15, 1999 ("Closing Date"), North Carolina Natural Gas Corporation will, through a merger transaction, become a wholly owned subsidiary of Carolina Power & Light ("CP&L"). NCNG, as it existed prior to this merger, will be referred to herein as "Pre-Merger NCNG." 2. Wells was employed as Chief Executive Officer of Pre-Merger NCNG and entered into an Employment Agreement with Pre-Merger NCNG on September 11, 1985 ("Prior Agreement"). 3. NCNG and Wells wish to enter into an employment relationship whereby Wells will be employed as Chief Executive Officer of NCNG after the Closing Date. 4. NCNG and Wells wish to rescind his Prior Agreement and enter into this new Employment Agreement which will supersede all prior agreements on the subject matter. 5. The parties wish to enter into this Agreement to set forth certain terms related to that relationship. PROVISIONS NOW, THEREFORE, in consideration of the mutual covenants and promises contained herein and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged and accepted, the parties hereto hereby agree as follows: 1. TERM OF EMPLOYMENT. ------------------ (a). Employment. The Company hereby agrees to employ Wells, and Wells hereby accepts employment with NCNG, for the Employment Term stated herein, subject to the terms and conditions hereof. (b). Employment Term. Unless sooner terminated in accordance with the provisions of Section 6, Wells' term of employment with NCNG under this Agreement (the "Employment Term") shall commence on the Closing Date ("Employment Date"), and shall continue until July 15, 2002. Should Wells' employment with NCNG continue past July 15, 2002, then such employment shall not be subject to this Employment Agreement. 2. RESPONSIBILITIES; OTHER ACTIVITIES. ---------------------------------- Wells shall occupy the position of Chief Executive Officer of NCNG and shall undertake the general responsibilities and duties of such position as directed by NCNG's Board of Directors. During the Employment Term, Wells shall perform faithfully the duties of Wells' position, devote all of Wells' working time and energies to the business and affairs of NCNG and shall use Wells' best efforts, skills and abilities to promote NCNG. 3. SALARY. ------ As compensation for the services to be performed hereunder: Wells will be paid a salary at the annual rate of Two Hundred Sixty Seven Thousand Three Hundred Dollars ($267,300) (less applicable withholdings) beginning on the Employment Date. Annual salary for each subsequent year of the Employment Term shall be subject to adjustment by the NCNG Board of Directors at its discretion, provided that Wells' annual salary shall not be less than $267,300.00. Annual salary shall be deemed earned proportionally as Wells performs services over the course of the Salary Year. Payments of annual salary shall be made, except as otherwise provided herein, in accordance with NCNG's standard payroll policies and procedures. 4. PRIOR AGREEMENT. ---------------- The parties agree that the Prior Agreement between Pre-Merger NCNG and Wells dated September 11, 1985 is no longer in effect and that this Employment Agreement supersedes Wells' Prior Agreement with Pre-Merger NCNG. 5. BENEFITS. -------- During the Employment Term, Wells shall be entitled to participate in all Company sponsored benefit programs as NCNG or CP&L may have in effect in accordance with their terms. Provided, however, that nothing contained in this Agreement shall require NCNG or CP&L to continue to offer such benefits or programs or to limit NCNG's or CP&L's absolute right to modify or eliminate these benefits. (a). Existing Pre-Merger NCNG Plans. Wells will continue participating in the following existing Pre-Merger NCNG Plans until December 31, 1999, in accordance with their terms: North Carolina Natural Gas Executive Pension Restoration Plan, North Carolina Natural Gas Employees' Pension Plan, North Carolina Natural Gas 401(k) Plan, and all other health and welfare plans as described in the existing Pre-Merger NCNG Handbook, in which Wells is eligible to participate. Wells' rights to benefits under these Plans will be based upon the terms of these Plans. (b). Terminating Pre-Merger NCNG Plans. The parties acknowledge that the following Pre-Merger North Carolina Natural Gas plans will terminate, in accordance with their terms, on or around the Closing Date: the NCNG Long Term Incentive Plan; the NCNG Annual Incentive Plan; the NCNG Employee Stock Purchase Plan; and the NCNG Key Employee Stock Option Plan. Wells' rights to benefits in those plans will be based upon the terms of those plans. (c). CP&L Plans and Post-Merger NCNG Plans. Wells will be eligible to participate in the following benefit plans subject to their terms: (i). Management Incentive Compensation Program. Wells will be eligible to participate in the CP&L Management Incentive Compensation Program (MICP) beginning in 2000, for which payment will be made on or before March 31, 2001, in accordance with the terms of the plan. Pursuant to the terms of the MICP, Wells' target compensation under such program will be approximately 35% of base salary earnings. Wells will be entitled to a 1999 Bonus for the remainder of 1999 to be calculated under the terms of the CP&L MICP and prorated accordingly. (ii). Long Term Incentives. Wells will be eligible to participate in the CP&L Performance Share Sub-Plan under the 1997 Equity Incentive Plan in accordance with the terms of the plan. Wells' participation in this plan shall begin January 1, 2000. (iii). Restricted Stock Agreement. NCNG and Wells have entered into a Restricted Stock Agreement effective July 15, 1999. (iv). Management Deferred Compensation Plan. Wells will be eligible to participate in CP&L's management Deferred Compensation Plan in accordance with the terms of the plan. Wells' participation in this plan shall begin January 1, 2000. (v). Supplemental Retirement Plan. Wells will be eligible for participation in CP&L's Supplemental Retirement Plan (SRP), subject to its terms. Wells' participation in this plan shall begin January 1, 2000. Wells will also be eligible to participate in the CP&L Restoration Retirement Plan on January 1, 2000, subject to its terms. (vi). Executive Permanent Life Insurance Program. Wells shall be eligible to participate in CP&L's Executive Permanent Life Insurance Program, subject to its terms. Wells' participation in this plan shall begin January 1, 2000. (vii). Personal Accident Insurance Program. Wells shall be eligible to participate in CP&L's Personal Accident Insurance Program, subject to its terms. Wells' participation in this plan shall begin January 1, 2000. (viii). Stock Purchase Savings Plan. Wells shall be eligible to participate in CP&L's Stock Purchase Savings Plan, subject to its terms. Wells' participation in this plan shall begin January 1, 2000. (ix). Financial/ Estate Planning. Consistent with CP&L's practice with respect to other senior executives, Wells will be reimbursed for financial and estate planning including financial planning and tax preparation. Wells shall be immediately eligible for this benefit. (x). Choice Benefits Program. Wells shall be eligible to participate in CP&L's Choice Benefits Program, subject to its terms. Wells' participation in this program shall begin January 1, 2000. (xi). Vacation. Wells shall be entitled to five (5) weeks of paid vacation days beginning January 1, 2000. (xii). Holiday. Wells will be eligible for ten (10) paid holidays in each calendar year as provided in the NCNG Handbook. (xiii). Automobile Allowance. Wells will be eligible to receive an automobile allowance of $1350 per month (less withholdings) subject to the terms of NCNG's policies. Wells will also be eligible for a cellular phone and reserved parking at NCNG's expense. Wells shall be eligible for his automobile allowance at the expiration of his current automobile lease. (xiv). Annual Physical. NCNG will pay for an annual physical examination by a physician of Wells' choice beginning January 1, 2000. (xv). Capital City Club. NCNG will pay an initiation fee and monthly dues for a membership at the Capital City Club for Wells. Wells shall be immediately eligible for this benefit. (xvi). Airline Club Membership. NCNG will provide airline club membership in accordance with NCNG policy. Wells shall be immediately eligible for this benefit. (xvii). Country Club Membership. At Wells' option, if joined, NCNG will pay an initiation fee and monthly dues for a membership for Wells at a country club approved by the NCNG Board of Directors. Business related expenses will be reimbursed consistent with NCNG's expense account guidelines. Wells shall be immediately eligible for this benefit. (xviii). Personal Computer. NCNG will provide a personal computer to Wells to be used at his personal residence. Wells shall be immediately eligible for this benefit. (d). Funding of Benefits under NCNG Executive Pension Restoration Plan. (i). Under the NCNG Restoration Pension Plan as referenced in Section 5(a), Wells shall be entitled to benefits that shall have accrued thereunder through December 31, 1999. As further provided in the Plan, such benefits are payable from the general assets of NCNG. (ii). Conditions for Trust. NCNG agrees to establish a trust, as described in Section 5(d)(iii) below, to fund the payment of benefits to Wells under NCNG's Executive Pension Restoration Plan in the event that: (aa). A change-in-control of NCNG or CP&L occurs; or (bb). Wells retires under the NCNG Employee's Pension Plan or CP&L's Supplemental Retirement Plan (as applicable). Retirement by Wells shall be deemed to have occurred in the event that his employment is terminated with NCNG and he becomes eligible to begin receiving benefits under the NCNG Executive Pension Restoration Plan. (iii). Trust. Should the conditions specified in Section 5(d)(ii) transpire, and should NCNG thereby be required to establish a trust as provided therein, such trust shall be: (aa). A trust of which NCNG is the grantor, within the meaning of subpart E, Part I, subchapter J, chapter 1, subtitle A of the Internal Revenue Code; (bb). A trust under which Wells is a beneficiary as of his retirement date or as of the change-in-control date (as applicable); and (cc). A trust the assets of which shall be subject to the claims of NCNG's general creditors in accordance with Internal Revenue Service Revenue Procedure 92-64. (iv). Further Modifications. Nothing in this Agreement shall in any way limit or prohibit NCNG from amending or terminating NCNG's Employee's Pension Plan, CP&L's Supplemental Retirement Plan, NCNG's Executive Pension Restoration Plan, or any other benefit plan of NCNG or CP&L. (v). Change-in-Control. (aa). Defined. A Change-in-Control of NCNG or CP&L shall be deemed to have occurred only in the event that any one of the following circumstances or conditions transpires: (i). The acquisition by any person (including a group, within the meaning of Section 13(d) or 14(d)(2) of the Securities Exchange Act of 1934, as amended) of beneficial ownership of 15 percent or more of the NCNG's or CP&L's then outstanding voting securities; (ii). A tender offer is made and consummated for the ownership of 51 percent or more of NCNG's or CP&L's then outstanding voting securities; (iii). The first day on which less than 66 2/3 percent of the total membership of the Board of Directors of NCNG or CP&L are Continuing Directors of either NCNG or CP&L ("Continuing Directors" being members of such Board as of the effective date of this Agreement), provided, however, that any person becoming a director subsequent to such date whose election or nomination for election was supported by 75 percent or more of the directors who then comprised Continuing Directors shall be considered to be a Continuing Director); or (iv). Approval by the stockholders of the NCNG or CP&L of a merger, consolidation, liquidation or dissolution of the NCNG or CP&L, or of the sale of all or substantially all of the assets of NCNG or CP&L; (bb). Holding Company or Structural Reorganization. Movement of NCNG or CP&L to a holding company structure, issuance of stock to the shareholders of CP&L or any holding company, or any other corporate reorganization among affiliated companies whereby the ultimate ownership of NCNG does not materially change as a result of a the transaction shall not be deemed to be a Change-in-Control. (cc). Effective Date for Change-in-Control. A Change-in-Control shall not be deemed to have occurred until Wells receives written certification from CP&L's President and Chief Executive Officer or, in the event of his or her inability to act, CP&L's Chief Financial Officer, or any Executive or Senior Vice President of the CP&L that one of the events set forth in Section 5(d)(v)(aa) above has occurred. The officers referred to in the previous sentence shall be those officers in office immediately prior to the occurrence of one of the events set forth above in Section 5(d)(v)(aa). Any determination that such an event has occurred shall, if made in good faith on the basis of information available at that time, be conclusive and binding on NCNG and Wells and Wells' beneficiaries for all purposes of this Agreement. 6. TERMINATION OF EMPLOYMENT. ------------------------- (a). The employment relationship between Wells and NCNG may be terminated by either NCNG or Wells with or without advance notice and may be terminated with or without cause as defined below. (b). Termination Without Cause or Change in Control. If Wells' employment is terminated before the end of the Employment Term Without Cause or as a result of a Change in Control (as defined in Section 5(d)) of NCNG, then Wells will be provided with severance benefits as described below, subject to paragraph 6(h). (i). Severance Benefits. In accordance with a termination under this paragraph 6(b), and subject to paragraph 6(h), Wells shall be entitled to the benefits described below. All payments shall be subject to required payroll withholdings, including any withholdings for excise taxes for parachute payments. In addition, Wells acknowledges that he is liable for all federal and state income and excise taxes due on these severance or other payments from NCNG. (aa). Salary. Wells shall be entitled to continuation of his then current base annual salary for two (2) years and eleven (11) months following such termination, paid on a semi-monthly basis. Provided, however, that if Wells is re-employed before the expiration of the two (2) years and eleven (11) months period following termination, remaining severance shall be reduced to the difference, if any, between the salary continued hereunder and the salary in the new position. (bb). Welfare Benefit Plans and 401(k) Plan. NCNG shall pay Wells a monthly sum to compensate Wells for the employer-paid portion of medical, life, AD&D and disability coverage and for the loss of the company match under the 401(k) plan. Such sum shall be grossed up to cover state and federal income taxes, but not any excise taxes due for parachute payments which may apply. Provided, however, that these payments shall cease sixty (60) days following Wells' re-employment before the end of the two (2) year and eleven (11) month period following termination. Upon re-employment, NCNG shall have no further obligation to Wells under this paragraph 6(b)(i)(bb). (cc). Retirement Plan. In order to compensate Wells for loss of pension benefits, NCNG shall calculate a "make up" pension benefit. This "make up" pension benefit shall equal the value which would have been added to Wells' pension benefit, under the retirement plan in which he is participating at the time of termination, had his employment been continued for two (2) years and eleven (11) months beyond the termination date, or to the date sixty (60) days following Wells' re-employment, whichever is earlier. The "make up" pension benefit shall be calculated within a reasonable period of time following such date. The net present value of the "make up" pension benefit (less applicable withholdings) shall be payable, in semi-monthly payments, over a five (5) year period beginning on the first of the month following such calculation. (i). Calculation. If Wells' employment is terminated under this paragraph on or before December 31, 1999, then the "make up" pension benefits will be calculated based upon the final average pay as it would have been determined under the NCNG Employees' Pension Plan and the North Carolina Natural Gas Executive Pension Plan as of the date of termination. If Wells' employment is terminated on or after January 1, 2000, then this "make up" pension benefit shall be calculated based upon the base salary as determined under the CP&L Supplemental Retirement Plan and the CP&L Restoration Retirement Plan as of the date of termination. (dd). Re-employment. Wells acknowledges that benefits under paragraph 6(b) are affected by his re-employment before the expiration of two (2) years and eleven (11) months from the date of termination. Wells agrees that he shall provide written notice to NCNG of any such re-employment within fourteen (14) days of the date re-employment commences. Such notice shall include the terms of employment, including start date, salary, benefit availability, and other information as may be requested by the NCNG Board of Directors. Such notice shall be delivered to: Vice President, Human Resources, Carolina Power & Light Company, P. O. Box 1551, Raleigh, North Carolina, 27602. For purposes of this Agreement, re-employment shall include, but not be limited to, work as an employee, agent, consultant, independent contractor, or in any other capacity, for an employer, firm, or other entity, or for one's own business. (c). Constructive Termination. If Wells is reassigned to another position with significantly and materially reduced responsibilities, or his annual salary is reduced by 15% or more, then, at Wells' option, Wells may deem such action to be a Constructive Termination. Should Wells wish to deem such action a Constructive Termination, then Wells must notify, in writing, the NCNG Board of Directors within 30 days of the date Wells received notification of the change in his duties or salary. Should Wells declare such action to be a Constructive Termination, then he shall be entitled to the benefits described in paragraph 6(b), subject to paragraph 6(h). (d). Voluntary Termination - If Wells terminates his employment voluntarily for any reason at any time, then he shall be eligible to retain all benefits under existing benefit programs which have vested pursuant to the terms of those programs, but he shall not be entitled to any form of salary continuance or any form of severance benefit. (e). Termination for Cause - The Company may elect at any time to terminate Wells' employment immediately hereunder and remove Wells from employment for Cause. For purposes of this paragraph 6, cause for the termination of employment shall be defined as: (i) the willful and continued failure by him substantially to perform his duties with the Company (other than any such failure resulting from his incapacity due to physical or mental illness), or (ii) the willful engaging by him in misconduct which is materially injurious to the Company, monetarily or otherwise. Upon the termination of Wells' employment for Cause, NCNG shall have no further obligation to Wells under this Agreement except as specifically provided in this Agreement. Upon such termination, Wells shall be entitled to all earned but unpaid salary accrued to the date of termination. Any continued rights and benefits Wells, or Wells' legal representatives, may have under employee benefit plans and programs of NCNG upon Wells' termination for cause, if any, shall be determined in accordance with the terms and provisions of such plans and programs. (f). Termination Due to Death. In the event of the death of Wells at any time during the Employment Term, Wells' employment hereunder shall terminate and NCNG shall have no further obligation to Wells under this Agreement except as specifically provided in this Agreement. Wells' estate shall be entitled to receive all earned but unpaid salary accrued to the date of termination. Any rights and benefits Wells, or Wells' estate or other legal representatives, may have under employee benefit plans and programs of NCNG upon Wells' death during the Employment Term, if any, shall be determined in accordance with the terms and provisions of such plans and programs. (g). Termination Due to Medical Condition. (i). At any time NCNG may terminate Wells' employment hereunder, subject to the Americans With Disabilities Act or other applicable law, due to medical condition if (i) for a period of 180 consecutive days during the Employment Term, Wells is totally and permanently disabled as determined in accordance with the Company's long-term disability plan, if any, as in effect during such time or (ii) at any time during which no such plan is in effect, Wells is substantially unable to perform Wells' duties hereunder because of a medical condition for a period of 180 consecutive days during the Employment Term. (ii). Upon the termination of Wells' employment due to medical condition, NCNG shall have no further obligation to Wells under this Agreement except as specifically provided in this Agreement. Upon such termination, Wells shall be entitled to all earned but unpaid salary accrued to the date of termination. Any continued rights and benefits Wells, or Wells' legal representatives, may have under employee benefit plans and programs of NCNG upon Wells' termination due to medical condition, if any, shall be determined in accordance with the terms and provisions of such plans and programs. (h). Release of Claims - In order to receive continuation of salary and benefits under this paragraph 6, Wells agrees to execute a written release of all claims against NCNG, and its employees, officers, directors, subsidiaries and affiliates, on a form acceptable to NCNG. 7. ASSIGNABILITY. ------------- No rights or obligations of Wells under this Agreement may be assigned or transferred by Wells, except that (a) Wells' rights to compensation and benefits hereunder may be transferred by will or laws of intestacy to the extent specified herein and (b) Wells' rights under employee benefit plans or programs described in Section 5 may be assigned or transferred in accordance with the terms of such plans or programs, or regular practices thereunder. NCNG may assign or transfer its rights and obligations under this Agreement. 8. CONFIDENTIALITY. Wells will not disclose the terms of this Agreement except (i) to financial and legal advisors under an obligation to maintain confidentiality, or (ii) as required by law, including but not limited to, a valid court order or subpoena (and in such event will use Wells' best efforts to obtain a protective order requiring that all disclosure be kept under court seal) and will notify NCNG promptly upon receipt of such order or subpoena. 9. MISCELLANEOUS. ------------- (a). Governing Law. This Agreement shall be governed by, and construed in accordance with, the laws of the State of North Carolina without reference to laws governing conflicts of law. (b). Entire Agreement. This Agreement contains all of the understandings and representations between the parties hereto pertaining to the subject matter hereof and supersedes all undertakings and agreements, including specifically the Prior Agreement entered into on September 11, 1985, whether oral or in writing, previously entered into by them with respect thereto. (c). Amendment or Modification; Waiver. No provision in this Agreement may be amended or waived unless such amendment or waiver is agreed to in writing, signed by Wells and by an officer of NCNG thereunto duly authorized to do so. Except as otherwise specifically provided in the Agreement, no waiver by a party hereto of any breach by the other party hereto of any condition or provision of the Agreement to be performed by such other party shall be deemed a waiver of a similar or dissimilar provision or condition at the same or any prior or subsequent time. (d). Notice. Any notice (with the exception of notice of termination by NCNG, which may be given by any means and need not be in writing) or other document or communication required or permitted to be given or delivered hereunder shall be in writing and shall be deemed to have been duly given or delivered if (i) mailed by United States mail, certified, return receipt requested, with proper postage prepaid, or (ii) otherwise delivered by hand or by overnight delivery, against written receipt, by a common carrier or commercial courier or delivery service, to the party to whom it is to be given at the address of such party as set forth below (or to such other address as a party shall have designated by notice to the other parties given pursuant hereto): If to Wells: Calvin B. Wells North Carolina Natural Gas 150 Rowan Street Fayetteville, NC 28301 If to NCNG: Carolina Power & Light Company 411 Fayetteville Street Raleigh, North Carolina 27602 Attention: Vice President-Human Resources Any such notice, request, demand, advice, schedule, report, certificate, direction, instruction or other document or communication so mailed or sent shall be deemed to have been duly given, if sent by mail, on the third business day following the date on which it was deposited at a United States post office, and if delivered by hand, at the time of delivery by such commercial courier or delivery service, and, if delivered by overnight delivery service, on the first business day following the date on which it was delivered to the custody of such common carrier or commercial courier or delivery service, as all such dates are evidenced by the applicable delivery receipt, airbill or other shipping or mailing document. (e). Severability. In the event that any provision or portion of this Agreement shall be determined to be invalid or unenforceable for any reason, the remaining provisions or portions of this Agreement shall be unaffected thereby and shall remain in full force and effect to the fullest extent permitted by law. (f). References. In the event of Wells' death or a judicial determination of Wells' incompetence, reference in this Agreement to Wells shall be deemed, where appropriate, to refer to Wells' legal representative, or, where appropriate, to Wells' beneficiary or beneficiaries. (g). Headings. Headings contained herein are for convenient reference only and shall not in any way affect the meaning or interpretation of this Agreement. (h). Counterparts. This Agreement may be executed in several counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. (i). Rules of Construction. The following rules shall apply to the construction and interpretation of this Agreement: (i). Singular words shall connote the plural number as well as the singular and vice versa, and the masculine shall include the feminine and the neuter. (ii). All references herein to particular articles, paragraphs, sections, subsections, clauses, Schedules or Exhibits are references to articles, paragraphs, sections, subsections, clauses, Schedules or Exhibits of this Agreement. (iii). Each party and its counsel have reviewed and revised (or requested revisions of) this Agreement, and therefore any rule of construction requiring that ambiguities are to be resolved against a particular party shall not be applicable in the construction and interpretation of this Agreement or any exhibits hereto or amendments hereof. (iv). As used in this Agreement, "including" is illustrative, and means "including but not limited to." (j). Remedies. Remedies specified in this Agreement are in addition to any others available at law or in equity. (k). Withholding Taxes. All payments under this Agreement shall be subject to applicable income, excise and employment tax withholding requirements. IN WITNESS WHEREOF, the parties hereto have executed, or have caused this Agreement to be executed by their duly authorized officer, as the case may be, all as of the day and year written below. By: _______________________________ Date: ___________________ Calvin B. Wells By: _______________________________ Date: ___________________ North Carolina Natural Gas Corporation Title: _______________________________ EXHIBIT 10B(34) August 2, 1999 Mr. Larry M. Smith 205 South 26th Street West Des Moines, Iowa 50265 Dear Larry: I am pleased to confirm the offer of employment with Carolina Power & Light Company as the Vice President & Controller at an annual salary of $168,000. The offer is contingent on approval from the Board of Directors, satisfactory completion of an employment background investigation, and eligibility to be employed in the United States. We ask that you kindly inform of your decision to accept our offer by August 9, 1999. Please return one copy of this letter with your signature to indicate your acceptance of our offer. Also, please read, sign, and return the Fair Credit Reporting Act Disclosure and Authorization Statement which describes your federal rights related to any employment background check. We are looking forward to having you join us as a vital member of the team and feel that you can make a significant contribution to CP&L in our Financial Services Group. If I can answer any questions about the offer or provide any additional information, please call me at 919-546-5533. Sincerely, /s/Glenn E. Harder Glenn E. Harder Chief Financial Officer Attachment ACCEPTED: /s/Larry M. Smith 8/5/99 - --------------------------------- Signature/Date c: Randy Mizelle Glenn E. Harris [] [] [] [] [] [] [] [] [] [] [] [] [] [] [] [] [] [] [] [] TO BE COMPLETED ONLY IF OFFER IS ACCEPTED: Birthdate: 2/26/56 ------- VP & CONTROLLER COMPENSATION/BENEFITS/PERQUISITES BASE SALARY $168,000 annually, subject to periodic - ----------- review and normally adjusted in March, at the time other department head salaries are reviewed. SHORT-TERM Participation in Management Incentive INCENTIVE Compensation Program with an annual - ---------- target of 25% of actual base salary earnings. LONG-TERM Participation in the Performance Share INCENTIVE Sub-Plan which provides for an annual - --------- award of 25% of base salary awarded in performance shares equivalent in value to the market price of the Company's common stock at the time of the granting of the award, earned over a three-year period and adjusted based on performance. SPLIT-DOLLAR LIFE Participant in a permanent life INSURANCE PLAN insurance program with a target benefit - ----------------- of 3 times projected base salary assuming a salary growth of 5%. Participation in this "split dollar" program is conditional upon passing underwriting and waiving all but $50,000 coverage in the group term plan within Choice Benefits. AUTOMOBILE Car Allowance of $1200 per month with - ---------- cellular telephone. LUNCHEON CLUB Initiation fees and dues provided to the - ------------- Capital City Club. ANNUAL PHYSICAL One annual physical examination covered, - ---------------- to be provided by a physician of employee's choice. BENEFITS Choice Benefits Program including - -------- options for medical, dental, employee and dependent life, and AD&D insurance. PENSION PLAN Participation in Company funded - ------------ retirement plan that provides lump sum and/or lifetime benefits for you and your surviving spouse upon completion of 5 years of employment. STOCK PURCHASE Provides for $.50 match per dollar up to SAVINGS PLAN six percent (6%) of base salary. - -------------- Additional contributions are possible for another $.50 based upon meeting Company performance goals. DISABILITY INCOME Coverage under plan that provides for - ----------------- 60% of salary (or 70% of base salary including Family Social Security benefits). VACATION One week during the balance of 1999. - -------- Four weeks beginning January 2000. Per company policy thereafter. HOLIDAYS Current company policy is 10 days. - -------- TERMINATION Employment may be terminated at will by - ----------- the Company or by you without notice. If, following a Change-of-Control and within 2 years of employment, employment is terminated other than for good cause by the Company, you will be provided one year's base salary over the following 12 months, paid on a semi-monthly basis, subject to signing a release agreement. A Change-of-Control will be deemed to occur if there is a change in the form of ownership of CP&L (e.g., CP&L is acquired or otherwise changes form of ownership). Change in CP&L's corporate structure such as reorganization under or into a holding company, shall not be considered the basis for constructive termination. Good cause for the termination of employment shall be defined as: (i) any act of Mr. Smith's including, but not limited to, misconduct, negligence, unlawfulness, dishonesty or inattention to the business, which is detrimental to CP&L's interests; or (ii) Mr. Smith's unsatisfactory job performance or failure to comply with CP&L's direction, policies, rules or regulations. EXHIBIT NO. 12 COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND PREFERRED DIVIDENDS COMBINED AND RATIO OF EARNINGS TO FIXED CHARGES EXHIBIT 21 SUBSIDIARIES OF CAROLINA POWER & LIGHT COMPANY AT DECEMBER 31, 1999 The following is a list of certain subsidiaries of Carolina Power & Light Company and their respective states of incorporation: Interpath Communications, Inc. North Carolina Virginia North Carolina Natural Gas Corporation Delaware Cape Fear Energy Corporation (1) North Carolina NCNG Cardinal Pipeline Investment Corporation (1) North Carolina NCNG Energy Corporation (1) North Carolina NCNG Pine Needle Investment Corporation (1) North Carolina Strategic Resource Solutions Corp. North Carolina ACT Controls, Inc. (2) North Carolina Applied Computer Technologies Corp. (2) Delaware Spectrum Controls, Inc. (2) North Carolina SRS Engineering Corp. (2) North Carolina (1) Subsidiary of North Carolina Natural Gas Corporation. (2) Subsidiary of Strategic Resource Solutions Corp. EXHIBIT NO. 23(a) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement No. 33-33520 on Form S-8, Registration Statement No. 33-5134 on Form S-3, Post-Effective Amendment No. 1 to Registration Statement No. 33-38349 on Form S-3, Registration Statement No. 333-69237 on Form S-3, Registration Statement No. 333-70679 on Form S-8 and Registration Statement No. 333-89685 on Form S-8 of Carolina Power & Light Company, of our report dated February 8, 2000, except for Note 2, as to which the date is March 3, 2000 appearing in this Annual Report on Form 10-K of Carolina Power & Light Company for the year ended December 31, 1999. /s/ DELOITTE & TOUCHE LLP Raleigh, North Carolina March 21, 2000 ARTICLE UT LEGEND THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM (CONSOLIDATED FINANCIAL STATEMENTS AS OF DECEMBER 31, 1999) AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. /LEGEND MULTIPLIER 1,000 PERIOD-TYPE 12-MOS FISCAL-YEAR-END DEC-31-1999 PERIOD-END DEC-31-1999 BOOK-VALUE PER-BOOK TOTAL-NET-UTILITY-PLANT $6,764,813 OTHER-PROPERTY-AND-INVEST $492,436 TOTAL-CURRENT-ASSETS $1,079,333 TOTAL-DEFERRED-CHARGES $297,749 OTHER-ASSETS $859,688 TOTAL-ASSETS $9,494,019 COMMON $1,606,096 CAPITAL-SURPLUS-PAID-IN $(794) RETAINED-EARNINGS $1,807,345 TOTAL-COMMON-STOCKHOLDERS-EQ $3,412,647 PREFERRED-MANDATORY $0 PREFERRED $59,376 LONG-TERM-DEBT-NET $3,028,561 SHORT-TERM-NOTES $168,240 LONG-TERM-NOTES-PAYABLE $0 COMMERCIAL-PAPER-OBLIGATIONS $0 LONG-TERM-DEBT-CURRENT-PORT $197,250 PREFERRED-STOCK-CURRENT $0 CAPITAL-LEASE-OBLIGATIONS $0 LEASES-CURRENT $0 OTHER-ITEMS-CAPITAL-AND-LIAB $2,627,945 TOT-CAPITALIZATION-AND-LIAB $9,494,019 GROSS-OPERATING-REVENUE $3,357,615 INCOME-TAX-EXPENSE $258,421 OTHER-OPERATING-EXPENSES $2,517,072 TOTAL-OPERATING-EXPENSES $2,775,493 OPERATING-INCOME-LOSS $582,122 OTHER-INCOME-NET $(20,403) INCOME-BEFORE-INTEREST-EXPEN $561,719 TOTAL-INTEREST-EXPENSE $179,464 NET-INCOME $382,255 PREFERRED-STOCK-DIVIDENDS $(2,967) EARNINGS-AVAILABLE-FOR-COMM $379,288 COMMON-STOCK-DIVIDENDS $300,244 TOTAL-INTEREST-ON-BONDS $137,067 CASH-FLOW-OPERATIONS $832,120 EPS-BASIC 2.56 EPS-DILUTED 2.55

914160_1999.txt

914160_1999

1999

914160

ITEM 1. BUSINESS - ------- -------- Unless the context otherwise requires, the term "Company" refers to Canandaigua Brands, Inc. and its subsidiaries, and all references to "net sales" refer to gross revenue less excise taxes and returns and allowances to conform with the Company's method of classification. All references to "Fiscal 1999", "Fiscal 1998" and "Fiscal 1997" shall refer to the Company's fiscal year ended the last day of February of the indicated year. Industry data disclosed in this Annual Report on Form 10-K has been obtained from Adam's Media Handbook Advance, NACM, AC Nielsen, The U.S. Wine Market: Impact Databank Review and Forecast and the Zenith Guide. The Company has not independently verified this data. References to positions within industries are based on unit volume. The Company is a leading producer and marketer of branded beverage alcohol products in the United States and the United Kingdom. According to available industry data, the Company ranks as the second largest supplier of wine, the second largest importer of beer and the fourth largest supplier of distilled spirits in the United States. The Matthew Clark Acquisition (as defined below) established the Company as a leading British producer of cider, wine and bottled water and as a leading beverage alcohol wholesaler in the United Kingdom. The Company is a Delaware corporation organized in 1972 as the successor to a business founded in 1945 by Marvin Sands, Chairman of the Board of the Company. The Company has aggressively pursued growth in recent years through acquisitions, brand development, new product offerings and new distribution agreements. The Matthew Clark Acquisition and the Black Velvet Acquisition (as defined below) continued a series of strategic acquisitions made by the Company since 1991 by which it has diversified its offerings and as a result, increased its market share, net sales and cash flow. The Company has also achieved internal growth by developing new products and repositioning existing brands to focus on the fastest growing sectors of the beverage alcohol industry. The Company markets and sells over 170 national and regional branded products to more than 1,000 wholesale distributors in the United States. The Company also distributes its own branded products and those of other companies to more than 16,000 customers in the United Kingdom. The Company operates 20 production facilities in the United States, Canada and the United Kingdom and purchases products for resale from other producers. RECENT ACQUISITIONS MATTHEW CLARK ACQUISITION On December 1, 1998, the Company acquired control of Matthew Clark plc ("Matthew Clark") and has since acquired all of Matthew Clark's outstanding shares (the "Matthew Clark Acquisition"). Matthew Clark grew substantially in the 1990s through a series of strategic acquisitions, including Grants of St. James's in 1993, the Gaymer Group in 1994 and Taunton Cider Co. in 1995. These acquisitions served to solidify Matthew Clark's position within its key markets and contributed to an increase in net sales to approximately $671 million for Matthew Clark's fiscal year ended April 30, 1998. Matthew Clark has developed a number of leading market positions, including positions as a leading independent beverage supplier to the on-premise trade, the number one producer of branded boxed wine, - 2 - the number one branded producer of fortified British wine, the number one branded bottler of sparkling water and the number two producer of cider. The Matthew Clark Acquisition strengthens the Company's position in the beverage alcohol industry by providing the Company with a presence in the United Kingdom and a platform for growth in the European market. The acquisition of Matthew Clark also offers potential benefits including distribution opportunities to market California-produced wine and U.S.-produced spirits in the United Kingdom, as well as the potential to market Matthew Clark products in the U.S. ACQUISITION OF BLACK VELVET CANADIAN WHISKY BRAND AND RELATED ASSETS On April 9, 1999, in an asset acquisition, the Company acquired several well-known Canadian whisky brands, including Black Velvet, the third best selling Canadian whisky and the 16th best selling spirits brand in the United States, production facilities located in Alberta and Quebec, Canada, case goods and bulk whisky inventories and other related assets from affiliates of Diageo plc (collectively, the "Black Velvet Acquisition"). Other principal brands acquired in the transaction were Golden Wedding, OFC, MacNaughton, McMaster's and Triple Crown. In connection with the transaction, the Company also entered into multi-year agreements with Diageo to provide packaging and distilling services for various brands retained by Diageo. The addition of the Canadian whisky brands from this transaction strengthens the Company's position in the North American distilled spirits category, and enhances the Company's portfolio of brands and category participation. The acquired operations are being integrated with the Company's existing spirits business. RECENT DEVELOPMENTS-PENDING ACQUISITIONS OF SIMI WINERY AND FRANCISCAN ESTATES SIMI WINERY On April 1, 1999, the Company entered into a definitive agreement with Moet Hennessy, Inc. to purchase all of the outstanding capital stock of Simi Winery, Inc. ("Simi"). (The acquisition of the capital stock of Simi is hereafter referred to as the "Simi Acquisition.") The Simi Acquisition includes the Simi winery (located in Healdsburg, California), equipment, vineyards, inventory and worldwide ownership of the Simi brand name. Founded in 1876, Simi is one of the oldest and best known wineries in California, combining a strong super-premium and ultra-premium brand with a flexible and well-equipped facility and high quality vineyards in the key Sonoma appellation. FRANCISCAN ESTATES On April 21, 1999, the Company entered into (i) a definitive purchase agreement with Franciscan Vineyards, Inc. ("Franciscan") and its shareholders to, among other matters, purchase all of the outstanding capital stock of Franciscan and (ii) definitive purchase agreements with certain parties related to Franciscan to acquire certain vineyards and related vineyard assets (collectively, the "Franciscan Acquisition"). Pursuant to the Franciscan Acquisition, the Company will: (i) acquire the Franciscan Oakville Estate, Estancia and Mt. Veeder brands; (ii) acquire wineries located in Rutherford, Monterey and Mt. Veeder, California; (iii) acquire vineyards in the Napa Valley, Alexander Valley, Monterey and Paso Robles appellations and additionally, will enter into long-term grape contracts with certain parties related to Franciscan to purchase additional grapes grown in the Napa and Alexander Valley appellations; (iv) acquire distribution rights to the Quintessa and Veramonte brands; and (v) - 3 - acquire equity interests in entities that own the Veramonte brand, the Veramonte winery (which is located in the Casablanca Valley, Chile) and vineyards also located in the Casablanca Valley. Franciscan's net sales for its fiscal year ended December 31, 1998, were approximately $50 million on volume of approximately 600,000 cases. Franciscan is one of the foremost super-premium and ultra-premium wine companies in California. While the super-premium and ultra-premium wine categories represented only 9% of the total wine market by volume in 1997, they accounted for more than 25% of sales dollars. More importantly, super-premium and ultra-premium wine sales grew at an annual rate of 10% between 1995 and 1997, and by more than 18% in 1998. Given its fiscal 1998 volume of approximately 600,000 cases sold, Franciscan has recorded a three-year compound annual growth rate of more than 17%. When completed, the Simi and Franciscan Acquisitions will establish the Company as a leading producer and marketer of super-premium and ultra-premium wine. The Simi and Franciscan operations complement each other and offer synergies in the areas of sales and distribution, grape usage and capacity utilization. Together, Simi and Franciscan represent the sixth largest presence in the super-premium and ultra-premium wine categories. The Company intends to operate Simi and Franciscan, and their properties, together as a separate business segment. The Company's strategy is to further penetrate the super-premium and ultra-premium wine categories, which have higher gross profit margins than popularly-priced wine. The agreements for the Simi and Franciscan Acquisitions are subject to certain customary conditions prior to closing, which the Company expects will be satisfied. The Company cannot guarantee, however, that those transactions will be completed upon the agreed upon terms, or at all. PRIOR ACQUISITIONS The Company made a series of significant acquisitions between 1991 and 1995, commencing with the acquisition of the Cook's, Cribari, Dunnewood and other wine brands and related wine production facilities in 1991. In 1993, the Company diversified into the imported beer and distilled spirits categories by acquiring Barton Incorporated, through which the Company acquired distribution rights with respect to Corona Extra and other Modelo brands, St. Pauli Girl and other imported beer brands, and the Barton, Ten High, Montezuma and other distilled spirits brands. Also in 1993, the Company acquired the Paul Masson, Taylor California Cellars and other wine brands and related production facilities. In 1994, the Company acquired the Almaden, Inglenook and other wine brands, a grape juice concentrate business and related facilities. In 1995, the Company acquired the Mr. Boston, Canadian LTD, Skol, Old Thompson, Kentucky Tavern, Glenmore and di Amore distilled spirits brands; the rights to the Fleischmann's and Chi-Chi's distilled spirits brands under long-term license agreements; the U.S. rights to the Inver House, Schenley and El Toro distilled spirits brands; and related production facilities and assets. Through these acquisitions, the Company has become more competitive by diversifying its portfolio; developing strong market positions in the growing beverage alcohol product categories of varietal table wine and imported beer; strengthening its relationships with wholesalers; expanding its distribution and enhancing its production capabilities; and acquiring additional management, operational, marketing, and research and development expertise. - 4 - BUSINESS SEGMENTS The Company operates primarily in the beverage alcohol industry in the United States and the United Kingdom. The Company reports its operating results in four segments: Canandaigua Wine (branded wine and brandy, and other, primarily grape juice concentrate); Barton (primarily beer and spirits); Matthew Clark (branded wine, cider and bottled water, and wholesale wine, cider, spirits, beer and soft drinks); and Corporate Operations and Other (primarily corporate related items). Information regarding net sales, operating income and total assets of each of the Company's business segments and information regarding geographic areas is set forth in Note 15 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K. CANANDAIGUA WINE Canandaigua Wine produces, bottles, imports and markets wine and brandy in the United States. It is the second largest supplier of wine in the United States and exports wine to approximately 65 countries from the United States. Canandaigua Wine sells table wine, dessert wine, sparkling wine and brandy. Its leading brands include Inglenook, Almaden, Paul Masson, Arbor Mist, Manischewitz, Taylor, Marcus James, Estate Cellars, Vina Santa Carolina, Dunnewood, Mystic Cliffs, Cook's, J. Roget, Richards Wild Irish Rose and Paul Masson Grande Amber Brandy. Most of its wine is marketed in the popularly-priced category of the wine market. As a related part of its U.S. wine business, Canandaigua Wine is a leading grape juice concentrate producer in the United States. Grape juice concentrate competes with other domestically produced and imported fruit-based concentrates. Canandaigua Wine's other wine-related products and services include bulk wine, cooking wine, grape juice and Inglenook-St. Regis, a leading de-alcoholized line of wine in the United States. BARTON Barton produces, bottles, imports and markets a diversified line of beer and distilled spirits. It is the second largest marketer of imported beer in the United States and distributes five of the top 25 imported beer brands in the United States: Corona Extra, Modelo Especial, Corona Light, Pacifico and St. Pauli Girl. Corona Extra is the number one imported beer nationwide. Barton's other imported beer brands include Negra Modelo from Mexico, Tsingtao from China, Peroni from Italy and Double Diamond and Tetley's English Ale from the United Kingdom. Barton also operates the Stevens Point Brewery, a regional brewer located in Wisconsin, which produces Point Special, among other brands. Barton is the fourth largest supplier of distilled spirits in the United States and exports distilled spirits to approximately fifteen countries from the United States. Barton's principal distilled spirits brands include Fleischmann's, Mr. Boston, Canadian LTD, Chi-Chi's prepared cocktails, Ten High, Montezuma, Barton, Monte Alban, Inver House and the recently acquired Black Velvet brand. Substantially all of Barton's spirits unit volume consists of products marketed in the price value category. Barton also sells distilled spirits in bulk and provides contract production and bottling services for third parties. - 5 - MATTHEW CLARK The Company acquired Matthew Clark in the fourth quarter of Fiscal 1999. Matthew Clark is a leading producer and distributor of cider, wine and bottled water and a leading drinks wholesaler throughout the United Kingdom. Matthew Clark also exports its branded products to approximately 50 countries from the United Kingdom. Matthew Clark is the second largest producer and marketer of cider in the United Kingdom. Matthew Clark distributes its cider brands in both the on-premise and off-premise markets and these brands compete in both the mainstream and premium brand categories. Matthew Clark's leading mainstream cider brands include Blackthorn and Gaymer's Olde English. Blackthorn is the number two mainstream cider brand and Gaymer's Olde English is the UK's second largest cider brand in the take-home market. Matthew Clark's leading premium cider brands are Diamond White and K. Matthew Clark is the largest supplier of wine to the on-premise trade in the United Kingdom. Its Stowells of Chelsea brand maintains a leading share in the branded boxed wine segment. Matthew Clark also maintains a leading market share position in fortified British wine through its QC and Stone's brand names. It also produces and markets Strathmore bottled water in the United Kingdom, the leading bottled sparkling water brand in the country. Matthew Clark is a leading independent beverage supplier to the on-premise trade in the United Kingdom and has one of the largest customer bases in the United Kingdom, with more than 16,000 on-premise accounts. Matthew Clark's wholesaling business involves the distribution of branded wine, spirits, cider, beer and soft drinks. While these products are primarily produced by third parties, they also include Matthew Clark's cider and wine branded products. CORPORATE OPERATIONS AND OTHER Corporate Operations and Other includes traditional corporate related items and the results of an immaterial operation. MARKETING AND DISTRIBUTION UNITED STATES The Company's products are distributed and sold throughout the United States through over 1,000 wholesalers, as well as through state alcoholic beverage control agencies. Both Canandaigua Wine and Barton employ full-time, in-house marketing, sales and customer service organizations to develop and service their sales to wholesalers and state agencies. The Company believes that the organization of its sales force into separate segments positions it to maintain a high degree of focus on each of its principal product categories. The Company's marketing strategy places primary emphasis upon promotional programs directed at its broad national distribution network, and at the retailers served by that network. The Company has extensive marketing programs for its brands including promotional programs on both a national basis and regional basis in accordance with the strength of the brands, point-of-sale materials, consumer media advertising, event sponsorship, market research, trade advertising and public relations. - 6 - During Fiscal 1999, the Company increased its advertising expenditures to put more emphasis on consumer advertising for certain wine brands, including newly introduced brands, and for its imported beer brands, primarily with respect to the Mexican brands. In addition, promotional spending for the Company's wine brands increased to address competitive factors. UNITED KINGDOM The Company's UK-produced branded products are distributed throughout the United Kingdom by Matthew Clark. The products are packaged at one of three production facilities. Shipments of cider and wine are then made to Matthew Clark's national distribution center for branded products. All branded products are then distributed to either the on-premise or off-premise markets with some of the sales to on-premise customers made through Matthew Clark's wholesale business. Matthew Clark's wholesale products are distributed through thirteen depots located throughout the United Kingdom. On-premise distribution channels include hotels, restaurants, pubs, wine bars and clubs. The off-premise distribution channels include grocers, convenience retail, cash and carry, and wholesalers. Matthew Clark employs a full-time, in-house marketing and sales organization that targets off-premise customers for Matthew Clark's branded products. Matthew Clark also employs a full-time, in-house branded products marketing and sales organization that services specifically the on-premise market in the United Kingdom. Additionally, Matthew Clark employs a full-time, in-house marketing and sales organization to service the customers of its wholesale business. TRADEMARKS AND DISTRIBUTION AGREEMENTS The Company's products are sold under a number of trademarks, most of which are owned by the Company. The Company also produces and sells wine and distilled spirits products under exclusive license or distribution agreements. Important agreements include (1) a long-term license agreement with Hiram Walker & Sons, Inc. (which expires in 2116) for the Ten High, Crystal Palace, Northern Light and Imperial Spirits brands; and (2) a long-term license agreement with the B. Manischewitz Company (which expires in 2042) for the Manischewitz brand of kosher wine. On September 30, 1998, under the provisions of an existing long-term license agreement, Nabisco Brands Company agreed to transfer to Barton all of its right, title and interest to the corporate name "Fleischmann Distilling Company" and worldwide trademark rights to the "Fleischmann" mark for alcoholic beverages. Pending the completion of the assignment of such interests, the license will remain in effect. The Company also has other less significant license and distribution agreements related to the sale of wine and distilled spirits with terms of various durations. All of the Company's imported beer products are marketed and sold pursuant to exclusive distribution agreements with the suppliers of these products. These agreements have terms that vary and prohibit the Company from importing other beer from the same country. The Company's agreement to distribute Corona and its other Mexican beer brands exclusively throughout 25 primarily U.S. western states expires in December 2006 and, subject to compliance with certain performance criteria, continued retention of certain Company personnel and other terms under the agreement, will be automatically renewed for additional terms of five years. Changes in control of the Company or of its subsidiearies involved in importing the Mexican beer brands, changes in the position of the Chief Executive Officer of Barton Beers, Ltd. (including by death or disability) or the termination of the President of Barton Incorporated, may be a basis for the supplier, unless it consents to such changes, to terminate the - 7 - agreement. The supplier's consent to such changes may not be unreasonably withheld. The Company's agreement for the importation of St. Pauli Girl expires in June 2003. The Company's agreement for the importation of Tetley's English Ale expires in December 2007. The Company's agreement for the exclusive importation of Tsingtao throughout the entire United States expires in December 1999 and, subject to compliance with certain performance criteria and other terms under the agreement, will be automatically renewed until December 2002. Prior to their expiration, these agreements may be terminated if the Company fails to meet certain performance criteria. The Company believes it is currently in compliance with its material imported beer distribution agreements. From time to time, the Company has failed, and may in the future fail, to satisfy certain performance criteria in its distribution agreements. Although there can be no assurance that its beer distribution agreements will be renewed, given the Company's long-term relationships with its suppliers the Company expects that such agreements will be renewed prior to their expiration and does not believe that these agreements will be terminated. The Company owns the trademarks for most of the brands that it acquired in the Matthew Clark Acquisition. The Company has a series of distribution agreements and supply agreements in the United Kingdom related to the sale of its products with varying terms and durations. COMPETITION The beverage alcohol industry is highly competitive. The Company competes on the basis of quality, price, brand recognition and distribution. The Company's beverage alcohol products compete with other alcoholic and nonalcoholic beverages for consumer purchases, as well as shelf space in retail stores and marketing focus by the Company's wholesalers. The Company competes with numerous multinational producers and distributors of beverage alcohol products, some of which have significantly greater resources than the Company. In the United States, Canandaigua Wine's principal competitors include E & J Gallo Winery and The Wine Group. Barton's principal competitors include Heineken USA, Molson Breweries USA, Labatt's USA, Guinness Import Company, Brown-Forman Beverages, Jim Beam Brands and Heaven Hill Distilleries, Inc. In the United Kingdom, Matthew Clark's principal competitors include Halewood Vintners, H.P. Bulmer, Tavern, Waverley Vintners and Perrier. In connection with its wholesale business, Matthew Clark distributes the branded wine of third parties that compete directly against its own wine brands. PRODUCTION In the United States, the Company's wine is produced from several varieties of wine grapes grown principally in California and New York. The grapes are crushed at the Company's wineries and stored as wine, grape juice or concentrate. Such grape products may be made into wine for sale under the Company's brand names, sold to other companies for resale under their own labels, or shipped to customers in the form of juice, juice concentrate, unfinished wine, high-proof grape spirits or brandy. Most of the Company's wine is bottled and sold within eighteen months after the grape crush. The Company's inventories of wine, grape juice and concentrate are usually at their highest levels in November and December immediately after the crush of each year's grape harvest, and are substantially reduced prior to the subsequent year's crush. The bourbon whiskeys, domestic blended whiskeys and light whiskeys marketed by the Company are primarily produced and aged by the Company at its distillery in Bardstown, Kentucky, though it may from time to time supplement its inventories through purchases from other distillers. Following the Black Velvet Acquisition, the majority of the Company's Canadian whisky requirements - 8 - are produced and aged at its Canadian distilleries in Lethbridge, Alberta, and Valleyfield, Quebec. At its Albany, Georgia, facility, the Company produces all of the neutral grain spirits and whiskeys it uses in the production of vodka, gin and blended whiskey it sells to customers in the state of Georgia. The Company's requirements of Scotch whisky, tequila, mezcal and the neutral grain spirits it uses in the production of gin and vodka for sale outside of Georgia, and other spirits products, are purchased from various suppliers. The Company operates three facilities in the United Kingdom that produce, bottle and package cider, wine and water. To produce Stowells of Chelsea, wine is imported in bulk from various countries such as Chile, Germany, France, Spain, South Africa and Australia, which are then packaged at the Company's facility at Bristol and distributed under the Stowells of Chelsea brand name. The Strathmore brand of bottled water (which is available in still, sparkling, and flavored varieties) is sourced and bottled in Forfar, Scotland. Cider production was consolidated at the Company's facility at Shepton Mallet, where apples of many different varieties are purchased from U.K. growers and crushed. This juice, along with European-sourced concentrate, is then fermented into cider. SOURCES AND AVAILABILITY OF RAW MATERIALS The principal components in the production of the Company's branded beverage alcohol products are packaging materials (primarily glass) and agricultural products, such as grapes and grain. The Company utilizes glass and PET bottles and other materials such as caps, corks, capsules, labels and cardboard cartons in the bottling and packaging of its products. Glass bottle costs are one of the largest components of the Company's cost of product sold. The glass bottle industry is highly concentrated with only a small number of producers. The Company has traditionally obtained, and continues to obtain, its glass requirements from a limited number of producers. The Company has not experienced difficulty in satisfying its requirements with respect to any of the foregoing and considers its sources of supply to be adequate. However, the inability of any of the Company's glass bottle suppliers to satisfy the Company's requirements could adversely affect the Company's operations. Most of the Company's annual grape requirements are satisfied by purchases from each year's harvest which normally begins in August and runs through October. The Company believes that it has adequate sources of grape supplies to meet its sales expectations. However, in the event demand for certain wine products exceeds expectations, the Company could experience shortages. The Company purchases grapes from over 800 independent growers, principally in the San Joaquin Valley and Monterey regions of California and in New York State. The Company enters into written purchase agreements with a majority of these growers on a year-to-year basis. The Company currently owns or leases approximately 4,200 acres of vineyards, either fully bearing or under development, in California and New York. This acreage supplies only a small percentage of the Company's total needs. The Company continues to consider the purchase or lease of additional vineyards, and additional land for vineyard plantings, to supplement its grape supply. The distilled spirits manufactured by the Company require various agricultural products, neutral grain spirits and bulk spirits. The Company fulfills its requirements through purchases from various sources through contractual arrangements and through purchases on the open market. The Company believes that adequate supplies of the aforementioned products are available at the present time. - 9 - The Company manufactures cider, perry, light and fortified British wine from materials that are purchased either on a contracted basis or on the open market. In particular, supplies of cider apples are sourced through long term supply arrangements with owners of apple orchards. There are adequate supplies of the various raw materials at this particular time. GOVERNMENT REGULATION The Company's operations in the United States are subject to extensive Federal and state regulation. These regulations cover, among other matters, sales promotion, advertising and public relations, labeling and packaging, changes in officers or directors, ownership or control, distribution methods and relationships, and requirements regarding brand registration and the posting of prices and price changes. All of the Company's operations and facilities are also subject to Federal, state, foreign and local environmental laws and regulations and the Company is required to obtain permits and licenses to operate its facilities. In the United Kingdom, the Company has secured a Customs and Excise License to carry on its excise trade. Licenses are required for all premises where wine is produced. The Company holds a license to act as an excise warehouse operator. Registrations have been secured for the production of cider and bottled water. Formal approval of product labeling is not required. In Canada, the Company's operations are also subject to extensive federal and provincial regulation. These regulations cover, among other matters, advertising and public relations, labeling and packaging, environmental matters and customs and duty requirements. The Company is also required to obtain licenses and permits in order to operate its facilities. The Company believes that it is in compliance in all material respects with all applicable governmental laws and regulations and that the cost of administration and compliance with, and liability under, such laws and regulations does not have, and is not expected to have, a material adverse impact on the Company's financial condition, results of operations or cash flows. EMPLOYEES The Company had approximately 2,300 full-time employees in the United States at the end of April 1999, of which approximately 870 were covered by collective bargaining agreements. Additional workers may be employed by the Company during the grape crushing season. The Company had approximately 1,700 full-time employees in the United Kingdom at the end of April 1999, of which approximately 420 were covered by collective bargaining agreements. Additional workers may be employed during the peak season. The Company had approximately 230 full-time employees in Canada at the end of April 1999, of which approximately 185 were covered by collective bargaining agreements. The Company considers its employee relations generally to be good. - 10 - ITEM 2. ITEM 2. PROPERTIES - ------- ---------- Through the Company's four business segments, the Company currently operates wineries, distilling plants, bottling plants, a brewery, cider and water producing facilities, most of which include warehousing and distribution facilities on the premises. The Company also operates separate distribution centers under the Matthew Clark segment's wholesaling business. The Company believes that all of its facilities are in good condition and working order and have adequate capacity to meet its needs for the foreseeable future. CANANDAIGUA WINE Canandaigua Wine maintains its headquarters in owned and leased offices in Canandaigua, New York. It operates three wineries in New York, located in Canandaigua, Naples and Batavia and six wineries in California, located in Madera, Gonzales, Escalon, Fresno, and Ukiah. All of the facilities in which these wineries operate are owned, except for the winery in Batavia, New York, which is leased. Canandaigua Wine considers its principal wineries to be the Mission Bell winery in Madera, California; the Canandaigua winery in Canandaigua, New York; and the Monterey Cellars winery in Gonzales, California. The Mission Bell winery crushes grapes, produces, bottles and distributes wine and produces grape juice concentrate. The Canandaigua winery crushes grapes and produces, bottles and distributes wine. The Monterey Cellars winery crushes grapes and produces, bottles and distributes wine for Canandaigua Wine's account and, on a contractual basis, for third parties. Canandaigua Wine currently owns or leases approximately 4,200 acres of vineyards, either fully bearing or under development, in California and New York. BARTON Barton maintains its headquarters in leased offices in Chicago, Illinois. It owns and operates four distilling plants, two in the United States and two in Canada. The two distilling plants in the United States are located in Bardstown, Kentucky; and Albany, Georgia; and the two distilling plants in Canada, which were acquired in connection with the Black Velvet Acquisition, are located in Valleyfield, Quebec; and Lethbridge, Alberta. Barton considers its principal distilling plants to be the facilities located in Bardstown, Kentucky; Valleyfield, Quebec; and Lethbridge, Alberta. The Bardstown facility distills, bottles and warehouses distilled spirits products for Barton's account and, on a contractual basis, for other participants in the industry. The two Canadian facilities distill, bottle and store Canadian whisky for Barton's own account, and distill and/or bottle and store Canadian whisky, vodka, rum, gin and liqueurs for third parties. In the United States, Barton also operates a brewery and three bottling plants. The brewery is located in Stevens Point, Wisconsin; and the bottling plants are located in Atlanta, Georgia; Owensboro, Kentucky; and Carson, California. All of these facilities are owned by Barton except for the bottling plant in Carson, California, which is operated and leased through an arrangement involving an ongoing management contract. Barton considers the bottling plant located in Owensboro, Kentucky to be one of its principal facilities. The Owensboro facility bottles and warehouses distilled spirits products for Barton's account and also performs contract bottling. - 11 - MATTHEW CLARK Matthew Clark maintains its headquarters in owned offices in Bristol, England. It currently owns and operates two facilities in England that are located in Bristol and Shepton Mallet and one facility in Scotland, located in Forfar. Matthew Clark considers all three facilities to be its principal facilities. The Bristol facility produces, bottles and packages wine; the Shepton Mallet facility produces, bottles and packages cider; and the Forfar facility produces, bottles and packages water products. Matthew Clark also owns another facility in England, located in Taunton, the operations of which have now been consolidated into its Shepton Mallet facility. Matthew Clark plans to sell the Taunton property. To distribute its products that are produced at the Bristol and Shepton Mallet facilities, Matthew Clark operates, in England, the National Distribution Centre, located at Severnside. This distribution facility is leased by Matthew Clark. To support its wholesaling business, Matthew Clark operates thirteen distribution centers located throughout the United Kingdom, all of which are leased. These thirteen distribution centers are used to distribute products produced by third parties, as well as by Matthew Clark. Matthew Clark has been and continues to consolidate the operations of its wholesaling distribution centers. CORPORATE OPERATIONS AND OTHER The Company maintains its corporate headquarters in offices leased in Fairport, New York. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ------- ----------------- The Company and its subsidiaries are subject to litigation from time to time in the ordinary course of business. Although the amount of any liability with respect to such litigation cannot be determined, in the opinion of management such liability will not have a material adverse effect on the Company's financial condition, results of operations or cash flows. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- --------------------------------------------------- Not Applicable. EXECUTIVE OFFICERS OF THE COMPANY Information with respect to the current executive officers of the Company is as follows: NAME AGE OFFICE HELD - ---- --- ----------- Marvin Sands 75 Chairman of the Board Richard Sands 48 President and Chief Executive Officer Robert Sands 40 Chief Executive Officer, International, Executive Vice President and General Counsel; and President and Chief Executive Officer of Canandaigua Wine Company, Inc. Peter Aikens 60 President and Chief Executive Officer of Matthew Clark plc Alexander L. Berk 49 President and Chief Executive Officer of Barton Incorporated George H. Murray 52 Senior Vice President and Chief Human Resources Officer Thomas S. Summer 45 Senior Vice President and Chief Financial Officer - 12 - Marvin Sands is the founder of the Company, which is the successor to a business he started in 1945. He has been a director of the Company and its predecessor since 1946 and was Chief Executive Officer until October 1993. Marvin Sands is the father of Richard Sands and Robert Sands. Richard Sands, Ph.D., has been employed by the Company in various capacities since 1979. He was elected Executive Vice President and a director in 1982, became President and Chief Operating Officer in May 1986 and was elected Chief Executive Officer in October 1993. He is a son of Marvin Sands and the brother of Robert Sands. Robert Sands was appointed Chief Executive Officer, International in December 1998 and was appointed Executive Vice President and General Counsel in October 1993. He was elected a director of the Company in January 1990 and served as Vice President and General Counsel from June 1990 through October 1993. From June 1986 until his appointment as Vice President and General Counsel, Mr. Sands was employed by the Company as General Counsel. In addition, since the departure in April 1999 of the former President of Canandaigua Wine Company, Inc., a wholly-owned subsidiary of the Company, Mr. Sands has assumed, on an interim basis, the position of President and Chief Executive Officer of that company. In this capacity, Mr. Sands is in charge of the Canandaigua Wine segment, until a permanent successor is appointed. He is a son of Marvin Sands and the brother of Richard Sands. Peter Aikens serves as President and Chief Executive Officer of Matthew Clark plc, a wholly-owned subsidiary of the Company. In this capacity, Mr. Aikens is in charge of the Company's Matthew Clark segment, and has been since the Company acquired control of Matthew Clark in December 1998. He has been the Chief Executive Officer of Matthew Clark plc since May 1990 and has been in the brewing and drinks industry for most of his career. Alexander L. Berk serves as President and Chief Executive Officer of Barton Incorporated, a wholly-owned subsidiary of the Company. In this capacity, Mr. Berk is in charge of the Company's Barton segment. From 1990 until February 1998, Mr. Berk was President and Chief Operating Officer of Barton and from 1988 to 1990, he was the President and Chief Executive Officer of Schenley Industries. Mr. Berk has been in the alcoholic beverage industry for most of his career, serving in various positions. George H. Murray joined the Company in April 1997 as Senior Vice President and Chief Human Resources Officer. From August 1994 to April 1997, Mr. Murray served as Vice President - Human Resources and Corporate Communications of ACC Corp., an international long distance reseller. For eight and a half years prior to that, he served in various senior management positions with First Federal Savings and Loan of Rochester, New York, including the position of Senior Vice President of Human Resources and Marketing from 1991 to 1994. Thomas S. Summer joined the Company in April l997 as Senior Vice President and Chief Financial Officer. From November 1991 to April 1997, Mr. Summer served as Vice President, Treasurer of Cardinal Health, Inc., a large national health care services company, where he was responsible for directing financing strategies and treasury matters. Prior to that, from November 1987 to November 1991, Mr. Summer held several positions in corporate finance and international treasury with PepsiCo, Inc. Executive officers of the Company hold office until the next Annual Meeting of the Board of Directors and until their successors are chosen and qualify. - 13 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - ------- ---------------------------------------------------------------------- MATTERS ------- The Company's Class A Common Stock (the "Class A Stock") and Class B Common Stock (the "Class B Stock") trade on the Nasdaq Stock Market (registered trademark) under the symbols "CBRNA" and "CBRNB," respectively. The following tables set forth for the periods indicated the high and low sales prices of the Class A Stock and the Class B Stock as reported on the Nasdaq Stock Market (registered trademark). CLASS A STOCK --------------------------------------------------------- 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER ----------- ----------- ----------- ----------- Fiscal 1998 High $ 32 1/4 $ 42 3/4 $ 53 1/2 $ 58 1/2 Low $ 21 7/8 $ 29 3/8 $ 39 1/2 $ 43 3/4 Fiscal 1999 High $ 59 3/4 $ 52 3/8 $ 52 1/8 $ 61 1/2 Low $ 45 9/16 $ 40 1/4 $ 35 1/4 $ 45 5/8 CLASS B STOCK --------------------------------------------------------- 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER ----------- ----------- ----------- ----------- Fiscal 1998 High $ 37 $ 43 $ 54 5/8 $ 57 3/4 Low $ 27 $ 35 1/2 $ 40 3/4 $ 45 Fiscal 1999 High $ 59 3/4 $ 51 1/2 $ 52 $ 62 1/4 Low $ 45 1/2 $ 40 3/4 $ 37 1/4 $ 46 7/8 At May 14, 1999, the number of holders of record of Class A Stock and Class B Stock of the Company were 977 and 290, respectively. The Company's policy is to retain all of its earnings to finance the development and expansion of its business, and the Company has not paid any cash dividends since its initial public offering in 1973. In addition, the Company's current bank credit agreement, the Company's indenture for its $130 million 8 3/4% Senior Subordinated Notes due December 2003, its indenture for its $65 million 8 3/4% Series C Senior Subordinated Notes due December 2003 and its indenture for its $200 million 8 1/2% Senior Subordinated Notes due March 2009 restrict the payment of cash dividends. - 14 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - ------- ----------------------- For the fiscal years ended February 28, 1999 and 1998, see Management's Discussion and Analysis of Financial Condition and Results of Operations under Item 7 Item 7 of this Annual Report on Form 10-K and Notes to Consolidated Financial Statements as of February 28, 1999, under Item 8 of this Annual Report on Form 10-K. During January 1996, the Board of Directors of the Company changed the Company's fiscal year end from August 31 to the last day of February. All periods presented have been restated to reflect the Company's change in inventory valuation method from LIFO to FIFO (see Note 1 in the Notes to Consolidated Financial Statements as of February 28, 1999, under Item 8 of this Annual Report on Form 10-K). - 15 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS - ------- ----------------------------------------------------------------------- OF OPERATIONS ------------- INTRODUCTION - ------------ The following discussion and analysis summarizes the significant factors affecting (i) consolidated results of operations of the Company for the year ended February 28, 1999 ("Fiscal 1999"), compared to the year ended February 28, 1998 ("Fiscal 1998"), and Fiscal 1998 compared to the year ended February 28, 1997 ("Fiscal 1997"), and (ii) financial liquidity and capital resources for Fiscal 1999. This discussion and analysis should be read in conjunction with the Company's consolidated financial statements and notes thereto included herein. The Company operates primarily in the beverage alcohol industry in the United States and the United Kingdom. The Company reports its operating results in four segments: Canandaigua Wine (branded wine and brandy, and other, primarily grape juice concentrate); Barton (primarily beer and spirits); Matthew Clark (branded wine, cider and bottled water, and wholesale wine, cider, spirits, beer and soft drinks); and Corporate Operations and Other (primarily corporate related items). During the fourth quarter of Fiscal 1999, the Company changed its method of determining the cost of inventories from the last-in, first-out ("LIFO") method to the first-in, first-out ("FIFO") method. All previously reported results have been restated to reflect the retroactive application of this accounting change as required by generally accepted accounting principles. For further discussion of the impact of this accounting change, see Note 1 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K. RECENT ACQUISITIONS On December 1, 1998, the Company acquired control of Matthew Clark and has since acquired all of Matthew Clark's outstanding shares. Prior to the Matthew Clark Acquisition, the Company was principally a producer and supplier of wine and an importer and producer of beer and distilled spirits in the United States. The Matthew Clark Acquisition established the Company as a leading British producer of cider, wine and bottled water and as a leading beverage alcohol wholesaler in the United Kingdom. (See also the discussions regarding Matthew Clark under Item 1 "Business" of this Annual Report on Form 10-K.) The results of operations of Matthew Clark have been included in the consolidated results of operations of the Company since the date of acquisition, December 1, 1998. On April 9, 1999, in an asset acquisition, the Company acquired several well-known Canadian whisky brands, including Black Velvet, production facilities located in Alberta and Quebec, Canada, case goods and bulk whisky inventories and other related assets from affiliates of Diageo plc. In connection with the transaction, the Company also entered into multi-year agreements with Diageo to provide packaging and distilling services for various brands retained by Diageo. The addition of the Canadian whisky brands from this transaction strengthens the Company's position in the North American distilled spirits category, and enhances the Company's portfolio of brands and category participation. The Matthew Clark and Black Velvet Acquisitions are significant and the Company expects them to have a material impact on the Company's future results of operations. - 16 - RECENT DEVELOPMENTS - PENDING ACQUISITIONS OF SIMI AND FRANCISCAN On April 1, 1999, the Company entered into a definitive agreement with Moet Hennessy, Inc. to purchase all of the outstanding capital stock of Simi. The Simi Acquisition includes the Simi winery, equipment, vineyards, inventory and worldwide ownership of the Simi brand name. On April 21, 1999, the Company entered into definitive purchase agreements with Franciscan and its shareholders, and certain parties related to Franciscan to, among other matters, purchase all of the outstanding capital stock of Franciscan and acquire certain vineyards and related vineyard assets. Pursuant to the Franciscan Acquisition, the Company will: (i) acquire the Franciscan Oakville Estate, Estancia and Mt. Veeder brands; (ii) acquire wineries located in Rutherford, Monterey and Mt. Veeder, California; (iii) acquire vineyards in the Napa Valley, Alexander Valley, Monterey and Paso Robles appellations and additionally, will enter into long-term grape contracts with certain parties related to Franciscan to purchase additional grapes grown in the Napa and Alexander Valley appellations; (iv) acquire distribution rights to the Quintessa and Veramonte brands; and (v) acquire equity interests in entities that own the Veramonte brand and the Veramonte winery and certain vineyards located in the Casablanca Valley, Chile. The agreements for the Simi and Franciscan Acquisitions are subject to certain customary conditions prior to closing, which the Company expects will be satisfied. The Company cannot guarantee, however, that those transactions will be completed upon the agreed upon terms, or at all. RESULTS OF OPERATIONS - --------------------- FISCAL 1999 COMPARED TO FISCAL 1998 NET SALES The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 1999 and Fiscal 1998. Fiscal 1999 Compared to Fiscal 1998 ----------------------------------------- Net Sales ----------------------------------------- %Increase/ 1999 1998 Decrease ---------- ---------- ---------- Canandaigua Wine: Branded $ 598,782 $ 570,807 4.9 % Other 70,711 71,988 (1.8)% ---------- ---------- Net sales $ 669,493 $ 642,795 4.2 % ---------- ---------- Barton: Beer $ 478,611 $ 376,607 27.1 % Spirits 185,938 191,190 (2.7)% ---------- ---------- Net sales $ 664,549 $ 567,797 17.0 % ---------- ---------- Matthew Clark: Branded $ 64,879 $ -- -- Wholesale 93,881 -- -- ---------- ---------- Net sales $ 158,760 $ -- -- ---------- ---------- Corporate Operations and Other $ 4,541 $ 2,196 106.8 % ---------- ---------- Consolidated Net Sales $1,497,343 $1,212,788 23.5 % ========== ========== - 17 - Net sales for Fiscal 1999 increased to $1,497.3 million from $1,212.8 million for Fiscal 1998, an increase of $284.6 million, or 23.5%. Canandaigua Wine ---------------- Net sales for Canandaigua Wine for Fiscal 1999 increased to $669.5 million from $642.8 million for Fiscal 1998, an increase of $26.7 million, or 4.2%. This increase resulted primarily from (i) the introduction of two new products, Arbor Mist and Mystic Cliffs, in Fiscal 1999, (ii) Paul Masson Grande Amber Brandy growth, and (iii) Almaden boxed wine growth. These increases were partially offset by declines in other wine brands and in the Company's grape juice concentrate business. Barton ------ Net sales for Barton for Fiscal 1999 increased to $664.5 million from $567.8 million for Fiscal 1998, an increase of $96.8 million, or 17.0%. This increase resulted primarily from an increase in sales of beer brands led by Barton's Mexican portfolio. This increase was partially offset by a decrease in revenues from Barton's spirits contract bottling business. Matthew Clark ------------- Net sales for Matthew Clark for Fiscal 1999 since the date of acquisition, December 1, 1998, were $158.8 million. GROSS PROFIT The Company's gross profit increased to $448.0 million for Fiscal 1999 from $343.8 million for Fiscal 1998, an increase of $104.3 million, or 30.3%. The dollar increase in gross profit resulted primarily from the sales generated by the Matthew Clark Acquisition completed in the fourth quarter of Fiscal 1999, increased beer sales and the combination of higher average selling prices and lower average costs for branded wine sales. As a percent of net sales, gross profit increased to 29.9% for Fiscal 1999 from 28.3% for Fiscal 1998. The increase in the gross profit margin resulted primarily from higher selling prices and lower costs for Canandaigua Wine's branded wine sales, partially offset by a sales mix shift towards lower margin products, particulary due to the growth in Barton's beer sales. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses increased to $299.5 million for Fiscal 1999 from $231.7 million for Fiscal 1998, an increase of $67.8 million, or 29.3%. The dollar increase in selling, general and administrative expenses resulted primarily from expenses related to the Matthew Clark Acquisition, as well as marketing and promotional costs associated with the Company's increased branded sales volume. The year-over-year comparison also benefited from a one time charge for separation costs incurred in Fiscal 1998 related to an organizational change within Barton. Selling, general and administrative expenses as a percent of net sales increased to 20.0% for Fiscal 1999 as compared to 19.1% for Fiscal 1998. The increase in percent of net sales resulted primarily from (i) Canandaigua Wine's investment in brand building and efforts to increase market share and (ii) the Matthew Clark Acquisition, as Matthew Clark's selling, general and administrative expenses as a percent of net sales is typically higher than for the Company's other operating segments. - 18 - NONRECURRING CHARGES The Company incurred nonrecurring charges of $2.6 million in Fiscal 1999 related to the closure of a production facility in the United Kingdom. No such charges were incurred in Fiscal 1998. OPERATING INCOME The following table sets forth the operating profit/(loss) (in thousands of dollars) by operating segment of the Company for Fiscal 1999 and Fiscal 1998. Fiscal 1999 Compared to Fiscal 1998 ----------------------------------- Operating Profit/(Loss) ----------------------------------- %Increase/ 1999 1998 (Decrease) -------- -------- ---------- Canandaigua Wine $ 46,283 $ 45,440 1.9 % Barton 102,624 77,010 33.3 % Matthew Clark 8,998 -- -- Corporate Operations and Other (12,013) (10,380) (15.7)% -------- -------- Consolidated Operating Profit $145,892 $112,070 30.2 % ======== ======== As a result of the above factors, operating income increased to $145.9 million for Fiscal 1999 from $112.1 million for Fiscal 1998, an increase of $33.8 million, or 30.2%. INTEREST EXPENSE, NET Net interest expense increased to $41.5 million for Fiscal 1999 from $32.2 million for Fiscal 1998, an increase of $9.3 million or 28.8%. The increase resulted primarily from additional interest expense associated with the borrowings related to the Matthew Clark Acquisition. EXTRAORDINARY ITEM, NET OF INCOME TAXES The Company incurred an extraordinary charge of $11.4 million after taxes in Fiscal 1999. This charge resulted from fees related to the replacement of the Company's bank credit facility, including extinguishment of the Term Loan. No extraordinary charges were incurred in Fiscal 1998. NET INCOME As a result of the above factors, net income increased to $50.5 million for Fiscal 1999 from $47.1 million for Fiscal 1998, an increase of $3.3 million, or 7.1%. For financial analysis purposes only, the Company's earnings before interest, taxes, depreciation and amortization ("EBITDA") for Fiscal 1999 were $184.5 million, an increase of $39.3 million over EBITDA of $145.2 million for Fiscal 1998. EBITDA should not be construed as an alternative to operating income or net cash flow from operating activities and should not be construed as an indication of operating performance or as a measure of liquidity. - 19 - FISCAL 1998 COMPARED TO FISCAL 1997 NET SALES The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 1998 and Fiscal 1997. Fiscal 1998 Compared to Fiscal 1997 --------------------------------------- Net Sales --------------------------------------- %Increase/ 1998 1997 (Decrease) ---------- ---------- ---------- Canandaigua Wine: Branded $ 570,807 $ 537,745 6.1 % Other 71,988 112,546 (36.0)% ---------- ---------- Net sales $ 642,795 $ 650,291 (1.2)% ---------- ---------- Barton: Beer $ 376,607 $ 298,925 26.0 % Spirits 191,190 185,289 3.2 % ---------- ---------- Net sales $ 567,797 $ 484,214 17.3 % ---------- ---------- Corporate Operations and Other $ 2,196 $ 508 332.3 % ---------- ---------- Consolidated Net Sales $1,212,788 $1,135,013 6.9% ========== ========== Net sales for Fiscal 1998 increased to $1,212.8 million from $1,135.0 million for Fiscal 1997, an increase of $77.8 million, or 6.9%. Canandaigua Wine ---------------- Net sales for Canandaigua Wine for Fiscal 1998 decreased to $642.8 million from $650.3 million for Fiscal 1997, a decrease of $7.5 million, or 1.2%. This decrease resulted primarily from lower sales of grape juice concentrate, bulk wine and other branded wine products, partially offset by an increase in table wine sales and brandy sales. Barton ------ Net sales for Barton for Fiscal 1998 increased to $567.8 million from $484.2 million for Fiscal 1997, an increase of $83.6 million, or 17.3%. This increase resulted primarily from additional beer sales, largely Mexican beer, and additional spirits sales. GROSS PROFIT The Company's gross profit increased to $343.8 million for Fiscal 1998 from $322.2 million for Fiscal 1997, an increase of $21.5 million, or 6.7%. The dollar increase in gross profit resulted primarily from increased beer sales, higher average selling prices and cost structure improvements related to - 20 - branded wine sales, higher average selling prices in excess of cost increases related to grape juice concentrate sales and higher average selling prices and increased volume related to branded spirits sales. These increases were partially offset by lower sales volume of grape juice concentrate and bulk wine. As a percent of net sales, gross profit decreased slightly to 28.3% for Fiscal 1998 from 28.4% for Fiscal 1997. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses increased to $231.7 million for Fiscal 1998 from $209.0 million for Fiscal 1997, an increase of $22.7 million, or 10.9%. The dollar increase in selling, general and administrative expenses resulted principally from marketing and selling costs associated with the Company's branded sales volume, and a one-time charge for separation costs related to an organizational change within the Barton segment. Selling, general and administrative expenses as a percent of net sales increased to 19.1% for Fiscal 1998 as compared to 18.4% for Fiscal 1997. The increase in percent of net sales resulted from the one-time charge for separation costs and from a change in the sales mix in the Canandaigua Wine segment towards branded products, which have a higher percent of marketing and selling costs relative to sales. OPERATING INCOME The following table sets forth the operating profit/(loss) (in thousands of dollars) by operating segment of the Company for Fiscal 1998 and Fiscal 1997. Fiscal 1998 Compared to Fiscal 1997 ------------------------------------- Operating Profit/(Loss) ------------------------------------- %Increase/ 1998 1997 (Decrease) -------- -------- ----------- Canandaigua Wine $ 45,440 $ 51,525 (11.8)% Barton 77,010 73,073 5.4 % Corporate Operations and Other (10,380) (11,388) 8.9 % -------- -------- Consolidated Operating Profit $112,070 $113,210 (1.0)% ======== ======== As a result of the above factors, operating income decreased to $112.1 million for Fiscal 1998 from $113.2 million for Fiscal 1997, a decrease of $1.1 million, or 1.0%. INTEREST EXPENSE, NET Net interest expense decreased to $32.2 million for Fiscal 1998 from $34.1 million for Fiscal 1997, a decrease of $1.9 million or 5.5%. The decrease was primarily due to a decrease in the Company's average borrowings which was partially offset by an increase in the average interest rate. PROVISION FOR INCOME TAXES The Company's effective tax rate for Fiscal 1998 decreased to 41.0% from 41.7% for Fiscal 1997 as Fiscal 1997 reflected a higher effective tax rate in California caused by statutory limitations on the Company's ability to utilize certain deductions. - 21 - NET INCOME As a result of the above factors, net income increased to $47.1 million for Fiscal 1998 from $46.2 million for Fiscal 1997, an increase of $0.9 million, or 2.1%. For financial analysis purposes only, the Company's earnings before interest, taxes, depreciation and amortization ("EBITDA") for Fiscal 1998 were $145.2 million, an increase of $0.2 million over EBITDA of $145.0 million for Fiscal 1997. EBITDA should not be construed as an alternative to operating income or net cash flow from operating activities and should not be construed as an indication of operating performance or as a measure of liquidity. FINANCIAL LIQUIDITY AND CAPITAL RESOURCES - ----------------------------------------- GENERAL The Company's principal use of cash in its operating activities is for purchasing and carrying inventories. The Company's primary source of liquidity has historically been cash flow from operations, except during the annual fall grape harvests when the Company has relied on short-term borrowings. The annual grape crush normally begins in August and runs through October. The Company generally begins purchasing grapes in August with payments for such grapes beginning to come due in September. The Company's short-term borrowings to support such purchases generally reach their highest levels in November or December. Historically, the Company has used cash flow from operating activities to repay its short-term borrowings. The Company will continue to use its short-term borrowings to support its working capital requirements. The Company believes that cash provided by operating activities and its financing activities, primarily short-term borrowings, will provide adequate resources to satisfy its working capital, liquidity and anticipated capital expenditure requirements for both its short-term and long-term capital needs. FISCAL 1999 CASH FLOWS OPERATING ACTIVITIES Net cash provided by operating activities for Fiscal 1999 was $107.3 million, which resulted from $112.3 million in net income adjusted for noncash items, less $5.0 million representing the net change in the Company's operating assets and liabilities. The net change in operating assets and liabilities resulted primarily from post acquisition activity attributable to the Matthew Clark Acquisition resulting in a decrease in other accrued expenses and liabilities and accounts payable, partially offset by a decrease in accounts receivable. INVESTING ACTIVITIES AND FINANCING ACTIVITIES Net cash used in investing activities for Fiscal 1999 was $382.4 million, which resulted primarily from net cash paid of $332.2 million for the Matthew Clark Acquisition and $49.9 million of capital expenditures, including $7.0 million for vineyards. Net cash provided by financing activities for Fiscal 1999 was $301.0 million, which resulted primarily from proceeds of $635.1 million from issuance of long-term debt, including $358.1 million of long-term debt incurred to acquire Matthew Clark. This amount was partially offset by principal - 22 - payments of $264.1 million of long-term debt, repurchases of $44.9 million of the Company's Class A Common Stock, payment of $17.1 million of long-term debt issuance costs and repayment of $13.9 million of net revolving loan borrowings. As of February 28, 1999, under the 1998 Credit Agreement, the Company had outstanding term loans of $625.6 million bearing interest at 7.6%, $83.1 million of revolving loans bearing interest at 7.3%, undrawn revolving letters of credit of $4.0 million, and $212.9 million in revolving loans available to be drawn. Total debt outstanding as of February 28, 1999, amounted to $925.4 million, an increase of $500.2 million from February 28, 1998. The ratio of total debt to total capitalization increased to 68.0% as of February 28, 1999, from 50.0% as of February 28, 1998. During June 1998, the Company's Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Common Stock. The repurchase of shares of common stock will be accomplished, from time to time, in management's discretion and depending upon market conditions, through open market or privately negotiated transactions. The Company may finance such repurchases through cash generated from operations or through the bank credit agreement. The repurchased shares will become treasury shares. As of May 28, 1999, the Company had purchased 1,018,836 shares of Class A Common Stock at an aggregate cost of $44.9 million, or at an average cost of $44.05 per share. THE COMPANY'S CREDIT AGREEMENT On December 14, 1998, the Company, its principal operating subsidiaries (other than Matthew Clark and its subsidiaries), and a syndicate of banks, for which The Chase Manhattan Bank acts as administrative agent, entered into a First Amended and Restated Credit Agreement (the "1998 Credit Agreement"), effective as of November 2, 1998, which amends and restates in its entirety the credit agreement entered into between the Company and The Chase Manhattan Bank on November 2, 1998. The 1998 Credit Agreement includes both US dollar and British pound sterling commitments of the syndicate banks of up to, in the aggregate, the equivalent of $1.0 billion (subject to increase as therein provided to $1.2 billion) with the proceeds available for repayment of all outstanding principal and accrued interest on all loans under the Company's bank credit agreement dated as of December 19, 1997, payment of the purchase price for the Matthew Clark shares, repayment of Matthew Clark's credit facilities, funding of permitted acquisitions, payment of transaction expenses and ongoing working capital needs of the Company. The 1998 Credit Agreement provides for a $350.0 million Tranche I Term Loan facility due in December 2004, a $200.0 million Tranche II Term Loan facility due in June 2000, a $150.0 million Tranche III Term Loan facility due in December 2005, and a $300.0 million Revolving Credit facility (including letters of credit up to a maximum of $20.0 million) which expires in December 2004. Portions of the Tranche I Term Loan facility and the Revolving Credit facility are available for borrowing in British pound sterling. A brief description of the 1998 Credit Agreement is contained in Note 6 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K. The Company expects to finance the purchase price for the Simi and Franciscan Acquisitions with borrowings under an amendment to the 1998 Credit Agreement. - 23 - SENIOR SUBORDINATED NOTES As of February 28, 1999, the Company had outstanding $195.0 million aggregate principal amount of 8 3/4% Senior Subordinated Notes due December 2003, being the $130.0 million aggregate principal amount of 8 3/4% Senior Subordinated Notes due December 2003 issued in December 1993 (the "Original Notes") and the $65.0 million aggregate principal amount of 8 3/4% Series C Senior Subordinated Notes due December 2003 issued in February 1997 (the "Series C Notes"). The Original Notes and the Series C Notes are currently redeemable, in whole or in part, at the option of the Company. A brief description of the Original Notes and the Series C Notes is contained in Note 6 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K. On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 (the "$200 Million Notes"). The Company used the proceeds from the sale of the $200 Million Notes to fund the Black Velvet Acquisition ($185.5 million) and to pay the fees and expenses related thereto with the remainder of the net proceeds to be used for general corporate purposes or to fund future acquisitions. The $200 Million Notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. The Company may also redeem up to $70.0 million of the $200 Million Notes using the proceeds of certain equity offerings completed before March 1, 2002. A brief description of the $200 Million Notes is contained in Note 17 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K. CAPITAL EXPENDITURES During Fiscal 1999, the Company incurred $49.9 million for capital expenditures, including $7.0 million related to vineyards. The Company plans to spend approximately $49.6 million for capital expenditures, exclusive of vineyards, in fiscal 2000. In addition, the Company continues to consider the purchase, lease and development of vineyards. See "Business - Sources and Availability of Raw Materials" under Item 1 of this Annual Report on Form 10-K. The Company may incur additional expenditures for vineyards if opportunities become available. Management reviews the capital expenditure program periodically and modifies it as required to meet current business needs. COMMITMENTS The Company has agreements with suppliers to purchase various spirits and blends of which certain agreements are denominated in British pound sterling. The future obligations under these agreements, based upon exchange rates at February 28, 1999, aggregate approximately $17.2 million for contracts expiring through December 2002. At February 28, 1999, the Company had open currency forward contracts to purchase various foreign currencies of $12.4 million which mature within twelve months. The Company's use of such contracts is limited to the management of currency rate risks related to purchases denominated in a foreign currency. The Company's strategy is to enter only into currency exchange contracts that are matched to specific purchases and not to enter into any speculative contracts. - 24 - EFFECTS OF INFLATION AND CHANGING PRICES The Company's results of operations and financial condition have not been significantly affected by inflation and changing prices. The Company has been able, subject to normal competitive conditions, to pass along rising costs through increased selling prices. ACCOUNTING PRONOUNCEMENT In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. SFAS No. 133 requires that every derivative be recorded as either an asset or liability in the balance sheet and measured at its fair value. SFAS No. 133 also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company formally document, designate and assess the effectiveness of transactions that receive hedge accounting. The Company is required to adopt SFAS No. 133 on a prospective basis for interim periods and fiscal years beginning March 1, 2000. The Company believes the effect of adoption on its financial statements will not be material based on the Company's current risk management strategies. YEAR 2000 ISSUE For purposes of the following Year 2000 discussion, the information presented includes the effect of the Black Velvet Acquisition. The Company has in place detailed programs to address Year 2000 readiness in its internal systems and with its key customers and suppliers. The Year 2000 issue is the result of computer logic that was written using two digits rather than four to define the applicable year. Any computer logic that processes date-sensitive information may recognize the date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations or system failures. Pursuant to the Company's readiness programs, all major categories of information technology systems and non-information technology systems (i.e., equipment with embedded microprocessors) in use by the Company, including manufacturing, sales, financial and human resources, have been inventoried and assessed. In addition, plans have been developed for the required systems modifications or replacements. With respect to its information technology systems, the Company has completed the entire assessment phase and approximately 75% of the remediation phase. With respect to its non-information technology systems, the Company has completed the entire assessment phase and approximately 64% of the remediation phase. Selected areas, both internal and external, are being tested to assure the integrity of the Company's remediation programs. The testing is expected to be completed by September 1999. The Company plans to have all internal mission-critical information technology and non-information technology systems Year 2000 compliant by September 1999. The Company is also communicating with its major customers, suppliers and financial institutions to assess the potential impact on the Company's operations if those third parties fail to become Year 2000 compliant in a timely manner. While this process is not yet complete, based upon responses to date, it appears that many of those customers and suppliers have only indicated that they have in place Year 2000 readiness programs, without specifically confirming that they will be Year 2000 compliant in a timely manner. Risk assessment, readiness evaluation, action plans and contingency plans - 25 - related to the Company's significant customers and suppliers are expected to be completed by September 1999. The Company's key financial institutions have been surveyed and it is the Company's understanding that they are or will be Year 2000 compliant on or before December 31, 1999. The costs incurred to date related to its Year 2000 activities have not been material to the Company, and, based upon current estimates, the Company does not believe that the total cost of its Year 2000 readiness programs will have a material adverse impact on the Company's financial condition, results of operations or cash flows. The Company's readiness programs also include the development of contingency plans to protect its business and operations from Year 2000-related interruptions. These plans should be complete by September 1999 and, by way of examples, will include back-up procedures, identification of alternate suppliers, where possible, and increases in inventory levels. Based upon the Company's current assessment of its non-information technology systems, the Company does not believe it necessary to develop an extensive contingency plan for those systems. There can be no assurances, however, that any of the Company's contingency plans will be sufficient to handle all problems or issues which may arise. The Company believes that it is taking reasonable steps to identify and address those matters that could cause serious interruptions in its business and operations due to Year 2000 issues. However, delays in the implementation of new systems, a failure to fully identify all Year 2000 dependencies in the Company's systems and in the systems of its suppliers, customers and financial institutions, a failure of such third parties to adequately address their respective Year 2000 issues, or a failure of a contingency plan could have a material adverse effect on the Company's business, financial condition, results of operations or cash flows. For example, the Company would experience a material adverse impact on its business if significant suppliers of beer, glass or other raw materials, or utility systems fail to timely provide the Company with necessary inventories or services due to Year 2000 systems failures. The statements set forth herein concerning Year 2000 issues which are not historical facts are forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. In particular, the costs associated with the Company's Year 2000 programs and the time-frame in which the Company plans to complete Year 2000 modifications are based upon management's best estimates. These estimates were derived from internal assessments and assumptions of future events. These estimates may be adversely affected by the continued availability of personnel and system resources, and by the failure of significant third parties to properly address Year 2000 issues. Therefore, there can be no guarantee that any estimates, or other forward-looking statements will be achieved, and actual results could differ significantly from those contemplated. EURO CONVERSION ISSUES Effective January 1, 1999, eleven of the fifteen member countries of the European Union (the "Participating Countries") established fixed conversion rates between their existing sovereign currencies and the euro. For three years after the introduction of the euro, the Participating Countries can perform financial transactions in either the euro or their original local currencies. This will result in a fixed exchange rate among the Participating Countries, whereas the euro (and the Participating Countries' currency in tandem) will continue to float freely against the U.S. dollar and other currencies of the non-participating countries. The Company does not believe that the effects of the conversion will have a material adverse effect on the Company's business and operations. - 26 - ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - -------- ---------------------------------------------------------- The Company is exposed to market risk associated with changes in interest rates and foreign currency exchange rates. To manage the volatility relating to these risks, the Company periodically enters into derivative transactions including foreign currency exchange contracts and interest rate swap agreements. The Company has limited involvement with derivative financial instruments and does not use them for trading purposes. The Company uses derivative instruments solely to reduce the financial impact of these risks. The fair value of long-term debt is subject to interest rate risk. Generally, the fair value of long-term debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of the Company's total long-term debt, including current maturities, was approximately $844.6 million at February 28, 1999. A hypothetical 1% increase from prevailing interest rates at February 28, 1999, would result in a decrease in fair value of long-term debt by approximately $7.7 million. Also, a hypothetical 1% increase from prevailing interest rates at February 28, 1999, would result in an approximate increase in cash required for interest on variable interest rate debt during the next five fiscal years as follows: 2000 $ 6.2 million 2001 $ 5.1 million 2002 $ 3.8 million 2003 $ 3.4 million 2004 $ 2.9 million The Company periodically enters into interest rate swap agreements to reduce its exposure to interest rate changes relative to its long-term debt. At February 28, 1999, the Company had no interest rate swap agreements outstanding. The Company has exposure to foreign currency risk as a result of having international subsidiaries in the United Kingdom. The Company uses local currency borrowings to hedge its earnings and cash flow exposure to adverse changes in foreign currency exchange rates. At February 28, 1999, management believes that a hypothetical 10% adverse change in foreign currency exchange rates would not result in a material adverse impact on either earnings or cash flow. The Company also has exposure to foreign currency risk as a result of contracts to purchase inventory items that are denominated in various foreign currencies. In order to reduce the risk of foreign currency exchange rate fluctuations resulting from these contracts, the Company periodically enters into foreign exchange hedging agreements. At February 28, 1999, the potential loss on outstanding foreign exchange hedging agreements from a hypothetical 10% adverse change in foreign currency exchange rates would not be material. - 27 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- ------------------------------------------- CANANDAIGUA BRANDS, INC. AND SUBSIDIARIES ----------------------------------------- INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ AND --- SUPPLEMENTARY SCHEDULES ----------------------- FEBRUARY 28, 1999 ----------------- Page ---- The following information is presented in this Annual Report on Form 10-K: Report of Independent Public Accountants............................. 28 Consolidated Balance Sheets - February 28, 1999 and 1998............. 29 Consolidated Statements of Income for the years ended February 28, 1999, 1998 and 1997................................ 30 Consolidated Statements of Changes in Stockholders' Equity for the years ended February 28, 1999, 1998 and 1997............ 31 Consolidated Statements of Cash Flows for the years ended February 28, 1999, 1998 and 1997................................ 32 Notes to Consolidated Financial Statements........................... 33 Selected Financial Data.............................................. 14 Selected Quarterly Financial Information (unaudited)................. 52 Schedules I through V are not submitted because they are not applicable or not required under the rules of Regulation S-X. Individual financial statements of the Registrant have been omitted because the Registrant is primarily an operating company and no subsidiary included in the consolidated financial statements has minority equity interest and/or noncurrent indebtedness, not guaranteed by the Registrant, in excess of 5% of total consolidated assets. - 28 - ARTHUR ANDERSEN LLP REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Canandaigua Brands, Inc.: We have audited the accompanying consolidated balance sheets of Canandaigua Brands, Inc. (a Delaware corporation) and subsidiaries as of February 28, 1999 and 1998, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended February 28, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Canandaigua Brands, Inc. and subsidiaries as of February 28, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended February 28, 1999 in conformity with generally accepted accounting principles. As explained in Note 1 to the financial statements, the Company has given retroactive effect to the change in accounting for inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. /s/ Arthur Andersen LLP Rochester, New York April 22, 1999 - 29 - CANANDAIGUA BRANDS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data) February 28, --------------------------- 1999 1998 ----------- ----------- ASSETS ------ CURRENT ASSETS: Cash and cash investments $ 27,645 $ 1,232 Accounts receivable, net 260,433 142,615 Inventories, net 508,571 411,424 Prepaid expenses and other current assets 59,090 26,463 ----------- ----------- Total current assets 855,739 581,734 PROPERTY, PLANT AND EQUIPMENT, net 428,803 244,035 OTHER ASSETS 509,234 264,786 ----------- ----------- Total assets $ 1,793,776 $ 1,090,555 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ CURRENT LIABILITIES: Notes payable $ 87,728 $ 91,900 Current maturities of long-term debt 6,005 24,118 Accounts payable 122,746 52,055 Accrued Federal and state excise taxes 49,342 17,498 Other accrued expenses and liabilities 149,451 104,896 ----------- ----------- Total current liabilities 415,272 290,467 ----------- ----------- LONG-TERM DEBT, less current maturities 831,689 309,218 ----------- ----------- DEFERRED INCOME TAXES 88,179 59,237 ----------- ----------- OTHER LIABILITIES 23,364 6,206 ----------- ----------- COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred Stock, $.01 par value- Authorized, 1,000,000 shares; Issued, none in 1999 and 1998 -- -- Class A Common Stock, $.01 par value- Authorized, 120,000,000 shares; Issued, 17,915,359 shares in 1999 and 17,604,784 shares in 1998 179 176 Class B Convertible Common Stock, $.01 par value- Authorized, 20,000,000 shares; Issued, 3,849,173 shares in 1999 and 3,956,183 shares in 1998 39 40 Additional paid-in capital 239,912 231,687 Retained earnings 281,081 230,609 Accumulated other comprehensive income- Cumulative translation adjustment (4,173) -- ----------- ----------- 517,038 462,512 ----------- ----------- Less-Treasury stock- Class A Common Stock, 3,168,306 shares in 1999 and 2,199,320 shares in 1998, at cost (79,559) (34,878) Class B Convertible Common Stock, 625,725 shares in 1999 and 1998, at cost (2,207) (2,207) ----------- ----------- (81,766) (37,085) ----------- ----------- Total stockholders' equity 435,272 425,427 ----------- ----------- Total liabilities and stockholders' equity $ 1,793,776 $ 1,090,555 =========== =========== The accompanying notes to consolidated financial statements are an integral part of these balance sheets. - 30 - - 31 - - 32 - - 33 - CANANDAIGUA BRANDS, INC., AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FEBRUARY 28, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: DESCRIPTION OF BUSINESS - Canandaigua Brands, Inc., and its subsidiaries (the Company) operate primarily in the beverage alcohol industry. The Company is principally a producer and supplier of wine and an importer and producer of beer and distilled spirits in the United States. It maintains a portfolio of over 170 national and regional brands of beverage alcohol which are distributed by over 1,000 wholesalers throughout the United States and selected international markets. The Company is also a leading United Kingdom-based producer of its own brands of cider, wine and bottled water and a leading independent beverage supplier to the on-premise trade, distributing its own branded products and those of other companies to more than 16,000 on-premise establishments in the U.K. PRINCIPLES OF CONSOLIDATION - The consolidated financial statements of the Company include the accounts of Canandaigua Brands, Inc., and all of its subsidiaries. All intercompany accounts and transactions have been eliminated. MANAGEMENT'S USE OF ESTIMATES AND JUDGMENT - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. FOREIGN CURRENCY TRANSLATION - The "functional currency" for translating the accounts of the Company's operations outside the U.S. is the local currency. The translation from the applicable foreign currencies to U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. The resulting translation adjustments are recorded as a component of accumulated other comprehensive income. Gains or losses resulting from foreign currency transactions are included in selling, general and administrative expenses. CASH INVESTMENTS - Cash investments consist of highly liquid investments with an original maturity when purchased of three months or less and are stated at cost, which approximates market value. The amounts at February 28, 1999 and 1998, are not significant. FAIR VALUE OF FINANCIAL INSTRUMENTS - To meet the reporting requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the Company calculates the fair value of financial instruments using quoted market prices whenever available. When quoted market prices are not available, the Company uses standard pricing models for various types of financial instruments (such as forwards, options, swaps, etc.) which take into account the present value of estimated future cash flows. The methods and assumptions used to estimate the fair value of financial instruments are summarized as follows: ACCOUNTS RECEIVABLE: The carrying amount approximates fair value due to the short maturity of these instruments, the creditworthiness of the customers and the large number of customers constituting the accounts receivable balance. NOTES PAYABLE: These instruments are variable interest rate bearing notes for which the carrying value approximates the fair value. LONG-TERM DEBT: The carrying value of the debt facilities with short-term variable interest rates approximates the fair value. The fair value of the fixed rate debt was estimated by discounting cash flows using interest rates currently available for debt with similar terms and maturities. - 34 - FOREIGN EXCHANGE HEDGING AGREEMENTS: The fair value of currency forward contracts is estimated based on quoted market prices. LETTERS OF CREDIT: At February 28, 1999 and 1998, the Company had letters of credit outstanding totaling approximately $4.0 million and $3.9 million, respectively, which guarantee payment for certain obligations. The Company recognizes expense on these obligations as incurred and no material losses are anticipated. The carrying amount and estimated fair value of the Company's financial instruments are summarized as follows as of February 28: INTEREST RATE FUTURES AND CURRENCY FORWARD CONTRACTS - From time to time, the Company enters into interest rate futures and a variety of currency forward contracts in the management of interest rate risk and foreign currency transaction exposure. The Company has limited involvement with derivative instruments and does not use them for trading purposes. The Company uses derivatives solely to reduce the financial impact of the related risks. Unrealized gains and losses on interest rate futures are deferred and recognized as a component of interest expense over the borrowing period. Unrealized gains and losses on currency forward contracts are deferred and recognized as a component of the related transactions in the accompanying financial statements. Discounts or premiums on currency forward contracts are recognized over the life of the contract. Cash flows from derivative instruments are classified in the same category as the item being hedged. The Company's open currency forward contracts at February 28, 1999, hedge purchase commitments denominated in foreign currencies and mature within twelve months. INVENTORIES - During the fourth quarter of fiscal 1999, the Company changed its method of determining the cost of inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. The primary reasons for the change in accounting method are: management's belief that the FIFO method of accounting better matches revenues and expenses of the Company, and therefore, will result in a better measurement of operating results; and the FIFO method of accounting will provide improved financial comparability to other publicly-traded companies in the industry. All previously reported results have been restated to reflect the retroactive application of this accounting change as required by generally accepted accounting principles. The effect of this change was to increase current assets, current liabilities and retained earnings by $17.4 million, $7.1 million, and $10.3 million, respectively, as of February 28, 1998. The effect of the change increased net income for the year ended February 28, 1998, by $2.9 million, or $0.15 per share on a diluted basis, and increased net income for the year ended February 28, 1997, by $18.5 million, or $0.95 per share on a diluted basis. The effect of the change on the first quarter of fiscal 1999 was to decrease net income $0.5 million, or $0.02 per share on a diluted basis. The effect of the change on the second and third quarters of fiscal 1999 was to increase net income $1.0 million, or $0.05 per share on a diluted basis, and $0.5 million, or $0.03 per share on a diluted basis, respectively. - 35 - Elements of cost include materials, labor and overhead and consist of the following as of February 28: 1999 1998 -------- -------- (in thousands) Raw materials and supplies $ 32,388 $ 14,439 Wine and distilled spirits in process 344,175 304,037 Finished case goods 132,008 92,948 -------- -------- $508,571 $411,424 ======== ======== A substantial portion of barreled whiskey and brandy will not be sold within one year because of the duration of the aging process. All barreled whiskey and brandy are classified as in-process inventories and are included in current assets, in accordance with industry practice. Bulk wine inventories are also included as work in process within current assets, in accordance with the general practices of the wine industry, although a portion of such inventories may be aged for periods greater than one year. Warehousing, insurance, ad valorem taxes and other carrying charges applicable to barreled whiskey and brandy held for aging are included in inventory costs. PROPERTY, PLANT AND EQUIPMENT - Property, plant and equipment is stated at cost. Major additions and betterments are charged to property accounts, while maintenance and repairs are charged to operations as incurred. The cost of properties sold or otherwise disposed of and the related accumulated depreciation are eliminated from the accounts at the time of disposal and resulting gains and losses are included as a component of operating income. DEPRECIATION - Depreciation is computed primarily using the straight-line method over the following estimated useful lives: Depreciable Life in Years ------------------------- Buildings and improvements 10 to 33 1/3 Machinery and equipment 3 to 15 Motor vehicles 3 to 7 Amortization of assets capitalized under capital leases is included with depreciation expense. Amortization is calculated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. OTHER ASSETS - Other assets, which consist of goodwill, distribution rights, trademarks, agency license agreements, deferred financing costs, prepaid pension benefits, cash surrender value of officers' life insurance and other amounts, are stated at cost, net of accumulated amortization. Amortization is calculated on a straight-line or effective interest basis over the following estimated useful lives: Useful Life in Years -------------------- Goodwill 40 Distribution rights 40 Trademarks 40 Agency license agreements 16 to 40 Deferred financing costs 5 to 10 At February 28, 1999, the weighted average remaining useful life of these assets is approximately 38 years. The face value of the officers' life insurance policies totaled $2.9 million at both February 28, 1999 and 1998. - 36 - LONG-LIVED ASSETS AND INTANGIBLES - In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," the Company reviews its long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable on an undiscounted cash flow basis. The statement also requires that long-lived assets and certain identifiable intangibles to be disposed of be reported at the lower of carrying amount or fair value less cost to sell. The Company did not record any asset impairment in fiscal 1999. ADVERTISING AND PROMOTION COSTS - The Company generally expenses advertising and promotion costs as incurred, shown or distributed. Prepaid advertising costs at February 28, 1999 and 1998, are not material. Advertising and promotion expense for the years ended February 28, 1999, 1998, and 1997, were approximately $173.1 million, $111.7 million and $101.3 million, respectively. INCOME TAXES - The Company uses the liability method of accounting for income taxes. The liability method accounts for deferred income taxes by applying statutory rates in effect at the balance sheet date to the difference between the financial reporting and tax basis of assets and liabilities. ENVIRONMENTAL - Environmental expenditures that relate to current operations are expensed as appropriate. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities are recorded when environmental assessments and/or remedial efforts are probable, and the cost can be reasonably estimated. Generally, the timing of these accruals coincides with the completion of a feasibility study or the Company's commitment to a formal plan of action. Liabilities for environmental costs were not material at February 28, 1999 and 1998. COMPREHENSIVE INCOME- During fiscal 1999, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130). This statement establishes rules for the reporting of comprehensive income and its components. Comprehensive income consists of net income and foreign currency translation adjustments and is presented in the Consolidated Statements of Changes in Stockholders' Equity. The adoption of SFAS No. 130 had no impact on total stockholders' equity. Prior year financial statements have been reclassified to conform with the SFAS No. 130 requirements. EARNINGS PER COMMON SHARE - Basic earnings per common share excludes the effect of common stock equivalents and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period for Class A Common Stock and Class B Convertible Common Stock. Diluted earnings per common share reflects the potential dilution that could result if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted earnings per common share assumes the exercise of stock options using the treasury stock method and assumes the conversion of convertible securities, if any, using the "if converted" method. 2. ACQUISITIONS: MATTHEW CLARK ACQUISITION - On December 1, 1998, the Company acquired control of Matthew Clark plc (Matthew Clark) and has since acquired all of Matthew Clark's outstanding shares (the Matthew Clark Acquisition). The total purchase price, including assumption of indebtedness, for the acquisition of Matthew Clark shares was approximately $475.0 million, net of cash acquired. Matthew Clark, founded in 1810, is a leading U.K.-based producer and distributor of its own brands of cider, wine and bottled water and a leading independent drinks wholesaler in the U.K. The purchase price for the Matthew Clark shares was funded with proceeds from loans under a First Amended and Restated Credit Agreement (the "1998 Credit Agreement"), effective as of November 2, 1998, between the - 37 - Company and The Chase Manhattan Bank, as administrative agent, and a syndicate of banks who are parties to the 1998 Credit Agreement. The Matthew Clark Acquisition was accounted for using the purchase method; accordingly, the Matthew Clark assets were recorded at fair market value at the date of acquisition, December 1, 1998. The excess of the purchase price over the estimated fair market value of the net assets acquired (goodwill), 99.3 million British pound sterling ($164.3 million as of December 1, 1998), is being amortized on a straight-line basis over 40 years. The results of operations of the Matthew Clark Acquisition have been included in the Consolidated Statements of Income since the date of the acquisition. During fiscal 1999, the Company incurred and paid approximately $2.6 million in nonrecurring charges related to the closing of a Matthew Clark cider production facility. The charges were part of a production facility consolidation program that was begun prior to the acquisition. The unaudited pro forma results of operations for fiscal 1999 (shown in the table below) reflect total nonrecurring charges of $21.5 million ($0.69 per share on a diluted basis) related to this facility consolidation program, of which $18.9 million was incurred prior to the acquisition. The following table sets forth unaudited pro forma results of operations of the Company for the years ended February 28, 1999 and 1998. The unaudited pro forma fiscal 1999 results of operations give effect to the Matthew Clark Acquisition as if it occurred on March 1, 1998. The unaudited pro forma fiscal 1998 results of operations give effect to the Matthew Clark Acquisition as if it occurred on March 1, 1997. The unaudited pro forma fiscal 1999 and fiscal 1998 results of operations are presented after giving effect to certain adjustments for depreciation, amortization of goodwill, interest expense on the acquisition financing and related income tax effects. The unaudited pro forma results of operations are based upon currently available information and upon certain assumptions that the Company believes are reasonable under the circumstances. The unaudited pro forma results of operations do not purport to present what the Company's results of operations would actually have been if the aforementioned transactions had in fact occurred on such date or at the beginning of the period indicated, nor do they project the Company's financial position or results of operations at any future date or for any future period. 1999 1998 ----------- ----------- (in thousands, except per share data) Net sales $ 2,017,497 $ 1,883,813 Income before extraordinary item $ 49,126 $ 55,879 Extraordinary item, net of income taxes $ (11,437) $ -- Net income $ 37,689 $ 55,879 Earnings per common share: Basic: Income before extraordinary item $ 2.68 $ 2.99 Extraordinary item (0.62) -- ----------- ----------- Earnings per common share - basic $ 2.06 $ 2.99 =========== =========== Diluted: Income before extraordinary item $ 2.62 $ 2.92 Extraordinary item (0.61) -- ----------- ----------- Earnings per common share - diluted $ 2.01 $ 2.92 =========== =========== Weighted average common shares outstanding: Basic 18,293 18,672 Diluted 18,754 19,105 - 38 - 3. PROPERTY, PLANT AND EQUIPMENT: The major components of property, plant and equipment are as follows as of February 28: 1999 1998 --------- --------- (in thousands) Land $ 25,700 $ 15,103 Buildings and improvements 104,152 74,706 Machinery and equipment 380,069 244,204 Motor vehicles 20,191 5,316 Construction in progress 35,468 17,485 --------- --------- 565,580 356,814 Less - Accumulated depreciation (136,777) (112,779) --------- --------- $ 428,803 $ 244,035 ========= ========= 4. OTHER ASSETS: The major components of other assets are as follows as of February 28: 1999 1998 --------- --------- (in thousands) Goodwill $ 311,908 $ 150,595 Distribution rights, agency license agreements and trademarks 179,077 119,346 Other 53,779 23,686 --------- --------- 544,764 293,627 Less - Accumulated amortization (35,530) (28,841) --------- --------- $ 509,234 $ 264,786 ========= ========= 5. OTHER ACCRUED EXPENSES AND LIABILITIES: The major components of other accrued expenses and liabilities are as follows as of February 28: 1999 1998 -------- -------- (in thousands) Accrued advertising and promotions $ 38,604 $ 16,048 Accrued salaries and commissions 15,584 23,704 Other 95,263 65,144 -------- -------- $149,451 $104,896 ======== ======== - 39 - 6. BORROWINGS: Borrowings consist of the following as of February 28: SENIOR CREDIT FACILITY - On December 14, 1998, the Company, its principal operating subsidiaries (other than Matthew Clark and its subsidiaries), and a syndicate of banks (the Syndicate Banks), for which The Chase Manhattan Bank acts as administrative agent, entered into the 1998 Credit Agreement, effective as of November 2, 1998, which amends and restates in its entirety the credit agreement entered into between the Company and The Chase Manhattan Bank on November 2, 1998. The 1998 Credit Agreement includes both U.S. dollar and British pound sterling commitments of the Syndicate Banks of up to, in the aggregate, the equivalent of $1.0 billion (subject to increase as therein provided to $1.2 billion) with the proceeds available for repayment of all outstanding principal and accrued interest on all loans under the Company's bank credit agreement dated as of December 19, 1997, payment of the purchase price for the Matthew Clark shares, repayment of Matthew Clark's credit facilities, funding of permitted acquisitions, payment of transaction expenses and ongoing working capital needs of the Company. The Company incurred an extraordinary loss of $19.3 million ($11.4 million after taxes) in the fourth quarter of 1999 resulting from fees related to the replacement of the bank credit agreement, including extinguishment of the Term Loan. - 40 - The 1998 Credit Agreement provides for a $350.0 million Tranche I Term Loan facility due in December 2004, a $200.0 million Tranche II Term Loan facility due in June 2000, a $150.0 million Tranche III Term Loan facility due in December 2005, and a $300.0 million Revolving Credit facility (including letters of credit up to a maximum of $20.0 million) which expires in December 2004. Portions of the Tranche I Term Loan facility and the Revolving Credit facility are available for borrowing in British pound sterling. The Tranche I Term Loan facility requires quarterly repayments, starting at $6.3 million in December 1999, increasing annually thereafter with a balloon payment at maturity of approximately $110.0 million. The Tranche II Term Loan facility requires no principal payments prior to the stated maturity. The Tranche III Term Loan facility requires quarterly repayments, starting at $0.4 million in December 1999 and increasing to approximately $18.0 million in March 2004. There are certain mandatory term loan prepayments, including those based on excess cash flow, sale of assets, issuance of debt or equity, and fluctuation in the U.S. dollar/British pound sterling exchange rate, in each case subject to baskets and thresholds which (other than with respect to those pertaining to fluctuations in the U.S. dollar/British pound sterling exchange rate, which were inapplicable under the previous bank credit agreement) are generally more favorable to the Company than those contained in its previous bank credit agreement. The rate of interest payable, at the Company's option, is a function of the London interbank offering rate (LIBOR) plus a margin, federal funds rate plus a margin, or the prime rate plus a margin. The margin is adjustable based upon the Company's Debt Ratio (as defined in the 1998 Credit Agreement). The initial margin on LIBOR borrowings ranges between 1.75% and 2.50% and (other than for the Tranche II Term Loan facility) may be reduced after November 30, 1999, to between 1.125% and 1.50%, depending on the Company's Debt Ratio. Conversely, if the Debt Ratio of the Company should increase, the margin would be adjusted upwards to between 2.0% and 2.75% for LIBOR based borrowings. In addition to interest, the Company pays a facility fee on the Revolving Credit commitments, initially at 0.50% per annum and subject to reduction after November 30, 1999, to 0.375%, depending on the Company's Debt Ratio. Each of the Company's principal operating subsidiaries (other than Matthew Clark and its subsidiaries) has guaranteed the Company's obligation under the 1998 Credit Agreement, and the Company and those subsidiaries have given security interests to the Syndicate Banks in substantially all of their assets. The Company and its subsidiaries are subject to customary secured lending covenants including those restricting additional liens, incurring additional indebtedness, the sale of assets, the payment of dividends, transactions with affiliates and the making of certain investments. The primary financial covenants require the maintenance of a debt coverage ratio, a senior debt coverage ratio, a fixed charges ratio and an interest coverage ratio. Among the most restrictive covenants contained in the 1998 Credit Agreement is the requirement to maintain a fixed charges ratio of not less than 1.0 at the last day of each fiscal quarter for the most recent four quarters. As of February 28, 1999, under the 1998 Credit Agreement, the Company had outstanding term loans of $625.6 million bearing interest at 7.62% and $83.1 million of revolving loans bearing interest at 7.25%. The Company had average outstanding Revolving Credit Loans of approximately $75.5 million, $59.9 million and $88.8 million for the years ended February 28, 1999, 1998 and 1997, respectively. Amounts available to be drawn down under the Revolving Credit Loans were $212.9 million and $89.2 million at February 28, 1999 and 1998, respectively. The average interest rate on the Revolving Credit Loans was 6.23%, 6.57% and 6.58% for fiscal 1999, fiscal 1998, and fiscal 1997, respectively. SENIOR SUBORDINATED NOTES - On December 27, 1993, the Company issued $130.0 million aggregate principal amount of 8.75% Senior Subordinated Notes due in December 2003 (the Original Notes). Interest on the Original Notes is payable semiannually on June 15 and December 15 of each year. The Original Notes are unsecured and subordinated to the prior payment in full of all senior indebtedness of the Company, which includes the 1998 Credit Agreement. The Original Notes are guaranteed, on a senior subordinated basis, by all of the Company's significant operating subsidiaries (other than Matthew Clark and its subsidiaries). - 41 - The Trust Indenture relating to the Original Notes contains certain covenants, including, but not limited to, (i) limitation on indebtedness; (ii) limitation on restricted payments; (iii) limitation on transactions with affiliates; (iv) limitation on senior subordinated indebtedness; (v) limitation on liens; (vi) limitation on sale of assets; (vii) limitation on issuance of guarantees of and pledges for indebtedness; (viii) restriction on transfer of assets; (ix) limitation on subsidiary capital stock; (x) limitation on the creation of any restriction on the ability of the Company's subsidiaries to make distributions and other payments; and (xi) restrictions on mergers, consolidations and the transfer of all or substantially all of the assets of the Company to another person. The limitation on indebtedness covenant is governed by a rolling four quarter fixed charge ratio requiring a specified minimum. On October 29, 1996, the Company issued $65.0 million aggregate principal amount of 8.75% Series B Senior Subordinated Notes due in December 2003 (the Series B Notes). In February 1997, the Company exchanged $65.0 million aggregate principal amount of 8.75% Series C Senior Subordinated Notes due in December 2003 (the Series C Notes) for the Series B Notes. The terms of the Series C Notes are substantially identical in all material respects to the Original Notes. DEBT PAYMENTS - Principal payments required under long-term debt obligations during the next five fiscal years and thereafter are as follows: (in thousands) 2000 $ 6,005 2001 224,972 2002 35,963 2003 42,876 2004 244,826 Thereafter 285,532 --------- $ 840,174 ========= 7. INCOME TAXES: The provision for income taxes consists of the following for the years ended February 28: - 42 - A reconciliation of the total tax provision to the amount computed by applying the expected U.S. Federal income tax rate to income before provision for income taxes is as follows for the years ended February 28: Deferred tax liabilities (assets) are comprised of the following as of February 28: 1999 1998 -------- -------- (in thousands) Depreciation and amortization $ 89,447 $ 70,303 LIFO reserve 16,546 6,469 Inventory reserves 6,975 6,974 Other accruals (15,009) (18,193) -------- -------- $ 97,959 $ 65,553 ======== ======== At February 28, 1999, the Company has state and U.S. Federal net operating loss (NOL) carryforwards of $5.4 million and $2.7 million, respectively, to offset future taxable income that, if not otherwise utilized, will expire as follows: state NOLs of $0.6 million and $4.8 million during fiscal 2002 and fiscal 2003, respectively, and Federal NOL of $2.7 million during fiscal 2011. 8. PROFIT SHARING RETIREMENT PLANS AND RETIREMENT SAVINGS PLAN: Effective March 1, 1998, the Company's existing retirement savings and profit sharing retirement plans and the Barton profit sharing and 401(k) plan were merged into the Canandaigua Brands, Inc. 401(k) and Profit Sharing Plan (the Plan). The Plan covers substantially all employees, excluding those employees covered by collective bargaining agreements and Matthew Clark employees. The 401(k) portion of the Plan permits eligible employees to defer a portion of their compensation (as defined in the Plan) on a pretax basis. Participants may defer up to 10% of their compensation for the year, subject to limitations of the Plan. The Company makes a matching contribution of 50% of the first 6% of compensation a participant defers. The amount of the Company's contribution under the profit sharing portion of the Plan is in such discretionary amount as the Board of Directors may annually determine, subject to limitations of the Plan. Company contributions were $6.8 million, $5.9 million and $5.7 million for the years ended February 28, 1999, 1998 and 1997, respectively. - 43 - The Company's subsidiary, Matthew Clark, currently provides for two pension plans: the Matthew Clark Group Pension Plan; and the Matthew Clark Executive Pension Plan (the Plans). The Plans are defined benefit plans with assets held by a Trustee who administers funds separately from the Company's finances. The following table summarizes the funded status of the Company's pension plans and the related amounts that are primarily included in "other assets" in the Consolidated Balance Sheets. (in thousands) Change in benefit obligation: Benefit obligation at December 1, 1998 $ 165,997 Service cost 1,335 Interest cost 2,671 Plan participants' contributions 481 Benefits paid (1,517) Foreign currency exchange rate changes (5,287) --------- Benefit obligation at February 28, 1999 $ 163,680 ========= Change in plan assets: Fair value of plan assets at December 1, 1998 $ 194,001 Actual return on plan assets 7,935 Plan participants' contributions 481 Benefits paid (1,517) Foreign currency exchange rate changes (6,294) --------- Fair value of plan assets at February 28, 1999 $ 194,606 ========= Funded status of the plan as of February 28, 1999: Funded status $ 30,927 Unrecognized actuarial loss (3,950) --------- Prepaid benefit cost $ 26,977 ========= Assumptions as of February 28, 1999: Rate of return on plan assets 8.0% Discount rate 6.5% Increase in compensation levels 4.5% Components of net periodic benefit cost for the three month period ended February 28, 1999: Service cost $ 1,335 Interest cost 2,671 Expected return on plan assets (3,848) --------- Net periodic benefit cost $ 158 ========= - 44 - 9. STOCKHOLDERS' EQUITY: COMMON STOCK - The Company has two classes of common stock: Class A Common Stock and Class B Convertible Common Stock. Class B Convertible Common Stock shares are convertible into shares of Class A Common Stock on a one-to-one basis at any time at the option of the holder. Holders of Class B Convertible Common Stock are entitled to ten votes per share. Holders of Class A Common Stock are entitled to only one vote per share but are entitled to a cash dividend premium. If the Company pays a cash dividend on Class B Convertible Common Stock, each share of Class A Common Stock will receive an amount at least ten percent greater than the amount of the cash dividend per share paid on Class B Convertible Common Stock. In addition, the Board of Directors may declare and pay a dividend on Class A Common Stock without paying any dividend on Class B Convertible Common Stock. At February 28, 1999, there were 14,747,053 shares of Class A Common Stock and 3,223,448 shares of Class B Convertible Common Stock outstanding, net of treasury stock. STOCK REPURCHASE AUTHORIZATION - In January 1996, the Company's Board of Directors authorized the repurchase of up to $30.0 million of its Class A Common Stock and Class B Convertible Common stock. The Company was permitted to finance such purchases, which became treasury shares, through cash generated from operations or through the bank credit agreement. Throughout the year ended February 28, 1997, the Company repurchased 787,450 shares of Class A Common Stock totaling $20.8 million. The Company completed its repurchase program during fiscal 1998, repurchasing 362,100 shares of Class A Common Stock for $9.2 million. In June 1998, the Company's Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Convertible Common Stock. The Company may finance such purchases, which will become treasury shares, through cash generated from operations or through the bank credit agreement. During fiscal 1999, the Company repurchased 1,018,836 shares of Class A Common Stock for $44.9 million. INCREASE IN NUMBER OF AUTHORIZED SHARES OF CLASS A COMMON STOCK- In July 1998, the stockholders of the Company approved an increase in the number of authorized shares of Class A Common Stock from 60,000,000 shares to 120,000,000 shares, thereby increasing the aggregate number of authorized shares of the Company to 141,000,000 shares. LONG-TERM STOCK INCENTIVE PLAN - Under the Company's Long-Term Stock Incentive Plan, nonqualified stock options, stock appreciation rights, restricted stock and other stock-based awards may be granted to employees, officers and directors of the Company. Grants, in the aggregate, may not exceed 4,000,000 shares of the Company's Class A Common Stock. The exercise price, vesting period and term of nonqualified stock options granted are established by the committee administering the plan (the Committee). Grants of stock appreciation rights, restricted stock and other stock-based awards may contain such vesting, terms, conditions and other requirements as the Committee may establish. During fiscal 1999 and fiscal 1998, no stock appreciation rights were granted. During fiscal 1999, no restricted stock was granted and during fiscal 1998, 25,000 shares of restricted Class A Common Stock were granted. At February 28, 1999, there were 1,228,753 shares available for future grant. - 45 - A summary of nonqualified stock option activity is as follows: Weighted Weighted Shares Avg. Avg. Under Exercise Options Exercise Option Price Exercisable Price --------- -------- ----------- -------- Balance, February 29, 1996 1,093,725 $ 28.70 28,675 $ 4.44 Options granted 1,647,700 $ 22.77 Options exercised (3,750) $ 4.44 Options forfeited/canceled (1,304,700) $ 32.09 --------- Balance, February 28, 1997 1,432,975 $ 18.85 51,425 $ 10.67 Options granted 569,400 $ 38.72 Options exercised (117,452) $ 15.33 Options forfeited/canceled (38,108) $ 17.66 --------- Balance, February 28, 1998 1,846,815 $ 25.23 360,630 $ 25.46 Options granted 728,200 $ 50.57 Options exercised (203,565) $ 20.08 Options forfeited/canceled (116,695) $ 37.13 --------- Balance, February 28, 1999 2,254,755 $ 33.26 492,285 $ 24.55 ========= The following table summarizes information about stock options outstanding at February 28, 1999: Options Outstanding Options Exercisable ------------------------------------- ---------------------- Weighted Avg. Weighted Weighted Remaining Avg. Avg. Range of Number Contractual Exercise Number Exercise Exercise Prices Outstanding Life Price Exercisable Price - --------------- ----------- ------------- -------- ----------- -------- $ 4.44 - $11.50 21,525 2.7 years $ 9.64 21,525 $ 9.64 $17.00 - $25.63 817,015 6.5 years $ 17.25 256,775 $ 17.57 $26.75 - $31.25 340,440 7.5 years $ 28.47 106,400 $ 27.37 $35.38 - $57.13 1,075,775 9.2 years $ 47.41 107,585 $ 41.39 --------- ------- 2,254,755 7.9 years $ 33.26 492,285 $ 24.55 ========= ======= The weighted average fair value of options granted during fiscal 1999, fiscal 1998 and fiscal 1997 was $26.21, $20.81 and $10.27, respectively. The fair value of options is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: risk-free interest rate of 5.3% for fiscal 1999, 6.4% for fiscal 1998 and 6.6% for fiscal 1997; volatility of 40.6% for fiscal 1999, 41.3% for fiscal 1998 and 42.7% for fiscal 1997; expected option life of 7.0 years for fiscal 1999, 6.9 years for fiscal 1998 and 4.7 years for fiscal 1997. The dividend yield was 0% for fiscal 1999, 1998 and 1997. Forfeitures are recognized as they occur. INCENTIVE STOCK OPTION PLAN - Under the Company's Incentive Stock Option Plan, incentive stock options may be granted to employees, including officers, of the Company. Grants, in the aggregate, may not exceed 1,000,000 shares of the Company's Class A Common Stock. The exercise price of any incentive stock option may not be less than the fair market value of the Company's Class A Common Stock on the date of grant. The vesting period and term of incentive stock options granted are established by the Committee. The maximum term of incentive stock options is ten years. During fiscal 1999 and fiscal 1998, no incentive stock options were granted. - 46 - EMPLOYEE STOCK PURCHASE PLAN - The Company has a stock purchase plan under which 1,125,000 shares of Class A Common Stock can be issued. Under the terms of the plan, eligible employees may purchase shares of the Company's Class A Common Stock through payroll deductions. The purchase price is the lower of 85% of the fair market value of the stock on the first or last day of the purchase period. During fiscal 1999, fiscal 1998 and fiscal 1997, employees purchased 49,850, 78,248 and 37,768 shares, respectively. The weighted average fair value of purchase rights granted during fiscal 1999, fiscal 1998 and fiscal 1997 was $12.35, $11.90 and $8.41, respectively. The fair value of purchase rights is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: risk-free interest rate of 4.7% for fiscal 1999, 5.3% for fiscal 1998 and 5.6% for fiscal 1997; volatility of 33.5% for fiscal 1999, 35.1% for fiscal 1998 and 65.4% for fiscal 1997; expected purchase right life of 0.5 years for fiscal 1999, 0.5 years for fiscal 1998 and 0.8 years for fiscal 1997. The dividend yield was 0% for fiscal 1999, 1998 and 1997. PRO FORMA DISCLOSURE - The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans. The Company adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123). Accordingly, no incremental compensation expense has been recognized for its stock-based compensation plans. Had the Company recognized the compensation cost based upon the fair value at the date of grant for awards under its plans consistent with the methodology prescribed by SFAS No. 123, net income and earnings per common share would have been reduced to the pro forma amounts as follows for the years ended February 28: The pro forma effect on net income may not be representative of that to be expected in future years. - 47 - 10. EARNINGS PER COMMON SHARE: The following table presents earnings per common share for the years ended February 28: 1999 1998 1997 -------- -------- -------- (in thousands, except per share data) Income before extraordinary item $ 61,909 $ 47,130 $ 46,183 Extraordinary item, net of income taxes (11,437) -- -- -------- -------- -------- Income applicable to common shares $ 50,472 $ 47,130 $ 46,183 ======== ======== ======== Weighted average common shares outstanding - basic 18,293 18,672 19,333 Stock options 461 433 188 -------- -------- -------- Weighted average common shares outstanding - diluted 18,754 19,105 19,521 ======== ======== ======== Earnings per common share: Basic: Income before extraordinary item $ 3.38 $ 2.52 $ 2.39 Extraordinary item (0.62) -- -- -------- -------- -------- Earnings per common share - basic $ 2.76 $ 2.52 $ 2.39 ======== ======== ======== Diluted: Income before extraordinary item $ 3.30 $ 2.47 $ 2.37 Extraordinary item (0.61) -- -- -------- -------- -------- Earnings per common share - diluted $ 2.69 $ 2.47 $ 2.37 ======== ======== ======== 11. COMMITMENTS AND CONTINGENCIES: OPERATING LEASES - Future payments under noncancelable operating leases having initial or remaining terms of one year or more are as follows during the next five fiscal years and thereafter: (in thousands) 2000 $ 13,292 2001 11,478 2002 10,576 2003 10,109 2004 9,624 Thereafter 102,122 -------- $157,201 ======== Rental expense was approximately $8.2 million, $5.6 million and $4.7 million for fiscal 1999, fiscal 1998 and fiscal 1997, respectively. PURCHASE COMMITMENTS AND CONTINGENCIES - The Company has agreements with three suppliers to purchase blended Scotch whisky through December 2002. The purchase prices under the agreements are denominated in British pound sterling. Based upon exchange rates at February 28, 1999, the Company's aggregate future obligation is approximately $17.2 million for the contracts expiring through December 2002. - 48 - At February 28, 1999, the Company had two agreements with Diageo plc (Diageo) to purchase Canadian blended whisky through September 1, 2000, with a maximum obligation of approximately $4.9 million. The Company also had an agreement with Diageo to purchase Canadian new distillation whisky through December 1999 at purchase prices of approximately $1.4 million to $1.7 million. These agreements have been superseded as a result of the Company's definitive agreement with Diageo. See Note 17 - Subsequent Events. At February 28, 1999, the Company also had an agreement with a different supplier to purchase Canadian new distillation whisky through December 2005, with a maximum obligation of approximately $6.4 million. All of the Company's imported beer products are marketed and sold pursuant to exclusive distribution agreements from the suppliers of these products. The Company's agreement to distribute Corona Extra and its other Mexican beer brands exclusively throughout 25 primarily western states was renewed effective November 22, 1996, and expires December 2006, with automatic five year renewals thereafter, subject to compliance with certain performance criteria and other terms under the agreement. The remaining agreements expire through December 2007. Prior to their expiration, these agreements may be terminated if the Company fails to meet certain performance criteria. At February 28, 1999, the Company believes it is in compliance with all of its material distribution agreements and, given the Company's long-term relationships with its suppliers, the Company does not believe that these agreements will be terminated. In connection with previous acquisitions, the Company assumed purchase contracts with certain growers and suppliers. In addition, the Company has entered into other purchase contracts with various growers and suppliers in the normal course of business. Under the grape purchase contracts, the Company is committed to purchase all grape production yielded from a specified number of acres for a period of time ranging up to nineteen years. The actual tonnage and price of grapes that must be purchased by the Company will vary each year depending on certain factors, including weather, time of harvest, overall market conditions and the agricultural practices and location of the growers and suppliers under contract. The Company purchased $126.6 million of grapes under these contracts during fiscal 1999. Based on current production yields and published grape prices, the Company estimates that the aggregate purchases under these contracts over the remaining term of the contracts will be approximately $846.4 million. The Company's aggregate obligations under bulk wine purchase contracts will be approximately $40.6 million over the remaining term of the contracts which expire through fiscal 2001. EMPLOYMENT CONTRACTS - The Company has employment contracts with certain of its executive officers and certain other management personnel with remaining terms ranging up to two years. These agreements provide for minimum salaries, as adjusted for annual increases, and may include incentive bonuses based upon attainment of specified management goals. In addition, these agreements provide for severance payments in the event of specified termination of employment. The aggregate commitment for future compensation and severance, excluding incentive bonuses, was approximately $6.4 million as of February 28, 1999, of which approximately $1.8 million is accrued in other liabilities as of February 28, 1999. EMPLOYEES COVERED BY COLLECTIVE BARGAINING AGREEMENTS - Approximately 32% of the Company's full-time employees are covered by collective bargaining agreements at February 28, 1999. Agreements expiring within one year cover approximately 5% of the Company's full-time employees. LEGAL MATTERS - The Company is subject to litigation from time to time in the ordinary course of business. Although the amount of any liability with respect to such litigation cannot be determined, in the opinion of management such liability will not have a material adverse effect on the Company's financial condition, results of operations or cash flows. - 49 - 12. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK: Gross sales to the five largest customers of the Company represented 25.2%, 26.4% and 22.9% of the Company's gross sales for the fiscal years ended February 28, 1999, 1998 and 1997, respectively. Gross sales to the Company's largest customer, Southern Wine and Spirits, represented 10.9%, 12.1% and 10.5% of the Company's gross sales for the fiscal years ended February 28, 1999, 1998 and 1997, respectively. Accounts receivable from the Company's largest customer represented 8.5%, 14.1% and 11.3% of the Company's total accounts receivable as of February 28, 1999, 1998 and 1997, respectively. Gross sales to the Company's five largest customers are expected to continue to represent a significant portion of the Company's revenues. The Company's arrangements with certain of its customers may, generally, be terminated by either party with prior notice. The Company performs ongoing credit evaluations of its customers' financial position, and management of the Company is of the opinion that any risk of significant loss is reduced due to the diversity of customers and geographic sales area. 13. SUMMARIZED FINANCIAL INFORMATION - SUBSIDIARY GUARANTORS: The following table presents summarized financial information for the Company, the parent company, the combined subsidiaries of the Company which guarantee the Company's senior subordinated notes (Subsidiary Guarantors) and the combined subsidiaries of the Company which are not Subsidiary Guarantors, primarily Matthew Clark (Subsidiary Nonguarantors). The Subsidiary Guarantors are wholly owned and the guarantees are full, unconditional, joint and several obligations of each of the Subsidiary Guarantors. Separate financial statements for the Subsidiary Guarantors of the Company are not presented because the Company has determined that such financial statements would not be material to investors. The Subsidiary Guarantors comprise all of the direct and indirect subsidiaries of the Company, other than Matthew Clark and certain other subsidiaries which individually, and in the aggregate, are inconsequential. There are no restrictions on the ability of the Subsidiary Guarantors to transfer funds to the Company in the form of cash dividends, loans or advances. 14. ACCOUNTING PRONOUNCEMENT: In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. SFAS No. 133 requires that every derivative be recorded as either an asset or liability in the balance sheet and measured at its fair value. SFAS No. 133 also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company formally document, designate and assess the effectiveness of transactions that receive hedge accounting. The Company is required to adopt SFAS No. 133 on a prospective basis for interim periods and fiscal years beginning March 1, 2000. The Company believes the effect of adoption on its financial statements will not be material based on the Company's current risk management strategies. 15. BUSINESS SEGMENT INFORMATION: Effective March 1, 1998, the Company has adopted the provisions of Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. Adoption of this statement had no impact on the Company's consolidated financial position, results of operations or cash flows. Comparative information for earlier years has been restated. The restatement of comparative information for interim periods in the initial year of adoption is to be reported for interim periods in the second year of application. The Company reports its operating results in four segments: Canandaigua Wine (branded wine and brandy, and other, primarily grape juice concentrate); Barton (primarily beer and spirits); Matthew Clark (branded wine, cider and bottled water, and wholesale wine, cider, spirits, beer and soft drinks); and Corporate Operations and Other (primarily corporate related items). Segment selection was based upon internal organizational structure, the way in which these operations are managed and their performance evaluated by management and the Company's Board of Directors, the availability of separate financial results, and materiality considerations. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on operating profits of the respective business units. - 51 - Segment information for the years ended February 28, 1999, 1998 and 1997, is as follows: (in thousands) 1999 1998 1997 ---------- ---------- ---------- CANANDAIGUA WINE: Net sales: Branded $ 598,782 $ 570,807 $ 537,745 Other 70,711 71,988 112,546 ---------- ---------- ---------- Net sales $ 669,493 $ 642,795 $ 650,291 Operating profit $ 46,283 $ 45,440 $ 51,525 Long-lived assets $ 191,762 $ 185,317 $ 185,298 Total assets $ 650,578 $ 632,636 $ 608,759 Capital expenditures $ 25,275 $ 25,666 $ 24,452 Depreciation and amortization $ 20,838 $ 21,189 $ 19,955 BARTON: Net sales: Beer $ 478,611 $ 376,607 $ 298,925 Spirits 185,938 191,190 185,289 ---------- ---------- ---------- Net sales $ 664,549 $ 567,797 $ 484,214 Operating profit $ 102,624 $ 77,010 $ 73,073 Long-lived assets $ 50,221 $ 51,574 $ 51,504 Total assets $ 478,580 $ 439,317 $ 410,351 Capital expenditures $ 3,269 $ 5,021 $ 4,988 Depreciation and amortization $ 10,765 $ 10,455 $ 9,453 MATTHEW CLARK: Net sales: Branded $ 64,879 $ -- $ -- Wholesale 93,881 -- -- ---------- ---------- ---------- Net sales $ 158,760 $ -- $ -- Operating profit $ 8,998 $ -- $ -- Long-lived assets $ 169,693 $ -- $ -- Total assets $ 631,313 $ -- $ -- Capital expenditures $ 10,444 $ -- $ -- Depreciation and amortization $ 4,836 $ -- $ -- - 52 - (in thousands) 1999 1998 1997 ---------- ---------- ---------- CORPORATE OPERATIONS AND OTHER: Net sales $ 4,541 $ 2,196 $ 508 Operating loss $ (12,013) $ (10,380) $ (11,388) Long-lived assets $ 17,127 $ 7,144 $ 12,750 Total assets $ 33,305 $ 18,602 $ 24,171 Capital expenditures $ 10,869 $ 516 $ 2,209 Depreciation and amortization $ 2,151 $ 1,517 $ 2,431 CONSOLIDATED: Net sales $1,497,343 $1,212,788 $1,135,013 Operating profit $ 145,892 $ 112,070 $ 113,210 Long-lived assets $ 428,803 $ 244,035 $ 249,552 Total assets $1,793,776 $1,090,555 $1,043,281 Capital expenditures $ 49,857 $ 31,203 $ 31,649 Depreciation and amortization $ 38,590 $ 33,161 $ 31,839 The Company's areas of operations are principally in the United States. Operations outside the United States consist of Matthew Clark's operations, which are primarily in the United Kingdom. No other single foreign country or geographic area is significant to the consolidated operations. 16. SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED): A summary of selected quarterly financial information is as follows: - 53 - 17. SUBSEQUENT EVENTS: DEBT OFFERING - On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 (the $200 Million Notes). The net proceeds of the offering (approximately $195.0 million) were used to fund the acquisition of the Black Velvet Canadian Whisky brand and other assets from affiliates of Diageo plc (see Acquisitions below) and to pay the fees and expenses related thereto with the remainder of the net proceeds to be used for general corporate purposes or to fund future acquisitions. Interest on the $200 Million Notes is payable semiannually on March 1 and September 1 of each year, beginning September 1, 1999. The $200 Million Notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. The Company may also redeem up to $70.0 million of the $200 Million Notes using the proceeds of certain equity offerings completed before March 1, 2002. The $200 Million Notes are unsecured and subordinated to the prior payment in full of all senior indebtedness of the Company, which includes the 1998 Credit Agreement. The $200 Million Notes are guaranteed, on a senior subordinated basis, by certain of the Company's significant operating subsidiaries. The Indenture and Supplemental Indenture governing the $200 Million Notes contains certain covenants, including, but not limited to, (i) limitation on indebtedness; (ii) limitation on restricted payments; (iii) limitation on transactions with affiliates; (iv) limitation on senior subordinated indebtedness; (v) limitation on liens; (vi) limitation on sale of assets; (vii) limitation on guarantees by certain subsidiaries for indebtedness; (viii) limitation on certain subsidiary capital stock; (ix) limitation on the creation of any restriction on the ability of the Company's subsidiaries to make distributions and other payments; and (x) restrictions on mergers, consolidations and the transfer of all or substantially all of the assets of the Company to another person. The limitation on indebtedness covenant is governed by a rolling four quarter fixed charge ratio requiring a specified minimum. ACQUISITIONS- On April 9, 1999, in an asset acquisition, the Company acquired several well-known Canadian whisky brands, including Black Velvet, production facilities located in Alberta and Quebec, Canada, case goods and bulk whisky inventories and other related assets from affiliates of Diageo plc. Other principal brands acquired in the transaction were Golden Wedding, OFC, MacNaughton, McMaster's and Triple Crown. In connection with the transaction, the Company also entered into multi-year agreements with Diageo to provide packaging and distilling services for various brands retained by Diageo. The purchase price was approximately $185.5 million and was financed by the proceeds from the sale of the $200 Million Notes. On April 1, 1999, the Company entered into a definitive agreement with Moet Hennessy, Inc. to purchase all of the outstanding capital stock of Simi Winery, Inc. (the Simi Acquisition). The Simi Acquisition includes the Simi winery, equipment, vineyards, inventory and worldwide ownership of the Simi brand name. The Simi Acquisition - 54 - is expected to close in the second quarter of fiscal 2000 and the purchase price is expected to be financed through the Company's bank credit facility. On April 21, 1999, the Company entered into definitive purchase agreements with Franciscan Vineyards, Inc. (Franciscan) and its shareholders, and certain parties related to Franciscan to, among other matters, purchase all of the outstanding capital stock of Franciscan and acquire certain vineyards and related vineyard assets (collectively, the Franciscan Acquisition). Pursuant to the Franciscan Acquisition, the Company will: (i) acquire the Franciscan Oakville Estate, Estancia and Mt. Veeder brands; (ii) acquire wineries located in Rutherford, Monterey and Mt. Veeder, California; (iii) acquire vineyards in the Napa Valley, Alexander Valley, Monterey and Paso Robles appellations and additionally, will enter into long-term grape contracts with certain parties related to Franciscan to purchase additional grapes grown in the Napa and Alexander Valley appellations; (iv) acquire distribution rights to the Quintessa and Veramonte brands; and (v) acquire equity interests in entities that own the Veramonte brand and the Veramonte winery and certain vineyards located in the Casablanca Valley, Chile. The Franciscan Acquisition is expected to close in the second quarter of fiscal 2000 and the purchase price is expected to be financed through the Company's bank credit facility. - 55 - ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------- ----------------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- -------------------------------------------------- The information required by this Item (except for the information regarding executive officers required by Item 401 of Regulation S-K which is included in Part I hereof in accordance with General Instruction G(3)) is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under those sections of the proxy statement titled "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance", which proxy statement will be filed within 120 days after the end of the Company's fiscal year. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - -------- ---------------------- The information required by this Item is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under that section of the proxy statement titled "Executive Compensation" and that caption titled "Director Compensation" under "Election of Directors", which proxy statement will be filed within 120 days after the end of the Company's fiscal year. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - -------- -------------------------------------------------------------- The information required by this Item is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under those sections of the proxy statement titled "Beneficial Ownership" and "Stock Ownership of Management", which proxy statement will be filed within 120 days after the end of the Company's fiscal year. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- ---------------------------------------------- The information required by this Item is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under that section of the proxy statement titled "Executive Compensation", which proxy statement will be filed within 120 days after the end of the Company's fiscal year. - 56 - PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------- ---------------------------------------------------------------- (a) 1. Financial Statements The following consolidated financial statements of the Company are submitted herewith: Report of Independent Public Accountants Consolidated Balance Sheets - February 28, 1999 and 1998 Consolidated Statements of Income for the years ended February 28, 1999, 1998 and 1997 Consolidated Statements of Changes in Stockholders' Equity for the years ended February 28, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended February 28, 1999, 1998 and 1997 Notes to Consolidated Financial Statements 2. Financial Statement Schedules The following consolidated financial information is submitted herewith: Selected Financial Data Selected Quarterly Financial Information (unaudited) All other schedules are not submitted because they are not applicable or not required under Regulation S-X or because the required information is included in the financial statements or notes thereto. Individual financial statements of the Registrant have been omitted because the Registrant is primarily an operating company and no subsidiary included in the consolidated financial statements has minority equity interests and/or noncurrent indebtedness, not guaranteed by the Registrant, in excess of 5% of total consolidated assets. 3. Exhibits required to be filed by Item 601 of Regulation S-K The following exhibits are filed herewith or incorporated herein by reference, as indicated: 2.1 Asset Purchase Agreement dated August 3, 1994 between the Company and Heublein, Inc. (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K dated August 5, 1994 and incorporated herein by reference). - 57 - 2.2 Amendment dated November 8, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.2 to the Company's Registration Statement on Form S-3 (Amendment No. 2) (Registration No. 33-55997) filed with the Securities and Exchange Commission on November 8, 1994 and incorporated herein by reference). 2.3 Amendment dated November 18, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.8 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1994 and incorporated herein by reference). 2.4 Amendment dated November 30, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.9 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1994 and incorporated herein by reference). 2.5 Asset Purchase Agreement among Barton Incorporated (a wholly-owned subsidiary of the Company), United Distillers Glenmore, Inc., Schenley Industries, Inc., Medley Distilling Company, United Distillers Manufacturing, Inc., and The Viking Distillery, Inc., dated August 29, 1995 (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K, dated August 29, 1995 and incorporated herein by reference). 2.6 Recommended Cash Offer, by Schroders on behalf of Canandaigua Limited, a wholly-owned subsidiary of the Company, to acquire Matthew Clark plc (filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference). 2.7 Asset Purchase Agreement dated as of February 21, 1999 by and among Diageo Inc., UDV Canada Inc., United Distillers Canada Inc. and the Company (filed as Exhibit 2 to the Company's Current Report on Form 8-K dated April 9, 1999 and incorporated herein by reference). 3.1 Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference). 3.2 Amended and Restated By-Laws of the Company (filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference). 4.1 Indenture, dated as of December 27, 1993, among the Company, its Subsidiaries and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1993 and incorporated herein by reference). 4.2 First Supplemental Indenture, dated as of August 3, 1994, among the Company, Canandaigua West, Inc. (a subsidiary of the Company now known as Canandaigua Wine Company, Inc.) and The Chase Manhattan Bank (as - 58 - successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Registration Statement on Form S-8 (Registration No. 33-56557) and incorporated herein by reference). 4.3 Second Supplemental Indenture, dated August 25, 1995, among the Company, V Acquisition Corp. (a subsidiary of the Company now known as The Viking Distillery, Inc.) and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1995 and incorporated herein by reference). 4.4 Third Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and The Chase Manhattan Bank (filed as Exhibit 4.4 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 4.5 Fourth Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and The Chase Manhattan Bank (filed as Exhibit 4.5 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference). 4.6 Fifth Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and The Chase Manhattan Bank (filed herewith). 4.7 Indenture with respect to the 8 3/4% Series C Senior Subordinated Notes due 2003, dated as of October 29, 1996, among the Company, its Subsidiaries and Harris Trust and Savings Bank (filed as Exhibit 4.2 to the Company's Registration Statement on Form S-4 (Registration No. 333-17673) and incorporated herein by reference). 4.8 First Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and Harris Trust and Savings Bank (filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 4.9 Second Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and Harris Trust and Savings Bank (filed as Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference). 4.10 Third Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and Harris Trust and Savings Bank (filed herewith). 4.11 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit - 59 - 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference). 4.12 Indenture with respect to 8 1/2% Senior Subordinated Notes due 2009, dated as of February 25, 1999, among the Company, as issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference). 4.13 Supplemental Indenture No. 1, dated as of February 25, 1999, by and among the Company, as Issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference). 10.1 Barton Incorporated Management Incentive Plan (filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference). 10.2 Marvin Sands Split Dollar Insurance Agreement (filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference). 10.3 Letter agreement, effective as of October 7, 1995, as amended, addressing compensation, between the Company and Daniel Barnett (filed as Exhibit 10.23 to the Company's Transition Report on Form 10-K for the Transition Period from September 1, 1995 to February 29, 1996 and incorporated herein by reference). 10.4 Employment Agreement between Barton Incorporated and Alexander L. Berk dated as of September 1, 1990 as amended by Amendment No. 1 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated November 11, 1996 (filed as Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 10.5 Amendment No. 2 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated October 20, 1998 (filed herewith). 10.6 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference). 10.7 Long-Term Stock Incentive Plan, which amends and restates the Canandaigua Wine Company, Inc. Stock Option and Stock Appreciation Right Plan (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended May 31, 1997 and incorporated herein by reference). - 60 - 10.8 Amendment Number One to the Long-Term Stock Incentive Plan of the Company (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.9 Incentive Stock Option Plan of the Company (filed as Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.10 Amendment Number One to the Incentive Stock Option Plan of the Company (filed as Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.11 Annual Management Incentive Plan of the Company (filed as Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.12 Amendment Number One to the Annual Management Incentive Plan of the Company (filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 10.13 Lease, effective December 25, 1997, by and among Matthew Clark Brands Limited and Pontsarn Investments Limited (filed herewith). 10.14 Supplemental Executive Retirement Plan of the Company (filed herewith). 11.1 Statement re Computation of Per Share Earnings (filed herewith). 18.1 Letter re Change in Accounting Principles (filed herewith). 21.1 Subsidiaries of Company (filed herewith). 23.1 Consent of Arthur Andersen LLP (filed herewith). 27.1 Financial Data Schedule for fiscal year ended February 28, 1999 (filed herewith). 27.2 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1998 (filed herewith). 27.3 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1998 (filed herewith). 27.4 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1998 (filed herewith). 27.5 Restated Financial Data Schedule for the fiscal year ended February 28, 1998 (filed herewith). 27.6 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1997 (filed herewith). - 61 - 27.7 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1997 (filed herewith). 27.8 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1997 (filed herewith). 27.9 Restated Financial Data Schedule for the fiscal year ended February 28, 1997 (filed herewith). 99.1 1989 Employee Stock Purchase Plan of the Company, as amended by Amendment Number 1 through Amendment Number 5 (filed as Exhibit 99.1 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 99.2 Amendment Number 6 to the 1989 Employee Stock Purchase Plan of the Company (filed herewith). (b) Reports on Form 8-K The following Reports on Form 8-K were filed by the Company with the Securities and Exchange Commission during the fourth quarter of the fiscal year ended February 28, 1999: (i) Form 8-K dated December 1, 1998. This Form 8-K reported information under Item 2 (Acquisition or Disposition of Assets) and Item 7 (Financial Statements and Exhibits). The following financial statements were filed with this Form 8-K: The Matthew Clark plc Balance Sheets, as of 30 April 1998 and 1997, and the related Consolidated Profit and Loss Accounts and Consolidated Cash Flow Statements for each of the three years in the period ended 30 April 1998, and the report of KPMG Audit Plc, independent auditors, thereon, together with the notes thereto. The pro forma condensed combined balance sheet (unaudited) as of August 31, 1998, and the pro forma condensed combined statement of income (unaudited) for the year ended February 28, 1998, and the pro forma condensed combined statement of income (unaudited) for the six months ended August 31, 1998, and the notes thereto. (ii) Form 8-K/A dated December 1, 1998. This Form 8-K/A reported information under Item 7 (Financial Statements and Exhibits). The following financial statements were filed with this Form 8-K/A: The Matthew Clark plc Balance Sheets, as of 30 April 1998 and 1997, and the related Consolidated Profit and Loss Accounts and Consolidated Cash Flow Statements for each of the three years in the period ended 30 April 1998, and the report of KPMG Audit Plc, independent auditor, thereon, together with the notes thereto. - 62 - The Matthew Clark plc Balance Sheets (unaudited), as of October 31, 1998 and 1997 and the related Consolidated Profit and Loss Accounts (unaudited) and Consolidated Cash Flow Statements (unaudited) for the six month periods ended October 31, 1998 and 1997, together with the notes thereto. The pro forma condensed combined balance sheet (unaudited) as of November 30, 1998, the pro forma combined statement of income (unaudited) for the year ended February 28, 1998, the pro forma combined statement of income (unaudited) for the nine months ended November 30, 1998, and the notes thereto, and the pro forma combined statement of income (unaudited) for the twelve months ended November 30, 1998, and the notes thereto. (iii) Form 8-K dated December 2, 1998. This Form 8-K reported information under Item 5 (Other Events). (iv) Form 8-K dated February 22, 1999. This Form 8-K reported information under Item 5 (Other Events). - 63 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 CANANDAIGUA BRANDS, INC. By:/s/ Richard Sands ---------------------------------- Richard Sands, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Richard Sands /s/ Thomas S. Summer - ---------------------------------- ---------------------------------- Richard Sands, President, Chief Thomas S. Summer, Senior Vice Executive Officer and Director President and Chief Financial (Principal Executive Officer ) Officer (Principal Financial Dated: June 1, 1999 Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Marvin Sands /s/ Robert Sands - ---------------------------------- ---------------------------------- Marvin Sands, Chairman of the Board Robert Sands, Director Dated: June 1, 1999 Dated: June 1, 1999 /s/ George Bresler /s/ James A. Locke - ---------------------------------- ---------------------------------- George Bresler, Director James A. Locke, III, Director Dated: June 1, 1999 Dated: June 1, 1999 /s/ Thomas C. McDermott /s/ Paul L. Smith - ---------------------------------- ---------------------------------- Thomas C. McDermott, Director Paul L. Smith, Director Dated: June 1, 1999 Dated: June 1, 1999 - 64 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BATAVIA WINE CELLARS, INC. By: /s/ Ned Cooper ---------------------------------- Ned Cooper, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Ned Cooper ---------------------------------- Ned Cooper, President (Principal Executive Officer) Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Treasurer (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Director - 65 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 CANANDAIGUA WINE COMPANY, INC. By: /s/ Robert Sands ---------------------------------- Robert Sands, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, President, Chief Executive Officer and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Treasurer (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director - 66 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 CANANDAIGUA EUROPE LIMITED By: /s/ Douglas Kahle ---------------------------------- Douglas Kahle, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Douglas Kahle ---------------------------------- Douglas Kahle, President (Principal Executive Officer) Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Treasurer (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director - 67 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 CANANDAIGUA LIMITED By: /s/ Robert Sands ---------------------------------- Robert Sands, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Chief Executive Officer and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Finance Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director - 68 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 POLYPHENOLICS, INC. By: /s/ Richard Keeley ---------------------------------- Richard Keeley, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Richard Keeley ---------------------------------- Richard Keeley, President and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Vice President and Treasurer (Principal Financial Officer and Principal Accounting Officer) - 69 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 ROBERTS TRADING CORP. By: /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, President and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, President and Treasurer (Principal Executive Officer, Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Director - 70 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON INCORPORATED By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President, Chief Executive Officer and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Director - 71 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON BRANDS, LTD. By: /s/ Edward L. Golden ---------------------------------- Edward L. Golden, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, President and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director - 72 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON BEERS, LTD. By: /s/ Richard Sands ---------------------------------- Richard Sands, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Chief Executive Officer and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director - 73 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON BRANDS OF CALIFORNIA, INC. By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director - 74 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON BRANDS OF GEORGIA, INC. By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director - 75 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON DISTILLERS IMPORT CORP. By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Alexander L. Berk ----------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director - 76 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 BARTON FINANCIAL CORPORATION By: /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, President, Secretary and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Charles T. Schlau ---------------------------------- Charles T. Schlau, Treasurer and Director (Principal Financial Officer and Principal Accounting Officer) - 77 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 STEVENS POINT BEVERAGE CO. By: /s/ James P. Ryan ---------------------------------- James P. Ryan, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ James P. Ryan ---------------------------------- James P. Ryan, President, Chief Executive Officer and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director - 78 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 MONARCH IMPORT COMPANY By: /s/ James P. Ryan James P. Ryan, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ James P. Ryan ---------------------------------- James P. Ryan, Chief Executive Officer (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director - 79 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: June 1, 1999 THE VIKING DISTILLERY, INC. By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer) Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer) Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director - 80 - INDEX TO EXHIBITS EXHIBIT NO. - ----------- 2.1 Asset Purchase Agreement dated August 3, 1994 between the Company and Heublein, Inc. (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K dated August 5, 1994 and incorporated herein by reference). 2.2 Amendment dated November 8, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.2 to the Company's Registration Statement on Form S-3 (Amendment No. 2) (Registration No. 33-55997) filed with the Securities and Exchange Commission on November 8, 1994 and incorporated herein by reference). 2.3 Amendment dated November 18, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.8 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1994 and incorporated herein by reference). 2.4 Amendment dated November 30, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.9 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1994 and incorporated herein by reference). 2.5 Asset Purchase Agreement among Barton Incorporated (a wholly-owned subsidiary of the Company), United Distillers Glenmore, Inc., Schenley Industries, Inc., Medley Distilling Company, United Distillers Manufacturing, Inc., and The Viking Distillery, Inc., dated August 29, 1995 (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K, dated August 29, 1995 and incorporated herein by reference). 2.6 Recommended Cash Offer, by Schroders on behalf of Canandaigua Limited, a wholly-owned subsidiary of the Company, to acquire Matthew Clark plc (filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference). 2.7 Asset Purchase Agreement dated as of February 21, 1999 by and among Diageo Inc., UDV Canada Inc., United Distillers Canada Inc. and the Company (filed as Exhibit 2 to the Company's Current Report on Form 8-K dated April 9, 1999 and incorporated herein by reference). 3.1 Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference). 3.2 Amended and Restated By-Laws of the Company (filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference). 4.1 Indenture, dated as of December 27, 1993, among the Company, its Subsidiaries and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1993 and incorporated herein by reference). - 81 - 4.2 First Supplemental Indenture, dated as of August 3, 1994, among the Company, Canandaigua West, Inc. (a subsidiary of the Company now known as Canandaigua Wine Company, Inc.) and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Registration Statement on Form S-8 (Registration No. 33-56557) and incorporated herein by reference). 4.3 Second Supplemental Indenture, dated August 25, 1995, among the Company, V Acquisition Corp. (a subsidiary of the Company now known as The Viking Distillery, Inc.) and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1995 and incorporated herein by reference). 4.4 Third Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and The Chase Manhattan Bank (filed as Exhibit 4.4 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 4.5 Fourth Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and The Chase Manhattan Bank (filed as Exhibit 4.5 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference). 4.6 Fifth Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and The Chase Manhattan Bank (filed herewith). 4.7 Indenture with respect to the 8 3/4% Series C Senior Subordinated Notes due 2003, dated as of October 29, 1996, among the Company, its Subsidiaries and Harris Trust and Savings Bank (filed as Exhibit 4.2 to the Company's Registration Statement on Form S-4 (Registration No. 333-17673) and incorporated herein by reference). 4.8 First Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and Harris Trust and Savings Bank (filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 4.9 Second Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and Harris Trust and Savings Bank (filed as Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference). 4.10 Third Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and Harris Trust and Savings Bank (filed herewith). 4.11 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference). - 82 - 4.12 Indenture with respect to 8 1/2% Senior Subordinated Notes due 2009, dated as of February 25, 1999, among the Company, as issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference). 4.13 Supplemental Indenture No. 1, dated as of February 25, 1999, by and among the Company, as Issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference). 10.1 Barton Incorporated Management Incentive Plan (filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference). 10.2 Marvin Sands Split Dollar Insurance Agreement (filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference). 10.3 Letter agreement, effective as of October 7, 1995, as amended, addressing compensation, between the Company and Daniel Barnett (filed as Exhibit 10.23 to the Company's Transition Report on Form 10-K for the Transition Period from September 1, 1995 to February 29, 1996 and incorporated herein by reference). 10.4 Employment Agreement between Barton Incorporated and Alexander L. Berk dated as of September 1, 1990 as amended by Amendment No. 1 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated November 11, 1996 (filed as Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 10.5 Amendment No. 2 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated October 20, 1998 (filed herewith). 10.6 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference). 10.7 Long-Term Stock Incentive Plan, which amends and restates the Canandaigua Wine Company, Inc. Stock Option and Stock Appreciation Right Plan (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended May 31, 1997 and incorporated herein by reference). 10.8 Amendment Number One to the Long-Term Stock Incentive Plan of the Company (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.9 Incentive Stock Option Plan of the Company (filed as Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). - 83 - 10.10 Amendment Number One to the Incentive Stock Option Plan of the Company (filed as Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.11 Annual Management Incentive Plan of the Company (filed as Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference). 10.12 Amendment Number One to the Annual Management Incentive Plan of the Company (filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 10.13 Lease, effective December 25, 1997, by and among Matthew Clark Brands Limited and Pontsarn Investments Limited (filed herewith). 10.14 Supplemental Executive Retirement Plan of the Company (filed herewith). 11.1 Statement re Computation of Per Share Earnings (filed herewith). 18.1 Letter re Change in Accounting Principles (filed herewith). 21.1 Subsidiaries of Company (filed herewith). 23.1 Consent of Arthur Andersen LLP (filed herewith). 27.1 Financial Data Schedule for fiscal year ended February 28, 1999 (filed herewith). 27.2 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1998 (filed herewith). 27.3 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1998 (filed herewith). 27.4 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1998 (filed herewith). 27.5 Restated Financial Data Schedule for the fiscal year ended February 28, 1998 (filed herewith). 27.6 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1997 (filed herewith). 27.7 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1997 (filed herewith). 27.8 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1997 (filed herewith). 27.9 Restated Financial Data Schedule for the fiscal year ended February 28, 1997 (filed herewith). 99.1 1989 Employee Stock Purchase Plan of the Company, as amended by Amendment Number 1 through Amendment Number 5 (filed as Exhibit 99.1 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference). 99.2 Amendment Number 6 to the 1989 Employee Stock Purchase Plan of the Company (filed herewith).

923120_1999.txt

923120_1999

1999

923120

ITEM 1. BUSINESS INTRODUCTION Greenbrier is a leading supplier of transportation equipment and services to the railroad and related industries. With operations in North America and Europe, the manufacturing segment produces double-stack intermodal railcars, conventional railcars and marine vessels, and performs repair and refurbishment activities for both intermodal and conventional railcars. In addition to manufacturing, Greenbrier is engaged in complementary leasing and services activities. The lease fleet consists of 33,000 owned or managed railcars as of August 31, 1999. Greenbrier believes this fleet is among the larger non-railroad owned fleets in the United States. In September 1998, Greenbrier acquired a 60 percent interest in a railcar manufacturer located in Swidnica, Poland. In August 1999, the Company increased its ownership interest to 84 percent. This facility establishes a European manufacturing base and provides access to the European markets. This expansion has required the development of a sales and marketing force knowledgeable about the European market. Also in September 1998, Greenbrier entered into a 50 percent joint venture with Bombardier Transportation to build railroad freight cars at Bombardier's existing manufacturing facility in Sahagun, Mexico. The facility serves the North American marketplace and provides better access to the growing market in Mexico. Greenbrier is a Delaware corporation formed in 1981. The Company's principal executive offices are located at One Centerpointe Drive, Lake Oswego, Oregon 97035, and its telephone number is (503) 684-7000. PRODUCTS AND SERVICES Greenbrier operates in two primary business segments: the manufacture of railcars and marine vessels and the refurbishment and repair of railcars; and the leasing and management of surface transportation equipment and related services. A summary of selected consolidated financial information for these two business segments as well as domestic and foreign operations is set forth in Note 18 of the Notes to Consolidated Financial Statements. NEW RAILCAR PRODUCTS INTERMODAL RAILCARS Intermodal transportation is the movement of cargo in standardized containers or trailers. Intermodal containers and trailers are generally freely interchangeable among railcar, truck or ship, making it possible to move cargo in a single container or trailer from a point of origin to its final destination without the repeated loading and unloading of freight required by traditional shipping methods. A major innovation in intermodal transportation has been the articulated double-stack railcar which transports stacked containers on a single platform. An articulated railcar is a unit comprised of up to five platforms, each of which is linked by a common set of wheels and axles. The double-stack railcar provides significant operating and capital savings over other types of intermodal railcars. These savings are the result of (i) increased train density (two containers are carried within the same longitudinal space conventionally used to carry one trailer or container); (ii) a railcar weight reduction per container of approximately 50 percent; (iii) easier terminal handling characteristics; (iv) reduced equipment costs of approximately 30 percent over the cost of providing the same carrying capacity with conventional equipment; (v) better ride quality leading to reduced damage claims; and (vi) increased fuel efficiency resulting from weight reduction and improved aerodynamics. Greenbrier is the leading manufacturer of double-stack railcars with an estimated cumulative North American market share of 60 percent. In 1999, 3,300 double-stack railcars were manufactured and sold by the Company, which it believes represents 94 percent of the North American market during such period. Greenbrier's comprehensive line of articulated and non-articulated double-stack railcars offers varying load capacities and configurations. Current double-stack products include: MAXI-STACK-Registered Trademark- - The Maxi-Stack is a series of double-stack railcars that features the ride-quality and operating efficiency of articulated stack cars. The Maxi-Stack IV is a three-platform articulated railcar with 53-foot wells that can accommodate all current container sizes in all three wells. The Maxi-Stack III is a five-platform railcar that features the ability to carry containers up to 48 feet in length in all wells and up to 53 feet in length on the top level. The Maxi-Stack AP is a three-platform all-purpose railcar that is more versatile than other intermodal cars because it allows the loading of either trailers or double-stack containers on the same platform. HUSKY-STACK-Registered Trademark- - The Husky-Stack is a non-articulated (stand-alone) or draw bar connected series of double-stack railcars with the capability of carrying containers up to 42 percent heavier than a single Maxi-Stack platform. The All-Purpose Husky-Stack is a non-articulated version of the Maxi-Stack AP. Husky-Stack 2+2 is a 56-foot railcar that allows the double-stack loading of up to four 28-foot containers. Husky-Stack also provides a means to extend double-stack economics to small load segments and terminals. CONVENTIONAL RAILCARS In 1999, over 50 percent of Greenbrier's manufactured railcars were conventional railcars. The leading manufacturer of boxcars in North America, Greenbrier produces a wide variety of 100-ton capacity boxcars, which are primarily used in the forest products industry. Greenbrier also produces custom-built high-capacity boxcars for special applications such as automotive parts or canstock movement. In addition to boxcars, center-partition cars for lumber and other building materials, flat cars for auto-rack service, high cubic capacity covered hopper railcars for grain transportation, gondolas for scrap steel services and various other conventional railcar types are manufactured. Greenbrier's European facility manufactures pressurized tank cars for liquid petroleum gas, non-pressurized tank cars for light oil products, coal cars and articulated flat cars. Production of Auto-Max-Registered Trademark-, a fully integrated, two-unit railcar designed to transport a mix of full-size pickups, automobiles and sport utility vehicles in a tri-level configuration began in the fourth quarter of 1999. The adjustable decks in Auto-Max can also be moved to a bi-level configuration, assuring the ability to adjust to automobile industry model changes. RAIL SERVICES Greenbrier is actively engaged in the repair and refurbishment of railcars for third parties as well as its own lease fleet. In certain situations, repair and refurbishment of the Company's lease fleet is performed in unaffiliated facilities. Refurbishment and repair facilities are located in Portland and Springfield, Oregon; Cleburne and San Antonio, Texas; Finley, Washington; Atchison, Kansas; and Golden, Colorado (acquired subsequent to August 31, 1999). The Springfield facility has a long-term contract with a third-party primarily for the repair of railcars. Greenbrier believes it is one of only a few railcar lessors with its own refurbishing capabilities. In addition, Greenbrier operates wheel reconditioning shops in Portland, Oregon; Pine Bluff, Arkansas; Tacoma, Washington; and Sahagun, Mexico. MARINE VESSEL FABRICATION The Portland, Oregon manufacturing facility is located on a deep water port on the Willamette River. Until 1984, the Company's predecessor designed and built ocean-going barges and other types of marine vessels for maritime shipping companies. In 1995, Greenbrier re-entered the marine vessel market and expanded and upgraded the marine facilities, which include the largest side-launch ways on the West Coast. The upgraded marine facilities also enhance steel plate burning and fabrication capacity providing flexibility for railcar production. Since 1995 vessels manufactured include conventional deck barges for aggregates and other heavy industrial products and ocean-going dump barges. LEASING AND SERVICES Greenbrier currently manages a lease fleet of railcars of which 44 percent are owned and the remainder are managed for institutional investors, railroads and other leasing companies. Management services include equipment marketing and re-marketing, maintenance management and administration. Greenbrier participates in both the finance and the operating lease segments of the market. The aggregate rental payments over the operating lease terms do not fully amortize the acquisition costs of the leased equipment. As a result, the Company is subject to the customary risk that it may not be able to sell or re-lease equipment after the operating lease term expires. However, the Company believes it can effectively manage the risks typically associated with operating leases due to its railcar expertise and its refurbishing and re-marketing capabilities. Most of the leases are "full service" leases, whereby Greenbrier is responsible for maintenance, taxes and administration. The fleet is maintained, in part, through Greenbrier's own facilities and engineering and technical staff. Assets from the owned lease fleet are periodically sold to take advantage of market conditions, manage risk and maintain liquidity. The following table summarizes the lease fleet: (1) Each platform of an articulated car is treated as a separate car. (2) Railcar equipment held for sale consists mainly of hulks that will either be sold or refurbished and placed on lease. A substantial portion of the equipment in the lease fleet has been acquired through an agreement entered into in August 1990 with Southern Pacific Transportation Company, which has since merged with Union Pacific, to purchase, refurbish and re-market over 10,000 railcars. The railcars were refurbished to predetermined specifications by Greenbrier or unaffiliated contract shops after satisfactory re-marketing arrangements were in place. RAW MATERIALS AND COMPONENTS Manufactured products require a supply of raw materials including steel and numerous specialty components such as brakes, wheels and axles. Approximately 50 percent of the cost of each freight car represents specialty components purchased from third-parties. Customers often specify particular components and suppliers of such components. Although the number of alternative suppliers of certain specialty components has declined in recent years, there are at least two suppliers for most such components. Inventory levels are continually monitored to ensure adequate support of production. Advance purchases are periodically made to avoid possible shortages of material due to capacity limitations of component suppliers and possible price increases. Binding long-term contracts with suppliers are not typically entered into as the Company relies on established relationships with major suppliers to ensure the availability of raw materials and specialty items. Fluctuations in the price of components and raw materials have not had a material effect on earnings and are not anticipated to have a material effect in the foreseeable future. In 1999, approximately 61 percent of domestic requirements for steel were purchased from Oregon Steel Mills, Inc., approximately 73 percent of the Company's Canadian requirements were purchased from Algoma Steel Inc., and approximately 52 percent of the Company's European requirements were purchased from Czestochowa Steel Works. The top ten suppliers for all inventory purchases accounted for approximately 29 percent of total purchases, of which no supplier accounted for more than 10 percent. The Company maintains good relationships with its suppliers and has not experienced any significant interruptions in recent years in the supply of raw materials or specialty components. A member of the TrentonWorks Limited board of directors serves as Chairman of the board of directors of Algoma Steel Inc. MARKETING AND PRODUCT DEVELOPMENT A fully integrated marketing and sales effort is utilized whereby Greenbrier seeks to leverage relationships developed in each of its manufacturing and leasing and services operations to provide customers with a diverse range of equipment and financing alternatives designed to satisfy a customer's unique needs. These custom programs may involve a combination of railcar products and financing, leasing, refurbishing and re-marketing services, depending on whether the customer is buying new equipment, refurbishing existing equipment, or seeking to outsource the maintenance or management of equipment. Through customer relationships, insights are derived into the potential need for new products and services. Marketing and engineering personnel collaborate to evaluate opportunities and identify and develop new products. Research and development costs incurred for new product development during 1999, 1998 and 1997 were $1,107,000, $1,470,000 and $1,097,000, respectively. CUSTOMERS AND BACKLOG The manufacturing customer base includes every transportation company that utilizes double-stack or conventional railcars as well as financial institutions that provide equipment to the transportation industry. A portion of the customer base includes TTX Company, Burlington Northern Sante Fe ("BNSF"), Union Pacific, Canadian National Railway Company, Norfolk Southern Railway Company, NorRail, Inc. and General Electric Railcar Services. The following table lists the Company's backlog in units and dollars for new railcars at the dates shown: - ---------- (1) Each platform of an articulated car is treated as a separate car. The backlog is based on customer purchase or lease orders that the Company believes are firm. Customer orders, however, are subject to cancellation and other customary industry terms and conditions. Historically, little variation has been experienced between the number of railcars ordered and the number of railcars actually sold. The backlog is not necessarily indicative of future results of operations. Payment for railcars manufactured is typically received when the cars are completed and accepted by a third-party customer. Leasing customers include Class I Railroads, regional and short line railroads, other leasing companies, shippers and carriers such as Union Pacific, BNSF, Oregon Steel Mills, and First Union Rail. In 1999, sales to the two largest customers, TTX Company and BNSF, accounted for 28 percent and 17 percent of total revenues and 34 percent and 18 percent of manufacturing revenues. Sales to Union Pacific accounted for approximately 41% of leasing and services revenues. No other customers accounted for more than 10 percent of total, manufacturing or leasing and services revenues. COMPETITION Greenbrier is affected by a variety of competitors in each of its principal business activities. There are currently seven major railcar manufacturers competing in North America. Two of these producers build railcars principally for their own fleets and five producers - Trinity Industries, Inc., Thrall Car Manufacturing Co., Johnstown America Corp., National Steel Car, Ltd. and the Company - compete principally in the general railcar market. Some of these producers have substantially greater resources than the Company. Greenbrier competes on the basis of type of product, reputation for quality, price, reliability of delivery and customer service and support. Competition in Europe, with 20-30 railcar producers, is more fragmented than in North America. In railcar leasing, principal competitors in North America include The CIT Group, DJ Joseph, First Union Rail, GATX Corporation, General Electric Railcar Services, NorRail, Inc. and Helm Financial Corp. Greenbrier does not currently provide significant leasing services in Europe. PATENTS AND TRADEMARKS Greenbrier pursues a proactive program for protection of intellectual property resulting from its research and development efforts. Greenbrier has obtained patent and trademark protection for significant intellectual property as it relates to its manufacturing business. The Company holds several United States and foreign patents of varying duration and has several patent applications pending. ENVIRONMENTAL MATTERS The Company is subject to national, state, provincial and local environmental laws and regulations concerning, among other matters, air emissions, waste water discharge, solid and hazardous waste disposal and employee health and safety. Greenbrier maintains an active program of environmental compliance and believes that its current operations are in material compliance with all applicable national, state, provincial and local environmental laws and regulations. Prior to acquiring manufacturing facilities, the Company conducts investigations to evaluate the environmental condition of subject properties and negotiates contractual terms for allocation of environmental exposure arising from prior uses. Upon commencing operations at acquired facilities, the Company endeavors to implement environmental practices, which are at least as stringent as those mandated by applicable laws and regulations. Environmental studies have been conducted of owned and leased properties, which indicate additional investigation and some remediation may be necessary. The Portland, Oregon manufacturing facility is located on the Willamette River. The U.S. Environmental Protection Agency is considering possible classification of portions of the river bed, including the portion fronting the facility, as a federal "superfund" site due to sediment contamination. There is no indication that Greenbrier has contributed to contamination of theWillamette River bed, although uses by prior owners of the property may have contributed. Nevertheless, ultimate classification of the Willamette River may have an impact on the value of the Company's investment in the property and may require the Company to initially bear a portion of the cost of any mandated remediation. Greenbrier may be required to perform periodic maintenance dredging in order to continue to launch vessels from its launch ways on the river and classification as a superfund site could result in some limitations on future launch activity. The outcome of such actions cannot be estimated; however, management believes that any ultimate liability resulting from environmental issues will not materially effect the financial position or results of operations of the Company. REGULATION The Federal Railroad Administration (the "FRA") in the United States and Transport Canada in Canada administer and enforce laws and regulations relating to railroad safety. These regulations govern equipment and safety appliance standards for freight cars and other rail equipment used in interstate commerce. The Association of American Railroads (the "AAR") also promulgates a wide variety of rules and regulations governing the safety and design of equipment, relationships among railroads with respect to railcars in interchange and other matters. The AAR also certifies railcar builders and component manufacturers that provide equipment for use on North American railroads. The effect of these regulations is that the Company must maintain its certifications with the AAR as a car builder and component manufacturer, and products sold and leased by the Company must meet AAR, Transport Canada and FRA standards. In Europe, many countries have deregulated their railroads and the privatization process is underway. However, each country currently has its own market with different certifications required in each. To address cross-border issues, the European Union has proposed international rail routes that would run on a common standard with few customs restrictions. EXECUTIVE OFFICERS OF THE COMPANY The following are the executive officers of the Company. ALAN JAMES, 69, is Chairman of the Board of Directors of Greenbrier, a position he has held since 1994. Mr. James was President of Greenbrier from 1974 to 1994. WILLIAM A. FURMAN, 55, is President, Chief Executive Officer and a director of Greenbrier, positions he has held since 1994. Mr. Furman is also Chief Executive Officer of Gunderson, Inc., Managing Director of TrentonWorks Limited, and Chairman of the Board of Directors of WagonySwidnica, S.A. Mr. Furman was Vice President of Greenbrier from 1974 to 1994. Mr. Furman serves as a director of Schnitzer Steel Industries, Inc., a steel recycling and manufacturing company. ROBIN D. BISSON, 45, has been Senior Vice President Marketing and Sales since 1996 and President of Greenbrier Railcar, Inc., a subsidiary that engages in railcar leasing, since 1991. Mr. Bisson was Vice President of Greenbrier Railcar, Inc. from 1987 to 1991 and has been Vice President of Greenbrier Leasing Corporation, a subsidiary that engages in railcar leasing, since 1987. LARRY G. BRADY, 60, is Senior Vice President and Chief Financial Officer of the Company. Prior to becoming Senior Vice President in 1998 he was Vice President and Chief Financial Officer since 1994. Mr. Brady has been Senior Vice President of Greenbrier Leasing Corporation since he joined the Company in 1991. From 1974 to 1990, he was a partner with Touche Ross & Co. (which subsequently became Deloitte & Touche LLP). A. DANIEL O'NEAL, JR., 63, has been Chairman of Autostack Corporation, a subsidiary that engages in vehicle transportation, since 1992; a director of Gunderson, Inc. since 1985 and serves as a director of the Company. From 1973 until 1980, Mr. O'Neal served as a commissioner of the Interstate Commerce Commission, and from 1977 until 1980 served as its Chairman. From 1989 until 1996 he was chief executive officer and owner of a freight transportation services company. He is currently Chairman of Powertech Toolworks, Inc., a computer services company, and Chairman of World2Market.com, an internet retail company. MARK J. RITTENBAUM, 42, is Vice President and Treasurer of the Company, a position he has held since 1994. Mr. Rittenbaum is also Vice President of Greenbrier Leasing Corporation and Greenbrier Railcar, Inc., positions he has held since 1993 and 1994. TIMOTHY A. STUCKEY, 49, has been President of Gunderson Rail Services since May 1999 and President of Autostack Corporation since 1992, prior to which he served as Executive Vice President of Autostack since 1990, and Assistant Vice President of Greenbrier Leasing Corporation since 1987. NORRISS M. WEBB, 60, is Executive Vice President and General Counsel of the Company, a position he has held since 1994. He is also Vice President, Secretary and a director of Gunderson, Inc. Mr. Webb was Vice President of the Company from 1981 to 1994. L. CLARK WOOD, 57, has been President of Manufacturing Operations since April 1998, President of Gunderson, Inc. since 1990 and Chief Executive Officer of TrentonWorks Limited since June 1995. Mr. Wood was Vice President and Director of Railcar Sales at Trinity Industries, Inc., a railroad freight car manufacturer, from 1985 to 1990. Executive officers are elected by the Board of Directors. There are no family relationships among any of the executive officers of the Company. Mr. James, Chairman of the Board of Directors, and Mr. Furman have entered into a Stockholders' Agreement pursuant to which they have agreed, among other things, to vote as directors to elect Mr. Furman as President and Chief Executive Officer of the Company, Mr. James as Chairman, and certain persons as executive officers and each to vote for the other and for the remaining existing directors in electing directors of the Company. EMPLOYEES As of August 31, 1999, Greenbrier had 3,737 full-time employees, consisting of 3,609 employees engaged in railcar and marine manufacturing, and railcar services, and 128 employees engaged in leasing and services activities. A total of 1,210 employees at the manufacturing facility in Trenton, Nova Scotia, Canada are covered by collective bargaining agreements which expire in 2000. In addition, 325 employees at the manufacturing facility in Swidnica, Poland are also covered by collective bargaining agreements that can be terminated by either party with three months notice. A stock incentive plan and a stock purchase plan are available for all North American employees. A discretionary bonus program is maintained for salaried and most hourly employees not covered by collective bargaining agreements. Greenbrier believes that its relations with its employees are generally good. ITEM 2. ITEM 2. PROPERTIES The Company operates at the following facilities in North America and Europe as of August 31, 1999: (1) The property in Sahagun, Mexico, is leased by Gunderson Concarril from Bombardier Transportation, Greenbrier's joint venture partner. Marketing and administrative offices are also leased in various locations throughout North America and Europe. Greenbrier believes that its facilities are in good condition and that the facilities, together with anticipated capital improvements and additions, are adequate to meet its operating needs for the foreseeable future. The need for expansion and upgrading of the railcar manufacturing and refurbishment facilities is continually evaluated in order to take advantage of increased market opportunities for new railcar designs and repair and refurbishment services. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Greenbrier is involved as a defendant in litigation in the ordinary course of business, the outcome of which cannot be predicted with certainty. In addition, litigation has been initiated by former shareholders of Interamerican Logistics Inc. ("Interamerican"), which was acquired in the fall of 1996. The plaintiffs allege that Greenbrier violated the agreements pursuant to which it acquired ownership of Interamerican and seek damages aggregating $4.5 million Canadian. Management believes the claim is without merit and intends to vigorously defend its position. Accordingly, management believes that any ultimate liability resulting from litigation will not materially affect the financial position, results of operations or cash flows of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reference is made to the information set forth in the section entitled "Common Stock" on page 44 of the 1999 Annual Report to Stockholders, which section is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to the information set forth in the section entitled "Selected Financial Information" on page 22 of the Company's 1999 Annual Report to Stockholders, which section is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to the information set forth in the section entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 23 to 27 of the 1999 Annual Report to Stockholders, which section is incorporated herein by reference. ITEM 7a. ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Greenbrier has assessed its exposure to market risk for its variable rate debt and foreign currency exposures and believes that exposures to such risks are not material. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements and report of independent auditors set forth in the 1999 Annual Report to Stockholders are incorporated herein by reference: Consolidated Balance Sheets as of August 31, 1999 and 1998, and the Consolidated Statements of Operations, Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss) and Consolidated Statements of Cash Flows for each of the years ended August 31, 1999, 1998 and 1997, on pages 29 to 32, the Notes to Consolidated Financial Statements on pages 33 to 41, the report of independent auditors thereon on page 28 and the section entitled Quarterly Results of Operations on page 42. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT There is hereby incorporated by reference the information under the caption "Election of Directors" in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy Statement is anticipated to be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's year ended August 31, 1999, and the information under the caption "Executive Officers of the Company" in Part I, Item 1, "Business," of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There is hereby incorporated by reference the information under the caption "Executive Compensation" in Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy Statement is anticipated to be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's year ended August 31, 1999. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is hereby incorporated by reference the information under the captions "Voting" and "Stockholdings of Certain Beneficial Owners and Management" in Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy Statement is anticipated to be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's year ended August 31, 1999. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is hereby incorporated by reference the information under the caption "Certain Relationships and Related Party Transactions" in Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy Statement is anticipated to be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's year ended August 31, 1999. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The Consolidated Financial Statements, together with the report thereon of Deloitte & Touche LLP, dated October 25, 1999, appearing on pages 28 to 41 of the 1999 Annual Report to Stockholders are incorporated by reference into this Annual Report on Form 10-K. With the exception of the aforementioned information and that which is specifically incorporated in Parts I and II, the 1999 Annual Report to Stockholders is not to be deemed filed as part of this Annual Report on Form 10-K. SCHEDULE I (CONTINUED) THE GREENBRIER COMPANIES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In thousands) STATEMENTS OF CASH FLOWS SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE GREENBRIER COMPANIES, INC. Dated: November 24, 1999 By: /s/ William A. Furman ---------------------------------- William A. Furman President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

1031029_1999.txt

1031029_1999

1999

1031029

ITEM 1. BUSINESS GENERAL StarTek, Inc. (the "Company" or "StarTek") has an established position as a global provider of process management services and owns and operates branded vertical market Internet web sites. The Company's process management service platforms include E-commerce support and fulfillment, provisioning management for complex telecommunications systems, high-end inbound technical support, and a comprehensive offering of supply chain management services. As an outsourcer of process management services as its core business, StarTek allows its clients to focus on their primary business, reduce overhead, replace fixed costs with variable costs, and reduce working capital needs. The Company has continuously expanded its process management business and facilities to offer additional outsourcing services in response to growing needs of its clients and to capitalize on market opportunities, both domestically and internationally. StarTek has a strategic partnership philosophy through which it assesses each of its client's needs, and together with its clients develops and implements customized outsourcing solutions. Management believes StarTek's entrepreneurial culture, long-term relationships with clients and suppliers, efficient operations, dedication to quality, and use of advanced technology and management techniques provide StarTek a competitive advantage in attracting clients to outsource non-core operations. StarTek's principal client, based on 1999 revenues, has utilized StarTek's outsourced services since 1996. StarTek's existing process management services clients are primarily in computer software, Internet, E-commerce, computer hardware, technology, and telecommunications industries which are characterized by rapid growth, complex and evolving product offerings, and large customer bases, which require frequent, often sophisticated customer interaction. Currently, the Company is also targeting financial services, consumer products, and health care companies. Management believes there are substantial opportunities to cross-sell StarTek's wide spectrum of outsourced process management services to its existing and future client base. The Company intends to capitalize on the increasing trend toward outsourcing by focusing on potential clients in additional industries which could benefit from the Company's expertise in developing and delivering integrated, cost-effective, outsourced services. StarTek currently has five operating facilities in Colorado, and one facility each in Wyoming, Tennessee, and Texas. The Company's Europe operations are performed from its facility in Hartlepool, England. The Company's Asia operations are managed by employees co-located with a subcontractor in Singapore. StarTek owns a portfolio of branded vertical market Internet web sites and operates certain sites, including airlines.com and wedding.com. In September 1999, StarTek and The Reader's Digest Association, Inc. entered into certain arrangements whereby StarTek obtained a 19.9% ownership interest in Good Catalog Company, doing business as gifts.com. Gifts.com provides an Internet web site accessed through the URL www.gifts.com that sells gifts on-line. StarTek expects to combine its process management service platforms with certain Internet web site businesses arising from a portfolio of Internet domain names to establish a solid position in the Internet connected world. The Company's business was founded in 1987 and, through its wholly owned subsidiaries, has provided outsourced process management services since inception. On December 30, 1996, StarTek, Inc. was incorporated in Delaware, and in June 1997 StarTek completed an initial public offering of its common stock. Prior to December 30, 1996, StarTek USA, Inc. and StarTek Europe, Ltd. conducted business as affiliates under common control. In 1998, the Company formed StarTek Pacific, Ltd., a Colorado corporation and Domain.com, Inc., a Delaware corporation, both of which are also wholly owned subsidiaries of the Company. StarTek, Inc. is a holding company for the businesses conducted by its wholly owned subsidiaries. StarTek's principal executive offices are located at 100 Garfield Street, Denver, Colorado 80206 and its telephone number is (303) 361-6000. StarTek's home page on the Internet is located at www.startek.com. PROCESS MANAGEMENT SERVICE PLATFORMS The Company offers a wide spectrum of process management service platforms designed to provide cost-effective and efficient management for portions of its clients' operations. The Company works closely with its clients to develop, refine, and implement efficient and productive integrated outsourced solutions that link StarTek with its clients and their customers. The processes that create such solutions generally include development of product manufacturing specifications, packaging, and distribution requirements, as well as product-related software programs for telephone, facsimile, E-mail, and Internet interactions involving product order processing, fulfillment, and technical support. Substantially all of the Company's process-related teleservices activities are inbound telephone calls rather than outbound calls. Process management service platforms StarTek provides include, but are not necessarily limited to: Supply Chain Management. Product order processing is generally the process by which a call or an Internet message from a client's customer is received, identified, and routed to a StarTek service representative. Typically, a customer calls or E-mails to request product service information, to place an order for an advertised product, or to obtain assistance regarding a previous order or purchase. The information and results of the message are then communicated either to StarTek's employees for order processing and fulfillment or, if StarTek does not manage the client's inventory, the Company transmits the customer's request directly to the client. For telephone calls, StarTek utilizes automated call distributors to identify each inbound call by the number dialed by the customer, and immediately route the call to a StarTek service representative trained for that product. Product orders also occur as a result of a customer visiting the web site of a client and placing orders which are received by StarTek or a StarTek service representative offering products in connection with a technical support call. To facilitate product orders, the Company can process credit card charges and other payment methods in connection with its product order processing. StarTek personnel are responsible for maintaining and managing multiple supplier relationships. When the Company is selected by a client to provide product assembly and packaging services, the Company qualifies, selects, certifies, and manages sourcing and manufacturing of various products and related components including, among other things, printing of boxes, labels, manuals, and other printed materials to be included with the client's product, and the mass duplication of software onto various media. Such products and related components are then assembled and packaged at certain of the Company's facilities. The Company monitors quality of its suppliers through visits to manufacturing facilities, and utilizes just-in-time production to minimize inventory in the Company's warehouses. Management believes the Company's strong, long-term relationships with multiple suppliers allows StarTek to be flexible and responsive to its clients, while minimizing cost and dependency on any single supplier. StarTek personnel assemble and package products in various containers, including folding cartons, set-up boxes, compact disc jewel cases, digi-packs, binders, and slip cases. The Company assembles and packages products in the United States, the United Kingdom, and Singapore. The Company's assembly lines have been designed with significant flexibility, enabling the Company to assemble and package various types of products and rapidly change the type of product produced. During peak periods of operations, the Company's capacity is dependent upon: (i) complexity of products to be assembled; (ii) availability of materials from suppliers; (iii) availability of temporary personnel to increase capacity; (iv) number of shifts operated by the Company; and (v) ability to activate additional production lines. StarTek's inventory management systems enable the Company to ship and track products to distribution centers, individual stores, and its clients' customers directly. Product orders are received by the Company via file transfer protocol (FTP), the Internet, electronic data interchange (EDI), facsimile, as well as through the Company's product order teleservices and E-commerce support services described elsewhere. E-commerce Support and Product Order Fulfillment. StarTek develops, operates, and maintains Internet web sites and the Company's personnel process, pack, and ship product orders received by telephone, E-mail, facsimile, and the Internet, 24 hours per day, seven days per week. The Company provides same-day shipping of customer orders if the product is available. Provisioning Management. StarTek personnel are responsible for managing installation and providing on-going support services for large-scale telecommunications networks for clients' customers, most of whom are Fortune 1000 companies. Service representatives manage relationships between StarTek's clients and its customers on a transparent basis. StarTek's installation management and on-going network support services, on an outsourced basis, enable its clients to provide telecommunications services to customers more efficiently and cost effectively. High-End Technical Support Teleservices. StarTek service representatives provide high-end technical support services by telephone, E-mail, facsimile, and the Internet, 24 hours per day, seven days per week. Technical support inquiries are generally driven by a customer's purchase of a product or service, or by a customer's need for ongoing technical assistance. Customers of StarTek's clients dial a technical support number listed in their product or service manuals and, based on touch-tone responses, are automatically connected to an appropriate StarTek service representative who is specially trained in use of computerized knowledge databases for the applicable product. Each StarTek service representative acts as a transparent extension of the client when resolving complaints, diagnosing and resolving product or service problems, or answering technical questions. INTERNATIONAL OPERATIONS StarTek provides process management services on an international basis from the United Kingdom and Singapore. The Company's facility in the United Kingdom provides most of the Company's process management service platforms for clients throughout Europe, including supply chain management and inbound technical support services in several languages. The Company currently provides supply chain management through a subcontract relationship with a company in Singapore. The subcontract relationship generally operates on a purchase order basis. International operations, in the aggregate, generated approximately 24.0% of the Company's revenues during 1999. See Note 15 to the consolidated financial statements set forth herein for a further description of revenues, operating profit, and identifiable assets classified by the major geographic areas in which the Company operates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of "Risks Associated with International Operations and Expansion". DOMAIN.COM OPERATIONS StarTek, through it wholly owned subsidiary Domain.com, Inc., owns a portfolio of branded vertical market Internet web sites and operates certain sites, including airlines.com and wedding.com. In September 1999, StarTek, through its wholly owned subsidiary Domain.com, Inc., and The Reader's Digest Association, Inc. entered into certain arrangements whereby StarTek obtained a 19.9% ownership interest in Good Catalog Company, doing business as gifts.com. Gifts.com provides an Internet web site accessed through the URL www.gifts.com that sells gifts on-line. Since inception of gifts.com's Internet web site operations, StarTek has provided various E-commerce support and product order fulfillment services in connection with certain products and services sold through gifts.com's web site. StarTek expects to combine its process management service platforms with other Internet web site businesses arising from a portfolio of Internet domain names to establish a solid position in the Internet connected world. BUSINESS STRATEGY StarTek's strategic objectives are to increase revenues and earnings by maintaining and enhancing its established position as a global provider of process management services; and to enhance shareholder value, revenues, and earnings by developing ownership interests in Internet web site businesses arising from a portfolio of Internet domain names. To reach these objectives, the Company intends to: Provide Integrated, Outsourced Process Management Services. StarTek seeks to provide integrated, outsourced process management services which enable its clients to provide their customers with high-quality services at lower cost than through a client's own in-house operations. The Company believes its ability to tailor operations, materials, and employee resources objectively, and provide process management services on a cost-effective basis will allow the Company to become an integral part of its clients' businesses. Develop Strategic Partnerships and Long-Term Relationships. StarTek seeks to develop long-term client relationships, primarily with Fortune 500 companies. The Company invests significant resources to establish strategic partnership relationships and to understand each client's processes, culture, decision parameters, and goals so as to develop and implement customized solutions. The Company believes this solution-oriented, value-added, integrated approach to addressing its clients' needs distinguishes StarTek from its competitors and plays a key role in the Company's ability to attract and retain clients on a long-term basis. Maintain Low-Cost Position through the StarTek Process Management System. StarTek strives to establish a competitive advantage by frequently redefining its operational processes to reduce cost and improve quality. The Company believes its continuous improvement philosophy and modern process management techniques enable the Company to reduce waste and increase efficiency by: (i) controlling overproduction; (ii) minimizing waiting time due to inefficient work sequences; (iii) reducing nonessential handling of materials; (iv) eliminating nonessential movement and processing; (v) implementing fail-safe processes; (vi) improving inventory management; and (vii) preventing defects. Emphasize Quality. StarTek strives to achieve the highest quality standards in the industry. To this end, the Company, through certain of its wholly owned subsidiaries, has received ISO 9002 certifications, an international standard for quality assurance and consistency in operating procedures for substantially all of its facilities and services. Certain of the Company's existing clients require evidence of ISO 9002 certification prior to selecting an outsourcing provider. Capitalize on Sophisticated Technology. Management believes it has established a competitive advantage by capitalizing on sophisticated technology and proprietary software, including automatic call distributors, inventory management software, order management software, transportation management software, knowledge databases, call tracking systems, resource scheduling software, and computer telephony integration software. The Company further believes these capabilities enable StarTek to improve efficiency, serve as a transparent extension of its clients, receive telephone calls and data directly from its clients' systems, and report detailed information concerning the status and results of the Company's services and interaction with clients on a daily basis. Develop Ownership Interests in Internet Web Site Businesses. Management believes the Company can continue to develop ownership interests in Internet web site businesses arising from a portfolio of Internet domain names. Management believes shareholder value can be enhanced in a variety of ways which include, among others, joint ventures with third parties to develop web site businesses based upon its Internet domain names. These opportunities are being pursued at this time. CLIENTS StarTek provided process management services to approximately 45 clients in 1999. StarTek's current client base consists of companies engaged primarily in computer software, Internet, E-commerce, computer hardware, technology, and telecommunications industries. Currently, the Company is also targeting financial services, consumer products, and health care companies. Microsoft Corporation accounted for approximately 77.5% of the Company's revenues in 1999. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a further discussion of the Company's "Reliance on Principal Client Relationship" and "Risks Associated with the Company's Contracts". SALES AND MARKETING The Company's marketing objective is to develop long-term relationships with existing and potential clients to become the preferred worldwide provider of process management services. StarTek invests substantial resources to create a strategic partnership with its clients to understand their existing operations, customer service processes, culture, decision parameters, and goals. A StarTek team assesses the client's outsourcing service needs, and, together with the client, develops and implements customized solutions. Management believes, as a result of StarTek's strategic relationship with its clients and comprehensive understanding of their businesses, the Company can identify new revenue generating opportunities, customer interaction possibilities, and product service improvements not adequately addressed by the client. The Company's sales strategy emphasizes multiple contacts with a client to strengthen its relationship and facilitate cross selling of services. StarTek markets its process management services through a variety of methods, including personal sales calls, client referrals, attendance at trade shows, advertisements in industry publications, and cross-selling of services to existing clients. As part of its marketing efforts, the Company encourages visits to its facilities where the Company demonstrates its services, quality procedures, and ability to accommodate additional business. Management believes an essential element to revenue growth is the ability to flexibly, effectively, and efficiently expand service capacity to meet client needs as its clients grow or outsource more of their non-core operations to the Company. In addition, to attract new clients to StarTek's services, the Company must have resources to develop a strategy to meet new clients' outsourcing goals promptly, as well as the ability to implement operations for such clients quickly and accurately. TECHNOLOGY StarTek employs technology and proprietary software that incorporates digital switching, relational knowledge database management systems, call tracking systems, workforce management systems, object-oriented software modules, and computer telephony integration. The Company's digital switching technology is designed to enable calls to be routed to the next available teleservice representative with the appropriate product knowledge, skill, and language abilities. Call tracking and workforce management systems generate and track historical call volumes by client, enabling the Company to schedule personnel efficiently, anticipate fluctuations in call volume, and provide clients with detailed information concerning the status and results of the Company's services on a daily basis. Management believes StarTek's proprietary technology platform provides the Company with a competitive advantage in maintaining existing clients and attracting new clients. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of "Risks Associated with Rapidly Changing Technology". EMPLOYEES AND TRAINING StarTek's success in recruiting, hiring, and training large numbers of full-time skilled employees, and obtaining large numbers of hourly and temporary employees during peak periods is critical to the Company's ability to provide high quality outsourced services. To maintain good employee relations and to minimize turnover, the Company offers competitive pay, hires employees who are eligible to receive the full range of employee benefits, and provides employees with clear, visible career paths. To meet its service objectives, the Company also utilizes temporary services. As of December 31, 1999, the Company had approximately 2,522 full-time equivalent employees. The number of temporary employees varies substantially due to the seasonal nature of the Company's clients' businesses. Management believes demographics surrounding StarTek's facilities, and the Company's reputation, stability, and compensation plans should allow the Company to continue to attract and retain qualified employees. However, the Company is adversely affected in some locations where unemployment levels are currently at low levels compared to historic norms, resulting in a shortage of available qualified employees. If low unemployment levels continue to persist in these areas, the Company's ability to attract qualified employees will continue to be adversely affected. Management believes StarTek's current operations in eight separate locations helps reduce this risk exposure. The Company considers its employee relations to be good. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of factors relating to the Company's "Dependence on Labor Force" and "Dependence on Key Personnel". In keeping with StarTek's continuous improvement philosophy, the Company is committed to training all of its employees. StarTek provides formal training for senior management, supervisors, process managers, quality coordinators, and service representatives. StarTek also maintains an employee quality program to backup every employee, including specialized quality coordinators who teach problem solving, assist with service calls, and offer immediate performance feedback. On a more informal basis, the Company provides on-the-job process training and tutoring for all product assembly and packaging personnel. Employee teams gather daily to receive information about products to be produced and techniques to be utilized, and have an opportunity to ask questions and receive one-on-one training, as necessary. The Company's in-house training programs for technical support and telecommunications process management employees involve an in-depth, structured learning environment that builds technical competence and teaches critical software skills necessary to provide effective services to its clients. Each client service representative is designated and trained to support a particular product or group of products for a particular client. These client service representatives receive training in product knowledge, call listening, and computer skills prior to answering any customer calls independently. This training time depends on the complexity of the product for which such representative will provide services. Further, the Company uses live and taped call reviews and customer feedback surveys to continue to monitor and enhance its level of customer support services. INDUSTRY AND COMPETITION Management believes businesses throughout the world are increasingly focusing on their core competencies, and are increasingly engaging outsourced service companies to perform specialized, non-core functions and services. Outsourcing of non-core activities offers a strategic advantage to companies in a wide range of industries by offering them an opportunity to reduce operating costs and working capital needs, improve their reaction to business cycles, manage capacity, and improve customer and technical information gathering and utilization. To realize these advantages, companies are outsourcing the process of planning, implementing, and controlling the efficient flow of goods, services, teleservices, and related information from point of origin, to point of consumption. Additionally, rapid technological changes and rising customer expectations for high-quality goods and services make it increasingly difficult and expensive for companies to maintain the necessary personnel and product capabilities in-house to support a product's life-cycle on a cost-effective basis. Management believes companies that focus on providing these services as their core business, including StarTek, are expected to continue to benefit from these outsourcing trends. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of the Company's "Highly Competitive Market". StarTek competes on the basis of quality, reliability of service, price, efficiency, speed, and flexibility in tailoring services to client needs. Management believes StarTek's comprehensive and integrated services differentiate the Company from non-client competitors who may only be able to provide one or a few of the outsourced services StarTek provides. The Company continuously explores new outsourcing service opportunities, typically in circumstances where clients are experiencing inefficiencies in non-core areas of their businesses. Management believes it can develop superior outsourced solutions to such inefficiencies on a cost-effective basis. Management believes StarTek competes primarily with in-house process management operations of its current and potential clients. Such in-house operations include Internet operations, E-commerce support, technical support teleservices, and supply chain management. StarTek also competes with certain companies that provide similar services on an outsourced basis. There are numerous competitors of all sizes that provide product order teleservices and product fulfillment distribution services. ITEM 2. ITEM 2. PROPERTIES FACILITIES StarTek's principal executive offices are located in Denver, Colorado. Currently, StarTek owns and operates (unless otherwise noted) the following facilities, containing, in the aggregate, approximately 872,850 square feet: Substantially all of the Company's facility space can be used to support several of the Company's process management service platforms. Management believes StarTek's existing facilities are adequate for the Company's current operations, but continued capacity expansion will be required to support continued growth. Management intends to maintain a certain amount of excess capacity to enable StarTek to readily provide for needs of new clients, and increasing needs of existing clients. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of "Risks of Business Interruptions". --------------- (a) This facility was closed in December 1999, and is currently for sale. (b) Certain process management services previously provided from the Denver facility were completely transferred to other facilities by January 31, 2000. Currently, a relatively small portion of the Denver facility provides for certain executive, corporate, and information technology functions, while management evaluates possible operating activities which could be located in this facility. (c) See Note 9 to the consolidated financial statements set forth herein for a description of the Tennessee financing arrangement. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has been involved from time to time in litigation arising in the normal course of business, none of which is currently expected by management to have a material adverse effect on the Company's business, financial condition or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the three months ended December 31, 1999. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS MARKET PRICE OF COMMON STOCK StarTek's common stock has traded under the symbol "SRT" on the New York Stock Exchange since June 19, 1997, the effective date of the Company's initial public offering. High and low sale prices of StarTek's common stock for 1998 and 1999 were: The closing sale price for StarTek's common stock on March 1, 2000 was $44.25. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of "Volatility of Stock Price". HOLDERS OF COMMON STOCK As of March 1, 2000, there were approximately 3,389 stockholders of record and 13,988,011 shares of common stock outstanding. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results" set forth herein for a discussion of "Control by Principal Stockholders". DIVIDEND POLICY StarTek currently intends to retain all earnings to finance the continued growth of its business and does not expect to pay any dividends in the foreseeable future. The payment of any dividends will be at the discretion of the Company's Board of Directors and will depend upon, among other things, availability of funds, future earnings, capital requirements, contractual restrictions, general financial condition of the Company, and general business conditions. Under its $5 million line of credit, the Company may not pay dividends in an amount which would cause a failure to meet its financial covenants. See Note 7 to the consolidated financial statements, and "Management's Discussion and Analysis of Financial Condition and Results of Operations"--"Liquidity and Capital Resources" set forth herein for a description of these financial covenants. SALES OF UNREGISTERED SECURITIES The Company did not issue or sell any unregistered securities during the three months ended December 31, 1999, except for the following stock options, all of which were granted at exercise prices equal to the market value of the Company's common stock on the date the options were granted: On October 1, 1999, the Company granted options to purchase 300 shares of common stock, in the aggregate, to three employees pursuant to the Company's Stock Option Plan. These options vest at a rate of 20% per year beginning October 1, 2000, expire on October 1, 2009, and are exercisable at $50.06 per share; On November 22, 1999, the Company granted options to purchase 22,700 shares of common stock, in the aggregate, to 25 employees pursuant to the Company's Stock Option Plan. These options vest at a rate of 20% per year beginning November 22, 2000, expire on November 22, 2009, and are exercisable at $32.81 per share; and On December 14, 1999, the Company granted an option to purchase 10,000 shares of common stock to one director pursuant to the Company's Director Stock Option Plan. This option fully vested on December 14, 1999 and is exercisable at $38.63 per share. The foregoing stock option grants were made in reliance upon exemptions from registration provided by Sections 4(2) and 3(b) of the Securities Act of 1933, as amended, and regulations promulgated thereunder. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K. Additionally, the following selected financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this Form 10-K. SELECTED UNAUDITED PRO FORMA INFORMATION: The Company was an S corporation for federal and state income tax purposes from July 1, 1992 through June 17, 1997, and accordingly, was not subject to federal or state income taxes. The S corporation election was terminated on June 17, 1997 in contemplation of the Company's initial public offering. Since June 18, 1997, the Company has been a C corporation for federal and state income tax purposes. Pro forma net income: (i) reflects the elimination of management fee expense; and (ii) includes a provision for federal, state and foreign income taxes at an effective rate of 37.3% during the applicable S corporation period. Management fee expense was discontinued in connection with the initial public offering in June 1997. Pro forma presentation was not applicable for the years ended December 31, 1998 and 1999. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS All statements contained in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" or elsewhere in this Form 10-K that are not statements of historical facts are forward-looking statements that involve substantial risks and uncertainties. Forward-looking statements are preceded by terms such as "may", "will", "should", "anticipates", "expects", "believes", "plans", "future", "estimate", "continue", and similar expressions. The following are important factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements; these include, but are not limited to, inflation and general economic conditions in the Company's and its clients' markets, risks associated with the Company's reliance on a principal client, loss or delayed implementation of a large project which could cause quarterly variation in the Company's revenues and earnings, difficulties in managing rapid growth, risks associated with rapidly changing technology, dependence on labor force, risks associated with international operations and expansion, control by principal stockholders, dependence on key personnel, dependence on key industries and trends toward outsourcing, risks associated with the Company's contracts, highly competitive markets, risks of business interruptions, volatility of the Company's stock price, and risks related to the Company's investment in and note receivable from Good Catalog Company doing business as gifts.com, risks related to the Company's Internet web site operations, and risks related to the Company's portfolio of Internet domain names. These factors include risks and uncertainties beyond the Company's ability to control; and, in many cases, the Company and its management cannot predict the risks and uncertainties that could cause actual results to differ materially from those indicated by use of forward-looking statements. All forward-looking statements herein are made as of the date hereof, and the Company undertakes no obligation to update any such forward-looking statements. All forward-looking statements herein are qualified in their entirety by the information set forth in "Factors That May Affect Future Results" below. OVERVIEW StarTek has historically generated revenues through the provision of process management services, which include E-commerce support and fulfillment, provisioning management for complex telecommunications systems, high-end inbound technical support, and a comprehensive offering of supply chain management services. The Company recognizes revenues as process management services are completed. Substantially all of the Company's significant arrangements with its clients for its services generate revenues based, in large part, on the number and duration of customer inquiries, and the volume, complexity and type of components involved in the handling of clients' products. Changes in the complexity or type of components in the product units assembled by the Company may have an effect on the Company's revenues, independent of the number of product units assembled. An essential element of the Company's ability to grow is availability of capacity to readily provide for the needs of new clients and increasing needs of existing clients. StarTek operates from facilities in the United States, United Kingdom and Singapore. The Company's capacity expanded during 1999 through: (i) lease of a 30,000 square-foot building in Big Spring, Texas; (ii) expansion of previously existing space in Hartlepool, England from 53,000 to 73,000 square feet; and (iii) purchase of an 88,000 square-foot building in Greeley, Colorado. These three additions, together with the Company's previously existing capacity, provided adequate capacity to accommodate revenue and earnings growth experienced by the Company during 1999. Management believes StarTek's existing facilities are adequate for the Company's current and near term operations, but continued capacity expansion will be required to support continued growth. Management intends to maintain a certain amount of excess capacity to enable StarTek to readily provide for needs of new clients and increasing needs of existing clients. The 10,500 square-foot Greeley facility purchased in 1993 was closed in December 1999, and is currently for sale. Certain process management services previously provided from the Denver facility were completely transferred to other facilities by January 31, 2000. Currently, a relatively small portion of the Denver facility provides for certain executive, corporate, and information technology functions, while management evaluates possible operating activities which could be located in this facility. The Company's cost of services primarily include labor, telecommunications, materials, and freight expenses that are variable in nature and certain facility expenses. All other operating expenses, including expenses attributed to technology support, sales and marketing, human resource management, and other administrative functions not allocable to specific client services, are included in selling, general and administrative expenses, which generally tend to be either semi-variable or fixed in nature. From July 1992, through June 17, 1997, the Company operated as an S corporation and, accordingly, was not subject to federal or state income taxes. As an S corporation, in addition to general compensation for services rendered, the Company historically paid certain management fees, bonuses and other fees to the principal stockholders and/or their affiliates in amounts on an annual basis which were approximately equal to the annual earnings of the Company, and all such amounts were reflected as management fee expense in the consolidated statement of operations. Upon receipt of such management fees and bonuses, the principal stockholders historically contributed approximately 53% of such amounts to the Company to provide necessary working capital, with substantially all of the remaining balance used to pay applicable federal and state income taxes. The amounts so contributed are reflected in additional paid-in-capital on the Company's consolidated balance sheets. Effective with the closing of the Company's initial public offering, these management fees and bonus arrangements were discontinued. Compensation has continued to be payable to certain principal stockholders as general compensation for services rendered in the form of salaries or advisory fees and all such payments are included in selling, general and administrative expenses in the consolidated statement of operations. At current rates, such payments, in the aggregate, approximate $516,000 annually. The Company frequently purchases components of its clients' products as an integral part of its process management services and in advance of providing its product assembly and packaging services. These components are packaged, assembled, and held by StarTek pending shipment. The Company generally has the right to be reimbursed from clients for unused inventories. Client-owned inventories are not reflected in the Company's consolidated balance sheets. See Note 1 and 4 to the consolidated financial statements set forth herein for a further description of the Company's inventories. RESULTS OF OPERATIONS The following tables should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Form 10-K. The following table sets forth, for the periods indicated, certain consolidated statement of operations data expressed as a percentage of revenues: The following table sets forth certain unaudited pro forma consolidated statement of operations data, expressed in dollars and as a percentage of revenues for the year ended December 31, 1997 (dollars in thousands, except per share data) (a): - ------------------------------------ (a) The Company was an S corporation for federal and state income tax purposes from July 1, 1992 through June 17, 1997, and accordingly, was not subject to federal or state income taxes. The S corporation election was terminated on June 17, 1997 in contemplation of the Company's initial public offering. Since June 18, 1997, the Company has been a C corporation for federal and state income tax purposes. Pro forma net income: (i) reflects the elimination of management fee expense; and (ii) includes a provision for federal, state and foreign income taxes at an effective rate of 37.3% during the applicable S corporation period. Management fee expense was discontinued in connection with the initial public offering in June 1997. Pro forma presentation was not applicable for the years ended December 31, 1998 and 1999. 1999 Compared to 1998 Revenues. Revenues increased $64.2 million, or 45.6%, from $141.0 million in 1998 to $205.2 million in 1999. This increase was primarily from existing and new clients, partially offset by decreases in the volume of services provided to other existing clients. Also, management believes changes in the timing of the volume of services provided to the Company's clients due to year 2000 buying patterns contributed to the increase in revenues experienced by the Company during 1999. Cost of Services. Cost of services increased $51.8 million, or 45.0%, from $115.1 million in 1998 to $166.9 million in 1999. As a percentage of revenues, cost of services was 81.6% and 81.3% in 1998 and 1999, respectively. This percentage amount remained relatively consistent. Gross Profit. Due to the foregoing factors, gross profit increased $12.4 million in 1999, or 48.0%, from $25.9 million in 1998 to $38.3 million in 1999. As a percentage of revenues, gross profit was 18.4% and 18.7% in 1998 and 1999, respectively. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $5.6 million, or 38.2%, from $14.7 million in 1998 to $20.3 million in 1999, primarily as a result of increased personnel and related expansion costs incurred to service increasing business. As a percentage of revenues, selling, general and administrative expenses decreased from 10.4% in 1998 to 9.9% in 1999. Operating Profit. As a result of the foregoing factors, operating profit increased from $11.2 million in 1998 to $18.0 million in 1999. As a percentage of revenues, operating profit increased from 8.0% in 1998 to 8.8% in 1999. Net Interest Income and Other. Net interest income and other was $2.3 million in 1998 and $2.8 million in 1999. The majority of net interest income and other continues to be derived from cash equivalents and investment balances, partially offset by interest expense incurred as a result of the Company's various debt and lease arrangements. Income Before Income Taxes. As a result of the foregoing factors, income before income taxes increased $7.4 million, or 54.9%, from $13.4 million in 1998 to $20.8 million in 1999. As a percentage of revenues, income before income taxes increased from 9.6% in 1998 to 10.2% in 1999. Income Tax Expense. Income tax expense for 1998 and 1999 reflects a provision for federal, state, and foreign income taxes at an effective rate of 36.5% and 37.5%, respectively. Net Income. Based on the factors discussed above, net income increased $4.5 million, or 52.4%, from $8.5 million in 1998 to $13.0 million in 1999. 1998 Compared to 1997 Revenues. Revenues increased $51.8 million, or 58.1%, from $89.2 million for 1997 to $141.0 million for 1998. This increase was primarily due to an increase in the volume of services provided to one of the Company's principal clients, together with certain existing and new clients, partially offset by decreases in the volume of services provided to other existing clients. Cost of Services. Cost of services increased $43.2 million, or 59.9%, from $71.9 million for 1997 to $115.1 million for 1998. As a percentage of revenues, costs of services increased from 80.7% for 1997 to 81.6% for 1998. This percentage increase was primarily due to higher overall costs of certain business for a principal client at lower relative margins, mix of services performed and training and start-up expenses related to the new Greeley, Colorado, Laramie, Wyoming and Clarksville, Tennessee facilities, all of which became operational during 1998. Gross Profit. Due to the foregoing factors, gross profit increased $8.7 million, or 50.9%, from $17.2 million for 1997 to $25.9 million for 1998. As a percentage of revenues, gross profit decreased from 19.3% for 1997 to 18.4% for 1998. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $6.0 million, or 69.1%, from $8.7 million for 1997 to $14.7 million for 1998, primarily as a result of increased personnel costs incurred to service increasing business and costs associated with capacity expansion. As a percentage of revenues, selling, general and administrative expenses increased from 9.8% for 1997 to 10.4% for 1998. Management Fee Expense. Management fee expense was $3.1 million for 1997 and zero for 1998. Effective with the closing of the Company's initial public offering in June 1997, management fees were discontinued. Operating Profit. As a result of the foregoing factors, operating profit increased from $5.3 million for 1997 to $11.2 million for 1998. As a percentage of revenues, operating profit increased from 6.0% for 1997 to 8.0% for 1998. Net Interest Income and Other. Net interest income and other was $0.9 million for 1997 and $2.3 million for 1998. This increase was primarily a result of an increase in interest income derived from cash equivalents and investments available for sale balances during 1998, whereas there were line of credit and substantially more capital lease borrowings outstanding during the first half of 1997, substantially all of which were repaid from the net proceeds received by the Company from its June 1997 initial public offering. Income Before Income Taxes. As a result of the foregoing factors, income before income taxes increased $7.1 million, or 114.5%, from $6.3 million for 1997 to $13.4 million for 1998. As a percentage of revenues, income before income taxes increased from 7.0% for 1997 to 9.6% for 1998. Income Tax Expense. The Company was taxed as an S corporation for federal and state income tax purposes from July 1, 1992 through June 17, 1997, when S corporation status was terminated in contemplation of the Company's initial public offering. Accordingly, the Company was not subject to federal or state income taxes prior to June 17, 1997. During 1997, a provision for income taxes as a C corporation was made for the period June 18, 1997 through December 31, 1997 as adjusted for a foreign tax benefit item, less a one-time credit to record a net deferred tax asset of $0.3 million upon termination of S corporation status. Income tax expense for 1998 reflects a provision for federal, state and foreign income taxes at an effective rate of 36.5%. Net Income. Based on the factors discussed above, net income increased $4.3 million, or 105.5%, from $4.2 million for 1997 to $8.5 million for 1998. As a percentage of revenues, net income increased from 4.7% for 1997 to 6.1% for 1998. Pro Forma Management Fee Expense; Pro Forma Operating Profit; Pro Forma Income Before Income Taxes; Pro Forma Income Tax Expense and Pro Forma Net Income for 1997 compared to actual results for 1998. Pro forma amounts for 1997 reflect the elimination of management fees and bonuses to stockholders and their affiliates as these fees and bonuses were discontinued upon the closing of the Company's June 1997 initial public offering, and provide for related income taxes at 37.3% of pre-tax income as if the Company were taxed as a C corporation for the entire year of 1997. Pro forma presentation was not applicable to 1998. As a result of the foregoing factors: (i) pro forma management fee expense is zero for 1997 and actual management fee expense is zero for 1998; (ii) pro forma operating profit was $8.5 million for 1997 compared to actual operating profit of $11.2 million for 1998, while such operating profit represented 9.5% and 8.0% of revenues, respectively; (iii) income before income taxes increased $4.0 million, or 43.1%, from a pro forma amount of $9.4 million for 1997 to an actual amount of $13.4 million for 1998; (iv) income tax expense increased $1.4 million, or 39.9%, from a pro forma amount of $3.5 million for 1997 to an actual amount of $4.9 million for 1998; and (v) net income increased $2.6 million, or 45.1%, from a pro forma amount of $5.9 million for 1997 to an actual amount of $8.5 million for 1998. LIQUIDITY AND CAPITAL RESOURCES In June 1997, the Company completed an initial public offering of its common stock, which yielded net proceeds to the Company of approximately $41.0 million. The Company applied such proceeds to repay substantially all of its then outstanding debt, and for working capital and other general corporate purposes, including capital expenditures to expand its operating capacity. Since fully applying the net proceeds received from its June 1997 initial public offering, the Company has primarily financed its operations, liquidity requirements, capital expenditures, and capacity expansion through cash flows from operations and, to a lesser degree, through various forms of debt financing and leasing arrangements. The Company has a $5.0 million line of credit with Norwest Bank Colorado, N.A. (the "Bank"), which matures on April 30, 2001. Borrowings under the line of credit bear interest at the Bank's prime rate (8.5% as of December 31, 1999). Under this line of credit, the Company is required to maintain working capital of $17.5 million and tangible net worth of $25.0 million. The Company may not pay dividends in an amount which would cause a failure to meet these financial covenants. As of December 31, 1999 and the date of this Form 10-K, the Company was in compliance with these financial covenants. Collateral for the line of credit is trade accounts receivable of certain of the Company's wholly owned subsidiaries. As of December 31, 1999 and the date of this Form 10-K, no amount was outstanding under the $5.0 million line of credit. On October 26, 1998, the Company, through its wholly owned subsidiary StarTek USA, Inc., entered into an equipment loan agreement with a finance company maturing November 2, 2002. In connection with the equipment loan, the Company received cash of $3.6 million in exchange for providing, among other things, certain collateral, which generally consisted of equipment, furniture, and fixtures used in the Company's business. The equipment loan provides for interest at a fixed annual rate of interest of 7.0% and for the Company to pay forty-eight equal monthly installments, which, in the aggregate, totaled approximately $4.2 million at inception of the equipment loan. In addition to the collateral described above, the Company granted to the finance company a secondary security interest in certain of its wholly owned subsidiaries' account receivable. On February 16, 1999, the Company entered into a lease agreement for 46,350 square feet of building space in Grand Junction, Colorado. The facility is used for a call center, general office use, and other services offered by the Company (the "Grand Junction Facility"). The term of the lease agreement commenced on May 1, 1999 and unless earlier terminated or extended, continues until April 30, 2009. Pursuant to the terms of the lease agreement, the Company was granted, among other things: (i) a right of first refusal to purchase the property, of which the leased space is a part, during the lease term; and (ii) a right to terminate the lease agreement anytime after the end of the fifth year, by giving the landlord 180 day prior written notice to terminate. Assuming the lease agreement is not terminated after the end of the fifth year, total minimum rental commitments, in the aggregate, excluding certain taxes and utilities as defined, are approximately $1.1 million and are payable on a monthly basis from May 1999 through April 2009. On July 16, 1999, the Company entered into a lease agreement for an additional 20,000 square feet of building space in Hartlepool, England, to be used for the continuing operations of StarTek Europe, Ltd. (a wholly owned subsidiary of the Company). The term of the lease agreement commenced on May 1, 1998 and unless earlier terminated, extended, or otherwise revised, continues until April 30, 2013. If the Company and the landlord do not complete a new lease agreement for additional premises, as defined, the Company was granted the right to terminate the lease agreement on May 1, 2003 by giving the landlord at least six months written notice to terminate. Additionally, if a new lease agreement for additional premises, as defined, is consummated, the Company was granted the right to terminate the lease agreement on May 1, 2008 by giving the landlord at least six months written notice to terminate. Pursuant to the terms of the lease agreement, the Company was granted an option, which commences on May 1, 2008 and expires on July 31, 2008, to purchase the leased property at market value as determined at such time. The lease agreement provides for quarterly lease payments which, in the aggregate for the periods described, are: 106,000 British Pounds from May 1, 1998 through April 30, 1999, all of which the Company has paid; 584,000 British Pounds from May 1, 1999 through April 30, 2003, a portion of which the Company has paid pursuant to the quarterly lease payment schedule provided for in the lease agreement; and 1,095,000 British Pounds from May 1, 2003 through April 30, 2008. Quarterly lease payments from May 1, 2008 through April 30, 2013 will equal lease payments as agreed to between the landlord and the Company, or by formula in the absence of such an agreement. Effective September 15, 1999, the Company, through its wholly owned subsidiary Domain.com, Inc. ("Domain.com"), entered into a contribution agreement (the "Contribution Agreement") and stockholders agreement with The Reader's Digest Association, Inc. ("Reader's Digest") and Good Catalog Company, previously a wholly owned subsidiary of Reader's Digest. On November 8, 1999, pursuant to the Contribution Agreement, Domain.com purchased 19.9% of the outstanding common stock of Good Catalog Company for approximately $2.6 million in cash. Reader's Digest owns the remaining 80.1% of the outstanding common stock of Good Catalog Company. The Contribution Agreement provides for: (i) an assignment from Domain.com to Good Catalog Company of Domain.com's right, title, and interest in and to the URL www.gifts.com; and (ii) an undertaking by Good Catalog Company to effect a change in its name to Gifts.com, Inc. Domain.com has the right to designate at least one member of Good Catalog Company's board of directors, which will consist of at least five directors. Effective November 1, 1999, Domain.com, Reader's Digest, and Good Catalog Company entered into a loan agreement pursuant to which Domain.com advanced an unsecured loan of $7.8 million and Reader's Digest advanced an unsecured loan of $18.4 million to Good Catalog Company ( the "Loans"). The Loans mature November 1, 2002, bear interest at a rate equal to a three month LIBO rate plus 2.0% per annum, and interest is payable quarterly. Currently, Good Catalog Company, doing business as gifts.com, provides an Internet web site accessed through the URL www.gifts.com that sells gifts on-line. The Company agreed to perform certain fulfillment services for Good Catalog Company in connection with certain products and services to be sold in connection with gifts.com. On October 14, 1999, the Company purchased an 88,000 square-foot building in Greeley, Colorado for $4.2 million in cash. The building is used for certain executive and other offices, E-commerce support operations, and telecommunications provisioning management business. On October 22, 1999, the Company, through its wholly owned subsidiary StarTek USA, Inc., completed an equipment loan arrangement with a finance company maturing October 22, 2003. In connection with the equipment loan, the Company received cash of $2.0 million in exchange for providing, among other things, certain collateral which generally consisted of computer hardware and software, various forms of telecommunications equipment, and furniture and fixtures whose estimated cost was equal to the principal amount of the equipment loan. The equipment loan arrangement provides for interest at the prime rate minus 1.60% (6.9% as of December 31, 1999), and forty-eight consecutive monthly payments. StarTek USA, Inc. is required, from time to time, to maintain certain operating ratios. As of December 31, 1999 and the date of this Form 10-K, StarTek USA, Inc. was in compliance with these financial covenants. On November 1, 1999, the Company entered into a lease agreement for 30,000 square feet of building space in Big Spring, Texas. The facility is principally used for a call center supporting Internet and telecommunications clients, and for general office use and other services offered by the Company. The term of the lease agreement commenced on November 1, 1999 and unless earlier terminated or extended, continues until November 1, 2014. Pursuant to the terms of the lease agreement, the Company was granted, among other things: (i) a right to terminate the lease agreement in the fifth or tenth year. Assuming the lease agreement is not terminated after the end of the fifth or tenth year, total minimum rental commitments, in the aggregate, excluding certain taxes and utilities as defined, are approximately $0.9 million, and are payable on a monthly basis from November 1999 through November 2014. Pursuant to an incentive agreement and through the tenth year of the lease agreement, the Company shall be reimbursed for the actual amount of its lease payments. In November 1999, the Company received $2.3 million in cash in connection with its Big Spring, Texas operations through a non-interest bearing fifteen-year promissory note. The principal balance of the promissory note declines without payment over fifteen years based on the level of employment at the Company's Big Spring, Texas facility during the term of the promissory note. As of December 31, 1999, the Company had cash, cash equivalents, and investment balances of $35.9 million, working capital of $40.2, and stockholders' equity of $71.0 million. Investments available for sale primarily consisted of corporate bonds, foreign government bonds denominated in U.S. dollars, bond mutual funds, real estate investment trusts, equity mutual funds, and publicly traded common stock of U.S. based companies. Trading securities generally consisted of publicly traded common stock of U.S. based companies, and international equity mutual funds, together with certain hedging securities, and various forms of derivative securities. StarTek's cash and cash equivalents are not restricted. The Company's investments available for sale and trading securities could be materially and adversely affected by: (i) various domestic and foreign economic conditions, such as recession, increasing interest rates, adverse foreign currency exchange fluctuations, foreign and domestic inflation, and other factors; (ii) the inability of certain corporations to repay their debts, including interest amounts, to the Company; and (iii) changes in market price of common stocks, international equity mutual funds, hedging securities, and other derivative securities held by the Company due to the level of trading in such securities, and other risks generally attributable to U.S. based publicly traded companies. See "Quantitative and Qualitative Disclosure About Market Risk" set forth herein for further discussions regarding the Company's cash, cash equivalents, investments available for sale, and trading securities. Net cash provided by operating activities increased from $13.1 million in 1998 to $15.8 million in 1999. This increase was primarily a result of increases in net income, accrued and other liabilities, depreciation and amortization expense, and income taxes payable. The positive effects of the foregoing were partially offset by increases in net deferred tax assets, net purchases of trading securities, net trade accounts receivable, inventories, and prepaid expenses and other assets; and decreases in accounts payable. Microsoft Corporation ("Microsoft") accounted for approximately 77.5% of the Company's revenues in 1999. Correspondingly, the Company's cash flows from operating activities were in the past and presently continue to be substantially dependent upon its Microsoft related process management services operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"--"Factors That May Affect Future Results" set forth herein for a further discussion of the Company's "Reliance on Principal Client Relationship" and "Risks Associated with the Company's Contracts". Net cash used in investing activities was $24.2 million in 1998 and $28.9 million in 1999. This increase was primarily due to $2.6 million and $7.8 million paid to Good Catalog Company in exchange for a 19.9% equity interest in and a note receivable from Good Catalog Company, respectively. The effects of the foregoing were partially offset by decreases, in the aggregate of $5.7 million, related to net purchases of property, plant, and equipment and net purchases of investments available for sale. Net cash provided by financing activities was $3.6 million in 1998, which primarily consisted of $3.7 million of net proceeds received from an October 1998 equipment loan and other borrowings, partially offset by approximately $0.1 million of principal payments for the October 1998 equipment loan and various capital lease obligations. Net cash provided by financing activities was $5.6 million in 1999, which primarily consisted of $2.4 million of proceeds received from exercises of employee stock options and $4.3 million of proceeds received from borrowing arrangements entered into during 1999, partially offset by $1.1 million of principal payments on borrowings and capital lease obligations. The effect of currency exchange rate changes on the translation of the Company's United Kingdom and Singapore operations was not substantial during 1999. The terms of the Company's agreements with its clients and its subcontracts are typically in U.S. dollars except for certain of its agreements related to its United Kingdom and Singapore operations. If the international portion of the Company's business continues to grow, more revenues and expenses will be denominated in foreign currencies, and this will increase the Company's exposure to fluctuations in currency exchange rates. See "Quantitative and Qualitative Disclosure About Market Risk" set forth herein for a further discussion of the Company's exposure to foreign currency exchange risks in connection with certain of its investments. Management believes the Company's current cash, cash equivalents, investments, anticipated cash flows from future operations, and $5.0 million of currently available financing under its line of credit, will be sufficient to support its operations, capital expenditures, and various repayment obligations under its debt and lease agreements for the foreseeable future. However, liquidity and capital requirements depend on many factors, including, but not limited to, the Company's ability to retain or successfully and timely replace its principal client and the rate at which the Company expands its business, whether internally or through acquisitions and strategic alliances. To the extent funds generated from sources described above are insufficient to fund the Company's activities in the short or long-term, the Company will be required to raise additional funds through public or private financing. No assurance can be given that additional financing will be available, or that if available, it will be available on terms favorable to the Company. QUARTERLY RESULTS Note 17 to the consolidated financial statements set forth herein reflects certain unaudited statement of operations data for the quarters in 1998 and 1999. Unaudited quarterly information has been prepared on the same basis as annual information and, in management's opinion, includes all adjustments necessary to present fairly information for quarters presented. See "Management's Discussion and Analysis of Financial Condition and Results of Operations"-- "Factors That May Affect Future Results"--"Variability of Quarterly Operating Results" set forth herein for a further discussion of the Company's quarterly results. For quarterly periods in 1998 and 1999, revenues, cost of services and gross profits fluctuated principally due to the seasonal pattern of certain of the businesses served by the Company and an increase in the volume of services provided to the Company's principal client, together with certain existing and new clients, partially offset by decreases in the volume of services provided to other existing clients. Revenues, cost of services, and gross profit from the fourth quarter of 1998 to the first quarter of 1999 declined principally due to the seasonal pattern of certain businesses served by the Company. Also, management believes changes in the timing of the volume of services provided to the Company's clients due to year 2000 buying patterns contributed to the increase in revenues experienced by the Company in the third quarter of 1999 by accelerating significant revenues into the third quarter of 1999 revenues that may have otherwise occurred in the fourth quarter of 1999 and potentially the first quarter of 2000. The following table sets forth certain unaudited statement of operations data, expressed as a percentage of revenues: Gross profit as a percentage of revenues, remained relatively constant from the fourth quarter of 1998 to the first quarter of 1999, and for each of the comparative quarters between 1998 and 1999 as a substantial portion of the Company's revenues continued to be derived from the Company's principal client and the terms of the Company's arrangements with its principal client have also, in large part, remained constant. For the quarterly periods in 1998 and 1999, selling, general and administrative expenses fluctuated principally due to personnel and related expansion costs incurred to service increasing business. Additionally, for the quarterly periods in 1998 and 1999, selling, general and administrative expenses fluctuated partially due to the spreading of fixed and semi-variable costs over a revenue base that fluctuates from quarter to quarter. Operating profit fluctuated within the quarterly periods of 1998 and 1999 based primarily on the factors noted above. Net income also fluctuated within the quarterly periods in 1998 and 1999 based primarily on the factors noted above, and based on an increase in net interest income and other derived from the Company's cash equivalents and investments in 1999 partially offset by a provision for income taxes in 1999 of 37.5%. INFLUENCE OF YEAR 2000 In 1999, management discussed the nature and progress of StarTek's plans to become Year 2000 ready. In late 1999, management believed the Company completed its remediation and testing of certain systems. Because of those planning and implementation efforts, management believes: (i) the Company experienced no significant disruptions in mission critical information technology and non-information technology systems; and (ii) those systems successfully responded to the Year 2000 date change. The Company expensed approximately $150,000 related to remediating its systems. Management is not aware of any substantial problems, resulting from Year 2000 issues, with StarTek's services, internal systems, or products and services of third parties. Management plans to continue to monitor StarTek's mission critical computer applications and those of its important suppliers throughout 2000 in an effort to insure StarTek addresses any latent Year 2000 problems responsively. Management does not anticipate incurring any material costs related to its ongoing monitoring of Year 2000 issues. INFLATION AND GENERAL ECONOMIC CONDITIONS Although the Company cannot accurately anticipate the effect of domestic and foreign inflation on its operations, the Company does not believe inflation has had, or is likely in the foreseeable future to have, a material adverse effect on its results of operations or financial condition. FACTORS THAT MAY AFFECT FUTURE RESULTS Reliance on Principal Client Relationship Microsoft Corporation ("Microsoft") accounted for approximately 77.5% of the Company's revenues in 1999. Loss of Microsoft as a client would have a material adverse effect on the Company's business, results of operations, and financial condition. The Company provides various outsourced services to various divisions of Microsoft, which began its outsourcing relationship with the Company in April 1996. There can be no assurance the Company will be able to retain Microsoft as a client or, if it were to lose Microsoft as a client, it would be able to timely replace Microsoft with clients which generate a comparable amount of revenues. Additionally, the amount and growth rate of revenues derived from the Microsoft relationship in the past is not necessarily indicative of revenues that may be expected from Microsoft in the future. Variability of Quarterly Operating Results The Company's business is highly seasonal and is at times conducted in support of product launches for new and existing clients. Historically, the Company's revenues have been substantially lower in the quarters preceding the fourth quarter due to timing of its clients' marketing programs and product launches, which are typically geared toward the holiday buying season. Additionally, the Company has experienced, and expects to continue to experience, quarterly variations in operating results as a result of a variety of factors, many of which are outside the Company's control, including: (i) timing of existing and future client product launches; (ii) expiration or termination of existing client projects; (iii) timing and amount of costs incurred to expand capacity in order to provide for further revenue growth from current and future clients; (iv) seasonal nature of certain clients' businesses; (v) cyclical nature of certain high technology clients' businesses; and (vi) changes in the amount and growth rate of revenues generated from the Company's principal client. Difficulties in Managing Business Undergoing Rapid Growth StarTek has experienced rapid growth over the past several years and anticipates continued future growth. Continued growth depends on a number of factors, including the Company's ability to: (i) initiate, develop, and maintain new and existing client relationships, particularly relationships with its principal client; (ii) expand its sales and marketing organization; (iii) recruit, motivate, and retain qualified management, customer support, and other personnel; (iv) rapidly expand capacity of its existing facilities or identify, acquire or lease suitable additional facilities on acceptable terms and complete build-outs of such facilities in a timely and economic fashion; (v) provide high quality services to its clients; and (vi) maintain relationships with high-quality and reliable suppliers. Continued rapid growth can be expected to place significant strain upon the Company's management, employees, operations, operating and financial systems, and other resources. To accommodate such growth and to compete effectively, the Company must continue to implement and improve its information systems, procedures, and controls and expand, train, motivate, and manage its workforce. There can be no assurance the Company's personnel, systems, procedures, and controls will be adequate to support the Company's future operations. Further, there can be no assurance the Company will be able to maintain or accelerate its current growth, effectively manage its expanding operations, or achieve planned growth on a timely and profitable basis. If the Company is unable to manage growth effectively or if growth does not occur, its business, results of operations, and financial condition could be materially and adversely affected. Risks Associated with Rapidly Changing Technology Continued and substantial world-wide use and development of the Internet as a delivery system for computer software, hardware, computer games, other computer related products, and products in general could significantly and adversely affect demand for the Company's services. Additionally, the Company's success is significantly dependent on its computer equipment, telecommunications equipment, software systems, operating systems, and financial systems. There can be no assurance the Company will be able to timely and successfully develop and market any new services, such services will be commercially successful, or clients' and competitors' technologies or services will not render the Company's services obsolete. Furthermore, the Company's failure to successfully and timely implement sophisticated technology or to respond effectively to technological changes in general, would have a material adverse effect on the Company's success, growth prospects, results of operations, and financial condition. Dependence on Labor Force StarTek's success is largely dependent on its ability to recruit, hire, train, and retain qualified employees. The Company's business is labor intensive and continues to experience relatively high personnel turnover. The Company's operations, especially its technical support teleservices, generally require specially trained employees. Increases in the Company's employee turnover rate could increase the Company's recruiting and training costs and decrease its operating efficiency and productivity. Also, the addition of new clients or implementation of new projects for existing clients may require the Company to recruit, hire, and train personnel at accelerated rates. There can be no assurance the Company will be able to successfully recruit, hire, train, and retain sufficient qualified personnel to adequately staff for existing business or future growth. Additionally, since a substantial portion of the Company's operating expenses consist of labor related costs, continued labor shortages together with increases in wages (including minimum wages as mandated by the U.S. federal government, employee benefit costs, employment tax rates, and other labor related expenses) could have a material adverse effect on StarTek's business, operating profit, and financial condition. Furthermore, certain of StarTek's facilities are located in areas with relatively low unemployment rates and/or relatively high labor costs, thus potentially making it more difficult and costly to hire qualified personnel. Risks Associated with International Operations and Expansion StarTek currently conducts business in Europe and Asia, in addition to its North America operations. Such international operations accounted for approximately 24.0% of the Company's revenues for the year ended December 31, 1999. A component of the Company's growth strategy continues to be expansion of its international operations. There can be no assurance the Company will be able to continue or expand its capacity to market, sell, and deliver its services in international markets, or develop relationships with other businesses to expand its international operations. Additionally, there are certain risks inherent in conducting international business, including: (i) exposure to foreign currency fluctuations against the U.S. dollar; (ii) potentially longer working capital cycles; (iii) greater difficulties in collecting accounts receivable; (iv) difficulties in complying with a variety of foreign laws and foreign tax regulations; (v) unexpected changes in foreign government programs, policies, regulatory requirements and labor laws; (vi) difficulties in staffing and effectively managing foreign operations; and (vii) political instability and adverse tax consequences. There can be no assurance one or more of such factors will not have a material adverse effect on the Company's international operations and, consequently, on the Company's business, results of operations, growth prospects, and financial condition. Control by Principal Stockholders As of March 1, 2000, A. Emmet Stephenson, Jr., Chairman of the Board and co-founder of the Company, and his family beneficially own approximately 65.5% of the Company's outstanding common stock. As a result, Mr. Stephenson and his family will be able to elect the entire Board of Directors of the Company and to control substantially all other matters requiring action by the Company's stockholders. Additionally, substantially all of the Company's revenues, operating expenses, and operating results in general are derived from the Company's wholly owned subsidiaries. Mr. Stephenson is the sole director for each of the Company's wholly owned subsidiaries. Such voting concentration may discourage, delay or prevent a change in control of the Company and its wholly owned subsidiaries. In connection with Domain.com, Inc.'s 19.9% equity interest in Good Catalog Company, Mr. Stephenson is also a director of Good Catalog Company. Previously, Good Catalog Company was a wholly owned subsidiary of The Reader's Digest Association, Inc. Domain.com, Inc. is a wholly owned subsidiary of StarTek, Inc. Currently, Good Catalog Company, doing business as gifts.com, sells gifts on-line through an Internet web site accessed through the URL www.gifts.com. Dependence on Key Personnel The Company's success to date has depended in part on the skills and efforts of Mr. Stephenson and Michael W. Morgan, President, Chief Executive Officer, Director, and co-founder of the Company. As of March 1, 2000, Mr. Stephenson and his family and Mr. Morgan beneficially own approximately 65.5% and 4.7% of the Company's outstanding common stock, respectively. Mr. Stephenson and Mr. Morgan have not entered into employment agreements with the Company and there can be no assurance the Company can retain the services of these individuals. The loss of either Mr. Stephenson, Mr. Morgan, or the Company's inability to hire and retain other qualified officers, directors and key employees, could have a material adverse effect on the Company's success, growth prospects, results of operations, and financial condition. Dependence on Key Industries and Trends Toward Outsourcing StarTek's current client base generally consists of companies engaged primarily in the computer software, computer hardware, Internet, E-commerce, technology, and telecommunications industries. The Company's business and growth is largely dependent on continued demand for its services from clients in these industries and industries targeted by the Company, and current trends in such industries to outsource various non-core functions which are offered on an outsourced basis by the Company. A general economic downturn in the computer industry or in other industries targeted by the Company, or a slowdown or reversal of the trend in these industries to outsource services provided by the Company could materially and adversely affect the Company's business, results of operations, growth prospects, and financial condition. Risks Associated with the Company's Contracts The Company typically enters into written agreements with each client for outsourced services, or performs services on a purchase order basis. Under substantially all of the Company's significant arrangements with its clients, including its principal client, the Company typically generates revenues based on the number and duration of customer inquiries, and volume, complexity, and type of components involved in its clients' products. Consequently, the amount of revenues generated from any particular client is generally dependent upon customers' purchase and use of StarTek's clients' products. There can be no assurance as to the number of customers who will be attracted to the products of the Company's clients or the Company's clients will continue to develop new products that will require the Company's services. Although the Company currently seeks to sign multi-year contracts with its clients, the Company's contracts generally: (i) permit termination upon relatively short notice by its clients; (ii) do not designate the Company as its clients' exclusive outsourcing service provider; (iii) do not penalize its clients for early termination, and; (iv) generally hold the Company responsible for work performed which does not meet certain pre-defined specifications. To the extent the Company works on a purchase order basis, agreements with its clients frequently do not provide for minimum purchase requirements, except in connection with certain of its technical support services. Substantially all of the Company's contracts require the Company, through its wholly owned subsidiaries and for certain of its facilities and services, to maintain ISO 9002 certification. Highly Competitive Markets The markets in which StarTek operates are highly competitive. Management expects competition to persist and intensify in the future. The Company's competitors include small firms offering specific applications, divisions of large companies, large independent firms and, most significantly, in-house operations of StarTek's existing and potential clients. A number of competitors have or may develop financial and other resources greater than those of the Company. Similarly, there can be no assurance additional competitors with greater name recognition and resources than the Company will not enter the markets in which the Company operates. In-house operations of the Company's existing and potential clients are significant competitors of the Company. As a result, StarTek's performance and growth could be materially and adversely affected if its clients decide to provide in-house services currently outsourced, or if potential clients retain or increase their in-house capabilities. Moreover, a decision by its principal client to consolidate its outsourced services with a company other than StarTek would materially and adversely affect the Company's business. Additionally, competitive pressures from current or future competitors could result in substantial price erosion, which could materially and adversely affect the Company's business, results of operations, and financial condition. Risks of Business Interruptions StarTek's operations depend on its ability to protect its facilities, clients' products, confidential client information, computer equipment, telecommunications equipment, and software systems against damage from Internet interruption, fire, power-loss, telecommunications interruption, E-commerce interruption, natural disaster, theft, unauthorized intrusion, computer viruses, other emergencies, and ability of its suppliers to deliver component parts quickly. While the Company maintains certain procedures and contingency plans to minimize the detrimental impact of such events, there can be no assurance such procedures and plans will be successful. In the event the Company experiences temporary or permanent interruptions or other emergencies at one or more of its facilities, the Company's business could be materially and adversely affected and the Company may be required to pay contractual damages to its clients, or allow its clients to terminate or renegotiate their arrangements with the Company. While the Company maintains property and business interruption insurance, such insurance may not adequately and/or timely compensate the Company for all losses it may incur. Further, some of the Company's operations, including telecommunication systems and telecommunication networks, and the Company's ability to timely and consistently access and use 24 hours per day, seven days per week, telephone, Internet, E-commerce, E-mail, facsimile connections, and other forms of communication are substantially dependent upon telephone companies, Internet service providers, T1 lines, etc. If such communications are interrupted on a short or long-term basis, the Company's services would be similarly interrupted and delayed. Volatility of Stock Price The market price of StarTek's common stock may be highly volatile and could be subject to wide fluctuations in response to quarterly variations in operating results, the success of the Company in implementing its business and growth strategies, announcements of new contracts or contract cancellations, announcements of technological innovations or new products and services by the Company or its competitors, changes in financial estimates by securities analysts, or other events or factors. Additionally, the stock market has experienced substantial price and volume fluctuations that have particularly affected the market prices of equity securities of many companies, and that have often been unrelated to the operating performance of such companies. These broad market fluctuations may adversely affect the market price of StarTek's common stock. Additionally, since approximately 29.8% of StarTek's outstanding common stock is currently available to the public for trading, any change in demand for such shares can be expected to substantially influence market prices of StarTek's outstanding common stock. Risks related to Investment in and Note Receivable from Good Catalog Company, doing business as gifts.com Through its wholly owned subsidiary Domain.com, Inc., the Company's investment in and note receivable from Good Catalog Company, doing business as gifts.com, of approximately $10.4 million, in the aggregate, involves a high degree of risk. The business of gifts.com is difficult to evaluate because it has a limited operating history under its current business model. Good Catalog Company was a wholly owned subsidiary of The Reader's Digest Association, Inc. Gifts.com's current management team and its current web site were both formed in late 1999. Accordingly, an investor in the Company's common stock must consider the challenges, risks, and uncertainties frequently encountered by early stage companies using new and unproven business models in new and rapidly evolving markets. These challenges influencing gifts.com's ability to substantially increase its revenues and thereby achieve profitability, include gifts.com's ability to: (i) execute on its business model; (ii) increase brand recognition; (iii) manage growth in its operations; (iv) cost-effectively attract and retain a high volume of online customers and build a critical mass of repeat customers at a reasonable cost; (v) effectively manage, control, and account for inventory; (vi) upgrade and enhance its web site, transaction-processing systems, order fulfillment capabilities, and inventory management systems; (vii) increase awareness of its online store; (viii) establish pricing to meet customer expectations; (ix) compete effectively in its market; (x) adapt to rapid regulatory and technological changes related to E-commerce and the Internet; and (xi) protect its trademarks, service marks, and copyrights. These and other uncertainties generally attributable to businesses engaging in E-commerce and the Internet must be considered when evaluating the Company's investment in and note receivable from Good Catalog Company, and the Company's participation in the business of gifts.com. An impairment of the Company's investment in and note receivable from Good Catalog Company could have an adverse effect on the Company's results of operations and financial condition. Risks related to the Company's Internet web site operations Through its wholly owned subsidiary Domain.com, Inc., the Company's Internet web site operations involve a high degree of risk. The businesses of airlines.com and wedding.com, for example, are difficult to evaluate because each are early stage and have a limited operating history. Accordingly, an investor in the Company's common stock must consider the challenges, risks, and uncertainties frequently encountered by early stage companies using new and unproven business models in new and rapidly evolving markets. These challenges influencing, for example, airlines.com's and wedding.com's ability to substantially increase revenues and thereby achieve profitability, include the ability to: (i) execute on business models; (ii) increase brand recognition; (iii) manage growth in operations; (iv) cost-effectively attract and retain a high volume of online customers and build a critical mass of repeat customers at a reasonable cost; (v) upgrade and enhance web sites, transaction-processing systems, and order fulfillment capabilities; (vi) increase awareness of online offerings; (vii) establish pricing to meet customer expectations; (viii) compete effectively; (ix) adapt to rapid regulatory and technological changes related to E-commerce and the Internet; and (x) protect trademarks, service marks, and copyrights. These and other uncertainties generally attributable to businesses engaging in E-commerce and the Internet must be considered when evaluating prospects of the Company's Internet web site operations. Risks related to the Company's portfolio of Internet domain names Through its wholly owned subsidiary Domain.com, Inc., the Company owns a portfolio of Internet domain names. The estimated fair market value of domain names owned by the Company is difficult to assess because the Company, to date, has had limited activity related to its Internet domain name portfolio. An investor in the Company's common stock must consider the challenges, risks, and uncertainties frequently encountered by early stage companies using new and unproven business models in new and rapidly evolving markets. These challenges influencing the Company's ability to benefit from its portfolio of Internet domain names include the Company's ability to: (i) execute on its business model; (ii) increase brand recognition of the Internet domain names within the Company's portfolio; and (iii) protect trademarks, service marks, and copyrights related to the domain names. These and other uncertainties generally attributable to businesses engaging in E-commerce and the Internet must be considered when evaluating the Company's portfolio of Internet domain names, and prospects of the Company's Internet web site operations anticipated to be developed from these domain names. ITEM 7a. ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The following discusses the Company's exposure to market risk related to changes in interest rates and other general market risks, equity market prices and other general market risks, and foreign currency exchange rates. All of the Company's investment decisions are supervised or managed by its Chairman of the Board. On May 19, 1999 and as amended on August 19, 1999, the Company's Board of Directors approved the Company's current investment portfolio policy which provides for, among other things, investment objectives and investment portfolio allocation guidelines. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors, including but not limited to, changes in interest rates and other general market risks, equity market prices and other general market risks, foreign currency exchange rates, and those set forth in the "Management's Discussion and Analysis of Financial Condition and Results of Operations"--"Factors That May Affect Future Results" appearing elsewhere in this Form 10-K. Also, see Note 1 and 3 to the consolidated financial statements set forth herein for a further discussion of the Company's cash, cash equivalents, and investments. Interest Rate Sensitivity and Other General Market Risks Cash and Cash Equivalents. As of December 31, 1999, the Company had $11.9 million in cash and cash equivalents, which was not restricted, and consisted of: (i) approximately $11.6 million invested in various money market funds, overnight investments, and various commercial paper securities at a combined weighted average interest rate of approximately 5.0%; and (ii) approximately $0.3 million in various non-interest bearing accounts. Management considers cash equivalents to be short-term, highly liquid investments readily convertible to known amounts of cash, and so near their maturity they present insignificant risk of changes in value because of changes in interest rates. The Company does not expect any material loss with respect to its cash and cash equivalents as a result of interest rate changes, and the estimated fair value of its cash and cash equivalents approximates original cost. Investments Available for Sale. As of December 31, 1999, the Company had investments available for sale, which, in the aggregate, had an original cost and fair market value of $23.7 million and $22.8 million, respectively. These investments available for sale generally consisted of corporate bonds, foreign government bonds denominated in U.S. dollars, bond mutual funds, and various forms of equity securities. The Company's investment portfolio is subject to interest rate risk and will fall in value if interest rates increase. Fair market value of and estimated cash flows from the Company's investments in corporate bonds are substantially dependent upon credit worthiness of certain corporations expected to repay their debts, including interest, as they become due, to the Company. If such corporations' financial condition and liquidity adversely changes, the Company's investments in their debts can be expected to be materially and adversely affected. The Company's investments in foreign government bonds denominated in U.S. dollars entail special risks of global investing. These risks include, but are not limited to: (i) currency exchange fluctuations which could adversely affect the ability of foreign governments to repay their debts in U.S. dollars; (ii) foreign government regulations; and (iii) the potential for political and economic instability. Fair market value of such investments in foreign government bonds (denominated in U.S. dollars) can be expected to be more volatile than that of U.S. government bonds. These risks are intensified for the Company's investments in debt of foreign governments located in countries generally considered to be emerging markets. The table below provides information about maturity dates and corresponding weighted average interest rates related to certain of the Company's investments available for sale as of December 31, 1999: Management believes the Company currently has the ability to hold these investments until maturity, and therefore, if held to maturity, the Company would not expect the future proceeds from these investments to be affected, to any significant degree, by the effect of a sudden change in market interest rates. Declines in interest rates over time will, however, reduce the Company's interest income derived from future investments. As of December 31, 1999 and as part of its investments available for sale portfolio, the Company was invested in: (i) various bond mutual funds which, in the aggregate, had an original cost and fair market value of approximately $2.0 million and $1.9 million, respectively; and (ii) equity securities which, in the aggregate, had an original cost and fair market value of approximately $3.8 million and $3.3 million, respectively. Debt securities within bond mutual funds as of December 31, 1999: (i) had a weighted average yield of approximately 11.8%, and a weighted average maturity of approximately 3.4 years; (ii) are primarily invested in investment grade bonds of U.S. and foreign issuers denominated in U.S. and foreign currencies, and interests in floating or variable rate senior collateralized loans to corporations, partnerships, and other entities in a variety of industries and geographic regions; (iii) include certain foreign currency risk hedging instruments which are intended to reduce fair market value fluctuations; (iv) are subject to interest rate risk and will fall in value if market interest rates increase; and (v) are subject to the quality of the underlying securities within the mutual funds. The Company's investments in bond mutual funds entail special risks of global investing, including, but not limited to: (i) currency exchange fluctuations; (ii) foreign government regulations; and (iii) the potential for political and economic instability. The fair market value of the Company's investments in bond mutual funds can be expected to be more volatile than that of a U.S.-only fund. These risks are intensified for certain investments in debt of foreign governments (included in bond mutual funds) which are located in countries generally considered to be emerging markets. Additionally, certain of the bond mutual fund investments are also subject to the effect of leverage, which in a declining market can be expected to result in a greater decrease in fair market value than if such investments were not leveraged. Outstanding Debt of the Company. As of December 31, 1999, the Company had outstanding debt of approximately $7.4 million, approximately $2.7 million of which bears interest at an annual fixed rate of 7.0%, and approximately $2.3 million of which bears no interest, as long as the Company complies with the terms of this debt arrangement. On October 22, 1999, the Company completed a $2.0 million equipment loan arrangement whereby the Company is expected to repay its debt at a variable rate of interest over a forty-eight month period. Management believes a hypothetical 10.0% increase in interest rates would not have a material adverse effect on the Company. Increases in interest rates could, however, increase interest expense associated with the Company's existing variable rate $2.0 million equipment loan and future borrowings by the Company, if any. For example, the Company may from time to time effect borrowings under its $5.0 million line of credit for general corporate purposes, including working capital requirements, capital expenditures and other purposes related to expansion of the Company's capacity. Borrowings under the $5.0 million line of credit bear interest at the lender's prime rate. As of December 31, 1999, the Company had no outstanding line of credit obligations. The Company has not hedged against interest rate changes. Equity Price Risk and Other General Market Risks Equity Securities. As of December 31, 1999, the Company held in its investments available for sale portfolio certain equity securities with original cost and fair market value, in the aggregate, of $3.8 million and $3.3 million, respectively. The Company's investments in equity securities consisted of real estate investment trusts, equity mutual funds, and publicly traded common stock of U.S. based companies. A substantial decline in the value of equity securities and equity prices in general would have a material adverse affect on the Company's equity investments. Also, the price of common stock held by the Company would be materially and adversely affected by poor management, shrinking product demand, and other risks that may affect single companies, as well as groups of companies. The Company has partially hedged against some equity price changes. Trading Securities. As of December 31, 1999, the Company was invested in trading securities which, in the aggregate, had an original cost and fair market value of approximately $1.4 million and $1.2 million, respectively. Trading securities consisted primarily of publicly traded common stock of U.S. based companies and international equity mutual funds, together with certain hedging securities and various forms of derivative securities. Trading securities were held to meet short-term investment objectives. The Company entered into hedging and derivative securities in an effort to maximize its return on investments in trading securities while managing risk. As part of trading securities and as of December 31, 1999, the Company was invested in securities sold short related to a total of 24,421 shares of U.S. equity securities which, in the aggregate, had a basis and estimated fair market value of approximately $1.8 million and $2.2 million, respectively, all of which were reported net as components of trading securities. These securities sold short were used in conjunction with and were substantially offset by other trading securities, which taken together, represented a risk arbitrage portfolio in U.S. equity securities. Management believes the risk of loss to the Company in the event of nonperformance by any party under these agreements is not substantial. Because of potential limited liquidity of some of these instruments, recorded values of these transactions may be different from values that might be realized if the Company were to sell or close out the transactions. Management believes such differences are not substantial to the Company's results of operations, financial condition, or liquidity. Hedging and derivative securities may involve elements of credit and market risk in excess of the amounts recognized in the accompanying consolidated financial statements. A substantial decline and/or change in value of equity securities, equity prices in general, international equity mutual funds, hedging securities, and derivative securities could have a material adverse effect on the Company's trading securities. Also, the price of common stock, hedging securities, and other derivative securities held by the Company as trading securities would be materially and adversely affected by poor management, shrinking product demand, and other risks that may affect single companies, as well as groups of companies. Foreign Currency Exchange Risk Approximately 17.3% of the Company's revenues in 1999 were derived from arrangements whereby the Company received payments from its clients in currencies other than U.S. dollars. Terms of the Company's agreements with its clients and its subcontracts are typically in U.S. dollars except for certain of its agreements related to its United Kingdom and Singapore operations. If an arrangement provides for the Company to receive payments in a foreign currency, revenues realized from such an arrangement may be less if the value of such foreign currency declines. Similarly, if an arrangement provides for the Company to make payments in a foreign currency, cost of services and operating expenses for such an arrangement may be more if the value of such foreign currency increases. For example, a 10% change in the relative value of such foreign currency could cause a related 10% change in the Company's previously expected revenues, cost of services, and operating expenses. If the international portion of the Company's business continues to grow, more revenues and expenses will be denominated in foreign currencies, and this will increase the Company's exposure to fluctuations in currency exchange rates. In the past, the Company has not hedged against foreign currency exchange rate changes related to its day to day operations in the United Kingdom and Singapore. Certain of the Company's investments classified as bond mutual funds (discussed in further detail above as part of "Interest Rate Sensitivity and Other General Market Risks") include investments in various forms of currency risk hedging instruments which are intended to reduce fair market value fluctuations of such mutual funds. ITEM 8. ITEM 8. FINANCIAL STATEMENT AND SUPPLEMENTARY FINANCIAL DATA Consolidated financial statements and supplementary data of the Company required by Item 8. are set forth herein at the pages indicated in Item 14(a). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEMS 10. THROUGH 13. Information required by Item 10. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Document List 1. Financial Statements Response to this portion of Item 14. is submitted per the Index to Financial Statements, Supplementary Data, and Financial Statement Schedules on page 25 of this Form 10-K. 2. Supplementary Data and Financial Statement Schedules Response to this portion of Item 14. is submitted per the Index to Financial Statements, Supplementary Data, and Financial Statement Schedules on page 25 of this Form 10-K. 3. An Index of Exhibits is on pages 44 and 45 of this Form 10-K. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Company during the three months ended December 31, 1999, except for: Current Report on Form 8-K relating to the Company's October 20, 1999 announcement of Mr. Thomas O. Ryder's resignation from the Company's board of directors in connection with the formation of the gifts.com business by Good Catalog Company. Good Catalog company is 19.9% owned by StarTek and 80.1% owned by The Reader's Digest Association, Inc. Mr. Ryder is Chairman and Chief Executive Officer of The Reader's Digest Association, Inc. Gifts.com provides an Internet web site accessed through the URL www.gifts.com that sells gifts on-line. STARTEK, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS, SUPPLEMENTARY DATA AND FINANCIAL STATEMENT SCHEDULES Note. All schedules have been included in the Consolidated Financial Statements or notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders StarTek, Inc. We have audited the accompanying consolidated balance sheets of StarTek, Inc. and subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of operations, cash flows and stockholders' equity for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of StarTek, Inc. and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Ernst & Young LLP Denver, Colorado February 11, 2000 STARTEK, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. STARTEK, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. STARTEK, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. STARTEK, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES StarTek, Inc.'s business was founded in 1987 and, through its wholly owned subsidiaries, has provided outsourced process management services since inception. On December 30, 1996, StarTek, Inc. (the "Company" or "StarTek") was incorporated in Delaware, and in June 1997 StarTek completed an initial public offering of its common stock. Prior to December 30, 1996, StarTek USA, Inc. and StarTek Europe, Ltd. conducted business as affiliates under common control. In 1998, the Company formed StarTek Pacific, Ltd., a Colorado corporation and Domain.com, Inc., a Delaware corporation, both of which are also wholly owned subsidiaries of the Company. StarTek, Inc. is a holding company for the businesses conducted by its wholly owned subsidiaries. The consolidated financial statements include accounts of all wholly owned subsidiaries after elimination of significant intercompany accounts and transactions. Business Operations StarTek has an established position as a global provider of process management services and owns and operates branded vertical market Internet web sites. The Company's process management services include E-commerce support and fulfillment, provisioning management for complex telecommunications systems, high-end inbound technical support, and a comprehensive offering of supply chain management services. As an outsourcer of process management services as its core business, StarTek allows its clients to focus on their primary business, reduce overhead, replace fixed costs with variable costs, and reduce working capital needs. The Company has continuously expanded its process management business and facilities to offer additional outsourcing services in response to growing needs of its clients and to capitalize on market opportunities, both domestically and internationally. The Company has process management operations in North America, Europe, and Asia. StarTek owns a portfolio of branded vertical market Internet web sites and operates certain sites, including airlines.com and wedding.com. In September 1999, StarTek and The Reader's Digest Association, Inc. entered into certain arrangements whereby StarTek obtained a 19.9% ownership interest in Good Catalog Company, doing business as gifts.com. Gifts.com provides an Internet web site accessed through the URL www.gifts.com that sells gifts on-line. StarTek expects to combine its process management service platforms with certain Internet web site businesses arising from a portfolio of Internet domain names to establish a solid position in the Internet connected world. The Company's investment in Good Catalog Company is carried at cost because the Company does not exercise significant influence over financial or operating policies of such company Capital Stock Immediately prior to the closing of the Company's initial public offering in June 1997, the Company declared a 322.1064-for-one stock split of the Company's common stock. All references in the notes to the consolidated financial statements to shares, related prices in per share calculations, per share amounts, and stock option plan information have been restated to reflect the split. Foreign Currency Translation Assets and liabilities of the Company's foreign operations are translated into U.S. dollars at current exchange rates. Revenues and expenses are translated at average monthly exchange rates. Resulting translation adjustments, net of applicable deferred income taxes (1997 tax benefit of $42, 1998 tax of $53, and 1999 tax of $15), are reported as a separate component of stockholders' equity. Foreign currency transaction gains and losses are included in determining net income. Such gains and losses were not material for any period presented. Comprehensive Income Financial Accounting Standards Board Statement No. 130, "Reporting Comprehensive Income", establishes rules for the reporting and display of comprehensive income. Comprehensive income is defined essentially as all changes in stockholders' equity, exclusive of transactions with owners. Comprehensive income was $4,007, $8,127, and $12,891 for 1997, 1998, and 1999, respectively. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the Company's management to make estimates and assumptions that affect amounts reported in the Company's consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Reclassifications Certain reclassifications of the 1997 and 1998 consolidated financial statements and related notes have been made to conform to the 1999 presentation. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Revenue Recognition Revenues are recognized as services are completed. Training Training costs pertaining to start-up and ongoing projects are expensed during the year incurred. Fair Value of Financial Instruments Financial instruments consist of cash and cash equivalents, investments, accounts receivable, accounts payable, notes receivable, debt, and capital lease obligations. Carrying values of cash and cash equivalents, accounts receivable, and accounts payable approximate fair value. Investments are reported at fair value. Management believes differences between fair values and carrying values of notes receivable, debt, and capital lease obligations would not be materially different because interest rates approximate market rates for material items. Cash and Cash Equivalents The Company considers cash equivalents to be short-term, highly liquid investments readily convertible to known amounts of cash and so near their maturity they present insignificant risk of changes in value because of changes in interest rates. Investments Investments available for sale consist of debt and equity securities reported at fair value, with unrealized gains and losses, net of tax (tax benefits of $56, $356, and $360 for 1997, 1998, and 1999, respectively) reported as a separate component of stockholders' equity. There have been no unrealized gains and losses or declines in value judged to be other than temporary on investments available for sale. Original cost of investments available for sale, which are sold, is based on the specific identification method. Interest income from investments available for sale is included in net interest income and other. Trading securities are carried at fair market values. Fair market values are determined by the most recently traded price of the security as of the balance sheet date. Gross unrealized gains and losses from trading securities are reflected in income currently and as part of net interest income and other. Derivative Instruments and Hedging Activities In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, ("SFAS No. 133") "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards requiring every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at fair value. SFAS No. 133 requires changes in the derivative's fair value be recognized currently in income unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allow a derivative's gains and losses to offset related results on the hedged item in the statement of operations, and requires a company to formally document, designate, and assess effectiveness of transactions that receive hedge accounting treatment. SFAS No. 133 is effective for the Company's fiscal quarters of fiscal years beginning after June 15, 2000. The Company has not yet quantified the impacts of adopting SFAS No. 133 on its consolidated financial statements and has not determined timing or method of adoption of SFAS No. 133. Inventories Inventories are valued at average costs that approximate actual costs computed on a first-in, first-out basis, not in excess of market value. Investment in Good Catalog Company, at cost Equity investments of less than 20% in non-publicly traded companies are carried at cost. Changes in value of these investments are not recognized unless impairment in value is deemed to be other than temporary. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Property, Plant and Equipment Property, plant, and equipment are stated at cost. Additions, improvements, and major renewals are capitalized. Maintenance, repairs, and minor renewals are expensed as incurred. Depreciation and amortization is computed using the straight-line method based on: Estimated Useful Lives ---------------------------- Buildings and improvements 7 to 30.5 years Equipment 3 to 5 years Furniture and fixtures 7 years Income Taxes Effective July 1, 1992, StarTek USA, Inc. elected Subchapter S status for income tax purposes, and StarTek Europe, Ltd. elected Subchapter S status at inception. On June 17, 1997, Subchapter S status was terminated and the Company has thereafter been taxable as a C corporation. During the Subchapter S status period, income and expenses of the Company were reportable on tax returns of stockholders and no provision was made for federal, state, and foreign income taxes. Subsequent to termination of the Company's Subchapter S status, the Company began accounting for income taxes using the liability method of accounting for income taxes as prescribed by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". Deferred income taxes reflect net effects of temporary differences between carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. The Company is subject to foreign income taxes on its foreign operations. Management Fee Expense Prior to the Company's June 24, 1997 initial public offering, and in addition to general compensation for services rendered, certain S corporation stockholders and an affiliate were paid certain management fees, bonuses, and other fees in connection with services rendered to the Company, which were not included in selling, general and administrative expenses. These management fees have been reflected as management fee expense as set forth below. Effective with the closing of the Company's June 24, 1997 initial public offering, these management fees, bonuses, and other fees were discontinued. After the closing of the June 24, 1997 initial public offering, all compensation payable to persons who are now stockholders of the Company (or an affiliate of such stockholder) are in the form of advisory fees, salaries and bonuses (which at current rates aggregate approximately $516 annually) and are included in selling, general and administrative expenses. These advisory fees and salaries were: 2. EARNINGS PER SHARE Basic earnings per share is computed on the basis of weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of weighted average number of common shares outstanding plus effects of outstanding stock options using the "treasury stock" method. Components of basic and diluted earnings per share were: STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 3. INVESTMENTS As of December 31, 1998, investments available for sale consisted of: As of December 31, 1999, investments available for sale consisted of: As of December 31, 1999, amortized costs and estimated fair values of investments available for sale by contractual maturity were: Bond mutual funds were primarily invested in investment grade bonds of U.S. and foreign issuers denominated in U.S. and foreign currencies, and interests in floating or variable rate senior collateralized loans to corporations, partnerships, and other entities in a variety of industries and geographic regions. Equity securities consisted of real estate investment trusts, equity mutual funds, and publicly traded common stock of U.S. based companies. As of December 31, 1999, the Company was also invested in trading securities which, in the aggregate, had an original cost and fair market value of approximately $1,429 and $1,146, respectively. Trading securities consisted primarily of publicly traded common stock of U.S. based companies and international equity mutual funds, together with certain hedging securities and various forms of derivative securities. Trading securities were held to meet short-term investment objectives. The Company entered into hedging and derivative securities in an effort to maximize its return on investments in trading securities while managing risk. As part of trading securities and as of December 31, 1999, the Company was invested in securities sold short related to a total of 24,421 shares of U.S. equity securities which, in the aggregate, had a basis and estimated fair market value of approximately $1,845 and $2,160, respectively, all of which were reported net as components of trading securities. These securities sold short were used in conjunction with and were substantially offset by other trading securities, which taken together, represented a risk-arbitrage portfolio in U.S. equity securities. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 3. INVESTMENTS (CONTINUED) Risk of loss to the Company in the event of nonperformance by any party under these agreements is not considered substantial. Because of potential limited liquidity of some of these instruments, recorded values of these transactions may be different from values that might be realized if the Company were to sell or close out the transactions. Such differences are not considered substantial to the Company's results of operations, financial condition, or liquidity. Hedging and derivative securities may involve elements of credit and market risk in excess of the amounts recognized in the accompanying consolidated financial statements. A substantial decline and/or change in value of equity securities, equity prices in general, international equity mutual funds, hedging securities, and derivative securities could have a material adverse effect on the Company's trading securities. Also, the price of common stock, hedging securities, and other derivative securities held by the Company as trading securities would be materially and adversely affected by poor management, shrinking product demand, and other risks that may affect single companies, as well as groups of companies. 4. INVENTORIES The Company frequently purchases components of its clients' products as an integral part of its process management services. At the close of an accounting period, packaged and assembled products (together with other associated costs) are reflected as finished goods inventories pending shipment. The Company generally has the right to be reimbursed from its clients for unused inventories. Client-owned inventories are not reflected in the Company's balance sheet. Inventories consisted of: 5. INVESTMENT IN AND NOTE RECEIVABLE FROM GOOD CATALOG COMPANY Effective September 15, 1999, the Company, through its wholly owned subsidiary Domain.com, Inc. ("Domain.com"), entered into a contribution agreement (the "Contribution Agreement") and stockholders agreement with The Reader's Digest Association, Inc. ("Reader's Digest") and Good Catalog Company, previously a wholly owned subsidiary of Reader's Digest. On November 8, 1999, pursuant to the Contribution Agreement, Domain.com purchased 19.9% of the outstanding common stock of Good Catalog Company for approximately $2,606 in cash. Reader's Digest owns the remaining 80.1% of the outstanding common stock of Good Catalog Company. The Contribution Agreement provides for: (i) an assignment from Domain.com to Good Catalog Company of Domain.com's right, title, and interest in and to the URL www.gifts.com; and (ii) an undertaking by Good Catalog Company to effect a change in its name to Gifts.com, Inc. Domain.com has the right to designate at least one member of Good Catalog Company's board of directors, which will consist of at least five directors. Effective November 1, 1999, Domain.com, Reader's Digest, and Good Catalog Company entered into a loan agreement pursuant to which Domain.com advanced an unsecured loan of $7,818 and Reader's Digest advanced an unsecured loan of $18,433 to Good Catalog Company ( the "Loans"). The Loans mature November 1, 2002, bear interest at a rate equal to a three month LIBO rate plus 2.0% per annum (approximately 8.0% as of December 31, 1999), and interest is payable quarterly. Currently, Good Catalog Company, doing business as gifts.com, provides an Internet web site accessed through the URL www.gifts.com that sells gifts on-line. The Company agreed to perform certain fulfillment services for Good Catalog Company in connection with certain products and services to be sold in connection with gifts.com. During 1999 and included in the accompanying 1999 consolidated statement of operations, the Company recognized approximately $1,100 of revenues related to fulfillment services performed by the Company for Good Catalog Company, and approximately $89 of interest income related to Good Catalog Company's $7,818 debt to Domain.com. Included in trade accounts receivable in the accompanying consolidated balance sheet as of December 31, 1999, was approximately $622 due from Good Catalog Company to the Company in connection with the Company's provision of fulfillment services to Good Catalog Company during 1999. Management has evaluated its investment in and note receivable from Good Catalog Company for recoverability. Management reviewed certain financial data and held discussions with Good Catalog Company management. As of December 31, 1999, management believes its investment in and note receivable from Good Catalog are recoverable and no impairment loss provision is necessary. Should available information in the future indicate a material impairment in carrying values of the Company's investment in and note receivable from Good Catalog Company, an adjustment would be recorded. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 6. PROPERTY, PLANT AND EQUIPMENT Management decided to dispose of a 10,500 square-foot facility and related land in Greeley, Colorado, and is actively searching for a buyer. Process management service operations at this facility ceased in December 1999. As of December 31, 1999, management believes carrying values of this facility and related land, which, in the aggregate, total approximately $198, are recoverable and no impairment loss provision is necessary. Should available information in the future indicate a material impairment in carrying values of this facility and related land, an adjustment would be recorded. Certain process management services previously provided from the Company's Denver facility were completely transferred to other facilities by January 31, 2000. Currently, a relatively small portion of the Denver facility provides for certain executive, corporate, and information technology functions, while management evaluates possible operating activities which could be located in this facility. As of December 31, 1999, management believes carrying values of this facility and related land are recoverable and no impairment loss provision is necessary. Should available information in the future indicate a material impairment in carrying values of this facility and related land, an adjustment would be recorded. 7. LINE OF CREDIT As of December 31, 1998 and 1999, the Company had a revolving line of credit agreement with a bank whereby the bank agreed to loan the Company up to $5,000. No amount was outstanding under the line of credit as of December 31, 1998 and 1999. Interest is payable monthly and accrues at the prime rate of the bank (8.5% as of December 31, 1999). This revolving line of credit matures on April 30, 2001. The Company has pledged as security certain of its wholly owned subsidiaries' accounts receivable under the revolving line of credit agreement. The Company must maintain working capital of $17,500 and tangible net worth of $25,000. The Company may not pay dividends in an amount which would cause a failure to meet these financial covenants. As of and for the year ended December 31, 1999, the Company was in compliance with the various financial and other covenants provided for under the line of credit. 8. LEASES Amortization of equipment held under capital lease obligations is included in depreciation and amortization expense. Included in property, plant, and equipment in the accompanying consolidated balance sheets was the following equipment held under capital leases: STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 8. LEASES (CONTINUED) The Company also leases equipment under various non-cancelable operating leases. As of December 31, 1999, future minimum rental commitments for capital and operating leases were: Rent expense, including equipment rentals, for 1997, 1998, and 1999 was $271, $410, and $1,054, respectively. On November 1, 1999, the Company entered into a lease agreement for 30,000 square feet of building space in Big Spring, Texas. The facility is principally used for a call center supporting Internet and telecommunications clients, and for general office use and other services offered by the Company. The term of the lease agreement commenced on November 1, 1999 and unless earlier terminated or extended, continues until November 1, 2014. Pursuant to the terms of the lease agreement, the Company was granted, among other things: (i) a right to terminate the lease agreement in the fifth or tenth year. Assuming the lease agreement is not terminated after the end of the fifth or tenth year, total minimum rental commitments, in the aggregate, excluding certain taxes and utilities as defined, are approximately $903, and are payable on a monthly basis from November 1999 through November 2014. Pursuant to an incentive agreement and through the tenth year of the lease agreement, the Company shall be reimbursed for the actual amount of its lease payments. 9. TENNESSEE FINANCING AGREEMENT On July 8, 1998, the Company entered into certain financing agreements with the Industrial Development Board of the County of Montgomery, Tennessee, (the "Board") in connection with the Board's issuance to StarTek USA, Inc. of an Industrial Development Revenue Note, Series A not to exceed $4,500 (the "Facility Note") and an Industrial Development Revenue Note, Series B not to exceed $3,500 (the "Equipment Loan"). The Facility Note bears interest at 9% per annum commencing on October 1, 1998, payable quarterly and maturing on July 8, 2008. Concurrently, the Company advanced $3,575 in exchange for the Facility Note and entered into a lease agreement, maturing July 8, 2008, with the Board for the use and acquisition of a 305,000 square-foot process management and distribution facility in Clarksville, Tennessee (the "Facility Lease"). The Facility Lease provides for the Company to pay to the Board lease payments sufficient to pay, when and as due, the principal of and interest on the Facility Note due to the Company from the Board. Pursuant to the provisions of the Facility Lease and upon the Company's payment of the Facility Lease in full, the Company shall have the option to purchase the 305,000 square-foot, Clarksville, Tennessee facility for a lump sum payment of one hundred dollars. The Equipment Loan bears interest at 9% per annum, generally contains the same provisions as the Facility Note, and provides for an equipment lease, except the Equipment Loan and equipment lease mature on January 1, 2004. As of December 31, 1999, the Company had used approximately $4,012 and $1,745 of the Facility Note and Equipment Loan, respectively, and correspondingly entered into further lease arrangements with the Board. All transactions related to the purchase of the notes by the Company from the Board and the lease arrangements from the Board to the Company have been offset against each other, and accordingly have no impact on the consolidated balance sheets. The assets acquired are included in property, plant and equipment. Similarly, the interest income and interest expense related to the notes and lease arrangements, respectively, have also been offset. The lease payments are equal to the amount of principal and interest payments on the notes, and accordingly have no impact on the consolidated statements of operations. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 10. LONG-TERM DEBT On October 26, 1998, the Company, through its wholly owned subsidiary StarTek USA, Inc., entered into an equipment loan agreement with a finance company maturing November 2, 2002. In connection with the equipment loan, the Company received cash of $3,629 in exchange for providing, among other things, certain collateral which generally consisted of equipment, furniture, and fixtures used in the Company's business. The equipment loan provides for interest at a fixed annual interest rate of 7.0% and for the Company to pay forty-eight equal monthly installments, which, in the aggregate, totaled approximately $4,176 at inception of the equipment loan. In addition to the collateral described above, the Company granted to the finance company a secondary security interest in certain of its wholly owned subsidiaries' accounts receivable. During the years ended December 31, 1998 and 1999, interest expense incurred on the equipment loan was $21 and $224, respectively. On October 22, 1999, the Company, through its wholly owned subsidiary StarTek USA, Inc., completed an equipment loan arrangement with a finance company maturing October 22, 2003. In connection with the equipment loan, the Company received cash of $2,031 in exchange for providing, among other things, certain collateral which generally consisted of computer hardware and software, various forms of telecommunications equipment, and furniture and fixtures whose estimated cost was equal to the principal amount of the equipment loan. The equipment loan arrangement provides for interest at the prime rate minus 1.60% (6.9% on December 31, 1999), and forty-eight consecutive monthly payments. StarTek USA, Inc. is required, from time to time, to maintain certain operating ratios. During the year ended December 31, 1999, interest expense incurred on the equipment loan was $22. As of December 31, 1999, StarTek USA, Inc. was in compliance with these financial covenants. In November 1999, the Company received $2,300 in cash in connection with its Big Spring, Texas operations through a non-interest bearing fifteen-year promissory note with incentive provisions. The principal balance of the promissory note declines without payment over fifteen years based on the level of employment at the Company's Big Spring, Texas facility during the term of the promissory note. The Company has other debt obligations totaling $349 as of December 31, 1999 with interest up to 6.0% annually and maturing through 2007. Future scheduled annual principal payments on long-term debt, including amounts related to the promissory note with waiver provisions and the promissory note with incentive provisions, as of December 31, 1999 were: STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 11. INCOME TAXES The Company was taxed as an S corporation for federal and state income tax purposes from July 1, 1992 through June 17, 1997, when S corporation status was terminated in contemplation of the Company's initial public offering. Since June 18, 1997, the Company has been taxable as a C corporation and income taxes have been accrued since that date. The Company is subject to foreign income taxes on certain of its operations. Pretax income from the taxable period June 18, 1997, through December 31, 1997 was $6,818, of which $6,143 and $675 were attributable to domestic and foreign operations, respectively. Significant components of the provision for income taxes for the years ended December 31, 1997, 1998, and 1999 were: Income tax benefits associated with disqualifying dispositions of incentive stock options during 1999 reduced income taxes payable as of December 31, 1999 by $1,654. Such benefits were recorded as an increase to additional paid-in capital. Significant components of deferred tax assets, which required no valuation allowance, and deferred tax liabilities included in the accompanying balance sheets as of December 31 were: Differences between U.S. federal statutory income tax rates and the Company's effective tax rates for the years ended December 31, 1997, 1998, and 1999 were: 12. NET INTEREST INCOME AND OTHER STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 13. STOCKHOLDERS' EQUITY Immediately prior to closing of the Company's initial public offering in June 1997, the Company declared a 322.1064-for-one stock split of the Company's common stock. All references in notes to consolidated financial statements to shares and related prices in per share calculations, per share amounts, and stock option plan information have been restated to reflect the split. Immediately prior to closing the initial public offering, the Company also declared an $8,000 dividend approximating additional paid-in capital and retained earning of the Company as of the closing date, payable to principal stockholders pursuant to certain promissory notes. Promissory notes payable to principal stockholders were paid from net proceeds of the Company's initial public offering. As of December 31, 1998, common stock and additional paid-in capital consisted of: At the Company's May 19, 1999 annual meeting of stockholders, a proposal to amend the Company's Certificate of Incorporation to reduce the number of shares of common stock the Company has the authority to issue from 95,000,000 shares to 18,000,000 shares and eliminate the authorization of preferred stock was approved by an affirmative vote of holders of a majority of the shares of common stock outstanding. As of December 31, 1999, common stock and additional paid-in capital consisted of: 14. STOCK OPTIONS 1987 Stock Option Plan Effective July 24, 1987, the stockholders of StarTek USA, Inc. approved a Stock Option Plan ("Plan"), which provided for the grant of stock options, stock appreciation rights ("SARs") and supplemental bonuses to key employees. Stock options were intended to qualify as "incentive stock options" as defined in Section 422A of the Internal Revenue Code unless specifically designated as "nonstatutory stock options." Options granted under the Plan could be exercised for a period of not more than 10 years and one month from date of grant, or any shorter period as determined by StarTek USA, Inc.'s Board of Directors. The option price of any incentive stock option would be equal to or exceed the fair market value per share on date of grant, or 110% of fair market value per share in case of a 10% or greater stockholder. Options generally vested ratably over a five-year period from date of grant. Unexercised, vested options remained exercisable for three calendar months from date of termination of employment. During 1995, StarTek USA, Inc.'s Board of Directors accelerated the vesting on all outstanding options under the Plan to allow holders to exercise any granted options. Subsequently, all outstanding options were exercised. In the aggregate, option holders paid $18 in cash and delivered a note of $213 bearing interest at 4.63% to StarTek USA, Inc. in exchange for shares of common stock. This note was secured by 288,607 shares of StarTek USA, Inc. common stock. On January 22, 1997, the note and all accrued interest thereon were repaid in full. Options for 2,124,936 shares of common stock were available for grant at the end of 1996. The Plan was terminated effective January 24, 1997. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 14. STOCK OPTIONS (CONTINUED) 1997 Stock Option Plan On February 13, 1997, the Company's Board of Directors approved the StarTek, Inc. Stock Option Plan (the "Option Plan") and, on January 27, 1997, the Director Stock Option Plan (the "Director Option Plan"). The Option Plan was established to provide stock options, SARs and incentive stock options (cumulatively referred to as "Options") to key employees, directors (other than non-employee directors), consultants, and other independent contractors. The Option Plan provides for Options to be granted for a maximum of 985,000 shares of common stock, which are to be awarded by determination of committee of non-employee directors. Unless otherwise determined by the committee, all Options granted under the Option Plan vest 20% annually beginning on the first anniversary of the Options' grant date and expire at the earlier of: (i) ten years (or five years for participants owning greater than 10% of the voting stock) from the Options' grant date; (ii) three months after termination of employment; (iii) six months after the participant's death; or (iv) immediately upon termination for "cause". The Director Option Plan was established to provide stock options to non-employee directors who are elected to serve on the Company's board of directors and serve continuously from commencement of their term (the "Participants"). The Director Option Plan provides for stock options to be granted for a maximum of 90,000 shares of common stock. Participants were automatically granted options to acquire 10,000 shares of common stock upon the closing of the Company's June 1997 initial public offering. Additionally, each Participant will be automatically granted options to acquire 3,000 shares of common stock on the date of each annual meeting of stockholders thereafter at which such Participant is reelected to serve on the Company's board of directors. All options granted under the Director Option Plan fully vest upon grant and expire at the earlier of: (i) date of Participant's membership on the Company's board of directors is terminated for cause; (ii) ten years from option grant date; or (iii) one year after Participant's death. Stock option activity during 1997, 1998, and 1999 consisted of: As of December 31, 1997, the exercise price for options outstanding, each of which is exercisable on a basis of one option for one share of the Company's common stock, was $15.00, except for 8,000 options exercisable at $13.06 per share. As of December 31, 1998, the exercise price per share for options outstanding was $15.00 for 583,000 options, $13.06 for 8,000 options, $12.69 for 6,000 options, $12.25 for 7,600 options, and $10.38 for 9,200 options. As of December 31, 1999, the exercise price for options outstanding was $50.06 for 300 options, $42.75 for 89,650 options, $38.63 for 10,000 options, $32.81 for 22,700 options, $31.00 for 6,600 options, $18.50 for 47,200 options, $15.00 for 406,300 options, $13.06 for 2,000 options, $12.69 for 6,000 options, $12.25 for 7,600 options, and $10.38 for 7,360 options. As of December 31, 1999, there were 10,000 fully vested options exercisable at $38.63 per share, 6,000 fully vested options exercisable at $18.50 per share, 83,500 fully vested options exercisable at $15.00 per share, 800 fully vested options exercisable at $13.06 per share, 6,000 fully vested options exercisable at $12.69 per share, and 1,520 fully vested options exercisable at $12.25 per share. Options for 262,750 and 48,000 shares of the Company's common stock were available for future grant as of December 31, 1999 under the Option Plan and Director Option Plan, respectively. The Company elected to follow Accounting Principles Board Opinion No. 25, ("APB 25") "Accounting for Stock Issued to Employees" and related interpretations in accounting for its stock options. Under APB 25, because the exercise price of the Company's stock options equals the market price of the underlying stock on date of grant, no compensation expense has been recognized. Pro forma information regarding net income and net income per share is required by Statement of Financial Accounting Standards No. 123, (SFAS 123") "Accounting For Stock Based Compensation", and has been determined as if the Company had accounted for its stock options under the fair value method as provided for by SFAS 123. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 14. STOCK OPTIONS (CONTINUED) Fair value of options granted during 1997 was estimated as of date of grant using a Black-Scholes option pricing model and assuming a 6.0% risk free rate, a seven year life, a 30.0% expected volatility, and no dividends. Fair value of options granted during 1998 was estimated as of date of grant using a Black-Scholes option pricing model and assuming a 5.5% risk-free interest rate, a seven year life, a 55.1% expected volatility, and no dividends. Fair value of options granted during 1999 was estimated as of date of grant using a Black-Scholes option pricing model assuming a range of 6.0% to 6.3% for the risk-free rate, a seven year life, a 72.1% expected volatility, and no dividends. Weighted average grant date fair market value of options granted during 1997, 1998, and 1999 was approximately $7.00 per share, $7.00 per share, and $24.24 per share, respectively. Had this method been used in the determination of pro forma net income for 1997, pro forma net income would have decreased by $367 and pro forma basic and diluted earnings per share would have decreased by $0.03. Had this method been used in the determination of net income for 1998, net income would have decreased by $559 and basic and diluted earnings per share would have decreased by $0.04. Similarly, had this method been used in the determination of net income for 1999, net income would have decreased by $848 and basic and diluted earnings per share would have decreased by $0.06. The Black-Scholes option valuation model was developed for use in estimating fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require input of highly subjective assumptions, including expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect fair value estimates, in management's opinion, the existing models do not necessarily provide a reliable single measure of fair value of the Company's stock options. 15. GEOGRAPHIC AREA INFORMATION The Company, operating in a single industry segment, provides a variety of integrated, outsourcing services to other businesses throughout the world. As of and for the year ended December 31, 1997, the Company's operations in Asia were not material and are included with North America in the following table. As of December 31, 1997, 1998 and 1999 the Company's long-lived assets located in Europe and Asia were not material and are included with North America in the following table. The Company's North America operations are located in the United States of America. The Company's Europe operations are located in the United Kingdom. The Company's Asia operations are located in Singapore. Revenues, operating profit, and identifiable assets, classified by major geographic areas in which the Company operates were: 16. PRINCIPAL CLIENTS Two clients accounted for 56.3% and 25.4% of revenues for the year ended December 31, 1997. One client accounted for 72.5% and 77.5% of revenues for the year ended December 31, 1998 and 1999, respectively. The loss of its principal client for the year ended December 31, 1999 would have a material adverse effect on the Company's business, operating results, and financial condition. To limit the Company's credit risk, management performs ongoing credit evaluations of its clients and maintains allowances for potentially uncollectible accounts. Although the Company is directly impacted by economic conditions in which its clients operate, management does not believe substantial credit risk exists as of December 31, 1999. STARTEK, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 17. QUARTERLY DATA (UNAUDITED) STARTEK, INC. INDEX OF EXHIBITS - ------------------ * Filed with this Form 10-K. ** Filed with this Form 10-K. Certain portions of the exhibit have been omitted pursuant to a request for confidential treatment and have been filed separately with the Securities and Exchange Commission. SIGNATURES Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned thereunto duly authorized. STARTEK, INC. - -------------------------------------------- (Registrant) By: /s/ Dennis M. Swenson - -------------------------------------------- Dennis M. Swenson Executive Vice President, Chief Financial Officer, Secretary, and Treasurer Date: March 8, 2000 - -------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ Michael W. Morgan - -------------------------------------------- Michael W. Morgan President, Chief Executive Officer and Director (Principal Executive Officer) Date: March 8, 2000 - -------------------------------------------- /s/ Dennis M. Swenson - -------------------------------------------- Dennis M. Swenson Executive Vice President, Chief Financial Officer, Secretary, and Treasurer (Principal Financial and Accounting Officer) Date: March 8, 2000 - -------------------------------------------- /s/ E. Preston Sumner, Jr. - -------------------------------------------- E. Preston Sumner, Jr. Executive Vice President and Chief Operating Officer Date: March 8, 2000 - -------------------------------------------- /s/ A. Emmet Stephenson, Jr. - -------------------------------------------- A. Emmet Stephenson, Jr. Chairman of the Board Date: March 8, 2000 - -------------------------------------------- /s/ Ed Zschau - -------------------------------------------- Ed Zschau Director Date: March 8, 2000 - -------------------------------------------- /s/ Jack D. Rehm - -------------------------------------------- Jack D. Rehm Director Date: March 8, 2000 - -------------------------------------------- STARTEK, INC. INDEX OF EXHIBITS - ------------------ * Filed with this Form 10-K. ** Filed with this Form 10-K. Certain portions of the exhibit have been omitted pursuant to a request for confidential treatment and have been filed separately with the Securities and Exchange Commission.

1110757_1999.txt

1110757_1999

1999

1110757

ITEM 1. BUSINESS Omitted pursuant to First Union Residential Securitization Transactions, Inc., SEC No-Action Letter (April 1, 1997) (the "No-Action Letter"). ITEM 2. ITEM 2. PROPERTIES Pursuant to the No-Action Letter, the following represents relevant information regarding real estate owned by the Trust: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The registrant knows of no material pending legal proceedings involving the Trust or the Trustee, the Servicer or the registrant with respect to the Trust, other than routine litigation incidental to the duties of the respective parties under the Pooling and Servicing Agreement. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) No established public trading market for the Certificates exists. (b) As of December 31, 1999, the number of holders of record of the publicly offered Certificates was 3. (c) Omitted pursuant to the No-Action Letter. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA Omitted pursuant to the No-Action Letter. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Omitted pursuant to the No-Action Letter. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Not Applicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Omitted pursuant to the No-Action Letter. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Omitted pursuant to the No-Action Letter. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Omitted pursuant to the No-Action Letter. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) None. (b) Not applicable. (c) Not applicable. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Not applicable. (b) Not applicable. (c) None. (d) None. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Exhibits 99.1 Annual Independent Accountants' Servicing Report concerning servicing activities under the Pooling and Servicing Agreement for the Servicer's fiscal year ended November 30, 1999, in accordance with the No-Action Letter. 99.2 Annual Statement of Compliance under the Pooling and Servicing Agreement for the Servicer's fiscal year ended November 30, 1999, in accordance with the No-Action Letter. 99.3 Aggregate Statement of Principal and Interest Distributions to Certificateholders. (b) On or about October 29, 1999 and November 30, 1999, reports on Form 8-K were filed in order to provide the Monthly Statements to Certificateholders and quarterly financial statements for the period ended September 30, 1999 for Ambac Assurance Corporation, the provider of credit enhancement. No other reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) Not applicable. (d) Omitted pursuant to the No-Action Letter. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. EQUITY ONE ABS, INC. Date: March 28, 2000 By: /s/ John N. Martella -------------------------------------- John N. Martella, Executive Vice President SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT (a)(1) No annual report is provided to the Certificateholders other than with respect to aggregate principal and interest distributions. (a)(2) No proxy statement, form of proxy or other proxy soliciting material has been sent to any Certificateholder with respect to any annual or other meeting of Certificateholders. INDEX TO EXHIBITS Exhibit Number Description - ------ ----------- 99.1 Annual Independent Accountants' Servicing Report concerning servicing activities under the Pooling and Servicing Agreement for the Servicer's fiscal year ended November 30, 1999, in accordance with the No-Action Letter. 99.2 Annual Statement of Compliance under the Pooling and Servicing Agreement for the Servicer's fiscal year ended November 30, 1999, in accordance with the No-Action Letter. 99.3 Aggregate Statement of Principal and Interest Distributions to Certificateholders.

716314_1999.txt

716314_1999

1999

716314

Item 1. Business - ------- -------- (a) General Development of Business ------------------------------- Registrant is a Delaware company incorporated in 1983. It is the successor to Graham Manufacturing Co., Inc., which was incorporated in 1936. The Registrant's business consists of two segments, one operated by Registrant in the United States and one operated by its indirectly wholly-owned subsidiary in the United Kingdom. UNITED STATES OPERATIONS During the Fiscal Year ended March 31, 1999 ("FY 1998-99") the Registrant's U.S. operations consisted of its engineering and manufacturing business in Batavia, NY. Prior to January 1, 1999, business was carried out through the Registrant's wholly-owned subsidiary, Graham Manufacturing Co., Inc. ("GMC"). Effective January 1, 1999, GMC merged into the Registrant. The Registrant is a well-recognized supplier of steam jet ejector vacuum systems, surface condensers for steam turbines, liquid ring vacuum pumps and compressors, dry pumps and various types of heat exchangers such as Heliflow and plate and frame exchangers. It possesses expertise in combining these various products into packaged systems for sale to its customers in a variety of industrial markets, including oil refining, chemical, petrochemical, power, pulp and paper, othe process applications, and shipbuilding. FY 1998-99 U.S. sales were $48.9 million, a decrease of 5.6% from the previous fiscal year. New orders in FY 1998-99 were $36.3 million, down 39% from the previous fiscal year. Year End backlog stood at $14.6 million, compared to $27.3 million on March 31, 1998 and $21.0 million on March 31, 1997. This decrease was due mainly to the worldwide recession in the Registrant's principal markets, exacerbated by the virtual cessation in Asia of capital projects that employ equipment of the type sold by the Registrant. Condenser orders were down, as were orders for ejectors and plate heat exchangers. Sales of water heaters were down. The chemical and refinery markets accounted for slightly less than half of the revenue for FY 1998-99. Sales of smaller equipment, which accounts for approximately half of the Registrant's U.S. business, suffered from sluggish performance during the first part of the year, but returned during the second half to levels consistent with those of the previous fiscal year. The decrease in sales put pressure on margins, which were generally down. The Registrant's U.S. export sales represented 52% in FY 1998-99. Export sales reflected a near disappearance of new orders page 3 of 63 from Asia and Latin America. Although the Asian and Latin American economies appear to have bottomed out, management does not expect these economies to regain full vitality for at least another year. Refinery work, still affected by the uncertainty of oil prices and the consolidation of the large oil companies, is expected to continue at a sluggish pace until plant utilization goes up. These factors are expected to continue to depress the core markets for sales of large equipment, although export sales, and sales to Asia particularly, are expected to be affected by Asian financial uncertainties. The Registrant had 297 employees in the United States as of as March 31, 1999. UNITED KINGDOM OPERATIONS During FY 1998-99, the Registrant's U.K. operations were undertaken by its indirectory wholly-owned subsidiary, Graham Precision Pumps Limited (GPPL) in Congleton, Cheshire, England. GPPL is wholly-owned by Graham Vacuum & Heat Transfer Limited, which in turn is wholly-owned by the Registrant. Graham Vacuum and Heat Transfer Limited has no employees. GPPL manufactures liquid ring vacuum pumps, rotary piston pumps, oil sealed rotary vane pumps, atmospheric air operated ejectors and complete vacuum pump systems that are factory assembled with self-supporting structure. Sales for FY 1998-99 stood at $5,647,000. This figure represents the Registrant's lowest U.K. sales in the last three years. U.K. sales in FY 1998-99 were affected by the strength of the Pound Sterling versus other currencies and the recession in the U.K. manufacturing sector. Orders for offshore oil production, which traditionally had shown vitality, ceased almost entirely. However, GPPL saw success in FY 1998-99 in obtaining orders for package systems, an opportunity combining the Company's various competencies in the manufacture of liquid ring vacuum pumps, ejectors and condenser technology. GPPL employed 63 people on March 31, 1999. page 4 of 63 Capital Expenditures - -------------------- The Registrant's capital expenditures for FY 1998-99 amounted to $1,189,000. Of this amount, $1,179,000 was for the U.S. business and $10,000 was for the U.K. business. (b) Financial Information About Industry Segments --------------------------------------------- (1) Industry Segments and (2) Information as to Lines of Business ------------------------------------------------------------- Graham Corporation operates in only one industry segment which is the design and manufacture of vacuum and heat transfer equipment. The information required under this item regarding this industry segment is set forth in statements contained in Notes 1 and 3 to the Consolidated Financial Statements on pages 24-28 and 30 of the Annual Report on Form 10-K. (c) Narrative Description of Business --------------------------------- (1) Business Done and Intended to be Done ------------------------------------- (i) Principal Products and Markets ------------------------------ The Registrant designs and manufactures vacuum and heat transfer equipment, primarily custom built. Its products include steam jet ejector vacuum systems, surface condensers for steam turbines, liquid ring vacuum pumps and compressors and various types of heat exchangers including helical coil exchangers marketed under the registered name "Heliflow" and plate and frame exchangers. These products function to produce a vacuum or to condense steam or otherwise transfer heat, or any combination of these tasks. They accomplish this without involving any moving parts and are available in all metals and in many non-metallic and corrosion resistant materials as well. This equipment is used in a wide range of industrial process applications: power generation facilities, including fossil fuel plants and nuclear plants as well as cogeneration plants and geothermal power plants that harness naturally occurring thermal energy; petroleum refineries; chemical plants; pharmaceutical plants; plastics plants; fertilizer plants; breweries and titanium plants; liquefied natural gas production and soap manufacturing; air conditioning systems; food processing plants and other process industries. Among these the principal markets for the Registrant's products are the chemical, petrochemical, petroleum refining, and electric power generating industries. The Registrant's equipment is sold by a combination of direct company sales engineers and independent sales representatives located in over 40 major cities in the United States and abroad. page 5 of 63 (ii) Status of Publicly Announced New Products or -------------------------------------------- Segments -------- The Registrant has no plans for new products or for entry into new industry segments that would require the investment of a material amount of the Registrant's assets or that otherwise is material. (iii) Sources and Availability of Raw Materials ----------------------------------------- Registrant experienced no serious material shortages in FY 1998-99. (iv) Material Patents, Trademarks ---------------------------- Registrant holds no material patents, trademarks, licenses, franchises or concessions the loss of which would have a materially adverse effect upon the business of the Registrant. (v) Seasonal Variations ------------------- No material part of the Registrant's business is seasonal. (vi) Working Capital Practices (Not Applicable) ------------------------- (vii) Principal Customers ------------------- Registrant's principal customers include the large chemical, petroleum and power companies, which are end users of Registrant's equipment in their manufacturing and refining processes, as well as large engineering contractors who build installations for such companies and others. No material part of Registrant's business is dependent upon a single customer or on a few customers, the loss of any one or more of whom would have a materially adverse effect on Registrant's business. No customer of Registrant or group of related customers regularly accounts for as much as 10% of Registrant's consolidated annual revenue. (viii) Order Backlog ------------- Backlog of unfilled orders at March 31, 1999 was $15,438,000 compared to $28,199,000 at March 31, 1998, $22,348,000 at March 31, 1997 and $25,578,000 at December 31, 1996. (ix) Government Contracts (Not Applicable) -------------------- page 6 of 63 (x) Competition ----------- Registrant's business is highly competitive and a substantial number of companies having greater financial resources are engaged in manufacturing similar products. Registrant is a relatively small factor in the product areas in which it is engaged with the exception of steam jet ejectors. Registrant believes it is one of the leading manufacturers of steam jet ejectors. (xi) Research Activities ------------------- During the year ended December 31, 1996, the three month transition period ending March 31, 1997, FY 1997-98 and FY 1998-99, Registrant spent approximately $375,000, $91,000, $404,000 and $371,000, respectively on research activities relating to the development of new products or the improvement of existing products. (xii) Environmental Matters --------------------- Registrant does not anticipate that compliance with federal, state and local provisions, which have been enacted or adopted regulating the discharge of material in the environment or otherwise pertaining to the protection of the environment, will have a material effect upon the capital expenditures, earnings and competitive position of the Registrant and its subsidiaries. (xiii) Number of Persons Employed -------------------------- On March 31, 1999, Registrant and its subsidiaries employed 360 persons. (d) Financial Information About Foreign and Domestic Operations and --------------------------------------------------------------- Export Sales ------------ (The information called for under this Item is set forth in Note 3 to Consolidated Financial Statements, on page 30 of this Annual Report on Form 10-K.) Item 2. Item 2. Properties - ------- ---------- United States: Registrant's corporate headquarters is located at 20 Florence Avenue, Batavia, New York. Registrant owns and operates a plant on approximately thirty-three acres in Batavia consisting of about 204,000 square feet in several connected buildings built over a period of time to meet increased space requirements, including 162,000 square feet in manufacturing facilities, 48,000 square feet for warehousing and a 6,000 square-foot building for product research and development. A 14,000 square foot extension to the Heavy Fabrication Building was completed in 1991. page 7 of 63 Registrant's principal offices are in a 45,000 square-foot building located in Batavia adjacent to its manufacturing facilities which is owned by the Company. The plant and office building have been pledged to secure certain domestic long-term borrowings. The Registrant leases U.S. sales offices in Los Angeles and Houston. United Kingdom: Registrant's subsidiary, Graham Precision Pumps Limited, has a 41,000 square-foot manufacturing facility located on 15 acres owned by that company in Congleton, Cheshire, England. Assets of the Registrant with a book value of $26,480,000 have been pledged to secure certain domestic long-term borrowings. Short and long-term borrowings of Registrant's United Kingdom subsidiary are secured by assets of the subsidiary, which have a book value of $3,518,000. Item 3. Item 3. Legal Proceedings - ------- ----------------- The United States Environmental Protection Agency ("EPA") named the Company's predecessor-in-interest, Graham Manufacturing Co., Inc. as a Potentially Responsible Party pursuant to the Comprehensive Environmental Response, Compensation and Liability Act, as amended, in connection with the Batavia Landfill Site in the Town of Batavia, New York. A Pilot Allocation "Final Allocation Report" issued on September 30, 1998 by the allocator selected under the EPA pilot, allocated 1.597% of total remedial costs to the Company. In April 1999, EPA announced that it will proceed with a modification of the remedy for the site announced in a 1995 Record of Decision. EPA's estimate of the modified remedy is approximately $26,000,000 making the Company's full potential exposure in accordance with this estimate $416,000. EPA's estimate has not been audited or evaluated for appropriateness or accuracy and may contain significant portions which are not eligible for recovery. The Company has recorded a $300,000 liability for this item. The current portion of this liability is included in the caption "Accrued Expenses and Other Liabilities" and the long-term portion is included in the caption "Other Long-Term Liabilities" in the Consolidated Balance Sheets. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------- (Not applicable) page 8 of 63 PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Security - ------- --------------------------------------------------------- Holder Matters -------------- (a) The information called for under this Item is set forth under Item 8, "Financial Statements and Supplementary Data," in the Statement of Quarterly Financial Data appearing on page 52 of this Annual Report on Form 10-K. (b) On June 15, 1999, there were approximately 330 holders of the Registrant's common stock. This figure includes stockholders of record and individual participants in security position listings who have not objected to the disclosure of their names; it does not, however, include individual participants in security position listings who have objected to disclosure of their names. On June 15, 1999, the closing price of the Registrant's common stock on the American Stock Exchange was $8.875 per share. (c) The Registrant has not paid a dividend since January 4, 1993, when it paid a dividend of $.07 per share. Currently it does not have plans to resume paying a dividend in the foreseeable future. Restrictions on dividends are described in Note 7 to the Consolidated Financial Statements, to be found on pages 36 to 37 of this Report. page 9 of 63 Item 6. Item 6. Selected Financial Data - ------- ----------------------- (1) The financial data presented for 1999 and 1998 is for the twelve months ended March 31, 1999 and 1998,respectively. The financial data presented for 1997 is for the three month transition period ended March 31, 1997. The financial data presented for 1996-1989 is for the respective twelve months ended December 31. (2) Per share data has been adjusted to reflect a three-for-two stock split on July 25,1996. page 10 of 63 page 11 of 63 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations --------------------- Graham Corporation (consolidated) consists of two operating segments as determined by geographic areas (USA, UK). Effective January 1, 1999 Graham Manufacturing Co., Inc. and Graham Corporation (USA) were merged, with the surviving entity being Graham Corporation. Graham Precision Pumps, Ltd. remained a 100% owned subsidiary of Graham Corporation's UK 100% owned holding company, Graham Vacuum and Heat Transfer, Limited. As of April 1, 1997 Graham Corporation changed its financial year end from December 31, to March 31. The Company reported a transition period for three months ended March 31, 1997. Sales, net income and all other key financial indicators reflected the favorable financial conditions reported for the financial year immediately preceding and following the three months ended March 31, 1997. ANALYSIS OF CONSOLIDATED OPERATIONS - -------------------------------------------------------------------------------- 1999 COMPARED TO 1998 Consolidated net sales (after elimination of intercompany sales) for the twelve months ended March 1999 was $52,978,000 as compared to $56,206,000 for the year ended March 1998. Sales in 1998 were the highest in Graham Manufacturing Company's history and were particularly benefited by a few large condenser orders. Consolidated gross profit margins were 28% as compared to 32% for 1998. Margins decreased in the USA from 31% to 27% as a result of fewer sales together with greater production fixed costs, and less indirect production absorption into inventory at March 31, 1999. Profit margins in the UK decreased to 30% from 31%. UK operations experienced comparable indirect production costs to the preceding year with lower current year sales dollars. Consolidated Selling, General and Administration expenses as a result of cost cutting measures decreased about 4% from 1998 and, stated as a percent of sales, remained consistent with 1998, at 22%. page 12 of 63 Interest expense in 1999 and 1998 was 0.5% and 0.4% of sales, respectively. Bank indebtedness was approximately 2% of equity for 1999 and 4% for 1998. The effective consolidated income tax rate for FYE March 1999 was 13.6% as compared to last year of 31% and an approximate statutory rate of 39%. The USA 1999 effective rate was 24% and the UK rate resulted in income of $278,000. The USA company received tax exempt income in 1999 in excess of $500,000. In the UK, tax loss carryforwards that were previously considered unusable were determined to be utilizable. As a result of this, the related SFAS No. 109 valuation allowance was reduced. Net income for the current year was $2,369,000 or $1.46 diluted earnings per share as compared to $3,766,000 or $2.21 diluted earnings per share in 1998. 1998 COMPARED TO 1996 Consolidated net sales were $56,206,000 for the fiscal year ended March 31, 1998 compared to $51,487,000 for the twelve months ended December 31, 1996. Sales from USA operations were 11% greater than 1996 as a result of increased surface condenser and ejector sales. Sales from UK operations were down about 2% for 1998. The strong Pound Sterling compared to other world currencies gave Graham Precision Pumps great difficulty. The Pound, compared to the Deutsche Mark and French Franc, reached a nine year high. Consolidated gross profit margins were 32% in 1998 and 30% in 1996. Domestically, margins rose as a result of strong demand for the Company's products in general and, in particular, a few excellent large orders. Despite currency disadvantages, UK operations were able to increase by 1% gross profit margin percentages from 1996 to 31%. Sales per employee in the UK rose from $84,000 to $97,000. Consolidated selling, general and administrative expenses remained consistent from 1996 at 22% of sales. Consolidated interest expense declined to about 0.4% of consolidated sales from 0.7% in 1996. Since 1994, when bank debt was equal to 77% of equity, the Company managed to reduce this ratio to 9% in 1996 and 4% in 1998. The effective income tax rate for 1998 was 31%, up from 22% but still below the statutory rate as a result of utilization of UK carryforward tax losses. Net income for 1998 was $3,766,000 or $2.21 diluted earnings per share. This compared to 1996 of $3,102,000 and $1.93 per share. page 13 of 63 SHAREHOLDERS' EQUITY 1999 COMPARED TO 1998 Shareholders' Equity decreased 6% in 1999. During the year the Company acquired 164,700 shares of its stock, for a cost of $2,337,000. Treasury shares can be used to fund employee benefit programs and other reasons determined appropriate by the Board. Additionally, the UK operation took a charge to equity of $1,191,000. The charge approximates the difference between the fair market value of pension plan assets as of March 31, 1999 and the present value of future cash outlays of pension obligations as of March 31, 1999. A significant amount of this liability related to the drop in long-term interest rates and the resulting effect of lowering the discount rate used to present value future dollars. This portion of the charge can reverse with increased interest rates and/or future funding of the pension plan. The aforementioned charges were 67% offset by net income. 1998 COMPARED TO 1996 Shareholders' Equity increased 49% in 1998 over 1996. About 75% of this increase was due to net income and another 18% due to the exercise of stock options. LIQUIDITY AND CAPITAL RESOURCES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 1999 COMPARED TO 1998 Consolidated cash flow from operations in 1999 was $2,361,000 compared to $7,259,000 in 1998. Cash from operations page 14 of 63 was down from the prior year due to decreased net income and the related effects on working capital accounts due to the timing recognition between accounting for certain sales for financial presentation on the percentage-of-completion method and accrual method for income tax purposes. Consolidated working capital decreased 4% to $11,989,000 as of March 31, 1999 due to the general downward trend in business conditions. Cash was used for purchasing the Company's stock, capital expenditures and reducing interest bearing debt. In recent years the Company's liquidity has been primarily generated from operations. USA operations expects to continue supporting cash needs for operations through earnings, liquidity and capital resources in FYE March 2000. UK operation needs are anticipated to substantially be supported through earnings. In addition, limited capital infusions from consolidated sources may occur. Capital expenditures are budgeted to be less than $1,000,000 in FYE 2000. At March 31, 1999 the domestic unused bank line of credit available was $11,919,000. The UK operation had an unused line of credit available of $794,000. 1998 COMPARED TO 1996 Net cash provided from operations in 1998 was $7,259,000 compared to $4,726,000 for 1996. The favorable position was due to improved profits and the ability to obtain progress payments on jobs in work-in-progress. Inventories increased over balances on hand at March 31, 1997 largely due to the accounting change recognizing certain sales on the percentage-of-completion method. As of March 31, 1998 the Company had consolidated working capital of $12,459,000. This represents a 51% increase over December 31, 1996. Capital expenditures in 1998 were $1,400,000 compared to 1996 of $1,291,000. Ninety-five percent of the capital expenditures in 1998 were invested in the USA facilities. NEW ORDERS AND BACKLOG Consolidated orders in the current year were down 37% from 1998 and 27% from 1996. The decrease in new orders in the current year as compared to the previous two years reflects the page 15 of 63 global cessation of capital expenditures in the market segments Graham serves and, in particular, the decline in Asia where new orders were down in excess of $7,000,000. By product, surface condensers booked FYE 1999 were fewer by $18,000,000 compared to March 1998. Orders for surface condensers in 1998 were up from 1996 in excess of $8,000,000 and ejector orders were up over $1,800,000. Bookings in 1998 were the highest in the Company's history. The consolidated backlog as of March 31, 1999 was $15,438,000 down 45% from 1998 and 40% from 1996. The backlog at year end will be shipped before March 31, 2000 and represents orders from traditional markets in Graham's established product lines. MARKET RISK (QUANTITATIVE AND QUALITATIVE DISCLOSURES) The principal market risks (i.e., the risk of loss arising from changes in market rates and prices) to which Graham is exposed are: - interest rates - foreign exchange rates - equity price risk The Company is exposed to interest rate risk primarily through its borrowing activities and less so through investments in marketable securities. It is the Company's practice to hold investments to maturity. Management's strategy for managing risks associated with interest rate fluctuations on debt is to hold interest bearing debt to the absolute minimum and carefully assess the risks and rewards for incurring long-term debt. Assuming year end 1999 variable rate debt, a 1% change in interest rates would impact annual interest expense by two thousand dollars. Graham's international consolidated sales exposure approximates fifty percent of annual sales. Operating in world markets involves exposure to movements in currency exchange rates. Currency movements can affect sales in several ways. Foremost, the ability to competitively compete for orders against competition having a relatively weaker currency. Business lost due to this cannot be quantified. Secondly, redemption value of sales can be adversely impacted. The substantial portion of Graham's sales are collected in US dollars. The Company enters into forward foreign exchange agreements to hedge its exposure against unfavorable changes in foreign currency values on significant sales contracts negotiated in foreign currencies. Graham uses derivatives for no other reason. Foreign operations constitute about 15% of Graham's 1999 consolidated net income. As currency exchange rates change, translations of the income statements of our UK business into US dollars affects year-over-year comparability of operating results. page 16 of 63 We do not hedge translation risks because cash flows from UK operations are mostly reinvested in the UK. A 10% change in foreign exchange rates would impact reported net income by approximately $35,000. The Company has a Long-Term Incentive Plan which provides for awards of share equivalent units (SEU) for outside directors based upon the Company's performance. The outstanding SEU's are recorded at fair market value thereby exposing the Company to equity price risk. Gains and losses recognized due to market price changes are included in the quarterly results of operations. Based upon the SEU's outstanding at March 31, 1999 and 1998 and a $8 per share price, a twenty to forty percent change in the respective year end market price of the Company's common stock would positively or negatively impact the Company's operating results by $19,000 to $37,000 for 1999 and $22,000 to $43,000 for 1998. In 1999, the gain, net of tax, recorded due to the decline in the stock price was not significant. Assuming the net income target of $500,000 is met and SEU's are granted to the five outside directors in accordance with the plan over the next five years, based upon the March 31, 1999 market price of the Company's stock of $8 per share, a twenty to forty percent change in the stock price would positively or negatively impact the Company's operating results by $29,000 to $57,000 in 2000, $39,000 to $77,000 in 2001, $41,000 to $81,000 in 2002, $43,000 to $85,000 in 2003, and $45,000 to $89,000 in 2004. OTHER MATTERS The Company has completed its Y2K readiness program. The program included the following phrases: identifying affected software, hardware, manufacturing, and telecommunication equipment; assessing the possible impact of the Year 2000 issue; hardware and software remediation; testing; surveying the Year 2000 readiness of customers and suppliers; and developing a contingency plan. Costs required to be compliant were minor. Although Graham believes its internal operations are Year 2000 ready, the Company cannot assure anyone that its customers, suppliers or governmental agencies will be ready. Increases in material and labor costs traditionally have been offset by cost cutting measures and selling price increases. Obtaining price increases are largely a factor of supply and demand for Graham's products, whereas inflation factors can originate from influences outside of the Company's direct global competition. Graham will continue to monitor the impact of inflation in order to minimize its effects in future years through sales growth, pricing, product mix strategies, productivity improvements, and cost reductions. The Company's USA operations are governed by federal environmental laws, principally the Resource Conservation and Recovery Act, the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), the Clean Air Act, and the page 17 of 63 Clean Water Act, as well as state counterparts ("Environmental Laws"). Environmental Laws require that certain parties fund remedial actions regardless of fault, legality or original disposal or ownership of the site. The Company is currently participating in an environmental assessment at one site under these laws. Future remediation expenses at this site are subject to a number of uncertainties, including the method and extent of remediation (dependent, in part, on existing laws and technology), the percentage and type of material attributable to the Company, the financial viability of site owners and the other parties, and the availability of state and federal funds. Graham has provided for its anticipated costs relevant to this project. ACCOUNTING STANDARD CHANGES As of April 1, 1998 the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." This statement requires reporting and disclosure of comprehensive income and its components in financial statement format. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non owner sources. Comprehensive earnings are reported under Consolidated Statement of Changes In Shareholders' Equity. Effective April 1, 1998 the Company adopted SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information," and SFAS No. 132, "Employers' Disclosure about Pensions and Other Postretirement Benefits." SFAS No. 131 establishes standards for reporting information about operating segments by public companies in their financial statements. It also establishes related disclosures about products and services, geographic areas and major customers. SFAS No. 132 standardizes the disclosure requirements, requires additional information on charges in the benefit obligations and fair values of plan assets and eliminates certain disclosures. In June 1998 the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The statement establishes accounting and reporting standards for derivative instruments, and for hedging activities. The statement is effective for fiscal years beginning after June 15, 2000. Graham uses derivatives on a limited basis as hedges for foreign currency exposure. The Company is currently studying the pronouncement. FORWARD LOOKING Winning the competitive edge in the new millennium will require mature companies to reinvent themselves to capture opportunities and keep pace with emerging markets, information technology and leave in the distance traditionally cost-prohibitive infrastructures. The era of virtual customer, continuous page 18 of 63 reengineering, and superior quality is today an entrenched organizational mind-set for survival. In the 21st century the focus will emphasize growth. Graham believes potentially Asian markets could significantly grow from the current 25% world share of GDP. Graham has a well established, successful strategy for selling into Asia and a history of customer loyalty. The Company believes growth will come from harvesting ideas from its customers and increased coordination between R&D and marketing; which will lead to new products and product enhancements. Additionally, the Company is actively pursuing acquisition opportunities. The immediate prospects for obtaining significant new orders in Asia and elsewhere will be difficult. The world economy is expected to further weaken in the year 1999. The European community, for the immediate future, may have plateaued in 1998. Significant Latin American economies could be affected by political events in months ahead which could weaken adjacent dependent economies. Although the USA economy is proving to be resilient so far, substantial markets Graham serves are experiencing consolidation, which has caused freezes on capital investments. The Company is in excellent financial condition and will continue to implement its strategies for growth and will further position itself to take full advantage of new business opportunities. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk ---------------------------------------------------------- Included in Item 7, Management's Discussion and Analysis -- Market Risk. page 19 of 63 Item 8. Item 8. Financial Statements and Supplementary Data ------------------------------------------- (Financial Statements, Notes to Financial Statements, Quarterly Financial Data) - -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. page 20 of 63 - -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEETS - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. page 21 of 63 - -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS - -------------------------------------------------------------------------------- See Notes of Consolidated Financial Statements. page 22 of 63 - -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY - -------------------------------------------------------------------------------- See Notes of Consolidated Financial Statements. page 23 of 63 - -------------------------------------------------------------------------------- Notes To Consolidated Financial Statements Note 1 - The Company and Its Accounting Policies: - -------------------------------------------------------------------------------- Graham Corporation and its subsidiaries are primarily engaged in the design and manufacture of vacuum and heat transfer equipment used in the chemical, petrochemical, petroleum refining, and electric power generating industries and sells to customers throughout the world. The Company's significant accounting policies follow. PRINCIPLES OF CONSOLIDATION AND USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The consolidated financial statements include the accounts of the Company and its majority-owned domestic and foreign subsidiaries. All significant intercompany balances, transactions and profits are eliminated in consolidation. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the related revenues and expenses during the reporting period. Actual amounts could differ from those estimated. Certain amounts in prior periods have been reclassified to conform to the current presentation. TRANSLATION OF FOREIGN CURRENCIES Assets and liabilities of foreign subsidiaries are translated into U.S. dollars at currency exchange rates in effect at year end and revenues and expenses are translated at average exchange rates in effect for the year. Gains and losses resulting from foreign currency transactions are included in results of operations. Gains and losses resulting from translation of foreign subsidiary balance sheets are reflected as a separate component of shareholders' equity. Translation adjustments are not adjusted for income taxes since they relate to an investment which is permanent in nature. REVENUE RECOGNITION The Company recognizes revenue and all related costs on contracts with a duration in excess of three months and with revenues of $1,000,000 and greater using the percentage-of-completion method. The percentage-of-completion is determined by relating actual labor incurred to-date to management's estimate of page 24 of 63 total labor to be incurred on each contract. Contracts in progress are reviewed monthly, and sales and earnings are adjusted in current accounting periods based on revisions in contract value and estimated costs at completion. All contracts with values less than $1,000,000 are accounted for on the completed contract method and included in income upon substantial completion or shipment to the customer. INVESTMENTS Investments consist primarily of fixed-income debt securities with maturities of beyond three months and less than twelve months. All investments are classified as held-to-maturity under the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115) as the Company has the positive intent and ability to hold the securities to maturity. In accordance with SFAS 115, the investments are stated at amortized cost which approximates fair value due to their short term and highly liquid nature. INVENTORIES Inventories are stated at the lower of cost or market. Cost is determined on the first-in, first-out method. Progress payments for orders are netted against inventory to the extent the payment is less than the inventory balance relating to the applicable contract. Progress payments that are in excess of the corresponding inventory balance are presented as customer deposits in the Consolidated Balance Sheets. PROPERTY AND DEPRECIATION Property, plant and equipment are stated at cost. Major additions and improvements are capitalized, while maintenance and repairs are charged to expense as incurred. Depreciation and amortization are provided based upon the estimated useful lives under the straight line method. Estimated useful lives range from approximately five to twenty-five years for office and manufacturing equipment and forty years for buildings and improvements. Upon sale or retirement of assets, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the results of operations. Impairment losses are recognized when the carrying value of an asset exceeds its fair value. The Company regularly assesses all of its long-lived assets for impairment and determined that no impairment loss need be recognized in the periods reported. INCOME TAXES The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been page 25 of 63 recognized in the Company's financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using currently enacted tax rates. The Company evaluates the available evidence about future taxable income and other possible sources of realization of deferred tax assets and records a valuation allowance to reduce deferred tax assets to an amount that represents the Company's best estimate of the amount of such deferred tax assets that more likely than not will be realized. STOCK-BASED COMPENSATION Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (SFAS 123) encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," (APB 25) and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Compensation cost for share equivalent units is recorded based on the quoted market price of the Company's stock at the end of the period. PER SHARE DATA Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share is calculated by dividing net income by the weighted average number of common and, when applicable, potential common shares outstanding during the period. A reconciliation of the numerators and denominators of basic and diluted earnings per share is presented below. page 26 of 63 Options to purchase 55,200 shares of common stock at $21.44 per share, 9,000 shares at $21.25, 2,250 shares at $17.88, 8,250 shares at $17, 2,250 shares at $16.13, 26,250 shares at $13.17, 8,250 shares at $11.33 and 9,000 shares at $11 were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares, resulting in an anti-dilutive effect. STOCK SPLIT On July 25, 1996, the Board of Directors authorized a three-for-two stock split distributed on August 23, 1996 to shareholders of record at the close of business on August 9, 1996. The Company distributed cash in lieu of fractional shares resulting from the stock split. The Company's par value of $.10 per share remained unchanged and as a result $53,000 was transferred from capital in excess of par value to common stock. CASH FLOW STATEMENT The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Actual interest paid was $292,000 in 1999, $254,000 in 1998, $65,000 for the three months ended March 31, 1997, and $384,000 in 1996. In addition, actual income taxes paid were $1,499,000 in 1999, $951,000 in 1998, $627,000 for the three months ended March 31, 1997, and $1,084,000 in 1996. Non cash activities during 1999, 1998 and 1996 included capital expenditures totaling $290,000, $68,000 and $134,000, respectively, which were financed through the issuance of capital leases. In addition, in 1999 a minimum pension liability adjustment, net of a tax benefit, was recognized totalling $1,191,000. ACCOUNTING AND REPORTING CHANGES Effective April 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130). This statement requires reporting and disclosure of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income is comprised of net income and other comprehensive income or loss items, which are reflected as a separate component of equity. For the Company, other comprehensive income or loss items include foreign currency translation adjustments and minimum pension liability adjustments. The financial statements presented for prior periods have been reclassified to reflect the adoption of SFAS 130. page 27 of 63 In the fourth quarter of fiscal year 1999, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement establishes new standards for reporting information about operating segments in interim and annual financial statements. The basis for determining the Company's operating segments is the manner in which financial information is used by the Company in its operations. Segment information is presented in Note 14 of the Consolidated Financial Statements. In fiscal year 1999, the Company adopted Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits" (SFAS 132). SFAS 132 revises employers' disclosures about pension and other postretirement benefit plans but does not change the measurement or recognition of those plans. Restatement of disclosures for prior years has been made for comparative purposes. These disclosures are included in Note 8 of the Consolidated Financial Statements. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and derivatives utilized for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. Management is evaluating the impact this statement may have on the Company's financial statements. page 28 of 63 - -------------------------------------------------------------------------------- Note 2 - Inventories: - -------------------------------------------------------------------------------- Major classifications of inventories are as follows: - -------------------------------------------------------------------------------- page 29 of 63 - -------------------------------------------------------------------------------- Note 3 - Property, Plant and Equipment: - -------------------------------------------------------------------------------- Major classifications of property, plant and equipment are as follows: page 30 of 63 - -------------------------------------------------------------------------------- Note 4 - Leases: - -------------------------------------------------------------------------------- The Company leases equipment and office space under various operating leases. Rent expense applicable to operating leases was $188,000, $191,000, $38,000, and $148,000 in 1999, 1998, 1997 and 1996, respectively. Property, plant and equipment include the following amounts for leases which have been capitalized. Amortization of property, plant and equipment under capital lease amounted to $182,000, $158,000, $39,000, and $59,000 in 1999, 1998, 1997 and 1996, respectively, and is included in depreciation expense. As of March 31, 1999, future minimum payments required under non-cancelable leases are: page 31 of 63 - -------------------------------------------------------------------------------- Note 5 - Debt: - -------------------------------------------------------------------------------- Short-Term Debt Due Banks The Company and its subsidiaries had short-term borrowings outstanding as follows: The United Kingdom subsidiary has a revolving credit facility agreement which provides a line of credit of 657,000 pounds sterling ($1,057,000 at the March 31,1999 exchange rate) including letters of credit and long-term borrowings. The interest rate is the bank's rate plus 1 1/2%. The bank's base rate was 5 1/2% and 7 1/4% at March 31, 1999 and 1998, respectively. The United Kingdom operations had available unused lines of credit of $794,000 at March 31, 1999. The weighted average interest rate on short-term borrowings in 1999 and 1998 was 7.9% and 10.8%, respectively. Long-Term Debt - -------------- The Company and its subsidiaries had long-term borrowings outstanding as follows: The United States revolving credit facility agreement provides a line of credit of up to $13,000,000 including letters of credit, through October 31, 1999. The agreement allows the Company to borrow at prime minus a variable percentage based upon certain financial ratios. The Company was able to borrow at a rate of prime minus 100 basis points at March 31, 1999 and 1998. The agreement allows the Company at any time to convert balances outstanding not less than $2,000,000 and up to $9,000,000 into a two-year term loan. This conversion feature is available page 32 of 63 through October 1999, at which time the Company may convert the principal outstanding on the revolving line of credit to a two-year term loan. The Company had no amounts outstanding on its revolving credit facility, excluding letters of credit, at March 31, 1999 and 1998. The bank's prime rate was 7.75% and 8.5% at March 31, 1999 and 1998, respectively. The United States operations had available unused lines of credit of $11,919,000 at year end. The Employee Stock Ownership Plan Loan Payable requires quarterly payments of $50,000 through 2000. (See Note 8 for a description of the Plan.) The United Kingdom term loan has a fixed rate of 9%. This term loan is due in 2000 and is repayable in equal monthly installments. Long-term debt requirements, excluding capital leases, are: 2000 - $300,000 and 2001 - $101,000. The Company is required to pay commitment fees of 1/4% on the unused portion of the domestic revolving credit facility. No other financing arrangements require compensating balances or commitment fees. Assets with a book value of $26,480,000 have been pledged to secure certain domestic long-term borrowings. The United Kingdom short-term and long-term bank borrowings are secured by assets of the United Kingdom subsidiary which have a book value of $3,518,000. Several of the loan agreements contain provisions pertaining to the maintenance of minimum working capital balances, tangible net worth, capital expenditures and financial ratios as well as restrictions on the payment of cash dividends to shareholders and incurrence of additional long-term debt. The most restrictive dividend provision limits the payment of dividends to shareholders to the greater of $400,000 or 25% of consolidated net income. In addition, the United States operations cannot make any loans or advances exceeding $500,000 to any affiliates without prior consent of the bank. page 33 of 63 - -------------------------------------------------------------------------------- Note 6 - Financial Instruments and Derivative Financial Instruments - -------------------------------------------------------------------------------- CONCENTRATIONS OF CREDIT RISK: Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments, short-term investments and trade receivables. The Company places its temporary cash investments and short-term investments with high credit quality financial institutions and actively evaluates the credit worthiness of these financial institutions. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their geographic dispersion. At March 31, 1999 and 1998, the Company had no significant concentrations of credit risk. LETTERS OF CREDIT: The Company has entered into standby letter of credit agreements with financial institutions relating to the guarantee of future performance on certain contracts. At March 31, 1999 and 1998, the Company was contingently liable on outstanding standby letters of credit aggregating $1,168,000 and $2,111,000, respectively. FOREIGN EXCHANGE RISK MANAGEMENT: The Company, as a result of its global operating and financial activities, is exposed to market risks from changes in foreign exchange rates. In seeking to minimize the risks and/or costs associated with such activities, the Company may utilize foreign exchange forward contracts with fixed dates of maturity and exchange rates. The Company does not hold or issue financial instruments for trading or other speculative purposes and only contracts with high quality financial institutions. If the counterparties to the exchange contracts do not fulfill their obligations to deliver the contracted foreign currencies, the Company could be at risk for fluctuations, if any, required to settle the obligation. At March 31, 1999 and 1998, there were no foreign exchange forward contracts held by the Company. FAIR VALUE OF FINANCIAL INSTRUMENTS: Based on the methods and assumptions detailed below, the differences between the carrying amounts and estimated fair values of the Company's investments and short-and long-term debt are insignificant. The methods and assumptions used to estimate the fair value of financial instruments are summarized as follows: page 34 of 63 INVESTMENTS - The fair value of investments is based on quoted market prices which approximates book value due to the short term and highly liquid nature of the investments. SHORT-TERM DEBT DUE BANKS - The carrying value of short-term debt approximates fair value due to the short-term maturity of this instrument. LONG-TERM DEBT - The carrying values of credit facilities with variable rates of interest approximate fair values. The fair value of fixed rate debt, which approximates the carrying value, was estimated by discounting cash flows using rates currently available for debt of similar terms and remaining maturities. page 35 of 63 - -------------------------------------------------------------------------------- Note 7 - Income Taxes: - -------------------------------------------------------------------------------- An analysis of the components of pre-tax income from continuing operations is presented below: The reconciliation of the provision calculated using the United States Federal tax rate with the provision for income taxes presented in the financial statements is as follows: The deferred income tax asset recorded in the Consolidated Balance Sheets results from differences between financial statement page 36 of 63 and tax reporting of income and deductions. A summary of the composition of the deferred income tax asset follows: Deferred income taxes include the impact of foreign net operating loss carryforwards which may be carried forward indefinitely and investment tax credits which expire from 2006 to 2009. In accordance with the provisions of SFAS 109, a valuation allowance of $328,000 at March 31, 1999 is deemed adequate to reserve for the foreign net loss carryforwards which are not considered probable of realization. The Company does not provide for additional U.S. income taxes on undistributed earnings considered permanently invested in its United Kingdom subsidiary. At March 31, 1998, such undistributed earnings totaled $1,980,000. It is not practicable to determine the amount of income taxes that would be payable upon the remittance of assets that represent those earnings. page 37 of 63 - -------------------------------------------------------------------------------- Note 8 - Employee Benefit Plans: - -------------------------------------------------------------------------------- Retirement Plans - ---------------- The Company has qualified defined benefit plans covering substantially all employees. The Company's plan covering employees in the United States is non-contributory. Benefits are based on the employee's years of service and average earnings for the five highest consecutive calendar years of compensation for the ten year period preceding retirement. The plan for employees in the United Kingdom is contributory with the employer's share being actuarially determined. Benefits are based on the employee's years of service and average earnings for the three highest years for the ten year period preceding retirement. The Company's funding policy for the United States plan is to contribute the amount required by the Employee Retirement Income Security Act of 1974. The pension obligations to employees covered by the Company's former domestic plan, terminated in 1986, were settled through the purchase of annuity contracts for each participant which guaranteed these future benefit payments. The components of pension cost are: The actuarial assumptions are: Pension expense for the U.S. Plan and the U.K. Plan for the three month period ending March 31, 1997 was $38,000 and $2,000, respectively. page 38 of 63 Changes in the Company's benefit obligation, plan assets and funded status for the pension plans are presented below: The Company recognized an additional minimum pension liability for the underfunded U.K. defined benefit plan. The additional minimum pension liability is equal to the excess of the accumulated benefit obligation over plan assets and the accrued liability net of an intangible asset and deferred tax asset. Amounts recognized in the Consolidated Balance Sheets consist of the following: The current portion of the pension liability as of March 31, 1999 and 1998 is included in the caption "Accrued Compensation" and the long-term portion is separately presented in the Consolidated Balance Sheets. Assets of the United States plan consist primarily of equity securities at March 31, 1999 and 1998. Assets of the United Kingdom plan consist of an investment contract with an insurance company which is primarily invested in equity securities. The vested benefit obligation of the United Kingdom plan is the actuarial present value of the vested benefits to which the employee is currently entitled but based on the employee's expected date of separation or retirement. The unrecognized net asset at transition is being amortized over the remaining service lives of the participants which approximates 19 years for the domestic plan and 13 years for the United Kingdom plan. page 39 of 63 The Company has a Supplemental Executive Retirement Plan for certain key executives. This unfunded plan provides retirement benefits associated with wages in excess of the legislated qualified plan maximums. Pension expense recorded in 1999, 1998, 1997 and 1996 related to this plan was $26,000, $6,000, $10,000 and $39,000, respectively. At March 31, 1999 and 1998, the related liability was $81,000 and $55,000, respectively, and is included in the caption "Accrued Pension Liability" in the Consolidated Balance Sheets. The Company has a defined contribution plan covering substantially all domestic employees. Company contributions to this plan are based on the profitability of the Company and amounted to $593,000, $647,000, $215,000, and $651,000 in 1999, 1998, 1997 and 1996, respectively. The Company has a deferred compensation plan that allows certain key employees to defer a portion of their compensation. The principal and interest earned on the deferred balances are payable upon retirement. The accrued compensation liability under this plan was $1,126,000 and $1,231,000 at March 31, 1999 and 1998, respectively. Employee Stock Ownership Plan - ----------------------------- The Company has a noncontributory Employee Stock Ownership Plan (ESOP) that covers substantially all employees in the United States. In 1990, the Company borrowed $2,000,000 under loan and pledge agreements. The proceeds of the loans were used to purchase 87,454 shares of the Company's common stock. The purchased shares are pledged as security for the payment of principal and interest as provided in the loan and pledge agreements. It is anticipated that funds for servicing the debt payments will essentially be provided from contributions paid by the Company to the ESOP, from earnings attributable to such contributions, and from cash dividends paid to the ESOP on shares of the Company stock which it owns. During 1999, 1998, 1997 and 1996 the Company recognized expense associated with the ESOP using the shares allocated method. This method recognizes interest expense as incurred on all outstanding debt of the ESOP and compensation expense related to principal reductions based on shares allocated for the period. Dividends received on unallocated shares that are used to service the ESOP debt reduce the amount of expense recognized each period. The compensation expense associated with the ESOP was $200,000, $200,000, $50,000 and $200,000 in 1999, 1998, 1997 and 1996, respectively. The ESOP received no dividends on unallocated shares in 1999, 1998, 1997, and 1996. Interest expense in the amount of $25,000, $42,000, $13,000 and $72,000 was incurred in 1999, 1998, 1997 and 1996, respectively. Dividends paid on allocated shares accumulate for the benefit of the employees. page 40 of 63 Other Postretirement Benefits - ----------------------------- In addition to providing pension benefits, the Company has a United States plan which provides health care benefits for eligible retirees and eligible survivors of retirees. The Company recognizes the cost of these benefits on the accrual basis as employees render service to earn the benefits. Early retirees who are eligible to receive benefits under the plan are required to share in twenty percent of the medical premium cost. In addition, the Company's share of the premium costs has been capped. The components of postretirement benefit cost are: Postretirement benefit cost for the three month period ending March 31, 1997 was $40,000. The assumptions used to develop the accrued postretirement benefit obligation were: The medical care cost trend rate used in the actuarial computation ultimately reduces to 5% in 2005 and subsequent years. This was accomplished using 1/2% decrements for the years 2000 through 2005. Changes in the Company's benefit obligation, plan assets and funded status for the plan are as follows: page 41 of 63 The current portion of the postretirement benefit obligation is included in the caption "Accrued Compensation" and the long-term portion is separately presented in the Consolidated Balance Sheets. Assumed medical care cost trend rates have a significant effect on the amounts reported for the postretirement benefit plan. A one percentage point change in assumed medical care cost trend rates would have the following effects: page 42 of 63 - -------------------------------------------------------------------------------- Note 9 - Stock Compensation Plans: - -------------------------------------------------------------------------------- The 1995 Graham Corporation Incentive Plan to Increase Shareholder Value provides for the issuance of up to 192,000 shares of common stock in connection with grants of incentive stock options and non-qualified stock options to officers, key employees and outside directors. The options may be granted at prices not less than the fair market value at the date of grant and expire no later than ten years after the date of grant. The 1989 Stock Option and Appreciation Rights Plan provides for the issuance of up to 188,700 shares of common stock in connection with grants of non-qualified stock options and tandem stock appreciation rights to officers, key employees and certain outside directors. The options may be granted at prices not less than the fair market value at the date of grant, and expire no later than ten years after the date of grant. The Company has a Long-Term Incentive Plan which provides for awards of share equivalent units for outside directors based upon the Company's performance. Each unit is equivalent to one share of the Company's common stock. Share equivalent units are payable in cash or stock upon retirement. The cost of performance units earned and charged to pre-tax income under this Plan in 1999, 1998, 1997 and 1996 was $50,000, $50,000, $10,000 and $40,000, respectively. The Company applies APB 25 and related Interpretations in accounting for its plans. Under the intrinsic value method, no compensation expense has been recognized for its stock option plans. Had compensation cost for the Company's two stock option plans been determined based on the fair value at the grant date for awards under those plans in accordance with the optional methodology prescribed under SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below: The weighted average fair value of the options granted during 1999, 1998, and 1996 is estimated as $3.97 $8.02, and $4.63, page 43 of 63 respectively, using the Black Scholes option pricing model with the following weighted average assumptions: Information on options and rights under the Company's plans is as follows: At March 31, 1999, the options outstanding had a weighted average remaining contractual life of 7.17 years. There were 168,050 options exercisable at March 31, 1999 which had a weighted average exercise price of $14.47. The remaining options are exercisable at a rate of 20 percent per year from the date of grant. The outstanding options expire December 1999 to October 2008. The number of options available for future grants were 84,100 at March 31, 1999 and 119,100 at March 31, 1998. page 44 of 63 - -------------------------------------------------------------------------------- Note 10 - Shareholder Rights Plan: - -------------------------------------------------------------------------------- On February 23, 1990 the Company adopted a Shareholder Rights Plan. Under the Plan, as of March 7, 1990, one share Purchase Right ("Right") is attached to each outstanding share of Common Stock. When and if the Rights become exercisable, each Right would entitle the holder of a share of Common Stock to purchase from the Company an additional share of Common Stock for $46.67 per share, subject to adjustment. The Rights become exercisable upon certain events: (i) if a person or group of persons acquires 20% or more of the Company's outstanding Common Stock; or (ii) if a person or group commences a tender offer for 30% or more of the Company's outstanding Common Stock. The Company may redeem the Rights for $.01 per Right at any time prior to the close of business on the date when the Rights become exercisable. After the Rights become exercisable, if the Company is acquired in a business combination transaction, or if at least half of the Company's assets or earning power are sold, then each Right would entitle its holder to purchase stock of the acquirer (or Graham, if it were the surviving company) at a discount of 50%. The number of shares that each Right would entitle its holder to acquire at discount would be the number of shares having a market value equal to twice the exercise price of the Right. page 45 of 63 - -------------------------------------------------------------------------------- Note 11 - Contingencies: - -------------------------------------------------------------------------------- The United States Environmental Protection Agency ("EPA") named the Company's predecessor-in-interest, Graham Manufacturing Co., Inc. as a Potentially Responsible Party pursuant to the Comprehensive Environmental Response, Compensation and Liability Act, as amended, in connection with the Batavia Landfill Site in the Town of Batavia, New York. A Pilot Allocation "Final Allocation Report" issued on September 30, 1998 by the allocator selected under the EPA pilot, allocated 1.597% of total remedial costs to the Company. In April 1999, EPA announced that it will proceed with a modification of the remedy for the site announced in a 1995 Record of Decision. EPA's estimate of the modified remedy is approximately $26,000,000 making the Company's full potential exposure in accordance with this estimate $416,000. EPA's estimate has not been audited or evaluated for appropriateness or accuracy and may contain significant portions which are not eligible for recovery. The Company has recorded a $300,000 liability for this item. The current portion of this liability is included in the caption "Accrued Expenses and Other Liabilities" and the long-term portion is included in the caption "Other Long-Term Liabilities" in the Consolidated Balance Sheets. page 46 of 63 - -------------------------------------------------------------------------------- Note 12 - Related Party Transactions: - -------------------------------------------------------------------------------- Director H. Russel Lemcke is President of the H. Russel Lemcke Group, which the Company has engaged to assist it in making an acquisition in fulfillment of its strategic plan. Pursuant to this engagement, which commenced in May 1999, the Company pays to Mr. Lemcke a retainer of $2,500 per month, together with out-of-pocket expenses. In the event that the Company were to acquire another business entity as a result of such assistance, Mr. Lemcke would be paid a fee of $100,000 plus 1% of the purchase price of the acquired entity. page 47 of 63 - -------------------------------------------------------------------------------- Note 13 - Fiscal Year End Change: - -------------------------------------------------------------------------------- In 1997, the Company changed its fiscal year end to March 31. Fiscal 1997 is a three month transition period ended March 31, 1997. The unaudited Statement of Operations for the comparable three month period in 1996 was as follows: page 48 of 63 - -------------------------------------------------------------------------------- Note 14 - Segment Information: - -------------------------------------------------------------------------------- The Company's business consists of two operating segments based upon geographic area. These segments were determined based upon the manner in which financial information is used by management in operating the Company. The United States segment designs and manufactures heat transfer and vacuum equipment. Heat transfer equipment includes surface condensers, Heliflows, water heaters and various types of heat exchangers. Vacuum equipment includes steam jet ejector vacuum systems and liquid ring vacuum pumps. These products are sold individually or combined into package systems for use in several industrial markets. The Company also services and sells spare parts for its equipment. The operating segment located in the United Kingdom manufactures vacuum equipment which includes liquid ring vacuum pumps, piston pumps, ejectors and complete vacuum pump systems. Intersegment sales represent intercompany sales made based upon a competitive pricing structure. All intercompany profits in inventory are eliminated in the consolidated accounts and are included in the eliminations caption below. In computing segment net income or loss, corporate expenses incurred by the United States segment have been charged to the United Kingdom segment on a management fee basis. Operating segment information is presented below: page 49 of 63 The operating segment information above is reconciled to the consolidated totals as follows: Total segment interest revenue, interest expense, depreciation and amortization, income tax expense (benefit) and expenditures for long-lived assets are equivalent to the consolidated totals for each of these items. Operating segments incurred research and development costs of $371,000, $404,000, $91,000 and $375,000 in 1999, 1998, 1997 and 1996, respectively. Net sales by product line follows: page 50 of 63 The breakdown of net sales and long-lived assets by geographic area is: page 51 of 63 - -------------------------------------------------------------------------------- Quarterly Financial Data: - -------------------------------------------------------------------------------- A capsule summary of the Company's unaudited quarterly sales and earnings per share data for 1999 and 1998 is presented below: page 52 of 63 INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders of Graham Corporation Batavia, New York We have audited the accompanying consolidated balance sheets of Graham Corporation and subsidiaries as of March 31, 1999 and 1998, and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for the years ended March 31, 1999 and 1998, for the three month period ended March 31, 1997, and for the year ended December 31, 1996. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Graham Corporation and subsidiaries as of March 31, 1999 and 1998, and the results of their operations and their cash flows for the years ended March 31, 1999 and 1998, for the three month period ended March 31, 1997, and for the year ended December 31, 1996 in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP Deloitte & Touche LLP Rochester, New York May 21, 1999 page 53 of 63 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- --------------------------------------------------------------- Financial Disclosure -------------------- (Not Applicable) PART III -------- Item 10. Item 10. Directors and Executive Officers - -------- -------------------------------- The information called for under this Item pursuant to Item 401 of the Commission's Regulation S-K is set forth in statements under "Election of Directors" on pages 3 and 7 of the Registrant's Proxy Statement for its 1999 Annual Meeting of Stockholders, which statements are hereby incorporated herein by reference. Item 11. Item 11. Executive Compensation - -------- ---------------------- The information called for under this Item is set forth in statements under "Directors' Fees" on pages 5 and 6 of Registrant's Proxy Statement for its 1999 Annual Meeting of Stockholders and also under "Compensation of Executive Officers" on pages 8 to 12 of such proxy statement, which statements are hereby incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - -------- -------------------------------------------------------------- (a) Security Ownership of Certain Beneficial Owners ----------------------------------------------- The information called for under this Item is set forth in statements under "Principal Stockholders" on page 2 of Registrant's Proxy Statement for its 1999 Annual Meeting of Stockholders, which statements are hereby incorporated herein by reference. (b) Security Ownership of Management -------------------------------- The information called for under this Item is set forth in statements under "Principal Stockholders" on page 2, "Election of Directors" on pages 3 to 6 and "Executive Officers" on page 7 of Registrant's Proxy Statement for its 1999 Annual Meeting of Stockholders, which statements are hereby incorporated herein by reference. (c) Changes in Control ------------------ (Not applicable.) page 54 of 63 Item 13. Item 13. Certain Relationships and Related Transactions - -------- ---------------------------------------------- The information called for under this Item is set forth in statements under "Principal Stockholders" on page 2 and "Election of Directors" on pages 3 to 6 of Registrant's Proxy Statement for its 1999 Annual Meeting of Stockholders, which statements are hereby incorporated herein by reference. Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-k - -------- --------------------------------------------------------------- (a) (1) The following are Financial Statements and related information filed as part of this Annual Report on Form 10-K. page 55 of 63 Other financial statement schedules not included in this Annual Report on Form 10-K have been omitted because they are not applicable or because the required information is shown in the financial statements or notes thereto. page 56 of 63 INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Graham Corporation Batavia, New York We have audited the consolidated financial statements of Graham Corporation and subsidiaries as of March 31, 1999 and 1998, and for the years ended March 31, 1999 and 1998, for the three month period ended March 31, 1997, and for the year ended December 31, 1996 and have issued our report thereon dated May 21, 1999; such report is included elsewhere in this Annual Report on Form 10-K. Our audits also included the consolidated financial statement schedule of Graham Corporation and subsidiaries, listed in Item 14(a)2. This financial statement schedule is the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Deloitte & Touche LLP Deloitte & Touche LLP Rochester, New York May 21, 1999 page 57 of 63 GRAHAM CORPORATION AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS Notes: (a) Represents costs charged against the reserve associated with the discontinued operation. (b) Represents foreign currency translation adjustment. (c) Represents a reversal of the reserve and a foreign currency translation adjustment. (d) Represents a bad debt recovery and a foreign currency translation adjustment. page 58 of 63 (a) (3) The following exhibits are required to be filed by Item 14(c) of Form 10-K: Exhibit No. - ----------- *3.1 Articles of Incorporation of Graham Corporation +3.2 By-laws of Graham Corporation *4.1 Certificate of Incorporation of Graham Corporation (included as Exhibit 3.1) **4.2 Shareholder Rights Plan of Graham Corporation ***10.1 1989 Stock Option and Appreciation Rights Plan of Graham Corporation ****10.2 1995 Graham Corporation Incentive Plan to Increase Shareholder Value +10.3 Graham Corporation Outside Directors' Long-Term Incentive Plan +10.4 Employment Contracts between Graham Corporation and Named Executive Officers +10.5 Senior Executive Severance Agreements with Named Executive Officers 11 Statement regarding computation of per share earnings Computation of per share earnings is included in Note 1 of the Notes to Consolidated Financial Statements +18 Letter regarding change in accounting principles 21 Subsidiaries of the registrant 23 Consent of Deloitte and Touche LLP 27 Financial Data Schedule - ---------------- + Incorporated herein by reference from the Annual Report of Registrant on Form 10-K for the fiscal year ended March 31, 1998. * Incorporated herein by reference from the Annual Report of Registrant on Form 10-K for the year ended December 31, 1989. ** Incorporated herein by reference from the Registrant's Current Report on Form 8-K dated February 26, 1991, as amended by Registrant's Amendment No. 1 Form 8 dated June 8, 1991. *** Incorporated herein by reference from the Registrant's Proxy Statement for its 1991 Annual Meeting of Shareholders. **** Incorporated herein by reference from the Registrant's Proxy Statement for its 1996 Annual Meeting of Shareholders. (b) The Registrant filed no reports on Form 8-K during the last quarter of the fiscal year covered by this Annual Report on Form 10-K. page 59 of 63 Cross Reference Sheet for Annual Report on Form 10-K for the year ended March 31, 1999, setting forth item numbers and captions of Form 10-K (and related Items of Regulation S-K referred to therein) under which information is incorporated by reference and the pages in the Registrant's Proxy Statement for the 1999 Annual Meeting of Stockholders where that information appears. page 60 of 63 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. GRAHAM CORPORATION ------------------------------------ DATE: June 18, 1999 By /s/ J. Ronald Hansen ------------------------------------ J. Ronald Hansen Vice President-Finance & Administration and Chief Financial Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature President and Chief /s/ Alvaro Cadena Executive Officer; June 18, 1999 - ------------------------------- Director Alvaro Cadena Vice President-Finance & Administration and Chief /s/ J. Ronald Hansen Financial Officer (Principal June 18, 1999 - ------------------------------- Accounting Officer) J. Ronald Hansen /s/ Philip S. Hill Director June 18, 1999 - ------------------------------- Philip S. Hill /s/ Cornelius S. Van Rees Director June 18, 1999 - ------------------------------- Cornelius S. Van Rees /s/ Jerald D. Bidlack Director; Chairman of June 18, 1999 - ------------------------------- the Board Jerald D. Bidlack /s/ Helen H. Berkeley Director June 18, 1999 - ------------------------------- Helen H. Berkeley /s/ H. Russel Lemcke Director June 18, 1999 - ------------------------------- H. Russel Lemcke page 61 of 63 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------- EXHIBITS filed with FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) of THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED March 31, 1999 -------------------- GRAHAM CORPORATION - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- page 62 of 63 GRAHAM CORPORATION FORM 10-K March 31, 1999 EXHIBIT NUMBER DESCRIPTION OF DOCUMENT ------ ----------------------- 21 Subsidiaries of the Registrant 23 Consent of Deloitte & Touche LLP 27 Financial Data Schedule page 63 of 63

889567_1999.txt

889567_1999

1999

889567

Item 1. Business (a) Jefferson Futures Reserve I, L.P. (the "Fund", the "Partnership", the "Registrant) a limited partnership that was organized on August 14, 1991, commenced trading on May 5, 1993. The business of the Fund is the speculative trading of commodity interests. The General Partner for the Fund Advanced Futures Strategies, Inc. (the "General Partner"). Lamborn Securities, Inc. ("Lamborn") will act as the selling agent for the Fund. There were changes made during 1999 that affected asset allocation to the Trading Advisors. Willowbridge Associates, Inc. was dropped as a trading advisor as of May 1, 1999, and the and the allocation of the trading assets to Willowbridge Associates was increased slightly. The commodity broker for the Fund is Fimat Futures U.S.A., Inc. (The "Broker"). The Fund will terminate on December 31, 2011, or upon any occurrence that would require dissolution as specified in the Funds prospectus. The Fund will pay a flat fixed-rate commission fee of .75 of 1% (9% annually) of the Partnerships Net Assets (before deducting for management and incentive fees) to the Broker as of the end of each month. The Broker will then pay all executions costs connected with the clearing the Partnerships account, including all NFA, exchange, floor brokerage, give-up, clearing, and other fees. The Broker may then remit to the Selling Agent a potion of such brokerage fee. The Fund incurs ongoing legal, accounting, administrative, and other miscellaneous costs. The Fund has no Employees. The fund does not engage in operations in any foreign countries other than trading on foreign exchanges. Trendlogic's management agreement remains in place from the previous year. Pursuant to the terms of such agreement, the Fund, via the General Partner, pays the Advisors a monthly management fee on all Net Allocated Assets (as defined in the Fund's Prospectus), in the respective Advisor's trading account ranging from 0 - 2.5% annually. The Fund pays the Advisors a quarterly incentive fee ranging from 10 - 17.5% of Trading Profits (as defined in the Prospectus), if any, achieved on the Net Allocated Assets in the respective Advisor's account as of such fiscal quarter. Trading Profits (Loss), as defined, are equal to the net of gains and losses realized during such fiscal quarter from transactions initiated by the Advisors, plus or minus the net change during such fiscal quarter in unrealized gains or losses from transactions initiated by such advisor, less the allocated portion of fixed brokerage commission fees paid or accrued), minus any accumulated Trading Loss relating to periods prior to such fiscal quarter (adjusted as provided below for redemptions and distributions allocated to the Advisors during such fiscal quarter) incurred by the Advisor since the quarter end as of which an incentive fee was previously paid to the Advisor or, if no incentive fee has ever been paid to the Advisor, from the inception of trading. The Cumulative Trading Loss (CTL), if any, shall be reduced as of each month-end in which distributions, redemptions, or reallocations from the Advisor are deemed to have occurred. For purposes hereof, redemptions are deemed to have occurred on the applicable Redemption Date (as defined in the Limited Partnership Agreement) and distributions and redemptions are deemed to have occurred as of the month-end in which such distributions were payable or such reallocations were effected. The Fund's final prospectus dated October 27, 1992 contains a more detailed description of the fee calculations. The Trading Advisors and the General Partner are required to be registered under regulations of the CFTC and the NFA, a commodity industry self-regulatory organization. The Commodity Broker is required to be registered with the CFTC and the NFA as a Future Commission Merchant and is subject to certain financial and other requirements in order to maintain its registration. Item 2. Item 2. Properties. The Fund does not own or lease any real property. The General Partner uses its offices to perform administrative services for the Fund at no cost to the Fund. Item 3. Item 3. Legal Proceedings. The General Partner is not aware of any pending legal proceedings to which the Fund or the General Partner is a party or to which any of its assets are subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted during the fiscal year ended December 31, 1999 to a vote of security holders through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholders Matters. There is no established public trading market for the Units, nor will one develop. Units may be transferred or redeemed subject to the condition imposed by the Agreement of Limited Partnership. As of December 31, 1999 a total of 437 Units were outstanding and held by approximately 65 Unit Holders including 26.0 Units of General Partnership interest. The General Partner, pursuant to the Limited Partnership Agreement, has the sole discretion in determining what distributions, if any, the Partnership will make to its Unit Holders. The General Partner has not made any distributions as of December 31, 1999. Item 6. Item 6. Selected Financial Data. The following is a summary of operations and total assets of the Partnership for the years ended December 31, 1999, December 31, 1998, December 31, 1997, December 31, 1996, and December 31, 1995. See Following Page For Selected Financial Data. JEFFERSON FUTURES RESERVE I, L.P. SELECTED FINANCIAL DATA FOR THE YEARS ENDED DECEMBER 31, 1999, 1998, 1997, 1996 AND 1995 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Liquidity The Partnership's assets are on deposit in separate commodity interest trading accounts with the Broker and are used by the Partnership as margin to engage in commodity futures, forward contracts and other commodity interest trading. The Broker holds such assets in either non-interest bearing bank accounts or in securities approved by the CFTC for investment of customer funds. The Partnership's assets held by the Broker may be used as margin solely for the Partnership's trading. Since the Partnership's sole purpose is to trade in commodity futures contracts and other commodity interests, it is expected that the Partnership will continue to own such liquid assets for margin purposes. The Partnership's investment in commodity futures contracts, forward contracts and other commodity interests may be illiquid. If the price for a futures contract for a particular commodity has increased or decreased by an amount equal to the "daily limit", positions in the commodity can neither be taken nor liquidated unless traders are willing to effect trades at or within the limit. Commodity futures prices have occasionally moved the daily limit for several consecutive days with little or no trading. Such market conditions could prevent the Partnership from promptly liquidating its commodity futures positions. There is no limitation on daily price moves in trading forward contracts on foreign currencies. The markets for some world currencies have low trading volume and are illiquid, which may prevent the Partnership from trading in potentially profitable markets or prevent the Partnership from promptly liquidating unfavorable positions in such markets and subjecting it to substantial losses. Either of these market conditions could result in restrictions on redemptions. Capital Resources The purpose of the Fund is to trade commodity interests; as such, the Fund does not have, nor does it expect to have, any capital assets and has no material commitments for capital expenditures. The Fund's use of assets is solely to provide necessary margin or premiums for, and to pay for any losses incurred in connection with its trading activities. Results of Operations Total assets of the partnership as of December 31, 1999 were $295,871, $697,219, at December 31, 1998, $783,601, at December 31, 1996 were $1,116,477, at December 31, 1995 were $1,652,303, and at December 31, 1994 they were $1,715,818. The Fund permits units to be redeemed after the first six months of operation of the Fund, with a redemption charge of 4% for any withdrawals from 6-9 months. The other redemption fees will be 3%, 2%, 1%, and 0%, for redemptions occurring 10-12 months, 13-15 months, 16-18 months, and after 18 months, respectively. During the year ended December 31, 1994 total redemptions were $236,626, during 1995 redemptions totaled $294,488, during 1996 redemptions totaled $431,970, during 1997 redemptions totaled $227,241, during 1998 redemptions totaled $85,385, and during 1999 redemptions totaled $226,746. As of December 31, 1999, the Net Asset Value per Unit was $603, a loss of 34.9%. At December 31, 1998, the Net Asset Value per Unit was approximately $925, a gain of 5.54% over the prior years N.A.V. As of December 31, 1997, the Net Asset Value per Unit was approximately $876, a loss of 14.38% over the prior years N.A.V. At December 31, 1996, the Net Asset Value per Unit was approximately $1,023, a loss of 3.2% over the prior years N.A.V. As of December 31, 1995, the Net Asset Value per Unit was approximately $1,057, a gain of 13.2% over the prior years N.A.V. At December 31, 1994, the Net Asset Value per Unit was approximately $934, which reflects a net gain of 2.3% for the year ended December 31, 1994. In 1999, the partnership had a net loss of $168,138, with the Advisors having a combined trading loss of $123,613. In 1998, the partnership had a net gain of $31,519, with the Advisors having a combined trading gain of $99,515. In 1997, the partnership had a net loss of $114,690, with the Advisors having a combined trading loss of $25,762. In 1996, the partnership had a net loss of $56,511, with the Advisors having a combined trading gain of $14,041 for the same period. In 1995, the partnership had a net gain of $209,921, with the Advisors having a combined trading gain of $371,711 for the same period. The partnership had a net gain for the year ended December 31, 1994 of $30,498. For the same period, the Advisors had a combined trading gain of $142,627. Item 8. Item 8. Financial Statements and Supplementary Data. The information required by this item is attached hereto. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The Fund has no directors or executive officers, as it is managed by the General Partner. There are no "significant employees" of the fund. The Funds General Partner is Advanced Futures Strategies, Inc., a Delaware corporation incorporated on August 1, 1991. The General Partner has been registered with the CFTC as a Commodity Pool Operator and Commodity Trading Advisor since October 29, 1991, and is also an NFA member. In July 1994, Mr George D.F. Lamborn acquired all the shares of the General Partner that he did not previously own. Mr. Lamborn has been a majority shareholder of the General Partner since inception. There were no material changes in the General Partner's management or activities. The only principals of the General Partner are as follows: George D.F. Lamborn is the President and sole principal shareholder of the General Partner. Since December 1990, Mr. Lamborn has also served as the President, Director and sole shareholder of Lamborn Asset Management Inc., ("LAMI") and introducing broker guaranteed by the Broker and the parent company of Lamborn Securities Inc. ("LSI"), the Selling Agent and an introducing broker guaranteed by the Broker, and of Lamborn Commodity Pool Management, Inc., a Commodity Pool Operator. Mr. Lamborn has also served in various industry positions, including serving as President of the Futures Industry Association, as a co-founder and Director of NFA, on several CFTC and Exchange Advisory Committees, as well as serving as Chairman for the Coffee, Sugar & Cocoa Exchange and the CSC Clearing Corporation. From August 1989 through December 1990, He was Chairman for Balfour Maclaine Futures, Inc., a futures commission merchant. From 1985 through August, 1989, he served as a Senior Vice President and Manager of the Futures Division at Thompson McKinnon Securities, Inc. From 1983 to 1985, he was the Chairman of Donaldson, Lufkin & Jenrette Futures, Inc. From 1981 to 1983, he was Co-Chairman of Refco International. He previously held the positions of Senior Managing Director at Shearson American Express and President of Donaldson, Lufkin & Jenrette Futures. Mr. Lamborn attended Brown University. Phillip L. Fondren, is the Vice-President and Secretary of the General Partner. In 1975 he joined Shearson Hayden Stone and managed its Metals Department until 1983. It was under his guidance that it developed its bullion trading business and became an international bullion dealer. In 1983 he became Executive Vice President of Commodity Services of Shearson Lehman Brothers. In 1987 Mr. Fondren joined Thompson McKinnon Securities, Inc. and developed its foreign exchange, metals, and energy business. In 1989 he joined the Balfour Maclaine Corporation to establish its foreign exchange and bullion business. He was also responsible for managing its Portfolio Management business. From December 1990 to December 1991, he was the President of Balfours' futures brokerage company. In February, 1992, Mr. Fondren started his own firm, Altra Management Services, Inc., a consulting business which provides services in the foreign exchange and managed futures industries. Item 11. Item 11. Executive Compensation. The Fund has no officers or directors. the General Partner or the Broker performs the services for the Fund as described in the Prospectus. The General Partner may receive an incentive fee from the Fund in the amount of the difference between 20% of the Net Increase in Net Asset Value and the actual incentive fees accrued and paid to the Advisors for trading gains which are calculated on their allocated portion of the Fund assets. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The Partnership has no directors or officers: the Limited Partnership Agreement delegates all management of the Partnership's affairs to the General Partner. The registrant does not know of any arrangement the operation of which may at a subsequent date result in a change in control of the registrant. As of December 31, 1999, the General Partner owned 26 units of General Partner Interest valued at $15,680. As of December 31, 1999, the following persons were known to the registrant to be beneficial owners of more than 5% of the Units Title of Name and Address Amount and Nature Percent of Class Of Beneficial Owner of Beneficial Ownership Class - -------- ------------------- ----------------------- ---------- Limited Chester Jarmolowski $ 15,077 5.8% Partner- 2301 Ferguson Road ship Allison Park, PA Unit 15101 Item 13. Item 13. Certain Relationships and Related Transactions. Except as described in the Prospectus and Items 11 and 12 above, there are no relationships or related transaction which are required to be described herein other than as described below. The public offering of the Units began on October 27, 1992 and concluded as of May 4, 1993. Lamborn Securities Inc. acted as the selling agent of the Units and received commission payments from the Broker totaling $ 77,572 as of December 1993. There were no new partnership units sold during 1999, 1998, 1997, 1996, 1995 or 1994. In addition, Advanced Computer Strategies, Inc. paid for the organizational and offering expenses of the Partnership, totaling $615,000. ACS was partially reimbursed for its payment of such expenses by the Partnership from a payment of 5% of subscription proceeds and will receive non-trading income earned on the Partnership's assets, and redemption penalties charged for early redemption of Units up to a maximum of a total of 15% of the Fund's subscription proceeds. PART IV Item 14. Item 14. Exhibits, Financial Statements Schedules, and Reports on Form 8-K. (a) (1) and (2)Financial Statements and Financial Statements Schedules. The Financial Statements and Report of Independent Auditors listed in the accompanying index are file as part of this annual report. (3) Exhibits. --------- *3.01 Limited Partnership Agreement of the Partnership *3.02 Certificate of Limited Partnership of the Registrant *3.03 Request for Redemption *4.01 Specimen of Unit Certificate *10.01 Form of Customer Agreement and Supplement to Customer Agreement between Registrant and Brody, White & Company, Inc. *10.02 Form of Subscription Agreement *10.03 Form of Escrow Agreement between Registrant and United Missouri Bank, n.a. *10.04 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Chang-Crowell Management Corporation. *10.05 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and G.K. Capital Management, Inc. *10.06 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Oppenheimer Futures Trading Advisory Services, Inc. *10.07 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Intertrade, Inc. *10.08 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Willowbridge Associates, Inc. *10.08(a) Form of Amendment No. 1 to the Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Willowbridge Associates, Inc. **10.09 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Witter & Lester, Inc. ***10.10 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Silver Knight Investment Management, Ltd. ****10.11 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and Crow Trading, Inc. ****10.12 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and FX 500 Ltd. *******10.13 Form of Management Agreement among Registrant, Advanced Computer Strategies, Inc. and TrendLogic Associates, Inc. ** 13.01 1993 Annual Report to Limited Partners. *** 13.02 1994 Annual Report to Limited Partners. **** 13.03 1995 Annual Report to Limited Partners *****13.04 1996 Annual Report to Limited Partners ******13.05 1997 Annual Report to Limited Partners *******13.06 1998 Annual Report to Limited Partners 13.07 1999 Annual Report to Limited Partners * Incorporated by reference from the Partnership's Registration Statement on Form S-1 (File No. 33-49716). ** Incorporated by reference from the Partnership's 1993 Form 10K *** Incorporated by reference from the Partnership's 1994 Form 10K **** Incorporated by reference from the Partnership's 1995 Form 10K ***** Incorporated by reference from the Partnership's 1996 Form 10K ****** Incorporated by reference from the Partnership's 1997 Form 10K ******* Incorporated by reference from the Partnership's 1998 Form 10K Exhibit 13.06 is filed herewith in. The registrant has no subsidiaries. (b) Reports on Form 8-K None SIGNATURES Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 20th day of March 2000. JEFFERSON FUTURES RESERVE I, L.P. (Registrant) /s/ George Lamborn ------------------------------------ George Lamborn, President Advance Computer Strategists, Inc. General Partner Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 20th day of March 2000. /s/ George Lamborn - --------------------------------------- George Lamborn, President and Director Advance Computer Strategists, Inc. General Partner

1096219_1999.txt

1096219_1999

1999

1096219

ITEM 1. BUSINESS COMPANY OVERVIEW Neoforma.com is a leading provider of business-to-business e-commerce services in the large and highly fragmented market for medical products, supplies and equipment. Our services enable users to efficiently and cost-effectively buy and sell new and used medical products in an open, online marketplace. Our marketplace aggregates suppliers of a wide range of medical products and presents their offerings to the physicians, hospitals and other healthcare organizations that purchase these products. We believe that our services provide supply chain efficiencies for both suppliers and purchasers of medical products and extend the reach of existing sales and distribution channels. We offer three primary services -- Shop, Auction and Plan -- that together address the entire healthcare purchasing lifecycle, from planning through procurement to liquidation. Our Shop service provides a unified marketplace where purchasers can easily locate and buy new medical products, and suppliers can access new customers and markets. Our Auction service creates an efficient marketplace for idle assets by enabling users to list, sell and buy used, refurbished and surplus medical products. Our Plan service provides interactive content to healthcare facility planners to reduce the complexities of planning and outfitting facilities. We also offer a wide range of content to healthcare practitioners and purchasers to enable them to make more informed purchasing decisions. OUR SERVICES Shop Our Shop service, released in August 1999, provides a unified marketplace where purchasers can easily identify, locate and purchase new medical products, and suppliers can access new customers and markets. As of March 17, 2000, Shop had over 142,000 different stockkeeping units, or SKUs, available for purchase under agreements with 204 manufacturers and distributors. Our agreements with distributors provide listings of products from an additional 1,100 manufacturers. We have agreements with additional manufacturers and distributors that will provide us with access to an estimated 160,000 additional SKUs, which we are currently adding to Shop. The products currently available through Shop range from disposable gloves to surgical instruments and diagnostic equipment. Shop provides detailed descriptions, photographic images and vendors' shipping and billing policies for listed products. We currently provide pricing information for more than 80% of the SKUs listed on Shop. With regard to products that do not contain pricing information, prospective purchasers are provided with contact information to allow them to obtain price quotes directly from the seller of the product. Listings are displayed in a consistent format and organized by standard classification schemes to facilitate the selection of products. Shop's search capabilities further assist purchasers in locating and selecting products from multiple suppliers. Moreover, we also provide suppliers the ability to directly update their product information on our website to include revised pricing, new product introductions or additional information. Purchasers can use Shop to order products at list or customer-specific prices or to obtain price quotes from the supplier. Shop accelerates the process of negotiating and completing transactions between purchasers and sellers. Our system automatically notifies the supplier by electronic transmission directly to their order management system or via an email when the purchaser places an order through Shop. When the supplier responds to or updates the order in any fashion, our system automatically notifies the buyer. This process is aided by our customer service organization, which answers questions about our system as necessary. We do not take ownership or possession of the products sold through Shop. Suppliers are responsible for providing product availability and delivery information through our website. They are also responsible for shipping, delivery and returns. Suppliers can choose to accept payment by open accounts with the purchasers, payment upon delivery, letter of credit or credit card. The purchaser is required to provide payment information to the supplier through our website when placing the order, and the supplier is responsible for payment processing and collection. We derive our revenue from Shop from transaction fees charged to suppliers for confirmed orders, and fees to digitize their product information for display on our website and for maintenance of product information and content on our website. As of December 31, 1999, we had derived approximately $83,000 in revenues from our Shop services. Shop product information is provided to us by suppliers in a variety of electronic formats or in paper form, and is internally reviewed and categorized by our medical editors. We use an independent firm to assist us in converting this information into a consistent electronic format that conforms to our classification systems. We believe that our ability to process large volumes of product information allows us to rapidly increase our product database and provides significant flexibility to suppliers in loading and updating information. We plan to extend Shop's functionality by introducing new information reporting and order management features, allowing users to track their use of our services and helping them better ensure compliance with their procurement procedures and policies. We also intend to enable Shop to electronically transmit information directly to the purchasing systems used by many medical product purchasers. In addition, we intend to enhance customer-specific pricing capabilities, allowing our services to better integrate with the processes of large purchasing organizations. We believe these enhancements will be particularly important to large purchasing organizations, such as hospitals, integrated delivery networks, or IDNs, and members of group purchasing organizations, or GPOs, that are focused on achieving new efficiencies and frequently rely on pre-negotiated pricing. Our future success relies on our ability to address the needs of large healthcare providers by successfully developing and introducing these capabilities in a timely manner. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors That May Affect Operating Results -- If we are unable to expand our registered user base and the functionality of our services, we may not provide an attractive alternative to the websites or systems used by large healthcare organizations and we may not achieve market acceptance with these organizations." Auction Our Auction service enables users to list, sell and buy used and refurbished equipment and surplus medical products. Auction includes online listings of used, refurbished and surplus products for bids through our AdsOnline service, live auctions through our AuctionLive service and online auctions through our AuctionOnline service. We introduced our AdsOnline service in May 1999, which enables sellers to list their used, refurbished and surplus medical products for bids from prospective buyers. When a buyer submits a bid for a product listed on AdsOnline, the seller is automatically notified via an email from our website that a buyer has placed a bid for one of its products. The seller can then access our website to obtain information about the bid, including the identity of the buyer, the amount of the bid and the period of time that the buyer has indicated that it will keep its bid open. The seller can accept the bid it finds most attractive or choose not to accept any bids. The buyer is automatically notified via an email if a seller has accepted its bid. We introduced our AuctionLive service in August 1999 with the acquisition of General Asset Recovery, a live auction house and asset management company focused on medical products. Our live auctions are conducted by us at one of our warehouses in Chicago, a facility in Los Angeles or onsite at a seller's facility. These auctions are conducted by an auctioneer, where each product may have a minimum opening price and the product is sold to the highest bidder. In addition, our website contains photographs and more detailed information regarding products that will be available in future live auctions. We introduced our AuctionOnline service in November 1999. This service enables sellers to sell their used and surplus medical products, individually or in lots, to the highest bidder in an online auction. Prospective bidders can access a product webpage for each item that typically features a concise product description and full-color image. In addition, a table lists the minimum opening bid, the bid range, the minimum incremental bid, the current winning bidders and the amount of their bids and the time of auction close. After a prospective buyer bids on a product, the corresponding bidder list is instantly updated to reflect the bid and the prospective buyer's new position in the list of bidders. When the auction closes, the highest bidder wins the product at his or her final bid price. Our AuctionOnline service automatically determines the winning bidder and sends an e-mail message to confirm his or her purchase the same day. We offer a complete solution for managing used, refurbished and surplus healthcare equipment. We work with sellers to determine which of our three Auction services is the best method for selling their used, refurbished and surplus medical products. Our Auction agreements typically appoint us as seller's agent for the purpose of selling their designated used, refurbished and surplus medical products through any of our Auction services. Purchasers may choose to remit the purchase price to us in a variety of payment methods and we then send these proceeds, net of our commissions and fees and any taxes owed by the purchaser, to the seller within a specified time period. We generally take possession of products sold through our Auction services, and in shipping the sold items to the winning bidders, we transfer the risk of loss or damage to the purchaser once the product leaves our warehouse. We are not responsible for delivery and returns. For products sold through our AdsOnline service for which we do not take possession, payment alternatives, shipping, delivery and return obligations are substantially identical to those for our Shop service. We also provide an online asset recovery service that allows sellers to specify that their products initially be offered to their other departments and facilities and subsequently to the public. In addition, the seller may choose to offer unsold products for charitable donation. We have entered into agreements with several IDNs and a number of other healthcare providers to allow them to use this additional service. We derive revenue from our Auction service primarily from commissions paid by sellers, equal to a percentage of the sale price. In addition, in our live and online auctions, the purchaser also typically pays a fee, commonly referred to as a buyer's premium, equal to a percentage of the purchase price. We also derive revenues from subscription fees we charge sellers that utilize our asset recovery service. Plan Our Plan service, first introduced in July 1998 and enhanced in November 1999, provides interactive content to architects, healthcare facility planners and materials managers and purchasers to reduce the complexities of planning and outfitting facilities. Plan offers interactive photographic images of actual rooms and suites from medical facilities that we believe represent industry best practices, together with floor plans and descriptions of products typically used in these rooms. This service allows users to conduct virtual tours of these facilities, providing rich information for considering room plans and equipment purchases. Visitors can zoom in to see room details, including equipment placement, and can navigate to view different parts of the room in these 360 degree panoramic images. Plan currently displays more than 1,000 rooms from the University of Chicago's Center for Advanced Medicine and seven additional facilities, and we intend to continue to add rooms from other advanced facilities. Site visitors can browse a list of departments or can search to find specific rooms. The responsibility for designing and equipping facilities is shared by architects, facility and equipment planners and materials managers and purchasers. Because there is little standardized information, these professionals must spend substantial time determining and coordinating project requirements. The information provided through Plan allows these professionals to match facility requirements to real-world examples. This enables these professionals to find necessary information that may not have been included in their original project plans and to move quickly from information gathering to creating designs and equipment lists. Plan associates each room with a list of product categories typically found there. These categories link to our Shop and Auction services, enabling these professionals to view and purchase equipment in a few steps. We have recently begun offering suppliers and service providers the ability, for a fee, to sponsor rooms on Plan. By sponsoring rooms that feature one or more of their products or that are associated with the services they provide, suppliers and service providers can use these rooms as part of their own marketing campaigns. As a result of our acquisition of FDI Information Resources, Inc. in November 1999, we began selling licenses for software tools and technical specification information for the construction and redesign of healthcare facility projects. We intend to add new fee-based services to Plan, such as subscription-based access to more detailed content and data. Resources In addition to our three principal services, since July 1998, we have provided healthcare professionals with information resources to assist them in making informed and efficient purchasing decisions. Healthcare professionals can receive personalized news, review online product and vendor information and obtain information from other websites. In addition, users can access online continuing medical education courses and research regulatory and shipping requirements that may affect the price or delivery of their purchases. In September 1999, we significantly expanded the amount of information that we provide, and organized this information into a separate Resources section of our website to facilitate its use. As a result of our acquisition of U.S. Lifeline, Inc. on March 16, 2000, we intend to provide users with additional healthcare industry and supply-chain information regarding the products available in our marketplace. Suppliers Shop. As of March 17, 2000, we had online commerce agreements with 204 manufacturers and distributors to list their products on Shop. Our agreements with distributors provide listings of products from an additional 1,100 manufacturers. Our agreements with these suppliers provide for the payment to us of a fee equal to a negotiated percentage of the purchase price of products than they sell through Shop. These agreements generally do not require that the supplier list any specific number of products or maintain any listing for any period of time. Auction. On Auction, suppliers include hospitals and healthcare organizations liquidating used equipment, manufacturers and distributors selling surplus products and finance companies selling leased equipment at the end of the lease term. We have entered into agreements with a number of Auction suppliers for whom we provide asset recovery services. See "-- Our Services -- Auction" for a description of these agreements. Strategic Supplier Relationships. We work with a number of key suppliers, including Owens & Minor, General Electric Medical Systems or GEMS, and GeriMedix. We currently list from Owens & Minor approximately 1,625 products aimed at traditional physicians' offices for sale through Shop. Under our October 1999 agreement, GEMS has agreed to list products on Shop. GEMS also has the option to sponsor rooms on Plan on mutually agreed upon terms, and in the event that it sponsors any rooms, GEMS has agreed to promote Plan to its customers. In addition, GEMS has agreed to use Auction to sell a specified number of items of equipment. This agreement expires in December 2000, subject to automatic renewal unless either party elects to terminate. In connection with this agreement, we issued approximately 275,000 shares of our preferred stock to GE Capital Equity Investments, an affiliate of GEMS, in October 1999. GE Capital Equity Investments, Inc., also purchased 1,760,563 additional shares of preferred stock in our October 1999 financing. Under our November 1999 agreement with GeriMedix, a regional distributor of medical products and supplies to the long-term care facility market, we have agreed to collaborate with GeriMedix to enable GeriMedix to offer its products for sale in our online marketplace and through a co-branded website. In connection with this agreement, we purchased 5% of the equity interest of IntraMedix LLC, the majority owner of GeriMedix, for $2.5 million. PURCHASERS Purchasers currently using Shop include physician offices, multi-specialty groups, clinics and other healthcare providers. Buyers for large organizations, such as hospitals, IDNs and GPOs that purchase a large volume of products under negotiated contracts with suppliers, currently use Shop primarily to purchase products for which they do not have existing supplier contracts. We plan to add customer-specific pricing capabilities in order to enable these organizations to use Shop for their purchases of products for which they have contracts. Our Auction services have been used by a wide range of healthcare providers to purchase used, refurbished and surplus medical products. We believe that a large percentage of the products that are sold through our Auction services are purchased for use outside the U.S. or in rural communities in the U.S. If we are not able to quickly build a critical mass of purchasers who use our services, and increase the use of our services by large healthcare providers, our ability to expand our business would be seriously harmed. STRATEGIC ALLIANCES We enter into alliances with leading Internet, technology and healthcare-related organizations and medical products suppliers to increase usage of our services, broaden the scope of our content, extend the functionality of our technology and build additional marketing resources. We have entered into strategic alliances in the following areas. Web Portals. Many healthcare professionals use specific portal websites that provide a variety of healthcare-related information, online interaction and e-commerce services. We believe that, by entering into relationships with companies that operate these websites, we can attract their visitors to use our services and build our brand recognition. We have developed strategic alliances with VerticalNet and Ariba to provide us with increased market visibility and site traffic. VerticalNet owns and operates a number of industry-specific websites known as vertical trade communities, including health industry communities such as Medical Design Online, Hospital Networks.com and Nurses.com. Under our agreement, VerticalNet has agreed to use our marketplace to offer any medical products listed for sale on its vertical trade communities, and we have agreed to use VerticalNet to offer any used and excess laboratory products listed for sale on our marketplace. We have also agreed to establish links between our respective websites. In addition, VerticalNet will develop and maintain a co-branded career center and a co-branded training and education center, and will provide us with specified content created for its medical online communities. VerticalNet will also have the non-exclusive right to sell sponsorships on our Plan service website and the exclusive right to sell advertising on the co-branded sites. Our agreement with VerticalNet expires in 2001, subject to automatic renewals for additional one-year periods unless either party elects to terminate. We recently entered into a healthcare channel alliance with Ariba. Under the agreement, we will integrate our medical marketplace with Ariba's network in order to offer hospitals and healthcare institutions access to additional products and suppliers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" for more information about our agreements with VerticalNet and Ariba. Computer and Network Hardware Providers. We believe that alliances with computer hardware providers will help us build recognition of our brand. We have established relationships with Dell Marketing, an affiliate of Dell Computer, and Cisco Systems. We have entered into an agreement with Dell to develop and undertake complementary marketing programs and to link our websites. Our agreement with Cisco provides for complementary marketing efforts and for joint promotional activities. For example, Cisco uses our website as a means of demonstrating its equipment to healthcare providers. As a result, we gain increased exposure of our services to large healthcare organizations. In addition, we agreed to use Cisco technologies in our website. This agreement expires in 2002. Technology Partners. We believe that by integrating our services with existing systems used by many purchasers and sellers of medical products, we will further streamline their medical products supply chains. We have entered into an agreement with Superior Consultant, a supplier of Digital Business Transformation(TM) services to large healthcare organizations, including Internet-related services, systems integration, outsourcing and consulting, which enables Superior clients to utilize digital technologies and process innovations to improve their businesses. Under the agreement, we have agreed to market Superior's services to our users, and Superior has agreed to introduce our services to appropriate clients, based on their interests, and to incorporate our services into its Digital Business Transformation(TM) offerings. The agreement also provides for joint marketing activities. We are collaborating with SAP, a leading provider of enterprise software, to integrate our services with SAP's R/3 enterprise software product. This integration is intended to further automate the order management and transaction routing process within our marketplace. In addition, we are integrating our services with MySAP.com, SAP's Internet business service. We are also working together with enterprise application integrators such as CrossWorlds, TIBCO and STC in order to integrate our marketplace applications and services with purchasers' and suppliers' systems. We have entered into a strategic relationship with Ariba which will allow us to offer Ariba's ORMX procurement solution in our marketplace. This solution will further enable us to offer our purchasing customers a mechanism to automate and streamline the procurement process. Content Providers. We believe that as we increase the breadth and depth of our content for our online marketplace, we will be able to attract and retain more users. Since content is often expensive and time-consuming to develop, we enter into relationships with other companies to provide content for our marketplace. ECRI, a leading non-profit health services research agency focusing on healthcare technology, provides us with detailed information about medical products and technology and facility planning. NewsReal has created a specialized healthcare headlines service to provide our users with personalized healthcare business news from over 60 different sources. Reuters provides us with its standard healthcare business news feed. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" for a description of our agreement with ECRI. Medical Product Suppliers. We believe that by establishing relationships with key suppliers of medical products, we increase the depth and breadth of the products listed on our online marketplace, and benefit from their marketing resources. We have entered into agreements with Owens & Minor, General Electric Medical Systems and GeriMedix. See "Suppliers -- Strategic Supplier Relationships" for more information about our strategic supplier relationships. TECHNOLOGY In order to establish a secure and reliable marketplace for suppliers and purchasers of new and used medical products, our underlying infrastructure is built on an open, multi-tier, distributed architecture using well-established applications and hardware from leading technology companies such as Sun Microsystems, Netscape and Oracle. Our infrastructure enables us to continuously enhance the features and functionality of our services to meet the evolving needs of our users. Infrastructure Open Architecture. Our open architecture supports integration with our users' many existing legacy systems. The ability to integrate these diverse systems has enabled us to aggregate a wide range of purchasers and suppliers in our marketplace. Our architecture is based on industry standards enabling us to rapidly introduce new features and functionality. Scalability, Performance and Availability. Our highly modular, distributed architecture is designed to enable us to readily add capacity as the number of users and transactions increase on our system. We have fully redundant hardware systems, which when combined with our distributed architecture, enables us to provide our services on an uninterrupted basis, even in the event of partial system failure. By locating our data center at an Exodus Communications hosted facility, we are able to easily and rapidly expand our network bandwidth and maintain the physical security of our systems. Secure e-Commerce Marketplace. Our platform contains a variety of features to ensure the secure transmission of business information among multiple trading partners and to protect against communication failures. We use SSL, or secure sockets layer, an Internet security protocol, at appropriate points in the transaction flow to protect user information during transactions. User information is encrypted to provide a high degree of security. Our employees do not have access to user information, except as necessary to perform customer service functions. The system authenticates users through standard secure login and password technologies. Functionality Our systems are designed to replace manual processes traditionally used by purchasers and suppliers. We have incorporated these processes into an easy-to-use, intuitive online marketplace application and services that can be accessed with standard web browsers, without requiring any special software. To support our online marketplace, we have developed customized search technologies to meet the requirements of purchasers of medical products, supplies and equipment. In order to enable users to quickly navigate to individual products, we have incorporated industry standard classifications, which support the purchasing process by grouping items that are similar and by mapping to other industry standard classification systems. We have developed technologies to support customer-specific pricing, requisition management, quick order lists and procurement workflow to help our users replace the manual processes of creating and submitting purchase orders. Furthermore, we plan to integrate the technology we acquired from Pharos Technologies, Inc. with Shop, Auction and Plan to enable users to conduct comprehensive searches on complex product information. The Pharos technology is also designed to allow suppliers to rapidly update and organize their product information from their desktop and publish customized subsets of their product information. Although to date we have not experienced unscheduled system interruptions of our online marketplace, outages may occur from time to time as system usage increases. The volume of traffic on our website and the number of transactions being conducted by users has been increasing and will require us to expand and upgrade our technology, transaction processing systems and network infrastructure and add new engineering personnel. We may be unable to accurately project the rate or timing of increases, if any, in the use of our services or timely expand and upgrade our systems and infrastructure to accommodate such increases in a timely manner. Any failure to expand or upgrade our systems to keep pace with the growth in demand for capacity could cause the website to become unstable and possibly cease to operate for periods of time. Unscheduled downtime could harm our business. SALES, MARKETING AND SUPPORT We sell our services through our direct field sales force and our internal telemarketing staff. Our direct field sales force focuses on purchasers in physician offices, clinics, hospitals and large healthcare organizations. Our direct field sales force has significant experience in the sale of medical products, equipment and information technology systems. Our telemarketing programs are directed primarily at suppliers of medical products, supplies and equipment. We plan to augment our internal sales resources by working with the sales forces of our strategic partners. Our marketing programs include traditional and Internet-based marketing initiatives to increase awareness of the Neoforma.com brand and attract new purchasers and suppliers to our services. These programs include a variety of public relations initiatives, such as participation in industry conferences and trade shows, and ongoing relationships with healthcare, Internet and technology reporters and industry analysts. We also promote our services through advertising in healthcare industry trade journals and business publications. In addition, we conduct web-based marketing activities to attract new users to our online marketplace. Our relationships with Internet portals such as VerticalNet and Ariba, suppliers such as General Electric Medical Systems and Owens & Minor, technology companies such as Cisco, Dell and SAP, and professional services providers such as Superior Consultant provide us with additional marketing resources. These companies conduct a number of activities designed to strengthen awareness of our brand and our services. Our worldwide sales and marketing group consisted of 94 full-time employees as of December 31, 1999. We intend to expand our sales and marketing group and to establish additional sales offices. Competition for sales and marketing personnel is intense, and we may not be able to attract, assimilate or retain additional qualified personnel in the future. We believe that we can strengthen our relationships with purchasers and suppliers by providing good account management, customer support and service. Our customer service group provides ongoing support to customers, including site assistance, product searches, basic product questions and order processing questions. PRODUCT DEVELOPMENT We intend to continue to expand and enhance the functionality of our services. We are currently focusing our product development resources on integrating our services with other information systems used by suppliers and purchasers of healthcare products. In addition, we are developing the capability to allow suppliers to provide customer-specific pricing through Shop, and providing increased functionality to our online Auction service. Our future success, and in particular, our ability to fully address the needs of large healthcare providers, depends on our ability to successfully develop and introduce these capabilities in a timely manner. There are a number of risks and challenges involved in the development of new features and technologies. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors That May Affect Operating Results -- If we fail to develop the capability to integrate our online services with enterprise software systems of purchasers and suppliers of medical products and to enable our services to support customer-specific pricing, these entities may choose not to utilize our online marketplace, which would harm our business." Our product development organization includes our product strategy group and our engineering group. The product strategy group is responsible for translating user needs into specifications and prototypes for new functions and services. Our engineering group is responsible for developing the technology that implements these initiatives, and maintaining and improving the technology, infrastructure and databases that we use to provide our services. As of December 31, 1999, our product development organization included 54 full-time employees. Our quality assurance group works with our product development organization throughout the development cycle to ensure that the new features and functions of our website meet our standards. In addition, we have a seven person group that focuses on emerging technologies and market opportunities. In cases requiring specialized expertise, we have augmented the resources of our product development organization with independent contractors. Our product development expenses were $179,000 in 1997, $1.5 million in 1998 and $6.8 million in 1999. To date, substantially all software development costs related to our services have been expensed as incurred. We believe that significant investments in product development will be required to remain competitive. PROPRIETARY RIGHTS AND LICENSING Our success and ability to compete depend on our ability to develop and maintain the proprietary aspects of our technology. We rely on a combination of copyright, trademark and trade secret laws and contractual restrictions to establish and protect the proprietary aspects of our technology. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. Finally, we seek to avoid disclosure of our intellectual property by restricting access to our source code and by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any resulting litigation could result in substantial costs and diversion of resources and could seriously harm our business. Our success and ability to compete also depend on our ability to operate without infringing upon the proprietary rights of others. In the event of a successful claim of infringement against us and our failure or inability to license the infringed technology, our business would be seriously harmed. COMPETITION The online market for medical products, supplies and equipment is new, rapidly evolving and intensely competitive. Our primary competition includes e-commerce providers that have established online marketplaces for medical products, supplies and equipment. These competitors include companies such as Medibuy, Ventro and Cimtek Medical. We also face potential competition from a number of sources. Many companies have created websites to serve the information needs of healthcare professionals, providing medical information, discussion groups, bulletin boards and directories. Many of these companies are introducing e-commerce functions that may compete with our services. In addition, providers of online marketplaces and online auction services that currently focus on other industries could expand the scope of their services to include medical products. Existing suppliers of medical products may also establish online marketplaces that offer services to suppliers and purchasers, either on their own or by partnering with other companies. Moreover, live auction houses focusing on medical products may establish online auction services. New companies may also be formed that compete with us. Our industry is subject to increasing consolidation and there are a growing number of strategic relationships among industry participants. These trends may intensify competition. For example, Medibuy recently announced its agreement to acquire Premier Health Exchange including a long-term, exclusive agreement to provide e-commerce services for Premier Partners, one of the largest GPOs in the United States. In addition, Johnson & Johnson, General Electric Medical Systems, Baxter International, Abbott Laboratories and Medtronic recently announced that they are creating a healthcare exchange for the purchase and sale of medical products. We believe that companies in our market compete to provide services to suppliers based on: - brand recognition; - number of purchasers using their services, and the volume of their purchases; - level of bias, or perceived bias, towards particular suppliers; - compatibility with suppliers' existing distribution methods; - the amount of the fees charged to suppliers; - ease of use and convenience; - ability to integrate their services with suppliers' existing systems and software; and - quality and reliability of their services. In addition, we believe that companies in our market compete to provide services to purchasers based on: - brand recognition; - breadth, depth and quality of product offerings; - ease of use and convenience; - ability to integrate their services with purchasers' existing systems and software; - quality and reliability of their services; and - customer service. Competition is likely to intensify as our market matures. As competitive conditions intensify, competitors may: - enter into strategic or commercial relationships with larger, more established healthcare, medical products and Internet companies; - secure services and products from suppliers on more favorable terms; - devote greater resources to marketing and promotional campaigns; - secure exclusive arrangements with buyers that impede our sales; and - devote substantially more resources to website and systems development. Our current and potential competitors' services may achieve greater market acceptance than ours. Our existing and potential competitors may have longer operating histories in the medical products market, greater name recognition, larger customer bases or greater financial, technical and marketing resources than we do. As a result of these factors, our competitors and potential competitors may be able to respond more quickly to market forces, undertake more extensive marketing campaigns for their brands and services and make more attractive offers to purchasers and suppliers, potential employees and strategic partners. In addition, new technologies may increase competitive pressures. We cannot be certain that we will be able to expand our purchaser and supplier base, or retain our current purchasers and suppliers. We may not be able to compete successfully against current and future competitors and competition could seriously harm our revenue, gross margins and market share. EMPLOYEES As of December 31, 1999, we had 269 full-time employees, including 54 in product development, 94 in sales, marketing and customer service, 16 in business development, 72 in operations, and 33 in general and administrative functions. Our future success will depend in part on our ability to attract, train, retain, integrate and motivate highly qualified sales, technical and management personnel, for whom competition is intense. Our employees are not represented by any collective bargaining unit, and we have never experienced a work stoppage. We believe our relations with our employees are good. We also use independent contractors to support our services. We use a firm based in India to digitize and format product information for our Shop service. We plan to use a third party specializing in Internet support to respond to our most common customer service requests. We also use independent contractors for specific product development services requiring specialized expertise. ITEM 2. ITEM 2. PROPERTIES FACILITIES Our executive, administrative and operating offices are located in approximately 33,378 square feet of leased office space located in Santa Clara, California under leases originally scheduled to expire in April 2004 and September 2006. We recently entered into an agreement to sublease approximately 116,000 square feet of office space in San Jose, California under a sublease that is scheduled to expire in March 2007. We intend to relocate our executive, administrative and operating offices to this San Jose facility and have entered into agreements to terminate our leases in Santa Clara. We also maintain 19,875 square feet of office and warehouse space for our AuctionLive service in the metropolitan area of Chicago, Illinois. We have also entered into a lease for a second warehouse in the Chicago, Illinois metropolitan area, expiring in November 2001, to provide an additional 120,000 square feet of space to store consigned items until they are sold in auctions. We are seeking to lease a warehouse in Los Angeles, California for our Auction services. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In a letter dated January 14, 2000, Forma Scientific, Inc., an affiliate of Thermo Electron Company, notified us that it believes our use of the "Neoforma" and "Neoforma.com" trademarks violates its trademark rights in "Forma" and "Forma Scientific," and asked us to discontinue use of our trademarks. Forma Scientific has filed a complaint in the United States District Court for the Southern District of Ohio, Eastern Division alleging trademark infringement, violation of the Ohio Deceptive Trade Practices Act, unfair competition and other claims and seeking compensatory damages and punitive damages, preliminary and permanent injunctive relief and transfer of the Neoforma.com Internet domain name to Forma Scientific. Forma Scientific provided us with a courtesy copy, but has not served us with this complaint. We believe that we have meritorious defenses to Forma Scientific's claims and intend to vigorously defend ourselves in any litigation that may arise from these claims. If any litigation were to be decided adversely to us, we could be enjoined from future use of the names Neoforma and Neoforma.com and we might be required to pay damages to Forma Scientific. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors That May Affect Operating Results -- We have received notice of a trademark infringement claim brought by a third party and we may be subject to further intellectual property claims and if we were to subsequently lose our intellectual property rights, we could be unable to operate our current business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the forth quarter of 1999, our stockholders also approved, by written consent, an amendment of our certificate of incorporation to authorize a Series E preferred stock and to establish the rights, privileges and preferences of each class or series of our capital stock outstanding at that time. The foregoing resolution was approved with 27,893,916 shares out of 34,946,053 or 80% voting in favor. During the fourth quarter of 1999, our stockholders also approved, by written consent, the following resolutions in connection with our initial public offering: amendment and restatement of our certificate of incorporation to change our corporate name; amendment and restatement of our certificate of incorporation to increase the authorized number of shares; approval of our current certificate of incorporation; approval of our 1999 Equity Incentive Plan; approval of our 1999 Employee Stock Purchase Plan and approval of director and officer indemnity agreements. The foregoing resolutions were approved with 45,124,670 shares out of 53,276,559 or 85% voting in favor. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT. MANAGEMENT EXECUTIVE OFFICERS AND DIRECTORS The following table sets forth information regarding our executive officers and directors as of December 31, 1999: Robert J. Zollars has served as our Chairman, President and Chief Executive Officer since July 1999. From January 1997 to July 1999, he served as Executive Vice President and Group President of Cardinal Health, Inc., a healthcare products and services company, where he was responsible for four of its wholly- owned subsidiaries: Pyxis Corporation, Owen Healthcare, Inc., Medicine Shoppe International and Cardinal Information Corporation. From January 1992 to December 1996, he served as President of Hospital Supply, Scientific Products and U.S. Distribution of Baxter Healthcare Corporation, which in October of 1996 was spun off as Allegiance Corporation, a healthcare products and service company. Mr. Zollars holds an M.B.A. in finance from John F. Kennedy University and a B.S. in marketing from Arizona State University. Jeffrey H. Kleck has served as a Senior Vice President since July 1999, and co-founded Neoforma.com in April 1996. Dr. Kleck served as our Chief Executive Officer from March 1996 to July 1999 and as one of our directors from April 1996 to October 1999. Dr. Kleck was a senior engineer from June 1991 to February 1997 and Marketing Product Manager from February 1997 to February 1998 at Varian Associates, Inc., a manufacturer of medical radiology equipment. He is a visiting scientist at Los Alamos Laboratory. Dr. Kleck holds a Ph.D. in biomedical physics from, and is a member of the faculty of the School of Medicine at, the University of California, Los Angeles. He holds an M.S. in engineering management from Stanford University and M.S. and B.S. degrees in nuclear engineering from Texas A&M University. Wayne D. McVicker has served as our Senior Vice President and President of Neoforma Plan since October 1999 and as a director since April 1996. Mr. McVicker co-founded Neoforma.com in April 1996, and served as our President from April 1996 to February 1999 and as our Vice President of Strategy from February 1999 to October 1999. From September 1987 to February 1997, Mr. McVicker worked at Varian Associates, Inc., as manager of its architectural planning department. In addition, Mr. McVicker is a licensed architect. Frederick J. Ruegsegger has served as our Chief Financial Officer since July 1999. From December 1996 to July 1999, Mr. Ruegsegger worked at Axys Pharmaceuticals, Inc., a biopharmaceutical company, most recently as Senior Vice President of Finance and Corporate Development and Chief Financial Officer. From July 1993 to December 1996, Mr. Ruegsegger was President, Chief Executive Officer and a director of EyeSys Technologies Inc., an eye care diagnostic equipment and software company. Mr. Ruegsegger holds a Master of Management from J. L. Kellogg Graduate School of Management, Northwestern University, and a B.S. in economics from the University of Illinois. Bhagwan D. Goel has served as our Executive Vice President of Products and Services since October 1999. From October 1998 to September 1999, Mr. Goel was Senior Vice President and General Manager, Commerce at InfoSeek Corporation, a provider of Internet services and software. From October 1996 to September 1998, Mr. Goel was Vice President of Products and Services at Internet Shopping Network Inc., an online retailer. From November 1993 to October 1995, Mr. Goel was Vice President of Product Development at Worldview Systems Corporation, a provider of online travel information. From October 1989 to October 1995, Mr. Goel worked at Knowledgeset Corporation, a software company that provides electronic retrieval systems, most recently as Director of Product Development. Mr. Goel holds an M.S. in electrical engineering from the University of Toledo and a B.S. in electrical engineering from the Indian Institute of Technology, New Delhi. Robert Flury has served as our Senior Vice President of Business Development since February 1999. From December 1997 to January 1999, Mr. Flury was Vice President and General Manager of the healthcare business unit at PeopleSoft Inc., an enterprise software company. From February 1997 to December 1997, Mr. Flury was a senior vice president at Visix Software Inc., a software company. From October 1994 to February 1997, Mr. Flury was a Senior Vice President of the middleware line of business at Software AG, an enterprise software company. Mr. Flury is a C.P.A. and holds an M.B.A. and a B.B.A. in accounting from Georgia State University. Daniel A. Eckert has served as our Executive Vice President of Sales since August 1999 and President of Neoforma Shop since November 1999. From April 1998 to August 1999, Mr. Eckert was President and Chief Operating Officer of Fisher Healthcare, a division of Fisher Scientific International, which is a distributor of medical products. From September 1992 to April 1998, Mr. Eckert held several positions at McKesson Corporation, including Senior Vice President of Corporate Sales for the Health Systems Group, Senior Vice President of Sales and Marketing for McKesson/General Medical Corporation and Vice President of Acute Care. Mr. Eckert holds an A.B. degree in English and political science from Occidental College, and completed the Fuqua School of Business' Healthcare Distributor Executive Program at Duke University. Robert W. Rene has served as our Executive Vice President of Strategy and Chief Marketing Officer since December 1999. From April 1999 to December 1999, Mr. Rene was a strategy, marketing and Internet business development consultant to e-commerce companies. From January 1998 to April 1999, Mr. Rene was Executive Vice President, Marketing at United Paramount Network, a television network. From April 1996 to September 1997, Mr. Rene held several positions at Americast, a company which provides digital cable service, including Senior Vice President, Marketing/Strategy/Business Development, Chief Marketing Officer and Senior Vice President, Marketing/Advertising. From December 1993 to March 1996, Mr. Rene held several positions at Young & Rubicam, Inc., a marketing and communications enterprise, including Senior Vice President, Marketing/Corporate Ventures and Account Managing Director. Mr. Rene holds a J.D. and an M.B.A. from Stanford University and a B.A. in Economics/Government from Cornell University. S. Wayne Kay has served as our Senior Vice President of Supply-Chain Development since December 1999. From February 1994 to December 1999, Mr. Kay was the President and Chief Executive Officer of the Health Industry Distributors Association, a business trade association of medical products distributors and home healthcare providers. Mr. Kay holds a B.S. in microbiology from Virginia Tech, a B.A. in Business Administration from the University of San Francisco and an M.B.A. from Pepperdine University. Erik Tivin has served as our Senior Vice President of Auction Services and President of Neoforma GAR, Inc. since August 1999. From July 1998 to August 1999, Mr. Tivin served as owner and President of General Asset Recovery, LLC., a live auction house, which was acquired by Neoforma.com. From January 1990 to July 1998, he served as President of General Industrial Tool, a wholesale industrial equipment company. David Douglass has served as one of our directors since February 1999. Since February 1990, Mr. Douglass has served as a General Partner at Delphi Ventures L.P., a venture capital firm. Mr. Douglass holds an M.B.A. from Stanford University and a B.A. in political science from Amherst College. Terence Garnett has served as one of our directors since April 1998. Mr. Garnett has been a managing director of Garnett Capital since January 2000. Before joining Garnett Capital, from April 1995 to December 1999, Mr. Garnett was a venture partner of Venrock Associates, a venture capital firm. From August 1994 to April 1995, Mr. Garnett was a private investor. From October 1991 to August 1994, he was a senior vice president of worldwide marketing and business development and senior vice president of the new media division at Oracle Corporation, a software company. He also serves as a director of Niku Corp., CrossWorlds Software, Inc. and several other private companies. Mr. Garnett holds an M.B.A. from Stanford University and a B.S. in computer science from the University of California, Berkeley. Madhavan Rangaswami has served as one of our directors since April 1998. Since February 1997, Mr. Rangaswami has served as a Managing Director at Sand Hill Group LLC, a consulting and private investment company. From March 1995 to March 1996, Mr. Rangaswami served as Vice President of Worldwide Marketing at the Baan Company N.V., an enterprise software company. Prior to that, he held executive positions at Avalon Software Inc., a software company, and Oracle Corporation. Mr. Rangaswami holds an M.B.A. from Kent State University, and degrees in law and accounting from the University of Madras. Richard D. Helppie has served as one of our directors since October 1999. Since August 1996, he has served as Chairman of the board of directors and Chief Executive Officer of Superior Consultant Holdings Corporation, a consulting firm comprised of two subsidiaries founded by Mr. Helppie, Superior Consultant Company, Inc. and UNITIVE Corporation. He has served as Chairman of the board of directors and Chief Executive Officer of Superior Consultant Company, a healthcare management and information systems consulting firm, since 1984 and as Chief Executive Officer of UNITIVE Corporation, a information technology consulting firm, since 1993. He has also served as President of Clearwater Aviation Company, Inc. since 1993. In addition, Mr. Helppie is a director of drkoop.com, Inc. Andrew J. Filipowski has served as one of our directors since October 1999. He is the President, Chief Executive Officer and Chairman of the Board of divine interVentures, inc., a venture investment firm that he co-founded in May 1999. He is also Chairman of the Board of PLATINUM Venture Partners, Inc., a venture investment firm that he founded in February 1992. Mr. Filipowski founded PLATINUM technology, inc. in April 1987 and served as its President, Chief Executive Officer and Chairman of the Board until it was acquired by Computer Associates in June 1999. PLATINUM technology, inc. was a software company that produced, acquired and distributed system software tools. Mr. Filipowski serves on the board of directors of Blue Rhino Corporation, Bluestone Software, Inc., eShare Technologies, Inc., Platinum Entertainment, Inc., and System Software Associates, Inc. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PRICE RANGE OF COMMON STOCK Our common stock has been traded on the Nasdaq National Market under the symbol "NEOF" since January 24, 2000, the date of our initial public offering. Prior to that time, there was no public market for our common stock. On March 17, 2000, the last reported sale price of our common stock on the Nasdaq National Market was $29.19 per share. The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future. In addition, the market prices of securities of other technology companies, particularly Internet-related companies, have been highly volatile. RECENT SALES OF UNREGISTERED SECURITIES In the fourth quarter of 1999, we issued and sold 5,043,718 shares of our common stock for aggregate consideration of $7.7 million pursuant to the exercise of previously granted stock options by 121 employees. In October 1999, we issued and sold 12,418,633 shares of Series E and Series E-1 Preferred Stock to a group of investors for aggregate consideration for $5.68 per share and issued 275,000 shares of Series E-1 Preferred Stock in connection with a strategic alliance. In October 1999, we also issued a warrant to purchase 436,623 shares of common stock at a price of $0.10 per shares to an executive search firm. In November 1999, we issued 176,057 shares of Series E Preferred Stock to investors at a price of $5.68 per share and also issued 350,000 shares of common stock to the former shareholders of FDI Resources, Inc. in connection with our acquisition of FDI. Each share of Series E and Series E-1 Preferred Stock automatically converted into one share of our common stock upon the closing of our initial public offering. The preferred stock issuances in the fourth quarter of 1999 described in this Item 5 were made in reliance upon the exemption from registration set forth in Section 4(2) of the Securities Act relating to sales by an issuer not involving any public offering. The issuances of shares of our common stock in connection with the exercise of stock options were either made in reliance upon the exemption from registration set forth in Rule 701 of the Securities Act or in reliance on Section 4(2). None of these issuances involved a distribution or public offering. No underwriters were engaged in connection with the foregoing issuances of securities, and no underwriting discounts or commissions were paid. HOLDERS OF RECORD As of March 17, 2000, there were approximately 295 holders of record of our common stock. This number does not include stockholders for whom shares were held in a "nominee" or "street name." DIVIDENDS We have never declared or paid any cash dividends on our capital stock and do not anticipate paying cash dividends in the foreseeable future. We currently intend to retain future earnings, if any, to fund the expansion and growth of our business. Payment of future dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion. USE OF PROCEEDS We sold 8,050,000 shares of common stock, in our initial public offering, pursuant to a Registration Statement on Form S-1 (File No. 333-89077), which was declared effective by the Securities and Exchange Commission on January 21, 2000. The managing underwriters of the offering were Merrill Lynch, Pierce, Fenner & Smith Incorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens Inc. and William Blair & Company, L.L.C. The aggregate gross proceeds of the offering were $104.7 million. Our total expenses in connection with the offering were approximately $9.2 million, of which $7.3 million was for underwriting discounts and commissions and $1.9 million was for other expenses paid to persons other than our directors or officers, persons owning more than 10 percent of any class of our equity securities, or our affiliates. Our net proceeds from the offering were approximately $95.4 million. The net offering proceeds have been used for general corporate purposes, including sales and marketing, product development and working capital. We also paid $3.5 million to the former shareholders of U.S. Lifeline, Inc., or USL, in connection with our acquisition of USL in March 2000 and $3.0 million in connection with an investment in Pointshare, Inc. in March 2000. Funds that have not been used have been invested in short-term, investment grade securities. We also may use a portion of the net proceeds to acquire or invest in additional businesses, technologies, products or services. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data for the period from inception (March 6, 1996) through December 31, 1996, and for the years ended December 31, 1997, 1998 and 1999 are derived from our consolidated financial statements, which have been audited by Arthur Andersen LLP, independent public accountants, and are included elsewhere in this report. The consolidated balance sheet data as of December 31, 1996 are derived from audited financial statements not included in this report. When you read this selected consolidated financial data, it is important that you also read the historical financial statements and related notes included in this report, as well as the section of this report entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations." Historical results are not necessarily indicative of future results. See Note 2 of notes to consolidated financial statements for an explanation of the determination of the number of shares used in computing per share amounts. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion of our financial condition and results of operations in conjunction with our consolidated financial statements and related notes. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of factors including those discussed in "-- Factors That May Affect Operating Results" and elsewhere in this report. OVERVIEW Neoforma.com is a leading provider of business-to-business e-commerce services in the large and highly fragmented market for medical products, supplies and equipment. Our marketplace aggregates suppliers of a wide range of new and used medical products and presents their offerings to the physicians, hospitals and other healthcare organizations that purchase these products. We believe that our services will streamline the procurement processes and extend the reach of existing sales and distribution channels, as well as reduce transaction costs for both buyers and sellers of medical products, supplies and equipment. We offer three primary services. Our Shop service provides a unified marketplace where purchasers can easily identify, locate and purchase new medical products and suppliers can access new customers and markets. Healthcare providers can use Shop to purchase a wide range of products, from disposable gloves to surgical instruments and diagnostic equipment. Our Auction service creates an efficient marketplace for idle assets by enabling users to list, sell and buy used and refurbished equipment and surplus medical products. Our Plan service provides interactive content to healthcare facility planners and designers, including 360 degree interactive photographs of rooms and suites in medical facilities that we believe represent industry best practices, together with floor plans and information about the products in the room. This information helps reduce the complexities of planning and outfitting facilities, which we believe increases the appeal of our website to the facility planners responsible for many product purchasing decisions. We incorporated on March 4, 1996. From inception, our operating activities have related primarily to the initial planning and development of our marketplace and the building of our operating infrastructure. We first introduced the Neoforma.com website in 1997 and have since released a number of enhancements to provide new services and content. Initially, our website provided only information for healthcare professionals. We began offering e-commerce services with the introduction of our initial Auction service, AdsOnline, in May 1999 and expanded our services with the introduction of our second Auction service, AuctionLive, in August 1999, our third Auction service, AuctionOnline, in November 1999 and Shop in August 1999. Since we introduced our Auction and Shop services, we have focused on expanding and enhancing our services, establishing relationships with suppliers of medical products, expanding our purchaser base, developing strategic alliances, promoting our brand name and building our operating infrastructure. We have recognized limited revenue to date. We expect that our principal source of revenue will be transaction fees paid by the sellers of medical products that use our Shop and Auction services. These transaction fees represent a negotiated percentage of the sale price of the medical products sold through Shop or Auction. We expect our Plan service to facilitate transactions on our Shop and Auction services by linking Plan content to products and equipment listed on Shop and Auction. We recognize transaction fees as revenue when the seller confirms a purchaser's order. For live and online auction services, we recognize seller transaction fees, as well as a buyer's premium, when the product is sold. We also expect to receive revenue from the following sources: - sponsorship fees paid by sellers of medical products and services used in planning and outfitting healthcare facilities in exchange for the right to feature their brands and products on our Plan service; - subscription fees paid by healthcare providers and manufactures and distributors of medical products for our management and disposition of their used medical equipment through our asset recovery service on Auction; - license fees from the sale of software tools and related technical information for the equipping and planning of healthcare facilities; - development fees from participating sellers to digitize their product information for display on our website; and - product revenue related to the sale of medical equipment that we purchase for resale through our live and online auction services. Development fees are recognized as development services are performed. Sponsorship and subscription fees will be recognized ratably over the period of the agreement. Product revenue representing the difference between the amount we pay for the equipment and the price paid on resale is recognized when the product is shipped or delivered, depending on the shipping terms associated with each transaction. With respect to software licenses, we expect to generally recognize revenue upon shipment of the product and will recognize revenue from related service contracts, training and customer support ratably over the period of the related contract. Our operating expenses have increased significantly since our inception, and the rate of this increase has accelerated since our introduction of our Auction and Shop services. These increases are primarily due to additions to our staff as we have expanded all aspects of our operations. During fiscal 1999, we incurred expenses in the amount of $3.1 million, including $2.4 million related to the valuation of a warrant issued to an executive search firm, in connection with the hiring of Robert J. Zollars, our Chief Executive Officer, and five other executive officers who have been hired since February 1999. As a result of our expansion, we have grown from six employees as of December 31, 1997, to 59 full-time employees as of December 31, 1998, to 269 full-time employees as of December 31, 1999. On August 6, 1999, we acquired General Asset Recovery LLC, or GAR, a live auction house and asset management company focused on medical products. The total purchase price was approximately $9.7 million, including $1.7 million in cash, the issuance of a promissory note in the principal sum of $7.8 million, the assumption of $100,000 in liabilities and acquisition-related expenses of approximately $100,000. The promissory note is payable over five years and bears interest at 7% per annum. This acquisition was accounted for using the purchase method of accounting. As a result of this acquisition, we began recording an aggregate of approximately $9.7 million in goodwill beginning in the third quarter of fiscal year 1999, which will be amortized on a straight-line basis over a seven-year period. In November 1999, we acquired certain assets of FDI Information Resources, LLC, a company in the business of developing and licensing equipment planning software. Under the terms of the agreement, we acquired the rights to software and certain customer contracts. The acquisition was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the intangible assets acquired and liabilities assumed on the basis of their respective fair values on the acquisition date. The total purchase price of approximately $3.4 million consisted of 350,000 shares of common stock valued at approximately $3.2 million, estimated assumed liabilities of approximately $97,000 and estimated acquisition-related expenses of approximately $112,000. In the initial allocation of the purchase price, $240,000, $600,000 and $2.5 million were allocated to acquired software, assembled workforce and trade names and goodwill, respectively. The acquired software, assembled workforce and trade names and goodwill will be amortized over an estimate useful life of three years. In order to acquire certain software and technology for use in our Shop, Auction and Plan services, on January 18, 2000 we acquired Pharos Technologies, Inc., a developer of content management software that facilitates the locating, organizing and updating of product information in an online marketplace. The acquisition was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the intangible assets acquired and liabilities assumed on the basis of their respective fair values on the acquisition date. The total purchase price of approximately $22.8 million consisted of approximately 2,000,000 shares of common stock valued at approximately $22.0 million, forgiveness of loan outstanding to Pharos of $500,000, estimated assumed liabilities of approximately $94,000 and estimated acquisition-related expenses of approximately $230,000. Of the shares issued to the previous owners of Pharos, approximately 700,000 shares were subject to repurchase rights which lapse over a period of the original terms of the shares, which specify a vesting period of four years. In the initial allocation of the purchase price, $367,000, $3.0 million, $3.0 million and $16.5 million were allocated to tangible assets, acquired in-process research and development, developed technology and goodwill, respectively. The acquired in-process research and development was charged to expense during the first quarter of fiscal 2000. The developed technology will be amortized when such technology has been put into productive use over an estimated useful life of three years. The goodwill will be amortized over an estimated useful life of five years. On March 16, 2000, we acquired U.S. Lifeline, Inc., or USL, a healthcare content company. With one of the largest supply chain databases in the industry, USL provides supply chain information to senior-level executives in the manufacturing, distribution, provider and GPO communities through web-based subscription products, industry newsletters and research. The total purchase price of $6.3 million consisted of 61,283 shares of our common stock valued at approximately $2.8 million and $3.5 million in cash. This acquisition will be accounted for using the purchase method of accounting. On March 24, 2000, we entered into an agreement to acquire all of the outstanding capital stock of EquipMD, Inc., a privately held business-to-business procurement company serving a wide range of purchasing needs of 15,000 physicians in approximately 4,000 practices. Under the terms of the agreement, we will acquire all of the outstanding capital stock and options of EquipMD for approximately 5.4 million shares of our common stock. Consummation of the acquisition, which will be accounted for as a purchase transaction, is expected in the second quarter of this year, subject to customary closing conditions. Since inception, we have incurred significant losses and, as of December 31, 1999, had an accumulated deficit of $56.1 million. We expect operating losses and negative cash flow to continue for the foreseeable future. We anticipate our losses will increase significantly due to substantial increases in our expenses for sales and marketing, product development, operating infrastructure, general and administrative staff and development of strategic alliances. We have a limited operating history on which to base an evaluation of our business and prospects. You must consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets such as the online market for the purchase and sale of new and used medical products, supplies and equipment. To address these risks, we must, among other things, expand the number of users of our online services, enter into new strategic alliances, increase the functionality of our services, implement and successfully execute our business and marketing strategy, respond to competitive developments and attract, retain and motivate qualified personnel. We may not be successful in addressing these risks, and our failure to do so could seriously harm our business. RESULTS OF OPERATIONS Due to our limited operating history, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as an indication of future performance. Year Ended December 31, 1998 as Compared to Year Ended December 31, 1999 Revenue. Since inception, we have been in the development stage and have had only limited revenue. We had total revenue of $1.0 million for the year ended December 31, 1999 primarily from transaction fees paid by sellers of medical products using our AuctionLive service. We did not have any revenue for the year ended December 31, 1998. For the year ended December 31, 1999, the gross value of transactions was approximately $3.6 million, which resulted in net revenue for Neoforma.com's Shop, Auction and Plan services of $83,000, $916,000 and $5,000, respectively. Operations. Operations expenses consist primarily of expenditures for digitizing and inputting content and for the operation and maintenance of our website. These expenditures consist primarily of fees for independent contractors and personnel expenses for our customer support and site operations personnel. Operations expenses increased from approximately $627,000 for the year ended December 31, 1998 to $5.0 million for the year ended December 31, 1999. The increase was primarily due to an increase in operations personnel costs, and an increase in payments to third party consultants. These increases were primarily due to hiring personnel and increased expenditures for digitizing and inputting content and for the enhancement of the infrastructure of our website. We expect our operations expenses to significantly increase as we expand our operating infrastructure and add content and functionality to our website. Product Development. Product development expenses consist primarily of personnel expenses and consulting fees associated with the development and enhancement of our services and website. Product development expenses increased from $1.5 million for the year ended December 31, 1998 to $6.8 million for the year ended December 31, 1999. The increase was primarily due to an increase in personnel costs, and an increase in fees paid to third parties. These increases were primarily due to hiring personnel and increased expenses incurred during development of our Auction and Shop services. We believe that continued investment in product development is critical to attaining our strategic objectives and, as a result, expect product development expenses to increase significantly in future periods. We expense product development costs as they are incurred. Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions, advertising, promotions and related marketing costs. Selling and marketing expenses increased from approximately $1.4 million for the year ended December 31, 1998 to $14.3 million for the year ended December 31, 1999. The increase was primarily due to an increase in sales and marketing personnel costs, an increase in expenses related to travel, an increase in expenses related to advertising and attendance at trade shows and expenses incurred in connection with our strategic alliances with Superior Consultant and VerticalNet. These increases were primarily due to significant expansion of our sales and marketing efforts and the hiring of additional sales and marketing personnel. We intend to significantly increase our selling and marketing expenses as we expand our sales force and invest in new marketing campaigns. In addition, we expect to continue to make significant payments in connection with our strategic alliances with Superior Consultant, VerticalNet, ECRI and Ariba, which will further increase our selling and marketing expenses in the periods in which these payments are made. See "-- Liquidity and Capital Resources." General and Administrative. General and administrative expenses consist of expenses for executive and administrative personnel, facilities, professional services and other general corporate activities. General and administrative expenses increased from approximately $1.1 million for the year ended December 31, 1998 to $9.6 million for the year ended December 31, 1999. The increase was primarily due to an increase in executive and administrative personnel costs related to the hiring of our chief executive officer, our chief financial officer and additional finance, accounting and administrative personnel, an increase in recruiting, legal and accounting and litigation settlement expenses, primarily as a result of the litigation expenses with respect to the hiring of one of our executive officers, and an increase in expenses related to other consultants, in each case associated with our growth. We expect general and administrative expenses to increase as we continue to expand our staff and incur additional costs to support the growth of our business and the costs of being a public company. We further expect our general and administrative expenses to increase due to the integration of GAR, FDI, Pharos and USL with our business. Amortization of Intangibles. Intangibles include goodwill and the value of software purchased in acquisitions. Intangibles are amortized on a straight-line basis over a period of three to seven years. Amortization of intangibles increased to $715,000 for the year ended December 31, 1999. The increase was a result of the acquisition of GAR in August 1999 and FDI in November 1999. We expect that the amortization of intangibles will increase significantly in future periods due to our recent and pending acquisitions. Amortization of Deferred Compensation. Deferred compensation represents the aggregate difference, at the date of grant, between the exercise price of stock options and the estimated fair value for accounting purposes of the underlying stock. Deferred compensation is amortized over the vesting period of the underlying options, generally four years, based on an accelerated vesting method. In connection with the grant of stock options to employees during fiscal 1998 and for the year ended December 31, 1999, we recorded deferred compensation of $60.6 million. For the year ended December 31, 1999, we recognized amortization of deferred compensation of $13.2 million. At December 31, 1999, the remaining deferred compensation of approximately $47.4 million will be amortized as follows: $25.2 million during fiscal 2000, $13.3 million during fiscal 2001, $6.7 million during fiscal 2002 and $2.2 million during fiscal 2003. The amortization expense relates to options awarded to employees in all operating expense categories. The amount of deferred compensation has not been separately allocated to these categories. The amount of deferred compensation expense to be recorded in future periods could decrease if options for which accrued but unvested compensation has been recorded are forfeited. Cost of Warrant Issued to Recruiter. For the year ended December 31, 1999, we recorded $2.4 million related to the valuation of a warrant issued to an executive search firm in connection with services rendered in the search for our Chief Executive Officer. Other Income (Expense). Other income (expense) consists of interest and other income and expense. Interest income for the year ended December 31, 1999 was $659,000 compared to $66,000 for the year ended December 31, 1998. The increase in interest income was due to an increase in our average net cash and cash equivalents balance as a result of our issuance of preferred stock in February and October 1999. Interest expense increased from $22,000 for the year ended December 31, 1998 to $676,000 for the year ended December 31, 1999, primarily as a result of the amortization of the fair value of a warrants issued in connection with debt. Other income for the year ended December 31, 1999 was $29,000. Income Taxes. As of December 31, 1999, we had federal and state net operating loss carryforwards of approximately $31.5 million which will be available to reduce future taxable income. The federal net operating loss carryforwards expire beginning in 2013 through 2018. A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset due to our lack of earnings history. Federal and state tax laws impose significant restrictions on the amount of the net operating loss carryforwards that we may utilize in a given year. See Note 12 of notes to consolidated financial statements. Period From Inception to December 31, 1996, as Compared to Year Ended December 31, 1997 as Compared to Year Ended December 31, 1998 Revenue. We had no revenue for the period from inception to December 31, 1998. Operations. We had no operations expenses in 1996 and 1997. We began operating and maintaining our website and acquiring and processing content in 1998, and as a result, incurred operations expenses of $627,000. Product Development. Product development expenses increased from $31,000 in 1996 to $179,000 in 1997 to $1.5 million in 1998. The increase in 1998 was primarily due to increased personnel expenses as we developed features and added functionality to our website. Selling and Marketing. Selling and marketing expenses increased from $111,000 in 1996 to $153,000 in 1997 to $1.4 million in 1998. The increase in 1998 was primarily due to the significant expansion of our sales and marketing efforts and the hiring of additional sales and marketing personnel. General and Administrative. General and administrative expenses increased from $54,000 in 1996 to $76,000 in 1997 to $1.1 million in 1998. The increase in 1998 was primarily due to expenses related to increased personnel, professional service fees and facility expenses associated with our growth. Amortization of Deferred Compensation. Amortization of deferred compensation for the fiscal year ended December 31, 1998 was $5,000. No amortization of deferred compensation was expensed for fiscal years 1997 or 1996. Other Income (Expense). Interest income increased from none in 1996 and 1997 to $66,000 in 1998. The increase in interest income was due to an increase in cash and cash equivalents that resulted from our issuance of preferred stock during 1998. Interest expense increased from none in 1996 to $15,000 in 1997 to $22,000 in 1998. Other income was $142,000 in 1996, $7,000 in 1997 and none in 1998. Other income was primarily related to fees received from projects unrelated to our current business model. Income Taxes. As of December 31, 1998, we had federal and state net operating loss carryforwards of approximately $4.5 million which will be available to reduce future taxable income. The federal net operating loss carryforwards expire beginning in 2013 through 2018. A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset due to our lack of earnings history. Federal and state tax laws impose significant restrictions on the amount of the net operating loss carryforwards that we may utilize in a given year. See Note 12 of notes to consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES In January 2000, we completed our initial public offering and issued 8,050,000 shares of our common stock at an initial public offering price of $13.00 per share. Net cash proceeds to us from the initial public offering were approximately $95.4 million. From our inception until our initial public offering, we financed our operations primarily through private sales of preferred stock through which we raised net proceeds of $89.0 million through December 31, 1999. We have also financed our operations through an equipment loan and lease financing and bank and other borrowings. As of December 31, 1999, we had outstanding bank, other borrowings and notes payable related to the GAR acquisition of $11.1 million. As of December 31, 1999, we had approximately $25.3 million of cash and cash equivalents. In June 1998, we entered into a $750,000 secured credit facility with Silicon Valley Bank. This facility included a $225,000 term loan due December 1999 and an equipment loan facility providing for up to $525,000 of equipment loans. In July 1999, we converted the $433,000 of outstanding equipment loans into a term loan due July 2000. Our term loans from Silicon Valley Bank bear interest at the lender's prime rate (8.25% as of December 31, 1999). At December 31, 1999, there were no borrowings outstanding under the term loan and $404,000 outstanding under the equipment loan. This facility is secured by substantially all of our assets other than equipment. In consideration for this credit facility, we granted Silicon Valley Bank a warrant to purchase 45,000 shares of common stock at an exercise price of $0.77 per share. In consideration for the conversion of our equipment loan to a term loan and the release of its security interest in equipment, we granted Silicon Valley Bank a warrant to purchase 10,000 shares of common stock at an exercise price of $1.18 per share. In May 1999, Comdisco provided us with a $2.0 million subordinated loan to provide working capital. We agreed to pay Comdisco principal and interest at a rate of 12.5% per annum in 36 equal monthly installments, commencing July 1999. This loan is secured by all of our assets. In connection with this loan, we issued Comdisco a warrant to purchase 228,813 shares of common stock at $1.18 per share. As of December 31, 1999, the outstanding balance on the note was approximately $1.7 million. In July 1999, Comdisco provided us with a $2.5 million loan and lease facility to finance computer hardware and software equipment. Amounts borrowed to purchase hardware bear interest at 9% per annum and are payable in 48 monthly installments consisting of interest only payments for the first year and principal and interest payments for the remaining 39 months, with a balloon payment of the remaining principal payable at maturity. Amounts borrowed to purchase software bear interest at 8% per annum and are payable in 30 monthly installments consisting of interest only payments for the first four months and principal and interest payments for the remaining 26 months, with a balloon payment of the remaining principal payable at maturity. As of December 31, 1999, we had outstanding approximately $2.1 million in hardware loans due September 2003 and approximately $254,000 in software loans due March 2002. This facility is secured by the computer equipment purchased with the loans. In connection with this facility, we issued Comdisco a warrant to purchase 137,711 shares of common stock at $1.18 per share. In August 1999, as a result of the GAR acquisition, we issued a promissory note in the principal amount of $7.8 million payable monthly over five years bearing interest at a rate of 7% per annum. As of December 31, 1999, the outstanding balance on the note was approximately $6.9 million. In May 1999, we entered into an agreement with ECRI, a non-profit health services research agency focusing on healthcare technology. The agreement provides us with content from ECRI's database of information about medical products and manufacturers and a license to use elements of its classification system. In addition, the agreement provides for joint marketing activities and collaboration in the development of Plan's database of product and vendor information. This agreement requires us to make revenue sharing payments to ECRI during the three-year term of the agreement and for two years following expiration or termination of the agreement based on a percentage of revenue derived from our Plan service. During the second and third years of the term of the agreement, we are required to pay to ECRI a minimum nonrefundable fee equal to $600,000 per year, which shall be credited against any revenue sharing payments payable to ECRI. In October 1999, we entered into an agreement with Superior Consultant Company, Inc., a wholly owned subsidiary of Superior Consultant Holdings Corporation, providing for collaboration between us and Superior. Superior is a supplier of Digital Business Transformation(TM) services to large healthcare organizations, including Internet-related services, systems integration, outsourcing and consulting, which enable Superior clients to utilize digital technologies and process innovations to improve their businesses. Under the agreement, we have agreed to market Superior's services to our users, and Superior has agreed to introduce our services to appropriate clients, based on their interests, and to incorporate our services into its Digital Business Transformation(TM) offerings. The agreement also provides for joint marketing activities. In consideration, we have agreed to make payments to Superior in an aggregate amount of up to approximately $2.0 million, as well as a percentage of specified Neoforma.com e-commerce transaction revenue and potential fixed payments based on the success of our joint marketing activities. We have also agreed to utilize Superior's services on a preferred basis for systems integration, development, infrastructure, process improvement and consulting assistance, totaling at least $1.5 million of services from Superior, at a discount from Superior's standard fees. Our agreement with Superior expires in October 2002. As of December 31, 1999 we had paid Superior $1.5 million. In October 1999, we entered into an agreement with Dell Marketing, L.P. pursuant to which we agreed to develop complementary marketing programs with Dell and establish hyperlinks between our respective websites. We agreed to use Dell as our exclusive supplier of desktops, portables, workstations, servers and storage devices unless such products did not meet our reasonable technical requirements. We also agreed to purchase at least $5.0 million of Dell products and $100,000 of data center consulting services. As of December 31, 1999 we had purchased $1.5 million in equipment from Dell. In November 1999, we entered into a co-branding agreement with VerticalNet, Inc. Under the agreement, VerticalNet will transfer to our website all listings of new and used medical products offered for sale through its website (on an exclusive basis to the extent it has the right to do so), and we will transfer to VerticalNet all listings of used and excess laboratory products offered for sale on our website (on an exclusive basis to the extent we have the right to do so). We have also agreed to establish links between our respective websites. In addition, VerticalNet will develop and maintain a co-branded career center and a co-branded training and education center, and will provide us with specified content created for its medical online communities. VerticalNet also has the non-exclusive right to sell sponsorships on our Plan service and the exclusive right to sell advertising on the co branded sites. We have agreed to pay VerticalNet $2,000,000 of development and promotional fees over the next two years under this agreement, of which we paid $687,000 in the fourth quarter of 1999. We and VerticalNet have agreed to each pay the other commissions equal to a percentage of net revenues earned through product listings transferred to its website by the other, and to share specified sponsorship and advertising revenue. In March 2000, we entered into a Hosting Alliance Agreement with Ariba, Inc. Under this agreement we will offer Ariba's ORMX procurement solution to users of our marketplace. In March 2000, we purchased 600,000 shares of the Series D preferred stock of Pointshare, Inc., a privately held corporation in exchange for $3.0 million. Pointshare is a company that provides online business to business administrative services to healthcare communities. Our ownership represents approximately 2% of the Pointshare common shares outstanding, assuming a 1:1 conversion ratio of preferred stock to common stock. We will account for this investment using the cost method. Net cash used in operating activities was $87,000 for the period from inception through December 31, 1996, $322,000 for the year ended December 31, 1997 and $4.0 million for the year ended December 31, 1998. Net cash used in operating activities for the year ended December 31, 1999 was $25.8 million. Net cash used in operating activities from inception through December 31, 1999 related primarily to funding net operating losses and increases in prepaid expenses, which were partially offset by increases in accrued expenses and accounts payable. Net cash used in investing activities was $1,000 for the period from inception through December 31, 1996, $13,000 for the year ended December 31, 1997 and $825,000 for the year ended December 31, 1998. Net cash used in investing activities for the year ended December 31, 1999 was $37.8 million. Net cash used in investing activities from inception through the year ended December 31, 1999 related primarily to the purchase of equipment to operate our website and cash paid for the acquisition of General Asset Recovery LLC. Net cash provided by financing activities was $95,000 for the period from inception through December 31, 1996, $360,000 for the year ended December 31, 1997 and $5.6 million for the year ended December 31, 1998. For the year ended December 31, 1999, net cash provided by financing activities was $88.0 million. Net cash provided from financing activities for the period from inception to December 31, 1999 related primarily to preferred stock issuances of approximately $88.4 million. We currently anticipate that our available funds, will be sufficient to meet our anticipated needs for working capital and capital expenditures through at least the next 12 months. Our future long-term capital needs will depend significantly on the rate of growth of our business, the timing of expanded service offerings and the success of these services once they are launched. Any projections of future long-term cash needs and cash flows are subject to substantial uncertainty. If our available funds and cash generated from operations, are insufficient to satisfy our long-term liquidity requirements, we may seek to sell additional equity or debt securities, obtain a line of credit or curtail expansion of our services. If we issue additional securities to raise funds, those securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders may experience dilution. We cannot be certain that additional financing will be available to us on favorable terms when required, or at all. YEAR 2000 Many existing computer programs use only two digits to identify a year. These programs were designed and developed without addressing the impact of the change in the century. If not corrected, many computer software applications could fail or create erroneous results beyond the year 2000. Prior to the end of 1999, we completed a review of the year 2000 compliance of our internally developed proprietary software, including testing to determine how our systems will function at and beyond the year 2000. Based upon our assessment, we believe that our internally developed proprietary software is year 2000 compliant. In addition, we assessed the year 2000 readiness of our third-party supplied software, computer technology and other services, which include software for use in our accounting, database and security systems, and implemented corrective actions that we believed were necessary to address potential year 2000 issues in these areas. To date, we have not experienced any year 2000-related problems with our internally developed software or our third-party supplied software and computer systems, and we are not aware of any failure by our third-party suppliers to be year 2000 compliant that could impact our business or operations. However, such problems or failures could arise or become apparent in the future, and any such problems or failures could have negative consequences for us. Such consequences could include difficulties in operating our website effectively, taking customer orders or conducting other fundamental parts of our business. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" SFAS No. 133 will be effective for us on January 1, 2001. SFAS No. 133 requires certain accounting and reporting standards for derivative financial instruments and hedging activities. Because we do not currently hold any derivative instruments and does not engage in hedging activities, management does not believe that the adoption of SFAS No. 133 will have a material impact on our financial position or results of operations. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements." SAB 101 provides guidance on applying generally accepted accounting principles to revenue recognition issues in financial statements. We will adopt SAB 101 as required in the second quarter of 2000. Management does not expect the adoption of SAB 101 to have a material impact on our consolidated results of operations and financial position. FACTORS THAT MAY AFFECT OPERATING RESULTS The risks described below are not the only ones facing our company. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations. Our business, financial condition or results of operations may be seriously harmed by any of these risks. BECAUSE WE HAVE ONLY RECENTLY INTRODUCED OUR PRIMARY SERVICES AND BECAUSE WE OPERATE IN A NEW AND RAPIDLY EVOLVING MARKET, YOU MAY HAVE DIFFICULTY ASSESSING OUR BUSINESS AND OUR FUTURE PROSPECTS We incorporated in March 1996. Prior to May 1999, our operations consisted primarily of the initial planning and development of our marketplace and the building of our operating infrastructure. We introduced our initial Auction service, AdsOnline, in May 1999, our second Auction service, AuctionLive, in August 1999 and our third Auction service, AuctionOnline, in November 1999 and we introduced our Shop service in August 1999. As a result, we have generated revenues of only $1.0 million for the 1999 fiscal year. Because we have only recently introduced our services, it is difficult to evaluate our business and our future prospects. For example, it is difficult to predict whether the market will accept our services and the level of revenue we can expect to derive from our services. Because we are an early stage company in the online market for the purchase and sale of new and used medical products, supplies and equipment, which is a new and rapidly evolving market, we cannot be certain that our business strategy will be successful. Our business will be seriously harmed, and may fail entirely, if we do not successfully execute our business strategy or if we do not successfully address the risks we face. In addition, due to our limited operating history, we believe that period-to-period comparisons of our revenue and results of operations are not meaningful. WE HAVE A HISTORY OF LOSSES, ANTICIPATE INCURRING LOSSES IN THE FORESEEABLE FUTURE AND MAY NEVER ACHIEVE PROFITABILITY We have experienced losses from operations in each period since our inception, including net losses of $1.0 million for the 1999 fiscal year. In addition, as of December 31, 1999, we had an accumulated deficit of approximately $31.9 million. We have not achieved profitability and we expect to continue to incur substantial operating losses for the foreseeable future. We have generated limited revenue to date. If our revenue does not increase substantially or if our expenses increase further than we expect, we may never become profitable. We anticipate that our operating losses will increase in the future, as we expect substantial increases in our costs and expenses in a number of areas, including: - marketing and promotion of our company and our services, including building recognition of our brand name; - expanding our direct field sales force; - expanding and enhancing our operating infrastructure, including hardware and software systems and administrative personnel; - extending the functionality of our online marketplace; and - expanding our services. OUR OPERATING RESULTS ARE VOLATILE AND DIFFICULT TO PREDICT, AND IF WE FAIL TO MEET THE EXPECTATIONS OF INVESTORS OR SECURITIES ANALYSTS, THE MARKET PRICE OF OUR COMMON STOCK WOULD LIKELY DECLINE SIGNIFICANTLY Our revenue and operating results are likely to fluctuate significantly from quarter to quarter, due to a number of factors. These factors include: - the amount and timing of payments to our strategic partners; - variability in the amount of equipment that we auction in a given quarter; - changes in the fees we charge users of our services; - budgetary fluctuations of purchasers of medical products, supplies and equipment; and - changes in general economic and market conditions. Fluctuations in our operating results may cause us to fail to meet the expectations of investors or securities analysts. If this were to happen, the market price of our common stock would likely decline significantly. In addition, as a result of our limited operating history, the emerging nature of our market and the evolving nature of our business model, we are unable to accurately forecast our revenue. We incur expenses based predominantly on operating plans and estimates of future revenue. Our expenses are to a large extent fixed. We may be unable to adjust our spending in a timely manner to compensate for any unexpected revenue shortfalls. Accordingly, a failure to meet our revenue projections would have an immediate and negative impact on profitability. IF BUYERS AND SELLERS OF MEDICAL PRODUCTS DO NOT ACCEPT OUR BUSINESS MODEL OF PROVIDING AN ONLINE MARKETPLACE FOR THE PURCHASE AND SALE OF MEDICAL PRODUCTS, DEMAND FOR OUR SERVICES MAY NOT DEVELOP AND THE PRICE OF OUR COMMON STOCK WOULD DECLINE We offer an online marketplace that aggregates a number of suppliers and purchasers of medical products. This business model is new and unproven and depends upon buyers and sellers in this market adopting a new way to purchase and sell medical products, supplies and equipment. If buyers and sellers of medical products do not accept our business model, demand for our services may not develop and the price of our common stock would decline. Suppliers and purchasers of medical products could be reluctant to accept our new, unproven approach, which involves new technologies and may not be consistent with their existing internal organization and procurement processes. Suppliers and purchasers may prefer to use traditional methods of selling and buying medical products, such as using paper catalogs and interacting in person or by phone with representatives of manufacturers or distributors. In addition, many of the individuals responsible for purchasing medical products do not have ready access to the Internet and may be unwilling to use the Internet to purchase medical products. Even if suppliers and purchasers accept the Internet as a means of selling and buying medical products, they may not accept our online marketplace for conducting this type of business. Instead, they may choose to establish and operate their own websites to purchase or sell new and used medical products. Reluctance of suppliers and purchasers to use our services would seriously harm our business. IF WE CANNOT QUICKLY BUILD A CRITICAL MASS OF PURCHASERS AND SUPPLIERS OF MEDICAL PRODUCTS, SUPPLIES AND EQUIPMENT, WE WILL NOT ACHIEVE A NETWORK EFFECT AND OUR BUSINESS MAY NOT SUCCEED To encourage suppliers to list their products on our online marketplace, we need to increase the number of purchasers who use our services. However, to encourage purchasers to use our marketplace, it must offer a broad range of products from a large number of suppliers. If we are unable to quickly build a critical mass of purchasers and suppliers, we will not be able to benefit from a network effect, where the value of our services to each participant significantly increases with the addition of each new participant. Our inability to achieve a network effect would reduce the overall value of our Shop and Auction services to purchasers and suppliers and, consequently, would harm our business. IT IS IMPORTANT TO OUR SUCCESS THAT OUR SERVICES BE USED BY LARGE HEALTHCARE ORGANIZATIONS AND WE MAY NOT ACHIEVE MARKET ACCEPTANCE WITH THESE ORGANIZATIONS Currently, we believe that most of the registered users of our website are relatively small healthcare providers such as physicians offices, and these users have accounted for most of the purchases of new medical products through Shop. It is important to our success that our services be used by large healthcare organizations, such as hospitals, integrated delivery networks and members of large purchasing organizations. In order for these large organizations to accept our services, we must integrate our services with their information systems. In addition, we will need to develop customer-specific pricing capabilities before these organizations can use our services to purchase products covered by their negotiated agreements with suppliers. Finally, we will need to significantly increase the number of suppliers using our services to address the needs of these large organizations, which typically require a wide range of medical products. Many of these large healthcare organizations have established, or may establish, websites that enable sales of their products directly to consumers or electronic data interchange systems designed specifically for their needs and integrated with their existing processes and technologies. If we are unable to extend our capabilities and expand our registered user base as described above, we may not provide an attractive alternative to these websites or systems and may not achieve market acceptance by these large organizations. In addition, we believe that we must establish relationships with group purchasing organizations in order to increase our access to these organizations. Group purchasing organizations represent groups of buyers in the negotiation of purchasing contracts with sellers and consequently have the ability to significantly influence the purchasing decisions of their members. The inability to enter into and maintain favorable relationships with other group purchasing organizations and the hospitals they represent could impact the breadth of our customer base and could harm our growth and revenues. One of the largest group purchasing organizations, Premier Purchasing Partners, has a long-term, exclusive agreement for e-commerce services with Premier Health Exchange. One of our competitors, Medibuy, recently announced an agreement to acquire Premier Health Exchange. IF WE DO NOT SUCCEED IN EXPANDING THE BREADTH OF THE PRODUCTS OFFERED THROUGH OUR ONLINE MARKETPLACE, SOME PURCHASERS OF MEDICAL PRODUCTS MAY CHOOSE NOT TO UTILIZE OUR SERVICES WHICH WOULD LIMIT OUR POTENTIAL MARKET SHARE The future success of our Shop service depends upon our ability to offer purchasers a wide range of medical products. The products currently listed on our Shop service are primarily oriented to the physicians' office market. Large healthcare organizations generally require a much broader range of products. To increase the breadth of the products listed on Shop, we must establish relationships with additional suppliers and expand the number and variety of products listed by existing suppliers. If we are unable to maintain and expand the breadth of medical products, supplies and equipment listed on Shop, the attractiveness of our services to purchasers will be diminished, which would limit our potential market share. A number of factors could significantly reduce, or prevent us from increasing, the number of suppliers and products offered on our online marketplace, including: - reluctance of suppliers to offer medical products in an online marketplace that potentially includes their competitors; - exclusive or preferential arrangements signed by suppliers with our competitors; - perceptions by suppliers that we give other suppliers preferred treatment on our online marketplace; and - consolidation among suppliers, which we believe is currently occurring. WE EXPECT THAT A SIGNIFICANT PORTION OF THE MEDICAL PRODUCTS, SUPPLIES AND EQUIPMENT SOLD THROUGH OUR SHOP SERVICE WILL COME FROM A LIMITED NUMBER OF KEY MANUFACTURERS AND DISTRIBUTORS, AND THE LOSS OF A KEY MANUFACTURER OR DISTRIBUTOR COULD RESULT IN A SIGNIFICANT REDUCTION IN THE REVENUE WE GENERATE THROUGH THIS SERVICE Although to date we have generated only minimal revenues from our Shop service, we expect that a significant portion of the products to be sold through and revenue to be generated from our Shop service will come from a limited number of key manufacturers and distributors. These parties are generally not obligated to list any medical products on our Shop service. If any of these key manufacturers or distributors cease doing business with us or reduce the number of products they list on our Shop service, the revenue we generate through this service could be significantly reduced. Our supplier agreements are nonexclusive and, accordingly, these suppliers can sell their medical products, supplies and equipment to purchasers directly or through our competitors. WE EXPECT THAT A SIGNIFICANT PORTION OF THE MEDICAL PRODUCTS, SUPPLIES AND EQUIPMENT SOLD THROUGH OUR SHOP SERVICE WILL COME FROM A LIMITED NUMBER OF KEY MANUFACTURERS AND DISTRIBUTORS, AND THE LOSS OF A KEY MANUFACTURER OR DISTRIBUTOR COULD RESULT IN A SIGNIFICANT REDUCTION IN THE REVENUE WE GENERATE THROUGH THIS SERVICE Although to date we have generated only minimal revenues from our Shop service, we expect that a significant portion of the products to be sold through and revenue to be generated from our Shop service will come from a limited number of key manufacturers and distributors. These parties are generally not obligated to list any medical products on our Shop service. If any of these key manufacturers or distributors cease doing business with us or reduce the number of products they list on our Shop service, the revenue we generate through this service could be significantly reduced. Our supplier agreements are nonexclusive and, accordingly, these suppliers can sell their medical products, supplies and equipment to purchasers directly or through our competitors. WE MAY CONTINUE TO MAKE NEW ACQUISITIONS, WHICH COULD HARM OUR PROFITABILITY, PUT A STRAIN ON OUR RESOURCES OR CAUSE DILUTION TO OUR STOCKHOLDERS We have acquired technologies and other companies in order to expand our business and the services we offer, and we intend to make similar acquisitions in the future. See "Management's Discussion and Analysis of Financial Condition and Future Operating Results -- Overview" for a summary of our recent acquisitions. Integrating newly acquired organizations and technologies into our company could be expensive, time consuming and may strain our resources. In addition, we may lose current users of our services if any acquired companies have relationships with competitors of our users. Consequently, we may not be successful in integrating any acquired businesses or technologies and may not achieve anticipated revenue and cost benefits. In addition, future acquisitions could result in potentially dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or amortization expenses related to goodwill and other intangible assets, any of which could harm our business. For example, in connection with the acquisition of General Asset Recovery, we recorded approximately $9.7 million in goodwill, which will be amortized over a period of seven years, and in connection with the FDI acquisition, we will record an aggregate of approximately $3.3 million in goodwill in the fourth quarter of 1999, which will be amortized over a period of three years. IF WE DO NOT TIMELY ADD PRODUCT INFORMATION TO OUR ONLINE MARKETPLACE OR IF THAT INFORMATION IS NOT ACCURATE, OUR REPUTATION MAY BE HARMED AND WE MAY LOSE USERS OF OUR ONLINE SERVICES Currently, we are responsible for entering product information into our database and categorizing the information for search purposes. If we do not do so in a timely manner, we will encounter difficulties in expanding our online marketplace. We currently have a backlog of products to be entered in our system. We will not derive revenue from the sale of products by these suppliers until the information is entered in our system. Timely entering of this information in our database depends upon a number of factors, including the format of the data provided to us by suppliers and our ability to accurately enter the data in our product database, any of which could delay the actual entering of the data. We use an independent company to assist us in digitizing and inputting the data provided to us by suppliers, and we rely on this company to accurately input the data. If this company fails to input data accurately, our reputation could be damaged, and we could lose users of our online services. IF SUPPLIERS DO NOT TIMELY PROVIDE US WITH ACCURATE, COMPLETE AND CURRENT INFORMATION ABOUT THEIR PRODUCTS AND COMPLY WITH GOVERNMENT REGULATIONS, WE MAY BE EXPOSED TO LIABILITY OR THERE MAY BE A DECREASE IN THE ADOPTION AND USE OF OUR ONLINE MARKETPLACE If suppliers do not provide us in a timely manner with accurate, complete and current information about the products they offer and promptly update this information when it changes, our database will be less useful to purchasers. We cannot guarantee that the product information available from our services will always be accurate, complete and current, or that it will comply with governmental regulations. This could expose us to liability if this incorrect information harms users of our services or result in decreased adoption and use of our online marketplace. We also rely on suppliers using our services to comply with all applicable governmental regulations, including packaging, labeling, hazardous materials, health and environmental regulations and licensing and record keeping requirements. Any failure of our suppliers to comply with applicable regulations could expose us to civil or criminal liability or could damage our reputation. BECAUSE SOME OF THE PARTICIPANTS IN OUR ONLINE MARKETPLACE ARE STOCKHOLDERS OR HAVE STRATEGIC RELATIONSHIPS WITH US, WE MAY FIND IT DIFFICULT TO ATTRACT COMPETING COMPANIES, WHICH COULD LIMIT THE BREADTH OF PRODUCTS OFFERED ON AND USERS OF OUR ONLINE MARKETPLACE Some suppliers participating in our online marketplace are our stockholders or have strategic relationships with us. For example, General Electric Medical Systems is entitled to sponsor rooms in our Plan service and has agreed to conduct other activities with us, and an affiliate of General Electric Medical Systems owns 2,035,563 shares of our common stock. See "Business -- Suppliers." These relationships may deter other suppliers, particularly those that compete directly with these participants, from participating in our online marketplace due to perceptions of bias in favor of one supplier over another. This could limit the array of products offered on our online marketplace, damage our reputation and limit our ability to maintain or increase our user base. IF WE FAIL TO DEVELOP THE CAPABILITY TO INTEGRATE OUR ONLINE SERVICES WITH ENTERPRISE SOFTWARE SYSTEMS OF PURCHASERS AND SUPPLIERS OF MEDICAL PRODUCTS AND TO ENABLE OUR SERVICES TO SUPPORT CUSTOMER-SPECIFIC PRICING, THESE ENTITIES MAY CHOOSE NOT TO UTILIZE OUR ONLINE MARKETPLACE, WHICH WOULD HARM OUR BUSINESS If we do not maintain and expand the functionality and reliability of our services, purchasers and suppliers of medical products may not use our marketplace. We believe that we must develop the capability to integrate our online services with enterprise software systems used by many suppliers of medical products and by many large healthcare organizations, and to enable our services to support customer-specific pricing. We may incur significant expenses to develop these capabilities, and may not succeed in developing them in a timely manner. In addition, developing the capability to integrate our services with suppliers' and purchasers' enterprise software systems will require the cooperation of and collaboration with the companies that develop and market these systems. Suppliers and purchasers use a variety of different enterprise software systems provided by third-party vendors or developed internally. This lack of uniformity increases the difficulty and cost of developing the capability to integrate with the systems of a large number of suppliers and purchasers. Failure to provide these capabilities would limit the efficiencies that our services provide, and may deter many purchasers and suppliers from using our online marketplace, particularly large healthcare organizations. WE FACE INTENSE COMPETITION, AND IF WE ARE UNABLE TO COMPETE EFFECTIVELY, WE MAY BE UNABLE TO MAINTAIN OR EXPAND THE BASE OF PURCHASERS AND SELLERS OF MEDICAL PRODUCTS USING OUR SERVICES AND WE MAY LOSE MARKET SHARE OR BE REQUIRED TO REDUCE PRICES The online market for medical products, supplies and equipment is new, rapidly evolving and intensely competitive. Our primary competition includes e-commerce providers that have established online marketplaces for medical products, supplies and equipment. We also face potential competition from a number of sources. Many companies have created websites to serve the information needs of healthcare professionals. Many of these companies are introducing e-commerce functions that may compete with our services. In addition, providers of online marketplaces and online auction services that currently focus on other industries could expand the scope of their services to include medical products. Existing suppliers of medical products may also establish online marketplaces that offer services to suppliers and purchasers, either on their own or by partnering with other companies. Moreover, live auction houses focusing on medical products may establish online auction services. See "Business -- Competition" for more information about our current and potential competitors. Competition is likely to intensify as our market matures. As competitive conditions intensify, competitors may: - enter into strategic or commercial relationships with larger, more established healthcare, medical products and Internet companies; - secure services and products from suppliers on more favorable terms; - devote greater resources to marketing and promotional campaigns; - secure exclusive or preferential arrangements with purchasers or suppliers that limit sales through our marketplace; and - devote substantially more resources to website and systems development. For example, one of our competitors, Medibuy, recently announced its agreement to acquire Premier Health Exchange, including a long-term, exclusive agreement to provide e-commerce services for Premier Purchasing Partners, one of the largest group purchasing organizations in the United States. In addition, Johnson & Johnson, General Electric Medical Systems, Baxter International, Abbott Laboratories and Medtronic recently announced that they are creating a healthcare exchange for the purchase and sale of medical products. Many of our existing and potential competitors have longer operating histories in the medical products market, greater name recognition, larger customer bases and greater financial, technical and marketing resources than we do. As a result of these factors, our competitors and potential competitors may be able to respond more quickly to market forces, undertake more extensive marketing campaigns for their brands and services and make more attractive offers to purchasers and suppliers, potential employees and strategic partners. In addition, new technologies may increase competitive pressures. We cannot be certain that we will be able to maintain or expand our user base. We may not be able to compete successfully against current and future competitors and competition could result in price reductions, reduced sales, gross margins and operating margins and loss of market share. IF WE ARE NOT ABLE TO INCREASE RECOGNITION OF, OR LOSE THE RIGHT TO USE, THE NEOFORMA.COM BRAND NAME, OUR ABILITY TO ATTRACT USERS TO OUR ONLINE MARKETPLACE WILL BE LIMITED We believe that recognition and positive perception of the Neoforma.com brand name in the healthcare industry are important to our success. We intend to significantly expand our advertising and publicity efforts in the near future. However, we may not achieve our desired goal of increasing the awareness of the Neoforma.com brand name. Even if recognition of our name increases, it may not lead to an increase in the number of visitors to our online marketplace or increase the number of users of our services. Furthermore, in a letter dated January 14, 2000, Forma Scientific, Inc. notified us that it believes our use of "Neoforma" and "Neoforma.com" violates its trademark rights in "Forma" and "Forma Scientific." Based on our preliminary investigation, we believe that we have meritorious defenses to Forma Scientific's claims and intend to vigorously defend ourselves in any litigation that may arise from these claims. However, if any litigation were to be decided adversely to us, we could be enjoined from future use of the names Neoforma and Neoforma.com. The loss of the use of the Neoforma.com brand would seriously harm our business. IF PARTICIPATING SELLERS ON OUR SHOP AND AUCTION SERVICES DO NOT PROVIDE TIMELY AND PROFESSIONAL DELIVERY OF MEDICAL PRODUCTS, SUPPLIES AND EQUIPMENT, PURCHASERS MAY NOT CONTINUE USING OUR SERVICES We rely on suppliers to deliver the medical products, supplies and equipment sold through our Shop service to purchasers. We also often rely on sellers to deliver products sold through our Auction service. In addition, suppliers do not guarantee the availability or timely delivery of products listed on to Shop. If these sellers fail to make delivery in a professional, safe and timely manner, then our services will not meet the expectations of purchasers, and our reputation and brand will be damaged. In addition, deliveries that are non-conforming, late or are not accompanied by information required by applicable law or regulations could expose us to liability or result in decreased adoption and use of our services. WE MAY BE SUBJECT TO LITIGATION FOR DEFECTS IN PRODUCTS SUPPLIED BY SELLERS USING OUR SERVICES, AND THIS TYPE OF LITIGATION MAY BE COSTLY AND TIME-CONSUMING TO DEFEND Because we facilitate the sale of new and used medical products by sellers using our services, we may become subject to legal proceedings regarding defects in these medical products, even though we generally do not take title to these products. Any claims, with or without merit, could: - be time-consuming to defend; - result in costly litigation; or - divert management's attention and resources. IF WE ARE UNABLE TO ATTRACT QUALIFIED PERSONNEL OR RETAIN OUR EXECUTIVE OFFICERS AND OTHER KEY PERSONNEL, WE MAY NOT BE ABLE TO COMPETE SUCCESSFULLY IN OUR INDUSTRY Our success depends on our ability to attract and retain qualified, experienced employees. Competition for qualified, experienced employees in both the Internet and the healthcare industry, particularly in the San Francisco Bay Area, is intense, and we may not be able to compete effectively to retain and attract employees. Should we fail to retain or attract qualified personnel, we may not be able to compete successfully in our industry, and our business would be harmed. We believe that our success will depend on the continued services of executive officers and other key employees. Other than initial offer letters containing information regarding compensation, we currently have employment agreements with only two members of our senior management. However, these agreements do not prevent these executives from terminating their employment at any time. As a result, our employees, including these executives, serve at-will and may elect to pursue other opportunities at any time. The loss of any of our executive officers or other key employees could harm our business. Other than the limited key person life insurance policies we have with our founders, Jeffrey H. Kleck and Wayne D. McVicker, we do not maintain any key person life insurance. MANY OF OUR EXECUTIVES AND OTHER EMPLOYEES HAVE RECENTLY JOINED OUR COMPANY, AND IF THEY ARE UNABLE TO EFFECTIVELY WORK TOGETHER, WE MAY NOT BE ABLE TO EFFECTIVELY MANAGE OUR GROWTH AND OPERATIONS Many of our executive officers and other employees joined us only recently and have had a limited time to work together. For example, our Chief Executive Officer, Robert J. Zollars, joined us in July 1999, our Chief Financial Officer, Frederick J. Ruegsegger, joined us in July 1999, our Executive Vice President of Products and Services, Bhagwan D. Goel, joined us in October 1999, our Executive Vice President of Sales and President of Neoforma Shop, Daniel A. Eckert, accepted employment with us in July 1999 and joined us in November 1999 and our Executive Vice President of Strategy and Chief Marketing Officer, Robert W. Rene, joined us in December 1999. We cannot assure you that they will be able to work effectively together to manage our growth and continuing operations. OUR STRATEGY TO EXPAND OUR SERVICES INTERNATIONALLY IN ORDER TO INCREASE THE USE OF OUR ONLINE MARKETPLACE BY SUPPLIERS AND PURCHASERS OF MEDICAL PRODUCTS MAY REQUIRE SIGNIFICANT MANAGEMENT ATTENTION AND FINANCIAL RESOURCES, AND IF WE ARE UNABLE TO EXECUTE THIS STRATEGY, OUR GROWTH WILL BE LIMITED AND OUR OPERATING RESULTS MAY BE HARMED In order to increase the market awareness and the use of our online marketplace by suppliers of medical products, we intend to expand our services internationally. If we fail to execute this strategy, our growth will be limited and our operating results may be harmed. We have limited experience with the healthcare industry outside the U.S. and with marketing our services internationally. Our entry into international markets may require significant management attention and financial resources, which may harm our ability to effectively manage our existing business. Furthermore, entry into some international markets would require us to develop foreign language versions of our services. Accordingly, our planned international expansion may not be successful. We cannot be sure that we will be able to attract purchasers and sellers of medical products in foreign jurisdictions to our online marketplace. In addition, the market for the purchase and sale of medical products in many foreign countries is different from that in the U.S. For example, in many foreign countries, the government or a government-controlled entity is the principal purchaser of medical products. Competitors which have greater local market knowledge may exist or arise in these international markets and impede our ability to successfully expand in these markets. IF WE ARE UNABLE TO MAINTAIN OUR STRATEGIC ALLIANCES OR ENTER INTO NEW ALLIANCES, WE MAY BE UNABLE TO INCREASE THE ATTRACTIVENESS OF OUR ONLINE MARKETPLACE OR PROVIDE SATISFACTORY SERVICES TO USERS OF OUR SERVICES Our business strategy includes entering into strategic alliances with leading technology and healthcare-related companies to increase users of our online marketplace, increase the number and variety of products that we offer and provide additional services and content to our users. We may not achieve our objectives through these alliances. These agreements do not, and future relationships may not, afford us any exclusive marketing or distribution rights. Many of these companies have multiple relationships and they may not regard us as significant for their business. These companies may pursue relationships with our competitors or develop or acquire services that compete with our services. In addition, in many cases these companies may terminate these relationships with little or no notice. If any existing alliance is terminated or we are unable to enter into alliances with leading technology and healthcare-related companies, we may be unable to increase the attractiveness of our online marketplace or provide satisfactory services to purchasers and suppliers of medical products. OUR RECENT GROWTH HAS PLACED A SIGNIFICANT STRAIN ON OUR MANAGEMENT SYSTEMS AND RESOURCES, AND IF WE FAIL TO SUCCESSFULLY MANAGE FUTURE GROWTH, WE MAY NOT BE ABLE TO MANAGE OUR BUSINESS EFFICIENTLY AND MAY BE UNABLE TO EXECUTE OUR BUSINESS PLAN We have grown rapidly and will need to continue to grow to execute our business strategy. Our total number of employees grew from six as of December 31, 1997, to 59 as of December 31, 1998 and 269 as of December 31, 1999, and we anticipate further significant increases in the number of our employees. Our growth has placed significant demands on management as well as on our administrative, operational and financial resources and controls. We expect our future growth to cause similar, and perhaps increased, strain on our systems and controls. For example, our rapid growth requires that we integrate and manage a large number of new employees. In addition, we are in the process of substantially upgrading our information systems including our accounting system. We also need to institute new systems such as an auction inventory tracking system. Any failure to successfully upgrade our systems and controls could result in inefficiencies in our business and could cause us to be unable to implement our business plan. IF OUR SYSTEMS ARE UNABLE TO PROVIDE ACCEPTABLE PERFORMANCE AS THE USE OF OUR SERVICES INCREASES, WE COULD LOSE USERS OF OUR SERVICES AND WE WOULD HAVE TO SPEND CAPITAL TO EXPAND AND ADAPT OUR NETWORK INFRASTRUCTURE, EITHER OF WHICH COULD HARM OUR BUSINESS AND RESULTS OF OPERATIONS We introduced our Shop service in August 1999, the AdsOnline component of our Auction service in August 1999 and the AuctionOnline component of our Auction service in November 1999. Accordingly, we have processed a limited number and variety of transactions on our website. To date, these transactions have consisted of sales of new medical products through Shop and sales of used and refurbished medical products on AdsOnline. Our systems may not accommodate increased use while providing acceptable overall performance. We must continue to expand and adapt our network infrastructure to accommodate additional users and increased transaction volumes. This expansion and adaptation will be expensive and will divert our attention from other activities. If our systems do not continue to provide acceptable performance as use of our services increases, our reputation may be damaged and we may lose users of our services. OUR INFRASTRUCTURE AND SYSTEMS ARE VULNERABLE TO NATURAL DISASTERS AND OTHER UNEXPECTED EVENTS, AND IF ANY OF THESE EVENTS OF A SIGNIFICANT MAGNITUDE WERE TO OCCUR, THE EXTENT OF OUR LOSSES COULD EXCEED THE AMOUNT OF INSURANCE WE CARRY TO COMPENSATE US FOR ANY LOSSES The performance of our server and networking hardware and software infrastructure is critical to our business and reputation and our ability to process transactions, provide high quality customer service and attract and retain users of our services. Currently, our infrastructure and systems are located at one site at Exodus Communications in Sunnyvale, California, which is an area susceptible to earthquakes. We depend on our single-site infrastructure and any disruption to this infrastructure resulting from a natural disaster or other event could result in an interruption in our service, reduce the number of transactions we are able to process and, if sustained or repeated, could impair our reputation and the attractiveness of our services or prevent us from providing our services entirely. Our systems and operations are vulnerable to damage or interruption from human error, natural disasters, power loss, telecommunications failures, break-ins, sabotage, computer viruses, intentional acts of vandalism and similar events. We do not have a formal disaster recovery plan or alternative provider of hosting services. In addition, we may not carry sufficient business interruption insurance to compensate us for losses that could occur. Any failure on our part to expand our system or Internet infrastructure to keep up with the demands of our users, or any system failure that causes an interruption in service or a decrease in responsiveness of our online services or website, could result in fewer transactions and, if sustained or repeated, could impair our reputation and the attractiveness of our services or prevent us from providing our services entirely. IF WE ARE UNABLE TO SAFEGUARD THE SECURITY AND PRIVACY OF THE CONFIDENTIAL INFORMATION OF THE USERS OF OUR ONLINE MARKETPLACE, THESE USERS MAY DISCONTINUE USING OUR SERVICES A significant barrier to the widespread adoption of e-commerce is the secure transmission of personally identifiable information of Internet users as well as other confidential information over public networks. If any compromise or breach of security were to occur, it could harm our reputation and expose us to possible liability. We use SSL, or secure sockets layer, an Internet security technology, at appropriate points in the transaction flow and encrypt information on our servers to protect user information during transactions, and we employ a security consulting firm that periodically tests our security measures. Despite these efforts, a party may be able to circumvent our security measures and could misappropriate proprietary information or cause interruptions in our operations. We may be required to make significant expenditures to protect against security breaches or to alleviate problems caused by any breaches. IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR COMPETITORS MAY GAIN ACCESS TO OUR TECHNOLOGY, WHICH COULD HARM OUR BUSINESS We regard our intellectual property as critical to our success. If we are unable to protect our intellectual property rights, our business would be harmed. We rely on trademark, copyright and trade secret laws to protect our proprietary rights. We have applied for registration of several marks including the Neoforma.com logo. Our trademark registration applications may not be approved or granted, or, if granted, may be successfully challenged by others or invalidated through administrative process or litigation. WE HAVE RECEIVED NOTICE OF A TRADEMARK INFRINGEMENT CLAIM BROUGHT BY A THIRD PARTY AND WE MAY BE SUBJECT TO FURTHER INTELLECTUAL PROPERTY CLAIMS AND IF WE WERE TO SUBSEQUENTLY LOSE OUR INTELLECTUAL PROPERTY RIGHTS, WE COULD BE UNABLE TO OPERATE OUR CURRENT BUSINESS We may from time to time be subject to claims of infringement of other parties' proprietary rights or claims that our own trademarks, patents or other intellectual property rights are invalid. In a letter dated January 14, 2000, Forma Scientific, Inc. notified us that it believes our use of the "Neoforma" and "Neoforma.com" trademarks violates its trademark rights in "Forma" and "Forma Scientific", and asked us to discontinue use of our trademarks by January 28, 2000. Forma Scientific has filed a complaint in federal court, although we have not yet been served with this complaint. Based on our preliminary investigation, we believe that we have meritorious defenses to Forma Scientific's claims and intend to vigorously defend ourselves in any litigation that may arise from these claims. If any litigation were to be decided adversely to us, we could be enjoined from future use of the names Neoforma and Neoforma.com and we might be required to pay damages to Forma Scientific. See "Legal Proceedings." Any claims regarding our intellectual property, with or without merit, could be time consuming and costly to defend, divert management attention and resources or require us to enter into royalty or license agreements. License agreements may not be available on commercially reasonable terms, if at all. In addition, there has been a recent increase in the number of patent applications related to the use of the Internet to perform business processes. Enforcement of intellectual property rights in the Internet sector will become a greater source of risk as the number of business process patents increases. The loss of access to any key intellectual property right, including use of the Neoforma.com brand name, could result in our inability to operate our current business. See "-- If we are not able to increase recognition of, or lose the right to use, the Neoforma.com brand name, our ability to attract users to our online marketplace will be limited." IF WE LOSE ACCESS TO THIRD-PARTY SOFTWARE INCORPORATED IN OUR SERVICES, WE MAY NOT BE ABLE TO OPERATE OUR ONLINE MARKETPLACE We currently rely on software that we have licensed from a number of suppliers. For example, we use software that we license from NetDynamics, Inc., a subsidiary of Sun Microsystems, to provide part of our website infrastructure, we use information retrieval software that we license from SearchCafe Development Corporation to provide part of our search capabilities, we use software that we license from Moai, Inc. to provide a substantial part of the functionality of our AuctionOnline service, we use software that we license from SAP to further automate the order management and transaction routing process within our marketplace, we use software that we license from Ariba to further enable us to offer our purchasing customers a mechanism to automate and streamline the procurement process and we use software that we license from CrossWorlds, TIBCO and STC to integrate our marketplace applications and services with purchasers' and suppliers' systems. These licenses may not continue to be available to us on commercially reasonable terms, or at all. In addition, the licensors may not continue to support or enhance the licensed software. In the future, we expect to license other third party technologies to enhance our services, to meet evolving user needs or to adapt to changing technology standards. Failure to license, or the loss of any licenses of, necessary technologies could impair our ability to operate our online marketplace until equivalent software is identified, licensed and integrated or developed by us. In addition, we may fail to successfully integrate licensed technology into our services, which could similarly harm development and market acceptance of our services. THE SUCCESS OF OUR BUSINESS DEPENDS ON THE PARTICIPANTS IN THE MARKET FOR MEDICAL PRODUCTS, SUPPLIES AND EQUIPMENT ACCEPTING THE INTERNET FOR DISTRIBUTION AND PROCUREMENT Business-to-business e-commerce is currently not a significant sector of the market for medical products, supplies and equipment. The Internet may not be adopted by purchasers and suppliers in the medical products, supplies and equipment market for many reasons, including: - reluctance by the healthcare industry to adopt the technology necessary to engage in the online purchase and sale of medical products; - failure of the market to develop the necessary infrastructure for Internet-based communications, such as wide-spread Internet access, high-speed modems, high-speed communication lines and computer availability; - their comfort with existing purchasing habits, such as ordering through paper-based catalogs and representatives of medical manufacturers and distributors; - their concern with respect to security and confidentiality; and - their investment in existing purchasing and distribution methods and the costs required to switch methods. Should healthcare providers and suppliers of medical products choose not utilize or accept the Internet as a means of purchasing and selling medical products, our business model would not be viable. REGULATION OF THE INTERNET IS UNSETTLED, AND FUTURE REGULATIONS COULD INHIBIT THE GROWTH OF E-COMMERCE AND LIMIT THE MARKET FOR OUR SERVICES A number of legislative and regulatory proposals under consideration by federal, state, local and foreign governmental organizations may lead to laws or regulations concerning various aspects of the Internet, such as user privacy, taxation of goods and services provided over the Internet and the pricing, content and quality of services. Legislation could dampen the growth in Internet usage and decrease or limit its acceptance as a communications and commercial medium. If enacted, these laws and regulations could limit the market for our services. In addition, existing laws could be applied to the Internet, including consumer privacy laws. Legislation or application of existing laws could expose companies involved in e-commerce to increased liability, which could limit the growth of e-commerce. IF REGULATIONS WITH RESPECT TO HOW AUCTIONS MAY BE CONDUCTED ARE IMPOSED BY STATES, OUR BUSINESS COSTS MAY INCREASE, WHICH WOULD HARM OUR RESULTS OF OPERATIONS Numerous states, including the State of California, where our headquarters are located, have regulations regarding how auctions may be conducted and the liability of auctioneers in conducting these auctions. No legal determination has been made with respect to the applicability of these regulations to our online business to date and little precedent exists in this area. One or more states may attempt to impose these regulations upon us in the future, which could increase our cost of doing business. IF THERE ARE CHANGES IN THE POLITICAL, ECONOMIC OR REGULATORY HEALTHCARE ENVIRONMENT THAT AFFECT THE PURCHASING PRACTICE OR OPERATION OF HEALTHCARE ORGANIZATIONS, OR IF THERE IS CONSOLIDATION IN THE HEALTHCARE INDUSTRY, WE COULD BE REQUIRED TO MODIFY OUR SERVICES OR TO INTERRUPT DELIVERY OF OUR SERVICES The healthcare industry is highly regulated and is subject to changing political, economic and regulatory influences. Regulation of the healthcare organizations with which we do business could impact the way in which we are able to do business with these organizations. In addition, factors such as changes in reimbursement policies for healthcare expenses, consolidation in the healthcare industry and general economic conditions affect the purchasing practices and operation of healthcare organizations. Changes in regulations affecting the healthcare industry, such as any increased regulation by the Food and Drug Administration of the purchase and sale of medical products, could require us to make unplanned enhancements of our services, or result in delays or cancellations of orders or reduce demand for our services. Federal and state legislatures have periodically considered programs to reform or amend the U.S. healthcare system at both the federal and state level. These programs may contain proposals to increase governmental involvement in healthcare, lower reimbursement rates or otherwise change the environment in which healthcare industry providers operate. We do not know what effect any proposals would have on our business. Many healthcare industry participants are consolidating to create integrated healthcare delivery systems with greater market power. As the healthcare industry consolidates, competition to provide services to industry participants will become more intense and the importance of establishing a relationship with each industry participant will become greater. These industry participants may try to use their market power to negotiate fee reductions of our services. If we were forced to reduce our fees, our operating results could suffer if we cannot achieve corresponding reductions in our expenses. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk: Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We invest in high-credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer. As stated in our policy, we ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in safe and high-credit quality securities and by constantly positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer, guarantor or depository. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. The table below presents principal amounts and related weighted average interest rates by date of maturity for our investment portfolio (in thousands): ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements required pursuant to this item are included in Item 14 of this Annual Report on Form 10-K and are presented beginning on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III With the exception of the information specifically stated as being incorporated by reference from our proxy statement in Part III of this Annual Report on Form 10-K, our proxy statement is not to be deemed as filed as part of this report. The proxy statement will be filed with the Securities and Exchange Commission by April 29, 2000. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information concerning our directors required by Item 10 is incorporated by reference herein to section entitled "Proposal No. 1 -- Election of Directors" of the proxy statement for our 2000 Annual Meeting of Stockholders that we will file by April 29, 2000. The information concerning our executive officers required by Item 10 is incorporated by reference to the section of our proxy statement entitled "Executive Officers." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the sections entitled "Executive Compensation" and "Proposal No. 1 -- Election of Directors" of our proxy statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to the section entitled "Security Ownership of Certain Beneficial Owners and Management" of our proxy statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated herein by reference to the section entitled "Certain Transactions" of our proxy statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Index To Consolidated Financial Statements The following Consolidated Financial Statements of the Registrant are filed as part of this report: Independent Auditors' Report. Consolidated Balance Sheets as of December 31, 1999 and 1998. Consolidated Statements of Operations for the Years ended December 31, 1999, 1998 and 1997 and the period from inception through December 31, 1999. Consolidated Statements of Changes in Stockholders' Equity from Inception to December 31, 1999. Consolidated Statements of Cash Flows for the Years ended December 31, 1999, 1998 and 1997 and the period from inception through December 31, 1999. Notes to Consolidated Financial Statements. (a)(2) Index to Consolidated Financial Statement Schedules The following Consolidated Financial Statement Schedule of the Registrant is filed as part of this report: Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the accompanying consolidated financial statements or Notes thereto. (a)(3) Index to Exhibits - --------------- ** Incorporated by reference to the Company's Registration Statement on Form S-1 File No. 333-89077. + Confidential treatment has been granted with respect to portions of this exhibit. Other financial statement schedules are omitted because the information called for is not required or is shown either in the financial statements or the notes thereto. (b) Reports on Form 8-K None. (c) Exhibits The Company hereby files as part of this Annual Report on Form 10-K the exhibits listed in Item 14(a)(3) above. Exhibits which are incorporated herein by reference can be inspected and copied at the public reference facilities maintained by the Commission, 450 Fifth Street, NW, Room 1024, Washington, D.C. and at the Commission's regional offices at 219 South Dearborn Street, Room 1204, Chicago, Illinois; 26 Federal Plaza, Room 1102, New York, New York and 5757 Wilshire Boulevard, Suite 1710, Los Angeles, California. Copies of such material can also be obtained from the Public Reference Section of the Commission, 450 Fifth Street, NW, Washington, D.C. 20549, at prescribed rates. (d) Financial Statement Schedules The Company hereby files as part of this Annual Report on Form 10-K the consolidated financial statement schedules listed in Item 14(a)(2) above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DATE: March 30, 2000 NEOFORMA.COM, INC By: /s/ FREDERICK J. RUEGSEGGER ------------------------------------ Frederick J. Ruegsegger Chief Financial Officer and Secretary POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Frederick J. Ruegsegger his attorney-in-fact, with full power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. NEOFORMA.COM, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Neoforma.com, Inc.: We have audited the accompanying consolidated balance sheets of Neoforma.com, Inc. (a Delaware corporation in the development stage) as of December 31, 1999 and 1998, and the related statements of operations, changes in stockholders' deficit and cash flows for the three years in the period ended December 31, 1999 and for the period from inception (March 6, 1996) to December 31, 1999. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Neoforma.com, Inc. as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the three years in the period ended December 31, 1999 and for the period from inception (March 6, 1996) to December 31, 1999 in conformity with accounting principles generally accepted in the United States. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed under Item 14(a)(2) is presented for purposes of complying with the Securities and Exchange Commission rules and is not part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN LLP San Jose, California February 16, 2000 NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ASSETS The accompanying notes are an integral part of these consolidated balance sheets NEOFORMA.COM, INC (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------- (1) Excludes amortization of stock-based compensation of none and $935 for the years ended December 31, 1998 and 1999, respectively. (2) Excludes amortization of stock-based compensation of $3 and $1,348 for the years ended December 31, 1998 and 1999, respectively. (3) Excludes amortization of stock-based compensation of $2 and $2,557 for the years ended December 31, 1998 and 1999, respectively. (4) Excludes amortization of stock-based compensation of none and $8,371 for the years ended December 31, 1998 and 1999, respectively. The accompanying notes are an integral part of these consolidated financial statements. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) FOR THE PERIOD FROM INCEPTION (MARCH 6, 1996) THROUGH DECEMBER 31, 1999 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The accompanying notes are an integral part of these consolidated financial statements. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED) FOR THE PERIOD FROM INCEPTION (MARCH 6, 1996) THROUGH DECEMBER 31, 1999 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The accompanying notes are an integral part of these consolidated financial statements. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying notes are an integral part of these consolidated financial statements. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND DEVELOPMENT STAGE RISKS: Neoforma, Inc. (the "Company"), was incorporated on March 4, 1996 in the state of California for the purpose of providing business-to-business e-commerce services for the medical products, supplies and equipment marketplace. On November 4, 1998, the Company re-incorporated in the state of Delaware. On September 14, 1999, the Company changed its name to Neoforma.com, Inc. All information for the year ended December 31, 1996 represents the period from inception (March 6, 1996) to December 31, 1996. From inception, the Company has been primarily engaged in organizational activities, including designing and developing its website, recruiting personnel, establishing office facilities, raising capital and developing a marketing plan. The Company began revenue generation activities in 1999 but no significant revenue had been generated as of December 31, 1999. Accordingly, the Company is classified as a development stage company. Successful completion of the Company's development program and, ultimately, the attainment of profitable operations is dependent upon future events, including obtaining adequate financing to fulfill its development activities, increasing its customer base, implementing and successfully executing its business and marketing strategy and hiring and retaining quality personnel. Negative developments in any of these conditions could have a material adverse effect on the Company's business, financial condition and results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries General Asset Recovery, LLC and FDI Information Resources, LLC. All significant intercompany accounts and transactions have been eliminated in consolidation. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECLASSIFICATIONS Certain reclassifications have been made to the 1998 consolidated financial statements to conform to the 1999 presentation. REVENUE RECOGNITION The Company categorizes their services into three primary service lines. These service lines are Shop, Auction, and Plan. Shop revenue is derived from transaction fees paid or payable by suppliers of medical products on the Company's website and development fees from participating suppliers to digitize the supplier product information for display on the Company's website. Auction revenue is derived from transaction fees paid or payable by suppliers of medical products on the Company's website and from consigned inventory sold at live auctions and on-line auctions. In addition, Auction revenue includes transaction fees associated with the gross sales of purchased inventory less the direct costs of purchased inventory. Plan revenue is derived from licensing software and its related maintenance, website sponsorship fees and subscription fees for asset management and facilities planning services. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) In general, the Company recognizes revenues when there is persuasive evidence of an arrangement, the fee is fixed and determinable, the product has been delivered to the customer or the service has been rendered and collection is probable. If an acceptance period is required, revenues are recognized upon the earlier of customer acceptance or the expiration of the acceptance period. Deferred revenue primarily consists of revenue deferred under annual maintenance contracts on which amounts have been received from customers and for which the earnings process has not been completed. Transaction fee revenue, except in the case where the Company purchases inventory for sale in auctions, represents the Company's negotiated percentage of the purchase price or gross transaction fee at the time an order which was originated by a purchaser of medical equipment or supplies ("purchaser") is confirmed or accepted by the supplier. Thus, the Company reports transaction fee revenue net of amounts retained by the supplier. The gross transaction fee on a transaction is the price of a product listed on the website. The Company reports transaction fees on the net-basis as the Company does not believe that it acts as a principal in connection with orders to be shipped or delivered by a supplier to a purchaser because, among other things, the Company does not establish the prices of products listed on the website; the Company does not take title to products to be shipped from the supplier to the purchaser, nor does it take title to or assume the risk of loss of products prior to or during shipment; the Company does not bear the credit and collections risk of the purchaser to the supplier; and the Company does not bear the risk that the product will be returned. In the case of sales associated with purchased inventory, the transaction fee revenue represents the fee from the purchaser less the direct costs of purchased inventory. Transaction fees associated with purchased inventory are recognized at the time of shipment or delivery, depending on the shipping terms associated with each transaction. The Company defers a portion of the transaction fee at the time of acceptance for potential transaction fee returns, which are related primarily to orders placed by non-bona fide purchasers or orders for which a supplier's content on the website is not posted according to the specifications of the supplier. Website sponsorship fees and other revenue includes sponsorship fees, development fees, asset management consulting fees, license fees, maintenance fees, and subscription fees. Sponsorship, development, and asset management consulting fee revenue is recognized as services are performed and billable according to the terms of the service arrangement. License fees are recognized when the software has been delivered and there are no other contingencies related to the Company's performance. If license fees are contingent upon the Company's performance subsequent to delivery, the Company defers recognition of such fees or the fair market value of the undelivered element requiring performance until performance is complete. Subscription and maintenance fee revenue is recognized ratably over the period of the service agreement. CONCENTRATION OF CREDIT RISK Financial instruments that may subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Cash is on deposit with one financial institution. Cash investments include high quality short-term money market instruments through a high credit quality financial institution. The Company does not require collateral on trade accounts receivable as the Company's customer base primarily consists of healthcare providers, and suppliers of medical product, equipment and supplies. The Company provides reserves for credit losses. MAJOR CUSTOMERS No customers made up more than 10% of total revenues for any of the periods presented. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The following customers accounted for 10% or more of total outstanding receivables. CASH AND CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash and cash equivalents consist of cash in banks, investments in money market accounts, treasury bills and marketable securities and are stated at cost which approximates fair market value. INVESTMENTS The Company accounts for short-term and long-term investments in accordance with Statement of Financial Accounting Standards No. 115 ("SFAS 115"), "Accounting for Certain Investments in Debt and Equity Instruments." Accordingly, all of the Company's short-term and long-term investments are classified as "available-for-sale" and stated at fair value. Investments with original maturities greater than ninety days and less than one year are classified as short-term investments. Investments with original maturities greater than one year are classified as long-term investments. Investments classified as cash equivalents amounted to approximately $22,476,000 at December 31, 1999. There were no investments classified as cash equivalents at December 31, 1998. Investments classified as cash equivalents are recorded at cost and included in cash and cash equivalents at December 31, 1999. The difference between amortized cost (cost adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income) and fair value, representing unrealized holding gains and losses on short-term and long-term investments are recorded as a separate component of stockholders' equity until realized. The Company's policy is to record debt securities as available-for-sale because the sale of such securities may be required before maturity. Any gains or losses on the sale of debt securities are determined on a specific identification basis. Realized gains and losses are netted and included in interest income in the accompanying statements of operations. There were no investments during the years ended December 31, 1997 and 1998. At December 31, 1999, the Company's available-for-sale securities mature on various dates through May 2001. The amortized cost, aggregate fair value, and gross unrealized holding gains and losses by major security type were as follows: NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) ACCOUNTS RECEIVABLE Accounts receivable consists primarily of net amounts to be collected from suppliers or purchasers of services rendered, in the case of our live auction services, purchasers for services rendered. Accounts receivable is recorded net of allowance for doubtful accounts. PREPAID CONSULTING FEES In October 1999, the Company issued 275,000 shares of its Series E-1 preferred stock, valued at $1.6 million, in exchange for marketing consulting services to be rendered by General Electric Medical Systems ("GEMS") through December 31, 2000. As a result, the Company recorded prepaid consulting fees which are amortized into sales and marketing expenses on a straight-line basis through December 31, 2000. The net unamortized portion of the prepaid consulting fees are included in prepaids and other current assets in the accompanying financial statements. In addition to the agreement to provide consulting services, GEMS has agreed to list products on Shop, has the option to sponsor rooms on Plan, and has agreed to sell a specified number of items of equipment on Auction. PROPERTY AND EQUIPMENT Property and equipment are stated at cost, and are depreciated on a straight-line basis over two to four years. Leasehold improvements are amortized, using the straight-line method, over the shorter of the lease term or the useful lives of the improvements. Repairs and maintenance costs are expensed as incurred. INTANGIBLES Intangibles consists of goodwill, which represents the amount of purchase price in excess of the fair value of the tangible net assets, acquired software, and acquired assembled work force and customer lists in the acquisitions of General Asset Recovery LLC and FDI Information Resources LLC (see note 3). Intangibles are amortized on a straight-line basis over a period of 3 to 7 years. Intangibles are evaluated quarterly for impairment and written down to net-realizable value, if necessary. No impairment has been recorded to date. Intangible assets include the following: NON-MARKETABLE INVESTMENT In December 1999, the Company purchased 526,250 shares of IntraMedix LLC ("IntraMedix"), a privately held corporation in exchange for $2,500,000. IntraMedix is a company that provides procurement services related to the distribution of geriatric care products to the nursing home community. At December 31, 1999, the Company's ownership represented approximately 5% of the IntraMedix, Inc. common shares outstanding. The Company accounts for this investment using the cost method. IntraMedix is a related party to GeriMedix, a supplier with which the Company has an agreement to perform Shop services. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) IMPAIRMENT OF LONG-LIVED ASSETS The Company evaluates the recoverability of long-lived assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." SFAS No. 121 requires recognition of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. PRODUCT DEVELOPMENT COSTS Product development costs include expenses incurred by the Company to develop and enhance the Company's website and related website services. Product development costs are expensed as incurred. COST OF WARRANT ISSUED TO RECRUITER For the year ended December 31, 1999, the Company expensed $2.4 million related to the valuation of a warrant issued to an executive search firm in connection with services rendered in the search for the Company's Chief Executive Officer (see note 10). STOCK BASED COMPENSATION PLAN The Company has elected to account for stock-based compensation expense under APB No. 25 and make the required pro forma disclosures for compensation expense as required by SFAS No. 123 (see Note 11). COMPREHENSIVE INCOME Effective January 1, 1998, the Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting comprehensive income and its components in financial statements. Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. For the year ended December 31, 1999, the Company recorded approximately $40,000 of unrealized holding losses. The Company had no components of comprehensive income for the years ended December 31, 1997 and 1998. The Company has integrated the presentation of comprehensive income (loss) with the Consolidated Financial Statements of Changes in Stockholders' Equity (Deficit). SEGMENT INFORMATION Effective January 1, 1998, the Company adopted the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The Company identifies its operating segments based on business activities, management responsibility and geographical location. During the years ended December 31, 1996, 1997, 1998 the Company operated in a single business segment providing e-commerce content to healthcare professionals in the medical product, supplies, and equipment industry. For the year ended December 31, 1999, the Company generated 84% and 7% of its revenues from transaction fees associated with live Auction sales and on-line Shop services, respectively. Through December 31, 1999, foreign operations have not been significant in either revenue or investment in long-lived assets. BASIC AND DILUTED NET LOSS PER SHARE AND PRO FORMA BASIC AND DILUTED NET LOSS PER SHARE Basic net loss per share on a historical basis is computed using the weighted-average number of shares of common stock outstanding. Diluted net loss per common share was the same as basic net loss per share for all periods presented since the effect of any potentially dilutive security is excluded, as they are anti-dilutive as a NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) result of the Company's net losses. The total number of shares excluded from the diluted loss per share calculation relating to these securities was approximately 300,000, 18 million, and 44 million shares for the years ended December 31, 1997, 1998 and 1999, respectively. Pro forma basic and diluted net loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding for the period (excluding shares subject to repurchase) plus the weighted average number of common shares resulting from the automatic conversion of outstanding shares of convertible preferred stock, which occurred upon the closing of the planned initial public offering. The following table presents the calculation of basic and diluted and pro forma basic and diluted net loss per share (in thousands, except per share amounts): RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" SFAS No. 133 will be effective for the Company on January 1, 2001. SFAS No. 133 requires certain accounting and reporting standards for derivative financial instruments and hedging activities. Because the Company does not currently hold any derivative instruments and does not engage in hedging activities, management does not believe that the adoption of SFAS No. 133 will have a material impact on the Company's financial position or results of operations. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements." SAB 101 provides guidance on applying generally accepted accounting principle to revenue recognition issues in financial statements. The Company will adopt SAB 101 as required in the second quarter of 2000. Management does not expect the adoption of SAB 101 to have a material impact on its consolidated results of operations and financial position. 3. ACQUISITIONS: In August 1999, the Company acquired substantially all of the assets of General Asset Recovery LLC ("GAR"), a live auction house and asset management company focused on medical products. The acquisition NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed on the basis of their respective fair values on the acquisition date. According to the terms of the agreement, a segment of GAR's operations related to the auction of non-medical industrial products ("Industrial") was sold back to one of the original owners of GAR for nominal consideration. Accordingly, the revenue and direct costs associated with the Industrial operations have been eliminated in the pro forma tables presented below. The total purchase price of approximately $9.7 million consisted of $1.7 million in cash, a note payable of $7.8 million, the assumption of $100,000 of liabilities and acquisition-related expenses of $100,000. In the initial allocation of the purchase price, $25,000 was allocated to tangible assets and $9,675,000 was allocated to intangible assets. The intangible assets will be amortized over an estimated life of seven years. The note payable is due over a five-year period and bears interest at 7% per annum. The unaudited pro forma results of operations of the Company and General Asset Recovery LLC for the years ended December 31, 1998 and 1999, assuming the acquisition took place at the beginning of each year, are as follows (in thousands, except per share amounts): In November 1999, the Company acquired certain assets of FDI Information Resources, LLC ("FDI"), a company in the business of developing and licensing equipment planning software. Under the terms of the agreement, the Company acquired the rights to software and certain customer contracts. The acquisition was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the intangible assets acquired and liabilities assumed on the basis of their respective fair values on the acquisition date. The total purchase price of approximately $3.4 million, consisted of 350,000 shares of common stock valued at $3,150,000, estimated assumed liabilities of approximately $97,000, and estimated acquisition-related expenses of approximately $112,000. In the initial allocation of the purchase price, $600,000, $240,000, and $2,519,000 were allocated to acquired software, assembled workforce and trade names, and goodwill, respectively. (see note 2.) The acquired software, assembled workforce and trade names and goodwill will be amortized over an estimate useful life of three years. The unaudited pro forma results of operations of the Company, GAR and FDI for the years ended December 31, 1998 and 1999, assuming the acquisitions took place at the beginning of each period, are as follows (in thousands, except per share amounts): In November 1999, the Company issued a note receivable to Pharos Technologies, Inc. ("Pharos") in the amount of $500,000. Subsequent to December 31, 1999, the Company acquired Pharos (see Note 14.) As NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) part of its consideration for the acquisition, in accordance with the terms of the note, the Company forgave the entire principal amount together with any accrued interest. Notes receivable are included in other assets in the accompanying financial statements. In January 2000, the Company acquired Pharos Technologies, Inc., ("Pharos") a developer of content management software that facilitates the locating, organizing and updating of product information in an online marketplace. The acquisition was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the intangible assets acquired and liabilities assumed on the basis of their respective fair values on the acquisition date. The total purchase price of approximately $22.8 million, consisted of approximately 2.0 million shares of common stock valued at $22 million, forgiveness of loan outstanding to Pharos of $500,000, estimated assumed liabilities of approximately $94,000, and estimated acquisition-related expenses of approximately $230,000. Of the shares issued to the previous owners of Pharos, approximately 700,000 shares were subject to repurchase rights which lapse over a period of the original terms, which specify a vesting period of 4 years. In the initial allocation of the purchase price, $367,000, $3,000,000, $3,000,000, and $16,457,000 was allocated to tangible assets, acquired in-process research and development, developed technology, and goodwill, respectively. The acquired in-process research and development will be expensed upon consummation of the acquisition. The developed technology will be amortized when such technology has been put into productive use over an estimated useful life of 3 years. The goodwill will be amortized over an estimated useful life of 5 years. 4. PROPERTY AND EQUIPMENT: As of December 31, 1998 and 1999, property and equipment consisted of the following (in thousands): 5. LOANS AND NOTES PAYABLE: In 1996 and 1997, certain stockholders exchanged cash for notes payable. The interest rate for the notes was 5.6%. These notes were convertible into Series B preferred stock. As of December 31, 1998, $170,000 of the $385,000 notes payable were converted and the remainder was paid in full. In June 1998, the Company entered into a $750,000 secured credit facility with a bank. This facility included a $225,000 term loan due December 1999 and an equipment loan facility providing for up to $525,000 of equipment loans. In July 1999, the Company converted $433,000 of outstanding equipment loans into a term loan due June 2000, which bears interest at the lender's prime rate (8.25% as of December 31, 1999). In December 1999, the Company repaid the term loan, in-full. At December 31, 1999, there were borrowings of approximately $404,000 under the equipment loan. This facility is secured by substantially all of the Company's assets other than equipment. In consideration for this credit facility, the Company granted the bank a warrant to purchase 45,000 shares of Series C preferred stock at an exercise price of $0.77 per share. In July 1999, in consideration for the conversion of the equipment loan to a term loan and the release of the NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) security interest in equipment, the Company granted the bank a warrant to purchase 10,000 shares of Series D preferred stock at an exercise price of $1.18 per share (see note 10). In May 1999, the Company entered into a subordinated loan agreement (the "loan agreement") with a lender under which it can borrow up to $2.0 million. The loan agreement bears interest at 12.5% and expires in July 2002. At December 31, 1999 there were borrowings of approximately $1.7 million outstanding under the loan agreement. The loan agreement is collateralized by all of the assets of the Company. In addition, a warrant to purchase 228,813 shares of preferred Series D stock at an exercise price of $1.18 per share was issued in conjunction with the loan agreement (see note 10). In July 1999, the Company entered into a $2.5 million loan/lease facility with a lender to finance computer hardware and software equipment. Hardware amounts bear interest at 9% per annum and are payable in 48 monthly installments consisting of interest-only payments for the first nine months and principal and interest payments for the remaining 39 months, with a balloon payment of the remaining principal payable at maturity. Software amounts bear interest at 8% per annum and are payable in 30 monthly installments consisting of interest-only for the first four months and principal and interest for the remaining 26 months, with a balloon payment of the remaining principal payable at maturity. The computer equipment purchased secures this facility. In connection with this facility, the Company issued the lender a warrant to purchase 137,711 shares of our Series D preferred stock at $1.18 per share (see note 10). At December 31, 1999, the principal balance was $2.1 million. As part of the purchase price of GAR (see note 3), the Company issued in August 1999 a promissory note payable to an owner of GAR in the amount of $7.8 million. The note bears interest at 7% per annum and is payable in 60 monthly installments of scheduled principal amounts plus interest. At December 31, 1999 the remaining principal balance was approximately $6.9 million. Future maturities of principal on the loans and notes payable as of December 31, 1999 are as follows (in thousands): 6. COMMITMENTS: The Company leases its office facilities under an operating lease. Rent expense for the years ended December 31, 1996, 1997, 1998 and 1999 was approximately $22,000, $40,000, $304,000, and, $793,000, respectively. In January 2000, the Company entered into an agreement to lease a new building. The lease payments are included in the table below. Future minimum obligations under non-cancelable operating leases are as follows (in thousands): NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) In May 1999, the Company entered into an agreement with a non-profit health services research organization (the "organization"), which allows the Company to use content from the organization's database of information about medical products and manufacturers and obtain a license to use elements of its classification system. Additionally, the agreement provides for joint marketing activities and collaboration in the creation of a database of product and vendor information. This agreement requires the Company to make revenue sharing payments to the organization during the three-year term of the agreement and for two years following expiration or termination of the agreement with respect to revenue derived from the Company's Plan service. During the second and third years, the Company is required to pay a nonrefundable fee of $600,000 per year, in equal monthly installments, which shall be credited against any revenue sharing profits payable. In October 1999, the Company entered into a three-year agreement with a consulting firm (the "Consultant"), which is a stockholder as a result of the Series E financing, in which the Consultant agreed to introduce the Company's services to appropriate clients, based on their interests, and to incorporate the Company's services into certain of its service offerings. The agreement also provides for joint marketing activities. In consideration, the Company has agreed to make payments to the Consultant in an aggregate amount of up to approximately $2.0 million, as well as a percentage of specified Neoforma.com e-commerce transaction revenue and other payments. The Company has also agreed to utilize the Consultant's services on a preferred basis for systems integration, development, infrastructure, process improvement and consulting assistance, totaling at least $1.5 million of services from the Consultant, at a discount from the Consultant's standard fees. For the year ended December 31, 1999, the Company recorded expenses amounting to $1.5 million related to this agreement and are included in sales and marketing expenses in the accompanying financial statements. In October 1999, the Company entered into an agreement with a hardware vendor, which is a stockholder as a result of the Series E financing, pursuant to which the Company agreed to develop complementary marketing programs with the vendor and establish hyperlinks between their respective internet websites. The Company agreed to use the vendor as its exclusive supplier of certain hardware products and agreed to purchase at least $5,000,000 of the vendor's products and $100,000 of consulting services on a mutually agreed upon schedule. For the year ended December 31, 1999, the Company recorded expenditures amounting to $1.5 million related to this agreement and are included primarily in property and equipment in the accompanying financial statements. In November 1999, we entered into a co-branding agreement with a consultant. Under the agreement, the consultant will transfer to our website all listings of new and used medical products offered for sale through its website (on an exclusive basis to the extent it has the right to do so), and we will transfer to the consultant all listings of used and excess laboratory products offered for sale on our website (on an exclusive basis to the extent we have the right to do so). We have also agreed to establish links between our respective websites. In addition, the consultant will develop and maintain a co-branded career center and a co-branded training and education center, and will provide us with specified content created for its medical online communities. This consultant also has the non-exclusive right to sell sponsorships on our Plan service and the exclusive right to sell advertising on the co-branded sites. We have agreed to pay this consultant $2,000,000 of development and promotional fees over the next two years under this agreement, of which we paid $687,000 in the fourth quarter of 1999. We and this consultant have agreed to each pay the other commissions equal to a percentage of net revenues earned through product listings transferred to its website by the other, and to share specified sponsorship and advertising revenue. 7. LITIGATION: On August 6, 1999, Fisher Scientific International, Inc. ("Fisher") filed a petition in the District Court of Montgomery County, Texas, against the Company and an individual that the Company had hired to serve as NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Executive Vice President of Sales. Fisher previously employed this individual and Fisher alleged, among other things, unfair competition. On November 11, 1999 the case was settled out of court. The terms of the settlement are such that the Company agreed to issue 176,057 shares of the Company Series E Preferred Stock at $5.68 per share to Fisher in exchange for cash and reimbursement of Fisher's legal fees. For the year ended December 31, 1999 the Company paid approximately $600,000 in reimbursement of Fisher's legal fees. These litigation expenses are included in general and administrative expenses for the year ended December 31, 1999. In January 2000, Forma Scientific, Inc. an affiliate of Thermo Electron Company, notified the Company that it believes that the Company is violating its trademark rights to its name. The Company believes that it has meritorious defenses to the asserted claims and intends to defend the litigation vigorously. 8. STOCKHOLDERS' EQUITY: On October 12, 1999, the Company amended and restated its certificate of incorporation. The number of authorized shares was increased to 200,000,000 and 40,747,048 shares of common stock and preferred stock, respectively. The preferred stock authorized is designated as 9,000,000, 2,860,000, 5,109,937, 10,572,886, 11,168,662, and 2,035,563 shares of Series A, B, C, D, E, and E-1 preferred stock, respectively (see note 9). COMMON STOCK As of December 31, 1999, the Company has reserved the following shares of common stock for future issuance as follows (in thousands): During the year ended December 31, 1998, the Company amended an agreement to issue approximately 26,000 shares of common stock in exchange for services rendered. As of December 31, 1998, approximately 17,000 of the shares were due but had not been issued. In February 1999, approximately 13,000 of the shares were issued. Approximately 9,000 additional shares of common stock were due under the terms of the same agreement for the year ended December 31, 1999. As of December 31, 1999, such shares had not been issued; however, the related expense associated with the issued shares is included in the accompanying consolidated statements of operations. During the year ended December 31, 1999, the Company entered into an investment advisory agreement with consultant to issue options to purchase common shares in exchange for services. In accordance with the service agreement, the Company is required to grant the options to purchase common shares equal to $15,000 divided by the exercise price. The exercise price of the stock options shall be equal to the fair market value of the Company's common stock at the time of the option grant. The options will be granted every six months of the agreement, provided services are rendered. The service provider agreed to exercise the options at the time that they vest. At December 31, 1999 no options had been issued under the terms of this arrangement. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) In January 2000, the Company completed its initial public offering of 8,050,000 shares of its common stock, which raised $104.7 million. Proceeds, net of underwriters discount of $7.3 million and offering costs of $2.0 million, amounted to $95.4 million. PREFERRED STOCK Preferred stock consists of 9,000,000 shares designated as Series A preferred stock ("Series A") and 2,860,000 shares designated as Series B preferred stock ("Series B"). The Series A preferred stock was issued in exchange for 9,000,000 shares of previously issued common stock. The Series B preferred stock was issued for cash at $0.50 per share. Upon the Company's initial public offering in January 2000, all outstanding shares of convertible preferred stock were converted into common stock. The rights and preferences of the outstanding Series A and B preferred stock are as follows: DIVIDENDS The holders of Series A and B preferred stock are entitled to receive non-cumulative dividends at $.02 and $.04 per share, respectively, or, if greater, an amount equal to that paid on any other outstanding shares of the Company, except that the shares of a given series of preferred stock shall not receive any greater dividend as a result of the Company's payment of a dividend on any such series of preferred stock. Such dividends shall be payable only when, as, and if declared by the Board of Directors. No dividends shall be payable on any common stock until dividends to Series A and Series B preferred stock have been paid or declared by the Board of Directors. As of December 31, 1999, no dividends had been declared. LIQUIDATION PREFERENCE In the event of any liquidation, dissolution or winding up of the Company, holders of Series A and B are entitled to receive (along with the liquidation preference available to Series C and Series D stockholders -- see Note 9), in preference to holders of common stock, the amount of $0.25 and $0.50 per share, respectively, plus all declared but unpaid dividends. Such amounts will be adjusted for any stock split, stock dividends and recapitalizations. If such assets of the Company are not available to sufficiently satisfy the full preferential amount of all series of preferred stock then the entire assets and funds of the Company shall be distributed among the holders of all series of the preferred stock in accordance with the aggregate preference payment to which they are entitled. After the payment or the setting aside of the payment set forth above, the remaining assets of the corporation shall be distributed on a pro-rata basis to the holders of the preferred stock, on an as-converted basis, and the holders of common stock until the holders of the Series A, B, C and D have received an additional $0.25, $0.50, $0.77 and $1.18 per share, respectively. After the distributions to the holders of preferred stock and redeemable preferred stock have been made the remaining assets of the corporation available for distribution to shareholders shall be distributed pro-rata among the holders of common stock. VOTING RIGHTS The holders of the Series A and Series B are entitled to a number of votes equal to a number of shares of common stock into which such preferred stock is convertible. CONVERSION Each share of Series A and Series B is convertible into one share of common stock at the option of the holder at any time after the date of issuance of such shares, and automatically converts at the consummation of the Company's sale of common stock in an underwritten public offering which results in net cash proceeds NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) to the Company of at least $60,000,000 and an offering price to the public of a least $7.00 per share. The conversion rate is subject to adjustment for dilution, including but not limited to, stock splits, stocks dividends and stock combinations. 9. MANDATORILY REDEEMABLE PREFERRED STOCK: In August 1998, the Company completed an offering of 5,064,937 shares of Series C mandatorily redeemable preferred stock ("Series C") at $0.77 per share. Total proceeds of the offering amounted to approximately $3.9 million. On February 19, 1999, the Company completed an offering of 10,196,361 shares of Series D mandatorily redeemable preferred stock ("Series D") at $1.18 per share. Total proceeds of the offering amounted to approximately $12.0 million. On October 12, 1999, the Company completed an offering of 10,658,070 shares of Series E mandatorily redeemable preferred stock ("Series E") and 2,035,563 shares of Series E-1 mandatorily redeemable preferred stock ("Series E-1") at $5.68 per share. Included in the issuance of the Series E-1 is 275,000 shares issued in connection with a strategic alliance the Company entered into in October 1999. Thus, the net cash proceeds amounted to approximately $70.5 million. In addition, the Company agreed to issue 176,057 shares of the Company's Series E at 5.68 per share in settlement of a lawsuit in exchange for cash and reimbursement of legal fees (see Note 7). Upon the Company's initial public offering in January 2000, all outstanding shares of mandatorily redeemable preferred stock were converted into common stock. The rights and preferences of the outstanding Series C, D, E and E-1 redeemable preferred stock are as follows: DIVIDENDS The holders of Series C, Series D, Series E and Series E-1, redeemable preferred stock are entitled to receive non-cumulative dividends at $0.062, $0.0944, $0.4544, and $0.4544 per share annum, respectively, or, if greater, an amount equal to that paid on any other outstanding shares of the Company, except that the shares of a given series of preferred stock shall not receive any greater dividend as a result of the Company's payment of a dividend on any such series of preferred stock. Such dividends shall be payable only when, as, and if declared by the Board of Directors. As of December 31, 1999, no dividends had been declared. If the offering price to the public of the Company's Common Stock in the IPO is at least $7.00 per share but less than $10.00 per share, the Company will record a preferred stock dividend of up to approximately $22 million relating to the Series E and E-1 beneficial conversion rights that will be triggered on the effective date of the Company's IPO. If the public offering price is $10.00 per share or more there will not be a preferred stock dividend charge. LIQUIDATION PREFERENCE In the event of any liquidation, dissolution or winding up of the Company, holders of preferred stock of Series C, Series D, Series E, Series E-1 are entitled to receive (along with the liquidation preference available to Series A and Series B stockholders -- See Note 8) in preference to the amount of $0.77, $1.18, $5.68, and $5.68 per share, respectively, plus all declared but unpaid dividends. Such amounts will be adjusted for any stock split, stock dividends and recapitalizations. In the occurrence, or in the event the Company assets and funds are unable to sufficiently satisfy the full preferential amounts of all series of preferred stock, the NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Company will then distribute their entire assets and funds that are legally available among the holders of all series of preferred stock in accordance with the aggregate preference payment to which they are entitled. After the payment or the setting aside of the payment set forth above, the remaining assets and funds of the Company that are legally available shall be distributed, on a pro-rata basis to the holders of the preferred stock, on an as-converted basis, and the holders of common stock until the holders of the series A, B, C, D, E, and E-1, have received an additional $0.25, $0.50, $0.77, $1.18, $5.68 and $5.68 per share, respectively. After the distributions to the holders of preferred stock and redeemable preferred stock have been made, the remaining assets of the corporation available for distribution to stockholders shall be distributed pro rata solely among the holders of common stock. VOTING RIGHTS The holders of the Series C, D, E and E-1 are entitled to the number of votes equal to a number of shares of common stock into which such redeemable preferred stock is convertible. CONVERSION Each share of Series C, D, E, and E-1 is convertible into one share of common stock at the option of the holder at any time after the date of issuance of such shares, and automatically converts at the consummation of the Company's sale of common stock in an underwritten public offering which results in net cash proceeds to the Company of at least $60,000,000 and an offering price to the public of at least $7.00 per share. The conversion rate is subject to adjustment for dilution, including, but not limited to, stock splits, stock dividends and stock combinations. The Series E and E-1 will be subject to the following adjustment: If the offering price to the public of the Company's common stock in the IPO is at least $7.00 per share but less than $10.00 per share, each share of Series E and E-1 will convert into the number of shares of common stock determined by (1) dividing the offering price to the public by $10.00 and multiplying the quotient obtained by the conversion price of the Series E and E-1 then in effect (the "Conversion Price") and (2) dividing $5.68 by the Conversion Price. The Series E-1 will be subject to the following additional adjustments: (1) If the Company achieves $11.75 million or more of combined revenue from its Shop and Plan operations for fiscal year 2000, as set forth in the financial plan provided to the investors by the Company (the "Financial Plan"), then each share of Series E-1 will be converted into 0.7143 shares of common stock; and (2) If the Company achieves $5 million or less of combined revenue from its Shop and Plan operations for fiscal year 2000, as set forth in the Financial Plan, and a holder of Series E-1 shares is in compliance with the terms of its commercial agreement with the Company, then each share of Series E-1 will be converted into 1.6667 shares of common stock. MANDATORY REDEMPTION Upon the affirmative vote of the holders of the majority of the Series C, Series D, Series E, and Series E-1 the Company can be required to redeem all shares of Series C, Series D, Series E and Series E-1 outstanding as of the date of such demand, which date shall hereinafter be referred to as the "Redemption Date." The Redemption Price of the Series C, Series D, Series E and Series E-1 will be $0.77, $1.18, and NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) $5.68 per share, respectively, subject to adjustment for dilution. The stockholders cannot require redemption prior to seven years after the issuance of the Series C, Series D, Series E, and Series E-1. Beginning with the first year anniversary of the Redemption Date, the Company shall be required to redeem annually no more than that number of shares of Series C, Series D, Series E and Series E-1, equal to 25% of the Series C, Series D, Series E, and Series E-1, outstanding as of the Redemption Date. From and after the Redemption Date, all rights of the shares designated for redemption shall cease with respect to such shares. If the funds of the Company legally available for redemption of Series C, Series D, Series E and Series E-1 on any Redemption Date are insufficient to redeem the total number of shares of the Series C, Series D, Series E, and Series E-1 to be redeemed on such date, those funds which are legally available will be used to redeem the maximum number of such shares on a pro rata basis among the holders of Series C, Series D, Series E and Series E-1 based on each holder's share of the total redemption price. At any time thereafter when additional funds of the Company are legally available for the redemption of the shares of the Series C, Series D, Series E and Series E-1 such funds will immediately be set aside for the redemption Date but which it has not redeemed. 10. WARRANTS: In June 1998, the Company issued a warrant to purchase 45,000 shares of Series C preferred stock at an exercise price of $0.77 per share in conjunction with a loan agreement. The fair value of the warrant at the date of issuance was determined to be approximately $7,000 and was estimated using the Black-Scholes valuation model with the following assumptions: risk-free rate of 5.6%; expected life of one year; and expected volatility of 70%. This amount is being recognized as additional interest expense over the expected life of the loan agreement. In May 1999, the Company issued a warrant to purchase 228,813 shares of Series D preferred stock at an exercise price of $1.18 per share in conjunction with a loan agreement. The warrant is exercisable immediately and expires the later of May 12, 2006 or three years from the effective date of an initial public offering. The fair value of the warrant at the date of issuance was determined to be approximately $640,000 and was estimated using the Black-Scholes valuation model with the following assumptions: risk-free interest rate of 5.0%; expected life of one year; and expected volatility of 70%. This amount will be recognized as additional interest expense over the expected life of the loan agreement. In July 1999, the Company issued a warrant to purchase 10,000 shares of Series D at an exercise price of $1.18 per share in conjunction with a loan agreement. The fair value of the warrant at the date of issuance was determined to be approximately $40,000 and was estimated using the Black-Scholes valuation model with the following assumptions: risk-free rate of 5.3%; expected life of one year; and expected volatility of 70%. This amount will be recognized as additional interest expense over the expected life of the loan agreement. In July 1999, the Company issued a warrant to purchase 137,711 shares of Series D at $1.18 per share in connection with an equipment lease line. The warrant is exercisable immediately and expires the later of July 7, 2006 or three years from the effective date of an initial public offering. The fair value of the warrant at the date of issuance was determined to be approximately $559,000 and was estimated using the Black-Scholes valuation model with the following assumptions: risk-free interest rate of 5.3%; expected life of one year; and expected volatility of 70%. This amount will be recognized as additional interest expense over the expected life of the lease line. In September 1999, the Company issued to a retained executive search firm a warrant to purchase 436,623 shares of the Company's common stock at an exercise price of $0.10 per share. The warrant is exercisable immediately and expires on September 9, 2009. The fair value of the warrant was determined to be approximately $2.4 million and was estimated using the Black-Scholes valuation model with the following NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) assumptions: risk-free interest rate of 5.5%; expected life of four months; and expected volatility of 70%. This expense is included in cost of warrant issued to recruiter for the year ended December 31, 1999. As of December 31, 1999, none of the warrants mentioned above had been exercised. 11. STOCK OPTIONS: 1997 STOCK PLAN The Company, under the 1997 Stock Plan (the "Plan"), reserved approximately 14.7 million shares of common stock. The stock is reserved for the employees, directors, and consultants. The term of each option will be stated in the option agreement and is not to exceed 10 years after the grant date. If the optionee owns stock representing more than 10% of the voting power the term of the option will not exceed 5 years after the grant date. Option pricing shall be no less than 85% of the fair market value per share on the date of the grant. If the optionee owns stock representing more than 10% of the voting power the option price shall not be less than 110% of the fair market value per share on the date of the grant. If the stock option is an incentive stock option, then the price for the stock cannot be less than 100% of the fair market value per share on the date of the grant. Any option granted shall be exercisable at such times and under such conditions as determined by the Board of Directors. However, for most options 25% of the shares subject to the option shall vest 12 months after the vesting commencement date, and 1/48 of the shares shall vest each month thereafter. Options under the Plan are exercisable immediately, subject to repurchase rights held by the Company, which lapse over the vesting period as determined. The Company's right of repurchase will lapse at a rate determined by the Board of Directors. However, for most options the Company's right to repurchase will lapse at a rate of 25% of the shares after the first 12 months and 1/48 of the shares, per month, after the vesting commencement date. 1999 EQUITY INCENTIVE PLAN In November 1999, the board of directors approved the 1999 Equity Incentive Plan ("the 1999 Plan") to replace the 1997 Stock Plan. The Company has reserved approximately 5,000,000 shares of common stock for issuance under the 1999 Plan, and the 1999 Plan stipulates that the amount authorized will automatically be increased each year by shares equal to 5% of the total outstanding shares as of December 31 of the preceding year. Incentive stock options may only be granted to employees under the 1999 plan, and they must be granted at an option price no less than 100% of the fair market value of the common stock on the date of grant. If the optionee owns stock representing more than 10% of the outstanding voting stock, incentive stock options must be granted at an option price no less than 110% of the fair market value of the common stock on the date of grant. Nonqualified stock options may be granted to employees, officers, directors, consultants, independent contractors or advisors to the Company, and must be granted at an option price no less than 85% of the fair market value of the common stock on the date of grant. All options granted under the 1999 Plan carry a maximum term of 10 years from the date of grant, and shall be exercisable at such times and under such conditions as determined by the board of directors at the date of grant. However, for most options 1/4 of the shares subject to the option shall vest 12 months after the vesting commencement date, and 1/48 of the shares subject to the option shall vest each month thereafter. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Activity under the Plan was as follows (in thousands, except per share amounts): - --------------- (a) During the year ended December 31, 1999, the Company granted options to purchase approximately 8,402,000 shares of common stock to certain Company executives, directors, and consultants. Such options were issued outside of the Plan. The Company accounts for the Plan under the provisions of APB No. 25. Had compensation expense for the stock option plans been determined consistent with SFAS No. 123, net losses would have increased to the following pro forma amounts (in thousands, except per share data): The weighted-average fair value of options granted during the years ended December 31, 1997 and 1998 and 1999 was $0.03, $0.07, and $4.60, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option pricing model using the following assumptions: risk-free interest rates ranging from 4.07 to 6.40 percent; expected dividend yields of zero percent for all four periods; an average expected life of 3.5 years; and expected volatility of 0% for all periods except the year ended December 31, 1999, for which a volatility factor of 70% was used. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The following table summarizes the stock options outstanding and exercisable as of December 31, 1999 (shares in thousands): During October, 1999 the Board of Directors approved a change in the Plan providing for the exercise of options prior to an employee's vesting date. At December 31, 1999, 9,908,501 shares previously issued under the Plan were subject to repurchase at a weighted-average exercise price of $0.88 per share. At December 31, 1999, approximately 136,000 outstanding options were vested and exercisable. DEFERRED COMPENSATION In connection with the grant of certain stock options to employees during fiscal 1998 and 1999, the Company recorded deferred compensation of approximately $60.6 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. Such amount is presented as a reduction of stockholders' equity and amortized over the vesting period of the applicable options using an accelerated method of amortization. Under the accelerated method, each vested tranche of options is accounted for as a separate option grant awarded for past services. Accordingly, the compensation expense is recognized over the period during which the services have been provided; however, the method results in a front-loading of the compensation expense. Based on the above assumptions, the weighted-average fair values per share of options granted were $0.29 and $3.81 for the year ended December 31, 1998 and 1999, respectively. The Company recorded amortization of deferred compensation of $13.2 million during the year ended December 31, 1999. In January 2000, the Company granted options under the Plan that resulted in additional deferred compensation. The Company recorded additional deferred compensation of approximately $4,656 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. The total amount of deferred compensation after recording the additional deferred compensation amounts to $65.2 million. 1999 EMPLOYEE STOCK PURCHASE PLAN In November 1999, the board of directors approved the 1999 Employee Stock Purchase Plan (the "ESPP") to become effective on the first day on which price quotations are available for the Company's common stock on the NASDAQ National Market. The Company has reserved 750,000 shares of common stock for issuance under the ESPP, and the terms of the ESPP stipulate that that amount will automatically be increased each year by shares equal to 1% of the total outstanding shares of common stock as of December 31 of the preceding year. Subject to certain eligibility requirements, employees may elect to withhold up to a maximum of 15% of their cash compensation for participation in the ESPP. Each offering NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) period under the ESPP will be two years in duration and will consist of four six-month purchase periods. The first offering period is expected to commence on the first day on which price quotations are available for the Company's common stock on the NASDAQ National Market with subsequent purchasing periods commencing on February 1 and August 1 each year. The purchase price for common stock purchased under this plan will be 85% of the lesser of the fair market value of our common stock on the first day of the applicable offering period or the last day of the purchase period. 12. INCOME TAXES: Effective January 1, 1998, the Company accounts for income taxes pursuant to the provisions of SFAS No. 109, "Accounting for Income Taxes." SFAS 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined using the current applicable enacted tax rate and provisions of the enacted tax law. Due to the Company's loss position, there was no provision for income taxes for the years ended December 31, 1998 and December 31, 1999. At inception, the Company elected S-Corporation status. As of January 1, 1998, the Company elected C-Corporation status for Federal and state purposes. As a result, the Company is not entitled to any tax benefits associated with the period prior to C-Corporation election. At December 31, 1999, the Company had cumulative net operating loss carry forwards of approximately $31.5 million for Federal and state income tax purposes, expiring in the years ended 2018 and 2006, respectively. At December 31, 1999, the Company had cumulative research and development credit carry forwards of approximately $271,000 and $442,000 for Federal and state income tax purposes, respectively. These credits are subject to expiration through various periods through 2018. The Tax Reform Act of 1986 contains provisions which may limit the net operating loss and credit carryforwards to be used in any given year upon the occurrence of certain events, including a significant change in ownership. The estimated tax effects of significant temporary differences and carryforwards that give rise to deferred income tax assets are as follows (in thousands): Due to uncertainty surrounding the realization of the deferred tax attributes in future years, the Company has recorded a valuation allowance against its net deferred tax assets. The provision for income taxes at the Company's effective tax rate differed from the benefit from income taxes at the statutory rate due mainly to the increase in valuation allowance and no benefit of the operating losses was recognized. NEOFORMA.COM, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The provision for income taxes differs from the expected tax benefit amount computed by applying the statutory federal income tax rate of 35% to loss before taxes is as follows: 13. RELATED PARTY TRANSACTIONS During 1996 and 1997, the Company borrowed a total of $433,000 from certain shareholders and officers. During 1997, $48,000 of the loans from these individuals was repaid in cash. At December 31, 1997, $385,000 of the loans from these individuals is included in notes payable. During 1998, $170,000 of the notes payable were converted to 340,000 shares of Series B and the remaining $215,000 was repaid in cash. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS INDEX TO EXHIBITS

777844_1999.txt

777844_1999

1999

777844

ITEM 1. BUSINESS (a) General Development of Business. CompuSonics Video Corporation ("Registrant") was organized under the laws of the State of Colorado on August 14, 1985. The Registrant's principal activities since inception have been devoted to obtaining equity capital for the development of a digital video recording and playback system with a view towards its manufacture and marketing. The Registrant has no substantial operations, research and development, earnings, cash flows, product development or sources of financing. On December 13, 1985, the Registrant concluded a public offering of 30,000,000 Units, each Unit consisting of one share of its common stock and one Class A Warrant, and received net proceeds of $727,971. On November 16, 1987, the Registrant acquired The Tyler-Shaw Corporation, a New York corporation ("Tyler-Shaw"), which was engaged in the business of direct mail marketing. Effective July 31, 1992, Tyler-Shaw was considered inactive. Tyler-Shaw has no substantial operations, research and development, earnings, cash flows, product development or sources of financing. In August, 1998, the Company hired a manager experienced in Internet programming to investigate the possibility of implementing a new business activity for the Company known as website development and maintenance. The rapid development of the Internet and its graphical element, the World Wide Web, has made the use of the Internet commonplace among many companies around the world. The Company's management concluded that significant opportunities existed in this emerging technology and developed a business model where the Company would seek programming contracts with related and outside companies to do this type of work on a consulting and project basis. The manager hired to do the business investigation was named the Director of Technology Development and the Company began its consulting work in the fourth calendar quarter of 1998, when the Company established its operations in Chicago and hired additional staff. The Company focuses its efforts on the development of commercial sites on the World Wide Web. The Company develops e-commerce applications, where a manufacturer or distributor would sell its products on the Internet, internal coordination sites called Intranets, that are used by employees of a company to communicate with each other and share information, and Extranets, used by companies to communicate and share information with outside groups such as suppliers and major customers. The technical management of the Company has significant experience in this type of work and has two current clients for these type of projects, while currently prospecting for additional business in this area. The ability of the Company to generate additional business is directly related to staffing levels of employees. As such, the Company expects to hire additional employees as the level of business grows. On June 22, 1999, the Company loaned $150,000 to Pro Golf International, Inc. ("PGI"), a subsidiary of Ajay Sports, Inc. The Company received a promissory note that is subordinated to PGI's primary lender. The unpaid principal balance will bear an interest rate of 10% and will be due and payable in full on July 22, 2000. The Company has made a proposal to PGI to do website development and maintenance work for PGI and its related companies. (b) Financial Information about Industry Segments. Prior to the year ended July 31, 1992, the Registrant engaged in two business segments: (1) Development and marketing of a digital video recording and playback system, and (2) Direct mail marketing. All of the Registrant's revenues for the past four fiscal years have been from the direct mail marketing segment. The Registrant had no revenues for the current year or for the two immediately preceding years and considers its direct mail marketing segment inactive. (c) Narrative Description of Business. (c) (1) (i): THE COMPUSONICS VIDEO SYSTEM - ---------------------------- The Registrant has developed a system to make video recordings, digitilize video images and playback digital data on a television monitor. Digitizing and random access capabilities represent significant improvements over conventional analog recorders. Conventional analog video recorders convert electrical impulses representing visual images into waveforms, which are then stored on magnetic tape or disk. On playback, waveforms are converted back into electrical impulses, which are converted to visual images through a television picture tube or similar device. In an analog system, the accuracy of the reproduced image is dependent upon the quality of the tape or disk, as well as the quality of the playback system itself. Further, the noise generated by the surface defects on the tape or disk is apparent when the image is played back. Advances in computer technology, particularly in digital memory devices, have been applied in the development of both audio and video digital recording and playback systems. CompuSonics Corporation, owner of 7.1% of the Common Stock of the Registrant, has produced audio digital systems that utilize advanced microcomputer chips to record and reproduce audio signals using its proprietary digital audio technology, known as "CSX". The Registrant has exclusive license to utilize the CSX technology in the development and production of its products. The motion picture industry currently uses digital image processors for the creation of special effects and picture enhancements. These image processors use small digital memories to store and manipulate images that have been digitized and transferred from analog sources. In the Registrant's proposed system, video signals would be converted into numerical data representing video images. Data would then be stored in a temporary buffer memory. Each video frame image would be processed, through licensed CSX technology, to reduce the amount of data to the minimum required to produce an image for playback closely resembling the image as initially recorded. Data representing the video image would be stored on a floppy disk or other computer information storage disk. Playback of the digital data would occur on a television monitor with a compatible signal receiving capability. The accompanying high fidelity audio signal could be routed to a suitably equipped stereo television set or through a conventional stereo system adjacent to the monitor. Proposed Products The Registrant has no developed products at this time. The digital video system that the Registrant was developing consisted of a group of proposed products that would record, playback, edit and transmit video data and audio data in connection with the video. The Registrant will most likely attempt to sublicense manufacturing rights or enter into production contracts with non-affiliated parties. There are no current prospects for such sublicenses or contracts and the prospects of success cannot be determined. Marketing The Registrant has had no marketing activities since 1990, other than the marketing of its Internet consulting services in August 1998. DIRECT MAIL MARKETING - --------------------- Tyler-Shaw's business consisted of offering specialized products to direct mail list owners through a process called syndication. Tyler-Shaw's president terminated employment in March, 1991, and it's Pennsylvania office was closed. A short-term arrangement with a consultant lapsed in July, 1991 and hasn't been renewed. Since that time the company has been inactive. (c) (1) (ii) Except for its proposed products listed above, there has been no public announcement of, and the Registrant has not otherwise made public, information about a new product or industry segment that would require the investment of a material amount of the assets of the Registrant or that otherwise is material. (c) (1) (iii) The Registrant anticipates that any production of new products will be organized by second-party marketers and manufacturers, therefore the sources and availability of raw materials is not material concerns. (c) (l)(iv) The Registrant holds all rights to United States and certain foreign patent and patent applications for a digital video recording and playback system. On July 21, 1987, patent number 4,682,248 were issued to the Registrant with three claims of the Registrant being allowed. On July 5, 1988, patent number 4,755,889 was issued to the Registrant with four claims being allowed. The Japanese patent number 2,053,230 was issued on May 10, 1996 for an "Audio Digital Recording & Playback System" and will remain in effect until April 19, 2014, providing all renewals are paid. This patent is the Japanese counterpart of U.S. Patent No. 4,636,876 and 4,472,747. The Japanese patent number 2,596,420 was issued on January 9, 1997 for an "Audio Digital Recording & Playback System" and will remain in effect until September 17, 2006 providing all renewals are paid. This patent is the Japanese counterpart of U.S. Patent No. 4,755,889. There can be no assurance that patents will be issued in connection with the remaining applications. If future patents are granted and any of them are tested in litigation, such patents may not afford protection as broad as the claims made in the patent applications. Furthermore, expense required to enforce patent rights against infringers would be costly. However, the Registrant believes the patent protection obtained, and any further issuances, will greatly assist efforts to protect its technology from being copied. The Registrant has also been granted a limited exclusive license by CompuSonics Corporation to utilize its proprietary digital audio technology, CSX, for the limited purpose of incorporating that technology into its proposed video system to process the audio portions of recorded material. CompuSonics Corporation, a Colorado corporation, and a shareholder of the Registrant, has been engaged in marketing and promoting its CSX Technology licensing and engineering consulting services on a reduced and limited basis. (c)(l)(v) The Registrant's business is not seasonally affected. (c) (1) (vi) The Registrant has no marketable product and as such is not required to carry significant amounts of inventory. (c) (l) (vii) The Registrant has attempted to market its technology. Therefore the success of the Registrant is dependent upon the ability of the Registrant to locate customers who will purchase the proposed products or technology offered by the Registrant. There can be no guarantee that such customers can be located. The subsidiary, Tyler-Shaw, acted as a sales representative and syndicator of consumer products through direct mail marketing programs principally in conjunction with major credit card companies. Tyler-Shaw is currently inactive and the success of the subsidiary is doubtful. (c) (1) (viii) There is no backlog at this time. (c) (1) (ix) No material portion of the Registrant's business is subject to renegotiations of profits or termination of contracts or subcontracts at the election of the government. (c) (l)(x) The Registrant competes with all companies engaged in design, manufacture and marketing of digital video recording and playback systems. The Registrant's primary competition in the home entertainment market will be the VideoCassette Recorder ("VCR") and related recording technologies. VCRs and related equipment are manufactured and sold by numerous large, well-financed companies with established distribution channels. Rental and sale of videocassettes is also well established and there are numerous outlets for pre-produced and blank videocassettes. Costs for purchasing new VCRs have been decreasing since their market introduction and VCRs are readily available for rent. It is anticipated that the Registrant's DVR will be significantly more expensive to purchase than a VCR. The Registrant anticipates that its system would compete with the VCR on the basis of the high quality of its video and audio on playback and because of the ability to more precisely index and locate selected material for playback. The Registrant is aware of the development of systems similar to its own. There can be no assurance that such systems will not soon be marketed by competitors. It can be expected that most of the Registrant's competitors will have extensive experience and possess financial, technological and personnel resources substantially greater than that of the Registrant. The Registrant's subsidiary, Tyler-Shaw, which is currently inactive, was in competition with all companies engaged in direct mail marketing. It can be expected that most of the Registrant's direct mail marketing competitors will have extensive experience and possess financial, technological and personnel resources substantially greater than the Registrant's. In August, 1998, the Company hired a manager experienced in Internet programming to investigate the possibility of implementing a new business activity for the Company known as website development and maintenance. The rapid development of the Internet and its graphical element, the World Wide Web, has made the use of the Internet commonplace among many companies around the world. The Company's management concluded that significant opportunities existed in this emerging technology and developed a business model where the Company would seek programming contracts with related and outside companies to do this type of work on a consulting and project basis. The manager hired to do the business investigation was named the Director of Technology Development and the Company began its consulting work in the fourth calendar quarter of 1998, when the Company established its operations in Chicago and hired additional staff. The Company focuses its efforts on the development of commercial sites on the World Wide Web. The Company develops e-commerce applications, where a manufacturer or distributor would sell its products on the Internet, internal coordination sites called Intranets, that are used by employees of a company to communicate with each other and share information, and Extranets, used by companies to communicate and share information with outside groups such as suppliers and major customers. The technical management of the Company has significant experience in this type of work and has two current clients for these type of projects, while currently prospecting for additional business in this area. The ability of the Company to generate additional business is directly related to staffing levels of employees. As such, the Company expects to hire additional employees as the level of business grows. (c)(l)(xi) During the period from August 1, 1989, through July 31, 1999, the Registrant did not expend any funds on research and development. (c) (l)(xii) The Registrant is not materially affected by the federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment. (c)(l) (xiii) As of July 31, 1999, the Registrant had three employees. As of October 16, 1999, the Registrant has two employees. (d) Financial Information about Foreign and Domestic Operations and Export Sales. The Registrant has no material international operations or direct export sales. ITEM 2. ITEM 2. PROPERTIES The Registrant has been using space, at no charge, in the office of a related entity for the purposes of administration and development. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Registrant is not a present party to any material pending legal proceedings and no such proceedings were known as of the end of the fiscal year. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the Registrant's shareholders during the fourth quarter ended July 31, 1999. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Market Information The principal market on which the Registrant's common stock, $.001 par value (the "Common Stock"), is traded is the over-the-counter market under the symbol "CPVD". Prices for the Common Stock have been reported in the National Daily Quotation Service "Pink Sheets" published by the National Quotation Bureau, Inc. since December 16, 1985. The range of high and low bid quotations for the Registrant's Common Stock since the quarter ended October 31, 1996 is as follows: High Bid* Low Bid* October 31, 1996 ** ** January 31, 1997 ** ** April 30, 1997 ** ** July 31, 1997 ** ** October 31, 1997 ** ** January 31, 1998 ** ** April 30, 1998 ** ** July 31, 1998 ** ** October 31, 1998 .0001 .0001 January 31, 1999 .0001 .0001 April 30, 1999 .0001 .0001 July 31, 1999 .0125 .010 ** No Bid reported for Common Stock On July 31, 1999, the respective bid and ask prices reported for the Common Stock were $.0125* and $ .01*. *Prices are inter-dealer quotations as reported by the National Quotation Bureau, Inc., New York, New York, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. (b) Holders. As of July 31, 1999, the number of record holders of the Registrant's Common Stock was approximately 5,284. (c) Dividends. The Registrant has never paid a dividend with respect to its Common Stock and does not intend to pay a dividend in the foreseeable future. The shares of Series A Preferred Stock are entitled to a $1.00 per share annual preference, which must be paid before any dividends are payable on the Common Stock. There are no preferred shares outstanding. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Note: * Less than $.01 per share. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Working capital decreased by $24,134 for the period from August 1, 1998 through July 31, 1999. This was mainly caused by the net income for the year of $21,261. Net income from operations was $65,152 which consisted mostly of $212,210 in consulting income offset by $101,817 staff salaries, patent fees of $7,156; management fees of $4,150 to a related company and professional fees of $7,231 for auditing services, stock transfer fees and other professional fees. In accordance with SFAS 115, the Registrant reported the 28,475 shares of Williams Controls, Inc. common stock (Nasdaq "WMCO") at fair market value at closing price on July 31, 1999 of $88,984. The stock is classified as available-for-sale securities and originally cost $25,035. In the past the Registrant has relied on a related company to provide the working funds it has required but there is no assurance that this will continue in future years. Results of Operations - ---------------------- Year ended July 31, 1999 Compared to July 31, 1998 Operating revenue for the years ended July 31, 1999 and 1998 were $212,210 and $-0- respectively. The Company currently has consulting agreements with two affiliated companies to do website development and maintenance consulting work. They are Williams Controls, Inc. ("Williams") and Ajay Sports, Inc. ("Ajay"). The work product includes redesigns of the companies websites, the development of intranet products, and ongoing maintenance of the sites as new features are added. The subsidiary that had provided revenues, in the years prior to 1992, has been inactive during the last seven years and the Registrant does not expect income from this operation in future years. General and administrative expenses were $147,058 for the year ended July 31, 1999 compared to $16,334 for the year ended July 31, 1998. As discussed above, the expenses incurred were for the staff salaries of $101,817 extension of currently held patents, $7,156; Professional fees of $7,231; and Management fees of $4,150 to a related party for services including accounting and SEC report preparation. During the year ended July 31, 1999, other income and expense consisted of interest expense of $45,134 on notes payable. The Registrant has initiated replacement of the Registrant's most significant computer programs with new updates that are warranted to be year 2000 compliant. Installation of these updates was completed on September 8, 1999. All other programs subject to year 2000 concerns will be evaluated utilizing internal and external resources to reprogram, replace or test each of them. Year ended July 31, 1998 Compared to July 31, 1997 Operating revenue for the years ended July 31, 1998 and 1997 were $-0-. The subsidiary that had provided revenues, in the years prior to 1992, has been inactive during the last five years and the Registrant does not expect income from this operation in future years. General and administrative expenses were $16,334 for the year ended July 31, 1998 compared to $7,026 for the year ended July 31, 1997. As discussed above, the expenses incurred were for the extension of currently held patents, $8,229; Professional fees of $6,714: and Management fees of $1,200 to a related party for services including accounting and SEC report preparation. Legal fees and patent fees decreased substantially from prior years. During the year ended July 31, 1998, other income and expense consisted of interest expense of $42,927 on notes payable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements and supplementary data immediately follow the signature page of this document and are listed under Item 14 of Part IV of this Annual Report on the Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) and (b) Identification of Directors and Executive Officers. Name Age Position ----- ---- ----------- Robert R Hebard 46 Chairman of the Board, Chief Executive Officer, President and Treasurer Robert J. Flynn 64 Vice President, Director, and Secretary The directors of the Registrant are elected to hold office until the next annual meeting of shareholders and until their respective successors have been elected and qualified. Officers of the Registrant are elected by the Board of Directors and hold office until their successors are elected and qualified. (c) Identification of Certain Significant Employees. The Registrant is subject to Section 13(a) of the Securities Exchange Act of 1934 and is therefore not required to identify or disclose information concerning its significant employees. (d) Family Relationships. There are no family relationships between any director, executive officer or person nominated or chosen by the Registrant to become a director or executive officer. (e) Business Experience. (e) (1) Background. Robert R. Hebard. Mr. Hebard has received his Bachelors Degree in Marketing/Management from Cornell University in 1975 and an MBA from Canisus College in 1982. Mr. Hebard is the currently the Chairman and President of the Registrant. Mr. Hebard is also currently President and Chairman of Enercorp, Inc., a publicly held business development company. He is also a director, Vice President and Secretary of Woodward Partners, Inc. Mr. Hebard is corporate Secretary and is on the Board of Directors for Ajay Sports, Inc. since September, 1990. In June, 1999 Mr. Hebard was appointed as the corporate Secretary and a member of the Board of Directors of Pro Golf International, Inc. and Pro Golf Online, Inc., two majority owned subsidiaries of Ajay. Robert J. Flynn. Mr. Flynn has been Chairman of the Board of Funding Enterprises, a Southfield, Michigan based marketing company for 20 years. He has been active in the securities and insurance fields since 1963 and in the marketing of Real Estate securities since 1968. Mr. Flynn is licensed as a registered security representative and insurance agent. Since 1981, he has been Chairman of the Act 78 Southfield Police and Fire Commission. Mr. Flynn received a B.S. degree from Cornell University in 1958. (e) (2) Directorships. Mr. Hebard is a director of Woodward Partners, Inc., Enercorp, Inc., and Ajay Sports, Inc.; latter two of which are publicly-held companies. Mr. Flynn is Chairman of the Board of Funding Enterprises. (f) Involvement in Certain Legal Proceedings. (f) (1) During the past five years, there have been no filings of petitions under the federal bankruptcy laws or any state insolvency laws, nor has there been appointed by any court a receiver, fiscal agent or similar officer by or against any director or executive officer of the Registrant or any partnership in which such person was a general partner or any corporation or business association of which he was an executive officer within two years before the time of such a filing, except as stated in Item 10 (e) (1), above. (f)(2) No director or executive officer of the Registrant has, during the past five years, been convicted in a criminal proceeding or is the named subject of a pending criminal proceeding. (f)(3) During the past five years, no director or executive officer of the Registrant has been the subject of any order, judgement or decree not subsequently reversed, suspended or vacated by any court of competent jurisdiction permanently or temporarily enjoining him from or otherwise limiting the following activities: (i) acting as a futures commission merchant, introducing broker, commodity trading advisor, commodity pool operator, floor broker, leverage transaction merchant, any other person regulated by the Commodity Futures Trading Commission, or an associated person of any of the foregoing, or an investment advisor, underwriter, broker or dealer in securities, or as an affiliated person, director or employee of any investment company, bank, savings and loan association or insurance company, or engaging in or continuing any conduct or practice in connection with such activity; (ii) engaging in any type of business practice; or (iii) engaging in any activity in connection with the purchase or sale of any security or commodity or in connection with any violation of federal or state securities laws or federal commodities law. (f)(4) During the past five years no director or executive officer of the Registrant has been the subject of any order, judgment or decree not subsequently reversed, suspended or vacated by any federal or state authority barring, suspending or otherwise limiting for more than 60 days the right of such person to engage in any activity described in paragraph (f) (3) (i) of this Item or to be associated with persons engaged in any such activity. (f)(5) During the past five years no director or executive officer of the Registrant has been found by a court of competent jurisdiction in a civil action or by the Securities and Exchange Commission to have violated any federal or state securities law. (f)(6) During the past five years no director or executive officer of the Registrant was found by a court of competent jurisdiction in a civil action or by the Commodity Futures Trading Commission to have violated any federal commodities law, which judgment or finding has not been subsequently reversed, suspended or vacated. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (a) (1) Cash Compensation. The following sets forth all remuneration paid in the fiscal year ended July 31, 1999, to all officers of the Registrant and the total amount of remuneration paid to the officers and directors as a group: Number of persons Capacities in Cash in group (1) which served compensation ----------------- ------------- ------------ Registrant: All executive officers Various None as a group Subsidiary: No officers or directors received remuneration exceeding $100,000 during the fiscal year ended July 31, 1999. (b) (1) Compensation Pursuant to Plans. Incentive Stock Option Plan The Board of Directors of the Registrant, in October 1985, adopted an Incentive Stock Option Plan (the "Plan") for key employees. Options covering a total of 7,000,000 shares of Common Stock are available for grant under the Plan. The Plan is administered by the Board of Directors, who are responsible for establishing the criteria to be applied in administering the Plan. The Board of Directors is empowered to determine the total number of options to be granted to any one optionee, provided that the maximum fair market value of the stock for which any employee may be granted options during a single calendar year may not exceed $100,000 plus one-half of the excess of $100,000 over the aggregate fair market value of stock for which an employee was granted options in each of the three preceding calendar years. The exercise price of the options cannot be less than the market value of the Common Stock on the date of grant (110% of market value in the case of options to an employee who owns ten percent or more of the Registrant's voting stock) and no option can have a term in excess of ten years. In the event of certain changes or transactions such as a stock split, stock dividend or merger, the Board of Directors has the discretion to make such adjustments in the number and class of shares covered by an option or the option price as they deem appropriate. Options granted under the Plan are nontransferable during the life of the optionee and terminate within three months upon the cessation of the optionee's employment, unless employment is terminated for cause in which case the option terminates immediately. Only one option has been granted under the plan and it has lapsed. (b) (2) Pension Table. The Registrant has no defined benefit and actuarial plan providing for payments to employees upon retirement. (b) (3) Alternative Pension Plan Disclosure. The Registrant has no defined benefit and actuarial plan providing for payments to employees upon retirement. (b) (4) Stock Option and Stock Appreciation Rights Plans. During the period from August 1, 1988, through July 31, 1999, no stock options were granted. (c) Other Compensation. No other compensation having a value of the lesser of $100,000 or ten percent of the compensation reported in the table in paragraph (a) (1) of this Item was paid or distributed to all executive officers as a group during the period from August 1, 1989, through July 31, 1999. (d) Compensation of Directors. (d) (1) Standard Arrangements. The Registrant reimburses its directors for expenses incurred by them in connection with business performed on the Registrant's behalf, including expenses incurred in attending meetings. No such reimbursements were made for the period from August 1, 1989 through July 31, 1999. The Registrant does not pay any director's fees. (d) (2) Other Arrangements. There are no other arrangements pursuant to which any director of the Registrant was compensated during the period from August 1, 1989, through July 31, 1999, for services as a director other than as listed above in (d) (1). (e) Termination of Employment and Change of Control Arrangement. The Registrant has no formal plan or arrangement with respect to any such persons, which will result from a change in control of the Registrant or a change in the individual's responsibilities following a change in control. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a)(b) Security Ownership of Certain Beneficial Owners and Security Ownership of Management. The following table sets forth the number of shares of the Registrant's common stock, its only class of voting securities, owned by executive officers and directors, individually, and beneficial owners of more than five percent of the Registrant's Common Stock, and executive officers as a group, as of October 1, 1999. Number of Shares and Nature of Beneficial Percent Name and address Ownership (1) of Class - ----------------------- ----------------- ---------- CompuSonics Corporation 11,300,000 (2) 7.1% 2345 Yale Street Palo Alto, California 94306 TICO, Inc. 30,000,000 18.7% 7001 Orchard Lake Road Suite 424 West Bloomfield, Michigan 48322 Acrodyne Profit Sharing Trust 9,617,594 6.0% 7001 Orchard Lake Road Suite 424 West Bloomfield, Michigan 48322 Thomas W. Itin 64,652,594 (3) 40.4% 7001 Orchard Lake Road Suite 424 West Bloomfield, Michigan 48322 Robert R. Hebard 15,000,000 (4) 9.4% 7001 Orchard Lake Road Suite 424 West Bloomfield, Michigan 48322 Officer and directors 15,000,000 (5) 9.4% as a group (one person) (1) All shares are beneficially owned of record unless otherwise indicated. (2) A transfer of 18,700,000 shares from CompuSonics Corporation to Equitex has not been recorded by the Registrants' stock transfer agent as of October 1, 1999 but has been reflected in the above numbers. The shares have subsequently been transferred from Equitex to other parties. (3) Mr. Itin has held in his name -0- shares of the Registrant. Mr. Itin has beneficial ownership of the following: TICO, Inc. 30,000,000 TICO 35,000 SICO 5,000,000 Acrodyne Profit Sharing Trust 9,617,594 Other Trusts 20,000,000 ---------- 64,652,594 ========== Mr. Itin is a controlling person in TICO, Inc. Mr. Itin is controlling partner in TICO and a general partner in SICO. Shares, in TICO, Inc.'s name, are held as nominee for Thomas W. Itin. Mr. Itin is the trustee and beneficiary of Acrodyne Profit Sharing Trust. Therefore, he can be considered as having beneficial ownership of the shares of these entities. Mr. Itin's wife is a trustee of certain other trusts holding a total of 20,000,000 shares. Mr. Itin is not a beneficiary of the above mentioned trusts in which his wife is trustee and disclaims any beneficial ownership. (4) Includes 5,000,000 shares owned directly and 10,000,000 shares held in trust for his children. Mr. Hebard is not a trustee or beneficiary of the trust and disclaims any beneficial interest in them. (5) Includes only active management as of October 1, 1999. (c) Changes in Control. On August 19, 1993 Equitex transferred all its interest in the Registrant including stocks, notes and accounts receivable to Thomas W. Itin or his assigns. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with Management and Others. License Agreement On September 17, 1985, the Registrant and CompuSonics Corporation, a shareholder of the Registrant, entered into a license agreement pursuant to which the Registrant received an exclusive license to the digital audio technology, CSX, owned by CompuSonics Corporation for the limited purpose of integrating the audio technology into the Registrant's proposed digital recording and playback system. The agreement limited the licensed rights for use only in connection with the video system. No continuing royalty payments or fees are to be paid. The Registrant is not in violation of any of the license restrictions. The license may not be transferred by the Registrant. The technology licensed allows the Registrant to utilize digital audio in its system rather than an analog-based audio. CompuSonics Corporation has been developing the licensed digital audio technology since its inception and is currently engaged in marketing and promoting its CSX Technology licensing and engineering consulting services on a limited basis. Assignment Agreement and Issuance of Preferred Stock The Registrant issued 300,000 shares of Series A Preferred Stock to CompuSonics Corporation which were converted in September 1988 into 30,000,000 shares of Common Stock in return for the assignment by CompuSonics Corporation of its rights under United States and certain foreign patent applications, and all rights to a digital video recording and playback system. The digital video system patent application was prepared with the assistance of CompuSonics Corporation's president at the time. Patent application fees and patent counsel fees were also paid by CompuSonics Corporation. The value of the services and the fees advanced total $34,500 of which $19,000 was expended for patent application fees and patent attorney fees and $15,500 represents salary expense for assistance provided by CompuSonics Corporation personnel. The assignment of patent application and all other rights to the digital video system gives the Registrant the right to develop the technology assigned. CompuSonics Corporation has relinquished the right to develop this video technology. Loans The Registrant previously had outstanding notes and accounts payable to an affiliated party and shareholder, Equitex, Inc. In August 1993, Equitex, Inc. transferred all its interest in the Registrant including these notes and accounts payable to an affiliated party. The notes and accounts payable totaling $50,112 with interest as of July 31, 1999, are unsecured and bear interest at the rate of 10 and 12% per annum, and are due upon demand. The Registrant and its subsidiary Tyler-Shaw together, in addition to the above stated amounts, have outstanding notes and accounts payable to an affiliated party totaling $809,570 with interest as of July 31, 1999. The loans are at 10.50% & 10.25% interest, respectively. These loans are Collaterized by all the assets of Tyler-Shaw and the Registrant. The Registrant also has an outstanding note payable to a non-affiliated party in the amount of $32,550, including interest of 10.50%. From August 1, 1989, through July 31, 1999, the Registrant did not purchase any equipment of material value. (b) Certain Business Relationships. (b) (1) During the Registrant's most recently completed fiscal year, none of its directors or nominees for election as directors have owned, of record or beneficially, in excess of ten percent of the equity interest in any business or professional entity that made during that year, or proposes to make during the Registrant's current year, payments to the Registrant for property or services in excess of five percent of: (i) the Registrant's consolidated gross revenues for its last full fiscal year or (ii) the other entity's consolidated gross revenues for its last full fiscal year. (b) (2) No nominee or director of the Registrant is, or during the last full fiscal year has been, an executive of or owns, or during the last full fiscal year has owned, of record or beneficially, in excess of a ten percent equity interest in any business of professional entity to which the Registrant has made during the Registrant's last full fiscal year or proposes to make during the Registrant's current fiscal year, payments for property or services in excess of five percent of (i) the Registrant's consolidated gross revenues for its last full fiscal year, or (ii) the other entity's consolidated revenues for its last full fiscal year. (b) (3) No nominee or director, except as disclosed under Item 13(a) Loan section of this report, of the Registrant is, or during the last full fiscal year has been, an executive of or owns, or during the last full fiscal year has owned, of record or beneficially in excess of ten percent equity interest in any business or professional entity to which the Registrant was indebted at the end of the Registrant's last full fiscal year in an aggregate amount in excess of five percent of the Registrant's total consolidated assets at the end of such fiscal year. (b) (4) No nominee or director of the Registrant is, or during the last fiscal year has been, a member of or of counsel to a law firm that the Registrant has retained during the last fiscal year or proposes to retain during the current fiscal year. (b) (5) No nominee for or director of the Registrant is, or during the last fiscal year has been, a partner or executive officer of any investment banking firm that has performed services for the Registrant, other than as a participating underwriter in a syndicate, during the last fiscal year or that the Registrant proposes to have performed services during the current year. (b) (6) The Registrant is not aware of any other relationship between nominees for election as directors or its directors and the Registrant that are similar in nature and scope to those relationships listed in paragraphs (b) (1) through (5) of this Item 13. (c) Indebtedness of Management. No director, executive, officer, nominee for election as a director, any member, except as disclosed under Item 13(a) Loan section of this report, of the immediate family of any of the foregoing, or any corporation or organization of which any of the foregoing persons is an executive officer, partner or beneficial holder of ten percent or more of any class of equity securities, or any trust or other estate in which any such person has a substantial beneficial interest or as to which such person serves as a trustee or in a similar capacity, was indebted to the Registrant in an amount in excess of $100,000 at any time since August 14, 1985. (d) Transactions with Promoters. This filing is not on a Form S-1 or Form 10 and therefore the Registrant is not required to report any information concerning transactions with promoters. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report Form 10-K immediately following the signature page. 1. Financial Statements and Supplementary Data. Page --------- Independent Auditor's Report to Consolidated Balance Sheets at July 31, 1999 and 1998 Consolidated Statements of Operations for the years ended July 31, 1999, 1998 and 1997 Consolidated Statements of Changes in Stockholders' Deficit for the years ended July 31, 1999, 1998 and 1997 Statements of Cash Flows for the years ended July 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements to Schedules of Investments at July 31, 1999 and 1998 2. Financial statement schedules required to be filed are listed below and may be found at the page indicated. Schedules have been omitted because they are not required or the information is included in the financial statements and notes thereto. 3. Exhibits. None (b) Reports on Form 8-K Form 8-K was filed on May 6, 1999 to announce the extension of Class A and Class B Warrants from May 15, 1999 to May 15, 2000. (c) Exhibits required by Item 601 of Regulation S-K Exhibit 3.1 ............................Articles of Incorporation * Exhibit 3.2 .................................................Bylaws * Exhibit 3.3 ................Designation of Series A Preferred Stock - Exhibit 11 Statement of Computation of Per Share Earnings (Loss)...F-4 Exhibit 16 Letter re Change in Certifying Accountant FILED HEREWITH Exhibit 27 Financial Date Schedule FILED HEREWITH * Incorporated by reference from the Registrant's Registration Statement on Form S-18, No. 1-14200, and effective November 27, 1985. Required exhibits are listed in Item 14 (a) (3) of this Annual Report on Form 10-K. (d) Financial Statement Schedules. Required financial statement schedules are attached hereto and are listed in Item 14(a) (2) of this Annual Report on Form 10-K SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registration has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. COMPUSONICS VIDEO CORPORATION (Registrant) By: \s\Robert R. Hebard --------------------------- Robert R. Hebard, President Date: November 12, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 12th day of November, 1999. Signature Title ----------- ------- \s\Robert R. Hebard ------------------- Robert R. Hebard Chairman of the Board of Directors Chief Executive Officer and Treasurer \s\Robert J. Flynn -------------------- Robert J. Flynn Vice President and Director The foregoing constitute all of the Board of Directors. INDEPENDENT AUDITOR'S REPORT Board of Directors CompuSonics Video Corporation and Subsidiaries We have audited the accompanying balance sheet of CompuSonics Video Corporation and Subsidiaries as of July 31, 1999, and the related statement of operations, changes in stockholders' deficit, and cash flows for the year ended July 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of the Company as of July 31, 1998 and 1997 were audited by other auditors whose reports dated October 26, 1998 and October 20, 1997 included an explanatory paragraph that described going concern uncertainties. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CompuSonics Video Corporation and Subsidiaries as of July 31, 1999 and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as whole. The schedule on is presented for purposes of complying with the rules of the Securities and Exchange Commission and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as whole. /s/ JL Stephan Co PC - ---------------------- J L Stephan Co PC Traverse City, Michigan September 15,1999 COMPUSONICS VIDEO CORPORATION & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 31, 1999 ------------- Note 1. Significant Accounting Policies A. Business History CompuSonics Video Corporation (the "Company") was incorporated under the laws of the State of Colorado on August 14, 1985, for the purpose of developing, manufacturing and marketing a digital video recording and playback system. On January 20, 1988, the Company acquired all the outstanding stock of TS Industries, Inc. ("TSI") in a transaction accounted for as a pooling of interests. (See Note 2). TSI was incorporated in the State of Colorado on July 28, 1987, but did not commence operations until the acquisition of The Tyler-Shaw Corporation, a New York Corporation ("TSC"). TSI acquired TSC from Edward B. Rubin, its sole shareholder, under an agreement dated July 23, 1987 (the "Agreement") between Mr. Rubin, Equitex, Inc. ("Equitex") and TICO, Inc. ("TICO"). On November 1, 1987, Equitex and TICO assigned all their rights under the Agreement to TSI. Equitex and TICO each owned 50% of the issued and outstanding capital stock of TSI, prior to the exchange of TSI stock for the Company's stock. This acquisition was accounted for under the purchase method of accounting (See Note 2). TSC acted as a syndicator of consumer products through direct mail marketing programs. As of July 31, 1992, TSC was considered inactive and all relating assets were written off along with the reversal of its prior accruals. CompuSonics Video Corporation has no proven products or operations in the digital equipment area. At this time, Tyler Shaw is without any operations. In August, 1998, the Company hired a manager experienced in Internet programming to investigate the possibility of implementing a new business activity for the Company known as website development and maintenance. The rapid development of the Internet and its graphical element, the World Wide Web, has made the use of the Internet commonplace among many companies around the world. The Company's management concluded that significant opportunities existed in this emerging technology and developed a business model where the Company would seek programming contracts with related and outside companies to do this type of work on a consulting and project basis. The manager hired to do the business investigation was named the Director of Technology Development and the Company began its consulting work in the fourth calendar quarter of 1998, when the Company established its operations in Chicago and hired additional staff. The Company focuses its efforts on the development of commercial sites on the World Wide Web. The Company develops e-commerce applications, where a manufacturer or distributor would sell its products on the Internet, internal coordination sites called Intranets, that are used by employees of a company to communicate with each other and share information, and Extranets, used by companies to communicate and share information with outside groups such as suppliers and major customers. COMPUSONICS VIDEO CORPORATION & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 31, 1999 ------------- The technical management of the Company has significant experience in this type of work and has two current clients for these type of projects, while currently prospecting for additional business in this area. The ability of the Company to generate additional business is directly related to staffing levels of employees. As such, the Company expects to hire additional employees as the level of business grows. B. Consolidation The consolidated financial statements include the consolidated financial information of TSI since that entity's inception. This consolidated financial information of TSI includes the operations of its wholly owned subsidiary, TSC, since its acquisition on November 16, 1987. All significant inter company balances and transactions have been eliminated in consolidation. C. Patents Patent costs for the years ended July 31, 1991 and prior were amortized on the straight-line method over the estimated useful life of the patents of 17 years. Due to the lack of a marketable product, research and marketing development, and the lack of adequate capital to protect and take advantage of these patents, effective with the year ended July 31, 1992, all unamortized patent costs were fully amortized. All patent maintenance costs are expensed when incurred. Patents were issued on July 21, 1987 and July 5, 1988. During the year ended July 31, 1999 the cost to maintain these patents and record them in foreign countries was $7,156 which was recorded as patent fees expense. D. Income Taxes The Company and it's wholly owned subsidiaries file a consolidated federal income tax return. Due to the Company's net operating losses there is no provision for federal income taxes in these financial statements. Tax credits will be reflected in the income statement under the flow-through method as a deduction of income taxes in the year in which they are used. At July 31, 1999, the Company's carryforwards are as follows: Net General Year of Net Operating Loss Capital Business Expiration Book Tax Loss Credits ----------- ------------------- ------- --------- 2001 -0- -0- -0- 11,763 2002 302,543 306,786 -0- 18,390 2003 329,338 223,481 -0- -0- 2004 66,722 110,507 -0- -0- 2005 155,215 143,453 -0- -0- 2006 80,080 55,410 730 -0- 2007 236,002 228,734 -0- -0- 2008 84,714 99,931 22,500 -0- 2009 55,673 55,664 -0- -0- 2010 57,605 57,499 -0- -0- 2011 63,576 63,576 -0- -0- 2012 48,566 48,566 -0- -0- 2013 59,261 59,261 -0- -0- The primary difference between the book and tax net operating loss carryforwards result from differences in depreciation and amortization methods and the treatment of unrealized loss of market value of certain investments. E. Net Loss (Gain) Per Common Share The net loss (gain) per common share is computed by dividing the net loss (gain) for the period by the weighted average number of shares outstanding. All "cheap stock" issued prior to the public offering is included in the computation as if it were outstanding from inception. F. Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less cash equivalents. G. Equipment and Depreciation Equipment was stated at cost. Depreciation was computed for financial reporting purposes on a straight-line basis over an estimated life. Depreciation expense for the years ended July 31, 1999, 1998 and 1997 was $735, $0 and $0 respectively. COMPUSONICS VIDEO CORPORATION & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 31, 1999 ------------- Note 2. Marketable Securities During the years ended July 31, 1999 and 1998 the Company held common stock in Williams Controls, Inc. (Nasdaq "WMCO") in which a major shareholder and former officer/director of the Company is an officer. The stock had a cost of $25,035 and a fair market value at July 31, 1999 and 1998 of $88,984 and $80,086 respectively. In accordance with SFAS 115, the Company has classified the WMCO stock as an available-for-sale security and has reported it at its fair market value effective July 31, 1999. These securities are collateral for loans from a related party. Note 3. Notes Payable and Notes Receivable A. Related Entity Notes Payable Since the inception of the Company to October 1999, related companies have provided loans to meet the operating cash flow need. These notes are rewritten as the loan amount increases. Notes payable to related entities bear interest at 10 to 12 percent per annum, and are due and payable within 180 days or on demand and are dated as follows: July 31, ------------------- 1999 1998 ---- ---- June 21, 1988 (3) 12% 600 600 August 30, 1989 (3) 12% 6,500 6,500 January 14, 1993 (3) 10% 5,000 5,000 December 19, 1999 (1) 10.25% 381,217 227,157 September 11, 1999 (2) 10.25% 159,123 159,123 (1) Owed to Acrodyne Corporation ("Acrodyne"). Collateralized by al lassets of CompuSonics Video Corporation. (2) Owed to Acrodyne. Collateralized by all of the assets of Tyler-Shaw. (3) Owed to Acrodyne, unsecured, and transferred from Equitex, Inc. (see note 8). B. Non - Related Entity Notes Payable July 31, -------------------- 1999 1998 ---- ---- October 20, 1999 (1) 10.50% 20,100 20,100 COMPUSONICS VIDEO CORPORATION & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 31, 1999 ------------- (1) Owed to First Equity Corporation. Collaterized by all assets of CompuSonics Video Corporation. C. Notes Receivable - Related On June 22, 1999, the Company loaned $150,000 to Pro Golf International, Inc. ("PGI"), a subsidiary of Ajay Sports, Inc. The Company received a promissory note that is subordinated to PGI's primary lender. The unpaid principal balance will bear an interest rate of 10% and will be due and payable in full on July 22, 2000. The Company has made a proposal to PGI to do website development and maintenance work for PGI and its related companies. Note 4. Stockholders' Equity A. Preferred Stock Under the Company's Certificate of Incorporation, up to 75,000,000 shares of preferred stock, with classes and terms as designated by the Company, may be issued and outstanding at any point in time. The Company had 300,000 authorized shares of Series A Convertible Preferred Stock ($.001 par value) outstanding at July 31, 1988. In September 1988, all the outstanding shares were converted at $.001 per share, at the holder's option, into 30,000,000 shares of common stock. B. Public Offering of Common Stock In December 1985 the Company completed a public offering of 30,000,000 units, each consisting of one share of the Company's common stock, $.001 par value, and one Class A purchase warrant. One Class A warrant entitles the holder to purchase one share of common stock plus a Class B warrant for $.05 during the twelve month period originally ending November 27, 1986 and currently extended to May 15, 2000. The Company may redeem the Class A warrants at $.001 per warrant if certain conditions are met. One Class B warrant entitles the holder to purchase one share of the Company's common stock for $.08 per share for a twelve-month period originally ended November 27, 1987 and currently extended to May 15, 2000. The offering was made pursuant to an underwriting agreement whereby the units were sold by the Underwriter on a "best efforts, all or none" basis at a price of $.03 per unit. The Underwriter received a commission of $.003 per unit and a nonaccountable expense allowance of $27,000. The public offering was successfully completed on December 13, 1985 and the Company received $727,971 as the net offering proceeds for the 30,000,000 units sold. As of July 31, 1999, 6,250 Class A warrants have been exercised for total proceeds of $313. COMPUSONICS VIDEO CORPORATION & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 31, 1999 ------------- Also pursuant to the underwriting agreement, the Company sold to the Underwriter, for $100, warrants to purchase 3,000,000 shares of the Company's common stock at a price of $.036 per share. These warrants were exercisable for a period of four years beginning December 13, 1986. These warrants were not exercised and have expired. C. Incentive Stock Option Plan On October 4, 1985, the Company's board of directors authorized an Incentive Stock Option Plan covering up to 7,000,000 shares of the Company's common stock for key employees. The board of directors is authorized to determine the exercise price, the time period, the number of shares subject to the option and the identity of those receiving the options. Note 5. Related Party Transactions The Company currently occupies office space, at no charge, in the office of Acrodyne, a related entity. TSC also utilizes space in a related entity at no charge for the purposes of accounting and administration. The Company believes its current facilities are sufficient for its presently intended business activity. The accounts payable, as of July 31, 1999 and 1998, include management fees owed to Acrodyne of $500 and $600 respectively (see note 6(b)). The Company also has an unsecured advance payable, to Acrodyne of $26,016 as of July 31, 1999. This payable was transferred from Equitex, Inc. to Acrodyne Corporation in August, 1993 (see note 8). The accrued interest payable at July 31, 1999 and 1998 to Acrodyne was $281,226 and $238,202 respectively. See Note 3, herein, regarding loans made to the Company by a related entity. The Company currently has consulting agreements with two affiliated companies to do website development and maintenance consulting work. They are Williams Controls, Inc. ("Williams") and Ajay Sports, Inc. ("Ajay"). The work product includes redesigns of the companies websites, the development of intranet products, and ongoing maintenance of the sites as new features are added. During the years ended July 31, 1999 and 1998 the Company held common stock in a company in which the Company's major shareholder and former officer/director (see Note 7) is an officer and director (see Note 2). In August 1990 the Company entered into a management fee agreement with the related entity, at the time, whereby the Company will pay direct labor cost plus overhead for management services rendered. Management fees expense totaled $4,150, $1,200, and $1,200 for the years ended July 31, 1999, 1998, and 1997. Note 6. Cash Flows Disclosure Interest and income taxes paid for the years ended July 31, 1999, 1998 and 1997 were as follows: 1999 1998 1997 -------- --------- --------- Income Taxes $ -0- $ -0- $ -0- ========= ======== ========= Interest $ -0- $ -0- $ -0- ========= ======== ========= Note 7. Transfer of Interest On August 19, 1993, Equitex transferred all its interest in the Company including stocks, notes and accounts receivable to Thomas W. Itin or his assigns. Mr. Itin is the former President and Chairman of the Board of the Company. Thomas W. Itin is Chairman of the Board and President of Acrodyne and WMCO. Note 8. Change in Control Effective November 10, 1993, the President and Chairman of the Board of Directors of the Company resigned due to commitments to other companies in which he is an officer and director. Robert R. Hebard was elected as director and chairman of the board and president. Mr. Hebard is assistant secretary of an investee, WMCO. Note 9. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates. Note 10. Other Subsequent Events On August 27, 1999, the Registrant filed a Form 8-K regarding the Registrant's engagement with the accounting firm of J.L. Stephan Co., P.C. to act as its independent accounting firm, to replace Hirsch Silberstein & Subelsky, P.C. The decision by Hirsch Silberstein & Subelsky, P.C. to resign was a result of one of its members, Ronald N. Silberstein, leaving the firm to become Ajay Sports, Inc.'s Chief Financial Officer and Chief Administrative Officer. Following Mr. Silberstein's departure, the Registrant was advised that the firm will concentrate its practice of providing accounting related services to individuals and privately held businesses. COMPUSONICS VIDEO CORPORATION & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 31, 1999 ------------- Note 11. Concentration of Risk The Company provides internet consulting services to other businesses. Substantially all consulting revenue for the year ended July 31, 1999 was from two businesses, both of whom are related parties. Note 12. Contingencies The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the financial statements, the Company has prior years' net losses of $59,261 and $48,566 for the years ended July 31, 1998 and 1997, respectively, and as of July 31, 1999 had a working capital deficiency of $627,070 and net stockholders' deficiency of $620,684. The Company earned commission income of $212,210, $0, and $0 during the years ended July 31, 1999, 1998 and 1997 and was mainly dependent upon a related party to fund its working capital prior to the current year. Management adopted a plan in August 1998 to provide contractual internet consulting services. The Company's ability to continue as a going concern is partially dependent on the retention of these consulting contracts. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

898306_1999.txt

898306_1999

1999

898306

ITEM 1 -- BUSINESS GENERAL Except as expressly indicated or unless context otherwise requires, as used in this report, the "Company" means Safety 1st, Inc., a Massachusetts corporation organized in March, 1984, and its subsidiaries. All references to fiscal 1998, 1997, and 1996 refer to the years ended January 2, 1999, January 3, 1998, and December 31, 1996, respectively. Safety 1st, Inc. (the "Company") is a leading developer, marketer and distributor of juvenile products. The Company believes that it has increased consumer awareness of child safety issues and that its flagship brand name, Safety 1st(R), is closely associated with child safety among consumers. The Company's first products, the original yellow and black, diamond shaped Baby on Board and Child on Board automobile window displays, provided the Company with national attention and distribution for its juvenile products. The Company has continually broadened its line of safety products from basic items, such as outlet plugs and drawer and cabinet locks, to safety gates, bed rails and balcony guards. The Company believes that it is currently the leading supplier of child safety products in the United States. By capitalizing on the strength of its Safety 1st brand name, the Company has expanded its product offerings into related categories. In 1987, the Company began its successful expansion into the child care, convenience and activity product categories, and now sells items such as baby monitors, walker alternatives, activity gyms, bath seats, toddler cups, pacifiers, teethers, gates, potty trainers, booster seats, infant health care items, bath accessories, feeding products and travel accessories. In late 1993, the Company introduced a new line of home security products, which includes locks, bolts and latches for doors, windows and cabinets. The Company believes that sales within the juvenile products industry increased over the past several years because of the introduction of new products and the increased marketing efforts of juvenile product manufacturers combined with favorable demographic trends. Between 1989 and 1996 the Company experienced significant growth with net sales increasing from $7.7 million to $105.8 million. In 1996, the Company faced significant financial and operational challenges and recorded a net loss of $44.8 million. The Company recognized that its product offerings had exceeded a manageable level and included products outside of its core competency. This, combined with the continual expansion of the customer base, had led to additional complexity in all operational aspects of the business, as well as a significant increase in general and administrative expenses, and an increase in the Company's working capital requirements. As a result, the Company evaluated its business strategy and took the first steps to refocus its business on its traditional core product lines, trade channels and customer base. An extensive analysis of each product was conducted based on various criteria including certain sales, quality, inventory turn, margin contribution and profitability objectives. The analysis indicated that approximately 350 of the Company's 650 products did not meet these criteria, and a strategic decision was made to eliminate these products from the line. In addition, the Company took decisive steps to further simplify operations with the reduction of package assortment options available to a retailer for a given product, and decreasing the number of stock keeping units (SKUs) from 2,300 to 600 at the end of 1996. During 1997 and 1998, the Company began to experience the positive effects of the initiatives undertaken in 1996. With a much sharper focus, simplified business practices, and a significantly reduced product line, the Company rebuilt its operational structure and placed stronger emphasis on improved fiscal management. The Company currently distributes approximately 375 products to approximately 2,000 customers, the largest among them being Wal-Mart, Toys-R-Us, and Kmart. In 1998, point of sale data compiled by an independent tracking firm, The NPD Group, Inc., indicated the Company had gained or maintained leadership positions in virtually all of its core product categories, including child safety products, infant health products, potty seats, booster seats, bath tubs, bath accessories, nursery monitors, alternative walkers, bath seats, and bed rails. The Company maintains its belief that continued development of new, innovative, high quality products which meet the Company's new profitability standards, combined with strong brand name recognition and commitment to customer service, will continue to enhance its image as a leader in the juvenile products market and facilitate its continued growth in its core product categories. JUVENILE MARKET OVERVIEW The juvenile products industry has experienced significant growth in retail sales over the past decade. The Company believes this growth is the result of marketing-driven expansion coupled with favorable demographic trends. In addition to child safety, childcare, convenience and activity products, the juvenile products industry includes baby apparel, such as sleepware and bibs, and furniture, such as cribs and juvenile bedding items. The Company believes that the juvenile products industry will continue to grow and intends to continue capitalizing on the strength of its Safety 1st brand name through new product introductions. Despite a slight decrease in the annual birth rate in recent years, sales in the juvenile industry increased from approximately $1.5 billion in 1985 to approximately $4.4 billion in 1997. The Company believes there are several demographic factors contributing to this growth. According to industry statistics, for example, first time parents are the largest group of purchasers of juvenile products, and have accounted for approximately 40% of total births over the past few years. The Company believes that today's first time parents are generally more aware of and place a greater emphasis on child safety. Studies also indicate that couples are marrying later in life, have higher disposable income per family due to more dual income households, and consequently, are more willing to spend money on their children. BUSINESS STRATEGY Corporate Objectives. The Company's overall objectives are to enhance its reputation as a leading supplier of juvenile products while broadening its product offerings; to increase sales to existing customers; and to expand its customer base domestically and internationally, consistent with a managed growth philosophy and more stringent profitability objectives. Creation of New and Innovative Products. A key to the Company's success is its ability to develop and market high quality new products with innovative features at competitive prices that meet the Company's profitability criteria. In addition to creating new products, the Company has and intends to enter into additional licensing agreements enabling the Company to use well-known trademarks on several lines of its juvenile products. In 1997, the Company also began leveraging its own brand by licensing the "Safety 1st" name to a line of baby strollers which are distributed by Delta Enterprises. The Company intends on licensing the Safety 1st brand name only within categories that the Company does not plan on entering, and will only align itself with non-competing manufacturers that share the same high quality standards and innovative style. Management believes that product innovations developed by the Company, and if applicable by non-competing manufacturers, will continue to enhance the marketability of its products, as well as its status as an industry leader. Expansion of Markets and Customer Base. The Company has continually expanded its child safety product line while also developing child care, convenience and activity products. This expansion has enabled the Company to broaden its customer base, from mass merchants and specialty retailers, to strategic food and drug chains, hardware and home center chains, catalog showrooms, warehouse clubs and mail order catalogs. The expansion of the Company's product line has also enabled it to increase the retail space allocated to its products by its customers. The key elements of its product and marketing strategy include producing supplemental product categories that complement the capacity of the existing line; enhance category assortments with "good, better, best" product offerings; develop products on a global basis; and meet world-wide standards. International Expansion. The Company continues to successfully increase its market base through expanding international channels of distribution. The Company sells products in over 60 countries worldwide either directly to house accounts, through distributorships or through its two foreign subsidiaries. In January, 1996, the Company completed the acquisition of EEZI Group Holdings Ltd., a privately owned distributor of child care products located in England, (now the Company's wholly-owned subsidiary, Safety 1st (Europe) Ltd. ("Safety 1st Europe"). In February, 1996, the Company purchased Orleans Juvenile Products, Inc., a privately owned Canadian corporation that was the Canadian distributor of Safety 1st products, now the Company's wholly-owned subsidiary operating under the name Safety 1st Home Products Canada, Inc. ("Safety 1st Canada"). Brand Name Recognition. The Company's strong brand name recognition is a competitive advantage that has facilitated its expansion into new markets. The Company believes that it was the first marketer of child safety products to use four-color photography as part of its product packaging for blister cards. Management believes that the Company's blue and yellow graphic packaging, and photography depicting actual use of the product, has contributed to strong brand awareness at the consumer level, stimulated juvenile product market growth and product sales, and enhanced the perception of the Company as a juvenile products industry innovator and leader. Commitment to Serving Customer Needs. The Company is committed to responding quickly and efficiently to its customers' needs. The Company utilizes an electronic data interchange system, which permits customers to place orders directly through computerized telecommunications. Management has instilled at every level of its staff the philosophy that satisfying the needs of the customer is critical to the continued success of the Company. PRODUCTS The Company develops and markets high quality, competitively priced child safety and child care, convenience and activity products that are characterized by innovative features and colorful designs. The Company's broad line of juvenile products are designed to enhance the safety of, or to be used by, newborns to children five years of age. Initially, the Company was a vendor of small products packaged in blister packs (i.e., transparent plastic). Because of their small size, large quantities of blister pack products are usually stocked by retailers in peg board shelving areas. Beginning in 1990, the Company continued the expansion of its product line by introducing bulk products (i.e., larger products requiring packaging in boxes), such as the swivel bath seat and the potty seat. Because of their size and packaging, bulk products require significantly greater shelf space for marketing by retailers. The Company strives to create a range of product price points for its product categories. For many peg and bulk product categories the Company enters, it develops an innovative assortment of products to offer its customers a choice of different features and price points. The following table sets forth the amounts and percentages of the Company's net sales for the three years ended (dollars in thousands): JUVENILE PRODUCTS Child Safety Products The Company's safety-related products consist of a broad line of items designed to enhance the safety of children at home and while traveling. The Company's first products, introduced in 1984, were the original yellow and black, diamond shaped Baby on Board and Child on Board automobile window displays. Although a limited number of child safety items, such as outlet plugs, cabinet latches and wooden security gates, existed prior to 1984, there was no developed child safety category within the juvenile market. The introduction of the child and baby automobile display signs helped develop consumer awareness of the need for child safety and stimulated the significant growth of the child safety product market to the point where the concept of "child proofing" one's home or surroundings is a concept recognized by parents today. The Company markets an extensive line of home safety products, including kitchen safety items, such as drawer and cabinet latches, stove knob covers, stove guards, and oven and refrigerator door locks; electricity-related safety items, such as outlet plugs and switch locks; bathroom safety items, such as toilet lid locks, inflatable bathtub spout and knob covers and toilet seat covers; and other home safety items, such as balcony guards, window locks and door stops. The Company also markets a broad line of travel related safety items, including sun-screens for automobiles, safety harnesses, stroller weather shields, back seat baby mirrors and car seat neck supporters. In addition, the Company packages and sells multiple home and travel safety items in kits. According to an independent tracking study provided by The NPD Group, the Company currently holds over 50% market share in the child safety category of the juvenile industry. Child Care, Convenience and Activity Products In 1987, the Company decided to build on its success in the child safety products market and expanded into the development and marketing of child care, convenience and activity products. The Company has since added feeding and drinking related items, including nurser bottles, juice cups, spill proof travel cups, and its Sip 'N Go(R) juice box holders; and general convenience accessories, including car and toy bags, pacifier holders, bath tubs and cushions for newborns, swivel bath seats for older infants, high chair mats, booster seats, and bathroom accessories such as bathtub toys and potty seats. The Company's activity products include electronic toys, walker alternatives, traditional walkers and a musical baby gym. The Company's health and hygiene products include baby thermometers, fever pacifiers (with temperature indicator), a small object tester, medicine droppers and spoons and baby nail clippers. NEW PRODUCT INTRODUCTIONS Juvenile Products The Company began shipping approximately 54 new juvenile products for sale in 1998, including the Four Wheelin' Walker, and an assortment of additional safety, feeding/teething, healthcare, playtime and bath accessories. Certain of these new products are either patented or have a patent pending. In the fall of 1998, in keeping with the new managed growth philosophy, the Company introduced additional new juvenile products for sale in 1999. This new assortment includes several bouncers, an ear thermometer, and the Bouncing Buggy upgrade, in addition to new items in the booster, potty, monitor, and feeding categories. The Company currently markets products utilizing the Baby Looney Tunes trademarks under its license agreement with Warner Brothers, and has developed 19 new products utilizing characters including baby Bugs Bunny for sales in 1998. PRODUCT DESIGN AND DEVELOPMENT During the past several years, the Company has introduced the following quantities of new products: Almost all of the Company's juvenile products are conceived and developed by the Company's internal product development group, which is comprised of the marketing, research and development, and engineering departments. The goal of this team approach is to create new and improved products and develop useful innovations to products currently on the market. Once the marketing department researches a category and identifies a market trend, or recognizes an opportunity to add innovation to a particular market segment, it completes competitive analysis. Product ideas are then developed, rough sketches are produced by the research and development department, and management determines the appropriate price point for that product. The decision to introduce a product is made only after analysis and determination by the Company's management that a high quality product can be engineered and produced on a cost effective basis while meeting established return on investment objectives. The Company utilizes a sophisticated Computer Aided Design ("CAD") system in its engineering process. The Company believes this is a valuable resource not widely used in the juvenile industry. The technology enables the Company to produce one of a kind "proving models" prior to cutting steel on expensive molds. These models are functioning samples, and unlike standard prototypes, provide the product design engineers with the opportunity to test the integrity of the product and make necessary adjustments before full production, substantially decreasing lead time and reducing product time to market. Prototype samples are also used to establish packaging parameters early in the development cycle and used as sales samples. Final engineering specifications are prepared and sent to third party manufacturers where molds are built for final production. Substantially all of the Company's new juvenile products are introduced at the Juvenile Products Manufacturer's Association trade show in the fall. New products are generally available for sale during the first quarter of the following year. SALES AND MARKETING During 1998, the Company sold its products to approximately 2,000 customers worldwide. The Company's largest customers are mass merchants, such as Wal-Mart, Toys-R-Us and Kmart. The Company also sells to food and drug chains, such as Rite Aid and CVS; hardware and home center chains, such as Home Depot and Lowes; warehouse clubs including BJ's; mail order catalogs such as Perfectly Safe; and specialty retailers. For the fiscal year ending January 2, 1999, approximately 23.7%, 22.0%, and 6.4% of the Company's net sales were to three customers. No other customer of the Company accounted for more than 5% of the Company's net sales during fiscal 1998. The Company's products are sold in the United States through the Company's internal sales staff and a network of approximately 50 independent sales organizations paid on a commission basis. Independent sales representatives are supervised by the Company's sales staff. The Company is responsible for training the sales representatives and updating them with respect to new products, special promotions and merchandising displays. The Company's internal sales staff is also responsible for monitoring customer satisfaction and is involved in every phase of the selling process with major customers. The Company's employees and its independent sales representatives attend numerous trade shows to further its marketing efforts. The Company exports its juvenile products to approximately 60 countries worldwide, including Canada, the United Kingdom, France and Australia. Foreign sales were approximately $23.5 million, for the year ended January 2, 1999, accounting for 19.5% of net sales. The acquisition of Safety 1st Europe is helping to increase the Company's presence in the European market. In 1996, Safety 1st Europe began a private label program with MotherCare, one of the largest retailers in the U.K. The program includes nine products that the Company produces for MotherCare and packages under the MotherCare brand name. The private label program is in addition to the products MotherCare purchases from the Company under the Safety 1st brand name. In 1997, the Company also established a distributor in France who is managing the new business relationship with Carrefour, one of the leading hyper-markets in France. In conjunction with its new distributors in Europe, the Company has discontinued the use of the public warehouse facilities in Rotterdam. The Company believes that its colorful and graphic packaging has significantly contributed to strong brand awareness among consumers. In 1995, the Company developed a new contemporary look for its bulk packaging. The successful response of the new bulk packaging prompted the Company in 1996 to incorporate the new design in its entire juvenile line for 1997. The new look incorporates the success of the Company's blue and yellow trademark with four color graphics, and adds a more contemporary style with multi-language text to give the products a broader reach to the customer. In 1997, the Company developed seven-language packaging to further improve efficiencies for international customers while giving the brand a more cohesive look for the global marketplace. The Company continually focuses its efforts on increasing public awareness of the importance of child safety. The Company sponsors child safety awareness programs and other community events that support its commitment to children issues. In addition, the Company advertises its juvenile product line in trade magazines, such as Juvenile Merchandising and Small World, and in selected consumer publications such as American Baby and Child Magazine. SOURCES OF SUPPLY Manufacturing is performed to the Company's specifications by manufacturers located in the United States, China, Taiwan, Thailand, Korea, Japan, Mexico, and the United Kingdom. In 1998, the Company derived approximately 58% of its sales from products manufactured in the Far East, mainly in China and Taiwan. Because of substantially higher costs in shipping larger products, the Company sources a greater percentage of its bulk products in the United States rather than in the Far East. Neither the Company nor any of its subsidiaries owns or operates its own manufacturing facilities. Company employees regularly visit suppliers to supervise the manufacture of products and to ensure timely delivery and compliance with the Company's manufacturing specifications. The Company engages independent testing laboratories in the United States and in the Far East to perform quality control tests of products prior to shipment. Except for certain purchases by Safety 1st Europe, all purchases by the Company are in U.S. dollars. The Company's suppliers generally ship goods on the basis of open credit terms or payment upon the acceptance of goods by the Company. To a lesser extent, some suppliers require shipment against letters of credit. Goods produced in the Far East are generally transported to the United States by ship and then transported by rail to the Company's warehouse facilities or in certain instances are shipped directly to foreign and United States customers. Goods produced domestically are typically shipped to the Company's warehouse facilities, although on occasion, domestically produced goods are transported directly to customers. Prior to shipment, the Company has products tested for quality at the supplier's factory or at independent local laboratories. Upon delivery of goods to the Company's warehouse and distribution facilities, the Company conducts quality control tests on a spot basis. The Company bears the risk of loss while the goods are in transit from its suppliers, but, in the opinion of Company management, the Company carries adequate insurance to protect it from this risk. During 1998, the Company purchased approximately 18.0%, 16.1%, 9.0%, 6.4%, 5.2%, and 4.6% respectively, of its products from six manufacturers located in the United States and China. The Company is not a party to any long-term contractual arrangements with any specific manufacturer and often uses more than one manufacturer to produce a single product with duplicate molds. The Company currently owns substantially all tools and molds used by its suppliers to produce its products. Foreign manufacturing is subject to a number of risks, including transportation delays and interruptions, political and economic disruptions, the imposition of tariffs, quotas and other import or export controls, currency fluctuations and changes in governmental policies. From time to time, the United States Congress has attempted to impose additional restrictions on trade with China. Enactment of legislation or the imposition of restrictive regulations conditioning or revoking China's "most favored nation" ("MFN") trading status or other trade sanctions could have a material adverse effect upon the Company's business because products originating from China could be subjected to substantially higher rates of duty. Due to continuing uncertainties over China's MFN status, the Company continues to explore alternative manufacturing sources located outside of China. Because the Company relies on foreign manufacturers, the Company is required to order products further in advance of customer orders than would generally be the case if such products were manufactured domestically. The principal raw materials and supplies used in the production and sale of the Company's juvenile products are plastics, paper products and electronic components. Raw materials are purchased by the manufacturers who deliver completed products to the Company. The Company believes that an adequate supply of the raw materials and supplies used in the manufacture of its products is readily available from existing and alternative sources and at reasonable prices. DISTRIBUTION U.S. product distribution is centralized at the Company's warehouse facility located in North Londonderry, New Hampshire. Safety 1st Canada leases a distribution facility in Montreal, Canada and Safety 1st Europe leases a warehouse facility in England, which is used to service customers primarily located in the United Kingdom. Product is shipped to these locations direct from the Far East, direct from U.S. suppliers and, when necessary, from the Londonderry warehouse facility for distribution throughout Canada and Europe. Upon arrival at the New Hampshire, Montreal, or United Kingdom distribution facilities, the goods are inspected, spot tested for quality, stocked and, if necessary, repackaged for reshipment to the Company's customers. The goods are delivered to the Company's customers by independent shippers or customer carriers. The Company maintains sufficient inventory to enable it to meet customer requirements and minimize out of stock occurrences. As an additional service to its customers, the Company frequently pre-tickets and bar codes its products in accordance with customer specifications. BACKLOG A significant portion of the Company's orders are short-term purchase orders from customers that place orders on an as-needed basis. The amount of unfilled orders at any time has not been indicative of future sales. As a result, the Company does not believe that the amount of its unfilled customer orders at any time is meaningful. COMPETITION The juvenile products industry is highly competitive and includes numerous domestic and foreign competitors, some of which are substantially larger and have greater financial and other resources than the Company. The Company competes on the basis of product innovations, brand name recognition, price, quality, customer service and breadth of product line. TRADEMARKS AND PATENTS The Company owns the registered trademark "Safety 1st", which is its primary trademark. The Company believes that consumer recognition of such trademark has contributed to the Company's success. The Company uses a number of additional trademarks, some of which are registered with the United States Patent and Trademark office and in other nations in which it sells its products. A significant number of products incorporate patented devices or designs. The Company aggressively protects its patent and trademark rights. GOVERNMENT REGULATION In the United States, the Company is subject to the provisions of, among other laws, the Federal Consumer Product Safety Act and the Federal Hazardous Substance Act (the "Acts"), which empower the Consumer Product Safety Commission (the "CPSC") to require the repair, replacement or refund of the purchase price of products that present a substantial risk of injury to the public, and in the event the CPSC finds that no feasible consumer product safety standard under the Acts would adequately protect the public, to order such product banned. The CPSC may also issue civil and criminal penalties for knowing violations of the Acts. Any such determination by the CPSC is subject to court review. The Company is also subject to regulations of the Federal Communications Commission (the "FCC") in connection with its audio and video monitors. The Company maintains a quality control program with its manufacturers and engages special legal counsel to facilitate compliance with applicable product safety laws and the regulations of the CPSC and FCC. Similar laws exist in some states and cities in the United States and in many jurisdictions throughout the world, and may affect the ability of the Company to market its products in such jurisdictions. The Company believes that it is in material compliance with all applicable federal and state laws and regulations. EMPLOYEES As of February 27, 1999, the Company had a total of 315 full-time employees, of which 264 were based in the United States, 25 were based in Canada, and 26 were based in the United Kingdom. Of the Company's 315 full-time employees, 6 were employed in executive capacities, 62 in sales, marketing, and product development, 202 in distribution and operations, and 45 in financial, administrative, and clerical capacities. The Company utilizes a temporary labor force to a large degree to assist in the operation of its North Londonderry, New Hampshire warehouse facility. None of the Company's employees are represented by a labor union, and the Company considers its employee relations to be satisfactory. ITEM 2 ITEM 2 -- PROPERTIES The Company's principal executive offices are located in Chestnut Hill, Massachusetts, where the Company occupies approximately 30,000 square feet of space as a tenant at will, since the expiration of its lease on December 31, 1996. The current annual rent is approximately $590,000 per year. The Company maintains warehouse and distribution facilities in leased premises located in North Londonderry, New Hampshire, containing approximately 240,000 square feet of warehouse and distribution space. The facility is leased pursuant to a lease for a ten-year term expiring January 2005, at an annual rent of approximately $845,000 per year plus real estate taxes and other operating costs. The Company has an option to extend this lease for an additional ten-year period at an annual rent of $1,095,000 per year. The Company also has the right to terminate the lease prior to expiration by giving six months prior notice and, in the case of a termination during the initial ten-year term, by making a termination payment. The Company occupies a 50,000 square foot sales office and warehouse facility in Montreal, Canada, a sales and administrative office in England, and a 28,000 square foot warehouse facility in Norfolk, England. The Company also maintains a show room in Bentonville, Arkansas. The Company believes that its leased properties are in good condition and adequate for its needs. ITEM 3 ITEM 3 -- LEGAL PROCEEDINGS On September 8, 1997, Tele Electronics (Taiwan) Co., Ltd. ("Tele Electronics") filed a lawsuit in Middlesex Superior Court in Massachusetts against the Company alleging breach of contract arising out of two purchase orders. The suit seeks monetary damages for the alleged breach of contract in the amount of $3.45 million and also alleges unfair and deceptive business practices and seeks, under this theory, an award equal to three times the alleged contractual damages. Tele Electronics also sought preliminary injunctive relief which, after a hearing, the Court denied. The Company denies the allegations of the lawsuit, believes it has meritorious defenses, is defending the matter vigorously and has also filed a counterclaim against Tele Electronics for damages caused by various acts and omissions of Tele Electronics, relating to prior purchase orders. The Company's counterclaim seeks monetary damages totaling approximately $1.3 million. The Company encounters personal injury litigation related to its products and other litigation in the ordinary course of business. With respect to the matters discussed above, the Company maintains product liability and other insurance in amounts deemed adequate by management. The Company believes that there are no claims or litigation pending, the outcome of which could have a material adverse effect on the Company's operations or financial condition. ITEM 4 ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS No matters were submitted to a vote of the Company's security-holders during the last quarter for the year ended January 2, 1999. PART II ITEM 5 ITEM 5 -- MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock is quoted on The Nasdaq Stock Market's National Market (the "Nasdaq National Market") under the symbol "SAFT". The following table sets forth the high and low bids for the Common Stock for the periods indicated as reported by the Nasdaq National Market. On March 15, 1999, the last reported sales price as quoted on the Nasdaq National Market was $3.125 per share. As of March 15, 1999, the Company's Common Stock was held by approximately 2,300 stockholders of record or through nominees or street name accounts with brokers. The Company is currently prohibited from declaring or paying any cash dividends based on the covenants of its credit facility and the terms of its outstanding Preferred Stock. Therefore, the Company does not anticipate declaring or paying any cash dividends or other distributions on its Common Stock in the foreseeable future. The declaration of and payment of any cash dividends in the future will depend upon the Company's compliance with the terms of the credit facility, earnings, financial condition, capital needs, and on other factors deemed relevant by the Board of Directors. ITEM 6 ITEM 6 -- SELECTED FINANCIAL DATA The following selected financial data as of and for the three annual fiscal periods ended January 2, 1999, have been derived from the Company's financial statements appearing elsewhere in this report which have been audited by Grant Thornton LLP, independent certified public accountants. The selected financial data for the years ended December 31, 1995 and 1994, is derived from the Company's financial statements, which have been audited by Grant Thornton LLP, independent certified public accountants. The selected financial data should be read in conjunction with the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report (dollars in thousands, except per share amounts). - ---------- ITEM 7 ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Statement of Forward-Looking Information: The Company may occasionally make forward-looking statements and estimates, such as forecasts and projections of the Company's future performance or statements of management's plans and objectives. These forward-looking statements may be contained in SEC filings, Annual Reports to Shareholders, Press Releases and oral statements, among others, made by the Company. Actual results could differ materially from those in such forward-looking statements. Therefore, no assurances can be given that the results in such forward-looking statements will be achieved. Important factors that could cause the Company's actual results to differ from those contained in such forward-looking statements include, among others, those factors set forth in Exhibit 99 to this report. OVERVIEW The Company believes that its sales growth has resulted primarily from the successful introduction of new products, the expansion of its customer base and increased sales to its existing customers. In 1987, the Company expanded its product line from child safety products to include child care, convenience and activity items. Some of the products that the Company in recent years added are bulk items (i.e., larger products requiring packaging in boxes) that have significantly higher unit prices but provide lower gross margins than the Company's other products, which are generally smaller products packaged in blister packs (i.e. transparent plastic). In 1994, the Company introduced a line of home security products. Between 1989 and 1996, the Company experienced significant growth, with net sales increasing from $7.7 million to $105.8 million. In 1996, the Company faced significant financial and operational challenges and recorded a net loss of $44.8 million. The Company recognized that its product offerings had exceeded a manageable level and included products outside of its core competency. This, combined with the continual expansion of the customer base, had led to additional complexity in all operational aspects of the business, as well as a significant increase in general and administrative expenses, and an increase in the Company's working capital requirements. As a result, the Company evaluated its business strategy and took the first steps to refocus its business on its traditional core product lines, trade channels and customer base. An extensive analysis of each product was conducted based on revised performance requirements of certain sales, quality, inventory turn, margin contribution and profitability objectives. The analysis indicated that approximately 350 of the Company's 650 products did not meet these criteria, and a strategic decision was made to eliminate these products from the line. In addition, the Company took decisive steps to further simplify operations with the reduction of package assortment options available to a retailer for a given product, decreasing the number of stock keeping units (SKUs) from 2,300 to 600 at the end of 1996. During 1997 and 1998, the Company began to experience the positive effects of the initiatives undertaken in 1996. With a sharper focus, simplified business practices, and a significantly reduced product line, the Company rebuilt its operational structure and placed stronger emphasis on improved fiscal management. RESULTS OF OPERATIONS The following table sets forth, for the fiscal years indicated, certain financial data (dollars in thousands): Fiscal Year Ended January 2, 1999 Compared to fiscal Year Ended January 3, 1998 Net sales for the year ended January 2, 1999 were $121,280,000, an increase of $16,302,000 from net sales of $104,978,000 for the year ended January 3, 1998. Juvenile sales comprised 98.6% of the net sales for the year ended January 2, 1999, and home security sales made up the balance. Gross profit increased to $46,269,000, or 38.2% of net sales for the year ended January 2, 1999 from $42,384,000, or 40.4% of net sales for the year ended January 3, 1998. Gross profit percentage was impacted by the following factors; (i) devaluation of the Canadian dollar, which increased cost of goods sold for the Canadian subsidiary because all inventory purchases are made in the U.S. dollars; (ii) unusually high number of product returns due to the Company's toy replacement program for the Bounce N' Ride Buggy product, and (iii) higher mix of bulk products sold, which generally carry a lower gross margin than peg products. Selling, general, and administrative expenses increased by $5,634,000 to $40,057,000 or 33.0% of net sales for the year ended January 2, 1999. The increase is primarily attributed to an increase in selling related expenses caused by the sales increase as well as an increase in payroll and payroll related costs. In the fourth quarter of 1998, the Company recorded special charges of $2,069,000. Approximately $1,100,000 of the charge relates to the Company's elimination of the chemical diisononyl phthalate ("phthalates") from all of its products which are intended for the mouth, including pacifiers and teethers. This action was taken in response to a public announcement issued by the Consumer Products Safety Commission which stated that, although there is no substantial evidence that the use of phthalates is a health hazard, consumers may want to avoid giving mouthable products that include phthalates to children under three years of age. The Company has discontinued the use of phthalates in the manufacture of its mouthable products and anticipates that these products will be available in phthalate-free versions during the first half of 1999. The remaining $969,000 of the special charges relates to several one-time items that occurred in the fourth quarter, including the resolution of two legal matters which had previously been in dispute, as well as severance costs. As a result of the above factors, operating income for the year ended January 2, 1999 was $4,143,000 or 3.4% of net sales, a decrease of $3,231,000 from $7,374,000, or 7.0% of net sales, for the year ended January 3, 1998. Operating income for the year ended January 2, 1999 excluding the special charges was $6,212,000 or 5.1% of net sales, a decrease from the comparable period in 1998. Net interest expense for the year ended January 2, 1999 was $4,054,000 versus $4,117,000 for the year ended January 3, 1998. During 1997, the Company refinanced its existing credit facility-refer to the "Liquidity and Capital Resources" section below. Net loss available for common shareholders for the year ended January 2, 1999 was ($1,011,000) or ($0.14) per share on a diluted basis, including a tax benefit of $1,105,000 related to a change in valuation of net deferred tax assets. Realization of the $11,115,000 net deferred tax assets is dependent on the Company's ability to generate approximately $32,000,000 in taxable income during the carryforward period. Management believes it is more likely than not that the asset will be realized based upon the strategic initiatives undertaken in 1996 to simplify operations by reducing the number of SKU's, discontinuing products that did not meet certain sales, quality, and profitability criteria and to tighten expense control. During 1997 and 1998, the Company began to experience the positive effects of these initiatives and expects to continue to benefit in future years. However, there can be no assurances that the Company will meet its expectations of future income. As a result, the amount of the deferred tax assets considered realizable could be reduced in the near and long-term if estimates of future income are reduced. Such an occurrence could materially adversely affect the Company's financial position and results of operations. The Company will continue to evaluate the realizability of the net deferred tax assets quarterly. In addition, in the year ended January 3, 1998, the Company recorded accretion of $6,472,000 representing the excess of the redeemable preferred stock redemption value over the carrying value. This acceleration related to the change in terms of the redeemable preferred stock which provides for immediate redemption at either the Company or the holders' option. Excluding these items, net income available to common shareholders, which takes into account both dividends and accretion on redeemable preferred stock, would have been $1,212,000, or $0.15 per share on a diluted basis, for the fiscal year ended January 3, 1998. Fiscal Year Ended January 3, 1998 Compared to Fiscal Year Ended December 31, Net sales for the year ended January 3, 1998 were $104,978,000 a decrease of $774,000 from net sales of $105,752,000 for the year ended December 31, 1996. Juvenile sales comprised 97% of the net sales for the year ended January 3, 1998 and home security sales made up the balance. Gross profit increased to $42,384,000 or 40.4% of net sales for the year ended January 3, 1998 from $16,773,000 or 15.9% of net sales for the year ended December 31, 1996, and $39,204,000 or 34.9%, excluding the 1996 restructuring charges. The increase in gross profit percentage is due to favorable product mix, improved product costs, and significant reductions in products returned by customers. Selling, general, and administrative expenses decreased by $19,962,000 to $34,423,000 for the year ended January 3, 1998 from $54,385,000 for the year ended December 31, 1996. Excluding the 1996 restructuring charges, selling, general and administrative expenses were $41,536,000 for the year ended December 31, 1996. The decrease is primarily attributed to continued focus on cost controls during the year ended January 3, 1998 primarily in the areas of temporary help, professional fees, and freight costs. Also during the year ended January 3, 1998, the Company recorded a pre-tax charge of $587,000 related to the impairment of long-lived assets. Net interest expense for the year ended January 3, 1998 was $4,117,000 versus $4,100,000 for the year ended December 31, 1996. During 1997, the Company refinanced its existing credit facility - refer to the "Liquidity and Capital Resources" section below. Net income available for common shareholders for the year ended January 3, 1998 was $3,140,000 or $0.40 per share on a diluted basis, including a tax benefit of $8,400,000 related to a change in valuation allowance. In addition, the Company recorded accretion of $6,472,000 representing the excess of the redeemable preferred stock redemption value over the carrying value. This acceleration related to the change in terms of the redeemable preferred stock which provides for immediate redemption at either the Company or the holders' option. Excluding these items net income available to common shareholders, which takes into account both dividends and accretion on redeemable preferred stock would have been $1,212,000 or $0.15 per share on a diluted basis, compared to a loss of $44,849,000 or $6.27 per share for the year ended December 31, 1996. During 1996, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" ("SFAS 121"). Primarily as a result of the Company's change in strategy, the Company recorded an impairment loss of $11.6 million in accordance with SFAS 121 for those long-lived assets such as molds and tools, molds in process and patents. The amount of the impairment loss is the excess of the carrying amount of the impaired assets over the fair value of the assets. Operating income for 1997 was $7,374,000 versus an operating loss of $49,208,000 for 1996, an increase of $56,582,000, due to the above factors. Interest expense increased from $4,100,000 during 1996 to $4,117,000 in 1997. The Company recorded an income tax benefit of $7,195,000 in 1997 versus $8,459,000 in 1996. The income tax benefit primarily relates to the recognition of certain net operating loss carryforwards. In 1996, the Company had deferred tax assets arising from net operating loss carryforwards and deductible temporary differences of $14,400,000 before a valuation allowance of $10,300,000 and offset against deferred tax liabilities of $1,900,000. LIQUIDITY AND CAPITAL RESOURCES On July 30, 1997, the Company entered into a five-year $55,000,000 refinancing of its existing $45,000,000 credit facility. The refinancing included a $40,000,000 credit facility providing for $27,500,000 of revolving working capital financing and a $12,500,000 term loan. In January 1998, this credit facility was amended to increase the revolving line of credit from $27,500,000 to $35,000,000. The credit facility, which expires in July 2002, has an interest rate, at the Company's option, of LIBOR plus 2.75% or prime plus 1.75% (8.0% at January 2, 1999) on the revolving credit facility, and LIBOR plus 3% or prime plus 2% (8.3% at January 2, 1999) on the term loan. In addition, the loan agreement requires the Company to pay a commitment fee equal to .50% per annum of the average unused commitment and letter of credit fees equal to 1.4% of the face amount of each letter of credit. As of January 2, 1999, the Company had $801,510 available to be borrowed under the revolving credit facility based upon the advance rate formula in the loan agreement. The principal amount of the term loan is payable in twenty consecutive equal installments of $625,000, nineteen of which are payable on the first day of each calendar quarter commencing October 1, 1997 and the final installment is payable on July 30, 2002. The credit facility contains certain financial covenants and restrictions including minimum tangible net worth, minimum current ratio, minimum EBITDA (as defined), minimum fixed charge coverage, and limits on capital expenditures and dividend payments, and is collateralized by all assets of the Company. The July 30, 1997 refinancing also included a $15,000,000 private placement of 15,000 shares of six-year Series A redeemable preferred stock and the issuance of ten-year warrants to purchase approximately 1,270,000 shares of the Company's common stock, subject to adjustment, at an exercise price of $0.01 per share, as described in Notes 2 and 3 to the consolidated financial statements. The Company has exchanged the Series A Preferred Stock with its holders for Series B Preferred Stock which contains substantially identical features other than redemption rights. The holders of the Series B Preferred Stock have the right to redeem the Series B Preferred Stock immediately under certain conditions including the surrender of the ten-year warrants. Upon such occurrence, if the Company redeemed any of the preferred shares, the Company would be in default of covenants under its credit facility which prohibits the redemption of the preferred stock. Conversely, failure to honor the redemption could result in a default under the terms of the preferred stock. On September, 1, 1998 the Company's United Kingdom subsidiary entered into a three-year pound sterling 2,500,000 financing arrangement consisting of an Inventory Facility and an Invoice Discounting Facility. The maximum permitted borrowing amounts are pound sterling 1,250,000 and pound sterling 2,500,000 for the Inventory Facility and the Invoice Discounting Facility, respectively. The credit facility, which expires in September 2001, has an interest rate of Lloyds Bank Plc Base Rate plus 2% for the first twelve months and Lloyds Bank Plc Base Rate plus 2.25% for the remaining twenty-four months. For the year-ended January 2, 1999, the average interest rate of these borrowings for the year ended January 2, 1999 was 7.25%. The loan agreement requires the Company to pay a commitment fee equal to .50% per annum of the difference between total borrowings and pound sterling 1,200,000 for the first twelve months of the facility, pound sterling 1,750,000 for the second twelve months of the facility and pound sterling 2,500,000 for the final twelve months of the facility. As of January 2, 1999, the Company had pound sterling 211,000 or $350,000 available under this facility based on the advance rate formula in the loan agreement. For the period from January 1, 1997 through July 30, 1997, the Company had financed its operations with a $45,000,000 credit facility consisting of a $25,000,000 term-loan and a $20,000,000 revolving credit facility, both of which were scheduled to expire on May 1, 1998. The annual rate of interest on all borrowings for the initial six months of the facility was equal to the prime rate plus 2.65%, increasing by one percent every three months thereafter to a maximum annual rate of prime plus 5.65%. Net cash provided by operations was $7,629,000 for the year ended January 2, 1999 versus net cash used in operations of $5,300,000 for the year ended January 3, 1998. The increase in the net cash provided by operations was due to improved working capital management, as evidenced by the decrease in inventory and accounts receivable for fiscal 1998 despite growing sales in excess of 15%. For the year ended January 2, 1999, cash flow used in investing activities was $5,677,000 related to the purchase of property and equipment, principally molds for new product introductions as well as the purchase of an integrated computer system which is in the process of being implemented. Net cash used in financing activities was $1,894,000, primarily related to net paydowns on the revolving credit facility as well as payment of the notes payable issued in connection with the acquisition of Orleans Juvenile Products, Inc. in February 1996. The Company believes that its current bank facilities will be sufficient to meet its operating and other cash requirements for the next twelve months. NEW ACCOUNTING REQUIREMENTS The Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), and Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"), in fiscal 1998. Both standards did not have a material effect on the Company's reported financial position or results of operations. SFAS 130 establishes standards for the reporting and display of comprehensive income, which equals the total of net income and all other non-owner changes in equity. SFAS 131 changes the way companies report segment information and requires segments to be determined and reported based on how management measures performance and makes decisions about allocating resources. It also requires public companies to report certain information about their products and services, the geographic areas in which they operate, and their major customers. YEAR 2000 The Year 2000 ("Y2K") problem is a result of computer programs being written using two digits (rather than four) to define the applicable year. Any of the Company's programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a major system failure or miscalculations. In addition, the Company's major customers and vendors must also be Y2K compliant to ensure that customer orders will be properly processed and that vendors will be able to supply the Company with inventory per the terms of its purchase orders. There could be a material disruption in the Company's business if the computer systems of the Company, its customers or its vendors are not Y2K compliant. The Company is addressing the Y2K issue in a three-part approach. The first task completed was to upgrade the Company's internal computer systems to become Y2K compliant for recurring transaction processing and financial record-keeping. In January 1999 the Company migrated to a new BaaN computer system which enables all significant internal systems to be Y2K compliant. The implementation cost of this system was approximately $5,400,000. The second issue addressed by the Company was to work with the Company's customers to ensure that sales orders, particularly those generated via EDI transmissions, will be able to be processed with Year 2000 dates. The Company's major customers are large retailers such as Walmart and Toys 'R Us, who have invested substantial resources relating to Year 2000 issues, and virtually all of the Company's major accounts have been tested for Y2K processing issues with no significant problems noted to date. The final issue is to ensure that the Company's vendors will be able to fulfill purchase orders with Year 2000 dates. The Company uses approximately 10 significant vendors to source the majority of its product, and all of these vendors (as well as the smaller vendors) are being thoroughly reviewed by the Company at this time to ensure that they will be Y2K compliant. Based on the work performed to date, the Company believes that there will be no material disruption in its business resulting from Y2K issues. The Company is developing contingency plans for both customers and vendors to increase its readiness for potential issues, which will be completed during fiscal 1999. The cost to complete these contingency plans is estimated to be less than $100,000. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE EXPOSURE The Company's interest rate exposure primarily relates to its revolving credit facility, which contains interest rates based on either LIBOR or the prime rate. The Company has locked in the majority of its interest rates for outstanding borrowings for six months, and therefore concludes that any near-term change in interest rates comparable to historical interest rate movements would not materially affect the consolidated results of operations or financial position for fiscal 1999. CURRENCY RATE EXPOSURE The Company's UK and Canadian subsidiaries use the local currency as the functional currency, and therefore foreign currency translation adjustments are reflected as a component of stockholders' equity. In addition, these subsidiaries purchase the majority of their inventory from the US entity in US dollars, and thus there is foreign currency risk in that fluctuations in the US dollar versus the local currency could result in increases in cost of goods sold for the UK and Canadian subsidiaries. To the extent that the Company expands its international operations, the Company will be exposed to increased risk of currency fluctuation. ITEM 8 ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA SAFETY 1ST, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGE ---- Report of Independent Certified Public Accountants............... 17 Consolidated Financial Statements: Balance Sheets.............................................. 18 Statements of Operations.................................... 19 Statements of Changes in Stockholders' Equity............... 20 Statements of Cash Flows.................................... 21 Notes to Financial Statements............................... 22 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors Safety 1st, Inc. We have audited the accompanying consolidated balance sheets of Safety 1st, Inc. and subsidiaries (the "Company") as of January 2, 1999 and January 3, 1998, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three fiscal years in the period ended January 2, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Safety 1st, Inc. and subsidiaries at January 2, 1999 and January 3, 1998, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 2, 1999, in conformity with generally accepted accounting principles. Boston, Massachusetts GRANT THORNTON LLP February 12, 1999 SAFETY 1ST, INC. CONSOLIDATED BALANCE SHEETS ASSETS LIABILITIES AND STOCKHOLDERS' EQUITY The accompanying notes are an integral part of these statements. SAFETY 1ST, INC. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these statements. SAFETY 1ST, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY The accompanying notes are an integral part of these statements. SAFETY 1ST, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See Note 10 for non-cash acquisition related items. The accompanying notes are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 31, 1996 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Business Safety 1st, Inc. and subsidiaries (the "Company") is a developer, marketer and distributor of juvenile products including child safety and child care, convenience, activity, and home security products. The Company sells primarily to retailers. Any risk of collection losses is concentrated in this industry. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Safety 1st (Europe) Ltd., Safety 1st Home Products Canada, Inc., 3232301 Canada Inc., and Safety 1st International, Inc. All significant intercompany transactions have been eliminated. Change in Fiscal Year Effective in 1997, the Company changed its reporting period from a calendar year to a 52/53 week period ending on the Saturday closest to December 31. The Company's 1997 fiscal year ended on January 3, 1998. There was no material effect on the statement of operations. All references to fiscal 1998, 1997 and 1996 refer to the years ended January 2, 1999, January 3, 1998, and December 31, 1996, respectively. Inventory Inventory is valued at the lower of cost (first-in, first-out) or market. Advertising Advertising costs are expensed as incurred. Advertising expenses, which consist primarily of promotional and cooperative advertising allowances provided to customers, were approximately $5,464,000, $3,497,000 and $5,708,000 for the years ended January 2, 1999, January 3, 1998 and December 31, 1996, respectively. Revenue Recognition The Company recognizes revenue at the time of shipment to its customers. Property and Equipment Property and equipment are recorded at cost, including interest on funds borrowed to finance the construction of capital additions. The Company owns the molds and tools used in the production of the Company's products by third party manufacturers. For the years ended January 2, 1999 and January 3, 1998, approximately $62,000 and $153,000, respectively, of interest incurred in connection with the construction of molds was included in the cost of the molds. For the years ended January 2, 1999 and January 3, 1998, approximately $266,000 and $203,000 respectively, of interest was capitalized into software systems in process. The molds and tools are depreciated using the straight-line method over 5 to 7 years. Computer equipment and software, furniture and fixtures and warehouse equipment are depreciated using the straight-line method over their estimated useful lives of 3 to 7 years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the estimated useful life of the asset. Patents, Trademarks and Licensing Agreements The cost of patents and trademarks is amortized using the straight-line method over their estimated useful life of 7 years and 20 years, respectively. The cost of acquiring licensing agreements is amortized over the life of the respective agreement. Goodwill The Company amortizes costs in excess of fair value of net assets of businesses acquired using the straight-line method over a period not to exceed 25 years. Impairment is reviewed quarterly. Translation of Foreign Currencies Operating statement accounts are translated at the average rates during the period and assets and liabilities are translated using the exchange rate at each balance sheet date. Foreign currency transaction gains and losses are included in net income, translation adjustments, if significant, are recorded as a separate component of stockholders' equity, as the functional currency is the local currency. Income Taxes The Company utilizes the asset/liability method of accounting for income taxes. Under the asset/liability method, deferred income taxes are determined based on the differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect. A valuation allowance is provided for net deferred tax assets based on expected levels of future earnings. Research and Product Development Costs Research and product development costs are charged to expense when incurred. Research and development costs for the years ended January 2, 1999, January 3, 1998 and December 31, 1996 were approximately $1,118,000, $757,000 and $2,060,000, respectively. Use of Estimates In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Some of the more significant estimates include depreciation and amortization of long-lived assets, deferred income taxes, inventory valuations, allowances for defectives, promotions and returns, and product liability and accruals for other contingencies. Actual results could differ from those estimates. Accounting For Stock Based Compensation In October 1995, the FASB issued Statement of Financial Accounting Standard No. 123, "Accounting for Stock Based Compensation" ("SFAS 123") which establishes a fair value based method of accounting for stock-based compensation. As permitted by SFAS 123, the Company elected to account for employee stock- based compensation using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's common stock at the date of grant over the amount an employee must pay to acquire stock. In addition, SFAS 123 also requires that transactions with other than employees, entered into after December 31, 1995, in which goods or services are the consideration received for the issuance of equity instruments shall be accounted for based on the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. The Company has adopted SFAS 123 for disclosure purposes and for non-employee stock options. The effect on the results of operations and financial position is disclosed in Note 9. 2. REVOLVING CREDIT FACILITY AND TERM LOAN On July 30, 1997, the Company entered into a five-year $55,000,000 refinancing of its existing $45,000,000 credit facility. The refinancing included a $40,000,000 credit facility providing for $27,500,000 of revolving working capital financing and a $12,500,000 term loan. In January 1998, this credit facility was amended to increase the revolving line of credit from $27,500,000 to $35,000,000. The credit facility, which expires in July 2002, has an interest rate, at the Company's option, of LIBOR plus 2.75% or prime plus 1.75% (8.0% as of January 2, 1999) on the revolving credit facility, and LIBOR plus 3% or prime plus 2% (8.3% as of January 2, 1999) on the term loan. In addition, the loan agreement requires the Company to pay a commitment fee equal to .50% per annum of the average unused commitment and letter of credit fees equal to 1.4% of the face amount of each letter of credit. As of January 2, 1999, the Company had $802,000 available to be borrowed under the revolving credit facility based upon the advance rate formula in the loan agreement. The principal amount of the term loan is payable in twenty consecutive equal installments of $625,000, nineteen of which are payable on the first day of each calendar quarter. Total principal payments were $2,500,000 in 1998 and $1,250,000 in 1997, and are scheduled to total $2,500,000 in each of the years 1999 through 2001, with the final payment of $1,250,000 scheduled to be made in 2002. As of January 2, 1999, $8,750,000 was outstanding under the term loan of which $6,250,000 is classified as long-term debt. The credit facility contains certain financial covenants and restrictions including minimum tangible net worth, minimum current ratio, minimum EBITDA (as defined), minimum fixed charge coverage, and prohibitions on redemption of preferred stock, in addition to limits on capital expenditures and dividend payments, and is collateralized by all assets of the Company. The refinancing also included a $15,000,000 private placement of 15,000 shares of six-year Series A redeemable preferred stock and the issuance of ten-year warrants to purchase approximately 1,270,000 shares of the Company's common stock, at an exercise price of $0.01 per share, as described in Note 3. For the period from January 1, 1997 through July 30, 1997, the Company financed its operations with a $45,000,000 credit facility consisting of a $25,000,000 term-loan and a $20,000,000 revolving credit facility, both of which were scheduled to expire on May 1, 1998. The annual rate of interest on all borrowings for the initial six months of the facility was equal to the prime rate plus 2.65% increasing by one percent every three months thereafter to a maximum annual rate of prime plus 5.65%. For the years ended January 2, 1999 and January 3, 1998, the average borrowings under revolving credit facilities were $35,250,000 and $36,900,000, respectively. The weighted average interest rate of these borrowings for the years ended January 2, 1999 and January 3, 1998 was 11.3% and 11.2%, respectively. In connection with the acquisition and restructuring of the credit facility, the Company incurred $194,000 and $1,662,000, of deferred debt financing costs, of which $391,000 and $178,000, have been reflected in interest expense on the consolidated statements of operations for the years ended January 2, 1999 and January 3, 1998, respectively. On September, 1, 1998 the Company's United Kingdom subsidiary (Safety 1st (Europe) Ltd) entered into a three-year pound sterling 2,500,000 financing arrangement consisting of an Inventory Facility and an Invoice Discounting Facility. The maximum permitted borrowing amounts are pound sterling 1,250,000 and pound sterling 2,500,000 for the Inventory Facility and the Invoice Discounting Facility, respectively. The credit facility, which expires in September 2001, has an interest rate of Lloyds Bank Plc Base Rate plus 2% for the first twelve months and Lloyds Bank Plc Base Rate plus 2.25% for the remaining twenty-four months (8.25% at January 2, 1999). For the year-ended January 2, 1999, the average interest rate of these borrowings for the year ended January 2, 1999 was 9.0%. The loan agreement requires the Company to pay a commitment fee equal to .50% per annum of difference between total borrowings and pound sterling 1,200,000 for the first twelve months of the facility, pound sterling 1,750,000 for the second twelve months of the facility and pound sterling 2,500,000 for the final twelve months of the facility. As of January 2, 1999, the Company had pound sterling 95,000, or $157,000, available under this facility based on the advance rate formula in the loan agreement. 3. REDEEMABLE PREFERRED STOCK In connection with the refinancing of the Company's credit facility on July 30, 1997, as described in Note 2, the Company issued in a private placement 15,000 shares, $1 par value, six year Series A redeemable preferred stock (of the 100,000 shares of preferred stock authorized) with a liquidation preference of $1,000 per share plus accrued but unpaid dividends at the dividend rate of either 10% in cash or 13.25% non-cash, compounded quarterly. The redeemable preferred stock includes the issuance of ten-year warrants to purchase approximately 1,270,000 shares of the Company's common stock. The proceeds of $15,000,000 from the private placement were allocated to redeemable preferred stock and the warrants in the amount of $8,528,000 (net of issuance costs of $472,000) and $5,686,000 (net of issuance costs of $314,000), respectively, based on the estimated values at issue date. The excess of the redeemable preferred stock redemption value of $15,000,000 over the carrying value of $8,528,000 was accreted in the fiscal year ended January 3, 1998. This acceleration of the accretion is due to a change in terms of the redeemable preferred stock which provides for immediate redemption at either the Company's option or, if certain conditions are met, at the holders' option. Pursuant to an agreement among the parties in December 1997, the change was effected by an exchange between the Company and the holders of Series A Preferred Stock for shares of Series B Preferred Stock containing substantially identical features other than the provision relating to the rights of immediate redemption. Accrued but unpaid dividends of $3,044,000, are included in the carrying value of the preferred stock at January 2, 1999. 4. IMPAIRMENT OF LONG-LIVED ASSETS AND DISCONTINUED PRODUCTS During 1996, the Company adopted Statement of Financial Accounting Standard No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long Lived Assets to be Disposed Of" ("SFAS 121"). This statement requires that long-lived assets, certain identifiable intangibles, and goodwill be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, and an estimate of future undiscounted cash flows is less than the carrying amount of the asset. Generally, fair value represents the Company's expected future cash flows generated by the associated product discounted at a rate commensurate with the risk involved. For the year ended January 3, 1998, the Company recorded a pre-tax charge of approximately $587,000 related to the impairment of long-lived assets. For the year ended December 31, 1996, a pre-tax charge of $47,400,000, as described below, was recorded primarily in connection with the Company's efforts to reduce its inventory stock keeping units ("SKU"), to streamline product offerings and discontinue products that did not meet certain sales, inventory turns and profitability objectives. As part of this charge in 1996, the Company recorded an impairment loss of approximately $11,600,000 in accordance with SFAS 121, for those long-lived assets such as molds and tools, mold in process and patents where the sum of the estimated future undiscounted cash was less than the carrying amount of the impaired asset. In addition, during 1996, the Company recorded a cost of sales charge of approximately $14,300,000 relating to discontinued products, inventory reserves, reduction of capitalized overhead and other inventory related matters and $1,400,000 primarily related to the reduction of vendor credits. In addition, the Company recorded a net revenue charge of $6,600,000 relating to returns and defective products, customer credits and other transactions. Selling, general and administrative expenses included a charge of $13,000,000 for reserves for customer credits related to advertising and promotional allowances, lease termination fees, severance costs, write-off of certain assets, accrual of product related reserves, non-employee stock compensation expense and other matters. In addition, the Company recorded a charge of $500,000 relating to deferred financing costs. 5. RELATED PARTY MATTERS Fees for services, including expenses, provided by a firm associated with the former Chief Financial Officer amounted to approximately $155,000 , $378,000 and $1,957,000 during the years ended January 2, 1999, January 3, 1998 and December 31, 1996, respectively. Fees for services, including expenses, provided by a firm associated with a director of the Company amounted to approximately $484,000, $834,000 and $970,000 during the years ended January 2, 1999, January 3, 1998 and December 31, 1996, respectively. Services rendered by these firms included fees in connection with the Company's acquisition of subsidiaries, refinancing of debt, accounting, tax and finance services and other business, legal and tax matters. 6. COMMITMENTS AND CONTINGENCIES Leases The Company leases certain warehouse facilities under an operating lease arrangement. The agreement, which expires in January 2005, includes minimum rental payments of approximately $845,000 per year plus real estate taxes and other operating costs. The Company has an option to extend this lease for an additional ten year period at an annual rent of approximately $1,095,000. The Company also has the right to terminate the lease prior to expiration by giving six months prior notice and (in case of a termination during the initial ten year term) paying a termination payment. The termination provision includes a payment table where the cost of termination is reduced for each year of the lease term. The Company leases certain computer software under an arrangement which has been classified as a capital lease. The lease has a thirty-six month payment term and ownership of the asset transfers to the Company at the conclusion of the lease. The total leased capital assets included in other assets at January 2, 1999 and January 3, 1998 was $487,000. The Company leases office, warehousing and other facilities under various arrangements. In addition, the Company leases certain equipment under operating leases. Rent expense under operating leases for the years ended January 2, 1999, January 3, 1998 and December 31, 1996, was approximately $1,400,000, $1,200,000 and $1,900,000, respectively. Minimum annual rentals for the five fiscal years subsequent to January 2, 1999 and in the aggregate are: Letters of Credit As of January 2, 1999, the Company was contingently liable for unsecured letters of credit of approximately $1,400,000. These letters of credit were issued to secure delivery of overseas merchandise. Royalty and License Agreements The Company has various license agreements, pursuant to which it has the non-exclusive right to utilize the licensing company's name or logos. In addition, the Company pays royalties to developers for product ideas. Royalty fees range from 2.5% to 12% of related product sales. Royalty fees for the years ended January 2, 1999, January 3, 1998 and December 31, 1996 were $698,000, $528,000 and $1,493,000, respectively. Contingencies On September 8, 1997, Tele Electronics (Taiwan) Co., Ltd. ("Tele Electronics") filed a lawsuit in Middlesex Superior Court in Massachusetts against the Company alleging breach of contract arising out of two purchase orders. The suit seeks monetary damages for the alleged breach of contract in the amount of $3.45 million and also alleges unfair and deceptive business practices and seeks, under this theory, an award equal to three times the alleged contractual damages. Tele Electronics also sought preliminary injunctive relief which, after a hearing, the Court denied. The Company denies the allegations of the lawsuit, believes it has meritorious defenses, is defending the matter vigorously and has also filed a counterclaim against Tele Electronics for damages caused by various acts and omissions of Tele Electronics, relating to prior purchase orders. The Company's counterclaim seeks monetary damages totaling approximately $1.3 million. The Company encounters personal injury litigation related to its products in the ordinary course of business. The Company maintains product liability insurance in amounts deemed adequate by management. With respect to the matters discussed above, the Company believes that there are no claims or litigation pending, the outcome of which could have a material adverse effect on the Company's operations or financial condition. 7. MAJOR CUSTOMERS AND SUPPLIERS For the years ended January 2, 1999, January 3, 1998 and December 31, 1996, two customers accounted for approximately 46% (24% and 22%), 44% (23% and 21%) and 36% (22% and 14%), respectively, of net sales. For the years ended January 2, 1999, January 3, 1998, and December 31, 1996, two suppliers accounted for approximately 34% (18% and 16%), 37% (20% and 17%), and 33% (21% and 12%), respectively, of total purchases. Certain of the Company's products are manufactured in China and are therefore subject to certain trade restrictions. From time to time, the United States Congress has attempted to impose additional restrictions on trade with China. Enactment of legislation, or the imposition of restrictive regulations conditioning or revoking China's "most favored nation" trading status or other trade sanctions, could have a material adverse effect upon the Company's business and products originating from China and the Company could be subjected to substantially higher rates of duty. 8. INCOME TAXES The Company records taxes in accordance with Statement of Financial Accounting Standards No. 109 ("SFAS 109") "Accounting for Income Taxes" which requires use of the asset/liability method of accounting for income taxes. The asset/liability method measures deferred income taxes by applying enacted statutory rates in effect at the balance sheet date to the differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. The resulting asset or liability is adjusted to reflect changes in the tax laws as they occur. Income (loss) before income taxes is as follows: The components of income tax (benefit) expense were as follows: The components of the net deferred tax asset (liability) were as follows: The Company has recorded a valuation allowance of $800,000 as of January 2, 1999. The net change in the valuation allowance for fiscal 1998 is $1,145,000 which has been included as a component of the income tax benefit. The Company has approximately $31,000,000 of net operating losses available which expire in years 2011 through 2012. Realization of the $11,115,000 net deferred tax asset is dependent on the Company's ability to generate approximately $32,000,000 in taxable income during the carryforward period. Management believes it is more likely than not that the asset will be realized based upon the strategic initiatives undertaken in 1996 to simplify operations by reducing the number of SKU's, discontinuing products that did not meet certain sales, quality, and profitability objectives and to tighten expense control. During 1997 and 1998, the Company began to experience the positive effects of these initiatives and expects to continue to benefit in future years. However, there can be no assurances that the Company will meet its expectations of future income. As a result, the amount of the deferred tax assets considered realizable could be reduced in the near and long term if estimates of future income are reduced. Such an occurrence could materially adversely affect the Company's financial position and results of operations. The Company will continue to evaluate the realizability of the deferred tax assets quarterly. Deferred income taxes are not provided on the undistributed earnings of foreign subsidiaries aggregating approximately $1,615,000 at January 2, 1999 as such earnings are expected to be permanently reinvested in these companies. The differences between the statutory federal income tax rate of 34% and income taxes reported in the statements of operations are as follows: 9. EMPLOYEE BENEFIT PLANS Stock Option Plans As of January 2, 1999, the Company had four stock option plans providing for the granting of options to purchase up to 2,400,000 shares of common stock of which, as of such date, 1,883,775 options were outstanding. These plans provide for the awarding of incentive and non-qualified stock options to employees, directors, independent contractors and others who may contribute to the success of the Company. Options are exercisable within ten years (5 years for greater than 10% shareholders with respect to incentive stock options) of the date of grant at a price determined by the Board of Directors or a committee of the Board of Directors. Substantially all of these options vest over a period not to exceed thirty months. In addition to these four plans, the Company has issued 35,000 non-qualified options (15,000 options at $12.00 per share and 20,000 options at $21.25 per share) to a former director of the Company at a price not less than the fair market value on the dates of the grants. During 1995, all of the 15,000 options with an option price of $12 per share were exercised, and in July 1996, the 20,000 options were repriced to $6.50. A summary of changes in these option plans and the non-plan options during the years ended January 2, 1999, January 3, 1998 and December 31, 1996 are as follows: The Compensation Committee of the Board of Directors voted on July 30, 1996, to amend certain stock option agreements by changing the exercise price to $6.50 per share. These agreements covered 629,756 shares with original exercise prices ranging from $12.00 to $27.00 per share. The following table summarizes option data as of January 2, 1999: The Company measures compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25 in accounting for its stock compensation plans. Accordingly, no compensation cost has been recorded for options granted to employees or directors in the years ended January 2, 1999, January 3, 1998 and December 31, 1996. Compensation cost charged to operations, which the Company recorded for options granted to non-employees, other than directors, was $701,000 for the year ended December 31, 1996. The weighted average fair value at the date of grant for options granted during the years ended January 2, 1999, January 3, 1998 and December 31, 1996 was $2.01, $1.98 and $6.25, respectively. The fair value of options at the date of grant was estimated using the Black-Scholes model with the following weighted average assumptions: Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards consistent with the provisions of SFAS 123, the Company's net income (loss) available to common shareholders and income (loss) per common share on a diluted basis would have been reduced to the pro forma amounts indicated below: The initial application of SFAS 123 for pro forma disclosure may not be representative of the future effects of applying the statement. Profit Sharing Plan The Company sponsors a Defined Contribution 401-k Plan (401-k Plan), whereby participants may contribute a percentage of compensation, but not in excess of the maximum allowed under the Internal Revenue Code. The 401-k Plan provides for a matching contribution by the Company at the discretion of the Board of Directors. For the years ended January 2, 1999, January 3, 1998, and December 31, 1996, the Company did not elect to contribute to this plan. 10. ACQUISITIONS On January 4, 1996, the Company acquired all of the outstanding stock of EEZI Group Holdings Ltd., a United Kingdom distributor of juvenile products, now named Safety 1st (Europe) Ltd., for cash of $260,000, issuance of notes payable of $949,000 ($205,000 outstanding as of January 2, 1999 after post-closing adjustments), and payment of acquisition costs of $1,032,000. The fair value of assets acquired, including goodwill, was $2,668,000 and liabilities assumed was $426,000. The excess of the aggregate of purchase price over the fair value of net assets acquired of $2,181,000 was recognized as goodwill and is being amortized over 25 years. The net assets acquired included primarily inventory and fixed assets. Effective February 1, 1996, the Company acquired all of the outstanding stock of Orleans Juvenile Products Inc., the Canadian distributor of the Company's products, for cash of $1,067,000, issuance of notes payable of $1,650,000 and payment of acquisition costs of $624,000. The fair value of assets acquired, including goodwill, was $9,496,000 and liabilities assumed was $6,155,000. The purchase price was allocated to the net assets acquired based upon their estimated fair value. The excess of the purchase price over the fair value of assets acquired of $4,349,000 was recognized as goodwill and is being amortized over 25 years. The net assets acquired included primarily accounts receivable, inventory, accounts payable and bank debt. These acquisitions have been recorded using the purchase method of accounting. The accompanying consolidated statements of operations reflect the operating results of the acquired entities since the effective date of the acquisitions. 11. OPERATING SEGMENTS The consolidated financial statements include the accounts of wholly-owned subsidiaries in the United Kingdom and Canada. These geographic locations are also considered the Company's operating segments. METHOD OF DETERMINING SEGMENT PROFIT OR LOSS Management evaluates the performance of its operating segments individually to monitor the different factors affecting financial performance. Segment profit or loss includes substantially all of the segment's costs of production, distribution and administration. The Company manages income taxes on a global basis, thus evaluates segment performance based on operating profit or loss. The Company manages financial costs, such as exchange gains and losses and interest income and expense, on a global basis. Information about the Company's operations in the different geographic areas as of and for the fiscal years ended January 2, 1999, and January 3, 1998 is as follows (amounts in thousands): Transfers between the geographic areas primarily represent intercompany export sales and are accounted for based on established sales prices between the related companies. In computing operating profit, no allocations of general corporate expenses have been made. Identifiable assets of geographic areas are those assets related to the Company's operations in each area. Cash at January 2, 1999 includes approximately $343,000 of amounts held in foreign bank accounts. International sales from domestic operations were approximately $6,998,000, $7,759,000 and $9,562,000, for the years ended January 2, 1999, January 3, 1998, and December 31, 1996, respectively. Foreign currency fluctuations could have a material effect on the Company's financial position and results of operations. 12. EARNINGS PER SHARE Basic earnings per share are based on the weighted-average number of shares of common stock outstanding at year-end, which are as follows: 7,218,000 in 1998, 7,187,288 in 1997, and 7,157,078 in 1996. Diluted earnings per share are based on the weighted-average number of shares of common stock and common stock equivalents outstanding at year-end, which were as follows: 7,218,000 in 1998, 7,827,876 in 1997 and 7,157,078 in 1996. Weighted-average share figures for 1997 include common stock equivalents of 640,588. Common stock equivalents have been excluded from weighted-average shares for 1996 and 1998 as inclusion would be anti-dilutive. Options to purchase 1,883,775 and 397,968 shares of common stock at prices ranging from $4.75 to $19.00 were outstanding at January 2, 1999 and January 3, 1998, respectively, but were not included in the computation of diluted earnings per share because the exercise prices of the options were greater than the average market price of the common stock for the respective period. 13. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the unaudited quarterly results of operations for the years ended January 2, 1999 and January 3, 1998 (dollars in thousands, except per share amounts): (1) Special charges for the fourth quarter ended January 2, 1999 totaled $2,069,000. Approximately $1,100,000 of the charge relates to the Company's elimination of the chemical diisononyl phthalate ("phthalates") from all of its products which are intended for the mouth, including pacifiers and teethers. This action was taken in response to a public announcement issued by the Consumer Products Safety Commission which stated that although there is no substantial evidence that the use of phthalates is a health hazard, consumers may want to avoid giving mouthable products that include phthalates to children under three years of age. The Company has discontinued the use of phthalates in the manufacture of its mouthable products and anticipates that these products will be available in phthalate-free versions during the first half of 1999. The remaining $969,000 of the special charges relates to several one-time items that occurred in the fourth quarter, including the resolution of two matters which had previously been in dispute, as well as severance costs. (2) The Company recorded a tax benefit of $2,000,000 ($.25 per share) related to a change in the valuation allowance. (3) The Company recorded an adjustment in the fourth quarter of fiscal 1997 of $587,000 in connection with impairment of long-lived assets. The adjustment decreased fourth quarter net income by $370,000 ($.05 per share). In addition, the Company recorded a tax benefit of $6,400,000 ($.89 per share) related to a change in the valuation allowance, and also recorded accelerated accretion relating to its preferred stock of $6,372,000 (which reduced earnings by $0.88 per share). (4) The sum of the quarterly net income (loss) per share amounts does not equal the annual amount reported, as per share amounts are computed independently for each quarter and for the twelve months based on the weighted average common shares outstanding in each such period. ITEM 9 ITEM 9 -- CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is included in Registrant's definitive proxy statement for the 1998 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 11 ITEM 11 -- EXECUTIVE COMPENSATION The information required by this item is included in Registrant's definitive proxy statement for the 1998 Annual Meeting of Shareholders and is incorporated herein by reference, except that the sections in said definitive proxy statement which respond to paragraphs (k) and (l) of Item 402 of Regulation S-K shall not be deemed incorporated herein by reference or "filed" with the Securities and Exchange Commission or subject to Section 18 of the Securities Exchange Act of 1934. ITEM 12 ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is included in Registrant's definitive proxy statement for the 1998 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 13 ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is included in Registrant's definitive proxy statement for the 1998 Annual Meeting of Shareholders and is incorporated herein by reference. PART IV ITEM 14 ITEM 14 -- EXHIBITS. FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements. Financial Statement Schedules and Exhibits (1) Financial Statements Included in Part II, Item 8 of this Report Report of the Independent Certified Public Accountants Consolidated Balance Sheets at January 2, 1999 and January 3, 1998 Consolidated Statements of Operations for the Three Fiscal Years Ended January 2, 1999, January 3, 1998 and December 31, 1996 Consolidated Statements of Changes in Stockholders' Equity for the Three Fiscal Years Ended January 2, 1999, January 3, 1998, and December 31, 1996 Consolidated Statements of Cash Flows for the Three Fiscal Years Ended January 2, 1999, January 3, 1998 and December 31, 1996 (2) Financial Statement Schedule Included in PART IV, Item 14(c) of this Report on pages 42 and 43: Report of Independent Certified Public Accountants on Financial Statement Schedule For the three Fiscal Years Ended January 2, 1999, January 3, 1998 and December 31, 1996 Schedule II - Valuation and Qualifying Accounts Schedules other than that listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. (3) Exhibits The Company will furnish to any shareholder, upon written request, any exhibit listed below upon payment by such shareholder to the Company of the Company's reasonable expenses in furnishing such exhibit. Exhibit Description 3(a) Registrant's Restated Articles of Organization (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-59016) filed on March 4, 1993, as amended, and incorporated herein by reference) 3(b) Registrant's Restated By-laws (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-59016) filed on March 4, 1993, as amended, and incorporated herein by reference) 4(a) Specimen Certificates (Exhibit 4 to the Registrant's Report on Form 10-Q for the period ended March 31, 1996 and incorporated herein by reference) 4(b)** Designation of Series A Preferred Stock of the Company 4(c) *** Designation of Series B Preferred Stock of the Company 10(a) Lease dated January 21, 1994 between Reva Goode and Bessie Kriensky and Registrant, relating to leased premises at 210 Boylston St., Chestnut Hill, MA (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-74784) filed on February 3, 1994, as amended, and incorporated herein by reference) 10(b)* Employment Agreement between Registrant and Michael I. Lerner (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-59016) filed on March 4, 1993, as amended, and incorporated herein by reference) 10(c)* Employment Agreement between Registrant and Michael S. Bernstein (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-59016) filed on March 4, 1993, as amended, and incorporated herein by reference) 10(d)* 1993 Incentive and Non-Qualified Stock Option Plan (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-59016) filed on March 4, 1993, as amended, and incorporated herein by reference) 10(e)* 1993-A Employee and Director Stock Option Plan (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-74784) filed on February 3, 1994, as amended, and incorporated herein by reference) 10(f)* Registrant's 401(k) Plan (Exhibit to the Registrant's Registration Statement on Form S-1 (No. 3359016) filed on March 4, 1993, as amended, and incorporated herein by reference) 10(g) Indenture of Lease dated September 13, 1994 entered into by Glenbervie, Inc. and the Registrant pertaining to leased premises in Londonderry, NH (Exhibit 10.1 to the Registrant's Report on Form 10-Q for the period ended September 30, 1994 and incorporated herein by reference) 10(h) Agreement for Purchase of Shares dated as of January 4, 1996, between Stephen Paul Tollman and Registrant (excluding Schedules and Exhibits other than Purchase Price and Warranty Schedules) (Exhibit 10(h) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference) 10(i) Stock Purchase Agreement dated as of March 15, 1996, by and among Registrant, its subsidiary 3232301 Canada Inc., and Stephen Orleans (excluding Schedules and Exhibits) (Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference) 10(j)* 1996 Employee and Director Stock Option Plan adopted as of September 18, 1996 (Exhibit 10.15 to the Registrant's Report on Form 10-Q for the period ended September 30, 1996 and incorporated herein by reference) 10(k)* 1996 Nonqualified Stock Option Plan adopted as of September 18, 1996 (Exhibit 10.16 to the Registrant's Report on Form 10-Q for the period ended September 30, 1996 and incorporated herein by reference) 10(l)* Employment Agreement dated February 19, 1997, between Registrant and Richard E. Wenz (Exhibit 10(o) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference) 10(m) Amendment to Lease dated November 14, 1996, between the Reigstrant and Glenbervie, Inc. (Exhibit 10(p) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference) 10(n)** Stock and Warrant Purchase Agreement dated as of July 30, 1997, among Company, BT Capital Partners, Inc. and Bear, Stearns & Co., Inc. 10(o)** Warrant dated July 30, 1997, for 63,418 shares of the Company's common stock issued to BT Capital Partners, Inc. 10(p)** Warrant dated July 30, 1997, for 63,418 shares of the Company's common stock issued to Bear, Stearns & Co., Inc. 10(q)** Warrant dated July 30, 1997 for 570,755 shares of the Company's common stock issued to BT Capital Partners, Inc. 10(r)** Warrant dated July 30, 1997 for 570,755 shares of the Company's common stock issued to Bear, Stearns & Co., Inc. 10(s)** Registration Rights Agreement dated as of July 30, 1997, among the Company, BT Capital Partners, Inc., Bear, Stearns & Co., Inc., and Michael Lerner 10(t)** Voting Agreement dated as of July 30, 1997, among the Company, Michael Lerner, Michael S. Bernstein, BT Capital Partners, Inc. and Bear, Stearns & Co., Inc. 10(u)** Letter dated July 30, 1997 from BT Capital Partners, Inc. to the Company regarding compliance with certain regulations of the United States Small Business Administration 10(v)** Credit Agreement dated as of July 30, 1997, among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank 10(w)*** First Amendment dated October 29, 1997, to Credit Agreement dated as of July 30, 1997, among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank 10(x)*** Second Amendment and Waiver to Credit Agreement dated as of January 23, 1998, to Credit Agreement dated as of July 30, 1997, among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank 10(y)*** $7,000,000 Revolving Note dated January 23, 1998, executed by the Company and Safety 1st Home Products Canada, Inc., in favor BNY Financial Corporation 10(z)*** $7,000,000 Revolving Note dated January 23, 1998, executed by the Company and Safety 1st Home Products Canada, Inc., in favor BT Commercial Corporation 10(aa)*** $7,000,000 Revolving Note dated January 23, 1998, executed by the Company and Safety 1st Home Products Canada, Inc., in favor Finova Capital Corporation 10(bb)*** $7,000,000 Revolving Note dated January 23, 1998, executed by the Company and Safety 1st Home Products Canada, Inc. in favor of LaSalle National Bank 10(cc)*** $7,000,000 Revolving Note dated January 23, 1998, executed by the Company and Safety 1st Home Products Canada, Inc., in favor Summit Commercial/Gibralter Corp. 10(dd)*** Waiver to Credit Agreement dated as February 18, 1998 among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank 10(ee)*** Share Exchange Agreement 10(ff)*** Third Amendment and Waiver to Credit Agreement 10(gg)**** Fourth Amendment to Credit Agreement (dated as of July 30, 1999) among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank, dated as of May 15, 1998. 10(hh)**** Fifth Amendment to Credit Agreement (date as of July 30, 1997) among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank, dated as of July 4, 1998. 10(ii)**** Loan Agreement dated as of 1st September, 1998 between Safety 1st (Europe) Limited, as Borrower, and BNY International Limited. 10(jj)**** Invoice Discounting Agreement dated as of 1st September, 1998 between Safety 1st (Europe) Limited and BNY International Limited. 10(kk)**** Company's side letter dated July 24, 1998 to BNY International Limited waiving ownership claims in goods shipped to Safety 1st (Europe) Limited and proceeds therefrom. 10(ll) Sixth Amendment to Credit Agreement (date as of July 30, 1997) among the Company and Safety Home Products Canada, Inc., as Borrowers, BT Commercial Corporation, as Lender and Agent, and Bankers Trust Company, as Issuing Bank, dated as of March 22, 1999. 21 List of Subsidiaries of the Registrant (Exhibit 21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference) 23 Consent of Independent Certified Public Accountants 27 Financial Data Schedule 99 Important Factors Regarding Forward-Looking Statements * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c) hereof. ** Previously filed with the Company's report on Form 8-K dated August 6, 1997 and incorporated herein by reference. *** Previously filed with Company's report on Form 10-K dated April 2, 1998 and incorporated herein by reference. **** Previously filed with Company's report on Form 10-Q dated November 16, 1998 and incorporated herein by reference. The Company agrees to furnish the Securities and Exchange Commission, upon request, a copy of each agreement with respect to long-term debt of the Company, the authorized principal amount of which does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (b) Reports On Form 8-K None (c) Exhibits - See (a)(3) above (d) Financial Statement Schedules - See (a)(2) above SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SAFETY 1ST, INC. (Registrant) By: /s/ Michael Lerner Date: March 30, 1999 ------------------------------- Michael Lerner Chairman of the Board Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SAFETY 1ST, INC. (Registrant) By: Date: March 30, 1999 ------------------------------- Michael Lerner Chairman of the Board Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON SCHEDULE To the Board of Directors Safety 1st, Inc. In connection with our audits of the consolidated financial statements of Safety 1st, Inc. and Subsidiaries referred to in our report dated February 12, 1999 which is included in the annual report on Form 10-K, we have also audited Schedule II for each of the three fiscal years in the period ended January 2, 1999. In our opinion, this schedule presents fairly, in all material respects, the information required to be set forth therein. GRANT THORNTON, LLP Boston, Massachusetts February 12, 1999 SCHEDULE II SAFETY 1ST, INC. VALUATION AND QUALIFYING ACCOUNTS

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ITEM 1. BUSINESS GENERAL Transmedia Network Inc. and its subsidiaries (the "Company") own and market a charge card ("the Transmedia Card") offering savings to the Company's card members on dining as well as lodging, travel, retail catalogues and long distance telephone calls. The Company's primary business activity is to acquire, principally through cash advances and purchases, rights to receive food and beverage credits at full retail value from restaurants ("rights to receive"), which are then sold for cash to holders of the Transmedia Card. These rights to receive are primarily purchased by the Company for cash but may also be acquired in exchange for services. On June 30, 1999, the Company acquired from SignatureCard, Inc. ("SignatureCard"), a subsidiary of Montgomery Ward & Co., Incorporated, assets related to a membership discount program that SignatureCard operated under the Dining a la Card ("DALC") trade name and service mark. The assets acquired included various intellectual property rights and computer software, membership and merchant data, rights-to-receive, and most significantly, a registered card platform (the "Registered Card Program"), among other things. The Company simultaneously entered into a collaboration agreement with SignatureCard pursuant to which the Company obtains access to their sponsor relationships with the world's leading airlines. SignatureCard will receive a portion of the profits derived from members initially acquired from SignatureCard or subsequently generated through their efforts. The Registered Card Program complements the Company's existing proprietary Transmedia Card. In contrast to the Transmedia Card, which is a private label charge card linked electronically to a member's bank credit card of choice, registered card members can make discounted purchases with one of their existing major credit cards so that the discount is "blind" to both merchant and guests. This allows members to accumulate savings by using conventional charge cards, such as MasterCard, Visa, AMEX and Discover. The Company believes that the registered card concept has broader consumer and restaurant appeal due to its discrete nature and presently contemplates shifting the majority of its marketing efforts to this platform. Prior to the acquisition of DALC, the Company's areas of operation included Central and South Florida, the New York, Chicago and Los Angeles metropolitan areas, Boston and surrounding New England, Philadelphia, San Francisco, Detroit, Indianapolis, Milwaukee, Denver, Phoenix, North and South Carolina, Georgia, parts of Tennessee, Dallas/Ft Worth and Houston. Franchised areas include most of New Jersey, Washington, D.C., Maryland, Virginia, and parts of Texas. With the acquisition of Dining a la Card, the Company now has a presence in new areas such as St. Louis, Kansas City, San Diego, Memphis, Minneapolis, Seattle and other parts of Washington, and to a lesser degree, Cincinnati, Pittsburgh, Las Vegas, New Orleans, Portland, Salt Lake City, Tulsa, and Hawaii. Licensing arrangements for the Transmedia Card tradename and servicemark exist for the United Kingdom, Canada, and Europe, as well as the Asia-Pacific region and are presently being terminated. The Company, in the past, derived income from franchising and licensing the Transmedia Card tradename and servicemark and related proprietary rights and know-how, including rights to solicit restaurants, hotels, resorts and motels and acquire food, beverage and lodging credits, within and outside the United States. The Company also received revenue from licensing the Transmedia Card. The Company no longer grants new franchises and has reacquired most of the formerly franchised territories. CORPORATE STRUCTURE The Company commenced operations in 1984 and was reincorporated as a Delaware corporation in 1987. Currently, it has the following principal operating subsidiaries: Transmedia Restaurant Company Inc., which is responsible for obtaining and servicing restaurants and other service establishments such as hotels, resort destinations and retailers where the Transmedia Card and the Registered Card Program may be used. Transmedia Service Company Inc., which is responsible for (i) soliciting and servicing all members in the United States, (ii) providing support services to Transmedia Restaurant Company, and (iii) all domestic franchising of the Transmedia Card and related proprietary rights and know- how. TMNI International Incorporated, which licensed the Transmedia Card, service marks, proprietary software and know-how outside the United States. TNI Funding I, Inc., which was established as a special purpose corporation for purposes of the securitization of cash advances to merchants referred to as rights-to-receive. DESCRIPTION OF RIGHTS TO RECEIVE, PRIVATE LABEL CARD AND REGISTERED CARD PROGRAMS The Company's primary business is the acquisition of rights to receive from participating establishments which are then sold for cash to holders of the Transmedia Card (the "Private Label Program") or members of the Registered Card Program. "Rights to Receive" are rights to receive goods and services, principally food and beverages, which are acquired and purchased from participating restaurants, for an amount typically equal to approximately fifty percent (50%) of the food and beverage credits. Alternatively, the Company may acquire such Rights to Receive either by financing the merchant's purchase of other goods and services or providing advertising and media placement services to the participating establishments. Approximately ninety-five percent (95%) of Rights to Receive are purchased for cash. The Company typically purchases food and beverage credits that are anticipated to be utilized in a period of no more than six to nine months; however, it is not always possible for the Company to predict with accuracy the amount of time in which such credits will be consumed, due to seasonality or the opening of new market areas. The Transmedia Card, the Company's proprietary private label charge card, is selectively issued to applicants who are determined to be creditworthy by virtue of their having a current, valid MasterCard, Visa, Discover or American Express credit card. The Transmedia cardmembers have a choice of programs, including (i) a card which offers a 25% savings at participating establishments for which there is a $49 annual fee, (ii) a Turn Meals into Miles(R) program which offers mileage credits with participating airlines of 10 miles for each dollar spent on food and beverage at participating establishments for an annual fee of $9.95, and (iii) a no-fee Transmedia Card which affords them 20% savings at participating establishments. Each account may have more than one user and, accordingly, more than one cardmember. The Company's cardmember solicitation efforts over the last fiscal year have been, by design, focused on the fee paying cardmembers who, while more expensive to acquire, tend to use the card more frequently and spend more per dine. The Company also previously offered a silver and gold fee-based Transmedia Card program designed to supplement the existing dining only fee program and entitled the cardmember access to additional benefits and savings at either no-cost or a reduced fee depending upon the cardmembers' election. Renewal fees are $29.95 under the silver program and $49.95 under the gold program. When cardmembers present the Transmedia Card, they sign for the goods or services rendered, as well as for the taxes and tips, as they would with any other charge card. The Company, upon obtaining the receipt (directly or via electronic point of sale transmission) from the appropriate establishment, gives the establishment credit against Rights to Receive which are owned by the Company. The Company then (i) processes the receipt through the cardmember's electronically linked MasterCard, Visa, Discover or American Express card account, which remits to the Company the full amount of the bill, and (ii) either credits the cardmember's MasterCard, Visa, Discover or American Express account the appropriate discount or the cardmember's airline account the appropriate mileage. Taxes and tips are remitted back to the various establishments. At the present time, the Registered Card Program is primarily marketed through airline reward programs. Members enrolled in the program simply register a valid major credit card with Transmedia and then present their registered credit card while dining at a participating restaurant. On a daily basis, a complete detail of all registered credit card numbers is transmitted electronically to a central processor and aggregator of transactions. The aggregator also receives a complete detail of all merchants who are currently members of the Registered Card Program. Based on the Company's agreements with various processors throughout the country, the aggregator receives data for all the credit card transactions from participating merchants. These transactions are then matched to the current registered card file. These matched transactions are transmitted electronically back to the Company and qualified as to whether they are eligible for rebate. Qualified transactions are then used to provide member savings, as well as to invoice and collect from merchants. Savings are delivered to the members in the form of a direct credit on their statement, cash rebate or mileage credit program. The credit or cash rebate provides members with either a monthly check or credit equivalent to 20% of their total spend with participating merchants. Alternatively, members can elect to receive rebates in the form of frequent flyer miles with major airlines, such as United, American, TWA, US Airways, Continental, British Airways, Northwest and Delta Airlines. DOMESTIC FRANCHISING From 1990 to 1994, the Company franchised the Transmedia Card (then known as The Restaurant Card) and related proprietary rights and know-how, including rights to solicit restaurants and acquire Rights to Receive, in the United States, as part of an expansion strategy to develop a national presence. In recent years, however, the Company has adopted a strategy of systematically reacquiring the franchise territories. At September 30, 1999, the Company's remaining franchises were in the following territories: a large part of New Jersey, the Washington, D.C./Baltimore, Maryland region, southern Virginia, and parts of Texas. The Company has also granted an option to acquire a franchise for the State of Hawaii. From January 1997 through December 1999, the Company reacquired the former franchise territories of California, Nevada, Oregon and Washington, Carolinas, Georgia and eastern Tennessee and Dallas/Forth Worth, Houston, San Antonio and Austin. The Company now conducts the operations in all of these reacquired territories directly. The remaining franchises operate under a ten year franchise agreement that is renewable for an additional ten-year term for all locations. Each agreement provides that the Company will assist the franchisee with marketing, advertising, training and other administrative support and licenses the franchisee to use the Company's trademarks in connection with the solicitation of new cardmembers (which is not restricted to the franchisee's territory) and the purchase of Rights to Receive from restaurants in the territory granted to the franchisee. The franchisee is responsible for, among other things, soliciting cardmembers and participating establishments, purchasing Rights to Receive from participating establishments in its territory, and maintaining adequate insurance. In addition to the initial consideration for the grant of the franchise, the franchisee pays to the Company the following continuing fees during the term of the franchise agreement: (i) 7 1/2% of the total meal credits used within the franchisee's territory; (ii) 2 1/2% of the total meal credits sold within the franchisee's territory into the Company's advertising and development fund; (iii) a processing fee of $.20 per sales transaction from the franchisee's territory; and (iv) a monthly service charge of $1.00 per participating establishment in the franchisee's territory. After completing the DALC acquisition, the Company established separate representation agreements with the remaining franchises for those restaurants participating in the Registered Card Program in the respective franchise territory. LICENSING In November 1995, the Company entered into a license arrangement under which a licensee was authorized to solicit Rights to Receive from various types of resorts, hotels and other entities. The territory covered by the license agreement was the continental United States, excluding the State of Minnesota. The term of this arrangement was ten years, with a potential renewal period of ten years and under this arrangement, the Company compensated the licensee through a commission. In December 1996, the Company terminated the license agreement. (See Item 3). In 1993, the Company, through its subsidiary, TMNI International Incorporated, granted an exclusive, perpetual license to Transmedia Europe, Inc. to establish the Company's business in Europe, Turkey and the countries that formerly comprised the Union of Soviet Socialist Republics. In 1994, the Company granted an exclusive perpetual license to Transmedia Asia Pacific Inc. to establish the Company's business in Australia, New Zealand and the Asia-Pacific region (such region covering approximately 16 major countries and areas including, among others, Japan, Hong Kong, Taiwan, Korea, the Philippines and India). The licensee also took an option to purchase a franchise for the State of Hawaii. Both licenses are governed by a Master License Agreement which provides that, among other things, (i) the licensees have the right to sublicense the rights granted under the Master License Agreement to others within the territory, provided that each such sublicense is approved by the Company, (ii) the Company will assist the licensees with training relating to sales, administration, technical and operations of the business, and (iii) the licensees are solely responsible for developing its own market, paying its own expenses for advertising and soliciting cardmembers and participating establishments in its territory. In consideration for the licenses, the Company was paid initial fees aggregating $2,375,000, received an equity interest in the licensee and the right to receive royalties on gross dining volumes. In December 1996, Transmedia Europe Inc. amended the sublicense it had granted for France and expanded the sublicensee's territory to include Belgium and Luxembourg, Italy, Spain and Switzerland (other than the German speaking area). In December 1996, the Company entered into an agreement with Transmedia Europe, Inc. and Transmedia Asia Pacific Inc. amending both of the licenses, among other things, to permit the companies to be reorganized under one entity and to allow them to acquire and operate worldwide the business of Countdown plc., which conducts a discount savings program in Europe and, to a lesser extent, in the United States. Upon closing of the Countdown acquisition, the Company received $250,000 in cash and a $500,000 note bearing interest at 10%, which was payable on April 1, 1998. At September 30, 1999, the licensee had not yet made payments on the note. Given the uncertainty regarding resolution of this matter, the Company has provided a reserve for the face value of the note and related accrued interest. The Company is in negotiations with its licensee to reacquire the licenses for Transmedia Europe and Asia-Pacific, Inc. With the acquisition of DALC, the Company established a reciprocity relationship with CardPlus Japan. AREAS OF OPERATION The Company's areas of operation include Central and South Florida, New York, Chicago and Los Angeles metropolitan areas, Boston and surrounding New England, Philadelphia, San Francisco, Detroit, Indianapolis, Milwaukee, Denver, Phoenix, North and South Carolina, Georgia, parts of Tennessee, Dallas/Forth Worth and Houston. Franchised areas include most of New Jersey, Washington, D.C., Maryland, Virginia and parts of Texas. With the acquisition of Dining a la Card, the Company now has a presence in new areas such as St. Louis, Kansas City, San Diego, Memphis, Minneapolis, Seattle and other parts of Washington, and to a lesser degree, Cincinnati, Pittsburgh, Las Vegas, New Orleans, Portland, Salt Lake City, Tulsa, and Hawaii. Licensing arrangements continue to exist for the United Kingdom, Canada, and Europe, as well as the Asia-Pacific region. PARTICIPATING MERCHANTS AND MEMBERS As of September 30, 1999, the most recent quarterly directories published by the Company, listed 6,400 merchants available to Transmedia cardmembers. As of that date, the Transmedia Card was held by approximately 1,000,000 members, comprised of 690,000 accounts with an average of 1.45 members per account. Separate quarterly directories distributed to members of the Registered Card Program listed 4,180 merchants available to 1,700,000 members of this program. Of these members, 663,000 were non-airline members. The Company has a combined merchant base of 9,500 separate restaurants after eliminating duplicate program participants. The following table sets forth (i) the number of restaurants listed in directories published by the Company and (ii) the number of members, as of the fiscal years ended September 30, 1995 through 1999: The majority of all restaurants listed in the directories published by the Company renew their contracts with the Company after the initial amount of Rights to Receive is expended. At the second renewal, the Company retains approximately eighty (80%) of those restaurants continuing in business. After the second renewal, however, attrition tends to increase because the restaurants, with the Company's help, have either become successful and no longer require the Company's financial and marketing resources, the Company chooses not to renew the restaurant, or the restaurant has gone out of business. Offsetting this decrease are new restaurants that choose to participate as old ones go out of business, and restaurants that were formerly on the program that often re-sign as they further expand and/or desire the program's benefits again. This provides the Company with a continuous flow of new restaurant prospects. The Company believes that in no area where the Company operates is it close to restaurant or member saturation. The increase in membership is mainly due to the addition of 1,700,000 members with the acquisition of DALC. This increase is offset by a reduction of 200,000 members participating in the Transmedia program from 1,200,000 at September 30, 1998 to 1,000,000 at September 30, 1999. The reduction in the Transmedia Card members is a result of the Company's strategy of forcing attrition in the inactive no-fee members and focusing on marketing only the fee-based membership. For fiscal 1999, fee-paying members have a net increase of 50,000 members while the no-fee members have a net decrease of 250,000 members. New fee paying members acquired in 1999 amounted to 95,000, while new no-fee members added were approximately 90,000. MARKETING The Company markets the Transmedia Card through the use of advertising, direct mail and through promotion with co-marketing partners such as banks and affinity groups. Additionally, the Company periodically develops promotions such as frequent dining rewards or additional seasonal discounts to help stimulate utilization by existing cardmembers. Towards the latter part of fiscal 1998, the Company shifted its cardmember acquisition strategy to focus predominantly on the solicitation of fee paying consumers, offering a 25% discount, private label charge card program. The no-fee, lower discount offer is now used only in large volume campaigns that have demonstrated good spending patterns in the past. The Company continues to implement its strategy of marketing primarily fee-based memberships with large marketing partners, principally financial institutions. While recently adopted consumer credit regulations have caused us to alter certain solicitation techniques that produced favorable response rates, the Company is currently testing a series of offers and rollouts and other alternatives such as "earn your fee" through rebates. The various solicitation methods are determined to be successful when the incremental cost of solicitation and promotion is substantially offset by the initial fee income and where future renewal income may have a positive contribution towards profitability. The Company has sent solicitation mailings with marketing partners of approximately 6.5 million pieces during the year ended September 30, 1999. The registered card member base acquired in the DALC transaction is heavily skewed towards airline programs, which enjoy higher renewal rates because the product is both free and in a desirable currency, i.e. frequent flier miles. The increased use of airline programs as a primary source for registered card members has resulted from the dining program's attractiveness to the airlines because of the enhanced value of the frequent flyer membership and the opportunity to sell miles in advance. From the Company's perspective, the business and vacation traveler is an excellent demographic segment and the cost of acquisition is low. There are formal guidelines for the enrollment of registered card members. For the airline members, SignatureCard had established marketing alliances with United Airlines, American Airlines, British Airways, Northwest Airlines, Delta Airlines, Continental Airlines, Trans World Airlines, and US Airways. Under the terms of the DALC acquisition and Service Collaboration Agreement, SignatureCard consented to delegate their duties with respect to dining under the various airline agreements. It is through SignatureCard's sponsor relationship with the airlines that the Company is able to enroll airline members through a variety of methods that often depend on whether the frequent flyer has a relationship with the airlines affinity partners, particularly card issuers such as Citibank, First Card, American Express and Bank of America. The earn miles by dining program is considered advantageous to both the airline carriers and the Company. The airlines benefit because the dining program enhances loyalty among their frequent flyer members and also allows them to sell miles, in advance, similar to a prepaid ticket. The arrangement is attractive to the Company because (1) mileage is purchased on an as needed basis which improves cash flow, (2) by offering airline members 10 miles for each dollar spent at participating merchants, the cost of the 20% rebate discount is effectively reduced if airline miles are elected, and (3) there is no charge by the airline for adding new members. SignatureCard benefits through a profit sharing agreement provided for in the Service Collaboration Agreement with the Company based on revenue generated from members acquired either in the acquisition or subsequently through SignatureCard's efforts. There were no amounts payable under this agreement at September 30, 1999. EMPLOYEES As of September 30, 1999, the Company employed 211 persons, including 26 former SignatureCard employees. The Company had initially employed forty-eight of the former employees for a planned period of transition estimated through March 2000. With the completion of the integration of the registered card operation in November 1999, five of those employees remained in the Chicago offices of whom only one will be permanent. Additionally, the Company has added twelve new employees in its corporate headquarters for information technology, contract administration and the call center. The Company believes that its relationships with its employees are good. COMPETITION The discount dining business remains competitive and the Company competes for both members and participating merchants, such as restaurants, hotels and other applicable service establishments. The Company also anticipates growing competition from various e-commerce ventures. Competitors include discount programs offered by major credit card companies, other companies that offer different kinds of discount marketing programs and numerous small companies which offer services which may compete with the services offered or to be offered by the Company. Certain of the Company's competitors may have substantially greater financial resources and expend considerably larger sums than does the Company for new product development and marketing. Further, the Company must compete with many larger and better-established companies for the hiring and retaining of qualified marketing personnel. The Company believes that the unique features of its programs: the Private Label Card can be used by members at participating establishments with very few restrictions; the programs provide substantial savings without the need for a member to present discount coupons when paying for a meal; and participating establishments are provided with cash in advance of customer charges -- contribute to the Company's competitiveness and allow the Company to offer better value and service to its members and merchants. The Company has also initiated the development of a broader e-commerce strategy, focused on the "dining space" in which it already maintains a dominant position, that it plans to roll out in fiscal year 2000. ITEM 2. ITEM 2. PROPERTIES The Company's present executive office consists of 14,546 square feet, located in Miami, Florida, which the Company occupies pursuant to two lease agreements expiring on February 28, 2002. Both leases provide for a total annual base rental of $294,750. The lease for the executive offices is currently being renegotiated to allow for expansion of an additional 4,944 square feet. The lease cost is expected to be approximately $357,345 per annum with a term of two years and two, two-year renewal periods. The Company's Miami office also houses both the Company's member and merchant service center. The Company leases 5,710 square feet of office space in New York City. The lease, which expires on June 30, 2001, provides for minimum annual rentals of $199,850. In addition, the Company has a five-year office lease in Philadelphia, Pennsylvania for approximately 1,641 square feet, which commenced October 1, 1998. The lease provides for a base annual rent of $27,897 in the first three years and $29,128 for the following two years. In Boston, Massachusetts, the Company has a sixty-four month lease with an option for a three-year renewal, for approximately 1,500 square feet, which commenced May 1, 1995. The lease provides for base annual rentals of $31,418. In Chicago, the Company has a six-year office lease for approximately 1,876 square feet, which commenced August 1, 1998. The lease provides for an initial annual lease rental of $45,024, increasing by approximately 2% each year thereafter. In North Carolina, the Company has a two-year lease, with an option for an additional year, for approximately 3,000 square feet for an annual rental of $36,000, which commenced March 1, 1999. In Detroit, the Company leases an executive office for a twelve-month period that began on April 1, 1999 for a total rental of $15,000. In Tampa, the Company leases an executive office for a twelve-month period that began on July 1, 1999 for a total rental of $9,681. In Phoenix, the Company leases an executive office for a twelve-month period that began on February 1, 1999 for a total rental of $6,336. In Denver, the Company leases an executive office on a month to month basis that began on June 1, 1999 for a monthly rental of $1,400. In Atlanta, the Company leases an executive office for a six-month period that began on July 1, 1999 for a total rental of $6,990. In Dallas, the Company leases an executive office for a five-year period that commenced November 1, 1998. The lease provides for base annual rentals of $25,745. In San Francisco, the Company has a five-year lease that commenced on May 15, 1998 for an initial annual lease rental of $40,128 increasing by approximately 5% each year thereafter. In Los Angeles, the Company has a thirty-seven month lease that commenced on February 1, 1998 for a base annual rental of $46,953. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In December 1996, the Company terminated its license agreement with Sports & Leisure Inc. ("S&L"). In February 1997, S&L commenced an action against the Company in the 11th Judicial Circuit, Dade County, Florida, alleging that the Company improperly terminated the S&L license agreement and seeking money damages. In the quarter ended December 31, 1998, a reserve of $1,000,000 was established and recorded in selling, general and administrative expenses to cover management's best estimate at the time of the potential cost and expenses of this litigation and other legal matters. The Company, in order to avoid prolonged litigation, settled the outstanding lawsuit with its former licensee in November of 1999. Under the terms of the settlement S&L. will receive $2,100,000 in cash and 280,000 shares of common stock for a total of $2,835,000. Based on the fair value of the common stock included in the settlement and net of reserve amounts previously provided by the Company, a charge of $1,835,000 has been recognized in the fourth quarter ended September 30, 1999. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the quarter ended September 30, 1999, no matters were submitted to a vote of the security holders. EXECUTIVE OFFICERS OF THE REGISTRANT NAME POSITION AGE - ---- -------- --- Gene M. Henderson Director, President and Chief Executive 52 Officer Stephen E. Lerch Executive Vice President and 45 Chief Financial Officer James M. Callaghan Vice President; President of Transmedia 60 Restaurant Company Inc. Christine Donohoo Vice President, President of 49 Transmedia Service Company Inc. Paul A. Ficalora Executive Vice President 48 of Transmedia Restaurant Company Inc. Gregory Borges Treasurer 63 Kathryn Ferara Secretary and Vice President of Operations 43 Mr. Henderson was appointed as President and Chief Executive Officer of the Company in October 1998. Previously, Mr. Henderson was President and Chief Executive Officer of DIMAC Marketing, a full service direct marketing company based in St. Louis. Prior to that, Mr. Henderson was Chief Operating Officer of Epsilon, an operating unit of American Express. Mr. Callaghan was elected Vice President of the Company and President of Transmedia Restaurant Company Inc., a subsidiary, in 1994. He was also a director of the Company from 1991 to 1998. Mr. Callaghan joined the Company in 1989 and served as its Executive Vice President, Vice President, Sales and Marketing and Treasurer. Christine Donohoo joined the Company in January 1999, as Vice President and President of Transmedia Service Company Inc. Mrs. Donohoo was formerly Senior Vice President of Credit Card Marketing for Nationsbank (now Bank of America). Mr. Lerch was elected Executive Vice President and Chief Financial Officer of the Company, as well as Vice President of TMNI International Incorporated, Transmedia Restaurant Company Inc. and Transmedia Service Company Inc, subsidiaries, in 1997. Previously, Mr. Lerch was a Partner at Coopers and Lybrand LLP (now PriceWaterhouse Coopers), where he worked from 1978 to 1997. Mr. Ficalora was elected Executive Vice President of the Restaurant Company in 1994, having served as Vice President, Operations of the Company from 1992 until 1994, and Director of Franchise Sales from 1991 to 1992. Mr. Borges was elected Treasurer of the Company in 1992. He joined the Company in 1985 as Controller. Mrs. Ferara was elected Secretary of the Company in 1992. She joined the Company in 1989 as Office Manager and Assistant Secretary. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the New York Stock Exchange under the symbol "TMN". The following table sets forth the high and low sale prices for the common stock for each fiscal quarter ended from December 31, 1997 as reported on the New York Stock Exchange, as well as the dividends paid during each such fiscal quarter. The payment of dividends, if any, in the future, will depend upon, among other things, the Company's earnings and financial requirements, as well as general business conditions. QUARTER ENDED LOW HIGH DIVIDEND PAID ------------- --- ---- ------------- December 31, 1997 $3.813 $ 6.313 $0.02 March 31, 1998 5.000 6.686 -- June 30, 1998 5.438 8.313 -- September 30, 1998 3.188 6.188 -- December 31, 1998 1.938 4.625 -- March 31, 1999 2.375 5.125 -- June 30, 1999 3.000 4.188 -- September 30, 1999 2.688 4.375 -- The aggregate number of holders of record of the Company's Common Stock on December 6, 1999 was approximately 406. On August 5, 1999, the New York Stock Exchange notified the Company of the pending adoption of amendments to its continued listing criteria and of the Company's noncompliance with the new standards. In accordance with the requirements of the notification, the Company submitted to the Exchange its plan to come into compliance with the new criteria. On September 16, 1999, the Company was advised by the Exchange that its plan had been accepted and that it will continue to be listed on the Exchange. The Company's performance relative to the plan of compliance is subject to monitoring by the Exchange over the next six fiscal quarters. The rights offering that closed on November 9, 1999 and resulted in the issuance of $10 million in Series A preferred stock was intended, in part, to position the Company to come into compliance with these standards. The Company commenced trading of its Series A preferred stock on the Exchange on that date under the symbol TMN PrA. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS) RESULTS OF OPERATIONS (1999 VERSUS 1998) Gross dining sales for the fiscal year ended September 30, 1999 increased 26.1% to $120,472 as compared to $95,549 for the year ended September 30, 1998, primarily reflecting the registered card dining sales associated with the acquisition of Dining a la Card (DALC). Sales for the registered card program from June 30, 1999, the date of acquisition, through September 30, 1999 were $25,942. Actual sales for the Transmedia private label program decreased 1.1% to $94,530 compared to $95,549 for the year ended September 30, 1998. The Company continues to experience a decline in private label sales in its largest and most established market of New York. Sales for New York decreased 8.6% to $38,211 as compared to $41,788 for the year ended September 30, 1998. Other noticeable declines occurred in Boston and Philadelphia that decreased 16% and 9%, respectively. During 1999, Transmedia's private label program experienced a higher average monthly spend per cardmember and a higher overall utilization by the cardmember base. However, part of this increased utilization is a function of a forced reduction in inactive cardmembers and a corresponding lower member base in the denominator. The overall private label cardmember base has been reduced when compared to the prior year, and the average number of monthly active accounts decreased from 112 thousand in 1998 to 107 thousand in 1999. Offsetting the sales territories showing decreases were continued higher sales volumes in Chicago, Indiana, Wisconsin, Denver, and Phoenix. Additionally, sales for the reacquired franchise territories of Carolinas, Georgia and Dallas/Ft. Worth (which were reacquired in 1998), and the more recently reacquired Houston territory amounted to approximately $4,610 for the year ended September 30, 1999, compared to $1,474 in 1998. Private-label cardmember accounts decreased 16.9% to 690,000 for the year and total cardmembers at September 30, 1999 were approximately 1,000,000 or 1.45 cardmembers per account. The net decrease in accounts in fiscal 1999 is primarily due to the Company's continued policy of proactively eliminating inactive no-fee accounts while marketing extensively the fee-paying membership that tends to have higher activity. Registered card membership at September 30, 1999 was approximately 1,700,000. Of these members, 663,000 were non-airline members. Airline members, which accounted for approximately 61% of total membership and approximately 68% of sales, do not pay membership fees and typically receive rebates in the form of frequent flyer mileage. The total merchants available to members of the private label and registered card programs were 6,400 and 4,180 at September 30, 1999, respectively. Of the 6,400 merchants available to the members of the private label program, 5,800 are merchants in Company-owned sales territories. There are no franchise territories associated with the registered card program. Due to duplication of merchants in both programs, the total Company-owned merchants listed in both directories at September 30, 1999, were approximately 9,500. At September 30, 1999, the average Rights to Receive balance per participating Company merchant in the private label program was $6.9 versus $7.7 at September 30, 1998. With the inclusion of the registered card program, the combined average Rights to Receive balance per participating Company merchant was $8.0 at September 30, 1999. Rights-to-Receive turnover for the private label program for fiscal 1999 was 1.2, or 10.0 months on hand, compared to 1.2, or 9.9 months on hand, in the prior year. With the inclusion of the DALC portfolio, the Rights to Receive turnover for the combined portfolio is 1.2 or 9.8 months on hand. The Company is presently negotiating a single financing facility intended to securitize the rights to receive in both programs. By having both a private label and a registered card program to offer restaurants, and consolidating the programs into a single securitized debt facility, the Company believes that it can optimize its asset allocation efficiency, more effectively manage credit risk and bring the overall months of Rights to Receive on hand, presently at just between nine and ten months, down to a more acceptable level of six to seven months. Cost of sales increased to 58.2% of gross dining sales from 57.0% a year earlier. The increase in cost of sales is directly related to the addition of the DALC registered card portfolio which was traditionally offered to merchants at an advance rate less than the customary Transmedia private label rate of 2:1 and therefore results in a somewhat higher cost of sales than the private label portfolio. Since the acquisition, however, all new restaurants signed on under the registered card program, as well as the majority of those renewed, have been converted to the 2:1 proposition. While this initially results in a somewhat slower inventory turn, the individual dining transactions are more profitable due to the corresponding reduction in the cost of the Rights to Receive consumed. The provision for Rights-to-Receive losses on the private label program, which are included in cost of sales, decreased to $3,308 or 3.5% of gross sales in 1999, compared to $3,822 or 4.0% in the prior year period. The provision for losses recorded for the registered card program amounted to $780 or 3% of gross sales in 1999. Processing fees based on transactions processed remained constant as a percentage of private label gross dining sales at 3.2% for 1999 and 1998. Member discounts as a percentage of sales decreased slightly from 22.4% in 1998 to 22.0% in 1999. While the effective rate of discount on private label sales increased from 22.4% to 22.9%, reflecting more usage by fee-paying, 25% discount members, the overall decrease is a result of the inclusion of the registered card portfolio during the last quarter of 1999. The majority of the registered card members are enrolled in the airline program and earn 10 miles for each dollar spent at participating merchants. The Company purchases airline mileage from the airlines on an as needed basis at a contractual rate that allows the Company to effectively reduce the cost of the member rebate in the airline program to less than that of the 20% cash rebates. Membership and renewal fee income increased to $8,281, of which $3,387 was initial fee income in 1999, compared to $7,321, of which $701 was initial fee income in 1998. The increased initial fee income is reflective of the Company's continued marketing of the 25% savings fee card with the private label program. Renewal fee income relating to the registered card program was $53. The Company's strategy is to continue to enroll members of the airline mileage programs for which there is very little acquisition cost and the rebate percentage tends to be lower and also to commence marketing a fee-based registered card. Marketing of the private label fee program will continue on a lesser scale and focus on key partner affinity programs. Fee income is recognized over a twelve-month period beginning in the month the fee is received. Cardholder membership fees are cancelable and refunded to members, if requested, on a prorata basis based on the remaining portion of the membership. Continuing franchise fee and royalty income decreased to $1,073 from $1,249. This decrease resulted primarily from the purchase of the Houston franchise territories in 1999. Processing income relates to the Company's full service electronic processing services that commenced during fiscal 1997 and comprises the sale or lease of point-of-sale terminals to merchants, principally restaurants, as well as fees received for serving as the merchants' processor for all of their credit card transactions. Overall selling, general and administrative expenses increased $3,068 or 16.4% over the prior year, mainly as a result of additional costs associated with maintaining separate infrastructures to support both programs during the period of transition. Many of these additional costs will be eliminated when the integration is completed and both dining programs are processed and supported on one platform. The integration of the registered card program was completed in November 1999. At that time substantially all operations in Chicago ceased and the transition agreement with Signature Card was terminated. As a percentage of gross dining sales, selling general and administrative expenses were 18.0% in 1999 compared to 19.5% in 1998. However, this expense increased overall by $3,068 from $18,607 to $21,675. The principal components of the increase include sales commission and related expenses ($3,245 in 1999 versus $2,818 in 1998), depreciation and amortization, principally on the software development costs ($3,462 in 1999 versus $3,194 in 1998), professional fees, mainly legal fees ($2,460 in 1999 versus $2,253 in 1998), rent and other office expenses ($1,819 in 1999 versus $1,530 in 1998), telephone ($1,504 in 1999 versus $1,063 in 1998) and software development and maintenance, inclusive of Y2K charges ($1,800 in 1999 versus $653 in 1998). Salaries and benefits increased $1,636 or 20.0% over the prior year. With the acquisition of DALC, the Company employed forty-eight of the former SignatureCard employees for the expected transition period. In addition, the Company contracted with SignatureCard for customer service, information technology and facilities services. At September 30, 1999, there were 26 former SignatureCard employees still on the payroll. With the completion of the integration of SignatureCard in November 1999, five of those employees remained of which only one will be permanent and all services under the transition agreement were terminated. The Company has added twelve new employees in the corporate headquarters to information technology, contract administration and the call center. In 1999, member acquisition expenses were $6,447 versus $5,097 in 1998. Included in member acquisition expenses is the amortization of deferred acquisitions costs, which amounted to $3,335 in 1999 and $701 in 1998. Costs capitalized in 1999 and 1998 were $4,184 and $1,184, respectively. The Company used various techniques at different levels of cost to solicit new members. Consumer privacy regulations adopted in 1999 required the Company to change certain methods of solicitations that had resulted in favorable response rates. Prospective cardmembers continue to be solicited through direct mail and the use of affinity and loyalty programs with major credit card issuers and corporations. Third party and strategic marketing partners are compensated through a commission on fees received and to a lesser degree, on an activation basis or through wholesaling of the fee based savings card. The mix of solicitation programs used has a direct correlation to the overall acquisition cost per member and the spending profile of members acquired. The Company seeks to employ the most cost-effective means of acquiring active and frequent users of the card and typically uses solicitation methods whereby the fees earned substantially offset the cost of acquisition. The Company, in order to avoid prolonged litigation, settled the outstanding lawsuit with its former licensee, Sports & Leisure, Inc., in November of 1999. Under the terms of the settlement, Sports & Leisure, Inc. will receive $2,100 in cash and 280,000 shares of common stock for a total of $2,835. Based on the fair value of the common stock included in the settlement and net of reserve amounts previously provided by the Company in the first quarter of 1999, a charge of $1,835 has been recognized in the fourth fiscal quarter of 1999. The amended employment agreement and termination of the consulting agreement of the Chief Executive Officer resulted in a one-time charge of $3,081 1998. Components included in the charge were a lump-sum cash payment of $2,750, cancellation of indebtedness of $135, and health insurance for the remainder of his life. The after tax impact of the charge was approximately $1,900. Also, the Company recorded a charge of $463 in fiscal 1998 relating to the remaining outstanding obligation under consulting agreements with former employees that the Company has determined it no longer requires nor intends to utilize. The Company recognized an asset impairment loss of $2,169 ($.18 per share) in 1998. The continued lag in dining sales in California, reacquired from a former franchise in January 1997, indicated that the projected undiscounted cash flows from this former franchise were less than the carrying value of the excess of cost over net assets acquired. Additional investments in both merchants and new card members as well as expansion into new markets in reacquired franchise territory were required to generate sales sufficient to realize the value of the intangible asset. Operating loss in 1999 was $5,994 compared to $7,465 in 1998. Other income, net of expense in 1999 was a net expense amounting to $2,404 versus $2,971 in 1998, a decrease of $567. The principal reasons for the change included $1,149 of realized gain on sale of securities available for sale which is offset by additional interest expense and financing costs in 1999, as a result of the additional $39 million of term loans, in part, used to purchase the DALC Rights to Receive. Earnings before taxes amounted to a loss of $8,398 in 1999 compared with loss of $10,436 in 1998. Due to the Company's continued losses, an additional valuation reserve of $2,000 has been applied to the net deferred tax asset for fiscal 1999. At September 30, 1999, the net deferred tax asset, principally related to net operating loss carryforward amount to $2,000 has been fully reserved. The effective tax rate for fiscal 1999 was 24% and reflects the valuation reserve of $2,000 applied to the net deferred tax asset. Net loss was $10,398 or $.80 per share in 1999, versus net loss of $7,836 or $.67 per share in 1998. RESULTS OF OPERATIONS (1998 VERSUS 1997) Gross dining sales for the fiscal year ended September 30, 1998 decreased 5.7% to $95,549 as compared to $101,301 for the year ended September 30, 1997. Lower sales volume in the Company's larger, more established markets were only partially offset by increased sales in new regions and reacquired franchises. Sales volume in the New York metropolitan area and South Florida, two of the Company's largest and most competitive markets, declined 17% and 19%, respectively, compared to the prior year. Noticeable declines also occurred in Philadelphia and Detroit. Factors driving the decline in dining sales were lower spend per cardmember and lower overall utilization by the cardmember base. Offsetting these decreases were higher sales volumes in other markets such as Chicago, Denver, Phoenix, Wisconsin and Indiana. Gross dining sales associated with the Carolinas, Georgia and Dallas/Fort Worth reacquired franchise territories amounted to approximately $1,474 since their acquisition in 1998. Cardmember accounts decreased 7.3% to 838,118 for the year and total cardmembers at September 30, 1998 were 1,203,080 or 1.44 cardmembers per account. The net decrease in accounts is primarily due to the Company's new policy in fiscal 1998 of proactively eliminating inactive no-fee accounts. The total restaurants available to cardmembers remained fairly consistent between years. At September 30, 1998, the Company had 7,274 restaurants listed in its directories (7,087 at September 30, 1997), of which 5,495 were in Company-owned sales territories and 757 were overseas. The increase in Company-owned restaurants from 4,922 a year ago relates primarily to the acquisition of the Carolinas, Georgia and Dallas/Fort Worth franchise territories. At September 30, 1998, the average Rights to Receive balance per participating Company restaurant was $7,706 versus $8,198 at September 30, 1997. Rights-to-Receive turnover for fiscal 1998 was 1.2, or 9.9 months on hand, compared to 1.3, or 9.2 months on hand, in the prior year. The lower turnover is attributable to the decreased sales volumes in New York and South Florida and an increased investment in the California marketplace. Cost of sales increased to 57.0% of gross dining sales from 56.3% a year earlier. Provision for Rights-to-Receive losses, which are included in cost of sales, amounted to 3,822 in 1998, compared to $3,209 in the prior year. Processing fees based on transactions processed remained constant as a percentage of gross dining sales at 3.2% for 1998 and 1997. Cardmember discounts as a percentage of sales remained stable. Membership and renewal fee income slightly increased to $7,321, of which $701 was initial fee income in 1998, compared to $7,251, of which $670 was initial fee income in 1997. Initial fee income remains lower, on a relative basis, due to the continued marketing of the no-fee product in 1998 and does not yet reflect the Company's new focus on marketing the 25% savings fee card. Fee income is recognized over a twelve-month period beginning in the month the fee is received. Cardholder membership fees are cancelable and refunded to cardmembers, if requested, on a prorata basis based on the remaining portion of the membership. Continuing franchise fee and royalty income decreased to $1,249 from $1,438. This decrease resulted primarily from the purchase of the Carolinas, Georgia and Dallas/Fort Worth franchise territories in 1998. Processing income relates to the Company's full service electronic processing services that commenced during fiscal 1997 and comprises the sale or lease of point-of-sale terminals to merchants, principally restaurants, as well as fees received for serving as the merchants' processor for all of their credit card transactions. Overall selling, general and administrative expenses increased $1,200 or 4.7% over the prior year. As a percentage of gross dining usage, selling general and administrative expenses were 28% in 1998 compared to 25.3% in 1997. The principal components of the increase include salaries and related expenses ($8,189 in 1998 versus $7,923 in 1997), depreciation and amortization, principally on the software development costs ($3,194 in 1998 versus $2,232 in 1997), office related expenses ($2,882 in 1998 versus $2,688 in 1997), and legal ($1,418 in 1998 versus $983 in 1997). Additionally, the acquisition of the Carolina and Georgia franchise in December 1997, and the Dallas/Fort Worth territory in July 1998, resulted in additional costs associated with establishing these sales territories. In 1998, cardmember acquisition expenses were $5,097 versus $4,650 in 1997. Included in cardmember acquisition expenses is the amortization of deferred acquisitions costs, which amounted to $701 in 1998 and $670 in 1997. Costs capitalized in 1998 and 1997 were $1,184 and $446, respectively. The amended employment agreement and termination of the consulting agreement of the Chief Executive Officer resulted in a one-time charge of $3,081 in the first quarter of 1998. Components included in the charge were a lump-sum cash payment of $2,750, cancellation of indebtedness of $135, and health insurance for the remainder of his life. The after tax impact of the charge was approximately $1,900. Also, the Company recorded a charge of $463 relating to the remaining outstanding obligation under consulting agreements with former employees that the Company has determined it no longer requires nor intends to utilize. The continued lag in dining sales in California, reacquired from a former franchise in January 1997, indicated that presently the undiscounted cash flows from this former franchise are less than the carrying value of the excess of cost over net assets acquired. Additional investments in both merchants and new card members as well as expansion into new markets in reacquired franchise territory will be required to generate sales sufficient to realize the value of the intangible asset. Accordingly, the Company recognized an asset impairment loss of $2,169 ($.18 per share). Operating loss in 1998 was $7,465, a $8,163 decrease from 1997. Other income, net of expense in 1998 was a net expense amounting to $2,971 versus $1,382 in 1997, an increased expense of $1,589. The principal reasons for the change included $449 additional interest expense and financing costs in 1998, as a result of the $33 million securitization and the write-down of $710 relating to the Company's international licensees. Offsetting these expenses was a realized gain of $200 on securities available-for-sale Earnings before taxes amounted to a loss of $10,436 in 1998 compared with loss of $684 in 1997. The effective tax rate in 1998 and 1997 was 25% and 38.0%, respectively. The change in the effective tax rate for fiscal 1998 reflects the valuation reserve of $972 applied to the net deferred tax asset. Net loss was $7,836 or $.67 per share in 1998, versus net income of $424 or $.04 per share in 1997. LIQUIDITY AND CAPITAL RESOURCES The Company's working capital decreased to $49,398 at September 30, 1999 from $45,995 at September 30, 1998. EQUITY GROUP INVESTMENT On March 4, 1998, the Company issued and sold 2.5 million common shares and non-transferable warrants to purchase an additional 1.2 million common shares for a total of $10,625 to affiliates of Equity Group Investments, Inc., a privately held investment company. Net proceeds amounted to $9,825 after transaction costs. The non-transferable warrants have a term of five years; one third of the warrants are exercisable at $6.00 per share, another third are exercisable at $7.00 per share and the third are exercisable at $8.00 per share. As part of this strategic investment, Equity Group nominated and the shareholders elected two candidates for the Board of Directors who joined three of the Company's existing directors and two new independent directors. FINANCING OF DINING A LA CARD ACQUISITION In connection with the acquisition of Dining A La Card on June 30, 1999, the Company obtained a senior secured revolving bridge loan from the Chase Manhattan Bank (note 4). The loan permitted the Company to borrow an amount equal to the lesser of (i) $35 million and (ii) the amount available under a borrowing base formula based on the amount of registered card rights-to-receive which meet certain eligibility criteria. At September 30, 1999, the borrowing base capacity was $31.5 million and the amount drawn down by the Company was $29 million. The facility expired on December 30, 1999 and was paid off with the proceeds of the $80 million securitization described further in this section. RIGHTS OFFERING On November 9, 1999, the Company completed its Rights Offering to existing shareholders resulting in the issuance of 4,149,378 convertible, redeemable preferred shares. The preferred shares have a dividend rate of 12%, of which 6% is payable in cash, quarterly in arrears, and the remaining 6% accrues unless otherwise paid currently at the Company's discretion, until conversion by the holder. Each preferred share may be converted into common stock at the option of the holder at any time. The initial rate of conversion is one to one. Subsequent conversion rates could be higher to the extent of accrued but unpaid dividends. If not previously converted, the Company may commence redemption of the preferred shares on the fifth anniversary of the rights offering. The proceeds from the stock issuance of $10,000 were used to retire the $10,000 bridge loan obtained from GAMI Investment. Pursuant to its subscription privileges and as a Standby Purchaser for any unsubscribed shares, EGI acquired 2.84 million of the preferred shares. The additional investment provides EGI with the right to designate an additional member to the Board of Directors. The size of the Board will increase by one if EGI chooses to exercise that right. The terms of this loan also required the Company to pay GAMI, at closing, a cash fee of $500, which was reimbursable to the Company upon the consummation of the rights offering and the issuance to Samstock L.L.C. of warrants to purchase 1 million shares of the Company's common stock in consideration of providing the loan and if it acted as a standby purchaser in connection with the rights offering. SECURITIZATION OF RIGHTS TO RECEIVE On December 24, 1996, the Company made an initial transfer of $33 million of rights-to-receive to a special purpose corporation ("SPC"), an indirect wholly owned subsidiary, as part of a revolving securitization. The Rights-to-Receive, which were sold to the SPC without recourse, were in turn transferred to a limited liability corporation ("Issuer"), which issued $33 million of five-year term fixed rate securities, bearing interest at 7.4%, in a private placement to various third party investors. In exchange for the rights-to-receive, which have a retail value of approximately $66 million before cardmember discounts, the Company received approximately $32 million, after transaction costs, and a 1% equity interest in the Issuer. Excess cash flows generated from the securitized assets as the rights-to-receive are exchanged for meals by Company cardholders, are remitted to the Company on a monthly basis as a return on capital from the Issuer. Excess cash flows are determined after payments of interest to noteholders and investors, as well as trustee and servicing fees. During the five-year revolving period, the Issuer is responsible for the ongoing purchase of rights-to-receive from the Company to ensure that the initial pool of $33 million is continually replenished as the rights-to-receive are utilized by cardholders. Rights-to-receive currently held by the Issuer, as well as cash and certain deposits restricted under the securitization agreement, have been separately depicted in the consolidated balance sheet. The Company has engaged Chase Securities Inc. to arrange an $80 million securitization facilty, using the assets of its recently acquired registered card rights-to-receive portfolio combined with the existing securitized portfolio. The permanent financing vehicle will be established with an asset backed commercial paper conduit administered by the Chase Manhattan Bank. This loan will permit the Company to borrow an amount equal to the lesser of (i) $80 million and (ii) the amount available under a borrowing base formula based on the amount of aggregate rights-to-receive which meet certain eligibility criteria. The interest rate applicable to the facility will be either (1) the Eurodollar which is a rate 1.25% in excess of a rate per annum equal to the LIBOR Rate and will be limited to interest periods of up to three months and (2) the Alternate Base Rate which is the higher of (i) Chase's Prime rate and (ii) the Federal Funds Effective Rate plus 1.5%. The new facility was closed on December 30, 1999 and $65 million was drawn down. Simultaneously, the 1996 securitization was terminated and the outstanding principal plus a termination penalty was paid off in the aggregate of $33.9 million. Additionally, the outstanding balance of the Chase bridge loan of $27.1 million was paid off. Financing fees of $1.1 million were also paid. In addition to this $80 million securitization facility, the Company is negotiating a warehouse line of credit with Chase Securities to fund the growth in new markets and the purchase of the corresponding new Rights to Receive. The Company's inventory of Rights to Receive increased by $34,107 to a total of $76,454 at September 30, 1999. The reason for this increase is the acquisition of DALC which represents $36,434 of the Rights to Receive balance at September 30, 1999. In many instances the Rights to Receive purchased by the Company are secured by the furniture, fixtures and kitchen equipment of the related restaurants as filed pursuant to the Uniform Commercial Code. The Company also attempts to obtain personal guarantees from the restaurant owners. Analysis of Rights to Receive Management of the Company believes that continued increase in the number of restaurants that participate in the private label and registered card dining programs is essential to attract and retain members. The Company strives to constantly manage the dynamics of each market by balancing the rights-to-receive acquired to the cardmember demand. This balance is critical to achieving the participating restaurants objectives of incremental business and yield management and the cardmembers desire for an adequate amount of desirable dining establishments. Management believes that the purchase of Rights to Receive can be funded generally from cash generated from operations, and from funds made available through the securitization. GENERAL The Company expects to continue to make significant marketing expenditures over the next fiscal year, with a primary focus on fee paying registered card members. The Company believes that member acquisition cost can either be substantially funded by the initial fee income or minimized through the ongoing relationship with SignatureCard and their airline agreements. Furthermore, the Company believes that the rights to receive inventory levels in the existing markets, currently averaging approximately ten months on hand on an aggregate basis, are sufficient to absorb much of the new member demand over the next fiscal year, particularly when targeting new members in existing markets. The Company believes that there will be sufficient capacity available under the new securitization and the warehouse line currently being negotiated to fund the entry into new territories and the expansion of existing markets. Capital expenditures by the Company over the past three fiscal years (approximately $7.7 million) have been due almost exclusively to the Company's development and acquisition of computer hardware and software supporting the credit card processing technology necessary to the operation of the dining programs, the Cardmember Service Center and the integration of the registered card platform. The Company believes that cash on hand at September 30, 1999, together with cash generated from operations and available under the securitization facility will satisfy the Company's operating capital needs during the 2000 fiscal year. SFAS No. 109 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. A valuation allowance was recorded for the remaining amount of the net deferred tax assets as of September 30, 1999, due to the Company's recurring losses. The valuation allowance at September 30, 1999 and 1998 was $6,005 and $972, respectively. The net deferred tax asset relates primarily to net operating loss carryforwards which are available through 2019 and amount to $12,044 at September 30, 1999. Operating activities during fiscal 1999 resulted in net cash provided of $3,361. However, further expansion into new markets and planned increases in existing markets could reverse this trend depending on the rate of growth management deems appropriate. As described in the above paragraph, funds generated from operations, as well as capacity under the securitization, should be sufficient to fund such growth over the next twelve months. Additionally, the Company's continued focus on acquiring fee-paying cardmembers is expected to generate net positive cash flows in fiscal 2000. Cash used in investing activities was $38,148 in the fiscal year ended September 30, 1999, compared with $3,624 used in 1998 and $11,887 used in 1997. Cash utilized in investing activities were due primarily to the acquisition of DALC, and the development and acquisition of computer hardware and software necessary for the operation of the Company's Cardmember Service Center and the integration of the registered card platform into the Company's exisiting systems. Management believes that cash to be used in investing activities associated with capital expenditures in the fiscal year ended September 30, 2000 will approximate $2.5 million. Cash flows provided by financing activities were $39,098 for the fiscal year ended September 30, 1999, compared with cash flows provided by financing activities of $8,353 in 1998 and $14,499 in 1997. In 1999, the principal source of cash flow was proceeds from short term borrowing of $29,000 from Chase Manhattan Bank and $10,000 from GAMI Investments, Inc used to finance the purchase of DALC. In 1998, the principal source of cash flow was from the issuance of common stock in connection with the investment by the Equity Group Investment, Inc. In 1997, the principal source of cash flow was proceeds from the issuance of secured non-recourse notes relating to the securitization. On August 5, 1999, the New York Stock Exchange notified the Company of the pending adoption of amendments to its continued listing criteria and of the Company's noncompliance with the new standards. In accordance with the requirements of the notification, the Company submitted to the Exchange its plan to come into compliance with the new criteria. On September 16, 1999, the Company was advised by the Exchange that its plan had been accepted and that it will continue to be listed on the Exchange. The Company's performance relative to the plan of compliance is subject to monitoring by the Exchange over the next six fiscal quarters. The rights offering that closed on November 9, 1999, and resulted in the issuance of $10 million in Series A preferred stock was intended, in part, to position the Company to come into compliance with these standards. The Company commenced trading of its Series A preferred stock on the Exchange on that date under the symbol TMN PFA. YEAR 2000 In 1998, the Company initiated a plan ("Plan") to identify, assess, and remediate "Year 2000" issues within each of its computer programs and certain equipment which contain micro-processors. The Plan addressed the issue of computer programs and embedded computer chips being unable to distinguish between the year 1900 and 2000, if a program or chip uses only two digits rather than four to define the applicable year. The Company divided the Plan into six major phases: assessment, planning, validation, conversion, implementation and testing. After completing the assessment and planning phase in late 1998, the Company hired an independent consulting firm to validate the Plan. All software development and installation effected during 1999 is currently in compliance. The Company worked with an outside vendor on the conversion, implementation and testing phases. Systems that were determined not to be Year 2000 compliant have been either replaced or reprogrammed, and thereafter tested for Year 2000 compliance. The Company believes that at September 30, 1999 the conversion, implementation and testing phases had been materially completed. The original budget for the total cost of remediation (including replacement software and hardware) and testing, as set forth in the Plan, was $500. The Company's aggregate spending on the Year 2000 remediation at September 30, 1999, which has been expensed, was $641. The Company has identified and contacted critical suppliers and customers whose computerized systems interface with the Company's systems, regarding their plans and progress in addressing their Year 2000 issues. The Company has received varying information from such third parties on the state of compliance or expected compliance. Contingency plans are being developed in the event that any critical supplier or customer is not compliant. The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-party suppliers and customers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's operations, liquidity or financial conditions. FORWARD-LOOKING STATEMENTS The Company has made, and continues to make, various forward-looking statements with respect to its financial position, business strategy, projected costs, projected savings and plans and objectives of management. Such forward-looking statements are identified by the use of forward-looking words or phrases such as "anticipates," "intends," "expects," "plans," "believes," "estimates," or words or phrases of similar import. Although the Company believes that its expectations are based on reasonable assumptions within the bounds of its knowledge, investors and prospective investors are cautioned that such statements are only projections and that actual events or results may differ materially from those expressed in any such forwarding looking statements. The Company's actual consolidated quarterly or annual operating results have been affected in the past, or could be affected in the future, by factors, including, without limitation, general economic, business and market conditions; relationships with credit card issuers and other marketing partners; regulations affecting the use of credit card files, extreme weather conditions; participating restaurants' continued acceptance of discount dining programs and the availability of other alternative sources of capital to them. ITEM 8. ITEM 8. FINANCIAL STATEMENTS Independent Auditors' Report F - 1 Financial Statements: Consolidated Balance Sheets, F - 2 September 30, 1999 and 1998 Consolidated Statements of Income F - 3,4 and Comprehensive Income/(Loss) for each of the years in the three-year period ended September 30, 1999 Consolidated Statements of Shareholders' F - 5 Equity for each of the years in the three-year period ended September 30, 1999 Consolidated Statements of Cash Flows F - 6,7,8 for each of the years in the three-year period ended September 30, 1999 Notes to Consolidated Financial Statements F - 9 Schedule II - Valuation and Qualifying Accounts F - 30 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Transmedia Network Inc. and subsidiaries: We have audited the accompanying consolidated balance sheets of Transmedia Network Inc. and subsidiaries (the "Company") as of September 30, 1999 and 1998, and the related consolidated statements of operations, and comprehensive loss, shareholders' equity and cash flows for each of the years in the three-year period ended September 30, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Transmedia Network Inc. and subsidiaries as of September 30, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 1999, in conformity with generally accepted accounting principles. December 3, 1999, except as to notes (4) and (21), which are as of December 30, 1999 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS September 30, 1999 and 1998 (in thousands) See accompanying notes to consolidated financial statements. TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS For each of the years in the three-year period ended September 30, 1999 (in thousands, except income per share) (Continued) TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS, CONTINUED For each of the years in the three-year period ended September 30, 1999 See accompanying notes to consolidated financial statements. TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For each of the years in the three-year period ended September 30, 1999 (in thousands) See accompanying notes to consolidated financial statements. TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For each of the years in the three-year period ended September 30, 1999 (in thousands) (Continued) TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED Supplemental schedule of noncash investing and financing activities: Noncash investing and financing activities: At September 30, 1999, 1998 and 1997, the Company adjusted its available for sale investment portfolio to fair value resulting in a net (decrease) increase to Shareholders' equity of ($394), ($447) and $74, net of deferred income taxes. There is no dividend payable outstanding as of September 30, 1999, 1998 and 1997. The acquisition of Dining a la Card for $35,000, 400,000 shares of common stock, with a put value of $8 per share, and options to purchase 400,000 shares of common stock, was recorded at the end of the third quarter of fiscal 1999 as follows (Note 2): Fair value of assets acquired: Rights-to-receive $ 40,782 Other assets 231 Accrued expenses (663) Stock options outstanding (697) Guaranteed value of puts (1,471) Common stock issued (1,729) -------- Cash paid $ 36,453 ======== The acquisition of the Houston franchisee was recorded during the second quarter of fiscal year 1999 as follows (see Note 13): Fair value of assets acquired: Rights-to-receive $ 127 Other assets 13 Excess of cost over net assets acquired 536 -------- Less: Cash paid 648 -------- Liabilities assumed $ 28 ======== TRANSMEDIA NETWORK INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED The acquisition of the Dallas/Ft. Worth franchisee was recorded during the fourth quarter of fiscal year 1998 as follows (see Note 13): Fair value of assets acquired: Rights-to-receive $ 266 Other assets 8 Excess of cost over net assets acquired 1,541 -------- 1,815 Less: Cash paid 1,758 -------- Liabilities assumed $ 57 ======== The acquisition of the rights-to-receive and cancellation of the franchise of East American Trading Company, for 170,000 shares of common stock, was recorded during the first quarter of fiscal year 1998 as follows (see Note 13): Fair value of assets acquired: Rights-to-receive $ 267 Excess of cost over net assets acquired 740 -------- Net assets acquired $ 1,007 ======== The acquisition of the West Coast franchisee in fiscal year 1997 (see Note 13) was recorded as follows: Fair value of assets acquired: Rights-to-receive $ 2,659 Other assets 45 Excess of cost over net assets acquired 5,017 -------- 7,721 Less: Cash paid 7,454 -------- Liabilities assumed $ 267 ======== See accompanying notes to consolidated financial statements. TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) DESCRIPTION OF BUSINESS Transmedia Network Inc. and subsidiaries' (the "Company") owns and markets a charge card ("the Transmedia Card") offering savings to the Company's card members on dining as well as lodging, travel, retail catalogues and long distance telephone calls. The Company's primary business activity is to acquire, principally through cash advances, the rights-to-receive food and beverage credits at full retail value from restaurants ("Rights-to-receive"), which are then sold for cash to its members. These Rights-to-receive are primarily purchased by the Company for cash but may also be acquired in exchange for services. The Company's areas of operation included Central and South Florida, the New York, Chicago and Los Angeles metropolitan areas, Boston and surrounding New England, Philadelphia, San Francisco, Detroit, Indianapolis, Milwaukee, Denver, Phoenix, North and South Carolina, Georgia, parts of Tennessee and Dallas/Ft Worth. Franchised areas include most of New Jersey, Washington, D.C., Maryland, Virginia, and parts of Texas. Licensing arrangements exist for the United Kingdom, Canada, and Europe, as well as the Asia-Pacific region. On June 30, 1999, the Company acquired from SignatureCard, Inc. ("SignatureCard"), a subsidiary of Montgomery Ward & Co., Incorporated, assets related to a membership discount program SignatureCard operated under the trade name and service mark "Dining A La Card". The assets acquired included various intellectual property rights and computer software, membership and merchant data, rights-to-receive, and most significantly, a registered card platform, among other things. The registered card program is primarily marketed through airline reward programs where savings are passed on to members in the form of frequent flyer miles. With the acquisition of Dining a la Card, the Company now has a presence in new areas such as St. Louis, Kansas City, San Diego, Memphis, Minneapolis, Seattle and other parts of Washington, and to a lesser degree, Cincinnati, Pittsburgh, Las Vegas, New Orleans, Portland, Salt Lake City, Tulsa, and Hawaii. The Statement of Income includes the results of the acquired registered card operation commencing June 30, 1999. Transmedia Network Inc.'s corporate structure consists of three wholly owned subsidiaries: Transmedia Restaurant Company Inc., functions as the sales organization and is responsible for merchant acquisition and relationship management; TMNI International Incorporated is responsible for all foreign licensing; and Transmedia Service Company Inc., is responsible for all card member-related facets of the business, including the card member service center, domestic franchising, and support services to Transmedia Restaurant Company. In 1997, TNI Funding I, Inc. was established as a special purpose corporation as part of the securitization discussed in Note 5. TNI Funding I, Inc. is a wholly owned subsidiary of Transmedia Service Company, Inc. All intercompany accounts and transactions have been eliminated in consolidation. (B) CASH AND CASH EQUIVALENTS Cash and cash equivalents are instruments with original maturities at the date of purchase of three months or less. (C) RIGHTS-TO-RECEIVE Rights-to-receive ("Rights") are composed primarily of food and beverage credits acquired from restaurants. Rights are stated at the gross amount of the commitment to the establishment. Accounts payable-rights-to-receive represent the unfunded portion of the total commitments. F - 9 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Cost is determined by the first-in, first-out method. The Company reviews the realizability of the Rights on a periodic basis and provides for anticipated losses on Rights-to-receive from restaurants that have ceased operations or whose credits are not utilized by cardholders. These losses are offset by recoveries from restaurants previously written off. (D) SECURITIES AVAILABLE FOR SALE All of the Company's investments are available to be sold in response to the Company's liquidity needs and asset-liability management strategies, among other reasons. Investments available-for-sale on the balance sheet are stated at fair value. Unrealized gains and losses are excluded from earnings and are reported in a separate component of shareholders' equity (cumulative other comprehensive income), net of related deferred income taxes. A decline in the fair value of an available-for-sale security below cost that is deemed other than temporary results in a charge to income, resulting in the establishment of a new cost basis for the security. All declines in fair values of the Company's investment securities in 1999 and 1998 were deemed to be temporary. Dividends are recognized when earned. Realized gains and losses are included in earnings and are derived using the specific-identification method for determining the cost of securities sold. (E) PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation on property and equipment used in the business is calculated on the straight-line method over an estimated useful life of five years. Amortization of leasehold improvements is calculated over the shorter of the lease term or estimated useful life of the asset. Equipment held for sale or lease consists primarily of electronic terminals used for credit card processing and is stated at cost. Depreciation is calculated on a straight-line basis over a three-year life. (F) EXCESS OF COST OVER NET ASSETS ACQUIRED Excess of cost over net assets acquired has resulted primarily from the acquisition of franchise territories (see note 13) and is amortized on a straight line basis over the expected periods to be benefited, generally 20 years. The Company's accounting policy regarding the assessment of the recoverability of intangibles is to review the carrying value of goodwill and other intangibles if the facts and circumstances suggest that they may be impaired. The Company assesses the recoverability of intangible assets by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company's average cost of funds. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved. (G) DEFERRED MEMBERSHIP AND RENEWAL FEE INCOME Initial membership and renewal fees are billed in advance and amortized on a straight-line basis over twelve months, which represents the standard membership period. Membership fees are cancelable and are refunded to members, if requested, on a prorata basis based on the remaining portion of the membership period. F - 10 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Certain costs of acquiring members are deferred and amortized, on a straight-line basis over 12 months. The acquisition costs capitalized as assets by the Company represent initial fee-paying member acquisition costs resulting from direct-response campaign costs that are recorded as incurred. Campaign costs include incremental direct costs of direct-response advertising, such as printing of brochures, campaign applications and mailing. Such costs are deferred only to the extent of initial membership fees generated by the campaign. Acquisition expenses represent the cost of acquiring members and consist primarily of direct-response advertising costs incurred in excess of fees received and amortization of previously deferred costs and costs associated with soliciting no-fee members. (H) REVENUE RECOGNITION Gross dining sales represent the retail value of the rights-to-receive that are recognized when members use either of the two programs at a dining establishment. Continuing franchise fee revenue represents royalties calculated as a percentage of the franchisees' sales and is recognized when earned. Initial franchise fees and license fees are recognized when material services or conditions relating to the sale of the franchise have been substantially performed. Commission income represents income earned on discounted products and services provided by third parties to the Company's members. Such services consist of retail catalogues, phone cards and travel services. Processing income represent the net fees charged to restaurants when the Company serves as merchant of record for processing of all other non-Transmedia point of sale transactions. Processing income is recognized when collected. (I) COST OF SALES AND MEMBER DISCOUNTS Cost of sales is composed of the cost of rights-to-receive sold, related processing fees and provision for rights-to-receive losses. Member discount represents the cost of the specific discount earned by members whenever one of the two programs is used. (J) INCOME TAXES The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. (K) STOCK BASED COMPENSATION In fiscal 1997, the Company adopted the disclosure only provision of Statement of Financial Accounting Standards ("SFAS") No.123, "Accounting for Stock-Based Compensation." The F - 11 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Company continues to account for its stock compensation arrangements using the intrinsic value method in accordance with Accounting Principles Board ("APB") Opinion No.25, "Accounting for Stock Issued to Employees." (L) LOSS PER COMMON AND COMMON EQUIVALENT SHARE Basic loss per share is based on the weighted average number of common shares outstanding during the period presented. Diluted loss per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding in the periods, assuming exercise of options and warrants calculated under the treasury stock method, based on average stock market prices at the end of the periods. (M) COMPREHENSIVE INCOME AND LOSS Comprehensive income and loss presents a measure of all changes in shareholders' equity except for changes in equity resulting from transactions with shareholders in their capacity as shareholders. The Company's other comprehensive loss presently consists of net unrealized holding (losses) gains on investments available for sale. Total comprehensive losses were ($10,098), ($8,283), and ($350) for the years ended September 30, 1999, 1998 and 1997, respectively. (N) RECLASSIFICATION Certain prior year amounts have been reclassified to conform to the 1999 presentation. (O) USE OF ESTIMATES Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates. The principal estimates used by the Company relate to the provision for rights to receive losses and the valuation allowance for net deferred tax assets. (2) ACQUISITION OF DINING A LA CARD On June 30, 1999, the Company concluded the acquisition from SignatureCard, Inc. ("SignatureCard"), a subsidiary of Montgomery Ward & Co., Incorporated, of assets related to a membership discount dining program SignatureCard operated under the Dining A La Card trade name and service mark. The assets acquired included various intellectual property rights and computer software, membership and merchant data, rights-to-receive, and, most significantly, a registered card platform, among other things. The acquisition was accounted for under the purchase method, and accordingly, the results of operations of the acquired company have been included in the consolidated results of Transmedia Network Inc., since the effective date of acquisition. The purchase price of $40,783 has been allocated, in its entirety, to the rights to receive. As consideration for the assets, the Company (1) paid SignatureCard $35,000 in cash at closing, (2) issued to SignatureCard 400,000 shares of the Company's common stock and (3) issued to SignatureCard a three-year option to purchase an additional 400,000 shares of the Company's common stock at a price of $4.00 per share. The options, which are included in the cost of the acquired assets, were valued using the Black-Scholes model and assigned a value of $697. The shares issued were valued at $4.32 per share using an average price over the measurement period. Commencing F - 12 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) December 31, 1999, SignatureCard, at any time prior to June 30, 2002, may require the Company to repurchase all or part of the 400,000 shares issued at the closing at a price of $8.00 per share. The guaranteed value of the puts recorded at September 30, 1999, is $2,336. In addition, during the two-year period following the closing, the Company has agreed to share with SignatureCard certain amounts recovered from rights to receive acquired, but not funded, at closing. In connection with the acquisition of Dining A La Card, the Company entered into a Services Collaboration Agreement with SignatureCard. Under this agreement, SignatureCard will continue to provide dining members from its airline frequent flyer partner programs and other marketing programs. It will also share, for 12.5 years, certain profits the Company derives from SignatureCard-generated members as well as a portion of the membership fee revenues generated from fee paying members acquired in this transaction or subsequently through SignatureCard's efforts. To finance the acquisition, the Company obtained a $35,000 senior secured revolving bridge loan facility from The Chase Manhattan Bank (from which $29,000 was drawn down at closing) and a $10,000 term loan from GAMI Investments, Inc., an affiliate of EGI (which was drawn down in full) See Note 4. In connection with this acquisition, the Company paid a fee for transaction advisory services to Equity Group Investments LLC, an affiliate of the Company's largest stockholder ("EGI"), which is included in the cost of the acquired assets, of $386. (3) INVESTMENT BY EQUITY GROUP INVESTMENTS, INC. On March 4, 1998, the Company sold 2.5 million new-issued common shares and non-transferable warrants to purchase an additional 1.2 million common shares for a total of $10,625 to affiliates of Equity Group Investments, Inc., ("EGI") a privately held investment company. Net proceeds amounted to $9,825 after transaction costs. The non-transferable warrants have a term of five years; one third of the warrants are exercisable at $6.00 per share, another third are exercisable at $7.00 per share and the final third are exercisable at $8.00 per share. As part of this strategic investment, EGI nominated and the stockholders elected two candidates to the Board of Directors who joined three of the Company's existing directors and two new independent directors. As more fully described in Note 21, EGI invested an additional $6,846 in November, 1999, as a result of a Standby Purchase Agreement that they provided to support the Company's $10 million rights offering and eventual issuance of convertible preferred stock. As consideration for the standby note agreement, EGI received one million warrants, exercisable over a five-year period, at a price of $2.48. (4) FINANCING ACTIVITIES The facility obtained for the acquisition of Dining a la Card through Chase Manhattan Bank permits the Company to borrow up to an aggregate principal amount equal to the lesser of (i) $35,000 and (ii) the amount available under a borrowing base formula based on the amount of registered card program rights to receive receivables which meet certain eligibility criteria (which was $36,600 at the closing). The facility is secured by liens on substantially all of the Company's assets (including those purchased pursuant to the acquisition), other than those subject to an existing securitization facility, as well as the stock of the three principal subsidiaries: Transmedia Restaurant Company Inc., Transmedia Service Company Inc., and TMNI International Incorporated. The remaining proceeds of the facility are available in connection with the ongoing registered card business. Amounts drawn down under the facility accrue interest, at the Company's election, at either (i) 0.25% plus the greater of (a) the prime rate publicly announced by Chase in effect in New York, New York F - 13 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) and (b) the federal funds effective rate from time to time plus 1.5% or (ii) one month LIBOR plus 1.25%, and mature on December 30, 1999, or upon the earlier effectiveness of a permanent securitization facility of the registered card program rights-to-receive. The effective rate of interest at September 30, 1999 was 7.4%. Interest is payable monthly in arrears. Any amounts overdue under the facility accrues interest at the applicable rate plus 2%. The agreement contains customary events of default, as well a cross default to all other material indebtedness, including the Company's existing securitization facility and the GAMI loan. In connection with this facility, the Company paid a $500 fee to Chase upon the closing and was required to pay a monthly unused line fee equal to 0.375% of the average unused amount. The facility was paid off on December 30, 1999 with the proceeds of the $80 million securitization described below. Financing fees of $1.1 million were also paid. On December 30, 1999, the Company entered into the $80 million securitization of the combined rights to receive of both the private label and the registered card dining program. The proceeds drawn down at closing, approximately $65 million based on a similar borrowing base formula used in the bridge loan, were utilized to terminate and payoff $33 million non recourse notes from the 1996 securitization and the $27 million outstanding under the bridge loan. Additionally, the Company was required to pay a termination payment of approximately $900 to the investors of the 1996 securitization. The interest rate applicable to the facility will be either (1) the Eurodollar which is a rate 1.25% in excess of a rate per annum equal to the LIBOR Rate and will be limited to interest periods of up to three months and (2) the Alternate Base Rate which is the higher of (i) Chase's Prime rate and (ii) the Federal Funds Effective Rate plus 1.5%. The GAMI facility is a term loan made through an affiliate of EGI in the amount of $10,000 and was unsecured and subordinated to the Chase facility. Interest accrued on the principal amount outstanding was at the prime rate (as announced from time to time by Chase) plus 4%, payable monthly in arrears. The effective rate of interest at September 30, 1999 was 12.25%. The GAMI agreement required the Company to conduct a rights offering of rights to purchase a new series of preferred stock to be offered to each existing stockholder of record on a pro rata basis. The proceeds of the rights offering were earmarked to repay all outstanding amounts under this loan. In connection with the rights offering, EGI, through its affiliate and the Company's largest stockholder, Samstock L.L.C., agreed to act as a standby purchaser whereby, after exercising its initial rights and any additional subscription privileges, would purchase any shares not otherwise subscribed for by other stockholders. The rights offering closed on November 9, 1999, and $10 million of convertible preferred stock was issued (see Note 21). The proceeds were used to retire the GAMI obligation. The terms of this loan also required the Company to pay GAMI, at closing a cash fee of $500, which was reimbursable to the Company upon the consummation of the rights offering and the issuance to Samstock L.L.C. of warrants to purchase 1 million shares of the Company's common stock in consideration of providing the loan and if it acted as a standby purchaser in connection with the rights offering. (5) SALE OF RIGHTS-TO-RECEIVE On December 24, 1996, the Company made an initial transfer of $33 million of rights-to-receive to a special purpose corporation ("SPC"), an indirect wholly owned subsidiary, as part of a revolving securitization. The rights-to-receive, which were sold to the SPC without recourse, were in turn transferred to a limited liability corporation ("Issuer"), which issued $33 million of fixed rate securities in a private placement to various third party investors. F - 14 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) In exchange for the rights-to-receive, which have a retail value of approximately $66 million before member discounts, the Company received approximately $32 million, after transaction costs, and a 1% equity interest in the Issuer. Future excess cash flows, expected to be generated from the securitized assets as the rights-to-receive are exchanged for meals by Company cardholders, are remitted to the Company on a monthly basis as a return on capital from the Issuer. Excess cash flows are determined after payments of interest to noteholders and investors, as well as trustee and servicing fees. Rights-to-receive currently held by the Issuer, as well as cash and certain deposits restricted under the securitization agreement, have been separately depicted in the consolidated balance sheet. The private placement certificates have a five-year term before amortization of principal and have an interest rate of 7.4%. During this revolving period, the Issuer is responsible for the ongoing purchase of rights-to-receive from the Company to ensure that the initial pool of $33 million is continually replenished as the rights-to-receive are utilized by cardholders. It is anticipated that replenishment of rights-to-receive will provide for a continuous stream of additional net revenue throughout the period. As more fully discussed in Note 4, on December 30, 1999, the Company entered into a new securitization agreement and simultaneously terminated the 1996 facility and paid off the non-recourse notes. (6) AMENDED COMPENSATION AGREEMENTS On December 29, 1997, the Company and Melvin Chasen, former Chairman of the Board, Chief Executive Officer and President, agreed to amend his employment agreement and to terminate his consulting agreement. As part of the agreement, Mr. Chasen agreed to a five-year non-compete and confidentiality agreement with the Company and relinquished his right to receive $1 million in the event of the sale of a control block of stock, as described in Note 2 above. Pursuant to this agreement, the Company made cash payment of $2.75 million to Mr. Chasen and recognized a one-time pre-tax charge of $3.1 million in the quarter ending December 31, 1997. During 1998, the Company entered into consulting agreements with certain former senior management personnel. These agreements required these personnel to perform services at the Company's request for a period not to exceed more than one year. The Company determined that it no longer requires, nor intended to utilize the service of these individuals, and recorded a charge of $463 relating to the remaining outstanding obligation under the consulting agreements for the year ended September 30, 1998 (7) SECURITIES AVAILABLE FOR SALE Securities available for sale consist of marketable equitable securities that are recorded at fair value and have an aggregate cost basis of $280 as of September 30, 1999, 1998 and 1997. Gross unrealized gains were $545, $1,030, and $1,774 and gross unrealized losses were $194, $43, and $66 as of September 30, 1999, 1998 and 1997, respectively. Realized gains were $1,149 and $200 for the years ended September 30, 1999 and 1998, respectively. There were no realized gains in 1997. Deferred income taxes associated with the net unrealized gains were $134, $375, and $649 at September 30, 1999, 1998 and 1997, respectively. F - 15 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (8) EQUIPMENT HELD FOR SALE OR LEASE Equipment held for sale and lease consists primarily of electronic terminals used for credit card processing. The cost of the terminals on hand is determined on a first in, first out basis. The amount presented on the balance sheet represents the net book value of terminals after reduction for terminals sold and accumulated depreciation of $972 and $490 on terminals under lease at September 30, 1999 and 1998. (9) PROPERTY AND EQUIPMENT Property and equipment consist of the following: Depreciation and amortization expense for the years ended September 30, 1999, 1998 and 1997 was $2,859, $2,711, and $1,812, respectively. (10) FAIR VALUES OF FINANCIAL INSTRUMENTS The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties. The fair value of cash and cash equivalents, restricted cash, accounts receivable, rights-to-receive, accounts payable, accrued expenses and notes payable is based on the short maturity of these instruments which approximate the carrying amounts at September 30, 1999 and 1998. The fair value of the rights-to-receive approximates the carry value due to their short-term nature. The fair value of the securities available for sale is based upon quoted market prices for these or similar instruments. (11) STOCK OPTION PLANS In March 1996, the 1996 Long-Term Incentive Plan (the "1996 Plan") was approved for adoption by the Company's stockholders as a successor plan to the 1987 Stock Option and Rights Plan (the "1987 Plan"). The 1996 Plan was amended August 5, 1998 to allow for non-employee directors to choose to take directors fees in either cash or a current or deferred stock award. In addition, the amount of shares available for grant under the 1996 Plan was increased to 1,505,966. Under the 1996 Plan, the Company may grant awards, which may include stock options, stock appreciation rights, restricted stock, deferred stock, stock granted as a bonus or in lieu of other awards, dividend equivalents and other stock based awards to directors, officers and other key employees and consultants of the Company. Stock options granted under the 1996 Plan may not include more than 505,966 incentive stock options for federal income tax purposes. The exercise price under an incentive stock option to a person owning stock representing more than 10 percent of the common stock must equal at least 110 percent of the fair market value at the date of grant. Options are exercisable beginning not less than one year after date of F - 16 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) grant. All options expire either five or ten years from the date of grant and each becomes exercisable in installments of 25 percent of the underlying shares for each year the option is outstanding, commencing on the first anniversary of the date of grant. At September 30, 1999, there were 443,716 shares available for grant under the 1996 Stock Plan. The per share weighted average fair value of stock options granted during 1999 and 1998 was approximately $2.70 and $4.95 on the date of grant using the Black-Scholes option-pricing model with the following assumption: 1999-expected no dividend yield risk-free interest rate or 6.25%, and expected lives ranging from five to ten years; 1998-expected no dividend yield, risk-free interest rate or 5.25%, and expected lives ranging from five to ten years. The Company has continued to comply with APB No.25 to account for stock options and accordingly, no compensation expense has been recognized in the financial statements. Had the Company determined compensation expense based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's net income would have been reduced to the pro forma amounts indicated below: The full impact of the calculation of compensation expense for stock options under SFAS No. 123 is not reflected in the pro forma net income amounts presented above because compensation expense is reflected over the option's vesting period which could be up to five years. Stock option activity during the periods indicated is as follows: At September 30, 1999, the range of weighted average exercise prices and remaining contractual life of outstanding options was $2.0 to $15.00 and 2.75 to 10 years, respectively. At September 30, 1999 and 1998, the number of options exercisable were 901,593 and 630,918 and the F - 17 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) weighted-average exercise price of those options was $5.30 and $6.99, respectively. (12) INCOME TAXES The tax effects of the temporary differences that give rise to significant portions of the deferred tax assets and liabilities at September 30, 1999 and 1998 are as follows: SFAS No. 109 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. A valuation allowance was recorded for the full amount of the net deferred tax assets as of September 30, 1999, due to the Company's recurring losses. The valuation allowance at September 30, 1999 and 1998 was $6,005 and $972, respectively. The decrease in deferred tax liability related to securities available for sale was ($241), and ($274) during 1999 and 1998, respectively. A net operating loss carryforward of $12,044 was available at the year ended September 30, 1999. The loss will expire in 2019. F - 18 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Income tax provision (benefit) for the years ended September 30, 1999, 1998 and 1997 is as follows: Reconciliation of the statutory federal income tax rate and the Company's effective rate for the years ended September 30, 1999, 1998 and 1997, is as follows: (13) FRANCHISE AGREEMENTS The Company, as franchiser, had previously entered into various ten-year franchising agreements to assist in its national expansion through the years 1990 to 1995. In accordance with these agreements, franchisees were granted a territory with a defined minimum of full-service restaurants that accept certain major credit cards. The Company provides marketing, advertising, training and other administrative support.The franchisees are responsible for soliciting restaurants and cardholders, advancing consideration to the restaurants to obtain rights-to-receive food and beverage credits, and maintaining adequate insurance. F - 19 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) In consideration for granting the franchises, the franchisees paid the Company initial franchise fees and an initial fee to the Company's advertising and development fund. Continuing fees paid by the franchisees are as follows: o 7.5 percent of the total food and beverage credits used within the franchisee's territory. o 2.5 percent of the total credits used within the franchisee's territory to be deposited into the advertising and development fund. o A processing fee of twenty cents per sale transaction. o A weekly service charge of twenty-three cents per participating restaurant in the franchisee's territory. The Company ceased francising in 1995, and in 1997, the Board authorized a systematic reacquisition of the franchise territories. In 1997, the Company reacquired for cash the right to operate its business in California, Oregon, Washington and a portion of Nevada, Western's rights-to-receive and its furniture, fixtures and equipment, as well as the assumption of certain obligations. The transaction closed on January 2, 1997. The purchase price was approximately $7,454 of which $5,017 represented the cost of the franchise, which has been recorded as the excess of cost over net assets acquired. The Company had previously received 60,000 shares of publicly traded common stock in connection with the initial sale of this franchise, representing 2.3 percent of the franchisee's common stock. The shares are included in securities available for sale. In addition, a director of the Company owns 6.5 percent of the franchisee's common stock. In fiscal 1998, the Company determined that lagging performance in the reacquired West Coast sales territories indicated that the undiscounted cash flows from this former franchise would be less than the carrying value of the long-lived assets related to the franchise. Accordingly, the Company recognized an asset impairment loss of $2,169 ($.18 per share) for the difference between the carrying value of the related excess of cost over net assets acquired and the fair value of the asset based on discounted estimated future cash flows. On December 4, 1997, the Company acquired all the rights-to-receive of East America Trading Company, its franchisee in the Carolinas and Georgia, and terminated and canceled the franchise agreement in exchange for 170,000 shares of Transmedia Network stock. On July 15, 1998, and February 10, 1999, respectively the Company acquired all the rights-to-receive, and the right to conduct business, in the Dallas/Fort Worth and Houston sales territories from its franchisee, the Texas Restaurant Card, Inc (TRC). The aggregate purchase price was approximately $2,406 of which $1,653 represented the cost of the franchise, which has been recorded as the excess of cost over net assets acquired. The Company assumed operational control of these reacquired territories. (See Note 21) (14) LICENSE AGREEMENTS The Company has an agreement for exclusive perpetual licenses of its software and trademark in the Asia-Pacific region and the continent of Europe. In accordance with the agreements, the Company agreed to assist the licensees with training relating to sales, administration, technology and operations of the business. All material services or conditions relating to the license sales have been substantially performed or satisfied by the Company. The licensee may grant sublicenses in the territories and is responsible for the operations of the business in the respective regions, including procuring member restaurants and providing related services and activities throughout the territory. F - 20 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) In consideration for granting the exclusive licenses, the licensee paid the Company license fees aggregating $2,375 for the master license agreements and has granted to the Company a five percent equity interest in the new entities which will operate in the United Kingdom, Australia and New Zealand. The shares comprising the equity interests are included in securities available for sale. The principal continuing fees to be paid by the licensee are royalties of two percent of gross sales of the Australia and New Zealand sublicensee and the United Kingdom sublicensee, and 25 percent of any other amounts that the licensee receives from the sublicensee. In December 1996, the Company amended its agreements with its international licensees, Transmedia Europe, Inc. and Transmedia Asia-Pacific, Inc. permitting them to acquire, on a worldwide basis, the business of Countdown, plc Holding Corp. ("Countdown"). Upon closing of the Countdown acquisition, the Company received $250 in cash and a $500 note bearing interest at 10%, which was payable on April 1, 1998. The Company continues to negotiate with its licensee to reacquire the licenses for Transmedia Europe and Asia-Pacific, Inc. To date, the Company has not received payment on either the aforementioned note receivable or certain outstanding royalty obligations. Both the note and accrued interest has been reserved. In fiscal 1999, the Company realized gains of $1,149 in connection with the sale of the licensee securities. (15) LEASES The Company leases certain equipment and office space under long-term lease agreements. Future minimum lease payments under noncancelable operating leases as of September 30, 1999 are as follows: Rent expense charged to operations was $794, $710, and $625 for the years ended September 30, 1999, 1998 and 1997, respectively. (16) RELATED PARTY TRANSACTIONS On June 30, 1999, the Company entered into a short term loan with GAMI, an affiliate of Samstock, its largest stockholder, to provide interim debt financing in a total aggregate amount of $10,000 (See Note 4). During the year ended September 30, 1999, the Company paid interest relating to the GAMI loan of $310. F - 21 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) The Company has a management agreement with EGI, an affiliate of Samstock, its largest stockholder, in which EGI provides investment advisory and other managerial services to the Company. During the year ended September 30, 1999, the Company paid approximately $250 to EGI for these services. (17) COMMITMENTS On July 14, 1995, the Company entered into an unconditional guaranty agreement with a financial institution, to extend credit in the amount of $450 to a franchisee, which agreement is still outstanding at September 30, 1999. The Company has amended its employment agreement with the president of its wholly-owned subsidiary, Transmedia Restaurant Company. The agreement provides for salary at an annual rate of $335 through September 30, 2001, plus eligibility for a bonus up to 50% of his salary. The Company has an ongoing Service Collaboration Agreement with SignatureCard as a result of the DALC acquisition. In exchange for providing the Company with members, either through their own marketing efforts or their agreement with the airlines, SignatureCard is entitled to receive a profit participation, if applicable, based on dining sales generated by those members, as well as a percentage of the fees received from those members. For the three-month period, from acquisition to September 30, 1999, SignatureCard received approximately $106 in fees. There was no profit participation due at that date. (18) YEAR 2000 COMPUTER COMPLIANCE In 1998, the Company initiated a plan ("Plan") to identify, assess, and remediate "Year 2000" issues within each of its computer programs and certain equipment which contain micro-processors. The Plan addressed the issue of computer programs and embedded computer chips being unable to distinguish between the year 1900 and 2000, if a program or chip uses only two digits rather than four to define the applicable year. The Company divided the Plan into six major phases: assessment, planning, validation, conversion, implementation and testing. After completing the assessment and planning phase in late last 1998, the Company hired an independent consulting firm to validate the Plan. All software development and installation is currently believed to be in compliance. The Company worked with an outside vendor on the conversion, implementation and testing phases. Systems that were determined not to be Year 2000 compliant have been either replaced or reprogrammed, and thereafter tested for Year 2000 compliance. The Company believes that at September 30, 1999 the conversion, implementation and testing phases have been materially completed. The original budget for the total cost of remediation (including replacement software and hardware) and testing, as set forth in the Plan, was $500. The Company's aggregate spending on the Year 2000 remediation at September 30, 1999, which has been expensed, was $641. The Company has identified and contacted critical suppliers and customers whose computerized systems interface with the Company's systems, regarding their plans and progress in addressing their Year 2000 issues. The Company has received varying information from such third parties on the state of compliance or expected compliance. Contingency plans are being developed in the event that any critical supplier or customer is not compliant. The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-party F - 22 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) suppliers and customers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's operations, liquidity or financial conditions. (19) BUSINESS AND CREDIT CONCENTRATIONS Most of the Company's customers are located in the New York City, California, Massachusetts and Florida areas. No single customer accounted for more than 5 percent of the Company's sales in any fiscal year presented. No single restaurant's rights-to-receive balance was greater than 5 percent of the total rights-to-receive balance at September 30, 1999 or 1998. Airline membership represents approximately 61% of the total registered card members and approximately 38% of the Company's total membership. (20) LITIGATION In December 1996, the Company terminated its license agreement with Sports & Leisure Inc. ("S&L"). In February 1997, S&L commenced an action against the Company in the 11th Judicial Circuit, Dade County, Florida, alleging that the Company improperly terminated the S&L license agreement and seeking money damages. In the quarter ended December 31, 1998, a reserve of $1,000 was established and recorded in selling, general and administrative expenses to cover management's estimate of the potential cost and expenses of this litigation and other legal matters. On November 19, 1999, the Company, in an effort to avoid prolonged litigation, settled the outstanding lawsuit with its former licensee. Under the terms of the settlement S & L, Inc. will receive $2.1 million in cash and 280,000 shares of common stock for a total of approximately $2,835 or 22 cents per share. The impact of the settlement based on the fair value of the common stock and net of the $1,000 reserve amount previously provided by the Company in the first quarter of fiscal 1999, is approximately $1.835 million and has been recognized in the fourth quarter ended September 30, 1999. (21) SUBSEQUENT EVENTS On November 9, 1999, the Company completed its Rights Offering to existing stockholders resulting in the issuance of 4,149,378 convertible, redeemable preferred shares. The preferred shares have a dividend rate of 12%, of which 6% is payable in cash, quarterly in arrears, and the remaining 6% accrues unless otherwise paid currently at the Company's discretion, until conversion by the holder. Each preferred share may be converted into common stock at the option of the holder at any time. The initial rate of conversion is one to one. Subsequent conversion rates could be higher to the extent of accrued but unpaid dividends. If not previously converted, the Company may commence redemption of the preferred shares on the fifth anniversary of the rights offering. The proceeds from the stock issuance of $10,000 were used to retire the $10,000 bridge loan obtained from GAMI Investment. Pursuant to its subscription privileges and as a Standby Purchaser for any unsubscribed shares, EGI acquired 2.84 million of the preferred shares. The additional investment provides EGI with the right to designate an additional member to the Board of Directors. The size of the Board will increase by one if EGI chooses to exercise that right. On December 16, 1999, the Company acquired all the Rights-to-Receive, and the right to conduct business of the San Antonio and Austin sales territory from its franchisee, the Texas Restaurant Card, F - 23 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Inc. The purchase price was $950 of which $788 represents the cost of the franchise which has been recorded as the excess of cost over net assets acquired. With the acquisition of these sales territories, the Company has reacquired all of the sales territories of the Texas Restaurant Card, Inc., and the right to conduct business in Texas and has settled any and all obligations under the franchise agreement, as amended. (22) SELECTED QUARTERLY FINANCIAL DATA (a) Selected quarterly financial data is as follows: F - 24 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (B) UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS On June 30, 1999 the Company acquired most of the assets and operations related to a membership discount dining program SignatureCard operated under the Dining A La Card trade name and service mark. Accordingly, the Company's Consolidated Statements of Operations for the year ended September 30, 1998 reflects the operations of Transmedia only. Unaudited Pro forma Consolidated Statements of Operations have been provided herein to report the results of operations for the years ended September 30, 1998 and for comparative purposes, the nine-month period ending September 30, 1999 as though the companies had combined at the beginning of the periods being reported. The pro forma consolidated results do not purport to be indicative of results that would have occurred had the acquisition been in effect for the periods presented, nor do they purport to be indicative of the results that will be obtained in the future. TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) TRANSMEDIA NETWORK INC. AND SUBSIDIARIES UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEAR ENDED SEPTEMBER 30, 1998 (AMOUNTS IN THOUSANDS) See notes to unaudited pro forma financial information F - 26 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) TRANSMEDIA NETWORK INC. AND SUBSIDIARIES UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS FOR THE NINE MONTH PERIOD ENDING SEPTEMBER 30, 1999 (AMOUNTS IN THOUSANDS) See notes to unaudited pro forma financial information F - 27 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) NOTES TO UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION 1. SIGNIFICANT ACCOUNTING POLICIES There are currently no material differences in the significant accounting policies of Transmedia Network, Inc. and Dining A La Card ("the Companies") therefore, no consideration has been given to conforming the Companies' significant accounting policies in this pro forma presentation. The Companies do not expect to have material changes to current accounting policies in connection with the transaction. 2. RECLASSIFICATIONS Certain reclassifications have been made to the historical statement of operations of Dining A La Card to conform to the presentation used by Transmedia Network Inc. These reclassification relates to the presentation of rights to receive losses and cost of sales. 3. UNAUDITED PRO FORMA STATEMENT OF OPERATIONS ADJUSTMENTS FOR THE TWELVE MONTHS ENDING SEPTEMBER 30, 1998 (A) Dining A La Card statement of operations is for the twelve-month period ending December 31, 1998 while Transmedia's statement of operations is for the twelve-month period ending September 30, 1998. (B) Dining A La Card rights-to-receive losses of $25,962 have been reclassified to cost of sales to conform with Transmedia's presentation. (C) In accordance with the Marketing Collaboration Agreement between Transmedia and Signature, SignatureCard will receive 67% of all membership dues collected from Dining A La Card members. (D) To remove marketing amortization, since under the Marketing Collaboration Agreement, SignatureCard will provide Dining A La Card members to Transmedia at no cost. (E) To record the amortization of deferred financing cost of $567 over the estimated six-month life of the GAMI loan, plus record interest expense on the outstanding debt. (F) To adjust the income tax benefit using Transmedia's statutory rate for 1998 of 38%, and record an income tax valuation allowance required by SFAS No. 109. (G) To eliminate Dining A La Card's equity loss in CardPlus Japan since Transmedia did not purchase those assets. (H) To remove Dining A La Card's internal interest expense included in general and administrative and a portion of the general and administrative expenses allocated from Signature, which was eliminated as part of the acquisition. (I) To remove one time write-down of Dining A La Card's RTR portfolio of approximately $8,000 and bring to fair value. (J) Remove cumulative effect of accounting change 4. UNAUDITED PRO FORMA STATEMENT OF OPERATIONS ADJUSTMENTS FOR THE NINE MONTHS ENDING SEPTEMBER 30, 1999 (K) Dining A La Card interim statement of operations is for the six-month period ending June 30, 1999. A statement of operations for the nine-month period ending June 30, 1999 for Dining A La Card is not available and therefore not presented. Dining A La Card operations from June 30, 1999 to September 30, 1999 are included in Transmedia's operations. For comparability purposes, Transmedia derived its statement of operations for the nine-month period ending September 30, 1999 by removing the operations for the three months ending December 31, 1998 from the operation for the twelve-months ending F - 28 TRANSMEDIA NETWORK INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) September 30, 1999. For the period excluded, Transmedia's reported gross dining sales of $22,756 and a net loss of $1,353, which were reported in the 10-Q for that period and are incorporated herein by reference. (L) Dining A La Card rights-to-receive losses of $2,749 have been reclassified to cost of sales to conform with Transmedia's presentation. (M) In accordance with the Marketing Collaboration Agreement between Transmedia and SignatureCard, SignatureCard will receive 67% of all membership dues collected from Dining A La Card members. (N) To remove marketing amortization, since under the Marketing Collaboration Agreement, SignatureCard will provide Dining A La Card members to Transmedia at no cost. (O) To record the amortization of deferred financing cost of $567 over the estimated six month life of the GAMI loan, plus record interest expense on the outstanding debt. (P) To adjust the income tax benefit using Transmedia's statutory rate for 1999 of 38%, and record an income tax valuation allowance required by SFAS No. 109. (Q) To eliminate Dining A La Card's equity loss in Cardplus Japan since Transmedia did not purchase those assets. (R) To remove Dining A La Card's internal interest expense included in general and administrative and a portion of the general and administrative expenses allocated from SignatureCard, which were eliminated as part of the acquisition. (S) To remove gain on sale of dining assets which resulted from Transmedia's purchase of Dining A La Card. TRANSMEDIA NETWORK, INC. SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS For each of the years in the three-years ended September 30, 1999 (in thousands) F - 30 ITEM 9. ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information called for by Item 10 is set forth under the heading "Executive Officers of the Registrant" in Part I hereof and in "Election of Directors" in the Company's 1999 Proxy Statement, which is incorporated herein by this reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information called for by Item 11 is set forth under the heading "Executive Compensation" in the Company's 1999 Proxy Statement, which is incorporated herein by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information called for by Item 12 is set forth under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Company's 1999 Proxy Statement, which is incorporated herein by this reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information called for by Item 13 is set forth under the heading "Certain Relationships and Related Transactions" in the Company's 1999 Proxy Statement, which is incorporated herein by this reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K The following documents are being filed as part of this Report: (a)(1) Financial Statements: Transmedia Network Inc. See "Index to Financial Statements" contained in Part II, Item 8. (a)(2) Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts (a)(3) Exhibits DESIGNATION DESCRIPTION - ----------- ----------- 1.1 Form of Standby Purchase Agreement between Transmedia Network Inc. and Samstock, L.L.C. (k) 3.1 Certificate of Incorporation of Transmedia Network Inc., as amended. (b) 3.2 Certificate of Amendment to the Certificate of Incorporation of Transmedia Network Inc. (e) 3.3 Certificate of Amendment to the Certificate of Incorporation of Transmedia Network Inc., as filed with the Delaware Secretary of State on March 22,1994.(a) 3.4 Form of Amendment to the Certificate of Incorporation of Transmedia Network Inc. (k) 3.5 Form of Certificate of Designations, Preferences and Rights of Series A Senior Convertible Redeemable Preferred Stock. (k) 3.6 By-Laws of Transmedia Network Inc. (c) 4.1 Form of Series A Preferred Stock certificate (k) 4.2 Form of Rights Agreement between Transmedia Network Inc. and American Stock Transfer & Trust Company, as subscription agent. (k) 4.3 Second Amended and Restated Investment Agreement dated as of June 30, 1999 among Transmedia Network Inc., Samstock, L.L.C., EGI-Transmedia Investors, L.L.C., and, with respect to Section 5 of the Agreement only, Robert M. Steiner, as trustee under declaration of trust dated March 9, 1983, as amended, establishing the Robert M. Steiner Revocable Trust.(k) 10.1 Asset Purchase Agreement, dated as ofMarch 17, 1999, between Transmedia Network Inc. and SignatureCard, Inc., as amended by Amendment No. 1 thereto dated as of April 15, 1999 and Amendment No. 2 thereto dated as of May 31, 1999.(j) 10.2 Option Agreement, dated as of June 30, 1999, between Transmedia Network Inc. and SignatureCard, Inc. (j) 10.3 Services Collaboration Agreement, dated as of June 30, 1999, between Transmedia Network Inc. and SignatureCard, Inc.(j) 10.4 Credit Agreement, dated as of June 30, 1999, between Transmedia Network Inc. and The Chase Manhattan Bank.(j) 10.5 Security Agreement, dated as of June 30, 1999, between Transmedia Network Inc. and The Chase Manhattan Bank. (j) 10.6 Pledge Agreement, dated as of June 30, 1999, between Transmedia Network Inc. and The Chase Manhattan Bank. (j) 10.7 Credit Agreement, dated as of June 30, 1999, between GAMI Investments, Inc., Transmedia Network Inc., Transmedia Restaurant Company Inc., Transmedia Service Company Inc. and TMNI International Incorporated. (j) 10.8 1987 Stock Option and Rights Plan, as amended. (a) 10.9 Form of Stock Option Agreement (as modified) between Transmedia Network Inc. and certain Directors.(g) 10.10 Amended and Restated Employment Agreement dated as of November 15, 1996 between Transmedia Network Inc. and Melvin Chasen.(f) 10.11 Amended and Restated Consulting Agreement dated as of November 15, 1996 between Transmedia Network Inc. and Melvin Chasen.(f) 10.12 Second Restated and Amended Employment Agreement dated as of October 1, 1998 between Transmedia Network Inc. and James Callaghan. (k) 10.13 Master License Agreement dated December 14, 1992 between Transmedia Network Inc. and Conestoga Partners, Inc.(d) 10.14 First Amendment to Master License Agreement dated April 12, 1993, between Transmedia Network Inc. and Conestoga Partners, Inc. (e) 10.15 Second Amendment to Master License Agreement -- Assignment and Assumption Agreement dated August 11, 1993 among Transmedia Network Inc., TMNI International Incorporated and Transmedia Europe, Inc.(e) 10.16 Master License Agreement Amendment No. 3 dated November 22, 1993 between TMNI International Incorporated and Transmedia Europe, Inc.(e) 10.17 Master License Agreement dated March 21, 1994 between TMNI International Incorporated and Conestoga Partners II, Inc. licensing rights in the Asia Pacific region. (a) 10.18 Agreement, dated as of December 6, 1996, among Transmedia Network Inc., TMNI International Incorporated, Transmedia Europe Inc. and Transmedia Asia Pacific Inc.(f) 10.19 Stock Purchase and Sale Agreement, dated as of November 6, 1997, among Transmedia Network Inc., Samstock, L.L.C., and Transmedia Investors, L.L.C. (h) 10.20 Form of Warrant to purchase Common Stock.(i) 10.21 Amended and Restated Agreement Among Stockholders Agreement, dated as of March 3, 1998, among Transmedia Network Inc., Samstock, L.L.C., EGI-Transmedia Investors, L.L.C., Melvin Chasen, Iris Chasen and Halmstock Limited Partnership. (i) 10.22 Stockholders Agreement, dated as of March 3, 1998, among Transmedia Network Inc., EGI-Transmedia Investors, L.L.C., Samstock, L.L.C. and Melvin Chasen and Halmstock Limited Partnership. (i) 10.23 Security Agreement dated as of December 1, 1996 among TNI Funding Company I, L.L.C. as Issuer, The Chase Manhattan Bank as Trustee and as Collateral Agent, TNI Funding I, Inc., as Seller and Transmedia Network Inc., as Servicer. (g) 10.24 Purchase Agreement dated as of December 1, 1996 among Transmedia Network Inc., Transmedia Restaurant Company Inc., Transmedia Service Company Inc. and TNI Funding I, Inc., as Purchaser.(g) 10.25 Purchase and Servicing Agreement dated as of December 1, 1996 among TNI Funding Company I, L.L.C., as Issuer, TNI Funding I, Inc. as Seller, Transmedia Network Inc., as Servicer, Frank Felix Associates, Ltd., as Back-up Servicer and The Chase Manhattan Bank, as Trustee.(g) 10.26 Indenture dated as of December 1, 1996 between TNI Funding Company I, L.L.C., as Issuer and The Chase Manhattan Bank, as Trustee.(g) 10.27 Letter of Agreement dated January 29, 1997 between Transmedia Network Inc. and Stephen E. Lerch. (g) 10.28 Transmedia Network Inc. 1996 Long-Term Incentive Plan (including Amendments through August 5, 1998).(b) 10.29 Employment Agreement dated as of January 5, 1999 between Transmedia Network Inc. and Christine Donohoo.(k) 10.30 Employment Agreement dated as ofOctober 14, 1998 between Transmedia Network Inc. and Gene M. Henderson.(k) 12.1 Statement regarding calculation of earnings to fixed charges. (k) 21.1 Subsidiaries of Transmedia Network Inc.(a) 23.2 Consent of KPMG LLP. (l) 23.3 Consent of Arthur Andersen LLP. (l) 24.1 Power of Attorney (included in the signature page hereto). (l) 27.1 Financial datat schedule Legend: (a) Filed as an exhibit to Transmedia's Annual Report on Form 10-K for the fiscal year ended September 30, 1994 and incorporated by reference. (b) Filed as an exhibit to Transmedia's Annual Report on Form 10-K for the fiscal year ended September 30, 1998, and incorporated by reference thereto. (c) Filed as an exhibit to the Post Effective Amendment to the Registration Statement on Form S-1 (Registration No. 33-5036), and incorporated by reference thereto. (d) Filed as an exhibit to Transmedia's Annual Report on Form 10-K for the fiscal year ended September 30, 1992, and incorporated by reference thereto. (e) Filed as an exhibit to Transmedia's Annual Report on Form 10-K for the fiscal year ended September 30, 1993, and incorporated by reference thereto. (f) Filed as an exhibit to Transmedia's Annual Report on Form 10-K for the fiscal year ended September 30, 1996, and incorporated by reference thereto. (g) Filed as an exhibit to Transmedia's Annual Report on Form 10-K/A for the fiscal year ended September 30, 1997, and incorporated by reference thereto. (h) Filed as an exhibit to Transmedia's Current Report on Form 8-K dated as of November 6, 1997, and incorporated by reference thereto. (i) Filed as an exhibit to Transmedia's Current Report on Form 8-K filed on March 3, 1998. (j) Filed as an exhibit to Transmedia's Current Report on Form 8-K filed on July 14, 1999, and incorporated by reference thereto. (k) Filed as an exhibit to Transmedia's Registration Statement in Form S-2 (registration no. 333-84947), and incorporated by reference thereto. (i) The Company did not file any Form 8-K Current Reports during the fourth quarter of the fiscal year ended September 30, 1999. (ii) Exhibits: See paragraph (a) (3) above for items filed as exhibits to this Annual Report on Form 10-K as required by Item 601 of Regulation S-K. (iii) Financial Statement Schedules: See paragraphs (a)(1) and (a)(2) above for financial statement schedules and supplemental financial statements filed as part of this Annual Report on Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 5th day of January, 2000. TRANSMEDIA NETWORK INC. By: /s/STEPHEN E. LERCH ------------------------------------ Name: Stephen E. Lerch Title: Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the Registrant, Transmedia Network Inc., in the capacities and on the dates indicated. CAPACITY IN SIGNATURE WHICH SIGNED DATE --------- ------------ ---- /s/ F. Philip Handy Chairman of the Board, January 4, 2000 - ------------------------- F. Philip Handy /s/ Gene M. Henderson Director January 4, 2000 - ------------------------- President and Gene M. Henderson Chief Executive Officer /s/ Rod Dammeyer Director January 4, 2000 - ------------------------- Rod Dammeyer /s/ Lester Wunderman Director December 30, 1999 - ------------------------- Lester Wunderman /s/ George Wiedemann Director January 4, 2000 - ------------------------- George Wiedemann /s/ Jack Africk Director January 4, 2000 - ------------------------- Jack Africk Director January __, 2000 - ------------------------- Herbert Gardner EXHIBIT INDEX EXHIBIT DESCRIPTION - ------- ----------- 27.1 Financial data schedule

799089_1999.txt

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1999

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ITEM 1. BUSINESS Informix Corporation is a leading supplier of information management software and solutions to governments and enterprises worldwide. We design, develop, manufacture, market and support - Object-relational and relational database management systems - Connectivity interfaces and gateways - Graphical and character-based application development tools for building database applications that allow customers to access, retrieve and manipulate business data Our software solutions include high performance online transaction processing applications, data warehouse applications, and dynamic web/content management applications. We offer complete database solutions by building strategic relationships with application, hardware, and systems integration providers. Our solutions are used in many industries, including retail, telecommunications, financial services, healthcare, pharmaceutical/biochemistry, manufacturing, and media and publishing. On November 30, 1999, we reached a definitive agreement to acquire Ardent Software, Inc. ("Ardent"), a leading provider of data integration solutions in the business intelligence and Internet markets. Under terms of the agreement, 3.5 shares of Informix common stock will be exchanged for each outstanding Ardent share and Informix will assume all outstanding Ardent options and warrants. We expect to close the transaction in the first quarter of 2000. The acquisition of Ardent will enhance our ability to deliver complete, integrated software solutions for data processing, data movement and analysis in electronic commerce. On October 8, 1999, we expanded our ability to deliver distributed eBusiness applications by acquiring Cloudscape, Inc. ("Cloudscape"), a privately-held provider of synchronized database solutions for the remote and occasionally connected workforce. We issued approximately 10 million shares of Informix common stock in exchange for all of Cloudscape's outstanding stock and options. Cloudscape's small footprint, sophisticated application and data synchronization technology is now offered as part of our database server products. See "Products--Solutions" below. BACKGROUND Today's organizations generate and store ever-increasing amounts of information. Databases and database management systems were developed to electronically store, manage, retrieve and analyze information (data) in the most efficient way possible. In general, databases represent large aggregations of data records, such as sales transactions, inventories, and customer profiles. Database management systems ("DBMS") control the organization, storage, retrieval, security and integrity of data in a database. By managing user read/write authorizations, the DBMS also allows concurrent access to the stored data by multiple users without corrupting the underlying data. Relational databases, developed in 1970, address the issues of data redundancy and data dependence common in pre-relational or hierarchical databases. By organizing the data into pre-defined and related tables, relational database management systems ("RDBMS") protect the integrity of the data and improve the efficiency of the database. A relational database also has the important advantage of being easy to extend with new data categories. Organizations commonly employ RDBMS software for use in storing, managing and retrieving the large amounts of data necessary to support four types of systems: - Internal management information systems, such as accounting, human resources and manufacturing - Mission-critical online transaction processing ("OLTP") systems that process business information from a large number of locations or users - Data warehousing/data mart systems that aggregate data from multiple OLTP systems and perform sophisticated analyses to support business decisions - Internet applications, including dynamic site publishing, information retrieval and electronic commerce. We believe that technological advances, including the development and commercialization of the Internet, will continue to lead to increasingly sophisticated customer requirements for data storage and management beyond the functionality offered by conventional RDBMS products. In recent years, the types and quantities of data required to be stored and managed has grown increasingly complex and includes audio, video, text and three dimensional graphics in addition to conventional character data. Since 1996, we have devoted substantial resources to the development of object-relational database management systems, which provide RDBMS functionality for complex data such as images, video, audio and spatial data, and tools for applications in multimedia and entertainment, digital media publishing, retail and financial services. We market our products to end-users on a worldwide basis directly through our sales force and indirectly through application resellers, original equipment manufacturers ("OEMs") and distributors. The principal geographic markets for our products are North America, Europe, the Asia/Pacific region, and Latin America. In recent years, approximately half of our total revenues have been generated outside North America. Our customers include businesses ranging from small corporations to Fortune 1000 companies. We also market our products to state, local and national governments. PRODUCTS Our products can be divided into three main categories: - SOLUTIONS, which combine both software and services into business solutions for data warehousing, web-based enterprise repositories and electronic commerce. - SOFTWARE PRODUCTS, which include our database management systems, integration products and tools. - SERVICES, including maintenance, consulting, education and training and customer support. SOLUTIONS In 1999, we continued to develop complete solutions, including our database engines, related application software and consulting services, for data warehousing, Web-based enterprise repositories and electronic commerce. INFORMIX DECISION FRONTIER-TM- SOLUTION SUITE is our integrated suite of products for deploying data warehouses and data marts. Informix Decision Frontier Solution Suite consists of: - INFORMIX DYNAMIC SERVER.2000 with Advanced Decision Support and Extended Parallel Options--our core database system with features designed to support large general purpose data warehouses. - INFORMIX RED BRICK DECISION SERVER--our database designed specifically for single-purpose data marts. - INFORMIX METACUBE--our relational online analytical processing (ROLAP) business analysis environment for Informix and Oracle databases. Metacube provides a multidimensional view of warehouse data so it can be compared and analyzed over various combinations of business dimensions, such as time and geography. - INFORMIX DATASTAGE--an extract, transfer and load tool for extracting data from multiple sources and loading it into the data warehouse. - SEAGATE CRYSTAL INFO--a distributed report creation system that presents data analysis results flexibly and attractively. - INFORMIX DECISION FASTSTART--a consulting and service package that helps customers reduce the timetable for designing and implementing data warehouses. In addition, we also developed two Informix Decision Solution Suites for specific industry markets: Informix Decision Solution for Telecommunications and Informix Decision Solution for Financial Services. INFORMIX INTERNET FOUNDATION.2000 is an application development platform for the Internet which provides the tools and features to publish business-critical data to the Internet and enable sophisticated Internet applications and electronic commerce. Informix Internet Foundation.2000 consists of: - INFORMIX DYNAMIC SERVER.2000--designed for the most demanding OLTP, e-commerce, and Web applications. Informix Dynamic Server.2000 is fully integrated with Informix's unique extensibility technology, including support for DataBlade modules. - INFORMIX J/FOUNDATION--an open, flexible, embedded Java Virtual Machine (JVM) environment that delivers scalable and highly performant Java applications by executing them directly in the server. - INFORMIX WEB DATABLADE MODULE--a collection of tools, functions, and examples that ease development of "intelligent," interactive, Web-enabled database applications. - EXCALIBUR TEXT DATABLADE MODULE--provides full-text searching of any type of text, directly inside of the Database engine. - INFORMIX OFFICE CONNECT--allows extraction of data from an Informix database regardless of the data type and then transfer to a customized Microsoft Excel document. INFORMIX MEDIA360 provides a complete environment to collect, index, retrieve, and distribute content and media assets. It is tightly integrated with object-relational technology, leading content creation tools, Web publishing, electronic commerce, and analytic solutions. INFORMIX I.REACH is our Web-based enterprise repository solution that allows organizations to manage enterprise information across intranet, extranet and Internet environments. Informix i.Reach allows content authors to publish and distribute their own content, reducing the time and cost associated with managing and maintaining corporate information. INFORMIX I.SELL is our electronic storefront solution that integrates our database technology with application server technology and application software to provide a complete, rapidly deployable electronic commerce solution. Electronic commerce Web sites built with Informix i.Sell are capable of dynamically merchandising products tailored to each shopper, handling large numbers of transactions, and collecting and analyzing customer data to improve profitability. SOFTWARE PRODUCTS DATABASE MANAGEMENT SYSTEMS INFORMIX INTERNET FOUNDATION.2000 provides the tools and features to publish business-critical data to the Internet and enable sophisticated Internet applications and electronic commerce. Informix Internet Foundation.2000 has the following major components: - INFORMIX DYNAMIC SERVER.2000 is the database server for Informix Internet Foundation.2000 and is the next generation of our flagship database server. Informix Dynamic Server.2000 delivers an industry-proven transaction engine for mission-critical applications while providing an upgrade path to the Internet. Capable of supporting thousands of concurrent users, Informix Dynamic Server.2000 delivers reliability, availability, and scalability to power the largest transaction processing systems. - INFORMIX J/FOUNDATION has integrated Java, the programming language of the Internet, into J/Foundation--an open, flexible, embedded Java Virtual Machine (JVM) environment that delivers scalable Java applications by executing them directly in the server. - INFORMIX WEB DATABLADE MODULE VERSION 4.0, the new release of the Web DataBlade module, extends the functionality of both Informix Dynamic Server.2000 and Informix Internet Foundation.2000 with features that ease the development, management, and deployment of database applications for the Web. - INFORMIX EXCALIBUR TEXT DATABLADE MODULE VERSION 1.30 module provides full text searching of documents and text fields directly inside the database engine in virtually any format that contains ASCII and ISO characters. Fuzzy search capabilities allow users to find results regardless of errors in data entry that would otherwise cause them to be overlooked in standard text searches. Boolean, phrase, and synonym searching allow users a wide range of capabilities in customizing their queries. This DataBlade module supports any language, word, or phrase that can be expressed in an 8-bit, single-byte character set. Formatted documents such as PDF, Microsoft Word, and HTML can be filtered prior to indexing. - INFORMIX OFFICE CONNECT VERSION 1.0 is a new product that simplifies the task of retrieving data (time series, opaque, or SQL2) and visualizing it in Microsoft Excel worksheets--regardless of the data types behind the data. Informix Office Connect's sophisticated connection and model-view controller architecture provides power and ease of use. This design utilizes database schema images (model views of the database structure) to generate optimized SQL commands that populate Excel worksheets and manage all interactions between the client and the database server. - INFORMIX DATABLADE DEVELOPERS KIT VERSION 4.0 allows customers to create DataBlade modules using the DataBlade Developers Kit when a DataBlade module does not currently exist to fit the customer's particular need. This allows the database server to accommodate new business requirements as they evolve. - INFORMIX CONNECT 2.30 (I-CONNECT) is a runtime connectivity product that includes the runtime libraries of our application programming interfaces that comprise Informix Client SDK. These libraries are required by applications running on client machines to access Informix servers. I-Connect is needed when finished applications are ready to be deployed. - INFORMIX SERVER ADMINISTRATOR 1.0, the first in a new generation of Web browser-based and cross-platform administrative tools, is a tool that provides access to every Informix Dynamic Server command line function and presents the output in an easy-to-read format. CLOUDSCAPE product family provides a 100% Pure Java SQL DBMS and synchronization to address the stringent demands of eBusiness. Our Cloudscape product family allows companies to create synchronized applications that can be deployed outside the firewall to partners, customers and mobile workers. The Cloudscape product family is designed to support three fundamental needs: - The creation of sophisticated, cost-effective deployed eBusiness applications, typically eCatalogs and deployed portals. - The local data management needs of Java applications, particularly those meant for resale, where platform independence is a critical requirement. - The database-enabling of Java-supported devices of all kinds, including telecommunication switches, non-traditional computing devices, and future light-weight devices. INFORMIX DYNAMIC SERVER.2000. The core of our product offering is Informix Dynamic Server.2000-TM- ("IDS.2000"), our powerful, multithreaded enterprise database server designed for scalability, manageability, and performance. IDS.2000 offers full RDBMS functionality across various hardware architectures (uniprocessor, symmetric multiprocessor, symmetric multiprocessor clusters, and massively parallel processing architectures) and database models (relational and object-relational) to enable seamless migration of applications, data and skills. As an open system built to support industry standards, IDS.2000 uses a single architecture for the Windows NT, UNIX and Linux operating systems. We also provide workgroup, personal and developer versions of IDS.2000, which have been adapted for workgroup, single-user and development environments. Based on our Dynamic Scalable Architecture, IDS.2000 features parallel data processing capability, replication and connectivity options built into its core. IDS.2000 supports extensibility, as well as SQL3 and DataBlades modules. Extensibility includes the ability to add new objects and data types, such as images, audio, video and spatial data, business specific procedures and logic, and new indexing search methods to the server. DataBlade modules encapsulate specific datatypes and logic for integration with IDS.2000 so that organizations can extend the functionality of the database to support datatypes unique to an organization. RED BRICK DECISION SERVER. Unlike traditional OLTP databases, Informix Red Brick Decision Server is a specialized database technology designed to meet the requirements of data marts and single-subject data warehouse without the complexity and overhead that OLTP technology imposes. EXTENDED PARALLEL SERVER is designed for the largest, most demanding, and complex data warehouse applications, using a sophisticated shared-nothing underlying architecture. Informix Extended Parallel Server provides: - No ceilings scalability across every available hardware resource. - Query performance in complex, ad hoc environments. - Fully parallel load functionality so that data can be loaded within a narrow batch window. - Data access performance through advanced, patented indexing methods. - Data skew management tools so that system resources are efficiently utilized. - Query management tools to help control the impact of intensive, concurrent query processing. METACUBE is our on-line analytical processing (OLAP) product. MetaCube is a fully extensible business intelligence solution, optimized for smarter data access, analysis, and reporting. As an integral component of Informix Decision Frontier-TM-, MetaCube delivers the most complete, flexible, and customizable decision-support environment for data warehouses and data marts. TOOLS INFORMIX DATASTAGE is an integrated set of tools designed to simplify and automate the extraction, transformation, and maintenance of data from multiple operational sources into Informix data mart targets. Informix DataStage's visual design tool enhances productivity by enabling users to design the data movement process using a direct visual model. INFORMIX VISIONARY is a no-code, enabling technology that brings powerful visual information and exploration capabilities. Informix Visionary provides a window, or portal, into all corporate data through the creation of "worlds" or applications. Users can explore each of these worlds or applications to see ever-increasing levels of detail. The full product suite includes Visionary Studio, a no-code authoring environment, and a runtime viewer that can be embedded as an ActiveX control, providing seamless integration with other best-of-breed development tools. INFORMIX DATA DIRECTOR product suite is an advanced solution for building Web-ready, dynamic content management applications. Data Director greatly reduces the amount of application code developers need to write for client/server solutions by automating all of the data access operations of the client application. Informix Data Director for Visual Basic is a powerful, model-driven data access and data management platform that enables Visual Basic developers to create scalable database-aware forms. Informix Data Director for Web is a robust and visually intuitive development environment that enables developers to quickly prototype, build, and deploy dynamic Web applications. INFORMIX 4GL product family includes Informix 4GL Rapid Development System, Informix 4GL Interactive Debugger and Informix 4GL Compiler. Together they form a comprehensive fourth-generation application development and production environment that provides abundant power and flexibility without the need for third-generation languages like C or COBOL. INFORMIX DYNAMIC 4GL is the latest addition to the Informix 4GL product family and enables transformation of character-based 4GL programs into Windows and Motif Graphical User Interface database applications, with a simple recompile. Informix Dynamic 4GL offers customers a choice of deployment options from character, Windows 3.11, Windows 95, Windows NT and X11 Window System (UNIX and Macintosh) clients, to NT and UNIX servers. Informix Dynamic 4GL's "thin client" three-tier architecture, combined with these flexible deployment options, allows customers to deploy new, state-of-the-art Graphical User Interface applications within existing desktop and network infrastructures. INTEGRATION PRODUCTS Where companies once stored their data on mainframes, today their applications may be spread across divergent computing platforms, operating systems, and databases, including proprietary and open, relational and non-relational. These disparate applications present a major challenge for IS departments, which need to ensure that end users have easy access to the data they need--regardless of where the data is located. To address this challenge, Informix offers a variety of connectivity and gateway products that make enterprisewide data access a reality. CONNECTIVITY PRODUCTS INFORMIX CLIENT SDK offers customers a single packaging of several application programming interfaces (APIs) needed to develop for Informix servers. These interfaces allow developers to write applications in the language they are familiar with, whether it be Java, C++, C, or ESQL. INFORMIX ESQL/C provides the convenience of entering SQL statements directly into the C language source code. Developers can use SQL to issue commands to the Informix server and to manage the result sets of data from queries. Informix ESQL/C provides low level control over the application for session management and error handling and gives the developer direct access to all database functions. INFORMIX CLI is the Informix implementation of the Open Database Connectivity (ODBC) 2.5 standard for developers and end users wanting to deploy applications that require access across heterogeneous databases. Informix CLI allows any ODBC compliant application to connect to any Informix server. INFORMIX OBJECT INTERFACE FOR C++ allows developers using C++ to work with the Informix server product line through a single object oriented application programming interface. It delivers the scalability and extensibility of Informix servers to application software developers in a programming model familiar to C++ and Microsoft Component Object Model (COM) programmers. Informix Object Interface for C++ supports datatype extensibility and user defined function extensibility. INFORMIX CONNECT is a runtime connectivity product which includes the runtime libraries of the Informix application programming interfaces. Informix Connect is the runtime component of ClientSDK. INFORMIX JDBC DRIVER is a native Java driver that connects platform independent client side Java applications to any currently shipping and supported Informix database. The Informix JDBC Driver is based on the JDBC 1.22 specification from Sun Microsystems, and provides a standard database connectivity API to use for all current and future Java applications built on Informix. INFORMIX DCE/NET is a DCE based connectivity product that allows customers to access Informix databases transparently through Microsoft's Open Database Connectivity (ODBC) interface while taking advantage of such DCE features as security and naming services. INFORMIX OPEN is a set of libraries that allows Informix ODBC compliant applications to connect to and interact with an Informix, Oracle, or Sybase database server. GATEWAY PRODUCTS INFORMIX ENTERPRISE GATEWAY MANAGER is a member of the Informix Enterprise Gateway family, a complete set of standards based gateways. Enterprise Gateway Manager is a high performance gateway solution that allows Informix application users and developers to transparently access Oracle, Sybase, DB2, and other non-Informix databases. INFORMIX ENTERPRISE GATEWAY FOR EDA/SQL allows tools and applications running on UNIX and Microsoft Windows to access data located anywhere in your enterprise. It provides both SQL and remote procedure call access to over 60 relational and nonrelational data sources on 35 different hardware platforms and operating systems. INFORMIX ENTERPRISE GATEWAY WITH DRDA integrates IBM relational databases (i.e., DB2, DB2/400, and DB2/VM) with Informix applications on open systems without the need for host resident software. DATABLADES Informix DataBlade modules extend Informix Dynamic Server.2000 to manage rich, diverse data. DataBlade modules integrate traditional alphanumeric data types with rich content, without sacrificing the reliability and scalability of the traditional relational DBMS. We offer DataBlade modules for text, rich content, unicode, video, geodetic, spatial and time series data. Additional DataBlade modules are available from third parties, including DataBlade modules for local languages, advanced search and retrieval capabilities, digital media, spatial and geo-spatial applications, messaging, data warehousing (data cleansing, qualification and queries), bio-informatics and medical imaging and security. TEXT DATABLADE allows full-text search of data in the database. The Text DataBlade is designed to provide advanced search and retrieval functionalities not available in the base DBMS product, such as clustering, summarization and support for over 100 different file formats. DIGITAL MEDIA DATABLADE enables intelligent and contextual search of captions to improve the retrieval of multimedia content. It provides image retrieval and feature management for digital images, and allows for support analysis and visual retrieval of video sequences. GEOSPATIAL DATABLADE provides for the manipulation, query, analysis, and display of geographic data. It adds spatial data management functionality to the server in conformance with the OpenGIS Consortium's standard, and enables developers to deliver sophisticated spatially enabled applications. It also allows for the storage and manipulation of objects in four dimensions--latitude, longitude, altitude, and time. It is specifically designed to manage spatio-temporal data with global content, such as satellite image metadata. DATA WAREHOUSE DATABLADE provides native support within the database for near-online optical storage. WEB/ECOM DATABLADE is a complete set of tools, functions, and examples for developing complex database driven web sites. It extends the server with transactional publish and subscribe capability. FINANCIAL DATABLADE provides support for the management and analysis of time-series and temporal data. HEALTHCARE DATABLADE allows non-M databases to access and update information stored in M-based databases. SECURITY DATABLADE transparently adds high granular database security by providing role-based access and encryption to the item or object level. UNICODE DATABLADE allows customers to store, access and manipulate native Unicode data in the same way in which variable character data is manipulated. SERVICES We maintain field-based and centralized corporate technical staffs to provide a comprehensive range of assistance to our customers. These services include pre-sales and post-sales technical assistance, consulting, product and sales training and technical support services. Consultants and trainers provide services to customers to assist them in the use of our products and the design and development of applications that utilize our products. We provide post-sales support to our customers on an optional basis for annual fees which generally range from 16% to 24% of the license fees paid by the customer. These support services usually include product updates. MARKETING AND CUSTOMERS We distribute our products through the channels of direct end-user licensing, OEMs, application vendors addressing specific markets, and distributors. We have chosen a multiple channel distribution strategy to maintain broad market coverage and product availability. We have generally avoided exclusive relationships with our licensees and other resellers of our products. Discount policies and reseller licensing programs are intended to support each distribution channel with a minimum of channel conflict. For 1999, sales of licenses directly to end users accounted for 65% of our total license revenues and sales to OEMs and sales through distributors and resellers accounted for 35% of our total license revenues. At December 31, 1999, our sales, marketing and support staff totaled 1,002 employees in the North America region; 153 employees in the Latin America region; 625 employees in Europe, the Middle East and Africa; and 356 employees in the Asia/Pacific region. LICENSING END-USER LICENSING We license our products to organizations worldwide through our direct sales force, value-added resellers and telemarketing. We believe that the common core technology of our database management system products, based on standard operating systems and the SQL database language, helps us sell into major corporations and government agencies that wish to standardize their diverse computing environments. As a result, certain of these end-user organizations have entered into general purchasing agreements with us which offer volume discounts. APPLICATION VENDOR AND OEM LICENSING Since our inception, we have licensed application vendors to distribute our products. A typical application vendor develops an application (e.g., an insurance agency management system) using one of our products. The application vendor purchases a license for the use of our product to develop the application program. Depending on the application developed, the vendor may purchase a run-only license, a full version license or multiple product licenses. In addition, the application vendor may resell our products to end users for use in conjunction with its own applications. Application vendors develop applications using a wide array of application development tools, including products offered by third parties. Applications developed using our products are generally portable across various brands of computers and different operating systems. We have specialized programs to support the application vendor distribution channel. Under these programs, we provide to selected application vendors a combination of marketing development services, consulting and technical marketing support and discounts. Our products are also distributed by hardware manufacturers under OEM licenses as an embedded part of their product. DISTRIBUTOR LICENSING We have established a network of full service international distributors who provide local service and support, as well as our products, to their respective national markets. We use distributors to supplement our direct sales force, which enables us to increase our worldwide market coverage. PRODUCT DEVELOPMENT The computer software industry is highly competitive and rapidly changing. Consequently, we dedicate considerable resources to research and development efforts to enhance our existing product lines and to develop new products to meet new market opportunities. Most of our current software products have been developed internally; however, we have acquired certain software products from others and plan to do so again in the future. Major product releases resulting from research and development projects in 1999 included Informix Internet Foundation.2000, Informix Dynamic Server.2000, Informix Client SDK 2.3, Excalibur Text DataBlade Module 1.2 EPA, Informix Dynamic 4GL 3.0, Informix MetaCube ROLAP Option 4.2, Informix Visionary 1.1, Informix JDBC Driver 2.00.JC1, DataBlade Developer's Kit (DBDK) Version 3.7, Informix I-Spy, Informix i.Sell, Informix Dynamic Server 7.31, Informix Client SDK 2.20, Informix JDBC Driver 1.40.JC1, Informix i.Reach, Informix Visionary 1.0. Our current product development efforts are focused on: - Improving and enhancing current products and developing new products, with particular emphasis on parallel computer architecture, user-defined database extensions, Web technology integration, graphical desk top and system administration, analytical templates, and support for industry standard and emerging development tools. - Improving our products to provide greater speed and support for larger numbers of concurrent users. - Adapting new products to the broad range of computer brands and operating systems that we currently support, and adapting current products to new brands of computers and operating systems that represent attractive market opportunities for our products. As of December 31, 1999, we had 993 regular employees engaged in research and development. The market for qualified development engineers remains highly competitive. Our research and development expenditures for 1999, 1998 and 1997 were $163.3 million, $149.6 million, and $141.5 million, respectively, representing approximately 19%, 20% and 21% of net revenues for these periods. In addition, during 1999, 1998 and 1997, we capitalized product development costs of $22.7 million, $18.6 million, and $20.8 million, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Costs and Expenses." COMPETITION Competitors in the RDBMS market compete primarily on the basis of product price and performance characteristics, name recognition, technical product support, product training and services. With respect to product performance, we believe that the principal competitive factors include: - Application development productivity (I.E., the speed with which applications can be built). - Database performance (I.E., the speed at which database storage and retrieval functions are executed). - Product function and features. - The ability to support large warehouses of information. - Reliability, availability and serviceability. - The distribution of software applications and data across networks of computers from multiple suppliers. - The ability to manage complex data and solve more complex business problems based on such data. The RDBMS software market is extremely competitive and subject to rapid technological change and frequent new product introductions and enhancements. Our competitors in the market include several large vendors that develop and market databases, applications, development tools or decision support products. Our principal competitors include Computer Associates International, Inc.; IBM; Microsoft; NCR/Teradata; Oracle and Sybase. Additionally, as we expand our business into the data warehousing and Web/electronic commerce markets, we expect to compete with companies offering highly specialized products in each of these market segments. INTELLECTUAL PROPERTY Our success depends on proprietary technology. To protect our proprietary rights, we rely primarily on a combination of patent, copyright and trademark laws, trade secrets, confidentiality procedures, contractual provisions contained in our license agreements and technical measures. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which provide only limited protection. We hold seven United States patents and several pending applications. Our products are generally licensed to end-users on a "right-to-use" basis pursuant to a license that restricts the use of the products for the customer's internal business purposes. We also rely on "shrink wrap" and "click wrap" licenses, which include a notice informing the end-user that, by opening the product packaging or, in the case of an online transaction, by downloading the product, the end-user agrees to be bound by our license agreement printed on the package or displayed on the customer's computer screen. Despite such precautions, it may be possible for unauthorized third parties to copy aspects of our current or future products or to obtain and use information that we regard as proprietary. In particular, we have licensed the source code of our products to certain customers under certain circumstances and for restricted uses. We have also entered into source code escrow agreements with a number of our customers that generally require release of source code to the customer in the event of our bankruptcy, liquidation or otherwise ceasing to conduct business. EMPLOYEES As of December 31, 1999, Informix and its subsidiaries employed 3,672 regular employees worldwide, including 2,136 in sales, marketing and support, 993 in research and development, 58 in operations and 485 in administration and finance. Of our total employees at December 31, 1999, approximately 1,392 were located outside North America. None of our employees located in the United States are represented by a labor union. A small number of employees located outside the United States are represented by labor unions, and the degree and scope of representation varies from country to country. We have not experienced any work stoppages either domestically or internationally. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information concerning our executive officers as of February 1, 2000. ROBERT J. FINOCCHIO, JR. has served as our Chairman since July 1997. From July 1997 until July 1999, Mr. Finocchio served as our President and Chief Executive Officer. From December 1988 until May 1997, Mr. Finocchio was employed with 3Com Corporation ("3Com"), a global data networking company, where he held various positions, most recently serving as President, 3Com Systems. Prior to his employment with 3Com, Mr. Finocchio held various executive positions in sales and service with Rolm Communications, a telecommunications and networking company, most recently as Vice President of Rolm Systems Marketing. Mr. Finocchio also serves as a director of Latitude Communications, UpShot.com, Turnstone Systems, Inc., Echelon Corporation and Resonate Inc. Mr. Finocchio is also a Regent of Santa Clara University. Mr. Finocchio holds a B.S. in economics from Santa Clara University and an M.B.A. from the Harvard Business School. JEAN-YVES F. DEXMIER has served as our President and Chief Executive Officer since July 1999. Previously, Mr. Dexmier served as our Executive Vice President, Field Operations from January 1999 until July 1999. He served as our Executive Vice President and Chief Financial Officer from October 1997 to January 1999 and as our Secretary from October 1997 to February 1998. Mr. Dexmier served as a strategy consultant to high technology companies from February 1997 to September 1997. From November 1995 until February 1997, Mr. Dexmier served as Senior Vice President and Chief Financial Officer of Octel Communications Corporation, a provider of voice messaging systems ("Octel"). From April 1995 to October 1995, Mr. Dexmier served as Chief Financial Officer for Kenetech Corporation, a wind energy company. From May 1994 to March 1995, Mr. Dexmier served as Chief Financial Officer for Air Liquide America Corporation, a U.S. subsidiary of the French-based group Air Liquide, a worldwide producer of industrial gases. From January 1991 to January 1994, Mr. Dexmier served as Chief Financial Officer for Thomson Consumer Electronics, Inc., a subsidiary of Thomson SA, a worldwide electronics manufacturer. Mr. Dexmier holds a B.S. in mathematics from Lycee Pasteur, a Ph.D. in electronics from the Ecole Nationale Superieure de l'Aeronautique et de l'Espace and an M.B.A. in economics and finance from the Ecole Polytechnique. In addition, he attended the executive management program at the University of Michigan School of Business Administration. HOWARD A. BAIN, III resigned effective March 20, 2000 after serving as our Executive Vice President and Chief Financial Officer since January 1999. Prior to joining us, Mr. Bain held various positions at Symantec Corporation, a software management and security technology company, since October 1991. Most recently Mr. Bain was Vice President, Worldwide Operations and CFO at Symantec Corporation. Mr. Bain graduated from California Polytechnic University in 1971 with a B.S. in business and is a Certified Public Accountant. KAREN BLASING has served as our Vice President, Business Development Finance since May 1998. Prior to that time, Ms. Blasing served as our Corporate Controller since June 1996 and as a Vice President of Informix since August 1997 before resigning from such positions in April 1998. Ms. Blasing joined Informix in November 1992 as its Director of Financial Reporting and Analysis. From January 1989 to October 1992, Ms. Blasing was a Senior Financial Manager at Oracle Corporation, a provider of information management software and services. Ms. Blasing holds a B.S. in both economics and business from the University of Montana and an M.B.A. from the University of Washington. CHARLES W. CHANG has served as our Senior Vice President and Group Executive of the i.Intelligence group since October 1999. Previously, from August 1999 until October 1999, Mr. Chang was our Vice President and General Manager, Data Warehouse. Mr. Chang joined Informix after a tenure as senior vice president and general manager of Business Objects Corporation, a provider of integrated enterprise decision support tools. Mr. Chang also has more than 20 years experience with IBM in sales and general management positions. Prior to his departure, he was director of worldwide sales for IBM's data management products, a $1.7 billion operation. Prior to this position, Mr. Chang led IBM's Internet Division in Asia Pacific, managing the sales and marketing for IBM's e-business initiative in the region. Mr. Chang holds a bachelor's degree in math from UCLA, as well as a master's degree in management from the University of Southern California. Chang is also a graduate of the executive program at UCLA's Anderson School. JAMES F. HENDRICKSON, JR. has served as our Senior Vice President and Group Executive, i.Informix group, since October 1999. He has also served as our Vice President, Customer Services, since July 1992 until October 1999 and as our Lenexa (Kansas) Site General Manager from February 1995 until October 1999. From 1991 until the time he joined us, Mr. Hendrickson was Senior Vice President of Sales and Support at Image Business Systems, a developer of document image management software for client/ server systems. Mr. Hendrickson holds a B.S. in mechanical engineering from Stanford University and an M.B.A. in business and administration from the University of California, Los Angeles. GARY LLOYD has served as our Vice President, Legal and General Counsel since January 1998 and as our Secretary since February 1998. From November 1997 until January 1998, Mr. Lloyd served as our interim General Counsel. From March 1994 until October 1997, Mr. Lloyd was with the law firm of Farella Braun & Martel L.L.P. From 1984 until February 1994, Mr. Lloyd served in a variety of positions at the Securities and Exchange Commission, most recently as its Assistant Director, Division of Enforcement. Mr. Lloyd holds a B.A. in political science and English from Kent State University and a J.D. from Case Western Reserve University. WAYNE E. PAGE joined the Company in October 1999 as Vice President, Human Resources. Mr. Page spent the previous two years as a senior consultant for The Hay Group. From 1996 to 1997, Mr. Page was a client manager and human resources consultant with Alexander & Alexander (Aon), a human resources consulting firm. From 1991 to 1996, he served as health and welfare practice leader and senior manager for KPMG LLP, an accounting firm. From 1989 to 1991, he held a similar position with Ernst & Young, an accounting firm. Prior to these eight years of human resources consulting with KPMG LLP and Ernst & Young, Mr. Page had 17 years of corporate human resources experience with the Central Companies and Transamerica Corporation. Mr. Page holds a BS in Human Resources from The Ohio State University and attended the Ohio State University College of Law. WILLIAM F. O'KELLY joined the Company in August 1999 as the Company's Vice President, Treasurer. Mr. O'Kelly also served as a financial consultant to the Company from May 1998 until August 1999. Previously, Mr. O'Kelly was Chief Financial Officer at Chemical Supplier Technology Inc. and Corporate Controller at Air Liquide America Corporation, an industrial and medical gases company, from August 1993 until December 1995. Mr. O'Kelly holds at B.S. in accounting from the University of Florida. MICHAEL A. STONEBRAKER has served as our Vice President and Chief Technology Officer since February 1996. Dr. Stonebraker co-founded Illustra, a database management software company acquired by Informix in February 1996, and served in a consulting capacity with Illustra as its Chief Technology Officer until February 1996. Dr. Stonebraker is a professor emeritus of Electrical Engineering and Computer Sciences at the University of California, Berkeley, where he joined the faculty in 1971. Dr. Stonebraker holds a B.S. in electrical engineering from Princeton University and an M.S. and Ph.D. in computer information and control engineering from the University of Michigan. F. STEVEN WEICK has served as the Company's Senior Vice President and Group Executive, i.Foundation group since October 1999. Previously, from October 1998 until October 1999, Mr. Weick served as the Company's Vice President, Research and Development. Mr. Weick joined us in 1997 as Vice President of Server Development. Prior to joining us, Mr. Weick was Vice President of Engineering for MapInfo Inc., a business mapping solutions company from 1995 to August 1997. Mr. Weick led development activities for five years at Tandem Computers, the last three as Vice President of Communications Hardware and Software Products, and earlier led the Non-Stop SQL server, compiler and tools development groups. Mr. Weick began his career at IBM in 1965 as a development engineer; he held numerous positions at IBM, including: chief architect for database products, consultant to the corporate technical committee, development manager responsible for DB2, and program manager for compilers. Mr. Weick holds a B.S. in mathematics from Purdue University and an M.B.A. from Pepperdine University. ITEM 2. ITEM 2. PROPERTIES Our headquarters and principal marketing, finance, sales, administration, customer service and research and development operations are located in five buildings throughout a corporate office park in Menlo Park, California. We currently lease approximately 206,000 square feet of space in these buildings. The lease agreements for two of the buildings expire in September 2001. The lease agreements for the remaining three buildings expire in March 2003. We lease an additional 33,000 square feet in two nearby buildings. The lease agreements for these buildings expire in October 2000 and May 2003. We also occupy approximately 135,000 square feet in Lenexa, Kansas. This facility incorporates a portion of the research and development, customer service and telemarketing organizations and serves as the principal domestic manufacturing facility. These buildings are leased to us under two separate lease agreements, both of which expire in April 2003, subject to our renewal rights of two additional five-year terms. Some of the research and development operations for our products as well as a portion of our customer service and sales training operations are located in Oakland, California. We lease approximately 130,000 square feet at this site which is scheduled to expire in May 2003. We also lease approximately 47,000 square feet on two separate floors in Portland, Oregon which is primarily utilized for research and development. The lease for one floor of this facility expires on March 15, 2000. To replace this space, we have leased 60,000 square feet in another downtown Portland building for a term of five years. The lease for the remaining floor of the original building, which expires on October 31, 2003, is being marketed for sub-lease. The entire Portland operation will be relocated to the newly acquired office space. In October 1999, through the acquisition of Cloudscape, we assumed the lease obligations for a number of facilities in North America, of which only the Oakland, California location is significant. The current plans are to relocate the Oakland Cloudscape employees to our existing Oakland office in the second quarter of 2000 and dispose of the existing Oakland Cloudscape lease. We also lease office space, principally for sales and support offices, in a number of facilities in the United States, Canada and outside North America. We believe that our current facilities are adequate to meet our needs through the next twelve months. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On May 26, 1999, we entered into a memorandum of understanding regarding the settlement of pending private securities and related litigation against us, including a federal class action, a derivative action, and a state class action. In November 1999, the settlement was approved by the applicable Federal and state courts. The settlement resolves all material litigation arising out of the restatement of our financial statements that was publicly announced in November 1997. In accordance with the terms of the memorandum of understanding, we paid approximately $3.2 million in cash during the second quarter of 1999 and an additional amount of approximately $13.8 million of insurance proceeds was contributed directly by certain of our insurance carriers on behalf of certain of our current and former officers and directors. We will also issue a minimum of nine million shares of our common stock, which will have a guaranteed value of $91 million for a maximum term of one year from the date of final approval of the settlement by the courts. Our former independent auditors, Ernst & Young LLP, will pay $34 million in cash. The total amount of the settlement will be $142 million. As of December 31, 1999, we had issued 2.9 million of the minimum amount of 9 million shares issuable pursuant to the memorandum of understanding. In July 1997, the Securities and Exchange Commission ("SEC") issued a formal order of private investigation of the Company and certain unidentified other entities and persons with respect to non-specified accounting matters, public disclosures and trading activity in the Company's securities. During the course of the investigation, the Company learned that the investigation concerned the events leading to the restatement of the Company's financial statements, including fiscal years 1994, 1995 and 1996, that was publicly announced in November 1997. The Company and the SEC have entered into a settlement of the investigation as to the Company. Pursuant to the settlement, the Company consented to the entry by the SEC of an Order Instituting Public Administrative Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease and Desist Order (the "Order"). The Order was issued by the SEC on January 11, 2000. Pursuant to the Order, the Company neither admitted nor denied the findings, except as to jurisdiction, contained in the Order. The Order directs the Company to cease and desist from committing or causing any violation, and any future violation, of Section 17(a) of the Securities Act of 1933 ("Securities Act"), and Sections 10(b), 13(a) and 13(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and Rules 10b-5, 12b-20 13a-1, 13a-13 and 13b2-1 under the Exchange Act. Pursuant to the Order, the Company also is required to cooperate in the SEC's continuing investigation of other entities and persons. As a consequence of the issuance of the Order, the Company is statutorily disqualified, pursuant to Section 27A(G)(1)(A)(ii) of the Securities Act and Section 21E(b)(1)(A)(ii) of the Exchange Act, for a period of three years from the date of the issuance of the Order, from relying on the protections of the "safe harbor" for forward-looking statements set forth in Section 27(A)(c) of the Securities Act and Section 21(E)(c) of the Exchange Act. EXPO 2000 filed an action against Informix Software GmbH (the Company's German subsidiary) in the Hanover (Germany) district court in September 1998 seeking recovery of approximately $6.0 million, plus interest, for breach of a sponsorship contract signed in 1997. Informix filed a counterclaim for breach of contract and seeks recovery of approximately $3.1 million. During settlement negotiations prior to the filing of the action, EXPO 2000 stated that it would accept approximately $2.5 million to settle. In March 1999, a panel of three judges appointed by the court recommended a settlement pursuant to which EXPO 2000 and Informix would release the other from all claims. EXPO 2000 declined to accept the recommendation. In August 1999, the court entered a judgment against Informix in the amount of approximately $6.0 million, although approximately $2.1 million of judgment is conditioned upon the return to Informix by EXPO 2000 of certain software. Informix has filed an appeal. The Company has reserved $2.5 million for the expected outcome of the appeal. PATENT INFRINGEMENT LAWSUIT On February 3, 2000, International Business Machines Corporation ("IBM") filed an action against us in the United States District Court for the District of Delaware alleging infringement of six United States patents owned by IBM. The Informix products that IBM alleges infringe its patents are Informix Online Dynamic Server versions 5, 6 and 7, Informix SE version 6, Informix NewEra version 1, Informix NET, Informix STAR, Illustra Visual Information Retrieval, and Illustra Visual Intelligence Viewer. In its complaint, IBM seeks a permanent injunction against further alleged infringement, unspecified compensatory damages, unspecified treble damages, and interest, costs and attorneys' fees. We strongly believe that the allegations in the complaint are without merit and intend to defend the action vigorously and to assert such counterclaims against IBM as may be appropriate. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS We did not submit any matters to a vote of security holders during the fourth quarter of fiscal 1999. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Our Common Stock is traded on the National Market of The Nasdaq Stock Market under the symbol "IFMX." The following table lists the high and low sales prices of our Common Stock for the periods indicated. At December 31, 1999, there were approximately 3,902 stockholders of record of our Common Stock, as shown in the records of our transfer agent. DIVIDEND POLICY We have never declared or paid cash dividends on our Common Stock. We expect to retain future earnings, if any, for use in the operation of our business and do not anticipate paying any cash dividends on our Common Stock in the foreseeable future. The holders of our Series B Convertible Preferred Stock (the "Series B Preferred") are entitled to receive a cumulative dividend at an annual rate of 5% of the face value of each share of Series B Preferred, resulting in an aggregate annual dividend accrual of $0.4 million, based on the 7,000 shares of Series B Preferred outstanding at December 31, 1999. The dividend is generally payable upon the conversion or redemption of the Series B Preferred and may be paid in cash or, at our election and subject to certain conditions, in shares of Common Stock. In addition, the Certificate of Designation of the Series B Preferred prohibits us from paying any dividend or other distribution on any security ranking junior to the Series B Preferred. In the first quarter of 1999, we paid $1.3 million to the Series B Preferred stockholders as a result of certain contractual provisions under our Registration Rights Agreement with the Series B Preferred stockholders. This amount was recognized in fiscal 1998 as an additional dividend to the Series B Preferred stockholders. The Series B Preferred is convertible at the election of the holders into shares of Common Stock. The currently outstanding Series B Preferred was originally issued on November 19, 1997. The Series B Preferred will automatically convert into Common Stock three years following the date of its issuance. Each share of Series B Preferred, which has a face value of $1,000, is convertible into (i) shares of Common Stock at a per share price equal to the lowest of (A) $7.84--the average of the closing bid prices for the Common Stock for the 22 trading days immediately prior to the 180th day following the initial issuance date of the Series B Preferred, (B) 101% of the average of the closing bid prices for the Common Stock for the 22 trading days ending five trading days prior to the date of actual conversion or (C) 101% of the lowest closing bid price for the Common Stock during the five trading days immediately prior to the date of actual conversion and (ii) warrants to acquire that number of shares of Common Stock equal to 20% of the shares determined pursuant to item (i). The exercise price for these warrants is $7.84 per share. The conversion price of the Series B Preferred is subject to modification and adjustment upon the occurrence of specified events. In October 1999, in connection with our acquisition of Cloudscape, Inc. ("Cloudscape") pursuant to an agreement and plan of reorganization dated September 15, 1999, we issued to the shareholders of Cloudscape an aggregate of 9,583,000 shares of our common stock (the "Shares") on October 15, 1999 in exchange for all of the outstanding common stock of Cloudscape. The issuance of the Shares was exempt from registration under the Securities Act of 1933, as amended, by virtue of Section 4(2) thereof. The issuance did not involve any underwriters, underwriting discounts or commissions, or any public offering. Each of the Cloudscape shareholders represented its intention to acquire the Shares for investment only and not with a view to, or for sale in connection with any, distribution thereof. Appropriate legends were affixed to the share certificates issued to Cloudscape shareholders. Cloudscape shareholders had adequate access to information about Informix. Subsequent to the issuance, the Shares were registered on a registration statement on Form S-3. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL OVERVIEW FIVE-YEAR SUMMARY - ------------------------------ (1) In 1999, we recorded restructuring-related adjustments that increased operating income by $0.6 million and, in connection with our acquisition of Cloudscape in October 1999, recorded a charge to operations of $2.8 million for merger related expenses. In addition, we recorded a charge of $97.0 million related to the settlement of private securities and related litigation against us. (2) In 1998, we recorded restructuring-related adjustments that increased operating income by $10.3 million and, in connection with our acquisition of Red Brick in December 1998, recorded a charge to operations of $2.6 million for in-process research and development which had not yet reached technological feasibility and had no alternative future uses. (3) In 1997, we recorded a restructuring charge of $108.2 million, a write-down of certain assets in Japan of $30.5 million and a write-down of capitalized software of $14.7 million. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL PERFORMANCE OF INFORMIX, WHICH INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH UNDER "FACTORS THAT MAY AFFECT FUTURE RESULTS," "BUSINESS" AND ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K. OVERVIEW Informix Corporation is a leading supplier of information management software and solutions to governments and enterprises worldwide. We design, develop, manufacture, market and support - Object-relational and relational database management systems - Connectivity interfaces and gateways - Graphical and character-based application development tools for building database applications that allow customers to access, retrieve and manipulate business data We also offer complete solutions, which include our database management software, our own and third-party software, and our consulting services, to help customers design and deploy data warehouses, Web-based enterprise repositories and electronic commerce applications. On November 30, 1999, we reached a definitive agreement (the "Ardent Agreement") to acquire Ardent Software, Inc. ("Ardent"), a leading provider of data integration infrastructure software for data warehouse, business intelligence, and e-business applications. In accordance with the Ardent Agreement, 3.5 shares of our common stock will be exchanged for each outstanding Ardent share. The transaction is expected to be accounted for as a pooling-of-interests and completion of the transaction, which is subject to the approval of stockholders of both companies, is expected to occur in the first quarter of 2000. On October 8, 1999, we completed our acquisition of Cloudscape, Inc. ("Cloudscape"), a privately-held provider of synchronized database solutions for the remote and occasionally connected workforce. In the acquisition, the former shareholders of Cloudscape received shares of our common stock in exchange for their shares of Cloudscape at the rate of approximately 0.56 shares of our common stock for each share of Cloudscape common stock (the "Cloudscape Merger"). The Cloudscape Merger was accounted for as a pooling-of-interests. An aggregate of 9,583,000 shares of our common stock were issued pursuant to the Merger, and an aggregate of 417,000 options and warrants to purchase Cloudscape common stock were assumed by us. On October 1, 1999, the Company reorganized its operating business divisions into four new business groups: the TransAct Business Group, which is responsible for delivering on-line transaction processing products; the i.Foundation Business Group, which is responsible for delivering products that provide the technological foundation for Internet-based electronic commerce solutions; the i.Informix Business Group, which is responsible for delivering Internet-based solutions for electronic commerce; and the i.Intelligence Business Group, which is responsible for delivering Internet-based data warehouse products and solutions. On May 26, 1999, we entered into a memorandum of understanding regarding the settlement of pending private securities and related litigation against us, including a federal class action, a derivative action, and a state class action. In November 1999, the settlement was approved by the applicable Federal and state courts. The settlement resolves all material litigation arising out of the restatement of our financial statements that was publicly announced in November 1997. In accordance with the terms of the memorandum of understanding, we paid approximately $3.2 million in cash during the second quarter of 1999 and an additional amount of approximately $13.8 million of insurance proceeds was contributed directly by certain of our insurance carriers on behalf of certain of our current and former officers and directors. We will also issue a minimum of nine million shares of our common stock, which will have a guaranteed value of $91 million for a maximum term of one year from the date of final approval of the settlement by the courts. Our former independent auditors, Ernst & Young LLP, will pay $34 million in cash. The total amount of the settlement will be $142 million. As of December 31, 1999, we had issued 2.9 million of the minimum amount of 9 million shares issuable pursuant to the memorandum of understanding. In July 1997, the Securities and Exchange Commission ("SEC") issued a formal order of private investigation of the Company and certain unidentified other entities and persons with respect to non-specified accounting matters, public disclosures and trading activity in the Company's securities. During the course of the investigation, the Company learned that the investigation concerned the events leading to the restatement of the Company's financial statements, including fiscal years 1994, 1995 and 1996, that was publicly announced in November 1997. The Company and the SEC have entered into a settlement of the investigation as to the Company. Pursuant to the settlement, the Company consented to the entry by the SEC of an Order Instituting Public Administrative Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease and Desist Order (the "Order"). The Order was issued by the SEC on January 11, 2000. Pursuant to the Order, the Company neither admitted nor denied the findings, except as to jurisdiction, contained in the Order. See "Factors Affecting Operating Results--Settlement of SEC investigation could harm our business." RESULTS OF OPERATIONS The following table and discussion compares the results of operations for the years ended December 31, 1999, 1998 and 1997. Our operating results for 1999 improved over the prior year due to revenue growth of 18% while costs and expenses increased by only 13% when compared to 1998. Growth in consolidated revenues was experienced by all regions during fiscal 1999 as sales increased by 20%, 19%, 18% and 18% in Latin America, North America, Europe and Asia/Pacific, respectively. As a percentage of net revenues, all operating expense categories for 1999 either decreased or remained consistent when compared to 1998 as we continued our effort to keep operating expenses in line with revenues. Revenue growth combined with lower operating costs resulted in an increase of $45.2 million, or 85%, in operating income to $98.5 million for 1999 from $53.3 million in 1998. REVENUES We derive revenues from licensing software and providing post-license technical product support and updates to customers and from consulting and training services. LICENSE REVENUES. License revenues may involve the shipment of product by us or the granting of a license to a customer to manufacture products. Our products are sold directly to end-user customers or through resellers, including OEMs, distributors and value added resellers (VAR's). License revenues for 1999 increased 15% to $442.8 million from $383.9 million in 1998. The higher license revenue growth rate experienced in 1999 was due to continued demand for our established products and the introduction and market positioning of new products and versions including our Red Brick and Cloudscape product offerings. Each of our regions reported increased license revenues for fiscal 1999 when compared to fiscal 1998, as follows: - Europe, Middle-East and Africa ("EMEA") license revenues increased to $148.4 million as compared to $125.2 million, an increase of 19% - North America license revenues increased to $200.4 million as compared to $170.2 million, an increase of 18% - Latin America license revenues increased to $36.3 million as compared to $33.9 million, an increase of 7% - Asia/Pacific license revenues increased to $57.7 million as compared to $54.6 million, an increase of 6% License revenues for 1998 increased slightly to $383.9 million from $378.2 million in 1997. This modest increase in license revenues reflected a number of factors which affected us during 1998, including an overall decrease in revenue growth rates in the RDBMS industry worldwide, continued uncertainty in the Asia/Pacific economies and financial markets as well as changes to our European management. Our increased focus on reseller channels in 1996 resulted in a significant build-up of licenses that had not been resold or utilized by the resellers. As discussed in Note 1 to our Consolidated Financial Statements, revenue from license agreements with resellers is recognized as earned by us when the licenses are resold or utilized by the reseller and all of our related obligations have been satisfied. Accordingly, amounts received from customers and financial institutions in advance of revenue being recognized are recorded as a liability in "advances from customers and financial institutions" in our Consolidated Financial Statements. Advances in the amount of $34.3 million and $121.1 million had not been recognized as earned revenue as of December 31, 1999 and 1998, respectively. During the year ended December 31, 1999, we received $6.5 million in customer advances and recognized revenue from previously recorded customer advances of $82.0 million. Included in the $82.0 million recognized were $69.1 million of licenses which were resold or utilized by the reseller, $11.4 million related to contractual reductions in customer advances and $1.5 million related to previously-deferred revenue for solution sales which has now been recognized. Contractual reductions result from settlements between us and resellers in which the customer advance contractually expires or a settlement is structured wherein the rights to resell our products terminate without sell through or deployment of the software. As of December 31, 1999, we had reached structured settlements with three resellers with remaining rights to resell a total of $1.0 million of our products, which will be utilized by December 31, 2000 pursuant to the minimum future reduction terms of the settlement. Management believes that the level of licenses sold through these resellers is likely to continue; however, revenue may not be sustained following full utilization of the "advances from customers and financial institutions" because there may be less incentive for resellers to sell our products. In order to properly recognize revenue on arrangements where the reseller has duplication rights, we rely on accurate and timely reports from resellers of the quantity of licenses that have been resold or utilized. In instances where a reseller does not submit a timely report, we accrue royalty revenue through the end of the reporting period provided we have vendor specific historical information. From time to time, late or inaccurate reports are identified or corrected for a variety of reasons, including resellers updating their reports or as a result of our proactive activities such as audits of the resellers' royalty reports. As a result, audits form these late or updated reports, which was not previously accrued, is recognized in the period during which the reports are received. Such revenue amounted to approximately $6.0 million for 1998 and was not significant for 1999. We expect that the late or inaccurate reporting of resale or utilization of licenses by resellers and the resulting fluctuations will continue for the foreseeable future. Our license transactions can be relatively large in size and difficult to forecast both in timing and dollar value. As a result, license transactions have caused fluctuations in net revenues and net income (loss) because of the relatively high gross margin on such revenues. As is common in the industry, a disproportionate amount of our license revenue is derived from transactions that close in the last weeks or days of a quarter. The timing of closing large license agreements also increases the risk of quarter-to-quarter fluctuations. We expect that these types of transactions and the resulting fluctuations in revenue will continue. SERVICE REVENUES. Service revenues are comprised of maintenance, consulting and training revenues. Service revenues increased 22% to $428.7 million in 1999 and 23% to $351.6 million in 1998 from $285.7 million in 1997. Service revenues accounted for 49%, 48%, and 43% of total revenues in 1999, 1998 and 1997, respectively. The increase in service revenues, both in absolute dollars and as a percentage of total revenues, was attributable primarily to the renewal of maintenance contracts in connection with our growing installed customer base. As our products continue to grow in complexity, more support services are expected to be required. We intend to satisfy this requirement through internal support, third-party services and OEM support. Maintenance revenues increased 28% to $325.6 million for 1999 and 35% to $253.6 million for 1998 from $188.1 million for 1997. Consulting and training revenues increased 5% to $103.1 million for 1999 and remained flat at $97.9 million for 1998 as compared to $97.6 million in 1997. COSTS AND EXPENSES COST OF SOFTWARE DISTRIBUTION. Cost of software distribution consists primarily of: (1) manufacturing and related costs such as media, documentation, product assembly and purchasing costs, freight, customs and third party royalties; and (2) amortization of previously capitalized software development costs and any write-offs of previously capitalized software. Cost of software distribution increased $7.7 million, or 22%, to $43.1 million for 1999 compared to $35.4 million for 1998. This increase was primarily due to an increase in royalties related to new products and the write-off of capitalized software costs. During the third quarter of 1999, approximately $2.4 million of previously capitalized software costs were written down to the estimated net realizable value after it was determined that the projected sales of certain tools products and system management programs were not sufficient to realize the capitalized product development costs. Amortization of capitalized software remained relatively flat at $19.3 million in 1999 compared to $20.7 million and $21.4 million in 1998 and 1997, respectively. The amortization of capitalized software will vary from period to period as new products are released and other products become fully amortized. Cost of software distribution decreased to $35.4 million in 1998 from $63.0 million in 1997. This decrease was primarily caused by a write-down in 1997 of $14.7 million to net realizable value of certain of our database tool products related to our acquisition of CenterView Software, Inc. in the first quarter of 1997, a decrease in third party software royalties, the write-off of certain unused application software in the second quarter of 1997 and a reduction in labor, materials and shipping costs. COST OF SERVICES. Cost of services consists primarily of maintenance, consulting and training expenses. Cost of services for 1999 increased 11% to $173.7 million from $155.9 million in 1998 due primarily to a 10% increase in average headcount during 1999, a portion of which resulted from the addition of the Red Brick consulting team subsequent to the completion of the acquisition in December 1998. Cost of services decreased as a percentage of net service revenues to 41% for 1999 compared to 44% for 1998. The increase in gross service margins from 56% in 1998 to 59% during 1999 was due to a higher percentage of customer maintenance support revenue in 1999 which typically has a higher profit margin than consulting and training services revenue. Maintenance represented approximately 76% of service revenues in 1999 compared to 72% in 1998. Cost of services for 1998 decreased by 7% to $155.9 million as compared to $166.9 million in 1997 and decreased as a percentage of net service revenues to 44% for 1998 compared to 58% for 1997. These decreases were primarily attributable to decreases of 11% in average headcount for 1998 over the same period in 1997 as well as improved efficiency and better control of outsourced expenses. SALES AND MARKETING EXPENSES. Sales and marketing expenses consist primarily of salaries, commissions, marketing and communications programs and related overhead costs. Sales and marketing expenses increased 15% to $312.1 million for 1999 from $271.9 million for 1998 due primarily to increased advertising and marketing efforts during 1999 in connection with the introduction of several new products and our new corporate logo and identity in order to increase brand awareness. This increase was in line with net revenue growth rates as sales and marketing expenses as a percentage of net revenues were 36% and 37% for 1999 and 1998, respectively. Sales and marketing expenses decreased 35% to $271.9 million for 1998 from $418.1 million for 1997. The decrease in sales and marketing expenses in 1998 as compared to 1997 was primarily the result of a significant reduction in average sales and marketing headcount worldwide. We intend to invest more resources in marketing and communications programs during 2000 than we have in recent years in order to attempt to create greater market awareness and visibility. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses consist primarily of salaries, project consulting and related overhead costs for product development. Research and development expenses increased 9% to $163.3 million for 1999 from $149.6 million for 1998 and $141.5 million for 1997. The increase in research and development expenses during 1999 was attributable primarily to increased amortization of intangible assets resulting from the acquisition of Red Brick and a slight increase in average headcount during 1999, offset by an increase of $4.0 million in the amount of product development expenditures capitalized in 1999 compared to 1998. The increase for 1998 was primarily due to increased salary and benefits and a 10% decrease in the amount of product development expenditures capitalized in 1998 compared to 1997. This decrease in capitalized expenditures was attributable to the fact that, during the first half of 1997, a large portion of expenditures incurred were on products that had reached technological feasibility but had not yet been commercially released. As a percentage of net revenues, research and development expenses have decreased slightly to 19% for 1999, from 20% and 21% for 1998 and 1997, respectively, which is the level that we believe is consistent with our long-term objectives for research and development spending. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist primarily of finance, legal, information systems, human resources, bad debt expense and related overhead costs. General and administrative expenses were $78.6 million in 1999 as compared with $77.0 million in 1998, an increase of 2%. During 1999, general and administrative expenses decreased as a percentage of net revenues to 9% from 10% in 1998. During 1998, general and administrative expenses decreased 13% to $77.0 million from $88.1 million for 1997. The decrease in 1998 in absolute dollars and as a percentage of net revenues was primarily the result of a reduction in bad debt expense due to our efforts to better manage both the amount and credit risk of our accounts receivable balances, offset by increases in legal and other professional service fees, consulting fees and average headcount. WRITE-OFF OF GOODWILL AND OTHER LONG-TERM ASSETS. During the first quarter of 1997, our Japanese subsidiary experienced a significant sales shortfall and operating losses. Accordingly, we evaluated the ongoing value of the subsidiary's long-lived assets (primarily computer and other equipment) and goodwill. Based on this evaluation, we determined that the subsidiary's assets had been impaired and wrote them down by $30.5 million to their estimated fair values. Fair value was determined by using estimated future discounted cash flows and/or resale market quotes as appropriate. WRITE-OFF OF ACQUIRED RESEARCH AND DEVELOPMENT. In connection with our acquisition of Red Brick in December 1998, and our acquisition of Centerview Software, Inc. ("Centerview") in February 1997, we recorded charges of $2.6 million and $7.0 million in 1998 and 1997, respectively. Our December 1998, acquisition of Red Brick has been accounted for as a purchase. We issued approximately 7.6 million shares of our Common Stock to acquire all of the outstanding shares of Red Brick common stock. We also reserved an additional 2.5 million shares of our Common Stock for issuance in connection with the assumption of Red Brick's outstanding stock options and warrants. The purchase price was allocated to the fair value of the acquired assets and assumed liabilities based on their fair values at the date of acquisition. The total purchase price of $55.8 million included the issuance of stock and the assumption of stock options (together $35.9 million, net of issuance costs), direct acquisition costs of $1.0 million, accrued merger and integration costs of $7.9 million and liabilities assumed of $11.0 million. Of the total purchase price, $2.6 million was allocated to in-process research and development expense that had not yet reached technological feasibility and had no alternative future uses, $7.8 million was allocated to cash and short-term investments, approximately $10.2 million was allocated to other tangible assets, $7.4 million was allocated to capitalized software, $4.7 million was allocated to the acquired workforce and $23.1 million was allocated to goodwill. Goodwill, capitalized software and the acquired workforce are intangible assets which are being amortized over their estimated lives, which average five years. The following two in-process research and development projects were acquired in the acquisition of Red Brick: RED BRICK WAREHOUSE ("WAREHOUSE")--a high-performance, client/server RDBMS software product specifically designed for data warehousing, data mart, data mining, and OLAP applications. Warehouse has been Red Brick's core product and, as of December 31, 1998 (the "Valuation Date"), was being sold as version 5.1, which was released in January 1998. We released Informix Red Brick Warehouse version 5.1.7 on schedule during May 1999. RED BRICK FORMATION ("FORMATION")--an ETML (Extract, Transfer, Move, Load) product which was originally released as version 1.3 in September 1998 (the current version as of the Valuation Date). Formation is considered to be in the early stages of its product life cycle. New features and functionality are currently under development and will be added in subsequent releases. We released Red Brick version 1.4 on schedule during May 1999 and we are currently in the process of evaluating the future use of Formation version 2.0 due to the acquisition of similar technology as a result of the pending merger with Ardent. The fair value of the in-process technology was based on a discounted cash flow model, similar to the traditional Income Approach. The Income Approach involves five steps: (1) the annual after-tax cash flows the asset will generate over its remaining useful life are estimated; (2) these cash flows are converted to their present value equivalents using a required rate of return which accounts for the relative risk of not realizing the annual cash flows and for the time value of money; (3) the residual value, if any, of the asset at the end of its remaining useful life is estimated; (4) the estimated residual value is converted to its present value equivalent; and (5) the present value of the estimated annual after-tax cash flows is added to the present value of the residual value to obtain an estimate of the asset's fair value. The discount rate used in discounting the estimated cash flows is based on the risks associated with achieving such estimated cash flows upon successful completion of the acquired projects. Associated risks include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, and risks related to the impact of potential changes in market conditions and technology. In developing cash flow estimates, revenues were forecasted based on relevant factors, including aggregate revenue growth rates for the business as a whole, characteristics of the potential market for the technology and the anticipated life of the underlying technology. Projected annual revenues for the Warehouse and Formation projects were assumed to increase from product release through 2000, decline slightly in 2001 and decline significantly in 2002 which is estimated to be the end of the in-process technology's economic life. Cost of software distribution and services, sales and marketing expense, research and development expense and general and administrative expense were estimated as a percentage of revenues throughout the forecast period. Gross profit was assumed to be between 74% and 80% for both the Warehouse project and the Formation project. As certain other assets contribute to the cash flow attributable to the two projects, returns to these other assets or capital charges were calculated and deducted from the after-tax operating income to isolate the cash flow solely attributable to the two projects. Accordingly, returns were deducted for working capital, fixed assets (i.e. property and equipment) and the workforce in place. Informix then discounted the estimated cash flows attributable to Warehouse and Formation using a 18.0% discount rate. The fair value of the in-process research and development was allocated as approximately $2.0 million and $0.6 million to the Warehouse and Formation projects, respectively. The acquisition of Red Brick was a tax-free reorganization under the Internal Revenue Code. Therefore, the charge for in-process research and development and amortization of acquired intangible assets is not deductible for income tax purposes. In February 1997, we acquired all of the outstanding capital stock of CenterView, a privately-owned company which developed and sold software application development tools. The aggregate purchase price paid was approximately $8.7 million, which included cash and direct acquisition costs. The transaction was accounted for as a purchase and, based on an independent appraisal of the assets acquired and liabilities assumed, the purchase price was allocated to the net tangible and intangible assets acquired including developed software technology, acquired workforce, in-process technology, and goodwill. The in-process technology, which, based on the independent appraisal, was valued at $7 million, had not reached technological feasibility at the date of acquisition and had no alternative future uses in other research and development projects. Consequently, its value was charged to operations in the first quarter of fiscal 1997, the period in which the acquisition was consummated. The remaining identifiable intangible assets are being amortized over three to five years. The in-process research and development project acquired in the acquisition of CenterView consisted of the client/server software, "Data Director," that combines the functionality of high-end client/server tools with the price and openness of visual programming environments. Data Director is an integrated development extension for Microsoft Visual Basic that enables companies to build corporate Intranet and client/server applications in a single environment. As of the date of acquisition, Data Director Version 2.1 was considered developed technology while Data Director Versions 3.0 and 4.0 were considered in-process technology which had not reached technological feasibility and did not have any alternative future uses. Data Director Version 3.0 was scheduled for first customer release in July 1997 while Version 4.0 was anticipated to reach first customer release in April 1998, with commercial release to occur approximately two to three months after first customer introduction of the product. The expected aggregate costs to complete both Data Director Versions 3.0 and 4.0 were approximately $12.6 million. The fair value of the in-process technology was based on projected cash flows which were discounted based on the risks associated with achieving such projected cash flows upon successful completion of the acquired projects. Associated risks include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, and risks related to the impact of potential changes in market conditions and technology. In developing cash flow projections, revenues were forecasted based on relevant factors, including aggregate revenue growth rates for the business as a whole and for the database application development market, product family revenues, the aggregate size of the database application development market, anticipated product development and product introduction schedules, product sales cycles, and the estimated life of the underlying technology. Projected annual revenues for the Data Director in-process development projects were assumed to increase from product release through 1999, decline slightly in 2000 and decline significantly in 2001, which was estimated to be the end of the in-process technology's economic life. Gross profit was assumed to be 90% throughout the technology life cycle based on percentages estimated in Informix's aggregate business model. Estimated operating expenses, income taxes and capital charges to provide a return on other acquired assets were deducted from gross profit to arrive at net operating income. Operating expenses were estimated as a percentage of revenue and included general and administrative expenses, sales and marketing expenses and development costs to maintain the technology once it achieved technological feasibility. The net cash flows of the in-process research and development projects were discounted to their present values using a discount rate of 20%. This discount rate approximated the overall rate of return for the acquisition of CenterView as a whole and reflected the inherent uncertainties surrounding the successful development of the in-process research and development projects and the uncertainty of technological advances. We are currently selling two versions of Data Director, one for Visual Basic applications and the other for Web applications. MERGER AND RESTRUCTURING CHARGES. During the quarter ended December 31, 1999, we recorded a charge of $2.8 million associated with the merger with Cloudscape. This amount included $1.2 million for financial advisor, legal and accounting fees related to the merger and $1.6 million for costs associated with combining the operations of the two companies; including expenditures of $0.7 million for severance and related costs, $0.4 million for closure of facilities and $0.5 million for the write-off of redundant assets. Accrued merger costs totaling $1.3 million remained as a liability in our Consolidated Financial Statements as of December 31, 1999. (See Note 11 to our Consolidated Financial Statements.) In June and September 1997, we approved plans to restructure our operations to bring expenses in line with forecasted revenues and substantially reduced our worldwide headcount and modified operations to improve efficiency. Accordingly, we recorded restructuring charges totaling $108.2 million for 1997. The significant components of these restructuring changes were severance and benefits, write-off of assets, and facility charges. Severance and benefits represented the reduction of approximately 670 employees, primarily sales and marketing personnel, on a worldwide basis. Temporary employees and contractors were also reduced. Write-off of assets included the write-off or write-down in carrying value of equipment as a result of our decision to reduce the number of Information Superstores throughout the world, as well as the write-off of equipment associated with headcount reductions. The equipment subject to the write-offs and write-downs consisted primarily of computer servers, workstations, and personal computers that were no longer utilized in our operations. Facility charges included early termination costs associated with the closing of certain domestic and international sales offices. During 1999 and 1998, adjustments of $0.6 million and $10.3 million, respectively, were recorded to the results of operations. These adjustments, which appear as a credit to restructuring charges in our Consolidated Statement of Operations for the years ended December 31, 1999 and 1998, were due primarily to adjusting the estimated severance and facility components of the 1997 restructuring charge to actual costs incurred. We have substantially completed actions associated with our restructuring except for subleasing or settling our remaining long-term operating leases related to vacated properties. The terms of these operating leases expire at various dates through 2003. Accrued restructuring costs totaling $1.8 million remained as a liability in our Consolidated Financial Statements as of December 31, 1999, all of which related to facility charges. (See Note 13 to our Consolidated Financial Statements.) OTHER INCOME (EXPENSE) INTEREST INCOME. Interest income for 1999 was $11.1 million as compared to $11.7 million and $5.8 million for 1998 and 1997, respectively. Excluding approximately $2.4 million of interest income related to income tax refunds received in fiscal 1998, interest income earned during 1999 on cash and short-term investments actually increased by 19% over 1998. This increase is consistent with the increase in the average interest-bearing cash and short-term investment balances during 1999 when compared to the same period in 1998. The increase in 1998 when compared to 1997 also resulted from an increase in the average interest-bearing cash and short-term investment balances in 1998 due to increased sales and operating income as well as approximately $2.4 million in interest income related to income tax refunds received during 1998. INTEREST EXPENSE. Interest expense decreased to $4.3 million for 1999 from $5.8 million and $9.4 million for 1998 and 1997, respectively. These decreases are due primarily to a decline in the amortization of interest charges incurred in connection with the financing of customer accounts receivable prior to 1998, in addition to a decline in interest charges related to payments on capital leases. We did not enter into any accounts receivable financing transactions in 1999 and 1998. LITIGATION SETTLEMENT EXPENSE. During 1999, we incurred a charge of $97.0 million in connection with our entering into a memorandum of understanding regarding the settlement of the private securities and related litigation against us. The charge consists of $3.2 million in cash, $91.0 million in common stock and approximately $2.8 million in legal fees required to obtain and complete the settlement. The charge excludes approximately $13.8 million of insurance proceeds which, according to the terms of the memorandum of understanding, were contributed directly by our insurance carriers. OTHER INCOME (EXPENSE), NET. Other income (expense), net, increased to net other income of $2.5 million for 1999 from a net other expense of $4.6 million for 1998. For 1999, other income included approximately $3.7 million of net realized gains on the sale of long-term investments, offset by a downward adjustment of $0.5 million to the carrying value of certain investments and approximately $0.3 million of net foreign currency transaction losses. During 1998, other income (expense), net, decreased to a net other expense of $4.6 million from net other income of $10.5 million for 1997. Other income (expense), included $4.8 million of foreign currency transaction losses and $8.0 million of foreign currency transaction gains in 1998 and 1997, respectively. Approximately $7.5 million of the $8.0 million of foreign currency transaction gains recognized in 1997 resulted primarily from a change in our foreign currency denominated intercompany accounts payable and accounts receivable balances arising from the restatement of our 1996, 1995 and 1994 financial statements. Other components of other income (expense) for 1997 included $8.1 million of net realized gains on the sale of long-term investments offset by a downward adjustment of $4.5 million to the carrying value of certain investments. INCOME TAXES In 1999, income tax expense of $21.9 million resulted primarily from foreign withholding taxes and taxable earnings in certain foreign jurisdictions. We have provided a valuation allowance for the net deferred tax assets that are dependent on taxable income beyond 2000 in foreign jurisdictions, and domestic taxable income. The expected tax expense of $3.8 million, computed by applying the federal statutory rate of 35% to the income before income taxes, was offset primarily by a $12.7 million decrease in the valuation allowance and a $19.4 million net foreign tax expense. In 1998, income tax expense resulted primarily from foreign withholding taxes and taxable earnings in certain foreign jurisdictions. We have provided a valuation allowance for the net deferred tax assets that are dependent on future taxable income. The expected tax expense of $19.1 million, computed by applying the federal statutory rate of 35% to the income before income taxes, was offset primarily by a $11.2 million decrease in the valuation allowance and a $4.4 million net foreign tax benefit. In 1997, income tax expense resulted primarily from foreign withholding taxes and taxable earnings in certain foreign jurisdictions. The expected tax benefit computed by applying the federal statutory rate to the loss before income taxes was substantially offset by a corresponding increase in the valuation allowance for net deferred tax assets. We have provided a valuation allowance for the net deferred tax assets in excess of amounts recoverable through carryback of net operating losses. Accordingly, the net deferred tax asset at December 31, 1997 of $34 million was provided for anticipated IRS tax refunds, which were received during 1998. QUARTERLY OPERATING RESULTS In the first quarter of 1997, we experienced a substantial shortfall in license revenues compared to forecasts, resulting in a substantial loss for the quarter. The shortfall in revenue was due to slow growth in demand for RDBMS products as well as our inability to close a number of sales transactions that management anticipated would close by the end of the quarter, especially in Europe. As a result of the shortfall in license revenues for this quarter, we, in the second and third quarters of 1997, initiated two internal restructurings of our operations intended to reduce operating expenses and improve our financial condition. These restructurings included reductions in headcount and leased facilities and the downsizing, elimination or conversion into solutions labs of our planned Information Superstores. Costs associated with the restructurings totaled approximately $108.2 million and had a material adverse impact on our results of operations for 1997 "See Restructuring Charges." Additionally, during 1997, we had a major restatement for all of the periods included in the three years ended December 31, 1996, as well as for the quarter ended March 31, 1997. At that time, our administrative processes were weak which contributed to the existence of significant weaknesses in our internal controls. Following these events, customers were concerned about Informix's viability and, accordingly, our management was concerned about whether customers would honor their financial obligations to us. The restructuring activities and the restatement of financial results impacted the environment in which we operated, and, accordingly, impacted the estimates and assumptions used by management in the preparation of our financial statements. As of December 31, 1997, we made certain estimates including allowances for uncollectable accounts receivable based on the probability of collections, estimates for product returns associated with ongoing customer uncertainty about our financial condition and contingencies associated with continuing issues related to 1997. These estimates, in the ordinary course of business, change as a result of management actions and environmental changes. During the last quarter of 1997 and the first two quarters of 1998, we took a number of actions to help restore customer confidence regarding the ongoing viability of Informix. These actions included: (i) generating a total of $63.3 million proceeds from an offering of Series B Preferred Stock and the exercise of warrants related to outstanding Series A-1 Preferred Stock and increasing the balance of cash, cash equivalents and short term investments; (ii) visits to key customers by senior management to reinforce our customers' confidence in us, (iii) signing significant new contracts with existing customers and winning new customers in a variety of application areas including data warehousing and Web/content management; (iv) demonstrating continued ability to generate a meaningful revenue stream; (v) decreasing employee turnover and increasing the ability to attract new employees and senior management talent; and (vi) introducing significant new products and increasing research and development funding. All of these factors contributed to customers honoring their financial obligations to Informix, while reducing the probability of product return and collections problems. Additionally, during the first two quarters of 1998, the following actions were taken and improvements made in the quality of our accounts receivable balances. The actions taken included: (i) centralizing European credit and collections for most countries and outsourcing this function to a professional credit and collections firm; (ii) improving our Europe region's accounts receivable aging from a balance of $8.5 million outstanding greater than 90 days as of December 31, 1997 to a balance of $3.9 million outstanding greater than 90 days as of June 30, 1998; and (iii) refining our methodology for estimating general uncollectible accounts receivable over and above specific accounts receivable reserves. The improvement in both our financial condition and the credit and collections processes which resulted from our actions led to a decrease of risk such that reserves for product return and bad debts were reduced by $1.7 million and $5.0 million in the first and second quarters of 1998, respectively. We believe the actions taken by management improved our operating environment and helped restore customer confidence in our company and its products. As of December 31, 1997, our accrued liabilities included accruals for certain claims against us. During the first quarter of 1998, our lawyers determined that there was no merit to a specific claim for which we had recorded a liability of $1.9 million. Accordingly, we reversed this $1.9 million accrual during the first quarter of 1998. In addition, we reduced an accrued liability related to another specific claim by $2.0 million and $0.8 million during the second and third quarters of 1998, respectively, based on a legal opinion and a settlement offer. We recorded restructuring charges of $59.6 million and $49.7 million in the second and third quarters of 1997, respectively. The total restructuring expense decreased by $1.2 million during the fourth quarter of 1997 primarily due to adjusting the original estimate of the loss incurred on the sale of land to the actual loss. We recorded restructuring-related adjustments to decrease restructuring expense by $3.3 million, $1.4 million, $2.6 million and $3.0 million in the first, second, third, and fourth quarters of 1998, respectively, and $0.6 million during the first quarter of 1999 primarily due to adjusting the estimated severance and facility charges to actual costs incurred. In the first quarter of 1997, we recorded a charge of $30.5 million to write down the carrying values of certain of our Japanese subsidiary's long-lived assets to their fair values. During the same quarter, we also recorded a charge of $14.7 million to write down the carrying value of capitalized software development costs for certain products to their net realizable values. In connection with our acquisition of Red Brick in December 1998, we recorded a charge to operations in the fourth quarter of 1998 of $2.6 million for in-process research and development which had not yet reached technological feasibility and had no alternative future uses. In connection with our acquisition of Cloudscape in October 1999, we recorded a charge of $2.8 million to operations in the fourth quarter of 1999 for merger costs. During the second quarter of 1999, we incurred a charge of $97.0 million in connection with our entering into a memorandum of understanding regarding the settlement of the private securities and related litigation against us. LIQUIDITY AND CAPITAL RESOURCES OPERATING CASH FLOWS. We generated positive cash flows from operations totaling $18.6 million for 1999 primarily from improved operating profitability and a reduction in cash outflows for accounts payable and accrued liabilities offset by an increase in the amount of license revenue recognized from customer advances and an increase in the effect of changes in current assets and deferred maintenance revenue on operating cash flows. INVESTING CASH FLOWS. Net cash and cash equivalents used for investing activities increased by approximately $21.1 million for 1999 when compared to 1998. This increase was due primarily to a net increase of approximately $21.2 million in our investment in available-for-sale securities of excess cash generated from operating income during 1999. Other significant changes in investing activities during 1999 when compared to 1998 include a $7.0 million decrease in purchases of strategic investments, an increase in proceeds from the sale of strategic investments of $4.3 million, an increase in capital expenditures of $4.0 million and an increase in the capitalization of software development costs of $4.0 million. FINANCING CASH FLOWS. Net cash and cash equivalents provided by financing activities during 1999 consisted primarily of proceeds from the sale of our common stock and advances from customers and financial institutions offset by principal payments on capital leases and payments for structured settlements with resellers. The $45.5 million decrease in cash and cash equivalents provided by financing activities during 1999 when compared to 1998 was due primarily to net proceeds of $32.9 million received by us during 1998 from the issuance of 140,000 additional shares of our series A-1 preferred stock at $250 per share and net proceeds of approximately $10.0 million received during 1998 from the issuance of convertible preferred stock by Cloudscape, which was subsequently converted into common stock prior to the Cloudscape Merger. SUMMARY. We believe that our current cash, cash equivalents and short-term investments balances and cash flows from operations will be sufficient to meet our working capital requirements for at least the next 12 months. DISCLOSURES ABOUT MARKET RATE RISK MARKET RATE RISK. The following discussion about our market rate risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates, foreign currency exchange rates and equity security price risk. We do not use derivative financial instruments for speculative or trading purposes. INTEREST RATE RISK. Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We maintain a short-term investment portfolio consisting mainly of debt securities with an average maturity of less than two years. We do not use derivative financial instruments in our investment portfolio and we place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We are averse to principal loss and ensure the safety and preservation of our invested funds by limiting default, market and reinvestment risk. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10 percent from levels at December 31, 1999 and 1998, the fair value of the portfolio would decline by an immaterial amount. We have the ability to hold our fixed income investments until maturity and believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows would not be material. EQUITY SECURITY PRICE RISK. We hold a small portfolio of marketable-equity traded securities that are subject to market price volatility. Equity price fluctuations of plus or minus 10% would have had a $1.3 million and $1.0 million impact on the value of these securities in 1999 and 1998, respectively. FOREIGN CURRENCY EXCHANGE RATE RISK. We enter into foreign currency forward exchange contracts to reduce our exposure to foreign currency risk due to fluctuations in exchange rates underlying the value of intercompany accounts receivable and payable denominated in foreign currencies (primarily European and Asian currencies) until such receivables are collected and payables are disbursed. A foreign currency forward exchange contract obligates us to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates or to make an equivalent U.S. dollar payment equal to the value of such exchange. These foreign exchange forward contracts are denominated in the same currency in which the underlying foreign receivables or payables are denominated and bear a contract value and maturity date which approximate the value and expected settlement date of the underlying transactions. For contracts that are designated and effective as hedges, discounts or premiums (the difference between the spot exchange rate and the forward exchange rate at inception of the contract) are accreted or amortized to other expenses over the contract lives using the straight-line method while unrealized gains and losses on open contracts at the end of each accounting period resulting from changes in the spot exchange rate are recognized in earnings in the same period as gains and losses on the underlying foreign currency denominated receivables or payables are recognized, and generally offset. We operate in certain countries in Latin America, Eastern Europe, and Asia/Pacific where there are limited forward foreign currency exchange markets and thus we have unhedged exposures in these currencies. Most of our international revenue and expenses are denominated in local currencies. Due to the substantial volatility of currency exchange rates, among other factors, we cannot predict the effect of exchange rate fluctuations on our future operating results. Although we take into account changes in exchange rates over time in our pricing strategy, we do so only on an annual basis, resulting in substantial pricing exposure as a result of foreign exchange volatility during the period between annual pricing reviews. In addition, the sales cycle for our products is relatively long, depending on a number of factors including the level of competition and the size of the transaction. We periodically assess market conditions and occasionally reduce this exposure by entering into foreign currency forward exchange contracts to hedge up to 80% of the forecasted net income of our foreign subsidiaries of up to one year in the future. These forward foreign currency exchange contracts do not qualify as hedges for financial reporting purposes and, therefore, are marked to market. Notwithstanding our efforts to manage foreign exchange risk, there can be no assurances that our hedging activities will adequately protect us against the risks associated with foreign currency fluctuations. The table below provides information about our foreign currency forward exchange contracts. The information is provided in U.S. dollar equivalents and presents the notional amount (contract amount), the weighted average contractual foreign currency exchange rates and fair value. Fair value represents the difference in value of the contracts at the spot rate at December 31, 1999 and the forward rate, plus the unamortized premium or discount. All contracts mature within twelve months. FORWARD CONTRACTS - ------------------------------ * Not meaningful YEAR 2000 COMPLIANCE GENERAL Many computer systems and software products were originally coded to accept only two-digit entries in the date code field. These date code fields need to accept four-digit entries to distinguish 21st century dates from 20th century dates. As a result, computer systems and/or software used by many companies needed to be upgraded to comply with Year 2000 requirements prior to January 1, 2000. Prior to January 1, 2000, significant uncertainties existed in the software industry concerning the potential effects associated with such compliance. Now that January 1, 2000 has come and gone with very few significant reported Year 2000-related incidents, the level of uncertainty surrounding such incidents has diminished. Our original Year 2000 compliance efforts included: - Reviewing and updating the Year 2000 compliance status of the software and systems used in our internal business processes - Obtaining appropriate assurances of compliance from the manufacturers of these products and agreements, as necessary, to modify or replace all non-compliant products This program was substantially completed by December 31, 1999. In addition, we converted certain of our software and systems to commercial products from third parties that were known to be Year 2000 compliant. This conversion required: - The dedication of substantial time from our administrative and management information personnel - The assistance of consulting personnel from third party software vendors - The training of our personnel using such systems Based on the information available to date, we believe that we were able to complete our Year 2000 compliance review and make necessary modifications prior to the end of 1999. To the extent that we will continue to rely on the products of other vendors to resolve Year 2000 issues, there can be no guarantee that we will not experience delays in implementing such products. We could incur substantial costs and disruption of our business if key systems, or a significant number of systems, were to fail as a result of Year 2000 problems or if we were to experience delays in implementing Year 2000 compliant software products. STATE OF READINESS Our Year 2000 project was divided into four major sections: - Product Readiness - Information Systems Operations & Applications Software (IS Systems) - Third-party Suppliers - Global Business Processes (includes Facilities, Legal, Manufacturing, Technical Support, Sales, Product Management and Development, Marketing and Finance) There were five general phases of our Year 2000 Project applicable to each of the four sections: - Awareness Phase. Increasing employee awareness through various forms of communication - Mission Critical Inventory Phase. Taking an inventory of mission critical items relevant to Year 2000 (including computer hardware, software, telecommunications equipment, embedded controllers within our facilities, and other non-computer related equipment), assigning priorities to identified items for assessment and possible renovation, and assessing the status of Year 2000 compliance of items which we have determined to be material to our business - Repair or Replace Phase. Repairing or replacing material items that are not Year 2000 compliant. Material items are those items that we believe have a significant negative impact on customer service, involve a risk to the safety of individuals, may cause damage to property or the environment, or may significantly affect revenue - Update Testing Phase. Testing of updates given by third party suppliers - Business Contingency Phase. Designing and implementing contingency plans for each internal organization and critical location during the Year 2000 rollover period As of December 31, 1999 we had substantially completed all of the phases for each of the four sections of the project. PRODUCT READINESS. All of our currently supported products are Year 2000 compliant, meaning that the use or occurrence of dates on or after January 1, 2000 will not adversely affect the performance or functionality of our products with respect to four-digit year dates or the ability of our products to correctly create, store, process, and output information related to such date data, including Leap Year calculations. However, Year 2000 compliance of our products may be affected by other parts of the system in which they are being used, as discussed below. Our products often depend on data from other parts of the system in which they are being used. Year 2000 compliance is not effective unless all of the hardware, operating system, other software, and firmware being used along with our products correctly interpret and/or translate date data into a four-digit year date and properly exchange date data with our products. We have tested our currently supported products under different Year 2000 test scenarios. We will continue to improve our testing efforts with each new release of our software products. From time to time, our Year 2000 Program Office has updated the history table of each product family when a Year 2000 or DBCENTURY-related product deficiency was found and fixed in a certain interim or maintenance release. We have made Year 2000 testing scenarios part of our standard test suite. Our Year 2000 Program Office finished incorporating the Red Brick product compliance information and plans into our Year 2000 Program Plan during the first quarter of 1999. Informix did not experience any Year 2000 related issues with Cloudscape products or facilities. IS SYSTEMS. - IS Operations Systems. Our IS operations systems consist of all computer hardware, systems software and telecommunications. Our current hardware inventory includes PC Desktops, PC Laptops, UNIX servers, UNIX workstations, and NT workgroup servers. Our current software inventory includes Windows 95 operating system and MS Office products, Product Development environment tools for UNIX, and various management systems. Our telecommunications equipment includes both voice and data services, including PBX systems, voicemail, ACD, video conferencing, local area networks, wide area networks, and remote access equipment. We completed remediation of all mission critical IS Operations components by the end of December 1999. Non-critical systems were also made Year 2000 compliant by November 1999. Testing was ongoing as hardware or system software was renovated or replaced, although, the level of testing was significantly limited by our technical ability to emulate our complex systems and networks and cost/ benefit considerations. We began contingency planning in December 1998, completed draft contingency plans by September 1999 and continued to refine and rehearse through the end of December 1999. - IS Applications Systems. Our IS applications systems consist of all enterprise-wide applications either supplied by third-party vendors or internally-developed. We completed our remediation efforts of all mission critical IS applications by the end of March 1999. We made all important and non-important IS applications systems Year 2000 compliant by the end of December 1999. None of our other information technology projects have been delayed due to the implementation of the Year 2000 project. THIRD-PARTY SUPPLIERS. We identified and prioritized critical suppliers and communicated with them about our plans and progress in addressing the Year 2000 problem and how their individual compliance could impact our success. We completed detailed evaluations of most critical suppliers. These evaluations were followed by the development and implementation of contingency plans where appropriate, which began, in certain departments, in the fourth quarter of 1998 and drafted by the end of September 1999. Follow-up reviews with each of our critical suppliers were completed by the end of December 1999 in order to ascertain alternative communication channels and emergency procedures in the event of widespread outages. GLOBAL BUSINESS PROCESSES. We have completed the assessment of the hardware, software and associated embedded computer chips that are used in the operation of all of our critical facilities. All repair and testing of embedded systems within our critical facilities was completed by the end of December 1999. We have also completed the preparation in our key business areas, including Finance, Product Development and Legal. Customer Service completed their Support Plans for the Year 2000 Rollover Weekend, and documented their offerings on the Informix Year 2000 Web Site. We began contingency planning for these organizations and their respective critical business processes in the first quarter of 1999, and were completed with such planning, testing and training by December 1999. COSTS The total cost associated with required modifications to become Year 2000 compliant is not expected to be material to our financial position. The estimated total cost of the Year 2000 project is approximately $3.0 million. The total amount expended on the project through December 31, 1999 was approximately $2.5 million. The estimated future cost of completing the Year 2000 project is estimated to be approximately $0.5 million. Our Year 2000 Project is expected to significantly reduce our level of uncertainty about the Year 2000 problem and, in particular, about the Year 2000 compliance and readiness of our material third-party suppliers. We believe that the possibility of significant interruptions of normal operations has been reduced with the implementation of new business systems and the completion of the project as scheduled. However, although the rollover from 1999 to 2000 has passed, many software industry experts believe that there is still reason to expect the occurrence of the Year 2000-related incidents of some kind or the other. To date, we have not experienced any disruption of our business or key systems as a result of year 2000 problems. Similarly, we have not been informed of any year 2000 problems encountered by our customers relating to their use of our software products. It is possible, however, that Informix or its customers may encounter year 2000 problems at a later time. If such problems were to arise, we could incur substantial costs or the interruption in or a failure of certain normal business activities or operations, which could hurt our business. If our customers experience year 2000 related problems as a result of their use of our software products, then those customers could assert claims for damages which, if successful, could result in significant costs, damage our operations or adversely affect our ability to sell our products. EUROPEAN MONETARY CONVERSION On January 1, 1999, eleven of the fifteen member countries of the European Economic Community entered into a three-year transition phase during which a common currency, the "Euro," was introduced. Between January 1, 1999 and January 1, 2002, governments, companies and individuals may conduct business in these countries in both the Euro and existing national currencies. On January 1, 2002, the Euro will become the sole currency in these countries. During the transition phase, we will continue to evaluate the impact of conversion to the Euro on our business. In particular, we are reviewing: - Whether our internal software systems can process transactions denominated either in current national currencies or in the Euro, including converting currencies using computation methods specified by the European Economic Community - The cost to us if we must modify or replace any of our internal software systems - Whether we will have to change the terms of any financial instruments in connection with our hedging activities Based on current information and our initial evaluation, we do not expect the cost of any necessary corrective action to have a material adverse effect on our business. We have reviewed the effect of the conversion to the Euro on the prices of our products in the affected countries. As a result, we have made some adjustments to our prices to attempt to eliminate differentials that were identified. However, we will continue to evaluate the impact of these and other possible effects of the conversion to the Euro on our business. We cannot guarantee that the costs associated with conversion to the Euro or price adjustments will not in the future have a material adverse effect on our business. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging Activities," which establishes standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS 133 is effective for fiscal years beginning after June 15, 2000. Earlier application of SFAS 133 is encouraged but should not be applied retroactively to financial statements of prior periods. The adoption of this statement is not expected to have a material impact on our operating results, financial position or cash flows. In December 1998, the AICPA issued Statement of Position 98-9 ("SOP 98-9"), "Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions." This amendment clarified the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement. SOP 98-9 is effective for all transactions entered into by us beginning in fiscal year 2000. The adoption of this statement is not expected to have a material impact on our operating results, financial position or cash flows. RECENT DEVELOPMENTS On February 3, 2000, International Business Machines Corporation ("IBM") filed an action against us in the United States District Court for the District of Delaware alleging infringement of six United States patents owned by IBM. The Informix products that IBM alleges infringe its patents are Informix Online Dynamic Server versions 5, 6 and 7, Informix SE version 6, Informix NewEra version 1, Informix NET, Informix STAR, Illustra Visual Information Retrieval, and Illustra Visual Intelligence Viewer. In its complaint, IBM seeks a permanent injunction against further alleged infringement, unspecified compensatory damages, unspecified treble damages, and interest, costs and attorneys' fees. We strongly believe that the allegations in the complaint are without merit and intend to defend the action vigorously and to assert such counterclaims against IBM as may be appropriate. FACTORS THAT MAY AFFECT FUTURE RESULTS CURRENT AND POTENTIAL STOCKHOLDERS SHOULD CONSIDER CAREFULLY EACH OF THE FOLLOWING FACTORS IN MAKING THEIR INVESTMENT DECISIONS. THESE FACTORS SHOULD BE CONSIDERED TOGETHER WITH THE OTHER INFORMATION INCLUDED OR INCORPORATED BY REFERENCE IN THIS ANNUAL REPORT ON FORM 10-K. RISK FACTORS OUR QUARTERLY OPERATING RESULTS ARE SUBJECT TO FLUCTUATIONS CAUSED BY MANY FACTORS, WHICH COULD RESULT IN OUR FAILING TO ACHIEVE REVENUE OR PROFITABILITY EXPECTATIONS. Our quarterly and annual results of operations have varied significantly in the past and are likely to continue to vary in the future due to a number of factors described below and elsewhere in this "Managements' Discussion and Analysis of Financial Conditions and Results of Operations" section, many of which are beyond our control. Any one or more of the factors listed below or other factors could cause us to fail to achieve our revenue or profitability expectations. In particular, the failure to meet market expectations could cause a sharp drop in our stock price. These factors include: - Changes in demand for our products and services, including changes in industry growth rates, - The size, timing and contractual terms of large orders for our software products, - Adjustments of delivery schedules to accommodate customer or regulatory requirements, - The budgeting cycles of our customers and potential customers, - Any downturn in our customers' businesses, in the domestic economy or in international economies where our customers do substantial business, - Changes in our pricing policies resulting from competitive pressures, such as aggressive price discounting by our competitors or other factors, - Our ability to develop and introduce on a timely basis new or enhanced versions of our products and solutions, - Changes in the mix of revenues attributable to domestic and international sales, and - Seasonal buying patterns which tend to peak in the fourth quarter. INTENSE COMPETITION COULD ADVERSELY AFFECT OUR ABILITY TO SELL OUR PRODUCTS OR GROW OUR BUSINESS. We may not be able to compete successfully against current and/or future competitors and such inability could impair our ability to sell our products. The market for our products is highly competitive, diverse and is subject to rapid change. Moreover, we expect that the technology for database products generally, and, in particular, the technology underlying database solutions and products for the Internet and datawarehousing products, will continue to change rapidly. For example, as customers embrace the Internet, we need to develop and enhance our software solutions to support Internet applications. It is possible that our products will be rendered obsolete by technological advances. We currently face competition from a number of sources, including several large vendors that develop and market databases, applications, development tools, decision support products, consulting services and/or complete database-driven solutions for the Internet. Our principal competitors include Computer Associates, IBM, Microsoft, NCR/Teradata, Oracle and Sybase. Additionally, as we expand our business in the markets of datawarehousing and Web/e-commerce, we expect to compete with a different group of companies, including small, highly-focused companies offering single products or services that we include as part of an overall solution. A number of our competitors have significantly greater financial, technical, marketing and other resources than we have. As a result, these competitors may be able to respond more quickly to new or emerging technologies, evolving markets and changes in customer requirements or to devote greater resources to the development, promotion and sale of their products than we can. COMPETITION MAY AFFECT THE PRICING OF OUR PRODUCTS OR SERVICES, AND CHANGES IN PRODUCT MIX MAY OCCUR, EITHER OF WHICH MAY REDUCE OUR MARGINS. Existing and future competition or changes in our product or service pricing structure or product or service offerings could result in an immediate reduction in the prices of our products or services. Also, a significant change in the mix of software products and services that we sell, including the mix between higher margin software and maintenance products and lower margin consulting and training, could materially adversely affect our operating results for future quarters. Additionally, if significant price reductions in our products or services were to occur and not be offset by increases in sales volume, our operating margins would be adversely affected. For example, several of our competitors have announced the development of enhanced versions of their principal database products that are intended to improve the performance or expand the capabilities of their existing products. New or enhanced products by existing competitors or new competitors could result in greater price pressure on both our products. In addition, the following factors could affect the pricing of relational database management solutions products and related products: - The industry movement to new operating systems, like Windows NT, Linux and other low-cost operating systems available through other appliances, - Access to relational database management solutions products through low-end desktop computers, - Access to database-driven solutions, including object-relational database management systems products, through the Internet, - The bundling of software products for promotional purposes or as a long-term pricing strategy by competitors, and - Our own practice of bundling our software products for enterprise licenses or for promotional purposes with our partners. In particular, the pricing strategies of competitors in the software database industry have historically been characterized by aggressive price discounting to encourage volume purchasing by customers. We may not be able to compete effectively against competitors who continue to aggressively discount the prices of their products. OUR PROPOSED ACQUISITION OF ARDENT MAY NOT BE APPROVED BY BOTH COMPANIES' STOCKHOLDERS OR, IF THE ACQUISITION IS APPROVED, DIFFICULTIES INTEGRATING ARDENT MAY PREVENT US FROM REALIZING THE BENEFITS OF THE MERGER. The completion of our proposed acquisition of Ardent is subject to approval by both companies' stockholders. If the stockholders of either company do not approve the proposed acquisition, it would disrupt our operational plans and could harm our future operating results. Even if we complete the proposed acquisition, we could encounter difficulties integrating Ardent's operations and personnel. Integration difficulties may disrupt the combined company's business and could prevent the achievement of the anticipated benefits of the merger. The difficulties, costs and delays involved in integrating the companies, which may be substantial, may include: - Distracting management and other key personnel, particularly sales and marketing personnel and senior engineers involved in product development and product definition, from the business of the combined company, - Inability to effectively market and distribute Ardent's products or develop Ardent technology so as to produce new or enhanced products that will be accepted in the marketplace, - Perceived and potential adverse changes in business focus or product offerings, - Failure to generate significant revenue from the sale of newly developed Ardent products, - Failure to integrate complex software technology, product lines and software development plans, - Potential incompatibility of business cultures, - Costs and delays in implementing common systems and procedures, particularly integrating different information systems, - Inability to retain and integrate key management, technical, sales and customer support personnel, - Inability to maintain Ardent's existing relationships with its partners, - Inability to maintain Ardent's existing customers base or replace the Ardent products used by those customers with Informix products, and - Disruption in our sales force may result in a loss of current customers or the inability to close sales with potential customers. In addition, if we complete the acquisition, we will incur substantial transactional and integration expenses of approximately $30 to $40 million associated with combining the operations of the two companies and the fees of financial advisors, attorneys and accountants. These expenses will prevent us from spending those amounts on other possibly more productive uses. Although we believe that the costs will not exceed this estimate, the estimate may be incorrect or unanticipated contingencies may occur that substantially increase the costs of combining Ardent's operations with our own. IF WE DO NOT RESPOND ADEQUATELY TO OUR INDUSTRY'S EVOLVING TECHNOLOGY STANDARDS OR DO NOT CONTINUE TO MEET THE SOPHISTICATED NEEDS OF OUR CUSTOMERS, SALES OF OUR PRODUCTS MAY DECLINE. Our future success will depend on our ability to address the increasingly sophisticated needs of our customers by supporting existing and emerging hardware, software, database and networking platforms. We will have to develop and introduce commercially viable enhancements to our existing products and solutions on a timely basis to keep pace with technological developments, evolving industry standards and changing customer requirements. If we do not enhance our products to meet these evolving needs, we will not sell as many products. Our position in existing, emerging or potential markets could be eroded rapidly by product advances. Our product development efforts will continue to require substantial financial and operational investment. We may not have sufficient resources to make the necessary investment or to attract and retain qualified software development engineers. In addition, we may not be able to internally develop new products or solutions quickly enough to respond to market forces. As a result, we may have to acquire technology or access to products or solutions through mergers and acquisitions, investments and partnering arrangements. We may not have sufficient cash, access to funding, or available equity to engage in such transactions. Moreover, we may not be able to forge partnering arrangements or strategic alliances on satisfactory terms, or at all, with the companies of our choice. WE HAVE EXPERIENCED, AND ANTICIPATE THAT WE WILL CONTINUE TO EXPERIENCE, TURNOVER AT OUR SENIOR MANAGEMENT LEVELS, WHICH COULD HARM OUR BUSINESS AND OPERATIONS. In July 1999, we announced the appointment of Jean-Yves F. Dexmier as a member of the board of directors and president and chief executive officer, while Robert J. Finocchio resigned his position as president and chief executive officer. Mr. Finocchio continues to be actively involved in our management in his capacity as the chairman of the board. During the past nine months, several of our senior executive officers have resigned, including our (i) vice president and treasurer, (ii) vice president, human resources and (iii) vice president, web and e-commerce division, all three of whom have since been replaced, as well as the vice president, corporate controller, who resigned when we replaced the corporate controller position with two controller positions, both of which report directly to our chief financial officer. Also, our vice president, corporate marketing, resigned effective December 31, 1999 and our executive vice president and chief financial officer, Howard A. Bain III, resigned effective March 20, 2000. It is possible that this high turnover at our senior management levels will continue and that other senior executive officers could also resign. Of our senior executive officers and key employees, only Robert J. Finocchio, chairman of the board, and the former president and chief executive officer, is bound by an employment agreement, the terms of which are nonetheless at-will. In addition, we do not maintain key man life insurance on our employees and have no plans to do so. The loss of the services of one or more of our current senior executive officers or key employees could harm our business and could affect our ability to successfully implement our business objectives. Our future success will depend to a significant extent on the continued service of our current senior executives. If we were to lose the services of one or more of our current senior executives or key employees, this could adversely affect our ability to grow our business and achieve our business objectives, particularly if one or more of those executives or key employees decided to join a competitor or otherwise compete directly or indirectly with Informix. OUR EXECUTIVE TEAM MAY NOT BE ABLE TO SUCCESSFULLY WORK TOGETHER TO MEET ITS BUSINESS OBJECTIVES. Since the beginning of 1998, we have expanded our ability to deliver products and solutions for the Internet, including e-commerce solutions, and business intelligence solutions driven by our datawarehouse technology. Our management team has not worked together for a significant length of time and may not be able to successfully implement this strategy. If the management team is unable to accomplish our business objectives, it could materially adversely affect our ability to grow our business. As noted above, Mr. Dexmier was appointed as the president and chief executive officer in July 1999. In addition, two new executive officers, the vice president and treasurer and the vice president, i.Intelligence Business Group, joined Informix in July 1999 and the vice president, human resources, joined Informix in October 1999. Almost all of Informix's other executive officers have joined the company since the beginning of fiscal 1998. WE MAY NOT BE ABLE TO RETAIN OUR KEY PERSONNEL OR, IF WE COMPLETE THE ACQUISITION OF ARDENT, TO INTEGRATE AND RETAIN ARDENT'S KEY PERSONNEL, WHICH MAY PREVENT US FROM MEETING OUR BUSINESS OBJECTIVES. We may not be able to retain our key personnel, including certain sales, consulting, technical and marketing personnel, or attract other qualified personnel in the future. In addition, if we complete the acquisition of Ardent we may not be able to retain Ardent's key personnel, including its current management. Our success depends upon the continued service of key qualified personnel. The competition to attract, retain and motivate these personnel is intense. We have at times experienced, and continue to experience, difficulty recruiting qualified software, customer support and other personnel. The loss of such key personnel could result in our inability to effectively develop, market and sell our products thereby harming our financial results. ANY CANCELLATIONS OR DELAYS IN PLANNED CUSTOMER PURCHASES OF OUR PRODUCTS OR SERVICES COULD MATERIALLY ADVERSELY AFFECT OUR NET INCOME AND COULD SUBSTANTIALLY REDUCE QUARTERLY REVENUES. Because we do not know when, or if, potential customers will place orders and finalize contracts, we cannot accurately predict revenue and operating results for future quarters. If there is a downturn in potential customers' businesses, the domestic economy in general, or in international economies where we derive substantial revenue, potential customers may defer or cancel planned purchases of our products. Because we base operating expenses on anticipated revenue levels and because a high percentage of our expenses are relatively fixed, delays in the recognition of revenues from even a limited number of product license transactions could cause significant variations in operating results from quarter to quarter, which could cause net income to fall significantly short of anticipated levels. IF A LARGE NUMBER OF THE ORDERS THAT ARE TYPICALLY BOOKED AT THE END OF A QUARTER ARE NOT BOOKED, OUR NET INCOME FOR THAT QUARTER COULD BE SUBSTANTIALLY REDUCED. Our software license revenue in any quarter often depends on orders booked and shipped in the last month, weeks or days of that quarter. At the end of each quarter, we typically have either minimal or no backlog of orders for the subsequent quarter. If a large number of orders or several large orders do not occur or are deferred, revenue in that quarter could be substantially reduced. SEASONAL TRENDS IN SALES OF OUR SOFTWARE PRODUCTS COULD ADVERSELY AFFECT OUR QUARTERLY OPERATING RESULTS. Our sales of software products have been affected by seasonal purchasing trends that materially affect our quarter-to-quarter operating results. We expect these seasonal trends to continue in the future. Revenue and operating results in our quarter ending December 31 are typically higher relative to other quarters because many customers make purchase decisions based on their calendar year-end budgeting requirements and because we measure our sales incentive plans for sales personnel on a calendar year basis. As a result, we have historically experienced a substantial decline in revenue in the first quarter of each fiscal year relative to the preceding quarter. THE LENGTHY SALES CYCLE FOR PRODUCTS MAKES REVENUES SUSCEPTIBLE TO FLUCTUATIONS. Any delay in the sales cycle of a large transaction or a number of smaller transactions could result in significant fluctuations in our quarterly operating results. Our sales cycles typically take many months to complete and vary depending on the product, service or solution that is being sold. The length of the sales cycle may vary depending on a number of factors over which we have little or no control, including the size of a potential transaction and the level of competition that we encounter in our selling activities. The sales cycle can be further extended for sales made through third party distributors. OUR FUTURE REVENUE AND OUR ABILITY TO MAKE INVESTMENTS IN DEVELOPING OUR PRODUCTS IS SUBSTANTIALLY DEPENDENT UPON OUR INSTALLED CUSTOMER BASE CONTINUING TO LICENSE OUR PRODUCTS AND RENEW OUR SERVICE AGREEMENTS. We depend on our installed customer base for future revenue from services and licenses of additional products. If our customers fail to renew their maintenance agreements, our revenue will be harmed. The maintenance agreements are generally renewable annually at the option of the customers and there are no minimum payment obligations or obligations to license additional software. Therefore, current customers may not necessarily generate significant maintenance revenue in future periods. In addition, customers may not necessarily purchase additional products or services. Our services revenue and maintenance revenue also depend upon the continued use of these services by our installed customer base. Any downturn in software license revenue could result in lower services revenue in future quarters. Moreover, if either license revenue or revenue from services declines, we may not have sufficient cash to finance investments or acquire technology. THE SUCCESS OF OUR INTERNATIONAL OPERATIONS IS DEPENDENT UPON MANY FACTORS WHICH COULD ADVERSELY AFFECT OUR ABILITY TO SELL OUR PRODUCTS INTERNATIONALLY AND COULD AFFECT OUR PROFITABILITY. International sales represented approximately 51% of our total revenue during the year ended December 31, 1999. The international operations are, and any expanded international operations will be, subject to a variety of risks associated with conducting business internationally that could adversely affect our ability to sell our products internationally, and therefore, our profitability, including the following: - Difficulties in staffing and managing international operations, - Problems in collecting accounts receivable, - Longer payment cycles, - Fluctuations in currency exchange rates, - Seasonal reductions in business activity during the summer months in Europe and certain other parts of the world, - Uncertainties relative to regional, political and economic circumstances, - Recessionary environments in foreign economies, and - Increases in tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries. In particular, instability in the Asian/Pacific and Latin American economies and financial markets, which together accounted for approximately 19% of our total net revenues during the year ended December 31, 1999, could adversely affect our ability to sell our products internationally. FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN CURRENCY TRANSACTION LOSSES. Despite efforts to manage foreign exchange risk, our hedging activities may not adequately protect us against the risks associated with foreign currency fluctuations. As a consequence, we may incur losses in connection with fluctuations in foreign currency exchange rates. Most of our international revenue and expenses are denominated in local currencies. Due to the substantial volatility of currency exchange rates, among other factors, it is not possible to predict the effect of exchange rate fluctuations on our future operating results. Although we take into account changes in exchange rates over time in our pricing strategy, we do so only on an annual basis, resulting in substantial pricing exposure as a result of foreign exchange volatility during the period between annual pricing reviews. In addition, as noted previously, the sales cycles for our products is relatively long. Foreign currency fluctuations could, therefore, result in substantial changes in the financial impact of a specific transaction between the time of initial customer contact and revenue recognition. In addition to the hedging program, we have implemented a foreign exchange hedging program consisting principally of the purchase of forward foreign exchange contracts in the primary European and Asian currencies. This program is intended to hedge the value of intercompany accounts receivable or intercompany accounts payable denominated in foreign currencies against fluctuations in exchange rates until such receivables are collected or payables are disbursed. Additionally, uncertainties related to the Euro conversion could adversely affect our hedging activities. IF THE INTERNET DOES NOT CONTINUE TO DEVELOP AS WE ANTICIPATE, OR IF OUR PRODUCT OFFERINGS ARE NOT ACCEPTED IN THIS MARKET, WE MAY NOT BE ABLE TO GROW OUR BUSINESS. The Internet is a rapidly evolving market. We are unable to predict whether and to what extent Internet computing and electronic commerce will be embraced by consumers and traditional businesses. Our successful introduction of database-driven products and solutions for the Internet market will depend in large measure on: - The commitment by hardware and software vendors to manufacture, promote and distribute Internet access appliances, - The lower cost of ownership of Internet computing relative to client/server architecture, and - The ease of use and administration relative to client/server architecture. In addition, if a sufficient number of vendors do not undertake a commitment to the market, the market may not accept Internet computing or Internet computing may not generate significant revenues for our business. Also, standards for network protocols, as well as other industry-adopted and de facto standards for the Internet, are evolving rapidly. There can be no assurance that standards we have chosen will position our products to compete effectively for business opportunities as they arise on the Internet. The widespread acceptance and adoption of the Internet by traditional businesses for conducting business and exchanging information is likely only if the Internet provides these businesses with greater efficiencies and improvements. The failure of the Internet to continue to develop as a commercial or business medium could materially adversely affect our business. Even if the Internet and electronic commerce are widely accepted and adopted by consumers and businesses, our database products and database-driven solutions for the Internet may not succeed. We recently announced our intention to focus a substantial part of our product development and sales efforts on developing and selling technology and services for the Internet market. This market is new to our product development, marketing and sales organizations. We may not be able to market and sell products and solutions in this market successfully. In addition, our database products and database-driven solutions for the Internet may not compete effectively with our competitors' products and solutions. Further, we may not generate significant revenue and/or margin in this market. Any of these events could materially, adversely affect our business, operating results and financial condition. IF THE DATA WAREHOUSE MARKET DOES NOT CONTINUE TO GROW, OR IF OUR PRODUCT OFFERINGS IN THIS MARKET ARE NOT ACCEPTED, WE MAY NOT BE ABLE TO SELL OUR PRODUCTS OR GROW OUR BUSINESS. The data warehouse market may not continue to grow, or may not grow rapidly, and our customers may not expand their use of data warehouse products. In addition, we may not be able to market and sell our products and solutions in this market or otherwise compete effectively and generate significant revenue. Although demand for data warehouse software has grown in recent years, the market is still emerging. Our future financial performance in this area will depend to a large extent on: - Continued growth in the number of organizations adopting data warehouses, - Our success in developing partnering arrangements with developers of software tools and applications for the data warehouse market, and - Existing customers expanding their use of data warehouses. RECENT ORGANIZATIONAL CHANGES COULD DISRUPT OUR BUSINESS OPERATIONS AND COULD ADVERSELY AFFECT THE SALES OF OUR PRODUCTS. On October 1, 1999, we reorganized our operating business divisions into four new business groups: the TransAct Business Group, which is responsible for delivering on-line transaction processing products; the i.Foundation Business Group, which is responsible for delivering products that provide the technological foundation for Internet-based electronic commerce solutions; the i.Informix Business Group, which is responsible for delivering Internet-based solutions for electronic commerce; and the i.Intelligence Business Group, which is responsible for delivering Internet-based data warehouse products and solutions. We may not achieve the anticipated benefits of this reorganization. In addition, the reorganization could disrupt our current business operations, including our product development and sales efforts. Further, any such disruption or other operational difficulty encountered while implementing the organization could distract our management team and cause uncertainty and confusion among our customers. IF WE FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS MAY BE ABLE TO USE OUR TECHNOLOGY OR TRADEMARKS AND THIS WOULD WEAKEN OUR COMPETITIVE POSITION, REDUCE OUR REVENUE AND INCREASE COSTS. Our success will continue to be heavily dependent upon proprietary technology. We rely primarily on a combination of patent, copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. These means of protecting proprietary rights may not be adequate, and the inability to protect intellectual property rights may adversely affect our business and/or financial condition. We currently hold eight United States patents and several pending applications. There can be no assurance that any other patents covering our inventions will be issued or that any patent, if issued, will provide sufficiently broad protection or will prove enforceable in actions against alleged infringers. Our ability to sell our products and prevent competitors from misappropriating our proprietary technology and trade names is dependent upon protecting our intellectual property. Our products are generally licensed to end-users on a "right-to-use" basis under a license that restricts the use of the products for the customer's internal business purposes. We also rely on "shrink-wrap" and "click-wrap" licenses, which include a notice informing the end-user that by opening the product packaging, or in the case of a click-on license by clicking on an acceptance icon and downloading the product, the end-user agrees to be bound by the license agreement. Despite such precautions, it may be possible for unauthorized third parties to copy aspects of our current or future products or to obtain and use information that is regarded as proprietary. In addition, we have licensed the source code of our products to certain customers under certain circumstances and for restricted uses. In addition, we have also entered into source code escrow agreements with a number of our customers that generally require release of source code to the customer in the event the company enters bankruptcy or liquidation proceedings or otherwise ceases to conduct business. We may also be unable to protect our technology because: - Competitors may independently develop similar or superior technology, - Policing unauthorized use of software is difficult, - The laws of some foreign countries do not protect proprietary rights in software to the same extent as do the laws of the United States, - "Shrink-wrap" and/or "click-wrap" licenses may be wholly or partially unenforceable under the laws of certain jurisdictions, and - Litigation to enforce intellectual property rights, to protect trade secrets, or to determine the validity and scope of the proprietary rights of others could result in substantial costs and diversion of resources. IN THE FUTURE, THIRD PARTIES COULD, FOR COMPETITIVE OR OTHER REASONS, ASSERT THAT OUR PRODUCTS INFRINGE THEIR INTELLECTUAL PROPERTY RIGHTS. As discussed above under "Recent Developments," IBM recently filed a lawsuit against us claiming that some of our products infringe certain of IBM's patents ("IBM claim"). Other third parties may claim that our current or future products infringe their proprietary rights. These claims, with or without merit, could harm our business by increasing costs and by adversely affecting our ability to sell our products. Any claim of this type, including the IBM claim, could affect our relationships with our existing customers and prevent future customers from licensing our products. Any such claim, including the IBM claim, with or without merit, could be time consuming to defend, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Royalty or license agreements may not be available on acceptable terms or at all. It is expected that software product developers will increasingly be subject to infringement claims as the number of products and competitors in the software industry segment grows and the functionality of products in different industry segments overlaps. ERRORS IN OUR PRODUCTS OR THE FAILURE OF PRODUCTS TO CONFORM TO CUSTOMER SPECIFICATIONS OR EXPECTATIONS COULD RESULT IN OUR CUSTOMERS DEMANDING REFUNDS FROM US, ASSERTING CLAIMS FOR DAMAGES OR LIMITING SALES OF PRODUCTS. Because our software products are complex, they often contain errors or "bugs" that can be detected at any point in a product's life cycle. While we continually test our products for errors and work with customers through our customer support services to identify and correct bugs in our software, it is expected that product errors will continue to be found in the future. Although many of these errors may prove to be immaterial, some could be significant. Detection of any significant errors may result in, among other things, loss of, or delay in, market acceptance and sales of our products, diversion of development resources, injury to our reputation, or increased service and warranty costs. THE FAILURE OF OUR PRODUCTS TO CONFORM TO CUSTOMER SPECIFICATIONS OR EXPECTATIONS COULD RESULT IN DECREASED SALES OF OUR PRODUCTS. A key determinative factor in future success will continue to be the ability of our products to operate and perform well with existing and future leading, industry-standard application software products intended to be used in connection with relational and object-relational database management system products. Failure to meet in a timely manner existing or future interoperability and performance requirements of certain independent vendors could adversely affect the market for our products. Commercial acceptance of our products and services could also be adversely affected by critical or negative statements or reports by brokerage firms, industry and financial analysts and industry periodicals about Informix, its products or business, or by the advertising or marketing efforts of competitors, or by other factors that could adversely affect consumer perception. POTENTIAL YEAR 2000 PROBLEMS MAY OCCUR WHICH COULD RESULT IN SIGNIFICANT COSTS TO INFORMIX. To date, we have not experienced any disruption of our business or key systems as a result of year 2000 problems. Similarly, we have not been informed of any year 2000 problems encountered by our customers relating to their use of our software products. It is possible, however, that Informix or its customers may encounter year 2000 problems at a later time. If such problems were to arise, we could incur substantial costs or the interruption in or a failure of certain normal business activities or operations, which could hurt our business. If our customers experience year 2000 related problems as a result of their use of our software products, then those customers could assert claims for damages which, if successful, could result in significant costs, damage our operations or adversely affect our ability to sell our products. IF THE RDBMS AND ORDBMS MARKETS DO NOT GROW AS QUICKLY AS WE ANTICIPATE, WE MAY SELL FEWER PRODUCTS. If the growth rates for the relational and object-relational database management systems, or RDBMS or ORDBMS, respectively, decline for any reason, there will be less demand for our products, which would have a negative impact on our business and financial results. The future growth rate of the RDBMS market cannot be predicted. Delays in market acceptance of our ORDBMS products could result in fewer product sales. In recent years, the types and quantities of data required to be stored and managed has grown increasingly complex and includes, in addition to conventional character data, audio, video, text and three-dimensional graphics in a high-performance scalable environment. Since 1996, we have invested substantial resources in developing our ORDBMS product line. The market for ORDBMS products is new and evolving, and its growth depends upon a growing need to store and manage complex data and upon broader market acceptance of our products as a solution for this need. Organizations may not choose to make the transition from conventional RDBMS products to ORDBMS products. OUR INABILITY TO RELY ON THE STATUTORY "SAFE HARBOR" AS A RESULT OF THE SETTLEMENT OF THE SEC INVESTIGATION COULD HARM OUR BUSINESS. In July 1997, the SEC issued a formal order of private investigation of Informix and certain unidentified other entities and persons with respect to accounting matters, public disclosures and trading activity in our securities that were not described in the formal order. During the course of the investigation, we learned that the investigation concerned the events leading to the restatement of its financial statements, including fiscal years 1994, 1995 and 1996, that was publicly announced in November 1997. Effective January 11, 2000, Informix and the SEC have entered into a settlement of the investigation as to Informix. Pursuant to the settlement, we consented to the entry by the SEC of an Order Instituting Public Administrative Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease and Desist Order. Pursuant to the order, we neither admitted nor denied the findings, except as to jurisdiction, contained in the order. The order prohibits us from violating and causing any violation of the anti-fraud provisions of the federal securities laws, for example by making materially false and misleading statements concerning its financial performance. The order also prohibits us from violating or causing any violation of the provisions of the federal securities laws requiring Informix to: (1) file accurate quarterly and annual reports with the SEC; (2) maintain accurate accounting books and records; and (3) maintain adequate internal accounting controls. Pursuant to the order, we are also required to cooperate in the SEC's continuing investigation of other entities and persons. In the event that we violate the order, we could be subject to substantial monetary penalties. As a consequence of the issuance of the order, we will not, for a period of three years from the date of the issuance of the order, be able to rely on the "safe harbor" for forward-looking statements contained in the federal securities laws. The "safe harbor," among other things, limits potential legal actions against us in the event a forward-looking statement concerning our anticipated performance turns out to be inaccurate, unless it can be proved that, at the time the statement was made, we actually knew that the statement was false. If we become a defendant in any private securities litigation brought under the federal securities laws, our legal position in the litigation could be materially adversely affected by our inability to rely on the "safe harbor" provisions for forward-looking statements. FAILURE TO CONTINUE TO STRENGTHEN OUR INTERNAL ACCOUNTING CONTROLS COULD ADVERSELY AFFECT OUR BUSINESS. Although we have made significant progress in our efforts to strengthen our accounting controls and processes, we may not be able to hire and retain enough finance personnel to continue to do so. If we are unable to continue to strengthen our accounting controls and processes, that inability could adversely affect our ability to accurately forecast and report our financial results. In addition, any customer uncertainty about our internal accounting controls could have an adverse effect on our ability to sell our products. WE MAY NOT BE ABLE TO REALIZE THE POTENTIAL FINANCIAL OR STRATEGIC BENEFITS OF FUTURE BUSINESS ACQUISITIONS WHICH COULD HURT OUR ABILITY TO GROW ITS BUSINESS AND SELL ITS PRODUCTS. In the future we may acquire or invest in other businesses that offer products, services and technologies that we believe would help expand or enhance our products and services or help expand our distribution channels. If we were to make such an acquisition or investment, the following risks could impair our ability to grow our business and develop new products and ultimately could impair our ability to sell our products: - Difficulty in combining the technology, operations or work force of the acquired business, - Disruption of our on-going businesses, - Difficulty in realizing the potential financial or strategic benefits of the transaction, - Difficulty in maintaining uniform standards, controls, procedures and policies, and - Possible impairment of relationships with employees and customers as a result of any integration of new businesses and management personnel. In addition, the consideration for any future acquisition could be paid in cash, shares of our common stock, or a combination of cash and common stock. If the consideration is paid in the our common stock, existing stockholders would be further diluted. Any amortization of goodwill or other assets resulting from any acquisition could materially adversely affect our operating results and financial condition. THE RIGHTS OF OUR SERIES B PREFERRED STOCKHOLDERS MAY ADVERSELY AFFECT THE RIGHTS OF OUR COMMON STOCKHOLDERS. Holders of our series B preferred shares have certain rights that may adversely affect holders of our common stock. At December 31, 1999, 7,000 shares of our series B preferred stock remained outstanding. RIGHTS TO CONSENT TO CORPORATE TRANSACTIONS. Our agreements with the purchasers of our series B preferred stock contain covenants that could impair our ability to engage in various corporate transactions in the future, including financing transactions and certain transactions involving a change-in-control or acquisition of our assets or equity, or that could otherwise be disadvantageous to Informix and the holders of our common stock. In particular, an acquisition of our assets or equity may not be effected without the consent of the holders of the outstanding series B preferred stock or without requiring the acquiring entity to assume the series B preferred stock or cause the series B preferred stock to be redeemed. These provisions are likely to make an acquisition more difficult and expensive and could discourage potential acquirors. We made certain covenants in connection with the issuance of the series B preferred stock which could limit our ability to obtain additional financing by, for example, providing the holders of the series B preferred stock certain rights of first offer and prohibiting Informix from issuing additional preferred stock without the consent of the series B preferred stockholders. CONVERSION RIGHTS. The shares of our series B preferred stock are convertible into shares of our common stock based on the trading prices of our common stock during future periods. Any conversion of series B preferred stock into our common stock will dilute the existing common stockholders. We are also obligated to issue upon conversion of the series B preferred stock additional warrants to acquire shares of our common stock equal to 20% of the total number of shares of common stock into which the series B preferred stock converts. The exercise of these warrants will have further dilutive effect to the holders of our common stock. As of December 31, 1999, 7,000 shares of series B preferred stock remained outstanding and, assuming a $4.00 per share conversion price, were convertible into 1,750,000 shares of our common stock, and warrants to purchase an aggregate of 350,000 additional shares of our common stock would become issuable upon such conversion. If the conversion price of the series B preferred stock is determined during a period when the trading price of our common stock is low, the resulting number of shares of common stock issuable upon conversion of the series B preferred stock could result in greater dilution to the holders of our common stock. As of December 31, 1999, series B preferred stockholders had converted an aggregate of 43,000 shares of series B preferred stock into 8,694,804 shares of our common stock and warrants to purchase an aggregate of 1,938,947 shares of our common stock. PENALTY PROVISION. The terms of our series B preferred financing agreements also include certain penalty provisions that are triggered if we fail to satisfy certain obligations. For instance, we must keep a registration statement in effect for the resale of shares of our common stock issued or issuable upon conversion of the series B preferred shares and upon exercise of the warrants. WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS THAT COULD RESULT IN SIGNIFICANT COSTS. We may be subject to claims for damages related to product errors in the future. A material product liability claim could materially adversely affect our business because of the costs of defending against these types of lawsuits, diversion of key employees' time and attention from the business and potential damage to our reputation. Although we have not experienced any product liability claims to date, the sale and support of our products entail the risk of such claims. While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. Our license agreements with our customers typically contain provisions designed to limit exposure to potential product liability claims. Such limitation of liability provisions may not be effective under the laws of certain jurisdictions to the extent local laws treat certain warranty exclusions as unenforceable. PROVISIONS IN OUR CHARTER DOCUMENTS WITH RESPECT TO UNDESIGNATED PREFERRED STOCK MAY DISCOURAGE POTENTIAL ACQUISITION BIDS FOR INFORMIX. Our board of directors is authorized to issue up to 5,000,000 shares of undesignated preferred stock in one or more series. Of the 5,000,000 shares of preferred stock, 440,000 shares have been designated series A preferred, none of which is outstanding; 440,000 shares have been designated series A-1 preferred, none of which is outstanding; and 50,000 shares have been designated series B preferred, of which 7,000 shares remained outstanding as of December 31, 1999. Subject to the prior consent of the holders of the series B preferred stock, our board of directors can fix the price, rights, preferences, privileges and restrictions of such preferred stock without any further vote or action by its stockholders. However, the issuance of shares of preferred stock may delay or prevent a change in control transaction without further action by our stockholders. As a result, the market price of our common stock and the voting and other rights of the holders of our common stock may be adversely affected. The issuance of preferred stock with voting and conversion rights may adversely affect the voting power of the holders of our common stock, including the loss of voting control to others. OTHER PROVISIONS IN OUR CHARTER DOCUMENTS WITH RESPECT TO UNDESIGNATED PREFERRED STOCK MAY DISCOURAGE POTENTIAL ACQUISITION BIDS FOR INFORMIX AND PREVENT CHANGES IN OUR MANAGEMENT WHICH ITS STOCKHOLDERS MAY FAVOR. Other provisions in our charter documents could discourage potential acquisition proposals and could delay or prevent a change in control transaction that our stockholders may favor. The provisions include: - Elimination of the right of stockholders to act without holding a meeting, - Certain procedures for nominating directors and submitting proposals for consideration at stockholder meetings, and - A board of directors divided into three classes, with each class standing for election once every three years. These provisions are intended to enhance the likelihood of continuity and stability in the composition of the board of directors and in the policies formulated by the board of directors and to discourage certain types of transactions involving an actual or threatened change of control. These provisions are designed to reduce our vulnerability to an unsolicited acquisition proposal and, accordingly, could discourage potential acquisition proposals and could delay or prevent a change in control. Such provisions are also intended to discourage certain tactics that may be used in proxy fights but could, however, have the effect of discouraging others from making tender offers for shares of our common stock, and consequently, may also inhibit fluctuations in the market price of our common stock that could result from actual or rumored takeover attempts. These provisions may also have the effect of preventing changes in our management. In addition, we have adopted a rights agreement, commonly referred to as a "poison pill," that grants holders of our common stock preferential rights in the event of an unsolicited takeover attempt. These rights are denied to any stockholder involved in the takeover attempt and this has the effect of requiring cooperation with our board of directors. This may also prevent an increase in the market price of our common stock resulting from actual or rumored takeover attempts. The rights agreement could also discourage potential acquirors from making unsolicited acquisition bids. DELAWARE LAW MAY INHIBIT POTENTIAL ACQUISITION BIDS WHICH MAY ADVERSELY AFFECT THE MARKET PRICE FOR INFORMIX COMMON STOCK AND PREVENT CHANGES IN ITS MANAGEMENT THAT ITS STOCKHOLDERS MAY FAVOR. Informix is incorporated in Delaware and is subject to the antitakeover provisions of the Delaware General Corporation Law, which regulates corporate acquisitions. Delaware law prevents certain Delaware corporations, including those corporations, such as Informix, whose securities are listed for trading on the Nasdaq National Market, from engaging, under certain circumstances, in a "business combination" with any "interested stockholder" for three years following the date that the stockholder became an interested stockholder. For purposes of Delaware law, a "business combination" would include, among other things, a merger or consolidation involving Informix and an interested stockholder and the sale of more than 10% of Informix's assets. In general, Delaware law defines an "interested stockholder" as any entity or person beneficially owning 15% or more of the outstanding voting stock of a corporation and any entity or person affiliated with or controlling or controlled by such entity or person. Under Delaware law, a Delaware corporation may "opt out" of the antitakeover provisions. Informix does not intend to "opt out" of these antitakeover provisions of Delaware Law. OUR COMMON STOCK LIKELY WILL BE SUBJECT TO SUBSTANTIAL PRICE AND VOLUME FLUCTUATIONS WHICH MAY PREVENT STOCKHOLDERS FROM RESELLING THEIR SHARES AT OR ABOVE THE PRICE AT WHICH THEY PURCHASED THEIR SHARES. Fluctuations in the price and trading volume of our common stock may prevent stockholders from reselling their shares above the price at which they purchased their shares. Stock prices and trading volumes for many software companies fluctuate widely for a number of reasons, including some reasons which may be unrelated to their businesses or results of operations. This market volatility, as well as general domestic or international economic, market and political conditions, could materially adversely affect the market price of our common stock without regard to our operating performance. In addition, our operating results may be below the expectations of public market analysts and investors. If this were to occur, the market price of our common stock would likely decrease significantly. The market price of our common stock has fluctuated significantly in the past and may continue to fluctuate significantly because of: - Market uncertainty about the company's business prospects or the prospects for the RDBMS ORDBMS markets in general, - Revenues or results of operations that do not match analysts' expectations, - The introduction of new products or product enhancements by Informix or its competitors, - General business conditions in the software industry, - Changes in the mix of revenues attributable to domestic and international sales, and - Seasonal trends in technology purchases and other general economic conditions. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is set forth in the section of Management's Discussion and Analysis of Financial Condition and Results of Operations Captioned "Disclosures about Market Rate Risk." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is set forth in our Financial Statements and Notes thereto beginning at page of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. On May 20, 1998, we filed a current report on Form 8-K (the "Form 8-K") regarding our dismissal of Ernst & Young LLP as our independent accountants and the engagement of KPMG LLP as our independent accountants. The contents of that report are as follows: FORM 8-K FILED ON MAY 20, 1998 ITEM 4. CHANGES IN REGISTRANT'S CERTIFYING ACCOUNTANT On May 12, 1998, the Company's Board of Directors approved a resolution (i) to dismiss Ernst & Young LLP ("E&Y") as the Company's independent auditors, effective upon management's notification of E&Y of the dismissal; and (ii) concurrent with such notification, to engage KPMG LLP ("KPMG") as Informix's independent accountants upon such terms as may be negotiated by management. On May 13, 1998, the Company's management notified E&Y of the dismissal. On May 19, 1998, the Company engaged KPMG as the Company's independent accountants. E&Y's reports with respect to the Company's financial statements for the fiscal years ended December 31, 1996 and 1997 did not contain an adverse opinion or a disclaimer of opinion and were not qualified as to uncertainty, audit scope or accounting principles. In connection with the audits of the Company's financial statements for each of the two fiscal years ended December 31, 1996 and 1997 and in the subsequent interim period, except as described in the next paragraph, there were no disagreements with E&Y on any matter of accounting principles or practices, financial statement disclosure or auditing scope and procedures which, if not resolved to the satisfaction of E&Y would have caused E&Y to make reference to the matter in their report. E&Y advised the Company that it disagreed with the Company's recognition of revenue resulting from software license transactions with industrial manufacturers which occurred during the first quarter ended March 31, 1998. The disagreement was resolved to the satisfaction of E&Y with the result that approximately $6.2 million in revenue has been deferred and will be recognized over a period which Informix expects to be approximately two years. The Company immediately filed an amendment to its quarterly report on Form 10-Q for the quarter ended March 31, 1998 to restate its financial results for the period. The Audit Committee has discussed the accounting for these transactions with management and E&Y. The Company authorized E&Y to respond fully to the inquiries of KPMG as the successor independent accountants of the Company. Prior to accepting its engagement as the Company's successor independent accountants, KPMG had the opportunity to discuss with E&Y the subject matter of the disagreement described above and other matters relevant to Informix. KPMG did not offer any report or advice to Informix concerning such disagreement that was important to the Company's decision in reaching a resolution. RESPONSE OF ERNST & YOUNG LLP On May 29, 1998 Ernst & Young furnished us with the following response letter concerning the information contained in the Form 8-K which response letter we filed with the Commission on Form 8-K/A on June 2, 1998 (the "Form 8-K/A"). Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Gentlemen: We have read Item 4 of Form 8-K dated May 20, 1998, of Informix Corporation and believe it is not complete as to reportable events as described in Item 304(a)(1)(v) of Regulation S-K. We believe the ninth paragraph of Item 4 included on page 3 therein should be replaced by the following two sentences. On April 29, 1998, E&Y informed the Audit Committee of the Board that, in connection with the audit of Informix's fiscal 1997 consolidated financial statements, the lack of appropriate resources, analyses, and process structure in the accounting and financial reporting departments of Informix resulted in delays in closing the books, numerous and material amounts of post-closing entries and audit adjustments required to be recorded by Informix, and difficulty in accumulating accurate information necessary for financial statement disclosure in a timely manner. E&Y considers this condition to be a material weakness. We are in agreement with the statements contained in the first sentence of the second paragraph, the third paragraph, the fourth paragraph, the first sentence of the fifth paragraph, the first part of the second sentence of the fifth paragraph through and including the words "has been deferred", the fourth sentence of the fifth paragraph as it relates to our Firm, the first sentence of the sixth paragraph, the seventh paragraph, the first and second sentence of the eighth paragraph, and the first sentence of the tenth paragraph on pages 2 and 3 therein. In addition, we have no basis to agree or disagree with other statements of the registrant contained therein. Regarding the registrant's statements concerning the lack of internal controls to prepare financial statements, included in the eighth and ninth paragraphs of Item 4 on page 2 and 3 therein, we had considered such matters in determining the nature, timing and extent of procedures performed in our audit of the registrant's consolidated financial statements for the years ended December 31, 1997, 1996, 1995, and 1994. /s/ Ernst & Young LLP PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information regarding directors required by Item 10 is incorporated by reference from our definitive proxy statement for our annual stockholders' meeting to be held on June 6, 2000. The information regarding executive officers required by Item 10 is provided in Item 1 - -Business. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated by reference from our definitive proxy statement for our annual stockholders' meeting to be held on June 6, 2000. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated by reference from our definitive proxy statement for our annual stockholders' meeting to be held on June 6, 2000. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated by reference from our definitive proxy statement for our annual stockholders' meeting to be held on June 6, 2000. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following are filed as a part of this Annual Report and included in Item 8: (A) 1. FINANCIAL STATEMENTS (A) 2. FINANCIAL STATEMENT SCHEDULE Schedule II--Valuation and Qualifying Accounts (A) 3. EXHIBITS - ------------------------------ (1) Filed herewith (2) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1 (333-43991) (3) Incorporated by reference to exhibits filed with the Registrant's quarterly report on Form 10-Q for the fiscal quarter ended July 2, 1995 (4) Incorporated by reference to exhibits filed with the Registrant's report on Form 8-K filed with the Commission on August 25, 1997 (5) Incorporated by reference to exhibits filed with the Registrant's report on Form 8-K filed with the Commission on December 4, 1997 (6) Incorporated by reference to exhibits filed with the amendment to the Registrant's Registration Statement on Form 8-A/A (File No. 000-15325) filed with the Commission on September 3, 1997 (7) Incorporated by reference to exhibits filed with the amendment to the Registrant's Registration Statement on Form 8-A/A (File No. 000-15325) filed with the Commission on December 3, 1997 (8) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1 (File No. 33-8006) (9) Incorporated by reference to exhibit filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1988 (10) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 33-31116) (11) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 33-50608) (12) Incorporated by reference to exhibits filed with Registrant's Registration Statements on Form S-8 (File Nos: 33-22862, 33-31117 and 33-506-10) (13) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 333-31369) filed with the Commission on July 16, 1997 (14) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 333-31371) filed with the Commission on July 16, 1997 (15) Incorporated by reference to exhibits filed with the Registrant's quarterly report on Form 10-Q for the fiscal quarter ended September 28, 1997 (16) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1989 (17) Incorporated by reference to exhibits filed with Registrant's report on Form 8-K filed with the Commission on December 2, 1997 (18) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1986 (19) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1991 (20) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1992 (21) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1993 (22) Incorporated by reference to exhibits filed with the Registrant's amendment to its annual report on Form 10-K/A for the fiscal year ended December 31, 1996 filed with the Commission on November 18, 1997 (23) Incorporated by reference to exhibits filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1996 (24) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File no. 333-61843) filed with the Commission on August 19, 1998. (25) Incorporated by reference to exhibits filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1997. (26) Incorporated by reference to exhibits filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1998. SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS Schedules not listed above have been omitted because the information required to be set forth therein is not applicable. (b) Reports on Form 8-K On October 15, 1999 and November 10, 1999, the Registrant filed current reports on Form 8-K in connection with the acquisition of Cloudscape, Inc. On December 6, 1999, the Registrant filed a current report on Form 8-K in connection with the signing of an Agreement and Plan of Reorganization dated November 30, 1999, by and among the Registrant, Ardent Software, Inc. and Iroquois Acquisition Corporation. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Menlo Park, State of California, on the 25(th) day of February, 2000. POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, THAT EACH PERSON WHOSE SIGNATURE APPEARS BELOW HEREBY CONSTITUTES AND APPOINTS JEAN-YVES F. DEXMIER AND GARY LLOYD AND EACH ONE OF THEM, ACTING INDIVIDUALLY AND WITHOUT THE OTHER, AS HIS ATTORNEY-IN-FACT, EACH WITH FULL POWER OF SUBSTITUTION, FOR HIM IN ANY AND ALL CAPACITIES, TO SIGN ANY AND ALL AMENDMENTS TO THIS REPORT ON FORM 10-K AND TO FILE THE SAME, WITH EXHIBITS THERETO AND OTHER DOCUMENTS IN CONNECTION THEREWITH, WITH THE SECURITIES AND EXCHANGE COMMISSION, HEREBY RATIFYING AND CONFIRMING ALL THAT EACH OF SAID ATTORNEYS-IN-FACT, OR HIS SUBSTITUTE OR SUBSTITUTES MAY DO OR CAUSE TO BE DONE BY VIRTUE HEREOF. PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT ON FORM 10-K HAS BEEN SIGNED ON BEHALF OF THE REGISTRANT BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATES INDICATED. INFORMIX CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT AUDITORS Board of Directors and Stockholders-- Informix Corporation We have audited the accompanying consolidated balance sheets of Informix Corporation and subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, stockholders' equity, and cash flows for the years then ended. Our audits also included the financial statement schedule as listed in the Index at Item 14(a) as of and for the years ended December 31, 1999 and 1998. The consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Informix Corporation and subsidiaries at December 31, 1999 and 1998 and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule as of and for the years ended December 31, 1999 and 1998, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Mountain View, California January 26, 2000 REPORT OF INDEPENDENT AUDITORS Board of Directors and Stockholders-- Informix Corporation We have audited the accompanying consolidated statements of operations, stockholders' equity, and cash flows of Informix Corporation for the year ended December 31, 1997. Our audit also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of Informix Corporation's operations and its cash flows for the year ended December 31, 1997, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP San Jose, California March 2, 1998 INFORMIX CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) See Notes to Consolidated Financial Statements. INFORMIX CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) See Notes to Consolidated Financial Statements. INFORMIX CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See Notes to Consolidated Financial Statements. INFORMIX CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY - ---------------------------------------- (1) Disclosure of reclassification amount for the years ended: See Notes to Supplemental Consolidated Financial Statements. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND OPERATIONS. The Company is a leading multinational supplier of information management software and solutions to governments and enterprises worldwide. The Company designs, develops, manufactures, markets and supports relational and object-relational database management systems, connectivity interfaces and gateways and graphical and character-based application development tools for building database applications that allow customers to access, retrieve and manipulate business data. The Company also offers complete solutions, which include its database management software, its own and third party software and consulting services to help customers design and rapidly deploy data warehousing (decision support), web-based enterprise repository and electronic commerce applications. The principal geographic markets for the Company's products are North America, Europe, Asia/ Pacific, and Latin America. Customers include businesses ranging from small corporations to Fortune 1000 companies, principally in the manufacturing, financial services, telecommunications, media, retail/wholesale, hospitality, and government services sectors. BASIS OF PRESENTATION. The consolidated financial statements have been prepared to give retroactive effect to the merger with Cloudscape, Inc. ("Cloudscape") on October 8, 1999. The consolidated financial statements have been restated for all periods presented as if Cloudscape and the Company had always been combined. Prior to the combination, Cloudscape's fiscal year ended March 31. In recording the pooling-of-interests combination, Informix's statements of operations for the years ended December 31, 1998 and 1997 have been combined with the Cloudscape statements of operations for the years ended March 31, 1999 and 1998, respectively. As a consequence, the results of Cloudscape for the three-month period ended March 31, 1999 are included in the results of operations for both the year ended December 31, 1998 and the year ended December 31, 1999. Cloudscape revenues and net loss for the three-month period ended March 31, 1999 were $347,000 and $2,020,000, respectively. The consolidated balance sheet of Informix at December 31, 1998 has been combined with the balance sheet of Cloudscape as of March 31, 1999. USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of Informix Corporation and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation. FOREIGN CURRENCY TRANSLATION. For foreign operations with the local currency as the functional currency, assets and liabilities are translated at year-end exchange rates, and statements of operations are translated at the exchange rates during the year. Exchange gains or losses arising from translation of such foreign entity financial statements are included as a component of other comprehensive income (loss). For foreign operations with the U.S. dollar as the functional currency, monetary assets and liabilities are remeasured at the year-end exchange rates as appropriate and non-monetary assets and liabilities are remeasured at historical exchange rates. Statements of operations are remeasured at the exchange rates during the year. Foreign currency transaction gains and losses are included in other income (expense), net. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The Company recorded net foreign currency transaction gains (losses) of $(0.3) million, $(4.8) million and $8.0 million for the years ended December 31, 1999, 1998 and 1997, respectively. DERIVATIVE FINANCIAL INSTRUMENTS. The Company enters into foreign currency forward exchange contracts to reduce its exposure to foreign currency risk due to fluctuations in exchange rates underlying the value of intercompany accounts receivable and payable denominated in foreign currencies (primarily European and Asian currencies) until such receivables are collected and payables are disbursed. A foreign currency forward exchange contract obligates the Company to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates or to make an equivalent U.S. dollar payment equal to the value of such exchange. These foreign currency forward exchange contracts are denominated in the same currency in which the underlying foreign currency receivables or payables are denominated and bear a contract value and maturity date which approximate the value and expected settlement date of the underlying transactions. For contracts that are designated and effective as hedges, discounts or premiums (the difference between the spot exchange rate and the forward exchange rate at inception of the contract) are accreted or amortized to other expenses over the contract lives using the straight-line method while unrealized gains and losses on open contracts at the end of each accounting period resulting from changes in the spot exchange rate are recognized in earnings in the same period as gains and losses on the underlying foreign denominated receivables or payables are recognized and generally offset. Contract amounts in excess of the carrying value of the Company's foreign currency denominated accounts receivable or payable balances are marked to market, with changes in market value recorded in earnings as foreign exchange gains or losses. The Company operates in certain countries in Latin America, Eastern Europe, and Asia/Pacific where there are limited forward currency exchange markets and thus the Company has unhedged exposures in these currencies. Most of the Company's international revenue and expenses are denominated in local currencies. Due to the substantial volatility of currency exchange rates, among other factors, the Company cannot predict the effect of exchange rate fluctuations on the Company's future operating results. Although the Company takes into account changes in exchange rates over time in its pricing strategy, it does so only on an annual basis, resulting in substantial pricing exposure as a result of foreign exchange volatility during the period between annual pricing reviews. In addition, the sales cycles for the Company's products is relatively long, depending on a number of factors including the level of competition and the size of the transaction. The Company periodically assesses market conditions and occasionally attempts to reduce this exposure by entering into foreign currency forward exchange contracts to hedge up to 80% of the forecasted net income of its foreign subsidiaries of up to one year in the future. These foreign currency forward exchange contracts do not qualify as hedges and, therefore are marked to market. Notwithstanding the Company's efforts to manage foreign exchange risk, there can be no assurances that the Company's hedging activities will adequately protect the Company against the risks associated with foreign currency fluctuations. REVENUE RECOGNITION POLICY. In October 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-2 (SOP 97-2), "Software Revenue Recognition" which superseded SOP 91-1 and provides guidance on generally accepted accounting principles for recognizing revenue on software transactions. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post contract customer support, installation, or training. Under SOP 97-2, the determination of fair value is based on objective evidence which is specific to the vendor. If such evidence of fair value for each element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) arrangement are delivered. SOP 97-2 was amended in February 1998 by Statement of Position 98-4 (SOP 98-4) "Deferral of the Effective Date of a Provision of SOP 97-2" and was amended again in December 1998 by Statement of Position 98-9 (SOP 98-9) "Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions." Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement. The Company adopted the provisions of SOP 97-2 and SOP 98-4 as of January 1, 1998 and as a result, changed certain business practices. The adoption has, in certain circumstances, resulted in the deferral of software license revenues that would have been recognized upon delivery of the related software under prior accounting standards. SOP 98-9 is effective for all transactions entered into by the Company in fiscal year 2000. The adoption of this statement is not expected to have a material impact on the Company's operating results, financial position or cash flows. The Company's revenue recognition policy is as follows: LICENSE REVENUE. The Company recognizes revenue from sales of software licenses to end users upon persuasive evidence of an arrangement, delivery of the software to a customer and determination that collection of a fixed or determinable license fee is considered probable. Revenue for transactions with application vendors, OEMs and distributors is currently recognized as earned when the licenses are resold or utilized by the reseller and all related obligations of the Company have been satisfied. The Company provides for sales allowances on an estimated basis. The Company accrues royalty revenue through the end of the reporting period based on reseller royalty reports or other forms of customer-specific historical information. In the absence of customer-specific historical information, royalty revenue is recognized when the customer-specific objective information becomes available. Any subsequent changes to previously recognized royalty revenues are reflected in the period when the updated information is received from the reseller. SERVICE REVENUE. Maintenance contracts generally call for the Company to provide technical support and software updates and upgrades to customers. Maintenance revenue is recognized ratably over the term of the maintenance contract, generally on a straight-line basis. Other service revenue, primarily training and consulting, is generally recognized at the time the service is performed and it is determined that the Company has fulfilled its obligations resulting from the services contract, or on a contract accounting basis. When the fee for maintenance and service is bundled with the license fee, it is unbundled from the license fee using the Company's objective evidence of the fair value of the maintenance and/or services represented by the Company's customary pricing for such maintenance and/or services. ADVANCES FROM CUSTOMERS AND FINANCIAL INSTITUTIONS. Amounts received in advance of revenue being recognized are recorded as a liability on the accompanying financial statements. These amounts may be received either from the customer or from a financing entity to whom the customer payment streams are sold. The Company's license arrangements with some of its customers provide contractually for a non-refundable fee payable by the customer in single or multiple installment(s) at the initiation or over the term of the license arrangement. If the Company fails to comply with certain contractual terms of a specific license agreement, the Company could be required to refund the amount(s) received to the customer or the financial institution in the event of an assignment of receivables. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Prior to fiscal 1998, the Company's arrangements for financing of license contracts with customers frequently took the form of a non-recourse sale of the future payment streams. When such customer contracts were sold to a third-party financing entity, they were typically sold at a discount which represented the financing cost. Such discounts offset revenues in cases where the license was recorded as a sale. For transactions where the financing was received prior to the recognition of revenue, the financing discount has been charged ratably to interest expense over the financing period, which approximates the "interest method." SALES OF RECEIVABLES. Prior to January 1, 1998, the Company financed amounts due from customers with financial institutions on a non-recourse basis. The Company accounted for these transactions in accordance with Statement of Financial Accounting Standards No. 77 (SFAS 77), "Reporting by Transferors for Transfers of Receivables with Recourse." Effective January 1, 1998 any such transactions would be accounted for by the Company in accordance with Statement of Financial Accounting Standards No. 125 (SFAS 125), "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." If at the time of the transfer the amounts due from the customer have been recognized as revenue and a receivable, the transfer is accounted for as the sale of a receivable and the receivable is removed from the books and the financing fees are charged to operations immediately as interest expense. The Company did not enter into any such transactions during fiscal 1999 and 1998. SALES OF FUTURE REVENUE STREAMS. If at the time of transfer the amounts due from the customers have not been recognized as revenue or a receivable, the transfer is accounted for as the sale of a future revenue stream in accordance with EITF 88-18. Accordingly, the receipt of cash is treated as a borrowing and recorded as "advances from customers and financial institutions" and the financing fees are amortized to interest expense over the term of the financing arrangement. The Company has not financed, and does not expect to finance, amounts due from customers subsequent to December 31, 1997. CONCURRENT TRANSACTIONS. During fiscal 1997, the Company entered into software license agreements with certain computer and service vendors where the Company concurrently committed to acquire goods and services. If the agreement is with a reseller, revenue is recognized as earned on these transactions as the licenses are resold by the customer. If the agreement is with an end user, revenue is generally recognized as earned upon delivery of software. The computer equipment and services are recorded at their fair value. These concurrent transactions for 1997 included software license agreements of approximately $21 million and commitments by the Company to acquire goods and services in the aggregate of approximately $50 million. The Company did not enter into any concurrent transactions in fiscal 1999 and 1998. SOFTWARE COSTS. The Company accounts for its software development expenses in accordance with Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed." This statement requires that, once technological feasibility of a developing product has been established, all subsequent costs incurred in developing that product to a commercially acceptable level be capitalized and amortized ratably over the revenue life of the product. The Company uses a detail program design approach in determining technological feasibility. Software costs also include amounts paid for purchased software and outside development on products which have reached technological feasibility. All software costs are amortized as a cost of software distribution either on a straight-line basis, or on the basis of each product's projected revenues, whichever results in greater amortization, over the remaining estimated economic life of the product, which is generally estimated to be INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) three years. The Company recorded amortization of $19.3 million, $20.7 million, and $21.4 million of software costs in 1999, 1998 and 1997, respectively, in cost of software distribution. The Company accounts for the costs of computer software developed or obtained for internal use in accordance with Statement of Position 98-1 (SOP 98-1), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," which was effective for fiscal years beginning after December 15, 1998. This statement requires that certain costs incurred during a software development project be capitalized. These costs generally include external direct costs of materials and services consumed in the project, and internal costs such as payroll and benefits of those employees directly associated with the development of the software. During the year ended December 31, 1999, the Company capitalized approximately $2.8 million under SOP 98-1, which will be amortized over the estimated useful life of the software developed, which is generally three years. PROPERTY AND EQUIPMENT. Depreciation of property and equipment is calculated using the straight-line method over its estimated useful life, generally the shorter of the applicable lease term or three-to-seven years for financial reporting purposes. The Company reviews property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of property and equipment to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. Property and equipment to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. BUSINESSES ACQUIRED. The purchase price of businesses acquired, accounted for as purchase business combinations, is allocated to the tangible and identifiable intangible assets acquired based on their estimated fair values with any amount in excess of such allocations being designated as goodwill. Intangible assets are amortized over their estimated useful lives, which to date range from three to seven years. As of December 31, 1999, 1998 and 1997, the Company had $44.9 million, $48.3 million and $19.2 million of intangible assets, with accumulated amortization of $16.9 million, $6.8 million and $10.9 million, respectively, as a result of these acquisitions. The carrying value of goodwill is reviewed if the facts and circumstances suggest that it may be impaired. If this review indicates that the goodwill will not be recoverable, as determined based on the undiscounted cash flows of the acquired business over the remaining amortization period, the Company's carrying value is reduced to net realizable value. The carrying values of identifiable intangible assets are reviewed in a manner consistent with the policy for reviewing impairment of property and equipment, as described above. During 1997, the Company wrote down $30.5 million of impaired long-term assets related to the shortfall in business activity of its Japanese subsidiary (see Note 13). STOCK-BASED COMPENSATION. As permitted under Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," the Company has elected to follow Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees" in accounting for stock-based awards to employees (see Note 7). CONCENTRATION OF CREDIT RISK. The Company designs, develops, manufactures, markets, and supports computer software systems to customers in diversified industries and in diversified geographic locations. The Company performs ongoing credit evaluations of its customers' financial condition and generally requires no collateral. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) No single customer accounted for 10% or more of the consolidated net revenues of the Company in 1999, 1998 or 1997. CASH, CASH EQUIVALENTS, SHORT-TERM INVESTMENTS, AND LONG-TERM INVESTMENTS. The Company considers liquid investments purchased with a remaining maturity of three months or less to be cash equivalents. The Company considers investments with a maturity of more than three months but less than one year to be short-term investments. Investments with a remaining original maturity of more than one year are considered long-term investments. Short-term and long-term investments are classified as available-for-sale and are carried at fair value. The Company invests its excess cash in accordance with its short-term and long-term investments policy, which is approved by the Board of Directors. The policy authorizes the investment of excess cash in government securities, municipal bonds, time deposits, certificates of deposit with approved financial institutions, commercial paper rated A-1/P-1, and other specific money market instruments of similar liquidity and credit quality. The Company has not experienced any significant losses related to these investments. The Company invests in equity instruments of privately-held, information technology companies for business and strategic purposes. These investments are included in long-term investments and are accounted for under the cost method when ownership is less than 20%. For these non-quoted investments, the Company's policy is to regularly review the assumptions underlying the operating performance and cash flow forecasts in assessing the carrying values. When the Company determines that a decline in fair value below the cost basis is other than temporary, the related investment is written down to fair value. SECURITIES HELD-TO-MATURITY AND AVAILABLE-FOR-SALE. Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity when the Company has the positive intent and the ability to hold the securities until maturity. Held-to-maturity securities are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization, as well as any interest on the securities, is included in interest income. Marketable equity securities and debt securities not classified as held-to-maturity are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a component of other comprehensive income (loss). The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense), net. The cost of securities sold is based on the specific identification method. Interest on securities classified as available-for-sale is included in interest income. The Company realized gross gains of approximately $3.7 million and $8.5 million on the sale of available-for-sale marketable securities during 1999 and 1997, respectively. During 1997 the Company realized gross losses of approximately $1.2 million on the sale of available-for-sale equity securities. Realized losses during 1999 were not significant. Realized gains and losses were not significant in 1998. FAIR VALUE OF FINANCIAL INSTRUMENTS. Fair values of cash, cash equivalents, short and long term investments and foreign currency forward contracts are based on quoted market prices. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RECLASSIFICATIONS. Certain prior period amounts have been reclassified to conform to the current period presentation. NOTE 2--BALANCE SHEET COMPONENTS INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3--FINANCIAL INSTRUMENTS The following is a summary of available-for-sale debt and marketable equity securities: Maturities of debt securities at market value at December 31, 1999 are as follows (in thousands): INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--DERIVATIVE FINANCIAL INSTRUMENTS The Company enters into foreign currency forward exchange contracts primarily to hedge the value of intercompany accounts receivable or accounts payable denominated in foreign currencies against fluctuations in exchange rates until such receivables are collected or payables are disbursed. The Company periodically assesses market conditions and occasionally attempts to reduce this exposure by entering into foreign currency forward exchange contracts to hedge up to 80% of anticipated net income of foreign subsidiaries of up to a maximum of one year in the future. From an accounting perspective, these hedges are considered to be speculative. The Company's outstanding foreign currency forward exchange contracts used to hedge anticipated net income are marked to market with unrealized gains and losses recognized as incurred in results of operations. The purpose of the Company's foreign exchange exposure management policy and practices is to attempt to minimize the impact of exchange rate fluctuations on the value of the foreign currency denominated assets and liabilities being hedged. Substantially all forward foreign exchange contracts entered into by the Company have maturities of 360 days or less. There are no significant unrealized gains or losses on these contracts at December 31, 1999 and 1998. At December 31, 1999 and 1998, the Company had approximately $87.0 million and $93.9 million of foreign currency forward exchange contracts outstanding, respectively. The table below summarizes by currency the contractual amounts of the Company's foreign currency forward exchange contracts at December 31, 1999 and December 31, 1998. The information is provided in U.S. dollar equivalents and presents the notional amount (contract amount), the unrealized gain (loss) and fair value. Fair value represents the difference in value of the contracts at the spot rate at December 31, 1999 and the forward rate, plus the unamortized premium or discount. All contracts mature within twelve months. FORWARD CONTRACTS INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED) While the contract amounts provide one measure of the volume of these transactions, they do not represent the amount of the Company's exposure to credit risk. The amount of the Company's credit risk exposure (arising from the possible inabilities of counterparties to meet the terms of their contracts) is generally limited to the amounts, if any, by which the counterparties' obligations exceed the obligations of the Company as these contracts can be settled on a net basis at the option of the Company. The Company controls credit risk through credit approvals, limits and monitoring procedures. As of December 31, 1999 and 1998, other than foreign currency forward exchange contracts discussed immediately above, the Company does not currently invest in or hold any other derivative financial instruments. NOTE 5--PREFERRED STOCK In August 1997, the Company sold 160,000 shares of newly authorized Series A Convertible Preferred Stock, face value $250 per share, which shares are generally not entitled to vote on corporate matters, to a private investor for aggregate net proceeds of $37.6 million and issued a warrant to the same investor to purchase up to an additional 140,000 shares of Series A Convertible Preferred Stock at an aggregate purchase price of up to $35 million. In November 1997, the Company canceled the Series A Convertible Preferred Stock in exchange for the same number of shares of a substantially identical Series A-1 INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5--PREFERRED STOCK (CONTINUED) Convertible Stock (the "Series A-1 Preferred") issued to the same investor, with a corresponding change to the warrant shares. The mandatory redemption provisions of the new Series A-1 Preferred differ from the Series A Convertible Preferred Stock. The redemption provisions in the Series A-1 Preferred effectively preclude the Company from having to redeem the preferred stock except by actions solely within its control. Accordingly, the Consolidated Balance Sheet reflects the Series A-1 Preferred under stockholder's equity. The Series A-1 Preferred shares are convertible into common shares at any time, at the holder's option, at a per share price equal to 101% of the average price of the Company's common stock for the 30 days ending five trading days prior to conversion, but not greater than the lesser of (i) 105% of the common stock's average price of the first five trading days of such thirty day period, or (ii) $12 per share. If not converted prior, the Series A-1 Preferred will automatically convert into common shares eighteen months after their issuance, subject to extension of the automatic conversion date in certain defined circumstances of default. However, if at the time of conversion, the aggregate number of shares of common stock already issued and to be issued as a result of the conversion of the shares of the Series A-1 Convertible Preferred Stock were to exceed 19.9% of the total number of shares of then outstanding common stock, then such excess does not convert unless or until stockholder approval is obtained. On February 13, 1998, the holders of the Series A-1 Preferred Stock exercised warrants to purchase 60,000 additional shares of Series A-1 Preferred at $250 per share resulting in net proceeds to the Company of $14.1 million. In addition, pursuant to the Series A-1 Subscription Agreement, the Series A-1 Preferred stockholders converted 220,000 shares of Series A-1 Preferred into 12,769,908 shares of the Company's Common Stock. On November 25, 1998, the holders of the Series A-1 Preferred Stock exercised their remaining warrants to purchase 80,000 additional shares of Series A-1 Preferred at $250 per share resulting in net proceeds to the Company of $18.8 million. In addition, pursuant to the Series A-1 Subscription Agreement, the Series A-1 Preferred stockholders converted the remaining 80,000 shares of Series A-1 Preferred into 4,642,525 shares of the Company's Common Stock. As a result of these conversions, no Series A-1 Preferred Stock or Series A-1 Preferred warrants were outstanding at December 31, 1998. In November 1997, the Company sold 50,000 shares of newly authorized Series B Convertible Preferred Stock ("Series B Preferred"), face value $1,000 per share, which shares are generally not entitled to vote on corporate matters, to private investors for aggregate proceeds of $50.0 million (excluding a $1.0 million fee paid to a financial advisor of the Company). In connection with the sale, the Company also agreed to issue a warrant to such investors upon conversion of such Series B Preferred to purchase 20% of the shares of Common Stock into which the Series B Preferred is convertible, but no less than 1,500,000 shares at a per share exercise price which is presently indeterminable and will depend on the trading price of the Common Stock of the Company in the period prior to the conversion of the Series B Preferred. The Company also agreed to issue additional warrants to purchase up to an aggregate of 200,000 shares at a per share exercise price which is presently indeterminable and will depend on the trading price of the Common Stock of the Company in the period prior to the conversion of the Series B Preferred. The Series B Preferred is convertible at the election of the holder into shares of Common Stock beginning six months after issuance, and upon the occurrence of certain events, including a merger. The Series B Preferred will automatically convert into Common Stock three years following the date of its issuance. Each Series B Preferred share is convertible into the number of shares of Common Stock at a per share price equal to the lowest of (i) the average of the closing prices for the Common Stock for the 22 days immediately prior to INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5--PREFERRED STOCK (CONTINUED) the 180th day following the initial issuance date, (ii) 101% of the average closing price for the 22 trading days prior to the date of actual conversions, or (iii) 101% of the lowest closing price for the Common Stock during the five trading days immediately prior to the date of actual conversion. The conversion price of the Series B Preferred is subject to modification and adjustment upon the occurrence of certain events. The Company reserved 22.8 million shares of Common Stock for issuance upon conversion of the Series B Preferred and upon the exercise of the Series B Warrants. The Series B Preferred accrues cumulative dividends at an annual rate of 5% of per share face value. The dividend is generally payable upon the conversion or redemption of the Series B Preferred, and may be paid in cash or, at the holder's election, in shares of Common Stock. On June 10, 1998, a holder of the Series B Preferred Stock converted 500 shares of Series B Preferred into 80,008 shares of the Company's Common Stock. In connection with such conversion, the Company also issued such Series B Preferred Stockholder a warrant to purchase up to 66,000 shares of Common Stock at a purchase price of $7.84 per share. Also, during the quarter ended June 30, 1998, the Company issued a warrant pursuant to the provisions of the Series B Preferred to purchase up to an additional 50,000 shares of Common Stock at a purchase price of $7.84 per share to a financial advisor of the Company because, as of May 15, 1998, the closing sales price of the Company's Common Stock was less than $12.50. Such warrant was issued in connection with services provided by such financial advisor related to the sale of shares of the Series B Preferred in November 1997. During the third and fourth quarters of fiscal 1998, holders of the Series B Preferred Stock converted a total of 26,200 shares of Series B Preferred into 6,391,639 shares of the Company's Common Stock. In connection with such conversions, the Company also issued such Series B Preferred Stockholders warrants to purchase up to 1,428,319 shares of Common Stock at a purchase price of $7.84 per share and paid cash dividends in the amount of $1,170,068 to such stockholders. The Company reserved 22.8 million shares of Common Stock for issuance upon conversion of the Series B Preferred and upon exercise of the Series B Warrants. During fiscal 1999, holders of the Series B Preferred Stock converted a total of 16,300 shares of Series B Preferred into 2,223,156 shares of the Company's Common Stock. In connection with such conversions, the Company also issued such Series B Preferred Stockholders warrants to purchase up to 444,628 shares of Common Stock at a purchase price of $7.84 per share and paid cash dividends in the amount of $1,528,699 to such stockholders. The fair value of the warrants issued in connection with the Series A-1 Preferred and Series B Preferred are deemed to be a discount to the conversion price of the respective equity instruments available to the preferred stockholders. The discounts were recognized as a return to the preferred stockholders (similar to a dividend) over the minimum period during which the preferred stockholders could realize this return, immediate for the Series A-1 Preferred and six months for the Series B Preferred. The discount has been accreted to additional paid in capital (accumulated deficit) in the Company's balance sheet and has been disclosed as a decrease in the amount available to common stockholders on the face of the Company's statements of operations and for purposes of computing net income (loss) per share. The fair value assigned to the warrants is based on an independent appraisal performed by a nationally recognized investment banking firm. The appraisal was completed utilizing the Black-Scholes valuation model. This model requires assumptions related to the remaining life of the warrant, the risk free INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5--PREFERRED STOCK (CONTINUED) interest rate at the time of issuance, stock volatility, and an illiquidity factor associated with the security. These assumptions and the values assigned to the Series A-1 and Series B warrants were as follows: In connection with the issuance of the Series B Convertible Preferred Stock in November 1997, the Company paid a fee of $1,000,000 for financial advisory services provided in connection with such financing. In addition, the Company issued 100,000 shares of its Common Stock, and also agreed to issue a warrant to purchase an additional 50,000 shares of the Company's Common Stock to the service provider in the event that, as of May 17, 1998, the trading price of the Company's Common Stock is less than $12.50 per share. Such warrant will be exercisable according to the same terms as the warrants issued in connection with the issuance of the Series B Convertible Preferred Stock. On June 9, 1998, the Company filed a Post-Effective Amendment to its Registration Statement on Form S-1 pertaining to the Company's sale of its Series B Preferred. The Securities and Exchange Commission ("SEC") reviewed the Post-Effective Amendment and declared it effective on August 13, 1998. The Series B Preferred stockholders claimed that during August 1998 they were prevented from selling shares of Series B Preferred stock until the SEC completed its review of the Post-Effective Amendment and, as a result, the Company had failed to comply with certain terms of a Registration Rights Agreement between the Series B Preferred stockholders and the Company. As a result, the Company recorded a $1.3 million dividend as of December 31, 1998, which was paid in cash to the Series B Preferred stockholders in the first quarter of 1999. As of December 31, 1998, 6,343,000 shares of preferred stock were outstanding that related to Series A, B, and C preferred stock issuances by Cloudscape, Inc. ("Cloudscape Preferred Stock") in fiscal 1996, 1997, and 1998, respectively. Each series of Cloudscape Preferred Stock maintained noncumulative dividend rights and liquidation preferences to any proceeds received in the event of a liquidation of Cloudscape. Additionally, the Cloudscape Preferred Stock was convertible into Cloudscape Common Stock on a one-for-one basis and the holders of the Cloudscape Preferred Stock were entitled to the number of votes based on an as-if converted basis. Immediately prior to the merger between Informix and Cloudscape on October 8, 1999, all the Cloudscape preferred shareholders converted their Cloudscape Preferred Stock into an equal number of shares of Cloudscape Common Stock. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6--NET INCOME (LOSS) PER COMMON SHARE The following table sets forth the computation of basic and diluted net income (loss) per common share: The Company excluded potentially dilutive securities for each period presented from its diluted EPS computation because either the exercise price of the securities exceeded the average fair value of the Company's common stock or the Company had net losses, and, therefore, these securities were anti-dilutive. A summary of the excluded potentially dilutive securities and the related exercise/conversion features follows: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6--NET INCOME (LOSS) PER COMMON SHARE (CONTINUED) The stock options have per share exercise prices ranging from $0.08 to $33.25, $6.75 to $42.09, and $0.08 to $34.25, at December 31, 1999, 1998 and 1997, respectively. The warrants to purchase shares of Common Stock of the Company (the "Series B Warrants") were issued in connection with the conversion of certain shares of the Company's Series B Preferred into shares of Common Stock of the Company. Upon conversion of the Series B Preferred, the holders are eligible to receive Series B Warrants to purchase that number of shares of the Company's Common Stock equal to 20% of the shares of the Company's Common Stock into which the Series B Preferred is convertible. As of December 31, 1999, approximately 1,939,000 Series B Warrants have been issued at a per share exercise price of $7.84. The Series B Warrants are exercisable through November 2002. Warrants to purchase shares of the Company's Series A-1 Preferred (the "Series A-1 Warrants") were exercised into shares of Series A-1 Preferred at a per share price of $250 and converted into 8,125,000 shares of Common Stock during 1998. No Series A-1 Warrants were outstanding as of December 31, 1998 and 1999. Certain of the outstanding shares of Cloudscape Common Stock held by employees are subject to repurchase upon termination of employment. The number of shares subject to this repurchase right decreases as the shares vest over time, generally for four years. As of December 31, 1999, 1998 and 1997, 212,000, 1,407,000, and 992,000 shares, respectively, were subject to repurchase at a weighted-average exercise price of $0.24, $0.13, and $0.02, respectively. NOTE 7--EMPLOYEE BENEFIT PLANS OPTION PLANS Under the Company's 1986 Employee Stock Option Plan, options are granted at fair market value on the date of the grant. Options are generally exercisable in cumulative annual installments over three to five years. Payment for shares purchased upon exercise of options may be by cash or, with Board approval, by full recourse promissory note or by exchange of shares of the Company's common stock at fair market value on the exercise date. Unissued options under the 1986 Plan expired on July 29, 1996, which was 10 years after adoption of the plan. Additionally, 1,600,000 shares were authorized for issuance under the 1989 Outside Directors Stock Option Plan, whereby non-employee directors are automatically granted non-qualified stock options upon election or re-election to the Board of Directors. At December 31, 1999, 635,000 shares were available for grant under this Plan. In April 1994, the Company adopted the 1994 Stock Option and Award Plan; 8,000,000 shares were authorized for grant under this Plan. Options can be granted to employees on terms substantially equivalent to those described above. The 1994 Stock Option and Award Plan also allows the Company to award performance shares of the Company's common stock to be paid to recipients on the achievement of certain performance goals set with respect to each recipient. In May 1997, the Company's stockholders approved an additional 8,000,000 shares to be reserved for issuance under the Company's 1994 Stock Option and Award Plan. At December 31, 1999, 2,531,662 shares were available for grant under this Plan. In July 1997, the Company's Board of Directors approved a resolution authorizing the grant of a maximum of 500,000 non-statutory stock options to executives and other employees, as determined by the Board, under the newly created 1997 Non-Statutory Stock Option Plan ("the 1997 Stock Plan"). The INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7--EMPLOYEE BENEFIT PLANS (CONTINUED) authorization of such shares for grant under the 1997 Stock Plan is not subject to stockholder approval. Terms of each option are determined by the Board or committee delegated such duties by the Board. Concurrent with the authorization of the 1997 Stock Plan, the Board granted the Company's current Chairman of the Board and former chief executive officer 500,000 options to purchase the Company's common stock thereunder. Such options vest ratably over five years beginning with the first anniversary of the date of grant. In September 1997, the Company's Board of Directors authorized the repricing of outstanding options to purchase Common Stock under the Company's stock option plans. Employees were eligible to participate only if they remained actively employed at the effective date of the repricing and were only permitted to exchange options granted and outstanding prior to May 1, 1997. The repricing/option exchange was effective November 21, 1997 (the "Repricing Effective Date"). The repricing program offered eligible employees the opportunity to exchange eligible outstanding options with exercise prices in excess of the closing sales price of the Company's Common Stock on the Repricing Effective Date for a new option with an exercise price equal to such price. Other than the exercise price, each new option issued upon exchange has terms substantially equivalent to the surrendered option, including the number of shares, vesting terms and expiration except that options issued in connection with the exchange may not be exercised for a period of one year from the Repricing Effective Date. In addition, officers of the Company participating in the option exchange were required to forfeit 20% of the shares subject to each option being surrendered. The exercise price for repriced options was $7.1563, the closing sales price of the Company's Common Stock on the Repricing Effective Date. In December 1997, the Company's Board of Directors authorized the repricing of outstanding options to purchase Common Stock under the Company's stock option plans. Employees were eligible to participate only if they remained actively employed at the effective date of the repricing and were only permitted to exchange options granted and outstanding prior to May 1, 1997. The repricing/option exchange was effective January 9, 1998 (the "Repricing Effective Date"). The repricing program offered eligible employees the opportunity to exchange eligible outstanding options with exercise prices in excess of the closing sales price of the Company's Common Stock on the Repricing Effective Date for a new option with an exercise price equal to such price. Other than the exercise price, each new option issued upon exchange has terms substantially equivalent to the surrendered option, including the number of shares, vesting terms and expiration except that options issued in connection with the exchange may not be exercised for a period of one year from the Repricing Effective Date. In addition, Officers and Directors of the Company were not eligible to have their shares repriced. The exercise price for repriced options was $5.0938, the closing sales price of the Company's Common Stock on the Repricing Effective Date. In July 1998, the Company adopted the 1998 Non-Statutory Stock Option Plan ("the 1998 Stock Option Plan"); 5,500,000 shares were originally authorized for grant under this Plan. During 1999, the Company's Board of Directors authorized an additional 5,000,000 shares for grant under the 1998 Stock Option Plan. Options can be granted to employees on terms substantially equivalent to those described above. At December 31, 1999, 2,272,878 shares were available for grant under this Plan. As a result of its acquisition of Red Brick Systems, Inc. ("Red Brick") in December 1998, the Company assumed all outstanding Red Brick stock options which had been issued under Red Brick's 1995 Stock Option Plan (including options granted under the predecessor 1991 Stock Option Plan) and Supplemental Stock Option Plan. Each Red Brick stock option so assumed is subject to the same terms and conditions as the original grant, except that each option was adjusted at a ratio of 0.6 shares of INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7--EMPLOYEE BENEFIT PLANS (CONTINUED) Informix Common Stock for each one share of Red Brick Common Stock, and the exercise price was adjusted by dividing the exercise price by 0.6. As a result of its acquisition of Cloudscape, Inc. ("Cloudscape") in October 1999, the Company assumed all outstanding Cloudscape stock options which had been issued under Cloudscape's 1996 Equity Incentive Plan. Each Cloudscape stock option so assumed is subject to the same terms and conditions as the original grant, except that each option was adjusted at a ratio of approximately 0.56 shares of Informix Common Stock for each one share of Cloudscape Common Stock, and the exercise price was adjusted by dividing the exercise price by approximately 0.56. Following is a summary of activity for all stock option plans for the three years ended December 31, 1999: The following table summarizes information about options outstanding at December 31, 1999: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7--EMPLOYEE BENEFIT PLANS (CONTINUED) In connection with all stock option plans, 30,089,289 shares of Common Stock were reserved for issuance as of December 31, 1999, and 7,082,302 options were exercisable. At December 31, 1998, 31,869,993 shares of Common Stock were reserved for issuance, and 6,143,986 options were exercisable. EMPLOYEE STOCK PURCHASE PLAN The Company had a qualified Employee Stock Purchase Plan (the Plan) under which 7,600,000 shares of common stock, in the aggregate, were authorized for issuance. Under the terms of the Plan, employees could contribute, through payroll deductions, up to 10 percent of their base pay and purchase up to 20,000 shares per quarter (with the limitation of purchases of $25,000 annually in fair market value of the shares). Employees could elect to withdraw from the Plan during any quarter and have their contributions for the period returned to them. Also, employees could elect to reduce the rate of contribution one time in each quarter. The price at which employees could purchase shares was 85 percent of the lower of the fair market value of the stock at the beginning or end of the quarter. The Plan was qualified under Section 423 of the Internal Revenue Code of 1986, as amended. During 1997, the Company issued 573,343 shares under this Plan. The Plan was terminated on July 1, 1997, which was 10 years after the offering date for the Plan's first offering period. In May 1997, the Company's stockholders approved the 1997 Employee Stock Purchase Plan (the "1997 ESPP"). The Company has reserved 4,000,000 shares of Common Stock for issuance under the 1997 ESPP. The 1997 ESPP permits participants to purchase Common Stock through payroll deductions of up to 15 percent of an employee's compensation, including commissions, overtime, bonuses and other incentive compensation. The price of Common Stock purchased under the 1997 ESPP is equal to 85 percent of the lower of the fair market value of the Common Stock at the beginning or at the end of each calendar quarter in which an eligible employee participates. The Plan qualifies as an employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986, as amended. During 1999 and 1998, the Company issued approximately 1,187,000 shares and 1,613,000 shares, respectively, under the 1997 ESPP. No shares of Common Stock were issued under this plan during fiscal 1997. STOCK-BASED COMPENSATION As permitted under Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," the Company has elected to continue to follow Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees" in accounting for stock-based awards to employees. Under APB 25, the Company generally recognizes no compensation expense with respect to such awards. Pro forma information regarding the net income (loss) and net income (loss) per share is required by SFAS 123 for awards granted or modified after December 31, 1994 as if the Company had accounted for its stock based awards to employees under the fair value method of SFAS 123. The fair value of the Company's stock-based awards to employees was estimated using a Black-Scholes option pricing model. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7--EMPLOYEE BENEFIT PLANS (CONTINUED) The fair value of the Company's stock-based awards was estimated assuming no expected dividends and the following weighted-average assumptions: For pro forma purposes, the estimated fair value of the Company's stock based awards is amortized over the award's vesting period (for options) and the three month purchase period (for stock purchases under the ESPP). The Company's pro forma information follows: Calculated under SFAS 123, the weighted-average fair value of the options granted during 1999, 1998 and 1997 was $5.24, $3.58 and $5.26 per share, respectively. The weighted average fair value of employee stock purchase rights granted under the ESPP during 1999, 1998 and 1997 were $2.83, $1.91 and $3.83 per share, respectively. 401(k) PLAN The Company has a 401(k) plan covering substantially all of its U.S. employees. Under this plan, participating employees may defer up to 15 percent of their pre-tax earnings, subject to the Internal Revenue Service annual contribution limits. The Company matches 50 percent of each employee's contribution up to a maximum of $2,000. The Company's matching contributions to this 401(k) plan for 1999, 1998 and 1997 were $4.2 million, $3.5 million and $4.2 million, respectively. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 8--COMMITMENTS AND CONTINGENCIES The Company leases certain computer and office equipment under capital leases having terms of three-to-five years. Amounts capitalized for such leases are included on the consolidated balance sheets as follows: During 1998 and 1997, the Company financed approximately $1.9 million and $10.5 million, respectively, of equipment purchases under capital lease arrangements. The Company did not finance a significant amount of equipment purchases under capital lease arrangements during 1999. Amortization of the cost of leased equipment is included in depreciation expense. The Company leases certain of its office facilities and equipment under non-cancelable operating leases and total rent expense was $35.7 million, $30.7 million and $34.8 million in 1999, 1998 and 1997, respectively. In November 1996, the Company leased approximately 200,000 square feet of office space in Santa Clara, California. The lease term is for fifteen years and minimum lease payments amount to $96.0 million over the term. The minimum lease payments increase within a contractual range based on changes in the Consumer Price Index. In the fourth quarter of 1997, the Company assigned the lease to an unrelated third party. The Company remains contingently liable for minimum lease payments under this assignment. Future minimum payments, by year and in the aggregate, under the capital and non-cancelable operating leases as of December 31, 1999, are as follows: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 8--COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company has several active software development and service provider contracts with third-party technology providers. These agreements contain financial commitments by the Company of $8.7 million, $7.8 million and $4.7 million in fiscal 2000, 2001 and 2002, respectively. In addition, the Company makes annual payments of approximately $1.9 million to third-party technology providers, and will continue to do so for such period as the Company utilizes the related technology in its products. NOTE 9--BUSINESS SEGMENTS In recent years, the Company has operated under four reportable operating segments which report to the Company's president and chief executive officer, (the "Chief Operating Decision Maker"). These reportable operating segments, North America, Europe, Asia/Pacific and Latin America, are organized, managed and analyzed geographically and operate in one industry segment: the development and marketing of information management software and related services. The Company has evaluated operating segment performance based primarily on net revenues and certain operating expenses. The Company's products are marketed internationally through the Company's subsidiaries and through application resellers, OEMs and distributors. Financial information for the Company's North America, Europe, Asia/Pacific and Latin America operating segments is summarized below by year: - ------------------------------ (1) The Company makes allocations of revenue to operating segments depending on the location of the country where the order is placed, the location of the country where the license is installed or service is delivered, the type of revenue (license or service) and whether the sale was through a reseller or to an end user. The accounting policies of the segments are the same as those described in Note 1--Summary of Significant Accounting Policies. (2) Operating income/(loss) excludes the effect of transfers between segments. (3) Represents consolidating adjustments such as elimination of intercompany balances. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9--BUSINESS SEGMENTS (CONTINUED) The reconciliation of the operating income (loss) of the Company's reportable operating segments to the Company's income (loss) before income taxes is as follows: On October 1, 1999, the Company created four new business groups which began reporting to the Company's Chief Operating Decision Maker: the TransAct Business Group, which is responsible for delivering on-line transaction processing products; the i.Foundation Business Group, which is responsible for delivering products that provide the technological foundation for Internet-based electronic commerce solutions; the i.Informix Business Group, which is responsible for delivering Internet-based solutions for electronic commerce; and the i.Intelligence Business Group, which is responsible for delivering Internet- based data warehouse products and solutions. Financial information for the Company's TransAct, i.Foundation, i.Informix and i.Intelligence business groups for 1999 is summarized below (due to the creation of these business groups in the fourth quarter of 1999, certain information was not practicable to obtain for current and prior years): The Company's revenues are derived from licensing its database servers and related tools and connectivity/gateway software, and performing services, which include maintenance and consulting/training. Information as to the Company's revenues from external customers for all reportable segments is as follows: - ------------------------ (1) Financial data for the Company's license revenues by product is not practicable to obtain due to the bundling of software products and services into the Company's solutions offerings. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9--BUSINESS SEGMENTS (CONTINUED) Information as to the Company's operations in different geographical areas is as follows: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9--BUSINESS SEGMENTS (CONTINUED) No single customer accounted for 10% or more of the consolidated revenues of the Company in fiscal 1999, 1998 or 1997. NOTE 10--INCOME TAXES The provision for income taxes applicable to income (loss) before income taxes consists of the following: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10--INCOME TAXES (CONTINUED) Income (loss) before income taxes consists of the following: The provision for income taxes differs from the amount computed by applying the federal statutory income tax rate to income (loss) before income taxes. The sources and tax effects of the differences are as follows: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10--INCOME TAXES (CONTINUED) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31, 1999 and 1998 are as follows: At December 31, 1999, the Company had approximately $66.5 million, $209.1 million and $209.1 million of foreign, federal and state net operating loss carryforwards, respectively. The foreign and state net operating loss carryforwards expire at various dates beginning in 1999. The federal net operating loss carryforwards expire at various dates beginning in 2007. Income taxes paid amounted to $10.0 million, $4.7 million and $11.3 million in 1999, 1998 and 1997, respectively. The valuation allowance for deferred tax assets decreased by $12.7 million in 1999 and $17.4 million in 1998 and increased by $133.4 million in 1997. The net deferred tax asset of $5.5 million at December 31, 1999 represents the tax effect of net operating loss carryforwards existing in certain foreign jurisdictions that the Company believes are more likely than not to be realized, based on the earnings in those jurisdictions. Subsequently recognized tax benefits relating to the valuation allowance for deferred tax assets at December 31, 1999 will be as follows: INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--BUSINESS COMBINATIONS On November 30, 1999, the Company reached a definitive agreement (the "Ardent Agreement") to acquire Ardent Software, Inc. ("Ardent"), the leading provider of data integration infrastructure software for data warehouse, business intelligence, and e-business applications. In accordance with the Ardent Agreement, 3.5 shares of the Company's common stock will be exchanged for each outstanding Ardent share and the Company will assume all outstanding Ardent options. The transaction is expected to be accounted for as a pooling of interests and completion of the transaction, which is subject to the approval of stockholders of both companies, is expected to occur in the first quarter of 2000. On October 8, 1999, the Company completed its acquisition of Cloudscape, a privately-held provider of synchronized database solutions for the remote and occasionally connected workforce. In the acquisition, the former shareholders of Cloudscape received shares of the Company's Common Stock in exchange for their shares of Cloudscape at the rate of approximately 0.56 shares of Informix Common Stock for each share of Cloudscape Common Stock (the "Merger"). An aggregate of 9,583,000 shares of Informix Common Stock were issued pursuant to the Merger, and an aggregate of 417,000 options and warrants to purchase Cloudscape Common Stock were assumed by Informix. The Company recorded a charge of $2.8 million for accrued merger and integration costs. This amount included $1.2 million for financial advisor, legal and accounting fees related to the merger and $1.6 million for costs associated with combining the operations of the two companies including expenditures of $0.7 million for severance and related costs, $0.4 million for closure of facilities and $0.5 million for the write-off of redundant assets and other costs. As of December 31, 1999, $1.1 million had been paid for financial advisor, legal and accounting fees, $0.2 million had been paid for severance and related costs and $0.2 million had been charged for the write-off of redundant assets. The Merger was accounted for as a pooling-of-interests combination and, accordingly, the consolidated financial statements for periods prior to the combination have been restated to include the accounts and results of operations of Cloudscape. The results of operations previously reported by the separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized below. No adjustments were necessary to conform accounting policies of the combined entities. On December 31, 1998, the Company acquired Red Brick Systems, Inc. ("Red Brick"), a provider of scalable decision support solutions for data warehousing, data marts, OLAP and data mining. Under terms INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--BUSINESS COMBINATIONS (CONTINUED) of the acquisition, the Company issued approximately 7.6 million shares of its Common Stock in exchange for all outstanding shares of Red Brick Common Stock. In addition, the Company issued options to purchase approximately 2.5 million shares of the Company's Common Stock in exchange for outstanding unvested options to purchase Red Brick common stock. The acquisition was accounted for using the purchase method of accounting, and a summary of the purchase price for the acquisition is as follows (in thousands): The purchase price was allocated as follows: In-process research and development represents the fair value of technologies acquired for use in the Company's own development efforts. The Company determined the amount of the purchase price to be allocated to in-process research and development based on an independent appraisal of certain intangible assets which indicated that approximately $2.6 million of the acquired intangible assets consisted of in-process research and development that had not yet reached technological feasibility and had no alternative future uses. Accordingly, the Company recorded a charge to operations of $2.6 million in the fourth quarter of fiscal 1998. The remaining intangible assets acquired, with an assigned value of approximately $35.2 million, were included in "Intangible Assets" in the accompanying consolidated balance sheets, and are being amortized over three to five years. Accrued merger and integration costs recorded in connection with the acquisition of Red Brick included approximately $1.6 million for severance and other acquisition-related costs, $4.7 million for costs associated with the shutdown and consolidation of the Red Brick facilities and $1.6 million for costs associated with settling acquired royalty commitments for abandoned technology. As of December 31, 1999, $0.9 million had been paid for severance and other acquisition-related costs, $1.5 million had been paid for costs associated with the shutdown and consolidation of Red Brick facilities and $1.0 million had been paid to settle acquired royalty commitments for abandoned technology. During 1999, accrued merger and integration costs were reduced by $3.1 million, which resulted in a corresponding $3.1 million decrease INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11--BUSINESS COMBINATIONS (CONTINUED) in goodwill. These adjustments were the result of a decrease of approximately $2.3 million in the estimated costs associated with various former Red Brick facilities due to a change in the amount of sublease income to be received for such facilities, a decrease of approximately $0.7 million in severance-related costs and a decrease of $0.1 million in royalty commitments. The following pro forma finanacial information presents the combined results of operations of Informix and Red Brick as if the acquisition had occurred as of the beginning of 1998 and 1997, after giving effect to certain adjustments, including amortization of goodwill and excluding the write-off of acquired in-process research and development. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the two companies constituted a single entity during such periods. In February 1997, the Company acquired all of the outstanding capital stock of CenterView Software, Inc. ("CenterView"), a privately-owned company which develops and sells software application development tools. The aggregate purchase price paid was approximately $8.7 million, which included cash and direct acquisition costs. The transaction has been accounted for as a purchase and, based on an independent appraisal of the assets acquired and liabilities assumed, the purchase price has been allocated to the net tangible and intangible assets acquired, including developed software technology, acquired workforce, in-process technology, and goodwill. The in-process technology, which based on the independent appraisal has been valued at $7 million, had not, at the date of acquisition, reached technological feasibility and had no alternative future uses in other research and development projects. Consequently, its value was charged to operations in the first quarter of fiscal 1997, the period the acquisition was consummated. The remaining identifiable intangible assets are being amortized over three to five years. NOTE 12--LITIGATION Commencing in April 1997, a series of class action lawsuits purportedly by or on behalf of stockholders and a separate but related stockholder action were filed in the United States District Court for the Northern District of California. These actions name as defendants the Company, certain of its present and former officers and directors and, in some cases, its former independent auditors. The complaints allege various violations of the federal securities laws and seek unspecified but potentially significant damages. Similar actions were also filed in California state court and in Newfoundland, Canada. Stockholder derivative actions, purportedly on behalf of the Company and naming virtually the same individual defendants and the Company's former independent auditors, were also filed, commencing in August 1997, in California state court. While these actions allege various violations of state law, any monetary judgments in these derivative actions would accrue to the benefit of the Company. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12--LITIGATION (CONTINUED) Pursuant to Delaware law and certain indemnification agreements between the Company and each of its current and former officers and directors, the Company is obligated to indemnify its current and former officers and directors for certain liabilities arising from their employment with or service to the Company. This includes the costs of defending against the claims asserted in the above-referenced actions and any amounts paid in settlement or other disposition of such actions on behalf of these individuals. The Company's obligations do not permit or require it to provide such indemnification to any such individual who is adjudicated to be liable for fraudulent or criminal conduct. Although the Company has purchased directors' and officers' liability insurance to reimburse it for the costs of indemnification for its directors and officers, the coverage under its policies is limited. Moreover, although the directors' and officers' insurance coverage presumes that 100 percent of the costs incurred in defending claims asserted jointly against the Company and its current and former directors and officers are allocable to the individuals' defense, the Company does not have insurance to cover the costs of its own defense or to cover any liability for any claims asserted against it. The Company has not set aside any financial reserves relating to any of the above-referenced actions. On May 26, 1999, the Company entered into a memorandum of understanding regarding the settlement of pending private securities and related litigation against the Company. The settlement will resolve all material litigation arising out of the restatement of the Company's financial statements that was publicly announced in November, 1997. In accordance with the terms of the memorandum of understanding, the Company paid approximately $3.2 million in cash during the second quarter of 1999 and an additional amount of approximately $13.8 million of insurance proceeds was contributed directly by certain insurance carriers on behalf of certain of the Company's current and former officers and directors. The Company will also contribute a minimum of 9 million shares of the Company's common stock, which will have a guaranteed value of $91 million for a maximum term of one year from the date of the final approval of the settlement by the courts. The Company's former independent auditors, Ernst & Young LLP, will pay $34 million in cash. The total amount of the settlement, which has received final approval from both the federal and state courts will be $142 million. In July 1997, the Securities and Exchange Commission ("SEC") issued a formal order of private investigation of the Company and certain unidentified other entities and persons with respect to non-specified accounting matters, public disclosures and trading activity in the Company's securities. During the course of the investigation, the Company learned that the investigation concerned the events leading to the restatement of the Company's financial statements, including fiscal years 1994, 1995 and 1996, that was publicly announced in November 1997. The Company and the SEC have entered into a settlement of the investigation as to the Company. Pursuant to the settlement, the Company consented to the entry by the SEC of an Order Instituting Public Administrative Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease and Desist Order (the "Order"). The Order was issued by the SEC on January 11, 2000. Pursuant to the Order, the Company neither admitted nor denied the findings, except as to jurisdiction, contained in the Order. The Order directs the Company to cease and desist from committing or causing any violation, and any future violation, of Section 17(a) of the Securities Act of 1933 ("Securities Act"), and Sections 10(b), 13(a) and 13(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and Rules 10b-5, 12b-20 13a-1, 13a-13 and 13b2-1 under the Exchange Act. Pursuant to the Order, the Company also is required to cooperate in the SEC's continuing investigation of other entities and persons. As a consequence of the issuance of the Order, the Company is statutorily disqualified, pursuant to Section 27A(G)(1)(A)(ii) of the Securities Act and Section 21E(b)(1)(A)(ii) of the Exchange Act, for a INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12--LITIGATION (CONTINUED) period of three years from the date of the issuance of the Order, from relying on the protections of the "safe harbor" for forward-looking statements set forth in Section 27(A)(c) of the Securities Act and Section 21(E)(c) of the Exchange Act. EXPO 2000 filed an action against Informix Software GmbH (the Company's German subsidiary) in the Hanover (Germany) district court in September 1998 seeking recovery of approximately $6.0 million, plus interest, for breach of a sponsorship contract signed in 1997. Informix filed a counterclaim for breach of contract and seeks recovery of approximately $3.1 million. During settlement negotiations prior to the filing of the action, EXPO 2000 stated that it would accept approximately $2.5 million to settle. In March 1999, a panel of three judges appointed by the court recommended a settlement pursuant to which EXPO 2000 and Informix would release the other from all claims. EXPO 2000 declined to accept the recommendation. In August 1999, the court entered a judgment against Informix in the amount of approximately $6.0 million, although approximately $2.1 million of judgment is conditioned upon the return to Informix by EXPO 2000 of certain software. Informix has filed an appeal. The Company has reserved $2.5 million for the expected outcome of the appeal. On February 3, 2000, International Business Machines Corporation ("IBM") filed an action against us in the United States District Court for the District of Delaware alleging infringement of six United States patents owned by IBM. The Informix products that IBM alleges infringe its patents are Informix Online Dynamic Server versions 5, 6 and 7, Informix SE version 6, Informix NewEra version 1, Informix NET, Informix STAR, Illustra Visual Information Retrieval, and Illustra Visual Intelligence Viewer. In its complaint, IBM seeks a permanent injunction against further alleged infringement, unspecified compensatory damages, unspecified treble damages, and interest, costs and attorneys' fees. We strongly believe that the allegations in the complaint are without merit and intend to defend the action vigorously and to assert such counterclaims against IBM as may be appropriate. From time to time, in the ordinary course of business, the Company is involved in various legal proceedings and claims. The Company does not believe that any of these proceedings and claims will have a material adverse effect on the Company's business or financial condition. NOTE 13--NONRECURRING CHARGES In accordance with Statement of Financial Accounting Standards No. 121 (SFAS 121), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," the Company records impairment losses on long-lived assets used in its operations when events and circumstances indicate that the assets might be impaired and the estimated future undiscounted cash flows to be generated by those assets are less than the assets' carrying amounts. During the first quarter of 1997, the Company's Japanese subsidiary experienced a significant shortfall in business activity compared to historical levels. Accordingly, the Company evaluated the ongoing value of the subsidiary's long-lived assets (primarily computer and other equipment) and goodwill. Based on this evaluation, the Company determined that the subsidiary's assets had been impaired and wrote them down by $30.5 million to their estimated fair values. Fair value was determined using estimated future discounted cash flows and/or estimated resale values as appropriate. In February 1997, the Company acquired CenterView Software (see Note 11) and, as a direct result, revised its database application tool business strategy to incorporate CenterView's developed technology and "Data Director" product. This revision to the tools business strategy significantly altered the Company's current and future marketing plans for its own NewEra family of application tools, including INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13--NONRECURRING CHARGES (CONTINUED) projected future NewEra product revenues. As a result, the Company reevaluated the net realizable value of its NewEra products and found it to be significantly below the net balance of related capitalized software development costs. Accordingly, the Company recorded a charge during the first quarter 1997 of $14.7 million to reduce the carrying value of these capitalized product development costs to the revised estimated net realizable value of the NewEra products. In June 1997 and again in September 1997, the Company approved plans to restructure its operations in order to bring expenses in line with forecasted revenues. In connection with these restructurings, the Company substantially reduced its worldwide headcount and consolidated facilities and operations to improve efficiency. The following analysis sets forth the significant components of the restructuring expense charge and adjustments to restructuring expense included in the Company's consolidated statements of operations for the years ended December 31, 1999, 1998 and 1997 as well as the significant components of the restructuring reserve at December 31, 1999 (in millions): Severance and benefits represent the reduction of approximately 670 employees, primarily sales and marketing personnel, on a worldwide basis. Temporary employees and contractors were also reduced. Write-off of assets include the write-off or write-down in carrying value of equipment as a result of the Company's decision to reduce the number of Information Superstores throughout the world, as well as the write-off of equipment associated with headcount reductions. The equipment subject to the write-offs and write-downs consisted primarily of computer servers, workstations, and personal computers that are no longer utilized in the Company's operations. Facility charges include early termination costs associated with the closing of certain domestic and international sales offices. For the years ended December 31, 1999 and 1998, the Company recorded restructuring-related adjustments to decrease restructuring expense by $0.6 million and $10.3 million, respectively, primarily due to adjusting the estimated severance and facility charges to actual costs incurred. The Company has substantially completed actions associated with its restructuring except for subleasing or settling its remaining long-term operating leases related to vacated properties. The terms of such operating leases expire at various dates through 2003. INFORMIX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 14--COMPREHENSIVE INCOME (LOSS) On January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive Income," which establishes standards for displaying comprehensive income and its components. The components of accumulated other comprehensive income (loss) consist of the following items: The tax effect on components of comprehensive income (loss) is not significant. NOTE 15--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging Activities," which establishes standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS 133 is effective for fiscal years beginning after June 15, 2000. Earlier application of SFAS 133 is encouraged but should not be applied retroactively to financial statements of prior periods. The Company is currently evaluating the requirements and impact of SFAS 133. INFORMIX CORPORATION SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS - ------------------------ (1) Uncollectible accounts written off, net of recoveries (2) Allowance for doubtful accounts acquired from Cloudscape in 1999 and Red Brick in 1998 (Note 11) EXHIBIT INDEX - ------------------------ (1) Filed herewith (2) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1 (333-43991) (3) Incorporated by reference to exhibits filed with the Registrant's quarterly report on Form 10-Q for the fiscal quarter ended July 2, 1995 (4) Incorporated by reference to exhibits filed with the Registrant's report on Form 8-K filed with the Commission on August 25, 1997 (5) Incorporated by reference to exhibits filed with the Registrant's report on Form 8-K filed with the Commission on December 4, 1997 (6) Incorporated by reference to exhibits filed with the amendment to the Registrant's Registration Statement on Form 8-A/A (File No. 000-15325) filed with the Commission on September 3, 1997 (7) Incorporated by reference to exhibits filed with the amendment to the Registrant's Registration Statement on Form 8-A/A (File No. 000-15325) filed with the Commission on December 3, 1997 (8) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1 (File No. 33-8006) (9) Incorporated by reference to exhibit filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1988 (10) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 33-31116) (11) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 33-50608) (12) Incorporated by reference to exhibits filed with Registrant's Registration Statements on Form S-8 (File Nos: 33-22862, 33-31117 and 33-506-10) (13) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 333-31369) filed with the Commission on July 16, 1997 (14) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File No. 333-31371) filed with the Commission on July 16, 1997 (15) Incorporated by reference to exhibits filed with the Registrant's quarterly report on Form 10-Q for the fiscal quarter ended September 28, (16) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1989 (17) Incorporated by reference to exhibits filed with Registrant's report on Form 8-K filed with the Commission on December 2, 1997 (18) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1986 (19) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1991 (20) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1992 (21) Incorporated by reference to exhibits filed with Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1993 (22) Incorporated by reference to exhibits filed with the Registrant's amendment to its annual report on Form 10-K/A for the fiscal year ended December 31, 1996 filed with the Commission on November 18, 1997 (23) Incorporated by reference to exhibits filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1996 (24) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 (File no. 333-61843) filed with the Commission on August 19, 1998. (25) Incorporated by reference to exhibits filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1997. (26) Incorporated by reference to exhibits filed with the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1998.

277356_1999.txt

277356_1999

1999

277356

ITEM 1. BUSINESS. Riverside Group, Inc., a Florida corporation formed in 1965 ("Riverside", also "Parent Company"), is a holding company focused through its wholly-owned subsidiary, Cybermax, Inc. ("Cybermax") on providing e-commerce solutions to the building industry, as well as web software application development and hosting services. The Company also is engaged in the supply and distribution of building materials through its 36%- owned subsidiary, Wickes Inc. ("Wickes") and its 47%-owned subsidiary, Buildscape, Inc. ("Buildscape"). Wickes is a leading supplier and manufacturer of building materials in the United States, with 101 sales and distribution facilities and 25 manufacturing facilities located in 23 states. Buildscape provides e-commerce services and building-related content to the home building professional as well as consumers. Unless the context indicates otherwise, the term "the Company" as used herein refers to Riverside and its subsidiaries. HISTORICAL DEVELOPMENT From 1986 through the first half of 1996, Riverside conducted life and property and casualty insurance operations. The property and casualty insurance operations were discontinued in 1993 and sold in September 1995. Riverside began disposing of its life insurance operations at the end of 1994 and in June 1996 completed a merger of its remaining life insurance operations with a third party that resulted in the ownership by Riverside of a non-controlling interest in the third party. Riverside disposed of this interest on December 31, 1997. Riverside obtained its initial investment in Wickes in 1990 through the acquisition of American Founders Life Insurance Company, which at the time of its acquisition owned approximately 10% of Wickes' common stock. In 1993, as part of a Wickes recapitalization plan, including an initial public common stock offering, Riverside increased its beneficial ownership of Wickes' common stock to approximately 36%. On June 20, 1996, Riverside purchased from Wickes 2,000,000 newly-issued shares of Wickes' common stock for $10,000,000 in cash. In 1998 and early 1999, Riverside sold 1,151,900 shares of its Wickes' common stock. As of March 15, 2000, Riverside beneficially owns 3,000,513 shares of Wickes' common stock, which constitutes 36% of Wickes' outstanding voting and non-voting common stock. See "Wickes." In January 1998, Riverside formed various operating subsidiaries, which acquired certain e-commerce and advertising operations from Wickes. In October of 1999, the Company decreased its ownership in Buildscape to 47%. See "Buildscape". In February 1998, Riverside acquired the assets of Cybermax from a third party. See "Cybermax". LINES OF BUSINESS The following table sets forth certain financial data for the past three years for the following segments: Buildscape, Cybermax, Wickes and the Parent Group. Wickes' operations are consolidated with those of the Company and its subsidiaries for the first through the third quarter of 1998, all of 1997, and the third and fourth quarters of 1996. The Company accounted for its investment in Wickes' under the equity method for the fourth quarter of 1998 and all of 1999. Buildscape's operations are consolidated with those of the Company and its subsidiaries for all of 1998 and through October 21, 1999. The Company accounted for its investment in Buildscape under the equity method for the remainder of 1999. The "Parent Group" includes real estate, parent company, and discontinued operations and all eliminating entries for inter-company transactions. (1) After October 21, 1999, the Company's balance sheet and statements of operations reflect the Company's investment in Buildscape on the equity method. See Note 6 of Notes to the Company's Consolidated Financial Statements included elsewhere herein. (2) Prior to July 1, 1996 and after September 30, 1998, the Company's balance sheet and statements of operations reflect the Company's investment in Wickes on the equity method. See Note 3 of Notes to the Company's Consolidated Financial Statements included elsewhere herein. (3) Includes $1,407,000, $1,502,000, and $1,473,000 for an interest allocation from Riverside on its 13% subordinated notes and 11% secured notes for 1999, 1998 and 1997, respectively. INTERNET AND E-COMMERCE OPERATIONS Effective January 15, 1998, Riverside acquired certain operations of Wickes that Wickes had determined to discontinue as a result of Wickes' plan to streamline its operations and focus primarily on its core professional builder business. The operations transferred include e-commerce and advertising on the Internet. The consideration given or to be given by Riverside to Wickes in the transaction consists of Riverside's three-year $871,844 unsecured promissory note and future payments of ten percent of the transferred operations' net income (subject to a maximum of $430,000). In connection with this acquisition, Riverside established various operating subsidiaries to conduct businesses acquired from Wickes, as well as related operations. Buildscape was established to provide e-commerce and advertising services for the building materials industry on the Internet. Cybermax was established to provide e-commerce solutions to the building industry, as well as software application development and hosting services. BUILDSCAPE The Company provides services to the e-commerce market through its 47%-owned subsidiary, Buildscape. For a description of the reduction by the Company of its percentage ownership in the fourth quarter of 1999, in connection with a Buildscape financing, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Buildscape markets home building related content, service and commerce online to the home building industry consumer and professional. To better serve differing needs within the home building marketplace, Buildscape is creating two separate online communities. Www.buildscape .com is a consumer site and www.buildscapepro.com is targeted toward the home building professional. There are no member fees to use either of Buildscape's web sites. CHANNELS OF BUILDSCAPE.COM Buildscape.com, the consumer site, consists of four basic channels and provides content, service and commerce, as follows: SUPERSTORE. Through relationships with affiliate distributors, manufacturers, and suppliers, Buildscape's online store offers over 65,000 products available for direct shipment within the 48 contiguous United States. A percentage of product sales revenue is shared between Buildscape and its affiliates. AUCTION. For a pre-negotiated fee, sellers are able to post products online. Interested buyers are able to bid for and purchase these products using Buildscape's online auction site. RESOURCES. Home building related content is available online at no charge and includes in- depth stories, industry news, product reviews, design ideas and tips from qualified industry professionals as well as a database of building professionals searchable by geographic area and specialty. Consumers can also apply for online home mortgages and purchase house plans. Buildscape has completed agreements with web affiliates Prism Mortgage, Hanley Wood and Improvenet. Prism Mortgage hosts an online residential mortgage loan service whereby Buildscape receives a fee for each closed loan that originates from Buildscape's web site. Hanley Wood provides relative content directly to Buildscape and hosts a separate site for house plans purchasable online, whereby Buildscape is paid a percentage of house plan sales it generates through the web site. Improvenet hosts an online customer/contractor project matching service whereby Buildscape receives a fee for each project that originates from Buildscape's web site. Both companies pay monthly fees to share banner add and direct advertisements between their respective web sites. INTERACT. Building professionals and do-it-yourselfers can post industry related questions and answers at no charge on Buildscape's message board. Questions and answers are sorted by topic and date and remain on the message boards for future reference by users. BUILDSCAPEPRO.COM Buildscape's newly launched web site, buildscapepro.com, is designed to provide a range of supply chain, construction material procurement and project execution solutions for affiliate lumberyards and their customers. A separate buildscapepro.com site will be tailored specifically to each affiliate lumberyard's available product line and local pricing. Buildscapepro.com will provide all the features of Buildscape.com, as well as features designed for the building professional. In addition to the lumberyard's onsite inventory, customers will be able to order over 100,000 direct ship items that can be shipped to their local lumberyard for delivery or pick-up. For all products purchased online through buildscapepro.com, Buildscape will receive a variable percentage of gross- margin depending on whether the product is available through the local lumberyard or Buildscape's direct ship national catalog. Buildscape.com has begun pilot operations through an agreement reached in early 2000 with Wickes. Development pilot projects are underway under this agreement with Wickes in Pensacola, Florida, and Pascagoula, Mississippi. During 2000, Buildscape intends to complete its pilot program with Wickes and, subject to finalization of terms with Wickes, to begin implementation of the program in each of Wickes' approximately 100 sales and distribution facilities. Buildscape is also attempting to reach pilot program agreements with other major buildings materials chains with the goal of establishing a nationwide system of affiliate lumberyards. OTHER SERVICES In addition to offering items found on the complete bill of materials for a construction project, additional online services and content will be accessible through a variety of interfaces, including Internet presence and wireless personal digital assistance (" PDA") technology, as well as phone and facsimile; all of which improve the way lumberyards and their customers do business. COMPETITION Buildscape competes primarily with numerous other Internet companies who provide content and commerce services to the home building products market, many of which possess greater financial resources than Buildscape. E-commerce in the building industry is in the development stage, but the Company believes that Buildscape, through its relationship with the Company and Wickes possess a significant competitive advantage. CYBERMAX In February 1998, Riverside acquired from a third party the assets of Cybermax. Cybermax is a professional services company specializing in e-business solutions encompassing commerce/web development, networking, multimedia, marketing and promotional services to enable Cybermax's clients to meet their e-business objectives. Cybermax generated sales of approximately $1,171,000 in 1999 compared to sales of approximately $486,000 in 1998. In 1998, these operations were in the start-up phase. One customer accounted for approximately 53% of these sales in 1999 and 40% in 1998. MARKET DIFFERENTIATION Cybermax has several unique market differentiators to distinguish itself from traditional Information Technology ("IT") professional services and web development competitors. They are: INDUSTRY SPECIFIC FOCUS Cybermax has established itself as a competitor in e-commerce solutions to the building industry. This focus includes manufacturers, distributors/ jobbers, mass-merchandisers, retailers, builders, professional tradespeople and trade associations. Cybermax seeks to continue to leverage its position in the building industry to expand into other vertical markets. CROSS INDUSTRY APPLICATIONS Cybermax has developed multiple business applications that can be deployed across multiple industries to expand market reach and growth. DEVELOPMENT OF A PACKAGED ENTERPRISE SUPPLY CHAIN ENGINE Leveraging features and functions designed by Cybermax and built into various websites. Cybermax has developed a very powerful proprietary transaction engine, coupled with a core set of business-to-business open-architected applications capable of addressing customer driven requirements anytime, any place, using any multiple of business rules and policies. This "engine" can be used to power numerous e-business applications for a broad cross industry segment. CUSTOMERS Cybermax has built numerous "high profile" electronic commerce solutions for industry. To date, Cybermax has developed over 200 web sites that are commerce enabled. With the background and momentum Cybermax has created during the past year, Cybermax is poised to re-launch itself through an aggressive marketing communications program utilizing trade and industry analyst outlets, Internet, print and collateral advertising promotion. PRODUCTS AND SERVICES As an e-commerce solutions provider, Cybermax offers a full array of consulting and technical support services divided over five service areas - e-business solutions, network services, multimedia solutions, promotional services, and marketing programs. These product and service groups can be offered individually or combined to create a full-service offering to address the most demanding needs of an e-Commerce customer, from the initiation of an e-Commerce strategy all the way through development and service deployment. E-BUSINESS SOLUTIONS Cybermax's e-Business Solutions division is the "front-end" group for business development and maintenance of client relationships at the account level. All other business units within the entity will function in a service-support role to the consulting unit. E-BUSINESS OFFERING Within e-business solutions, Cybermax offers a broad range of custom and packaged services including: CUSTOM WEB SITE DEVELOPMENT Cybermax will continue to seek out custom web site development incorporating full- commerce capabilities. This area is Cybermax's core competency and primary revenue resource. Custom developed sites encompass Internet (customers), Intranet (employees) and extranet (partners and suppliers) features and functions, tied to comprehensive back office application modules. COMMERCE VALUE WEB SITES Commerce Value Web sites is the name applied to a group of prepackaged templated web site designs offered for a fixed-cost price. This is a low-cost, high value offering providing each customer a professionally designed web site for a fraction of the cost of a custom site. Cybermax also packages an online Web Wizard Template, which allows the customer to maintain his/her own site content and graphics without any knowledge of programming or web development. PACKAGED COMMERCE STORE The Cybermax Private Store module enables customers to create and populate their own online virtual stores, from which they can sell and promote a diverse assortment of goods and services. This store can also be customized to provide Intranet and extranet functionality for administration and restricted password-protected access for select customers. The Private Store module contains a shopping basket and online payment options via credit card or open account billing capture. Shipping modules for package delivery are also available as part of the store functionality. NETWORK SERVICES OFFERINGS Cybermax offers a full range of network services providing customers one-stop shopping for Internet/web access, e-mail messaging and web hosting services. These network services sold separately and in combination with Cybermax's e-business solutions extend the resources and revenues that can be derived from Cybermax's customers, providing cross-selling and up-selling opportunities for Cybermax. DIAL AND DEDICATED ACCESS SERVICES Cybermax offers national Internet service access via a number of local access points-of- presence ("POP"). These low speed (56kbps) circuits offer unlimited Internet access for a monthly fee. Internet access fees include one e-mail account address per customer inclusive in the monthly service fee and additional e-mail accounts can be ordered at extra cost. WEB HOSTING SERVICES Web hosting is an integral part of web development through Cybermax's Network Services business unit. Hosting allows Cybermax to develop customer sites online, where the client - regardless of business locale - can view and critique site development as it unfolds. With Cybermax's ability to host sites it creates, Cybermax can also manage, maintain and modify sites quickly and supply support whenever the need arises seven days a week, 24 hours a day. MESSAGING SERVICES E-mail messaging allows commerce site customers to communicate with customers immediately at little or no incremental cost (included in web site hosting and ISP access accounts). CUSTOMER SUPPORT SERVICES Cybermax performs customer service support for its ISP and web hosting customers. In 2000, Cybermax seeks to expand its customer services support for partner customers such. COMPETITION The web design and internet service provider businesses each have become highly competitive. Cybermax, however, has specialized in building Extranets/E-Commerce Web sites for participants in the building industry. The Company believes that this provides Cybermax with a significant competition advantage. WICKES The Company retails and distributes building materials through its 36%-owned subsidiary Wickes. For a description of the reduction by the Company of its percentage ownership in Wickes during 1998 and early 1999, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations". The information concerning Wickes contained in this report was obtained from Wickes' Annual Report on Form 10-K for the fiscal year ended December 25, 1999 (the "Wickes Form 10- K"), filed by Wickes with the Securities and Exchange Commission (the "Commission"). For further information concerning Wickes, reference is made to the Wickes Form 10-K and the periodic reports and other information filed by Wickes with the Commission. Wickes is a leading supplier and manufacturer of building materials in the United States. Wickes sells its products and services primarily to residential and commercial building professionals, repair and remodeling ("R&R") contractors and, to a lesser extent, project do-it- yourselfer consumers ("DIYers") involved in major home improvement projects. At February 29, 2000, the Company operated 101 sales and distribution facilities in 23 states in the Midwest, Northeast, and South and 25 component manufacturing facilities that produce and distribute roof and floor trusses, framed wall panels, and pre-hung door units. INDUSTRY OVERVIEW According to the Home Improvement Research Institute ("HIRI") (an independent research organization for manufacturers, retailers and wholesalers allied to the home improvement industry), sales of home improvement products (defined as lumber, building materials, hardware, paint, plumbing, electrical, tools, floor coverings, glass, wallpaper, and lawn and garden products) associated with the maintenance and repair of residential housing and new home construction were estimated to be $248.6 billion in 1999. Despite some consolidation over the last ten years, particularly in metropolitan areas, the building material industry remains highly fragmented. Wickes believes that no building material supplier accounted for more than 15.4% of the total market in 1999. In general, building material suppliers concentrate their marketing efforts either on building professionals or consumers. Professional-oriented building material suppliers, such as Wickes, tend to focus on single-family residential contractors, R&R contractors, project DIYers and, to some extent, commercial contractors. These suppliers compete principally on the basis of service, product assortment, price, scheduled job-site delivery and trade credit availability. In contrast, consumer- oriented building material retailers target the mass consumer market, where competition is based principally on price, merchandising, location and advertising. Consumer-oriented warehouse and home center retailers typically do not offer as wide a range of services, such as specialist advice, trade credit, manufactured components, and scheduled job-site delivery, as do professional-oriented building material suppliers. Industry sales are linked to a significant degree to the level of activity in the residential building industry, which tends to be cyclical and seasonal due to weather. New residential construction is determined largely by household formations, interest rates, housing affordability, availability of mortgage financing, regional demographics, consumer confidence, job growth, and general economic conditions. According to the U.S. Bureau of the Census, U.S. housing starts totaled 1.35 million in 1995, 1.48 million in 1996, 1.47 million in 1997, 1.62 million in 1998, and increased to 1.66 million in 1999. The Blue Chip Economic Indicators Consensus Forecast, dated March 10, 2000, projects 2000 housing starts to be 1.58 million, down slightly from 1999. Housing starts in Wickes' primary geographical market, the Midwest, increased 7.9% in 1999. Wickes' two other geographical markets, the Northeast and South, experienced increases in 1999 housing starts of 3.4% and 2.5%, respectively. Nationally, single family housing starts, which generate the majority of Wickes' sales to building professionals, increased by 4.7% from 1.27 million starts in 1998 to 1.33 million starts in 1999. Repair and remodeling expenditures tend to be less cyclical than new residential construction. These expenditures are generally undertaken with less regard to economic conditions, but both repair and remodeling projects (including projects undertaken by DIYers) tend to increase with increasing sales of both existing and newly constructed residences. HIRI estimates that sales of home improvement products to repair and remodeling professionals represented $40.5 billion, or approximately 16.3% of total 1999 sales of the building material supply industry, while direct sales to DIYers amounted to $122.4 billion. BUSINESS STRATEGY Wickes' mission is to be the premier provider of building materials and services and manufacturer of value-added building components to the professional segments of the building and construction industry. Wickes is streamlined and goal-oriented, focusing on the professional builder and contractor market. Wickes targets five customer groups: the production or volume builder; the custom builder; the tradesman; the repair and remodeler; and the commercial developer. Its marketing approach encompasses three channels of distribution: Major Markets, Conventional Markets, and Wickes Direct. These channels are supported by Wickes network of building components manufacturing operations. In Major Markets, Wickes serves the national, regional, and large local builder in larger markets with a total solutions approach and specialized services. In Conventional Markets, Wickes provides the smaller building professional in less-populous markets with tailored products and services. Wickes Direct provides materials flow and logistics management services to commercial customers. Wickes also serves building professionals through its network of 25 component manufacturing facilities that produce value-added, wood framed wall panels, roof and floor truss systems, and pre-hung interior and exterior doors. Wickes announced its "Build 2003" program in 1999 as part of Wickes initiative to build public awareness of its corporate goals. Using 1998 results as a performance baseline, management outlined seven objectives it aims to achieve by the end of 2003: (1) Minimum sales growth of 6% annually: Wickes achieved a 19.2% sales gain in 1999 and same store sales growth of 18.1%. (2) Internally manufacture 75% of wall panel, roof truss, floor deck and prehung door needs: Wickes made steady progress in 1999, internally producing 46% of these building components in 1999, up from the 40% level achieved in 1998. (3) Increase EBITDA (see Part II, Item 6 for definition) as a percentage of net sales by a minimum 25%: Wickes generated EBITDA as a percentage of net sales (before gains on sale of fixed assets) of 3.80% in 1999, a strong improvement from the 3.34% achieved in 1988. (4) Improve debt-to-equity ratio and achieve 1:1 debt-to-equity by year-end 2003: Wickes improved this leverage ratio in 1999 to a 7.2:1 ratio from 8.3:1 at the end of 1998. (5) Generate a return on capital in excess of its peer group: Wickes' 14.4% return on capital employed in 1999 was well above the estimated 8.5% average of its publicly traded, building materials distribution peer group. (6) Extend its earnings season: Wickes achieved positive EBITDA of $1.6 million in the first quarter 1999 after reporting slightly negative EBITDA in the same period of 1998. (7) Provide consistency in earnings growth: Wickes has demonstrated seven consecutive quarters of earnings growth. CUSTOMERS Wickes has a broad base of customers, with no single customer accounting for more than 2.0% of net sales in 1999. In 1999, 93% (compared with 89% in 1998) of Wickes' sales were on trade credit, with the remaining 7% as cash and credit card transactions. HOME BUILDERS Wickes' primary customers are single-family home builders. In 1999, all home builder customers accounted for 62% of Wickes' sales, compared with 61% in 1998. The majority of Wickes' sales to these customers are of high-volume commodity items, such as lumber, building materials, and manufactured housing components. Wickes will continue its intense focus on this customer segment, offering new products and developing additional services to meet their needs. COMMERCIAL / MULTI-FAMILY CONTRACTORS Wickes Direct and Wickes International concentrate on sales to commercial contractors (primarily those engaged in constructing motels, restaurants, nursing homes, extended stay facilities, and similar projects) and multi-family residential contractors. Sales to these customers are made on a direct ship basis as well as through the Wickes' sales and distribution facilities. In 1999, sales to these customers accounted for approximately 19% of Wickes sales, compared with 17% in 1998. During 1999, Wickes integrated the Wickes Direct domestic program more closely with its manufacturing operations. REPAIR & REMODELERS In 1999, R&R customers accounted for approximately 9% of Wickes' sales, compared with 10% in 1998. The R&R segment consists of a broad spectrum of customers, from part-time handymen to large, sophisticated business enterprises. Some R&R contractors are involved exclusively with single product application, such as roofing, siding, or insulation, while some specialize in remodeling jobs, such as kitchen or bathroom remodeling or the construction of decks, garages, or full room additions. Wickes offers the product and project expertise, special order capability, design assistance, and credit terms to serve the widely varying needs of this diverse market. DIYERS Sales to DIYers (both project and convenience) represented about 10% of Wickes' sales in 1999, compared with 12% in 1998. The percentage of sales to DIYers varies widely from one sales and distribution facility to another, based primarily on the degree of local competition from warehouse and home center retailers. Wickes' sales and distribution facilities do not have the large showrooms or broad product assortments of the major warehouse or home center retailers. For small purchases, the showrooms serve as a convenience rather than a destination store. Consequently, Wickes' focus on consumer business is toward project DIYers -- customers who are involved in major projects such as building decks or storage buildings or remodeling kitchens or baths. PRODUCTS To provide its customers with the quality products needed to build, remodel and repair residential and commercial properties, Wickes offers a wide variety of building products, totaling approximately 63,000 SKUs Company wide and the ability to special order additional products. Wickes believes that these special order services are extremely important to its customers, particularly the building professional. In 1999, approximately 31% of Wickes' sales were of special order items, compared with 32% in 1998. Each of Wickes' sales and distribution facilities tailors its product mix to meet the demands of its local market. Approximately 5,500 SKUs are typically stocked in a particular sales and distribution facility. Wickes categorizes its products into four groups: Commodity Wood Products -- lumber, plywood, treated lumber, sheathing, wood siding and specialty lumber; Building Products -- roofing, vinyl siding, doors, windows, mouldings, drywall and insulation; Hardlines -- hardware products, paint, tools, kitchen and bathroom cabinets, plumbing products, electrical products, light fixtures and floor coverings; and Manufactured Housing Components -- roof and floor trusses, and interior and exterior wall panels. Commodity Wood Products, Building Products, Hardlines, and Manufactured Housing Components represented 37%, 34%, 10% and 19%, respectively, of Wickes' sales for 1999 and 44%, 36%, 10% and 10%, respectively, of sales for 1998. MANUFACTURING Wickes owns and operates 25 component manufacturing facilities that supply Wickes' customers with higher-margin, value-added products such as framed wall panels, roof and floor trusses, and pre-hung interior and exterior doors. These facilities include 17 stand alone operations as well as eight additional operations that exist at Wickes' sales and distribution facilities. These manufacturing operations enable Wickes to serve the needs of its professional customers for such quality, custom-made products. In 1999, Wickes' manufacturing operations supplied approximately 46% of the pre-hung doors, roof trusses, wall panels, and floor decks sold by the Wickes. Wickes believes that these value-added, engineered manufactured products improve customer service and provide an attractive alternative to job-site construction. As resources permit, Wickes plans to expand its manufacturing facilities to take advantage of these increased opportunities and to supply a greater number of its sales and distribution facilities with these products. SUPPLIERS AND PURCHASING Wickes purchases its products from numerous vendors. The great majority of commodity items are purchased directly from manufacturers, while the remaining products are purchased from a combination of manufacturers, wholesalers and other intermediaries. No single vendor accounted for more than 4.4% of Wickes' purchases in 1999, and Wickes is not dependent upon any single vendor for any material product. Wickes believes that alternative sources of supply are readily available for substantially all of the products it offers. The great majority of Wickes' commodity purchases are made on the basis of individual purchase orders rather than supply contracts. In certain product lines, though, Wickes has negotiated some advantageous volume pricing agreements for a portion of the product line's purchases. Because approximately 34% of Wickes' average inventory consists of commodity wood products and manufactured housing components, which are subject to price volatility, Wickes attempts to match its inventory levels to short-term demand in order to minimize its exposure to price fluctuations. In addition, Wickes enters into futures contracts to hedge longer term pricing commitments. Wickes has developed an effective coordinated purchasing program that allows it to minimize costs through volume purchases, and Wickes believes that it has greater purchasing power than many of its smaller, local independent competitors. Wickes seeks to develop close relationships with its suppliers in order to obtain favorable pricing and service arrangements. Wickes' computerized inventory tracking and forecasting system, as part of its inventory replenishment system, is designed to track and maintain appropriate levels of products at each sales and distribution facility. These systems have increased Wickes' operating efficiencies by providing an automated inventory replenishment system. Wickes has active rail sidings at 60 of its sales and distribution and manufacturing facilities, enabling suppliers to ship products purchased by Wickes directly to these facilities by rail. Wickes also utilizes one distribution center owned by a third party, located in Chicago, Illinois, through which approximately 2% of Wickes' wood products inventory is delivered. SEASONALITY Historically, Wickes' first quarter and, occasionally, its fourth quarter are adversely affected by weather patterns in the Midwest and Northeast, that result in seasonal decreases in levels of construction activity in these areas. The extent of such decreases in activity is a function of the severity of winter weather conditions. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." COMPETITION The building material industry is highly competitive. Due to the fragmented nature of the industry, Wickes' competitive environment varies by location and by customer segment. Reduced levels of construction activity have, in the past, resulted in intense price competition among building material suppliers that has, at times, adversely affected Wickes' gross margins. Within the building professionals market, Wickes competes primarily with local independent lumber yards and regional and local building material chains. Building professionals generally select building material suppliers based on price, job site delivery, quality and breadth of product lines, reliability of inventory levels, and the availability of credit. Wickes believes that it competes favorably on each of these bases. Wickes believes that it has a significant competitive advantage in rural markets and small communities, conventional markets, where it competes primarily with local independent lumber yards, regional building material chains, and, to a lesser extent, with national building center chains and warehouse and home center retailers, which generally locate their units in more densely populated areas. In Major Markets Wickes believes that its total package of services and ability to serve the large builder provides it with a competitive advantage. OTHER OPERATIONS INVESTMENT IN GREENLEAF As of September 30, 1998, the Company entered into and completed an agreement with Greenleaf Technologies Corporation ("Greenleaf"), based in Iselin, New Jersey, whereby the Company acquired common shares of Greenleaf in exchange for 100% of the common stock of a former wholly owned subsidiary of the Company. In January 2000, the Company and Greenleaf settled a dispute covering the terms of this transaction. Giving effect to the settlement, the Company received 10,000,000 shares of Greenleaf common stock and a five year option to acquire an additional 2,000,000 shares for an exercise price of $.25 per share. In addition, another 3,000,000 shares have been placed in escrow to be used to fund a mutually acceptable joint venture related to technology and interest, related products to be owned in equal amounts by Greenleaf and the Company. See Note 5 to the Consolidated Financial Statements included elsewhere herein. At April 12, 2000, the calculated market value of the Company's investment in Greenleaf was approximately $24.1 million based on Greenleaf's stock price of $2.81 per share on the Over- the-Counter Bulletin Board. The calculated value has been determined by multiplying 13,500,000 shares owned and under option by the Company less 73,413 options given to employees of the Company by the stock price listed on the Over-the-Counter Bulletin Board on that date. During the first quarter of 2000, Greenleaf's stock has traded with an average weekly volume of 176,100 shares to 2,084,900 shares. Greenleaf develops and markets encryption services designed for the software and entertainment industries including games, applications and music. Greenleaf's innovative software security protection offers new ways to bundle and distribute PC-based content on advanced media including DVD-ROM and the Internet. The information concerning Greenleaf contained in this report was obtained from Greenleaf's Form 10-SB filed on November 15, 1999 ("the Greenleaf Form 10-SB"), filed by Greenleaf with the Securities and Exchange Commission (the "Commission"). On February 23, 1999, Greenleaf announced that it had reached an Agree- ment with Accolade Inc., now known as Infogrames North America ("Infogrames") and Warner Advanced Media Operations ("Warner"), a business unit of Time Warner Inc.) (NYSE: TWX), to form a joint venture referred to as "WAG". Under the WAG banner, the three companies will join to market multiple computer game titles on a single DVD disc for distribution to the personal computer Original Equipment Manufacturers ("OEM") market. The DVD software will be encrypted by the Company utilizing its proprietary "DigiGuard(TM)" security technology. On May 6, 1999, Greenleaf announced that it would debut the Accolade Family Spectacular, the initial game bundle to be released by WAG, at the E3 Expo industry trade show. On August 30, 1999, the Company and Broadcast DVD, Inc. ("BroadcastDVD") announced a three-year, exclusive partnership to include BroadcastDVD's FILM- FEST, a video magazine that exposes viewers to prestigious film festivals of the world, in the DVD disc packages to be marketed by the WAG joint venture. Contents of the video magazine are currently anticipated to include interviews with The Blair Witch Project directors Daniel Myrick and Eduardo Sanchez, and filmakers and celebrities including Tim Roth, Eric Stoltz, Sheryl Crow, Guy Pearce and Robert Carlyle. Also expected to be included is an hour of award-winning short films from the latest film festivals. In September 1999, Greenleaf entered into an agreement to acquire all the outstanding shares of Future Com South Florida, Inc. ("Future Com") in exchange for 4,000,000 shares of Greenleaf's restricted common stock. Of these shares, 2,000,000 shares were to be issued to William Gale, the president and Chief Executive Officer of Future Com, and 2,000,000 shares were to be issued to Warren Blanck, the Secretary and Treasurer of Future Com. Future Com was formed by Mr. Gale and Mr. Blanck for the purpose of acquiring and managing mobile communications radio licenses and/or systems. As a wholly-owned subsidiary of Greenleaf, Future Com intends to continue to pursue this line of business. Greenleaf completed the acquisition in November 1999. COMPUTER SOFTWARE AND HARDWARE PRODUCTS Beginning in late 1998 the efforts of Greenleaf and Greenleaf Research and Development Inc. ("GRD") have been concentrated on developing and marketing a line of proprietary computer software and hardware to customers in the entertainment industry. As described below, Greenleaf's customers then utilize Greenleaf's products to facilitate sales via electronic media, including the Internet. Greenleaf's line of computer data security and communications solutions assists customers in protecting their intellectual property and information assets from access by unauthorized parties. In addition, Greenleaf's products provide an alternative to traditional methods of bundling and distributing software-based entertainment content through electronic media. To date, Greenleaf has developed the following two proprietary software products: DIGIGUARD(TM) Greenleaf's DigiGuard(TM) product consists of a suite of software packages to support the locking, unlocking, and playing of entertainment media. DigiGuard(TM) protects data contained on CD-ROMs and DVDs, allowing customers to securely bundle various entertainment content, such as games, music and movies, on a single disc or for transmission via the Internet. DigiGuard(TM) creates access "keys" to unlock protected content. Each "key" is unique for each user to protect the integrity of the content. After meeting certain criteria, such as a credit card number exchange for payment, customers may unlock a product via the Internet or by phone. MUSICLOCK(TM) Greenleaf's MusicLock(TM) product allows distributors to deliver digitally-recorded songs to radio stations over the Internet. MusicLock(TM) prevents premature access to the recording by allowing playback of the songs only after a pre-determined time, which allows music distributors to control the distribution of new releases while reducing distribution costs for the record labels. MusicLock(TM) allows record promoters to distribute new releases in advance of the release date with the security of knowing that material cannot be played until the designated time and date. REAL ESTATE OPERATIONS As of December 31, 1999, Riverside's investment in real estate includes $8,919,000 of land held for sale and $77,000 of commercial rental property. LAND HELD FOR SALE Included in the investment in land held for sale are approximately 137 acres of land located within Highlands Park in Smyrna, Georgia, and 9 acres of land located within Belfort Park in Jacksonville, Florida, referred to as "Highlands" and "Belfort", respectively. HIGHLANDS. Highlands originally consisted of 1,000 acres and has been an active development since 1983 with approximately 767 acres being sold over the last 12 years. Highlands is a planned industrial development just outside of Atlanta, Georgia. The land is subdivided into numerous parcels planned for commercial, office and light industrial use. In its current state, the property has road frontage and access to County water, sewer, electrical, gas and telephone. In addition, many of the properties have been graded. Riverside completed the sale of .841 acres for approximately $67,000 and 61 acres for approximately $3.5 million, in 1999 and 1998, respectively. The Company currently has approximately the remaining 137 acres of its investment in Highlands under contract to sell, subject to the buyer's satisfaction with its due diligence investigation. The net sales proceeds is estimated to be $14.1 million, approximately $11.3 million of which would be used to pay off the existing mortgage debt plus accrued interest. Under the contract, the closing is to to occur, if at all by August of 2000. BELFORT. Belfort originally consisted of approximately 28 acres of vacant and unimproved commercial land, with 21.17 acres being sold over the last two years. All 6.83 remaining acres are designated for office use. The Company did not have any sales in 1999. During 1998, Riverside completed the sale of 12 acres designed for office use for approximately $2.9 million. The Company currently has all 6.83 acres of this property under arrangement to sell for approximately $1.6 million subject to the buyer's satisfaction with its due diligence investigation and other conditions. EMPLOYEES As of February 14, 2000, Riverside and its wholly-owned subsidiaries had 26 full-time employees, and Buildscape had 53 employees. As of December 25, 1999, Wickes had approximately 4,219 employees, of whom 3,668 were employed on a full-time basis. The Company believes that it has maintained favorable relations with its employees. None of these employees are represented by a union or covered by a collective bargaining agreement. ITEM 2. ITEM 2. PROPERTIES. Riverside's executive offices are in leased space in Jacksonville, Florida. Wickes' 101 sales and distribution facilities are located in 23 states, with 67 in the Midwest, 17 in the Northeast and 17 in the South. See "Item 1. Business - Markets." Wickes believes that its facilities generally are in good condition and will meet Wickes' needs in the foreseeable future. Wickes' Conventional Market building centers generally consist of a showroom averaging 9,600 square feet and covered storage averaging 38,400 square feet. Wickes' sales and distribution facilities located in Major Markets tend to be more specialized. Since the beginning of 1997, Wickes has completed Resets in fourteen sales and distribution facilities located in Conventional Markets. Wickes' sales and distribution facilities are situated on properties ranging from 1.0 to 28.2 acres and averaging 9.3 acres. Wickes also operates 17 stand alone component manufacturing facilities, which have an average of 40,300 square feet under roof on 6.9 acres. Wickes owns 84 of its sales and distribution facilities and 82 of the sites on which such facilities are located. The remaining 17 sales and distribution facilities and 19 sites are leased. As of December 25, 1999, Wickes also held for sale the assets of 7 closed facilities with an aggregate book value of $2.5 million. In addition to its sales and distribution facilities, Wickes operates 17 stand alone component manufacturing plants. Six of these plants are located on sales and distribution facility sites. Of the remaining 11 plants, seven are on owned sites and four are on leased properties. Wickes also owns or leases a large fleet of trucks and other vehicles, including vehicles specialized for the delivery of certain of Wickes' products. As of February 29, 2000, the fleet included approximately 194 heavy duty trucks, 87 of which provide roof-top or second story delivery and 49 other vehicles equipped with truck mounted forklifts, 516 medium duty trucks, 568 light duty trucks and automobiles, 574 forklifts, 102 specialized millwork delivery vehicles, and 47 vehicles equipped to install blown insulation. Wickes leases its corporate headquarters, a portion of which is subleased, located at 706 North Deerpath Drive in Vernon Hills, Illinois. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Wickes has been identified as a potential responsible party in two Superfund landfill clean up sites. In Browning-Ferris Industries, et al v. Richard Ter Maat, et al. v. Wickes Lumber Company, et al., Case No. 92 C 22059 filed in the United State District Court for the Northern District of Illinois, Wickes has been named as a potentially responsible party for cleanup of the MIG-DeWanne Landfill located in Boone County, Illinois. Wickes has also received notification from the United States Environmental Protection Agency regarding cleanup of the Adams/Quincy Landfills #2 & #3 located in Quincy, Illinois. Based on the amounts claimed and Wickes' prior experience, it is expected that Wickes' liability in these two matters will not be material. Wickes is one of many defendants in two class action suits filed in August of 1996 by approximately 200 claimants for unspecified damages as a result of health problems claimed to have been caused by inhalation of silica dust, a byproduct of concrete and mortar mix, allegedly generated by a cement plant with which Wickes has no connection other than as a customer. LIBRADO AMADOR, ET AL. V. ALAMO CONCRETE PRODUCTS LIMITED, WICKES LUMBER COMPANY, ET AL., Case No. 16696, was filed in the 229th Judicial District Court of Duval County, Texas. JAVIER BENAVIDES, ET AL. V. MAGIC VALLEY CONCRETE, INC., WICKES LUMBER COMPANY, ET AL., CASE NO. DC-96-89 was filed in the 229th Judicial District Court of Starr County, Texas. Wickes has entered into a cost-sharing agreement with its insurers, and any liability is expected to be minimal. Wickes is one of many defendants in approximately 145 actions, each of which seeks unspecified damages, in various Michigan state courts against manufacturers and building material retailers by individuals who claim to have suffered injuries from products containing asbestos. Each of the plaintiffs in these actions is represented by one of two law firms. Wickes is aggressively defending these actions and does not believe that these actions will have a material adverse effect on Wickes. Since 1993, Wickes has settled 16 similar actions for insignificant amounts, and another 186 of these actions have been dismissed. The Company and Wickes is involved in various other legal proceedings which are incidental to the conduct of its business. Certain of these proceedings involve potential damages for which the Company's insurance coverage may be unavailable. While the Company does not believe that any of these proceedings will have a material adverse effect on the Company's financial position, results of operations or liquidity, there can be no assurance of this. The Company's assessment of the matters described in this Item 3 and other forward-looking statements ("Forward-Looking Statements") in this report are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are inherently subject to uncertainty. The outcome of the matters described in this Item 3 may differ from the Company's assessments of these matters as a result of a number of factors including but not limited to: matters unknown to the Company at the present time, development of losses materially different from the Company's experience, Wickes' ability to prevail against its insurers with respect to coverage issues to date, the financial ability of those insurers and other persons from whom Wickes may be entitled to indemnity, and the unpredictability of matters in litigation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock trades over-the-counter and is quoted on the OTC Bulletin Board under the trading symbol "RSGI." Prior to July 28, 1997, the Company's common stock was traded on the Nasdaq National Stock Market. From that date to July 8, 1999, the Company's Common Stock was traded on the Nasdaq SmallCap Stock Market. As of March 17, 2000, there were 4,767,123 shares outstanding held by approximately 1,644 shareholders of record. The following table sets forth, for the periods indicated through July 7, 1999, the high and low closing sale prices for the Company's common stock as reported on SmallCap Stock Market and from July 8, 1999, through December 31, 1999, the high and low bid quotation for the Company's Common Stock on the OTC Bulletin Board. Prices do not include retail markups, markdowns or commissions. The Company did not pay any cash dividends on its common stock during the last two fiscal years and does not anticipate payment of such dividends for the foreseeable future. Payment of dividends in the future is subject to the discretion of the Board of Directors of the Company and is dependent upon the Company's overall financial condition, capital requirements, compliance with contractual requirements, earnings, and such other factors as the Board of Directors may deem relevant. In addition, the terms of the Company's $1,800,000 short-term loan from Imagine Investments Inc. ("Imagine") prohibit the payment of cash dividends without the prior approval of Imagine. See "Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes contained elsewhere herein. Since the operations of Wickes are consolidated with those of the Company and its subsidiaries for the first through the third quarter of 1998, all of 1997, and accounted for on the equity method for the fourth quarter of 1998 and all of 1999, comparisons between periods may not be meaningful in certain respects. In addition, the operations of Buildscape are consolidated with those of the Company and its subsidiaries for all of 1998 and through October 21, 1999, and accounted for on the equity method for the remainder of 1999. FORWARD-LOOKING INFORMATION CAUTIONARY STATEMENT. In addition, the discussion above of the Company's future operations, liquidity needs and sufficiency constitutes Forward-Looking Information and is inherently subject to uncertainty as a result of a number of risk factors including, among other things: (i) the success of and level of cash flow generated by Cybermax, (ii) the Company's ability to achieve the level of real estate sales required to meet scheduled real estate debt principal and interest payments and to avoid the requirement that the Company provide additional collateral for this debt, (iii) the Company's ability to borrow, which may depend upon, among other things, the trading price of Wickes common stock, the value and liquidity of the Company's Greenleaf securities, and the success of Cybermax and Buildscape, (iv) the ability of the Company to raise funds through sales of Wickes common stock and Greenleaf securities and (v) uncertainty concerning the possible existence of indemnification claims resulting from the Company's discontinued operations. Future real estate sales depend upon a number of factors, including interest rates, general economic conditions, and conditions in the commercial real estate markets in Atlanta, Georgia and Jacksonville, Florida. In addition to the factors described above, the Company's ability to sell Wickes common stock or Greenleaf securities would depend upon, among other things, the trading prices for these securities, and, in light of the relatively low trading volume for these securities, possibly the Company's ability to find a buyer or buyers for these securities in a private transaction or otherwise. RESULTS OF OPERATIONS The Company reported results of operations for the years ended December 31, 1999, 1998 and 1997 as follows (in thousands): (1) Wickes' operations are consolidated with those of the Company and its subsidiaries for the first through the third quarter of 1998, and all of 1997. The Company accounted for its investment in Wickes under the equity method for the fourth quarter of 1998 and all of 1999. (2) Includes net realized investment gains(losses) of $(257,000), $(499,000), and $897,000, in 1999, 1998 and 1997, respectively. 1999 includes a reserve for losses of $278,000 for sales of the Company's real estate in 2000. 1998 includes losses of $1,202,000 related to the sales of the Company's common stock in Wickes. 1998 also includes a reserve for losses of $635,000 for sales of the Company's common stock of Wickes in 1999. (3) In 1998 the Company recorded charges of $5.9 million for restructuring and unusual items for Wickes. In 1997 the Company recorded a benefit of $0.6 million for restructuring and unusual items for Wickes. (4) In 1998, the Company recorded $3.3 million in deferred income tax expense. This increased the valuation allowance against its deferred tax asset to 100%. (5) In 1999, the Company recorded a $3.9 million gain for the sale of 38% of its common shares and 100% of its preferred shares of Buildscape. (6) Buildscape's operations are consolidated with those of the Company and its subsidiaries for 1998 and from January 1, 1999 through October 21, 1999. The Company accounted for its investment in Buildscape on the equity method for the remainder of 1999. BUILDSCAPE On October 21, 1999, Imagine made a $10 million investment into Buildscape by converting $3 million of debt into common stock, exchanging 520,000 shares of Riverside stock for Buildscape common stock and investing an additional $5 million for Buildscape preferred shares. In this transaction, Imagine acquired from Riverside 1,880,933 of Buildscape's 5,000,000 outstanding shares of common stock in exchange for (i) the cancellation of $3 million of indebtedness and (ii) 520,000 shares of Riverside's common stock held by Imagine. In connection with the transaction, Imagine was granted the right to vote the Company's common shares on all matters with the exception of change in control. As of October 22, 1999, the Company owns 62% of the Buildscape common stock, however, since the Company's voting rights are controlled by Imagine, the Company is accounting for its investment in Buildscape on the equity method. The Company retained the remaining 3,119,067 outstanding shares of Buildscape's common stock. In addition, Buildscape issued to Imagine in exchange for $5,000,000, 1,666,667 shares of Buildscape's voting Series A Cumulative Convertible Preferred Stock with a $5 million aggregate liquidation preference. As a result of this transaction, the Company owns (before Buildscape employee's stock options) 47% of Buildscape on a fully converted basis. Imagine owns 38% of the common and 100% of the preferred shares of Buildscape, or 53% on the same basis. The Company recorded a gain of $3.9 million on the transaction. As a result of a reduction in the Company's ownership of Buildscape to a level below 50%, the Company accounted for investment in Buildscape on the equity method after October 21,1999. From January 1998 through October 21, 1999, the financial statements of the Company included those of Buildscape on a consolidated basis. The following table sets forth information concerning the results of Buildscape for January 1, 1999 through October 21, 1999 and 1998, respectively (in thousands): Buildscape had advertising revenue of $159,000 in 1999 compared to $30,000 in 1998. Revenue generated from Buildscape's auctions and superstores were $257,000 in 1999. Buildscape did not actively start selling its products and services until late in the fourth quarter of 1998. CYBERMAX The following table sets forth information concerning the results of Cybermax 1999 and 1998, respectively (in thousands): Web design services contributed approximately 76% of Cybermax sales in 1999 compared to 44% in 1998. The increase in sales is due primarily to the increase in sales and marketing efforts in 1999. Internet access operations, including network support and other services contributed approximately 24% of Cybermax sales in 1999, compared to 55% in 1998. Selling, general and administrative expense increased in 1999 primarily as a result of the increased overhead required to increase the sales levels achieved in 1999 and to further increase sales efforts in future years. During 1998, the Company's technical staff and sales staff were part of Cybermax's operations. Their services were allocated primarily to the start up operations of Buildscape. As a result, Cybermax charged Buildscape for these services. This reimbursement is included in selling, general and administration expense. WICKES The Company estimates that, after inter-company eliminations, net of goodwill amortization of approximately $521,000 and net of interest expense allocated from Riverside on its 13% and 11% Notes of $1,407,000, Wickes contributed earnings of $840,000 to the Company's results of operations in 1999. For the first nine months of 1998, the Company consolidated its operations with those of Wickes. During the first nine months of 1998, losses attributable to Wickes were $2,263,000. Included in this amount is $844,000 of operating loss, goodwill amortization of $296,000, and $1,123,000 of interest expense allocated from Riverside on its 13% Notes. During the fourth quarter of 1998, losses attributable to Wickes were approximately $2,008,000. This amount includes $208,000 of equity in Wickes earnings, $379,000 of interest expense allocated from Riverside on its 13% Notes and losses of $1,837,000 incurred from the sale of Wickes common stock. The Company estimates that, after inter-company eliminations, net of goodwill amortization of approximately $534,000 and net of interest expense allocated from Riverside on its 13% Notes of $1,123,000, Wickes contributed losses of $2,770,000 to the Company's results of operations in 1997. WICKES The following discussions of Wickes' full year operations for 1999, 1998 and 1997 was obtained from the Wickes Form 10-K. The following table sets forth, for the periods indicated, the percentage relationship to net sales of certain expense and income items. The table and subsequent discussion should be read in conjunction with the financial statements and notes thereto appearing elsewhere herein. Wickes' operations, as well as those of the building material industry generally, have reflected substantial fluctuations from period to period as a consequence of various factors, including levels of construction activity, general regional and local economic conditions, weather, prices of commodity wood products, interest rates and the availability of credit, all of which are cyclical in nature. Wickes anticipates that fluctuations from period to period will continue in the future. Because a substantial percentage of Wickes' sales are attributable to building professionals, certain of these factors may have a more significant impact on Wickes than on companies more heavily focused on consumers. Wickes' first quarter and, occasionally, its fourth quarter are adversely affected by weather patterns in the Midwest and Northeast, which result in seasonal decreases in levels of construction activity in these areas. The extent of such decreases in activity is a function of the severity of winter weather conditions. Weather conditions in 1997 and 1999 were relatively normal throughout the year. During the first quarter of 1998, Wickes experienced mild winter weather conditions in Wickes' Midwest region, which was partially offset by increased precipitation in the Northeast and South. Wickes recorded net income of $7.6 million in 1999, compared with a net loss of $1.0 million in 1998, an improvement of $8.6 million. The primary components of this improvement include an increase in gross profit dollars of $38.2 million, a $5.9 million decrease in restructuring and unusual items, a 0.7% decrease in SG&A as a percentage of net sales and a $1.2 million decrease in provision for doubtful accounts. These improvements were partially offset by a $1.1 million increase in depreciation, goodwill and trademark amortization, a $1.7 million increase in interest expense, a $5.1 million increase in provision for income taxes and a reduction in other income of $1.2 million. Wickes recorded a net loss of $1.0 million in 1998, compared with a net loss of $1.6 million in 1997, an improvement of $0.6 million. The primary components of this improvement include an increase in gross profit of $12.4 million and a decrease in losses attributable to Riverside International LLC of $1.5 million. These improvements were partially offset by a $6.5 million increase in restructuring and unusual items expense, a reduction in other income of $3.9 million, and increases in SG&A expense of $1.5 million and provision for doubtful accounts of $1.2 million. PARENT COMPANY AND OTHER SUBSIDIARIES The following discussion relates to the operations of the Parent Company and its subsidiaries, other than Buildscape, Cybermax and Wickes (the "Parent Group"). The Parent Group's non-interest operating expenses for 1999 decreased 73% to $421,000 compared to $1,549,000 in 1998. The primary reason for the decrease is that in 1999 all expenses relating to any of the Company's operating subsidiaries were paid directly by the subsidiary, thereby eliminating allocations. As a result, the Parent Company's expenses for 1999 include only expenses relating to public reporting (such as legal fees, audit fees, transfer agent fees and director fees) and depreciation of the Parent Company's property, plant and equipment and reserve for doubtful accounts. The Parent Groups non-interest operating expenses for 1998 decreased 30% to $1,549,000 compared to $2,222,000, in 1997. The primary reason for the decrease includes an increase of allocable expenses from the Parent Group to its subsidiaries, principally Buildscape and Cybermax. The Parent Group allocated expenses to its subsidiaries of $2,085,000 and $1,139,000 in 1998 and 1997, respectively. In addition, in 1997 a reserve was established for approximately $434,000, with respect to a receivable from an affiliate owned by Mr. Wilson. This affiliate provides the Company use of its airplane. During 1997, the Company's use of this airplane was primarily by Wickes (see Note 15 of Notes to Consolidated Financial Statements - - "Related Party Transactions"). This reserve was reduced by $104,000 in 1998 as a result of the Company's use of this plane. These deceases were offset by approximately $731,000 of expenses incurred by Wixx Energy Company ("Wixx") in 1998. Included in the expenses incurred by Wixx was a reserve for approximately $241,000 for loans made in 1996 and 1995 to a company controlled by one of the Company's directors. (See Note 15. of Notes to Consolidated Statements - "Related Party Transactions"). In September of 1998, Wixx ceased operations. Interest expense (excluding an interest allocation to Wickes for the Parent Company's 13% subordinated notes and 11% secured notes of $1,407,000, $1,502,000 and $1,473,000 in 1999, 1998 and 1997, respectively) for 1999, 1998 and 1997 was $1,058,000, $1,189,000 and $1,635,000, respectively. In 1999, interest expense consisted of $90,000 on the Company's other loans and $968,000 on the Company's real estate mortgage debt. In 1998, interest expense consisted of $15,000 on the Parent Company's other bank debt and $1,174,000 on the Parent Company's real estate mortgage debt. In 1997, interest expense consisted of $167,000 on the Parent Company's other bank debt and $1,468,000 on the Parent Company's real estate mortgage debt. Interest expense on the Parent Company's real estate debt will continue to decrease as a result of real estate sales. The principal balance on the mortgage debt was reduced by $4.7 million and $1.5 million in 1998 and 1997, respectively. Revenues of the Parent Group (excluding investment income) for 1999, 1998 and 1997 were approximately $80,000, $546,000, and $605,000, respectively. The Parent Group's income primarily consists of non-recurring items, such as settlement proceeds from legal proceedings; therefore, comparisons between periods are not meaningful. Included in other income was $407,000 and $598,000 for 1998 and 1997, respectively, for settlements relating to the Company's former property and casualty insurance operations. REAL ESTATE INVESTMENTS The Company's real estate investments consist of $7,308,000 in Georgia properties, $1,681,000 in Florida properties and $7,000 in other states. During 1999, the Company sold approximately .841 acres of its Georgia properties for $67,000, which generated gains of $20,000, compared to 1998 when the Company sold approximately 61 acres of its Georgia properties for $3,471,000, which generated gains of $751,000. In addition, during 1999, the Company sold a lot in Florida for $283,000 which generated gains of $1,000. During 1998, the Company sold approximately 12 acres of its Florida properties for $2,933,000 resulting in gains of $608,000. Included in the Company's net realized investment gains(losses) for 1999, 1998 and 1997 were net realized gains on real estate investments of $(257,000), $1,338,000 and $897,000, respectively. In 1999, the Company established a reserve for approximately $278,000 for its Florida properties. DISCONTINUED OPERATIONS On December 1, 1997, the Company completed the sale of its mortgage lending operations to an unrelated third party. The Company did not realize any gain or loss from the transaction, but did agree to indemnify the purchaser against losses on the construction loan portfolio that was transferred. As of March 15, 2000, the Company has 62,500 shares of its Wickes common stock pledged as collateral for this indemnification obligation. As the construction loan portfolio decreases, the shares held as collateral will be released. The Company believes that these indemnities will not have a material adverse effect on the Company's financial position on results of operations. The following table sets forth comparative information concerning the results of the Company's former mortgage lending operations. ---- Revenues from loans $ 1,363 Other income 3 --------- Total revenues 1,366 Selling, general & administrative expenses(1) 1,077 Interest expense 677 --------- Total expense 1,754 --------- Net loss $ (388) ========= (1) Net of reimbursements of $955,000 during 1997 by the Parent Company from Wickes. INCOME TAXES In 1999 the Company incurred a $0 tax expense. A 100% valuation allowance has been recorded to reduce the deferred tax assets to the amount where more likely than not, will be realized in the future. The current income tax provisions consists of state and local tax liabilities for Wickes. See Note 13 of Notes to Consolidated Financial Statements included elsewhere herein. LIQUIDITY AND CAPITAL RESOURCES THE PARENT GROUP The Parent Company's general liquidity requirements consist primarily of funds for payment of debt and related interest and for operating expenses and overhead. Operations (exclusive of Wickes, which is prohibited from paying dividends under its debt instruments) consist primarily of real estate sales and Cybermax's operations. Also, real estate sales proceeds are required to be applied to real estate debt reduction and are not available to the Parent Company for other purposes. The Parent Company's cash on hand and available borrowings will not be sufficient to support its operations and overhead through 2000. Therefore, the Parent Company will need to obtain significant additional funds through asset sales or additional borrowings or other financing for such purposes and may need to reduce the level of its operations. As described below, the principal source of funds for these purposes, and for the payment of interest on the Parent Company's indebtedness, has been sales of shares of Wickes and Greenleaf common stock. In addition, the $10,000,000 principal amount of the Company's 11% Notes is due in September 2000, and the $1,800,000 principal amount of the Company's short-term loan from Imagine is due August 2000. For a detailed discussion of the Parent Company's liquidity, debt repayment obligations, and management's plans related thereto, see Note 11 of Notes to Consolidated Financial Statements included elsewhere herein. In addition to the above, the following transactions took place in 1999: o During 1999 Buildscape borrowed $3,350,000 from Imagine. These loans were assumed by Riverside and cancelled in connection with the acquisition by Imagine of a majority interest in Buildscape on October 21, 1999. For additional information concerning this transaction, see Note 6 to the Consolidated Financial Statements included elsewhere herein. As a result of this transaction, Buildscape operates independently of the Company and its operations. o In February of 1998, the Company completed the acquisition of the e-commerce and advertising operations formerly owned by Wickes. The disposition of these operations by Wickes was part of the determination made by Wickes to discontinue or sell non-core operations. For these operations, the Company paid consideration of approximately $872,000 in the form of a 3-year unsecured promissory note. The terms of the promissory note include interest based on the prime lending rate plus two percentage points due monthly and principal due in thirteen equal quarterly installments, beginning May 15, 1998 and ending May 15, 2001. In addition, the Company agreed to pay 10% of future net income of these operations, subject to a maximum of $429,249 plus interest. At March 15, 2000, the Company had made payments of $545,046 under the promissory note but was delinquent with respect to required payments of approximately $82,486 of principal and interest. In March of 2000, the Company and Wickes renegotiated the terms of the note, deferring all principal payments past due and due in the year ending December 31, 2000, for one year, at which time the principal payments would be due on a quarterly basis. The interest on this note will be paid on a quarterly basis. o On August 25, 1999, the Company and the holders of the 13% Subordinated Notes ("the 13% Notes") completed an agreement whereby the Company's 13% Notes that were scheduled to mature in September 1999, were replaced with new subordinated promissory notes due September 30, 2000 bearing 11% interest ("the 11% Notes"). In March of 2000, the Company and the 11% Note holders modified their original agreement, which allows the Company to use 100% of the net sales proceeds from the sale of its Greenleaf shares to beapplied again the semi-annual interest due on March 31, 2000, in lieu of payment against the principal balance of the notes. In addition, the Company agreed to make a principal payment of approximately $550,000 on or before April 30, 2000. For information regarding the collateral for and terms of the 11% Notes, see Note 10 to the Consolidated Financial Statements included elsewhere herein. o On August 27, 1999, the Company entered into a short-term loan agreement with Imagine pursuant to which the Company borrowed $711,055 in August 1999 and $1,088,945 in September 1999. The Company used these borrowings to fund its operations including (1) interest of approximately $631,507 on the 11% Notes, (2) delinquent principal and interest of approximately $349,924 on the Wickes debt (3) expenses of approximately $104,000 in connection with the replacement of the Company's 13% Notes and (4) delinquent payables of approximately $417,196. This loan is due August 31, 2000. In addition, as of March 31, 2000, the Company has made payments of approximately $9,500 to Imagine but $58,650 of interest is past due. For information regarding the collateral for and terms of this short-term loan agreement, see Note 10 to the Consolidated Financial Statements included elsewhere herein. o For a description of recent sales by the Company of Wickes and Greenleaf common stock, see Note 11 to the Consolidated Financial Statements included elsewhere herein. During 1999, stockholders' equity decreased by $1,874,000. Included were losses attributable to Buildscape for approximately $4,583,000, which was offset by a $3,994,000 gain on the sale of Buildscape. Cybermax's operation and the Parent Company's debt accounted for approximately $2,929,000 of the decrease. These decreases were offset by $1,253,000 of unrealized gains recorded on the Company's Greenleaf common stock. Earnings of approximately $840,000 attributable to Wickes partially offset these losses. In addition, the Company retired 520,000 shares of its common stock, which accounted for approximately $422,000 of the decrease. YEAR 2000 The Year 2000 issue is the result of certain computer programs that were designed to use two digits rather than four to define the applicable year. As a result, if the Company's computer programs with date-sensitive functions are not Year 2000 compliant, they may recognize a date using "00" as the Year 1900 rather than the Year 2000. This could cause system failures, miscalculations, the inability to process transactions, send invoices, or process similar business activities. The Company's total cost for the Year 2000 project was approximately $350,000, of which approximately $306,000 was used to replace the Company's accounting software system. The remaining $44,000 is for the replacement of systems, equipment and software which was accelerated due to the Year 2000 problem, and has been capitalized over the systems and software estimated useful life. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," standardizes the accounting for derivative instruments by requiring that all derivatives be recognized as assets and liabilities and measured at fair value. the statement is effective for fiscal years beginning after June 15, 1999. The Company believes adoption of the statement will not have a material effect on its financial statements. ITEM 7.A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Financial statements of the Company are set forth herein beginning on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information required by this Item is incorporated herein by reference from the definitive proxy statement to be filed in connection with the Company's Annual Meeting of Stockholders scheduled to be held on May 23, 2000. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information required by this Item is incorporated herein by reference from the definitive proxy statement to be filed in connection with the Company's Annual Meeting of Stockholders scheduled to be held on May 23, 2000. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this Item is incorporated herein by reference from the definitive proxy statement to be filed in connection with the Company's Annual Meeting of Stockholders scheduled to be held on May 23, 2000. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this Item is incorporated herein by reference from the definitive proxy statement to be filed in connection with the Company's Annual Meeting of Stockholders scheduled to be held on May 23, 2000. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) LIST OF FINANCIAL STATEMENTS AND SCHEDULES FILED AS A PART OF THIS REPORT: (1) Financial Statements: EXHIBITS 3.1* Restated Articles of Incorporation, as amended to date(previously filed as Exhibit 3.01 to the Company's Annual Report on Form 10-K for the year ended December 31, 1994). 3.2* Amended and Restated Bylaws, as amended to date (previously filed as Exhibit 3.02 to the Company's Annual Report on Form 10-K for the year ended December 31, 1994) 4.1 (a)* Credit Agreement dated April 1, 1999 between the registrant and the signatories thereto (incorporated by reference to Exhibit 4.1(a) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). (b)* Form of 11% Secured Promissory Note dated April 1, 1999 (incorporated by reference to Exhibit 4.1(b) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). (c)** Modification to Credit Agreement dated March 24, 2000 between the registrant and Mitchell W. Legler, as agent for the Holders. 4.2 (a)* Amendment to Loan Agreement dated May 20, 1999 among the registr- ant, Cybermax, Inc., Cybermax Tech, Inc. Buildscape, Inc. and Imagine Investments, Inc. (incorporated by reference to Exhibit 4.2(a) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). (b)* Amended and Restated Term Promissory Note dated May 20, 1999 (incorporated by reference to Exhibit 4.2(b) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). (c)* Amendment to Stock Option Agreement dated May 20, 1999 between Cybermax Tech, Inc. and Imagine Investments, Inc.(incorporated by reference to Exhibit 4.2(c) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). 4.3 (a)* Loan Agreement dated August 12, 1999 among the registrant, Cybermax, Inc., Cybermax Tech, Inc., Buildscape, Inc. and Imagine Investments, Inc. (incorporated by reference to Exhibit 4.3(a) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999) (b)* Promissory Note dated August 12, 1999 (incorporated by reference to Exhibit 4.3(b) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). (c)* Stock Option Agreement dated August 12, 1999 between Cybermax Tech, Inc. and Imagine Investments, Inc.(incorporated by refer- ence to Exhibit 4.3(c) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending June 30, 1999). 4.4 (a)* Loan Agreement dated August 27, 1999 between the registrant, and Imagine Investments, Inc.*(incorporated by reference to Exhibit 4.1(a) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending September 30, 1999) (b)* Demand Promissory Note dated August 27, 1999 (incorporated by reference to Exhibit 4.1(b) to the Quarterly Report Form 10-Q filed by the Company for the quarter ending September 30, 1999). (c)* Stock Pledge Agreement dated August 27, 1999 between the registrant and Imagine Investments, Inc (incorporated by reference to Exhibit 4.1(c)to the Quarterly Report Form 10-Q filed by the Company for the quarter ending September 30, 1999). 10.1 (a)* Non-Qualified Stock Option Plan (previously filed as Exhibit 10.1(a) to the Company's Annual Report as Form 10-K for the year ended December 31, 1997). (b)* Form of Non-Qualified Stock Option Agreement (previously filed as Exhibit 10.1(b) to the Company's Annual Report as Form 10-K for the year ended December 31, 1997). 10.2 (a)* Agreement dated November 4, 1997 between the Registrant and Wickes Inc. (incorporated by reference to Exhibit 10.1 to the Form 10-Q filed by Wickes for the September 1997 quarter). (b)* Agreement and Closing Agreement dated November 4, 1997 between the Registrant and Wickes Inc. (incorporated by reference to Exhibit 10.9(b) to the Wickes Inc. 1997 Form 10-K). 10.3* Agreement dated September 30, 1998 between Cybermax Tech, Inc. and Greenleaf Technologies Corporation (incorporated by refer- ence to Exhibit 99.1 to the 8-K filed by the registrant on October 15, 1998). 10.4* Stock Purchase Agreement dated October 5, 1998 between the registrant and Imagine Investment, Inc. (incorporated by reference to Exhibit 99.2 to the 8-K filed by the registrant on October 15, 1998). 10.5* Agreement dated October 15, 1999 among Imagine Investments, Inc., Riverside Group, Inc., Cybermax, Inc., Cybermax Tech, Inc. and Buildscape, Inc. (incorporated by reference to Exhibit 2.1 to the 8-K filed by the registrant on October 15, 1998). 10.6* Series A Cumulative Convertible Preferred Stock Purchase Agreement dated October 15, 1999 among Riverside Group, Inc., Buildscape, Inc. and Imagine Investments, Inc. (incorporated by reference to Exhibit 2.2 to the 8-K filed by the registrant on October 15, 1998). 10.7** Agreement between Buildscape, Inc. and Wickes, Inc. 10.8** Settlement Agreement dated January 28, 2000 between the registr- ant, Greenleaf Technologies Corporation, Cybermax Tech, Inc. and Cybermax, Inc. 21.01** Subsidiaries of the Company. 23.01** Consent of PricewaterhouseCoopers LLP 27.01** Financial Data Schedule (S.E.C. use only). *Incorporated by reference. **filed herewith SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. RIVERSIDE GROUP, INC. /s/ J. Steven Wilson J. Steven Wilson Chairman of the Board, President and Chief Executive Officer Dated: March 30, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: /s/ J. Steven Wilson /s/Edward M. Carey, Sr. - -------------------------------- ----------------------- J. Steven Wilson Edward M. Carey, Sr. Principal Executive Officer Director, March 30, 2000 and Director, March 30, 2000 /s/ Varina M. Steuert /s/ Catherine J. Gray - ------------------------------- --------------------- Varina M. Steuert Catherine J. Gray Director, March 30, 2000 Senior Vice President, Chief Financial Officer, (Principal Accounting and financial Officer), March 30, 2000 March 30, 2000 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders, Riverside Group, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and common stockholders' equity and cash flows present fairly, in all material respects, the consolidated financial position of Riverside Group, Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their consolidated operations and cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These consolidated financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. The accompanying consolidated financial statements have been prepared assuming that Riverside will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management plans in regard to these matters are also described in Note 11. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Jacksonville, Florida PricewaterhouseCoopers LLP April 14, 2000 See Accompanying Notes to Consolidated Financial Statements. See Accompanying Notes to Consolidated Financial Statements. See Accompanying Notes to Consolidated Financial Statements. Riverside Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows (in thousands) See Accompanying Notes to Consolidated Financial Statements. F- 5 RIVERSIDE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING PRINCIPLES ORGANIZATION Riverside Group, Inc., a Florida corporation formed in 1965 ("Riverside", also "Parent Company") is a holding company ocused through its wholly-owned subsidiary, Cybermax, Inc. ("Cybermax"), on providing e-commerce solutions to the building industry, as well as web software application development and hosting services. Unless the context indicates otherwise, the term "Company" as used herein refers to Riverside and its subsidiaries. The Company also engages in the supply and distribution of building materials through its 36%- owned subsidiary, Wickes Inc. ("Wickes") and its 47%-owned subsidiary, Buildscape, Inc. ("Buildscape"). Buildscape provides e-commerce services and building related contact to the home building professional as well as consumer. The consolidated financial statements present the results of operations, financial position, and cash flows of Riverside and all of its wholly-owned and majority-owned subsidiaries. The Company's wholly-owned and majority-owned subsidiaries include: Cybermax, and its subsidiaries, Wixx Energy, Inc. ("Wixx"), Wickes Financial Services Center, Inc. ("WFSC"), NRG Network, Inc. ("NRG"); and the parent's two principal insurance holding company subsidiaries, American Financial Acquisition Corporation ("AFAC") and Dependable Insurance Group, Inc. ("DIGI"), and their subsidiaries. For a description of the Company's accounting for its investment in Wickes, (see Note 3. "Investment in Wickes"). The Company dissolved WFSC and NRG on December 31, 1999. Cybermax's wholly-owned subsidiaries include Cybermax Tech, Inc. ("CT"). CT was dissolved on October 31, 1999, when the Company sold 38% of its common stock of Buildscape. CT's wholly-owned subsidiaries include Buildscape through October 21, 1999, after the Company sold 38% of its common stock to Imagine Investments, Inc. ("Imagine") (see Note 6. "Investment in Buildscape") and Gameverse, Inc. ("Gameverse"), through September 30, 1998, when the Company sold Gameverse to Greenleaf Technologies Corporation ("Greenleaf") (see Note 5. "Investment in Greenleaf"). During the fourth quarter of 1999, CT contributed its investment in Buildscape to Cybermax who contributed it to Riverside. Dependable Group's wholly owned subsidiary is: Wickes Mortgage Lending, Inc. ("WML"), a mortgage lending company, from April 1996 through December 1997 when it was sold (see Note 4. "Sale of Mortgage Lending Operations"). SALE OF MORTGAGE LENDING OPERATIONS The Company has included the operations of WML as discontinued operations for all periods presented in the consolidated statements of operations. BASIS OF FINANCIAL STATEMENT PRESENTATION The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). All significant intercompany accounts and transactions have been eliminated. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity date of three months or less at date of purchase to be cash equivalents. ACCOUNTS RECEIVABLE The Company's accounts receivable potentially subject the Company to credit risk, as collateral is generally not required. The Company's risk of loss is limited due to advance billings to customers for services, the use of preapproved charges to customer credit cards, and the ability to terminate access on delinquent accounts. The carrying amount of the Company's receivables approximates their net realizable value. ALLOWANCE FOR LOSSES The Company provides for valuation allowances for estimated losses on real estate when a significant and permanent decline in value occurs. In providing valuation allowances, costs of holding real estate, including the cost of capital, are considered. The Company's real estate is reviewed periodically to determine potential problems at an early date. INVESTMENT SECURITIES, AVAILABLE FOR SALE The Company accounts for its investment in Greenleaf securities according to the provisions of FAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement requires that all applicable investments be classified as trading securities, available-for-sale, or held-to-maturity securities. The Company did not have any investments classified as trading securities during the periods presented. The statement further requires that held-to-maturity securitie be reported at fair value, with unrealized gains and losses excluded from earnings, but reported within shareholders' equity in accumulated other comprehensive income (net of the effect of income taxes) until they are sold. At the time of sale, any gains or losses, calculated by teh specifice identification method, will be recognized as a component of operating results. The fair value of these securities are based upon the last reported price on the exchange on which they are traded. INVESTMENT IN REAL ESTATE Investments in real estate are carried at the lower of cost or appraised value. Foreclosed property is valued at the lower of the carrying amount or fair market value. PROPERTY, PLANT AND EQUIPMENT Property, plant, and equipment are stated at cost, less accumulated depreciation, and are depreciated using the straight-line method. Estimated useful lives range from 3 to 5 years. Gains and losses from dispositions of property, plant and equipment are included in the Company's results of operations as other operating income. During 1998, the Company disposed of property and equipment for a net gain of $1,574,000, of which $510,000 was from the sale of excess properties. IMPAIRMENT OF LONG-LIVED ASSETS The Company accounts for the "Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" in accordance with Statement of Financial Accounting Standards ("SFAS") No. 121. This statement requires that long-lived assets and certain identifiable intangibles to be held and used by an entity, be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company recorded a write down of $635,000 in 1998, relating to 365,000 shares of Wickes' common stock that was disposed of in the first quarter of 1999. While additional shares may be sold on the open market or in private transactions in the future, the Company cannot estimate whether or not such sales will occur at a gain or loss. No assurances can be given that such losses will not occur. OTHER ASSETS Other assets consists primarily of deferred financing costs which are amortized over the expected terms of the related debt. EXCESS OF COSTS OVER FAIR VALUE OF NET ASSETS ACQUIRED The Company amortizes the excess of costs over fair value of net assets ("goodwill") acquired over 10 years. The Company evaluates the recoverability of goodwill based upon expectations of non- discounted cash flows and income from operations for each subsidiary having a material goodwill balance. Based upon this evaluation, the Company believes that no impairment of goodwill exists at December 31, 1999. Net goodwill of $4.7 million and $5.2 million is included in the Company's investment in Wickes at December 31, 1999 and December 31, 1998, respectively. PARTIALLY-OWNED COMPANIES For 1997, the Company's investment in an international operation is recorded under the equity method. The Company's share of losses is reflected as equity in loss of affiliated company in the Consolidated Statements of Operations. ACCOUNTS PAYABLE The Company includes outstanding checks in excess of bank balances in accounts payable. There were $99,200 in outstanding checks in excess of bank balances at December 31, 1998. INCOME TAXES The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". Tax provisions and credits are recorded at statutory rates for taxable items included in the consolidated statements of operations regardless of the period for which such items are reported for tax purposes. Deferred income taxes are recognized for temporary differences between financial statement and income tax bases of assets and liabilities for which income tax benefits will be realized in future years. Deferred tax assets are reduced by a valuation allowance when the Company cannot make the determination that it is more likely than not that some portion of the related tax asset will be realized. SFAS No. 109 requires that the current and non-current components of deferred tax balances be reported separately based on the financial statement classification of the related asset or liability which cause a temporary difference between tax and financial reporting. Items which are not directly related to an asset or liability that exists for financial reporting purposes are classified as current or non-current based on the expected reversal date of the temporary difference. EARNINGS PER SHARE Basic and Diluted earnings per common share are calculated in accordance with SFAS No. 128, "Earnings Per Share". Earnings per share are based upon the weighted average number of shares of common stock outstanding (5,128,131 in 1999, 5,213,186 in 1998, and 5,193,570 in 1997 ). On October 21, 1999, the Company retired 520,000 shares of its common stock previously held by Imagine received by the Company in connection with the Buildscape sale (see Note 6. "Investment in Buildscape"). During 1997, the Company issued 50,000 stock options at an exercise price of $3.00 per share. In addition during 1997, the Company purchased and retired 9,000 shares of its common stock. Since the Company had a net loss in 1999 and 1998, the options had an anti-dilutive effect, and therefore, are excluded from the calculation of diluted earnings per share. STOCK-BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require companies to recognize compensation expense for grants of stock, stock options, and other equity instruments to employees based on new fair value accounting rules. Although expense recognition for employee stock based compensation is not mandatory, the pronouncement requires companies that choose not to adopt the new fair value accounting to disclose the pro forma net income and earnings per share under the new method. The Company elected not to adopt SFAS No. 123, and continued to apply the terms of Accounting Principles Board Opinion No. 25. The Company determined the impact on net income and earnings per share of the fair value based accounting method would be immaterial (see Note 12. " Employee Benefit Plans"). REVENUE RECOGNITION The Company recognizes revenue when services are provided. Services are generally billed one month in advance. Advance billings and collections relating to future access services are recorded as deferred revenue and recognized as revenue when earned. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," standardizes the accounting for derivative instruments by requiring that all derivatives be recognized as assets and liabilities and measured at fair value. The statement is effective for fiscal years beginning after June 15, 1999. The Company believes adoption of the statement will not have a material effect on its financial statements. USES OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates reported. FINANCIAL STATEMENT PRESENTATION AND RECLASSIFICATION Certain reclassifications have been made to the 1998 financial statement presentation to conform with the 1999 financial statement presentation. STATEMENT OF CASH FLOWS SUPPLEMENTARY DISCLOSURE The Company and its subsidiaries, exclusive of Wickes ("Parent Group") paid $1,544,000, $2,728,000, and $2,867,000, of interest in 1999, 1998, and 1997, respectively. Wickes paid $12,919,000, and $19,790,000, of interest in 1998, and 1997, respectively. The Parent Group made no income tax payments in 1999, 1998, and 1997. Wickes paid $769,000, and $1,344,000, of income taxes in 1998, and 1997, respectively. Net cash used in discontinued operations totaled approximately $1.2 million in 1997. The Company did not pay any dividends on its common stock during 1999 and 1998. In 1998 the Company acquired 100% of the assets of Cybermax, a Jacksonville, Florida based Internet service provider. The purchase price of the acquisition of Cybermax was approximately $100,000, in the form of a promissory note. In January 1998, Riverside completed the acquisition of certain operations of Wickes that Wickes had determined to discontinue. In connection with the acquisition, Riverside acquired approximately $126,000 of fixed assets in exchange for a three-year promissory note. Amortization expense of $1,914,000 in the Company's Consolidated Statement of Cash Flows for 1998 includes $1,127,000 of deferred financing costs of Wickes. These costs are included as interest expense in the Company's Consolidated Statements of Operations. In October 1999, the Company sold 1,880,000 shares of Buildscape common stock in exchange for (i) the cancellation of $3 million of indebtedness and (ii) 520,000 shares of Riverside's common stock held by Imagine. The calculated market value on Riverside's stock was approximately $422,500 on the date of the sale. The following table represents the assets and liabilities of Wickes as of October 1, 1998. Because Riverside changed its method of accounting for its investment in Wickes to the equity method, these amounts were reclassified to investment in Wickes, net of minority interest on the Company's Consolidated Balance Sheet at December 31, 1998: 2. RESTRUCTURING AND UNUSUAL CHARGES During 1997, Wickes recorded a $1.5 million restructuring charge for discontinued programs and reductions in its corporate headquarters workforce. The $1.5 million included approximately $0.9 million for severance and postemployment benefits for approximately 25 headquarters employees. The discontinued programs included Wickes' mortgage lending, utilities marketing and certain internet programs. This charge was offset by a $2.1 million reduction in accrued costs for a restructuring plan formulated by Wickes in late 1995, which was completed in 1997. The $2.1 million reversal included four centers identified for closure that had significantly improved market conditions and would remain open, as well as a change in the estimate of facility carrying costs for sold facilities and those remaining to be sold. During the first quarter of 1998 Wickes implemented a restructuring plan (the "1998 Plan") which resulted in the closing or consolidation of eight sales and distribution and two manufacturing facilities in February, the sale of two sales and distribution facilities in March, and further reductions in headquarters staffing. As a result of the 1998 Plan, Wickes recorded a restructuring charge of $5.4 million in the first quarter and an additional charge of $0.5 million in the third quarter. The $5.9 million cumulative charge included $4.1 million in estimated losses on the disposition of closed facility assets and liabilities, $2.1 million in severance and postemployment benefits related to the 1998 plan, offset by a benefit of $300,000 for adjustments to prior years' restructuring accruals. The $4.1 million in estimated losses includes the write-down of assets (excluding real estate), to their net realizable value, of $3.4 million and $700,000 in real estate carrying costs. The $2.1 million in severance and postemployment benefits covered approximately 250 employees, 25 of which were headquarters employees, that were released as a result of reductions in headquarters staffing and the closing or consolidation of the ten operating facilities. The $300,000 benefit from prior years was a result of accelerated sales of previously closed facilities during the fourth quarter of 1997 and first quarter of 1998. The acceleration of these sales resulted in a change in the estimate of facility carrying costs for the sold facilities. At December 26, 1998 the accrued liability for restructuring had been reduced to zero. 3. INVESTMENT IN WICKES In a series of transactions in 1993 in connection with Wickes' equity and debt recapitalization plan (which included Wickes' initial public offering of common stock), Riverside acquired a net 1,842,774 additional shares of Wickes common stock and an option for 374,516 shares of Wickes common stock. The aggregate purchase price for these shares and option was $5.9 million including a $1.1 million promissory note. In August 1995, Riverside exercised its option for an exercise price of $2.3 million and paid its promissory note in full. After these transactions, Riverside owned 2,217,290 shares, or approximately 36% of Wickes' outstanding common stock. At December 31, 1995, the Company's retained earnings included $4.0 million of Wickes' undistributed earnings. Riverside acquired two million newly-issued shares of Wickes' common stock on June 20, 1996 for $10.0 million in cash. These additional shares increased Riverside's ownership in Wickes from 36% to 52% of Wickes' total common shares and from 39% to 55% of Wickes' voting common shares. In September and October of 1997, Riverside sold approximately 65,000 shares of its Wickes' common stock for $290,000. (See Note 15. "Related Party Transactions"). In connection with the purchase from Wickes of its newly-issued shares, Wickes agreed to provide the Company with certain rights to have some or all of the shares registered for the Company's benefit under the Securities Act of 1933. In August of 1998, the Company requested that 1,000,000 shares be registered pursuant to Rule 415 under the 1933 Act. At the Company's request, Wickes has not, however, sought to have this registration statement declared effective by the Securities and Exchange Commission pending the Company's consideration of the various alternatives available to it. On October 5,1998, the Company and Imagine entered into a Stock Purchase Agreement dated the same date (the "Imagine Agreement"). Under the Imagine Agreement, the Company granted Imagine (i) an option to acquire 750,000 shares of Wickes common stock at a purchase price of $3.25 per share in cash (the "Call Option") and (ii) a right of first refusal expiring April 5, 2000 with respect to all of the shares of Wickes common stock beneficially owned by the Company. On November 4, 1998, the Company and Imagine entered into Amendment No. 1 to the Imagine Agreement, which extended the expiration date of the Call Option until November 19, 1998 and the expiration of the Put Option until November 30, 1998. On November 18, 1998, the Company and Imagine entered into Amendment No. 2 to the Imagine Agreement, which extended the amended expiration date of the Call Option until November 30, 1998. On November 30, 1998, the Company and Imagine entered into Amendment No. 3 to the Imagine Agreement, which extended the amended expiration date of the Call Option until December 9, 1998. On December 9, 1998, the Company and Imagine entered into Amendment No. 4 to the Imagine Agreement, which extended the amended expiration date of the Call Option until December 23, 1998. On December 23, 1998, the Company and Imagine entered into Amendment No. 5 to the Imagine Agreement, which extended the amended expiration date of the Call Option until January 23, 1999. Pursuant to the Imagine Agreement, the Company sold 250,000 shares of Wickes' common stock on October 5, 1998 to Imagine for $812,250 in cash. On November 12, 1998, Imagine partially exercised the Call Option, purchasing 200,000 shares for $650,000 in cash. On December 22, 1998, Imagine partially exercised the Call Option, purchasing 185,000 shares of Wickes' common stock for $601,250 in cash. On January 26, 1999, Imagine exercised the Call Option with respect to the remaining 365,000 shares. A condition to the obligations of Imagine under the Imagine Agreement was that the Company create two vacancies on its Board of Directors and that Robert T. Shaw and Harry T. Carneal be elected to fill such vacancies. On October 5, 1998, two directors of the Company, Kenneth H. Kirschner and Frederick H. Schultz, resigned from the Company's Board of Directors, and Messrs. Shaw and Carneal were elected to fill these vacancies. On November 12, 1998, Messrs. Shaw and Carneal were also elected to the Wickes Board of Directors. During 1999, Messrs. Shaw and Carneal resigned from the Company's Board of Directors. On December 30, 1998, the Company sold 82,000 shares of Wickes' common stock to Imagine for $307,500 in cash in a separate transaction. In addition, in December 1998, the Company sold 16,600 shares of Wickes' common stock for $68,300 in cash in the open market. At December 31, 1999, Riverside beneficially owned 3,000,513 shares of Wickes' common stock, which constituted 36% of Wickes' outstanding voting and non-voting common stock. As a result of the above transactions, results of operations are consolidated with Wickes, beginning July 1, 1996 through September 30, 1998. Prior to July 1, 1996, and after September 30, 1998, the Company's consolidated balance sheets and consolidated statements of operations and cash flows reflect Riverside's investment in Wickes on the equity method. The acquisition of additional shares has been recorded as a step acquisition using the purchase method of accounting. Summary audited financial information of Wickes for years 1999, 1998 and 1997 follows (in thousands): At any given time approximately 1% to 2% of Wickes' total inventory will be classified as delete or obsolete merchandise. Delete or obsolete merchandise consists of inventory that, while in good sellable condition, will be discontinued for one of several business reasons. This inventory, which may consist of items from any of Wickes' product lines, historically has been marked down in value by approximately 20% to 30% of its original cost. In September of 1998, Wickes entered into a transaction in which it exchanged delete/obsolete merchandise, with an impaired book value of $1.2 million, for barter credits at a stated value of $1.6 million. As part of the barter transaction Wickes had agreed to sell the merchandise for the new owner, on a clearance basis, and remit the proceeds, up to $350,000, to the owner. Wickes entered into the transaction to free valuable showroom and storage space for new merchandise. The value of this merchandise had been previously reduced from its original cost of approximately $1.6 million to $1.2 million, based on Wickes' most recent sales information. Initially the exchange was considered to be a non-monetary exchange, as outlined under APB 29 and EITF 93-11, and no further impairment was recorded at that time. The barter credits were recorded as a prepaid expense with a value of $1.2 million. Subsequent to the second quarter of 1999, Wickes restated its September 1998 financial statements to account for the barter transaction as a monetary transaction, upon receiving written confirmation from a second "Big Five" accounting firm and after careful review and concurrence of its Board of Directors Audit Committee. A non-cash charge of $844,000 has now been recorded to reduce the value of the inventory exchanged, and the resulting book value of the barter credits, from approximately $1.2 million to $350,000. As a result of this change, Wickes will also record increased future earnings for each dollar of barter credits used in excess of $350,000. The following table reconciles the amounts Wickes previously reported to the amounts Wickes reported in the condensed consolidated statements of operations for the year ended December 26, 1998 (amounts in thousands, except per share data). Wickes restated 1998 earnings in 1999. Such restatement changed the Company's net investment and related equity in earnings of subsidiary to reflect a reduction of approximately $257,000. Such adjustment has been made to the 1998 financial statements filed in this Form 10-K. 4. SALE OF MORTGAGE LENDING OPERATIONS Beginning in 1995, Riverside marketed construction and permanent mortgage loans to and through the professional building customers of Wickes. In early 1997, Riverside began to reduce the extent of mortgage operations. In December, 1997, Riverside completed the sale of its remaining mortgage operations to a third party, which continues to market mortgage loans through Wickes. During 1997, after reimbursement of $955,000 received by the Parent Company on behalf of WML, from Wickes, the Parent Company incurred pre-tax loss of $388,000 on its mortgage operations. 5. INVESTMENT IN GREENLEAF As of September 30, 1998, the Company entered into and completed an agreement with Greenleaf, based in Iselin, New Jersey, whereby the Company has acquired common shares of Greenleaf in exchange for 100% of the common stock of the Company's wholly owned subsidiary, Gameverse. As a result of the transaction, the Company owned 14,687,585 shares, or approximately forty percent of Greenleaf's outstanding common shares. The Company also received two five year options to acquire additional newly-issued shares of Greenleaf's common stock (1) 5,733,333 shares at an average exercise price of $.25 per share; (2) 1,581,249 shares at an exercise price of $.15 per share. In accordance with the Accounting Principles Board Opinion Number 29: Accounting for Nonmonetary Transactions, the Company has recorded zero basis in its investment in Greenleaf. The calculated market value of the Company's investment in Greenleaf at the time of the transaction was approximately $6.7 million based on Greenleaf's stock price of $.46 per share on the over-the- counter Bulletin Board. As a result of Greenleaf's dissatisfaction with the transaction, on January 28, 2000, the Company and Greenleaf executed a Settlement Agreement (the "Greenleaf Settlement"). In the Greenleaf Settlement, the Company retained 10,000,000 shares of the 14,687,585 shares that it had originally received. The Company also retained a five year option to acquire 2,000,000 additional newly issued shares of Greenleaf's common stock at an exercise price of $.25 per share. In addition to the 10,000,000 retained shares, 3,000,000 of the Greenleaf's shares are held in an escrow account (the "Escrow Shares"), pursuant to an escrow agreement acceptable to Greenleaf and the Company. The proceeds from the sale of the escrow shares are to be used to fund a mutually agreeable joint venture for the marketing of technology and internet-related products, to be owned in equal amounts by Greenleaf and the Company. In connection with the settlement, Riverside granted Greenleaf a stock option to purchase 5% of the issued and outstanding shares of Cybermax. The exercise price is $1,000,000 and the expiration date of the option is September 30, 2003. In addition, the Company entered into an agreement with a subsidiary of Greenleaf, Future Com. ("Future"), for use of satellite air time, related technology, hardware and software, on an as-needed basis, at fair market value. At December 31, 1999, the calculated market value of the Company's investment in Greenleaf was approximately $5.5 million based on Greenleaf's stock price of $.41 per share on the Over-the-Counter Bulletin Board. The calculated value was determined by multiplying 13,500,000 shares owned by the Company by the stock price listed on the Over-the-Counter Bulletin Board on the respective date. At April 12, 2000, the calculated market value of the Company's investment in Greenleaf was approximately $24.1 million based on Greenleaf's stock price of $1.80 per share on the Over-the-Counter Bulletin Board. The calculated value has been determined by multiplying 13,500,000 shares owned and under option by the Company less 73,413 options shares given to employees of the Company by the stock price listed on the Over-the-Counter Bulletin Board on that date. During the first quarter of 2000, Greenleaf's stock has traded with an average weekly volume of 176,100 shares to 2,084,900 shares. 6. INVESTMENT IN BUILDSCAPE On October 21, 1999, Imagine made a $10 million investment into Buildscape by converting $3 million of debt into common stock, exchanging 520,000 shares of Riverside stock for Buildscape common stock, and investing an additional $5 million for Buildscape preferred shares. In this transaction, Imagine acquired from Riverside 1,880,933 of Buildscape's 5,000,000 outstanding shares of common stock in exchange for (i) the cancellation of $3 million of indebtedness and (ii) 520,000 shares of Riverside's common stock held by Imagine. In connection with the transaction, Imagine was granted the right to vote the Company's common shares on all matters with the exception of change in control. As of October 22, 1999, the Company owns 62% of the Buildscape common stock, however, since the Company's voting rights are controlled by Imagine, the Company is accounting for its investment in Buildscape on the equity method. The Company retained the remaining 3,119,067 outstanding shares of Buildscape's common stock. In addition, Buildscape issued to Imagine in exchange for $5,000,000, 1,666,667 shares of Buildscape's voting Series A Cumulative Convertible Preferred Stock with a $5 million aggregate liquidation preference. As a result of this transaction, the Company owns (before Buildscape employee's stock options) 47% of Buildscape on a fully converted basis. Imagine owns 38% of the common and 100% of the preferred shares of Buildscape, or 53% on the same basis. The Company recorded a gain of $3.9 million on the transaction. From January 1998 through October 21, 1999, the financial statements of the Company included those of Buildscape on a consolidated basis. Summary audited financial information for Buildscape for years 1999 and 1998 follows (in thousands): 7. INVESTMENTS REAL ESTATE INVESTMENTS Investment in real estate consists of the following (in thousands): Certain of the Company's real estate was acquired from affiliates and has been recorded at historical carryover cost. Commercial rental property carrying values are net of accumulated depreciation of $94,000, and $157,000, at December 31, 1999 and 1998, respectively. As of December 31, 1999, the Company had $7,308,000 of its investments in real estate in Georgia properties, and $1,681,000 in Florida properties, and $7,000 in other states. NET INVESTMENT INCOME The major categories of investment income(loss) are summarized as follows (in thousands): INVESTMENT SECURITIES - AVAILABLE FOR SALE In accordance with SFAS 115 and Securities and Exchange Commission ("SEC") Rule 144, 3,056,724 shares of the Company's common stock in Greenleaf is classifiedas available for sale at December 31, 1999. The amortized basis is $0, the estimated fair market value is $1,253,257, resulting in gross unrealized gains of $1,253,257. In March 2000 the Company received the legal opinion considered necessary in order for the Company to have the ability to sell shares of its investment in Greenleaf. Sales of such shares are limited by Rule 144 of the SEC to 1% of Greenleaf's outstanding shares in a 90 day period. Based on the Company's intention to sell the maximum number of shares allowed in order to fund current operations and debt, such shares have been classified as available for sale and accordingly the value of such shares has been reflected as a component of comprehensive income, net of any applicable tax. No taxes have been provided as the Company has available net operating loss carryforwards and strategies which would result in no tax liability upon the sale of these securities. 8. PROPERTY, PLANT, AND EQUIPMENT Property, plant and equipment consists of (in thousands): The Company reviews assets held for sale in accordance with the SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The Company recorded a loss of $156,000 to report land, land improvements and buildings held for sale at their net realizable value in 1997. This charge is included under Restructuring and Unusual items on the Consolidated Statement of Operations. 9. ACCRUED LIABILITIES The following table summarizes the accrued liabilities (in thousands): 10. LONG-TERM DEBT Long-term and mortgage debt obligations are summarized as follows (in thousands): As of December 31, 1999, Prime and London InterBank Offered Rate ( "LIBOR") three-month rates were 8.50% and 6.09% respectively. SUBORDINATED NOTES ("THE 13% NOTES")/COLLATERALIZED NOTES ("THE 11% NOTES") These notes may be prepaid in whole or in part without premium. The 13% Notes were recorded at an original discount of $1,256,000 which is being amortized using the interest method over the term of the notes. On August 25, 1999, the Company and the 13% Note Holders executed an agreement (the "11% agreement"), whereby the Company's 13% Notes that were scheduled to mature in September 1999, were replaced with new unsubordinated promissory notes due September 30, 2000 bearing 11% interest. The 11% Notes are secured by a junior lien on the collateral securing the Company's real estate indebtedness and 10 million shares of Greenleaf common stock. On March 24, 2000, the Company and the 11% Note Holders executed a modification to the 11% agreement. This modification allows the Company to use 100% of the net sales proceeds from the sale of its Greenleaf shares to be applied against the semi-annual interest payment due March 31, 2000 in lieu of payment against the principal. In addition, the Company agrees to make a principal reduction of $550,000 on the 11% Notes on or before April 30, 2000. For further information regarding this modification see Note 16. "Subsequent Events". OTHER WICKES PROMISSORY NOTE In February of 1998, Riverside completed the acquisition of e-commerce and advertising operations formerly owned by Wickes. The disposition of these operations by Wickes was part of the determination made by Wickes to discontinue or sell non-core operations. For these operations, Riverside paid consideration of approximately $872,000 in the form of a 3-year unsecured promissory note. The terms of the promissory note include interest based on the prime lending rate plus two percentage points due monthly and principal due in thirteen equal quarterly installments, beginning May 15, 1998 and ending May 15, 2001. In addition, Riverside agreed to pay ten percent of future net income of these operations, subject to a maximum of $429,249 plus interest. At December 31, 1998, the Company had made payments of $115,752 under the Wickes promissory note but was delinquent with respect to required payments of approximately $169,474 of principal and interest. Wickes has deferred these payments and interest thereon until June 30, 1999. During this extension, the interest rate will be based on the prime lending rate plus four percentage points. At August 10, 1999, the Company had made payments of $195,752 under the Wickes promissory note but was delinquent with respect to required payments of approximately $239,518 of principal and interest. Wickes had deferred these payments and interest thereon until September 30, 1999. On September 3, 1999 the Company made a payment of approximately $349,924 of principal and interest, which brought this debt current at that time. In November 1999, the Company received an extension from Wickes deferring approximately $77,332 of principal and interest originally due November 15, 1999 until February 15, 2000 and the Companies agreed to restructure the terms of the debt. During this extension, the interest rate, on the amount deferred will be based on the prime lending rate plus four percentage points. In March of 2000, the Company and Wickes renegotiated the terms of the note, deferring all principal payments, including the delinquent principal payments due in November of 1999 and February of 2000, for one year at which time the principal payments would be due on a quarterly basis. The interest on this note will be payable on a quarterly basis. For further information regarding this extension see Note 16. "Subsequent Events". IMAGINE SHORT-TERM LOAN On August 27, 1999, the Company entered into a short-term loan agreement with Imagine pursuant to which the Company borrowed $711,055 in August 1999 and $1,088,945 in September 1999. The loan is due August 31, 2000. The loan bears interest at an annual rate of 12.75%, and is guaranteed by Riverside and is secured by a pledge of 840,845 shares of Wickes common stock and 100% of the outstanding shares of Cybermax stock. The pledged Wickes stock is to be released to the borrower in one or more stages in increments of 81,000 shares. The shares released are required to be sold for the sole purpose of covering interest payments on this debt, interest on the 11% Notes and/or principal and interest on its debt payments due to Wickes. In addition, the Company's shares of Wickes common stock are subject to securities law restrictions on resale. The Company has granted to Imagine, a right of first refusal with respect to all the shares of Wickes beneficially owned by it. For further information regarding the Company's use of the funds, see Note 11. "Commitments and Contingencies". At April 14, 2000, the Company had made payments of $9,553 under the Imagine short-term loan but was delinquent with respect to required payments of approximately $116,662 of interest. The Company has not received a waiver from Imagine on this delinquency. In connection with the Greenleaf Settlement, the Company granted Greenleaf a stock option to purchase 5% of the issued and outstanding shares of Cybermax. Since 100% of the outstanding shares of Cybermax stock are pledged to Imagine under the short-term loan agreement, the Company is currently in violation. The Company believes that if Greenleaf exercises this stock option, then the Imagine short-term loan will be paid in full. MORTGAGE DEBT Riverside purchased certain real estate owned by its former life company subsidiary. In connection therewith, Riverside issued a series of seven non-recourse promissory notes (the "Notes") with an aggregate principal amount of $17,798,000 equal to 90% of the purchase price of the real estate parcels. Principal and interest payments are due in annual installments, commencing on June 6, 1997. Each annual installment is calculated based upon equal payments amortized over a term of 20 years. A balloon payment of the remaining principal balance is due on the seventh anniversary of the Notes. The Notes bear interest at a rate adjusted quarterly, equal to LIBOR, plus three hundred basis points. The Notes are collateralized by first priority mortgages covering all of the real estate. On each anniversary of the Notes, Riverside is required to provide the lender with an independent appraisal of the real estate, subject to the mortgages ("Appraised Values"). If the outstanding principal amount of the Notes exceeds 85% of the Appraised Value on the first anniversary or 80% of the Appraised Value with each anniversary thereafter, Riverside is required by December 31 of that year to make an additional principal payment on the Notes in an amount equal to such excess. A parcel of real estate that is subject to the mortgage may be sold by Riverside only in cash transactions and with the prior consent of the lender. Subject to certain exclusions, the entire sales proceeds is required to be paid to the lender to fund an escrow account for the payment of property taxes, and to pay accrued and unpaid interest and any remaining principal balance on the Notes. As additional security for the Notes, Riverside pledged as collateral 3,600 shares of Circle Series C preferred stock, 2,267,000 shares of Circle Common Stock and 1,000,000 shares of Wickes' common stock. The Circle stock pledged as collateral was converted to cash when Circle was acquired by a third party on December 31, 1997. On April 20, 1998, Riverside amended certain terms of its mortgage debt. In connection with the amendment, (i) the Parent Company pledged an additional 325,000 shares of Wickes common stock in substitution for the $1.4 million cash then held by the lender as collateral and (ii) agreed to having each share held as collateral valued at 75% of its per share market value. On December 30, 1999, the Company had made payments of $34,945 under the mortgage debt, but was delinquent with respect to required payments of $461,239. On December 31, 1999, American Founders agreed to amend certain terms of its mortgage with the Company. In connection with the amendment, (i) all interest due through December 31, 1999, was deferred until the next land sale (ii) additional interest will accrue on the interest due on June 6, 1999 at a rate of LIBOR plus 3 points (iii) as future sales occur, all past due interest and taxes will be paid first; then future interest through June 6th of each year will be paid; thereafter, proceeds will be applied to principal. In addition, the Company paid the lender a $10,000 fee in consideration for this deferral. As of December 31, 1999, there were 2,016,168 shares of Wickes' common stock held as collateral on the real estate. AGGREGATE MATURITIES Aggregate amounts of future minimum principal payments on long-term and mortgage debt are as follows (in thousands): YEAR 2000 $ 11,813 2001 268 2002 201 2003 102 Thereafter 11,243 -------- $ 23,627 ======== 11. COMMITMENTS AND CONTINGENCIES WICKES INC. At December 25, 1999, Wickes had accrued approximately $132,000 for remediation of certain environmental and product liability matters, principally underground storage tank removal. Many of the sales and distribution facilities presently and formerly operated by the Wickes contained underground petroleum storage tanks. All such tanks known to Wickes located on facilities owned or operated by Wickes have been filled or removed in accordance with applicable environmental laws in effect at the time. As a result of reviews made in connection with the sale or possible sale of certain facilities, Wickes has found petroleum contamination of soil and ground water on several of these sites and has taken, and expects to take, remedial actions with respect thereto. In addition, it is possible that similar contamination may exist on properties no longer owned or operated by Wickes, the remediation of which Wickes could under certain circumstances be held responsible. Since 1988, Wickes has incurred approximately $2.0 million of costs, net of insurance and regulatory recoveries, with respect to the filling or removing of underground storage tanks and related investigatory and remedial actions. Insignificant amounts of contamination have been found on excess properties sold over the past five years. Wickes has accrued $43,000 for estimated clean-up costs at 11 of its locations. Wickes has been identified as having used two landfills which are now Superfund clean up sites, for which it has been requested to reimburse a portion of the clean up costs. Based on the amounts claimed and Wickes' prior experience, Wickes has accrued $28,000 for these matters. Wickes is one of many defendants in two class action suits filed in August of 1996 by approximately 200 claimants for unspecified damages as a result of health problems claimed to have been caused by inhalation of silica dust, a byproduct of concrete and mortar mix, allegedly generated by a cement plant with which Wickes has no connection other than as a customer. Wickes has entered into a cost-sharing agreement with its insurers, and any liability is expected to be minimal. Wickes is one of many defendants in approximately 145 actions, each of which seeks unspecified damages, in various Michigan state courts against manufacturers and building material retailers by individuals who claim to have suffered injuries from products containing asbestos. Each of the plaintiffs in these actions is represented by one of two law firms. Wickes is aggressively defending these actions and does not believe that these actions will have a material adverse effect on the Company. Since 1993, Wickes has settled 30 similar actions for insignificant amounts, and another 224 of these actions have been dismissed. None of these suits have made it to trial. Losses in excess of the $132,000 reserved as of December 25, 1999 are possible but an estimate of these amounts cannot be made. The Company is involved in various other legal proceedings which are incidental to the conduct of its business. Certain of these proceedings involve potential damages for which the Company's insurance coverage may be unavailable. While the Company does not believe than any of these proceedings will have a adverse effect on the Company's financial position, results of operations or liquidity, there can be no assurance of this. The Company and its subsidiaries have various operating leases for which approximately $296,000, $10,461,000, and $10,817,000, was expensed in 1999, 1998 and 1997, respectively. As of December 31, 1999, the Company and its subsidiaries lease its home office property for approximately $226,000 per year. This lease expires in May 31, 2001. The Company's total future minimum commitments for noncancelable operating leases are as follows (in thousands): YEAR AMOUNT 2000 $ 234 2001 103 2002 18 2003 1 2004 -- ------- Total $ 356 ======= In connection with the sale of Dependable, the Company agreed to indemnify the purchaser for certain losses on various categories of liabilities. Terms of the indemnities provided by the Company vary with regards to time limits and maximum amounts. AFAC subordinated debentures in the amount of $2.1 million are pledged as collateral on these indemnities. Although future loss development will occur over a number of years, the Company believes, based on all information presently available, that these indemnities will not have a material adverse effect on the Company's financial position or results of operations. On December 1, 1997, the Company completed the sale of its mortgage lending operation to an unrelated third party. The Company did not realize any gain or loss from the transaction, but agrees to indemnify the purchaser against losses on the construction loan portfolio that was transferred. The Company currently has 62,500 shares of its Wickes' common stock pledged as collateral for this indemnification obligation. As the construction loan portfolio decreases, the shares held as collateral will be released. The Company believes that these indemnities will not have a material adverse effect on the Company's financial position or results of operations. PARENT COMPANY LIQUIDITY AND MANAGEMENT'S PLANS The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. In light of the Company's current projected earnings and cash flow from operations, management believes the Company does not have the financial resources to maintain its current level of operations without obtaining significant additional funds through asset sales, additional borrowings or other financing or reducing the level of its operations. As described below, the principal source of funds for these purposes in the past, and for the payment of interest on the Company's indebtedness, has been borrowings and sales of shares of Wickes common stock. However, since the Company has executed the Greenleaf Settlement, the Company will now be able to sell shares of its Greenleaf stock to cover some of its operating deficit and debt obligations. The Company is currently working on additional options as discussed below. At April 14, 2000, the Company estimates that it will have approximately $482,000 of accounts payable and other current liabilities (excluding interest payable), approximately $176,000 of which are past due. In March of 2000, the Company and Wickes renegotiated the terms of the Company's note to Wickes, deferring all principal payments due for one year, including the delinquent principal payments for November of 1999 and February of 2000. As of April 14, 2000, $116,662 of interest is currently past due on the Company's note to Imagine. Additionally, the $10,000,000 principal of the Company's 11% Notes is due in September 2000, and the $1,800,000 principal of the Company's short-term loan from Imagine is due August 2000. The principal user of the Company's cash during 1999 was Buildscape. On October 21, 1999, Imagine, acquired a majority voting interest in Buildscape and provided Buildscape with independent funding. For additional information concerning this transaction, see Note 6. "Investment in Buildscape". As a result of this transaction, Buildscape will operate independently of the Company and its operations. In order to continue its operations, Buildscape will need to obtain additional financing in the near future. On August 25, 1999, the Company and the holders of the 13% Notes completed an agreement whereby the Company's 13% Notes that were scheduled to mature in September 1999, were replaced with the 11% Notes. For information regarding the collateral on the 11% Notes, see Note 10. "Long-Term Debt". In March of 2000, the Company and the 11% Note holders modified their original agreement, which allows the Company to use 100% of the net sales proceeds from the sale of its Greenleaf shares to be applied against the semi-annual interest due on March 31, 2000, in lieu of payment against the principal balance of the notes. In addition, the Company agreed to make a principal payment of approximately $550,000 on or before April 30, 2000. The two assets that the Company may sell to cover immediate cash needs are Wickes and Greenleaf shares. On April 14, 2000, virtually all of the Parent Company's 3,000,513 shares of Wickes common stock are pledged to secure various obligations of the Company, as discussed below, Imagine has released from pledge 81,970 shares to be sold. The Company currently owns ten million shares of Greenleaf common stock and has a five year option to purchase two million shares at .$25 per share. All ten million shares owned are pledged to secure the Company's 11% Notes, and any proceeds of sale are required to be applied as discussed above. In addition, three million shares of the Greenleaf's shares are held in an escrow account, pursuant to an escrow agreement between the Company and Greenleaf. For further information regarding the reduction of the Company's shares of Greenleaf stock, see Note 5. "Investment in Greenleaf" and Note 16. "Subsequent Events". The Company has begun selling shares of Wickes and Greenleaf stock to meet the immediate cash requirements of interest due March 31 on the 11% Notes, interest due on the Wickes note and operations. Through April 13, 2000, the Company has sold 61,100 shares of Wickes and 250,000 shares of Greenleaf stock for proceeds of approximately $581,344 and $355,825, on each. The Company sold sufficient shares of Greenleaf prior to March 31 to make the interest payment on the 11% notes within the allowable grace period prescribed in the note agreement. Proceeds from the sale of Wickes shares will be used for the interest due to Wickes and current operating costs. Based upon available information, the Company believes that it may sell approximately 750,000 shares of Greenleaf, or 1% of their total outstanding shares, in a 90 day period under Rule 144. Pursuant to the settlement reached with Greenleaf (see Note 5. "Investment in Greenleaf") during the first 90 day period, up to 20% of these shares are reserved to be sold by the escrow agent. From the three million shares held in escrow, the Company anticipates being able to sell the total number of shares permitted to be sold by it in the market over the next 45 days. The proceeds received from the sales after paying interest and principal payment on the 11% Notes and the escrow fund, would be split 50% with the 11% Note holders and the balance, if any, will be available to cover operating costs of the Company. The Company also plans to sell an additional 41,000 shares of Wickes stock, the balance of the amount allowable under Rule 144, over the next 30 days to fund operating costs. The Company's subsidiary, Cybermax, is generating sales and the Company projects by the end of this year, Cybermax will generate cash from operations sufficient to fund its operations. There can be no assurance of this, however. On August 27, 1999, the Company entered into a short-term loan agreement with Imagine pursuant to which the Company borrowed $711,055 in August 1999 and $1,088,945 in September 1999. The Company used these borrowings to fund its operations including (1) interest of approximately $631,507 on the 11% Notes, (2) delinquent principal and interest of approximately $349,924 on the Wickes debt (3) expenses of approximately $104,000 in connection with the replacement of the Company's 13% Notes and (4) delinquent payables of approximately $417,196. The loan is due August 31, 2000. As described above, $58,650 of interest is past due. The loan bears interest at an annual rate of 12.75% is guaranteed by Riverside and is secured by a pledge of 840,845 shares of Wickes common stock and 100% of the Cybermax stock. This stock is to be released to the Borrower in one or more stages in increments of 81,000 shares. The shares released are required to be sold for the sole purpose of covering interest payments on this debt, interest on the 11% Notes and/or principal and interest on its debt payments due to Wickes. The Company has granted to Imagine a right of first refusal that expires in April 2000 with respect to all the shares of Wickes beneficially owned by it. The Company's $11.3 million of real estate indebtedness is secured by the Company's real estate and 2,016,168 shares of Wickes common stock. Approximately $1,005,366 of payments due at December 31, 1999 has been deferred. See Note 10. "Long-Term Debt". Additional collateral would be required in the event there is any collateral deficit, at any quarterly valuation date, which would depend upon factors including the market value of Wickes' common stock and the timing and amount of real estate sales. The Company currently has all of its remaining 144 acres of its investment in real estate under contract to sell. The sales proceeds, estimated at $15.7 million (after closing costs) will be used to pay off the current mortgage debt of $11.3 million plus accrued interest and property taxes and the balance of the proceeds will be used to pay down the principal due on the 11% notes. The closing on the sale is subject to the buyer obtaining re-zoning permits. The buyer is entitled not to close on the sale without forfeiture of the earnest money if the permits are not received . If the permits are received, the buyer will forfeit earnest money of $10,000 if he fails to close the sale. The extensions available, under the sales agreement, to obtain the re-zoning permits allow the buyer until August 22, 2000 to close this sale. The Company is having discussions with present and prospective lenders regarding refinancing all, or the portion due after application of the real estate proceeds, of the 11% notes due September 30, 2000 and the note payable to Imagine due August 31, 2000. The Company anticipates that sales of Greenleaf and /or Wickes shares or other asset sales or borrowings will make up the shortfall on these loans. There can be no assurance of this, however. The Company's assessment of the matters described in this note and other forward-looking statements ("Forward-Looking Statements") in these notes are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are inherently subject to uncertainty. The outcome of certain matters described in this note may differ from the Company's assessment of these matters as a result of a number of factors including but not limited to: matters unknown to the Company at the present time, development of losses materially different from the Company's experience, Wickes' ability to prevail against its insurers with respect to coverage issues to date, the financial ability of those insurers and other persons from whom Wickes may be entitled to indemnity, and the unpredictability of matters in litigation. In addition, the discussion above of the Company's future operations, liquidity needs and sufficiency constitutes Forward-Looking Information and is inherently subject to uncertainty as a result of a number of risk factors including, among other things: (i) the success of and level of cash flow generated by Cybermax, (ii) the Company's ability to achieve the level of real estate sales required to meet scheduled real estate debt principal and interest payments and to avoid the requirement that the Company provide additional collateral for this debt, (iii) the Company's ability to borrow, which may depend upon, among other things, the trading price of Wickes common stock, the value and liquidity of the Company's Greenleaf securities, and the success of Cybermax and Buildscape, (iv) the ability of the Company to raise funds through sales of Wickes and Greenleaf common stock and (v) uncertainty concerning the possible existence of indemnification claims resulting from the Company's discontinued operations. Future real estate sales depend upon a number of factors, including re-zoning permits, interest rates, general economic conditions, and conditions in the commercial real estate markets in Atlanta, Georgia and Jacksonville, Florida. In addition to the factors described above, the Company's ability to sell Wickes and Greenleaf common stock would depend upon, among other things, the trading prices for these securities, and, in light of the relatively low trading volume for Wickes, possibly the Company's ability to find a buyer or buyers for these securities in a private transaction or otherwise. 12. EMPLOYEE BENEFIT PLANS ESOP The Company has an Employee Stock Ownership Plan and Trust ("ESOP") in which employees of the Company who work more than 1,000 hours in a plan year are eligible to participate. The Company's Board of Directors determines the amount, if any, of the annual contribution to the ESOP, and each participant shares in this contribution prorata based upon the amount of the participant's compensation as compared to all participants' compensation for such year. As of December 31, 1998, the ESOP owned 181,417 shares of the Company's common stock, of which 48,705 shares were pledged under ESOP loans from the Company. Contributions to the ESOP for payment of principal and interest on the ESOP loans, were $65,000, and $97,000 in 1998 and 1997, respectively. Loans from the Company to the ESOP of $268,000 in 1994 were used to purchase additional shares of common stock. Notes receivable from the ESOP issued to purchase common shares are held by the Company and its subsidiaries. Statement of Position ("SOP") 93-6 issued in 1994 requires presentation of all leveraged shares held by the ESOP ("Unearned ESOP shares") as a reduction to additional paid in capital. Accordingly, the unpaid balance of the notes receivable of $443,000 was reclassified to stockholders' equity in 1994. As of December 31, 1998, this amount has been reduced to $189,500 by the cost of ESOP shares released by repayments on these notes. Unearned ESOP shares are not treated as outstanding for the calculation of earnings per common share. The fair value of unearned ESOP shares as of December 31, 1998 was approximately $184,843. The Company terminated the ESOP plan effective December 29, 1999. The Board approved the termination of the plan and directed the ESOP to sell the unallocated shares and apply the proceeds to the unpaid balance of the note. The ESOP had approximately 58,000 unallocated shares on the date of termination. The ESOP sold 15,000, 15,000 and 20,000 shares respectively, of the Company's stock to the Company's Chairman, President and Chief Executive Officer, Chief Financial Officer and Senior Vice President of Cybermax. The Company received promissory notes of $12,188, $12,188 and $16,250, respectively, from the Company's Chairman of the Board, Chief Financial Officer and Senior Vice President of Cybermax for payment of these shares. All of the notes bear an interest rate 8.50% and are collateralized by the shares sold to these officers. The remaining 8,000 shares are being held pending the outcome of the Internal Revenue Service review of the termination of the plan and will be sold upon completion of this process. In accordance with Rule 5.02.30 of Regulation S-X of the SEC Act of 1934, these promissory notes are reflected as a reduction to Paid in Capital on the Company's Consolidated Balance Sheet. All 58,000 shares are considered issued and outstanding at December 31, 1999. STOCK OPTION PLANS In 1985 the Company established the Riverside Group, Inc. Non-qualified Stock Option Plan (a fixed option plan for employees and directors). Additional information with respect to stock options is as follows: The Company applies APB Opinion No. 25 and related interpretations in accounting for its Option Plan and, accordingly, no compensation cost has been recognized related to the stock option. Had compensation cost been determined in accordance with SFAS 123, the impact on the Company's net income and earnings per share would have been immaterial for 1998 and 1997. In January of 1997, the Company granted a non qualified stock option for 50,000 shares of its stock with an exercise price of $3.00 per share. The Company did not grant any options in 1999 or 1998, respectively. 401(K) PLAN The Company has a Deferred Compensation Plan for all its eligible employees which allows participants to defer up to ten percent of their salary pursuant to Section 401(k) of the Internal Revenue Code. The Company matches contributions up to a maximum of 3% of compensation for employees contributing up to 6%. Employees are 100% vested in their contributions and vest in the Company's contribution over a period of seven years. The Company's contribution was $11,000, $11,000, and $23,000, during 1999, 1998 and 1997, respectively. 13. INCOME TAXES Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company will file a consolidated tax return for 1999 which will include all its subsidiaries with the exception of Wickes. The activities of Buildscape after October 21, 1999 will be reported on a separate tax return. Riverside's ownership in Wickes and Buildscape post October 21, 1999, is below the requirements which allow consolidation for tax purposes, therefore a separate return will be filed for these companies. At December 31, 1999, the Company has net operating loss carry forwards available to offset income of approximately $49 million expiring in years 2000 through 2019. To the extent carry forwards existing at the subsidiaries' acquisition dates have been utilized, the tax benefits are reflected as reductions to the excess of cost over fair value of net assets acquired and the value of acquired insurance in force. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance has been established to reduce deferred tax assets to the amount which more likely than not will be realized in the future. The components of the deferred tax assets and liabilities at December 31, 1999 and 1998 are as follows (in thousands): SFAS 109 requires that the current and non-current components of deferred tax balances be reported separately based on the financial statement classification of the related asset or liability which causes a temporary difference between tax and financial reporting purposes. Items which are not directly related to an asset or liability that exists for financial reporting purposes are classified as current or non-current based on the expected reversal date of the temporary difference. Total long term deferred tax assets have been combined with long term deferred tax liabilities and presented as a net amount on the balance sheet. The income tax provision for 1999 consists of both current and deferred amounts. The components of income tax provision are as follows: Actual income tax expense(benefit) on income(loss) differs from expected tax expense computed by applying the Federal corporate tax rates of 34% in 1999, 1998 and 1997 as follows (in thousands): 14. FAIR VALUE OF FINANCIAL INSTRUMENTS In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial Instruments," information has been provided about the fair value of certain financial information. The following methods and assumptions were used to estimate the fair value of each material class of financial instruments covered by the Statement for which is practicable to estimate that value. INVESTMENT IN WICKES INC. - The fair value of Wickes is determined by the NASDAQ National Market System quoted market price. INVESTMENT IN GREENLEAF TECHNOLOGIES CORP. - The market value of Greenleaf is determined by the Over-the-Counter Bulletin Board price as described below. INVESTMENT IN BUILDSCAPE, INC. - The market value of Buildscape is determined by the share price used in the Imagine transaction. (see Note 6. "Investment in Buildscape") LONG TERM DEBT - The carrying amount is a reasonable estimate of fair value, as the stated rates of interest represent current market rates. MORTGAGE DEBT - The carrying amount is a reasonable estimate of fair value, as the stated rates of interest represent current market rates. The estimated fair value of the Company's financial instruments at December 31, 1999 are summarized as follows (in thousands): 15. RELATED PARTY TRANSACTIONS The Company reimburses its share of actual costs incurred from the Company's use of an airplane owned by an affiliate of Mr. Wilson. Reimbursement expenses were $195,000 in 1999, $398,500 in 1998, and $925,000 in 1997. In 1997, the Company established a reserve for approximately $434,000 related to salaries and expenses either incurred in 1997 or incurred in prior years and charged to this affiliate and not previously paid. In 1998, the Company (exclusive of Wickes) incurred $104,000 of costs from the use of the airplane. This amount reduced the reserve recorded in 1997 to $330,000. In 1999, the Parent Company incurred (exclusive of Wickes) $195,000 of costs from use of the airplane, of which $11,000 reduced the reserve. This amount reduced the reserve to $319,000. A former director and executive officer of the Company was during most of 1998, and all of 1997, a shareholder of the law firm that is general counsel to the Company. The Company paid this firm $515,000 and $834,000, for legal services provided to the Company during 1998 and 1997, respectively. No reimbursements were made in 1999. Included in operations for 1999, 1998 and 1997 is income related to office expenses and tax services either paid to the Company or charged by the Company to Wilson Financial of $34,000, ($632), and $22,000, respectively. At December 31, 1999 and 1998, there was an intercompany balance of approximately $82,000 and $103,000, respectively, owed by Wilson Financial to Riverside related to these net expenses. This balance was reclassified from current assets to long term assets at December 31, 1999 and 1998, respectively. Riverside made loans to a company owned by one of its directors in the amount of $154,114 and $225,000 in 1996 and 1995, respectively. Riverside restructured these notes in 1996, extending the maturity date to June 30, 1997. In 1998 and 1997, Riverside owed this company consulting fees of $67,500 and $90,000, respectively, for services rendered in connection with the natural gas program of Wixx. Both parties agreed to apply the fees against the outstanding principal and interest on the notes. In September of 1998, Riverside decided to discontinue the natural gas program of Wixx. As a result, Riverside established a reserve in the amount of $240,000 in respect to the outstanding principal less the future board of directors fees that Riverside will apply to the remaining balance. Included in operations for 1999, 1998 and 1997 is income related to tax and accounting services paid to the Company by a former affiliate of the Company of $65,000, $12,500 and $7,080, respectively. In late September and early October 1997, the Company sold an aggregate of 64,875 shares of Wickes common stock to Kenneth M. Kirschner, former Vice Chairman and director of the Company, and an executive officer of Wickes, and Frederick H. Schultz, a former director of the Company. The aggregate purchase price was $290,000, or $4.47 per share, which equaled the 30- day average closing bid price for Wickes common stock on the NASDAQ National Stock Market prior to the sales. In the fourth quarter of 1997, J. Steven Wilson, the Company's Chairman, President and Chief Executive Officer advanced $160,000 to the Company. The Company repaid this in June 1998. In addition, the Company advanced Mr. Wilson $150,000 in June 1998. Mr. Wilson repaid this in March of 1999. During December of 1999, three executive officers of the Company and its subsidiaries, purchased 50,000 shares of the Company's common stock in connection with the termination of the Company's ESOP Plan. The Company received promissory notes for $40,626 for payment of these shares. For further information regarding this transaction, see Note 12. "Employee Benefits". These notes have been recorded as a component of stockholders' equity. During 1999, the Company entered into a short-term loan agreement with Imagine. The loan is for $1,800,000, bears interest at an annual rate of 12.75%, and is due August 31,2000. For further information on this short-term loan agreement, see Note 10. "Long-Term Debt." On October 21, 1999, the Company sold 38% of its Buildscape common stock and 100% of its Buildscape preferred stock to Imagine for the cancellation of $3.0 million of indebtedness and 520,000 shares of its Riverside common stock. For further information on this transaction, see Note 6. "Investment in Buildscape". 16. SUBSEQUENT EVENTS On January 28, 2000, the Company and Greenleaf executed a Settlement Agreement. In this agreement, the Company retained 10,000,000 shares of the 14,687,585 shares that it had originally received. The Company also retained a five year option to acquire 2,000,000 additional newly issued shares of Greenleaf's common stock at an exercise price of $.25 per share. In addition to the ten million retained shares, three million of the Greenleaf's shares are held in an escrow account, pursuant to an escrow agreement acceptable to all parties. The proceeds from the sale of the escrow shares are to be used to fund a mutually agreeable joint venture for the marketing of technology and internet-related products, to be owned in equal amounts by Greenleaf and the Company. For further information concerning the Company's obligation on this transaction see Note 5. "Investment in Greenleaf." At December 31, 1999, the Company made payments of $545,046 under its promissory note but was delinquent with respect to required payments of approximately $82,486 of principal and interest to Wickes. In March of 2000, the Company and Wickes renegotiated the terms of the note, deferring all principal payments due through February of 2000, for one year, at which time the principal payments would be due on a quarterly basis. The interest on this note will be paid on a quarterly basis. On March 24, 2000, the Company and the holders of the 11% Notes executed a modification to the agreement dated August 25, 1999. This modification allowed the Company to use 100% of the net sales proceeds from the sale of its Greenleaf Shares to be applied against the semi-annual interest payment due March 31, 2000, in lieu of payment against the principal. In addition, the Company agrees to make a principal reduction of $550,000 on or before April 30, 2000. On April 14, 2000, the Company's Board of Directors approved the issuance of grants and the right to acquire options held by the Company related to one of the Company's investments in Greenleaf. The grants and options approved by the Board of Directors were pursuant to that described and committed to certain officers and employees on October 1, 1998. The terms of the commitments to the employees which were approved by the Board of Directors began the vesting period for the options on October 1, 1998. Accordingly, in the second quarter of 2000, the Company will record a charge to income which represents the value of the shares granted and the vested portion of options granted as represented by the passage of time from the commitment date until the date approved by the Board of Directors. Such approval effectively results in the awarding of vested grants and options and the recognition of compensation expense accordingly. Management has proposed the grant of additional shares and options to certain officers and employees. The issuance of these is subject to the Company's Board of Directors review and approval. The Board has engaged an outside consulting firm to conduct a compensation review and advise them with respect to these issues. 17. INDUSTRY SEGMENT INFORMATION AND QUARTERLY RESULTS OF OPERATIONS The following table sets forth certain financial data for the past three years for the following segments: Buildscape, Cybermax, Wickes and the Parent Group. Wickes' operations are consolidated with those of the Company and its subsidiaries for the first through the third quarter of 1998, all of 1997, and the third and fourth quarters of 1996. The Company accounted for its investment in Wickes' under the equity method for the fourth quarter of 1998 and all of 1999. Buildscape's operations are consolidated with those of the Company and its subsidiaries for all of 1998 and through October 21, 1999. The Company accounted for its investment in Buildscape under the equity method for the remainder of 1999. The "Parent Group" includes real estate, parent company, and discontinued operations and all eliminating entries for inter-company transactions. (1) After October 21, 1999, the Company's balance sheet and statements of operations reflect the Company's investment in Buildscape on the equity method. (2) Prior to July 1, 1996 and after September 30, 1998, the Company's balance sheet and statements of operations reflect the Company's investment in Wickes on the equity method. (3) Includes $1,407,000, $1,502,000, and $1,473,000 for an interest allocation from Riverside on its 11% secured notes, 13% subordinated notes for 1999, 1998 and 1997, respectively. INDEPENDENT AUDITORS REPORT --------------------------- To the Board of Directors and Stockholders of Wickes Inc. Vernon Hills, IL We have audited the accompanying consolidated balance sheet of Wickes Inc. and subsidiaries as of December 25,1999 and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for the year then ended. Our audit also included the financial statement schedule for the year ended December 25, 1999 listed in the Index at Item 14. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Wickes Inc. and subsidiaries as of December 25, 1999, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule for the year ended December 25, 1999, when considered in relation to the basic 1999 consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Deloitte & Touche LLP Chicago, IL February 22, 2000 WF-1 REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Wickes Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, changes in stockholders' equity and cash flows present fairly, in all material respects, the financial position of Wickes Inc. and its subsidiaries at December 26, 1998, and the results of their operations and their cash flows for each of the two years ended December 26, 1998 and December 27, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 15 to the 1999 consolidated financial statements (Note 16 in the 1998 consolidated financial statements), Wickes Inc. has restated previously issued consolidated financial statements to change its accounting for a barter transaction. /s/ PricewaterhouseCoopers LLP Chicago, Illinois February 23, 1999 except for Note 15 in the 1999 financial statements (Note 16 in the 1998 financial statements), as to which the date is August 31, 1999. WF-2 WF-3 WF-4 WF-5 WF-6 1. Description of Business - -- ----------------------- Wickes Inc. (formerly Wickes Lumber Company), through its sales and distribution facilities, markets lumber, building materials and services primarily to professional contractors, repair and remodelers, and do-it- yourself home owners, principally in the Midwest, Northeast and Southern United States. Wickes Inc.'s wholly-owned subsidiaries are: Lumber Trademark Company ("LTC"), a holding company for the "Flying W" trademark; and GLC Division, Inc. ("GLC"), which subleases certain real estate to Wickes Inc. 2. Accounting Policies - -- ------------------- Principles of Consolidation - --------------------------- The consolidated financial statements present the results of operations, financial position, and cash flows of Wickes Inc. and all its wholly-owned subsidiaries (the "Company"). All significant intercompany balances have been eliminated. Fiscal Year - ----------- The Company's fiscal year ends on the last Saturday in December. All periods presented represent 52-week years. Cash and Cash Equivalents - ------------------------- The Company considers all highly liquid investments with a maturity date of three months or less to be cash equivalents. Accounts Receivable - ------------------- The Company extends credit primarily to qualified professional contractors and professional repair and remodelers, generally on a non-collateralized basis. Inventory - --------- Inventory consists principally of finished goods. The Company utilizes the first-in, first-out (FIFO) cost flow assumption for valuing its inventory. Inventory is valued at the lower of cost or market, but not in excess of net realizable value. Property, Plant and Equipment - ----------------------------- Property, plant and equipment are stated at cost and are depreciated under the straight-line method. Estimated useful lives range from 15 to 39 years for WF-7 buildings and improvements. Leasehold improvements are depreciated over the life of the lease. Machinery and equipment lives range from 3 to 10 years. Expenditures for maintenance and repairs are charged to operations as incurred. Gains and losses from dispositions of property, plant, and equipment are included in the Company's statement of operations as other operating income. Rental Equipment - ---------------- Rental equipment consists of hand tools and power equipment held for rental. This equipment is depreciated under the straight-line method over a 5-to-10 year life. Other Assets - ------------ Other assets consist primarily of deferred financing costs and goodwill which are being amortized on the straight-line method, goodwill over 20 to 35 years and deferred financing costs over the expected terms of the related debt agreements. The Company's investment in an international operation was recorded under the equity method. The Company's share of losses is reflected as equity in loss of affiliated company on the Consolidated Statements of Operations. As of December 27, 1997, the Company's investment had been reduced to zero and there is no obligation to make additional investments. Amortization expense for deferred financing costs is reflected as interest expense on the Company's Consolidated Statements of Operations. Trademark - --------- The Company's "Flying W" trademark is being amortized over a 40-year period. Postretirement Benefits Other Than Pensions - ------------------------------------------- The Company provides certain health and life insurance benefits for eligible retirees and their dependents. The Company accounts for the costs of these postretirement benefits over the employees' working careers in accordance with Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Postemployment Benefits - ----------------------- The Company provides certain other postemployment benefits to qualified former or inactive employees. The Company accounts for the costs of these postemployment benefits in the period when it is probable that a benefit will be provided in accordance with SFAS No. 112, "Employers' Accounting for Postemployment Benefits." WF-8 Income Taxes - ------------ The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." Tax provisions and credits are recorded at statutory rates for taxable items included in the consolidated statements of operations regardless of the period for which such items are reported for tax purposes. Deferred income taxes are recognized for temporary differences between financial statement and income tax bases of assets and liabilities. Deferred tax assets are reduced by a valuation allowance when the Company cannot make the determination that it is more likely than not that some portion of the related tax asset will be realized. Earnings Per Common Share - ------------------------- Earnings per common share are calculated in accordance with SFAS No. 128, "Earnings Per Share." Weighted average shares outstanding have been adjusted for dilution using the treasury stock method. Use of Estimates in the Preparation of Financial Statements - ----------------------------------------------------------- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates reported. Impairment of Long-Lived Assets - ------------------------------- The Company evaluates assets held for use and assets to be disposed of in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." This statement requires that long-lived assets and certain identifiable intangibles held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company has historically reviewed excess property held for sale, and when appropriate, recorded these assets at the lower of their carrying amount or fair value (see Note 5). Stock-Based Compensation - ------------------------ SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require, companies to recognize compensation expense for grants of stock, stock options, and other equity instruments to employees based on the fair value of such instruments. The pronouncement requires companies that choose not to adopt the fair value method of accounting to disclose the pro forma net income and earnings per share under the fair value method. As permitted by SFAS 123, the Company elected to continue the intrinsic value method of accounting WF-9 prescribed by APB Opinion 25. As required, the Company has disclosed the pro forma net income and pro forma earnings per share as if the fair value based accounting methods had been used to account for stock-based compensation cost (see Note 9). Segment Reporting - ----------------- In June 1997, the FASB issued SFAS Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement, effective for financial statements for fiscal years beginning after December 15, 1997, requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Generally, financial information is required to be reported on the basis that it is used internally for evaluating segment performance and deciding how to allocate resources to segments. Based on this criteria, the Company has determined that it operates in one business segment, that being the supply and distribution of lumber and building materials to building professionals and do-it-yourself customers, primarily in the Midwest, Northeast, and South. Thus, all information required by SFAS No. 131 is included in the Company's financial statements. No single customer represented more than 10% of the Company's total sales in 1999, 1998, and 1997. Recently Issued Accounting Pronouncements - ----------------------------------------- SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," standardizes the accounting for derivative instruments by requiring that all derivatives be recognized as assets and liabilities and measured at fair value. In June 1999, SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of SFAS No. 133," was issued amending SFAS No. 133 by deferring the effective date for one year, to fiscal years beginning after June 15, 2000. The Company is currently evaluating the effects of this pronouncement. 3. Restructuring and Unusual Charge - -- -------------------------------- During 1997, the Company recorded a $1.5 million restructuring charge for discontinued programs and reductions in its corporate headquarters workforce. The $1.5 million included approximately $0.9 million for severance and postemployment benefits for approximately 25 headquarters employees. The discontinued programs included the Company's mortgage lending, utilities marketing and certain internet programs. This charge was offset by a $2.1 million reduction in accrued costs for a restructuring plan formulated by the Company in late 1995, which was completed in 1997. The $2.1 million reversal included four centers identified for closure that had significantly improved market conditions and would remain open, as well as a change in the estimate of facility carrying costs for sold facilities and those remaining to be sold. WF-10 During the first quarter of 1998, the Company implemented a restructuring plan (the "1998 Plan") which resulted in the closing or consolidation of eight sales and distribution and two manufacturing facilities in February, the sale of two sales and distribution facilities in March, and further reductions in headquarters staffing. As a result of the 1998 Plan, the Company recorded a restructuring charge of $5.4 million in the first quarter and an additional charge of $0.5 million in the third quarter. The $5.9 million cumulative charge included $4.1 million in estimated losses on the disposition of closed facility assets and liabilities, $2.1 million in severance and postemployment benefits related to the 1998 plan, offset by a benefit of $300,000 for adjustments to prior years' restructuring accruals. The $4.1 million in estimated losses included the write-down of assets (excluding real estate), to their net realizable value, of $3.4 million and $700,000 in real estate carrying costs. The $2.1 million in severance and postemployment benefits covered approximately 250 employees, 25 of which were headquarters employees, that were released as a result of reductions in headquarters staffing and the closing or consolidation of the ten operating facilities. The $300,000 benefit from prior years was a result of accelerated sales of previously closed facilities during the fourth quarter of 1997 and first quarter of 1998. The acceleration of these sales resulted in a change in the estimate of facility carrying costs for the sold facilities. At December 26, 1998, the accrued liability for restructuring had been reduced to zero. For further information regarding the sale of closed center real estate see Note 5. 4. Acquisitions - -- ------------ The Company made four acquisitions during 1999, all component facilities. The total purchase price of these acquisitions was $14.3 million, of which $13.0 million was paid in cash in 1999 with the remainder to be paid in 2000 and 2001, payable in cash or stock at the option of the Company. In January, the Company acquired the assets of a wall panel manufacturer located in Cookeville, Tennessee. In March, the Company acquired the assets of Porter Building Products, a manufacturer of trusses and wall panels, located in Bear, Delaware. In October, the Company acquired the assets of Advanced Truss Systems, Inc. of Kings Mountain, North Carolina. Advanced Truss Systems is a manufacturer of engineered wood trusses, servicing the greater Charlotte, North Carolina, market. In November, the Company acquired the assets of United Building Systems, Inc. of Lexington, Kentucky. United Building Systems is a manufacturer of wall panels and roof and floor trusses, in the Lexington, Kentucky, market. The costs of these acquisitions have been allocated on the basis of the fair value of the assets acquired and the liabilities assumed. The excess of the purchase price over the fair value of the net assets acquired for three of the acquisitions resulted in goodwill, which is being amortized over a 20-year period on a straight-line basis. All acquisitions have been accounted for as purchases. Operations of the companies acquired have been included in the accompanying consolidated financial statements from their respective acquisition dates. WF-11 During 1998, the Company acquired the operating assets of Eagle Industries Inc., a component manufacturer, for a total cost of $1.8 million. The acquisition was accounted for as a purchase and the cost has been allocated on the basis of the fair value of the assets acquired and liabilities assumed. This operation has been included in the accompanying consolidated financial statements from its date of acquisition. The Company had no acquisitions in 1997. The results of all acquisitions were not material to the Company's consolidated operations. 5. Property, Plant, and Equipment - -- ------------------------------ Property, plant and equipment is summarized as follows: Sale of Real Estate - ------------------- Except for the sale/leaseback of the Company's Succasunna, NJ sales and distribution facility in 1997, which included a $3,000,000 note receivable that was collected within 60 days, all sales of real estate have been for cash. In 1999, the Company sold five pieces of real estate, all of which were sales and distribution facilities, for a net gain of $1.4 million. One property, which WF-12 had been held for sale since the first quarter of 1990, had been previously written down by $200,000 from its original net book value and sold at a net loss of $23,000. The other four properties, one held for sale since 1992 and the others since 1998, had not been previously written down and each were sold for net gains. In 1998, the Company sold nine pieces of real estate, eight of which were sales and distribution facilities and one, an excess parcel of land, for a net gain of $1.6 million. Eight of the properties sold had been held for sale since the first quarter of 1998 and had not been previously written down from their original net book value. The ninth property, which had been held for sale since 1989, had been previously written down by $709,000 from its original net book value and sold at a net loss of $59,000. In 1997, the Company sold 12 pieces of real estate for a net gain of $6.0 million. These transactions included the sale/leaseback of the Company's headquarters and the Succasunna sales and distribution facility and the sale of nine sales and distribution facilities and one excess parcel of land. Of the properties sold, one sales and distribution facility was held for sale since 1989, had been previously written down $99,600 from its original net book value, and sold at a loss of $100,400. The other 11 properties had not been previously written down from book value and had been held for sale since 1992 (2 properties), 1995 (4 properties), 1996 (2 properties) and 1997 (3 properties). The Company reviews assets held for sale in accordance with SFAS No. 121. At December 25, 1999, the Company held seven properties for resale which had been written down to their estimated fair market values in 1997 and prior. In 1997, the Company recorded a loss of $156,000 to report land, land improvements and buildings held for sale at their fair value. The Company did not record any impairment to the cost of assets held for sale in 1999 or 1998. Certain of these properties are leased to others until such time that appropriate disposition can be affected. These charges are included in the caption "restructuring and unusual items" on the Consolidated Statement of Operations. 6. Accrued Liabilities - -- ------------------- Accrued liabilities consist of the following: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Long-Term Debt - -- -------------- Long-term debt obligations are summarized as follows: Revolving Line of Credit - ------------------------ At December 26, 1998, the Company had a revolving line of credit, which was to expire on March 31, 2001. Under this line of credit the Company could borrow against certain levels of accounts receivable and inventory, up to a maximum credit limit of $130,000,000. On February 17, 1999, the Company entered into a new revolving credit agreement with a group of financial institutions with an expiration date of June 30, 2003. The new revolving line of credit provided for, subject to restrictions and modifications discussed below, up to $160 million of revolving credit loans and credits. A commitment fee of 0.25% is payable on the unused amount of the new revolving line of credit. Until delivery to the lenders of the Company's financial statements for the period ending June 26, 1999, interest on amounts outstanding under the new revolving line of credit will bear interest at a spread above the base rate of BankBoston, N.A. of 0.50%, or 2.00% above the applicable LIBOR rate. After that time, depending upon the Company's rolling four-quarter interest coverage ratio, amounts outstanding under the new revolving line of credit will bear interest at a spread above the base rate of from 0% to 0.75% or from 1.50% to 2.25% above the applicable LIBOR rate. On July 8, 1999, the revolving credit agreement was amended to clarify the definition of unused availibilty to allow the full amount of the Company's borrowing base to be included in the unused availibilty calculation. WF-14 On September 9, 1999, the revolving credit agreement was amended to increase the total commitment from $160 million to $200 million from May 15 through November 15 of each year. At December 25, 1999, the amount available for additional borrowing was $38.8 million. The weighted-average interest rate for the years ending December 25, 1999 and December 26, 1998 was approximately 7.72% and 8.22%, respectively. With delivery to the lenders of the Company's financial statements for the period ending September 25, 1999, the Company's borrowing spreads were reduced to 1.75% above the applicable LIBOR and to 0.25% above the base rate. Substantially all of the Company's accounts receivable, inventory and general intangibles are pledged as collateral for the revolving line of credit. Availability is limited to 85% of eligible accounts receivable plus 60% of eligible inventory, with these percentages subject to change in the permitted discretion of the agent for the lenders. Covenants under the related debt documents require, among other things, that the Company maintain unused availability under the revolving line of credit of at least $15 million (subject to increase in certain circumstances) and maintain certain levels of tangible capital funds, as defined in the loan and credit agreement. In addition, these documents restrict, among other things, capital expenditures, the incurrence of additional debt, asset sales, dividends, investments, and acquisitions. In conjunction with the revolving credit agreement, the Company terminated its existing interest rate swap agreement and entered into a new interest rate swap agreement (see Note 12). Senior Subordinated Notes - ------------------------- On October 22, 1993, the Company issued $100,000,000 principal amount of 10- year unsecured senior subordinated notes, due December 15, 2003. Interest on the notes is 11-5/8%, payable semi-annually. Covenants under the related indenture restricts, among other things, the payment of dividends, the prepayment of certain debt, the incurrence of additional debt if certain financial ratios are not met, and the sale of certain assets unless the proceeds are applied to the notes. In addition, the notes require that, upon a change in control of the Company, the Company must offer to purchase the notes at 101% of the principal thereof, plus accrued interest. Aggregate Maturities - -------------------- The aggregate amount of long-term debt of $220.7 million matures in fiscal year 2003. WF-15 8. Commitments and Contingencies - -- ----------------------------- At December 25, 1999, the Company had accrued approximately $132,000 for remediation of certain environmental and product liability matters, principally underground storage tank removal. Many of the sales and distribution facilities presently and formerly operated by the Company contained underground petroleum storage tanks. All such tanks known to the Company located on facilities owned or operated by the Company have been filled or removed in accordance with applicable environmental laws in effect at the time. As a result of reviews made in connection with the sale or possible sale of certain facilities, the Company has found petroleum contamination of soil and ground water on several of these sites and has taken, and expects to take, remedial actions with respect thereto. In addition, it is possible that similar contamination may exist on properties no longer owned or operated by the Company, the remediation of which the Company could under certain circumstances be held responsible. Since 1988, the Company has incurred approximately $2.0 million of costs, net of insurance and regulatory recoveries, with respect to the filling or removing of underground storage tanks and related investigatory and remedial actions. Insignificant amounts of contamination have been found on excess properties sold over the past five years. The Company has accrued $43,000 for estimated clean-up costs at 11 of its locations. The Company has been identified as having used two landfills which are now Superfund clean up sites, for which it has been requested to reimburse a portion of the clean up costs. Based on the amounts claimed and the Company's prior experience, the Company has accrued $28,000 for these matters. The Company is one of many defendants in two class action suits filed in August of 1996 by approximately 200 claimants for unspecified damages as a result of health problems claimed to have been caused by inhalation of silica dust, a byproduct of concrete and mortar mix, allegedly generated by a cement plant with which the Company has no connection other than as a customer. The Company has entered into a cost-sharing agreement with its insurers, and any liability is expected to be minimal. The Company is one of many defendants in approximately 145 actions, each of which seeks unspecified damages, in various Michigan state courts against manufacturers and building material retailers by individuals who claim to have suffered injuries from products containing asbestos. Each of the plaintiffs in these actions is represented by one of two law firms. The Company is aggressively defending these actions and does not believe that these actions will have a material adverse effect on the Company. Since 1993, the Company has settled 30 similar actions for insignificant amounts, and another 224 of these actions have been dismissed. None of these suits have made it to trial. Losses in excess of the $132,000 reserved as of December 25, 1999 are possible but an estimate of these amounts cannot be made. WF-16 The Company is involved in various other legal proceedings which are incidental to the conduct of its business. Certain of these proceedings involve potential damages for which the Company's insurance coverage may be unavailable. While the Company does not believe that any of these proceedings will have a material adverse effect on the Company's financial position, annual results of operations or liquidity, there can be no assurance of this. Leases - ------ The Company has entered into operating leases for corporate office space, retail space, equipment and other items. These leases provide for minimum rents. These leases generally include options to renew for additional periods. Total rent expense under all operating leases was $13,640,000, $12,193,000, and $10,616,000 for the years ended December 25, 1999, December 26, 1998, and December 27, 1997, respectively. Future minimum commitments for noncancelable operating leases are as follows: 9. Stockholders' Equity - -- -------------------- Preferred Stock - --------------- As of December 25, 1999, the Company had authorized 3,000,000 shares of preferred stock, none of which were issued or outstanding. Common Stock - ------------ The Company currently has one class of common stock: Common Stock, par value $.01 per share. At December 25, 1999, there were 20,000,000 shares of Common Stock authorized and 8,224,888 shares issued and outstanding. In addition, at WF-17 December 25, 1999, 895,369 shares of Common Stock were reserved for issuance under the Company's 1993 Long-Term Incentive Plan and 1993 Director Incentive Plan. Warrants - -------- The Company's unexercised outstanding warrants for 3,068 shares of Common Stock expired in May 1998, and, as of December 25, 1999, there were no warrants outstanding or Common Stock reserved for issuance under warrants. Stock Compensation Plans - ------------------------ As of December 25, 1999, the Company has two stock-based compensation plans (both fixed option plans), which are described below. Under the 1993 Long- Term Incentive plan as amended on November 30, 1994, the Company may grant options and other awards to its employees for up to 835,000 shares of common stock. Under the 1993 Director Incentive plan, the Company may grant options and other awards to directors with for up to 75,000 shares. The exercise price of grants equals or exceeds the market price at the date of grant. The options have a maximum term of 10 years. For non-officers, the options generally become exercisable in equal installments over a three- year period from the date of grant. For officers the vesting periods can vary by grant. Since the Company applies APB Opinion 25 and related interpretations in accounting for its plans, no compensation cost has been recognized in conjunction with these plans. Had compensation cost for the Company's stock-based compensation plans been determined consistent with SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below (in thousands, except per share data): The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1999, 1998, and 1997, respectively: dividend yield of 0% for all years, expected volatility of 49%, 48%, and 43%; risk-free interest rates of 5.1%, 5.6%, and 6.6%; and expected lives of 5.6, 5.6, and 6.6 years. WF-18 A summary of the status of the Company's fixed stock option plans as of December 25, 1999, December 26, 1998, and December 27, 1996 and changes during the years ended on those dates is presented as follows: Weighted-average fair value of options granted during the year where: The following table summarizes information about fixed stock options outstanding at December 25, 1999: WF-19 Earnings Per Share - ------------------ The Company calculates earnings per share in accordance with SFAS No. 128. The following is the reconciliation of the numerators and denominators used for basic and diluted earnings per share: In years where net losses are incurred, diluted weighted-average common shares are not used in the calculation of diluted EPS as it would have an anti-dilutive effect on EPS. In addition, options to purchase 227,000 weighted-average shares of common stock during 1999 were not included in the diluted EPS as the options' exercise prices were greater than the average market price. 10. Employee Benefit Plans - --- ---------------------- 401(k) Plan - ----------- The Company sponsors a defined contribution 401(k) plan covering substantially all of its full-time employees. Additionally, the Company provides matching contributions up to a maximum of 2.5% of participating employees' salaries and wages. Total expenses under the plan for the years ended December 25, 1999, December 26, 1998, and December 27, 1997 were $1,754,000, $1,480,000, and $1,606,000, respectively. WF-20 Postretirement Benefits Other Than Pensions - ------------------------------------------- The Company provides life and health care benefits to retired employees. Generally, employees who have attained an age of 60, have rendered 10 years of service and are currently enrolled in the medical benefit plan are eligible for postretirement benefits. The Company accrues the estimated cost of retiree benefit payments during the employee's active service period. The following tables reconcile the postretirement benefit, the plan's funded status and actuarial assumptions, as required by Statement of Financial Accounting Standard No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." WF-21 Postemployment Benefits - ----------------------- The Company provides certain postemployment benefits to qualified former or inactive employees who are not retirees. The Company had accrued $161,000 and $165,000 at December 25, 1999 and December 26, 1998, respectively. These benefits include salary continuance, severance, and healthcare. Salary continuance and severance pay are based on normal straight-line compensation and calculated based on years of service. Additional severance pay is granted to eligible employees who are 40 years of age or older and have been employed by the Company five or more years. The Company accrues the estimated cost of benefits provided to former or inactive employees who have not yet retired over the employees' service period or as an expense at the date of the event triggering the benefit. WF-22 11. Income Taxes - --- ------------ The Company and its subsidiaries file a consolidated federal income tax return. As of December 25, 1999, the Company has net operating loss carryforwards available to offset income of approximately $35.9 million expiring in the years 2006 through 2018. The income tax provision consists of both current and deferred amounts. The components of the income tax provision are as follows: Tax provision and credits are recorded at statutory rates for the taxable items included in the consolidated statements of operations regardless of the period for which such items are reported for tax purposes. Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The valuation allowance primarily relates to losses incurred on certain investments which the Company believes may not be fully deductible for tax purposes. Management has determined, based on the Company's positive earnings in 1999 and its expectations for the future, that operating income of the Company will more likely than not be sufficient to fully recognize its remaining net deferred tax assets. The components of the deferred tax assets and liabilities at December 25, 1999, December 26, 1998 and December 27, 1997, respectively, are as follows: WF-23 The following table summarizes significant differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rates to income before taxes: WF-24 12. Financial Instruments - --- --------------------- The Company uses financial instruments in its normal course of business as a tool to manage its assets and liabilities. The Company does not hold or issue financial instruments for trading purposes. Gains and losses relating to hedging contracts are deferred and recorded in income or as an adjustment to the carrying value of the asset at the time the transaction is complete. Payments or receipts of interest under interest rate swap arrangements are accounted for as an adjustment to interest expense. The fair value of such financial instruments is determined through dealer quotes. For cash and cash equivalents, accounts receivable, accounts payable and notes payable, the carrying amount approximates fair value due to the short maturity of these instruments. The estimated fair values of the Company's material financial instruments are as follows: Long-Term Debt - -------------- The fair value of the Company's long-term debt, is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Lumber Futures Contracts - ------------------------ The Company enters into lumber futures contracts as a hedge against future lumber price fluctuations. All futures contracts are purchased to protect long-term pricing commitments on specific future customer purchases. At December 25, 1999, the Company had 15 lumber futures contracts outstanding with a total market value of $552,000 and an immaterial net unrealized loss. These contracts all mature in 2000. WF-25 Interest Rate Swap - ------------------ At December 26, 1998, the Company had in place an interest rate swap agreement which effectively fixed the interest rate on $40 million of the Company's borrowings under its floating rate revolving line of credit at 8.11% (subject to adjustments in certain circumstances), for three years. This interest rate swap was operative while the 30-day LIBOR borrowing rate remained below 6.7%. The agreement also included a floor LIBOR rate at 4.6%. At December 23, 1998 the 30-day LIBOR borrowing rate was 5.625%. The fair value of the interest rate swap agreement, in accordance with SFAS No. 107, at December 26, 1998 was a negative $400,000. On February 17, 1999, in conjunction with the Company's new revolving credit agreement (see Note 7), the Company terminated its interest rate swap agreement and entered into a new interest rate swap agreement. This new agreement effectively fixed the Company's borrowing cost at 7.75% (based on the LIBOR plus 2.00% pricing in effect on February 17, 1999), reduced from 8.11% under the old agreement, for three years, on $40 million of the Company's borrowings under its floating rate revolving line of credit. At September 25, 1999, the Company's performance reduced the rate charged to LIBOR plus 1.75%, fixing the Company's borrowing cost on $40 million at 7.50% through December 25, 1999. Unlike the prior agreement, this interest rate swap has no provisions for termination based on changes in the 30-day LIBOR borrowing rate. 13. Related Party Transactions - ------------------------------- In February 1998, as part of the determination made by the Company to discontinue or sell non-core programs, the Company sold certain operations to its majority stockholder for a three-year $870,000 unsecured promissory note and 10% of future net income of these operations (subject to a maximum of $429,000 plus interest). At December 25, 1999 this stockholder had made payments of $545,046 under the promissory note and was delinquent with respect to required payments of approximately $82,486 of principal and interest. The Company and the stockholder have reached an agreement that requires all accrued interest to be paid by March 31, 2000 and that extends the terms for repayment of principal. In 1999, the Company paid approximately $660,000 in reimbursements primarily to affiliates of the Company's chairman, for costs related to services provided to the Company during 1999 by certain employees of the affiliated company and use of a corporate aircraft. Total payments in 1998 and 1997 for similar services were approximately $730,000 and $1,289,000, respectively. In June of 1996, the Company entered into a mortgage lending agreement with an affiliate of the Company's chairman. In exchange for providing home construction loans to the Company's customers the Company reimbursed this affiliate for certain start-up expenses. Reimbursements in 1998 and 1997 were approximately WF-26 $115,000 and $1,045,000, respectively, and were expensed as incurred. In late 1997, this affiliate's involvement in the program ceased. No reimbursements were made in 1999. A former director and executive officer of the Company was, during most of 1998 and all of 1997, a shareholder of the law firm that is general counsel to the Company. The Company paid this firm $741,000 and $665,000 for legal services provided to the Company during 1998 and 1997, respectively. 14. Other Operating Income - -------------------------- Other operating income on the Company's Statement of Operations includes primarily the sale or disposal of property, plant and equipment, service charges assessed customers on past due accounts receivables and casualty gains/losses. The sale of property, plant and equipment includes the sale of 5, 9, and 12 pieces of real estate in 1999, 1998 and 1997, respectively. In 1998, casualty gains of $1.0 million were recorded as a result of the differences between insured replacement cost and net book value resulting from fire and storm damage at certain of the Company's sales and distribution facilities. The following table summarizes the major components of other operating income by year. 15. Barter Transaction - ----------------------- At any given time approximately 1% to 2% of the Company's total inventory will be classified as delete or obsolete merchandise. Delete or obsolete merchandise consists of inventory that, while in good sellable condition, will be discontinued for one of several business reasons. This inventory, which may consist of items from any of the Company's product lines, historically has been marked down in value by approximately 20% to 30% of its original cost. WF-27 In September of 1998, the Company entered into a transaction in which it exchanged delete/obsolete merchandise, with an impaired book value of $1.2 million, for barter credits at a stated value of $1.6 million. As part of the barter transaction the Company had agreed to sell the merchandise for the new owner, on a clearance basis, and remit the proceeds, up to $350,000, to the owner. The Company entered into the transaction to free valuable showroom and storage space for new merchandise. The value of this merchandise had been previously reduced from its original cost of approximately $1.6 million to $1.2 million, based on the Company's most recent sales information. Initially the exchange was considered to be a non-monetary exchange, as outlined under APB 29 and EITF 93-11, and no further impairment was recorded at that time. The barter credits were recorded as a prepaid expense with a value of $1.2 million. Subsequent to the second quarter of 1999, the Company restated its September 1998 financial statements to account for the barter transaction as a monetary transaction, upon receiving written confirmation from a second "Big Five" accounting firm and after careful review and concurrence of its Board of Directors Audit Committee. A non-cash charge of $844,000 has now been recorded to reduce the value of the inventory exchanged, and the resulting book value of the barter credits, from approximately $1.2 million to $350,000. As a result of this change, the Company will also record increased future earnings for each dollar of barter credits used in excess of $350,000. The following table reconciles the amounts previously reported to the amounts currently being reported in the condensed consolidated statements of operations for the year ended December 26, 1998 (amounts in thousands, except per share data). 16. Selected Quarterly Financial Data (unaudited) - -------------------------------------------------- The following table contains selected unaudited quarterly financial data for the years ended December 25, 1999, December 26, 1998 and December 27, 1997. Quarterly earnings/(loss) per share may not total to year end earnings/(loss) per share due to the issuance of additional shares of Common Stock during the course of the year. WF-28 WF-29 INDEPENDENT AUDITORS' REPORT To the Directors and Stockholders of Buildscape, Inc. (A Development Stage Company): We have audited the accompanying balance sheets of Buildscape, Inc. (a development stage company) (the "Company") as of December 31, 1999 and 1998, and the related statements of operations, stockholders' equity (deficit) and cash flows for the years then ended and for the period from date of inception through December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Buildscape, Inc. at December 31, 1999 and 1998, and the results of its operations and its cash flows for the years then ended and for the period from date of inception through December 31, 1999, in conformity with accounting principles generally accepted in the United States of America. The Company is in the development stage at December 31, 1999. As discussed in Note 1 to the financial statements, successful completion of the Company's development program and, ultimately, the attainment of profitable operations, is dependent upon future events, including obtaining adequate financing to fulfill its development activities and achieving a level of sales adequate to support the Company's cost structure. Dallas, Texas March 10, 2000 BS-1 BUILDSCAPE, INC. (A Development Stage Company) BALANCE SHEETS DECEMBER 31, 1999 AND 1998 BS-3 BUILDSCAPE, INC. (A Development Stage Company) STAATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) YEARS ENDED DECEMBER 31, 1999 AND 1998, AND THE PERIOD FROM DATE OF INCEPTION THROUGH DECEMBER 31, 1999 - ---------------------------------------------------------- See notes to financial statements. BS-4 BUILDSCAPE INC. (A Development Stage Company) STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1999 AND 1998, AND THE PERIOD FROM DATE OF INCEPTION THROUGH DECEMBER 31, 1999 - --------------------------------------------- BS-5 (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999 AND 1998 - -------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BUSINESS - Buildscape, Inc. (a development stage company) (the "Company") was incorporated on January 13, 1998, to provide home- building materials, service and commerce online to consumers and profess- ionals in the home-building industry. Prior to incorporation, the Company was funded by the Riverside Group, Inc. ("Riverside"). On October 21, 1999, Imagine Investments, Inc. ("Imagine") acquired from Riverside 1,880,933 shares of the Company's 5,000,000 outstanding shares of common stock in exchange for (i) the cancellation of $3 million of indebtedness and (ii) 520,000 shares of Riverside's common stock held by Imagine. Riverside retained the remaining 3,119,067 outstanding shares of the Company's common stock. In addition, the Company issued to Imagine 1,666,667 shares of the Company's voting Series A Cumulative Convertible Preferred Stock with a $5 million aggregate liquidation preference in exchange for $5,000,000. As a result of this transaction, Riverside owns 47% of the Company on a fully converted basis. Imagine owns 38% of the common shares and 100% of the preferred shares of the Company, or 53%, on a fully converted basis. The Company has experienced cumulative operating losses, and its operations are subject to certain risks and uncertainties, including, among others, risks associated with technology and regulatory trends, evolving industry standards, growth and acquisitions, actual and prospective competition by entities with greater financial and other resources, the development of the Internet market and the need for additional capital. There can be no assurances that the Company will be successful in becoming profitable or generating positive cash flow in the future. The Company is considered to be a development stage company. CASH AND CASH EQUIVALENTS - The Company considers all highly liquid investment instruments with a maturity date of three months or less at date of purchase to be cash equivalents. INVENTORIES - Inventories consist principally of finished goods such as tools and other building supplies and materials. The Company uses the first-in, first-out ("FIFO") method for valuing its inventory. Inventory is valued at the lower of cost or market, but not in excess of net realizable values. FURNITURE AND EQUIPMENT - Furniture and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, generally three years or less. REVENUE RECOGNITION - Revenue consists of sales of products sold through the Company's online superstore and auction sites and of advertising fees. The Company recognizes revenue when earned. In the case of product sales, revenue is recognized when the product is shipped. Advertising revenue, which is all cash, is recognized over the term of the contract. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. BS-6 INCOME TAXES - On October 21, 1999, the Company went through an ownership change, which was considered a Section 382 exchange in the Internal Revenue Code. As a result of this change, the net operating loss carryforward available for use each year will be subject to an annual limitation. Prior to October 21, 1999, the Company was included in the consolidated federal and state income tax returns of Riverside. Income taxes were calculated on a separate return filing basis. Subsequent to October 21, 1999, the Company will file a separate tax return. Therefore, a portion of the Company's losses may be utilized in the consolidated Riverside tax return. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued in June 1998 and establishes standards for accounting and reporting for derivative instruments. It requires entities to record all derivative instruments on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and on the type of hedge transaction. The portion of all hedges not effective in achieving offsetting changes in fair value is recognized in earnings. SFAS No. 133, as amended, is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. Management has completed its evaluation of the impact of the provisions of this statement on the Company's financial statements and believes its adoption will not have a material effect on its financial statements. COMPREHENSIVE INCOME - The Company has no elements of comprehensive income. SEGMENTS - The Company is in a single-market segment. LONG-LIVED ASSETS - The carrying value of long-lived assets is periodically reviewed to determine whether impairment exists. The review is based on comparing the carrying amount of the assets to the undiscounted estimated cash flows over the remaining useful lives. No impairment is indicated as of December 31, 1999. 2. FURNITURE AND EQUIPMENT Furniture and equipment at December 31 consisted of the following: 1999 1998 ---- ---- Computer equipment $ 319,159 $ 127,072 Computer software 741,505 4,541 Furniture and office equipment 14,966 -- ----------- ----------- Total 1,075,630 131,613 Accumulated depreciation and amortization (170,647) (42,787) ----------- ----------- Furniture and equipment - net $ 904,983 $ 88,826 =========== =========== Depreciation expense was $127,860 and $42,787 for 1999 and 1998, respectively. BS-7 3. OTHER ASSETS Other assets at December 31 consisted of the following: 1999 1998 ---- ---- Organization costs $ -- $ 81,359 Security deposit 4,568 -- ----------- ----------- Total 4,568 81,359 Accumulated amortization -- (10,648) ----------- ----------- Other assets - net $ 4,568 $ 70,711 =========== =========== Amortization expense was $10,648 for 1998. During 1999, in accordance with Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities," the Company expensed the remaining $70,711 of organization costs. 4. NOTE PAYABLE At December 31, 1998, the Company had a note payable to Riverside of $804,779. The note was unsecured, with principal payable in quarterly installments and including interest, calculated at Bankers Trust Company's prime lending rate plus 2% (9.75% at December 31, 1998), with a maturity on May 15, 2001. In 1999, the note was contributed as equity by Riverside. At December 31, 1999, the Company did not have any notes payable outstanding. 5. STOCKHOLDERS' EQUITY COMMON STOCK - Upon incorporation on January 13, 1998, the Company issued 1,000 shares of common stock, $0.01 par value per share, at a purchase price of $10. On October 15, 1999, the Board approved a 5,000-to-1 common stock split. All periods presented have been restated to reflect the split. SERIES A CUMULATIVE CONVERTIBLE, VOTING PREFERRED STOCK - The Company has authorized the issuance of up to 3,000,000 shares of its Series A Cumulative Convertible Preferred Stock ("Series A Preferred"). On October 21, 1999, the Company sold 1,666,667 shares, par value $0.01 per share, at a purchase price of $3.00 per share. Each share of preferred stock is convertible into one share of common stock and has voting rights equal to its applicable common stock conversion amount. Upon the consummation of a qualified public offering of common stock, each share of Series A Preferred outstanding will be automatically converted into common stock. In the event of liquidation or dissolution, the preferred shares have liquidation privileges of $5,000,000 before any distributions are made to holders of common stock, and receive a pro rata share of any dividends declared for common stock based on the number of shares of common stock into which such preferred shares are then convertible. DISTRIBUTION TO STOCKHOLDER - In 1997, $710,158 of expenses related to the start-up of the Company were paid by Riverside. These costs were recognized by the Company and recorded as an equity contribution. In 1998, the costs incurred by Riverside prior to the incorporation of the Company were repaid to Riverside and recorded by the Company as a distribution to stockholder. CAPITAL CONTRIBUTION FROM STOCKHOLDER - During 1998, Riverside provided services to the Company, including technical, marketing, human resources, accounting, tax and executive management. Riverside also provided office space and a telephone system for home office operations, insurance, and various office supplies and equipment. These services were included, at cost, in the results of operations in the amount of $4,630,765 and as a capital contribution. BS-8 CURRENT STOCK OPTION PLAN - Effective January 1, 1999, the Board of Directors approved the adoption of a stock option plan to be administered by a committee. Each option is exercisable in accordance with certain price and vesting restrictions. The committee shall, in any agreement, prescribe a vesting schedule that governs when the option becomes fully vested and exercisable. Unless the agreement prescribes a different schedule, the options shall be vested and exercisable as follows: one-third on or after the date that is one calendar year from the date the option was granted, two-thirds after two calendar years and 100% after three calendar years. During 1999, 926,100 options were granted at an exercise price of $1.00 per share, of which 5,250 of these options were forfeited during the year. Also during 1999, 8,000 options were granted at a price of $3.00 per share. As of December 1999, no options were vested or exercisable. The Company applies the provisions of APB No. 25 and related interpretations in accounting for its stock option plan. Accordingly, no compensation cost has been recognized for its stock option plan, since the exercise price of the Company's stock option grants was the estimated fair market value of the underlying stock on the date of the grant. Had compensation costs for the stock option plan been determined based on the fair value at the grant date consistent with SFAS No. 123, "Accounting for Stock Based Compensation," the Company's net loss for 1999 would not have been significantly affected. 6. COMMITMENTS AND CONTINGENCIES The Company shares executive offices with Riverside in leased office spaces. Riverside allocates rent based on square footage to the Company. In addition, the Company leases offices in various states, which expire in 2001. Future minimum commitments on operating leases at December 31, 1999, are as follows: Year ending: 2000 $ 118,007 2001 49,369 Thereafter -- --------- Total $ 167,376 7. EMPLOYEE BENEFIT PLANS The Company has a deferred compensation plan for all of its eligible employees, which allows participants to defer up to 10% of their compensation pursuant to Section 401(k) of the Internal Revenue Code. The Company matches up to a maximum of 3% of the compensation for employees contributing up to 6%. Employees are 100% vested in their contributions and vest in the Company's contribution over a period of seven years. The Company's contribution to the 401(k) plan was $19,958 for 1999. 8. RELATED PARTIES For certain costs, including office space and overhead; business services, such as Internet connectivity telephone service; human resources; and accounting, the Company and Riverside have entered into a shared services agreement. This agreement allocates expenses to each company based on its proportioned usage. During 1999, the Company paid $313,886 for these services. BS-9 The Company reimburses its share of actual costs incurred from its use of an airplane owned by an affiliate of the President and CEO of the Company. The amount of expenses reimbursed were $202,591 and $13,068 for 1999 and 1998, respectively. During 1999, the Company had interest expense on debt payable to Imagine in the amount of $121,732. The Company also paid interest in the amount of $57,408 to Riverside. Also during 1999, the Company paid commissions to Wickes, Inc., a company in which Riverside and Imagine own common stock totaling approximately 49%, in the amount of $43,062 from advertising revenue received on advertisements over the Company's website. 9. FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. CASH AND CASH EQUIVALENTS, ACCOUNTS RECEIVABLE, ACCOUNTS PAYABLE AND ACCRUED EXPENSES - The carrying amounts of these items are a reasonable estimate of their fair value. NOTE PAYABLE - Interest rates that are currently available to the Company for issuance of debt with similar terms and remaining maturities are used to estimate fair value for bank debt. The carrying amounts comprising this item are reasonable estimates of fair value. The fair value estimates are based on pertinent information available to management as of December 31, 1999. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and current estimates of fair value may differ significantly from the amounts presented. BS-10 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders, Riverside Group, Inc.: Our report on the consolidated financial statements of Riverside Group, Inc. and subsidiaries is included on page of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 36 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. PricewaterhouseCoopers LLP Jacksonville, Florida April 14,2000 S-1 Riverside Group, Inc. and Subsidiaries Schedule II - Valuation and Qualifying Accounts for the Years Ended December 31, 1999 and December 31, 1998 (dollars in thousands) (1) Net of reserved and collected amounts. (2) Allowance for doubtful accounts charged to restructuring reserve. S-2 SCHEDULE III Riverside Group, Inc. (Parent Only) Condensed Financial Information of Registrant Balance Sheets (unaudited, in thousands) S-3 Schedule III Riverside Group, Inc. (Parent Only) Condensed Financial Information of Registrant Condensed Statements of Operations (unaudited, in thousands) S-4 MODIFICATION TO CREDIT AGREEMENT This Agreement is made as of the ____ day of March, 2000, by and between RIVERSIDE GROUP, INC., a Florida corporation (the "Company") and MITCHELL W. LEGLER, as agent for the Holders, as defined below (the "Agent"). Recitation of Facts A. The Company, the Agent and the Holders are parties to a Credit Agreement dated as of April 1, 1999 (the "Credit Agreement"). B. The capitalized terms used herein shall have the meanings ascribed to them in the Credit Agreement unless other meanings are set forth herein. C. Section 4.3 of the Credit Agreement provides that, subject to certain conditions, the Agent will release the Greenleaf Shares from the Agent's security interest upon the sale of such shares provided that 50% of the net proceed of sale is applied to prepayment of the Notes. D. The Company has requested that it be permitted to apply up to 100% of the net sales proceeds of the Greenleaf Shares to the payment of accrued but unpaid interest due to the Holders on March 31, 2000 (the "March Interest Payment"). The Agent has agreed to such release upon the terms and conditions set forth below. Agreement In consideration of the release by the Agent of Greenleaf Shares as set forth herein and for other good and valuable consideration, the Company and the Agent agree as follows: 1. Use of Proceeds. Notwithstanding the provisions of Section 4.3 of the Credit Agreement, the net proceeds from the sale of released Greenleaf Shares shall be applied as follows: (a) First, 100% of the net sales proceeds shall be applied to the March Interest Payment; (b) Second, 100% of the additional net sales proceeds shall be applied to reduce the principal balance of the Notes by the amount applied to the March Interest Payment under subparagraph (a); (c) Thereafter, net sales proceeds shall be applied as set forth, and subject to the conditions, in Section 4.3 of the Credit Agreement. (d) The Company agrees that, unless the Agent shall otherwise consent, it will sell Greenleaf Shares which are Collateral before selling or otherwise disposing of any such shares which are not Collateral until such time as prepayment of principal of the Notes has been made in an aggregate amount equal to the net sales proceeds previously applied to the March Interest Payment. Thereafter, the provisions of the last sentence of Section 4.3 of the Credit Agreement shall apply. 2. Principal Reduction. The Company agrees to make a principal reduction of $550,000.00 on the Notes on or before April 30, 2000. 3. Ratification. The Company hereby ratifies and confirms its obligations under the Credit Agreement and this Agreement and represents and warrants to the Agent that the Company has no defenses, offsets, counterclaim or claims in any way relating to the Credit Agreement or the Collateral Documents or in connection with any of the transactions described in the Credit Agreement. 4. Default. Any default under this Agreement shall be an Event of Default under the Credit Agreement. IN WITNESS WHEREOF, the parties have executed this Agreement as of the date above written. RIVERSIDE GROUP, INC. By _________________________________ Its_______________________________ ___________________________________ MITCHELL W. LEGLER, as agent for the Holders Exhibit 10.6 - ---------------------------------------------------------------------------- AGREEMENT --------- THIS AGREEMENT is made and entered into as of __________, 2000, by and between Buildscape, Inc., a Florida corporation ("Buildscape"), and Wickes Inc., a Delaware corporation (the "Lumber Company") WITNESSETH: ----------- WHEREAS, Buildscape is developing and operating an Internet based business intended to become a virtual community of building trades professionals, their customers, their suppliers and their service providers in the home construction and home improvement industry through its websites, buildscape.com and buildscapePRO.com (the "Site") and through other communications channels; WHEREAS, Buildscape desires to explore with the Lumber Company various business opportunities, including without limitation, the distribution of building materials directly from local lumberyards; WHEREAS, the Lumber Company is a leading full-line building materials and finishing products retailer; WHEREAS, the Lumber Company desires to develop a relationship whereby customers of the Lumber Company may use a uniquely branded version of the Site and the internet for, among other things, placing orders for building materials and products in designated geographic areas; and WHEREAS, Buildscape and the Lumber Company intend this Agreement, among other things, (i) to reflect their initial relationship and their respective roles in the Lumber Company Site through a pilot period and (ii) to be modified as described herein upon completion of the pilot period to reflect more fully the final terms of such relationship and roles. NOW, THEREFORE, as consideration for the promises and mutual covenants and agreements contained herein, the parties hereto hereby agree as follows. Section 1. Definitions. ------------ As used herein, the following terms shall have the following meanings: "Affiliate" shall mean, with respect to a party, any Person that, ----------- directly or indirectly, Controls, or is Controlled by, or is under common Control with, such party. "Agreement" shall mean this Agreement, together with the schedules ----------- attached hereto. "BOSS" shall have the meaning given to it in Subsection 2.1 hereof. ------ "Buildscape" and "BuildscapePRO" shall have the meanings set forth in ------------ --------------- the preamble hereto. "Buildscape Trademarks" shall mean those Trademarks owned or licensed ----------------------- and utilized or utilizable by Buildscape in the course of its business and identified in writing from time to time by Buildscape to the Lumber Company. "Confidential Information" means information regarding the terms of -------------------------- this Agreement and all trade secrets, know-how and nonpublic information that relates to research, development, trade secrets, know-how, inventions, source codes, technical data, software programming, concepts, designs, procedures, manufacturing, purchasing, accounting, engineering, marketing, merchandising, selling, business plans or strategies and other proprietary or confidential information. "Control" shall mean the possession, directly or indirectly, of the --------- power to direct or cause the direction of the management and policies of a Person, whether by contract or through the ownership of voting securities, including the ownership of more than fifty percent (50%) of the equity, partnership or similar interest in such Person. "Customer Area" shall mean, with respect to the Lumber Company or an --------------- Other Lumberyard, the total geographical area served by the retail distribution facilities operated at the time of determination by the Lumber Company or such Other Lumberyard. For this purpose, a distribution facility shall be conclusively presumed to serve the area comprised within a 50-mile radius of such facility. "Derivative" means (i) any enhancement, improvement or modification or ------------ (ii) any "derivative work" (as such term is defined in the U.S. Copyright Act, as amended from time to time). "Initial Term" shall have the meaning set forth in Section 10 hereof. -------------- "Internet" means the Internet or the World Wide Web (or any successor ---------- or other online network including those using delivery over television, cable, set top boxes, intranets, extranets and personal digital assistants). "Internet Lumber Operations" shall mean the sale over the Internet of ---------------------------- building materials and products which are the same as or competitive with Lumberyard Products or National Catalog. "IPR" means any copyright, Trademark, patent, trade secret, or other ----- intellectual property or proprietary right of any kind (including applications therefor and, in the case of patents, any continuation or divisional patent applications claiming priority thereto), whether arising under the laws of the United States or any other nation, state or jurisdiction (including any foreign equivalents thereto). "Lumber Company" shall have the meaning set forth in the preamble ----------------- hereto. "Lumber Company Customer Area" shall mean the Customer Area of the ------------------------------- Lumber Company. "Lumber Company Customer Data" shall have the meaning given to it in ------------------------------ Subsection 7.1 hereof. "Lumber Company Customers" shall mean current customers of the Lumber -------------------------- Company and customers registering on the Site and assigned to the Lumber Company. "Lumber Company Site" shall have the meaning given to it in Subsection --------------------- 2.1 hereof; provided, however, that this term shall not be deemed to refer ------------------ to any non-commerce Internet site operated or utilized by the Lumber Company otherwise than in conjunction with Buildscape under this Agreement. "Lumber Company Trademarks" shall mean those Trademarks owned or ----------------------------- licensed and utilized or utilizable by the Lumber Company in the course of its business and identified in writing from time to time by the Lumber Company to Buildscape. "Lumberyard Products" are products inventoried, sold and shipped by --------------------- the Lumber Company. "National Catalog Products" are products sold and shipped by ----------------------------- Buildscape. "Offline Lumberyard" shall mean any Person primarily engaged in the -------------------- non-Internet sale of Lumberyard Products to building professionals or end users. "Other Lumberyards" shall have the meaning given to it in Subsection -------------------- 4.2 hereof. "Other Lumberyard Internet Agreement" shall have the meaning given to ------------------------------------- it in Subsection 4.2 hereof. "Person" shall mean any individual, corporation, partnership, limited -------- liability company, trust, association or other entity or organization, including any governmental or political subdivision or any agency or instrumentality thereof. "Pilot Period" shall mean the period beginning on the date hereof and -------------- ending on the earlier to occur of (i) the first anniversary of the date hereof, (ii) the date the Relationship Managers agree pursuant to Subsection 3.2 hereof that the Lumber Company Site is ready to be provided to additional markets or (iii) the date the parties agree to terminate this Agreement. "Relationship Managers" shall have the meaning given to it in ------------------------ Subsection 5.3 hereof. "Site" shall have the meaning set forth in the preamble hereto. ------ "Third Party" shall mean any Person that is not a party hereto or a ------------- wholly owned Affiliate of a party hereto. "Trademark(s)" means all common law or registered trademarks, logos, -------------- service marks, trade names, Internet domain names and trade dress rights and similar or related rights arising under any of the laws of the United States or any other country or jurisdiction, whether now existing or hereafter adopted or acquired. Section 2. General. -------- 2.1 General Agreements of the Parties. Buildscape and the Lumber ---------------------------------- Company desire to explore the feasibility of developing and operating a uniquely branded version of the Site (the "Lumber Company Site") that will be the Lumber Company's primary direct Internet presence for Lumber Company Customers for the purposes of (i) attracting home building, remodeling, home improvement, decorating, home management, property management, restoration and light construction trade professionals and do-it- yourselfers to participate in the Site's on-line community and (ii) selling over the Internet National Catalog Products and Lumberyard Products. The parties contemplate that the features and functions of the Site would generally provide for: [CERTAIN CONFIDENTIAL MATERIAL HAS BEEN OMITTED AND FILED SEPARATELY WITH THE S.E.C. PURSUANT TO A REQUEST FOR CONFIDENTIAL TREATMENT ] 2.2 Collaboration. Buildscape and the Lumber Company will -------------- collaborate to develop the look, feel and functionality of the Lumber Company Site, subject to constraints imposed by Buildscape's design intentions, support requirements and technology architecture, making it accessible by current and potential Lumber Company Customers. 2.3 Maintenance of the Lumber Company Site. Once developed, it is --------------------------------------- contemplated that Buildscape would use reasonable best efforts to maintain the Lumber Company Site in order that availability, reliability, security and response time meet the then current generally accepted standards for business to business e-commerce sites on the World Wide Web. 2.4 General Guidelines. Buildscape and the Lumber Company currently ------------------- contemplate that the Site and the Lumber Company Site would be generally operated in accordance with the guidelines set forth on Schedule 1 hereto. The parties agree to use their reasonable best efforts to reach specific agreement on all aspects of the matters described on such schedule and to enter into an amendment to this Agreement reflecting such agreements on or prior to completion of the Pilot Period, subject to the terms of the termination provisions stated in Subsection 11.2 hereof. 2.5 Technology Integration. The integration of the Lumber Company's ----------------------- and Buildscape's information systems and the development of a highly integrated computer interface, including business rules and data formats for the purposes of conducting product transactions through the Lumber Company Site will generally take place in accordance with the mutually agreed terms that will be incorporated in the amendment to this Agreement contemplated by Subsection 2.4 hereof. Each party will pay its own costs associated with such technology integration. Each party will provide all necessary technical support on an on-going basis in order to maintain and enhance the technical interface contemplated hereby. Section 3. Pilot Program and Deployment. ----------------------------- 3.1 Pilot Program. The Lumber Company and Buildscape agree to --------------- identify, within 30 days of the date hereof, a market from among those markets currently served by the Lumber Company to be used as the Pilot Market. Buildscape will use good faith efforts (i) to commence a limited pilot program in this market within 120 days of the date hereof, consisting of selected Lumber Company Customers and features of the Lumber Company Site and with the intent to deploy the Lumber Company Site in such a way as to gain a detailed understanding, among other things, of the needs of such customers, the relative attractiveness of various features of the Lumber Company Site to such customers, the economics of the relationships contemplated hereby, and the nature and extent of the interface and integration required for full functionality of the Lumber Company Site; and (ii) to test, revise as necessary and make ready for deployment to all Lumber Company Customers in the test market all features of the Lumber Company Site within 210 days of the date hereof. It is currently contemplated that the limited pilot program will be commenced in February 2000 and completed in July 2000. 3.2 Deployment. After the Lumber Company Site has become fully ----------- operational and made available to all Lumber Company Customers in the test market area, and when the Relationship Managers agree the parties are ready to provide the Lumber Company Site to additional markets, a schedule will be established to identify the order in which the Lumber Company markets will be given access to the Lumber Company Site, and the responsibilities of each party to achieve that goal. This schedule will be incorporated in a written document signed by the parties and attached to, and made a part of, this Agreement as a schedule hereto. Prior to commencement of the activities contemplated on such schedule, the parties will enter into the amendment to this Agreement contemplated by Subsection 2.4 hereof 3.3 Reasonable Best Efforts. The parties agree that to a great ------------------------- extent, the complete development and implementation of currently planned features and functions of the Lumber Company Site, and full enhancement of the Site and the Lumber Company Site in the future, will require a close, working relationship and significant input and contribution from the Lumber Company of management efforts, capital expenditures, sales initiatives and the Lumber Company Customer Data. In this regard, the parties intend to use their reasonable best efforts to maximize the attractiveness, appeal and reputation of the Lumber Company Site. Section 4. Relationships and Restrictions. ------------------------------- 4.1 Lumber Company. During the term of this Agreement, the Lumber --------------- Company shall not directly engage on its own behalf in Internet Lumber Operations, shall utilize the Lumber Company Site as its sole Internet presence for Internet Lumber Operations, and shall not promote any other Internet site for Internet Lumber Operations. The Lumber Company acknowledges and agrees that the development, construction, programming and hosting of the Lumber Company Site involves significant investment by Buildscape and is being undertaken in reliance upon the representation by the Lumber Company that it will maintain a continued economic relationship with Buildscape pending successful completion of the Pilot Market effort and substantially as set forth in this agreement. Nothing herein shall restrain the Lumber Company from selling products through, or providing related product support for, other third party Internet sites. 4.2 Buildscape. During the term of this Agreement, Buildscape agrees ----------- that Buildscape will use the Lumber Company exclusively for fulfilling local deliveries of Lumberyard Products in the Lumber Company Customer Area subject to the conditions set forth below. Nothing contained in this Agreement shall prohibit Buildscape from entering into and performing any agreement with other lumberyards for Internet Lumber Operations (an "Other Lumberyard Internet Agreement", and such lumberyards "Other Lumberyards") within the Lumber Company Customer Area; provided that (i) Buildscape will -------- use good faith efforts to select such Other Lumberyards so as to minimize the extent to which the Lumber Company and any Other Lumberyard would serve the same customer territories, while seeking to provide service to as much of the United States as possible, and (ii) Buildscape may not enter into an Other Lumberyard Internet Agreement with an Other Lumberyard whose Customer Area includes more than 20% of the Lumber Company Customer Area without obtaining the consent of the Lumber Company, which may be withheld in the Lumber Company's sole discretion. Subject to the foregoing sentence, both parties acknowledge that some overlap of customer territories will occur between the Lumber Company and Other Lumberyards. 4.3 Promotional Activities. (a) During the term of this Agreement, ----------------------- the Lumber Company will not promote the Internet Lumber Operations of any Person other than Buildscape. (b) Buildscape shall not display the Trademark of any Person primarily engaged in operations competitive to those conducted by the Lumber Company within the Lumber Company Site. 4.4 Nature of Relationship. The parties are independent contractors ----------------------- under this Agreement. Each party acknowledges and agrees that it is not and will not be during the term of this Agreement an employee or an agent of the other party. Nothing in this Agreement will be deemed to constitute, create, give effect to or otherwise recognize a joint venture, partnership, franchise or business entity of any kind. Nothing in this Agreement will be construed as providing for the sharing of profits or losses arising out of the efforts of the parties hereto. Section 5. Relationship Modification Process. ---------------------------------- 5.1 Intentionally Omitted. ---------------------- 5.2 Area Liaisons. (a) The parties shall each appoint liaisons in -------------- each of the following areas: (i) information technology, (ii) finance, (iii) merchandising, (iv) distribution, (v) marketing, (vi) operations, and (vii) customer recruiting (the "Area Liaisons"). The respective Area Liaisons shall be available to meet on an ad hoc basis to oversee and address issues, interpretations of this Agreement and business rules, complaints and expansion of the relationship contemplated by this Agreement. All of the Area Liaisons shall meet, either in person or by teleconference, at least once each calendar quarter to discuss opportunities, general strategies and goals of the parties with respect to the Site. (b) All recommended changes to the relationship contemplated hereby, after appropriate study and discussion, shall be forwarded in writing by the Area Liaisons to the Relationship Managers. In addition, any dispute not resolved by the Area Liaisons after appropriate discussion shall be referred to the Relationship Managers for resolution. 5.3 Relationship Manager. (a) Each party shall appoint a senior --------------------- executive officer to oversee and have overall responsibility for the administration of this Agreement and the business relationship contemplated by this Agreement (the "Relationship Manager"). The Relationship Managers shall meet, either in person or by telephone conference, as needed and in no event less than once each month. (b) The Relationship Managers shall consider proposed changes or modifications to the relationship contemplated hereby. All decisions of the Relationship Managers shall be reflected in a written amendment to either the process manual (to be mutually developed by the parties) or this Agreement, signed by the Relationship Managers. Any dispute not resolved by the Relationship Managers will be subject to the dispute resolution procedures set forth in Section 16 hereof. Section 6. Compensation. ------------- The respective compensation of Buildscape and the Lumber Company hereunder is described on Schedule 2 hereto. ---------- Section 7. Data; Reports and Records; Audit Procedures. -------------------------------------------- 7.1 Historical Data Sharing. The Lumber Company will, to the extent ------------------------ reasonably possible, develop and share with Buildscape the Lumber Company Customer account data and profiles, including but not limited to previous buying patterns, knowledge of their building activity, average number of projects, average project costs and other information ("Lumber Company Customer Data"), to aid in the initial development of customer profiles for the Lumber Company Site. The Lumber Company will share such the Lumber Company Customer account data and profiles on a market by market basis in preparation for, and reasonably in advance of, introducing new geographic markets to the Lumber Company Site. 7.2 Data Ownership. The Lumber Company and Buildscape will, as ---------------- between one and the other, own the Lumber Company Customer Data as follows: (1) the Lumber Company will own all the Lumber Company Customer Data relating to the Lumber Company Customers who place their orders with the Lumber Company other than through the Lumber Company Site; (2) the Lumber Company and Buildscape will own jointly all the Lumber Company Customer Data relating to the Lumber Company Customers whose orders are placed through the Lumber Company Site; and (3) Buildscape will own all the Lumber Company Customer Data as it specifically relates to orders placed by the Lumber Company Customers through versions of the Site other than the Lumber Company Site. 7.3 Reports. Buildscape shall furnish to the Lumber Company -------- quarterly reports regarding Lumber Company Customers in such form and containing such information as to which the parties may reasonably agree. Buildscape shall keep true and complete records of all transactions and correspondence with Lumber Company Customers. Such records and all accounting records of Buildscape pertaining to the Lumber Company Customers hereunder may be examined by representatives of the Lumber Company, whether during or after the term of this Agreement, during normal business hours upon reasonable advance written notice and subject to the Buildscape's reasonable security and confidentiality provisions., 7.4 Audit Procedures. (a) The Lumber Company will be entitled, once ----------------- during any six-month period (except as provided below), to audit, at the Lumber Company's expense, Buildscape's records with respect to sales to the Lumber Company Customers through the Lumber Company Site to ensure that the fees paid to the Lumber Company pursuant to this Agreement are accurate. Buildscape will be entitled, once during any six-month period (except as provided below), to audit, at Buildscape's expense, the Lumber Company's records with respect to sales to the Lumber Company Customers through the Lumber Company Site to ensure that the fees paid to Buildscape pursuant to this Agreement are accurate. If a party discovers a Material Discrepancy, (i) then the party causing the audit will be reimbursed by the other party for all reasonable costs of the audit, including costs of any reimbursement to the other party, and (ii) such party will be entitled to conduct the audits contemplated by this Section 7.4 once during any three- month period until two consecutive audits have been conducted without the discovery of any Material Discrepancy. All amounts discovered in the audit and agreed to that are less or more than the contracted amount, will be paid to the appropriate party within five days of agreement as to the difference and will bear interest at a rate of one and one-half percent (1.5%) for each whole month after the payment was due, or such lesser amount necessary to comply with all applicable laws. (b) The audits contemplated by this Subsection 7.4 shall only be conducted upon reasonable advance written notice and subject to the other party's reasonable security and confidentiality provisions. The parties agree to cooperate with each other in these reviews, furnish the other with reasonably requested information in a timely manner, and provide the other with reasonably timely access to personnel during normal business hours for audit purposes at no charge; provided, however, that a party may charge the other for its reasonable costs for any technical resources or extraordinary personnel time required by the other and necessary for such audit or verification report. (c) A "Material Discrepancy" in fees paid to the Lumber Company or Buildscape will be deemed to occur if the total amount of fees due a party based on the audit report exceeds the amount of fees actually paid by the other party by five percent (5%) or more. If a party discovers a Material Discrepancy, after reviewing applicable supporting documentation, the parties will promptly attempt to agree on such analysis. If it is agreed a Material Discrepancy occurred, then the party causing the audit shall be reimbursed by the other party for all reasonable costs of the audit, including costs of any reimbursement to the other party for technical resources or extraordinary personnel time, as described in (a) and (b) above. In all other circumstances, the auditing party will bear the costs of audits performed by or at its direction. If the parties are unable to agree, the parties will follow the dispute resolutions found in Section 16 hereof. (d) Any amounts discovered in the audit that are less or more than the contracted amount, and that are not disputed, will be paid to the appropriate party within 5 days of agreement as to the difference. 7.5 Confidentiality of Customer Data. Except as provided in this --------------------------------- Section 7, Buildscape will neither transmit nor disclose the Lumber Company Customer Data owned by the Lumber Company or jointly owned by Buildscape and the Lumber Company to any third party, including Other Lumberyards, or permit such data to be utilized in any manner by any Other Lumberyard. Buildscape may utilize the Lumber Company Customer Data owned by the Lumber Company or jointly owned by Buildscape and the Lumber Company for the purposes of marketing various products and services to the Lumber Company Customers, provided that such the Lumber Company Customer Data, to the extent that it particularly identifies a customer, is not disclosed to any third parties and such products and services are not being offered directly by Other Lumberyards to the Lumber Company customers. Additionally, Buildscape may use aggregate and statistical information and otherwise use the Lumber Company Customer Data for any purpose so long as such data does not identify the Lumber Company or a Lumber Company Customer. This Section 7 shall survive the termination of this Agreement. Section 8. Trademark and Technology License. --------------------------------- 8.1 Buildscape Grant. Buildscape hereby grants to the Lumber Company ----------------- and any of its wholly owned entities a non-exclusive, royalty-free, worldwide license in all jurisdictions in which Buildscape has any rights, to use, reproduce, distribute and display the Buildscape Trademarks as authorized in this Agreement, subject to mutual agreement of the parties hereto. 8.2 Lumber Company Grant. The Lumber Company hereby grants to ----------------------- Buildscape a non-exclusive, royalty-free, worldwide license in all jurisdictions in which the Lumber Company has any rights, to use, reproduce, distribute and display the Lumber Company Trademarks as authorized in this Agreement, subject to mutual agreement of the parties hereto. 8.3 Quality Control. Each party will have the right to exercise ----------------- quality control over the use of its Trademarks by the other party to the degree necessary, in the sole opinion of the owner of such Trademarks, to maintain the validity and enforceability of such Trademarks and to protect the goodwill associated therewith. Each party will, in its use of the other's Trademarks, adhere to a level of quality at least as high as that used by such party in connection with its use of its own Trademarks. If the owner of a Trademark, in its reasonable opinion, finds that use of such Trademark by the other party materially threatens the goodwill of such Trademark, the user of such Trademark will, upon notice from the owner, immediately, and no later than ten (10) days after receipt of such owner's notice, take all measures reasonably necessary to correct the deviation(s) or misrepresentation(s) in, or misuse of, the applicable Trademark. 8.4 Use. Each party shall use the other's Trademarks in ---- accordance with sound trademark and trade name usage principles and in compliance with all applicable laws and regulations of the United States (including all laws and regulations relating to the maintenance of the validity and enforceability of such Trademarks) and will not use the Trademarks in any manner that might tarnish, disparage, or reflect adversely on the Trademarks or the owner of such Trademarks. Each party shall use, in connection with the other's Trademarks, all legends, notices and markings required by law. No party may materially alter the appearance of another's Trademarks in any advertising, marketing, distribution, or sales materials, or any other publicly distributed materials without the prior written consent of the other party. 8.5 Lumber Company IPR License. Lumber Company hereby grants to ---------------------------- Buildscape, to the extent it is permitted to do so under applicable law and agreements, if any, pursuant to which the Lumber Company has acquired such content, a non-exclusive, non-sublicenseable, royalty-free, worldwide license to reproduce, distribute, publicly perform, publicly display and digitally perform and prepare Derivative works of all Content in conjunction with the Site or the Lumber Company Site where such Content: (i) has been included at any time in the Site or Lumber Company Site or (ii) has been included in any IPR subject to Joint IPR Rights. As used herein "Content" means all text, pictures, sound, graphics, video and other data supplied by Lumber Company to Buildscape pursuant to this Agreement), as such Content may be modified from time to time. Section 9. Intellectual Property. ---------------------- 9.1 Preexisting Property. All IPR owned by a party prior to the date --------------------- of this Agreement will remain the sole property of such party. 9.2 Developed Property. (a) All IPR created solely by one party ------------------- (the "Sole IP Rights") in connection with its activities under this Agreement will be owned by such party. (b) All IPR created jointly by both parties (the "Joint IP Rights") in connection with their activities under this Agreement will be jointly owned by both parties and each party will be free to exploit such Joint IP Rights without accounting to the other, provided, however, that all ------------------- modifications, enhancements, revisions, Derivative works or other changes (collectively "Changes") made solely by either party to any IPR that originally was subject to Joint IP Rights shall be subject only to Sole IP Rights and the other party shall have no rights to such Changes under this Agreement or otherwise. (c) Notwithstanding Subsections 9.1 and 9.2 hereof, in the event that Buildscape develops, solely or jointly, any modifications, improvements or enhancements to the Site and/or the Lumber Company Site, including all computer hardware and software interface technology and related specifications which enable the Site and/or the Lumber Company Site to interface or communicate with the Lumber Company's information systems, and any training materials related to the Site and/or the Lumber Company Site ("Site Improvements"), all IPR in and to such Site Improvements shall be owned solely by Buildscape and considered Buildscape's Sole IP Rights, and the Lumber Company hereby assigns all right, title and interest it may have in such IPR to Buildscape. The Lumber Company will provide Buildscape with all reasonable assistance to perfect and otherwise enforce Buildscape's rights in the Site Improvements. 9.3 Protection of Joint IP Rights. The parties will cooperate in ------------------------------- developing a strategy for identifying and protecting, prosecuting and maintaining the Joint IP Rights, including registering or applying for patent, utility model or copyright rights ("Filings") to protect or perfect rights in and to such Joint IP Rights. All costs incurred by the parties directly in connection with the making and prosecution of such Filings and maintenance of Joint IP Rights will be borne equally by the parties. Each party will cooperate and supply any information that is reasonably necessary to assist the other in the preparation, filing and prosecution of documentation necessary to protect the Joint IP Rights. Such cooperation will include the execution of any and all documentation necessary to properly complete any Filing. In the event that either party declines to protect any specific Joint IP Right, then the other party may, in its sole discretion, take whatever action it deems appropriate at its sole cost and expense, including making such Filings as it deems appropriate, to protect any aspect of the Joint IP Rights in the name of such party as sole owner of such Joint IP Rights. All other Joint IP Rights, and especially those in the nature of trade secrets, will be identified specifically by the parties and appropriate measures adopted to safeguard the value thereof. The parties may issue instructions to guide the handling of all Joint IP Rights constituting trade secrets which will be reasonable under the circumstances. In any event, each party will be obliged to treat these Joint IP Rights in accordance with the same degree of care such party uses to protect its own trade secrets, but in any event not less than a reasonable degree of care. 9.4 Enforcement of Rights in Joint Intellectual Property. (a) If ----------------------------------------------------- either party believes that any Joint IP Right is being infringed or is being misused by a third party, such party will promptly notify the other party of such infringement or misuse. If, within sixty (60) days from the date such notice is received, the parties agree that action is warranted, the parties will cooperate in the filing and maintenance of a claim, demand, investigation, suit or other proceeding (an "Action"), as appropriate, regarding such infringement or misuse. Each of the parties will bear its own internal costs and expenses in connection with the filing and prosecution of such Action, and out-of-pocket fees and expenses will be borne equally by the parties. All damages, profits, awards and royalties obtained by the parties in connection with such Action will be shared equally. (b) If either party declines to participate in, or the parties are unable to agree on, the filing or prosecution or an Action relating to any Joint IP Right within such sixty (60) day period, then the other party (the "Participating Party") may proceed in its sole discretion and at its sole expense to file and prosecute such Action for infringement or misuse in its own name or, if required by law, jointly with the other party and in such event the Participating Party is hereby authorized to take action in the name of the other party as well; provided however, that if the Participating Party takes action in the name of the other party, the Participating Party will indemnify and hold the other party harmless from and against any and all monetary damages, fines, fees, penalties, obligations, deficiencies, losses and out-of-pocket expenses that the other party incurs or is subject to directly as a result of such Action. The Participating Party will receive for its sole benefit any damages, profits, awards and royalties recoverable for such infringement or misuse as the result of such Action. (c) If both parties initially agree to mutually prosecute any Action relating to any Joint IP Right, either party may elect at any time to settle or withdraw for any reason from the prosecution of such Action; provided, however, the settling party will not as part of any settlement grant a license in the Joint IP Right which renders the Action moot. In such circumstance, the withdrawing or settling party, as the case may be, will bear one-half (1/2) of the total out-of-pocket fees and expenses incurred in pursuing such Action up to the time of withdrawal or settlement. Going forward, the continuing party will bear all of the fees and expenses incurred for such Action and may proceed in its sole discretion to prosecute, settle (including licenses granted in connection therewith) or discontinue prosecution of such Action. Any damages, profits, awards and royalties recovered or to be recovered for such Action will be apportioned between the parties in direct proportion to the ratio of each party's out-of-pocket fees and expenses compared to the total out- of-pocket fees and expenses of both parties and taking into account any benefits recovered by the non-continuing party as the result of any settlement. Section 10. Term of Agreement. ------------------ This Agreement will be effective from the date of this Agreement and shall continue for a period ending on the fourth anniversary of the date hereof (the "Initial Term") and shall automatically be extended and renewed for subsequent consecutive renewal terms of one calendar year each unless this Agreement is terminated pursuant to Section 11 hereof. Section 11. Termination. ------------ 11.1 On Expiration. Upon not less than ninety (90) days' prior --------------- notice to the other party, either the Lumber Company or Buildscape may terminate this Agreement effective on expiration of the Initial Term or any renewal term. 11.2 Pilot Period. By notice given to the other party within 30 days ------------- after completion of the Pilot Period, either the Lumber Company or Buildscape may terminate this Agreement effective on the date set forth in such notice, which shall be at least 30 days and no more than 60 days after the date such notice is given. 11.3 Bankruptcy, etc. Effective immediately upon notice to the other ---------------- party, either the Lumber Company or Buildscape may terminate this Agreement, without penalty, upon the receivership or bankruptcy of the other party. 11.4 Breach. Upon any material breach of the provisions hereof by ------- Buildscape or the Lumber Company, the Lumber Company or Buildscape, respectively, may upon notice to the other party giving the reasons therefor and indicating that the other party has 30 days within which to remedy the breach terminate this Agreement upon expiration of such 30-day period; provided, that if such breach is remedied within such period, this --------- Agreement will remain in full force and effect as though no breach had occurred. 11.5 Violation of Law. Either party, in its sole discretion, may ------------------ terminate at any time this Agreement immediately upon notice to the other in the event it is conclusively and non-appealably determined by a court or administrative agency with jurisdiction in the matter, that either this Agreement or the conduct of the other party pursuant hereto violates, in any respect that would have a materially adverse effect on such party or the relationship contemplated hereby, any applicable federal, state, or local law. 11.6 Continuation of Obligations. Notwithstanding the termination of ---------------------------- this Agreement, the obligations and provisions contained in Sections 7, 9, and 11 through 18 hereof shall survive and shall continue in full force and effect after any such termination. 11.7 Effect on Licenses. Upon termination of this Agreement all -------------------- licenses granted pursuant to this Agreement shall terminate. 11.8 Site Software. In the event this Agreement is terminated --------------- pursuant to Subsection 11.1 hereof or by the Lumber Company pursuant to Subsection 11.4, then Buildscape will grant the Lumber Company a license to use the computer software ("Site Software") owned by Buildscape, or if not owned by Buildscape to the extent Buildscape is permitted to grant such license without cost, and required for the operation of the Lumber Company Site, to enable the Lumber Company to operate and maintain the Lumber Company Site for a transition period of up to 120 days. The Lumber Company --- shall prior to commencement of such license agree to pay Buildscape a reasonable fee (which shall not be less than any prevailing fee charged by Buildscape at the time to Third Parties for similar licenses). The Lumber Company may not use the Site Software for any other purpose (including, creating versions of the Site for any Third Party) other than operation of the Lumber Company Site. The Lumber Company acknowledges that the Site Software may not constitute all software required to operate and maintain the Lumber Company Site, and the Lumber Company will be required to obtain the rights to use any other required software from the owner thereof. Section 12. Representations and Warranties. ------------------------------- 12.1 Representations and Warranties of Buildscape. Buildscape hereby --------------------------------------------- represents and warrants to the Lumber Company as follows: (i) Authorization. All corporate action on the part -------------- of Buildscape, its officers, directors and stockholders necessary for the authorization, execution and delivery of this Agreement, and the performance of all obligations of Buildscape hereunder has been taken, and this Agreement, when executed and delivered by Buildscape, will constitutes valid and legally binding obligation of Buildscape, enforceable against Buildscape in accordance with its terms. (ii) Intellectual Property. Buildscape owns or ----------------------- possesses sufficient legal rights to all IPR necessary for its business as now conducted without any conflict with, or infringement of, the rights of others. Buildscape has not received any written communications alleging that any Buildscape IPR have violated or would violate any of the IPR of any Third Party. Buildscape is not aware that any of its employees is obligated under any contract or other agreement, or subject to any judgment, decree or order of any court or administrative agency, that would interfere with such employee's ability to promote the interests of Buildscape or that would conflict with Buildscape's business. Neither the execution, delivery or performance of this Agreement, nor the carrying on of Buildscape's business as now conducted by the employees of Buildscape, will conflict with or result in a breach of the terms, conditions, or provisions of, or constitute a default under, any contract, covenant or instrument under which any such employee is now obligated. (iii) Compliance with Other Instruments. The --------------------------------------- execution, delivery and performance of this Agreement will not result in any violation of or conflict with or constitute, with or without the passage of time and giving of notice, a default under any provision of Buildscape's charter or bylaws or any instrument, judgment, order, writ, decree or contract to which Buildscape is a party or by which Buildscape is bound, or any provision of any federal or state statute, rule or regulation applicable to Buildscape, the effect of which would have a material adverse effect on the ability of Buildscape to perform its obligations under this Agreement or result in the creation of any lien, charge or encumbrance upon any asset of Buildscape. (iv) EXCEPT AS EXPRESSLY SET FORTH HEREIN, BUILDSCAPE MAKES NO REPRESENTATIONS OR WARRANTIES OF ANY KIND WHATSOEVER, DIRECTLY OR INDIRECTLY, EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE, WITH RESPECT TO ANY GOODS OR SERVICES TO BE PROVIDED UNDER THIS AGREEMENT. 12.2 Representations and Warranties of the Lumber Company. The -------------------------------------------------------- Lumber Company hereby represents and warrants to Buildscape as follows: (i) Authorization. All corporate action on the part -------------- of the Lumber Company, its officers, directors and stockholders necessary for the authorization, execution and delivery of this Agreement, and the performance of all obligations of the Lumber Company thereunder has been taken, and this Agreement, when executed and delivered by the Lumber Company, will constitute valid and legally binding obligation of the Lumber Company, enforceable against the Lumber Company in accordance with its terms. (ii) Intellectual Property. The Lumber Company owns ---------------------- or possesses sufficient legal rights to all IPR necessary for its business as now conducted without any conflict with, or infringement of, the rights of others. The Lumber Company has not received any written communications alleging that any the Lumber Company IPR have violated or would violate any of the IPR of any Third Party. The Lumber Company is not aware that any of its employees is obligated under any contract or other agreement, or subject to any judgment, decree or order of any court or administrative agency, that would interfere with such employee's ability to promote the interests of the Lumber Company or that would conflict with the Lumber Company's business. Neither the execution, delivery or performance of this Agreement, nor the carrying on of the Lumber Company's business as now conducted by the employees of the Lumber Company, will conflict with or result in a breach of the terms, conditions, or provisions of, or constitute a default under, any contract, covenant or instrument under which any such employee is now obligated. (iii) Compliance With Other Instruments. The --------------------------------------- execution, delivery and performance of this Agreement will not result in any violation of or be in conflict with or constitute, with or without the passage of time and giving of notice, a default under any provision of the Lumber Company's, charter or bylaws or any instrument, judgment, order, writ, decree or contract to which the Lumber Company is a party or by which the Lumber Company is bound, or any provision of any federal or state statute, rule or regulation applicable to the Lumber Company, the effect of which would have a material adverse effect on the ability of the Lumber Company to perform its obligations under this Agreement or result in the creation of any lien, charge or encumbrance upon any asset of the Lumber Company. (iv) EXCEPT AS EXPRESSLY SET FORTH HEREIN, THE LUMBER COMPANY MAKES NO REPRESENTATIONS OR WARRANTIES OF ANY KIND WHATSOEVER, DIRECTLY OR INDIRECTLY, EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE, WITH RESPECT TO ANY GOODS OR SERVICES TO BE PROVIDED UNDER THIS AGREEMENT. Section 13. Indemnification. ---------------- 13.1 Indemnification. The Lumber Company and Buildscape each shall ---------------- indemnify the other, its Affiliates and its officers, directors, employees, representatives, shareholders, successors, assigns, and agents (the "Indemnified Parties") against, and hold all of them harmless from any and all debts, claims, deficiencies, actions, proceedings, demands, assessments, orders, writs, decrees, liabilities, suits, costs, judgments, penalties, obligations, losses, damages and other expenses (including reasonable attorneys' and accounting fees) (collectively, "Damages") of any nature and of any kind whatsoever which may be made against or incurred by any of them resulting from a Third Party claim ("Third Party Claim") resulting from or arising out of or in any way connected with (i) any breach by the other party of any representation, warranty, agreement or covenant made by such other party in this Agreement or (ii) any sales effected by such party on or through the Site or the Lumber Company Site to the extent that such Damages do not result from the action or inaction of an Indemnified Party. 13.2 Operation of Indemnity. Upon the occurrence of any event for ----------------------- which any party is entitled to indemnification under this Agreement, such party ("Indemnified Party") shall promptly notify the other party ("Indemnitor") of the type of Damages and the amount of such Damages. No failure of an Indemnified Party to promptly notify an Indemnitor shall relieve the Indemnitor from any obligation to indemnify the Indemnified Party unless and to the extent the Indemnitor is actually prejudiced by such delay in notification. Within 10 days of delivery of such notice, Indemnitor shall either pay to the Indemnified Party, by certified or official bank check, the full amount of such Damages or provide a certificate from a responsible officer setting forth in reasonable detail the reasons why Indemnitor does not believe that the claim constitutes Damages under this Agreement. The Indemnified Party shall have the right to offset the amount of any Damages for which it reasonably believes it is entitled to indemnification against all amounts which Indemnified Party may at any time owe to Indemnitor. 13.3 Claims by Third Party. Subject to the provisions of Section 14 ---------------------- hereof, if a Third Party Claim is made or proceeding is commenced against an Indemnified Party, such Indemnified Party will promptly notify the Indemnitor in writing. No failure of an Indemnified Party to so notify the Indemnitor shall relieve the Indemnitor from the obligation to indemnify the Indemnified Party unless and to the extent the Indemnitor is actually prejudiced by such failure. Such Indemnified Party will accord the Indemnitor the opportunity to assume entire control for the defense, compromise or settlement of any such Third Party Claim through its own counsel and at its own expense; provided that no such compromise or settlement shall include any non-monetary terms and conditions applicable to such Indemnified Party without the consent of the Indemnified Party; and provided further, that the Indemnified Party may retain its own counsel at its own expense (the Indemnitor shall only be liable for the cost of one such counsel for all Indemnified Parties) if the Indemnitor, within thirty (30) days (or such shorter period required to file a responsive pleading) after notice of any Third Party Claim, fails to assume the defense of such Third Party Claim. If the Indemnitor Party does not assume entire control of the defense, compromise or settlement of such Third Party Claim, the Indemnified Party may compromise or settle any such Third Party Claim. Buildscape and the Lumber Company each agrees to cooperate fully with respect to the defense of any Third Party Claim. Section 14. Infringement Claims. -------------------- 14.1 Lumber Company. The Lumber Company reserves, and shall continue --------------- to have, any and all rights to commence, prosecute, compromise and settle any claim, action or proceeding for infringement, unfair competition, unauthorized use, misappropriation or violation of any of the Lumber Company IPR by any Third Party or any claim, action or proceeding to defend any of the Lumber Company IPR (collectively, the "Lumber Company IPR Claims"). The Lumber Company may commence, prosecute, compromise, defend or settle any such the Lumber Company IPR Claims, in its sole discretion, but shall not have any obligation to do so. The Lumber Company shall notify Buildscape of any Lumber Company IPR Claims related to the Site or the Lumber Company Site and shall keep Buildscape reasonably informed regarding the status of any such Lumber Company IPR Claim and notify Buildscape if the Lumber Company elects to discontinue further prosecution or defense of the same. 14.2 Buildscape. Buildscape reserves, and shall continue to have, ----------- any and all rights to commence, prosecute, compromise and settle any claim, action or proceeding for infringement, unfair competition, unauthorized use, misappropriation or violation of any of the Buildscape IPR by any Third Party or any action or proceeding to defend any of the Buildscape IPR (collectively, the "Buildscape IPR Claims"). Buildscape may commence, prosecute, compromise, defend or settle any such Buildscape IPR Claims in its sole discretion, but shall not have any obligation to do so. Buildscape shall notify the Lumber Company of any Buildscape IPR Claims related to the Site or the Lumber Company Site and shall keep the Lumber Company reasonably informed regarding the status of any such Buildscape IPR Claim and notify the Lumber Company if Buildscape elects to discontinue further prosecution or defense of the same. Section 15. Additional Obligations of the Parties. -------------------------------------- 15.1 Nondisclosure. (a) A party receiving any Confidential -------------- Information (the "Receiving Party") of the other party (the "Disclosing Party") shall exercise a reasonable degree of care, but in no event less than the same degree of care that it uses to protect its own confidential information of a like nature, to keep confidential and not disclose such Confidential Information. Without limiting the generality of the foregoing, the Receiving Party shall disclose the Confidential Information of the other party only to those of its employees and contractors (i) who have a reasonable need to know the Confidential Information in order for the Receiving Party to perform under this Agreement, and (ii) who are contractually obligated to comply with the disclosure and usage restrictions set forth in this Agreement provided that Confidential -------------- Information may only be disclosed to such contractors after the Receiving Party provides not less than ten days (10) notice to the Disclosing Party of its intent to do so and the Disclosing Party does not object thereto, any such objection not to be made unreasonably. Such notice must specifically identify the contractor and the purpose of the disclosure by the Receiving Party. In addition, each party may, without the prior written consent of the other party disclose the existence and terms of this Agreement to potential sources of financing who are contractually obligated to maintain the confidentiality of such information. (b) The obligations set forth for release by the Receiving Party in (a) above shall not apply to any Confidential Information to the extent it: (i) is approved by prior written authorization of the Disclosing Party; (ii) is disclosed in order to comply with a judicial order issued by a court of competent jurisdiction, in which event the Receiving Party shall give prior written notice to the Disclosing Party of such disclosure as soon as practicable and shall cooperate with the Disclosing Party in using all reasonable efforts to obtain an appropriate protective order or equivalent, provided that the information shall continue to be Confidential Information to the extent it is covered by such protective order or equivalent; (iii) becomes generally available to the public through any means other than a breach by the Receiving Party of its obligations under this Agreement; (iv) was in the possession of the Receiving Party without obligation of confidentiality prior to receipt or disclosure under this Agreement as evidenced by written records made prior to such receipt or disclosure; (v) is developed independently by the Receiving Party without the use of or benefit from any of the Confidential Information of the other party or without breach of this Agreement, as evidenced by written records of the Receiving Party in existence as of disclosure by the Disclosing Party; or (vi) is required to be disclosed by any national securities exchange, by government rule or regulation (e.g., in connection with a securities filing) or by any other provisions of applicable law, provided that the Receiving Party gives the Disclosing Party advance written notice (to the extent practicable) of the disclosure and cooperates with the Disclosing party in any reasonable attempt to limit the scope of the required disclosure. In any dispute over whether information is Confidential Information under this Agreement, it will be the burden of the Receiving Party to show that such contested information falls within the exceptions set forth in this paragraph. 15.2 No Contest of the Lumber Company IPR. Buildscape shall not ------------------------------------- contest or otherwise challenge (in any legal action or otherwise), or assist or encourage any other Person to contest or challenge, the validity of any the Lumber Company IPR; provided that the foregoing shall not preclude Buildscape from claiming that the IPR in question is Buildscape IPR. 15.3 No Contest of Buildscape IPR. The Lumber Company shall not ------------------------------- contest or otherwise challenge (e.g., in any legal action or otherwise), or assist or encourage any other Person to contest or challenge, the validity of any Buildscape IPR; provided that the foregoing shall not preclude the Lumber Company from claiming that the IPR in question is the Lumber Company IPR. 15.4 Use of IPR. Except as expressly set forth herein, this ------------- Agreement shall not be construed as granting any rights whatsoever to any party with respect to the IPR of the other Party, and neither Party shall claim any such rights to IPR of the other Party. Section 16. Resolution of Disputes. ----------------------- 16.1 General. If any dispute relating to this Agreement arises -------- between the parties, other than a dispute as to rights to IPR, that is not otherwise resolved, then each party shall follow the dispute resolution procedures set forth in this Section 16 unless otherwise agreed in writing by the parties at the time the dispute arises. 16.2 Initiation of Procedures. If a party seeks to initiate the ------------------------- procedures under this Section 16, such party will give written notice thereof to the other party. Such notice will (a) state that it is a notice initiating the procedures under this section, (b) describe briefly the nature of the dispute and the initiating party's claim or position in connection with the dispute, and (c) identify an individual with authority to settle the dispute on such party's behalf. Within ten (10) days after receipt of any notice under this Subsection 16.2, the receiving party will give the initiating party written notice that describes briefly the receiving party's claims and positions in connection with the dispute and identifies an individual with the authority to settle the dispute on behalf of the receiving party. 16.3 Pre-Arbitration Discussion. The parties will cause the ---------------------------- individuals identified in their respective notices under Subsection 16.2 hereof to promptly make such investigation of the dispute as such individuals deem appropriate. Promptly and in no event later than ten (10) days after the date of the initiating party's notice under Subsection 16.2 hereof, such individuals will commence discussions concerning resolution of the dispute. If the dispute has not been resolved within 30 days after commencement of such discussions, then any party may request that the other party make its chief executive officer available to discuss resolution of such dispute. Each party will cause its chief executive officer to meet together with the other party's chief executive officer to discuss such dispute at a mutually agreed upon time within 15 days after a party makes such request. If the dispute has not been resolved within 15 days after the chief executive officers of the parties have first met, then the parties shall enter into mediation with a mutually agreed upon mediator or mediation firm. If the mediator is unable to resolve the dispute within 15 days following the commencement of mediation or the parties are unable to agree on a mediator, any party may submit the dispute to arbitration in accordance with Subsection 16.4 hereof. 16.4. Dispute Resolution; Arbitration. (a) If any dispute under --------------------------------- this Agreement arises and the parties are unable to resolve such dispute in accordance with Subsections 16.1, 16.2 and 16.3 hereof, the unresolved matter shall be resolved by binding arbitration if a party requests arbitration in accordance with this Subsection 16.4 hereof. The place of arbitration shall be in Jacksonville, Florida. Arbitration shall be conducted under the auspices of the American Arbitration Association ("AAA"). Except as otherwise provided in this Subsection 16.4, the Rules of the AAA shall govern all proceedings; and in the case of conflict between the AAA Rules and this Agreement, the provisions of this Agreement shall govern. (b) Any party may initiate arbitration by making a demand on the other parties in accordance with the AAA Rules. The dispute or controversy shall be submitted to a panel of three neutral arbitrators, all of whom shall be selected from the list of neutrals maintained by the AAA, as existing at the time arbitration is invoked, one of whom shall be selection by Buildscape, one of whom shall be selected by the Lumber Company, and the third of whom shall be selected by joint agreement of the arbitrators selected by Buildscape and the Lumber Company. (c) The parties shall have the right of discovery in accordance with the Federal Rules of Civil Procedure and shall make the disclosures required by Rule 26(a) thereof, except that discovery may commence immediately upon the service of the demand for arbitration. A party's unreasonable refusal to cooperate in discovery shall be deemed to be refusal to proceed with arbitration and, until AAA has designated all three arbitrators, the parties may enforce their rights (including the right of discovery) in the courts. Such enforcement in the courts shall not constitute a waiver of a party's right to arbitration. Upon appointment of all three arbitrators, the arbitrators shall have the power to enforce the parties' discovery rights. (d) The parties shall be bound by the decision of the arbitrators and accept their decision as the final determination of the matter in dispute, except as provided under Florida law permitting the appeal of arbitration results on grounds of bias or misbehavior on the part of an arbitrator. Under no circumstances, other than an appeal under Florida law based on allegations of bias or misbehavior on the part of an arbitrator, shall either party appeal or contest the decision of the arbitrators. The prevailing party shall be entitled to enter a judgment in any court upon any arbitration award made pursuant to this Subsection 16.4. The arbitrators shall award the costs and expenses of the arbitration, including reasonable attorneys' fees, disbursements, arbitration expenses, arbitrators' fees and the administrative fee of the AAA, to the prevailing party as shall be determined by the arbitrators. 16.5 Exclusive Remedy. The procedures set forth in this Section 16 ----------------- shall be the parties' sole remedy for resolving disputes, other than disputes as to rights to IPR and disputes for which arbitration in accordance with Section 16.4 hereof is not requested, under the Agreement. The provisions of this Section 16 shall not apply to disputes as to rights to IPR or as to which arbitration is not requested. Section 17. Damages ------- 17.1 Direct Damages. OTHER THAN EACH PARTY'S PAYMENT OBLIGATIONS ---------------- UNDER SECTION 6 HEREOF, AND EACH PARTY'S INDEMNIFICATION OBLIGATIONS UNDER SECTION 16 HEREOF, IN NO EVENT SHALL A PARTY'S CUMULATIVE LIABILITY TO THE OTHER ARISING OUT OF OR RELATED TO THIS AGREEMENT, WHETHER BASED IN CONTRACT, NEGLIGENCE, STRICT LIABILITY, TORT OR OTHER LEGAL OR EQUITABLE THEORY, EXCEED THE GREATER OF (I) $100,000 OR (II) THE AMOUNTS RECEIVED BY SUCH PARTY FROM THE OTHER UNDER THIS AGREEMENT. 17.2 Consequential Damages. In no event will either party have any ---------------------- liability, whether based in contract, tort (including negligence), warranty or other legal or equitable grounds, for any loss of interest, profit or revenue by the other party or for any consequential, indirect, incidental, special, punitive or exemplary damages suffered by the other party, arising from or related to this Agreement, even if such party has been advised of the possibility of such losses or damages. Section 18. Miscellaneous. -------------- 18.1 Insurance. Each party shall maintain at all times and at its ---------- own expense insurance in such amounts, and with such coverage and terms, as are commercially reasonable in light of the business conducted by such party. 18.2 Assignment; Sale of Assets or Capital Stock. This Agreement --------------------------------------------- shall be binding upon and inure to the benefit of the parties hereto, and the legal representatives, successors in interest and permitted assigns, respectively, of each such party. This Agreement shall not be assigned in whole or in part by any party without the prior written consent of the other party. 18.3 Notices. All notices, requests, demands, applications, services -------- of process, and other communications that are required to be or may be given under this Agreement shall be in writing and shall be deemed to have been duly given if sent by telecopy or facsimile transmission, or delivered by courier or overnight delivery service, first class mail, postage prepaid, return receipt requested, to the parties to this Agreement at the following addresses: If to Buildscape: Buildscape, Inc. 7800 Belfort Parkway Jacksonville, Florida 32256 FAX: 904-296-0584 Attention: President If to the Lumber Company: Wickes Inc. 706 North Deerpath Drive Vernon Hills, Illinois 60061 FAX: 367-847-3750 Attention: President or to such other address as the party shall have furnished to the other party by notice given in accordance with this Subsection 18.3. Such notice shall be effective (a) if delivered in person or by courier or overnight delivery service, upon actual receipt by the intended recipient, or (b) if sent by telecopy or facsimile transmission, on the date of transmission unless transmitted after normal business hours, in which case on the following date, or (c) if mailed, upon the date of first attempted delivery. 18.4 Waiver. No provision of this Agreement shall be deemed to be ------- waived and no breach excused unless such waiver or consent shall be in writing and signed by the party that is claimed to have waived or consented. The failure of a party at any time, or from time to time, to require performance by the other party of any provision hereof shall in no way affect the rights of such party thereafter to enforce the same nor shall the waiver by a party of any breach of any provision hereof by the other party constitute a waiver of any succeeding breach of such provision, or a waiver of any provision itself, or a waiver of any other provisions hereof. 18.5 Severability. This Agreement will be enforced to the fullest ------------- extent permitted by applicable law. If for any reason any provision of this Agreement is held to be invalid or unenforceable to any extent, then: (a) such provision will be interpreted, construed or reformed to the extent reasonably required to render the same valid, enforceable and consistent with the original intent underlying such provision; (b) such provision will be void to the extent it is held to be invalid or unenforceable; (c) such provision will remain in effect to the extent that it is not invalid or unenforceable; and (d) such invalidity or unenforceability will not affect any other provision of this Agreement or any other agreement between the parties. 18.6 Governing Law. This Agreement shall be governed by and --------------- construed according to the laws of the State of Florida without regard to its choice of law provisions. The parties consent to the jurisdiction of any Florida court located within Duval County and the United States District Court for the Middle District of Florida (Jacksonville Division) and waive any right to assert that any such court constitutes an inconvenient or improper forum. 18.7 Publicity. Neither party shall, without the approval of the ---------- other, make any press release or other public announcement concerning the transactions contemplated by this Agreement, except as and to the extent that any such party shall be so obligated by law or by the rules, regulations or policies of any national securities exchange or association or governmental entity, in which case the other party shall be advised and the parties shall use their best efforts to cause a mutually agreeable release or announcement to be issued; provided, however, that the parties hereby acknowledge and agree that communications among employees of the parties and their attorneys, representatives and agents necessary to consummate the transactions contemplated hereby shall not be deemed a public announcement for purposes of this Subsection 18.7. Upon the execution and delivery of this Agreement, the parties hereto will cooperate in respect of the immediate issuance of a mutually acceptable press release relating to the transactions contemplated by this Agreement. 18.8 Entire Agreement. All schedules to this Agreement are ------------------ incorporated in and constitute a part of this Agreement. This Agreement including the schedules hereto and thereto, each as amended from time to time, constitute the entire understanding between the parties in relation to the subject matter hereof and supersede all prior discussions, agreements and representations related to this subject matter, whether oral or written and whether or not executed by a party. Unless otherwise provided in this Agreement, no modification, amendment or other change may be made to this Agreement or any part thereof unless reduced to writing and executed by authorized representatives of all parties. 18.9 Counterparts. This Agreement may be executed in two or more ------------- counterparts, each of which will be deemed an original, but all of which together will constitute one and the same instrument. 18.10 Titles and Subtitles. The titles and subtitles used in this --------------------- Agreement and in the schedules hereto are used for convenience only and are not to be considered in construing or interpreting this Agreement. 18.11 Force Majeure. Neither party shall be responsible for a --------------- failure to meet its obligations under this Agreement to the extent caused by the following: (a) materially inaccurate data submitted by the other party; (b) any failure by the other party to meet its obligations stated in this Agreement; (c) any failure of equipment, facilities or services not controlled or supplied by such party; or (d) failure(s) caused by acts of God, acts of nature, riots and other major civil disturbances, strike by such party's personnel, sabotage, injunctions or applicable laws or regulations, in each case without breach by such party of any obligations under this Agreement with regard to either such event or such failure. The Lumber Company or Buildscape, as applicable, agrees to use its commercially reasonable efforts to restore performance of its obligations under this Agreement as soon as reasonably practicable following any such event. 18.12 Injunctive Relief. The parties acknowledge that a material ------------------ breach of this Agreement would cause irreparable harm, the extent of which would be difficult to ascertain. Accordingly, they agree that, such party will be entitled to obtain immediate injunctive relief in the event of a material breach of this Agreement to enjoin such breach pending resolution pursuant to this Agreement. 18.13 Attorneys' Fees. Subject to the provisions of Section 16 ----------------- hereof, in the event any action is commenced to enforce the provisions of this Agreement, then the prevailing party in such action shall be entitled to recover from the other party such prevailing party's costs and expenses, including attorneys fees incurred in connection with such action. (SIGNATURE PAGE FOLLOWS) IN WITNESS WHEREOF, each of the parties hereto has caused this Agreement to be executed on its behalf by its officers thereunto duly authorized, all as of the date first above written. BUILDSCAPE, INC. By_/s/______________________________ ---------------------------------- WICKES INC. By_/s/______________________________ ---------------------------------- [CERTAIN CONFIDENTIAL MATERIAL HAS BEEN OMITTED AND FILED SEPARATELY WITH THE S.EC. PURSUANT TO A REQUEST FOR CONFIDENTIAL TREATMENT ] SETTLEMENT AGREEMENT This SETTLEMENT AGREEMENT is made as of the 28th day of January, 2000 by and among GREENLEAF TECHNOLOGIES CORPORATION ("Greenleaf"), a Delaware corporation, with an office at 8834 Capital of Texas Highway North, Suite 150, Austin, Texas 78759, and RIVERSIDE GROUP, INC. ("Riverside"), a Florida corporation, CYBERMAX TECH, INC., a Florida corporation ("Cybermax"), CYBERMAX, INC., a Florida corporation, ("Cybermax, Inc."), wholly owned subsidiaries of Riverside, Catherine Gray ("Gray") and J. Steven Wilson ("Wilson"), all having an office at 7800 Belfort Parkway, Suite 100, Jacksonville, Florida. W I T N E S S E T H: WHEREAS, Greenleaf entered into an agreement (the "Purchase Agreement") with Cybermax dated as of September 30, 1998 for the purchase by Greenleaf from Cybermax of all of the outstanding shares of capital stock (the "Gameverse Shares") of Gameverse, Inc. ("Gameverse"); and WHEREAS, as consideration for the Gameverse Shares, Greenleaf issued to Cybermax 14,687,585 shares of the voting common stock of Greenleaf and options (the "Greenleaf Shares") and options to purchase an aggregate of 7,314,582 shares of the voting common stock of Greenleaf (the "Greenleaf Options"); and WHEREAS, Greenleaf has filed a complaint in the United States District Court for the District of New Jersey (Docket No. 99-5720), wherein Greenleaf has alleged certain misrepresentations against Riverside, Cybermax, Gameverse, Jared Nielsen, Catherine Gray and J. Steven Wilson (the "Pending Litigation"), which all defendants in the Pending Litigation deny and dispute; and WHEREAS, the parties in the Pending Litigation, without admission of fault or liability on the part of any of them, have resolved their differences and desire to enter into a complete and final settlement of all of their claims, differences and causes of action with respect to the Purchase Agreement and the claims and disputes which are, or could be, asserted in the Pending Litigation. NOW, THEREFORE, in exchange for good and valuable consideration, including the mutual promises set forth herein, the receipt and sufficiency of which is hereby acknowledged, and intending to be legally bound hereby, the parties agree as follows: 1. Greenleaf Shares and Options. In full settlement of all claims which Greenleaf may have against Riverside, Cybermax, Gray and/or Wilson with respect to the Purchase Agreement and the claims and disputes which are, or could be, asserted in the Pending Litigation, the parties agree as follows: a. Riverside and/or Cybermax shall retain Ten Million (10,000,000) of the Greenleaf Shares and Two Million (2,000,000) of the Greenleaf Options exercisable at $.25 each pursuant to the terms of a certain "Option Agreement A" originally dated September 30, 1998 to be amended and restated in the form attached hereto as Exhibit A; and b. One Million Six Hundred Eighty-Seven Thousand Five Hundred Eighty-Five (1,687,585) of the Greenleaf Shares and Five Million Three Hundred Fourteen Thousand Five Hundred Eighty-Two (5,314,582) of the Greenleaf Options shall be canceled by Greenleaf without payment to Riverside or Cybermax; and c. Three Million (3,000,000) of the Greenleaf Shares shall be placed in escrow (the "Escrow Shares") with Randall S.D. Jacobs, Esq. pursuant to an escrow agreement acceptable to all parties, and shall be sold upon mutually agreeable terms pursuant to Rule 144 as in effect under the Securities Act of 1933, as amended ("Rule 144"). Riverside and Cybermax shall each be responsible for any state and federal income taxes imposed upon the proceeds of such sales other than any applicable federal alternative minimum tax ("AMT"). Any such AMT found to be due and owing upon such sales shall be paid from the proceeds of sale of the Escrow Shares prior to funding the Joint Venture or distribution to the parties in accordance with the terms of subparagraph 1.d of this Settlement Agreement; and d. The proceeds from the sale of the Escrow Shares shall be used to fund a mutually agreeable joint venture ("Joint Venture") for the marketing of technology and internet- related products, to be owned in equal amounts by Greenleaf and Riverside. The parties shall negotiate in good faith and use their reasonable best efforts to form and operate the Joint Venture in a mutually beneficial manner. Peter Jegou on behalf of Greenleaf and Ed Salem on behalf of Riverside shall undertake to resolve any disagreements as to the formation and operation of the Joint Venture, subject to ratification by the Board of Directors of the respective companies. In the event the parties fail to reach agreement with respect to the form and operation of the Joint Venture, notwithstanding their good faith negotiations and reasonable best efforts, the proceeds of sale of the Escrow Shares, less any taxes due and owing upon sale, shall be distributed in equal shares to Greenleaf and Riverside. 2. Grant of Riverside Option. Riverside and Greenleaf shall enter into a Stock Option Agreement in the form attached hereto as Exhibit B pursuant to which Riverside shall grant to Greenleaf a non-qualified stock option (the "Riverside Option Agreement"), that being an option not intended to qualify as an incentive stock option within the meaning of Section 422A of the Internal Revenue Code of 1986, as amended (the "Code"), to purchase that number of shares of Cybermax, Inc. equal to five percent (5%) of the issued and outstanding shares of Cybermax, Inc. (the "Cybermax, Inc. Shares"). The exercise price for the Riverside Option shall be One Million Dollars ($1,000,000). The Riverside Option Agreement shall contain a cashless exercise provision. The Riverside Option shall be exercisable immediately and at any time prior to 5:30 p.m., eastern standard time, on September 30, 2003, in accordance with the terms of the Riverside Option Agreement. 3. Grant of Exclusivity. Riverside shall, through its subsidiaries Cybermax, Inc. and Buildscape, Inc. appoint Greenleaf as its exclusive encription vendor and shall enter into an Exclusivity Agreement for such services, on an as-needed basis, at fair market value. The parties shall negotiate in good faith and use their reasonable best efforts to agree to the terms of an Exclusivity Agreement that will be mutually beneficial. 4. Future Com Agreement. Riverside shall enter into an agreement with Future Com, a Greenleaf subsidiary, for the use of satellite air time, related technology, hardware and software, on an as-needed basis, at fair market value. The parties shall negotiate in good faith and use their reasonable best efforts to agree to the terms of a Future Com Agreement that will be mutually beneficial. 5. Riverside, Cybermax and Cybermax, Inc. Representations. Riverside, Cybermax and Cybermax, Inc. represent and warrants to Greenleaf as follows: a. Title to the Shares and Options. Riverside is the lawful record and beneficial owner of the Greenleaf Shares and the Greenleaf Options, and with the exception of the claims asserted by Greenleaf in the Pending Litigation owns the shares and options that will be canceled pursuant to subparagraph 1.b of this Settlement Agreement and the shares that will be deposited into escrow pursuant to subparagraph 1.c (together the "Unencumbered Shares"), free and clear of all security interests, liens, encumbrances, claims and equities of every kind, and which Unencumbered Shares are duly authorized, validly issued and outstanding, fully paid and nonassessable. b. No Other Equity Securities. As of the date of this Settlement Agreement, neither Riverside nor Cybermax or Cybermax, Inc. owns, directly or indirectly any issued and outstanding equity securities of Greenleaf or securities convertible or exchangeable for such equity securities. c. Capacity of and Execution by Riverside, Cybermax and Cybermax, Inc. The President, any Vice President or Edward B. Salem (authorized signer) of Riverside have full legal power and capacity to execute, deliver and perform this Settlement Agreement, and to deliver certificates representing the Greenleaf Shares and the Greenleaf Options owned by Riverside and have full legal power to transfer such securities in accordance with the Settlement Agreement. Without limiting the generality of the foregoing, no authorization, consent or approval or other order or action of or filing with any court, administrative agency, or other governmental or regulatory body or authority is required for the execution and delivery by Riverside, Cybermax or Cybermax, Inc. of this Settlement Agreement or the consummation by any of them of the transactions contemplated hereby; this Settlement Agreement has been duly and validly executed and delivered by Riverside, Cybermax and Cybermax, Inc. and constitutes the valid and binding obligation of each of them enforceable in accordance with its terms, except as its enforceability is limited by bankruptcy, reorganization, insolvency, fraudulent conveyance, moratorium and similar laws presently or hereafter in effect affecting the enforcement of creditors' rights generally and subject to general principles of equity; and the transfer and delivery of the Unencumbered Shares in accordance with this Settlement Agreement will vest good title to the Shares in Greenleaf or other transferee, free and clear of all security interests, liens, encumbrances, claims and equities of every kind other than restrictions on disposition contained in applicable federal and state securities laws. d. Conflict with Other Instruments. Neither the execution and delivery of this Agreement by Riverside, Cybermax or Cybermax, Inc. nor the consummation by any of them of the transactions contemplated in this Settlement Agreement will (a) conflict with, or result in a breach of, the terms, conditions or provisions of, or constitute a default (or an event which would by notice or lapse of time or both would become a default) or permit acceleration or termination of obligations under, or result in the creation of a lien or encumbrance on any of the properties of Riverside, Cybermax or Cybermax, Inc. pursuant to, (i) the certificate of incorporation or by-laws of either of them or (ii) any indenture, mortgage, lease, agreement, or other instrument which is material in nature to which any of them is a party or by which it or they, or any of its or their properties, may be bound or affected, or (b) violate any law, rule, order or regulation, material in nature, to which either of them is subject or by which it or they or its or their properties are bound. e. Corporate Existence, Power and Authority. Riverside, Cybermax and Cybermax, Inc. are corporations duly organized, validly existing and in good standing under the laws of the State of Florida and have all requisite corporate power and authority to enter into this Settlement Agreement and to carry out the transactions contemplated in this Settlement Agreement and to carry on their businesses as now being conducted by them and to own, lease or otherwise hold their properties. f. Corporate Action. The execution and delivery of this Settlement Agreement by Riverside, Cybermax and Cybermax, Inc. and the consummation by Riverside, Cybermax and Cybermax, Inc. of the transactions contemplated in this Settlement Agreement have been authorized by all requisite corporation action on the part of Riverside, Cybermax and Cybermax, Inc. g. Cooperation In Sale of Shares and Further Assurances. In the event Greenleaf seeks to sell any Cybermax, Inc. Shares obtained upon exercise of its its rights under the Riverside Option Agreement, Riverside, Cybermax and Cybermax, Inc. shall take all necessary and appropriate steps to cooperate in and assist the sale of such shares pursuant to the provisions of Rule 144 and any other applicable law, rule or regulation, including without limitation making Rule 144 available (including fulfilling all periodic reporting require- ments under Federal securities laws) and causing counsel to issue an appropriate legal opinion. At any time, and from time to time, within a reasonable time after written requires by Greenleaf, Cybermax, Inc. will make, execute and deliver, or cause to be made, executed and delivered, to Greenleaf and, where appropriate, cause to be recorded and/or filed, any and all such other and further instruments or documents, or other items as Greenleaf may reasonably deem necessary or desirable to effectuate or complete the sale of any of the Cybermax, Inc. Shares issued pursuant to Greenleaf's exercise of rights under the Riverside Option Agreement. 6. Representations, Warranties and Covenants of Greenleaf. Greenleaf represents, warrants and covenants to Riverside, Cybermax and Cybermax, Inc. as follows: a. Corporate Existence, Power and Authority. Greenleaf is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware and has all requisite corporate power and authority to enter into this Settlement Agreement and to carry out the transactions contemplated in this Settlement Agreement and to carry on its business as now being conducted by it and to own, lease or otherwise hold its properties. b. Corporate Action. The execution and delivery of this Settlement Agreement by Greenleaf and the consummation by Greenleaf of the transactions contemplated in this Settlement Agreement have been authorized by all requisite corporation action on the part of Greenleaf. c. Capacity of and Execution by Greenleaf. The President and Secretary of Greenleaf have full legal power and capacity to execute, deliver and perform this Settlement Agreement. Without limiting the generality of the foregoing, no authorization, consent or approval or other order or action of or filing with any court, administrative agency, or other governmental or regulatory body or authority is required for the execution and delivery by the Greenleaf of this Settlement Agreement or Greenleaf's consummation of the transactions contemplated hereby; this Settlement Agreemen has been duly and validly executed and delivered by Greenleaf and constitutes the valid and binding obligation of Greenleaf enforceable in accordance with its terms, except as its enforceability is limited by bankruptcy, reorganization, insolvency, fraudulent conveyance, moratorium and similar laws presently or hereafter in effect affecting the enforcement of creditors' rights generally and subject to general principles of equity. d. Conflict with Other Instruments. Neither the execution and delivery of this Settlement Agreement by Greenleaf nor the consummation by Greenleaf of the transactions contemplated in this Settlement Agreement will (a) conflict with, or result in a breach of, the terms, conditions or provisions of, or constitute a default (or an event which would by notice or lapse of time or both would become a default) or permit acceleration or termination of obligations under, or result in the creation of a lien or encumbrance on any of the properties of Greenleaf pursuant to, (i) the certificate of incorporation or by-laws of Greenleaf or (ii) any indenture, mortgage, lease, agreement, or other instrument which is material in nature to which Greenleaf or Greenleaf is a party or by which it, or any of its properties, may be bound or affected, or (b) violate any law, rule, order or regulation, material in nature, to which Greenleaf or either Greenleaf is subject or by which it or its properties are bound. e. Cooperation In Sale of Shares and Further Assurances. In the event Riverside seeks to sell any Greenleaf Shares retained under this Settlement Agreement, or obtained upon exercise of its rights under "Option Agreement A" as modified by this Settlement Agreement, Greenleaf shall take all necessary and appropriate steps to cooperate in and assist the sale of such shares pursuant to the provisions of Rule 144 and any other applicable law, rule or regulation, including without limitation making Rule 144 available (including fulfilling all periodic reporting requirements under Federal securities laws) and causing counsel to issue an appropriate legal opinion. At any time, and from time to time, within a reasonable time after written request by Riverside, Greenleaf will make, execute and deliver, or cause to be made, executed and delivered, to Riverside and, where appropriate, cause to be recorded and/or filed, any and all such other and further instruments or documents, or other items as Riverside may reasonably deem necessary or desirable to effectuate or complete the sale of any of the Greenleaf Shares or shares of Greenleaf common stock issued pursuant to Riverside's exercise of rights under "Option Agreement A" or any shares of Greenleaf common stock obtained by Riverside pursuant to stock splits, stock dividends or other corporate action. 7. Cooperation in the Event of Nielsen Claim. In the event Jared Nielsen commences any suit or proceeding against Riverside, Cybermax, Cybermax, Inc. or Greenleaf relating to or regarding this Settlement Agreement, the Purchase Agreement, the Greenleaf Shares, the Greenleaf Options or Gameverse, or Jared Nielsen claims any right, title or interest in any of the transactions between Greenleaf on the one hand and Riverside, Cybermax or Cybermax, Inc. on the other hand, Greenleaf, Riverside, Cybermax and Cybermax, Inc., their officers, employees, agents and representatives shall cooperate with each other in the defense of any such suit, proceeding or claim. Such cooperation shall include without limitation making such persons available for interviews, providing documents for inspection, making out affidavits or certifications and giving testimony at any trial or hearing. 8. Indemnification Against Nielsen Claim. Riverside, Cybermax and, Cybermax, Inc. agree to indemnify and hold harmless Greenleaf and its affiliates and their officers, employees, agents and representatives, at any time without limitation, against, and in respect of, liabilities, contingent or otherwise, losses, claims, costs, or damages, or any amounts which may become payable, resulting from or arising out of, or in connection with any claims by Jared Nielsen relating to Gameverse, including, but not limited to, any ownership interest in Gameverse or in any of the patents, trademarks, licenses and copyrights listed on Exhibit C hereto (the "Nielsen Claim"). Greenleaf shall give Riverside, Cybermax and Cybermax, Inc. a reasonable opportunity, at their expense, of defending or settling the Nielsen Claim, subject to the right of Greenleaf to participate fully in such defense at its own costs. To the extent that they do not agree to defend or settle such claim, Greenleaf shall have the right to defend or settle the same and hold Riverside, Cybermax and Cybermax, Inc. responsible pursuant to this indemnification. 9. Forgiveness of Debt. Riverside agrees to forgive and discharge Greenleaf's current indebtedness to Riverside in the amount of $111,820 representing reimbursement for employee expenses paid by Riverside subsequent to the closing of the Purchase Agreement in or about September 1998. 10. Release and Stipulation of Dismissal. Greenleaf, Riverside, Cybermax , Cybermax, Inc., Gray and Wilson shall execute a Release in the form attached hereto as Exhibits D-1 through D-4 and counsel for the parties hereto shall enter into a Stipulation of Dismissal with prejudice of the Pending Litigation in the form attached hereto as Exhibit E. It is the intention of the parties that the Releases and Stipulation of Dismissal shall bar and preclude forever the claims subject to the Releases and Stipulation of Dismissal and that the Pending Litigation shall not be reopened or reinstated for any reason, including without limitation any claim of breach of this Settlement Agreement, claim that this Settlement Agreement, the Releases or Stipulation was procured by misrepresentation or fraud or claim that the consideration obtained by Greenleaf herein (including the Riverside Option) is lacking or inadequate. In the event of a claim of breach of this Settlement Agreement, the parties' exclusive right and remedy shall be the commencement of a separate action or arbitration in accordance with the terms of paragraph 14 of this Settlement Agreement. 11. No Admission of Liability. This Settlement Agreement is not an admission on the part of any party of any fault or liability whatsoever or that any party in any way acted improperly or unlawfully. 12. Notices. All notices and other communications required or relating to this Settleme Agreement shall be in writing and shall be deemed to have been given when it is personally delivered, telecopied, deposited in the United States mails, by registered or certified mail, or sent by reputable overnight courier service, to the respective party at the address set forth at the beginning of this Settlement Agreement or such other address as a party shall provide pursuant to this paragraph. 13. Severability. Should any provisions of this Settlement Agreement be held to be illegal, void or unenforceable, such provision shall be of no force and effect. However, the illegality or unenforceability of any such provision shall have no effect upon, and shall not impair the enforceability of, any other provision of this Settlement Agreement. 14. Governing Law/Jurisdiction. This Settlement Agreement shall be governed by and construed in accordance with the laws of the State of New Jersey, excluding the choice of law rules thereof. The parties agree that the courts of the State of New Jersey and the U.S. District Court sitting in the State of New Jersey are to have exclusive jurisdiction over this Settlement Agreement with the exception of any claim or dispute arising under paragraphs 3 and 4 of this Settlement Agreement. In the event of a claim or dispute under either of those paragraphs, the parties agree tosubmit such claim or dispute to binding arbitration in New Jersey in accordance with the Commercial Rules of the American Arbitration Association then in effect. 15. Amendments. This Settlement Agreement may only be changed or amended by an written agreement signed by the parties hereto. 16. Binding Effect. This Settlement Agreement shall be binding and inure to each of the parties, and their respective successors and assignees. 17. Assignability. This Settlement Agreement is not assignable by a party without theprior written consent of the other party. 18. Counterparts. This Settlement Agreement may be executed in one or more counterparts, each of which shall be deemed an original, but all of which taken together shall constitute one and the same Settlement Agreement. 19. Waiver of Enforcement. The failure of any party to enforce at and time any of the provisions of this Settlement Agreement shall not be construed to be a waiver of any such provision or of any other provision in this Settlement Agreement, nor in any way effect the validity of this Settlement Agreement or the right of any party to enforce each and every provision in the future. No waiver of any breach of this Settlement Agreement shall be held to be a waiver of any other or subsequent breach or affect the right of a party at a later time to enforce same. Any party may, at its sole option, waive provision of this Settlement Agreement, provided such waiver is in writing. 20. Descriptive Headings. All section and subsection headings and titles contained herein are inserted for convenience of reference only and are to be ignored in any construction, interpretation or enforcement of the provisions hereof. 21. Independent Counsel. The parties acknowledge and agree that they have been represented by counsel or had the opportunity to consult with independent counsel in connectionwith this Settlement Agreement and the terms and conditions ofthis Settlement Agreement, and that they have had the opportunity to review this Settlement Agreement with counsel of their choosing. The parties further acknowledge that Greenleaf has been represented by the law firm of Greenbaum, Rowe, Smith, Ravin, Davis, & Himmel LLP, and Riverside, Cybermax and Cybermax, Inc. have been represented by the firm of Saiber Schlesinger Satz & Goldstein LLC. 22. Entire Agreement. This Settlement Agreement constitutes the complete understanding and agreement of the parties hereto with respect to the matters contained herein. All prior agreements between the parties, including without limitation the Purchase Agreement, are superseded by this Settlement Agreement and are of no force or effect except as stated herein. By signing below, the parties indicate that they have carefully read and understood the terms of this Settlement Agreement, enter into the Settlement Agreement knowingly, voluntarily and of their own free will, understand its terms and significance and intend to abide by its provisions without exception. IN WITNESS WHEREOF, this Settlement Agreement has been executed as of the date and year first above written. GREENLEAF TECHNOLOGIES CORPORATION By: _______________________________ RIVERSIDE GROUP, INC. By: _______________________________ CYBERMAX TECH, INC. By: _______________________________ CYBERMAX, INC. By: _______________________________ ------------------------------- Catherine Gray ------------------------------- J. Steven Wilson Exhibit 23.01 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement of Riverside Group, Inc. on Form S-8 (File No. 33-16244), of our report dated April 14, 2000 relating to the finanacial statements, which appears in the Annual Report to Shareholders, which is incorporated in this Annual Report on this Form 10-K. We also consent to the incorporation by reference of our reort dated April 14, 2000 relating to the financial statements which appear in this Form 10-K. PricewaterhouseCoopers LLP Jacksonville, Florida April 14, 2000

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Item 1. Business Omitted. Item 2. Item 2. Properties Omitted. Item 3. Item 3. Legal Proceedings The Registrant is not aware of any material legal proceeding with respect to, the Company, the Master Servicer or the Trustee, as related to the Trust. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote or consent of Holders of the Offered Certificates during the fiscal year covered by this report. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Trust does not issue stock. There is currently no established secondary market for the Certificates. As of December 31, 1999, the number of holders of each Class of Offered Certificates was 8. Item 6. Item 6. Selected Financial Data Omitted. Item 7. Item 7. Management's Discussion and Analysis of Financial condition and Results of Operations Omitted. Item 8. Item 8. Financial Statements and Supplementary Data Omitted. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There was no change of accountants or disagreement with accountants on any matter of accounting principles or practices or financial disclosure. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Omitted. Item 11. Item 11. Executive Compensation Omitted. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Omitted. Item 13. Item 13. Certain Relationships and Related Transactions No reportable transactions have occurred. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as part of this report: (1) Financial Statements: Omitted. (2) Financial Statement Schedules: Omitted. (3) Exhibits: Annual Servicer Statement of Compliance, filed as Exhibit 99.1 hereto. Annual Statement of Independent Accountants Report for the Servicer, filed as Exhibit 99.2 hereto. (b) Reports on Form 8-K: The following Current Reports on Form 8-K were filed by the Registrant during the last quarter of 1999. Current Reports on Form 8-K, dated October 25, 1999, November 26, 1999, and December 27, 1999, were filed for the purpose of filing the Monthly Statement sent to the Holders of the Offered Certificates for payments made on the same dates. The items reported in such Current Report were Item 5 (Other Events). (c) Exhibits to this report are listed in Item (14)(a)(3) above. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE CHASE MANHATTAN BANK, not in its individual capacity but solely as Trustee under the Agreement referred to herein Date: March 30, 2000 By: /s/Kimberly K. Costa ----------------------------- Kimberly K. Costa Vice President SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. The registrant has not sent an annual report or proxy material to its security holders. The registrant will not be sending an annual report or proxy material to its security holders subsequent to the filing of this form. EXHIBIT INDEX Exhibit Description 99.1 Servicer's Annual Statement of Compliance 99.2 Servicer's Annual Independent Accountant's Report EXHIBIT 99.1 - Servicer's Annual Statement of Compliance To be supplied upon receipt by the Trustee EXHIBIT 99.2 - Servicer's Annual Independent Accountant's Report To be supplied upon receipt by the Trustee

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ITEM 1. Business. Through internal development and by acquisitions, Air Products and Chemicals, Inc. has established an internationally recognized industrial gas and related industrial process equipment business, and developed strong positions as a producer of certain chemicals. The industrial gases business segment recovers and distributes industrial gases such as oxygen, nitrogen, argon, and hydrogen and a variety of medical and specialty gases. This segment also includes the Company's power generation and flue gas treatment businesses. The chemicals business segment produces and markets polymer chemicals, performance chemicals, and chemical intermediates. The equipment and services business segment supplies cryogenic and other process equipment and related engineering services. Financial information concerning the Company's business segments appears in Note 20 to the Consolidated Financial Statements included under Item 8 herein, which information is incorporated herein by reference, as are all other specific references herein to information appearing in such 1999 Financial Review Section of the Annual Report. As used in this Report, the term "Air Products" or "Company" includes subsidiaries and predecessors of the registrant or its subsidiaries, unless the context indicates otherwise. INDUSTRIAL GASES The principal industrial gases sold by the Company are oxygen, nitrogen, argon (primarily recovered by the cryogenic distillation of air), hydrogen, carbon monoxide, carbon dioxide (purchased, purified, or recovered through the processing of natural gas or the by-product streams from process plants), synthesis gas (combined streams of hydrogen and carbon monoxide), and helium (purchased or refined from crude helium). Medical and specialty gases are manufactured or blended by the Company or purchased for resale. The industrial gas segment now also includes the Company's power generation and flue gas treatment businesses. These businesses were formerly reported in the Equipment and Services segment. The Company's industrial gas business involves two principal modes of supply: "Tonnage" or "on-site" supply--For large volume or "tonnage" users of industrial gases, a plant is built adjacent to or near the customer's facility--hence the term "on-site". Alternatively, the gases are delivered through a pipeline from nearby locations. Supply is generally made under contracts having terms in excess of three years. In at least nine areas--the Houston (Texas) Ship Channel including the Port Arthur, Texas, area; "Silicon Valley", California; Los Angeles, California; Phoenix, Arizona; Decatur, Alabama; Central Louisiana; Rotterdam, The Netherlands; Singapore; and Bahia, Brazil--Air Products' hydrogen, oxygen, carbon monoxide, or nitrogen gas pipelines serve multiple customers from one or more centrally located plants. Industrial gas companies in which the Company has less than controlling interests have pipelines in Korea, Thailand, Malaysia, Taiwan, and South Africa. Merchant supply--Smaller volumes of industrial gas products are delivered to thousands of customers in liquid or gaseous form by tanker trucks or tube trailers. These merchant customers use equipment designed and installed by Air Products to store the product near the point of use, normally in liquid state, and vaporize the product into gaseous state for their use as needed. Increasingly, some customers are being supplied by small on-site generators using noncryogenic technology based on adsorption and membrane technology, which, in certain circumstances, the Company sells to its customers. Merchant customers' contract terms normally are from three to five years. Merchant gases and various specialty gases are also delivered in cylinders, dewars, and lecture bottle sizes. Oxygen, nitrogen, argon, and hydrogen sold to merchant customers are usually recovered at large "stand-alone" facilities located near industrial areas or high-tech centers, or at small noncryogenic generators, or are taken from tonnage plants used primarily to supply tonnage users. Tonnage plants are frequently designed to have more capacity than is required by their principal customer to recover additional product that is liquefied for sale to a merchant market. Air Products also designs and builds systems for recovering oxygen, hydrogen, nitrogen, carbon monoxide, and low dew point gases using adsorption technology. Tonnage and merchant sales of atmospheric gases--oxygen, nitrogen, and argon--constituted approximately 26% of Air Products' consolidated sales in fiscal 1999 and were approximately 25% and 24% in fiscal years 1998 and 1997 respectively. Tonnage and merchant sales of industrial gases--principally oxygen, nitrogen, and hydrogen--to the chemical process industry and the electronics industry, the largest consuming industries, were approximately 14% and 9% respectively, of Air Products' consolidated sales in fiscal 1999. Other important consumers of Air Products' industrial and specialty gases are the basic steel industry, the oil industry (which uses inert nitrogen for oil well stimulation and field pressurization and hydrogen and oxygen for refining), and the food industry (which uses liquid nitrogen for food freezing). Air Products believes that it is the largest liquefier of hydrogen which it supplies to many customers including the National Aeronautics and Space Administration for its space shuttle program. Helium is sold for use in magnetic resonance imaging equipment, controlled atmospheres processes, and welding. Medical gases are sold in the merchant market to hospitals and clinics, primarily for inhalation therapy. Specialty gases include fluorine products, rare gases such as xenon, krypton, and neon, and more common gases of high-purity or gases which are precisely blended as mixtures. Specialty chemicals for use by the electronics industry include silane, nitrogen trifluoride, carbon tetrafluoride, hexaflouromethane, and tungsten hexafluoride. These gases and chemicals are used in numerous industries and in electronic and laboratory applications. In certain circumstances, the Company sells equipment related to the use, handling, and storage of such specialty gases and specialty chemicals. Sales of industrial gases to merchant customers and/or sales of specialty products to the electronics industry are made principally through field sales forces from 131 offices in 37 states in the United States and Puerto Rico, and from 191 offices in 24 foreign countries. In addition, industrial gas companies in which the Company has investments operate in more than 30 foreign countries. Electricity and hydrocarbons, including natural gas as a feedstock for producing certain gases, are important to Air Products' industrial gas business. See "Raw Materials and Energy". The Company's large truck fleet, which delivers products to merchant customers, requires a readily available supply of gasoline or diesel fuel. Also, environmental and health laws and regulations will continue to affect the Company's industrial gas businesses. See "Environmental Controls". Power Generation Air Products operates and has 50% interests in a 49-megawatt fluidized-bed coal-fired power generation facility in Stockton, California; an 85-megawatt coal waste burning power generation facility in western Pennsylvania; a 120-megawatt gas-fired combined cycle power generation facility in Orlando, Florida; and a 24-megawatt gas-fired combined cycle power generation facility near Rotterdam, The Netherlands. A 112-megawatt gas-fueled power generation facility, in which the Company has a 48.9% interest, operates in Thailand and supplies electricity to a state-owned electricity generating authority and steam and electricity to an Air Products industrial gases affiliate. Pure Air Air Products operates and owns a 50% interest in a facility utilizing Mitsubishi Heavy Industries, Ltd. flue gas desulfurization (FGD) technology systems for removing sulfur dioxide from the flue gas of a coal-fired power generation plant in Indiana. Additional information with respect to the Company's power generation and flue gas treatment businesses is included in Notes 8 and 16 to the Consolidated Financial Statements included under Item 8 herein. BOC Transaction In July 1999, the Company and L'Air Liquide S.A. of France agreed to the terms of a recommended offer under which they would acquire the BOC Group plc, the leading British industrial gases company. The Company will contribute approximately $5.9 billion in cash to the transaction, expected to be funded initially with debt financing through or supported by a credit facility provided by The Chase Manhattan Bank. This transaction provides a unique opportunity for the Company to acquire attractive, complementary assets that will increase its size and scale to compete around the world and extend its presence in high growth areas, advancing its strategy of building a leading global industrial gas company. Additional information about the acquisition is included in Note 18 to the Consolidated Financial Statements included under Item 8 herein. CHEMICALS The Company's chemicals businesses consist of polymer chemicals, performance chemicals, and chemical intermediates where the Company is able to differentiate itself by the performance of its products in the customer's application, the technical service which the Company provides, and the scale of production and the production technology employed by the Company. Polymer Chemicals Air Products' polymer chemicals are water-based and water-soluble products derived primarily from vinyl acetate monomer. The principal products of these businesses are polymer emulsions, pressure sensitive adhesives, and polyvinyl alcohol. Total sales from these businesses constituted approximately 14% of Air Products' consolidated sales in fiscal year 1999, and 12% in each of fiscal years 1998 and 1997. Polymer Emulsions-The Company's major emulsion products are vinyl acetate homopolymer emulsions and AIRFLEX(R) vinyl acetate-ethylene copolymer emulsions. The Company also produces emulsions which incorporate vinyl chloride and various acrylates in the polymer. These products are used in adhesives, nonwoven fabric binders, paper coatings, paints, inks, and carpet backing binder formulations. Air Products owns 65% of a world-wide joint venture with Wacker-Chemie GmbH that produces polymer emulsions and pressure sensitive adhesives. The Company also owns 20% of a world-wide joint venture with Wacker-Chemie that produces redispersible powders made from polymer emulsions. Pressure Sensitive Adhesives-These products are water-based acrylic emulsions which are used for both permanent and removable pressure sensitive adhesives primarily for labels and tapes. Polyvinyl Alcohol-These polymer products are water-soluble synthetic resins which are used in textile warp sizes, surface sizes for paper, adhesives, safety glass laminates, and as emulsifying agents in polymerization. As a co-product of polyvinyl alcohol, acetic acid is a merchant product sold to a variety of markets including textiles, pharmaceuticals, and electronics. Performance Chemicals Air Products' performance chemicals are differentiated from the competition based on their performance when used in the customer's products and the technical service which the Company provides. The principal products of these businesses are specialty additives, polyurethane additives, and epoxy additives. Total sales from these businesses constituted approximately 8% of Air Products' consolidated sales in each of fiscal years 1999, 1998, and 1997. Specialty Additives-These products are primarily acetylenic alcohols and amines which are used as performance additives in coatings, lubricants, electro-deposition processes, agricultural formulations, and corrosion inhibitors. Polyurethane Additives-These products include catalysts and surfactants which are used as performance control additives and processing aids in the production of both flexible and rigid polyurethane foam around the world. The principal end markets for polyurethane foams include furniture cushioning, insulation, carpet underlay, bedding, and automobile seating. Epoxy Additives-These products include polyamides, aromatic amines, cycloaliphatic amines, reactive diluents, and specialty epoxy resins which are used as performance additives in epoxy formulations by epoxy manufacturers worldwide. The end markets for epoxies are coatings, flooring, adhesives, reinforced composites, and electrical laminates. Chemical Intermediates The chemical intermediates businesses use the Company's proprietary technology and scale of production to differentiate themselves from the competition. The principal intermediates sold by the Company include amines and polyurethane intermediates. The Company also produces certain industrial chemicals (ammonia, methanol, and nitric acid) as raw materials for its differentiated products. Total third-party sales from the chemical intermediates businesses constituted 11% of Air Products' consolidated sales in each of fiscal years 1999, 1998, and 1997. Amines-The Company produces a broad range of amines using ammonia and methanol, which are both manufactured by Air Products, and other alcohol feedstocks purchased from various suppliers. Other, more specialized amines, are produced by the hydrogenation of purchased intermediates. Substantial quantities of these products are sold under long-term contracts to a small number of customers. These products are used by the Company's customers as raw materials in the manufacture of herbicides, pesticides, water treatment chemicals, animal nutrients, polyurethane coatings, artificial sweeteners, rubber chemicals, and pharmaceuticals. Ammonia is a feedstock for its alkylamines and the excess over this requirement is marketed as ammonium nitrate prills and solutions which are primarily used by customers as fertilizers or in other agricultural applications. Methanol is principally used by Air Products as a feedstock in methylamine production and the excess over this requirement is marketed to the methanol market. Polyurethane Intermediates-The Company produces dinitrotoluene ("DNT") and toluene diamine ("TDA") for use as intermediates by the Company's customers in the manufacture of a major precursor of flexible polyurethane foam. The principal end markets for flexible polyurethane foams include furniture cushioning, carpet underlay, bedding, and seating in automobiles. Virtually all of the Company's production of DNT and TDA is sold under long-term contracts to a small number of customers. * * * Chemical sales are supported from various locations in the United States, England, Germany, Brazil, Mexico, The Netherlands, Japan, China, Singapore, and South Africa, and through sales representatives or distributors in most industrialized countries. Dry products are delivered in railcars, trucks, drums, bags, and cartons. Liquid products are delivered by barge, rail tank cars, tank-trailers, drums and pails, and, at one location, by pipeline. The chemicals business depends on adequate energy sources, including natural gas as a feedstock for the production of certain products (see "Raw Materials and Energy"), and will continue to be affected by various environmental and health laws and regulations (see "Environmental Controls"). EQUIPMENT AND SERVICES The Company designs and manufactures equipment for cryogenic air separation, gas processing, natural gas liquefaction, and hydrogen purification. Air Products also designs and builds systems for recovering hydrogen, nitrogen, carbon monoxide, carbon dioxide, and low dew point gases using membrane technology. Additionally, a broad range of plant design, engineering, procurement, and construction management services is provided for the above areas. Equipment is manufactured for use by the industrial gases segment and for sale in industrial markets which include the Company's international industrial gas affiliates. The backlog of orders (including letters of intent) believed to be firm from other companies and equity affiliates for equipment was approximately $175 million on September 30, 1999, approximately 27% of which relates to cryogenic air separation, as compared with a total backlog of approximately $302 million on September 30, 1998. It is expected that approximately $136 million of the backlog on September 30, 1999, will be completed during fiscal 2000. GENERAL Foreign Operations Air Products, through subsidiaries and affiliates, conducts business in numerous countries outside the United States. The structure of the Air Products industrial gas business in Europe mirrors the Company's United States operation. Air Products' international business is subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls, import and export controls, and other economic, political, and regulatory policies of local governments. Majority and wholly owned industrial gas subsidiaries operate in Argentina, Brazil, Canada, Mexico, and throughout Europe and Asia in 14 and eight countries respectively. Subsequent to fiscal year end, the Company acquired the 51 percent of shares that it previously did not own in Korea Industrial Gases Ltd., the largest industrial gas company in Korea. There are 50% industrial gas joint ventures in Africa, Canada, South Africa, four countries in Europe, and two in Asia, and less than controlling interests in Canada and Mexico, two countries in Europe, and five in Asia. The Company has a 50% interest in a power generation facility in The Netherlands and a 48.9% interest in Thailand. The principal geographic markets for the Company's chemical products are North America, Europe, Asia, Brazil, and Mexico. Majority and wholly owned subsidiaries operate in Germany, Italy, The Netherlands, the U.K., Australia, Singapore, and Korea. The Company also has 50% joint ventures in Japan for distribution of POLYCAT(R) and manufacture and sale of DABCO(R) amine catalysts. The polymer emulsions and pressure sensitive adhesives joint venture with Wacker-Chemie GmbH has headquarters in the United States and production facilities in the U.S., Germany, Mexico, and Korea. Headquarters for the 20% investment in the redispersible powder venture with Wacker-Chemie are in Germany with manufacturing facilities in Germany and the United States. Financial information about Air Products' foreign operations and investments is included in Notes 8, 10, and 20 to the Consolidated Financial Statements included under Item 8 herein. Information about foreign currency translation is included in Note 1 to the Consolidated Financial Statements included under Item 8 herein, under "Foreign Currency", and information on Company exposure to currency fluctuations is included in Note 5 to the Consolidated Financial Statements included under Item 8 herein, under "Foreign Exchange Contracts". Export sales from operations in the United States to unconsolidated customers amounted to $528 million, $650 million, and $571 million in 1999, 1998, and 1997 respectively. Total export sales in fiscal 1999 included $43 million in export sales to affiliated customers. The sales to affiliated customers were primarily equipment sales. Technology Development Air Products conducts research and development principally in its laboratories located in Trexlertown, Pennsylvania, as well as in Manchester and Basingstoke, England; Utrecht, The Netherlands; and Barcelona, Spain. The Company also funds and works closely on research and development programs with a number of major universities and conducts a sizable amount of research work funded by others, principally the United States Government. The Company's market-oriented approach to technology development encompasses research and development and engineering, as well as commercial development. The amount expended by the Company on research and development during fiscal 1999 was $123 million, and was $112 million and $114 during fiscal 1998 and 1997 respectively. In the industrial gases and equipment and services segments, technology development is directed primarily to developing new and improved processes and equipment for the production and delivery of industrial gases and cryogenic fluids, developing new products, and developing new and improved applications for industrial gases. It is through such applications and improvements that the Company has become a major supplier to the electronics, polymer, petroleum, rubber, plastics, food processing, and paper industries. Through fundamental research into sieve and polymer materials, advanced process engineering, and integrated manufacturing methods, the Company discovers, develops, and improves the economics of noncryogenic gas separation technologies. Additionally, technology development for the equipment and services businesses is directed primarily to reducing the capital and operating costs of its facilities and to commercializing new technologies in gas production and separation and in power production. In the chemicals segment, technology development is primarily concerned with new products and applications to strengthen and extend our present positions in polymer and performance chemicals. In addition, a major continuing effort supports the development of new and improved manufacturing technology for chemical intermediates and various types of polymers. A corporate research group supports the research efforts of the Company's various businesses. This group includes the Company's Corporate Science and Technology Center which conducts exploratory research in areas important to the long-term growth of the Company's core businesses, e.g., gas and fluid separations, polymer science, organic synthesis, and fluorine chemicals. As of November 1, 1999, Air Products owned 928 United States patents and 1,694 foreign patents. The Company is also licensed to practice under patents owned by others. While the patents and licenses are considered important, Air Products does not consider its business as a whole to be materially dependent upon any particular patent or patent license, or group of patents or licenses. Raw Materials and Energy The Company manufactures hydrogen, carbon monoxide, synthesis gas, anhydrous ammonia, carbon dioxide, and methanol principally from natural gas. Such products accounted for approximately 8% of the Company's consolidated sales in fiscal 1999. The Company's principal raw material purchases are chemical intermediates produced by others from basic petrochemical feedstocks such as olefins and aromatic hydrocarbons. These feedstocks are generally derived from various crude oil fractions or from liquids extracted from natural gas. The Company purchases its chemical intermediates from many sources and generally is not dependent on one supplier. However, with respect to vinyl acetate monomer which supports the polymer business, the Company is heavily dependent on a single supplier under a long-term contract which produces vinyl acetate monomer from several facilities. The Company characterizes the availability of these chemical intermediates as generally being readily available. The Company uses such raw materials in the production of emulsions, polyvinyl alcohol, amines, polyurethane intermediates, specialty additives, polyurethane additives, and epoxy additives. Such products accounted for approximately 34% of the Company's consolidated sales in fiscal 1999. Natural gas is an energy source at a number of the Company's facilities. The Company's industrial gas facilities use substantial amounts of electrical power. Any shortage of electrical power or interruption of its supply or increase in its price which cannot be passed through to customers for competitive reasons will adversely affect the merchant industrial gas business of the Company. In addition, the Company purchases finished and semi-finished materials and chemical intermediates from many suppliers. During fiscal 1999 no significant difficulties were encountered in obtaining adequate supplies of energy or raw materials. Environmental Controls The Company is subject to various environmental laws and regulations in the United States and foreign countries where it has operations. Compliance with these laws and regulations results in higher capital expenditures and costs. Additionally, from time to time the Company is involved in proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act (the federal Superfund law), similar state laws, and the Resource Conservation and Recovery Act (RCRA) relating to the designation of certain sites for investigation and possible cleanup. Additional information with respect to these proceedings is included under Item 3, Legal Proceedings, below. The Company's accounting policies on environmental expenditures are discussed in Note 1 to the Consolidated Financial Statements included under Item 8 herein. The amounts charged to earnings on an after-tax basis related to environmental protection totaled $27 million in 1999, $24 million in 1998, and $26 million in 1997. These amounts represent an estimate of expenses for compliance with environmental laws, as well as remedial activities, and costs incurred to meet internal Company standards. Such costs are estimated to be approximately $28 million in 2000 and $29 million in 2001. Although precise amounts are difficult to define, the Company estimates that in fiscal 1999 it spent approximately $7 million on capital projects to control pollution (including expenditures associated with new plants) versus $10 million in 1998. Capital expenditures to control pollution in future years are estimated at $11 million in 2000 and $10 million in 2001. The exact amount to be expended by the Company and its power generation business joint ventures on equipment to control pollution will depend upon the timing of the capital projects and timing and content of regulations promulgated by environmental regulatory bodies during the life of any capital investment. Efforts are made to pass these costs through to customers. To the extent long-term contracts have been entered into for supply of product such as for the industrial gas on-site business and for certain chemical products, the cost of any environmental compliance generally is contractually passed through to the customer. It is the Company's policy to accrue environmental investigatory and noncapital remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The potential exposure for such costs is estimated to range from $10 million to a reasonably possible upper exposure of $26 million. The balance sheet at September 30, 1999 includes an accrual of $19 million. At September 30, 1998, the balance sheet accrual was $23 million. In addition to the environmental exposures discussed in the preceding paragraph, there will be spending at a Company-owned manufacturing site where the Company is undertaking RCRA remediation action. The Company estimates capital costs to implement the anticipated remedial program will range from $23 to $30 million. Spending was $7.5 million through fiscal 1999 and is estimated at $10 million for fiscal 2000 and $1 million for 2001. Operating and maintenance expenses associated with continuing the remedial program are estimated to be approximately $1 million per year beginning in fiscal 2000 and continuing for an estimated period of up to 30 years. A former owner and operator at the site has agreed to reimburse the Company approximately 20% of the costs incurred in the remediation. In fiscal 1999 an insurance recovery related to this environmental site was received in the amount of $7.7 million. The cost estimates have not been reduced by the value of such reimbursement. Actual costs to be incurred in future periods may vary from the estimates given inherent uncertainties in evaluating environmental exposures. Subject to the imprecision in estimating future environmental costs, the Company does not expect that any sum it may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed above would have a materially adverse effect on its financial condition or results of operations in any one year. Competition The Company's businesses face strong competition from others, some of which are larger and have greater resources than Air Products. Air Products' industrial gas business competes in the United States with three major sellers and with several regional sellers. Competition in industrial gas markets is based primarily on price, reliability of supply, and furnishing or developing applications for use of such gases by customers, and in some cases the provisions of other services or products such as power and steam generation. A similar competitive situation exists in European industrial gas markets in which the Company competes against one or more larger entrenched competitors in most countries. The number of the Company's principal competitors in the chemicals business varies from product to product, and it is not practical to identify such competitors because of the broad range of the Company's chemical products and the markets served, although the Company believes it has a leading or strong market position in most of its chemical products. For amines the competition is principally from other large chemical companies that also have the ability to provide competitive pricing, reliability of supply, technical service assistance, and quality products and services. The possibility of back integration by large customers is the major competitive factor for the sale of polyurethane intermediates. In its other chemical products, the Company competes with a large number of chemical companies, some of which are larger, possess greater financial resources, and are more vertically integrated than the Company. Competition in these products is principally on the basis of price, quality, product performance, reliability of product supply, and technical service assistance. The Company's equipment and services businesses and its power generation business compete in all aspects with a great number of firms, some of which have greater financial resources than Air Products. Another important factor in certain export sales is financing provided by governmental entities in the United States and the United Kingdom as compared with financing offered by their counterparts in other countries. Competition is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Air Products believes that its comprehensive project development capability, operating experience, engineering and financing capabilities, and construction management experience will enable it to compete effectively. Insurance The Company's policy is to obtain public liability and property insurance coverage that is currently available at what management determines to be a fair and reasonable price. The Company, for itself and its power generation and flue gas treatment joint venture affiliates for which it assumes turnkey construction or operating responsibility, maintains public liability and property insurance coverage at amounts which management believes are sufficient, after retention, to meet the Company's anticipated needs in light of historical experience to cover future litigation and claims. There is no assurance, however, that the Company will not incur losses beyond the limits of, or outside the coverage of, its insurance. Employees On September 30, 1999, the Company (including majority-owned subsidiaries) had approximately 17,400 full-time employees of whom approximately 7,200 were located outside the United States. The Company has collective bargaining agreements with unions at numerous locations which expire on various dates over the next three to four years. The Company considers relations with its employees to be satisfactory. The Company does not believe that any expiring collective bargaining agreements will result in a material adverse impact on the Company. Year 2000 Software failures due to processing efforts potentially arising from calculations using the Year 2000 dates are a known risk. The Company is currently evaluating and managing the financial and operating risks associated with this problem. Additional information regarding the Company's Year 2000 efforts is included under Item 7 herein. Executive Officers of the Company The Company's executive officers and their respective positions and ages on December 15, 1999 follow. Except where indicated, each of the executive officers listed below has been employed by the Company in the position indicated during the past five fiscal years. Information with respect to offices held is stated in fiscal years. - ------------------ (A) Member, Board of Directors. (B) Member, Executive Committee of the Board of Directors. (C) Member, Finance Committee of the Board of Directors. (D) Member, Management Committee. (E) Member, Corporate Executive Committee. ITEM 2. ITEM 2. Properties. The principal executive offices of Air Products are located at its headquarters in Trexlertown, near Allentown, Pennsylvania. Additional administrative offices are located in owned facilities in Hersham, near London, England, and Brampton, near Toronto, Canada, and in leased facilities in the Allentown area, Pennsylvania; Tokyo, Japan; Hong Kong, the People's Republic of China; Singapore; and Sao Paulo, Brazil. The management considers the Company's facilities, described in more detail below, to be adequate to support the business efficiently. The following information with respect to properties is as of September 30, 1999. Industrial Gases The industrial gases segment has approximately 190 plant facilities in 38 states, the majority of which recover nitrogen, oxygen, and argon. The Company has eight facilities which produce specialty gases and 31 facilities which recover hydrogen throughout the United States. Helium is recovered at two plants in Kansas and Texas, and acetylene is manufactured at six plants in six states in the United States. There are 144 sales offices and/or cylinder distribution centers located in 39 states. The property on which the above plants are located is owned by Air Products at approximately one-fourth of the locations, and leased by Air Products at the remaining locations. However, in virtually all cases, the plant itself is owned and operated by Air Products. Air Products owns approximately half of its sales offices and cylinder distribution centers, including related real estate, and leases the other half. Air Products' European plant facilities total 64, and include eight plants which recover hydrogen, seven plants which manufacture dissolved acetylene, and one which recovers carbon monoxide. The majority of European plants recover nitrogen, oxygen, and argon. In addition, there are four specialty gas centers. There is a combined total of 123 sales offices and/or cylinder distribution centers in Europe, and several additional facilities located in Brazil, Canada, Japan, the People's Republic of China, Puerto Rico, Singapore, Indonesia, Taiwan, Korea, Malaysia, and the Middle East. Representative offices are located in Taiwan, and in Beijing and Shanghai in the People's Republic of China. Chemicals The chemicals segment manufactures amines, nitric acid, methanol, anhydrous ammonia, and ammonia products at its Pace, Florida facility; alkylamines at its St. Gabriel, Louisiana facility; polyvinyl acetate emulsions at its South Brunswick, New Jersey facility; styrene emulsions, styrene acrylics, polyvinyl acetate acrylics, and polyvinyl acetate emulsions at its San Juan del Rio facility in Mexico; polyvinyl acetate emulsions at its Cologne, Germany facility; nitric acid, dinitrotoluene, toluene diamine, polyvinyl alcohol, and acetic acid at its Pasadena, Texas facility; polyvinyl acetate emulsions, polyvinyl alcohol, acetic acid, and acetylenic chemicals at its Calvert City, Kentucky facility; specialty amines at its Wichita, Kansas facility; methylamines, dimethyl formamide, choline chloride, and dimethyl amino ethanol at its Teeside, England facility; and epoxy additives at its facilities in Manchester, England, Los Angeles, California, and Cumberland, Rhode Island. The chemicals segment manufactures polyurethane additives and polyurethane specialty products (AIRTHANE(R)/VERSATHANE(R)) at its Paulsboro, New Jersey facility which is leased in part and owned in part. The chemicals segment also manufactures polyvinyl acetate emulsions at five smaller locations. The chemicals segment has 15 plant facilities, four sales offices, and two laboratories in the United States, and operates three plants, nine sales/representative offices, and four laboratories in Europe, two laboratories in Brazil, Korea, China, and Japan, one plant in Mexico, two plants in Korea, one plant in Brazil, and sales offices in Australia, Brazil, Mexico, Japan, Korea, and Singapore, and representative offices in Beijing, Shanghai, and Hong Kong in the People's Republic of China. Substantially all of the chemicals segment's plants and real estate are owned. Approximately 75% of the offices are leased by the Company and 25% are owned. Equipment and Services The principal facilities utilized by the equipment and services segment include five plants and two sales offices in the United States, two plants and two offices in Europe, one office in Japan, and one sales office in the People's Republic of China. Air Products owns approximately 50% of the facilities and real estate in this segment and leases the remaining 50%. ITEM 3. ITEM 3. Legal Proceedings. In the normal course of business Air Products and its subsidiaries are involved in legal proceedings including proceedings involving governmental authorities. During April, 1999 the Kentucky Department of Environmental Protection ("KDEP") forwarded a Notice of Violation alleging the Company's Calvert City, Kentucky chemical manufacturing facility had exceeded the significant net emission rate for ozone (measured as volatile organic compounds ("VOCs")) of Kentucky's Prevention of Significant Air Quality regulation with respect to calendar years 1993, 1995, 1997, and related construction permits. KDEP has also cited the facility for delayed installation of a device to control VOCs. There are also other proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act (the federal Superfund law), the Resource Conservation and Recovery Act (RCRA), and similar state environmental laws relating to the designation of certain sites for investigation or remediation. Presently there are approximately 45 sites on which a final settlement has not been reached where the Company, along with others, has been designated a Potentially Responsible Party by the Environmental Protection Agency or is otherwise engaged in investigation or remediation. The Company does not expect that any sums it may have to pay in connection with these matters would have a materially adverse effect on its consolidated financial position, nor is there any material additional exposure expected in any one year in excess of the amounts the Company currently has accrued. Additional information on the Company's environmental exposure is included under "Environmental Controls". ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders Not applicable. PART II ITEM 5. ITEM 5. Market for the Company's Common Stock and Related Stockholder Matters. The Company's Common Stock, ticker symbol "APD", is listed on the New York and Pacific Stock Exchanges. Market and dividend information for the Company's Common Stock appear under "Eleven-Year Summary of Selected Financial Data" on page 62 of the 1999 Financial Review Section of the Annual Report to Shareholders which is incorporated herein by reference. In addition, the Company has authority to issue 25,000,000 shares of preferred stock in series. The Board of Directors is authorized to designate the series and to fix the relative voting, dividend, conversion, liquidation, redemption and other rights, preferences, and limitations as between series. When preferred stock is issued, holders of Common Stock are subject to the dividend and liquidation preferences and other prior rights of the preferred stock. There currently is no preferred stock outstanding. The Company's Transfer Agent and Registrar is First Chicago Trust Company, a Division of Equiserve, P.O. Box 2506, Jersey City, New Jersey 07303-2506, telephone (800) 519-3111, TDD (201) 222-4955, internet website www.equiserve.com, and e-mail address [email protected]. As of November 30, 1999 there were 11,922 record holders of the Company's Common Stock. ITEM 6. ITEM 6. Selected Financial Data. The tabular information appearing under "Eleven-Year Summary of Selected Financial Data" on page 62 of the 1999 Financial Review Section of the Annual Report to Shareholders is incorporated herein by reference. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The textual information appearing under "Management's Discussion and Analysis" on pages 23 through 30 of the 1999 Financial Review Section of the Annual Report to Shareholders is incorporated herein by reference. ITEM 7a. ITEM 7a. Quantitative and Qualitative Disclosures about Market Risk. The textual information appearing under "Financial Instruments Sensitivity Analysis" on pages 30 and 31 of the 1999 Financial Review Section of the Annual Report to Shareholders is incorporated herein by reference. ITEM 8. ITEM 8. Financial Statements. The consolidated financial statements and the related notes thereto together with the report thereon of Arthur Andersen LLP dated October 29, 1999 appearing on pages 33 through 62 of the 1999 Financial Review Section of the Annual Report to Shareholders, are incorporated herein by reference. ITEM 9. ITEM 9. Disagreements on Accounting and Financial Disclosure Not applicable. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Company. The biographical information relating to the Company's directors contained on pages 6 through 9 of the Proxy Statement relating to the Company's 2000 Annual Meeting of Shareholders is incorporated herein by reference. Biographical information relating to the Company's executive officers is set forth in Item 1 of Part I of this Report. ITEM 11. ITEM 11. Executive Compensation. The information under "Director Compensation", "Report of the Management Development and Compensation Committee", "Executive Compensation Tables", "Severance and Other Change In Control Arrangements", and "Stock Performance Graph", appearing on pages 10 through 17 of the Proxy Statement relating to the Company's 2000 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. The information required for this Item is set forth in the sections headed "Persons Owning More than 5% of Air Products Stock" and "Air Products Stock Beneficially Owned by Officers and Directors" contained on pages 18 and 19 of the Proxy Statement relating to the Company's 2000 Annual Meeting of Shareholders and such information is incorporated herein by reference. ITEM 13. ITEM 13. Certain Relationships and Related Transactions. Not applicable. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this Report: 1. The 1999 Financial Review Section of the Company's 1999 Annual Report to Shareholders. Information contained therein is not deemed filed except as it is incorporated by reference into this Report. The following financial information is incorporated herein by reference: 2. The following additional information should be read in conjunction with the financial statements in the Company's 1999 Financial Review Section of the Annual Report to Shareholders: All other schedules are omitted because the required matter or conditions are not present or because the information required by the Schedules is submitted as part of the consolidated financial statements and notes thereto. 3. Exhibits. Exhibit No. Description (3) Articles of Incorporation and By-Laws. 3.1 By-Laws of the Company. (Filed as Exhibit 3.1 to the Company's Form 8-K Report dated September 18, 1997.)* 3.2 Restated Certificate of Incorporation of the Company. (Filed as Exhibit 3.2 to the Company's Form 10-K Report for the fiscal year ended September 30, 1987.)* 3.3 Amendment to the Restated Certificate of Incorporation of the Company dated January 25, 1996. (Filed as Exhibit 3.3 to the Company's Form 10-K Report for the fiscal year ended September 30, 1996.)* (4) Instruments defining the rights of security holders, including indentures. Upon request of the Securities and Exchange Commission, the Company hereby undertakes to furnish copies of the instruments with respect to its long-term debt. 4.1 Rights Agreement, dated as of March 19, 1998, between the Company and First Chicago Trust Company of New York. (Filed as Exhibit 1 to the Company's Form 8-A Registration Statement dated March 19, 1998, as amended by Form 8-A/A dated July 16, 1998).* 4.2 Amended and Restated Credit Agreement dated as of September 16, 1999 among the Company, Additional Borrowers parties thereto, Lenders parties thereto, and The Chase Manhattan Bank (as amended). (10) Material Contracts. 10.1 1990 Deferred Stock Plan of the Company, as amended and restated effective October 1, 1989. (Filed as Exhibit 10.1 to the Company's Form 10-K Report for the fiscal year ended September 30, 1989.)* 10.2 1997 Long-Term Incentive Plan of the Company effective October 1, 1996. (Filed as Exhibit 10.2(c) to the Company's Form 10-K Report for the fiscal year ended September 30, 1996.)* 10.3 Amended and Restated 1997 Annual Incentive Plan of the Company effective April 1, 1998. (Filed as Exhibit 10.3(a) to the Company's Form 10-K Report for the fiscal year ended September 30, 1998.)* 10.4 Supplementary Pension Plan of the Company, as amended effective October 1, 1988. (Filed as Exhibit 10.4 to the Company's Form 10-K Report for the fiscal year ended September 30, 1989.)* 10.4(a) Amendment to the Pension Plan for Salaried Employees and the Pension Plan for Hourly Rated Employees of the Company, adopted September 20, 1995. (Filed as Exhibit 10.4(d) to the Company's Form 10-K Report for the fiscal year ended September 30, 1995.)* 10.4(b) Amendment to Supplementary Pension Plan of the Company, adopted September 20, 1995. (Filed as Exhibit 10.4(e) to the Company's Form 10-K Report for the fiscal year ended September 30, 1995.)* 10.4(c) Amendment to Supplementary Pension Plan of the Company, adopted November 2, 1995. (Filed as Exhibit 10.4(c) to the Company's Form 10-K Report for the fiscal year ended September 30, 1996.)* 10.5 Supplementary Savings Plan of the Company as amended October 1, 1989. (Filed as Exhibit 1.5 to the Company's Form 10-K Report for the fiscal year ended September 30, 1989.)* 10.5(a) Amendment to Supplementary Savings Plan of the Company effective April 1, 1998. (Filed as Exhibit 10.3(a) to the Company's Form 10-K Report for the fiscal year ended September 30, 1998.)* 10.6 Amended and Restated Deferred Compensation Plan for Directors of the Company, effective May 19, 1998. (Filed as Exhibit 10.6(a) to the Company's Form 10-K Report for the fiscal year ended September 30, 1998.)* 10.7 Stock Option Plan for Directors of the Company, effective January 27, 1994, as amended October 21, 1999. 10.8 Letter dated July 1, 1997 concerning pension for an executive officer. (Filed as Exhibit 10.7(b) to the Company's Form 10-K Report for the fiscal year ended September 30, 1998.)* 10.9 Letter dated July 7, 1997 concerning pension for an executive officer. (Filed as Exhibit 10.7(c) to the Company's Form 10-K Report for the fiscal year ended September 30, 1998.)* 10.10 Letter dated July 1, 1997 concerning pension for an executive officer. 10.11 Air Products and Chemicals, Inc. Severance Plan effective March 15, 1990. (Filed as Exhibit 10.8(a) to the Company's Form 10-K Report for the fiscal year ended September 30, 1992.)* 10.12 Air Products and Chemicals, Inc. Change of Control Severance Plan effective March 15, 1990. (Filed as Exhibit 10.8(b) to the Company's Form 10-K Report for the fiscal year ended September 30, 1992.)* 10.13 Amended and Restated Trust Agreement by and between the Company and PNC Bank, N.A. relating to the Supplementary Pension Plan dated as of August 1, 1999. 10.14 Amended and Restated Trust Agreement by and between the Company and PNC Bank, N.A. relating to the Supplementary Savings Plan dated as of August 1, 1999. 10.15 Form of Split Employment Contracts for an executive officer with the Company dated November 6, 1999 and with an affiliate of the Company dated June 4, 1996, and amended by letter dated November 6, 1999. 10.16 Form of Severance Agreements which the Company has with each of its U.S. Executive Officers and European Executive Officer. 10.17 Acquisition Agreement One by and between L'Air Liquide S.A. and the Company dated June 14, 1999 regarding the BOC transaction.** 10.18 Agreement by and between L'Air Liquide S. A. and the Company dated July 2, 1999 (and incorporating amendments made July 7, 1999)regarding the BOC transaction.** 10.19 Press Release regarding the BOC transaction dated July 13, 1999. (Reported as Item 5 in the Form 8-K filed on July 13, 1999.)* (11) Earnings per share. (12) Computation of Ratios of Earnings to Fixed Charges. (13) 1999 Financial Review Section of the Annual Report to Shareholders for the fiscal year ended September 30, 1999, which is furnished to the Commission for information only, and not filed except as expressly incorporated by reference in this Report. (21) Subsidiaries of the registrant. (24) Power of Attorney. (27) Financial Data Schedule, which is submitted electronically to the Securities and Exchange Commission for information only, and not filed. (b) Reports on Form 8-K filed during the quarter ended September 30, 1999: Current Reports on Form 8-K dated July 13, 1999, July 16, 1999, and July 23, 1999, were filed in which Item 5 of such Form was reported. *Previously filed as indicated and incorporated herein by reference. Exhibits incorporated by reference are located in SEC File No. 1-4534. **Certain information in this Exhibit has been omitted pursuant to a Request for Confidential Treatment and such information has been filed separately with the Securities and Exchange Commission. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: December 16, 1999 AIR PRODUCTS AND CHEMICALS, INC. (Registrant) By: /s/ Leo J. Daley ---------------------------------------- Leo J. Daley, Vice President--Finance Principal Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. * W. Douglas Brown, Vice President, General Counsel and Secretary, by signing his name hereto, does sign this document on behalf of the above noted individuals, pursuant to a power of attorney duly executed by such individuals which is filed with the Securities and Exchange Commission herewith. /s/ W. Douglas Brown ------------------------------------------- W. Douglas Brown Attorney-in-Fact REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE To: Air Products and Chemicals, Inc. We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Air Products and Chemicals, Inc.'s Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated 29 October 1999. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule referred to in Item 14(a)(2) in this Form 10-K is the responsibility of the Company's management and is presented for the purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN LLP Philadelphia, Pennsylvania 29 October 1999 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS To: Air Products and Chemicals, Inc. As independent public accountants, we hereby consent to the incorporation of our reports included or incorporated by reference in this Form 10-K, into the Company's previously filed Registration Statements on Form S-8 and Form S-3 (File Nos. 333-33851, 333-02461, 33-2068, 333-36231, 33-57023, 33-65117, 333-21145, 333-45239, 333-18955, 333-21147, 333-60147, 333-71405, 333-73105, and 333-90773). ARTHUR ANDERSEN LLP Philadelphia, Pennsylvania 15 December 1999 NOTES: (1) Includes collections on accounts previously written off and additions applicable to businesses acquired. (2) Primarily includes write-offs of uncollectible accounts. (3) Charges to the accrual for termination payments.

881464_1999.txt

881464_1999

1999

881464

ITEM 1. BUSINESS AMYLIN PHARMACEUTICALS, INC. Amylin Pharmaceuticals, Inc is engaged in the discovery and development of potential drug candidates for the treatment of metabolic disorders. We pioneered research of a hormone called "amylin." We are developing SYMLIN(TM) (pramlintide acetate) for the treatment of people with diabetes who use insulin. SYMLIN is a synthetic analog of the human hormone, amylin, that was invented by our scientists. We have completed clinical testing of SYMLIN that we believe is sufficient to support United States Food and Drug administration approval to market SYMLIN. We are currently preparing a New Drug Application for planned submission to the FDA in mid-2000. We are also preparing a Marketing Approval Application for submission to European regulatory authorities, for submission following our FDA submission. Our second drug candidate, AC2993 (synthetic exendin-4), is in Phase 2 clinical studies. AC2993 is our code name for synthetic exendin-4. Exendin-4 is a naturally occurring peptide initially derived from the salivary secretions of the Gila monster. Our third drug candidate, AC3056, is a compound that we in-licensed from Aventis Pharma (formerly Hoechst Marion Roussel). We are evaluating AC3056 in preclinical testing for potential utility in the treatment of metabolic disorders relating to cardiovascular disease. AMYLIN, THE HORMONE Amylin is a hormone that was discovered at Oxford University and reported in 1987. Amylin is made in and secreted from the same cells in the pancreas that make and secrete insulin. These pancreatic cells are called "beta cells." Amylin and insulin work together with another pancreatic hormone, glucagon, to maintain normal glucose concentrations. Amylin concentrations normally increase after meals. However, in people with type 1 diabetes, amylin concentrations are extremely low or undetectable under fasting conditions, and do not increase after meals. In type 2 diabetes patients whose disease has progressed to the point where they need insulin therapy, the normal post-meal increase in amylin concentrations does not occur. Amylin has been shown in animal studies to exert multiple actions involved in the regulation of nutrient uptake. These actions include inhibiting food intake, slowing the emptying of the contents of the stomach into the small intestine, slowing the rate of digestion of food in the stomach and small intestine, and inhibiting the release of glucagon, a glucose-elevating hormone. Slowing of the emptying of the stomach and inhibiting glucagon release are actions of amylin that have been demonstrated to occur in humans. DIABETES Diabetes is a major global health problem, and is the fourth or fifth leading cause of death in most developed countries. The American Diabetes Association estimates that the total annual economic cost of diabetes in the US in 1997 was $98 billion. The 1997 per capita cost of health care for people with diabetes was $10,071, nearly four times that for people without diabetes. In 1997, an estimated 124 million people worldwide had diabetes -- about 2% of the world's population. Of these, approximately 3.5 million had type 1 diabetes, and 120.5 million had type 2 diabetes. Type 1 diabetes destroys the ability of the pancreas to produce insulin and amylin, and most often is diagnosed in children and young adults. Lifelong daily insulin therapy is essential for people with type 1 diabetes. Type 2 diabetes is a complex metabolic disorder resulting from the body's inability to make enough insulin or to properly use available insulin. Diet and exercise therapy, in addition to a number of oral medications that either stimulate insulin production or improve sensitivity to insulin, are used to treat type 2 diabetes. However, no single therapy is currently able to control the disease over its full course from impaired glucose tolerance stages to insulin dependency. As the disease progresses, treatments often become ineffective and must be supplemented or replaced. Insulin becomes part of the treatment regimen for many people with type 2 diabetes when oral therapies become ineffective. Additional insulin injections are often added to the treatment regimen when desired blood sugar control cannot be achieved with other available therapies. In both type 1 and type 2 diabetes, poor control of blood sugar, also known as blood glucose, concentrations has been shown to result in long-term complications. Effective treatments for diabetes target the control of blood glucose to limit complications involving small blood vessels, such as retinopathy (eye damage), nephropathy (kidney damage), neuropathy (nerve damage), and peripheral vascular disease. Other metabolic effects resulting from diabetes and associated metabolic disorders such as high blood pressure, abnormal fat metabolism (dyslipidemia) and obesity, may result in complications involving large blood vessels, which lead to heart attacks, strokes and amputations of lower extremities. It is these complications and associated metabolic disorders that lead to increased pain, suffering and early death compared with the general population. A recognized indicator of average blood glucose concentrations over a 3-to 4-month period is called "HbA1c," an abbreviation for glycated hemoglobin. Lower HbA1c values indicate better blood glucose control. HbA1c values in people without diabetes are usually less than 6%, indicating that less than 6% of the hemoglobin in their red blood cells has been modified by glucose. American Diabetes Association Clinical Practice Recommendations (1999) suggest that people with diabetes should aim for an HbA1c value that is lower than 7%. Fewer than 10% of people with diagnosed diabetes in the US are able to achieve the American Diabetes Association's recommended glucose control targets, indicating a clear therapeutic need. Further, there is a pressing need to develop new treatment strategies that improve the overall metabolic profile of patients with diabetes and reduce the risk of complications without increased pain and suffering. In 1993, a landmark study in type 1 diabetes, called the Diabetes Control and Complications Trial (DCCT), showed that improved glucose control -- as measured by any reduction in HbA1c -- reduced the incidence of long-term complications. In 1998, a similar landmark study in type 2 diabetes, the United Kingdom Prospective Diabetes Study (UKPDS), reported similar conclusions for type 2 diabetes Aggressive use of insulin and other available therapies to achieve target glucose control can be associated with an increased risk of low blood glucose concentrations, called hypoglycemia, and weight gain. For example, the UKPDS found that people with type 2 diabetes who used an intensive insulin regimen had gained approximately 5.5 pounds at the end of 24 months. SYMLIN(TM) (PRAMLINTIDE ACETATE) The primary patient population focus for SYMLIN is people with diabetes whose therapy includes multiple insulin injections per day. We estimate that this group is made up of 5.3 million people in North America and Europe, based on published and proprietary estimates. Within this population group, approxi- mately 1.9 million people (40%) have type 1 diabetes, and the remaining 3.4 million (60%) have type 2 diabetes. We have performed extensive clinical trials aimed at understanding the effects of SYMLIN in people with diabetes. Over 1,400 participants, including people with diabetes and healthy volunteers, took part in our 34 completed Phase 1 and Phase 2 studies. These studies investigated the short-term safety and tolerability of SYMLIN, mechanisms of action, interactions with insulin and oral drugs, and effects on short- and medium-term measures of glucose control. In these studies, SYMLIN reduced post-meal glucose increases in people with type 1 diabetes and in people with type 2 diabetes who use insulin. SYMLIN also significantly reduced average 24-hour plasma glucose concentrations in people with type 1 diabetes and in people with type 2 diabetes who use insulin. These improvements in glucose control were achieved without an increase in the incidence of hypoglycemic events or clinically important safety issues. Over 3,500 participants took part in our completed Phase 3 studies for SYMLIN. We completed six double-blind, placebo-controlled studies (two in type 1 diabetes in the US, two in type 2 diabetes in the US, one each in type 1 and type 2 diabetes in Europe/Canada). In double-blind, placebo-controlled studies neither the physician or the patient knows which patients are receiving the study drug and which patients are receiving placebo (inactive material). Additionally, we completed two longer term open-label safety studies and open- label extensions of the Phase 3 placebo-controlled studies to assess longer-term effects of SYMLIN. In open-label studies, all participants receive study drug. Our Phase 3 studies are summarized below: FIRST SET OF PHASE 3 CLINICAL STUDIES: STUDIES IA AND IIA Based on findings in Phase 2 studies, initial Phase 3 clinical studies were conducted in the US to explore the effects of SYMLIN administration (in addition to insulin) for one year on metabolic control in people. Study IA examined the effects of SYMLIN administration in people with type 1 diabetes and Study IIA examined the effects of SYMLIN administration in people with type 2 diabetes who use insulin. We reported the results of both initial Phase 3 studies in August 1997. In Study IA, participants receiving 30/60 micrograms of SYMLIN four times a day achieved a sustained, statistically significant decrease in HbA1c from baseline at one year, compared with those who received insulin alone (-0.4% for SYMLIN; -0.1% insulin only) without an increase in the frequency of patient-reported severe hypoglycemic events. In addition, patients receiving SYMLIN did not gain weight. Instead, they achieved a weight loss, while those receiving only insulin gained weight, a common result of intensifying insulin therapy. After one year, SYMLIN recipients had a statistically significant improvement in body weight compared to the participants who received insulin alone. A positive effect on the lipid profiles of patients receiving SYMLIN was also observed. In Study IIA, the HbA1c concentrations for patients receiving 75 or 150 micrograms of SYMLIN three times a day were significantly reduced at 13 and 26 weeks, compared with those who received insulin alone. A reduction in HbA1c was maintained over one year, but due in part to insufficient patient numbers, did not achieve statistical significance at one year. SYMLIN administration also resulted in a statistically significant weight loss compared with those receiving insulin alone. Again, participants receiving insulin alone gained weight. The most common drug-related side effect in the first two clinical studies was initial transient nausea, which in most patients was relatively mild and usually dissipated during the initial 4 to 8 weeks of treatment. SECOND SET OF PHASE 3 CLINICAL STUDIES: STUDIES IB AND IIB In October 1998, the Company announced results from two six-month Phase 3 European/Canadian studies of SYMLIN, one in type 1 diabetes (Study IB) and one in insulin-using type 2 diabetes (Study IIB). In Study IB, the average reduction in HbA1c after 26 weeks of SYMLIN treatment compared with those who received insulin alone was 0.2% for the 90 micrograms two or three times a day dosage groups, and 0.3% for the 60 micrograms three times a day dosage group. Unexpectedly, the glucose control effect observed in the group who received the highest SYMLIN dosage (90 micrograms three times a day) did not reach statistical significance. This highest dosage group had been designated in advance as the primary dosage group for statistical analysis for regulatory purposes. As a consequence, under the procedure specified in the statistical analysis plan, the results from the primary SYMLIN dosage group alone did not meet the regulatory requirements to support a New Drug Application, even though the other two dosage groups did achieve statistical significance. In Study IIB , the average reduction in HbA1c after 26 weeks of SYMLIN treatment compared with those who received insulin alone was 0.2% for the 90 micrograms two times daily dosage group, 0.3% for the 90 micrograms three times a day dosage group, and 0.3% for the 120 micrograms two times a day dosage group. Two of these dosage groups, including the highest dosage (90 micrograms three times a day), did not achieve statistical significance. As in Study IB, because the highest dosage group had been designated in advance as the primary evaluation group and did not achieve statistical significance, the regulatory requirements for a positive study were not met even though another dosage group did achieve statistical significance. ADDITIONAL ANALYSES OF FIRST TWO SETS OF PHASE 3 STUDIES We conducted further analyses of data from the first four Phase 3 studies of SYMLIN. In these four studies, approximately half of all participants who received SYMLIN evidenced an early reduction in HbA1c. After 4 weeks, these participants experienced a reduction in HbA1c of at least 0.5%. The percentage of patients in the SYMLIN treatment groups who experienced an early reduction in HbA1c was about twice the percentage in the group of patients treated with insulin alone. The participants identified by their early response achieved average HbA1c reductions that ranged from 0.6 to 1.1% at 6 months. In the type 1 diabetes studies, those participants who experienced an early glycemic response and received the well-tolerated dosages of 30 micrograms four times daily or 60 micrograms three times daily had no increase in severe hypoglycemia and showed a reduction in body weight over the course of the studies. In the insulin-using type 2 diabetes studies, the participants who experienced an early glycemic response also achieved and maintained a reduction in body weight during treatment with SYMLIN. This weight loss was independent of the lowering of HbA1c. OPEN-LABEL PHASE 3 STUDY RESULTS At the close of Studies IA and IIA in 1997, participants were given the opportunity to voluntarily receive SYMLIN in an open-label extension study in which all participants received SYMLIN. In the type 1 study (Study IA), approximately 70% of the participants who had received SYMLIN voluntarily continued using SYMLIN in the open-label extension. Approximately half of the patients in the open label extension study experienced an early glycemic response, as defined above using the initial 4-week HbA1c reduction criterion. Participants who experienced an early glycemic response and completed 24 months of therapy exhibited average HbA1c reductions 0.9% (6 months), 0.8% (12 months), 0.8% (18 months) and 0.6% (24 months). As in Study IA, approximately 70% of the participants in the insulin-using type 2 diabetes study (Study IIA) receiving SYMLIN voluntarily continued using the drug candidate in the open-label extension. Approximately 50% of the patients experienced an early glycemic response, as defined above. Participants who experienced an early glycemic response within these dosing groups who completed 24 months of SYMLIN therapy achieved HbA1c reductions of 1.1 - 1.2% (6 months), 0.9 - 1.0% (12 months) and 0.9% (24 months). Paralleling the positive trends in glucose control, study subjects who completed 24 months of therapy maintained or decreased their body weight. In a separate open-label clinical use study in the US that we began in 1996, we examined the long-term effects of SYMLIN in people with type 1 diabetes. Patients completing 18 months of SYMLIN therapy achieved average HbA1c reductions of 0.6% (6 months), 0.5% (12 months) and 0.4% (18 months). Participants who experienced an early glycemic response as defined above, and completed 18 months of SYMLIN therapy achieved average HbA1c reductions of 0.9% (6 months), 0.8% (12 months) and 0.8% (18 months). In all of these open-label studies, the percentage of patients in the SYMLIN treatment groups who experienced any early reduction in HbA1c was about twice the percentage in the group of patients treated with insulin alone. THIRD SET OF PHASE 3 STUDIES: STUDIES IC AND IIC In August 1999, we reported results of our final Phase 3 study in people with type 2 diabetes who use insulin (Study IIC). In the intent-to-treat analysis, which is the statistical analysis required by the FDA, patients receiving SYMLIN in addition to their usual diabetes therapy achieved a statistically significant reduction in HbA1c at 6 months. Those receiving a dosage of 120 micrograms twice a day achieved a reduction of 0.7% in the primary endpoint of HbA1c at 6 months, compared to a reduction of 0.3% in the control group. For patients in the SYMLIN 120 micrograms twice a day group who completed one year of treatment, the reduction in HbA1c was 0.7%, compared with a reduction of 0.1% for the control group. The lower dosage group, SYMLIN 90 micrograms twice a day, did not reach statistical significance. In the SYMLIN 120 micrograms twice a day group, the 44% of participants who evidenced an early glycemic response had an average reduction in HbA1c of at least 1.0% from Week 13 through the end of the one-year study. Participants receiving SYMLIN 120 micrograms twice a day lost 3.1 pounds at the end of one year, while those in the control group gained 1.5 pounds. In November 1999 we reported results from our final Phase 3 clinical study in type 1 diabetes (Study IC). For the SYMLIN 60 micrograms three times a day group, HbA1c was reduced by 0.3% at 6 months, compared to those receiving insulin alone. Those receiving SYMLIN 60 micrograms four times a day also achieved a significant reduction in HbA1c at 6 months. Patients receiving SYMLIN who completed one year of therapy achieved an HbA1c reduction of 0.4% at study end compared to those receiving insulin alone. To better understand the effects of SYMLIN independent of the effects of insulin, a stable insulin group was predefined in Study IC as those participants who did not vary their insulin usage by more than 10% from baseline. SYMLIN recipients in this stable insulin group achieved a reduction in HbA1c of 0.7% at one year compared to placebo recipients who met the stable insulin criterion. Participants in the SYMLIN 60 micrograms three times a day group who evidenced an early glycemic response had an average reduction in HbA1c of 0.7% at one year. As in previous studies, the percentage of SYMLIN patients experiencing an early glycemic response was about twice the percentage of patients who received insulin alone. SYMLIN recipients demonstrated significantly improved weight control during the study compared with those receiving insulin alone. Over 40% of the study participants were overweight upon study entry. In a predefined analysis of these overweight participants, those receiving SYMLIN 60 micrograms three times a day lost 3.5 pounds, while those receiving insulin alone gained 3.5 pounds by the end of one year. Based on the results of our clinical studies to date, we believe we have sufficient data to support the submission of an NDA to the FDA in mid-2000 and a submission to European regulatory authorities after our FDA submission. AC2993 (SYNTHETIC EXENDIN -4) AC2993 is a 39-amino acid peptide that exhibits several of the anti-diabetic actions of the mammalian hormone glucagon-like peptide (GLP-1). Unlike GLP-1, AC2993 has demonstrated a prolonged duration of action. In animal models, AC2993 has been shown to stimulate secretion of insulin in the presence of elevated blood glucose concentrations, but not during periods of low blood glucose concentrations (hypoglycemia). AC2993 has also been shown in animals to modulate gastric emptying to slow the entry of ingested nutrients into the bloodstream. It has also been demonstrated that chronic subcutaneous administration of AC2993 lessened food consumption in obese animals, leading to reduced body weight. Most importantly, in animal models of type 2 diabetes, AC2993 administration resulted in a lowering of blood glucose to near-normal concentrations. Using diabetic animal models, our research scientists have demonstrated that AC2993 is biologically active when administered via oral, sublingual, pulmonary, tracheal and nasal routes. In October 1998, we announced positive results from a UK Phase 1 safety and tolerability study of AC2993 (0.01 to 0.30 microgram per kilogram) administered by injection to healthy, fasted volunteers. Doses of up to 0.1 microgram per kilogram were well tolerated, while tolerability of higher doses was limited by nausea and vomiting. Biological effects were observed at all tested doses, including the lowest dose of 0.01 microgram per kilogram at which a statistically significant stimulation in insulin secretion was observed. A statistically significant reduction in plasma glucose was observed at doses of 0.05 microgram per kilogram and above. This study identified dose-limiting effects and a maximum tolerated dose. Further, the data indicated that biologic effects of AC2993 occur at less than the maximum tolerated dose. Additionally, independent clinical studies by researchers affiliated with Massachusetts General Hospital (Harvard Medical School) and the National Institute on Aging have demonstrated that AC2993 has a very potent insulin stimulatory effect in people who have elevated plasma glucose concentrations. In January 1999, we filed an investigational new drug application for AC2993, and initiated a clinical study with the drug candidate in people with type 2 diabetes. In April 30, 1999, we announced results from a single-blind, dose-rising, placebo-controlled study in the US that assessed the safety, tolerability and efficacy of AC2993 in eight male subjects with type 2 diabetes. Each subject received three or four single subcutaneous doses of AC2993 (0.1 to 0.4 microgram per kilogram body weight) and placebo at 48-hour intervals, and ingested a standardized liquid meal with each dose. No safety issues were identified during the study and the data indicated that AC2993 was tolerated at doses up to 0.3 microgram per kilogram. There was a dose-dependent lowering of plasma glucose concentrations following AC2993 administration compared to placebo. Additionally, AC2993 administration reduced both post-meal increases in glucagon concentrations and the rate of nutrient release from the stomach. Patients reported sustained sensations of fullness and satiety following AC2993 administration compared to placebo. Plasma concentrations of AC2993 were detectable up to 15 hours after administration. In October 1999, we reported results from a Phase 2 crossover study in which participants received subcutaneous AC2993 or placebo twice daily for five days. On the first and last days of the study, a standard liquid meal was ingested. The plasma glucose concentration during the first five hours following the standardized meal was reduced on average by 34% (from 213 to 141 mg/dL) when participants were treated with AC2993 compared to placebo. The 24 participants included people who used diet and exercise to manage their diabetes, those who used oral hypoglycemic agents, and those who used insulin. The dose of AC2993 used was 0.1 microgram per kilogram of body weight. The safety and tolerability profile observed in this single-blind, placebo-controlled study was similar to that in previous studies of AC2993. In January 2000, we reported additional results from the Phase 2 study first reported in October 1999. These additional analyses showed that AC2993 suppressed the post-meal rise in triglyceride concentrations in people with type 2 diabetes. Elevations in post-meal triglycerides are recognized as a cardiovascular risk factor. Additional analyses from this study also confirmed that administration of AC2993 reduced post-meal increases in glucagon concentrations and slowed the rate of nutrient release from the stomach. In January 2000, we announced results from a Phase 2 study of AC2993 in type 2 diabetes that used doses lower than those previously evaluated in type 2 diabetes. These lower dosages demonstrated significant glucose lowering effects. In addition, a substantially reduced incidence of side effects, such as nausea and vomiting, was associated with these lower doses. Fourteen subjects with type 2 diabetes of varying severity received single subcutaneous doses of AC2993 (0.01 to 0.1 microgram per kilogram body weight) or placebo at 24-hour intervals. In this single-blind study designed to further define the preferred dose of AC2993, a standardized liquid meal was ingested with each dose. A dose proportional glucose-lowering effect was observed in the range of doses studied, and a no-effect dose for glucose lowering was determined. Additional Phase 2 studies of AC2993 are underway and planned for 2000. AC3056 We are currently evaluating AC3056, a compound we in-licensed from Aventis Pharma (formerly Hoechst Marion Roussel), in laboratory and animal tests for potential utility in the treatment of metabolic disorders relating cardiovascular disease. In animal studies, AC3056 has been shown to reduce serum low density lipids (LDLs), but not serum high density lipids (HDLs), to inhibit lipoprotein oxidation, and to inhibit cell adhesion molecules in vascular cells. We plan to submit an investigational new drug application with the FDA in the first half of 2000 which, if accepted, would allow us to begin Phase 1 clinical trials. RESEARCH ACTIVITIES The metabolic components of diabetes, obesity and dyslipidemia are linked in many ways that may allow us to leverage our decade of expertise to move new metabolic drugs into the clinic. Our scientists are using their abilities to determine biological function in laboratory and animal tests to investigate actions and potential utilities of new peptide hormone candidates. We are also using our ability to optimize pharmaceutical properties of peptide drugs to develop new peptide hormone analogs. Additionally, our scientists have been engaged in research on uncoupling proteins that are believed to divert nutrient calories into heat formation. SALE OF CABRILLO LABORATORIES In January 1999, we announced the creation of a new division of our company, Cabrillo Laboratories, a contract product development organization. In February 1999, we signed a non-binding letter of intent with Magellan Laboratories Incorporated regarding the sale to Magellan of the Cabrillo Laboratories division. The sale was completed on April 30, 1999. Cabrillo Laboratories, now a division of Magellan, continues to provide product development services, such as analytical chemistry, formulation development, process development, clinical material packaging, quality control and stability testing to Amylin and to other companies. The transaction included a cash payment of $2.1 million to Amylin and a $500,000 credit for future services to be provided by Magellan to Amylin. Amylin also granted to Magellan a warrant for the purchase of 50,000 shares of common stock of Amylin. STRATEGIC ALLIANCES We evaluate, on an ongoing basis, potential collaborative relationships with established pharmaceutical and biotechnology companies with the goal of maximizing the economic value of SYMLIN and AC2993. We are considering a wide range of commercialization options for SYMLIN, including some combination of (1) a worldwide distribution arrangement with a major pharmaceutical company, (2) regional distribution and marketing arrangements and (3) performance of some commercialization activities by Amylin. We are also examining collaborative research, development, and commercialization opportunities for AC2993. JOHNSON & JOHNSON From June 1995 to August 1998, Amylin and Johnson & Johnson collaborated on the development and commercialization of SYMLIN pursuant to a worldwide collaboration agreement. Under the collaboration agreement, Johnson & Johnson made payments to us totaling approximately $174 million. These payments included funding of one-half of the SYMLIN development costs during the term of the agreement, draw downs from the development loan facility under a loan and security agreement, the purchase of $30 million of our common stock, milestone, license and option fee payments, and the funding of SYMLIN pre-marketing costs. Our collaboration with Johnson & Johnson terminated in August 1998. As a result of Johnson & Johnson's withdrawal, Johnson & Johnson relinquished its rights to share in SYMLIN profits. Additionally, following the collaboration termination, all patent and other rights associated with SYMLIN and related compounds reverted to us. In conjunction with the collaboration, we received proceeds of approximately $30.6 million from a draw down under the development loan facility. The loan carries an interest rate of 9.0%. Additionally, as of December 31, 1999 we owed Johnson & Johnson approximately $13.4 million for our share of pre-launch marketing expenses. As of December 31, 1999 the total principal and interest due to Johnson and Johnson was approximately $50.6 million. In conjunction with the borrowing, Amylin issued warrants to Johnson & Johnson to purchase 1,530,950 shares of our common stock with a fixed exercise price of $12 per share and a 10-year exercise period. The loan is secured by our issued patents and patent applications relating to amylin, including those relating to SYMLIN. At February 15, 2000, Johnson & Johnson owned 3,963,357 shares of our common stock, which represents 6.3% of our outstanding common stock as of March 1, 2000. AVENTIS PHARMA In March 1997, Amylin entered into a license agreement with Hoechst Marion Roussel, now known as Aventis Pharma after the merger of Hoechst Marion Roussel and Rhone Poulenc Rorer. Under the license agreement, Amylin received exclusive worldwide rights to AC3056, which is currently being evaluated in preclinical studies to evaluate its potential utility in the treatment of metabolic disorders relating to cardiovascular disease. Under the terms of the license agreement, we are responsible for conducting the preclinical evaluation and clinical development of AC3056. Upon completion of Phase 2 clinical studies, Aventis Pharma will have a one-time right to elect to collaborate with us in the continuing development and commercialization of AC3056 in a 50:50 cost-and-profit sharing arrangement. If Aventis Pharma exercises this option, we will continue to be responsible for developing and registering AC3056, and Aventis Pharma will be responsible for manufacturing and marketing. If the option is exercised, Amylin and Aventis Pharma will assume equal responsibility for all past and future research and development, manufacturing and commercialization expenses and will share equally in any operating profits from commercialization. If Aventis Pharma does not exercise its option, we will retain all development and commercialization rights, and Aventis Pharma will be entitled to a royalty based on any future net sales. In such case, we will be free to collaborate with other companies on the development, manufacture, and commercialization of AC3056. PATENTS, PROPRIETARY RIGHTS, AND LICENSES We believe that patents and other proprietary rights are important to our business. Our policy is to file patent applications to protect technology, inventions and improvements that may be important to the development of our business. Amylin also relies upon trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain its competitive position. We plan to enforce our issued patents and our rights to proprietary information and technology. We review third-party patents and patent applications in our fields of endeavor, both to shape our own patent strategy and to identify useful licensing opportunities. At March 17, 2000, we owned or held exclusive rights to 28 issued U.S. patents and a number of other still-pending U.S. applications. We have has a total of eight pending and 12 issued U.S. patents relevant to the development and commercialization of SYMLIN. We have a total of 12 pending and one issued US patent relevant to the development and commercialization of AC2993. Amylin also has filed foreign counterparts of many of these issued patents and applications. Included within our patent portfolio are issued patents for (1) SYMLIN and other amylin agonist analogues invented by our researchers; (2) the amylin molecule, which was discovered by University of Oxford researchers Tony Willis and Garth Cooper, a co-founder of Amylin; (3) amylin agonist pharmaceutical compositions, including (a) compositions containing SYMLIN, (b) compositions containing SYMLIN and insulin, (c) compositions containing amylin, and (d) compositions containing amylin and insulin; (4) methods for treating diabetes using any amylin agonist; (5) methods for synthesis of amylin and amylin analogues; and (6) methods for preparing products that include an amylin agonist in composition for parenteral administration; and (7) methods of stimulating insulin release by administering exendin-4. Generally, our policy is to file foreign counterparts in countries with significant pharmaceutical markets. MANUFACTURING We contract with others for manufacture of SYMLIN and AC2993. We currently rely on three manufacturers for bulk SYMLIN, one manufacturer for dosage form SYMLIN in vials and one manufacturer for dosage form SYMLIN in cartridges. We currently rely on one manufacturer of pens for delivery of SYMLIN in cartridges. We have selected manufacturers that we believe comply with current good manufacturing practice and other regulatory standards. We have established a quality control and quality assurance program, including a set of standard operating procedures, analytical methods and specifications, designed to ensure that SYMLIN and AC2993 are manufactured in accordance with current good manufacturing practice and other domestic and foreign regulations. Under our collaboration agreement regarding AC3056, Aventis Pharma has agreed to supply quantities of AC3056 manufactured in accordance with current good manufacturing practices that are sufficient to complete initial Phase 1 clinical studies. GOVERNMENT REGULATION Regulation by governmental authorities in the United States and foreign countries is a significant factor in the development, manufacture and marketing of pharmaceutical products. All of our potential products, including SYMLIN and AC2993, will require regulatory approval by governmental agencies prior to commercialization. In particular, human therapeutic products are subject to rigorous preclinical testing and clinical trials and other pre-market approval requirements by the FDA and regulatory authorities in foreign countries. Various federal and state statutes and regulations also govern or influence the manufacturing, safety, labeling, storage, record keeping and marketing of such products. The activities required before a pharmaceutical agent may be marketed in the United States begin with preclinical testing. Preclinical tests include laboratory evaluation of product chemistry and animal studies to assess the potential safety and activity of the product and its formulations. The results of these studies must be submitted to the FDA as part of an Investigational New Drug (IND) application, which must be reviewed by the FDA before proposed clinical trials can begin. Typically, clinical studies involve a three-phase process. In Phase 1, clinical studies are conducted with a small number of subjects to determine the early safety and tolerability profile and the pattern of drug distribution and metabolism. In Phase 2, clinical studies are conducted with groups of patients afflicted with a specified disease in order to determine preliminary efficacy, dosing regimens and expanded evidence of safety. In Phase 3, large-scale, multicenter, adequate and well-controlled, comparative clinical studies are conducted with patients afflicted with a target disease in order to provide enough data for the statistical proof of efficacy and safety required by the FDA and others. The results of the preclinical testing and clinical studies are then submitted to the FDA for a pharmaceutical product in the form of a New Drug Application (NDA) for approval to commence commercial sales. In responding to an NDA, the FDA may grant marketing approval, request additional information, or deny the application if it determines that the application does not satisfy its regulatory approval criteria. Among the conditions for NDA approval is the requirement that the prospective manufacturer's quality control and manufacturing procedures conform with current good manufacturing practices. In complying with these practices, manufacturers must continue to expend time, money and effort in the area of production and quality control and quality assurance to ensure full technical compliance. Manufacturing facilities are subject to periodic inspections by the FDA to ensure compliance. We are also subject to various federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals and the use and disposal of hazardous or potentially hazardous substances, including radioactive compounds and infectious disease agents, used in connection with our research. Clinical testing, manufacture and sale of products outside of the United States is subject to regulatory approval by other jurisdictions which may be more or less rigorous than in the United States. MARKETING AND SALES We are considering a wide range of commercialization options for SYMLIN, including some combination of 1) a worldwide distribution arrangement with a major pharmaceutical company, 2) regional distribution and marketing arrangements and 3) performance of some commercialization activities by Amylin. We are also examining collaborative research, development, and commercialization opportunities for AC2993. We have limited experience in market development and no experience in sales, marketing or distribution. To market any of our products, we must obtain access to marketing and sales forces with technical expertise and with supporting distribution capability. COMPETITION Our target population for SYMLIN is people with diabetes whose therapy includes multiple insulin injections per day. This population includes people with type 1 diabetes and those people with type 2 diabetes whose disease has progressed to a point at which they receive several insulin injections per day. We believe that SYMLIN is the only non-insulin-based drug candidate in late-stage clinical development for improving metabolic control in people with type 1 diabetes. Further, many people with type 2 diabetes are unable to achieve satisfactory glucose and weight control with available oral drugs or insulin. SYMLIN or AC2993 may be complementary to, or competitive with, these other agents. Although competitive activity in the diabetes market is intense, most recent activity has resulted in additional treatment options for people with type 2 diabetes who are responsive to oral hypoglycemic therapy. If approved for marketing, SYMLIN or AC2993 may compete with established therapies for market share. In addition, many companies are pursuing the development of novel pharmaceuticals that target diabetes. These companies may develop and introduce products competitive with or superior to SYMLIN or AC2993. Such competitive or potentially competitive products include pioglitazone, rosiglitazone, troglitazone, metformin, acarbose, repaglinide, miglitol, bromocriptine and other oral hypoglycemic agents such as sulfonylureas. Similarly, if AC3056 is ultimately approved for marketing, it may compete with established therapies for market share. Potentially competitive products include HMG-CoA reductase inhibitors known as statins. The lengthy process of seeking regulatory approvals and the subsequent compliance with applicable federal and state statutes and regulations require the expenditure of substantial resources. Any failure by us or our collaborators or licensees to obtain, or any delay in obtaining, regulatory approvals could adversely affect the marketing of any products developed by us and our ability to receive product revenue, royalty revenue or profit sharing payments. Competition of SYMLIN, AC2993 or AC3056 will be determined in part by the indications for which the these products are developed and ultimately approved by regulatory authorities. An important factor in competition may be the timing of market introduction of our products and competitors' products. Accordingly, the relative speed with which Amylin or any future corporate partners can develop products, complete the clinical studies and approval processes and supply commercial quantities of the products to the market are expected to be important competitive factors. We expect that competition among products approved for sale will be based, among other things, on product efficacy, safety, convenience, reliability, availability, price and patent position. EMPLOYEES As of March 1, 2000, Amylin has 60 full-time and 15 part-time employees. A significant number of our management and professional employees have had experience with pharmaceutical, biotechnology or medical product companies. We believe that we have been highly successful in attracting skilled and experienced scientific personnel. None of our employees is covered by collective bargaining agreements and we consider our relations with our employees to be good. DIRECTORS AND OFFICERS Our directors and officers are as follows: - --------------- (1) Member of the Compensation Committee. (2) Member of the Audit Committee. MR. BRYSON has served as a director since July 1999. Mr. Bryson was a thirty-two year employee of Eli Lilly & Company and served as its President and Chief Executive Officer from 1991 to 1993. He was Executive Vice President from 1986 until 1991, and served as a member of Eli Lilly's board of directors from 1984 until his retirement in 1993. Mr. Bryson was Vice Chairman of Vector Securities International from April 1994 to 1996. Mr. Bryson is President of Life Science Advisors, a consulting firm focused on assisting biopharmaceutical and medical device companies in building shareholder value. He also serves as a director for the following publicly traded companies: Ariad Pharmaceuticals, Chiron Corporation, Fusion Medical Technologies, Inc. and Quintiles Transnational Corp. Mr. Bryson received a B.S. in Pharmacy from the University of North Carolina. MR. COOK has been our Chairman of the Board and Chief Executive Officer since March 1998. Mr. Cook previously served as a member of our board, and a consultant to us since 1994. Mr. Cook is a founder and serves as Chairman of the Board of Microbia, Inc., a privately held biotechnology company. Mr. Cook is also a founder of Clinical Products, Ltd., Life Science Advisors, LLC, Cambrian Associates, LLC, and Mountain Ventures, Inc. Mr. Cook retired as a Group Vice-President of Eli Lilly in 1993 after more than 28 years of service. Mr. Cook is also a director of Dura Pharmaceuticals, Inc. and NABI, Inc. Mr. Cook received a B.S. in Engineering from the University of Tennessee. DR. BLAIR has served as a director since December 1988 and serves on the Compensation Committee. He has been a managing member of Domain Associates, L.L.C., a venture capital investment firm, since 1985. Domain Associates manages Domain Partners, L.P., Domain Partners II, L.P., Domain Partners III, L.P. and Domain Partners IV, L.P. and is the U.S. venture capital advisor to Biotechnology Investments, Ltd. From 1969 to 1985, Dr. Blair was an officer of three investment banking and venture capital firms. Dr. Blair is a director of Aurora Biosciences, Inc., Dura Pharmaceuticals, Inc., Trega Biosciences, Inc. and Vista Medical Technologies, Inc. Dr. Blair received a B.S.E. from Princeton University and the M.S.E. and Ph.D. degrees from the University of Pennsylvania in electrical engineering. MR. GAITHER has served as a director since November 1995 and serves on the Compensation Committee. He has been a partner of the law firm Cooley Godward LLP since 1971 where he also served as managing partner from 1984 to 1990. Prior to joining Cooley Godward in 1969, Mr. Gaither served as Staff Assistant to the President of the United States from July 1966 to January 1969. He is a director of Basic American, Inc., Levi Strauss & Co., NVIDIA Corporation and Siebel Systems, Inc. and serves on the executive committee of the Board of Visitors at Stanford Law School. He previously served as President of the Board of Trustees of Stanford University and as Chairman of its Investment Committee. He is a trustee of the Carnegie Endowment for International Peace, The James Irvine Foundation, RAND Corporation, and The William and Flora Hewlett Foundation. Mr. Gaither received his J.D. from Stanford University. MS. GRAHAM has served as a director since November 1995 and serves on the Audit Committee. Since 1993, Ms. Graham has served as President of the Vascular Intervention Group of Guidant Corporation, a medical device company, which includes Advanced Cardiovascular Systems and Devices for Vascular Intervention. She has also served as President and Chief Executive Officer of Advanced Cardiovascular Systems since January 1993. Prior to joining Advanced Cardiovascular, she held various positions with Eli Lilly from 1979 to 1992, including sales and strategic planning positions. She serves on the Board of Directors and the Executive Committee for the California Healthcare Institute and on the Advisory Board of the California Institute for Federal Policy Research and is a HIMA special representative to the Payment and Health Care Delivery Committee. She is also a member of the Committee 200. Ms. Graham received an M.B.A. from Harvard University. MR. GREENE is one of Amylin's co-founders and has served as a director since our inception in September 1987. Mr. Greene serves on our Audit Committee. Mr. Greene is an entrepreneur who has founded, managed, and financed several medical technology companies. From September 1987 to July 1996, Mr. Greene served as our Chief Executive Officer. He was a full time employee from September 1989 until September 1996, and a half-time employee and Chairman of our Executive Committee until March 1998. From October 1986 until July 1993, Mr. Greene was a founding general partner of Biovest Partners, a seed venture capital firm. He was Chief Executive Officer of Hybritech from March 1979 until its acquisition by Eli Lilly in March 1986, and he was co-inventor of Hybritech's patented monoclonal antibody assay technology. Prior to joining Hybritech, he was an executive with the medical diagnostics division of Baxter Healthcare Corporation from 1974 to 1979 and a consultant with McKinsey & Company from 1967 to 1974. He is Chairman of the Board of Cytel Corporation, and a director of Biosite Diagnostics, Inc. and The International Biotechnology Trust plc, a British investment company. Mr. Greene received an M.B.A. from Harvard University. MR. KAILIAN has served as a director since November 1995 and serves on the Audit Committee. Mr. Kailian has served as President and Chief Executive Officer and as a director of COR Therapeutics, Inc. since March 1990. From 1967 to 1990, Mr. Kailian was employed by Marion Merrell Dow, Inc., a pharmaceutical company, and its predecessor companies, in various general management, product development, marketing and sales positions. Among the positions held by Mr. Kailian were President and General Manager, Merrell Dow USA and Corporate Vice President of Global Commercial Development, Marion Merrell Dow, Inc. Mr. Kailian is also a director of the Biotechnology Industry Organization and the California Healthcare Institute and is a director and serves on the compensation committee of Axys Pharmaceuticals, Inc. Mr. Kailian holds a B.A. from Tufts University. MR. RUMSFELD has served as a director since September 1999. Mr. Rumsfeld also previously served as a member of the our board of directors from 1991 to 1996. Mr. Rumsfeld is Chairman of the Board of Gilead Sciences, Inc. He also is a member of the boards of directors of ABB (Asea Brown Boveri) Ltd., Forstmann Little & Co., Tribune Company and RAND Corporation. He is also currently Chairman of the Salomon Smith Barney International Advisory Board. Mr. Rumsfeld was Chairman and Chief Executive Officer of General Instrument Corporation from October 1990 to August 1993 and served as a senior advisor to William Blair & Co., an investment banking firm, from 1985 to 1990. He was Chief Executive Officer of G.D. Searle & Co. from 1977 to 1985. Mr. Rumsfeld formerly served as U.S. Secretary of Defense, White House Chief of Staff, U.S. Ambassador to NATO, and as a U.S. Congressman. He has also served as the President's envoy to the Middle East and recently completed service as Chairman of the U.S. Government Commission to Assess the Ballistic Missile Threat to the United States. He is a recipient of the Presidential Medal of Freedom, the United States' highest civilian award. DR. SKYLER has served as a director since August 1999. He is Professor of Medicine, Pediatrics, and Psychology and Co-Director of the Medicine Research Center at the University of Miami in Florida. He is also Director of the Operations Coordinating Center for the National Institute of Diabetes & Digestive & Kidney Diseases (NIDDK) Diabetes Prevention Trial in Type 1 Diabetes. Dr. Skyler has served as President of the American Diabetes Association, and is currently Vice President of the International Diabetes Federation. Dr. Skyler is a member of the Florida Governor's Diabetes Advisory Council, and serves on the editorial board of diabetes and general medicine journals. He received his M.D. from Jefferson Medical College, and completed postdoctoral studies at Duke University Medical Center. DR. BARON joined Amylin as Vice President of Clinical Research in December 1999. Dr. Baron previously worked for the Indiana University School of Medicine in Indianapolis, where he served as Professor of Medicine and Director, Division of Endocrinology and Metabolism. Prior to this position at Indiana, Dr. Baron held academic and clinical positions in the Division of Endocrinology and Metabolism at University of California, San Diego, and the Veterans Administration Medical Center in San Diego. He is the recipient of several prestigious awards for his research in diabetes and vascular disease, including the 1996 Outstanding Clinical Investigator Award from the American Federation for Medical Research, several from the American Diabetes Association, and is a current National Institutes of Health MERIT award recipient. Dr. Baron is currently Principal Investigator for several diabetes studies, including the Early Diabetes Intervention Program study sponsored by the NIH and Bayer Pharmaceuticals. He earned his M.D. from the Medical College of Georgia, Augusta, and completed postdoctoral studies at the University of California, San Diego. MR. BRADBURY, an executive officer, has served as our Senior Vice President of Corporate Development since April 1998. Mr. Bradbury previously served as Vice President of Marketing from June 1995 to April 1998, and Director of Marketing, Amylin Europe Limited, from July 1994 to May 1995. Prior to joining Amylin, Mr. Bradbury was employed by SmithKline Beecham Pharmaceuticals from September 1984 to July 1994, where he held a number of positions, most recently as Associate Director, Anti-Infectives in the Worldwide Strategic Product Development Division. Mr. Bradbury holds a B.Pharm. (Hons.) from Nottingham University and a Diploma in Management Studies from Harrow and Ealing Colleges of Higher Education and is a member of the Royal Pharmaceutical Society of Great Britain. MR. BROWN, an executive officer, has served as Senior Vice President of Operations since March 2000 and previously served as Vice President of Operations from October 1998 to February 2000. Mr. Brown previously served as our Senior Director, Information Technology from May 1994 to October 1998. From 1989 to 1993, Mr. Brown was Director, Information Systems, Europe, for Eli Lilly. From 1988 to 1989, Mr. Brown was Director, Information Systems for the Medical Devices and Diagnostics Division of Eli Lilly; he served as Director, Information Systems of IVAC Corporation, one of the seven companies in that division, from 1983 to 1988. Mr. Brown received a B.S. in Commerce and Engineering and a M.B.A. in Operations Research from Drexel University. DR. DATA has served as Senior Vice President of Regulatory Affairs and Quality since August 1999. Dr. Data previously served as Executive Vice President, Product Development and Regulatory for CoCensys. Before that, Dr. Data held several positions at The Upjohn Company, the most recent of which was Corporate Vice President for Pharmaceutical Regulatory Affairs and Project Management. Previously, she held a number of positions at Hoffman-La Roche, including Vice President of Clinical Research and Development. Dr. Data has been an adjunct assistant professor in medicine and pharmacology at Duke University Medical Center since 1982 and at Cornell Medical Center since 1986. She earned her M.D. from Washington University School of Medicine and her Ph.D. in Pharmacology from Vanderbilt University. DR. KOLTERMAN, an executive officer, has served as Senior Vice President of Clinical Affairs since February 1997. Dr. Kolterman previously served as Vice President, Medical Affairs from July 1993 to February 1997 and Director, Medical Affairs from May 1992 to July 1993. From 1983 to May 1992, he was Program Director of the General Clinical Research Center and Medical Director of the Diabetes Center, at the University of California, San Diego Medical Center. Since 1989, he has been Adjunct Professor of Medicine at UCSD. From 1978 to 1983, he was Assistant Professor of Medicine in the Endocrinology and Metabolism Division at the University of Colorado School of Medicine, Denver. He was a member of the Diabetes Control and Complications Trial (DCCT) Study Group at the time of its completion in 1993 and presently serves as a member of the Epidemiology of Diabetes Intervention and Complications (EDIC) Study. He is also a past-President of the California Affiliate of the American Diabetes Association. Dr. Kolterman earned a M.D. from Stanford University School of Medicine. MS. DAHL, an executive officer, has served as Vice President and General Counsel since January 1999. Ms. Dahl previously served as Vice President and Associate General Counsel from November 1998 to December 1998. From 1996 to 1998, Ms. Dahl held the position of Associate General Counsel, and from 1993 to 1996, she served as Senior Attorney. Prior to joining Amylin, from 1989 to 1993, she was an attorney in private practice with the law firm of Lyon & Lyon. From 1987 to 1989, Ms. Dahl was in private practice with the law firm of Brobeck, Phleger & Harrison. From 1986 to 1987, she served as a judicial clerk to the Honorable David R. Thompson of the U.S. Court of Appeals for the Ninth Circuit. Ms. Dahl received a J.D. degree from the University of Oregon and a B.S. degree in Zoology from the University of Wisconsin. DR. YOUNG has served as Vice President of Research since October 1998 and served as Vice President of Physiology from January 1994 until October 1998. From 1989 to 1993 he held a number of positions in our physiology department. Prior to 1989, Dr. Young was a lecturer in the Department of Physiology at the University of Auckland, New Zealand and a part-time general medical practitioner. From 1984 to 1987, Dr. Young was a Clinical Research Scientist at the National Institutes of Health in Phoenix, Arizona, where he studied insulin resistance and diabetes. He received his M.B., Ch.B. (M.D.) and his Ph.D. in Physiology from the University of Auckland, New Zealand. RISK FACTORS RELATED TO OUR BUSINESS Except for the historical information contained or incorporated by reference, this annual report on Form 10-K and the information incorporated by reference contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed here. Factors that could cause or contribute to differences in our actual results include those discussed in the following section, as well as those discussed in Part II, Item 7 entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere throughout this annual report and in any other documents incorporated by reference into this annual report. You should consider carefully the following risk factors, together with all of the other information included in this annual report on Form 10-K. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock. RESULTS FROM OUR CLINICAL TRIALS MAY NOT BE SUFFICIENT TO OBTAIN REGULATORY CLEARANCE TO MARKET SYMLIN OR AC2993 IN THE UNITED STATES OR ABROAD ON A TIMELY BASIS, OR AT ALL. Our drug candidates are subject to extensive government regulations related to development, clinical trials, manufacturing and commercialization. The process of obtaining FDA and other regulatory approvals is costly, time consuming, uncertain and subject to unanticipated delays. The FDA may refuse to approve an application for approval of a drug candidate if it believes that applicable regulatory criteria are not satisfied. The FDA may also require additional testing for safety and efficacy. Moreover, if the FDA grants regulatory approval of a product, the approval may be limited to specific indications or limited with respect to its distribution. Foreign regulatory authorities may apply similar limitations or may refuse to grant any approval. The data collected from our clinical trials may not be sufficient to support approval of SYMLIN or AC2993 by the FDA or any foreign regulatory authorities. With respect to SYMLIN, the results of the first four Phase 3 clinical studies were not sufficient, standing alone, to support an application with the FDA for marketing approval. In some of these first four studies, the statistical requirements agreed in advance with the FDA were not met. However, the results of our final two Phase 3 clinical studies for SYMLIN that were reported in August and November 1999 met the statistical requirements that we agreed with the FDA. We believe that the results of our entire SYMLIN clinical trial program, including the two most recently completed Phase 3 clinical studies of SYMLIN, should support regulatory approval of SYMLIN. However, it is possible that the FDA or other regulatory authorities may deem our SYMLIN clinical trial results insufficient to meet regulatory requirements for marketing approval or may limit approval for only selected uses. Manufacturing facilities operated by the third party manufacturers with whom we contract to manufacture SYMLIN may not pass an FDA or other regulatory authority preapproval inspection for SYMLIN. Any failure or delay in obtaining these approvals could prohibit or delay us from marketing SYMLIN. Consequently, even if we believe that preclinical and clinical data are sufficient to support regulatory approval for SYMLIN, the FDA and foreign regulatory authorities may not ultimately approve SYMLIN for commercial sale in any jurisdiction. If SYMLIN does not meet applicable regulatory requirements for approval, we may not have the financial resources to continue research and development of SYMLIN or any of our other product candidates and we may not be able to generate revenues from the commercial sale of any of our products. DELAYS IN THE CONDUCT OR COMPLETION OF OUR CLINICAL TRIALS OR THE ANALYSIS OF THE DATA FROM OUR CLINICAL TRIALS MAY RESULT IN DELAYS IN OUR PLANNED FILINGS FOR REGULATORY APPROVALS, OR ADVERSELY AFFECT OUR ABILITY TO ENTER INTO NEW COLLABORATIVE ARRANGEMENTS. We cannot predict whether we will encounter problems with any of our completed or ongoing clinical studies that will cause us or regulatory authorities to delay or suspend our ongoing clinical studies or delay the analysis of data from our completed or ongoing clinical studies. If the results of our ongoing and planned clinical studies for AC2993 are not available when we expect or if we encounter any delay in the analysis of our clinical studies for SYMLIN or AC2993: - we may delay the submission of our applications for regulatory approval of SYMLIN with regulatory authorities in North America and Europe; - we may not have the financial resources to continue research and development of any of our product candidates; and - we may not be able to enter into collaborative arrangements relating to any product subject to delay in regulatory filing. Any of the following reasons could delay the completion of our ongoing and future clinical studies: - delays in enrolling volunteers; - lower than anticipated retention rate of volunteers in a trial; or - serious side effects experienced by study participants relating to the drug candidate. EVEN IF WE OBTAIN INITIAL REGULATORY APPROVAL FOR OUR PRODUCTS, IF WE FAIL TO COMPLY WITH EXTENSIVE CONTINUING REGULATIONS ENFORCED BY DOMESTIC AND FOREIGN REGULATORY AUTHORITIES, IT COULD HARM OUR ABILITY TO GENERATE REVENUES AND THE MARKET PRICE OF OUR STOCK COULD FALL. Even if we are able to obtain United States regulatory approval for SYMLIN, the approval will be subject to continual review, and newly discovered or developed safety issues may result in revocation of the marketing approval. Moreover, if and when we obtain marketing approval for SYMLIN, the marketing of the product will be subject to extensive regulatory requirements administered by the FDA and other regulatory bodies, including adverse event reporting requirements and the FDA's general prohibition against promoting products for unapproved uses. The SYMLIN manufacturing facilities are also subject to continual review and periodic inspection and approval of manufacturing modifications. Domestic manufacturing facilities are subject to biennial inspections by the FDA and must comply with the FDA's Good Manufacturing Practices regulations. In complying with these regulations, manufacturers must spend funds, time and effort in the areas of production, record keeping, personnel and quality control to ensure full technical compliance. The FDA stringently applies regulatory standards for manufacturing. Failure to comply with any of these postapproval requirements can, among other things, result in warning letters, product seizures, recalls, fines, injunctions, suspensions or revocations of marketing licenses, operating restrictions and criminal prosecutions. Any of these enforcement actions or any unanticipated changes in existing regulatory requirements or the adoption of new requirements could adversely affect our ability to market products and generate revenues and thus adversely affect our ability to continue as a going concern and cause our stock price to fall. The manufacturers of SYMLIN also are subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and hazardous substance disposal. In the future, our manufacturers may incur significant costs to comply with those laws and regulations which could increase our manufacturing costs and reduce our ability to operate profitably. EXISTING PRICING REGULATIONS AND REIMBURSEMENT LIMITATIONS MAY REDUCE OUR POTENTIAL PROFITS FROM THE SALE OF OUR PRODUCTS. The requirements governing product licensing, pricing and reimbursement vary widely from country to country. Some countries require approval of the sale price of a drug before it can be marketed. In many countries, the pricing review period begins after product licensing approval is granted. As a result, we may obtain regulatory approval for a product in a particular country, but then be subject to price regulations that reduce our profits from the sale of the product. Also, in some foreign markets pricing of prescription pharmaceuticals is subject to continuing government control even after initial marketing approval. Our ability to commercialize our products successfully also will depend in part on the extent to which reimbursement for the cost of our products and related treatments will be available from government health administration authorities, private health insurers and other organizations. Third-party payors are increasingly challenging the prices charged for medical products and services. If we succeed in bringing SYMLIN and/or AC2993 to the market, we cannot assure you that either product will be considered cost effective and that reimbursement will be available or will be sufficient to allow us to sell SYMLIN and/or AC2993 on a competitive basis. WE WILL REQUIRE FUTURE CAPITAL AND ARE UNCERTAIN OF THE AVAILABILITY OR TERMS OF ADDITIONAL FUNDING. IF OUR CAPITAL BECOMES INSUFFICIENT AND ADDITIONAL FUNDING IS UNAVAILABLE, INADEQUATE, OR NOT AVAILABLE ON ACCEPTABLE TERMS, IT MAY ADVERSELY AFFECT THE VALUE OF YOUR SHARES. We must continue to find sources of capital in order to complete the development and commercialization of SYMLIN and AC2993. Our future capital requirements will depend on many factors, including: - the time and costs involved in obtaining regulatory approvals; - the costs of manufacturing SYMLIN and AC2993; - our ability to establish one or more marketing, distribution or other commercialization arrangements for SYMLIN and AC2993; - progress with our preclinical studies and clinical studies; - scientific progress in our other research programs and the magnitude of these programs; - the costs involved in preparing, filing, prosecuting, maintaining, and enforcing patents or defending ourselves against competing technological and market developments; and - the potential need to repay outstanding indebtedness. You should be aware that: - we may not obtain additional financial resources in the necessary time frame or on terms favorable to us, if at all; - any available additional financing may not be adequate; and - we may be required to use future financing to repay existing indebtedness to our current or future creditors, including Johnson & Johnson. As of December 31, 1999, the total principal and interest due to Johnson & Johnson was approximately $50.6 million, which is secured by our issued patents and patent applications relating to amylin, including several that relate to SYMLIN. In the event our capital becomes insufficient and we are unable to obtain additional financing on acceptable terms, we would not have the financial resources to continue research and development of SYMLIN, AC2993 or any of our other product candidates and we would curtail or cease our operations, which would adversely affect the value of your shares. WE HAVE A HISTORY OF OPERATING LOSSES, ANTICIPATE FUTURE LOSSES, MAY NOT GENERATE REVENUES FROM PRODUCT SALES AND MAY NEVER BECOME PROFITABLE. We have experienced significant operating losses since our inception in 1987. As of December 31, 1999, we had an accumulated deficit of approximately $292 million. We expect to incur significant additional operating losses over the next several years. We have derived substantially all of our revenues to date from development funding, fees and milestone payments under collaborative agreements and from interest income. To date, we have not received any revenues from product sales. To achieve profitable operations, we, alone or with others, must successfully develop, manufacture, obtain required regulatory approvals and market our products. We may not ever become profitable. If we become profitable, we may not remain profitable. WE HAVE NOT PREVIOUSLY SOLD, MARKETED OR DISTRIBUTED A PRODUCT, AND OUR ABILITY TO ENTER INTO THIRD PARTY RELATIONSHIPS IS IMPORTANT TO OUR SUCCESSFUL DEVELOPMENT AND COMMERCIALIZATION OF PRODUCTS AND POTENTIAL PROFITABILITY. We have not previously sold, marketed or distributed a product. To market any of our products, we must obtain access to marketing and sales forces with technical expertise and with supporting distribution capability. We believe that we will likely need to enter into marketing and distribution arrangements with third parties for SYMLIN and AC2993 or find a corporate partner who can provide support for commercialization of SYMLIN and/or AC2993. We may not be able to enter into marketing and distribution arrangements or find a corporate partner for these drug candidates. If we do not, or are not able to enter into a marketing or distribution arrangement or find a corporate partner who can provide support for commercialization of SYMLIN and/or AC2993, we may perform some marketing and distribution activities for those potential drug products. We may not be able to successfully perform these marketing or distribution activities. Moreover, any new marketer or distributor or corporate partner for SYMLIN or AC2993 may not establish adequate sales and distribution capabilities or gain market acceptance for products, if any. OUR COMMERCIALIZATION PLANS FOR SYMLIN AND AC2993 ARE DEPENDENT ON THE PERFORMANCE OF, AND OUR RELATIONSHIPS WITH, THIRD PARTIES THAT PROVIDE US WITH PRODUCT DEVELOPMENT, CLINICAL AND REGULATORY SUPPLIES AND SERVICES. We depend to a significant degree on third parties to perform the majority of product development, clinical and regulatory functions for our product candidates. In particular, we rely to a significant degree on third parties for the preparation of our planned regulatory submissions for SYMLIN. While we believe that business relations between us and our third-party suppliers and service providers have been good, we cannot predict whether third-party suppliers and service providers will continue to cooperate with us in the performance of our most important services or functions. Any difficulties or interruptions of service with our third-party product development, clinical and regulatory suppliers and service providers could disrupt the development of our product candidates, the completion of our clinical trials, the manufacture of our products and delay our submissions for regulatory approval of SYMLIN. WE DO NOT MANUFACTURE OUR OWN PRODUCTS AND MAY NOT BE ABLE TO OBTAIN ADEQUATE SUPPLIES, WHICH COULD CAUSE DELAYS OR REDUCE PROFIT MARGINS. The manufacturing of sufficient quantities of new drugs is a time consuming and complex process. We currently have no facilities for the manufacture of clinical study or commercial supplies of SYMLIN or AC2993. We currently rely on third parties to manufacture SYMLIN and AC2993. We work with three contract suppliers who have the capabilities for the commercial manufacture of SYMLIN. We, alone or together with a new corporate partner, may not be able to make the transition to commercial production. While we believe that our business relations between us and our contract manufacturers are good, we cannot predict whether these manufacturers will meet our requirements for quality, quantity or timeliness for the manufacture of SYMLIN or AC2993. Therefore, we may not be able to obtain supplies of products on acceptable terms or in sufficient quantities, if at all. Our dependence on third parties for the manufacture of products may also reduce our profit margins and ability to develop and deliver products with sufficient speed. If any of our existing manufacturers cease to manufacture SYMLIN, we may need to locate and engage another manufacturer. The cost and time to establish manufacturing facilities to produce SYMLIN would be substantial. As a result, using a new manufacturer could disrupt our ability to supply SYMLIN or reduce our profit margins. Any delay or disruption in the manufacturing of SYMLIN could require us to raise additional funds. OUR OTHER RESEARCH AND DEVELOPMENT PROGRAMS MAY NOT RESULT IN ADDITIONAL DRUG CANDIDATES, WHICH COULD REQUIRE US TO RAISE ADDITIONAL FUNDS. Our research and development programs other than SYMLIN, AC2993 and AC3056 are at an early stage. Any additional product candidates will require significant research, development, preclinical and clinical testing, regulatory approval and commitments of resources before commercialization. We cannot predict whether our research will lead to the discovery of any additional product candidates that could generate revenues for us. If we do not develop additional drug candidates or if our discovery efforts are delayed, we may have to raise additional funds to continue our business. IF OUR PATENTS ARE DETERMINED TO BE UNENFORCEABLE OR IF WE ARE UNABLE TO OBTAIN NEW PATENTS BASED ON CURRENT PATENT APPLICATIONS OR FOR FUTURE INVENTIONS, WE MAY NOT BE ABLE TO PREVENT OTHERS FROM USING OUR INTELLECTUAL PROPERTY. We own or hold exclusive rights to 28 issued United States patents and approximately 30 pending United States patent applications. Of these issued patents and patent applications, we have a total of 11 issued U.S. patents and nine pending applications that we believe are relevant to the development and commercialization of SYMLIN and one issued US patent and 12 pending applications that we believe are relevant to the development and commercialization of AC2993. We also own or hold exclusive rights to various foreign patent applications that correspond to issued United States patents or pending United States patent applications. Our success will depend in part on our ability to obtain patent protection for our products and technologies both in the United States and other countries. We cannot guarantee that any patents will issue from any pending or future patent applications owned by or licensed to us. For instance, a third party may successfully circumvent our patents. Our rights under any issued patents may not provide us with sufficient protection against competitive products or otherwise cover commercially valuable products or processes. In addition, because patent applications in the United States are maintained in secrecy until patents issue and publication of discoveries in the scientific or patent literature often lag behind actual discoveries, we cannot be sure that the inventors of subject matter covered by our patents and patent applications were the first to invent or the first to file patent applications for these inventions. In the event that a third party has also filed a patent for any of its inventions, we may have to participate in interference proceedings declared by the US Patent and Trademark Office to determine priority of invention, which could result in substantial cost to us, even if the eventual outcome is favorable to us. Furthermore, we may not have identified all United States and foreign patents that pose a risk of infringement. LITIGATION REGARDING PATENTS AND OTHER PROPRIETARY RIGHTS MAY BE EXPENSIVE, CAUSE DELAYS IN BRINGING PRODUCTS TO MARKET AND HARM OUR ABILITY TO OPERATE. Our success will depend in part on our ability to operate without infringing the proprietary rights of third parties. Legal standards relating to the validity of patents covering pharmaceutical and biotechnological inventions and the scope of claims made under these patents are still developing. As a result, the ability to obtain and enforce patents is uncertain and involves complex legal and factual questions. Third parties may challenge or infringe upon existing or future patents. In the event that a third party challenges a patent, a court may invalidate the patent or determine that the patent is not enforceable. Proceedings involving our patents or patent applications or those of others could result in adverse decisions about: - the patentability of our inventions and products relating to our drug candidates; and/or - the enforceability, validity or scope of protection offered by our patents relating to our drug candidates. The manufacture, use or sale of any of our drug candidates may infringe on the patent rights of others. If we are unable to avoid infringement of the patent rights of others, we may be required to seek a license, defend an infringement action or challenge the validity of the patents in court. Patent litigation is costly and time consuming. We may not have sufficient resources to bring these actions to a successful conclusion. In addition, if we do not obtain a license, develop or obtain non-infringing technology, and fail successfully to defend an infringement action or to have infringing patents declared invalid, we may: - incur substantial money damages; - encounter significant delays in bringing our drug candidates to market; and/or - be precluded from participating in the manufacture, use or sale of our drug candidates or methods of treatment requiring licenses. CONFIDENTIALITY AGREEMENTS WITH EMPLOYEES AND OTHERS MAY NOT ADEQUATELY PREVENT DISCLOSURE OF TRADE SECRETS AND OTHER PROPRIETARY INFORMATION. In order to protect our proprietary technology and processes, we also rely in part on confidentiality agreements with our corporate partners, employees, consultants, outside scientific collaborators and sponsored researchers and other advisors. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position. COMPETITION IN THE BIOTECHNOLOGY AND PHARMACEUTICAL INDUSTRIES MAY RESULT IN COMPETING PRODUCTS, SUPERIOR MARKETING OF OTHER PRODUCTS AND LOWER REVENUES OR PROFITS FOR US. We believe that competition may be intense for all of our product candidates. Our competitors include multinational pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions. A number of our competitors are pursuing the development of novel pharmaceuticals which target the same diseases that we are targeting, and we expect that the number of companies seeking to develop products and therapies for the treatment of diabetes and other metabolic disorders will increase. Many of our competitors have substantially greater financial, technical and human resources than we do. In addition, many of these competitors have significantly greater experience than we do in undertaking preclinical testing and human clinical studies of new pharmaceutical products and in obtaining regulatory approvals of human therapeutic products. Accordingly, our competitors may succeed in obtaining FDA approval for products more rapidly than we do and provide these competitors with an advantage for the marketing of products with similar potential uses. Furthermore, if we are permitted to commence commercial sales of products, we may also be competing with respect to manufacturing efficiency and marketing capabilities, areas in which we have limited or no experience. Our target patient population for SYMLIN is people with diabetes whose therapy includes multiple insulin injections daily. AC2993 is currently being studied for the treatment of type 2 diabetes. Other products are currently in development or exist in the market that may compete directly with the products that we are seeking to develop and market. Various products are available to treat type 2 diabetes, including: In addition, several companies are developing various approaches to improve treatments for type 1 and type 2 diabetes. We cannot predict whether our products, even if successfully tested and developed, will have sufficient advantages over existing products to cause health care professionals to adopt them over other products or that our products will offer an economically feasible alternative to existing products. WE MAY NOT BE ABLE TO KEEP UP WITH THE RAPID TECHNOLOGICAL CHANGE IN THE BIOTECHNOLOGY AND PHARMACEUTICAL INDUSTRIES, WHICH COULD MAKE OUR PRODUCTS OBSOLETE AND REDUCE OUR REVENUES. Biotechnology and related pharmaceutical technologies have undergone and continue to be subject to rapid and significant change. Our future will depend in large part on our ability to maintain a competitive position with respect to these technologies. Any products that we develop may become obsolete before we recover expenses incurred in developing those products, which may require that we raise additional funds to continue our operations. OUR FUTURE SUCCESS DEPENDS ON OUR ABILITY TO RETAIN OUR CHIEF EXECUTIVE OFFICER AND OUR SENIOR VICE PRESIDENT OF CLINICAL AFFAIRS AND TO ATTRACT, RETAIN AND MOTIVATE QUALIFIED PERSONNEL. We are highly dependent on Joseph C. Cook, Jr., our Chairman and Chief Executive Officer, and Orville G. Kolterman, M.D., our Senior Vice President of Clinical Affairs, and the other principal members of our scientific and management staff, the loss of whose services might impede the achievement of our research and development objectives. Recruiting and retaining qualified scientific personnel to perform research and development work in the future will also be critical to our success. Although we believe we will be successful in attracting and retaining skilled and experienced scientific personnel, we may not be able to attract and retain these personnel on acceptable terms given the competition between numerous pharmaceutical and biotechnology companies, universities and other research institutions for experienced scientists and management personnel. We do not maintain "key person" insurance on any of our employees. In addition, we rely on consultants and advisors, including scientific and clinical advisors, to assist us in formulating research and development strategy. Our consultants and advisors may be employed by employers other than us and may have commitments to for consulting or advisory contracts with other entities that may limit their availability to us. OUR BUSINESS HAS A SUBSTANTIAL RISK OF PRODUCT LIABILITY CLAIMS, AND INSURANCE MAY BE EXPENSIVE OR UNAVAILABLE. Our business exposes us to potential product liability risks that are inherent in the testing, manufacturing and marketing of human therapeutic products. Product liability claims could result in a recall of products or a change in the indications for which they may be used. Although we currently have product liability insurance, we cannot assure you that insurance will provide adequate coverage against potential liabilities. Furthermore, product liability insurance is becoming increasingly expensive. As a result, we may not be able to maintain current amounts of insurance coverage, obtain additional insurance or obtain insurance at a reasonable cost or in sufficient amounts to protect against losses that could have a material adverse effect on us. OUR ACTIVITIES INVOLVE THE USE OF HAZARDOUS MATERIALS, WHICH SUBJECT US TO REGULATION, RELATED COSTS AND DELAYS AND POTENTIAL LIABILITIES. Our research and development involves the controlled use of hazardous materials, chemicals and various radioactive compounds. Although we believe that our safety procedures for handling and disposing of those materials comply with the standards prescribed by state and federal regulations, the risk of accidental contamination or injury from these materials cannot be eliminated. If an accident occurs, we could be held liable for resulting damages, which could be substantial. We are also subject to numerous environmental, health and workplace safety laws and regulations, including those governing laboratory procedures, exposure to blood-borne pathogens and the handling of biohazardous materials. Additional federal, state and local laws and regulations affecting our operations may be adopted in the future. We may incur substantial costs to comply with and substantial fines or penalties if we violate any of these laws or regulations. PROVISIONS IN AMYLIN'S CORPORATE CHARTER AND BYLAWS MAY DISCOURAGE TAKE-OVER ATTEMPTS AND THUS DEPRESS THE MARKET PRICE OF OUR STOCK. Provisions in Amylin's certificate of incorporation, as amended, may have the effect of delaying or preventing a change of control or changes in its management. These provisions include: - the right of the board of directors to elect a director to fill a vacancy created by the expansion of the board of directors; and - the ability of the board of directors to issue, without stockholder approval, up to 7,375,000 shares of preferred stock with terms set by the board of directors. Each of these provisions could discourage potential take-over attempts and could adversely affect the market price of our common stock. SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK BY EXISTING STOCKHOLDERS OR BY US COULD CAUSE OUR STOCK PRICE TO FALL. Sales by existing stockholders of a large number of shares of our common stock in the public market or the perception that additional sales could occur could cause the market price of our common stock to drop. As of March 1, 2000, we had approximately 62.5 million shares of common stock outstanding, of which approximately 37.9 million are freely tradeable, approximately 12.6 million may be sold in accordance with Rule 144 and approximately 12.0 million are currently restricted but may be sold in the future in accordance with registration statements covering the shares. Likewise, additional equity financings or other share issuances by us, including shares issued in connection with strategic alliances, could adversely affect the market price of our common stock. SIGNIFICANT VOLATILITY IN THE MARKET PRICE FOR OUR COMMON STOCK COULD EXPOSE US TO LITIGATION RISK. The market prices for securities of biopharmaceutical and biotechnology companies, including our common stock, have historically been highly volatile, and the market from time to time has experienced significant price and volume fluctuations that are unrelated to the operating performance of these biopharmaceutical and biotechnology companies. Given the uncertainty of our future funding and our planned filing for regulatory approval of SYMLIN, we expect that we may continue to experience volatility of our stock price throughout 2000. In addition, the following factors may have a significant effect on the market price of our common stock: - announcements of additional clinical study results; - announcements of determinations by regulatory authorities with respect to our drug candidates; - developments in our relationships with current or future collaborative partners; - fluctuations in our operating results; - public concern as to the safety of drugs developed by us; - technological innovations or new commercial therapeutic products by us or our competitors; - developments in patent or other proprietary rights; - governmental policy or regulation; and - general market conditions. Broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company's securities, securities class-action litigation has often been instituted against those companies. This type of litigation, if instituted, could result in substantial costs and a diversion of management's attention and resources, which would materially adversely affect our business, financial condition and results of operations. ITEM 2. ITEM 2. PROPERTIES Amylin's administrative offices and research laboratories are located in San Diego, California. As of March 1, 2000, we occupy 30,395 square feet of office and laboratory space. The Company's lease on this property will expire on August 31, 2004. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Since February 10, 2000, our common stock has been traded on the Nasdaq National Market under the symbol "AMLN." From February 1, 1999 to February 9, 2000, our common stock traded on the Nasdaq SmallCap Market. Before February 1999, our common stock traded on the Nasdaq National Market. The following table sets forth, for the periods indicated, the high and low sales prices per share of Common Stock on the Nasdaq National Market or the Nasdaq SmallCap Market, as applicable: The last reported sale price of our common stock on the Nasdaq National Market on March 1, 2000 was $17.00. As of March 1, 2000, there were approximately 1,043 shareholders of record of our common stock. We have never declared or paid any cash dividends on our capital stock. We currently intend to retain any future earnings for funding growth and, therefore, do not anticipate paying any cash dividends in the foreseeable future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Please read the following selected financial data in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," the Consolidated Financial Statements and related notes included elsewhere in this annual report on Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Amylin Pharmaceuticals, Inc. is engaged in the discovery and development of potential drug candidates for the treatment of metabolic disorders. Since its inception in September 1987, Amylin has devoted substantially all of its resources to its research and development programs. Substantially all of the Company's revenues to date have been derived from fees and expense reimbursements under collaborative agreements and from interest income. Amylin has no product sales and has not received any revenues from the sale of products. We have been unprofitable since our inception and expect to incur additional operating losses for the next several years. As of December 31, 1999, the Company's accumulated deficit was approximately $292 million. From June 1995 to August 1998, Amylin and Johnson & Johnson collaborated on the development and commercialization of SYMLIN. Under the Collaboration Agreement, Johnson & Johnson made payments to Amylin totaling approximately $174 million. These payments included funding of one-half of the SYMLIN development costs, draw downs from the development loan facility under a loan and security agreement, the purchase of $30 million of the Company's common stock, milestone, license and option fee payments, and the funding of SYMLIN pre-marketing costs. The Johnson & Johnson collaboration provided for, among other things, a fifty-fifty sharing arrangement whereby each party would be responsible for one-half of all development and commercialization costs and would share one-half of all profits derived from SYMLIN. As a result of Johnson & Johnson's withdrawal, Johnson & Johnson has relinquished all rights to share in any SYMLIN profits. Additionally, following the collaboration termination in August 1998, all product and other rights associated with SYMLIN and related compounds reverted to Amylin. Following the termination of the Johnson & Johnson collaboration agreement, Amylin significantly reduced its workforce and operating expenses. On March 24, 1999, we announced that we raised $15 million in a private placement of shares of Series A Preferred Stock to a select group of investors. The financing was led by $6.7 million in investments by Amylin board members and their affiliated funds. On October 7, 1999, we announced that we raised $18.5 million in a private placement of shares of common stock. These funds were raised from a select group of institutional and private investors, predominately those investors who participated in the March 1999 financing. On February 22, 2000, we announced that we raised gross proceeds of $100 million from the sale of newly issued common stock to select institutional and individual investors in a private placement. RESULTS OF OPERATIONS REVENUE We recognized no revenues in 1999. Our revenues were $16.2 million in 1998 and $42.6 million in 1997. The revenues recognized in 1998 and 1997 are related to our collaboration agreement with Johnson & Johnson that terminated in August 1998. OPERATING EXPENSES Our total operating expenses decreased to $27.1 million in 1999 from $63.8 million in 1998 and $97.9 million in 1997. These reductions were primarily a result of reductions in work force in 1998 and reductions in operating expenses in the fourth quarter of 1998 and 1999. Our research and development expenses decreased to $19.2 million in 1999 from $53.6 million in 1998, and $82.3 million in 1997. General and administrative expenses also decreased to $7.9 million in 1999, from $10.2 million in 1998, and $15.6 million in 1997. These reductions were primarily the result of reductions in work force in 1998 and reductions in operating expenses in the fourth quarter of 1998 and 1999. OTHER INCOME AND EXPENSE Interest and other income is principally comprised of interest income from investment of our cash reserves. Interest income increased to $2.2 million in 1999 from $1.4 million in 1998, and compared with $2.6 million in 1997. The increase in 1999 is as a result of higher overall cash reserves available for investment. The decrease in 1998 was primarily due to an overall lower cash balance available for investment. Interest and other expense principally comprised of interest expense resulting from long-term debt obligations. We have used debt financing to acquire laboratory and other equipment. In addition, in accordance with the terms of our collaboration agreement with Johnson & Johnson, Johnson & Johnson advanced our share of SYMLIN pre-launch marketing expenses incurred during the term of the collaboration. Separately, in September 1997, we received proceeds of approximately $30.6 million from a draw down under our development loan facility with Johnson & Johnson. The proceeds were used to fund our one-half share of development expenses for SYMLIN during the second through fourth quarters of 1997. In conjunction with the borrowing under the development loan facility, we issued warrants to Johnson & Johnson to purchase 1,530,950 shares of our common stock. The estimated value of the warrants will be amortized to interest expense over the life of the development loan facility. Both the development loan and the pre-marketing loan were provided under the terms and conditions of our loan and security agreement with Johnson & Johnson and will be repaid with interest over time, subject to certain exceptions set forth in the loan and security agreement. As of December 31, 1999 we owed Johnson & Johnson approximately $13.4 million for our share of pre-launch marketing expenses. As of December 31, 1999 the total principal and interest due to Johnson and Johnson was approximately $50.6 million. Interest and other expense was $5.7 million in 1999, as compared with $5.0 million in 1998 and $2.0 million in 1997. The increases in interest expense were primarily due to the interest associated with the development loan debt, amortization of the valuation placed on the warrants, and interest expense related to the pre-marketing loan. NET LOSS The net loss for the year ended December 31, 1999 was $30.6 million as compared to $51.1 million in 1998 and $54.6 million in 1997. The decrease in net loss from 1998 and 1999 was primarily a result of significant reductions in work force in 1998 and reduced operating expenses in 1999. The decrease in net loss from 1997 to 1998 was due to significant reductions in work force and operating expenses in 1998. These reductions were offset by decreased collaboration revenue in 1998 and a lack of collaboration revenue in 1999. Amylin expects to incur substantial operating losses over the next few years due to continuing expenses associated with its research and development programs, including the preparation of regulatory submissions for and commercialization of SYMLIN and the clinical development of AC2993 and AC3056, and research, preclinical development and potential clinical testing of additional product candidates, and related general and administrative support. LIQUIDITY AND CAPITAL RESOURCES Since our inception, we have financed our operations primarily through private placements of common stock and preferred stock, sale of common stock, reimbursement of SYMLIN development expenses through our collaboration with Johnson & Johnson, and debt financings. At December 31, 1999 we had $22.5 million in cash, cash equivalents and short-term investments as compared to $10.8 million at December 31, 1998. We invest our cash in U.S. government and other highly rated debt instruments. In February 2000, we announced that we raised gross proceeds of $100 million from newly issued common stock to select institutional and individual investors. We intend to use our financial resources for the development, registration and preparation for commercialization of SYMLIN, for our AC2993 development program, including clinical trials, for our AC3056 development program, including the submission of an IND and clinical trials, and for other general corporate purposes. Research and development expenses will include costs of supplying materials for and/or conducting clinical trials. The amounts actually expended for each purpose may vary significantly depending upon numerous factors, including the progress of our research and development programs, the results of preclinical and clinical studies, the timing of regulatory submissions and approvals, if any, technological advances, determinations as to commercial potential of our compounds, and the status of competitive products. Expenditures will also depend upon the availability of additional sources of funds, the establishment of commercial or collaborative arrangements with other companies, and other factors. We do not expect to generate a positive internal cash flow for the next few years due to substantial additional research and development costs, including costs related to research, preclinical testing, clinical trials, manufacturing costs, and general and administrative expenses necessary to support such activities. Operating losses may fluctuate from quarter to quarter as a result of differences in the timing of expenses incurred and revenues recognized. Our future capital requirements will depend on many factors, including our ability to complete the preparation of an NDA, and a European application for marketing approval for SYMLIN, or ability to establish commercialization arrangements for SYMLIN and AC2993, our ability to progress with our other ongoing and new preclinical studies and clinical trials, the time and costs involved in obtaining regulatory approvals, scientific progress in our research and development programs, the magnitude of these programs, the costs involved in preparing, filing, prosecuting, maintaining, enforcing or defending itself against patents, competing technological and market developments, changes in collaborative relationships, and any costs of manufacturing scale-up. We plan to use the cash from our financing and investment activities to carry on our current business, including the preparation of submissions for marketing approval for SYMLIN, the continuation of our AC2993 clinical program, the continuation of our AC3056 preclinical program and for research activities. Prior to marketing, any drug we develop must undergo rigorous preclinical and clinical testing and an extensive regulatory approval process mandated by the FDA and equivalent foreign authorities. Subject to compliance with FDA and foreign authority regulations, we continue to undertake extensive clinical testing in an effort to demonstrate optimal dose, safety, and efficacy for our drug candidates in humans. Further testing of SYMLIN, AC2993, AC3056, and the Company's other drug candidates in research or development may reveal undesirable and unintended side effects or other characteristics that may prevent or limit their commercial use. As is the case for any drug in clinical testing, we or regulatory authorities may suspend clinical trials at any time if the patients participating in such trials are being exposed to unacceptable health risks. We may encounter problems in clinical trials which would cause us or the regulatory authorities to delay or suspend clinical trials. In addition, we may not obtain regulatory approval of any of our drug candidates for any indication. Products, if any, resulting from Amylin's research programs are not expected to be commercially available for a number of years. We believe that patent and other proprietary rights are important to business, and in this regard, we intend to file applications as appropriate for patents covering our products and processes. Litigation, which could result in substantial cost, may also be necessary to enforce our patents. Litigation, whether or not there is any basis for it, may also be required to determine the scope and validity of third-party proprietary rights. IMPACT OF YEAR 2000 In prior years, we discussed the nature and progress of our plans to become Year 2000 ready. In late 1999, we completed our remediation and testing of systems. As a result of those planning and implementation efforts, we experienced no significant disruptions in mission critical information technology and non-information technology systems and we believe those systems successfully responded to the Year 2000 date change. We are not aware of any material problems resulting from Year 2000 issues, either with our products, our internal systems, or the products and services of third parties. We will continue to monitor our mission critical computer applications and those of our suppliers and vendors throughout the year 2000 to ensure that any latent Year 2000 matters that may arise are addressed promptly. We have no reason to believe that Year 2000 issues will have a material impact on our business or financial condition. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We invest our excess cash primarily in U.S. government securities and marketable securities of financial institutions and corporations with strong credit ratings. These instruments have various short term maturities. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that, while the instruments we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive investments. Our debt is not subject to significant swings in valuation as interest rates on our debt approximate current interest rates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplemental data required by this item are set forth at the pages indicated in Item 14(a)(1). ITEM 9. ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item with respect to executive officers and directors is incorporated by reference from the information under the caption of "Election of Directors," contained in the proxy statement to be filed with the SEC pursuant to Regulation 14A in connection with Amylin's 2000 annual meeting. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the information under the caption "Executive Compensation" contained in the proxy statement to be filed with the SEC pursuant to Regulation 14A in connection with Amylin's 2000 annual meeting. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the information under the caption "Security Ownership of Certain Beneficial Owners and Management" contained in the proxy statement to be filed with the SEC pursuant to Regulation 14A in connection with Amylin's 2000 annual meeting. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the information under the caption contained in "Certain Transactions" contained in the proxy statement to be filed with the SEC pursuant to Regulation 14A in connection with Amylin's 2000 annual meeting. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) INDEX TO CONSOLIDATED FINANCIAL STATEMENTS The financial statements required by this item are submitted in a separate section beginning on page of this Report. (a)(2) FINANCIAL STATEMENT SCHEDULES: All schedules have been omitted because they are not applicable or required, or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto. (a)(3) INDEX TO EXHIBITS -- See Item 14(c) below. (b) REPORTS ON FORM 8-K Not applicable. (c) EXHIBITS - --------------- + Indicates management or compensatory plan or arrangement required to be identified pursuant to Item 14(c). * The Registrant has requested confidential treatment with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission. (1) Filed as an exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-44195) or amendments thereto and incorporated herein by reference. (2) Certain confidential portions deleted pursuant to Order Granting Application Under the Securities Act of 1933 and Rule 406 Thereunder Respecting Confidential Treatment dated January 17, 1992. (3) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (4) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993. (5) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. (6) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1995. (7) Certain confidential portions deleted pursuant to Order Granting Application Under the Securities Exchange Act of 1934 and Rule 24b-2 Thereunder Respecting Confidential Treatment dated March 7, 1997. (8) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1995. (9) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (10) Certain confidential portions deleted pursuant to Order Granting Application Under the Securities Exchange Act of 1934 and Rule 24b-2 Thereunder Respecting Confidential Treatment dated December 20, 1996. (11) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1996. (12) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997. (13) Certain confidential portions deleted pursuant to Order Granting Application Under the Securities Exchange Act of 1934 and Rule 24b-2 Thereunder Respecting Confidential Treatment dated June 24, 1997. (14) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997. (15) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (16) Filed as an exhibit to the Registrant's Registration Statement on Form S-8 (No. 333-51577) or amendments thereto and incorporated herein by reference. (17) Filed as an exhibit to the Registrant's Registration Statement on Form S-3 (No. 33-58831) or amendments thereto and incorporated herein by reference. (18) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998. (19) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1998. (20) Filed as an exhibit to the Registrant's Registration Statement on Form S-3 (No. 333-58831) or amendments thereto and incorporated herein by reference. (21) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999. (22) Filed as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1999. (23) Filed as an exhibit to the Registrant's Registration Statement (No. 333-87033) or amendments thereto and incorporated herein by reference. (d) FINANCIAL STATEMENT SCHEDULES The financial statement schedules required by this item are listed under Item 14(a)(2). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. AMYLIN PHARMACEUTICALS, INC. By: /s/ JOSEPH C. COOK, JR. ------------------------------------ Joseph C. Cook, Jr. Chairman of the Board and Chief Executive Officer Date: March 27, 2000 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Joseph C. Cook, Jr., and Nancy K. Dahl, and each of them, as his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place, and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming that all said attorneys-in-fact and agents, or any of them or their or his substitute or substituted, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders Amylin Pharmaceuticals, Inc. We have audited the accompanying consolidated balance sheets of Amylin Pharmaceuticals, Inc. as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity (net capital deficiency), and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Amylin Pharmaceuticals, Inc. at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. /s/ ERNST & YOUNG LLP San Diego, California February 22, 2000 AMYLIN PHARMACEUTICALS, INC. CONSOLIDATED BALANCE SHEETS ASSETS See accompanying notes. AMYLIN PHARMACEUTICALS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes. AMYLIN PHARMACEUTICALS, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1999 See accompanying notes. AMYLIN PHARMACEUTICALS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BUSINESS ACTIVITY Amylin Pharmaceuticals, Inc. was incorporated in Delaware on September 29, 1987. The Company is engaged in the discovery and development of potential drug candidates for the treatment of metabolic disorders. The Company is planning to submit marketing approval applications for its lead drug candidate, SYMLIN, for use in treatment of people with type 1 or insulin-using type 2 diabetes. The Company is also conducting Phase 2 clinical trials of AC2993, a second diabetes drug candidate. The Company plans to submit an Investigational New Drug Application for AC3056 in the first half of 2000, which would allow the Company to begin Phase 1 clinical trials. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Amylin Europe Limited. All significant intercompany transactions and balances have been eliminated in consolidation. RESEARCH REVENUES UNDER COLLABORATIVE AGREEMENTS AND RESEARCH AND DEVELOPMENT EXPENSES Research revenues under collaborative agreements are recorded when earned as research activities are performed. Payments in excess of amounts earned are deferred. Internally funded research and development costs are expensed as incurred. CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS Cash, cash equivalents and short-term investments consist principally of U.S. government securities and other highly liquid debt instruments. The Company considers instruments with remaining maturities of less than 90 days to be cash equivalents. CONCENTRATION OF CREDIT RISK The Company invests its excess cash in U.S. government securities and debt instruments of financial institutions and corporations with strong credit ratings. The Company has established guidelines relative to diversification and maturities that maintain safety and liquidity. These guidelines are periodically reviewed. INVESTMENTS The Company has classified its debt securities as available-for-sale, and accordingly, carries its short-term investments at fair value, and unrealized holding gains or losses on these securities are carried as a separate component of stockholders' equity. The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses and declines in value judged to be other-than-temporary (of which there have been none to date) on available-for-sale securities are included in interest income. The cost of securities sold is based on the specific identification method. LONG-LIVED ASSETS Depreciation of equipment is computed using the straight-line method over three to five years. Leasehold improvements are amortized over the shorter of the estimated useful lives of the assets or the remaining term of the lease. Amortization of equipment under capital leases is reported with depreciation of property and equipment. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The Company also records the assets to be disposed of at the lower of their carrying amount or fair value less cost to sell. To date, the Company has not experienced any impairment losses on its long-lived assets used in operations. While the Company's current and historical operating and cash flow losses are indicators of impairment, the Company believes the future cash flows to be received support the carrying value of its long-lived assets and accordingly, the Company has not recognized any impairment losses as of December 31, 1999. PATENTS The Company has filed several patent applications with the United States Patent and Trademark Office and in foreign countries. Legal costs and expenses incurred in connection with pending patent applications have been deferred. Costs related to successful patent applications are amortized using the straight-line method over the lesser of the remaining useful life of the related technology or the remaining patent life, commencing on the date the patent is issued. Accumulated amortization at December 31, 1999 and 1998 was $477,000 and $344,000, respectively. Deferred costs related to patent applications are charged to operations at the time a determination is made not to pursue such applications. The Company wrote off previously capitalized patent costs of $112,000 in 1999. NET LOSS PER SHARE In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard ("SFAS") No. 128, Earnings per Share. SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. The adoption of SFAS 128 had no effect on the Company's financial statements. OPTIONS The Company has elected to follow Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees and related Interpretations ("APB 25") in accounting for its employee stock options. Under APB 25, when the exercise price of the Company's employee stock options is not less than the market price of the underlying stock on the date of grant, no compensation expense is recognized. The value of options or stock awards issued to non-employees have been determined in accordance with SFAS No. 123, Accounting for Stock-Based Compensation and EITF 96-18. Deferred charges for options granted to non-employees are periodically remeasured as the options vest. COMPREHENSIVE INCOME Effective January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive Income, which requires that all components of comprehensive income, including net income, be reported in the financial statements in the period in which they are recognized. Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income and other comprehensive income, including unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income. Prior year financial statements have been reclassified to conform to the requirements of SFAS No. 130. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 2. INVESTMENTS The following is a summary of investments as of December 31, 1999 and 1998, including $7,412,000 and $7,628,000 classified as cash equivalents in the accompanying balance sheets as of December 31, 1999 and 1998, respectively. All respective investments mature in less than two years. The gross realized gains on sales of available-for-sale securities totaled $948 and $1,400 and the gross realized losses totaled $1,890 and $500 for the years ended December 31, 1999 and 1998, respectively. Approximately $18,290,000 and $3,454,000 mature in 2000 and 2001, respectively. 3. DEBT AND LEASE COMMITMENTS The Company leases its facilities and some machinery and equipment under operating and capital leases. The minimum annual rent on the Company's facilities is subject to increases based on stated rental adjustment terms of certain leases, taxes, insurance and operating costs. Certain equipment leases require the Company to provide the lessor with a guaranteed residual at the end of the lease term at which time title to the equipment passes to the Company. Minimum future annual obligations for leases for years ending after December 31, 1999 and for equipment notes payable are as follows: Rent expense for 1999, 1998, and 1997 was $961,000, $2,402,000 and $2,697,000, respectively. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DEBT In 1996, the Company entered into a master line of credit agreement (as amended) to provide up to $5,000,000 of net financing for standard equipment. As of December 31, 1999, the Company had an outstanding loan balance of $574,651. Borrowings are payable over forty-eight months to include principal and monthly interest based on the average of three and five-year U.S. Treasury maturities (approximately 10.25% at December 31, 1999). The outstanding loan balance is due as of October, 2000. The credit agreement provides the lender with a security interest in all equipment financed under the line. In November 1997, the Company entered into a commitment agreement to enter into a financing agreement which will provide up to $2,700,000 of financing for equipment purchases. As of December 31, 1999, the Company had an outstanding loan balance of $2,160,000. Borrowings under this agreement are payable over a sixty-month period. Principal payments commenced on January 1, 1999. Monthly interest payments are calculated based on prime plus 0.5% (approximately 9.25% at December 31, 1999) of the outstanding principal balance and commenced with the outstanding balance in 1998. The credit agreement provides the lender with a security interest in all equipment financed under the agreement and requires payment of a security deposit of 50% of the outstanding balance should the Company's cash and investment balances fall below $10,000,000. On April 30, 1999, the Company entered into an agreement with Magellan Laboratories Incorporated for the sale of the assets of the Company's Cabrillo Laboratories division, for which the Company received a cash payment of $2.1 million. Additionally, the Company and Magellan entered in to an agreement pursuant to which Magellan agreed to perform a portion of the Company's future product development services. Magellan agreed to maintain certain product development capabilities important for the preparation of the Company's regulatory filings for SYMLIN and Amylin committed to contract with Magellan for $2 million in services for the 12 month period ended April 30, 2000. As a further component, the Company issued Magellan a warrant for the purchase of 50,000 shares of common stock in exchange for a $500,000 credit for future laboratory services to be provided by Magellan to the Company. Amylin also agreed to offer Magellan the right of first refusal to provide up to $4 million dollars of certain contracted services. 4. STOCKHOLDERS' EQUITY STOCK PURCHASE PLAN In November 1991, the Company adopted the Employee Stock Purchase Plan (the "Purchase Plan"), under which 600,000 shares of common stock may be issued to eligible employees, including officers. The price of common stock under the Purchase Plan is equal to the lessor of 85% of the market price on the effective date of an employee's participation in the plan or 85% of the fair market value of the common stock at the purchase date. At December 31, 1999, 475,347 shares of common stock had been issued under the plan. STOCK OPTIONS Under the Company's 1991 Stock Option Plan (the "Plan"), 7,800,000 shares of common stock are reserved for issuance upon exercise of options granted to employees and consultants of the Company. The Plan provides for the grant of incentive and nonstatutory stock options. The exercise price of incentive stock options must equal at least the fair market value on the date of grant, and the exercise price of nonstatutory stock options may be no less than 85% of the fair market value on the date of grant. Additionally, the Company is authorized to issue supplemental stock options for up to 70,000 options outside of the Plan. The maximum term of all options granted is ten years. Under the Company's Non-Employee Directors' Stock Option Plan (the "Directors' Plan") 350,000 shares of common stock are reserved for issuance upon exercise of nonqualified stock options granted to Non-Employee Directors of the Company. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table summarizes option activity: At December 31, 1999, 1,919,733 shares remained available for grant or sale. Following is a further breakdown of the options outstanding as of December 31, 1999: Adjusted pro forma information regarding net loss and loss per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options and stock purchase plan under the fair value method of SFAS No. 123. The fair value for these options was estimated at the date of grant using the "Black-Scholes" method for option pricing with the following weighted average assumptions for 1999, 1998 and 1997, respectively: risk-free interest of 6.00%, 5.50% and 5.71%; dividend yield of 0%; volatility factors of the expected market price of the Company's common stock of 221.0%, 73.5% and 65.4%; and a weighted-average expected life of the option of five years. For purposes of adjusted pro forma disclosures, the estimated fair value of the option is amortized to expense over the option's vesting period. The Company's adjusted pro forma information is as follows: The weighted-average fair value of options granted during 1999, 1998, and 1997 was $2.01, $1.66 and $7.14, respectively. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) STOCK WARRANTS In May 1997, in conjunction with an amendment to a License Agreement, the Company issued warrants to the licensor to purchase 20,000 shares of the Company's common stock with a fixed exercise price of $11.375 per share and a 10-year exercise period. On September 30, 1997, in conjunction with the draw down under the development loan facility with Johnson & Johnson, the Company issued a warrant to Johnson & Johnson to purchase 1,530,950 shares of the Company's common stock at an exercise price of $12.00 per share which expires on September 29, 2007 (see "Collaborative Agreements"). In April, 1999, in conjunction with a Services Agreement, the Company issued warrants to the holder to either purchase 50,000 shares of the Company's common stock with a fixed exercise price of $.96562 per share or convert this warrant into shares equal to the value of this warrant as determined per the Services Agreement. This warrant has a 2-year exercise period. The Company valued the warrant under the Black-Scholes methodology at $55,000, which was expensed as an additional cost of the transaction. On December 8, 1999, in conjunction with an Assignment Agreement, the Company issued warrants to the assignor to purchase 10,000 shares of the Company's common stock with a fixed exercise price of $3.313 per share and a 3-year exercise period. The Company valued the warrant under the Black-Scholes methodology at $57,000, which was expensed as an additional cost of the transaction. SHARES RESERVED FOR FUTURE ISSUANCE The following shares of common stock are reserved for future issuance at December 31, 1999: ISSUANCE OF PREFERRED/COMMON STOCK In March 1999, the Company raised $15 million through a private placement of 125,000 shares of Series A Preferred Stock at a price of $120.00 per share. The Series A Preferred Stock automatically converted to 12,594,009 shares of Common Stock on September 2, 1999. In October 1999, the Company raised $18.5 million in a private placement of shares of Common Stock. These funds were raised from a select group of institutional and private investors, predominately those investors who participated in the Company's March 1999 financing. 5. COLLABORATIVE AGREEMENTS JOHNSON & JOHNSON From June 1995 to August 1998, Amylin and Johnson collaborated on the development and commercialization of SYMLIN pursuant to a worldwide collaboration agreement. Under the collaboration agreement, Johnson & Johnson made payments to Amylin totaling approximately $174 million. These payments included funding of one-half of the SYMLIN development costs, draw downs from the development loan facility under a loan and security agreement, the purchase of $30 million of Amylin common stock, milestone, license and option fee payments, and the funding of SYMLIN pre-marketing costs. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Johnson & Johnson collaboration provided for, among other things, a fifty-fifty sharing arrangement whereby each party would be responsible for one-half of all development and commercialization costs and would share one-half of all profits derived from SYMLIN. As a result of Johnson & Johnson's withdrawal from the collaboration, Johnson & Johnson has relinquished its rights to share in SYMLIN profits. Additionally, following the collaboration termination in August 1998, all product and other rights associated with SYMLIN and related compounds reverted to Amylin, subject to the terms of the loan and security agreement. In conjunction with the collaboration, the Company received proceeds of approximately $30.6 million from a draw down under the development loan facility with Johnson & Johnson. The loan carries an interest rate of 9.0%. Additionally, as of December 31, 1999, the Company owed Johnson & Johnson approximately $13.4 million for its share of pre-launch marketing expenses. As of December 31, 1999, the total principal and interest due to Johnson & Johnson was approximately $50.6 million, which is $45,227,000 on the accompanying balance sheet, net of debt discount of $5,373,000 as of December 31, 1999. The Company estimates the fair value of this note to approximate market as the note is at market interest rates. In conjunction with the development loan borrowing, the Company issued warrants to Johnson & Johnson to purchase 1,530,950 shares of our common stock with a fixed exercise price of $12 per share and a SYMLIN 10-year exercise period. The development and marketing loans are secured by the Company's issued patents and patent applications relating to amylin, including those relating to SYMLIN. In September 1998, Amylin entered into a repurchase agreement with Ortho-Biotech, Inc., an affiliate of Johnson & Johnson, which provided that Johnson & Johnson will order and purchase certain amounts of SYMLIN from third party vendors and will place in inventory such amounts of SYMLIN for possible future purchase by Amylin. Johnson & Johnson will purchase the SYMLIN from certain vendors based upon agreed upon prices. The repurchase price of the compound shall be the same price paid by Johnson & Johnson to the supplier. Amylin must repurchase the SYMLIN in full on the first to occur of certain events, including the execution of our agreement with a major company relating to the development, commercialization and/or sale of SYMLIN, receipt of regulatory approval for the sale of SYMLIN, or change of control of Amylin. As of December 31, 1999, Ortho-Biotech had purchased inventory under this agreement totaling $8.5 million. In September 1998 the Company entered into an agreement with Ortho-Biotech, Inc. and Bachem for the assignment of the rights and obligations of Ortho-Biotech to purchase quantities of SYMLIN from Bachem under a July 1997 agreement among Amylin, Ortho-Biotech and Bachem. Pursuant to this agreement, Bachem has agreed to supply certain quantities of SYMLIN to Amylin over a period of several years. A portion of this material is inventory that Amylin has agreed to repurchase from Johnson & Johnson under the repurchase agreement discussed above. In connection with this agreement, Amylin has provided an irrevocable letter of credit in the amount $1,000,000 in favor of Bachem which is secured by an equal deposit included in the short term investment balance of $14.3 million as of December 31, 1999. AMYLIN PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. INCOME TAXES Significant components of Amylin's deferred tax assets as of December 31, 1999 and 1998 are shown below. A valuation allowance of $122,293,000, of which $12,471,000 is related to 1999 changes, has been recognized as of December 31, 1999 to offset the deferred tax assets as realization of such assets is uncertain. At December 31, 1999, Amylin had federal foreign tax net operating loss carryforwards of approximately $272,883,000, California foreign tax net operating loss carryforwards of approximately $31,510,000, and foreign tax net operating loss carryforwards of approximately $7,028,000. The difference between the federal and California tax loss carryforwards is attributable to the capitalization of research and development expenses for California tax purposes and the fifty percent limitation on California loss carryforwards. The federal tax carryforwards will begin expiring in 2002 unless previously utilized. The California tax loss carryforwards will continue to expire in 2000. The Company also has federal research and development tax credit carryforwards of $11,001,000, and California research and development tax credit carryforwards of $4,010,000, both of which will begin expiring in 2003 unless previously utilized. Pursuant to Internal Revenue Code Sections 382 and 383, the use of the Company's net operating loss and credit carryforwards may be limited if a cumulative change in ownership of more than 50% occurs within a three-year period. However, the Company does not believe that this type of limitation would have a material impact upon the future utilization of these carryforwards. 7. SUBSEQUENT EVENT In February, 2000, the Company announced that it received gross proceeds of $100 million from the sale of newly issued Common Stock priced at $12 per share to select institutional and individual investors in a private placement. The Company agreed to file a registration statement for these newly issued shares within 30 days of the closing of the transaction.

856386_1999.txt

856386_1999

1999

856386

Item 1. Business. Overview Gehl Company (the "Company" or "Gehl") designs, manufactures, sells and finances equipment used in the light construction equipment and the agriculture equipment industries. Construction equipment is comprised of skid steer loaders, telescopic handlers, asphalt pavers, mini-excavators, and mini- loaders and is sold to contractors, sub-contractors, owner operators, rental stores and municipalities. Agriculture equipment is sold to customers in the dairy and livestock industries, and includes a broad range of products including haymaking, forage harvesting, materials handling (skid steer loaders and attachments), manure handling and feedmaking equipment. The Company believes that it is one of the largest non-tractor agriculture equipment manufacturers in North America. On October 2, 1997, the Company acquired all of the issued and outstanding shares of capital stock of Brunel America, Inc. and Subsidiaries, including Mustang Manufacturing Company, Inc. ("Mustang") from Brunel Holdings, plc. Mustang designs, manufactures and sells skid steer loaders and related attachments. Gehl acquired the Brunel America, Inc. stock for $26.7 million; and entered into a five year non-competition agreement with the seller pursuant to which Gehl paid $1.0 million. The Company borrowed $27.7 million under its existing credit facility to fund the acquisition. The acquisition has been accounted for as a purchase transaction and the results of the Mustang operation have been included in the Company's operating results since the date of the acquisition. Construction equipment is manufactured in Minnesota, Pennsylvania and in two South Dakota facilities and Agriculture equipment is manufactured in plants in Wisconsin, Pennsylvania and South Dakota. The Company was founded in 1859 and was incorporated in the State of Wisconsin in 1890. The statements which are not historical facts contained in this Form 10-K and other information provided by the Company are forward-looking statements intended to qualify for the safe harbors from liability established by the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated. These factors include, without limitation, competitive conditions in the markets served by the Company, changes in the Company's plans regarding capital expenditures, general economic conditions, changes in commodity prices, especially milk, market acceptance of existing and new products offered by the Company, changes in the cost of raw materials and component parts purchased by the Company, and interest rate and foreign currency fluctuations. These factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. The Company undertakes no obligation to update publicly such statements to reflect subsequent events or circumstances. Business Segments The Company operates in two business segments, construction equipment and agriculture equipment. The following table shows certain information relating to the Company's segments: (dollars in thousands) Years ended December 31, 1997 1998 1999 Amount % Amount % Amount % Net sales: Construction Equipment $101,635 51.6% $156,008 59.5% $170,364 59.6% Agriculture Equipment 95,420 48.4 106,211 40.5 115,458 40.4 -------- ----- -------- ----- -------- ----- Total $197,055 100% $262,219 100% $285,822 100% Income from operations: Construction Equipment $16,277 74.5% $19,384 71.1% $23,661 67.5% Agriculture Equipment 5,571 25.5 7,894 28.9 11,396 32.5 -------- ----- -------- ----- -------- ----- Total $21,848 100% $27,278 100% $35,057 100% The Company had no intersegment sales or transfers during the years set forth above. For segment information with respect to identifiable assets, depreciation/amortization and capital expenditures for the construction equipment and agriculture equipment markets, see Note 13 of "Notes to Consolidated Financial Statements", included on Page 27 of the Gehl Company 1999 Annual Report to Shareholders, which pages are incorporated by reference herein. Construction Equipment Products: Construction equipment is marketed in the following five product areas: 1. Skid Steer Loaders - Six models of Gehl skid steer loaders are offered which feature a choice of hand-operated T-bar controls, hand only or hand and foot controls; and four models of Mustang skid steer loaders are offered which feature a choice of T-bar, hand only and hand/foot controls. The skid steer loader, with its fixed-wheel four-wheel drive, is used principally for material handling duties. The skid steer loader may also be used with a variety of attachments, including dirt, snow and cement buckets, pallet forks and hydraulically-operated devices such as cold planers, backhoes, brooms, trenchers, snowblowers, industrial grapples, tree diggers, concrete breakers, augers and many more. 2. Telescopic Handlers - Gehl markets nine models of Dynalift telescopic handlers and one model of the Dyna-Handler, rough-terrain telescopic forklifts, all with digging capabilities. These handlers are designed to handle heavy loads (up to 12,000 pounds) reaching horizontally and vertically (up to 55 ft.) for use by a variety of customers, including masons, roofers, building contractors and farmers. 3. Asphalt Pavers - Four models of Power Box pavers are marketed by Gehl. These pavers allow variable paving widths from 4 1/2 to 13 feet and are used for both commercial and municipal jobs such as county and municipal road, sidewalk, golf cart path, jogging trail, parking lot, driveway, trailer court and tennis court preparation. 4. Mini-excavators - Twelve models of mini-excavators are marketed under both Gehl and Mustang brand names. The units range in size from 1.5 metric ton to 8 metric ton. All units come standard with auxiliary hydraulics. An industry exclusive leveling system is offered on a number of models. These units can be equipped with a wide variety of attachments. 5. Mini-loaders - Gehl markets two models, one rigid frame and one articulated unit, of mini-loaders. The units are powered by a 20 h.p. engine and are the only mini-loaders offered in the industry where the operator is seated on the unit. Gehl believes that it offers the only mini-loader in the industry with articulated frame and telescopic boom features which enable the operator to complete a task without disturbing the underlying grass or soil. Marketing and Distribution: The Company maintains a separate distribution system for Construction equipment. The Company markets its Construction equipment in North America through 298 independent dealers (with 708 outlets) and worldwide through 80 distributors. The Company has no Company-owned dealers and its dealers may sell equipment produced by other construction equipment manufacturers. The top ten dealers and distributors of Construction equipment accounted for approximately 18% of the Company's sales for the year ended December 31, 1999; however, no single dealer or distributor accounted for more than 4% of the Company's sales for that period. Sales of the Construction equipment skid steer loader product line accounted for more than 25% of the Company's net sales in 1997, 1998 and 1999. Sales of the Construction equipment telescopic handler product line accounted for more than 21% of the Company's net sales in 1997, 1998 and 1999. The Company believes that maintenance and expansion of its dealer network is important to its success in the light construction equipment market. The Company also believes that it needs to continue to further develop sales relationships with key large rental companies to meet the demands of the changing marketplace. Various forms of support are provided for its Construction equipment dealers, including sales and service training, and, in the United States and Canada, floor plan financing for its dealers and retail financing for both its dealers and their customers. The light construction equipment dealers in North America are also supported by district sales managers who provide a variety of services, including training, equipment demonstrations and sales, warranty and service assistance, and regional field service representatives to assist in training and routine dealer service support functions. Industry and Competition: Gehl's Construction equipment product lines face competition in each of their markets. In general, each line competes with a small group of from seven to twelve different companies. The Company competes within the light construction equipment markets based primarily on price, quality, service and distribution. The primary markets for Gehl's Construction equipment outside of North America are in Europe, Australia, Latin America, the Middle East and the Pacific Rim. The Company believes it is a significant competitor in the skid steer loader market in most of these markets. Agriculture Equipment Products: Agriculture equipment is marketed in five product areas. 1. Haymaking - Gehl's haymaking line includes a broad range of products used to harvest and process hay crops for livestock feed. The Company offers disc mowers, a wide range of pull-type disc mower conditioners, hay rakes and variable-chamber round balers. 2. Forage Harvesting - The Company believes that it currently manufactures and sells one of the industry's most complete lines of forage harvesting equipment, including forage harvesters, wagons and blowers. 3. Material Handling - This line consists of six different models of Gehl skid steer loaders and the Dyna-Handler forklift. The skid steer loader is a compact, fixed-wheel four-wheel drive unit typically equipped with a bucket or fork and is used for moving a variety of material. The Dyna-Handler is a rough-terrain telescopic forklift with digging capabilities. The skid steer loader and Dyna- Handler forklift are marketed by dealers who handle Agriculture equipment and by dealers who handle Construction equipment. 4. Manure Handling - Gehl offers a broad range of manure spreaders, including the Scavenger "V-Tank" side-discharge manure spreader which incorporates a hydraulically controlled auger allowing the spreader to handle a wide range of semi-liquid waste products, including municipal sludge. For handling mostly solid manure, the Company also markets four models of rear-discharge box spreaders. 5. Feedmaking - The Company believes that it offers the broadest line of portable feedmaking equipment in the industry. The Company offers the Gehl Mix-All line of grinder mixers and a line of mixer feeders and a feeder wagon for both mixing feed rations and delivery to livestock feeders. Marketing and Distribution: In North America, Gehl's agricultural equipment is sold through approximately 385 geographically dispersed dealers (with 423 outlets). Fifty- four of these dealers are located in Canada. Agriculture equipment is also marketed through 21 distributors in Europe, the Middle East, the Pacific Rim and Latin America. The Company has no Company-owned dealers and its dealers may sell equipment produced by other agricultural equipment manufacturers. It has been and remains the Company's objective to increase the share of Gehl products sold by a Gehl dealer. Gehl is not dependent for its sales on any specific Agriculture dealer or group of dealers. The top ten dealers and distributors in Agriculture equipment accounted for approximately 5% of the Company's sales for the year ended December 31, 1999 and no one dealer or distributor accounted for over .7% of the Company's sales during that period. Sales of the Agriculture equipment skid steer loader product line accounted for more than 13% of the Company's net sales in 1997, 1998 and 1999. The Company provides various forms of support for its dealer network, including sales and service training. The Company also provides floor plan and retail finance support for products sold by its dealers in the United States and Canada. The Company employs district sales managers to assist its agricultural dealers in the promotion and sale of its product and regional service managers to assist in warranty and servicing matters. The Company currently operates three service parts distribution centers located in: Memphis, Tennessee; Syracuse, New York; and Minneapolis, Minnesota. The Company also contracts with two service parts distribution locations in Rockwood, Ontario and Saskatoon, Saskatchewan. Industry and Competition: The agriculture equipment industry has seen significant consolidation and retrenchment since 1980. This has served to reduce the total number of competitors, to strengthen certain major competitors, and to reduce the strength of certain other companies in the industry. The Company competes within the agriculture equipment industry based primarily on products sold, price, quality, service and distribution. The agriculture equipment markets in North America are highly competitive and require substantial capital outlays. The Company has four major competitors as well as numerous other limited line manufacturers and importers. The largest manufacturers in the agriculture equipment industry, the Company's major competitors, generally produce tractors and combines as well as a full line of tillage and planting equipment. Such manufacturers also market, to varying degrees, haymaking, forage harvesting, materials handling, manure handling and/or feedmaking equipment, the areas in which the Company's agriculture products are concentrated. No single competitor competes with the Company in each of its product lines. The Company believes that it is the only non-tractor manufacturer in the industry that produces equipment in each of these product lines. Smaller manufacturers which compete with the Company produce only a limited line of specialty items and often compete only in regional markets. Gehl's agriculture equipment is primarily distributed to customers in the dairy and livestock industries. Compared to a more volatile period in the late 1980's and early 1990's, milk prices, cash income, land values, and the general economy were more favorable and stable for the dairy farmer in the mid through late 1990's. These more favorable conditions and lower debt to equity ratios as compared with those generally experienced in most of the 1980's led to increased buying by farmers of agriculture equipment in 1993 and 1994. However, declines in the total number of farms prevented total industry demand to reach its 1989-1993 volume peaks in most product areas. In 1995-1999, industry market demand varied, with demand for the Company's products generally lower than its peak years. Approximately 90% of the Company's agriculture dealers also carry the tractor and combine product lines of a major manufacturer. In addition to selling the tractors and combines of a major manufacturer, many of these dealers carry the major manufacturer's entire line of products, some of which directly compete with Gehl's products offered. Dealers of Gehl's Agriculture equipment also market equipment manufactured by limited line manufacturers which compete with specific product lines offered by the Company. The primary markets for Gehl's Agriculture equipment outside of North America are in Europe and the Pacific Rim. In these markets, the Company competes with both agriculture equipment manufacturers from the United States, some of which have manufacturing facilities in foreign countries, and foreign manufacturers. The Company does not believe, however, that it is presently a significant competitor in any of these foreign markets. Backlog The backlog of unfilled equipment orders (which orders are subject to cancellation in certain circumstances) as of December 31, 1999 was $20.0 million versus $28.0 million at December 31, 1998. Virtually all orders in the backlog at December 31, 1999 are expected to be shipped in 2000. The decreased backlog at December 31, 1999 was due to the reduced levels of backlog for both Agriculture equipment and Construction equipment. This trend of decreasing backlog which, in general, has been occurring since 1994, is believed to be a function of dealer order patterns, pursuant to which dealers place orders at points in time closer to their expected need and due to the increased manufacturing capacity of the Company's plants, which has allowed the Company to supply equipment in a more expedited fashion. Given the segments that the Company ships into, there exists some seasonality in its sales trends, primarily in the Company's second and third quarter, which historically have tended to be its strongest quarters for sales, while sales levels have historically tended to be lower in the first and fourth quarters. Floor Plan and Retail Financing Floor Plan Financing: The Company, as is typical in the industry, generally provides floor plan financing for its dealers. Products shipped to dealers under the Company's floor plan financing program are recorded by the Company as sales and the dealers' obligations to the Company are reflected as accounts receivable. The Company provides interest-free floor plan financing to its dealers, for Construction equipment for varying periods of time generally up to six months and for Agriculture equipment generally for up to one year. Dealers who sell products utilizing floor plan financing are required to make immediate payment for those products to the Company upon sale or delivery to the retail customer. At the end of the interest-free period, if the equipment remains unsold to retail customers, the Company generally charges interest to the dealer at 3.25% above the prime rate or on occasion provides an interest- free extension of up to six months upon payment by the dealer of a curtailment of 25% of the original invoice price to the dealer. This type of floor plan equipment financing accounts for approximately 90% of Gehl's dealer accounts receivable, with all such floor planned receivables required to be secured by a first priority security interest in the equipment sold. Retail Financing: The Company also provides retail financing primarily to facilitate the sale of equipment to end users. Additionally, a number of dealers purchase equipment which is held for rental to the public. The Company also provides retail financing to such dealers in connection with these purchases. Retail financing in the United States is provided by the Company primarily through Gehl Finance, the Company's finance division. Retail financing is provided in Canada by third parties at rates subsidized by the Company. The Company does not offer or sponsor retail financing outside of North America. The Company maintains arrangements with third parties pursuant to which the Company sells, with recourse, certain of the Company's retail finance contracts. The finance contracts require periodic installments of principal and interest over periods of up to 60 months; interest rates are based on market conditions. The majority of these contracts have maturities of 12 to 48 months. The Company continues to service the finance contracts it sells, including cash collections. See Note 3 of "Notes to Consolidated Financial Statements," Page 22, and "Management's Discussion and Analysis," Pages 16 and 17 of the Gehl Company 1999 Annual Report to Shareholders, which pages are incorporated by reference herein. Employees As of December 31, 1999, the Company had 1,118 employees, of which 758 were hourly employees and 360 were salaried employees. At the production facilities in West Bend, Wisconsin, one of five Gehl production facilities, 230 hourly employees are covered by a collective bargaining agreement with the United Paperworkers International Union (formerly the Allied Industrial Workers) which expires January 10, 2003. None of the remaining employees of the Company are represented by unions. There have been no labor-related work stoppages at the Company's facilities during the past twenty-six years. Manufacturing The Company is currently expanding its South Dakota skid loader manufacturing facility and believes that its present manufacturing facilities, as expanded, will be sufficient to provide adequate capacity for its operations in 2000. Component parts needed in the manufacture of the Company's equipment are primarily produced by the Company. The Company obtains raw materials (principally steel), component parts that it does not manufacture, most notably engines and hydraulics, and supplies from third party suppliers. All such materials and components used are available from a number of sources. The Company is not dependent on any supplier that cannot be readily replaced and has not experienced difficulty in obtaining necessary purchased materials. In addition to the equipment it manufactures, the Company markets equipment acquired from third party suppliers. Products acquired from these suppliers accounted for less than 10% of the Company's sales in 1999. Research and Development The Company attempts to maintain and strengthen its market position through internal new product development and incremental improvements to existing products. The Company's research and development is devoted to developing new products that meet specific customer needs and to devising incremental improvements to existing products. Research and development performed by the Company includes the designing and testing of new and improved products as well as the fabrication of prototypes. The Company expended approximately $3.0 million, $2.8 million and $2.3 million on research and development for the years ended December 31, 1999, 1998 and 1997, respectively. Patents and Trademarks The Company possesses rights under a number of domestic and foreign patents and trademarks relating to its products and business. While the Company considers the patents and trademarks important in the operation of its business, including the Gehl name, the Mustang name, the Dynalift name and the group of patents relating to the Scavenger manure spreader, the business of the Company is not dependent, in any material respect, on any single patent or trademark or group of patents or trademarks. Export Sales Information regarding the Company's export sales is included in Note 13 of "Notes to Consolidated Financial Statements," Page 27, of the Gehl Company 1999 Annual Report to Shareholders, which page is incorporated by reference herein. Item 2. Item 2. Properties. The following table sets forth certain information as of December 31, 1999, relating to the Company's principal manufacturing facilities. See "Management's Discussion and Analysis - Liquidity and Capital Resources, Capital Expenditures," Page 16, of the Gehl Company 1999 Annual Report to Shareholders, which page is incorporated by reference herein. For information regarding collateral pledges, see Note 6 of "Notes to Consolidated Financial Statements", included on Page 23, of the Gehl Company 1999 Annual Report to Shareholders, which page is incorporated by reference herein. Approximate Owned or Principal Uses Floor Area Leased in Square Feet West Bend, WI 450,000 Owned General offices and engineering, research and development and manufacture of Agriculture equipment Madison, SD 130,000 Owned Manufacture of Gehl skid steer loaders for dealers of Construction equipment and Agriculture equipment Lebanon, PA 170,000 Owned(1) Manufacture of Agriculture equipment and Construction equipment Yankton, SD 130,000 Owned Manufacture of Construction equipment Owatonna, MN 235,000 Owned Manufacture of Mustang skid steer loaders (1) This facility is financed with the proceeds from the sale of industrial development bonds maturing in 2010. The Company also operates three service parts centers located in: Memphis, Tennessee; Syracuse, New York; and Minneapolis, Minnesota. The Company leases these facilities, except for the Minneapolis center which is owned. The leases have terms ranging from three to five years. The Company anticipates no difficulty in retaining adequate leased facilities, either by renewing existing leases prior to expiration or by replacing them with equivalent leased facilities. Item 3. Item 3. Legal Proceedings. The Company is a defendant from time to time in actions for product liability and other matters arising out of its ordinary business operations. The Company believes that the actions presently pending will not have a material adverse effect on its consolidated financial position or results of operations. To the Company's knowledge, there are no material legal proceedings to which any director, officer, affiliate or more than 5% shareholder of the Company (or any associate of the foregoing persons) is a party adverse to the Company or any of its subsidiaries or has a material interest adverse to the Company or its subsidiaries. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders during the quarter ended December 31, 1999. Executive Officers of the Registrant. Set forth below is certain information concerning the executive officers of the Company as of February 1, 2000: Name, Age and Position Business Experience William D. Gehl, 53, Mr. Gehl has served as Chairman of the Board Chairman, President, Chief of Directors of the Company since April, 1996. Executive Officer and Mr. Gehl has served as President and Chief Director Executive Officer of the Company since November, 1992 and has served as a director of the Company since 1987. From January, 1990 until joining the Company, Mr. Gehl served as Executive Vice President, Chief Operating Officer, General Counsel and Secretary of The Ziegler Companies, Inc. (a financial services holding company). Mr. Gehl held various senior managment positions with The Ziegler Companies from 1978 to 1990. Malcolm F. Moore, 49, Mr. Moore has served as Executive Vice Executive Vice President President and Chief Operating Officer and Chief Operating Officer since joining the Company in August, 1999. From 1997 to 1999, Mr. Moore was associated with the Moore Group (a private investment consulting firm focused on the thermal processing equipment industry). From 1996 to 1997, Mr. Moore served as President and Chief Executive Officer of Pangborn Corporation (a manufacturer of blast cleaning and surface preparation systems and equipment). From 1993 to 1996, Mr. Moore served as President of LINAC Holdings, (the U.S. financial Holding Co. for all the U.S. based thermal processing equipment companies owned by Ruhrgas AG). Kenneth P. Hahn, 42, Mr. Hahn joined the Company as Corporate Vice President of Finance, Controller in April, 1988. Mr. Hahn was Treasurer and Chief appointed Vice President of Finance and Financial Officer Treasurer in February, 1997 and became Chief Financial Officer in January, 1999. Michael J. Mulcahy, 53, Mr. Mulcahy has served as General Counsel Vice President, Secretary of the Company since 1974 and became and General Counsel Secretary in 1977 and a Vice President in 1986. Mr. Mulcahy has also served, since 1988, as President of Equipco Insurance Company, Ltd., which provides liability insurance coverage for equipment manufacturers, including the Company. Richard J. Semler, 60, Mr. Semler joined the Company in May, 1960 Vice President of and has servied in his current position with Data Systems the Company since January, 1977. All officers of the Company are elected annually by the Board of Directors following the Annual Meeting of Shareholders. The 2000 Annual Meeting of Shareholders is currently scheduled for April 20, 2000. The Company has an employment agreement with William D. Gehl, pursuant to which he is to serve as President and Chief Executive Officer of the Company through the expiration of the agreement on December 31, 2001. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters. Pursuant to the terms of the Gehl Company Director Stock Grant Plan, each of the non-employee directors of the Company (i.e., Messrs. N.C. Babson, T. J. Boldt, F. M. Butler, J. T. Byrnes, W. P. Killian, A. W. Nesbitt, J. W. Splude and H. Viets) received on December 31, 1999 a grant of shares of Company common stock as part of their annual retainer fee. An aggregate of 1,183 shares of Company common stock were granted under the Director Stock Grant Plan. These shares were issued in transactions exempt from registration under Section 4(2) of the Securities Act of 1933, as amended. Information required by this item is also included on Pages 28 and 29 of the Gehl Company 1999 Annual Report to Shareholders, which pages are hereby incorporated herein by reference. Item 6. Item 6. Selected Financial Data. Information required by this item is included on Page 28 of the Gehl Company 1999 Annual Report to Shareholders, which page is hereby incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Information required by this item is included on Pages 14 through 17 of the Gehl Company 1999 Annual Report to Shareholders, which pages are hereby incorporated herein by reference. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Information required by this item is included on Page 17 of the Gehl Company 1999 Annual Report to Shareholders, which page is hereby incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. Information required by this item is included on Page 13 and Pages 18 through 27 of the Gehl Company 1999 Annual Report to Shareholders, which pages are hereby incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. There have been no changes in or disagreements with the Company's accountants regarding accounting and financial disclosure required to be reported pursuant to this item. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Pursuant to Instruction G, the information required by this item with respect to directors is hereby incorporated herein by reference from the caption entitled "Election of Directors" set forth in the Company's definitive Proxy Statement for its 2000 Annual Meeting of Shareholders ("Proxy Statement")1. Information with respect to executive officers of the Company appears at the end of Part I, Pages 8 through 9 of this Annual Report on Form 10-K. Item 11. Item 11. Executive Compensation. Pursuant to Instruction G, the information required by this item is hereby incorporated herein by reference from the captions entitled "Board of Directors" and "Executive Compensation" set forth in the Proxy Statement; provided, however, that the subsection entitled "Executive Compensation - Report on Executive Compensation" shall not be deemed to be incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Pursuant to Instruction G, the information required by this item is hereby incorporated by reference herein from the caption "Principal Shareholders" set forth in the Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. There are no relationships or related transactions to be reported pursuant to this item. ______________________________________________________________________________ 1 The Proxy Statement will be filed with the Commission pursuant to Regulation 14A within 120 days after the end of the Company's fiscal year. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1 and 2. Financial statements and financial statement schedule. Reference is made to the separate index to the Company's consolidated financial statements and schedule contained on Page 14 hereof. 3. Exhibits. Reference is made to the separate exhibit index contained on Pages 17 through 21 hereof. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Company during the quarter ended December 31, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GEHL COMPANY Date: February 25, 2000 By /s/ William D. Gehl William D. Gehl, Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ William D. Gehl Chairman of the Board, President, February 25, 2000 William D. Gehl Chief Executive Officer and Director (Principal Executive Officer) /s/ Kenneth P. Hahn Vice President of Finance February 25, 2000 Kenneth P. Hahn and Treasurer (Principal Financial and Accounting Officer) /s/ Nicholas C. Babson Director February 25, 2000 Nicholas C. Babson /s/ Thomas J. Boldt Director February 25, 2000 Thomas J. Boldt /s/ Fred M. Butler Director February 25, 2000 Fred M. Butler /s/ John T. Byrnes Director February 25, 2000 John T. Byrnes /s/ William P. Killian Director February 25, 2000 William P. Killian /s/ Arthur W. Nesbitt Director February 25, 2000 Arthur W. Nesbitt /s/ John W. Splude Director February 25, 2000 John W. Splude /s/ Dr. Hermann Viets Director February 25, 2000 Dr. Hermann Viets GEHL COMPANY INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page(s) in Annual Report* The following documents are filed as part of this report: (1)Financial Statements: Report of Independent Accountants 13 Consolidated Balance Sheets at December 31, 1999 and 1998 18 Consolidated Statements of Income for the three years ended December 31, 1999 19 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1999 19 Consolidated Statements of Cash Flows for the three years ended December 31, 1999 20 Notes to Consolidated Financial Statements 21-27 * Incorporated by reference from the indicated pages of the Gehl Company 1999 Annual Report to Shareholders. Page in Form 10-K (2)Financial Statement Schedule: Report of Independent Accountants on Financial Statement Schedule 15 For the three years ended December 31, 1999 -- Schedule II - Valuation and Qualifying Accounts 16 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Gehl Company Our audits of the consolidated financial statements referred to in our report dated February 10, 2000 appearing in the 1999 Annual Report to Shareholders of Gehl Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICEWATERHOUSECOOPERS LLP Milwaukee, Wisconsin February 10, 2000 GEHL COMPANY AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (in thousands) Additions ------------------- Balance at Charged to Balance Beginning Costs and Acquired at end Period Description of Year Expenses Balances Deductions of Year - ------ ----------- --------- ---------- -------- ---------- ------- Year Ended December 31, Allowance for Doubtful Accounts- Trade Receivables. $ 561 $ 144 $ 313 $ 25 $ 993 Returns and Dealer Discounts 1,879 2,674 - 2,705 1,848 Product Discontinuance 775 - - 458 317 ------ ------ ----- ------ ------ Total $3,215 $2,818 $ 313 $3,188 $3,158 ====== ====== ====== ====== ====== Allowances of Doubtful Accounts - Retail Contracts . . $ 591 $355 $ 28 $ 91 $ 883 ====== ====== ====== ====== ====== Inventory Obsolescence Reserve $1,740 $576 $ 265 $ 982 $1,599 ====== ====== ====== ====== ====== Income Tax Valuation Allowance . . $1,235 $ - $ - $ 268 $ 967 ====== ====== ====== ====== ====== Year Ended December 31, Allowance for Doubtful Accounts- Trade Receivables $ 993 $ 383 $ - $ 71 $1,305 Returns and Dealer Discounts 1,848 3,644 - 3,243 2,249 Product Discontinuance 317 (243) - 74 - ------ ------ ------ ------ ------ Total $3,158 $3,784 $ - $3,388 $3,554 ====== ====== ====== ====== ====== Allowances of Doubtful Accounts - Retail Contracts . . $ 883 $ 280 $ - $ 170 $ 993 ====== ====== ====== ====== ====== Inventory Obsolescence Reserve $1,599 $ 722 $ - $ 613 $1,708 ====== ====== ====== ====== ====== Income Tax Valuation Allowance . . $ 967 $ - $ - $ 113 $ 854 ====== ====== ====== ====== ====== Year Ended December 31, Allowance for Doubtful Accounts- Trade Receivables . $1,305 $ 557 $ - $ 175 $1,687 Returns and Dealer Discounts 2,249 5,075 - 4,563 2,761 ------ ------ ------ ------ ------ Total $3,554 $5,632 $ - $4,738 $4,448 ====== ====== ====== ====== ====== Allowances of Doubtful Accounts - Retail Contracts . . $ 993 $ 810 $ - $ 299 $1,504 ====== ====== ====== ====== ====== Inventory Obsolescence Reserve $1,708 $ 647 $ - $ 613 $1,742 ====== ====== ====== ====== ====== Income Tax Valuation Allowance . . $ 854 $ - $ - $ 308 $ 546 ====== ====== ====== ====== ====== GEHL COMPANY INDEX TO EXHIBITS Exhibit Number Document Description (2) Stock Purchase Agreement, dated as of September 12, 1997, between Gehl Company and Brunel Holdings, plc [Incorporated by reference to Exhibit 2 of the Company's Current Report on Form 8-K, dated October 17, 1997] (3.1) Restated Articles of Incorporation, as amended, of Gehl Company [Incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 28, 1997.] (3.2) By-laws of Gehl Company, as amended [Incorporated by reference to Exhibit 3.3 of the Company s Annual Report on Form 10-K for the year ended December 31, 1998] (4.1) Amended and Restated Loan and Security Agreement by and between ITT Commercial Finance Corp. and Gehl Company and its subsidiaries, dated October 1, 1994 [Incorporated by reference to Exhibit 4.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1994] (4.2) First Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, f/k/a ITT Commercial Finance Corp. and Gehl Company and its subsidiaries, dated May 10, 1995 [Incorporated by reference to Exhibit 4.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended July 1, 1995] (4.3) Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, f/k/a ITT Commercial Finance Corp., Deutsche Financial Services Canada Corporation and Gehl Company and its subsidiaries, dated December 1, 1995 [Incorporated by reference to Exhibit 4.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995] (4.4) Third Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, Deutsche Financial Services Canada Corporation and Gehl Company and its subsidiaries, dated as of July 15, 1996 [Incorporated by reference to Exhibit 4.4 of the Company s Annual Report on Form 10-K for the year ended December 31, 1997] (4.5) Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, Deutsche Financial Services Canada Corporation and Gehl Company and its subsidiaries, dated October 2, 1997 [Incorporated by reference to Exhibit 4.1 of the Company's Current Report on Form 8-K dated October 17, 1997] (4.6) Fifth Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, Deutsche Financial Services, a division of Deutsche Bank Canada, and Gehl Company and its subsidiaries, dated as of February 5, 1998 [Incorporated by reference to Exhibit 4.6 of the Company s Annual Report on Form 10-K for the year ended December 31, 1997] (4.7) Sixth Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, Deutsche Financial Services, a division of Deutsche Bank Canada and Gehl Company and its subsidiaries, dated as of June 1, 1998 [Incorporated by reference to Exhibit 4.1 of the Company s Quarterly Report on Form 10-Q for the quarter ended June 27, 1998] (4.8) Seventh Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, Deutsche Financial Services, a division of Deutsche Bank Canada and Gehl Company and its subsidiaries, dated as of September 1, 1998 [Incorporated by reference to Exhibit 4.1 of the Company s Quarterly Report on Form 10-Q for the quarter ended September 26, 1998] (4.9) Eighth Amendment to Amended and Restated Loan and Security Agreement by and between Deutsche Financial Services Corporation, Deutsche Financial Services, a division of Deutsche Bank Canada and Gehl Company and its subsidiaries, dated as of December 30, 1999 (4.10) Loan Agreement between Pennsylvania Economic Development Financing Authority and Gehl Company, dated as of September 1, 1990 [Incorporated by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 29, 1990] (4.11) First Supplemental Loan Agreement between Pennsylvania Economic Development Financing Authority and Gehl Company, dated as of April 23, 1993 [Incorporated by reference to Exhibit 4.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1993] (4.12) Second Supplemental Loan Agreement between Pennsylvania Economic Development Financing Authority and Gehl Company, dated as of February 1, 1994 [Incorporated by reference to Exhibit 4.10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993] (4.13) Mortgage and Security Agreement by and between Gehl Company and First Pennsylvania Bank N.A., dated as of September 1, 1990 [Incorporated by reference to Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 29, 1990] (4.14) Rights Agreement, dated as of May 28, 1997, between Gehl Company and Firstar Bank Milwaukee N.A.(as successor to Firstar Trust Company) [Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form 8-A, dated as of May 28, 1997] (4.15) Loan Agreement by and between South Dakota Board of Economic Development and Gehl Company, dated May 26, 1998 [Incorporated by reference to Exhibit 4.2 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 27, 1998] (4.16) Promissory Note signed by Gehl Company payable to South Dakota Board of Economic Development, dated May 26, 1998 [Incorporated by reference to Exhibit 4.3 of the Company s Quarterly Report on Form 10-Q for the quarter ended June 27, 1998] (4.17) Mortgage by and between Gehl Company and South Dakota Board of Economic Development, dated May 26, 1998 [Incorporated by reference to Exhibit 4.4 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 27, 1998] (4.18) Employment Agreement by and between Gehl Company and South Dakota Board of Economic Development, dated May 26, 1998 [Incorporated by reference to Exhibit 4.5 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 27, 1998] (4.19) Loan Agreement by and between the City of Madison, a political subdivision of the State of South Dakota, and Gehl Company, dated September 8, 1998 [Incorporated by reference to Exhibit 4.2 of the Company s Quarterly Report on Form 10-Q for the quarter ended September 26, 1998] (4.20) Promissory Note signed by Gehl Company payable to the City of Madison, a political subdivision of the State of South Dakota, dated September 8, 1998 [Incorporated by reference to Exhibit 4.3 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998] (4.21) Mortgage by and between Gehl Company and the City of Madison, a political subdivision of the State of South Dakota, dated September 8, 1998 [Incorporated by reference to Exhibit 4.4 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998] (10.1)* Form of Supplemental Retirement Benefit Agreement between Gehl Company and Messrs. Hahn, Moore, Mulcahy and Semler [Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1999] (10.2)* Gehl Company Director Stock Grant Plan [Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 29, 1997] (10.3)* Amendment to Amended and Restated Employment Agreement between Gehl Company and William D. Gehl dated as of December 18, 1998 [Incorporated by reference to Exhibit 10.3 of the Company s Annual Report on Form 10-K for the year ended December 31, 1998] (10.4)* Supplemental Retirement Benefit Agreement by and between William D. Gehl and Gehl Company [Incorporated by reference to Exhibit 10.4 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995] (10.5)* Gehl Company Shareholder Value Added Management Incentive Compensation Plan [Incorporated by reference to Exhibit 10.6 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995] (10.6)* Gehl Savings Plan, as amended and restated executed March 17, 1997 [Incorporated by reference to Exhibit 10.8 of the Company's Annual Report on Form 10-K for the year ended December 31, 1997] (10.7)* Gehl Company Retirement Income Plan "B", as amended [Incorporated by reference to Exhibit 10.7 to the Company's Annual Report on Form 10-K for the year ended December 31, 1994] (10.8)* Gehl Company 1987 Stock Option Plan, as amended [Incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996] (10.9)* Form of Stock Option Agreement used in conjunction with the Gehl Company 1987 Stock Option Plan [Incorporated by reference to Exhibit 4.2 to the Company's Form S-8 Registration Statement (Reg. No. 33-38392)] (10.10)* Gehl Company 1995 Stock Option Plan, as amended [Incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996] (10.11)* Form of Stock Option Agreement for executive officers used in conjunction with the Gehl Company 1995 Stock Option Plan [Incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995] (10.12)* Form of Stock Option Agreement for non-employee directors used in conjunction with the Gehl Company 1995 Stock Option Plan [Incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995] (10.13)* Form of Change in Control and Severance Agreement between Gehl Company and Messrs. Hahn, Mulcahy and Semler [Incorporated by reference to Exhibit 10-14 of the Company' Annual Report on Form 10-K for the year ended December 31, 1998] (10.14) Technical Assistance and License Agreement by and between Gehl Company and Rheiner Maschinenfabrik Windhoff AG, dated as of May 4, 1985, as amended [Incorporated by reference to Exhibit 10.13 to the Company's Form S-1 Registration Statement (Reg. No. 33-31571)] (10.15) Distributorship Agreement by and between Gehl Company and Gehl GmbH, dated as of April 15, 1985 [Incorporated by reference to Exhibit 10.16 to the Company's Form S-1 Registration Statement (Reg. No. 33-31571)] (10.16) Trademark Licensing Agreement by and between Gehl Company and Gehl GmbH, dated as of April 15, 1985 [Incorporated by reference to Exhibit 10.17 to the Company's Form S-1 Registration Statement (Reg. No. 33-31571)] (13) Portions of the Gehl Company 1999 Annual Report to Shareholders that are incorporated by reference herein (21) Subsidiaries of Gehl Company [Incorporated by reference to Exhibit 21 of the Company's Annual Report of Form 10-K for the year ended December 31, 1998] (23) Consent of PricewaterhouseCoopers LLP (27) Financial Data Schedule (99) Proxy Statement for 2000 Annual Meeting of Shareholders (To be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of the Company's fiscal year; except to the extent incorporated by reference, the Proxy Statement for the 2000 Annual Meeting of Shareholders shall not be deemed to be filed with the Securities and Exchange Commission as part of this Annual Report on Form 10-K) * A management contract or compensatory plan or arrangement. Except as otherwise noted, all documents incorporated by reference are to Commission File No. 0-18110.

1067054_1999.txt

1067054_1999

1999

1067054

ITEM 3. LEGAL PROCEEDINGS. Metallurg, Inc. and certain of its subsidiaries are parties to a variety of legal proceedings relating to their operations. The ultimate legal and financial liability of Metallurg in respect of all legal proceedings in which it is involved cannot be estimated with any certainty. However, based upon examination of such matters and consultation with counsel, management does not expect that the ultimate outcome of these contingencies, net of liabilities already accrued in Metallurg's Consolidated Balance Sheet, will have a material adverse effect on Metallurg's consolidated financial position, although the resolution in any reporting period of one or more of these matters could have a significant impact on Metallurg's results of operations and/or cash flows for that period. For discussion of environmental matters, see "Items 1 and 2. Business and Properties - - Environmental Matters." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year ended January 31, 1999. PART II ITEM 5. ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Metallurg Holdings was formed on June 10, 1998 with 1,000 shares of common stock, par value $.01, authorized. On June 29, 1998, the Company issued 350 such shares. At the time of the Merger, this common stock was cancelled and the total number of shares of all classes of stock which Metallurg Holdings was authorized to issue was increased to 50,000 shares, of which 30,000 shares were designated Common Stock, $.01 par value ("Common Stock"), 10,000 shares were designated Series A Voting Convertible Preferred Stock, $.01 par value ("Series A Preferred Stock") and 10,000 shares were designated Series B Non-Voting Convertible Preferred Stock, $.01 par value ("Series B Preferred Stock"). In connection with the Merger, 5,202.335 shares of Series A Preferred Stock and 4,500 shares of Series B Preferred Stock were issued. In December 1998, an additional 24 shares of Series B Preferred Stock were issued. At January 31, 1999, no Common Stock was issued and outstanding; however, 5,202.335 shares of Series A Preferred Stock and 4,524 shares of Series B Preferred Stock were issued and outstanding. On July 13, 1998, Metallurg, Inc. was acquired by a group of investors led by and including Safeguard International. The acquisition was accomplished by Metallurg Acquisition Corp., a Delaware corporation and a wholly owned subsidiary of Metallurg Holdings, merging with and into Metallurg, Inc., with Metallurg, Inc. being the surviving company and Metallurg Holdings becoming the sole parent of Metallurg, Inc. Metallurg Holdings was formed on June 10, 1998 and is owned by Safeguard International (an international private equity fund that invests primarily in equity securities of companies in process industries), certain limited partners of Safeguard International, certain individuals and a private equity fund which is associated with Safeguard International. At the time of the Merger, each outstanding share of Metallurg, Inc. common stock was converted into the right to receive $30 in cash. In connection with the Merger, Metallurg, Inc. received the consents of 100% of the registered holders of its 11% Senior Notes due 2007 to a one-time waiver of the change of control provisions of the Senior Note Indenture to make such provisions inapplicable to the Merger and to amend the definition of "Permitted Holders" under the Senior Note Indenture to reflect the post-Merger ownership of Metallurg, Inc. No other modifications to terms of outstanding debt were affected in this regard. As of July 13, 1998, in connection with the Merger, all of the then outstanding shares of common stock of Metallurg, Inc. were cancelled and 100 shares of common stock, $0.01 par value, were issued to Metallurg Holdings. On November 20, 1998, Metallurg, Inc. consummated a 50,000 for 1 stock split and, as a result, Metallurg, Inc. has 5,000,000 shares of common stock, $0.01 par value, outstanding, all of which are owned by Metallurg Holdings and all of which are pledged as security to the holders of Metallurg Holdings' Senior Discount Notes. There is no public trading market for the Company's equity securities On July 13, 1998, Metallurg Holdings sold $121,000,000 of its 123/4% Senior Discount Notes due 2008. The offering was made pursuant to Rule 144A of the Securities Act of 1933, as amended, through BancBoston Securities, Inc. The 144A notes were subsequently exchanged for similar notes registered under the Securities Act of 1933, as amended. On November 20, 1998, the Board of Directors of Metallurg, Inc. adopted the Metallurg, Inc. 1998 Equity Compensation Plan (the "ECP"), to provide (i) designated employees of Metallurg, (ii) certain Key Advisors, as defined in the plan, and advisors who perform services for Metallurg and (iii) non-employee members of the Board of Directors of Metallurg, Inc. (the "Board") with the opportunity to receive grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock and performance units. Under the ECP, 500,000 shares of common stock were made available for stock awards and stock options. Metallurg believes that the ECP will encourage the participants to contribute materially to the growth of Metallurg, thereby benefiting Metallurg's shareholders, and will align the economic interests of the participants with those of the shareholders. Pursuant to the ECP, Metallurg's Board awarded to eligible executives and non-employee Board members options to purchase up to 450,000 and 12,500 shares of common stock at an exercise price of $30.00 per share, effective as of November 20, 1998 and January 4, 1999, respectively. Such options have a term of ten years and vest 20% on the date of grant and will vest 20% on each of the first four anniversaries of the date of grant. Prior to the Merger, 15,000,000 shares of common stock of Metallurg, Inc. were authorized; subsequent to November 1998, 10,000,000 shares of common stock of Metallurg, Inc. were authorized. On April 14, 1997, Metallurg, Inc. issued 4,706,406 shares of new common stock to prepetition unsecured claimholders and $39,461,000 of senior-secured notes pursuant to the Reorganization Plan. These 12% senior-secured notes were retired with the proceeds of the Senior Notes Offering described below. On April 14, 1997, Metallurg, Inc. adopted the Metallurg, Inc. Management Stock Award and Stock Option Plan (the "SASOP"), which was to be administered by the Compensation Committee of the Board for a term of 10 years. Under terms of the SASOP, the Board was to grant stock awards and stock options (including incentive stock options, nonqualified stock options or a combination of both) to officers and key employees of Metallurg. Under the SASOP, 500,000 shares of common stock were made available for stock awards and stock options. Pursuant to the plan, the Board granted to eligible executives 250,000 shares of common stock (the "Initial Stock Awards") which had a fair value at the date of grant of $10 per share. Twenty percent of each Initial Stock Award was transferable on the date of grant and Metallurg, Inc. recognized compensation expense of $500,000 at March 31, 1997. An additional 40% was to become transferable on each of the first and second anniversary of the date of grant and compensation expense was to be charged to earnings ratably over this restriction period. Additionally, the Board granted to eligible employees options to purchase 167,000 shares of common stock at an exercise price of $11.38 (fair market value on the date of grant), effective as of September 1, 1997 and 20,000 shares of common stock at $8.43 (fair market value on the date of grant), effective as of April 1, 1998. Such options vested 33 1/3% on the date of grant and another 33 1/3% were to vest on each of the first and second anniversary of the date of grant. At the time of the Merger, the Initial Stock Awards then outstanding became fully vested and Metallurg, Inc. recorded additional compensation expense of approximately $355,000. In addition, outstanding stock options became fully vested and holders were therefore entitled to receive $30 per share as part of the purchase of Metallurg, Inc. Metallurg, Inc. recorded compensation expense of $3,541,000, which represents the excess of the $30 per share purchase price over the exercise price noted above. Metallurg Inc. was reimbursed for such stock option cancellation costs by a capital contribution from Safeguard International at the time of the Merger. On November 20, 1997, Metallurg, Inc. paid a special dividend of $3.90 per share to the holders of Metallurg, Inc.'s common stock and a dividend equivalent to the holders of stock options then outstanding. Also on November 20, 1997, Metallurg, Inc. sold $100,000,000 of 11% Senior Notes due 2007. The offering was made pursuant to Rule 144A under the Securities Act of 1933, as amended, through Salomon Brothers, Inc. and BancBoston Securities, Inc. as initial purchasers. The Rule 144A notes were subsequently exchanged for similar notes registered under the Securities Act of 1933, as amended. The net proceeds of the Senior Notes Offering were approximately $96,000,000. Metallurg used the proceeds to (i) retire Metallurg's 12% senior-secured notes due 2007 ($42,953,000, including interest and prepayment penalty), (ii) repay the outstanding balance of the German Subfacility (but not reduce the commitment thereunder) ($11,666,000), (iii) retire the LSM Term Loan Facility ($8,529,000, including prepayment penalty) and (iv) pay a cash dividend and dividend equivalent to the holders of Metallurg, Inc.'s common stock and stock options ($19,891,000). The remaining net proceeds of the 11% Senior Notes due 2007 were for general corporate purposes. "German Subfacility" and "LSM Term Loan Facility" are defined in "Item 8. Financial Statements and Supplementary Data." Other than as set forth above in this section, the Company issued no securities during 1998. Metallurg Holdings does not presently intend to pay any dividends, although it may choose to do so in the future. Metallurg Holdings is restricted from paying dividends to its shareholders as a result of the Indenture relating to the offering of its Senior Discount Notes, which, in general, prohibits Metallurg Holdings from making dividends in an amount greater than 50% of its net income, as defined in the Indenture. Metallurg, Inc. is restricted from paying dividends to its shareholders as a result of the Indenture related to the Senior Notes Offering, which also, in general, prohibits Metallurg, Inc. from making dividends in an amount greater than 50% of its net income, as defined in the Indenture. In addition, Metallurg, Inc.'s revolving credit facility with BankBoston prohibits the payment of dividends. Metallurg Holdings is a holding company with limited operations of its own. Substantially all of Metallurg Holdings' operating income is generated by its subsidiaries. As a result, Metallurg Holdings' will rely upon distributions or advances from its subsidiaries to provide the funds necessary to meet its debt service obligations. In some cases, however, Metallurg Holding's subsidiaries are restricted in their ability to pay dividends. Prior to 1998, Metallurg's German subsidiaries, EWW, in which Metallurg, Inc. owns a 98.0% interest, and GfE, in which Metallurg, Inc. owns a 99.2% interest, were prohibited from paying dividends under German law because their stated capital as reported in the commercial register was higher than their actual capital as reported under German accounting principles. In 1998, Metallurg made certain filings to reduce the stated capital of its German operating subsidiaries which eliminated such statutory restrictions on the payment of dividends. Metallurg's Turkish subsidiary is limited in its ability to pay dividends from retained earnings, as a result of historical currency devaluation. In addition, working capital facilities and other financing arrangements at Metallurg's subsidiaries restrict such subsidiaries' ability to pay dividends. For example, EWW must obtain the consent of a German governmental authority, which guarantees a portion of EWW's DM 15 million (approximately $9 million) working capital facility, in order to pay dividends to Metallurg. EWW's ability to pay dividends to Metallurg is also restricted by the terms of a settlement arrangement entered into with a German state pension board with regard to its pension liability. The stock of EWW has been pledged to secure obligations owed by EWW to the German governmental authority and the German state pension board. LSM is party to a working capital facility which limits its ability to pay dividends in an amount of up to 100% of LSM's annual net income. In addition, Metallurg's Swiss merchanting subsidiary may only pay dividends to Metallurg in amounts up to 50% of its net income. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table presents selected historical financial data (dollars in thousands) of Metallurg Holdings for the period June 10, 1998 (inception) to January 31, 1999. Metallurg Holdings' results of operations and financial position reflect the acquisition of Metallurg on July 13, 1998. The acquisition was accounted for as a purchase and accordingly, Metallurg Holdings' consolidated financial statements are not directly comparable to prior period financial data presented herein. Also presented are selected historical financial data of Metallurg for each of the years in the three-year period ended December 31, 1996, the three months ended March 31, 1996, the nine months ended December 31, 1996, the quarter ended March 31, 1997, the three quarters ended January 31, 1998, and the year ended January 31, 1999. Information as of December 31, 1994 and 1995 and for the year ended December 31, 1994 is derived from the consolidated financial statements of Metallurg, which have been audited by Deloitte & Touche LLP, independent public accountants. The information as of March 31, 1997 and January 31, 1998 and for the year ended December 31, 1996, for the quarter ended March 31, 1997 and for the three quarters ended January 31, 1998 is derived from the consolidated financial statements of Metallurg included elsewhere herein, which have been audited by Deloitte & Touche LLP, independent public accountants. The information as of January 31, 1999 and for the year ended January 31, 1999 is derived from the consolidated financial statements of Metallurg Holdings and Metallurg, included elsewhere herein, which have been audited by PricewaterhouseCoopers LLP, independent accountants. The selected financial data for Metallurg as of March 31, 1996 and for the three months ended March 31, 1996, and for the nine months ended December 31, 1996 are unaudited and reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results of operations for such periods. Financial information contained herein for periods after March 31, 1997 reflects the effects of the Reorganization Plan, including the implementation of fresh-start reporting, as of March 31, 1997. Accordingly, Metallurg's consolidated financial statements for periods and dates prior to March 31, 1997 are not directly comparable to subsequent consolidated financial statements. The results of operations for the quarter ended March 31, 1997 and the three quarters ended January 31, 1998 are not necessarily indicative of results for the full year. The information in this table should be read in conjunction with "Item 7". Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements of Metallurg, and related notes thereto, included in "Item 8. Financial Statements and Supplementary Data." SELECTED FINANCIAL DATA (a) As part of the Reorganization Plan, Shieldalloy entered into settlement agreements with various environmental regulatory authorities with regard to all of Shieldalloy's known significant environmental remediation liabilities. Pursuant to these agreements, Shieldalloy has agreed to perform environmental remediation, which as of January 31, 1999 had an estimated cost of completion of $40.4 million, including approximately $16.7 million to be incurred by Shieldalloy through the end of 2001. See "Items 1 and 2. Business and Properties-Environmental Regulation." (b) Reflects (in 1997) discharge of indebtedness income, net of tax effects, relating to the consummation of the Reorganization Plan and (in 1998) the early extinguishment of debt. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read in conjunction with the consolidated financial statements and the related notes thereto of Metallurg Holdings and Metallurg included elsewhere in this report. FORWARD-LOOKING STATEMENTS Certain matters discussed under the captions "Business and Properties" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Annual Report on Form 10-K may constitute forward-looking statements for purposes of Section 21E of the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance and achievements of Metallurg to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Factors which may cause Metallurg's results to be materially different include the cyclical nature of Metallurg's business, Metallurg's dependence on foreign customers (particularly customers in Europe), the economic strength of Metallurg's markets generally and particularly the strength of the demand for iron, steel, aluminum and superalloys and titanium alloy industries in those markets, the accuracy of Metallurg's estimates of the costs of environmental remediation and the extension or expiration of existing anti-dumping duties. OVERVIEW The industries which Metallurg supplies are cyclical. See "Items 1 and 2. Business and Properties - Products and Markets - Dependence on Cyclical Markets." Throughout 1997 and into 1998, market conditions for most of Metallurg's products were favorable. However, sales prices and demand for several of Metallurg's major products declined during the second half of 1998. Metallurg believes that the price declines were the result of the economic turmoil seen in Asia, Latin America and Russia in 1997 and 1998. This led to lower steel production almost everywhere except in the U.S. during the first half of 1998. In the second half of 1998, Japan, Russia, Brazil and certain other Asian countries exported large volumes of steel to the U.S. causing domestic production to be drastically curtailed in the latter months of 1998. In addition, civilian airliner production did not reach the levels forecast by a major producer, and the economic turmoil abroad caused postponements and cancellation of orders for airliners as trans-Pacific and Asian air passenger volumes fell sharply. These factors contributed to lower sales of products to the superalloy and titanium alloy industries. As a result of the negative developments in the steel industry, the market price of ferrovanadium, a significant product for Metallurg, declined from approximately $13 per pound in the middle of 1998 to approximately $6 per pound at the end of January 1999. The developments in the aerospace industry led to a reduction in superalloy and titanium alloy demand which impacted negatively on price and particularly on volumes of Metallurg's chromium and vanadium aluminum products. During the two quarters ended January 31, 1999, Metallurg recognized lower of cost or market inventory provisions of approximately $7.9 million relating to ferrovanadium and several chrome products. The market price of ferrovanadium has declined to approximately $5.25 per pound at mid-April 1999 and management anticipates additional inventory writedowns during the first quarter, the amount of which is indeterminable at this time because it is dependent on future market conditions. Metallurg has substantial operations outside the United States. At January 31, 1999, Metallurg's operations located outside the United States represented approximately 62% of Metallurg's assets based on book values. Approximately 80% of Metallurg's employees were outside the United States. Approximately 41% of Metallurg's sales (based on customer location) for the year ended January 31, 1999 were made in North America, 46% in Europe, 4% in Asia, 2% in South America and 7% throughout the rest of the world. See "Items 1 and 2. Business and Properties -- Products and Markets - Foreign Operations and Currency Fluctuations." Metallurg Holdings was formed on June 10, 1998 and is owned by Safeguard International (an international private equity fund that invests primarily in equity securities of companies in process industries), certain limited partners of Safeguard International, certain individuals and a private equity fund which is associated with Safeguard International. On July 13, 1998, Metallurg, Inc. was acquired by a group of investors led by Safeguard International. The acquisition was accomplished by Metallurg Acquisition Corp., a Delaware subsidiary and a wholly owned subsidiary of Metallurg Holdings, merging with and into Metallurg, Inc. with Metallurg, Inc. being the surviving company and Metallurg Holdings becoming the sole parent of Metallurg, Inc. At the time of the Merger, each outstanding share of Metallurg, Inc. common stock was converted into the right to receive $30 in cash. In connection with the Merger, Metallurg, Inc. received the consents of 100% of the registered holders of its 11% Senior Notes due 2007 to a one-time waiver of the change of control provisions of the Senior Note Indenture to make such provisions inapplicable to the Merger and to amend the definition of "Permitted Holders" under the Senior Note Indenture to reflect the post-merger ownership of Metallurg, Inc. No other modifications to terms of outstanding debt were affected in this regard. As of July 13, 1998, in connection with the Merger, all of the then outstanding shares of common stock of Metallurg, Inc. were cancelled and 100 shares of common stock, $0.01 par value, were issued to Metallurg Holdings. On November 20, 1998, Metallurg, Inc. consummated a 50,000 for 1 stock split and, as a result, Metallurg, Inc. has 5,000,000 shares of common stock, $0.01 par value, outstanding, all of which are owned by Metallurg Holdings and pledged as security to the holders of Metallurg Holdings' Senior Discount Notes. In April 1997, Metallurg, Inc. and Shieldalloy consummated the Reorganization Plan. Metallurg, Inc. settled its prepetition liabilities by distributing cash and issuing shares of its common stock, $.01 par value, and its 12% senior-secured notes. As a result of the Plan, Metallurg, Inc. and Shieldalloy reduced their indebtedness and shareholder obligations (including undrawn letters of credit) from approximately $151.0 million to approximately $39.5 million. In addition, as part of the Reorganization Plan, LSM incurred an additional $8.1 million of indebtedness to fund a portion of the Reorganization Plan. As part of the Reorganization Plan, Shieldalloy entered into various settlements with the relevant environmental authorities with regard to its obligations to remediate certain conditions at its New Jersey and Ohio facilities. As a result of Metallurg, Inc.'s change in its fiscal year from a calendar year to January 31, effective as of April 1, 1997, the consolidated operating results of Metallurg for the year ending January 31, 1999 include the results of Metallurg, Inc. (a holding company), for the year ended January 31, 1999 and the results of its operating subsidiaries (whose fiscal years remain the calendar year) for the year ended December 31, 1998. The consolidated balance sheet data of Metallurg at January 31, 1999 reflect the financial position of Metallurg, Inc. at January 31, 1999 and of the operating subsidiaries at December 31, 1998. The consolidated operating results of Metallurg for the four quarters ended January 31, 1998 include the results of Metallurg, Inc. for the thirteen months ended January 31, 1998 and the results of its operating subsidiaries for the year ended December 31, 1997. The consolidated balance sheet data of Metallurg at January 31, 1998 reflect the financial position of Metallurg, Inc. at January 31, 1998 and of the operating subsidiaries at December 31, 1997. METALLURG HOLDINGS' RESULTS OF OPERATIONS - FOR THE PERIOD JUNE 10, 1998 (INCEPTION) TO JANUARY 31, 1999 The net loss of $15.5 million includes the consolidation of Metallurg for the period subsequent to the acquisition (a loss of $7.9 million, which excludes certain Merger-related costs of $3.5 million, relating to the cancellation of compensatory stock options, which are accounted for as purchase price by Metallurg Holdings), $4.5 million of interest expense on its Senior Discount Notes, $2.9 million of amortization of acquisition, goodwill and deferred issuance costs and $0.2 million of general overhead costs. As Metallurg Holdings is a holding company and does not have any material operations or assets other than the ownership of Metallurg, the following discussion of the Company's business and properties relates to Metallurg, unless otherwise indicated. METALLURG'S RESULTS OF OPERATIONS - Effective March 31, 1997, Metallurg implemented fresh-start reporting relating to its emergence from bankruptcy. Accordingly, all assets and liabilities were restated to reflect their respective fair values and the consolidated financial statements after that date are those of a new reporting entity and are not directly comparable to the pre-confirmation periods. The amounts presented below for Metallurg for the four quarters ended January 31, 1998 represent the mathematical addition of the historical amounts for the predecessor company and the reorganized company only for purposes of the discussion below. Significant differences between periods due to fresh-start reporting adjustments are explained below, when necessary. (In thousands) RESULTS OF OPERATIONS - YEAR ENDED JANUARY 31, 1999 COMPARED TO THE FOUR QUARTERS ENDED JANUARY 31, 1998 Total revenues decreased by 4.0%, from $632.6 million in the four quarters ended January 31, 1998 to $607.2 million in the year ended January 31, 1999. Although volume and selling prices of ferrovanadium increased significantly in the first half of 1998, market prices then declined by over 30% in the fourth quarter of 1998, reducing the overall growth in revenues from ferrovanadium sales during the year. Revenues from sales of chromium metal increased in the year ended January 31, 1999, due primarily to increased volume. These increases were more than offset, however, by a reduction in sales of low carbon ferrochrome, ferroboron, aluminum master alloys and compacted products, due primarily to lower volumes. Revenues from sales of products not produced by Metallurg, primarily cobalt, silicon and manganese products, also declined during this period, due primarily to lower volumes. Gross margins decreased from $88.5 million in the four quarters ended January 31, 1998 to $81.3 million in the year ended January 31, 1999, a decrease of 8.1%, due principally to the decreases in low carbon ferrochrome margins resulting from lower selling prices and less favorable product mix. In aluminum master alloys and compacted products, a decrease in volume was more than offset by improvements in product mix and cost reductions. Gross margins also reflect lower of cost or market inventory provisions of approximately $7.9 million relating to ferrovanadium and several chrome products, which Metallurg recognized during the last two quarters ended January 31, 1999. The values of Metallurg's assets were reduced pursuant to fresh-start reporting, reducing depreciation expense by $1.4 million and $1.1 million in the year ended January 31, 1999 and the four quarters ended January 31, 1998, respectively, and increasing gross margins by equal amounts. Selling, general and administrative expenses (SG&A) were comparable in the two periods. For the four quarters ended January 31, 1998, SG&A represented 9.3% of Metallurg's sales compared to 9.7% for the year ended January 31, 1999. Operating income decreased from $29.9 million in the four quarters ended January 31, 1998 to $14.8 million in the year ended January 31, 1999, a decrease of 50.5%. The decrease in operating income reflected the decrease in gross margin, discussed above, as well as Merger-related costs of $7.9 million incurred in the year ended January 31, 1999. These costs included: (a) $3.5 million for payments to cancel compensatory stock options; (b) $0.6 million in consent fees incurred in order to obtain a one-time waiver of the change of control provisions of the Indenture with regard to Metallurg's Senior Notes and to amend the Indenture to reflect the post-Merger ownership of Metallurg, Inc.; (c) $2.8 million for payments made pursuant to existing employment agreements with Metallurg management; and (d) approximately $1.0 million of other Merger-related costs. Interest income (expense), net is as follows (in thousands): Interest expense increased significantly in the year ended January 31, 1999, as Metallurg accrued approximately $11 million of interest expense on its $100 million aggregate principal amount of 11% Senior Notes due 2007, which were issued in November 1997. Metallurg used a portion of the proceeds from the 11% Senior Notes to retire $39.5 million of the then outstanding 12% Senior-Secured Notes of Metallurg, Inc. due 2007. In the four quarters ended January 31, 1998, Metallurg accrued approximately $4.6 million of interest expense on these 12% Senior-Secured Notes and approximately $2.0 million of interest expense on the 11% Senior Notes. Metallurg did not accrue interest on debt incurred prior to entering Chapter 11 proceedings. As a result, approximately $2.1 million of contractual interest on these unsecured obligations, which were reported as part of liabilities subject to compromise, was not reflected in the quarter ended March 31, 1997. Income tax provision, net of tax benefits, is as follows (in thousands): The differences between the statutory Federal income tax rate and Metallurg's effective rate result primarily because of: (i) the U.S. taxability of foreign dividends; (ii) the excess of the statutory Federal income tax rate over foreign tax rates; (iii) certain deductible temporary differences which, in other circumstances would have generated a deferred tax benefit, have been fully provided for in a valuation allowance; (iv) the deferred tax effects of certain tax assets, primarily foreign net operating losses, for which the benefit had been previously recognized approximating $0.1 million in the year ended January 31, 1999; and (v) the deferred tax effects of certain deferred tax assets for which a corresponding credit has been recorded to "Additional paid-in capital" approximating $0.7 million the year ended January 31, 1999. The deferred tax expenses referred to in items (iv) and (v) above will not result in cash payments in future periods. Net income decreased from $64.2 million for the four quarters ended January 31, 1998 to $1.9 million for the year ended January 31, 1999. Included in prior year net income is an extraordinary item of $42.2 million, representing primarily the cancellation of debt resulting from the consummation of Metallurg's Reorganization Plan, and a $5.1 million credit, representing the effects of revaluing Metallurg's assets and liabilities under fresh-start reporting. In addition, other income included gains on the sales of Metallurg's New York office building and of certain plant assets of one of Metallurg's German subsidiaries totaling $4.4 million. The decrease in the current year results from reduced gross margins, Merger-related costs and increased interest expenses, is noted above. RESULTS OF OPERATIONS -- FOUR QUARTERS ENDED JANUARY 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1996 Total revenue for Metallurg decreased from $650.0 million in the year ended December 31, 1996 to $632.6 million in the four quarters ended January 31, 1998, a decrease of 2.7%. Sales attributable to Frankel Metal Company ("FMC"), Metallurg's former titanium scrap processing subsidiary, accounted for a decrease of $10.3 million. Reduced volumes and selling prices for manganese and ferrosilicon products in the U.S., resulting from strong competition and lack of supply at competitive prices, respectively, accounted for a decrease in sales. In addition, sales of low carbon ferrochrome declined as customers slowed down their buying in the quarter ended January 31, 1998. Offsetting this decrease, however, were increased volumes and selling prices for ferrovanadium and ferrotitanium, resulting from a strong steel market. In addition, the installation in 1997 of a new plant for the production of chromium metal in the U.K. contributed to an increase in sales. Gross margins increased from $83.5 million in the year ended December 31, 1996 to $88.5 million in the four quarters ended January 31, 1998, an increase of 6.0%. Increases in volumes and selling prices of ferrovanadium and ferrotitanium, as discussed above, accounted for much of the increase. Although Metallurg's United Kingdom aluminum powder producing division recorded decreased sales in the four quarters ended January 31, 1998 compared to the year ended December 31, 1996, margins relating to such division increased due to a change in product mix. The values of Metallurg's assets were reduced pursuant to fresh-start reporting, reducing depreciation expense in the four quarters ended January 31, 1998 by $1.1 million and increasing gross margin by an equal amount. Gross margins related to ferrosilicon products, however, declined as a result of reduced volumes and selling prices, as discussed above. In aluminum master alloys and compacted products, increased volumes improved production variances and significantly offset a decrease in margins at Metallurg's United Kingdom operations caused by the impact of a strong British pound. Gross margins related to FMC accounted for a further decrease in gross margins of $1.6 million during this period. SG&A increased from $57.1 million in the year ended December 31, 1996 to $58.6 million in the four quarters ended January 31, 1998, an increase of 2.6%. For the year ended December 31, 1996, SG&A represented 8.8% of Metallurg's sales compared to 9.3% for the four quarters ended January 31, 1998. SG&A increased principally as a result of increased bonus accruals and awards under the Stock Award and Stock Option Plan of Metallurg incurred in connection with the consummation of the Reorganization Plan, additional costs related to the audit of the March 31, 1997 financial statements and the inclusion of an extra month of the holding company's operations. Operating loss was $11.2 million in the year ended December 31, 1996, compared to operating income of $29.9 million in the four quarters ended January 31, 1998. The loss in 1996 was due principally to an environmental provision of $37.6 million, representing the anticipated future costs of remediation and maintenance of various environmental projects, primarily at Shieldalloy. The improvement resulted from an increase in margins on sales of ferrovanadium, ferrotitanium and aluminum powders due to the strength of the steel, superalloy and chemical industries, partially offset by a decrease in margins on aluminum master alloys and briquettes resulting from a highly competitive marketplace. Operating income for the year ended December 31, 1996 included $1.5 million of environmental expenses related to the operation of the water remediation facility at Shieldalloy's Newfield NJ site. As a result of Metallurg's adoption of SOP 96-1, "Environmental Remediation Liabilities", operating income in the four quarters ended January 31, 1998 does not include such water remediation expenses. In addition, as discussed above, as a result of the change of the holding company's fiscal year, operating income of $29.9 million in the four quarters ended January 31, 1998 included approximately $0.4 million of expenses related to the operations of the holding company for the month of January 1998. Interest income (expense), net is as follows (in thousands): Interest expense increased in the four quarters ended January 31, 1998, as Metallurg recognized interest expense of $4.6 million on its 12% senior-secured notes through November 1997 and accrued interest expense of $2.0 million on its 11% Senior Notes which were issued in November 1997. As a result of the change in the fiscal year, the four quarters ended January 31, 1998 contain an additional month of interest expense of approximately $0.9 million. Metallurg did not accrue interest on debt incurred prior to entering Chapter 11 proceedings and therefore, approximately $2.1 million and $8.6 million of contractual interest on these unsecured obligations, which were reported as part of liabilities subject to compromise, were not reflected in the four quarters ended January 31, 1998 and the year ended December 31, 1996, respectively. Income tax provision, net of tax benefits is as follows (in thousands): The differences between the statutory Federal income tax rate and Metallurg's effective rate are principally due to: (i) the excess of foreign tax rates over the statutory Federal income tax rate (ii) certain deductible temporary differences which, in the absence of fresh-start reporting would have generated a deferred tax benefit, have been fully provided for in a valuation allowance, (iii) the deferred tax effects of certain tax assets, primarily foreign net operating losses, for which the benefit had been previously recognized approximating $2.3 million in the four quarters ended January 31, 1998 and (iv) the deferred tax effects of certain deferred tax assets for which a corresponding credit has been recorded to "Additional paid-in capital" approximating $2.9 million in the four quarters ended January 31, 1998. The deferred tax expenses referred to in items (iii) and (iv) above will not result in cash payments in future periods. Net income was $64.2 million for the four quarters ended January 31, 1998 compared to a loss of $28.5 million for the year ended December 31, 1996 due primarily to an extraordinary item of $42.2 million, representing the cancellation of debt resulting from the consummation of Metallurg's Reorganization Plan, and a $5.1 million credit, representing the effects of revaluing Metallurg's assets and liabilities under fresh-start reporting. Net income for the four quarters ended January 31, 1998 included a loss of approximately $1.2 million related to the operations of Metallurg, Inc. for the month of January 1998. Reorganization expenses for the year ended December 31, 1996 totaled $3.5 million compared to $2.7 million in the four quarters ended January 31, 1998. In the four quarters ended January 31, 1998, other income included gains on the sales of Metallurg's New York office building and of certain plant assets of one of Metallurg's German subsidiaries. In the year ended December 31, 1996, other income included an additional gain on the sale of land in Turkey. RESULTS OF OPERATIONS - 1996 COMPARED TO 1995 Total revenues for Metallurg decreased by 5.7%, from $689.4 million in 1995 to $650.0 million in 1996, due to a significant decrease in prices of certain products, particularly ferrovanadium and ferrotitanium, and a decrease in the availability to Metallurg of raw materials from the former Soviet Union. As described below, worldwide consumption of aluminum was unchanged from 1995, but pricing competition among suppliers adversely affected Metallurg's sales. Gross margins decreased by 2.8% in 1996 compared to 1995. The price increase of ferrovanadium in the first quarter of 1995 was not repeated in 1996, as quoted prices stayed relatively steady throughout 1996. As a result, margins on vanadium products fell by 45% in 1996, compared to the prior year. Tonnage sales and prices of low carbon ferrochrome continued to improve in 1996 as demand from the expanding aerospace industry increased, resulting in a 20% rise in margins from 1995. Chromium metal margins increased by almost 80% due to price improvements resulting from the strength of the aerospace industry and the closure of an important competitor. Sales of aluminum products fell by 8% and margins by 40%, as LSM declined to compete at some of the very low prices offered by competitors. In the fourth quarter of 1996, a sharp appreciation of sterling by almost 20% against the European currencies also negatively impacted LSM. Gross margins of aluminum products at Metallurg's Brazilian operations fell by 40% as overseas competition cut prices in an effort to penetrate the South American market. SG&A increased by 8.1% from $52.8 million in 1995 to $57.1 million in 1996 due principally to the restructuring of German operations into a holding company with several operating subsidiaries. In connection with this restructuring, certain personnel who had previously concentrated solely on production aspects of the business became more involved in general management and administrative functions. This resulted in lower costs of production and increased SG&A expenses being reported in 1996. SG&A represented 8.8% of Metallurg's sales in 1996, compared to 7.7% in 1995. Operating loss was $11.2 million in 1996, compared to operating income of $15.7 million in 1995. The loss in 1996 was principally due to an environmental provision of $37.6 million, representing the anticipated future costs of remediation and maintenance of various environmental projects, primarily at Shieldalloy. In 1995, operating income included a charge of $11.7 million for a restructuring of Metallurg's principal German subsidiary into separate business units and a restructuring of Metallurg's mining operations in Brazil. In connection with the restructuring of Metallurg's principal German subsidiary into separate business units, certain manufacturing facilities were decommissioned and environmental expenses of $3.6 million were recognized representing the estimated costs of remedial cleanup of the decommissioned areas. Operating income in 1996 also was negatively impacted by the increase in SG&A and decrease in gross margins in 1996, compared to 1995 as described above. Other expense for 1996 was $6.8 million. The significant items included in this expense consisted of the allowance of additional unsecured prepetition claims of $10.5 million relating to withdrawal by Shieldalloy from a multi-employer pension plan, the settlement of certain environmental claims and additional claims by institutional debtholders. This was partially offset by the gain on the sale in 1996 of a parcel of land owned by Metallurg's Turkish subsidiary. For the years ended December 31, 1996 and 1995, Metallurg recorded tax provisions of $8.5 million and $8.2 million, respectively, including current foreign tax provisions of $8.1 million, and $8.3 million, respectively, on net foreign income of $25.8 million and $2.7 million, respectively. These foreign tax provisions were calculated on a jurisdiction by jurisdiction basis and resulted from income producing jurisdictions aggregating income of $36.1 million and $27.1 million in the years ended December 31, 1996 and 1995, respectively. Due to domestic losses in 1996 and utilization of net operating loss carryforwards in 1995, no U.S. current tax provisions were recorded in each of the years. Metallurg did not record benefits for foreign operations with losses based on the uncertainty of realization of such benefits. Net loss was $28.5 million in 1996, compared to net income of $1.7 million in 1995. As discussed above, the principal reasons for this net loss were the environmental provision of $37.6 million and the other expense of $6.8 million, offset partially by $11.7 million in restructuring charges relating to Metallurg's German and Brazilian subsidiaries recorded in 1995. LIQUIDITY AND FINANCIAL RESOURCES General. The Company's sources of liquidity include cash and cash equivalents, cash from operations and amounts available under credit facilities. In July 1998, Metallurg Holdings issued the Senior Discount Notes which yielded gross proceeds of $65.2 million, which proceeds were used, in part, to consummate the acquisition of Metallurg, Inc. In November 1997, Metallurg, Inc. issued $100 million principal amount of 11% Senior Notes due 2007, the proceeds of which were used to retire Metallurg, Inc.'s then existing 12% senior-secured notes (approximately $39.5 million), repay certain debt of the UK and German subsidiaries (approximately $20.0 million) and to pay a cash dividend (approximately $20.0 million). The balance of the net proceeds were for general corporate purposes. The Company believes that these sources are sufficient to fund the current and anticipated future requirements of working capital, capital expenditures, pension benefits, potential acquisitions and environmental expenditures through at least January 31, 2000. At January 31, 1999, the Company had $38.4 million of cash and cash equivalents and working capital of $167.5 million. Metallurg had $37.3 million in cash and cash equivalents and working capital of $166.2 million, as compared to $43.0 million and $167.8 million, respectively, at January 31, 1998. For the year ended January 31, 1999, Metallurg generated $3.6 million in cash from operations and received proceeds of approximately $1.1 million on the sale of its Luxembourg affiliate. Capital expenditures approximated $15.7 million and in February 1998, Metallurg purchased an additional 5% interest in a Russian magnesium metal producer for approximately $2.0 million. Credit Facilities and Other Financing Arrangements. Metallurg Holdings is a holding company, and its ability to meet its payment obligations on the Senior Discount Notes is dependent upon the receipt of dividends and other distributions from its direct and indirect subsidiaries. Metallurg Holdings does not have, and may not in the future have, any material assets other than the common stock of Metallurg, Inc. Metallurg, Inc. and its subsidiaries are parties to various credit agreements, including the Senior Note Indenture and the Revolving Credit Facility (as defined below), which impose substantial restrictions on Metallurg, Inc.'s ability to pay dividends to Metallurg Holdings. Metallurg, Inc. has a credit facility with certain financial institutions led by BankBoston, N.A. as agent (the "Revolving Credit Facility") which provides Metallurg, Inc., Shieldalloy and certain of their subsidiaries with up to $50.0 million of financing resources at a rate per annum equal to (i) the Alternate Base Rate plus 1.0% per annum, (the Alternate Base Rate is the greater of the Base Rate or the Federal Funds Effective Rate plus 0.5%), or (ii) the reserve adjusted Eurodollar rate plus 2.5% for interest periods of one, two or three months. The Revolving Credit Facility permits borrowings of up to $50.0 million for working capital requirements and general corporate purposes, up to $30.0 million of which may be used for letters of credit in the United States. Pursuant to the Revolving Credit Facility, BankBoston, N.A. through its Frankfurt office, is providing up to DM 20.5 million (approximately $12.3 million) of financing to GfE and its subsidiaries (the "German Subfacility"), which is guaranteed by Metallurg, Inc. and the other U.S. borrowers. Outstanding obligations under the Revolving Credit Facility are limited to a borrowing base based on eligible accounts receivable, eligible inventory and certain equipment. To the extent that the outstanding amounts to GfE and its subsidiaries exceed the borrowing base of those companies, a reserve will be established against the U.S. borrowing base. At January 31, 1999, there were no outstanding loans; however, there were $23.8 million of letters of credit outstanding in the U.S. under the Revolving Credit Facility and immaterial amounts outstanding under the German Subfacility. Substantially all of the assets of the U.S. borrowers and guarantors under the Revolving Credit Facility are pledged to secure all of the obligations under the Revolving Credit Facility (including the German Subfacility), and all accounts receivable, inventory, the stock of GfE's subsidiaries and certain other assets are pledged to secure the German Subfacility. The Revolving Credit Facility and the German Subfacility contain various covenants that restrict, among other things, payments of dividends, share repurchases, capital expenditures, investments in subsidiaries and borrowings. The revolving credit agreement, which expires on April 14, 2000, also requires Metallurg, Inc. and certain subsidiaries to comply with various covenants, including the maintenance of minimum levels of quarterly earnings before interest, taxes, depreciation and amortization, as defined in the Indenture ("Adjusted EBITDA"). These companies were required to maintain quarterly Adjusted EBITDA of $1.0 million. For the quarter ended December 31, 1998, Adjusted EBITDA of such companies was a loss of $7.3 million; accordingly, BankBoston waived that requirement of the agreement as of, and for the quarter ended, December 31, 1998 and amended the agreement to eliminate the Adjusted EBITDA quantitative covenants so long as certain other defined cash positions are maintained as prescribed in the agreement. In August 1998, GfE entered into a term loan with IKB Deutsche Industriebank in the amount of DM 10.0 million (approximately $6.0 million). The loan, which matures in 2008, bears interest at a rate of 4.5% and is secured by certain property of GfE. The GfE group also has unsecured term loans approximating DM 3.0 million (approximately $1.8 million) maturing through 2004 and bearing interest at a weighted average rate of 6%. LSM has several credit facilities which provide LSM and its subsidiaries with up to pound sterling 7.0 million (approximately $11.6 million) of borrowings, up to pound sterling 3.3 million (approximately $5.5 million) of foreign exchange exposure and up to pound sterling 2.3 million (approximately $3.8 million) for other ancillary banking arrangements including bank guarantees (the "LSM Credit Facility"). Borrowings under the LSM Credit Facility are payable on demand. The facility expires in October 1999 and outstanding loans under the LSM Credit Facility bear interest at the lender's base rate plus 1.0%. At January 31, 1999, there were no outstanding borrowings under the LSM Credit Facility. In 1998, LSM increased a facility for borrowings and foreign exchange exposure to pound sterling 4.0 million (approximately $6.6 million). This facility, which expires in December 1999, is unsecured and borrowings bear interest at a rate of 1% over the bank's base rate. At January 31, 1999, there were no borrowings under these facilities. On April 11, 1997, LSM entered into a term loan facility with NM Rothschild & Sons Limited in the amount of pound sterling 5.0 million (approximately $8.1 million) (the "LSM Term Loan Facility"), the proceeds of which were used to make a dividend to Metallurg in order to fund the Reorganization Plan. EWW has committed lines of credit with several banks in the aggregate amount of DM 15.2 million (approximately $9.1 million) which reduce on an annual basis by DM 3.0 million beginning July 1, 1999 and currently bear interest at rates from 7.5% to 8.5%. As of January 31, 1999, there was DM 3.6 million (approximately $2.1 million) outstanding under this facility. In addition, several of the other foreign subsidiaries of Metallurg have credit facility arrangements with local banking institutions to provide funds for working capital and general corporate purposes. These local credit facilities contain restrictions which vary from company to company. At January 31, 1999, there were $1.0 million of outstanding loans under these local credit facilities. Metallurg's subsidiaries are, in certain circumstances, subject to restrictions under local law and under their credit facilities that limit their ability to pay dividends to Metallurg. EWW has a contingent obligation to a German state pension authority which as of January 31, 1999, was DM 1.7 million (approximately $1.0 million). Metallurg expects that EWW will pay approximately DM 0.8 million (approximately $0.5 million) to the pension authority in 1999 in respect of this obligation. Capital Expenditures. Metallurg invested $15.7 million in capital projects during the year ended January 31, 1999. Metallurg's capital expenditures include projects related to improving Metallurg's operations, productivity improvements, replacement projects and ongoing environmental requirements (which are in addition to expenditures discussed in "Environmental Remediation Costs"). Capital expenditures are budgeted to increase significantly over prior year levels to approximately $23.2 million in the year ended January 31, 2000, including $13.8 million of capital investments which Metallurg believes will result in decreased costs of production, improved efficiency and expanded production capacities. The remaining capital expenditures planned are primarily for replacement and major repairs of existing facilities, some of which were deferred from earlier periods. Although Metallurg has budgeted these items in the year ended January 31, 2000, Metallurg has not committed to complete these projects during that period as such commitments are contingent on senior management approval and other conditions. Metallurg believes that these projects will be funded through internally generated cash, borrowings under the Revolving Credit Facility and local credit lines. Market Risk. Metallurg uses financial instruments to manage the impact of foreign exchange rate changes on earnings and cash flows. Accordingly, Metallurg enters into forward exchange contracts to protect the value of existing foreign currency assets and liabilities and to hedge future foreign currency product costs. Gains and losses on these contracts are offset by the gains and losses on the underlying transactions. Metallurg uses sensitivity analysis to assess the market risk associated with its foreign currency transactions. Market risk here is defined as the potential change in fair value resulting from an adverse movement in foreign currency exchange rates. A 10% depreciation movement in foreign currency rates could result in a net loss of $3.2 million on Metallurg's foreign currency exchange contracts and a 10% appreciation movement in foreign currency rates could result in a net gain of $2.8 million on Metallurg's contracts. In either scenario, the gain or loss on the forward contract is offset by the gain or loss on the underlying transaction and therefore, has no impact on future earnings and cash flows. Metallurg does not enter into financial instruments for trading or speculative purposes. Year 2000 Readiness. Metallurg has completed an internal review of its subsidiaries' information technology systems in connection with its assessment of Year 2000 readiness and is in the process of replacing or modifying some of the management and accounting systems at its subsidiaries to upgrade them generally and to make them Year 2000 ready. Metallurg expects to spend between $1.0 million and $2.0 million on these systems changes. Metallurg expects that the information technology systems for all of its subsidiaries will be Year 2000 ready by August 31, 1999, and a substantial percentage has been completed to date. Those systems that are not being replaced are being, or have been, modified by Metallurg personnel to assure that they are Year 2000 ready. Accordingly, no additional cost has been recognized for such internal upgrades. Metallurg is currently assessing whether any of its non-information technology will need to be modified to become Year 2000 ready. Metallurg has not received written assurances from its significant suppliers and customers to determine the state of their readiness with regard to Year 2000. Metallurg believes that they will be prepared for Year 2000 based on its normal interactions with its customers and suppliers and because of the wide attention that the issue has received. Metallurg has not yet seen the need for contingency plans for the Year 2000 issue, but this need will continue to be monitored as it obtains more information about the state of readiness of its suppliers and customers. Metallurg presently believes that the Year 2000 issue will not pose significant operational problems for its business systems as it believes that all needed modifications and conversions will be timely made. If any of Metallurg's suppliers or customers do not, or if Metallurg itself does not, successfully deal with the Year 2000 issue, Metallurg could experience delays in receiving or shipping products and in receiving payments. The severity of these possible problems would depend on the nature of the problem and how quickly it could be corrected or an alternative implemented, which is unknown at this time. The anticipated costs for Metallurg to become Year 2000 ready and the anticipated timing to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including timely performance by third parties who will provide Metallurg with the software for its new systems. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the ability to locate and correct all relevant computer codes, the ability to successfully integrate new business systems with existing operations and similar uncertainties. Some risks of the Year 2000 issue are beyond the control of Metallurg and its suppliers and customers. In particular, Metallurg cannot predict the effect that the Year 2000 issue will have on the general economy. Environmental Remediation Costs. In 1996, Metallurg elected early adoption of the American Institute of Certified Public Accountants Statement of Position ("SOP") 96-1, "Environmental Remediation Liabilities," which among other requirements, states that losses associated with environmental remediation obligations are accrued when such losses are deemed probable and reasonably estimable. Such accruals generally are recognized no later than the completion of the remedial feasibility study and are adjusted as further information develops or circumstances change. Costs of future expenditures for environmental remediation obligations are generally not discounted to their present value. During the year ended January 31, 1999, Metallurg expended $3.0 million for environmental remediation. As part of the Reorganization Plan, Shieldalloy entered into settlement agreements with various environmental regulatory authorities with regard to all of the significant environmental remediation liabilities of which it is aware. Pursuant to these agreements, Shieldalloy has agreed to perform environmental remediation which, as of January 31, 1999, had an estimated cost of completion of $40.4 million. Of this amount, approximately $3.6 million is expected to be expended in 1999, $5.7 million in 2000 and $7.4 million in 2001. In addition, Metallurg estimates it will make expenditures of $4.8 million with respect to environmental remediation at its foreign facilities. Of this amount, approximately $2.0 million is expected to be expended in 1999, $0.9 million in 2000 and $0.8 million in 2001. These amounts are not included in the calculation of operating income. Metallurg believes that while its remediation obligations and other environmental costs, in the aggregate, will reduce its liquidity, its cash balances, cash from operations and cash available under its credit facilities are sufficient to fund its current and anticipated future requirements for environmental expenditures. Effects of Recently Issued Accounting Standards. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Metallurg is currently evaluating the impact SFAS No. 133 will have on its financial statements. EFFECTS OF INFLATION Inflation has not had a significant effect on Metallurg's operations. However, there can be no assurance that inflation will not have a material effect on Metallurg's operations in the future. Metallurg is subject to price fluctuations in its raw materials and products. These fluctuations have affected and will continue to affect Metallurg's results of operations. See "Results of Operations." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following audited consolidated financial statements of Metallurg Holdings, Inc. and Metallurg, Inc. are presented herein, pursuant to the requirements of Item 8, on the pages indicated below: METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES - REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Metallurg Holdings, Inc. In our opinion, the accompanying consolidated balance sheet as of January 31, 1999 and the related statements of consolidated operations and of consolidated cash flows of Metallurg Holdings, Inc. and its subsidiaries (the "Company") present fairly, in all material respects, the financial position of the Company at January 31, 1999, and the results of its operations and its cash flows for the period June 10, 1998 (inception) to January 31, 1999, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP New York, New York April 23, 1999 METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES STATEMENT OF CONSOLIDATED OPERATIONS (IN THOUSANDS) - -------------------------------------------------------------------------------- See notes to consolidated financial statements. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS, EXCEPT SHARE DATA) - -------------------------------------------------------------------------------- See notes to consolidated financial statements. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES STATEMENT OF CONSOLIDATED CASH FLOWS (IN THOUSANDS) See notes to consolidated financial statements. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Metallurg Holdings, a Delaware corporation, was formed on June 10, 1998 and is owned by Safeguard International, an international private equity fund that invests primarily in equity securities of companies in process industries. On July 13, 1998, Metallurg Acquisition Corp., a wholly owned subsidiary of Metallurg Holdings, merged with and into Metallurg, Inc., with Metallurg, Inc. being the surviving company and Metallurg Holdings becoming the sole parent of Metallurg. Metallurg manufactures and sells high quality metal alloys and specialty metals used by manufacturers of steel, aluminum, superalloys and chemicals and other metal consuming industries. Metallurg sells more than 500 different products to over 3,000 customers worldwide (primarily in North America and Europe). Metallurg, Inc. and one of its subsidiaries, Shieldalloy Metallurgical Corporation ("Shieldalloy"), emerged from bankruptcy on April 14, 1997. Basis of Presentation and Consolidation - Metallurg Holdings and Metallurg, Inc. both report on a fiscal year ending January 31. The operating subsidiaries of Metallurg, Inc. report on a calendar year ending December 31. Accordingly, the consolidated financial statements of Metallurg Holdings include the accounts of Metallurg Holdings for the period June 10, 1998 (inception) to January 31, 1999, of Metallurg, Inc. for the period July 13, 1998 to January 31, 1999 (post-Merger) and of Metallurg, Inc.'s operating subsidiaries for the period July 13, 1998 to December 31, 1998 (post-Merger). All material intercompany transactions and balances have been eliminated in consolidation. The accounts of foreign subsidiaries have been translated into U.S. dollars in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52. Accounting Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents - The Company presents all highly liquid instruments, maturing within 30 days or less when purchased, as cash equivalents. Inventories - Inventories are stated at the lower of cost or market. The cost of inventories is determined using principally the average cost and specific identification methods. Assets Held for Sale - Assets held for sale are stated at the lower of cost or estimated net realizable value which, for long-lived assets, is calculated in accordance with SFAS No. 121, as discussed below. Metallurg's Brazilian operating subsidiary adopted a plan to restructure mining and certain other operations in 1995. The remaining carrying amount of assets no longer needed in these operations, and which are being held for sale in 1999, totaled $711,000. Goodwill - Goodwill, which represents the excess of acquisition cost over the estimated fair value of net assets acquired in business combinations, is being amortized on a straight-line basis over 20 years. The Company assesses whether its long-lived assets are impaired, based on an evaluation of undiscounted projected cash flows, whenever significant events or changes occur that might impair recovery of recorded costs through the remaining amortization period. In the event an impairment of long-lived assets is present, the recoverability of goodwill will be assessed. Investments in Affiliates - Investments in affiliates in which the Company has a 20% to 50% ownership interest and exercises significant management influence are accounted for in accordance with the equity method. Investments in which the Company has less than a 20% interest are carried at cost. The Company's investments in affiliates consist primarily of a $3.2 million or 10% interest in Solikamsk Magnesium Works, a Russian magnesium metal producer. Property and Depreciation - Major renewals and improvements are capitalized, while maintenance and repairs are expensed when incurred. Depreciation is computed using the straight-line or declining-balance methods over the estimated useful lives of the assets. Upon sale or retirement, the costs and related accumulated depreciation are eliminated from the respective accounts and any resulting gain or loss is included in income. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Revenue Recognition - Sales represent amounts invoiced to customers by Metallurg and such revenue is recognized when the product is shipped and title to the product passes to the customer. In certain instances, Metallurg arranges sales for which the supplier invoices the customer directly. In such cases, Metallurg receives commission income, which is recognized when the supplier passes title to the customer. Environmental Remediation Costs - In accordance with SOP No. 96-1, "Environmental Remediation Liabilities", losses associated with environmental remediation obligations are accrued when such losses are deemed probable and reasonably estimable. Such accruals generally are recognized no later than the completion of the remedial feasibility study and are adjusted as further information develops or circumstances change. Cost of future expenditures for environmental remediation obligations are generally not discounted to their present value. Valuation of Long-Lived Assets - In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets to be Disposed Of", the Company periodically evaluates the carrying value of long-lived assets to be held and used, including goodwill and other intangible assets, when events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flow from such asset is separately identifiable and is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Fair market value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair market values are reduced for the cost to dispose. Income Taxes - The Company uses the liability method whereby deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. The Company does not provide for U.S. Federal income taxes on the accumulated earnings considered permanently reinvested in certain of its foreign subsidiaries which approximated $40,000,000 at January 31, 1999. These earnings have been invested in facilities and other assets and have been subject to substantial foreign income taxes, which may or could offset a major portion of any tax liability resulting from their remittance and inclusion in U.S. taxable income. Accordingly, the Company does not provide for U.S. income taxes on foreign currency translation adjustments related to these foreign subsidiaries. Retirement Plans - Pension costs of Metallurg and its domestic consolidated subsidiaries are funded or accrued currently. Metallurg's foreign subsidiaries maintain separate pension plans for their employees. Such foreign plans are either funded currently or accruals are recorded in the respective balance sheets to reflect pension plan liabilities. Stock-Based Compensation - Metallurg accounts for stock-based compensation using the intrinsic value method, in accordance with Accounting Principles Board Opinion No. 25. Accordingly, compensation cost for stock options is measured as the excess, if any, of the market price of Metallurg's common stock at the date of grant over the amount an employee must pay to acquire the stock. Disclosures required with respect to alternative fair value measurement and recognition methods prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation" are presented in Note 12. Foreign Exchange Gains and Losses - Metallurg recognized foreign exchange transaction losses of approximately $192,000 for the period June 10, 1998 (inception) to January 31, 1999. Translation gains and losses resulting from reporting foreign subsidiaries in U.S. dollars are recorded directly to shareholders' equity. Financial Instruments - Metallurg enters into foreign exchange contracts in the regular course of business to manage exposure against fluctuations on sales and raw material purchase transactions denominated in currencies other than the functional currencies of its businesses. Unrealized gains and losses are deferred and recognized in income or as adjustments of carrying amounts when the hedged transactions are included in income. Gains and losses on unhedged foreign currency transactions are included in income. Metallurg does not hold or issue financial instruments for trading purposes. The counterparties to these contractual arrangements are a diverse group of major financial institutions with which Metallurg also has other financial relationships. Metallurg is exposed to credit risk generally limited to unrealized gains in such contracts in the event of nonperformance by counterparties of those financial instruments, but it does not expect any counterparties to fail to meet their obligations given their high credit ratings. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Recently Issued Accounting Pronouncements - In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company is currently evaluating the impact SFAS No. 133 will have on its financial statements. 2. ACQUISITION TRANSACTIONS On July 13, 1998, Metallurg was acquired by a group of investors led by Safeguard International. The acquisition was accomplished by Metallurg Acquisition Corp., a wholly owned subsidiary of Metallurg Holdings, a Delaware corporation, merging with and into Metallurg, with Metallurg being the surviving company and Metallurg Holdings becoming the sole parent of Metallurg. Metallurg Holdings was formed on June 10, 1998 and is owned by Safeguard International (an international private equity fund that invests primarily in equity securities of companies in process industries), certain limited partners of Safeguard International, certain individuals and a private equity fund. At the time of the Merger, each outstanding share of Metallurg, Inc. common stock, par value $.01 per share, was converted into the right to receive $30 in cash, representing an aggregate cash price of approximately $152,200,000 (including payments for cancellation of compensatory options). Metallurg Holding's purchase of Metallurg was recorded under the purchase method of accounting in accordance with APB Opinion No. 16, "Business Combinations". The total value of the transaction, including existing indebtedness and environmental, pension and other liabilities, net of cash, was approximately $300,000,000. The excess of the purchase price over the estimated fair value of the net assets acquired was approximately $101,500,000 and is being amortized over a period of 20 years. The purchase price allocation is subject to finalization in 1999. In order to finance the Merger, (i) Safeguard International and certain of its limited partners contributed approximately $97,000,000 of capital to Metallurg Holdings (the "Equity Contribution"); and (ii) Metallurg Holdings received approximately $62,900,000 net proceeds upon consummation of the offering (the "Offering") of $121,000,000 aggregate principal amount at maturity of 12-3/4% Senior Discount Notes due 2008 (the "Discount Notes"). As used herein, the term "Acquisition Transactions" means the Equity Contribution, the Offering, the Merger, the Consent Solicitation (as defined herein) and the execution of a supplemental indenture to the indenture governing Metallurg's 11% Senior Notes due 2007 (the "Senior Notes"). In connection with the Merger, Metallurg received the consents (the "Consents Solicitation") of 100% of the registered holders of its Senior Notes to a one-time waiver of the change of control provisions of the Senior Note Indenture to make such provisions inapplicable to the Merger and to amend the definition of "Permitted Holders". Merger-related costs of $7,888,000 were incurred, and recorded as expense by Metallurg, in the year ended January 31, 1999 and included (a) $3,541,000 for payments to cancel compensatory stock options; (b) $625,000 in consent fees incurred in order to obtain the one-time waiver of the change of control provisions of the Senior Note Indenture; (c) $2,822,000 for payments made pursuant to existing employment agreements with Metallurg management and (d) $900,000 of other merger-related costs. Metallurg was reimbursed for the compensatory stock option cancellation costs of $3,541,000 by a capital contribution from Safeguard International at the time of the Merger, which amount is included in Metallurg Holdings' acquisition cost. Accordingly, Metallurg Holdings recognized the balance of such costs, totaling $4,347,000, in the post-Merger period ended January 31, 1999. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) PRO FORMA RESULTS (UNAUDITED) The pro forma information presented herein is based upon the historical financial statements of Metallurg Holdings and Metallurg included elsewhere herein. The pro forma information illustrate the estimated effects of (i) the adoption of fresh-start reporting following the consummation of the Reorganization Plan of Metallurg in March 1997 (ii) the issuance of Senior Notes of Metallurg due 2007 and the application of the proceeds thereto, (iii) the issuance of the 12-3/4% Senior Discount Notes of Metallurg Holdings due 2008 and (iv) the Merger and the transactions related thereto (collectively, the "Pro Forma Transactions"), as if each of the listed transactions had occurred as of January 1, 1997. 4. SEGMENTS AND RELATED INFORMATION The Company adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information" in the period ended January 31, 1999 which changes the way the Company reports information about its reportable segments. The accounting policies of the reportable segments are the same as those described in Note 1 of the Notes to Consolidated Financial Statements. The financial data of Metallurg Holdings include the accounts of Metallurg Holdings for the period June 10, 1998 (inception) to January 31, 1999, of Metallurg, Inc. for the period July 13, 1998 to January 31, 1999 (post-Merger) and of Metallurg, Inc.'s operating subsidiaries for the period July 13, 1998 to December 31, 1998 (post-Merger). The results of Metallurg Holdings, Inc., the parent holding company, consist primarily of interest expense on the Discount Notes, amortization of acquisition goodwill and deferred debt issuance costs and general overhead expenses. Such costs are reported in the segment "Other" below. Metallurg operates in one significant industry segment, the manufacture and sale of ferrous and non-ferrous metals and alloys. Metallurg is organized geographically, having established a worldwide sales network built around its core production facilities in the United States, the United Kingdom and Germany. In addition to selling products manufactured by Metallurg, Metallurg distributes complementary products manufactured by third parties. Reportable Segments Shieldalloy: This unit is comprised of two production facilities in the U.S. The New Jersey plant manufactures and sells aluminum alloy grain refiners and alloying tablets for the aluminum industry, metal powders for the welding industry and specialty ferroalloys for the superalloy and steel industries. The Ohio plant manufactures and sells ferrovanadium and vanadium based chemicals used mostly in the steel and petrochemical industries. In addition to its manufacturing operations, Shieldalloy imports and distributes complementary products manufactured by affiliates and third parties. LSM: This unit is comprised mainly of three production facilities in the UK which manufacture and sell aluminum alloy grain refiners and alloying tablets for the aluminum industry, chromium metal and specialty ferroalloys for the steel and superalloy industries and aluminum powder for various metal powder consuming industries. GfE: This unit is comprised of two production facilities and a sales office in Germany. The Nuremburg plant manufactures and sells a wide variety of specialty products, including vanadium based chemicals and sophisticated metals, alloys and powders used in the titanium, superalloy, electronics, steel, biomedical and optics industries. The Morsdorf plant produces medical prostheses, implants and surgical instruments for orthopedic applications. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) EWW: This production unit, also located in Germany, produces various grades of low carbon ferrochrome used in the superalloy, welding and steel industries. Summarized financial information concerning the Company's reportable segments is shown in the following table (in thousands). See "Notes to Consolidated Financial Statements - 1. Summary of Significant Accounting Policies - Basis of Presentation and Consolidation." Each segment records direct expenses related to its employees and operations. The "Other" column includes corporate related items, fresh-start adjustments and results of subsidiaries not meeting the quantitative thresholds as prescribed by applicable accounting rules. The Company does not allocate general corporate overhead expenses to operating segments. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Metallurg sells its products in over fifty countries. The following full year revenue by country, based on the location of the user, (in thousands) is of the Company and the portion of such revenue arising prior to the Merger date is deducted therefrom. The following table presents property, plant and equipment by country based on the location of the assets. 5. INVENTORIES Inventories, net of reserves, consist of the following (in thousands): METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 6. GOODWILL Goodwill represents the excess of the purchase price and related costs over the estimated fair value of the net assets of Metallurg, Inc. acquired by Metallurg Holdings on July 13, 1998. See Notes "1. Summary of Significant Accounting Policies -- Goodwill" and "2. Acquisition Transactions". Goodwill is being amortized on a straight-line basis over 20 years. For the period June 10, 1998 (inception) to January 31, 1999, amortization expense was $2,750,000. 7. PROPERTY, PLANT AND EQUIPMENT The major classes of property, plant and equipment are as follows (in thousands): Depreciation expense related to property, plant and equipment charged to operations for the period June 10, 1998 (inception) to January 31, 1999 was approximately $3,700,000. 8. RETIREMENT PLANS Metallurg Holdings does not have any benefit plans. The following data represents Metallurg's defined benefit plans for the year ended January 31, 1999. Metallurg adopted SFAS No. 132, "Employers' Disclosure about Pensions and other Postretirement Benefits" in the year ended January 31, 1999. SFAS No. 132 changes current financial disclosure requirements from those that were required under SFAS No. 87, "Employers' Accounting for Pensions", SFAS No. 88, "Employers' Accounting for Settlement and Curtailments of Defined Benefit Pension Plans and for Termination Benefits" and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Defined Benefit Plans The following table summarizes the changes in benefit obligation and changes in plan assets of Metallurg for the year ended January 31, 1999 (in thousands): METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The following table summarizes the components of net periodic benefit cost (in thousands): Metallurg and its domestic consolidated subsidiaries have defined benefit pension plans covering substantially all salaried and certain hourly paid employees. The plans generally provide benefit payments using a formula based on an employee's compensation and length of service. These plans are funded in amounts equal to the minimum funding requirements of the Employee Retirement Income Security Act. Substantially all plan assets are invested in cash and short-term investments or listed stocks and bonds. The funded status of these plans are as follows (in thousands): Metallurg's United Kingdom subsidiary maintains a defined benefit pension plan covering all eligible employees. Substantially all plan assets are invested in listed stocks and bonds. The funded status of this plan is as follows (in thousands): METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Metallurg's German subsidiaries maintain unfunded defined benefit pension plans covering substantially all eligible employees. The plans had been amended in 1992 in a manner that terminated any credit for future service. These plans were amended in 1998 and accordingly, (i) credit for future service was reinstated, retroactive to January 1, 1993, for certain employees and (ii) benefits were adjusted for cost of living increases not recognized subsequent to 1992. Accrued pension liabilities were $38,576,000 at January 31, 1999. Other Benefit Plans Metallurg maintains a discretionary defined contribution profit sharing plan covering substantially all of the salaried employees of Metallurg and its domestic consolidated subsidiaries. The related expense was approximately $104,000 in the period June 10, 1998 (inception) to January 31, 1999. Balance sheet accruals for pension plans of Metallurg's other foreign subsidiaries approximate or exceed the related actuarially computed value of accumulated benefit obligations. Accrued pension liabilities for these plans were $506,000 at January 31, 1999. Pension expense relating to Metallurg's other foreign subsidiaries' pension plans was $115,000 for the period June 10, 1998 (inception) to January 31, 1999. 9. BORROWINGS Long-term debt consists of the following (in thousands): Metallurg Holdings At the time of the Merger, Metallurg Holdings received approximately $62,900,000 net proceeds upon consummation of the offering of $121,000,000 aggregate principal amount at maturity of Senior Discount Notes due 2008 in a Rule 144A private placement to qualified institutional investors (the "Offering"). In October 1998, Metallurg Holdings completed the exchange of its 12 3/4% Series A Senior Discount Notes due 2008 for an identical face amount of Senior Discount Notes. The Discount Notes will accrete at a rate of 12 3/4%, compounded semi-annually, to July 15, 2003. Cash interest will not accrue or be payable prior to such date. Commencing July 15, 2003, the Senior Discount Notes will accrue cash interest at a rate of 12 3/4% per annum, payable semi-annually in arrears on January 15 and July 15 of each year, commencing January 15, 2004. The Discount Notes are redeemable at the option of Metallurg Holdings, in whole or in part, at any time on or after July 15, 2003. Prior to July 15, 2001, a maximum of 34% of the Senior Discount Notes may be redeemed with net proceeds of one or more public equity offerings of Metallurg Holdings. The Senior Discount Notes are senior, secured obligations of Metallurg Holdings and rank pari passu in right of payment with all existing and future unsubordinated indebtedness and senior in right of payment to all subordinated indebtedness of Metallurg Holdings. However, the Senior Discount Notes are effectively subordinated to all existing and future liabilities of Metallurg, Inc. and its subsidiaries. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The Senior Discount Notes are secured by an assignment and pledge to a trustee of (a) all of the outstanding equity interests held by Metallurg Holdings in Metallurg, Inc. and (b) all promissory notes issued from time to time to Metallurg Holdings by Metallurg, Inc. The Indenture contains limitations on, among other things, the ability of Metallurg Holdings to incur indebtedness and enter into certain mergers, consolidations or assets sales. In the period June 10, 1998 (inception) to January 31, 1999, Metallurg Holdings recognized approximately $4,523,000 of interest expense related to the Senior Discount Notes. Other interest expense, including that of Metallurg, totaled $7,309,000 during this period. Metallurg Holdings is a holding company, and its ability to meet its payment obligations on the Senior Discount Notes is dependent upon the receipt of dividends and other distributions from its direct and indirect subsidiaries. Metallurg Holdings does not have, and may not in the future have, any material assets other than the common stock of Metallurg. Metallurg, Inc. and its subsidiaries are parties to various credit agreements, including the Senior Note Indenture and the Revolving Credit Facility, which impose substantial restrictions on Metallurg, Inc.'s ability to pay dividends to Metallurg Holdings. Metallurg, Inc. and Domestic Subsidiaries In November 1997, Metallurg, Inc. sold the $100,000,000 Senior Notes which mature in 2007 and accrue interest at a rate of 11% per annum, payable semi-annually commencing in June 1998. The Senior Notes are redeemable at the option of the Company, in whole or in part, at any time on or after December 2002. Prior to December 1, 2000, a maximum of 34% of the Senior Notes may be redeemed with net proceeds of one or more public equity offerings of Metallurg. The Senior Notes are fully and unconditionally guaranteed by the U.S. subsidiaries of Metallurg on a senior unsecured basis. The Indenture contains limitations on, among other things, the ability of Metallurg to incur indebtedness and enter into certain mergers, consolidations or asset sales. In addition, Metallurg is prohibited from making dividends in an amount greater than 50% of its net income under terms of the Indenture. Pursuant to the Plan, Metallurg, Inc. and Shieldalloy (the "Borrowers") entered into an agreement with certain financial institutions led by BankBoston, N.A., as agent, for a Revolving Credit Facility, in the amount of $40,000,000, to provide working capital and to finance other general corporate purposes. In October 1997, this facility was increased to $50,000,000 and the German Subfacility (as discussed below) was established. Borrowings under this facility bear interest at a rate per annum equal to (i) the Base Rate plus 1% per annum (the Base Rate is the greater of BankBoston N.A.'s base rate or the Federal Funds Effective Rate plus 0.5%) or (ii) the reserve adjusted Eurodollar rate plus 2.5% for interest periods of one, two or three months. Metallurg, Inc. is required to pay a fee of 0.375% per annum on the unused portion of the commitment. The total amount the Borrowers may borrow at any time is limited to a borrowing base calculation that is based on eligible accounts receivable, inventory and certain fixed assets. At January 31, 1999, there were no borrowings under this facility; however, outstanding letters of credit approximated $23,789,000. Substantially all assets of the Borrowers are pledged as collateral under this agreement. The revolving credit agreement, which expires on April 14, 2000, prohibits Metallurg, Inc. from making dividends and requires the Borrowers and certain subsidiaries to comply with various covenants, including the maintenance of minimum levels of quarterly earnings before interest, taxes, depreciation and amortization, as defined in the Indenture ("Adjusted EBITDA"). These companies were required to maintain quarterly Adjusted EBITDA of $1,000,000. For the quarter ended December 31, 1998, Adjusted EBITDA of such companies was a loss of $7,300,000; accordingly, BankBoston waived that requirement of the agreement as of, and for the quarter ended, December 31, 1998 and amended the agreement to eliminate the Adjusted EBITDA quantitative covenants so long as certain other defined cash positions are maintained as prescribed in the agreement. Metallurg's Foreign Subsidiaries Pursuant to the Revolving Credit Facility, BankBoston, N.A., through its Frankfurt office, is providing to GfE and its subsidiaries, up to DM 20,500,000 (approximately $12,300,000) of financing. The German Subfacility is guaranteed by Metallurg, Inc. and the other U.S. borrowers and outstanding obligations are limited to a borrowing base which is based on eligible accounts receivable, eligible inventory and certain equipment. The German Subfacility contains various covenants that restrict, among other things, the payment of dividends, share repurchases, capital expenditures, investments to subsidiaries and borrowings. All accounts receivable, inventory, the stock of GfE's subsidiaries and certain other assets are pledged to secure the German Subfacility. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) At January 31, 1999, borrowings under the German Subfacility were immaterial. Short-term unsecured borrowings of the GfE group with local banks totaled DM 1,200,000 (approximately $700,000) at January 31, 1999. In August 1998, GfE entered into a term loan with IKB Deutsche Industrie Bank in the amount of DM 10,000,000 (approximately $6,000,000). The loan, which matures in 2008, bears interest at a rate of 4.5% and is secured by certain property of GfE. The GfE group also has term loans approximating DM 3,027,000 (approximately $1,800,000) maturing through 2004 and bearing interest at a weighted average rate of 6.0%. LSM, a United Kingdom subsidiary, has several credit facilities which provide LSM and its subsidiaries up to pound sterling 7,000,000 (approximately $11,600,000) of borrowings, up to pound sterling 3,300,000 (approximately $5,500,000) of foreign exchange exposure and up to pound sterling 2,300,000 (approximately $3,800,000) for other ancillary banking arrangements, including bank guarantees. The facility expires in October 1999 and bears interest at the lender's base rate plus 1.0%. The facility is unsecured and contains restrictions on dividends. In 1998, LSM increased a facility for borrowings and foreign exchange exposure to pound sterling 4,000,000 (approximately $6,600,000). This facility, which expires in December 1999, is unsecured and borrowings bear interest at a rate of 1% over the bank's base rate. At January 31, 1999, there were no borrowings under these facilities. EWW, a German subsidiary, has committed lines of credit with several banks in the aggregate amount of DM 15,200,000 (approximately $9,100,000). The credit facilities decrease by DM 3,000,000 per year beginning in 1999 and currently bear interest at rates from 7.5% to 8.5%. The credit agreements require EWW to pledge certain assets, which include accounts receivable, inventory and fixed assets. At January 31, 1999, there were DM 3,600,000 (approximately $2,100,000) of borrowings under these agreements. EWW also has a term loan of DM 2,400,000 (approximately $1,400,000) maturing in 2001. The term loan is secured by a mortgage on certain real property and bears interest at 4.5%. In 1998, EWW borrowed DM 1,500,000 (approximately $900,000) to fund capital additions. The loan, which matures in 2008, bears interest at 4.25%. Metallurg's other foreign subsidiaries maintain short-term secured and unsecured borrowing arrangements, generally in local currencies, with various banks. Borrowings under these arrangements aggregated $1,021,000 at January 31, 1999 at a weighted average interest rate of 10.9%. Interest expense totaled $11,832,000 for the year period June 10 (inception) to January 31, 1999. The scheduled maturities of long-term debt during the next five years are $1,074,000 in 1999, $989,000 in 2000, $963,000 in 2001, $413,000 in 2002, $285,000 in 2003 and $227,535,000 thereafter. 10. FINANCIAL INSTRUMENTS The carrying value of cash and cash equivalents, trade receivables, other current assets, accounts payable and accrued liabilities approximate fair value due to the short-term maturities of these assets and liabilities. Fair values for investments in affiliates are not readily available. The aggregate fair value of short-term bank debt approximates its carrying amount because of recent and frequent repricing based on market conditions. Based on quoted market prices, the fair value of Metallurg Holdings' Senior Discount Notes, issued in July 1998, approximates $40,000,000. Based on quoted market prices, the fair value of Metallurg, Inc.'s $100,000,000 Senior Notes, issued in November 1997, approximates $89,000,000 at January 31, 1999. The carrying amount of other long-term debt approximates fair value. Metallurg enters into foreign exchange contracts in the regular course of business to manage exposure against fluctuations on sales and raw material purchase transactions denominated in currencies other than the functional currencies of its businesses. The contracts generally mature within 12 months and are principally unsecured foreign exchange contracts with carefully selected banks. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The aggregate notional amounts of the contracts outstanding as of January 31, 1999 were approximately $29,800,000 and were predominately denominated in the following currencies: Deutsche Marks, Pounds Sterling and U.S. Dollars. The notional values provide an indication of the extent of Metallurg's involvement in such instruments but do not represent its exposure to market risk, which is essentially limited to risk related to currency rate movements. Unrealized gains on these contracts at January 31, 1999 were approximately $117,000. 11. INCOME TAXES For financial reporting purposes, income (loss) before income tax provision includes the following components (in thousands): The reconciliation of income tax from continuing operations computed at the U.S. Federal statutory tax rate to the Company's effective tax rate is as follows (in thousands): METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The income tax provision (benefit) represents the following (in thousands): U.S. Federal income tax refunds receivable of $4,180,000 at January 31, 1999 relate primarily to the Federal tax deposits in excess of estimated liabilities and carryback claims related to environmental expenses and net operating losses, are reflected in prepaid expenses in the accompanying Consolidated Balance Sheets. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities are as follows (in thousands): METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) At January 31, 1999, the Company has net operating loss carryforwards relating to domestic operations of approximately $4,953,000 (subject to certain limitations relative to utilization) which expire through 2010 and Alternative Minimum Tax Credit carryforwards of approximately $700,000 which can be carried forward indefinitely. The Company's consolidated foreign subsidiaries have income tax loss carryforwards aggregating approximately $76,973,000, a substantial portion of which relates to German operations which do not expire under current regulations and certain Brazilian operations which partially expire through 2004. Due to significant uncertainties surrounding the realization of certain loss carryforwards, the related deferred tax assets have been substantially provided for in the valuation allowances at January 31, 1999. However, during the period ended March 31, 1997, the Company determined that a German subsidiary has sufficiently demonstrated the ability to generate earnings and the valuation allowance of $6,032,000 relating to that subsidiary was appropriately reversed. Such benefit from a reduction in valuation allowance was partly offset by a deferred tax provision relating to an adjustment of U.K. pension liabilities. For the year ended January 31, 1999, none of the deferred tax benefit, which amounts to approximately $3,000,000, will result in cash payments in future periods. Included within the deferred tax benefit are the deferred tax effects of certain deferred tax assets for which a corresponding debit has been recorded to "Additional paid-in capital" approximating $1,300,000 and the deferred tax effects of certain deferred tax assets, primarily foreign net operating losses, for which a benefit has previously been recognized in the amount of $572,000. The adoption of fresh-start reporting results in an increase of additional paid-in capital, rather than an income tax benefit, as the benefits relating to existing deferred tax assets are recognized. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 12. SHAREHOLDERS' EQUITY (DEFICIT) Metallurg Holdings was formed on June 10, 1998 with 1,000 shares of common stock, par value $.01, authorized. On June 29, 1998, Metallurg Holdings issued 350 such shares. At the time of the Merger, this common stock was cancelled and the total number of shares of all classes of stock which Metallurg Holdings was authorized to issue was changed to 50,000 shares, of which 30,000 shares shall be Common Stock, $.01 par value ("Common Stock") 10,000 shares shall be Series A Voting Convertible Preferred Stock, $.01 par value ("Series A Preferred Stock") and 10,000 shares shall be Series B Non-Voting Preferred Stock, $.01 par value ("Series B Preferred Stock"). In connection with the Merger, 5,202.335 shares of Series A Preferred Stock and 4,500 shares of Series B Preferred Stock were issued. In December 1998, an additional 24 shares of Series B Preferred Stock were issued to investors. At January 31, 1999, no Common Stock was issued and outstanding; however 5,202.335 shares of Series A Preferred Stock and 4,524 shares of Series B Preferred Stock were issued and outstanding. Total comprehensive loss was $15,450,000 for the period June 10, 1998 (inception) to January 31, 1999. Stock Compensation Plans On November 20, 1998, the Board of Directors adopted the Metallurg, Inc. 1998 Equity Compensation Plan (the "ECP"). Pursuant to Metallurg's ECP, the Compensation Committee of Metallurg's Board awarded to eligible executives and non-employee Board members options to purchase up to 450,000 and 12,500 shares of common stock at an exercise price of $30.00 per share, effective as of November 20, 1998 and January 4, 1999, respectively. Such options have a term of ten years and vest 20% on the date of grant and will vest 20% on each of the first four anniversaries of the date of grant. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Metallurg has elected the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". Had Metallurg used the fair value method at the date of grant of the stock options, additional compensation expense of $2,235,000 would have been recorded, resulting in a pro forma net loss of $17,700,000. The weighted average fair value of Metallurg options granted was $4.83 per share at January 31, 1999. This fair value was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions: On April 14, 1997, Metallurg had adopted the Metallurg, Inc. Management Stock Award and Stock Option Plan (the "SASOP"). Certain eligible employees were granted options to purchase 167,000 shares of common stock at $11.38 (fair market value on the date of grant), effective as of September 1, 1997 and 20,000 shares of common stock at $8.43 (fair market value on the date of grant), effective as of April 1, 1998. Such options vested 33 1/3% on the date of grant and 33 1/3% were to vest on the first and second anniversary of the date of grant. At the time of the Merger, outstanding stock options became fully vested and holders were therefore entitled to receive $30 per share as part of the purchase of Metallurg. Metallurg recorded compensation expense of $3,541,000, which represented the excess of the $30 per share purchase price over the exercise prices noted above. Metallurg was reimbursed for such stock option cancellation costs by a capital contribution from Safeguard International at the time of the Merger. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 13. OTHER INCOME (EXPENSE), NET Other income (expense), net consists of the following (in thousands): In August 1998, one of the Company's German subsidiaries was successful in recovering approximately $1,351,000 of additional proceeds from a government-owned insurance agency representing final settlement for claims under the company's political risk insurance policy related to an investment in the former Zaire. 14. ENVIRONMENTAL LIABILITIES Shieldalloy operates manufacturing facilities in Newfield, New Jersey and Cambridge, Ohio, which produce alloys and other specialty products. The historical manufacture of several products at the two facilities has resulted in the production of various by-products, which Shieldalloy is obligated to clean up under Federal and state environmental laws and regulations. These clean-up obligations are under the jurisdiction of the United States Environmental Protection Agency, the New Jersey Department of Environmental Protection, the Ohio Environmental Protection Agency, the United States Nuclear Regulatory Commission ("NRC"), the United States Department of Interior and the Ohio Department of Health. The Company has also provided for certain estimated costs associated with its sites in Germany and Brazil. Total environmental liabilities consist of the following (in thousands): Shieldalloy entered into Administrative Consent Orders ("ACO's") with the State of New Jersey, dated October 5, 1988 and September 5, 1984, under which Shieldalloy, as required, has conducted a remedial investigation and feasibility study ("RI/FS") of alternatives to remedy groundwater contamination at the Newfield facility. The ACO's also require Shieldalloy to evaluate, and where appropriate remediate certain additional environmental conditions pursuant to state laws and regulations. These activities include the closure of nine wastewater lagoons, soil remediation, surface water and sediment clean up, as well as miscellaneous operation and maintenance activities and onsite controls. Metallurg accrued its best estimate of the associated costs with respect to remedial activities at the site which it expects to disburse over the next thirteen years. During 1995, $8,000,000 in a prepetition letter of credit was drawn upon and deposited in a trust fund. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) During the quarter ended March 31, 1997, remaining prepetition letters of credit, in the amount of $8,200,000, were drawn upon and deposited in a trust fund. Subsequently, pursuant to an agreement with the State of New Jersey, Metallurg was permitted to withdraw cash from the environmental trust and substitute letters of credit in an equivalent dollar amount. At January 31, 1999, outstanding letters of credit issued as financial assurances in favor of various environmental agencies total $21,419,000. The costs of providing financial assurance over the term of the remediation activities have been contemplated in the accrued amounts. As a result of NRC-regulated manufacturing activities, slag piles have accumulated at the Cambridge and Newfield sites which contain low levels of naturally occurring radioactivity. As related production has ceased at the Cambridge location, Shieldalloy required to decommission the slag piles. Shieldalloy obtained approval from the State of Ohio and is currently awaiting approval from the NRC to stabilize and cap the slag piles in situ. As long as production continues at the Newfield location, the NRC will allow the slag pile to remain in place, subject to submission of a conceptual decommissioning plan and financial assurance for implementation of that plan. The Company obligation of the decommissioning plan and financial assurance for implementation of that plan for these sites is partially assured by cash funds held in trust. As a condition precedent to consummation of the Plan, $1,500,000 in a prepetition letter of credit, relating to both the Newfield and Cambridge facilities, was drawn upon and deposited in a trust fund. In 1987, Shieldalloy purchased the Cambridge manufacturing facility from Foote Mineral Company. Cyprus Foote Mineral Company ("Cyprus Foote") is the successor in interest to Foote. During 1995, Shieldalloy, Cyprus Foote and the State of Ohio entered into a Consent Order for Permanent Injunction (the "Consent Order") under which Shieldalloy and Cyprus Foote agreed to conduct an RI/FS of the Cambridge site and the State of Ohio agreed to review such information on an expedited basis and issue a Preferred Plan setting forth a final remedy for the site. On December 16, 1996, the State of Ohio issued its Preferred Plan and, subsequently, Shieldalloy and Cyprus Foote agreed to perform remedial design and remedial action at the site. These activities include remediation of slag piles, clean up of wetland soils and clean up of on-site and off-site sediments. Pursuant to the Consent Order, Shieldalloy and Cyprus Foote are jointly and severally liable to the State of Ohio in respect of these obligations. However, Shieldalloy has agreed with Cyprus Foote that it shall perform and be liable for the performance of these remedial obligations. Therefore, the Company has accrued its best estimate of associated costs which it expects to substantially disburse over the next five years. With respect to the financial assurance obligations to the State of Ohio, Cyprus Foote has agreed to provide financial assurance of approximately $9,000,000 as required by the State of Ohio and Shieldalloy has purchased an annuity contract which will provide for future payments into the trust fund to cover certain of the estimated operation and maintenance costs over the next 100 years. Metallurg's German subsidiaries have accrued environmental liabilities in the amount of $4,443,000 at January 31, 1999, to cover the costs of closing an off-site dump and for certain environmental conditions at a subsidiary's Nuremberg site. In Brazil, costs of $389,000 have been accrued at January 31, 1999, to cover reclamation costs of the closed mine sites. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 15. CONTINGENT LIABILITIES In addition to environmental matters, which are discussed in Note 14, Metallurg continues defending various claims and legal actions arising in the normal course of business. Management believes, based on the advice of counsel, that the outcome of such litigation will not have a material adverse effect on Metallurg's consolidated financial position, results of operations or liquidity. There can be no assurance that existing or future litigation will not result in an adverse judgment against Metallurg which could have a material adverse effect on Metallurg's future results of operations or cash flows. 16. LEASES Metallurg leases office space, facilities and equipment. The leases generally provide that Metallurg pays the tax, insurance and maintenance expenses related to the leased assets. At January 31, 1999, future minimum lease payments required under non-cancelable operating leases having remaining lease terms in excess of one year are as follows (in thousands): Rent expense under operating leases for the period June 10, 1998 (inception) to January 31, 1999 was approximately $885,000. METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 17. SUPPLEMENTAL GUARANTOR INFORMATION Under the terms of the Senior Notes, Shieldalloy, Metallurg Holdings Corporation, Metallurg Services, Inc. and MIR (China), Inc. (collectively, the "Guarantors"), wholly-owned domestic subsidiaries of Metallurg, Inc., will fully and unconditionally guarantee on a joint and several basis Metallurg, Inc.'s obligations to pay principal, premium and interest in respect of the Senior Notes due 2007. Management has determined that separate, full financial statements of the Guarantors would not be material to potential investors and, accordingly, such financial statements are not provided. Supplemental financial information of the Guarantors is presented below: CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED JANUARY 31, 1999 (IN THOUSANDS) METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 17. SUPPLEMENTAL GUARANTOR INFORMATION - (CONTINUED) CONDENSED CONSOLIDATING BALANCE SHEET AT JANUARY 31, 1999 (IN THOUSANDS) METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 17. SUPPLEMENTAL GUARANTOR INFORMATION - (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR YEAR ENDED JANUARY 31, 1999 (IN THOUSANDS) METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS) The management company of Safeguard International was paid a one-time financial advisory fee in 1998 of $2.5 million for services performed, and reimbursed for various expenses incurred, in connection with the acquisition of Metallurg, Inc. See Note "2. Acquisition Transactions." Dr. Schimmelbusch and Messrs. Spector and Holly each received $400,000 of the proceeds from the financial advisory fee in their capacities as members of the management company. Dr. Schimmelbusch and Messrs. Plum, Holly and Spector, all of whom are directors of Holdings, and Mr. Fastuca, an executive officer of Holdings, are directors and/ or officers of various companies that are associated, directly or indirectly, with Safeguard Scientifics, Inc., which has an ownership interest in Safeguard International Fund. Pursuant to these positions, they receive compensation from such entities. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Metallurg Holdings, Inc. Our audit of the consolidated financial statements referred to in our report dated April 23, 1999 appearing in this Annual Report on Form 10-K also included an audit of Financial Statement Schedule VIII of this Form 10-K. In our opinion, this Financial Statement Schedule VIII presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PricewaterhouseCoopers LLP New York, New York April 29, 1999 METALLURG HOLDINGS, INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS) NOTES: (a) Allowance account value at the time of the Merger. (b) Uncollectible accounts written off, less recoveries. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Metallurg, Inc. In our opinion, the accompanying consolidated balance sheet as of January 31, 1999 and the related statements of consolidated operations and of consolidated cash flows present fairly, in all material respects, the financial position of Metallurg, Inc. and its subsidiaries (the "Company") at January 31, 1999, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. The consolidated balance sheet of the Company as of January 31, 1998 and March 31, 1997 and the related statements of consolidated operations and consolidated cash flows for the three quarters ended January 31, 1998 (Reorganized Company), the quarter ended March 31, 1997 and the year ended December 31, 1996 (Predecessor Company) were audited by other independent accountants whose report dated April 1, 1998 expressed an unqualified opinion on those statements. PricewaterhouseCoopers LLP New York, New York March 31, 1999 INDEPENDENT AUDITORS' REPORT Metallurg, Inc.: We have audited the accompanying consolidated balance sheets of Metallurg, Inc. and consolidated subsidiaries as of January 31, 1998 and March 31, 1997 (Reorganized Company balance sheets) and the related statements of consolidated operations and of consolidated cash flows for the three quarters ended January 31, 1998 (Reorganized Company operations), the quarter ended March 31, 1997 and for the year ended December 31, 1996 (Predecessor Company operations). Our audits also included the financial statement schedule, Schedule VIII - Valuation and Qualifying Accounts and Reserves for the three quarters ended January 31, 1998 and the quarter ended March 31, 1997 (Reorganized Company) and the year ended December 31, 1996 (Predecessor Company), appearing on page 104. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Notes 1 and 3 to the consolidated financial statements, on April 14, 1997, the U.S. Bankruptcy Court for the Southern District of New York entered an order confirming the Company's plan of reorganization which became effective after the close of business on that day. Accordingly, the accompanying consolidated balance sheets as of January 31, 1998 and March 31, 1997 and the statements of consolidated operations and of consolidated cash flows for the three quarters ended January 31, 1998 have been prepared in conformity with the American Institute of Certified Public Accountants Statement of Position No. 90-7, "Financial Reporting for Entities in Reorganization Under the Bankruptcy Code," for the Company as a new entity with assets, liabilities, and a capital structure having carrying values not comparable with the prior periods as described in Notes 1 and 3. In our opinion, the Reorganized Company's balance sheets present fairly, in all material respects, the financial position of Metallurg, Inc. and consolidated subsidiaries at January 31, 1998 and March 31, 1997 and the results of their consolidated operations and their consolidated cash flows for the three quarters ended January 31, 1998, and the Predecessor Company consolidated financial statements, referred to above, present fairly, in all material respects, the results of their consolidated operations and their consolidated cash flows for the quarter ended March 31, 1997 and for the year ended December 31, 1996 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, effective January 1, 1996, the Company elected early adoption of the American Institute of Certified Public Accountants Statement of Position No. 96-1, "Environmental Remediation Liabilities." DELOITTE & TOUCHE LLP New York, New York April 1, 1998 METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF CONSOLIDATED OPERATIONS (IN THOUSANDS) See notes to consolidated financial statements. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) See notes to consolidated financial statements. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS (IN THOUSANDS) See notes to consolidated financial statements. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Metallurg, Inc. and its majority-owned subsidiaries (collectively, "Metallurg") manufacture and sell high quality metal alloys and specialty metals used by manufacturers of steel, aluminum, superalloys and chemicals and other metal consuming industries. Metallurg sells more than 500 different products to over 3,000 customers worldwide (primarily in North America and Europe). Basis of Presentation and Consolidation - The consolidated financial statements include the accounts of Metallurg, Inc. and its majority-owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation. The accounts of foreign subsidiaries have been translated into U.S. dollars in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52. On July 13, 1998, Metallurg was acquired by a group of institutional co-investors led by Safeguard International Fund, L.P. ("Safeguard International"). Metallurg is now a wholly owned subsidiary of Metallurg Holdings Inc., ("Metallurg Holdings") a Delaware corporation formed on June 10, 1998 by Safeguard International to effect the acquisition. The financial statements do not reflect the pushdown of purchase accounting adjustments recorded by Metallurg Holdings. On February 26, 1997, the Fourth Amended and Restated Joint Plan of Reorganization (the "Plan") of Metallurg, Inc. and one of its subsidiaries, Shieldalloy Metallurgical Corporation ("Shieldalloy") (collectively, the "Debtors"), was confirmed by the U.S. Bankruptcy Court for the Southern District of New York. Transactions contemplated by the Plan were consummated on April 14, 1997 (the "Effective Date"). For financial reporting purposes, Metallurg has reflected the effects of the Plan consummation as of March 31, 1997. As a result of the consummation of the Plan and the adoption of fresh-start reporting under the American Institute of Certified Public Accountants' Statement of Position ("SOP") No. 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code", Metallurg was required to report its financial results for the period ended January 31, 1998 in two separate periods. One period contains financial statements for the quarter ended March 31, 1997, which includes the effects of the adoption of fresh-start reporting and consummation of the Plan and is referred to as the "Predecessor Company". The other period contains financial statements for the three quarters ended January 31, 1998 for the reorganized Company. The financial statements of Metallurg after consummation of the Plan are not directly comparable to Metallurg's financial statements of prior periods. Effective April 1, 1997, the reporting period of Metallurg, Inc. was changed from a calendar year ending December 31 to a fiscal year ending January 31 and began reporting the results of its operating subsidiaries, which retained a calendar year-end, on a one-month lag. As a result of this change, the three quarters ended January 31, 1998 include the results of Metallurg, Inc. for the ten months ended January 31, 1998 and the results of its operating subsidiaries for the nine months ended December 31, 1997. Accounting Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents - Metallurg presents all highly liquid instruments, maturing within 30 days or less when purchased, as cash equivalents. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Inventories - Inventories are stated at the lower of cost or market. The cost of inventories is determined using principally the average cost and specific identification methods. Assets Held for Sale - Assets held for sale are stated at the lower of cost or estimated net realizable value which, for long-lived assets, is calculated in accordance with SFAS No. 121, as discussed below. Metallurg's Brazilian operating subsidiary adopted a plan to restructure mining and certain other operations in 1995. The remaining carrying amount of assets no longer needed in these operations, and which are being held for sale in 1999, totaled $711,000. At March 31, 1997, an office building owned by Metallurg's United Kingdom subsidiary, valued at approximately $1,180,000 was held for sale. Investments in Affiliates - Investments in affiliates in which Metallurg has a 20% to 50% ownership interest and exercises significant management influence are accounted for in accordance with the equity method. Investments in which the Company has less than a 20% interest are carried at cost. Property and Depreciation - In accordance with fresh-start reporting, property, plant and equipment previously stated at cost have been restated to the estimated fair value as of March 31, 1997 and historical accumulated depreciation has been eliminated. Major renewals and improvements are capitalized, while maintenance and repairs are expensed when incurred. Depreciation is computed using the straight-line or declining-balance methods over the estimated useful lives of the assets. Upon sale or retirement, the costs and related accumulated depreciation are eliminated from the respective accounts and any resulting gain or loss is included in income. Revenue Recognition - Sales represent amounts invoiced to customers by Metallurg and such revenue is recognized when the product is shipped and title to the product passes to the customer. In certain instances, Metallurg arranges sales for which the supplier invoices the customer directly ("agency sales"). In such cases, Metallurg receives commission income, which is recognized when the supplier passes title to the customer. Environmental Remediation Costs - In accordance with SOP No. 96-1, "Environmental Remediation Liabilities", losses associated with environmental remediation obligations are accrued when such losses are deemed probable and reasonably estimable. Such accruals generally are recognized no later than the completion of the remedial feasibility study and are adjusted as further information develops or circumstances change. Cost of future expenditures for environmental remediation obligations are generally not discounted to their present value. Valuation of Long-Lived Assets - In 1995, Metallurg adopted SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of". In accordance with this standard, Metallurg periodically evaluates the carrying value of long-lived assets to be held and used, including goodwill and other intangible assets, when events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flow from such asset is separately identifiable and is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Fair market value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair market values are reduced for the cost to dispose. Income Taxes - Metallurg uses the liability method whereby deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of Metallurg's assets and liabilities. Metallurg does not provide for U.S. Federal income taxes on the accumulated earnings considered permanently reinvested in certain of its foreign subsidiaries which approximated $40,000,000, $37,000,000 and $38,000,000 at January 31, 1999, January 31, 1998 and March 31, 1997, respectively. These earnings have been invested in facilities and other assets and have been subject to substantial foreign income taxes, which may or could offset a major portion of any tax liability resulting from their remittance and inclusion in U.S. taxable income. Accordingly, Metallurg does not provide for U.S. income taxes on foreign currency translation adjustments related to these foreign subsidiaries. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Retirement Plans - Pension costs of Metallurg and its domestic consolidated subsidiaries are funded or accrued currently. Metallurg's foreign subsidiaries maintain separate pension plans for their employees. Such foreign plans are either funded currently or accruals are recorded in the respective balance sheets to reflect pension plan liabilities. Stock-Based Compensation - Metallurg accounts for stock-based compensation using the intrinsic value method, in accordance with Accounting Principles Board Opinion No. 25. Accordingly, compensation cost for stock options is measured as the excess, if any, of the market price of Metallurg's common stock at the date of grant over the amount an employee must pay to acquire the stock. Disclosures required with respect to alternative fair value measurement and recognition methods prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation" are presented in Note 12. Foreign Exchange Gains and Losses - Foreign exchange transaction gains of $618,000, $987,000, $712,000 and $1,853,000 were recorded for the year ended January 31, 1999, the three quarters ended January 31, 1998, the quarter ended March 31, 1997 and the year ended December 31, 1996, respectively. Translation gains and losses resulting from reporting foreign subsidiaries in U.S. dollars are recorded directly to shareholders' equity. Financial Instruments - Metallurg enters into foreign exchange contracts in the regular course of business to manage exposure against fluctuations on sales and raw material purchase transactions denominated in currencies other than the functional currencies of its businesses. Unrealized gains and losses are deferred and recognized in income or as adjustments of carrying amounts when the hedged transactions are included in income. Gains and losses on unhedged foreign currency transactions are included in income. Metallurg does not hold or issue financial instruments for trading purposes. The counterparties to these contractual arrangements are a diverse group of major financial institutions with which Metallurg also has other financial relationships. Metallurg is exposed to credit risk generally limited to unrealized gains in such contracts in the event of nonperformance by counterparties of those financial instruments, but it does not expect any counterparties to fail to meet their obligations given their high credit ratings. Extraordinary Item - In November 1997, Metallurg recognized an extraordinary charge of $792,000, net of tax of $473,600, as a result of the early retirement of Metallurg's 12% senior-secured notes due 2007 and the United Kingdom subsidiary's term loan due 2000. The notes were redeemed at 103% and 101% of principal amount, respectively, with accrued interest to the date of redemption. In the quarter ended March 31, 1997, Metallurg recognized an extraordinary gain of $43,032,000 net of tax of nil, relating to the discharge of indebtedness at the consummation of the Plan of Metallurg, Inc. and Shieldalloy. Recently Issued Accounting Pronouncements - In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Metallurg is currently evaluating the impact SFAS No. 133 will have on its financial statements. Reclassification - Certain prior year amounts were reclassified to conform to 1999 presentations. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 2. MERGER On July 13, 1998, Metallurg was acquired by a group of investors led by Safeguard International. The acquisition was accomplished by Metallurg Acquisition Corp., a wholly owned subsidiary of Metallurg Holdings, a Delaware corporation, merging with and into Metallurg, with Metallurg being the surviving company and Metallurg Holdings becoming the sole parent of Metallurg. Metallurg Holdings was formed on June 10, 1998 and is owned by Safeguard International (an international private equity fund that invests primarily in equity securities of companies in process industries), certain limited partners of Safeguard International, certain individuals and a private equity fund. In connection with the Merger, Metallurg received the consents of 100% of the registered holders of its $100,000,000 Senior Notes to a one-time waiver of the change of control provisions of the Senior Note Indenture to make such provisions inapplicable to the Merger and to amend the definition of "Permitted Holders" under the Senior Note Indenture to reflect the post-merger ownership of Metallurg. No other modifications to terms of outstanding debt were affected in this regard. At the time of the Merger, each outstanding share of Metallurg common stock was converted into the right to receive $30 in cash. As of July 13, 1998, in connection with the Merger, all of the then outstanding shares of common stock of Metallurg were cancelled and 100 shares of common stock, $0.01 par value, were issued to Metallurg Holdings. Merger-related costs of $7,888,000 were incurred, and recorded as expense by Metallurg, in the year ended January 31, 1999 and included (a) $3,541,000 for payments to cancel compensatory stock options; (b) $625,000 in consent fees incurred in order to obtain the one-time waiver of the change of control provisions of the Senior Note Indenture; (c) $2,822,000 for payments made pursuant to existing employment agreements with Metallurg management and (d) $900,000 of other merger-related costs. 3. PLAN OF REORGANIZATION AND FRESH-START REPORTING Costs of administration of the Chapter 11 proceedings approximating $2,663,000 and $3,535,000 were recorded by the Debtors during the quarter ended March 31, 1997 and the year ended December 31, 1996, respectively, and have been included as reorganization expense in the Statements of Consolidated Operations. Those expenses consisted primarily of legal, administration, consulting and other similar expenses. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Condensed financial statements for the Debtors follow (in thousands): METALLURG, INC. AND SHIELDALLOY METALLURGICAL CORP. CONDENSED STATEMENTS OF OPERATIONS METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) METALLURG, INC. AND SHIELDALLOY METALLURGICAL CORP. CONDENSED BALANCE SHEET METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) METALLURG, INC. AND SHIELDALLOY METALLURGICAL CORP. CONDENSED STATEMENTS OF CASH FLOWS On the Effective Date, claims related to prepetition liabilities and administrative expenses were discharged through distributions of $59,366,000 in cash, the issuance of $39,461,000 of senior-secured notes and 4,706,406 shares of new common stock. The value of the cash and securities distributed was less than the recorded liabilities and the resultant net gain of $47,211,000 was recorded as an extraordinary item, net of tax effects of nil due to statutory exemption and utilization of net operating loss carryforwards. Such net operating loss carryforwards had previously been offset in full by a valuation allowance. Metallurg was required to adopt fresh-start reporting because the holders of the existing voting shares immediately prior to filing and confirmation of the Plan received less than 50% of the voting shares of the emerging entity and its reorganization value was less than the total of its post-petition liabilities and allowed claims. SOP 90-7 required Metallurg to revalue its assets and liabilities to their estimated fair value and to recognize as a reduction of long-term assets the excess of the fair value of its identifiable assets over the total reorganization value of its assets as of the Effective Date. Accordingly, Metallurg's property, plant and equipment and other noncurrent assets were reduced by approximately $5,520,000. In addition, Metallurg's accumulated equity of approximately $4,733,000 and cumulative foreign currency translation adjustment of approximately $14,587,000 were eliminated. As a result of the adjustments made to reflect fresh-start reporting, a pre-tax revaluation credit of $5,107,000 is included in Metallurg's results of operations for the quarter ended March 31, 1997. The total reorganization value assigned to Metallurg's assets was estimated by calculating projected cash flows before debt service requirements for a three-year period, plus an estimated terminal value of Metallurg calculated using an estimate of normalized operating performance and discount rates ranging from 13.5% to 16.5%. This amount was increased by (i) the estimated net realizable value of assets to be sold and (ii) estimated cash in excess of normal operating requirements. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The effect of the Plan and the implementation of fresh-start reporting on Metallurg's consolidated balance sheet as of March 31, 1997 were as follows (in thousands): Notes: (a) To record the distribution of cash and securities, the settlement of liabilities subject to compromise and other transactions in accordance with the Plan. (b) To adjust assets and liabilities to their estimated fair value. (c) To reduce long-term assets for the excess of the fair value of identifiable net assets over the total reorganization value as of the Effective Date. (d) To eliminate the accumulated deficit and cumulative foreign currency translation adjustment in accordance with fresh-start reporting. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 4. SEGMENTS AND RELATED INFORMATION Metallurg adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information" in the year ended January 31, 1999 which changes the way Metallurg reports information about its reportable segments. The accounting policies of the reportable segments are the same as those described in Note 1 of the Notes to Consolidated Financial Statements. Information for prior periods presented have been restated in order to conform to the current year presentation. Metallurg operates in one significant industry segment, the manufacture and sale of ferrous and non-ferrous metals and alloys. Metallurg is organized geographically, having established a worldwide sales network built around Metallurg's core production facilities in the United States, the United Kingdom and Germany. In addition to selling products manufactured by Metallurg, Metallurg distributes complementary products manufactured by third parties. Reportable Segments Shieldalloy: This unit is comprised of two production facilities in the U.S. The New Jersey plant manufactures and sells aluminum alloy grain refiners and alloying tablets for the aluminum industry, metal powders for the welding industry and specialty ferroalloys for the superalloy and steel industries. The Ohio plant manufactures and sells ferrovanadium and vanadium based chemicals used mostly in the steel and petrochemical industries. In addition to its manufacturing operations, Shieldalloy imports and distributes complementary products manufactured by affiliates and third parties. LSM: This unit is comprised mainly of three production facilities in the UK which manufacture and sell aluminum alloy grain refiners and alloying tablets for the aluminum industry, chromium metal and specialty ferroalloys for the steel and superalloy industries and aluminum powder for various metal powder consuming industries. GfE: This unit is comprised of two production facilities and a sales office in Germany. The Nuremburg plant manufactures and sells a wide variety of specialty products, including vanadium based chemicals and sophisticated metals, alloys and powders used in the titanium, superalloy, electronics, steel, biomedical and optics industries. The Morsdorf plant produces medical prostheses, implants and surgical instruments for orthopedic applications. EWW: This production unit, also located in Germany, produces various grades of low carbon ferrochrome used in the superalloy, welding and steel industries. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Summarized financial information concerning the Metallurg's reportable segments is shown in the following table (in thousands). Each segment records direct expenses related to its employees and operations. The "Other" column includes corporate related items, fresh-start adjustments and results of subsidiaries not meeting the quantitative thresholds as prescribed by applicable accounting rules. Metallurg does not allocate general corporate overhead expenses to operating segments. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The following table presents revenue by region based on the location of the user of the product. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Metallurg sells its products in over fifty countries. Information regarding sales by country is not readily available for prior periods. In the year ended January 31, 1999, however, sales by country include: The following table presents property, plant and equipment by country based on the location of the assets. 5. INVESTMENT IN AFFILIATES In February 1998 and in August 1996, Metallurg purchased 5% interests, respectively, in Solikamsk Magnesium Works, a Russian magnesium metal producer, for approximately $2,000,000 and $1,000,000, respectively. Also during March 1998, Metallurg sold its minority investment in Compagnie des Mines et Metaux S.A., a Luxembourg affiliate, for proceeds of approximately $1,100,000, resulting in a gain of approximately $900,000. In March 1997, Metallurg sold its 50% interest in AMPAL for proceeds approximating book value of $1,200,000. In December 1996, SMC sold its wholly owned subsidiary, Frankel Metal Company, a processor of titanium scrap, to FMC's management and recorded a net loss on the sale of $460,000. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 6. INVENTORIES Inventories, net of reserves, consist of the following (in thousands): 7. PROPERTY, PLANT AND EQUIPMENT The major classes of property, plant and equipment are as follows (in thousands): Depreciation expense related to property, plant and equipment charged to operations for the year ended January 31, 1999, the three quarters ended January 31, 1998, the quarter ended March 31, 1997 and the year ended December 31, 1996 was $7,959,000, $5,320,000, $2,126,000 and $10,621,000, respectively. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 8. RETIREMENT PLANS Metallurg adopted SFAS No. 132, "Employers' Disclosure about Pensions and other Postretirement Benefits" in the year ended January 31, 1999. SFAS No. 132 changes current financial disclosure requirements from those that were required under SFAS No. 87, "Employers' Accounting for Pensions", SFAS No. 88, "Employers' Accounting for Settlement and Curtailments of Defined Benefit Pension Plans and for Termination Benefits" and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". Defined Benefit Plans The following table summarizes the changes in benefit obligation and changes in plan assets for the periods presented (in thousands): METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The following table summarizes the components of net periodic benefit cost (in thousands): Metallurg and its domestic consolidated subsidiaries have defined benefit pension plans covering substantially all salaried and certain hourly paid employees. The plans generally provide benefit payments using a formula based on an employee's compensation and length of service. These plans are funded in amounts equal to the minimum funding requirements of the Employee Retirement Income Security Act. Substantially all plan assets are invested in cash and short-term investments or listed stocks and bonds. The funded status of these plans are as follows (in thousands): Metallurg's United Kingdom subsidiary maintains a defined benefit pension plan covering all eligible employees. Substantially all plan assets are invested in listed stocks and bonds. The funded status of this plan is as follows (in thousands): METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Metallurg's German subsidiaries maintain unfunded defined benefit pension plans covering substantially all eligible employees. The plans had been amended in 1992 in a manner that terminated any credit for future service. These plans were amended in 1998 and accordingly, (i) credit for future service was reinstated, retroactive to January 1, 1993, for certain employees and (ii) benefits were adjusted for cost of living increases not recognized subsequent to 1992. Accrued pension liabilities were $38,576,000, $35,883,000 and $38,528,000 at January 31, 1999, January 31, 1998 and March 31, 1997, respectively. Other Benefit Plans Metallurg maintains a discretionary defined contribution profit sharing plan covering substantially all of the salaried employees of Metallurg and its domestic consolidated subsidiaries. The related expense was $207,000, $165,000, $62,000 and $229,000 in the year ended January 31, 1999, the three quarters ended January 31,1998, the quarter ended March 31, 1997 and the year ended December 31, 1996, respectively. Balance sheet accruals for pension plans of Metallurg's other foreign subsidiaries approximate or exceed the related actuarially computed value of accumulated benefit obligations. Accrued pension liabilities for these plans were $506,000, $385,000 and $419,000 at January 31, 1999, January 31, 1998 and March 31, 1997, respectively. Pension expense relating to Metallurg's other foreign subsidiaries' pension plans was $213,000, $353,000, $96,000 and $228,000 for the year ended January 31, 1999, the three quarters ended January 31, 1998, the quarter ended March 31, 1997 and the year ended December 31, 1996. Metallurg maintained certain non-qualified retirement benefit arrangements for certain individuals. Pension expense relating to certain of those arrangements was $300,000 in the year ended December 31, 1996. No expense was recorded for these arrangements subsequent to 1996. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) BORROWINGS Long-term debt consists of the following (in thousands): Metallurg, Inc. and Domestic Subsidiaries In November 1997, Metallurg, Inc. sold the $100,000,000 Senior Notes which mature in 2007 and accrue interest at a rate of 11% per annum, payable semi-annually commencing in June 1998. The Senior Notes are redeemable at the option of Metallurg, Inc., in whole or in part, at any time on or after December 2002. Prior to December 1, 2000, a maximum of 34% of the Senior Notes may be redeemed with net proceeds of one or more public equity offerings of Metallurg. The Senior Notes are fully and unconditionally guaranteed by the U.S. subsidiaries of Metallurg, Inc. on a senior unsecured basis. The Indenture contains limitations on, among other things, the ability of Metallurg to incur indebtedness and enter into certain mergers, consolidations or asset sales. In addition, Metallurg, Inc. is prohibited from making dividends in an amount greater than 50% of its net income under terms of the Indenture. Pursuant to the Plan, Metallurg, Inc. and Shieldalloy (the "Borrowers") entered into an agreement with certain financial institutions led by BankBoston, N.A., as agent, for a revolving credit facility (the "Revolving Credit Facility"), in the amount of $40,000,000, to provide working capital and to finance other general corporate purposes. In October 1997, this facility was increased to $50,000,000 and the German Subfacility (as discussed below) was established. Borrowings under this facility bear interest at a rate per annum equal to (i) the Base Rate plus 1% per annum (the Base Rate is the greater of BankBoston N.A.'s base rate or the Federal Funds Effective Rate plus 0.5%) or (ii) the reserve adjusted Eurodollar rate plus 2.5% for interest periods of one, two or three months. Metallurg, Inc. is required to pay a fee of 0.375% per annum on the unused portion of the commitment. The total amount the Borrowers may borrow at any time is limited to a borrowing base calculation that is based on eligible accounts receivable, inventory and certain fixed assets. At January 31, 1999, there were no borrowings under this facility; however, outstanding letters of credit approximated $23,789,000. Substantially all assets of the Borrowers are pledged as collateral under this agreement. The revolving credit agreement, which expires on April 14, 2000, prohibits Metallurg, Inc. from making dividends and requires the Borrowers and certain subsidiaries to comply with various covenants, including the maintenance of minimum levels of quarterly earnings before interest, taxes, depreciation and amortization, as defined in the Indenture ("Adjusted EBITDA"). These companies were required to maintain quarterly Adjusted EBITDA of $1,000,000. For the quarter ended December 31, 1998, Adjusted EBITDA of such companies was a loss of $7,300,000; accordingly, BankBoston waived that requirement of the agreement as of, and for the quarter, ended December 31, 1998 and amended the agreement to eliminate the Adjusted EBITDA quantitative covenants so long as certain other defined cash positions are maintained as prescribed in the agreement. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) At September 2, 1993 (the "Petition Date"), the Debtors were in default of certain provisions of certain debt agreements. With minor exceptions, repayment of the amounts outstanding at that date had been deferred pursuant to the Chapter 11 proceedings. Subsequent to the Chapter 11 filings, the Debtors did not accrue interest on any of these obligations, except for secured debt, incurred on or before the Petition Date. Contractual interest on these unsecured obligations approximated $2,136,000 and $8,600,000 in excess of interest expense reflected in the Statements of Consolidated Operations for the quarter ended March 31, 1997 and the year ended December 31, 1996, respectively. Foreign Subsidiaries Pursuant to the Revolving Credit Facility, BankBoston, N.A., through its Frankfurt office, is providing to GfE and its subsidiaries, up to DM 20,500,000 (approximately $12,300,000) of financing (the "German Subfacility"). The German Subfacility is guaranteed by Metallurg, Inc. and the other U.S. borrowers and outstanding obligations are limited to a borrowing base which is based on eligible accounts receivable, eligible inventory and certain equipment. The German Subfacility contains various covenants that restrict, among other things, the payment of dividends, share repurchases, capital expenditures, investments in subsidiaries and borrowings. All accounts receivable, inventory, the stock of GfE's subsidiaries and certain other assets are pledged to secure the German Subfacility. At January 31, 1999, borrowings under the German Subfacility were immaterial. Short-term unsecured borrowings of the GfE group with local banks totaled DM 1,200,000 (approximately $700,000) at January 31, 1999. In August 1998, GfE entered into a term loan with IKB Deutsche Industrie Bank in the amount of DM 10,000,000 (approximately $6,000,000). The loan, which matures in 2008, bears interest at a rate of 4.5% and is secured by certain property of GfE. The GfE group also has term loans approximating DM 3,027,000 (approximately $1,800,000) maturing through 2004 and bearing interest at a weighted average rate of 6.0%. LSM, a United Kingdom subsidiary, has several credit facilities which provide LSM and its subsidiaries up to pound sterling 7,000,000 (approximately $11,600,000) of borrowings, up to pound sterling 3,300,000 (approximately $5,500,000) of foreign exchange exposure and up to pound sterling 2,300,000 (approximately $3,800,000) for other ancillary banking arrangements, including bank guarantees. The facility expires in October 1999 and bears interest at the lender's base rate plus 1.0%. The facility is unsecured and contains restrictions on dividends. In 1998, LSM increased a facility for borrowings and foreign exchange exposure to pound sterling 4,000,000 (approximately $6,600,000). This facility, which expires in December 1999, is unsecured and borrowings bear interest at a rate of 1% over the bank's base rate. At January 31, 1999, there were no borrowings under these facilities. EWW, a German subsidiary, has committed lines of credit with several banks in the aggregate amount of DM 15,200,000 (approximately $9,100,000). The credit facilities decrease by DM 3,000,000 per year beginning in 1999 and currently bear interest at rates from 7.5% to 8.5%. The credit agreements require EWW to pledge certain assets, which include accounts receivable, inventory and fixed assets. At January 31, 1999, there were DM 3,600,000 (approximately $2,100,000) of borrowings under these agreements. EWW also has a term loan of DM 2,400,000 (approximately $1,400,000) maturing in 2001. The term loan is secured by a mortgage on certain real property and bears interest at 4.5%. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) In 1998, EWW borrowed DM 1,500,000 (approximately $900,000) to fund capital additions. The loan, which matures in 2008, bears interest at 4.25%. Metallurg, Inc.'s other foreign subsidiaries maintain short-term secured and unsecured borrowing arrangements, generally in local currencies, with various banks. Borrowings under these arrangements aggregated $1,021,000 at January 31, 1999 at a weighted average interest rate of 10.9%. Interest expense totaled $12,833,000, $8,270,000, $1,706,000 and $3,043,000 for the year ended January 31, 1999, the three quarters ended January 31, 1998, the quarter ended March 31, 1997 and the year ended December 31, 1996. The scheduled maturities of long-term debt during the next five years are $1,074,000 in 1999, $989,000 in 2000, $963,000 in 2001, $413,000 in 2002, $285,000 in 2003 and $106,535,000 thereafter. 10. FINANCIAL INSTRUMENTS The carrying value of cash and cash equivalents, trade receivables, other current assets, accounts payable and accrued liabilities approximate fair value due to the short-term maturities of these assets and liabilities. Fair values for investments in affiliates are not readily available. The aggregate fair value of short-term bank debt approximates its carrying amount because of recent and frequent repricing based on market conditions. Based on quoted market prices, the fair value of Metallurg, Inc.'s $100,000,000 Senior Notes, issued in November 1997, approximates $89,000,000 and $103,700,000 at January 31, 1999 and 1998, respectively. The carrying amount of other long-term debt approximates fair value. Metallurg enters into foreign exchange contracts in the regular course of business to manage exposure against fluctuations on sales and raw material purchase transactions denominated in currencies other than the functional currencies of its businesses. The contracts generally mature within 12 months and are principally unsecured foreign exchange contracts with carefully selected banks. The aggregate notional amounts of the contracts outstanding as of January 31, 1999, January 31, 1998 and March 31, 1997 were approximately $29,800,000, $44,200,000 and $42,000,000, respectively. These contracts are predominately denominated in the currencies: Deutsche Marks, Pounds Sterling and U.S. Dollars. The notional values provide an indication of the extent of Metallurg's involvement in such instruments but do not represent its exposure to market risk, which is essentially limited to risk related to currency rate movements. Unrealized gains on these contracts at January 31, 1999, January 31, 1998 and March 31, 1997 were approximately $117,000, $231,000 and $1,493,000, respectively. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 11. INCOME TAXES For financial reporting purposes, income (loss) before income tax provision and extraordinary item includes the following components (in thousands): The reconciliation of income tax from continuing operations computed at the U.S. Federal statutory tax rate to Metallurg's effective tax rate is as follows (in thousands): METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The income tax provision (benefit) represents the following (in thousands): U.S. Federal income tax refunds receivable of $4,180,000, $2,070,000 and $1,043,000 at January 31, 1999, January 31, 1998, and March 31, 1997, respectively, relate primarily to the Federal tax deposits in excess of estimated liabilities and carryback claims related to environmental expenses and net operating losses, and are reflected in prepaid expenses in the accompanying Consolidated Balance Sheets. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of Metallurg's deferred tax assets and liabilities are as follows (in thousands): At January 31, 1999, Metallurg has net operating loss carryforwards relating to domestic operations of approximately $4,637,000 (subject to certain limitations relative to utilization) which expire through 2010 and Alternative Minimum Tax Credit carryforwards of approximately $700,000 which can be carried forward indefinitely. Metallurg, Inc.'s consolidated foreign subsidiaries have income tax loss carryforwards aggregating approximately $76,973,000, a substantial portion of which relates to German operations which do not expire under current regulations and certain Brazilian operations which partially expire through 2004. Due to significant uncertainties surrounding the realization of certain loss carryforwards, the related deferred tax assets have been substantially provided for in the valuation allowances at January 31, 1999. However, during the period ended March 31, 1997, Metallurg determined that a German subsidiary has sufficiently demonstrated the ability to generate earnings and the valuation allowance of $6,032,000 relating to that subsidiary was appropriately reversed. Such benefit from a reduction in valuation allowance was partly offset by a deferred tax provision relating to an adjustment of U.K. pension liabilities. Included within the deferred tax benefit are the deferred tax effects of certain deferred tax assets for which a corresponding credit has been recorded to "Additional paid-in capital" approximating $700,000 and the deferred tax effects of certain deferred tax assets, primarily foreign net operating losses, for which a benefit has previously been recognized in the amount of $130,000. The adoption of fresh-start reporting results in an increase of additional paid-in capital, rather than an income tax benefit, as the benefits relating to existing deferred tax assets are recognized. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 12. SHAREHOLDERS' EQUITY (DEFICIT) At December 31, 1996, 10,000 shares of common stock were authorized, of which 2,005 shares were outstanding. This stock had no par value and a stated value of $10 per share. In addition, 300,000 shares of preferred stock were authorized, having a par value of $100 per share, of which no shares were outstanding at December 31, 1996. Effective April 14, 1997, the Certificate of Incorporation of Metallurg, Inc. was amended, whereby the authorized number of shares of common stock was increased to 15,000,000 shares with a par value of $.01 per share, and each original outstanding share of common stock of Metallurg, Inc. was subsequently canceled. In addition, in accordance with the Plan, 4,706,406 shares were issued to prepetition unsecured claimholders. Metallurg, Inc. was subsequently merged into a new corporation, organized under the laws of the State of Delaware, and all common shares then outstanding were exchanged on a one-for-one basis for shares in the new corporation. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) At the time of the Merger, each outstanding share of Metallurg, Inc. common stock was converted into the right to receive $30 in cash. As of July 13, 1998, in connection with the Merger, all of the then outstanding shares of common stock of Metallurg, Inc. were canceled and 100 shares of common stock, $0.01 par value, were issued to Metallurg Holdings. In November 1998, the Certificate of Incorporation of Metallurg, Inc. was amended to provide for 10,000,000 authorized shares of common stock and Metallurg, Inc. consummated a 50,000 for 1 stock split and, as a result, Metallurg, Inc. has 5,000,000 shares of common stock, $0.01 par value, outstanding, all of which are owned by Metallurg Holdings. Total comprehensive income (loss) totaled $871,000, $6,945,000, $56,730,000 and $(24,227,000) for the year ended January 31, 1999, the three quarters ended January 31, 1998, the quarter ended March 31, 1997 and the year ended December 31, 1996. Stock Compensation Plans On November 20, 1998, the Board of Directors adopted the Metallurg, Inc. 1998 Equity Compensation Plan (the "ECP"), to provide (i) designated employees of Metallurg, Inc. and its subsidiaries, (ii) certain advisors who perform services for Metallurg, Inc. or its subsidiaries and (iii) non-employee members of the Board of Directors of Metallurg, Inc. (the "Board") with the opportunity to receive grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock and performance units. Under the ECP, 500,000 shares of common stock were made available for stock awards and stock options. Metallurg believes that the ECP will encourage the participants to contribute materially to the growth of Metallurg, thereby benefiting Metallurg's shareholders, and will align the economic interests of the participants with those of the shareholders. Pursuant to the Company's ECP, the Compensation Committee of Metallurg's Board awarded to eligible executives and non-employee Board members options to purchase up to 450,000 and 12,500 shares of common stock at an exercise price of $30.00 per share, effective as of November 20, 1998 and January 4, 1999, respectively. Such options have a term of ten years and vest 20% on the date of grant and will vest 20% on each of the first four anniversaries of the date of grant. On April 14, 1997, Metallurg, Inc. had adopted the Metallurg, Inc. Management Stock Award and Stock Option Plan (the "SASOP"), which was to be administered by the Compensation Committee of the Board of Directors for a term of 10 years. Under the terms of the SASOP, the Board was to grant stock awards and stock options (including incentive stock options, nonqualified stock options or a combination of both) to officers and key employees of Metallurg. Under the SASOP, 500,000 shares of common stock were made available for stock awards and stock options. Pursuant to the Plan, the Board granted to eligible executives 250,000 shares of common stock (the "Initial Stock Awards"). Twenty percent of each Initial Stock Award was transferable on the date of grant and 40 percent was to become transferable on the first and second anniversary of the date of grant. Additionally, the Board granted to eligible employees options to purchase 167,000 shares of common stock at $11.38 (fair market value on the date of grant), effective as of September 1, 1997, and 20,000 shares of common stock at $8.43 (fair market value on the date of grant), effective as of April 1, 1998. Such options vested 33 1/3% on the date of grant and 33 1/3% were to vest on the first and second anniversary of the date of grant. At the time of the Merger, the Initial Stock Awards then outstanding became fully vested and Metallurg recorded additional compensation expense of approximately $355,000. In addition, outstanding stock options became fully vested and holders were therefore entitled to receive $30 per share as part of the purchase of Metallurg. Metallurg recorded compensation expense of $3,541,000, which represents the excess of the $30 per share purchase price over the exercise prices noted above. Metallurg was reimbursed for such stock option cancellation costs by a capital contribution from Safeguard International at the time of the Merger. Metallurg accounted for the SASOP using the intrinsic value method in accordance with APB No. 25. Accordingly, compensation expense related to the Initial Stock Awards of $750,000, $1,250,000 and $500,000 was recognized in the year ended January 31, 1999, the three quarters ended January 31, 1998 and the quarter ended March 31, 1997, respectively, and no compensation expense was recognized for the stock options granted. Metallurg has elected the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Had Metallurg used the fair value method at the date of grant of the stock options, additional compensation expense would have been recorded, resulting in the following pro forma amounts (in thousands): The weighted average fair value of options granted were $4.83 and $1.47 per share at January 31, 1999 and 1998, respectively. This fair value was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions: METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 13. OTHER INCOME (EXPENSE), NET Other income (expense), net consists of the following (in thousands): In the year ended January 31, 1999, one of Metallurg, Inc.'s German subsidiaries was successful in recovering approximately $1,351,000 of additional proceeds from a government-owned insurance agency representing final settlement for claims under the company's political risk insurance policy related to an investment in the former Zaire. In the three quarters ended January 31, 1998, one of Metallurg, Inc.'s German subsidiaries sold certain plant assets no longer in productive use and recorded a gain of approximately $1,700,000. During 1997, Metallurg, Inc, sold one of its commercial real estate properties located in New York City in contemplation of the Plan. A gain of $2,747,000 is reflected in other income in the quarter ended March 31, 1997. Upon reaching settlement in 1996 with various prepetition creditors, the District 65 Pension Plan and certain environmental regulatory authorities, the Debtors recorded additional expenses of approximately $10,500,000. Turk Maadin Sirketi A.S., a Turkish chrome ore mining operation, entered into an agreement in 1995 to sell a parcel of land no longer in productive use in an installment sale arrangement. As a result, a gain on this transaction of $3,787,000 has been reflected in other income in 1996. 14. ENVIRONMENTAL LIABILITIES Shieldalloy operates manufacturing facilities in Newfield, New Jersey and Cambridge, Ohio, which produce alloys and other specialty products. The historical manufacture of several products at the two facilities has resulted in the production of various by-products, which Shieldalloy is obligated to clean up under Federal and state environmental laws and regulations. These clean-up obligations are under the jurisdiction of the United States Environmental Protection Agency, the New Jersey Department of Environmental Protection, the Ohio Environmental Protection Agency, the United States Nuclear Regulatory Commission ("NRC"), the United States Department of Interior and the Ohio Department of Health. Metallurg has also provided for certain estimated costs associated with its sites in Germany and Brazil. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Total environmental liabilities consist of the following (in thousands): Shieldalloy entered into Administrative Consent Orders ("ACO's") with the State of New Jersey, dated October 5, 1988 and September 5, 1984, under which Shieldalloy, as required, has conducted a remedial investigation and feasibility study ("RI/FS") of alternatives to remedy groundwater contamination at the Newfield facility. The ACO's also require Shieldalloy to evaluate, and where appropriate, remediate certain additional environmental conditions pursuant to state laws and regulations. These activities include the closure of nine wastewater lagoons, soil remediation, surface water and sediment clean up, as well as miscellaneous operation and maintenance activities and onsite controls. Metallurg accrued its best estimate of the associated costs with respect to remedial activities at the site which it expects to disburse over the next thirteen years. During 1995, $8,000,000 in a prepetition letter of credit was drawn upon and deposited in a trust fund. During the quarter ended March 31, 1997, remaining prepetition letters of credit, in the amount of $8,200,000, were drawn upon and deposited in a trust fund. Subsequently, pursuant to an agreement with the State of New Jersey, Metallurg was permitted to withdraw cash from the environmental trust and substitute letters of credit in an equivalent dollar amount. At January 31, 1999, outstanding letters of credit issued as financial assurances in favor of various environmental agencies total $21,419,000. The costs of providing financial assurance over the term of the remediation activities have been contemplated in the accrued amounts. As a result of NRC-regulated manufacturing activities, slag piles have accumulated at the Cambridge and Newfield sites which contain low levels of naturally occurring radioactivity. As related production has ceased at the Cambridge location, Shieldalloy is required to decommission the slag piles. Shieldalloy obtained approval from the State of Ohio and is currently awaiting approval from the NRC to stabilize and cap the slag piles in situ. As long as production continues at the Newfield location, the NRC will allow the slag pile to remain in place, subject to submission of a conceptual decommissioning plan and financial assurance for implementation of that plan. Metallurg obligation of the decommissioning plan and financial assurance for implementation of that plan for these sites is partially assured by cash funds held in trust. As a condition precedent to consummation of the Plan, $1,500,000 in a prepetition letter of credit, relating to both the Newfield and Cambridge facilities, was drawn upon and deposited in a trust fund. In 1987, Shieldalloy purchased the Cambridge manufacturing facility from Foote Mineral Company. Cyprus Foote Mineral Company ("Cyprus Foote") is the successor in interest to Foote. During 1995, Shieldalloy, Cyprus Foote and the State of Ohio entered into a Consent Order for Permanent Injunction (the "Consent Order") under which Shieldalloy and Cyprus Foote agreed to conduct an RI/FS of the Cambridge site and the State of Ohio agreed to review such information on an expedited basis and issue a Preferred Plan setting forth a final remedy for the site. On December 16, 1996, the State of Ohio issued its Preferred Plan and, subsequently, Shieldalloy and Cyprus Foote agreed to perform remedial design and remedial action at the site. These activities include remediation of slag piles, clean up of wetland soils and clean up of on-site and off-site sediments. Pursuant to the Consent Order, Shieldalloy and Cyprus Foote are jointly and severally liable to the State of Ohio in respect of these obligations. However, Shieldalloy has agreed with Cyprus Foote that it shall perform and be liable for the performance of these remedial obligations. Therefore, Metallurg has accrued its best estimate of associated costs which it expects to substantially disburse over the next five years. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) With respect to the financial assurance obligations to the State of Ohio, Cyprus Foote has agreed to provide financial assurance of approximately $9,000,000 as required by the State of Ohio and Shieldalloy has purchased an annuity contract which will provide for future payments into the trust fund to cover certain of the estimated operation and maintenance costs over the next 100 years. Metallurg, Inc.'s German subsidiaries have accrued environmental liabilities in the amounts of $4,443,000, $4,827,000, and $5,611,000 at January 31, 1999, January 31, 1998 and March 31, 1997, respectively, to cover the costs of closing an off-site dump and for certain environmental conditions at a subsidiary's Nuremberg site. In Brazil, costs of $389,000, $374,000 and $475,000 have been accrued at January 31, 1999, January 31, 1998 and March 31, 1997, respectively, to cover reclamation costs of the closed mine sites. 15. CONTINGENT LIABILITIES In addition to environmental matters, which are discussed in Note 14, Metallurg continues defending various claims and legal actions arising in the normal course of business. Management believes, based on the advice of counsel, that the outcome of such litigation will not have a material adverse effect on Metallurg's consolidated financial position, results of operations or liquidity. There can be no assurance, however, that existing or future litigation will not result in an adverse judgment against Metallurg which could have a material adverse effect on Metallurg's future results of operations or cash flows. 16. LEASES Metallurg leases office space, facilities and equipment. The leases generally provide that Metallurg pays the tax, insurance and maintenance expenses related to the leased assets. At January 31, 1999, future minimum lease payments required under non-cancelable operating leases having remaining lease terms in excess of one year are as follows (in thousands): Rent expense under operating leases for the year ended January 31, 1999, the three quarters ended January 31, 1998, the quarter ended March 31, 1997 and the year ended December 31, 1996 was $1,756,000, $938,000, $511,000 and $868,000, respectively. METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 17. SUPPLEMENTAL GUARANTOR INFORMATION Under the terms of the Senior Notes, Shieldalloy, Metallurg Holdings Corporation, Metallurg Services, Inc. and MIR (China), Inc. (collectively, the "Guarantors"), wholly-owned domestic subsidiaries of Metallurg, Inc., will fully and unconditionally guarantee on a joint and several basis Metallurg, Inc.'s obligations to pay principal, premium and interest in respect of the Senior Notes due 2007. Management has determined that separate, full financial statements of the Guarantors would not be material to potential investors and, accordingly, such financial statements are not provided. Supplemental financial information of the Guarantors is presented below: CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED JANUARY 31, 1999 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING BALANCE SHEET AT JANUARY 31, 1999 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR YEAR ENDED JANUARY 31, 1999 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE THREE QUARTERS ENDED JANUARY 31, 1998 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING BALANCE SHEET AT JANUARY 31, 1998 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE THREE QUARTERS ENDED JANUARY 31, 1998 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE QUARTER ENDED MARCH 31, 1997 METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING BALANCE SHEET AT MARCH 31, 1997 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE QUARTER ENDED MARCH 31, 1997 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1996 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 1996 (IN THOUSANDS) METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS) (a) Includes Merger-related costs of $4,416, $2,607 and $865 in the 2nd, 3rd and 4th quarters, respectively. (b) Includes a $5,107 fresh-start revaluation. (c) Includes an extraordinary gain of $43,032, net of tax, reflecting the discharge of indebtedness income relating to the consummation of the Reorganization Plan. (d) Includes an extraordinary loss of $792, net of tax, reflecting the early extinguishment of debt. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Metallurg, Inc. Our audit of the consolidated financial statements referred to in our report dated March 31, 1999 appearing in this Annual Report on Form 10-K also included an audit of Financial Statement Schedule VIII of this Form 10-K. In our opinion, this Financial Statement Schedule VIII presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. The consolidated financial statements and financial statement schedule VIII for periods prior to the period ended January 31, 1999 were audited by other independent accountants whose report dated April 1, 1998 expressed an unqualified opinion on those statements and related financial statement schedule. PricewaterhouseCoopers LLP New York, New York April 29, 1999 METALLURG, INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES IN THOUSANDS: PART III ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The change in the Company's independent certifying accountants has been previously reported in Metallurg Holdings' Current Report on Form 8-K, filed on November 25, 1998. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The following table sets forth certain information with respect to the directors and executive officers of the Company: Each director of the Company holds office until the next annual meeting of stockholders of the Company or until his or her successor has been elected and qualified. Officers of the Company are selected by the Board of Directors and serve at the discretion of the Board of Directors. Heinz C. Schimmelbusch. Dr. Schimmelbusch became Chief Executive Officer, President and a Director of Metallurg Holdings in July 1998, as well as Chairman of the Board and a Director of Metallurg, Inc. He is a Managing Director of the general partner and of the management company of Safeguard International Fund, L.P. He is also Chairman of Allied Resource Corporation, a company he founded in 1994 to invest in mining, advanced materials and recycling. Until 1994, Dr. Schimmelbusch was Chairman of the Management Board of Metallgesellschaft AG, Germany, a multi-billion dollar multinational company in the process industries, and Chairman of the Supervisory Board of LURGI AG, Germany's leading process engineering firm; of Buderus AG, a leading manufacturer of commercial and residential heating equipment; of Dynamit Nobel AG, a leading manufacturer of explosives and specialty chemicals; and of Norddeutsche Affinerie AG, Europe's largest copper producer. Dr. Schimmelbusch has also served on the Boards of several German and other foreign corporations and institutions, including Allianz Versicherungs AG, Munich; Philipp Holzmann AG, Frankfurt; Mobil Oil AG, Hamburg; Teck Corporation, Vancouver; and on the Advisory Boards of Dresdner Bank AG and the European Bank of Reconstruction and Development. Dr. Schimmelbusch has been the founder and Chairman of a number of public companies in the process industries, including: Inmet Corporation, Toronto, (formerly Metall Mining Corporation); Methanex Corporation, Vancouver; and B.U.S. Umweltservice AG, Frankfurt. Dr. Schimmelbusch is a director of Safeguard Scientifics, Inc., a diversified information technology company, a position he has held since 1989, and of Systems & Computer Technology Corporation, a systems integration services and software company. Arthur R. Spector. Mr. Spector was elected to serve as a Director of Metallurg Holdings and Metallurg, Inc. in July 1998. He has been an Executive Vice President of Metallurg Holdings since July 1998. He is a Managing Director of the general partner and of the management company of Safeguard International. From January 1997 to March 1998, Mr. Spector served as a managing director of TL Ventures LLC, a venture capital management company organized to manage day-to-day operations of TL Ventures III L.P. and TL Ventures III Offshore L.P. From January 1995 through December 1996, Mr. Spector served as Director of Acquisitions of Safeguard Scientifics, Inc. From July 1992 until May 1995, Mr. Spector served as Vice Chairman and Secretary of Casino & Credit Services, Inc. From October 1991 to December 1994, Mr. Spector was Chief Executive Officer and a director of Perpetual Capital Corporation, a merchant banking organization. He has also been an officer of Abraham Lincoln Federal Savings Bank and State National Bank of Maryland. Mr. Spector serves as Chairman of Neoware Systems, Inc., a manufacturer of network computers; and as a director of USDATA Corporation, a company which produces factory and process automation software; and Docucorp International, Inc., a document automation company. Mr. Spector holds a B.S. degree in electronics from the Wharton School of the University of Pennsylvania and a J.D. from the University of Pennsylvania Law School. Michael R. Holly. Mr. Holly became a Director of Metallurg Holdings in July 1998. He is also a Managing Director of the general partner and of the management company of Safeguard International. Mr. Holly is also Executive Vice President and Chief Financial Officer of Puralube, Inc. a co-investment by Safeguard Scientifics, Inc. and Allied Resource Corporation which is commercializing a technology on a worldwide basis that re-refines used oil into high-quality base lube oils. Mr. Holly is a senior executive with over 30 years of combined experience in the areas of finance operations, marketing and strategic planning. Mr. Holly has spent the last five years providing merger and acquisition advisory services to a variety of companies, including the last four years working in close association with Safeguard Scientifics, Inc. Mr. Holly is a Certified Public Accountant and spent 12 years with Price Waterhouse LLP and three years with Coopers & Lybrand. For ten years, Mr. Holly served as the combined Chief Operating and Chief Financial Officer of a national professional services organization. Samuel A. Plum Mr. Plum was appointed a director of Metallurg Holdings in October 1998 and was appointed a director of Metallurg, Inc. in November 1998. He has been a Managing General Partner of the general partner of SCP Private Equity Partners, L.P. since its commencement in August 1996 and was a Managing Director of Safeguard Scientifics, Inc. from 1993 to 1996. From February 1989 to January 1993, Mr. Plum served as president of Charterhouse, Inc. and Charterhouse North American Securities, Inc., the U.S. investment banking and broker-dealer divisions of Charterhouse PLC, a merchant bank located in the United Kingdom. From 1973 to 1989, Mr. Plum served in various capacities, including Managing Director and partner, at the investment banking divisions of PaineWebber Inc. and Blyth Eastman Dillon & Co., Inc., respectively. Mr. Plum is Chairman of Vortex Sound Communications, Inc. and also serves as a director of Index Stock Photography, Inc., PacWest Telecomm, Inc. and the Philadelphia Zoological Society. Past directorships include Tishman Holding Corporation, Icon CMT Corp., Quaker Fabrics Corporation and the National Audobon Society, the latter two as Chairman. Mr. Plum holds a B.A. degree in History from Harvard University and an M.B.A. degree from the Harvard Graduate School of Business Administration. Douglas A. Fastuca. Mr. Fastuca has been Chief Financial Officer and Treasurer of Metallurg Holdings since 1998. He also serves as Vice President of Corporate Development of Metallurg, Inc. and is a Director of the management company of Safeguard International. Before joining Safeguard International, Mr. Fastuca was Director of Business Development in SEI Investment's Global Asset Management Unit from 1993 to 1997. He started his business career with General Electric holding financial assignments in manufacturing and international operations at GE Lighting and as a corporate auditor at GE Capital. Mr. Fastuca has a B.A. degree from Bucknell University and an M.B.A. from the Harvard Graduate School of Business Administration. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. None of the executive officers or directors of the Company received compensation from the Company during the year-ended January 31, 1999. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth, as of April 15, 1999, information with respect to each person (including any "group" as that term is used in Section 13(d)(3) of the Exchange Act of 1934, as amended) who is known to the Company to be the beneficial owner of more than 5% of any class of the Company's voting securities). None of the directors, officers or management of the Company own any equity securities of the Company. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The management company of Safeguard International was paid a one-time financial advisory fee in 1998 of $2.5 million for services performed, and reimbursed for various expenses incurred, in connection with the acquisition of Metallurg, Inc. Dr. Schimmelbusch and Messrs. Spector and Holly each received $400,000 of the proceeds from the financial advisory fee in their capacities as members of the management company. Dr. Schimmelbusch and Messrs. Plum, Holly and Spector, all of whom are directors of Holdings, and Mr. Fastuca, an executive officer of Holdings, are directors and/or officers of various companies that are associated, directly or indirectly, with Safeguard Scientifics, Inc., which has an ownership interest in Safeguard International Fund. Pursuant to these positions, they receive compensation from such entities. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as a part of this report: (1) A list of the financial statements filed as part of this report appears on page 27. (2) The financial statement schedules required to be filed as part of this report appear on pages 57 and 104. (3) The following exhibits are filed as part of this report: EXHIBIT NUMBER DESCRIPTION OF EXHIBIT - ------ ---------------------- 2.1 Merger Agreement, dated as of June 15, 1998, by and among Metallurg Holdings, Inc., Metallurg Acquisition Corp. and Metallurg, Inc. (incorporated herein by reference to Exhibit S42.1 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on July 29, 1998 (File No. 333-6077)). 3.1 Certificate of Incorporation of Metallurg Holdings, Inc. (incorporated herein by reference to Exhibit S43.1 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on July 29, 1998 (File No. 333-60077)). 3.2 By-laws of Metallurg Holdings, Inc. (incorporated herein by reference to Exhibit S43.2 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on July 29, 1998 (File No. 333-60077)). 4.1 Amended and Restated Stockholders Agreement, dated as of October 13, 1998, by and among the Company, Safeguard International Fund, L.P., State of Michigan Retirement Systems-Safeguard Limited Partnership and SCP Private Equity Partners, L.P. 4.2 Amended and Restated Registration Rights Agreement, dated as of October 13, 1998, by and among the Company, Safeguard International Fund, L.P., State of Michigan Retirement Systems-Safeguard Limited Partnership and SCP Private Equity Partners, L.P. 4.3 Joinder Agreement, dated as of December 7, 1998, by and among the Company, Joseph H. Marren, Scott M. Honour, Mark W. Lanigan, Robert McEvoy, Scott Morrison and the Company, Safeguard International Fund, L.P., State of Michigan Retirement Systems-Safeguard Limited Partnership and SCP Private Equity Partners, EXHIBIT NUMBER DESCRIPTION OF EXHIBIT - ------ ---------------------- L.P. 4.4 Indenture, dated as of July 13, 1998, by and between Metallurg Holdings, Inc. and United States Trust Company of New York (incorporated herein by reference to Exhibit S44.1 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on July 29, 1998 (File No. 333-60077)). 4.5 Form of 12-3/4% Series A Senior Discount Notes due 2008, dated as of July 13, 1998 (incorporated by reference to Exhibit 4.4) 4.6 Form of 12-3/4% Series B Senior Discount Notes due 2008, dated as of July 13, 1998 (incorporated by reference to Exhibit 4.4) 4.7 Registration Agreement, dated as of July 13, 1998, by and between Metallurg Holdings, Inc. and BancBoston Securities Inc. (incorporated herein by reference to Exhibit S44.4 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on July 29, 1998 (File No. 333-60077)). 4.8 Indenture, dated as of November 25, 1997, by and among Metallurg, Inc., Shieldalloy Metallurgical Corporation, Metallurg Holdings Corporation, Metallurg Services, Inc., MIR (China), Inc. and IBJ Schroder Bank & Trust Company (incorporated herein by reference to Exhibit S44.1 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 4.9 Form of 11% Series A Senior Notes due 2007, dated as of November 25, 1997 (incorporated herein by reference to Exhibit S44.2 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 4.10 Form of 11% Series B Senior Notes due 2007, dated as of November 25, 1997 (incorporated herein by reference to Exhibit S44.3 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 4.11 Registration Agreement, dated as of November 20, 1997, by and among Metallurg, Inc., Shieldalloy Metallurgical Corporation, Metallurg Holdings Corporation, Metallurg Services, Inc., MIR (China), Inc., Salomon Brothers Inc and BancBoston Securities Inc. (incorporated herein by reference to Exhibit S44.4 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 and Amendments No. 1 through 4 thereto, filed through March 13, 1998 (File No. 333-42141)). 10.1 Pledge Agreement, dated as of July 13, 1998, by and between Metallurg Holdings, Inc. and United States Trust Company of New York (incorporated herein by reference to Exhibit S410.1 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on July 27, 1998 (File No. 333- EXHIBIT NUMBER DESCRIPTION OF EXHIBIT - ------ ---------------------- 60077)). 10.2 Loan Agreement dated April 14, 1997 among Metallurg, Inc. and Shieldalloy Metallurgical Corporation as Borrowers, Metallurg Services, Inc., MIR (China), Inc. and Metallurg Holdings Corporation, as Guarantors, and BankBoston, N.A. as Agent for the lending institutions, as amended by the First, Second and Third Amendments thereto (incorporated herein by reference to Exhibit S410.1 to the Form S-4 Registration filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)) and as amended by the Fourth Amendment thereto (incorporated herein by reference to Exhibit S410.3 to the Form S-4 Registration Statement filed by Metallurg Holdings, Inc. with the Securities and Exchange Commission on October 14, 1998 (File No. 333-60077)). 10.3 Fifth and Sixth Amendments to the Loan Agreement dated April 14, 1997, among Metallurg, Inc. and Shieldalloy Metallurgical Corporation as Borrowers, Metallurg Services, Inc., MIR (China), Inc. and Metallurg Holdings Corporation, as Guarantors, and BankBoston, N.A. as Agent for the lending institutions. 10.4 German Loan Agreement, dated October 20, 1997, by and among GfE Gesellschaft fur Elektrometallurgie mbH, GfE Umwelttechnik GmbH, GfE Giesserei-und Stahlwerksbedarf GmbH, GfE Metalle und Metarielien GmbH and Keramed Medizintechnik GmbH and BankBoston, N.A. acting through its Frankfurt, Germany branch (incorporated herein by reference to Exhibit S410.2 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 10.5 First and Second Amendments to German Loan Agreement, dated October 20, 1997, by and among GfE Gesellschaft fur Elektrometallurgie mbH, GfE Umwelttechnik GmbH, GfE Giesserei-und Stahlwerksbedarf GmbH, GfE Metalle und Metarielien GmbH and Keramed Medizintechnik GmbH and BankBoston, N.A. acting through its Frankfurt, Germany branch. 10.6 Joint Disclosure Statement for the Fourth Amendment and Restated Joint Plan of Reorganization dated December 18, 1996 (incorporated by reference to Exhibit T3E.1 to the Form T-3 filed by Metallurg, Inc. with the Securities and Exchange Commission on March 21, 1997 (File No. 022-22265)). 10.7 Supplement to Joint Disclosure Statement for the Fourth Amended and Restated Joint Plan of Reorganization dated December 18, 1996 (incorporated herein by reference to Exhibit T3E.1 to the Form T-3 filed by the Company with the Securities and Exchange Commission on March 21, 1997 (File No. 022-22265)). 10.8 Settlement Agreement dated December 27, 1996 between Metallurg Inc., Shieldalloy Metallurgical Corporation, the Environmetal Protection Agency, the Department of the Interior, the Nuclear Regulatory Commission and the New Jersey Department of Environmental Protection (incorporated herein by reference to Exhibit S410.5 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and EXHIBIT NUMBER DESCRIPTION OF EXHIBIT - ------ ---------------------- Exchange Commission on December 30, 1997 (File No. 333-42141)). 10.9 Permanent Injunction Consent Order dated December 23, 1996 between the State of Ohio, Shieldalloy Metallurgical Corporation and Cyprus Foote Mineral Company (incorporated herein by reference to Exhibit S410.6 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 10.10 1997 Stock Award and Sock Option Plan (incorporated herein by reference to Exhibit S410.8 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 10.11 1998 Equity Compensation Plan of Metallurg, Inc. 10.12 Management Incentive Compensation Plan (incorporated herein by reference to Exhibit S410.9 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 10.13 Employment Agreements dated April 14, 1997 with Michael A. Banks and J. Richard Budd III (incorporated herein by reference to Exhibit S410.10 to the Form S-4 Registration Statement filed by Metallurg, Inc. with the Securities and Exchange Commission on December 30, 1997 (File No. 333-42141)). 10.14 Employment Agreements dated October 30, 1998; November 19, 1998; November 19, 1998; November 20, 1998; and January 4, 1999; by and between Metallurg, Inc. and each of Alan D. Ewart, Eric E. Jackson, Robin A. Brumwell, Barry C. Nuss and Ellen T. Harmon, respectively. 10.15 Consulting Agreement, dated as of October 30, 1998, and Agreement, dated August 9, 1998, each by and between Metallurg, Inc. and Michael A. Standen. 10.16 Notes dated April 15, 1997, April 15, 1998, and July 13, 1998, by and between Metallurg, Inc., as Lender, and each of Robin A. Brumwell, Barry C. Nuss, J. Richard Budd III and Michael A. Banks, respectively, as Borrowers; Note dated April 15, 1997, by and between Metallurg, Inc., as Lender, and Michael A. Standen, as Borrower. 10.17 Intercompany Tax Allocation Agreement, dated July 13, 1998, by and among Metallurg Holdings, Inc., Metallurg, Inc. and various subsidiaries thereof. 16.1 Letter from Arthur Andersen LLP to the Securities and Exchange Commission re agreement with Metallurg Holdings, Inc. comments concerning change in certifying accountant (incorporated by reference to Exhibit 16 to the Current Report on Form 8-K filed with the Securities and Exchange Commission by Metallurg Holdings, Inc. on November 25, 1998 (File No.333-60077)). 21.1 Subsidiaries of Metallurg Holdings, Inc. EXHIBIT NUMBER DESCRIPTION OF EXHIBIT - ------ ---------------------- 27.1 Financial Data Schedule (b) Metallurg Holdings, Inc. filed a Current Report on Form 8-K on November 25, 1998 reporting a change in certifying accountant. (c) The exhibits listed under Item 14(a)(3) are filed herewith or incorporated herein by reference. (d) The Consolidated Financial Statements and the financial statement schedules listed under Item 14(a)(2) are filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the undersigned registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized as of the 28th day of April, 1999. METALLURG HOLDINGS, INC. By: /s/ Douglas A. Fastuca Douglas A. Fastuca Chief Financial Officer and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the date indicated.

1064735_1999.txt

1064735_1999

1999

1064735

ITEM 1. BUSINESS INTRODUCTION Triton PCS, Inc. and its subsidiaries are direct and indirect wholly owned subsidiaries of Triton PCS Holdings, Inc. In this report, we refer to Triton PCS Holdings, Inc. as "Holdings" and references to "Triton," "we" "us" and "our" are to Holdings and its direct and indirect subsidiaries collectively, unless the context requires otherwise. Our principal offices are located at 1100 Cassatt Road, Berwyn, Pennsylvania 19312, and our telephone number at that address is (610) 651-5900. Our World Wide Web site address is HTTP://WWW.TRITONPCS.COM. The information in our website is not part of this report. OVERVIEW We are a rapidly growing provider of wireless personal communications services in the southeastern United States. Our personal communications services licenses cover approximately 13 million potential customers in a contiguous geographic area encompassing portions of Virginia, North Carolina, South Carolina, Tennessee, Georgia and Kentucky. In February 1998, we entered into a joint venture with AT&T, our largest equity sponsor. As part of the agreement, AT&T contributed personal communications services licenses for 20 MHz of authorized frequencies covering 11 million potential customers within defined areas of our region in exchange for an equity position in Triton. Since that time, we have expanded our coverage area to include an additional 2 million potential customers through acquisitions and license exchanges with AT&T. As part of the transactions with AT&T, we were granted the right to be the exclusive provider of wireless mobility services using equal emphasis co-branding with AT&T within our region. We believe our markets are strategically attractive because of their proximity to AT&T's wireless systems in the Washington, D.C., Charlotte, North Carolina and Atlanta, Georgia markets, which collectively cover a population of more than 27 million individuals. Our market location is attractive, as we are the preferred provider of wireless mobility services to AT&T's digital wireless customers who roam into our markets. Our strategy is to provide extensive coverage to customers within our region, to offer our customers coast-to-coast coverage and to benefit from roaming revenues generated by AT&T's and other carriers' wireless customers who roam into our covered area. Our management team is led by Michael Kalogris and Steven Skinner, the former Chief Executive Officer and Chief Operating Officer of Horizon Cellular Group, respectively. Our network build-out is scheduled for three phases. In 1999, we completed Phase I and most of Phase II of this build-out and successfully launched personal communications services in 27 markets. We are now able to provide service to over 11.4 million individuals, or 87% of our potential customers. Our network in these 27 markets includes 1,014 cell sites and six switches. Since we began offering services in these 27 markets, our subscriber base and the number of minutes generated by non-Triton subscribers roaming onto our network have grown dramatically. During 1999, our subscriber base grew from 33,844 subscribers to 195,204 subscribers, and roaming minutes generated by non-Triton subscribers increased from approximately 0.7 million minutes per month to approximately 16.5 million minutes per month. We expect to complete Phase II by the end of the first quarter of 2000, which will cover six additional markets, 1.6 million potential customers and 226 new cell sites. When Phase II is complete, we will be able to provide services to 98% of the potential customers in our licensed area. Phase III of our network build-out will focus on covering major highways linking the cities in our licensed area, as well as neighboring cities where AT&T and other carriers use compatible wireless technology. We expect Phase III to be completed by year-end 2001 and to add approximately 1,050 cell sites and two switches to our network. Upon completion of Phase III, we will be able to provide services to 13 million potential customers, and our network will include approximately 2,300 cell sites and eight switches and span approximately 18,000 highway miles. Our markets have attractive demographic characteristics for wireless communications services, including population growth rates that are higher than the national average and population densities that are 87% greater than the national average. Our goal is to provide our customers with simple, easy-to-use wireless services with coast-to-coast service, superior call quality, personalized customer care and competitive pricing. We utilize a mix of sales and distribution channels, including a network of 60 company-owned retail stores, over 180 agents with 406 indirect outlets, including nationally recognized retailers such as Circuit City, Office Depot, Staples and Best Buy, and 82 direct sales representatives covering corporate accounts. We currently plan to add approximately 30 additional company-owned retail stores in 2000. We believe that as a Member of the AT&T Wireless Network, we will attract customers by capitalizing on AT&T's national brand and its extensive digital wireless network. We have also entered into an agreement with two other Members of the AT&T Wireless Network, TeleCorp PCS and Tritel PCS, to operate with those affiliates under a common regional brand name, SunCom, throughout an area covering approximately 43 million potential customers primarily in the south-central and southeastern United States. We believe this arrangement will allow us to establish a strong regional brand name within our markets. STRATEGIC ALLIANCE WITH AT&T One of our most important competitive advantages is our strategic alliance with AT&T, the largest provider of wireless communications services in the United States. As part of its strategy to rapidly expand its digital wireless coverage in the United States, AT&T has focused on constructing its own network and making strategic acquisitions in selected cities, as well as entering into agreements with four independent wireless operators, including Triton, to construct and operate personal communications services networks in other markets. Our strategic alliance with AT&T provides us with many business, operational and marketing advantages, including the following: o RECOGNIZED BRAND NAME. We market our wireless services to our potential customers giving equal emphasis to the SunCom and AT&T brand names and logos. o EXCLUSIVITY. We are AT&T's exclusive provider of facilities-based wireless mobility communications services using equal emphasis co-branding with AT&T in our covered markets, and, from time to time, we may participate with AT&T in other programs. o PREFERRED ROAMING PARTNER. We are the preferred carrier for AT&T's digital wireless customers who roam into our coverage area. o COVERAGE ACROSS THE NATION. With the use of advanced multi-mode handsets which transition between personal communications services and cellular frequencies, our customers have access to coast-to-coast coverage through our agreements with AT&T, other Members of the AT&T Wireless Network and with other third-party roaming partners. o VOLUME DISCOUNTS. We receive preferred terms on certain products and services, including handsets, infrastructure equipment and administrative support from companies who provide these products and services to AT&T. o MARKETING. We benefit from AT&T's nationwide marketing and advertising campaigns, including the success of AT&T's national rate plans, in the marketing of our own plans COMPETITIVE STRENGTHS In addition to the advantages provided by our strategic alliance with AT&T, we have the following competitive strengths: o ATTRACTIVE LICENSED AREA. Our markets have favorable demographic characteristics for wireless communications services, such as population growth that is higher than the national average and population densities that are 87% greater than the national average. o ADVANCED TECHNOLOGY. We are building our personal communications services network using time division multiple access digital technology. This technology is also used by AT&T, and, therefore, our network is compatible with AT&T's network and other time division multiple access digital technology networks. This technology allows wireless communications service providers to offer enhanced features, higher network quality, improved in-building penetration and greater network capacity relative to analog cellular service. In addition, handsets operating on a digital system are capable of sleep-mode while turned on but not in use, thus increasing standby availability for incoming calls as users will be able to leave these phones on for significantly longer periods than they can with wireless phones using an earlier technology. o EXPERIENCED MANAGEMENT. We have a management team with a high level of experience in the wireless communications industry. Our senior management team has an average of 11 years of experience with wireless leaders such as AT&T, Bell Atlantic and Horizon Cellular. Our senior management team also owns in excess of 10% of Holdings' Class A common stock. o CONTIGUOUS SERVICE AREA. We believe our contiguous service area allows us to cost effectively offer large regional calling areas to our customers. Further, we believe that we generate operational cost savings, including sales and marketing efficiencies, by operating in a contiguous service area. o STRONG CAPITAL BASE. Our business plan from inception through year-end 2001 will be fully funded with capital of approximately $1.5 billion, consisting of $191.5 million of irrevocable equity contributions, $133.2 million of AT&T capital contributions, up to $600.0 million of borrowings under our senior credit facilities, approximately $291.0 million of net proceeds from a senior subordinated notes offering completed in 1998, approximately $71.1 million of proceeds from the sale of communications towers and approximately $190.2 million of net proceeds from the completion of Triton PCS Holdings, Inc.'s initial public offering. BUSINESS STRATEGY Our objective is to become the leading provider of wireless communications services in the markets we serve. We intend to achieve this objective by pursuing the following business strategies: o OPERATE A SUPERIOR, HIGH QUALITY NETWORK. We are committed to making the capital investment required to develop and operate a superior, high quality network. Our network, when complete, will include approximately 2,300 cell sites and eight switches and span approximately 18,000 highway miles. We believe this network will enable us to provide extensive coverage within our region and consistent quality performance, resulting in a high level of customer satisfaction. o PROVIDE SUPERIOR COAST-TO-COAST AND IN-MARKET COVERAGE. Our market research indicates that scope and quality of coverage are extremely important to customers in their choice of a wireless service provider. We have designed extensive local calling areas, and we offer coast-to-coast coverage through our arrangements with AT&T, its affiliates and other third-party roaming partners. Our network covers those areas where people are most likely to take advantage of wireless coverage, such as suburbs, metropolitan areas and vacation locations. o PROVIDE ENHANCED VALUE AT LOW COST. We offer our customers advanced services and features at competitive prices. Our affordable, simple pricing plans are designed to promote the use of wireless services by enhancing the value of our services to our customers. We include usage-enhancing features such as call waiting, voice mail, three-way conference calling and short message service in our basic packages. We market our services with a simple, all-in-one focus: digital phone, pager and voice mail. We also allow customers to purchase large packages of minutes per month for a low fixed price. These minutes can generally be used throughout the southeast region of the United States without paying additional roaming fees or long distance charges. o DELIVER QUALITY CUSTOMER SERVICE. We believe that superior customer service is a critical element in attracting and retaining customers. Our systems have been designed with open interfaces to other systems. This design allows us to select and deploy the best software package for each application in our administrative systems. Our point-of-sale activation process is designed to ensure quick and easy service initiation, including customer qualification. We also emphasize proactive and responsive customer care, including rapid call-answer times, welcome packages and anniversary calls. We currently operate state-of-the-art customer care facilities in Richmond, Virginia and Charleston, South Carolina that house our customer service and collections personnel. LICENSE ACQUISITION TRANSACTIONS Our original personal communications services licenses were acquired as part of our joint venture agreement with AT&T. On June 30, 1998, we acquired an existing cellular system serving Myrtle Beach and the surrounding area from Vanguard Cellular Systems for a purchase price of approximately $164.5 million. We integrated the Myrtle Beach system, which used time division multiple access digital technology, into our personal communications services network as part of our Phase I network deployment. Substantially all of our revenues prior to 1999 were generated by services provided in Myrtle Beach. We have used our position in Myrtle Beach to secure roaming arrangements with other carriers that enable us to offer regional calling plans on a cost-effective basis. On December 31, 1998, we acquired from AT&T a personal communications services license covering the Norfolk, Virginia basic trading area, as well as a recently deployed network plant and infrastructure, for an aggregate purchase price of $111.0 million. The integration and launch of our Norfolk personal communications services were completed as part of our Phase I network build-out. On June 8, 1999, we completed an exchange of personal communications services licenses with AT&T. As part of this transaction, we transferred Hagerstown and Cumberland, Maryland personal communications services licenses that cover approximately 512,000 potential customers, with an estimated value of $5.1 million, for Savannah and Athens, Georgia personal communications services licenses that cover approximately 517,000 potential customers, with an estimated value of $15.5 million. We also issued to AT&T 53,882 shares of our Series A preferred stock and 42,739 shares of our Series D preferred stock, with estimated values of $5.8 million and $4.6 million, respectively, in connection with the exchange. The build out of our Savannah and Athens license will be included in the completion of Phase II of our network deployment plan. SUMMARY MARKET DATA The following table presents statistical information concerning the markets covered by our licenses. 1998 potential customers and estimated % Growth 1997 - 2002 figures are based on 1998 estimates published by Paul Kagan Associates, Inc. in 1999. Potential Density and Local Interstate Traffic Density figures are based on 1997 estimates published by Paul Kagan Associates, Inc. in 1998. (1) Licensed major trading areas are segmented into basic trading areas. (2) The estimated average annual population growth rate for 1997-2002 was applied to estimates of 1999 potential customers to calculate the 1999 potential customers in each market. (3) Number of potential customers per square mile. (4) Daily vehicle miles traveled (interstate only) divided by interstate highway miles in the relevant area. (5) Total potential customers in the licensed area. (6) Weighted by potential customers. Projected average annual population growth in our licensed area. (7) Weighted by population equivalents. Average number of potential customers per square mile in our licensed area. (8) Weighted by interstate miles. Average daily vehicle miles traveled (interstate only) divided by interstate highway miles in our licensed area. (9) Average number of potential customers per square mile for the U.S. SALES AND DISTRIBUTION Our sales strategy is to utilize multiple distribution channels to minimize customer acquisition costs and maximize penetration within our licensed service area. Our distribution channels include a network of company-owned retail stores, independent retailers and a direct sales force for corporate accounts, as well as direct marketing channels such as telesales, neighborhood sales and online sales. We also work with AT&T's national corporate account sales force to cooperatively exchange leads and develop new business. o COMPANY-OWNED RETAIL STORES. We make extensive use of company-owned retail stores for the distribution and sale of our handsets and services. We believe that company-owned retail stores offer a considerable competitive advantage by providing a strong local presence, which is required to achieve high penetration in suburban and rural areas and the lowest customer acquisition cost. We have opened 60 company-owned SunCom stores as of December 31, 1999. o RETAIL OUTLETS. We have negotiated distribution agreements with national and regional mass merchandisers and consumer electronics retailers, including Circuit City, Office Depot, Staples, Best Buy, Metro Call and Zap's. We currently have over 180 agents with 406 retail outlet locations where customers can purchase our services. o DIRECT SALES. We focus our direct sales force on high-revenue, high-profit corporate users. Our direct corporate sales force consists of 82 dedicated professionals targeting wireless decision-makers within large corporations. We also benefit from AT&T's national corporate accounts sales force, which supports the marketing of our services to AT&T's large national accounts located in certain of our service areas. o DIRECT MARKETING. We use direct marketing efforts such as direct mail and telemarketing to generate customer leads. Telesales allow us to maintain low selling costs and to sell additional features or customized services. o WEBSITE. Our web page provides current information about our markets our product offerings and us. We have established an online store on our website, www.suncom.com. The web page conveys our marketing message, and we expect it will generate customers through online purchasing. We deliver all information that a customer requires to make a purchasing decision at our website. Customers are able to choose rate plans, features, handsets and accessories. The online store will provide a secure environment for transactions, and customers purchasing through the online store will encounter a transaction experience similar to that of customers purchasing service through other channels. MARKETING STRATEGY Our marketing strategy has been developed on the basis of extensive market research in each of our markets. This research indicates that the limited coverage of existing wireless systems, relatively high cost, and inconsistent performance has reduced the attractiveness of wireless service to existing users and potential new users. We believe that our affiliation with the AT&T brand name and the distinctive advantages of our time division multiple access digital technology, combined with simplified, attractive pricing plans, will allow us to capture significant market share from existing analog cellular providers in our markets and to attract new wireless users. We are focusing our marketing efforts on three primary market segments: o current cellular users; o individuals with the intent to purchase a wireless product within six months; and o corporate accounts. For each segment, we are creating a specific marketing program including a service package, pricing plan and promotional strategy. We believe that targeted service offerings will increase customer loyalty and satisfaction, thereby reducing customer turnover. The following are key components of our marketing strategy: o REGIONAL CO-BRANDING. We have entered into agreements with TeleCorp PCS and Tritel PCS, two other companies affiliated with AT&T, to adopt a common regional brand, SunCom. We market our wireless services as SunCom, Member of the AT&T Wireless Network and use the globally recognized AT&T brand name and logo in equal emphasis with the SunCom brand name and logo. We believe that use of the AT&T brand reinforces an association with reliability and quality. We and the other SunCom companies are establishing the SunCom brand as a strong local presence with a service area covering approximately 43 million potential customers. We enjoy preferred pricing on equipment, handset packaging and distribution by virtue of our affiliation with AT&T and the other SunCom companies. o PRICING. Our pricing plans are competitive and straightforward, offering large packages of minutes, large regional calling areas and usage enhancing features. One way we differentiate ourselves from existing wireless competitors is through our pricing policies. We offer pricing plans designed to encourage customers to enter into long term service contract plans. We offer our customers regional, network only and national rate plans. Our rate plans allow customers to make and receive calls anywhere within the southeast region and the District of Columbia without paying additional roaming or long distance charges. By contrast, competing flat rate plans generally restrict flat rate usage to such competitors' owned networks. By virtue of our roaming arrangements with AT&T, its affiliates and other third-party roaming partners, we believe we can offer competitive regional, network only and national rate plans. Our sizable licensed area allows us to offer large regional calling areas at rates as low as $.08 per minute throughout the Southeast. CUSTOMER CARE. We are committed to building strong customer relationships by providing our customers with service that exceeds expectations. We currently operate state-of-the-art customer care facilities in Richmond, Virginia and Charleston, South Carolina that house our customer service and collections personnel. We supplement these facilities with customer care services provided by Convergys Corporation in Clarksville, Tennessee. Through the support of approximately 225 customer care representatives and a sophisticated customer care platform provided by Integrated Customer Systems, we have been able to implement one ring customer care service using live operators and state-of-the-art call routing, so that over 90% of incoming calls to our customer care centers are answered on the first ring. FUTURE PRODUCT OFFERINGS. We may bundle our wireless communications services with other communications services through strategic alliances and resale agreements with AT&T and others. We also may offer service options in partnership with local business and affinity marketing groups. Examples of these arrangements include offering wireless services with utility services, banking services, cable television, Internet access or alarm monitoring services in conjunction with local information services. Such offerings provide the customer access to information, such as account status, weather and traffic reports, stock quotes, sports scores and text messages from any location. ADVERTISING. We believe our most successful marketing strategy is to establish a strong local presence in each of our markets. We are directing our media and promotional efforts at the community level with advertisements in local publications and sponsorship of local and regional events. We combine our local efforts with mass marketing strategies and tactics to build the SunCom and AT&T brands locally. Our media effort includes television, radio, newspaper, magazine, outdoor and Internet advertisements to promote our brand name. In addition, we use newspaper and radio advertising and our web page to promote specific product offerings and direct marketing programs for targeted audiences. SERVICES AND FEATURES We provide affordable, reliable, high-quality mobile telecommunications service. Our advanced digital personal communications services network allows us to offer customers the most advanced wireless features that are designed to provide greater call management and increase usage for both incoming and outgoing calls. o FEATURE-RICH HANDSETS. As part of our service offering, we sell our customers the most advanced, easy-to-use, interactive, menu-driven handsets that can be activated over the air. These handsets have many advanced features, including word prompts and easy-to-use menus, one-touch dialing, multiple ring settings, call logs and hands-free adaptability. These handsets also allow us to offer the most advanced digital services, such as voice mail, call waiting, call forwarding, three-way conference calling, e-mail messaging and paging. o MULTI-MODE HANDSETS. We exclusively offer multi-mode handsets, which are compatible with personal communication services, digital cellular and analog cellular frequencies and service modes. These multi-mode handsets allow us to offer customers coast-to-coast nationwide roaming across a variety of wireless networks. These handsets incorporate a roaming database, which can be updated over the air that controls roaming preferences from both a quality and cost perspective. NETWORK BUILD-OUT The principal objective for the build-out of our network is to maximize population coverage levels within targeted demographic segments and geographic areas, rather than building out wide-area cellular-like networks. We have successfully launched service in 27 cities, 1,014 cell sites and six switches. We expect to complete Phase II by the end of the first quarter 2000, which will add six new cities, cover approximately 4,400 highway miles, and add 226 of cell sites. The Phase III network design will complete our initial network build-out plan. We expect Phase III to add four cities, approximately 13,000 highway miles, approximately 1,050 cell sites and two switches to our network by year-end 2001. The build-out of our network involves the following: o PROPERTY ACQUISITION, CONSTRUCTION AND INSTALLATION. Two experienced vendors, Crown Castle International Corp. and American Tower, identify and obtain the property rights we require to build out our network, which includes securing all zoning, permitting and government approvals and licenses. As of December 31, 1999, we had signed leases or options for 1,032 sites, 9 of which were awaiting required zoning approvals. Crown Castle and American Tower also act as our construction management contractors and employ local construction firms to build the cell sites. o INTERCONNECTION. Our digital wireless network connects to local exchange carriers. We have negotiated and received state approval of interconnection agreements with telephone companies operating or providing service in the areas where we are currently operating our digital personal communications services network. We use AT&T as our inter-exchange or long-distance carrier. o ROAMING. In areas where time division multiple access-based personal communications services are not available, we offer a roaming option on the traditional analog cellular and digital cellular systems via multi-mode handsets capable of transmitting over either cellular or personal communications services frequencies. Under the terms of our agreements with AT&T, our customers who own multi-mode handsets are able to roam on AT&T's network, and we benefit from roaming agreements with AT&T, other Members of the AT&T Wireless Network and third-party operators of wireless systems. NETWORK OPERATIONS The effective operation of our network requires public switched interconnection and backhaul agreements with other communications providers, long distance interconnection, the implementation of roaming arrangements, the development of network monitoring systems and the implementation of information technology systems. SWITCHED INTERCONNECTION/BACKHAUL. Our network is connected to the public switched telephone network to facilitate the origination and termination of traffic between our network and both the local exchange and long distance carriers. We have signed agreements with numerous carriers. LONG DISTANCE. We have executed a wholesale long distance agreement with AT&T providing for preferred rates for long distance services. ROAMING. Through our arrangements with AT&T and via the use of multi-mode handsets, our customers have roaming capabilities on AT&T's wireless network. Further, we have established roaming agreements with third-party carriers at preferred pricing, including in-region roaming agreements covering all of our launched service areas. NETWORK MONITORING SYSTEMS. Our network monitoring systems provide around-the-clock monitoring and maintenance of our entire network. Our network-monitoring center is equipped with sophisticated systems that constantly monitor the status of all-base stations and switches and record network traffic. The network monitoring systems provide continuous monitoring of system quality for blocked or dropped calls call clarity and evidence of tampering, cloning or fraud. We designed our network-monitoring center to oversee the interface between customer usage, data collected at switch facilities and our billing systems. We manage usage reports, feature activation and related billing times on a timely and accurate basis. Our network-monitoring center is located in the Richmond, Virginia switching center, and we also have back-up network monitoring center capabilities in our Greenville, South Carolina switching center. We utilize Ericsson's network operations center in Richardson, Texas for off-hour network monitoring and dispatch, thereby providing constant network monitoring and support. In addition, we have contracted with Wireless Facilities, Inc. to provide network monitoring and dispatching 24 hours a day, seven days a week, to begin in the second quarter of 2000. INFORMATION TECHNOLOGY. We operate management information systems to handle customer care, billing, network management and financial and administrative services. These systems focus on three primary areas: o network management, including service activation, pre-pay systems, traffic and usage monitoring, trouble management and operational support systems; o customer care, including billing systems and customer service and support systems; and o business systems, including financial, purchasing, human resources and other administrative systems. We have incorporated sophisticated network management and operations support systems to facilitate network fault detection, correction and management, performance and usage monitoring and security. We employ system capabilities developed to allow over-the-air activation of handsets and to implement fraud protection measures. We maintain stringent controls for both voluntary and involuntary deactivations. We try to minimize subscriber disconnections by preactivation screening to identify any prior fraudulent or bad debt activity; credit review; and call pattern profiling to identify needed activation and termination policy adjustments. These systems have been designed with open interfaces. This design allows us to select and deploy the best software package for each application included in our administrative system. We are developing a state-of-the-art database and reporting system, which will also allow us to cross-link billing, marketing and customer care systems to collect customer profile and usage information. We believe this information provides us with the tools necessary to increase revenue through channel and product profitability analysis and to reduce customer acquisition costs through implementation of more effective marketing strategies. TIME DIVISION MULTIPLE ACCESS DIGITAL TECHNOLOGY We are building our network using time division multiple access digital technology on the IS-136 platform. This technology allows for the use of advanced multi-mode handsets, which allow roaming across personal communications services and cellular frequencies, including both analog and digital cellular. This technology allows for enhanced services and features over other technologies, such as short-messaging, extended battery life, added call security and improved voice quality, and its hierarchical cell structure enables us to enhance network coverage with lower incremental investment through the deployment of micro, as opposed to full-size, cell sites. This will enable us to offer customized billing options and to track billing information per individual cell site, which is practical for advanced wireless applications such as wireless local loop and wireless office applications. Management believes that time division multiple access digital technology provides significant operating and customer benefits relative to analog systems. In addition, management believes that time division multiple access digital technology provides customer benefits, including available features and roaming capabilities, and call quality that is similar to or superior to that of other wireless technologies. Time division multiple access technology allows three times the capacity of analog systems. Some manufacturers, however, believe that code division multiple access technology will eventually provide system capacity that is greater than that of time division multiple access technology and global systems for mobile communications. Time division multiple access digital technology is the digital technology choice of two of the largest wireless communications companies in the United States, AT&T and SBC Communications. This technology served an estimated 19 million subscribers worldwide and nine million subscribers in North America as of December 31, 1998, according to the Universal Wireless Communications Consortium, an association of time division multiple access service providers and manufacturers. We believe that the increased volume of time division multiple access users has increased the probability that this technology will remain an industry standard. Time division multiple access equipment is available from leading telecommunication vendors such as Lucent, Ericsson and Northern Telecom, Inc. REGULATION The FCC regulates aspects of the licensing, construction, operation, acquisition and sale of personal communications services and cellular systems in the United States pursuant to the Communications Act, as amended from time to time, and the associated rules, regulations and policies it promulgates. LICENSING OF CELLULAR AND PERSONAL COMMUNICATIONS SERVICES SYSTEMS. A broadband personal communications services system operates under a protected geographic service area license granted by the FCC for a particular market on one of six frequency blocks allocated for broadband personal communications services. Broadband personal communications services systems generally are used for two-way voice applications. Narrowband personal communications services, in contrast, are used for non-voice applications such as paging and data service and are separately licensed. The FCC has segmented the United States into personal communications services markets, resulting in 51 large regions called major trading areas, which are comprised of 493 smaller regions called basic trading areas. The FCC awarded two broadband personal communications services licenses for each major trading area and four licenses for each basic trading area. Thus, generally, six licensees will be authorized to compete in each area. The two major trading area licenses authorize the use of 30 MHz of spectrum. One of the basic trading area licenses is for 30 MHz of spectrum, and the other three are for 10 MHz each. The FCC permits licensees to split their licenses and assign a portion, on either a geographic or frequency basis or both, to a third party. In this fashion, AT&T assigned us 20 MHz of its 30 MHz licenses covering our licensed areas. Two cellular licenses are also available in each market. Cellular markets are defined as either metropolitan or rural service areas. Generally, the FCC awarded initial personal communications services licenses by auction. Initial personal communications services auctions began with the 30 MHz major trading area licenses and concluded in 1998 with the last of the basic trading area licenses. However, in March 1998, the FCC adopted an order that allowed financially troubled entities that won personal communications services 30 MHz C-Block licenses at auction to obtain some financial relief from their payment obligations by returning some or all of their C-Block licenses to the FCC for reauctioning. The FCC completed the reauction of the returned licenses in April 1999, and some licenses were not sold. In January 2000, the FCC announced that certain personal communications services licenses previously held by licensees that had declared bankruptcy had cancelled and were available for reauction. The FCC announced that the unsold and reclaimed personal communications services licenses will be reauctioned in July 2000. These auctions place additional spectrum in the hands of our potential competitors. A petition for rulemaking and a petition for waiver concerning the eligibility rules for the July, 2000 auction, as well as a petition for reconsideration of the decision to auction many of the reclaimed licenses, are pending at the FCC. Under the FCC's current rules specifying spectrum aggregation limits affecting broadband personal communications services and cellular licensees, no entity may hold ATTRIBUTABLE interests, generally 20% or more of the equity of, or an officer or director position with, the licensee, in licenses for more than 45 MHz of personal communications services, cellular and certain specialized mobile radio services where there is significant overlap, except in rural areas. In rural areas, up to 55 MHz of spectrum may be held. Passive investors may hold up to a 40% interest. Significant overlap will occur when at least 10% of the population of the personal communications services licensed service area is within the cellular and/or specialized mobile radio service area(s). In a September 15, 1999 FCC order revising the spectrum cap rules, the FCC noted that new broadband wireless services, such as third generation wireless, may be included in the cap when spectrum is allocated for those services. The FCC also may license other spectrum that may be used to provide services that compete with our services. Most recently, the FCC announced that it will auction licenses for fixed, mobile and broadcasting services in the 747-762 and 777-792 MHz bands in May 2000. Services offered over this spectrum will not included in the FCC's spectrum cap aggregation limitations. All personal communications services licenses have a 10-year term, at the end of which they must be renewed. The FCC will award a renewal expectancy to a personal communications services licensee that has: o provided substantial service during its past license term; and o has substantially complied with applicable FCC rules and policies and the Communications Act. Cellular radio licenses also generally expire after a 10-year term in the particular market and are renewable for periods of 10 years upon application to the FCC. Licenses may be revoked for cause and license renewal applications denied if the FCC determines that a renewal would not serve the public interest. FCC rules provide that competing renewal applications for cellular licenses will be considered in comparative hearings, and establish the qualifications for competing applications and the standards to be applied in hearings. Under current policies, the FCC will grant incumbent cellular licenses the same renewal expectancy granted to personal communications services licensees. All personal communications services licensees must satisfy certain coverage requirements. In our case, we must construct facilities that offer radio signal coverage to one-third of the population of our service area within five years of the original license grants to AT&T and to two-thirds of the population within ten years. Licensees that fail to meet the coverage requirements may be subject to forfeiture of their license. We anticipate the last phase of our network build-out to be completed by year-end 2001. Our cellular license, which covers the Myrtle Beach area, is not subject to coverage requirements. For a period of up to five years, subject to extension, after the grant of a personal communications services license, a licensee will be required to share spectrum with existing licensees that operate certain fixed microwave systems within its license area. To secure a sufficient amount of unencumbered spectrum to operate our personal communications services systems efficiently and with adequate population coverage, we have relocated two of these incumbent licensees and will need to relocate two more licensees. In an effort to balance the competing interests of existing microwave users and newly authorized personal communications services licensees, the FCC has adopted: o a transition plan to relocate such microwave operators to other spectrum blocks; and o a cost sharing plan so that if the relocation of an incumbent benefits more than one personal communications services licensee, those licensees will share the cost of the relocation. Initially, this transition plan allowed most microwave users to operate in the personal communications services spectrum for a two-year voluntary negotiation period and an additional one-year mandatory negotiation period. For public safety entities that dedicate a majority of their system communications to police, fire or emergency medical services operations, the voluntary negotiation period is three years, with an additional two-year mandatory negotiation period. In 1998, the FCC shortened the voluntary negotiation period by one year, without lengthening the mandatory negotiation period for non-public safety personal communications services licensees in the C, D, E and F Blocks. Parties unable to reach agreement within these time periods may refer the matter to the FCC for resolution, but the incumbent microwave user is permitted to continue its operations until final FCC resolution of the matter. The transition and cost sharing plans expire on April 4, 2005, at which time remaining microwave incumbents in the personal communications services spectrum will be responsible for the costs of relocating to alternate spectrum locations. Our cellular license is not encumbered by existing microwave licenses. Personal communications services and cellular systems are subject to certain FAA regulations governing the location, lighting and construction of transmitter towers and antennas and may be subject to regulation under Federal environmental laws and the FCC's environmental regulations. State or local zoning and land use regulations also apply to our activities. We expect to use common carrier point to point microwave facilities to connect the transmitter, receiver, and signaling equipment for each personal communications services or cellular cell, the cell sites, and to link them to the main switching office. The FCC licenses these facilities separately and they are subject to regulation as to technical parameters and service. The Communications Act preempts state and local regulation of the entry of, or the rates charged by, any provider of private mobile radio service or of commercial mobile radio service, which includes personal communications services and cellular service. The FCC does not regulate commercial mobile radio service or private mobile radio service rates. The Communications Act permits states to regulate the "other terms and conditions of CMRS." The FCC has not clearly defined what is meant by the "other terms and conditions" of CMRS, however, and has upheld the legality of state universal service requirements on CMRS carriers. The United States Court of Appeals for the 5th and District of Columbia Circuits have affirmed the FCC's determination. TRANSFERS AND ASSIGNMENTS OF CELLULAR AND PERSONAL COMMUNICATIONS SERVICES LICENSES. The Communications Act and FCC rules require the FCC's prior approval of the assignment or transfer of control of a license for a personal communications services or cellular system. In addition, the FCC has established transfer disclosure requirements that require licensees who assign or transfer control of a personal communications services license within the first three years of their license terms to file associated sale contracts, option agreements, management agreements or other documents disclosing the total consideration that the licensee would receive in return for the transfer or assignment of its license. Non-controlling interests in an entity that holds a FCC license generally may be bought or sold without FCC approval, subject to the FCC's spectrum aggregation limits. However, we may require approval of the Federal Trade Commission and the Department of Justice, as well as state or local regulatory authorities having competent jurisdiction, if we sell or acquire personal communications services or cellular interests over a certain size. FOREIGN OWNERSHIP. Under existing law, no more than 20% of an FCC licensee's capital stock may be owned, directly or indirectly, or voted by non-U.S. citizens or their representatives, by a foreign government or its representatives or by a foreign corporation. If a FCC licensee is controlled by another entity, as is the case with our ownership structure, up to 25% of that entity's capital stock may be owned or voted by non-US citizens or their representatives, by a foreign government or its representatives or by a foreign corporation. Foreign ownership above the 25% level may be allowed should the FCC find such higher levels not inconsistent with the public interest. The FCC has ruled that higher levels of foreign ownership, even up to 100%, are presumptively consistent with the public interest with respect to investors from certain nations. If our foreign ownership were to exceed the permitted level, the FCC could revoke our FCC licenses, although we could seek a declaratory ruling from the FCC allowing the foreign ownership or take other actions to reduce our foreign ownership percentage in order to avoid the loss of our licenses. We have no knowledge of any present foreign ownership in violation of these restrictions. RECENT INDUSTRY DEVELOPMENTS. The FCC has announced rules for making emergency 911 services available by cellular, personal communications services and other commercial mobile radio service providers, including enhanced 911 services that provide the caller's telephone number, location and other useful information. Commercial mobile radio service providers currently are required to be able to process and transmit 911 calls without call validation, including those from callers with speech or hearing disabilities and relay a caller's automatic number identification and cell site. By 2001, commercial mobile radio service providers must be able to identify the location of a 911 caller within 125 meters in 67% of all cases. On September 15, 1999, the FCC adopted an order modifying the deadlines for identifying caller locations. Wireless carriers may now implement the identification requirement through either network based or handset-based technologies. Carriers that use handset-based technologies must: o begin selling compliant handsets by March 1, 2001; o ensure that 50% of all newly activated handsets are compliant by October 1, 2001 and that at least 95% of all newly activated digital handsets are compliant by October 1, 2002; o comply with additional requirements relating to passing location information upon the request of 911 operators; and o make reasonable efforts to achieve 100% penetration of compliant handsets by no later than December 31, 2004. Carriers that use network-based technologies must provide location information for 50% of callers within six months and 100% of callers within 18 months of a request from a 911 operator. The FCC will require network-based solutions to be accurate for 67% of calls to within 100 meters and for 95% of calls to within 300 meters and handset-based solutions to be accurate for 67% of calls to within 50 meters and for 95% of calls to within 150 meters. On October 12, 1999, Congress adopted legislation that would establish national rules governing emergency services, which was signed into law on October 26, 1999. The legislation: o makes 911 the national emergency number for wireline and wireless phones; o extends limited liability protection to wireless users, wireless providers and public safety officials; o allows carriers to use a customer's network information for emergency purposes; and o allows carriers to disclose the customer's network information, including location information, to family members and guardians in emergency situations. On November 18, 1999, the FCC eliminated carrier cost recovery as a precondition to enhanced 911 deployment. The FCC's new cost-recovery rules require wireless carriers to implement enhanced 911 services without any specific mechanism to recoup their costs. Pending the development of adequate technology, the FCC has granted waivers of the requirement to provide 911 service to users with speech or hearing disabilities to various providers, and we have obtained a waiver. On June 9, 1999, the FCC also adopted rules designed to ensure that analog cellular calls to 911 are completed. These rules, which do not apply to digital cellular service or to personal communications services, give each cellular provider a choice of three ways to meet this requirement. State actions incompatible with the FCC rules are subject to preemption. In 1996, Congress passed legislation designed to open local telecommunications markets to competition. On August 8, 1996, the FCC released its order implementing cost-based carrier interconnection provisions of the Telecommunications Act. Although many of the provisions of this order were struck down by the United States Court of Appeals for the Eighth Circuit, the United States Supreme Court reversed the Eighth Circuit and upheld the FCC in all respects material to our operations. While appeals have been pending, the rationale of the FCC's order has been adopted by many states' public utility commissions, with the result that the charges that cellular and personal communications services operators pay to interconnect their traffic to the public switched telephone network have declined significantly from pre-1996 levels. In its implementation of the Telecommunications Act, the FCC established federal universal service requirements that affect commercial mobile radio service operators. Under the FCC's rules, commercial mobile radio service providers are potentially eligible to receive universal service subsidies for the first time; however, they are also required to contribute to both federal and state universal service funds. Many states are also moving forward to develop state universal service fund programs. A number of these state funds require contributions, varying greatly from state to state, from commercial mobile radio service providers. On July 30, 1999, the United States Court of Appeals for the Fifth Circuit affirmed most of the aspects of the FCC's universal service programs that are relevant to Triton. On October 8, 1999, the FCC implemented the Fifth Circuit's Order by revising its universal service rules to, among other changes, remove intrastate revenues from the universal service mandatory contribution base. On August 1, 1996, the FCC released a report and order expanding the flexibility of cellular, personal communications services and other commercial mobile radio service providers to provide fixed as well as mobile services. Such fixed services include, but need not be limited to, wireless local loop services, for example, to apartment and office buildings, and wireless backup to private branch exchange or switchboards and local area networks, to be used in the event of interruptions due to weather or other emergencies. The FCC has not yet decided whether such fixed services should be subjected to universal service obligations, or how they should be regulated, but it has proposed a presumption that they be regulated as commercial mobile radio service services. The FCC has adopted rules on telephone number portability that will enable customers to migrate their landline and cellular telephone numbers to cellular or personal communications services providers and from a cellular or personal communications services provider to another service provider. On February 8, 1999, the FCC extended the deadline for compliance with this requirement to November 24, 2002, subject to any later determination that an earlier implementation of number portability is necessary to conserve telephone numbers. The FCC has also adopted rules requiring providers of wireless services that are interconnected to the public switched telephone network to provide functions to facilitate electronic surveillance by law enforcement officials. On August 29, 1999, the FCC adopted an order requiring wireless providers to provide information that identifies the cell sites at the origin and destination of a mobile call to law enforcement personnel in response to a lawful court order or other legal requirement. Providers may petition the FCC for a waiver of these law enforcement obligations if they can demonstrate under a multi-factor test that these requirements are not reasonably achievable. Wireless carriers have been given until September 30, 2001 to implement fully the law enforcement assistance obligations. In addition, state commissions have become increasingly aggressive in their efforts to conserve numbering resources. These efforts may impact wireless service providers disproportionately by imposing additional costs or limiting access to numbering resources. Examples of state conservation methods include: o number pooling; o number rationing; and o transparent overlays. Number pooling is especially problematic for wireless providers because it is dependent on number portability technology. In addition, the FCC has rejected transparent overlays, although that decision is subject to petitions for reconsideration before the FCC. On March 17 2000, the FCC adopted rules to promote more efficient allocation and use of numbering resource. This order has not been released. According to the FCC's press release, the FCC adopted a requirement that carriers share blocks of telephone numbers, which are assigned in-groups of 10,000 and reclamation requirements to ensure that carriers return their unused numbers to the North American Numbering Plan Administrator. Commercial mobile radio service providers are not required to implement the number-sharing requirement until November 2002. When they are required to implement local number portability, the FCC also adopted a further notice of proposed rulemaking to examine whether the November 2002 local portability deadline should be extended. On October 21, 1999, the FCC released an order holding that neither interim or long-term number portability obviates the need for 10-digit dialing in an area code overlay. The FCC also eliminated the requirement that new entrants must guaranteed to receive a block of numbers from the existing area code where an overlay is being implemented. In the latter half of 1999, the FCC granted interim number conservation authority to several state commissions, including Ohio, Wisconsin, Texas, New Hampshire, Connecticut, California, Florida, Maine, Massachusetts and New York. The FCC granted these states interim authority to establish requested number assignment and utilization requirements until the FCC promulgates a decision in its numbering optimization proceeding. The FCC has determined that the interstate, interexchange offerings, commonly referred to as long distance, of commercial mobile radio service providers are subject to the interstate, interexchange rate averaging and integration provisions of the Communications Act. Rate averaging requires us to average our interstate long distance commercial mobile radio service rates between high cost and urban areas. The FCC has delayed implementation of the rate integration requirements with respect to wide area rate plans we offer pending further reconsideration of its rules. The FCC also delayed the requirement that there be commercial mobile radio service long distance rate integration among commercial mobile radio service affiliates. On December 31, 1998, the FCC reaffirmed, on reconsideration, that its interexchange rate integration rules apply to interexchange commercial mobile radio service services. The FCC initiated a further proceeding to determine how integration requirements apply to typical commercial mobile radio service offerings, including single-rate plans. Until this further proceeding is concluded, the FCC will enforce long distance rate integration on our services only where we separately state a long distance toll charge and bill to our customers. To the extent that we offer services subject to the FCC's rate integration and averaging requirements, these requirements generally reduce our pricing flexibility. We cannot assure you that the FCC will decline to impose rate integration or averaging requirements on us or decline to require us to integrate our commercial mobile radio service long distance rates across our commercial mobile radio service affiliates. The FCC recently adopted new rules limiting the use of customer proprietary network information by telecommunications carriers, including Triton, in marketing a broad range of telecommunications and other services to their customers and the customers of affiliated companies. The new rules give wireless carriers broader discretion to use customer proprietary network information, without customer approval, to market all information services used in the provision of wireless services. The FCC also allowed all telephone companies to use customer proprietary network information to solicit lost customers. While all customers must establish a customer's approval prior to using customer proprietary network information for purposes not explicitly permitted by the rules, the specific details of gathering and storing this approval are now left to the carriers. The FCC's order was issued following a decision by the U.S. Court of Appeals for the 10th Circuit, which overturned the FCC's rules, but not the underlying statute, on First Amendment grounds. The FCC appealed the court's order to the full 10th Circuit. On November 30, 1999, the 10th Circuit denied the FCC's rehearing request. Because the 10th Circuit did not invalidate the customer proprietary network information provision in the Communications Act, carriers are still obligated under the Communications Act not to misuse customer proprietary network information. The FCC has adopted rules governing customer billing by commercial mobile radio services providers. The FCC adopted detailed billing rules for landline telecommunications service providers and extended some of those rules to commercial mobile radio services providers. Commercial mobile radio service providers must comply with two fundamental rules: (i) clearly identify the name of the service provider for each charge; and (ii) display a toll-free inquiry number for customers. In December 1999, the FCC granted waivers of these rules, so that their effect is suspended until April 1, 2000. The FCC has adopted an order that determines the obligations of telecommunications carriers to make their services accessible to individuals with disabilities. The order requires telecommunications services providers, including Triton, to offer equipment and services that are accessible to and useable by persons with disabilities, if that equipment can be made available without much difficulty or expense. The rules require us to develop a process to evaluate the accessibility, usability and compatibility of covered services and equipment. While we expect our vendors to develop equipment compatible with the rules, we cannot assure you that we will not be required to make material changes to our network, product line, or services. In June 1999, the FCC initiated an administrative rulemaking proceeding to help facilitate the offering of calling party pays as an optional wireless service. Under the calling party pays service, the party placing the call to a wireless customer pays the wireless airtime charges. Most wireless customers in the U.S. now pay both to place calls and to receive them. Adoption of rules that permit calling party pays to be offered on a widespread basis by all commercial mobile radio service providers could make commercial mobile radio service providers more competitive with traditional landline telecommunications providers for the provision of regular telephone service. STATE REGULATION AND LOCAL APPROVALS The states in which we operate do not regulate wireless service at this time. In the 1993 Budget Act, Congress gave the FCC the authority to preempt states from regulating rates or entry into commercial mobile radio service, including cellular and personal communications services. The FCC, to date, has denied all state petitions to regulate the rates charged by commercial mobile radio service providers. States may, however, regulate the other terms and conditions of commercial mobile radio service. The siting of cells also remains subject to state and local jurisdiction, although the FCC is considering issues relating to siting in a pending rulemaking. States also may require wireless service providers to charge and collect from their customers fees such as the fee to defray the costs of state emergency 911 services programs. There are several state and local legislative initiatives that are underway to ban the use of wireless phones in motor vehicles. New York State's motor vehicle commissioner is calling for a study to determine if it is necessary to ban the use of wireless phones while driving. San Francisco and Chicago are considering such action and a suburb near Cleveland, Ohio has enacted a law that requires drivers to keep both hands on the steering wheel while the vehicle is moving. Should this become a nationwide initiative, commercial mobile radio service providers could experience a decline in the number of minutes of use by subscribers. COMPETITION We compete directly with two cellular providers and other personal communications services providers in each of our markets except Myrtle Beach, where we are one of two cellular providers, and against enhanced specialized mobile radio providers in some of our markets. These cellular providers have an infrastructure in place and have been operational for a number of years, and some of these competitors have greater financial, technical resources and spectrum than we do. These cellular operators may upgrade their networks to provide services comparable to those we offer. The technologies primarily employed by our digital competitors are code division multiple access and global system for mobile communications, two competing digital wireless standards. We will also compete with personal communications services license holders in each of our markets. We believe that the ownership of other personal communications services licenses in our licensed area is fragmented. We believe that most personal communications services license holders have not commenced the rollout of their networks in our licensed area. However, we expect to compete directly with one or more personal communications service providers in each of our markets in the future. We also expect to face competition from other existing communications technologies such as specialized mobile radio and enhanced specialized mobile radio, which is currently employed by Nextel Communications, Inc. in our licensed area. Although the FCC originally created specialized mobile radio as a non-interconnected service principally for fleet dispatch, in the last decade it has liberalized the rules to permit enhanced specialized mobile radio, which, in addition to dispatch service, can offer services that are functionally equivalent to cellular and personal communications services and may be less expensive to build and operate than personal communications services systems. The FCC requires all cellular and personal communications services licensees to provide service to resellers. A reseller provides wireless service to customers but does not hold a FCC license or own facilities. Instead, the reseller buys blocks of wireless telephone numbers and capacity from a licensed carrier and resells service through its own distribution network to the public. Thus, a reseller is both a customer of a wireless licensee's services and a competitor of that licensee. Several small resellers currently compete with us in our licensed area. Several years ago, the FCC initiated an administrative proceeding seeking comments on whether resellers should be permitted to install separate switching facilities in cellular systems. Although it tentatively concluded it would not require interconnection, this issue is still pending at the FCC. The FCC is also considering whether resellers should receive direct assignments of telephone numbers from the North American Numbering Plan Administrator. With respect to cellular and personal communications services license, the resale obligations terminate five years after the last group of initial licenses of currently allotted personal communications services spectrum were awarded. Accordingly, our resale obligations end on November 24, 2002, although licensees will continue to be subject to the provisions of the Communications Act requiring non-discrimination among customers. We have also agreed to permit AT&T to resell our services. The FCC is scheduled to offer additional spectrum for wireless mobile licenses this year. In May 2000, the FCC has scheduled the 700 MHz auction that is exempt from Spectrum Cap limitations, and in July 2000, the FCC has scheduled the C-Block and F-Block reauction. Some applicants have received and others are seeking FCC authorization to construct and operate global satellite networks to provide domestic and international mobile communications services from geostationary and low-earth-orbit satellites. One such system, the Iridium system, began commercial operations in 1998, and another, Globalster, began service in February 2000. We anticipate that market prices for two-way wireless services generally will decline in the future based upon increased competition. Our ability to compete successfully will depend, in part, on our ability to anticipate and respond to various competitive factors affecting the industry, including new services that may be introduced, changes in consumer preferences, demographic trends, economic conditions and competitors' discount pricing strategies, all of which could adversely affect our operating margins. We plan to use our digital feature offerings, coast-to-coast digital wireless network through our AT&T joint venture, contiguous presence providing an expanded home-rate billing area and local presence in secondary markets to combat potential competition. We expect that our extensive digital network, once deployed, will provide cost-effective means to react effectively to any price competition. INTELLECTUAL PROPERTY The AT&T globe design logo is a service mark owned by AT&T and registered with the United States Patent and Trademark Office. Under the terms of our license agreement with AT&T, we use the AT&T globe design logo and certain other service marks of AT&T royalty-free in connection with marketing, offering and providing wireless mobility telecommunications services using time division multiple access digital technology and frequencies licensed by the FCC to end-users and resellers within our licensed area. The license agreement also grants us the right to use the licensed marks on certain permitted mobile phones. AT&T has agreed not to grant to any other person a right or license to provide or resell, or act as agent for any person offering, those licensed services under the licensed marks in our licensed area except: o to any person who resells, or acts as our agent for, licensed services provided by us, or o any person who provides or resells wireless communications services to or from specific locations such as buildings or office complexes, even if the applicable subscriber equipment being used is capable of routine movement within a limited area and even if such subscriber equipment may be capable of obtaining other telecommunications services beyond that limited area and handing-off between the service to the specific location and those other telecommunications services. In all other instances, AT&T reserves for itself and its affiliates the right to use the licensed marks in providing its services whether within or outside of our licensed area. The license agreement contains numerous restrictions with respect to the use and modification of any of the license marks. We have entered into agreements with TeleCorp PCS and Tritel PCS to adopt and use a common regional brand name, SunCom. Under these agreements, we have formed the Affiliate Licensing Company with TeleCorp PCS and Tritel PCS for the purpose of sharing ownership of and maintaining the SunCom brand name. Each of the companies shares equally in the ownership of the SunCom brand name and the responsibility of securing protection for the SunCom brand name in the United States Patent and Trademark Office, enforcing our rights in the SunCom brand name against third parties and defending against potential claims against the SunCom brand name. The agreements provide parameters for each company's use of the SunCom brand name, including certain quality control measures and provisions in the event that any one of these company's licensing arrangements with AT&T is terminated. An application for registration of the SunCom brand name was filed in the United States Patent and Trademark Office on September 4, 1998, and the application is pending. Affiliate Licensing Company owns the application for the SunCom brand name. The application has undergone a preliminary examination at the United States Patent and Trademark Office, and no pre-existing registrations or applications were raised as a bar or potential bar to the registration of the SunCom brand name. We also filed an application for registration of the m-net Technology trademark, relating to our multi-mode handsets, in the United States Patent and Trademark Office on October 19, 1998, and the application is pending. We are the sole owner of the application for the m-net Technology trademark. The application has undergone a preliminary examination at the United States Patent and Trademark Office, and no pre-existing registrations or applications were raised as a bar or potential bar to the registration of the m-net Technology trademark. EMPLOYEES As of December 31, 1999, we had 994 employees. We believe our relations with our employees are good. ITEM 2. ITEM 2. PROPERTIES Triton maintains its executive offices in Berwyn, Pennsylvania. We also maintain two regional offices in Richmond, Virginia and Charleston, South Carolina. We lease these facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS We are not a party to any lawsuit or proceeding which, in management's opinion, is likely to have a material adverse effect on our business or operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE Omitted puruant to General Instruction I(2) of the Form 10-K requirement. PART II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S STOCK None. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following tables present selected financial data derived from audited financial statements of Triton for the period from March 6, 1997 to December 31, 1997 and the years ended December 31, 1997, 1998 and 1999. In addition, subscriber and customer data for the same periods are presented. The following financial information is qualified by reference to and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and related notes. Period from March 6, 1997 to December 31, December 31, 1997 1998 1999 ----------------- -------- -------- (in thousands, except per share data) Statement of Operations Data: Revenues: Service ........................... $ -- $ 11,172 $ 63,545 Roaming ........................... -- 4,651 44,281 Equipment ......................... -- 755 25,405 -------- -------- -------- Total revenues .................. -- 16,578 133,231 -------- -------- -------- Expenses: Costs of services and equipment... -- 10,466 107,521 Selling and marketing ............ -- 3,260 59,580 General and administrative ....... 2,736 15,589 42,354 Non-cash compensation ............. -- 1,120 3,309 Depreciation and amortization ..... 5 6,663 45,546 -------- -------- -------- Total operating expenses ........ 2,741 37,098 258,310 Loss from operations ................ 2,741 20,520 125,079 Interest and other expense .......... 1,228 30,391 41,061 Interest and other income ........... 8 10,635 4,852 Gain on sale of property, equipment and marketable securities, net ..... -- -- 11,928 -------- -------- -------- Loss before taxes ................... 3,961 40,276 149,360 Income tax benefit .................. -- 7,536 -- -------- -------- -------- Net loss ............................ $ 3,961 $ 32,740 $149,360 ======== ======== ======== December 31, 1998 1999 -------- -------- (in thousands) Balance Sheet Data: Cash and cash equivalents......................... $146,172 $186,251 Working capital................................... 146,192 134,669 Property, plant and equipment, net................ 198,953 421,864 Total assets...................................... 686,859 979,797 Long-term debt and capital lease obligations...... 465,689 504,636 Shareholder's equity.............................. 175,979 328,113 December 31, 1998 1999 -------- -------- (in thousands, except subscriber and customer data) Other Data: Subscribers (end of period)....................... 33,844 195,204 Launched potential customers (end of period)..... 248,000 11,450,000 EBITDA(1)......................................... $(12,737) $ (76,224) Cash flows from: Operating activities............................ $ (4,130) $ (72,549) Investing activities............................ (372,372) (170,511) Financing activities............................ 511,312 283,139 (1) "EBITDA" is defined as operating loss plus depreciation and amortization expense and non-cash compensation. EBITDA is a key financial measure but should not be construed as an alternative to operating income, cash flows from operating activities or net income (or loss), as determined in accordance with generally accepted accounting principles. EBITDA is not a measure determined in accordance with generally accepted accounting principles and should not be considered a source of liquidity. We believe that EBITDA is a standard measure commonly reported and widely used by analysts and investors in the wireless communications industry. However, our method of computation may or may not be comparable to other similarly titled measures of other companies. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The following discussion and analysis is based upon our financial statements as of the dates and for the periods presented in this section. You should read this discussion and analysis in conjunction with our financial statements and the related notes contained elsewhere in this report. We were incorporated in October 1997. In February 1998, we entered into a joint venture with AT&T whereby AT&T contributed to us personal communications services licenses covering 20 MHz of authorized frequencies in a contiguous geographic area encompassing portions of Virginia, North Carolina, South Carolina, Tennessee, Georgia and Kentucky. As part of this agreement, AT&T became our largest equity holder, and we were granted the right to be the exclusive provider of wireless mobility services using equal emphasis co-branding with AT&T in our licensed markets. On June 30, 1998, we acquired an existing cellular system serving Myrtle Beach and the surrounding area from Vanguard Cellular Systems of South Carolina, Inc.. In connection with this acquisition, we began commercial operations and earning recurring revenue in July 1998. We integrated the Myrtle Beach system into our personal communications services network as part of our Phase I network deployment. Substantially all of our revenues prior to 1999 were generated by cellular services provided in Myrtle Beach. Our results of operations do not include the Myrtle Beach system prior to our acquisition of that system. We began generating revenues from the sale of personal communications services in the first quarter of 1999 as part of Phase I of our personal communications services network build-out. Our personal communications services network build-out is scheduled for three phases. We completed the first phase of our build-out in the first half of 1999 with the launch of 15 markets and completed most of Phase II during 1999 launching 12 additional markets. We expect to complete Phase II by the end of the first quarter of 2000 and the third Phase of our build-out in 2001. REVENUE We derive our revenue from the following sources: SERVICE. We sell wireless personal communications services. The various types of service revenue associated with wireless communications services for our subscribers include monthly recurring charges and monthly non-recurring airtime charges for local, long distance and roaming airtime used in excess of pre-subscribed usage. Our customers' roaming charges are rate plan dependent and based on the number of pooled minutes included in their plans. Service revenue also includes monthly non-recurring airtime usage charges associated with our prepaid subscribers and non-recurring activation and de-activation service charges. EQUIPMENT. We sell wireless personal communications phones and accessories that are used by our customers in connection with our wireless services. ROAMING. We charge per minute fees to other wireless telecommunications companies for their customers' use of our network facilities to place and receive wireless services. A particular focus of our strategy is to reduce subscriber churn. Industry data suggest that those providers, including personal communications services providers that have offered poor or spotty coverage, poor voice quality, unresponsive customer care or confusing billing suffer higher than average churn rates. Accordingly, we have launched, and will continue to launch, service in our markets only after comprehensive and reliable coverage and service can be maintained in that market. In addition, our billing systems have been designed to provide customers with simple, understandable bills and flexible billing cycles. We offer simplified rate plans in each of our markets that are tailored to meet the needs of targeted customer segments. We offer local, regional and national rate plans that include local, long distance and roaming services, as well as bundled minutes with multiple options, designed to suit customers' needs. Finally, proactive subscriber retention is an important initiative for our customer care program. We believe our roaming revenues will be subject to seasonality. We expect to derive increased revenues from roaming during vacation periods, reflecting the large number of tourists visiting resorts in our coverage area. We believe that our equipment revenues will also be seasonal, as we expect sales of telephones to peak in the fourth quarter, primarily as a result of increased sales during the holiday season. COSTS AND EXPENSES Our costs of services and equipment include: EQUIPMENT. We purchase personal communications services handsets and accessories from third party vendors to resell to our customers for use in connection with our services. Because we subsidize the sale of handsets to encourage the use of our services, the cost of handsets is higher than the resale price to the customer. We do not manufacture any of this equipment. ROAMING FEES. We incur fees to other wireless communications companies based on airtime usage by our customers on other wireless communications networks. TRANSPORT AND VARIABLE INTERCONNECT. We incur charges associated with interconnection with other carriers' networks. These fees include monthly connection costs and other fees based on minutes of use by our customers. VARIABLE LONG DISTANCE. We pay usage charges to other communications companies for long distance service provided to our customers. These variable charges are based on our subscribers' usage, applied at pre-negotiated rates with the other carriers. CELL SITE COSTS. We will incur expenses for the rent of towers, network facilities, engineering operations, field technicians, and related utility and maintenance charges. Recent industry data indicate that transport, interconnect, roaming and long distance charges that we currently incur will continue to decline, due principally too competitive pressures and new technologies. Cell site costs are expected to increase due to escalation factors included in the lease agreements. Other Expenses include: SELLING AND MARKETING. Our selling and marketing expense includes the cost of brand management, external communications, retail distribution, sales training, direct, indirect, third party and telemarketing support. GENERAL AND ADMINISTRATIVE. Our general and administrative expense includes customer care, billing, information technology, finance, accounting, legal services, network implementation, product development, and engineering management. Functions such as customer care, billing, finance, accounting and legal services are likely to remain centralized in order to achieve economies of scale. DEPRECIATION AND AMORTIZATION. Depreciation of property and equipment is computed using the straight-line method, generally over three to twelve years, based upon estimated useful lives. Leasehold improvements are amortized over the lesser of the useful lives of the assets or the term of the lease. Network development costs incurred to ready our network for use are capitalized. Amortization of network development costs begins when the network equipment is ready for its intended use and is amortized over the estimated useful life of the asset. Our personal communications services licenses and our cellular license are being amortized over a period of 40 years. NON-CASH COMPENSATION. We have recorded $21.3 million of deferred compensation associated with the issuances of common and preferred stock to employees. The compensation is being recognized over five years as the stock vests. In addition, we sold to certain directors and an officer, subject to stock purchase agreements, an aggregate of 3,400 shares of Holdings Series C preferred stock. Compensation expense was recognized for the excess of the fair market value at the date of issuance over the amounts paid. INTEREST INCOME (EXPENSE) AND OTHER. Interest income is earned primarily on our cash and cash equivalents. Interest expense through December 31, 1999 consists of interest on our credit facility and our senior subordinated discount notes, net of capitalized interest. Other expenses include amortization of certain financing charges. Our ability to improve our margins will depend on our ability to manage our variable costs, including selling general and administrative expense, costs per gross added subscriber and costs of building out our network. We expect our operating costs to grow as our operations expand and our customer base and call volumes increase. Over time, these expenses should represent a reduced percentage of revenues as our customer base grows. Management will focus on application of systems and procedures to reduce billing expense and improve subscriber communication. These systems and procedures will include debit billing, credit card billing, over-the-air payment and Internet billing systems. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1999 COMPARED TO THE YEAR ENDED DECEMBER 31, 1998 Total revenue was $133.2 million and $16.6 million for the years ended December 31, 1999 and 1998, respectively. Service revenue was $63.5 million and $11.2 million for the years ended December 31, 1999 and 1998, respectively. Equipment revenue was $25.4 million and $0.8 million for the years ended December 31, 1999 and 1998, respectively. Roaming revenue was $44.3 million and $4.7 million for the years ended December 31, 1999 and 1998, respectively. This revenue was primarily related to launching 27 markets as part of our Phase I and Phase II network build-out. Cost of service and equipment was $107.5 million and $10.5 million for the years ended December 31, 1999 and 1998, respectively. These costs were primarily related to launching 27 markets as part of our Phase I and Phase II network build-out. Selling and marketing expenses were $59.6 million and $3.3 million for the years ended December 31, 1999 and 1998, respectively. The increase of $56.3 million was due to increased salary and benefit expenses for new sales and marketing staff and advertising and promotion associated with launching 27 markets as part of our Phase I and Phase II network build-out. General and administrative expenses were $42.4 million and $15.6 million for the years ended December 31, 1999 and 1998, respectively. The increase of $26.8 million was due to the development and growth of infrastructure and staffing related to information technology, customer care and other administrative functions incurred in conjunction with the commercial launch of 27 markets during 1999. Non-cash compensation expense was $3.3 million and $1.1 million for the years ended December 31, 1999 and 1998, respectively. This increase is attributable to the issuance of additional shares in 1999 and to an increase in the vesting of certain restricted shares as compared to the same period in 1998. Depreciation and amortization expense was $45.5 million and $6.7 million for the years ended December 31, 1999 and 1998, respectively. This increase of $38.8 million was related to depreciation of our fixed assets, as well as the initiation of amortization on personal communications services licenses and the AT&T agreements upon the commercial launch of our Phase I and Phase II markets. Interest expense was $41.1 million, net of capitalized interest of $12.3 million, and $30.4 million, net of capitalized interest of $3.5 million, for the years ended December 31, 1999 and 1998, respectively. The increase is attributable to increased borrowings as compared to the same period in 1998. Interest income was $4.9 million and $10.6 million for the years ended December 31, 1999 and 1998, respectively. This reduction is due primarily to lower average cash balances resulting from the continued Phase I and Phase II build-out. Gain on sale of property, equipment and marketable securities was $11.9 million for the year ended December 31, 1999, relating primarily to the gain recorded on the tower sale of $11.6 million, and the gain on the sale of marketable securities of $1.0 million, partially off set by a $0.8 million loss on the sale of furniture and fixtures. We recorded no gains on the sale of assets in 1998. Income tax benefit for years ended December 31, 1999 and 1998 was $0 and $7.5 million, respectively. The decrease was due to the inability to recognize additional tax benefits in 1999. Net loss was $149.4 million and $32.8 million for the years ended December 31, 1999 and 1998, respectively. The net loss increased $116.6 million primarily due to the initial launch of commercial service as discussed in the items above. YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE PERIOD FROM MARCH 6, 1997 (INCEPTION) TO DECEMBER 31, 1997 Total revenue for the year ended December 31, 1998 was $16.6 million, which was comprised of services, roaming and equipment revenues related to our Myrtle Beach operations, which we acquired in June 1998. We had no revenue for the period from March 6, 1997 to December 31, 1997. Costs of services and equipment were $10.5 million for the year ended December 31, 1998. These costs were associated with our Myrtle Beach operations. We had no costs of services and equipment for the period from March 6, 1997 to December 31, 1997. Selling and marketing costs were $1.7 million for the year ended December 31, 1998, relating primarily to advertising, marketing and promotional activities associated with our Myrtle Beach operations. We had no selling and marketing expense for the period from March 6, 1997 to December 31, 1997. General and administrative expenses increased by $12.9 million to $15.6 million for the year ended December 31, 1998, as compared to the period from March 6, 1997 to December 31, 1997. The increase was due primarily to administrative costs associated with the Myrtle Beach network and our establishment of our corporate and regional operational infrastructure. Non-cash compensation expense was $1.1 million for the year ended December 31, 1998, relating to the vesting of shares issued as compensation. We had no non-cash compensation for the period from March 6, 1997 to December 31, 1997. Depreciation and amortization expense was $6.7 million and $5,000 for year ended December 31, 1998 and for the period from March 6, 1997 to December 31, 1997, respectively. This amount relates primarily to the depreciation of the tangible and intangible assets acquired in the Myrtle Beach transaction and amortization attributable to certain agreements executed in connection with the AT&T joint venture. Interest expense was $30.4 million, net of capitalized interest of $3.5 million, and $1.2 million for the year end December 31, 1998 and for the period March 6, 1997 to December 31, 1997, respectively. No interest was capitalized in 1997. This increase is attributable to increased borrowings in the year ended December 31, 1998. Interest and other income was $10.6 million and $8,000 for the year ended December 31, 1998 and for the period from March 6, 1997 to December 31, 1997, respectively. This amount relates primarily to interest income on our cash and cash equivalents. For the year ended December 31, 1998, we recorded a tax benefit of $7.5 million related to temporary deductible differences, primarily net operating losses. For the year ended December 31, 1998, our net loss was $32.7 million, as compared to $4.0 million for the period from March 6, 1997 to December 31, 1997. The net loss increased $28.7 million, resulting primarily from the items discussed above. LIQUIDITY AND CAPITAL RESOURCES We have funded, and expect to continue to fund, our capital requirements with: o the proceeds from Holding's initial public offering of in October 1999; o the proceeds from equity investments by Holding's shareholders; o borrowings under our credit facility; o the proceeds from an offering of senior subordinated discount notes completed in 1998; and, o the proceeds from the sale of our communications towers. The construction of our network and the marketing and distribution of wireless communications products and services have required, and will continue to require, substantial capital. These capital requirements include license acquisition costs, capital expenditures for network construction, funding of operating cash flow losses and other working capital costs, debt service and financing fees and expenses. We estimate that our total capital requirements, assuming substantial completion of our network build-out, which will allow us to offer services to nearly 100% of the potential customers in our licensed area, from our inception until December 31, 2001 will be approximately $1.4 billion. We believe that cash on hand and available credit facility borrowings, will be sufficient to meet our projected capital requirements through the end of 2001. Although we estimate that these funds will be sufficient to build- out our network and to enable us to offer services to nearly 100% of the potential customers in our licensed area, it is possible that additional funding will be necessary. EQUITY CONTRIBUTIONS. In October 1999, Holdings completed an initial public offering of shares of its common stock and raised approximately $190.2 million, net of $16.8 million of costs. We expect to use the proceeds for general corporate purposes, including capital expenditures in connection with the expansion of its personal communications services network, sales and marketing activities, and working capital. As part of our joint venture agreement with AT&T, AT&T transferred personal communications services licenses covering 20 MHz of authorized frequencies in exchange for 732,371 shares of Holdings' Series A preferred stock and 366,131 shares of Holdings' Series D preferred stock. The Series A preferred stock provides for cumulative dividends at a rate of 10% on the $100 liquidation value per share plus unpaid dividends. These dividends accrue and are payable quarterly; however, we may defer all cash payments due to the holders until June 30, 2008 and quarterly dividends are payable in cash thereafter. The Series A preferred stock is redeemable at the option of its holders beginning in 2018 and at our option, at its accreted value, on or after February 4, 2008. We may not pay dividends on, or, subject to specified exceptions, repurchase shares of, our common stock without the consent of the holders of the Series A preferred stock. The Series D preferred stock provides for dividends when, as and if declared by our board of directors and contains limitations on the payment of dividends on our common stock. In connection with the consummation of the joint venture with AT&T, we received contributions from institutional equity investors, as well as Michael Kalogris and Steven Skinner, in the aggregate amount of $140.0 million, in return for the issuance of 1.4 million shares of Holdings' Series C preferred stock. We also received equity contributions from Holdings' shareholders in the aggregate amount of $35.0 million in return for the issuance of 350,000 shares of Holdings Series C preferred stock in order to fund a portion of our acquisition of an existing cellular system in Myrtle Beach, South Carolina. In addition, we received equity contributions from Holdings' shareholders in the aggregate amount of approximately $30.1 million in return for the issuance of 165,187 shares of Holdings' Series C preferred stock and 134,813 shares of Holdings' Series D preferred stock in order to fund a portion of our Norfolk license acquisition. On June 8, 1999, we completed an exchange of licenses with AT&T. We transferred licenses covering the Hagerstown and Cumberland, Maryland areas and received licenses covering the Savannah and Athens, Georgia areas. We issued to AT&T 53,882 shares of Holdings Series A preferred stock and 42,739 shares of Holdings' Series D preferred stock in connection with this exchange. CREDIT FACILITY. On February 3, 1998, we entered into a loan agreement that provided for a senior secured bank facility with a group of lenders for an aggregate amount of $425.0 million of borrowings. On September 22, 1999, we entered into an amendment to that loan agreement under which the amount of credit available to us was increased to $600.0 million. The bank facility provides for: o a $175.0 million senior secured Tranche A term loan maturing on August 4, 2006; o a $150.0 million senior secured Tranche B term loan maturing on May 4, 2007; o a $175.0 million senior secured Tranche C term loan maturing on August 4, 2006; and o a $100.0 million senior secured revolving credit facility maturing on August 4, 2006. The terms of the bank facility will permit us, subject to various terms and conditions, including compliance with specified leverage ratios and satisfaction of build-out and subscriber milestones, to draw up to $600.0 million to finance working capital requirements, capital expenditures, permitted acquisitions and other corporate purposes. Our borrowings under these facilities are subject to customary terms and conditions. We must begin to repay the term loans in quarterly installments, beginning on February 4, 2002, and the commitments to make loans under the revolving credit facility are automatically and permanently reduced beginning on August 4, 2004. In addition, the credit facility requires us to make mandatory prepayments of outstanding borrowings under the credit facility, commencing with the fiscal year ending December 31, 2001, based on a percentage of excess cash flow and contains financial and other covenants customary for facilities of this type, including limitations on investments and on our ability to incur debt and pay dividends. As of December 31, 1999, we had drawn $150.0 million under the Tranche B term loan, which we expect to use to fund future operations. SENIOR DISCOUNT NOTES. On May 7, 1998, we completed an offering of $512.0 million aggregate principal amount at maturity of 11% senior subordinated discount notes due 2008 under Rule 144A of the Securities Act. The proceeds of the offering, after deducting an initial purchasers' discount of $9.0 million, were $291.0 million. The notes are guaranteed by all of our subsidiaries. The indenture for the notes contains customary covenants, including covenants that limit our subsidiaries' ability to pay dividends to us, make investments and incur debt. The indenture also contains customary events of default. TOWER SALE. We entered into an agreement on July 13, 1999 with American Tower Corporation to sell all of our owned personal communications tower facilities, along with certain other related assets, and we completed the sale on September 22, 1999. The proceeds from the sale were $71.1 million. At the closing of the transaction, the parties entered into certain other agreements, including: o a master license and sublease agreement providing for our lease of the tower facilities from American Tower; o an amendment to an existing build-to-suit agreement between us and American Tower providing for American Tower's construction of 100 additional tower sites that we will then lease from American Tower; and o an amendment to an existing site acquisition agreement expanding the agreement to provide for American Tower to perform site acquisition services for 70% of the tower sites we develop through December 31, 2000. Cash and cash equivalents totaled $186.3 million at December 31, 1999, as compared to $146.2 million at December 31, 1998. This increase of $40.1 million was due primarily to the net proceeds from our initial public offering of $190.2 million and the private equity investors of $95.0 million offset by capital expenditures of $264.9 million related to our network build out. Working capital totaled approximately $134.7 million at December 31, 1999, as compared to $146.2 million at December 31, 1998. NEW ACCOUNTING PRONOUNCEMENTS On July 8, 1999, the Financial Accounting Standards Board ("FASB") issued SFAS No. 137, "Deferral of the Effective Date of SFAS 133", which defers the effective date of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" to all fiscal quarters of all fiscal years beginning after June 15, 2000. Management is currently evaluating the financial impact of adoption of SFAS No. 133. The adoption is not expected to have a material effect on Triton's consolidated results of operations, financial position, or cash flows. The Securities and Exchange Commission recently released Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition, which provides guidance on the recognition, presentation, and disclosure of revenue in the financial statements. Management is currently assessing the impact, if any, the SAB will have on Triton's financial position and results of operations. ITEM 7A. ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISKS We utilize interest rate swaps to hedge against the effect of interest rate fluctuations on our senior debt portfolio. We do not hold or issue financial instruments for trading or speculative purposes. Through December 31, 1999, we entered into two interest rate swap transactions having an aggregate non-amortizing notional amount of $75 million. Both instruments terminate on December 4, 2003. As of December 31, 1998 and 1999, we were in a net gain position. Net gain or loss positions are settled quarterly. We pay a fixed rate (4.76% and 4.805%) and receive a floating rate, equivalent to the three month London interbank offered rate, on respective $40 million and $35 million notional amounts. A 100 basis point fluctuation in market rates would not have a material effect on our overall financial condition. Swap counterparties are major commercial banks. Our cash and cash equivalents consist of short-termed assets having initial maturities of three months or less and are managed by high credit quality financial institutions. While these investments are subject to a degree of interest rate risk, it is not considered to be material relative to our overall investment income position. ITEM 8. ITEM 8. FINANCIAL STATEMENTS TRITON PCS, INC. Consolidated Financial Statements: Report of PricewaterhouseCoopers LLP Consolidated Balance Sheets as of December 31, 1998 and 1999 Consolidated Statements of Operations for the period March 6, 1997 (inception) to December 31, 1997, and the years ended December 31, 1998 and 1999 Consolidated Statements of Shareholder's Equity (Deficit) for the period March 6, 1997 (inception) to December 31, 1997, and the years ended December 31, 1998 and 1999 Consolidated Statements of Cash Flows for the period March 6, 1997 (inception) to December 31, 1997, and the years ended December 31, 1998 and 1999 Notes to Consolidated Financial Statements F - 1 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholder of Triton PCS, Inc.: In our opinion, the consolidated financial statements listed in the index appearing under item 8 on page of this Form 10-K present fairly, in all material respects, the financial position of Triton PCS, Inc., as defined in Note 1 to the financial statements, and its subsidiaries (Triton) at December 31, 1998 and 1999, and the results of their operations and their cash flows for the period from March 6, 1997 (inception) to December 31, 1997 and the years ended December 31, 1998 and 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of Triton's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers LLP Philadelphia, Pennsylvania February 25, 2000 F - 2 See accompanying notes to consolidated financial statements. F - 3 See accompanying notes to consolidated financial statements. F - 4 F - 5 TRITON PCS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Period from March 6, 1997 (inception) to December 31, 1997, and years ended December 31, 1998 and 1999 (1) ORGANIZATION AND NATURE OF BUSINESS On March 6, 1997, Triton Communications L.L.C. ("L.L.C.") was formed to explore various business opportunities in the wireless telecommunications industry, principally related to personal communications services (PCS) and cellular activities. During the period March 6, 1997 through October 1, 1997, L.L.C.'S activities consisted principally of hiring a management team, raising capital and negotiating strategic business relationships, primarily related to PCS business opportunities. On October 1, 1997, Triton PCS Holdings, Inc. ("Holdings" or "Parent") was organized to pursue PCS-related activities. Holdings subsequently formed a wholly owned subsidiary, Triton PCS, Inc. ("Triton") which directly or indirectly owns several related wholly owned subsidiaries (collectively the "Company"). Subsequent to October 2, 1997, these PCS-related activities continued but were conducted primarily through Triton and its subsidiaries. Consequently, for purposes of the accompanying financial statements, L.L.C. has been treated as a "predecessor" entity. As a result of certain financing relationships and the similar nature of the business activities conducted by each respective legal entity, L.L.C. and Triton are considered companies under common control and were combined for financial reporting purposes for periods prior to October 2, 1997. All significant intercompany accounts or balances have been eliminated in consolidation. The consolidated financial statements incorporate the PCS-related business activities of L.L.C. and the activities of Triton. The consolidated accounts of Triton include Triton PCS Inc.; Triton PCS Holdings Company L.L.C.; Triton Management Company, Inc.; Triton PCS Property Company L.L.C.; Triton PCS Equipment Company L.L.C.; Triton PCS Operating Company L.L.C.; and Triton PCS License Company L.L.C. All significant intercompany accounts or balances have been eliminated in consolidation. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. (b) CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash on hand, demand deposits and short term investments with initial maturities of three months or less. Triton maintains cash balances at financial institutions, which at times exceed the $100,000 FDIC limit. Bank overdraft balances are classified as a current liability. (c) MARKETABLE SECURITIES Marketable securities consist of debt securities with initial maturities greater than three months. Triton classifies all such debt securities as available for sale and records them at fair value with unrealized holding gains and losses to be included as a separate component of other comprehensive income until realized. (d) INVENTORY Inventory, consisting primarily of wireless handsets and accessories held for resale, is valued at lower of cost or market. Cost is determined by the first-in, first-out method. F - 7 (e) PROPERTY AND EQUIPMENT Property and equipment is carried at original cost. Depreciation is calculated based on the straight-line method over the estimated useful lives of the assets which are ten to twelve years for network infrastructure and equipment and three to five years for office furniture and equipment. In addition, Triton capitalizes interest on expenditures related to the buildout of the network. Expenditures for repairs and maintenance are charged to expense as incurred. When property is retired or otherwise disposed, the cost of the property and the related accumulated depreciation are removed from the accounts, and any resulting gains or losses are reflected in the statement of operations. Capital leases are included under property and equipment with the corresponding amortization included in depreciation. The related financial obligations under the capital leases are included in current and long-term obligations. Capital leases are amortized over the useful lives of the respective assets. (f) CONSTRUCTION IN PROGRESS Construction in progress includes expenditures for the design, construction and testing of Triton's PCS network and also includes costs associated with developing information systems. Triton capitalizes interest on certain of its construction in progress activities. Interest capitalized for the year ended December 31, 1998 and 1999 totaled $3.5 million and $12.3 million, respectively. When the assets are placed in service, Triton transfers the assets to the appropriate property and equipment category and depreciates these assets over their respective estimated useful lives. (g) INVESTMENT IN PCS LICENSES Investments in PCS Licenses are recorded at their estimated fair value at the time of acquisition. Licenses are amortized on a straight-line basis over 40 years. (h) DEFERRED TRANSACTION COSTS Costs incurred in connection with the negotiation and documentation of the AT&T transaction (see Note 3), were deferred and included in the aggregate purchase price allocated to the net assets acquired upon completion of the transaction. Costs incurred in connection with the negotiation and documentation of the bank financing and Triton's issuance of senior subordinated discount notes were deferred and amortized over the terms of the bank financing and notes using the effective interest rate method. (i) LONG-LIVED ASSETS Triton periodically evaluates the carrying value of long-lived assets when events and circumstances warrant such review. The carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flows from such assets are separately identifiable and are less than the carrying value. In the event a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Fair market value is determined by using the anticipated cash flows discounted at a rate commensurate with the risk involved. Measurement of the impairment, if any, will be based upon the difference between carrying value and the fair value of the asset. (j) REVENUE RECOGNITION Revenues from operations consist of charges to customers for monthly access, airtime, roaming charges, long-distance charges, and equipment sales. Revenues are recognized as services are rendered. Unbilled revenues result from service provided from the billing cycle date to the end of the month and from other carrier's customers using Triton's systems. Equipment sales are recognized upon delivery to the customer and reflect charges to customers for wireless handset equipment purchases. (k) INCOME TAXES Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. F - 8 (l) FINANCIAL INSTRUMENTS Triton utilizes derivative financial instruments to reduce interest rate risk. Triton does not hold or issue financial instruments for trading or speculative purposes. Management believes losses related to credit risk are remote. The instruments are accounted for on an accrual basis. The net cash amounts paid or received are accrued and recognized as an adjustment to interest expense (m) ADVERTISING COSTS Triton expenses advertising costs when the advertisement occurs. Total advertising expense amounted to $643,000 in 1998 and $25.8 million in 1999. (n) CONCENTRATIONS OF CREDIT RISK Financial instruments, which potentially subject Triton to concentration of credit risk, consist principally of cash and equivalents, marketable securities, and accounts receivable. Triton's credit risk is managed through diversification and by investing its cash and cash equivalents and marketable securities in high-quality money market instruments and corporate issuers. Concentrations of credit risk with respect to accounts receivable are limited due to a large customer base. Initial credit evaluations of customers' financial condition are performed and security deposits are obtained for customers with a higher credit risk profile. Triton maintains reserves for potential credit losses and such losses have not exceeded management expectations. (o) RECLASSIFICATIONS Certain reclassifications have been made to prior period financial statements to conform to the current period presentation (p) NEW ACCOUNTING PRONOUNCEMENTS On July 8, 1999, the Financial Accounting Standards Board ("FASB") issued SFAS No. 137, "Deferral of the Effective Date of SFAS 133", which defers the effective date of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" to all fiscal quarters of all fiscal years beginning after June 15, 2000. Triton is currently evaluating the financial impact of adoption of SFAS No. 133. The adoption is not expected to have a material effect on Triton results of operations, financial position, or cash flows. The Securities Exchange and Commission recently released Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition, which provides guidance on the recognition, presentation, and disclosure of the revenue in the financial statement. Triton is currently assessing the impact, if any, the SAB will have on Triton's financial position, results of operations, and cash flows. (3) AT&T TRANSACTION On October 8, 1997, Holdings entered into a Securities Purchase Agreement with AT&T Wireless PCS, Inc. ("AT&T"), a subsidiary of AT&T Corp., and the shareholders of Holdings, whereby Triton was to become the exclusive provider of wireless mobility services in the AT&T Southeast regions. On February 4, 1998, Holdings executed the Closing Agreement with AT&T and the other shareholders of Holdings finalizing the transactions contemplated in the Security Purchase Agreement. Under the Closing Agreement, the Company issued 732,371 shares of Holdings' Series A convertible preferred stock and 366,131 shares of Holdings' Series D convertible preferred stock to AT&T in exchange for 20 MHz A and B block PCS licenses covering certain areas in the southeastern United States and the execution of certain related agreements, as further described below. The fair value of the FCC licenses was $92.8 million with an estimated useful life of 40 years. This amount is substantially in excess of the tax basis of such licenses, and accordingly, the Company recorded a deferred tax liability, upon the closing of the transaction. In accordance with the Closing Agreement, Triton and AT&T and the other shareholders of Holdings consented to executing the following agreements: F - 9 (a) SHAREHOLDER'S AGREEMENT The Shareholder's Agreement expires on February 4, 2009. The agreement was amended and restated on October 27, 1999 in connection with Holdings initial public offering and includes the following sub-agreements: RESALE AGREEMENT - Triton is required to enter into a Resale Agreement at the request of AT&T, which provides AT&T with the right to purchase and resell on a nonexclusive basis access to and usage of Triton's services in Triton's Licensed Area. Triton will retain the continuing right to market and sell its services to customers and potential customers in competition with AT&T. EXCLUSIVITY - None of Holdings Shareholders will provide or resell, or act as the agent for any person offering, within the Territory wireless mobility telecommunications services initiated or terminated using Time Division Multiple Access and frequencies licensed by the FCC (Company Communications Services), except AT&T and its affiliates may (i) resell or act as agent for Triton in connection with the provision of Company Communications Services, (ii) provide or resell wireless telecommunications services to or from certain specific locations, and (iii) resell Company Communications Services for another person in any area where Triton has not placed a system into commercial service, provided that AT&T has provided Triton with prior written notice of AT&T's intention to do so and only dual band/dual mode phones are used in connection with such resale activities. Additionally, with respect to the markets listed in the Roaming Agreement, Triton and AT&T agreed to cause their respective affiliates in their home carrier capacities to program and direct the programming of customer equipment so that the other party in its capacity as the serving carrier is the preferred provider in such markets, and refrain from inducing any of its customers to change such programming. BUILD-OUT - Triton is required to conform to certain requirements regarding the construction of Triton's PCS system. In the event that Triton breaches these requirements, AT&T may terminate its exclusivity provisions. DISQUALIFYING TRANSACTIONS - In the event of a merger, asset sale, or consolidation, as defined, involving AT&T and another person that derives annual revenues in excess of $5.0 billion, derives less than one third of its aggregate revenues from wireless telecommunications, and owns FCC licenses to offer wireless mobility telecommunication services to more than 25% of the population within Triton's territory, AT&T and Triton have certain rights. AT&T may terminate its exclusivity in the territory in which the other party overlaps that of Triton. In the event that AT&T proposes to sell, transfer, or assign to a non-affiliate its PCS system owned and operated in Charlotte, NC; Atlanta, GA; Baltimore, MD; and Washington, DC, BTAs, then AT&T will provide Triton with the opportunity for a 180 day period to have AT&T jointly market Triton's licenses that are included in the MTA that AT&T is requesting to sell. (b) LICENSE AGREEMENT Pursuant to a Network Membership License Agreement, dated February 4, 1998 as amended, (the "License Agreement"), between AT&T and Triton, AT&T granted to Triton a royalty-free, nontransferable, nonsublicensable, limited right, and license to use certain Licensed Marks solely in connection with certain licensed activities. The Licensed Marks include the logo containing the AT&T and globe design and the expression "Member, AT&T Wireless Services Network." The "Licensed Activities" include (i) the provision to end-users and resellers, solely within the Territory, of Company Communications Services on frequencies licensed to Triton for Commercial Mobile Radio Services (CMRS) provided in accordance with the AT&T Agreement (collectively, the Licensed Services) and (ii) marketing and offering the Licensed Services within the Territory. The License Agreement also grants to Triton the right and license to use Licensed Marks on certain permitted mobile phones. The License Agreement, along with the Exclusivity and Resale Agreements, have a fair value of $20.3 million with an estimated useful life of 10 years. Amortization commenced upon the effective date of the agreement. (c) ROAMING AGREEMENT Pursuant to the Intercarrier Roamer Service Agreement, dated as of February 4, 1998 (as amended, the "Roaming Agreement"), between AT&T and Triton, each of AT&T and Triton agrees to provide (each in its capacity as serving provider, the "Serving Provider") wireless mobility radiotelephone service for registered customers of the other party's (the "Home Carrier") customers while such customers are out of the Home Carrier's F - 10 geographic area and in the geographic area where the Serving Carrier (itself or through affiliates) holds a license or permit to construct and operate a wireless mobility radio/telephone system and station. Each Home Carrier whose customers receive service from a Serving Carrier shall pay to such Serving Carrier 100% of the Serving Carrier's charges for wireless service and 100% of pass-through charges (i.e., toll or other charges). The fair value of the Roaming Agreement, as determined by an independent appraisal, was $5.5 million, with an estimated useful life of 20 years. Amortization commenced upon the effective date of the agreement. (4) ACQUISITIONS (a) SAVANNAH/ATHENS EXCHANGE On June 8, 1999, Triton completed an exchange of certain licenses with AT&T, transferring licenses to the Hagertown, MD and Cumberland, MD Basic Trading Areas ("BTAs") covering 512,000 potential customers in exchange for licenses to certain counties in the Savannah, GA and Athens, GA BTAs, which cover 517,000 potential customers. All acquired licenses are contiguous to Triton's existing service area. In addition, consideration of approximately $10.4 million in Holdings Series A and Series D preferred stock was issued to AT&T. (b) NORFOLK ACQUISITION On December 31, 1998, Triton acquired from AT&T (the Norfolk Acquisition) (i) an FCC license to use 20MHz of authorized frequencies to provide broadband PCS services throughout the entirety of the Norfolk, Virginia BTA and (ii) certain assets of AT&T used in the operation of the PCS system in such BTA for an aggregate purchase price of approximately $111 million. The excess of the aggregate purchase price over the fair market value of tangible net assets acquired of approximately $46.3 million was assigned to FCC licenses and is being amortized over 40 years. The build-out of the network relating to the Norfolk Acquisition, including the installation of a switch, has been completed. The Norfolk Acquisition was funded through the use of proceeds from the Subordinated Debt offering (see note 11); the issuance of 134,813 shares of Holdings Series D preferred stock, valued at $14.6 million, and the issuance of 165,187 shares of Holdings Series C preferred stock valued at $16.5 million. In addition, 766,667 shares of Holdings Class A Common Stock were issued as anti-dilutive protection in accordance with a prior agreement among the Holdings shareholders. (c) MYRTLE BEACH ACQUISITION On June 30, 1998, Triton acquired an existing cellular system (the Myrtle Beach System) which serves the South Carolina 5-Georgetown Rural Service Area (the SC-5) for a purchase price of approximately $164.5 million. The acquisition has been accounted for using the purchase method and, accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based upon management's best estimate of their fair value. The purchase price was allocated to FCC licenses of approximately $123.4 million; subscriber lists of approximately $20 million; fixed assets of approximately $24.7 million and other net assets of $3.8 million. The Myrtle Beach Acquisition was funded through the use of proceeds from the Subordinated Debt offering and the issuance of 350,000 shares of Holdings Series C preferred stock valued at $35.0 million, to certain cash equity shareholders. In addition, 894,440 shares of Holdings common stock were issued as anti-dilutive protection in accordance with a prior agreement among the shareholders. Results of operations after the acquisition date are included in the Statement of Operations from July 1, 1998. The following unaudited pro forma information has been prepared assuming that this acquisition had taken place on January 1, 1997. The pro forma information includes adjustments to interest expense that would have been incurred to finance the purchase, additional depreciation based on the fair market value of the property, plant and equipment acquired, and the amortization of intangibles arising from the transaction. F - 11 1997 1998 ------------ ----------- Unaudited (Dollars in thousands) Net revenues $ 23,608 $ 31,116 Net loss $ 47,336 $ 38,945 (5) TOWER SALE On September 22, 1999, Triton sold and transferred to American Tower Corporation ("ATC"), 187 of its towers, related assets and certain liabilities. The purchase price was $71.1 million, reflecting a price of $380,000 per site. Triton also contracted with ATC for an additional 100 build-to-suit towers in addition to its current contracted 125 build-to-suit towers, and the parties extended their current agreement for turnkey services for co-location sites through 2001. An affiliate of an investor has acted as Tritons financial advisor in connection with the sale of the personal communications towers. Triton also entered into a master lease agreement with ATC, in which Triton has agreed to pay ATC monthly rent for the continued use of the space that Triton occupied on the towers prior to the sale. The initial term of the lease is for 12 years and the monthly rental amount is subject to certain escalation clauses over the life of the lease and related option. Annual payments under the operating lease are $2.7 million. The carrying value of towers sold was $25.7 million. After deducting $1.6 million of selling costs, the gain on the sale of the towers was approximately $43.8 million, of which $11.7 million was recognized immediately, and $32.1 million was deferred and will be recognized over the operating leases term. As of December 31, 1999, $0.3 million have been amortized. (6) STOCK COMPENSATION In October 1997 Holdings granted 3,159,416 shares of restricted common stock to certain management employees. The shares are subject to five-year vesting provisions. At the issuance date, the estimated value of the shares was insignificant, and, accordingly, no deferred compensation was recognized. In February 1998 Holdings granted 1,354,035 shares of restricted common stock to certain employees through a common stock trust intended for future grants to management employees and independent directors. Deferred compensation for stock granted to employees of $0.3 million net of amounts forfeited for shares returned to the trust, was recorded in 1998 based on the estimated fair value at the date of issuance. In June 1998 and December 1998 additional shares of 894,440 and 766,667, respectively were issued as anti-dilutive protection related to capital contributions received by Holdings for the Myrtle Beach and Norfolk transactions. Deferred compensation of $2.8 million and $2.3 million respectively, was recorded for stock granted to employees, including stock granted out of the trust, net of forfeitures. Deferred compensation was recorded based on the estimated value of the shares at the date of issuances. In January 1999, Holdings granted, through the trust, 61,746 shares of restricted common stock to an employee and deferred compensation of $0.2 million was recorded. The shares are subject to five-year vesting provisions. In March 1999, an employee terminated employment with Triton and forfeited $0.1 million of deferred compensation and returned 74,095 shares to the trust. On June 8, 1999, 109,222 additional shares were issued as anti-dilutive protection related to capital contributions received by Holdings in connection with the license exchange and acquisition transaction. The shares are subject to five-year vesting provisions. Deferred compensation of $1.2 million was recorded based on the estimated value of the shares at the date of issuance. On June 30, 1999, Holdings granted, through the trust, 593,124 shares of restricted common stock to certain management employees. The shares are subject to five-year vesting provisions. Deferred compensation of $8.5 million was recorded based on the estimated fair value at the date of issuance. F - 12 On August 9, 1999, Holdings granted, through the trust, 356,500 shares of restricted common stock to certain management employees. These shares are subject to vesting provisions. Deferred compensation of approximately $5.1 million was recorded based on the estimated fair value at the date of issuance. In September 1999, Holdings sold to certain directors and an officer, subject to stock purchase agreements, an aggregate of 3,400 shares of Series C preferred stock for a purchase price of $100.00 per share. Compensation expense of $0.8 million was recorded based on the excess of the estimated fair value at the date of issuance over amounts paid (7) INTANGIBLE ASSETS December 31, Amortizable 1998 1999 Lives --------- -------- ----------- (Dollars in thousands) PCS Licenses $ 257,799 $277,969 40 years AT&T agreements 26,026 26,026 10-20 years Subscriber lists 20,000 20,000 5 years Bank financing 10,994 12,504 8.5-10 years Trademark - 64 40 years --------- -------- 314,819 336,563 Less: accumulated amortization (6,552) (21,025) --------- -------- Intangible assets, net $ 308,267 $315,538 ========= ======== Amortization for the year ended December 31, 1998 and 1999 totaled $5.6 and $14.5 million, respectively. (8) SHORT-TERM DEBT (a) CONVERTIBLE NOTES At various dates in 1997, certain private equity investors provided $1.6 million in financing to L.L.C. in the form of convertible promissory notes. The notes originally bore interest at 14% annually, payable at maturity. On January 15, 1998, L.L.C. assigned the notes to Triton. Triton in conjunction with Holdings, and the noteholders subsequently negotiated a revised arrangement under which no interest would be paid on the notes, which became convertible into approximately $3.2 million worth of Holding's Series C preferred stock. The conversion of L.L.C. notes into Holdings equity occurred on February 4, 1998. The $1.6 million preferred return to the investors was accounted for as a financing cost during the period the notes were outstanding. (b) NONINTEREST-BEARING LOANS During 1997, Holdings Cash Equity Investors provided short-term financing in the form of $11.8 million noninterest-bearing loans. Pursuant to the Closing Agreement, such loans were converted to equity of Holdings as a reduction of the requirements of the initial cash contributions of the investors. No gain or loss was recognized on the conversion of the shares. (9) LONG-TERM DEBT December 31, 1998 1999 (Dollars in thousands) Bank credit facility $ 150,000 $ 150,000 Senior subordinated debt 313,648 350,639 Capital lease obligation 2,322 5,274 ---------- --------- 465,970 505,913 Less current portion of long-term debt 281 1,277 ---------- --------- Long-term debt $ 465,689 $ 504,636 ========== ========= F - 13 The weighted average interest rate for total debt outstanding during 1998 and 1999 was 10.33% and 11.04%, respectively. The average rate at December 31, 1998 and 1999 was 10.16% and 12.38%, respectively. (10) BANK CREDIT FACILITY On February 3, 1998, Triton and Holdings (collectively referred to as the "Obligors") entered into a Credit Agreement with certain banks and other financial institutions, to establish a $425.0 million senior collateralized Bank Credit Facility (the "Facility"). On September 22, 1999, the Obligors entered into an amended agreement whereby the Facility was increased to $600.0 million. The Facility provides for (i) a $175 million Tranche A term loan, maturing August 2006, (ii) a $150 million Tranche B term loan, maturing May 2007, (iii) a $175 million Tranche C term loan, maturing August 2006, and (iv) a $100 million Revolving Facility, maturing August 2006. The lenders' commitment to make loans under the Revolving Facility automatically and permanently reduce, beginning in August 2004, in eight quarterly reductions (the amount of each of the first two reductions, $5.0 million, the next four reductions, $10.0 million, and the last two reductions, $25.0 million). The Tranche A and Tranche C Term Loans are required to be repaid, beginning in February 2002, in eighteen consecutive quarterly installments (the amount of each of the first four installments, $4,375,000, the next four installments, $6,562,500, the next four installments, $8,750,000, the next four installments, $10,937,500, and the last two installments, $26,250,000). The Tranche B Term Loan is required to be repaid beginning in February 2002, in twenty-one consecutive quarterly installments (the amount of the first sixteen installments, $375,000, the next four installments, $7.5 million, and the last installment, $114.0 million). Loans accrue interest, at the Obligor's option, at (i) (a) the LIBOR rate (as defined per the credit agreement) plus (b) the Applicable Rate (Loans bearing interest described in (i), "Eurodollar Loans") or (ii) (a) the higher of (1) the Administrative Agent's prime rate or (2) the Federal Funds Effective Rate (as defined per the Credit Agreement) plus 0.5%, plus (b) the Applicable Rate (Loans bearing interest described in (ii), "ABR Loans"). The Applicable Rate means, with respect to the Tranche B Term Loan, 2.00% per annum, in the case of an ABR Loan, and 3.00% per annum, in the case of a Eurodollar Loan, and, with respect to Tranche A and C Term Loans and the Revolving Facility, a rate between 0.0% and 1.25% per annum (dependent upon the Obligor's leverage ratio, or ratio of end-of-period debt to earnings before interest, taxes, depreciation, and amortization ("EBITDA")) in the case of an ABR Loan, and a rate between 1.00% and 2.25% per annum (dependent upon the Obligor's leverage ratio), in the case of a Eurodollar Loan. A per annum rate equal to 2% plus the rate otherwise applicable to such Loan will be assessed on past due principal amounts, and accrued interest payable in arrears. The Facility provides for an annual commitment fee between .375% and .75% to be paid on undrawn commitments under the Tranche A and C Term Loans and the Revolver Facility (dependent upon the level of drawn commitments). The Obligor incurred commitment fees of approximately $2 million in both 1998 and 1999. Under the Facility, the Obligor must also fix or limit the interest cost with respect to at least 50% of its total outstanding indebtedness. At December 31, 1999, approximately 85% of the outstanding debt was fixed. At December 31, 1999 committed availability under the Facility was $450 million. All obligations of the Obligor under the Facilities are unconditionally and irrevocably guaranteed by each existing and subsequently acquired or organized domestic subsidiary of the Company. Borrowings under the Facility, and any related hedging contracts provided by the lenders thereunder, are collateralized by a first priority lien on substantially all of the assets of the Company and each existing and subsequently acquired or organized domestic subsidiary of the Company, including a first priority pledge of all the capital stock held by Holdings, or any of its subsidiaries, provided that the pledge of shares of foreign subsidiaries may be limited to 65% of the outstanding shares of such foreign subsidiaries. The PCS Licenses will be held by one or more single purpose subsidiaries of the Company and will not be pledged to secure the obligations of the Company under the Facility, although the equity interests of such subsidiaries will be pledged thereunder. Each single purpose subsidiary will not be allowed, by the Company, to incur any liabilities or obligations other than the Bank Facility Guarantee issued by it, the security agreement entered into by it in connection with the Facility, and, in the case of any single purpose subsidiary established to hold real estate, liabilities incurred in the ordinary course of business of such subsidiary which are incident to being the lessee of real property of the purchaser, owner or lessee of equipment, and taxes and other liabilities incurred in the ordinary course in order to maintain its existence. The Facility contains financial and other covenants, customary for a facility of this type, including covenants relating to the population covered by Triton's network, number of subscribers and level of service revenue generated, the amount of indebtedness that Triton may incur including customary representations, warranties, indemnities and conditions precedent to borrowing, limitations on dividends, distributions, redemptions and repurchases of capital stock, and events of default. F - 14 The Term Loans are required to be prepaid, and commitments under the Revolving Facility reduced, in an aggregate amount equal to (i) 50% of excess cash flow of each fiscal year commencing with the fiscal year ending December 31, 2001, (ii) 100% of the net proceeds of asset sales, outside the ordinary course of business, or otherwise precluded, (iii) unused insurance proceeds, as defined per the Credit Agreement, (iv) 100% of net cash proceeds received from additional debt issuance, over and above the first $150.0 million (senior and/or subordinated) which Triton may subsequently incur pursuant to the build-out of its PCS network, and (v) 50% of the net cash proceeds received from additional equity issuances other than (1) in connection with certain Equity Commitments, and (2) in the case of (iv) and (v), if, after giving effect to such issuance(s), (a) Triton's ratio of senior debt to EBITDA is less than 5 to 1 and (b) Triton is in pro forma compliance with required Credit Facility covenants. Loans under the Facility are available to fund capital expenditures related to the construction of Triton's PCS network, the acquisition of related businesses, working capital needs of Triton, subscriber acquisition costs, and other permitted business activities, as defined per the Credit Agreement. All indebtedness under the Facility constitutes debt which is senior to Triton's 11% Senior Subordinated Discount Notes. (11) SUBORDINATED DEBT On May 7, 1998, Triton completed an offering (the "Offering") of $512 million of 11% Senior Subordinated Discount Notes ("the Notes"), pursuant to Rule 144A of the Securities Act of 1933, as amended. The net proceeds of the Offering (after deducting an Initial Purchaser's Discount of $9 million) were approximately $291 million. Commencing on November 1, 2003, cash interest will be payable semiannually. Each Note was offered at an original issue discount. Although cash interest will not be paid prior to May 1, 2003, the original issue discount will accrue from the issue date to May 1, 2003. Triton's publicly held notes may be redeemed at the option of Triton, in whole or in part, at various points in time after May 1, 2003 at redemption prices specified in the indenture governing the notes plus accrued and unpaid interest, if any. The Notes are guaranteed on a joint and several basis by all of the subsidiaries of Triton but are not guaranteed by Holdings. The Guarantees are unsecured obligations of the guarantors, and are subordinated in right to the full payment to all senior debt of the guarantors, including all of their obligations under their guarantees of the Credit Facility. Upon a change in control, each holder of the Notes may require Triton to repurchase such Holder's Notes, in whole or in part, at a purchase price equal to 101% of the accreted value thereof or the principal amount at maturity, as applicable, plus accrued and unpaid interest to the purchase date. The debt principal begins to mature in 2003 and is fully repaid in 2008. (12) INCOME TAXES There was no income tax benefit recorded in 1999. The income tax benefit for the year ended December 31, 1998 consists of the following: Current Deferred Total -------------------------------------- US Federal $ - $ 7,054 $ 7,054 State $ - $ 482 $ 482 -------------------------------------- $ - $ 7,536 $ 7,536 -------------------------------------- The income tax benefit differs from those computed using the statutory U.S. Federal income tax rate as set forth below: 1998 1999 -------------------- U.S. Federal statutory rate 35.00% 35.00% State income taxes, net of federal benefit 0.80% 0.00% Change in federal valuation allowance (16.56%) (34.12%) Other, net (0.53%) (0.88%) -------------------- Effective Tax Rate 18.71% 0.00% ==================== F - 15 The tax effects of significant temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows: 1998 1999 --------------------------- Deferred tax assets: Non-deductible accrued liabilities $ 1,049 $ 411 Capitalized startup costs 2,736 2,176 Deferred gain - 12,465 Net operating loss carryforward 16,022 76,607 --------------------------- 19,807 91,659 Valuation allowance (8,506) (66,684) Net deferred tax assets 11,301 24,975 --------------------------- Deferred liabilities Intangible assets 21,438 23,173 Capitalized interest 1,150 1,139 Depreciation and amortization 376 12,326 --------------------------- Deferred tax liabilities 22,964 36,638 --------------------------- Net deferred tax liabilities $11,663 $11,663 =========================== In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management believes it is more likely than not Triton will realize the benefits of the deferred tax assets, net of the existing valuation allowance at December 31, 1999. (13) FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value estimates, assumptions, and methods used to estimate the fair value of Triton's financial instruments are made in accordance with the requirements of Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments. Triton has used available market information to derive its estimates. However, because these estimates are made as of a specific point in time, they are not necessarily indicative of amounts Triton could realize currently. The use of different assumptions or estimating methods may have a material effect on the estimated fair value amounts. The carrying amounts of cash and cash equivalents, accounts and notes receivable, bank overdraft liability, accounts payable and accrued expenses are a reasonable estimate of their fair value due to the short-term nature of the instruments. F - 16 The fair value of marketable securities is estimated based on quoted market prices. We did not hold any marketable securities at December 31, 1999. At December 31, 1998, marketable securities consisted of the following: Long-term debt is comprised of subordinated debt, bank term loan, and capital leases. The fair value of subordinated debt is stated at quoted market value. The carrying amount of bank loans are a reasonable estimate of its fair value because market interest rate interest are variable. Capital leases are recorded at their net present value, which approximates fair value. Triton enters into interest rate swaps to hedge against the effect of interest rate fluctuation on the variable portion of its debt. We do not hold or issue financial instruments for trading or speculative purposes. A 100 basis point fluctuation in market rates would not have a material effect on Triton's overall financial condition. As of December 31, 1999 Triton had two interest rate swap transactions outstanding as follows: As of December 31, 1999, the aggregate non-amortizing swap notional amount was $75 million. Triton pays a fixed rate and receives 3-Month USD-LIBOR-BBA. Net interest positions are settled quarterly. Swap counter-parties are major commercial banks. Management believes that determining a fair value for Holdings preferred stock is impractical due to the closely held nature of these investments. (14) RELATED-PARTY TRANSACTIONS Triton is associated with Triton Cellular Partners L.P. (Triton Cellular) by virtue of certain management overlap. As part of this association, certain costs are incurred on behalf of Triton Cellular and subsequently reimbursed to Triton. Such costs totaled $148,000, $482,000 and $2.2 million during 1997, 1998 and 1999, respectively. In addition, pursuant to an agreement between Triton and Triton Cellular, allocations for management services rendered are charged to Triton Cellular. Such allocations totaled $469,000 and $505,000 for 1998 and 1999, respectively. The outstanding balance at December 31, 1998 and 1999 was $951,000 and $1.0 million, respectively. Triton expects settlement of these outstanding charges during 2000. In January 1998, we entered into a master service agreement with a related party pursuant to which the related party will provide Triton with radio frequency design and system optimization support services. In February 1998, Triton entered into a credit facility for which affiliates of certain investors serve as agent and lenders. In connection with execution of the credit facility, the agent and lenders receive customary fees and expenses. In May 1998, Triton consummated a private offering of senior subordinated notes. Affiliates of several cash investors were initial purchasers in the private offering and received a placement fee of $6.3 million. F - 17 (15) COMMITMENTS AND CONTINGENCIES (a) LEASES Triton has entered into various leases for its offices, land for cell sites, cell sites, and furniture and equipment under capital and operating leases expiring through 2027. Triton has various capital lease commitments of approximately $5.3 million as of December 31, 1999. As of December 31, 1999, the future minimum rental payments under these lease agreements having an initial or remaining term in excess of one year were as follows: Operating Capital --------- -------- (in thousands) 2000 $ 21,755 $ 1,582 2001 21,247 1,572 2002 20,709 1,475 2003 19,236 1,115 2004 7,288 297 Thereafter 116,754 - -------- -------- Total $206,989 6,041 ======== Interest expense 767 -------- Net present value of future payments 5,274 Current portion of capital lease obligation 1,277 -------- $ 3,997 ======== Rent expense under operating leases was $3.0 million and $13.2 million for the year ended December 31, 1998 and 1999, respectively. (b) LITIGATION Triton has been involved in litigation relating to claims arising out of its operations in the normal course of business. Triton does not believe that an adverse outcome of any of these legal proceedings will have a material adverse effect on Triton's results of operations. (16) PREFERRED STOCK AND SHAREHOLDER'S EQUITY (a) CAPITAL CONTRIBUTIONS On February 4, 1998, pursuant to the Securities Purchase Agreement, Holdings issued $140.0 million of equity to certain institutional investors and management shareholders in exchange for irrevocable capital commitments aggregating $140.0 million. The Securities Purchase Agreement provided that the cash contributions be made to Holdings. Holdings directed that all cash contributions subsequent to the initial cash contributions be made directly to Triton. All contributions have been received as of December 31, 1999. (b) INITIAL PUBLIC OFFERING On October 27, 1999, Holdings completed an initial public offering of shares of its Class A common stock and raised approximately $190.2 million, net of $16.8 million of costs. Affiliates of Affordable Housing Community Development Corporation and J.P. Morgan Investment Corporation, each of which beneficially owns more than 5% of the Company's stock, served as underwriters and received underwriter's fees in connection with the initial public offering. (17) 401(K) SAVINGS PLAN Triton sponsors a 401(k) Savings Plan which permits employees to make contributions to the Savings Plan on a pre-tax salary reduction basis in accordance with the Internal Revenue Code. F - 18 Substantially all full-time employees are eligible to participate in the next quarterly open enrollment after 90 days of service. Triton matches a portion of the voluntary employee contributions. The cost of the Savings Plan charged to expense was $65,000 in 1998 and $482,400 in 1999. (18) SUPPLEMENTAL CASH FLOW INFORMATION F - 19 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS None. PART III ITEM 10. ITEM 10. EXECUTIVE OFFICERS AND DIRECTORS Omitted pursuant to General Instruction I(2) of the Form 10-K requirement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION AND EMPLOYMENT AGREEMENTS Omitted pursuant to General Instruction I(2) of the Form 10-K requirement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN BENEFICIAL OWNERS Omitted pursuant to General Instruction I(2) of the Form 10-K requirement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Omitted pursuant to General Instruction I(2) of the Form 10-K requirement. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND FORMS 8-K (a) EXHIBITS 3.1 Certificate of Incorporation to Triton PCS, Inc. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.2 By-laws of Triton PCS, Inc. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.3 Certificate of Incorporation of Triton Management Company, Inc. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.4 Bylaws of Triton Management Company, Inc. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.5 Certificate of Formation of Triton PCS Holdings Company L.L.C (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.6 Certificate of Formation of Triton PCS License Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.7 Limited Liability Company Agreement of Triton PCS License Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.8 Limited Liability Company Agreement of Triton PCS Holdings Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.9 Certificate of Formation of Triton PCS Equipment Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.10 Limited Liability Company Agreement of Triton PCS Equipment Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.11 Certificate of Formation of Triton PCS Operating Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.12 Limited Liability Company Agreement of Triton PCS Operating Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.13 Certificate of Formation of Triton PCS Property Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 3.14 Limited Liability Company Agreement of Triton PCS Property Company L.L.C. (incorporated by reference to the corresponding exhibit to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-7715). 4.2 Indenture, dated as of May 4, 1998, between Triton PCS, Inc., the Guarantors party thereto and PNC Bank, National Association (incorporated by reference to Exhibit 4.1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 4.3 First Supplemental Indenture, dated as of March 30, 1999, to the Indenture dated as of May 4, 1998 (incorporated by reference to Exhibit 4.1 to the Form 10-Q of Triton PCS, Inc. and its subsidiaries, for the quarter ended March 31, 1999). 10.1 Credit Agreement, dated as of February 3, 1998 (the "Credit Agreement"), among Triton PCS, Inc., Triton PCS Holdings, Inc., the Lenders (as defined therein) party thereto, and The Chase Manhattan Bank, as administrative agent (incorporated by reference to Exhibit 10.1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.2 First Amendment, Consent and Waiver, dated as of April 16, 1998, to the Credit Agreement (incorporated by reference to Exhibit 10.2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.3 Second Amendment, dated as of July 29, 1998, to the Credit Agreement (incorporated by reference to Exhibit 10.2.1 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.4 Fourth Amendment, dated as of March 29, 1999, to the Credit Agreement (incorporated by reference to Exhibit 10.1 to the Form 10-Q of Triton PCS, Inc. and its subsidiaries, for the quarter ended March 31, 1999). 10.5 Fifth Amendment, dated as of September 22, 1999, to the Credit Agreement (incorporated by reference to Exhibit 10.7 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.6 Securities Purchase Agreement, dated as of October 8, 1997, (the "Securities Purchase Agreement") among AT&T Wireless PCS, Inc., the cash equity investors listed on the signature pages thereto, the management stockholders listed on the signature pages thereto and Triton PCS, Inc., now known as Triton PCS Holdings, Inc. (incorporated by reference to Exhibit 10.3 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.7 Amendment No. 1 to Securities Purchase Agreement, dated as of March 10, 1998 (incorporated by reference to Exhibit 10.4 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.8 Closing Agreement, dated as of February 4, 1998, among AT&T Wireless PCS, Inc., the cash equity investors listed on the signature pages thereto, the management stockholders listed on the signature pages thereto, and Triton PCS Holdings, Inc. (incorporated by reference to Exhibit 10.5 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.9 Asset Purchase Agreement, dated as of March 10, 1998, between Triton PCS, Inc. and Vanguard Cellular Systems of South Carolina, Inc. (incorporated by reference to Exhibit 10.6 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.10 Preferred Stock Purchase Agreement by and among Cash Equity Investors, Management Stockholders, Independent Directors, and Triton PCS Holdings, Inc. dated as of June 29, 1998 (incorporated by reference to Exhibit 10.7 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.11 License Exchange and Acquisition Agreement dated as of June 8, 1999 by and among Triton PCS Holdings, Inc., Triton PCS License Company L.L.C., and AT&T Wireless PCS, Inc. (incorporated by reference to Exhibit 10.13 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.12 Preferred Stock Repurchase and Issuance Agreement, dated as of December 7, 1998 by and among J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., the investors listed as cash equity investors on the signature pages thereto, Triton PCS Holdings, Inc., and certain of Triton PCS Holdings, Inc.'s other stockholders listed on the signature pages thereto (incorporated by reference to Exhibit 10.14 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.13 Norfolk Preferred Stock Purchase Agreement, dated as of December 31, 1998 by and among the cash equity investors listed on Schedule I thereto, the management stockholders listed on Schedule II thereto, the independent directors listed on Schedule III thereto, and Triton PCS Holdings, Inc. (incorporated by reference to Exhibit 10.15 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.14 AT&T Wireless Services Network Membership License Agreement, dated as of February 4, 1998, between AT&T Corp. and Triton PCS Operating Company L.L.C. (incorporated by reference to Exhibit 10.8 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.15 Amendment No. 1 to AT&T Wireless Services Network Membership License Agreement, dated as of December 31, 1998, between AT&T Corp. and Triton PCS Operating Company L.L.C. (incorporated by reference to Exhibit 10.17 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.16 Amendment No. 2 to AT&T Wireless Services Network Membership License Agreement, dated as of June 8, 1999, between AT&T Corp. and Triton PCS Operating Company L.L.C. (incorporated by reference to Exhibit 10.18 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.17 Stockholders' Agreement, dated as of February 4, 1998, among AT&T Wireless PCS, Inc., Triton PCS Holdings, Inc., CB Capital Investors, L.P., J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., Private Equity Investors III, L.P., Equity-linked Investors-II, Toronto Dominion Capital (USA), Inc., First Union Capital Partners, Inc., DAG-Triton PCS, L.P., Michael E. Kalogris, Steven R. Skinner, David D. Clark, Clyde Smith, Patricia Gallagher and David Standig (incorporated by reference to Exhibit 10.9 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.18 Amendment No. 1 to Stockholders' Agreement, dated as of December 31, 1998, among AT&T Wireless PCS, Inc., Triton PCS Holdings, Inc., CB Capital Investors, L.P., J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., Private Equity Investors III, L.P., Equity-linked Investors-II, Toronto Dominion Capital (USA), Inc., First Union Capital Partners, Inc., DAG- Triton PCS, L.P., Michael E. Kalogris, Steven R. Skinner, David D. Clark, Clyde Smith, David Standig, Michael Mears, Michael E. Kalogris, as Trustee under Amended and Restated Common Stock Trust Agreement for Management Employees and Independent Directors, dated June 26, 1998, Scott Anderson and John Beletic (incorporated by reference to Exhibit 10.20 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.19 Amendment No. 2 to Stockholders' Agreement, dated as of June 8, 1999, among AT&T Wireless PCS, Inc., Triton PCS Holdings, Inc., CB Capital Investors, L.P., J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., Private Equity Investors III, L.P., Equity-linked Investors-II, Toronto Dominion Capital (USA), Inc., First Union Capital Partners, Inc., DAG-Triton PCS, L.P., Michael E. Kalogris, Steven R. Skinner, David D. Clark, Clyde Smith, David Standig, Michael Mears, Michael E. Kalogris, as Trustee under Amended and Restated Common Stock Trust Agreement for Management Employees and Independent Directors, dated June 26, 1998, Scott Anderson and John Beletic (incorporated by reference to Exhibit 10.21 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.20 Investors Stockholders' Agreement, dated as of February 4, 1998, among CB Capital Investors, L.P., J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., Private Equity Investors III, L.P., Equity-Linked Investors-II, Toronto Dominion Capital (USA), Inc., DAG-Triton PCS, L.P., First Union Capital Partners, Inc., and the stockholders named therein (incorporated by reference to Exhibit 10.10 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.21 Intercarrier Roamer Service Agreement, dated as of February 4, 1998, between AT&T Wireless Services, Inc. and Triton PCS Operating Company L.L.C. (incorporated by reference to Exhibit 10.11 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.22 Amendment No. 1 to Intercarrier Roamer Service Agreement, dated as of December 31, 1998, between AT&T Wireless Services, Inc. and Triton PCS Operating Company L.L.C. (incorporated by reference to Exhibit 10.24 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.23 Amendment No. 2 to Intercarrier Roamer Service Agreement, dated as of June 8, 1999, between AT&T Wireless Services, Inc. and Triton PCS Operating Company L.L.C. (incorporated by reference to Exhibit 10.25 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). ++ 10.24 Ericsson Acquisition Agreement, dated as of March 11, 1998, between Triton Equipment Company L.L.C. and Ericsson, Inc. (incorporated by reference to Exhibit 10.15 to Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). ++ 10.25 First Addendum to Acquisition Agreement, dated as of May 24, 1999, between Triton PCS Equipment Company L.L.C. and Ericsson, Inc. (incorporated by reference to Exhibit 10.27 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.26 Employment Agreement, dated as of February 4, 1998, among Triton Management Company, Inc., Triton PCS Holdings, Inc. and Michael E. Kalogris (incorporated by reference to Exhibit 10.16 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.27 Amendment No. 1 to Employment Agreement, dated as of June 29, 1998, among Triton Management Company, Inc., Triton PCS Holdings, Inc., and Michael E. Kalogris (incorporated by reference to Exhibit 10.16.1 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.28 Amendment No. 2 to the Employment Agreement by and among Triton Management Company, Inc., Triton PCS Holdings, Inc. and Michael E. Kalogris, dated December, 1998 (incorporated by reference to Exhibit 10.39 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.29 Amendment No. 3 to the Employment Agreement by and among Triton Management Company, Inc., Triton PCS Holdings, Inc. and Michael E. Kalogris, dated June 8, 1999 (incorporated by reference to Exhibit 10.40 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.30 Employment Agreement, dated as of January 8, 1998, between Triton Management Company and Clyde Smith (incorporated by reference to Exhibit 10.17 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.31 Employment Agreement, dated as of February 4, 1998, between Triton Management Company and Steven R. Skinner (incorporated by reference to Exhibit 10.18 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.32 Amendment No. 1 to Employment Agreement, dated as of June 29, 1998, among Triton Management Company, Inc., Triton PCS Holdings, Inc., and Steven R. Skinner (incorporated by reference to Exhibit 10.18.1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.33 Amendment No. 2 to the Employment Agreement by and among Triton Management Company, Inc., Triton PCS Holdings, Inc. and Steven R. Skinner, dated as of December 31, 1998 (incorporated by reference to Exhibit 10.41 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.34 Amendment No. 3 to the Employment Agreement by and among Triton Management Company, Inc., Triton PCS Holdings, Inc. and Steven R. Skinner, dated as of June 8, 1999 (incorporated by reference to Exhibit 10.42 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.35 Amended and Restated Common Stock Trust Agreement for Management Employees and Independent Directors, dated as of June 26, 1998 (incorporated by reference to Exhibit 10.19 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.36 Form of Pledge Agreement, dated as of February 4, 1998, between certain shareholders and Triton PCS, Inc. Each of (a) Michael E. Kalogris, (b) Steven R. Skinner, (c) Sixty Wall Street SBIC Fund, L.P., (d) CB Capital Investors, L.P., (e) J.P. Morgan Investment Corporation, (f) DAG-Triton PCS, L.P., (g) First Union Capital Partners, Inc., (h) Toronto Dominion Capital (USA), Inc. and (i) Private Equity Investors III, L.P., are party to separate Pledge Agreements. The terms of each Pledge Agreement are identical other than (1) the shareholder party thereto and (2) the number of shares of stock held by such shareholder and, therefore, the number of shares subject to the applicable Pledge Agreement (incorporated by reference to Exhibit 10.20 to Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.37 Master Tower Site Lease Agreement, dated as of May 28, 1998, between Triton PCS Property Company L.L.C. and AT&T Corp (incorporated by reference to Exhibit 10.23 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.38 Independent Director Stock Award Plan adopted as of February 4, 1998 (incorporated by reference to Exhibit 10.24 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.39 Asset Purchase Agreement dated as of August 20, 1998 between Triton PCS Holdings, Inc. and AT&T Wireless PCS, Inc (incorporated by reference to Exhibit 10.29 to Amendment No. 1 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.40 Asset Purchase Agreement, dated as of July 13, 1999, among Triton PCS Operating Company, L.L.C., Triton PCS Property Company L.L.C. and American Tower, L.P (incorporated by reference to Exhibit 10.38 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.41 Form of Stockholders Letter Agreement for management employees (incorporated by reference to Exhibit 10.43 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.42 Form of Stockholders Letter Agreement for independent directors (incorporated by reference to Exhibit 10.44 to Post-Effective Amendment No. 2 to the Form S-4 Registration Statement of Triton PCS, Inc. and its subsidiaries, File No. 333-57715). 10.43 Triton PCS Holdings, Inc. 1999 Stock and Incentive Plan (incorporated by reference to Exhibit 10.45 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.44 Triton PCS Holdings, Inc. Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.46 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.45 Form of First Amended and Restated Stockholders' Agreements among AT&T Wireless PCS, L.L.C., Triton PCS Holdings, Inc., CB Capital Investors, L.P., J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., Private Equity Investors III, L.P., Equity-linked Investors-II, Toronto Dominion Capital (USA), Inc., First Union Capital Partners, Inc., DAG-Triton PCS, L.P., Michael E. Kalogris, Steven R. Skinner, David D. Clark, Clyde Smith, Patricia Gallagher and David Standig (incorporated by reference to Exhibit 10.47 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 10.46 Form of Amendment No. 1 to Investors Stockholders' Agreement among CB Capital Investors, L.P., J.P. Morgan Investment Corporation, Sixty Wall Street SBIC Fund, L.P., Private Equity Investors III, L.P., Equity-Linked Investors-II, Toronto Dominion Capital (USA), Inc., DAG-Triton PCS, L.P., First Union Capital Partners, Inc., and the stockholders named therein (incorporated by reference to Exhibit 10.48 to the Form S-1 Registration Statement of Triton PCS Holdings, Inc., File No. 333-85149). 24.1 Power of Attorney (set forth on the signature page of this report). 27.1 Financial Date Schedule - --------------------- ++ Portions of this exhibit have been omitted under a SEC order granting confidential treatment under the Securities Act. (b) (1) FINANCIAL STATEMENTS The following financial statements have been included as Part of this report: Report of PricewaterhouseCoopers LLP Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Shareholder's Equity (Deficit) Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (b) (2) Financial Statement Schedules. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors and Shareholder of Triton PCS, Inc.: Our audits of the consolidated financial statements of Triton PCS Inc., and its subsidiaries referred to in our report dated February 25, 2000 appearing under Item 8 on page of this Form 10-K also included an audit of the financial statement schedule listed under Item 14(b)(2) of this Form 10-K. In our opinion, the financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PricewaterhouseCoopers Philadelphia, Pennsylvania February 25, 2000 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (b) FORM 8-K None. SIGNATURES Pursuant to the requirements of the Securities Act of 1934, as amended, the Registrant has duly caused this Registration Statement to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Berwyn, State of Pennsylvania on March 29, 2000. Triton PCS, Inc. By: /s/ MICHAEL E. KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer Triton Management Company, Inc. By: /s/ MICHAEL KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer Triton PCS Holdings Company L.L.C. By: Triton Management Company, Inc, its manager By: /s/ MICHAEL KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer Triton PCS Property Company L.L.C., Inc. By: Triton Management Company, Inc., its manager By: /s/ MICHAEL KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer Triton PCS Equipment Company L.L.C. By: Triton Management Company, Inc., its manager By: /s/ MICHAEL KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer Triton PCS Operating Company L.L.C. By: Triton Management Company, Inc., its manager By: /s/ MICHAEL KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer Triton PCS License Company L.L.C. By: Triton Management Company, Inc., its manager By: /s/ MICHAEL KALOGRIS ------------------------------------------- Sole Director and Chief Executive Officer By: /s/ DAVID CLARK ------------------------------------------- Senior Vice President, Chief Financial Officer, and Secretary

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Item 3. Legal Proceedings I. We are a member of several trade associations. As a participating member of these trade associations, we also are active in legal proceedings challenging administrative regulations which are considered by the trade association to be poor policy. In some instances, the legal challenges brought by the trade associations request that the government consider the full impact and results of the proposed regulation on business operations. For example, the EPA is requiring air quality controls and air measurement obligations that industry considers too burdensome. II. Water rights adjudication proceedings. A. The following state water rights adjudication proceedings are pending in Arizona Superior Court: 1. In re the General Adjudication of All Rights to Use Water in the Little Colorado River System and Source, No. 6417 (Superior Court of Arizona, Apache County). (a) Petition was filed by us on or about February 17, 1978, and process has been served on all potential claimants. Virtually all statements of claimant have been filed. (b) The principal parties, in addition to us, are the State of Arizona, the Navajo Nation, the Hopi Indian Tribe, the San Juan Southern Paiute Tribe and the United States on its own behalf and on behalf of those Indian tribes. In this adjudication and in the adjudications reported in items 2.(a), (b) and (c) below, the United States and the Indian tribes seek to have determined and quantified their rights to use water arising under federal law on the basis that, when the Indian reservations and other federal reservations were established by the United States, water was reserved from appropriation under state law for the use of those reservations. (c) This proceeding could affect, among other things, our rights to impound water in Show Low Lake and Blue Ridge Reservoir and to transport this water into the Salt River and Verde River watersheds for exchange with the Salt River Valley Water Users’ Association. We have filed statements of claimant for these and other water claims. This litigation is stayed pending the outcome of current settlement negotiations. The Court has not set a final schedule of cases to go to trial, should the litigation resume. 2. In re the General Adjudication of All Rights to Use Water in the Gila River System and Source, Nos. W-1 (Salt River), W-2 (Verde River), W-3 (Gila River) and W-4 (San Pedro River) (Superior Court of Arizona, Maricopa County). As a result of consolidation proceedings, this action now includes general adjudication proceedings with respect to the following three principal river systems and sources: (a) The Gila River System and Source Adjudication: (i) Petition was filed by us on February 17, 1978. Process has been served on water claimants in the upper and lower reaches of the watershed and virtually all statements of claimant have been filed. (ii) The principal parties, in addition to us, are the Gila Valley Irrigation District, the San Carlos Irrigation and Drainage District, the State of Arizona, the San Carlos Apache Tribe, the Gila River Indian Community and the United States on its own behalf and on behalf of the tribe and the community. (iii) This proceeding could affect, among other things, our claim to the approximately 3,000 acre-feet of water that it diverts annually from Eagle Creek, Chase Creek or the San Francisco River and its claims to percolating groundwater that is pumped from wells located north of its Morenci Branch operations in the Mud Springs and Bee Canyon areas and in the vicinity of the New Cornelia Branch at Ajo. We have filed statements of claimant with respect to waters that it diverts from these sources. This proceeding also could affect water right claims associated with recently acquired Cyprus operations at Sierrita, Twin Buttes and the Christmas mine, and miscellaneous former Cyprus land holdings in the area encompassed by the Gila River System and Source Adjudication. Statements of claimant have been filed in connection with these claims, and are under review for possible amendment and supplementation. (iv) In 1997, issues of dispute arose between Phelps Dodge and the San Carlos Apache Tribe regarding our use and occupancy of the Black River Pump Station which delivers water to the Morenci operation. On May 12, 1997, the Tribe filed suit against us in San Carlos Apache Court, seeking our eviction from the Tribe’s Reservation and claiming substantial compensatory and punitive damages, among other relief. In May 1997, we reached an agreement with the Tribe, and subsequently federal legislation (Pub. L. No. 105-18, 5003, 111 stat. 158, 181-87) was adopted which mandated dismissal of the tribal court suit. The legislation prescribes arrangements intended to ensure a future supply of water for the Morenci mining complex in exchange for certain payments by us. The legislation does not address any potential claims by the Tribe relating to our historical occupancy and operation of our facilities on the Tribe’s Reservation, but does require that any such claims be brought, if at all, exclusively in federal district court. By order dated October 13, 1997, the tribal court dismissed the lawsuit with prejudice, as contemplated by the legislation. The 1997 legislation required that the Company and the Tribe enter a lease for the delivery of Central Arizona Project water through the Black River Pump Station to Morenci on or before December 31, 1998. In the event a lease was not signed, the legislation expressly provided that the legislation would become the lease. The legislation included the principal terms for that eventuality. To date, we have not entered into a lease with the Tribe, but are relying on our rights under the legislation and are prepared to enforce those rights if necessary. We are cooperating with the United States, which operates the pump station, to reach an agreement with the Tribe on the lease issue. (v) On May 4, 1998, we executed a settlement agreement with the Gila River Indian Community (the Community) that resolves the issues between us and the Community pertinent to this litigation. This settlement is subject to the approval of the Secretary of the Interior and the passage of federal legislation. (b) The Salt River System and Source Adjudication: (i) Petition was filed by the Salt River Valley Water Users’ Association on or about April 25, 1974. Process has been served, and statements of claimant have been filed by virtually all claimants. (ii) Principal parties, in addition to us, include the petitioner, the State of Arizona and the United States, on its own behalf and on behalf of various Indian tribes and communities including the White Mountain Apache Tribe, the San Carlos Apache Tribe, the Fort McDowell Mohave-Apache Indian Community, the Salt River Pima-Maricopa Indian Community and the Gila River Indian Community. (iii) We have filed a statement of claimant to assert our interest in the water exchange agreement with the Salt River Valley Water Users’ Association by virtue of which it diverts from the Black River water claimed by the Association and repays the Association with water impounded in Show Low Lake and Blue Ridge Reservoir on the Little Colorado River Watershed, and to assert our interest in “water credits” to which we are entitled as a result of our construction of the Horseshoe Dam on the Verde River. (iv) The Salt River Pima-Maricopa Indian Community, Salt River Valley Water Users’ Association, the principal Salt River Valley Cities, the State of Arizona and others have negotiated a settlement as among themselves for the Verde and Salt River system. The settlement has been approved by Congress, the President and the Arizona Superior Court. Under the settlement, the Salt River Pima-Maricopa Indian Community waived all water claims it has against all other water claimants (including us) in Arizona. (v) Active proceedings with respect to other claimants have not yet commenced in this adjudication. (vi) This proceeding could affect, among other things, the water claims associated with the recently acquired Cyprus operation at Miami, and miscellaneous former Cyprus land holdings in the area encompassed by the Salt River System and Source Adjudication. Statements of claimant have been filed in connection with these claims, and are under review for possible amendment and supplementation. (c) The Verde River System and Source Adjudication: (i) Petition was filed by the Salt River Valley Water Users’ Association on or about February 24, 1976, and process has been served. Virtually all statements of claimant have been filed. (ii) The principal parties, in addition to us, are the petitioner, the Fort McDowell Mohave-Apache Indian Community, the Payson Community of Yavapai Apache Indians, the Salt River Pima-Maricopa Indian Community, the Gila River Indian Community, the United States on its own behalf and on behalf of those Indian communities, and the State of Arizona. (iii) This proceeding could affect, among other things, our Horseshoe Dam “water credits” with the Salt River Valley Water Users’ Association resulting from its construction of the Horseshoe Dam on the Verde River. (See the Black River water exchange referred to in Paragraph II.A. 2.(b)(iii) above.) We have filed statements of claimant with respect to Horseshoe Dam and water claims associated with the former operations of the United Verde Branch. (iv) The Fort McDowell Mohave-Apache Indian Community, Salt River Valley Water Users’ Association, the principal Salt River Valley Cities, the State of Arizona and others have negotiated a settlement as among themselves for the Verde River system. This settlement has been approved by Congress, the President and the Arizona Superior Court. Under this settlement, the Fort McDowell Mohave-Apache Indian Community waived all water claims it has against all other water claimants (including us) in Arizona. B. The following proceedings involving water rights adjudication are pending in the U.S. District Court for the District of Arizona: 1. On June 29, 1988, the Gila River Indian Community filed a complaint-in-intervention in United States v. Gila Valley Irrigation District, et al., and Globe Equity No. 59 (D. Ariz.). The underlying action was initiated by the United States in October 1925 to determine conflicting claims to water rights in certain portions of the Gila River watershed. Although we were named and served as a defendant in that action, we were dismissed without prejudice as a defendant in March 1935. In June 1935, the Court entered a decree setting forth the water rights of numerous parties, but not ours. The Court retained, and still has, jurisdiction of the case. The complaint-in-intervention does not name us as a defendant; however, it does name the Gila Valley Irrigation District as a defendant. Therefore, the complaint-in-intervention could affect the approximately 3,000 acre-feet of water that we divert annually from Eagle Creek, Chase Creek or the San Francisco River pursuant to the agreement between us and the Gila Valley Irrigation District. During 1998, we purchased farmlands with associated water rights that are the subject of this litigation. As a result, we have been named and served as a party in this case. The lands and associated water rights are not currently used in connection with any mining operation of ours. The recently acquired Cyprus Miami Mining Corporation was named and served as a defendant in this action in 1989. These proceedings may affect water rights associated with former Cyprus Miami lands in the Gila River Watershed. 2. Prior to January 1, 1983, various Indian tribes filed several suits in the U.S. District Court for the District of Arizona claiming prior and paramount rights to use waters which are presently being used by many water users, including us, and claiming damages for prior use in derogation of their allegedly paramount rights. These federal proceedings have been stayed pending state court adjudication. 3. Cyprus Sierrita Corporation’s predecessor in interest was a defendant in United States, et al. v. City of Tucson, et al., No. CIV 75-39 (D. Ariz.). This is a consolidation of several actions seeking a declaration of the rights of the United States, the Papago Indian Tribe (now known as the Tohono O’Odham Nation), and individual allottees of the Tohono O’Odham Nation, to surface water and groundwater in the Santa Cruz River Watershed; damages from the defendants’ use of surface water and groundwater from the Watershed in derogation of those rights; and injunctive relief. Congress in 1982 enacted the Southern Arizona Water Rights Settlement Act, which was intended to resolve the water right claims of the Tohono O’Odham Nation and its member allottees relating to the San Xavier Reservation and the Schuk Toak District of the Sells Papago Reservation. The allottees contested the validity of the Act and contended that the Court could not dismiss the litigation without their consent. This prompted additional litigation, and eventually culminated in settlement negotiations. The Court suspended most aspects of the litigation to enable the parties to negotiate a settlement with the allottees. The Court’s recent attention has been devoted to the composition of appropriate classes of allottees and identification of class representatives, so that any settlement that is reached would bind the allottees. It is anticipated that a settlement and authorizing legislation would conclude all litigation on behalf of the Tohono O’Odham Nation, its allottee members, and the United States as Trustee for the nation and its allottee members, relating to water rights. As of this writing, however, a settlement has not been reached. The outcome of this dispute could impact water right claims associated with the recently acquired Cyprus operations at Sierrita and Twin Buttes, and miscellaneous former Cyprus land holdings in the Santa Cruz River Watershed. III. The Connecticut Department of Environmental Protection (the Department) advised the Company during February 1999, that it intended to file suit regarding purported violations of the state air emissions limitations associated with the Phelps Dodge Norwich rod mill in Norwich, Connecticut. As threatened, the action would seek substantial money penalties. During 1999, the Company initiated several measures designed to address the Department’s concerns. No complaint has yet been filed, and the Company is continuing to work with the Department to resolve these issues. IV. On October 1, 1997, the Environmental Protection Agency (EPA) issued a Notice of Violation (NOV) to Cyprus Amax’s (now the Company’s) Sierrita operations in southeastern Arizona. The NOV alleged certain emission standards and permitting violations associated with the molybdenum roasting facility at Sierrita. Cyprus Amax and the Corporation entered into tolling agreements with the EPA to allow time for further investigation. The Company does not believe that the outcome of this proceeding will have a material adverse effect on it. V. Cyprus Tohono Corporation (Tohono) has negotiated a Consent Decree with the EPA that resolves outstanding issues relating to a process line break in 1992. The Consent Decree required Tohono to pay a penalty of $100,000 and perform two Supplemental Environmental Projects with an estimated total cost of $225,000. VI. In 1999, the Pinal Creek Group, comprising Cyprus Miami Mining Corporation (a wholly owned subsidiary of the Company) and other companies, continued remediation and assessment of groundwater quality in the shallow alluvial aquifers along Pinal Creek near Miami, Arizona. The removal, remediation and assessment work is being conducted in accordance with the requirements of the Arizona Department of Environmental Quality’s Water Quality Assurance Revolving Fund program. In addition, the remedial and removal action is consistent with the National Contingency Plan prepared by the EPA as required by CERCLA. The ongoing removal, remediation and assessment program, initiated in 1989, has resulted in continued improvement of the sub-surface water quality in the area. In November 1997, Cyprus Miami, as a member of the Pinal Creek Group, joined with the State of Arizona in seeking approval of the District Court for entry of a Consent Decree resolving all matters related to an enforcement action contemplated by the State of Arizona with respect to the groundwater matter. On August 13, 1998, the court approved the Decree that committed Cyprus Miami and the other Pinal Creek Group members to complete the remediation work outlined in the remedial action plan that was submitted to the State in May 1997. Approximately $143 million remained in the Company’s Pinal Creek remediation reserve at December 31, 1999. Cyprus Miami has commenced contribution litigation against other parties involved in this matter and has asserted claims against certain of its past insurance carriers. While significant recoveries are expected, the Company cannot reasonably estimate the amount and, therefore, has not taken potential recoveries into consideration in the recorded reserve. Item 4. Item 4. Submission of Matters to a Vote of Security Holders A special meeting of the shareholders of the Company was held on October 13, 1999. A total of 45,529,685 common shares, or about 78.49 percent of our issued and outstanding common shares, were represented at the meeting. Set forth below is a description of the matters voted upon at the meeting and a summary of the voting regarding each matter: Proposal 1: to approve the issuance of up to 17,082,064 shares of Phelps Dodge’s common stock in connection with an exchange offer made to the shareholders of Asarco Incorporated and a subsequent merger of that entity with a subsidiary of the Company. Proposal 2: to approve the issuance of up to 28,357,520 shares of Phelps Dodge’s common stock in connection with an exchange offer made to the shareholders of Cyprus Amax Minerals Company and a subsequent merger of that entity with a subsidiary of the Company. Executive Officers of Phelps Dodge Corporation The executive officers of Phelps Dodge Corporation are elected to serve at the pleasure of its Board of Directors. As of March 1, 2000, the executive officers of Phelps Dodge Corporation were as follows: Except as stated below, all of the above have been officers of Phelps Dodge Corporation for the past five years. Mr. Snider was elected Senior Vice President in September 1998. Prior to his election, Mr. Snider was Vice President of the Corporation, a position he held since 1997. Prior to that time, he was Vice President, Arizona operations, of Phelps Dodge Mining Company. Mr. Colton was elected Senior Vice President in November 1999. He was elected Vice President and General Counsel in April 1998. Prior to that time, Mr. Colton was Vice President and Counsel for Phelps Dodge Exploration, a position he held since 1995. Mr. Peru was elected Senior Vice President and Chief Financial Officer in January 1999. Prior to that time, Mr. Peru was Senior Vice President for Organization Development and Information Technology, a position he held since January 1997. Prior to that, Mr. Peru was Vice President and Treasurer of Phelps Dodge Corporation, a position he held since 1995. Mr. Pulatie was elected Senior Vice President, Human Resources in March 1999. Mr. Pulatie joined Phelps Dodge in March 1999 after a 34-year career with Motorola Inc. Part II Item 5. Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters The information called for in Item 5 appears on pages 50 and 51 of this report. Item 6. Item 6. Selected Financial Data (a) For a further discussion of earnings, please see Management’s Discussion and Analysis. (b) In 1997, we adopted Statement of Financial Accounting Standards (SFAS) No. 128, “Earnings per Share.” For comparative purposes, all prior period earnings per common share computations have been restated to reflect the effect of SFAS No. 128. Note: See Management’s Discussion and Analysis for a discussion of the effect on our results of material changes in the price we receive for copper or in unit production costs. Item 7. Item 7. Management’s Discussion and Analysis The information called for in Item 7 appears on pages 31 through 51 of this report. Item 8. Item 8. Financial Statements and Supplementary Data The information called for in Item 8 appears on pages 56 through 92 of this report. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure None. MANAGEMENT’S DISCUSSION AND ANALYSIS The U.S. securities laws provide a “safe harbor” for certain forward-looking statements. This annual report contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected in such forward-looking statements. Statements regarding the expected commencement dates of operations, projected quantities of future production, capital costs, production rates and other operating and financial data are based on expectations that the Company believes are reasonable, but we can give no assurance that such expectations will prove to have been correct. Factors that could cause actual results to differ materially include, among others: risks and uncertainties relating to general U.S. and international economic and political conditions, the cyclical and volatile price of copper and other commodities, political and economic risks associated with foreign operations, unanticipated ground and water conditions, unanticipated grade and geological problems, metallurgical and other processing problems, availability of materials and equipment, delays in the receipt of or failure to receive necessary government permits, appeals of agency decisions or other litigation, volatility in the price of oil (the main feedstock for our carbon black operations), changes in laws or regulations or the interpretation and enforcement thereof (including changes in treaties or laws governing international trade or tariffs), the occurrence of unusual weather or operating conditions, force majeure events, lower than expected ore grades, the failure of equipment or processes to operate in accordance with specifications or expectations, unanticipated difficulties consolidating acquired operations and obtaining expected synergies, labor relations, accidents, delays in anticipated start-up dates, environmental risks and the results of financing efforts and financial market conditions. These and other risk factors are discussed in more detail herein. Many such factors are beyond our ability to control or predict. Readers are cautioned not to put undue reliance on forward-looking statements. We disclaim any intent or obligations to update these forward-looking statements, whether as a result of new information, future events or otherwise. Earnings In 1999, consolidated earnings were $21.7 million, or 35 cents per common share, before non-recurring items. (All references to per share earnings or charges are based on diluted earnings per share.) Results for the year include those of Cyprus Amax Minerals Company (Cyprus Amax) for the two and one-half month period beginning on October 16, 1999 (the effective acquisition date by Phelps Dodge). Non-recurring items and their impact on earnings are illustrated in the following table: * Please see Note 3 to the Consolidated Financial Statements for further discussion of these non-recurring items. In the 1999 fourth quarter, the Company recognized non-recurring, pre-tax charges for asset impairments of $320.4 million at Phelps Dodge Mining Company (PD Mining) and $21.7 million at Phelps Dodge Industries (PD Industries). The PD Mining impairments included the write down of the Hidalgo smelter in New Mexico ($201.5 million) and the Metcalf concentrator at the Morenci operations in Arizona ($88.0 million). As a result of the successful acquisition of Cyprus Amax and the planned conversion of Morenci to a mine-for-leach operation, the Hidalgo smelter is expected to be reconfigured to allow it to continue to be a reliable source of acid. Also, as a result of the Cyprus Amax acquisition and conversion of Morenci to mine-for-leach, it was determined that the Metcalf concentrator, which was on standby, will be permanently closed and the Morenci concentrator, which will be required through the mine-for-leach start-up, will be maintained thereafter on standby to provide alternative processing capability. In addition, as the Company began integrating the acquired Cyprus Amax mining properties, a review of copper resources was performed and a determination of the viability of each resource reviewed was made. Based on that review, PD Mining wrote off a mine development project at the Tyrone operation in New Mexico ($11.9 million) and wrote off a mine development project at the Copper Basin operation in Arizona ($6.8 million). Management further decided to write down a real estate development project in Arizona ($12.2 million). The Phelps Dodge Industries impairment charge comprised $6.7 million for the write off of an equity investment in China (charged to non-operating expense) and $15.0 million for the impairment of value of the Wire and Cable Group’s telecommunications assets ($3.1 million of which was charged to non-operating expense). The minority interest add-back against the impairment of value of the Wire and Cable Group’s telecommunications assets totaled $1.5 million. In the 1999 fourth quarter, the Company also recognized a non-recurring, pre-tax charge of $28.2 million for estimated future costs associated with environmental matters applicable to PD Mining. For further information, see Environmental Matters later in this discussion and Note 19 to the Consolidated Financial Statements. On June 30, 1999, Phelps Dodge announced a wide-ranging plan to reduce costs and improve operating performance by further curtailing higher cost copper production, restructuring certain wire and cable assets to respond to changing market conditions, suspending operations at Columbian Chemicals Company’s carbon black plant in the Philippines, and selling a non-core South African fluorspar mining unit. These actions resulted in a non-recurring, pre-tax charge of $36.6 million in 1999 at PD Mining, $42.2 million in 1999 at the wire and cable segment ($1.9 million of which was charged to non-operating expense) and $17.7 million in 1999 at Columbian Chemicals Company. The minority interest add-back to the restructuring reserve in 1999 totaled $2.2 million at the wire and cable segment and $0.2 million at Columbian Chemicals Company. During 1999, culminating with Notices of Tax Due received in December, the Company reached a settlement with the Internal Revenue Service on several issues raised in its audits of the years 1990 through 1994. As a result, the Company recorded a $30 million reduction in its tax liabilities. In 1998, consolidated earnings were $91.8 million, or $1.57 per common share, before non-recurring items. Non-recurring items included an after-tax gain of $131.1 million, or $2.24 per common share, from the disposition of Accuride Corporation (Accuride), and an after-tax loss of $32.0 million, or 55 cents per common share, in the fourth quarter. The fourth quarter non-recurring loss included $26.4 million, or 45 cents per common share, from the sale of our 44.6 percent interest in a South African mining company, and $5.6 million, or 10 cents per common share, for costs associated with previously announced curtailments and indefinite closures primarily at PD Mining. Net income including non-recurring items was $190.9 million, or $3.26 per common share. Earnings in 1997 were $440.1 million, or $7.14 per common share, before non-recurring, after-tax charges of $31.6 million, or 51 cents per common share. The non-recurring charges primarily reflected provisions for estimated future costs associated with environmental matters and an early retirement program at PD Mining. Net income including non-recurring charges was $408.5 million, or $6.63 per common share. Note 3 to the Consolidated Financial Statements contains further information to which reference should be made for a fuller understanding of the non-recurring items in 1999, 1998 and 1997. Consolidated financial results (in millions except per common share amounts): Sales Consolidated 1999 revenues were $3,114.4 million, compared with $3,063.4 million in 1998. The 1999 increase principally resulted from the October 16, 1999, acquisition of Cyprus Amax ($253 million) and higher sales of carbon black ($88 million), partially offset by lower average copper prices ($70 million) and lower sales of wire and cable products ($146 million). The $850.9 million decrease in 1998 versus 1997 principally resulted from lower average copper prices ($472 million), the absence of Accuride ($333 million) and lower wire and cable sales ($48 million), partially offset by higher sales volumes of carbon black ($25 million) and copper ($3 million). Copper Prices Copper is an internationally traded commodity, and its price is effectively determined by the two major metals exchanges - the New York Commodity Exchange (COMEX) and the London Metal Exchange (LME). The prices on these exchanges generally reflect the worldwide balance of copper supply and demand, but also are influenced significantly from time to time by speculative actions and by currency exchange rates. The price of copper, our principal product, was a significant factor influencing our results over the three-year period ended December 31, 1999. We principally base our selling price on the COMEX spot price per pound of copper cathode, which averaged 72 cents in 1999, 75 cents in 1998 and $1.04 in 1997. The COMEX price averaged 84 cents per pound for the first two months of 2000, and closed at 79 cents on March 6, 2000. Internationally, our copper selling prices are based on LME spot price per tonne of cathode. Any material change in the price we receive for copper, or in our unit production costs, has a significant effect on our results. Our share of current annual production is approximately 2.4 billion pounds of copper. Accordingly, each 1 cent per pound change in the average annual copper price, or in average annual unit production costs, causes a variation in annual operating income before taxes of approximately $24 million. Due to the market risk arising from the volatility of copper prices, our objective is to sell copper cathode and rod at the COMEX average price in the month of shipment and copper concentrate at the LME average price in the month of settlement with our customers. We initially record copper concentrate sales at a provisional price at the time of shipment, and adjust the pricing for all outstanding shipments to reflect market conditions at the end of each quarter. A final adjustment is made to the price of the shipments upon settlement with our customers. Molybdenum Prices Molybdenum oxide is used primarily in the steel industry for corrosion resistance, strengthening and heat resistance. Molybdenum chemicals are used in a number of diverse applications such as catalysts for petroleum refining and feedstock for pure molybdenum metal used in electronics and lubricants. A substantial portion of Phelps Dodge’s expected 2000 molybdenum production is committed for sale throughout the world pursuant to annual agreements based on prevailing market prices at the time of sale. Molybdenum sales generally are characterized by cyclical and volatile prices, little product differentiation and strong competition. Prices for metallurgical products generally reference prior period Platt’s Metals Week, Ryans’ Notes, or Metal Bulletin for technical grade molybdenum or ferromolybdenum. Prices for chemical products are generally less directly based on the previously noted reference prices. Prices are influenced by production costs of domestic and foreign competitors, worldwide economic conditions, world supply/ demand balances, inventory levels, the U.S. dollar exchange rate and other factors. Molybdenum prices also are affected by the demand for end-use products in, for example, the construction, transportation and durable goods markets. A substantial portion of world molybdenum production is a by-product of copper mining, which is relatively insensitive to molybdenum price levels. Exports from China can also influence competitive conditions. Copper Hedging Some of our wire, cathode and rod customers request a fixed sales price instead of the COMEX or LME average price in the month of shipment or receipt. As a convenience to these customers, we enter into copper swap and futures contracts to hedge the sales in a manner that will allow us to receive the COMEX or LME average price in the month of shipment or receipt while our customers receive the fixed price they requested. We accomplish this by liquidating the copper futures contracts and settling the copper swap contracts during the month of shipment or receipt, which generally results in the realization of the COMEX or LME average price. Because of the nature of the hedge settlement process, the net hedge value, rather than the sum of the face values of our outstanding futures contracts, is a more accurate measure of our market risk from the use of such hedge contracts. The contracts that may result in market risk to us are those related to the customer sales transactions under which copper products have not yet been shipped. At December 31, 1999, we had futures and swap contracts for approximately 111 million pounds of copper with a net hedge value of $87 million and a total face value of approximately $125 million. At that date, we had $7 million in gains on these contracts not yet recorded in our financial statements because the copper products under the related customer transactions had not yet been shipped or received. At year-end 1998, we had futures and swap contracts in place for approximately 86 million pounds of copper at a net hedge value of $65 million and a total face value of approximately $138 million. We had $7 million in deferred, unrealized losses at that time. At year-end 1997, we had futures and swap contracts in place for approximately 140 million pounds of copper at a net hedge value of $130 million and an approximate total face value of $146 million. We had $19 million in deferred, unrealized losses at that time. We do not acquire, hold or issue futures contracts for speculative purposes. All of our copper futures and swap contracts have underlying customer agreements or other related transactions. We have prepared an analysis to determine how sensitive our net futures contracts are to copper price changes. In our market risk analysis, if copper prices had dropped a hypothetical 10 percent at the end of 1999, we would have had a net loss from our copper futures contracts of approximately $9 million. That loss would have been virtually offset by a similar amount of gain on the related customer contracts. From time to time, we may purchase or sell copper price protection contracts for a portion of our expected future mine production. We do this to limit the effects of potential decreases in copper selling prices. For 1999 production, we had fourth quarter protection contracts that gave us a minimum monthly average LME price of 69 cents per pound for approximately 200 million pounds of copper cathode that expired without payment. We did not have any copper price protection contracts at the end of 1998 or 1997. For first quarter 2000 production, we have protection contracts in place that will give us a minimum monthly average LME price of 71 cents per pound for approximately 200 million pounds of copper cathode. For overall 2000 production, we have a combination of minimum (approximately 72 cents) and maximum (approximately 95 cents) annual average LME prices per pound for approximately 110 million pounds of copper cathode. Aluminum Hedging During 1999, our Venezuelan wire and cable operation entered into aluminum futures contracts with a financial institution to lock in the cost of aluminum ingot needed in manufacturing aluminum cable contracted by customers. At December 31, 1999, we had futures contracts for approximately 1 million pounds of aluminum with a net hedge and total face value of approximately $1 million. At the end of the year, these contracts did not have any significant gains or losses that were not recorded in our financial statements. At December 31, 1998, we had futures contracts for approximately 6 million pounds of aluminum with a net hedge and total face value of approximately $4 million. Prior to 1998, we had not entered into aluminum futures contracts. A sensitivity analysis of our aluminum futures contracts indicates that a hypothetical 10 percent unfavorable change in aluminum prices at the end of 1999 would have resulted in a loss of approximately $0.1 million. That loss would have been virtually offset by a similar amount of gain on the related customer contracts. Foreign Currency Hedging We are a global company and we transact business in many countries and in many currencies. Foreign currency transactions increase our risks because exchange rates can change between the time agreements are made and the time foreign currencies are actually exchanged. One of the ways we manage these exposures is by entering into forward exchange and currency option contracts in the same currency as the transaction to lock in or minimize the effects of changes in exchange rates. With regard to foreign currency transactions, we may hedge or protect transactions for which we have a firm legal obligation or when anticipated transactions are likely to occur. We do not enter into foreign exchange contracts for speculative purposes. In the process of protecting our transactions, we may use a number of offsetting currency contracts. Because of the nature of the hedge settlement process, the net hedge value, rather than the sum of the face value of our outstanding contracts, is a more accurate measure of our market risk from the use of such contracts. At December 31, 1999, we had a net hedge and total face value of approximately $34 million in forward exchange contracts to hedge intercompany loans between our international subsidiaries or foreign currency exposures with our trading partners. At December 31, 1998, we had a net hedge and total face value of approximately $44 million in forward exchange contracts to hedge intercompany loans between our international subsidiaries. At year-end 1997, we had foreign currency protection in place for $158 million that represented both the net hedged amount and the total face value of the forward contracts. We did not have any significant gains or losses at year end that had not been recorded in our financial statements for each of the three years in the period ended December 31, 1999. At year-end 1999, our foreign currency protection contracts included the British pound, euro, German mark and Thai baht. A sensitivity analysis of our exposure to market risk with respect to our forward foreign exchange contracts indicates that if exchange rates had moved against the rates in our protection agreements by a hypothetical 10 percent, we would have incurred a potential loss of approximately $4 million. This loss would have been virtually offset by a gain on the related underlying transactions. Interest Rate Hedging In some situations, we may enter into structured transactions using currency swaps that result in lower overall interest rates on borrowings. We do not enter into currency swap contracts for speculative purposes. At December 31, 1999, we had currency swap contracts in place swapping fixed-rate U.S. dollar loans into floating-rate Brazilian real loans with an approximate net hedged and total face value of $21 million. At year-end 1998, we had currency swap contracts in place with an approximate net hedged value of $31 million and a total face value of $36 million. These currency swaps involved swapping fixed-rate Brazilian real loans into fixed-rate U.S. dollar loans, and swapping floating-rate U.S. dollar loans into fixed-rate Thai baht loans. At the end of 1999, we prepared an analysis to determine our sensitivity to changes in interest and exchange rates. A hypothetical interest rate move against our currency swap rates of 1 percent (or 100 basis points) would be insignificant. A hypothetical 10 percent unfavorable change in exchange rates would cause us to incur additional costs of approximately $1 million. In addition, we are vulnerable to increasing costs from interest rates associated with floating-rate debt. We may enter into interest rate swap contracts to manage or limit such interest expense costs. We do not enter into interest rate swap contracts for speculative purposes. At the end of 1999, we had interest rate swap contracts in place with an approximate net hedged and total face value of $485 million. At the end of 1999, we prepared an analysis to determine the sensitivity of our interest rate swap contracts to changes in interest rates. A hypothetical interest rate move against our interest rate swaps of 1 percent (or 100 basis points) would have resulted in a potential loss of approximately $12 million over the life of the swap. Business Segments Results for 1999, 1998 and 1997 can be meaningfully compared by separate reference to our reporting divisions, Phelps Dodge Mining Company and Phelps Dodge Industries. Phelps Dodge Mining Company is a business segment that includes our worldwide copper operations from mining through rod production, marketing and sales; molybdenum operations from mining through manufacturing, marketing and sales; other mining operations and investments, and worldwide mineral exploration and development programs. Through December 31, 1997, Phelps Dodge Industries included our specialty chemicals segment, our wire and cable segment, and our wheel and rim operations. Effective January 1, 1998, 90 percent of Accuride Corporation and its subsidiaries, our wheel and rim business, was sold to an affiliate of Kohlberg Kravis Roberts and Co. (KKR), and the existing management of Accuride. The remaining 10 percent interest was sold to RSTW Partners III, L.P., on September 30, 1998. In 1998, we adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” that requires financial information to be reported on the basis that it is used by management to evaluate segment performance and determine the allocation of resources between segments. All prior year segment information presented in this report has been restated to reflect the reporting requirements of this new standard. Significant events and transactions have occurred within each segment which, as indicated in the separate discussions presented below, are material to an understanding of the particular year’s results and to a comparison with results of the other periods. (See Note 21 to the Consolidated Financial Statements for further segment information.) RESULTS OF PHELPS DODGE MINING COMPANY PD Mining is our international business segment that comprises a group of companies involved in vertically integrated copper operations including mining, concentrating, electrowinning, smelting, refining, rod production, marketing and sales, and related activities. PD Mining sells copper to others primarily as rod, cathode or concentrate, and as rod to our wire and cable segment. In addition, PD Mining at times smelts and refines copper and produces copper rod for customers on a toll basis. It is also an integrated producer of molybdenum, with mining, roasting and processing facilities producing molybdenum concentrate as well as metallurgical and chemical products. In addition, it produces gold, silver, molybdenum and copper chemicals as by-products, and sulfuric acid from its air quality control facilities. This business segment also includes worldwide mineral exploration programs. * 1999 includes the results of the acquired Cyprus Amax properties since the date of the merger, October 16, 1999. ** Worldwide copper production and sales exclude the amounts attributable to (i) the 15 percent undivided interest in the Morenci, Arizona, copper mining complex held by Sumitomo Metal Mining Arizona, Inc. (Sumitomo), (ii) the one-third partnership interest in Chino Mines Company in New Mexico held by Heisei Minerals Corporation (Heisei), (iii) the 20 percent interest in Candelaria in Chile held by SMMA Candelaria, Inc., a jointly owned indirect subsidiary of Sumitomo Metal Mining Co., Ltd., and Sumitomo Corporation, and (iv) the 49 percent interest in the El Abra copper mining operation in Chile held by Corporación Nacional del Cobre de Chile (Codelco). *** Operating income for 1999 includes non-recurring, pre-tax charges of $385.2 million comprising the following: asset impairments of $320.4 million, environmental provisions of $28.2 million, and restructuring costs of $36.6 million. 1998 includes a non-recurring, pre-tax charge of $5.5 million for costs associated with curtailments and indefinite closures. 1997 includes a non-recurring, pre-tax charge of $40.5 million for an early retirement program and environmental provisions. (See Note 3 to the Consolidated Financial Statements.) Operating income has been presented in compliance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (with 1997 restated). PD Mining - Operating Income Our PD Mining segment reported operating income of $84.2 million in 1999, before $385.2 million of non-recurring, pre-tax charges. The pre-tax, non-recurring items are as follows: $320.4 million of asset impairments included the write-down of the Hidalgo smelter in New Mexico ($201.5 million), the Metcalf concentrator at the Morenci operations in Arizona ($88.0 million), a real estate development project in Arizona ($12.2 million), a mine development project at the Tyrone operations in New Mexico ($11.9 million), and mine development at the Copper Basin operation in Arizona ($6.8 million); $28.2 million for environmental provisions; and $36.6 million for the restructuring plan announced in the 1999 second quarter. The 1999 decrease in operating income before non-recurring items reflected lower average copper prices ($53 million), partially offset by lower copper production costs (approximately $30 million). Operating income in 1998 was $115.8 million before $5.5 million of non-recurring, pre-tax charges associated with a production curtailment at Chino Mines Company (Chino) in New Mexico and the indefinite closures of operations at our Ojos del Salado operation in Chile and Cobre Mining Company (Cobre) in New Mexico. Operating income in 1997 was $499.7 million before $40.5 million of non-recurring, pre-tax charges which reflected an early retirement program and estimated future costs associated with environmental matters. The decrease in 1998 operating income compared with 1997 reflected lower average copper prices (approximately $470 million), partially offset by higher volumes of copper sold from mine production (approximately $8 million) and lower exploration costs (approximately $33 million). Copper unit production costs generally have been stable for the three-year period ended December 31, 1999, primarily as a result of ongoing cost-containment programs and high levels of production of low-cost cathode copper at our solution extraction/electrowinning (SX/ EW) plants in Arizona, New Mexico, Peru and Chile. In 1999, we produced a total of 511,500 tons of cathode copper at our SX/ EW facilities, compared with 430,800 tons in 1998 and 418,000 tons in 1997. The SX/ EW method is a cost-effective process of extracting copper from certain types of ores. In 1999, operations outside the United States provided 14 percent of PD Mining’s sales, compared with 11 percent in 1998 and 9 percent in 1997. During the year, operations outside the United States contributed 67 percent of the segment’s operating income, compared with reductions of 9 percent in 1998 and contributions of 9 percent in 1997. PD Mining - Operations Update On October 16, 1999, Phelps Dodge acquired Cyprus Amax Minerals Company. This included (i) the Bagdad mine in northwestern Arizona, consisting of an open-pit mine, an approximate 85,000 ton-per-day sulfide ore concentrator producing copper and molybdenum concentrates, and an oxide leaching system with an SX/ EW plant producing copper cathode; (ii) the Sierrita mine in south central Arizona, consisting of an open-pit mine, an approximate 115,000 ton-per-day sulfide ore concentrator, a molybdenum recovery plant, two molybdenum roasters, and an oxide and low-grade sulfide ore dump leaching system with an SX/ EW plant producing copper cathodes; (iii) the Miami mine near Miami, Arizona, consisting of an open-pit mine producing acid soluble copper ore for heap leaching operations, an SX/ EW plant producing copper cathode, a smelter, an electrolytic refinery, and a copper rod plant; (iv) a copper rod plant in Chicago, Illinois; (v) an 82 percent interest in the Cerro Verde mine in Peru, consisting of two open pits, a heap leach operation and an SX/ EW plant; (vi) a 51 percent interest in the El Abra mine in northern Chile, consisting of an open-pit mine, crushing facility, on/off leach pad and an SX/ EW plant producing copper cathodes; (vii) the Henderson mine near Empire, Colorado, consisting of an underground block caving mine, a conveying system and a concentrator that produces molybdenum disulfide concentrates; (viii) the Climax mine in Colorado, consisting of an underground and open-pit mine and concentrator which are on standby; (ix) conversion facilities in the United States and Europe that use molybdenum roasters and chemical conversion plants to convert molybdenum concentrates into such products and technical grade molybdic oxide, ferromolybdenum, pure molybdic oxide, ammonium molybdates, and molysulfide powder; and (x) other mining-related facilities. On June 30, 1999, Phelps Dodge announced a plan to reduce costs and improve operating performance by curtailing higher cost copper production by temporarily closing our Hidalgo smelter in New Mexico and the smaller of two concentrators at our Morenci mining operations in Arizona, as well as curtailing production by 50 percent at our copper refinery in El Paso, Texas. In the fourth quarter of 1999, as a result of the successful acquisition of Cyprus Amax and the planned conversion of Morenci to a mine-for-leach operation, the Hidalgo smelter was written down by $201.5 million and the Metcalf concentrator at Morenci by $88.0 million. The Hidalgo smelter is expected to be reconfigured to allow it to continue to be a reliable source of sulfuric acid. The Henderson molybdenum mine completed a major project in early October 1999 to replace a 20-year-old underground and surface rail transportation system with a modern conveyor and underground primary crusher. In addition, it began development of a new production level using more efficient high-lift caving methods. As a result, PD Mining’s 1999 operating results included the impact of the start-up costs at Henderson. The new crushing and conveying system is expected to be operating at full capacity by March 31, 2000. On October 21, 1998, we announced that we would curtail production at Chino. The production curtailment occurred in phases between October 31, 1998, and the first quarter of 1999. The curtailment reduced copper production by 35,000 tons annually. In addition, we announced the immediate, indefinite suspension of operations at our Ojos del Salado mine. This shutdown reduced copper production by more than 20,000 tons annually. Ojos del Salado remained on care and maintenance status at year end. On February 3, 1998, we acquired Cobre. The primary assets of Cobre include the Continental Mine, which comprises an open-pit copper mine, two underground copper mines, two mills, and the surrounding 11,000 acres of land, including mineral rights, located in southwestern New Mexico adjacent to our Chino operations. On October 21, 1998, we indefinitely suspended underground mining at Cobre due to low copper prices. On March 17, 1999, the remaining operations were suspended, reducing copper production by 35,000 tons per year. All Cobre operations remained on care and maintenance status at year end. We have additional sources of copper that could be placed in production should market circumstances warrant. However, permitting and significant capital expenditures would be required to develop such additional production capacity. The 1999 exploration program continued to place emphasis on the search for and delineation of large scale copper, gold and other base metal deposits. Phelps Dodge expended $41.0 million on worldwide exploration during 1999, compared with $42.0 million in 1998 and $74.1 million in 1997. Approximately 25 percent of the 1999 expenditures occurred in the United States with 19 percent being spent at our mine sites. This compares with 26 percent in 1998 (19 percent at mine sites) and 33 percent in 1997 (23 percent at mine sites). The balance of exploration expenditures was spent principally in Australasia, Brazil, Chile, Mexico, Canada and Peru. During 1999, exploration efforts continued at our existing copper operations. In New Mexico, additional mine-for-leach mineralized material was delineated at the Tyrone mine in the Niagara area, and exploration drilling at Chino indicated extensions to known open-pit copper mineralized material. The mineralized material at Niagara amounted to 500 million tons of leach material at an estimated grade of 0.29 percent copper. In Arizona, additional mine-for-leach mineralized material also was delineated in the Western Copper area of the Morenci mine. Environmental permitting is in progress to advance development of the Dos Pobres and San Juan mineral deposits in the Safford District of eastern Arizona. The two deposits contain a total of 630 million tons of leach material at an estimated grade of 0.32 percent copper. Additionally, the Dos Pobres deposit contains 330 million tons of milling material at an estimated grade of 0.65 percent copper. Internationally, Mineracão Serra do Sossego S.A., a 50/50 joint venture with Companhia Vale do Rio Doce (CVRD) located in Brazil, continued to evaluate the Sossego deposit. The deposit contains an estimated 240 million tons of mineralized material at an estimated grade of 1.14 percent copper and 0.34 grams per ton gold. A prefeasibility study, which will further define the mineralized material and determine the viability of the project, is expected to be completed in the second quarter of 2000. Work continues on our 70 percent-owned Piedras Verdes property in Sonora, Mexico. The final prefeasibility study was accepted by the minority partner and a feasibility study is expected to commence in 2000. The results of the prefeasibility study indicate leachable mineralized material of 290 million tons at an estimated grade of 0.33 percent copper. In 1999, economic evaluation and environmental remediation continued on our Ambatovy nickel/cobalt deposit in central Madagascar. Mineralized material of 210 million tons at an estimated grade of 1.1 percent nickel and 0.1 percent cobalt was previously identified in a feasibility study. Two copper exploration properties, Kansanshi located in Zambia and Frieda River located in Papua New Guinea, were added with the acquisition of Cyprus Amax. Work continued in 1999 at Kansanshi, and a prefeasibility study is scheduled to be completed in June 2000. The Frieda River project was terminated and the property was returned to the owners. PD Mining - Other Matters In December 1996, the United States District Court of the Eastern District of New York ruled that our 1986 sale of property in Maspeth, New York, to the United States Postal Service was to be rescinded. The Court ordered us to return the $14.8 million originally paid by the Postal Service for the property and to pay interest on the sales price for a portion of the time since that sale. In August 1997, we returned $14.8 million to the Postal Service for the Maspeth property and paid $6.6 million of interest to the Postal Service. In 1997, issues of dispute arose between Phelps Dodge and the San Carlos Apache Tribe regarding our use and occupancy of the Black River Pump Station which delivers water to the Morenci operation. On May 12, 1997, the Tribe filed suit against us in San Carlos Apache Court, seeking our eviction from the Tribe’s Reservation and claiming substantial compensatory and punitive damages, among other relief. In May 1997, we reached an agreement with the Tribe, and subsequently federal legislation (Pub. L. No. 105-18, 5003, 111 stat. 158, 181-87) was adopted which mandated dismissal of the tribal court suit. The legislation prescribes arrangements intended to ensure a future supply of water for the Morenci mining complex in exchange for certain payments by us. The legislation does not address any potential claims by the Tribe relating to our historical occupancy and operation of our facilities on the Tribe’s Reservation, but does require that any such claims be brought, if at all, exclusively in federal district court. By order dated October 13, 1997, the tribal court dismissed the lawsuit with prejudice, as contemplated by the legislation. The 1997 legislation required that the Company and the Tribe enter a lease for the delivery of Central Arizona Project water through the Black River Pump Station to Morenci on or before December 31, 1998. In the event a lease was not signed, the legislation expressly provided that the legislation would become the lease. The legislation included the principal terms for that eventuality. To date, we have not entered into a lease with the Tribe, but are relying on our rights under the legislation and are prepared to enforce those rights if necessary. We are cooperating with the United States, which operates the pump station, to reach an agreement with the Tribe on the lease issue. RESULTS OF PHELPS DODGE INDUSTRIES PD Industries, our manufacturing division, produces engineered products principally for the global energy, telecommunications, transportation and specialty chemicals sectors. Its operations are characterized by products with significant market share, internationally competitive cost and quality, and specialized engineering capabilities. The manufacturing division includes our specialty chemicals segment, our wire and cable segment and, until they were sold in 1998, our wheel and rim operations (Accuride Corporation). Our specialty chemicals segment includes Columbian Chemicals Company and its subsidiaries (Columbian Chemicals or Columbian). Our wire and cable segment consists of three worldwide product line businesses including magnet wire, energy and telecommunications cables, and specialty conductors. * Other includes Accuride which was sold in 1998. Ninety percent of Accuride was sold to an affiliate of KKR and the existing management of Accuride effective January 1, 1998, and the remaining 10 percent interest was sold to RSTW Partners III, L.P., on September 30, 1998, resulting in a total pre-tax gain of $198.7 million. (See Note 3 to the Consolidated Financial Statements for a further discussion of this sale.) ** Operating income has been presented in compliance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (with 1997 restated). *** Includes a pre-tax charge of $17.7 million in 1999 as a result of the suspension of operations at Columbian’s carbon black plant in the Philippines. **** Includes a pre-tax charge of $11.9 million in 1999 for impairment of value of the Wire and Cable Group’s majority-owned telecommunications assets and $40.4 million related to the company’s June 30, 1999, restructuring plan. 1998 includes a pre-tax charge of $2.3 million for an early retirement program. PD Industries reported sales of $1,327.8 million in 1999, compared with $1,385.7 million in 1998. The decrease principally reflected lower sales in the wire and cable segment ($146 million), primarily in South America. That decrease was partially offset by higher sales volumes in the carbon black segment ($88 million), which included sales from facilities acquired in Brazil and Korea in the 1998 fourth quarter and 1999 first quarter, respectively. PD Industries - Operating Income Our PD Industries segment reported operating income of $119.7 million in 1999 before non-recurring, pre-tax charges of $70.0 million. The non-recurring charges in operating income are as follows: $11.9 million of asset impairments to write down the value of our wire and cable segment’s telecommunications assets and $58.1 million for the June 30, 1999, restructuring plan at both the wire and cable and specialty chemicals segments of PD Industries. In addition to the non-recurring items in operating expense, asset impairment charges of $6.7 million and $3.1 million were recorded in non-operating expense for the impairment of an equity basis investment in China as well as the telecommunications assets of an equity basis investment in the Philippines, respectively ($1.9 million was recorded as non-operating expense related to the June 30, 1999, restructuring plan). See Note 3 to the Consolidated Financial Statements for further discussion of these non-recurring items. PD Industries reported operating income of $157.2 million in 1998, before the effect of a $198.7 million pre-tax gain from the sale of Accuride and $2.3 million of non-recurring, pre-tax charges primarily for an early retirement program at PD Magnet Wire. This compares with 1997 operating income of $158.0 million before Accuride’s $49.8 million contribution. 1998 earnings approximated the corresponding prior year period, excluding Accuride, despite continuing Asian economic difficulties. This reflected strong performances by our U.S. and European carbon black businesses and the addition of the wire and cable operation in Brazil that was acquired in December 1997. In 1999, operations outside the United States provided 55 percent of PD Industries’ sales, compared with 53 percent in 1998 and 49 percent in 1997. During the year, operations outside the United States contributed 59 percent of PD Industries’ operating income, compared with 54 percent in 1998 and 43 percent in 1997. Specialty Chemicals - Operating Income On June 30, 1999, we announced the planned closure of our manufacturing facility in Bataan, Philippines. Production was discontinued at the facility in November 1999, and the suspension resulted in a pre-tax, non-recurring charge to operating income of $17.7 million. The Philippine plant, which had a relatively small production capacity of 18,000 metric tons, did not have economies of scale necessary to compete profitably with imports from larger regional producers. Columbian Chemicals has opened a distribution company, Philippine Carbon Black Distribution Company, Inc., that will market and distribute carbon blacks, principally from Columbian Chemicals Korea, in the Philippines. Columbian’s 1999 operating income before non-recurring items was more than in 1998, principally as a result of increased carbon black sales volumes ($35 million, primarily as result of the October 1998 acquisition of Copebras S.A., a Brazilian carbon black manufacturing business, and the January 1999 acquisition of an 85 percent interest in the Korean carbon black business of Korea Kumho Petrochemical Co., Ltd.). Columbian’s 1998 operating income was higher than in 1997 as a result of increased carbon black sales volumes (12 percent higher) and lower feedstock costs, partially offset by lower carbon black sales pricing. European demand was driven by strong vehicle production and North American growth was driven by an increase in our production capacity that allowed us to gain a greater market share. In January 1999, we acquired an 85 percent interest in the Korean carbon black manufacturing business of Korea Kumho Petrochemical Co., Ltd., for $76.1 million. Columbian manages and operates the business, including the 110,000 metric-ton-per-year manufacturing plant located in Yosu, South Korea. In October 1998, we acquired Copebras S.A., a subsidiary of Minorco, for $220 million. This manufacturing facility has an annual production capacity of 170,000 metric tons of carbon black. Columbian manages and operates the company. Wire and Cable - Operating Income Our wire and cable segment reported operating income of $9.5 million in 1999 before non-recurring, pre-tax charges. The pre-tax, non-recurring items were as follows: $11.9 million of asset impairments to write down our international telecommunications assets and $40.4 million for the June 30, 1999, restructuring plan. In addition to the non-recurring items in operating income, the wire and cable segment incurred the following charges in non-operating expense: asset impairment charges of $6.7 million and $3.1 million for the impairment of an equity basis investment in China as well as the telecommunications assets of an equity basis investment in the Philippines, respectively, and $1.9 million related to the June 30, 1999, restructuring plan. Please see Note 3 to the Consolidated Financial Statements for further discussion of these non-recurring items. The wire and cable segment’s 1999 operating income was less than that in 1998 by $60.1 million, before the effect of non-recurring items, primarily as a result of economic difficulties that plagued most of Latin America and Asia. The downturn in Latin America began with the Brazilian currency crisis in early 1999. This factor, along with political and economic instability in the Andean region, significantly impacted results at our Latin American operations where operating income decreased by $46 million. In Asia, economic problems continued to hamper the performance of our wire and cable operations where operating income decreased by $3 million from already depressed levels. Efforts continue to be made to increase exports outside the region, although progress has been slower than expected. Operating income in 1998 was $69.6 million before $2.3 million of non-recurring, pre-tax charges for an early retirement program. Lower operating income in 1998 compared to 1997 in the wire and cable segment resulted from lower selling prices, continuing Asian economic difficulties that began in 1997, the effect of political uncertainty in Venezuela and continued depressed demand in the U.S. aerospace and electronic components industries served by our specialty conductors business. These negative factors were partially offset by our acquisition of PD Alcoa in Brazil, which contributed $12.8 million in 1998. Operating income decreased in Asia by $16 million, and by $20 million in the United States as a result of the depressed demand in the U.S. aerospace and electronic components industries. In the 1998 fourth quarter, we restructured our magnet wire facilities in Hopkinsville, Kentucky, and Fort Wayne, Indiana, reducing jobs to cut costs and improve our competitive position. This resulted in a non-recurring charge of $2.3 million principally reflecting provisions for early retirements. On July 15, 1998, we purchased Eldra Elektrodaht-Erzeugung GmbH’s 49 percent interest in Phelps Dodge Eldra GmbH resulting in the operation becoming our wholly owned subsidiary under the name of Phelps Dodge Magnet Wire (Austria) GmbH. The production capacity of the facility has been expanded twice since 1992 nearly doubling the annual capacity to 11,000 metric tons of magnet wire. In June 1998, our wire and cable segment and Sumitomo Electric Industries, Ltd., dissolved joint-venture partnerships at five wire and cable manufacturing and support companies. The dissolution was achieved through the exchange of cash and ownership shares in the companies. The transaction resulted in a pre-tax gain of $10.3 million. In March 1998, we began commercial production at Phelps Dodge Magnet Wire de Mexico, S.A. de C.V., a $42 million magnet wire manufacturing plant in Monterrey, Mexico. The new facility uses state-of-the-art technology and currently has installed capacity of 20,400 metric tons out of a planned capacity of 38,000 metric tons of magnet wire. In December 1997, we acquired for $72 million a 60 percent interest in the copper and aluminum wire and cable manufacturing business of Alcoa Aluminio, S.A., of Brazil. Its product line is focused on energy transmission and distribution, with dominance in aluminum conductors and solid participation in the copper wire and cable business. During the first quarter of 1998, we began managing and operating this joint venture. PD Industries - Other Operations Accuride was sold in 1998. Ninety percent was sold to an affiliate of KKR and the existing management of Accuride effective January 1, 1998, and the remaining 10 percent interest was sold to RSTW Partners III, L.P., on September 30, 1998, resulting in a pre-tax gain of $198.7 million and an after-tax gain of $131.1 million. (See Note 3 to the Consolidated Financial Statements.) OTHER MATTERS RELATING TO THE STATEMENT OF CONSOLIDATED OPERATIONS Depreciation, Depletion and Amortization Expense Depreciation, depletion and amortization expense was $329.1 million in 1999, compared with $293.3 million in 1998 and $283.7 million in 1997. The 1999 increase primarily resulted from the acquisition of Cyprus Amax ($52 million), partially offset by a decrease in Phelps Dodge’s U.S. and international mine production. The 3 percent increase in 1998 over 1997 resulted from increased U.S. and international mine production and an increase in U.S. depreciation rates partially offset by the effect of the sale of Accuride. (Please refer to Note 1 to the Consolidated Financial Statements for a discussion of depreciation methods.) Selling and General Administrative Expense Selling and general administrative expense was $141.6 million in 1999, compared with $122.9 million in 1998 and $141.8 million in 1997. The 1999 increase primarily resulted from the acquisition of Cyprus Amax which had $14.6 million in selling and general administrative expenses from October 16 through December 31, and an increase in corporate expense for incentive plans and other general administrative expenses. The 13 percent decrease in 1998 from 1997 reflected the absence of Accuride ($13 million) and a decrease in corporate expense for legal and professional fees, incentive plans and other general administrative expenses. Exploration and Research and Development Expense Exploration and research and development expense was $52.2 million in 1999, compared with $55.0 million in 1998 and $87.8 million in 1997. The 1999 decrease resulted from continuing cutbacks in exploration programs in view of current market conditions, partially offset by the addition of Cyprus Amax’s exploration spending of $4.9 million from October 16 through December 31. The 37 percent decrease in 1998 compared with 1997 primarily resulted from the closure of PD Mining’s U.S. exploration offices during the 1997 fourth quarter, but also reflected generally lower exploration expenditures worldwide. Interest Expense Net interest expense was $120.2 million in 1999, compared with $94.5 million in 1998 and $62.5 million in 1997. The 27 percent increase in 1999 was primarily due to the assumption of Cyprus Amax’s debt. The 51 percent increase in 1998 over 1997 principally resulted from interest associated with corporate debt issued in the 1997 fourth quarter and decreases in capitalized interest resulting from the completion of the Candelaria expansion in October 1997. Miscellaneous Income and Expense, Net Miscellaneous income, net of miscellaneous expense, was $9.1 million in 1999, compared with $8.8 million in 1998 and $33.4 million in 1997. The 1999 increase primarily resulted from a $30.0 million payment received from ASARCO Incorporated (Asarco) for terminating its merger agreement with Phelps Dodge, partially offset by $16.0 million in expenses related to the Asarco transaction and $11.9 million in equity basis investment asset impairments in the wire and cable segment. The 1998 decrease compared with 1997 primarily resulted from a $27.0 million pre-tax loss on the sale of our 44.6 percent interest in the Black Mountain mine in South Africa, partially offset by a pre-tax gain of $10.3 million from the dissolution of joint-venture partnerships between Phelps Dodge and Sumitomo Electric Industries, Ltd., at five wire and cable manufacturing and support companies. In addition, 1998 dividend income from our 13.9 percent interest in Southern Peru Copper Corporation (SPCC) was $8.4 million lower than in 1997. Provision for Taxes on Income The effective tax rate changed from 40 percent in 1998 to a 39 percent benefit in 1999. The effective tax rate increased from 31 percent in 1997 to 40 percent in 1998. This increase was due to a decrease in the U.S. tax benefit for percentage depletion resulting from lower copper prices, as well as increased taxes on foreign earnings resulting from a change in the mix of those earnings. In December of 1999, we received and accepted Notices of Tax Due from the Internal Revenue Service (IRS) for the years 1992 and 1993. The IRS audit of the year 1994 resulted in a refund. Issues settled in the years 1992 through 1994 also impacted the years 1990 and 1991 and enabled us to enter a closing agreement with the IRS for the years 1990 and 1991. We are currently awaiting receipt of an executed copy of the closing agreement from the IRS. As a result of these settlements, we have recorded a $30 million reduction in our tax liabilities. Phelps Dodge Corporation’s federal income tax returns for the years 1995 through 1997 are currently under examination by the IRS. The Cyprus Amax federal income tax returns for the years 1994 through 1996 also are currently under examination by the IRS. The IRS has raised a number of issues in the current examinations that may result in proposed additional assessments of income tax at the conclusion of the current examinations. Our management believes that it has made adequate provision so that final resolution of the issues involved, including application of those determinations to subsequent open years, will not have an adverse effect on our consolidated financial condition or results of operations. Discount Rate - Pensions and Other Postretirement Benefits Under current financial accounting standards, any significant year-to-year movement in the rate of interest on long-term, high-quality corporate bonds necessitates a change in the discount rate used to calculate the actuarial present value of our accumulated pension and other postretirement benefit obligations. The discount rate increased to 7.75 percent at December 31, 1999, compared with 6.75 percent at December 31, 1998. (For a further discussion of these issues, see Notes 16 and 17 to the Consolidated Financial Statements.) Year 2000 Phelps Dodge and Cyprus Amax both had identified and prepared for Year 2000 (Y2K) issues as discussed separately in their respective September 30, 1999, Form 10-Qs. Both companies had created and staffed a Y2K program management office to oversee and coordinate the Y2K conversion. Event management command centers were manned continually from December 27, 1999, through January 3, 2000, with all sites being monitored and events reported through this facility. There were no significant Y2K events reported. The program management offices were shut down in mid-January and any problems that may occur in the future will be handled as a normal event within the established processes. The costs incurred to prepare for Y2K were not material to our financial position. CHANGES IN FINANCIAL CONDITION; CAPITALIZATION Cash and Cash Equivalents Cash and cash equivalents at the end of 1999 were $234.2 million, compared with $221.7 million at the beginning of the year. Operating activities provided $204.5 million of cash during the year, which was used along with the issuance of Phelps Dodge stock to purchase Cyprus Amax, and to fund investing activities and dividend payments on common stock. Working Capital During 1999, net working capital (excluding cash and cash equivalents, debt and adjustments for foreign currency exchange rate changes) increased by $127.3 million. This net increase resulted principally from: • a $144.5 million increase in accounts receivable primarily due to the effect of higher copper prices, eliminations of receivable factoring at Cyprus Amax after the acquisition and an increase in receivables resulting from increased business at Columbian Chemicals’ Brazilian and Korean plants that were acquired in late 1998 and early 1999, respectively; and • a $32.9 million decrease in inventories and supplies primarily due to reduced copper inventories and lower wire and cable business in Asia and Latin America. Investing Activities The total purchase price for Cyprus Amax was $1,855 million including $1,125 million for the issuance of 20.6 million shares of Phelps Dodge common stock, $10 million for the conversion of Cyprus Amax stock options, cash of $693 million and acquisition costs of $27 million (financial advisory, legal, accounting, and printing costs). In addition, certain acquisition-related stock compensation and the resulting tax obligations of Cyprus Amax of $29 million were recorded in purchase accounting and paid by Phelps Dodge. Capital expenditures and investments were $120.5 million in 1999 for PD Mining and $149.5 million for PD Industries (including $76.1 million for the acquisition of an 85 percent interest in the Korean carbon black manufacturing business of Korea Kumho Petrochemical Co., Ltd.). Investing activities in 1998 included PD Mining capital expenditures of $201.3 million and an investment of $108.7 million in Cobre Mining Company. They also included PD Industries’ $111.8 million of capital expenditures and an investment of $219.9 million in the Brazilian carbon black business. The Accuride divestiture and the sale of Black Mountain generated cash proceeds of $449.5 million and $18.5 million, respectively. Capital expenditures and investments for 2000 are expected to be approximately $330 million for PD Mining and approximately $100 million for PD Industries. These capital expenditures and investments are expected to be funded primarily from cash reserves and operating cash flow. Financing Activities and Liquidity The Company’s total debt at December 31, 1999, was $2,755.0 million, compared with $1,021.0 million at year-end 1998. Debt increased primarily as a result of the acquisition of Cyprus Amax and financing for the first quarter 1999 purchase of a carbon black business in Korea. The debt acquired with the purchase of Cyprus Amax totaled $1,595.6 million. The Company’s ratio of debt to total capitalization was 45.0 percent at December 31, 1999, compared with 27.6 percent at December 31, 1998. An existing revolving credit agreement between us and several lenders was amended on June 25, 1997. The agreement, as amended and restated, allows us to borrow up to $1 billion from time to time until its scheduled maturity on June 25, 2002. The agreement allows for two, one-year renewals beyond the scheduled maturity date if we request and receive approval from those lenders representing at least two-thirds of the commitments provided by the facility. In the event of such approval, total commitments under the facility would depend upon the willingness of other lenders to assume the commitments of those lenders electing not to participate in the renewal. Interest is payable at a fluctuating rate based on the agent bank’s prime rate, or a fixed rate, based on the LIBOR, or at fixed rates offered independently by the several lenders, for maturities of between seven and 360 days. This agreement provides for a facility fee of six and one-half basis points (0.065 percent) on total commitments. The agreement requires us to maintain a minimum consolidated tangible net worth of $1.1 billion and limits indebtedness to 50 percent of total consolidated capitalization. There were no borrowings under this agreement at either December 31, 1999, or December 31, 1998. We established a commercial paper program on August 15, 1997, under a private placement agency agreement with two placement agents. The agreement permits us to issue up to $1 billion of short-term promissory notes (generally known as commercial paper) at any one time. Commercial paper may bear interest or be sold at a discount, as mutually agreed by the placement agents and us at the time of each issuance. Our commercial paper program requires that issuances of commercial paper be backed by an undrawn line of credit; the revolving credit agreement described above provides such support. Borrowings under this commercial paper program were $349.4 million at December 31, 1999. There were no borrowings under the commercial paper program at December 31, 1998. Short-term borrowings, excluding borrowings under our corporate commercial paper program, were $101.8 million, all by our international operations, at December 31, 1999, compared with $116.1 million at December 31, 1998. The decrease was primarily due to repayments of outstanding debt by our wholly owned subsidiary, Columbian Chemicals Brasil, partially offset by acquired short-term debt of $7.5 million. The current portion of our long-term debt, scheduled for payment in 2000, is $131.3 million including $7.1 million for our international manufacturing operations, $94.7 million primarily for our international mining operations and $29.5 million for corporate debt repayments. Dividend payments on our common shares increased from $117.3 million in 1998 to $124.3 million in 1999, reflecting the increased number of common shares outstanding due to our fourth quarter 1999 issuance of 20.6 million shares as part of the Cyprus Amax acquisition. The dividend was $2.00 per common share in 1999 and 1998. In connection with the acquisition of Cyprus Amax, Cyprus Amax called for redemption of all 4,664,302 of its Series A Convertible Preferred shares. Prior to the redemption date, a total of 3,968,801 shares were redeemed for cash and the remainder was converted to Cyprus Amax common shares, which were subsequently exchanged for 0.5 million shares of Phelps Dodge common stock as part of the acquisition. The cash required for the redemption totaled $208.3 million including accumulated dividends. A share purchase program announced on May 7, 1997, provided for the purchase of up to an additional 6 million of our common shares, approximately 10 percent of our then outstanding shares. We purchased 6,554,000 of our common shares in 1997 at a total cost of $511.5 million, including 3,606,000 shares at a cost of $292.9 million, under the 1997 share authorization. During 1998, we purchased 731,500 of our common shares at a total cost of $35.4 million under the 1997 program. There were no shares purchased during 1999. There were 78.7 million common shares outstanding on December 31, 1999. We may continue to make purchases in the open market as circumstances warrant, and may also consider purchasing shares in privately negotiated transactions. Environmental Matters Phelps Dodge or its subsidiaries have been advised by the EPA, United States Forest Service and several state agencies that they may be liable under CERCLA or similar state laws and regulations for costs of responding to environmental conditions at a number of sites that have been or are being investigated by the EPA, the Forest Service, or states, to establish whether releases of hazardous substances have occurred and, if so, to develop and implement remedial actions. Phelps Dodge has been named a “potentially responsible party” (PRP) or has received requests for information for several sites. Of the sites in which Phelps Dodge or its subsidiaries have been named a PRP, 19 are on the “National Priorities List” (NPL) and two have been proposed for listing. For all such sites, Phelps Dodge had an aggregate reserve of $208.7 million as of December 31, 1999, including reserves for Pinal Creek in Arizona, and Langeloth in Pennsylvania, for its share of the estimated liability. Liability estimates are based on an evaluation of among other factors, currently available facts, existing technology, presently enacted laws and regulations, Phelps Dodge’s experience in remediation, other companies’ remediation experience, Phelps Dodge’s status as a PRP, and the ability of other PRPs to pay their allocated portions. The cost range for reasonably expected outcomes for all sites excluding Pinal Creek and Langeloth is estimated to be from $28 million to $110 million, and work on these sites is expected to be substantially completed in the next several years, subject to inherent delays involved in the process. The sites for which Phelps Dodge has received a notice of potential liability or an information request that are currently considered to be the most significant are the Pinal Creek site, which has a cost range for reasonably expected outcomes estimated to be from $143 million to $250 million, and the former American Zinc and Chemical site in Langeloth, which has a cost range for reasonably expected outcomes estimated to be from $10 million to $67 million. The Pinal Creek site is described in more detail in the legal proceedings section of this report. Phelps Dodge has reserved $143 million for the Pinal Creek site. Cyprus Amax received an information request from the Pennsylvania Department of Environmental Protection regarding the former American Zinc and Chemical site. The site is currently being investigated by the state of Pennsylvania. Phelps Dodge has reserved $20 million for this site. Phelps Dodge believes certain insurance policies partially cover the foregoing environmental liabilities; however, some of the insurance carriers have denied coverage. We are presently litigating these disputes. Further, Phelps Dodge believes that it has other potential claims for recovery from other third parties, including the U.S. Government and other PRPs, as well as liability offsets through lower cost remedial solutions. Neither insurance recoveries nor other claims or offsets have been recognized in the financial statements unless such offsets are considered probable of realization. As of December 31, 1998, we had a reserve balance of $106.0 million for estimated future costs associated with environmental matters at shutdown operations or closed facilities within active operations. During 1999, net spending against that reserve totaled $20.0 million including $2.8 million for the acquired Cyprus Amax properties between October 16 and December 31. During the second quarter of 1999, we recorded an additional $8.3 million provision for estimated future costs associated with environmental matters directly related to our restructuring plan announced on June 30, 1999. Additionally, we recorded a $28.2 million provision in the fourth quarter of 1999 for estimated future costs associated with environmental matters. The acquisition of Cyprus Amax increased our reserve by $213.6 million. As of December 31, 1999, the reserve balance was $336.1 million. The 1990 Amendments to the federal Clean Air Act require the EPA to develop and implement many new requirements, and they allow states to establish new programs to implement some of the new requirements, such as the requirements for operating permits under Title V of the 1990 Amendments and hazardous air pollutants under Title III of the 1990 Amendments. Because the EPA has not yet adopted or implemented all of the changes required by Congress, the air quality laws will continue to expand and change in coming years as the EPA develops new requirements and then implements them or allows the states to implement them. In response to these new laws, several of our subsidiaries have submitted applications for Title V operating permits. These programs will likely increase our regulatory obligations and compliance costs. These costs could include implementation of maximum achievable control technology for any of our facilities if they are determined to be a major source of federal hazardous air pollutants (HAPs). For example, it is probable that some of our carbon black plants and possibly one of our smelters will be regulated as a major source of HAPs. Until more of the implementing regulations are adopted, and more experience with the new programs is gained, it is not possible to determine the full impact of the new requirements. We record liabilities for environmental expenditures when it is probable that obligations have been incurred and the costs can be reasonably estimated. Our estimates of these costs are based upon available facts, existing technology, and current laws and regulations and are recorded on an undiscounted basis. Where the available information is sufficient to estimate the amount of liability, that estimate has been used. Where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. Based upon the information available to us, the range of obligations, both individually and in the aggregate, from known environmental liabilities are not expected to result in material additional costs beyond those already identified. We have other potential environmental liabilities that cannot be reasonably estimated. This is due to factors such as the unknown extent of the remedial actions that may be required. In addition, in the case of certain sites not owned by us, the extent of our liability in proportion to the liability of other parties is difficult to estimate. While we cannot currently estimate the total additional loss we may incur for these environmental liabilities, we will make appropriate additional accruals if information comes to our attention in the future that would allow us to reasonably estimate our probable losses. Furthermore, we will make additional accruals if there are future changes in laws, regulations and/or regulatory interpretations, and such changes result in additional liabilities, these potential liabilities could be material. The possibility of recovery of some of the environmental remediation costs from insurance companies or other parties exists. However, we do not recognize these recoveries in our financial statements until they become probable. Our operations are subject to many environmental laws and regulations in jurisdictions both in the United States and in other countries in which we do business. For further discussion of these laws and regulations, please see PD Mining - Environmental and Other Regulatory Matters and PD Industries - Environmental Matters. The estimates given in those discussions of the capital expenditures to comply with environmental laws and regulations in 2000 and 2001, and the expenditures in 1999, are separate from the reserves and estimates described above. In the United States, the Emergency Planning and Community Right-to-know Act was expanded in 1997 to cover mining operations. This law, which has applied to other Phelps Dodge businesses for more than a decade, requires companies to report to the EPA the amount of certain materials managed in or released from their operations each year. During June 1999, we reported the volume of naturally occurring metals and other substances that we managed during 1998 once the usable copper was extracted. These materials are very high in volume and how they are managed is covered by existing regulations and permit requirements. On December 23, 1994, Chino, located near Silver City, New Mexico, entered into an Administrative Order on Consent (AOC) with the New Mexico Environment Department. This AOC requires Chino to study the environmental impacts and potential health risks associated with portions of the Chino property affected by historical mining operations. We acquired Chino at the end of 1986. The studies began in 1995 and, while we currently are unaware of any additional liabilities that need to be accrued, until the studies are completed, it is not possible to determine the nature, extent, cost, and timing of remedial work that could be required under the AOC. Remedial work is expected to be required under the AOC. In 1993 and 1994, the New Mexico and Arizona legislatures, respectively, passed laws requiring the reclamation of mined lands in those states. The New Mexico Mining Commission adopted rules for the New Mexico program during 1994, and our operations began submitting the required permit applications in December 1994. The Arizona State Mine Inspector adopted rules for the Arizona program in January 1997, and our operations began submitting the required reclamation plans in 1997. Colorado also has a similar program. Reclamation is an ongoing activity and we recognize estimated reclamation costs using a units of production basis calculation. These laws and regulations will likely increase our regulatory obligations and compliance costs with respect to mine closure and reclamation. Other Matters In 1995, legislation was introduced in both the U.S. House of Representatives and the U.S. Senate to amend the Mining Law of 1872. None of the bills was enacted into law. Also, mining law amendments were added to the 1996 budget reconciliation bill, which was vetoed by the President. Among other things, the amendments contained in the 1996 bill would have imposed a 5 percent net proceeds royalty on minerals extracted from federal lands, required payment of fair market value for patenting federal lands, and required that patented lands used for non-mining purposes revert to the federal government. Several of these same concepts likely will continue to be pursued legislatively in the future. The Secretary of the Interior also ordered the Bureau of Land Management (BLM) to form a task force to review BLM’s hardrock mining surface management regulations and propose revisions to expand environmental and reclamation requirements, among other things. While the effect of such changes on our current operations and other currently owned mineral resources on private lands would be minimal, passage of mining law amendments or revisions to the hardrock mining surface management regulations could result in additional expenses in the development and operation of new mines on federal lands. In February 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This statement became effective for fiscal years beginning after December 15, 1997. We adopted this statement in 1998. In June 1998, the FASB issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This statement requires recognition of all derivatives as either assets or liabilities on the balance sheet and measurement of those instruments at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income (loss). Proper accounting for changes in the fair value of derivatives held is dependent on whether the derivative transaction qualifies as an accounting hedge and on the classification of the hedge transaction. The statement was originally required to be adopted in the first quarter of 2000. Citing concerns about companies’ ability to modify their information systems and educate their managers in time to apply SFAS 133, FASB has delayed its effective date for one year. We will adopt SFAS 133 in the first quarter of 2001. We are evaluating the effect this statement will have on our financial reporting and disclosures as well as on our derivative and hedging activities. In the 1999 first quarter, we adopted SOP 98-5, “Reporting on the Costs of Start-Up Activities.” The implementation resulted in a $3.5 million after-tax charge, or 6 cents per common share, representing the write off of previously unamortized start-up costs at our Candelaria mining operation in Chile and our magnet wire operation in Monterrey, Mexico. CAPITAL OUTLAYS Capital outlays in the following table exclude capitalized interest and the minority joint-venture interest portions of the expenditures at Morenci, Chino, El Abra and Candelaria. INFLATION The principal impact of general inflation upon our financial results has been on unit production costs, especially supply costs, at our mining and industrial operations. It is important to note, however, that the selling price of our principal product, copper, does not necessarily parallel the rate of inflation or deflation. DIVIDENDS AND MARKET PRICE RANGES The principal market for our common stock is the New York Stock Exchange. At March 6, 2000, there were 27,671 holders of record of our common shares. In the 1996 second quarter, the quarterly dividend was increased to 50 cents from 45 cents on each common share and continued at that rate throughout 1997, 1998 and 1999. Additional information required for this item is provided in the Quarterly Financial Data table. QUARTERLY FINANCIAL DATA * As reported in the Wall Street Journal. PHELPS DODGE CORPORATION AND CONSOLIDATED SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS The consolidated balance sheet at December 31, 1999 and 1998, and the related consolidated statements of operations, of cash flows and of common shareholders’ equity for each of the three years in the period ended December 31, 1999, and notes thereto, together with the report thereon of PricewaterhouseCoopers LLP dated January 26, 2000, appear on pages 52 to 92 of this report. The additional financial data referred to below should be read in conjunction with these financial statements. Schedules not included with the additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. The individual financial statements of the Company have been omitted because the Company is primarily an operating company and all subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interests and/or indebtedness to any person other than the Company or its consolidated subsidiaries in amounts which together exceed 5 percent of total consolidated assets at December 31, 1999. Separate financial statements of subsidiaries not consolidated and investments accounted for by the equity method, other than those for which summarized financial information is provided in Note 4 to the Consolidated Financial Statements, have been omitted because, if considered in the aggregate, such subsidiaries and investments would not constitute a significant subsidiary. ADDITIONAL FINANCIAL DATA Financial statement schedule for the years ended December 31, 1999, 1998 and 1997: II - Valuation and qualifying accounts and reserves on page 97. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Phelps Dodge Corporation Our audits of the consolidated financial statements referred to in our report dated January 26, 2000, included an audit of the Financial Statement Schedule listed in the foregoing index titled “Additional Financial Data.” In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PricewaterhouseCoopers LLP Phoenix, Arizona January 26, 2000 REPORT OF MANAGEMENT Our management is responsible for the preparation, integrity and objectivity of the consolidated financial statements presented in this annual report. The statements have been prepared in accordance with accounting principles generally accepted in the United States and include amounts that are based on management’s best estimates and judgments. Management also accepts responsibility for the preparation of other financial information included in this document. Management maintains a system of internal controls to provide reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management’s authorization. The system includes formal policies and procedures that are communicated to employees with significant roles in the financial reporting process and updated as necessary. The system also includes the careful selection and training of qualified personnel, an organization that provides a segregation of responsibilities and a program of internal audits that independently evaluates the effectiveness of internal controls and recommends possible improvements. The Audit Committee, currently consisting of five non-employee directors, meets at least three times a year to review, among other matters, internal control conditions and internal and external audit plans and results. It meets periodically with senior officers, internal auditors and independent accountants to review the adequacy and reliability of our accounting, financial reporting and internal controls. Our independent accountants, PricewaterhouseCoopers LLP, have audited the annual financial statements in accordance with auditing standards generally accepted in the United States. The independent accountants’ report expresses an informed judgment as to the fair presentation of our reported operating results, financial position and cash flows. This judgment is based on the results of auditing procedures performed and such other tests that they deemed necessary, including consideration of our internal control structure. Our management also recognizes its responsibility for fostering a strong ethical climate so that our affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in our code of business ethics and policies, which is distributed throughout the Company. The code of conduct addresses: • the necessity of ensuring open communication within the Company; • potential conflicts of interest; • compliance with all applicable laws (including financial disclosure); and • the confidentiality of proprietary information. We maintain a systematic program to assess compliance with these policies. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Phelps Dodge Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of cash flows and of common shareholders’ equity present fairly, in all material respects, the financial position of Phelps Dodge Corporation and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of Phelps Dodge’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As described in Note 1 to the consolidated financial statements, Phelps Dodge changed its method of accounting for start-up costs effective January 1, 1999. PricewaterhouseCoopers LLP Phoenix, Arizona January 26, 2000 STATEMENT OF CONSOLIDATED OPERATIONS See Notes to Consolidated Financial Statements CONSOLIDATED BALANCE SHEET See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENT OF CASH FLOWS Supplemental schedule of noncash investing and financing activities: In 1999, as partial consideration for the acquisition of Cyprus Amax, the Company issued 20.6 million common shares valued at $1,125 million. (See Note 2.) See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENT OF COMMON SHAREHOLDERS’ EQUITY Disclosure of reclassification amount: * The 1998 reclassification adjustment resulted from the sale of Black Mountain. ** The 1999 reclassification adjustment represents the write-off of cumulative translation adjustments as a result of the sale of PD Mining Ltd. See Notes to Consolidated Financial Statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in tables stated in millions except as noted) 1. Summary of Significant Accounting Policies Basis of Consolidation. The consolidated financial statements include the accounts of Phelps Dodge Corporation (the Company, which may be referred to as Phelps Dodge, PD, we, us or ours), and its majority-owned subsidiaries. Interests in mining joint ventures in which we own more than 50 percent are reported using the proportional consolidation method. Interests in other majority-owned subsidiaries are reported using the full consolidation method; the consolidated financial statements include 100 percent of the assets and liabilities of these subsidiaries and the ownership interests of minority participants are recorded as “Minority interests in consolidated subsidiaries.” All material intercompany balances and transactions are eliminated. Investments in unconsolidated companies owned 20 percent or more are recorded on an equity basis. Investments in companies less than 20 percent owned, and for which we do not exercise significant control, are carried at cost. Management’s Estimates and Assumptions. The preparation of financial statements in conformity with generally accepted accounting principles requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Foreign Currency Translation. Except as noted below, the assets and liabilities of foreign subsidiaries are translated at current exchange rates, while revenues and expenses are translated at average rates in effect for the period. The related translation gains and losses are included in accumulated other comprehensive income (loss) within common shareholders’ equity. For the translation of the financial statements of certain foreign subsidiaries dealing predominantly in U.S. dollars and for those affiliates operating in highly inflationary economies, assets and liabilities receivable or payable in cash are translated at current exchange rates, and inventories and other non-monetary assets and liabilities are translated at historical rates. Gains and losses resulting from translation of such financial statements are included in operating results, as are gains and losses incurred on foreign currency transactions. Statement of Cash Flows. For the purpose of preparing the Consolidated Statement of Cash Flows, we consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Inventories and Supplies. Inventories and supplies are stated at the lower of cost or market. Cost for metal inventories is determined by the last-in, first-out method (LIFO), and cost for substantially all other inventories is determined by the first-in, first-out method (FIFO) or a moving average method. Cost for substantially all supplies is determined by a moving average method. Property, Plant and Equipment. Property, plant and equipment are carried at cost. Cost of significant assets includes capitalized interest incurred during the construction and development period. Expenditures for replacements and betterments are capitalized; maintenance and repair expenditures are charged to operations as incurred. The principal depreciation method used for mining, smelting and refining operations is the units of production method applied on a group basis. Buildings, machinery and equipment for other operations are depreciated using the straight-line method over estimated lives of five to 40 years, or the estimated life of the operation if shorter. Upon disposal of assets depreciated on a group basis, cost less salvage is charged to accumulated depreciation. Values for mining properties represent mainly acquisition costs or pre-1932 engineering valuations. Depletion of mines is computed on the basis of an overall unit rate applied to the pounds of principal products sold from mine production. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Mine exploration costs and development costs to maintain production of operating mines are charged to operations as incurred. Mine development expenditures at new mines and major development expenditures at operating mines that are expected to benefit future production are capitalized and amortized on the units of production method over the estimated commercially recoverable minerals. Environmental Expenditures. Environmental expenditures are expensed or capitalized depending upon their future economic benefits. Liabilities for such expenditures are recorded when it is probable that obligations have been incurred and the costs reasonably can be estimated. For closed facilities and closed portions of operating facilities with closure obligations, an environmental liability is considered probable and is accrued when a closure determination is made and approved by management. Environmental liabilities attributed to CERCLA or analogous state programs are considered probable when a claim is asserted, or is probable of assertion, and we have been associated with the site. Other environmental remediation liabilities are considered probable based on the specific facts and circumstances. Our estimates of these costs are based upon available facts, existing technology and current laws and regulations, and are recorded on an undiscounted basis. Where the available information is sufficient to estimate the amount of liability, that estimate has been used. Where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The possibility of recovery of some of these costs from insurance companies or other parties exists; however, we do not recognize these recoveries in our financial statements until they become probable. Mine Closure Costs. Reclamation is an ongoing activity and we recognize estimated reclamation costs on a units of production basis. Goodwill. Included in “Other assets and deferred charges” are costs in excess of the net assets of businesses acquired. These amounts are amortized on a straight-line basis over periods of 15 to 30 years. Impairments. We evaluate our long-term assets to be held and used, our identifiable intangible assets, and goodwill for impairment when events or changes in economic circumstances indicate the carrying amount of such assets may not be recoverable. We use an estimate of the future undiscounted net cash flows of the related asset or asset grouping over the remaining life to measure whether the assets are recoverable and measure any impairment by reference to fair value. Fair value is generally estimated using the Company’s expectation of discounted net cash flows. Long-term assets to be disposed of are carried at the lower of cost or fair value less the costs of disposal. Revenue Recognition. Revenue is recorded when title passes to the customer. The passing of title is based on terms of the contract which is generally upon shipment. Copper revenue is recognized based on the monthly average of prevailing commodity prices according to the terms of the contracts. Price estimates used for provisionally priced concentrate shipments are based on management’s judgment of expected price levels and are adjusted to actual prices at settlement. We use futures contracts and other financial instruments as hedges for our sales and cash management program. Gains and losses on such transactions related to sales are matched to specific sales contracts and charged or credited to sales revenue. Hedging Programs. We do not purchase, hold or sell derivative financial contracts unless we have an existing asset, obligation or anticipate a future activity that is likely to occur that will result in exposing us to market risk. Derivative financial instruments are used to manage well-defined commodity price, foreign exchange and interest rate risks from our primary business activities. For a discussion on why we use derivative financial contracts, our year-end derivative position and related financial results, please refer to Note 20. Commodity futures contracts - We recognize gains and losses on commodity futures contracts in income when the underlying customer sale is recognized. We also recognize gains and losses whenever a previous customer contract is no longer expected to occur. Copper option contracts - We initially record net premiums paid on copper option contracts as prepaid assets and then amortize the premium on a straight-line basis over the hedge protection period. We recognize hedging gains and losses in income at the maturity of the option contract. We record any premiums received NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) on the sale of option contracts as accrued expenses until the maturity of the option contract when the premium received is recorded as income. Foreign exchange contracts - We initially record premiums paid on currency option contracts and unrecognized gains and losses on forward exchange contracts as prepaid assets. Hedge premiums on forward exchange contracts are amortized on a straight-line basis over the hedge protection period. Gains and losses on forward exchange contracts are credited or charged to miscellaneous income or expense. Changes in market value of forward exchange contracts protecting actual transactions are recognized in the period incurred. For currency option contracts, we recognize unamortized premium and hedging gains and losses in income when the underlying hedged transaction is recognized or when a previously hedged transaction is no longer expected to occur. Currency swap contracts - For certain of our currency swap contracts, which are in substance forward exchange contracts, we amortize hedge premiums on a straight-line basis over the hedge protection period while gains and losses are recognized in income in the period incurred. For other types of currency swap contracts, we recognize costs associated with such agreements to interest expense over the term of the agreement. Interest rate swaps - The costs associated with interest rate swap agreements are amortized to interest expense over the term of the agreement. Stock Compensation. In accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” we apply Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations to account for our stock option plans. Note 15 to the Consolidated Financial Statements contains a summary of the pro forma effects on reported net income and earnings per share for 1999, 1998 and 1997 if we had elected to recognize compensation cost based on the fair value of the options granted as prescribed by SFAS No. 123. Income Taxes. In addition to charging income for taxes actually paid or payable, the provision for taxes reflects deferred income taxes resulting from changes in temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. The effect on deferred income taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Pension Plans. We have trusteed, non-contributory pension plans covering substantially all of our U.S. employees and some employees of international subsidiaries. The benefits are based on, in the case of certain plans, final average salary and years of service and, in the case of other plans, a fixed amount for each year of service. Our funding policy provides that payments to the pension trusts shall be at least equal to the minimum funding requirements of the Employee Retirement Income Security Act of 1974 for U.S. plans or, in the case of international subsidiaries, the minimum legal requirements in that particular country. Additional payments may also be provided from time to time. Postretirement Benefits Other Than Pensions. We have several postretirement health care and life insurance benefit plans covering most of our U.S. employees and, in some cases, employees of international subsidiaries. Postretirement benefits vary among plans and many plans require contributions from employees. We account for these benefits on an accrual basis. Our funding policy provides that payments shall be at least equal to our cash basis obligation, plus additional amounts that may be approved by us from time to time. Postemployment Benefits. We have certain postemployment benefit plans covering most of our U.S. employees and, in some cases, employees of international subsidiaries. The benefit plans may provide severance, disability, supplemental health care, life insurance or other welfare benefits. We account for these benefits on an accrual basis. Our funding policy provides that payments shall be at least equal to our cash basis obligation. Additional amounts may also be provided from time to time. Earnings Per Share. In 1997, we adopted SFAS No. 128, “Earnings Per Share.” Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) common shares outstanding for the period. Diluted earnings per share is similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. Stock options excluded from the computation of diluted earnings per share because option prices exceeded fair market value were as follows: New Accounting Standards. In the 1999 first quarter, we adopted SOP 98-5, “Reporting on the Costs of Start-Up Activities.” The implementation resulted in a $3.5 million after-tax charge, or 6 cents per common share, representing the write off of previously unamortized start-up costs at our Candelaria mining operation in Chile and our magnet wire operation in Monterrey, Mexico. We adopted SFAS No. 130, “Reporting Comprehensive Income,” in the 1998 first quarter. The required information has been presented in the Consolidated Financial Statement of Common Shareholders’ Equity. We also adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” in 1998. The required information has been presented in Note 21 - Business Segment Data. In February 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” We adopted this statement in 1998. They have no effect on our results of operations, financial position, capital resources or liquidity. Prior year disclosures have been restated for comparative purposes. In June 1998, FASB issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This statement requires recognition of all derivatives as either assets or liabilities on the balance sheet and measurement of those instruments at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income (loss). Proper accounting for changes in fair value of derivatives held is dependent on whether the derivative transaction qualifies as an accounting hedge and on the classification of the hedge transaction. The statement was originally required to be adopted in the first quarter of 2000. Citing concerns about companies’ ability to modify their information systems and educate their managers in time to apply SFAS 133, FASB has delayed its effective date for one year. We will NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) adopt SFAS 133 in the first quarter of 2001. We are evaluating the effect this statement will have on our financial reporting and disclosures as well as on our derivative and hedging activities. Reclassification. For comparative purposes, certain prior year amounts have been reclassified to conform with the current year presentation. 2. Acquisitions Cyprus Amax Acquisition In the 1999 fourth quarter, Phelps Dodge acquired all the issued and outstanding shares of Cyprus Amax Minerals Company (Cyprus Amax). Prior to the acquisition, Cyprus Amax was a worldwide producer of copper and molybdenum. The acquisition of Cyprus Amax was accounted for using the purchase method and accordingly, the results of Cyprus Amax operations have been included in the accompanying consolidated financial statements from the date of the acquisition, October 16, 1999. The total purchase price for Cyprus Amax was $1,855 million including $1,125 million for the issuance of 20.6 million shares of Phelps Dodge common stock, $10 million for the conversion of Cyprus Amax stock options, cash of $693 million and acquisition costs of $27 million (financial advisory, legal, accounting, and printing costs). In addition, certain acquisition-related stock compensation and the resulting tax obligations of Cyprus Amax of $29 million were recorded in purchase accounting and paid by Phelps Dodge. In connection with the acquisition of Cyprus Amax, Cyprus Amax called for redemption of all 4,664,302 of its Series A Convertible Preferred shares. Prior to the redemption date, a total of 3,968,801 shares were redeemed for cash and the remainder converted to Cyprus Amax common shares, which were subsequently exchanged for 0.5 million shares of Phelps Dodge common stock as part of the acquisition. The cash required for the redemption totaled $208.3 million, including accumulated dividends. Allocation of the purchase price was based on an estimate of the fair value for the assets acquired and liabilities assumed at October 16, 1999, and is subject to final adjustment based on the completion of final valuation and other procedures. Assets acquired were $4.2 billion, including cash of $785 million. Liabilities assumed totaled $2.4 billion including debt of $1,595.6 million which was reduced by $15.2 million to reflect the fair value of the obligations at the acquisition date. Liabilities recorded at acquisition included costs of $22 million associated with merging Cyprus Amax’s operations into the Company’s operations such as lease and other contract cancellation costs, and employee termination costs, primarily for duplicate administrative and management functions. Costs for these liabilities incurred in connection with the integration plan are expected to be substantially paid out by the end of 2000. Phelps Dodge has decided to sell the Australian coal assets acquired in the merger. These assets consist of a 50 percent interest in the Springvale underground mine located in New South Wales, Australia, and a 48 percent interest in Oakbridge Limited which has three operating mines also located in New South Wales. These assets have been classified on the balance sheet as other current assets and prepaid expenses and were assigned an estimated net realizable value of $140 million based on an estimated pre-tax value of $150 million less $10 million for transaction costs and other provisions. The unaudited pro forma information set forth below is presented to show the estimated effect of the merger on the consolidated operations of Phelps Dodge had it been consummated at the beginning of each period, after giving effect to certain adjustments, including additional depreciation and amortization of assets acquired. The pro forma financial information gives effect to Cyprus Amax’s disposition of its coal (1999) and lithium (1998) segments. Accordingly, the operating results and resulting gain (loss) of these segment’s have been excluded from income (loss) from continuing operations and included in net income (loss). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The unaudited pro forma financial information is provided for illustrative purposes only and does not purport to represent what the actual consolidated results of operations of Phelps Dodge would have been had the acquisition of Cyprus Amax occurred on the dates presented, nor is it necessarily indicative of future consolidated operating results. The pro forma adjustments do not include operating efficiencies and cost savings that Phelps Dodge expects to achieve. KKPC Acquisition In January 1999, we acquired an 85 percent interest in the Korean carbon black manufacturing business of Korea Kumho Petrochemical Co., Ltd., for $76.1 million. Our Columbian Chemicals subsidiary manages and operates the business, including the 110,000 metric-ton-per-year manufacturing plant located in Yosu, South Korea. Copebras Acquisition In October 1998, we acquired the Brazilian carbon black manufacturing business of Copebras S.A., a subsidiary of Minorco, for $220.0 million. This manufacturing facility has an annual production capacity of 170,000 metric tons of carbon black. Cobre Acquisition On February 3, 1998, we acquired the stock of Cobre Mining Company Inc. (Cobre) for $108.7 million including acquisition costs. The acquisition was at a price of $3.85 per common share for Cobre’s 27 million common shares, including shares issuable upon the exercise of outstanding warrants and options. The primary assets of Cobre include the Continental Mine, which comprises an open-pit copper mine, two underground copper mines, two mills, and the surrounding land, including mineral rights, located in southwestern New Mexico adjacent to the Company’s Chino Mines Company (Chino) operations. On October 21, 1998, we indefinitely suspended underground mining at Cobre due to low copper prices. On March 17, 1999, the remaining operations were suspended. Cobre remains on care and maintenance status. 3. Non-Recurring Charges and Provisions 1999 Asset Impairments and Provisions During the 1999 fourth quarter, we recorded non-recurring, pre-tax charges for asset impairments of $320.4 million at Phelps Dodge Mining Company (PD Mining) and $21.7 million at Phelps Dodge Industries (PD Industries). The PD Mining impairments included the write-down of the Hidalgo smelter in New Mexico ($201.5 million) and the Metcalf concentrator at the Morenci operations in Arizona ($88.0 million). As a result of the successful acquisition of Cyprus Amax and the planned conversion of Morenci to a mine-for-leach operation, the Hidalgo smelter is expected to be reconfigured to allow it to continue to be a reliable source of acid. Management also determined that the Metcalf concentrator, which was on standby, would thereafter be permanently closed and the Morenci concentrator, which will be required through the mine-for-leach start-up, subsequently will be maintained on standby to provide alternative processing capability. In NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) addition, as the Company began integrating the acquired Cyprus Amax mining properties, a review of copper resources was performed and a determination of the viability of each resource reviewed was made. Based on that review, PD Mining wrote off a mine development project at the Tyrone operation in New Mexico ($11.9 million) and wrote off a mine development project at the Copper Basin operation in Arizona ($6.8 million). Management further decided to write down a real estate development project in Arizona ($12.2 million). The PD Industries’ impairment charge comprised $6.7 million for the write off of an equity investment in China (charged to non-operating expense) and $15.0 million for the impairment of value of the wire and cable segment’s telecommunications assets ($3.1 million of which was charged to non-operating expense). The minority interest add-back against the impairment of value of the telecommunications assets totaled $1.5 million. During the 1999 fourth quarter, the Company also recognized a non-recurring, pre-tax charge of $28.2 million for estimated future costs associated with environmental matters applicable to PD Mining. See Note 19 to the Consolidated Financial Statements for further discussion of environmental matters. 1999 Restructuring Charges On June 30, 1999, we announced a plan to reduce costs and improve operating performance at all three of our business segments by (i) curtailing higher cost copper production by temporarily closing our Hidalgo smelter in New Mexico and the Metcalf concentrator, as well as curtailing production by 50 percent at our copper refinery in El Paso, Texas; (ii) selling a non-core South African fluorspar mining unit; (iii) restructuring certain wire and cable assets to respond to changing market conditions; and (iv) suspending operations at Columbian Chemicals Company’s carbon black plant in the Philippines. These actions resulted in a total non-recurring, pre-tax charge of $84.7 million (or $58.7 million, $1.01 per share, after taxes and minority interests) in the 1999 second quarter, a pre-tax charge of $1.1 million (or $0.7 million, $0.01 per share, after taxes) in the 1999 third quarter and a pre-tax charge of $10.9 million (or $6.3 million, $0.09 per share, after taxes and minority interests) in the 1999 fourth quarter. Total 1999 non-recurring charges for the June 30, 1999, restructuring plan were $96.7 million (or $65.7 million, $1.07 per share, after taxes and minority interests). PD Mining’s $36.6 million in non-recurring, pre-tax charges from the June 30, 1999, restructuring plan included $7.0 million from a loss on the sale of our fluorspar mining operation in South Africa. Also included in the restructuring plan were charges associated with employee severance ($6.9 million), pension and other postretirement obligations ($9.0 million), environmental cleanup ($7.3 million) and mothballing and take or pay contracts ($6.4 million). Approximately 900 positions, including temporary and contract employees, have been or are in the process of being eliminated as part of the plan. The current liability components of the restructuring plan related to employee severance, mothballing and take or pay contracts during 1999 were as follows: * Reclassified to pension and postretirement benefit obligations. Our specialty chemicals segment had non-recurring, pre-tax charges of $19.9 million in the 1999 second quarter from the June 30, 1999, restructuring plan. Included in that amount were costs associated with asset and investment write-offs ($14.9 million), environmental and disposal and dismantling ($3.0 million), and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) employee severance ($2.0 million). That non-recurring charge was decreased by $2.2 million in the 1999 fourth quarter to $17.7 million, primarily due to a reassessment of expected obligations. Approximately 80 positions have been or are in the process of being eliminated as part of the plan. The current liability components of the restructuring plan related to employee severance and disposal and dismantling costs during 1999 were as follows: * Revised assessment of severance expenses. Our wire and cable segment had non-recurring, pre-tax charges of $42.2 million in 1999 from the June 30, 1999, restructuring plan. Included in the 1999 restructuring plan charges were fixed and other asset write-offs ($23.8 million), lease payments ($1.7 million), employee severance and relocation ($6.4 million), equipment disposal, dismantling and relocation ($4.6 million), pension and postretirement obligations ($3.8 million) and the write off of an equity basis investment ($1.9 million). Nearly 200 full-time, permanent positions have been or are in the process of being eliminated as part of the plan. The current liability components of the restructuring plan related to employee severance and relocation and equipment disposal and dismantling and relocation during 1999 were as follows: * Relocation costs are charged to expense as incurred. ** Reclassification of severance to pension and postretirement benefit obligations. Sale of Accuride Effective January 1, 1998, we sold a 90 percent interest in our wheel and rim manufacturing business, Accuride Corporation and related subsidiaries (Accuride), to an affiliate of Kohlberg Kravis Roberts and Co. (KKR) and the existing management of Accuride. That sale resulted in a pre-tax gain of $186.1 million, ($122.8 million after taxes, or $2.10 per common share). The remaining 10 percent interest in Accuride was sold to RSTW Partners III, L.P., on September 30, 1998, resulting in a pre-tax gain of $12.6 million ($8.3 million after taxes, or $0.14 per common share). Under the terms of the sales agreements, we received total proceeds of $465.9 million from the two transactions, less $16.4 million in working capital adjustments and transaction costs. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Sale of Black Mountain Effective October 1, 1998, we sold our 44.6 percent interest in Black Mountain Mineral Development Company to Amcoal Colliery and Industrial Operations Limited, a public company incorporated in South Africa. The sale resulted in a pre-tax loss of $27.0 million ($26.4 million after taxes, or $0.45 per common share) including the write off of cumulative translation adjustments. Under the terms of the sales agreement, we received total proceeds of $18.5 million from the transaction. 1998 Charges During 1998, we recorded non-recurring, pre-tax charges of $5.5 million, at PD Mining for costs associated with indefinite closures and curtailments of certain mining operations and $2.3 million at the wire and cable segment for an early retirement program. These charges reduced net income by $5.6 million, or 10 cents per common share, after taxes. 1997 Charges During 1997, we recorded non-recurring, pre-tax charges of $42.1 million primarily at PD Mining. These charges reflect additional provisions of $23.0 million for estimated future costs associated with environmental matters and $19.1 million for a voluntary early retirement program. These charges reduced net income in 1997 by $29.0 million, or 47 cents per common share, after taxes. 4. Investments and Long-Term Receivables Investments and long-term receivables were as follows: Equity earnings (losses) were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Dividends from equity basis investments were received as follows: Our retained earnings include undistributed earnings of equity basis investments of: 1999 - $67.9; 1998 - $63.5; 1997 - $69.3. Condensed financial information for our equity basis investments as of December 31, 1999, was as follows: 5. Interest Expense, Net of Amount Capitalized We reported net interest expense in 1999 of $120.2 million, compared with $94.5 million in 1998 and $62.5 million in 1997. Net interest expense increased in 1999, primarily due to the inclusion of $24.5 million of interest expense on Cyprus Amax acquired debt. The debt acquired with the purchase of Cyprus Amax totaled $1,595.6 million, which was reduced by $15.2 million to reflect the fair value of the obligations at the acquisition date. Net interest expense increased in 1998, primarily due to the full year inclusion of $250.0 million of notes payable issued in the fourth quarter of 1997, and the completion in 1997 of the Candelaria expansion project resulting in a decrease of capitalized interest costs. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 6. Miscellaneous Income and Expense, Net Miscellaneous income and expense, net for the years ended December 31 were as follows: * Asset impairment of equity basis investments in Cobre Colada ($1.8), PD Philippines ($3.1) and PD Yantai ($6.7). ** Dissolution of joint ventures between Phelps Dodge and Sumitomo Electric Industries, Ltd., at five wire and cable manufacturing and support companies. *** The exchange of shares of a cost basis investment in a wire and cable business located in Greece. 7. Income Taxes We use the asset and liability approach for accounting and reporting income taxes. Changes in tax rates and laws are reflected in income from operations in the period such changes are enacted. Balance sheet classification of deferred income taxes is determined by the balance sheet classification of the related asset or liability. Geographic sources of income (loss) before taxes, minority interests and equity in net earnings of affiliated companies for the years ended December 31 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The provision (benefit) for income taxes for the years ended December 31 were as follows: A reconciliation of the U.S. statutory tax rate to our effective tax rate was as follows: We paid federal, state, local and foreign income taxes of approximately $31 million in 1999, compared with approximately $77 million in 1998 and $173 million in 1997. At December 31, 1999, we had alternative minimum tax credits of approximately $236 million available for carryforward for federal income tax purposes. These credits can be carried forward indefinitely, but may only be used to the extent the regular tax exceeds the alternative minimum tax in any given year. The Company has alternative minimum foreign tax credit carryforwards for federal income tax purposes of approximately $31 million, of which approximately $5 million will expire in 2000 if not used. The Company has U.S. net operating loss carryforwards for regular tax purposes of $384 million expiring from 2000 to 2014, and Chilean net operating loss carryforwards of $488 million that do not expire. The U.S. losses include $148 million of Cyprus Amax Separate Return Limitation Year net operating losses and $236 million of Cyprus Amax U.S. net operating loss carryforwards that are subject to annual limitations after the acquisition because of the U.S. Internal Revenue Code Section 382 change in ownership rules. The annual limitation on the use of these losses is approximately $98 million. The Company also has alternative minimum tax net operating loss carryforwards of approximately $206 million which expire in 2019. A valuation allowance of $138 million has been recorded against all of these benefits. In December 1999, we received and accepted Notices of Tax Due for the years 1992 and 1993 from the Internal Revenue Service (IRS). The IRS audit of the year 1994 resulted in a refund. Issues settled for the years 1992 through 1994 also impacted the years 1990 and 1991 and enabled us to enter a closing agreement with the IRS for the years 1990 and 1991. We are currently awaiting receipt of an executed copy of the closing NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) agreement from the IRS. As a result of these settlements, we recorded a $30 million reduction in our tax liabilities. The Phelps Dodge federal income tax returns for the years 1995 through 1997 are currently under examination by the IRS. The Cyprus Amax federal income tax returns for the years 1994 through 1996 are also currently under examination by the IRS. The IRS has raised a number of issues in the current examinations that may result in proposed additional assessments of income tax at the conclusion of the current examinations. Our management believes that it has made adequate provision so that final resolution of the issues involved, including application of those determinations to subsequent open years, will not have an adverse effect on our consolidated financial condition or results of operations. Deferred income tax assets (liabilities) comprised the following at December 31: Income taxes have not been provided on our share ($571 million) of undistributed earnings of international manufacturing and mining interests abroad over which we have sufficient influence to control the distribution of such earnings and have determined that such earnings have been reinvested indefinitely. These earnings could become subject to additional tax if they were remitted as dividends, if foreign earnings were lent to any of our U.S. entities, or if we sell our stock in the subsidiaries. It is estimated that repatriation of these foreign earnings would generate additional foreign tax withholdings and U.S. tax, net of foreign tax credits, in the amounts of $83 million and $61 million, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 8. Inventories and Supplies Inventories at December 31 were as follows: Inventories valued by the last-in, first-out method would have been greater if valued at current costs by approximately $82 million and $110 million at December 31, 1999 and 1998, respectively. Supplies in the amount of $149.0 million and $110.9 million at December 31, 1999 and 1998, respectively, are stated net of a reserve for obsolescence of $8.4 million and $6.7 million, respectively. 9. Property, Plant and Equipment Property, plant and equipment at December 31 comprised the following: 10. Other Assets and Deferred Charges Other assets and deferred charges at December 31 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 11. Accounts Payable and Accrued Expenses Accounts payable and accrued expenses at December 31 were as follows: * Short-term portion of these reserves. Please refer to Note 12, Other Liabilities and Deferred Credits, for further discussion. ** Please refer to Note 3, Non-recurring Charges and Provisions, for further discussion of this reserve. *** Interest paid by the Company in 1999 was $121.0 million, compared with $94.9 million in 1998 and $72.6 million in 1997. 12. Other Liabilities and Deferred Credits Other liabilities and deferred credits at December 31 were as follows: * Please refer to Note 17, Postretirement and Other Employee Benefits Other Than Pensions, for further discussion. ** Environmental reserves increased $170.0 million, primarily due to the acquired Cyprus Amax reserves of $213.6 million, partially offset by the reclassification of $27.7 million to current liability. *** Closure and restructuring includes $112.8 million in closure reserves from the Cyprus Amax acquisition. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 13. Long-Term Debt and Other Financing Long-term debt at December 31 is summarized below: Annual maturities of debt outstanding at December 31, 1999, are as follows: 2000 - $131.3; 2001 - $205.2; 2002 - $365.4; 2003 - $138.4; 2004 - $234.4. An existing revolving credit agreement between the Company and several lenders was amended on June 25, 1997. The agreement, as amended and restated, permits borrowings of up to $1 billion from time to time until its scheduled maturity on June 25, 2002. The agreement allows for two, one-year renewals beyond the scheduled maturity date if we request and receive approval from those lenders representing at least two-thirds of the commitments provided by the facility. In the event of such approval, total commitments under the facility would depend upon the willingness of other lenders to assume the commitments of those lenders electing not to participate in the renewal. Interest is payable at a fluctuating rate based on the agent bank’s prime rate or at a fixed rate, based on the London Interbank Offered Rate (LIBOR) or at fixed rates offered independently by the several lenders, for maturities of between seven and 360 days. This agreement provides for a facility fee of six and one-half basis points (0.065 percent) on total commitments. The agreement requires us to maintain a minimum consolidated tangible net worth of $1.1 billion and limits indebtedness to 50 percent of total consolidated capitalization. There were no borrowings under this agreement at either December 31, 1999, or December 31, 1998. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) We established a commercial paper program on August 15, 1997, under a private placement agency agreement between us and two placement agents. The agreement permits us to issue up to $1 billion of short-term promissory notes (generally known as commercial paper) at any one time. Commercial paper may bear interest or be sold at a discount, as mutually agreed by us and the placement agents at the time of each issuance. Our commercial paper program requires that issuances of commercial paper be backed by an undrawn line of credit; the revolving credit agreement described above provides such support. Borrowings under this commercial paper program were $349.4 million at December 31, 1999. There were no borrowings under the commercial paper program at December 31, 1998. Short-term borrowings, excluding borrowings under our corporate commercial paper program, were $101.8 million, all by our international operations, at December 31, 1999, compared with $116.1 million at December 31, 1998. The decrease was primarily due to repayments of outstanding borrowings by our wholly owned subsidiary in Brazil. The weighted average interest rate on total short-term borrowings at December 31, 1999, and December 31, 1998, was 7.8 percent and 24.4 percent, respectively. In order to fund the cash portion of the Cyprus Amax acquisition price, we borrowed $650 million from a U.S. bank on October 21, 1999, under a one-month bridge financing facility. Interest and costs of $3.2 million (or 6.0075 percent annualized) were paid in November with cash acquired through the merger. As of December 31, 1999, our 80 percent-owned joint-venture Candelaria mining operation in Chile, had outstanding project financing of $269.8 million. The debt comprises $237.0 million of floating-rate, dollar-denominated debt and $32.8 million of fixed-rate, dollar-denominated debt. The debt and repayments are scheduled to vary from period to period with all debt maturing by the year 2008. Candelaria did not borrow funds in 1999. All floating rate debt is tied to six-month LIBOR, but has been converted to 7.84 percent, fixed-rate debt with the use of interest rate swap agreements. The debt obligations and the interest rate swaps are non-recourse to us. Under the proportional consolidation method, the debt amounts listed above represent our 80 percent share. In October 1999, as part of the acquisition of Cyprus Amax, the Company assumed long-term debt with a stated value of $1,595.6 million, which was reduced by $15.2 million to reflect the fair market value of these obligations at the acquisition date. The net discount will be amortized over the term of the notes, debentures and bonds and recorded as interest expense. Following is a brief description of the debt assumed in the merger: Immediately after the acquisition, a $100 million term loan facility scheduled to mature in 2001 was retired with available cash. The 10.125 percent Notes, due in 2002, bear interest payable semi-annually on April 1 and October 1. In the event of both a Designated Event and a Rating Decline (as defined in the agreement), each holder of a note may require the Company to redeem the holder’s notes, in whole or in part, at 100 percent of the principal amount plus accrued interest to the date of redemption. The 9.875 percent Notes, due June 13, 2001, are not redeemable prior to maturity and are secured by certain principal property of the Company. The interest is paid semi-annually on June 13 and December 13. The 8.375 percent Debentures, due in 2023, bear interest payable semi-annually on February 1 and August 1. The debentures are not redeemable prior to February 1, 2003. On or after that date, at the option of the Company, the debentures may be redeemed in whole or in part at 103.73 percent of the principal amount, together with any accrued and unpaid interest, declining at the rate of 0.375 percent per year to February 1, 2013, and at 100 percent thereafter. The debentures are general unsecured obligations of the Company and rank senior in right of payment to all subordinated securities. The 7.375 percent Notes, due May 15, 2007, bear interest payable semi-annually on May 15 and November 15. The notes are not redeemable by the Company prior to maturity. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The 6.5625 percent Notes, due October 15, 2005, bear interest payable semi-annually on October 15 and April 15. The notes are not redeemable by the Company prior to maturity. On December 31, 1999, our 51 percent-owned El Abra mining joint venture had outstanding financing composed of senior debt consisting of $850 million in project financing provided by a syndicate of banks and $150 million of original financing provided by a German financial institution. The Company currently has guarantees outstanding of $157.9 million of the original $850 million tranche. Cyprus Amax’s proportional share of the original $1 billion borrowings was $510 million, of which $402.6 million remains outstanding at year-end 1999. The debt has a 9.5 year term, due May 15, 2007, and requires semi-annual principal payments that began on May 15, 1998. The weighted average interest rate on this debt at December 31, 1999, was 6.6 percent. The loan agreement specifies certain restrictions on additional borrowings by El Abra and on dividend and subordinated debt payments. Under the proportional consolidation method, the debt amounts listed above represent our 51 percent share. On December 31, 1999, our 82 percent-owned Cerro Verde mine, had project financing composed of two tranches, an $80 million facility that requires semi-annual installments of varying amounts through April 1, 2005, and a $30 million revolving bullet loan currently due in the year 2003. There was $90.0 million outstanding under these facilities at year-end 1999. The bullet facility may be extended for one year on each anniversary. The weighted average interest rate on this debt at December 31, 1999, was 9.6 percent. Both financings are secured by proceeds from sales collections, plus a pledge of $45 million in assets on the bullet loan. The various pollution control and industrial development revenue bonds are due from 2001 through 2009. The interest on the bonds is paid either quarterly or semi-annually at various times of the year. The weighted average interest rates on these bonds at December 31, 1999, ranged from 3.9 percent to 13.9 percent. In September 1999, Cyprus Amax obtained a $34 million bank loan for the Cerro Verde copper mine in Peru of which $23 million was outstanding at December 31, 1999. The loan is payable on September 30, 2004. The weighted average interest rate at December 31, 1999, was 10.5 percent. 14. Shareholders’ Equity During the 1999 fourth quarter, we issued 20.6 million common shares along with a cash payment to acquire Cyprus Amax. On May 7, 1997, we announced that our board of directors had authorized the purchase of up to 6 million of our common shares, approximately 10 percent of our then outstanding shares. As of December 31, 1999, there were 78,656,000 shares outstanding and 1.7 million shares authorized for purchase under the 1997 authorization. During 1998, we purchased 731,500 common shares under the 1997 authorization at a total cost of $35.4 million. We have 6,000,000 authorized preferred shares with a par value of $1.00 each; no shares were outstanding at either December 31, 1999, or December 31, 1998. We have in place a Preferred Share Purchase Rights Plan that contains provisions to protect stockholders in the event of unsolicited offers or attempts to acquire Phelps Dodge, including acquisitions in the open market of shares constituting control without offering fair value to all stockholders and other coercive or unfair takeover tactics that could impair the board of directors’ ability to represent the stockholders’ interests fully. 15. Stock Option Plans; Restricted Stock Executives and other key employees have been granted options to purchase common shares under stock option plans adopted in 1987, 1993 and 1998. The option price equals the fair market value of the common shares on the day of the grant and an option’s maximum term is 10 years. Options granted vest ratably over a three-year period. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) If an optionee exercises an option under the 1987, 1993 or 1998 plan with already owned shares of the Company, the optionee receives a “reload” option that restores the option opportunity on a number of common shares equal to the number of shares used to exercise the original option. A reload option has the same terms as the original option except that it has an exercise price per share equal to the fair market value of a common share on the date the reload option is granted and is exercisable six months after the date of grant. The 1998 plan provides (and the 1993 and 1987 plan provided) for the issuance to executives and other key employees, without any payment by them, of common shares subject to certain restrictions (Restricted Stock). There were 281,850 shares of Restricted Stock outstanding at December 31, 1999, and 1,040,258 shares available for grant. Under the 1989 Directors Stock Option Plan (the 1989 plan), options to purchase common shares have been granted to directors who have not been employees of the Company or its subsidiaries for one year or are not eligible to participate in any plan of the Company or its subsidiaries entitling participants to acquire stock, stock options or stock appreciation rights. In 1996, we suspended the plan, thereby eliminating the annual grant of options to directors. The 1989 plan was replaced with the 1997 Directors Stock Unit Plan which provides to each non-employee director an annual grant of stock units having a value equivalent to our common shares. At December 31, 1999, 3,147,968 shares were available for option grants (including 1,040,258 shares as Restricted Stock awards) under the 1998 plan. These amounts are subject to future adjustment as described in the plan agreement. No further options may be granted under the 1993, 1989 or 1987 plans. During 1999, the Company awarded 97,400 shares of Restricted Stock under the 1998 plan, with a weighted-average fair value at the date of grant of $57.29 per share. Compensation expense related to this award was $5.6 million for 1999. In addition, former Cyprus Amax stock options were converted to 1,870,804 in Phelps Dodge options. These options retain the terms by which they were originally granted under the Cyprus Amax Management Incentive Program. These options carry a maximum term of 10 years and became fully vested upon the acquisition of Cyprus Amax. Exercise periods ranged up to eight years at acquisition. No further options may be granted under this plan. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Changes during 1997, 1998 and 1999 in options outstanding for the combined plans were as follows: * Exercise prices for options outstanding at December 31, 1999, range from a minimum of approximately $27 per share to a maximum of approximately $102 per share. The average remaining maximum term of options outstanding is approximately seven years. The following table summarizes information concerning options outstanding based on a range of exercise prices. Exercisable options at December 31, 1999: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Changes during 1997, 1998 and 1999 in Restricted Stock were as follows: In accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” we apply APB Opinion 25 and related interpretations in accounting for our stock option plans and, accordingly, do not recognize compensation cost. If we had elected to recognize compensation cost based on the fair value of the options granted at grant date as prescribed by SFAS No. 123, net income and earnings per share would have been reduced to the pro forma amounts indicated in the table below: The fair value of each option grant is estimated on the date of grant using a Black-Scholes option-pricing model with the following assumptions: The weighted-average fair value of options granted during 1999 was $12.18 per share, compared with $10.84 in 1998 and $10.62 in 1997. 16. Pension Plans Our pension plans cover substantially all of our U.S. employees and certain employees of our international subsidiaries. Benefits are based on years of service and depending on the plan either final average salary or a fixed amount for each year of service. Participants generally vest in their benefits after five years of service. In a number of these plans, the plan assets exceed the accumulated benefit obligations (overfunded plans) and in the remainder of the plans, the accumulated benefit obligations exceed the plan assets (underfunded plans). For the underfunded plans, the aggregate benefit obligation is $52 million and the aggregate fair value of plan assets is $4 million. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following table presents the benefit obligation, changes in plan assets, the funded status of the pension plans and the assumptions used: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Our pension plans were valued between December 1, 1997, and January 1, 1998, and between December 1, 1998, and January 1, 1999. The obligations were projected to and the assets were valued as of the end of 1998 and 1999. Effective October 16, 1999, nine qualified and two non-qualified pension plans were obtained in conjunction with the acquisition of Cyprus Amax Minerals Company. The majority of plan assets are invested in a diversified portfolio of stocks, bonds and cash or cash equivalents. A small portion of the plan assets is invested in pooled real estate and other private corporate investment funds. The assumptions used and the annual cost related to these plans consist of the following: We recognize a minimum liability in our financial statements for our underfunded pension plans. The accrued pension benefit cost for the underfunded plans is $44 million while the minimum liability is $51 million. “Other Liabilities and Deferred Credits” at December 31, 1999, included $7 million relating to this minimum liability, compared with $13 million at December 31, 1998. This amount was offset by a $2 million intangible asset, a $3 million reduction in “Common Shareholders’ Equity” and a $2 million deferred tax benefit at December 31, 1999, compared with a $4 million intangible asset, a $6 million reduction in “Common Shareholders’ Equity” and a $3 million deferred tax benefit at December 31, 1998. 17. Postretirement and Other Employee Benefits Other Than Pensions We record obligations for postretirement medical and life insurance benefits on the accrual basis. One of the principal requirements of the method is that the expected cost of providing such postretirement benefits be accrued during the years employees render the necessary service. Our postretirement plans provide medical insurance benefits for many employees retiring from active service. The coverage is provided on a noncontributory basis for certain groups of employees and on a contributory basis for other groups. The majority of these benefits are paid by the Company. We also provide life insurance benefits to our U.S. employees who retire from active service on or after normal retirement age of 65 and to some of our international employees. Life insurance benefits also are available under certain early retirement programs or pursuant to the terms of certain collective bargaining agreements. The majority of the costs of such benefits were paid out of a previously established fund maintained by an insurance company. The following table presents the change in benefit obligation, change in plan assets and the funded status of the other postretirement benefit plans and the assumptions used: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The components of net periodic postretirement benefit cost were as follows: For 1999 measurement purposes, the annual rate of increase in the cost of covered health care benefits was assumed to average 11.0 percent for 2000 and is projected to decrease to 5.5 percent by 2008 and remain at that level. For 1998 measurement purposes, the annual rate of increase in the cost of covered health care benefits was assumed to average 6.9 percent for 1999 and was projected to decrease to 5.0 percent by 2008 and remain at that level. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A 1 percentage-point change in assumed health care cost trend rates assumed for postretirement benefits would have the following effects: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) We also sponsor savings plans for the majority of our employees. The plans allow employees to contribute a portion of their pre-tax and/or after-tax income in accordance with specified guidelines. We match a percentage of the employee contributions up to certain limits. Our contributions amounted to $5.3 million in 1999, $5.0 million in 1998, and $5.4 million in 1997. 18. Commitments Phelps Dodge leases mineral interests and various other types of properties, including shovels, offices, and miscellaneous equipment. Certain of the mineral leases require minimum annual royalty payments, and others provide for royalties based on production. Summarized below as of December 31, 1999, are future minimum rentals and royalties under non-cancelable leases: Summarized below as of December 31, 1999, is future sub-lease income: Rent and royalty charged to expense were: 19. Contingencies Phelps Dodge or its subsidiaries have been advised by the EPA, United States Forest Service and several state agencies that they may be liable under CERCLA or similar state laws and regulations for costs of responding to environmental conditions at a number of sites that have been or are being investigated by the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) EPA, the Forest Service or states to establish whether releases of hazardous substances have occurred and, if so, to develop and implement remedial actions. Phelps Dodge has been named a “potentially responsible party” (PRP) or has received requests for information for several sites. Of the sites in which Phelps Dodge or its subsidiaries have been named a PRP, 19 are on the “National Priorities List” (NPL) and two have been proposed for listing. For all such sites, Phelps Dodge had an aggregate reserve of $208.7 million as of December 31, 1999, including reserves for Pinal Creek in Arizona, and Langeloth in Pennsylvania, for its share of the estimated liability. Liability estimates are based on an evaluation of among other factors, currently available facts, existing technology, presently enacted laws and regulations, Phelps Dodge’s experience in remediation, other companies’ remediation experience, Phelps Dodge’s status as a PRP, and the ability of other PRPs to pay their allocated portions. The cost range for reasonably expected outcomes for all sites excluding Pinal Creek and Langeloth is estimated to be from $28 million to $110 million, and work on these sites is expected to be substantially completed in the next several years, subject to inherent delays involved in the process. The sites for which Phelps Dodge has received a notice of potential liability or an information request that are currently considered to be the most significant are the Pinal Creek site, which has a cost range for reasonably expected outcomes estimated to be from $143 million to $250 million, and the former American Zinc and Chemical site in Langeloth, which has a cost range for reasonably expected outcomes estimated to be from $10 million to $67 million. Phelps Dodge has reserved $143 million for the Pinal Creek site. Cyprus Amax received an information request from the Pennsylvania Department of Environmental Protection regarding the former American Zinc and Chemical site. The site is currently being investigated by the state of Pennsylvania. Phelps Dodge has reserved $20 million for this site. Phelps Dodge believes certain insurance policies partially cover the foregoing environmental liabilities; however, some of the insurance carriers have denied coverage. We are presently litigating these disputes. Further, Phelps Dodge believes that it has other potential claims for recovery from other third parties, including the U.S. Government and other PRPs, as well as liability offsets through lower cost remedial solutions. Neither insurance recoveries nor other claims or offsets have been recognized in the financial statements unless such offsets are considered probable of realization. As of December 31, 1998, we had a reserve balance of $106.0 million for estimated future costs associated with environmental matters at shutdown operations or closed facilities within active operations. During 1999, net spending against that reserve totaled $20.0 million including $2.8 million at Cyprus Amax between October 16 and December 31. During the second quarter of 1999, we recorded an additional $8.3 million provision for estimated future costs associated with environmental matters directly related to our restructuring plan announced on June 30, 1999. Additionally, we recorded a $28.2 million provision in the fourth quarter of 1999 for estimated future costs associated with environmental matters. The acquisition of Cyprus Amax increased our reserve by $213.6 million. As of December 31, 1999, the reserve balance was $336.1 million. In 1993 and 1994, the New Mexico and Arizona legislatures, respectively, passed laws requiring the reclamation of mined lands in those states. The New Mexico Mining Commission adopted rules for the New Mexico program during 1994, and our operations began submitting the required permit applications in December 1994. The Arizona State Mine Inspector adopted rules for the Arizona program in January 1997, and our operations began submitting the required reclamation plans in 1997. Colorado also has a similar program. Reclamation is an ongoing activity and we recognize estimated reclamation costs using a units of production basis calculation. These laws and regulations will likely increase our regulatory obligations and compliance costs with respect to mine closure and reclamation. In 1997, issues of dispute arose between Phelps Dodge and the San Carlos Apache Tribe regarding our use and occupancy of the Black River Pump Station which delivers water to the Morenci operation. On May 12, 1997, the Tribe filed suit against us in San Carlos Apache Court, seeking our eviction from the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Tribe’s Reservation and claiming substantial compensatory and punitive damages, among other relief. In May 1997, we reached an agreement with the Tribe, and subsequently federal legislation (Pub. L. No. 105-18, 5003, 111 stat. 158, 181-87) was adopted which mandated dismissal of the tribal court suit. The legislation prescribes arrangements intended to ensure a future supply of water for the Morenci mining complex in exchange for certain payments by us. The legislation does not address any potential claims by the Tribe relating to our historical occupancy and operation of our facilities on the Tribe’s Reservation, but does require that any such claims be brought, if at all, exclusively in federal district court. By order dated October 13, 1997, the tribal court dismissed the lawsuit with prejudice, as contemplated by the legislation. The 1997 legislation required that the Company and the Tribe enter a lease for the delivery of Central Arizona Project water through the Black River Pump Station to Morenci on or before December 31, 1998. In the event a lease was not signed, the legislation expressly provided that the legislation would become the lease. The legislation included the principal terms for that eventuality. To date, we have not entered into a lease with the Tribe, but are relying on our rights under the legislation and are prepared to enforce those rights if necessary. We are cooperating with the United States, which operates the pump station, to reach an agreement with the Tribe on the lease issue. 20. Derivative Financial Instruments Held for Purposes Other Than Trading and Fair Value of Financial Instruments We do not purchase, hold or sell derivative contracts unless we have an existing asset, obligation or anticipate a future activity that is likely to occur and will result in exposing us to market risk. We will use various strategies to manage our market risk, including the use of derivative contracts to limit, offset or reduce our market exposure. Derivative instruments are used to manage well-defined commodity price, foreign exchange and interest rate risks from our primary business activities. The fair values of our derivative instruments, as summarized later in this note, are based on quoted market prices for similar instruments and on market closing prices at year end. A summary of the derivative instruments we hold is listed as follows: Copper Hedging Copper is an internationally traded commodity, and its prices are effectively determined by the two major metals exchanges - the New York Commodity Exchange (COMEX) and the London Metal Exchange (LME). The prices on these exchanges generally reflect the worldwide balance of copper supply and demand, but also are influenced significantly from time to time by speculative actions and by currency exchange rates. Some of our wire, cathode and rod customers request a fixed sales price instead of the COMEX or LME average price in the month of shipment or receipt. As a convenience to these customers, we enter into copper swap and futures contracts to hedge the sales in a manner that will allow us to receive the COMEX or LME average price in the month of shipment or receipt while our customers receive the fixed price they requested. We accomplish this by liquidating the copper futures contracts and settling the copper swap contracts during the month of shipment or receipt, which generally results in the realization of the COMEX or LME average price. Because of the nature of the hedge settlement process, the net hedge value, rather than the sum of the face values of our outstanding futures contracts is a more accurate measure of our market risk from the use of such hedge contracts. The contracts that may result in market risk to us are those related to the customer sales transactions under which copper products have not yet been shipped. At December 31, 1999, we had futures and swap contracts for approximately 111 million pounds of copper with a net hedge value of $87 million and a total face value of approximately $125 million. At that date, we had $7 million in gains on these contracts not yet recorded in our financial statements because the copper products under the related customer transactions had not yet been shipped or received. These futures contracts had maturities of 30 months or less. At year-end 1998, we had futures and swap contracts in place NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) for approximately 86 million pounds of copper at a net hedge value of $65 million and a total face value of approximately $138 million. We had $7 million in deferred, unrealized losses at that time. From time to time, we may purchase or sell copper price protection contracts for a portion of our expected future mine production. We do this to limit the effects of potential decreases in copper selling prices. For first quarter 2000 production, we have protection contracts in place that will give us a minimum monthly average LME price of 71 cents per pound for approximately 200 million pounds of copper cathode. For overall 2000 production, we have a combination of minimum (approximately 72 cents) and maximum (approximately 95 cents) annual average LME prices per pound for approximately 110 million pounds of copper cathode. Aluminum Hedging During 1999, our Venezuelan wire and cable operation entered into aluminum futures contracts with a financial institution to lock in the cost of aluminum ingot needed in manufacturing aluminum cable contracted by customers. At December 31, 1999, we had futures contracts for approximately 1 million pounds of aluminum with a net hedge and total face value of approximately $1 million. At the end of the year, these contracts did not have any significant gains or losses that were not recorded in our financial statements. The maturities on these aluminum futures contracts were less than one year. At December 31, 1998, we had futures contracts for approximately 6 million pounds of aluminum with a net hedge and total face value of approximately $4 million. Prior to 1998, we had not entered into aluminum futures contracts. Foreign Currency Hedging We are a global company and we transact business in many countries and in many currencies. Foreign currency transactions increase our risks because exchange rates can change between the time agreements are made and the time foreign currencies are actually exchanged. One of the ways we manage these exposures is by entering into forward exchange and currency option contracts in the same currency as the transaction to lock in or minimize the effects of changes in exchange rates. With regard to foreign currency transactions, we may hedge or protect transactions for which we have a firm legal obligation or when anticipated transactions are likely to occur. We do not enter into foreign exchange contracts for speculative purposes. In the process of protecting our transactions, we may use a number of offsetting currency contracts. Because of the nature of the hedge settlement process, the net hedge value rather than the sum of the face value of our outstanding contracts is a more accurate measure of our market risk from the use of such contracts. At December 31, 1999, we had a net hedge and total face value of approximately $34 million in forward exchange contracts to hedge intercompany loans between our international subsidiaries or foreign currency exposures with our trading partners. The forward exchange contracts on December 31, 1999, had maturities of less than one year. At year-end 1998, we had foreign currency protection in place for $44 million to hedge intercompany loans. At year-end 1997, we had $158 million in both the net hedged amount and the total face value of the forward contracts. We did not have any significant gains or losses at year end that had not been recorded in our financial statements for each of the three years in the period ended December 31, 1999. At year-end 1999, our foreign currency protection contracts included the British pound, euro, German mark and Thai baht. Interest Rate Hedging In some situations, we may enter into structured transactions using currency swaps that result in lower overall interest rates on borrowings. We do not enter into currency swap contracts for speculative purposes. At year-end 1999, we had currency swap contracts in place with an approximate net hedged value and total face value of $21 million. These currency swaps involved swapping fixed-rate U.S. dollar loans into floating-rate Brazilian real loans. The currency swap contracts on this date had maturities of less than a year. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) In addition, we are vulnerable to increasing costs from interest rates associated with floating-rate debt. We may enter into interest rate swap contracts to manage or limit such interest expense costs. We do not enter into interest rate swap contracts for speculative purposes. At year-end 1999, we had interest rate swap contracts in place with an approximate net hedged and total face value of $485 million. The interest rate swap on this date had maturities of nine years or less. At year-end 1998, our Candelaria copper mine had interest rate swaps to convert $264.9 million of floating-rate, dollar-denominated debt into fixed-rate debt for the life of the debt (through the year 2008). Under the terms of the floating-rate debt agreement, the Candelaria borrowings are scheduled to vary from period to period during the life of the debt. In order to match the projected changes in debt balances, the face value of the interest rate swaps approximate the amounts of the underlying debt. Credit Risk We are exposed to credit loss in cases when the financial institutions in which we have entered into derivative transactions (commodity, foreign exchange and currency/ interest rate swaps) are unable to pay us when they owe us funds as a result of our protection agreements with them. To minimize the risk of such losses, we only use highly rated financial institutions that meet certain requirements. We also periodically review the credit worthiness of these institutions to ensure that they are maintaining their ratings. We do not anticipate that any of the financial institutions that we have dealt with will default on their obligations. The methods and assumptions we used to estimate the fair value of each group of financial instrument for which we can reasonably determine a value are as follows: Cash and cash equivalents - the financial statement amount is a reasonable estimate of the fair value because of the short maturity of those instruments. Investments and long-term receivables - the fair values of some investments are estimated based on quoted market prices for those or similar investments. The fair values of other types of instruments are estimated by discounting the future cash flows using the current rates at which similar instruments would be made with similar credit ratings and maturities. Long-term debt - the fair value of substantially all of our long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current notes offered to us for debt with similar remaining maturities. Derivative hedge instruments - the fair values of some derivative instruments are estimated based on quoted market prices and on calculations using market closing prices for those or similar instruments. Financial guarantees and standby letters of credit - the fair value of guarantees and letters of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle our obligations with the holders of the guarantees or letters of credit at year-end 1999. As a whole, we have various guarantees and letters of credit totaling $248 million. There is no market for our guarantees or standby letters of credit. Therefore, it is not practicable to establish their fair value. The estimated fair values of our financial instruments as of December 31, 1999, were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) * Our largest cost basis investment is our minority interest in Southern Peru Copper Corporation (SPCC), which is carried at a book value of $13.2 million. Based on the New York Stock Exchange closing market price of SPCC shares as of December 31, 1999, the estimated fair value of our investment in SPCC is approximately $173 million. Our ownership interest in SPCC is represented by our share of a class of SPCC common stock that is currently not registered for trading on any public exchange. 21. Business Segment Data Our business consists of two divisions, Phelps Dodge Mining Company and Phelps Dodge Industries. The principal activities of each division are described below, and the accompanying tables present results of operations and other financial information by significant geographic area and by segment. Phelps Dodge Mining Company (PD Mining) is our international business segment that comprises a group of companies involved in vertically integrated copper operations including mining, concentrating, electrowinning, smelting, refining, rod production, marketing and sales, and related activities. PD Mining sells copper to others primarily as rod, cathode or concentrate, and as rod to our wire and cable segment. In addition, PD Mining at times smelts and refines copper and produces copper rod for customers on a toll basis. It is also an integrated producer of molybdenum, with mining, roasting and processing facilities producing molybdenum concentrate as well as metallurgical and chemical products. In addition, it produces gold, silver, molybdenum and copper chemicals as by-products, and sulfuric acid from its air quality control facilities. This business segment also includes worldwide mineral exploration programs. Phelps Dodge Industries is our manufacturing division comprising two business segments that produce engineered products principally for the global energy, telecommunications, transportation and specialty chemicals sectors. The two business segments are specialty chemicals which comprises Columbian Chemicals Company and its subsidiaries, and wire and cable which comprises three worldwide product line businesses and a shared support services operation. The three product line businesses in the wire and cable segment are magnet wire, energy and telecommunications cables, and specialty conductors. Phelps Dodge Industries also included Accuride Corporation and its subsidiaries, our wheel and rim operations, until Accuride was sold effective January 1, 1998. Intersegment sales reflect the transfer of copper from Phelps Dodge Mining Company to Phelps Dodge Industries at the same prices charged to outside customers. The following tables give a summary of financial data by geographic area and business segment for the years 1997 through 1999. Major unusual items during the three-year period included (i) the fourth quarter 1999 acquisition of Cyprus Amax; pre-tax asset impairments of $320.4 million at Phelps Dodge Mining Company and $21.7 million at Phelps Dodge Industries; a pre-tax charge of $28.2 million for environmental provisions at Phelps Dodge Mining Company; a pre-tax charge of $36.6 million at Phelps Dodge Mining Company and $59.9 million at Phelps Dodge Industries for a restructuring plan announced on June 30, 1999; (ii) a 1998 pre-tax provision of $5.5 million at Phelps Dodge Mining Company for costs associated with indefinite mine shutdowns and curtailments; a $2.3 million pre-tax provision in our wire and cable segment, primarily for an early retirement program; and a $198.7 million pre-tax gain in other segments from the disposition of Accuride; and (iii) a 1997 pre-tax provision of $40.5 million included at Phelps Dodge Mining Company for costs associated with a voluntary early retirement program, environmental matters and other; and a 1997 pre-tax provision of $5.4 million included in Corporate, Unallocated and Reconciling Eliminations and operating income for costs associated with environmental matters and a voluntary early retirement NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) program. (See Notes 2 and 3 to the Consolidated Financial Statements for a further discussion of these issues.) Financial Data by Geographic Area NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Financial Data by Business Segment NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) * Other segments include Accuride Corporation which was sold effective January 1, 1998. (See Note 3 to the Consolidated Financial Statements for a further discussion of this sale.) ** Represents corporate, unallocated and reconciling elimination activities and assets. PART III Items 10, 11, 12 and 13. The information called for by Part III (Items 10, 11, 12 and 13) is incorporated herein by reference from the material included under the captions “Election of Directors,” “Beneficial Ownership of Securities,” “Executive Compensation” and “Other Matters” in Phelps Dodge Corporation’s definitive proxy statement (to be filed pursuant to Regulation 14A) for its Annual Meeting of Shareholders to be held May 3, 2000 (the 2000 Proxy Statement), except that the information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I of this report. The 2000 Proxy Statement is being prepared and will be filed with the Securities and Exchange Commission and furnished to shareholders on or about April 1, 2000. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K. (b) Reports on Form 8-K: The Corporation filed 6 reports on Form 8-K during the quarter ended December 31, 1999. The following is a list of the filings and the date they were filed. Phelps Dodge filed a Current Report on Form 8-K on October 6, 1999, with respect to an Agreement and Plan of Merger among Phelps Dodge Corporation, AAV Corporation and Asarco Incorporated dated October 5, 1999. Phelps Dodge filed a Current Report on Form 8-K on October 8, 1999, with respect to a press release issued on October 8, 1999, stating that it could not raise its offer for Asarco Incorporated. Phelps Dodge filed a Current Report on Form 8-K on October 13, 1999, with respect to a press release issued on October 13, 1999, stating that its shareholders approved the issuance of shares for Cyprus Amax Minerals Company and Asarco Incorporated. The press release also stated that Phelps Dodge expected completion of the Cyprus Amax exchange offer and that it will not increase its offer for Asarco Incorporated. Phelps Dodge filed a Current Report on Form 8-K on October 22, 1999, stating that it had completed its exchange offer for Cyprus Amax Minerals Company. Phelps Dodge filed a Current Report on Form 8-K on December 2, 1999, with respect to a press release issued on December 2, 1999, that Phelps Dodge Corporation had completed the acquisition of Cyprus Amax Minerals Company. Phelps Dodge filed a Current Report on Form 8-K on December 30, 1999, for an amendment filed to provide unaudited pro forma combined financial information for the merger among Phelps Dodge Corporation, CAV Corporation and Cyprus Amax Minerals Company. Schedule II PHELPS DODGE CORPORATION AND CONSOLIDATED SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PHELPS DODGE CORPORATION (Registrant) By: RAMIRO G. PERU Ramiro G. Peru Senior Vice President and Chief Financial Officer March 20, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. J. STEVEN WHISLER J. Steven Whisler President, Chief Executive Officer and Director (Principal Executive Officer) March 20, 2000 RAMIRO G. PERU Ramiro G. Peru Senior Vice President and Chief Financial Officer (Principal Financial Officer) March 20, 2000 STANTON K. RIDEOUT Stanton K. Rideout Vice President and Controller (Principal Accounting Officer) March 20, 2000 Douglas C. Yearley (Chairman of the Board), Robert N. Burt, Archie W. Dunham, William A. Franke, Paul Hazen, Manuel J. Iraola, Marie L. Knowles, Robert D. Krebs, Southwood J. Morcott, Gordon R. Parker, Directors March 20, 2000 By: RAMIRO G. PERU Ramiro G. Peru Attorney-in-fact EXHIBIT INDEX

799167_1999.html

799167_1999

1999

799167

ITEM 1. BUSINESS (a) General Development of Business. Marten Transport, Ltd. is a long-haul truckload carrier providing protective service and time- sensitive transportation. "Protective service transportation" means temperature controlled or insulated carriage of temperature-sensitive materials and general commodities. We have operating authority, both contract and common, granted by the Interstate Commerce Commission ("ICC") and are currently regulated by the United States Department of Transportation ("DOT") and the Federal Highway Administration ("FHWA"). As of December 31, 1999, we operated a fleet of 1,633 tractors and 2,305 trailers. Most of our trailers are protective service trailers. As of December 31, 1999, 1,084 tractors and 2,303 trailers in our fleet were company-owned and 549 tractors and 2 trailers were under contract with independent contractors. As of December 31, 1999, we had 1,492 employees, including 1,178 drivers. Our employees are not represented by a collective bargaining unit. Organized under Wisconsin law in 1970, we are a successor to a sole proprietorship Roger R. Marten founded in 1946. In 1988, we reincorporated under Delaware law. Our executive offices are located at 129 Marten Street, Mondovi, Wisconsin 54755. Our telephone number is (715) 926-4216. (b) Financial Information About Segments. Since our inception, substantially all of our revenue, operating profits and assets have related primarily to one business segment-long-haul truckload carriage providing protective service and time-sensitive transportation. (c) Narrative Description of Business. We specialize in protective service transportation of foods and other products requiring temperature-controlled carriage or insulated carriage. We also provide dry freight carriage. In 1999, we earned approximately 78% of our revenue from hauling protective service products and 22% of our revenue from hauling dry freight. Most of our dry freight loads require the special services we offer or allow us to position our equipment for hauling protective service loads. The specialized transportation services we offer include: •dependable, late-model tractors allowing timely deliveries; •late-model, temperature controlled trailers; •scheduled pickups and deliveries; •assistance in loading and unloading; •availability of extra trailers placed for customers' convenience; •sufficient equipment to respond promptly to customers' varying needs; and •an on-line computer system, which is used to obtain information on the status of deliveries. Marketing and Customers Our senior management and marketing personnel seek customers whose products require protective or other specialized services and who ship multiple truckloads per week. To minimize empty miles, we also solicit customers whose shipping requirements allow us to balance the number of loads originating and terminating in any given area. Our marketing strategy emphasizes service. A key element of this strategy is our strong commitment to satisfying the individualized requirements of our customers. In addition, we have developed an electronic data interchange ("EDI") system. We use this system to provide customers with current information on the status of shipments in transit. Customers also place orders, and we bill customers, electronically using this system. We also use a satellite tracking system to enhance monitoring of shipment locations. We maintain marketing offices in our Mondovi, Wisconsin headquarters, as well as in other locations throughout the United States. Marketing personnel travel in their regions to solicit new customers and maintain contact with customers. Once we establish a customer relationship, the customer's primary contact is one of our customer service managers. Working from our terminal in Mondovi, the customer service managers regularly contact customers to solicit additional business on a load-by-load basis. Each customer service manager is assigned to particular customers and takes responsibility for monitoring overall transportation, service requirements and shipments for each customer. These efforts to coordinate shipper needs with equipment availability have been instrumental in maintaining an average empty mile rate of 6.6% in 1999. We set our own freight rates instead of using those published by tariff publishing bureaus. This allows us to offer rates that are more responsive to market conditions and the level of service required by particular customers. We have designed our rate structure to compensate us for the cost of protective service revenue equipment as well as for hauling loads into areas generating empty miles. We derived approximately 15% of our revenue in 1999 from The Procter & Gamble Company. The Pillsbury Company accounted for approximately 12% of our revenue in 1999, 11% of our revenue in 1998 and 13% of our revenue in 1997. Operations Our operations are designed to efficiently use our equipment while emphasizing individualized service to customers. Our EDI system provides real-time and on-line shipment tracking information, increases equipment utilization and assists management in long-range planning and trend analysis. In 1999, we implemented an optimization system which is designed to effectively meet the routing needs of drivers while satisfying customer and company requirements. We maintain our dispatch operations in our Mondovi, Wisconsin headquarters. We assign customer service managers to particular customers and regions. Customer service managers work closely with our fleet managers, marketing personnel and drivers. Customer service managers also coordinate with our marketing personnel to match customer needs with our capacity and location of revenue equipment. Fleet managers, who are assigned a group of drivers regardless of load destination, use our optimization system in dispatching loads. After dispatching a load, a fleet manager takes responsibility for its proper and efficient delivery and tracks the status of that load through daily contact with drivers. During these daily contacts, fleet managers and drivers discuss the driver's location, load temperature and any problems. We constantly update this information, along with information concerning available loads, on our EDI computer system. We use this computer-generated information to meet delivery schedules, respond to customer inquiries and match available equipment with loads. Our primary traffic lanes are between the Midwest and the following regions: West Coast, Pacific Northwest, Southwest, Southeast and the East Coast; and from California to the Pacific Northwest and the Midwest. The average length of a trip (one-way) was 1,069 miles during 1999, 1,081 miles during 1998 and 1,092 miles during 1997. Our loads generally move directly from origin to destination, which eliminates the need for freight terminals. We operate maintenance facilities in Mondovi, Wisconsin; Ontario, California; Forest Park, Georgia; and Wilsonville, Oregon. We have agreements with various fuel distributors which allow our drivers to purchase fuel at a discount while in transit. We also purchase fuel in bulk in Mondovi and at our maintenance facilities. Drivers As of December 31, 1999, we employed 1,178 drivers and had contracts with independent contractors for the services of 549 tractors. Independent contractors provide both a tractor and a qualified driver for our use. We recruit drivers from throughout the United States. The ratio of drivers to tractors as of December 31, 1999, was approximately 1 to 1. Our drivers are not represented by a collective bargaining unit. Our turnover of drivers and independent contractors was approximately 53% in 1999. Based on industry surveys, we believe our driver turnover rate is in line with the industry. We select drivers, including independent contractors, using our specific guidelines for safety records, driving experience and personal evaluations. We maintain stringent screening, training and testing procedures for our drivers to reduce the potential for accidents and the corresponding costs of insurance and claims. We train new drivers at our Wisconsin terminal in all phases of our policies and operations, as well as in safety techniques and fuel-efficient operation of the equipment. All new drivers must also pass DOT required tests prior to assignment to a vehicle. We maintain a toll-free number, satellite tracking and a staff of fleet managers to communicate and support drivers while on the road for extended periods. To retain qualified drivers and promote safe operations, we purchase premium quality tractors and equip them with optional comfort and safety features. These features include air ride suspension on the chassis and cab, air conditioning, high-quality interiors, power steering, anti-lock brakes, engine brakes and double sleeper cabs. We pay company-employed drivers a fixed rate per mile. The rate increases based on length of service. Drivers are also eligible for bonuses based upon safe, efficient driving. We believe that our compensation program provides an important incentive to attract and retain qualified drivers. We pay independent contractors a fixed rate per mile. Independent contractors pay for their own fuel, insurance, maintenance and repairs. Drivers that have been with us for at least six months and independent contractors that have been under contract with us for at least six months are also eligible to purchase shares of our Common Stock under a stock purchase plan we sponsor. We pay the brokerage commissions on purchases of our Common Stock and the plan's administrative costs. Revenue Equipment The trucking industry requires significant capital investment in revenue equipment. We finance a portion of our revenue equipment purchases using long-term debt. We purchase tractors and trailers manufactured to our specifications. Freightliner or Peterbilt manufacture most of our tractors. Most of our tractors are equipped with 435/500 or 370/435 horsepower Detroit Diesel or Cummins engines. These engines enable the equipment to maintain constant speed with optimum fuel economy under conditions often encountered by our equipment, such as mountainous terrain and maximum weight loads. Utility, Great Dane or Wabash manufacture most of our single van trailers. Most of our trailers are equipped with Thermo-King cooling and heating equipment, air ride suspensions and anti-lock brakes. Our single van refrigerated trailers are either 53 feet long (2,265 trailers) or 48 feet long (38 trailers). All of our trailers are 102 inches wide and have at least 106 inches of inside height. We standardize equipment to simplify driver training, control the cost of spare parts inventory, enhance our preventive maintenance program and increase fuel economy. The following table shows the type and age of equipment we own as of December 31, 1999: We replace our tractors and trailers based on factors such as age, the market for used equipment and improvements in technology and fuel efficiency. We have a comprehensive maintenance program for our company-owned tractors and trailers to minimize equipment downtime and enhance resale or trade-in value. We regularly perform inspections, repairs and maintenance at our facilities in Mondovi, Wisconsin; Ontario, California; Forest Park, Georgia; and Wilsonville, Oregon, and at independent contract maintenance facilities. Employees As of December 31, 1999, we employed 1,492 people. This total consists of 1,178 drivers, 103 mechanics and maintenance personnel, and 211 support personnel. Support personnel includes management and administration. Our employees are not represented by a collective bargaining unit. We consider relations with our employees to be good. Competition The trucking industry is highly competitive. Our primary competitors are other protective service truckload carriers and private carriage fleets. For freight not requiring protective service trailers, our competitors also include dry freight truckload carriers and railroads. To compete, we rely primarily on our quality of service and our ability to provide protective service and other specialized services. We have less financial resources, own less equipment and carry less freight than several other truckload carriers offering protective service. Regulation We are a motor common and contract carrier. The DOT and the FHWA, along with various state agencies, regulate our operations. These regulatory authorities have broad powers, generally governing activities such as authority to engage in motor carrier operations, rates and charges, and certain mergers, consolidations and acquisitions. The Motor Carrier Act of 1980 (the "MCA") substantially increased competition among motor carriers and limited the level of regulation in the industry. The MCA allowed applicants to obtain ICC operating authority more easily and allowed interstate motor carriers to change their rates without ICC approval. The law also removed many route and commodity restrictions. The Trucking Industry Regulatory Reform Act of 1994 (the "TIRRA") has further increased industry competition and limited industry regulation. The TIRRA repealed tariff filing for individually determined rates, simplified the granting of operating authority, and pre-empted price, route and service regulation by the states. The ICC Termination Act of 1995 abolished the ICC and transferred its regulatory authority to the DOT and the FHWA. Motor carrier operations are subject to the DOT's safety requirements governing interstate operations. Matters such as weight and dimensions of equipment are also regulated by federal and state authorities. We also have operating authority between the United States and the Canadian Provinces of Alberta, British Columbia, Manitoba, Ontario, Quebec and Saskatchewan. ITEM 2. ITEM 2. PROPERTIES Our executive offices and principal terminal are located on approximately seven acres in Mondovi, Wisconsin. This facility consists of approximately 28,000 square feet of office space and approximately 21,000 square feet of equipment repair and maintenance space. Originally constructed in 1965, these facilities were expanded in 1971, 1980, 1987 and 1993. We maintain a maintenance facility in Ontario, California. We purchased this facility in 1997 for $1.5 million from R & R Properties, a sole-proprietorship owned by Randolph L. Marten. From 1985 through 1997, we leased this facility from R & R Properties. Total rental expense for this lease was $126,000 in 1997. This facility includes approximately 2,700 square feet of office space, 8,000 square feet of equipment repair and maintenance space and a parking lot of 150,000 square feet. We purchased a maintenance facility in Jonesboro, Georgia in 1993. The building at this facility is approximately 12,500 square feet and consists of office space and a two and one-half bay service and repair space. This facility also has parking for up to forty tractors and trailers. In 2000, we sold the facility in Jonesboro, Georgia and purchased a maintenance facility in Forest Park, Georgia. The building in Forest Park is approximately 11,000 square feet and consists of office space and a five-bay service and repair space. This facility also has parking for up to sixty-five tractors and trailers. We purchased a maintenance facility in Wilsonville, Oregon in 1995. The building at this facility is approximately 20,000 square feet and consists of office space and an eight-bay service and repair space. This facility also has an eight-acre paved and fenced yard area. ITEM 3. ITEM 3. LEGAL PROCEEDINGS We periodically are a party to routine litigation incidental to our business. Primarily, this litigation involves claims for personal injury and property damage caused while transporting freight. There are currently no material pending legal, governmental, administrative or other proceedings to which we are a party or of which any of our property is the subject which are unreserved. We partially self-insure for losses relating to workers' compensation, auto liability, general liability and cargo claims, along with employees' group health benefits. We self-insure for property damage claims. We also maintain an insurance policy that limits annual total losses to $7.5 million for auto liability, workers' compensation and general liability claims. We believe that our current liability limit is reasonable. However, we could suffer losses over our policy limits. Losses in excess of our policy limits could negatively affect our financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1999. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers, with their ages and the offices held as of March 1, 2000, are as follows: Randolph L. Marten has been a full-time employee of ours since 1974. Mr. Marten has been a Director since October 1980, our President since June 1986 and our Chairman of the Board since August 1993. Mr. Marten also served as our Chief Operating Officer from June 1986 until August 1998 and as a Vice President from October 1980 to June 1986. Darrell D. Rubel has been a Director since February 1983, our Chief Financial Officer since January 1986, our Treasurer since June 1986, our Assistant Secretary since August 1987 and our Executive Vice President since May 1993. Mr. Rubel also served as a Vice President from January 1986 until May 1993 and as our Secretary from June 1986 until August 1987. Robert G. Smith has been our Chief Operating Officer since August 1998. Mr. Smith also served as our Vice President of Operations from June 1993 until May 1999 and as our Director of Operations from September 1989 to June 1993. Mr. Smith served as director of operations for Transport Corporation of America, an irregular-route truckload carrier, from January 1985 to September 1989. Timothy P. Nash has been our Vice President of Sales since November 1990 and served as our Regional Sales Manager from July 1987 to November 1990. Mr. Nash served as a regional sales manager for Overland Express, Inc., a long-haul truckload carrier, from August 1986 to July 1987. Franklin J. Foster has been our Vice President of Finance since December 1991 and served as our Director of Finance from January 1991 to December 1991. Mr. Foster served as a vice president in commercial banking for First Bank National Association from October 1985 to January 1991. Our executive officers are elected by the Board of Directors to serve one-year terms. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information in the "Common Stock Data" section of our 1999 Annual Report on page 12 is incorporated in this Report by reference. We had no unregistered sales of equity securities during the fourth quarter of the year ended December 31, 1999. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The financial information in the "Five-Year Financial Summary" section of our 1999 Annual Report on the inside front cover thereof is incorporated in this Report by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of our 1999 Annual Report on pages 3 and 4 is incorporated in this Report by reference. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our credit facility described in Note 2 to the financial statements carries interest rate risk. Amounts borrowed under this agreement are subject to interest charges at a rate equal to either the London Interbank Offered Rate plus applicable margins, or the bank's Reference Rate. The Reference Rate is generally the prime rate. Should the lender's Reference Rate change, or should there be changes to the London Interbank Offered Rate, our interest expense will increase or decrease accordingly. As of December 31, 1999, we had borrowed approximately $36.9 million subject to interest rate risk. On this amount, a 1% increase in the interest rate would cost us $369,000 in additional gross interest cost on an annual basis. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our Financial Statements and the Report of Independent Public Accountants on pages 5 through 12 of our 1999 Annual Report are incorporated in this Report by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT A. Directors of the Registrant. The information in the "Election of Directors-Information About Nominees" and "Election of Directors-Other Information About Nominees" sections of our 2000 Proxy Statement is incorporated in this Report by reference. B. Executive Officers of the Registrant. Information about our executive officers is included in this Report under Item 4A, "Executive Officers of the Registrant." C. Compliance with Section 16(a) of the Exchange Act. The information in the "Section 16(a) Beneficial Ownership Reporting Compliance" section of our 2000 Proxy Statement is incorporated in this Report by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information in the "Election of Directors-Director Compensation" and "Compensation and Other Benefits" sections of our 2000 Proxy Statement is incorporated in this Report by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the "Principal Stockholders and Beneficial Ownership of Management" section of our 2000 Proxy Statement is incorporated in this Report by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the "Certain Transactions" section of our 2000 Proxy Statement is incorporated in this Report by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The following Financial Statements are incorporated in this Report by reference from the pages noted in our 1999 Annual Report: Report of Independent Public Accountants-page 12 Balance Sheets as of December 31, 1999 and 1998-page 5 Statements of Operations for the years ended December 31, 1999, 1998 and 1997-page 6 Statements of Changes in Shareholders' Investment for the years ended December 31, 1999, 1998 and 1997-page 6 Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997-page 7 Notes to Financial Statements-pages 8 through 12 2. Financial Statement Schedules: None. 3. Exhibits: The exhibits to this Report are listed in the Exhibit Index on pages 11 through 13. A copy of any of the exhibits listed will be sent at a reasonable cost to any shareholder as of March 22, 2000. Requests should be sent to Darrell D. Rubel, Executive Vice President and Chief Financial Officer, at our corporate headquarters. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Report under Item 14(c): (1)Marten Transport, Ltd. 1986 Incentive Stock Option Plan, as amended. (2)Marten Transport, Ltd. 1986 Non-Statutory Stock Option Plan, as amended. (3)Employment Agreement, dated May 1, 1993, with Darrell D. Rubel. (4)Marten Transport, Ltd. 1995 Stock Incentive Plan. (5)Amendment to Employment Agreement, dated January 27, 1999, with Darrell D. Rubel (b) Reports on Form 8-K filed in the fourth quarter of 1999: None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Marten Transport, Ltd., the Registrant, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on March 27, 2000 by the following persons on behalf of the Registrant and in the capacities indicated. Signature Title /s/ RANDOLPH L. MARTEN Randolph L. Marten Chairman of the Board, President (Principal Executive Officer) and Director /s/ DARRELL D. RUBEL Darrell D. Rubel Executive Vice President, Chief Financial Officer, Treasurer, Assistant Secretary (Principal Financial and Accounting Officer) and Director /s/ LARRY B. HAGNESS Larry B. Hagness Director /s/ THOMAS J. WINKEL Thomas J. Winkel Director /s/ JERRY M. BAUER Jerry M. Bauer Director /s/ CHRISTINE K. MARTEN Christine K. Marten Director MARTEN TRANSPORT, LTD. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K For the Year Ended December 31, 1999 FORWARD-LOOKING INFORMATION PART I ITEM 1. BUSINESS ITEM 2. PROPERTIES ITEM 3. LEGAL PROCEEDINGS ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ITEM 6. SELECTED FINANCIAL DATA ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. EXECUTIVE COMPENSATION ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

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1999

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ITEM 1. BUSINESS. -------- GENERAL We are an integrated retailer and marketer of flowers, plants, and complementary gifts and decorative accessories. We operate the largest company-owned network of floral specialty retail stores in the United States, with 231 retail locations in 28 markets as of August 31, 1999. We are building a national brand and transforming the retail floral industry by integrating our operations throughout the floral supply chain, from product sourcing to delivery, and by managing every interaction with the customer, from order generation to order fulfillment. We ultimately intend to provide all of our retail customers with a unique and enhanced shopping experience under the Gerald Stevens brand. Our national sales and marketing division permits us, through multiple distribution channels, including the Internet, dial-up numbers and direct mail, to serve customers who do not visit or phone our retail stores. This division includes National Flora, the largest yellow page advertiser of floral products, Calyx & Corolla, the largest direct marketer of flowers, The Flower Club, a leading corporate affinity marketer, and four primary websites. We currently promote these websites on leading Internet properties, including Yahoo! and Lycos. To ensure superior customer service and efficient order processing, we operate four national call centers. To distribute orders in markets where we do not have our own stores, we use several flowers-by-wire services and operate Florafax, the fourth largest U.S. floral wire service, with approximately 5,000 member florists covering all 50 states. To provide the freshest and highest quality products to our retail customers, we operate our own sourcing operation. Our leading floral importer and wholesaler, AGA Flowers, has long-term supply agreements and other relationships to purchase cut flowers with many of the finest growers in the United States, Central America and South America. These supply arrangements help us to eliminate several steps in the floral distribution chain, ensuring a reliable source of high-quality products at favorable prices. By reducing the time needed to transport flowers from farms to our retail stores, we extend the vase life of our flowers, leading to greater customer satisfaction. We believe our execution of this integrated operating model will make the Gerald Stevens brand synonymous with superior service, quality and value and build the most recognized and respected floral and gift brand in the United States. Once established, we believe the Gerald Stevens brand will drive increased consumption of all of our products, particularly flowers. On April 30, 1999, we completed a business combination with Gerald Stevens Retail, Inc. and changed our business name from Florafax International, Inc. to Gerald Stevens, Inc. Our principal executive offices are now located at 301 E. Las Olas Boulevard, Fort Lauderdale, Florida 33301, and our telephone number is (954) 713-5000. From September 1, 1999 through November 12, 1999, we acquired a total of 17 floral businesses with stores in 49 retail locations. As of November 12, 1999, we were in negotiations to acquire additional floral businesses with 19 retail locations. The negotiations are in various stages, and any or all of the acquisitions may not be completed due to failure to reach definitive agreements, failure to complete satisfactory due diligence reviews or other reasons. No material part of our revenues were derived outside of the United States in the 1999, 1998 and 1997 fiscal years, and during these years, we had no material assets outside the United States. For additional information concerning our operations by business segment for the 1999, 1998 and 1997 fiscal years, see Note 13 to the Notes to Consolidated Financial Statements included in Item 8. INDUSTRY OVERVIEW O THE FLORAL INDUSTRY. Supply Chain. The majority of cut flowers sold at retail in the United States are grown outside of the United States, principally in Colombia, Mexico, Ecuador and the Netherlands. Flowers grown outside of the United States are shipped from the farms to importers in the United States. The majority of European products arrive in New York while most Central American and South American products arrive in Miami. After clearing customs and inspections, floral importers divide the flowers into smaller lot sizes and repack the flowers for shipment to wholesalers or bouquet companies. Wholesalers then market the flowers to retail florists, supermarkets, other mass market outlets, and bouquet companies. Flowers sold to bouquet companies are usually arranged and packaged for the consumer market and the bouquets are then sold in bulk by the bouquet companies to supermarkets and mass-market retailers. In aggregate, the supply chain typically delivers a flower to the retailer approximately 10 to 12 days after the flower is first cut. Moreover, the extensive handling of the product and the temperature fluctuations to which it is subjected adversely affect the life of the flower. Order Generation. Order generators market and advertise in various media to generate floral orders via dial-up numbers, the Internet or direct mail. As order generators typically lack fulfillment capabilities, they forward these orders through a wire service to a retail florist for delivery. Order generators typically receive a fee equal to 20% of the order for their services. Some order generators also impose a service charge on the customer for handling the order. Large order generators typically receive rebates from wire services for sending orders through their services. Wire Services. Wire services establish networks of retail florists and facilitate the transmission and financial settlement of floral orders among the network members. Wire services publish a membership directory that enables florists to select which florist will deliver an arrangement outside the sending florist's own delivery area. Alternatively, florists can allow the wire service to choose which florist will deliver an arrangement. Some wire services also supply various hardgoods, including vases and other materials, that florists may use in the ordinary course of business. Wire services typically collect a fee of approximately 7% of the value of an order exchanged via the wire service; however, the fee collected from larger florists and order generators is often offset by a rebate. Wire services also typically charge a monthly membership fee to member florists. Since wire services generally do not own their member florists, they have little control over the quality of the product and service of the delivering florist. Retail. Retailers sell flowers, plants and, in certain cases, complementary gifts and decorative accessories to customers. Retailers include floral shops, supermarkets, garden centers, discount warehouses and lawn and garden centers. Floral shops also receive orders for out-of-town delivery that they forward, typically through wire services, to other floral shops for fulfillment and local delivery. Direct from Farm. The direct-from-farm business consists of certain order generators, primarily catalogs and websites, that use third-party overnight shippers like FedEx to distribute products directly from importers or growers to consumers. This business, while growing, accounts for less than 1% of overall floral purchases. The majority of direct-from-farm flowers are pre-made "bunches" of flowers requiring the recipient to arrange them into a bouquet. O THE FLORAL INDUSTRY'S SIZE AND OPPORTUNITY. Size. The domestic retail floral industry is a large and growing industry with attractive business economics. According to industry sources: o Retail floral industry revenue was approximately $15 billion in 1998. o When added to the complementary gifts and accessories market, the combined industry exceeds $60 billion. o Sales by florists grew by 5.5% in 1998. o Gross margins for retailers average approximately 60%. Opportunity to Create a National Network. We believe that the domestic retail floral industry presents opportunities for innovation, differentiation and the creation of a national brand due to the following industry characteristics: o Highly fragmented, with the top ten floral chains accounting for less than 5% of total retail sales. o Absence of a national retail brand. o Unique customer purchasing characteristics, with 40% of product orders placed outside of a retail location, approximately 90% of which are local calls made to local florists. o Inefficient and decentralized supply chain, with transactions among growers, importers, wholesalers and retailers creating substantial incremental costs but providing little additional value to the end user. o Lack of integrated order generation and fulfillment companies. o Under-marketed, with marketing expenditures typically less than 3% of sales. o Large, under-marketed customer lists. Opportunity to Grow the Market. We believe the retail floral industry also presents opportunities to expand floral consumption as a result of the following factors: o The United States is not among the top ten countries in the world in per capita consumption of flowers; per capita spending in the United States is significantly less than that of most western European countries, according to the Floral Council of Holland. o Favorable customer demographics and lifestyle trends should generate additional industry growth. o Customers value an extended vase life for flowers, which can be achieved by streamlining the supply chain. o Retail florists have focused on the gift-giving customer, largely ignoring the opportunity to increase self-consumption. o The Internet allows for visual merchandising and targeted marketing of flowers. BUSINESS STRATEGY Our goal is to become the premier specialty floral and gift retailer and marketer in the United States. We intend to accomplish this by selling a broad selection of floral and floral-related products, providing superior customer service and building strong customer loyalty. Because of our management team's extensive experience in developing nationally branded specialty retailers, we believe we have the skills and experience necessary to establish Gerald Stevens as the preeminent brand in the floral industry. Key elements of our strategy include: O BUILD A NATIONAL NETWORK OF RETAIL STORES. Rapidly Expand Our Retail Store Base. We plan to expand our retail operations in order to increase our market share in existing markets and to open and/or acquire stores in new markets where the opportunity exists to become the leading floral retailer. Through August 31, 1999, we have acquired many of the top floral retailers in the United States, with a total of 231 retail locations in 28 markets. We believe these initial acquisitions have provided us with a significant competitive advantage in developing a national brand. Over the next five years, our strategy is to develop a retail network in the country's largest 100 markets and operate over 1,000 stores. Enhance the Efficiency of Our Local Order Fulfillment and Distribution Network. Our retailing network is based on a "hub-and-satellite" system, which we believe is the most efficient operating structure for the retail floral industry based upon the success of the leading floral retail chains, several of which we have acquired. A hub facility serves as a distribution center and warehouse for surrounding satellite stores within a market. We currently operate hub facilities in twelve markets. We plan to have at least one hub in each of the major markets in which we will operate, either through acquisition or construction. We believe that a hub facility will eliminate cost redundancies and delivery inefficiencies resulting from the typically decentralized floral supply chain. Satellite stores are stand-alone or store-in-store retail outlets in supermarkets and grocery stores. Ideally, our satellite stores will be located in high-traffic, high-visibility areas to service walk-in business and promote brand awareness. We plan to connect our satellite stores with their supporting hub facilities through internal information systems, allowing us to provide customers with efficient service and a wider product variety. Create an Innovative In-Store Experience. We have developed a concept store that is designed to maximize revenue within the hub-and-satellite network by catering to the walk-in customer. This store will create a unique and enhanced shopping experience through an expanded product mix, innovative merchandising and store design, a knowledgeable staff of professional florists and exceptional customer service. Over the next two years, our plan is to introduce elements of this concept store to a number of our acquired stores in order to develop the Gerald Stevens brand and bring consistency to our national retail network. The remodeling of our acquired stores will likely coincide with the renaming of these stores as Gerald Stevens stores. O BUILD OUR ORDER-GENERATION BUSINESSES. Capitalize on Our Traditional Order-Generation Businesses. We have acquired several order-generation businesses to permit us to serve customers who do not visit or phone our retail stores. In addition, we are compiling a national customer database that will allow us to target our advertising and promotions. Through the use of more sophisticated database marketing techniques, our strategy is to use our order-generation capabilities to increase non-holiday and advance sales to customers in all channels. Our call centers and sales organization provide us with a platform to continue to add national corporate accounts. Where possible, we expect to distribute orders generated by these businesses through our retail store network, assuring our customers of high-quality products and superior customer service. Most order generators lack fulfillment capabilities and transmit their orders through wire services to independent local florists for production and delivery. We believe our retail stores will provide us with a significant competitive advantage over order generators who lack fulfillment capabilities, particularly at holidays and other peak times. Develop and Promote E-Commerce Operations. Similar to traditional order-generation businesses, we believe that online flower order generation must be coupled with an owned or affiliated local delivery network. This approach provides the greatest ability to manage all aspects of an order, from order taking to delivery confirmation, and ensures product quality and customer service consistency. Our e-commerce strategy is to position Gerald Stevens as a premier online floral and related gift marketer through a multi-branded strategy targeted at specific audiences. To promote our websites, we have marketing contracts with major online portals, including Yahoo! and Lycos. We plan to continue to make investments in the promotion of our websites. We also intend to continually upgrade our website offerings in order to provide existing and new customers with broad product offerings and convenient ordering processes. O BUILD OUR CONSUMER-DIRECT BUSINESS. Our Calyx & Corolla subsidiary is the leading direct marketer of floral products and the largest direct-from-grower floral operation in the United States. This business arranges for the overnight delivery of products directly from third-party growers and our own import operation. This business enables us to offer our customers "farm fresh" flowers and unique floral products, fruit and gourmet food gift baskets and other gift items that we may not stock at our retail stores. This business also permits us to promote recurring gifts such as flower-of-the-month and plant-of-the-month offerings where same-day delivery is not required. We market these products to our customers primarily through the use of catalogs and the Internet. O CREATE SUPPLY CHAIN EFFICIENCIES. We believe the current floral supply chain is inefficient in that it adds little incremental value and creates substantial incremental costs. We believe that a retailer with direct-from-farm relationships can reduce inefficiencies in delivery time and cost by minimizing the use of flower wholesalers. As a result, we expect to cut the time it takes to deliver flowers from growers to our stores by up to seven days, while at the same time reducing the cost of the product to us. We believe that improved quality and longer vase life of flowers will lead to greater customer satisfaction and loyalty. O DEVELOP OUR INFORMATION SYSTEMS. Our plan is to develop information systems that will give us a competitive advantage. To this end, we are integrating our information systems to support real-time order and inventory processing throughout all of our business units. This capability will allow us to enhance the customer's overall experience across our retail network and throughout our order-generation businesses. By combining enhanced information systems with sophisticated merchandising, database and supply chain management techniques, we believe these information systems will improve our profitability. OPERATIONS O RETAIL NETWORK. Our retail stores are among the leading retail floral operations in their markets, with a total of 231 retail locations in 28 markets across the United States on August 31, 1999. We intend to continue to expand our retail network through the acquisition of additional floral businesses in our current markets and in new markets. From September 1, 1999 through November 12, 1999, we acquired a total of 17 floral businesses with stores in 49 retail locations. On November 12, 1999, we were in negotiations to acquire additional floral businesses, with stores in 19 retail locations. The negotiations are in various stages, and any or all of the acquisitions may not be completed due to failure to reach definitive agreements, failure to complete satisfactory due diligence reviews or other reasons. In most cases, our initial market entry will be through the acquisition of key existing retailers followed by the acquisition of smaller retailers. Our acquisition of key existing retailers will focus on the most respected and established retailers in a market. We intend to retain the management of well-run retailers to benefit from their market knowledge, name recognition and local reputation, and to promote greater levels of customer retention and loyalty. Smaller stores we acquire may be in non-strategic locations, and therefore ultimately may be moved to a better location or integrated into a hub facility. We will keep the telephone numbers of acquired companies to maximize customer retention. We believe that by acquiring existing stores, we acquire loyal customers in a cost-efficient manner. Given the results of our recent acquisitions, we expect to retain a substantial amount of the acquired stores' customers even when the former locations are relocated to one of our other facilities. Hub Facilities. Hub facilities in a typical market are up to 40,000 square foot facilities that provide centralized call-in order taking, floral arranging and delivery. A typical major market will have one or two hub facilities. Hub facilities eliminate cost redundancies inherent in the typical decentralized floral market, such as duplicative labor functions, inventory spoilage and delivery inefficiencies, and allow us to control product quality and consistency. Hub facilities also produce standard floral arrangements for our retail stores. Depending on the location within its market, a hub facility may also serve as a retail location. Satellite Stores. Our retail stores are either stand-alone or store-in-store outlets located in high-traffic, high-visibility areas to service walk-in business. We believe that introducing attractive, well-merchandised retail stores in high-traffic areas will help promote growth in the walk-in segment of the floral and gift industry and promote awareness of the Gerald Stevens brand. Because we can vary our store size and format while maintaining a consistent Gerald Stevens look and feel, our retail stores will be located in a variety of settings, including downtown and suburban retail centers, office buildings, supermarkets and university campuses. These retail locations will be connected to supporting hub facilities through internal information systems, allowing us to provide the customer with efficient service and increased product variety. Each store will vary its product mix depending upon the size of the store, its location and customer preferences. We expect that our satellite stores will differentiate themselves from our competitors by offering an enhanced customer experience within the floral shop through improved marketing, merchandising and service. Our store-in-store locations provide the supermarkets, grocery stores and department stores in which they are located a one-stop solution for quality floral products and services. These locations benefit from the high traffic and brand appeal of the store in which they are located. Where possible, each of these store-in-store locations will be operated by a Gerald Stevens employee to ensure quality and consistency of product and service, as well as to promote our brand. Customer Experience. Our Gerald Stevens concept retail store will create a unique and enhanced shopping experience for our customers. Our stores will feature specially designed fixtures, be divided into easy-to-shop categories and feature professionals demonstrating the art of flower arranging. The store design is intended to give customers a warm, inviting place to browse and learn about our products. In our stores, customers will find fresh-cut flowers and bouquets displayed creatively and in abundance, with informational tags and signage to guide the customer through the store. The traffic pattern of the Gerald Stevens store will draw customers through the store in a logical progression, exposing the customer to the breadth of available floral products and gift items. In addition to flowers and plants, our stores will carry a number of complementary gifts and decorative accessories, including greeting cards, stationery and other paper products, gourmet confections, gift baskets, decorative accessories, collectibles and seasonal/holiday decorations. We believe that expanding the product mix of our stores to include these products is a natural extension of our floral product offerings since these products, like flowers, are commonly used as gifts to communicate personal expressions to others and for self-consumption to create a warm and friendly home environment. We believe that offering gifts and decorative accessories will not only enable us to meet the needs of our existing customers who currently purchase these products at competing specialty retailers, but will also allow us to attract new customers who do not normally purchase flowers or plants. In addition to providing our customers with a unique and enhanced in-store experience and a broader array of merchandise, we are committed to providing superior customer service. We intend to provide same-day delivery on a national scale from all distribution points, and expanded hours through our call centers, which offer customers the opportunity to place orders 24 hours a day, 7 days a week. O ORDER GENERATION. As a complement to our retail network, we operate several order-generation businesses, including National Flora and The Flower Club. These businesses focus on generating floral orders through channels that include mailing inserts, yellow page advertisements and corporate affinity programs. Through National Flora, we are the largest yellow page advertiser of floral products. We generate orders through a variety of additional advertising efforts, including Internet websites, affinity partnerships, corporate programs and direct mail marketing. We forward these orders primarily to National Flora's preferred network of stores and to our stores. Through The Flower Club, we have relationships with major corporate partners. We engage in joint marketing campaigns with these corporate partners throughout the year in an effort to provide member florists with orders during slower periods of the year. Orders generated by The Flower Club are transmitted by our Florafax wire service business to member florists. Our corporate partners include many nationally recognized companies, including airlines, credit card issuers, retailers and other businesses. We market directly to the customers of these companies by inserting marketing materials into their customers' periodic statements. Our order-generation businesses are currently supported by four call centers with a total of approximately 350 call stations in three time zones. Our call centers are located in Vero Beach, Florida; Tulsa, Oklahoma; San Francisco, California; and Medford, Oregon. These call centers service our order-generation businesses 24 hours a day, 7 days a week, and provide after-hours phone answering for our retail stores enabling our local customers to place an order through a Gerald Stevens representative at any time. O E-COMMERCE. We intend to become a premier floral and gift marketer on the Internet. We believe the Internet will enhance our ability to develop customer relationships and to introduce new products more quickly and with less financial risk than otherwise possible. Currently, we operate a number of websites. We acquired many of these websites in connection with our purchases of local florists. We also developed a number of websites internally. Going forward, we anticipate concentrating on the GeraldStevens.com and calyxandcorolla.com websites, which we will continuously enhance and promote. We intend for each of these websites to appeal to a different customer segment and offer users targeted content and products. The content will be designed to educate and inform customers, as well as to encourage additional consumption. Product selection will be targeted by customer segment and will encompass all distribution channels that we currently offer. We are committed to marketing and promoting these operations in our stores, through traditional advertising mediums and via relationships with strategic or high-traffic websites. We have entered into agreements with a number of companies, including Yahoo! and Lycos. We also intend to pursue a number of online direct-marketing strategies including the development of an affiliate network and the implementation of outbound e-mail marketing programs. In addition, through FlowerLink, we provide an opportunity for florists to participate in the growth of the Internet by developing and hosting customized websites for them. In exchange for providing free order processing and customer service, we collect a transaction fee for each order placed through one of these websites. Approximately 900 florists are members of FlowerLink. O DIRECT MARKETING On July 30, 1999, we acquired Calyx & Corolla, Inc., the largest direct marketer of flowers with over $20.0 million in annual sales. The Calyx & Corolla acquisition strengthens our position as the largest floral and gift retailer in the country and enhances our reputation with the well-known and highly trusted Calyx & Corolla brand. Additionally, this acquisition will serve as a platform for our direct-marketing efforts and expands our customer database by over 1.5 million floral customers. In 1988, Calyx & Corolla pioneered the limited inventory/direct-from-source model that is being so vigorously pursued by Internet retailers today. Over the past 11 years, Calyx & Corolla has developed partnerships with more than 30 high-quality flower and plant growers who package and ship flowers and vases to customers via overnight delivery upon receipt of an order. This "just-in-time" product procurement process allows Calyx & Corolla to eliminate its inventory risk while at the same time giving its customers fresh, just-cut flowers. It also allows Calyx & Corolla's customers to customize their floral orders. We plan to capture same-day delivery sales that Calyx & Corolla currently foregoes through our network of retail stores. Additionally, we plan to leverage Calyx & Corolla's expertise and infrastructure to provide unique and hard-to-find direct-from-grower offerings to customers of our retail stores, our Internet sites and our call centers and to make in-store gift catalogs available to our customers. Given the strength of the Calyx & Corolla brand, we intend to expand the marketing of the calyxandcorolla.com website, which has experienced significant revenue gains over last year. O FLOWERS-BY-WIRE. We operate Florafax, a flowers-by-wire business that enables member florists to send and deliver floral orders throughout the United States. We act as an intermediary among florists, and we send their orders primarily by telephone or fax. Our order-allocation system has the ability to distribute orders ratably to our member florists. Based on our experience in the flowers-by-wire business and observation of other wire services, we believe that most other wire services typically do not select florists to receive orders in an equitable manner, but simply require the florist that originates the order to select the shop that will fill that order. On our system, once an order is taken, the system analyzes the area to ascertain which member florists deliver to that location. The system then determines which florist should receive that order based on distribution criteria and then sends the order via facsimile or telephone. We believe that our order-allocation system is presently the only system in the industry that distributes orders in an equitable manner to member florists. We list our member florists and their advertisements in the Florafax Directory, which is published and distributed several times a year. We produce the Florafax Directory, brochures and sales and promotional materials for use by us and our member florists. O CHARGE AND CREDIT CARD SERVICES. We offer an electronic credit card and charge card processing system. This system allows merchants to accept credit cards and charge cards by automatically providing authorization codes for each transaction and capturing all the transaction data electronically. This system allows florists and non-floral merchants to receive frequent, automatic deposits directly to their bank accounts. We sell and lease system terminals and optional printers at competitive rates. SUPPLIERS AGA Flowers, our leading Miami-based importer, primarily imports cut flowers, principally from Colombia and Ecuador. We purchase cut flowers, plants and greens grown in the United States, principally from California. Although we do not generally enter into long-term contracts with our suppliers, through AGA Flowers we actively manage relationships with more than 40 growers in South America and Central America which allow us to obtain high-quality flowers in large quantities and when needed. In addition, we enter into standing order arrangements with other importers and wholesalers that provide us fixed-quantity purchases on a fixed-price basis throughout the year, with higher quantities at those prices during peak demand periods to ensure an adequate supply of flowers. We believe that we have good relationships with our suppliers and that the larger number of current and potential suppliers should continue to make perishable floral products available to us as needed. AGA Flowers also supplies fresh-cut flowers and bouquets to wholesalers, distributors and large retailers, including supermarkets. Over 60% of the floral products imported by AGA Flowers are sold to these third parties. We expect this percentage to decrease as we acquire more florist shops, AGA fulfills more of our shops' floral product needs, and AGA's sales to third parties remain relatively constant. INFORMATION SYSTEMS In the 1999 fiscal year we spent approximately $5.5 million, and over the next two to three years we intend to invest approximately an additional $15.0 million, to develop our information systems. We believe these investments will enhance our competitive advantage over other flower retailers and marketers. Our systems will include leading retail applications designed to support large-chain specialty retailers. Our systems will also allow us to use historical customer data to further enhance the execution, service, and identification of new markets and marketing opportunities. COMPETITION We face competition throughout the retail floral industry. Our retail stores compete with traditional floral shops, supermarkets, garden centers, vendors and other retailers based upon price, credit terms, breadth of product offering, product quality, customer service and location. We also compete with gift and other specialty retailers with our non-floral products. Both our traditional and our Internet order-generation businesses face significant competition from others providing similar services. In particular, dial-up numbers and websites in the retail floral industry have become significantly more competitive in recent years. We compete by buying large yellow pages advertisements with priority placement, by marketing our numbers and websites in various media, and by offering call center service 24 hours a day, 7 days a week. Our floral wire service business is one of five national wire services in the country, and the three larger wire services have substantial market share. To the extent we are unable to compete successfully against our existing and future competitors, our business, operating results and financial condition may be materially adversely affected. While we believe that we compete effectively within each segment in the retail floral industry, additional competitors with greater resources may enter the industry and compete effectively against us. SERVICE MARKS, TRADEMARKS AND TRADE NAMES We have registered or are in the process of registering a variety of service marks, trademarks and trade names for use in our business, including: o Gerald Stevens SM o National Flora TM o The Flower Club TM o Calyx & Corolla TM We regard our intellectual property as being an important factor in the marketing of our company and our brand. We are not aware of any facts that would negatively impact our continuing use of any of our service marks, trademarks or trade names. EMPLOYEES On August 31, 1999, we employed approximately 2,150 full-time and 1,625 part-time employees. We also employ approximately 970 additional employees during peak seasons. Of our non-seasonal employees, approximately 75 are corporate personnel. None of our employees are represented by unions. We consider our employee relations to be good. REGULATION We are subject to laws and regulations that are applicable to various Internet activities. There are many legislative and regulatory proposals under consideration by federal, state, local and foreign governments and agencies, including matters relating to online content, Internet privacy, Internet taxation, access charges, liability for information retrieved from or transmitted over the Internet, domain names, database protection, unsolicited commercial e-mail messages and jurisdiction. New regulations may increase our costs of compliance and doing business, decrease the growth in Internet use, decrease the demand for our services or otherwise have a material adverse effect on our business. We are also subject to federal, state and local environmental, health and safety laws and regulations. Under environmental laws, we may be responsible for investigating and remediating environmental conditions relating to conditions at the numerous real properties at which we operate. These obligations could arise whether we own or lease the property. We are not aware of any pending federal environmental legislation that we expect to have a material adverse impact on our company. Our import operations are generally subject to United States federal regulations governing international trade and the importation of products into the United States. Imports into the United States are subject to various tariffs and customs duties imposed by the federal government. Such tariffs and duties are subject to change. In addition, when a particular foreign country limits the amount of a particular product that may be exported from the United States to such country, the United States government from time to time may retaliate by imposing a new or additional tariff on other products that the country exports into the United States. These retaliatory tariffs could be material. In addition, the United States from time to time imposes anti-dumping duties on imports into the United States. Dumping is the practice whereby importers sell products in the United States at prices below the products' home market value. Anti-dumping duties generally are paid by the importer. RISK FACTORS Our business, financial condition, results of operations and prospects, and the prevailing market price and performance of our common stock, may be adversely affected by a number of factors, including the matters discussed below. Our Potential Inability to Implement Our Growth Strategy. Our business strategy will focus on growing our revenue and operations internally by opening new retail locations and expanding sales through other order-generation businesses, including our websites on the Internet, as well as by making acquisitions of floral and gift businesses. The success of our growth strategy will depend on a number of factors including our ability to: o assess the value, strengths and weaknesses of acquisition candidates; o evaluate the costs and projected returns of expanding our operations; o expand our customer base; o market our products and services effectively over the Internet and in traditional media; o lease desirable store locations on suitable terms and complete construction on a timely basis; o promptly and successfully integrate acquired businesses and new retail locations with existing operations; and o obtain financing to support this growth. We may not be able to identify suitable acquisition candidates or locations for new stores. If we are not able to identify suitable acquisition candidates or if acquisitions of suitable candidates are prohibitively expensive, we may be forced to alter our growth strategy. Our growth strategy may affect short-term cash flow and net income as we increase our indebtedness and incur additional expenses. As a result, our operating results may fluctuate and our growth strategy may not result in improving our profitability. If we fail to implement our growth strategy successfully, the market price of our common stock may decline. In addition, we may not be able to retain a sufficient portion of the customers of the retail stores that we acquire. We may expand our operations not only within our current lines of business, but also into other related and complementary businesses. Our entry into any new lines of business may not be successful, as we may lack the understanding and experience to operate profitably in new lines of business. Demands on Our Resources Due to Growth. Our anticipated growth could place significant demands on our management and our operational, financial and marketing resources. These demands are due to our plans to: o acquire and integrate numerous floral and gift retailers; o open new locations; o increase the number of our employees; o expand the scope of our operating and financial systems; o broaden the geographic area of our operations; o increase the complexity of our operations; o increase the level of responsibility of management personnel; and o continue to train and manage our employee base. Our management and resources, now and in the future, may not be adequate to meet the demands resulting from our expected growth. Continued Net Losses Could Hinder Our Growth Strategy. We have experienced losses during our most recent fiscal year. Our net loss for fiscal 1999 was $12.3 million, which includes merger expense of $4.1 million and a non-cash compensation expense of $1.4 million related to non-plan stock options during the fiscal year. We acquired most of our retail operations in an April 1999 merger with Gerald Stevens Retail, which was established in May 1998 and commenced operations in October 1998 upon completion of its acquisition of ten floral businesses. For the period from its inception to September 30, 1998, Gerald Stevens Retail was a development stage company with no revenue and generated a net loss of $2.1 million. If we incur net losses in future periods, we may not be able to implement our growth strategy in accordance with our present plans and our stock price may decline. Our Financial Results May Not Be Indicative of Future Results. The financial statements included in this report cover periods when Gerald Stevens and some of our acquired businesses were not under common control or management. These financial statements may not be indicative of our future financial condition, operating results, growth trends or prospects. You must evaluate our prospects in light of the risks, expenses and difficulties frequently encountered by companies in the early stages of a new growth strategy. Our strategy of building a nationally branded floral and gift retailer and marketer may not lead to growth, profitability or increased market prices for our common stock. We Need to Improve Our Information Systems. We need to make improvements to and integrate our information systems. Although we spent approximately $5.5 million in the 1999 fiscal year, and over the next two to three years we intend to invest approximately an additional $15.0 million for our information systems, this budget may not be sufficient. We also need to hire more accounting and information systems personnel. We may experience delays, disruptions and unanticipated expenses in implementing, integrating and operating our information systems. Failure to fully integrate and enhance our information systems or hire additional personnel could have a material adverse effect on our business, financial condition, results of operations and growth prospects. We May Have Difficulties Integrating Acquired Businesses with Our Company. Until we complete and install our information systems, we will use and depend upon the information and operating systems of our acquired entities. We may not be able to efficiently combine our operations with those of the businesses we have acquired without encountering difficulties. These difficulties could result from having different and potentially incompatible operating practices, computers or other information systems. By consolidating personnel with different business backgrounds and corporate cultures into one company, we may experience additional difficulties. As a result, we may not achieve anticipated cost savings and operating efficiencies and we may have difficulties managing, operating and integrating our businesses. We May Incur Unexpected Liabilities When We Acquire Businesses. During the acquisition process, we may not discover some of the liabilities of businesses we acquire. These liabilities may result from a prior owner's non-compliance with applicable federal, state or local laws. For example, we may be liable after an acquisition of a business for the prior owner's failure to pay taxes or comply with environmental regulations. Environmental liabilities could arise regardless of whether we own or lease our properties. While we will try to minimize our potential exposure by conducting investigations during the acquisition process, we will not be able to identify all existing or potential liabilities. We also generally will require each seller of an acquired business to indemnify us against undisclosed liabilities. In most cases, this indemnification obligation will be supported by deferring payment of a portion of the purchase price or other appropriate security. However, this indemnification may not be adequate to fully offset any undisclosed liabilities associated with the business acquired. Goodwill Resulting from Acquisitions May Adversely Affect Our Results. Goodwill and related amortization are expected to increase principally as a result of future retail floral business acquisitions, and the amortization of goodwill and other intangible assets could adversely affect our financial condition and results of operations. We have considered various factors, including projected future cash flows, in determining the purchase prices of our acquired retail floral businesses, and we do not believe that any material portion of the goodwill related to any of these acquisitions will dissipate over a period shorter than 40 years. However, our earnings in future years could be significantly adversely affected if management later determines either that the remaining balance of goodwill is impaired or that a shorter amortization period is applicable. We Will Depend on Additional Capital for Our Growth. Our ability to remain competitive, sustain our expected growth and expand our operations largely depends on our access to capital. We anticipate making numerous acquisitions of floral businesses, which will require ongoing capital expenditures. We also expect to make expenditures to continue integrating the acquired floral businesses with our existing businesses. To date, we have financed capital expenditures and acquisitions primarily through private equity and our revolving bank credit facility. We have a $40 million revolving credit facility under which we have outstanding borrowings of approximately $24.2 million on November 15, 1999. We are in discussions with a number of financial institutions in an effort to increase the revolving credit facility to between $50 and $75 million. We may not be successful in obtaining an increased credit facility. In addition, to execute our growth strategy and meet our capital needs, we plan to issue additional equity securities as part of the purchase price of future acquisitions, which may have a dilutive effect on the interests of our stockholders. However, additional capital may not be available on terms acceptable to us. Our failure to obtain sufficient additional capital could curtail or alter our growth strategy or delay capital expenditures. Debt Covenants May Restrict Our Growth. Restrictive covenants contained in our credit facility may limit our ability to finance future acquisitions, new locations and other expansion of our operations. Credit facilities obtained in the future likely will contain similar restrictive covenants. These covenants may also require us to achieve specific financial ratios. With regard to acquisitions, our credit facility requires that, in the event that our consolidated leverage ratio is greater than 2.0 to 1.0, and the cash portion of the cost of a business acquisition exceeds $3.0 million, certain acquisition-specific covenants are applicable. These covenants include the requirement that at least 35% of the cost of an acquisition be paid in the form of common stock, that the proceeds of loans used to pay the cost of an acquisition cannot exceed three times the acquired company's earnings before interest, taxes, depreciation and amortization, and that the lender be provided certain financial information and give consent to the acquisition. Our credit facility also requires us to maintain financial ratios that limit total debt and capital expenditures. Consolidated debt in the future cannot exceed earnings before interest, taxes, depreciation and amortization by a ratio of 2.75 to 1.00 or exceed consolidated stockholders' equity. In addition, the ratio of EBIT plus lease payments to the sum of interest expense, current maturities of debt, cash income taxes and lease payments must not be less than 1.10 to 1.00 prior to December 31, 2000 and 1.25 to 1.00 thereafter. Capital expenditures cannot exceed $42 million for the 2000 fiscal year, $50 million for the 2001 fiscal year and $52 million for the 2002 fiscal year. Any of these covenants could become more restrictive over time. Our ability to respond to changing business and economic conditions and to secure additional financing for operating and capital needs may be significantly restricted by these covenants. Furthermore, we may be prevented from engaging in transactions including acquisitions that are important to our growth strategy. Any breach of these covenants could cause a default under our debt obligations and result in our debt becoming immediately due and payable. We are not certain whether we would have, or would be able to obtain, sufficient funds to make these accelerated payments. Our Quarterly Operating Results Will Fluctuate Due to Seasonality. Unit sales of floral products have historically been seasonal, concentrated primarily in the second and third fiscal quarters as a result of holidays such as Valentine's Day, Easter and Mother's Day. In contrast to the second and third fiscal quarters, the first and fourth fiscal quarters have relatively few flower-giving holidays. Negative fluctuations have been particularly pronounced and net losses have been incurred in these quarters. In the past, we have experienced, and we expect to continue to experience, quarterly variations in revenue and cash flows. Other factors that could cause quarterly variations include additional selling, general and administrative expenses to acquire and support new business and the timing and magnitude of capital expenditures. We intend to plan our operating expenditures based on revenue forecasts. Any revenue shortfall below these forecasts in any quarter would likely decrease our operating results for that quarter. Customers May Reduce Discretionary Purchases of Flowers and Gifts. We believe that the floral and gift industry is influenced by general economic conditions and particularly by the level of personal discretionary spending by customers. As a result, the floral and gift industry could experience periods of decline and recession during economic downturns. The industry may experience sustained periods of decline in sales in the future. Any material decline in personal discretionary spending could have a negative effect on our business, financial condition, results of operations or prospects. Competition May Adversely Impact Our Performance. The floral and gift industry is highly competitive. Competition exists in each segment of the industry. We expect competition from: o flower growers, importers, wholesalers and bouquet companies, including Dole Food Company, Inc. and USA Floral Products, Inc.; o floral wire services, including FTD, Teleflora and AFS; o retailers including traditional floral and gift shops, supermarkets, mass merchandisers and garden centers; and o traditional and online order generators of floral and gift products, including 1-800-FLOWERS. In many of our markets, our competitors are larger and have greater financial resources than we do. The Gerald Stevens brand is new, and may not be marketed effectively by us. We may not be able to compete successfully against our existing competitors and any future competitors. We May Incur Anti-dumping Liability. The majority of flowers sold in the United States are grown in other countries. Flower-importing companies are subject to anti-dumping duties. Generally, if the United States Department of Commerce determines that a foreign grower sold flowers to an importer in the United States for a price less than the home market price or constructed value of the flowers, then the Commerce Department may impose an anti-dumping duty upon the importer. The precise amount of duty is calculated after a review of sales over a twelve-month period and a comparison of the prices of the United States sales with the prices of home market sales or constructed value. If we are required to pay a duty as a result of a Commerce Department anti-dumping review, it may have a material adverse effect on our business, financial condition, results of operations or prospects. Political and Economic Events in Foreign Countries May Limit Supply of Flowers. Flowers are imported principally from countries in South America and Central America. The political and economic climate in several of these countries from time to time has been volatile. In some of these countries, this volatility has adversely affected many aspects of the economy, including flower production. At times, this volatility has also impacted trade relations with the United States. As a result, future political and economic events in these flower-growing countries may reduce the production or export of flowers. Any adverse changes in the production or export of flowers from flower-producing countries could have a material impact on our business, financial condition, results of operations or prospects. Potential Adverse Effects of Bad Weather in Flower-Growing Regions. The supply of perishable floral products depends significantly on weather conditions where the products are grown. Severe weather, including unexpected cold weather, may have an adverse effect on the available supply of flowers, especially at times of peak demand. For example, in order for a sufficient supply of roses to be available for sale on Valentine's Day, rose-growing regions must not suffer a freeze or other harsh conditions in the weeks leading up to the holiday. Any shortages or disruptions in the supply of fresh flowers, or any inability on our part to procure our flower supply from alternate sources at acceptable prices in a timely manner, could lead to the inability to fulfill orders during periods of high demand, and the loss of customers. We May Have Difficulties Transporting Flowers. The perishable nature of flowers requires the floral industry to have a transportation network that can move products quickly from the farm to the retailer. Flowers grown in South America and Central America are typically transported via charter flights to the United States, principally to Miami. After flowers arrive in Miami or other ports of entry, they are distributed throughout the United States primarily via refrigerated trucks. There may be disruptions in service at Miami International Airport, fuel shortages, work stoppages in the air charter or trucking industries or other problems encountered in transporting flowers. Problems with Order-Transmission Networks and the Compatibility of Our Systems. A large percentage of floral industry revenue is dependent upon the ability of the party taking an order from a customer to transmit the order to a delivering florist outside the immediate geographic market. Over the past several years, this process has increasingly relied on electronic communications and computers to create networks that serve as the transmission medium for orders. We believe that a substantial number of floral industry participants use one or more of these networks, particularly FTD's Mercury network. In the event that one or more of these networks were to become disabled, or our systems were unable to communicate with the network or any other transmission medium, or one or more of our businesses were not permitted to use such network or medium, we may not be able to use our normal computer-based methods for communicating orders. In this event, we would either need to route orders via alternative wire services, requiring reconfiguration of the existing wire interfaces and programming logic, or be required to make individual telephone calls or send faxes to florists. Conducting business primarily through telephone and fax orders would cause us to operate in a slower and more costly manner. Any of these situations could have a negative impact on our business, financial condition, results of operations or prospects. Relationships with Floral Wire Service Businesses May Deteriorate. The retail floral industry has traditionally relied upon floral wire services, including FTD, Teleflora, AFS and our Florafax wire service business, to act as intermediaries to effectively manage, among other things, financial settlement among florists and serve as a clearinghouse for orders. To our knowledge, these intermediaries do not currently operate retail stores but do engage in other marketing and floral order-generation activities. One or more of these wire services may seek to prohibit our order-generation business or our retail operations from settling orders through their wire services, or using their technology to transmit orders. These actions may have a short-term material adverse impact on our business, financial condition, results of operations or prospects. Wire service intermediaries also provide financial rebates or incentives to those florists, order generators and other parties that transmit and/or financially settle a large number of orders through their system. These rebates and incentives provide a significant portion of our operating profit. Any change in the industry's rebate or incentive structure may have a short-term material impact on our business, financial condition, results of operations or prospects. Relationships with Member Florists of Our Wire Service Business May Deteriorate. Some of the member florists of our floral wire service business may not want to continue as members if they perceive that we are in competition with them through our retail stores. This risk may be heightened when we acquire or open retail operations in markets where our member florists are located. Loss of member florists could have a negative impact on our business, financial condition, results of operations or prospects. Uncertainty of Internet Use and its Impact on Our Business. We believe that the Internet and electronic commerce will play an increasingly important role in floral and gift-related merchandising and order taking over the coming years. As such, we intend to devote significant financial resources to our Internet operations. However, the use of the Internet and e-commerce by customers to purchase flowers and gifts may not increase as rapidly as we expect, and other purchasing mediums may replace the Internet. Additionally, there are few barriers to entry on the Internet. Our competitors may be better funded or have other proprietary technologies or approaches to e-commerce that may make it difficult for us to compete on the Internet. In any of these instances, our business, financial condition, results of operations or prospects may be materially adversely impacted. In addition, if the use of the Internet for direct-from-grower sales does rapidly increase and such sales replace locally delivered floral arrangements, then the revenue we plan to generate by owning and operating numerous retail stores may be materially adversely affected. Also, as e-commerce becomes more prevalent and the use of Internet phone directories increases, the value we receive from advertisements in traditional phone books may decrease. We May Face Increased Government Regulation of the Internet. There are an increasing number of federal, state, local and foreign laws and regulations pertaining to the Internet. In addition, a number of federal, state, local and foreign legislative and regulatory proposals are under consideration. Laws or regulations may be adopted with respect to the Internet relating to liability for information retrieved from or transmitted over the Internet, online content, user privacy and quality of services. Changes in tax laws relating to electronic commerce could adversely affect our business. The applicability to the Internet of existing laws covering issues such as intellectual property, libel, personal privacy and other areas is uncertain and developing. New legislation or regulations could decrease growth in the use of the Internet, impose additional burdens on e-commerce or alter how we do business. This could decrease demand for our online product offerings, increase our cost of doing business, increase the costs of products sold on the Internet or otherwise have an adverse effect on our business, financial condition, results of operations and prospects. Year 2000 Issue May Adversely Affect Our Computer Systems and Operations. Businesses we acquire may not have taken appropriate steps to address their Year 2000 issues. Critical issues these companies must address include Year 2000 readiness of their telephone switches, voicemail systems, store server hardware and operating systems, and the business software installed on their store systems. Any acquired businesses that have not adequately addressed these issues pose immediate operational and financial risks. We may incur significant costs to replace or upgrade equipment and software to ensure Year 2000 compliance. These costs could have a negative impact on our business, financial condition, results of operations or prospects. Additionally, we may experience significant Year 2000-related operating problems. These problems may include our inability to: o input floral orders into the system; o communicate electronically with our retail stores; o communicate with vendors; o conduct accounting and banking functions; and o manage the business effectively due to lack of information. We may be materially adversely affected by any of these problems. Our Directors and Executive Officers Have Limited Industry Experience. Other than Ruth Owades, Kenneth Royer and Andrew Williams, none of our directors and executive officers have significant experience in the floral and gift industry. Our directors and executive officers may not ultimately be successful in the floral and gift industry. In addition, we believe that our success will depend to a significant extent upon the efforts and abilities of the management of companies that we acquire. We Depend Heavily on Our Senior Management. We believe that our success will depend to a significant extent upon the efforts and abilities of our Chairman, Steven Berrard, our President and Chief Executive Officer, Gerald Geddis, our other executive officers and the senior management of the companies that we acquire. While we have entered into employment agreements with our executive officers and the senior management of some companies we have acquired, these individuals may not remain with us throughout the term of the agreements or thereafter. Our employment agreements with Mr. Geddis, Albert Detz and Adam Phillips terminate on December 31, 2000, our employment agreement with Steven Nevill terminates on February 2, 2001, and our employment agreement with Eleanor Callison terminates on September 27, 2001. We do not have "key person" life insurance policies covering any of our employees. We will likely also depend on the senior management of any significant business that we acquire in the future. If we lose the services of one or more of these key employees before we are able to attract qualified replacement personnel, our business could be adversely affected. Our Significant Stockholders Are Able to Influence Corporate Action. As a result of its stock ownership and board representation, New River Capital Partners will be in a position to influence our corporate actions such as mergers or takeover attempts in a manner that could conflict with the interests of our other stockholders. New River Capital Partners owns 7,977,104 shares, or 17.8%, of our common stock. In addition, two of the nine members of our board of directors, including the Chairman, are representatives of New River Capital Partners. In addition, our executive officers own 4,326,880 shares of our common stock, or approximately 9.7%. Although there are no agreements or understandings between New River Capital Partners and our executive officers as to voting, if such parties voted in concert they would exert significant influence over us. Our Stock Price May Be Volatile. The market price for our common stock has been volatile and may be affected by a number of factors, including the announcement of acquisitions or other developments by us or our competitors, quarterly variations in our or other industry participants' results of operations, changes in earnings estimates or recommendations by securities analysts, developments in the floral and gift industry, sales of a substantial number of shares of our common stock in the public market, general market conditions, general economic conditions and other factors. Some of these factors may be beyond our control or may be unrelated to our results of operations or financial condition. Such factors may lead to further volatility in the market price of our common stock. Possible Depressing Effect of Shares Eligible for Future Sale. We have issued a substantial number of shares of our common stock pursuant to our acquisition program, and we expect to issue additional shares of common stock as part of the purchase price for future acquisitions. The shares of common stock issued pursuant to our acquisition program will be registered with the SEC periodically, making them immediately available for resale. We have issued to our employees, officers and directors options to purchase shares of our common stock. The shares issuable upon exercise of the options have been registered with the SEC. Any actual sales or any perception that sales of a substantial number of shares may occur could adversely affect the market price of our common stock and could impair our ability to raise capital through an offering of equity securities. Possible Dilution in Value of Common Stock and Voting Power. If we issue additional shares of common stock, including shares that may be issued pursuant to option grants, earn-out arrangements and future acquisitions, purchasers of common stock may experience dilution in the net tangible book values per share of the common stock. In addition, because our stockholders do not have any preemptive right to purchase additional shares in the future, their voting power will be diluted by any issuance of shares. ITEM 2. ITEM 2. PROPERTIES. ---------- Our corporate headquarters are located in leased premises at 301 East Las Olas Blvd., Suite 300, Ft. Lauderdale, FL 33301. On August 31, 1999, we owned two hub locations and four satellite locations, leased or licensed space inside 37 supermarkets and department stores, and leased our other hub facilities and satellite stores. None of these individual locations are material to us. We consider each of these stores to be in good operating condition and suitable for their current use. The following table lists our other principal non-retail properties, of which the Vero Beach property is owned and the others are leased: We expect to make significant capital expenditures to provide consistent features and signage for our retail stores. We expect to make significant capital expenditures to develop hub locations. We believe that all of our facilities are sufficient for our current needs. ITEM 3 ITEM 3 LEGAL PROCEEDINGS. ----------------- We are party to pending legal proceedings arising in the ordinary course of business. While we cannot predict the results of these proceedings with certainty, we do not believe that any of these matters are material to our financial condition or results of operations. On February 8, 1999, we were named as a defendant in a civil lawsuit entitled Harvey Seslowsky v. Gerald Stevens, Inc., Eric Lambert, Steven Berrard, Thomas Byrne, Thomas Aucamp, Gerald Geddis, and Michael van der Kieft, in the Circuit Court for Broward County, Florida. The plaintiff alleges that the defendants used his idea and business plan when they formed Gerald Stevens. The lawsuit seeks unspecified monetary damages. We believe the claims against us are without merit, and we are vigorously defending against the claims. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. --------------------------------------------------- This Item is inapplicable, as no matters were submitted to a vote of our security holders during the quarter ended August 31, 1999. EXECUTIVE OFFICERS Our executive officers are as follows: NAME AGE POSITION ---- --- -------- Gerald R. Geddis 49 Chief Executive Officer, President and Director Eleanor Marcus Callison 45 Senior Vice President and Chief Marketing Officer Albert J. Detz 51 Senior Vice President and Chief Financial Officer Steven J. Nevill 34 Senior Vice President and Chief Information Officer Adam D. Phillips 36 Senior Vice President, Chief Administrative Officer, General Counsel and Secretary GERALD R. GEDDIS, a member of our board of directors since April 30, 1999, has served as our Chief Executive Officer and President since April 30, 1999. He co-founded Gerald Stevens Retail with Mr. Berrard in May 1998 and served as its Chief Executive Officer and President until its merger with us on April 30, 1999. From 1988 to 1996, Mr. Geddis served in various executive positions at Blockbuster Entertainment Group, a division of Viacom Inc. He served Blockbuster as President from 1995 to 1996, and as Chief Operating Officer in 1996. During his tenure at Blockbuster, Mr. Geddis was involved in all facets of the company's operations, including worldwide store operations, merchandising, marketing and training. For the 17 years prior to 1988, Mr. Geddis served in various positions with Tandy Corporation. ELEANOR MARCUS CALLISON has served as our Senior Vice President and Chief Marketing Officer since September 27, 1999. From September 1997 until joining Gerald Stevens, she was Vice President - Advertising for Hallmark Cards, Inc., where she was responsible for the planning, development, and execution of all Hallmark consumer communications, brand advertising, database marketing and consumer affairs. In the 16 years before she joined Hallmark, Ms. Callison held various positions, most recently senior vice president, at Leo Burnett Advertising USA, where she had responsibility for numerous large retail accounts, including McDonald's, Disney and Kraft Foods. ALBERT J. DETZ has served as our Senior Vice President and Chief Financial Officer since April 30, 1999. Prior to joining Gerald Stevens Retail in July 1998 as its Senior Vice President and Chief Financial Officer, Mr. Detz worked at Blockbuster from 1991 to 1997, having most recently served as Senior Vice President and Chief Financial Officer from October 1994 to June 1997. Prior to Blockbuster, Mr. Detz served in various finance-related positions, including Vice President, Corporate Controller, for 11 years within the Computer Systems Division of Gould Electronics, Inc., and at Encore Computer Corporation. Prior to these experiences, Mr. Detz worked in the audit department of Coopers & Lybrand. Additionally, Mr. Detz is Vice President, Chief Financial Officer of Data Core Software Corporation, a development stage business for which his services are primarily of a consulting nature. STEVEN J. NEVILL has served as our Senior Vice President and Chief Information Officer since April 30, 1999. From 1996 until joining Gerald Stevens Retail as Senior Vice President in February 1999, Mr. Nevill was a principal at Kurt Salmon Associates where he was responsible for a wide variety of projects, including information systems strategy, systems development, logistics assessment and re-engineering. From 1991 to 1995, Mr. Nevill was Director of Strategic Services for the American Retail Group where he was involved in the creation of strategic plans, development and implementation of new systems and technology platforms for all functions, and a variety of special systems initiatives. ADAM D. PHILLIPS, a member of our board of directors since October 18, 1999, has served as our Senior Vice President, Chief Administrative Officer, General Counsel and Secretary since April 30, 1999. From January 1998 until joining Gerald Stevens Retail as Senior Vice President in July 1998, Mr. Phillips was a shareholder of the law firm of Akerman, Senterfitt & Eidson, P.A. in Fort Lauderdale, Florida. From 1993 through 1997, Mr. Phillips served in various capacities at Blockbuster, having most recently served as Executive Vice President, Chief Administrative Officer and General Counsel in 1996 and 1997. While at Blockbuster, Mr. Phillips was responsible for the company's legal, human resources and communications departments. Prior to joining Blockbuster, Mr. Phillips was associated with the law firm of Kirkland & Ellis in Chicago, Illinois. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. --------------------------------------------------------------------- Our common stock began trading on the Nasdaq National Market under the symbol "GIFT" on May 3, 1999. Prior to that date, our common stock traded on the Nasdaq SmallCap Market under the symbol "FIIF" beginning on May 30, 1997. Prior to that date, our common stock traded in the "Over the Counter" or "Pink Sheet" market. The number of registered stockholders of our common stock on November 15, 1999 was 1,482 based on information furnished by our transfer agent. The table below sets forth by quarter, for the fiscal years ended August 31, 1998 and 1999, the high and low intra-day sale prices for our common stock as reported by Nasdaq. On November 15, 1999, the closing price of our common stock on the Nasdaq National Market was $12.25 per share. We urge you to obtain current market quotations for shares of our common stock. We have never paid dividends on our common stock and we do not anticipate paying cash dividends in the foreseeable future. We intend to retain future earnings to fund the development and growth of our business. Any payment of dividends in the future will be at the discretion of our board of directors and will be dependent upon our earnings, financial condition, capital requirements and other factors deemed relevant by our board of directors. Our credit facility also restricts our ability to pay dividends. SALES OF UNREGISTERED SECURITIES DURING THE 1999 FISCAL FOURTH QUARTER During our 1999 fiscal fourth quarter, we issued 860,276 shares of our common stock in connection with our acquisition of all of the assets or stock of companies acquired during such quarter, or in connection with a merger transaction between one of our subsidiaries and an acquired company. We made all such issuances in reliance upon Section 4(2) of the Securities Act of 1933, as amended. During such quarter, we also issued 934,455 shares of our common stock to the former shareholders of Calyx & Corolla, Inc. in connection with a merger transaction with such company. We issued such shares in reliance on Section 3(a)(10) of the Securities Act of 1933, as amended. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ----------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS ------------------------------------ OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ------------------------------------------------ GENERAL Gerald Stevens, Inc. ("Gerald Stevens," or the "Company"), formerly known as Florafax International, Inc., is a leading integrated retailer and marketer of flowers, plants, and complementary gifts and decorative accessories. The Company operates the largest company-owned network of floral specialty retail stores in the United States, with 231 locations in 28 markets as of August 31, 1999. We are building a national brand and transforming the retail floral industry by integrating our operations throughout the floral supply chain, from product sourcing to delivery, and by managing every interaction with the customer, from order generation to order fulfillment. The Company owns and operates its own import operation and has relationships with leading growers around the world. Our national sales and marketing division permits us, through multiple distribution channels including the Internet, dial-up numbers and direct mail, to serve customers who do not visit or phone our retail stores. On April 30, 1999, Gerald Stevens and Gerald Stevens Retail, Inc. ("Gerald Stevens Retail"), formerly known as Gerald Stevens, Inc., completed a merger accounted for as a pooling of interests. This Management's Discussion and Analysis of Financial Condition and Results of Operations gives retroactive effect to the merger, and should be read in conjunction with our accompanying Consolidated Financial Statements. In the merger, we issued 1.35 shares of our common stock for each share of Gerald Stevens Retail common stock outstanding at the effective time of the merger. In total, we issued approximately 28.1 million shares of our common stock to the stockholders of Gerald Stevens Retail, resulting in the former Gerald Stevens Retail stockholders owning approximately 77.5% of the shares of our common stock immediately following the merger. ACQUISITIONS From October 1, 1998 through August 31, 1999 we acquired 69 retail florist businesses with 231 stores located in 28 markets throughout the United States for total aggregate consideration of $98.7 million, consisting of $66.8 million in cash and 7,060,934 shares of our common stock valued at share prices ranging from $3.52 per share to $15.30 per share. Previously, in July 1998, the Company had purchased letter of intent rights totaling $1.5 million related to 8 of these retail florist businesses. These costs were subsequently allocated as an additional component of the cost of acquiring these businesses. Additionally, in October 1998, we acquired AGA Flowers, Inc., a floral import business located in Miami, Florida for total consideration of $2.9 million, consisting of $1.5 million in cash and 417,078 shares of our common stock valued at $3.52 per share. In March 1999, we acquired National Flora, Inc., a floral order generation business, for total consideration of $19.7 million, consisting of $10.0 million in cash and 1,552,500 shares of our common stock valued at $6.30 per share. In July 1999, we acquired Calyx & Corolla, Inc., a catalog and Internet-based floral order generation business for total consideration of $11.6 million, consisting of approximately $.1 million in cash, 934,455 shares of our common stock valued at $10.80 per share, and our assumption of stock option and warrant obligations which converted into rights to acquire 152,081 shares of our common stock at exercise prices ranging from $.36 per share to $9.44 per share. All of the acquisitions discussed in the preceding paragraphs were accounted for as business combinations under the purchase method of accounting and are included in our consolidated financial statements from the date of acquisition. During the third and fourth quarters of fiscal 1999, we also acquired certain intangible assets related to floral businesses that discontinued their operations. The acquired intangible assets related principally to customer lists, telephone numbers and yellow page advertising contractual rights. Total aggregate consideration paid for all such intangible asset acquisitions was $4.5 million, consisting of $2.8 million in cash and 159,823 shares of our common stock. The net book value of goodwill and other specifically identifiable intangible assets at August 31, 1999 totaled $129.9 million, which represents 75.1% of total assets and 95.5% of total stockholders equity at that date. The amortization of this $129.9 million balance will result in future annual amortization expense of approximately $4.1 million, based principally upon the amortization of goodwill related to the acquisition of retail floral businesses over useful lives of 40 years, the amortization of goodwill related to the acquisition of order generation businesses over useful lives of 20 to 40 years and the amortization of other intangible assets over useful lives of 5 to 10 years. Goodwill, other intangible assets, and related amortization are expected to increase, principally as a result of future retail floral business acquisitions, and the amortization of goodwill and other intangible assets could adversely affect financial condition and results of operations. The Company has considered various factors, including projected future cash flows, in determining the purchase prices of its business and other intangible asset acquisitions and does not believe that any material portion of the assigned intangible asset costs of these acquisitions will dissipate over a period shorter than their respective assigned useful lives. However, earnings in future years could be materially adversely affected if management later determines either that the remaining goodwill or other intangible asset balance is impaired or that a shorter amortization period is applicable. Gerald Stevens' strategic plan contemplates the closing or relocation of a number of its acquired retail stores within each of its targeted market areas. These store closures or relocations are expected to occur mainly during the projected two-year market development period following our initial entry into a market. The decision to close or relocate a particular store will be made after completion of that area's market development plan and will be based upon various factors including quality of real estate location, expected growth and demographic trends, and store profit contributions. A store's proximity to the market's hub distribution facility and our ability to transfer call center, floral design and customer delivery functions from that store to the hub facility will significantly impact the decision to close or relocate a particular store. We have completed our assessment of which retail stores to close or relocate for all acquisitions consummated prior to December 31, 1998. For acquisitions consummated after December 31, 1998, management is in the process of completing such assessment. We expect to complete our assessment of retail store closures and relocations for all acquisitions consummated through August 31, 1999 by February 2000. Additional purchase liabilities recorded relative to acquisitions consummated prior to December 31, 1998 were approximately $1.6 million for costs associated with the shut down and consolidation of certain acquired retail stores (considering existing contractual lease obligations and management's estimate of future operating lease costs). Once management finalizes its assessment of the remaining retail stores to be closed or relocated, additional purchase liabilities are expected to be recognized. During the year ended August 31, 1999 no exit costs were paid and charged against the established liability. RESULTS OF OPERATIONS Upon consummation of our merger with Gerald Stevens Retail, we redefined the manner in which we evaluate and report the operating results of our newly combined business for internal purposes. In this regard, we have chosen to break down our component businesses into two segments: (1) Retail and (2) Order Generation. The Retail segment consists of all retail and import businesses and operations while the Order Generation segment consists of all non-retail order generation and fulfillment businesses and operations. The tables below present the results of operations through operating income (loss) of Gerald Stevens' Retail and Order Generation segments and Corporate for the years ended August 31, 1999, 1998 and 1997. The Retail segment 1999 results include the post-acquisition operating results of the 69 retail florist businesses and one import business acquired by the Company during the year ended August 31, 1999. The Order Generation segment 1999, 1998 and 1997 results include the operating results of the Company's former wire service, credit and charge card processing and The Flower Club business units. The Order Generation segment 1999 results additionally include the post-acquisition operating results of National Flora and Calyx & Corolla and the operating results of Gerald Stevens' newly formed Internet-based order generation business unit. Prior to the acquisition of our initial retail florist and import businesses on October 1, 1998, we operated only in the Order Generation segment. Year Ended August 31, 1999 Compared to Year Ended August 31, 1998 Retail Segment. Product sales within the Retail segment for the year ended August 31, 1999 include sales of floral and gift products at retail businesses of $66.6 million and sales of floral product by Gerald Stevens' import business of $9.4 million. Service and other revenue within the Retail segment is generated at the Company's retail businesses and consists of delivery and other service fees charged to customers and commissions on orders transmitted to and fulfilled by other retail florists. Cost of product sales within the Retail segment for the year ended August 31, 1999 include cost of products sold at retail businesses of $24.9 million and cost of products sold at Gerald Stevens' import business of $7.0 million. Gross margins as a percentage of total revenue for the year ended August 31, 1999 averaged 66.6% at retail businesses and 25.5% at Gerald Stevens' import business. Retail segment operating expenses for the year ended August 31, 1999 include expenses at retail businesses of $37.5 million and expenses at Gerald Stevens' import business of $1.5 million. Operating expenses are comprised primarily of salaries and benefit expenses, and to a lesser extent include occupancy, vehicle, depreciation and amortization expenses. Retail segment selling, general and administrative expenses for the year ended August 31, 1999 include expenses at retail businesses of $7.8 million and expenses at Gerald Stevens' import business of $.2 million. Selling, general and administrative expenses consist primarily of advertising expense, commissions paid on orders transmitted from third parties, and legal and accounting expenses. Order Generation Segment. Product sales within the Order Generation segment for the year ended August 31, 1999 reflect $1.4 million of sales made by Calyx & Corolla from date of acquisition. Service and other revenue within the Order Generation segment consists of order generation commissions and processing fees, wire service dues and fees, and credit card processing fees. Total Order Generation segment service and other revenue for the year ended August 31, 1999 increased by $9.0 million, or 55.4% to $25.2 million compared to the same period in the prior year. This significant increase in revenue is due primarily to our acquisition of National Flora, which generated $5.4 million in revenue this year from date of acquisition. Additionally, continued increases in The Flower Club revenue, revenue from the Company's newly formed Internet-based order generation business unit, and other revenue generated at Calyx & Corolla from date of acquisition also contributed to the current year's service and other revenue increase. Cost of goods sold within the Order Generation segment for the year ended August 31, 1999 reflect $.4 million of costs incurred at Calyx & Corolla from date of acquisition. Calyx & Corolla gross margins as a percentage of total revenue averaged 76.0% from date of acquisition. Total Order Generation segment selling, general and administrative expenses for the year ended August 31, 1999 increased by $10.1 million or 73.9%, to $23.7 million compared to the same period in the prior year. Selling, general and administrative expenses incurred by National Flora and Calyx & Corolla this year from date of acquisition totaled $5.9 million and represent a significant portion of the expense increase in the current year. Additionally, start-up costs incurred in connection with the Company's newly formed Internet-based order generation business unit this year of approximately $2.3 million also caused current year expenses to be higher. To a lesser extent, expense increases related to the expansion of The Flower Club business unit and expenses related to our acquired Flowerlink website also contributed to the higher fiscal 1999 expense levels. During the year ended August 31, 1998, the Company recorded an expense of $3.5 million related to the modification of a servicing agreement with MPI. Prior to modifying this servicing agreement, MPI acted as an agent that interfaced with The Flower Club's corporate customers. By modifying the servicing agreement, Gerald Stevens began interfacing with the corporate customers directly, thereby strengthening these relationships. See "MPI Agreement." Corporate. Total Corporate selling, general and administrative expenses for the year ended August 31, 1999 increased to $12.5 million from $2.2 million in the same period in the prior year due primarily to expenses incurred at Gerald Stevens' new, larger corporate headquarters in Ft. Lauderdale, Florida and related to the significant expansion of the Company into retail and other related segments of the floral industry. Additionally, non-cash compensation expense of $1.4 million recorded in connection with the vesting of certain non-plan stock options also contributed to the current year expense increase. The non-plan stock options are fully vested and will cause no further compensation expense to be recorded in future periods. We plan to significantly expand our business over the next several years, largely through the acquisition of retail florist businesses. We also expect Corporate expenses to increase significantly over this time period, due principally to integration costs planned to be incurred in connection with the development and implementation of centralized operational and financial systems and the establishment of the Gerald Stevens brand name. See "Liquidity and Capital Resources." During the year ended August 31, 1999, we incurred a total of $4.6 million in investment banking, accounting and legal costs in connection with our merger with Gerald Stevens Retail. In accordance with the accounting rules governing business combinations accounted for as a pooling of interests, all merger-related costs were recognized as an expense during the period in which they were incurred. Interest. Interest expense for the year ended August 31, 1999 was $.8 million compared to interest expense of $82,000 in the same period of the prior year. The increase in interest expense during fiscal 1999 is due to increased borrowings under the Company's revolving credit facilities to finance the expansion of its business activities. Interest income for the year ended August 31, 1999 was $.4 million compared to interest income of $.2 million in the same period of the prior year. The increase in interest income this year is related primarily to earnings from the short-term investment of proceeds received in connection with common stock sold during fiscal 1999. Income Taxes. The provision for income taxes for the year ended August 31, 1999 was $2.3 million compared to an income tax benefit of $.7 million in the same period of the prior year. The current period expense is due principally to (i) the establishment of a deferred tax asset valuation allowance of $1.4 million which, because of the expected future combined operating results of the merged company, is now required, (ii) the amortization of a deferred tax asset related to the utilization of net operating loss carryfowards of $.8 million and (iii) state income tax provisions of $.1 million. The Company recorded an income tax benefit of $.7 million from the utilization of net operating loss carryforwards during the same period of the prior year. Gerald Stevens' future effective tax rate will depend on various factors including the mix between state taxable income or losses, amounts of nondeductible goodwill, and the timing of adjustments to the valuation allowance on our net deferred tax assets. Year Ended August 31, 1998 Compared to Year Ended August 31, 1997 Order Generation Segment. Total revenue for the year ended August 31, 1998 increased by $2.3 million, or 16.6%, to $16.2 million compared to the same period in the prior year. Order generation commissions and processing fees continued to grow during fiscal 1998 and represented approximately $1.5 million of the year-to-year increase. The increase in commissions and processing fees was due primarily to orders generated by The Flower Club. To a lesser extent, growth in wire service dues and fees and credit card processing fees also contributed to the fiscal 1998 revenue increase. Total Order Generation segment selling, general and administrative expenses for the year ended August 31, 1998 increased by $2.0 million, or 17.5%, to $13.6 million compared to the same period in the prior year. Increases in selling, advertising and promotion expenses related to the expansion of The Flower Club business accounted for the majority of the fiscal 1998 expense increase. Corporate. Total Corporate selling, general and administrative expenses for the year ended August 31, 1998 increased by $1.8 million to $2.2 million compared to the same period in the prior year. This significant increase is due primarily to start-up expenses of approximately $1.6 million incurred during the latter part of fiscal 1998 in connection with Gerald Stevens' expansion into the retail distribution segment of the floral industry. These start-up expenses consist principally of legal, audit, consulting and compensation costs. Other Income (Expense). Other income (expense) for the year ended August 31, 1997 totaled $.8 million and consisted of a gain, net of related legal fees, of $1.0 million recognized in connection with the resolution of a 1990 lawsuit, offset by charges of $.2 million related to consulting agreement and contingency reserve write-offs. Income Taxes. During the year ended August 31, 1998, the Company recognized an income tax benefit of $.7 million compared to an income tax benefit of $.5 million in the same period of the prior year. The income tax benefits recognized during both the 1998 and 1997 fiscal years were due primarily to the utilization of net operating loss carryforwards. LIQUIDITY AND CAPITAL RESOURCES. We had cash and cash equivalents of $4.6 million and $7.1 million, as of August 31, 1999 and 1998, respectively. Cash and cash equivalents decreased by $2.5 million during the year ended August 31, 1999 and increased by $2.9 million and $.5 million during the years ended August 31, 1998 and 1997, respectively. The major components of these changes are discussed below. Cash used in operating activities during the year ended August 31, 1999 was $5.0 million, inclusive of the unfavorable impact of $4.6 million in banking, accounting and legal costs paid in connection with our merger with Gerald Stevens Retail. Cash used in operating activities during the year ended August 31, 1998 was $1.1 million, inclusive of the unfavorable impact of $3.5 million paid to MPI under the terms of a contract modification agreement. Operating activities provided $3.1 million in cash during the year ended August 31, 1997 due principally to improvements in net income related to The Flower Club's business. The cash portion of the purchase prices for all acquisitions completed by the Company during the year ended August 31, 1999, net of cash acquired, aggregated $74.9 million, as more fully described in the preceding section entitled "Acquisitions." Capital expenditures during the year ended August 31, 1999 totaled $6.8 million compared to capital expenditures of $1.4 million and $.8 million during the years ended August 31, 1998 and 1997, respectively. Capital expenditures during fiscal 1999 primarily include computer hardware, software, and communication system expenditures related to the planned expansion of our retail and order generation businesses. Capital expenditures during fiscal 1998 and 1997 relate principally to the purchase of the land and building that were previously leased as the Company's former corporate headquarters, and other facility and equipment expansion costs. In July 1999, we completed a public equity offering in which 5,000,000 shares of our common stock were sold. Proceeds received from the offering, net of underwriting discounts and expenses, were approximately $55.2 million. Additionally, during the year ended August 31, 1999, we issued 6,219,537 shares of our common stock in private placement transactions for total consideration of $21.1 million, net of placement fees and expenses. A total of 712,305 shares of common stock were also issued for total consideration of $1.6 million in connection with the exercise of stock options and warrants during fiscal 1999. The Company borrowed a net amount of $4.3 million on its revolving credit facilities during the year ended August 31, 1999. In August 1998, in connection with the initial capitalization of Gerald Stevens Retail, a total of 12,863,290 shares of common stock were issued to various founding stockholders for total consideration of $9.3 million, with proceeds totaling $5.1 million received in fiscal 1998 and the $4.2 million stock subscription balance received at the beginning of fiscal 1999. In August 1998, we also paid $1.5 million in cash and issued 641,997 shares of our common stock in connection with the acquisition of International Floral Network, Inc., a business whose acquired assets consisted solely of rights to acquire 33 retail florist businesses under non-binding letters of intent with the owners of those businesses. A total of 196,000 shares of common stock were issued for total consideration of $29,000 in connection with the exercise of stock options and warrants during fiscal 1998. In May 1998, the Company borrowed $2.5 million to finance a portion of the MPI contract modification costs. During the fourth quarter of fiscal 1998, $.5 million of the loan was repaid, with the balance of $2.0 million repaid during fiscal 1999. During fiscal 1998 and 1997, the Company also repurchased 519,975 shares of treasury stock at a total cost of $1.6 million. In September, 1998, Gerald Stevens Retail entered into a revolving credit agreement with a bank whereby such bank agreed to loan Gerald Stevens Retail up to $20.0 million for a term of 18 months. In February 1999, the credit agreement was amended to increase the line of credit to $40.0 million. In June 1999, Gerald Stevens Retail and its primary lender amended and restated their existing $40.0 million revolving credit agreement and Gerald Stevens, the parent of Gerald Stevens Retail, agreed to guarantee payment of all obligations under the amended and restated agreement and terminated their existing $5.0 million line of credit. The amended and restated credit agreement provides for borrowings over a term of 36 months which will bear interest at either the Eurodollar market rate plus a percentage ranging from 125 to 250 basis points, depending on the consolidated leverage ratio for the previous quarter, or at Gerald Stevens' option, at a base rate equal to the sum of the higher of the federal funds rate plus 0.5% or the prime rate plus a percentage ranging from 0 to 100 basis points depending on our consolidated leverage ratio for the previous quarter. The line of credit will be used to finance business acquisitions and capital expenditures and to provide working capital for general corporate purposes. Outstanding borrowings under the credit facility at August 31, 1999 and November 15, 1999 were $4.3 million and $24.2 million, respectively. Gerald Stevens' effective Eurodollar borrowing rate and its base rate as of November 15, 1999 are 7.96% and 9.25%, respectively. Borrowings under the amended and restated credit agreement are secured by all Gerald Stevens' current and future assets, including a pledge of the stock of each business that is acquired by Gerald Stevens. The credit agreement contains covenants requiring bank approval of certain business acquisitions, and the maintenance of agreed upon financial ratios, as more specifically described in the following paragraphs. In the event that Gerald Stevens' consolidated leverage ratio is greater than 2.0 to 1.0, and the cash portion of the cost of a business acquisition exceeds $3.0 million, certain acquisition-specific covenants are applicable. These covenants include, among other things, the requirement that at least 35.0% of the cost of an acquisition be paid for in the form of common stock, that the proceeds of loans used to pay the cost of an acquisition cannot exceed three times the acquired company's earnings before interest, taxes, depreciation and amortization, and that the lender be provided certain financial information and give consent to the acquisition. The amended and restated credit agreement also requires Gerald Stevens to maintain financial ratios which limit total debt and capital expenditures. Consolidated debt cannot exceed earnings before interest, taxes, depreciation and amortization by a ratio of 2.75 to 1.00 (3.00 to 1.00 on or prior to August 31, 1999) or exceed consolidated stockholders' equity. In addition, the ratio of earnings before interest and taxes plus lease payments, to the sum of interest expense, current maturities of debt, cash income taxes and lease payments must not be less than 1.10 to 1.00 prior to December 31, 2000 and 1.25 to 1.00 thereafter. Capital expenditures cannot exceed $22.0 million for the 1999 fiscal year, $42.0 million for the 2000 fiscal year, $50.0 million for the 2001 fiscal year and $52.0 million for the 2002 fiscal year. At August 31, 1999, the Company was in compliance with all debt covenants. We are currently in discussions with a number of financial institutions regarding their participation in a proposed syndication of our bank credit facility. In this regard, we intend to increase the borrowing limits under our credit facility from $40.0 million to approximately $50.0 to $75.0 million. However, there can be no assurance that we will be successful in increasing such borrowing limits. We intend to implement our business strategy largely by the acquisition of retail florists and other floral related businesses throughout the country. Following acquisition, we expect to incur significant expenditures to remodel and retrofit some of our acquired stores to be consistent with the Gerald Stevens store format or to close or relocate certain other acquired stores. Additionally, we plan to fill out regional markets by constructing a number of new hub or satellite stores. To facilitate our high rate of planned growth and to effectively integrate business activities and processes, we expect to incur substantial computer and communication costs in the future. Over the next two to three years, we expect to spend approximately $10.0 million for remodeling and retrofitting acquired stores, $50.0 million for construction of new stores and $15.0 million on information systems. We also expect to incur significant expenditures over the next several years in connection with the development and marketing of our newly formed Internet-based order generation business unit and the establishment of the Gerald Stevens brand name. The Internet-based floral order generation industry is highly competitive and there can be no assurance that Gerald Stevens' new Internet-based business unit will be successful in achieving sufficient market share to enable it to operate on a profitable basis. We intend to finance the costs of our business acquisitions and capital expenditures with a combination of debt and equity capital, as well as cash generated from internal operations. Specifically, we expect to finance the cost of future business acquisitions by paying cash and issuing shares of common stock to the sellers of these businesses in approximately equal values. In addition to increasing our line of credit, we also may offer to sell, in either private placements or public offerings, shares of our common stock as circumstances and market conditions dictate. We believe that cash flows from operating activities, in addition to borrowings from our current credit facilities, will provide adequate funds to meet the ongoing cash requirements of our existing business over the next 12 months. However, failure to increase our current bank borrowing limits or otherwise raise additional capital could limit the planned expansion of our existing business in the short-term. We believe that we will be successful in raising additional debt and equity capital in the future. However, we cannot provide assurance that the occurrence of unplanned events, including temporary or long-term adverse changes in global capital markets, will not interrupt or curtail our short-term or long-term growth plans. MPI AGREEMENT Effective May 1, 1998, we entered into an agreement with Marketing Projects, Inc. that (1) modified the rights and obligations of both parties under an existing marketing servicing agreement and (2) provided for our acquisition of MPI's proprietary marketing systems. Also on May 1, 1998, we entered into a non-compete and non-disclosure agreement with MPI and the principal employees of MPI. Total consideration of $3.7 million was paid to MPI at the time of closing and we are further obligated to pay up to $125,000 in cash in each of eight subsequent fiscal quarters, contingent upon the attainment of certain quarterly revenue targets. Of total consideration paid, $3.5 million has been recorded as a contract modification charge, $150,000 has been allocated to the purchase of MPI's proprietary marketing systems and $100,000 has been allocated to the non-compete agreement, with amortization provided over 1 and 2 years, respectively. The MPI transaction was initially accounted for as a purchase business combination. However, as the result of subsequent evaluations, Company management determined that the contract modification accounting treatment discussed above better reflected the substance of the transaction. As a result, our originally filed Consolidated Financial Statements for the year ended August 31, 1998 have been restated for this change. YEAR 2000 ISSUE We are currently performing the final steps of resolving Year 2000 issues. We have successfully completed final Year 2000 testing at our major import, call center, corporate, and retail sites. For secondary sites, we are currently approximately 95% complete in remediation and hardware/software upgrade efforts. Dedicated management and technical personnel have been assigned to complete replacement/upgrade efforts at remaining secondary sites. We have also used independent third parties to review, assess, and comment on our Year 2000 efforts. We will continue to acquire florists who may have outstanding Year 2000 issues. Year 2000 readiness of potential acquisitions usually is assessed prior to purchase. Only companies who are either compliant, or who can be made compliant with minimal cost and effort, are purchased. The relative low level of technology employed in the floral industry minimizes this issue. All acquisitions will have their critical systems compliant by January 1, 2000, with specific contingencies and work-arounds designated for any systems that cannot be made fully compliant. We expect these to be minor and not material to our operations or financial condition. We have received certification from our primary vendors regarding Year 2000 readiness. We have received and implemented Year 2000 compliant versions of all existing commercially available software packages that we are reliant on. All new software packages, hardware, and communications equipment implemented or developed during 1999 have been fully certified as Year 2000 compliant. Additionally, we have developed a contingency plan which includes the replacement of any non-compliant technology with fully compliant technology that is being used today by one of Gerald Stevens' businesses. We have conducted a review of significant third parties that support any critical aspect of our business. We have received confirmation from all critical third-party trading partners, support organizations, and suppliers that they are, or plan to be, Year 2000 compliant. We expect to spend approximately $100,000 to address remaining Year 2000 issues through the end of calendar 1999. Based on our assessment of our Year 2000 issues and considering our primary and contingency plans, we do not expect Year 2000 issues to have a material impact on our business, operations, or our financial condition or results of operations. INFLATION Our business will be affected by general economic trends. Because some of our inventory is grown in countries other than the United States, economic conditions in those countries could affect the cost of product purchases. During the past year, we have not experienced noticeable effects of inflation and believe that cost increases due to inflation should be able to be passed on to our customers. SEASONALITY The floral industry has historically been seasonal with higher revenue and profits generated during holidays such as Thanksgiving, Christmas, Valentine's Day, Easter and Mother's Day. Conversely, during the summer months, floral retailers tend to experience a decline in revenue and profits. In addition, the floral industry in general may be affected by economic conditions and other factors, including floral promotions, competition and the climate in key flower-growing regions. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In June 1999, the Financial Accounting Standards Board ("FASB") issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of Effective Date of FASB Statement No. 133. SFAS No. 137 defers for one year the effective date of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 will now apply to all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS No. 133 will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. The Company will adopt SFAS No. 133 as required for its first quarterly filing of fiscal year 2001. We believe the adoption of this Statement will not have a material effect on the earnings and financial position of the Company. FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K, as well as our other reports filed with the SEC and our press releases and other communications, contain forward-looking statements which reflect the Company's current views with respect to future events and financial performance. Forward-looking statements include all statements regarding our expected financial position, results of operations, cash flows, dividends, financing plans, strategy, budgets, capital and other expenditures, competitive positions, growth opportunities, benefits from new technology, plans and objectives of management, and markets for stock. Like any other business, we are subject to risks and other uncertainties that could cause such forward-looking statements to prove incorrect. In addition to general economic, business and market conditions, we are subject to risks and uncertainties that could cause such forward-looking statements to prove incorrect, including those stated in the "Risk Factors" section of the Form 10-K and the following: o Our ability to accomplish our anticipated growth strategies and to integrate acquired businesses. o Our need to improve our information systems. o Unexpected liabilities incurred in our acquisitions. o Our dependence on additional capital for growth. o A decline in customer discretionary spending. o Weather, governmental regulations, transportation problems or other factors that could prevent us from obtaining sufficient products when needed. o Our ability to maintain business relationships within the industry, including relationships with wire services, wholesalers, growers, importers and other florist shops. o Our ability to develop relationships with supermarkets, mass merchants, department stores and other businesses to expand our store-in-store operations. o Our ability to develop a profitable Internet business. o An inability to pursue potential transactions as a result of certain restrictions imposed on us to protect the pooling-of-interests accounting treatment of our April 30, 1999 merger with Gerald Stevens Retail. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. ---------------------------------------------------------- Our exposure to market risk is limited primarily to the fluctuating interest rates associated with our variable rate indebtedness. Our variable interest rates are subject to interest rate changes in the United States and Eurodollar market. We do not currently use, nor have we historically used, derivative financial instruments to manage or reduce market risk. At August 31, 1999, we had $5.1 million of variable rate indebtedness, representing approximately 81% of our total debt outstanding, at an average interest rate of 9.25%. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. --------------------------------------------------------- INDEX TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS -------------------------------------------------- To the Board of Directors and Stockholders of Gerald Stevens, Inc.: We have audited the accompanying consolidated balance sheets of Gerald Stevens, Inc. (a Delaware corporation) and subsidiaries as of August 31, 1999 and 1998, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Gerald Stevens, Inc. and subsidiaries, as of August 31, 1999 and 1998, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Miami, Florida, November 3, 1999. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors and Stockholders Gerald Stevens, Inc. We have audited the consolidated statements of operations, changes in stockholders' equity, and cash flows of Gerald Stevens, Inc. for the year ended August 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Gerald Stevens, Inc. for the year ended August 31, 1997 in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP Tampa, Florida October 8, 1998 GERALD STEVENS, INC. CONSOLIDATED BALANCE SHEETS (In thousands, Except Share Data) The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. GERALD STEVENS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, Except Per Share Data) GERALD STEVENS, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (In thousands) The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. GERALD STEVENS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. GERALD STEVENS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AUGUST 31, 1999 1. GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Operations Gerald Stevens, Inc. ("Gerald Stevens," or the "Company"), formerly known as Florafax International, Inc., is a leading integrated retailer and marketer of flowers, plants and complementary gifts and decorative accessories. The Company operates the largest company-owned network of floral specialty retail stores in the United States, with 231 locations in 28 markets as of August 31, 1999. We are building a national brand and transforming the retail floral industry by integrating our operations throughout the floral supply chain, from product sourcing to delivery, and by managing every interaction with the customer, from order generation to order fulfillment. The Company owns and operates its own import operation and has relationships with leading growers around the world. Our national sales and marketing division permits us, through multiple distribution channels, including the Internet, dial-up numbers and direct mail, to serve customers who do not visit or phone our retail stores. Principles of Consolidation The consolidated financial statements include the accounts of Gerald Stevens and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Basis of Presentation Previously reported amounts have been reclassified to make them consistent with the current presentation. Cash and Cash Equivalents Gerald Stevens considers all highly liquid instruments purchased with an original maturity of three months or less to be cash equivalents. As of August 31, 1999 and 1998, cash and cash equivalents included $4.2 million and $6.9 million, respectively, of interest bearing cash. Also included in cash and cash equivalents as of August 31, 1999 and 1998, are $224,000 and $106,000, respectively, of restricted cash relating to Gerald Stevens' credit card processing agreement with its sponsoring bank. Fair Values of Financial Instruments The carrying amounts for the Company's cash and cash equivalents, accounts receivable, notes payable, accounts payable, accrued liabilities and long-term debt are reflected in the consolidated financial statements at cost, which approximates fair value. Inventory Inventory is stated at lower of cost or market, with cost determined principally by the first-in, first-out (FIFO) basis using the retail method. The Company believes that the FIFO retail method provides improved information for the operation of its business in a manner consistent with the method used widely in the retail industry. Concentration of Credit Risk Financial instruments that potentially subject Gerald Stevens to a concentration of credit risk consist primarily of accounts receivable. Concentration of credit risk with respect to trade accounts receivable is limited due to the Company's large number of repeat customers throughout the United States. A portion of receivables are related to balances owed by major credit card companies. The timing of the related cash realization and fees accrued are determined based upon agreements with these companies. Allowances relating to accounts receivable have been recorded based upon previous experience and other relevant factors, in addition to management's periodic evaluation. Property and Equipment Property and equipment are stated at cost. Major renewals and improvements are capitalized; maintenance and repairs are charged to expense as incurred. Gain or loss on disposition of property and equipment is recorded at the time of disposition. On September 1, 1998, Gerald Stevens adopted the provisions of Statement of Position ("SOP") 98-1, Accounting For The Costs of Computer Software Developed or Obtained For Internal Use, which requires the capitalization of costs incurred in connection with developing or obtaining software for internal use. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the assets, generally 30 years for buildings, 3 to 10 years for furniture, fixtures, and equipment, and 3 to 5 years for vehicles, computer hardware, software and communication systems. Leasehold improvements are depreciated over the lesser of useful lives or lease terms including available option periods. Intangible Assets Intangible assets consisted of the following: August 31, 1999 1998 ---- ---- (In thousands) Goodwill $ 126,999 $ 3,515 Other 4,926 616 --------- --------- 131,925 4,131 Less: Accumulated amortization (2,028) (340) --------- --------- $ 129,897 $ 3,791 ========= ========= Goodwill consists of the excess of purchase price over the fair value of assets and liabilities acquired in acquisitions accounted for under the purchase method of accounting. (See Note 2.) Included in goodwill for both periods is $2.0 million from an acquisition prior to October 31, 1970 which is not required to be amortized. Otherwise, goodwill is amortized over periods ranging from 20 to 40 years, which management believes is a reasonable life in light of the characteristics present in the floral industry, such as the significant number of years that the industry has been in existence, the continued trends by consumers in purchasing flowers for many different occasions and the stable nature of the customer base. Other intangible assets represent primarily contractual rights related to customer lists, telephone numbers and yellow page advertisements that were acquired by the Company from floral businesses that have discontinued their operations. Other intangible assets are amortized over periods ranging from 5 to 10 years. Amortization expense related to goodwill and other intangible assets was $2.0 million, $63,000 and $ 0 for the years ended August 31, 1999, 1998 and 1997, respectively. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of, Gerald Stevens periodically analyzes the carrying value of its goodwill and other intangible assets to assess recoverability from future operations using an undiscounted projected cash flow approach. Impairments are recognized in operating results to the extent that carrying value exceeds fair value. Deferred Financing Costs Deferred financing costs, net of accumulated amortization, were $657,000 and $20,000, at August 31, 1999 and 1998, respectively. These costs are included in other assets and relate to amounts incurred in connection with securing various bank credit facilities. Amortization is recorded on a straight-line basis over the term of the financing agreement. Revenue Recognition and Deferred Revenue Revenue from sales of products, delivery fees, and order generation commissions and fees are recognized at the time of product delivery. Revenue from wire service and credit card processing dues and fees are recognized at the time that services are provided. Payments received from customers in advance of product delivery are recorded as deferred revenue, which is classified within the current liabilities section of the balance sheets. Stock-Based Compensation As allowed by SFAS No. 123, Accounting for Stock-Based Compensation, Gerald Stevens accounts for stock-based compensation to employees in accordance with Accounting Principles Board No. 25, Accounting for Stock Issued to Employees, and, in cases where fixed plan exercise prices equal or exceed fair market value, recognizes no compensation expense for the stock option grants. In cases where exercise prices are less than fair value, compensation is recognized over the period of performance or the vesting period. In the case of variable plans, compensation expense is recognized at the time when both exercise price and the number of shares exercisable are determinable. Advertising Costs Yellow page advertising costs are expensed on a straight-line basis over the life of the directory, which is generally one year. Internet portal advertising costs are expensed on a straight-line basis over the term of the portal agreement. The costs of producing and distributing mail order catalogs are capitalized and amortized proportionately over the period that catalog sales are expected to be generated. All other advertising costs are expensed at the time the advertisement is first shown. Prepaid catalog costs at August 31, 1999 and 1998 were $351,000 and $0, respectively. Advertising expense totaled $11.7 million, $1.4 million and $.9 million in the years ended August 31, 1999, 1998 and 1997, respectively. Income Taxes Gerald Stevens accounts for income taxes under the provisions of SFAS No.109, Accounting for Income Taxes. SFAS No. 109 requires the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recorded in income in the period that includes the enactment date. Seasonality The floral industry has historically been seasonal, with higher revenue and profits generated during holidays such as Thanksgiving, Christmas, Valentine's Day, Easter and Mother's Day. Conversely, during the summer months, floral retailers tend to experience a decline in revenue and profits. In addition, economic conditions and other factors, including floral promotions, competition and the weather conditions in key flower-growing regions, in general may affect the floral industry. Segments Gerald Stevens has adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, for the year ended August 31, 1999. The Statement uses a management approach to report financial and descriptive information about a company's operating segments. Operating segments are revenue-producing components of the enterprise for which separate financial information is produced internally for company management. See Note 13. Comprehensive Income Gerald Stevens has adopted SFAS No. 130, Reporting Comprehensive Income, for the year ended August 31, 1999. The Statement requires that total comprehensive income and comprehensive income per share be disclosed with equal prominence as net income and earnings per share. Comprehensive income is defined as all changes in stockholders' equity exclusive of transactions with owners such as capital contributions and dividends. Comprehensive income (loss) is equal to net income (loss) for all periods presented. Impact of Recently Issued Accounting Standards In June 1999, the Financial Accounting Standards Board ("FASB") issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of Effective Date of FASB Statement No. 133. SFAS No. 137 defers for one year the effective date of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 will now apply to all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS No. 133 will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. The Company will adopt SFAS No. 133 as required for its first quarterly filing of fiscal year 2001. We believe the adoption of this Statement will not have a material effect on the earnings and financial position of the Company. 2. ACQUISITIONS On April 30, 1999, Gerald Stevens, formerly Florafax International, Inc., completed a merger with Gerald Stevens Retail, Inc. ("Gerald Stevens Retail") which was formerly known as Gerald Stevens, Inc. Gerald Stevens Retail was formed on May 7, 1998 and through September 30, 1998 was in the development stage, had no revenue and all of its efforts were directed to developing a business strategy, raising capital and acquiring leading retail flower shops and other floral related businesses. On October 1, 1998, Gerald Stevens Retail commenced its operations upon the completion of its acquisition of ten operating flower businesses and, as a result, emerged from the development stage. Under the terms of the merger agreement, based on an exchange formula, Gerald Stevens issued 28.1 million shares of its common stock for all of Gerald Stevens Retail's common stock outstanding. The merger was accounted for under the pooling of interests method of accounting. Accordingly, our consolidated financial statements give retroactive effect to the merger. Details of the separate results of operations of Gerald Stevens and Gerald Stevens Retail prior to the merger are as follows: Eight Months Year Ended Ended April 30, August 31, 1999 1998 --------------- ---------- Revenue: Gerald Stevens, as previously reported $ 11,638 $ 16,221 Gerald Stevens Retail 48,860 - ----------- --------- $ 60,498 $ 16,221 =========== ========= Net loss: Gerald Stevens, as previously reported $ (4,257) $ (623) Gerald Stevens Retail (3,014) (1,645) =========== ========= $ (7,271) $ (2,268) =========== ========= From October 1, 1998 through August 31, 1999, we acquired 69 retail florist businesses with 231 stores located in 28 markets throughout the United States for total aggregate consideration of $98.7 million, consisting of $66.8 million in cash and 7,060,934 shares of our common stock valued at share prices ranging from $3.52 per share to $15.30 per share. Previously, in July 1998, the Company had purchased letter of intent rights totaling $1.5 million related to 8 of these retail florist businesses. These costs were subsequently allocated as an additional component of the cost of acquiring these businesses. Additionally, in October 1998, we acquired AGA Flowers, Inc., a floral import business located in Miami, Florida for total consideration of $2.9 million, consisting of $1.5 million in cash and 417,078 shares of our common stock valued at $3.52 per share. In March 1999, we acquired National Flora, Inc., a floral order generation business, for total consideration of $19.7 million, consisting of $10.0 million in cash and 1,552,500 shares of our common stock valued at $6.30 per share. In July 1999, we acquired Calyx & Corolla, Inc., a catalog and Internet-based floral order generation business for total consideration of $11.6 million, consisting of approximately $.1 million in cash, 934,455 shares of our common stock valued at $10.80 per share, and our assumption of stock option and warrant obligations which converted into rights to acquire 152,081 shares of our common stock at exercise prices ranging from $.36 per share to $9.44 per share. All of the acquisitions discussed in the preceding three paragraphs were accounted for as business combinations under the purchase method of accounting and are included in our consolidated financial statements from the date of acquisition. During the third and fourth quarters of fiscal 1999, we also acquired certain intangible assets related to floral businesses that discontinued their operations. The acquired intangible assets related principally to customer lists, telephone numbers and yellow page advertising contractual rights. Total aggregate consideration paid for all such intangible asset acquisitions was $4.5 million, consisting of $2.8 million in cash and 159,823 shares of our common stock. Gerald Stevens' strategic plan contemplates the closing or relocation of a number of its acquired retail stores within each of its targeted market areas. We have completed our assessment of which retail stores to close or relocate for all acquisitions consummated prior to December 31, 1998. For acquisitions consummated after December 31, 1998, management is in the process of completing such assessment. We expect to complete our assessment of retail store closures and relocations for all acquisitions consummated through August 31, 1999 by February 2000. Additional purchase liabilities recorded relative to acquisitions consummated prior to December 31, 1998 were approximately $1.6 million for costs associated with the shut down and consolidation of certain acquired retail stores (considering existing contractual lease obligations and management's estimate of future operating lease costs). Once management finalizes its assessment of the remaining retail stores to be closed or relocated, additional purchase liabilities are expected to be recognized. During the year ended August 31, 1999, no exit costs were paid and charged against the established liability. The preliminary purchase price allocation for businesses acquired under the purchase method of accounting is as follows: August 31, 1999 --------------- (in thousands) Tangible assets (includes cash acquired of $6,339) $ 35,516 Intangible assets 129,516 Liabilities (26,105) --------- $ 138,927 ========= The pro forma results of operations, assuming each of the acquisitions described above was consummated as of the beginning of the periods presented, are as follows: 1999 1998 ---- ---- (In thousands except per share data) Revenue $ 221,484 $ 216,383 ========= ========= Net income (loss) $ (2,781) $ 4,440 ========= ========= Diluted net income (loss) per share $ (0.06) $ 0.10 ========= ========= Gerald Stevens is a party to letters of intent and agreements, subject to customary conditions, to acquire various retail flower shops and other floral businesses. To the extent consummated, we expect that these pending acquisitions will be accounted for under the purchase method of accounting. 3. PROPERTY AND EQUIPMENT, NET Property and equipment consisted of the following: Property and equipment includes $2.8 million and $.1 million of computer software costs that were capitalized during the years ended August 31, 1999 and 1998, respectively. Depreciation and amortization expense related to property and equipment was $1.6 million, $0.8 million, and $0.3 million for the years ended August 31, 1999, 1998 and 1997, respectively. 4. ACCRUED LIABILITIES Accrued liabilities consisted of the following: August 31, 1999 1998 ---- ---- (In thousands) Salaries and benefits $ 3,787 $ 144 Wire service 3,104 - Store closure costs 1,632 - Acquired business consideration 1,459 - Other 5,585 1,955 ----- ----- $ 15,567 $2,099 ========= ====== 5. DEBT Notes Payable Notes payable at August 31, 1999 and 1998 were $2.0 million and $80,000, respectively. The effective interest rates associated with these notes range from 7.00% to 10.12%. Notes payable at August 31, 1999 consists principally of mortgage notes and vehicle, equipment, and leasehold improvement installment notes assumed by the Company in connection with acquisitions completed during the latter part of the fiscal year. These notes are expected to be substantially paid off in full during the first quarter of fiscal 2000. Long-Term Debt At August 31, 1998, long-term debt included approximately $2.0 million of borrowings under Gerald Stevens' $5.0 million line of credit. The line of credit was collateralized by substantially all of the Company's assets, with interest payable monthly at the prime rate of the lending institution. In September 1998, Gerald Stevens Retail entered into a revolving credit agreement with a bank whereby such bank agreed to loan Gerald Stevens' Retail up to $20.0 million for a term of 18 months. In February 1999, the credit agreement was amended to increase the line of credit to $40.0 million. In June 1999, Gerald Stevens Retail and its primary lender amended and restated their existing $40.0 million revolving credit agreement and Gerald Stevens, the parent of Gerald Stevens Retail, agreed to guarantee payment of all obligations under the amended and restated agreement and terminated their existing $5.0 million line of credit. The amended and restated credit agreement provides for borrowings over a term of 36 months which will bear interest at either the Eurodollar market rate plus a percentage ranging from 125 to 250 basis points, depending on the consolidated leverage ratio for the previous quarter, or at Gerald Stevens option, at a base rate equal to the sum of the higher of the federal funds rate plus 0.5% or the prime rate plus a percentage ranging from 0 to 100 basis points depending on our consolidated leverage ratio for the previous quarter. The line of credit will be used to finance business acquisitions and capital expenditures and to provide working capital for general corporate purposes. Outstanding borrowings under the credit facility at August 31, 1999 were $4.3 million. Gerald Stevens' effective Eurodollar borrowing rate and its base rate as of August 31, 1999 are 7.75% and 9.25%, respectively. Borrowings under the amended and restated credit agreement are secured by all Gerald Stevens' current and future assets, including a pledge of the stock of each business that is acquired by Gerald Stevens. The credit agreement contains covenants requiring bank approval of certain business acquisitions, and the maintenance of agreed upon financial ratios, as more specifically described in the following paragraphs. In the event that Gerald Stevens' consolidated leverage ratio is greater than 2.0 to 1.0, and the cash portion of the cost of a business acquisition exceeds $3.0 million, certain acquisition specific covenants are applicable. These covenants include, among other things, the requirement that at least 35.0% of the cost of an acquisition be paid for in the form of common stock, that the proceeds of loans used to pay the cost of an acquisition cannot exceed three times the acquired company's earnings before interest, taxes, depreciation and amortization, and that the lender be provided certain financial information and give consent to the acquisition. The amended and restated credit agreement also requires Gerald Stevens to maintain financial ratios which limit total debt and capital expenditures. Consolidated debt cannot exceed earnings before interest, taxes, depreciation and amortization by a ratio of 2.75 to 1.00 (3.00 to 1.00 on or prior to August 31, 1999) or exceed consolidated stockholders' equity. In addition, the ratio of earnings before interest and taxes plus lease payments, to the sum of interest expense, current maturities of debt, cash income taxes and lease payments must not be less than 1.10 to 1.00 prior to December 31, 2000 and 1.25 to 1.00 thereafter. Capital expenditures cannot exceed $22.0 million for the 1999 fiscal year, $42.0 million for the 2000 fiscal year, $50.0 million for the 2001 fiscal year and $52.0 million for the 2002 fiscal year. At August 31, 1999, the Company was in compliance with all debt covenants. We are currently in discussions with a number of financial institutions regarding their participation in a proposed syndication of our bank credit facility. In this regard, we intend to increase the borrowing limits under our credit facility from $40.0 million to approximately $50.0 to $75.0 million. However, there can be no assurance that we will be successful in increasing such borrowing limits. 6. INCOME TAXES The provision (benefit) for income taxes for the years ended August 31, 1999, 1998 and 1997 consist of the following: 1999 1998 1997 ---- ---- ---- (In thousands) Current: Federal $ -- $ -- $ 39 State 145 -- 79 ------- ------- ------- 145 -- 118 ------- ------- ------- Deferred: Federal 1,971 (616) (575) State 211 (66) (62) ------- ------- ------- 2,182 (682) (637) ------- ------- ------- Income tax provision (benefit) $ 2,327 $ (682) $ (519) ======= ======= ======= The reconciliation of the US federal statutory tax rate to Gerald Stevens effective tax rate is as follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Gerald Stevens' deferred income tax asset are as follows: August 31, August 31, 1999 1998 ---- ---- (In thousands) Reserves $ 805 $ 182 Accrued liabilities and other 610 110 Depreciation and amortization 162 180 Net operating losses 4,502 1,070 General business credits 101 232 Basis difference in intangible assets 804 1,432 ------ ------- 6,984 3,206 Valuation allowance (6,984) (1,024) ------ ------- Net deferred income tax asset $ -- $ 2,182 ====== ======= SFAS No. 109 requires a valuation allowance to reduce the deferred tax assets reported if, based on the weight of the evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. At August 31, 1999, the valuation allowance of $7.0 million is necessary as management believes that the net deferred tax asset will not be realized. This represents a change in the valuation allowance for the current year of $6.0 million. As of August 31, 1999, Gerald Stevens has available net operating loss carryforwards of $12.0 million which expire at various dates beginning from 2004 through 2019. 7. STOCKHOLDERS' EQUITY On January 28, 1997, the Company's stockholders approved an increase in the number of shares of authorized common stock from 18,000,000 to 70,000,000. On April 30, 1999, the Company's stockholders approved an increase in the number of shares of authorized common stock from 70,000,000 to 250,000,000. In August 1998, in connection with the initial capitalization of Gerald Stevens Retail, a total of 12,863,290 shares of common stock were issued to various founding shareholders for total consideration of $9.3 million, with proceeds totaling $5.1 million received in fiscal 1998 and $4.2 million in stock subscription balances received at the beginning of fiscal 1999. In August 1998, we also issued 641,997 shares of our common stock valued at $0.5 million in connection with the acquisition of International Floral Network, Inc., a business whose acquired assets consisted solely of rights to acquire 33 retail florist businesses under non-binding letters of intent with the owners of those businesses. Additionally, during the year ended August 31, 1998, the Company issued a total of 196,000 shares of common stock for total consideration of $29,000 in connection with the exercise of stock options and warrants. During the year ended August 31, 1999, Gerald Stevens issued 6,219,537 shares of its common stock in private placement transactions for total consideration of $21.1 million, net of placement fees and expenses. In July 1999, the Company sold 5,000,000 shares of its common stock in a public equity offering for total consideration of $55.2 million, net of underwriting discounts and expenses. Additionally, a total of 712,305 shares of common stock were issued for total consideration of approximately $1.6 million in connection with the exercise of stock options and warrants during this same period. From October 1, 1998 to August 31, 1999, Gerald Stevens issued 10,124,770 shares of its common stock with an aggregate value of $54.8 million to fund the non-cash portion of the total consideration for acquisitions completed during the period. Options and warrants issued in connection with the acquisition of Calyx & Corolla, Inc. resulted in additional consideration of $1.4 million based on the fair market value of such options and warrants at the closing date. As a result of the merger with Gerald Stevens Retail, Gerald Stevens recorded compensation expense and additional paid-in-capital of approximately $1.4 million in connection with the vesting of certain non-plan options. 8. STOCK OPTIONS AND WARRANTS The Company has a 1996 Nonemployee Directors' Stock Option Plan ("Director Plan") and a Management Incentive Stock Plan ("Management Plan"), which were adopted by the Board of Directors in 1995 and approved by the shareholders in 1996. In 1998, the Company approved an additional non-qualified stock option plan ("1998 Plan"). The Director Plan, Management Plan and 1998 Plan are collectively referred to as the "Plans." Under the Plans, the Company has granted non-qualified options to certain directors, officers and key employees to purchase shares of the Company's common stock at a price equal to the fair market value of the common stock at the date of the grant. Generally, options have a term of ten years and vest (i) under the Director Plan, 100%, six months after issuance, (ii) under the Management Plan, 25% upon issuance with additional vesting of 25% after each year of continuous employment, or, in increments of 25% per year over a four-year period on the anniversary of the grant date and (iii) under the 1998 Plan, in increments of 25% per year over a four-year period on the anniversary of the grant date. On June 25, 1997, the Board of Directors granted options for the purchase of 305,000 shares of common stock at fair market value to officers and key employees of Gerald Stevens at an exercise price of $4.00 per share. These options vest in 25% increments when the market price of Gerald Stevens' common stock reaches $5.00, $7.50, $10.00 and $12.50 per share, respectively, for twenty consecutive trading days. As of August 31, 1999, all options had vested and were exercisable. As a result, compensation expense of $1.4 million and $76,000 was recorded for the years ended August 31, 1999 and 1998, respectively. In connection with the acquisition of Calyx & Corolla, Inc. the Company assumed Calyx & Corolla options that converted into rights to purchase Gerald Stevens common stock. Subsequent to the acquisition, no additional options may be issued under the Calyx & Corolla plans. Subsequent to April 30, 1999, the effective date of the merger between Gerald Stevens and Gerald Stevens Retail, stock options are expected to be granted only under the Management Plan with vesting in increments of 25% per year over a four-year period on the anniversary of the grant date, with no additional options expected to be granted under the Director Plan and 1998 Plan. A summary of the status of the Company's stock-based compensation plans as of the end of the 1999, 1998 and 1997 fiscal years, and changes during the fiscal years then ended is presented below: The following table summarizes information about stock options outstanding under the Plans at August 31, 1999: In October 1995, the FASB issued SFAS No. 123, defined in Note 1, which encourages but does not require companies to recognize compensation expense for stock awards based on their fair value at the date of grant. SFAS No. 123 requires pro forma information regarding net income and earnings per share to be presented as if Gerald Stevens had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1999, 1998 and 1997: risk-free interest rates from 4.2% to 7.5%; dividend yield of zero; volatility factors of 50% prior to 1998, 60% for 1998 and 70% for 1999; and weighted-average expected lives of the options from five to six years. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options expected term to exercise. Gerald Stevens' pro forma information required under SFAS No. 123 is as follows: 1999 1998 1997 ---- ---- ---- (In thousands except per share data) Net income (loss): As reported (12,307) (2,268) 3,433 Pro forma (13,047) (2,623) 3,264 Diluted earnings (loss) per share: As reported (0.35) (0.26) 0.39 Pro forma (0.37) (0.31) 0.37 On February 28, 1996, in connection with the issuance of a secured convertible note, Gerald Stevens issued warrants to purchase 650,000 shares of common stock of Gerald Stevens at an exercise price of $1.00 per share. In connection with the acquisition of Calyx & Corolla, Inc., the Company assumed Calyx & Corolla warrants that converted into rights to acquire 14,815 shares of Gerald Stevens common stock at an exercise price of $9.44 per share. During fiscal year 1997, 19,000 warrants were exercised for total proceeds of $19,000. During fiscal year 1998, 219,000 warrants were exercised in a cashless exercise, as allowed in the warrant agreement for 176,000 shares of common stock. Additionally, 9,000 warrants were exercised for total proceeds of $9,000. During fiscal year 1999, 163,055 warrants were exercised for total proceeds of $163,000. At August 31, 1999 and 1998, Gerald Stevens had 254,678 and 402,918 warrants outstanding, respectively, all of which are currently exercisable. Warrants assumed in the Calyx & Corolla acquisition expire on July 16, 2000. All remaining warrants expire on January 1, 2001. 9. EARNING PER SHARE The components of basic and diluted earnings per share are as follows: 10. RELATED PARTY TRANSACTIONS During fiscal 1998, Gerald Stevens purchased the land and buildings used for its Vero Beach operations for approximately $0.7 million. The transaction was financed with cash from operations. The property was previously leased from a trust administered by a relative of the then current Chairman of the Board. On May 7, 1998, the Company entered into a services agreement with a corporation controlled by a member of Gerald Stevens' board of directors. This corporation provided certain management services to the Company and incurred certain expenses on behalf of the Company, with the cost of such items reimbursed by the Company. Through May 31, 1999, a total of $.9 million was paid for all such services provided through that date, which is included in selling, general, and administrative expenses in the accompanying consolidated statement of operations. The parties mutually agreed to terminate the services agreement on May 31, 1999. The Company also has a supply agreement with flower farms affiliated with two of Gerald Stevens' stockholders as more fully described in Note 11. 11. COMMITMENTS AND CONTINGENCIES Leases Noncancellable lease obligations of Gerald Stevens at August 31, 1999 call for minimum annual lease payments under various operating leases for buildings, vehicles and equipment as follows: 2000......................... $ 9,483 2001......................... 8,402 2002......................... 7,471 2003......................... 6,447 2004......................... 4,255 Thereafter................... 9,227 -------- $ 45,285 ======== Total rent expense for fiscal years 1999, 1998 and 1997 was $4.0 million, $261,000 and $245,000, respectively. Supply Agreement On October 1, 1998, Gerald Stevens entered into a five-year supply agreement with certain flower farms (the "Farms"). The agreement requires that the Farms provide to Gerald Stevens a certain percentage of their flowers on a consignment basis. The Farms must produce and deliver a minimum number of stems for Gerald Stevens during the growing year commencing on October 1, and ending on September 30. Each July, during the term of the agreement, the parties will meet to establish the minimum stem obligation for each flower type for the upcoming growing year. Gerald Stevens has no obligation to pay for any flowers it receives from the Farms unless and until such flowers are sold by Gerald Stevens. Business Combinations Gerald Stevens may be required to make additional payments of up to $1.1 million to the sellers of three of the businesses that it acquired. Because the outcome of the contingencies underlying these payments are not yet determinable, the payments have not been recorded as a component of the cost of these acquisitions at August 31, 1999. Litigation There are various claims, lawsuits, and pending actions against Gerald Stevens incident to the operations of its businesses. It is the opinion of management, after consultation with counsel, that the ultimate resolution of such claims, lawsuits and pending actions will not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. 12. RETIREMENT PLAN During the 1998 and 1997 fiscal years, Gerald Stevens sponsored a 401(k) retirement plan covering all full-time employees who had completed one year of service. Eligible employees could elect quarterly to contribute up to 15% of their compensation, up to the maximum contribution allowed by law. Gerald Stevens matched contributions up to a maximum of 3% of compensation. This plan was terminated in 1999. On December 1, 1998, Gerald Stevens adopted a new 401(k) Plan, effective January 1, 1999. No employee participated in both plans simultaneously. All employees who have met minimum age and length of service requirements are eligible to participate. Employer matching contributions are fifty percent of the first 3% of compensation contributed by the employee to the plan and generally require year-end employment and 1,000 hours worked during the calendar year. An additional contribution may be made at the discretion of Gerald Stevens. In connection with the matching contribution, Gerald Stevens' contribution in the 1999, 1998 and 1997 fiscal years was $232,000, $41,000 and $30,000, respectively. 13. BUSINESS SEGMENTS Gerald Stevens operates in two principal business segments: retail and order generation. The Company's reportable segments are strategic business units that offer different products and services. The Company evaluates the performance of its segments based on revenue and operating income. The Company's retail segment consists of the 69 retail florists acquired during the year as well as its import business. The Company's order generation business consists primarily of Florafax, National Flora, Calyx & Corolla and on-line businesses. There is no material intersegment revenue. The following table presents financial information regarding the Company's different business segments as of and for the years ended August 31: 1999 1998 1997 ---- ---- ---- (In thousands) Net revenues: Retail $ 83,971 $ -- $ -- Order generation 26,625 16,221 13,911 --------- --------- --------- $ 110,596 $ 16,221 $ 13,911 ========= ========= ========= Operating income (loss): Retail $ 5,102 $ -- $ -- Order generation 2,579 (873) 2,338 Corporate (17,101) (a) (2,203) (420) --------- --------- --------- $ (9,420) $ (3,076) $ 1,918 ========= ========= ========= Identifiable assets: Retail $ 117,177 $ -- $ -- Order generation 50,664 21,335 10,594 Corporate 5,182 -- -- --------- --------- --------- $ 173,023 $ 21,335 $ 10,594 ========= ========= ========= Depreciation and amortization expense: Retail $ 2,151 $ -- $ -- Order generation 1,245 403 261 Corporate 206 479 -- --------- --------- --------- $ 3,602 $ 882 $ 261 ========= ========= ========= Capital expenditures: Retail $ 1,705 $ -- $ -- Order generation 1,235 1,382 844 Corporate 3,890 -- -- --------- --------- --------- $ 6,830 $ 1,382 $ 844 ========= ========= ========= (a) Includes merger expenses of $4,642. 14. MPI AGREEMENT Effective May 1, 1998, the Company entered into an agreement with Marketing Projects, Inc. that (1) modified the rights and obligations of both parties under a marketing servicing agreement and (2) provided for the acquisition of MPI's proprietary marketing systems by the Company. Also on May 1, 1998, the Company entered into a non-compete and non-disclosure agreement with MPI and the principal employees of MPI. Total consideration of $3.7 million was paid to MPI at the time of closing and the Company is further obligated to pay up to $125,000 in cash in each of the following eight fiscal quarters, contingent upon the attainment of certain quarterly revenue targets. Of the total consideration paid, $3.5 million has been recorded as a contract modification charge, $150,000 has been allocated to the purchase of MPI's proprietary marketing systems and $100,000 has been allocated to the non-compete agreement, with amortization provided over 1 and 2 years, respectively. Since the quarterly contingent payments are based upon the attainment of future revenue targets, Gerald Stevens will record such payments as sales commissions to the extent and at the time they become earned. 15. SUPPLEMENTAL QUARTERLY FINANCIAL DATA (UNAUDITED) 16. SUBSEQUENT EVENTS (UNAUDITED) Business Combinations From September 1, 1999 through November 12, 1999, Gerald Stevens acquired 17 retail florist businesses for total consideration of $12.8 million, consisting of $7.4 million in cash and 507,370 shares of its common stock valued at share prices ranging from $9.68 to $11.53 per share. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE. --------------------- This item is inapplicable, as no such changes or disagreements have occurred. PART III Except for biographical information regarding our executive officers beginning on page 21, the information required by Items 10, 11, 12 and 13 of Part III of Form 10-K will be set forth in our Proxy Statement for our 2000 Annual Meeting of Stockholders, and is hereby incorporated by reference into this report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. ----------------------------------------------------------------- Financial Statements and Schedules. Reference is made to Index set forth on page 35 of this Annual Report on Form 10-K. Reports of Independent Certified Public Accountants on schedules ...........S-1 Schedule II--Valuation of Qualifying Accounts ..............................S-2 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable and therefore, have been omitted. Reports on Form 8-K. We filed the following Reports on Form 8-K during the fourth quarter of our 1999 fiscal year. Exhibits. The exhibits to this Report are listed below. Other than exhibits that are filed herewith, all exhibits listed below are incorporated herein by reference. Exhibits indicated by an asterisk (*) are the management contracts and compensatory plans, contracts or arrangements required to be filed as exhibits to this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GERALD STEVENS, INC. By: /s/ A. Detz ---------------------------- A. Detz (Senior Vice President and Chief Financial Officer) Date: November 24, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on November 24, 1999. Signature Title /s/ G. Geddis President and Director (Principal Executive Officer) S. Berrard* } T. Byrne* } R. Johnson* } R. Owades* } /s/ A. Phillips } Directors K. Puttick* } K. Royer* } A. Williams* } /s/ A. Detz Senior Vice President - -------------------- (Principal Financial Officer) (A. Detz) /s/ E. Baker Vice President and Controller - -------------------- (Principal Accounting Officer) (E. Baker) - ------- * By signing his name hereto, Albert J. Detz is signing this document on behalf of each of the persons indicated above pursuant to powers of attorney duly executed by such persons and filed with the Securities and Exchange Commission. By: /s/ A. Detz ---------------------------- A. Detz (Attorney-in-Fact) REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Gerald Stevens, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements as of August 31, 1999 and 1998 and the years then ended included in this Form 10-K and have issued our report thereon dated November 3, 1999. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The information listed under Schedule II of this Form 10-K is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Miami, Florida, November 3, 1999. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors and Stockholders Gerald Stevens, Inc. We have audited the consolidated financial statements of Gerald Stevens, Inc. for the year then ended August 31, 1997 and issued our report thereon dated October 8, 1998. Our audit also included the financial statement schedule listed under Schedule II of this Form 10-K. This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audit. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP Tampa, Florida October 8, 1998 S-1 GERALD STEVENS, INC. SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (In thousands) Notes: (A) Includes amounts charged to goodwill as part of the determination of the fair value of net assets acquired. (B) Includes amounts written off, net of recoveries. S-2

1075046_1999.txt

1075046_1999

1999

1075046

ITEM 1. BUSINESS BUSINESS OF TROY FINANCIAL CORPORATION Troy Financial Corporation ("Troy Financial") is a Delaware corporation that has registered with the Federal Reserve as the bank holding company for The Troy Savings Bank (the "Bank"). Troy Financial's primary business is the business of the Bank and the Bank's subsidiary companies. Troy Financial and the Bank are collectively referred to as the "Company". Presently, Troy Financial has no plans to own or lease any property, but instead uses the premises and equipment of the Bank. Troy Financial does not employ any persons other than certain officers of the Bank who are not separately compensated by Troy Financial. Troy Financial may utilize the support staff of the Bank from time to time, if needed, and additional employees will be hired as appropriate to the extent Troy Financial expands its business in the future. Troy Financial is subject to regulation and supervision by the Federal Reserve. See "--Regulation." The Troy Savings Bank is a community oriented savings bank headquartered in Troy, New York. The Bank operates through 14 full service branch offices in a six county market area. As a full service financial institution, the Bank places a particular emphasis on residential and commercial real estate loan products, as well as retail and business banking products and services. The Bank and its subsidiaries also offer a complete range of trust, insurance and investments services, including securities brokerage, annuity and mutual funds sales, money management and retirement plan services, and other traditional investment/brokerage activities to individuals, families and businesses throughout the six New York State counties of Albany, Saratoga, Schenectady, Warren, Washington and Rensselaer, the county in which Troy is located. The Company's goal is to be the primary source of financial products and services for its business and retail customers. The Company's business strategy is to serve as a community based, full-service financial services firm by offering a wide variety of business and retail banking products, and trust, insurance, investment management and brokerage services to its potential and existing customers throughout its market area. In addition, Troy Financial intends to establish or acquire a commercial bank and trust company that can accept municipal deposits to complement the Company's municipal investment activities. The Company delivers its products and services and interacts with its customers primarily through its 14 branches and 15 proprietary automated teller machines ("ATMs") and its 24-hour telephone banking service ("Time$aver"). The Company's branches are staffed by managers, branch operations supervisors and customer sales and service representatives ("CSSRs") who are trained and encouraged to market and service the Company's products and services, including those of the Company's subsidiaries. The Bank is subject to regulation, examination and supervision by the FDIC and the New York State Banking Department ("NYSBD"), and is a member of the Federal Home Loan Bank System ("FHLB System"). The Bank's deposits are insured by the FDIC to the maximum extent provided by law. See "--Regulation." LENDING ACTIVITY The Company focuses its lending activity primarily on the origination of commercial real estate loans, commercial business loans, residential mortgage loans and consumer loans. The types of loans that the Company may originate are subject to federal and state law and regulations. Interest rates charged by the Company on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and the rates offered by its competitors. These factors are, in turn, affected by general and economic conditions, monetary policies of the federal government, including the Federal Reserve, legislative tax policies and governmental budget matters. All loan approval decisions are made locally, by individual loan officers or loan committees, depending upon the size of the loan, and the Company responds to all loan requests in a prompt and timely manner. LOAN PORTFOLIO COMPOSITION. At September 30, 1999, the Company's loan portfolio totaled $566.9 million, or 62.0% of total assets, and consisted primarily of single family residential mortgage loans and commercial real estate loans, as well as construction loans, commercial business loans and consumer loans. - 2 - The commercial real estate loan portfolio totaled $216.7 million, or 38.2% and 23.7% of the Company's loans and total assets, respectively, at September 30, 1999. Approximately 75% of the loans are secured by properties located in the Company's six county market area, and an additional 11% are secured by properties located in the New York City area. Approximately 26% of the properties securing the loans are apartment buildings and cooperatives, 26% are office buildings and warehouses and 17% are retail buildings. The Company's commercial real estate loans range in size from $89,000 to $10.0 million, and the median outstanding principal balance at September 30, 1999 was approximately $230,000. The 20 largest commercial real estate loans range in size from $2.8 million to $10.0 million, and the Company had 55 loans with outstanding balances of more than $1.0 million at September 30, 1999. The Company's largest commercial real estate exposure at September 30, 1999 involving a single entity was $27.0 million to a local real estate investor and related real estate interests with whom the Company has had a fourteen year relationship. The commercial business loan portfolio totaled $66.3 million, or 11.7% of the Company's loans and 7.2% of total assets, at September 30, 1999, and includes fixed and adjustable rate loans and adjustable rate lines of credit to a diverse customer base which includes manufacturers, wholesalers, retailers, service providers, educational institutions and government funded entities. The Company's commercial business loans range in size from $10,000 to $10.0 million, with an average principal balance outstanding of approximately $151,000 as of September 30, 1999. The Company's 20 largest commercial business loans at that date ranged in terms of total exposure, including outstanding balances and unfunded commitments, from $2.0 million to $10.0 million. The Company's portfolio of single family residential mortgage loans totaled $221.7 million, or 39.1% of loans and 24.2% of total assets, at September 30, 1999, and consisted primarily of fixed rate and adjustable rate loans secured by detached, single family homes located in the Company's market area, as well as secured home equity and home improvement loans. As of September 30, 1999, the Company's largest single family residential mortgage loan had an outstanding balance of $744,000. As of that date, the typical residential mortgage loan held by the Company in its portfolio had an average principal balance of approximately $80,000, an initial loan-to-value ("LTV") ratio of 80% and was secured by a detached, single family home. The consumer loan portfolio totaled $48.9 million, or 8.6% of the Company's loans and 5.3% of total assets, at September 30, 1999. The Company's consumer loan portfolio includes home equity lines of credit, fixed rate consumer loans, overdraft protection and "Creative Loans", which start with a modest below market interest rate that increases each year. The Company's home equity lines of credit and Creative Loans represented 13.9% and 18.9% of the Company's consumer loan portfolio, respectively, at September 30, 1999. Personal fixed rate loans originated through direct mail marketing programs represented $21.3 million, or 43.6% of the Company's consumer loan portfolio at September 30, 1999. The following table presents the composition of the Company's loan portfolio, excluding loans held for sale, in dollar amounts and percentages at the dates indicated. - 3 - The following table presents, at September 30, 1999, the dollar amount of all loans in the Company's portfolio, excluding loans held for sale, and contractually due after September 30, 2000, and whether such loans have fixed or adjustable interest rates. - 4 - Loan Maturity and Repricing. The following table shows the contractual maturities of the Company's loan portfolio at September 30, 1999. The table does not include loans held for sale, and does not take into account possible prepayments or scheduled principal amortization. The Company generally does not purchase loans from other financial institutions. The Company does, however, sell or enter into commitments to sell certain of its fixed rate mortgage loans to Freddie Mac, as well as to other parties. Historically the Company has sold substantially all of its 15- and 30-year conforming fixed rate mortgage loans into the secondary mortgage market. During 1999 and 1998 the Company sold $46.7 million and $44.5 million of fixed rate mortgage loans into the secondary mortgage market. In late fiscal year 1998, the Company began to hold certain 15-year fixed rate mortgage loans in its loan portfolio. In order to reduce the interest rate risk associated with mortgage loans held for sale, as well as outstanding loan commitments and uncommitted loan applications with rate lock agreements which are intended to be held for sale, the Company enters into formal commitments to sell loans in the secondary market, and may also enter into option agreements. The Company typically retains servicing rights on loans sold in order to generate fee income. As of September 30, 1999, the Company was servicing mortgage loans for others, with an aggregate outstanding principal balance of $230.6 million. The following is a more detailed discussion of the Company's current lending practices. Commercial Real Estate Lending. The Company originates commercial real estate loans primarily in its six county market area, as well as New York City and northern New York, and to a lesser extent in other states. Approximately 11%, 9% and 6%, respectively, of the Company's commercial real estate loans are secured by real estate located in New York City, primarily Manhattan, Brooklyn and the Bronx; northern New York; and states other than New York. At September 30, 1999, the Company's commercial real estate loan portfolio by sector is as follows: 36% in apartment buildings and cooperatives; 29% in office and warehouse buildings; 19% in retail buildings; 4% in buildings owned by non-profit organizations; 4% in the hospitality industry; and 8% in other property types. The volume of the Company's commercial real estate lending increased substantially in fiscal 1999 after relatively consistent activity in the prior two years. The Company has originated $105.2 million, $27.4 million and $30.5 million of new loans in fiscal years 1999, 1998 and 1997, respectively. As part of the Company's commercial real estate lending marketing effort, the Company's commercial real estate loan officers call on prospective borrowers, follow up on branch walk-ins and referrals and interact with representatives of the local real estate industry. In addition to developing business, the Company's commercial real estate loan officers are responsible for the underwriting of commercial real estate loans. The Company's underwriting standards focus on a review of the potential borrower's cash flow, LTV ratios and rent-rolls, as well as the borrower's leverage and working capital ratios, the real estate securing the loan, personal guarantees and the borrower's other on-going projects. In general, - 5 - the Company seeks to underwrite loans with an LTV ratio of 75% or less, although under certain circumstances it will accept an LTV ratio of up to 90%. The Company assigns each commercial real estate loan a risk rating which focuses on the loan's risk of loss. Following the loan officer's initial underwriting and preparation of a credit memorandum, the loan file is reviewed by the Vice President and Director of Commercial Real Estate Lending who then has authority to approve the loan if the loan amount is less than $100,000, in the case of unsecured loans, and less than $227,150, in the case of loans secured by commercial real estate. Unsecured loans between $100,000 and $1.5 million and secured loans between $227,000 and $1.5 million require approval of the Company's Commercial Mortgage Credit Committee. All loans in excess of $1.5 million require approval of the Loan Committee of the Board of Directors. The commercial real estate loan officers are also responsible for monitoring the Company's portfolio of commercial real estate loans on an on-going basis, which includes reviewing annual financial statements, verification that loan covenants have not been violated and property inspections. In addition, the Company employs an annual review process in which an outside consultant, who was previously the director of commercial lending for a large New York commercial bank, reviews 75% to 80% of the Company's commercial real estate portfolio to confirm the Company's assigned risk rating and to review the Company's overall monitoring of the loan portfolio. Commercial Business Lending. Since 1993, the Company has actively sought to originate commercial business loans in its market area. During the year-ended September 30, 1999, the Company originated $52 million of commercial business loans. The Company's commercial loans generally range in size up to $10.0 million, and the borrowers are located within the Company's market area. The Company offers both fixed rate loans, with terms ranging from three to seven years, and adjustable rate lines of credit. As of September 30, 1999, 40.0% of the Company's outstanding commercial loan portfolio consisted of variable rate loan products. As a general rule, the Company sets the interest rates on its loans based on the Company's prime rate or other index rates, plus a premium, and its variable-rate loans reprice at least every 90 days. The Company's commercial loans includes loans used for equipment financing, working capital and accounts receivable, and these loans are made to a diverse customer base which includes manufacturers, wholesalers, retailers, service providers, educational institutions and government funded entities. The Company solicits commercial loan business through its commercial loan officers who call on potential borrowers and follow-up on referrals from other Company employees. The commercial loan officers market the Company's commercial loan products by focusing on the Company's competitive pricing, the Company's reputation for service and the Company's ties to the local business communities. In many cases, the Company's senior management, including the President, will meet with prospective borrowers. The Company also has a small business lending program whereby the Company lends money to small, locally owned and operated businesses. During the year-ending September 30, 1999, the Company originated 124 new small business loans of up to $50,000, and as of September 30, 1999, the Company had over $14.0 million of such loans outstanding. Many of the Company's small business loans are secured by cash collateral or marketable securities or are guaranteed by the Small Business Administration. In addition to developing business, the Company's commercial loan officers are responsible for the underwriting of the commercial loans and the monitoring of the ongoing relationship between the borrower and the Company. Following the loan officer's initial underwriting and preparation of a credit memorandum, the potential loan is reviewed by the Vice President and Director of Commercial Lending who then has authority to approve the loan if the loan amount is less than $100,000. Loans between $100,000 and $1.0 million require approval of the Company's Commercial Loan Credit Committee, and loans in excess of $1.0 million require approval of the Loan Committee of the Board of Directors. The Company's underwriting standards focus on a review of the potential borrower's cash flow, as well as the borrower's leverage and working capital ratios. To a lesser extent, the Company will consider the collateral securing the loan and whether there is a personal guarantee on the loan. To assist with the initial underwriting and ongoing maintenance of the Company's commercial loans, the Company employs the same risk rating system as is used by the Company's commercial real estate loan department. See "-- Commercial Real Estate Lending." At the time a loan is initially underwritten, as well as every time a loan is reviewed, the Company assigns a risk rating. - 6 - The Company monitors its commercial loan portfolio by closely watching all loans with a risk rating which indicates certain adverse factors, such as debt ratios or cash flow issues. In addition, the Company receives delinquency reports beginning on the 10th of every month. If a loan payment is more than 20 days late, then the commercial loan officer begins active loan management, which initially will include calling the borrower or sending a written notice. Moreover, because the Company's lines of credit expire every 12 months, or five months after the borrower's fiscal year end, and the borrower is required to renew the line of credit at such time, the Company, in effect, reunderwrites the loan annually. Because a term loan often includes a line of credit, the status of the borrower and loan is reviewed annually because of the line of credit review. In all reviews, the Company analyzes the borrower's most current financial statements, and in some cases will visit the borrower or inspect the borrower's business and properties. Single Family Residential Lending. During the year ending September 30, 1999, the Company originated $95.8 million of single family residential real estate loans. Substantially all of the Company's residential mortgage loans were originated through the Family Mortgage Banking Co., Inc. (the "FMB"), the Company's mortgage banking subsidiary. FMB currently employs six loan counselors who are responsible for developing the Company's mortgage business by meeting with referrals, networking with representatives of the local real estate industry and sponsoring home buying seminars. In addition, the Company's CSSRs are trained to refer potential mortgage customers to FMB. Although FMB meets with applicants and assists with the application process, the Company handles the processing, underwriting, funding and closing of all residential mortgage loans. The single family residential mortgage loans not originated through FMB generally are originated through independent mortgage brokers or by the Company. The Company currently makes a variety of fixed rate and adjustable rate ("ARMs") mortgage loans which are secured by one- to four-family residences located in the Company's six county market area. The Company offers mortgage loans that conform to Freddie Mac guidelines, as well as jumbo loans, which presently are loans in amounts over $227,150, and loans with other non-conforming features. The Company will underwrite a single family residential mortgage loan with an LTV ratio of up to 95% with private mortgage insurance, and the Company's fixed rate mortgages generally have maturities of 10 to 30 years. The Company offers a variety of ARM programs based on market demand. The Company generally amortizes an ARM over 30 years. On select ARMs, the Company offers a conversion option, whereby the borrower, at his or her option, can convert the loan to a fixed interest rate after a predetermined period of time, generally 10 to 57 months. Interest rates are generally adjusted based on a specified margin over the Constant Treasury Maturity Index. Interest rate adjustments on such loans are limited to both annual adjustment caps and a maximum adjustment over the life of the loan. The origination of ARMs, as opposed to fixed rate loans, helps to reduce the Company's exposure to increases in interest rates. During periods of rising interest rates, however, ARMs may increase credit risks not inherent in fixed rate loans, primarily because, as interest rates rise, the underlying payments of the borrower rise, thereby increasing the potential for default. The annual and lifetime adjustable caps do however help to reduce such risks. The volume and type of ARMs originated through FMB are affected by numerous market factors, including the level of interest rates, competition, consumer preferences and the availability of funds. At September 30, 1999, the Company held $55.5 million of ARMs in its loan portfolio, most of which were one-year ARMs. Single family residential loans are generally underwritten according to Freddie Mac guidelines. The Company requires borrowers who obtain mortgage loans with an LTV ratio greater than 80% to obtain private mortgage insurance in an amount sufficient to reduce the Company's exposure to not more than 80% of the lower of the purchase price or appraised value. In addition, the Company requires escrow accounts for the payment of taxes and insurance if the LTV ratio exceeds 80%, but will permit borrowers to request an escrow account waiver if the LTV ratio is less than 80%. Substantially all mortgage loans originated by the Company include due-on-transfer clauses which provide the Company with the contractual right to deem the loan immediately due and payable, in most instances, if the borrower transfers ownership of the property without the Company's consent. The Company's staff underwriters have authority to approve loans in amounts up to $227,150. Loans between $227,150 and $1.0 million require the approval of the Company's Commercial Mortgage Credit Committee, and loans in excess of $1.0 million require the approval of the Loan Committee of the Board of Directors. - 7 - In an effort to help low and moderate income home buyers in the Company's communities, the Company participates in residential mortgage programs and products sponsored by the State of New York Mortgage Agency ("SONYMA") and the Federal Housing Authority ("FHA"). SONYMA and FHA mortgage programs provide low and moderate income households with smaller down payment and below-market rate loans. The Company typically sells the SONYMA loans back to SONYMA for sale in the secondary market. The Company is also a charter member of the Capital District Affordable Housing Partnership, a local lending consortium which makes mortgage funds available to home buyers who are unable to obtain conventional financing. The Company participates in the Capital District Community Loan and the FHLB Home Buyer's Club. In the past five years, the Company has also made available to low-to-moderate income first-time home buyers over $15 million of conventional no down payment mortgages for its loan portfolio. To complement the Company's portfolio of residential mortgage loan products, the Company also originates fixed rate home equity mortgage loans. These loans are secured by a first or second mortgage on the owner-occupied property. During fiscal 1999, the Company originated $7.8 million of home equity mortgage loans. As of September 30, 1999, the average size of the Company's outstanding home equity mortgage loans in its residential mortgage loan portfolio was $19,000. Consumer Lending. In addition to the Company's residential mortgage and construction loans, the Company offers a variety of consumer credit products, including home equity lines of credit, variable rate or Creative Loans, fixed rate consumer loans and overdraft protection. The objective of the Company's consumer lending program is to maintain a profitable loan portfolio and to serve the credit needs of the Company's customers and the communities in which it does business, while providing for adequate liquidity, diversification and safe and sound banking practices. The Company offers home equity lines of credit in amounts up to $100,000. The home equity lines of credit have fixed interest rates and are available only if the LTV ratio is less than 80%. The Company's Creative Loans begin with a modest below market interest rate which increases each year, and are generally secured by personal property and do not carry prepayment penalties. The average balance on the Company's Creative Loans for fiscal 1999 was $11.1 million. The Company's fixed rate consumer loans are typically made to finance the purchase of new or used automobiles. In such cases, the Company offers 100% financing on new automobiles with terms available up to 60 months and 80% financing on used automobiles with loan terms dependent upon the year of vehicles. The Company also offers unsecured lines of credit or overdraft protection to credit qualified depositors who maintain checking accounts with the Company. In addition to covering overdrafts on checking accounts, these unsecured lines of credit are accessible to borrowers from ATMs throughout the world. The Company markets its consumer credit products through its branches, local advertisements and direct mailings. Applications can be completed at any branch of the Company, and in most cases, the Company will respond to a customer's completed credit application within 24 hours, including the funding of the loan if the borrower is approved. Individual authority to approve consumer loans varies by the amount of the loan and whether it is real estate related. Consumer loans are underwritten according to the Company's Consumer Loans Underwriting practices, and loan approval is based primarily on review of the borrower's employment status, credit report and credit score. Construction Lending. The Company offers residential construction loans to individuals who are constructing their own homes in the Company's market area. Generally, the builders utilized by the Company's construction loan borrowers are ones with whom the Company is familiar and has a long-standing relationship. The Company's loan administration group monitors the periodic disbursements of all construction loans, and before advances are made the Company's independent appraisers provide reports comparing the progress of the construction to the preconstruction schedule. In many cases, the Company converts construction loans to traditional residential or commercial mortgage loans, as the case may be, following completion of construction. During the year ended September 30, 1999, the Company originated $6.5 million of residential construction loans. Residential construction loans outstandings are reported with residential mortgage loans. As of September 30, 1999, the Company had $13.8 million of commercial real estate construction loans outstanding, or 2.4% of the Company's loans and 1.5% of total assets. - 8 - The Company's construction loans generally have terms of up to six months, and require payments of interest only. If construction is not completed on schedule, the Company charges the borrower additional fees in connection with an extension of the loan. The Company's staff underwriters have approval authority of up to $227,150. Loans in excess of $227,150 require approval of the Commercial Mortgage Credit Committee, and loans in excess of $1.5 million require approval of the Loan Committee of the Board of Directors. The Company will not make construction loans in excess of $1.5 million, or greater than 95% of the estimated cost of construction. Construction lending generally involves greater credit risk than permanent financing on owner-occupied real estate. The risk of loss is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction, compared to the estimated cost, including interest, of construction, and the ability of the builder to complete the project. If the estimate of the value proves to be inaccurate, then the Company may be confronted with a project that, when completed, has a value which is insufficient to assure full repayment of the loan. The Company also makes construction loans on commercial real estate projects where the borrowers are well known to the Company and have the necessary liquidity and financial capacity to support the projects through to completion, and where the source of permanent financing, either the Company or another institution, can be verified. All commercial real estate construction lending is done on a recourse basis. As of September 30, 1999, the Company had $13.8 million of commercial real estate construction loans outstanding, or 2.4% of the Company's loans and 1.5% of total assets. Loan Review. As part of the portfolio monitoring process, all commercial business loans, regardless of size, and all commercial real estate loans over $750,000 are subjected to an annual detailed loan review process. All classified loans (see below) in both portfolios are subjected to this process quarterly. Current financial information is analyzed and the loan rating is evaluated to determine if it still accurately represents the level of risk posed by the credit. These reviews are then reviewed by an outside consultant who opines on the reasonableness of the loan officers' conclusions with respect to the loan's risk rating and the related allowance for loan loss, if any. For the classified loans, these quarterly reviews and review by the consultant are complemented by a quarterly loan officers' meeting with the consultant and the Company's Chief Credit Officer. The conclusions reached at these meetings become an integral part of the quarterly analysis of loan loss reserve adequacy. Delinquent Loans. It is the policy of the management of the Company to monitor the Company's loan portfolio to anticipate and address potential and actual delinquencies. The procedures taken by the Company vary depending on the type of loan. With respect to single family residential mortgage loans and consumer loans, when a borrower fails to make a payment on the loan, the Company takes immediate steps to have the delinquency cured and the loan restored to current status. On the 15th of every month, the Credit Administration Department runs delinquency reports. The Company's collection manager and her staff then contact the borrower by telephone to ascertain the reason for the delinquency and the prospects of repayment. Written notices are also sent at that time. The borrower is again contacted by telephone on the 20th and 26th of the month if payment has not been received. After 30 days another notice is sent and the borrower is reported as delinquent. The Credit Administration Department continues to call the borrower, and if payment has not been received by the 60th day, then another notice is sent informing the borrower that the loan must be brought current within the next 30 days or foreclosure proceedings will be commenced. Generally, the Company does not accrue interest on loans more than 90 days past due. The Company's procedures for single family residential loans which have previously been sold by the Company but which the Company currently services are identical during the first 60 days. After 60 days, the Company follows the Freddie Mac or applicable investor guidelines and timeframes regarding delinquent loan accounts. With respect to commercial real estate and commercial business loans, the Credit Administration Department delivers delinquency reports to the respective departments beginning on the 10th of every month. If a loan payment is more than 20 days late, then the loan officer begins active loan management. Classified Assets. The Company's classification policies require the classification of loans and other assets such as debt and equity securities, considered to be of lesser quality, as "substandard," "doubtful" or "loss" assets. An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the - 9 - borrower or of the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets classified as "loss" are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. At September 30, 1999, the Company had classified $10.7 million and $10,000 of assets as "substandard" and "doubtful," respectively. At such date, the Company did not have any assets classified as "loss." At September 30, 1999, the Company had three lending relationships each with an outstanding principal balance in excess of $1.0 million which had an internal adverse classification. Each of the classified loans was a commercial real estate loan and classified as "substandard." A brief description of the loans follows: o One commercial real estate loan with an outstanding principal balance of $2.4 million. The loan is secured by a warehouse industrial property located outside of New York State and is also personally guaranteed. As of September 30, 1999, the loan was on non-accrual status and considered impaired. Subsequent to September 30, 1999, the Company foreclosed on the loan and sold the property. o A $1.9 million commercial real estate loan secured by a multi-family residential property located outside of New York State. The property which secures the loan, prior to the borrower's purchase, was the subject of the Company's foreclosure proceedings. As of September 30, 1999, the loan is current and the borrower is seeking to refinance with other financial institutions. o Three cross-collateralized commercial real estate loans totalling $1.3 million and secured by multi-family residential apartment projects located in upstate New York outside of the Company's market area. As of September 30, 1999, the loans were on non-accrual status and considered impaired. The Company has begun foreclosure proceedings. In addition to classified assets, the Company also has certain "special mention" or "watch list" assets which have characteristics, features or other potential weaknesses that warrant special attention. At September 30, 1999, special mention assets totaled $4.2 million, or 0.46% of total assets. Non-Performing Assets. It is the policy of the Company to place a loan on non-accrual status when the loan is contractually past due 90 days or more, or when, in the opinion of management, the collection of principal and/or interest is in doubt. At such time, all accrued but unpaid interest is reversed against current period income and, as long as the loan remains on non-accrual status, interest is recognized only when received, if considered appropriate by management. In certain cases, the Company will not classify a loan which is contractually past due 90 days or more as non-accruing if management determines that the particular loan is well secured and in the process of collection. In such cases, the loan is simply reported as "past due." Loans are removed from non-accrual status when such loans become current as to principal and interest or when, in the opinion of management, the loans are expected to be fully collectible as to principal and interest. The Company did not have any loans classified as 90 days past due and still accruing interest at September 30, 1999. Non-performing loans also include troubled debt restructurings ("TDRs"). TDRs are loans whose repayment criteria have been renegotiated to below market terms (given the credit risk inherent in the loan) due to the borrowers' inability to repay the loans in accordance with the loans' original terms. At September 30, 1999, the Company classified $616,000, or 0.07% of total assets, as TDRs. The Company classifies property that it acquires as a result of foreclosure or settlement in lieu thereof as other real estate owned ("OREO"). The Company records OREO at the lower of the unpaid principal balance or fair value less estimated costs to sell at the date of acquisition and subsequently recognizes any decrease in fair value by a charge to income. At September 30, 1999, the Company had $76,000 of OREO resulting from single family residential mortgage loans, and $1.8 million of OREO resulting from commercial real estate loans. - 10 - The following presents the amounts and categories of non-performing assets at the dates indicated. For the fiscal years ended 1999, 1998 and 1997, the gross interest income that would have been recorded had the non-accrual loans been on an accrual basis or had the rate not been reduced with respect to the loans restructured in trouble debt restructurings amounted to $553,000, $591,000 and $528,000, respectively. The amounts included in interest income on these loans were $227,000, $411,000 and $99,000 for the fiscal years ended 1999, 1998 and 1997, respectively. Allowance for Loan Losses. In originating loans, there is a substantial likelihood that loan losses will be experienced. The risk of loss varies with, among other things, general economic conditions, the type of loan, the creditworthiness of the borrower and, in the case of a collateralized loan, the quality of the collateral securing the loan. In an effort to minimize loan losses, the Company monitors its loan portfolio by reviewing delinquent loans and taking appropriate measures. In addition, with respect to the Company's commercial real estate and commercial business loans, the Company closely watches all loans with a risk rating that indicates potential adverse factors. Moreover, on an annual basis, the Company reviews borrowers' financial statements, including rent-rolls if appropriate, and in some cases inspects borrowers' properties, in connection with the annual renewal of lines of credit. The Company's outside consultant periodically reviews the credit quality of the loans in the Company's commercial real estate and commercial business loan portfolios, and, together with the Company's Commercial Loan Credit Committee, reviews on a quarterly basis all classified loans over $100,000 with a risk rating that indicates the loan has certain weaknesses. Based on management's on-going review of the Company's loan portfolio, including the risks inherent in the portfolio, historical loan loss experience, general economic conditions and trends and other factors, the Company maintains an allowance for loan losses to cover probable loan losses. The allowance for loan losses is established through a provision for loan losses charged to operations. The provision for loan losses is based upon a number of factors, including the historical loan loss experience, changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry trends, and general economic conditions that may affect borrowers' abilities to pay. Loans are charged against the allowance for loan losses when management believes that the collectibility of all or a portion of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb probable losses on existing loans that may become uncollectible based on evaluation of the collectibility of loans and prior loan loss experience. Based on information currently known to - 11 - management, management considers the current level of reserves adequate to cover probable loan losses, although there can be no assurance that such reserves will in fact be sufficient to cover actual losses. At September 30, 1999, the Company's allowance for loan losses was $10.8 million, or 1.90% of total loans, and 136.6% of non-performing loans at that date. Net charge-offs during the year ending September 30, 1999 were $746,000. As a result of the current level of non-performing loans and net charge-offs, as well as consideration of the general economic trends in the Company's market area, the Company anticipates that its provision for loan losses will remain at approximately its current levels through at least the first fiscal quarter ending December 31, 1999. There can be no assurance, however, that such loan losses will not exceed estimated amounts or that the provision for loan losses will not increase in future periods. The Company will continue to monitor and modify its allowance for loan losses as conditions dictate. The following table is a summary of the activity in the Company's allowance for loan losses for the last five years: - 12 - The following table presents the Company's percent of allowance for loan losses to total allowance and the percent of loans to total loans in each of the categories listed at the dates indicated. This allocation is based on management's assessment as of a given point in time of the risk characteristics of each of the component parts of the total loan portfolio and is subject to changes as and when the risk factors of each such component part change. The allocation is neither indicative of the specific amounts or the loan categories in which future charge-offs may be taken nor is it an indicator of future loss trends. The allocation of the allowance to each category does not restrict the use of the allowance to absorb losses in any category. Securities The Company separates its securities portfolio into securities available for sale and investment securities held to maturity. At September 30, 1999, the Company had $280.9 million, or 30.7% of total assets in securities available for sale and $2.5 million, or 0.3% of total assets, in investment securities held to maturity. These portfolios consist primarily of U.S. government securities and agency obligations, corporate debt securities, municipal securities, - 13 - mortgage-backed securities, mutual funds and equity securities. Management determines the appropriate classification of securities at the time of purchase. If management has the positive intent and ability to hold debt securities to maturity, then they are classified as investment securities held to maturity and are carried at amortized cost. Securities that are identified as trading account assets for resale over a short period are stated at fair value with unrealized gains and losses reflected in current earnings. All other debt and equity securities are classified as securities available for sale and are reported at fair value, with net unrealized gains or losses reported, net of income taxes, as a separate component of equity. At September 30, 1999, the Company did not hold any securities considered to be trading securities. As a member of the FHLB of New York, the Company is required to hold FHLB stock, which is carried at cost because the FHLB stock is not marketable and may only be resold to the FHLB of New York. The Company's investment policy focuses investment decisions on maintaining a balance of high quality, diversified investments. In making its investments, the Company also considers liquidity, the potential need for collateral to be used for pledging purposes, and earnings. Investment decisions are made by the Company's Trust and Investment Officer who has authority to purchase, sell or trade securities qualifying as eligible investments under applicable law and in conformance with the Company's investment policy. In addition, the Company's Director of Municipal Finance is authorized to purchase municipal securities for the Company's portfolio. Under the Company's investment policy, securities eligible for the Company to purchase include: U.S. Treasury obligations, securitized loans from the Company's loan portfolio, municipal securities, certain corporate obligations, equity mutual funds, common stock, preferred stock, convertible preferred, convertible notes and bonds, U.S. governmental agency or agency sponsored obligations, collateralized mortgage obligations and REMICs, banker's acceptances and commercial paper, certificates of deposit and federal funds. - 14 - The following table presents the composition of the Company's securities available for sale and investment securities held to maturity in dollar amounts and percentages at the dates indicated. - 15 - The following table presents information regarding the carrying value, weighted average yields and contractual maturities of the Company's debt securities available for sale and investment securities held to maturity portfolios as of September 30, 1999. Weighted average yields are based on amortized cost. - ---------- (1) Weighted average yields are presented on a tax equivalent basis, using an assumed tax rate of 35%. - 16 - The following is a more detailed discussion of the Company's securities available for sale and investment securities held to maturity portfolios. U.S. Government Securities and Agency Obligations. The Company invests in U.S. Treasury securities, and also debt securities and mortgage-backed securities issued by government agencies and government- sponsored agencies such as Fannie Mae, the FHLBs, Ginnie Mae and Freddie Mac. At September 30, 1999, the Company's investment in U.S. Treasury securities totaled $10.3 million, comprised of $309,000 of U.S. Treasury Bills with an average yield of 4.89% and $10.0 million of U.S. Treasury Notes with an average yield of 5.25%. At September 30, 1999, all such securities were classified as available for sale. At the same date, the Company also held, as available for sale, $161.6 million of non-government guaranteed bonds issued by the FHLBs, Freddie Mac and Fannie Mae, of which $129.6 million are discount notes. These securities had an average yield of 5.52%, and of these securities which were rated, all had ratings of "AAA." The Company's investment policy does not limit the amount of U.S. government and agency obligations that can be held. Corporate Debt Securities. The Company's corporate debt securities portfolio, at September 30, 1999, totaled $6.7 million, and consisted of general corporate obligations, public utility and telephone bonds. All of the Company's corporate debt securities were rated "BBB" or higher, and $5.7 million and $1.0 million were classified as available for sale and held to maturity, respectively. The Company's investment policy limits the amount of corporate debt securities to 25% of the Company's total securities portfolio or approximately $70.9 million at September 30, 1999. Municipal Securities. At September 30, 1999, $64.2 million, of the Company's securities consisted of tax exempt municipal bonds and notes, all of which were classified as available for sale. Of that $64.2 million, $44.8 million were invested in general obligations of jurisdictions in the State of New York, of which $40.5 million represented relationship investments in 54 separate municipalities, including counties, cities, school districts, towns, villages and fire districts. In addition, the Company held $19.4 million in bonds of various municipalities throughout the United States. The Company also held $9.1 million in taxable municipal securities in bonds of municipalities within New York State. The Company's municipal securities have a weighted average maturity of 13 months and a taxable equivalent yield of 5.83% at September 30, 1999. Interest earned on municipal bonds is exempt from federal and, in some cases, state income taxes. The Company's investment policy limits the amount of municipal securities to 15% of the Company's total assets or approximately $137.3 million at September 30, 1999. Mutual Funds and Equity Securities. At September 30, 1999, the Company's mutual funds and equity securities portfolio totaled $12.8 million, all of which was classified as available for sale. The single largest investment in one issuer was $7.3 million of FHLB of New York stock, which the Company is required to hold as a member institution. At September 30, 1999, the Company also had a $5.4 million investment in Federated mutual funds, consisting of $4.0 million in a Federated ARMs Fund, which invests primarily in adjustable and floating rate mortgage securities, and $1.4 million in various other Federated mutual funds, which invest primarily in the common stock of nationally recognized corporations. The Company's investment policy limits the Company's investments in common and preferred stock and mutual funds to 3% of the Company's total assets, or $27.5 million at September 30, 1999. The investment policy presently limits the Company's investment in the securities of any single issuer to $500,000 and limits an investment in any stock mutual fund to .75% of total assets ($6.9 million at September 30, 1999). SOURCES OF FUNDS The Company's lending and investment activities are primarily funded by deposits, repayments and prepayments of loans and securities, proceeds from the sale of loans and securities, proceeds from maturing securities and cash flows from operations. In addition, the Company borrows from the FHLB of New York to fund its operations. Deposits. The Company offers a variety of deposit accounts with a range of interest rates and terms. The Company's deposit accounts consist of interest bearing checking, non-interest bearing checking, business checking, regular savings, money market savings and time deposit accounts. The maturities of the Company's time deposit accounts range from three months to five years. In addition, the Company offers IRAs and Keogh accounts. To enhance its deposit products and increase its market share, the Company offers overdraft protection and direct - 17 - deposit for its retail banking customers and cash management services for its business customers. In addition, the Company offers a low-cost interest bearing checking account service to its customers over 55 years of age. Rates on deposit products are set by the Company's ALCO Committee. At September 30, 1999, the Company's deposits totaled $563.4 million or 83.2% of interest bearing liabilities. At September 30, 1999, the balance of core deposits, which is defined to include NOW accounts, money market accounts, savings accounts and non-interest bearing checking accounts, totaled $335.7 million, or 59.6% of total deposits. At September 30, 1999, the Company had a total of $227.7 million in time deposit accounts, or 40.4% of total deposits, and $177.2 million had maturities of one year or less. The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. The Company's deposits are obtained primarily from the six counties in which the Company's branches are located. The Company relies primarily on the competitive pricing of its deposit products and customer service and long-standing relationships to attract and retain these deposits, although market interest rates and rates offered by competing financial institutions affect the Company's ability to attract and retain deposits. The Company uses traditional means of advertising its deposit products, including local radio and print media, and does not solicit deposits from outside its market area. In addition, the Company does not use brokers to obtain deposits, and at September 30, 1999, the Company had no brokered deposits. The following table presents the dollar amount and percent of deposits in the various types of deposit programs offered by the Company as of the dates indicated. - 18 - The following table sets forth, by various rate categories, the amount of the Company's time deposit accounts outstanding by maturities at the dates indicated. At September 30, 1999, the Company had outstanding $227.7 million in time deposit accounts, maturing as follows: Borrowings. The principal source of the Company's borrowing is through FHLB advances and repurchase agreements. The FHLB system functions in a reserve credit capacity for member savings associations and certain other home financing institutions. Members of a FHLB are required to own stock in the FHLB, and, at September 30, 1999, the Company owned approximately $7.3 million of FHLB stock. The Company uses FHLB advances as an alternative funding source to fund its lending activities when it determines that it can profitably invest the borrowed funds over their term. As of September 30, 1999, the Company had outstanding FHLB advances of approximately $145.2 million. Such borrowings had a weighted average interest rate of 5.49% and a weighted average term of 1.9 years. At September 30, 1999, the Company also had $3.7 million of borrowed funds in the form of securities sold under agreements to repurchase at an agreed upon price and date. The Company generally enters into these agreements only as an accommodation to its business customers but may utilize this funding source more often in the future. TRUST SERVICES The Trust Department of the Company offers a full range of services, including living trusts, executor services, testamentary trusts, employee benefit plan management, custody services and investment management, primarily to corporations, unions and other institutions. The Trust Department has retained the services of two independent financial services firms to provide investment advice and to ratify the decisions of the Trust Department. Operation of the Trust Department is overseen by a Trust Committee which consists of two trust officers and four members of the Company's Board of Directors who rotate on a semi-annual basis. The Trust Department markets its services through its trust officers who call on the Company's existing customers, the Company's CSSRs and branch managers who cross-sell the Trust Department's services, and free seminars open to the public. As of September 30, 1999, the Trust Department managed over $315.3 million of assets, which includes $113.7 million over which the Trust Department has discretionary investment authority. The Trust Department's fee income, which totaled $665,000 for the year ended September 30, 1999, supplements the Company's rate-sensitive interest income. - 19 - SAVINGS BANK LIFE INSURANCE Since 1939, the Company, through its Savings Bank Life Insurance Department ("SBLI"), has been offering a wide variety of low-cost insurance policies, including whole life, single premium life, senior life and children's term, to its customers who live or work in the State of New York. New York law mandates that SBLI activities be segregated from those of the Company and, while the SBLI does not directly affect the Company's earnings, management believes that offering SBLI is beneficial to the Company's relationship with its customers. The SBLI pays its own expenses and reimburses the Company for expenses incurred on its behalf. SUBSIDIARY ACTIVITIES The following are descriptions of the Bank's wholly owned subsidiaries, which are indirectly owned by Troy Financial. The Family Investment Services Co., Inc. The Family Investment Services Co. ("FISC"), which was incorporated in May 1989, is the Bank's wholly owed full-service brokerage firm, offering a complete range of investment products, including mutual funds and debt, equity and government securities, on a fee-per-transaction basis. FISC's goal is to market its products and services to the Company's existing customers who seek alternatives to traditional financial institution savings products. As a complement to the Company's municipal investment activities, FISC intends to begin underwriting general obligation securities of state and political subdivisions. FISC has two full time employees who interface with the Company's branches to facilitate referrals from the CSSRs and branch managers, as well as one officer who assists customers with investment decisions and trading. As of September 30, 1999, FISC held approximately $79.0 million of customer assets. FISC is a member of the National Association of Securities Dealers and is insured by the Securities Insurance Protection Corporation. Family Mortgage Banking Co. FMB, which was incorporated in April 1987, is the Bank's wholly owned mortgage banking subsidiary. The Company originates the majority of its residential real estate and residential construction loans through FMB. Other Subsidiaries. The Bank has ten other wholly owned subsidiaries: The Family Advertising Co. is an advertising agency; T.S. Capital is licensed by the Small Business Administration as a Small Business Investment Corporation in order to offer small business loans and make equity investments in small businesses; The Family Insurance Agency, Inc. is an insurance agency that offers a full range of life and health insurance products, as well as taxed-deferred annuities; and T.S. Real Property Inc., Troy SB Real Estate Co., 32 Second Street, Camel Hill Corporation, 507 Heights Corp. and Realty Umbrella, Ltd. are all related to the management of, or investment in, the Company's foreclosed or purchased real estate. Troy Realty Funding Corp. is a real estate investment trust formed in 1999 to enhance both portfolio yields and capital growth. The Bank funded Troy Realty Funding Corp with approximately $197 million in commercial real estate mortgages. The interest income earned on those assets is passed through to the Bank in the form of dividends. COMPETITION The Company faces significant competition for both deposits and loans. The deregulation of the financial services industry and the commoditization of savings and lending products has led to increased competition among savings banks and other financial institutions for a significant portion of the deposit and lending activity that had traditionally been the arena of savings banks and savings and loan associations. The Company competes for deposits with other savings banks, savings and loan associations, commercial banks, credit unions, money market and other mutual funds, insurance companies, brokerage firms and other financial institutions, many of which are substantially larger in size and have greater financial resources than the Company. The Company's competition for loans comes principally from savings banks, savings and loan associations, commercial banks, mortgage banks, credit unions, finance companies and other institutional lenders, many of whom maintain offices in the Company's market area. The Company's principal methods of competition include providing competitive loan and deposit pricing, personalized customer service, access to senior management of the Company and continuity of banking relationships. - 20 - Although the Company is subject to competition from other financial institutions, some of which have much greater financial and marketing resources, the Company believes it benefits by its position as a community oriented financial services provider with a long history of serving its market area. Management believes that the variety, depth and stability of the communities which the Company services support the service and lending activities conducted by the Company. REGULATION Troy Financial, as a bank holding company, is subject to regulation, supervision, and examination by the Federal Reserve Board. The Bank, as a New York-chartered bank and trust company, is subject to regulation, supervision, and examination by the FDIC as its primary federal regulator and by the Superintendent as its state regulator. Bank Holding Company Regulation Troy Financial is a bank holding company subject to the regulation, supervision, and examination of the Federal Reserve Board under the Bank Holding Company Act. Troy Financial is required to file periodic reports and other information with the Federal Reserve, and the Federal Reserve may conduct examinations of Troy Financial and the Bank. Troy Financial is subject to capital adequacy guidelines of the Federal Reserve. The guidelines apply on a consolidated basis and require bank holding companies to maintain a ratio of tier 1 capital to total assets of 4.0% to 5.0%. There is a minimum ratio of 3.0% established for the most highly rated bank holding companies. The Federal Reserve's capital adequacy guidelines also require bank holding companies to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8.0%, and a minimum ratio of tier 1 capital to risk-weighted assets of 4.0%. As of September 30, 1999, Troy Financial's ratio of tier 1 capital to total assets was 21.21%, its ratio of tier 1 capital to risk-weighted assets was 28.71%, and its ratio of qualifying total capital to risk-weighted assets was 29.96%. Troy Financial's ability to pay dividends to its stockholders and expand its line of business through the acquisition of new banking or nonbanking subsidiaries can be restricted if its capital falls below levels established by the Federal Reserve's guidelines. In addition, any bank holding company whose capital falls below levels specified in the guidelines can be required to implement a plan to increase capital. The Federal Reserve is empowered to initiate cease and desist proceedings and other supervisory actions for violations of the Bank Holding Company Act, or the Federal Reserve's regulations, orders or notices issued thereunder. Under Federal Reserve regulations, banks and bank holding companies which do not meet minimum capital adequacy guidelines are considered to be undercapitalized and are required to submit an acceptable plan for achieving capital adequacy. Federal Reserve approval is required if Troy Financial seeks to acquire direct or indirect ownership or control of any voting shares of a bank if, after such acquisition, Troy Financial would own or control directly or indirectly more than 5% of the voting stock of the bank. Federal Reserve approval also must be obtained if a bank holding company acquires all or substantially all of the assets of a bank or merges or consolidates with another bank holding company. Bank holding companies like Troy Financial are currently prohibited from engaging in activities other than banking and activities so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Federal Reserve regulations contain a list of permissible nonbanking activities that are closely related to banking or managing or controlling banks. These activities include lending activities, certain data processing activities, securities brokerage and investment advisory services, trust activities and leasing activities. A bank holding company must file an application or notice with the Federal Reserve prior to acquiring more than 5% of the voting shares of a company engaged in such activities. On November 12, 1999, President Clinton signed legislation to reform the U.S. banking laws, including the Bank Holding Company Act. The changes made to the Bank Holding Company Act by this legislation, referred to - 21 - as the Gramm-Leach-Bliley Act, will be effective on March 11, 2000, and will expand the permissible activities of bank holding companies like Troy Financial. Upon the effective date of the legislation, Troy Financial will be permitted to own and control depository institutions and to engage in activities that are financial in nature or incidental to financial activities, or activities that are complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. The legislation identifies certain activities that are deemed to be financial in nature, including nonbanking activities currently permissible for bank holding companies to engage in both within and outside the United States, as well as insurance and securities underwriting and merchant banking activities. The Federal Reserve is authorized under the legislation to identify additional activities that are permissible financial activities, but only after consultation with the Department of the Treasury. In order to take advantage of this new authority, a bank holding company's depository institution subsidiaries must be well capitalized and well managed and have at least a satisfactory record of performance under the Community Reinvestment Act. The Bank currently meets these requirements. No prior notice to the Federal Reserve would be required to acquire a company engaging in these activities or to commence these activities directly or indirectly through a subsidiary. Under the Change in Bank Control Act, persons who intend to acquire control of a bank holding company, either directly or indirectly or through or in concert with one or more persons, must give 60 days' prior written notice to the Federal Reserve. "Control" would exist when an acquiring party directly or indirectly has voting control of at least 25% of Troy Financial's voting securities or the power to direct the management or policies of the company. Under Federal Reserve regulations, a rebuttable presumption of control would arise with respect to an acquisition where, after the transaction, the acquiring party has ownership, control or the power to vote at least 10% (but less than 25%) of Troy Financial's common stock. The New York Banking Law requires prior approval of the New York Banking Board before any action is taken that causes any company to acquire direct or indirect control of a banking institution that is organized in the State of New York. The term "control" is defined generally to mean the power to direct or cause the direction of the management and policies of the banking institution and is presumed to exist if the company owns, controls or holds with power to vote 10% or more of the voting stock of the banking institution. Bank Regulation The Bank is a New York-chartered savings bank, and its deposit accounts are insured up to applicable limits by the Federal Deposit Insurance Corporation (the "FDIC") under the Bank Insurance Fund ("BIF"). The Bank is subject to extensive regulation by the New York State Banking Department ("NYSBD") as its chartering agency, and by the FDIC as the deposit insurer. The Bank must file reports with the NYSBD and the FDIC concerning its activities and financial condition, and it must obtain regulatory approval prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions and opening or acquiring branch offices. The NYSBD and the FDIC conduct periodic examinations to assess the Bank's compliance with various regulatory requirements. This regulation and supervision is intended primarily for the protection of the deposit insurance funds and depositors. The regulatory authorities have extensive discretion in connection with the exercise of their supervisory and enforcement activities, including the setting of policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. The Bank derives its lending, investment and other powers primarily from the applicable provisions of the New York Banking Law and the regulations adopted thereunder. Under these laws and regulations, savings banks, including the Bank, may invest in real estate mortgages, consumer and commercial loans, certain types of debt securities, including certain corporate debt securities and obligations of federal, state and local governments and agencies, certain types of corporate equity securities and certain other assets. A savings bank may also exercise trust powers upon approval of the NYSBD. Under the New York Banking Law, the Bank is not permitted to declare, credit or pay any dividends if capital stock is impaired or would be impaired as a result of the dividend. In addition, the New York Banking Law provides that the Bank cannot declare and pay dividends in any calendar year in excess of its "net profits" for such year combined with its "retained net profits" of the two preceding years, less any required transfer to surplus or a fund for the retirement of preferred stock, without prior regulatory approval. - 22 - The Bank is subject to minimum capital requirements imposed by the FDIC that are substantially similar to the capital requirements imposed on Troy Financial. The FDIC regulations require that the Bank maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8.0%, and a minimum ratio of tier 1 capital to risk-weighted assets of 4.0%. In addition, under the minimum leverage-based capital requirement adopted by the FDIC, the Bank must maintain a ratio of tier 1 capital to average total assets (leverage ratio) of at least 3% to 5%, depending on the Bank's CAMELS rating. As of September 30, 1999, the Bank's ratio of total capital to risk-weighted assets was 20.61%, its ratio of tier 1 capital to risk-weighted assets was 19.36%, and the Bank's ratio of tier 1 capital to average total assets was 14.48%. Capital requirements higher than the generally applicable minimum requirements may be established for a particular bank if the FDIC determines that a bank's capital is, or may become, inadequate in view of its particular circumstances. Failure to meet capital guidelines could subject a bank to a variety of enforcement actions, including actions under the FDIC's prompt corrective action regulations. State banks are limited in their investments and activities engaged in as principal to those permissible under applicable state law and that are permissible for national banks and their subsidiaries, unless such investments and activities are specifically permitted by the Federal Deposit Insurance Act or the FDIC determines that such activity or investment would pose no significant risk to the BIF. The FDIC has by regulation determined that certain real estate investment and securities underwriting activities do not present a significant risk to the BIF provided they are conducted in accordance with the regulations. Provisions of the Gramm-Leach-Bliley Act which will be effective on March 11, 2000, will expand the permissible activities of national banks to include the activities noted above that will be permissible for bank holding companies, other than insurance underwriting, merchant banking and real estate development or investment activities. The FDIC, as well as the NYSBD, has extensive enforcement authority over insured savings banks, including the Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices. The Bank is subject to quarterly payments on semiannual insurance premium assessments for its FDIC deposit insurance. The FDIC implements a risk-based deposit insurance assessment system. Deposit insurance assessment rates currently are within a range of $0.00 to $0.27 per $100 of insured deposits, depending on the assessment risk classification assigned to each institution. Under current FDIC assessment guidelines, the Bank expects that it will not incur any FDIC deposit insurance assessments during the next fiscal year, although the current system for assigning assessment risk classifications to insured depository institutions is being reviewed by the FDIC and the deposit insurance assessments are subject to change. The Bank is subject to separate assessments to repay bonds ("FICO bonds") issued in the late 1980's to recapitalize the former Federal Savings and Loan Insurance Corporation. The annual rate of assessments for the payments on the FICO bonds for the quarter beginning on October 1, 1999 is 1.184 basis points for BIF-assessable deposits and 5.92 basis points for SAIF-assessable deposits. Transactions between the Bank and any of its affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. Currently, a subsidiary of a bank that is not also a depository institution is not treated as an affiliate of a bank for purposes of Sections 23A and 23B, but the Gramm-Leach-Bliley Act provides that certain subsidiaries of the Bank which engage in activities not permissible for a national bank to engage in directly would be considered affiliates for purposes of Sections 23A and 23B. Generally, Sections 23A and 23B (i) limit the extent to which a bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and limit such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms that are consistent with safe and sound banking practices. The term "covered transaction" includes the making of loans, purchase of or investment in securities issued by the affiliate, purchase of assets, issuance of guarantees and other similar types of transactions. Most loans by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100 to 130 percent of the loan amount, depending on the nature of the collateral. In addition, any covered transaction by a bank with an affiliate and any sale of assets or provision of services to an affiliate must be on terms that are substantially the same, or at least as favorable, to the bank as those prevailing at the time for comparable transactions with nonaffiliated companies. The Bank is also restricted in the loans it may make to its executive officers, directors, any owner of 10% or more of its stock and to certain entities affiliated with any such person. - 23 - The Bank is subject to certain FDIC standards designed to maintain the safety and soundness of individual banks and the banking system. The FDIC has prescribed safety and soundness guidelines relating to (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth and quality; (vi) earnings; and (vii) compensation and benefit standards for officers, directors, employees and principal stockholders. A state nonmember bank not meeting one or more of the safety and soundness guidelines may be required to file a compliance plan with the FDIC. Under the FDIC's prompt corrective action regulations, insured institutions will be considered (i) "well capitalized" if the institution has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, and a leverage ratio of 5% or greater (provided that the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specified capital level for any capital measure), (ii) "adequately capitalized" if the institution has a total risk-based capital ratio of 8% or greater, a Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or greater (3% or greater if the institution is rated composite CAMELS 1 in its most recent report of examination and is not experiencing or anticipating significant growth), (iii) "undercapitalized" if the institution has a total risk-based capital ratio that is less than 8%, or a Tier 1 risk-based ratio of less than 4% and a leverage ratio that is less than 4% (3% if the institution is rated composite CAMELS 1 in its most recent report of examination and is not experiencing or anticipating significant growth), (iv) "significantly undercapitalized" if the institution has a total risk-based capital ratio that is less than 6%, Tier 1 risk-based capital ratio of less than 3% or a leverage ratio that is less than 3%, and (v) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets that is equal to or less than 2%. Under certain circumstances, the FDIC can reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). At September 30, 1999, the Bank was classified as a "well capitalized" institution. An institution that is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized is required to submit an acceptable capital restoration plan to its appropriate federal banking agency, which would be the FDIC for the Bank. An undercapitalized institution also is generally prohibited from increasing its average total assets, making acquisitions, establishing any branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC. In addition, the FDIC may take any other action that it determines will better carry out the purpose of prompt corrective action initiatives. The Bank is not permitted to pay dividends if, as the result of the payment, it would become undercapitalized, as defined in the prompt corrective action regulations of the FDIC. In addition, if the Bank becomes "undercapitalized" under these regulations, payment of dividends would be prohibited without the prior approval of the FDIC. The Bank also could be subject to these dividend restrictions if the FDIC determines that the Bank is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. Under Federal Reserve regulations, the Bank is required to maintain non-interest-earning reserves against its transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve regulations require that reserves of 3% must be maintained against aggregate transaction accounts of $44.3 million or less (subject to adjustment by the Federal Reserve). Reserves of 10% (subject to adjustment by the Federal Reserve between 8% and 14%) must be maintained against that portion of total transaction accounts in excess of $44.3 million. The first $5.0 million of otherwise reservable balances (subject to adjustment by the Federal Reserve) are exempted from the reserve requirements. The Bank is in compliance with the foregoing requirements. Because required reserves must be maintained in the form of either vault cash, a non-interest-bearing account at a Federal Reserve Bank or a pass-through account as defined by the Federal Reserve, the effect of this reserve requirement is to reduce the Bank's interest-earning assets. Various proposals have been before Congress, which would permit the payment of interest on required reserve balances. The Bank is unable to predict whether or when such legislation will be enacted. The Bank is a member of the Federal Home Loan Bank System (the "FHLB System"). The FHLB System consists of 12 regional Federal Home Loan Banks and provides a central credit facility primarily for member - 24 - institutions. The Bank, as a member of FHLB of New York, is required to acquire and hold shares of capital stock in the FHLB of New York in an amount equal to the greater of 1.0% of the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, 5% of its FHLB of New York advances outstanding, or one per cent of thirty per cent of total assets. At September 30, 1999, the Bank owned $7.3 million of FHLB of New York common stock. Advances from the FHLB of New York are secured by a member's shares of stock in the FHLB of New York and certain types of mortgages and other assets. Interest rates charged for advances vary depending upon maturity and cost of funds to the FHLB of New York. As of September 30, 1999, the Company had $145.2 million of outstanding advances from the FHLB of New York. ITEM 2. ITEM 2. PROPERTIES The Company currently conducts its business through 14 full-service banking offices. The following table sets forth the Company's offices as of September 30, 1999. - 25 - ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to, nor is its property the subject of, any material pending legal proceeding, other than ordinary routine litigation incidental to the business of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Common Stock is currently traded over the counter and quoted on the Nasdaq Stock Market National Market Tier under the symbol "TRYF." Because Troy Financial first issued stock on March 31, 1999, closing sale prices are available for the last two quarters of fiscal 1999 only. The following table sets forth the closing sale prices for the Common Stock for the periods indicated. No dividends were paid in fiscal 1999. The closing price of the Common Stock on September 30, 1999 was $10.8125. The approximate number of holders of record of the Company's Common Stock at September 30, 1999 was 4,600. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following summary financial and other information about the Company is derived from the Company's audited consolidated financial statements for each of the five fiscal years ending September 30, 1999, 1998, 1997, 1996 and 1995. - 26 - - 27 - - ---------- (1) Excludes effect of the $4.1 million stock contribution to The Troy Savings Bank Community Foundation.. (2) Excludes effect of the $4.5 million contribution to The Troy Savings Bank Charitable Foundation. (3) Net interest rate spread represents the difference between the tax effected yield on average interest earning assets and the rate on average interest bearing liabilities. (4) Net interest rate margin represents the tax effected net interest income as a percentage of average interest earning assets. (5) The efficiency ratio represents non-interest expenses less other real estate owned expense, divided by recurring revenues, such as net interest income on a tax effected basis and non-interest income, excluding gains and losses on securities. - 28 - (1) Earnings per share data only applies to periods since the Company's initial public offering on March 31, 1999. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Troy Financial was formed in December 1998 to be the bank holding company of the Bank upon the Bank's conversion from a New York-chartered mutual savings bank to a New York-chartered stock savings bank. Upon the Bank's conversion on March 31, 1999, Troy Financial completed its initial public offering of stock, issuing 12,139,021 shares of common stock, par value $.0001 per share ("Common Stock"), including 408,446 shares contributed to The Troy Savings Bank Community Foundation ( the "Foundation"). Troy Financial sold 11,730,575 shares of Common Stock at a price of $10 per share through a subscription offering to certain depositors of the Bank. Net proceeds to Troy Financial from the offering were $113.7 million after conversion costs and offering costs. Troy Financial invested approximately $57 million of the net proceeds as capital of the Bank, and Troy Financial used $9.6 million of the net proceeds from the conversion to fund a loan to the Bank's employee stock ownership plan (the "ESOP") which allowed the ESOP to purchase 971,122 shares of Common Stock in the open market. Troy Financial's Common Stock is traded on the Nasdaq Stock Market's National Market Tier under the symbol "TRYF." The consolidated financial condition and operating results of Troy Financial are primarily dependent upon its wholly owned subsidiary, the Bank, and the Bank's subsidiaries, and all references to Troy Financial prior to March 31, 1999, except where otherwise indicated, are to the Bank. The Bank is a community based, full service financial institution offering a wide variety of business and retail banking products. The Bank and its subsidiaries also offer a full range of trust, insurance, and investment services. Troy Financial also intends to apply to establish a commercial bank and trust company that can accept municipal deposits to complement Troy Financial's municipal investment activities. The Bank's primary sources of funds are deposits and borrowings, which it uses to originate real estate mortgages, both residential and commercial, commercial business loans, and consumer loans throughout its primary market area which consists of the six New York counties of Albany, Saratoga, Schenectady, Warren, Washington, and Rensselaer (Troy). Troy Financial's profitability, like many financial institutions, is dependent to a large extent upon its net interest income, which is the difference between the interest it receives on interest earning assets, such as loans and investments, and the interest it pays on interest bearing liabilities, principally deposits and borrowings. Results of operations are also affected by the Bank's provision for loan losses, non-interest expenses such as salaries and employee benefits, occupancy and other operating expenses and to a lesser extent, non-interest income - 29 - such as mortgage servicing fees and service charges on deposit accounts. Financial institutions in general, including Troy Financial, are significantly affected by economic conditions, competition and the monetary and fiscal policies of the federal government. Lending activities are influenced by the demand for and supply of housing, competition among lenders, interest rate conditions and funds availability. Deposit balances and cost of funds are influenced by prevailing market rates on competing investments, customer preferences and levels of personal income and savings in the Bank's primary market area. COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 1999 AND SEPTEMBER 30, 1998 Troy Financial's total assets were $915.1 million at September 30, 1999, an increase of $198.5 million, or 27.7% from the $716.6 million at September 30, 1998. The $198.5 million increase was principally due to net proceeds from Troy Financial's initial stock offering of $113.7 million as well as a $100.3 million increase in borrowings from the Federal Home Loan Bank of New York ("FHLB"), which was partially offset by a $14.8 million decrease in deposits, primarily attributable to authorized withdrawals from deposit accounts to pay for subscription orders in the stock offering. The funds were principally invested in loans and securities available for sale, primarily commercial real estate loans, commercial business loans, and U. S. Government agency discount bonds. Cash and cash equivalents were $35.9 million at September 30, 1999, an increase of $18.0 million from the $17.9 million at September 30, 1998. The increase principally reflects the Bank's determination to hold excess cash reserves in anticipation of an increased demand for cash by depositors in the quarter ending December 31, 1999 in anticipation of Year 2000 liquidity needs. The Bank's securities available for sale portfolio was $280.9 million at September 30, 1999, an increase of $83.1 million, or 42% over the $197.8 million as of September 30, 1998. The increase in securities was principally due to a $54.8 million increase in U.S. Government securities and agency obligations, a $21.6 million increase in obligations of states and political subdivisions, a $4.0 million increase in FHLB stock, and a $13.4 million increase in mortgage backed securities, partially offset by a $11.3 million decrease in corporate debt securities. The Bank used approximately eighty percent of its FHLB borrowings to fund the purchase of government discount bonds in order to maintain its qualifying assets ratio at its current level to preserve favorable New York State bad debt deduction rates. - 30 - Total loans receivable were $566.9 million as of September 30, 1999, an increase of $101.3 million or 21.8% over the $465.6 million as of September 30, 1998. Commercial real estate loans increased $50.5 million to $216.7 million at September 30, 1999 or 38.2% of total loans, from $166.2 million at September 30, 1998, or 35.7% of total loans. Commercial business loans increased $21.1 million to $66.3 million, or 11.7% of total loans at September 30, 1999, up from $45.2 million, or 9.7% of total loans at September 30, 1998. The increase in commercial real estate loans and commercial business loans is consistent with Troy Financial's strategy to increase these loan portfolios as part of its emphasis on commercial banking activities. Residential real estate loans increased $19.2 million, or 9.5%, as Troy Financial elected to hold 15 year fixed rate residential mortgages in its portfolio instead of selling them in the secondary mortgage market. Residential loans as a percentage of total loans decreased from 43.5% to 39.1%. The consumer loan portfolio increased $6.9 million from $42.0 million at September 30, 1998 to $48.9 million at September 30, 1999. The increase in the consumer loan portfolio was principally the result of a direct mail marketing program implemented in the quarter ended June 30, 1999. Although the consumer loan portfolio increased in dollars, as a percentage of total loans it decreased from 9.0% at September 30, 1998 to 8.6% at September 30, 1999. - 31 - Non-performing assets at September 30, 1999 were $9.7 million, or 1.06% of total assets, compared to $13.5 million, or 1.89% of total assets at September 30, 1998. The $3.8 million decrease in non-performing loans at September 30, 1999 as compared to September 30, 1998 was attributable primarily to the repayment during fiscal 1999 of three commercial real estate loans. - 32 - The allowance for loan losses is established through a provision for loan losses charged to earnings based on Troy Financial's evaluation of risks inherent in its entire loan portfolio. Such evaluation, which includes a review of all known loans for which full collectibility may not be reasonably assured, considers the market value of the underlying collateral, growth and composition of the loan portfolio, delinquency trends, adverse situations that may affect borrowers' ability to repay, prevailing economic conditions and trends and other factors that warrant recognition in providing for an adequate allowance for loan losses. - 33 - While Troy Financial believes it uses the best information available to determine the allowance for loan losses, unforeseen economic and market conditions could result in adjustments to the allowance for loan losses, and net earnings could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. In addition, various regulatory agencies, as an integral part of their examination process, periodically review Troy Financial's allowance for loan losses and other real estate owned. Such agencies may require Troy Financial to recognize additions to the allowance for loan losses or writedowns of other real estate owned based on their judgements about information available to them at the time of their examination which may not be currently available to management. Management believes Troy Financial's allowance for loan losses is adequate at September 30, 1999; however, future adjustments could be necessary and Troy Financial's results of operations could be adversely affected if circumstances differ substantially from the assumptions used in the determination of the allowance for loan losses. ANALYSIS OF NET INTEREST INCOME Troy Financial's earnings are dependent largely on its net interest income, which is the difference between the amount that Troy Financial receives from its interest earning assets and the amount that Troy Financial pays out on its interest bearing liabilities. - 34 - Average Balance Sheet. The following table sets forth certain information relating to Troy Financial's interest earning assets and interest bearing liabilities for the periods indicated. The yields and rates were derived by dividing tax effected interest income or interest expense by the average balance of assets or liabilities, respectively, for the periods shown. Statutory tax rates were used to calculate tax exempt income on a tax equivalent basis. Average balances were computed based on average monthly balances. Management believes that the use of average monthly balances instead of daily balances does not have a material effect on the information presented. The yields on loans include deferred fees and discounts which are considered yield adjustments. Non-accruing loans have been included in loan balances. The yield on securities available for sale is computed based on amortized cost. (continued) - 35 - - 36 - Rate/Volume Analysis. The following table presents the extent to which changes in interest rates and changes in the volume of interest earning assets and interest bearing liabilities have affected Troy Financial's interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (1) changes attributable to changes in volume (changes in volume multiplied by prior year rate); (2) changes attributable to changes in rate (changes in rate multiplied by prior year volume); and The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. - 37 - COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 1999 AND SEPTEMBER 30, 1998 General. Troy Financial recorded net income of $2.1 million for the year ended September 30, 1999, compared to a net loss of $878,000 for the year ended September 30, 1998. The increase was principally the result of higher net interest income, lower provision for loan losses, and higher non-interest income, partially offset by higher non-interest expenses and income tax expense. Troy Financial's earnings per share were $0.32 for the period April 1, 1999 through September 30, 1999, following the initial public offering. Net Interest Income. Net interest income on a tax equivalent basis for the year ended September 30, 1999, was $29.3 million, an increase of $4.3 million, or 17.4%, when compared to the year ended September 30, 1998. The increase was primarily attributable to a $102.8 million increase in average interest earning assets which more than offset the $42.2 million increase in average interest bearing liabilities. The increase in interest earning assets was principally funded by the net proceeds received from the initial public offering and a $45.7 million increase in average borrowings. Net interest income was also positively affected by the 36 basis point decrease in average cost of funds, which partially offset the 51 basis point decrease in average yield on average interest earning assets. Troy Financial has utilized longer term borrowings with the FHLB to provide some stability in its funding costs and to match the maturities of some of its longer term commercial real estate loans. Interest and dividend income for the year ended September 30, 1999 was $53.0 million on a tax equivalent basis, an increase of $3.9 million, or 8.0%, over the prior year. The increase in the volume of earning assets more than offset the 51 basis point decrease in the average yield on earning assets. The average balance of taxable available for sale securities increased by $63.5 million for the year ended September 30, 1999, compared to 1998, which offset the 60 basis points decrease in average yield. Troy Financial has invested primarily in short-term government agency discount bonds providing liquidity comparable to federal funds while still offering a yield greater than the 5.07% average yield for federal funds sold and other short term investments. The average loan yield for the year ended September 30, 1999 was 7.82%, down 38 basis points from the previous year, but 246 basis points higher than the 5.36% average yield on taxable available for sale securities. Troy Financial has also invested in tax-exempt municipal securities, primarily maturing within one year. The average tax equivalent yield on these securities for 1999 was 5.87%, similar to the yield in 1998 and 80 basis points higher than the average yield on federal funds sold and other short term investments for the year ended September 30, 1999. Interest expense for the year ended September 30, 1999, was $23.8 million, a decrease of $411,000, or 1.7% over the year ended September 30, 1998. The change was principally due to a 36 basis point decrease in the average cost of funds, which more than offset the increase in average volume of interest bearing liabilities. The average balance of interest bearing liabilities was $611.6 million for the year ended September 30, 1999, an increase of $42.2 million, or 7.4%, primarily attributable to an increase in average borrowings of $45.7 million, which offset a $3.4 million decrease in average interest bearing deposits, primarily the result of approximately $26 million in authorized withdrawals from deposit accounts to pay for stock subscription orders, net of deposit growth. The average balance of FHLB borrowings was $57.3 million for the year ended September 30, 1999, as compared to $13.7 million in the previous year. The increase in average FHLB debt more than offset the $20.6 million decline in average time deposit accounts, which Troy Financial experienced as a result of the decrease in time deposits rates. Troy Financial's net interest margin was 3.89% for the year ended September 30, 1999, compared to 3.84% for 1998. The slight increase in net interest margin reflects a $102.8 million increase in average earning assets, due primarily to Troy Financial's initial public offering and higher borrowings, which more than offset the 51 basis point decline in average yield on earning assets, and the 36 basis point decrease in average cost of funds, which more than offset the increase in average interest bearing liabilities. The decline in average cost of funds was principally caused by the decrease in rates paid on savings accounts and time deposits as well as the decrease in average rates paid on FHLB borrowings, which was partially offset by the increase in average borrowings. The decrease in the yield on interest earning assets was caused by the investment of a substantial portion of the offering proceeds in short-term government agency bonds and federal funds, with lower yields than long-term securities, but which provide the liquidity required to fund higher yielding loan growth. - 38 - Provision For Loan Losses. The provision for loan losses was $3.3 million for fiscal 1999, compared to $4.1 million for fiscal 1998. The decrease in the provision was primarily attributable to a reduction in non-performing loans of $3.8 million from $11.6 million at September 30, 1998 to $7.9 million at September 30, 1999. The allowance for loan losses provides coverage of 136.6% of non-performing loans at September 30, 1999, as compared to 70.9% as of September 30, 1998. The percentage of the allowance for loan losses to period end loans was 1.90% and 1.77% for fiscal years ended 1999 and 1998, respectively. The decrease in provision was also the result of a decrease of $1.5 million in net charge-offs to $746,000 for the year ended September 30, 1999 compared to the prior year. In determining the appropriate provision for loan losses, management also considers general economic conditions and real estate trends in Troy Financial's market area, both of which can impact the inherent risk of loss in Troy Financial's current loan portfolio. Troy Financial anticipates its provision for loan losses to remain at approximately its current levels through at least the first fiscal quarter ending December 31, 1999 and for its allowance for loan losses to continue to increase, as the mix of Troy Financial's loan portfolio includes an increasing percentage of higher credit risk loan types, such as commercial real estate loans and commercial business loans. Commercial real estate loans and commercial business loans now represent 49.9% of the total loan portfolio at September 30, 1999 compared to 45.4% at September 30, 1998. Non-Interest Income. Non-interest income was $3.0 million for the year ended September 30, 1999, an increase of $495,000, or 19.4% from the year ended September 30, 1998. The increase was principally caused by increases in net gains from mortgage loan sales, trust service fees, loan servicing fees, and service charges on deposits. Net gains from mortgage loan sales were up $169,000, or 222.4%, during the year ended September 30, 1999, as compared to 1998. Trust service fees were up $206,000, or 44.9%, as a result of a higher balance of assets managed than in the prior year. Loan servicing fees were up $91,000, or 21.1% as a result of a higher balance of loans serviced for the year ended September 30, 1999, as compared to the year ended September 30, 1998. Service charges on deposit accounts were up $34,000, or 4.0%, compared to the prior year, due primarily to a $20.7 million increase in transaction accounts from September 30, 1999 to September 30, 1998. Non-Interest Expense. Non-interest expense for the year ended September 30, 1999 was $25.8 million, an increase of $734,000, or 2.9%, over the prior year. During fiscal 1999, Troy Financial established a Community Foundation to which it contributed 408,446 shares of common stock. In connection with this contribution of common stock to the Community Foundation, Troy Financial recorded a pre-tax expense equal to the value of the contribution ($4.1 million ) in the second quarter of fiscal 1999. In fiscal 1999, in addition to the contribution of common stock to the Community Foundation, Troy Financial also contributed the Troy Savings Bank Music Hall to the Music Hall Foundation. The pre-tax expense related to this contribution was $229,000. Under the Internal Revenue Code ("IRC"), there is an annual charitable deduction limitation of 10% of our annual, pre-contribution, taxable income. The non-deductible part of our contribution expense, however, may be carried forward for five years, subject to the annual 10% limitation. To the extent that our charitable deductions exceed this 10% deduction limitation, based on estimated future taxable income, we would not be able to recognize the full tax benefit associated with our contributions. However, based on anticipated future taxable income we believe that we will be able to deduct the full amount of the contributions over the next five years. The contribution of common stock to the Community Foundation is intended to allow our local communities to share in our potential growth and any profitability over the long term. Troy Financial's future contribution expense will decline as a result of these foundations. In fiscal years 1999, 1998 and 1997, the direct costs paid by Troy Financial, excluding any allocated cost, associated with operating the Music Hall were $81,000, $78,000 and $88,000, respectively. As Troy Financial no longer owns the Music Hall, these expenses will no longer impact Troy Financial's financial results. Also contributing to Troy Financial's increased non-interest expense for the year ended September 30, 1999 was a $621,000 increase in compensation and employee benefits expense during the year ended September 30, 1999, as compared to the prior year, as Troy Financial began to record expenses for its employee stock ownership plan and supplemental retirement and benefit restoration plan for certain executive officers, both of which were adopted in connection with the Bank's conversion to the stock form. The increase in expense was partially offset by a reduction in staffing levels over the comparable period last year. Professional, legal and other fees increased by $438,000, or 47.4% for the year ended September 30, 1999, over the prior year, primarily caused by increased fees - 39 - associated with operating a stock form organization as compared to a mutual savings bank. Other real estate owned expense was down $306,000, or 28.2%, for the year ended September 30, 1999, as compared to 1998. The decrease in expense was principally caused by a decrease in foreclosure costs. Other expense increased by $216,000, or 7.5%, for the year ended September 30, 1999, as compared to 1998. This increase was primarily attributable to $408,000 for Y2K remediation expenses, an increase of $107,000 for advertising, partially offset by a reduction in subsidiary operating expenses in the year ended September 30, 1999. Income Taxes. Income tax benefit for the year ended September 30, 1999, was $85,000, as compared to an income tax benefit of $1.9 million for 1998. The decrease in income tax benefit was primarily caused by the $4.7 million increase in income before taxes for the year ended September 30, 1999, as compared to the prior year. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 1998 AND SEPTEMBER 30, 1997 General. The Company had a net loss of $878,000 for the year ended September 30, 1998, compared to net income of $3.7 million for the year ended September 30, 1997. The 1998 net loss was primarily the result of a $4.8 million contribution expense, $4.5 million of which was related to the Company's cash contribution and commitment to The Troy Savings Bank Charitable Foundation ("Charitable Foundation"). Also contributing to the loss were increases in the Company's other real estate owned expense and compensation and employee benefits expense of $707,000 and $645,000, respectively, for the year ended September 30, 1998. These increased expenses were partially offset by a $3.5 million decrease in income tax expense in fiscal 1998 as compared to fiscal 1997, primarily associated with the tax benefit recorded in connection with the Company's contribution and binding, irrevocable commitment to the Charitable Foundation and otherwise reduced income before taxes. Net Interest Income. The Company's tax equivalent net interest income for the year ended September 30, 1998 was $24.9 million, down $92,000, compared to the year ended September 30, 1997. This decrease was primarily the result of a nine basis point decrease in yield on average interest earning assets and a nine basis point increase in the rate paid on average interest bearing liabilities. A $17.8 million increase in average interest earning assets, which exceeded the $7.3 million increase in average interest bearing liabilities by $10.5 million, partially offset the impact of the decline in yields on the Company's interest earning assets. The Company's net interest margin for the year ended September 30, 1998 was 3.84%, a decrease of 12 basis points from 3.96% for the year ended September 30, 1997. The yield on average interest earning assets decreased from 7.66% to 7.57%, while the rate paid on average interest bearing liabilities increased from 4.16% to 4.25%. Interest Income. The Company's interest income for the year ended September 30, 1998 was $49.1 million, an increase from $48.4 million for the year ended September 30, 1997. Interest on loans decreased $536,000 from $38.9 million for the year ended September 30, 1997 to $38.3 million for the year ended September 30, 1998. The average balance of loans decreased $4.4 million to $467.4 million, and the average yield on loans decreased three basis points from 8.23% to 8.20% for the year ended September 30, 1998. Tax equivalent interest income on securities available for sale decreased by $39,000 and interest income on investment securities held to maturity declined by $53,000 for the year ended September 30, 1998. The average balance of securities available for sale increased only slightly from $124.7 million for the year ended September 30, 1997 to $125.2 million for the year ended September 30, 1998. At the same time, the tax effected average yield on securities available for sale decreased five basis points from 5.97% to 5.92%. The interest income on federal funds sold increased $1.0 million to $2.5 million, and the average balance of federal funds sold and other short-term investments increased from $27.6 million to $45.6 million. Reductions in market interest rates throughout 1998 led to changes in the mix of the Company's interest earning assets and changes in interest income. Lower loan rates resulted in increased residential loan refinancings and fixed rate loans. Because the Company sold most of its fixed rate residential loans, interest income on loans held for sale increased. The interest rate environment also resulted in increased refinancings by commercial mortgage customers, some of which refinanced with other institutions. The Company sought to take advantage of the interest rate environment by borrowing funds from the FHLB, and investing in short-term investments, thereby increasing short term interest income by $1.1 million. The Company continued to invest in short term federal funds due to the favorable short term interest rates offered by these instruments compared to other comparable investment alternatives. The average yield on federal funds sold and other short-term investments increased from 5.45% to 5.59%. - 40 - Interest Expense. The Company's interest expense increased by $842,000 to $24.2 million for the year ended September 30, 1998. The increase is attributable to increased average balances and rates paid on deposits and borrowings. The two largest categories of interest bearing deposits are savings accounts and time deposits. Interest expense on savings accounts decreased by $196,000 to $6.5 million for the year ended September 30, 1998, primarily due to a $6.4 million decrease in the average balance of savings accounts. Interest on time deposits for the year ended September 30, 1998 was $14.7 million, up $614,000 from the year ended September 30, 1997. This increase was the result primarily of a 16 basis point increase in the rates paid on these deposits and a $3.5 million increase in the average balance of time deposits for the year ended September 30, 1998. Interest expense on the Company's NOW and money market accounts was relatively flat, increasing only $104,000 from fiscal 1997 to fiscal 1998. The slight increase was attributable to a $5.3 million increase in the average balances of these deposits accounts. Interest expense on the Company's borrowings increased $315,000 in fiscal 1998 compared to fiscal 1997. The increase is attributable to a $5.3 million increase in the average balance of borrowings, coupled with a 14 basis point increase in the average rate paid on borrowings. The increase in borrowings reflects the Company's use of alternative funding sources in lieu of relatively higher cost time deposit accounts. Provision for Loan Losses. The provision for loan losses was $4.1 million for fiscal 1998, compared to $3.9 million for fiscal 1997. Many of the adverse credit quality trends noted in fiscal 1997 continued into fiscal 1998. During fiscal 1998, net loan charge-offs were $2.2 million, representing a 25.0% increase from fiscal 1997, when net loan charge-offs were $1.8 million. In addition, nonperforming loans increased from $8.7 million at September 30, 1997 to $11.6 million at September 30, 1998. This increase is consistent with the trends noted at September 30, 1997 when significant increases in classified loans and loans 60 to 89 days delinquent were noted. In determining the appropriate provision for loan losses, management also considers general economic conditions and real estate trends in the Company's market area, both of which can impact the inherent risk of loss in the Company's current loan portfolio. Management believes that there has been a general decline in the real estate values in the Company's market area, resulting in a decrease in the values of the collateral securing much of the Company's loan portfolio. Management believes that this trend is reflected in the increased level of net loan charge-offs experienced in fiscal years 1998 and 1997 compared to fiscal years 1996, 1995 and 1994. In fiscal years 1998 and 1997, net loan charge-offs as a percentage of average loans were .48% and .38%, respectively, as compared to .21%, .22%, and .15% in fiscal years 1996, 1995, and 1994, respectively. The increased provision in fiscal 1998 also reflects the change in the mix of assets in the Company's loan portfolio as commercial business loans and consumer loans increased as a percentage of total loans from 6.31% and 6.41%, respectively, at September 30, 1997 to 9.70% and 9.02%, respectively, at September 30, 1998. Non-interest Income. The Company's non-interest income decreased by $185,000 to $2.6 million for the year ended September 30, 1998. A $356,000 decrease in the Company's other income and a $28,000 decrease in the Company's loan servicing fees contributed to the decline in non-interest income. Such declines were partially offset by the Company's trust service fees, net gains from mortgage loan sales and deposit service charges, which increased by $97,000, $62,000 and $36,000, respectively, from fiscal 1997 to fiscal 1998. The Company's other non-interest income in 1997 includes a one-time $389,000 federal affordable housing award. Service charges on deposits increased due to increases in demand deposit account balances and additional commercial relationships. Trust service fees increased due to increases in assets under management. These increases reflect the Company's strategy of becoming a more full service relationship institution. Net gains from mortgage loan sales increased as a result of the decline in mortgage rates and a corresponding increase in fixed rate loans held for sale. Non-interest Expense. The Company's non-interest expense increased 35.3% from $18.5 million for the year ended September 30, 1997 to $25.1 million for the year ended September 30, 1998. The primary cause of this increase was a $4.8 million contribution expense, all but $306,000 of which was related to The Company's cash contribution and binding, irrevocable commitment to the Charitable Foundation. Also contributing to the Company's increased non-interest expense for the year ended September 30, 1998 was a $707,000 increase in other real estate owned expense, a $645,000 increase in compensation and employee benefits expense, and a $198,000 increase in professional, legal and other fees expense. The increase in other real estate owned expense is attributable to losses on the disposals of, and additional writedowns taken on, the Company's foreclosed assets or other real estate owned. The increase in compensation expense was primarily related to general merit increases for the Company's employees during the year ended September 30, 1998, and, to a lesser extent, increased staffing levels and health insurance costs. The increase in professional, legal and other fees is a result of - 41 - additional services relating to establishment of the Charitable Foundation, general business counseling and consulting costs, and costs associated with Year 2000 issues and system conversions. Income Taxes. For fiscal 1998, the Company recognized a $1.9 million income tax benefit, as compared to a $1.6 million income expense for the year ended September 30, 1997. The reduction in income tax expense is primarily the result of the fiscal 1998 pre-tax loss of $2.8 million as compared to the fiscal 1997 pre-tax income of $5.2 million. Also contributing to the change in income tax expense was an increase in the level of investments in tax exempt securities from an average investment of $3.2 million during fiscal 1997 to an average investment of $56.0 million during fiscal 1998, the result of which was a significant increase in tax exempt income. LIQUIDITY AND CAPITAL RESOURCES Liquidity is defined as the ability to generate cash flow to meet present and future financial obligations and commitments. Troy Financial's liquid assets include cash and cash equivalents, loans held for sale, securities held to maturity that mature within one year and securities available for sale. At September 30, 1999, Troy Financial's liquid assets as a percentage of deposits which have no withdrawal restrictions, time deposits which mature within one year, short-term borrowings (including repurchase agreements) and long-term debt maturing within one year was 52%. Troy Financial's primary sources of funds are deposits, borrowings and proceeds from the redemption and maturity of federal funds sold and other short-term securities. Although not a recurring source of funds, the sale of shares in the initial public offering provided significant funding in fiscal 1999. Troy Financial's primary cash outflows are new loan originations, purchases of securities, and deposit withdrawals. Management monitors its liquidity position on a daily basis. Although maturities and scheduled amortization of loans are a predictable source of funds, deposit outflows, mortgage prepayments and mortgage loan sales are greatly influenced by changes in interest rates, economic conditions, and competitors. Troy Financial attempts to provide stable and flexible sources of funding through the management of its liabilities, including core deposit products offered through its branch network, as well as FHLB advances. Management believes that the level of Troy Financial's liquid assets combined with daily monitoring of cash inflows and outflows provide adequate liquidity to fund outstanding loan commitments, meet daily withdrawal requirements of Troy Financial's depositors, and meet all other daily obligations of Troy Financial. Consistent with its goals to operate a sound and profitable financial organization, Troy Financial actively seeks to maintain a "well capitalized" institution in accordance with regulatory standards. As of September 30, 1999 and 1998, total equity was $180.4 million and $71.0 million, respectively, or 19.7% and 9.9% of total assets at those respective dates. As of September 30, 1999, Troy Financial exceeded all of the capital requirements of the Federal Reserve Bank and the Bank exceeded all of the capital requirements of the FDIC. See note 17 to the consolidated financial statements for further information regarding regulatory capital requirements. Troy Financial has received approval to purchase up to 9% of its stock, or 1.1 million shares, as part of a stock repurchase program to be completed by March 31, 2000. MANAGEMENT OF INTEREST RATE RISK Interest rate risk is the most significant market risk affecting Troy Financial. Other types of market risk, such as movements in foreign currency exchange rates and commodity prices, do not arise in the normal course of Troy Financial's business operations. Interest rate risk can be defined as an exposure to a movement in interest rates that could have an adverse effect on Troy Financial's net interest income. Interest rate risk arises naturally from the imbalance in the repricing, maturity and/or cash flow characteristics of assets and liabilities. A significant portion of Troy Financial's loans are adjustable or variable rate which could result in reduced levels of interest income during periods of falling rates. In addition, in periods of falling interest rates, prepayments of loans typically increase, which would lead to reduced net interest income if such proceeds could not be reinvested at a comparable spread. Also in a falling rate environment, certain categories of deposits may reach a point where market forces prevent further reduction in the interest rate paid on those instruments. Generally, during extended - 42 - periods when short-term and long-term interest rates are relatively close, a flat yield curve, net interest margins could become smaller, thereby reducing net interest income. The net effect of these circumstances is reduced interest income, offset only by a nominal decrease in interest expense, thereby narrowing the net interest margin. The principal objectives of Troy Financial's interest rate risk management program are to: (a) measure, monitor, evaluate and develop strategies in response to the interest rate risk profile inherent in Troy Financial's assets and liabilities, (b) determine the appropriate level of risk, given Troy Financial's business strategy, operating environment, capital and liquidity requirements, and performance objectives and (c) manage the risk consistent with Troy Financial's guidelines. Through such management, Troy Financial seeks to reduce the vulnerability of its operations to changes in interest rates by matching the maturities of Troy Financial's assets with those of Troy Financial's liabilities and off-balance sheet financial instruments. The responsibility for interest rate risk management oversight is the function of Troy Financial's Asset/ Liability Management Committee ("ALCO"). Troy Financial's ALCO reviews Troy Financial's asset/liability policies and interest rate risk position. Troy Financial's ALCO is chaired by Troy Financial's chief financial officer, and includes Troy Financial's President, Trust and Investment Officer and other members of Troy Financial's senior management team. The ALCO meets at least monthly to review consolidated statement of condition structure, formulate strategy in light of expected economic conditions and review performance against guidelines established to control exposure to the various types of inherent risk, and reports Troy Financial's interest rate risk position to Troy Financial's Board of Directors on a quarterly basis. Troy Financial's ALCO considers variability of net interest income under various rate scenarios. The ALCO also evaluates the overall risk profile and determines actions to maintain and achieve a posture consistent with policy guidelines. Troy Financial, of course, cannot predict the future movement of interest rates, and such movement could have an adverse impact on Troy Financial's consolidated financial condition and results of operations. In recent years, Troy Financial has primarily utilized the following strategies to manage interest rate risk: (a) emphasizing the origination of adjustable rate loans such as, adjustable residential loans ( although in the current rate environment adjustable rate loan originations have slowed) , and to a lesser extent commercial real estate, commercial business and consumer loans; (b) selling substantially all of its 30 year fixed rate residential mortgage loans in the secondary market; (c) utilizing FHLB advances to better structure the maturities of its interest rate sensitive liabilities; and (d) investing in short-term securities which generally bear lower yields, compared to longer-term investments, but which better position Troy Financial for increases in interest rates. In addition, although Troy Financial has generally sold all of its 15- and 30-year conforming fixed rate mortgage loans into the secondary mortgage market, beginning in late fiscal 1998, Troy Financial determined to hold in its loan portfolio substantially all of its 15-year fixed rate mortgage loans in order to increase its interest income. Troy Financial will periodically review the strategy to hold 15-year loans in portfolio as part of its monitoring of interest rate risk. In order to reduce the interest rate risk associated with the portfolio of conventional mortgage loans held for sale, as well as outstanding loan commitments and uncommitted loan applications with rate lock agreements which are intended to be held for sale, Troy Financial enters into agreements to sell loans in the secondary market to - 43 - unrelated investors, and may also enter into option agreements. At September 30, 1999, Troy Financial had mandatory commitments and cancelable options to sell fixed rate mortgage loans at set prices amounting to approximately $9.0 million. The primary tool utilized by management to measure interest rate risk is a balance sheet/income statement simulation model. The model is used to execute simulations of Troy Financial's net interest income performance based upon potential changes in interest rates over a select period of time. The model's input data includes earning assets and interest-bearing liabilities, their associated cash flow characteristics, repricing opportunities, maturities and current rates. In addition, management makes certain assumptions in relation to prepayment speeds for all assets and liabilities which possess optionality, including loans and mortgage-backed securities. These assumptions are based on industry standards for prepayments. The model is first run under an assumption of a flat rate scenario ( i.e. no change in current interest rates ) over a twelve month period. A second and third model are run in which a gradual increase and decrease, respectively, of 200 basis points takes place over a twelve month period. Under these scenarios, assets subject to repricing or prepayment are adjusted to account for faster or slower prepayment assumptions. The resultant changes in net interest income are then measured against the flat rate scenario. The following table summarizes the percentage change in interest income and interest expense by major earning asset and interest-bearing liability categories as of September 30, 1999 in the rising and declining rate scenarios from the forecasted interest income and interest expense amounts in a flat rate scenario. Under the declining rate scenario, net interest income is expected to increase from the flat rate scenario by less than 1% over a twelve month period. Under the rising rate scenario, net interest income is expected to increase from the flat rate scenario by less than one-half of one percent over a twelve month period. This level of variability is well within interest rate risk profile guidelines acceptable to Troy Financial. YEAR 2000 READINESS DISCLOSURE STATEMENT The "Year 2000" issue is the result of computer programs and equipment that depend on embedded chip technology and software using two digits rather than four digits to define the applicable year. For dates on or after January 1, 2000, software and hardware as well as embedded processors may not be able to recognize or process dates correctly. This could result in system failures or miscalculations causing disruption of operations, including, among other things, system or equipment shutdowns, malfunctions or a temporary inability to process transactions or engage in normal business activities. - 44 - Troy Financial began testing certain in-house systems in October 1998, and performed all necessary testing of critical core banking systems by June 30, 1999. The economic cost of the Year 2000 Project includes not only direct incremental amounts expended by Troy Financial for upgrading or replacing software, systems and equipment, but also the use of internal resources devoted to the Year 2000 Project that would have otherwise been devoted to other business opportunities. It is difficult to quantify the economic costs of internal resources so re-directed. During the fiscal year ended September 30, 1999, Troy Financial expensed approximately $408,000 on Year 2000-related matters and capitalized approximately $760,000 for a new branch automation system. During the first quarter of fiscal 2000, we expect to capitalize approximately $450,000 in additional costs as we complete the upgrades to the new branch automation system. The upgrades for the new branch automation system, although not considered by Troy Financial as mission critical, were accelerated as a result of the Year 2000 Project. During the quarter ended March 31, 1999, Troy Financial engaged an independent information technology consultant to provide verification and validation of Troy Financial's risk and cost estimates, systems testing and contingency plans. The results of the study showed no significant exceptions. Troy Financial's investment subsidiary changed its primary data processing service provider during the quarter ended June 30, 1999. Troy Financial is monitoring the Year 2000 readiness of this provider and anticipates that there will be no significant exceptions. The potential impact of Year 2000 on Troy Financial's customers, both borrowers and depositors, has been examined. Troy Financial is aware that if significant commercial borrowers suffer losses or illiquidity because of their own Year 2000 problems, including those of others with whom they do business or on whom they are dependent, Troy Financial may suffer losses from or experience illiquidity. Troy Financial's standard loan documentation programs were revised to take into account customers' Year 2000 compliance in evaluating and rating credit risk. Loan documentation generally includes representations from borrowers about Year 2000 readiness and provides the right to examine the borrowers' systems and procedures in order to determine Year 2000 compliance. The Year 2000 Project has resulted in Troy Financial's core banking systems' hardware, software, and firmware being tested and certified as Year 2000 compliant so as to ensure continuation of all aspects of its core business processes. For non-mission critical systems, Troy Financial and its subsidiaries have developed contingency plans for non-compliant systems. The contingency plans vary with the affected systems. Troy Financial has obtained assurances that its primary vendors, key service providers, and, as noted above, significant credit customers are Year 2000 compliant. Beginning in January 1999, Troy Financial commenced testing and validating its vendors' confirmations of Year 2000 compliance, except in situations involving non-mission critical systems and processes or situations where contingency plans indicate less than one day of interruptions before replacement, correction or changes are possible. In those situations, Troy Financial will rely upon vendors' confirmations. Troy Financial is monitoring the Year 2000 readiness of major vendors which Troy Financial relies upon for bank operations. Troy Financial intends to pursue legal action against vendors in situations where it finds that such vendors' representations concerning Year 2000 compliance are found to be false. Troy Financial is not aware of any limitation that would preclude such actions. Contingency plans and alternative arrangements have been made, or will be made in advance, wherever possible. Failure of Troy Financial's mission critical systems could impair the ability of Troy Financial to do business and service its customers; failure of large or numerous borrowers to repay their loans could impair Troy Financial's capital; failure of utilities and the public infrastructure could adversely affect Troy Financial's operations. Despite Troy Financial's efforts with respect to Year 2000 readiness, including its Year 2000 Project, there can be no assurance that partial or total systems interruptions or business interruptions or the associated costs would not have an adverse effect upon Troy Financial's business, consolidated financial condition, results of operations and business prospects. IMPACT ON INFLATION AND CHANGING PRICES Troy Financial's consolidated financial statements are prepared in accordance with generally accepted accounting principles which require the measurement of financial condition and operating results in terms of - 45 - historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increasing cost of Troy Financial's operations. Unlike those of most industrial companies, Troy Financial's assets and liabilities are nearly all monetary. As a result, interest rates have a greater impact on Troy Financial's performance than do the effects of general levels of inflation. In addition, interest rates do not necessarily move in the direction, or to the same extent, as the price of goods and services. IMPACT OF NEW ACCOUNTING STANDARDS In November 1995, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock Based Compensation" ("SFAS No. 123"). This statement establishes financial accounting standards for stock-based employee compensation plans. SFAS No. 123 permits Troy Financial to choose either a new fair value based method or the Accounting Principles Board ("APB") Opinion 25 intrinsic value based method of accounting for its stock-based compensation arrangements. SFAS No. 123 requires pro forma disclosures of net income and earnings per share computed as if the fair value based method had been applied in financial statements of companies that follow accounting for such arrangements under APB Opinion 25. SFAS No. 123 applies to all stock-based employee compensation plans in which an employer grants shares of its stock or other equity instruments to employees except for employee stock ownership plans. SFAS No. 123 also applies to plans in which the employer incurs liabilities to employees in amounts based on the price of the employer's stock (e.g., stock option plans, stock purchase plans, restricted stock plans and stock appreciation rights). This statement also specifies the accounting for transactions in which a company issues stock options or other equity for services provided by nonemployees or to acquire goods or services from outside suppliers or vendors. Troy Financial will utilize the intrinsic value based method prescribed by APB Opinion No. 25 to account for its stock-based compensation plans. Accordingly, the impact of adopting this statement will not be material to Troy Financial's consolidated financial statements. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As amended by SFAS No. 137, this statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. Troy Financial is currently evaluating the impact of this statement on its consolidated financial statements. FORWARD-LOOKING STATEMENTS When used in this annual report or other filings by Troy Financial with the Securities and Exchange Commission, in Troy Financial's press releases or other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project", "believe", or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, certain disclosures and information customarily provided by financial institutions, such as analysis of the adequacy of the allowance for loan losses or an analysis of the interest rate sensitivity of Troy Financial's assets and liabilities, are inherently based upon predictions of future events and circumstances. Furthermore, from time to time, Troy Financial may publish other forward-looking statements relating to such matters as anticipated financial performance, business prospects, and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, Troy Financial notes that a variety of factors could cause Troy Financial's actual results and experience to differ materially from the anticipated results or other expectations expressed in Troy Financial's forward-looking statements. Some of the risks and uncertainties that may affect the operations, performance, development and results of Troy Financial's business, the interest rate sensitivity of its assets and liabilities, and the adequacy of its allowance for loan losses, include but are not limited to the following: o deterioration in local, regional, national or global economic conditions which could result, among other things, in an increase in loan delinquencies, a decrease in property values, or a change in the housing turnover rate; - 46 - o the effect of certain customers and vendors of critical systems or services failing to adequately address issues relating becoming Year 2000 compliant; o changes in market interest rates or changes in the speed at which market interest rates change; o changes in laws and regulations affecting the financial service industry; o changes in competition; and o changes in consumer preferences. Troy Financial wishes to caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including those described above, could affect Troy Financial's financial performance and could cause Troy Financial's actual results or circumstances for future periods to differ materially from those anticipated or projected. Troy Financial does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The information required herein is incorporated by reference from the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in Item 7 above. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TROY FINANCIAL CORPORATION AND SUBSIDIARY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS - 47 - INDEPENDENT AUDITORS' REPORT The Shareholders and the Board of Directors Troy Financial Corporation: We have audited the accompanying consolidated statements of condition of Troy Financial Corporation and subsidiary (the "Company") as of September 30, 1999 and 1998, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended September 30, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Troy Financial Corporation and subsidiary as of September 30, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 1999, in conformity with generally accepted accounting principles. /s/ KPMG LLP Albany, New York November 5, 1999 - 48 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Condition September 30, 1999 and 1998 (In thousands, except share and per share data) See accompanying notes to consolidated financial statements. - 49 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Income Years ended September 30, 1999, 1998 and 1997 (In thousands, except per share data) See accompanying notes to consolidated financial statements. - 50 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Changes in Shareholders' Equity Years ended September 30, 1999, 1998 and 1997 (In thousands, except share and per share data) See accompanying notes to consolidated financial statements. - 51 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended September 30, 1999, 1998 and 1997 (In thousands) - 52 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended September 30, 1999, 1998 and 1997 (In thousands) See accompanying notes to consolidated financial statements. - 53 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of Troy Financial Corporation (the "Parent Company") and its subsidiary (referred to together as the "Company") conform to generally accepted accounting principles and reporting practices followed by the banking industry. The more significant policies are described below. (A) ORGANIZATION The Company is a bank-based financial services company. The Parent Company's subsidiary, The Troy Savings Bank ("the Bank"), provides a wide range of banking, financing, fiduciary and other financial services to corporate, individual and institutional customers through its branch offices and subsidiary companies. The Bank is regulated by the Federal Deposit Insurance Corporation ("FDIC") and the New York State Banking Department. The Bank completed its conversion from a mutual savings bank to a stock savings bank on March 31, 1999. Concurrent with the Bank's conversion, the Parent Company completed its initial public offering of common stock and used 50% of the net proceeds to purchase all of the common stock of the Bank issued in the conversion. Prior to its initial public offering, the Parent Company had no significant results of operations; therefore, financial information prior to March 31, 1999 reflects the operations of the Bank. (B) BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Parent Company and the Bank. All material intercompany accounts and transactions have been eliminated. The Company utilizes the accrual method of accounting for financial reporting purposes. Amounts in the prior years' consolidated financial statements have been reclassified whenever necessary to conform with the current year's presentation. (C) USE OF ESTIMATES The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. - 54 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of other real estate owned acquired in connection with foreclosures. In connection with the determination of the allowance for loan losses and the valuation of other real estate owned, management obtains appraisals for properties. Management believes that the allowance for loan losses is adequate and that other real estate owned is recorded at its fair value less an estimate of the costs to sell the properties. While management uses available information to recognize losses on loans and other real estate owned, future additions to the allowance for loan losses or writedowns of other real estate owned may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and other real estate owned. Such agencies may require the Company to recognize additions to the allowance for loan losses or writedowns of other real estate owned based on their judgments about information available to them at the time of their examination which may not be currently available to management. A substantial portion of the Company's loans are secured by real estate located throughout the six New York State counties of Albany, Rensselaer, Saratoga, Schenectady, Warren and Washington. In addition, a substantial portion of the other real estate owned is located in those same markets. Accordingly, the ultimate collectibility of a substantial portion of the Company's loan portfolio and the recovery of a substantial portion of the carrying amount of other real estate owned is dependent upon general economic and real estate market conditions in these counties. (D) CASH AND CASH EQUIVALENTS For purposes of the consolidated statements of cash flows, cash and cash equivalents consists of cash on hand, due from banks and federal funds sold. (E) LOANS HELD FOR SALE Loans held for sale are recorded at the lower of cost or fair value, determined on an aggregate basis. It is the intention of management to sell these loans in the near future. Gains and losses on the disposition of loans held for sale are determined on the specific identification method. Loans held for sale, as well as commitments to originate fixed rate mortgage loans at a set interest rate, which will subsequently be sold in the secondary mortgage market, are regularly evaluated and, if necessary, a valuation allowance is recorded for unrealized losses attributable to changes in market interest rates. - 55 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (F) MORTGAGE SERVICING RIGHTS The Company accounts for mortgage servicing rights applicable to mortgage loans sold on or after January 1, 1997 in accordance with Statement of Financial Accounting Standards (SFAS) No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 125 requires entities to recognize as separate assets the rights to service mortgage loans for others, regardless of how those servicing rights were acquired. Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income. Additionally, capitalized mortgage servicing rights are assessed for impairment based on the fair value of those rights, and any impairment is recognized through a valuation allowance by a charge to income. (G) SECURITIES AVAILABLE FOR SALE AND INVESTMENT SECURITIES HELD TO MATURITY Management determines the appropriate classification of securities at the time of purchase. If management has the positive intent and ability to hold debt securities to maturity, they are classified as investment securities held to maturity and are carried at amortized cost. Securities that are identified as trading account assets for resale over a short period are stated at fair value with unrealized gains and losses reflected in current earnings. All other debt and equity securities are classified as securities available for sale and are reported at fair value, with net unrealized gains or losses reported, net of income taxes, in accumulated other comprehensive income or loss (a separate component of shareholders' equity). At September 30, 1999 and 1998, the Company did not hold any securities considered to be trading securities. As a member of the Federal Home Loan Bank of New York (FHLB), the Bank is required to hold FHLB stock, which is carried at cost since there is no readily available market value. Unrealized losses on securities which reflect a decline in value which is other than temporary, if any, are charged to income. Gains or losses on disposition of securities are based on the net proceeds and the amortized cost of the securities sold, using the specific identification method. The amortized cost of securities is adjusted for amortization of premium and accretion of discount, which is calculated on an effective interest method. (H) NET LOANS RECEIVABLE Loans receivable are reported at the principal amount outstanding, net of unearned discount, net deferred loan fees and costs, and the allowance for loan losses. Unearned discounts and net loan fees and costs are accreted to income using an effective interest method. - 56 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Loans considered doubtful of collection by management are placed on a non-accrual status for the recording of interest. Generally, loans past due 90 days or more as to principal or interest are placed on non-accrual status except for (1) those loans which, in management's judgment, are adequately secured and in the process of collection and (2) certain consumer and open-end credit loans which are usually charged-off when they become 120 days past due. When a loan is placed on non-accrual status, all previously accrued income that has not been collected is reversed from current year interest income. Subsequent cash receipts are generally applied to reduce the unpaid principal balance, however, interest on loans can also be recognized as cash is received. Amortization of the related unearned discount and net deferred loan fees and costs is suspended when a loan is placed on non-accrual status. Loans are removed from non-accrual status when they become current as to principal and interest or when, in the opinion of management, the loans are expected to be fully collectible as to principal and interest. (I) ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectibility of all or a portion of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb probable losses on existing loans. Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the historical loan loss experience, changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans and current economic conditions that may affect borrowers' ability to pay. A loan is considered impaired when it is probable that the borrower will not repay the loan according to the original contractual terms of the loan agreement, or when a loan (of any loan type) is restructured in a troubled debt restructuring subsequent to October 1, 1995. The allowance for loan losses related to impaired loans is based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain loans where repayment of the loan is expected to be provided solely by the underlying collateral (collateral dependent loans). The Company's impaired loans are generally commercial-type loans which are collateral dependent. - 57 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (J) OTHER REAL ESTATE OWNED Other real estate owned, representing properties acquired in settlement of loans, is recorded on an individual asset basis at the lower of cost (defined as the fair value at foreclosure or repossession) or the fair value of the asset acquired less an estimate of the costs to sell the property. At the time of foreclosure, the excess, if any, of the recorded investment in the loan over the fair value of the property received is charged to the allowance for loan losses. Subsequent declines in the value of such property and net operating expenses of such properties are charged directly to non-interest expenses. Properties are regularly reappraised and written down to the fair value less the estimated cost to sell the property, if necessary. The recognition of gains and losses from the sale of other real estate owned is dependent on a number of factors relating to the nature of the property sold, terms of the sale, and the future involvement of the Company in the property sold. If a real estate transaction does not meet certain down payment and loan amortization requirements, income recognition is deferred and recognized under an alternative method. (K) PREMISES AND EQUIPMENT Premises and equipment are carried at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the terms of the related leases or the useful lives of the assets. (L) INCOME TAXES The Bank accounts for income taxes in accordance with the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for unused tax carryforwards. Deferred tax assets are recognized subject to management's judgment that those assets will more likely than not be realized. A valuation allowance is recognized if, based on an analysis of available evidence, management believes that all or a portion of the deferred tax assets will not be realized. Adjustments to increase or decrease the valuation allowance are charged or credited, respectively, to income tax expense. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. - 58 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (M) FINANCIAL INSTRUMENTS In the normal course of business, the Company is a party to certain financial instruments with off-balance-sheet risk such as commitments to extend credit, unused lines of credit and standby letters of credit. The Company's policy is to record such instruments when funded. (N) OFFICIAL BANK CHECKS The Company's official checks (including tellers' checks, loan disbursement checks, interest checks, expense checks, money orders and payroll checks) are drawn on deposit accounts at the Company and are ultimately paid through the Company's Federal Reserve Bank correspondent account. (O) TRUST ASSETS AND SERVICE FEES Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the consolidated statements of condition since these assets are not assets of the Company. Trust service fees are reported on the accrual basis. (P) EMPLOYEE BENEFIT COSTS The Company maintains a non-contributory pension plan covering substantially all employees, as well as a supplemental retirement and benefit restoration plan covering certain executive officers selected by the Board of Directors. The costs of these plans, based on actuarial computations of current and future benefits for employees, are charged to current operating expenses. The Company also provides certain post-retirement medical, dental and life insurance benefits to substantially all employees and retirees. The cost of post-retirement benefits other than pensions is recognized on an accrual basis as employees perform services to earn the benefits. Compensation expense is recognized for the Company's Employee Stock Ownership Plan ("ESOP") equal to the average fair value of shares committed to be released for allocation to participant accounts. Any difference between the average fair value of the shares committed to be released for allocation and the ESOP's original acquisition cost is charged or credited to shareholders' equity (additional paid-in capital). The cost of unallocated ESOP shares (shares not yet released for allocation) is reflected as a reduction of shareholders' equity. - 59 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (Q) EARNINGS PER SHARE Basic earnings per share is calculated by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted earnings per share is computed in a manner similar to that of basic earnings per share except that the weighted-average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares (such as stock options and unvested restricted stock) were issued during the reporting period. The Company did not have any potentially dilutive common shares outstanding as of or for the year ended September 30, 1999. Unallocated common shares held by the ESOP are not included in the weighted-average number of common shares outstanding for either the basic or diluted earnings per share calculations. (R) COMPREHENSIVE INCOME Comprehensive income represents the sum of net income and items of "other comprehensive income," which are reported directly in shareholders' equity, net of tax, such as the change in the net unrealized gain or loss on securities available for sale. The Company has reported comprehensive income and its components in the consolidated statements of changes in shareholders' equity. Accumulated other comprehensive income or loss, which is a component of shareholders' equity, represents the net unrealized gain or loss on securities available for sale, net of tax. (S) SEGMENT REPORTING During the year ended September 30, 1999, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This Statement requires public companies to report certain financial and other information about significant revenue-producing segments of the business for which such information is available and is utilized by the chief operating decision maker, if the segment meets certain quantitative requirements as defined by SFAS No. 131. The Company's operations are solely in the financial services industry and include providing to its customers traditional banking services. The Company operates primarily in the geographical regions of Rensselaer, Albany, Schenectady, Saratoga, Washington and Warren counties of New York. Management makes operating decisions and assesses performance based on an ongoing review of its traditional banking operations, which constitute the Company's only reportable segment under SFAS No. 131. - 60 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (2) LOANS HELD FOR SALE AND MORTGAGE SERVICING RIGHTS At September 30, 1999 and 1998, loans held for sale consisted of conventional residential mortgages originated for subsequent sale. At September 30, 1999 and 1998, there was no valuation reserve necessary for loans held for sale. The company retains the servicing rights on certain mortgage loans sold. At September 30, 1999 and 1998, the unamortized balance of mortgage servicing rights on loans sold with servicing retained was approximately $774 thousand and $318 thousand, respectively. The estimated fair value of these mortgage servicing rights was in excess of their carrying value at both September 30, 1999 and 1998, and therefore no impairment reserve was necessary. (3) SECURITIES AVAILABLE FOR SALE The amortized cost and approximate fair value of securities available for sale at September 30 are as follows: - 61 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 During 1999, proceeds from sales of securities available for sale totaled $44.1 million, with gross gains of $9 thousand. During 1998, proceeds from sales of securities available for sale totaled $54.8 million, with gross gains of $9 thousand and gross losses of $1 thousand. During 1997, there were no sales of securities available for sale. As of September 30, 1999, the contractual maturity of debt securities available for sale (mortgage-backed securities are shown separately) at amortized cost and approximate fair value is as follows: Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. - 62 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Mortgage-backed securities available for sale consist entirely of direct pass-through Freddie Mac and Ginnie Mae securities. Other than U.S. government sponsored enterprise securities (securities issued by Freddie Mac or Fannie Mae) at September 30, 1999, and U.S. Treasury securities at September 30, 1998, there were no securities of a single issuer that exceeded 10% of shareholders' equity at each respective date. (4) INVESTMENT SECURITIES HELD TO MATURITY The amortized cost and approximate fair value of investment securities held to maturity as of September 30 are as follows: The amortized cost and approximate fair value of investment securities held to maturity at September 30, 1999, by contractual maturity (mortgage-backed securities are shown separately), are as follows: - 63 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities held to maturity consist entirely of direct pass-through Ginnie Mae securities. (5) Net Loans Receivable A summary of net loans receivable at September 30 is as follows: Non-performing loans at September 30 are as follows: - 64 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 All restructured loans were performing according to their modified terms at September 30, 1999, 1998 and 1997. Had the above non-accrual loans been on accrual status, or had the interest rate not been reduced with respect to the loans restructured in trouble debt restructurings, the additional interest that would have been earned was approximately $326 thousand, $180 thousand and $429 thousand for 1999, 1998 and 1997, respectively. There are no commitments to extend further credit on the restructured loans. Changes in the allowance for loan losses for the years ended September 30 were as follows: At September 30, 1999 and 1998, the recorded investment in loans that are considered to be impaired under SFAS No. 114 totaled $4.9 million and $8.4 million, respectively, for which the related allowance for loan losses was $373 thousand and $1.2 million, respectively. As of September 30, 1999 and 1998, there were no impaired loans which did not have an allowance for loan loss. The average recorded investment in impaired loans for the years ended September 30, 1999, 1998 and 1997 was $6.0 million, $5.9 million and $7.0 million, respectively. The total interest income recognized on impaired loans during the period of impairment was approximately $200 thousand, $0 thousand and $99 thousand for 1999, 1998 and 1997, respectively. The interest income recognized on impaired loans during the period of impairment using the cash basis of income recognition was approximately $137 thousand, $0 thousand and $98 thousand for 1999, 1998 and 1997, respectively. Certain executive officers of the Company were customers of and had other transactions with the Company in the ordinary course of business. Loans to these parties were made in the ordinary course of business at the Company's normal credit terms, including interest rate and collateralization. The aggregate of such loans totaled less than 5% of total shareholders' equity at September 30, 1999 and 1998. - 65 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (6) ACCRUED INTEREST RECEIVABLE Accrued interest receivable consists of the following at September 30: (7) OTHER REAL ESTATE OWNED Other real estate owned at September 30 consists of the following: (8) PREMISES AND EQUIPMENT, NET A summary of premises and equipment at September 30 is as follows: Depreciation and amortization expense was approximately $1.3 million, $1.6 million and $1.4 million for the years ended September 30, 1999, 1998 and 1997, respectively. - 66 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (9) DEPOSITS A summary of deposits at September 30 is as follows: The contractual maturities of time deposits for the years subsequent to September 30, 1999 are as follows: - 67 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Interest expense on deposits and escrow accounts for the years ended September 30 consisted of the following: Individual time deposits in excess of $100 thousand totaled approximately $24.5 million and $33.4 million at September 30, 1999 and 1998, respectively. (10) SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND SHORT-TERM BORROWINGS A summary of securities sold under agreements to repurchase and short-term borrowings as of September 30 and for the years then ended is presented below: - 68 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Securities sold under agreements to repurchase generally mature within ninety days. The Company maintains control over the securities underlying the agreements. Short-term borrowings represent borrowings with original maturities of one year or less. The Company has established overnight and term lines of credit with the FHLB. If advanced, such lines of credit will be collateralized by qualifying loans, securities and FHLB stock. Total availability under these lines was approximately $84.6 million and $67.1 million at September 30, 1999 and 1998, respectively. Participation in the FHLB program requires an investment in FHLB stock. The recorded investment in FHLB stock, included in securities available for sale on the consolidated statements of condition, amounted to $7.3 million and $3.3 million at September 30, 1999 and 1998, respectively. (11) LONG-TERM DEBT At September 30, 1999, long-term debt included a $3.5 million, 5.89% fixed rate amortizing loan and other long-term borrowings of $41.0 million with a weighted-average interest rate of 5.81%. All long-term debt is with the FHLB. The following table sets forth maturities of the long-term debt as of September 30, 1999: Collateral for the long-term debt at September 30, 1999 includes a blanket lien on general assets of the Company and approximately $20.3 million of pledged securities. (12) INCOME TAXES The components of income tax (benefit) expense for the years ended September 30 are as follows: - 69 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 The following is a reconciliation of the expected income tax (benefit) expense and the actual income tax (benefit) expense for the years ended September 30. The expected income tax (benefit) expense has been computed by applying the statutory federal tax rate to income before income tax (benefit) expense: - 70 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at September 30 are presented below: In addition to the deferred tax assets and liabilities described above, the Company had a deferred tax asset of $266 thousand at September 30, 1999, and a deferred tax liability of $273 thousand at September 30, 1998, related to the net unrealized gain or loss on securities available for sale. A corporation's annual tax deduction for charitable contributions is subject to a limitation based on a percentage of taxable income. Contributions in excess of this limitation are carried forward and may be deducted in one or more of the succeeding five tax years. As a result of the cash contributions and commitment to The Troy Savings Bank Charitable Foundation, as well as the contribution of common stock to the Troy Savings Bank Community Foundation, at September 30, 1999, the Company had an unused charitable contribution carryforward of approximately $8.0 million ($3.1 million after-tax), which is available for deduction through 2003 and 2004. Deferred tax assets are recognized subject to management's judgement that realization is more likely than not. Based on the sufficiency of temporary taxable items, historical taxable income, as well as estimates of future taxable income, the Company believes it is more likely than not that the gross deferred tax assets at September 30, 1999 and 1998 will be realized. - 71 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 As a thrift institution, the Bank is subject to special provisions in the Federal and New York State tax laws regarding its allowable tax bad debt deductions and related tax bad debt reserves. These deductions historically have been determined using methods based on loss experience or a percentage of taxable income. Tax bad debt reserves are maintained equal to the excess of allowable deductions over actual bad debt losses and other reserve reductions. These reserves consist of a defined base-year amount, plus additional amounts ("excess reserves") accumulated after the base year. SFAS No. 109 requires recognition of deferred tax liabilities with respect to such excess reserves, as well as any portion of the base-year amount which is expected to become taxable (or "recaptured") in the foreseeable future. Certain amendments to the Federal and New York State tax laws regarding bad debt deductions were enacted in July and August 1996, respectively. The Federal amendments include elimination of the percentage of taxable income method for tax years beginning after December 31, 1995, and imposition of a requirement to recapture into taxable income (over a period of approximately six years) the bad debt reserves in excess of the base-year amounts. The Bank previously established, and will continue to maintain, a deferred tax liability with respect to such excess Federal reserves. The New York State amendments redesignate the Bank's state bad debt reserves at December 31, 1995 as the base-year amount and also provide for future additions to the base-year reserve using the percentage of taxable income method. As a result of the redesignation of the New York State base-year reserve, the Bank reduced its deferred tax liabilities related to the previous excess New York State reserve resulting in a deferred tax benefit in fiscal 1997 of approximately $349 thousand. In accordance with SFAS No. 109, deferred tax liabilities have not been recognized with respect to the Federal base-year reserve of $7.9 million and "supplemental" reserve (as defined) of $1.0 million at September 30, 1999, and the state base-year reserve of $18.9 million at September 30, 1999, since the Company does not expect that these amounts will become taxable in the foreseeable future. Under the tax laws, as amended, events that would result in taxation of these reserves include (1) redemptions of the Bank's stock or certain excess distributions to the Parent Company and (2) failure of the Bank to maintain a specified qualifying assets ratio or meet other thrift definition tests for New York State tax purposes. The unrecognized deferred tax liability at September 30, 1999 with respect to the Federal base-year reserve and supplemental reserve was $2.7 million and $340 thousand, respectively. The unrecognized deferred tax liability at September 30, 1999 with respect to the state base-year reserve was approximately $1.1 million (net of Federal benefit). - 72 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (13) EARNINGS PER SHARE The following table sets forth certain information regarding the calculation of basic earnings per share for the year ended September 30, 1999, based on net income for the six-month period from April 1, 1999 to September 30, 1999. Earnings per share information for periods prior to the Company's initial public offering on March 31, 1999 is not applicable. Unallocated ESOP shares are not considered outstanding for earnings per share computations. The shares become outstanding for earnings per share computations when they are released for allocation. During the year ended September 30, 1999, the Company did not have any potentially dilutive securities outstanding. On October 1, 1999, the Company granted 1,015,617 stock options with an exercise price of $10.813 and 446,165 shares of restricted stock with a grant date fair value of $10.813 per share. The options have a term of ten years and vest in equal annual installments over a five year period. The restricted shares vest in equal annual installments over a five year period. (14) EMPLOYEE BENEFIT PLANS The Company maintains a non-contributory pension plan with Retirement System Group, Inc. covering substantially all its full-time employees. The benefits are generally computed as two percent of the highest three year "average annual earnings" multiplied by years of credited service, subject to various caps and adjustments as provided for in the plan. The amounts contributed to the plan are determined annually on the basis of (a) the maximum amount that can be deducted for federal income tax purposes or (b) the amount certified by an actuary as necessary to avoid an accumulated funding deficiency as defined by the Employee Retirement Income Security Act of 1974. Contributions are intended to provide not only for benefits attributed to service to date but also those expected to be earned in the future. Assets of the plan are primarily invested in pooled equity and fixed income funds. - 73 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 The following table sets forth the pension plan's funded status and amounts recognized in the Company's consolidated financial statements at September 30: Net periodic pension cost recognized in the Company's consolidated statements of income for the years ended September 30 included the following components: - 74 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 The actuarial assumptions used in determining the actuarial present value of the projected benefit obligations as of September 30 were as follows: The Company maintains a 401(k) savings plan covering all salaried and commissioned employees who become eligible to participate upon attaining the age of twenty-one and completing one year of service. Participants may contribute from 2% to 15% of their compensation. The Company made matching contributions equal to 50% of the participants' contributions (up to a limit of 3% of the participants' compensation) in fiscal 1997 and 1998, and through March 31, 1999 of fiscal 1999. Employer matching contributions vest 20% per year beginning after one year of participation in the plan. Employer matching contributions were approximately $77 thousand, $146 thousand and $125 thousand for the years ended September 30, 1999, 1998 and 1997, respectively. The plan was amended effective April 1, 1999 to discontinue employer matching contributions. The Company has established a self-funded employee welfare benefit plan to provide health care coverage (hospital medical, major medical and prescription drug) for eligible employees and their dependents who enroll in the plan. This self insurance program is administered by an unrelated company. Under the terms of the self insurance program, the Company could incur up to a maximum of approximately $913 thousand for the cost of covered claims for the plan year ending December 31, 1999. The Company has purchased a $1.0 million insurance policy to cover claims in excess of the maximum costs under the plan. In addition, there are lower maximum cost limitations for individual claims. The Company provides certain medical, dental and life insurance benefits for retired employees (post-retirement benefits). Substantially all of the Company's employees will become eligible for those benefits if they reach normal retirement age while working for the Company and have the required years of service. - 75 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 The following table sets forth the post-retirement benefit plan's funded status and amounts recognized in the Company's consolidated financial statements at September 30: Net periodic post-retirement benefit cost recognized in the Company's consolidated statements of income for the years ended September 30 included the following components: The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 7.25%, 6.50% and 7.25% as of September 30, 1999, 1998 and 1997, respectively. - 76 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 For measurement purposes, 5% and 3% annual rates of increase in the per capita cost of covered medical and dental costs, respectively, were assumed for fiscal 1999 and thereafter. The medical and dental cost trend rate assumptions have a significant effect on the amounts reported. To illustrate, increasing the assumed medical and dental cost trend rates one percentage point in each year would increase the accumulated post-retirement benefit obligation as of September 30, 1999 by approximately $319 thousand (9.2%) and increase the aggregate of the service and interest cost components of net periodic post-retirement benefit cost for fiscal 1999 by approximately $49 thousand (11.9%). Decreasing the assumed medical and dental cost trend rates one percentage in each year would decrease the accumulated post-retirement benefit obligation as of September 30, 1999 by approximately $288 thousand (8.3%) and decrease the aggregate of the service and interest cost components of net periodic post-retirement benefit cost for fiscal 1999 by approximately $43 thousand (10.4%). The Company established an ESOP in conjunction with the Company's initial public offering to provide substantially all employees of the Company the opportunity to also become shareholders. The ESOP borrowed $9.6 million from the Company and used the funds to purchase 971,122 shares of the common stock of the Company in the open market. The loan will be repaid principally from the Company's discretionary contributions to the ESOP over a period of fifteen years. At September 30, 1999, the loan had an outstanding balance of $9.6 million and an interest rate of 7.00%. Both the loan obligation and the unearned compensation will be reduced by the amount of loan repayments to be made by the ESOP at the end of each plan year ending on December 31. Shares purchased with the loan proceeds are held in a suspense account for allocation among participants as the loan is repaid. Shares released from the suspense account are allocated among participants at the end of the plan year on the basis of relative compensation in the year of allocation. Unallocated ESOP shares are pledged as collateral on the loan and are reported as a reduction of shareholders' equity. The Company reports compensation expense equal to the average market price of the shares to be released from collateral at the end of the plan year. The Company recorded approximately $423 thousand of compensation expense related to the ESOP for the year ended September 30, 1999. - 77 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 During the year ended September 30, 1999, the Company adopted a supplemental retirement and benefit restoration plan for certain executive officers to restore certain benefits that may be reduced due to Internal Revenue Service regulations and to provide supplemental benefits to selected participants in the ESOP who retire or otherwise terminate employment before the ESOP has repaid the loan it incurred to purchase the Company's common stock. The benefits under this plan are unfunded and as of September 30, 1999, the accumulated benefit obligation was approximately $896 thousand. The Company recorded an expense of approximately $158 thousand relating to this plan during the year ended September 30, 1999. (15) COMMITMENTS AND CONTINGENT LIABILITIES (A) LEASE OBLIGATIONS The Company leases several banking office facilities under various noncancellable operating leases. These leases expire (excluding renewal options) in periods ranging from one to ten years. Minimum rental commitments under lease contracts are as follows: - 78 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (B) DATA PROCESSING AGREEMENT During the year ended September 30, 1997, the Company renewed its data processing agreement through January 2002. At September 30, 1999, remaining commitments under this agreement were approximately $2.1 million. (C) OFF-BALANCE-SHEET FINANCING AND CONCENTRATIONS OF CREDIT The Company is a party to certain financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, unused lines of credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated financial statements. The contract amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance-sheet instruments. Contract amounts of financial instruments that represent the future extension of credit as of September 30 at fixed and variable interest rates are as follows: - 79 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since not all of the commitments are expected to be funded, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral, if any, required by the Company upon the extension of credit is based on management's credit evaluation of the customer. Mortgage and construction loan commitments are secured by a first lien on real estate. Collateral on extensions of credit for commercial loans varies but may include accounts receivable, inventory, property, plant and equipment, and income producing commercial property. Commitments to extend credit may be written on a fixed rate basis exposing the Company to interest rate risk given the possibility that market rates may change between commitment and actual extension of credit. - 80 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Standby letters of credit are conditional commitments issued by the Company to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Since a portion of these instruments will expire unused, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Company policies governing loan collateral apply to standby letters of credit at the time of credit extension. Certain residential mortgage loans are written on an adjustable-rate basis and include interest rate caps which limit annual and lifetime increases in the interest rates on such loans. Generally, adjustable rate residential mortgages have an annual rate increase cap of 2% and a lifetime rate increase cap of 5% to 6%. These caps expose the Company to interest rate risk should market rates increase above these limits. At September 30, 1999 and 1998 approximately $55.5 million and $75.6 million of adjustable rate residential loans had interest rate caps. The Company generally enters into rate lock agreements at the time that residential mortgage loan applications are taken. These rate lock agreements fix the interest rate at which the loan, if ultimately made, will be originated. Such agreements may exist with borrowers with whom commitments to extend loans have been made, as well as with individuals who have not yet received a commitment. The Company makes its determination of whether or not to identify a loan as held for sale at the time rate lock agreements are entered into. Accordingly, the Company is exposed to interest rate risk to the extent that a rate lock agreement is associated with a loan application or a loan commitment which is intended to be held for sale, as well as with respect to loans held for sale. At September 30, 1999 and 1998, the Company had rate lock agreements (certain of which relate to loan applications for which no formal commitment has been made) and conventional mortgage loans held for sale amounting to approximately $8.5 million and $20.3 million, respectively. In order to reduce the interest rate risk associated with the portfolio of conventional mortgage loans held for sale, as well as outstanding loan commitments and uncommitted loan applications with rate lock agreements which are intended to be held for sale, the Company enters into agreements to sell loans in the secondary market to unrelated investors, and may also enter into option agreements. At September 30, 1999 and 1998, the Company had mandatory commitments and cancelable options to sell conventional fixed rate mortgage loans at set prices amounting to approximately $9.0 million and $25.0 million, respectively. The Company believes that it will be able to meet these commitments without incurring any material losses. - 81 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (D) SERVICED LOANS Total loans serviced by the Company for unrelated third parties were approximately $230.6 million and $195.7 million at September 30, 1999 and 1998, respectively. (E) CONTINGENT LIABILITIES In the ordinary course of business there are various legal proceedings pending against the Company. Based on consultation with outside counsel, management believes that the aggregate exposure, if any, arising from such litigation would not have a material adverse effect on the Company's consolidated financial statements. (F) CHARITABLE FOUNDATION CONTRIBUTION COMMITMENT In fiscal 1998, the Bank contributed $1.0 million in cash to The Troy Savings Bank Charitable Foundation (the "Foundation") and entered into a binding, unconditional commitment to contribute an additional $4.0 million in cash to the Foundation over the next three years. In fiscal 1999, the Bank contributed an additional $1.0 million in cash to the Foundation. The remaining cash contributions due to the Foundation are $1.5 million for each of the next two fiscal years. As of September 30, 1999 and 1998, the present value of the above commitment was $3.5 million and $2.7 million, respectively, and was recorded as a liability in the consolidated statements of condition. A related contribution expense of $4.5 million was recorded in the 1998 consolidated statement of income. The difference between the present value of the initial commitment and the gross amounts due to the Foundation is being amortized into contribution expense over the initial three year payment period. Such amortization was $211 thousand in fiscal 1999. (G) CONCENTRATIONS OF CREDIT The Company grants commercial, consumer and residential loans primarily to customers throughout the six New York State counties of Albany, Rensselaer, Saratoga, Schenectady, Warren and Washington. Although the Company has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the real estate and construction related sectors of the economy. - 82 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (H) RESERVE REQUIREMENT The Company is required to maintain certain reserves of vault cash and/or deposits with the Federal Reserve Bank. The amount of this reserve requirement, included in cash and due from banks, was approximately $1.1 million and $1.0 million at September 30, 1999 and 1998, respectively. (I) LIQUIDATION ACCOUNT AND DIVIDEND RESTRICTIONS As part of the Bank's conversion from a mutual savings bank to a stock savings bank, the Company established a liquidation account in an amount equal to the Bank's total equity as of September 30, 1998. The liquidation account is maintained for the benefit of eligible depositors who continue to maintain their accounts at the Bank after the conversion. The liquidation account is reduced annually to the extent that eligible depositors have reduced their qualifying deposits. Subsequent increases do not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation, each eligible depositor will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. Neither the Company nor the Bank may pay dividends that would reduce shareholders' equity below the required liquidation account balance. Dividend payments by the Parent company must be within certain guidelines of the Federal Reserve Bank which provide, among other things, that dividends generally should be paid only from current earnings. The Bank's ability to pay dividends to the Parent Company is also subject to various restrictions. Under New York State Banking Law, dividends may be declared and paid only from the Bank's net profits, as defined. The approval of the Superintendent of Banks of the State of New York is required if the total of all dividends declared in any year will exceed the net profit for the year plus the retained net profits of the preceding two years. At September 30, 1999, the Bank had approximately $6.8 million in retained net profits which were available for dividend payments. (16) FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", requires that the Company disclose estimated fair values for its financial instruments. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected net cash flows, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. - 83 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Fair value estimates are based on existing on-and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include the deferred tax assets and liabilities and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates of fair value under SFAS No. 107. In addition there are significant intangible assets that SFAS No. 107 does not recognize, such as the value of core deposits, the Company's branch network, and other items generally referred to as "goodwill." Short-Term Financial Instruments The fair values of certain financial instruments are estimated to approximate their carrying values because the remaining term to maturity of the financial instrument is less than 90 days or the financial instrument reprices in 90 days or less. Such financial instruments include cash and cash equivalents, accrued interest receivable, accrued interest payable and securities sold under agreements to repurchase. Loans Held for Sale The estimated fair value of loans held for sale is calculated by either using quoted market rates or, in the case where a firm commitment has been made to sell the loan, the firm committed price. Securities Available for Sale and Investment Securities Held to Maturity Securities available for sale and investment securities held to maturity are financial instruments which are usually traded in broad markets. Fair values are based upon market prices. If a quoted market price is not available for a particular security, the fair value is determined by reference to quoted market prices for securities with similar characteristics. Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type including residential real estate, commercial real estate, construction, commercial loans and consumer loans. The estimated fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the respective loan portfolio. The estimated fair value for non-performing loans is based on recent external appraisals or estimated cash flows discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information. - 84 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no active market for many of these loans, management has no basis to determine whether the estimated fair value would be indicative of the value negotiated in an actual sale. Deposit Liabilities The estimated fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings accounts, N.O.W. and Super N.O.W. accounts, money market accounts and mortgagors' escrow deposits, is regarded to be the amount payable on demand. The estimated fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities as compared to the cost of borrowing funds in the market. Short-Term Borrowings and Long-Term Debt The estimated fair value of short-term borrowings and long-term debt is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for borrowings with similar maturities. Contributions Payable Contributions payable are recorded in the consolidated statements of condition at the present value of the remaining commitments, therefore the estimated fair value approximates the carrying value. Commitments to Extend Credit, Unused Lines of Credit and Standby Letters of Credit The fair value of commitments to extend credit, unused lines of credit and standby-letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit-worthiness of the counterparties. For fixed rate commitments to extend credit and unused lines of credit, fair value also considers the difference between current levels of interest rates and the committed rates. Based upon the estimated fair value of commitments to extend credit, unused lines of credit and standby letters of credit, there are no significant unrealized gains or losses associated with these financial instruments. - 85 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 Table of Financial Instruments The carrying values and estimated fair values of financial instruments as of September 30 were as follows: - 86 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (17) REGULATORY CAPITAL REQUIREMENTS FDIC regulations require savings institutions to maintain a minimum level of regulatory capital. Under the regulations in effect at September 30, 1999 and 1998, the Bank was required to maintain a minimum leverage ratio of Tier I ("leverage" or "core") capital to adjusted quarterly average assets of 4.0%; and minimum ratios of Tier I capital and total capital to risk-weighted assets of 4.0% and 8.0%, respectively. The Federal Reserve Bank has also adopted capital adequacy guidelines for bank holding companies on a consolidated basis substantially similar to those of the FDIC. Under its prompt corrective action regulations, the FDIC is required to take certain supervisory actions (and may take additional discretionary actions) with respect to an undercapitalized institution. Such actions could have a direct material effect on an institution's financial statements. The regulations establish a framework for the classification of savings institutions into five categories: well capitalized, adequately capitalized, under capitalized, significantly under capitalized, and critically under capitalized. Generally an institution is considered well capitalized if it has a Tier I capital ratio of at least 5.0% (based on total adjusted quarterly average assets); a Tier I risk-based capital ratio of at least 6.0%; and a total risk-based capital ratio of at least 10.0%. The foregoing capital ratios are based in part on specific quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the FDIC about capital components, risk-weighting and other factors. Management believes that, as of September 30, 1999 and 1998, the Bank and the Company met all capital adequacy requirements to which they were subject. Further, the most recent FDIC notification categorized the Bank as a well capitalized institution under the prompt corrective action regulations. There have been no conditions or events since that notification that management believes have changed the Bank's capital classification. - 87 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 The following is a summary of the actual capital amounts and actual and required capital ratios as of September 30 for the Bank and the consolidated Company: - 88 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 (18) CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY The Parent Company began operations in conjunction with the Bank's mutual-to-stock conversion and the Parent Company's initial public offering of its common stock. The following represents the Parent Company's balance sheet as of September 30, 1999, and its income statement and statement of cash flows for the period April 1, 1999 through September 30, 1999. - 89 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 - 90 - TROY FINANCIAL CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements September 30, 1999, 1998 and 1997 - 91 - ITEM 9. ITEM 9. CHARGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required herein is incorporated by reference from Troy Financial's definitive Proxy Statement for its annual meeting of shareholders to be held in February 2000, (the "Proxy Statement") which will be filed with the Securities and Exchange Commission within 120 days of Troy Financial's 1999 fiscal year end. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required herein is incorporated by reference from the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required herein is incorporated by reference from the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required herein is incorporated by reference from the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) The following consolidated financial statements are incorporated by reference from Item 8 hereof: Consolidated Statements of Condition -- September 30, 1999 and 1998. Consolidated Statements of Income -- Years Ended September 30, 1999, 1998, and 1997. Consolidated Statements of Changes in Shareholders' Equity -- Years Ended September 30, 1999, 1998, and 1997. Consolidated Statements of Cash Flows -- Years Ended September 30, 1999, 1998, and 1997. Notes to Consolidated Financial Statements. Independent Auditors' Report. (a)(2) There are no financial statements schedules which are required to be filed as part of this form since they are not applicable. (a)(3) See (c) below for all exhibits filed herewith and the Exhibit Index. (b) Reports on Form 8-K On September 30, 1999, Troy Financial filed a Form 8-K that included a press release dated September 29, 1999, stating its intention to repurchase up to 4% of its outstanding stock and to reissue the stock under its Long-Term Equity Compensation Plan. - 92 - (c) Exhibits. The following exhibits are either filed as part of this annual report on Form 10-K, or are incorporated herein by reference: Exhibit No. Exhibit ----------- ------- 3.1 Amended and Restated Certificate of Incorporation of the Company (incorporated by reference herein to Exhibit 3.1 to the Company's Registration Statement on Form S-1, File No. 333-68813) 3.2 Bylaws of the Company (incorporated by reference herein to Exhibit 3.2 to the Company's Registration Statement on Form S-1, File No. 333-68813) 4.1 Certificate of Incorporation of the Company (filed as Exhibit 3.1 hereto) 4.2 Bylaws of the Company (filed as Exhibit 3.2 hereto) 4.3 Specimen certificate evidencing shares of Common Stock of the (incorporated by reference herein to Exhibit 4.3 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.1 1999 Long-Term Equity Compensation Plan 10.2 Form of Employment Agreements (incorporated by reference herein to Exhibit 10.1 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.3 Form of Employment Protection Agreements (incorporated by reference herein to Exhibit 10.2 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.4 Form of Employee Change of Control Severance Plan (incorporated by reference herein to Exhibit 10.4 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.5 Form of Supplemental Retirement and Benefits Restoration Plan (incorporated by reference herein to Exhibit 10.5 to the Company's Registration Statement on Form S-1, File No. 333-68813) 21.1 Subsidiaries of Troy Financial Corporation 27.1 Financial Data Schedule (d) There are no other financial statements and financial statement schedules which were excluded form the Annual Report which are required to be included herein. - ------------ - 93 - SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, Troy Financial Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TROY FINANCIAL CORPORATION (Registrant) December 20, 1999 /s/ Daniel J. Hogarty -------------------------------- Daniel J. Hogarty, Jr. President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By: /s/ Daniel J. Hogarty --------------------------------- Daniel J. Hogarty, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Date: 12/20/99 ----------------------- By: /s/ Edward M. Maziejka ------------------------- Edward M. Maziejka, Jr. Chief Financial Officer (Principal Financial Officer) Date: 12/20/99 ----------------------- By: /s/ George H. Arakelian ------------------------- George H. Arakelian, Director Date: 12/20/99 ----------------------- By: /s/ Richard B. Devane ------------------------- Richard B. Devane, Director Date: 12/20/99 ----------------------- By: /s/ Michael E. Fleming ------------------------- Michael E. Fleming, Director Date: 12/20/99 - 94 - By: /s/ Willie A. Hammett --------------------------- Willie A. Hammett, Director Date: 12/20/99 ------------------------- By: /s/ Thomas B. Healy --------------------------- Thomas B. Healy, Director Date: 12/20/99 ------------------------ By: /s/ Keith D. Millsop -------------------------- Keith D. Millsop, Director Date: 12/20/99 ------------------------ By: /s/ Edward G. O'Haire -------------------------- Edward G. O'Haire, Director Date: 12/20/99 By: /s/ Marvin L. Wulf ------------------------- Marvin L. Wulf, Director Date: 12/20/99 - 95 - EXHIBIT INDEX EXHIBIT NO. EXHIBIT ----------- ------- 3.1 Amended and Restated Certificate of Incorporation of the Company (incorporated by reference herein to Exhibit 3.1 to the Company's Registration Statement on Form S-1, File No. 333-68813) 3.2 Bylaws of the Company (incorporated by reference herein to Exhibit 3.2 to the Company's Registration Statement on Form S-1, File No. 333-68813) 4.1 Certificate of Incorporation of the Company (filed as Exhibit 3.1 hereto) 4.2 Bylaws of the Company (filed as Exhibit 3.2 hereto) 4.3 Specimen certificate evidencing shares of Common Stock of the (incorporated by reference herein to Exhibit 4.3 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.1 1999 Long-Term Equity Compensation Plan 10.6 Form of Employment Agreements (incorporated by reference herein to Exhibit 10.1 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.7 Form of Employment Protection Agreements (incorporated by reference herein to Exhibit 10.2 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.8 Form of Employee Change of Control Severance Plan (incorporated by reference herein to Exhibit 10.4 to the Company's Registration Statement on Form S-1, File No. 333-68813) 10.9 Form of Supplemental Retirement and Benefits Restoration Plan (incorporated by reference herein to Exhibit 10.5 to the Company's Registration Statement on Form S-1, File No. 333-68813) 21.1 Subsidiaries of Troy Financial Corporation 27.1 Financial Data Schedule

860673_1999.txt

860673_1999

1999

860673

ITEM 1. BUSINESS. FORWARD-LOOKING STATEMENTS In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (Reform Act), the Dominguez Services Corporation (the Company) is hereby filing cautionary statements identifying important factors that could cause the Company's actual results to differ materially from those projected in forward-looking statements (as defined in the Reform Act) made by or on behalf of the Company in this Annual Report. Any statements that express such statements are often, but not always, expressed with phrases such as expectations, beliefs, plans, objectives, assumptions, or future events or performance, through the use of words or phrases such as "anticipate," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will likely result," and "will continue." Such statements are not statements of historical facts and may be forward-looking. Forward-looking statements involve estimates, assumptions, and uncertainties and are qualified in their entirety by reference to the following important factors, which are difficult to predict, contain uncertainties, are beyond the control of the Company, and could cause actual results to differ materially from those contained in forward-looking statements: - prevailing governmental policies and regulatory actions, including those of the California Public Utilities Commission ( the Commission), with respect to allowed rates of return, authorization of regulated rates, industry and rate structure, acquisition and disposal of assets and facilities, operation and construction of plant facilities, recovery of balancing account, and present or prospective competition; - economic and geographic factors including political and economic risks; - changes in and compliance with environmental and safety laws and policies; - water supply and weather conditions; - customer growth rate; - merger issues: - delays or change in anticipated closing date; - likelihood of approval by regulatory agencies; - changes in tax rates or policies or in rates of inflation; - unanticipated changes in operating expenses and capital expenditures; - emergency preparedness; - capital market conditions; - competition for non-regulatory opportunities; and - legal and administrative proceedings and settlements that influence the business and profitability of the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible for management to predict all of such factors, nor can it assess the impact of any such factor on the business, or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. GENERAL Dominguez Services Corporation is a holding company formed in 1990 through an Agreement of Merger with Dominguez Water Company. The Company's principal business is the ownership of all the common stock of Dominguez Water Company. The holding company structure provides operational and financial flexibility and allows the Company to engage in non-regulated activities. The Company has two wholly-owned subsidiaries: Dominguez Water Company and its operating subsidiaries (Dominguez), which are involved in regulated water supply and distribution, and DSC Investments, which is involved in non-regulated, water-related services and investments. A detailed description of the regulated and non-regulated businesses is contained in Item 8, Financial Statements and Supplementary Data, Note 17. Dominguez is regulated by the Commission and, as such, must obtain the Commission's approval to increase water rates to recover increases in operating expenses and authorization to include reinvested capital in ratebase. Most variations in revenues are due to weather conditions and the water usage of major industrial customers. Dominguez is comprised of its principal division, (the South Bay Division,) and its operating subsidiaries, the Kern River Valley Water Company, the Antelope Valley Water Company and the Redwood Valley Water Company Division (collectively referred to as the "Subsidiaries"). The South Bay Division has been providing water service for more than 88 years. Currently, the South Bay Division serves approximately 32,637 customers in a 35 square mile area including most of Carson, one-quarter of Torrance, and parts of Compton, Long Beach, Los Angeles, Los Angeles County, and Harbor City. The Kern River Valley Water Company and the Antelope Valley Water Company provide water service to approximately 4,096 and 1,271 customers, respectively. In 1998, Dominguez formed the Redwood Valley Water Company Division to acquire certain water companies located in northern California. Redwood Valley Water Company Division serves approximately 1,912 customers in six service areas. DSC Investments is primarily engaged in the transfer of water right leases between third parties. Income from the transfer of water right leases may significantly vary from year to year due to demands for groundwater by major pumpers in the West and Central Groundwater Basins. FINANCIAL PERFORMANCE AND OPERATIONS Financial results in 1999 improved significantly over 1998, primarily due to 1998 results including higher non-recurring costs associated with the Company's merger with California Water Service Group. Earnings per share for 1999 rose to $1.31, compared to $.61 in the same period in 1998, revenues increased to $28,497,000 from $25,267,000 in the same period last year, and net income reached $2,052,000, compared to $924,000 at year-end in 1998. Other factors having a positive impact on 1999 financial results were customer growth and higher sales. The Company completed the purchase of Lucerne Water Company, serving 1,242 customers and Armstrong Valley Water Company, serving 382 customers, in January; Hawkins Water Company, serving 51 customers, in August; and Coast Springs Water Company, serving 237 customers, in December. All four are located in northern California and are operated by the Company's newest subsidiary, Redwood Valley Water Company Division. Sales also increased both to business and residential customers. In 1999, Dominguez supplied 13,579 million gallons of water to 39,916 customers, compared to 12,412 million gallons of water to 37,882 customers in 1998. Although Dominguez South Bay has a diversified customer base, a substantial portion (51% in 1999 and 50% in 1998) of sales were derived from business and industrial usage. Furthermore, a single customer, a refinery, accounted for 38% of the business and industrial sales in 1999 and for 34% in 1998. The Company experienced no interruptions in service or operations as a result of the Year 2000 (Y2K). Precautionary measures taken by the Company in anticipation of computer problems that could have been caused by Y2K included: assessing computer software used in monitoring water and performing business functions such as billing; making necessary upgrades; working with vendors and outside service providers to ascertain their level of preparedness; and having teams on-site in all of the service areas to address any issues arising with the year change. THE MERGER On November 13, 1998, the Company executed an Agreement and Plan of Reorganization (the Merger Agreement) to merge with California Water Service Group (CWSG), the parent of California Water Service Company (Cal Water) and CWS Utility Services. Under the terms of the November 1998 Merger Agreement, each share of the Company's common stock issued and outstanding on the closing date would be converted into the right to receive 1.18 shares of CWSG common stock. The Company's Board of Directors (Board) received the opinion of its financial advisor, PaineWebber Inc., that this exchange ratio would be fair to the shareholders of the Company's common stock from a financial point of view. And, the Company expected that the proposed merger will be treated as a tax-free transaction under the applicable provisions of the Internal Revenue Code. Shares of CWSG common stock are traded under the symbol "CWT" on the New York Stock Exchange. CWSG operations provide water utility services to over 1.5 million people in 58 California communities. On March 16, 1999, the Company announced that it had received an unsolicited proposal from American States Water Company (ASWC) offering to acquire all of the Company's outstanding common stock in a stock-for-stock merger. Under the ASWC proposal, each share of the Company's common stock would have been converted into the right to receive a number of ASWC shares intended to provide $32.50 of value for each of the Company's shares. The ASWC proposal also provided for a collar pursuant to which the minimum and maximum conversion ratios would be 1.11 and 1.35 ASWC shares for each Company share. The Company's financial advisor advised the Company's Board that this proposal was more favorable to the Company's shareholders than the terms of the Merger Agreement. On March 22, 1999, the Company and CWSG executed an amendment to the November 1998 Merger Agreement which provides that each share of the Company's common stock will be converted into the right to receive a number of CWSG shares intended to provide $33.75 of value for each of the Company's shares. The amendment to the Merger Agreement also provides that the minimum and maximum conversion ratios will be 1.25 and 1.49 CWSG shares for each Company share. At a special meeting on May 12, 1999, Company shareholders overwhelmingly approved the Merger Agreement as amended. All regulatory approvals have been received, with the exception of that of the Commission. In its initial report filed in October 1999, the Commission staff recommended disapproval of the merger. Subsequently, CWSG and the Company issued a guarantee that customer rates would not increase as a result of the merger, expressing confidence that synergies achieved by the merger would offset merger costs. In succeeding discussions with Commission's Ratepayer Representation Branch (RRB), Cal Water and Dominguez proposed an enhanced guarantee, which included provisions that customer rates would not increase as a result of the merger, that Dominguez customers would continue to receive financial benefit of water rights currently owned by Dominguez, and that a portion of operating synergies achieved over those needed to offset merger costs be returned to customers. RRB of the Commission staff testified to its support of the merger, with the enhanced guarantee, on December 7, 1999. In a proposed decision issued in February 2000, the Administrative Law Judge recommended approval of the merger with certain conditions, many of which were proposed by Cal Water and Dominguez in the enhanced guarantee. Oral arguments were scheduled for March 2000, with a decision expected in the second quarter. Pursuant to the Merger Agreement, if regulatory approval is not received or if either the Company or CWSG decides not to complete the merger, certain payments are required under the terms of the Merger Agreement. WATER SUPPLY Dominguez obtains its water supplies from its own groundwater wells, a surface water source plus two water wholesalers of imported water. All Dominguez service areas, except for the Lucerne service area (Lucerne) of Redwood Valley Water Company Division, obtain either a portion or all of their supply from groundwater wells. Lucerne has a surface water treatment plant. The quantity that the South Bay Division is allowed to pump over a year's time is fixed by court adjudication. The adjudication established distinct groundwater basins that are managed by a court-appointed watermaster. The groundwater management fixes the safe yield of the basins and ensures the replenishment of the basins by utilizing impounded storm water, treated recycled water and treated purchased water when necessary. Groundwater basins have not been adjudicated in the Subsidiaries. In December 1997, Dominguez entered into a recycled water agreement with the West Basin Municipal Water District (West Basin) and ARCO. Under the terms of the agreement, Dominguez will sell ARCO recycled water purchased from West Basin for the same cost margin that Dominguez would otherwise have received providing ARCO with potable water. Dominguez expects to invest up to $2,000,000 in recycled water facilities for its South Bay Division service area, in exchange for which Dominguez will receive the recycled water at reduced rates. The recycled water plant was completed in December of 1999, and became fully operational in January 2000. Dominguez began supplying recycled water from West Basin to its largest customer from West Basin in December 1999. Having access to recycled water will reduce the South Bay Division's demand for imported potable water, the availability of which may be uncertain in the future. Reduced imported water supplies and annual population growth could create future drought conditions in Southern California; however, Dominguez believes that the availability of recycled water will significantly mitigate the impact of future droughts in the South Bay Division service area. In 1998, the Water Replenishment District of Southern California (WRD), a water district responsible for the oversight and management of the West and Central Groundwater Basins, awarded a grant to Dominguez of $1,820,000, which was to be paid in two equal installments. Dominguez received the first of its two payments for $910,000 in 1998, and received the second payment for $910,000 in 1999. Dominguez has earmarked $1,150,000 to fund its investment in recycled water facilities. The South Bay Division and Leona Valley service area of Antelope Valley Water Company purchase water from wholesalers to supplement groundwater. The South Bay Division purchases imported water from the Metropolitan Water District (MWD) of Southern California through West Basin. The Leona Valley service area purchases its imported water from the Antelope Valley - East Kern Water Agency (AVEK). Both of these wholesale suppliers obtain water from the California State Water Project (SWP), and MWD also obtains water from the Colorado River. Long-term imported water supplies depend upon several factors. Dominguez' future dependency on imported water will be subject to the availability and usage of recycled water in the region as well as customers' long-term water conservation efforts. Dominguez has and will continue to promote long-term water conservation efforts and will advance the use of recycled water. Legislative actions continue to play a role in the long-term availability of water for Southern California. The amount of SWP water available from northern California and water imported from the Colorado River may be significantly reduced in the future. Even with the use of recycled water and continuing conservation efforts, future drought conditions may require water rationing by all California water agencies and purveyors, including Dominguez. WATER QUALITY Dominguez is subject to water quality regulations promulgated by the United States Environmental Protection Agency (EPA) and the California Department of Health Services (DHS). Both groundwater and purchased water are subject to extensive analysis and testing. With occasional minor exceptions, Dominguez meets all current primary water standards. Beginning in mid-1997, Dominguez participated, along with many other large water companies throughout the United States, in an 18-month water sampling data acquisition program known as the Information Collection Rule. Data collected will be used by the EPA to establish future drinking water standards. Under the Federal Safe Drinking Water Act, the EPA is required to continue to establish new maximum levels for additional chemicals. The costs of future compliance are unknown, but Dominguez could be required to perform more quality testing and treatment. Management believes the Company's financial reserves will be sufficient to meet these anticipated requirements. During 1999, Dominguez expended $1,786,000 on water supply improvements. In 2000, Dominguez anticipates spending $2,622,000 for water supply capital improvements. REGULATORY AFFAIRS In March 1998, the Commission instituted its own proceeding (Investigation 98-03-013) to investigate whether existing standards and policies of the Commission regarding drinking water quality adequately protect the public health and safety with respect to contaminants such as Volatile Organic Compounds, Perchlorate, and MTBE, and whether those standards and policies are being uniformly complied with by Commission-regulated utilities. On February 1, 2000, the Administrative Law Judge issued a draft decision finding all Class A regulated water utilities (including Dominguez) satisfactorily complied with DHS regulations and testing requirements. The Company can not predict the outcome of this proceeding but does not anticipate any financial impact on the Company. In October 1997, the Commission instituted its own proceeding to set rules and provide guidelines for the acquisition and merger of water companies. This proceeding was initiated to develop guidelines necessary to implement a new law, referred to as Senate Bill 1268, requiring the Commission to use the standard of fair-market value when establishing the ratebase value for the acquired distribution system assets of a public water system. On October 22, 1999, the Commission issued its decision adopting the settlement agreement reached between RRB and the California Water Association. The settlement agreement sets forth guidelines regarding the regulatory approval process, establishing purchase price and incentives to encourage the acquisition of troubled small water companies. The Company believes that the decision will facilitate the acquisition of small troubled water companies in the future. In October 1997, the Commission also instituted its own rulemaking proceeding to develop rules for public-private partnerships. Dominguez participated with the Commission staff in workshops; however, all participants failed to reach a settlement and develop necessary guidelines. On February 1, 2000, the Administrative Law Judge issued a draft decision imposing a number of accounting and procedural requirements for regulated water utilities to engage in the sale of non-tariff goods or services. If the proposed draft decision is adopted, water utilities will be discouraged from and reluctant to offer non-tariff goods or services due to the imposed requirements. In the first quarter of 1999, Dominguez filed a joint application with Cal Water to approve the merger of their regulated utility companies (see "THE MERGER" above). In February 1999, Dominguez filed general rate increase applications for the South Bay Division and its subsidiaries, Antelope Valley Water Company and Kern River Valley Water Company. The Commission consolidated the applications into a single proceeding. In December 1999, the Company and RRB filed settlement agreements to increase rates by $1,416,000 for test year 2000, $336,000 for test year 2001 and $113,000 for attrition year 2002. In January 2000, the Leona Valley Town Council filed its opposition to the settlement agreement filed in the Antelope Valley Water Company (AVWC) application. The Administrative Law Judge granted an evidentiary hearing in the proceeding, limiting issues to the AVWC application, for March 1, 2000, and scheduled briefs to be filed on March 20, 2000. Because all the applications were consolidated into a single proceeding, the Commission has postponed its decision on the Dominguez South Bay and Kern River Valley Water Company rate applications. Dominguez anticipates that a Commission decision approving all settlement agreements will be ordered by June 2000. In July 1999, Dominguez received the Commission's approval to acquire the assets of Hawkins Water Service, serving 51 customers, for $50,000 cash. The ratebase for the acquired assets was set at $51,000 and the acquisition became effective on August 6, 1999. Dominguez also received the Commission's approval in 1999 to acquire the assets of Coast Springs Water Company, serving 237 customers, for $180,000 cash. The ratebase for the acquired assets was set at $179,000 and the acquisition became effective on December 8, 1999. NON-UTILITY SUBSIDIARY OPERATIONS DSC Investments invested $350,000 in Chemical Services Corporation (CSC) on December 20, 1996, and acquired a twenty percent equity ownership with the option to acquire an additional forty percent through the year 2001. Under the investment agreements, the Company was obligated to provide working cash and long-term financing to CSC for the leasing of chlorine generators, subject to the financial condition of CSC. In April 1999, a contract was drafted pursuant to which DSC Investments would sell back its equity ownership to CSC at a premium of $250,000, $160,000 of which would be applied to Dominguez' purchase of chlorine generation equipment from CSC. Both parties signed the contract in December of 1999 and payment was received from CSC in January 2000. During 1999, DSC Investments facilitated transfers of water right leases between third parties, adding $718,000 to the Company's revenue. The future income from the transfer of water right leases will depend upon the demands for groundwater by major industrial users and water purveyors in the West and Central Groundwater Basins. EMPLOYEE RELATIONS As of December 31, 1999, the Company had a total of 70 employees in utility and non-utility operations. None of the employees is represented by a labor organization, and there has never been a work stoppage or interruption due to a labor dispute. In general, wages, hours, and conditions of employment are equivalent to those found in the industry. All employees receive paid time off. Dominguez provides and pays the cost of group life, disability, medical and dental insurance, as well as pensions, for its employees. Throughout 1999, a significant effort has been made to communicate with employees about issues related to the merger with CWSG (see above). Pursuant to the Merger Agreement, all Dominguez employees were offered equivalent employment with Cal Water in December 1999. ENVIRONMENTAL MATTERS Dominguez' operations are subject to pollution control and water quality control as discussed in the "Water Quality" section. Other state and local environmental regulations apply to Dominguez operations and facilities. These regulations are primarily related to the handling, storage and disposal of hazardous materials. Dominguez is currently in compliance with all other state and local regulations. ITEM 2. ITEM 2. PROPERTIES. The Company's general administrative and executive offices are located at 21718 South Alameda Street in Carson, California. The South Bay Division has prior rights to lay distribution mains and for other uses on much of the public and private lands in its service area. Dominguez' claim of prior rights is derived from the original Spanish land grant covering the Dominguez service area. For this reason, Dominguez, unlike most other public utilities, generally receives compensation from the appropriate public authority when the relocation of its facilities is necessitated by the construction of roads or other projects. It is common for public utilities to bear the entire cost of such relocation. Primarily, the Company is comprised of facilities to pump and distribute both groundwater and purchased water to residential, commercial, and industrial customers. As of December 31, 1999, the Company has invested $8,531,000 in water supply, $34,492,000 in distribution, and $11,322,000 in other operating facilities. The Company believes that its current facilities are adequate to meet customer demand, subject to the addition of capital facilities, as the system requires. Substantially all of the property of Dominguez is subject to the lien of the Trust Indenture dated August 1, 1954, as supplemented and amended, to Chase Manhattan Bank and Trust Company, N.A., as Trustee, securing the two outstanding series of Dominguez' First Mortgage Bonds. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is routinely involved in legal actions. The Company does not believe these matters will have a material adverse effect, if any, on its financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) MARKET PRICE FOR COMMON SHARES (b) APPROXIMATE NUMBER OF HOLDERS OF COMMON SHARES The Nasdaq Stock Market maintenance standards require that Nasdaq National Market companies have at least 400 shareholders of round lots. As of December 31, 1999, the Company complied with the standard with 291 common shareholders of record and more than 779 beneficial shareholders, who have elected to hold their shares in street name. (c) DIVIDENDS DECLARED (d) DIVIDEND RESTRICTION The Company's available dividends to its shareholders are substantially dependent on the availability of dividends from Dominguez to the Company. Under the terms of its long-term debt agreements, Dominguez is limited in its payment of dividends (other than stock dividends) on all classes of stock to the net income accrued subsequent to December 31, 1992, plus the sum of $3,000,000. The approximate unrestricted earnings available for dividend payments amounted to $7,052,000 as of December 31, 1999. (e) NEW SHARES ISSUED DURING 1999 In January 1999, the Company issued 54,467 shares of its common stock in connection of its acquisition of certain water companies. The Company stock issued was exempted from registration under the Security Act of 1933 pursuant to Sec. 5(2) of the Act and or regulation D promulgated under the Act. In December 1999, the Company issued 2,800 shares of its common stock in connection with stock options that were exercised by an executive. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ELEVEN YEAR STATISTICAL REVIEW * Adjusted to reflect 3-for-2 stock split effected January, 1998. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. FORWARD-LOOKING STATEMENT In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (Reform Act), the Dominguez Services Corporation (the Company) is hereby filing cautionary statements identifying important factors that could cause the Company's actual results to differ materially from those projected in forward-looking statements (as defined in the Reform Act) made by or on behalf of the Company in this Annual Report. Any statements that express such statements are often, but not always, expressed with phrases such as expectations, beliefs, plans, objectives, assumptions, or future events or performance, through the use of words or phrases such as "anticipate," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will likely result," and "will continue." Such statements are not statements of historical facts and may be forward-looking. Forward-looking statements involve estimates, assumptions, and uncertainties and are qualified in their entirety by reference to the following important factors, which are difficult to predict, contain uncertainties, are beyond the control of the Company, and could cause actual results to differ materially from those contained in forward-looking statements: - prevailing governmental policies and regulatory actions, including those of the California Public Utilities Commission ( the Commission), with respect to allowed rates of return, authorization of regulated rates, industry and rate structure, acquisition and disposal of assets and facilities, operation and construction of plant facilities, recovery of balancing account, and present or prospective competition; - economic and geographic factors including political and economic risks; - changes in and compliance with environmental and safety laws and policies; - water supply and weather conditions; - customer growth rate; - merger issues: - delays or change in anticipated closing date; - likelihood of approval by regulatory agencies; - changes in tax rates or policies or in rates of inflation; - unanticipated changes in operating expenses and capital expenditures; - emergency preparedness; - capital market conditions; - competition for non-regulatory opportunities; and - legal and administrative proceedings and settlements that influence the business and profitability of the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible for management to predict all of such factors, nor can it assess the impact of any such factor on the business, or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. GENERAL The following discussion should be read in conjunction with the accompanying Consolidated Financial Statements and with the Eleven-Year Statistical Review in this report. A description of the regulated and non-regulated businesses is contained in Note 17 of Notes to Consolidated Financial Statements. The Company has two wholly-owned subsidiaries: Dominguez Water Company and its operating subsidiaries (Dominguez), which are involved in regulated water supply and distribution, and DSC Investments, which is involved in non-regulated, water-related services and investments. Dominguez is regulated by the Commission and, as such, must obtain the Commission's approval to increase water rates to recover increases in operating expenses and authorization to include reinvested capital in ratebase. Most variations in revenues are due to weather conditions and the water usage of major industrial customers. Dominguez is comprised of its principal division, (the South Bay Division), and its operating subsidiaries, the Kern River Valley Water Company, the Antelope Valley Water Company and Redwood Valley Water Company Division (collectively referred to as the "Subsidiaries"). The South Bay Division has been providing water service for more than 88 years to its customers. Currently, the South Bay Division serves approximately 32,637 customers in a 35 square mile area including most of Carson, one-quarter of Torrance, and parts of Compton, Long Beach, Los Angeles, Los Angeles County, and Harbor City. The Kern River Valley Water Company and the Antelope Valley Water Company provide water service to approximately 4,096 and 1,271 customers, respectively. In 1998, Dominguez formed the Redwood Valley Water Company Division to acquire certain water companies located in northern California. Redwood Valley Water Company Division serves approximately 1,912 customers in six service areas. DSC Investments is primarily engaged in the transfer of water right leases between third parties. Income from the transfer of water right leases may significantly vary from year to year due to demands for groundwater by major pumpers in the West and Central Groundwater Basins. THE MERGER On November 13, 1998, the Company executed an Agreement and Plan of Reorganization (the Merger Agreement) to merge with California Water Service Group (CWSG), the parent of California Water Service Company (Cal Water) and CWS Utility Services. Under the terms of the November 1998 Merger Agreement, each share of the Company's common stock issued and outstanding on the closing date would be converted into the right to receive 1.18 shares of CWSG common stock. The Company's Board of Directors (Board) received the opinion of its financial advisor, PaineWebber Inc., that this exchange ratio would be fair to the shareholders of the Company's common stock from a financial point of view. And, the Company expected that the proposed merger will be treated as a tax-free transaction under the applicable provisions of the Internal Revenue Code. Shares of CWSG common stock are traded under the symbol "CWT" on the New York Stock Exchange. CWSG operations provide water utility services to over 1.5 million people in 58 California communities. On March 16, 1999, the Company announced that it had received an unsolicited proposal from American States Water Company (ASWC) offering to acquire all of the Company's outstanding common stock in a stock-for-stock merger. Under the ASWC proposal, each share of the Company's common stock would have been converted into the right to receive a number of ASWC shares intended to provide $32.50 of value for each of the Company's shares. The ASWC proposal also provided for a collar pursuant to which the minimum and maximum conversion ratios would be 1.11 and 1.35 ASWC shares for each Company share. The Company's financial advisor advised the Company's Board that this proposal was more favorable to the Company's shareholders than the terms of the Merger Agreement. On March 22, 1999, the Company and CWSG executed an amendment to the November 1998 Merger Agreement which provides that each share of the Company's common stock will be converted into the right to receive a number of CWSG shares intended to provide $33.75 of value for each of the Company's shares. The amendment to the Merger Agreement also provides that the minimum and maximum conversion ratios will be 1.25 and 1.49 CWSG shares for each Company share. At a special meeting on May 12, 1999, Company shareholders overwhelmingly approved the Merger Agreement as amended. All regulatory approvals have been received, with the exception of that of the Commission. In its initial report filed in October 1999, the Commission staff recommended disapproval of the merger. Subsequently, CWSG and the Company issued a guarantee that customer rates would not increase as a result of the merger, expressing confidence that synergies achieved by the merger would offset merger costs. In succeeding discussions with Commission's Ratepayer Representation Branch (RRB), Cal Water and Dominguez proposed an enhanced guarantee, which included provisions that customer rates would not increase as a result of the merger, that Dominguez customers would continue to receive financial benefit of water rights currently owned by Dominguez, and that a portion of operating synergies achieved over those needed to offset merger costs be returned to customers. RRB of the Commission staff testified to its support of the merger, with the enhanced guarantee, on December 7, 1999. In a proposed decision issued in February 2000, the Administrative Law Judge recommended approval of the merger with certain conditions, many of which were proposed by Cal Water and Dominguez in the enhanced guarantee. Oral arguments were scheduled for March 2000, with a decision is expected in the second quarter. Pursuant to the Merger Agreement, if regulatory approval is not received or if either the Company or CWSG decide not to complete the merger, certain payments are required under the terms of the Merger Agreement. RESULTS OF OPERATIONS 1999 COMPARED TO 1998 Operating revenue totaled $28,497,000 for 1999; an increase of $3,230,000, or 12.8%, from the $25,267,000 recorded for 1998. Revenue growth in 1999 was attributable to higher sales and the acquisition of Redwood Valley Water Company Division. Consumption by residential and multi-family customers increased by 9.1% and by business-industrial customers by 15.4%. Redwood brought in $643,000 in sales. Operating expenses before taxes increased by $2,145,000, or 9.69%, compared to 1998. Operating expenses are comprised of several different components, including purchased and pumped water costs, operations and maintenance expenses and depreciation expense. Pumped and purchased water cost increases are primarily attributed to the higher sales. During the year the Company increased its pumping capacity by the completion of the well rehabilitation program which contributed to increased margin. Operations and maintenance expenses, and depreciation expense decreased in 1999 by $67,000, or 1.0%, and increased by $293,000, or 4.2% in 1998. Other income increased by $416,000, or 58%, due to increased activity in the transfer of water right leases and operating contracts. Interest costs increased by $94,000, or 11%. Additional interest costs came from loans absorbed from the newly acquired water companies during 1999. The extraordinary item related to merger expenses totaled $290,000 with a tax effect of $100,000 during 1999, comparing to merger expenses of $814,000 during 1998 with the tax effect of the extraordinary item $315,000. Net income increased by $1,128,000, or 122%, due to the reasons mentioned above. Earnings per share increased to $1.31 from $.61. The Company raised its annual dividend to common shareholders to $.96 in 1999 from $.92 in 1998, an increase of 4.4%. RESULTS OF OPERATIONS 1998 COMPARED TO 1997 Operating revenue totaled $25,267,000 for 1998, a decrease of $1,551,000, or 5.8%, from the $26,818,000 recorded for 1997. The decrease in revenue is due to a reduction in water sales. Consumption by residential and multi-family customers decreased by 6.2% and by business-industrial customers by 5.0%. Operating expenses before taxes decreased by $524,000, or 2.3%, compared to 1997. Operating expenses are comprised of several different components, including purchased and pumped water costs, operations and maintenance expenses and depreciation expense. Operations and maintenance expenses, and depreciation expense, increased in 1998 by $293,000, or 4.2%, and $98,000, or 7.3%, respectively. However, the cost to pump and purchase water decreased by a combined total of $915,000, or 6.4%. This is primarily attributed to lower sales and a resulting decrease in production costs. During 1998, the Company received a grant from the Water Replenishment District of Southern California (WRD), a water district responsible for the oversight and management of the West and Central Groundwater Basins, of which approximately $390,000 was applied to production costs. The reduction in cost would have been greater if several wells had not been out of service for rehabilitation. While the wells were not in service, higher priced purchased water was supplied to our customers. Other income increased by $102,000, or 19%, due to increased activity in the transfer of water right leases and operating contracts. Interest costs increased by $112,000, or 15%, due to a new bond issuance in December 1997. The extraordinary item related to merger expenses totaled $814,000. The tax effect of the extraordinary item is $315,000. Net income before the extraordinary item decreased by $598,000, or 29.6%, due to the reasons mentioned above. Earnings per share before the extraordinary item on common equity decreased from $1.34 to $.94. The Company raised its annual dividend to common shareholders to $.92 in 1998 from $.87 in 1997, an increase of 5.8%. RESULTS OF OPERATIONS 1997 COMPARED TO 1996 Operating revenue totaled $26,818,000 for 1997, an increase of $2,113,000, or 8.6%, over the $24,705,000 recorded for 1996. The increased revenue is due to higher sales to industrial customers and higher rates in the South Bay Division to cover the higher cost of imported water. Industrial sales increased by $1,419,000, or 13.8%. Operating expenses before taxes increased by $1,907,000, or 9.2%, primarily due to an increase in the cost of water. Additional water was purchased from West Basin to cover the increased water sales. The overall margin on water sales decreased from 52% to 47% due to additional water purchased. Operations and maintenance costs decreased by $476,000, or 6.3%. Other income increased by $108,000, or 24%, due to increased activity in the transfer of water right leases. Interest costs increased by $99,000, or 15%, due to additional borrowings for capital improvements during 1997. Net income increased $40,000, or 2%, due to the reasons mentioned above. Earnings per share on common equity increased from $1.31 to $1.34. The Company raised its annual dividend to common shareholders to $.87 in 1997 from $.83 in 1996, an increase of 4.8%. Effective January 2, 1998, the Company split its common stock three-for-two for shareholders of record on December 15, 1997. The Company paid cash in lieu of issuing fractional shares based on the closing price as of December 15, 1997. The par value of the common stock remained unchanged. Financial data in this report is adjusted to reflect the change. LIQUIDITY AND CAPITAL RESOURCES The Company's continuing operations provided sufficient cash in 1999 to cover operating expenses, interest and dividends. In 1999, Dominguez invested $3,450,000 in utility plant improvements. Approximately $264,000 was contributed or advanced by developers. The Company has available $4,500,000 under a revolving credit facility with Bank of America. As of December 31, 1999 and 1998, short-term borrowing under the facility totaled $400,000 and $450,000 respectively. If the Merger does not close, the Company will renew the credit facility when it expires in June 2000. The Company's 2000 capital budget is $4,274,000. Budgeted improvements include $2,622,000 for water production facilities and storage, an $850,000 investment to accommodate a regional recycled water treatment plant, and $433,000 for pipeline replacements. The Company will fund budgeted improvements from earnings available for reinvestment and short-term borrowings, if necessary. In December 1997, Dominguez entered into a recycled water agreement with the West Basin Municipal Water District (West Basin) and ARCO. Under the terms of the agreement, Dominguez will sell ARCO recycled water purchased from West Basin for the same cost margin that Dominguez would otherwise have received providing ARCO with potable water. The recycled water plant was completed in December of 1999, and became fully operational in January 2000. Having access to recycled water will reduce the South Bay Division's demand for imported water, the availability of which may be uncertain in the future. Reduced imported water supplies and annual population growth could create future drought conditions in Southern California; however, Dominguez believes that the availability of recycled water will significantly mitigate the impact of future droughts in the South Bay Division service area. In 1998, WRD awarded a grant to Dominguez of $1,820,000. Dominguez received the first of its two payments for $910,000 in 1998 and received the second payment for $910,000 in 1999. Dominguez used approximately $670,000 to offset the cost of purchasing higher-priced imported water in lieu of pumping its groundwater rights. The balance of the funds, approximately $1,150,000, will be used to meet Dominguez' expected $2,000,000 commitment in recycled water facilities, leaving a balance of $850,000 to be funded by Dominguez. REGULATORY AFFAIRS In March 1998, the Commission instituted its own proceeding (Investigation 98-03-013) to investigate whether existing standards and policies of the Commission regarding drinking water quality adequately protect the public health and safety with respect to contaminants such as Volatile Organic Compounds, Perchlorate, and MTBE, and whether those standards and policies are being uniformly complied with by Commission-regulated utilities. On February 1, 2000, the Administrative Law Judge issued a draft decision finding all Class A regulated water utilities (including Dominguez) satisfactorily complied with DHS regulations and testing requirements. The Company can not predict the outcome of this proceeding but does not anticipate any financial impact on the Company. In October 1997, the Commission instituted its own proceeding to set rules and provide guidelines for the acquisition and merger of water companies. This proceeding was initiated to develop guidelines necessary to implement a new law, referred to as Senate Bill 1268, requiring the Commission to use the standard of fair-market value when establishing the ratebase value for the acquired distribution system assets of a public water system. On October 22, 1999, the Commission issued its decision adopting the settlement agreement reached between RRB and the California Water Association. The settlement agreement sets forth guidelines regarding the regulatory approval process, establishing purchase price and incentives to encourage the acquisition of troubled small water companies. The Company believes that the decision will facilitate the acquisition of small troubled water companies in the future. In October 1997, the Commission also instituted its own rulemaking proceeding to develop rules for public-private partnerships. Dominguez participated with the Commission staff in workshops; however, all participants failed to reach a settlement and develop necessary guidelines. On February 1, 2000, the Administrative Law Judge issued a draft decision imposing a number of accounting and procedural requirements for regulated water utilities to engage in the sale of non-tariff goods or services. If the proposed draft decision is adopted, water utilities will be discouraged, from and reluctant to offer non-tariff goods or services due to the imposed requirements. In the first quarter of 1999, Dominguez filed a joint application with Cal Water to approve the merger of their regulated utility companies (see "THE MERGER" above). In February 1999, Dominguez filed general rate increase applications for the South Bay Division and its subsidiaries, Antelope Valley Water Company and Kern River Valley Water Company. The Commission consolidated the applications into a single proceeding. In December 1999, the Company and RRB filed settlement agreements to increase rates by $1,416,000 for test year 2000, $336,000 for test year 2001 and $113,000 for attrition year 2002. In January 2000, the Leona Valley Town Council filed its opposition to the settlement agreement filed in the Antelope Valley Water Company (AVWC) application. The Administrative Law Judge granted an evidentiary hearing in the proceeding, limiting issues to the AVWC application, for March 1, 2000, and scheduled briefs to be filed on March 20, 2000. Because all the applications were consolidated into a single proceeding, the Commission has postponed its decision on the Dominguez South Bay and Kern River Valley Water Company rate applications. Dominguez anticipates that a Commission decision approving all settlement agreements will be ordered by June 2000. In July 1999, Dominguez received the Commission's approval to acquire the assets of Hawkins Water Service, serving 51 customers, for $50,000 cash. The ratebase for the acquired assets was set at $51,000 and the acquisition became effective on August 6, 1999. Dominguez also received the Commission's approval in 1999 to acquire the assets of Coast Springs Water Company, serving 237 customers, for $180,000 cash. The ratebase for the acquired assets was set at $179,000 and the acquisition became effective on December 8, 1999. NON-UTILITY SUBSIDIARY OPERATIONS DSC Investments invested $350,000 in Chemical Services Corporation (CSC) on December 20, 1996, and acquired a twenty percent equity ownership with the option to acquire an additional forty percent through the year 2001. Under the investment agreements, the Company was obligated to provide working cash and long-term financing to CSC for the leasing of chlorine generators, subject to the financial condition of CSC. In April 1999, a contract was drafted pursuant to which DSC Investments would sell back its equity ownership to CSC at a premium of $250,000, $160,000 of which would be applied to Dominguez' purchase of chlorine generation equipment from CSC. Both parties signed the contract in December of 1999 and payment was received from CSC in January 2000. During 1999, DSC Investments facilitated transfers of water right leases between third parties, adding $718,000 to the Company's revenue. The future income from the transfer of water right leases will depend upon the demand for groundwater by major industrial users and water purveyors in the West and Central Groundwater Basins. ENVIRONMENTAL MATTERS Dominguez is subject to water quality regulations promulgated by the United States Environmental Protection Agency (EPA) and the California Department of Health Services (DHS). Both groundwater and purchased water are subject to extensive analysis and testing. With occasional minor exceptions, Dominguez meets all current primary water standards. Beginning in mid-1997, Dominguez participated, along with many other large water companies throughout the United States, in an 18-month water sampling data acquisition program known as the Information Collection Rule. Data collected will be used by the EPA to establish future drinking water standards. Under the Federal Safe Drinking Water Act, the EPA is required to continue to establish new maximum levels for additional chemicals. The costs of future compliance are unknown, but Dominguez could be required to perform more quality testing and treatment. Management believes the Company's financial reserves will be sufficient to meet these anticipated requirements. During 1999, Dominguez expended $1,786,000 on water supply improvements. In 2000, Dominguez anticipates spending $2,622,000 for water supply capital improvements. WATER SUPPLY Dominguez obtains its water supplies from its own groundwater wells, a surface water source plus two water wholesalers of imported water. All Dominguez' service areas, except for the Lucerne service area (Lucerne) of Redwood Valley Water Company Division, obtain either a portion or all of their supply from groundwater wells. Lucerne has a surface water treatment plant. The quantity that the South Bay Division is allowed to pump over a year's time is fixed by court adjudication. The adjudication established distinct groundwater basins that are managed by a court-appointed watermaster. The groundwater management fixes the safe yield of the basins and ensures the replenishment of the basins by utilizing impounded storm water, treated recycled water and treated purchased water when necessary. Groundwater basins have not been adjudicated in the Subsidiaries. The South Bay Division and Leona Valley service area of Antelope Valley Water Company purchase water from wholesalers to supplement groundwater. The South Bay Division purchases imported water from the Metropolitan Water District (MWD) of Southern California through West Basin. The Leona Valley service area purchases its imported water from the Antelope Valley - East Kern Water Agency (AVEK). Both of these wholesale suppliers obtain water from the California State Water Project (SWP), and MWD also obtains water from the Colorado River. Long-term imported water supplies depend upon several factors. Dominguez' future dependency on imported water will be subject to the availability and usage of recycled water in the region as well as customer's long-term water conservation efforts. Dominguez has and will continue to promote long-term water conservation efforts and will advance the use of recycled water. Legislative actions continue to play a role in the long-term availability of water for southern California. The amount of SWP water available from northern California and water imported from the Colorado River may be significantly reduced around the beginning year 2000. Even with the use of recycled water and continuing conservation efforts, future drought conditions may require water rationing by all water agencies and purveyors, including Dominguez. ACCOUNTING STANDARDS The Company currently applies accounting standards that recognize the economic effects of rate regulation and records regulatory assets and liabilities related to water distribution operations. If rate recovery of water-related costs becomes unlikely or uncertain, whether due to competition or regulatory action, these accounting standards may no longer apply. This change could result in the write-off of costs in an amount that could be material. However, based on a current evaluation of the various factors and conditions that are expected to affect future cost recovery, management believes that its regulatory assets will likely be recovered in the future. In 1998, the Financial Accounting Stands Board issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities" which is to be adopted by 2001. The Statement establishes new accounting and reporting standards for derivative financial instruments and hedging activities. The Company does not expect the adoption of the Standard to have a material impact on the Company's results of operations or financial statements. YEAR 2000 The Company successfully transitioned from 1999 to 2000 without technology or customer service disruptions as a result of preparation efforts by our employees. Year 2000 (Y2K) project teams were assembled to ensure the Company's Y2K preparedness. The estimated cost for Y2K preparedness was approximately $36,000. The Company has existing contingency plans in place for events such as extreme heat, storms, equipment failures, and accidents. Y2K contingency plans were based on the framework of existing emergency management system preparation and scenario development, and addressed the most reasonably likely worst case scenarios that could occur in the event that various Y2K issues are not resolved in a timely manner. Contingency planning is an ongoing process, which the Company continues to perform. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. CONSOLIDATED STATEMENTS OF INCOME AND COMMON SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these statements. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these statements. Notes to Consolidated Financial Statements as of December 31, 1999 NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of Dominguez Services Corporation (the "Company"), Dominguez Water Company ("Dominguez") and its subsidiaries. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities. These principles also require disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The Company operates in the water services industry. All significant intercompany transactions have been eliminated. Dominguez maintains its accounts in accordance with the uniform system of accounts prescribed by the California Public Utilities Commission (the Commission). ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. REVENUES: Water service revenues are recognized on an accrual basis. Unbilled revenue accrual is based on estimated usage from the latest meter reading to the end of the accounting period. PROPERTY, PLANT AND EQUIPMENT: Utility plant is carried at historical cost with subsequent additions at cost or donor's basis, which approximates cost, less cost of retirements, sales, and abandonments. Water rights are stated at the nominal amount of $1 plus purchased water rights at cost and past expenditures in connection with litigation in defense thereof. Depreciation of utility plant for financial statement purposes is computed using the Commission's remaining life accrual method. Under this method, composite straight-line depreciation rates are determined by periodic estimates of average remaining life of all utility plant assets. Costs of abandonment and salvages are charged or credited to accumulated depreciation. The effective composite depreciation rate was 2.5% in 1999 and 2.9% in 1998. Costs of maintenance and repairs are charged to operations; renewals and betterments are generally capitalized in the property accounts. PREPAID TAXES AND OTHERS: From 1987 through 1997, contributions in aid of construction and advances for construction were taxable for federal and state income tax purposes. The Company has paid these taxes and recorded deferred taxes in these consolidated financial statements. These taxes will be recovered over the tax life of the assets for contributions and the life of the contracts for advances. DEFERRED CHARGES: Debt expense on bonds is being amortized based on the percentage of the principal amount outstanding over the term of the debt. PRODUCTION COST BALANCING ACCOUNT: The Company records over- or under-collections of production costs when incurred in its books of accounts and financial statements based on the regulatory treatment afforded these costs. As of December 31, 1999 and 1998, the balancing account reflected an under-collection of $5,000. INVESTMENTS: The Company assumes all investments with maturities of three months or less to be cash equivalents. Investments in entities that are 50% or less owned are accounted for by the equity method. INCOME TAXES: The Company provides deferred income taxes for certain transactions which are recognized for income tax purposes in a period different from that in which they are reported in the financial statements. Investment Tax Credits (ITC) have been deferred and are being amortized as reductions to income tax expense proportionately over the lives of the properties giving rise to the credits. REGULATORY ASSETS: The Company currently applies accounting standards that recognize the economic effects of rate regulation and records regulatory assets and liabilities related to water distribution operations. If rate recovery of water-related costs becomes unlikely or uncertain, whether due to competition or regulatory action, these accounting standards may no longer apply. This change could result in the write-off of costs in an amount that could be material. However, based on a current evaluation of the various factors and conditions that are expected to affect future cost recovery, management believes that its regulatory assets will likely be recovered in the future. RESTRICTED CASH: Restricted cash represents surcharge proceeds plus interest earned, which is restricted to the payment of principal and interest on the California Safe Drinking Water Bonds. RECLASSIFICATIONS: The 1999 and 1998 consolidated financial statements include certain reclassifications necessary to conform to current year presentation. NOTE 2 CAPITAL STRUCTURE The Company has authorized issuance of up to 4,000,000 shares of common stock with par value of $1.00. As of December 31, 1999, 1,563,779 shares of stock were issued and outstanding and 40,740 options were granted with a weighted average exercise price of $16.94. At December 31, 1999, 2,800 options were exercised and 13,835 options were exercisable. As described in Note 15, the Company has executed a Merger Agreement to be acquired by CWSG. The Merger Agreement provides that all options become exercisable prior to the closing date. Effective January 2, 1998, the Company split its common stock three-for-two for shareholders of record on December 15, 1997. The Company paid cash in lieu of issuing fractional shares based on the closing price as of December 15, 1997. The par value of the common stock remained unchanged. Share information and the capital accounts in the consolidated financial statements have been retroactively restated to reflect the change. This restatement resulted in the transfer of $502,000 from paid-in-capital to common shares equity. NOTE 3 RESTRICTIONS ON DIVIDENDS The Company's available dividends to its shareholders are substantially dependent on the availability of dividends from Dominguez to the Company. Under the terms of its long-term debt agreements, Dominguez is limited in its payment of dividends (other than stock dividends) on all classes of stock to the net income accrued subsequent to December 31, 1992, plus the sum of $3,000,000. The approximate unrestricted earnings available for dividend payments amounted to $7,052,000 as of December 31, 1999. NOTE 4 LONG-TERM DEBT Under a trust indenture dated August 1, 1954, and twelve supplemental indentures, the Company pledged substantially all its property, water rights, and materials and supplies as collateral under the bonds. At December 31, 1999 and 1998, long-term debt outstanding was: Aggregate maturities for the five years commencing with 2000 are approximately $96,000 (2000), $113,000 (2001), $131,000 (2002), $140,000 (2003), and $349,000 (2004). NOTE 5 INTERIM DEBT The Company maintained an available line of credit of $4,500,000 in 1999 and 1998 with Bank of America. At the end of 1999 and 1998, the Company had $400,000 and $450,000 outstanding, respectively. Borrowing bears interest at the preference lending rate. NOTE 6 ADVANCES FOR CONSTRUCTION Advances for construction of main extensions are primarily refundable to depositors over a 20- or 40- year period. Refund amounts under the 20-year contracts are based on annual revenues from the extension. Balances at the end of the contract period are refunded in five equal annual installments. Beginning in June 1982, contracts provided for full refund at a 2-1/2% rate per year for 40 years. Estimated refunds for 2000 for all main extension contracts are $164,000. NOTE 7 CONTRIBUTIONS IN AID OF CONSTRUCTION Contributions in aid of construction are donations or contributions in cash, services or property from governmental agencies or individuals for the purpose of constructing utility facilities. Depreciation applicable to such plants is charged to the contributions in aid account rather than to depreciation expense. The charges continue until the cost applicable to such properties has been fully depreciated or the asset has been retired. NOTE 8 EMPLOYEE BENEFITS PENSION PLAN: The Company provides a qualified defined benefit pension plan for all its full-time employees. Benefits under this plan reflect the employee's compensation, years of service and age at retirement. Funding is based upon actuarially determined contributions that take into account the amount deductible for income tax purposes and the minimum contribution required under the Employee Retirement Income Security Act of 1974, as amended. Pension costs are determined in accordance with Statement of Financial Accounting Standards (SFAS) No. 87, including the use of the projected unit credit actuarial cost method. For ratemaking purposes, the Company recovers pension expense based on the method in place prior to SFAS No. 87. In 1998, the Company implemented SFAS No. 132, "Employer's Disclosures about Pensions and Other Postretirement Benefits," which standardizes disclosure requirements but does not affect the measurement of plan obligations. Prior periods have been restated to conform to the current year presentation. The components of the 1999 and 1998 provisions are summarized below: POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The Company charges the costs associated with its postretirement benefits other than pensions to expense during the employee's years of service. The Company is amortizing its $588,000 transition obligation related to prior service over 20 years. The Company provides health care benefits for retired employees until both the employee and his/her spouse have reached 65 years of age. Health care benefits are subject to deductibles, co-payment provisions and other limitations. The Company funds the plan up to tax-deductible limits, in accordance with ratemaking practices. Differences between expense determined under the new standard and amounts authorized for rate recovery are not expected to be material and are charged to earnings. The components of postretirement benefits other than pensions are summarized below: Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in the assumed health care cost trend rates would have the following effects: The Company also offers its employees a 401(k) plan. Employees make all contributions under the plan. STOCK-BASED COMPENSATION PLANS: The Company's 1997 Stock Incentive Plan (the Plan) was adopted by the Board on February 25, 1997, and contains provisions for four types of awards: (i) stock options to purchase shares of the Company's common stock, (ii) payment of awards earned under the Company's Annual Incentive Plan (AIP) in shares of stock, (iii) issuance of restricted stock, and (iv) payment of dividend equivalents which, at the discretion of the compensation committee, may be granted in conjunction with stock options or restricted stock awards to provide cash payments prior to the time the option is exercised or the shares are vested. SFAS No. 123, "Accounting for Stock-Based Compensation," if fully adopted, changes the methods for recognition of cost on plans similar to those of the Company. Adoption of the accounting requirements under SFAS No. 123 is optional; however, pro forma disclosures as if the Company had adopted the cost recognition method are required. Had compensation cost for stock options awarded under this plan been determined consistent with SFAS No. 123, the Company's net income and earnings per share would have reflected the following pro forma amounts: The Company may grant up to 75,000 options under the Plan. The Company has granted 40,740 through December 31, 1999. The options are issued at fair market value with exercise prices equal to the Company's stock price at the date of grant. Options vest over a four-year period, are exercisable in whole or in installments, and expire ten years from date of grant. In accordance with the Plan and the granted option agreements as of December 31, 1999, vesting of options granted will be accelerated so such options will be exercisable prior to a change in control of the Company. A summary of the status of the Company's stock option plan at December 31, 1999 and 1998, and changes during the years then ended, are presented in the table and narrative below: Amounts shown reflect the 3-for-2 stock split effected January 1998. 14,840 options outstanding at December 31, 1999, have an exercise price of $18.00 and a weighted average remaining contractual life of 9.54 years. The remaining 23,100 options have an exercise price of $16.33 and a weighted average remaining contractual life of 8.48 years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes pricing model with the following assumptions used for the grants in fiscal 1998: weighted average risk-free interest rate of 5.67%; weighted average volatility of 18.46%; expected life of 10 years; and a weighted average dividend yield of 6.36%. NOTE 9 INCOME TAXES The Company utilizes SFAS No. 109, "Accounting for Income Taxes," which requires the recognition of deferred taxes for all temporary differences between book and tax income. CURRENT AND DEFERRED TAXES: Income tax expense includes the current tax liability from operations and the change in deferred income taxes during the year. Investment tax credits are amortized over the life of related properties. The components of the net accumulated deferred income tax liabilities are: The current and deferred components of income tax expense are: A reconciliation of the federal statutory income tax rate to the effective rate is presented below: The Company has no net operating loss carryforward at December 31, 1999. NOTE 10 NEW BUSINESS AND DISPOSITIONS BUSINESS INVESTMENTS: DSC Investments invested $350,000 in Chemical Services Corporation (CSC) on December 20, 1996, and acquired a twenty percent equity ownership with the option to acquire an additional forty percent through the year 2001. Under the investment agreements, the Company was obligated to provide working cash and long-term financing to CSC for the leasing of chlorine generators, subject to the financial condition of CSC. In April 1999, a contract was drafted pursuant to which DSC Investments would sell back its equity ownership to CSC at a premium of $250,000, $160,000 of which would be applied to Dominguez' purchase of chlorine generation equipment from CSC. Both parties signed the contract in December of 1999 and payment was received from CSC in January 2000. In December 1997, Dominguez entered into a recycled water agreement with the West Basin Municipal Water District (West Basin) and ARCO. Under the terms of the agreement, Dominguez will sell ARCO recycled water purchased from West Basin for the same cost margin that Dominguez would otherwise have received providing ARCO with potable water. The recycled water plant was completed in December of 1999, and became fully operational in January 2000. Having access to recycled water will reduce the South Bay Division's demand for imported water, the availability of which may be uncertain in the future. Reduced imported water supplies and annual population growth could create future drought conditions in Southern California; however, Dominguez believes that the availability of recycled water will significantly mitigate the impact of future droughts in the South Bay Division service area. In 1998, the Water Replenishment District of Southern California (WRD), a water district responsible for the oversight and management of the West and Central Groundwater Basins, awarded a grant to Dominguez of $1,820,000. Dominguez received the first of its two payments for $910,000 in 1998 and received the second payment for $910,000 in 1999. Dominguez used approximately $670,000 to offset the cost of purchasing higher-priced imported water in lieu of pumping its groundwater rights. The balance of the funds, approximately $1,150,000, will be used to meet Dominguez' expected $2,000,000, commitment in recycled water facilities, leaving a balance of $850,000 to be funded by Dominguez. ACQUISITIONS: During 1998, Dominguez received the Commission's approval to acquire the assets of the Lucerne Water Company, an investor-owned water system serving 1,242 customers, in exchange for 42,092 shares of the Company's common stock. This acquisition, effective January 1, 1999, was accounted for using the purchase method. Ratebase for the acquired assets was set at $713,000, resulting in an additional credit of $262,000 recorded in paid in capital. Also in 1998, Dominguez received Commission approval to acquire the assets of the Rancho del Paradiso and Armstrong Valley Water Companies, investor-owned water systems serving 60 and 322 customers respectively, in exchange for 12,375 shares of the Company's common stock. This acquisition, effective January 1, 1999, was accounted for using the purchase method. Ratebase for the acquired assets was set at $188,000, resulting in an additional credit of $55,000 recorded in paid in capital. In July 1999, Dominguez received the Commission's approval to acquire the assets of Hawkins Water Service, serving 51 customers, for $50,000 cash. The ratebase for the acquired assets was set at $51,000 and the acquisition became effective on August 6, 1999. Dominguez also received the Commission's approval in 1999 to acquire the assets of Coast Springs Water Company, serving 237 customers, for $180,000 cash. The ratebase for the acquired assets was set at $179,000 and the acquisition became effective on December 8, 1999. NOTE 11 BUSINESS RISKS AND CONCENTRATION OF SALES Forty-six percent of the Company's water supply comes from its own groundwater wells, and fifty-four percent comes from wholesalers of imported water. The long-term availability of imported water supplies is dependent upon several factors. Drought conditions throughout the state, increases in population, tightening of water quality standards, and legislation may reduce water supplies. At this time, the Company does not anticipate any constraints on its imported water supplies due primarily to above-average precipitation in recent years. The Company is taking steps to reduce its dependence on imported water supplies, including working with the West Basin to bring recycled water into its South Bay Division service area. The Company continues to drill new wells in order to enable it to utilize its total adjudicated groundwater rights. Dominguez is subject to water quality regulations promulgated by the United States Environmental Protection Agency (EPA) and the California Department of Health Services (DHS). Both groundwater and purchased water are subject to extensive analysis and testing. With occasional minor exceptions, Dominguez meets all current primary water standards. Beginning in mid-1997, Dominguez participated, along with many other large water companies throughout the United States, in an 18-month water sampling data acquisition program known as the Information Collection Rule. Data collected will be used by the EPA to establish future drinking water standards. Under the Federal Safe Drinking Water Act, the EPA is required to continue to establish new maximum levels for additional chemicals. The costs of future compliance are unknown, but Dominguez could be required to perform more quality testing and treatment. Management believes the Company's financial reserves will be sufficient to meet these anticipated requirements. During 1999, Dominguez expended $1,786,000 on water supply improvements. In 2000, Dominguez anticipates spending $2,622,000 for water supply capital improvements. The Company's utility operations are performed under the purview of the Commission. Thus, the Company has no unilateral flexibility with regards to water charge for its utility products or services. Most variations are due primarily to weather conditions and the usage of major industrial customers. The Company is required to provide service to customers within its defined service territories. Although the Company has a diversified base of residential, business-industrial and public authority customers, a substantial portion of water consumption, 51% in 1999 and 50% in 1998, is attributable to business-industrial customers. One single refinery was responsible for 38% of this business-industrial consumption in 1999, and for 34% in 1998. Revenue details for 1999, 1998 and 1997 are as follows: NOTE 12 SUPPLEMENTAL CASH FLOW INFORMATION NOTE 13 RELATED PARTY TRANSACTIONS Dominguez annually refunds a portion of revenue received from several water mains for which Watson Land Company, Carson Estate Company, and Dominguez Properties advanced the construction funds to Dominguez. The refunds to Watson Land Company were $14,922 in 1999 and $17,250 in 1998. The refunds to Carson Estate Company were $1,110 in 1999 and $1,339 in 1998. The refunds to Dominguez Properties were $6,176 in 1999 and $6,176 in 1998. Dominguez also leases sites used for wells from Watson Land Company, Carson Estate Company, and Dominguez Properties. The rental costs for Watson Land Company were $40,735 in 1999 and 1998. The rental costs to Carson Estate Company were $21,095 in 1999 and $19,674 in 1998. The rental costs for Dominguez Properties were $3,846 in 1999 and 1998. Dominguez provides water service to these entities to the extent that they have property within it's division. NOTE 14 SUBSEQUENT EVENTS In February 1999, Dominguez filed general rate increase applications for the South Bay Division and its subsidiaries, Antelope Valley Water Company and Kern River Valley Water Company. The Commission consolidated the applications into a single proceeding. In December 1999, the Company and RRB filed settlement agreements to increase rates by $1,416,000 for test year 2000, $336,000 for test year 2001 and $113,000 for attrition year 2002. In January 2000, the Leona Valley Town Council filed its opposition to the settlement agreement filed in the Antelope Valley Water Company (AVWC) application. The Administrative Law Judge granted an evidentiary hearing in the proceeding, limiting issues to the AVWC application, for March 1, 2000, and scheduled briefs to be filed on March 20, 2000. Because all the applications were consolidated into a single proceeding, the Commission has postponed its decision on the Dominguez South Bay and Kern River Valley Water Company rate applications. Dominguez anticipates that a Commission decision approving all settlement agreements will be ordered by June 2000. NOTE 15 THE MERGER On November 13, 1998, the Company executed an Agreement and Plan of Reorganization (the Merger Agreement) to merge with California Water Service Group (CWSG), the parent of California Water Service Company (Cal Water) and CWS Utility Services. Under the terms of the November 1998 Merger Agreement, each share of the Company's common stock issued and outstanding on the closing date would be converted into the right to receive 1.18 shares of CWSG common stock. The Company's Board of Directors (Board) received the opinion of its financial advisor, PaineWebber Inc., that this exchange ratio would be fair to the shareholders of the Company's common stock from a financial point of view. And, the Company expected that the proposed merger will be treated as a tax-free transaction under the applicable provisions of the Internal Revenue Code. Shares of CWSG common stock are traded under the symbol "CWT" on the New York Stock Exchange. CWSG operations provide water utility services to over 1.5 million people in 58 California communities. On March 16, 1999, the Company announced that it had received an unsolicited proposal from American States Water Company (ASWC) offering to acquire all of the Company's outstanding common stock in a stock-for-stock merger. Under the ASWC proposal, each share of the Company's common stock would have been converted into the right to receive a number of ASWC shares intended to provide $32.50 of value for each of the Company's shares. The ASWC proposal also provided for a collar pursuant to which the minimum and maximum conversion ratios would be 1.11 and 1.35 ASWC shares for each Company share. The Company's financial advisor advised the Company's Board that this proposal was more favorable to the Company's shareholders than the terms of the Merger Agreement. On March 22, 1999, the Company and CWSG executed an amendment to the November 1998 Merger Agreement which provides that each share of the Company's common stock will be converted into the right to receive a number of CWSG shares intended to provide $33.75 of value for each of the Company's shares. The amendment to the Merger Agreement also provides that the minimum and maximum conversion ratios will be 1.25 and 1.49 CWSG shares for each Company share. At a special meeting on May 12, 1999, Company shareholders overwhelmingly approved the Merger Agreement as amended. All regulatory approvals have been received, with the exception of that of the Commission. In its initial report filed in October 1999, the Commission staff recommended disapproval of the merger. Subsequently, CWSG and the Company issued a guarantee that customer rates would not increase as a result of the merger, expressing confidence that synergies achieved by the merger would offset merger costs. In succeeding discussions with Commission's Ratepayer Representation Branch (RRB), Cal Water and Dominguez proposed an enhanced guarantee, which included provisions that customer rates would not increase as a result of the merger, that Dominguez customers would continue to receive financial benefit of water rights currently owned by Dominguez, and that a portion of operating synergies achieved over those needed to offset merger costs be returned to customers. RRB staff testified to its support of the merger, with the enhanced guarantee, on December 7, 1999. In a proposed decision issued in February 2000, the Administrative Law Judge recommended approval of the merger with certain conditions, many of which were proposed by Cal Water and Dominguez in the enhanced guarantee. Oral arguments were scheduled for March 2000, with a decision expected in the second quarter. Pursuant to the Merger Agreement, if regulatory approval is not received or if either the Company or CWSG decide not to complete the merger, certain payments are required under the terms of the Merger Agreement by the terminating party. NOTE 16 EARNINGS PER SHARE The following table reconciles basic and diluted earnings per share calculations. Shares in the table below have been restated to reflect the Company's stock split in January 1998 (See Note 2). NOTE 17 BUSINESS SEGMENTS In 1998, the Company adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." The Company is a diversified water resource management company specializing in the delivery of high quality water supplies and has operations in two business segments, "Regulated" and "Non-Regulated," as well as general corporate charges. "Other" captures extraordinary items related to the merger with CWSG. The Regulated business segment is comprised of water utilities, the largest of which is Dominguez Water Company, serving 100,000 people in the South Bay area of Los Angeles County. The Company's other water utilities, all located in California, are: Kern River Valley Water Company in Kern County, Antelope Valley Water Company in northern Los Angeles and Kern Counties, and Redwood Valley Water Company Division in Lake, Sonoma and Marin County. These subsidiaries in aggregate serve an additional 20,000 people. In the area of Non-Regulated water-related business segments, the Company in 1998 and 1997 held a twenty percent equity stake in Chemical Services Company, the developer, manufacturer, and marketer of proprietary chlorine generation and treatment products. The Company accounted for the CSC investment under the equity method. In 1999, the Company sold its investment in CSC. The Company is also active in water rights brokerage and water supply and system operation contracts. See note 10 for additional information. Income from water right brokerage is derived from the selling and purchasing of leased water rights to pump groundwater located from the central and west basins located in Los Angeles County. Profits and assets for each segment are presented below: REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Dominguez Services Corporation: We have audited the accompanying consolidated balance sheets of Dominguez Services Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, common shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Dominguez Services Corporation and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. /s/ Arthur Andersen LLP - ---------------------------------- Arthur Andersen LLP Los Angeles, California March 24, 2000 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The following table sets forth the names and ages of all directors and executive officers, indicating the positions and offices presently held by each. There is no "family relationship" between any of the executive officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Set for below is certain information with respect to each of the Company's executive officers. All officers have served at the discretion of the Board of Directors. SUMMARY COMPENSATION TABLE The following table sets forth the compensation paid by the Company and options and long-term incentive plans awarded in 1999 and its two prior fiscal years to the Company's Chief Executive Officer and five other executive officers of the Company whose total annual salary and bonus exceeded $90,000 in 1999. OPTIONS AND LONG-TERM INCENTIVE PLANS In accordance with the Plan and the granted option agreements as of December 31, 1999, vesting of options granted will be accelerated so such options will be exercisable prior to a change in control of the Company. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth information as of March 24, 2000, with respect to the beneficial ownership of the Company's common stock by (i) each person known by the Company to own beneficially five percent or more of any class of the Company's outstanding common stock, (ii) each director nominee and named executive officer, and (iii) all directors and executive officers as a group. Each shareholder has sole voting and investment power with respect to such shares unless otherwise indicated. *Less than one percent 1) All of such shares are owned by Mr. Baum as trustee of the Dwight C. Baum and Hildagarde E. Baum Trust. Mr. Baum has voting and investment powers with respect to such shares 2) All of such shares are owned by Watson Land Company, of which Mr. Cannon is president, chief executive officer, and a director. Mr. Cannon shares voting and investing powers with respect to such shares with the other directors of Watson Land Company. 3) 159,364 of such shares are owned by the Carson Dominguez Real Estate Corporation, of which Mr. Gloege is a director. Mr. Gloege shares voting and investing powers with respect to such shares with the other directors of Carson Dominguez Real Estate Corporation. The remaining 1,500 shares are owned by Mr. Gloege individually. 4) 148,293 of such shares are owned by the Carson Estate Company, of which Mr. Flynn is president and a director. Mr. Flynn shares voting and investing powers with respect to such shares with the other directors of Carson Estate Company. 159,364 of such shares are owned by the Carson Dominguez Real Estate Corporation, of which Mr. Flynn is president and a director. Mr. Flynn shares voting and investing powers with respect to such shares with the other directors of Carson Dominguez Real Estate Corporation. 5) This includes 2,130 shares owned by Mr. Brady individually and 5,625 currently exercisable options held by Mr. Brady. 6) This includes 6,591 shares owned by Mr. Tootle individually and 575 currently exercisable options held by Mr. Tootle. 7) Includes shares described in footnotes (2), (3) and (4) above, and includes 5,625 currently exercisable options held by Mr. Brady and 575 currently exercisable options held by Mr. Tootle. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Dominguez annually refunds a portion of revenue received from several water mains for which Watson Land Company, Carson Estate Company, and Dominguez Properties advanced the construction funds to Dominguez. The refunds to Watson Land Company were $14,922 in 1999 and $17,250 in 1998. The refunds to Carson Estate Company were $1,110 in 1999 and $1,339 in 1998. The refunds to Dominguez Properties were $6,176 in 1999 and $6,176 in 1998. Dominguez also leases sites used for wells from Watson Land Company, Carson Estate Company, and Dominguez Properties. The rental costs for Watson Land Company were $40,735 in 1999 and 1998.. The rental costs to Carson Estate Company were $21,095 in 1999 and $19,674 in 1998. The rental costs for Dominguez Properties were $3,846 in 1999 and 1998. Dominguez provides water service to these entities to the extent that they have property within its divisions. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K. None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DOMINGUEZ SERVICES CORPORATION: By /s/ Brian J. Brady ---------------------------------- Brian J. Brady, Chief Executive Officer By /s/ John S. Tootle ---------------------------------- John S. Tootle, Chief Financial Officer, Treasurer, Secretary By /s/ Cynthia C. Chu ---------------------------------- Cynthia C. Chu, Corporate Controller Assistant Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

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1999

912957

1074766_1999.txt

1074766_1999

1999

1074766

Item 1. Business. Not applicable. Item 2. Item 2. Properties. Not applicable. Item 3. Item 3. Legal Proceedings. Not applicable. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. (a) There is no established public trading market for the Certificates. (b) At December 31, 1999, the number of holders of record of Certificates was as follows: Certificates Number of Holders of Record ------------- --------------------------- Series CHR 1998-1 Amortizing class 7 Residual class 4 Item 6. Item 6. Selected Financial Data. Not applicable. Item 7. Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations. Not applicable. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Not applicable. Item 8. Item 8. Financial Statements and Supplementary Data. Not applicable. Item 9. Item 9. Changes in and disagreements with Accountants on Accounting and Financial Disclosure. None. Item 10. Item 10. Directors and Executive Officers of the Registrant. Not applicable. Item 11. Item 11. Executive Compensation Not applicable. PART III Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Set forth below is certain information with respect to each holder of record for each class of the Series CHR 1998-1 Certificates at December 31, 1999: Item 13. Item 13. Certain Relationships and Related Transactions. None. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 1. All Financial Statements. Not applicable. 2. Financial statement schedules required by Item 8 of this Form. Not applicable. 3. See attached Trustee's Distribution Statements for the February 1, 1999 and August 1, 1999 cash distributions. (filed as Exhibit 20). SIGNATURES Pursuant to the requirements of Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. Prudential Securities Structured Assets, Inc. By: /s/ Lawrence Motz Date: January 29, 2000 ----------------------------------------- Lawrence Motz Vice President Receipts on Corporate Securities Trust, Series NSC 1998-1 By: Prudential Securities Structured Assets, Inc. Date: January 29, 2000 ------------------------------------------ By: /s/ Lawrence Motz Date: January 29, 2000 ------------------------------------------ Lawrence Motz Vice President

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ITEM 1. BUSINESS Background and General JWGenesis Financial Corp. (the "Company" or "JWGenesis") is a diversified financial services holding company whose principal operating subsidiaries -- JWGenesis Financial Services, Inc. ("JWGFS") (formerly known as Corporate Securities Group, Inc.), JWGenesis Securities, Inc. ("JWG Securities"), JWGenesis Capital Markets, Inc. ("JWG Capital") and JWGenesis Financial Group, Inc. ("JWGFG") (formerly GSG Securities, Inc.) -- on a combined basis operate a full-service securities brokerage and investment banking business that offers "one-stop-shopping" to the Company's customers and clients. The Company provides a wide range of securities brokerage and investment services to a diversified client base, and provides investment banking services to corporate and institutional clients and high net worth individuals. JWGenesis was incorporated as a Florida corporation in January 1998; however, as a result of the Share Exchange on June 12, 1998 described elsewhere herein, JWGenesis succeeded to the business and operations of JWCharles Financial Services, Inc. ("JWCFS"), which was incorporated as a Florida corporation in December 1983. Also on June 12, 1998, as a result of the Combination described elsewhere herein (of which the Share Exchange was a part), JWGenesis acquired 100% of Genesis Merchant Group Securities, LLC ("Genesis") and succeeded to its business, which had commenced in 1989. On March 3, 1999, the Company divested itself of Genesis in a transaction that resulted in the Company's continued ownership and operation, through JWG Capital, of Genesis's New York City-based operations, which consist of corporate finance, capital markets, and certain institutional research and sales capabilities. As a result of a merger in 1990, JWCFS acquired certain operations that date back to 1973. JWG Securities is a New York Stock Exchange ("NYSE") member firm with branch offices in South Florida, California, Georgia, and New York. JWG Securities' branches are owned as well as managed by the Company, and its brokers are "full-service" oriented and receive compensation packages that are competitive with most regional and national wire-house brokerage firms. JWGFS, a National Association of Securities Dealers, Inc. ("NASD") member firm, is a general securities broker dealer that offers a full array of investment products and services to a variety of clients through a national network of independently owned offices. JWGFS offices can vary in size from one investment professional to many. JWG Securities and JWGFS clear trades through Fiserv Correspondent Services, Inc. ("Fiserv") and Bear Stearns Securities Corp. JWGFG, a NASD member firm, is a general securities broker dealer that offers a full array of investment products and services primarily through its branch offices located in Colorado, California, Florida, and Illinois. JWGFG brokers are "full-service" oriented and receive compensation packages that are competitive with most similarly situated firms. JWG Capital is a New York-based firm that specializes in investment banking services. A sixth subsidiary of the Company, DMG Securities, Inc. ("DMG"), is also engaged in the securities brokerage business. All of JWGenesis' operating subsidiaries are owned through its wholly-owned subsidiary, JWGenesis Financial, Inc. ("JWGFI"). The Company's activities generate revenue for the Company primarily in the form of commission and fee income, and market making and principal transactions revenues. The Company also derives revenues from corporate finance transactions, insurance brokerage services, consulting services, and interest income. Until June 1, 1999, when the Company sold its JWGenesis Clearing Corp. subsidiary ("JWG Clearing") and ceased its clearing services business, the Company also generated securities transactions processing fees ("clearing fees"). The following table indicates the percentage of total revenues represented by each of these activities during the past three years: Percentage of Total Revenues(1)(2) ---------------------------------- Year Ended December 31, ---------------------------------- 1999 1998 1997 ---- ---- ---- Commissions............................... 56% 53% 51% Market making and principal transactions, net ...................... 18% 21% 21% Gain on sale of subsidiary(3)............. 13% - - Interest.................................. 5% 12% 12% Clearing fees............................. 3% 11% 13% Other (including corporate finance and consulting).............................. 5% 3% 3% - ---------------- (1) Excludes the results of Genesis for the periods prior to June 12, 1998. (2) Includes the results of JWG Clearing through May 31, 1999. (3) Reflects the sale of JWG Clearing on June 1, 1999. The following table indicates the amounts and percentages of total revenues generated by each of the Company's principal investment banking and securities brokerage subsidiaries in each of the past three years: Revenues(1)(2) (Amounts in Millions of Dollars) --------------------------------------------------------------- Year Ended December 31, 1999 1998 1997 --------------------------------------------------------------- Amount % Amount % Amount % ---------- -------- ----------- ------- ---------- ------ JWGFS $53.3 37 $39.1 34 $34.2 35 JWG Capital (1) 2.5 2 13.2 12 - - JWG Securities 45.5 31 31.0 27 34.8 35 JWG Clearing (2) 15.4 11 28.1 25 26.4 27 JWGFG (3) 25.6 18 0.0 0 0.0 0 DMG Securities 1.2 1 2.0 2 2.9 3 - ---------------- (1) Excludes the results of Genesis for the periods prior to June 12, 1998. (2) Includes the results of JWG Clearing through May 31, 1999. (3) Reflects the acquisition of certain assets on January 1, 1999. Significant Developments Sale of JWGenesis Clearing Corp. On June 1, 1999, the Company completed the sale of JWG Clearing to Fiserv, Inc. through Fiserv, Inc.'s wholly owned subsidiary Fiserv Clearing, Inc. ("Fiserv"). JWG Clearing had functioned primarily as the Company's securities clearing, execution, and back office services unit, and only those operations comprised JWG Clearing at the time the sale was consummated. For the sale to Fiserv, the Company received cash consideration of approximately $59 million, and may receive additional consideration based on the outcome of various matters. Of this amount, approximately $19 million represented the net book value of JWG Clearing. Of the $40 million of purchase price in excess of the net book value of JWG Clearing, $25 million was recorded as income (reduced by certain expenses related to the sale) in 1999 and the remaining $15 million was recorded as deferred income and will be accreted into income ratably over 10 years. In connection with the JWG Clearing sale, among other things, the Company agreed not to compete for ten years in the securities clearing and execution business and not to solicit personnel of JWG Clearing or Fiserv and its affiliates; and the Company agreed, subject to certain limitations and exclusions (primarily related to independent contractor registered representatives, possible future acquisitions, and a one-year phase-in period), to use and cause its subsidiaries and affiliates to use the clearing services of designated Fiserv affiliates for at least 90% of their securities brokerage transactions, and, in the case of independent contractor registered representatives, to impose a surcharge on certain such transactions that are not cleared through a Fiserv affiliate, during the 10-year period following the sale. The Company has the right, however, to be released from the above obligations to use Fiserv affiliates or to impose a surcharge by repaying to Fiserv a portion of the sales price based on a prescribed formula that takes into account the price paid in the sale and the amount of clearing services business then being generated by the Company or its affiliate seeking the release. As a result of the sale and the above agreements, the Company ceased providing clearing services, both to third party correspondents (such as broker dealers, banks, and other financial institutions) and for its own securities brokerage transactions. Divestiture of Genesis On March 3, 1999, the Company divested Genesis -- which at the time consisted primarily of the Company's San Francisco-based brokerage processing services unit that had been acquired in the Combination on June 12, 1998 -- to an investor group of certain of the former owners of Genesis (the "Divestiture"). The Company had acquired Genesis on June 12, 1998 as part of a larger transaction (the "Combination") that included a statutory share exchange with JWGFI (then known as JW Charles Financial Services, Inc., or JWCFS) by which the Company acquired all of the outstanding shares of JWGFI common stock in exchange for shares of common stock of the Company on a one-for-one basis, and thus replaced JWGFI as the publicly held holding company (the "Share Exchange"). As part of the Divestiture, the investor group conveyed to the Company an aggregate of 426,563 shares of common stock of the Company that had been issued to them in the Combination, and Genesis transferred its corporate finance operations (based in its New York office) to JWG Capital, so that those operations would be retained by the Company. The JWGFG Acquisition On January 1, 1999, JWGFG Securities, Inc. ("JWGFG") acquired certain assets of six retail securities branch offices (and three satellite offices) from an unaffiliated broker-dealer. Prior to January 1, 1999, JWGFG was inactive. In connection with this asset purchase, JWGFG paid approximately $2.3 million in cash; JWGFI issued shares of its Series C Redeemable Preferred Stock that are redeemable, in the aggregate, for up to $2.5 million based upon the financial performance of the acquired branch offices over the three years in the period ending December 31, 2001; and the Company issued (i) a warrant for the purchase of up to 156,250 shares of its common stock, at an exercise price of $16 per share, which may only be exercised using redemptions of the Series C Redeemable Preferred Stock, and (ii) a three-year, fully vested option to purchase 75,000 shares of its common stock at an exercise price of $16 per share. The Company also issued options to purchase an aggregate of 375,000 shares of its common stock at an exercise price of $8 per share, exercisable through December 31, 2003, to senior management of the acquired branch offices (the "Senior Management Options"). The Senior Management Options vest over a three-year period based upon a formula tied to the revenues of the acquired branch offices. An additional 150,000 options, with a three-year term and a $16 per share exercise price, were made available by the Company to selected branch managers and registered representatives employed in the acquired branch offices. MVP.com, Inc. Investment In August 1999, the Company and John Elway formed MVP.com, Inc., initially as a 50/50 joint venture between them, to establish an Internet business (the "Old Joint Venture"). In November 1999, the Company and Mr. Elway entered into a series of transactions, led by Benchmark Capital Partners III, L.P. ("Benchmark") and certain of its affiliates, which resulted in the formation of a new MVP.com, Inc. ("MVP") and the addition of several new participants in the venture, including Benchmark, Freeman Spogli & Co., Michael Jordan, Wayne Gretzky, Galyan's Trading Company, Sportsline.com, CBS, and John Costello, the Chief Executive Officer of MVP. In connection with that series of transactions, the Company entered into a Series A Preferred Stock Purchase Agreement (the "Stock Purchase Agreement"), pursuant to which it purchased, for approximately $1.0 million, shares of preferred stock in MVP ("Preferred Shares") that were convertible into approximately 5% of MVP's common stock. The Company also entered into an Investor Rights Agreement (the "Investor Rights Agreement") which entitles it to acquire additional Preferred Shares in connection with certain future sales of stock by MVP. In 2000, the Company exercised rights under the Investor Rights Agreement to purchase additional Preferred Shares in order to reduce its percentage dilution as a result of subsequent financings by MVP. As a result, the Company has invested an aggregate of approximately $3.0 million for MVP Preferred Shares, which are convertible into approximately 4% of MVP's common stock. Holders of Preferred Shares are entitled to receive annual cash dividends at the rate of $0.027 per share, subject to adjustment for stock dividends, stock splits, and similar transactions. Upon any liquidation of MVP, holders of Preferred Shares have a priority right to receive $0.335 per share (as adjusted for any stock dividends, stock splits, and similar transactions), plus all declared and unpaid dividends on the Preferred Shares. With limited exceptions, the Preferred Shares vote equally with the shares of MVP common stock. Pursuant to the Investor Rights Agreement, the Company and other holders of MVP stock have certain demand and piggyback registration rights with respect to their shares of MVP stock. In connection with the November 1999 series of transactions, the Old Joint Venture sold substantially all of its assets, including its "mvp.com" name, URL, and all intellectual property rights, to MVP, and ceased operations. The Company is a passive investor only and has no role in the management of MVP. Tender Offer On February 11, 2000, the Company completed a partial tender offer for shares of its outstanding common stock, pursuant to which it purchased 1,750,000 shares for a price of $35 million. The Company conducted the tender offer in order to utilize excess cash derived from the sale of JWG Clearing in June 1999. 3-for-2 Stock Split Unless otherwise indicated, all information with respect to numbers of shares of common stock, prices of common stock, and earnings per common share appearing in this Form 10-K have been adjusted to reflect two separate three-for-two stock splits effected in the form of a 50% stock dividend, the first by its predecessor JWCFS on February 7, 1997, and the most recent on March 24, 2000. Retail Brokerage The Company conducts its retail brokerage business primarily through JWG Securities, JWGFS, JWGFG and DMG. The following table sets forth certain statistical information concerning registered representatives and branch offices of each of these subsidiaries: - ------------------- (1) Information is as of January 1, 1999, reflecting personnel hired as part of an assets acquisition that closed as of that date, exclusive of approximately 80 trainee personnel. JWGenesis Securities, Inc. JWG Securities is a NYSE member organization and a member of the NASD. JWG Securities' activities primarily consist of retail securities brokerage, management and participation in underwritings of equity and fixed income securities, distribution of mutual funds and unit trusts, and research and investment advisory services. JWG Securities has clearing agreements with Fiserv and Bear Stearns Securities Corp. ("Bear Stearns"), both NYSE member organizations, under which agreements they provide JWG Securities with back office support, transaction processing services on all principal national and international securities exchanges, and access to many other financial services and products. These agreements allow JWG Securities to offer a range of products and services that is generally offered only by firms that are larger and have more capital than JWG Securities. All of JWG Securities' registered representatives are in-house employees who, prior to their employment with JWG Securities, had industry experience. JWGenesis Financial Services, Inc. JWGFS, a general securities broker-dealer, provides products and services similar to those offered by JWG Securities for the accounts of its customers and for its own account. JWGFS is a member of the NASD and has clearing agreements with Bear Stearns and Fiserv, under which agreements they provide JWGFS with back office support, transaction processing services on all principal national and international securities exchanges, and access to many other financial services and products. These agreements allow JWGFS to offer a range of products and services that is generally offered only by firms that are larger and have more capital than JWGFS. All of JWGFS's branch offices operate as independently owned affiliates. In affiliated branch office situations, the office is owned and operated by an independent person who obtains appropriate NASD licenses to supervise or manage the branch office by virtue of affiliating with JWGFS and being subject to its supervisory jurisdiction. Each such office is responsible for its own overhead and other operational expenses, although all of its revenues from securities brokerage transactions accrue to JWGFS. JWGFS, on the other hand, pays commissions to the branch offices on the revenues generated by them (at higher rates than those that would be paid to registered representatives working at a branch office owned by JWGFS) and provides other support for the operations, including required home office supervisory functions and access to JWGFS's securities transaction clearing agreements with Bear Stearns and Fiserv. All registered representatives who are associated with JWGFS are licensed with the NASD, and all such persons have prior industry experience prior to opening their own office or working at one of JWGFS's independently owned affiliated offices. The affiliated branch office system permits the Company to expand its base of revenue and its network for the retail distribution of securities underwritten by the Company (and for trading in connection with the Company's market making activities), without the capital expenditures that would be required to open company-owned offices and the additional administrative and other costs of hiring registered representatives as in-house employees. JWGenesis Financial Group, Inc. JWGFG, a general securities broker-dealer, provides products and services similar to those offered by JWG Securities for the accounts of its customers and for its own account. JWGFG is a member of the NASD and has a clearing agreement with Fiserv, under which it provides JWGFG with back office support, transaction processing services on all principal national and international securities exchanges, and access to many other financial services and products. The Fiserv clearing agreement allows JWGFG to offer a range of products and services that is generally offered only by firms that are larger and have more capital than JWGFG. All of JWGFG's registered representatives are in-house employees. Through its retail branch network, JWGFG markets a wide variety of investment products, including common and preferred equities, tax-free and taxable bonds, unit trusts, mutual funds, insurance and annuity products, and options. DMG Securities, Inc. DMG, also a NASD member firm, conducts its brokerage operations from a single location in Virginia. DMG's office is owned and operated by an independent person who holds appropriate NASD licenses to supervise or manage the branch office by virtue of affiliating with DMG and being subject to its supervisory jurisdiction. The office is responsible for its own overhead and other operational expenses, and operates in a manner similar to that described for affiliated branch offices of JWGFS. DMG also has a clearing agreement with Fiserv that provides DMG with back office support, execution services on all principal national securities exchanges, and access to many of its in-house financial services and products. This agreement allows DMG to offer a range of products and services that is generally offered only by firms that are larger and have more capital than DMG. Corporate Finance The Company's corporate finance activities are conducted primarily through JWG Capital and involve a variety of activities, including public and private debt and equity financings for corporate clients, merger and acquisition advisory services, fairness opinions, business analyses and evaluations, and general financial consulting services. Such activities include securing the Company's participation in the distribution of securities -- both initial public offerings ("IPOs") and secondary offerings. The Company has traditionally concentrated its underwriting efforts in the IPO marketplace, seeking out emerging enterprises in industries that it believes offer reasonable opportunities for future growth. Following an offering, the Company (through a registered broker-dealer subsidiary) maintains after-market support by providing research analysis, after-market trading, and sponsorship in the investment community. JWG Capital personnel have experience in each stage of merger, acquisition, divestiture, buyout, and recapitalization transactions, including identifying prospective transactions and parties, optimal "packaging" of a client for a transaction, preparing for organizational meetings, structuring the transactions, negotiating terms, and facilitating the closing process. JWG Capital also renders valuation and fairness opinions, for both private and public companies. Its work generally includes a comprehensive operational and financial review of a client and the development of financial analyses that incorporate both quantitative and qualitative factors. Compensation for the Company's corporate finance and capital markets services includes cash fees in the form of underwriting commissions, retainers, consulting fees, and success fees and, in certain situations, stock purchase warrants or other equity participation positions. Research The Company maintains a Research Department (i) to provide coverage on a select but broad range of companies, daily market commentary, and trading ideas, (ii) to complement the Corporate Finance Department by offering their services as an added benefit to attracting and retaining corporate finance clients, and (iii) to increase the availability and use of in-house research by the Company's retail oriented registered representatives by fostering increased coordination among the Research, Syndicate, and Corporate Finance Departments. The Research Department provides comprehensive coverage of a select group of industries and companies that in many instances are not otherwise widely followed by the investment community. The Research Department publishes numerous materials for its clients, including quarterly earnings reports, company updates, company reports, which initiate research coverage, industry overviews, and emphasis lists, which encompass all covered industries. The Research Department follows the following principal areas: business services and outsourcing, retailing, communications, technology, electronic commerce, health care, biotechnology, leisure and entertainment, broadband, consumer products, pharmaceuticals, and special situations. Syndicate and Fixed Income The Syndicate Department coordinates the Company's participation in underwriting syndicates or selling groups of other underwriters and assists the Company in obtaining participation from other firms in underwritings managed by the Company. The Company historically has participated in a diverse range of offerings, including as an underwriter or selling group member. These offerings included both initial and secondary offerings of common and preferred equity and fixed income and closed-end funds offerings. The Company has been less active in underwriting activities over the past few years, but intends to renew its focus on this area in the future. Through its Fixed Income Department, the Company distributes both taxable and tax-exempt fixed income products (such as corporate, government and mortgage-backed securities as well as municipal bonds and unit investment trusts). The Company positions taxable fixed income securities and municipal bonds in both the primary and secondary markets as a principal and participates as an underwriter, dealer and selling group member for corporate, municipal taxable and non-taxable unit trusts offerings. Market Making and Principal Transactions Prior to the Divestiture on March 3, 1999 and the sale of JWG Clearing on June 1, 1999, the Company conducted market making and principal transactions activities using both JWG Clearing and Genesis. Activities related to research recommendations, institutional order flow and Genesis's brokerage processing services unit were conducted through Genesis, while activities related to the Company's retail brokerage and fully disclosed clearing business were conducted through JWG Clearing. All of the Company's market making and principal transaction activities are currently conducted exclusively through JWG Securities. JWG Securities currently acts as a market maker for approximately 50 securities that are traded in the over-the-counter securities market, including those followed by the Research Department. In its capacity as a market maker, the Company facilitates trading in select securities by buying and selling securities as a principal for its own account, rather than as an agent for the accounts of its customers. The Company attempts to derive profits through its market making activities by buying stock at its quoted bid price and then either selling the stock at its quoted market price or holding the stock in inventory for future sale at a higher price. If the market for such securities declines, however, or if the Company otherwise is unable to resell the securities at a favorable price, the Company could suffer losses and such losses could be substantial. The Company also engages in short sales, although primarily to fill customer orders. A short sale represents an obligation of the Company to deliver specified securities at the contracted price, thereby creating a liability to purchase the securities at a future time at prevailing market prices. Accordingly, these transactions result in off- balance-sheet risk as the Company's ultimate obligation to satisfy the sale of these securities may exceed the amount recognized by the Company at the time the short sale was executed. The Company's general policy has been not to hold a substantial volume of securities for any significant period of time, so as to reduce the risk of losses from market declines or unfavorable developments. The Company's market making activities historically have accounted for a significant portion of its revenues, and, except for a period during 1998 following its acquisition of the now-divested Genesis (whose securities holding policy was less conservative than the Company's general policy), losses incurred from time to time in connection with these activities were not significant. The Company anticipates that market making and principal transaction activities will continue to be a significant factor in the Company's operations and its prospects for profitability. Competition The Company competes with numerous investment banking and brokerage firms, consulting firms, and financial service companies that are larger, better financed, have longer operating histories, and, in some instances, offer a range of financial and other services to clients that exceed the services offered by the Company. In addition, there is increasing competition from other businesses that now offer financial services, such as commercial banking and insurance companies and certain accounting firms. The principal competitive factors in the securities industry are the quality and ability of professional personnel, the experience and reputation of the firm, the relative prices of services and products offered, the scope of such services and products (increasingly the ability to offer "one-stop-shopping" to customers and clients), and the efficiency of back office operations. The Company has tried to position itself competitively by targeting its investment banking services to middle-market companies, providing competitively priced products and services, and developing one-stop-shopping services. Additionally, the Company has targeted markets that it believes are not adequately served by, and are not a primary focus of, most of these other larger firms. The Company believes that its clearing services and back office support agreements with Bear Stearns and Fiserv provide it additional ability to compete with larger firms. Employees and Registered Representatives As of December 31, 1999, the Company and its subsidiaries had a total of approximately 236 salaried employees and 583 registered representatives. Of these totals, 301 registered representatives are independent contractors affiliated with one of the 131 affiliated, but independently owned and operated, JWGFS and DMG branch offices which existed at such time. Regulation The securities industry in the United States is subject to extensive regulation under various federal and state laws and regulations. The Securities and Exchange Commission (the "Commission" or the "SEC") is the federal agency charged with the administration of most of the federal securities laws. Much of the regulation of the securities industry, however, has been assigned to various self regulatory organizations ("SROs"), principally the NASD, and in the case of NYSE member firms, the NYSE. The SROs, among other things, promulgate regulations and provide oversight in areas of (i) sales practices, (ii) trade practices among broker-dealers, (iii) capital requirements, (iv) record keeping and (v) conduct of employees and affiliates of member organizations. In addition to promulgating regulations and providing oversight, the Commission and the SROs have the authority to conduct administrative proceedings which can result in the censure, fine, suspension or expulsion of a broker-dealer, its officers or employees. Furthermore, new legislation, changes in the rules and regulations promulgated by the Commission and SROs, or changes in the interpretation or enforcement of existing laws and rules often directly affect the operation and profitability of broker-dealers. The stated purpose of much of the regulation of broker-dealers is the protection of customers and the securities markets rather than the protection of creditors and shareholders of broker-dealers. Certain Matters Regarding Forward Looking Statements Certain statements included in this Form 10-K, including without limitation statements containing the words "believes," "anticipates," "intends," "expects" and words of similar import, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward- looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: the impact of general economic conditions on the capital markets; changes in or amendments to regulatory authorities' capital requirements or other regulations applicable to the Company or its subsidiaries; fluctuations in interest rates; increased levels of competition; and other factors referred to in this Form 10-K. Given these uncertainties, undue reliance should not be placed on such forward-looking statements. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements included herein to reflect future events or developments. Volatile Nature of the Securities Business The securities business is, by its nature, subject to significant risks-- particularly in volatile or illiquid markets. These risks include the risks of: . trading losses . losses resulting from the ownership . counterparty failure to meet or underwriting of securities commitments . customer fraud . employee fraud . issuer fraud . errors and misconduct . failures in connection with the processing . litigation of securities transactions Our principal business activities are retail securities brokerage, investment banking, and clearing and execution services. These businesses are highly competitive and subject to various risks, volatile trading markets, and fluctuations in the volume of market activity. The securities business is directly affected by many broad factors, including . economic and political conditions . broad trends in business . legislation and regulation affecting and finance the business and financial communities . currency values . inflation . market conditions . the availability and cost of short-term . the credit capacity or or long-term funding and capital perceived creditworthiness of the securities industry in the marketplace . interest rate levels and volatility These and other factors can contribute to lower price levels for securities and illiquid markets. Lower price levels of securities may result in: . reduced securities transactions volumes, with a correlative reduction in commission revenues; . losses from declines in the market value of securities held in trading, investment, and underwriting positions; and . reduced management fees calculated as a percentage of assets managed. In low volume periods, profitability levels are further adversely affected because certain expenses remain relatively fixed. Sudden sharp declines in securities' market values and the failure of issuers and counterparties to perform their obligations can result in illiquid markets. This in turn can make it difficult for us to sell securities, hedge our securities positions, and invest funds under our management. These negative market conditions, if prolonged, may also lower our revenues from investment banking and other activities. As a result of the varied risks associated with the securities business, which are beyond our control, our commissions and other revenues could be adversely affected. Revenue reductions and losses resulting from securities underwriting or ownership could have a material adverse effect on our results of operations and financial condition. In addition, our revenues and operating results may fluctuate from quarter to quarter and from year to year because of these risks. Significant Competition All aspects of our business are highly competitive. We compete directly with national and regional full service broker-dealers and, to a lesser extent, with discount brokers, dealers, investment banking firms, investment advisors, and certain commercial banks. The financial services industry has become considerably more concentrated as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. These mergers and acquisitions have increased competition from these firms, many of which have significantly greater equity capital and financial and other resources than we do. With respect to retail brokerage activities, certain regional firms with which we compete have operated in certain markets longer than we have and have established long-standing client relationships. In addition, we expect competition from commercial banks to increase because of recent and anticipated legislative and regulatory initiatives in the United States to remove or relieve certain restrictions on commercial banks' securities activities. We also compete with others in the financial services industry in recruiting new employees and retaining current employees. We expect to face increasing competition from companies offering electronic brokerage services, which is a rapidly developing industry. These competitors may have lower costs or provide fewer services, and may offer certain customers more attractive pricing or other terms, than we offer. We also anticipate competition from underwriters which attempt to conduct public offerings for emerging growth companies through new means of distribution, including transactions using electronic media such as the Internet. In addition, disintermediation may occur as issuers attempt to sell their securities directly to purchasers, including sales using electronic media such as the Internet. To the extent that issuers and purchasers of securities transact business without the assistance of financial intermediaries like us, our operating results could be adversely affected. Dependence on Key Personnel Most aspects of our business are dependent on highly skilled individuals. We devote considerable resources to recruiting, training, and compensating these individuals. In addition, one component of our strategy is to increase market penetration by recruiting experienced investment consultants. We cannot assure that these recruiting efforts will be successful--or, if successful, that they will enhance our business, results of operations, or financial condition. Competition for Professional Employees. From time to time, our employees may leave to pursue other opportunities. We have experienced losses of research, investment banking, operations, and sales and trading professionals. Competition for key personnel is intense. We cannot assure that losses of key personnel due to such competition, or for other reasons, will not occur in the future. The loss of an investment banking, operations, research, or sales and trading professional, particularly a senior professional with a broad range of contacts in an industry, could materially and adversely affect our operating results. Limitations of Employee Retention Mechanisms. We depend on many key employees, and in particular on our senior executive officers: Marshall T. Leeds, our Chairman, President, and Chief Executive Officer; and Joel E. Marks, our Vice Chairman and Chief Operating Officer -- each of whom has an employment agreement with us. The loss of any key employee could materially and adversely affect JWGenesis. While we generally do not have employment agreements with our employees, we attempt to retain employees with incentives such as long-term deferred compensation plans, stock issuances or other investment opportunities conditioned on continued employment, and options to buy stock that vest over a number of years of employment. These incentives, however, may be insufficient in light of the increasing competition for experienced professionals in the securities industry, particularly if our stock price were to decline, or fail to appreciate sufficiently. If that happened, our long-term deferred compensation plans might no longer be a competitive incentive for our key employees to stay with us. Dependence on Outside Sources of Financing Like others companies in the securities industry, we rely on external sources to finance a significant portion of our day-to-day operations. Our principal cash and liquidity sources are commissions and trading profits. We maintain working capital committed credit lines aggregating approximately $12.0 million. The financing available to us varies depending on market conditions, the volume of certain trading activities, credit ratings, credit capacity, and the overall availability of credit to the financial services industry. We cannot assure that adequate financing to support our business will be available in the future on attractive terms, or at all. Net Capital Requirements; Holding Company Structure The SEC, the NYSE, the NASD, and various other regulatory bodies in the United States have rules with respect to net capital requirements that affect us. These rules require that at least a substantial portion of a broker- dealer's assets be kept in cash or highly liquid investments. Our broker-dealer subsidiaries must comply with the net capital requirements, which could limit operations that require intensive use of capital, such as underwriting or trading activities. These rules could also restrict our ability to withdraw capital from our broker-dealer subsidiaries, even in circumstances where these subsidiaries have more than the minimum amount of required capital. This, in turn, could limit our ability to pay dividends, implement our strategies and pay interest on and repay the principal of our debt. In addition, a change in these rules, or the imposition of new rules, affecting the scope, coverage, calculation, or amount of the net capital requirements, could have similar adverse effects. Significant operating losses or any unusually large charge against net capital could also have a similar material adverse effect. Dependence on Systems Our business is highly dependent on communications and information systems. If these systems fail or are interrupted, our securities trading activities could experience delays, and we might be unable to execute client transactions. This could have a material adverse effect on our operating results. We cannot assure that we will not suffer any systems failures or interruptions. These failures or interruptions could have many causes, including earthquakes, fires, other natural disasters, power or telecommunications failures, acts of God, or acts of war. Nor can we assure that our back-up procedures and capabilities will be adequate if any failures or interruptions occur. Risk of Reduced Revenues Due to Decline in Trading of Growth Company Securities Our brokerage transaction revenues are generally substantially lower when public offering levels and trading activities of emerging growth company securities declines. We derive a significant portion of our revenues from brokerage transactions in growth company securities. In the past, brokerage transaction revenues have declined when underwriting activities in these industry sectors declined, the volume of trading on Nasdaq declined or when industry sectors or individual companies reported results below investors' expectations. Risks Associated with Regulation The securities industry and our business is extensively regulated by the SEC, state securities regulators, and other governmental regulatory authorities. Industry self-regulatory organizations ("SROs"), including the NASD, the New York Stock Exchange, the American Stock Exchange and other exchanges, also regulate our broker-dealer subsidiaries. Compliance with many of the regulations applicable to our company and our subsidiaries involves a number of risks, particularly in areas where applicable regulations may be subject to varying interpretation. If we do not comply with an applicable regulation, governmental regulators and SROs may institute administrative or judicial proceedings. In that event, we face many penalties, including . censure . cease-and-desist orders . civil penalties (including treble . the deregistration or suspension of damages in the case of insider the non-compliant broker-dealer's trading violations) officers or employees . fines Our operating results and financial condition may suffer material adverse consequences if these penalties or orders are imposed on us. The regulatory environment could also change. We may be adversely affected by new or revised legislation or regulations imposed by the SEC, other federal or state governmental regulatory authorities, or SROs. We also may be adversely affected by changes in the interpretation or enforcement of existing laws and rules by these governmental authorities and SROs. Risk of Losses From Underwriting and Trading We conduct our underwriting, securities trading, and market-making activities as a principal. These activities subject our capital to significant risks, including market, credit, counterparty, and liquidity risks. These activities often involve purchasing, selling, or short-selling securities as a principal in relatively illiquid markets or markets that suffer from rapidly fluctuating liquidity. From time to time, we have large position concentrations in a single issuer's securities, or commitments to a single issuer, or issuers in a specific industry, particularly as a result of underwriting activities. Our trading positions and underwriting activities are concentrated in a more limited number of industry sectors and portfolio companies than many other investment banks, which might result in higher trading losses than would occur if our positions and activities were less concentrated. In addition, there is a trend in all major capital markets--for competitive and other reasons-- toward larger commitments from lead underwriters. This means that, from time to time, an underwriter (including a co-manager) may retain significant position concentrations in individual securities. Unfavorable financial or economic conditions would likely reduce the number and size of transactions in which we provide underwriting, mergers and acquisitions advisory services, and other related services. Our investment banking revenues, in the form of underwriting discounts and financial advisory fees, are directly related to the number and value of the transactions in which we participate and would therefore be adversely affected by a market downturn. Risk of Losses Associated with Litigation and Securities Laws Many aspects of our business involve substantial liability risks. Underwriters are exposed to substantial liability under federal and state securities laws and other federal and state laws. Court decisions, including decisions on underwriters' liability and limitations on indemnification of underwriters by issuers, also expose us to liability. For example, an underwriter may be held liable for material misstatements or omissions of fact in a prospectus used to offer securities, or for statements made by its securities analysts or other personnel. Increasing Frequency of Securities Litigation. In recent years, litigation involving the securities industry has increased, including class actions in which substantial damages are at stake. Our underwriting activities usually involve offerings of emerging and mid-size growth company securities, which often involve higher risk and are more volatile than the securities of more established companies. In comparison with more established companies, emerging and mid-size growth companies are also more likely to be defendants in securities class actions, to carry directors and officers liability insurance policies with lower limits (or no such insurance), and to become insolvent. These factors increase the likelihood that a company underwriting an emerging or mid-size growth company's securities will be required to contribute to an adverse judgment or settlement of a securities lawsuit. Frequent Claims Against Underwriters. The plaintiffs' attorneys in securities class action lawsuits frequently name the managing underwriters of a public offering as defendants. We have not been a named defendant in any class action lawsuit relating to public offerings in which we were a managing underwriter. Plaintiffs' attorneys also may name investment banks providing advisory services in corporate finance transactions as defendants. We are not a defendant in any such lawsuit. We anticipate, however, that securities class action lawsuits naming us as a defendant may be filed from time to time in the future, particularly if we increase our activity as managing underwriters or corporate finance advisors. In such lawsuits, all members of the underwriting syndicate typically are included as defendant class members or are required by law, or pursuant to the terms of the underwriting agreement, to bear a portion of any expenses or losses (including amounts paid in settlement of the litigation) incurred by the underwriters as a group in litigating the claim, to the extent not covered by the securities issuer's indemnification obligation. If we became a party to such a lawsuit, our assets would be subject to risks. If the plaintiffs in any suits against us were successful, or if we settled such suits by making significant payments to the plaintiffs, our operating results and financial condition could be materially and adversely affected. As is common in the securities industry, we do not carry insurance that would cover any such payments. In addition, our charter documents allow indemnification of our officers, directors, and agents to the maximum extent permitted under Florida law. If our officers, directors, or agents are named as defendants in securities litigation, they may demand indemnification from us under these charter document provisions. In addition, the laws relating to securities class actions are currently in a state of flux. The eventual impact of the Private Securities Litigation Reform Act of 1995 on securities class action litigation is not known. Diversion of Management Attention. In addition to these financial costs and risks, defending litigation can, to a certain extent, divert the efforts and attention of our management and staff. Our management and other employees may have to devote substantial time defending litigation, which might materially divert their attention from other responsibilities. Securities class action litigation in particular is highly complex and can extend for a protracted period of time, consuming substantial management time and effort and substantially increasing the cost of such litigation. Risks Associated with Other Disputes. In the normal course of business, we are defendants in various civil actions and arbitrations arising out of our broker-dealer and underwriting activities, in our role as an employer, and as a result of other business activities. We have made significant payments to resolve disputed claims in the past, and we cannot assure that we will not make significant payments to resolve disputed claims in the future. Risks Associated with Management of Growth Over the past several years, we have experienced significant growth in our business activities and size, and we expect we will continue to grow in the future. Our growth requires and will continue to require increased investments in management personnel, financial and management systems and controls, and facilities. If our revenue did not also continue to grow, our operating margins would decline due to these increased expenses. In addition, as is common in the securities industry, we depend on the effective and reliable operation of our communications and information systems. We believe that our current and anticipated future growth will require us to implement new and enhanced communications and information systems, and to train our personnel to operate the new systems. Any difficulty or significant delay in implementing or operating our existing systems or any new ones, or in training our personnel, could adversely affect our ability to manage growth. ITEM 2. ITEM 2. PROPERTIES. The Company owns no real property. The Company currently leases its principal corporate offices and operations facilities, located at 980 North Federal Highway, Boca Raton, Florida 33432, where it occupies approximately 17,500 square feet of space. JWG Securities' branch offices are also leased premises, comprising an aggregate of approximately 46,000 square feet of office space in several cities. JWG Capital leases 5,400 square feet of space in New York. JWGFG branch offices are also leased premises, comprising an aggregate of approximately 60,000 square feet of office space in several cities. The Company believes that its office facilities are adequate for its current and reasonably foreseeable operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no material legal proceedings pending or threatened in which JWGenesis is a party or of which its property is the subject. The Company or its subsidiaries have been named in various arbitration and legal proceedings arising in the ordinary course of its securities brokerage business. Although arbitration and litigation involves contingencies that cannot be definitively predicted, including the unpredictability of actions that might be taken by an arbitration panel or jury on matters that are submitted to them, JWGenesis expects that the ultimate disposition of arbitration and litigation arising from the ordinary course of business will not have a material adverse impact upon its financial position and results of operations. The Company or its subsidiaries may be involved from time to time in other litigation arising in the normal course of business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted, during the fourth quarter of the fiscal year covered by this report, to a vote of security holders of the Company through the solicitation of proxies or otherwise. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock trades on The American Stock Exchange (the "AMEX") under the symbol "JWG". The following table sets forth, for the periods indicated, the quarterly high and low sales price information related to trading in the Company's common stock (and for the period prior to the Company's replacement of JWGFS as the public company on June 12, 1998, as a result of the statutory share exchange, the shares of common stock of JWGFS) on the AMEX. Such information has been obtained from AMEX. All per share prices have been adjusted to reflect the Company's three-for-two stock split effected in the form of a 50% stock dividend on March 24, 2000. Sales Price -------------------------------- High Low -------------- -------------- First Quarter.............................. $ 9.21 $ 7.62 Second Quarter............................. 8.54 6.62 Third Quarter.............................. 7.67 4.09 Fourth Quarter............................. 5.17 3.50 First Quarter.............................. $ 9.17 $ 3.99 Second Quarter............................. 14.42 6.67 Third Quarter.............................. 11.92 9.21 Fourth Quarter............................. 19.83 9.17 First Quarter (through March 27, 2000) $19.83 $14.00 The closing sales price for the Company's common stock on March 27, 2000 was $16.50. There were approximately 200 holders of record of the Company's common stock as of March 27, 2000. Investors who beneficially own common stock that is held in street name by brokerage firms are not included in this number. Accordingly, based upon the quantities of periodic reports requested by such brokerage firms, the Company believes that the actual number of individual beneficial owners of its common stock exceeds 2,000. No cash dividends have been declared or paid to date on the Company's common stock, and the Company does not anticipate payment of common stock dividends in the foreseeable future. The Company has adopted a policy of cash preservation for future use in the business, although the declaration and payment of cash dividends on the common stock is not subject to legal restrictions on the Board's authority. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following tables present selected historical financial data of the Company. On June 12, 1998, the Company and JWGFS (then known as JW Charles Financial Services, Inc.) effected the Share Exchange, and the Company acquired Genesis, as part of the Combination. See Item 1. "Business - Background and General". As a result of the Combination, the Company succeeded to the business and operations of JWGFS and Genesis. The following selected historical financial data of the Company relating to periods prior to June 12, 1998 are derived solely from financial statements of JWGFS for such periods and, except as otherwise expressly indicated, relate to matters prior to the Combination. Such financial statements for the years ended December 31, 1999, 1998, and 1997 appear elsewhere in this Form 10-K. The following selected historical financial data should be read in conjunction with such financial statements and related notes. On March 3, 1999, the Company divested Genesis in a transaction in which the Company nonetheless retained the investment banking, corporate finance and other capital markets operations that it had been conducting through Genesis, while divesting Genesis's brokerage processing business unit. See Item 1. "Business - - Significant Developments Divestiture of Genesis". The results of all of Genesis's operations during the period from the Combination on June 12, 1998 to March 3, 1999, are included in the Company's financial data and has some impact on the analysis of such data. On June 1, 1999, the Company sold JWG Clearing in a cash transaction for approximately $59.0 million. See Item 1. "Business - Significant Developments Sale of JWGenesis Clearing Corp." The results of JWG Clearing's operations during the period from January 1, 1997 to May 31, 1999 are included in the Company's historical financial data and has some impact on the analysis of such data. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General As a diversified financial services company, JWGenesis operates a full- service securities brokerage and investment banking business that offers "one- stop-shopping" for its customers and clients. The Company's varied activities generate revenue primarily in the form of commission and fee income, market making and principal transactions revenues, and interest income. Until June 1, 1999 when the Company sold JWG Clearing and ceased its clearing services business, the Company also generated securities transaction processing fees ("clearing fees"). The Company also derives revenues from corporate finance and other capital markets transactions, insurance brokerage services, and consulting services. The following discussions present the more significant factors affecting the Company's results of operations and financial condition during the years ended December 31, 1999, 1998 and 1997. As a result of the Combination effected on June 12, 1998, the Company succeeded to the respective businesses and operations of JWGFS and Genesis, and it replaced JWGFS as a public company. The discussions relating to periods prior to June 12, 1998, reflect the operations of JWGFS as if it were the Company during such periods, but they do not reflect any operations of Genesis before the Combination. The results of all of Genesis' operations during the period from the Combination on June 12, 1998, until its Divestiture on March 3, 1999, are included in the Company's financial data and have some impact on the analysis of such data. On June 1, 1999, the Company sold JWG Clearing in a cash transaction for approximately $59 million, and ceased all securities clearing operations. The results of JWG Clearing's operations through May 31, 1999, are included in the Company's financial data and have some impact on the analysis of such data. In these discussions, most percentages and dollar amounts have been rounded to aid presentation; as a result, all such figures are approximations. References to such approximations have generally been omitted. Results of Operations - Three Years Ended December 31, 1999 1999 represented the Company's fifteenth consecutive year of record revenues. The following tables set forth the principal components of the Company's revenues and expenses, respectively, for the last three years and the percentage changes from year to year. Total revenues of $184,945,000 recorded in 1999 increased 56% over last year's previous record of $118,890,000. The acquisition by JWGFG, the sale of JWG Clearing, and the unrealized gain on the MVP investment added $25,576,000, $23,877,000, and $5,645,000, respectively, to 1999 revenues, which otherwise would have been $129,847,000 or a 20% increase over 1998. During 1999, the Company experienced increases in all revenue categories, except clearing fees and interest; revenue in these latter two categories had been generated primarily by JWG Clearing, which was sold on June 1, 1999. During 1998, the Company experienced increases in all revenue categories primarily due to heightened client activity, both retail and clearing, associated with vibrant and generally rising stock market conditions. Market making and principal transactions, net, which represents the net realized and unrealized gain or loss experienced from trading or otherwise acting as principal in securities transactions, represented approximately 18%, 21%, and 21% of total revenues in 1999, 1998 and 1997, respectively. The decline as a percentage of total revenue in 1999 reflects the impact of the gain on the sale of JWG Clearing. The volume increase during 1999 in revenue from market making and principal transactions, net over the 1998 level, however, is primarily due to the inclusion of an unrealized gain of $5,645,000 related to the Company's investment in MVP and gains on the Company's investment in Knight/Trimark Group, Inc. in 1999 in excess of those recorded in 1998 in the amount of $2,550,000. Exclusive of these gains, market making and principal transactions, net would have increased by $656,000 or 3% in 1999 over 1998. The increase in market making and principal transactions, net in 1998 over 1997 was primarily due to the inclusion of an unrealized gain of $6,400,000 related to the Company's investment in Knight/Trimark Group, Inc. The gain on sale of subsidiary in 1999 of $23,877,000 resulted from the sale of JWG Clearing on June 1, 1999. In addition to this recognized gain, the Company recorded deferred income of $15 million related to the sale which is being accreted into income ratably over the next 10 years. Other income, which consists primarily of fee income, increased by $3,952,000 or 107% from 1998 to 1999, and $945,000 or 35% from 1997 to 1998. The increase in 1999 is primarily a result of investment banking success fees received by JWG Capital; miscellaneous fees received in connection with securities transactions in 1999 which were retained by JWG Clearing prior to June 1, 1999 and were reflected as "Clearing fees" prior to that date; and miscellaneous fees received in connection with securities transactions by JWGFG in 1999. The increase in 1998 was primarily a result of investment banking success fees received by Genesis. Commissions and clearing costs, which represent the portion of fee income payable by the Company to registered representatives or other broker-dealers as a result of securities transactions (and the related costs associated with the execution of such trades) increased in both 1999 and 1998, reflecting the Company's overall business growth. Employee compensation and benefits increased by 32% or $7,173,000 in 1999, primarily as a result of the acquisition by JWGFG, which accounted for $3,645,000 of the increase, and bonuses on the sale of JWG Clearing in the amount of $3,729,000. Excluding the impact of those two increases, the growth in employee compensation and benefits was less than 1%. Employee compensation and benefits increased by 36% or $5,796,000 in 1998, primarily as a result of the inclusion of Genesis, which accounted for $3,217,000 of the total increase. Excluding the impact of Genesis, the growth in employee compensation and benefits was consistent with and reflects the costs associated with the Company's overall business growth. Occupancy and equipment rental increased by $3,622,000 or 58% in 1999, primarily as a result of the operations of JWGFG, which accounted for $2,915,000 of the total increase, following the acquisition it made on January 1, 1999. Excluding the impact of JWGFG, the growth in occupancy and equipment rental was consistent with the growth of the Company's overall business. Occupancy and equipment rental expenses increased by $1,106,000 or 21% from 1997 to 1998, primarily as a result of the inclusion of Genesis in 1998, which accounted for $438,000 of the increase, and overall business growth. Communications increased by 85% or $3,852,000 in 1999 primarily as a result of the acquisition by JWGFG, which accounted for $2,598,000 of the total increase. Excluding the impact of JWGFG, communications expense would have increased by $1,254,000 or 28% due to the Company's overall business growth. Communications expense increased by 35% or $1,178,000 in 1998, primarily as a result of and the inclusion of Genesis, which accounted for $721,000 of the total increase, and the Company's overall business growth. Until June 1, 1999, interest income consisted primarily of interest earned on receivables from customers, securities owned, and customer money market fund balances relating to JWG Clearing. Interest expense consisted primarily of interest incurred on short-term borrowings and deposits on securities loaned used to finance JWG Clearing receivables from customers and securities owned. Both decreased in 1999 due to the sale of JWG Clearing on June 1, 1999. Interest income and interest expense had increased in 1998, primarily a result of a general increase in customer margin balances from 1997 to 1998 and an increase in the average outstanding loan balances used to fund increased customer balances from 1997 to 1998, reflecting the Company's overall business growth. Genesis had no material impact on interest income and interest expense for the 1998 period. Liquidity and Capital Resources The Company maintains a highly liquid balance sheet with the majority of the Company's assets consisting of cash and cash equivalents, securities owned, which are marked to market, and receivables from brokers, dealers and clearing brokers arising from customer related securities transactions. The nature of the Company's business as a market maker and securities dealer requires it to carry significant levels of securities inventories in order to meet its customer and internal trading needs. Accordingly, the liquidity can fluctuate significantly depending largely upon general economic and market conditions, volume of activity, customer demand and underwriting commitments. The Company's ability to support increases in its total assets is a function of its ability to generate funds internally and obtain short-term borrowings from its clearing firms and committed lines of credit. At December 31, 1999, the Company had stockholders' equity of $83,312,000, representing an increase of $33,043,000 from December 31, 1999, and the Company and cash and cash equivalents of $53,117,000. At December 31, 1999, the Company had an aggregate of $12,000,000 of additional borrowing capacity available under its committed lines of credit as described below under "Lines of Credit". The Company used $35,000,000 of its cash to consummate its partial self- tender offer in February 2000. As a result, at March 1, 2000, the Company had cash and cash equivalents of $25,782,000. The Company believes that its current borrowing arrangements (which are discussed below), combined with anticipated levels of internally generated funds, will be sufficient to fund its financial requirements for the foreseeable future based on the Company's current and anticipated level of operations and planned growth. Should the Company significantly expand either its market making activities or its underwriting of securities on a "firm-commitment" basis, however, the Company may need to obtain additional capital to support such activities and to comply with regulatory requirements. The Company is not dependent upon raising additional capital in order to maintain its current levels of operations. If the Company should find that its ability to generate funds internally is insufficient to satisfy its future capital needs, the Company will require additional financing from outside sources. Lines of Credit On January 19, 1996, the Company obtained an unsecured $2,500,000 revolving line of credit from Wilmington Trust Company for general corporate purposes (the "Wilmington Facility"). The Wilmington Facility matures on December 31, 2002, at which time any outstanding borrowings plus all accrued and unpaid interest will become due and immediately payable. Borrowings under the Wilmington Facility bear interest at Wilmington's National Commercial Rate, with interest payments due monthly in arrears. The Company is required to maintain certain debt covenants, including (i) minimum stockholders' equity equal to at least $7,000,000, plus 30% of net income for all future fiscal quarters, plus 75% of the net proceeds from any common stock issuances and (ii) net income, as defined, in excess of $1,500,000 for any four quarters within any consecutive six-quarter period. At December 31, 1999, there was no balance outstanding under the Wilmington Facility. In connection with the Wilmington Facility, the Company entered into a Marketing Agreement with Wilmington Trust FSB (the "Wilmington Marketing Agreement") and granted W T Investments, Inc. ("WTI") a common stock purchase warrant, which was amended and restated on February 27, 1998. Pursuant to the warrant, WTI was entitled to purchase 600,000 shares of the Company's common stock at any time prior to December 31, 2002 (the "Wilmington Warrant") at an exercise price per share of $7.53. As of March 27, 2000, options to purchase 150,000 shares remain unexercised. The Wilmington Marketing Agreement provides that the Company will market certain products and services, initially personal trust and asset management services, provided by Wilmington Trust FSB to the Company's brokers, clients and prospects. On December 18, 1996, the Company obtained an unsecured $2,500,000 revolving line of credit from SunTrust Bank, South Florida, N.A. for general corporate purposes (the "SunTrust Facility"). The SunTrust Facility matures on April 30, 2002, at which time any outstanding borrowings plus all accrued and unpaid interest will become due and immediately payable. Borrowings under the SunTrust Facility bear interest at the prime rate as announced from time to time by SunTrust Banks of Florida, Inc., with interest payments due quarterly in arrears. The Company is required to maintain certain debt covenants, including (i) minimum tangible net worth, excluding redeemable common and preferred stock, equal to at least $18 million, plus 75% of annual net income, plus 75% of net proceeds from issuances of common stock and (ii) net income, as defined, in excess of $1,500,000 for any four quarters within any consecutive six-quarter period. At December 31, 1999, there was no balance outstanding under the SunTrust Facility. In connection with the SunTrust Facility, the Company entered into a Marketing Agreement with SunTrust (the "SunTrust Marketing Agreement") and granted SunTrust a warrant, which has been exercised, to purchase 56,250 shares of the Company's common stock at any time prior to December 31, 2002, at an exercise price of $4.44 per share. The SunTrust Marketing Agreement provides that the Company will market certain products and services, through the Company's participation as an underwriter or selling group member of various municipal finance offerings underwritten by SunTrust Capital Markets, Inc., to the Company's brokers, clients and prospects. On September 17, 1999, the Company obtained a $7,000,000 senior secured credit line from GE Financial Assurance ("GEFA") for general corporate purposes (the "GEFA Facility"). The GEFA Facility matures on September 30, 2004, at which time any outstanding borrowings and unpaid interest will become due and immediately payable. Borrowings under the GEFA Facility bear interest at LIBOR with interest payments due quarterly in arrears. The Company is required to maintain certain debt covenants, including (i) tangible net worth equal to at least $30 million, plus 75% of net income earned after September 30, 1999, (ii) a fixed charge coverage ratio at the end of any period of four consecutive quarters greater than 1.2 to 1.0, and (iii) an interest coverage ratio at the end of any period of four consecutive quarters greater than or equal to 3.0 to 1.0. As additional consideration for the GEFA Facility, the Company issued GEFA a warrant to purchase up to 262,500 shares of its common stock at $9.25 per share at any time, subject to vesting, prior to May 14, 2004 (the "GEFA Credit Warrant"). The GEFA Credit Warrant vests with respect to one-fourteenth of the total GEFA Credit Warrant in connection with each $500,000 of borrowings or re- borrowings under the GEFA Facility. In connection with the GEFA Facility, the Company entered into a five-year Strategic Marketing Alliance (the "SMA") with GEFA pursuant to which GEFA will provide the Company's retail brokerage units with training, educational, marketing and promotional assistance. Under the terms of the SMA, the Company agreed to provide GEFA with preferred access to its retail sales force and issued GEFA an additional warrant to purchase up to 262,500 shares of its common stock at $9.25 per share at any time prior to May 14, 2004 (the "GEFA SMA Warrant"). The SMA warrant is fully vested. Broker-Dealer Capital Requirements JWGFS, JWG Securities, JWGFG, and DMG are subject to the Securities and Exchange Commission's Uniform Net Capital Rule (Rule 15c3-1 under the Securities Exchange Act of 1934), which requires the maintenance of minimum net capital and requires that JWGFS's, JWG Securities', JWGFG's and DMG's ratio of aggregate indebtedness to net capital (excess net capital), as defined by the Rule, not exceed 15 to 1. As of December 31, 1999, JWGFS, JWG Securities, JWGFG and DMG had net capital of $2,950,000; $2,998,000; $1,350,000; and $310,000, respectively, and excess net capital of $2,333,000; $2,579,000; $1,133,000; and $210,000, respectively, each of which complied with the applicable requirements of Rule 15c3-1. Effects of Recently Issued Accounting Standards During the current year, the FASB issued statement No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of Effective Date of FAS No. 133, Amendment of FAS No. 133". This Statement delayed the effective date of FAS 133 until all fiscal quarters of all fiscal years beginning after June 15, 2000. This Statement requires that derivatives be recognized in the balance sheet at fair value. Designation as hedges of specific assets or liabilities is permitted only if certain conditions are met. The Company will be required to record and mark to market any derivative financial instruments and related underlying assets, liabilities and firm commitments. Based on current operations, the impact of adopting FAS 137 is not anticipated to have a material effect on the Company's financial position or results of operations. Market Risk In 1997 the Securities and Exchange Commission issued market risk disclosure requirements to enhance disclosures of accounting policies for derivatives and other financial instruments and to provide quantitative and qualitative disclosures about market risk inherent in derivatives and other financial instruments. The Company manages risk exposure involving various levels of management. Position limits in trading and inventory accounts are established and monitored on an ongoing basis. Current and proposed underwriting, corporate development, merchant banking and other commitments are subject to due diligence reviews by senior management, as well as professionals in the appropriate business and support units involved. Credit risk related to various financing activities is reduced by the industry practice of obtaining and maintaining collateral. The Company monitors its exposure to counterparty risk through the use of credit exposure information, the monitoring of collateral values and the establishment of credit limits. The Company maintains inventories as detailed in Note 6 to its Consolidated Financial Statements. The fair value of these securities at December 31, 1999, was $20,001,000 in long positions and $1,606,000 in short positions. The Company performed an entity-wide analysis of its financial instruments and assessed the related risk and materiality in accordance with applicable rules. Based on this analysis, in the opinion of management, the market risk associated with the Company's financial instruments at December 31, 1999 will not have a material adverse effect on the consolidated financial position or results of operations of the Company. Impact of Inflation Although the precise effect of inflation on the present operations of the Company cannot accurately be determined, management believes that continuation of the general levels of inflation experienced in recent years will not have a significant impact on the Company's current and contemplated operations. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The information contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk" is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The response to this item is included in a separate section of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information contained under the heading "Election of Directors" in the Company's Proxy Statement for its 2000 Annual Meeting of Shareholders, to be filed with the Commission, is incorporated herein by reference to such portion of the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information contained under the heading "Executive Compensation" in the Company's Proxy Statement for its 2000 Annual Meeting of Shareholders, to be filed with the Commission, is incorporated herein by reference to such portion of the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information contained under the heading "Voting Securities Principal Stockholders" in the Company's Proxy Statement for its 2000 Annual Meeting of Shareholders, to be filed with the Commission, is incorporated herein by reference to such portion of the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information contained under the heading ("Certain Transactions") in the Company's Proxy Statement for its 2000 Annual Meeting of Shareholders, to be filed with the Commission, is incorporated herein by reference to such portion of the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this report: (1) Consolidated Financial Statements of JWGenesis Financial Corp. and subsidiaries: Consolidated Statements of Financial Condition as of December 31, 1999 and 1998. Consolidated Statements of Income For the Years Ended December 31, 1999, 1998 and 1997. Consolidated Statements of Changes in Stockholders' Equity For the Years Ended December 31, 1999, 1998 and 1997. Consolidated Statements of Cash Flows For the Years Ended December 31, 1999, 1998 and 1997. Notes to Consolidated Financial Statements. (2) All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because the required information is not required under the related instructions, is inapplicable, or is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the Consolidated Financial Statements or notes thereto. (3) Exhibits included herein: Exhibit Number Description of Exhibit - ---------------------------- -------------------------------------------------- 2.1 Stock Purchase Agreement dated April 16, 1999, by and among JWGenesis, Fiserv, Inc., Fiserv Clearing, Inc., JWGenesis Financial Services, Inc., and JWGenesis Clearing Corp. (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed with the Commission on April 30, 1999). 3(a) Articles of Incorporation of JWGenesis (incorporated by reference to Exhibit 3.1 to JWGenesis' Registration Statement on Form S-4 (File No. 333-47693) filed with the Commission on April 22, 1998 (the "Combination S-4")). 3(b) By-Laws, as amended, of JWGenesis (incorporated by reference to Exhibit 3(b) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1998 (the "1998 Form 10-K")). 10(a) Agreement for Securities Clearance Services between Corporate Securities Group, Inc. and Bear Stearns & Co., Inc. (incorporated by reference to Exhibit 10(d) to the Amendment to Application or Report on Form 8-K dated October 3, 1990) of JWCharles Financial Services, Inc. then known as Corporate Management Group, Inc., Commission No. 0-14772, the predecessor in interest of the Company (the "Predecessor"). Exhibit Number Description of Exhibit - ---------------------------- -------------------------------------------------- 10(b) Promissory Note and Loan Agreement between the Predecessor and Wilmington Trust Company dated January 19, 1996 (incorporated by reference to Exhibit 10(i) to the Predecessor's Annual Report on Form 10-K for the fiscal year ended December 31, 1995). 10(c) Amended and Restated Common Stock Purchase Warrant issued to W T Investments, Inc. dated February 27, 1998 (incorporated by reference to Item 10(f) of the Predecessor's Annual Report on Form 10-K for the year ended December 31, 1997). 10(d) Revolving Loan Agreement between the Predecessor and SunTrust Bank, South Florida, N.A. dated December 18, 1996 (incorporated by reference to Item 10(i) of the Predecessor's Annual Report on Form 10-K for the year ended December 31, 1996). 10(e) Common Stock Purchase Warrant issued to SunTrust Banks, Inc. dated August 26, 1996 (incorporated by reference to Item 10(m) of the Predecessor's Annual Report on Form 10-K for the year ended December 31, 1996). 10(f) Equity Exchange and Conciliation Agreement by and Among the Company, Marshall T. Leeds, Joel E. Marks, JWGenesis Capital Markets, LLC, The Will K. Weinstein Revocable trust, Philip C. Stapleton, Will K. Weinstein, and other Members of the Stapleton Group dated March 3, 1999 (incorporated by reference to Exhibit 2 to the Company's Current Report on Form 8-K filed with the Commission on March 18, 1999). 10(g) Transition Services Agreement, dated April 16, 1999 by and among the JWGenesis, Fiserv, Inc., Fiserv Clearing, Inc., JWGenesis Financial Services, Inc., and JWGenesis Clearing Corp. (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed with the Commission on June 15, 1999). 10(h) Form of Fully Disclosed Correspondent Agreement dated June 1, 1999 (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed with the Commission on June 15, 1999). 10(i) Stockholders Agreement among JWGenesis, Woody Springs LLC and MVP.com, Inc., dated as of July 15, 1999 (incorporated by reference to Exhibit 10(c) to the Company's Current Report on Form 8-K filed with the Commission on August 13, 1999). Exhibit Number Description of Exhibit - ---------------------------- -------------------------------------------------- 21 Subsidiaries of the Registrant. 99(a) Amended and Restated Agreement and Plan of Combination, dated as March 9, 1998, among JWGFS, the Company, Genesis and the owners of all of the equity interests in Genesis (incorporated by reference to Exhibit 2.1 to the Combination S-4). 99(b) Employment Agreement between the Company and Marshall T. Leeds (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998). 99(c) Employment Agreement between the Company and Joel E. Marks (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998). 99(d) Employment Agreement between the Company and Gregg S. Glaser (incorporated by reference to Exhibit 99(e) to the Company's Registration Statement on Form S-4, Commission File No. 33-66751) 99(e) Employment Agreement between JWGenesis and John Elway, dated as of July 15, 1999 (incorporated by reference to Exhibit 10(b) to the Company's Current Report on Form 8-K filed with the Commission on August 13, 1999). 99(f) Stock Option Agreement between JWGenesis and John Elway, dated as of July 15, 1999 (incorporated by reference to Exhibit 10(c) to the Company's Current Report on Form 8-K filed with the Commission on August 13, 1999). 99(g) Nonsolicitation Agreement between the Company and Marshall T. Leeds (the "Leeds Nonsolicitation Agreement") (incorporated by reference to Exhibit 99(h) to the Company's 1998 Form 10-K). 99(h) Agreement to amend the Leeds Nonsolicitation Agreement. 99(i) Nonsolicitation Agreement between the Company and Joel E. Marks (the "Marks Nonsolicitation Agreement") (incorporated by reference to Exhibit 99.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999). 99(j) Amendment to amend the Marks Nonsolicitation Agreement. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the fourth quarter of the Registrant's fiscal year. JWGenesis Financial Corp. and Subsidiaries Index to Consolidated Financial Statements - -------------------------------------------------------------------------------- Page Consolidated Financial Statements - --------------------------------- Report of Independent Certified Public Accountants Years Ended December 31, 1999, 1998 and 1997.......................... Consolidated Statements of Financial Condition December 31, 1999 and 1998............................................ Consolidated Statements of Income Years Ended December 31, 1999, 1998 and 1997.......................... Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 1999, 1998 and 1997.......................... Consolidated Statements of Cash Flows Years Ended December 31, 1999, 1998 and 1997.......................... Notes to Consolidated Financial Statements.............................. Financial Statement Schedules - ----------------------------- All schedules are omitted because they are either not applicable or the required information is included in the Consolidated Financial Statements or Notes thereto. Report of Independent Certified Public Accountants To the Board of Directors and Stockholders of JWGenesis Financial Corp. In our opinion, the accompanying consolidated statements of financial condition and the related consolidated statements of income, changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of JWGenesis Financial Corp. and its subsidiaries (the "Company"), at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. Tampa, Florida March 24, 2000 JWGenesis Financial Corp. and Subsidiaries Consolidated Statements of Financial Condition - -------------------------------------------------------------------------------- The accompanying Notes to Consolidated Financial Statements are an integral part of these financial statements. JWGenesis Financial Corp. and Subsidiaries Consolidated Statements of Income - -------------------------------------------------------------------------------- The accompanying Notes to Consolidated Financial Statements are an integral part of these financial statements. JWGenesis Financial Corp. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity - -------------------------------------------------------------------------------- The accompanying Notes to Consolidated Financial Statements are an integral part of these financial statements. JWGenesis Financial Corp. and Subsidiaries Consolidated Statements of Cash Flows - -------------------------------------------------------------------------------- Supplemental schedule of noncash investing and financing activities During fiscal 1999, 1998 and 1997, respectively, the Company issued 403,125, 174,375 and 168,750 shares of common stock relating to options exercised for which the consideration received was 118,324, 46,098 and 57,234 shares of common stock, respectively. In September 1997 and December 1998, respectively, the Company issued 532,277 and 74,742 shares of common stock in connection with the acquisition of The Americas Growth Fund, Inc. (Note 2). On June 12, 1998, the Company issued 2,250,000 shares of common stock in connection with the acquisition of Genesis Merchant Group Securities, LLC. In July 1998, the Company issued 538,025 shares of restricted common stock in connection with two executive members of management entering into a non-solicitation agreement with the Company. On March 3, 1999, the Company divested JWG Capital Markets for an aggregate of 426,563 shares of common stock of the Company. On April 12, 1999, the Company issued 450,000 options as part of a corporate spokesperson agreement. In May 1999, the Company issued 175,000 warrants in connection with a marketing agreement. The accompanying Notes to Consolidated Financial Statements are an integral part of these financial statements. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- 1. Nature of Business and Summary of Significant Accounting Policies: Operations JWGenesis Financial Corp. ("JWGFC" and the "Company") was incorporated as a Florida corporation on January 16, 1998. In a share exchange on June 12, 1998 (see Note 2), JWGFC succeeded the business and operations of JW Charles Financial Services, Inc. and its subsidiaries ("JWCFS") in a transaction which was accounted for in a manner similar to a pooling of interest. The period through June 12, 1998 as well as the year ended December 31, 1997 represents the results of operations of JWCFS. JWCFS was incorporated as a Florida corporation in December 1983. Through its subsidiaries, JWGFC is primarily engaged in the securities brokerage and investment banking business. Basis of Consolidation The accompanying consolidated financial statements include the accounts of JWGenesis Financial Corp. and its subsidiaries: JWGenesis Financial Inc. ("JWGFI"), formerly, JWGenesis Financial Services, Inc., formerly JWCFS; JWGenesis Financial Services, Inc. ("JWGFS"), formerly, Corporate Securities Group, Inc.; JWGenesis Securities, Inc. ("JWG Securities"); JWGenesis Capital Markets, Inc. ("JWG Capital"), formerly JWGenesis Capital Corp.; JWGenesis Insurance Services, Inc.; DMG Securities, Inc. ("DMG"); and JWGenesis Financial Group, Inc, ("JWGFG") formerly, GSG Securities, Inc. All consolidated subsidiaries are 100% owned by the Company. Prior to June 1, 1999 the consolidated financial statements included JWGenesis Clearing Corp. ("JWG Clearing"), which was a wholly owned subsidiary. From June 12, 1998 to March 3, 1999, the consolidated financial statements included JWGenesis Capital Markets, LLC ("JWG Capital Markets"), formerly Genesis Merchant Group Securities, LLC ("Genesis"), which was a majority owned subsidiary. JWGFC functions principally as a holding company and, therefore, it does not have any operations that are material to the consolidated financial statements. All significant intercompany transactions and accounts have been eliminated in consolidation. Management Estimates and Assumptions The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Segment Reporting In the fourth quarter of fiscal 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of Enterprise and Related Information" ("SFAS 131"). SFAS 131 supersedes SFAS 14, "Financial Reporting for Segments of a Business Enterprise," replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and addressing performance as the source of the Company's reportable segments. SFAS 131 also requires disclosures about products and services, geographic areas, and major customers. The adoption of SFAS 131 did not affect the Company's financial position or results of operations but did affect the disclosure of segment information (see Note 17). JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ Cash and Cash Equivalents Cash and cash equivalents consist of cash, including cash in banks and money market funds and United States Treasury bills with a maturity less than 90 days. Securities Owned and Securities Sold, Not Yet Purchased Securities owned, which are readily marketable and securities sold, not yet purchased are recorded at estimated fair value. Securities sold, not yet purchased represent obligations to the Company to deliver specified securities at the contracted prices, thereby creating a liability to purchase the securities at prevailing market prices. Securities owned, which are not readily marketable, are valued at estimated fair value as determined by management. The resulting difference between cost and estimated fair value is included in income. Investment Valuation In the absence of readily ascertainable market values, the investment in MVP.Com, Inc. ("MVP") (see Note 6) is valued using methods determined in good faith by the Company after consideration of all relevant information, including private market values, original cost, operating results and financial position. Because of the inherent uncertainty of valuation, these estimated values may differ materially from the amounts which might be ultimately realized upon the sale or other disposition of the investments. Cost in Excess of the Fair Value of Net Assets Acquired Cost in excess of the fair value of net assets acquired relates to the acquisition of Genesis Merchant Group Securities, LLC and the acquisition by JWGFG (see Note 2). The amount is being amortized on the straight-line method over 20 years. The carrying value of the cost in excess of the fair value of net assets acquired is reviewed for impairment whenever events or changes in circumstances indicate that it may not be recoverable. Furniture, Equipment and Leasehold Improvements Furniture, equipment and leasehold improvements are recorded at cost. Depreciation and amortization on furniture, equipment and leasehold improvements is provided utilizing the straight-line method over the estimated useful lives of the related assets, which range primarily from five to seven years. Transaction Reporting Securities transactions and the related revenues and expenses are recorded in the accounts on trade date. Clearing fees include service charges, execution fees and commissions on order flow. Income Taxes The Company utilizes the asset and liability approach defined in Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of JWGenesis Financial Corp. and Subsidiaries Index to Consolidated Financial Statements ------------------------------------------------------------------------------ temporary differences between the financial statement amounts and the tax bases of assets and liabilities. Earnings Per Common Share Earnings per common share are calculated in accordance with the provisions of Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS 128 requires the Company to report both basic earnings per common share, which is based on the weighted average number of common shares outstanding, and diluted earnings per common share, which is based on the weighted average number of common shares outstanding and all dilutive potential common shares outstanding. Stock-Based Compensation The Company adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") during 1996. Upon adoption of SFAS 123, the Company has retained the intrinsic value method of accounting for stock-based compensation and has disclosed pro forma net income and earnings per common share amounts (See Note 15). Reclassifications Certain amounts from prior years have been reclassified to conform to the current year presentation. These reclassifications are not material to the consolidated financial statements. 2. Acquisitions and Divestitures: Genesis Merchant Group Securities, LLC On January 21, 1998, the Company executed an Agreement and Plan of Combination (the "Combination") with Genesis and the owners (the "Genesis Members") of all of the outstanding equity interests in Genesis (the "Genesis Membership Interests"). Genesis was a San Francisco-based investment banking firm specializing in institutional research, sales and trading, corporate finance and brokerage processing services. Pursuant to a share exchange with JW Charles Financial Services, Inc. on June 12, 1998, JWGenesis Financial Corp. acquired all of the outstanding shares of JWCFS common stock in exchange for shares of JWGenesis Financial Corp. common stock on a one-for-one basis, and thus replaced JWCFS as the publicly held holding company (the "Share Exchange"). The Share Exchange was part of the Combination, consummated on the same date among JWCFS, JWGenesis Financial Corp., Genesis, and the owners of a majority of the equity interests in Genesis, in which the owners of Genesis exchanged their equity interests for 2,250,000 shares of JWGenesis Financial Corp. common stock. The Company accounted for the acquisition of Genesis using the purchase method of accounting. The results of operations of the acquired entity are included with those of the Company from the June 12, 1998 acquisition date. The cost included the issuance of 2,250,000 shares of common stock valued at approximately $17,850,000 and approximately $800,000 in acquisition costs. Assets acquired of approximately $6,800,000 and liabilities assumed of approximately $3,400,000 have been recorded at their estimated fair values. Cost exceeded the fair value of net assets acquired by approximately $15,250,000. JWGenesis Financial Corp. and Subsidiaries Index to Consolidated Financial Statements ------------------------------------------------------------------------------ JWG Capital Markets Divestiture On March 3, 1999, the Company divested JWG Capital Markets (the "Divestiture") which at the time consisted primarily of the Company's San Francisco-based brokerage processing services unit that had been acquired in the Combination on June 12, 1998 to an investor group of certain of the former owners of JWG Capital Markets (the "Investor Group"). In exchange and as part of the Divestiture, the Investor Group conveyed to the Company an aggregate of 426,563 shares of common stock of the Company that had been issued to them in the Combination. As part of the Divestiture, JWG Capital Markets transferred its investment banking, corporate finance and capital markets business to JWG Capital so that those operations would be retained by the Company. The Americas Growth Fund, Inc. On September 22, 1997, the Company completed its exchange tender offer (the "Exchange Offer") to acquire all of the outstanding shares of common stock of The Americas Growth Fund, Inc. ("AGRO") not already owned by the Company. AGRO is a non-diversified, closed-end, management investment company. Prior to the commencement of the Exchange Offer, the Company owned 26% of the outstanding shares of common stock of AGRO. A total of approximately 823,000 shares of AGRO common stock, representing approximately 65% of AGRO common stock tendered, were accepted for exchange by the Company according to the terms of the Exchange Offer on the basis of .647 shares of the Company's common stock for each share of AGRO resulting in the issuance by the Company of 532,276 shares of common stock at a price of $5.50 per share. The tendered shares together with the shares already owned by the Company represent approximately 91% of the outstanding shares of AGRO common stock, with the remaining 9% of AGRO shares held by minority shareholders. The AGRO acquisition was accounted for under the purchase method of accounting. The Company has consolidated the accounts of AGRO in the accompanying financial statements effective as of September 22, 1997. In accordance with the Exchange Offer, the purchase of the 65% of AGRO common stock tendered was allocated to the fair value of the net assets acquired as follows: Tangible assets acquired $2,948,000 Liabilities assumed (20,000) --------------- $2,928,000 --------------- In December 1998, the Company issued 74,742 shares of common stock at a price of $4.01 per share to acquire the remaining 9% of AGRO shares held by minority shareholders and merged into JWGFS. Pro forma information for AGRO is not presented as management has determined that this information does not materially impact the historical financial data. The JWGFG Acquisition On January 1, 1999, JWGFG acquired certain assets of six retail securities branch offices (and three satellite offices ) from an unaffiliated company ("the Seller"). In connection with this asset purchase, JWGFG paid the Seller approximately $2,300,000 in cash ($1,000,000 of which was used to repay an earlier loan from the Company to the Seller); JWGFS issued to the Seller shares of its Series C Redeemable Preferred Stock that are redeemable, in the aggregate, for up to $2,500,000 based upon the financial performance of the acquired branch offices over the three years in the period ending December 31, 2001; and the Company issued to the Seller a warrant for the purchase of up to 156,250 shares of its common stock at an exercise price of $16 per share, which may only be JWGenesis Financial Corp. and Subsidiaries Index to Consolidated Financial Statements ------------------------------------------------------------------------------ exercised with proceeds from redeemed Series C Redeemable Preferred Stock, and three-year, fully vested options to purchase 75,000 shares of its common stock at an exercise price of $16 per share. The Company also agreed to issue to designated members of the Seller's former senior management options to purchase an aggregate of 375,000 shares of its common stock at an exercise price of $8 per share, exercisable through December 31, 2003 (the "Senior Management Options"). The Senior Management Options vest over a three-year period based upon a formula tied to the performance of the acquired branch offices. An additional 150,000 options, with a three-year term and an $16 per share exercise price, were made available by the Company to selected branch managers and registered representatives employed in the acquired branch offices. JWG Clearing Divestiture On June 1, 1999, the Company completed the sale of JWG Clearing to Fiserv, Inc. ("Fiserv") through Fiserv's wholly owned subsidiary Fiserv Clearing, Inc. ("Fiserv Clearing"). JWG Clearing had functioned primarily as the Company's securities clearing, execution, and back office services unit, and only those operations comprised JWG Clearing at the time the sale was consummated. For the sale to Fiserv, the Company received cash consideration of approximately $59 million, and may receive additional consideration based on the outcome of various matters. Of this amount, approximately $19 million represented the net book value of JWG Clearing and $40 million represented the purchase price in excess of the net book value of JWG Clearing. Of the $40 million, $25 million was recorded as income (reduced by certain expenses related to the sale) in 1999 under the caption "gain on sale of subsidiary". The remaining $15 million was recorded as deferred income and is being accreted into income ratably over 10 years. In connection with the sale, the Company: (i) entered into a Transition Services Agreement pursuant to which, following the sale, it will continue to provide certain assistance and services to JWG Clearing and Fiserv Clearing, and will permit JWG Clearing and Fiserv Clearing to use certain facilities during a transition period for a monthly fee approximating actual costs; (ii) agreed not to compete for ten years in the securities clearing and execution business and not to solicit personnel of JWG Clearing or Fiserv and its affiliates; and (iii) agreed, subject to certain limitations, and exclusions (primarily related to independent contractor registered representatives, possible future acquisitions, and a one-year phase-in period), to use and cause its subsidiaries and affiliates to use the clearing services of designated Fiserv affiliates for at least 90% of their securities brokerage transactions and , in the case of independent contractor registered representatives, to impose a surcharge on certain such transactions that are not cleared through a Fiserv affiliate, during the 10-year period following the sale. The Company has the right, however, to be released from the above obligations to use Fiserv affiliates or to impose a surcharge by repaying to Fiserv a portion of the sales price based on a prescribed formula that takes into account the price paid in the sale and the amount of clearing services business then being generated by the Company or its affiliate seeking the release. 3. Clearing Agreements: JWGFS, JWGFG, JWG Securities and DMG have clearing agreements with unaffiliated clearing brokers. Under such agreements, the clearing brokers provide these subsidiaries with certain back-office support and clearing services on all principal exchanges. In order to facilitate transactions with these unaffiliated clearing brokers, the subsidiaries maintain cash balances of approximately $400,000 that earn interest at a rate equal to 1% above the rate customarily paid on credit balances to the clients of the clearing broker. The $400,000 is included in commissions and other receivables from clearing brokers on the accompanying consolidated statements of financial condition. JWGenesis Financial Corp. and Subsidiaries Consolidated Statements of Financial Condition ------------------------------------------------------------------------------- Credit losses could arise should the clearing brokers fail to perform. The Company does not require collateral. 4. Receivable from and Payable to Brokers and Dealers: Amounts receivable from and payable to brokers and dealers consist of the following: December 31, ------------ 1999 1998 ---- ---- Receivable: Securities failed to deliver $ - $ 850,000 Deposits on securities borrowed - 2,056,000 Other amounts due from brokers and dealers 8,965,000 354,000 --------------- -------------- $8,965,000 $3,260,000 --------------- -------------- Payable: Securities failed to receive $ - $ 786,000 Deposits on securities loaned - 34,151,000 Other amounts due to brokers and dealers 5,004,000 7,346,000 --------------- -------------- $5,004,000 $42,283,000 --------------- -------------- Deposits on securities borrowed and securities loaned represent cash on deposit with or received from other brokers and dealers relating to securities borrowed and securities loaned transactions, respectively. The Company monitored the market value of securities borrowed and loaned on a daily basis, with additional collateral obtained or refunded as necessary. There are no amounts for securities failed to deliver/receive and deposits on securities borrowed/loaned at December 31, 1999, as the Company sold the clearing operations (see Note 2). 5. Receivable from and Payable to Customers: Receivable from and payable to customers arose from cash and margin transactions executed by the Company on the customer's behalf. Receivables were collateralized by securities owned by customers. Such collateral is not reflected in the accompanying consolidated statements of financial condition. There are no amounts for December 31, 1999 as the Company sold the clearing operations (see Note 2). 6. Securities Owned and Securities Sold, Not Yet Purchased: Securities owned and securities sold, not yet purchased consist of securities, at estimated fair value, as follows: JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ December 31, ------------ 1999 1998 ---- ---- Securities owned: U.S. Government obligations $5,180,000 $ 840,000 State and municipal government obligations 3,240,000 3,257,000 Corporate obligations 3,152,000 1,921,000 Corporate stocks 1,461,000 1,150,000 Non-marketable 6,908,000 6,546,000 Other 60,000 32,000 --------------- -------------- $20,001,000 $13,746,000 --------------- -------------- December 31, ------------ 1999 1998 ---- ---- Securities sold, not yet purchased: U.S. Government obligations $ 19,000 $ 21,000 State and municipal government obligations 288,000 66,000 Corporate obligations 87,000 - Corporate stocks 1,010,000 110,000 Other 202,000 108,000 --------------- ------------- $1,606,000 $ 305,000 --------------- ------------- At December 31, 1999, the Company owned, of record, approximately 1,403,000 preferred shares of MVP, which are unregistered and for which there is presently no public market. Approximately 158,000 of such shares were allocated to Company management to cover bonus payments due and payable in accordance with the employment agreements in effect. The approximately 1,403,000 MVP shares have a historical cost of approximately $1,035,000 and are included in non-marketable securities at their estimated fair value of $6,500,000. The resulting difference in cost and estimated fair value of approximately $5,465,000 is included in market making and principal transactions in 1999. At December 31, 1998, the Company owned, of record, approximately 300,000 shares of Knight/Trimark Group, Inc. ("NITE"), which were subject to a lock-up agreement until January 11, 1999 and were unregistered at that time. Approximately 60,000 of such shares were allocated to Company management to cover bonus payments due and payable in accordance with the employment agreements in effect as of June 12, 1998, the date of the Combination. The approximate 300,000 NITE shares had a historical cost of $18,000 and were included in non-marketable securities at their estimated fair value of $6,400,000. The resulting difference in cost and estimated fair value of approximately $6,400,000 was included in market making and principal transactions in 1998. At December 31, 1999 the Company owned 8,442 shares which are carried at fair market value of approximately $388,000. 7. Short-Term Borrowings from Banks: Borrowings under JWG Clearing's financing agreement with a bank yielded interest based upon the federal funds rate, were restricted to a percentage of the market value of the related collateral securities, and were due on demand. At December 31, 1998 approximately $16,988,000 was outstanding under this arrangement. The market value of the collateral relating to this arrangement was approximately $23,000,000 at December 31, 1998 including customer margin account securities of approximately $19,000,000. The maximum and average amounts outstanding during the year ended December 31, 1998 were approximately $68,000,000, $37,000,000, respectively. The average interest rate during the same period was 6.3%. As a result of the sale of JWG Clearing on June 1, JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ 1999, the Company no longer has this agreement. 8. Notes Payable to Affiliate and Mandatorily Redeemable Common Stock: On May 15, 1995, the Company and Gilman Securities Corporation ("Gilman") renegotiated the terms of the Company's existing indebtedness to Gilman and entered into a $5,000,000 unsecured promissory note (the "Note"). The Note provided for a principal payment of $1,000,000 in May 1995 and thereafter quarterly principal payments of $250,000 each commencing on July 15, 1995. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ On June 12, 1998, the Company prepaid, without penalty, the entire remaining principal balance due to Gilman. The Company recorded interest expense of $208,000 and $628,000 for the years ended December 31, 1998 and 1997, respectively, related to this Note. On May 15, 1995, the Company entered into a Stock Repurchase Agreement (the "Old Agreement") with Gilman for the repurchase of all of the approximately 49% of the Company's outstanding shares of common stock owned by Gilman. On June 11, 1996, the Company entered into an Amended and Restated Stock Purchase Agreement (the "New Agreement") with Gilman whereby the Company accelerated the repurchase of all of the shares of its common stock owned by Gilman. The total consideration paid by the Company to Gilman consisted of a promissory note in the amount of $6,125,000 (the "Stock Loan"), along with the $1,155,000 in cash that was paid to Gilman under the Old Agreement. The difference between the purchase price under the Old Agreement and the New Agreement was accreted to retained earnings in the year ended December 31, 1996. The Company was required to make an annual principal payment each year on the Stock Loan in an amount equal to 50% of its annual net income, as defined, until the Stock Loan was paid in full. On April 15, 1998 and 1997, the Company made principal payments on the Stock Loan in the amount of $2,552,000 and $2,512,000, respectively. On June 12, 1998, the Company prepaid the entire outstanding principal balance of the Stock Loan without penalty. 9. Estimated Fair Value of Financial Instruments: Statement of Financial Accounting Standards No. 107, "Disclosure about Fair Value of Financial Instruments," requires the disclosure of the fair value of financial instruments, including assets and liabilities recognized and not recognized in the consolidated statements of financial condition. The Company's securities owned, which are readily marketable, and securities sold, not yet purchased are carried at estimated fair value. Management estimates that the aggregate net fair value of other financial instruments recognized on the consolidated statements of financial condition (including cash and cash equivalents, receivables and payables, and short-term borrowings) approximates their carrying value, as such financial instruments are short-term in nature, bear interest at current market rates or are subject to repricing. 10. Commitments and Contingencies: In the normal course of business, the Company enters into underwriting commitments. There were no outstanding underwriting commitments at December 31, 1999, 1998 and 1997. The Company leases its operations headquarters, branch offices and certain equipment under operating leases that generally allow for renewal and are in effect for various terms through 2003. Lease expense with respect to operating leases for the years ended December 31, 1999, 1998 and 1997 approximated $4,197,000, $2,166,000 and $1,650,000, respectively. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ Based upon long-term noncancelable leases and other contractual commitments, the future minimum commitments as of December 31, 1999 are as follows: 2000 $2,533,680 2001 1,803,001 2002 1,163,481 2003 715,842 2004 and thereafter 996,449 -------------- $7,212,453 -------------- The Company is a defendant or co-defendant in various lawsuits incidental to its securities business. The Company is contesting the allegations of the complaints in these cases and believes that there are meritorious defenses in each of these lawsuits. In view of the number and diversity of claims against the Company, the number of jurisdictions in which litigation is pending and the inherent difficulty of predicting the outcome of litigation and other claims, the Company cannot state with certainty what the eventual outcome of pending litigation or other claims will be. In the opinion of management, based on discussions with counsel, the outcome of the matters will not result in a material adverse effect on the financial position or results of operations of the Company. In the normal course of business, securities transactions of brokerage customers of the Company are introduced and cleared through a clearing broker on a fully disclosed basis. Pursuant to an agreement between the Company and the clearing broker, the clearing broker has the right to charge the Company for unsecured losses that result from a customer's failure to complete such transactions. Two executive members of management (the "Executives") have entered into nonsolicitation agreements with the Company for a period of seven years from July 1998 (the "Nonsolicitation Agreements"). In connection with those agreements and in consideration for the Executives' agreements to terminate the financial terms of their employment agreements with JWCFS in connection with the Share Exchange (see Note 2), the Company agreed to make certain payments in the form of cash and restricted shares. The Company agreed to make total cash payments to the Executives in four equal installments, the first paid in July 1998 and the remaining installments to be paid on January 15, 1999, 2000 and 2001, in an aggregate amount of approximately $750,000 for each installment. If the employment of either Executive is terminated for any reason other than cause, any unpaid cash amount must be paid within 30 days of termination. The Company also agreed to issue to the Executives an aggregate amount of approximately 538,025 shares of restricted common stock of the Company. Twenty-five percent of the shares issued to the Executives will vest on January 15, 2002 and an additional 25% on each January 15 thereafter through 2005. All unvested shares will be subject to forfeiture at any time there is a violation of the Nonsolicitation Agreements. Additionally, on June 15, 1999, the Company entered into an agreement with the Executives, whereby the Executives agreed to pay $1.35 million to the Company as liquidated damages in addition to the forfeiture of the unvested shares at any time there is a violation of the Nonsolicitation Agreements. In the event of a change in control of the Company, all such shares become immediately vested and the forfeiture provisions with respect to such shares will no longer be in force. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ 11. Income Taxes: The provision (benefit) for income taxes consists of: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's net deferred tax asset (liability) as of December 31 are as follows: 1999 1998 Deferred income $5,452,000 $ - Compenstory stock options 120,000 - Deferred compensation 229,000 198,000 Reserve for bad debts 25,000 490,000 Contingency accruals 558,000 555,000 Net operating loss carryforward 53,000 282,000 -------------- -------------- Gross deferred tax asset 6,437,000 1,525,000 -------------- -------------- Mark to market 2,062,000 1,856,000 Other 159,000 25,000 -------------- -------------- Gross deferred tax liability 2,221,000 1,881,000 -------------- -------------- Net deferred tax asset (liability) $4,216,000 $(356,000) -------------- -------------- JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- The Company's effective tax rate on pre-tax income differs from the statutory federal income tax rate due to the following: 12. Net Capital Requirements: The broker-dealer subsidiaries of the Company are subject to the requirements of Rule 15c3-1 under the Securities Exchange Act of 1934. This rule requires that aggregate indebtedness, as defined, not exceed fifteen times net capital, as defined. Net capital positions of the Company's broker-dealer subsidiaries were as follows: December 31, ------------ 1999 1998 ---- ---- JWGenesis Financial Services, Inc. Ratio of aggregate indebtedness to net capital 3.13 to 1 2.82 to 1 Net capital $ 2,950,000 $2,000,000 Required net capital $ 617,000 $ 376,000 JWGenesis Securities, Inc. Ratio of aggregate indebtednesss to net capital 2.09 to 1 2.59 to 1 Net capital $ 2,998,000 $1,399,000 Required net capital $ 419,000 $ 250,000 DMG Securities, Inc. Ratio of aggregate indebtedness to net capital 0.69 to 1 0.67 to 1 Net capital $ 310,000 $ 232,000 Required net capital $ 100,000 $ 100,000 JWGenesis Financial Group, Inc. Ratio of aggregate indebtedness to net capital 2.41 to 1 0.62 to 1 Net capital $ 1,350,000 $2,111,000 Required net capital $ 217,000 $ 50,000 Additionally, pursuant to Rule 15c3-1, JWGFS, JWG Securities, DMG and JWGFG must notify and obtain approval from the Securities and Exchange Commission and either the National Association of Securities Dealers, Inc. (JWGFS, DMG and JWGFG) or the NYSE (JWG Securities) for any advances or loans to JWGFC or any other affiliate, if such advances or loans would exceed in the aggregate, in any 30 calendar day period, 30% of that company's excess net capital and $500,000. Rule 15c3-1 also provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less 120% of the minimum net capital required by the rule. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ 13. Off-Balance-Sheet Risk: In the normal course of business, the Company's customer activities involve the execution, settlement and financing of various customer securities transactions that settle in accordance with industry practice, which for most securities, is currently three business days after trade date. These activities may expose the Company to off-balance sheet credit and market risk in the event the customer or other broker is unable to fulfill its contracted obligations and the Company is required to purchase or sell the financial instrument underlying the contract at a loss. The risk of default depends on the credit worthiness of the customer or issuer of the instrument held as collateral. The Company may execute customer transactions involving the sale of securities not yet purchased, which may be transacted on a margin basis subject to individual exchange regulations. Such transactions may expose the Company to off-balance sheet credit and market risk in the event margin requirements are not sufficient to fully cover losses that customers may incur. In the event the customer fails to satisfy its obligation, the Company may be required to purchase or sell financial instruments at prevailing market prices to fulfill the customers' obligations. 14. Common Stock Split: On February 16, 2000, the Company's Board of Directors declared a 3-for-2 stock split in the form of a stock dividend payable on March 24, 2000 to shareholders of record on March 3, 2000. The Company's capital accounts at December 31, 1999 and 1998 were adjusted to retroactively give effect to the dividend in the same manner as would be done if the dividend had been issued before December 31, 1999. All references in the consolidated financial statements and accompanying notes to amounts per share and to the number of common shares have been retroactively adjusted for the stock split. 15. Employee Benefit Plans: The Company has two stock option plans, "The 1990 Stock Option Plan" and "The 1998 Stock Option and Award Plan" (collectively, the "Option Plans"). A total of 4,200,000 shares of common stock have been reserved for issuance upon exercise of options designated as "incentive stock options" or "nonqualified options" and issued pursuant to the Option Plans. Options issued under the Option Plans are to be issued to certain officers and employees of the Company, and certain other key persons instrumental to the success of the Company. The Option Plans are administered by the Board of Directors of the Company, or a committee appointed by the Board of Directors, which determines, among other things, the persons to be granted options under the Option Plans, the number of shares subject to each option and the option exercise price. The option exercise price for each option is no less than the fair market value of the common stock subject to option. Options awarded under the Option Plans are generally subject to vesting over a period of one to three years and expire no later than five years from the date of grant. Information for the Option Plans for the years ended December 31, 1999, 1998 and 1997 is summarized as follows: JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ Exercise Weighted Number Price Average of Shares Range Exercise Price --------- ----- -------------- Balance, December 31, 1996 959,027 $ 1.30-2.99 $ 1.91 Granted 673,785 4.33-6.67 4.91 Exercised (25,500) 1.30-2.73 1.47 Forfeited (8,078) 4.49-6.67 5.09 ----------- -------------- ---------- Balance, December 31, 1997 1,599,234 1.30-6.05 3.17 Granted 701,070 4.83-8.33 6.97 Exercised (318,375) 1.30-2.73 1.45 Forfeited (432,558) 1.50-8.33 5.46 ----------- -------------- ---------- Balance, December 31, 1998 1,549,371 1.70-8.33 4.59 Granted 479,800 3.75-12.67 5.53 Exercised (684,922) 1.70-7.67 3.88 Forfeited (138,011) 4.15-8.33 6.45 ----------- -------------- ---------- Balance, December 31, 1999 1,206,238 $ 1.70-12.67 $ 5.16 ----------- -------------- ---------- The Company has a restricted stock plan providing for the issuance of up to 1,125,000 shares of its authorized but unissued common stock to nonexecutive employees and registered representatives. As of December 31, 1999, 1998 and 1997, 15,750 shares had been issued under the restricted stock plan and 1,109,250 shares of common stock have been reserved for future issuance. In accordance with the provisions of SFAS 123, the Company applies APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans and does not recognize compensation expense for its stock-based compensation plans other than for restricted stock. If the Company had elected to recognize compensation expense based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed by SFAS 123, the Company's net income and earnings per common share would be reduced to the pro forma amounts indicated below: Year Ended December 31, ------------ 1999 1998 1997 ---- ---- ---- Net income: As reported $ 24,662,000 $6,632,000 $6,103,000 Pro forma $ 22,880,000 $5,480,000 $5,404,000 Basic earnings per common share: As reported $ 2.79 $ .92 $ 1.18 Pro forma $ 2.59 $ .76 $ 1.05 Diluted earnings per common share: As reported $ 2.54 $ .83 $ 1.00 Pro forma $ 2.36 $ .69 $ .89 JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ These pro forma amounts may not be representative of future disclosures since the estimated fair value of stock options is amortized to expense over the vesting period and additional options may be granted in future years. For disclosure purposes the fair value of these options was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for stock purchase rights granted in 1999, 1998 and 1997, respectively: dividend yields of 0.0% for all years; expected volatility of 60%, 100% and 53.2%; risk-free interest rates of 5.5%, 5.5% and 6.0%; and expected life of 3.4 years, 5 years, and 5 years. The weighted average fair value of stock options granted in 1999, 1998 and 1997 was $5.16, $4.55 and $2.59, respectively. The weighted average remaining contractual life of options outstanding at December 31, 1999, 1998 and 1997 is 3.6, 3.2 and 3.3 years, respectively. At December 31, 1999, 1998 and 1997, the Company had options available for future grants of 974,401, 1,316,191 and 459,703, respectively. The following table summarizes information about the options exercisable at December 31: 1999 1998 1997 ---- ---- ---- Number of shares 2,283,000 804,000 593,000 Exercise price range $1.70-16.00 $1.70-7.00 $1.30-4.33 Weighted average exercise price $ 8.39 $ 3.96 $ 2.37 The Company adopted a Pension and Profit Sharing Plan (the "Plan") in 1986 which offers all full-time employees over the age of 21 of the Company tax advantages pursuant to Section 401(k) of the Internal Revenue Code. Under the terms of the Plan, participants may elect to defer up to 10% of their compensation. The Company will make a matching contribution to the Plan of 50% of the first 4% of compensation contributed by each participant who is employed by the Company or its subsidiary on December 31 of such year. Participant's contributions to the Plan are fully vested at all times and are not subject to forfeiture. The Company's matching contribution vests to each participant over a five-year vesting schedule based upon the participant's years of service with the Company. Contributions are made by participants by means of a payroll deduction program. Within specified limits, participants have the right to direct their savings into certain kinds of investments as specified in the Plan. Employee compensation and benefits include approximately $367,000, $310,000 and $225,000 of Company matching contributions made during 1999, 1998 and 1997, respectively. On October 1, 1997, the Company adopted an Employee Stock Purchase Plan ("ESPP"), which is authorized to issue up to 600,000 shares of common stock to its full-time employees to purchase shares of common stock through voluntary contributions, including periodic payroll deductions. Under the terms of the ESPP, employees are limited to a monthly contribution varying between $50 and $1,650 of after-tax dollars to purchase the Company's common stock. The purchase price of the stock is the lesser of 85% of the market price on the first day of the quarter, or on the stock purchase date designated after the end of each quarter. During 1999 and 1998, the ESPP purchased 144,419 and 118,448 shares, respectively, of common stock from the Company at average cost per share of $4.81 and $5.17. At December 31, 1999, the Company is committed to issue the ESPP, or purchase in the open market for issuance to the ESPP, an additional 23,809 shares of common stock. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ 16. Earnings Per Common Share: Presented below is basic and diluted earnings per share under SFAS 128 for the years ended December 31, 1999, 1998 and 1997: 17. Segment Analysis: The Company's reportable segments are: captive retail distribution, independently owned distribution, clearing and trading, capital markets and other. The captive retail distribution segment includes the 14 retail branches of JWG Securities located in Florida, California, Georgia and New York and six retail branch offices of JWGFG located in New York, Florida, Colorado, Illinois, and California. These branches provide securities brokerage services including the sale of equities, mutual funds, fixed income products and insurance to their retail clients. The independently owned retail distribution segment includes the 130 JWGFS offices and one DMG office, all of which are located in the U.S., providing securities brokerage services including the sale of equities, mutual funds, fixed income products and insurance to their retail clients. The clearing and trading segment comprises primarily JWG Clearing's operations through June 1, 1999 which were providing clearing services primarily on a fully disclosed basis to small broker dealers, the trading of equities and fixed income products as principal, and investments in trading firms including MVP, NITE and Strike Technologies LLC. The capital markets segment includes management and participation in underwritings (exclusive of sales credits, which are included in the distribution segments), mergers and acquisitions, public finance, institutional trading, institutional research and market making for institutional research. Other in 1999 consists primarily of the gain on sale of JWG Clearing (see Note 2). JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ The financial results of the Company's segments are the same as those described in the "Nature of Business and Summary of Significant Accounting Policies." Segment data includes charges allocating corporate overhead to each segment. Intersegment revenues and charges are eliminated between segments. The Company evaluates the performance of its segments and allocates resources to them based on return on investment. The Company has not disclosed asset information by segment as the information is not produced internally. All long-lived assets are located in the U.S. The Company's business is predominantly in the U.S. Information concerning operations in these segments of business is as follows: 18. Lines of Credit: On January 19, 1996, the Company obtained an unsecured $2,500,000 revolving line of credit from Wilmington Trust Company for general corporate purposes (the "Wilmington Facility"). The Wilmington Facility matures on December 31, 2002, at which time all outstanding borrowings plus all accrued and unpaid interest will become due and immediately payable. Borrowings under the Wilmington Facility bear interest at Wilmington's National Commercial Rate, with interest payments due monthly in arrears. The Company is required to maintain certain debt covenants, including (i) minimum stockholders' equity equal to at least $7,000,000, plus 30% of net income for all future fiscal quarters, plus 75% of the net proceeds from any common stock issuances and (ii) net income, as defined, in excess of $1,500,000 for any four quarters within any consecutive six-quarter period. At December 31, 1999 there was no balance outstanding under the Wilmington Facility. In connection with the Wilmington Facility, the Company entered into a marketing agreement with Wilmington Trust FSB (the "Wilmington Marketing Agreement") and granted W T Investments, Inc. a warrant to purchase 600,000 shares of the Company's common stock. At December 31, 1999, the Wilmington Warrant exercise price per share was $7.53. The Wilmington Marketing Agreement provides that the Company will market certain products and services, initially personal trust and asset management services, provided by Wilmington Trust FSB to the Company's brokers, clients and prospects. JWGenesis Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements ------------------------------------------------------------------------------ On December 18, 1996, the Company obtained an unsecured $2,500,000 revolving line of credit from SunTrust Bank, South Florida, N.A. for general corporate purposes (the "SunTrust Facility"). The SunTrust Facility matures on April 30, 2002, at which time all outstanding borrowings plus all accrued and unpaid interest will become due and immediately payable. Borrowings under the SunTrust Facility bear interest at the prime rate of interest as announced from time to time by SunTrust Banks of Florida, Inc., with interest payments due quarterly in arrears. The Company is required to maintain certain debt covenants, including (i) minimum tangible net worth equal to at least $18,000,000, plus 75% of net income for all future fiscal quarters, plus 75% of the net proceeds from any common stock issuances and (ii) net income, as defined, in excess of $1,500,000 for any four quarters within any consecutive six-quarter period. At December 31, 1999 there was no balance outstanding under the SunTrust Facility. In connection with the SunTrust Facility, the Company entered into a marketing agreement with SunTrust (the "SunTrust Marketing Agreement") and granted SunTrust Banks, Inc. a warrant to purchase 56,250 shares of the Company's common stock at any time prior to December 31, 2002. The exercise price per share is $4.44. The SunTrust Marketing Agreement provides that the Company will market certain products and services, through the Company's participation as an underwriter or selling group member of various municipal finance offerings underwritten by SunTrust Capital Markets, Inc., to the Company's brokers, clients and prospects. On September 15, 1999, the Company obtained a $7,000,000 senior secured credit line from GE Financial Assurance ("GEFA") for general corporate purposes (the "GEFA Facility"). The GEFA Facility matures on September 30, 2004, at which time any outstanding borrowings and unpaid interest will become due and immediately payable. Borrowings under the GEFA Facility bear interest at the LIBOR rate with interest payments due quarterly in arrears. The Company is required to maintain certain debt covenants, including (i) tangible net worth equal to at least $30 million, plus 75% of net income earned after September 30, 1999, (ii) a fixed charge coverage ratio at the end of any period of four consecutive quarters greater than 1.2 to 1.0 and (iii) an interest coverage ratio at the end of any period of four consecutive quarters greater than or equal to 3.0 to 1.0. As additional consideration for the GEFA Facility, the Company issued GEFA a five-year warrant to purchase up to 262,500 shares of its common stock at $9.25 per share at any time prior to May 14, 2004 (the "GEFA Credit Warrant"). The GEFA Credit Warrant vests with respect to one- fourteenth of the total GEFA Credit Warrant in connection with each $500,000 of borrowed or re-borrowed under the GEFA Facility. There were no borrowings under this agreement. In connection with the GEFA Facility, the Company entered into a five year Strategic Marketing Alliance (the "SMA") with GEFA pursuant to which GEFA will provide the Company's retail brokerage units with training, educational, marketing and promotional assistance. Under the terms of the SMA, the Company agreed to provide GEFA with preferred access to its retail sales force and issued GEFA a additional five-year warrant to purchase up to 262,500 shares of its common stock at $9.25 per share at any time prior to May 14, 2004 (the "GEFA SMA Warrant"). The SMA warrant is fully vested. 19. Subsequent Events: On February 11, 2000, the Company completed a partial tender offer for shares of its outstanding common stock, pursuant to which it purchased 1,750,000 shares for a price of $35 million. The Company conducted the tender offer in order to utilize excess cash derived from the sale of JWG Clearing in June 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 27, 2000 JWGENESIS FINANCIAL CORP. ------------------------- (Registrant) By: /s/ Marshall T. Leeds --------------------- Marshall T. Leeds President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Marshall T. Leeds Date: March 27, 2000 - --------------------------------------------- Marshall T. Leeds, Chairman, President and Chief Executive Officer (Principal Executive Officer) and Director /s/ Joel E. Marks Date: March 27, 2000 - --------------------------------------------- Joel E. Marks, Vice Chairman, Chief Operating Officer, Secretary, and Director /s/ Gregg S. Glaser Date: March 27, 2000 - --------------------------------------------- Gregg S. Glaser, Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) and Director /s/ Jeffrey H. Lehman Date: March 27, 2000 - -------------------------------------------- Jeffrey Lehman, Executive Vice President and Director /s/ Wm. Dennis Ferguson Date: March 27, 2000 - -------------------------------------------- Wm. Dennis Ferguson, Director /s/ Sanford Cohen Date: March 27, 2000 - -------------------------------------------- Sanford Cohen, Director

726513_1999.txt

726513_1999

1999

726513

ITEM 1. BUSINESS. Tribune Company ("Tribune" or the "Company") is a media company. Through its subsidiaries, the Company is engaged in the publishing of newspapers, books, educational materials and information in print and digital formats and the broadcasting, development and distribution of information and entertainment principally in metropolitan areas in the United States. The Company was founded in 1847 and incorporated in Illinois in 1861. As a result of a corporate restructuring in 1968, the Company became a holding company incorporated in Delaware. References in this report to "the Company" include Tribune Company and its subsidiaries, unless the context otherwise indicates. The information in this Item 1 should be read in conjunction with the information contained under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference. Certain prior year amounts have been reclassified to conform with the 1999 presentation. All Company share and per share data have been restated to reflect a two-for-one common stock split effective Sept. 9, 1999. This Annual Report on Form 10-K contains certain forward-looking statements that are based largely on the Company's current expectations. Forward-looking statements are subject to certain risks, trends and uncertainties that could cause actual results and achievements to differ materially from those expressed in the forward-looking statements. Such risks, trends and uncertainties, which in some instances are beyond the Company's control, include changes in advertising demand; newsprint prices; interest rates; competition; regulatory rulings and other economic conditions; the effect of professional sports team labor strikes, lock-outs and negotiations; the effect of acquisitions, investments and divestitures on the Company's results of operations and financial condition; and the Company's reliance on third-party vendors for various services. The words "believe," "expect," "anticipate," "estimate" and similar expressions generally identify forward-looking statements. Readers are cautioned not to place undue reliance on such forward-looking statements, which are as of the date of this filing. Recent Developments On March 13, 2000, Tribune and The Times Mirror Company ("Times Mirror") announced the signing of a definitive agreement for a merger of the two companies in a cash and stock transaction valued at approximately $8 billion. Times Mirror publishes the Los Angeles Times, Newsday, The Baltimore Sun, The Hartford Courant, The Morning Call, The (Stamford) Advocate, Greenwich Time and several smaller newspapers. Times Mirror also provides information to the aviation market and publishes magazines. The combined company will have a major presence in 18 of the nation's top 30 U.S. markets, including New York, Los Angeles and Chicago. Tribune will make a cash tender offer for up to 28 million Times Mirror shares (approximately 48% of shares outstanding) at a price of $95 per share. Following completion of the tender offer, Tribune and Times Mirror will merge in a transaction in which each remaining Times Mirror shareholder will receive 2.5 shares of Tribune common stock for each share of Times Mirror stock held. In addition, if fewer than 28 million Times Mirror shares are purchased in the tender offer, Times Mirror shareholders will be permitted to elect cash in the merger, up to the balance of the 28 million shares. The merger is subject to the approval of the shareholders of both companies. It is also subject to other customary conditions, including Hart-Scott-Rodino clearance. The Chandler Trusts, who control the vote of approximately 65% of Times Mirror, have signed a voting agreement committing to vote their shares in favor of the transaction. The companies expect the tender offer to be completed in mid-April and the merger to be completed in the second or third quarter of 2000. The companies expect the transaction to be tax-free to Times Mirror shareholders who elect to take Tribune stock. Further information concerning this transaction is included in the Company's two reports on Form 8-K, both dated March 13, 2000. Business Segments The Company's operations are divided into three industry segments, identified according to product: publishing, broadcasting and entertainment, and education. These segments operate primarily in the United States. The following table sets forth operating revenues and profit information for each segment of the Company (in thousands). The following table sets forth asset information for each industry segment (in thousands). The Company's results of operations, when examined on a quarterly basis, reflect the seasonality of the Company's revenues. In both publishing and broadcasting and entertainment, second and fourth quarter advertising revenues are typically higher than first and third quarter revenues. Results for the second quarter usually reflect spring advertising, while the fourth quarter includes advertising related to the holiday season. In education, second and third quarter revenues are typically higher than first and fourth quarter revenues. Results for the second and third quarters generally reflect the timing of sales to educational institutions for the upcoming school year, which begins in September. Fiscal years 1999, 1998 and 1997 all comprised 52 weeks. Publishing The publishing segment represented 49% of the Company's consolidated operating revenues in 1999. The 12-month combined average circulation in 1999 of the Company's daily newspapers was approximately 1.2 million daily and 1.9 million Sunday. The Company's primary newspapers are the Chicago Tribune, the South Florida-based Sun-Sentinel, The Orlando Sentinel and the Hampton Roads (VA)-based Daily Press. The Company formerly owned two daily newspapers and a weekly newspaper located in suburban areas in the San Diego, California market that were sold in July 1995. For 1999, the portion of total publishing operating revenues represented by each of the Company's newspaper subsidiaries was as follows: Chicago Tribune Company--52%; Sun-Sentinel Company--21%; Orlando Sentinel Communications Company--17%; and The Daily Press, Inc.--4%. In addition, the Company owns an entertainment listings, newspaper syndication and media marketing company, a Chicago-area cable television news channel and other publishing-related businesses. The Company also operates the Internet sites of the Company's newspapers and broadcasting stations, and develops new online products and services. Each of the Company's newspapers operates independently to most effectively meet the needs of the area it serves. Local management establishes editorial policies. The Company coordinates certain aspects of operations and resources in order to provide greater operating efficiency and economies of scale. The Company's newspapers compete for readership and advertising in varying degrees with other metropolitan, suburban and national newspapers, as well as with television, radio, Internet services and other media. Competition for newspaper advertising is based upon circulation levels, readership demographics, price, service, and advertiser results, while competition for circulation is based upon the content of the newspaper, service and price. The Company's newspapers are printed in Company-owned production facilities. The principal raw material is newsprint. In 1999, the Company's newspapers consumed approximately 386,000 metric tons of newsprint. Average newsprint transaction prices decreased 15% in 1997 from 1996. Average newsprint prices remained relatively steady in 1998, increasing 3% from 1997. Average newsprint prices declined throughout 1999, decreasing 11% from 1998. The Company is party to a contract with Donohue Inc., expiring in 2007, to supply newsprint based on market prices. Under the contract, the Company has agreed to purchase 257,000 metric tons of newsprint in each of the years 2000 to 2007, subject to certain limitations. In 1999, approximately 67% of the newspapers' newsprint supply was purchased from Donohue. The following table provides a breakdown of revenues for the publishing segment for the last three years. Operating Revenues (In thousands) comics to newspapers; commercial printing operations; delivery of other publications; direct mail operations; revenues from Internet/electronic products; cable television news programming; distribution of entertainment listings; and other publishing-related activities. Advertising revenues grew in 1999 mainly due to higher general revenues resulting from volume and rate increases and the September 1998 acquisition of Sun-Sentinel Community News Group (formerly South Florida Newspaper Network). Retail advertising revenues grew due to the acquisition of Sun-Sentinel Community News Group. General advertising revenues grew primarily due to increases in Chicago in the high-tech, financial and resorts categories and gains in automotive advertising in Orlando, Fort Lauderdale and Chicago. Classified advertising revenues decreased mainly due to declines in Chicago in the help wanted and real estate advertising categories, partially offset by improved automotive advertising; increased help wanted advertising in Fort Lauderdale; improved real estate advertising in Orlando; and higher Internet advertising. Other revenues increased in 1999 primarily from the acquisition of JDTV in February 1999 and higher revenues from direct mail and commercial printing operations. Chicago Tribune Company Founded in 1847, the Chicago Tribune is published daily, including Sunday, and primarily serves a nine-county market in northern Illinois and Indiana. This market ranks third in the United States in number of households. For the six months ended September 1999, the Chicago Tribune ranked 7th in average daily circulation and 4th in average Sunday circulation in the nation, based on Audit Bureau of Circulations ("ABC") averages. For the six months ended September 1999, the Chicago Tribune had a 34% lead in total daily paid circulation and a 149% lead in Sunday paid circulation over its principal competitor, the Chicago Sun-Times, based on ABC averages. The Chicago Tribune's total advertising volume and operating revenues are estimated to be substantially greater than those of the Sun-Times. The Chicago Tribune also competes with other city, suburban and national daily newspapers, direct mail operations, local and national Internet services and other media. Approximately 77% of the paper's daily and 62% of its Sunday circulation is sold through home delivery, with the remainder sold at newsstands and vending boxes. The daily edition's newsstand price increased by $.15 to $.50 in September 1992. The Sunday edition's newsstand price increased by $.25 to $1.75 in October 1995. In August 1999, the weekly home delivery price increased $.20 to $4.40. The following tables set forth selected information for the Chicago Tribune daily newspaper and other related activities. The 1999 improvement in advertising volume was mainly due to increased preprinted inserts for retailers and increased high-tech general advertising. The Chicago Tribune publishes Exito!, a weekly newspaper targeting Spanish-speaking households. Other businesses owned by Chicago Tribune Company include Tribune Direct Marketing, a direct mail operation; and RELCON, Inc., a publisher of free apartment and new-home guides and a provider of apartment-rental referral services to prospective renters. The Chicago Tribune also offers printing and delivery of other publications. Sun-Sentinel Company (Fort Lauderdale) The Sun-Sentinel is published daily, including Sunday, and leads the Broward/South Palm Beach market in circulation. The Miami/Fort Lauderdale market ranks 16th in the nation in terms of households. The paper's principal competition comes from the Miami Herald and national and local publications, as well as other media. Approximately 72% of the paper's daily and 68% of its Sunday circulation is sold through home delivery, with the remainder sold at newsstands and vending boxes. The daily Broward edition's newsstand price increased by $.10 to $.35 in May 1995. The daily South Palm Beach edition's newsstand price increased $.15 to $.50 in January 1996. The newsstand price of all Sunday editions was increased by $.25 to $1.00 in November 1989. In January 1992, the newsstand price of the South Palm Beach Sunday edition increased by $.25 to $1.25. In March 1996, the weekly home delivery price for the Broward edition increased $.15 to $2.75. In November 1996, the weekly home delivery price for the South Palm Beach edition increased $.25 to $3.00. The following tables set forth selected information for the Sun-Sentinel daily newspaper and other related activities. The 1999 decline in advertising volume was mainly due to decreased department store retail advertising. The Sun-Sentinel Company owns Gold Coast Shopper, a publication located in Deerfield Beach and City Link (formerly known as XS), a weekly publication. In May 1999, the Company purchased Florida New Homes and Condominiums Guide, a bimonthly real estate magazine. In December 1997, Exito!, a weekly publication of the Sun-Sentinel Company targeting young adults and Spanish-speaking households, ceased publication. The Sun-Sentinel also offers printing and delivery of other publications, direct mail services and publications targeted to specific consumer market segments, such as South Florida Parenting, acquired in 1994. Orlando Sentinel Communications Company The Orlando Sentinel is published daily, including Sunday, and serves primarily a five-county area in Central Florida. It is the only major daily newspaper in the Orlando market, although it competes with other Florida and national newspapers, as well as other media. The Orlando/Daytona Beach/Melbourne market ranks 22nd among U.S. markets in terms of households. Approximately 75% of the paper's daily and 68% of its Sunday circulation is sold through home delivery, with the remainder sold at newsstands and vending boxes. In March 1992, the newsstand price of the daily edition increased $.15 to $.50, except for most Thursday editions, which had been priced at $.50 since February 1991. The newsstand price of the Sunday edition was increased to $1.50 from $1.25 at the end of 1990. In January 1999, the weekly home delivery price increased by $.10 to $3.95. The following tables set forth selected information for The Orlando Sentinel daily newspaper and other related activities. The 1999 improvement in advertising volume was mainly due to higher preprinted inserts for retailers, partially offset by a decline in full run retail and help wanted classified inches. The Orlando Sentinel also publishes US/Express, a free weekly entertainment publication used to distribute advertising to non-subscribers, which is syndicated nationally; a group of parenting magazines, and the RELCON apartment guide for the Central Florida market. In 1997, The Orlando Sentinel began publishing New Homes and Auto Finder, which are free publications distributed in the Central Florida market. The Orlando Sentinel also offers printing and delivery of other publications. The Daily Press, Inc. (Newport News, Virginia) The Daily Press is published daily, including Sunday, and serves the Hampton Roads market. The Daily Press constitutes the only major daily newspaper in the market, although it competes with other regional and national newspapers, as well as other media. The Daily Press market includes Newport News, Hampton, Williamsburg and eight other cities and counties. This market, together with Norfolk, Portsmouth and Virginia Beach, is the 42nd largest U.S. market in terms of households. Approximately 82% of the paper's daily and 76% of its Sunday circulation is sold through home delivery, with the remainder sold at newsstands and vending boxes. The newsstand price of the daily edition increased by $.15 to $.50 in July 1996 The Sunday edition newsstand price was increased to $1.50 from $1.25 in October 1995. The weekly home delivery price was increased by $.30 to $3.05 in October 1995. The following tables set forth selected information for the Daily Press. The 1999 improvement in advertising volume was mainly due to increases in the food and drug, high-tech, automotive and help wanted advertising categories, partially offset by a decline in preprinted inserts from retailers. Related Businesses The Company is also involved in weekly publications, syndication activities, advertising placement services, entertainment listings, Internet and other online-related businesses, cable television news programming and other publishing-related activities. The Company acquired Sun-Sentinel Community News Group, a group of community-based weeklies, in September 1998. Sun-Sentinel Community News Group's publications include the Jewish Journal, a collection of newspapers serving South Florida's Jewish community. The syndication activities conducted primarily through Tribune Media Services ("TMS"), involve the marketing of comics, features and opinion columns to newspapers. TMS is also engaged in advertising placement services for television, cable and movie listings in newspapers and online and the development of news products and services for electronic and print media. In February 1999, TMS acquired both Premier DataVision, Inc. ("PDI") and JDTV, Inc. ("JDTV"). PDI distributes movie show-time data and advertisements. JDTV publishes television listings information for the cable and satellite television industries. Internet and other online-related businesses include the electronic publishing of each of the Company's daily newspapers with enhanced content on the Internet; operation of the Internet sites for the Company's broadcasting stations; and development of new online products and services. The Company also operates CLTV News, a regional 24-hour cable news channel in the Chicagoland area. CLTV News was launched in January 1993 and currently is available to more than 1.7 million cable households in the Chicago-area market. Total operating revenues for these publishing-related businesses are shown in the following table, net of intercompany revenues. Operating Revenues (In thousands) Fiscal Year Ended December -------- 1999................................ $108,742 1998................................ 52,364 1997................................ 30,827 Other revenues rose in 1999 primarily due to the acquisitions of JDTV and PDI (in February 1999) and Sun-Sentinel Community News Group (in September 1998) and increased revenues from Internet/electronic products. Broadcasting and Entertainment The broadcasting and entertainment segment represented 40% of the Company's consolidated operating revenues in 1999. At Dec. 26, 1999, the segment included WB television affiliates located in New York, Los Angeles, Chicago, Philadelphia, Boston, Dallas, Washington, D.C., Houston, Seattle, Miami, Denver, San Diego and Albany; FOX television affiliates in Seattle, Sacramento, Indianapolis, Hartford, Grand Rapids and Harrisburg; an ABC television affiliate in New Orleans; four radio stations, one located in Chicago and three located in Denver; the Chicago Cubs baseball team; and Tribune Entertainment, a company that develops and distributes first-run television programming for the Company's station group and national syndication. In March 1999, the Company acquired the assets of television station KCPQ-Seattle, with a fair value of approximately $380 million, in exchange for its WGNX-Atlanta television station and cash. In September 1999, the Company acquired the assets of television station WEWB-Albany (formerly WMHQ) for $18.5 million in cash. In November 1999, the Company acquired the assets of television station WBDC-Washington, D.C. for $125 million in cash. Federal Communications Commission ("FCC") regulations in effect at the time the exchange of WGNX-Atlanta for KCPQ-Seattle was consummated precluded the Company from owning both KCPQ and the Company's KTWB-Seattle (formerly KTZZ) television station. As part of the transaction, the Company transferred the assets of KTWB into a disposition trust. Pursuant to the terms of the disposition trust, an independent trustee was charged with finding a buyer for KTWB. On Aug. 5, 1999, the FCC adopted changes to its rules that now permit the Company to own both stations. The FCC revised its television duopoly rules to permit common ownership of two television stations within the same Nielsen Designated Market Area ("DMA"), provided that eight full-power independent television stations remain in the DMA and one of the stations is not among the top four-ranked stations in the DMA based on audience share. Based on the revised duopoly rule, the assets of KTWB were transferred back to the Company from the trust on Jan. 28, 2000. The operating results of KTWB have been included in the consolidated financial statements since its acquisition in June 1998. In June 1998, the Company exchanged substantially all of the assets of its WQCD radio station in New York and cash for the assets of television stations KTWB-Seattle and WXMI-Grand Rapids. The divestiture of WQCD was accounted for as a sale and the acquisition of the television stations was recorded as a purchase. In March 1997, the Company acquired Renaissance Communications Corp., a publicly traded company that owned six television stations, for $1.1 billion in cash. The stations acquired were KDAF-Dallas, WBZL-Miami, KTXL-Sacramento, WXIN-Indianapolis, WTIC-Hartford and WPMT-Harrisburg. The FCC order granting the Company's application to acquire the Renaissance stations contained waivers of two FCC rules. First, the FCC temporarily waived its duopoly rule relating to the overlap of WTIC's and WPMT's broadcast signals with those of other Tribune stations. The temporary waivers were granted subject to the outcome of the Aug. 5, 1999 FCC rulemaking which now permits the Company to own both stations. Second, the FCC granted a 12-month waiver of its rule prohibiting television/newspaper cross-ownership in the same market, which relates to the Miami television station and the Fort Lauderdale Sun-Sentinel newspaper. The FCC subsequently issued a rule review to consider modifying its cross-ownership rule. In March 1998, the FCC granted the Company a waiver extension to allow continued ownership of both the Miami television station and the Sun-Sentinel newspaper until the rule review has concluded. The Company cannot predict the outcome of the FCC cross-ownership rule review. In January 1996, the Company acquired television station KHWB-Houston for $102 million in cash. In February 1996, the Company acquired the remaining minority interest in WPHL-Philadelphia for $23 million in cash. In April 1996, the Company acquired television station KSWB-San Diego for $72 million in cash. In November 1995, the Company swapped its two Sacramento radio stations, KYMX and KCTC, for $3 million in cash and a Denver radio station. In June 1994, the Company acquired Farm Journal Inc., publisher of The Farm Journal, a leading farm magazine, for $17 million in cash. Farm Journal results were reported in radio until March 1997, when it was sold by the Company for approximately $17 million in cash. The acquisitions were accounted for as purchases. On Feb. 3, 2000, the Company acquired the remaining interest in Qwest Broadcasting LLC, which owned television stations WATL-Atlanta and WNOL-New Orleans, for $107 million in cash. The Company had owned a 33% equity interest and convertible debt in Qwest since it was formed in 1995. The acquisition was recorded as a purchase. The FCC's rule changes in August 1999 permit the Company to own both WNOL and the Company's WGNO-New Orleans television station. An application to acquire an additional television station, WTXX-Hartford, is currently pending before the FCC. The following table shows sources of revenue for the broadcasting and entertainment segment for the last three years. Operating Revenues (In thousands) Television In 1999, television contributed 85% of broadcasting and entertainment operating revenues. The Company's television stations compete for audience and advertising with other television and radio stations, cable television and other media serving the same markets. Competition for audience and advertising is based upon various interrelated factors including programming content, audience acceptance and price. Selected data for the Company's television stations is shown in the following table. Programming emphasis at the Company's WB and FOX-affiliated stations is placed on network-provided shows, syndicated series, feature motion pictures, local and regional sports coverage, news and children's programs. These stations acquire most of their programming from outside sources, including The WB Television Network ("The WB Network") and the FOX Network, although a significant amount is produced locally or supplied by Tribune Entertainment (see "Entertainment/Other"). Due to the growth and expansion of The WB Network's distribution system of local affiliates, WB programming is no longer aired on WGN Cable ("WGN Superstation"), which reaches over 48 million households outside of Chicago. WGN Superstation broadcasts movies and first-run programming. The Company's WGNO-New Orleans station, affiliated with the ABC Network, acquires much of its programming from that network. Contracts for purchased programming generally cover a period of one to five years, with payment also typically made over several years. The expense for amortization of television broadcast rights in 1999 was $309 million, which represented approximately 28% of total television operating revenues. Average audience share information for the Company's television stations for the past three years is shown in the following table. Average Audience Share (1) Year Ended December ------------------------- 1999 1998 1997 ----- ----- ----- WPIX - New York, NY....................... 9.5% 10.5% 10.0% KTLA - Los Angeles, CA.................... 8.0 7.8 8.3 WGN - Chicago, IL........................ 10.0 9.8 10.0 WPHL - Philadelphia, PA................... 5.5 4.8 4.5 WLVI - Boston, MA......................... 5.5 5.0 4.5 KDAF - Dallas, TX......................... 7.3 8.0 8.3 WBDC - Washington, D.C.................... 4.0 4.0 3.3 WATL - Atlanta, GA........................ 6.5 7.5 7.0 KHWB - Houston, TX........................ 6.5 6.3 6.5 KCPQ - Seattle, WA........................ 7.3 7.3 8.0 KTWB - Seattle, WA........................ 3.8 4.0 3.0 WBZL - Miami, FL.......................... 6.0 6.0 6.3 KWGN - Denver, CO......................... 6.8 6.5 8.0 KTXL - Sacramento, CA..................... 7.3 8.3 9.0 KSWB - San Diego, CA...................... 5.5 4.5 4.0 WXIN - Indianapolis, IN................... 6.5 7.3 8.0 WTIC - Hartford, CT....................... 6.8 6.8 7.5 WXMI - Grand Rapids, MI................... 7.5 7.8 8.5 WGNO - New Orleans, LA.................... 7.5 9.5 9.8 WNOL - New Orleans, LA.................... 7.0 6.8 7.0 WPMT - Harrisburg, PA..................... 6.0 6.3 7.8 WEWB - Albany, NY......................... 0.5 - (2) - (2) - ----- (1) Represents the estimated number of television households tuned to a specific station as a percent of total viewing households in a defined area. The percentages shown reflect the average Nielsen ratings shares for the February, May, July and November measurement periods for 7 a.m. to 1 a.m. daily. (2) Prior to acquisition in September 1999, WEWB-Albany was a public broadcasting station. Radio In 1999, the Company's radio operations contributed 4% of broadcasting and entertainment operating revenues. The largest radio station owned by the Company, measured in terms of operating revenues, is WGN in Chicago. Radio operations also include three stations in Denver and Tribune Radio Network (which produces and distributes farm and sports programming to radio stations, primarily in the Midwest). Also included were WQCD (which transferred station operations to Emmis Broadcasting through a management agreement in July 1997 and was subsequently exchanged for television stations KTWB-Seattle and WXMI-Grand Rapids in June 1998) and Farm Journal (until its sale in March 1997). Selected information for the Company's radio operations is shown in the following table. (2) Source: Arbitron Company 1999. (3) Source: Average of Winter, Spring, Summer and Fall 1999 Arbitron shares for persons 12 years old and over, 6 a.m. to midnight daily during the period measured. Entertainment/Other In 1999, entertainment/other contributed 11% of the segment's operating revenues. This portion of the broadcasting and entertainment segment includes Tribune Entertainment Company and the Chicago Cubs baseball team. Tribune Entertainment Company was formed to acquire and develop weekly programming for Company television stations and for syndication. Tribune Entertainment participates in the production and/or distribution of first-run programming, including television shows, music and variety shows, movies and specials. In 1999, Tribune Entertainment produced and syndicated a new weekly action hour, "Beastmaster," which airs on 164 stations that cover 95% of U.S. television households; and "DreamMaker," a one-hour show that was cancelled in January 2000. In September 1997, Tribune Entertainment launched two weekly action shows: "Gene Roddenberry's Earth: Final Conflict" and "NightMan." "Gene Roddenberry's Earth: Final Conflict" is aired on 183 stations that cover 98% of U.S. television households and has been renewed for the 1999-2000 and 2000-2001 television seasons. "NightMan" was not renewed for the 1999-2000 season. During the 1999-2000 television season, Tribune Entertainment originated or syndicated approximately 5.5 hours of first-run programs per week. On average, the Company's 22 television stations utilized approximately six hours per week of programming furnished by Tribune Entertainment. The Company owns the Chicago Cubs baseball team. In addition to providing local sports entertainment, the Cubs represent an important source of live programming for the Company's Chicago-based broadcasting operations and regional cable programming channel. In 1999, the Chicago Cubs reached an agreement with FOX Sports Chicago to provide coverage of selected Cubs games throughout the network's viewing region. Education The education segment represented 11% of the Company's consolidated operating revenues in 1999. The education segment specializes in learning products and services for use in schools and homes. The segment's primary business is supplemental and core curriculum materials for kindergarten through grade 12. The education segment also derives revenues from the adult basic education and consumer publishing markets. Subject areas include language arts, math, health and science, foreign language and social studies. In 1999, the education segment's revenues were derived as follows: 61% from the U.S. school channel, 31% from the U.S. consumer channel and 8% from sales outside the U.S. The market for education and consumer materials is highly competitive. The segment sells its products through several market channels, including direct-to-school, catalogs targeting teachers and administrators, parent/teacher stores, school and public libraries, bookstores, mass merchandisers, direct-to-consumer, teacher workshops, international distribution and educational toy stores. The segment utilizes both independent sales representatives and an internal sales force to sell its products. The segment's revenue is primarily driven by local school district funding rather than large state adoptions. Total operating revenues for the education segment for the last three years are shown below. Operating Revenues (In thousands) Fiscal Year Ended December -------- 1999................................ $339,606 1998................................ 329,310 1997................................ 225,533 Education operating revenues in 1999 improved mainly due to increased sales through the school market channel, partially offset by a decline in consumer book sales. In March 1999, the Company acquired Mimosa Publications, an Australia-based company that publishes reading, language arts, mathematics, science and English language teaching materials for several international school markets. In December 1999, the Company acquired Meeks-Heit Publishing Company, a publisher of a complete line of educational health materials and teacher supplements for the K-12 market. In December 1999, the Company acquired the high school academic product lines of South-Western Educational Publishing. In January 1998, the Company acquired ownership of the North American Sunshine line of educational materials, which are sold through The Wright Group. In July 1998, the Company acquired Living and Learning, a Cambridge, England-based publisher of supplemental and special education products. In September 1997, the Company acquired Shortland Publications Limited for $32 million in cash. Shortland is a New Zealand-based company that publishes reading, language arts, science and social studies materials for several international elementary school markets. In December 1997, the Company acquired approximately 80% of Landoll, Inc. for $77 million in cash. On Feb. 14, 2000, the Company acquired the remaining 20% of Landoll for approximately $18 million in cash. Landoll publishes children's educational and activity books for the retail market. In March 1996, the Company acquired Educational Publishing Corporation for $205 million in cash and NTC Publishing Group for $83 million in cash. Educational Publishing publishes supplemental and core curriculum education materials through its Creative Publications and Instructional Fair Publishing Group divisions. NTC Publishing publishes trade books and educational products for the school and consumer markets. In August 1995, the Company acquired Everyday Learning Corporation, a publisher of mathematics materials for grades K-12, for $25 million in cash. The acquisitions were accounted for as purchases. Investments The Company has investments in several public and private companies. See Note 5 to the Company's Consolidated Financial Statements in the 1999 Annual Report to Shareholders for a discussion of the Company's significant cost and equity method investments. The Company's principal equity method investments currently include The WB Network, Digital City and BrassRing Inc. The Company acquired a 13% equity interest in The WB Network in 1995 and exercised options to increase its ownership interest to 22% in 1997 and 25% in March 1998. The WB is a growing network that provides the Company's WB affiliate television stations with original prime-time and children's programming. In 1996, the Company purchased a 20% equity interest in Digital City, a venture with America Online to develop a national network of local interactive services. BrassRing is a national recruitment services company, which the Company formed in September 1999 with The Washington Post Company. Tribune's current 36% equity interest in BrassRing is expected to decline to 27.5% in March 2000, as a result of a proposed BrassRing acquisition to be effected as a merger. In 1995, the Company acquired a 33% equity interest in Qwest Broadcasting, which owned WB affiliate television stations in Atlanta and New Orleans. On Feb. 3, 2000, the Company acquired the remaining interest in Qwest Broadcasting. Non-Operating Items and Change in Accounting Principle In 1999, the Company elected early adoption of Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." See Note 1 to the Company's Consolidated Financial Statements in the 1999 Annual Report to Shareholders for further discussion. Also in 1999, the Company issued 8.0 million of its Exchangeable Subordinated Debentures due 2029 ("PHONES") indexed to the value of 16.0 million shares of America Online ("AOL") common stock. The Company also sold two million shares of AOL common stock, exchanged the Company's WGNX-Atlanta television station and cash for the assets of television station KCPQ-Seattle, and reclassified 16.0 million shares of AOL common stock and 5.5 million shares of Mattel common stock. In 1998, the Company sold its WQCD radio station subsidiary, sold a portion of its investment portfolio and wrote down certain investments. In 1997, the Company sold a portion of its investment portfolio and wrote down certain investments. See Note 2 to the Company's Consolidated Financial Statements in the 1999 Annual Report to Shareholders for a discussion of these non-operating items. Governmental Regulation Various aspects of the Company's operations are subject to regulation by governmental authorities in the United States. The Company's television and radio broadcasting operations are subject to FCC jurisdiction under the Communications Act of 1934, as amended. FCC rules, among other things, govern the term, renewal and transfer of radio and television broadcasting licenses, and limit concentrations of broadcasting control inconsistent with the public interest. Federal law also regulates the rates charged for political advertising and the quantity of advertising within children's programs. The Company is permitted to own both newspaper and broadcast operations in the Chicago market by virtue of "grandfather" provisions in the FCC regulations and in the Fort Lauderdale/Miami market by virtue of a temporary waiver of the television/newspaper cross-ownership rule. Congress removed national limits on the number of broadcast stations a licensee may own in 1996. However, federal law continues to limit the number of radio and television stations a single owner may own in a local market, and the percentage of the national television audience that may be reached by a licensee's television stations in the aggregate. On Aug. 5, 1999, the FCC revised its local station ownership limitations to allow, under certain conditions, common ownership of two television stations and certain radio/television combinations. The FCC did not revise its national audience reach limitation of 35%. The August 1999 changes may be subject to further review based on requests for reconsideration filed by interested parties. The television/newspaper cross-ownership rule remains under review by the FCC. Television and radio broadcasting licenses are subject to renewal by the FCC, at which time they may be subject to competing applications for the licensed frequencies. At Dec. 26, 1999, the Company had FCC authorization to operate 19 television stations and two AM and two FM radio stations. In 2000, the Company received FCC authorization to operate television stations KTWB-Seattle, WATL-Atlanta and WNOL-New Orleans. An application to acquire an additional television station, WTXX-Hartford, is currently pending before the FCC. The FCC has approved technical standards and channel assignments for digital television ("DTV") service. DTV will permit broadcasters to transmit video images with higher resolution than existing analog signals. Operators of full-power television stations have each been assigned a second channel for DTV while they continue analog broadcasts on the original channel. After the transition is complete, broadcasters will be required to return one of the two channels to the FCC and transmit exclusively in digital format. By law, the transition to DTV is to occur by Dec. 31, 2006, subject to extension under certain circumstances. Conversion to digital transmission will require all television broadcasters, including those owned by the Company, to invest in digital equipment and facilities. The Company does not believe that the required capital expenditures will have a material effect on its consolidated financial position or results of operations. The FCC has not yet issued regulations governing some aspects of DTV operation. These include the obligations of cable television systems and other multichannel video providers to carry DTV signals and additional "public interest" obligations that may be imposed on broadcasters' use of DTV. The FCC has adopted rules requiring broadcasters transmitting subscription-based services over the DTV channel to pay to the government fees in the amount of 5% on gross revenues collected from such services. From time to time, the FCC revises existing regulations and policies in ways that could affect the Company's broadcasting operations. In addition, Congress from time to time considers and adopts substantive amendments to the governing communications legislation. The Company cannot predict what regulations or legislation may be proposed or finally enacted or what effect, if any, such regulations or legislation could have on the Company's broadcasting operations. See "Item 3, Legal Proceedings" for a discussion of pending FCC rule review. Employees The average number of full-time equivalent employees of the Company in 1999 was 13,400, approximately 700 more than the average for 1998. The increase was mainly due to the net impact of the 1998 and 1999 acquisitions and divestitures and the growth of the Company's Internet/online businesses. Eligible employees participate in the Company's Employee Stock Ownership Plan ("ESOP"). Pension and other employee benefit plans are provided to employees of the Company. In connection with the establishment of the ESOP, the Company amended, effective January 1989, its Company-sponsored pension plan for employees not covered by a collective bargaining agreement. The pension plan continued to provide substantially the same pension benefits as under the pre-amended plan until December 1998. After this date, pension benefit credits are frozen in terms of pay and service. The Company also maintains several small plans for other employees. During 1999, the Company's publishing segment employed approximately 8,600 full-time equivalent employees, about 6% of whom were represented by a total of three unions. Contracts with unionized employees of the publishing segment expire at various times through September 2002. Broadcasting and entertainment had an average of 3,100 full-time equivalent employees in 1999. Approximately 22% of these employees were represented by a total of 22 unions. Contracts with unionized employees of the broadcasting and entertainment segment expire at various times through July 2003. Education had an average of 1,600 full-time equivalent employees in 1999. Approximately 3% of these employees were represented by one union. The contract with the unionized employees of the education segment expires in October 2001. Executive Officers of the Company Information with respect to the executive officers of the Company as of March 7, 2000 is set forth below. The descriptions of the business experience of these individuals include the principal positions held by them since March 1995. Dennis J. FitzSimons (49) Executive Vice President/Media Operations of the Company since January 2000; President since May 1997 and Executive Vice President until May 1997 of Tribune Broadcasting Company*. Jack W. Fuller (53) President since May 1997 of Tribune Publishing Company*; President and Publisher until May 1997 of Chicago Tribune Company*. Donald C. Grenesko (51) Senior Vice President/Finance and Administration since August 1996, Senior Vice President and Chief Financial Officer until August 1996 of the Company. David D. Hiller (46) Senior Vice President/Development of the Company. Crane H. Kenney (37) Vice President/General Counsel and Secretary since August 1996, Vice President/Chief Legal Officer from February 1996 to August 1996, Senior Counsel until January 1996 of the Company. Luis E. Lewin (51) Vice President/Human Resources since October 1996 and Director of Human Resources until October 1996 of the Company; Acting Publisher of Exito! in Chicago from December 1995 to September 1996. John W. Madigan (62) Chairman since January 1996, Chief Executive Officer since May 1995, President, and Chief Operating Officer until May 1995 of the Company; Director of the Company since 1975. Ruthellyn Musil (48) Vice President/Corporate Relations of the Company. Jeff R. Scherb (42) President of Tribune Interactive* since May 1999; Chief Technology Officer since August 1996 and Senior Vice President until May 1999 of the Company; Chief Technology Officer and Senior Vice President, Dun & Bradstreet Software until August 1996. - ----- * A subsidiary of the Company. ITEM 2. ITEM 2. PROPERTIES. The corporate headquarters of the Company are located at 435 North Michigan Avenue, Chicago, Illinois. The general character, location and approximate size of the principal physical properties used by the Company on Dec. 26, 1999 are listed below. In addition to those listed, the Company owns or leases transmitter sites, parking lots and other properties aggregating approximately 654 acres in 65 separate locations, and owns or leases an aggregate of approximately 1,486,000 square feet of space in 199 locations. The Company also owns the 39,000-seat stadium used by the Chicago Cubs baseball team. The Company considers its various properties to be in good condition and suitable for the purposes for which they are used. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries are defendants from time to time in actions for matters arising out of their business operations. In addition, the Company and its subsidiaries are involved from time to time as parties in various regulatory, environmental and other proceedings with governmental authorities and administrative agencies. In March 1997, the Company acquired Renaissance Communications Corp., a publicly traded company that owned six television stations, for $1.1 billion in cash. The stations acquired were KDAF-Dallas, WBZL-Miami, KTXL-Sacramento, WXIN-Indianapolis, WTIC-Hartford and WPMT-Harrisburg. The FCC order granting the Company's application to acquire the Renaissance stations contained waivers of two FCC rules. First, the FCC temporarily waived its duopoly rule relating to the overlap of WTIC's and WPMT's broadcast signals with those of other Tribune stations. The temporary waivers were granted subject to the outcome of the Aug. 5, 1999 FCC rulemaking, which now permits the Company to own both stations. Second, the FCC granted a 12-month waiver of its rule prohibiting television/newspaper cross-ownership in the same market, which relates to the Miami television station and the Fort Lauderdale Sun-Sentinel newspaper. The FCC subsequently issued a rule review to consider modifying its cross-ownership rule. In March 1998, the FCC granted the Company a waiver extension to allow continued ownership of both the Miami television station and the Sun-Sentinel newspaper until the rule review has concluded. The Company cannot predict the outcome of the FCC cross-ownership rule review. The Company does not believe that any of the matters or proceedings presently pending will have a material adverse effect on its consolidated financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is presently listed on the New York, Chicago and Pacific stock exchanges. The high and low sales prices of the Common Stock by fiscal quarter for the two most recent fiscal years, as reported on the New York Stock Exchange Composite Transactions list, were as follows: At March 7, 2000, there were 6,020 holders of record of the Company's Common Stock. Quarterly cash dividends declared on Common Stock were $.09 per share in 1999 and $.085 per share in 1998. Total cash dividends declared on Common Stock by the Company were $85,625,000 for 1999 and $82,426,000 for 1998. On Feb. 1, 1999, the Company issued 423,466 shares of Common Stock to shareholders of PDI in consideration for all of the issued and outstanding shares of PDI capital stock. These shares were issued in reliance upon the exemption provided by Section 4 (2) of the Securities Act of 1933, as amended. Other than the shares of Common Stock issued in connection with the PDI acquisition, during 1999, the Company did not sell any of its equity securities in transactions that were not registered under the Securities Act of 1933, as amended. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information for the years 1995 through 1999 contained under the heading "Eleven Year Financial Summary" in the Company's 1999 Annual Report to Shareholders is incorporated herein by reference. The following table shows basic earnings per share for the last 11 years. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information contained under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1999 Annual Report to Shareholders is incorporated herein by reference. YEAR 2000 COMPLIANCE - -------------------- The Company has experienced no significant operational effects as a result of the Year 2000 transition. The Company estimates total Year 2000 expenses will range from $17 million to $18 million, of which $15.9 million was incurred through Dec. 26, 1999. All costs have been expensed as incurred. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The information contained under the heading "Quantitative and Qualitative Disclosures About Market Risk" appearing on pages 36-38 in the Company's 1999 Annual Report to Shareholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's Consolidated Financial Statements and Notes thereto and the information contained under the heading "Business Segments" appearing on pages 39 through 63 of the Company's 1999 Annual Report to Shareholders, together with the report thereon of PricewaterhouseCoopers LLP dated January 21, 2000, except as to Note 17, which is as of February 14, 2000, appearing on page 68 of such Annual Report, and the information contained under the heading "Quarterly Results (Unaudited)" on pages 64 and 65, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information contained under the heading "Executive Officers of the Company" in Item 1 hereof, and the information contained under the heading "Board of Directors" and contained under the subheading "Section 16(a) Beneficial Ownership Reporting Compliance" under the heading "Stock Ownership" in the definitive Proxy Statement for the Company's May 2, 2000 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information contained under the heading "Executive Compensation" (except that portion relating to Item 13, below) and contained under the subheading "Director Compensation" under the heading "Board of Directors" in the definitive Proxy Statement for the Company's May 2, 2000 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information contained under the subheadings "Principal Shareholders" and "Management Ownership" under the heading "Stock Ownership" in the definitive Proxy Statement for the Company's May 2, 2000 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information contained under the subheading "Related Transactions" under the heading "Stock Ownership" and under the subheading "Compensation Committee Interlocks and Insider Participation" under the heading "Executive Compensation" (except that portion relating to Item 11, above) in the definitive Proxy Statement for the Company's May 2, 2000 Annual Meeting of Shareholders is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1)&(2) Financial Statements and Financial Statement Schedule filed as part of this report As listed in the Index to Financial Statements and Financial Statement Schedule on page 24 hereof. (a)(3) Index to Exhibits filed as part of this report As listed in the Exhibit Index beginning on page 27 hereof. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 13, 2000. TRIBUNE COMPANY (Registrant) /s/ John W. Madigan ------------------- John W. Madigan Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 13, 2000. Signature Title --------- ----- /s/ John W. Madigan ------------------- John W. Madigan Chairman, President and Chief Executive Officer and Director (principal executive officer) /s/ Donald C. Grenesko ---------------------- Donald C. Grenesko Senior Vice President/Finance and Administration (principal financial officer) /s/ R. Mark Mallory ------------------- R. Mark Mallory Vice President and Controller (principal accounting officer) Signature Title --------- ----- /s/ James C. Dowdle ------------------- James C. Dowdle Director /s/ Diego E. Hernandez ---------------------- Diego E. Hernandez Director /s/ Robert E. La Blanc ---------------------- Robert E. La Blanc Director /s/ Nancy Hicks Maynard ----------------------- Nancy Hicks Maynard Director /s/ Dudley S. Taft ------------------ Dudley S. Taft Director /s/ Arnold R. Weber ------------------- Arnold R. Weber Director TRIBUNE COMPANY AND FINANCIAL STATEMENT SCHEDULE Page Consolidated Statements of Income for each of the three fiscal years in the period ended December 26, 1999............................ * Consolidated Balance Sheets at December 26, 1999 and December 27, 1998...................................................... * Consolidated Statements of Cash Flows for each of the three fiscal years in the period ended December 26, 1999............... * Consolidated Statements of Shareholders' Equity for each of the three fiscal years in the period ended December 26, 1999............... * Notes to Consolidated Financial Statements................................ * Report of Independent Accountants on Consolidated Financial Statements.... * Report of Independent Accountants on Financial Statement Schedule......... 25 Financial Statement Schedule for each of the three fiscal years in the period ended December 26, 1999......................................... 26 Schedule II Valuation and qualifying accounts and reserves. - ----- * Incorporated by reference to the Company's 1999 Annual Report to Shareholders. See Item 8 of this Annual Report on Form 10-K. ----- All other schedules required under Regulation S-X are omitted because they are not applicable or not required. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Tribune Company Our audits of the consolidated financial statements referred to in our report dated January 21, 2000, except as to Note 17, which is as of February 14, 2000, appearing in the 1999 Annual Report to Shareholders of Tribune Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule listed in Item 14(a) of this Form 10-K. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PricewaterhouseCoopers LLP - ------------------------------ PricewaterhouseCoopers LLP Chicago, Illinois January 21, 2000, except as to Note 17, which is as of February 14, 2000 SCHEDULE II TRIBUNE COMPANY SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (In thousands of dollars) TRIBUNE COMPANY EXHIBIT INDEX Exhibits marked with an asterisk (*) are incorporated by reference to documents previously filed by Tribune Company with the Securities and Exchange Commission, as indicated. Exhibits marked with a circle (o) are management contracts or compensatory plan contracts or arrangements filed pursuant to Item 601(b)(10)(iii)(A) of Regulation S-K. All other documents listed are filed with this Report. Number Description ------ ----------- 3.1 * Restated Certificate of Incorporation of Tribune Company, dated April 21, 1987; Certificate of Designations of Series B Convertible Preferred Stock, dated April 4, 1989 (Exhibit 3.1 to Annual Report on Form 10-K for 1991). 3.1a * Amended Certificate of Designation of Series A Junior Participating Preferred stock, dated December 2, 1997 (Exhibit 3.1a to Annual Report on Form 10-K for 1997). 3.2 By-Laws of Tribune Company As Amended and In Effect on December 14, 1999. 4 * Rights Agreement between Tribune Company and First Chicago Trust Company of New York, as Rights Agent, dated as of December 12, 1997 (Exhibit 1 to Form 8-K Current Report dated December 12, 1997). 4.1 * Indenture, dated as of March 1, 1992 between Tribune Company and Bank of Montreal Trust Company (as successor to Continental Bank, National Association) (Exhibit 4.1 to Registration Statement on Form S-3, Registration No. 333-02831). 4.2 * Indenture, dated as of January 1, 1997 between Tribune Company and Bank of Montreal Trust Company (Exhibit 4 to Form 8-K Current Report dated January 14, 1997). 4.3 * Indenture, dated as of April 1, 1999 between Tribune Company and Bank of Montreal Trust Company (Exhibit 4 to Form 8-K Current Report dated April 5, 1999). 4.4 * Form of First Supplemental Indenture between Tribune Company and Bank of Montreal Trust Company relating to the DECS Securities (Exhibit 4.1 to Form 8-K Current Report dated July 30, 1998). 4.5 * Form of Global Note relating to the DECS Securities (Exhibit 4.2 to Form 8-K Current Report dated July 30, 1998). 4.6 * Form of Exchangeable Subordinated Debenture due 2029 relating to PHONES securities (Exhibit 4 to Form 8-K Current Report dated April 13, 1999). 10.1 o* Chicago Tribune Company Split-Dollar Insurance Plan dated June 29, 1978, together with first amendment dated August 28, 1981, covering certain employees of Tribune Company and Chicago Tribune Company (Exhibit 10.4 in File No. 2-86087). 10.2 o* Tribune Company Supplemental Retirement Plan, as amended and restated on January 1, 1989 (Exhibit 10.6 to Annual Report on Form 10-K for 1988). Number Description ------ ----------- 10.2a o* First Amendment of Tribune Company Supplemental Retirement Plan, effective January 1, 1994 (Exhibit 10.4b to Annual Report on Form 10-K for 1993). 10.3 o* Tribune Company Directors' Deferred Compensation Plan, as amended and restated on July 1, 1994 (Exhibit 10.7 to Annual Report on Form 10-K for 1994). 10.4 o* Tribune Company Bonus Deferral Plan, dated as of December 14, 1993 (Exhibit 10.8 to Annual Report on Form 10-K for 1993). 10.4a o* First Amendment of Tribune Company Bonus Deferral Plan, effective December 1, 1996 (Exhibit 10.4a to Annual Report on Form 10-K for 1996). 10.5 o* Tribune Company Amended and Restated 1984 Long-Term Performance Plan, effective as of July 25, 1989 (Exhibit 19.2 to Form 10-Q Quarterly Report for the quarter ended June 25, 1989); Forms of Incentive Stock Option Agreement and Non-Qualified Stock Option Agreements for Tribune Company Amended and Restated 1984 Long-Term Performance Plan (Exhibit 19.2 to Form 10-Q Quarterly Report for the quarter ended July 1, 1990). 10.6 o* Tribune Company 1992 Long-Term Incentive Plan, dated as of April 29, 1992 and as amended and in effect on April 19, 1994 (Exhibit 10.11 to Annual Report on Form 10-K for 1994). 10.7 o* Tribune Company Executive Financial Counseling Plan, dated October 19, 1988 and as amended effective January 1, 1994 (Exhibit 10.13 to Annual Report on Form 10-K for 1993). 10.8 o* Tribune Company Amended and Restated Transitional Compensation Plan for Executive Employees, effective as of December 7, 1998 (Exhibit 10.8 to Annual Report on Form 10-K for 1998). 10.9 o* Tribune Company Supplemental Defined Contribution Plan, effective as of January 1, 1994 and as amended effective January 1, 1999 (Exhibit 10.9 to Annual Report on Form 10-K for 1998). 10.10 o Tribune Company Employee Stock Purchase Plan (as amended and restated effective July 27, 1999). 10.11 o* 1988 Restricted Stock Plan For Outside Directors, dated February 16, 1988 (Exhibit 10.12 to Annual Report on Form 10-K for 1992). 10.11a o* Amendment effective April 28, 1992 to the 1988 Restricted Stock Plan For Outside Directors (Exhibit 10.12b to Annual Report on Form 10-K for 1993). 10.12 o Tribune Company 1995 Nonemployee Director Stock Option Plan (as amended and restated effective January 1, 2000). 10.13 o* Tribune Company Amended and Restated 1996 Nonemployee Director Stock Compensation Plan, dated as of February 17, 1998 (Exhibit 10.14 to Annual Report on Form 10-K for 1997). 10.14 o* Tribune Company 1997 Incentive Compensation Plan effective December 29, 1996 (Exhibit 10.15 to Form 10-Q Quarterly Report for the quarter ended March 30, 1997). 12 Computation of Ratios of Earnings to Fixed Charges. Number Description ------ ----------- 13 The portions of the Company's 1999 Annual Report to Shareholders which are specifically incorporated herein by reference. 21 Table of subsidiaries of Tribune Company. 23 Consent of Independent Accountants. 27 Financial Data Schedule. 99 Form 11-K financial statements for the Tribune Company Savings Incentive Plan (to be filed by amendment).

859139_1999.txt

859139_1999

1999

859139

ITEM 1. BUSINESS Delphi Financial Group, Inc. (the "Company," which term includes the Company and its consolidated subsidiaries unless the context indicates otherwise), organized as a Delaware corporation in 1987, is a holding company whose subsidiaries provide integrated employee benefit services. The Company manages all aspects of employee absence to enhance the productivity of its clients and provides the related insurance coverages: long-term and short-term disability, excess and primary workers' compensation, group life and travel accident. The Company's asset accumulation business emphasizes individual annuity products. The Company offers its products and services in all fifty states and the District of Columbia. The Company's two reportable segments are group employee benefit products and asset accumulation products. See Note A and Note P to the Consolidated Financial Statements for additional information regarding the Company's segments. OPERATING STRATEGY The Company's operating strategy is to offer financial products and services which have the potential for significant growth or which require expertise to meet the specialized needs of its customers and which offer the Company the opportunity to earn an above average return on its shareholders' capital. The Company has concentrated its efforts within certain niche insurance markets, primarily group employee benefits for small to mid-sized employers where nearly all the employment growth in the American economy has occurred in the last few years. The Company markets unbundled employee benefit products and absence management services as well as programs that integrate both employee benefit products and absence management services. The Company also operates an asset accumulation business that focuses primarily on offering fixed annuities to individuals planning for retirement. The Company's operating strategy has contributed to an average return on shareholders' equity of 21% from January 1988 to December 1999. Over this same period, net income and shareholders' equity have grown at a compound annual rate of 24% and 29%, respectively, and book value per share has grown at a compound annual rate of 23%. This strategy has also contributed to a 12% compound annual growth rate in insurance premiums and fee income during the period from January 1988 to December 1999 and an increase in total assets from $819.1 million at December 31, 1987 to $3,395.7 million at December 31, 1999, a compound annual growth rate of 13%. The Company's primary operating subsidiaries are as follows: Reliance Standard Life Insurance Company ("RSLIC"), founded in 1907 and having administrative offices in Philadelphia, Pennsylvania, and its subsidiary, First Reliance Standard Life Insurance Company ("FRSLIC"), underwrite a diverse portfolio of life and accident and health insurance products targeted principally to the employee benefits market. These companies also market asset accumulation products, primarily fixed annuities, to individuals and groups. The Company, through Reliance Standard Life Insurance Company of Texas ("RSLIC-Texas"), acquired RSLIC and FRSLIC in November 1987. Safety National Casualty Corporation ("SNCC") is an insurance specialist that focuses primarily on providing workers' compensation products to the self-insured market. Founded in 1942 and located in St. Louis, Missouri, SNCC is one of the oldest continuous writers of excess workers' compensation insurance in the United States. The Company acquired SNCC in March 1996. See "Other Transactions" and Note B to the Consolidated Financial Statements. Matrix Absence Management, Inc. ("Matrix") provides integrated disability and absence management services to the employee benefits market across the United States. Headquartered in San Jose, California, Matrix was acquired by the Company in June 1998. See "Other Transactions" and Note B to the Consolidated Financial Statements. GROUP EMPLOYEE BENEFIT PRODUCTS The Company emphasizes the origination of specialty insurance products directed to the employee benefits market, primarily group life, disability, workers' compensation and travel accident insurance. The Company also offers group dental insurance. The Company markets its group products to employer-employee groups and associations in a variety of industries. The Company insures groups ranging from 2 to more than 1,000 individuals, although the average size of insured groups currently ranges from 100 to 300 individuals. In underwriting its group employee benefit products, the Company attempts to avoid concentrations of business in any industry segment or geographic area. The following table sets forth, for the periods indicated, selected financial data concerning the Company's group employee benefit products: The profitability of group employee benefit products is affected by, among other things, differences between actual and projected claims experience and the ability to control administrative expenses. The table below shows the loss and expense ratios as a percent of premium income for the Company's group employee benefit products for the periods indicated. Changes in the components of the ratio between years primarily reflect changes in the Company's product mix. The Company's group life insurance products provide for the payment of a stated amount upon the death of a member of the insured group and policy terms are generally one year. Accidental death and dismemberment insurance, which provides for the payment of a stated amount upon the accidental death or dismemberment of a member of the insured group, is frequently sold in conjunction with group life policies and is included in premiums charged for group life insurance. The Company reinsures risks in excess of $150,000 per individual for employer provided group life insurance policies and $100,000 for voluntary group term life policies. See "Reinsurance." Group disability products offered by the Company, principally long-term disability insurance, generally provide a specified level of periodic benefits to persons who, because of sickness or injury, are unable to work for a specified period of time. The Company focuses group long-term disability sales toward employers engaged principally in service industries such as accounting, architecture and engineering, as well as certain retailing and manufacturing fields. Long-term disability benefits generally are paid monthly and typically are limited for any one employee to two-thirds of the employee's earned income up to a specified maximum benefit. The Company actively manages its disability claims, working with claimants to help them return to work as quickly as possible. When insureds' disabilities prevent them from returning to their original jobs, the Company, in appropriate cases, provides assistance in developing new productive skills for an alternative career. Premiums are generally determined annually for disability insurance and are based upon expected morbidity and emerging experience of the insured group, as well as assumptions regarding operating expenses and future interest rates. The Company reinsures risks in excess of $2,500 per individual per month. See "Reinsurance." The Company's workers' compensation products include excess workers' compensation, workers' compensation self-insured loss portfolio transfers, workers' compensation self-insurance bonds and primary workers' compensation insurance with risk sharing features. Historically, the Company has specialized in excess workers' compensation insurance which provides coverage to employers and groups who self-insure their workers' compensation risks. The coverage applies to losses in excess of the applicable self-insured retentions ("SIRs" or deductibles) of employers and groups, whose workers' compensation claims are generally handled by third-party administrators ("TPAs"). This product is principally targeted to mid-sized companies and association groups, particularly small municipalities, hospitals and schools. These companies and groups tend to be less prone to catastrophic workers' compensation exposures and less price sensitive than larger account business. Because claim payments do not begin until after the SIR is met, it takes an average of 15 years from the date the claim is incurred to the time claim payments begin. At that point, the payments are primarily for wage replacement, similar to the benefit provided under disability coverage. Medical payments, if any, tend to be stable and predictable. The Company began to actively market its other workers' compensation products during 1998 due to the weak pricing environment in the excess workers' compensation sector. These products are typically marketed to the same types of clients who have historically purchased the Company's excess workers' compensation product. The Company reinsures excess workers' compensation risks between $500,000 and $50.0 million per policy per occurrence and primary workers' compensation up to $3.0 million per policy per occurrence. See "Reinsurance." The Company's other group insurance products include business travel and "all risk" accidental death and dismemberment insurance. These policies pay a stated amount based on a predetermined schedule in the event of accidental dismemberment or death of a member of the insured group. The Company reinsures risks in excess of $150,000 per individual and, under a catastrophe reinsurance agreement, the amount of the Company's loss arising from any one occurrence is limited to $500,000. See "Reinsurance." The Company's other group insurance products also include group dental insurance, which provides coverage for preventive, restorative and specialized dentistry up to a stated maximum benefit per individual per year. The Company's group employee benefit products are sold primarily by independent brokers, agents and TPAs. The Company's home office and 23 sales offices located throughout the country provide nationwide sales support and service existing business. The Company believes that its national sales network minimizes expenses traditionally associated with large insurance company captive marketing systems. ASSET ACCUMULATION PRODUCTS The Company's asset accumulation products consist primarily of annuity products, principally single premium deferred annuities ("SPDAs") and flexible premium annuities ("FPAs"). An SPDA provides for a single payment by an annuity holder to the Company and the crediting of interest by the Company at the applicable crediting rate. An FPA provides for periodic payments by an annuity holder to the Company, the timing and amount of which are at the discretion of the annuity holder, and the crediting of interest by the Company at the applicable crediting rate. Interest credited on SPDAs and FPAs is not paid currently to the annuity holder but instead accumulates and is added to the annuity holder's account value. This accumulation is tax deferred. The crediting rate may be increased or decreased by the Company annually, typically on the policy anniversary, subject to specified guaranteed minimum crediting rates. Minimum guaranteed crediting rates currently range from 3.00% to 5.50%. Withdrawals may be made at any time, but some withdrawals may result in the assessment of surrender charges, market value adjustments, taxes, and/or tax penalties on the withdrawn amount. The Company principally markets SPDA products, including a product with a market value adjustment ("MVA") feature that provides for an adjustment to the accumulated value of the policy if it is surrendered during the surrender charge period. These products are sold predominantly through networks of independent agents. In 1999, the Company's SPDA products accounted for $77.3 million of asset accumulation product deposits, of which $66.5 million was attributable to the MVA annuity product. Three networks of independent agents accounted for approximately 55% of the deposits from these products during 1999, with no other network of independent agents accounting for more than 10% of these deposits. The Company believes that it has a good relationship with these networks. Prior to 1995, the Company's strategy with respect to this product line focused primarily on the acquisition of blocks of annuity business from other insurers. See "Reinsurance." The following table sets forth for the periods indicated selected financial data concerning the Company's asset accumulation products: At December 31, 1999, funds under management consisted of $566.9 million of SPDA liabilities and $78.7 million of FPA liabilities, with a weighted average crediting rate of 5.48%. Of these liabilities, $264.7 million were subject to surrender charges averaging 7.35% at December 31, 1999. Annuity liabilities not subject to surrender charges have been in force, on average, for 18 years. The Company prices its annuity products based on assumptions concerning prevailing and expected interest rates and other factors to achieve a positive difference, or spread, between its expected return on investments and the crediting rate. The Company achieves this spread by active portfolio management focusing on matching the durations of invested assets and related liabilities to minimize the exposure to fluctuations in market interest rates and by the adjustment of the crediting rate on its annuity products. In response to changes in interest rates, the Company increases or decreases the crediting rates on its annuity products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Asset/Liability Management and Market Risk." In light of the annuity holder's ability to withdraw funds and the volatility of market interest rates, it is difficult to predict the timing of the Company's payment obligations under its SPDAs and FPAs. Consequently, the Company maintains a portfolio of investments which are readily marketable and expected to be sufficient to satisfy liquidity requirements. See "Investments." OTHER PRODUCTS AND SERVICES The Company provides integrated disability and absence management services through Matrix, which was acquired in June 1998. See Note B to the Consolidated Financial Statements. The Company offers a comprehensive package of disability and absence management services designed to assist clients in identifying and minimizing lost productivity and benefit payment costs resulting from employee absence due to illness, injury or personal leave. Services that the Company offers include event reporting, leave of absence management, claims and case management and return to work management. The goal of these services is to enhance employee productivity and provide more efficient benefit delivery and enhanced cost containment. Included among the Company's clients for these services are approximately half of the Fortune 500 companies located in California, where most of Matrix's business was located prior to the acquisition. Subsequent to the acquisition of this business, the Company has begun to expand the offering of these services on a nationwide basis through the Company's national sales offices. In 1991, the Company introduced a variable flexible premium universal life insurance policy under which the related assets are segregated in a separate account not subject to claims of general creditors of the Company. Policyholders may elect to deposit amounts in the account from time to time, subject to underwriting limits and a minimum initial deposit of $1.0 million. Both the cash values and death benefits of these policies fluctuate according to the investment experience of the assets in the separate account; accordingly, the investment risk with respect to these assets is borne by the policyholders. The Company earns fee income from the separate account in the form of charges for management and other administrative fees. The Company is not presently actively marketing this product. The Company reinsures risks in excess of $200,000 per individual under indemnity reinsurance arrangements with various reinsurance companies. See "Reinsurance." UNDERWRITING PROCEDURES Premiums charged on insurance products are based in part on assumptions about the incidence and timing of insurance claims. The Company has adopted and follows detailed underwriting procedures designed to assess and qualify insurance risks before issuing policies to groups and individuals. To implement these procedures, the Company employs a professional underwriting staff. In underwriting group coverage, the Company focuses on the risk characteristics of the group to be insured as a whole. A prospective group is evaluated with particular attention paid to the claims experience of the group with prior carriers, the occupations of the insureds, the nature of the business of the group, the current economic outlook of the group in relation to others in its industry and of the industry as a whole, the appropriateness of the benefits or SIR applied for and income from other sources during disability. The Company's products generally afford it the flexibility to adjust premiums charged annually to its policyholders in order to reflect emerging mortality or morbidity experience. INVESTMENTS The Company's management of its investment portfolio is an important component of its profitability since a substantial portion of its operating income is generated from the difference between the yield achieved on invested assets and the interest credited on policyholder funds and reserves. The Company's overall investment strategy to achieve its objectives of safety and liquidity, while seeking the best available return, focuses on, among other things, managing the durations of the Company's interest-sensitive assets and liabilities and minimizing the Company's exposure to fluctuations in interest rates. For information regarding the composition and diversification of the Company's investment portfolio and asset/liability management, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and Notes A, C and I to the Consolidated Financial Statements. The following table sets forth for the periods indicated the Company's pretax investment results: (1) Average invested assets are computed by dividing the total of the amortized cost of investments at the beginning of the period reduced by investment related liabilities plus the individual quarter-end balances by five and deducting one-half of net investment income. (2) Consists principally of interest and dividend income less investment expenses. (3) The weighted average annual yield on the Company's investment portfolio for each period is computed by dividing net investment income (exclusive of realized and unrealized gains and losses) by average invested assets for the period. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." REINSURANCE The Company participates in various reinsurance arrangements both as the ceding insurer and as the assuming insurer. Arrangements in which the Company is the ceding insurer afford various levels of protection against excessive loss by assisting the Company in diversifying its risks and by limiting its maximum loss on risks that exceed retention limits. Under indemnity reinsurance transactions in which the Company is the ceding insurer, the Company is exposed to a degree of risk if the assuming company is unable to meet its obligations. To limit this risk, the Company monitors the financial condition of its reinsurers, including, among other things, the companies' financial ratings, and in certain cases receives collateral security from the reinsurer. Also, certain of the Company's reinsurance agreements require the reinsurer to set up trust arrangements for the Company's benefit in the event of certain ratings downgrades. The Company cedes portions of the risks relating to its group employee benefit and variable life insurance products under indemnity reinsurance agreements with various unaffiliated reinsurers. The terms of these agreements, which are typical for agreements of this type, provide, among other things, for the automatic acceptance by the reinsurer of ceded risks in excess of the Company's retention limits stated in the agreements. The Company pays reinsurance premiums to these reinsurers which are, in general, based upon percentages of premiums received by the Company on the business reinsured less, in certain cases, ceding commissions and experience refunds paid by the reinsurer to the Company. These agreements are generally terminable at any time as to new risks by either the Company or the reinsurer on appropriate notice; however, termination does not affect risks ceded during the term of the agreement, which generally remain with the reinsurer. See Note O to the Consolidated Financial Statements. In January 1998, an offering was completed whereby shareholders and optionholders of the Company received, at no cost, rights to purchase shares of Delphi International Ltd. ("Delphi International"), a newly-formed, independent Bermuda insurance holding company. During 1998, the Company entered into various reinsurance agreements with Oracle Reinsurance Company Ltd. ("Oracle Re"), a wholly owned subsidiary of Delphi International. Pursuant to these agreements, approximately $101.5 million of group employee benefit reserves ($35.0 million of long-term disability insurance reserves and $66.5 million of net excess workers' compensation and casualty insurance reserves) were ceded to Oracle Re. The Company has received collateral security from Oracle Re in an amount sufficient to support the ceded reserves. In May 1999, Oracle Re and the Company effected the partial recapture of approximately 35%, or $10 million, of the long-term disability liabilities ceded to Oracle Re. These agreements are not expected to have a material effect on the Company's financial condition, liquidity or results of operations. The Company has participated as an assuming insurer in a number of reinsurance pools. These reinsurance pools generally are administered by TPAs or managing underwriters who underwrite risks, coordinate premiums charged and process claims. The Company has the right, generally exercisable annually, to terminate or change its participation in any of these pools as to new business. In 1999, these reinsurance pools represented, in the aggregate, $59.7 million of premiums and $57.4 million of benefits, and the Company's five largest participations in these reinsurance pools represented $51.2 million of earned premiums and $49.5 million of benefits. In the fourth quarter of 1999, the Company discontinued its participation in a federal employee group life reinsurance pool in order to enhance available resources for products believed to offer greater financial potential. Premium income from this reinsurance pool totaled $32.8 million in 1999 and incurred benefits totaled $32.4 million. In addition, in the first quarter of 2000, the Company terminated, on a prospective basis, its participations in all except three of the other reinsurance pools in which the Company participated. The Company plans to terminate its participation in the remaining three reinsurance pools as of July 1, 2000. However, the terms of such pools provide for the continued assumption of risks by, and payments of premiums to, pool participants with respect to business written in the periods during which they formerly participated in such pools. The Company does not expect its withdrawals from these reinsurance pools to have a material impact on its underwriting results. In addition, the Company acquired five blocks of annuity policies between 1988 and 1992 that resulted in the assumption of $967.1 million of policyholder account balances. The first acquisition was an assumption reinsurance transaction, and the others were indemnity reinsurance transactions. In the case of each acquisition, assets supporting the related reserves were transferred to, and are managed by, the Company. Pursuant to the assumption reinsurance acquisition, the Company has the right to establish the crediting rate with respect to the business acquired. The Company has the right under each indemnity reinsurance transaction to recommend to the ceding company crediting rates with respect to the business acquired. The ceding company is solely responsible for payment of crediting rates to the extent that these rates exceed the greater of the recommended rate and certain benchmark rates. The aggregate lapse rates experienced on the annuity acquisitions have been consistent with the levels assumed in pricing the transactions and consequently have not adversely affected the Company's liquidity or results of operations. LIFE AND ACCIDENT AND HEALTH INSURANCE RESERVES The Company carries as liabilities actuarially determined reserves to satisfy its life, accident and health and annuity policy and contract obligations. These reserves, together with premiums to be received on policies in force and interest thereon at certain assumed rates, are calculated to be sufficient to satisfy policy and contract obligations. The Company performs periodic studies to compare current experience for mortality, interest and lapse rates with expected experience in the reserve assumptions to determine future policy benefit reserves for these products. Differences are reflected currently in earnings for each period. The Company has not experienced significant adverse deviations from its assumptions. The life and accident and health insurance reserves carried in the Consolidated Financial Statements are calculated based on accounting principles generally accepted in the United States ("GAAP") and differ from those reported by the Company for statutory financial statement purposes. These differences arise from the use of different mortality and morbidity tables and interest assumptions, the introduction of lapse assumptions into the reserve calculation and the use of the net level method on all insurance business. See Note A to Consolidated Financial Statements for certain additional information regarding reserve assumptions under GAAP. WORKERS' COMPENSATION INSURANCE RESERVES The Company carries as liabilities actuarially determined reserves for anticipated claims and claim expenses for its workers' compensation insurance and other casualty insurance products. Reserves for claim expenses represent the estimated probable costs of investigating those claims and, when necessary, defending lawsuits in connection with those claims. Reserves for claims and claim expenses are estimated based on individual loss data, historical loss data and industry averages and indices and include amounts determined on the basis of individual and actuarially determined estimates of future losses. Therefore, the ultimate liability could deviate from the amounts currently reflected in the Consolidated Financial Statements. Reserving practices under GAAP allow discounting of claim reserves related to workers' compensation losses to reflect the time value of money. Reserve discounting for these types of claims is common industry practice, and the discount factors used are less than the annual tax-equivalent investment yield earned by the Company on its invested assets. Reserves for claim expenses are not discounted. The following table provides a reconciliation of beginning and ending unpaid claims and claim expenses for the periods indicated and excludes the effects of reinsurance: (1) The change in estimated claims and claim expenses incurred in prior years reflects favorable claims development offset by the accretion of discount on reserves. The effects of the discount to reflect the time value of money have been removed from the loss development table which follows in order to present the gross loss development. This discount totaled $176.7 million, $180.8 million, and $192.2 million at December 31, 1997, December 31, 1998 and December 31, 1999, respectively. During 1999, $8.6 million of discount was amortized, and $20.0 million was accrued. The loss development table below illustrates the development of reserves from March 5, 1996 to December 31, 1999 and excludes the effects of reinsurance. (1) Amounts are as of or for the periods subsequent to March 5, 1996, the date the Company acquired its workers' compensation business. The "Reserve for unpaid claims and claim expenses" line of the table above shows the estimated reserve for unpaid claims and claim expenses recorded at the end of each of the periods indicated. These liabilities represent the estimated amount of losses and expenses for claims arising in the current year and all prior years that are unpaid at the end of each period. The "Cumulative amount of liability paid" line of the table represents the cumulative amounts paid with respect to the liability previously recorded as of the end of each succeeding period. The "Liability reestimated" line of the table shows the reestimated amount relating to the previously recorded liability and is based upon experience as of the end of each succeeding period. This estimate is either increased or decreased as additional information about the frequency and severity of claims for each period becomes available and is reviewed. The Company periodically reviews the estimated reserves for claims and claim expenses and any changes are reflected currently in earnings for each period. The Company has not experienced significant adverse deviations from its assumptions. The "Cumulative redundancy" line of the table represents the aggregate change in the estimated claim reserve liabilities from the dates indicated through December 31, 1999. The workers' compensation insurance reserves carried in the Consolidated Financial Statements are calculated in accordance with GAAP and, net of reinsurance, are approximately $41.2 million less than those reported by the Company for statutory financial statement purposes at December 31, 1999. This difference is primarily due to the use of different discount factors under GAAP and statutory accounting principles. See Note A to Consolidated Financial Statements for certain additional information regarding reserve assumptions under GAAP. COMPETITION The financial services industry is highly competitive. The Company competes with numerous other insurance and financial services companies both in connection with sales of insurance and asset accumulation products and integrated disability and absence management services and in acquiring blocks of business and companies. Many of these organizations have substantially greater asset bases, higher ratings from ratings agencies, larger and more diversified portfolios of insurance products and larger sales operations. Competition in asset accumulation product markets is also encountered from the expanding number of banks, securities brokerage firms and other financial intermediaries marketing alternative savings products, such as mutual funds, traditional bank investments and retirement funding alternatives. In November 1999, the Gramm-Leach-Bliley financial modernization act, which removed many of the restrictions on affiliations among banking, securities and insurance organizations, was signed into law. Although it is too early to assess the effects of this legislation, this act could result in additional competition in the markets in which the Company sells its products. The Company believes that its reputation in the marketplace, quality of service and investment returns have enabled it to compete effectively for new business in its targeted markets. The Company reacts to changes in the marketplace generally by focusing on products with adequate margins and attempting to avoid those with low margins. The Company believes that its smaller size, relative to some of its competitors, enables it to more easily tailor its products to the demands of customers. REGULATION The Company's insurance subsidiaries are regulated by state insurance authorities in the states in which they are domiciled and the states in which they conduct business. These regulations, among other things, limit the amount of dividends and other payments that can be made by the Company's insurance subsidiaries without prior regulatory approval and impose restrictions on the amount and type of investments these subsidiaries may have. These regulations also affect many other aspects of the Company's insurance subsidiaries' business, including, for example, risk-based capital ("RBC") requirements, various reserve requirements, the terms, conditions and manner of sale and marketing of insurance products and the form and content of required financial statements. These regulations are intended to protect policyholders rather than investors. The Company's insurance subsidiaries are required under these regulations to file detailed annual reports with the supervisory agencies in the various states in which they do business, and their business and accounts are subject to examination at any time by these agencies. To date, no examinations have produced any significant adverse findings or adjustments. In 1998, the National Association of Insurance Commissioners (the "NAIC") approved a codification of statutory accounting principles, effective January 1, 2001, which will serve as a comprehensive and standardized guide to statutory accounting principles. The adoption of the codification will change, to some extent, the accounting practices that the Company's insurance subsidiaries use to prepare their statutory financial statements; however, the Company does not believe that such changes will have a material adverse impact on the reported statutory financial condition of any such subsidiaries. From time to time, increased scrutiny has been placed upon the insurance regulatory framework, and a number of state legislatures have considered or enacted legislative measures that alter, and in many cases increase, state authority to regulate insurance companies. In addition to legislative initiatives of this type, the NAIC and insurance regulators are continuously involved in a process of reexamining existing laws and their application to insurance companies. Furthermore, while the federal government currently does not directly regulate the insurance business, federal legislation and administrative policies in a number of areas, such as employee benefits regulation, age, sex and disability-based discrimination, financial services regulation and federal taxation, can significantly affect the insurance business. It is not possible to predict the future impact of changing regulation on the operations of the Company and its insurance subsidiaries. The NAIC's RBC requirements for insurance companies take into account asset risks, insurance risks, interest rate risks and other relevant risks with respect to the insurer's business and specify varying degrees of regulatory action to occur to the extent that an insurer does not meet the specified RBC thresholds, with increasing degrees of regulatory scrutiny or intervention provided for companies in categories of lesser RBC compliance. The Company believes that its insurance subsidiaries are adequately capitalized under the RBC requirements and that the thresholds will not have any significant regulatory effect on the Company. However, were the insurance subsidiaries' RBC position to decline in the future, the insurance subsidiaries' continued ability to pay dividends and the degree of regulatory supervision or control to which they are subjected may be affected. The Company's insurance subsidiaries can also be required, under solvency or guaranty laws of most states in which they do business, to pay assessments to fund policyholder losses or liabilities of insurance companies that become insolvent. These assessments may be deferred or forgiven under most solvency or guaranty laws if they would threaten an insurer's financial strength and, in most instances, may be offset against future state premium taxes. None of the Company's insurance subsidiaries has ever incurred any significant costs of this nature. EMPLOYEES The Company and its subsidiaries employed approximately 794 persons at December 31, 1999. The Company believes that it enjoys good relations with its employees. OTHER SUBSIDIARIES The Company conducts certain of its investment management activities through its wholly-owned subsidiary, Delphi Capital Management, Inc. ("DCM"), and makes certain investments through other wholly-owned non-insurance subsidiaries. OTHER TRANSACTIONS On March 5, 1996, SIG Holdings, Inc. ("SIG") and its subsidiary SNCC were merged into a subsidiary of the Company (the "SIG Merger") for consideration of approximately $131.9 million consisting of $54.5 million of cash, net of approximately $1.0 million payable upon the exercise of certain SIG stock options, and approximately 5.7 million shares of the Company's Class A Common Stock, including shares reserved for issuance upon the exercise of stock options of SIG assumed by the Company in connection with the merger (the "SIG Options"), plus contingent consideration of up to $20.0 million if SIG met specified earnings targets subsequent to the merger. Because SIG had met all of the specified earnings targets, the Company paid $10.0 million of the contingent consideration consisting of $6.9 million of cash and 63,000 shares of the Company's Class A Common Stock during 1998 and the remaining $10.0 million of the contingent consideration consisting of $9.0 million of cash and 30,000 shares of the Company's Class A Common Stock in 1999. The Company also assumed $45.0 million of SIG's 8.5% senior secured notes due 2003 (the "SIG Senior Notes"). The SIG Senior Notes began maturing in $9.0 million annual installments in 1999 and are collateralized by all of the common stock of SNCC. On June 30, 1998, the Company acquired Matrix, a provider of integrated disability and absence management services to the employee benefits market. The purchase price of $33.8 million consisted of 409,424 shares of the Company's Class A Common Stock, $7.9 million of cash and $5.7 million of 8% subordinated notes due 2003 (the "Subordinated Notes"). Additional consideration of up to $4.2 million in cash will be payable if Matrix's earnings meet specified targets over the four-year period subsequent to the acquisition. See Note B to the Consolidated Financial Statements. Effective April 30, 1999, the Company completed the disposition of its Unicover Managers, Inc. subsidiary and a related company (collectively, "Unicover"), which were acquired in the fourth quarter of 1998, to certain of the former owners of Unicover. See Note Q to the Consolidated Financial Statements. In January 2000, the Company received from Unicover's pool and facility members and the retrocessionaires of Unicover's pools and facilities legal releases relating to, among other things, the Company's former ownership of Unicover. The releases were obtained in connection with a global Unicover-related settlement involving Reliance Insurance Company, its retrocessionaires and a group of ceding companies and brokers. The Company contributed to this settlement by agreeing to rescind a quota share reinsurance contract with Reliance Insurance Company. Accordingly, the Company restated its financial results for the first three quarters of 1999 to exclude the effects of this contract. ITEM 2. ITEM 2. PROPERTIES The Company leases its principal executive office at 1105 North Market Street, Suite 1230, Wilmington, Delaware under an operating lease expiring in October 2003. RSLIC owns its administrative office building at 2501 Parkway, Philadelphia, Pennsylvania, which consists of approximately 100,000 square feet. In the fourth quarter of 1999, the Company entered into an agreement to sell RSLIC's administrative office building. The sale is expected to close in mid-2000. In conjunction with the sale, the Company has entered into a nine-year lease agreement for approximately 108,000 square feet of office space in Philadelphia, Pennsylvania to which the Company will relocate its administrative office. SNCC owns its home office building at 2043 Woodland Parkway, Suite 200, St. Louis, Missouri, which consists of approximately 58,000 square feet. DCM and FRSLIC lease their offices at 153 East 53rd Street, 49th Floor, New York, New York under an operating lease expiring in July 2008. Matrix leases its principal office at 4777 Hellyer Avenue, Suite 200, San Jose, California under an operating lease expiring in December 2006. The Company also maintains sales and administrative offices throughout the country to provide nationwide sales support and service existing business. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the course of their respective businesses, the Company's subsidiaries are defendants in litigation; in the case of its insurance subsidiaries, principally involving insurance policy claims and agent disputes and in the case of its integrated disability and absence management subsidiary, benefit claims-related litigation. The ultimate disposition of such pending litigation is not expected to have a material adverse effect on the Company's financial condition, liquidity or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY The table below presents certain information concerning each of the executive officers of the Company: Mr. Rosenkranz has served as the President and Chief Executive Officer of the Company since May 1987 and has served as Chairman of the Board of Directors of the Company since April 1989. He is also Chairman of the Board of RSLIC-Texas, RSLIC, and FRSLIC and serves on the Board of Directors of SNCC. Mr. Rosenkranz, by means of beneficial ownership of the corporate general partner of Rosenkranz & Company, an irrevocable proxy and direct or beneficial ownership, has the power to vote all of the outstanding shares of Class B Common Stock, which represents 49.9% of the voting power of the Company's common stock as of March 3, 2000. Mr. Smith has served as Executive Vice President of the Company and DCM since November 1999 and as a Director of the Company since January 1995. From July 1994 to November 1999, he served as Vice President of the Company and DCM. Mr. Smith also serves as a Director of RSLIC-Texas, RSLIC, FRSLIC and SNCC. Prior to July 1994, Mr. Smith was Director, Investment Banking for Merrill Lynch & Company in New York, New York. Mr. Ilg has served as Chairman of the Board of SNCC since January 1999 and as President and Chief Executive Officer of RSLIC since April 1999. Prior to January 1999, Mr. Ilg served as Vice Chairman of the Board of SNCC, where he has been employed in various capacities since 1978. Mr. Ilg also serves as a Director of RSLIC and as President, Chief Executive Officer and a Director of RSLIC-Texas and FRSLIC. Mr. Coulter has served as Vice President and General Counsel of the Company and as Vice President, General Counsel and Assistant Secretary of RSLIC, FRSLIC and RSLIC-Texas since January 1998. He also served for RSLIC in similar capacities from February 1994 to August 1997, and in various capacities from January 1991 to February 1994. From August 1997 to December 1997, Mr. Coulter was Vice President and General Counsel of National Life of Vermont. Mr. Lucido has served as Vice President, Investments of the Company since July 1997 and as a Director of FRSLIC since August 1997. Prior to July 1997, Mr. Lucido was Managing Director, Chief Operating Officer and Corporate Secretary of Hyperion Capital Management, Inc. in New York, New York. Mr. Daurelle has served as Vice President and Treasurer of the Company since August 1998 and as Vice President and Treasurer of RSLIC, FRSLIC and RSLIC-Texas since May 1995. From October 1994 to April 1995, he was Senior Vice President and Chief Financial Officer for Mutual Assurance Company. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The closing price of the Company's Class A Common Stock was $25.9375 on March 3, 2000. There were approximately 2,700 holders of record of the Company's Class A Common Stock as of March 3, 2000. The Company's Class A Common Stock is listed on the New York Stock Exchange under the symbol DFG. The following table sets forth the high and low sales prices for the Company's Class A Common Stock. Prior periods have been restated to reflect the stock dividends distributed in 1998 and 1999. The Company presently intends to retain earnings to finance the development and growth of its business. Accordingly, cash dividends have not been declared or paid on the Class A Common Stock or the Class B Common Stock, and the Company does not anticipate payment of any cash dividends in the foreseeable future. Cash dividend payments are permitted under the terms of the Company's $180.0 million revolving credit facility (the "Credit Agreement") and $85.0 million 8% Senior Notes due 2003 (the "Senior Notes") subject to certain restrictions and covenants. See Note K to the Consolidated Financial Statements. In addition, dividend payments by the Company's insurance subsidiaries to the Company are subject to certain regulatory restrictions. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and "Business - Regulation." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data below should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes. (1) Reflects the acquisitions of Matrix in 1998 and SNCC in 1996. See Note B to the Consolidated Financial Statements. (2) Income from continuing operations excluding realized investment gains and losses and before interest and income tax expense and dividends on Capital Securities of Delphi Funding L.L.C. (3) In 1999, the Company disposed of Unicover and recognized an after-tax loss of $13.8 million on the disposition. After-tax income from Unicover's operations totaled $13.2 million in 1998. See Note Q to the Consolidated Financial Statements. The Company discontinued its long-term care business in 1996 and recorded a one-time after-tax charge of $5.8 million in 1996 attributable to this discontinuance. After-tax operating losses on this business were $0.8 million and $2.3 million in 1996 and 1995, respectively. (4) Restated to reflect stock dividends distributed during 1999. (5) Diluted book value per share is calculated by dividing shareholders' equity, as increased by the proceeds and tax benefit from the assumed exercise of outstanding stock options, by total shares outstanding, also increased by shares issued upon the assumed exercise of the options and deferred shares. (6) Diluted book value per share before net unrealized (depreciation) appreciation on investments is calculated by dividing shareholders' equity excluding net unrealized (depreciation) appreciation on investments, as increased by the proceeds and tax benefit from the assumed exercise of outstanding stock options, by total shares outstanding, also increased by shares issued upon the assumed exercise of the options and deferred shares. (7) Return on average shareholders' equity is calculated by dividing income from continuing operations, excluding after-tax realized investment gains and losses, by average shareholders' equity, excluding after-tax realized investment gains and losses, discontinued operations, extraordinary items and changes in accounting principles, as determined as of the beginning and end of each year. (8) The interest coverage ratio is calculated by dividing income from continuing operations before interest and income tax expense and dividends on the Capital Securities by interest expense (1996 excludes interest paid in connection with the settlement of prior-year federal income taxes). (9) Reflects the issuance of and the payment of dividends on $100.0 million of Capital Securities by Delphi Funding L.L.C. (the "Capital Securities"). See Note J to the Consolidated Financial Statements. (10) The debt to total capitalization ratio is calculated by dividing long-term debt by the sum of the Company's long-term debt, Capital Securities and shareholders' equity. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The discussion and analysis of the results of operations and financial condition of the Company below should be read in conjunction with the Consolidated Financial Statements and related notes. RESULTS OF OPERATIONS 1999 COMPARED TO 1998 Premium and Fee Income. Premium and fee income in 1999 was $485.3 million as compared to $426.9 million in 1998, an increase of 14%. This increase was primarily attributable to growth in the Company's group life, disability and travel accident products within its group employee benefits segment. This growth reflects high levels of new business production and normal growth in employment and salary levels for the Company's existing customer base. Excess workers' compensation premiums for 1999 were in line with 1998 levels reflecting improvements in the pricing environment in this market sector. As of December 31, 1999, the Company has terminated its participation in substantially all of the reinsurance pools in which it had historically participated. See "Business - Reinsurance." In 1999, reinsurance pools, in the aggregate, represented $59.7 million of premium income and $57.4 million of incurred benefits. The Company does not expect its withdrawals from these reinsurance pools to have a material impact on its underwriting results. Deposits from the Company's SPDA products, including the Company's MVA annuity product, were $77.3 million in 1999 as compared to $46.0 million in 1998. Deposits for these products, which are long-term in nature, are not recorded as premiums; instead, the deposits are recorded as a liability. The increase in annuity deposits in 1999 is principally the result of an increase in the number of networks of independent agents distributing the Company's annuity products, as well as enhancements made to the Company's products to improve their competitive position in the marketplace and a more favorable environment for fixed annuity sales due to increases in interest rates during 1999. Net Investment Income. Net investment income in 1999 was $180.9 million as compared to $168.7 million in 1998, an increase of 7%. This increase primarily reflects an increase in the weighted average annual yield on invested assets and an increase in average invested assets in 1999. The weighted average annual yield on invested assets, excluding realized and unrealized investment gains and losses, was 8.4% on average invested assets of $2,149.4 million in 1999 and 8.1% on average invested assets of $2,083.0 million in 1998. Benefits and Expenses. Policyholder benefits and expenses were $521.2 million in 1999 as compared to $470.6 million in 1998, an increase of 11%. Benefits and expenses for the Company's group employee benefit products increased by $43.8 million in 1999 primarily due to growth in this segment. The combined ratio (loss ratio plus expense ratio) for the Company's group employee benefits segment decreased from 96.5% in 1998 to 95.2% in 1999. This decrease was primarily attributable to changes in the Company's product mix. Benefits and interest credited on asset accumulation products decreased by $2.5 million in 1999 principally due to a decrease in average funds under management from $628.7 million in 1998 to $622.9 million in 1999, partially offset by an increase in the weighted average annual crediting rate on asset accumulation products from 5.2% in 1998 to 5.3% in 1999. Operating Income. Income from continuing operations excluding realized investment gains and losses and before interest and income tax expense and dividends in 1999 was $145.0 million as compared to $125.0 million in 1998, an increase of 16%. This increase is primarily attributable to the growth in the Company's group employee benefits segment and the increase in the yield on invested assets in 1999. Net Realized Investment (Losses) Gains. Net realized investment losses were $25.7 million in 1999 as compared to net realized investment gains of $8.1 million in 1998. The Company's investment strategy results in periodic sales of securities and the recognition of realized investment gains and losses. Interest Expense. Interest expense was $18.2 million in 1999 as compared to $17.4 million in 1998. This increase was primarily due to an increase in average outstanding borrowings under the Credit Agreement, partially offset by a decline in the weighted average borrowing rate on the Credit Agreement and a decrease in the average principal amount of the SIG Senior Notes due to the scheduled partial principal repayment on the notes in 1999. Income Tax Expense. The Company's effective tax rate decreased from 31.0% in 1998 to 30.6% in 1999 primarily due to a decrease in income taxed at the Company's marginal tax rate as a result of net realized investment losses in 1999 as compared to net realized investment gains in 1998. Discontinued Operations. Effective April 30, 1999, the Company completed the disposition of Unicover, which was acquired in the fourth quarter of 1998. The Company recognized a loss of $13.8 million on the disposition of the discontinued operations of Unicover, net of a related tax benefit of $8.7 million, in the first quarter of 1999. Income from Unicover's operations totaled $13.2 million in 1998, net of tax expense of $8.8 million. See Note Q to the Consolidated Financial Statements. 1998 COMPARED TO 1997 Premium and Fee Income. Premium and fee income in 1998 was $426.9 million as compared to $360.9 million in 1997, an increase of 18%. This increase was primarily attributable to the Company's group employee benefits segment and reflects strong production of new business, normal growth in employment and salary levels for the Company's existing customer base and expansion within the alternative risk transfer market. A decrease in excess workers' compensation premiums from prior year levels as a result of a weak pricing environment in this market sector did not have a material impact on underwriting results due to corresponding decreases in benefits. Deposits from the Company's SPDA products, including the Company's MVA annuity product, were $46.0 million in 1998 as compared to $55.5 million in 1997. Deposits for these products, which are long-term in nature, are not recorded as premiums; instead, the deposits are recorded as a liability. The decrease in deposits was principally attributable to a decline in the demand for fixed annuity products due to the low interest rate environment during 1998. Net Investment Income. Net investment income in 1998 was $168.7 million as compared to $162.4 million in 1997, an increase of 4%. The weighted average annual yield on invested assets, excluding realized and unrealized investment gains and losses, was 8.1% on average invested assets of $2,083.0 million in 1998 and 7.9% on average invested assets of $2,048.2 million in 1997. Benefits and Expenses. Policyholder benefits and expenses were $470.6 million in 1998 as compared to $404.9 million in 1997, an increase of 16%. Benefits and expenses for the Company's group employee benefit products increased by $60.6 million in 1998 primarily due to growth in this segment. The combined ratio (loss ratio plus expense ratio) for the Company's group employee benefits segment was 96.5% in 1998 and 95.9% in 1997. Benefits and interest credited on asset accumulation products decreased by $4.1 million in 1998 principally due to a decrease in average funds under management from $670.1 million in 1997 to $628.7 million in 1998. In addition, the weighted average annual crediting rate on asset accumulation products decreased from 5.3% in 1997 to 5.2% in 1998. Operating Income. Income from continuing operations excluding realized investment gains and losses and before interest and income tax expense and dividends in 1998 was $125.0 million as compared to $118.3 million in 1997, an increase of 6%. This increase is primarily attributable to the growth in the Company's group employee benefits segment and the increase in yield on invested assets in the asset accumulation products segment. Net Realized Investment Gains. Net realized investment gains were $8.1 million in 1998 as compared to $14.6 million in 1997. The Company's investment strategy results in periodic sales of securities and the recognition of realized investment gains and losses. Interest Expense. Interest expense was $17.4 million in 1998 as compared to $15.0 million in 1997. This increase was primarily due to additional borrowings under the Credit Agreement in 1998 to fund acquisitions and investment opportunities. Income Tax Expense. The Company's effective tax rate decreased from 32.4% in 1997 to 31.0% in 1998 primarily due to tax-exempt investment income. Discontinued Operations. During 1998, income from Unicover's operations totaled $13.2 million, net of tax expense of $8.8 million. Effective April 30, 1999, the Company completed the disposition of Unicover, which was acquired in the fourth quarter of 1998. LIQUIDITY AND CAPITAL RESOURCES General. The Company had approximately $286.0 million of financial resources available at the holding company level at December 31, 1999, which was primarily comprised of investments in the common stock of its investment subsidiaries and fixed maturity securities. The assets of these investment subsidiaries are primarily invested in fixed maturity securities, balances with independent investment managers and marketable securities. Substantially all of the amounts invested with independent investment managers are withdrawable at least annually, subject to applicable notice requirements. A shelf registration is also in effect under which up to $49.2 million in securities may be issued by the Company. Other sources of liquidity at the holding company level include dividends paid from subsidiaries, primarily generated from operating cash flows and investments, and borrowings available under the Credit Agreement. During 2000, RSLIC will be permitted, without prior regulatory approval, to make dividend payments of $30.0 million. In addition, SNCC will be permitted, without regulatory or other approval, to make dividend payments of $19.5 million in 2000. Additional dividends may also be paid by RSLIC and SNCC with the requisite approvals. See "Business Regulation." In general, dividends from the Company's non-insurance subsidiaries are not subject to regulatory or other restrictions. As of December 31, 1999, the Company had $23.0 million of borrowings available to it under the Credit Agreement. The Company's current liquidity needs, in addition to funding operating expenses, include principal and interest payments on outstanding borrowings under the Credit Agreement, the Senior Notes, the SIG Senior Notes and the Subordinated Notes and distributions on the Capital Securities. The maximum amount of borrowings available under the Credit Agreement will be reduced to the following amounts in October of each year: 2000 - $150.0 million, 2001 - $110.0 million and 2002 - $60.0 million. At the Company's current level of borrowings, a principal repayment of $7.0 million will be required under the Credit Agreement in October 2000. The Senior Notes mature in their entirety in October 2003 and are not subject to any sinking fund requirements nor are they redeemable prior to maturity. The SIG Senior Notes mature in $9.0 million annual installments, with the next installment payable in May 2000, and the Subordinated Notes mature in their entirety in June 2003. The junior subordinated debentures underlying the Capital Securities are not redeemable prior to March 25, 2007. See Note E to the Consolidated Financial Statements. The Company from time to time engages in discussions with respect to acquiring blocks of business and insurance and financial services companies, any of which could, if consummated, be material to the Company's operations. Sources of liquidity available to the Company on a parent company-only basis, including the undistributed earnings of its subsidiaries and additional borrowings available under the Credit Agreement, are expected to exceed the Company's current and long-term cash requirements. The principal liquidity requirements of the Company's insurance subsidiaries are their contractual obligations to policyholders. The primary sources of funding for these obligations, in addition to operating earnings, are the marketable investments included in the investment portfolios of these subsidiaries. The Company believes that these sources of funding will be adequate for its insurance subsidiaries to satisfy on both a short-term and long-term basis these contractual obligations throughout their estimated or stated period. Cash Flows. Operating activities increased cash and cash equivalents by $111.3 million in 1999 as compared with an increase of $19.0 million in 1998, excluding the effect of the cession of $101.5 million of policy liabilities to Oracle Re in 1998 and the recapture of $10.0 million of these liabilities in 1999 (see Note O to the Consolidated Financial Statements). Operating cash flows in 1999 include $58.1 million from a reinsurance transaction that was rescinded. These funds were returned to the ceding company in January 2000. Also contributing to the increase in operating cash flows in 1999 was a decrease in federal income taxes paid principally due to timing differences in recognizing income from investing activities. Net investing activities provided $96.6 million of cash during 1999 primarily from sales of securities, and financing activities used $159.1 million of cash principally due to a reduction in securities lending and reverse repurchase agreement liabilities. Investments. The Company's overall investment strategy to achieve its objectives of safety and liquidity, while seeking the best available return, focuses on, among other things, managing the durations of the Company's interest-sensitive assets and liabilities and minimizing the Company's exposure to fluctuations in interest rates. The Company's investment portfolio primarily consists of investments in fixed maturity securities, cash and short-term investments. The weighted average credit rating of the Company's fixed maturity portfolio as rated by Standard & Poor's Corporation was "AA" at December 31, 1999. While the investment grade rating of the Company's fixed maturity portfolio addresses credit risk, it does not address other risks, such as prepayment and extension risks, which are discussed below. During the year ended December 31, 1999, the Company reduced its investments in mortgage-backed securities to 21% of total invested assets or $524.5 million, from 35% of total invested assets, or $775.0 million, at December 31, 1998. Approximately 43% of the Company's mortgage-backed securities are guaranteed by U.S. Government sponsored entities as to the full amount of principal and interest and the remaining 57% consists of investments in trusts created by banks and finance and mortgage companies. Ninety-four percent of the Company's mortgage-backed securities portfolio, based on fair values, has been rated as investment grade by nationally recognized statistical rating organizations. Mortgage-backed securities subject the Company to a degree of interest rate risk, including prepayment and extension risk, which is generally a function of the sensitivity of each security's underlying collateral to prepayments under varying interest rate environments and the repayment priority of the securities in the particular securitization structure. The Company seeks to limit the extent of this risk by emphasizing the more predictable payment classes and securities with stable collateral. The Company maintains an investment program in which securities were financed using advances from the FHLB. The Company has utilized this program to manage the duration of its liabilities and to earn spread income, which is the difference between the financing cost and the earnings from the securities purchased with those funds. At December 31, 1999, the Company had outstanding advances of $75.0 million that do not begin to mature until 2003. In addition, the Company utilizes reverse repurchase agreements, futures and option contracts and interest rate swap contracts from time to time in connection with its investment strategy. These transactions require the Company to maintain securities or cash on deposit with the applicable counterparty as collateral. As the market value of the collateral or contracts changes, the Company may be required to deposit additional collateral or be entitled to have a portion of the collateral returned to it. The Company also maintains a securities lending program under which certain securities from its portfolio are loaned to other institutions for short periods of time. The collateral received for securities loaned is recorded at the fair value of the collateral, which is generally in an amount in excess of the market value of the securities loaned. The Company monitors the market value of the securities loaned and obtains additional collateral as necessary. The ability of the Company's insurance subsidiaries to make investments is subject to the insurance laws and regulations of their respective state of domicile. Each of these states has comprehensive investment regulations. In addition, the Credit Agreement and, as to SNCC, the SIG Senior Notes also contain limitations, with which the Company is currently in compliance in all material respects, on the composition of the Company's investment portfolio. The Company also continually monitors its investment portfolio and attempts to ensure that the risks associated with concentrations of investments in either a particular sector of the market or a single entity are limited. Asset/Liability Management and Market Risk. Because the Company's primary assets and liabilities are financial in nature, the Company's financial position and earnings are subject to risks resulting from changes in interest rates. The Company manages this risk by active portfolio management focusing on matching the durations of invested assets and related liabilities to minimize the exposure to fluctuations in interest rates and by the adjustment of the crediting rate on annuity products. In addition, the Company, at times, utilizes exchange-traded futures and option contracts to reduce the risk associated with changes in the value of its fixed maturity portfolio due to changes in the interest rate environment and to reduce the risk associated with changes in interest rates in connection with anticipated securities purchases. Generally, market prices of fixed maturity securities decline in an environment of increasing interest rates in a manner similar to that of U.S. Treasury securities. Therefore, in order to reduce the extent of this interest rate risk, the Company enters into option contracts and short U.S. Treasury futures, the value of which will rise in such an environment. At December 31, 1999, the Company had realized gains of $13.3 million on closed positions and unrealized gains of $15.3 million on open positions related to this program that have been deferred and recorded as adjustments to the amortized cost of the fixed maturity securities being hedged. The Company periodically analyzes the results of its asset/liability matching through cash flow analysis and duration matching under multiple interest rate scenarios. These analyses enable the Company to measure the potential gain or loss in fair value of its interest-rate sensitive financial instruments due to hypothetical changes in interest rates. Based on these analyses, if interest rates were to immediately increase by 10% from their year-end levels, the fair value of the Company's interest-sensitive assets, net of corresponding changes in the fair value of cost of business acquired and insurance and investment-related liabilities, would decline by approximately $85.7 million at December 31, 1999 as compared to a decline of approximately $69.8 million at December 31, 1998. These analyses incorporate numerous assumptions and estimates and assume no changes in the composition of the Company's investment portfolio in reaction to such interest rate changes. Consequently, the results of this analysis will likely be different from the actual changes experienced under given interest rate scenarios, and those differences may be material. A portion of the Company's trading account portfolio consists of equity securities which are subject to risks resulting from, among other things, changes in the level of equity prices. To reduce the extent of this risk, the Company has entered into corresponding short positions relating to certain of these securities. If the fair value of the Company's trading account securities were to decrease by 10% from their year-end levels, the fair value of these securities, net of the corresponding change in the fair value of the related short positions, would decrease by approximately $10.9 million at December 31, 1999 as compared to a decline of approximately $5.5 million at December 31, 1998. The Company manages the composition of its borrowed capital by considering factors such as the ratio of borrowed capital to total capital, future debt requirements, the interest rate environment and other market conditions. Approximately 45% of the Company's corporate debt was issued at fixed interest rates. A hypothetical 10% decrease in market interest rates would cause a corresponding $1.8 million increase in the fair value of the Company's fixed-rate corporate debt at December 31, 1999 as compared to an increase of $2.1 million at December 31, 1998. Because interest expense on the Company's floating-rate corporate debt fluctuates as prevailing interest rates change, changes in market interest rates would not materially affect its fair value. IMPACT OF YEAR 2000 The Year 2000 issue relates to whether computer systems will properly recognize date-sensitive information in years subsequent to 1999. Prior to 2000, the Company underwent a corporate-wide program to address the Year 2000 issue, as it relates to its own computer systems, as well as to instances in which computer systems of third parties may have a significant impact on the Company's operations, such as those of suppliers, business partners, customers, facilities and telecommunications. Since 1997, the Company has incurred $8.2 million of costs to address the Year 2000 issue, of which $6.1 million was expensed and $2.1 million was capitalized. The Company does not anticipate incurring any material additional costs related to the Year 2000 issue. The Company has not experienced any significant disruptions of business operations related to the Year 2000 issue to date and believes that the risk of any such disruption in the future is low, although no assurance can be given in this regard. It is possible that Year 2000 problems that are not currently apparent may arise in the future. Accordingly, the Company will continue to monitor its systems for Year 2000 compliance. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS In connection with, and because it desires to take advantage of, the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements in the above "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Form 10-K and in any other statement made by, or on behalf of, the Company, whether in future filings with the Securities and Exchange Commission or otherwise. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Some forward- looking statements may be identified by the use of terms such as "expects," "believes," "anticipates," "intends," "judgment" or other similar expressions. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company's control and many of which, with respect to future business decisions, are subject to change. Examples of such uncertainties and contingencies include, among other important factors, those affecting the insurance industry generally, such as the economic and interest rate environment, legislative and regulatory developments and market pricing and competitive trends relating to insurance products and services, and those relating specifically to the Company's business, such as the level of its insurance premiums and fee income, the claims experience and other factors affecting the profitability of its insurance products, the performance of its investment portfolio, the emergence of Year 2000 problems not currently apparent, acquisitions of companies or blocks of business, and ratings by major rating organizations of its insurance subsidiaries. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. The Company disclaims any obligation to update forward-looking information. ITEM 7A. ITEM 7A. MARKET RISK DISCLOSURE The information required by Item 7A is included in this Form 10-K under the heading "Asset/Liability Management and Market Risk" beginning on page 18 of this Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 is included in this Form 10-K beginning on page 24 of this Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 is included in the Company's definitive Proxy Statement, to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934 in connection with the Company's 2000 Annual Meeting of Stockholders, under the captions "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference, and in Item 4A in Part I of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is included in the Company's definitive Proxy Statement, to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934 in connection with the Company's 2000 Annual Meeting of Stockholders, under the caption "Executive Compensation" and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN OWNERS AND MANAGEMENT The information required by Item 12 is included in the Company's definitive Proxy Statement, to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934 in connection with the Company's 2000 Annual Meeting of Stockholders, under the caption "Security Ownership of Certain Beneficial Owners and Management" and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is included in the Company's definitive Proxy Statement, to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934 in connection with the Company's 2000 Annual Meeting of Stockholders, under the caption "Certain Relationships and Related Party Transactions" and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The financial statements and financial statement schedules filed as part of this report are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules on page 25 of this Form 10-K. (b) No reports on Form 8-K were filed during the fourth quarter of 1999. (c) The following Exhibits are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K: 2.1 Agreement and Plan of Merger, dated October 5, 1995, among the Company, SIG Holdings Acquisition Corp., and SIG Holdings, Inc. (8) 2.2 Agreement and Plan of Merger, dated June 11, 1998, by and among Delphi Financial Group, Inc., Matrix Absence Management, Inc. and the Shareholders named therein (13) 2.3 Stock Purchase Agreement, dated as of October 1, 1998, by and among Delphi Financial Group, Inc., Unicover Managers, Inc., Unicover Intermediaries, LLC and the Shareholders named therein (13) 2.4 Merger, Exchange and Release Agreement, dated April 30, 1999, by and among Delphi Financial Group, Inc., Unicover Managers, Inc., Unicover Intermediaries, LLC, Unicover Management Partners, LLC and the Buyers named therein (Exhibit 2.1) (14) 3.1 Restated Certificate of Incorporation of Delphi Financial Group, Inc. (Exhibit 3.2) (3) 3.2 Certificate of Amendment of Restated Certificate of Incorporation of Delphi Financial Group, Inc. (Exhibit 3.1) (10) 3.3 Restated Certificate of Incorporation of Delphi Financial Group, Inc. (Exhibit 3.2) (10) 3.4 Amended and Restated By-laws of Delphi Financial Group, Inc. (3) 4.1 Indenture, dated as of October 8, 1993, between Delphi Financial Group, Inc. and State Street Bank of Connecticut (formerly Shawmut Bank Connecticut, N.A.) as Trustee (8.0% Senior Notes due 2003) (4) 4.2 Amended and Restated Limited Liability Agreement of Delphi Funding L.L.C. dated as of March 25, 1997, among Delphi Financial Group, Inc., as Managing Member, Chestnut Investors III, Inc., as Resigning Member, and the Holders of Capital Securities described therein, as Members (Exhibit 4(a))(11) 4.3 Subordinated Indenture, dated as of March 25, 1997, between Delphi Financial Group, Inc. and Wilmington Trust Company as Trustee (Exhibit 4(b)) (11) 4.4 Guarantee Agreement dated March 25, 1997, between Delphi Financial Group, as Guarantor, and Wilmington Trust Company, as Trustee (Exhibit 4(c)) (11) 10.1 Third Amended and Restated Credit Agreement dated as of December 5, 1996, among the Company, the Lenders named therein, The Bank of New York, NationsBank, N.A. (South) and Fleet National Bank, as Co-Agents for the lenders, and Bank of America National Trust and Savings Association, as Administrative Agent for the lenders (Exhibit 10.4) (9) 10.2 Borrower Pledge Agreement, dated as of February 23, 1993, between the Company and Bank of America Illinois (Exhibit 10.5) (2) 10.3 Amendment, dated as of August 11, 1999, to the Third Amended and Restated Credit Agreement dated as of December 5, 1996, among the Company, the co-agents party thereto, the lenders party thereto, and Bank of America, N.A. (as successor by merger to Bank of America National Trust and Savings Association), as administrative agent. (Exhibit 10.29) (15) 10.4 Second Amended and Restated Employee Nonqualified Stock Option Plan (Exhibit 10.2) (5) 10.5 The Delphi Capital Management, Inc. Pension Plan for Robert Rosenkranz (Exhibit 10.3) (2) 10.6 Investment Consulting Agreement, dated as of November 10, 1988, between Rosenkranz, Inc. and the Company (Exhibit 10.8) (3) 10.7 Investment Consulting Agreement, dated as of November 6, 1988, between Rosenkranz, Inc. and Reliance Standard Life Insurance Company (Exhibit 10.9) (3) 10.8 Assumption Reinsurance Agreement, dated as of December 5, 1988, between John Alden Life Insurance Company and Reliance Standard Life Insurance Company (Exhibit 10.11) (3) 10.9 Delphi Financial Group, Inc. Long-Term Performance-Based Incentive Plan (12) 10.10 Settlement Agreement and Release of February 1988 among Insurers Service Corporation, Frank B. Hall & Co. Inc., Reliance Group Holdings Inc. and Safety National Casualty Corporation, as supplemented and amended by letter agreement dated March 4, 1996 (Exhibit 10.11) (7) 10.11 SIG Holdings, Inc. 1992 Long-Term Incentive Plan (Exhibit 10.12) (7) 10.12 Stockholders Agreement, dated as of October 5, 1995, among the Company and the affiliate stockholders named therein (Exhibit 10.30) (8) 10.13 Reliance Standard Life Insurance Company Nonqualified Deferred Compensation Plan (Exhibit 10.14)(8) 10.14 Reliance Standard Life Insurance Company Supplemental Executive Retirement Plan (Exhibit 10.15) (8) 10.15 Delphi Financial Group, Inc. Amended and Restated Directors Stock Option Plan (Exhibit 10.26) (12) 10.16 Indemnity Coinsurance Agreement and Administrative Services Agreement, dated as of October 3, 1994, between Reliance Standard Life Insurance Company and Protective Life Insurance Company (Exhibit 10.21) (6) 10.17 Indemnity Coinsurance Agreement, dated as of June 30, 1990, between Reliance Standard Life Insurance Company and John Alden Life Insurance Company (with exhibit 1 thereto) (Exhibit 10.22) (1) 10.18 Indemnity Coinsurance Agreement, dated as of October 31, 1990, between Reliance Standard Life Insurance Company and John Alden Life Insurance Company (with exhibit 1 thereto) (Exhibit 10.23) (1) 10.19 Indemnity Coinsurance Agreement, dated as of March 31, 1992, between Reliance Standard Life Insurance Company and Washington National Life Insurance Company of New York (filed with the Trust Agreement dated as of April 27, 1992, between Reliance Standard Life Insurance Company and Washington National Life Insurance Company of New York) (Exhibit 10.24) (1) 10.20 Indemnity Coinsurance Agreement, dated as of December 31, 1992, between Reliance Standard Life Insurance Company and Lamar Life Insurance Company (Exhibit 10.25) (1) 10.21 Employment Agreement, dated March 18, 1994, for Robert M. Smith, Jr. (Exhibit 10.31) (6) 10.22 SIG Holdings, Inc. Note Agreement, dated as of May 20, 1994 (8.5% Senior Secured Notes due 2003) (Exhibit 10.25) (7) 10.23 Borrower Pledge Agreement, dated as of May 20, 1994, between SIG Holdings, Inc., and the Chase Manhattan Bank, N.A., as collateral agent (Exhibit 10.26) (7) 10.24 Subsidiary Pledge Agreement, dated as of March 5, 1996, between SIG Holdings, Inc. and Bank of America National Trust and Savings Association, as Administrative Agent (Exhibit 10.27) (7) 10.25 Reinsurance Agreement, dated January 27, 1998, between Reliance Standard Life Insurance Company and Oracle Reinsurance Company Ltd. (Exhibit 10.27) (12) 10.26 Casualty Excess of Loss Reinsurance Agreement, dated January 27, 1998, between Safety National Casualty Corporation and Oracle Reinsurance Company Ltd. (Exhibit 10.28) (12) 11.1 Computation of Results per Share of Common Stock (16) 21.1 List of Subsidiaries of the Company (17) 23.1 Consent of Ernst & Young LLP (17) 24.1 Powers of Attorney (17) 27 Financial Data Schedule (17) - --------------------------------------------- (1) Incorporated herein by reference to the designated exhibit to the Company's Registration Statement on Form S-1 dated September 30, 1993 (Registration No. 33-65828). (2) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1992. (3) Incorporated herein by reference to the designated exhibit to the Company's Registration Statement on Form S-1 dated March 13, 1990 (Registration No. 33-32827). (4) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1993. (5) Incorporated herein by reference to the designated exhibit to the Company's Registration Statement on Form S-8 dated August 6, 1997 (Registration No. 333-32961). (6) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1994. (7) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1995. (8) Incorporated herein by reference to the designated exhibit to the Company's Registration Statement on Form S-4 dated January 30, 1996 (Registration No. 33-99164). (9) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1996. (10) Incorporated herein by reference to the designated exhibit to the Company's Form 10-Q for the quarter ended June 30, 1997. (11) Incorporated herein by reference to the designated exhibit to the Company's Current Report on Form 8-K dated March 21, 1997. (12) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1997. (13) Incorporated herein by reference to the designated exhibit to the Company's Form 10-K for the year ended December 31, 1998. (14) Incorporated herein by reference to the designated exhibit to the Company's Form 10-Q for the quarter ended March 31, 1999. (15) Incorporated herein by reference to the designated exhibit to the Company's Form 10-Q for the quarter ended September 30, 1999. (16) Incorporated herein by reference to Note N to the Consolidated Financial Statements included elsewhere herein. (17) Filed herewith. (d) The financial statement schedules listed in the Index to Consolidated Financial Statements and Financial Statement Schedules on page 25 of this Form 10-K are included under Item 8 and are presented beginning on page 48 of this Form 10-K. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Delphi Financial Group, Inc. By: /S/ ROBERT ROSENKRANZ ----------------------------------- Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES SELECTED QUARTERLY FINANCIAL RESULTS (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The results of interim periods may not be indicative of the results for the entire year. Computations of results per share for each quarter are made independently of results per share for the year. Due to transactions affecting the weighted average number of shares outstanding in each quarter, the sum of quarterly results per share does not equal results per share for the year. Results for the first quarter of 1999 include a loss on the disposition of Unicover, which was acquired in the fourth quarter of 1998. See Note Q to the Consolidated Financial Statements. In connection with a settlement pursuant to which the Company obtained certain legal releases relating to Unicover, the Company rescinded a quota share reinsurance contract with Reliance Insurance Company. Accordingly, the Company restated its financial results for the first three quarters of 1999 to exclude the effects of this contract. The effect of this restatement on originally reported amounts was a reduction in revenue of $25.1 million, $21.4 million and $18.9 million; after-tax income of $1.1 million, $1.5 million and $1.3 million; and basic and diluted results per share of $0.05, $0.07 and $0.06 in the first, second and third quarters of 1999, respectively. See "Other Transactions." Prior period results per share have been restated to reflect stock dividends distributed in 1999. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES REPORT OF INDEPENDENT AUDITORS Shareholders and Directors Delphi Financial Group, Inc. We have audited the accompanying consolidated balance sheets of Delphi Financial Group, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedules listed in the Index to Consolidated Financial Statements and Financial Statement Schedules. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Delphi Financial Group, Inc. and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ ERNST & YOUNG LLP Philadelphia, Pennsylvania February 4, 2000 DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation. The consolidated financial statements include the accounts of Delphi Financial Group, Inc. ("DFG") and all of its wholly-owned subsidiaries, including, among others, Reliance Standard Life Insurance Company ("RSLIC"), Safety National Casualty Corporation ("SNCC"), First Reliance Standard Life Insurance Company ("FRSLIC"), Reliance Standard Life Insurance Company of Texas ("RSLIC-Texas"), and Matrix Absence Management, Inc. ("Matrix"). The term "Company" shall refer herein collectively to DFG and its subsidiaries, unless the context indicates otherwise. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications have been made in the 1998 and 1997 consolidated financial statements to conform with the 1999 presentation. As of December 31, 1999, Mr. Robert Rosenkranz, Chairman of the Board, President and Chief Executive Officer of DFG, by means of beneficial ownership of the corporate general partner of Rosenkranz & Company, an irrevocable proxy and direct or beneficial ownership, had the power to vote all of the outstanding shares of Class B Common Stock, which represents 49.9% of the voting power of the Company's common stock. Nature of Operations. The Company manages all aspects of employee absence to enhance the productivity of its clients and provides the related insurance coverages: short-term and long-term disability, primary and excess workers' compensation, group life and travel accident. The Company's asset accumulation business emphasizes individual annuity products. The Company offers its products and services in all fifty states and the District of Columbia. The Company's two reportable segments are group employee benefit products and asset accumulation products. The Company's reportable segments are strategic operating divisions that offer distinct types of products with different marketing strategies. The Company evaluates the performance of its segments on the basis of income from continuing operations excluding realized investment gains and losses and before interest and income tax expense and dividends on Capital Securities of Delphi Funding L.L.C. The accounting policies of the Company's segments are the same as those used in the consolidated financial statements. Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Investments. Fixed maturity securities available for sale are carried at fair value with unrealized appreciation and depreciation included as a component of shareholders' equity, net of the related income tax benefit or expense. Other investments consist primarily of trading account securities and equity securities. Trading account securities include bonds, common stocks and preferred stocks and are carried at fair value with unrealized appreciation and depreciation included in net investment income. Interest income, dividend income and realized gains and losses from trading account securities are also included in net investment income. Equity securities are carried at fair value with unrealized appreciation or depreciation included as a component of shareholders' equity, net of the related income tax benefit or expense. Net realized investment gains and losses on investment sales are determined under the specific identification method and are included in income. Declines in the fair value of investments which are considered to be other than temporary are reported as realized losses. Cost of Business Acquired. Costs relating to the acquisition of new insurance business, such as commissions and policy issuance costs, are deferred when incurred. For certain asset accumulation products, these costs are amortized in relation to the incidence of expected gross profits over the life of the policies and products. Deferred acquisition costs for life, accident and health and workers' compensation insurance policies are amortized over the premium- paying period or the expected life of the related policies. The present value of estimated future profits ("PVFP"), which was recorded in connection with the acquisition of RSLIC and FRSLIC in 1987, is included in cost of business acquired. The PVFP related to annuities is subject to accrual of interest on the unamortized balance at the credited rate and amortization is a constant percentage of the present value of estimated future gross profits on the business. Amortization of the PVFP for group life and disability insurance is at the discount rate established at the time of the acquisition. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) Receivables from Reinsurers. Receivables from reinsurers for future policy benefits, unpaid claims and claim expenses and policyholder account balances are estimated in a manner consistent with the related liabilities associated with the reinsured policies. Separate Account. The separate account assets and liabilities represent funds invested in a separately administered variable life insurance product for which the policyholder, rather than the Company, bears the investment risk. The excess of separate account assets over the related liabilities represents the Company's deposit in the separate account which is maintained to support the operation of the separate account program. The Company receives a proportionate share of the income or loss earned by the assets of the separate account, which it generally reinvests in the separate account. Future Policy Benefits. The liabilities for future policy benefits for traditional nonparticipating business, excluding annuity business, have been computed using a net level method. Mortality, withdrawals and other assumptions are based either on the Company's past experience or various actuarial tables, modified as necessary for possible variations. Changes in these assumptions could result in changes in these liabilities. Unpaid Claims and Claim Expenses. The liability for unpaid claims and claim expenses includes amounts determined on an individual basis for reported losses and estimates of incurred but not reported losses developed on the basis of past experience. The methods of making these estimates and establishing the resulting reserves are continually reviewed and updated, with any resulting adjustments reflected in earnings currently. At December 31, 1999, reserves with a carrying value of $474.4 million have been discounted at rates ranging from 3.7% to 7.0%. Policyholder Account Balances. Policyholder account balances are comprised of the Company's reserves for interest-sensitive insurance products, including annuities. Reserves for annuity products are equal to the policyholder's accumulated value at any point in time. Income Taxes. RSLIC-Texas and RSLIC are taxed as life insurance companies and file a consolidated federal tax return. FRSLIC does not qualify as a life insurance company for federal income tax purposes and files a separate federal tax return. DFG, SNCC and the non-insurance subsidiaries of the Company file as a separate subgroup. The Company computes a balance sheet amount for deferred income taxes, which is included in other assets or other liabilities, at the rates expected to be in effect when the underlying differences will be reported in the Company's income tax returns. Premium Recognition. The Company's group insurance products consist primarily of short-duration contracts, and, accordingly, premiums for these products are reported as earned over the contract period. Deposits for asset accumulation products are not recorded as premiums; instead the deposits are recorded as a liability, since these products generally do not involve mortality or morbidity risk. Statements of Cash Flows. For purposes of the Statements of Cash Flows, the Company defines cash equivalents as highly liquid debt instruments purchased with maturities of three months or less. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) Recently Adopted Accounting Standards. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, which is required to be adopted in fiscal years beginning after June 15, 2000. SFAS No. 133 permits early adoption as of the beginning of any quarter after its issuance, but the Company has not yet determined whether it will do so. SFAS No. 133 will require all derivatives to be recognized on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in fair value of the derivative will either be offset against the change in fair value of the hedged item or items through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The portion of a derivative's change in fair value not effective as a hedge will be immediately recognized in earnings. The Company has not yet determined what the effects of SFAS No. 133 will be on the earnings and financial position of the Company. NOTE B - ACQUISITIONS On June 30, 1998, the Company acquired Matrix, a provider of integrated disability and absence management services to the employee benefits market. The purchase price of $33.8 million consisted of 409,424 shares of the Company's Class A Common Stock, $7.9 million of cash and $5.7 million of notes payable. Additional consideration of up to $4.2 million in cash will be payable if Matrix's earnings meet specified targets over the four-year period subsequent to the acquisition. The Matrix acquisition was accounted for using the purchase accounting method, and the results of Matrix were included in the Company's results from June 30, 1998, the date of the acquisition. Goodwill recorded in connection with the Matrix acquisition is being amortized on a straight-line basis over 25 years. The consideration for the 1996 acquisition of SIG Holdings, Inc. ("SIG") and its subsidiary, SNCC, included contingent consideration of up to $20.0 million if SIG met specified earnings targets subsequent to the merger. SIG met all of the specified earnings targets, and, accordingly, the Company paid the $20.0 million of contingent consideration in two installments as follows: $6.9 million of cash and 63,000 shares of the Company's Class A Common Stock in 1998 and $9.0 million of cash and 30,000 shares of the Company's Class A Common Stock in 1999. NOTE C - INVESTMENTS The amortized cost and fair value of investments in fixed maturity securities available for sale are as follows: DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE C - INVESTMENTS - (CONTINUED) The amortized cost and fair value of fixed maturity securities available for sale at December 31, 1999, by contractual maturity are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations, with or without prepayment penalties. Net investment income was attributable to the following: Net realized investment (losses) gains arose from the following: DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE C - INVESTMENTS - (CONTINUED) Proceeds from sales of fixed maturity securities during 1999, 1998 and 1997 were $1,741.6 million, $3,420.1 million and $1,199.6 million, respectively. Gross gains of $19.8 million, $98.2 million and $34.3 million and gross losses of $34.6 million, $52.9 million and $21.1 million, respectively, were realized on those sales. Sales of fixed maturity securities and gross gains and losses from such sales do not include sales of securities classified as trading account securities. During 1997, the Company reevaluated the amortization period for deferred futures losses associated with its mortgage-backed securities portfolio due to a decline in market interest rates to record low levels and accelerated the amortization by $9.9 million. The change in unrealized (depreciation) appreciation on investments, primarily fixed maturity securities, included as a component of shareholders' equity was as follows: (1) Net of tax (benefit) expense of $(53.9) million, $(28.7) million and $36.6 million, respectively. (2) Net of tax (benefit) expense of $(9.0) million, $2.8 million and $5.1 million, respectively. Unrealized gains (losses) on trading securities included in investment income totaled $5.4 million, $(14.3) million and $(1.4) million for 1999, 1998 and 1997, respectively. Bonds and short-term investments with amortized costs of $30.0 million and $29.0 million at December 31, 1999 and 1998, respectively, are on deposit with various states' insurance departments in compliance with statutory requirements. Additionally, certain assets of the Company are restricted under the terms of annuity reinsurance agreements. These agreements provide for the distribution of assets to the reinsured companies covered under the agreements prior to any general distribution to policyholders in the event of the Company's insolvency or bankruptcy. The amount of assets restricted for this purpose was $95.7 million and $108.5 million at December 31, 1999 and 1998, respectively. The Company maintains a securities lending program under which certain securities from its portfolio are loaned to other institutions for short periods of time. The collateral received for securities loaned is recorded at the fair value of the collateral, which is generally in an amount in excess of the market value of the securities loaned. The Company monitors the market value of the securities loaned and obtains additional collateral as necessary. Amounts related to this program were not material as of December 31, 1999. At December 31, 1998, deposits on loaned securities totaled $67.3 million and the market value of loaned securities totaled $65.6 million. Other investments at December 31, 1999 and 1998 include trading securities of $308.0 million and $99.9 million, respectively. To reduce its potential loss exposure, the Company has entered into short positions relating to certain of these securities. The liability for short positions related to the Company's trading portfolio totaled $198.7 million and $44.9 million at December 31, 1999 and 1998, respectively, and is included in other liabilities and policyholder funds on the balance sheet. Other investments also include equity securities of $55.5 million and $37.7 million, respectively, at December 31, 1999 and 1998, and other assets include amounts receivable from brokers for investment sales of $19.8 million and $159.9 million, respectively. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE C - INVESTMENTS - (CONTINUED) As of December 31, 1999 and 1998, approximately 21% and 35%, respectively, of the Company's total invested assets were comprised of mortgage-backed securities. The Company's mortgage-backed securities are diversified with respect to size and geographic distribution of the underlying mortgage loans. The Company also invests in certain non-investment grade securities as determined by nationally recognized statistical rating agencies. Non-investment grade securities included in fixed maturity securities had fair values of $132.0 million and $81.9 million at December 31, 1999 and 1998, respectively. Trading account securities included additional non-investment grade securities with fair values of $67.0 million and $35.8 million at December 31, 1999 and 1998, respectively. In the aggregate, non-investment grade securities constituted 8% and 5% of total invested assets at December 31, 1999 and 1998, respectively. The fair value of the Company's investment in the securities of any one issuer or securities backed by a single pool of assets, excluding U.S. Government obligations, whose value represented 10% or more of shareholders' equity at December 31, 1999 was as follows: Bankers Trust Corporation Secured Portfolio Notes, Series 1998-1 - $189.0 million and Tersk LLC - $80.6 million. The Bankers Trust notes, which are classified as available for sale corporate securities, are privately-placed structured notes maturing in 2008 having a variable crediting rate which is linked, on an amortizing basis over the term of the notes, to the actual investment performance of a special purpose entity which owns investments in a diversified portfolio of investment vehicles of independent investment managers. The Company's investment in Tersk LLC consisted of redeemable preferred securities of $72.6 million and common securities of $8.0 million at December 31, 1999. The Company from time to time utilizes exchange-traded futures and option contracts to reduce the risk associated with changes in the value of its fixed maturity portfolio due to changes in the interest rate environment and to reduce the risk associated with changes in interest rates in connection with anticipated securities purchases. Generally, market prices of fixed maturity securities decline in an environment of increasing interest rates in a manner similar to that of U.S. Treasury securities. Therefore, in order to reduce the extent of this interest rate risk, the Company enters into option contracts and short U.S. Treasury futures contracts, the value of which will rise in such an environment. Because these contracts reduce the Company's exposure to interest rate risk, they qualify as a hedge for accounting purposes. At December 31, 1999, the Company had realized gains of $13.3 million on closed positions and unrealized gains of $15.3 million on open positions related to these programs that have been deferred and recorded as adjustments to the amortized cost of the fixed maturity securities being hedged. If the hedged securities are sold or otherwise disposed of, the related realized gain or loss would be computed based upon the difference between the adjusted amortized cost of the security and the proceeds received. At December 31, 1999, the Company had outstanding short U.S. Treasury futures related to these programs with a notional value of $579.8 million. In addition, the Company at times enters into futures and option contracts and interest rate swap agreements in connection with its investment strategy that do not qualify for hedge accounting. Accordingly, these positions are carried at fair value with gains and losses included in income. During 1999, the Company recognized net investment income of $3.0 million and net realized losses of $14.0 million related to these instruments. At December 31, 1999, the Company had outstanding interest rate swap agreements with a notional value of $468.9 million and an average unexpired term ranging from 1 day to 11 months. The Company has reduced the interest-rate risk associated with certain of these swap agreements by entering into futures and option contracts. At December 31, 1999, the Company had outstanding long futures positions with a notional value of $186.6 million and a fair value of $180.4 million and short futures positions with a notional value of $44.3 million and a fair value of $41.1 million. Notional values are used to calculate contractual payments and are not representative of the potential gain or loss on a contract. Over-the-counter options and interest rate swaps subject the Company to credit risk to the extent that counterparties of the transactions fail to perform under the contracts. The Company manages this risk by only entering into these transactions with highly rated institutions. In addition, the agreements to which the Company is party typically contain collateral requirements and require periodic cash settlement for changes in market value. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE D - ACCIDENT AND HEALTH AND CASUALTY FUTURE POLICY BENEFITS AND UNPAID CLAIMS AND CLAIM EXPENSES The following table provides a reconciliation of the beginning and ending accident and health and casualty future policy benefits and unpaid claims and claim expenses: NOTE E - CORPORATE DEBT At December 31, 1999, the Company's outstanding borrowings under its $180 million revolving credit facility with a group of lenders (the "Credit Agreement") totaled $157.0 million. At December 31, 1998 the Company's outstanding borrowings under the Credit Agreement totaled $129.0 million. The borrowings under the Credit Agreement accrue interest at a floating rate which is indexed to various published interest indices, and a non-use fee is charged on any unused portion of the commitment. During 1999, the maximum amount of borrowings available under the Credit Agreement was reduced by $20 million and will continue to be reduced to the following amounts in October of each year: 2000 - $150.0 million, 2001 - $110.0 million and 2002 - $60.0 million. At the Company's current level of borrowings, a principal repayment of $7.0 million will be required under the Credit Agreement in October 2000. The final maturity of the Credit Agreement is on April 1, 2003. The debt is secured by a security interest in all of the common stock of RSLIC-Texas, the issued and outstanding common stocks of substantially all of the Company's non-insurance subsidiaries and, on a subordinated basis, the common stock of SNCC. The debt is also subject to certain restrictions and financial covenants considered ordinary for this type of borrowing. They include, among others, the maintenance of certain financial ratios, minimum statutory surplus requirements for RSLIC and SNCC, minimum consolidated equity requirements for the Company and certain investment and dividend limitations. As of December 31, 1999, the Company was in compliance in all material respects with the restrictions and covenants in the Credit Agreement. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE E - CORPORATE DEBT - (CONTINUED) The Company's $85.0 million of 8.0% Senior Notes due 2003 (the "Senior Notes") are senior unsecured obligations of the Company and, as such, are effectively subordinated to all existing and future obligations of the Company's subsidiaries, including the insurance subsidiaries' obligations to policyholders. The Senior Notes are not redeemable prior to maturity or entitled to any sinking fund. In certain instances, holders of the Senior Notes have the right to require the Company to repurchase any or all of the Senior Notes owned by such holders at 101% of the principal amount thereof, plus accrued and unpaid interest. The terms of the indenture pursuant to which the Senior Notes were issued contain certain covenants and restrictions which set forth, among other things, limitations on incurrence of indebtedness by the Company and its subsidiaries, limitations on payments of dividends on and repurchases of stock of the Company and limitations on transactions with stockholders and affiliates. As of December 31, 1999, the Company was in compliance in all material respects with the terms of the indenture. In 1996, the Company assumed $45.0 million of SIG's 8.5% senior secured notes (the "SIG Senior Notes"). The SIG Senior Notes began maturing in $9.0 million annual installments in 1999 and are collateralized by all of the common stock of SNCC. The terms of the note agreement pursuant to which the SIG Senior Notes were issued contain certain covenants and restrictions which set forth, among others, minimum statutory surplus requirements for SNCC, minimum consolidated equity requirements for SIG, as well as the maintenance of certain financial ratios. As of December 31, 1999, SIG was in compliance in all material respects with the terms of the note agreement. In conjunction with the acquisition of Matrix, the Company issued $5.7 million of 8% subordinated notes due 2003 (the "Subordinated Notes"). The Subordinated Notes are unsecured obligations of the Company, and payments of principal and interest on the notes are subordinated to all of the Company's senior debt obligations. Interest paid by the Company on its corporate debt totaled $17.9 million, $17.0 million and $14.5 million during 1999, 1998 and 1997, respectively. NOTE F - ADVANCES FROM THE FEDERAL HOME LOAN BANK The Company maintains an investment program in which securities were financed using advances from the Federal Home Loan Bank of Pittsburgh ("FHLB"). As of December 31, 1999 and 1998, advances from the FHLB, including accrued interest, totaled $75.5 million. Interest expense on the advances is included as an offset to investment income on the financed securities. The average interest rate on the outstanding advances was 7.8% at December 31, 1999 and 1998. The advances had a weighted average term of 4.5 years at December 31, 1999 and were collateralized by fixed maturity securities with a fair value of $95.4 million. NOTE G - INCOME TAXES Income tax expense is reconciled to the amount computed by applying the statutory federal income tax rate to income from continuing operations before income tax expense as follows: All of the Company's current and deferred income tax expense is due to federal income taxes as opposed to state income taxes. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE G - INCOME TAXES - (CONTINUED) Deferred tax assets and liabilities are determined based on the difference between the book basis and tax basis of assets and liabilities using tax rates in effect for the year in which the differences are expected to reverse. The components of the net deferred tax (asset) liability are as follows: Current tax expense, current tax (recoverable) liability and income taxes paid are as follows: NOTE H - PRESENT VALUE OF FUTURE PROFITS A summary of the activity related to the PVFP asset, which is included in cost of business acquired on the consolidated balance sheet, is shown below: An estimate of the percentage of the December 31, 1999 PVFP balance to be amortized over each of the next five years is as follows: 2000 - 14%, 2001 - 14%, 2002 - 13%, 2003 - 13% and 2004 - 11%. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE I - FAIR VALUES OF FINANCIAL INSTRUMENTS The fair values of the Company's financial instruments are shown below. Because fair values for all balance sheet items are not required to be disclosed by SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," the aggregate fair value amounts presented below do not necessarily represent the underlying value of the Company. The fair values for fixed maturity securities have been obtained from broker-dealers, nationally recognized statistical organizations and, in the case of certain structured notes, by reference to the fair values of the underlying investments. The carrying values for all other invested assets approximate fair values based on the nature of the investments. The carrying values of separate account assets and liabilities are equal to fair value. Policyholder account balances are net of reinsurance receivables and the carrying values have been decreased for related acquisition costs of $57.8 million and $29.6 million at December 31, 1999 and 1998, respectively. Fair values for policyholder account balances were determined by deducting an estimate of the future profits to be realized from the business, discounted at a current interest rate, from the adjusted carrying values. The Company believes the fair value of its variable rate long-term debt is equal to its carrying value. The Company pays a variable rate of interest on the debt which reflects changed market conditions since the time the terms were negotiated. The fair values of the Senior Notes, the SIG Senior Notes and the Subordinated Notes are based on the expected cash flows discounted to net present value. The fair values for advances from the FHLB were calculated using discounted cash flow analyses based on the interest rates for the advances at the balance sheet date. The carrying value of the liability for securities loaned or sold under agreements to repurchase approximates fair value as the liability is very short-term in nature. The carrying value of securities sold, not yet purchased is equal to fair value. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE J - CAPITAL SECURITIES OF DELPHI FUNDING L.L.C. In March 1997, Delphi Funding L.L.C. ("Delphi Funding"), a subsidiary of the Company, issued $100.0 million liquidation amount of 9.31% Capital Securities, Series A (the "Capital Securities") in a public offering. In connection with the issuance of the Capital Securities and the related purchase by the Company of all of the common limited liability company interests in Delphi Funding, the Company issued to Delphi Funding $103.1 million principal amount of 9.31% junior subordinated deferrable interest debentures, Series A, due 2027 (the "Junior Debentures"). Interest on the Junior Debentures is payable semiannually, but may, subject to certain exceptions, be deferred at any time or from time to time for a period not exceeding five years with respect to each deferral period, in which event distributions on the Capital Securities will also be deferred and the Company will not be permitted to pay cash dividends or make payments on any junior indebtedness. No interest payments on the Junior Debentures have been deferred since their issuance. The distribution and other payment dates on the Capital Securities correspond to the interest and other payment dates on the Junior Debentures. The Junior Debentures are not redeemable prior to March 25, 2007, but the Company has the right to dissolve Delphi Funding at any time and distribute the Junior Debentures to the holders of the Capital Securities. Pursuant to the related transaction documents, the Company has, on a subordinated basis, guaranteed all payments due on the Capital Securities. NOTE K - SHAREHOLDERS' EQUITY AND RESTRICTIONS The holders of the Company's Class A Common Stock are entitled to one vote per share, and the holders of the Company's Class B Common Stock are entitled to the number of votes per share equal to the lesser of (1) the number of votes such that the aggregate of all outstanding shares of Class B Common Stock will be entitled to cast 49.9% of all votes represented by the aggregate of all outstanding shares of Class A Common Stock and Class B Common Stock or (2) ten votes per share. The Company's Board of Directors declared 2% stock dividends which were distributed to stockholders on June 10, 1997, May 4, 1998, December 15, 1998, June 8, 1999 and December 15, 1999, respectively. Under the Credit Agreement, cash dividends on, together with any repurchases or redemptions by the Company of, its capital stock, may not, during any fiscal year, exceed 4% of the Company's Consolidated Equity (as defined in the Credit Agreement) as of the end of the preceding fiscal year, with unused amounts carrying over to subsequent fiscal years, except that in fiscal year 1999 dividends and repurchases were permitted in an aggregate amount equal to $56.1 million. The Credit Agreement also permits additional repurchases by the Company of its capital stock in an aggregate amount of up to $20.0 million over the term of the Credit Agreement. The Company's life insurance subsidiaries had consolidated statutory capital and surplus of $215.5 million and $203.9 million at December 31, 1999 and 1998, respectively. Consolidated statutory net income for the Company's life insurance subsidiaries, after interest expense of $0.9 million, $3.3 million and $4.9 million, respectively, on a surplus debenture payable to DFG, was $30.3 million, $18.7 million and $27.8 million in 1999, 1998 and 1997, respectively. The Company's casualty insurance subsidiary had statutory capital and surplus of $195.3 million and $207.2 million at December 31, 1999 and 1998, respectively, and statutory net income of $13.3 million, $48.1 million and $34.8 million in 1999, 1998 and 1997, respectively. Payment of dividends by the Company's insurance subsidiaries is regulated by insurance laws and are permitted based on, among other things, the level of prior-year statutory surplus and net income. The Company's insurance subsidiaries will be permitted to make dividend payments totaling $49.5 million during 2000 without prior regulatory approval. The Company's Board of Directors has authorized the Company to purchase up to 2.1 million shares of its outstanding Class A Common Stock from time to time on the open market. During 1999, the Company purchased 1.1 million shares of its Class A Common Stock for a total cost of $39.1 million. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE K - SHAREHOLDERS' EQUITY AND RESTRICTIONS - (CONTINUED) The following table provides a reconciliation of beginning and ending shares: NOTE L - COMMITMENTS AND CONTINGENCIES In the course of their respective businesses, the Company's subsidiaries are defendants in litigation; in the case of its insurance subsidiaries, principally involving insurance policy claims and agent disputes and in the case of its integrated disability and absence management subsidiary, benefit claims-related litigation. In the opinion of management, the ultimate disposition of such pending litigation will not have a material adverse effect on the Company's financial condition, liquidity or results of operations. NOTE M - STOCK OPTIONS The Company accounts for stock options in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no compensation expense has been recognized in the accompanying financial statements for the Company's stock option plans because the exercise price of the options granted equaled the market price of the underlying stock on the date of grant. If compensation expense for options granted had been recognized based on the provisions of SFAS No. 123, "Accounting for Stock- Based Compensation," the Company's net income would have been $46.1 million, $82.5 million and $71.6 million and earnings per share would have been $2.20, $3.91 and $3.53 ($2.10, $3.75 and $3.34, assuming dilution) in 1999, 1998 and 1997, respectively. The weighted average per share fair value used to calculate pro forma compensation expense for 1999, 1998 and 1997 was $16.17, $19.88 and $18.21, respectively. These fair values were estimated at the grant date using the Black-Scholes option pricing model with the following assumptions: risk-free interest rates ranging from 4.1% to 6.5%, volatility factors of the expected market price of the Company's common stock ranging from 25% to 37%, expected lives of the options ranging from five to ten years and dividend yields of 0%. DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE M - STOCK OPTIONS - (CONTINUED) Under the terms of the Company's employee stock option plan and outside directors' stock option plan, a total of 2,318,570 shares of Class A Common Stock have been reserved for issuance. The exercise price for options granted under these plans is the fair market value of the underlying stock as of the date of the grant and the maximum term of an option is ten years. The Company's long-term performance-based incentive plan for its chief executive officer (the "Performance Plan") provides for the award of up to 317,975 shares or options for shares of the Company's Class B Common Stock (79,494 restricted or deferred shares and options to purchase 238,481 shares) per year over a ten-year term contingent upon the Company meeting specified annual performance goals. The restricted or deferred shares may not be sold or otherwise disposed of until the earliest of the individual's retirement, disability or death or a change of ownership of the Company. The exercise price of the options awarded under the Performance Plan is the fair market value of the underlying stock as of the date of the grant and the maximum term of the options is ten years. The options become exercisable 30 days following the date of grant. For each of the years ended December 31, 1998 and 1997, 79,494 deferred shares and 238,481 options were awarded under the Performance Plan. The Company recognized $3.5 million, $4.0 million and $3.1 million of compensation expense in 1999, 1998 and 1997, respectively, related to the Performance Plan. Option activity with respect to the above plans was as follows: Information about options outstanding at December 31, 1999 was as follows: DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE M - STOCK OPTIONS - (CONTINUED) During 1996, the Company assumed 6.0 million SIG Options. Upon the exercise of the SIG Options, the holder is entitled to receive (i) .1399 of a share of Class A Common Stock for each SIG Option; plus (ii) an additional number of shares of Class A Common Stock equal to the quotient of (a) $1.90 multiplied by the number of SIG Options being exercised increased by an interest component from the time of the SIG Merger to the exercise date, divided by (b) the average closing share price for the Company's Class A Common Stock for the ten days prior to the exercise date. The SIG Options were granted annually from 1992 to 1996, have an exercise price of $0.02 and each grant vests over five years beginning in the fourth year after the grant date. All of the SIG Options expire on October 1, 2006. As of December 31, 1999, the weighted average contractual life of the outstanding SIG Options was 6.8 years. Activity with respect to the outstanding SIG Options was as follows: DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE N - COMPUTATION OF RESULTS PER SHARE DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE O - REINSURANCE The Company assumes and cedes reinsurance on both a coinsurance and a risk premium basis. The Company obtains reinsurance for amounts above certain retention limits which vary with age, plan of insurance and underwriting classification. Amounts of standard risks in excess of those limits are reinsured. Indemnity reinsurance treaties do not provide absolute protection to the Company since the ceding insurer remains responsible for policy claims to the extent that the reinsurer fails to pay such claims. To reduce this risk, the Company monitors the financial condition of its reinsurers, including, among other things, the companies' financial ratings, and in certain cases receives collateral security from the reinsurer. Also, certain of the Company's reinsurance agreements require the reinsurer to set up trust arrangements for the Company's benefit in the event of certain ratings downgrades. As of December 31, 1999, all of the Company's significant reinsurers were either rated "A-" (Excellent) or higher by A.M. Best Company or had supplied collateral in an amount sufficient to support the amounts receivable. In January 1998, an offering was completed whereby shareholders and optionholders of the Company received, at no cost, rights to purchase shares of Delphi International, a newly-formed, independent Bermuda insurance holding company. During 1998, the Company entered into various reinsurance agreements with Oracle Re, a wholly owned subsidiary of Delphi International. Pursuant to these agreements, approximately $101.5 million of group employee benefit reserves ($35.0 million of long-term disability insurance reserves and $66.5 million of net excess workers' compensation and casualty insurance reserves) were ceded to Oracle Re. The Company has received collateral security from Oracle Re in an amount sufficient to support the ceded reserves. In May 1999, Oracle Re and the Company effected the partial recapture of approximately 35%, or $10 million, of the group long-term disability liabilities ceded to Oracle Re. These agreements are not expected to have a material effect on the Company's financial condition, liquidity or results of operations. A summary of reinsurance activity follows: DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) DECEMBER 31, 1999 NOTE P - SEGMENT INFORMATION (1) Consists of operations that do not meet the quantitative thresholds for determining reportable segments and includes integrated disability and absence management services and certain corporate activities. (2) Income (loss) from continuing operations excluding net realized investment gains and losses and before interest and income tax expense and dividends on Capital Securities of Delphi Funding L.L.C. NOTE Q - DISCONTINUED OPERATIONS Effective April 30, 1999, the Company completed the disposition of its Unicover Managers, Inc. subsidiary and a related company (collectively, "Unicover"), which were acquired in the fourth quarter of 1998, to certain of the former owners of Unicover. The Company recognized a loss of $13.8 million on the disposition of the discontinued operations of Unicover, net of a related tax benefit of $8.7 million, in the first quarter of 1999. Revenue associated with Unicover for the first four months of 1999 totaled $24.6 million, and no operating income was associated with Unicover for such period. In 1998, revenue associated with Unicover totaled $23.0 million, and income from Unicover's operations totaled $13.2 million, net of tax expense of $8.8 million. SCHEDULE I DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1999 (DOLLARS IN THOUSANDS) SCHEDULE II DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT DELPHI FINANCIAL GROUP, INC. (PARENT COMPANY) BALANCE SHEETS (DOLLARS IN THOUSANDS) See notes to condensed financial statements SCHEDULE II (CONTINUED) DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) DELPHI FINANCIAL GROUP, INC. (PARENT COMPANY) STATEMENTS OF INCOME (DOLLARS IN THOUSANDS) See notes to condensed financial statements SCHEDULE II (CONTINUED) DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) DELPHI FINANCIAL GROUP, INC. (PARENT COMPANY) STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) See notes to condensed financial statements. SCHEDULE II (CONTINUED) DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) DELPHI FINANCIAL GROUP, INC. (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and related notes of Delphi Financial Group, Inc. and Subsidiaries. The Company received cash dividends from subsidiaries of $9.4 million, $9.4 million and $4.2 million in 1999, 1998 and 1997, respectively. SCHEDULE III DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (DOLLARS IN THOUSANDS) (1) Net written premiums for casualty insurance products totaled $81.3 million, $80.8 million and $67.5 million for the years ended December 31, 1999, 1998 and 1997, respectively. SCHEDULE IV DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES REINSURANCE (DOLLARS IN THOUSANDS) SCHEDULE VI DELPHI FINANCIAL GROUP, INC. AND SUBSIDIARIES SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS (DOLLARS IN THOUSANDS) - ----------------- (1) Based on interest rates ranging from 3.7% to 6.5%.

746210_1999.txt

746210_1999

1999

746210

ITEM 1. BUSINESS GENERAL View Tech, Inc. ("View Tech"), a Delaware corporation, commenced operations in July 1992 as a California corporation. In June 1995, the Company completed an initial public offering of common stock. In November 1996, concurrent with a merger with USTeleCenters, Inc. ("USTeleCenters"), a Massachusetts corporation, with and into View Tech Acquisition, Inc. ("VTAI"), a Delaware corporation and a wholly-owned subsidiary of View Tech, the Company reincorporated in Delaware. Following the merger, VTAI changed its name to "USTeleCenters, Inc." ("UST"). In November 1997, the Company, through its wholly-owned subsidiary, acquired the net assets of Vermont Telecommunications Network Services, Inc. ("NSI"), a Vermont corporation headquartered in Burlington, Vermont, which sells, manages and supports telecommunication network solutions as an agent for Bell Atlantic. On February 18, 2000, the Company completed the sales of its subsidiaries, UST and NSI, to OC Mergerco 4, Inc. Upon the sale of UST and NSI, the Company operates in one segment, video product sales and service. On or about December 1, 1999, the Company announced an agreement in principle to merge with All Communications, Inc. ("ACUC"). ACUC is a regional competitor of the Company, headquartered in the State of New Jersey. The merger agreement was signed by ACUC and the Company on or about December 27, 1999. A registration statement on Form S-4 relating to the merger was filed with the Securities & Exchange Commission (the "Commission") on or about January 21, 2000 (the "Registration Statement"). An Amended S-4 will be filed with the Commission shortly. The merger is expected to be completed following regulatory approval and stockholder approval by both ACUC and the Company. There is no assurance that the merger will ultimately be consummated. NARRATIVE DESCRIPTION OF BUSINESS The Company is a single source provider of voice, video and data equipment, network services and bundled telecommunications solutions for business customers nationwide. The Company has equipment distribution partnerships with Accord Telecommunications, Cisco Systems, Ezenia, FVC.com, Intel(C) Corporation, Lucent Technologies, Madge Networks, PictureTel Corporation, Polycom, Inc., Tandberg, VCON and VTEL Corporation. The Company currently has 19 offices nationwide. The Company is headquartered in Camarillo, California. Its offices are located at 3760 Calle Tecate, Suite A, Camarillo, California 93012. Its telephone number is 805/482-8277. VIDEO COMMUNICATIONS The Company's video communications group focuses on the sale, installation and service of video communications systems. Utilizing advanced technology, these systems enable users at separate locations to engage in face-to-face discussions and to exchange information with the relative affordability and convenience of using a telephone. In addition to the use of video conferences as a corporate communications tool, use of video communications systems is expanding into numerous productivity enhancing applications, including (i) the lecturing by teachers to students at multiple locations; (ii) the conduct by View Tech, Inc. Page 5 - -------------------------------------------------------------------------------- judges of criminal arraignment proceedings while the accused remains incarcerated; (iii) the utilization of video technology for the consultation and surgical applications for the health care industry; (iv) the coordination of emergency services by public utilities; (v) the conduct by businesses of multi- location staff training programs; and (vi) the coordination by engineers at separate design facilities of joint development of products. PRODUCTS Video The Company offers three types of video communications systems: integrated roll-about and room systems; vertical applications; and desktop computer systems. Roll-about systems may be moved conveniently from office to office and placed into operation quickly while room systems are stationary systems. Vertical applications include distance education and systems utilized in the healthcare industry. Finally, desktop computer systems involve personal computers with video communications capabilities which are generally used for one-on-one personal communications, or for a one-person presentation to a group. Apart from peripheral components manufactured by others, the Company primarily sells systems manufactured by PictureTel Corporation, Polycom, Inc. and VTEL Corporation. The prices of the complete systems sold by the Company range from $1,500 for a video communications desktop computer, to $30,000 for a roll-about system for a single location, to as much as $70,000 for a vertical application. Roll- about systems generally contain a minimum of a video camera, monitor and coding- decoding device to capture the image, display the image and to encode and decode the transmission over digital phone lines, respectively. Most installations have several additional peripherals including some of the following components: an inverse multiplexer, a multi-point control unit, a document camera, a keypad, a speakerphone, a videocassette recorder and/or an annotations slate and white board. The Company buys the components listed above from manufacturers and acquires the monitors, document cameras, video scan converters, videocassette recorders and white boards from various sources depending upon such factors as price and quality. Although the Company's desktop-computer systems involve different components, the desktop system has many of the capabilities of the roll-about and room systems. The Company's desktop video communications equipment is manufactured by PictureTel and others such as VCON, Inc. Data The Company sells products specifically designed to transmit data through the established local and long-distance telephone services infrastructure to business customers. Products from companies such as Adtran, Madge Networks, and Lucent Technologies allow business customers remote access into local area networks, and permit them to acquire bandwidth on demand and digitally transmit data. Video Services The Company offers its customers the convenience of single-vendor sourcing for most aspects of their communications needs and develops customized systems designed to provide efficient responses to customer communications technology requirements. The Company provides its customers with a full complement of video communications and telecommunications services to ensure customer satisfaction. Prior to the sale of its systems and services, the Company provides consulting services that include an assessment of customer needs and View Tech, Inc. Page 6 - -------------------------------------------------------------------------------- existing communications equipment, as well as cost-justification and return-on- investment analyses for systems upgrade. Once the Company has made recommendations with respect to the most effective method to achieve its customer's objectives and the customer has ordered a system, the Company delivers, installs and tests the communications equipment. When the system is functional, the Company provides training to all levels of its customer's organization, including executives, managers, management-information-systems and data-processing administrators, technical staff and end users. Training includes instruction in system operation, as well as planning and administration meetings. By means of thorough training, the Company helps to ensure that its customers understand the functionality of the systems and are able to apply the technology effectively. The Company's ViewCare(R) service product provides maintenance contracts and comprehensive customer support with respect to the communications equipment it provides. The Company offers a toll-free technical support hotline 24 hours a day, 365 days a year. Customers may also obtain answers to questions or follow- up training through video conferencing, telephone, facsimile, e-mail or the mail. The Company also provides onsite support and maintenance. The Company's service personnel maintain regular contact with customers. The Company also offers training programs for new users, refresher and advanced training programs for experienced users and consulting services related to new equipment and systems expansion and upgrades. Installation, training, maintenance, remote diagnostics, billing inquiry management, network order processing, new product introduction and system enhancements creating multi- purpose solutions are a few of the many after-sale services that the Company performs for its customers. During 1998 and 1999, the Company increased its MCU, MultiView Network Services(R), or bridge services, to its customers nationwide. The Company employs state-of-the-art conferencing servers in multiple U.S. call centers, providing seamless connectivity for all switched digital networks across the globe at an affordable rate. Because bridges cost between $30,000 and $200,000 per unit, the Company's customers typically elect to utilize such services when more than two locations participate simultaneously in video communication. Customers The Company focuses primarily on large organizations with complex application- specific requirements for video communications. The Company has installed video communications systems for a diversified customer base, including Pfizer Pharmaceuticals, PacifiCare, Region 18 Educational Service Center, Raytheon Corporation, and the State of Tennessee. The Company has attempted to focus its marketing efforts on specific industries. Among the industries in which the Company believes it has acquired substantial expertise are health care and distance-education. Sales and Marketing The Company has in place a number of programs to promote its video communications products and services. Representatives of the Company regularly attend video communications and advanced technology trade shows. The Company hosts seminars and provides potential customers with the opportunity to learn about the Company's products and services using video communications demonstration facilities located in each of the Company's offices. The Company also places advertisements aimed at selected markets in industry trade publications and utilizes limited and selective direct mail advertising. Dependence on Suppliers View Tech, Inc. Page 7 - -------------------------------------------------------------------------------- For the twelve months ended December 31, 1999, approximately 29% of the Company's revenues from continuing operations were attributable to the sale and servicing of equipment manufactured by PictureTel. Termination of or change of the Company's business relationships with PictureTel; disruption in supply, failure of PictureTel to remain competitive in product quality, function or price or a determination by PictureTel to reduce reliance on independent providers such as the Company, among other things, would have a material adverse effect on the Company's business, financial condition and results of operations. The Company is a party to an agreement with PictureTel that authorizes the Company to serve as a non-exclusive dealer and sales agent, respectively, in certain geographic territories. The PictureTel agreement can be terminated without cause upon written notice, subject to certain notification requirements. There can be no assurance that this agreement will not be terminated, or that it will be renewed on terms acceptable to the Company. This supplier has no affiliation with the Company and is a competitor of the Company. Competition The video communications industry is highly competitive. The Company competes with manufacturers of video communications equipment, which include PictureTel, VTEL and Lucent Technologies, and their networks of dealers and distributors, telecommunications carriers and other large corporations, as well as other independent distributors. Other telecommunications carriers and other corporations that have entered the video communications market include, AT&T, MCI, some of the Regional Bell Operating Companies ("RBOCs"), Intel Corporation, Microsoft Corporation, Sony Corporation and British Telecom. Many of these organizations have substantially greater financial and other resources than the Company, furnish many of the same products and services provided by the Company and have established relationships with major corporate customers that have policies of purchasing directly from them. Management believes that as the demand for video communications systems continues to increase, additional competitors, many of which will have greater resources than the Company, will enter the video communications market. A specific manufacturer's network of dealers and distributors typically involves discrete territories that are defined geographically, in terms of vertical market, or by application (e.g., project management or government procurement). The current agreement with PictureTel authorizes the Company to distribute PictureTel products in the following states: Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Georgia, Louisiana, Maine, Massachusetts, Mississippi, Montana, New Hampshire, New Jersey, New Mexico, New York, Oklahoma, Tennessee, Texas, Utah, Vermont and Wyoming. Because the agreement is non-exclusive, however, the Company is subject to competition within these territories from other PictureTel dealers, whose customers elsewhere may have branch facilities in these territories, and from PictureTel itself, which directly markets its products to certain large national corporate accounts. The agreement expires on August 1, 2000 and can be terminated without cause upon 60 days' written notice by PictureTel. There can be no assurance that the agreement will not be terminated, or that it will be renewed by PictureTel, which has no other affiliation with the Company and is a competitor of the Company. While there are suppliers of video communications equipment other than PictureTel, termination of the Company's relationship with PictureTel could have a material adverse effect on the Company. The Company believes that customer purchase decisions are influenced by several factors, including cost of equipment and services, video communication system features, connectivity and compatibility, a system's capacity for expansion and upgrade, ease of use and services provided by a vendor. Management believes its comprehensive knowledge of the operations of the industries it has targeted, the quality of the equipment the Company sells, the quality and depth of its services, its nationwide presence and ability to provide its customers with all of the equipment and services necessary to ensure the successful implementation and utilization of its video View Tech, Inc. Page 8 - -------------------------------------------------------------------------------- communications system enable the Company to compete successfully in the industry. Employees At March 1, 2000, the Company had 123 full-time employees. The Company had 41 full-time employees engaged in marketing and sales, 59 in technical services and 23 in finance, administration and operations. None of the Company's employees is represented by a labor union. The Company believes that its relations with its employees are good. ITEM 2. ITEM 2. PROPERTIES The Company's video business leases office facilities in Camarillo, Irvine, Sacramento and San Diego, California; New York, New York; Baton Rouge, Louisiana; Chicago, Illinois; Dallas and Houston, Texas; Durham, North Carolina; Englewood, Colorado; Nashville and Knoxville, Tennessee; Jacksonville, Florida; Salt Lake City, Utah; and Chesterfield, Missouri. The Durham and Jacksonville locations were closed during the first quarter of 2000. The rest of locations are currently principally engaged in video conferencing sales and services. Its videoconferencing headquarters is located in Camarillo, California and consists of a total of approximately 19,000 square feet. The Company's other facilities house sales, technical and administrative personnel and consist of aggregate square footage of approximately 42,000. When UST and NSI were part of the Company, they leased office facilities in Boston and Cape Cod, Massachusetts, and Burlington, Vermont. Such locations were principally engaged in the sale and service of telephony products and services. Obligations under these leases have been assumed by OC Mergerco 4, Inc. The Company believes that the facilities it presently leases, combined with those presently under negotiations, will be adequate for the foreseeable future and that additional suitable space, if required, can be located and leased on reasonable terms. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the ordinary course of business the Company experiences various types of claims which sometimes result in litigation or other legal proceedings. The Company does not anticipate that any of these proceedings that are currently pending will have any material adverse effect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None View Tech, Inc. Page 9 - -------------------------------------------------------------------------------- PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS STOCK MARKET AND OTHER INFORMATION The Company's common stock is traded on The Nasdaq Stock Market[_], ("Nasdaq"), under the symbol "VUTK" on the National Market and has been so traded since November 18, 1995. Prior to such date, the shares were traded on Nasdaq's SmallCap Market and also the Pacific Stock Exchange under the symbols "VUTK" and "VWK," respectively, since the Company's initial public offering on June 15, 1995 (the "IPO"). In addition, warrants to purchase up to 575,000 shares of the Company's common stock were traded on Nasdaq's National Market and prior to November 18, 1995 the warrants traded on Nasdaq's SmallCap Market and the Pacific Stock Exchange under the symbols "VUTKW" and "VWK WS," respectively. The terms of the warrants provided that one warrant plus $5.00 was required to purchase one additional share of the Company's common stock. The warrants were redeemable at the Company's option commencing June 15, 1996 upon 30 days notice to the warrant holders at $0.25 per share if the closing price of the common stock had been at least $8.00 for a period of 30 consecutive trading days ending within 10 days of the date the notice of redemption was mailed. The warrants expired on June 15, 1998. The following table sets forth the quarterly high and low bids for the Company's common stock as reported by Nasdaq's National Market for the periods indicated. On March 24, 2000, the last reported bid for the Company's common stock on the Nasdaq was $7.125. As of March 24, 2000, there were 169 holders of record of the Company's common stock. Dividends The Company has never paid any cash dividends on its common stock. It presently intends to retain earnings and capital, if any, for use in its business and does not expect to pay any dividends within the foreseeable future. Any payment of cash dividends in the future on the common stock will be dependent on the Company's financial condition, results of operations, current and anticipated cash requirements, plans for expansion, restrictions under debt obligations, as well as other factors that the Board of Directors deems relevant. Recent Sales of Unregistered Securities In November 1999, the Company consummated a subordinated debt offering pursuant to which it issued subordinated secured notes to a limited number of accredited purchasers from which it received proceeds of approximately $2.0 million. The notes have an interest rate of the prime rate plus 2-1/2%, will be repaid in seven months, and are secured by a pledge of the Company's assets on a subordinated position to the Company's other lenders. As partial consideration for purchase of the notes, the Company issued 5-year warrants to purchase 925,000 shares of the Company's common stock to these purchasers, on a proportional basis of each purchaser's purchase of the notes, with an exercise price of $1.625 a share. The notes and the warrants were issued under Section 4(2) of the Securities Act of 1933, as amended. View Tech, Inc. Page 10 - -------------------------------------------------------------------------------- U.S. Stock Transfer Corporation of Glendale, California serves as transfer agent and registrar of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Company's consolidated financial statements and the notes thereto appearing elsewhere in this Form 10-K. All statements contained herein that are not historical facts, View Tech, Inc. Page 11 - -------------------------------------------------------------------------------- including, but not limited to, statements regarding anticipated future capital requirements, the Company's future development plans, the Company's ability to obtain debt, equity or other financing, and the Company's ability to generate cash from operations, are based on current expectations. These statements are forward-looking in nature and involve a number of risks and uncertainties that may cause the Company's actual results in future periods to differ materially from forecasted results. Results of Operations The following table sets forth, for the periods indicated, information derived from the Company's consolidated financial statements expressed as a percentage of the Company's revenues: YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 - --------------------------------------------------------------------- Revenues Total revenues for the twelve months ended December 31, 1999 decreased by $1.8 million, or 5% to $35.5 million from $37.3 million in 1998. Product revenues fell by $3.9 million, or 14%, to $24.0 million from $27.9 million in the comparable period for 1998. The decrease in product revenues was primarily the result of a liquidity crisis which began in September and extended to late November which disrupted the Company's product supply and ability to fulfill customer orders. Service revenues for the twelve months ended December 31, 1999 increased by $2.1 million, or 23%, to $11.5 million from $9.4 million in the comparable period for 1998. The increase in service revenues was due primarily to the growth in the installed customer base and bridging services. View Tech, Inc. Page 12 - -------------------------------------------------------------------------------- Costs and Expenses Cost of equipment sold for 1999 decreased by $0.6 million, or 3%, to $19.4 million from $20.0 million in 1998. Cost of equipment sold as a percentage of product revenue increased to 80.9% in 1999 from 71.6% in 1998. During the fourth quarter of 1999, the Company recorded a $1.6 million inventory reserve covering demonstration equipment, finished goods, and spare parts inventories. Approximately 75% of the inventory reserve applied to demonstration equipment which had not been sold by December 31, 1999. The remainder of the reserve applied to certain finished goods and excess spare parts. Management believes such reserves are adequate to reflect inventory at its net realizable value. It is reasonably possible that a change in the estimate could occur in the near term. In addition to the reserve causing the unfavorable year-to-year comparison, equipment margins shrank as part of an industry-wide trend away from large room systems to desktop systems and due to increased competition. Cost of services provided for 1999 increased by $1.4 million, or 31%, to $5.9 million from $4.5 million in 1998. Cost of services provided as a percentage of service revenue increased to 51.1% in 1999 from 47.8% in 1998. Service margins decreased as a result of adding personnel and bridging equipment to the cost base in advance of increased installation and bridging revenues. Selling and marketing expenses for 1999 increased $2.1 million, or 27%, to $9.9 million from $7.8 million in 1998. Selling and marketing expenses as a percentage of revenues increased to 28.0% in 1999 from 21.0% in 1998. The increase in selling and marketing expenses was primarily due to higher sales compensation and recruitment fees as a result of hiring additional sales personnel ($1.2 million) and other operating expenses incurred as a result of the increased number of sales offices ($0.9 million). General and administrative expenses for 1999 increased by $1.4 million, or 24%, to $7.1 million from $5.7 million in 1998. General and administrative expenses as a percentage of total revenues increased to 20.0% in 1999 from 15.4% in 1998. The increase in general and administrative expenses was primarily due to incurring an extraordinary amount of legal and consulting fees related to managing the Company through its liquidity crisis and negotiations with its bankers, trade creditors, and subordinated lenders ($0.8 million) and a $0.4 million accrual for employee retention bonuses. The Company recorded a restructuring charge of $3.3 million during 1998. The components of the restructuring charge were an impairment write-down of goodwill of $1.5 million, employee termination costs of $1.1 million and other costs of $0.7 million. Interest expense for 1999 increased by $0.4 million, or 179%, to $0.7 million from $0.3 million in 1998. Interest expense as a percentage of total revenues increased to 2.0% in 1999 from 0.7% in 1998. The increase in interest expense was a result of writing off the unamortized balance of its line of credit origination fee ($0.3 million) and one month of amortization of debt issuance costs relating to the forbearance agreement and the subordinated debt ($0.2 million). Loss from discontinued operations increased by $5.6 million from income of $1.5 million in the year ended December 31, 1998 to a loss of $4.1 million in the comparable period for 1999. Discontinued operations incurred an operating loss of ($0.8) million for the year ended December 31, 1999 compared to operating income of $1.5 million for the year ended December 31, 1998. The primary factor driving the year-to-year decline in operating results were significant commission rate cuts (30-40%) effected by the Regional Bell Operating Companies in 1999. In addition, for the year ended December 31, 1999, a $3.3 million loss on disposal of discontinued operations was recognized. Net loss increased $9.2 million to a loss of $12.0 million in 1999 from a loss of $2.8 million in 1998. Net loss as a percentage of revenues increased View Tech, Inc. Page 13 - -------------------------------------------------------------------------------- to (33.8)% for 1999 compared to (7.6)% for 1998. Net loss per share increased to a loss of $(1.53) for 1999 compared to loss per share of $(0.41) for 1998. The weighted average number of shares outstanding increased to 7,842,518 for 1999 from 6,888,104 in 1998, primarily due to the full year impact of the issuance of common stock through a private placement in November 1998. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 - --------------------------------------------------------------------- Revenues Total revenues for the twelve months ended December 31, 1998 increased by $6.2 million, or 20%, to $37.2 million from $31.0 million in 1997. The increase in revenues was primarily related to the Company's nationwide expansion of its videoconferencing business by opening new sales offices and hiring sales personnel. Costs and Expenses Cost of equipment sold for 1998 increased by $2.3 million, or 13%, to $20.0 million from $17.7 million in 1997. Cost of equipment sold as a percentage of product revenue increased slightly to 71.6% in 1998 from 71.2% in 1997. Cost of services provided for 1998 increased by $1.6 million, or 53%, to $4.5 million from $2.9 million in 1998. Cost of services provided as a percentage of service revenue increased slightly to 47.8% in 1998 from 47.3% in 1997. Cost of equipment sold and services provided as a percentage of product sales and service revenues decreased to 65.7% in 1998 from 66.4% in 1997. The percentage decrease is primarily related to an increase in service business. Service business provides a higher profit margin than equipment sales. Selling and marketing expenses for 1998 increased by $1.5 million, or 23%, to $7.8 million from $6.3 million in 1997. Selling and marketing expenses as a percentage of revenues remained constant at 21% in 1998 and in 1997. The increase in selling and marketing expenses was primarily due to higher sales compensation as a result of hiring additional sales personnel ($1.1 million) and other operating expenses incurred as a result of the increased number of sales offices ($0.4 million). General and administrative expenses for 1998 increased by $0.1 million, or 2%, to $5.7 million from $5.6 million in 1997. General and administrative expenses as a percentage of total revenues decreased to 15.4% in 1998 from 18.2% in 1997. The percentage decrease was primarily due to synergies achieved as part of the integration and restructuring efforts. The Company recorded a restructuring charge of $4.2 million during 1998 ($3.3 million related to video operations and $0.9 million related to discontinued operations) which resulted in an increase in loss from operations of $2.5 million from a loss of $1.6 million in 1997 to a loss of $4.1 million in 1998. The significant components of the restructuring charge were an impairment write-down of goodwill of $1.5 million, employee termination costs of $1.8 million and facility exit costs of $0.2 million. Interest expense decreased by $92,000 to $246,000 in 1998 compared to $338,000 in 1997. This decrease was primarily due to lower borrowings related to video related credit facilities and capital lease obligations. Discontinued operations realized a profit for the twelve months ended December 31, 1998 of $1.5 million, a decrease of $.6 million, or 26%, from the $2.1 million profit realized for the comparable period in 1997. Two factors driving the decline in operating results were the declining results of the outside network sales business (commission rate cuts by RBOC's) View Tech, Inc. Page 14 - -------------------------------------------------------------------------------- and the increase in general management costs of the discontinued operation (no synergies achieved from the mergers/acquisitions). Net income decreased by $2.9 million to a loss of $2.8 million in 1998 from net income of $.1 million. Net loss as a percentage of revenues was (7.6)% for 1998 compared to net income as a percentage of revenues of 0.4% for 1997. Net income (loss) per share decreased to a loss of $(0.41) for 1998 compared to income per share of $0.02 for 1997. The weighted average number of shares outstanding increased to 6,888,104 for 1998 from 6,371,651 in 1997, primarily due to the private placement completed in November 1998. Liquidity and Capital Resources View Tech has financed its recent operations with the proceeds from private placements of equity securities, bank debt, secured interim loans, and vendor credit arrangements Effective November 21, 1997, the Company entered into a Credit Agreement (the "Agreement") with Imperial Bank and BankBoston (now Fleet Bank). On August 5, 1999, the Company received a Notice of Event of Default and Notice of Reservations of Rights from the lenders. On November 23, 1999, the Company signed a six-month forbearance agreement with the Banks to be implemented in conjunction with an infusion of $2.0 million in subordinated debt. During the term of the forbearance period, the maximum aggregate amount of the facility will be equal to $4.75 million subject to certain collateral base adjustments. Subject to certain default provisions, which include the failure to pay certain obligations, the departure of the current, interim chief executive officer and president, or a particular material event concerning the Company, the forbearance would continue until May 31, 2000. Interest on the sum owed is set at the prime rate plus 2-1/2%. Interest on any over-advances is the prime rate plus 4%. At December 31, 1999, the interest rate was 11.0%. At December 31, 1999, amounts utilized were $4,363,527. In return, the lenders received the following consideration: the exercise price of the lenders' existing 80,000 warrants, which are exercisable until November 21, 2004, was changed to $1.63 from $4.50. The change was effective as of the date of the forbearance agreement. Under the forbearance agreement, the lenders will also receive a supplemental fee of $150,000. The Company, as noted above, secured interim loans totaling $2.0 million, of which $1.5 million came from individual investors, and $0.5 million in credit from one of the Company's suppliers. The individual investors and the supplier are to be re-paid in seven months with interest at the prime rate plus 2-1/2% for the $2 million in loans. In return, the Company pledged all of its assets, in a subordinated position to the Banks, to the subordinated lenders. Further, the Company issued 925,000 shares of 5-year exercisable warrants to these subordinated lenders, on a proportional basis of each investor's investment, with an exercise price of $1.625 a share. The Company does not believe it has available funds to meet the Company's working capital requirements for the foreseeable future. It has incurred a net loss of $11,990,303 during the year ended December 31, 1999, a working capital deficit of $6,172,005, and stockholders' deficiency of $3,573,793 at December 31, 1999. In addition, the Company is in default of the repayment terms of its obligations related to a credit agreement and has obtained relief through a forbearance agreement which expires on May 31, 2000. The Company has subordinated debt of $2,000,000 due on June 30, 2000. These conditions raise substantial doubt about the ability of the Company to continue as a going concern and as a consequence, the report of the independent certified public accountants for the year ended December 31, 1999 includes a going concern explanatory paragraph. Management's plan is to complete the proposed merger with ACUC. However, there is no assurance that the merger will be ultimately consummated. Accordingly, the consolidated financial statements do not include any View Tech, Inc. Page 15 - -------------------------------------------------------------------------------- adjustments related to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities or any other adjustments that might be necessary should the Company be unable to continue as a going concern. Cash Flow Net cash used by operating activities for the twelve months ended December 31, 1999 was $1.3 million, primarily caused by the Company's net loss of $12.0 million and a decrease in accrued restructuring charges of $0.9 million, partially offset by a decrease in accounts receivable of $1.2 million, an increase in accounts payable of $1.7 million, an increase in deferred revenue of $1.2 million and an increase in payroll and other accrued liabilities of $1.0 million. The non cash and non operating components of net loss include depreciation and amortization of $1.1 million, a $1.6 million reserve on inventory and the loss on discontinued operations of $4.1 million. Net cash provided by discontinued operations for the twelve months ended December 31, 1999 was $0.1 million. Net cash used by investing activities for the twelve months ended December 31, 1999 was $0.9 million, relating to the purchase of office furniture and computer and bridging equipment. Net cash provided by financing activities for the twelve months ended December 31, 1999 was $1.8 million, resulting from the issuance of subordinated debt ($1.5 million) and common stock ($.3 million). Recent Accounting Pronouncements Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133") establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. Statement of Financial Accounting Standards No. 137 deferred the effective date of FAS 133 to be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Company does not expect adoption of SFAS 133 to have a material effect, if any, on its financial position, results of operations, or cash flows. Year 2000 The statements under this caption include "Year 2000 readiness disclosure" within the meaning of the Year 2000 Information and Readiness Disclosure Act. Many existing computer software programs and operating systems were designed such that the year 1999 was the maximum date that they would be able to process accurately. The failure of the Company's computer software programs, operating systems and product to process the change in calendar year from 1999 to 2000 had the potential to result in system malfunctions or failures. In the conduct of operations, the Company relies on equipment and commercial computer software primarily provided by independent vendors. In anticipation of potential system malfunctions or failures the Company undertook an assessment of its vulnerability to the so-called "Year 2000 issue" with respect to equipment, computer systems and product and with respect to vendors, and other parties with whom it conducts a substantial amount of business. To address the Year 2000 issue, management initiated a company-wide program to prepare the Company's computer systems and applications for the year 2000, as well as to identify critical third parties and major vendors, such as PictureTel, Polycom, and VTEL Corporation; and other parties such as Landlords and utility companies, which the Company relies upon to operate its business to assess their readiness for the year 2000. The Company's main computer applications include Platinum accounting software, Clientele customer service View Tech, Inc. Page 16 - -------------------------------------------------------------------------------- software, and OMS, the Company's internally developed Order Management System. Individual desktop computers are running on a Windows 95, 98 or NT operating system and include desktop applications such as Microsoft Office 97. The Company uses Dell personal computers on most desktops. For the year ended December 31, 1999, the Company spent a total of approximately $50,000 in connection with addressing the Year 2000 problem and does not anticipate any significant future costs. These costs were largely due to upgrading software systems and equipment. The Company's policy is to expense maintenance and modification costs and capitalize hardware and software purchases and upgrades. The Company funded the foregoing from operating cash flow. Since the change in the calendar from 1999 to 2000, the Company has not experienced any system malfunctions or failures. In addition, the Company has not experienced any loss in revenues due to the Year 2000 problem. Based on information to date, the Company is not aware of Third Parties with whom it conducts a significant amount of business that have experienced a material Year 2000 readiness issue affecting their ability to operate their business or raise adequate revenue to meet their contractual obligations to us. Although prepared to commit the necessary resources to enforce its contractual rights in the event any third parties with whom it conducts business encounter Year 2000 issues, the Company does not expect to incur any additional amounts to continue to monitor and prevent Year 2000 malfunctions and failures because it does not expect to encounter any material Year 2000 issues. Consequently, the Company does not feel that a contingency plan is necessary. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company maintains borrowings under a forbearance agreement with Imperial Bank and Fleet Bank and under a subordinated debt agreement which are not subject to material market risk exposure except for such risks relating to fluctuations in market interest rates. The carrying value of these borrowings approximates fair value since they bear interest at a floating rate based on the "prime" rate. There are no other material qualitative or quantitative market risks particular to the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA VIEW TECH, INC. Consolidated Financial Statements Reports of Independent Certified Public Accountants ................. 17 Consolidated Balance Sheets as of December 31, 1999 and 1998 ........ 19 Consolidated Statements of Operations for the years ended December 31, 1999, 1998, and 1997 ................................. 20 Consolidated Statements of Stockholders' Equity (Deficiency) for the years ended December 31, 1999, 1998 and 1997....................... 21 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998, and 1997 ................................. 22 Notes to Consolidated Financial Statements........................... 23 View Tech, Inc. Page 17 - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of View Tech, Inc. We have audited the accompanying consolidated balance sheet of View Tech, Inc. and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, stockholders' deficiency, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of View Tech, Inc. and subsidiaries at December 31, 1999, and the results of their operations and their cash flows for the year ended December 31, 1999, in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the financial statements, the Company has incurred a net loss of $11,990,303 during the year ended December 31, 1999, and, as of December 31, 1999, has a working capital deficit of $6,172,005 and stockholders' deficiency of $3,573,793. In addition, the Company is in default of the repayment term of its obligations related to a credit agreement and has obtained relief through a forbearance agreement which expires on May 31, 2000. The Company has subordinated debt of $2,000,000 due on June 30, 2000. These matters raise substantial doubt about the ability of the Company to continue as a going concern. Management's plans in regard to these matters are also described in Note 3. The financial statements do not include any adjustments that might result from the outcome of these uncertainties. /s/ BDO Seidman, LLP Los Angeles, California March 10, 2000 View Tech, Inc. Page 18 - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of View Tech, Inc.: We have audited the accompanying consolidated balance sheets of View Tech, Inc. and subsidiaries as of December 31, 1998 and 1997, and related consolidated statements of operations, stockholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of View Tech, Inc. as of December 31, 1998 and 1997, and the consolidated results of its operations and its consolidated cash flows for the years then ended, in conformity with generally accepted accounting principles. /s/ ARTHUR ANDERSEN LLP Boston, Massachusetts January 21, 1999 View Tech, Inc. Page 19 - -------------------------------------------------------------------------------- VIEW TECH, INC. CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these consolidated financial statements. View Tech, Inc. Page 20 - -------------------------------------------------------------------------------- VIEW TECH, INC. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these consolidated financial statements. View Tech, Inc. Page 21 - -------------------------------------------------------------------------------- VIEW TECH, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY) The accompanying notes are an integral part of these consolidated financial statements. View Tech, Inc. Page 22 - -------------------------------------------------------------------------------- VIEW TECH, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) The accompanying notes are an integral part of these consolidated financial statements. View Tech, Inc. Page 23 - -------------------------------------------------------------------------------- View Tech, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- THE BUSINESS View Tech, Inc.("the Company"), a Delaware corporation, commenced operations in July 1992 as a California corporation. In June 1995, the Company completed an initial public offering of common stock. In November 1996, View Tech merged with USTeleCenters, Inc. ("UST"), a Massachusetts corporation, and the Company reincorporated in Delaware. In November 1997, the Company, through its wholly-owned subsidiary, acquired the net assets of Vermont Telecommunications Network Services, Inc. ("NSI"), a Vermont corporation headquartered in Burlington, Vermont. On February 18, 2000, the Company sold its subsidiaries, UST and NSI, to OC Mergerco 4, Inc. ("OCM") as further described in Note 6 and has treated these entities as discontinued operations. Upon the sale of UST and NSI, the Company operates in one segment, video product sales and service. The Company entered into a merger agreement in December 1999 with All Communications, Inc. ("ACUC"), a regional competitor of the Company headquartered in the State of New Jersey. The merger is pending subject to regulatory approval and stockholder approval. On completion of the merger, each outstanding share of ACUC common stock will be converted into the right to receive 3.3 shares of fully paid and non-assessable Company common stock, $.0001 par value per share. Based on the number of currently outstanding shares of ACUC and Company stock as of January 11, 2000, assuming that all outstanding options and warrants of the two companies are exercised, the shareholders of ACUC, will own approximately 74.5% of the outstanding common stock following consummation of the merger. There is no assurance that the merger will ultimately be consummated. The Company is a single source provider of voice, video and data equipment, network services and bundled telecommunications solutions for business customers from its 19 offices throughout the United States. The Company has equipment distribution partnerships with Accord Telecommunications, Cisco Systems, Ezenia, FVC.com, Intel Corporation, Lucent Technologies, Madge Networks, PictureTel Corporation, Polycom, Inc., Tandberg, VCON, and VTEL Corporation. NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION. The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated. REVENUE RECOGNITION. The Company sells both products and services. Product revenue consists of revenue from the sale of video communications and telephone equipment and is recognized at the time of shipment. Service revenue is derived from services rendered in connection with the sale of new systems and from services rendered with respect to previously installed systems. Services rendered in connection with the sale of new systems consist of engineering services related to system integration, installation, technical training, user training, and one-year parts-and-service warranty. The majority of these services are rendered at or prior to installation, and all of the revenue is recognized when services are rendered. Revenue related to extended warranty contracts is deferred and recognized over the life of the extended warranty period. USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. PER SHARE DATA. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock View Tech, Inc. Page 24 - -------------------------------------------------------------------------------- outstanding. Diluted earnings per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding and the effect of the potentially dilutive shares. CASH AND CASH EQUIVALENTS. The Company considers all highly liquid investments with a maturity not exceeding three months at the date of purchase to be cash equivalents. INVENTORIES. Inventories are accounted for on the basis of the lower of cost or market. Cost is determined on a FIFO (first-in, first-out) basis. Included in inventory is demonstration equipment held for resale in the ordinary course of business. The Company generally sells its video demonstration equipment after the six-month holding period required by its primary equipment supplier. PROPERTY AND EQUIPMENT. Property and equipment are recorded at cost and include improvements that significantly add to utility or extend useful lives. Depreciation of property and equipment is provided using straight-line and accelerated methods over estimated useful lives ranging from one to ten years. Expenditures for maintenance and repairs are charged to expense as incurred. INTANGIBLES. Cost in excess of the fair value of net assets of purchased businesses (goodwill) is amortized using the straight-line method over 15 years, its estimated useful life. LONG-LIVED ASSETS. The Company assesses the realizability of long-lived assets in accordance with SFAS No. 121, Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets To Be Disposed of. SFAS No. 121 requires, among other things, that an entity review its long-lived assets including intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. During 1998, the Company recorded charges of approximately $1,465,000 relating to the impairment of goodwill that is included in restructuring costs in the consolidated statements of operations. During 1999, the Company recorded charges of $2.9 million relating to impairment of goodwill and fixed assets in connection with the sale of its discontinued operations. INCOME TAXES. The Company accounts for income taxes using SFAS No. 109, Accounting for Income Taxes, which requires a liability approach to financial accounting and reporting for income taxes. Deferred taxes are recognized for timing differences between the basis of assets and liabilities for financial statement and income tax purposes. The deferred tax assets and liabilities represent the future tax consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. CONCENTRATION OF RISK. Items that potentially subject the Company to concentrations of credit risk consist primarily of accounts receivable and the dependence on a major equipment vendor. Accounts receivable subject the Company to potential credit risk with customers. The Company performs on-going credit evaluations of its customers' financial condition but does not require collateral. Approximately 29% of the Company's revenues are attributable to the sale of equipment manufactured by PictureTel. Termination or change of the Company's business relationship with PictureTel, disruption in supply, failure of this supplier to remain competitive in quality, function or price, or a determination by such supplier to reduce reliance on independent distributors such as the Company could have a materially adverse effect on the Company. COMPREHENSIVE INCOME (LOSS). Comprehensive income (loss) is comprised of net income (loss) and all changes to stockholders' equity except those due to investments by owners and distributions to owners. Other than net income View Tech, Inc. Page 25 - -------------------------------------------------------------------------------- (loss), the Company does not have any other components of comprehensive income (loss) for each of the years ended December 31, 1999, 1998, and 1997. NEW ACCOUNTING PRONOUNCEMENTS. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133") establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. Statement of Financial Accounting Standards No. 137 deferred the effective date of FAS 133 to be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Company does not expect adoption of SFAS 133 to have a material effect, if any, on its financial position, results of operations, or cash flows. NOTE 3 - GOING CONCERN UNCERTAINTY The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred a net loss of $11,990,303 during the year ended December 31, 1999, and at December 31, 1999 has a working capital deficit of $6,172,005, and stockholders' deficiency of $3,573,793. In addition, the Company is in default of the repayment terms of its obligations related to a credit agreement and has obtained relief through a forbearance agreement which expires on May 31, 2000 (Note 10). The Company has subordinated debt of $2,000,000 due on June 30, 2000. These conditions raise substantial doubt about the ability of the Company to continue as a going concern. Management's plan is to complete the proposed merger with ACUC (Note 1). However, there is no assurance that the merger will be ultimately consummated. Accordingly, the consolidated financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities or any other adjustments that might be necessary should the Company be unable to continue as a going concern. NOTE 4 -- BUSINESS COMBINATION On November 29, 1996, the Company acquired USTeleCenters, which is an authorized sales agent for several of the Regional Bell Operating Companies ("RBOCs"). The transaction was accounted for as a pooling of interests in which USTeleCenters' shareholders exchanged all of their outstanding shares and options for View Tech common stock and options, respectively. USTeleCenters' shareholders and option holders (upon exercise of their options) received 2,240,976 shares of View Tech common stock and options to purchase 184,003 shares of View Tech common stock. The value of the transaction was approximately $16.5 million. In connection with the acquisition, the Company issued 24,550 shares in January 1997 to certain investment bankers. NOTE 5 -- ACQUISITIONS On November 13, 1997, the Company, through its wholly-owned subsidiary, acquired the net assets of Vermont Telecommunications Network Services, Inc. ("NSI") a Vermont corporation. Pursuant to the terms of the Asset Purchase Agreement, (the "Agreement"), the Company acquired ownership of the assets and assumed certain liabilities of NSI, effective November 1, 1997. The aggregate purchase price for the net assets of NSI consisted of (i) $2,000,000 cash paid at the closing, (ii) a promissory note in the original amount of $250,000, bearing interest at the rate of 8% per annum subsequently paid in full on November 21, 1998, (iii) a contingent note in the original amount of $250,000, bearing interest at the rate of 8% per annum and payable in full on November 21, 1999, and (iv) $400,000 paid by the issuance of 62,112 shares of the Company's common stock. The contingent note in the amount of $250,000 is due View Tech, Inc. Page 26 - -------------------------------------------------------------------------------- only if NSI, achieves EBIT, as defined, equal to or greater than $700,000 for the year ended December 31, 1998. In addition, View Tech is required to pay an additional amount equal to 40% of NSI's EBIT, as defined, in excess of $900,000 per calendar year commencing January 1, 1998 and ending December 31, 2000. The calculation of NSI's EBIT for the year ended December 31, 1998, was conclusively determined under the Agreement in December 1999 and a liability was calculated. This liability of $180,000 was assumed as part of the sale of UST and NSI by OC Mergerco 4, Inc. (see Note 6). The cash portion of the purchase price of $2,000,000 was paid utilizing the Company's bank line of credit. The excess of the acquisition price over the net assets acquired of approximately $2,708,000 was accounted for as goodwill and was being amortized over 15 years until December 1999 when an impairment loss of $2.1 million related to this goodwill was recognized as further described in Note 6. NSI, based in Burlington, Vermont, is an authorized agent selling Bell Atlantic services in Vermont, New Hampshire, upstate New York and western Massachusetts. The acquisition has been accounted for as a purchase transaction and, accordingly, the accompanying financial statements include the accounts and transactions of NSI since the acquisition date. NOTE 6 -- DISCONTINUED OPERATIONS On May 7, 1999, the Company executed a letter of intent to sell the assets of UST and NSI. However, by the end of September 1999, the negotiations with the original purchaser relative to said sale were terminated without completing the sale. The Company, in September 1999, initiated discussions with alternative parties which ultimately resulted in finding a buyer for UST and NSI. On February 18, 2000, the Company completed the sale of its subsidiaries to OC Mergerco 4, Inc. The Company sold net assets of UST and NSI as of December 31, 1999 to OC Mergerco 4, Inc. for cash consideration amounting to $182,147 and shares of the Common Stock of the Purchaser's parent company, Pentastar Communications, Inc. which the Company valued at $74,265. This sale resulted in a loss of $2.9 million. OC Mergerco 4, Inc. also assumed a $180,000 commitment to Zoltan Keve, the former principal of NSI, related to certain agreements signed in conjunction with the Company's purchase of NSI in November 1997 (see Note 5). In addition, the Company assumed the liability of funding the cash needs of the discontinued operation for the period January 1, 2000 to February 18, 2000 which amounted to $0.3 million. This liability was accrued at December 31, 1999 in the Company's financial statements. The balance sheets, statements of operations, and statements of cash flows have been restated to show the net effect of the discontinuance of the network business. Assets and liabilities to be disposed of consists of the following: Results of operations of UST and NSI are as follows: View Tech, Inc. Page 27 - -------------------------------------------------------------------------------- In accordance with EITF 87-24, interest expense has been allocated to discontinued operations based on the debt that could be identified as specifically attributable to those operations. No general corporate overhead has been allocated to these operations. NOTE 7 -- Restructuring and Other Costs During 1998, the Company recorded a restructuring and asset impairment charge of $4.2 million ($3.3 million related to continuing operations and $.9 million related to discontinued operations). The significant components of the restructuring charge are as follows: Impairment write-down of goodwill related to previous acquisitions.............. $1,465,000 Employee termination costs...................... 1,793,000 Facility exit costs............................. 157,000 Write-down of Property and Equipment............ 27,000 Travel related expenses......................... 140,000 Consulting expenses............................. 322,000 Other costs..................................... 297,013 ---------- $4,201,013 ========== The impairment write-down of goodwill relates to the Company's determination that there was no future expected cash flows from two acquisitions that represented $1,465,000 of goodwill. The employee termination costs relate to approximately 33 employees and officers of the Company. The Company closed one of its outside network sales offices. The Company also terminated its internet service provider reseller agreement. In connection with these decisions, the Company recorded employee termination, facility exit related expense, and a write-down of leasehold improvements. In addition, the Company's decision to eliminate duplicative corporate overhead functions resulted in employee termination and travel related expenses. The Company utilized the services of consultants in connection with the plan of restructuring. The total cash impact of the restructuring amounted to $2,709,621 of which $80,449 is included in the accompanying balance sheet at December 31, 1999. The Company anticipates the balance of the restructuring costs will be paid by February 29, 2000. The following table summarizes the activity against the restructuring charge: Restructuring Charge............................ $ 4,201,013 Cash paid................................... (2,629,172) Non-cash expenses........................... (1,491,392) ------------ Balance, December 31, 1999...................... $ 80,449 ============ View Tech, Inc. Page 28 - -------------------------------------------------------------------------------- NOTE 8 -- INVENTORY Inventories are summarized as follows: During the fourth quarter of 1999, the Company recorded an additional $1.6 million inventory reserve covering demonstration equipment, finished goods and spare parts inventories. Approximately 75% of the reserve applied to demonstration equipment which had not been resold by December 31, 1999. The remainder of the reserve applied to certain finished goods and excess spare parts. Management believes such reserves are adequate to reflect inventory at its net realizable value. It is reasonably possible that a change in the estimate could occur in the near term. NOTE 9 -- PROPERTY AND EQUIPMENT, NET Property and equipment are summarized as follows: Property and equipment under capital lease obligations, net of accumulated amortization, at December 31, 1999 and 1998 were $300,840 and $365,064, respectively. NOTE 10 -- SUBORDINATED DEBT The Company secured interim loans totaling $2.0 million, of which $1.5 million came from individual investors and $0.5 million in credit from one of the Company's suppliers (Note 11). The individual investors and the supplier are to be re-paid in seven months with interest at the prime rate plus 2-1/2% for the $2.0 million in loans. In return, the Company pledged all of its assets in a junior position to the Banks, to the subordinated lenders. Further, the Company issued 925,000 5-year exercisable warrants to the subordinated lenders, on a proportional basis of each investor's investment with an exercise price of $1.625 a share (Note 11). NOTE 11 -- LONG TERM DEBT View Tech, Inc. and its wholly-owned subsidiary, UST, entered into a $15 million credit agreement (the "Agreement") with Imperial Bank and BankBoston (now Fleet Bank) effective November 21, 1997. The Agreement provided for three separate loan commitments consisting of (i) a Facility A Commitment of up to $7 million for working capital purposes; (ii) a Facility B Commitment of up to $5 million, which expired on December 1, 1998; and (iii) a Facility C Commitment of up to $3 million for merger/acquisition activities. Amounts under the Agreement are collateralized by the assets of the Company. Funds available under the Agreement vary from time to time depending on many variables such as the amount of Eligible Trade Accounts Receivable and Eligible Inventory of the Company, as such terms are defined in the Agreement. View Tech, Inc. Page 29 - -------------------------------------------------------------------------------- On August 5, 1999, the Company received a Notice of Event of Default and Notice of Reservations of Rights from the lenders. The Facility C Commitment was terminated. On November 23, 1999, the Company signed a six-month forbearance agreement to be implemented in conjunction with an infusion of $2.0 million in subordinated debt (Note 10). During the term of the forbearance period, the maximum aggregate amount of the Facility A facility will be equal to $4.75 million subject to collateral base adjustments. Subject to certain default provisions, which include the failure to pay certain obligations, the departure of the current, interim chief executive officer and president, or a particular material event concerning the Company, the forbearance continues until May 31, 2000. Interest on the sum owed on Facility A is set at the prime rate plus 2-1/2%. Interest on any over-advances is the prime rate plus 4%. At December 31, 1999, the interest rate on Facility A was 11%. At December 31, 1999, amounts utilized under the Facility were $4,363,527. In return, the lenders received the following consideration: the exercise price of the lenders' existing 80,000 warrants, which are exercisable until November 21, 2004, was changed to $1.63 from $4.50 as of the date of the forbearance agreement. Under the forbearance agreement, the lenders will also receive a supplemental fee of $150,000. The fee was deferred and is being amortized to expense over the forbearance period. The change of the exercise price of the lenders' existing warrants and the issuance of warrants to the subordinated lenders at $1.63 and $1.625, respectively required the recognition of $1,081,405 in deferred debt issuance costs and additional paid-in capital. The fair value of the warrants at the repricing/issuance dates was estimated using the Black-Scholes option pricing model with the following weighted average assumptions: expected life - 1 year; volatility - 74.08%; dividend yield -0.00%; interest rate - 6.00%. Deferred debt issuance costs of $901,171 were included in other current assets at December 31, 1999. Long-term debt consists of the following: Capital Lease Obligations The Company leases certain equipment and furniture under capital lease arrangements. The following is a schedule of future minimum lease payments View Tech, Inc. Page 30 - -------------------------------------------------------------------------------- required under capital leases, together with their present value as of December 31, 1999: Years Ending December 31, 2000.................................... $ 156,331 2001.................................... 33,596 2002.................................... 5,613 --------- Net minimum lease payments.............. 195,540 Less amount representing interest....... 13,115 --------- Present value of net minimum lease payments......................... $ 182,425 ========= The current portion due under capital lease obligations at December 31, 1999 and 1998 was $146,795 and $130,794, respectively. Note Payable to Former NSI Owner In connection with the Company's acquisition of NSI, part of the purchase price consisted of a promissory note in the original amount of $250,000, bearing interest at the rate of 8% per annum which was paid in full on November 21, 1998. NOTE 12 -- COMMITMENTS AND CONTINGENCIES The Company leases various facilities under operating leases expiring through 2003. Certain leases require the Company to pay increases in real estate taxes, operating costs and repairs over certain base year amounts. Lease payments for the years ended December 31, 1999, 1998, and 1997, were approximately $1,219,000, $908,000, and $859,000, respectively. Minimum future rental commitments under non-cancelable operating leases are as follows: Years Ending December 31, 2000 ................................... $1,047,894 2001 ................................... 891,566 2002 ................................... 705,155 2003 and thereafter .................... 922,464 ---------- $3,567,079 ========== The Company has been named as a defendant in employee-related lawsuits or claims before administrative boards filed by former employees of UST and/or NSI. The Company is vigorously defending itself against such matters and does not expect the outcome to have a material adverse impact on its financial position, results of operations or cash flow. NOTE 13 -- COMMON AND PREFERRED STOCK COMMON STOCK. In November 1996, the Company increased the number of shares of common stock authorized for issuance from 10,000,000 to 20,000,000 and changed the par value of its stock from $0.01 to $0.0001 per share. WARRANTS AND OPTIONS. Included in the public stock offering in June 1995, was the sale of 575,000 warrants to the public. All warrants were exercisable at $5.00 per share for a period of two years commencing one year after the effective date of the registration statement. All unexercised warrants expired on June 15, 1998. View Tech, Inc. Page 31 - -------------------------------------------------------------------------------- Upon consummation of the public offering, the Company issued the underwriter 120,000 warrants to purchase common stock of the Company at an exercise price of $6.75 or 135% of the public offering price per share. Such warrants may be exercised at any time during the period of five years commencing June 15, 1995. In addition, the Company issued the underwriters 50,000 warrants at an exercise price of $6.918 per warrant or 138% of the public offering price. Each warrant is exercisable into one share of common stock at a price of $6.918 per share for a three-year period commencing on June 15, 1995. These warrants expired on June 15, 1998. In connection with the Company's credit agreement, the Company issued common stock warrants for the purchase of 80,000 shares of the Company's common stock. During 1998, the exercise price of the warrants was reduced to $4.50 per share. The exercise price was further reduced to $1.63 per share in connection with the forbearance agreement signed on November 23, 1999. The warrants are exercisable until November 21, 2004. PRIVATE OFFERINGS. In the first quarter of 1997, the Company completed a private placement with Telcom Holding, LLC, a Massachusetts limited liability company ("Telcom") formed by The O'Brien Group, Inc., a Massachusetts corporation. Telcom purchased (i) 650,000 shares of Common Stock and (ii) Common Stock Purchase Warrants exercisable at $6.50 per share of the Company to purchase up to 325,000 shares of Common Stock. The Company issued additional Common Stock Purchase Warrants to certain managing members of Telcom for the purchase of 162,500 shares of Common Stock at a purchase price per share of $6.50. On August 18, 1998, the Company received a notice (the "Initial Notice") from NASDAQ that it did not meet the applicable listing requirements as of June 30, 1998 because it did not have $4,000,000 in net tangible assets and therefore its Common Stock was subject to delisting. The Company sought immediate action to rectify this situation through the private placement of 826,668 shares of the Company's Common Stock to accredited investors. The offering was completed on November 10, 1998 and raised $1.2 million. Subsequently, in February, 1999, NASDAQ informed the Company that it was closing its de-listing proceedings. However, in or about January 2000, NASDAQ has informed the Company that it must re-apply for NASDAQ national market listing after the merger with ACUC and that it may not be approved to remain on the NASDAQ national market exchange. PREFERRED STOCK. The Company has 5,000,000 shares of authorized Preferred Stock. In November 1996, the Company changed the par value of the preferred stock from $0.01 to $0.0001 per share. The Preferred Stock may be issued in one or more series with such rights and preferences as may be determined by the Board of Directors. No shares of preferred stock have been issued. EMPLOYEE STOCK PURCHASE PLAN. The Company has an Employee Stock Purchase Plan (the "Purchase Plan") under which a maximum of 500,000 shares of Common Stock, (pursuant to the Amendment of the Purchase Plan approved by the Board of Directors of June 3, 1998), may be purchased by eligible employees. Substantially all full-time employees of the Company are eligible to participate in the Purchase Plan. Shares are purchased through accumulation of payroll deductions (of not less than 1% nor more than 10% of the employees compensation, as defined not to exceed 2,000 shares per purchase period) for the number of whole shares, determined by dividing the balance in the employee's account by the purchase price per share which is equal to 85% of the fair market value of the Common Stock, as defined. In 1999 and 1998, 114,504 and 159,204 shares were purchased under this Plan. The Company, in February 2000, terminated the Employee Stock Purchase Plan program. STOCK OPTION PLAN. In July 1994, the Company began granting stock options to key employees, consultants and certain non-employee directors. The options are intended to provide incentive for such persons' service and future services View Tech, Inc. Page 32 - -------------------------------------------------------------------------------- to the Company thereby promoting the interest of the Company and its stockholders. The Company currently maintains four stock option plans that generally require the exercise price of options to be not less than the estimated fair market value of the stock at the date of grant. Options vest over a maximum period of four years and may be exercised in varying amounts over their respective terms. In accordance with the provisions of such plans, all outstanding options become immediately exercisable upon a change in control, as defined, of the Company. The Company has authorized an aggregate of 2,322,000 shares of common stock to be available under all the current option plans. On October 20, 1998, the Company's Board of Directors authorized the repricing of certain options previously issued to employees. In accordance with APB Opinion 25, which the Company applies in accounting for its stock option plans, no additional compensation was recognized on the repricing of these options since the fair value of the common stock on this date was less than or equal to the revised exercise price of the options. On April 16, 1999 the Board of Directors authorized the Company to transfer all unused or returned as unexercised stock options in the 1995 Stock Option Plan to be transferred into the 1997 Stock Incentive Plan. The stockholders approved this transfer at the annual meeting on or about May 25, 1999. An S-8 was filed with the Commission to reflect this transfer into the 1997 Stock Incentive Plan. On April 16, 1999, the Board of Directors authorized an additional 400,000 stock options to be added to the 1997 Special Non-Officer Stock Option Plan. An S-8 filing to reflect that addition of stock options is expected to be filed no later than April 2000. On or about November 10, 1999, in an addendum to the October 8, 1999 employment contract among the Company, Nightingale & Associates and S. Douglas Hopkins, the Company agreed to provide stock options in the amount of 195,000 to S. Douglas Hopkins or his designees. The stock options are to be immediately vested upon registration and can be exercised over five years from the date of the grant. The strike or exercise price of the stock option award is $1.75, which was the fair market value on October 8, 1999 and which amount was above fair market value of the stock as of November 10, 1999. The Company also provided additional compensation to Mr. Hopkins or his designees which can be, and is now expected to be provided in the nature of 156,000 shares of common stock at the fair market value when Mr. Hopkins satisfactorily completes his tenure as Chief Executive Officer and President of the Company. The stock options and stock grant, however, have not, at present been registered with the Commission in any S-8 or other filing at this time. Activity in the plans on a consolidated basis is summarized as follows: View Tech, Inc. Page 33 - -------------------------------------------------------------------------------- At December 31, 1999, 741,971 options were exercisable at a weighted average exercise price of $2.87 per share. The options outstanding at December 31, 1999 have a weighted average remaining contractual life of 7.93 years. The range of exercise prices for options outstanding and options exercisable at December 31, 1999 are as follows: The Company applies APB Opinion 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized. Had compensation cost for the Company's stock option plan been determined based on the fair value at the grant dates for awards under those plans consistent with the method of FASB Statement 123, the Company's net income and earnings (loss) per share would have been reduced to the pro forma amounts indicated below. The weighted average fair value at the date of grant for options granted during the years ended December 31, 1999, 1998, and 1997, was $1.23, $2.91, and $4.83, respectively. The fair value of options at the grant date was estimated using the Black-Scholes option pricing model with the following weighted average assumptions: expected life - 5.0 years; volatility - 74.08%; dividend yield - 0%; interest rate - 6.0%. NOTE 14 -- EARNINGS (LOSS) PER SHARE In March 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 128, Earnings Per Share. This statement established standards for computing and presenting earnings per share and applies to entities with publicly traded common stock or potential common stock. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed by dividing net income (loss) by the diluted weighted average number of common and potentially dilutive shares outstanding during the period. The weighted average number of potentially dilutive shares has been determined in accordance with the treasury stock method. View Tech, Inc. Page 34 - -------------------------------------------------------------------------------- The reconciliation of basic and diluted shares outstanding is as follows: Options and warrants to purchase 3,593,128, 2,334,316, and 2,222,056 shares of common stock were outstanding during the years ended December 31, 1999, 1998, and 1997, respectively, but were not included in the computation of diluted EPS because the options' exercise price was either greater than the average market price of the common stock or the Company reported a net operating loss from continuing operations and their effect would have been antidilutive. NOTE 15 -- PENSION PLAN The Company participates in 401(k) retirement plans for its employees. Employer contributions to the 401(k) plans for the years ended December 31, 1999, 1998, and 1997 were approximately $85,000, $102,000, and $105,000, respectively. NOTE 16 -- PROVISION FOR INCOME TAXES The income tax provisions for the years ended December 31, 1999, 1998, and 1997 are as follows: Total income tax expense differs from the expected tax expense (computed by multiplying the federal statutory income tax rate of approximately 35, 34 and 34 percent for the periods ended December 31, 1999, 1998, and 1997 to income before income taxes) as a result of the following: View Tech, Inc. Page 35 - -------------------------------------------------------------------------------- The Company has recorded a valuation allowance against its deferred tax asset. The valuation allowance relates primarily to certain deferred tax assets for which realization is uncertain. The primary components of temporary differences which give rise to deferred taxes are as follows: Goodwill represents the benefit attributed to the difference between the Company's book and tax basis of the goodwill impairment charge discussed in Note 4. At December 31, 1999, the Company has net operating loss (NOL) carry- forwards of approximately $7,108,316 and $5,345,152 for federal and state income tax purposes, respectively. The federal NOL has a carryover period of 20 years and is available to offset future taxable income, if any, through 2019, and may be subject to an annual statutory limitation. NOTE 17 -- RELATED PARTY TRANSACTIONS In October 1997, the Company purchased five (5) videoconferencing systems from the former CEO and Director of the Company, for a purchase price of $162,500. The price the Company paid for these units was less than the wholesale price that the Company would otherwise pay for the same units. The units were subsequently sold by the Company at a profit. In March 1999, the Company's Board of Directors approved an investment of $100,000 in an entity named Concept 5, an information technology services company. William Shea, a Board member of the Company, is one of the Board members of Concept 5. This fact was disclosed to the Company's Board at the time of the Board's unanimous vote to invest said sum into Concept 5. The investment is carried at cost and is included in Other Assets on the accompanying balance sheets. NOTE 18 -- VALUATION ACCOUNTS AND RESERVES View Tech, Inc. Page 36 - -------------------------------------------------------------------------------- NOTE 19 - SUBSEQUENT EVENT On February 18, 2000, the Company completed the sale of its subsidiaries, UST and NSI, to OC Mergerco 4, Inc. (Note 6) ITEM 9. ITEM 9. CHANGE IN ACCOUNTANTS As stated in the Form 8-K the Company filed on February 29, 2000, the Company changed its outside independent auditors from Arthur Andersen, LLP to BDO Seidman, LLP. The purpose of this change in outside independent auditors was due to the impending merger and not for any reason related to disagreements with Arthur Andersen, LLP or to the audit opinions which they issued. View Tech, Inc. Page 37 - -------------------------------------------------------------------------------- PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the period ended December 31, 1999, which Proxy Statement will be filed with the Securities and Exchange Commission on or before the end of April 2000. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the period ended December 31, 1999, which Proxy Statement will be filed with the Securities and Exchange Commission on or before the end of April 2000. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the period ended December 31, 1999, which Proxy Statement will be filed with the Securities and Exchange Commission on or before the end of April 2000. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the period ended December 31, 1999, which Proxy Statement will be filed with the Securities and Exchange Commission on or before the end of April 2000. View Tech, Inc. Page 38 - -------------------------------------------------------------------------------- PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K A. List of documents filed as part of this Report: 1. Financial Statements included in Item 8: - Reports of Independent Certified Public Accountants - Consolidated Balance Sheets as of December 31, 1999 and 1998 - Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997 - Consolidated Statements of Stockholders' Equity (Deficiency) for the years ended December 31, 1999, 1998 and 1997 - Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 - Notes to Consolidated Financial Statements No schedules are included because the required information is inapplicable or is presented in the consolidated financial statements or related notes thereto. 2. Exhibits The exhibits listed on the accompanying Index of Exhibits are filed as part of this Annual Report. B. Reports on Form 8-K - None. View Tech, Inc. Page 39 - -------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. VIEW TECH, INC. Date: March 30, 2000 By: /s/ Christopher Zigmont ----------------------- Christopher Zigmont Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant as of this 30th day of March 2000 in the capacities and on the dates indicated. Signature Title - --------- ----- /s/ Paul C. O'Brien Chairman - -------------------------- Paul C. O'Brien /s/ S. Douglas Hopkins Chief Executive Officer, Director - -------------------------- S. Douglas Hopkins (Principal Executive Officer) /s/Christopher Zigmont CFO - -------------------------- Christopher Zigmont (Principal Financial and Accounting Officer) /s/ Franklin A. Reece, III Director - -------------------------- Franklin A. Reece, III /s/ William J. Shea Director - -------------------------- William J. Shea /s/ Robert F. Leduc Director - -------------------------- Robert F. Leduc /s/ David F. Millet Director - -------------------------- David F. Millet EXHIBIT INDEX Exhibit Number Description - ------ ----------- 2.1 Asset Purchase Agreement, dated as of November 13, 1997, as amended by Amendment No. 1 to the Asset Purchase Agreement, dated as of November 21, 1997, by and among Vermont Network Services Corporation, Vermont Telecommunications Network Services, Inc. and Zoltan B. Keve. (1) 2.2 Amendment No. 1 to Asset Purchase Agreement, dated as of November 21, 1997, by and among Vermont Network Services Corporation, Vermont Telecommunications Network Services, Inc. and Zoltan B. Keve. (1) 3.1 Certificate of Incorporation of the Company, as amended by Agreement and Plan of Merger, dated November 27, 1996. (2) 3.2 Bylaws of the Company. (2) 4.1 Warrant Agreement dated as of June 28, 1995 between the Company and U.S. Stock Transfer Corporation. (3) 4.2 Form of Warrant between the Company and Telcom Holding, LLC. (2) 10.1 Dealer Agreement between the Company and PictureTel Corporation dated as of March 30, 1995. (4) 10.2 Employment Agreement between the Company and Franklin A. Reece, III dated as of November 29, 1996. (2) 10.3 Severance and Consulting Agreement by and between, View Tech, Inc. and John W. Hammon, dated April 22, 1997. (5) 10.4 Tenth Amendment to Revolving Credit, Term Loan and Security Agreement between USTeleCenters, Inc. and The First National Bank of Boston, dated March 31, 1997.(5) 10.5 Employment Agreement between the Company and William M. McKay, dated as of December 9, 1996. (6) 10.6 1995 Stock Option Plan, as amended. (7) 10.7 Amendment to the Dealer Agreement between the Company and PictureTel Corporation, dated as of August 1, 1995. (3) 10.8 1997 Stock Incentive Plan. (8) 10.9 Promissory Note, dated November 21, 1997, of Vermont Network Services Corporation, payable to Vermont Telecommunications Network Services, Inc. in the amount of $250,000. (1) 10.10 Contingent Note, dated November 21, 1997, of Vermont Network Services Corporation, payable to Vermont Telecommunications Network Services, Inc. in the amount of $250,000. (1) 10.11 Subordination Agreement, dated as of July 26, 1996, by and among the Company, the First National Bank of Boston, BancBoston Leasing, Inc., and USTeleCenters, Inc. (9) 10.12 Sublease Agreement dated as of October 11, 1996, by and between Atlantic Steel Industries, Inc. and the Company, (together with prime Lease Agreement dated as of November 1, 1993 between Atlantic Steel Industries, Inc. and the State of California Public Employees' Retirement System). (2) 1 of 4 10.13 Common Stock and Common Stock Purchase Warrants Agreement, dated as of December 31, 1996, by and between the Company and Telcom Holding, LLC, a Massachusetts limited liability company. (2) 10.14 Letter Agreement, dated as of December 31, 1996, from the Company to Paul C. O'Brien and Mark P. Kiley. (2) 10.15 Common Stock Purchase Warrant, dated as of November 21, 1997, for the purchase of 60,000 shares of Common Stock of View Tech, Inc., a Delaware corporation, by Imperial Bank, a California banking corporation, on or before November 21, 2004 at a purchase price of $7.08 per share. (10) 10.16 Common Stock Purchase Warrant, dated as of November 21, 1997, for the purchase of 20,000 shares of Common Stock of View Tech, Inc., a Delaware corporation, by BankBoston, N.A., a national banking association, a participating lender, on or before November 21, 2004 at a purchase price of $7.08 per share. (10) 10.17 Revolving Note with City National Bank, dated February 20, 1996. (11) 10.18 Loan Agreements with Power-Data Services, Inc., dated February 15, 1996 and March 22, 1996. (11) 10.19 Credit Agreement, dated as of November 21, 1997, among, USTeleCenters, Inc., a Delaware corporation, View Tech, Inc. a Delaware corporation, and Imperial Bank, a bank organized under the laws of the State of California. (10) 10.20 Security Agreement, dated as of November 21, 1997, among USTeleCenters, Inc., a Delaware corporation, View Tech, Inc., a Delaware corporation, and Imperial Bank, a bank organized under the State of California. (10) 10.21 Amendment No. 2 dated as of May 1, 1998, to the Credit Agreement, dated as of November 21, 1997, among USTeleCenters, Inc., a Delaware corporation, (the borrower), View Tech, Inc., a Delaware corporation (the parent company), and Imperial Bank and BankBoston, N.A. (the banks). (17) 10.22 Amendment No. 3 dated as of August 14, 1998, to the Credit Agreement, dated as of November 21, 1997, among USTeleCenters, Inc., a Delaware corporation, (the borrower), View Tech, Inc., a Delaware corporation (the parent company), and Imperial Bank and BankBoston, N.A. (the banks). (17) 10.23 Amendment No. 4 dated as of October 27, 1998, to the Credit Agreement, dated as of November 21, 1997, among USTeleCenters, Inc., a Delaware corporation, (the borrower), View Tech, Inc., a Delaware corporation (the parent company), and Imperial Bank and BankBoston, N.A. (the banks). (17) 10.24 Amendment No. 1, Exhibit A, dated as of October 14, 1998, to the Common Stock Purchase Warrant, dated as of November 21, 1997, for the purchase of common stock of View Tech, Inc., a Delaware corporation, by Imperial Bank. (17) 10.25 Amendment No. 1, Exhibit B, dated as of October 14, 1998, to the Common Stock Purchase Warrant, dated as of November 21, 1997, for the purchase of common stock of View Tech, Inc., a Delaware corporation, by BankBoston, N.A. (17) 2 of 4 10.26 Memorandum of Understanding by and between the Company and former Chief Executive Officer, Robert G. Hatfield, effective April 17, 1998. (15) 10.27 Severance and Consulting Agreement by and between, View Tech, Inc. and Robert G. Hatfield, dated April 17, 1998. (16) 10.28 Separation Agreement, effective August 31, 1998, by and between View Tech, Inc. and David A. Kaplan, the former Chief Financial Officer. (17) 10.29 General Release between, David A. Kaplan, former Chief Financial Officer and View Tech, Inc. (17) 10.30 Settlement Agreement, Consulting Agreement & General Release, effective February 28, 1999, by and between View Tech, Inc. and Calvin M. Carrera, former Vice President and General Manager. (12) 10.31 Agreement and Plan of Merger by and between View Tech, Inc. and All Communications Corporation, dated December 27, 1999. (18) 10.32 Amendment No. 1 to Agreement and Plan of Merger, dated February 29, 2000 10.33 Settlement Agreement and Mutual Release by and between View Tech, Inc. and Ali Inanilan, dated March 14, 2000 10.34 Asset Purchase Agreement by and between View Tech, Inc. and OC Mergerco 4, Inc. dated as of December 31, 1999 21.1 Subsidiaries of the Company. (12) 23.1 Consent of Arthur Andersen LLP. (12) 23.2 Consent of BDO Seidman, LLP. (12) 27 Financial Data Schedule. (12) 99.1 View Tech, Inc. Special Non-Officer Stock Option Plan. (13) 99.2 Form of Special Non-Officer Stock Option Agreement. (13) 99.3 Form of Addendum to Stock Option Agreement; Involuntary Termination Following Corporate Transaction. (13) 99.4 Form of Stock Option Agreement. (14) 99.5 Form of Addendum to Stock Option Agreement: Involuntary Termination Following Corporate Transaction. (14) 99.6 Form of Addendum to Stock Option Agreement: Involuntary Termination Following Change in Control. (14) 99.7 1997 Non-Employee Directors Stock Option Plan. (14) 99.8 Form of Automatic Stock Option Agreement. (14) 99.9 Employee Stock Purchase Plan. (14) 99.10 Form of Stock Purchase Agreement under the Employee Stock Purchase Plan. (14) - ---------------------- (1) Filed as an exhibit to the Company's Report on Form 8-K dated December 5, 1997, and incorporated herein by reference. (2) Filed as an exhibit to the Company's Registration Statement on Form SB-2 (Registration No.333-19597) and incorporated herein by reference. 3 of 4 (3) Filed as an exhibit to the Company's Annual Report on Form 10-KSB for the fiscal year ended June 30, 1995, and incorporated herein by reference. (4) Filed as an Exhibit to the Company's Registration Statement on Form SB-2 (registration No.33-91232), and incorporated herein by reference. (5) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, and incorporated herein by reference. (6) Filed as an exhibit to the Company's Transitional Report on Form 10-K for the six month period ended December 31, 1997, and incorporated herein by reference. (7) Filed as an exhibit to the Company's Quarterly Report on Form 10-QSB for the fiscal quarter ended September 30, 1995, and incorporated herein by reference. (8) Filed as an exhibit to the Company's Registration Statement on Form S-4 (Registration No. 333-13459) and incorporated herein by reference. (9) Filed as an exhibit to the Company's Annual Report on Form 10-KSB for the fiscal year ended June 30, 1996, and incorporated herein by reference. (10) Filed as an exhibit to the Company's Report on Form 8-K dated February 5, 1998, and incorporated herein by reference. (11) Filed as an exhibit to the Company's Quarterly Report on Form 10-QSB for the fiscal quarter ended March 31, 1996, and incorporated herein by reference. (12) Filed herewith. (13) Filed as an exhibit to the Company's Registration Statement on Form S-8 filed on November 4, 1997, and incorporated herein by reference. (14) Filed as an exhibit to the Company's Registration Statement on Form S-8 filed on June 30, 1997, and incorporated herein by reference. (15) Filed as an exhibit to the Company's quarterly report on Form 10-Q for the fiscal quarter ended March 31, 1998, and incorporated herein by reference. (16) Filed as an exhibit to the Company's quarterly report on Form 10-Q for the fiscal quarter ended June 30, 1998, and incorporated herein by reference. (17) Filed as an exhibit to the Company's quarterly report on Form 10-Q for the fiscal quarter ended September 30, 1998, and incorporated herein by reference. (18) Filed as an exhibit to the Company's Registration Statement on form S-4 (No. 333-95145) filed on January 21, 2000, and incorporated herein by reference. 4 of 4

87196_1999.txt

87196_1999

1999

87196

ITEM 1. BUSINESS GENERAL Earl Scheib, Inc., a Delaware corporation, and its subsidiaries (collectively referred to as the "Company") is celebrating over 60 years in the automobile paint and repair business as the successor to a business founded as a sole proprietorship by Earl A. Scheib in 1937. The Company's principal executive offices are located at 8737 Wilshire Boulevard, Beverly Hills, California 90211. The Company maintains personnel, systems, advertising, real estate and accounting functions at its principal executive offices. See ITEM 2. ITEM 2. PROPERTIES The Company owns the land and buildings occupied by 69 of the Company's operating shops as of April 30, 1999. The remaining 105 of the Company's 174 shops were leased from outside third parties. The 174 shops are located in 145 cities in 31 states. In fiscal 1999, the Company began operations in 19 new shops and ceased operations in 6 shops. Leases for shop premises vary as to their terms, rental provisions, expiration dates and the existence of renewal options. The number of years remaining on leases for the Company's shops (excluding unexercised options) range from a month to month tenancy to 15 years. All of the leases, with two exceptions, have fixed rentals with no additional rents based upon shop sales. Many leases also require the Company to pay all or a portion of the real estate taxes, insurance charges and maintenance expenses relating to the leased premises. The Company maintains fire and liability insurance as well as umbrella earthquake coverage for its shops and other real estate interests. The Company secures sites for new stores by a variety of methods, including lease, purchase, assignment or sublease of existing facilities, build-to-suit leases, or purchase and development of sites that may be owned by the Company or sold and leased back by the Company under sale-and-leaseback arrangements. In many cases, the Company is able to lease or sublease existing buildings that have been previously used for other purposes, such as automobile repair shops or retail establishments. These sites must be suitable for the Company's needs, at a lease rate that is within the Company's guidelines and without the need for substantial expenditures to convert the facilities to the Company's needs. In connection with the opening of new shops, the Company generally makes capital investments and incurs expenditures (excluding expenditures to purchase land, buildings or leasehold interest) of approximately $175,000. These costs consist of construction of improvements, paint and supply inventories, fixtures, equipment, signs and pre-opening expense. The majority of the Company's stores are in stand-alone sites on main streets and have adjacent parking facilities. Store hours are generally from 7:30 a.m. to 6:00 p.m. Monday through Friday and 8:00 a.m. to 12:00 p.m. on Saturday. The Company's shops are generally 6,000 square feet with new shops ranging from approximately 3,500 square feet to 7,000 square feet and existing shops ranging in size from approximately 3,500 square feet to approximately 12,000 square feet. As of April 30, 1999, the Company had 2 parcels of real estate for sale. Both properties sold during the first quarter of fiscal 2000 for a net of $342,888. The properties had a net book value at April 30, 1999, of approximately $338,875 which are shown in the financial statements as Property held for sale. The gain on the sale of these properties was $4,013 and will be recognized in the first quarter of fiscal 2000. The Company owns its corporate offices, located at 8737 Wilshire Boulevard, Beverly Hills, California 90211. The facility has three floors and approximately 10,500 square feet of office space. In addition, the Company owns a manufacturing and warehousing facility in Springfield, Missouri. The Company manufac- tures and warehouses paint and related products used by the shops (and warehouses other necessary supplies) in this facility until needed by the Company's shops. This facility occupies approximately 30,600 square feet. The Company believes its operating properties are in good operating condition. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in certain legal proceedings and claims arising in the ordinary course of its business. Management believes that the final disposition of such matters should not have a material adverse effect on the Company's operations and/or financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II The Company's Annual Report to Shareholders for the year ended April 30, 1999 ("1999 Annual Report") is filed as Exhibit 13 to this Report on Form 10-K. The responses to Items 5, 6, 7 and 8 are contained in the 1999 Annual Report on the pages noted and are specifically incorporated herein by reference in this Report on Form 10-K. With the exception of these items, the 1999 Annual Report is not deemed filed as a part of this Report. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS "Market Information" appearing on page 15 of the 1999 Annual Report is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA "Selected Financial Data" appearing on page 14 of the 1999 Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing on pages 2 through 4 of the 1999 Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Company appearing on pages 5 through 13 of the 1999 Annual Report are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company, effective April 20, 1999, dismissed Deloitte & Touche, LLP, independent auditors, as its principal independent accountant. The dismissal was recommended by the Audit Committee of the Board of Directors. Deloitte & Touche, LLP's report on the Company's financial statements for either of the past two years did not contain an adverse opinion or disclaimer of opinion, nor was the report qualified or modified as to uncertainty, audit scope or accounting principles. Effective April 22, 1999, following the recommendation of the Audit Committee, the Company engaged Arthur Andersen, LLP, independent public accountants, as its new principal independent accountant to audit the Company's financial statements. The Company did not consult Arthur Andersen, LLP during its two most recent fiscal years with regard to any of the matters described in Item 304(a)(2) of Regulation S-K. PART III ITEMS 10., 12., 13. AND 14. The information required by these items is contained in the Company's definitive Proxy Statement dated July 29, 1999 which relates to election of the Company's directors and which was filed within the Commission within 120 days after the close of the Company's fiscal year pursuant to Regulation 14A of the Securities Exchange Act of 1934. PART IV ITEM 15. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS The following consolidated financial statements of the Company and Report of Independent Auditors, appearing on pages 5 through 13 of the 1999 Annual Report, are filed as part of this Report on Form 10-K: For the Fiscal Years Ended April 30, 1999, 1998 and 1997: Consolidated Statements of Operations Consolidated Statements of Shareholders' Equity Consolidated Balance Sheets as of April 30, 1999 and 1998 Consolidated Statements of Cash Flows Report of Independent Public Accountants 2. FINANCIAL STATEMENT SCHEDULES None. 3. EXHIBITS The Exhibits required to be filed hereunder are indexed on page E-1. (b) REPORTS ON FORM 8-K The Company filed a Current Report on Form 8-K on April 23, 1999 disclosing a change in its certifying accountant. "SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF The statements which are not historical facts contained in this Annual Report on Form 10-K are forward looking statements that involve risks and uncertainties, including, but not limited to, the effect of weather, the effect of economic conditions, the impact of competitive products, services and pricing, capacity and supply constraints or difficulties, changes in laws and regulations applicable to the Company, the impact of Year 2000 hardships, the impact of the Company's Europaint(R), the impact of advertising and promotional activities, the impact of the Company's expansion and fleet sales and the impact of various tax positions taken by the Company. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. EARL SCHEIB, INC. Date: July 29, 1999 By /s/ CHRISTIAN K. BEMENT ------------------------------------ Christian K. Bement President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: EXHIBIT INDEX E-1 EARL SCHEIB INC. AND SUBSIDIARIES AVAILABILITY OF EXHIBITS ------------------------ The Company will furnish upon request copies of the exhibits indicated on page E-1 of the Form 10-K at a cost of 25c per page, which is the reasonable cost to the Company in fulfilling the request.

1056294_1999.txt

1056294_1999

1999

1056294

Item 1. Business. Overview Brio Technology is a leader in developing, marketing and supporting enterprise business intelligence software. Enterprise business intelligence software is software that enables organizations to maximize the value of their corporate information through intuitive, interactive data access and analysis, resulting in more informed business decisions. Brio's product suite offers a comprehensive platform for rapidly implementing and deploying business intelligence solutions that meet the needs of both information technology- savvy "information producers" and non-technical "information consumers" throughout an organization. Brio's products are flexible enough to accomodate the growth of Brio's customers and to effectively incorporate a wide range of available corporate data sources, including data marts, data warehouses, operational data stores, and other computer software applications. Brio sells and markets its software and services through a direct sales and services organization located in North America, the United Kingdom, France and Australia as well as worldwide through its indirect channel of value-added resellers and distributors. See Note 4 of Notes to Consolidated Financial Statements for additional information about geographic revenue. Brio currently serves thousands of organizations worldwide with over 4,000 sites and features over one third of the Fortune 500 as customers. Brio customers include ARCO, Avis Rent a Car Systems, California State University System, Carrefour, Comcast Cable Communications, Hewlett-Packard, Hoffman LaRoche, IBM, Motorola, Sun Microsystems, the U.S. Army and Worldcom Network Services. Brio has entered into an agreement to acquire SQRIBE Technologies Corp., which acquisition is expected to close in July 1999. Industry Background In today's increasingly competitive markets, organizations in virtually every industry are seeking to improve the ability of business professionals to make more timely, fact-based business decisions. To accomplish this objective, organizations must establish and maintain a computer software infrastructure that empowers business professionals with the analytical tools and information to improve their decision making. Brio refers to this software infrastructure as a business intelligence environment. Over the last decade, many organizations have spent considerable effort and resources to collect, organize and distribute data, but have been unable to fully empower business professionals with the benefits of a business intelligence environment. At the same time, the Web has transformed the production and distribution of information throughout business organizations. The Web has created the opportunity for new populations of business professionals throughout the enterprise to have access to published business information. To fully capitalize on this opportunity, however, organizations require that: . their business intelligence software products take full advantage of the distribution and delivery benefits offered by the Web; . their software integrate with the organization's existing systems; and . their software provides a comprehensive solution to the organization's information needs. In the absence of a comprehensive platform, organizations have deployed partial solutions for their reporting and analysis needs. However, many organizations are realizing that incompatible, and disparate reporting and anlaysis tools have inhibited the production and distribution of information. As a result, Brio's believes that organizations need an integrated, end-to-end business intelligence product suite that unifies access to all business information, meets the needs of all users throughout the enterprise and is effective in traditional network as well as email and Web environments. Brio Solution Brio's Enterprise product suite and related services enable organizations to develop and deploy effective business intelligence solutions across an entire organization. Brio believes that its solution provides the following benefits for the enterprise and its information consumers and producers. Architected for the Enterprise Integrated, Comprehensive Product Suite. Brio provides a product suite that can be used either separately or together in a combined distributed client- server and/or Web-based implementation. By incorporating the same easy-to-use interface across all supported platforms and the same underlying core technologies, Brio products provide simple viewing capabilities, robust analysis and reporting features and powerful administrative functions for information producers and consumers. Scalable for Enterprise Deployment. Brio's multi-tier architecture utilizes the computing power of the server and the local computing power of the client, allowing Brio's solution to accommodate increases in the numbers and location of users, and in the quantity and types of source data accessed by users. Leverages Email and the Web. Brio's product suite economically enables information producers to broadcast data and reports to information consumers via email, printers and the Internet. Adaptive Reporting. Brio adaptive reporting feature permits information producers to control, on a report-by-report basis, the functionality available to information consumers in a report. This feature allows information producers to control user access while maximizing the usefulness of reports and data. Designed for Information Consumers Powerful Functionality, Easy to Use. Brio's product suite combines a consistent and intuitive user interface with powerful functionality that allows information consumers to easily customize, format and manipulate data, reports and analyses. Robust Solution for Mobile Users. Brio's product suite facilitates mobile, off-line analysis in both Web browser and PC-based environments and enable information consumers to work with reports, analyses, and data sets that have been sent via email, file servers or the Web. As a result, users in a mobile, off-line environment can view data and can create new analyses and reports to answer their individual questions. Engineered for Information Producers Simplifies Administration. Brio designs its product suite to be quickly and easily installed. Brio's technology centralizes and automates the installation and upgrade of Brio's Web-based client software. Brio's server products enable information technology departments to control user access and security privileges and to audit and manage user activity. Leverages Existing Customer Investments in Technology. Brio's products are designed to be compatible with existing customer database, application, reporting and analysis software, to take advantage of existing enterprise hardware environments and to leverage existing desktop and operating system infrastructure. Brio Strategy Brio's strategy is to be a leading provider of enterprise business intelligence software solutions. The following are key elements of Brio's strategy: Extend Technology Leadership. Brio has designed its products to satisfy customers' desire for rapid implementation, intuitive user interfaces, easy integration with existing database and other system software, high performance and limited information technology staff support. Brio's products incorporate a number of advanced technologies, including a proprietary data analysis engine, a distributed architecture, and Web access and delivery technology. In addition, Brio shipped its Web-based analysis extension to its product suite (Brio.Insight) in November 1996. In November 1997, Brio shipped its Java-based server extension to its product suite (on Demand Server). Brio intends to devote significant resources to research and development efforts and to form strategic relationships that will enable Brio to further enhance its products' functionality and ease of use. Broaden Distribution Channels. To date, Brio has sold its products primarily through its direct sales and services organizations located in the United States, Canada, the United Kingdom, France and Australia, and has sold its products worldwide through value added resellers, resellers and distributors. Brio intends to grow its direct sales organization to intensify its coverage of large organizations and to augment its telesales operation to cover smaller organizations. In addition, Brio will continue to both leverage and grow its existing network of value-added resellers, resellers and distributors to expand its indirect distribution channel worldwide. Expand Product Deployments Throughout the Enterprise. Brio's products and related services are designed to enable its customers to deploy business intelligence throughout their organization. Although most organizations initially deploy Brio's products on a departmental or pilot basis, Brio believes that initial customer success with this deployment can lead to significant opportunities for larger scale adoption of Brio's products within the organization. Brio intends to focus its sales and services efforts on large organizations seeking large-scale business intelligence deployments and on making initial customer pilots or deployments successful. Leverage Industry Relationships. To accelerate the adoption of Brio's products as a standard platform for business intelligence, Brio has formed strategic relationships that provide for enhanced compatibility with partner technology as well as increased market exposure and sales opportunities for Brio's products and services. Brio's partners include industry-leading providers of software and hardware, such as Microsoft, Oracle and IBM, that complement Brio's product and service offerings, and providers of a wide range of training, implementation and application development services related to Brio's products. Brio's strategic relationships with Microsoft, Oracle and IBM have to date consisted of: . Brio's participation in various sales and marketing initiatives sponsored by these companies, including joint presentations at industry trade shows and conferences, and . agreements by Brio to support certain technology standards promoted by these companies. Increase International Presence. Outside of the United States, Brio . has direct sales offices in Canada, the United Kingdom, France and Australia, . has established distributor relationships in more than 20 countries, including Belgium, Italy, Japan, The Netherlands and South Africa, and . has localized products in Chinese, French, Italian and Japanese. Brio intends to expand its global sales capabilities by increasing the size of its direct sales and sales support organizations, expanding its distribution channels in Europe, Latin America, and Asia/Pacific and continuing localization efforts of its products in selected markets. Provide Premium Customer Support and Service. Brio believes that offering quality service and support is important to customer satisfaction and provides a significant opportunity to build customer loyalty and to differentiate itself from its competition. Brio intends to increase its focus on customer satisfaction by investing in support services including additional staffing, a Web-based help line and systems infrastructure. In addition, Brio is committed to providing customer-driven product functionality through feedback from user groups, prospects, consultants, partners and customer surveys. Products and Technology Brio Enterprise is a business intelligence software product suite providing powerful query, analysis and reporting functionality across both client-server and Web-based computing environments. Designed to meet the needs of users throughout an organization, Brio's products combine powerful functionality with intuitive, easy-to-use interfaces. Brio's products are designed to enable an information technology department to maintain centralized control with auditing, security and simplified deployment while incorporating a system design that accommodates the needs of growing and diverse user populations and increasing amounts of data. Brio's products use advanced server technology to optimize use of computer network resources. Brio's system design, built on Brio's proprietary analytical processing technology, enables analytical processing to take place on the server or on the client computer. This design enhances the flexibility of the solution without losing analytical capabilities required for individuals to answer complex data-related business questions. Brio's "adaptive reporting" capability further enhances this flexibility by giving information technology departments the ability to control the analytical functionality available to an information consumer on a report-by-report basis. Brio Enterprise Client Products Brio's client products, whether Web-based or client-server based, share the same user-centric design, functionality and intuitive interface. Brio believes that the result is an easy-to-navigate suite of products that consistently guide the user from query and analysis through reporting and charting. Brio's client products allow users to create queries that are targeted at single or multiple data sources and that can combine data from local or server-based data sources without information technology department assistance. BrioQuery. All editions of BrioQuery unify query, analysis, reporting and charting capabilities in one product for client-server connected users. To meet the differing needs of these users, BrioQuery is available in three editions: BrioQuery Designer extends the core BrioQuery capabilities with database administration functionality, security, auditing and setup features to enable information technology departments to manage and control the business intelligence environment; BrioQuery Explorer is designed for power users or independent analysts who need direct access to database tables and repositories of pre-defined data and reports, and need to be able to create their own queries, analyses and reports; and BrioQuery Navigator is used by analysts or information consumers who do not have the technical ability or need to directly access database tables. These users typically only need access to pre-defined data and reports that they can use as a basis for independent analyses. Web-based Products. Brio's Web-based client products provide users with a wide range of report, query and analytical capabilities within standard Web browsers. Together with Brio's server-based products, they enable organizations to deploy software that facilitates simplified administration and maintenance. Brio.Insight. Employing the same user-interface as BrioQuery, Brio.Insight delivers interactive query, analysis, reporting and charting capabilities inside a standard Web browser. Whether connected to the Web, to the Brio Enterprise Server, or operating without connection, Brio.Insight enables users to go beyond viewing static reports and to perform independent analysis and reporting on the delivered information. Brio.Quickview. Brio.Quickview enables organizations to deliver a portfolio of "view only" reports to users through a Web browser. These portfolios can include fully formatted reports with color, highlights, charts and tables. When used in conjunction with the Brio Enterprise Server, Brio.Quickview provides users with the option to refresh the data that is used to create their portfolio, or to limit the view based on a set of criteria. Brio Enterprise Server Products Brio Enterprise Server. The Brio Enterprise Server product includes two powerful server modules, the Broadcast Server and the OnDemand Server, and a unified administration tool. The Brio Enterprise Server is designed to meet the information distribution and data access needs of information consumers, while providing information technology departments with centralized control, administration and security management functionality. Broadcast Server. The Broadcast Server enables information technology departments to control the integrity and distribution of business information. It allows information producers to take queries, analyses and reports created with BrioQuery, and to schedule automatic processing and delivery of such reports based on date, time, or event. The Broadcast Server pushes the reports and documents in a highly compressed format out to Web, client-server and mobile users via file transfer protocol, email, Web servers, and network file servers and printers. OnDemand Server. The OnDemand Server offers both mobile and desktop users easy and secure access to a variety of data sources. Users can make queries over the Web or on the server; the server can then pre-build reports and transmit them to Brio's Web client products, Brio.Insight and Brio.Quickview. With the OnDemand Server and Brio's adaptive reporting feature, information technology departments can determine on a report-by-report basis the level of Brio.Insight and Brio.Quickview functionality and interactivity that a particular user is allowed. The OnDemand Server also automates the installation and maintenance of Brio's Web client software. Platforms and Pricing Brio's server products are designed to operate on most popular server platforms including Windows NT and UNIX (AIX, HPUX, Sun Solaris). Pricing on the Brio Enterprise Server product, which includes both the Broadcast Server and the OnDemand Server, ranges from $30,000 to $45,000. Brio client products currently operate on a number of operating systems including Windows (95, NT and 3.1), PowerMac and UNIX (AIX, HPUX, Sun Solaris). Brio's products provide native and ODBC connectivity to a variety of data sources, including relational database management systems such as Oracle, DB2, SQL Server and Adaptive Server; non-relational database management systems such as Arbor Essbase, Oracle Express and Informix Metacube; and legacy systems such as SAS. Pricing ranges from approximately $50 for Brio.Quickview to $4,000 for BrioQuery Designer. Brio's success in the future will depend upon its ability to develop new products and its ability to sell larger, organization-wide sales of its products. Sales and Marketing Sales. To date, Brio has sold its products primarily through its direct sales and services organizations located in the United States, Canada, the United Kingdom, France and Australia, and has sold its products worldwide through value-added resellers, or "VARs", resellers and distributors. The direct sales process involves the generation of sales leads through direct mail, seminars and telemarketing, or requests for proposal from prospects. Brio's field sales force conducts multiple presentations and demonstrations of Brio's products to management and users at customer sites as part of the direct sales effort. Sales cycles typically range from three to nine months. The direct sales force is responsible for local partner support, joint sales efforts and channel management. The direct sales force is compensated for sales made through indirect channel partners as well as direct sales to ensure appropriate cooperation with Brio's VARs, resellers and distributors. To date, Brio has generated a majority of its sales from its direct sales force, and has supplemented its direct sales efforts with the efforts of VARs, resellers and distributors in a variety of locations throughout the world. These third parties perform some or all of the following functions: sales and marketing; systems implementation and integration; software development and customization; and ongoing consulting, training, service and technical support. Brio generally offers such parties discounts on products and training, a cooperative marketing program and field level assistance from Brio's direct sales force. Brio intends to leverage sales and marketing through indirect channel partners that will distribute or resell Brio's products in their respective markets. Indirect channel partners accounted for approximately 9% of total revenues for fiscal 1996, 7% of total revenues for fiscal 1997 and 15% of Brio's total revenues in fiscal 1998 and 1999. Brio intends to grow its direct sales organization and its telesales operation to cover smaller organizations. In addition, Brio will continue to leverage and grow its existing network of VARs, resellers and distributors to expand its indirect distribution channel worldwide. Brio currently expects that it will fund such expansion out of its working capital. Brio's agreements with its VARs generally provide VARs with a right to resell a customized version of Brio's products in conjunction with sales of the VAR's products or services. Brio typically offers its VARs a purchase discount to incent the VAR to sell Brio's products. Brio's agreements with its distributors generally require that such distributors make certain minimum purchases of Brio's products, none of which minimum purchases are material in amount either individually or in the aggregate. Brio recognizes revenue from such minimum purchases as the distributors sell Brio's products through to end customers. Brio does not typically grant exclusive sales territories to its distributors. Marketing. Brio is focused on building market awareness and acceptance of Brio and its products as well as on developing strategic partnerships. Brio has a marketing strategy with several key components: image and awareness building, direct marketing to both prospective and existing customers, a strong Web presence, as well as broad-scale marketing programs in conjunction with key local and global partners. Brio's corporate marketing strategy includes extensive public relations activities; a conference and trade show speakers program, as well as programs to work closely with key analysts and other influential third parties. Brio's direct marketing activities include participation in selected trade shows and conferences, targeted advertising, as well as ongoing direct mail efforts to existing and prospective customers. Brio has effectively used local, regional and Web-based seminars to assist prospects in selecting enterprise business intelligence solutions. Brio has used the Web to further the interest and lead generation process and to improve the quality of the leads that it provides to the sales organization. Brio's Web site has become an effective lead generation program. Brio has invested in building a partner and channel marketing function which helps to recruit, train, support and conduct cooperative marketing with technology partners, resellers and VARs. These programs help to foster strong relationships between Brio and its various partners. The marketing organization also provides a wide-range of programs, materials and events to support the sales organization in its efforts. Brio's sales and marketing organization consisted of 139 full-time employees as of March 31, 1999. The sales and marketing staff is based at Brio's corporate headquarters in Palo Alto, California. Brio also has field sales offices in the metropolitan areas of Chicago, New York, Los Angeles, Atlanta, Washington D.C. and Dallas. Research and Development Research and development created the products that have been the basis for Brio's success, and Brio intends to make substantial investments in research and development and related activities to maintain and enhance its product lines. Brio believes that its future success will, in large part, depend on its ability to maintain and improve current products, and to develop new products that meet enterprise business intelligence needs. Brio's research and development organization is divided into teams consisting of development engineers, product managers, quality assurance engineers and technical writers. As of March 31, 1999, Brio's research and development organization consisted of 52 full-time employees. Brio has expended $2.4 million in fiscal 1997, $5.2 million in fiscal 1998 and $7.2 million in fiscal 1999, on research and development. The research and development organization uses a phase-oriented development process, which includes constant monitoring of quality, schedule, functionality, costs and customer satisfaction. Product development is based upon a consolidation of the requirements from existing customers, technical support and engineering. The development group infrastructure provides documentation, quality assurance and delivery and support capabilities (as well as product design and implementation) for Brio's products. Customer and Technical Support Brio believes that a high level of customer support is important to the successful marketing and sale of its products. Maintenance and support contracts, which are typically for twelve months, are offered with the initial license, may be renewed annually and are typically set at a percentage of the total license fee. A large portion of Brio's direct sales to customers have maintenance and support contracts that entitle the customers to patches, updates and upgrades at no additional cost if and when available, and technical hotline support. In addition, Brio offers classes and training programs at Brio's headquarters, local training centers and customer sites. Customers purchasing maintenance are able to access hotline telephone support during normal business hours. Incoming customer calls are immediately logged into the support database at the time of the call. Brio supplements its standard telephone hotline support with a number of Web-based support services, including access to frequently asked questions, a patch download area, and an interface to Brio's technical support department's problem- tracking database, which allows customers to submit cases and view the status of any of their current cases on-line. Users of Brio's products can attend regional user group conferences throughout the year. To improve user access to explanatory materials, Brio provides on-line documentation with all of its products. Among other things, such documentation includes detailed explanations of product features as well as problem-solving tips for middleware connections. Competition The market in which Brio operates is still developing, and is intensely competitive, highly fragmented and characterized by rapidly changing technology and evolving standards. Brio's current and potential competitors offer a variety of software solutions and generally fall within four categories: . vendors of business intelligence software such as Cognos, Business Objects, Seagate and Hummingbird; . vendors offering alternative approaches to delivering analysis capabilities to users, such as MicroStrategy, Information Advantage and Actuate; . database vendors that offer products which operate specifically with their proprietary database, such as Microsoft, IBM, Oracle and Arbor; and . other companies that may in the future announce offerings of an enterprise business intelligence solution. Brio's competitive position in the market is uncertain, due principally to the variety of current and potential competitors, and the emerging nature of the market. Brio has experienced and expects to continue to experience increased competition from current and potential competitors, many of whom have significantly greater financial, technical, marketing and other resources than Brio. Such competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sales of their products than Brio. Brio expects additional competition as other established and emerging companies enter into the business intelligence software market and new products and technologies are introduced. Increased competition could result in price reductions, fewer customer orders, reduced gross margins, longer sales cycles and loss of market share, any of which could materially and adversely affect Brio's business, operating results and financial condition. Current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third parties, thereby increasing the ability of their products to address the needs of Brio's prospective customers. Brio's current or future indirect channel partners may establish cooperative relationships with current or potential competitors of Brio, thereby limiting Brio's ability to sell its products through particular distribution channels. Accordingly, it is possible that new competitors or alliances among current and new competitors may emerge and rapidly gain significant market share. Such competition could materially adversely affect Brio's ability to obtain new licenses, and maintenance and support renewals for existing licenses, on terms favorable to Brio. Further, competitive pressures may require Brio to reduce the price of its products, which could have a material adverse effect on Brio's business, operating results and financial condition. There can be no assurance that Brio will be able to compete successfully against current and future competitors, and the failure to do so could have a material adverse effect upon Brio's business, operating results and financial condition. Brio competes on the basis of the following factors: . product features; . time to market; . ease of use; . product performance; . product quality; . analytical capabilities; . user scalability; . open architecure; . customer support; and . price. Brio believes it presently competes favorably with respect to each of these factors. However, Brio's market is still evolving and there can be no assurance that Brio will be able to compete successfully against current and future competitors, and the failure to do so successfully could have a material adverse effect on Brio's business, operating results and financial condition. Proprietary Rights Brio currently relies primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. Brio also believes that factors such as the technological and creative skills of its personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are essential to establishing and maintaining a technology leadership position. Brio seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. Brio currently has one United States patent application. There can be no assurance that Brio's patent application will result in the issuance of a patent, or if issued, will not be invalidated, circumvented or challenged, or that the rights granted thereunder, if any, will provide competitive advantages to Brio or that any of Brio's future patent applications, if any, will be issued with the scope of the claims sought by Brio, if at all. Furthermore, there can be no assurance that others will not develop technologies that are similar or superior to Brio's technology or design around any patent that may come to be owned by Brio. Despite Brio's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of Brio's products or to obtain and use information that Brio regards as proprietary. Policing unauthorized use of Brio's products is difficult, and while Brio is unable to determine the extent to which piracy of its software products exists, software piracy can be expected to be a persistent problem. In addition, the laws of some foreign countries do not protect Brio's proprietary rights as fully as do the laws of the United States. There can be no assurance that Brio's means of protecting its proprietary rights in the United States or abroad will be adequate or that competitors will not independently develop similar technology. Brio has entered into source code escrow agreements with a number of customers and indirect channel partners requiring release of source code. Such agreements provide that the contracting party will have a limited, non- exclusive right to use the code subject to the agreement in the event that: . there is a bankruptcy proceeding by or against Brio; . if Brio ceases to do business; or . in some cases, if Brio fails to meet its contractual obligations. The provision of source code escrows may increase the likelihood of misappropriation by third parties. Brio expects that software product developers will increasingly be subject to infringement claims as the number of products and competitors in Brio's industry segment grows and the functionality of products in different industry segments overlaps. Any claims, with or without merit, could: . be time consuming to defend; . result in costly litigation; . divert management's attention and resources; . cause product shipment delays; or . require Brio to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on acceptable terms, if at all. In the event of a successful claim of product infringement against Brio and its failure or inability to license the infringed or similar technology, Brio's business, operating results and financial condition could be materially adversely affected. Finally, in the future Brio may rely upon software that it may license from third parties, including software that may be integrated with Brio's internally developed software and used in Brio's products to perform key functions. There can be no assurance that these third-party software licenses will be available on commercially reasonable terms. Brio's inability to obtain or maintain any third party software licenses could result in shipment delays or reductions until equivalent software could be developed, identified, licensed and integrated, which could have a material adverse effect on Brio's business, operating results and financial condition. Employees As of March 31, 1999, Brio had 257 employees, including 139 in sales and marketing, 30 in services and support, 52 in research and development and 36 in general and administrative functions. Brio believes its employee relations are good. Brio's success depends to a significant degree upon the continued contributions of its key management, engineering, sales and marketing personnel, many of whom would be difficult to replace. Brio has employment contracts with only three members of its executive management personnel, and currently maintains "key person" life insurance only on Yorgen Edholm, Brio's President and Chief Executive Officer, and Katherine Glassey, Brio's Executive Vice President, Products and Services and Chief Technology Officer. Brio does not believe such insurance would adequately compensate it for the loss of either Mr. Edholm or Ms. Glassey. Brio believes its future success will also depend in large part upon its ability to attract and retain highly skilled managerial, engineering, sales and marketing and finance personnel. Competition for such personnel is intense, and there can be no assurance that Brio will be successful in attracting and retaining such personnel. The loss of the services of any of the key personnel, the inability to attract or retain qualified personnel in the future or delays in either hiring required personnel, or the rate at which new people become productive, particularly sales personnel and engineers, could have a material adverse effect on Brio's business, operating results and financial condition. In particular, Brio has from time to time experienced and may continue to experience significant turnover of its sales force, due principally to the intensely competitive market for such personnel. Such turnover tends to slow sales efforts until replacement personnel can be recruited and trained to become productive members of Brio's sales force. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company and their ages as of March 31, 1999 are as follows: Yorgen H. Edholm is a co-founder of the Company and has been its President, Chief Executive Officer and Chairman of the Board of Directors since inception. Prior to founding the Company, Mr. Edholm was a manager with the Management Consulting Division of Arthur Young & Company in New York (now Ernst & Young, LLP) where he co-founded the microcomputer-based Decision Support Systems Group. Before that, Mr. Edholm was a product manager with Industri Mathematics AB in Stockholm, Sweden. Mr. Edholm holds a M.S. degree in Computer Science and Applied Mathematics from the School of Physical Engineering at the Royal Institute of Technology in Stockholm, Sweden and an M.B.A. degree in Organizational Behavior and International Economics from the Stockholm School of Economics in Stockholm, Sweden. Mr. Edholm is the spouse of Katherine Glassey. Katherine Glassey is a co-founder of the Company and has been its Executive Vice President of Products and Services and Chief Technology Officer since January 1997 and has been a director since inception. Prior to joining the Company, Ms. Glassey established and managed application development and consulting organizations for Metaphor Computer Systems, Inc. ("Metaphor"), a decision support hardware and software company. Before joining Metaphor, Ms. Glassey was a Senior Consultant with the Management Consulting Division of Arthur Young & Company in New York. During that time, she co-founded the microcomputer-based Decision Support Systems Group whose charter was to use personal computers to enable end-users to make decisions based on corporate data. Ms. Glassey holds a B.S. degree in Operations Research from Cornell University with a Minor in English Literature. Ms. Glassey is the spouse of Yorgen H. Edholm. Robert W. Currie joined the Company in September 1996 as Executive Vice President of Worldwide Operations. Prior to joining the Company, Mr. Currie was Vice President and General Manager of North American Operations at Sybase, Inc., a database software and systems company, from July 1995 to July 1996. From December 1993 to July 1995, Mr. Currie was Vice President and General Manager of European Operations at Sybase, Inc. Mr. Currie holds a B.S. degree in Business Administration from the University of Massachusetts. Chris M. Grejtak joined the Company in January 1997 as Executive Vice President, Marketing. Prior to joining the Company, Mr. Grejtak was Vice President, Marketing at Red Brick Systems, Inc., a data warehousing company, from December 1995 to December 1996. From July 1995 to December 1995, he was Vice President, Sales and Marketing at Avistar Systems, Inc., a video desktop conferencing software and hardware company. Mr. Grejtak was Vice President, Marketing at Network General Corporation ("Network General"), a network management software company, from November 1994 to June 1995. From August 1992 to November 1994, he was a Vice President and then President and CEO of Metaphor. Mr. Grejtak holds a B.A. degree in Sociology from Middlebury College. Karen J. Willem joined the Company in August 1997 as Executive Vice President, Finance and Operations and Chief Financial Officer. Prior to joining the Company, Ms. Willem was Vice President, Worldwide Sales Operations from April 1995 to January 1997 at Network General. From July 1991 to March 1995, Ms. Willem was Vice President and Corporate Controller at Network General. Ms. Willem holds a B.S. degree in Biology from Bucknell University and an M.B.A. degree in Finance from the University of Pittsburgh. Item 2. Item 2. Properties. Brio's principal executive offices are located in Palo Alto, California where Brio leases approximately 12,145 square feet under a lease that expires in October 2003 and approximately 30,000 square feet under a lease that expires in March 2000. Brio also leases space (typically less than 4,000 square feet) in various geographic locations primarily for sales and support personnel. Brio believes that its current facilities are adequate to meet its needs through the end of 1999, at which time Brio may need to lease additional space. Brio was incorporated in California in February 1989 and was reincorporated in Delaware in April 1998. Its principal executive offices are located at 3460 West Bayshore Road, Palo Alto CA 94303. Its telephone number at that location is (650) 856-8000. Item 3. Item 3. Legal Proceedings. On January 20, 1997, Business Objects, S.A. filed a complaint against Brio in the U.S. District Court for the Northern District of California in San Jose, California alleging that certain of Brio's products (including at least the BrioQuery Navigator, BrioQuery Explorer and BrioQuery Designer products) infringe at least claims 1, 2 and 4 of U.S. Patent No. 5,555,403. In April 1997, Brio filed an answer and affirmative defenses to the complaint, denying certain of the allegations in the complaint and asserting a counterclaim requesting declaratory relief that Brio is not infringing the patent and that the patent is invalid and unenforceable. In December 1997, venue for the case was changed to the Northern District of California in San Francisco, California. Based upon the advice of Brio's patent counsel, Blakely, Sokoloff, Taylor & Zafman, LLP, Brio believes that it has meritorious defenses to the claims made in the complaint and intends to defend the suit vigorously. A claims construction hearing was held on April 5, 1999. At the hearing, the court set the trial date for September 13, 1999. The court also issued its claims construction ruling on April 6, 1999. Brio and Business Objects, S.A. are currently conducting discovery. The pending litigation could result in substantial expense to Brio and significant diversion of effort by Brio's technical and management personnel. The complaint seeks injunctive relief and unspecified monetary damages, and Business Objects, S.A. is expected to seek lost profits and/or equivalent royalties. The complaint also alleges willful infringement, and seeks treble damages, costs and attorneys' fees. Litigation is subject to inherent uncertainties, especially in cases such as this where complex technical issues must be decided. Brio's defense of this litigation, regardless of the merits of the complaint or lack thereof, could be time-consuming or costly, or divert the attention of technical and management personnel, which could have a material adverse effect upon Brio's business, operating results and financial condition. There can be no assurance that Brio will prevail in the litigation given the complex technical issues and inherent uncertainties in patent litigation, particularly before the claims have been construed by the Court. In the event Brio is unsuccessful in the litigation, Brio may be required to pay damages to Business Objects, S.A. and could be prohibited from marketing its BrioQuery Navigator, BrioQuery Explorer and BrioQuery Designer products without a license, which license may not be available on acceptable terms. If Brio is unable to obtain such a license, Brio may be required to license a substitute technology or redesign to avoid infringement, in which case Brio's business, operating results and financial condition could be materially adversely affected. Collectively, sales of BrioQuery Navigator, BrioQuery Explorer and BrioQuery Designer represented substantially all of Brio's revenues in fiscal 1996 and represented a majority of Brio's revenues in fiscal 1997 and fiscal 1998 and a significant portion of Brio's revenues in fiscal 1999. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's Common Stock has been traded on the Nasdaq National Market under the symbol "BRYO" since the Company's initial public offering on May 1, 1998. The following table sets forth the high and low sales prices of the Company's Common Stock as reported by the Nasdaq National Market for the periods indicated. The Company has never declared or paid cash dividends on its capital stock. The Company currently intends to retain all available funds and any future earnings for use in the operation of its business and does not anticipate paying any cash dividends in the foreseeable future. In addition, the terms of the Company's primary credit facility prohibit the paying of dividends without the lender's consent. Item 6. Item 6. Selected Financial Data. The selected consolidated financial data set forth below should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," the Consolidated Financial Statements and the Notes thereto and the other information contained in this Report. The selected consolidated statements of operations data for the years ended March 31, 1999, 1998 and 1997, and the selected consolidated balance sheet data as of March 31, 1999 and 1998, are derived from, and are qualified by reference to, the audited Consolidated Financial Statements of Brio appearing elsewhere in this Report. The selected consolidated statement of operations data for the years ended March 31, 1996 and 1995, and the selected consolidated balance sheet data as of March 31, 1997, 1996 and 1995, are derived from audited Consolidated Financial Statements of Brio not included herein. The historical results of operations presented are not necessarily indicative of results to be expected for any subsequent period. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto and the other information included elsewhere in this Report. Certain statements in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" are forward- looking statements. The forward-looking statements contained herein are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward- looking statements. For a more detailed discussion of these and other business risks, see "Factors That May Affect Future Operating Results" below. Overview Brio designs, develops, markets and supports enterprise business intelligence software, which is software that enables organizations to maximize the value of their corporate information through intuitive, interactive data access and analysis. Brio had net losses of $6.0 million in fiscal 1997, $8.1 million in fiscal 1998 and $887,000 in fiscal 1999. Brio had an accumulated deficit of approximately $18.8 million as of March 31, 1999. See "Risk Factors That May Affect Future Operating Results" for a description of the risks related to Brio's operating results fluctuating in future periods. In February 1999, Brio entered into a definitive merger agreement with SQRIBE Technologies Corp., a Delaware corporation (SQRIBE). SQRIBE designs, develops, markets and supports a family of information retrieval and dissemination software products for relational databases. Brio will acquire SQRIBE in a tax-free, stock-for-stock transaction. Under the terms of the agreement, upon closing of the transaction, Brio stockholders will hold approximately 55% of Brio, with former SQRIBE stockholders holding approximately 45%. In addition, Brio will assume outstanding stock options of SQRIBE. The merger is expected to close in July 1999 and to be accounted for as a pooling of interest. Brio's revenues consist of license fees for software products and fees for services, including software maintenance and support, training and system implementation consulting. Revenues in current periods are generally attributable to the sale of the most recent version of Brio's products. Brio generally discontinues marketing older product versions when a new product version is introduced. The products are typically licensed on a per user basis with the price per user varying based on the selection of products licensed. Additionally, Brio also sells larger enterprise-wide implementations of their products through site licenses with the price per site varying based on the selection of . products licensed; . the number of authorized users for each product at each site; and . the number of licensed sites. Revenues from license fees are recognized upon shipment of the software if: . collection of the resulting receivable is probable; . the fee is fixed or determinable; and . vendor-specific objective evidence exists to allocate the total fee to all delivered and undelivered elements of the arrangement. If vendor- specific objective evidence does not exist to allocate the total fee to all delivered and undelivered elements of the arrangement, revenue is deferred until such evidence does exist, or until all elements are delivered, whichever is earlier. If payments are subject to extended payment terms and are not deemed fixed or determinable, Brio defers revenue until payments become due. If an acceptance period is required, Brio recognizes revenue upon the earlier of customer acceptance or the expiration of the acceptance period. Brio establishes allowances for potential product returns and credit losses, which have been insignificant to date. Brio charges fees for services separately from license fees. Brio recognizes revenues from maintenance and support services, including ongoing product support and periodic product updates, ratably over the term of each contract, which is typically twelve months. Payments for maintenance and support services are generally made in advance and are non-refundable. Brio recognizes revenues from training and consulting services when the services are performed. To date, Brio has derived revenues from license fees principally from direct sales of software products to end users through Brio's direct sales force. Although Brio believes that such direct sales will continue to account for a significant portion of revenues from license fees in the foreseeable future, Brio has recently developed and intends to continue to develop reselling relationships with value added resellers, resellers and distributors. Brio expects that revenues from sales through value added resellers, resellers and distributors will increase in the future as a percentage of revenues from license fees. Revenues from value added resellers, resellers and distributors, were 7% of total revenues for fiscal 1997 and 15% of total revenues for fiscal 1998 and 1999. Brio's ability to achieve revenue growth and improved operating margins, as well as increased worldwide sales, in the future will depend in large part upon its success in expanding and maintaining relationships with value added resellers, resellers and distributors. See "Factors That May Affect Future Operating Results" for a description of the risks related to Brio's sales strategy. Brio is also increasing its efforts to sell customers licenses to larger, enterprise-wide implementations of Brio's products, rather than departmental or local network sales, which may increase the complexity and length of the sales cycle. Brio has in the past and may in the future choose to grant greater pricing and other concessions, such as discounted training and consulting, for sales of site licenses. See "Factors That May Affect Future Operating Results" for a description of the risks related to the sales cycle of Brio's products. Brio has, to date, sold its products internationally through direct sales offices in the United Kingdom, France and Australia, and indirectly through established distribution relationships in more than 20 countries, including Belgium, Italy, Japan, The Netherlands and South Africa. Brio's direct sales offices in the United Kingdom and Australia were formed through the acquisition of distributors in those countries. Sales to customers outside of the United States and Canada, including sales generated by Brio's foreign subsidiaries, represented 14% of total revenues for fiscal 1997, 19% of total revenues for fiscal 1998, and 17% of total revenues for fiscal 1999. A substantial portion of Brio's international sales in the past have been denominated and collected in foreign currencies and Brio believes that a portion of Brio's cost of revenues and operating expenses will continue to be incurred in foreign currencies. To date, there have been no material effects of changes in foreign currency exchange rates on revenues or operating expenses. During fiscal 1999, Brio incurred foreign currency transaction losses of $127,000 resulting from intercompany receivables from its foreign subsidiaries. Although it is impossible to predict future exchange rate movements between the U.S. dollar and other currencies, to the extent the U.S. dollar strengthens or weakens against other currencies, a substantial portion of Brio's revenues, cost of revenues and operating expenses will be commensurately lower or higher than would be the case in a more stable foreign currency environment. Although Brio has not historically undertaken foreign exchange hedging transactions to cover its potential foreign currency exposure, it may do so in the future. See "Risk Factors--Brio's plans to expand internationally expose the combined company to financial and operational risks" for a description of the risks related to Brio's international sales strategy. Although Brio has experienced significant quarter-to-quarter revenue growth in fiscal 1997, 1998 and 1999, the same rate of sequential quarterly revenue growth may not be sustainable and profitability may not be attained in the future. Brio currently intends to commit substantial financial resources to . research and development, . customer support, . sales and marketing, including the expansion of its direct sales force, third-party partnering relationships and its indirect channel sales organization, and . increased staffing and systems infrastructure to support Brio's expanding operations . merger-related expenses and integration costs associated with the proposed merger with Sqribe Brio also expects that expenses relating to its litigation with Business Objects, S.A. will increase in future periods. As a result, Brio expects that its operating expenses will increase significantly in fiscal 2000. See "Risk Factors--The combined company's quarterly operating results will likely fluctuate" and "--The outcome of Brio's litigation with Business Objects, S.A. may be unfavorable" for a description of Brio's litigation and its impact on Brio's financials. Results of Operations The following table includes consolidated statements of operations data as a percentage of total revenues for the periods indicated: Fiscal Years Ended March 31, 1999, 1998 and 1997 Revenues Brio derives revenues from license fees and services, which include software maintenance and support, training and system implementation consulting. Total revenues increased by 100% from $13.4 million in fiscal 1997 to $26.8 million in fiscal 1998 and by 74% to $46.5 million in fiscal 1999. Revenues by geographic location were as follows for fiscal 1999, 1998 and 1997: Revenue from international sources increased by 168% from $1.9 million in fiscal 1997 to $5.2 million in fiscal 1998 and by 56% to $8.1 million in fiscal 1999. The increase in fiscal 1998 was due to Brio establishing direct sales offices in Australia, the United Kingdom and France, which resulted in increases in both license fees and services revenue in Europe and Asia. The increase in fiscal 1999 was due to increased demand for Brio products in Europe and Asia as Brio continued to expand direct and indirect sales efforts in these areas. See Note 4 of Notes to Consolidated Financial Statements for additional information about revenues in geographic areas. License Fees. Revenues from license fees increased by 92% from $10.3 million in fiscal 1997 to $19.8 million in fiscal 1998 and by 73% to $34.2 million in fiscal 1999. The increases in fiscal 1998 and 1999 were due to growing sales to new customers--approximately $4.8 million of the increase in fiscal 1998 and approximately $9.2 million of the increase in fiscal 1999--and increased follow-on sales to existing customers--approximately $4.7 million of the increase in fiscal 1998 and approximately $5.2 million of the increase in fiscal 1999. Services. Service revenues increased by 128% from $3.1 million in fiscal 1997 to $7.0 million in fiscal 1998 and by 76% to $12.3 million in fiscal 1999. The increases in fiscal 1998 and 1999 were due to an increase in maintenance and support revenues--approximately $2.2 million of the increase in fiscal 1998 and approximately $4.7 million of the increase in fiscal 1999-- and an increase in training and consulting revenues--approximately $1.7 million of the increase in fiscal 1998 and approximately $600,000 of the increase in fiscal 1999--related to increases in Brio's installed customer base. Cost of Revenues License Fees. Cost of revenues from license fees consists primarily of product packaging, shipping, media, documentation, and related personnel and overhead allocations. Cost of revenues from license fees increased by 20% from $839,000 in fiscal 1997 to $1.0 million in fiscal 1998 and by 50% to $1.5 million in fiscal 1999. The increase in absolute dollars was due to the increase in the number of licenses sold. The decrease as a percentage of total revenues was primarily due to an increase in the number of customers purchasing master disks, which are less expensive to produce and ship, as compared to "shrinkwrapped" product, and economies of scale associated with absorbing fixed costs over a larger revenue base. Cost of revenues from license fees may vary between periods due to the mix of customers purchasing master disks relative to customers purchasing "shrinkwrapped" product. Services. Cost of revenues from services consists primarily of personnel costs and third-party consulting fees associated with providing software maintenance and support, training and consulting services. Cost of revenues from services increased by 218% from $817,000 in fiscal 1997 to $2.6 million in fiscal 1998 and by 109% to $5.4 million in fiscal 1999. The increases in fiscal 1998 and 1999 were due principally to increases in personnel and related costs resulting from Brio's expansion of its support services in response to increased demand for maintenance and support, training and consulting services--approximately $1.7 million of the increase in fiscal 1998 and approximately $2.3 million of the increase in fiscal 1999--and increases in the use of outside consultants for training and consulting services-- approximately $900,000 of the increase in fiscal 1998 and approximately $500,000 of the increase in fiscal 1999. Cost of revenues from services may vary between periods due to the mix of services provided by Brio's personnel relative to services provided by outside consultants and to varying levels of expenditures required to build the services organization. Operating Expenses Research and Development. Research and development expenses consist primarily of personnel and related costs associated with the development of new products, the enhancement and localization of existing products, quality assurance and testing. Research and development expenses increased by 113% from $2.4 million in fiscal 1997 to $5.2 million in fiscal 1998 and by 38% to $7.2 million in fiscal 1999. The increases from year to year were primarily due to increased personnel and related costs required to continue to develop new products and enhance existing products. Brio believes that significant investment for research and development is essential to product and technical leadership and anticipates that it will continue to commit substantial resources to research and development in the future. Brio anticipates that research and development expenditures will continue to increase in absolute dollars, although such expenses may vary as a percentage of total revenues. Sales and Marketing. Sales and marketing expenses consist primarily of salaries and other personnel related costs, commissions, bonuses and sales incentives, travel, marketing programs such as trade shows and seminars, and promotion costs. Sales and marketing expenses increased by 67% from $13.6 million in fiscal 1997 to $22.7 million in fiscal 1998 and by 21% to $27.6 million in fiscal 1999. The increases were attributable to the costs associated with the expansion of Brio's sales and marketing organization, including domestically through the growth of the telesales organization, internationally through the establishment of subsidiary offices in the United Kingdom, Australia, and France and through the expansion of the worldwide field sales organization--approximately $5.7 million of the increase in fiscal 1998 and approximately $1.5 million of the increase in fiscal 1999--higher sales commissions, bonuses and sales incentives associated with increased revenues--approximately $1.9 million of the increase in fiscal 1998 and approximately $2.1 million of the increase in fiscal 1999--and increased domestic and international marketing expenses, including marketing activities, personnel and related costs--approximately $1.5 million of the increase in fiscal 1998 and approximately $1.3 million of the increase in fiscal 1999. The decrease as a percentage of total revenues was generally attributable to increases in revenues for the periods. Brio believes that as it continues to expand its direct sales and pre-sales support organization and its third-party partnering relationships and its indirect channel sales organization on a worldwide basis, sales and marketing expenses will continue to increase in absolute dollars. These expenses are currently intended to be funded by Brio's working capital. In particular, Brio expects that sales compensation, travel and related expenses will increase significantly as Brio continues to increase the number of its direct sales personnel and its emphasis on direct field sales efforts. Nonetheless, Brio expects sales and marketing expenses will continue to vary as a percentage of total revenues. General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, human resources, information systems, and general management, as well as legal, accounting and unallocated overhead expenses. General and administrative expenses increased by 75% from $1.7 million in fiscal 1997 to $3.0 million in fiscal 1998 and by 63% to $4.8 million in fiscal 1999. Substantially all of the increases were due to increased personnel and related costs--approximately $1.1 million of the increase in fiscal 1998 and 1999--and professional fees--approximately $200,000 of the increase in fiscal 1998 and approximately $700,000 of the increase in fiscal 1999--necessary to manage and support Brio's growth and facilities expansion. The decrease in general and administrative expenses as a percentage of total revenues is primarily attributable to increased efficiencies in Brio's administrative operations and increased revenues. Brio expects that its general and administrative expenses will increase in absolute dollars as Brio expands its staffing to support expanded operations, incurs expenses in its litigation with Business Objects, S.A., and continues its responsibilities as a public company. Brio expects that such expenses will continue to vary as a percentage of total revenues. Deferred Compensation. In connection with the granting of 1,369,368 stock options to employees during fiscal 1998, with a weighted average exercise price of $1.49 per share and a weighted average deemed fair market value of $1.91 per share, Brio recorded deferred compensation of $580,000, representing the difference between the deemed value of the common stock for accounting purposes and the option exercise price of such options at the date of grant. Such amount is presented as a reduction of stockholders' equity and amortized ratably over the vesting period of the applicable options. Approximately $105,000 was expensed during fiscal 1998 and approximately $129,000 was expensed during fiscal 1999, and the balance will be expensed ratably over the next three years as the options vest. See Note 7 of Notes to Consolidated Financial Statements for additional information regarding deferred compensation. Purchased In-Process Research and Development In connection with the acquisition of MerlinSoft, Inc. (Merlinsoft), Brio allocated $1.7 million of the purchase price to in-process research and development projects. This allocation represented the estimated fair value based on future cash flows that have been adjusted by the projects' completion percentage. While Brio relied upon an independent appraisal of the acquired intangible assets, management was primarily responsible for estimating their fair values. At the acquisition date, the development of these projects had not yet reached technological feasibility and the research and development in progress had no alternative future uses. Accordingly, these costs were expensed as of the acquisition date. The excess of the purchase price over identified intangible assets was approximately $600,000. Brio used a third-party appraiser to assess and value the in-process research and development. The value assigned to this asset was determined by identifying significant research projects for which technological feasibility had not been established. This included the development, programming and testing activities associated with the creation of software components which enable delivery of analytical applications. Valuation of development efforts in the future was excluded from the research and development appraisal. The purchased in-process research and development consisted of two projects. Both of these projects are aimed at the delivery of timely, in-depth, sophisticated analytical applications. The first product will provide data models for analysis in specific industries and functional areas, metric libraries, a web-based client and the ability for business users to manage application components ("Analysis Product"). The second product will include in-depth modeling features for margin analysis and what-if scenarios to determine the impact of various decisions and parameters ("Modeling Product"). The research and development costs incurred by MerlinSoft in the development of the Analysis Product were approximately $4,000 in 1997 and approximately $298,000 in 1998. The research and development costs incurred by MerlinSoft in the development of the Modeling Product were approximately $34,000 in 1998. At the date of acquisition, the research and development costs to complete the Analysis Product were estimated by MerlinSoft to be approximately $855,000 in fiscal 1999 and 2000. At the date of acquisition, the research and development costs to complete the Modeling Product project were estimated by Merlinsoft to be approximately $933,000 in fiscal 1999 and 2000. Management believes it is on schedule with the Analysis and Modeling Products and expects successful completion of the projects. The developmental technologies were evaluated in the context of Interpretation 4 of SFAS No. 2 and SFAS No. 86, where appropriate. In accordance with these provisions, research and development projects were evaluated individually to determine if technological feasibility had been achieved and if there was any alternative future use. Such evaluation consisted of a specific review of the efforts, including the overall objectives of the project, progress toward the objectives, and uniqueness of developments to these objectives. The issue of alternative future use was addressed in discussions with the management of Brio. This process included on-site management interviews and review of technical data. These projects had not reached technological feasibility due to issues involving the completion of scability, performance and security functions. Once completed, the technologies under development could only be economically used for the specific and intended purpose. The architecture, design, software code, interfaces, features, and functions of the technologies being developed are for specific purposes, and if Brio fails in its efforts, no alternative economic value will result from its efforts. If the projects fail, the economic contribution expected to be made by the research and development will not materialize. The value assigned to purchased in-process research and development was determined by estimating the contribution of the purchased in-process technology in developing a commercially viable product, estimating the resulting net cash flows from the expected sales of such a product, and discounting the net cash flows to their present value using an appropriate discount rate. Revenue growth rates for MerlinSoft were estimated based on a detailed forecast prepared by management, which took into account input from finance, marketing, and engineering representatives of Brio and MerlinSoft. Revenue growth rates beyond 2000 were based on industry growth expectations. The projections utilized in the transaction pricing and purchase price allocation analysis exclude the potential synergistic benefits related specifically to Brio's ownership. Selling, general and administrative expenses and profitability estimates were determined based on management forecasts as well as an analysis of comparable company's margin expectations. Due to the relatively early stage of the development and reliance on future, unproven products and technologies, the cost of capital (discount rate) for MerlinSoft was estimated using venture capital rates of return. Due to the nature of the forecast and the risks associated with the projected growth and profitability of the development projects, a discount rate of 25 to 30 percent was used to discount cash flows from the in-process projects. Brio believes that the foregoing assumptions used in the forecasts were reasonable at the time of the acquisition. No assurance can be given, however, that the underlying assumptions used to estimate sales, development costs or profitability, or the events associated with such projects, will transpire as estimated. For these reasons, actual results may vary from projected results. Remaining development efforts for MerlinSoft's research and development include various phases of development, programming and testing. Funding for such projects is expected to be obtained from internally generated sources. As evidenced by the continued support of the development of the in-process technology, and derivative products, management believes Brio has a reasonable chance of successfully completing the research and development programs. However, as with all of Brio's software development efforts, there is risk associated with the completion of the MerlinSoft research and development projects, and there is no assurance that technological or commercial success will be achieved. If the development of the in-process technology, and derivative products, is unsuccessful, the sales and profitability of Brio may be adversely affected in future periods. Commercial results are also subject to uncertain market events, and risks, which are beyond Brio's control, such as trends in technology, changes in government regulation, market size and growth, and product introduction or other actions by competitors. Interest and Other Income (Expense), Net Interest and other income (expense), net, is comprised primarily of interest income and foreign currency transaction gains or losses, and realized gains or losses from the sale of investments, net of interest expense. Interest expense is comprised of interest incurred on Brio's bank line of credit. Interest and other income (expense), net, increased from a net expense of $341,000 in fiscal 1998 to interest income, net, of $1,084,000 in fiscal 1999. The increase in interest and other income, net, is attributable to a decrease in the amount of borrowings on Brio's line of credit as a result of Brio's initial public offering and an increase in interest income due to larger cash balances associated with the closing of Brio's initial public offering in May 1998, offset by foreign currency transaction losses of approximately $127,000. See Note 2 of Notes to Consolidated Financial Statements for a description of foreign currency transactions, and Brio's policy related to accounting for short-term investments. Provision for Income Taxes The provision for income taxes of $297,000 in fiscal 1999, consisted of Federal and State alternative minimum taxes, as the Company utilized net operating loss carryforwards to offset income taxes generated from domestic operations. As of March 31, 1999, Brio had federal net operating loss carryforwards of approximately $800,000 and state net operating loss carryforwards of approximately $400,000 available to offset future taxable income, and expiring at various dates through 2018 if not utilized. Further, as of March 31, 1999, Brio had tax credit carryforwards of approximately $644,000 which expire at various dates through 2018. In addition, the Internal Revenue Code of 1986, as amended, contains certain provisions that may limit the net operating loss carryforwards available for use in any given period upon the occurrence of certain events, including a significant change in ownership interests. Brio has net deferred tax assets, including its net operating loss carryforwards, totaling approximately $5.6 million as of March 31, 1999. Brio has recorded a valuation allowance for its net deferred tax assets, to the extent the net deferred tax assets exceed current and prior year's regular tax, as a result of significant uncertainties regarding the realization of most of its assets, including the limited operating history of Brio, a recent history of losses and the variability of operating results. See Note 9 of Notes to Consolidated Financial Statements for additional information about Brio's income taxes. Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income." SFAS No. 130 was adopted by Brio in its fiscal year beginning April 1, 1998. The adoption of SFAS No. 130 did not have a material effect on Brio's consolidated financial statements. In June 1997, the FASB also issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." SFAS No. 131 was adopted by Brio in its fiscal year beginning on April 1, 1998. SFAS No. 131 establishes standards for disclosures about operating segments, products and services, geographic areas and major customers. The adoption of SFAS No. 131 did not have a material effect on Brio's consolidated financial statements. In December 1997, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 97-2 which superseded SOP 91-1, "Software Revenue Recognition." SOP 97-2 was effective for transactions entered into in Brio's fiscal years beginning April 1, 1998. Brio adopted SOP 97-2 for all transactions entered into beginning April 1, 1998. The adoption of SOP 97-2 did not have a material effect on Brio's consolidated financial position or the timing of Brio's revenue recognition, or cause changes to its revenue recognition policies. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. Management believes the adoption of SFAS No. 133 will not have a material effect on Brio's financial statements. Liquidity and Capital Resources As of March 31, 1999, Brio had cash, cash equivalents and short-term investments of $32.4 million. In addition, Brio maintains a bank line of credit which provides for up to $10.0 million in borrowings, with interest at the bank's prime rate. Brio can borrow up to 80% of eligible accounts receivable against this line, with an additional $1.5 million in non-formula availability. Borrowings are secured by substantially all of Brio's assets, including Brio's copyrights and trademarks to the extent required to secure the Bank's interest in the accounts receivables. The line of credit requires Brio to comply with various financial covenants, including quarterly requirements to maintain a minimum quick ratio of 2.0:1.0 and a minimum tangible net worth covenant. The line expires on December 1, 1999, when any amounts outstanding thereunder would be due and payable. As of March 31, 1999, there were no outstanding bank borrowings. Net cash used in operating activities was $4.7 million in fiscal 1997 and $3.8 million in fiscal 1998. Net cash generated by operating activities was $6.0 million in fiscal 1999. The decrease in fiscal 1998 was due primarily to favorable changes in the balances of operating assets and liabilities. Approximately $7.2 million of the increase in fiscal 1999 was due to decreases in net losses and approximately $2.7 million of the increase in fiscal 1999 was due to favorable changes in operating assets and liabilities. Net cash used in investing activities was $2.0 million in fiscal 1997, consisting of approximately $1.9 million for the purchase of property and equipment and approximately $95,000 for a one-time payment in connection with the acquisition of Brio's Australian subsidiary. Net cash used in investing activities was $1.7 million in fiscal 1998, consisting of purchases of property and equipment. Net cash used in investing activities was $18.3 million in fiscal 1999, consisting primarily of $13.9 million for the purchase of short-term investments, net, approximately $2.2 million for the purchase of property and equipment and approximately $2.2 million for the purchase of MerlinSoft, net of cash acquired. Net cash provided by financing activities was $7.1 million in fiscal 1997, $7.2 million in fiscal 1998 and $28.1 million in fiscal 1999, consisting primarily of proceeds from private sales of Preferred Stock--approximately $6.0 million in fiscal 1997 and approximately $5.8 million in fiscal 1998-- periodic borrowings, net of repayments, on the bank line of credit-- approximately $1.1 million in fiscal 1997 and approximately $1.3 million in fiscal 1998--and the net proceeds from Brio's initial public offering-- approximately $31.5 million in 1999. Year 2000 Readiness Background Computer systems have traditionally used a two-digit field to designate a year. This format will not recognize the century date change that will take place at the end of 1999. Such systems will recognize the year 2000 as 1900, not at all, or some year other than 2000. The inability to recognize the proper date can and will cause systems to process information incorrectly, resulting in system failures or other serious business problems. Risks Although Brio has been committed to ensuring all our systems are year 2000 compliant prior to December 1999, we may experience some operational interruptions due to the year 2000 problem. We may also experience operational difficulties caused by undetected errors or defects in the technology we use in our internal systems. Brio's year 2000 readiness team has developed and is implementing a four phase approach in order to prepare the organization for any interruption which may occur on the advent of the year 2000. Assessment Plan Brio's year 2000 readiness team developed a plan which consisted of four phases. . In phase one, Brio identified and contacted the vendors of all of Brio's internal information systems and non-informational technology systems to determine whether these systems could potentially present a year 2000 problem. Brio requires that all vendors who provide material hardware or software for Brio's information technology systems, or upgrades or replacements of those products, provide assurances of their year 2000 compliance. Brio completed phase one in December 1998. . In phase two, Brio will identify mission critical technology systems and proceed to test these systems for their year 2000 compliance. Testing will include automated polling of networked client and server computers, compilation of relevant data regarding the software used by Brio, and a manual review of the compiled data to locate systems which may be vulnerable to year 2000 problems. This phase will also include the establishment of replica systems for critical software and hardware systems, rolling forward the replica date to December 31, 1999, allowing the system to roll over into the year 2000 and observing the results. End users and Brio's year 2000 readiness team will then conduct simulations, and verify and evaluate compliance and test integrated systems for potential failure which might occur. Phase two is scheduled to be completed in September 1999. . In phase three, Brio's year 2000 readiness team, working with end users and management, will develop contingency plans for mission-critical technology systems. Phase three is scheduled to be completed in October 1999. . In phase four, Brio's year 2000 readiness team, information technology department staff and end users will perform tests and evaluate readiness of mission critical technology systems on December 31, 1999. In order to circumvent system failures resulting from any unanticipated year 2000 failures, all mission critical technology systems must be judged ready for the start of the next business day or the steps outlined in Brio's contingency plans will be initiated. Cost Brio anticipates that the total cost of the year 2000 program, including the cost of material upgrades, purchase of replica servers, software modifications and related consulting fees, will be approximately $150,000. Contingency Plans Brio has not yet finalized any contingency plans as a result of its year 2000 readiness program, but will prepare contingency plans upon the conclusion of its assessment of the results of our year 2000 simulation testing and third-party vendor and service provider responses. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS Because our plans to achieve profitability in the future require us to grow our work force, improve our infrastructure and acquire and develop new technologies, failure to successfully do so could lower our operating results and cause our stock price to decrease. If we cannot execute our growth strategy, our stock price could decrease. Successfully achieving our growth strategy depends upon the combined company's ability to: . expand, train and manage our work force; . continue to attract, retain and motivate qualified personnel; and . develop or acquire new businesses, products and technologies. In addition, if we cannot manage an expanding work force, improve our reporting systems and customer service infrastructure and manage the integration of acquired businesses, products or technologies, we will be unable to continue manage the growth of our operations, which could harm our business and financial results. Brio has a history of net losses, and may not be profitable in the future. Brio has a history of net losses, and cannot provide any assurance that we will experience revenue growth or profitability on a quarterly or annual basis in the future. In particular, Brio incurred net losses of $6.0 million in fiscal 1997, $8.1 million in fiscal 1998 and $887,000 in fiscal 1999. As of March 31, 1999, Brio had stockholders' equity of approximately $29.2 million. Brio anticipates increased operating expenses and a reduced rate of revenue growth in the future. Brio currently expects to increase its expenses, and our operating results will be harmed if these increased expenses are not accompanied by increased revenues. Brio does not expect to sustain in future periods the same rate of sequential quarterly revenue growth it has experienced in the past. In addition, Brio will likely increase its operating expenses significantly in fiscal 2000. Brio currently intends to commit substantial financial resources to research and development, customer support and sales and marketing, including the continued expansion of its domestic and international direct sales force, third-party partnering relationships and Brio's domestic and international indirect channel sales organization, and expects that expenses relating to Brio's litigation with Business Objects, S.A. will increase in future periods. Brio also expects to increase staffing and systems infrastructure in order to support expanding operations. Our prospects for increased future revenues must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in rapidly evolving markets. To address these risks, the combined company must: . successfully increase the scope of its operations; . respond to competitive developments; . continue to attract, retain and motivate qualified personnel; and . continue to commercialize products incorporating advanced technologies. Brio may not be able to achieve these goals. Brio's quarterly operating results will likely fluctuate based on factors beyond our control. Brio has experienced and expects to continue to experience significant fluctuations in quarterly operating results based on a number of factors, many of which are not within its control. Among other things, Brio's operating results have fluctuated in the past due to: . the timing of product enhancements and new product announcements; . the lengthy sales cycle of its products; . market acceptance of and demand for its products; . capital spending patterns of its customers; . customer order deferrals in anticipation of enhancements or new products; . its ability to attract and retain key personnel; . the mix of domestic and international sales; . the mix of license and service revenues; . personnel changes; and . changes in the timing and level of operating expenses. In addition, the announcement or introduction of new products by Brio or its competitors or any change in industry standards may cause customers to defer or cancel purchases of existing products. Furthermore, the introduction of products with reliability, quality or compatibility problems could result in reduced orders, delays in collecting accounts receivable and additional service costs. Accordingly, Brio's results of operations may also fluctuate in the future due to a number of additional factors, including but not limited to those discussed above, as well as: . the number and significance of product enhancements and new product announcements by competitors; . changes in customer buying patterns related to the year 2000 issue; . changes in pricing policies by Brio and its competitors; . Brio's ability to develop, introduce and market new and enhanced versions of its products on a timely basis; . customer order deferrals in anticipation of enhancements or new products offered by competitors; . nonrenewal of service agreements, software defects and other product quality problems; . the mix of direct and indirect sales; . currency fluctuations; . costs or damage awards associated with the current litigation between Brio and Business Objects, S.A.; and . general economic conditions. Due to these factors, quarterly revenue and operating results are difficult to forecast and may not meet expectations. Seasonality may affect Brio's results. Brio has experienced seasonality due to customer capital spending patterns and the general summer slowdown in sales. Brio expects to continue to experience seasonality as a result of these factors. This seasonality could materially hurt results of operations, particularly for the quarters ending June 30 or September 30. If Brio's operating results do not meeting financial analysts' expectations, our stock price may decline. In the future, our reported or anticipated operating results may fail to meet or exceed the expectations of securities analysts or investors. In that event, Brio's common stock price could be materially reduced. Because Brio depends on a direct sales force, any failure by Brio to attract and retain adequate sales personnel could slow its sales and increase its expenses, causing significant financial and operational risks. Brio may not be able to attract and retain adequate sales personnel, despite the expenditure of significant resources to do so, and the failure to do so could materially harm its ability to sell its products at expected levels. Because turnover tends to slow sales efforts until replacement personnel can be recruited and trained, failure to retain sales personnel could seriously hamper its business, operating results and financial condition. Competition for personnel with a sufficient level of expertise and experience for direct sales positions is intense, particularly among competitors who may have substantially greater resources than the combined company or greater resources dedicated to hiring direct sales personnel. In addition, Brio has experienced significant turnover of its sales force. Brio's success depends on key personnel who may not continue to work for it. The loss of the services of any of the key personnel or the inability to attract or retain qualified personnel in the future could harm Brio's business, operating results and financial condition. The success of Brio will depend to a significant degree upon the continued contributions of key management, engineering, sales and marketing personnel, many of whom would be difficult to retain or replace if they leave Brio. Because competition for qualified personnel is intense, Brio may not be successful in attracting and retaining the personnel it seeks. Brio has recently experienced difficulties in hiring highly qualified sales and engineering personnel, and may continue to have difficulty in attracting employees in those categories. Brio has employment contracts with only three members of its executive management personnel. Brio currently maintains "key person" life insurance only on Yorgen Edholm, its President and Chief Executive Officer, and Katherine Glassey, its Executive Vice President, Products and Services and Chief Technology Officer. Brio does not believe its current insurance would adequately compensate it for the loss of either Mr. Edholm or Ms. Glassey. Because the sales cycle for Brio's products is long, the timing of sales is difficult to predict and Brio's quarterly revenues and earnings may fluctuate significantly. Based in part on the lengthy sales cycle for Brio's products, quarterly revenues and operating results could vary significantly in the future. The sales cycle associated with the purchase of Brio's products is typically three to nine months in length and subject to a number of significant risks over which Brio has little or no control, including customers' budgeting constraints and internal acceptance review procedures. Sales transactions may be delayed during the customer acceptance process because Brio must provide a significant level of education to prospective customers regarding the use and benefits of its products. Further, to the extent that potential customers divert resources and attention to issues associated with the year 2000 issue, Brio's sales cycle could be further lengthened. Additionally, the sales cycle for Brio's products in international markets has historically been, and is expected to continue to be, longer than the sales cycle in the United States and Canada. Accordingly, if Brio's international operations expand, the average sales cycle for its products is expected to lengthen. In addition, Brio anticipates that an increasing portion of its revenue could be derived from larger orders, in which case the timing of receipt and fulfillment of those orders could cause material fluctuations in operating results, particularly on a quarterly basis. Because Brio expects to achieve revenue growth and increased margins through indirect sales channels, Brio's failure to develop and manage indirect sales channels could limit its sales growth and financial performance. Brio may not be able to continue to attract and retain additional indirect channel partners that will be able to market its products effectively and provide timely and cost-effective customer support and services. Brio may not be able to manage conflicts within its indirect channel or that its focus on increasing sales through the indirect channels will not divert management resources and attention from direct sales. In addition, Brio's agreements with indirect channel partners do not restrict the channel partners from distributing competing products, and in many cases may be terminated by either party without cause. The ability of Brio to achieve revenue growth and improved operating margins on product sales in the future will depend in large part upon its success in expanding and maintaining indirect channels worldwide. Indirect channels include value added resellers, resellers and distributors. To date, Brio has sold its products principally through its direct sales and service organizations and, to a lesser extent, through the indirect channel. Revenues from Brio's indirect channel were 7% of total revenues for fiscal 1997 and 15% of total revenues for fiscal 1998 and 1999. Brio's strategy of acquiring new businesses and technologies involves integration and transaction completion risks. As part of our business strategy, we expect to enter into business combinations and acquisitions. We recently signed an agreement to acquire SQRIBE Technologies Corp., which acquisition is expected to be completed in July 1999. The consummation of this acquisition is subject to certain conditions and approval by SQRIBE stockholders. We expect to record a one-time charge in the second fiscal quarter relating to expenses for such acquisition. Acquisition transactions are accompanied by a number of risks, including: . the difficulty of assimilating the operations and personnel of the acquired companies; . the potential disruption of our ongoing business and distraction of management; . the difficulty of incorporating acquired technology or content and rights into our products; . the correct assessment of the relative percentages of in-process research and development expense which can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset; . the failure to successfully develop an acquired in-process technology could result in the impairment of amounts currently capitalized as intangible assets; . unanticipated expenses related to technology integration; . the maintenance of uniform standards, controls, procedures and policies; . the impairment of relationships with employees and customers as a result of any integration of new management personnel; and . the potential unknown liabilities associated with acquired businesses. We may not be successful in addressing these risks or any other problems encountered in connection with such acquisitions. Brio is in a highly competitive industry and some of its competitors may be more successful in attracting and retaining customers. The market in which Brio operates is highly competitive. Brio expects that competition will continue to intensify. Increased competition could result in: . price reductions; . fewer customer orders; . reduced gross margins; . longer sales cycles; and . loss of market share. Brio or its competitors may announce enhancements to existing products, or new products embodying new technologies, industry standards or customer requirements that have the potential to supplant or provide lower-cost alternatives to Brio's existing products. Current and potential competitors offer a variety of software solutions and generally fall within four categories: . vendors of business intelligence software, including Cognos, Business Objects, Hummingbird and Seagate Software; . vendors offering alternative approaches to delivering analysis capabilities to users, including Information Advantage and MicroStrategy; . database vendors that offer products which operate specifically with their proprietary database, including Microsoft, IBM, and Oracle; and . other companies that may in the future announce offerings of enterprise business intelligence solutions. These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sales of their products than Brio. Brio expects additional competition as other established and emerging companies enter into the business intelligence software market and new products and technologies are introduced. Brio will compete on the basis of the following factors: . product features; . time to market; . ease of use; . product performance; . product quality; . analytical capabilities; . user scalability; . open architecture; . customer support; and . price. Brio's failure to compete favorably in these areas could limit its ability to attract and retain customers, which could have a material adverse affect on our results of operations. Market consolidation may create more formidable competitors. Alliances among current and new competitors may emerge and rapidly gain significant market share. The failure of Brio to compete successfully against current and future competitors could materially harm its business, operating results and financial condition by driving down prices and reducing revenue growth. Current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third parties, thereby increasing the ability of their products to address the needs of Brio's prospective customers. Current or future indirect channel partners of Brio may establish cooperative relationships with current or potential competitors, thereby limiting Brio's ability to sell its products through particular distribution channels. Such competition could have a material adverse effect on Brio's ability to obtain new licenses, and maintenance and support renewals for existing licenses, on favorable terms. Further, competitive pressures may require Brio to reduce the price of its products, which could have a material adverse effect on its revenues, profitability and business condition. Brio's litigation with Business Objects, S.A. could result in substantial expense to Brio and a significant diversion of effort by its management and technical personnel. In addition, if the outcome of this litigation is unfavorable, Brio may be required to pay damages and be enjoined from selling its products or required to obtain a license or modify its products to continue to sell them. Brio's pending litigation with Business Objects, S.A. could result in substantial expense to Brio and significant diversion of effort by its technical and management personnel. Business Object, S.A.'s complaint seeks injunctive relief and unspecified monetary damages, and Business Objects, S.A. is expected to seek lost profits and/or equivalent royalties. The complaint also alleges willful infringement, and seeks treble damages, costs and attorneys' fees. Litigation is subject to inherent uncertainties, especially in cases like this where complex technical issues must be decided. Brio's defense of this litigation, regardless of the merits or lack of merit of the complaint, could be time-consuming or costly, or divert the attention of technical and management personnel, which could have a material adverse effect upon Brio's business, operating results and financial condition. Brio may not prevail in the litigation given the complex technical issues and inherent uncertainties in patent litigation, particularly before the claims have been construed by the court. In the event Brio is unsuccessful in the litigation, it may be required to pay damages to Business Objects and could be prohibited from marketing its BrioQuery Navigator, BrioQuery Explorer and BrioQuery Designer products without a license, which may not be available on acceptable terms. If Brio is unable to obtain a license, it may be required to license a substitute technology or redesign to its products to avoid infringement, in which case its business, operating results and financial condition could be materially adversely affected. Collectively, sales of BrioQuery Navigator, BrioQuery Explorer and BrioQuery Designer represented substantially all of Brio's revenues in fiscal 1996 and a majority of its revenues in fiscal 1997 and fiscal 1998. For more information regarding Brio's litigation with Business Objects S.A., see "Information Regarding Brio--Business of Brio; Legal Proceedings." Brio's plans to expand internationally expose Brio to risks related to managing international operations, currency exchange rates, tariffs and other difficulties related to foreign operations. A key component of Brio's strategy is its planned expansion into additional international markets. If the international revenues generated by these expanded operations are not adequate to offset the expense of establishing and maintaining these foreign operations, Brio's business, operating results and financial condition could be materially harmed. In addition to the uncertainty as to Brio's ability to expand its international presence, there are risks inherent in doing business on an international level, including: . technical difficulties associated with product localization in foreign countries; . increased difficulty in controlling operating expenses; . unexpected changes in regulatory requirements; . tariffs and other trade barriers; . difficulties in staffing and managing foreign operations; . longer payment cycles; . problems in collecting accounts receivable; . political instability; . fluctuations in currency exchange rates; . seasonal reductions in business activity during the summer months in Europe; and . potentially adverse tax consequences. Each of these factors could adversely impact the success of Brio's international operations and, consequently, on Brio's business, operating results and financial condition. In particular, Brio's international sales are generally denominated and collected in foreign currencies, and Brio has not historically undertaken foreign exchange hedging transactions to cover potential foreign currency exposure. Brio incurred losses on foreign currency translations resulting from intercompany receivables from foreign subsidiaries in an amount of approximately $131,000 in fiscal 1998 and approximately $127,000 in fiscal 1999. Brio's future success will depend upon successful product development in the face of changing customer requirements and rapid technological change. Brio's failure to develop and introduce new products and product enhancements on a timely basis that meet changing customer requirements and technological changes could result in reduced demand for or market acceptance of Brio's products, which could hurt Brio's business, operating results and financial condition. Brio's products incorporate a number of advanced technologies, including proprietary data analysis engines, a distributed architecture, as well as Web access and delivery technology. Brio may be required to change and improve its products in response to changes in operating systems, applications, networking and connectivity software, computer and communications hardware, programming tools and computer language technology. Brio may not successfully respond to changing technology, identify new product opportunities or develop and bring new products to market in a timely and cost-effective manner. In the past Brio has experienced delays in software development. In particular, development efforts in the UNIX server environment are complex, and in the past Brio has encountered delays in developing products for this environment. Brio may experience delays in connection with current or future product development activities. Because Brio's future success will depend upon successful product development in the face of evolving industry standards, failure to introduce new products could hurt its growth and profitability. Brio's failure to introduce new products or product enhancements on a timely basis that are compatible with industry standards could delay or hinder demand for or market acceptance of its products, which could hurt Brio's growth and profitability. The market may not accept Brio's products, which would reduce revenues, growth and profitability. Brio is focusing its selling efforts increasingly on larger, enterprise-wide implementations of its products, and Brio expects these sales to constitute an increasing portion of any of its future revenue growth. Failure of a significant market for enterprise business intelligence products to develop, or failure of enterprise-wide implementations of Brio's products to achieve broad market acceptance, could materially harm Brio's business, operating results and financial condition. To date, Brio's selling efforts have resulted in limited enterprise-wide implementations of its products. Brio believes that most companies currently are not yet aware of the benefits of enterprise-wide business intelligence solutions or of its products and capabilities, nor have most companies deployed business intelligence solutions on an enterprise-wide basis. Brio's efforts to promote market awareness of its products and the problems its products address may not be sufficient to build market awareness of the need for enterprise business intelligence or acceptance of Brio's products. The year 2000 problem could cause Brio's software products to malfunction and Brio's customers to cease their purchasing of Brio's products. Brio's computer systems and applications could fail or create erroneous results unless corrected so that they can process data related to the year 2000 and beyond. Brio relies on its systems, applications and devices in operating and monitoring all major aspects of its business, including financial systems, customer services, infrastructure, networks and telecommunications equipment. Brio also relies, directly and indirectly, on external systems of business enterprises including customers, suppliers, creditors, financial organizations, and governmental entities, both domestic and international, for accurate exchange of data. Brio has not fully identified the impact of the year 2000 issue on its internal systems or whether it can resolve these issues without disruption of its business and without incurring significant expense. In addition, even if Brio's internal systems are not materially affected by the year 2000 issue, Brio could be affected through disruption in the operation of the enterprises with which it interacts. Furthermore, Brio believes that the purchasing patterns of customers and potential customers may be affected by year 2000 issues as companies expend significant resources to correct or patch their current software systems to comply with year 2000 requirements. These expenditures may result in reduced funds available to purchase software products like those offered by Brio, which could have a material adverse effect on Brio's business, operating results and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the impact of the year 2000 problem on Brio's operations. Product defects could adversely affect Brio's operating results. As a result of their complexity, Brio's software products may contain undetected errors, failures or viruses. Brio or its customers may discover errors in new products or enhancements after commencement of commercial shipments, resulting in loss of revenues, delay in market acceptance or damage to Brio's reputation, which could have a material adverse effect upon Brio's business, operating results and financial condition. Further, Brio's license agreements with customers typically contain provisions designed to limit Brio's exposure for potential claims based on errors or malfunctions of Brio's products. The limitation of liability provisions contained in Brio's license agreements may not be effective under the laws of all jurisdictions. Brio's sale and support of its products entails the risk of warranty claims, and Brio's insurance against product liability risks may not be adequate to cover a potential claim. A product liability claim brought against Brio could have a material adverse effect on its business, operating results and financial condition. Brio has no issued patents, and its intellectual property protection may not be adequate to prevent competitors from entering its markets or developing competing products. Brio's failure to protect its proprietary rights may allow competitors to enter its market or develop competing products, resulting in competitive harm to Brio. The methods used by Brio to protect its proprietary rights afford only limited protection. Brio currently relies primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. Brio currently has one U.S. patent application. This patent application may not result in the issuance of a patent. Even if a patent is issued, it may be invalidated, circumvented or challenged, and the rights granted under the patent, if any, may not provide Brio competitive advantages. Brio may not obtain any more patents. Others may develop technologies that are similar or superior to Brio's technology or design around any patent that Brio may come to own. Despite Brio's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of Brio's products or to obtain and use information that Brio regards as proprietary. Policing unauthorized use of Brio's products is difficult, and while Brio is unable to determine the extent to which piracy of its software products exists, Brio expect software piracy to be a persistent problem. In addition, the laws of some foreign countries do not protect proprietary rights as fully as do the laws of the U.S. Brio's means of protecting its proprietary rights in the U.S. or abroad may not be adequate, and competitors may independently develop similar technology. Investment Risks Brio's common stock has a limited trading history and a volatile price. There has only been a public market for Brio's common stock since April 30, 1998, and an active public market may not continue. The market price of the shares of Brio's common stock is likely to be highly volatile and may be significantly affected by a number of factors, including: . actual or anticipated fluctuations in our operating results; announcement of business partnerships; . technological innovations or new product introductions by us or our competitors; . changes of estimates of our future operating results by securities analysts; . developments with respect to copyrights or proprietary rights; or . general market conditions. In addition, the stock market has, from time to time, experienced significant price and volume fluctuations that have particularly affected the market prices of equity securities of many technology companies. Broad market fluctuations, as well as economic conditions generally and in the software industry specifically, may result in material adverse effects on the market price of Brio's common stock. In the past, following periods of volatility in the market price of a particular company's securities, securities class action litigation has often been brought against that company. Such litigation may occur in the future with respect to Brio, and could result in substantial costs and a diversion of management's attention and resources, which could have a material adverse effect upon Brio's business, operating results and financial condition. Anti-takeover provisions may adversely effect Brio's stock price and make it more difficult for a third party to acquire Brio. Provisions of Brio's charter documents may have the effect of delaying or preventing a change in control of Brio or its management, which could have a material adverse effect on the market price of Brio common stock. These include provisions: . relating to a classified board of directors and provisions eliminating cumulative voting; . eliminating the ability of stockholders to take actions by written consent; and . limiting the ability of stockholders to raise matters at a meeting of stockholders without giving advance notice. In addition, the Brio board of directors has authority to issue up to 2,000,000 shares of preferred stock and to fix the rights, preferences, privileges and restrictions, including voting rights, of these shares without any further vote or action by the stockholders. The rights of the holders of Brio common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that Brio may issue in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of Brio's outstanding voting stock, thereby delaying, deferring or preventing a change in control of Brio. Brio has no present plan to issue shares of preferred stock. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Brio's exposure to market risk for changes in interest rates relates primarily to Brio's investment portfolio. Brio maintains an investment policy which ensures the safety and preservation of its invested funds by limiting default risk, market risk, and reinvestment risk. As of March 31, 1999, Brio had $18.6 million of cash and cash equivalents with a weighted average variable rate of 4.2% and $13.9 million of short-term investments with a weighted average variable rate of 5.1%. Brio mitigates default risk by attempting to invest in high credit quality securities and by constantly positioning its portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity and maintains a prudent amount of diversification. Brio has no cash flow exposure due to rate changes for long-term debt obligations. Brio has entered into borrowing agreements to support general corporate purposes including capital expenditures and working capital needs, should the need arise. Brio currently has not short-term or long-term debt outstanding. Brio conducts business on a global basis in international currencies. As such, it is exposed to adverse or beneficial movements in foreign currency exchange rates. Brio may enter into foreign currency forward contracts to minimize the impact of exchange rate fluctuations on certain foreign currency commitments and balance sheet positions. The realized gains and losses on these contracts are deferred and offset against realized and unrealized gains and losses when the transaction occurs. At March 31, 1999 there were no outstanding foreign currency exchange contracts. Item 8. Item 8. Financial Statements and Supplementary Data BRIO TECHNOLOGY, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Brio Technology, Inc.: We have audited the accompanying consolidated balance sheets of Brio Technology, Inc. (a Delaware corporation) and subsidiaries as of March 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the three years in the period ended March 31, 1999. These financial statements and the schedule referred to below are the responsibility of Brio's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Brio Technology, Inc. and subsidiaries as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 1999, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commissions rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen LLP San Jose, California April 19, 1999 BRIO TECHNOLOGY, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts) The accompanying notes are an integral part of these consolidated balance sheets. BRIO TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) The accompanying notes are an integral part of these consolidated financial statements. BRIO TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (In thousands, except share amounts) BRIO TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (In thousands, except share amounts) The accompanying notes are an integral part of these consolidated financial statements. BRIO TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) The accompanying notes are an integral part of these consolidated financial statements. BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1999 1. ORGANIZATION AND OPERATIONS: Brio Technology, Inc. (Brio), was incorporated in California in 1989 and reincorporated in Delaware in April 1998 (see Note 7). Brio designs, develops, markets and supports software products that enable organizations to rapidly implement enterprise business intelligence solutions. Brio's products and services are designed to allow organizations to quickly deploy and effectively manage business intelligence solutions incorporating the wide range of available corporate data sources, including data marts, data warehouses, operational data stores, enterprise applications and legacy applications. Brio is subject to a number of risks associated with companies in a similar stage of development, including rapid technological growth, dependence on key personnel and the sales force, litigation (see Note 8), potential competition from larger, more established companies, dependence on product development, the ability to penetrate the market with its products and the ability to obtain adequate financing to support its growth. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation The consolidated financial statements include the accounts of Brio and its wholly-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ from those estimates. Foreign Currency Translation The functional currency of Brio's subsidiaries is the local currency. Accordingly, Brio applies the current rate method to translate the subsidiaries' financial statements into U.S. dollars. Translation adjustments are included in accumulated components of comprehensive loss in stockholders' equity (deficit) in the accompanying consolidated financial statements. Transaction gains and losses, which have not been material to date, are included in interest and other income (expense), net, in the accompanying consolidated statements of operations. Cash and Cash Equivalents Brio considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. At March 31, 1998 and 1999, Brio held its cash in checking and money market accounts. Short-Term Investments Management determines the appropriate classifications of investments in debt and equity securities at the time of purchase. All of Brio's investments are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported in accumulated components of comprehensive loss in stockholders' equity (deficit) in the accompanying consolidated financial statements. The fair value of Brio's available-for-sale securities is based on quoted market prices at the balance sheet dates. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) in interest and other income (expense), net, in the accompanying consolidated statements of operations. The cost of securities sold is based on the specific identification method. Interest on securities classified as available-for-sale is included in interest and other income (expense), net, in the accompanying consolidated statements of operations. A summary of the fair value of Brio's available-for-sale investment portfolio follows (in thousands): There were no investments in debt and equity securities at March 31, 1998. Inventories Brio's inventories are carried at the lower of cost or market on a first-in, first-out basis. Inventory consists principally of completed software packages including media and documentation. Property and Equipment Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives (three to seven years) of the assets. Leasehold improvements are amortized over the shorter of the term of the related lease or the estimated useful life of the asset. Property and equipment consists of the following (in thousands): Revenue Recognition Effective April 1, 1998, Brio adopted Statement of Position (SOP) 97-2, "Software Revenue Recognition." SOP 97-2 provides guidance on applying generally accepted accounting principles in recognizing revenue on software transactions. The adoption of SOP 97-2 did not have a material impact on Brio's consolidated financial position or the timing of Brio's revenue recognition, or cause changes to its revenue recognition policy. Brio's revenues are derived from two sources, license fees and services. Services include software maintenance and support, training and system implementation consulting. BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Revenues from license fees are recognized upon shipment of the software if collection of the resulting receivable is probable, the fee is fixed or determinable and vendor-specific objective evidence exists to allocate the total fee to all delivered and undelivered elements of the arrangement. Such undelivered elements in these arrangements typically consist of services. If vendor-specific objective evidence does not exist to allocate the total fee to all delivered and undelivered elements of the arrangement, revenue is deferred until such evidence does exist, or until all elements are delivered, whichever is earlier. Allowances are established for potential product returns and credit losses. In instances where payments are subject to extended payment terms, and the fee is not fixed or determinable, revenue is deferred until payments become due. If an acceptance period is required, revenue is recognized upon the earlier of customer acceptance or the expiration of the acceptance period. Maintenance revenue is recognized ratably over the term of the maintenance contract, which is typically twelve months. If maintenance is included in an arrangement which includes a license agreement, amounts related to maintenance are unbundled from the license fee based on vendor specific objective evidence. Consulting and training revenue is recognized when the services are performed. Cost of revenues consists primarily of third-party fees, related personnel and overhead allocations and overhead costs, the cost of media, documentation, packaging and shipping related to products sold. Deferred Revenue Deferred revenue represents amounts received from customers under certain license, maintenance and service agreements for which the revenue earnings process has not been completed. In situations where the services are not expected to be provided and revenue recognized within twelve months of the balance sheet date, such amounts are classified as noncurrent deferred revenue. Software Development Costs Under Statement of Financial Accounting Standards (SFAS) No. 86 "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed," costs incurred in the research and development of software products are expensed as incurred until technological feasibility has been established. Once established, these costs would be capitalized. Amounts that could have been capitalized under this Statement were insignificant and, therefore, no costs have been capitalized to date. Comprehensive Loss In 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 130, "Reporting Comprehensive Income," which was adopted by Brio in the quarter ended June 30, 1998. SFAS No. 130 requires companies to report a new, additional measure of income on the statement of operations or to create a new financial statement that has the new measure of income on it. "Comprehensive income (loss)" includes foreign currency translation gains and losses and other unrealized gains and losses that have been previously excluded from net income (loss) and reflected in equity instead. Brio has reported the components of comprehensive loss on its consolidated statements of stockholders' equity (deficit). Computation of Basic Net Loss Per Share Basic net loss per share is computed using the weighted average number of shares of common stock outstanding. No diluted net loss per share information is presented as Brio has incurred net losses in all periods presented. Potential common shares from conversion of preferred stock, stock options and warrants and contingently issuable shares have been excluded from the calculation of diluted net loss per share as they are BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) antidilutive. Potential common shares of 1,688,919, using the treasury stock method, were not included in the computation of diluted net loss per share for the year ended March 31, 1999, because Brio incurred a loss in this period and, therefore, the effect would be antidilutive. Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." SFAS No. 131 is effective for Brio's fiscal year beginning April 1, 1998. SFAS No. 131 establishes standards for disclosures about operating segments, products and services, geographic areas and major customers. Brio is organized and operates as one operating segment: the design, development, marketing and support of a suite of business intelligence software solutions. Brio sells its products domestically and internationally. See Note 4 regarding international sales. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The Statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. Management believes the adoption of SFAS No. 133 will not have a material effect on Brio's financial statements. 3. ACQUISITIONS: On February 23, 1999, Brio entered into a definitive merger agreement with SQRIBE Technologies Corp. Under the terms of the agreement, upon closing of the transaction, Brio stockholders will hold approximately 55% of Brio, with former SQRIBE stockholders holding approximately 45%. The transaction will be accounted for as a pooling of interests. In October 1998, Brio acquired all of the outstanding stock of MerlinSoft, Inc. (MerlinSoft), a California corporation, for cash. The total purchase price was $2.2 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $2.3 million were acquired. The results of operations of MerlinSoft and the estimated fair value of the assets acquired and liabilities assumed are included in Brio's financial statements from the date of acquisition. Intangibles arising from the acquisition are being amortized on a straight-line basis over three years. While Brio relied upon an third party appraisal of the acquired intangible assets, management was primarily responsible for estimating their fair values. Management estimates that $1.7 million of the purchased intangibles represented purchased in-process research and development that had not yet reached technological feasibility and had no alternative future use. The excess of the purchase price over identified assets was approximately $600,000. The purchased in-process research and development consisted of two projects. Both of these projects are aimed at the delivery of timely, in-depth, sophisticated analytical applications. The first product will provide data models for analyses in specific industries and functional areas, metric libraries, a web-based client, and the ability for business users to manage application components ("Analysis Product"). The second product will include in-depth modeling features for margin analysis, what-if scenarios to determine the impact of various decisions and parameters ("Modeling Product"). The research and development costs incurred by MerlinSoft in the development of the Analysis Product were approximately $4,000 in 1997 and approximately $298,000 in 1998. The research and development costs incurred by MerlinSoft in the development of the Modeling Product were approximately $34,000 in 1998. At the date of acquisition, the research and development costs to complete the Analysis Product were estimated by MerlinSoft to be approximately $855,000 in fiscal 1999 and 2000. At the date of acquisition, the research and development costs to complete the Modeling Product project were estimated BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) by MerlinSoft to be approximately $933,000 in fiscal 1999 and 2000. Management believes it is on schedule with the analysis and Modeling Products and expects successful completion of the projects. If these projects are not successfully developed, business, operating results, and financial condition of Brio may be adversely affected. Additionally, the value of other intangible assets acquired may become impaired. Comparative pro forma information has not been presented as the operations of MerlinSoft were not material to Brio's consolidated financial statements. On July 1, 1996, Brio purchased DataBasics, one of Brio's distributors in Australia, for $95,000 in cash. The acquisition was accounted for as a purchase and resulted in goodwill of $60,000 that is being amortized over a five year period. DataBasics was renamed Brio Technology Pty. Ltd., and is now a wholly-owned subsidiary of Brio. Sales to DataBasics for the year ended March 31, 1996 were $121,000. Comparative pro forma information related to this acquisition has not been presented as the prior operations of the acquired company were immaterial. On April 1, 1996, Brio purchased Brio Technology Ltd. from Management Decisions (MD), one of Brio's distributors in the United Kingdom. Brio paid a nominal value for the outstanding stock and operations of Brio Technology Ltd., and the acquisition was accounted for as a purchase. No goodwill resulted from this acquisition. Brio Technology Ltd. is now a wholly-owned subsidiary of Brio. Sales to MD for the year ended March 31, 1996 were $39,100. Comparative pro forma information related to this acquisition has not been presented as the prior operations of the acquired company were immaterial. 4. SIGNIFICANT CONCENTRATIONS: Financial instruments that potentially subject Brio to concentrations of credit risk consist principally of accounts receivable. Brio performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. Brio markets its products in the United States and Canada and in other foreign countries through its domestic sales personnel and its foreign subsidiaries. Revenues by geographic area were as follows: No one country in either of these areas comprised more than 10% of total revenues for fiscal 1999, 1998 and 1997. None of Brio's international operations have material items of long-lived assets. BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 5. COMMITMENTS: Brio leases various facilities under operating leases which expire on various dates through October 2003. Brio also leases office equipment under various non-cancelable operating leases with terms which expire through March 2003. Future minimum lease payments relating to these agreements as of March 31, 1999, are as follows (in thousands): Rent expense for the years ending March 31, 1999, 1998 and 1997 was $2,288,000, $1,533,000 and $798,000, respectively. 6. NOTES PAYABLE: At March 31, 1999, Brio had a $10,000,000 accounts receivable-based line of credit agreement. Interest on borrowings under the accounts receivable line accrues at the bank's prime rate (7.75% at March 31, 1999). At March 31, 1999, no amounts were outstanding under these arrangements. Borrowings under the accounts receivable line of credit were limited to 80% of eligible accounts receivable, in addition to up to $1.5 million in non-formula availability. The line of credit is collateralized by substantially all of Brio's assets, including Brio's intellectual property, accounts receivable and property and equipment. This line of credit requires Brio to comply with various financial covenants, including quarterly requirements to maintain a minimum quick ratio, and minimum tangible net worth. The line expires on December 1, 1999. 7. COMMON STOCK: In February 1998, the Board of Directors authorized the filing of a registration statement with the Securities and Exchange Commission to register shares of its common stock in connection with a proposed Initial Public Offering (IPO). On May 1, 1998, the offering was consummated and all of the currently outstanding convertible preferred stock converted to 5,466,172 shares of common stock upon the closing of the IPO. In April 1998, Brio's board of directors approved a one-for-two reverse stock split of its preferred and common stock. All preferred stock, common stock and per share amounts have been adjusted retroactively to give effect to the reverse stock split. In April 1998, Brio's board of directors approved the reincorporation of Brio in Delaware in connection with Brio's IPO which was consummated May 1, 1998. Upon reincorporation, Brio issued new shares with a par value of $0.001 per share to all preferred and common stockholders. As of March 31, 1999, Brio had reserved shares of its common stock for future issuance as follows: BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) During fiscal 1997, certain employees funded the purchase of common stock under the 1992 Stock Option Plan with fully secured notes payable to Brio. Stock Options Through March 31, 1999, Brio had reserved 1,158,467 shares of common stock for issuance under the 1992 Stock Option Plan (the "Plan"). Under the Plan, the Board of Directors may grant options to purchase Brio's common stock to employees, directors, or consultants at an exercise price of not less than 100% of the fair value of Brio's common stock. Any options granted must be granted by the tenth anniversary of the effective date of the Plan. Options issued under the Plan generally have a term of five years from the date of grant and generally vest ratably over four years. Brio's 1998 Stock Option Plan (the "1998 Plan") was adopted by Brio's Board of Directors in February 1998. A total of 2,250,000 shares of common stock have been reserved for issuance under the 1998 Plan. The shares reserved for issuance under the 1998 Plan increase annually on the first day of Brio's fiscal year through April 1, 2003, by the lesser of 600,000 or three percent of the shares outstanding on the last day of the immediately preceding fiscal year. Under the 1998 Plan, the Board of Directors may grant options to purchase Brio's common stock to employees, directors or consultants at an exercise price of not less than 100% of the fair value of Brio's common stock on the date of grant, in the case of incentive stock options, and not less than 85% of the fair value of Brio's common stock on the date of grant, in the case of nonqualified stock options. Options must all be granted by the tenth anniversary of the effective date of the 1998 Plan. Options issued under the 1998 Plan will generally have a term of 10 years from the date of grant and will generally vest ratably over four years. Brio's 1998 Directors' Stock Option Plan (the "Directors' Plan") was adopted by Brio's Board of Directors in February 1998. A total of 300,000 shares of common stock has been reserved for issuance under the Directors' Plan. Through March 31, 1999, 35,000 options were granted under the Directors' Stock Option Plan. The Directors' Plan provides for the initial grant of nonqualified stock options to purchase 20,000 shares of common stock on the date on which the optionee first becomes a non-employee director of Brio subsequent to the initial public offering (the "First Option"), and an additional option to purchase 5,000 shares of common stock on the next anniversary to existing and future non-employee directors of Brio if, on such date, the director has served on the board for at least six months (the "Subsequent Option"). The exercise price per share of all options granted under the Directors' Plan will equal the fair market value of a share of Brio's common stock on the date of grant of the option. Options issued under the Directors' Plan will have a term of 10 years from the date of grant; the First Option shall become exercisable in installments of 25% of the total number of shares subject to the First Option on each of the first, second, third and fourth anniversaries of the date of grant of the First Option; each Subsequent Option shall become exercisable in full on the day before the first anniversary of the date of grant of that Subsequent Option. BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Option activity under the Plans is as follows: Certain unvested options have been exercised and are subject to repurchase by Brio until such shares vest. As of March 31, 1999, 60,051 shares were subject to the right of repurchase at an exercise price of $0.60 per share. A summary of options outstanding and exercisable as of March 31, 1999, is as follows: Brio's 1998 Employee Stock Purchase Plan (the "Purchase Plan") was adopted by Brio's Board of Directors in February 1998. A total of 500,000 shares of common stock has been reserved for issuance under the Purchase Plan. The shares reserved for issuance under the Purchase Plan increase annually on the first day of Brio's fiscal year through April 1, 2000, by the lesser of 300,000 or two percent of the shares outstanding on the last day of the immediately preceding fiscal year. The Purchase Plan permits eligible employees to purchase common stock at 85% of the lower of the fair market value of Brio's common stock on the first day or the last day of each six- month offering period. BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Brio accounts for its stock option and employee stock purchase plans (the "Plans") under APB Opinion No. 25, "Accounting for Stock Issued to Employees." Had compensation expense for these Plans been determined consistent with SFAS No. 123, "Accounting for Stock Based Compensation," Brio's net loss would have increased to the following pro forma amounts (in thousands, except per share information): The weighted average grant date fair value of options granted during fiscal 1999, 1998 and 1997, was $7.13, $0.64 and $0.12, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 1998 and 1997: risk-free interest rates ranging from 5.2 to 6.7 percent; expected dividend yields of zero percent; expected lives of 3 to 4 years from the grant date; and expected volatility of 0.01 percent. In 1999, the assumptions were: risk-free interest rates ranging from 4.33 to 5.73 percent; expected dividend yield of zero percent; expected lives of 3.24 years from the grant date; and expected volatility of 100.9%. During fiscal 1999, Brio issued 105,137 shares under the Purchase Plan. The weighted average grant date fair value of each purchase right issued under the Purchase Plan during fiscal 1999 was $4.76. The fair value of the purchase rights granted in fiscal 1999 was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 4.24%; expected dividend yield of zero percent; expected life of one-half year; and expected volatility of 100.9%. Deferred Compensation In connection with the granting of 1,369,368 stock options to employees during the fiscal year ended March 31, 1998, with a weighted average exercise price of $1.49 per share and a weighted average deemed fair market value of $1.91 per share, Brio recorded deferred compensation of $580,000, representing the difference between the deemed value of the common stock for accounting purposes and the option exercise price of such options at the date of grant. Such amount is presented as a reduction of stockholder's equity (deficit) and amortized ratably over the vesting period of the applicable options. Approximately $129,000 and $105,000 was expensed during the fiscal year ended March 31, 1999 and 1998, respectively, and the balance will be expensed ratably over the next three years as the options vest. 8. CONTINGENCIES: On January 20, 1997, Business Objects, S.A. filed a complaint (the "Complaint") against Brio in the U.S. District Court for the Northern District of California in San Jose, California alleging that certain of Brio's products infringe U.S. Patent No. 5,555,403. The Complaint seeks injunctive relief and unspecified monetary damages. In April 1997, Brio filed an answer and affirmative defenses to the Complaint, denying certain of the allegations in the Complaint, and asserting a counterclaim requesting declaratory relief that Brio is not infringing the patent and that the patent is invalid and unenforceable. In December 1997, venue for the case was changed to the Northern District of California in San Francisco, California. Based on the advice of Brio's patent counsel, Brio believes that it has meritorious defenses to the claims made in the Complaint on both invalidity and non- BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) infringement grounds, and intends to defend the suit vigorously. A claims construction hearing was held on April 5, 1999. At the hearing, the court set the trial date for September 13, 1999. The court also issued its claims construction ruling on April 6, 1999. Brio and Business Objects, S.A. are currently conducting discovery. The pending litigation could result in substantial expense to Brio and significant diversion of effort by Brio's technical and management personnel. Litigation is subject to inherent uncertainties, especially in cases such as this where complex technical issues must be decided. Brio's defense of this litigation, regardless of the merits of the Complaint or lack thereof, could be time-consuming or costly, or divert the attention of technical and management personnel, which could have a material adverse effect upon Brio's business, operating results and financial condition. There can be no assurance that Brio will prevail in the litigation given the complex technical issues and inherent uncertainties in patent litigation. In the event Brio is unsuccessful in the litigation, Brio may be required to pay damages to Business Objects, S.A. and could be prohibited from marketing certain of its products without a license, which license may not be available on acceptable terms. If Brio is unable to obtain such a license, Brio may be required to license a substitute technology or redesign to avoid infringement, in which case Brio's business, operating results and financial condition could be materially adversely affected. Collectively, sales of BrioQuery Navigator, BrioQuery Explorer and BrioQuery Designer represented a majority of Brio's revenues in fiscal 1997 and fiscal 1998 and a significant portion of Brio's revenues in fiscal 1999. Given the early stages of discovery in this matter, Brio is unable to estimate the likelihood that they will prevail in this matter or amount of loss, if any, which may be incurred as a result of the Complaint. 9. INCOME TAXES: Brio accounts for income taxes using an asset and liability approach which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events which have been recognized in Brio's financial statements. Deferred tax assets and liabilities are determined using the current applicable enacted tax rate and provisions of the enacted tax law. The provision for income taxes of $297,000 in fiscal 1999 consisted of Federal and state alternative minimum taxes, as the Company utilized net operating loss carryforwards to offset current income taxes generated from domestic operations. The provision for income taxes differs from the statutory U.S. Federal income tax rate primarily due to state taxes, the utilization of net operating loss carryforwards, alternative minimum taxes, net change in the valuation allowance and foreign losses for which no tax benefit has been provided. Brio had a net deferred tax asset at March 31, 1999 and 1998 as follows (in thousands): BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) At March 31, 1999, Brio had Federal and state net operating loss carryforwards of $800,000 and $400,000, respectively, which expire at various dates through 2018. Brio believes that, based on a number of factors, there is sufficient uncertainty regarding the realizability of carryforwards and credits that a full valuation allowance has been recorded against the net deferred tax asset to the extent the net deferred asset exceeds current and prior year's regular tax. These factors include a history of operating losses, recent increases in expense levels to support Brio's growth, the competitive nature of Brio's market and the lack of predictability of revenue. Management will continue to assess the realizability of the tax benefits available to Brio based on actual and forecasted operating results. The Internal Revenue Code contains provisions which may limit the net operating loss and research and development credit carryforwards to be used in any given year upon the occurrence of certain events, including a significant change in ownership. SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Certain information required by Part III is omitted from this report because Brio will file a definitive proxy statement within 120 days after the end of its fiscal year pursuant to Regulation 14A (the "Proxy Statement") for its Annual Meeting of Stockholders to be held July 28, 1999, and the information included in the Proxy Statement is incorporated herein by reference. Item 10. Item 10. Directors and Executive Officers of the Registrant. (a) Executive Officers--See the section entitled "Executive Officers of the Registrant" in Part I, Item 1 hereof. (b) Directors--the information required by this Item is incorporated by reference to the section entitled "Election of Directors" in the Registrant's Proxy Statement. Item 11. Item 11. Executive Compensation. The information required by this Item is incorporated by reference to the sections entitled "Executive Compensation" in the Registrant's Proxy statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this Item is incorporated by reference to the sections entitled "Share Ownership of Directors, Executive Officers and Certain Beneficial Owners" of the Registrant's Proxy Statement. BRIO TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Item 13. Item 13. Certain Relationships and Related Transactions. The information required by this Item is incorporated by reference to the section entitled "Employment Agreements and Certain Relationships and Related Transactions" in the Registrant's Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following documents are filed as part of this report: (1) Financial Statements and Report of Arthur Andersen LLP, Independent Auditors (2) Financial Statement Schedule (3) Exhibits (numbered in accordance with Item 601 of Regulation S-K) (b) Reports on Form 8-K. None (c) Exhibits. 23.01 Consent of Independent Public Accountants 27.1 Financial Data Schedule SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BRIO TECHNOLOGY, INC. /s/ Yorgen H. Edholm By: _________________________________ Yorgen H. Edholm President, Chief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer) Date: June 28, 1999 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Yorgen H. Edholm and Karen J. Willem, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys- in-fact, or his or her substitute or substitutes may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

805020_1999.txt

805020_1999

1999

805020

ITEM 1. BUSINESS. COMPANY OVERVIEW Uni-Marts, Inc. (the "Company" or "Uni-Marts") is an independent operator of convenience stores and discount tobacco stores. At September 30, 1999, the Company operated 234 convenience stores and 22 Choice Cigarette Discount Outlets ("Choice") stores in Pennsylvania, New York, Delaware, Maryland and Virginia, of which 182 convenience stores and 12 Choice stores sold gasoline. See "Business -- Merchandising and Marketing." Most of the stores are located in small towns and rural locations where costs of operation are generally lower than in urban areas. Most Company stores located in urban and suburban areas have been acquired and are generally leased on a long-term basis. The Company currently purchases gasoline for 32 locations from Exxon and Mobil and for 161 locations from other independent suppliers. Gasoline is sold at one location on a commission basis. The size of the Company's stores generally ranges from approximately 1,200 to 3,300 square feet with newer stores generally having over 3,000 square feet. The Company's largest location is 10,000 square feet in size. Typically, the stores offer a complete line of over 2,500 popular consumer items. In addition, the Company offers products designed to increase store traffic, such as branded fast foods, as well as services, including the sale of lottery tickets, the acceptance of personal checks and automated teller machines ("ATMs"). The Company commenced its convenience store operations in 1972 and was incorporated in Delaware in 1977. In 1986, the Company's shares were distributed in a tax-free spin-off to the holders of the stock of Unico Corporation, formerly the Company's parent. The Company's executive offices are located at 477 East Beaver Avenue, State College, PA 16801-5690, and its phone number is (814) 234-6000. THE CONVENIENCE STORE INDUSTRY The convenience store industry is a retail, service-oriented industry. It is distinguished from other retail businesses by its emphasis on location and convenience and a commitment to customers who need to purchase items quickly at extended hours. Convenience stores feature a wide variety of items, including groceries, dairy products, tobacco products, beverages, prepared and self-service fast foods and health and beauty aids. In addition, many of the stores sell gasoline on a self-service basis. The stores are generally designed with ample customer parking and quick checkout procedures to maximize convenience, as well as to encourage impulse buying of high margin items. The convenience store industry is extremely fragmented. Currently, there are many external forces exerting pressure on owners of independent and small convenience store chains. One of the major forces is the need to comply with environmental regulations for underground storage tanks. The large capital expenditures required to comply with environmental regulations are also affecting many operators of gasoline service stations. As a result of these forces, there have been and continue to be significant opportunities for consolidation in the industry. Recent competitive trends across many retail sectors are having a positive influence on the convenience store industry as it changes the typical convenience store's merchandise mix in reaction to market conditions and customer preferences. In addition, convenience stores compete not only with other convenience stores, but with gasoline distributors which have converted retail outlets to convenience stores. To compete for a broader customer base, convenience stores are adding prepared foods and new services and improving store layouts to attract new customers. As consumer preferences and government regulations put pressure on tobacco sales, convenience store operators are improving gasoline dispensing facilities and installing branded fast-food outlets and ATMs. In addition, many convenience store operators have aggressively closed or remodeled underperforming stores. STRATEGY In fiscal year 1999, the Company reevaluated several of its key strategies to enhance its current operations. The Company's key strategies include the following: Development of a New Image for the Company and its Stores. The Company has designed a new logo and is working on the development of new exterior and interior store designs. New proprietary products have been and continue to be developed. The Company and its marketing firm continue to develop new advertising messages and design. Enhancement of Store Accessibility. Store sites will be easy to locate with easy ingress and egress and ample parking. Stores are designed to speed transactions and be equipped with modern, low maintenance machinery. Merchandising and Marketing. The Company has enhanced its category maintenance capabilities to deliver appealing, high quality, reasonably priced packaged products for ease of use. Foodservice products are being developed to lower employee involvement in preparation and lower customer efforts in selection and purchase. Upgrade Business Process Efficiency. The Company intends to update its business systems and technology to streamline key business processes. Completion of this process will allow more effective and efficient store management and provide greater flexibility to respond quickly to marketplace changes. Evaluation of Underperforming Stores. The Company has converted 22 underperforming locations to Choice stores to enhance the profitability of these locations. In fiscal year 1999, the Company closed or sold 20 locations. In fiscal year 2000, the Company is planning to convert 16 locations to Choice stores and will convert or close other locations as conditions warrant. The Company is continuing its emphasis on customer satisfaction, upgrading retail gasoline facilities and developing stores in small towns and rural areas. MERCHANDISING AND MARKETING The Company's merchandising and marketing programs are designed to promote convenience through store location, hours of operation, parking, customer service, product selection and checkout procedures. Store hours are intended to meet customer needs and the characteristics of the community in which each store is located. Approximately 80% of the Company's convenience stores are open 24 hours per day, while the majority of the remaining stores are open from 6:00 a.m. to 12:00 midnight. To alleviate checkout congestion, most of the Company's products and services are sold on a self-service basis. Most Company stores provide parking for customers. Uni-Marts has a merchandising and marketing department which develops and implements promotional and advertising programs, sometimes in conjunction with suppliers. In November 1998, the Company retained a marketing and communications firm experienced in the convenience store industry. Television, radio, billboard and newspaper advertisements are designed to generate sales, increase customer traffic and promote the Company's name and image. The Company maintains an employee training program which emphasizes the importance of service to customers and the development of merchandising and marketing skills for its store managers and store personnel. Convenience Store Merchandise Sales. The Company's stores offer dry grocery items, health and beauty aids, newspapers and magazines, dairy products, candy, frozen foods, beverages, tobacco products, fountain drinks and freshly-ground coffee and cappuccino products. In recent years, the Company has emphasized new merchandise products such as prepared foods and branded fast foods to increase sales volume and customer traffic. In addition, the Company continues to add customer services, such as ATMs, prepaid telephone cards, the acceptance of personal checks and lottery ticket and money order sales, all of which are designed to increase customer traffic. Many stores also offer a variety of prepared and self-service fast foods, including freshly made sandwiches, hot dogs, pizzas, fresh baked goods and nachos. In fiscal year 1994, as part of its strategy to increase sales of branded fast foods, the Company entered into an agreement with Blimpie International ("Blimpie"). The Company presently operates 30 Blimpie locations and has franchised 24 locations with third parties. The Company receives a commission on these franchise sales. Convenience Store Gasoline Sales. Convenience store operations and merchandise sales are enhanced by self-service gasoline facilities, which the Company plans to include in as many new locations as possible. Sales of gasoline products at the Company's stores are affected by wholesale and retail price volatility, competition and marketing decisions. At September 30, 1999, the Company had 194 locations offering gasoline, with 129 of these locations also offering kerosene. The Company offers Exxon gasoline at 21 locations, Mobil gasoline at 11 locations and Uni-Mart branded gasoline at most other locations. One location sells branded gasoline on a commission basis. Choice Cigarette Discount Outlets. During fiscal year 1999, the Company converted two underperforming convenience store locations to discount tobacco stores operating under the name of Choice Cigarette Discount Outlet. At September 30, 1999, the Company operated 22 Choice stores, with 12 of these locations offering unleaded gasoline. The Company expects to sell gasoline at converted locations if gasoline was sold there prior to conversion. Other convenience store locations will be converted if conditions warrant. In general, profitability has improved at locations converted to Choice stores. COMPANY OPERATIONS Store Management. Each Company-operated store is managed by a store manager. All Company stores are divided into groups of approximately nine stores by geographic area. Each group is managed by a store supervisor. A regional manager is responsible for a number of groups and their store supervisors. The regional managers report directly to the Senior Vice President of Operations, who oversees the day-to-day operations of the stores. Managers, supervisors and regional managers are compensated in part through incentive programs which provide for quarterly bonuses based primarily on increased profitability of the stores. The number of full-time and part-time employees per store depends on the sales volume of the store and its hours of operation. Franchises. At September 30, 1999, the Company had ten franchise stores which operate under various franchise agreements. Under all franchise agreements, the franchisee pays a royalty, which varies depending upon the agreement and whether the Company or the franchisee owns the convenience food store equipment. The royalty is based on the store's merchandise sales volume. As part of its services to nine franchise locations, the Company provides accounting services, merchandising and advertising assistance, store layout and design guidance, supplier and product selection and ongoing operational assistance. These franchisees are required to use the same internal control systems that the Company uses for the stores it operates. The Company does not provide these services for one franchise location. The Company has periodically closed franchised stores and does not intend to grant new franchises except in connection with new acquisitions or in other special circumstances. SEASONALITY The Company's business generally has been subject to moderate seasonal influences with higher sales in the third and fourth quarters of each fiscal year, since customers tend to purchase more convenience items and gasoline during the warmer months. Due to adverse weather conditions, merchandise sales for the second fiscal quarter have generally been lower than other quarters. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Seasonality and Unaudited Quarterly Results." DISTRIBUTION AND SUPPLY All stores are serviced at least weekly by vendors. The Company does not distribute products to its stores itself. In order to minimize costs and facilitate deliveries, the Company utilizes a single wholesale distributor for most in-store merchandise, pursuant to a six-year supply agreement that expires in July 2004. The Company believes that it could easily replace this distributor with one or more other distributors. Certain products, such as bakery items, dairy products, snacks, soft drinks, magazines and perishable products, are distributed by wholesale route salespeople. As part of the sale of its dairy operation in fiscal 1994, the Company entered into a 10-year supply agreement with the purchaser which provides for the Company's purchase of all dairy products sold at most of its Pennsylvania stores. In fiscal year 1998, the Company entered into 10-year gasoline supply agreements with Exxon and Mobil for stores that sell approximately 28% of the Company's gasoline volume. Gasoline is purchased for the remaining stores from various suppliers. A gasoline shortage, although unlikely, could adversely affect the Company's ability to sell gasoline at these locations. MANAGEMENT CONTROLS AND INFORMATION SYSTEMS The company developed an internal automation system that includes point-of-sale ("POS") scanning. The system is designed to improve the timeliness and accuracy of management information, reduce paperwork at the store level and enhance cash, pricing and inventory controls. As of September 30, 1999, installation of this new POS scanning system was completed in 38 of the company's convenience stores and 22 Choice stores. A new store back office system is currently being evaluated and a planned pilot test of that software will take place in fiscal 2000. The Company utilizes its current computer systems for inventory and accounting control, financial record-keeping and management reporting, allowing management to monitor and evaluate store operations. The Company's computer systems are also programmed to identify variances from budgeted amounts by store on a monthly and year-to-date basis. In addition, profit and loss statements by store compare the current year's results for the month and year-to-date to the previous year's comparable periods. Store managers are responsible for placing orders for grocery, tobacco, frozen food and non-food items directly into the central computer system of the Company's wholesale supplier. The computer systems are designed to compare current orders with historical order levels and to reject orders that appear to be incorrect. Orders and receiving reports are reviewed by store supervisors. Invoices are reviewed and compared to receiving reports by the Company's accounting personnel and are paid centrally. The Company believes that its automated accounting and inventory control systems provide the information required for management decisions and expense control. An internal review has been conducted by the Company of all software used in its data processing equipment to determine its exposure, if any, to the "year 2000 problem." This problem may cause significant difficulties with the electronic processing of information in the year 2000 and subsequent years due to the inability of many computer programs to differentiate between the years 1900 and 2000. The incremental costs to make the necessary corrections to prevent any such difficulties did not have a material effect on the Company's consolidated financial statements. As discussed more fully in "Management's Discussion and Analysis of Financial Condition and Results of Operation--Impact of the Year 2000 ("Y2K") Problem," the Company does not expect material difficulties with the Y2K problem in its internal computer systems and other systems affecting the operation of its stores. The Company believes that its existing and planned systems and controls can accommodate significant expansion in the number of Company stores. COMPETITION The convenience store industry is highly competitive, fragmented and regionalized. It is characterized by a few large companies, some medium-sized companies, such as the Company, and many small independent companies. Several competitors are substantially larger and have greater resources than the Company. The Company's primary competitors include national chains such as A- Plus and 7-Eleven and regional chains such as Sheetz, WaWa, Stop-N-Go, Convenient Food Mart, Turkey Hill, Coastal and Co/Go. The Company also competes with other convenience stores, small supermarkets, grocery stores and major and independent gasoline distributors who have converted units to convenience stores. Competition for gasoline sales is based on price and location. The Company competes primarily with self-service gasoline stations operated by independent dealers and major oil companies in addition to other convenience stores. ENVIRONMENTAL COMPLIANCE AND REGULATION The Company's gasoline operations are subject to federal, state and local environmental laws and regulations primarily relating to the underground storage tanks. The United States Environmental Protection Agency (the "EPA") has established standards for owners and operators of underground storage tanks ("USTs") relating to, among other things: (i) maintaining leak detection systems; (ii) upgrading UST systems; (iii) implementing corrective action in response to releases; (iv) closing out-of-use USTs to prevent future releases; (v) maintaining appropriate records; and (vi) maintaining evidence of financial responsibility for corrective action and compensating third parties for bodily injury and property damage resulting from UST releases. All states in which the Company operates also have adopted these regulatory programs. Under current federal and certain state regulatory programs, the Company was obligated to upgrade or replace all noncomplying underground storage tanks it owns or operates to meet corrosion protection and overfill/spill containment standards by December 1998. The Company has evaluated each of its stores which sell gasoline to determine the type of expenditures required to comply with these and other requirements under the federal and state UST regulatory programs. Management believes that the Company is currently in material compliance with all applicable federal and state laws and regulations. In the last eleven years, the Company has spent substantial amounts of money to upgrade its underground storage tanks to meet the applicable standards and requirements. The Company does not expect expenditures in fiscal year 2000 to maintain compliance at its locations to have a material adverse effect on the Company's financial position, results of operations or cash flows. The Company has adopted a program to ensure that new gasoline installations comply with federal and state regulations and that existing locations are upgraded if required under these regulations. GOVERNMENTAL REGULATION In addition to the laws and regulations referred to under "Environmental Compliance and Regulation," certain other aspects of the Company's business are governed by federal, state and local statutes. As a franchisor, the Company is also subject to federal and state laws governing franchising, which include, among other matters, the commencement and termination of franchises. A significant portion, approximately 29%, of the Company's merchandise sales is derived from the sale of tobacco products at its convenience stores and Choice stores. If the government were to impose significant regulations or restrictions on the sale of tobacco products, it could have a material adverse effect on the Company. Management believes that the Company is currently in material compliance with all applicable federal and state laws and regulations. TRADEMARKS The name "UNI-MART" and the Company's UNI-MART logo were registered with the U.S. Patent and Trademark Office as of May 13, 1997, and are owned by and licensed from Uni-Marts of America, Inc., a wholly owned subsidiary of the Company. EMPLOYEES As of September 30, 1999, the Company had approximately 2,000 employees, approximately 900 of whom were full-time. The Company believes that its employee relations are good. None of the Company's employees are covered by a collective bargaining agreement. ITEM 2. ITEM 2. PROPERTIES. The following table sets forth certain information with respect to administrative and storage facilities owned or leased by the Company as of September 30, 1999: The Company's above-referenced leased administrative offices and storage facility in State College and Oak Hall, Pennsylvania, respectively, are leased from HFL Corporation. HFL Corporation is controlled by Henry D. Sahakian, the Company's Chairman of the Board and Chief Executive Officer, and his brother, Daniel D. Sahakian, a Director of the Company. Of the Company's 234 convenience store locations, 118 are owned by the Company, 6 are leased from affiliated parties and 110 are leased from unaffiliated parties. Most leases are for initial terms of five to ten years with renewal terms of five years available at the Company's option. Under most leases, the Company is responsible for the payment of insurance, taxes and maintenance. Of the leased locations, 10 are subleased to franchisees. Of the Company's 22 discount tobacco locations, six are owned by the Company, one is leased from an affiliated party and 15 are leased from unaffiliated parties. The Company also owns five gasoline service stations, which are leased to unaffiliated operators. As of September 30, 1999, the Company had no stores under construction. The Company's store leases expire as follows: - --------------- (1) Most of the Company's leases have one or more renewal options at an agreed upon rental or fair market rental at the end of their initial terms. The Company has generally renewed its leases prior to their expiration. Where renewals have not been available or the Company otherwise determines to change location, the Company generally has been able to locate acceptable alternative facilities. The lease for the Company's administrative offices in State College, Pennsylvania, expires in December 2000. Management considers all properties currently in use, owned or leased, to be in good condition, well-maintained and suitable for current operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is not a party to any material pending legal proceeding. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is listed on the American Stock Exchange under the symbol "UNI." The transfer agent and registrar for shares of the Company's Common Stock is ChaseMellon Shareholder Services, L.L.C., Ridgefield Park, New Jersey. As of December 3, 1999, the Company had 6,957,914 shares of its Common Stock outstanding. Set forth below is a table which shows the high and low sale prices as reflected on the American Stock Exchange and dividends paid on Common Stock for each quarter in the two most recent fiscal years. In April 1997, the Company's Board of Directors elected to temporarily suspend the quarterly dividends on its Common Stock. The dividend will be considered for reinstatement upon the Company's return to profitability. However, there can be no assurance of future dividends because they are dependent not only on future earnings, but also capital requirements and financial condition. Certain of the Company's debt agreements require the Company to maintain a minimum tangible net worth of $24 million, which could possibly restrict the Company's ability to pay dividends on its Common Stock in the future. At December 3, 1999, the Company had approximately 354 stockholders of record of Common Stock. The Company believes that approximately 44 percent of its Common Stock is held in street or nominee names. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. SELECTED CONSOLIDATED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE, PER GALLON AND NUMBER OF STORES DATA) The following table of selected consolidated financial data of the Company, except for Operating Data and pro forma information, has been derived from the financial statements and related notes of the Company which have been audited by Deloitte & Touche LLP, Independent Auditors, as indicated in their report relating to the fiscal years ended September 30, 1999, 1998 and 1997, included elsewhere in this report. The data should be read in conjunction with the financial statements, related notes and other financial information included elsewhere in this report. ITEM 6. SELECTED FINANCIAL DATA (CONTINUED) - --------------- (1) In fiscal year 1997, the Company changed its method of calculating ending merchandise inventories under the retail inventory method. The cumulative effect of this accounting change, net of the income tax benefit, was approximately $1.5 million. The pro forma effect as if the accounting change was in effect in each of the years presented is as follows: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Matters discussed below should be read in conjunction with "Statements of Operations Data" and "Operating Data (Retail Locations Only)" on the preceding pages. The Company's revenues are derived primarily from sales of merchandise and gasoline at its convenience and discount tobacco stores. Revenues from both the sale of merchandise and gasoline at the Company's stores declined in fiscal year 1999 due to fewer stores in operation. However, average annual merchandise sales for stores open two full years increased to $552,000 in fiscal year 1999 from $492,000 in fiscal year 1998 and $474,000 in fiscal year 1997. Average gallons of gasoline sold at the Company's stores open two full years were 623,000 gallons in fiscal year 1999 compared to 566,000 gallons in fiscal year 1998 and 496,000 gallons in fiscal year 1997. This merchandise sales growth trend is primarily the result of increased sales of fast-food items and the addition of in-store traffic enhancing services, such as the sale of lottery tickets, money orders and prepaid telephone cards; ATMs; and the acceptance of personal checks. Tobacco sales represented approximately 29% of total merchandise sales in each of the last three fiscal years. There has been volatility in selling prices as a result of competition among cigarette manufacturers. Since the Company expects this volatility to continue, it has sought increased sales of other merchandise to offset the uncertainty in cigarette sales. Convenience stores selling gasoline have been heavily affected by environmental regulations, principally concerning underground storage tanks, which require large capital expenditures in order to achieve compliance. In the late 1980s, the Company began making significant expenditures to meet, and exceed, applicable standards. Management believes that the Company is currently in compliance with all applicable federal and state environmental laws and regulations and expects minimum expenditures in fiscal year 2000 to maintain compliance. In addition, the Company has adopted a program to ensure that new gasoline installations comply with federal and state regulations. The Company terminated its relationship with Getty Petroleum Corp. ("Getty") and its affiliates during fiscal year 1998. The Company is no longer required to purchase petroleum products from Getty and no longer operates 105 stores which were leased to the Company by Getty. In fiscal year 1998, these stores generated merchandise sales of $9.1 million and sold 7.9 million gallons of gasoline for total sales of $17.7 million. In fiscal year 1997, these stores generated merchandise sales of $44.8 million and sold 38.3 million gallons of gasoline, for total sales of $88.8 million. Termination of the relationship with Getty permits the Company to purchase petroleum products from a variety of competing sources. The Company sells gasoline at 194 locations, including one location where gasoline is sold on a commission basis. Branded gasoline is purchased under supply agreements for 32 locations and gasoline is purchased from various sources for 161 locations. These arrangements provide for purchases of gasoline at cost levels which are less than those offered by Getty. However, gasoline margins have historically been volatile and there can be no assurance that the Company's gasoline margins will be enhanced by purchasing such products from competitive sources. In addition, the Company has suspended its program of capital expenditures for branded fast-food installations and currently does not anticipate adding new installations in the near future. RESULTS OF OPERATIONS The following table sets forth the percentage relationship of certain expense items to total revenues. It should be noted that the primary factors influencing the percentage relationship of cost of sales to revenues are the volatility of gasoline prices, gross profits and a proportional increase in the number of stores selling gasoline. On a percentage basis, the gross profit on gasoline sales is significantly less than the gross profit on merchandise sold in the convenience stores. FISCAL YEAR 1999 COMPARED TO FISCAL YEAR 1998 The Company operated 234 convenience stores and 22 discount tobacco stores at September 30, 1999. During fiscal year 1999, the Company closed or sold 20 convenience stores and converted two convenience stores to discount tobacco stores. Total revenues in fiscal year 1999 were $252.3 million, a decline of $14.1 million, or 5.3%, in comparison to total revenues in fiscal year 1998 of $266.4 million. This decline is due largely to the operation of fewer stores and lower retail gasoline prices during fiscal year 1999. Merchandise sales in fiscal year 1999 were $146.7 million compared to $154.1 million in fiscal year 1998, a decline of $7.4 million, or 4.8%. This decline is primarily the result of fewer stores in operation. Merchandise sales at comparable stores increased 5.8%. Gasoline sales declined $6.0 million, or 5.5%, from $109.4 million in fiscal year 1998 to $103.4 million in fiscal year 1999, primarily as a result of lower sales prices per gallon sold. Gasoline gallons sold at comparable stores increased 8.1% in fiscal year 1999. Gross profits on merchandise sales in fiscal year 1999 declined $3.1 million compared to fiscal year 1998. The decline of 5.7% was primarily the result of the lower sales volumes caused by the operation of fewer stores. Merchandise gross profits were $52.1 million in fiscal year 1999 and $55.2 million in fiscal year 1998. Gasoline gross profits declined in fiscal year 1999 by $819,000, or 6.0%, in comparison to fiscal year 1998. The decrease from $13.7 million in fiscal year 1998 to $12.9 million in fiscal year 1999 is the result of lower gross profits per gallon of gasoline sold and, to a lesser degree, a slight decline in the total number of gallons sold. These decreases are the result of competitive pressures and fewer stores in operation. Although the total number of gallons sold declined slightly, gallons sold at comparable stores increased 8.1% in fiscal year 1999. Selling expenses were $52.6 million in fiscal year 1999 compared to $54.3 million in fiscal year 1998, a decline of $1.7 million, or 3.1%. This decline is the result of fewer stores in operation. Expense levels per average store increased, however, due to higher labor and maintenance costs. On average, labor cost per store increased 15.4% and maintenance cost per store almost doubled. General and administrative expense increased $528,000, or 7.6%. Certain executive officers were hired near the end of fiscal year 1998 and their salaries were reflected in expense for a full year in 1999 compared to a partial year in 1998. Officer salaries were approximately $450,000 higher in fiscal year 1999 compared to 1998. Depreciation and amortization expense declined by $420,000, or 6.6%, due to the operation of fewer stores. Interest expense also declined by $91,000, or 2.3%, primarily as a result of lower borrowing levels. The Company recorded a $208,000 provision for impairment of long-lived assets in fiscal year 1999 compared to $352,000 in fiscal year 1998. The Company recorded a pre-tax loss of $3.2 million in fiscal year 1999 compared to a pre-tax loss of $365,000 in fiscal year 1998. The income tax benefit of these losses was $948,000 in fiscal year 1999 and $237,000 in fiscal year 1998. In connection with refinancing most of its long-term debt in fiscal year 1998, the Company recorded an extraordinary loss from debt extinguishment of $244,000, net of the income tax benefit of $126,000. The net loss for fiscal year 1999 was $2.2 million, or $0.32 per share, compared to a net loss in fiscal year 1998 of $372,000, or $0.05 per share. FISCAL YEAR 1998 COMPARED TO FISCAL YEAR 1997 At September 30, 1998, the Company operated 126 fewer stores than operated one year previously. The Company formerly leased 105 of these stores, including ten franchised locations, from Getty, and these stores were returned to Getty. During fiscal year 1998, 21 other stores were closed or sold by the Company including ten franchised locations. Also, two convenience stores were converted to discount tobacco stores and one franchised location was converted to a Company-operated store. Total revenues in fiscal year 1998 were $266.4 million compared to $352.2 million in fiscal year 1997. This decline of $85.8 million, or 24.4%, is primarily the result of fewer stores in operation, as well as lower retail prices for gasoline. Merchandise sales declined $34.8 million, or 18.4%, from $188.9 million in fiscal year 1997 to $154.1 million in fiscal year 1998, primarily as a result of fewer stores in operation. Merchandise sales at comparable stores increased 0.7%. Sales of $12.4 million and $4.8 million at discount tobacco stores are included in merchandise sales for fiscal years 1998 and 1997, respectively. Gasoline sales in fiscal year 1998 were $109.4 million compared to $160.7 million in fiscal year 1997, a decline of $51.3 million, or 31.9%. This decrease is the result of a decline of 26.9 million gallons sold due to fewer stores in operation and lower sales prices per gallon sold. Gasoline gallons sold at comparable stores increased 3.4%. Gross profits on merchandise sales declined $10.0 million, or 15.4%, due largely to the decline in sales volume. Merchandise sales gross profits were $55.2 million in fiscal year 1998 compared to $65.2 million in fiscal year 1997. The gross profit decline from reduced sales volume was offset to some degree by higher gross profit rates due to changing product mix and improved purchasing arrangements. Gasoline gross profits were $13.7 million in fiscal year 1998 compared to $17.2 million in fiscal year 1997, a decline of $3.5 million, or 20.1%. This decrease is due to less total gallons sold due to fewer stores in operation and lower gross profits per gallon of gasoline sold due to competitive pressures. Selling expenses were $54.3 million in fiscal year 1998, a decrease of $15.0 million, or 21.7%, compared to $69.3 million in fiscal year 1997. This decline is primarily due to the fewer number of stores in operation in the current year. General and administrative expense in fiscal year 1998 declined $1.2 million, or 14.7%, due primarily to lower professional fees and staffing levels. Depreciation and amortization decreased by $951,000, or 13.0%, due to the disposal of equipment at stores closed during fiscal year 1998. Interest expense declined by $193,000, or 4.6%, due primarily to lower borrowing levels. The decline was reduced to some degree by higher interest rates. In fiscal year 1997, the Company recorded a provision for loss on disposal of certain assets to Getty of $1.6 million, with no similar provision in fiscal year 1998. The Company recorded a provision for the impairment of long-lived assets at certain closed and underperforming stores of $352,000 in fiscal year 1998 compared to an impairment provision in fiscal year 1997 of $1.1 million. The Company incurred a loss before income taxes, extraordinary item and cumulative effect of an accounting change of $365,000 in fiscal year 1998 compared to a loss of $6.8 million in fiscal year 1997. The net change of $6.5 million is the result of a $13.2 million decline in gross profits offset by a $19.7 million decrease in various expense categories. The Company recorded a $237,000 income tax benefit in fiscal year 1998 compared to an income tax benefit of $2.3 million in fiscal year 1997. This decline is due to the lower loss level, as well as changes in state income tax laws regarding the carry forward of net operating losses. In fiscal year 1998, the Company recorded a loss from debt extinguishment of $244,000, net of income tax benefit of $126,000. In fiscal year 1997, the Company recorded the cumulative effect of an accounting change of $1.5 million, net of income tax benefit of $0.7 million. The Company incurred a net loss of $372,000, or $0.05 per share, in fiscal year 1998, compared to a net loss in fiscal year 1997 of $6.0 million, or $0.91 per share. SEASONALITY AND UNAUDITED QUARTERLY RESULTS The Company's business generally has been subject to moderate seasonal influences with higher sales in the third and fourth fiscal quarters of each year, since customers tend to purchase more convenience items, such as ice, beverages and fast food, and more gasoline during the warmer months. Due to adverse weather conditions, merchandise sales for the second fiscal quarter have generally been lower than other quarters. However, because of price volatility, gasoline profit margins fluctuate significantly throughout the year. When the Company's relationship with Getty was terminated at the end of the first quarter of fiscal year 1998, it no longer operated 105 stores formerly leased from Getty. The loss of these stores reduced sales and operating expenses for the remainder of fiscal year 1998 and the closing of 20 stores in fiscal year 1999 had a similar effect. LIQUIDITY AND CAPITAL RESOURCES Most of the Company's sales are for cash and its inventory turns over rapidly. As a result, the Company's daily operations do not generally require large amounts of working capital. From time to time, the Company utilizes substantial portions of its cash to acquire and construct new stores and renovate existing locations. On December 30, 1998, the Company entered into a secured $10.0 million revolving loan agreement with a bank, with $3.0 million reserved for letters of credit. The Company utilized $3.5 million of this facility to pay its existing revolving credit facility and property loan. The Company also used this facility to replace its outstanding letter of credit which expired June 30, 1999. The revolving credit facility is subject to renewal at December 31, 1999. As of December 29, 1999, the bank has committed to an extension of up to nine months on a revolving credit facility subject to the Company's compliance with certain restrictive covenants at March 30, 2000 and June 29, 2000. The restrictive covenants include a minimum debt service coverage ratio, a minimum level of tangible net worth, a maximum debt to tangible net worth ratio, and a limit on unfunded capital expenditures. These covenants are unchanged from the existing credit agreement, except that the bank has agreed to reduce the required minimum tangible net worth covenant from $24 million at December 31, 1999 and September 30, 2000, to $23 million at March 31, 2000 and June 30, 2000. An additional covenant requirement of the extension agreement is that the Company's results from operations for the six and nine-month periods ending March 30, 2000 and June 29, 2000 must meet or exceed the budgeted amounts provided to the bank. Management is currently evaluating their refinancing alternatives and has obtained approval from its existing mortgage lender for a $10 million one-year revolving line of credit secured by real estate and store equipment. The terms of this loan are subject to completion of a formal commitment, but would include certain provisions which would require the Company to maintain a minimum net worth of $20 million and an aggregate fixed charge ratio of 1.25:1. If the Company elects to close on this facility, the bank loan would be repaid from the proceeds. Management believes that cash from operations and the available credit facilities will be sufficient to meet the Company's obligations for the fiscal year ending September 30, 2000. Capital requirements for debt service and capital leases for fiscal year 2000 are approximately $1.2 million. The Company anticipates capital expenditures of approximately $3.0 million in fiscal year 2000 for acquisition of real estate, remodeling of stores and upgrades of store equipment and gasoline-dispensing equipment. These expenditures are expected to be funded from cash flows from operations. The Company also is considering the start of a $4.0 million project pending the availability of funding. Approximately $1.25 million of the $4.0 million is committed contractually. IMPACT OF THE YEAR 2000 ("Y2K") PROBLEM BACKGROUND Many computer systems in use today were designed to utilize just two digits to represent a year rather than four digits. If a system element uses the two-digit convention for dates and the system is date sensitive, the system will malfunction when it first encounters the date January 1, 2000. The Company uses a variety of computers and computer software programs to operate and manage its business. The functioning of these systems is subject to problems if it does not properly interpret dates in the year 2000 and beyond. The Company also utilizes certain date-sensitive electronic equipment with embedded microchips such as cash registers and credit card readers. In addition, the Company deals with numerous suppliers of merchandise and services whose Y2K failure could be disruptive to the Company's business. The Company has been involved since early 1997 in developing and completing a program to deal with the Y2K problem. THE COMPANY'S Y2K PROGRAM The Company's Y2K program involved identification of Y2K problems in its various computer systems and date-sensitive electronic equipment, replacement or modification of the computer systems and software as required and extensive testing of the replacements and modifications. This portion of the Company's Y2K program has been completed. The Company has ranked its suppliers of goods and services according to the probability and impact of a Y2K problem with each vendor. The Company has contacted all suppliers except noncritical or nonessential suppliers to request written statements from them regarding their Y2K compliance. With the exception of some utility providers, positive responses have been received from over 95% of the other suppliers contacted. The Company has also completed contingency plans to handle Y2K problems with critical suppliers. Although the Company's Y2K program has been essentially completed, testing of systems and plans will continue until December 31, 1999. The total cost of the program will be approximately $400,000 most of which was expended prior to September 30, 1999. SUMMARY Based on its assessment and corrective efforts to date, the Company does not expect material difficulties with the Y2K problem in its internal computer systems. In addition, the Company does not expect material Y2K problems with other date-sensitive hardware or materially disruptive Y2K failures of its suppliers of merchandise and services. The Company's stores are geographically dispersed and it has a diverse supplier base. Although the Company does have a diverse supplier base, it does deal with a limited number of large suppliers whose Y2K failure could have a material effect on the Company's business. The Company believes that it could find alternative suppliers or handle developing Y2K problems with its current contingency plans. The Company's contingency plans were developed to mitigate possible Y2K failures. In management's opinion, the largest Y2K risks facing the Company are the inability of the Company's stores to process retail sales transactions or obtain merchandise to sell, as well as potential failure of public utility systems. IMPACT OF INFLATION The Company believes that inflation has not had a material effect on its results of operations in recent years. Generally, increases in the Company's cost of merchandise can be quickly reflected in higher prices of goods sold. However, any upward movement of gasoline costs may have short-term negative effects on profit margins, since the Company's ability to raise gasoline prices can be limited due to competition from other self-service gasoline outlets. In addition, fluctuation of gasoline prices can limit the ability of the Company to maintain stable gross margins. FORWARD-LOOKING STATEMENTS Certain statements contained in this report are forward looking, such as statements regarding the Company's plans and strategies or future financial performance. Although the Company believes that its expectations are based on reasonable assumptions within the bounds of its knowledge, investors and prospective investors are cautioned that such statements are only projections and that actual events or results may differ materially from those expressed in any such forward-looking statements. In addition to the factors discussed elsewhere in this report, the Company's actual consolidated quarterly or annual operating results have been affected in the past, or could be affected in the future, by additional factors, including, without limitation, general economic, business and market conditions; environmental, tax and tobacco legislation or regulation; volatility of gasoline prices, margins and supplies; merchandising margins; customer traffic; weather conditions; labor costs and the level of capital expenditures. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Uni-Marts, Inc. State College, Pennsylvania We have audited the accompanying consolidated balance sheets of Uni-Marts, Inc. and subsidiary (the "Company"), as of September 30, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended September 30, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Uni-Marts, Inc. and subsidiary as of September 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1999, in conformity with generally accepted accounting principles. As discussed in Note C, the Company changed its method of accounting for inventory in 1997. /s/ DELOITTE & TOUCHE LLP Deloitte & Touche, LLP Philadelphia, Pennsylvania November 11, 1999 (December 29, 1999 as to Note F) UNI-MARTS, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements UNI-MARTS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements UNI-MARTS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY See notes to consolidated financial statements UNI-MARTS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS UNI-MARTS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Supplemental Schedule of Noncash Operating Activity: During fiscal year 1997, the Company sold marketable securities for $448,300 and recognized a gain of $97,100. The cash proceeds from the sale were not received until after September 30, 1997. See notes to consolidated financial statements UNI-MARTS, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company is an independent operator of convenience stores and discount tobacco stores located in Pennsylvania, New York, Delaware, Maryland and Virginia. (1) Principles of Consolidation -- The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary. All material intercompany balances and transactions have been eliminated. (2) Inventories -- The Company values its merchandise inventories at the lower of cost (first-in, first-out method) or market, as determined by the retail inventory method. Gasoline inventories are valued at the lower of cost (first-in, first-out method) or market (see Note C). (3) Property, Equipment and Improvements -- Depreciation and amortization are calculated using the straight-line method over the useful lives of the related assets. Amortization of improvements to leased properties is based on the remaining terms of the leases or the estimated useful lives of such improvements, whichever is shorter. Interest costs incurred on borrowed funds during the period of construction of capital assets are capitalized as a component of the cost of acquiring those assets. The amount of interest capitalized in fiscal year 1997 was $57,400. No interest was capitalized in fiscal years 1999 and 1998. (4) Intangible and Other Assets -- Intangible and other assets consist of the following: Goodwill represents the excess of cost over the fair value of net assets acquired in business combinations and is amortized on a straight-line basis. Lease acquisition costs are the bargain element of acquired leases and are being amortized on a straight-line basis over the related lease terms. Amortization expense was $267,500 (1999), $439,500 (1998) and $431,200 (1997). (5) Asset Impairment -- It is the Company's policy to periodically review and evaluate the recoverability of fixed and intangible assets by assessing current and future profitability and cash flows and to determine whether the depreciation or amortization of the balances over their A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): remaining lives can be recovered through expected future results and cash flows. The Company recorded provisions of $208,300 (1999), $352,000 (1998) and $1,063,200 (1997) for asset impairment for certain real estate, leasehold improvements, store and gasoline equipment and goodwill at certain closed or underperforming stores. Fair value was determined based on a review of historical and projected cash flows. The Company also recorded a provision for loss on disposal of $1,624,600 in fiscal year 1997 for certain assets that were sold in January 1998. (6) Self-Insurance Reserves -- The Company assumes the risks for general liability and workers' compensation insurance exposures up to certain loss thresholds set forth in separate insurance contracts. The Company has established self-insurance reserves for these risks, which are recorded on a present value basis using a risk-free discount rate of 7.0%, using actuarial valuations provided by independent companies. At September 30, 1999 and 1998, the Company had self-insurance reserves totaling $2,868,900 and $2,551,500, respectively. (7) Income Taxes -- The Company recognizes deferred tax assets and liabilities for temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates. (8) Deferred Income and Other Liabilities -- The Company generally records revenues when products are sold or services rendered. In certain instances, the Company receives advance payments for purchase commitments or other services and records revenue from such payments in accordance with the terms of the related contractual arrangements. Deferred income and other liabilities includes the following: (9) Earnings Per Share -- Earnings per share for the years ended September 30, 1999, 1998 and 1997 were calculated based on the weighted average number of shares of common stock outstanding. Although there were potentially dilutive stock options for 576,441, 535,566 and 555,035 shares outstanding in fiscal years 1999, 1998 and 1997, respectively, they were not included as the effect was antidilutive. (10) Advertising Costs -- The Company expenses advertising costs in the period in which they are incurred. The Company incurred advertising costs of $1,894,600, $2,084,800 and $1,885,500 in fiscal years 1999, 1998 and 1997, respectively. (11) Estimates -- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates and assumptions. (12) New Accounting Pronouncements -- In fiscal year 1999, the Company adopted Statement Nos. 130, 131 and 132 of the Financial Accounting Standards Board ("FASB"). FASB A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): Statement No. 130, "Reporting Comprehensive Income," was adopted although the Company had no transactions involving other comprehensive income in any of the periods presented. FASB Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information," was adopted by the Company although the Company does not have more than one segment on which to report. FASB Statement No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," was adopted by the Company although its disclosures were in compliance with this statement. In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The Statement establishes accounting and reporting standards for derivative instruments. The Company is not required to adopt this standard until fiscal year 2001. At this time, the Company has not determined the impact this standard will have on the Company's financial statements. (13) Reclassifications -- Certain reclassifications have been made to the 1998 and 1997 financial statements to conform to the classifications used in 1999. B. OPERATIONS AND FINANCING: The Company has experienced net losses for each of the three years in the period ended September 30, 1999. The Company's ability to continue to operate beyond the immediate future will ultimately depend upon its ability to achieve levels of revenues necessary to support the Company's cost structure, reduce the costs of operating its stores and maintain adequate financing. Management's plans include the renewal or refinancing of its existing working credit facility (see Note F) and improved operating efficiencies resulting from the management and operational changes made during fiscal year 1999. The changes include the reduction of certain fixed expenses, the implementation of merchandising programs designed to improve gross margins and the closing or divesting of 20 underperforming stores. Management believes that cash from operations and the available credit facility will be sufficient to meet the Company's obligations for the fiscal year ending September 30, 2000. C. INVENTORIES: The following is a summary of inventories at September 30: During fiscal year 1997, the Company changed its method of calculating ending merchandise inventories under the retail inventory method. Prior to 1997, the Company utilized an average cost-to-retail ratio to value ending inventory. In fiscal year 1997, the Company began utilizing a method that weights the cost-to-retail ratio using multiple inventory categories. Management believes that this change in accounting improves the measurement of the Company's profitability based upon a changing product mix. C. INVENTORIES (CONTINUED): The cumulative effect of this accounting change was a charge to earnings of approximately $1,468,000, net of the related income tax benefit of $725,000. The pro forma effect as if the accounting change was in effect in the year presented is as follows: - --------------- * Includes cumulative effect of accounting change of $1,468,140. D. PROPERTY HELD FOR SALE: Property held for sale is carried at the lower of cost or net realizable value. The properties have been classified as current assets because the Company expects the properties to be sold within the next fiscal year. The properties are undeveloped land, a vacant rental property and closed convenience stores. E. PROPERTY, EQUIPMENT AND IMPROVEMENTS -- AT COST: Depreciation expense in fiscal years 1999, 1998 and 1997 was $5,700,700, $5,948,900 and $6,908,000, respectively, including the amortization of capitalized property and equipment leases. F. SHORT-TERM CREDIT FACILITIES: The Company has a short-term credit facility which is a secured $10.0 million revolving loan agreement with $3.0 million reserved for letters of credit. Borrowings of $1.8 million and letters of credit of $2.7 million were outstanding at September 30, 1999. This facility bears interest at a floating rate of LIBOR plus 2.8%. The interest rate at September 30, 1999 was 8.175%. The revolving credit facility is subject to renewal at December 31, 1999. The Company's revolving loan agreement contains covenants which provide for the maintenance of minimum tangible net worth as well as limitations on future indebtedness, sales and leasebacks and dispositions of assets, among other things. This agreement may restrict the Company's ability to declare and pay dividends on common stock. As of December 29, 1999, the bank has committed to an extension of up to nine months on a revolving credit facility subject to the Company's compliance with certain restrictive covenants at March 30, 2000 and June 29, 2000. The restrictive covenants include a minimum debt service coverage ratio, a minimum level of tangible net worth, a maximum debt to tangible net worth ratio, and a limit on unfunded capital expenditures. These covenants are unchanged from the existing credit agreement, except that the bank has agreed to reduce the required minimum tangible net worth covenant from $24 million at December 31, 1999 and September 30, 2000, to $23 million at March 31, 2000 and June 30, 2000. An additional covenant requirement of the extension agreement is that the Company's results from operations for the six and nine-month periods ending March 30, 2000 and June 29, 2000 must meet or exceed the budgeted amounts provided to the bank. Management is currently evaluating their refinancing alternatives and has obtained approval from its existing mortgage lender for a $10 million one-year revolving line of credit secured by real estate and store equipment. The terms of this loan are subject to completion of a formal commitment, but would include certain provisions which would require the Company to maintain a minimum net worth of $20 million and an aggregate fixed charge ratio of 1.25:1. If the Company elects to close on this facility, the bank loan would be repaid from the proceeds. G. LONG-TERM DEBT: The mortgage loans are collateralized by $48,211,900 of property, at cost. G. LONG-TERM DEBT (CONTINUED): Aggregate maturities of long-term debt during the next five years are as follows: On June 30, 1998, the Company completed a 20-year mortgage financing with Franchise Finance Corporation of America ("FFCA") pursuant to which the Company received long-term financing of $36.0 million. The Company repaid all of its long-term debt with these funds except for one mortgage with a balance of $220,300. Certain provisions of the loan agreements with FFCA require the Company's maintenance of a minimum net worth of $20 million and an aggregate fixed charge ratio of 1.25:1. This agreement could possibly restrict the Company's ability to declare and pay dividends on its common stock. H. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate fair value: CASH -- Cash is carried at fair value. CREDIT LINE PAYABLE -- Credit line payable is carried at fair value. LONG-TERM DEBT -- Fair value of the Company's long-term debt is estimated based on quoted market prices for the same or similar issues or on the current rates offered to the Company for similar debt. OBLIGATIONS UNDER CAPITAL LEASES -- Fair value of capital lease obligations is estimated based on current rates offered to the Company for similar debt. The estimated fair values of the Company's financial instrument liabilities are as follows: I. COMMITMENTS AND CONTINGENCIES: (1) Leases -- The Company leases its corporate headquarters, approximately one-half of its store locations and certain equipment. Future minimum lease payments under capital leases and noncancellable operating leases with initial or remaining terms in excess of one year at September 30, 1999 are shown below. Some of the leases provide for additional rentals when sales exceed a specified amount and contain variable renewal options and escalation clauses. Rental I. COMMITMENTS AND CONTINGENCIES (CONTINUED): income in connection with the leases of certain properties is also provided. Such rental income was $549,100 in 1999, $1,330,000 in 1998 and $1,299,700 in 1997. Rental expense under operating leases was as follows: (2) Change of Control Agreements -- The Company has change of control agreements with its executive officers pursuant to which each executive officer will receive remuneration of 2.99 times his base compensation if his employment is terminated due to a change of control as defined in the agreements. Remuneration which might be payable under these agreements has not been accrued in the consolidated financial statements as a change of control has not occurred. (3) Pursuant to ten-year agreements with two gasoline suppliers, the Company receives from the suppliers partial funding of the cost of the aboveground gasoline equipment and rebates for the purchase of gasoline. As of September 30, 1999, the total funding subject to this arrangement is $1,176,000. If the Company terminates these agreements before the expiration of the ten years, part of this funding must be repaid to the suppliers. (4) The Company has an agreement to purchase a property in Milroy, Pennsylvania, for $800,000, which is due on January 15, 2000. In addition, the Company is obligated to site work cost of approximately $450,000. (5) Litigation -- The Company is involved in litigation and other legal matters which have arisen in the normal course of business. Although the ultimate results of these matters are not currently determinable, management does not expect that they will have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows. J. INCOME TAXES: The provision for income taxes includes the following: The tax provision for fiscal year 1999 includes the benefit of net operating loss carryforwards of $2,204,400 for federal income tax purposes and $441,500 for state income tax purposes. During fiscal year 1999, the Company received tax refunds of approximately $753,700 resulting from the filing of its tax returns for fiscal years 1998 and 1997. Deferred tax liabilities (assets) are comprised of the following at September 30: The financial statements include noncurrent deferred tax liabilities of $2,561,500 and $4,131,400 in 1999 and 1998, respectively, and current deferred tax assets of $2,034,900 and $1,967,300 which are included in prepaid and current deferred taxes. J. INCOME TAXES (CONTINUED): A reconciliation of the provision for income taxes to an amount determined by application of the statutory federal income tax rate follows: K. RELATED PARTY TRANSACTIONS: During fiscal year 1997, the Company granted a loan of $800,000 to the Company's Chairman of the Board and Chief Executive Officer. Beginning in January 1999, the loan bears interest at the brokerage call rate plus 0.5% (7.5% at September 30, 1999) and requires payments of $60,000 plus interest on November 1, 1999, 2000, 2001, 2002 and 2003. A final payment of $300,000 is due on November 1, 2004. The loan is collateralized by 303,397 shares of the Company's Common Stock and 73,000 shares of the common stock of Unico Corporation. Certain directors and officers of the Company are also directors, officers and shareholders of Unico Corporation ("Unico"), formerly the Company's parent, and other affiliated companies. The following is a summary of significant transactions with these entities: (1) The Company leases three stores and certain other locations from Unico and leases its corporate headquarters and four additional locations from affiliates of Unico. Aggregate rentals in connection with these leases were $646,300 (1999), $629,800 (1998) and $672,600 (1997). (2) The Company charges an affiliate of Unico for general and administrative services provided. Such charges amounted to $12,300 (1999), $8,500 (1998) and $11,700 (1997). The Company received commissions from TeleBeam Incorporated ("TeleBeam") for coin-operated telephones installed at convenience store locations and for the sale of prepaid telephone cards. Payments received from TeleBeam were $213,900 (1999), $296,700 (1998) and $428,800 (1997). The Company also made payments to TeleBeam for discounted prepaid telephone cards and telephone service. Payments made to TeleBeam were $1,199,600 (1999), $748,700 (1998) and $577,000 (1997). The majority of the stock of TeleBeam is beneficially owned or controlled by persons related to the Company's Chairman and Chief Executive Officer. In fiscal year 1997, the Company purchased a property for $1,500,000 from a partnership in which a former director is also a partner. Prior to the purchase, the Company paid rents to the partnership of $35,500 (1997). The Company made payments of approximately $81,000 to a director of the Company during fiscal year 1999 for consulting fees and reimbursement of expenses. L. RETIREMENT SAVINGS AND INCENTIVE PLAN: The Company has a contributory retirement savings plan covering all employees meeting minimum age and service requirements. The Company will match one-half of employee contributions up to 3% of the employee's compensation. The Company's contributions are invested in the Company's Common Stock. The Board of Directors may elect to make additional contributions to be allocated among all eligible employees in accordance with provisions of the plan. The retirement savings plan expense, which is funded currently, was $96,600 (1999), $110,300 (1998) and $127,000 (1997). M. DEFERRED COMPENSATION PLAN AND PERFORMANCE UNIT PLAN: The Company has a nonqualified deferred compensation plan which permits key executives to elect annually (via individual contracts) to defer a portion of their compensation until their retirement, death or disability. The Company makes a 50% matching contribution not exceeding $5,000 annually per executive. The deferred compensation expense was $21,300, $15,600 and $25,700 for the years ended September 30, 1999, 1998 and 1997, respectively. The Company has recorded the assets and liabilities for the deferred compensation plan in the consolidated balance sheets because such assets and liabilities belong to the Company rather than to any plan or trust. The asset and matching liability of $237,600 and $487,500 at September 30, 1999 and 1998, respectively, include employee deferrals, accrued earnings and matching contributions of the Company. The asset amount is included in net intangible and other assets and the liability amount is included in deferred income and other liabilities. Subsequent to September 30, 1999, the deferred compensation plan assets were distributed to participants in satisfaction of plan liabilities. Liabilities for the deferred compensation plan at December 1, 1999 were $0. The Company also has a Performance Unit Plan to provide long-term incentives to senior executives. Under the Performance Unit Plan, the amount of compensation is determined over the succeeding three-year period based upon performance of the Company as well as individual goals for the senior executives. Compensation expense recognized under this plan was $0, $29,000 and $0 for fiscal years 1999, 1998 and 1997, respectively. N. EQUITY COMPENSATION PLANS: The Company has an Equity Compensation Plan, pursuant to which no additional stock options may be granted, and a 1996 Equity Compensation Plan, which became effective November 1, 1996. The Company has reserved 122,080 shares of common stock which can be issued in accordance with the terms of the Equity Compensation Plan and 1,000,000 shares of common stock which can be issued in accordance with the terms of the 1996 Equity Compensation Plan. Both the Equity Compensation Plan and the 1996 Equity Compensation Plan are collectively discussed as the "Plans" below. A committee of the Board of Directors has authority to administer the Plans, and the committee may grant qualified incentive stock options to employees of the Company, including officers, whether or not they are directors. The Plans also provide that all nonemployee directors will receive annual non-qualified stock option grants for 2,000 shares of common stock plus 500 shares for each full year the director has served as a member of the board, up to a maximum of 4,000 shares per grant, on the date of each annual meeting. In addition, newly appointed or elected nonemployee directors receive an initial grant for 5,000 shares. Nonemployee directors will also receive grants of stock equal in value to and in lieu of two-thirds of the retainer due to such director. The Company granted options to purchase 14,000, 32,000 and 26,000 shares of common stock to nonemployee directors under the Plans during N. EQUITY COMPENSATION PLANS (CONTINUED): fiscal years 1999, 1998 and 1997, respectively. The Company also granted 8,695, 7,140 and 6,223 shares of common stock to nonemployee directors during fiscal years 1999, 1998 and 1997, respectively, as part of their annual retainer. The exercise price of all options granted under the Plans may not be less than the fair market value of the common stock on the date of grant, and the maximum allowable term of each option is ten years. For qualified stock options granted to any person who holds more than 10% of the voting power of the outstanding stock, the exercise price may not be less than 110% of the fair market value, and the maximum allowable term is five years. Options granted under the Plans generally have various vesting schedules. Information regarding outstanding options is presented below. All options outstanding are exercisable according to their vesting schedule. Outstanding Options for Shares of Common Stock: The weighted average fair value of the stock options granted during fiscal years 1999, 1998 and 1997 were $1.03, $1.88 and $2.97, respectively. The fair value of each stock option granted is estimated on N. EQUITY COMPENSATION PLANS (CONTINUED): the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in the years ended September 30, The Company accounts for the Plans in accordance with Accounting Principles Board Opinion No. 25, under which no compensation cost has been recognized for stock option awards. Had compensation cost for the Plans been determined in accordance with Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS 123), the Company's pro forma net earnings (loss) and earnings (loss) per share for the fiscal years ended September 30, 1999, 1998 and 1997 would have been as follows: O. EMPLOYEE STOCK PURCHASE PLAN: In February 1999, the Company's stockholders approved a stock purchase plan. Under the stock purchase plan, eligible employees may purchase common stock in quarterly offering periods through payroll deductions of up to 25% of compensation. The price per share is 90% of the average market price throughout the quarter but not less than 90% of the lower of the market price at the beginning or end of the market period. The stock purchase plan provides for purchases by employees of up to an aggregate of 500,000 shares. During fiscal year 1999, employees purchased 2,004 shares pursuant to the stock purchase plan. P. NONQUALIFIED STOCK OPTIONS: On February 26, 1993, the Company made a one-time, special grant of non-qualified stock options to each of Henry D. Sahakian and Daniel D. Sahakian to purchase 150,000 shares of common stock of the Company at a price of $4.50 per share in exchange for their relinquishment of effective voting control of the Company as a result of the elimination of the super-majority voting provisions of the Class B Common Stock. These nonqualified stock options are not related to the Company's Equity Compensation Plan. Henry D. Sahakian exercised his option during fiscal year 1996 by exchanging 84,375 shares of the Company's Common Stock valued at $675,000. Daniel D. Sahakian exercised his option during fiscal year 1998 for a cash payment to the Company of $675,000. SUPPLEMENTARY FINANCIAL INFORMATION SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED): ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III In accordance with Instruction G(3), the information called for by Items 10, 11, 12 and 13 is incorporated by reference from the Registrant's Definitive Proxy Statement pursuant to Regulation 14A, to be filed with the Commission not later than 120 days after September 30, 1999, the end of the fiscal year covered by this report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS AND REPORTS ON FORM 8-K. (A) FINANCIAL STATEMENTS AND SCHEDULES The Financial Statements listed below are filed as part of this Annual Report on Form 10-K. (1) Financial Statements (2) Financial Statement Schedules The following financial statement schedule should be read in conjunction with the financial statements and notes thereto included in this report. Schedules not included below have been omitted because they are not applicable or required or because the required information is not material or is included in the financial statements or notes thereto. The following schedule for the years ended September 30, 1999, 1998 and 1997 is included in this report: (B) REPORTS ON FORM 8-K Uni-Marts, Inc. filed no reports on Form 8-K with the Securities and Exchange Commission during the last quarter of the fiscal year ended September 30, 1999. (C) EXHIBITS (D) SCHEDULES The schedules listed in Item 14(A) are filed as part of this Annual Report on Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNI-MARTS, INC. (Registrant) By: /s/ HENRY D. SAHAKIAN ------------------------------------ Henry D. Sahakian Chairman of the Board (Principal Executive Officer) By: /s/ N. GREGORY PETRICK ------------------------------------ N. Gregory Petrick Senior Vice President and Chief Financial Officer (Principal Accounting Officer) (Principal Financial Officer) Dated: December 29, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated: UNI-MARTS, INC. AND SUBSIDIARY SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS - --------------- (1) Specific account or note receivable written off to allowance. UNI-MARTS, INC. AND SUBSIDIARY EXHIBIT INDEX

44471_1999.txt

44471_1999

1999

44471

ITEM 1. BUSINESS GENERAL Guilford Mills, Inc. was incorporated under the laws of Delaware in August 1971, and is the successor by merger to businesses previously conducted since 1946. Guilford Mills, Inc. and its predecessors and subsidiaries are referred to as the "Company", unless the context indicates otherwise. Guilford Mills, Inc. produces fabrics using a broad range of technologies for a variety of customers and markets. It is the largest warp knitter in the world and a leader in technological advances in textiles. The Company has identified four segments in which it operates: Automotive, Apparel, Home Fashions and Other. Fabrics produced in the Automotive segment are sold to original equipment manufacturers (OEMs) and their suppliers. These fabrics are fabricated into seats and headliners of passenger cars, sport utility vehicles, conversion vans and light and heavy trucks. Automotive products utilize warp knit, circular knit, flat woven, woven velour and printing technologies. The Apparel segment fabrics and laces are used predominately in women's shapewear, swimwear, ready-to-wear and intimate apparel garments. Other uses include sleepwear, team sportswear and linings. The Apparel segment utilizes warp and circular knit technology. The Home Fashions segment produces fabrics for residential and office furniture, mattress ticking, and window treatment applications, including lace. The Company also designs, produces and distributes directly to retail a broad line of products for the home including window curtains, sheets, comforters, pillowcases, bedskirts and shower curtains. The remainder of Guilford's fabrics are sold for use in a broad range of industrial/specialty products and are included in the Other segment. The Company's polyester fibers spinning operations are also included in this segment. Reference is made to Note 16 of the Consolidated Financial Statements in the Annual Report to Stockholders for the fiscal year ended October 3, 1999 (the "Annual Report"), which note is incorporated herein by reference, for information regarding revenue, profit and assets by segment. PRODUCT DEVELOPMENT Working closely with the Company's customers, the Company has research and development departments in the U.S., U.K., and Mexico, consisting of approximately 120 employees, that are primarily responsible for the creation of new fabrics and styles. Sample warping and knitting machines are used to develop new fabrics which can be placed into production after customer acceptance. Total expenditures for research and development for fiscal years 1999, 1998 and 1997, were approximately $17.2 million, $19.6 million, and $14.9 million, respectively. The Company has numerous trademarks, trade names, patents and certain licensing agreements which it uses in connection with the advertising and promotion of its products across segments. Management believes that the loss or expiration of such trademarks, trade names and licensing agreements would not have a material adverse effect on the Company's operations. WORKING CAPITAL PRACTICES The Company knits based on internal forecasts and generally dyes and finishes based on customer orders and therefore, significant amounts of inventory are not required to meet rapid delivery to the Company's customers or to assure a continuous allotment of goods from suppliers. Customers are allowed to return goods for valid reasons and customer accommodations are not significant. To minimize the credit risk on such accounts and to obtain larger credit lines for many customers, the Company maintains credit insurance covering $24.0 million of certain outstanding accounts receivable as of October 3, 1999. In addition, approximately 17% of accounts receivable are factored without recourse. The Company has the ability to borrow against such receivables, although it has traditionally not done so as the related borrowing terms are less favorable than other available sources of financing. The Company generally takes advantage of discounts offered by vendors. The Company experiences seasonal fluctuations in its sales in the Apparel segment, with the highest sales occurring in the period from April to September. Sales in the Automotive, Home Fashions and Other segments experience insignificant seasonal fluctuations. The Company has a large number of customers. No customer accounted for 10% or more of total net sales during fiscal 1999, 1998 or 1997. The Company's net sales reflect substantial direct and indirect sales to certain large automotive original equipment manufacturers. The backlog of orders believed to be firm as of the end of the current and preceding fiscal years is not deemed to be material for an understanding of the Company's business as most orders are deliverable within a few months. EXPORT SALES U.S. export sales, as a percentage of total worldwide sales of the Company, were approximately 5.4% in fiscal 1999, 5.4% in fiscal 1998 and 5.5% in fiscal 1997. RAW MATERIALS Fabrics in all of the Company's segments are constructed primarily of synthetic yarns: nylon and polyester. In fiscal 1999, the Company internally produced 15% of the polyester yarns used. The Company purchases its nylon and the remaining polyester yarns from several domestic and foreign fiber producers. During fiscal 1999, the Company experienced periods of tightness of supply of nylon fiber, however, nylon fiber is currently readily available. Due to the price competition resulting from the Asian crisis, the Company purchased greater quantities of lower-priced polyester yarn from foreign suppliers during fiscal 1999. The Company's Apparel segment also uses spandex, acetate, cotton and rayon. A small amount of spandex is used in the Home Fashions segment. Both spandex and acetate are purchased substantially from one domestic producer. In fiscal 1999 all yarns, except nylon, were readily available throughout the year and either were or could be purchased from numerous sources. Management believes that an adequate supply of yarns is available to meet the Company's requirements. The chemicals and dyes used in the dyeing and finishing processes in all segments are available in large quantities from various suppliers. The foam backing used in the automotive fabric lamination process is purchased from two suppliers in the United States and two suppliers in Europe. In fiscal 1999, there was an adequate supply of foam. ENVIRONMENTAL MATTERS The production processes, particularly dyeing and finishing operations, involve the use and discharge of certain chemicals and dyes into the air and sewage disposal systems. The Company installs pollution control devices as necessary to meet existing and anticipated national, state and local pollution control regulations. The Company, including its foreign subsidiaries, does not anticipate that compliance with national, state, local and other provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will have a material adverse effect upon its capital expenditures, earnings or competitive position. Reference is made to Note 12 of the Consolidated Financial Statements in the Annual Report, which note is incorporated herein by reference, for information regarding certain other environmental matters. COMPETITION In all of the Company's segments, the principal methods of competition are pricing, styling and design, customer service and quality. In retail home fashions, distribution channels are an additional principal method of competition. The weight of each competitive factor varies by product line. In the past few years, the Apparel and Home Fashions segments have been impacted by imports of garments, window curtains and sheeting. In the United States, the Company has five major warp knit competitors and many other smaller competitors in the Apparel and Home Fashions segments. The Company also competes with some garment manufacturers that have warp knit equipment to manufacture their own fabrics. Some of these companies are divisions of large, well-capitalized companies while others are small manufacturers. There are four major and numerous smaller circular knit competitors in the Apparel segment. In the Automotive segment, the Company has three major domestic competitors and several smaller competitors. Guilford's automotive subsidiary in Europe competes with seven warp knitters in the United Kingdom and several in France. It also competes with many producers of circular knit and flat woven fabrics. The Company's operations in Mexico compete primarily with four warp knitters in the Apparel segment and one warp knitter in the Automotive segment. None of the Company's competitors are deemed to be dominant with respect to their markets. EMPLOYEES As of November 15, 1999, the Company employed 6,251 full-time employees worldwide. Approximately 1,258 employees (including 428 in Europe and 460 in Mexico) are represented by collective bargaining agreements. SAFE HARBOR-FORWARD-LOOKING STATEMENTS From time to time, the Company may publish forward-looking statements relative to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. All statements other than statements of historical fact included in or incorporated by reference into this Form 10-K, including, without limitation the statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Important factors that could cause actual results to differ materially from those discussed in such forward-looking statements include: 1. general economic factors including, but not limited to, changes in interest rates, foreign currency translation rates, consumer confidence, housing starts, trends in disposable income, changes in consumer demand for goods produced, and cyclical or other downturns 2. the overall level of automotive production and the production of specific car models 3. fashion trends 4. information and technological advances including Year 2000 issues 5. cost and availability of raw materials, labor and natural and other resources 6. domestic and foreign competition 7. domestic and foreign governmental regulations and trade policies 8. reliance on major customers 9. success of marketing, advertising and promotional campaigns or 10. inability to achieve cost reductions through consolidation and restructuring of acquired companies Item 2. Item 2. PROPERTIES Set forth below is a listing of facilities owned and leased by the Company. Management believes the facilities and manufacturing equipment are in good condition, well maintained, suitable and adequate for present production. Many of the Company's manufacturing facilities are utilized by more than one segment. Utilization of the facilities fluctuates from time to time due to the seasonal nature of operations and market conditions. The Company defines full utilization as five day, three shift production. On that basis, the manufacturing facilities are generally utilized approximately 80%. However, during fiscal 1999, automotive only facilities in the U.S. were operating at a full seven days to meet demand. Cut-and-sew operations in home fashions were running five days, one to two shifts depending on the product. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Reference is made to Note 12 of the Consolidated Financial Statements in the Annual Report, which note is incorporated herein by reference, for information regarding certain environmental matters. Several purported class action lawsuits have been filed on behalf of purchasers of the Company's common stock against the Company and certain of its officers and directors. These lawsuits were consolidated by order of the Court on January 8, 1999. A Consolidated and Amended Class Action Complaint (the "Consolidated Complaint") was filed on February 8, 1999. The Consolidated Complaint purports to allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, in connection with the Company's public disclosure of accounting irregularities at the Hofmann Laces unit in fiscal year 1998. Specifically, the Consolidated Complaint alleges that, during the alleged class period (January 20, 1998 through October 26, 1998), defendants materially misrepresented the Company's financial condition and overstated the Company's reported earnings. No specific amount of damages is sought in the Consolidated Complaint. On April 9, 1999, defendants filed a motion to dismiss the Consolidated Complaint. On July 21, 1999, the Court entered an order dismissing all claims against one of the Company's officers but denied the Company and one of its director's motion to dismiss. Plaintiffs filed their Second Amended Complaint on September 7, 1999, and defendants answered the Second Amended Complaint on September 24, 1999. On November 1, 1999, plaintiffs filed a motion seeking to certify a plaintiff class consisting of all persons or entities who purchased the common shares of Guilford Mills, Inc. from January 20, 1998 through October 26, 1998 inclusive. Guilford has until February 11, 2000, to oppose plaintiffs' class certification motion. The Company intends to vigorously defend the lawsuits. The Securities and Exchange Commission (the "Commission") has issued a formal Order Directing Private Investigation and Designating Officers To Take Testimony (the "Formal Order") with respect to accounting irregularities at the Hofmann Laces unit which the Company had previously disclosed in press releases in October and November 1998. Prior to the issuance of the Formal Order, the Company had voluntarily provided certain information to the Commission concerning the accounting irregularities at the Hofmann Laces unit. The Company has delivered documents to, and intends to continue cooperating fully with, the Commission. The Company is also involved in various litigation, including the matters described above, in the ordinary course of business. Although the final outcome of these legal and environmental matters cannot be determined, based on the facts presently known, it is management's opinion that the final resolution of these matters will not have a material adverse effect on the Company's financial position or future results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the Company's fourth quarter of fiscal 1999. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reference is made to the information set forth on page 39 in the section entitled "Common Stock Market Prices and Dividends" in the Annual Report, filed as Exhibit 13 to this report, which page is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA In thousands except per share data) 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Results of Operations ---------------------- Net sales $856,838 $894,534 $894,709 $830,320 $782,518 Income before extraordinary item 10,230 33,146 43,238 33,978 33,636 Net income 10,230 30,206 43,238 33,978 33,636 Per Share Data (1) ------------------ Basic: Income before extraordinary item 0.47 1.32 1.92 1.59 1.60 Net income 0.47 1.20 1.92 1.59 1.60 Diluted: Income before extraordinary item 0.47 1.30 1.78 1.47 1.48 Net income 0.47 1.19 1.78 1.47 1.48 Cash dividends 0.44 0.44 0.42 0.40 0.40 Balance Sheet Data ------------------ Working capital 127,660 211,278 213,974 177,658 178,233 Total assets 753,431 794,500 729,796 728,830 586,371 Long-term debt 146,137 176,872 134,560 209,435 166,368 Stockholders' investment 340,945 385,177 408,896 298,059 267,549 (1) All share data has been restated to reflect the effect of a three-for-two stock split effected in May 1997 in the form of a 50% stock dividend. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to the information set forth on pages 13 through 21 in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report, which pages are incorporated herein by reference. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Reference is made to the information set forth on page 20 in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report, which page is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to information set forth on pages 22 through 39 of the Annual Report, which pages are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information to be included under the captions "Directors and Nominees" and "Additional Information" contained in the section entitled "ELECTION OF DIRECTORS", and under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" all as set forth in the Company's definitive proxy statement, which will be filed with the Commission on or about December 22, 1999 pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "Proxy Statement"), is incorporated herein by reference. EXECUTIVE OFFICERS OF THE REGISTRANT (AS OF DECEMBER 13, 1999) Name Age Office or Business Experience - ---- --- ----------------------------- Charles A. Hayes 64 Chairman of the Board and Chief Executive Officer (since 1976); President and Chief Operating Officer (from 1991 to 1995); President (from 1968 to 1976) and Executive Vice President (from 1961 to 1968). John A. Emrich 55 Member of the Board of Directors (since 1995); President and Chief Operating Officer (since 1995); Senior Vice President and President/ Automotive Business Unit (from 1993 to 1995); Vice President/Planning and Vice President/ Operations for the Apparel and Home Fashions Business Unit (from 1991 to 1993); Director of Operations with FAB Industries, Inc. (from 1990 to 1991) and holder of various executive positions with the Company (from 1985 to 1990). Terrence E. Geremski 52 Member of the Board of Directors (since 1993); Executive Vice President and Chief Financial Officer (since 1997), Senior Vice President, Chief Financial Officer and Treasurer (from 1996 to 1997); Vice President, Chief Financial Officer and Treasurer (from 1992 to 1996); Vice President and Controller with Varity Corporation (from 1989 to 1991); and Vice President, Chief Financial Officer, Treasurer and holder of other executive positions with Dayton Walther Corp. (from 1979 to 1989). Don A. Alexander 39 Vice President/Technology (since 1999); Director of Research, Institute of Textile Technology (from 1987 to 1999); formerly holder of various technical and managerial positions with Milliken & Company (from 1985 to 1987). Mark E. Cook 40 Treasurer (since 1997); Director of Corporate Finance, Worthington Industries, Inc. (from 1995 to 1997); Director of Corporate Finance, Blount International, Inc. (from 1989 to 1995). Nathan M. Dry 54 Vice President/Apparel/Home Fashions (since 1999); Vice President/Commercial Products (from 1998 to 1999); Vice President/Product Development and Research (from 1996 to 1998); President of Dyeing and Printing Lumberton, Inc. (from 1990 to 1996). Robert A. Emken, Jr. 36 General Counsel and Secretary (since 1999); Associate Counsel (from 1991 to 1999); Associate, Womble Carlyle Sandridge & Rice, PLLC (from 1988 to 1991). Phillip D. McCartney 57 Vice President/Technical Operations (since 1989); formerly holder of various executive positions with FAB Industries, Inc. (from 1984 to 1989). Byron McCutchen 52 Senior Vice President and President/Fibers (since 1995); Senior Vice President of Fibers (from 1994 to 1995); Worldwide Business Manager-Dacron(R) Filament-E.I. DuPont Co. (from 1991 to 1994); and Specialty Business Manager- Dacron(R)-E.I. DuPont Co. (from 1990 to 1991). Richard E. Novak 56 Vice President/Human Resources (since 1996); Principal of Nova Consulting Group (from 1994 to 1996); Senior Vice President/Human Resources of Joseph Horne Company, Inc. (from 1987 to 1994). Richard J. Redpath 60 Vice President/Engineering (since 1999); Principal of The Evans Group (from 1997 to 1998); Director of Engineering, Binney & Smith (from 1994-1997); Director of Engineering of Worldwide Johnson & Johnson (from 1988 to 1994). Christopher J. Richard 43 Senior Vice President (since 1999);Vice President (from 1998-1999) and President/U.S. Automotive (since 1997); Vice President of Sales and Marketing, Garden State Tanning (from 1994 to 1997); holder of various executive positions with Collins & Aikman Corporation (from 1983 to 1994). Kim A. Thompson 41 Vice President/Corporate Controller (since 1997); Director of Financial Reporting (from 1994 to 1997); holder of various executive positions with Collins and Aikman Corporation (from 1980 to 1994). No family relationships exist between any executive officers of the Company. Item 11. Item 11. EXECUTIVE COMPENSATION The information to be included in the section "EXECUTIVE COMPENSATION" in the Proxy Statement is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information to be included in the section "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" in the Proxy Statement is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information to be included in the section "CERTAIN TRANSACTIONS" in the Proxy Statement is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS A PART OF THIS REPORT: 1. FINANCIAL STATEMENTS (reference is made to pages 22 through 38 of the Annual Report, which pages are incorporated herein by reference): Consolidated Balance Sheets as of October 3, 1999 and September 27, Consolidated Statements of Income for the Years Ended October 3, 1999, September 27, 1998 and September 28, 1997 Consolidated Statements of Stockholders' Investment for the Years Ended October 3, 1999, September 27, 1998 and September 28, 1997 Consolidated Statements of Cash Flows for the Years Ended October 3, 1999, September 27, 1998 and September 28, 1997 Notes to Consolidated Financial Statements Statement of Management's Responsibility Report of Independent Public Accountants 2. FINANCIAL STATEMENT SCHEDULE: Schedule II - Analysis of Valuation and Qualifying Accounts for the Years Ended October 3, 1999, September 27, 1998 and September 28, 3. EXHIBITS: EXHIBIT NO. DESCRIPTION OF EXHIBIT - ----------- ---------------------- (3) (a) Restated Certificate of Incorporation of the Company, dated June 8, 1999 (incorporated by reference to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended July 4, 1999 (the "7/4/99 10-Q")). (3) (b) By-Laws of the Company, as amended through November 5, 1998 (incorporated by reference to Exhibit (3)(b) to the Company's Annual Report on Form 10-K for the fiscal year ended September 27, 1998 (the "1998 Annual. Report")). (4) (a) Rights Agreement dated as of August 23, 1990 between the Company and The First National Bank of Boston, as Rights Agent (incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K filed with the SEC on September 7, 1990). (4) (b) Appointment of Successor Rights Agent, dated April 1, 1999, between the Company and American Stock Transfer & Trust Company (incorporated by reference to Exhibit (4)(a) to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended April 4, 1999). (4) (c) Form of Note Purchase Agreement, dated December 18, 1998, entered into by and between Guilford Mills, Inc. and each of the purchasers named in the purchasers' schedule thereto. (10) (a)* Guilford Mills, Inc. Non-Qualified Profit Sharing Plan for Certain of its Executive Officers and Key Employees, effective July 1, 1989 (incorporated by reference to Exhibit (10) (a) (7) to the Company's Annual Report on Form 10-K for the fiscal year ended July 1, 1990 (the "1990 Annual Report")). (10) (b)* First Amendment, dated September 1, 1993, to the Guilford Mills, Inc. Non-Qualified Profit-Sharing Plan (incorporated by reference to Exhibit (10)(b) to the Company's Annual Report on Form 10-K for the fiscal year ended September 28, 1997 (the "1997 Annual Report")). (10) (c)* Second Amendment, dated November 1, 1996, to the Guilford Mills, Inc. Non-Qualified Profit-Sharing Plan (incorporated by reference to Exhibit (10)(c) to the 1997 Annual Report). (10) (d)* Guilford Mills, Inc. 1991 Stock Option Plan (the "1991 Plan") (incorporated by reference to Exhibit 28 (a) to the Company's Registration statement on Form S-8 (Registration No. 33-47109)filed with the SEC on April 10, 1992 (the "Form S-8")). (10) (e)* Amendment to the 1991 Plan (incorporated by reference to Exhibit (10) (a) to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended March 30, 1997 (the "3/30/97 10-Q")). (10) (f)* Amendment to the 1991 Plan (incorporated by reference to Exhibit (10)(f) to the 1998 Annual Report). (10) (g)* Amendment to the 1991 Plan (incorporated by reference to Exhibit (10)(d) to the 7/4/99 10-Q). (10) (h)* Form of Stock Option Contract for key employees in the 1991 Plan (relating to incentive stock options) (incorporated by reference to Exhibit 28 (b) to the Form S-8). (10) (i)* Form of Stock Option Contract for Director participants in the 1991 Plan (incorporated by reference to Exhibit 28 (d) to the Form S-8). (10) (j)* Form of Stock Option Contract between the Company and certain of its officers pursuant to the 1991 Plan (incorporated by reference to Exhibit (10) (b) to the Quarterly Report on Form 10-Q for the fiscal quarter ended June 29, 1997 (the "6/29/97 10-Q")). (10) (k)* Guilford Mills, Inc. 1989 Restricted Stock Plan (the "Restricted Plan") (incorporated by reference to Exhibit 10 (b) (2) to the 1990 Annual Report). (10) (l)* Amendment to the Restricted Plan (incorporated by reference to Exhibit (10)(g) to the Annual Report on Form 10-K for the fiscal year ended October 2, 1994 (the "1994 Annual Report")). (10) (m)* Amendment to the Restricted Plan (incorporated by reference to Exhibit (10) (b) to the 3/30/97 10-Q). (10) (n)* Form of Restricted Stock Agreement between the Company and certain of its officers pursuant to the Restricted Plan (incorporated by reference to Exhibit (10) (a) to the 6/29/97 10-Q). (10) (o)* Amended and Restated Phantom Stock Agreement between the Company and Charles A. Hayes dated September 21, 1994 (incorporated by reference to Exhibit (10) (m) to the 1994 Annual Report). (10) (p)* Form of Executive Retirement and Death Benefit Agreements between the Company and certain of its executive officers and key employees (incorporated by reference to Exhibit (10) (d) (1) to the 1990 Annual Report). (10) (q)* Form of Pension and Death Benefit Agreement between the Company and certain of its executive officers and key employees (incorporated by reference to Exhibit (10) (d) (2) to the 1990 Annual Report). (10) (r)* Form of Deferred Compensation Agreement between the Company and certain of its officers and key employees (incorporated by reference to Exhibit (10) (d) (3) to the 1990 Annual Report). (10) (s)* Guilford Mills, Inc. Excess Benefit Plan (incorporated by reference to Exhibit (10) (a) to the Quarterly Report on Form 10-Q for the fiscal quarter ended December 29, 1996 ("12/29/96 10-Q")). (10) (t)* Guilford Mills, Inc. Trust for Non-Qualified Plans (incorporated by reference to Exhibit (10) (b) to the 12/29/96 10-Q). (10) (u)* Guilford Mills, Inc. Senior Managers' Life Insurance Plan and related Plan Agreement (incorporated by reference to Exhibit (10) (r) to the Annual Report on Form 10-K for the fiscal year ended June 28, 1992 ("1992 Annual Report")). (10) (v)* Guilford Mills, Inc. Senior Managers' Pre-Retirement Life Insurance Agreement (incorporated by reference to Exhibit (10) (s) to the 1992 Annual Report). (10) (w)* Guilford Mills, Inc. Senior Managers' Supplemental Retirement Plan and related Plan Agreement (incorporated by reference to Exhibit (10) (t) to the 1992 Annual Report). (10) (x)* Form of Severance Agreement between the Company and certain of its officers and employees (incorporated by reference to Exhibit (10) (u) to the 1992 Annual Report). (10) (y)* Form of Amendment to Severance Agreement between the Company and certain of its officers and employees (incorporated by reference to Exhibit (10) (v) to the 1994 Annual Report). (10) (z)* Form of Second Amendment to Severance Agreement between the Company and certain of its officers and employees (incorporated by reference to Exhibit (10) (w) to the 1994 Annual Report). (10) (a)(a)* Form of Amendment to Severance Agreement between the Company and certain of its officers and employees. (10) (b)(b) Stockholders' Agreement, dated as of April 30, 1991 by and among the Company, Maurice Fishman and Charles A. Hayes (the "1991 Stockholders' Agreement") (incorporated by reference to Exhibit (10) (e) to the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1991). (10) (c)(c) Amendment, dated June 29, 1994, to the 1991 Stockholders' Agreement (incorporated by reference to Exhibit (10) (y) to the 1994 Annual Report). (10) (d)(d) Second Amendment, dated January 1, 1995, to the 1991 Stockholders' Agreement, (incorporated by reference to Exhibit (10)(y) to the Company's Annual Report on Form 10-K for the fiscal year ended October 1, 1995 (the "1995 Annual Report")). (10) (e)(e) Third Amendment, dated June 22, 1995, to the 1991 Stockholders' Agreement (incorporated by reference to Exhibit(10)(z) to the 1995 Annual Report). (10) (f)(f) Fourth Amendment, dated May 23, 1997, to the 1991 Stockholders' Agreement (incorporated by reference to Exhibit (10)(e) to the 6/29/97 10-Q). (10) (g)(g) Fifth Amendment, dated June 22, 1999, to the 1991 Stockholders' Agreement (incorporated by reference to Exhibit (10)(b) to the 7/4/99 10-Q). (10) (h)(h) Stockholders' Agreement, dated as of June 22, 1990, by and among the Company, Charles A. Hayes, George Greenberg and Maurice Fishman (the "1990 Stockholders' Agreement") (incorporated by reference to Exhibit (10) (f) to the 1990 Annual Report). (10) (i)(i) Amendment, dated January 1, 1995, to the 1990 Stockholders' Agreement (incorporated by reference to Exhibit (10) (b)(b) to the 1995 Annual Report). (10) (j)(j) Second Amendment, dated June 22, 1995, to the 1990 Stockholders' Agreement (incorporated by reference to Exhibit (10)(c)(c) to the 1995 Annual Report). (10) (k)(k) Third Amendment, dated May 23, 1997, to the 1990 Stockholders' Agreement (incorporated by reference to Exhibit (10)(d) to the 6/29/97 10-Q). (10) (l)(l) Fourth Amendment, dated June 22, 1999, to the 1990 Stockholders' Agreement (incorporated by reference to Exhibit (10)(c) to the 7/4/99 10-Q). (10) (m)(m)* Summary of Short Term Incentive Plan (incorporated by reference to Exhibit (10) (f)(f) to the 1997 Annual Report). (10) (n)(n)* Management Compensation Trust Agreement between the Company and North Carolina Trust Company dated July 1, 1991 (incorporated by reference to Exhibit (10) (y) to the 1992 Annual Report). (10)(o)(o)* Amendment to the Management Compensation Trust Agreement between the Company and North Carolina Trust Company dated April 1, 1992 (incorporated by reference to Exhibit (10) (z) to the 1992 Annual Report). (10) (p)(p)* Second Amendment to the Management Compensation Trust Agreement between the Company and North Carolina Trust Company dated July 1, 1992 (incorporated by reference to Exhibit (10) (a) (a) to the 1992 Annual Report). (10) (q)(q) Revolving Credit Agreement, dated September 26, 1995, by and between the Company, as borrower, Gold Mills, Inc. as Guarantor, and the banks listed therein (incorporated by reference to Exhibit (10)(I) (i) to the 1995 Annual Report). (10) (r)(r) First Amendment to Revolving Credit Agreement, dated May 5, 1999, by and between the Company, as borrower, and Gold Mills, Inc., Raschel Fashion Interknitting, Ltd. and Curtains and Fabrics, Inc., as guarantors, and the banks listed therein (the "Credit Agreement")(incorporated by reference to Exhibit (10)(a) to the 7/4/99 10-Q). (10) (s)(s) Second Amendment, dated November 19, 1999, to the Credit Agreement. (10) (t)(t)* Amended and Restated Employment Agreement, dated February 25, 1998, by and among Raschel Fashion Interknitting, Ltd., Hofmann Laces, Ltd., Curtains and Fabrics, Inc. and Bruno Hofmann (incorporated by reference to Exhibit (10) (a) to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended March 29, 1998). (10) (u)(u) Stock Purchase Agreement, dated August 6, 1999, between Victor Posner and Guilford Mills, Inc. (13) Annual Report to Stockholders of the Company for the fiscal year ended October 3, 1999 (only those portions of such report incorporated by reference to the Annual Report on Form 10-K are filed herewith). (21) Subsidiaries of the Registrant. (23) Consent of Independent Public Accountants. (27) Financial Data Schedule. *Items denoted with an asterisk represent management contracts or compensatory plans or arrangements. (b) REPORTS ON FORM 8-K Not Applicable. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GUILFORD MILLS, INC. By: /s/ Terrence E. Geremski ------------------------ Terrence E. Geremski Executive Vice President and Chief Financial Officer Dated: December 22, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- Chairman of the Board of Directors and Chief Executive Officer (Principal Executive /s/ Charles A. Hayes Officer) December 22, 1999 - ------------------------ Charles A. Hayes Director; President and Chief Operating /s/ John A. Emrich Officer December 22, 1999 - ------------------------ John A. Emrich Director; Executive Vice President and Chief Financial Officer (Principal Financial and /s/ Terrence E. Geremski Accounting Officer) December 22, 1999 - ------------------------- Terrence E. Geremski Vice Chairman of the /s/ George Greenberg Board of Directors December 22, 1999 - ------------------------- George Greenberg /s/ Tomokazu Adachi Director December 22, 1999 - ------------------------ Tomokazu Adachi /s/ Donald B. Dixon Director December 22, 1999 - ------------------------- Donald B. Dixon /s/ Paul G. Gillease Director December 22, 1999 - ------------------------- Paul G. Gillease /s/ Stephen C. Hassenfelt Director December 22, 1999 - -------------------------- Stephen C. Hassenfelt SIGNATURE TITLE DATE --------- ----- ---- /s/ Bruno Hofmann Director December 22, 1999 - -------------------------- Bruno Hofmann /s/ Sherry R. Jacobs Director December 22, 1999 - -------------------------- Sherry R. Jacobs Director December 22, 1999 - --------------------------- Stig A. Kry /s/ Grant M. Wilson Director December 22, 1999 - ---------------------------- Grant M. Wilson Director December 22, 1999 - ---------------------------- Jacobo Zaidenweber INDEX TO FORM 10-K SCHEDULE Report of Independent Public Accountants................................... Schedule II - Analysis of Valuation and Qualifying Accounts for the Years Ended October 3, 1999, September 27, 1998 and September 28, 1997........... REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Stockholders and Board of Directors of Guilford Mills, Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements included in the Guilford Mills, Inc. Annual Report to Stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated November 11, 1999. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule on page is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen LLP ----------------------- ARTHUR ANDERSEN LLP Greensboro, North Carolina, November 11, 1999. GUILFORD MILLS, INC. SCHEDULE II ANALYSIS OF VALUATION AND Qualifying Accounts For the Years Ended October 3, 1999, September 27, 1998 and September 28, 1997 (In Thousands) (1) Deductions are for the purpose for which the reserve was created. Fiscal 1999 includes reversal of $470 of excess reserve into income. (2) Other amounts represent the effect of exchange rate fluctuations and the purchase of a business.

794170_1999.txt

794170_1999

1999

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ITEM 1. BUSINESS General Toll Brothers, Inc. ("Toll Brothers" or the "Company"), a Delaware corporation formed in May 1986, commenced its business operations, through predecessor entities, in 1967. Toll Brothers designs, builds, markets and arranges financing for single family detached and attached homes in middle and high income residential communities catering to move-up, empty nester and age-qualified homebuyers in eighteen states in six regions around the country. The communities are generally located on land the Company has either developed or acquired fully approved and, in some cases, improved. During fiscal 1999, the Company began building homes in the San Francisco, San Diego, Chicago and Detroit markets. Currently, the Company operates in the major suburban areas of southeastern Pennsylvania and Delaware, central New Jersey, the Virginia and Maryland suburbs of Washington, D.C., the Boston, Massachusetts metropolitan area, Fairfield and Hartford Counties, Connecticut, Westchester County, New York, southern and northern California, the Phoenix, Arizona metropolitan area, Raleigh and Charlotte North Carolina, Las Vegas, Nevada, Dallas and Austin, Texas, the east and west coasts of Florida, Columbus, Ohio, Nashville, Tennessee, the suburbs of Detroit Michigan, and the suburbs of Chicago, Illinois. The Company continues to explore additional geographic areas for expansion. The Company markets its homes primarily to middle-income and upper-income buyers, emphasizing high quality construction and customer satisfaction. In the five years ended October 31, 1999, Toll Brothers delivered more than 13,000 homes in 288 communities including 3,555 homes in 183 communities delivered in fiscal 1999. In March 1999, the Company acquired the homebuilding operations of the Silverman Companies, a Detroit, Michigan homebuilder and developer of luxury apartments, for cash and the assumption of debt. The Silverman Companies owned or controlled approximately 1,800 homesites and interests in over 1,000 existing and prospective apartments. The acquisition of the Silverman apartment assets is expected to be completed during the first half of fiscal 2000. In March 1999, the Company acquired land for homes, apartments, retail, office and industrial space in the master planned community of South Riding, located in Loudoun County, Virginia. The Company will use some of the property for its own homebuilding operation and will also sell homesites and commercial parcels to other builders. Land sales revenues from South Riding, which amounted to $17.3 million in fiscal 1999, should continue for the next several years. The Company also operates its own architectural, engineering, mortgage, title, security monitoring, landscape, lawn maintenance, insurance brokerage, cable T.V., broadband Internet access, component assembly and manufacturing operations. At October 31, 1999, the Company was offering homes for sale in 140 communities containing over 16,000 home sites which were owned or controlled through options; the Company also controlled approximately 16,200 home sites in 113 proposed communities. At October 31, 1999, the Company was offering single family detached homes at prices, excluding customized options, generally ranging from $127,000 to $1,073,000 with an average base sales price of $421,000. The offering price of the Company's attached homes, excluding customized options, generally ranged from $220,000 to $447,000, with an average base sales price of $339,000. In recognition of its achievements, the Company has received numerous awards from national, state and local homebuilder publications and associations. Toll Brothers is the only publicly traded home builder to have won all three of the industry's highest honors: America's Best Builder (1996), the National Housing Quality Award (1995), and Builder of the Year (1988). On October 31, 1999 and 1998, the Company had backlogs of $1,067,685,000 (2,381 homes) and $814,714,000 (1,892 homes), respectively. The Company expects that substantially all homes in backlog at October 31, 1999 will be delivered by October 31, 2000. The Company generally attempts to reduce certain risks homebuilders encounter by controlling land for future development through options whenever possible (which allows the Company to obtain the necessary governmental approvals before acquiring title to the land), by generally beginning construction of homes after executing an agreement of sale with a buyer and by using subcontractors to perform home construction and land development work on a fixed-price basis. In order to obtain better terms or prices, or due to competitive pressures, the Company has purchased several properties outright, or acquired the underlying mortgage, prior to obtaining all of the necessary governmental approvals needed to commence development. In 1998, the Company formed a group of entities (collectively, the "Real Estate Group")to take advantage of commercial real estate opportunities which may present themselves from time to time. These opportunities may result from commercially zoned parcels included with larger properties that the Company has acquired or may acquire for its homebuilding operations or from the direct acquisition of unrelated land or operating properties. In November 1998, Robert I. Toll, Bruce E. Toll, Zvi Barzilay, Joel Rassman, all of whom are executive officers and/or directors of the Company, and other Company officers (the "Partners") contributed their partnership interests in an apartment complex under construction in exchange for a fifty percent ownership interest in the Real Estate Group. Based upon independent valuations obtained by the Company and reviewed by the Board of Directors, the Board of Directors determined that the value of the assets received, net of liabilities assumed, was at least equal to the consideration given to the Partners. In December 1998, the Pennsylvania State Employees Retirement System ("PASERS") acquired a one- third interest in the Real Estate Group for $10,000,000. In fiscal 1999, the Company, the Partners and PASERS made additional cash contributions to the Real Estate Group to acquire several office buildings from unrelated parties. As of October 31, 1999, the Company had an investment of $7,285,000 which represented its one-third interest in the Real Estate Group. The Company provides development, finance and management services to the Real Estate Group and received fees under the terms of various agreements in the amount of $2,524,000 in fiscal 1999. The Company emphasizes its high-quality, detached single family homes that are marketed primarily to the "upscale" luxury market, generally comprised of those persons who have previously owned a principal residence seeking to buy a larger home - the so-called "move-up" market. The Company believes its reputation as a developer of homes for this market enhances its competitive position with respect to the sale of more moderately priced detached homes, as well as attached homes. The Company also sells to the 50+ year-old "empty-nester" market and believes that this market has strong growth potential. The Company has developed a number of home designs that it believes will appeal to this category of home buyer and has integrated these designs into its communities along with its other homes. In 1999, the Company opened for sale its first active adult, age-qualified community for households in which at least one member is 55 years of age. The Company expects to open three additional age-qualified communities during the next two years. The Company believes that the demographics of its move-up, empty nester and active adult, age-qualified up-scale markets provide potential for growth in the coming decade. According to the U.S. Census Bureau, the number of households earning $100,000 or more (in constant 1998 dollars) now stands at 10.5 million households, an increase by over 60% since 1985, and triple the rate of increase of all U.S. households over the past 15 years. According to Claritas, Inc., a provider of demographic information, approximately 4.5 million of these households are located in our current markets. The largest number of baby boomers, more than four million born annually between 1954 and 1964, are now 35 to 46 years of age and in their peak move-up home buying years. The leading edge of the baby boom generation is just now entering its 50's and the empty nester market. And the number of 55 to 64 year old households, which corresponds to the Company's age-qualified communities, is projected to increase by over 45% by the Year 2010 according to the U.S. Census Bureau. Toll Brothers also develops a number of master planned country club communities. In fiscal 1999, the Company opened four master planned country club communities containing more than 4,000 lots and expects to open four additional such communities during the next two years. These communities, many of which contain golf courses and other country club type amenities, enable the Company to offer multiple home types and sizes to a broad range of move-up and empty nester buyers. The Company realizes efficiencies from shared common costs such as land development and infrastructure costs and marketing. The Company currently has master planned communities in New Jersey, California, Michigan, Florida, North Carolina and Virginia. Each single family detached home community offers several home plans, with the opportunity for home buyers to select various exterior styles. The Company designs each community to fit existing land characteristics, blending winding streets, cul-de-sacs and underground utilities to establish a pleasant environment. The Company strives to create a diversity of architectural styles within an overall planned community. This diversity is created and enhanced by variations among the house models offered, in exterior design options for homes of the same basic floor plan, preservation of existing trees and foliage whenever practicable, and curving street layouts which allow relatively few homes to be seen from any vantage point. Normally, homes of the same type or color may not be built next to each other. The communities have attractive entrances with distinctive signage and landscaping. The Company believes this avoids a "development" appearance and gives each community a diversified neighborhood appearance that enhances home values. The Company's attached home communities generally offer one to three story homes, provide for limited exterior options and often contain commonly-owned recreational acreage such as playing fields, swimming pools and tennis courts. These communities have associations through which homeowners act jointly for their common interest. The Homes Most single family detached-home communities offer at least four different floor plans, each with several substantially different architectural styles. For example, the purchaser may select the same basic floor plan with a Colonial, Georgian, Federal or Provincial design, and exteriors may be varied further by the use of stone, stucco, brick or siding. Attached home communities generally offer two or three different floor plans with two, three or four bedrooms. In all of Toll Brothers' communities, a wide selection of options is available to the purchaser for an additional charge. The options typically are more numerous and significant for the more expensive homes. Major options include additional garages, additional rooms, finished lofts and additional fireplaces. As a result of the additional charges for such options, the average sales price was approximately 20% higher than the base sales price during fiscal 1999. Contracts for the sale of homes are at fixed prices. The prices at which homes are offered have generally increased from time to time during the sellout period for a community; however, there can be no assurance that sales prices will increase in the future. The Company uses some of the same basic home designs in similar communities. However, the Company is continuously developing new designs to replace or augment existing ones to assure that its homes reflect current consumer preferences. For new designs, the Company has its own architectural staff and also engages unaffiliated architectural firms. During the past year, the Company has introduced over 100 new models. (1) New contract and backlog amounts include $13,141,000 (46 homes) and $13,756,000 (54 homes), respectively, from an unconsolidated 50% owned joint venture. On October 31, 1999, significant site improvements had not commenced on approximately 8,846 of the 13,628 available home sites. Of the 13,628 available home sites, 1,375 were not owned by the Company, but were controlled through options. Of the 197 communities under development, 140 had homes being offered for sale, 32 had not yet opened for sale and 25 had been sold out, but not all closings had been completed. Of the 140 communities in which homes were being offered for sale, 132 were single-family detached-home communities containing a total of 153 homes under construction but not under contract (exclusive of model homes) and 8 were attached home communities containing a total of 14 homes under construction but not under contract (exclusive of model homes). Land Policy Before entering into an agreement to purchase a land parcel, the Company completes extensive comparative studies and analyses on detailed Company- designed forms that assist it in evaluating the acquisition. Toll Brothers generally attempts to follow a policy of acquiring options to purchase land for future communities. However, in order to obtain better terms or prices, or due to competitive pressures, the Company will acquire from time to time property outright. In addition, the Company has, at times, acquired the underlying mortgage on a property and subsequently obtained title to that property. The options or purchase agreements are generally on a non-recourse basis, thereby limiting the Company's financial exposure to the amounts invested in property and pre-development costs. The use of options or purchase agreements may increase the price of land that the Company eventually acquires, but significantly reduces the risk. It also allows the Company to obtain necessary development approvals before acquisition of the land, which generally enhances the value of the options and purchase agreements, and the land when acquired. The Company has the ability to extend many of these options for varying periods of time, in some cases by the payment of an additional deposit and in some cases without an additional payment. The Company's purchase agreements are typically subject to numerous conditions including, but not limited to, the Company's ability to obtain necessary governmental approvals for the proposed community. Often, the down payment on the agreement will be returned to the Company if all approvals are not obtained, although pre-development costs may not be recoverable. The Company has the right to cancel any of its land agreements by forfeiture of the Company's down payment on the agreement. In such instances, the Company generally is not able to recover any pre-development costs. During the early 1990's, due to the recession and the difficulties other builders and land developers had in obtaining financing, the number of buyers competing for land in the Company's market areas diminished, while the number of sellers increased, resulting in more advantageous prices for the Company's land acquisitions. Further, many of the land parcels offered for sale were fully approved, and often improved, subdivisions. Previously, such types of subdivisions generally were not available for acquisition in the Company's market areas. The Company purchased several such subdivisions outright and acquired control of several others through option contracts. Due to the improvement in the economy and the increased availability of capital during the past several years, the Company has experienced an increase in competition for available land in its market areas. The Company's ability to continue its development activities over the long-term will be dependent upon its continued ability to locate and enter into options or agreements to purchase land, obtain governmental approvals for suitable parcels of land, and consummate the acquisition and complete the development of such land. While the Company believes that there is significant diversity in its existing markets and that this diversity provides protection from the vagaries of individual local economies, it believes that greater geographic diversification will provide additional protection and more opportunities for growth. The Company continues to look for new markets. (1) Of the 16,249 planned home sites, 6,356 lots were owned by the Company. The aggregate purchase price of land parcels under option and purchase agreements at October 31, 1999 was approximately $512,904,000, of which the Company has paid or deposited $30,020,000. The Company evaluates all of the land under its control for proposed communities on an ongoing basis with respect to economic and market feasibility. During the year ended October 31, 1999, such feasibility analyses resulted in approximately $2,757,000 of capitalized costs related to proposed communities being charged to expense because they were no longer deemed to be recoverable. There can be no assurance that the Company will be successful in securing necessary development approvals for the land currently under its control or for land which the Company may acquire control of in the future or, that upon obtaining such development approvals, the Company will elect to complete its purchases under such options. The Company has generally been successful in the past in obtaining governmental approvals, has substantial land currently owned or under its control for which it has obtained or is seeking such approvals (as set forth in the table above), and devotes significant resources to locating suitable land for future development and to obtaining the required approvals on land under its control. Failure to locate sufficient suitable land or to obtain necessary governmental approvals, however, may impair the ability of the Company over the long-term to maintain current levels of development activities. The Company believes that it has an adequate supply of land in its existing communities or held for future development (assuming that all properties are developed) to maintain its operations at its current levels for several years. Community Development The Company expends considerable effort in developing a concept for each community, which includes determination of size, style and price range of the homes, layout of the streets and individual lots, and overall community design. After obtaining the necessary governmental subdivision and other approvals, which can sometimes take several years, the Company improves the land by grading and clearing it, installing roads, recreational amenities, underground utility lines and pipes, erecting distinctive entrance structures, and staking out individual home sites. Each community is managed by a project manager who is usually located at the site. Working with construction managers, marketing personnel and, when required, other Company and outside professionals such as engineers, architects and legal counsel, the project manager is responsible for supervising and coordinating the various developmental steps from acquisition through the approval stage, marketing, construction and customer service, including monitoring the progress of work and controlling expenditures. Major decisions regarding each community are made by senior members of the Company's management. The Company recognizes revenue only when title and possession are transferred to the buyer, which generally occurs shortly after home construction is substantially completed. The most significant variable affecting the timing of the Company's revenue stream, other than housing demand, is receipt of final regulatory approvals, which, in turn, permits the Company to begin the process of obtaining executed contracts for sales of homes. Receipt of such final approvals is not seasonal. Although the Company's sales and construction activities vary somewhat with the seasons, affecting the timing of closings, any such seasonal effect is relatively insignificant compared to the effect of receipt of final governmental approvals. Subcontractors perform all home construction and land development work, generally under fixed-price contracts. Toll Brothers acts as a general contractor and purchases some, but not all, of the building supplies it requires(See "Manufacturing/Distribution Facilities" in Item 2). While the Company has experienced some shortages from time to time in the availability of subcontractors in some markets, it does not anticipate any material effect from these shortages in its homebuilding operations. The Company's construction managers and assistant construction managers coordinate subcontracting activities and supervise all aspects of construction work and quality control. One of the ways the Company seeks to achieve home buyer satisfaction is by providing its construction managers with incentive compensation arrangements based on each home buyer's satisfaction as expressed by their responses on pre-closing and post-closing checklists. The Company maintains insurance to protect against certain risks associated with its activities including, among others, general liability, "all-risk" property, workers' compensation, automobile, and employee fidelity. The Company believes the amounts and extent of such insurance coverages are adequate. Marketing The Company believes that its marketing strategy, which emphasizes its more expensive "Estate" and "Executive" lines of homes, has enhanced the Company's reputation as a builder-developer of high-quality upscale housing. The Company believes this reputation results in greater demand for all of the Company's lines of homes. The Company generally includes attractive decorative moldings such as chair rails, crown moldings, dentil moldings and other aesthetic features, even in its less expensive homes, based on its belief that this additional construction expense improves its marketing effort. In addition to relying on management's extensive experience, the Company determines the prices for its homes through a Company-designed value analysis program that compares Toll Brothers homes with homes offered by other builders in the local marketing area. The Company accomplishes this by assigning a positive or negative dollar value to differences between itself and its competitors' product features, such as amenities, location and marketing. Toll Brothers expends great effort in creating its model homes, which play an important role in its marketing. In its models, Toll Brothers creates an attractive atmosphere, with bread baking in the oven, fires burning in fireplaces, and music playing in the background. Interior decorating varies among the models and is carefully selected based upon the lifestyles of prospective buyers. During the past several years, the Company has received a number of awards from various homebuilder associations for its interior merchandising. The sales office located in each community is generally staffed by Company sales personnel, who are compensated with salary and commission. In addition, a significant portion of Toll Brothers' sales is derived from the introduction of customers to its communities by local cooperating realtors. The Company advertises extensively in newspapers, other local and regional publications, and on billboards. The Company also uses videotapes and attractive color brochures to market its communities. The Internet has become an important source of information for our customers. In fiscal 1999, the Company welcomed its one-millionth visitor to its web site. A visitor to its web site can obtain information regarding the Company's communities and homes across the country and take a panoramic or video tour of the homes. The Company's web address is www.tollbrothers.com. All Toll Brothers homes are sold under the Company's limited warranty as to workmanship and mechanical equipment. Many homebuyers are also provided with a limited ten-year warranty as to structural integrity. Customer Financing The Company secures the availability of a variety of competitive market rate mortgage products from both national and regional lenders. Such availability is generally obtained at no cost to the Company and is committed for varying lengths of time and amounts. By making available an array of attractive mortgage programs to qualified purchasers, the Company is able to better coordinate and expedite the entire sales transaction by ensuring that mortgage commitments are received and that closings take place on a timely and efficient basis. During fiscal 1999, approximately 42% of the Company's closings were financed through mortgage programs offered by the Company and the Company's home buyers, on average, financed approximately 71% of the purchase price of their homes. Competition The homebuilding business is highly competitive and fragmented. The Company competes with numerous homebuilders of varying sizes, ranging from local to national in scope, some of which have greater sales and financial resources than the Company. Resales of homes also provide competition. The Company competes primarily on the basis of price, location, design, quality, service and reputation; however, during the past several years, the Company's financial stability, relative to others in its industry, has become an increasingly favorable competitive factor. The Company believes that, due to the increased availability of capital, competition has increased during the past several years. Regulation and Environmental Matters The Company is subject to various local, state and federal statutes, ordinances, rules and regulations concerning zoning, building design, construction and similar matters, including local regulations which impose restrictive zoning and density requirements in order to limit the number of homes that can eventually be built within the boundaries of a particular locality. In a number of the Company's markets there has been an increase in state and local legislation authorizing the acquisition of land, mainly by governmental, quasi-public and non-profit entities, as dedicated open space. In addition, the Company is subject to various licensing, registration and filing requirements in connection with the construction, advertisement and sale of homes in its communities in the states and localities in which it operates. These laws have not had a material effect on the Company, except to the extent that application of such laws may have caused the Company to conclude that development of a proposed community would not be economically feasible, even if any or all necessary governmental approvals were obtained.(see "Land Policy" in this Item 1). The Company may also be subject to periodic delays or may be precluded entirely from developing communities due to building moratoriums in the areas in which it operates. Generally, such moratoriums relate to insufficient water or sewage facilities, or inadequate road capacity. In order to secure certain approvals, the Company may have to provide affordable housing at below market rental or sales prices. The impact on the Company will depend on how the various state and local governments in the areas in which the Company engages, or intends to engage, in development implement their programs for affordable housing. To date, these restrictions have not had a material impact on the Company. The Company is also subject to a variety of local, state and federal statutes, ordinances, rules and regulations concerning protection of health and the environment ("environmental laws"), as well as the effects of environmental factors. The particular environmental laws which apply to any given community vary greatly according to the location of the site, the site's environmental condition and the present and former uses of the site. These environmental laws may result in delays, may cause the Company to incur substantial compliance and other costs, and may prohibit or severely restrict development in certain environmentally sensitive regions or areas. The Company maintains a policy of engaging independent environmental consultants to assess land for the potential of hazardous or toxic materials, wastes or substances prior to consummating its acquisition. Because it has generally obtained such assessments for the land it has purchased, the Company has not been significantly affected to date by the presence of such materials. Employees As of October 31, 1999, the Company employed 2,208 full-time persons; of these, 87 were in executive positions, 222 were engaged in sales activities, 207 were in project management activities, 794 were in administrative and clerical activities, 616 were in construction activities, 73 were in engineering activities and 209 were in the manufacturing/distribution facilities. The Company considers its employee relations to be good. Factors That May Affect Our Future Results (Cautionary Statements Under the Private Securities Litigation Reform Act of 1995) Certain information included in this report or in other materials we have filed or will file with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) contains or may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended. You can identify these statements by the fact that they do not relate strictly to historical or current facts. They contain words like "anticipate," "estimate", "expect," "project," "intend," "plan," "believe," "may," "could," "might" and other words or phrases of similar meaning in connection with any discussion of future operating or financial performance. Such statements include information relating to construction activities, plans for future development of residential communities, land acquisition and related activities as well as capital spending, financing sources and the effects of regulation and competition. From time to time, forward-looking statements are also included in the Company's other periodic reports on Forms 10-Q and 8-K, in press releases and in other material released to the public. Any or all of the forward-looking statements included in this report and in any other reports or public statements of the Company may turn out to be inaccurate. This can occur as a result of incorrect assumptions or as a consequence of known or unknown risks and uncertainties. Many factors mentioned in this report or in other reports or public statements of the Company, such as government regulation and the competitive environment, will be important in determining the Company's future performance. Consequently, actual results may differ materially from those that might be anticipated from forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. However, any further disclosures made on related subjects in our subsequent reports on Forms 10-K, 10-Q and 8-K should be consulted. The following cautionary discussion of risks, uncertainties and possible inaccurate assumptions relevant to our business includes factors we believe could cause our actual results to differ materially from expected and historical results. Other factors beyond those listed below could also adversely affect us. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995. We operate in a very competitive environment, which is characterized by competition from a number of other home builders in each market in which we operate. Actions or changes in plans by competitors may negatively affect the Company. Our business can be affected by changes in general economic and market conditions as well as local economic and market conditions where our operations are conducted and where prospective purchasers of our homes live. The plans for future development of our residential communities can be affected by a number of factors including, for example, time delays in obtaining necessary governmental permits and approvals and legal challenges to our proposed communities. Our operations depend on our ability to continue to obtain land for the development of our residential communities at reasonable prices. Changes in competition, availability of financing, customer trends and market conditions may impact on our ability to obtain land for new residential communities. The development of our residential communities may be affected by circumstances beyond our control, including weather interference, work stoppages, labor disputes, unforeseen engineering, environmental or geological problems and unanticipated shortages or increases in the cost of materials and labor. Any of these circumstances could give rise to delays in the completion of or increase the cost of developing one or more of our residential communities. We believe that our recorded tax balances are adequate. However, it is not possible to predict the effects of possible changes in the tax laws or changes in their interpretation. These changes or interpretations if made, could have a material negative effect on our operating results. The interest rate on our revolving credit agreement is subject to fluctuation based on changes in short-term interest rates and the ratings which national rating agencies assign to our outstanding debt securities. Our interest expense could increase as a result of these factors. Our business and earnings are substantially dependent on our ability to obtain financing for our development activities. Increases in interest rates, concerns about the market or the economy, or consolidation of financial institutions could increase our cost of borrowing and reduce our ability to obtain the funds required for our future operations. Our business and earnings are also substantially dependent on the ability of our customers to finance the purchase of their homes, and limitations on the availability of such financing or increases in the cost of such financing could adversely affect our operations. Claims have been brought against us in various legal proceedings, which have not had, and are not expected to have a material adverse effect on the business or the financial condition of the Company; however, additional legal and tax claims may arise from time to time, and it is possible that our cash flows and results of operations could be affected from time to time by the resolution of one or more of such matters. There is intense competition to attract and retain management and key employees in the markets where our operations are conducted. Our business could be adversely affected in the event of our inability to recruit or retain key personnel in one or more of the markets in which we conduct our operations. ITEM 2. ITEM 2. PROPERTIES Headquarters Toll Brothers' corporate offices, which are owned by the Company, contain approximately 70,000 square feet, and are located at 3103 Philmont Avenue, Huntingdon Valley, Montgomery County, Pennsylvania. Manufacturing/Distribution Facilities Toll Brothers owns a facility of approximately 200,000 square feet located in Morrisville, Pennsylvania. The Company also owns a facility of approximately 100,000 square feet located in Emporia, Virginia which it acquired in 1999. In both facilities it manufactures open wall panels, roof and floor trusses, and certain interior and exterior millwork to supply a portion of the Company's construction needs. These operations also permit Toll Brothers to purchase wholesale lumber, plywood, windows, doors, certain other interior and exterior millwork and other building materials to supply to its communities. The Company believes that increased efficiency, cost savings and productivity result from the operation of these plants and from such wholesale purchases of material. The Pennsylvania plant generally does not sell or supply to any purchaser other than Toll Brothers. The Virginia plant sells wall panels and roof and floor trusses to outside purchasers as well as to Toll Brothers. Regional and Other Facilities The Company leases office and warehouse space in various locations, none of which is material to the business of the Company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various claims and litigation arising principally in the ordinary course of business. The Company believes that the disposition of these matters will not have a material adverse effect on the business or the financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended October 31, 1999. EXECUTIVE OFFICERS OF THE REGISTRANT The following table includes information with respect to all executive officers of the Company as of October 31, 1999. All executive officers serve at the pleasure of the Board of Directors of the Company. Name Age Positions Robert I. Toll 58 Chairman of the Board, Chief Executive Officer and Director Zvi Barzilay 53 President, Chief Operating Officer and Director Joel H. Rassman 54 Senior Vice President, Treasurer, Chief Financial Officer and Director Robert I. Toll, with his brother Bruce E. Toll, the Vice Chairman of the Board and a Director of the Company, co-founded the Company's predecessors' operations in 1967. He has been the Company's Chief Executive Officer and Chairman of the Board since the Company's inception. Zvi Barzilay joined the Company as a project manager in 1980 and has been an officer of the Company since 1983. Mr. Barzilay was elected a Director of the Company in 1994. He has held the position of Chief Operating Officer since May 1998 and the position of President since November 1998. Joel H. Rassman has been a Senior Vice President of the Company since joining the Company in 1984. Mr. Rassman has been a Director of the Company since 1996. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is principally traded on the New York Stock Exchange (Symbol: TOL). It is also listed on the Pacific Exchange. The Company has not paid any cash dividends on its common stock to date and expects that, for the foreseeable future, it will follow a policy of retaining earnings in order to finance the continued development of its business. Payment of dividends is within the discretion of the Company's Board of Directors and will depend upon the earnings, capital requirements and operating and financial condition of the Company, among other factors. The Company's 8 3/4% Senior Subordinated Notes due 2006, 7 3/4% Senior Subordinated Notes due 2007, 8 1/8% Senior Subordinated Notes due 2009 and 8% Senior Subordinated Notes due 2009, contain restrictions on the amount of dividends the Company may pay on its common stock. In addition, the Company's Bank Revolving Credit Agreement requires the maintenance of minimum consolidated stockholders' equity which restricts the amount of dividends the Company may pay. As of October 31, 1999, under the most restrictive of these provisions, the Company could pay up to approximately $206,865,000 of cash dividends. At October 31, 1999, there were approximately 741 record holders of the Company's common stock. Note: Percentages for selling, general and administrative expense, interest expense and total costs and expenses are based on total revenues. FISCAL 1999 COMPARED TO FISCAL 1998 HOME SALES Revenues from home sales for fiscal 1999 as compared to 1998 increased by approximately $232 million, or 19%. The increase in revenues was attributable to a 15% increase in the number of homes delivered and a 4% increase in the average price of the homes delivered. The increased number of homes delivered was due to the greater number of communities from which the Company was delivering homes in fiscal 1999 as compared to fiscal 1998, the larger backlog of homes at the beginning of 1999 as compared to the beginning of 1998 and an increase in the number of homes sold during fiscal 1999 over the number sold in fiscal 1998. Part of the increase in the number of communities was attributable to the acquisition of the homebuilding operations of the Silverman Companies in March 1999. The increase in the average selling price per home delivered in fiscal 1999 as compared to fiscal 1998 was the result of a shift in the location of homes delivered to more expensive areas, changes in product mix to larger homes and increases in selling prices, offset in part by the delivery of lower priced products of the Silverman Companies. The value of new sales contracts signed in fiscal 1999 amounted to $1.64 billion (3,845 homes) compared to $1.38 billion (3,387 homes) in fiscal 1998. The increase in the value of new contracts signed was primarily attributable to an increase in the number of communities in which the Company was offering homes for sale, an increase in the number of contracts signed per community and an increase in the average selling price of the homes (due primarily to the location, size and increase in base selling prices). As of October 31, 1999, the backlog of homes under contract was $1.07 billion (2,381 homes), approximately 31% higher than the $815 million (1,892 homes) backlog as of October 31, 1998. The increase in backlog at October 31, 1999 was primarily attributable to the increase in the number of new contracts signed and price increases, as previously discussed. Home costs as a percentage of home revenues increased in 1999 as compared to 1998. The increase was the result of the higher percentage of closings from some of the Company's newer markets (Arizona, Florida, Nevada, North Carolina, Texas and Michigan) in 1999, which generally had higher costs as a percentage of revenues as compared to the Company's more established markets. The Company also had higher inventory writeoffs in 1999 ($5.1 million) as compared to 1998 ($2.0 million). These cost increases were partially offset by lower costs as a percentage of revenues in the Company's more established markets resulting from increased selling prices and lower overhead costs. LAND SALES In March 1999, the Company acquired land for homes, apartments, retail, office and industrial space in the master planned community of South Riding, located in Loudoun County, Virginia. The Company will use some of the property for its own homebuilding operations and also will sell homesites and commercial parcels to other builders. Land sales revenues from South Riding, which amounted to $17.3 million in fiscal 1999, should continue for the next several years. INTEREST AND OTHER INCOME The increase in interest and other income in fiscal 1999 as compared to fiscal 1998 was primarily the result of the Company's expansion of its ancillary businesses such as title insurance, mortgage operations and construction management. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES ("SG&A") SG&A expenses for fiscal 1999 increased by $23.5 million over 1998. The increased spending was primarily attributable to the increased number of communities in which the Company was operating, the geographic expansion of the Company's homebuilding operations, the increase in the number of homes sold and the expansion of the Company's ancillary businesses. As a percentage of revenues, SG&A in fiscal 1999 was slightly higher than in 1998. FISCAL 1998 COMPARED TO FISCAL 1997 Home Sales Revenues from home sales of $1.2 billion for fiscal 1998 exceeded fiscal 1997 revenues by $238 million or 25%. The increase was primarily due to a 23% increase in the number of homes delivered. The increase in the number of homes delivered was the result of the higher backlog of homes at the beginning of fiscal 1998 as compared to the beginning of fiscal 1997 and an increase in the number of homes sold during fiscal 1998 over the number of homes sold in fiscal 1997. The Company signed $1.38 billion (3,387 homes) of new sales contracts in fiscal 1998, a 29% increase over the $1.07 billion (2,701 homes) of new sales contracts signed in fiscal 1997. The increase in new sales contracts signed in fiscal 1998 was the result of an increase in the average number of selling communities in 1998 compared to 1997, an increase in the number of homes sold per community and an increase in the average sales price per home. The increase in the number of selling communities was the result of the Company's expansion in its newer markets and its entry into the Las Vegas market in November 1997. The increase in the average sales price per home was the result of the shift in the location of homes sold to more expensive areas, a change in product mix to larger homes, an increase in base selling prices and an increase in the total price of options that homebuyers selected. Home costs were higher as a percentage of home revenues in fiscal 1998 as compared to fiscal 1997 due to increased material costs and increased costs in the Company's newer markets resulting from generally higher construction costs as a percentage of selling price, and the relatively less efficient construction and construction-related activities, in these markets. Although the Company became more efficient in its newer markets during fiscal 1998, as compared to fiscal 1997, the increase in revenues from these newer markets as a percentage of total revenues resulted in the increase in the overall percentage of land and construction costs as a percentage of revenues. These increases were partially offset by decreased land and land development costs and decreased overhead costs. SG&A amounted to $106.7 million in fiscal 1998, a 24% increase over the $86.3 million spent in fiscal 1997. The increase in spending was primarily attributable to the increase in the number of homes delivered, the increased number of selling communities and the Company's continued geographic expansion. As a percentage of revenues, SG&A declined slightly in fiscal 1998 as compared to fiscal 1997 due to revenues increasing at a faster rate then spending. INTEREST EXPENSE The Company determines interest expense on a specific lot-by-lot basis for its homebuilding operations and on a parcel-by-parcel basis for its land sales. As a percentage of total revenues, interest expense will vary depending on many factors including the period of time that the land was owned, the length of time that the homes delivered during the period were under construction, and the interest rates and the amount of debt carried by the Company in proportion to the amount of its inventory during those periods. As a percentage of total revenues, interest expense was lower in fiscal 1999 as compared to 1998 and 1997. INCOME TAXES Income taxes for fiscal 1999, 1998, and 1997 were provided at effective rates of 36.7%, 36.1% and 37.0%, respectively. EXTRAORDINARY LOSS FROM EXTINGUISHMENT OF DEBT In January 1999, the Company called for redemption all of its outstanding 9 1/2% Senior Subordinated Notes due 2003 at 102% of principal amount plus accrued interest. The redemption resulted in the recognition of an extraordinary loss in 1999 of $1,461,000, net of $857,000 of income tax benefit. The loss represented the redemption premium and a write-off of unamortized deferred issuance costs. In February 1998, the Company entered into a five-year bank credit facility. The Company recognized an extraordinary charge in 1998 of $1,115,000, net of $655,000 of income tax benefit, related to the retirement of its previous revolving credit agreement and prepayment of $62 million of fixed rate long-term bank loans. In January 1997, the Company called for redemption all its outstanding 10 1/2% Senior Subordinated Notes due 2002 at 103% of principal amount plus accrued interest. The redemption resulted in an extraordinary loss in 1997 of $2,772,000, net of $1,659,000 of income tax benefit. CAPITAL RESOURCES AND LIQUIDITY Funding for the Company's operations has been principally provided by cash flows from operations, unsecured bank borrowings and, from time to time, the public debt and equity markets. Cash flow from operations, before inventory additions, has improved as operating results have improved. The Company anticipates that the cash flow from operations, before inventory additions, will continue to improve as a result of an increase in revenues from the delivery of homes from its existing backlog as well as from new sales contracts and from land sales. The Company has used the cash flow from operations, bank borrowings and public debt to acquire additional land for new communities, to fund additional expenditures for land development and construction costs needed to meet the requirements of the increased backlog and continuing expansion of the number of communities in which the Company is offering homes for sale, and to reduce debt. The Company expects that inventories will continue to increase and is currently negotiating and searching for additional opportunities to obtain control of land for future communities. The Company has a $440 million unsecured revolving credit facility with fifteen banks which extends through February 2003. As of October 31, 1999, the Company had $80 million of loans and approximately $34 million of letters of credit outstanding under the facility. The Company believes that it will be able to fund its activities through a combination of existing cash reserves, operating cash flow and other sources of credit similar in nature to those the Company has accessed in the past. INFLATION The long-term impact of inflation on the Company is manifested in increased land, land development, construction and overhead costs, as well as in increased sales prices. The Company generally contracts for land significantly before development and sales efforts begin. Accordingly, to the extent land acquisition costs are fixed, increases or decreases in the sales prices of homes may affect the Company's profits. Since the sales prices of homes are fixed at the time of sale and the Company generally sells its homes prior to commencement of construction, any inflation of costs in excess of those anticipated may result in lower gross margins. The Company generally attempts to minimize that effect by entering into fixed-price contracts with its subcontractors and material suppliers for specified periods of time, which generally do not exceed one year. Housing demand, in general, is adversely affected by increases in interest costs, as well as in housing costs. Interest rates, the length of time that land remains in inventory, and the proportion of inventory that is financed affect the Company's interest costs. If the Company is unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting prospective buyers' ability to adequately finance a home purchase, the Company's revenues, gross margins and net income would be adversely affected. Increases in sales prices, whether the result of inflation or demand, may affect the ability of prospective buyers to afford a new home. YEAR 2000 READINESS DISCLOSURE The Company has assessed its operating systems, computer software applications, computer equipment and other equipment with embedded electronic circuits ("Programs") that it currently uses to identify whether they are Year 2000 compliant and, if not, what steps are needed to bring them into compliance. The Company expects that all material Programs will be Year 2000 compliant by the end of calendar 1999. The costs incurred and expected to be incurred regarding Year 2000 compliance have been, and are expected to be, immaterial to the results of operations and financial position of the Company. Costs related to Year 2000 compliance are expensed as incurred. The Company has been reviewing whether its significant subcontractors, suppliers, financial institutions and other providers of goods and services ("Providers") are Year 2000 compliant. The Company is not aware of any Providers that do not expect to be compliant; however, the Company has no means of ensuring that its Providers will be Year 2000 ready. The inability of Providers to be Year 2000 ready in a timely fashion could have an adverse impact on the Company. The Company plans to respond to any such contingency involving any of its Providers by seeking to utilize alternative sources for such goods and services, where practicable. In addition, widespread disruptions in the national or international economy, including, for example, disruptions affecting financial markets, commercial and investment banks, governmental agencies and utility services, such as heat, lights, power and telephones, could also have an adverse impact on the Company. The likelihood and effects of such disruptions are not determinable at this time. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements, listed in Item 14(a)(1) and (2), which appear at pages through of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following is incorporated herein by reference: the information in Part I, Item 4 of this report immediately following the caption "Executive Officers of the Registrant"; the information in the Company's Proxy Statement for the 2000 Annual Meeting of Stockholders (the "2000 Proxy Statement") immediately following the caption "Election of Three Directors for Terms Ending 2003" to but not including the subcaption "Election of Three Directors for terms Ending 2003 - Meetings and Committees of the Board of Directors"; and the information in the 2000 Proxy Statement immediately following the caption "Section 16(a) Beneficial Ownership Reporting Compliance" to but not including the caption "Certain Transactions". ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following information is incorporated herein by reference: the information in the 2000 Proxy Statement in the section captioned "Proposal One - Election of Three Directors for Terms Ending 2003 - Compensation of Directors", and the information in the 2000 Proxy Statement immediately following the caption "Executive Compensation" to but not including the sub-caption "Executive Compensation - Formation of Real Estate Entities". ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the 2000 Proxy Statement immediately following the sub-caption "Voting Securities and Security Ownership - Security Ownership of Principal Stockholders and Management" to but not including the caption "Proposal One - Election of Three Directors for Terms Ending 2003" is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The following information is incorporated herein by reference: the information in the 2000 Proxy Statement in the section sub-captioned "Executive Compensation - Formation of Real Estate Entities"; the information in the 2000 Proxy Statement immediately following the caption "Certain Transactions" to but not including the caption "Stockholder Proposals"; and the information in the 2000 Proxy Statement immediately following the sub-caption "Executive Compensation - Compensation Committee Interlocks and Insider Participation" to but not including the sub-caption "Executive Compensation - Formation of Real Estate Entities". PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements and Financial Statement Schedule 1. Financial Statements Page Report of Independent Auditors Consolidated Statements of Income for the Years Ended October 31, 1999, 1998 and 1997 Consolidated Balance Sheets as of October 31, 1999 and 1998 Consolidated Statements of Cash Flows for the Years Ended October 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements - Summary Consolidated Quarterly Financial Data 2. Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts for the Years Ended October 31, 1999, 1998 and 1997 Schedules not listed above have been omitted because they are either not applicable or the required information is included in the financial statements or notes thereto. 3. Exhibits The following exhibits are included with this report or incorporated herein by reference: Exhibit Number Description 3.1 Certificate of Incorporation, as amended, is hereby incorporated by reference to Exhibit 3.1 of the Registrant's Form 10-K for the fiscal year ended October 31, 1989. 3.2 Amendment to the Certificate of Incorporation dated March 11, 1993, is hereby incorporated by reference to Exhibit 3.1 of Registrant's Form 10-Q for the quarter ended January 31, 1993. 3.3 By-laws, as amended, are hereby incorporated by reference to Exhibit 3.2 of the Registrant's Form 10-K for the fiscal year ended October 31, 1989. 4.1 Specimen Stock Certificate is hereby incorporated by reference to Exhibit 4.1 of the Registrant's Form 10-K for the fiscal year ended October 31, 1991. 4.2 Indenture dated as of March 15, 1993, among Toll Corp., as issuer, the Registrant, as guarantor, and NBD Bank, National Association, as Trustee, including Form of Guarantee, is hereby incorporated by reference to Exhibit 4.1 of Toll Corp.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission, March 10, 1993, File No. 33-58350. 4.3 Indenture dated as of November 12, 1996 between Toll Corp., as issuer, the Registrant, as guarantor, NBD Bank, a Michigan banking corporation, as Trustee, including form of guarantee, is hereby incorporated by reference to Exhibit 4.1 of the Registrant's Form 8-K dated November 6, 1996 filed with the Securities and Exchange Commission. 4.4 Authorizing Resolutions, dated as of November 6, 1996, relating to the $100,000,000 principal amount of 8 3/4% Senior Subordinated Notes of Toll Corp. due 2006, guaranteed on a Senior Subordinated Basis by Toll Brothers, Inc., is hereby incorporated by reference to Exhibit 4.2 of the Registrant's Form 8-K filed on November 15, 1996 with the Securities and Exchange Commission. Exhibit Number Description 4.5 Authorizing Resolutions, dated as of September 16, 1997, relating to the $100,000,000 principal amount of 7 3/4% Senior Subordinated Notes due 2007 of Toll Corp., guaranteed on a Senior Subordinated basis by Toll Brothers, Inc. is hereby incorporated by reference to Exhibit 4.5 of the Registrant's Form 10-K for the fiscal year ended October 31, 1997. 4.6 Authorizing Resolutions, dated as of January 22, 1999, relating to the $170,000,000 principal amount of 8.125% Senior Subordinated Notes of Toll Corp. Due 2009, guaranteed on a Senior Subordinated basis by Toll Brothers, Inc., is hereby incorporated by reference to Exhibit 4.1 of the Registrant's Form 8-K filed on January 25, 1999 with the Securities and Exchange Commission. 4.7 Authorizing Resolutions, dated as of April 13, 1999, relating to $100,000,000 principal amount of 8% Senior Subordinated Notes of Toll Corp. Due 2009, guaranteed on a Senior Subordinated basis by Toll Brothers, Inc. is hereby incorporated by reference to Exhibit 4.1 of the Registrant's Form 8-K filed on April 14, 1999 with the Securities and Exchange Commission. 4.8 Rights Agreement dated as of June 12, 1997 by and between the Company and ChaseMellon Shareholder Service, L.L.C., as Rights Agent, is hereby incorporated by reference to Exhibit 1 to the Company's Registration Statement on Form 8A dated June 20, 1997. 4.9 Amendment to Rights Agreement dated as of July 31, 1998, by and between the Company and ChaseMellon Shareholder Service, L.L.C. as Rights Agent incorporated herein by reference to Exhibit 1 to the Company's Registration Statement on Form 8-A/A dated August 21, 1998. 10.1 Credit Agreement dated as of February 25, 1998 among First Huntingdon Finance Corp., The Registrant, The First National Bank of Chicago, (Administrative Agent); Bank of America National Trust and Savings Association; (Co-Agent); CoreStates Bank, N.A., (Co-Agent); Credit Lyonnais New York Branch (Co-Agent); Comerica Bank; Nationsbank, National Association; Fleet National Bank; Guaranty Federal Bank, F.S.B.; Mellon Bank, N.A.; Banque Paribas; Bayerische Vereinsbank AG, New York Branch; Kredietbank N.V.; Suntrust Bank, Atlanta; The Fuji Bank Limited; and Bank Hapoalim B.M. Philadelphia Branch is hereby incorporated by reference to Exhibit 10.1 of the Registrant's Form 10-Q for the quarter ended April 30, 1998. Exhibit Number Description 10.2* Toll Brothers, Inc. Amended and Restated Stock Option Plan (1986), as amended and restated by the Registrant's Board of Directors on February 24, 1992 and adopted by its shareholders on April 6, 1992, is hereby incorporated by reference to Exhibit 19(a) of the Registrant's Form 10-Q for the quarterly period ended April 30, 1992. 10.3* Toll Brothers, Inc. Amended and Restated Stock Purchase Plan is hereby incorporated by reference to Exhibit 4 of the Registrant's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on August 4, 1987, File No. 33-16250. 10.4* Toll Brothers, Inc. Key Executives and Non-Employee Directors Stock Option Plan (1993) is hereby incorporated by reference to Exhibit 10.1 of the Registrant's Form 8K filed with the Securities and Exchange Commission on May 25, 1994. 10.5* Amendment to the Toll Brothers, Inc. Key Executives and Non-Employee Directors Stock Option Plan (1993) is hereby incorporated by reference to Exhibit 10.2 of the Registrant's's Quarterly Report on Form 10-Q for the quarter ended April 30, 1995. 10.6* Toll Brothers, Inc. Cash Bonus Plan is hereby incorporated by reference to Exhibit 10.2 of the Registrant's Form 8-K filed with the Securities and Exchange Commission on May 25, 1994. 10.7* Amendment to the Toll Brothers, Inc. Cash Bonus Plan dated May 29, 1996 is hereby incorporated by reference to Exhibit 10.7 of the Registrant's Form 10-K for the year ended October 31, 1996. 10.8* Amendment to the Toll Brothers, Inc. Cash Bonus Plan dated December 10, 1998. 10.9* Toll Brothers, Inc. Stock Option and Incentive Stock Plan (1995) is hereby incorporated by reference to Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended April 30, 1995. 10.10* Amendment to the Toll Brothers, Inc. Stock Option and Incentive Stock Plan (1995) dated May 29, 1996 is hereby incorporated by reference to Exhibit 10.9 the Registrant's Form 10-K for the year ended October 31, 1997. Exhibit Number Description 10.11* Toll Brothers, Inc. Stock Incentive Plan (1998) is hereby incorporated by reference to Exhibit 4 of the Registant's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on June 25, 1998, File No. 333-57645. 10.12* Stock Redemption Agreement between the Registrant and Robert I. Toll, dated October 28, 1995, is hereby incorporated by reference to Exhibit 10.7 of the Registrants Form 10-K for the year ended October 31, 1995. 10.13* Stock Redemption Agreement between the Registrant and Bruce E. Toll, dated October 28, 1995, is hereby incorporated by reference to Exhibit 10.8 of the Registrants Form 10-K for the year ended October 31, 1995. 10.14* Agreement dated March 5, 1998 between the Registrant and Bruce E. Toll regarding Mr. Toll's resignation and related matters is hereby incorporated by reference to Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended April 30, 1998. 10.15* Consulting and Non-Competition Agreement dated March 5, 1998 between the Registrant and Bruce E. Toll is hereby incorporated by reference to Exhibit 10.3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended April 30, 1998. 10.16* Agreement between the Registrant and Joel H. Rassman, dated June 30, 1988, is hereby incorporated by reference to Exhibit 10.8 of Toll Corp.'s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on September 9, 1988, File No. 33-23162. 12 Statement RE: Computation of Ratios of Earnings to Fixed Charges. 22 Subsidiaries of the Registrant. 23 Consent of Independent Auditors. 27 Financial Data Schedule. *This exhibit is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this report. (b) Reports on Form 8-K During the fourth quarter of the fiscal year ended October 31,1999, the Company did not file a current report on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the Township of Lower Moreland, Commonwealth of Pennsylvania on December 13, 1999. TOLL BROTHERS, INC. By: /s/ Robert I. Toll Robert I. Toll Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Robert I. Toll Chairman of the Board December 13, 1999 Robert I. Toll of Directors and Chief Executive Officer (Principal Executive Officer) /s/ Bruce E. Toll Vice Chairman of the Board December 13, 1999 Bruce E. Toll and Director /s/ Zvi Barzilay President, Chief Operating December 13, 1999 Zvi Barzilay Officer and Director /s/ Joel H. Rassman Senior Vice President, December 13, 1999 Joel H. Rassman Treasurer, Chief Financial Officer and Director (Principal Financial Officer) /s/ Joseph R. Sicree Vice President and December 13, 1999 Joseph R. Sicree Chief Accounting Officer (Principal Accounting Officer) Signature Title Date /s/ Robert S. Blank Director December 13, 1999 Robert S. Blank /s/ Richard J. Braemer Director December 13, 1999 Richard J. Braemer /s/ Roger S. Hillas Director December 13, 1999 Roger S. Hillas /s/ Carl B. Marbach Director December 13, 1999 Carl B. Marbach /s/ Paul E. Shapiro Director December 13, 1999 Paul E. Shapiro REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Toll Brothers, Inc. We have audited the accompanying consolidated balance sheets of Toll Brothers, Inc. and subsidiaries at October 31, 1999 and 1998, and the related consolidated statements of income, and cash flows for each of the three years in the period ended October 31, 1999. Our audits also included the financial statement schedule listed in the Index at item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Toll Brothers, Inc. and subsidiaries at October 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended October 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP Philadelphia, Pennsylvania December 13, 1999 * Due to rounding, the amounts may not add. See accompanying notes. See accompanying notes. See accompanying notes. Notes to Consolidated Financial Statements 1. Significant Accounting Policies Basis of Presentation The accompanying consolidated financial statements include the accounts of Toll Brothers, Inc. (the "Company"), a Delaware corporation, and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain amounts reported in prior years have been reclassified for comparative purposes. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Income Recognition The Company is primarily engaged in the development, construction and sale of residential homes. Revenues and cost of sales are recorded at the time each home sale is closed and title and possession have been transferred to the buyer. Closing normally occurs shortly after construction is substantially completed. Cash and Cash Equivalents Liquid investments or investments with original maturities of three months or less are classified as cash equivalents. The carrying value of these investments approximates their fair value. Property, Construction and Office Equipment Property, construction and office equipment are recorded at cost and are stated net of accumulated depreciation of $25,761,000 and $21,938,000 at October 31, 1999 and 1998, respectively. Depreciation is recorded by using the straight- line method over the estimated useful lives of the assets. Inventories Inventories are stated at the lower of cost or fair value. In addition to direct land acquisition, land development and home construction costs, costs include interest, real estate taxes and direct overhead costs related to development and construction, which are capitalized to inventories during the period beginning with the commencement of development and ending with the completion of construction. Land, land development and related costs are amortized to cost of homes closed based upon the total number of homes to be constructed in each community. Home construction and related costs are charged to cost of homes closed under the specific identification method. The Company capitalizes certain project marketing costs and charges them against income as homes are closed. Treasury Stock Treasury stock is recorded at cost. Re-issuances of treasury stock are accounted for on a first-in, first out basis. Differences between the cost of treasury shares and the re-issuance proceeds are charged to additional paid-in capital. Acquisition In March 1999, the Company acquired the homebuilding operations of the Silverman Companies, a Detroit, Michigan homebuilder and developer of luxury apartments, for cash and the assumption of debt. The Silverman Companies owned or controlled approximately 1,800 homesites and interests in over 1,000 existing and prospective apartments. The acquisition of the Silverman apartment assets is expected to be completed during the first half of fiscal 2000. The acquisition price is not material to the financial position of the Company. Segment Reporting Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," establishes standards for the manner in which public enterprises report information about operating segments. The Company has determined that its operations primarily involve one reportable segment, homebuilding. Construction in progress includes the cost of homes under construction, land and land development costs and the carrying cost of lots that have been substantially improved. For the years ended October 31, 1999, 1998, and 1997, the Company provided for inventory writedowns and the expensing of costs which it believed not to be recoverable of $5,092,000, $2,010,000, and $2,048,000, respectively. The Company has a $440,000,000 unsecured revolving credit facility with fifteen banks which extends through February 2003. Interest is payable on borrowings at .575% above the Eurodollar rate or at other specified variable rates as selected by the Company from time to time. The Company fixed the interest rate on $20,000,000 of borrowing at 6.39% until March 2002 through an interest rate swap with a bank. Had the Company not entered into the interest rate swap, the interest rate on this borrowing would have been 6% at October 31, 1999. As of October 31, 1999, letters of credit and obligations under escrow agreements of $34,444,000 were outstanding. The agreement contains various covenants, including financial covenants related to consolidated stockholders' equity, indebtedness and inventory. The agreement requires the Company to maintain a minimum consolidated stockholders' equity which restricts the payment of cash dividends and the repurchase of Company stock to approximately $206,865,000 as of October 31, 1999. The Company borrowed $56,000,000 from six banks at a fixed interest rate of 7.91% repayable in July 2001. The Company borrowed $50,000,000 from three banks at a fixed rate of 7.72% repayable in March 2002. Both loans are unsecured and the agreements contain substantially the same financial covenants as the Company's revolving credit facility. All issues of senior subordinated notes are subordinated to all senior indebtedness of the Company. The indentures restrict certain payments by the Company including cash dividends and the repurchase of Company stock. The notes are redeemable in whole or in part at the option of the Company at various prices on or after November 15, 2001 with regard to the 8 3/4% notes, on or after September 15, 2002 with regard to the 7 3/4% notes, on or after February 1, 2004 with regard to the 8 1/8% notes, and on or after May 1, 2004 with regard to the 8% notes. As of October 31, 1999, the aggregate fair value of all the outstanding subordinated notes, based upon their quoted market prices, was approximately $440,150,000. The annual aggregate maturities of the Company's loans and notes during the next five fiscal years are: 2000 - $12,453,000; 2001 - $66,767,000; 2002 - $52,065,000; 2003 - $82,032,000 and 2004 - $0. 4. Income taxes The Company's estimated combined federal and state tax rate before providing for the effect of permanent book-tax differences ("Base Rate") was 37% in 1999 and 1998, and 37.5% in 1997. The decrease in the Base Rate was due to a decrease in the Company's estimated effective state tax rate. The effective tax rates in 1999, 1998, and 1997 were 36.7%, 36.1% and 37.0%, respectively. The primary differences between the Company's Base Rate and effective tax rate were tax-free income, and in 1998, an adjustment due to the recomputation of the Company's deferred tax liability resulting from the change in the Company's estimated Base Rate and the deductibility of certain expenses at a higher basis for tax purposes than for book purposes. 5. Stockholders' Equity The Company's authorized capital stock consists of 45,000,000 shares of Common Stock, $.01 par value per share, and 1,000,000 shares of Preferred Stock, $.01 par value per share. The Company's Certificate of Incorporation, as amended, authorizes the Board of Directors to increase the number of authorized shares of Common Stock to 100,000,000 shares and the number of shares of authorized Preferred Stock to 15,000,000 shares. Changes in stockholders' equity for the three years ended October 31, 1999 were as follows (amounts in thousands): Additional Common Stock Paid-In Retained Treasury Shares Amount Capital Earnings Stock Total [S] [C] [C] [C] [C] [C] [C] Balance, November 1, 1996 33,919 $339 $43,018 $271,320 $ - $314,677 Net Income 65,075 65,075 Exercise of stock options 218 2 3,121 3,123 Executive bonus awards 134 2 2,293 2,295 Employee stock plan purchases 4 82 82 Balance, October 31, 1997 34,275 343 48,514 336,395 - 385,252 Net income 84,704 84,704 Purchase of treasury stock (133) (1) (3,346) (3,347) Exercise of stock options 285 3 3,240 1,405 4,648 Executive bonus award 161 1 3,563 3,564 Employee stock plan purchases 10 93 130 223 Conversion of debt 2,337 23 50,689 50,712 Balance, October 31, 1998 36,935 369 106,099 421,099 (1,811) 525,756 Net income 101,566 101,566 Purchase of treasury stock (801) (8) (16,696) (16,704) Exercise of stock options 177 2 (1,143) 3,699 2,558 Executive bonus award 106 1 342 2,119 2,462 Employee stock plan purchases 12 (15) 221 206 Contribution to employee 401(k) Plan 25 1 (44) 533 490 Balance, October 31, 1999 36,454 $ 365 $105,239 $522,665$( 11,935)$616,334 Stockholder Rights Plan The Company's stockholder rights plan, as amended, provides for a dividend of one right for each share of Common Stock of the Company to all stockholders of record at the close of business on July 11, 1997. The rights are not currently exercisable, but would become exercisable if certain events occurred relating to a person or group acquiring or attempting to acquire beneficial ownership of 15% or more of the Common Stock of the Company subsequent to July 11, 1997. If any person acquires 15% or more of the Common Stock of the Company, each right, will entitle the holder to acquire, upon payment of the exercise price of the right (presently $100), Common Stock of the Company having a market value equal to twice the right's exercise price. If, after a person has acquired 15% or more of the outstanding Common Stock of the Company, the Company is acquired in a merger or other business combination, or 50% or more of its assets or earning power is sold or transferred in one transaction or a series of related transactions, each right becomes a right to acquire common shares of the other party to the transaction having a value equal to twice the exercise price of the right. Rights are redeemable at $.001 per right by action of the Board of Directors at any time prior to the tenth day following the public announcement that a person or group, has acquired beneficial ownership of 15% or more of the Common Stock of the Company. Unless earlier redeemed, the rights will expire on July 11, 2007. Redemption of Common Stock In order to help provide for an orderly market in the Company's Common Stock in the event of the death of either Robert I. Toll or Bruce E. Toll (the "Tolls"), or both of them, the Company and the Tolls have entered into agreements in which the Company has agreed to purchase from the estate of each of the Tolls $10,000,000 of the Company's Common Stock (or a lesser amount under certain circumstances) at a price equal to the greater of fair market value (as defined) or book value (as defined). Further, the Tolls have agreed to allow the Company to purchase $10,000,000 of life insurance on each of their lives. In addition, the Tolls granted the Company an option to purchase up to an additional $30,000,000 (or a lesser amount under certain circumstances) of the Company's Common Stock from each of their estates. The agreements expire in October 2005. In April 1997, the Company's Board of Directors authorized the repurchase of up to 3,000,000 shares of its Common Stock, par value $.01, from time to time, in open market transactions or otherwise, for the purpose of providing shares for its various employee benefit plans. As of October 31, 1999, the Company had repurchased 935,000 shares of which 354,000 shares have been re-issued under its various employee benefit plans. 6. Stock-Based Benefit Plans Stock-Based Compensation Plans The Company accounts for its stock option plans according to Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" ("APB 25"). Accordingly, no compensation costs are recognized upon issuance or exercise of stock options. Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation"("FAS 123"), requires the disclosure of the estimated value of employee option grants and their impact on net income using option pricing models which are designed to estimate the value of options which, unlike employee stock options, can be traded at any time and are transferable. In addition to restrictions on trading, employee stock options may include other restrictions such as vesting periods. Further, such models require the input of highly subjective assumptions including the expected volatility of the stock price. Therefore, in management's opinion, the existing models do not provide a reliable single measure of the value of employee stock options. The effects of applying FAS 123 for the purposes of providing pro forma disclosures may not be indicative of the effects on reported net income and net income per share for future years, as the pro forma disclosures include the effects of only those awards granted on or after November 1, 1995. Stock Option Plans The Company's four stock option plans for employees, officers and non-employee directors provide for the granting of incentive stock options and non-statutory options with a term of up to ten years at a price not less than the market price of the stock at the date of grant. The Company's Stock Option and Incentive Stock Plan (1995) provides for automatic increases each January 1 in the number of shares available for grant by 2% of the number of shares outstanding (including treasury shares). The Company's Stock Incentive Plan (1998) provides for automatic increases each November 1 in the number of shares available for grant by 2.5% of the number of shares outstanding (including treasury shares). The 1995 Plan and the 1998 Plan restrict the number of options available for grant in a year to a maximum of 2,500,000 shares and the number of options that may be granted in a calendar year in each plan to the lesser of the number of shares available for grant or 2,500,000 shares. No additional options may be granted under the Company's Stock Option Plan (1986). Options exercisable and their weighted average exercise price as of October 31, 1999, 1998 and 1997 were 3,736,905 shares and $18.93, 3,286,706 shares and $17.90, and 2,336,186 shares and $13.99, respectively. Options available for grant at October 31, 1999, 1998 and 1997 under all the plans were 3,188,657, 3,893,663, and 2,412,372, respectively. Bonus Award Shares Under the terms of the Company's Cash Bonus Plan covering Robert I. Toll, Mr. Toll is entitled to receive cash bonus awards based upon the pretax earnings and stockholders' equity of the Company. In December 1998, Mr. Toll and the Board of Directors agreed that any bonus payable for each of the three fiscal years ended October 31, 2001 will be made (except for specific conditions) in shares of the Company's Common Stock using the value of the stock as of the date of the agreement ($24.25 per share). The stockholders approved the plan at the Company's 1999 Annual Meeting. The Company recognized compensation expense in 1999 of $1,395,000 which represented the fair market value of the shares issued to Robert. I. Toll (79,686 shares). On October 31, 1999, the closing price of the Company's Common Stock on the New York Stock Exchange was $17.50. In May 1996, the Board of Directors, Robert I. Toll and Bruce E. Toll agreed to a similar type of plan and payment arrangement for each of the three fiscal years ended October 31, 1998 based upon the value of the Company's Common Stock on the date of the agreement ($17.125 per share). The stockholders approved the plan at the Company's 1997 Annual Meeting. In March 1998, in connection with Bruce E. Toll's withdrawal from the day-to-day operations of the business, the Board of Directors and Bruce E. Toll agreed to modify his cash bonus award whereby his 1998 cash bonus award would be paid in cash and the amount would be calculated based upon 50% of the estimated bonus that would have been earned. The Company recognized $3,944,000 as compensation expense in 1998 which represented the fair market value of the shares issued to Robert I. Toll (106,186 shares) and the cash bonus paid to Bruce E. Toll. Robert I. Toll and Bruce E. Toll received 80,547 shares each for their 1997 bonus award. The 1997 award had a fair market value of $3,564,000 which the Company recognized as compensation expense in 1997. Employee Stock Purchase Plan The Company's Employee Stock Purchase Plan enables substantially all employees to purchase the Company's Common Stock for 95% of the market price of the stock on specified offering dates or at 85% of the market price of the stock on specified offering dates subject to restrictions. The plan, which terminates in December 2001, provides that 100,000 shares be reserved for purchase. As of October 31, 1999, a total of 39,551 shares were available for issuance. The number of shares and the average prices per share issued under this plan during each of the three fiscal years ended October 31, 1999, 1998 and 1997 were 12,182 shares and $16.97, 9,916 shares and $22.48, and 4,131 shares and $19.98, respectively. No compensation expense was recognized by the Company under this plan. 8. Employee Retirement Plan The Company maintains a salary deferral savings plan covering substantially all employees. The plan provides for Company contributions totaling 2% of all eligible compensation, plus 2% of eligible compensation above the social security wage base, plus matching contributions of up to 2% of eligible compensation of employees electing to contribute via salary deferrals. Company contributions with respect to the plan totaled $1,876,000, $1,591,000, and $1,399,000 for the years ended October 31, 1999, 1998 and 1997, respectively. 9. Extraordinary Loss from Extinguishment of Debt In January 1999, the Company called for redemption of all of its outstanding 9 1/2% Senior Subordinated Notes due 2003 at 102% of principal amount plus accrued interest. The redemption resulted in an extraordinary loss in fiscal 1999 of $1,461,000, net of $857,000 of income tax benefit. The loss represented the redemption premium and a write-off of unamortized deferred issuance costs. In February 1998, the Company entered into a five-year bank credit facility. The Company recognized an extraordinary charge in fiscal 1998 of $1,115,000, net of $655,000 of income tax benefit, related to the retirement of its previous revolving credit agreement and prepayment of $62 million of fixed rate long-term bank loans. In January 1997, the Company called for redemption of all of its outstanding 10 1/2% Senior Subordinated Notes due 2002 at 103% of principal amount plus accrued interest. The redemption resulted in an extraordinary loss in fiscal 1997 of $2,772,000, net of $1,659,000 of income tax benefit. The loss represented the redemption premium and the write-off of unamortized deferred issuance costs. 10. Commitments and Contingencies As of October 31, 1999, the Company had agreements to purchase land and improved homesites for future development with purchase prices aggregating approximately $512,904,000 of which $30,020,000 had been paid or deposited. Purchase of the properties is contingent upon satisfaction of certain requirements by the Company and the sellers. As of October 31, 1999, the Company had agreements of sale outstanding to deliver 2,381 homes with an aggregate sales value of approximately $1,067,685,000. As of that date, the Company had arranged, through a number of outside mortgage lenders, approximately $400,819,000 of mortgages related to those sales agreements. The Company is involved in various claims and litigation arising in the ordinary course of business. The Company believes that the disposition of these matters will not have a material effect on the business or on the financial condition of the Company. 11. Related Party Transaction In 1998, the Company formed a group of entities (collectively, the "Real Estate Group")to take advantage of commercial real estate opportunities which may present themselves from time to time. These opportunities may involve commercial parcels, attached to larger properties that the Company has acquired or may acquire for its homebuilding operations, or from the direct acquisition of unrelated land or operating properties. In November 1998, Robert I. Toll, Bruce E. Toll, Zvi Barzilay, Joel Rassman, all of whom are officers and directors of the Company, and other Company officers (the "Partners") contributed their partnership interests in an apartment complex under construction in exchange for a 50% ownership interest in the Real Estate Group. Based upon independent valuations obtained by the Company and reviewed by the Board of Directors, the Board of Directors believes that the value of the assets received, net of liabilities assumed, was at least equal to the consideration given to the Partners. In December 1998, the Pennsylvania State Employees Retirement System ("PASERS") acquired a one-third interest in the Real Estate Group for $10,000,000. In fiscal 1999, the Company, the Partners and PASERS made additional cash contributions to acquire several office buildings. As of October 31, 1999, the Company had an investment of $7,285,000 which represented its one-third interest in the Real Estate Group. This investment is accounted for on the equity method. The Company provides development, finance and management services to the Real Estate Group and received fees under the terms of various agreements in the amount of $2,524,000 in fiscal 1999. (A) Represents amount of reserves utilized, which is recorded at the time that affected homes are closed. (B) Applied to asset carrying value.

886835_1999.txt

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1999

886835

ITEM 3. LEGAL PROCEEDINGS We are a party to various routine legal proceedings primarily involving commercial claims, workers' compensation claims and claims for personal injury under the General Maritime Laws of the United States and the Jones Act. We insure against these risks to the extent deemed prudent by our management, but no assurance can be given that the nature and amount of such insurance will in every case fully indemnify us against liabilities arising out of pending and future legal proceedings related to our business activities. While the outcome of these lawsuits, legal proceedings and claims cannot be predicted with certainty, our management believes that the outcome of all such proceedings, even if determined adversely, would not have a material adverse effect on our business or financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 4A. EXECUTIVE OFFICERS OF REGISTRANT The following table sets forth certain information about our executive officers. TERENCE E. HALL has served as our Chairman of the Board, Chief Executive Officer, President and Director since December 1995. Since 1989 he also served as President and Chief Executive Officer of the following wholly- owned subsidiaries of Superior: Superior Well Service, Inc. and Connection Technology, Ltd. KENNETH BLANCHARD has served as one of our Vice Presidents since December 1995. Prior to this, he served as Vice President of Connection Technology, Ltd. CHARLES FUNDERBURG has served as one of our Vice Presidents since December 1995. Prior to this, he served as Vice President of Superior Well Service, Inc. ROBERT S. TAYLOR has served as our Chief Financial Officer since January 1996. From May 1994 to January 1996, he served as Chief Financial Officer of Kenneth Gordon (New Orleans), Ltd., an apparel manufacturer. From November 1989 to May 1994, he served as Chief Financial Officer of Plywood Panels, Inc. Prior thereto, Mr. Taylor served as controller for Plywood Panels, Inc. and Corporate Accounting Manager of D.H. Holmes Company, Ltd., a department store chain. JAMES A. HOLLEMAN has served as a Vice President since July 1999. From 1994 until July 1999, he served as Chief Operating Officer of Cardinal and has been active in Cardinal's business since 1981. Prior thereto, he was employed by Reading and Bates in Houston, Texas and Industrial Lift Trucks, Inc. in Lafayette, Louisiana. DALE L. MITCHELL has served as a Vice President since July 1999. From 1998 until July 1999, he served as Vice President of Marine Services of Cardinal. Prior to 1998, he served in numerous operational and managerial roles within Cardinal's Marine Services division. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock is traded on the Nasdaq National Market under the symbol "SESI." The following table sets forth the high and low bid prices per share of the Common Stock as reported by the Nasdaq National Market for each fiscal quarter during the past two fiscal years. As of March 15, 2000, there were 59,926,289 shares of Common Stock outstanding, which were held by approximately 165 record holders. We intend to retain all of the cash our business generates to meet our working capital requirements and fund future growth. We do not plan to pay cash dividends on our common stock in the foreseeable future. In addition, our credit facility prevents us from paying dividends or making other distributions to our stockholders. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data presented below for each of the past five fiscal years should be read together with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and Notes to Consolidated Financial Statements included elsewhere in this Annual Report. All amounts in the table below are in thousands, except per share data. (1) On July 15, 1999, we acquired Cardinal through a merger by issuing 30,239,568 shares of our common stock. Because Cardinal's shareholders held 51% of our outstanding common stock immediately after the merger, among other factors, the merger has been accounted for as a reverse acquisition which has resulted in the adjustment of our net assets existing at the time of the merger to their estimated fair value as required by the rules of purchase accounting. Our operating results have been included from July 15, 1999. Effective November 1, 1999, we acquired Production Management Companies, Inc. for $3.0 million in cash and 610,000 shares of our common stock. Additional payments, if any, of up to $11 million will be based upon a multiple of Production Management's future earnings before interest, taxes, depreciation and amortization. The acquisition was accounted for as a purchase, and Production Management's operating results have been included from November 1, 1999. (2) In 1998, Cardinal acquired all of the outstanding stock of three companies for an aggregate purchase price of $24.1 million with a combination of cash and stock as consideration for the acquisitions. Each of these acquisitions was accounted for using the purchase method and the results of operations of the acquired companies have been included from their respective acquisition dates. (3) The repayment of our combined indebtedness in July 1999 in connection with the Cardinal acquisition resulted in an extraordinary loss of $4.5 million, net of a $2.1 million income tax benefit, which included the premium on Cardinal's subordinated debt and the write-off of all unamortized debt acquisition costs. (4) In February, 1998, Cardinal completed a recapitalization and refinancing which was funded through senior secured debt, subordinated debt and equity investments. As a result of the recapitalization, Cardinal recorded an increase in equity of $57.5 million from the issuance of Class A common stock and Class C preferred stock; incurred $7.1 million of costs associated with the debt acquisition and reduction to net proceeds from the issuance of stock; recorded a reduction in equity of $114.8 million from the redemption of Class A common stock and Class C preferred stock; and recorded an extraordinary loss of $10.9 million for the estimated value of warrants of $10.5 million and unamortized debt acquisition costs of $379,000 (net of $214,000 income tax benefit). (5) In October 1995, Cardinal refinanced various debt instruments and recorded an extraordinary loss of $1.3 million, net of a $0.8 million income tax benefit, which included a prepayment premium and the write- off of debt acquisition costs and interest rate cap agreement costs. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements included elsewhere in this Annual Report. The following information contains forward-looking statements, which are subject to risks and uncertainties. Should one or more of these risks or uncertainties materialize, our actual results may differ from those expressed or implied by the forward-looking statements. See "Cautionary Statements." ACQUISITION OF CARDINAL HOLDING CORP. On July 15, 1999, we acquired Cardinal Holding Corp. through its merger with one of our wholly-owned subsidiaries. The merger was treated for accounting purposes as if we were acquired by Cardinal in a purchase business transaction. The purchase method of accounting required that we carry forward Cardinal's net assets at their historical book value and reflect our net assets at their estimated fair value at the date of the merger. Accordingly, all historical financial information presented in the consolidated financial statements included in this Annual Report for periods prior to July 15, 1999 reflect Cardinal's results on a stand-alone basis. Cardinal's historical operating results were substantially different than ours for the same periods and reflected substantial non-cash and extraordinary charges associated with a recapitalization and refinancing. Our 1999 results reflect twelve months of Cardinal's operations, five and one-half months of our operations after the merger and two months of operations of Production Management Companies, Inc., which we acquired effective November 1, 1999. Consequently, analyzing prior period results to determine or estimate our future operating potential will be difficult given the accounting treatment of the Cardinal merger, our subsequent acquisition of Production Management and the substantial non- cash and extraordinary charges Cardinal incurred prior to the merger. OVERVIEW We provide a broad range of specialized oilfield services and equipment to oil and gas companies in the Gulf of Mexico and throughout the Gulf Coast region. These services and equipment include: * well services including P&A services, coiled tubing services, well pumping and stimulation services, data acquisition services, gas lift services and electric wireline services, * mechanical wireline services, * the rental of liftboats * the rental of specialized oilfield equipment, * environmental cleaning services, * field management services, and * the manufacture and sale of drilling instrumentation and oil spill containment equipment. Over the past few years, we have significantly expanded the geographic scope of our operations and the range of production related services that we provide through both internal growth and strategic acquisitions. In July 1999, we completed the Cardinal acquisition, and in November 1999, we completed the Production Management acquisition thereby making these companies two of our wholly-owned subsidiaries. These acquisitions firmly established us as a market leader in providing most offshore production related services using liftboats as work platforms and allowed us to expand our scope of operations to include offshore platform and property management services. The decline in drilling and workover activity in the Gulf of Mexico triggered by low oil prices that began in 1998 adversely affected our 1999 results of operations. Our operating results are directly tied to industry demand for our services, most of which are performed in the Gulf of Mexico. While we have focused on providing production related services where, historically, demand has not been as volatile as for exploration related services, we expect our operating results to be highly leveraged to industry activity levels in the Gulf of Mexico. For additional industry segment information for 1999, see note 13 to our consolidated financial statements. COMPARISON OF THE RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999 AND 1998. Our 1999 revenues were $113.1 million compared to $82.2 million for 1998. Due to the accounting treatment required for the Cardinal acquisition, our 1999 operating results reflected twelve months of Cardinal's operations, five and one-half months of our operations after the merger and two months of operations of Production Management. 1998 reflects only Cardinal's operations on a stand-alone basis. Even though we had increased revenues in 1999, we experienced decreased demand in 1999 in all of our operating segments as a result of low industry activity levels. As demand for our services decreased in 1999 compared to 1998, our gross margins decreased to 40.4% in 1999 from 46.6% in 1998. Our decreased gross margin percentage is primarily due to our marine segment acquired in the Cardinal acquisition. Since our marine segment's cost of services are primarily fixed in nature, our gross margin percentage may vary substantially due to changes in day rates and utilization of our liftboats. Our rental tool segment contributed our highest gross margin percentage in 1999 and partially offset the decrease on a comparative basis since Cardinal did not have a rental tool segment. Our wireline segment also experienced a decline in gross margin percentage in 1999 compared to 1998. Our field management segment, which was acquired in the Production Management acquisition, contributed our lowest gross margin percentage. Of all of our production related services, the field management segment is expected to produce the lowest gross margin percentage since its largest cost of sales component is providing contract labor. Depreciation and amortization increased to $12.6 million in 1999 from $6.5 million in 1998. Most of the increase resulted from the larger asset base following the merger and the Production Management acquisition. Depreciation also increased as a result of our $9.2 million of capital expenditures in 1999 and Cardinal's 1998 acquisitions. General and administrative expenses increased to $23.1 million in 1999 from $16.2 million in 1998. The increase is the result of Cardinal's expenses for twelve months, our expenses for five and one-half months and Production Management for two months. In July 1999, in connection with the Cardinal acquisition, we refinanced our combined debt, which resulted in an extraordinary charge of $4.5 million, net of income taxes of $2.1 million. The majority of the extraordinary charge was non-cash in nature. During 1998, Cardinal incurred extraordinary charges of $10.9 million, net of income taxes of $0.2 million, in connection with a recapitalization and refinancing. These charges were also mostly of a non-cash nature. We recorded a 1999 net loss before extraordinary charges of $2.0 million, or $0.11 loss per diluted share. After extraordinary charges, we recorded a net loss of $6.5 million, or $0.25 loss per diluted share, as compared to a net loss of $9.7 million, or $1.27 loss per diluted share, for 1998. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997 The results of operations for the years ended December 31, 1998 and 1997 were prior to our acquisition of Cardinal and, accordingly, reflect Cardinal's results on a stand-alone basis. We do not believe Cardinal's historical operating results under different management are relevant other than to demonstrate the operating leverage associated with our marine segment. In 1998, Cardinal's operating results began to be impacted by the decline in industry activity levels in the Gulf as a result of the decline in oil and gas prices. The 1998 third quarter was impacted by a nearly continuous series of storms and hurricanes that significantly curtailed activity in September 1998. Revenues for 1998 were $82.2 million as compared to $63.4 million for 1997. Approximately 60% of the increase was due to the additional products and services Cardinal began providing in 1998, including coiled tubing services, pumping and stimulation services and two additional 200 foot liftboats. The remaining 40% was the result of acquisitions made during 1998. The 1998 gross margin was 46.6% compared to 47.2% for 1997. Most of the decrease in gross margin was related to slightly higher labor costs associated with Cardinal's acquisitions and new services. Depreciation and amortization expenses increased to $6.5 million in 1998 from $4.2 million in 1997. Most of the increase resulted from the larger asset base that resulted from Cardinal's 1998 acquisitions as well as from 1998 capital expenditures of $19.0 million, primarily for marine vessels. General and administrative expenses were $16.2 million for 1998 as compared to $10.4 million for 1997. This increase was due to the acquisitions Cardinal made in 1998, additional sales expenses associated with an expanded marketing program, an increase in employee benefits and a one time stock award to management which was recorded as compensation expense. Interest expense increased 142% to $13.2 million for 1998 compared to $5.5 million for 1997. This increase resulted from Cardinal's higher debt levels following a recapitalization and refinancing. Other expenses for 1997 represent consulting fees that were paid to Cardinal's previous owner prior to the recapitalization. In 1998, Cardinal completed a recapitalization and refinancing which resulted in an extraordinary charge of $10.9 million, net of income taxes of $0.2 million, which included the unamortized estimated value of stock warrants that were redeemed for $10.5 million and unamortized financing costs of $0.4 million. LIQUIDITY AND CAPITAL RESOURCES Our primary liquidity needs are for working capital, acquisitions, capital expenditures and debt service. Our primary sources of liquidity are cash flow from operations and borrowings under our revolving credit facility. Our 1999 net cash provided by operating activities was $14.5 million as compared to $3.6 million for 1998. The increase was due principally to the merger with Cardinal and acquisition of Production Management Companies, Inc. Our working capital at December 31, 1999 was $25.2 million. We had cash and cash equivalents of $8.0 million at December 31, 1999. In December 1999, we received a $6.6 million insurance settlement that we will use to refurbish our liftboat that was damaged in September 1999. We have a term loan and revolving credit facility that was implemented in July 1999 to provide $110 million term loan to refinance our long-term debt after the Cardinal acquisition, provide a $20 million revolving credit facility and $22 million that we can use to pay additional contingent consideration from our prior acquisitions. We amended the credit facility in November 1999 to increase the term loan by $10 million to refinance Production Management's existing indebtedness and to pay the cash portion of the acquisition price. Under the credit facility, the term loan requires quarterly principal installments that commenced December 31, 1999 in the amount of $519,000 and then increasing up to an aggregate of approximately $1.6 million a quarter until 2006 when $92 million will be due and payable. The credit facility bears interest at a LIBOR rate plus margins that depend on our leverage ratio. As of March 1, 2000, the amount outstanding under the term loan was $119.5 million and there were no borrowings outstanding under the revolving credit facility. At December 31, 1999, the weighted average interest rate on the credit facility was 9.28%. Indebtedness under the credit facility is secured by substantially all of our assets, including the pledge of the stock of our subsidiaries. The credit facility contains customary events of default and requires that we maintain debt coverage and leverage ratios. It also limits our ability to make capital expenditures, pay dividends or make other distributions, make acquisitions, make changes to our capital structure, create liens or incur additional indebtedness. In November 1999, we acquired Production Management Companies, Inc. for $3.0 million in cash and 610,000 shares of our common stock. Up to $11.0 million will be potentially payable in the future based upon a multiple of four times Production Management's average earnings before interest, taxes, depreciation, amortization less certain other adjustments. If the overall current industry activity levels continue, the additional consideration actually paid will be materially less than the maximum consideration. In 1999, we made capital expenditures of $9.2 million primarily to further expand our rental tool equipment. Other capital expenditures included electric wireline skids, plug and abandonment equipment and capital improvements to our liftboats. In September of 1999, one of our two hundred foot class liftboats was damaged in the Gulf of Mexico. In late December 1999, we received a $6.6 million insurance settlement for the damage, which is expected to pay for the vessel's refurbishment. We have identified capital projects that will require approximately $25 million for 2000. We believe that cash generated from our operations and availability under our revolving credit facility will provide sufficient funds for our identified capital projects and working capital requirements. We expect to pay approximately $21.4 million in the fourth quarter of 2000 for additional consideration related to our 1997 acquisitions. The consideration will be capitalized as additional purchase price of the acquired companies, and we expect to use the $22 million portion of the credit facility, which was designed to fund these payments. We significantly increased our financial leverage in 1999 with the Cardinal and Production Management acquisitions. In 2000, if market conditions improve, we will consider issuing equity to reduce our financial leverage. We intend to continue implementing our acquisition strategy to increase our scope of services. Depending on the size of any future acquisitions, we may also require additional equity or debt financing in excess of amounts available under our revolving credit facility. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (FAS) No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. FAS No. 133, as amended, is effective for all fiscal quarters of fiscal years beginning after June 15, 2000 and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. FAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are to be recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Earlier application of the provisions of the Statement is encouraged and is permitted as of the beginning of any fiscal quarter that begins after the issuance of the Statement. We have not yet assessed the financial impact of adopting this statement. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to market risk associated with interest rates. We make limited use of derivative financial instruments to manage risks associated with existing or anticipated transactions. We do not hold derivatives for trading purposes or use derivatives with leveraged or complex features. Derivative instruments are traded with creditworthy major financial institutions. At December 31, 1999, we were a party to interest rate swaps with notional amounts totaling $46.2 million that were designed to convert a similar amount of variable-rate debt to fixed rates. The swaps mature in March 2001 and October 2002, and the weighted average fixed interest rate is 5.81%. At December 31, 1999, the interest rate to be received by us averaged 5.2%. We consider these swaps to be a hedge against potentially higher future interest rates. As described in Note 10 to the consolidated financial statements, we would have recognized a gain of an estimated $350,000 had we terminated these agreements at December 31, 1999. At December 31, 1999, $73.3 million of our long-term debt had variable interest rates. Based on debt outstanding at December 31, 1999, a 10% increase or (decrease) in variable interest rates would increase or (decrease) our interest expense inclusive of swaps in the year 2000 by approximately $0.9 million or $(0.8) million. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Superior Energy Services, Inc.: We have audited the consolidated balance sheet of Superior Energy Services, Inc. and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for the year then ended. In connection with our audit of the consolidated financial statements, we also have audited the accompanying financial statement schedule, "Valuation and Qualifying Accounts," for the year ended December 31, 1999. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Superior Energy Services, Inc. and subsidiaries as of December 31, 1999, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP New Orleans, Louisiana February 25, 2000 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Superior Energy Services, Inc.: We have audited the accompanying consolidated balance sheet of Superior Energy Services, Inc. and subsidiaries (formerly Cardinal Holding Corp.) as of December 31, 1998, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for each of the two years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Superior Energy Services, Inc. and subsidiaries at December 31, 1998, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 1998, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Ernst & Young LLP New Orleans, Louisiana March 2, 1999 SUPERIOR ENERGY SERVICES, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1999 and 1998 (in thousands, except share data) See accompanying notes to consolidated financial statements SUPERIOR ENERGY SERVICES, INC. AND SUBSIDIARIES Consolidated Statements of Operations Years Ended December 31, 1999, 1998 and 1997 (in thousands, except per share data) See accompanying notes to consolidated financial statements SUPERIOR ENERGY SERVICES, INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity (Deficit) December 31, 1999, 1998 and 1997 (in thousands, except share data) See accompanying notes to consolidated financial statements SUPERIOR ENERGY SERVICES, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years Ended December 31, 1999, 1998 and 1997 (in thousands) See accompanying notes to consolidated financial statements SUPERIOR ENERGY SERVICES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1999, 1998 and 1997 (1) MERGER On July 15, 1999, Superior consummated a subsidiary merger (the "Merger") whereby it acquired all of the outstanding capital stock of Cardinal Holding Corp. ("Cardinal") from the stockholders of Cardinal in exchange for an aggregate of 30,239,568 shares of Superior's common stock (or 51% of the then outstanding common stock). The acquisition was effected through the merger of a wholly-owned subsidiary of Superior, formed for this purpose, with and into Cardinal, with the effect that Cardinal became a wholly-owned subsidiary of Superior. As used in the consolidated financial statements for Superior Energy Services, Inc., the term "Superior" refers to the Company as of dates and periods prior to the Merger and the term "Company" refers to the combined operations of Superior and Cardinal after the consummation of the Merger. Due to the fact that the former Cardinal shareholders received 51% of the outstanding common stock at the date of the Merger, among other factors, the Merger has been accounted for as a reverse acquisition (i.e., a purchase of Superior by Cardinal) under the purchase method of accounting. As such, the Company's consolidated financial statements and other financial information reflect the historical operations of Cardinal for periods and dates prior to the Merger. The net assets of Superior, at the time of the Merger, have been reflected at their estimated fair value pursuant to the purchase method of accounting at the date of the Merger. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company. All significant intercompany accounts and transactions are eliminated in consolidation. Certain previously reported amounts have been reclassified to conform to the 1999 presentation. (b) BUSINESS The Company provides a broad range of specialized oilfield services and equipment primarily to major and independent oil and gas companies engaged in the exploration, production and development of oil and gas properties offshore in the Gulf of Mexico and throughout the Gulf Coast region. These services and equipment include oil and gas well plug and abandonment services, coiled tubing services, engineering services, electric line services, mechanical wireline services, the rental of liftboats and the rental of specialized oilfield equipment. Additional services provided include offshore and dockside environmental cleaning services, contract operating and supplemental labor, offshore maintenance services, the manufacture and sale of drilling instrumentation and the manufacture and sale of oil spill containment equipment. A majority of the Company's business is conducted with major and independent oil and gas exploration companies. The Company continually evaluates the financial strength of their customers but does not require collateral to support the customer receivables. The Company's P&A, wireline, marine and tank cleaning services are contracted for specific projects on either a day rate or turnkey basis. Rental tools are leased to customers on an as-needed basis on a day rate basis. The Company derives a significant amount of its revenue from a small number of major and independent oil and gas companies. No single customer represented 10% or more of the Company's total revenue in 1999 or 1998. In 1997, one customer accounted for approximately 11.2% of the Company's total revenue, primarily in the marine and wireline segments. The inability of the Company to continue to perform services for a number of its large existing customers, if not offset by sales to new or existing customers, could have a material adverse effect on the Company's business and financial condition. (c) USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (d) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related lives as follows: Buildings and improvements 15 to 30 years Marine vessels and equipment 5 to 18 years Machinery and equipment 5 to 15 years Automobiles, trucks, tractors and trailers 2 to 5 years Furniture and fixtures 3 to 7 years Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. CHANGE IN ACCOUNTING ESTIMATE Effective October 1, 1999, the Company changed the estimated useful lives on its marine vessels from fifteen years to eighteen years. The Company believes the revised estimated useful lives will more appropriately reflect its financial results by better matching costs over the estimated useful lives of these assets. The effect of this change on net income for the three months ended December 31, 1999 was a reduction in depreciation expense of approximately $350,000. (e) GOODWILL The Company amortizes costs in excess of fair value of the net assets of businesses acquired using the straight-line method over a period not to exceed 30 years. Recoverability is reviewed by comparing the undiscounted fair value of cash flows of the assets, to which the goodwill applies, to the net book value, including goodwill, of assets. Goodwill amortization expense recorded for the years ended December 31, 1999, 1998 and 1997 was $1,480,000, $226,000 and none, respectively. (f) OTHER ASSETS Other assets consist primarily of debt acquisition costs and covenants not to compete. Debt acquisition costs are being amortized over the term of the related debt, which is approximately seven years. The amortization of debt acquisition costs, which is classified as interest expense, was $593,000, $565,000 and $266,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The covenants not to compete are being amortized over the terms of the agreements, which is four years. Amortization expense recorded on the covenants not to compete for the years ended December 31, 1999, 1998 and 1997 was $265,000, $163,000 and $68,000, respectively. (g) CASH EQUIVALENTS The Company considers all short-term deposits with a maturity of ninety days or less to be cash equivalents. (h) REVENUE RECOGNITION For the Company's marine, well services, wireline, rental tool operations and environmental cleaning services, revenue is recognized when services or equipment are provided. The Company contracts for marine, well services, wireline and environmental projects either on a day rate or turnkey basis, with a majority of its projects conducted on a day rate basis. The Company's rental tools are leased on a day rate basis, and revenue from the sale of equipment is recognized when the equipment is shipped. Reimbursements from customers for the cost of rental tools that are damaged or lost downhole are reflected as revenue at the time of the incident. (i) INCOME TAXES The Company provides for income taxes in accordance with Statement of Financial Accounting Standards (FAS) No. 109, ACCOUNTING FOR INCOME TAXES. FAS No. 109 requires an asset and liability approach for financial accounting and reporting for income taxes. Deferred income taxes reflect the impact of temporary differences between amounts of assets for financial reporting purposes and such amounts as measured by tax laws. (j) EARNINGS PER SHARE Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed in the same manner as basic earnings per share except that the denominator is increased to include the number of additional common shares that could have been outstanding assuming the exercise of stock options, convertible preferred stock and warrants and the potential shares that would have a dilutive effect on earnings per share. On July 15, 1999, the Company effected an approximate 364 to 1 stock issuance as a result of the Merger. All earnings per common share amounts, references to common stock, and stockholders' equity amounts have been restated as if the stock issuance had occurred as of the earliest period presented. The effect of the preferred dividends on arriving at the income available to common stockholders was $1,330,000 in 1999, $738,000 in 1998 and $30,000 in 1997. The number of dilutive stock options, convertible preferred stock shares and warrants used in computing diluted earnings per share were 1,244,000 in 1997, and these securities were anti-dilutive in 1998 and 1999. (k) FINANCIAL INSTRUMENTS The Company uses interest rate swap agreements to manage its interest rate exposure. The Company specifically designates these agreements as hedges of debt instruments and recognizes interest differentials as adjustments to interest expense in the period the differentials occur. Under interest rate swap agreements, the Company agrees with other parties to exchange, at specific intervals, the difference between fixed-rate and variable-rate interest amounts calculated by reference to an agreed-upon notional principal amount. The fair value of the interest rate swap agreements is estimated using quotes from counterparties and represents the cash receipt if the existing agreements had been settled at year-end. (l) COMPREHENSIVE INCOME In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (FAS) No. 130, REPORTING COMPREHENSIVE INCOME. FAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The Company adopted this standard in 1998. Such adoption had no effect on the Company's financial statement presentation as the Company has no items of other comprehensive income. (3) SUPPLEMENTAL CASH FLOW INFORMATION (IN THOUSANDS) (4) BUSINESS COMBINATIONS On July 15, 1999, the Company acquired Cardinal through a merger by issuing 30,239,568 shares of the Company's common stock. Because the Cardinal shareholders received 51% of the outstanding common stock at the date of the Merger, among other factors, the transaction has been accounted for as a reverse acquisition which has resulted in the adjustment of the net assets of Superior to its estimated fair value as required by the rules of purchase accounting. The valuation of Superior's net assets is based upon the 28,849,523 common shares outstanding prior to the Merger at the approximate trading price of $3.78 at the time of the negotiation of the Merger on April 21, 1999. The purchase price allocated to net assets was $54.2 million. The revaluation reflected excess purchase price of $54.8 million over the fair value of net assets, which was recorded as goodwill. The results of operations of Superior have been included from July 15, 1999. Effective November 1, 1999, the Company acquired Production Management Companies, Inc. ("PMI") for aggregate consideration consisting of $3.0 million in cash and 610,000 shares of the Company's common stock at an approximate trading price of $5.66. Additional consideration, if any, will be based upon a multiple of four times PMI's EBITDA (earnings before interest, income taxes, depreciation and amortization expense) less certain adjustments. The additional consideration will be paid on the first and third anniversary of the acquisition, and in no event will the total additional payments exceed $11 million. If the overall current industry activity levels continue, the additional consideration actually paid will be materially less than the maximum consideration. The acquisition was accounted for as a purchase, and PMI's assets and liabilities have been revalued at their estimated fair market value. The purchase price allocated to net assets was $3.5 million, and the excess purchase price of $3.0 million over the fair value of net assets was recorded as goodwill. The results of operations of PMI have been included from November 1, 1999. Effective July 1, 1999, Superior sold two subsidiaries for a promissory note having an aggregate principal amount of $8.9 million, which bears interest of 7.5% per annum. These two subsidiaries were originally acquired in the second quarter of 1998. As part of the sale, the purchasers were granted the right to resell the capital stock of the two companies to the Company in 2002 subject to certain terms and conditions. No gain or loss was recorded on this sale. In 1998, Cardinal acquired all of the outstanding stock of three companies for an aggregate purchase price of $24.1 million with a combination of cash and stock as consideration for the acquisitions. Each of these acquisitions was accounted for using the purchase method and the results of operations of the acquired companies have been included from their respective acquisition dates. The following unaudited pro forma information for the years ended December 31, 1999 and 1998, presents a summary of consolidated results of operations of Superior and Cardinal as if the Merger, the acquisitions, and the sales of subsidiaries, had occurred on January 1, 1998, with pro forma adjustments to give effect to amortization of goodwill, depreciation and certain other adjustments, together with related income tax effects (in thousands, except per share amounts). The above pro forma financial information is not necessarily indicative of the results of operations as they would have been had the acquisitions been effected on January 1, 1998. Most of Superior's acquisitions have involved additional contingent consideration based upon a multiple of the acquired companies' respective average EBITDA over a three year period from the respective date of acquisition. In no event will the maximum aggregate consideration exceed $49.3 million for all acquisitions inclusive of the PMI acquisition. If the overall current industry activity levels continue, the additional consideration actually paid will be materially less than the maximum consideration. The additional consideration is not currently reflected in the respective companies' purchase price. The additional consideration, if any, will be capitalized as additional purchase price. (5) PROPERTY, PLANT AND EQUIPMENT A summary of property, plant and equipment at December 31, 1999 and 1998 (in thousands) is as follows: The cost of property, plant and equipment leased to third parties was $7,065,000 at December 31, 1999 and 1998. (6) NOTES PAYABLE, LONG-TERM DEBT AND SUBORDINATED DEBT NOTES PAYABLE The Company's notes payable as of December 31, 1999 and 1998 consist of the following (in thousands): The notes payable outstanding at December 31, 1999 represent the additional contingent consideration that was earned by two of Superior's 1997 acquisitions and were paid according to their terms subsequent to year end. LONG-TERM DEBT The Company's long-term debt as of December 31, 1999 and 1998 consist of the following (in thousands): On July 15, 1999, the Company entered into a $152 million term loan and revolving credit facility. The credit facility was implemented to provide $110 million term loan to refinance the combined debt of Superior and Cardinal, provide a $20 million working capital facility and $22 million of borrowings that may be used to fund the additional consideration that may be payable as a result of Superior's prior acquisitions. The Company executed an amendment to the credit facility on November 3, 1999 to increase the maximum borrowings under the credit facility by $10 million to refinance PMI's existing indebtedness and to pay the cash portion of the acquisition price for PMI. Under the amended credit facility, the term loans require quarterly principal installments commencing December 31, 1999 in the aggregate amount of $519,000 and then increasing up to an aggregate of approximately $1.6 million a quarter until 2006 when $92 million will be due and payable. As amended, the term loan and revolving credit facility bears interest at a LIBOR rate plus margins that depend on the Company's leverage ratio. Indebtedness under the credit facility is secured by substantially all of the assets of the Company and its subsidiaries and a pledge of all the common stock of the Company's subsidiaries. Pursuant to the credit facility, the Company has also agreed to maintain certain debt coverage and leverage ratios. The credit facility also imposes certain limitations on the ability of the Company and its subsidiaries to make capital expenditures, pay dividends or other distributions, make acquisitions, make changes to the capital structure, create liens or incur additional indebtedness. At December 31, 1999, the Company was in compliance with all such covenants. Annual maturities of long-term debt for each of the five fiscal years following December 31, 1999 and in total thereafter are as follows (in thousands): SUBORDINATED DEBT In connection with the recapitalization (see note 8), Cardinal borrowed $20 million under the terms of a Senior Subordinated Notes Agreement, which was repaid in July 1999. The early extinguishment of the Cardinal and Superior indebtedness in July 1999 resulted in an extraordinary loss of $4.5 million, net of a $2.1 million income tax benefit, which included the premium on the subordinated debt and the write-off of unamortized debt acquisition costs. (7) INCOME TAXES The components of income tax expense (benefit) before the income tax effect of the extraordinary losses for the years ended December 31, 1999, 1998 and 1997 are as follows (in thousands): Income tax expense (benefit) differs from the amounts computed by applying the US. Federal income tax rate of 34% to income before income taxes as follows (in thousands): The significant components of deferred income taxes at December 31, 1999 and 1998 are as follows (in thousands): The net change in the valuation allowance for the year ended December 31, 1999 was an increase of $1.2 million. There was no valuation allowance at December 31, 1998 or 1997. The net deferred tax assets reflect management's estimate of the amount that will be realized from future profitability and the reversal of taxable temporary differences that can be predicted with reasonable certainty. As of December 31, 1999, the Company had a net operating loss carryforward of an estimated $15.6 million, which is available to reduce future Federal taxable income through 2014. (8) STOCKHOLDERS' EQUITY In July 1999, the Company's stockholders approved the 1999 Stock Incentive Plan ("1999 Incentive Plan") to provide long-term incentives to its key employees, including officers and directors, consultants and advisers to the Company ("Eligible Participants"). Under the 1999 Incentive Plan, the Company may grant incentive stock options, non-qualified stock options, restricted stock, stock awards or any combination thereof to Eligible Participants for up to 5,929,327 shares of the Company's common stock. The Compensation Committee of the Board of Directors establishes the term and the exercise price of any stock options granted under the 1999 Incentive Plan, provided the exercise price may not be less than the fair market value of the common share on the date of grant. In addition to the 1999 Incentive Plan, Superior maintains its 1995 Stock Incentive Plan ("1995 Incentive Plan"), as amended. Under the 1995 Incentive Plan, as amended, the Company may grant incentive stock options, non-qualified stock options, restricted stock, stock awards or any combination thereof to Eligible Employees which consists of its key employees, including officers and directors who are employees of the Company for up to 1,900,000 shares of the Company's common stock. All of the Company's 1995 Stock Incentive Plan's options which have been granted are vested. Prior to the Merger, Cardinal had no stock option plan. A summary of stock options granted under the incentive plans for the year ended December 31, 1999 is as follows: A summary of information regarding stock options outstanding at December 31, 1999 is as follows: The Company accounts for its stock based compensation under the principles prescribed by the Accounting Principles Board's Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES (Opinion No. 25). However, Statement of Financial Accounting Standards (FAS) No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION permits the continued use of the value based method prescribed by Opinion No. 25 but requires additional disclosures, including pro forma calculations of earnings and net earnings per share as if the fair value method of accounting prescribed by FAS No. 123 had been applied. The pro forma data presented below is not representative of the effects on reported amounts for future years (in thousands, except per share amounts). In 1999 and 1998, pursuant to the stock awards plan adopted by Cardinal, shares of Class A common stock and Class C preferred stock were awarded to certain members of management. Compensation expense was recorded for fair value of these awards, as estimated based on sales of similar stock. The stock awards plan was eliminated as a result of the Merger. In February 1998, Cardinal completed a recapitalization and refinancing which was funded through a combination of senior secured debt, subordinated debt and equity investments. As a result of the recapitalization, Cardinal recorded an increase in equity of $57.5 million from the issuance of Class A common stock and Class C preferred stock; incurred $7.1 million of costs associated with the debt acquisition and reduction to net proceeds from the issuance of stock; recorded a reduction in equity of $114.8 million from the redemption of Class A common stock and Class C preferred stock; and recorded an extraordinary loss of $10.9 million for the estimated value of warrants of $10.5 million and unamortized debt acquisition costs of $379,000 (net of $214,000 income tax benefit). (9) PROFIT-SHARING PLAN The Company maintains various defined contribution profit-sharing plans for employees who have satisfied minimum service and age requirements. Employees may contribute up to 15% of their earnings to the plans. The Company matches employees' contributions up to 2.5% of an employee's salary. The Company made contributions of $142,000, $299,000 and $209,000 in 1999, 1998 and 1997, respectively. (10) FINANCIAL INSTRUMENTS The Company utilizes derivative instruments on a limited basis to manage risks related to interest rates. The Company designates these agreements as hedges of debt instruments and recognizes interest differentials as adjustments to interest expense in the period the differential occurs. At December 31, 1999, 1998 and 1997, the Company had interest rate swap agreements with notional amounts totaling $46.2 million, $48.4 million and $10.6 million, respectively, to convert an equal amount of variable rate long-term debt to fixed rates. The swaps mature in March of 2001 and October of 2002. The swaps require the Company to pay a weighted-average interest rate of 5.81% in 1999 and 1998 and 5.8% in 1997 and to receive a variable rate, which averaged 5.2%, 5.5% and 5.6% in 1999, 1998 and 1997, respectively. As a result of these swap agreements, interest expense was increased by $299,000 in 1999, $107,000 in 1998 and $6,000 in 1997. The effect to the Company to terminate these swap agreements at December 31, 1999 is estimated to be a gain of approximately $350,000. With the exception of derivative instruments, the Company's financial instruments of cash and cash equivalents, accounts receivable, accounts payable and long-term debt have carrying values, which approximate their fair market value. (11) COMMITMENTS AND CONTINGENCIES The Company leases certain office, service and assembly facilities under operating leases. The leases expire at various dates over the next several years. Total rent expense was $683,000 in 1999, $749,000 in 1998 and $948,000 in 1997. Future minimum lease payments under non-cancelable leases for the five years ending December 31, 2000 through 2004 and thereafter are as follows: $1,264,000, $774,000, $683,000, $597,000, $455,000 and $331,000, respectively. In September 1999, one of the Company's two hundred-foot class liftboats was damaged in the Gulf of Mexico. The vessel was fully insured and management does not believe any related unasserted claims will have a material effect on the financial position, results of operations or liquidity of the Company. In late December, the Company received an insurance settlement of $6.6 million which is expected to pay for the refurbishment of the vessel, replace lost equipment and pay for the loss of hire during the period the vessel will be out of commission. From time to time, the Company is involved in litigation arising out of operations in the normal course of business. In management's opinion, the Company is not involved in any litigation, the outcome of which would have a material effect on the financial position, results of operations or liquidity of the Company. (12) RELATED PARTY TRANSACTIONS Cardinal paid consulting fees, which is reported in other expenses, to a related party of $1,150,000 in 1997. No such fees were paid in 1999 or 1998. (13) SEGMENT INFORMATION The Company's reportable segments, subsequent to the Merger, are as follows: well services, wireline, marine, rental tools, environmental, field management and other. Each segment offers products and services within the oilfield services industry. The well services segment provides plug and abandonment services, coiled tubing services, well pumping and stimulator services, data acquisition services, gas lift services and electric wireline services. The wireline segment provides mechanical wireline services that perform a variety of ongoing maintenance and repairs to producing wells, as well as performs modifications to enhance the production capacity and life span of the well. The marine segment operates liftboats for oil and gas production facility maintenance and construction operations as well as production service activities. The rental tools segment rents and sells specialized equipment for use with onshore and offshore oil and gas well drilling, completion, production and workover activities. The environmental segment provides offshore oil and gas cleaning services, as well as dockside cleaning of items including supply boats, cutting boxes, and process equipment. The field management segment provides contract operations and maintenance services, interconnect piping services, sandblasting and painting maintenance services, and transportation and logistics services. The other segment manufactures and sells drilling instrumentation and oil spill containment equipment. All the segments operate primarily in the Gulf Coast Region. The accounting policies of the reportable segments are the same as those described in Note 2 of the Notes to the Consolidated Financial Statements. The Company evaluates the performance of its operating segments based on operating profits or losses. Segment revenues reflect direct sales of products and services for that segment, and each segment records direct expenses related to its employees and its operations. Identifiable assets are primarily those assets directly used in the operations of each segment. Summarized financial information concerning the Company's segments as of December 31, 1999, 1998 and 1997 and for the years then ended is shown in the following tables (in thousands): (14) INTERIM FINANCIAL INFORMATION (UNAUDITED) The following is a summary of consolidated interim financial information for the years ended December 31, 1999 and 1998 (amounts in thousands, except per share data): (15) ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (FAS) No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. FAS No. 133, as amended, is effective for all fiscal quarters of fiscal years beginning after June 15, 2000 and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. FAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are to be recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Earlier application of the provisions of the Statement is encouraged and is permitted as of the beginning of any fiscal quarter that begins after the issuance of the Statement. The Company has not yet assessed the financial impact of adopting this statement. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this item will be included in the Company's definitive proxy statement in connection with its 2000 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information required by this item will be included in the Company's definitive proxy statement in connection with its 2000 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item will be included in the Company's definitive proxy statement in connection with its 2000 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item will be included in the Company's definitive proxy statement in connection with its 2000 Annual Meeting of Stockholders and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements The following financial statements are Included in Part II of this Report: Independent Auditors' Reports Consolidated Balance Sheets - December 31, 1999 and 1998 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements (2) Financial Statement Schedules Schedule II - Valuation and Qualifying accounts for the years ended December 31, 1999, 1998 and 1997. (3) Exhibits The exhibits filed as part of this Form 10-K are listed on the Index to Exhibits immediately preceding such exhibits, which index is incorporated herein by reference. (b) Reports on Form 8-K On November 12, 1999, the Company filed a current report on Form 8-K reporting, under Items 5 and 7, the results for the third quarter of 1999 and the consummation of the acquisition of Production Management Companies, Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SUPERIOR ENERGY SERVICES, INC. By:/s/ TERENCE E. HALL Terence E. Hall Chairman of the Board, Chief Executive Officer and President Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. INDEX TO EXHIBITS _______________ * Filed herein

85608_1999.txt

85608_1999

1999

85608

Item 1. Business - ----------------- General - ------- MATEC Corporation ("MATEC" or "Registrant") is incorporated under the laws of Maryland. As used herein the term "Company" refers to MATEC and its subsidiaries. The Company's current business is conducted through its Valpey-Fisher Corporation ("Valpey") subsidiary. In addition, the Company has a real estate complex located in Northborough, Massachusetts which is operated by its wholly owned subsidiary, MEKontrol, Inc. Financial Information about Industry Segments - --------------------------------------------- The Company operates in one business segment. Information about export sales is set forth in Note 13 of the Notes to Consolidated Financial Statements in the 1999 Annual Report to Stockholders, which Note is incorporated by reference. Narrative Description of Business - --------------------------------- Valpey is involved in the design, production, import, and sale of quartz crystals and oscillators, ultrasonic transducers and a wide variety of piezoelectric and high-precision optical components. The quartz crystals and oscillators are used as integral components in electronic circuitry to assure precise timing and frequency reference. Except for more costly atomic standards, quartz crystals and oscillators continue to be one of the most stable references for accurately controlling electronic frequencies and time. Valpey provides a wide-frequency range of crystals and oscillators including standard and custom-designed product. Capabilities include: - high-reliability, precision crystals and oscillators used in sophisticated industrial, military and aerospace applications. - ultra-high frequency crystals used in crystal filters and oscillators for OEM telecommunications and microwave applications. - high-volume, low-cost crystals and oscillators for consumer and commercial applications. Markets for Valpey's products include computers and computer peripheral equipment, internet, networking, PCS (personal communications services), satcom, telecommunications, telemetry, and wireless. Valpey has continued to invest in equipment and people to meet customer needs and to increase its manufacturing capabilities. Valpey received its ISO-9001 registration for the design and manufacture of crystals and crystal oscillators in 1997. The piezoelectric crystals and components are used for ultrasonic transducers in non-destructive testing ("NDT") and medical applications, accelerometers, and sensors that measure flow, proximity, acceleration, distance and force. The high-precision optical components include windows, mirrors, lenses and prisms made from sapphire, quartz, and a wide range of other materials. These components are utilized in a variety of sensors, imaging, and other types of photonic-based instrumentation. Valpey designs and manufactures ultrasonic transducers for NDT scientific, industrial, and medical markets. The quartz crystals and oscillators are sold by Valpey's direct sales personnel, independent manufacturers' representatives and distributors. Valpey's other products and services are sold primarily by its direct sales personnel. Raw Materials ------------- Quartz crystal bases, ceramic packages and ICs are the principal raw materials and are available from a number of domestic and foreign suppliers. Since the fourth quarter of 1999, the lead times for the delivery of certain raw materials has increased significantly over prior lead times due to the worldwide demand for these products. Production has not yet been signficantly affected. However, in order to meet future customer delivery requirements, Valpey may be required to change some of its inventory purchasing practices (ie stocking higher inventory levels) to compensate for the long delivery lead times. Valpey imports sub-assemblies and completed products from various Far East (including China, Japan, South Korea, Philippines, and Taiwan) suppliers for use in its domestically manufactured product and for resale to its customers. In order to eliminate the effects of currency fluctuations, Valpey currently purchases the product in U.S. dollars. However, Valpey is subject to the inherent risks involved in international trade such as political instability and restrictive trade policies. Customers --------- No customer accounted for more than 10% of Valpey's net sales in 1999 and 1998. During 1997, one customer accounted for 12% of net sales. Approximately 27% of Valpey's sales in 1999 were made to its five largest customers, compared to 26% in 1998 and 32% in 1997. Backlog ------- Valpey's backlog of firm orders was $6,404,000 at December 31, 1999 and $2,294,000 at December 31, 1998. Valpey expects to ship all of the December 31, 1999 backlog during 2000. Competition ----------- There are many domestic and foreign suppliers of quartz crystals and oscillators. A number of the competitors are larger and have greater resources than the Company. In addition, foreign competitors, particularly from the Far East, continue to dominate the U.S. markets. However, Valpey believes it can maintain a competitive position in its business based on its quality, strong design and application engineering, responsive customer service and a willingness to provide specialty small quantity orders. Environmental Regulations ------------------------- To the knowledge of the Company compliance with Federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment, has not had, nor will have a material effect upon capital expenditures, earnings from continuing operations or competitive position. As a result of the sale of its Bergen Cable subsidiary in 1998, the Company is performing environmental clean up at that site. See Note 8 of the Notes to Consolidated Financial Statements in the 1999 Annual Report to Stockholders, which Note is incorporated by reference. Employees --------- At December 31, 1999, the Company employed 101 full-time and 8 part-time employees. No employees of the Company are represented by a collective bargaining unit. The Company considers its relations with its employees to be satisfactory. Foreign and Domestic Operations and Export Sales - ------------------------------------------------ The Company's has no foreign operations. Financial information about export sales is set forth in Note 13 of the Notes to Consolidated Financial Statements in the 1999 Annual Report to Stockholders, which Note is incorporated by reference. Forward-Looking Statements - -------------------------- Items 1 and 7 of this Form 10-K contain forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Words such as "expects", "believes", "estimates", "plans" or similar expressions are intended to identify such forward-looking statements. The forward-looking statements are based on the Company's current views and assumptions and involve risks and uncertainties that include, but not limited to: the ability to develop, market and manufacture new innovative products competitively, the ability of the Company's suppliers to produce and deliver materials competitively, and the ability to limit the amount of the negative effect on operating results caused by pricing pressures. Item 2. Item 2. Properties - ------- ---------- Valpey owns its 32,000 square foot facility located in Hopkinton, Massachusetts. This facility contains office and manufacturing space and serves as the Company's corporate headquarters. The Company believes its facility is suitable for its current use and is in good repair. The Company believes that its facility is adequate to satisfy its production capacity needs for the immediate future. In addition, the Company's real estate operation owns a 35,000 square foot facility located in Northborough, Massachusetts. This facility is currently fully occupied and the Company considers this property to be in good repair. Item 3. Item 3. Legal Proceedings - ------- ----------------- Not applicable. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------- --------------------------------------------------- No matters were submitted to a vote of the Registrant's security holders during the last quarter of the fiscal year covered by this report. Executive Officers of the Registrant - ------------------------------------ The names, ages and offices of the executive officers of the Company are as follows: Name Age Office ---- --- ------ Ted Valpey, Jr. 67 President and Chief Executive Officer Michael Deery 54 President and Chief Operating Officer - Valpey Fisher Corporation Michael J. Kroll 51 Vice President and Treasurer The term of office for each officer of the Registrant is until the first meeting of the Board of Directors following the Annual Meeting of Stockholders and until a successor is chosen and qualified. Mr. Valpey has been President and Chief Executive Officer of the Registrant since April 28, 1997. He has been Chairman of the Corporation since 1982. Mr. Deery has been President and Chief Operating Officer of Valpey Fisher Corporation since September 1999. He was Vice President of International Manufacturing of Tambrands, Inc., a manufacturer of health care products, from prior to 1995 to 1998. Mr. Kroll has been Vice President and Treasurer of the Registrant since 1982. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related - ------- ---------------------------------------------------- Stockholder Matters ------------------- The information set forth on the inside front cover of the 1999 Annual Report to Stockholders under the caption "Common Stock Information" is incorporated by reference. Item 6. Item 6. Selected Financial Data - ------- ----------------------- The information set forth on page 3 of the 1999 Annual Report to Stockholders under the caption "Five Year Financial Summary" is incorporated by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial - ------- ------------------------------------------------- Condition and Results of Operations ----------------------------------- The information set forth on pages 3 through 5 of the 1999 Annual Report to Stockholders under the caption "Management's Discussion and Analysis" is incorporated by reference. Item 7A. Item 7A. Quantitative and Qualitative Disclosures about Market Risk - -------- ---------------------------------------------------------- The information set forth on page 5 of the 1999 Annual Report to Stockholders under the section "Quantitative and Qualitative Disclosures about Market Risk" included under the caption "Management's Discussion and Analysis" is incorporated by reference. Item 8. Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- The information contained in the Consolidated Financial Statements, Notes to Consolidated Financial Statements and the Independent Auditors' Report appearing on pages 6 through the inside back cover of the 1999 Annual Report to Stockholders is incorporated by reference. Item 9. Item 9. Changes In and Disagreements with Accountants on Accounting - ------- ----------------------------------------------------------- and Financial Disclosure ------------------------ Not applicable. PART III The information called for by Part III is hereby incorporated by reference from the information set forth and under the headings "Common Stock Ownership of Certain Beneficial Owners and Management", "Election of Directors", and "Executive Compensation" in Registrant's definitive proxy statement for the 2000 Annual Meeting of Stockholders, which meeting involves the election of directors, such definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K. In addition, information on Registrant's executive officers has been included in Part I above under the caption "Executive Officers of the Registrant". PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on - -------- ------------------------------------------------------- Form 8-K -------- (a) 1. The following Consolidated Financial Statements are incorporated by reference from the indicated pages of the 1999 Annual Report to Stockholders: Page Number(s) in Annual Report Consolidated Balance Sheets, December 31, 1999 and 1998 .................... 6 Consolidated Statements of Operations for the Years Ended December 31, 1999, 1998 and 1997 ................................. 7 Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997 ................................. 8 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1999, 1998 and 1997 ................................. 9 Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 1999, 1998 and 1997 ................................. 9 Notes to Consolidated Financial Statements ..... 10-16 Independent Auditors' Report ................... Inside back cover (a) 2. The following schedule to the Consolidated Financial Statements and the Independent Auditors' Report on Schedule are filed as part of this report. Page Number ----------- Independent Auditors' Report ...................... 12 Schedule II - Valuation Reserves .................. 13 All other schedules are omitted because they are not applicable, not required or because the required information is included in the Consolidated Financial Statements or notes thereto. (a) 3. The exhibits filed in this report or incorporated by reference, listed on the Exhibit Index on page 14, are as follows: Exhibit No. Description ----------- --------------------------------------------- 2. Agreement of Merger and Recapitalization 3.1 Articles of Incorporation 3.3 By-Laws 4.2 Common Stock Purchase Warrant 10.1 * 1992 Stock Option Plan 10.2 * 1999 Stock Option Plan 11. Calculation of Earnings Per Share 13. 1999 Annual Report to Stockholders 21. Subsidiaries of the Registrant 23. Independent Auditors' Consent 27. Financial Data Schedule * Management contract or compensatory plan or arrangement required to be filed as an Exhibit pursuant to Item 14(c) of this report. (b) Reports on Form 8-K The Registrant did not file any reports on Form 8-K during the last quarter of its year ended December 31, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MATEC Corporation Date: March 29, 2000 By:/s/ Ted Valpey, Jr. ------------------- Ted Valpey, Jr. President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ Ted Valpey, Jr. President, Chief Executive March 29, 2000 - ------------------------ Officer, Chairman of the Board Ted Valpey, Jr. and Director /s/ Michael J. Kroll Vice President and Treasurer - ------------------------ (Principal Financial Officer March 29, 2000 Michael J. Kroll and Principal Accounting Officer) /s/ Michael Deery Director March 29, 2000 - ------------------------ Michael Deery /s/ Eli Fleisher Director March 29, 2000 - ------------------------ Eli Fleisher /s/ Lawrence Holsborg Director March 29, 2000 - ------------------------ Lawrence Holsborg /s/ Michael P. Martinich Director March 29, 2000 - ------------------------- Michael P. Martinich /s/ John J. McArdle III Director March 29, 2000 - ------------------------ John J. McArdle III /s/ Robert W. Muir, Jr. Director March 29, 2000 - ------------------------ Robert W. Muir, Jr. /s/ Joseph W. Tiberio Director March 29, 2000 - ------------------------ Joseph W. Tiberio INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders MATEC Corporation Hopkinton, Massachusetts We have audited the consolidated financial statements of MATEC Corporation and subsidiaries as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated March 10, 2000; such consolidated financial statements and report are included in your 1999 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedule of MATEC Corporation and subsidiaries, listed in Item 14(a)2. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Deloitte & Touche LLP Boston, Massachusetts March 10, 2000 MATEC Corporation and Subsidiaries ---------------------------------- Schedule II - Valuation and Qualifying Accounts ----------------------------------------------- Additions Balance at Charged to Balance Beginning Costs and at End Description of Period Expenses Deductions of Period ----------- ---------- ---------- ---------- ---------- Allowance for Doubtful Accounts: Year Ended December 31, 1999 $ 75,000 $ 28,800 $ (10,800)(A) $ 93,000 ========= ========= ========= ========= December 31, 1998 $ 45,000 $ 18,002 $ (11,998)(A) $ 75,000 ========= ========= ========= ========= December 31, 1997 $ 35,000 $ (6,915) $ (16,915)(A) $ 45,000 ========= ========= ========= ========= Inventory Reserve: Year Ended: December 31, 1999 $1,212,000 $ 448,000 $(280,000)(B) $1,380,000 ========== ========= ========= ========== December 31, 1998 $ 857,000 $ 419,730 $ (64,730)(B) $1,212,000 ========== ========= ========= ========== December 31, 1997 $ 780,000 $ 123,667 $ (46,667)(B) $ 857,000 ========== ========= ========= ========== (A) Write-off of uncollectible accounts, net of recoveries. (B) Write-off of inventory. EXHIBIT INDEX ------------- Exhibit No. (inapplicable items are omitted) - ----------- 2. Agreement of Merger and Recapitalization between MATEC Corporation a Delaware corporation and MATEC Corporation a Maryland corporation (incorporated by reference to Exhibit A to the Proxy Statement of Registrant for its Special in Lieu of Annual Meeting of Stockholders held on June 18, 1998). 3.1 Articles of Incorporation (incorporated by reference to Exhibit B to the Proxy Statement of Registrant for its Special In Lieu of Annual Meeting of Stockholders held on June 18, 1998). 3.3 By-Laws (incorporated by reference to Exhibit 3.3 to Registrant's Form 10-Q for the quarterly period ended October 3, 1999). 4.2 Common Stock Purchase Warrant dated April 12, 1995 between the Registrant and Massachusetts Capital Resource Company (incorporated by reference to Exhibit 4.(a) on Registrant's Form 10-Q for the quarterly period ended July 2, 1995). 10.1 1992 Stock Option Plan (incorporated by reference to Exhibit 10.(a) on Registrant's Form 10-K for the year ended December 31, 1997). 10.2 1999 Stock Option Plan (incorporated by reference to Exhibit A to the Proxy Statement of Registrant for its Special In Lieu of Annual Meeting of Stockholders held on May 13, 1999). 11. Calculation of Earnings Per Share. Filed herewith. 13. Portions of the 1999 Annual Report to Stockholders. Filed herewith. 21. Subsidiaries of the Registrant. Filed herewith. 23. Independent Auditors' Consent. Filed herewith. 27. Financial Data Schedule. Filed for electronic purposes only.

1018349_1999.txt

1018349_1999

1999

1018349

ITEM 1. BUSINESS GENERAL The Company is a designer and manufacturer of large scale, complex stamping die systems used to form sheet metal parts. Most of the stamping die systems sold by the Company are used in the production of automobile and truck body parts such as roofs, hoods, fenders, doors, door frames, structural components and bumpers. The following table sets forth the Company's sales (in millions) and percentage of total sales by major customer in fiscal years 1995, 1996, 1997, 1998 and 1999. - ---------- * Less than 1.0% of the Company's total sales. INDUSTRY TRENDS The automotive industry continues to evolve towards the early stages of convergence between the OEM's and the supplier base. This trend will result in the OEM's focusing their capital expenditures on marketing and distribution, rather than manufacturing. A Bear Sterns & Co. Inc. automotive parts industry report (1) noted that the OEM's greatest single asset is their brands and that independent suppliers will become a critical component of the design, engineering and delivery of systems which will increasingly be outsourced in the future. Other significant trends within the North American automotive industry have had, and are likely to continue to have, an impact on the Company's business. Over the past several years, the industry has required that its tool suppliers utilize advanced computer integrated technology. This has required significant capital investment. In some cases, being unable or unwilling to make this investment, many independent tooling suppliers have exited the business. This has decreased the available domestic tooling capacity and has resulted in fewer qualified suppliers. The automotive industry's trend towards shorter product life cycles and introduction of a greater number of vehicle models will create growing demand for the Company's complex tooling systems. In accordance with this trend, DaimlerChrysler AG ("Chrysler"), Ford Motor Company ("Ford") and General Motors Corporation ("General Motors"), the three largest domestic automobile manufacturers (the "OEMs"), are forming alliances with select - ------------ (1) Source: Bear Sterns Equity Research Report on the Auto Parts Industry, dated September, 1998. suppliers which have the technological capability to successfully perform simultaneous engineering of product and manufacturing processes from concept to completion at the supplier level and utilizing computer data based design, manufacturing and validation processes. Some OEMs have formed "Platform" teams which provide the organizational structure for this simultaneous engineering process, and have included their critical or key suppliers in these teams. This simultaneous engineering concept allows model changes to be implemented more quickly and cost-effectively. By involving the ultimate tool and die manufacturer early in the design process, the OEMs are better able to design-in more cost-effective manufacturing processes, improve product quality, and avoid costly changes downstream. The emphasis on designing and manufacturing more fuel-efficient vehicles as the result of federal Corporate Average Fuel Economy ("C.A.F.E.") regulation has produced many new vehicle designs. In addition, automobile manufacturers are utilizing lightweight, high strength steels and aluminum in new model designs in order to decrease the weight of the vehicle and increase fuel efficiency. Therefore, suppliers will be required to have the ability to work with these types of materials in order to remain competitive. The Company has established an expertise in manufacturing dies used in the production of structural components made of light-weight, high strength steels and aluminum (largely utilized in large semi-trucks). Efforts by OEMs and their suppliers to reduce labor and other manufacturing costs have resulted in their tending to combine common parts into a single stamping press and reduce the number of "hits" required to manufacture a part. In addition, utilization of transfer presses has increased demand for transfer dies to reduce labor cost at the OEMs and their suppliers. Management believes these industry trends will continue with emphasis on simultaneous engineering and manufacturing processes centered around the utilization of fully computer integrated technologies. This should increase the Company's customer relationships with and importance to the OEMs and their tier one suppliers of sheet metal stamped parts and assemblies. PRODUCTS AND SERVICES Dies. The Company's dies are used in the high speed production of sheet metal stamped parts and assemblies. Production of such parts is a multiple step process involving a series of dies. Typically, the first die is used to cut the appropriate size metal blank from a sheet or coil of steel. The next die draws the metal blank into its primary shape and subsequent dies are used to bend edges or corners, create flanges, trim off excess metal and pierce assembly holes. A customer usually orders only one series of dies for each separate part. Normally, the dies do not require replacement due to usage because the life of well-maintained dies is sufficient to carry production to the point when styling changes dictate production of new dies. The dies manufactured by the Company generally include automation features, adding to the complexity of design and construction. These automation features facilitate rapid introduction and removal of the work piece or raw material into and out of the die, thereby increasing production speeds and reducing labor cost. During fiscal 1998, the Company purchased four large stamping presses and completed the installation of such presses during fiscal 1999. These additional presses provide the Company the opportunity to manufacture the largest dies for the largest parts used in an automobile. These parts would include double attached doors, body side apertures and very large hood and deck panels. The Company believes it is only one of three domestic die manufacturers and one of only eight in the world with this capacity. This large die press capacity will benefit the Company in that these types of large dies can result in larger dollar contracts. For example, a set of stamping dies currently manufactured by the Company generally sells for between $250,000 and $2,000,000 depending upon size and complexity, whereas a body side aperture can sell for between $4,000,000 and $6,000,000. Simultaneous Engineering of Product and Process. The OEMs are developing organizational structures involving internal design and engineering personnel as well as supplier representatives which they are using to develop new car models. These organizations are called "Platform" teams. This allows full implementation of simultaneous engineering -- the application of the product engineering and process engineering functions simultaneously and early in the process. The Company utilizes advanced Computer Aided Design/Computer Aided Manufacturing ("CAD/CAM") technology to design and manufacture its complex stamping dies. Due to this advanced computer capability, the Company is able to work very closely with its customers and is often assigned to these Platform teams early. Its process engineering input facilitates the teams' goals of introducing new models rapidly and efficiently. The Company has invested significantly to ensure that it utilizes the latest advanced technology and is capable of receiving and working directly from complex mathematical data received from its OEM customers. Management's investment in, and commitment to, advanced technology has solidified its quality reputation with its customers and helped the Company advance to tier one status. Prototype Tooling and Parts. With the advent of Platform team and simultaneous engineering methods, the Company has become responsible for the design and manufacture of both the prototype tooling, the final production tooling and specifies the final production process. Prototype tooling and parts are utilized during the design phase of new models, which the automobile manufacturers use to validate the fit and function of the respective components and assemblies and the repeatability of the respective production processes. The parts manufactured from prototype tools are also often used in crash testing. Typically, prototype tools associated with the primary metal forming operations are manufactured from an alloy casting or mild steel and subsequently machined using the mathematical database and related Computer Numerically Controlled ("CNC") programs. After machining, the prototype tools are assembled and tested to validate the integrity and repeatability of the final manufacturing process. The results of the validation process are incorporated into the mathematical database, which will then be used to manufacture the final production tools. After testing the primary forming operations, prototype parts are manufactured using special means such as computerized laser-cutting machines to trim off excess scrap and to incorporate various slots and holes. These parts are then sent to the automobile manufacturers for further testing and evaluation. The results of this testing and evaluation may require the incorporation of additional design and manufacturing process modifications. MANUFACTURING Traditionally, the die manufacturing process was comprised of various manual steps performed by craftsmen. After being awarded a contract, the Company would be presented with a wooden model of the part to be produced. From the model, plaster tooling aids were constructed. The plaster tooling aids were then traced and cut into steel. The steel was then ground, usually quite extensively, by hand to fit. Validation was also done by hand, by measuring specific points on the die face and comparing these to the original design blueprints. Today, with the Company's technology, the design and most of the manufacturing process is computer-driven, which increases accuracy and reduces the time required to produce a set of stamping dies. The process starts when the Company is assigned to a new Platform team and simultaneous engineering begins. An electronic "model" of the part to be produced is transmitted directly to the Company by transferring design information electronically ("EDI"), or sent on computer disk represented as a mathematical database. Company engineers use the mathematical database to generate computer-aided die designs and die face cutter path programs. These cutter path programs are used by the toolmakers and machinists to manufacture the inner workings of the tool. Most material is removed and the cutting is done by CNC machine tools, which utilize the computer-generated cutter path programs. Depending on the complexity of the tool, a prototype may be manufactured to prove-out the manufacturing process or to provide actual parts for crash testing and to test fit and function. Finally, after the die is constructed, it is evaluated statistically for process repeatability and dimensional validation on the Company's Coordinate Measuring Machine. During this automated validation process, the tool is statistically compared to the mathematical database. Having the optimum size and quantity of tryout presses is an important aspect of the construction and validation process, and the Company has therefore invested heavily to ensure its capability in this area. On average, 10 months elapse from the time the Company is awarded a contract until the final set of dies is shipped to the customer. The OEMs are facing growing pressure to reduce the time required to introduce a new car model. To meet shorter timeframes, OEMs are relying more heavily on simultaneous engineering and integrating suppliers more closely into the design process. This trend helps the Company by requiring more direct relationships between the OEMs and its suppliers such as the Company. RAW MATERIALS The steel, castings and other components utilized by the Company in the manufacturing process are available from many different sources and the Company is not dependent on any single source. The Company typically purchases its raw materials on a purchase order basis as needed and has generally been able to obtain adequate supplies of raw materials for its operations. MARKETING AND SALES The Company's marketing emphasis is on DaimlerChrysler, Ford and General Motors and their tier one suppliers. The Company maintains excellent relationships with DaimlerChrysler, Ford and General Motors which directly accounted for about 48%, in the aggregate, of the Company's revenues in 1999. For the year ended August 31, 1999, DaimlerChrysler, Ford, General Motors and their tier one suppliers accounted for approximately 76% of the Company's revenues. With the growing use of simultaneous engineering, the Company's marketing goal is to be assigned early to the new model Platforms. As one of only a few technically proficient suppliers assigned to a Platform, the Company's opportunity to win business for a new model is greatly enhanced. The Company works to achieve preferred supplier status with its customers to further increase its chances of being assigned to new model Platforms. Sales efforts are conducted primarily by Company's Vice President of Sales, President, senior management and project management personnel. Frequent contact is made with domestic and foreign automobile manufacturers and their purchasing agents, Platform managers and tier one suppliers. When the Company has been assigned to a new model Platform Team, the Platform Team manager is contacted to determine those parts and assemblies that will be assigned to various required suppliers. During the design phase, the Company recommends process and design changes to improve the cost and quality of the product. Generally, when the Company is assigned to a Platform Team, orders are obtained directly and without a formal bid process. The Company maintains a comprehensive computer database with historical information regarding dies it has previously manufactured. This assists the Company in quoting prices for dies and enables it to respond to most quotation requests quickly and accurately. If the customer decides to accept the Company's quotation, a purchase order is issued subject to price adjustments for engineering changes requested by the customer. Where no Platform Team is assembled, the Company bids on specific tooling assignments, and bids are awarded on a competitive basis among a group of qualified suppliers. For business done with tier one suppliers, the Company's sales process follows a more traditional process. The Company typically receives a package or request for quotation from the tier one supplier and is less involved in the design process of the part to be manufactured. Bids are generally awarded based on technological capability, price, quality and past performance. BACKLOG AND SEASONALITY The Company's backlog of awarded contracts, of which all are believed to be firm, was approximately $17.0 million and $16.2 million as of August 31, 1999 and 1998, respectively. Of the August 31, 1999 contract backlog, the Company expects all backlog contracts will be reflected in sales during fiscal years ended August 31, 2000 and 2001. The Company's sales of stamping dies do not follow a seasonal pattern; however, the timing of new model introductions and existing model restyling tooling programs are dependent on DaimlerChrysler, Ford and General Motors and their strategy of accelerating the introduction of new models. COMPETITION Large, complex automotive stamping dies are manufactured primarily by three supplier groups: a) domestic independent tool and die manufacturers, b) foreign independent tool and die manufacturers, and c) captive or in-house tool and die shops owned and operated by the OEMs. The independent tool and die manufacturer industry has significant barriers to entry, which can reduce competition in the large-scale die market. These barriers include the highly capital intensive and technically complex requirements of the industry. Additionally attracting and retaining employees skilled in the use of advanced design and manufacturing technology is a multi-year process. Finally, a new competitor would most likely lack much of the credibility and historical customer relationships that can take years to develop. Based upon the responses of 84 sheet metal die manufacturing companies to a 1998 survey by the National Tooling and Machining Association, only 18 companies reported average annual sales in excess of $10 million. Based upon the study and the Company's independent knowledge of its direct competitors, the Company believes it is among the 6 largest independent suppliers and that no one supplier is dominant. Finally, the OEMs maintain in-house, captive tool and die capacity to meet a portion of their needs. General Motors maintains the largest captive capacity and, based on estimates from various trade publications, supplies an estimated 75-80% of its own die construction needs. Ford produces approximately 50% and DaimlerChrysler 25% of their own respective needs. Independent suppliers like the Company tend to have a competitive advantage over the OEMs' in-house die shops due to the OEMs' higher cost structure. With the advent of simultaneous engineering in the automobile industry, proximity of the OEM's design engineers may effect the placement of the die manufacturer. However, foreign competition may have certain advantages over domestic die manufacturers including lower capital costs, currency exchange advantages, government assistance and lower labor costs. The Company believes that it is one of eight die manufacturing companies on a global basis with the large press capacity necessary to manufacture and validate large scale stamping die systems. EMPLOYEES The Company's work force consists of approximately 138 full-time employees, of which approximately 34 are salaried managerial and engineering personnel. The balance are hourly employees engaged in manufacturing and indirect labor support. Included among these hourly workers are approximately 102 skilled tradesmen who are either journeymen tool and die makers or machinists. None of the Company's employees are covered by a collective bargaining agreement. The Company has not experienced any work stoppages and considers its relations with its employees to be good. The Company has a discretionary contribution 401(K) plan. The Company has no contingent pension liabilities arising from any defined benefit plan. ENVIRONMENTAL MATTERS The Company is subject to environmental laws and regulations concerning emissions to the air, discharges to waterways, and generation, handling, storage, transportation, treatment and disposal of waste materials. The Company is also subject to other Federal and state laws and regulations regarding health and safety issues. The Company believes that it is currently in compliance with applicable environmental and health and safety laws and regulations. ITEM 2. ITEM 2. PROPERTIES The Company's facilities are located in Grand Rapids, Michigan, and consist of approximately 178,000 square feet of space, of which 28,000 square feet is utilized for office, engineering and employee service functions, 98,000 square feet is dedicated to the Company's tooling production and 52,000 square feet is under a four-year sublease to an unaffiliated tenant. Constructed in 1989, the facility is leased with a lease term of 20 years. The facility lease provides for annual payments of $934,500 plus an escalation of base rent of 1% for each of the first ten years and 2% for each of the second ten years. The Company has a purchase option on the building at the fair market value beginning in November 1996. The sublease requires annual lease payments of $224,724 commencing August 1, 1996 through July 1, 1998 and $231,468 per annum from August 1, 1998 through July 31, 2000. The sublease also requires the subtenant to pay 33.7% of common operating expenses of the facility. The sublease has two renewal options for two years each with annual lease payments of $231,468 and $238,412, respectively. During 1998, the tenant exercised its option to extend the lease period until July 31, 2000. The Company has exercised its option to terminate the sublease agreement on July 31, 2000. The Company believes its facilities are modern, well maintained, adequately insured and suitable for their present and intended uses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not presently a party to any legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the fiscal year, covered by this report, to a vote of security holders through the solicitation of proxies or otherwise. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the American Stock Exchange ("AMEX") under the symbol RTC. The common stock commenced trading on the AMEX on March 7, 1997, as a result of the Company's initial public offering. Prior to that date, there was no public market for the common stock. The table below sets forth the high and low sales prices as reported by AMEX for each period reported. As of October 19, 1999, the Company's common stock was held by 44 holders of record and approximately 795 beneficial shareholders. The Company has not historically paid cash dividends on its Common Stock. The payment of common stock cash dividends is within the discretion of the Company's Board of Directors, with prior written consent of its primary lender; however, in view of the potential working capital needs and in order to finance future growth, it is unlikely that the Company will pay any cash dividends on its common stock in the foreseeable future. On November 2, 1998, the Company's Board of Directors declared a five-percent common stock dividend, payable on December 18, 1998, to all shareholders of record on November 17, 1998. On December 18, 1998, an additional 153,245 common shares were issued as a stock dividend. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information required by this Item 6 is incorporated by reference to page 50 and 51 of the Company's 1999 Annual Report to Stockholders filed as Exhibit 13 hereto. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information required by this Item 7 is incorporated by reference to pages 52-54 of the Company's 1999 Annual Report to Stockholders filed as Exhibit 13 hereto. ITEM 8. ITEM 8. FINANCIAL STATEMENTS & SUPPLEMENTAL DATA The Registrant hereby incorporates the financial statements required by this Item 8 by reference to Item 14(a)(1) hereof, and the supplementary financial information required by this Item 8 by reference to page 54-67 of the Company's 1999 Annual Report to Shareholders filed as Exhibit 13 hereto. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On April 28, 1999, the Company filed a Form 8-K, Item 4. Changes in Registrant's Certifying Accountant (a) Previous independent accountants. Such filing indicated that on April 22, 1999, the Company - dismissed Plante & Moran LLP as its independent accountant. - The reports of Plante & Moran LLP on the financial statements for the past two fiscal years (fiscal 1997 and 1998) contained no adverse or disclaimer of opinion and were not qualified or modified as to uncertainty, scope or accounting principles. - The Company's Audit Committee participated in and recommended the decision to change independent accountants. - In connection with its audits for the two most recent fiscal years (1997 and 1998) and through April 28, 1999, there have been no disagreements with Plante & Moran LLP on any matter of accounting principles or practices, financial statement disclosure or auditing scope procedure or any reportable events. - During the two most recent fiscal years (1997 and 1998) and through April 28, 1999, there have been no reportable events (as defined in Regulation S-K Item 304 (a)(1)(v). - The Company had provided Plante & Moran LLP with a copy of the Form 8-K and attached a letter from Plante & Moran LLP addressed to the SEC stating that they agreed with the statement on such Form 8-K. On July 14, 1999, the Company filed a Form 8-K, Item 4. Changes in Registrant's Certifying Accountant (b) New independent accountants. Such filing indicated that the Company - Engaged Deloitte & Touche LLP as its new independent accountants - In November 1998, the Company engaged Deloitte & Touche LLP to assist the Audit Committee in its review of the Company's prior financial statements. In conjunction with this engagement, Deloitte & Touche LLP provided oral advice regarding matters relating to the Company's restated financial statements. - The Company has not consulted with Deloitte & Touche LLP on any matter that was either the subject of a disagreement, as that term is defined in Item 304(a)(1)(iv) of Regulation S-K, or a reportable event, as that term is defined in Item 304(a)(1)(v) of Regulation S-K. PART III The Registrant hereby incorporates the information required by Form 10-K, Items 10-13 by reference to the Registrant's definitive proxy statement for its 1999 annual meeting of shareholders which was filed with the Commission prior to November ___, 1999. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: 1. Financial Statements - The following financial statements and the report of independent auditors set forth on pages 54 - 67 of the Company's 1999 Annual Report to Shareholders filed as Exhibit 13 hereto are incorporated by reference in this Annual Report on Form 10-K. - Balance Sheets as of August 31, 1999 and 1998 - Notes to Financial Statements - For each of the three years in the period ended August 31, 1999: Statements of Common Shareholders' Equity Statement of Operations Statements of Cash Flows - Reports of Independent Auditors 2. Financial Statement Schedules - No such schedules are included because of the absence of the conditions under which they are required, or because the information called for is included in the financial statements or notes thereto. 3. Exhibits 10(l) Loan Agreement, Revolving Line of Credit Loan Note, Existing Equipment Term Loan Note, Non-Revolving Equipment Line of Credit Loan Note, Security Agreement and Assignment of Life Insurance Policy as Collateral between Registrant and Old Kent Bank dated June 12, 1997 (incorporated by reference to Exhibit 10(l) of the Registrant's Form 10K, filed November 26, 1997). 10(m) Amendments number 1, 2, 3, and 4 between Registrant and Old Kent Bank dated December 31, 1997, February 15, 1998, August 14, 1998 and August 14, 1998, respectively (incorporated by reference to Exhibit 10(m) of the Registrant's Form 10K, filed November 23, 1998). 10(n) Release of Policy as Collateral Security from NBD Bank dated December 2, 1997 (incorporated by reference to Exhibit 10(n) of the Registrant's Form 10K, filed November 23, 1998). 10(o) Assignment of Life Insurance Policy as Collateral Security to Old Kent Bank dated July 23, 1998 (incorporated by reference to Exhibit 10(o) of the Registrant's Form 10K, filed November 23, 1998). 10(p) 1998 Key Employee Stock Option Plan dated November 2, 1998 (incorporated by reference to Exhibit 10(p) of the Registrant's Form 10K, filed November 23, 1998). 10(q) Amendments number 5, 6, 7 and 8 between Registrant and Old Kent Bank dated October 31, 1998, January 1, 1999, February 27, 1999 and March 31, 1999, respectively. 10(r) First Restated Loan Agreement and $1,000,000 Term Loan Note between Registrant and Old Kent Bank dated August 31, 1999. 13 1999 Annual Report to Shareholders. 21 Subsidiaries - None 27 Financial Data Schedule. (b). Reports filed on Form 8-K during the fourth quarter of fiscal 1999 - The Company filed a Form 8-K on July 14, 1999, regarding Item 4 - Changes in Registrant's Certifying Accountant (b) New Independent Accountants. In such filing, the Company disclosed that, on the recommendation of its Audit Committee and Board of Directors, it has engaged Deloitte & Touche as its new independent accountants. SIGNATURES Pursuant to the requirement of Section 13 or 15(d) of the Securities and Exchange Act of 1934 the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 18th day of November, 1999, by the following persons on behalf of the Company and in the capacities indicated. Each Director of the Company whose signature appears below hereby appoints Kenneth K. Rieth and Peter C. Canepa, and each of them individually, as his attorney-in-fact to sign in his name and on his behalf as a Director of the Company, and to file with the Commission any and all amendments to this report on Form 10-K to the same extent and with the same effect as if done personally. /s/ Leonard H. Wood /s/ Kenneth K. Rieth - ------------------------- -------------------------- Leonard H. Wood, Director Kenneth K. Rieth, Director /s/ John C. Kennedy /s/ Daniel W. Terpsma - ------------------------- -------------------------- John C. Kennedy, Director Daniel W. Terpsma, Director /s/ Thomas H. Highley - ------------------------- Thomas H. Highley, Director SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. Not Applicable. ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON D.C. 20549 ---------------------- EXHIBITS TO FORM 10-K UNDER THE SECURITIES AND EXCHANGE ACT OF 1934 ---------------------- RIVIERA TOOL COMPANY ================================================================================ EXHIBIT INDEX EXHIBIT NO. - ---------- 10(l) Loan Agreement, Revolving Line of Credit Loan Note, Existing Equipment Term Loan Note, Non-Revolving Equipment Line of Credit Loan Note, Security Agreement and Assignment of Life Insurance Policy as Collateral between Registrant and Old Kent Bank dated June 12, 1997 (incorporated by reference to Exhibit 10(l) of the Registrant's Form 10K, filed November 26, 1997). 10(m) Amendments number 1, 2, 3, and 4 between Registrant and Old Kent Bank dated December 31, 1997, February 15, 1998, August 14, 1998 and August 14, 1998, respectively (incorporated by reference to Exhibit 10(m) of the Registrant's Form 10K, filed November 23, 1998). 10(n) Release of Policy as Collateral Security from NBD Bank dated December 2, 1997 (incorporated by reference to Exhibit 10(n) of the Registrant's Form 10K, filed November 23, 1998). 10(o) Assignment of Life Insurance Policy as Collateral Security to Old Kent Bank dated July 23, 1998 (incorporated by reference to Exhibit 10(o) of the Registrant's Form 10K, filed November 23, 1998). 10(p) 1998 Key Employee Stock Option Plan dated November 2, 1998 (incorporated by reference to Exhibit 10(p) of the Registrant's Form 10K, filed November 23, 1998). 10(q) Amendments number 5, 6, 7 and 8 between Registrant and Old Kent Bank dated October 31, 1998, January 1, 1999, February 27, 1999 and March 31, 1999, respectively. 10(r) First Restated Loan Agreement and $1,000,000 Term Loan Note between Registrant and Old Kent Bank dated August 31, 1999. 13 1999 Annual Report to Shareholders. 21 Subsidiaries - None 27 Financial Data Schedule.

1044880_1999.txt

1044880_1999

1999

1044880

ITEM 1. BUSINESS General On January 8, 1998, Medford Co-operative Bank (the "Bank") completed its conversion from mutual to stock form and became a wholly-owned subsidiary of Mystic Financial, Inc. ("Mystic" or the "Company"). On such date, the Company sold 2,711,125 shares of its common stock, par value $0.01 per share (the "Common Stock"), to the public, at a per share price of $10.00. The conversion of the Bank from mutual to stock form, the formation of the Company as the holding company for the Bank and the issuance and sale of the Common Stock are herein referred to collectively as the "Conversion." The Conversion raised $25.7 million in net proceeds. Mystic used $3.2 million of retained net proceeds to fund a loan to its Employee Stock Ownership Plan ("ESOP") to purchase 216,890 shares of the Common Stock in open-market purchases following completion of the Conversion. The Company's principal business activity consists of the ownership of the Bank. The Company also invests in short-term investment grade marketable securities and other liquid investments. The Company has no significant liabilities (other than those of the Bank). The Company neither owns nor leases any property but instead uses the premises and equipment of the Bank. At the present time, the Company does not employ any persons other than certain officers of the Bank who do not receive any extra compensation as officers of the Company. The Company utilizes the support staff of the Bank from time to time, as needed. Additional employees may be hired as deemed appropriate by the management of the Company. Unless otherwise disclosed, the information presented in this Annual Report on Form 10-K represents the activity of the Bank for the period prior to January 8, 1998 and the consolidated activity of Mystic and the Bank thereafter. The Bank is a Massachusetts chartered stock co-operative bank founded in 1886 with three full-service offices and one educational branch office in Medford, Massachusetts and another full-service office in Lexington, Massachusetts. The Bank's deposits have been federally insured since 1986 and are currently insured by the Bank Insurance Fund ("BIF") of the Federal Deposit Insurance Corporation ("FDIC") and the Share Insurance Fund of the Co-operative Central Bank. The Bank has been a member of the Co-operative Central Bank since 1932 and a member of the Federal Home Loan Bank ("FHLB") since 1988. The Bank is subject to comprehensive examination, supervision and regulation by the Commissioner of Banks of the Commonwealth of Massachusetts (the "Commissioner") and the FDIC. This regulation is intended primarily for the protection of depositors and borrowers. The Bank exceeded all of its regulatory capital requirements at June 30, 1999. The business of the Bank consists of attracting deposits from the general public and using these funds to originate various types of loans primarily in eastern Middlesex County, Massachusetts, including mortgage loans secured by one- to four-family residences, commercial loans secured by general business assets and commercial real estate loans secured by commercial property, and to invest in U.S. Government and Federal Agency and other securities. To a lesser extent, the Bank engages in various forms of consumer and home equity lending. The Bank's profitability depends primarily on its net interest income, which is the difference between the interest income it earns on its loans and investment portfolio and its cost of funds, which consists mainly of interest paid on deposits and on borrowings from the FHLB. Net interest income is affected by the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on these balances. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Bank has one active subsidiary, Mystic Securities Corporation, which was established for the sole purpose of acquiring and holding investment securities. All securities held by Mystic Securities Corporation are investments which are permissible for banks to hold under Massachusetts law. Market Area The Bank's main office and three branch offices are located in Medford, Middlesex County, Massachusetts. The Bank has a full-service office in Lexington, Middlesex County, Massachusetts, which it opened in November, 1998. The city of Medford, containing approximately 60,000 residents, is located approximately seven miles from downtown Boston in the northern suburbs of Boston, bounded by the towns of Malden, Everett, Somerville, Stoneham, Winchester and Arlington. The City of Medford is easily accessible from downtown Boston via Interstate 93 and is accessible via other state roads connecting the communities within the Route 128 corridor surrounding Boston. As an established metropolitan suburb, Medford consists mostly of developed single- and multi-family properties within a network of well-maintained neighborhoods. The city of Medford represents the primary market area for deposit and loan generation as most of the Bank's depositors and loan customers live in the areas surrounding the Bank's office locations. The Bank considers its primary market area to be the communities of Medford, Malden, Everett, Stoneham, Arlington, Winchester, Somerville, Melrose, Lexington and Bedford, Massachusetts. The economic base of the Bank's market area is diversified and includes a number of financial service institutions, industrial and manufacturing companies, hospitals and other health care facilities and educational institutions. The major employers in the Medford area are Tufts University, Lawrence Memorial Hospital, the City of Medford and Meadow Glen Mall, with approximately 1,600, 1,300, 1,200 and 1,000 employees each, respectively. Management believes that the housing vacancy rate in Medford is very low. The majority of the Bank's lending and deposit activity has historically been in Medford, although the commercial loan department has been largely responsible for expanded business throughout eastern Middlesex County. Middlesex County, located in eastern Massachusetts to the north and west of the city of Boston, is part of the Boston metropolitan area. Based on 1997 Bureau of Labor Statistics, the median household income for Middlesex County was $49,414. Management believes that the Bank's success as a home lender has been due, in part, to the favorable income, population and housing demographics in Medford and in the Bank's market area. At the same time, the growth of the market area and delineated lending area and their proximity to Boston has resulted in a highly competitive environment among the many financial institutions competing for deposits and loans. Competition The Bank experiences competition both in attracting and retaining savings deposits and in the making of mortgage, commercial and other loans. Direct competition for savings deposits primarily comes from larger commercial banks and other savings institutions located in or near the Bank's primary market area which often have significantly greater financial and technological resources than the Bank. Additional significant competition for savings deposits comes from credit unions, money market funds and brokerage firms. With regard to lending competition in the local market area, the Bank experiences the most significant competition from the same institutions providing deposit services, most of whom have placed an emphasis on real estate lending as a line of business. In addition, the Bank competes with local and regional mortgage companies, independent mortgage brokers and credit unions in originating mortgage and non-mortgage loans. The primary factors in competing for loans are interest rates and loan origination fees and the range of services offered by the various financial institutions. Competition from other financial institutions operating in the Bank's local community includes a number of both large and small commercial banks and savings institutions. The Bank has experienced growth in deposits in recent years primarily due to an increased emphasis on marketing products and services. However, competition remains high in the marketplace. Lending Activities The Bank originates loans through its three offices located in Medford, and its office in Lexington, Massachusetts. The principal lending activities of the Bank are the origination of conventional mortgage loans for the purpose of purchasing or refinancing owner-occupied, one- to four- family residential properties in its designated community reinvestment area, consisting of the Massachusetts communities of Medford, Malden, Everett, Stoneham, Arlington, Winchester, Somerville, Lexington and Melrose, and the origination of commercial loans secured by commercial real estate and commercial assets within eastern Middlesex County. To a lesser extent, the Bank also originates consumer loans including home equity and passbook loans. In the past several years, the Bank has made a major commitment to small business commercial lending. The Bank has expanded its commercial lending department with the addition of senior officers with considerable commercial lending expertise and has developed a support staff to run the commercial loan department. The Bank's ten largest loans, outstanding as of June 30, 1999, ranged from $873,000 to $2.1 million. Loan Portfolio. The following table presents selected data relating to the composition of the Bank's loan portfolio by type of loan on the dates indicated. One- to Four-Family Residential Real Estate Lending. The primary emphasis of the Bank's lending activity is the origination of conventional mortgage loans on one- to four-family residential dwellings located in the Bank's primary market area. As of June 30, 1999, loans on one- to four- family residential properties accounted for 69.3% of the Bank's loan portfolio. The Bank's mortgage loan originations are for terms of up to 30 years, amortized on a monthly basis with interest and principal due each month. Residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms as borrowers may refinance or prepay loans at their option, without penalty. Conventional residential mortgage loans granted by the Bank customarily contain "due-on- sale" clauses which permit the Bank to accelerate the indebtedness of the loan upon transfer of ownership of the mortgaged property. The Bank makes conventional mortgage loans and uses standard Federal National Mortgage Association ("FNMA") documents, to allow for the sale of qualifying loans in the secondary mortgage market. The Bank's lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or purchase price of the property, with the condition that private mortgage insurance is required on loans with a loan-to-value ratio in excess of 80%. Since the early 1980s the Bank has offered adjustable-rate mortgage loans with terms of up to 30 years. Adjustable-rate loans offered by the Bank include loans which reprice every one or three years and provide for an interest rate which is based on the interest rate paid on U.S. Treasury securities of a corresponding term, plus a margin of up to 250 basis points, or 2.5%. Additionally, the Bank offers an adjustable-rate loan product with an interest rate fixed for seven years which then reprices annually for its remaining term thereafter. The Bank currently offers adjustable-rate loans with initial rates below those which would prevail under the foregoing computations, based upon the Bank's determination of market factors and competitive rates for adjustable-rate loans in its market area. For adjustable-rate loans, borrowers are qualified at the initial rate. Historically, the Bank has retained all adjustable-rate mortgages it originates. However, in recent years, in order to generate liquidity, the Bank has sold some of these loans. The Bank's adjustable-rate mortgages include limits on increases or decreases of the interest rate of the loan. The interest rate may increase or decrease by 2% per year and 5% over the life of the loan for the Bank's one-year adjustable rate mortgages, by 3% per adjustment period and 6% over the life of the loan for the Bank's three-year adjustable rate mortgages and, by 2% per adjustment period and 5% over the life of the loan for the Bank's five-year adjustable rate mortgages. The Bank also offers an adjustable rate mortgage on which the rate is fixed for the first seven years; thereafter, the loan converts to a one-year adjustable-rate mortgage. The retention of adjustable-rate mortgage loans in the Bank's loan portfolio helps reduce the Bank's exposure to increases in interest rates. However, there are unquantifiable credit risks resulting from potential increased costs to the borrower as a result of the repricing of adjustable-rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. During the year ended June 30, 1999, the Bank originated $10.7 million in adjustable-rate mortgage loans and $36.9 million in fixed-rate mortgage loans. Of the fixed-rate loans originated, the Bank sold $13.1 million of fixed-rate loans with terms of greater than 15 years and retained $23.8 million of fixed-rate loans, a majority of which had terms of 15 years or less. Approximately 27% of all loan originations during fiscal 1999 were refinances of loans already in the Bank's loan portfolio. At June 30, 1999, the Bank's loan portfolio included $47.1 million in adjustable-rate one- to four-family residential mortgage loans or 30.5% of the Bank's net loan portfolio, and $60.1 million in fixed-rate one- to four-family residential mortgage loans, or 38.8% of the Bank's net loan portfolio. Commercial Real Estate Loans. At June 30, 1999, the Bank's commercial real estate loan portfolio consisted of 115 loans, totaling $34.0 million, or 22.0% of net loans. The Bank's largest loan is a commercial real estate loan with an outstanding balance of $2.1 million at June 30, 1999 secured by 78 residential apartment units in Medford and Malden, Massachusetts. Commercial real estate loans are administered by the commercial loan department as described below under "Commercial Loans." In May 1995, the Bank hired a commercial loan officer with over 20 years of experience in commercial lending in the Boston market area for the purpose of expanding the commercial lending program of the Bank. In 1996, the Bank added a second commercial loan officer with over 15 years of experience with commercial lending in the Bedford/Lexington area. With the help of these two officers, the Bank is originating commercial real estate loans and commercial loans to satisfy the working capital and short-term financing needs of established local businesses. Commercial real estate lending entails additional risks compared with one- to four-family residential lending. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject, to a greater extent, to adverse conditions in the real estate market or the economy. Also, commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers and the payment experience on such loans is typically dependent on the successful operation of a real estate project and/or the collateral value of the commercial real estate securing the loan. Commercial Loans. In the past several years, the Bank has made a major commitment to small business commercial lending. The Bank has worked to develop a niche of making commercial loans to companies which have from $500,000 to $15 million in sales and has recently become an approved lender of the Small Business Administration. At June 30, 1999, the Bank's commercial loan portfolio consisted of 143 loans, totaling $7.1 million, or 4.6% of net loans. Commercial loans are expected to comprise a growing portion of the Bank's loan portfolio in the future. Unless otherwise structured as a mortgage on commercial real estate, such loans generally are limited to terms of five years or less. Substantially all such commercial loans have variable interest rates tied to the prime rate as reported in The Wall Street Journal. Whenever possible, the Bank collateralizes these loans with a lien on commercial real estate, or alternatively, with a lien on business assets and equipment and the personal guarantees from principals of the borrower. Commercial business loans are generally considered to involve a higher degree of risk than residential mortgage loans because the collateral may be in the form of intangible assets and/or inventory subject to market obsolescence. Commercial loans may also involve relatively large loan balances to single borrowers or groups of related borrowers, with the repayment of such loans typically dependent on the successful operation and income stream of the borrower. Such risks can be significantly affected by economic conditions. In addition, commercial business lending generally requires substantially greater oversight efforts compared to residential real estate lending. Consumer Loans. The Bank's consumer loans consist of share secured loans, and other consumer loans, including automobile loans and credit card loans. At June 30,1999, the consumer loan portfolio totaled $1.5 million or 1.0% of net loans. Consumer loans are generally offered for terms of up to five years at fixed interest rates. Consumer loans generally do not exceed $25,000 individually. The Bank makes share secured loans up to 90% of the amount of the depositor's savings account balance. The interest rate on the loan is 4% higher than the rate being paid on the account. The Bank also makes other consumer loans, which may or may not be secured. The terms of such loans usually depend on the collateral. The Bank makes loans for automobiles, both new and used, directly to the borrowers. The loans are generally limited to 90% of the purchase price or the retail value listed by the National Automobile Dealers Book. The terms of the loans are determined by the age and condition of the collateral. Collision insurance policies are required on all these loans. The Bank makes unsecured credit card loans generally up to $5,000 at fixed rates of interest. At June 30, 1999, the Bank had 796 unsecured credit card loans totaling $367,000. Consumer loans are generally originated at higher interest rates than residential mortgage loans but also tend to have a higher credit risk than residential loans due to the loan being unsecured or secured by rapidly depreciable assets. Despite these risks, the Bank's level of consumer loan delinquencies generally has been low. No assurance can be given, however, that the Bank's delinquency rate on consumer loans will continue to remain low in the future, or that the Bank will not incur future losses on these activities. Home Equity Loans. The Bank also originates home equity loans which are loans secured by available equity based on the appraised value of owner-occupied one- to four-family residential property. Home equity loans will be made for up to 80% of the appraised value of the property (less the amount of the first mortgage). Home equity loans are offered at adjustable rates and fixed rates. The adjustable interest rate is the prime rate as reported in the Wall Street Journal. Fixed rate home equity loans have terms of ten years or less and adjustable rate home equity loans have terms of 15 years or less with up to a five year final payment if the loan is not fully amortized at the end of the 15 year term. At June 30, 1999, the Bank had $2.1 million in home equity loans with unused credit available to existing borrowers of $2.2 million. Construction Loans. In November 1998, the Bank hired an experienced commercial loan officer who specializes in construction lending. The Bank engages in construction lending for the construction of single family residences and commercial properties. Most are construction loans to developers for the construction of single family housing developments. There are also three loans for the construction of two day care centers and an addition to a commercial building, totaling $4.0 million. All construction loans are secured by first liens on the property. Loan proceeds are disbursed as construction progresses and inspections warrant. Loans involving construction financing present a greater risk than loans for the purchase of existing homes, since collateral values and construction costs can only be estimated at the time the loan is approved. Because payment on loans secured by construction properties are dependent upon the sale of completed homes or the successful operation of the completed property, repayment of such loans may be subject, to a greater extent, to adverse conditions in the real estate market or the economy. Loan Commitments. The Bank generally makes loan commitments to borrowers not exceeding 60 days. At June 30, 1999, the Bank had $6.9 million in loan commitments outstanding, all for the origination of one- to four-family residential real estate loans, home equity loans, commercial loans and commercial real estate loans. In addition, unadvanced funds on lines of credit and credit card loans were $7.9 million on June 30, 1999. Loan Solicitation and Loan Fees. Loan originations are derived from a number of sources, including the Bank's existing customers, referrals, realtors, advertising and "walk-in" customers at the Bank's office. Additionally, the Bank has two residential loan originators, both of whom actively cover the local community, working with local real estate brokers and agents to identify and contact potential new customers. Upon receipt of a loan application from a prospective borrower, a credit report and verifications are ordered to verify specific information relating to the loan applicant's employment, income and credit standing. For all mortgage loans, an appraisal of real estate intended to secure the proposed loan is obtained from an independent appraiser who has been approved by the Bank's board of directors. Fire and casualty insurance are required on all loans secured by improved real estate. Insurance on other collateral is required unless waived by the loan committee. The Board of Directors of the Bank has the responsibility and authority for the general supervision over the loan policies of the Bank. The Board has established written lending policies for the Bank. All residential and commercial real estate mortgages and commercial business loans must be ratified by the Bank's board of directors. In addition, certain designated officers of the Bank have authority to approve loans not exceeding specified levels, while the board of directors must approve loans in excess of (a) $300,000 for commercial real estate loans; (b) $100,000 for commercial loans; (c) loans over the current FNMA limit for residential mortgage loans; and (d) $20,000 for consumer loans. Interest rates charged by the Bank on all loans are primarily determined by competitive loan rates offered in its market area and interest rate costs of the source of funding for the loan. The Bank may charge an origination fee on new mortgage loans. The origination fees, net of direct origination costs, are deferred and amortized into income over the life of the loan. At June 30, 1999, the amount of net deferred loan origination fees was $12,000. Loan Maturities. The following table sets forth certain information at June 30, 1999 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity, including scheduled repayments of principal. Demand loans and loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less. Originations and Sales of Loans. The Bank is a qualified seller/servicer for FNMA. Beginning in 1987, the Bank began to sell a portion of its fixed-rate loans with terms in excess of 15 years to FNMA. All of the Bank's sales to FNMA have been made with servicing retained on the loans. At June 30, 1999, the Bank was servicing $22.6 million in loans for FNMA. Depending upon market conditions, the Bank retains a portion of its fixed rate loans from time to time. In addition, the Bank has also sold loans to other private investors. At June 30, 1999, the Bank was servicing $2.3 million of such loans. Originations for the year ended June 30, 1999 have continued to increase due to the addition of a mortgage loan originator and a second commercial lending officer. Loan sales were reduced during the same period as the Bank borrowed from the FHLB to fund loan originations. Historically, the Bank has not purchased loans. However, the Bank may in the future consider making limited loan purchases, including purchases of commercial loans and commercial real estate loans. The following table sets forth information with respect to originations and sales of loans during the periods indicated. Non-Performing Assets, Asset Classification and Allowances for Losses. Management and the Security Committee of the Board of Directors perform a monthly review of all delinquent loans and loans are placed on a non-accrual status when loans are 90 days past due or, in the opinion of management, the collection of principal and interest are doubtful. One of the primary tools used to manage and control problem loans is the Bank's "Watch-List," a listing of all loans or commitments larger than $25,000, that are considered to have characteristics that could result in loss to the Bank if not properly supervised. The list is managed by the Senior Lending Officer for Commercial Loans, Senior Loan Officer for Mortgage Lending, Chief Financial Officer, Chief Executive Officer, and Mortgage Servicing Officer (the "Watch-List Committee"), who meet periodically to discuss the status of the loans on the Watch-List and to add or delete loans from the list. The Directors can request that a loan relationship be placed on Watch-List status. Real estate acquired by the Bank as a result of foreclosure is classified as real estate owned until such time as it is sold. When such property is acquired, it is recorded at the lower of the unpaid principal balance or its fair value. Any required write-down of the loan to its fair value is charged to the allowance for loan losses. The following table sets forth the Bank's problem assets and loans at the dates indicated. At June 30, 1999, management was not aware of any loans not currently classified as non-accrual, 90 days past due or restructured but which may be so classified in the near future because of concerns over the borrower's ability to comply with repayment terms. Federal regulations require each banking institution to classify its asset quality on a regular basis. In addition, in connection with examinations of such banking institutions, federal and state examiners have authority to identify problem assets and, if appropriate, classify them. An asset is classified substandard if it is determined to be inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. As a general rule, the Bank will classify a loan as substandard if the Bank can no longer rely on the borrower's income as the primary source for repayment of the indebtedness and must look to secondary sources such as guarantors or collateral. An asset is classified as doubtful if full collection is highly questionable or improbable. An asset is classified as loss if it is considered uncollectible, even if a partial recovery could be expected in the future. The regulations also provide for a special mention designation, described as assets which do not currently expose a banking institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management's close attention. Assets classified as substandard or doubtful require a banking institution to establish general allowances for loan losses. If an asset or portion thereof is classified as a loss, a banking institution must either establish specific allowances for loan losses in the amount of the portion of the asset classified as a loss, or charge off such amount. Examiners may disagree with a banking institution's classifications and amounts reserved. If a banking institution does not agree with an examiner's classification of an asset, it may appeal this determination to the Regional Director of the FDIC. At June 30, 1999, the Bank had no assets classified as doubtful, loss, or substandard. In originating loans, the Bank recognizes that credit losses will occur and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. It is management's policy to maintain an adequate general allowance for loan losses based on, among other things, evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Further, after properties are acquired following loan defaults, additional losses may occur with respect to such properties while the Bank is holding them for sale. The Bank increases its allowances for loan losses and losses on real estate owned by charging provisions for losses against the Bank's income. Specific reserves are also recognized against specific assets when management believes it is warranted. While the Bank believes it has established its existing allowances for loan losses in accordance with GAAP there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase its allowance for loan losses, thereby negatively affecting the Bank's financial condition and earnings. Alternately, there can be no assurance that increases in the Bank's allowance for loan losses will occur. The FDIC has adopted a policy statement regarding maintenance of an adequate allowance for loan and lease losses and an effective loan review system. This policy includes an arithmetic formula for checking the reasonableness of an institution's allowance for loan loss estimate compared to the average loss experience of the industry as a whole. Examiners will review an institution's allowance for loan losses and compare it against the sum of (i) 50% of the portfolio that is classified doubtful; (ii) 15% of the portfolio that is classified as substandard; and (iii) estimated credit losses for the portions of the portfolio that have not been classified (including those loans designated as special mention). This amount is considered neither a "floor" nor a "safe harbor" of the level of allowance for loan losses an institution should maintain, but examiners will view a shortfall relative to the amount as an indication that they should review management's policy on allocating these allowances to determine whether it is reasonable based on all relevant factors. The following table analyzes activity in the Bank's allowance for loan losses for the periods indicated. The following table sets forth a breakdown of the allowance for loan losses by loan category at the dates indicated. Management believes that the allowance can be allocated by category only on an approximate basis. These allocations are not necessarily indicative of future losses and do not restrict the use of the allowance to absorb losses in any other loan category. Investment Activities General. The Bank is required to maintain an amount of liquid assets appropriate for its level of net savings withdrawals and current borrowings. It has generally been the Bank's policy to maintain a liquidity portfolio in excess of regulatory requirements. At June 30, 1999, the Bank's liquidity ratio was 32.2%. Liquidity levels may be increased or decreased depending upon the yields on investment alternatives, management's judgment as to the attractiveness of the yields then available in relation to other opportunities, management's expectations of the level of yield that will be available in the future and management's projections as to the short-term demand for funds to be used in the Bank's loan origination and other activities. Interest income from investments in various types of liquid assets provides a significant source of revenue for the Bank. As the New England economy experienced a severe downturn in the late 1980's, the Bank chose to invest excess liquidity in its investment portfolio. The Bank invests in U.S. Treasury and Federal Agency securities, bank certificates of deposits, equity securities, corporate debt securities and overnight federal funds. The balance of investment securities maintained by the Bank in excess of regulatory requirements reflects management's historical objective of maintaining liquidity at a level that assures the availability of adequate funds, taking into account anticipated cash flows and available sources of credit, for meeting withdrawal requests and loan commitments and making other investments. The Bank purchases securities through a primary dealer of U.S. Government obligations or such other securities dealers authorized by the Board of Directors and requires that the securities be delivered to a safekeeping agent before the funds are transferred to the broker or dealer. The Bank purchases investment securities pursuant to an investment policy established by the board of directors. Available for sale securities are reported at fair value with unrealized gains or losses reported as a separate component of other comprehensive income. Held-to-maturity securities are carried at amortized cost. Substantially all purchases of investment securities conform to the Company's interest rate risk policy. The following table sets forth the Company's investment securities at the dates indicated. The following table sets forth the scheduled maturities, carrying values and average yields for the Company's debt securities at June 30, 1999. Deposit Activity and Other Sources Of Funds General. Deposits are the primary source of the Bank's funds for lending and other investment purposes. In addition to deposits, the Bank derives funds from principal repayments and interest payments on loans and investments as well as other sources arising from operations in the production of net earnings. Loan repayments and interest payments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources, or on a longer term basis for general business purposes. Deposits. Deposits are attracted principally from within the Bank's primary market area through the offering of a broad selection of deposit instruments, including checking accounts, passbook savings, NOW accounts, demand deposits, money market accounts and certificates of deposit. Deposit account terms vary, with the principal differences being the minimum balance required, the time periods the funds must remain on deposit and the interest rate. The Bank's policies are designed primarily to attract deposits from local residents and businesses rather than to solicit deposits from areas outside its primary market. The Bank does not accept deposits from brokers due to the volatility and rate sensitivity of such deposits. Interest rates paid, maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations. During the past two years, there has been an increase in demand deposit and NOW accounts, resulting from the increase in commercial customers during this time period. NOW account balances are volatile due to a large deposit relationship with a law firm which maintains short-term deposits in real estate conveyancing accounts and has significant fluctuations in deposit account balances, particularly at month-ends. The following table sets forth the various types of deposit accounts at the Bank and the balances in these accounts at the dates indicated. For more information on the Bank's deposit accounts, see Note 6 of Notes to Consolidated Financial Statements. The following table indicates the amount of the Bank's certificates of deposit of $100,000 or more by time remaining until maturity at June 30, 1999. Borrowings. Savings deposits historically have been the primary source of funds for the Bank's lending and investment activities and for its general business activities. The Bank is authorized, however, to use advances from the FHLB to supplement its supply of lendable funds and to meet liquidity requirements. Due to recent lending activity and demand for liquidity, the Bank has utilized this borrowing power, and has received advances from the FHLB. Advances from the FHLB are secured by the Bank's stock in the FHLB, the Bank's deposits at the FHLB and a portion of the Bank's mortgage loans and investment securities. The Bank had FHLB advances of $19.0 million outstanding at June 30, 1999. The FHLB functions as a central reserve bank providing credit for savings institutions and certain other financial institutions. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the security of such stock and certain of its home mortgages and other assets (principally, securities which are obligations of, or guaranteed by the United States) provided certain standards related to creditworthiness have been met. Personnel As of June 30, 1999, the Bank had 52 full-time employees and 21 part- time employees. The employees are not represented by a collective bargaining unit and the Bank considers its relationship with its employees to be good. FEDERAL AND STATE TAXATION Federal Taxation General. The following is intended only as a discussion of material tax matters and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Company. The Bank has not been audited by the IRS during the last five years. For federal income tax purposes, the Company and the Bank file consolidated income tax returns and report their income on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's tax reserve for bad debts, discussed below. Bad Debt Reserves. The Bank, as a "small bank" (one with assets having an adjusted tax basis of $500 million or less) is permitted to maintain a reserve for bad debts with respect to its loans and to make, within specified formula limits, annual additions to the reserve which are deductible for purposes of computing the Bank's taxable income. Pursuant to the Small Business Job Protection Act of 1996, the Bank is now recapturing (taking into income) over a multi-year period a portion of the balance of its bad debt reserve as of June 30, 1997. Distributions. To the extent that the Bank makes "non-dividend distributions" to shareholders, such distributions will be considered to result in distributions from the Bank's "base year reserve," i.e., its reserve as of April 30, 1988, to the extent thereof and then from its supplemental reserve for losses on loans, and an amount based on the amount distributed will be included in the Bank's taxable income. Non-dividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not constitute non- dividend distributions and, therefore, will not be included in the Bank's income. The amount of additional taxable income created from a non-dividend distribution is equal to the lesser of the Bank's base year reserve and supplemental reserve for losses on loans; or an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, in certain situations approximately one and one-half times the non-dividend distribution would be includable in gross income for federal income tax purposes, assuming a 34% federal corporate income tax rate. Corporate Alternative Minimum Tax. The Internal Revenue Code of 1986, as amended (the "Code"), imposes a tax ("AMT")on alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI can be offset by net operating loss carryovers of which the Bank currently has none. AMTI is also adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. Thus, the Bank's AMTI is increased by an amount equal to 75% of the amount by which the Bank's adjusted current earnings exceeds its AMTI (determined without regard to this adjustment and prior to reduction for net operating losses). The Bank does not expect to be subject to the AMT. Although the corporate environmental tax of 0.12% of the excess of AMTI (with certain modifications) over $2.0 million has expired, under current Administration proposals, such tax will be retroactively reinstated for taxable years beginning after December 31, 1997 and before January 2009. Elimination of Dividends; Dividends Received Deduction. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. A 70% dividends received deduction generally applies with respect to dividends received from domestic corporations that are not members of such affiliated group, except that an 80% dividends received deduction applies if the Company and the Bank own more than 20% of the stock of a corporation paying a dividend. State and Local Taxation Prior to July, 1995, the Bank was subject to an annual Massachusetts excise (income) tax equal to 12.54% of its pre-tax income. In 1995, legislation was enacted to reduce the Massachusetts bank excise (income) tax rate and to allow Massachusetts-based financial institutions to apportion income earned in other states. Further, this legislation expands the applicability of the tax to non-bank entities and out-of-state financial institutions. The Massachusetts excise tax rate for co-operative banks is currently 10.95% of federal taxable income, adjusted for certain items. It is anticipated that this rate will be gradually reduced over the next few years so that the Bank's tax rate will become 10.5% by June 30, 2000. Taxable income includes gross income as defined under the Code, plus interest from bonds, notes and evidences of indebtedness of any state, including Massachusetts, less deductions, but not the credits, allowable under the provisions of the Code. No deductions, however, are allowed for dividends received until July 1, 1999. In addition, carryforwards and carrybacks of net operating losses are not allowed. The Bank's active subsidiary, Mystic Securities Corporation, was established solely for the purpose of acquiring and holding investments which are permissible for banks to hold under Massachusetts law. Mystic Securities Corporation is classified with the Massachusetts Department of Revenue as a "security corporation" under Massachusetts law, qualifying it to take advantage of the low 1.32% income tax rate on gross income applicable to companies that are so classified. State of Delaware. As a Delaware holding company not earning income in Delaware, the Company is exempted from Delaware corporate income tax but is required to file an annual report with and has paid an annual franchise tax to the State of Delaware. For additional information regarding taxation, see Note 8 of the Notes to Consolidated Financial Statements. REGULATION General As a co-operative bank chartered by the Commonwealth of Massachusetts, the Bank is subject to extensive regulation under state law with respect to many aspects of its banking activities; this state regulation is administered by the Commissioner. In addition, as a bank whose deposits are insured by the FDIC under the BIF, the Bank is subject to deposit insurance assessments by the FDIC, and the FDIC has examination and supervisory authority over the Bank, with a broad range of enforcement powers. Finally, the Bank is required to maintain reserves against deposits according to a schedule established by the Federal Reserve System. These laws and regulations have been established primarily for the protection of depositors and the deposit insurance funds, not bank stockholders. The following references to the laws and regulations under which the Bank is regulated are brief summaries thereof, do not purport to be complete, and are qualified in their entirety by reference to such laws and regulations. Massachusetts Banking Laws and Supervision Massachusetts co-operative banks such as the Bank are regulated and supervised by the Commissioner. The Commissioner is required to regularly examine each state-chartered bank. The approval of the Commissioner is required to establish or close branches, to merge with another bank, to form a bank holding company, to issue stock or to undertake many other activities. Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Commissioner is subject to sanctions. The Commissioner may under certain circumstances suspend or remove directors or officers of a bank who have violated the law, conducted a bank's business in a manner which is unsafe, unsound or contrary to the depositors' interests, or been negligent in the performance of their duties. All Massachusetts-chartered co-operative banks are required to be members of the Co-operative Central Bank and are subject to its assessments. The Co-operative Central Bank maintains the Share Insurance Fund, a private deposit insurer, which insures all deposits in member banks in excess of FDIC deposit insurance limits. In addition, the Co-operative Central Bank acts as a source of liquidity to its members in supplying them with low-cost funds, and purchasing certain qualifying obligations from them. Major changes in Massachusetts law in 1982 and 1983 substantially expanded the powers of co-operative banks, and made their powers virtually identical to those of state-chartered commercial banks. The powers which Massachusetts-chartered co-operative banks can exercise under these laws are summarized below. Lending Activities. A Massachusetts chartered co-operative bank may make a wide variety of mortgage loans. Fixed-rate loans, adjustable-rate loans, variable-rate loans, participation loans, graduated payment loans, construction loans, condominium and co-operative loans, second mortgage loans and other types of loans may be made in accordance with applicable regulations. Mortgage loans may be made on real estate in Massachusetts or in another New England state if the bank making the loan has an office there or under certain other circumstances. In addition, certain mortgage loans may be made on improved real estate located anywhere in the United States. Commercial loans may be made to corporations and other commercial enterprises with or without security. With certain exceptions, such loans may be made without geographic limitation. Consumer and personal loans may be made with or without security and without geographic limitation. Loans to individual borrowers generally will be limited to 20% of the total of the Bank's capital accounts and stockholders' equity. Investments Authorized. Massachusetts-chartered co-operative banks have broad investment powers under Massachusetts law, including so-called "leeway" authority for investments that are not otherwise specifically authorized. The investment powers authorized under Massachusetts law are restricted by federal law to permit, in general, only investments of the kinds that would be permitted for national banks. The Bank has authority to invest in all of the classes of loans and investments that are permitted by its existing loan and investment policies. Payment of Dividends. A co-operative bank may only pay dividends on its capital stock if such payment would not impair the bank's capital stock and surplus account. No dividends may be paid to stockholders of a bank if such dividends would reduce stockholders' equity of the bank below the amount of the liquidation account required by Massachusetts conversion regulations. Branches. With the approval of the Commissioner, bank branches may be established in any city or town in Massachusetts; in addition, co-operative banks may operate automated teller machines at any of their offices or, with the Commissioner's approval, anywhere in Massachusetts. Sharing of ATMs or "networking" is also permitted with the Commissioner's approval. Massachusetts chartered co-operative banks may also operate ATMs outside of Massachusetts if permitted to do so by the law of the jurisdiction in which the ATM is located. Interstate Acquisitions. An out-of-state bank may (subject to various regulatory approvals and to reciprocity in its home state) establish and maintain bank branches in Massachusetts by (i) merging with a Massachusetts bank that has been in existence for at least three years, (ii) acquiring a branch or branches of a Massachusetts bank without acquiring the entire bank, or (iii) opening such branches de novo. Massachusetts banks' ability to exercise similar interstate banking powers in other states depends upon the laws of the other states. For example, according to the law of the bordering state of New Hampshire, out-of-state banks may acquire New Hampshire banks by merger, but may not establish de novo branches in New Hampshire. Other Powers. Massachusetts-chartered co-operative banks may also lease machinery and equipment, act as trustee or custodian for tax qualified retirement plans, establish trust departments and act as professional trustee or fiduciary, provide payroll services for their customers, issue or participate with others in the issuance of mortgage- backed securities and establish mortgage banking companies and discount securities brokerage operations. Some of these activities require the prior approval of the Commissioner. Post-conversion Oversight. The Commissioner continues to oversee the Bank following the Conversion on a number of matters specifically relating to the Conversion. For example, the Bank has agreed to submit written quarterly progress reports to the Division for three years following the Conversion which detail the implementation of the Bank's conversion business plan's objectives and goals. Federal Banking Regulations Capital Requirements. Under FDIC regulations, state-chartered banks that are not members of the Federal Reserve System ("state non-member banks"), such as the Bank, are required to comply with minimum leverage capital requirements. For an institution determined by the FDIC to not be anticipating or experiencing significant growth and to have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and to be in general a strong banking organization, rated composite 1 under the Uniform Financial Institutions Ranking System (the CAMELS rating system) established by the Federal Financial Institutions Examination Council, the minimum capital leverage requirement is a ratio of Tier 1 capital to total assets of 3%. For all other institutions, the minimum leverage capital ratio is 3% plus an additional "cushion" amount of at least 100 to 200 basis points and therefore are required to have a ratio of Tier 1 capital to total assets of not less than 4%. Tier 1 capital is the sum of common stockholders' equity, non-cumulative perpetual preferred stock (including any related surplus) and minority investments in certain subsidiaries, less most intangible assets. The FDIC has also adopted risk-based capital guidelines to which the Bank is subject. The guidelines establish a systematic analytical framework designed to make regulatory capital requirements sensitive to differences in risk profiles among banking organizations. The FDIC guidelines require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets. The ratio of such regulatory capital to regulatory risk-weighted assets is referred to as the Bank's "risk-based capital ratio." Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items to four risk- weighted categories ranging from 0% to 100%, with higher levels of capital being required for the categories perceived as representing greater risk. Under the FDIC's risk-weighting system, cash and securities backed by the full faith and credit of the U.S. government are given a 0% risk weight. Mortgage-backed securities that qualify under the Secondary Mortgage Enhancement Act, including those issued, or fully guaranteed as to principal and interest, by the FNMA or the Federal Home Loan Mortgage Corporation ("FHLMC"), are assigned a 20% risk weight. Single-family first mortgages not more than 90 days past due with loan-to-value ratios under 80%, multi-family mortgages (maximum 36 dwelling units) with loan-to-value ratios under 80% and average annual occupancy rates over 80%, and certain qualifying loans for the construction of one- to four-family residences pre-sold to home purchasers, are assigned a risk weight of 50%. Consumer loans and commercial real estate loans, repossessed assets and assets more than 90 days past due, as well as all other assets not specifically categorized, are assigned a risk weight of 100%. State non-member banks must maintain a minimum ratio of qualifying total capital to risk-weighted assets of at least 8%, of which at least one-half must be Tier 1 capital. Qualifying total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock, preferred stock with a maturity of over 20 years, and certain other capital instruments. The includable amount of Tier 2 capital cannot exceed the amount of the institution's Tier 1 capital. Qualifying total capital is further reduced by the amount of the bank's investments in banking and finance subsidiaries that are not consolidated for regulatory capital purposes, reciprocal cross-holdings of capital securities issued by other banks and certain other deductions. The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") required each federal banking agency to revise its risk-based capital standards for insured institutions to ensure that those standards take adequate account of interest-rate risk ("IRR"), concentration of credit risk, and the risk of nontraditional activities, as well as to reflect the actual performance and expected risk of loss on multi-family residential loans. In August 1995, the FDIC, along with the other federal banking agencies, adopted a regulation providing that the agencies will take account of the exposure of a bank's capital and economic value to the risks of changes in interest rates in assessing a bank's capital adequacy. According to the agencies, applicable considerations include the quality of the bank's interest rate risk management process, the overall financial condition of the bank, and the level of other risks at the bank for which capital is needed. Institutions with significant interest rate risk may be required to hold additional capital. The agencies also issued a joint policy statement providing guidance on interest rate risk management, including a discussion of the critical factors affecting the agencies' evaluation of interest rate risk in connection with capital adequacy. The agencies have determined not to proceed with a previously issued proposal to develop a supervisory framework for measuring interest rate risk and to require an explicit capital component for interest rate risk. The following table shows the Company's and the Bank's leverage ratio, its Tier 1 risk-based capital ratio, and its total risk-based capital ratio, at June 30, 1999. As the preceding table shows, the Company and the Bank exceeded the minimum capital adequacy requirements at the date indicated. Enforcement. The FDIC has extensive enforcement authority over insured co-operative banks, including the Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices. The FDIC has authority under federal law to appoint a conservator or receiver for an insured bank under certain circumstances. The FDIC is required, with certain exceptions, to appoint a receiver or conservator for an insured state bank if that bank was "critically undercapitalized" on average during the calendar quarter beginning 270 days after the date on which the bank became "critically undercapitalized." For this purpose, "critically undercapitalized" means having a ratio of tangible equity to total assets equal to or less than 2%. See "-Prompt Corrective Action." The FDIC may also appoint a conservator or receiver for a state bank on the basis of the institution's financial condition or upon the occurrence of certain events, including: (i) insolvency (whereby the assets of the bank are less than its liabilities to depositors and others); (ii) substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices; (iii) existence of an unsafe or unsound condition to transact business; (iv) likelihood that the bank will be unable to meet the demands of its depositors or to pay its obligations in the normal course of business; and (v) insufficient capital, or the incurring or likely incurring of losses that will deplete substantially all of the institution's capital with no reasonable prospect of replenishment of capital without federal assistance. Deposit Insurance. The FDIC has adopted a risk-based deposit insurance assessment system. The FDIC assigns an institution to one of three capital categories based on the institution's financial information, as of the reporting period ending seven months before the assessment period, consisting of (1) well capitalized, (2) adequately capitalized or (3) undercapitalized, and one of three supervisory subcategories within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution's primary federal regulator and information that the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance funds. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Assessment rates for BIF deposits currently range from 0 basis points to 27 basis points. The Bank's assessment rate is currently 0 basis points. The FDIC is authorized to raise the assessment rates in certain circumstances, including to maintain or achieve the designated reserve ratio of 1.25%, which requirement the BIF currently meets. The FDIC has exercised its authority to raise rates in the past and may raise insurance premiums in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of the Bank. In addition, recent legislation requires BIF-insured institutions like the Bank to assist in the payment of FICO bonds. Under the Deposit Insurance Funds Act of 1996 (the "Funds Act"), the assessment base for the payments on the FICO bonds was expanded to add, beginning January 1, 1997, the deposits of BIF-insured institutions, such as the Bank. Until December 31, 1999, or such earlier date on which the last savings association ceases to exist, the rate of assessment for BIF- assessable deposits shall be one-fifth of the rate imposed on SAIF- assessable deposits. For the third and fourth quarter of 1999, the rates of assessment for the FICO bonds is 0.0116% and 0.0184% for BIF-assessable deposits and 0.0588% and 0.0580% for SAIF-assessable deposits. For the third and fourth quarters of 1999, the rates of assessment for FICO bonds is 0.0116% and 0.0184% for BIF-assessable deposits and 0.0588 for SAIF- assessable deposits. Under the Federal Deposit Insurance Act (the "FDI Act"), insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the Division. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance. Transactions with Affiliates and Insiders of the Bank. Transactions between an insured bank, such as the Bank, and any of its affiliates is governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity which controls, is controlled by or is under common control with the bank. Currently, a subsidiary of a bank that is not also a depository institution is not treated as an affiliate of the bank for purposes of Sections 23A and 23B, but the FRB has proposed treating any subsidiary of a bank that is engaged in activities not permissible for bank holding companies under the Bank Holding Company Act, as an affiliate for purposes of Sections 23A and 23B. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and limit all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms that are consistent with safe and sound banking practices. The term "covered transaction" includes the making of loans, purchase of assets, issuance of guarantees and similar other types of transactions. In addition, any covered transaction and certain other transactions, including the sale of assets or purchase of services, between a bank and any of its affiliates must be on terms that are substantially the same, or at least as favorable, to the bank as those that would be provided to a non-affiliate. Further, most loans by a bank to its affiliate must be supported by collateral in amounts ranging from 100 to 130 percent of the loan amounts. A bank's loans to its executive officers, directors, any owner of 10% or more of its stock and any of certain entities affiliated to any such person (each an "insider") are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the Federal Reserve Board's Regulation O thereunder. Under Section 22(h), loans to an insider may not exceed, together with all other outstanding loans to such person and affiliated interests, the loans-to-one-borrower limit applicable to national banks (generally 15% of the institution's unimpaired capital and surplus), and all loans to all such persons in the aggregate may not exceed the institution's unimpaired capital and unimpaired surplus. Regulation O also prohibits the making of loans in an amount greater than either (a) $500,000 or (b) the greater of $25,000 or 5% of the bank's unimpaired capital and surplus, unless such loans are approved in advance by a majority of the Board of Directors of the bank, with any "interested" director not participating in the voting. Further, Regulation O requires that loans to insiders be made on terms substantially the same as those that are offered in comparable transactions to other persons. Regulation O also prohibits a depository institution from paying the overdrafts over $1,000 of any of its executive officers or directors unless they are paid pursuant to written pre-authorized extension of credit or transfer of funds plans. Also, loans to an executive officer, other than loans for the education of the officer's children and certain loans secured by the officer's residence, may not exceed the lesser of (a) $100,000 or (b) the greater of $25,000 or 2.5% of the bank's capital stock, surplus fund and undivided profits. State chartered non-member banks are further subject to the requirements and restrictions of 12 U.S.C. [SECTION]1972 on certain tying arrangements and extensions of credit by correspondent banks. Specifically, this statute (i) prohibits a depository institution from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or certain of its affiliates or not obtain services of a competitor of the institution, subject to certain exceptions, and (ii) also prohibits extensions of credit to executive officers, directors, and greater than 10% stockholders of a depository institution by any other institution which has a correspondent banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features. Real Estate Lending Policies. FDIC regulations require that state- chartered non-member banks must adopt and maintain written policies that establish appropriate limits and standards for extensions of credit that are secured by liens or interest in real estate or are made for the purpose of financing permanent improvements to real estate. These policies must establish loan portfolio diversification standards, prudent underwriting standards, including loan-to-value limits, that are clear and measurable, loan administration procedures and documentation, approval and reporting requirements. The real estate lending policies must reflect consideration of the Interagency Guidelines for Real Estate Lending Policies (the "Interagency Guidelines") that have been adopted by the federal bank regulators. The Interagency Guidelines, among other things, call upon a depository institution to establish internal loan-to-value limits for real estate loans that are not in excess of the following supervisory limits: (i) for loans secured by raw land, the supervisory loan-to-value limit is 65% of the value of the collateral; (ii) for land development loans (i.e., loans for the purpose of improving unimproved property prior to the erection of structures), the supervisory limit is 75%; (iii) for loans for the construction of commercial, multi-family or other nonresidential property, the supervisory limit is 80%; (iv) for loans for the construction of one- to four-family properties, the supervisory limit is 85%; and (v) for loans secured by other improved property (e.g., farmland, completed commercial property and other income-producing property including non owner occupied, one- to four-family property), the limit is 85%. Although no supervisory loan-to-value limit has been established for owner-occupied, one to four-family and home equity loans, the Interagency Guidelines state that for any such loan with a loan-to-value ratio that equals or exceeds 90% at origination, an institution should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral. Safety and Soundness Standards. Pursuant to the requirements of FDICIA, as amended by the Riegle Community Development and Regulatory Improvement Act of 1994, each federal banking agency, including the FDIC, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal shareholder. In addition, the FDIC adopted regulations to require a bank that is given notice by the FDIC that it is not satisfying any of such safety and soundness standards to submit a compliance plan to the FDIC. If, after being so notified, a bank fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the FDIC may issue an order directing corrective and other actions of the types to which a significantly undercapitalized institution is subject under the "prompt corrective action" provisions of FDICIA. If a bank fails to comply with such an order, the FDIC may seek to enforce such an order in judicial proceedings and to impose civil monetary penalties. Prompt Corrective Action. FDICIA also established a system of prompt corrective action to resolve the problems of undercapitalized institutions. The FDIC, as well as the other federal banking regulators, adopted regulations governing the supervisory actions that may be taken against undercapitalized institutions. The regulations establish five categories, consisting of "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The FDIC's regulations defines the five capital categories as follows: Generally, an institution will be treated as "well capitalized" if its ratio of total capital to risk-weighted assets is at least 10%, its ratio of core capital to risk-weighted assets is at least 6%, its ratio of core capital to total assets is at least 5%, and it is not subject to any order or directive by the FDIC to meet a specific capital level. An institution will be treated as "adequately capitalized" if its ratio of total capital to risk-weighted assets is at least 8%, its ratio of core capital to risk-weighted assets is at least 4%, and its ratio of core capital to total assets is at least 4% (3% if the bank receives the highest rating on the CAMELS financial institutions rating system) and it is not a well-capitalized institution. An institution that has total risk-based capital of less than 8%, Tier 1 risk-based-capital of less than 4% or a leverage ratio that is less than 4% (or less than 3% if the institution is rated a composite "1" under the CAMELS rating system) would be considered to be "undercapitalized." An institution that has total risk-based capital of less than 6%, core capital of less than 3% or a leverage ratio that is less than 3% would be considered to be "significantly undercapitalized," and an institution that has a tangible capital to assets ratio equal to or less than 2% would be deemed to be "critically undercapitalized." At June 30, 1999, the Bank was categorized as "well capitalized." The severity of the action authorized or required to be taken under the prompt corrective action regulations increases as a bank's capital deteriorates within the three undercapitalized categories. All banks are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the bank would be undercapitalized. The FDIC is required to monitor closely the condition of an undercapitalized bank and to restrict the growth of its assets. An undercapitalized bank is required to file a capital restoration plan within 45 days of the date the bank receives notice that it is within any of the three undercapitalized categories, and the plan must be guaranteed by any parent holding company. The aggregate liability of a parent holding company is limited to the lesser of: (i) an amount equal to the five percent of the bank's total assets at the time it became "undercapitalized," and (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all capital standards applicable with respect to such bank as of the time it fails to comply with the plan. If a bank fails to submit an acceptable plan, it is treated as if it were "significantly undercapitalized." Banks that are significantly or critically undercapitalized are subject to a wider range of regulatory requirements and restrictions. The FDIC has a broad range of grounds under which it may appoint a receiver or conservator for an insured depositary bank. If one or more grounds exist for appointing a conservator or receiver for a bank, the FDIC may require the bank to issue additional debt or stock, sell assets, be acquired by a depository bank holding company or combine with another depository bank. Under FDICIA, the FDIC is required to appoint a receiver or a conservator for a critically undercapitalized bank within 90 days after the bank becomes critically undercapitalized or to take such other action that would better achieve the purposes of the prompt corrective action provisions. Such alternative action can be renewed for successive 90-day periods. However, if the bank continues to be critically undercapitalized on average during the quarter that begins 270 days after it first became critically undercapitalized, a receiver must be appointed, unless the FDIC makes certain findings that the bank is viable. Community Reinvestment. Under the Community Reinvestment Act ("CRA"), as implemented by FDIC regulations, a bank savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the FDIC, in connection with its examination of a bank, to assess the bank's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such bank. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Bank received an "Outstanding" CRA rating in its most recent examinations from both the FDIC and Commonwealth of Massachusetts. The CRA regulations establish an assessment system that bases a bank's rating on its actual performance in meeting community needs. In particular, the assessment system focuses on three tests: (a) a lending test, to evaluate the institution's record of making loans in its service areas; (b) an investment test, to evaluate the institution's record of investing in community development projects, affordable housing, and programs benefitting low or moderate income individuals and businesses; and (c) a service test, to evaluate the institution's delivery of services through its branches, ATMs, and other offices. Small banks would be assessed pursuant to a streamlined approach focusing on a lesser range of information and performance standards. The term "small bank" is defined as including banks with less than $250 million in assets or an affiliate of a holding company with banking and thrift assets of less than $1 billion, which would include the Bank. Holding Company Regulation Federal Regulation. The Company is subject to examination, regulation and periodic reporting under the Bank Holding Company Act (the "BHCA"), as administered by the Federal Reserve Board (the "FRB"). The FRB has adopted capital adequacy guidelines for bank holding companies on a consolidated basis substantially similar to those of the FDIC for the Bank. As of June 30, 1999, the Company's total capital and Tier 1 capital ratios exceeded these minimum capital requirements. The Company will be required to obtain the prior approval of the FRB to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior FRB approval will be required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than 5% of any class of voting shares of such bank or bank holding company. The Company will be required to give the FRB prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, will be equal to 10% or more of the Company's consolidated net worth. The FRB may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, FRB order or directive, or any condition imposed by, or written agreement with, the FRB. Such notice and approval is not required for a bank holding company that would be treated as "well capitalized" under applicable regulations of the FRB, that has received a composite "1" or "2" rating at its most recent bank holding company inspection by the FRB, and that is not the subject of any unresolved supervisory issues. The status of the Company as a registered bank holding company under the BHCA does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws. In addition, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of any company engaged in, non-banking activities. One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the principal activities that the FRB has determined by regulation to be so closely related to banking as to be a proper incident thereto are: (i) making or servicing loans; (ii) performing certain data processing services; (iii) providing discount brokerage services; (iv) acting as fiduciary, investment or financial advisor, (v) leasing personal or real property; (vi) making investments in corporations or projects designed primarily to promote community welfare; and (vii) acquiring a savings and loan association. Under FIRREA, depository institutions are liable to the FDIC for losses suffered or anticipated by the FDIC in connection with the default of a commonly controlled depository institution or any assistance provided by the FDIC to such an institution in danger of default. This law would have potential applicability if the Company ever acquired as a separate subsidiary a depository institution in addition to the Bank. There are no current plans for such an acquisition. Subsidiary banks of a bank holding company are subject to certain quantitative and qualitative restrictions imposed by the Federal Reserve Act on any extension of credit to, or purchase of assets from, or letter of credit on behalf of, the bank holding company or its subsidiaries, and on the investment in or acceptance of stocks or securities of such holding company or its subsidiaries as collateral for loans. In addition, provisions of the Federal Reserve Act and FRB regulations limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors and principal shareholders of the Bank, the Company, any subsidiary of the Company and related interests of such persons. Moreover, banks are prohibited from engaging in certain tie-in arrangements (with the bank's parent holding company or any of the holding company's subsidiaries) in connection with any extension of credit, lease or sale of property or furnishing of services. Federal Home Loan Bank System The Bank is a member of the FHLB System, which consists of 12 regional Federal Home Loan Banks subject to supervision and regulation by the Federal Housing Finance Board ("FHFB"). The Federal Home Loan Banks provide a central credit facility primarily for member institutions. As a member of the FHLB, the Bank is required to acquire and hold shares of capital stock in the FHLB in an amount equal to 1% of the aggregate unpaid principal of its home mortgage loans, home purchase contracts, and similar obligations, but not less than $500. The Bank was in compliance with this requirement with an investment in FHLB stock at June 30, 1999, of $1,080,000. The FHLB serves as a reserve or central bank for its member institutions within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It offers advances to members in accordance with policies and procedures established by the FHFB and the Board of Directors of the FHLB. Long-term advances may only be made for the purpose of providing funds for residential housing finance. Federal Reserve System Pursuant to regulations of the FRB, a bank must maintain average daily reserves equal to 3% on the first $46.5 million of net transaction accounts (subject to an exemption for the first $4.9 million), plus 10% on the remainder. This percentage is subject to adjustment by the FRB. Because required reserves must be maintained in the form of vault cash or in a non- interest bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution's interest- earning assets. As of June 30, 1999, the Bank met its reserve requirements. Federal Securities Laws The Company's Common Stock is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Accordingly, the Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the Exchange Act. ITEM 2. ITEM 2. PROPERTIES The following table sets forth certain information at June 30, 1999 regarding the Bank's office facilities, which are owned by the Bank, with the exception of the High School Educational Branch and Lexington office, which are leased, and certain other information relating to its property at that date. The Bank also owns an office building adjacent to its main office, located at 66 High Street, Medford, MA 02155, which had a net book value of $1.7 million at June 30, 1999. The Bank uses a portion of the top floor of this building to house some of its administrative and clerical services and leases the remaining space to third-party tenants. At June 30, 1999, the net book value of the Bank's computer equipment and other furniture, fixtures and equipment at its existing offices totaled $479,000. For more information, see Note 4 of the Notes to Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition and results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the Nasdaq National Market under the symbol "MYST." The table below shows the high and low sales price during the periods indicated. The Bank's common stock began trading on January 8, 1998, the date of the Conversion and initial public offering. At June 30, 1999, the last trading date in the Company's fiscal year, the Company's common stock closed at $11.875. At September 3, 1999, there were 2,444,878 shares of the Company's common stock outstanding, which were held of record by approximately 1,014 stockholders, not including persons or entities who hold the stock in nominee or "street" name through various brokerage firms. On July 14, 1999, the Board of Directors of the Company declared a quarterly cash dividend of $.06 per share of common stock, which was paid on August 17, 1999 to shareholders of record on July 30, 1999. On April 14, 1999, the Board of Directors of the Company declared a quarterly cash dividend of $.06 per share of common stock, which was paid on May 17, 1999 to shareholders of record on April 30, 1999. On January 13, 1999, the Board of Directors of the Company declared a quarterly cash dividend of $.05 per share of common stock, which was paid on February 17, 1999 to shareholders of record on January 29, 1999. On October 14, 1998, the Board of Directors of the Company declared a quarterly cash dividend of $.05 per share of common stock, which was paid on November 18, 1998 to shareholders of record on October 30,1998. On July 8, 1998, the Board of Directors of the Company declared a quarterly cash dividend of $.05 per share of common stock, which was paid on August 14, 1998 to shareholders of record on July 30, 1998. On April 8, 1998 the Board of Directors of the Company declared a quarterly cash dividend of $.05 per share of common stock, which was paid on May 15, 1998 to shareholders of record on April 30, 1998. The Board of Directors considers paying dividends, dependent on the results of operations and financial condition of the Company, tax considerations, industry standards, economic conditions, regulatory restrictions and other factors. There are significant regulatory limitations on the Company's ability to pay dividends depending on the dividends it receives from its subsidiary, Medford Co-operative Bank, which are subject to regulations and the Bank's continued compliance with all regulatory capital requirements and the overall health of the institution. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial data concerning the Company at the dates and for the years indicated. The following data is qualified in its entirety by the detailed information and consolidated financial statements appearing elsewhere in this Annual Report on Form 10- K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Medford Co-operative Bank (the "Bank") completed its conversion from a mutual to a stock institution and was simultaneously acquired by Mystic Financial, Inc. ("Mystic" or the "Company") on January 8, 1998. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes thereto included within this report. The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. When used in this discussion, the words "believes", "anticipates", "contemplates", "expects", and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. Those risks and uncertainties include changes in interest rates generally and changes in real estate values and other economic conditions in eastern Massachusetts, the Bank's principal market area. The Company undertakes no obligation to publicly release the results of any revisions to those forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. The business of the Bank consists of attracting deposits from the general public and using these funds to originate various types of loans primarily in eastern Middlesex County, Massachusetts, including mortgage loans secured by one- to four-family residences, commercial loans secured by general business assets, commercial real estate loans secured by commercial property, and to invest in U.S. Government and Federal Agency and other securities. To a lesser extent, the Bank engages in various forms of consumer and home equity lending. The Company's profitability depends primarily on its net interest income, which is the difference between the interest income it earns on its loans and investment portfolio and its cost of funds, which consists mainly of interest paid on deposits and on borrowings from the Federal Home Loan Bank of Boston (the "FHLB"). Net interest income is affected by the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on these balances. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Company's profitability is also affected by the level of other (noninterest) income and operating expenses. Other income consists primarily of service fees, loan servicing and other loan fees and gains on sales of investment securities. Operating expenses consist of salaries and benefits, occupancy related expenses, and other general operating expenses. The operations of the Bank, and banking institutions in general, are significantly influenced by general economic conditions and related monetary and fiscal policies of financial institution's regulatory agencies. Deposit flows and the cost of funds are influenced by interest rates on competing investments and general market rates of interest. Lending activities are affected by the demand for financing real estate and other types of loans, which in turn are affected by the interest rates at which such financing may be offered and other factors affecting loan demand and the availability of funds. Business Strategy The Bank's business strategy is to operate as a well-capitalized, profitable and independent community bank dedicated to financing home ownership, small business and consumer needs in its market area and providing quality service to its customers. The Bank has implemented this strategy by: (i) monitoring the needs of customers and providing quality service; (ii) emphasizing consumer-oriented banking by originating residential mortgage loans and consumer loans, and by offering various deposit accounts and other financial services and products; (iii) recently increasing its emphasis on commercial banking and lending by originating loans for small businesses and providing greater services in its commercial and commercial real estate loan department; (iv) maintaining high asset quality through conservative underwriting; and (v) producing stable earnings. Asset/Liability Management A principal operating objective of the Bank is to produce stable earnings by achieving a favorable interest rate spread that can be sustained during fluctuations in prevailing interest rates. Since the Bank's principal interest-earning assets have longer terms to maturity than its primary source of funds, i.e., deposit liabilities, increases in general interest rates will generally result in an increase in the Bank's cost of funds before the yield on its asset portfolio adjusts upward. The Bank has sought to reduce its exposure to adverse changes in interest rates by attempting to achieve a closer match between the periods in which its interest-bearing liabilities and interest-earning assets can be expected to reprice through the origination of adjustable-rate mortgages and loans with shorter terms and the purchase of other shorter term interest-earning assets. The term "interest rate sensitivity" refers to those assets and liabilities which mature and reprice periodically in response to fluctuations in market rates and yields. As noted above, one of the principal goals of the Bank's asset/liability program is to maintain and match the interest rate sensitivity characteristics of the asset and liability portfolios. In order to properly manage interest rate risk, the Bank's Board of Directors has established an Asset/Liability Management Committee ("ALCO") made up of members of management to monitor the difference between the Bank's maturing and repricing assets and liabilities and to develop and implement strategies to decrease the "negative gap" between the two. The primary responsibilities of the committee are to assess the Bank's asset/liability mix, recommend strategies to the Board that will enhance income while managing the Bank's vulnerability to changes in interest rates and report to the Board the results of the strategies used. Since the early 1980s, the Bank has stressed the origination of adjustable-rate residential mortgage loans and adjustable-rate home equity loans. The Bank regularly sells fixed rate loans with terms in excess of 15 years. Since 1995, the Bank has also emphasized commercial loans with short-term maturities or repricing intervals as well as commercial real estate mortgages with short-term repricing intervals. In addition, the Bank has used borrowings from the FHLB to match-fund the maturity or repricing interval of several larger commercial real estate mortgages. At June 30, 1999, the Bank's loan portfolio included $47.1 million of adjustable-rate one-to four-family mortgage loans, $30.9 million of adjustable-rate commercial real estate loans, $3.1 million of adjustable-rate or short-term commercial loans, and $2.1 million of adjustable-rate home equity loans. Together, these loans represent 53.8% of the Bank's net loans at June 30, 1999. See "Business-Lending Activities." In the future, in managing its interest rate sensitivity, the Bank intends to continue to stress the origination of adjustable-rate mortgages when possible and loans with shorter maturities and the maintenance of a consistent level of short-term securities. Interest Rate Sensitivity Analysis The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring an institution's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities, and is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income while a positive gap would result in an increase in net interest income, while conversely, during a period of falling interest rates, a negative gap would result in an increase in net interest income and a positive gap would negatively affect net interest income. The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at June 30, 1999 which are expected to mature or reprice in each of the time periods shown. In the table, investment securities held to maturity are presented at amortized cost; other interest-earning assets include marketable equity securities, FHLB stock, due from Co-operative Central Bank, federal funds sold and other short-term investments; fixed rate one-to four-family loans, adjustable rate one-to four-family loans, commercial real estate loans, and commercial loans do not include any amortization or prepayment amounts. Money market accounts, NOW accounts, regular and other deposits are shown to mature or reprice within a three month time period based on the contractual status of each type of account. Management believes the current one-year gap of negative 36.7% presents a risk to the net interest income should a sustained increase occur in the current level of interest rates. If interest rates increase, the Bank's negative one-year gap should cause the net interest margin to decrease. A conservative interest rate risk-gap policy provides a stable net interest income margin. Accordingly, management emphasizes a structured schedule of investment securities with greater emphasis on maturities and repricings within one year. It is possible that the actual interest rate sensitivity of the Bank's assets and liabilities could vary significantly from the information set forth in the table due to market and other factors. Certain shortcomings are inherent in the method of analysis presented above. Although certain assets and liabilities may have similar maturity or periods of repricing, they may react in different degrees to changes in the market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, generally have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayments and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Additionally, an interest rate increase may make it more difficult for borrowers to service their debt, thereby increasing the credit risk in the Bank's loan portfolio. Average Balances, Interest and Average Yields The following tables set forth certain information relating to the Company's average balance sheet and reflect the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balances of assets and liabilities, respectively, for the periods presented. Average balances are derived from daily balances. Loans on nonaccrual status are included in the average balances of loans shown in the table. Interest earned on loan portfolios is net of reserves for uncollected interest. The investment securities in the following table are presented at amortized cost. Rate/Volume Analysis The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to: (i) changes in volume (changes in volume multiplied by old rate); and (ii) changes in rates (change in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the changes in volume) are allocated between changes in rate and changes in volume. Financial Condition and Results of Operations The Company's operating results depend primarily upon its net interest income, which is the difference between the interest income earned on its interest-bearing assets (loans and investment securities), and the interest expense paid on its interest-bearing liabilities (deposits and FHLB borrowings). Operating results are also significantly affected by provisions for loan losses, other income and operating expenses. Each of these factors is significantly affected not only by the Company's policies, but, to varying degrees, by general economic and competitive conditions and by policies of state and federal regulatory authorities. Comparison of Financial Condition at June 30, 1999 and June 30, 1998 The Company's total assets amounted to $215.2 million at June 30, 1999 compared to $199.0 million at June 30, 1998, an increase of $16.2 million or 8.1%. The increase in total assets is primarily attributable to an increase in net loans of $16.1 million and an increase in investment securities of $6.6 million, partially offset by a decrease in cash and cash equivalents of $7.3 million. Cash and cash equivalents was $18.7 million at June 30, 1999 compared to $26.0 million at June 30, 1998. Cash and cash equivalents decreased at June 30, 1999 due to a decrease of $5.1 million in federal funds sold to $11.7 million at June 30, 1999 from $16.8 million at June 30, 1998. The decrease in federal funds sold was caused by a decrease in the liquidity needed for a large deposit relationship with a law firm which maintains short-term deposits in real estate conveyancing accounts and has significant fluctuations in its deposit account balances, particularly at month-ends. Net loans increased by $16.1million or 11.6% to $154.7 million or 71.9% of total assets at June 30, 1999 as compared to $138.6 million or 69.6% of total assets at June 30, 1998 as the Bank continued its emphasis on originating and retaining residential mortgage loans and commercial and commercial real estate loans. Investment securities held by the Company increased by $6.6 million or 23.8% to $34.4 million at June 30, 1999 from $27.8 million at June 30, 1998. The increase in the Company's investment portfolio reflects the Company's decision to invest a greater portion of its assets in short and medium term investment securities. Total deposits increased by $16.1 million or 11.1% to $160.9 million at June 30, 1999 from $144.8 million at June 30, 1998. The increase occurred primarily in certificates of deposit as a result of deposit promotions and the opening of the Bank's new office in Lexington, Massachusetts in November 1998. Total borrowings increased by $2.5 million to $19.0 million at June 30, 1999 from $16.5 million at June 30, 1998. The Company's continued use of borrowed funds reflects additional funding needed to support its growth in net loans. In addition, the Bank has secured longer-term borrowed funds with original maturities ranging up to 15 years in order to fund longer- term assets and improve its interest rate risk. Stockholders' equity decreased by $2.1 million to $34.0 million at June 30, 1999 from $36.1 million at June 30, 1998 because of an increase in treasury stock of $3.5 million resulting from the repurchase of common stock, dividends paid of $547,000, and a reduction in the net unrealized gain on securities available for sale of $38,000, offset by net income of $1.5 million and a reduction in unearned ESOP shares of $494,000. Comparison of the Operating Results for the Years Ended June 30, 1999 and Net Income. Net income was $1,502,000 for the year ended June 30, 1999 as compared to $1,547,000 for the year ended June 30, 1998. This $45,000 decrease in net income during the period was the result of an increase of $1.1 million in net interest income after provision for loan losses and an increase in other income of $101,000, offset by an increase in operating expenses of $1.3 million. The return on average assets for the year ended June 30, 1999 was .75% compared to .90% for the year ended June 30, 1998. The return on average equity for the year ended June 30, 1999 was 4.29% compared to 6.70% for the year ended June 30, 1998. Interest Income. Total interest and dividend income increased by $1.5 million or 12.6% to $13.7 million for the year ended June 30, 1999 from $12.2 million for the year ended June 30, 1998. The increase in interest income was primarily the result of a higher level of loans, investment securities, and other earning assets. The average balance of net loans for the year ended June 30, 1999 was $144.7 million compared to $125.0 million for the year ended June 30, 1998. The average yield on net loans was 7.86% for the year ended June 30, 1999 compared to 8.15% for the year ended June 30, 1998. Interest Expense. Total interest expense increased by $573,000 or 10.1% to $6.2 million for the year ended June 30, 1999 from $5.6 million for the year ended June 30, 1998. The reason for the increase in interest expense was the increase in the overall deposit balances as well as an increase in Federal Home Loan Bank of Boston borrowings. Average interest- bearing deposits increased by $8.9 million or 6.8% to $138.1 million for the year ended June 30, 1999. Average borrowings increased by $6.4 million to $18.6 million for the year ended June 30, 1999 from $12.2 million for the year ended June 30, 1998. The average rate on interest bearing deposits decreased 9 basis points to 3.70% for the year ended June 30, 1999 from 3.79% for the year ended June 30, 1998, while the average rate on borrowed funds decreased 20 basis points to 5.93% from 6.13% during the same period. Net Interest Income. Net interest income for the year ended June 30, 1999 was $7.5 million as compared to $6.6 million for the year ended June 30, 1998. The $962,000 or 14.7% increase is attributed to the $1.5 million increase in interest and dividend income partially offset by the $573,000 increase in interest expense on deposits and borrowed funds. The average yield on interest earning assets decreased 30 basis points to 7.23% for the year ended June 30, 1999 from 7.53% for the year ended June 30, 1998, while the average cost on interest-bearing liabilities decreased by 2 basis points to 3.97% for the year ended June 30, 1999 from 3.99% for the year ended June 30, 1998. As a result, the interest rate spread decreased to 3.26% for the year ended June 30, 1999 from 3.54% for the year ended June 30, 1998. The interest rate spread declined due to interest rates on interest-earning assets falling more quickly than interest rates on interest-bearing liabilities during a period of generally falling interest rates. The Company's net loans to total assets ratio increased to 71.9% at June 30, 1999 from 69.6% at June 30, 1998 as a result of growth in loan originations and an increase in loan portfolio retention. Provision for Loan Losses. The provision for loan losses was $145,000 for the year ended June 30, 1999 as compared to $245,000 for the year ended June 30, 1998. The decrease reflects the low amount of delinquent and non- performing loans. At June 30, 1999, the balance of the allowance for loan losses was $1,348,000 or .86% of total loans. During the year ended June 30, 1999, $36,000 was charged against allowance for loan losses while $3,000 in recoveries was credited to the allowance for loan losses. At June 30, 1998, the balance of the allowance for loan losses was $1,236,000 or .88% of total loans. During the year ended June 30, 1998, $2,000 was charged against allowance for loan losses while $16,000 in recoveries was credited to the allowance for loan losses. There were no non-performing loans at June 30, 1999. At June 30, 1998, non-performing loans were $150,000. Other Income. Other income was $1.1 million for the year ended June 30, 1999 compared to $1.0 million for the year ended June 30, 1998. The $101,000 or 9.8% increase was primarily the result of an increase in the gain on the sale of mortgage loans of $65,000, an increase in the gain on the sale of investment securities of $15,000, and an increase in miscellaneous income of $28,000, partially offset by a decrease in net rental income of $20,000. Operating Expenses. Operating expenses increased by $1.3 million or 26.6% to $6.1 million for the year ended June 30, 1999 from $4.8 million for the year ended June 30, 1998. Salaries and employee benefits increased by $504,000, of which $116,000 was attributable to a full year's worth of expense for the Company's Employee Stock Ownership Plan ("ESOP"), $94,000 was attributable to the Company's adoption of a Recognition and Retention Plan in March 1999, and $74,000 was attributable to accrued expense for supplemental benefits to the Company's Chief Executive Officer. Salaries and benefits also increased because of the opening of a new full-service office in Lexington, Massachusetts in November 1998 and normal salary increases. Occupancy and equipment expense increased by $115,000 due to rental expense, real estate taxes, and equipment depreciation costs associated with the opening of the Lexington office. Data processing expense increased by $72,000 due to higher loan and deposit activity, Year 2000 costs, and the opening of the Lexington office. Other general and administrative expenses increased by $577,000 as a result of promotional and other operating costs associated with the Lexington office, increased marketing and advertising expenses, and higher professional fees and liability insurance costs from operating as a public company. Annual operating expenses are expected to increase in future periods due to the increased cost of operating as a publicly held stock institution. Comparison of Financial Condition at June 30, 1998 and June 30, 1997 The Company's total assets amounted to $199.0 million at June 30, 1998 compared to $149.7 million at June 30, 1997, an increase of $49.4 million or 33.0%. The increase in total assets is primarily attributable to a $3.7 million increase in cash and due from banks, a $14.7 million increase in federal funds sold, a $1.4 million increase in short-term investments, a $5.4 million increase in investment securities, and an increase in net loans of $24.0 million. Cash and due from banks was $7.6 at June 30, 1998 compared to $4.0 million at June 30, 1997. Federal funds sold were $16.8 million at June 30, 1998 compared to $2.1 million at June 30, 1997. Short-term investments were $1.6 million at June 30, 1998 compared to $197,000 at June 30, 1997. Cash and due from banks, federal funds sold and short-term investments increased at June 30, 1998 due to proceeds from the stock offering and the Company's need to maintain liquidity for a large deposit relationship with a law firm which maintains short-term deposits in real estate conveyancing accounts and has significant fluctuations in its deposit account balances. Net loans increased by $24.0 million or 21.0% to $138.6 million or 69.6% of total assets at June 30, 1998 as compared to $114.6 million or 76.6% of total assets at June 30, 1997 as the Bank continued its emphasis on originating and retaining residential mortgage loans and commercial and commercial real estate loans. The percentage of net loans to total assets declined at June 30, 1998 despite the increase in net loans because of the increase in the Company's total assets. Investment securities held by the Company increased by $5.4 million or 25.5% to $26.8 million at June 30, 1998 from $21.3 million at June 30, 1997. The increase in the Company's investment portfolio reflects the Company's decision to invest a portion of the offering proceeds in short and medium term investment securities. Total deposits increased by $15.5 million or 12.0% to $144.8 million at June 30, 1998 from $129.3 million at June 30, 1997 as a result of a general increase in deposit balances. A significant portion of the increase in total deposits was due to a large deposit relationship with a law firm which maintains short-term deposits in real estate conveyancing accounts. Total borrowings increased by $9.0 million to $16.5 million at June 30, 1998 from $7.5 million at June 30, 1997. The Company's continued use of borrowed funds reflects additional funding needed to support its growth in net loans. Net loan growth exceeded the increase in total deposits by $8.6 million from June 30, 1997 through June 30, 1998. The Company and the Bank each received approximately one-half of the net proceeds from the stock offering and the Bank's portion of such proceeds was applied towards funding the growth in net loans and improving the Bank's liquidity. In addition, the Bank has secured longer-term borrowed funds with original maturities ranging up to 15 years in order to fund longer-term assets and improve its interest rate risk. Stockholders' equity increased by $24.2 million to $36.1 million at June 30, 1998 from $11.9 million at June 30, 1997 as a result of net proceeds from the issuance of common stock of $25.7 million, net income of $1,547,000 and an increase in the net unrealized gain on securities available for sale of $253,000. These increases were partially offset by the Company's $3.2 million loan to the Employee Stock Ownership Plan ("ESOP") and dividend payment of $135,000. Comparison of the Operating Results for the Years Ended June 30, 1998 and Net Income. Net income was $1,547,000 for the year ended June 30, 1998 as compared to $741,000 for the year ended June 30, 1997. This $806,000 increase in net income during the period was the result of an increase of $1.6 million in net interest income after provision for loan losses and an increase in other income of $153,000, partially offset by an increase in operating expenses of $444,000 and an increase in income taxes of $504,000. The return on average assets for the year ended June 30, 1998 was .90% compared to .54% for the year ended June 30, 1997. The return on average equity for the year ended June 30, 1998 was 6.70% compared to 6.40% for the year ended June 30, 1997. Interest Income. Total interest and dividend income increased by $2.3 million or 23.3% to $12.2 million for the year ended June 30, 1998 from $9.9 million for the year ended June 30, 1997. The increase in interest income was primarily the result of a higher level of loans. The average balance of net loans for the year ended June 30, 1998 was $125.0 million compared to $103.2 million for the year ended June 30, 1997. The average yield on net loans was 8.15% for the year ended June 30, 1998 compared to 8.13% for the year ended June 30, 1997. Interest Expense. Total interest expense increased by $737,000 or 15.0% to $5.6 million for the year ended June 30, 1998 from $4.9 million for the year ended June 30, 1997. The reason for the increase in interest expense was the increase in the overall deposit balances as well as an increase in Federal Home Loan Bank of Boston borrowings. Average interest- bearing deposits increased by $9.9 million or 8.3% to $129.3 million for the year ended June 30, 1998. Average borrowings increased by $8.9 million to $12.2 million for the year ended June 30, 1998 from $3.3 million for the year ended June 30, 1997. The average rate on interest bearing deposits decreased 15 basis points to 3.79% for the year ended June 30, 1998 from 3.94% for the year ended June 30, 1997, while the average rate on borrowed funds decreased 29 basis points to 6.13% from 6.42% during the same period. Net Interest Income. Net interest income for the year ended June 30, 1998 was $6.6 million as compared to $5.0 million for the year ended June 30, 1997. The $1.6 million or 31.6% increase is attributed to $2.3 million increase in interest and dividend income partially offset by the $737,000 increase in interest expense on deposits and borrowed funds. The average yield on interest earning assets decreased 10 basis points to 7.53% for the year ended June 30, 1998 from 7.63% for the year ended June 30, 1997, while the average cost on interest-bearing liabilities decreased by 1 basis point to 3.99% for the year ended June 30, 1998 from 4.00% for the year ended June 30, 1997. As a result, the interest rate spread decreased to 3.54% for the year ended June 30, 1998 from 3.63% for the year ended June 30, 1997. The interest rate spread declined due to the receipt of net conversion proceeds which have been invested in federal funds sold, short-term investments and investment securities at interest rates lower than the Company's average yield on loans. The Company's net loans to total assets ratio declined to 69.6% at June 30, 1998 from 76.6% at June 30, 1997 as a result of the conversion proceeds being invested in federal funds sold, short-term investments and investment securities and the growth in total assets. Provision for Loan Losses. The provision for loan losses was $245,000 for the year ended June 30, 1998 as compared to $272,000 for the year ended June 30, 1997. The decrease reflects the low amount of delinquent and non- performing loans. At June 30, 1998, the balance of the allowance for loan losses was $1,236,000 or .88% of total loans. During the year ended June 30, 1998, $2,000 was charged against allowance for loan losses while $16,000 in recoveries was credited to the allowance for loan losses. At June 30, 1997, the balance of the allowance for loan losses was $977,000 or .85% of total loans. During the year ended June 30, 1997, $57,000 was charged against allowance for loan losses while $20,000 in recoveries was credited to the allowance for loan losses. Non-performing loans at June 30, 1998 and 1997 were $150,000 and $365,000, respectively. Other Income. Other income was $1.0 million for the year ended June 30, 1998 compared to $882,000 for the year ended June 30, 1997. The $153,000 or 17.3% increase was primarily the result of an increase in the gain on the sale of mortgage loans of $27,000, an increase in the gain on the sale of investment securities of $59,000, and an increase in miscellaneous income of $31,000. Operating Expenses. Operating expenses increased by $444,000 or 10.3% to $4.8 million for the year ended June 30, 1998 from $4.3 million for the year ended June 30, 1997. Salaries and employee benefits increased by $214,000, of which $163,000 was attributable to the Company's adoption of an Employee Stock Ownership Plan ("ESOP"). Occupancy and equipment expense increased by $67,000 due to higher equipment depreciation costs. Data processing expense increased by $50,000 due to higher loan and deposit activity as well as Year 2000 costs. Other general and administrative expenses increased by $113,000 as a result of higher professional fees and liability insurance costs from operating as a public company. Annual operating expenses are expected to increase in future periods due to the increased cost of operating as a publicly held stock institution. Liquidity and Capital Resources The Bank's primary sources of funds consist of deposits, borrowings, repayment and prepayment of loans, sales and participations of loans, maturities of investments and interest-bearing deposits, and funds provided from operations. While scheduled repayments of loans and maturities of investment securities are predictable sources of funds, deposit flows and loan prepayments are greatly influenced by the general level of interest rates, economic conditions, and competition. The Bank uses its liquidity resources primarily to fund existing and future loan commitments, to fund net deposit outflows, to invest in other interest-earning assets, to maintain liquidity and to meet operating expenses. The Bank is required to maintain adequate levels of liquid assets. This guideline, which may be varied depending upon economic conditions and deposit flows, is based upon a percentage of deposits and short-term borrowings. The Bank has historically maintained a level of liquid assets in excess of regulatory requirements. The Bank's liquidity ratio at June 30, 1999 was 32.2%. The Bank began using FHLB borrowings in 1997 to augment its liquidity as its loan originations have continued to increase since 1996. A major portion of the Bank's liquidity consists of cash and cash equivalents, short-term U.S. Government and Federal Agency obligations, and corporate bonds. The level of these assets is dependent upon the Bank's operating, investing, lending and financing activities during any given period. The primary investing activities of the Bank include origination of loans and purchase of investment securities. During the year ended June 30, 1999, loan originations and purchases totaled $72.3 million while purchases of investment securities and FHLB stock totaled $25.5 million. These investments were funded primarily from loan repayments and loan sales of $56.0 million, investment security maturities and calls of $18.0 million, net deposit increases of $16.1 million, a net increase in borrowings of $2.5 million. Liquidity management is both a daily and long-term function of management. If the Bank requires funds beyond its ability to generate them internally, the Bank believes it could borrow additional funds from the FHLB. At June 30, 1999, the Bank had borrowings of $19.0 million from the FHLB. At June 30, 1999, the Bank had $14.8 million in outstanding commitments to originate loans and unadvanced funds on lines of credit and credit card loans. The Bank anticipates that it will have sufficient funds available to meet its current loan commitments. Certificates of deposit which are scheduled to mature in one year or less totaled $62.1 million at June 30, 1999. Based upon historical experience, management believes that a significant portion of such deposits will remain with the Bank. At June 30, 1999, the Company and the Bank exceeded all of their regulatory capital requirements. For further information regarding the Company's and the Bank's regulatory capital at June 30, 1999, see "Regulation-Federal Banking Regulations-Capital Requirements." Impact of Inflation and Changing Prices The consolidated financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and results of operations in terms of historical dollars without considering changes in the relative purchasing power of money over time because of inflation. Unlike most industrial companies, virtually all of the assets and liabilities of the Bank are monetary in nature. As a result, interest rates have a more significant impact on the Bank's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Impact of New Accounting Standards In June of 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 is effective for fiscal years beginning after December 15, 1997. Accounting principles generally require all recognized revenue, expenses, gains and losses to be included in net income. Various FASB statements, however, require companies to report certain changes in assets and liabilities as a separate component of the equity section of the balance sheet such as unrealized gains and losses on available for sale securities. This such item, along with net income, is a component of comprehensive income. It is required under SFAS 130 that all items of comprehensive income are to be reported in a "financial statement" that is displayed with the same prominence as other financial statements. Additionally, SFAS 130 requires the classification of items comprising other comprehensive income by their nature, and the accumulated balance of other comprehensive income must be displayed separately from retained earnings and additional paid-in capital in the equity section of the balance sheet. Management adopted this new disclosure requirement as of July 1, 1998. Also, in June of 1997, the FASB issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," ("SFAS 131"). SFAS 131 is effective for financial statements for periods beginning after December 15, 1997. SFAS 131 establishes standards for the way that public companies report information about operating segments in annual financial statements and selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Generally, financial information is required to be reported on the basis that it is used internally for evaluating segment performance and deciding how to allocate resources to segments. SFAS 131 also requires companies to report information about the way that the operating segments were determined, the product and services provided by the operating segments, differences between the measurements used in reporting segment information and those used by the company in its general purpose financial statements, and changes in the measurement of segment amounts from period to period. The Company's operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's banking operations are considered by management to be aggregated in one reportable segment. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 requires that all derivatives be recognized at fair value as either assets or liabilities on the consolidated balance sheet. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security or a foreign-currency-denominated forecasted transaction. The accounting for changes in fair value of a derivative depends on the intended use of the derivative and the resulting designation. SFAS 133 generally provides for matching the timing of a gain or loss recognition on the hedging instrument with the recognition of (a) the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk or (b) the earnings effect of the hedged forecasted transaction. SFAS 133 was originally effective for all fiscal quarters of fiscal years beginning after June 15, 1999, with earlier application encouraged. In June 1999, FASB issued Statement of Financial Accounting Standards No. 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," ("SFAS 137"). SFAS 137 defers the effective date of SFAS 133 to all fiscal quarters of all fiscal years, beginning after June 15, 2000. Retroactive application to prior periods is prohibited. The Bank does not generally use derivative instruments and therefore the adoption of the Statement is not expected to have a material impact on the financial statements of the Company. Year 2000 The "Year 2000 Problem" centers on the inability of computer systems to recognize the Year 2000. Many existing computer programs and systems were originally programmed with six digit dates that provided only two digits to identify the calendar year in the date field, without considering the upcoming change in the century. With the impending millennium, these programs and computers will recognize "00" as the year 1900 rather than the year 2000. Like most financial service providers, the Bank and its operations may be significantly affected by the Year 2000 problem due to the nature of financial information. Software, hardware, and equipment both within and outside the Bank's direct control and with whom the Bank electronically or operationally interfaces (e.g. third party vendors providing data processing, information system management, maintenance of computer systems, and credit bureau information) are likely to be affected. Furthermore, if computer systems are not adequately changed to identify the Year 2000, many computer applications could fail or create erroneous results. As a result, many calculations which rely on the date field information, such as interest, payment or due dates and other operating functions, will generate results which could be significantly misstated, and the Bank could experience a temporary inability to process transactions, send invoices or engage in similar normal business activities. In addition, under certain circumstances, failure to adequately addressthe Year 2000 problem could adversely affect the viability of the Bank's suppliers and creditors and the creditworthiness of its borrowers. Thus, if not adequately addressed, the Year 2000 problem could result in a significant adverse impact on the Bank's products, services and competitive condition. In order to address the Year 2000 issue and to minimize its potential adverse impact, in 1997 management began a process to identify areas that will be affected by the Year 2000 Problem, assess its potential impact on the operations of the Bank, monitor the progress of third party software vendors in addressing the matter, test changes provided by these vendors, and develop contingency plans for any critical systems which are not effectively reprogrammed. The Bank's plan is divided into the five phases: (1) awareness; (2) assessment; (3) renovation; (4) testing; and (5) implementation. Because the Bank outsources its data processing and item processing operations, a significant component of the Year 2000 plan is working with external vendors to test and certify their systems as Year 2000 compliant. The Bank's external vendors surveyed their programs and have corrected the applicable computer programs and replaced equipment so that the Bank's information systems were Year 2000 compliant at the end of 1998. This enabled the Bank to devote substantial time to the testing of the upgraded systems by June 30, 1999 in order to comply with all applicable regulations. The Bank has completed its timetable for addressing year 2000 issues. The Company presently believes that with the modifications to existing software and conversions to new software, the Year 2000 problem will be mitigated without causing a material adverse impact on the operations of the Company. However, if such modifications and conversions are not effective, the Year 2000 problem could have an impact on the operations of the Company. In addition, monitoring and managing the Year 2000 project has resulted in additional direct and indirect costs to the Company and the Bank. Direct costs include charges by third party software vendors for product enhancements, costs involved in testing software products for Year 2000 compliance, and costs for developing and implementing contingency plans for critical software products which are not enhanced. Indirect costs principally consist of the time devoted by existing employees in monitoring software vendor progress, testing enhanced software products and implementing any necessary contingency plans. The Company has incurred aggregate direct and indirect costs of approximately $110,600 and expects to incur an additional $40,000 of costs. Both direct and indirect costs of addressing the Year 2000 problem are charged to earnings as incurred. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. The Company has developed a contingency plan which would be implemented in the unforeseen event Year 2000 problems occur. The Company will continue to closely monitor its Year 2000 compliance plan. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. The Company's primary market risk exposure is interest rate risk. The ongoing monitoring and management of this risk is an important component of the Company's asset/liability management process which is governed by policies established by its Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the Asset/Liability Management Committee ("ALCO"). In this capacity, ALCO develops guidelines and strategies affecting the Company's asset/liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO Committee is composed of members of management to monitor the difference between the Company's maturing and repricing assets and liabilities and to develop and implement strategies to decrease the "negative gap" between the two. The primary responsibilities of the committee are to assess the Company's asset/liability mix, recommend strategies to the Board that will enhance income while managing the Company's vulnerability to changes in interest rates and report to the Board the results of the strategies used. Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change the interest income and expense streams associated with the Company's financial instruments also change thereby affecting net interest income ("NII"), the primary component of the Company's earnings. ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of NII to sustained interest rate changes. While ALCO routinely monitors simulated NII sensitivity over a rolling one-year horizon, it also utilizes additional tools to monitor potential longer-term risk. The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the Company's balance sheet. This sensitivity analysis is compared to Board and ALCO policy limits which specify a maximum tolerance level for NII exposure over a one year horizon, assuming no balance sheet growth, given both a 200 basis point upward and downward shift in interest rates. A parallel and pro rata shift in rates over a 12 month period is assumed. The Company uses various other assumptions in its sensitivity analysis. For investment securities, in the event of a call provision, if the interest rate is lower than the contractual rate, reinvestment is assumed at the lower rate. For residential mortgage loans, the Company uses the PSA method to generate different prepayment assumptions. Commercial loans and commercial real estate loans do not include any amortization or prepayment amounts. For money market accounts, NOW accounts, regular savings deposits, not all deposits within these categories are assumed to increase by the full extent of the interest rate shift based upon management's judgment as to deposit elasticity. The following reflects the Company's NII sensitivity analysis as of June 30, 1999. The preceding sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, changes in deposit levels, pricing decisions on loans and deposits, reinvestment of asset and liability cash flows, and others. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. In addition, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to: prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate changes caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of Mystic Financial, Inc. and subsidiary as of June 30, 1999 and 1998 are included in pages through of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following information included on pages 5 through 8, and page 16 of the Company's Proxy Statement for the 1999 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference: "Election of Directors," "Information as to Nominees and Continuing Directors," "Nominees for Election as Director," "Executive Officers," and " - Section 16(a) Beneficial Ownership Reporting Compliance." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following information included on pages 8 through 15 of the Proxy Statement is incorporated herein by reference: "Compensation of Directors and Executive Officers-Directors' Compensation," "-Executive Compensation," "-Employment Agreements," and "-Benefits." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following information included on pages 3 and 4 of the Proxy Statement is incorporated herein by reference: "Security Ownership of Certain Beneficial Owners and Management-Principal Stockholders of the Company" and "-Security Ownership of Management." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The following information included on page 15 of the Proxy Statement is incorporated herein by reference: "Compensation of Directors and Executive Officers-Transactions with Certain Related Persons." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Listed below are all financial statements and exhibits filed as part of this report: (1) The consolidated balance sheets of Mystic Financial, Inc. and subsidiary as of June 30, 1999 and 1998 and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended June 30, 1999, together with the related notes and the independent auditors' report of Wolf & Company, P.C. independent certified public accountants. (2) Schedules omitted as they are not applicable. (3) Exhibits 3.1 Certificate of Incorporation of Mystic Financial, Inc.* 3.2 Bylaws of Mystic Financial, Inc.* 4.3 Specimen of Stock Certificate of Mystic Financial, Inc.* 10.1 Employee Stock Ownership Plan and Trust Agreement of Mystic Financial, Inc.* 10.2 Employment Agreement between Medford Co-operative Bank and Robert H. Surabian.* 10.3 Employment Agreement between Medford Co-operative Bank and Ralph W. Dunham.* 10.4 Employment Agreement between Medford Co-operative Bank and John O'Donnell.* 10.5 Employment Agreement between Medford Co-operative Bank and Thomas G. Burke.* 21.1 Subsidiaries of the Registrant.* 23.1 Consent of Wolf & Company, P.C. 27.1 Financial Data Schedule (Submitted only with filing in electronic format). 99.1 Proxy Statement for the 1999 Annual Meeting of Stockholders of Mystic Financial, Inc. (previously filed with the Securities and Exchange Commission on September 20, 1999). - -------------------- Incorporated herein by reference to Registration Statement No. 333-34447 on Form S-1 of Mystic Financial, Inc. filed with the Securities and Exchange Commission on August 27, 1997, as amended. (b) The Company filed no reports on Form 8-K during the fourth quarter of the fiscal year ended June 30, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant certifies that it has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized, in the City of Medford, Commonwealth of Massachusetts, on September 8, 1999. Mystic Financial, Inc. By: /s/ Robert H. Surabian ------------------------------------- Robert H. Surabian President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons in the capacities and on the dates indicated. MYSTIC FINANCIAL, INC. AND SUBSIDIARY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Independent Auditors' Report Consolidated Balance Sheets as of June 30, 1999 and 1998 Consolidated Statements of Income for each of the years in the three-year period ended June 30, 1999 Consolidated Statements of Changes in Stockholders' Equity for each of the years in the three-year period ended June 30, 1999 Consolidated Statements of Cash Flows for each of the years in the three-year period ended June 30, 1999 Notes to Consolidated Financial Statements INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Mystic Financial, Inc. We have audited the consolidated balance sheets of Mystic Financial, Inc. and subsidiary as of June 30, 1999 and 1998, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended June 30, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mystic Financial, Inc. and subsidiary as of June 30, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 1999 in conformity with generally accepted accounting principles. Boston, Massachusetts July 23, 1999, except for Note 17 as to which the date is September 8, 1999 MYSTIC FINANCIAL, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS ASSETS See accompanying notes to consolidated financial statements. MYSTIC FINANCIAL, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME See accompanying notes to consolidated financial statements. MYSTIC FINANCIAL, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended June 30, 1999, 1998 and 1997 See accompanying notes to consolidated financial statements. MYSTIC FINANCIAL, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. MYSTIC FINANCIAL, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended June 30, 1999, 1998 and 1997 l. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation and business The consolidated financial statements include the accounts of Mystic Financial, Inc. (the "Company") and its wholly-owned subsidiary, Medford Co-operative Bank (the "Bank"). The Bank has two wholly-owned subsidiaries, Mystic Securities Corp., which engages in the purchase and sale of investment securities and Mystic Investment Inc. which is inactive. Mystic Financial, Inc. became the Bank's holding company on January 8, 1998 in connection with the Bank's conversion from mutual to stock form. All significant intercompany accounts have been eliminated in consolidation. The Bank provides a variety of financial services to individuals and businesses through its five offices in Medford and Lexington, Massachusetts. Its primary deposit products are checking, savings and term certificate accounts, and its primary lending products are residential and commercial mortgage, commercial and consumer loans. Use of estimates In preparing consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation reserve for deferred tax assets. Reclassification Certain amounts in the 1998 and 1997 consolidated financial statements have been reclassified to conform to the 1999 presentation. Cash equivalents Cash equivalents include amounts due from banks, federal funds sold and short-term investments with original maturities of three months or less. Short-term investments Short-term investments are carried at cost, which approximates fair value, and consist of money market funds and interest-bearing deposits in the Bank Investment Fund-Liquidity Fund. Investment securities Investments in debt securities that management has the positive intent and ability to hold to maturity are classified as "held to maturity" and carried at amortized cost. Investments classified as "available for sale" are carried at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income by the interest method over the terms of the securities. Declines in the fair value of investment securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date using the specific identification method. Loans The Bank grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio consists of mortgage loans in the Greater Boston area. The ability of the Bank's debtors to honor their contracts is dependent upon the local real estate market and economy in this area. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent. Loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost- recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Allowance for loan losses The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by the fair value of the existing collateral. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer loans for impairment disclosures. Mortgage loans held for sale Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value. Fair value is based on commitments on hand from investors or prevailing market prices. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Banking premises and equipment and real estate held for investment Land is carried at cost. Buildings, equipment and improvements are stated at cost, less accumulated depreciation, computed on the straight-line method over the estimated useful lives of the assets. It is general practice to charge the cost of maintenance and repairs to earnings when incurred; major expenditures for improvements are capitalized and depreciated. Pension plan It is the Company's policy to fund pension plan costs in the year of accrual. Income taxes Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted accordingly through the provision for income taxes. The Bank's base amount of its federal income tax reserve for loan losses is a permanent difference for which there is no recognition of a deferred tax liability. However, the loan loss allowance maintained for financial reporting purposes is a temporary difference with allowable recognition of a related deferred tax asset, if it is deemed realizable. Employee stock ownership plan ("ESOP") Compensation expense is recognized based on the current market price of shares committed to be released to employees. All shares released and committed to be released are deemed outstanding for purposes of earnings per share calculations. Dividends declared on all allocated shares held by the ESOP are charged to retained earnings. The value of unearned shares to be allocated to ESOP participants for future services not yet performed is reflected as a reduction of stockholders' equity. Stock compensation plans Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company's stock option plan have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them. The Company has elected to continue with the accounting methodology in Opinion No. 25 and, as a result, has provided pro forma disclosures of net income and earnings per share and other disclosures, as if the fair value based method of accounting had been applied. Earnings per common share Basic earnings per share represents income available to common stock divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed conversion. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method. Earnings per share data is not presented in these consolidated financial statements for the years ended June 30, 1998 and 1997 as shares of common stock were not issued until January 8, 1998. Comprehensive income The Company adopted SFAS No. 130, "Reporting Comprehensive Income," as of July 1, 1998. Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. The adoption of SFAS No. 130 had no effect on the Company's net income or stockholders' equity. The components of other comprehensive income and related tax effects are as follows: 2. INVESTMENT SECURITIES The amortized cost and estimated fair value of investment securities with gross unrealized gains and losses is as follows: The amortized cost and estimated fair value of debt securities by contractual maturity at June 30, 1999 is as follows: During the years ended June 30, 1999, 1998 and 1997, proceeds from sales of securities available for sale amounted to $1,071,000, $2,924,000 and $1,098,000, respectively. Gross realized gains for 1999, 1998 and 1997 amounted to $275,000, $363,000 and $172,000, respectively and gross realized losses were $33,000, $136,000 and $4,000, respectively. 3. LOANS A summary of the balances of loans follows: An analysis of the allowance for loan losses follows: The following is a summary of information pertaining to impaired and non-accrual loans: No additional funds are committed to be advanced in connection with impaired loans. On a fee basis, the Bank services loans it has originated and sold to others. At June 30, 1999 and 1998, such loans amounted to $24,886,000 and $16,879,000, respectively. As of June 30, 1999 and 1998, the Bank has no capitalized mortgage servicing rights. All loans serviced for others were sold without recourse provisions. 4. BANKING PREMISES AND EQUIPMENT A summary of the cost and accumulated depreciation of banking premises and equipment and their estimated useful lives follows: Depreciation expense for the years ended June 30, 1999, 1998 and 1997 amounted to $307,000, $278,000 and $210,000, respectively. 5. REAL ESTATE HELD FOR INVESTMENT Real estate held for investment represents property adjacent to the Bank's main office which is primarily leased as commercial retail and office space. The Bank occupies a portion of the building for its own activities. A summary of the cost and accumulated depreciation and estimated useful life is as follows: Depreciation expense for the years ended June 30, 1999, 1998 and 1997 amounted to $56,000, $57,000 and $56,000, respectively. The following is a schedule of minimum future rental income on noncancelable leases: The provisions of the lease agreements provide that the tenants are responsible for utilities and certain repairs. Certain of the leases also contain provisions that the tenants are responsible for a percentage of real estate taxes and certain other costs. Rental income for the years ended June 30, 1999, 1998 and 1997 amounted to $141,000, $149,000 and $135,000, respectively. 6. DEPOSITS A summary of deposit balances by type is as follows: A summary of certificate accounts by maturity, is as follows: 7. FEDERAL HOME LOAN BANK BORROWINGS Federal Home Loan Bank borrowings consist of the following: The following is a summary of maturities of borrowings at June 30, 1999: The Bank also has an available line of credit of $3,529,000 with the Federal Home Loan Bank of Boston ("FHLB") at an interest rate that adjusts daily. Borrowings under the line are limited to 2% of the Bank's total assets. All borrowings from the Federal Home Loan Bank of Boston are secured by a blanket lien on qualified collateral, defined principally as 75% of the carrying value of first mortgage loans on owner-occupied residential property and 90% of the market value of U.S. Government and federal agency securities. 8. INCOME TAXES Allocation of federal and state income taxes between current and deferred portions is as follows: The reasons for the differences between the statutory federal income tax rate and the effective tax rates are summarized as follows: The components of the net deferred tax asset included in other assets are as follows: The tax effects of each type of income and expense item that give rise to deferred taxes are as follows: A summary of the change in the net deferred tax asset is as follows: There was no change in the valuation reserve during the years ended June 30, 1999, 1998 and 1997. The federal income tax reserve for loan losses at the Bank's base year amounted to $2,663,000. If any portion of the reserve is used for purposes other than to absorb the losses for which established, approximately 150% of the amount actually used (limited to the amount of the reserve) would be subject to taxation in the fiscal year in which used. As the Bank intends to use the reserve only to absorb loan losses, a deferred income tax liability of $1,090,000 has not been provided. 9. COMMITMENTS AND CONTINGENCIES Loan commitments The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and advance funds under lines of credit and credit card loans. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the accompanying consolidated financial statements. The Bank's exposure to credit loss is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments. A summary of financial instruments outstanding whose contract amounts represent credit risk is as follows: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit and credit card loans may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The commitments for mortgage loans and home equity lines of credit are collateralized by real estate. Commercial loans and lines of credit are secured by various assets of the borrowers. Credit card loans are generally unsecured. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Letters of credit outstanding as of June 30, 1999 have expiration dates within five years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Employment agreements The Company and the Bank have entered into employment agreements with the President and three other officers. The agreements provide for base salaries, participation in employee benefit plans and, in the event of termination of employment, certain lump-sum severance payments and continuation of benefits. However, such employment may be terminated for cause, as defined in the agreements, without incurring any continuing obligations. In June 1998, the Company amended the President's employment agreement to provide him with a special benefit on his retirement. The President would be entitled to receive a lump sum benefit upon retirement equal to the dollar value of the shares of common stock expected to be allocated to the President under the ESOP over the ten year term of the ESOP loan reduced by the value of the shares of common stock actually allocated to the President's ESOP account. During the year ended June 30, 1999, the Company accrued compensation expense under this agreement amounting to $13,000. Lease commitments On July 28, 1998, the Bank entered into a lease agreement for its branch located in Lexington, Massachusetts. Pursuant to the terms of the noncancelable lease agreement in effect at June 30, 1999, the future minimum rent commitments for leased premises are as follows: The lease contains an option to extend for two five-year periods and also contains provisions for reimbursement of real estate taxes and certain other costs. The costs of such rentals and reimbursements are not included above. Rent expense for the year ended June 30, 1999 amounted to $91,000. Contingencies Various legal claims arise from time to time in the normal course of business which, in the opinion of management, will have no material effect on the Company's consolidated financial position or results of operations. 10. STOCKHOLDERS' EQUITY Stock conversion On January 8, 1998, the Bank converted from a mutual to a stock institution. Mystic Financial, Inc. became the Bank's holding company in connection with the conversion and issued 2,711,125 shares of common stock at $10.00 per share. Net proceeds were $25,737,000 after conversion costs of $1,374,000. During the years ended June 30, 1999 and 1998, the Company purchased 264,127 and 2,120 shares of common stock for $3,464,000 and $21,000, respectively. At the time of the conversion, the Bank established a liquidation account in the amount of $11,761,000. In accordance with Massachusetts statute, the liquidation account will be maintained for the benefit of eligible account holders who continue to maintain their accounts in the Bank after the conversion. The liquidation account will be reduced annually to the extent that eligible account holders have reduced their qualifying deposits. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation, each eligible account holder will be entitled to receive a distribution in an amount equal to their current adjusted liquidation account balance, to the extent that funds are available. Minimum regulatory capital requirements The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off- balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following tables) of total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of June 30, 1999 and 1998, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of June 30, 1999, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the following tables. There are no conditions or events that management believes have changed the Bank's category. The Company's and the Bank's actual capital amounts and ratios are also presented in the tables. 11. RELATED PARTY TRANSACTIONS At June 30, 1999 and 1998, total loans to directors and officers of the Company greater than $60,000 on an individual basis amounted to $2,069,000 and $912,000, respectively. During the years ended June 30, 1999 and 1998, total principal additions were $1,783,000 and $118,000, respectively, and total principal payments were $626,000 and $873,000, respectively. 12. EMPLOYEE BENEFIT PLANS Pension plans The Bank provides pension benefits for its employees through membership in Plan C of the Defined Benefit Plan of the Co-operative Banks Employees Retirement Association ("CBERA"). The plan is a multi-employer plan where the contributions by each bank are not restricted to provide benefits to the employees of the contributing bank. Each employee reaching the age of 21 and having completed 1,000 hours of service in one consecutive twelve-month period beginning with such employee's date of employment automatically becomes a participant in the retirement plan. A participant in the plan is not vested until they have performed two years of service, at which time they become 20% vested. Participants become 100% vested when credited with six years of service. Total pension expense for the years ended June 30, 1999, 1998 and 1997 amounted to $115,000, $132,000 and $104,000, respectively. In addition, the Bank has a savings and retirement plan, which qualifies under Section 401(k) of the Internal Revenue Code, for its employees through membership in Plan A of the Defined Benefit Plan of CBERA. Each employee reaching the age of 21 and having completed 1,000 hours of service in one consecutive twelve-month period beginning with such employee's date of employment automatically becomes a participant in the savings and retirement plan. The plan provides for voluntary contributions by participating employees ranging from one percent to twelve percent of their compensation, subject to certain limitations. The Bank matches 50% of an employee's voluntary contribution up to ten percent of the employee's compensation. Total expense under the Section 401(k) plan for the years ended June 30, 1999, 1998 and 1997 amounted to $63,000, $68,000 and $58,000, respectively. Employee stock ownership plan Effective January 8, 1998, the Company established and the Bank adopted an ESOP, for the benefit of eligible employees who have attained age 21 and have completed one year of service. The Company loaned the ESOP $3,194,000 to fund the purchase of 216,890 shares of common stock of the Company in open-market purchases following completion of the Bank's conversion from mutual to stock form. The Bank intends to make annual contributions to the ESOP in an aggregate amount at least equal to the principal and interest requirements on the loan. The loan is for a term of 10 years, bears interest at 8% per annum and requires annual principal payments of $319,000 plus interest. Shares purchased by the ESOP are pledged as collateral for the loan, and are held in a suspense account until released for allocation among participants in the ESOP as the loan is repaid. The pledged shares are released annually from the suspense account in an amount proportional to the repayment of the ESOP loan for each plan year. The released shares are allocated among the accounts of participants on the basis of the participant's compensation for the year of allocation. Benefits generally become vested at the rate of 20% per year with vesting to begin after an employee's completion of three years of service and full vesting to occur after seven years of service. Participants also become immediately vested upon termination of employment due to death, retirement at age 65 or older, permanent disability or upon the occurrence of a change of control. Forfeitures will be reallocated among remaining participating employees, in the same proportion as contributions. Vested benefits may be paid in a single sum or installment payments and are payable upon death, retirement at age 65 or older, disability or separation from service. Shares held by the ESOP include the following: Cash dividends received on allocated shares are allocated to participants and cash dividends received on shares held in suspense are applied to repay the outstanding debt of the ESOP. Total expense applicable to the ESOP amounted to $279,000 and $163,000 for the years ended June 30, 1999 and 1998, respectively. Stock option plan On March 24, 1999, the Company's stockholders approved the 1999 Stock Option Plan (the "Stock Option Plan"). Under the Stock Option Plan, the Company may grant options to its directors, officers and employees for up to 257,355 shares of common stock. Both incentive stock options and non-qualified stock options may be granted under the Stock Option Plan. The exercise price of each option equals the market price of the Company's stock on the date of grant and an option's maximum term is ten years. Options generally vest over a five year period. The Company applies APB Opinion 25 and related Interpretations in accounting for the Stock Option Plan. Accordingly, no compensation cost has been recognized. Had compensation cost for the Company's Stock Option Plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method prescribed by SFAS No. 123, the Company's net income and earnings per share for the year ended June 30, 1999 would have been adjusted to the pro forma amounts indicated below: The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants during the year ended June 30, 1999; dividend yield of 2.0%; expected life of 7 years; expected volatility of 14%; and a risk-free interest rate of 5.2%. During the year ended June 30, 1999, the Company granted options to purchase 226,364 shares at an exercise price of $12.06 per share, all of which were outstanding at June 30, 1999. The options vest over a period of five years and expire in ten years. At June 30, 1999, none of the options were exercisable. The weighted average fair value of the options granted during the year was $2.67. The weighted average remaining contractual life of the options outstanding at June 30, 1999 was 9.75 years. Recognition and retention plan On March 24, 1999, the Company's stockholders approved the Company's adoption of the 1999 Recognition and Retention Plan (the "RRP"), which allows the Company to grant restricted stock awards ("Awards") to certain officers, employees and outside directors. The RRP is authorized to acquire no more than 102,942 shares of Common stock in the open market. Shares vest at a rate of 20% per year with the first vesting period ending December 31, 1999. At June 30, 1999, Awards were granted with respect to 96,342 shares. The aggregate purchase price of all shares acquired by the RRP will be reflected as a reduction of stockholders' equity and amortized to compensation expense as the Company's employees and directors become vested in their stock awards. There were no shares distributed to employees or directors for the year ending June 30, 1999. Compensation expense accrued relating to the RRP amounted to $94,000, for the year ended June 30, 1999. Benefit restoration plan In June 1998, the Company adopted the Benefit Restoration Plan ("BRP") in order to provide the President with the benefits that would be due to him under the defined benefit pension plan, the 401(k) Plan and the ESOP if such benefits were not limited under the Internal Revenue Code. Total expense related to the BRP amounted to $61,000 for the year ended June 30, 1999. 13. RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The total amount of dividends which may be paid at any date is generally limited to the retained earnings of the Bank, and loans or advances are limited to 10% of the Bank's capital stock and surplus on a secured basis. At June 30, 1999, the Bank's retained earnings available for the payment of dividends was $14,335,000 and funds available for loans or advances amounted to $1,133,000. Accordingly, $11,143,000 of the Company's equity in the net assets of the Bank was restricted at June 30, 1999. In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank's capital to be reduced below applicable minimum capital requirements. 14. FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires disclosure of estimated fair values of all financial instruments where it is practicable to estimate such values. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments: Cash and cash equivalents: The carrying amounts of cash, federal funds sold and short-term investments approximate fair values. Investment securities: Fair values for investment securities, excluding Federal Home Loan Bank stock, are based on quoted market prices. The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank. Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for loans held for sale are based on quoted market prices. Fair values for all other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for non-performing loans are estimated using underlying collateral values when applicable. Deposit liabilities: Fair values for interest and non-interest checking, passbook savings, and certain types of money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for term certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities. Federal Home Loan Bank borrowings: Fair values for borrowings are estimated using discounted cash flow analysis based on the Bank's current incremental borrowing rates for similar types of borrowing arrangements. Accrued interest: The carrying amounts of accrued interest approximate fair value. Off-balance-sheet instruments: Fair values for off-balance- sheet lending commit-ments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing and are not material. The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows: 15. CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY Condensed financial information pertaining only to Mystic Financial, Inc., is as follows: BALANCE SHEETS -------------- June 30, 1999 and 1998 STATEMENTS OF INCOME -------------------- For the Year Ended June 30, 1999 and the Period January 8, 1998 to June 30, 1998 STATEMENTS OF CASH FLOWS ------------------------ For the Year Ended June 30, 1999 and the Period January 8, 1998 to June 30, 1998 16. SEGMENTS The Company, through the branch network of its subsidiary, Medford Co-operative Bank, provides a broad range of financial services to individuals and businesses in the Greater Boston area. These services include checking, savings and term certificate deposits; lending; credit card servicing; and ATM processing services. While the Company's chief decision-makers monitor the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's banking operations are considered by management to be aggregated in one reportable operating segment. 17. SUBSEQUENT EVENT On September 8, 1999, the Company's Recognition and Retention Plan Trust completed the purchase of 102,942 shares of Common Stock in the open market at an average price of $12.575 per share for the RRP (Note 12). 18. QUARTERLY DATA (UNAUDITED) N/A - Shares of common stock were not issued until January 8, 1998.

842184_1999.txt

842184_1999

1999

842184

Item 1. Business. (a) General Development of Business AIRFUND International Limited Partnership (the "Partnership") was organized as a limited partnership under the Massachusetts Uniform Limited Partnership Act (the "Uniform Act") on January 31, 1989 for the purpose of acquiring and leasing to third parties a specified portfolio of used commercial aircraft. Partners' capital initially consisted of contributions of $1,000 from the General Partner (AFG Aircraft Management Corporation, a Massachusetts corporation) and $100 from the Initial Limited Partner (AFG Assignor Corporation, a Massachusetts corporation). On July 26, 1989, the Partnership issued 3,040,000 units representing assignments of limited partnership interests (the "Units") to 4,147 investors. Unit holders and Limited Partners (other than the Initial Limited Partner) are collectively referred to as Recognized Owners. The General Partner is an affiliate of Equis Financial Group Limited Partnership (formerly known as American Finance Group), a Massachusetts limited partnership ("EFG"). The common stock of the General Partner is owned by AF/AIP Programs Limited Partnership, of which EFG and a wholly-owned affiliate are the 99% limited partners and AFG Programs, Inc., a Massachusetts corporation which is wholly-owned by Geoffrey A. MacDonald, is the 1% general partner. The capital contribution of the General Partner, in consideration of its general partner interests, was $1,000. The General Partner is not required to make any other capital contributions except as may be required under the Uniform Act and Section 6.1(b) of the Amended and Restated Agreement and Certificate of Limited Partnership (the "Restated Agreement, as amended"). (b) Financial Information About Industry Segments The Partnership is engaged in only one industry segment: the business of acquiring used commercial aircraft and leasing the aircraft to creditworthy lessees on an operating lease basis. Full-payout leases are those in which aggregate undiscounted noncancellable rents equal or exceed the acquisition cost of the leased equipment. Operating leases are those in which the aggregate undiscounted noncancellable rents are less than the acquisition cost of the leased equipment. Industry segment data is not applicable. (c) Narrative Description of Business The Partnership was organized to acquire a specified portfolio of used commercial jet aircraft subject to various full-payout and operating leases and to lease the aircraft to third parties as income-producing investments. More specifically, the Partnership's primary investment objectives were to acquire and lease aircraft, that would: 1. Generate quarterly cash distributions; 2. Preserve and protect Partnership capital; and 3. Maintain substantial residual value for ultimate sale of the aircraft. The Partnership has the additional objective of providing certain federal income tax benefits. The Closing date of the Offering of Units of the Partnership was July 26, 1989. The initial purchase of the aircraft and the associated lease commitments occurred on July 27, 1989. The acquisition of the Partnership's aircraft and its associated leases is described in Note 3 to the financial statements included in Item 14, herein. The Restated Agreement as amended, provides that the Partnership will terminate no later than December 31, 2004. However, the Partnership is a Nominal Defendant in a Class Action Lawsuit, the outcome of which could significantly alter the nature of the Partnership's organization and its future business operations. See Note 7 to the financial statements in the 1999 Annual Report. The Partnership has no employees; however, it is managed pursuant to a Management Agreement with EFG or one of its affiliates (the "Manager"). The Manager's role, among other things, is to (i) evaluate, select, negotiate, and consummate the acquisition of aircraft, (ii) manage the leasing, re-leasing, financing, and refinancing of aircraft, and (iii) arrange the resale of aircraft. The Manager is compensated for such services as provided for in the Restated Agreement, as amended, described in Item 13, herein and in Note 4 to the financial statements, included in Item 14, herein. The Partnership's investment in commercial aircraft is, and will continue to be, subject to various risks, including physical deterioration, technological obsolescence and defaults by lessees. A principal business risk of owning and leasing aircraft is the possibility that aggregate lease revenues and aircraft sale proceeds will be insufficient to provide an acceptable rate of return on invested capital after payment of all operating expenses. In addition, the leasing industry is very competitive. The Partnership will encounter considerable competition when the aircraft are re-leased or sold at the expiration of current lease terms. The Partnership must compete with lease programs offered directly by manufacturers and other equipment leasing companies, including lease programs organized and managed similarly to the Partnership, and including other EFG-sponsored partnerships and trusts, which may seek to re-lease or sell aircraft within their own portfolios to the same customers as the Partnership. Many competitors have greater financial resources and more experience than the Partnership, the General Partner and the Manager. In addition, default by a lessee under a lease may cause aircraft to be returned to the Partnership at a time when the General Partner or the Manager is unable to arrange for the re-lease or sale of such aircraft. This could result in the loss of a material portion of anticipated revenues. In recent years, market values for certain models of used commercial jet aircraft have deteriorated. Consistent price competition and other pressures within the airline industry have inhibited sustained profitability for many carriers. Most major airlines have had to re-evaluate their aircraft fleets and operating strategies. Aircraft condition, age, passenger capacity, distance capability, fuel efficiency, and other factors influence market demand and market values for passenger jet aircraft. Notwithstanding the foregoing, the ultimate realization of residual value for any aircraft is dependent upon many factors, including EFG's ability to sell and re-lease the aircraft. Changes in market conditions, industry trends, technological advances, and other events could converge to enhance or detract from asset values at any given time. Accordingly, EFG will attempt to monitor changes in the airline industry in order to identify opportunities which may be advantageous to the Partnership and which will maximize total cash returns for each aircraft. The General Partner will determine when each aircraft should be sold and the terms of such sale based upon numerous factors with a view toward achieving the investment objectives of the Partnership. The General Partner is authorized to sell the aircraft prior to the expiration of the initial lease terms and intends to monitor and evaluate the market for resale of the aircraft to determine whether an aircraft should remain in the Partnership's portfolio or be sold. As an alternative to sale, the Partnership may enter re-lease agreements when considered advantageous by the General Partner and the Manager. Revenue from major individual lessees which accounted for 10% or more of lease revenue during the years ended December 31, 1999, 1998 and 1997 is incorporated herein by reference to Note 2 to the financial statements in the 1999 Annual Report. Refer to Item 14(a)(3) for lease agreements filed with the Securities and Exchange Commission. EFG is a Massachusetts limited partnership formerly known as American Finance Group ("AFG"). AFG was established in 1988 as a Massachusetts general partnership and succeeded American Finance Group, Inc., a Massachusetts corporation organized in 1980. EFG and its subsidiaries (collectively, the "Company") are engaged in various aspects of the equipment leasing business, including EFG's role as Manager or Advisor to the Partnership and several other direct-participation equipment leasing programs sponsored or co-sponsored by EFG (the "Other Investment Programs"). The Company arranges to broker or originate equipment leases, acts as remarketing agent and asset manager, and provides leasing support services, such as billing, collecting, and asset tracking. The general partner of EFG, with a 1% controlling interest, is Equis Corporation, a Massachusetts corporation owned and controlled entirely by Gary D. Engle, its President, Chief Executive Officer and sole Director. Equis Corporation also owns a controlling 1% general partner interest in EFG's 99% limited partner, GDE Acquisition Limited Partnership ("GDE LP"). Mr. Engle established Equis Corporation and GDE LP in December 1994 for the sole purpose of acquiring the business of AFG. In January 1996, the Company sold certain assets of AFG relating primarily to the business of originating new leases, and the name "American Finance Group," and its acronym, to a third party. AFG changed its name to Equis Financial Group Limited Partnership after the sale was concluded. Pursuant to terms of the sale agreements, EFG specifically reserved the rights to continue using the name American Finance Group and its acronym in connection with the Partnership and the Other Investment Programs and to continue managing all assets owned by the Partnership and the Other Investment Programs. (d) Financial Information About Foreign and Domestic Operations and Export Sales Not applicable. Item 2. Item 2. Properties. Incorporated herein by reference to Note 3 to the financial statements in the 1999 Annual Report. Item 3. Item 3. Legal Proceedings. Incorporated herein by reference to Note 7 to the financial statements in the 1999 Annual Report. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. PART II Item 5. Item 5. Market for the Partnership's Securities and Related Security Holder Matters. (a) Market Information There is no public market for the resale of the Units and it is not anticipated that a public market for resale of the Units will develop. (b) Approximate Number of Security Holders At December 31, 1999, there were 3,882 record holders of Units in the Partnership. (c) Dividend History and Restrictions Historically, the amount of cash distributions to be paid to the Partners has been determined on a quarterly basis. Each quarter's distribution may have varied in amount and was made 95% to the Limited Partners and 5% to the General Partner. The Partnership did not declare distributions in any of the years ended December 31, 1999, 1998 and 1997. The Partnership is a Nominal Defendant in a Class Action Lawsuit described in Note 7 to the accompanying Annual Report. The proposed settlement to that lawsuit, if effected, will materially change the future organizational structure and business interests of the Partnership, as well as its cash distribution policies. The General Partner believes that it will be in the Partnership's best interests to continue to suspend the payment of quarterly cash distributions pending final resolution of the Class Action Lawsuit. Accordingly, future cash distributions are not expected to be paid until the Class Action Lawsuit is adjudicated. There are no formal restrictions under the Restated Agreement, as amended, that materially limit the Partnership's ability to pay cash distributions, except that the General Partner may suspend or limit cash distributions to ensure that the Partnership maintains sufficient working capital reserves to cover, among other things, operating costs and potential expenditures, such as refurbishment costs to remarket aircraft upon lease expiration. Liquidity is especially important as the Partnership matures and sells aircraft, because the remaining aircraft portfolio consists of fewer revenue-producing assets that are available to cover prospective cash disbursements. Insufficient liquidity could inhibit the Partnership's ability to sustain its operations or maximize the realization of proceeds from remarketing its remaining aircraft. The management and remarketing of aircraft can involve, among other things, significant costs and lengthy remarketing initiatives. Although the Partnership's lessees are required to maintain the aircraft during the period of lease contract, repair, maintenance, and/or refurbishment costs at lease expiration can be substantial. For example, an aircraft that is returned to the Partnership meeting minimum airworthiness standards, such as flight hours or engine cycles, nonetheless may require heavy maintenance in order to bring its engines, airframe and other hardware up to standards that will permit its prospective use in commercial air transportation. At December 31, 1999, the Partnership had ownership interests in five commercial jet aircraft. Three of the aircraft are Boeing 737 aircraft formerly leased to Southwest Airlines, Inc. The lease agreements for each of these aircraft expired on December 31, 1999 and Southwest elected to return the aircraft. The aircraft are Stage 2 aircraft, meaning that they are prohibited from operating in the United States after December 31,1999 unless they are retro-fitted with hush-kits to meet Stage 3 noise regulations promulgated by the Federal Aviation Administration. The cost to hush-kit an aircraft, such as the Partnership's Boeing 737s, can approach $2 million. At this time, the General Partner is attempting to remarket these assets without further capital investment by either re-leasing the aircraft to a user outside of the United States or selling the aircraft as they are without retro-fitting the aircraft to conform to Stage 3 standards. The remaining two aircraft in the Partnership's portfolio already are Stage 3 compliant. One of these aircraft had a lease term that expired in January 2000 and is being held in storage pending the outcome of ongoing remarketing efforts. The other aircraft has a lease term expiring in April 2001. Cash distributions consist of Distributable Cash from Operations and Distributable Cash from Sales or Refinancing. "Distributable Cash From Operations" means the net cash provided by the Partnership's normal operations after general expenses and current liabilities of the Partnership are paid, reduced by any reserves for working capital and contingent liabilities to be funded from such cash, to the extent deemed reasonable by the General Partner, and increased by any portion of such reserves deemed by the General Partner not to be required for Partnership operations and reduced by all accrued and unpaid Equipment Management Fees and, after Payout, further reduced by all accrued and unpaid Subordinated Remarketing Fees. Distributable Cash From Operations does not include any Distributable Cash From Sales or Refinancings. "Distributable Cash From Sales or Refinancings" means Cash From Sales or Refinancings as reduced by (i)(a) for a period of two years from Final Closing, Cash From Sales or Refinancings, which the General Partner reinvests in additional aircraft, and (b) amounts realized from any loss or destruction of any aircraft which the General Partner reinvests in replacement aircraft, and (ii) any accrued and unpaid Equipment Management Fees and, after Payout, any accrued and unpaid Subordinated Remarketing Fees. "Cash From Sales or Refinancings" means cash received by the Partnership from Sale or Refinancing transactions, as (i) reduced by (a) all debts and liabilities of the Partnership required to be paid as a result of Sale or Refinancing transactions, whether or not then due and payable (including any liabilities on aircraft which are not assumed by the buyer and any remarketing fees required to be paid to persons not affiliated with the General Partner, but not including any Subordinated Remarketing Fees required to be accrued) and (b) any reserves for working capital and contingent liabilities funded from such cash to the extent deemed reasonable by the General Partner and (ii) increased by any portion of such reserves deemed by the General Partner not to be required for Partnership operations. In the event the Partnership accepts a note in connection with any Sale or Refinancing transaction, all payments subsequently received in cash by the Partnership with respect to such note shall be included in Cash From Sales or Refinancings, regardless of the treatment of such payments by the Partnership for tax or accounting purposes. If the Partnership receives purchase money obligations in payment for aircraft sold, which are secured by liens on such aircraft, the amount of such obligations shall not be included in Cash From Sales or Refinancings until the obligations are fully satisfied. "Payout" is defined as the first time when the aggregate amount of all distributions to the Recognized Owners of Distributable Cash From Operations and Distributable Cash From Sales or Refinancings equals the aggregate amount of the Recognized Owners' original capital contributions plus a cumulative annual return of 10% (compounded quarterly and calculated beginning with the last day of the month of the Partnership's Closing Date) on their aggregate unreturned capital contributions. For purposes of this definition, capital contributions shall be deemed to have been returned only to the extent that distributions of cash to the Recognized Owners exceed the amount required to satisfy the cumulative annual return of 10% (compounded quarterly) on the Recognized Owners' aggregate unreturned capital contributions, such calculation to be based on the aggregate unreturned capital contributions outstanding on the first day of each fiscal quarter. Item 6. Item 6. Selected Financial Data. Incorporated herein by reference to the section entitled "Selected Financial Data" in the 1999 Annual Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Incorporated herein by reference to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report. Item 8. Item 8. Financial Statements and Supplementary Data. Incorporated herein by reference to the financial statements and supplementary data included in the 1999 Annual Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Partnership. (a-b) Identification of Directors and Executive Officers The Partnership has no Directors or Officers. As indicated in Item 1 of this report, AFG Aircraft Management Corporation is the sole General Partner of the Partnership. Under the Restated Agreement, as amended, the General Partner is solely responsible for the operation of the Partnership's properties. The Recognized Owners have no right to participate in the control of the Partnership's general operations, but they do have certain voting rights, as described in Item 12 herein. The names, titles and ages of the Directors and Executive Officers of the General Partner as of March 15, 2000 are as follows: (e) Business Experience Mr. MacDonald, age 51, is a co-founder, Chairman and a member of the Executive Committee of EFG and President and a Director of the General Partner. Mr. MacDonald was also a co-founder, Director, and Senior Vice President of EFG's predecessor corporation from 1980 to 1988. Mr. MacDonald is President of American Finance Group Securities Corp. and a limited partner in Atlantic Acquisition Limited Partnership ("AALP") and Old North Capital Limited Partnership ("ONC"). Prior to co-founding EFG's predecessors, Mr. MacDonald held various executive and management positions in the leasing and pharmaceutical industries. Mr. MacDonald holds a M.B.A. from Boston College and a B.A. degree from the University of Massachusetts (Amherst). Mr. Engle, age 51, is President and Chief Executive Officer of EFG and sole shareholder and Director of its general partner, Equis Corporation and a member of the Executive Committee of EFG and President of AFG Realty Corporation. Mr. Engle joined EFG in 1990 as Executive Vice President and acquired control of EFG and its subsidiaries in December 1994. Mr. Engle is Vice President and a Director of certain of EFG's subsidiaries and affiliates, a limited partner in AALP and ONC and controls the general partners of AALP and ONC. Mr. Engle is also Chairman, Chief Executive Officer, and a member of the Board of Directors of Semele Group, Inc. ("Semele"). From 1987 to 1990, Mr. Engle was a principal and co-founder of Cobb Partners Development, Inc., a real estate and mortgage banking company. From 1980 to 1987, Mr. Engle was Senior Vice President and Chief Financial Officer of Arvida Disney Company, a large-scale community development company owned by Walt Disney Company. Prior to 1980, Mr. Engle served in various management consulting and institutional brokerage capacities. Mr. Engle has a MBA from Harvard University and a BS degree from the University of Massachusetts (Amherst). Mr. Romano, age 40, became Executive Vice President and Chief Operating Officer of EFG, and Secretary of Equis Corporation in 1996 and is Secretary or Clerk of several of EFG's subsidiaries and affiliates. Mr. Romano joined EFG in November 1989, became Vice President and Controller in April 1993 and Chief Financial Officer in April 1995. Mr. Romano assumed his current position in April 1996. Mr. Romano is also Vice President and Chief Financial Officer of Semele. Prior to joining EFG, Mr. Romano was Assistant Controller for a privately held real estate development and mortgage origination company that he joined in 1987. Previously, Mr. Romano was an Audit Manager at Ernst & Whinney (now Ernst & Young LLP), where he was employed from 1982 to 1986. Mr. Romano is a Certified Public Accountant and holds a B.S. degree from Boston College. Mr. Coyne, age 39, is Executive Vice President, Capital Markets of EFG and President, Chief Operating Officer and a member of the Board of Directors of Semele. Mr. Coyne joined EFG in 1989, remained until May 1993, and rejoined EFG in November 1994. In September 1997, Mr. Coyne was appointed Executive Vice President of EFG. Mr. Coyne is a limited partner in AALP and ONC. From May 1993 through November 1994, he was employed by the Raymond Company, a private investment firm, where he was responsible for financing corporate and real estate acquisitions. From 1985 through 1989, Mr. Coyne was affiliated with a real estate investment company and an equipment leasing company. Prior to 1985, he was with the accounting firm of Ernst & Whinney (now Ernst & Young LLP). He has a BS in Business Administration from John Carroll University, a Masters Degree in Accounting from Case Western Reserve University and is a Certified Public Accountant. Mr. Butterfield, age 40, is Senior Vice President, Finance and Treasurer of EFG and certain of its affiliates and is Treasurer of the General Partner and Semele. Mr. Butterfield joined EFG in June 1992, became Vice President, Finance and Treasurer of EFG and certain of its affiliates in April 1996 and was promoted to Senior Vice President, Finance and Treasurer of EFG and certain of its affiliates in July 1998. Prior to joining EFG, Mr. Butterfield was an Audit Manager with Ernst & Young LLP, which he joined in 1987. Mr. Butterfield was employed in public accounting and industry positions in New Zealand and London (UK) prior to coming to the United States in 1987. Mr. Butterfield attained his Associate Chartered Accountant (A.C.A.) professional qualification in New Zealand and has completed his CPA requirements in the United States. He holds a Bachelor of Commerce degree from the University of Otago, Dunedin, New Zealand. Ms. Simonsen, age 49, joined EFG in February 1990 and was promoted to Senior Vice President, Information Systems of EFG in April 1996. Prior to joining EFG, Ms. Simonsen was Vice President, Information Systems with Investors Mortgage Insurance Company, which she joined in 1973. Ms. Simonsen provided systems consulting for a subsidiary of American International Group and authored a software program published by IBM. Ms. Simonsen holds a BA degree from Wilson College. Ms. Ofgant, age 34, is Senior Vice President, Lease Operations of EFG and certain of its affiliates. Ms. Ofgant joined EFG in July 1989, was promoted to Manager Lease Operations in April 1994, and became Vice President of Lease Operations in April 1996. In July 1998, Ms. Ofgant was promoted to Senior Vice President of Lease Operations. Prior to joining EFG, Ms. Ofgant was employed by Security Pacific National Trust Company. Ms. Ofgant holds a BS degree in Finance from Providence College. (f) Involvement in Certain Legal Proceedings None. (g) Promoters and Control Persons See Item 10 (a-b) above. Item 11. Item 11. Executive Compensation. (a) Cash Compensation Currently, the Partnership has no employees. However, under the terms of the Restated Agreement, as amended, the Partnership is obligated to pay all costs of personnel employed full or part-time by the Partnership, including officers or employees of the General Partner or its Affiliates. There is no plan at the present time to make any partners or employees of the General Partner or its Affiliates employees of the Partnership. The Partnership has not paid and does not propose to pay any options, warrants or rights to the officers or employees of the General Partner or its Affiliates. (b) Compensation Pursuant to Plans None. (c) Other Compensation Although the Partnership has no employees, as discussed in Item 11(a), pursuant to section 10.4(c) of the Restated Agreement, as amended, the Partnership incurs a monthly charge for personnel costs of the Manager for persons engaged in providing administrative services to the Partnership. A description of the remuneration paid by the Partnership to the General Partner and its Affiliates for such services is included in Item 13, herein and in Note 4 to the financial statements included in Item 14, herein. (d) Compensation of Directors None. (e) Termination of Employment and Change of Control Arrangement There exists no remuneration plan or arrangement with the General Partner or its Affiliates which results or may result from their resignation, retirement or any other termination. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. By virtue of its organization as a limited partnership, the Partnership has no outstanding securities possessing traditional voting rights. However, as provided for in Section 11.2(a) of the Restated Agreement, as amended (subject to Sections 11.2(b) and 11.3), a majority interest of the Recognized Owners has voting rights with respect to: 1. Amendment of the Restated Agreement; 2. Termination of the Partnership; 3. Removal of the General Partner; and 4. Approval or disapproval of the sale of all, or substantially all, of the assets of the Partnership (except in the orderly liquidation of the Partnership upon its termination and dissolution). As of March 1, 2000, the following person or group owns beneficially more than 5% of the Partnership's 3,040,000 outstanding Units: The general Partner of Old North Capital Limited Partnership ("ONC") is controlled by Gary D. Engle. In addition, the limited partnership interests of ONC are owned by Semele. Gary D. Engle is Chairman and CEO of Semele. The ownership and organization of EFG is described in Item 1 of this report. Item 13. Item 13. Certain Relationships and Related Transactions. The General Partner of the Partnership is AFG Aircraft Management Corporation, an affiliate of EFG. (a) Transactions with Management and Others All operating expenses incurred by the Partnership are paid by EFG on behalf of the Partnership and EFG is reimbursed at its actual cost for such expenditures. Fees and other costs incurred during the years ended December 31, 1999, 1998 and 1997, which were accrued or paid by the Partnership to EFG or its Affiliates, are as follows: As provided under the terms of the Management Agreement, EFG is compensated for its services to the Partnership. Such services include acquisition and management of equipment. For acquisition services, EFG was compensated by an amount equal to 1.6% of Equipment Base Price paid by the Partnership. For management services, EFG is compensated by an amount equal to 5% of gross operating lease rental revenues and 2% of gross full payout lease rental revenues received by the Partnership. Both acquisition and management fees are subject to certain limitations defined in the Management Agreement. Administrative charges represent amounts owed to EFG, pursuant to Section 10.4(c) of the Restated Agreement, as amended, for persons employed by EFG who are engaged in providing administrative services to the Partnership. Reimbursable operating expenses due to third parties represent costs paid by EFG on behalf of the Partnership which are reimbursed to EFG at actual cost. All rents and proceeds from the sale of aircraft are paid directly to EFG or to a lender. EFG temporarily deposits collected funds in a separate interest bearing account prior to remittance to the Partnership. At December 31, 1999, the Partnership was owed $4,888 by EFG for such funds and the interest thereon. These funds were remitted to the Partnership in January 2000. All aircraft were purchased from EFG or one of its Affiliates. The Partnership's acquisition cost was determined by the method described in Note 2 to the financial statements included in Item 14, herein. In 1990, EFG assigned its equipment Management Agreement with the Partnership to AF/AIP Programs Limited Partnership, and AF/AIP Programs Limited Partnership entered into an identical management agreement with EFG. AF/AIP Programs Limited Partnership also entered into a nonexclusive confirmatory agreement with EFG's former majority-owned subsidiary, AIRFUND Corporation ("AFC"), for the provision of aircraft remarketing services. Certain affiliates of the General Partner own Units in the Partnership as follows: - -------------------------------------------------------------------------------- Number of Percent of Total Affiliate Units Owned Outstanding Units - -------------------------------------------------------------------------------- Old North Capital Limited Partnership 205,040 6.74% - -------------------------------------------------------------------------------- The general partner of Old North Capital Limited Partnership ("ONC") is controlled by Gary D. Engle. ONC is a Massachusetts limited partnership formed in 1995 and an affiliate of EFG. In addition, the limited partnership interests of ONC are owned by Semele. Gary D. Engle is Chairman and CEO of Semele. (b) Certain Business Relationships None. (c) Indebtedness of Management to the Partnership None. (d) Transactions with Promoters See Item 13(a) above. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Documents filed as part of this report: (1) Financial Statements: Report of Independent Auditors..............................* Statement of Financial Position at December 31, 1999 and 1998...............................* Statement of Operations for the years ended December 31, 1999, 1998 and 1997........* Statement of Changes in Partners' Capital for the years ended December 31, 1999, 1998 and 1997........* Statement of Cash Flows for the years ended December 31, 1999, 1998 and 1997........* Notes to the Financial Statements...........................* (2) Financial Statement Schedules: None required. (3) Exhibits: Except as set forth below, all Exhibits to Form 10-K, as set forth in Item 601 of Regulation S-K, are not applicable. A list of exhibits filed or incorporated by reference is as follows: Exhibit Number ---------- 2.1 Plaintiffs' and Defendants' Joint Motion to Modify Order Preliminarily Approving Settlement, Conditionally Certifying Settlement Class and Providing for Notice of, and Hearing on, the Proposed Settlement was filed in the Registrant's Annual Report on Form 10-K/A for the year ended December 31,1998 as Exhibit 2.1 and is incorporated herein by reference. 2.2 Plaintiffs' and Defendants' Joint Memorandum in Support of Joint Motion to Modify Order Preliminarily Approving Settlement, Conditionally Certifying Settlement Class and Providing for Notice of, and Hearing on, the Proposed Settlement was filed in the Registrant's Annual Report on Form 10-K/A for the year ended December 31, 1998 as Exhibit 2.2 and is incorporated herein by reference. * Incorporated herein by reference to the appropriate portion of the 1999 Annual Report to security holders for the year ended December 31, 1999 (see Part II). Exhibit Number ---------- 2.3 Order Preliminarily Approving Settlement, Conditionally Certifying Settlement Class and Providing for Notice of, and Hearing on, the Proposed Settlement (August 20, 1998) was filed in the Registrant's Annual Report on Form 10-K/A for the year ended December 31, 1998 as Exhibit 2.3 and is incorporated herein by reference. 2.4 Modified Order Preliminarily Approving Settlement, Conditionally Certifying Settlement Class and Providing for Notice of, and Hearing on, the Proposed Settlement (March 22, 1999) was filed in the Registrant's Annual Report on Form 10-K/A for the year ended December 31, 1998 as Exhibit 2.4 and is incorporated herein by reference. 2.5 Plaintiffs' and Defendants' Joint Memorandum in Support of Joint Motion to Further Modify Order Preliminarily Approving Settlement, Conditionally Certifying Settlement Class and Providing for Notice of, and Hearing on, the Proposed Settlement is filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1999 as Exhibit 2.5 and is included herein. 2.6 Second Modified Order Preliminarily Approving Settlement, Conditionally Certifying Settlement Class and Providing for Notice of, and Hearing on, the Proposed Settlement (March 5, 2000) is filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1999 as Exhibit 2.6 and is included herein. 4 Amended and Restated Agreement and Certificate of Limited Partnership included as Exhibit A to the Prospectus, which is included in Registration Statement on Form S-1 (No. 33-25334). 10.1 Promissory Note in the principal amount of $1,800,000 dated March 8, 2000 between the Registrant, as lender, and Echelon Residential Holdings LLC, as borrower, is filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1999 as Exhibit 10.1 and is included herein. 10.2 Pledge Agreement dated March 8, 2000 between Echelon Residential Holdings LLC (Pledgor) and American Income Partners V-A Limited Partnership, as Agent for itself and the Registrant, is filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1999 as Exhibit 10.2 and is included herein. 13 The 1999 Annual Report to security holders, a copy of which is furnished for the information of the Securities and Exchange Commission. Such Report, except for those portions thereof which are incorporated herein by reference, is not deemed "filed" with the Commission. 23 Consent of Independent Auditors. 99(a) Lease agreement with Southwest Airlines, Inc. was filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 as Exhibit 99 (d) and is incorporated herein by reference. 99(b) Lease agreement with Southwest Airlines, Inc. was filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 as Exhibit 99 (d) and is incorporated herein by reference. 99(c) Lease agreement with Southwest Airlines, Inc. was filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 as Exhibit 99 (d) and is incorporated herein by reference. 99(d) Lease agreement with Finnair OY was filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996 as Exhibit 99 (e) and is incorporated herein by reference. 99(e) Lease agreement with Finnair OY was filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996 as Exhibit 99 (f) and is incorporated herein by reference. 99(f) Lease agreement with Aer Lease Limited was filed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1997 as Exhibit 99 (i) and is incorporated herein by reference. (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on behalf of the registrant and in the capacity and on the date indicated. AIRFUND International Limited Partnership By: AFG Aircraft Management Corporation, a Massachusetts corporation and the General Partner of the Registrant. By: /s/ Geoffrey A. MacDonald By: /s/ Gary D. Engle --------------------------- ----------------------------- Geoffrey A. MacDonald Gary D. Engle Chairman and a member of the President and Chief Executive Executive Committee of EFG and Officer and a member of the President and a Director of the Executive Committee of EFG and a General Partner Director of the General Partner (Principal Executive Officer) Date: March 30, 2000 Date: March 30, 2000 -------------------------- ----------------------------- By: /s/ Gary M. Romano By: /s/ Michael J. Butterfield --------------------------- ----------------------------- Gary M. Romano Michael J. Butterfield Executive Vice President and Chief Senior Vice President, Finance and Operating Officer of EFG and Clerk Treasurer of EFG and Treasurer of the General Partner of the General Partner (Principal Financial Officer) (Principal Accounting Officer) Date: March 30, 2000 Date: March 30, 2000 -------------------------- ----------------------------- EXHIBIT INDEX 1999 Form 10-K

353203_1999.txt

353203_1999

1999

353203

ITEM 1. BUSINESS Summit Bancshares, Inc. (the "Company") is a one-bank holding company registered under the Bank Holding Company Act of 1956, as amended. It was incorporated under the laws of the State of California on July 22, 1981. Its principal office is located at 2969 Broadway, Oakland, California 94611, and its telephone number is (510) 839-8800. On March 1, 1985, the Bank opened a banking facility at 112 La Casa Via, Walnut Creek, California 94596, which moved into new quarters located at 1700 N. Main, Walnut Creek, California 94598 in September, 1990. The telephone number is (925) 935-9220. In addition, a full service branch began operation in December 1985, in the Watergate III Tower at 2000 Powell Street, Emeryville, California 94608. The telephone number is (510) 428-1868. Also, on January 28, 1998, the Bank opened a new full service branch at 5820 Stoneridge Mall Road, Suite 100, Pleasanton, California 94588 which moved to new quarters located at 5673 W. Las Positas Blvd. Ste. 208, 94588 in July of 1998. The telephone number is (925) 224-7788. Summit Bancshares, Inc. owns all of the capital stock of Summit Bank (the "Bank"), its subsidiary bank, and its activities during 1999 were limited to acting as the Bank's holding company. The Bank has conducted the business of a commercial bank since July 1, 1982. The Bank provides commercial credit and other banking services to small and mid-sized businesses and professionals, including professional firms of physicians, attorneys, accountants, retailers and service firms, wholesalers and distributors, as well as real estate developers. Because of the concentration of medical facilities and related organizations, the growth of real estate opportunities and commercial/industrial businesses in the Bank's service area, the Bank primarily focuses its marketing efforts on health service businesses, real estate construction and commercial industrial loans; however, the Bank also offers a broad spectrum of financial services to the business community at large. The Bank offers various checking and savings accounts for both personal and business purposes, time certificates of deposit, cashier's checks, money orders, travelers checks, safe deposit boxes, installment collection services, night depository, depository pickup and courier services, telephone transfers, collection services for notes, Individual Retirement and Business Planning (formerly Keogh) Accounts. The Bank has not requested and does not have regulatory approval to offer trust services, although it may provide such services in the future. The Bank assists customers requiring services not offered by the Bank in obtaining such services from its correspondent banks and other financial services firms. Although the Bank does not actively solicit consumer business from the general public, it does offer banking services and facilities compatible with the need of its consumer customers. The banking offices in Walnut Creek and Pleasanton offer virtually the same services listed above, with the exception of safe deposit boxes. The Emeryville Office offers all the same services as the Oakland Office. On March 30, 1989, the State Banking Department, now known as the Department of Financial Institutions, approved the Bank's application to establish a new subsidiary, Summit Equities, Inc, whose purpose is to engage in real property investment activities as authorized by Section 751.3 of the California Financial Code. On November 13, 1992 the FDIC imposed regulations limiting real estate investment to those authorized by national banks, thus no real estate transactions are allowed to be transacted under this subsidiary. The corporation is exploring other avenues or types of approved investment activities. As of this date, the subsidiary has not conducted any business. SERVICE AREA - - ------------ The primary geographic market served by the Bank is consider to be Alameda County in its entirety and Contra Costa County except several cities and sparsely populated areas in the northern and easternmost sections. Pinole is partly excluded. Hercules, Rodeo, Crockett and Port Costa are excluded. West Pittsburg and cities east of it are excluded. The sparsely populated areas east of Mt. Diablo are excluded. These areas include a substantial number of commercial businesses, a large health services complex and substantial residential population. In Alameda County, the health services complex includes two major hospitals, approximately 327 physicians and a wide variety of health related and other professionals, and small and medium-sized businesses. Contra Costa County includes three major hospitals, approximately 390 physicians some of which are also affiliated with the hospitals in Alameda County and other professionals and small and medium-sized businesses. The Walnut Creek office is about 16 miles northeast of the head office in Oakland and located in the central business district in Walnut Creek. The site is approximately 1 mile west of John Muir Hospital, which is a 343-bed hospital employing approximately 1300 people and accommodates a large staff of approximately 310 visiting physicians. The surrounding service area includes 4 convalescent hospitals, an acute psychiatric care facility, and the 204-bed Kaiser Foundation Hospital, which employs over 1000 people in downtown Walnut Creek and is staffed by approximately 92 physicians. The Emeryville office is a further extension of the Bank's plan to expand into areas, which will further utilize specialized services directed at medium-sized businesses and professionals. Located west of Interstate 880 at 2000 Powell Street, it is servicing a commercial sector and an up-scale employee population. The Pleasanton office is about 30 miles southeast of the head office in Oakland and located in a commercial development known as Hacienda Industrial Park in the city of Pleasanton. It is also two blocks from Valleycare Medical Center. The Bank also obtains business clients from the various areas within the city of Oakland, adjacent to the John Muir and Kaiser areas of Walnut Creek, in and in the industrial and commercial areas of Emeryville and Pleasanton. The Bank's customers are primarily business and professional persons working in the vicinity of each branch, officers and employees of businesses and professional firms serviced by the Bank, and residents of areas close to the Bank. COMPETITION - - ----------- The banking business in the Oakland/East Bay metropolitan area is very competitive with respect to both loans and deposits, and is dominated by relatively few major banks which have offices operating throughout California. Among the advantages such banks have are their ability to finance wide-ranging advertising campaigns, to offer certain services (for example, trust services) which are not offered directly by the Bank, and to have substantially higher legal lending limits due to their greater capitalization. There are eleven other independent banks in Oakland, Walnut Creek, Pleasanton, and none in Emeryville. In competing for deposits, the Bank is subject to certain limitations not applicable to non-bank financial institution competitors. Over the past years, legislative changes have enabled the Bank to compete more effectively for deposits with savings and loan institutions but still remains at a competitive disadvantage when competing with money market funds. To compete with major financial institutions and other independent banks in its primary service areas, the Bank relies upon the experience of its executive officers in serving business clients, its specialized services, local promotional activity, and personal contacts by its officers, directors, and employees of the Company. For customers whose loan demands exceed the Bank's legal lending limit, the Bank arranges for such loans on a participation basis with correspondent banks as well as other independent banks. REGULATION AND SUPERVISION - - -------------------------- THE COMPANY. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHC Act"), and is registered as such with the Federal Reserve Board (FRB). A bank holding company is required to file with the FRB annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to examination by the FRB and is required to obtain FRB approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank, if after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank. The BHC Act further provides that the FRB shall not approve any such acquisition that would result in or further the creation of a monopoly, or the effect of which may be to substantially lessen competition, unless the anti competitive effects of the proposed transaction are clearly outweighed by the probable effect in meeting the convenience and needs of the community to be served. Furthermore, under the BHC Act, a bank holding company is, with limited exceptions, prohibited from (i) acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank, or (ii) engaging in any activity other than managing or controlling banks. With the prior approval of the FRB, however, a bank holding company may own shares of a company engaged in activities which the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The FRB has by regulation determined that certain activities are so closely related to banking as to be a proper incident thereto within the meaning of the BHC Act. These activities include, but are not limited to: operating an industrial loan company, industrial bank, Morris Plan Bank, savings association, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing investment and financial advice; operating as a trust company in certain instances, selling traveler's checks, United States savings bonds and certain money orders; providing certain courier services; providing management consulting advice to nonaffiliated depository institutions in some instances; acting as insurance agent for certain types of credit-related insurance; leasing property or acting as agent, broker or advisor for leasing property on a "full pay-out basis"; acting as a consumer financial counselor, including tax planning and return preparation; performing futures and options advisory services, check guarantee services and discount brokerage activities; operating a collection or credit bureau; or performing personal property appraisals. The Company has no present intention to engage in any of such permitted activities at this time. The FRB also has determined that certain activities are not so closely related to banking to be a proper incident thereto within the meaning of the BHC Act. Such activities include: real estate brokerage and syndication; land development; property management; underwriting of life insurance not related to credit transactions; and with certain exceptions, securities underwriting and equity funding. In the future, the FRB may add or delete from the list of activities permissible for bank holding companies. Under the BHC Act, a bank holding company and its subsidiaries are prohibited from acquiring any voting shares of or interest in all or substantially all of the assets of any bank located outside the state in which the operations of the bank holding company's banking subsidiaries are principally conducted, unless the acquisition is specifically authorized by the law of the state in which the bank to be acquired is located or unless the transaction qualifies under federal law as an "emergency interstate acquisition" of a closed or failing bank. The California interstate banking bill is described under "Interstate Banking" (below). A bank holding company and its subsidiaries are prohibited from certain tie-in arrangements in connection with any extension of credit, sale or lease of a property or furnishing of services. For example, with certain exceptions, a bank may not condition an extension of credit on a promise by its customer to obtain other services provided by it, its holding company or other subsidiaries, or on a promise by its customer not to obtain other services from a competitor. In addition, federal law imposes certain restrictions on transactions between the Company and its subsidiaries, including the Bank. As an affiliate of the Bank, the Company is subject, with certain exceptions, to provisions of federal law imposing limitations on, and requiring collateral for, extensions of credit by the Bank to its affiliates. Directors of the Company, and the companies, with which they are associated, have had and will continue to have banking transactions with the Bank in the ordinary course of the Bank's business. It is the firm intention of the Company that any loans and commitments to loan included in such transactions be made in accordance with applicable law, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons of similar creditworthiness, and on terms not involving more than the normal risk of collectability or presenting other unfavorable features. At December 31, 1999, loans to directors totaled $1,090,004 or 7.2% of the Company's shareholders' equity. THE BANK. The Bank is a member of the FDIC, which currently insures the deposits of each member bank to a maximum of $100,000 per depositor. For this protection, the Bank pays a semi-annual assessment and is subject to the rules and regulations of the FDIC pertaining to deposit insurance and other matters. The Bank is subject to regulation, supervision and regular examination by the Department of Financial Institutions (the "Department"). Although the Bank is a non-member of the Federal Reserve System, it is subject to regulation, supervision, but not examination by the FRB. The regulations of these agencies govern most aspects of the Bank's business, including the making of periodic reports by the Bank and the Bank's activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Subject to the regulations of the California Superintendent of Banks (the "Superintendent"), the Bank may invest in capital stock, obligations or other securities of other corporations, provided such corporations are not insurance companies, agents or brokers. In addition, the Bank may acquire any or all of the securities of a company that engages in activities that the Bank may engage in directly under California law without the prior approval of the FRB. California state-chartered banks are also specifically authorized to provide real estate appraisal services, management consulting and advisory services and electronic data processing services. The Company's primary source of income (other than interest earned on Company capital) is the receipt of dividends and management fees from the Bank. The ability of the Bank to pay management fees and dividends to the Company and its affiliates is subject to restrictions set forth in the California Financial Code and, under certain circumstances, is subject to approval of the Department. The board of directors of a state-chartered bank may declare a dividend out of so much of net profits as such board deems appropriate, subject to California law which restricts the amount available for cash dividends to the lesser of retained earnings or the bank's net income less cash dividends paid for its last three fiscal years. In the event that a bank has no retained earnings or net income for the prior three fiscal years, cash dividends may be paid out of net income for such bank's last preceding fiscal year or current fiscal year upon the prior approval of the Department. Although there are not specific regulations restricting dividend payments by bank holding companies other than state corporation law, supervisory concern focuses on the holding company's capital position, its ability to meet its financial obligations as they come due and the capacity to act as a source of financial strength to its subsidiary banks. The FRB and the Superintendent have authority to prohibit a bank from engaging in business practices, which are considered to be unsafe or unsound. Depending upon the financial condition of the Bank and upon other factors, the FRB or Superintendent could assert that the payments of dividends or other payments by the Bank to the Company might be such an unsafe or unsound practice. Also, if the Bank were to experience either significant loan losses or rapid growth in loans or deposits, or some other event resulting in a depletion or deterioration of the Bank's capital account were to occur, the Company might be compelled by federal banking authorities to invest additional capital in the Bank necessary to return the capital account to a satisfactory level. IMPACT OF ECONOMIC CONDITIONS AND MONETARY POLICIES. The earnings and growth of the Company are and will be affected by general economic conditions, both domestic and international, and by the monetary and fiscal policies of the United States Government and its agencies, particularly the FRB. One function of the FRB is to regulate the national supply of bank credit in order to mitigate recessionary and inflationary pressures. Among the instruments of monetary policy used to implement those objectives are open market transactions in United States Government securities and changes in the discount rate on member bank borrowings. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. However, the effect, if any, of such policies on the future business and earnings of the Company cannot be accurately predicted. The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133) in June 1998. This statement, among other things, establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. In June 1999, the FASB issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133, an amendment of FASB Statement No. 133", which deferred the effective date of implementation of SFAS 133 for one year. The provisions of SFAS 133, as amended, are effective for all fiscal quarters or all fiscal years beginning after June 15, 2000. SFAS 133 is not anticipated to have a significant impact on the Company's consolidated financial condition or results of operations. In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). This statement establishes standards for disclosures about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement supersedes SFAS No. 14 "Financial Reporting for Segments of a Business Enterprise. SFAS 131 became effective for the Company's 1998 fiscal year and required that comparative information from earlier years to be restated to conform to the requirements of this standard. SFAS 131 had no effects on the Company's current reporting and disclosures. LEGISLATION AND PROPOSED CHANGES. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory agencies. No prediction can be made as to the likelihood of any major changes or the impact such changes might have on the Company. Certain changes of potential significance to the Company which have been enacted recently or others which are currently under consideration by Congress or various regulatory or professional agencies are discussed below. FINANCIAL INSTITUTIONS REFORM, RECOVERY AND ENFORCEMENT ACT OF 1989. On August 9, 1989, President Bush signed into law the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). FIRREA contains provisions, which among other things: (1) establish two separate financial industry insurance funds, both administered by the FDIC - the Bank Insurance Fund and the Savings Association Fund; (2) abolish the Federal Home Loan Bank Board and establish the Office of Thrift Supervision as an office of the Treasury Department, with responsibility for examination and supervision of all savings and loan associations; (3) increase the insurance premiums paid by FDIC-insured institutions; (4) permit bank holding companies to acquire healthy savings and loan associations; (5) enhance federal banking agencies' enforcement authority over the operations of all insured depository institutions and increase the civil and criminal penalties that may be imposed in connection with violations of laws and regulations; (6) curtail investments and certain activities of state-chartered savings and loan associations; and (7) increase the capital requirements of savings and loan associations. Management of the Company does not believe that the provisions of FIRREA have had or will have a material adverse impact on the Company's consolidated financial position or results of operations. COMPETITIVE EQUALITY BANKING ACT. The Competitive Equality Banking Act of 1987 contained provisions which, among other things: (1) permanently closed the loophole which formerly allowed for the creation of "non-bank banks"; (2) limited the restrictions imposed on banks on the availability of funds deposited by check; and (3) provided explicit leasing authority for national banks. The enactment of this legislation has not had a material adverse effect on the Company's consolidated financial condition or results of operations. INTERSTATE BANKING. In September 1986, California adopted an interstate banking law. The law allows California banks and bank holding companies to be acquired by banking organizations in other states on a reciprocal basis (i.e., provided the other state's laws permit California banking organizations to acquire banking organizations in that state on substantially the same terms and conditions applicable to banking organizations solely within that state). The law took effect in two stages. The first stage, which became effective July 1, 1987, allowed acquisitions on a reciprocal basis within a region consisting of all 11 states (Alaska, Arizona, Colorado, Hawaii, Idaho, Nevada, New Mexico, Oregon, Texas, Utah and Washington) which currently permit acquisitions by California banking organizations of banks and bank holding companies in such states. The second stage, which became effective January 1, 1991, allows interstate acquisitions on a national reciprocal basis. The Company believes that this legislation will further increase competition as out-of-state financial institutions enter the California market. Most recently U.S. Bancorp purchased California Bancshares, Inc.; a community- based holding company with approximately 21 independent banks in the surrounding area in which the Bank operates. U. S. Bancorp was subsequently purchased by First Bank headquartered in Minneapolis. It is anticipated that such a purchase may in fact be beneficial to the Bank as it may open opportunities to prospects that enjoy dealing with a community bank. If there is a negative effect on the Bank it might be that this merger might increase the resources available to the 21 independent banks being purchased. CAPITAL ADEQUACY GUIDELINES. The FRB has issued capital adequacy guidelines establishing a risk-based capital framework consisting of a definition of capital comprised of a core component (essentially shareholders' equity less goodwill) ("Tier 1 capital"), a supplementary component ("Tier 2 capital"), a system for assigning assets & off-balance sheet items to four weighted risk categories (with higher levels of capital being required for the categories being perceived as representing greater credit risk) and a schedule for achieving a minimum risk-based capital ratio of 7.25% by the end of 1990 (which at least 3.625% should be in the form of common shareholders' equity) and 8% by the end of 1992 (which at least 4% should be in the form of common shareholders' equity). An institution's risk-based capital would be determined by dividing its qualifying capital by its risk -weighted assets. The guidelines make regulatory capital requirements more sensitive to the differences in risk profiles among banking institutions, take off- balance sheet items into account when assessing capital adequacy and minimize disincentives to holding liquid low-risk assets. In addition, the guidelines may require some banking institutions to increase the level of their common shareholders' equity. It is not anticipated that the guidelines will have a material adverse effect on the Company's financial condition or results of operations over the short term. At the end of 1999, the guidelines provided for a minimum risk-based capital ratio of 8%, and this provision may limit the Company's ability to increase its assets or require the Company to raise additional equity to facilitate growth. On August 2, 1990, the FRB adopted standards for compliance by banking organizations with risk-based capital guidelines to include a minimum leverage ratio of 4%. An institutions leverage ratio is determined by dividing Tier 1 capital by total average assets. The FRB emphasized that the leverage ratio constitutes a minimum requirement for well-run banking organizations having diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and a favorable composite rating under the applicable regulatory rating system. Banking organizations experiencing or anticipating significant growth, as well as those organizations which do not exhibit the characteristics of a strong well-run banking organization described above, will be required to maintain minimum capital ranging from 100 to 200 basis points in excess of the leverage ratio. The FRB leverage ratio establishes a new limit on the ability of banking organizations to increase assets and liabilities without increasing capital proportionately. In management's opinion, the leverage ratio will have no material effect on its capital needs in the foreseeable future. The Bank's leverage ratio at December 31, 1999 was 8.10% (See "Summit Bancshares, Inc. 1999 Annual Report - Footnote #8). EMPLOYEES - - --------- On December 31, 1999 the Bank employed 49 full time employees and 1 part time employees for a total equivalent of 49.4 full time employees. At the present time there are no salaried employees of the Company. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY The following table summarizes the distribution, by amount (in thousands) and percentage of the daily average assets, liabilities, and shareholders' equity of Summit Bancshares, Inc. (consolidated) for the year ended December 31, 1999. Comparative figures for the years ended December 31, 1998 and 1997, are also provided: The following is an analysis of Net Interest Income for 1999. Comparative figures for 1998 and 1997 are also presented on the following pages. Non-accrual loans are included in the average balances. Balances are expressed in thousands of dollars. *Includes loan fees of $412,691 1.) Investment income rate is not calculated on a tax equivalent basis. *Includes loan fees of $516,000 1.) Investment income rate is not calculated on a tax equivalent basis. *Includes loan fees of $ 594,000 Following is an analysis of changes in Interest Income and Expense (in thousands of dollars) for 1999 over 1998. A similar comparison for 1998 over 1997 is on the following page. Changes not solely attributed to volume or rates have been allocated proportionately to volume and rate components. INVESTMENT SECURITIES - - --------------------- The following table sets forth the book value as of December 31 for the securities indicated: The amortized cost and estimated fair values of investment in debt securities for 1999 are as follows: The amortized cost and estimated market value of debt securities at December 31, 1999 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. There were no sales of investments in debt securities during 1999. The following table is a summary of the relative maturities and yields of Summit Bancshares, Inc. investment securities as of December 31, 1999 and 1998. Yields on securities have been computed by dividing interest income, adjusted for amortization of premium and accretion of discount, by book values of the related securities. LOAN PORTFOLIO - - -------------- COMPOSITION OF LOANS - - -------------------- The following table shows the composition of loans (in thousands of dollars) of Summit Bancshares, Inc. as of December 31 for each respective year designated. MATURITY, DISTRIBUTION AND INTEREST RATE - - ---------------------------------------- SENSITIVITY OF LOANS - - -------------------- The following table shows the maturity distribution of loans (in thousands of dollars) as of December 31, 1999. All but seven loans for $4,834,522 reported above which have maturities of over one year are at floating interest rates. COMMITMENTS AND LINES OF CREDIT - - ------------------------------- The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of financial position. The contract amount of those instruments reflects the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At December 31, 1999, financial instruments whose contract amounts represent credit risk: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Company upon extension of credit is based on management's credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Most all guarantees expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Approximately 5.9% of the Company's loans are concentrated with health care professionals. NON-PERFORMING LOANS AND - - ------------------------ SUMMARY OF LOAN LOSS EXPERIENCE - - ------------------------------- (In thousands of dollars) The subsidiary Bank's policy is to recognize interest income on an accrual basis unless the full collectibility of principal and interest is uncertain. Loans that are delinquent 90 days as to principal or interest are placed on a non-accrual basis, unless they are well secured and in the process of collection, and any interest earned but uncollected is reversed from income. Collectibility is determined by considering the borrower's financial condition, cash flow, quality of management, the existence of collateral or guarantees and the state of the local economy. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. The reserve is increased by provisions and reduced by net charge-offs. The Bank makes credit reviews of the loan portfolio, considers current economic conditions, loan loss experience, and other factors in determining the adequacy of the reserve balance. The allowance for loan losses is based on estimates and ultimate losses may vary from current estimates. As adjustments become necessary, they are reported in earnings in the periods in which they become known. Any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed under Item III of Industry Guide 3 do not (i) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity or capital resources, or (ii) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment program. An analysis of activity in the allowance for loan losses for the years ended December 31 is as follows: TIME DEPOSITS IN THE AMOUNT OF $100,000 AND OVER - - ------------------------------------------------ The following table sets forth by time remaining to maturity, Summit Bank's issuance of time deposits in the amount of $100,000 or more (in thousands of dollars) as of December 31 of the respective year designated: RETURN ON EQUITY AND ASSETS - - --------------------------- The following table shows key financial ratios for the years ending December 31, 1999, 1998 and 1997 INTEREST RATE SENSITIVITY/INTEREST RATE RISK ANALYSIS - - ----------------------------------------------------- The following table provides an interest rate sensitivity and interest rate risk analysis for the year ended 1999. The table presents each major category of interest- earning assets and interest-bearing liabilities. INTEREST RATE RISK REPORTING SCHEDULE REPORTING INSTITUTION: SUMMIT BANK REPORTING DATE: 12/31/99 ITEM 2. ITEM 2. PROPERTIES When the Bank first entered into its initial lease agreement it signed a ten-year lease which commenced September 1, 1981 (with options to extend the lease on the same terms and conditions for two additional five-year periods). This space housed the permanent Head Offices for the Bank and the Company at 2969 Broadway, Oakland, California 94611 at the intersection of Broadway and 30th Street in the "Pill Hill" area. The premises consisted of approximately 3,800 square feet located in a portion of a single story building on the southwest corner at the intersection. The Bank spent approximately $388,448 on leasehold improvements at this location. Improvements consisted of a complete remodeling of the facility, including a new roof, new facade, new floor, partitions and structural improvements. In September 1987 the Bank entered into an additional ten-year lease for 6,010-sq. ft. adjacent to its location in Oakland. The Bank utilizes approximately 2,900-sq. ft. of this new area. The Bank's cost of leasehold improvements in this new location was approximately $294,000. Improvements consisted of a complete remodeling of the facility, including a new facade, new floor, partitions and structural improvements. The initial lease in the above paragraph has expired and has been rolled into this new lease. The current monthly rent for the entire 9,810-sq. ft. is $5,675.00 subject to yearly CPI adjustments. Commencing on December 1, 1984, the Bank leased 720 square feet of office space in a new building at 112 La Casa Via in Walnut Creek, California. This location housed the Bank's initial branch office. The building was fully serviced and the base rental was $1,274 per month subject to cost-of-living adjustments on the anniversary of each rental year. Necessary leasehold improvements were completed within the landlord's authorized allowance. The term of this lease expired on November 30, 1989, however, the Bank negotiated a month to month lease pending its move to new quarters in September 1990. Monthly rent was $1,502.83. In September 1989, the Bank entered into a new lease for 1,400-sq. ft. of office space located at the corner of No. Main Street and Civic Drive in downtown Walnut Creek. This new location is twice the physical size of the old location and is closer to the financial district of Walnut Creek. The Bank moved into this new location in September 1990. The new lease is for a term of 12 years commencing November 1, 1989 and terminates January 14, 2001. The Bank's cost for leasehold improvement in this new location was approximately $210,000. Improvements consisted of a complete remodeling of the facility, including enclosing an existing drive through facility, partitions and structural improvements. The lease provides for a monthly rent of $4,769.80, fixed for 12 years. The Emeryville Branch began operations in December 1985 on the ground floor of the Watergate III Building at 2000 Powell Street. The Bank currently occupies approximately 2,200 square feet of space at this location, at a base rent of $2.00 per net rentable square foot ($4,390 per month). The term of this lease expired August 31, 1992 with two successive options to extend the lease by one three-year option and one five-year option. The Bank renewed the lease at a base rent of $1.95 per net rentable square foot ($4,329 per month) with two three-year options effective 1-1-93 which expired December 31, 1995. The Bank subsequently renewed the lease at a base rent of $2.05 per net rentable square foot ($4,651 per month) with two three-year options effective 1-1-96. The Bank exercised one of it's options in January 1999 which brought the current base rent to $2.32 per sq. ft. or $5,264 per month until January 1, 2002. In September 1990 the Company purchased two contiguous parcels totaling 10,000-sq. ft. adjacent to the Bank's Walnut Creek Office for a price of $544,644. Included on one of the parcels is a single story, 2,500-sq. ft. concrete block building suitable for a restaurant. The Company entered into a five-year lease on April 1, 1991 with an individual who operates a Japanese restaurant at this location for a monthly rent of $4,350, triple net commencing April 1, 1992. The leasee in turn made improvements to the building to bring it to today's standards. On April 1, 1996, the Bank entered into a three-year lease agreement with the son of the previous lessee for a monthly rent of $4,350, triple net ending on March 31, 1999. The Bank is currently reviewing plans to remodel this building with the intention of making the property the future home of it's Walnut Creek office whose lease is expiring on January 2, 2001. The Pleasanton Branch began operations on January 28, 1998 at 5820 Stoneridge Mall Rd. The Branch occupies an office on the ground floor at this location with monthly rent of $1,669.00 commencing on December 1, 1997 for a term of one year. In June of 1998, the Pleasanton Branch moved to 5673 W. Las Positas Blvd. Ste. 208, 94588. The telephone number is (925) 224-7788. The rent at the Las Positas address is $3,150 as of December 31, 1999. ITEM 3. ITEM 3. LEGAL PROCEEDINGS From time to time the Company is a party to claims and legal proceedings arising in the ordinary course of business. Currently, the Company has no outstanding suits brought against it. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - ------------------------------------------------------------ Neither the Company nor the Bank submitted any matter covered by this report to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 1999 EXECUTIVE OFFICERS OF SUMMIT BANCSHARES, INC. --------------------------------------------- Pursuant to General Instruction G(3), the information required by Item 401(b) and (e) of Regulation S-K concerning executive officers of the Company and the Bank is presented here rather than in the Company's Proxy Statement for the Annual Meeting of Shareholders to be held on May 16, 2000. The following individuals are the executive officers of the Company as of December 31, 1999: The following individuals are the executive officers of the Bank as of December 31, 1999: The business experience of the executive officers follows: Shirley W. Nelson was President and Chief Executive Officer of the Bank and Holding Company since May 1983 and was elected in July 1989 to the position of Chairman. She remained President of the Bank until January, 1996. Prior to this assignment she was the Senior Vice President, Senior Loan Officer. She is currently a member of the Board of Directors' Audit Committee, Asset and Liability Committee, Loan Committee, and Personnel Committee. Kikuo Nakahara is Managing Director of American Express Tax and Business Services Inc. in Walnut Creek, California. Prior to this position he was a partner of Greene & Nakahara, an accounting firm in Walnut Creek since 1993, and which merged with IDS Financial Services Inc. in 1994. From 1978 to 1993 he was managing Director of Greene, Nakahara and Lew Accountancy Corporation in Oakland. He was a corporate member of Blue Shield and a speaker at continuing education courses sponsored by the California Society of Certified Public Accountants. George H. Hollidge has been President of Hollidge Transmissions, Inc., Oakland, transmission specialists, since 1980. Prior to 1980, Mr. Hollidge was a partner in Hollidge Hydramatic, transmission specialists. C. Michael Ziemann has been President and Chief Operating Officer of the Bank since January 1, 1996. Prior to this position he was Chief Administrative Officer subsequent to his position as CFO and Cashier to which he was appointed in April 1987. Prior to that he was active in the administration of the Bank and was the manager of the Bank's Walnut Creek Office since April 1985. Prior to joining the Bank, he held various positions during his 16 years with Bank of America in operations, branch management, and regional administration where he was a district administrator. Denise Dodini has been the Senior Vice President - Senior Loan Officer at the Bank since July 1994. Prior to joining the Bank, Denise had fifteen years of Banking experience with Bank of America, where she was involved in consumer, commercial, real estate, and corporate lending. Denise joined the Bank in October 1989 as a Vice President, Loan Officer where she assisted clients in the Oakland Office. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED - - ------ ---------------------------------------------------- SECURITY HOLDER MATTERS ----------------------- (A) MARKET INFORMATION. The stock of the Company is not listed on any stock exchange but is publicly traded in limited and infrequent transactions in the "over the counter" market. According to information made available to the Company by the Market Maker, Justin Mazzon, American Blue Chip Investment Management, 700 Larkspur Landing Circle, Larkspur, CA., the range of high and low bids for such common stock for each calendar quarter since January 1998 is as follows: As of February 28, 2000, there were 457,911 shares of common stock of the Company issued. (b) SHAREHOLDERS. As of February 28, 2000, there were 271 shareholders of record the common stock. There were no other classes of securities outstanding. (c) DIVIDENDS. On June 10, 1999 the Company paid a 75-cent per share cash dividend in addition to a similar 75 cent per share dividend on December 3, 1999. It is the present intention of the Company to issue semi-annual cash dividends so long as said dividends do not inhibit future development. Additionally, payment of cash dividends by the Company is dependent upon payment of dividends by the Bank to the Company. Payment of cash dividends by the Bank may under certain circumstances require approval of the California Department of Financial Institutions, and as a matter of law, the Bank may only declare cash dividends from the lesser of its retained earnings or its undistributed net income from the last three years, less any dividends paid during those three years. In the event that the Bank does not have retained earnings or net income for the last three fiscal years, the Bank may declare dividends only with the prior written consent of the Department of Financial Institutions. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial information of Summit Bancshares, Inc. for the years from the period January 1, 1995 through December 31, 1999 should be read in conjunction with the consolidated financial statements and the accompanying notes included elsewhere in this Annual Report. ITEM 7: ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section labeled Management's Discussion of Analysis of Financial Condition and Results of Operation appearing in the RegisTrant's Annual Report to stockholders for the year ended December 31, 1999 are incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated statement of financial position as of December 31, 1999 and 1998 and the consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1999, 1998, and 1997, together with the report of independent public accountant appearing in the Registrant's Annual Report to stockholders for the year ended December 31, 1999 are incorporated by reference herein. ITEM 9. ITEM 9. CHANGES ON AND WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL ------------------------------------------------------------ DISCLOSURES ----------- On March 27, 2000 Summit Bancshares Inc. dismissed the services of PricewaterhouseCoopers LLP as they informed the registrant that the local office will no longer be providing accounting services for community banks and that the last year in which they will provide services to the registrant will be for the year 1999. PricewaterhouseCoopers LLP's last two years reports did not contain an adverse opinion or disclaimer of opinion nor were they qualified or modified as to uncertainty, audit scope, or accounting principles. The decision to discontinue accounting services to the registrant was made by PricewaterhouseCoopers LLP as a policy matter and not as result of services performed for the registrant. During the registrant's two most recent fiscal years and any subsequent interim period through February 28, 2000, there were no disagreements with the former accountant on any matter of accounting principles or practices, financial statements disclosure, or auditing scope or procedure which disagreement(s), if not resolved to the satisfaction of PricewaterhouseCoopers LLP, would have caused it to make reference to the subject matter of the disagreement. On the recommendation of the Company's Audit Committee, Arthur Andersen LLP will be recommended to the Company's shareholders at its May 16, 2000 annual meeting to be its new principal accountant to audit its financial statements. At no time during the registrant's two most recent years did the registrant consult with Arthur Andersen LLP regarding the application of accounting principles to a specific transaction, either completed or proposed; or the type of audit opinion that might be rendered on the registrant's financial statements, and neither a written report was provided to the registrant or oral advice was provided that the new accountant concluded was an important factor considered by the registrant in reaching a decision as to the accounting, auditing or financial reporting issue. In addition, there were no reportable events as defined in Regulation S-K, Item 304(a) (1) (v) (A-D). PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------- The information required by paragraphs (a), (c) (d), (f) and (g) of this item is presented in the Company's Proxy Statement issued in connection with the Annual Meeting of Shareholders to be held on May 16, 2000 under "Election of Directors," which is incorporated in this Report by reference thereto and will be filed within 120 days after the end of the Company's fiscal year. The information concerning executive officers requested by paragraphs (b) and (e) is set forth under Part I in a separate Item captioned Executive Officers of Summit Bancshares, Inc. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ---------------------- The information required by this item in presented in the Company's Proxy Statement issued in connection with the Annual Meeting of Shareholders to be held on May 16, 2000. Under "Executive Compensation," which is incorporated in this Report by reference thereto and will be filed within 120 days after the end of the Company's fiscal year. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT --------------------------------------------------------------- The information required by this item is presented in the Company's Proxy Statement issued in connection with the Annual Meeting of Shareholders to be held on May 16, 2000, under "Principal Security Holders" and "Security Ownership of Management," which is incorporated in this Report by reference thereto and will be filed within 120 days after the end of the Company's fiscal year. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- The information required by this item is presented in the Company's Proxy Statement issued in connection with the Annual Meeting of Shareholders to be held May 16, 2000, under "Certain Relationships and Related Transactions," which is incorporated in this Report by reference thereto and will be filed within 120 days after the end of the Company's fiscal year. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. CONSOLIDATED FINANCIAL STATEMENTS. --------------------------------- The following Financial Statements are included in the Registrant's Annual Report to Shareholders for the year ended December 31, 1999 and are incorporated by reference herein pursuant to Item 8. Consolidated Statement of Financial Position - December 31, 1999 and Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997 Statements of Changes in Shareholders' Equity (Consolidated and Parent Company Only) for the years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements Report of Independent Accountants (b) 2. FINANCIAL STATEMENT SCHEDULES. ----------------------------- Not Applicable In accordance with the rules of Regulation S-X, the required schedules are not submitted because they are not applicable to or required of the Company. (c) 3. INDEX TO EXHIBITS. ----------------- The following exhibits are incorporated by reference pursuant to Item 601 of Regulation S-K: - - ---------------- 1. Incorporated by reference to Exhibit 2.1 of Registrant's Exhibits to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on December 21, 1981. 2. Incorporated by reference to Exhibit 2.2 of Registrant's Exhibits to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on December 21, 1981. 3. Incorporated by reference to Exhibit 3.1 of Registrant's Exhibits to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on December 21, 1981. 4. Incorporated by Reference to Exhibit 9.1 of Registrant's Exhibits to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on December 21, 1981. 5. Incorporated by reference to Exhibit 9.2 of Registrant's Exhibits to Post-Effective Amendment No. 1 to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on March 11, 1982. 6. Incorporated by reference to Exhibit 9.4 of Registrant's Exhibits to Post-Effective Amendment No. 1 to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on March 11, 1982. 7. Incorporated by reference to Exhibit 10.4 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1983. 8. Incorporated by reference to Exhibit 10.6 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1984. 9. Incorporated by reference to Exhibit 10.9 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10. Incorporated by reference to Exhibit 10.10 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 11. Incorporated by reference to Exhibit 10.6 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 12. Incorporated by reference to Exhibit 10.9 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 13. Incorporated by reference to Exhibit 10.10 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 14. Incorporated by reference to Exhibit 10.11 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 15. Incorporated by reference to Exhibit 10.12 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 16. Incorporated by reference to Exhibit 10.13 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 17. Incorporated by reference to Exhibit 2.2 of Registrant's Exhibits to Form S-18 Registration Statement, as filed with the Securities and Exchange Commission on December 21, 1981. 18. Incorporated by reference to Exhibit 10.15 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993. 19. Incorporated by reference to Exhibit 10.16 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993. (b) Reports on Form 8-K The Company did not file any Reports on Form 8-K during the quarter ended December 31, 1999. WEIGHTED AVERAGE SHARES TWELVE MONTHS ENDED DECEMBER 31, 1999 12/31/99 OPTIONS-FULLY DILUTED --------------------- SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. SUMMIT BANCSHARES, INC. KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints SHIRLEY W. NELSON and KIKUO NAKAHARA, and each or any one of them, as his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agents or any of them, or their substitutes or substitute, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities and Exchange Act of 1934, this Report has been executed in Oakland, California, by the following persons on behalf of the Registrant on the capacities and on the dates indicated.

793421_1999.txt

793421_1999

1999

793421

Item 1. Business. PARTNERSHIP PROFILE Phosphate Resource Partners Limited Partnership (PLP), through its joint venture investment in IMC-Agrico Company (IMC-Agrico), is one of the world's largest and lowest cost producers, marketers and distributors of phosphate crop nutrients and animal feed ingredients, with operations in central Florida and on the Mississippi River in Louisiana. IMC-Agrico's business includes the mining and sale of phosphate rock and the production, marketing and distribution of phosphate crop nutrients and animal feed ingredients. IMC-Agrico was formed as a joint venture partnership in July 1993 when PLP and IMC Global Inc. (IMC) contributed their respective phosphate crop nutrients businesses to IMC-Agrico. IMC-Agrico is 41.5 percent owned by PLP and 58.5 percent by IMC. In December 1997, Freeport-McMoRan Inc. (FTX), the former administrative managing general partner and owner of a 51.6 percent interest in PLP, merged into IMC (FTX Merger). In connection with the FTX Merger, IMC became administrative managing general partner (General Partner) of PLP. PLP is a publicly traded Delaware limited partnership. As of December 31, 1999, IMC held partnership units representing an approximate 51.6 percent interest in PLP. The remaining interests are publicly owned and traded on the New York Stock Exchange (NYSE). See "Other Matters - Relationship Between PLP and IMC," for further detail. All references herein to PLP refer to PLP's business activities as executed through its ownership interest in IMC-Agrico. The dollar amounts included throughout this Form 10-K are shown at PLP's 41.5% ownership percentage, unless otherwise noted. BUSINESS OPERATIONS INFORMATION In 1999, IMC implemented a company-wide rightsizing program (Rightsizing Program) which was designed to simplify and focus the core businesses through a facilities optimization and asset rightsizing program. In 1998, IMC initiated a plan to improve profitability (Project Profit). The initiative of Project Profit consisted primarily of a restructuring of operations at IMC- Agrico. For additional information on the Rightsizing Program and Project Profit see Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of this Annual Report on Form 10-K. The following discussion of continuing business operations should be read in conjunction with the information contained in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 10, "Operating Segments," of Notes to Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. IMC-Agrico Company ------------------ IMC is responsible for the operation of IMC-Agrico. Subject to the terms of the IMC-Agrico Partnership Agreement (Partnership Agreement), IMC has the sole authority to make certain decisions affecting IMC-Agrico, including authorizing certain capital expenditures for expansion; incurring certain indebtedness; approving significant acquisitions and dispositions; and determining certain other matters. IMC-Agrico's net sales were $592.0 million, $687.1 million and $683.8 million for the years ended December 31, 1999, 1998 and 1997, respectively. IMC-Agrico's operations consist of its phosphate crop nutrients business (Phosphates) and its animal feed ingredients business (Feed Ingredients). Phosphates Phosphates is a leading United States miner of phosphate rock, one of the primary raw materials used in the production of concentrated phosphates, with 18.0 million tons of annual capacity. Phosphates is also a leading United States producer of concentrated phosphates with an annual capacity of approximately four million tons of phosphoric acid (P2O5). P2O5 is an industry term indicating a product's phosphate content measured chemically in units of phosphorous pentoxide. Phosphates' concentrated phosphate products are marketed worldwide to crop nutrient manufacturers, distributors and retailers. Phosphates' facilities, which produce concentrated phosphates, are located in central Florida and Louisiana. Its annual capacity represents approximately 31 percent of total United States concentrated phosphate production capacity and approximately ten percent of world capacity. The Florida concentrated phosphate facilities consist of two plants: New Wales and South Pierce. The New Wales complex is the largest concentrated phosphate plant in the world with an estimated annual capacity of 1.9 million tons of phosphoric acid (P2O5 equivalent). New Wales primarily produces three forms of concentrated phosphates: diammonium phosphate (DAP), monoammonium phosphate (MAP) and merchant grade phosphoric acid. The South Pierce plant produces phosphoric acid and granular triple superphosphate (GTSP). A third facility, Nichols, which manufactured phosphoric acid, DAP and granular MAP (GMAP), was permanently closed as part of the Rightsizing Program and will be dismantled. The Louisiana concentrated phosphate facilities consist of three plants: Uncle Sam, Faustina and Taft. The Uncle Sam plant produces phosphoric acid, which is then shipped to the Faustina and Taft plants where it is used to produce DAP and GMAP. The Faustina plant manufactures phosphoric acid, DAP, GMAP and ammonia. The Taft facility manufactures DAP and GMAP. Concentrated phosphate operations are managed in order to balance Phosphates' output with customer needs. Phosphates suspended phosphoric acid production at its Faustina facility in November 1999, and suspended production at its Taft facility in July 1999 in response to reduced market demands. Summarized below are descriptions of the principal raw materials used in the production of concentrated phosphates: phosphate rock, sulphur and ammonia. Phosphate Rock All of the phosphate mines and related mining operations are located in central Florida. Phosphates extracts phosphate ore through surface mining after removal of a ten to 50 foot layer of sandy overburden and then processes the ore at one of its beneficiation plants where the ore goes through washing, screening, sizing and flotation procedures designed to separate it from sands, clays and other foreign materials. In conjunction with the Rightsizing Program and Project Profit, Phosphates permanently closed two phosphate mines during 1999, Payne Creek and Noralyn, respectively. As a result of the permanent mine closures, Phosphates currently maintains four operational mines. The Rightsizing Program and Project Profit, as they pertain to the facilities optimization program and strategic mining plan, were developed to maximize available resources, lower the cost of producing rock and enhance the management of phosphate rock inventory. Phosphates' rock production volume was 16.4 million tons for the year ended December 31, 1999 and 20.0 million tons for each of the years ended December 31, 1998 and 1997. Anticipated production in 2000 will be less than the average of the prior three years. Although Phosphates sells phosphate rock to other crop nutrient and animal feed ingredient manufacturers, it primarily uses phosphate rock internally in the production of concentrated phosphates. Tons used internally, primarily in the manufacture of concentrated phosphates, totaled 13.4 million, 14.8 million and 14.1 million for the years ended December 31, 1999, 1998 and 1997, respectively, representing 82 percent, 74 percent and 70 percent, respectively, of total tons produced. Rock shipments to customers totaled 4.8 million, 5.0 million and 4.6 million tons for the years ended December 31, 1999, 1998 and 1997, respectively. Phosphates estimates its proven reserves to be 493.3 million tons of phosphate rock as of December 31, 1999. Phosphates controls these reserves through ownership, long-term lease, royalty or purchase option agreements. Reserve grades range from 58 percent to 78 percent bone phosphate of lime (BPL), with an average grade of 66 percent BPL. BPL is the standard industry term used to grade the quality of phosphate rock. The phosphate rock mined by Phosphates in the last three years averaged 65 percent BPL, which management believes is typical for phosphate rock mined in Florida during this period. Phosphates estimates its reserves based upon the performance of exploration core drilling as well as technical and economic analyses to determine that reserves so classified can be economically mined at market prices estimated to prevail during the next five years. Phosphates also owns or controls phosphate rock resources in the southern extension of the central Florida phosphate district (Resources). Resources are mineralized deposits that may be economically recoverable; however, additional geostatistical analyses, including further explorations, permitting and mining feasibility studies, are required before such deposits may be classified as reserves. Based upon its preliminary analyses of these Resources, Phosphates believes that these mineralized deposits differ in physical and chemical characteristics from those historically mined by Phosphates but are similar to certain of the reserves being mined in current operations. These Resources contain estimated recoverable phosphate rock of approximately 113.0 million tons. Some of these Resources are located in what may be classified as preservational wetland areas under standards set forth in current county, state and federal environmental protection laws and regulations, and consequently, Phosphates' ability to mine these Resources may be restricted. Sulphur A significant portion of Phosphates' sulphur requirements is provided by the sulphur subsidiary of McMoRan Exploration Company (MMR) under a supply agreement with IMC. Phosphates' remaining sulphur requirements are provided by market contracts. Additionally, in late 1999, IMC, CF Industries, Inc. and Cargill Fertilizer executed a letter of intent to form a joint venture that will remelt sulphur for use at their respective Florida phosphate fertilizer operations. Ammonia Phosphates' ammonia needs are supplied by its Faustina ammonia production facility and by world suppliers, primarily under annual and multi-year contracts. Production from the Faustina plant, which has an estimated annual capacity of 560,000 tons of anhydrous ammonia, is used internally to produce certain concentrated phosphates. Sales and Marketing Domestically, Phosphates sells its concentrated phosphates to crop nutrient manufacturers, distributors and retailers. IMC-Agrico also uses concentrated phosphates internally for the production of animal feed ingredients (see Feed Ingredients). Virtually all of Phosphates' export sales of phosphate crop nutrients are marketed through the Phosphate Chemicals Export Association (PhosChem), a Webb-Pomerene Act organization, which IMC administers on behalf of itself and three other member companies. PhosChem believes that its sales represent approximately 51 percent of total United States exports of concentrated phosphates. The countries that account for the largest amount of PhosChem's sales of concentrated phosphates include China, Australia, India, Japan and Brazil. In 1999, Phosphates' exports to Asia were 44 percent of total shipments, with China representing 29 percent of those shipments. The table below shows Phosphates' shipments of concentrated phosphates in thousands of dry product tons, primarily DAP: As of December 31, 1999, Phosphates had contractual commitments from non-affiliated customers for the shipment of concentrated phosphates and phosphate rock amounting to approximately 2.7 million tons and 4.7 million tons, respectively, in 2000. Captive sales have decreased in 1999 as a result of the sale of the IMC AgriBusiness business unit (AgriBusiness) in April 1999. However, since April 1999, sales to AgriBusiness have been reflected as sales to customers. Competition Phosphates operates in a highly competitive global market. Among the competitors in the global phosphate crop nutrient market are domestic and foreign companies, as well as foreign government- supported producers. Phosphate crop nutrient producers compete primarily based on price and, to a lesser extent, product quality and innovation. Feed Ingredients ---------------- Feed Ingredients is one of the world's foremost producers and marketers of phosphate-based animal feed ingredients with a total annual capacity approaching 800,000 tons. In the fourth quarter of 1999, Feed Ingredients completed construction of an expansion of its deflourinated phosphate (Multifos(Registered Trademark)) capacity. The expansion increases capacity for Multifos(Registered Trademark) to 200,000 tons annually, which is approximately 25 percent of total capacity. The principal production facilities of Feed Ingredients are located adjacent to, and utilize raw materials from, Phosphates' concentrated phosphate complex at New Wales. Sales and Marketing Feed Ingredients supplies phosphate and potassium-based feed ingredients for poultry and livestock to markets in North America, Latin America and Asia. Feed Ingredients sources phosphate and potassium raw materials from IMC's production facilities. Feed Ingredients has a strong brand position in a $1.0 billion global market with products such as Biofos(Registered Trademark), Dynafos(Registered Trademark), Multifos(Registered Trademark), Dyna-K(Registered Trademark) and Dynamate(Registered Trademark). The table below shows Feed Ingredients' shipments of phosphate and potassium-based feed ingredients in thousands of tons: As of December 31, 1999, Feed Ingredients had contractual commitments from non-affiliated customers for the shipment of phosphate feed and feed grade potassium products amounting to approximately 0.6 million tons in 2000. Competition Feed Ingredients operates in a competitive global market. Major integrated producers of feed phosphates and feed grade potassium are located in the United States and Europe. Many smaller producers are located in emerging markets around the world. Many of these smaller producers are not manufacturers of phosphoric acid and are required to purchase this raw material on the open market. Competition in this global market is driven by price, quality and service. FACTORS AFFECTING DEMAND PLP's results of operations historically have reflected the effects of several external factors which are beyond its control and have in the past produced significant downward and upward swings in operating results. Revenues are highly dependent upon conditions in the North American agriculture industry and can be affected by crop failure, changes in agricultural production practices, government policies and weather. Furthermore, PLP's business is seasonal to the extent North American farmers and agricultural enterprises purchase more crop nutrient products during the spring and fall. PLP's export sales to foreign customers are subject to numerous risks, including fluctuations in foreign currency exchange rates and controls; expropriation and other economic, political and regulatory policies of local governments; and laws and policies affecting foreign trade and investment. Due to economic and political factors, customer needs can change dramatically from year to year. OTHER MATTERS Environmental Health and Safety Matters --------------------------------------- PLP's Program IMC-Agrico has adopted the following Environmental, Health and Safety (EHS) Policy (Policy): As a key to IMC-Agrico's success, IMC-Agrico is committed to the pursuit of excellence in health and safety, and environmental stewardship. Every employee will strive to continuously improve IMC- Agrico's performance and to minimize adverse environmental, health and safety impacts. IMC-Agrico will proactively comply with all environmental, health and safety laws and regulations. This Policy is the cornerstone of IMC-Agrico's comprehensive EHS plan (EHS Plan) to achieve sustainable, predictable, measurable and verifiable EHS performance. Integral elements of the EHS Plan include: (i) improving IMC-Agrico's EHS procedures and protocols; (ii) upgrading its related facilities and staff; (iii) formulating improvement plans in response to EHS audits conducted by the IMC Global Inc. audit team; and (iv) assuring management accountability. Each facility is in a different stage of plan integration. IMC-Agrico uses its own internal audits as well as the results of audits conducted by IMC to confirm that each facility has implemented the EHS Plan and has achieved regulatory compliance, continuous EHS improvement and integration of EHS management systems into day-to-day business functions. Through IMC-Agrico, PLP produces and distributes crop and animal nutrients. These activities subject IMC-Agrico to an ever-evolving myriad of international, federal, state, provincial and local EHS laws, which regulate, or propose to regulate: (i) product content; (ii) use of products by both IMC-Agrico and its customers; (iii) conduct of mining and production operations, including safety procedures used by employees; (iv) management and handling of raw materials; (v) air and water quality impacts by facilities; (vi) disposal of hazardous and solid wastes; and (vii) post-mining land reclamation. For new regulatory programs, it is difficult to ascertain future compliance obligations or estimate future costs until implementing regulations have been finalized and definitive regulatory interpretations have been adopted. IMC-Agrico intends to respond to these regulatory requirements at the appropriate time by implementing necessary physical or procedural modifications. PLP has expended, and anticipates that it will continue to expend, substantial resources, both financial and managerial, to comply with EHS standards. In 2000, PLP's share of IMC-Agrico's environmental capital expenditures will total approximately $22.3 million, primarily related to: (i) modification or construction of wastewater treatment areas in Florida; (ii) modification and construction projects associated with phosphogypsum stacks at the concentrates plants in Florida and Louisiana; and (iii) remediation of contamination at current or former operations. PLP's share of additional expenditures for land reclamation activities will total approximately $6.4 million. In 2001, PLP expects its share of IMC-Agrico's environmental capital expenditures will be approximately $36.1 million and expenditures for land reclamation activities to be approximately $5.6 million. No assurance can be given that greater-than-anticipated EHS capital expenditures will not be required in 2000 or in the future. Based on current information, it is the opinion of management that PLP's contingent liability arising from EHS matters, taking into account established reserves, will not have a material adverse effect on PLP's financial position or results of operations. Product Requirements and Impacts IMC-Agrico's primary businesses include the production and sale of crop and animal nutrients. International, federal, state and provincial standards: (i) require registration of many IMC-Agrico products before those products can be sold; (ii) impose labeling requirements on those products; and (iii) require producers to manufacture the products to formulations set forth on the labels. Various environmental, natural resource and public health agencies at all regulatory levels have begun evaluating alleged health and environmental impacts that might arise from the handling and use of products such as those manufactured by IMC-Agrico. Most of these evaluations are in the initial stages. During 1999, the United States Environmental Protection Agency (EPA), the state of California, and The Fertilizer Institute each completed independent assessments of potential risks posed by crop nutrient materials. These assessments concluded that, based on available data, crop nutrient materials generally do not pose harm to human health or the environment. Despite these conclusions, some agencies have implemented or are still considering standards that may modify customers' use of IMC-Agrico's products because of the alleged impacts. It is unclear whether any further evaluations that may be conducted will result in additional regulatory requirements for the producing industries, including IMC-Agrico or its customers. At this preliminary stage, PLP cannot estimate the potential impact of these standards on the market for IMC-Agrico products or on the expenditures by PLP that may be necessary to meet new requirements. Operating Requirements and Impacts Permitting IMC-Agrico holds numerous environmental, mining, and other permits or approvals authorizing operation at each of its facilities. A decision by a government agency to deny or delay issuing an application for a new or renewed permit or approval, or to revoke or substantially modify an existing permit or approval, could have a material adverse effect on IMC-Agrico's ability to continue operations at the affected facility. Expansion of IMC-Agrico's operations also is predicated upon securing the necessary environmental or other permits or approvals. Recently, a number of organizations and community groups in a variety of locations have relied upon guidance and materials issued by the EPA to challenge federally authorized permits that these groups believe might have a disproportionate impact on minority or low-income communities. A challenge of this type at one of IMC-Agrico's facilities, even though unfounded, could impact the ability of that facility to obtain timely permits. In addition, over the next two to six years, IMC-Agrico will be continuing its efforts to obtain permits in support of its anticipated Florida mining operations at the Ona and Pine Level properties. These properties contain in excess of 100.0 million tons of phosphate rock reserves. For years, IMC-Agrico has successfully permitted mining properties in Florida and anticipates that it will be able to permit these properties. Nevertheless, a denial of these permits or the issuance of permits with cost-prohibitive conditions would adversely impact IMC-Agrico by preventing it from mining at Ona or Pine Level. Management of Residual Materials Mining and processing of phosphate rock generates residual materials that must be managed. Overburden and sand tailings from rock mining are used in reclamation. Phosphate processing generates phosphogypsum that is stored in phosphogypsum stack systems. IMC-Agrico has incurred and will continue to incur significant costs to manage its phosphate residual materials in accordance with environmental laws, regulations and permit requirements. Florida law may require IMC-Agrico to close one or more of its unlined phosphogypsum stacks and/or associated cooling ponds after March 25, 2001 if the stack system or pond is demonstrated to cause an exceedance of Florida's groundwater quality standards. IMC-Agrico has already begun closure activities at its unlined gypsum stack at its New Wales facility in central Florida. IMC- Agrico cannot predict at this time whether Florida law will require closure of any of its other stack systems. The costs of such closure and decommissioning could be significant. In addition, IMC-Agrico currently operates an unlined cooling pond at New Wales. Monitoring indicates that discharges from the unlined cooling pond are within Florida groundwater standards. IMC-Agrico received a permit in August 1999 to continue operating this pond through March 25, 2001. Over the past several years, IMC-Agrico has successfully permitted this pond and anticipates that it will be able to obtain future permits. However, if IMC-Agrico does not receive the permit, it will need to line or relocate the cooling pond, which is estimated to cost approximately $45.0 million, of which PLP's share would be $18.7 million. Restructuring Charges In connection with IMC's Rightsizing Program, IMC-Agrico has discontinued mining or processing operations at a number of its facilities including the Payne Creek and Noralyn mines and the Nichols concentrates plant. Such discontinuation will trigger decommissioning, closure and reclamation requirements under a number of Florida regulations and IMC-Agrico permits. PLP's share of these activities is estimated to cost $17.0 million, for which reserves have been established. Although IMC-Agrico believes that it has reasonably estimated these costs, additional expenditures could be required to address unanticipated environmental conditions as they arise. PLP's share of additional expenditures can not currently be estimated. Remedial Activities Remediation at PLP Facilities Many of IMC-Agrico's facilities have been in operation for a number of years. The historical use and handling of regulated chemical substances, crop and animal nutrients and additives, or process tailings at these facilities by IMC-Agrico and predecessor operators have resulted in soil and groundwater contamination. In addition, through its own prior but discontinued operations, PLP assumed responsibility for contamination at some crop nutrient or oil and gas facilities. At many of these facilities, spills or other unintended releases of regulated substances have occurred previously and potentially could occur in the future, possibly requiring PLP to undertake or fund cleanup efforts. In some instances, PLP has agreed, pursuant to consent orders with the appropriate governmental agencies, to undertake certain investigations, which currently are in progress, to determine whether remedial action may be required to address contamination. At other locations, PLP has entered into consent orders with appropriate governmental agencies to perform required remedial activities that will address identified site conditions. Expenditures for these known conditions currently are not expected to be material. However, material expenditures by PLP could be required in the future to remediate the contamination at these or at other current or former sites. PLP believes that, pursuant to several indemnification agreements, it is entitled to at least partial, and in many instances complete, indemnification for the costs that they may expend to remedy environmental issues at certain facilities. These agreements address issues that resulted from activities occurring prior to PLP's acquisition of facilities or businesses from parties including ARCO; Conoco; The Williams Companies; Kerr-McGee Inc.; and certain other private parties. PLP has already received and anticipates receiving amounts pursuant to the indemnification agreements for certain of its expenses incurred to date as well as future anticipated expenditures. Remediation at Third-Party Facilities Along with impacting the sites at which PLP has operated, parties have alleged that historic operations at PLP or IMC-Agrico sites have resulted in contamination to neighboring off-site areas or third-party facilities. In some instances, PLP or IMC-Agrico have agreed, pursuant to consent orders with appropriate governmental agencies, to undertake investigations, which currently are in progress, to determine whether remedial action may be required to address contamination. Remedial liability at these sites, either alone or in the aggregate, currently is not expected to be material to PLP. As more information is obtained regarding these sites, this expectation could change. In September 1999, four plaintiffs filed Moore et al. vs. Agrico Chemical Company et al., a class-action lawsuit naming Agrico Chemical Company, FTX, PLP and a number of unrelated defendants. The suit seeks unspecified compensation for alleged property damage, medical monitoring, remediation of an alleged public health hazard and other appropriate damages purportedly arising from operation of the neighboring fertilizer and crop protection chemical facilities in Lakeland, Florida. Agrico Chemical Company owned the Landia portion of these facilities for approximately 18 months during the mid-1970s. Because the litigation is in its early stages, management cannot determine the magnitude of any exposure to Agrico Chemical Company or PLP; however, Agrico and PLP intend to vigorously contest this action and to seek any indemnification to which they may be entitled. Concurrent with this litigation, the EPA has undertaken on-site and off-site investigations of these facilities to determine whether any remediation of existing contamination may be necessary. Pursuant to an indemnification agreement with Agrico Chemical Company and PLP, The Williams Companies have assumed responsibility for any costs that Agrico Chemical Company might incur for remediation as a result of the EPA's actions. Superfund The Comprehensive Environmental Response Compensation and Liability Act (Superfund) imposes liability, without regard to fault or to the legality of a party's conduct, on certain categories of persons that are considered to have contributed to the release of "hazardous substances" into the environment. Currently, PLP is involved or concluding involvement at less than ten Superfund or equivalent state sites. PLP's remedial liability at these sites, either alone or in the aggregate, is not currently expected to be material. As more information is obtained regarding these sites and the potentially responsible parties involved, this expectation could change. Employees --------- PLP has no employees. Substantially all individuals who perform services for IMC-Agrico are employed by IMC-Agrico MP, Inc. (MP Co.). This includes former employees of PLP and IMC who were transferred to MP Co. when IMC-Agrico was formed. As of December 31, 1999, IMC-Agrico had 3,788 employees. The work force consisted of 877 salaried employees, 2,909 hourly employees and two temporary or part-time employees. Labor Relations --------------- IMC-Agrico has three collective bargaining agreements with the affiliated local chapters of the same international union. As of December 31, 1999, approximately 89 percent of the hourly work force were covered under collective bargaining agreements. No agreements were negotiated during 1999. One agreement covering approximately 59 percent of the union hourly work force will expire in 2000. IMC-Agrico has not experienced a significant work stoppage in recent years and considers its employee relations to be good. Relationship Between PLP and IMC -------------------------------- Management and Ownership IMC serves as General Partner of PLP and the management and officers of IMC perform all PLP management functions and carry out the activities of PLP. As of December 31, 1999, IMC held partnership interests that represented an approximate 51.6 percent interest in PLP. As a result of IMC's position as General Partner and of its ownership interest, IMC has the ability to control all matters relating to the management of PLP, including any determination with respect to the acquisition or disposition of PLP assets, future issuance of additional debt or other securities of PLP and any distributions payable in respect of PLP's partnership interests. In addition to such other obligations as it may assume, IMC has a general duty to act in good faith and to exercise its rights of control in a manner that is fair and reasonable to the public unitholders of partnership interests. During 1999, PLP distributed $0.43 per unit to the public unitholders. On February 1, 2000, PLP announced that it would make a cash distribution of $0.09 per unit to public unitholders for the quarter ended December 31, 1999. Total unpaid cash distributions due to IMC of $431.3 million existed as of December 31, 1999. PLP's distributable cash is shared ratably by PLP's public unitholders and IMC, except that IMC is entitled to recover its unpaid cash distributions on a quarterly basis from one half of any excess of future quarterly distributions over $0.60 cents per unit for all units. Financing Arrangements Reference is made to the information set forth in Note 7, "Financing Arrangements," of Notes to Financial Statements in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Conflicts of Interest The nature of the respective businesses of PLP and IMC and its affiliates may give rise to conflicts of interest between PLP and IMC. Conflicts could arise, for example, with respect to transactions involving potential acquisitions of businesses or mineral properties, the issuance of additional partnership interests, the determination of distributions to be made by PLP, the allocation of general and administrative expenses between IMC and PLP and other business dealings between PLP and IMC and its affiliates. Except in cases where a different standard may have been provided for, IMC has a general duty to act in good faith and to exercise rights of control in a manner that is fair and reasonable to the public unitholders. In resolving conflicts of interest, PLP's limited partnership agreement (PLP Agreement) permits IMC to consider the relative interest of each party to a potential conflict situation which, under certain circumstances, could include the interest of IMC and its other affiliates. Item 2. Item 2. Properties. Information regarding the plant and properties of PLP is included in Part I, Item 1, "Business," of this Annual Report on Form 10-K. Item 3. Item 3. Legal Proceedings. FTX Merger Litigation --------------------- In August 1997, five identical class action lawsuits were filed in Chancery Court in Delaware (Court) by unitholders of PLP. Each case named the same defendants and broadly alleged that FTX and FMRP Inc. (FMRP) had breached fiduciary duties owed to the public unitholders of PLP. IMC was alleged to have aided and abetted these breaches of fiduciary duty. In November 1997, an amended class action complaint was filed with respect to all cases. The amended complaint named the same defendants and raised the same broad allegations. The defendants moved the Court to dismiss the amended complaint in November 1998, and the cases were dismissed in May 1999. In May 1998, IMC and PLP (collectively, Plaintiffs) filed a lawsuit (IMC Action) in Court against certain former directors of FTX (Director Defendants) and MMR, a former affiliate of FTX. The Plaintiffs alleged that the Director Defendants, as the directors of PLP's former General Partner FTX, owed duties of loyalty to PLP and its limited partnership unitholders. The Plaintiffs further alleged that the Director Defendants breached their duties by causing PLP to enter into a series of interrelated non-arm's- length transactions with MMR. The Plaintiffs also alleged that MMR knowingly aided and abetted and conspired with the Director Defendants to breach their fiduciary duties. On behalf of the PLP public unitholders, the Plaintiffs sought to reform or rescind the contracts that PLP entered into with MMR and to recoup the monies expended as a result of PLP's participation in those agreements. On November 10, 1999, the Plaintiffs and MMR announced a settlement of the IMC Action pursuant to which MMR agreed to purchase PLP's 47.0 percent interest in PLP's multi-year oil and natural gas exploration program with MMR (Exploration Program), which includes three producing oil and gas fields plus an inventory of exploration prospects and leases, for a total of $32.0 million. In May 1998, Jacob Gottlieb filed an action (Gottlieb Action) on behalf of himself and all other PLP unitholders against the Director Defendants, MMR and IMC asserting the same claims that IMC asserted in the IMC Action. Because IMC and PLP had already asserted these claims, in July 1998, IMC filed a motion to dismiss the Gottlieb Action. The Court has not set a briefing schedule for IMC's motion to dismiss, and the plaintiff has made no substantial activity in this case within the past year. IMC and PLP have recently been advised that the plaintiff intends to withdraw the complaint without prejudice. For information on environmental proceedings, see Note 9, "Commitments and Contingencies," of Notes to Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Other ----- In the ordinary course of business, PLP is and will from time to time be involved in other legal proceedings of a character normally incident to its businesses. PLP believes that its potential liability in any such pending or threatened proceedings will not have a material adverse effect on the financial condition or results of operations of PLP. PLP, through IMC and IMC-Agrico, maintains liability insurance to cover some, but not all, potential liabilities normally incident to the ordinary course of its businesses with such coverage limits as management of IMC deems prudent. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. PART II. Item 5. Item 5. Market for Registrant's Partnership Units and Related Unitholder Matters. PLP's partnership units trade on the NYSE under the symbol PLP. The PLP unit price is reported daily in the financial press under "PLP" in most listings of NYSE securities. At March 15, 2000 the number of holders of record of the partnership's units was 7,749. Under federal law, ownership of PLP units is limited to "United States citizens." A United States citizen is defined as a person who is eligible to own interests in federal mineral leases, which generally includes: (i) United States citizens; (ii) domestic entities owned by United States citizens; and (iii) domestic corporations owned by United States citizens and/or certain foreign persons. The following table sets forth, for the periods indicated, the range of high and low sales prices, from the composite tape for NYSE issues. Ownership at December 31, 1999 was as follows: Cash distributions declared and paid to public unitholders during 1999 totaled $0.43 per unit. Cash distributions to public unitholders are determined by available distributable cash resulting from operations of the partnership and the terms of the PLP Agreement. Distributable cash is shared ratably by PLP's public unitholders and IMC, except that IMC will be entitled to receive the unpaid cash distributions, totaling $431.3 million as of December 31, 1999, from one-half of the quarterly distributable cash after the payment of $0.60 per unit to all unitholders. Cash and property distributions paid during 1999 and 1998 are shown below: Item 6. Item 6. Selected Financial Data. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. INTRODUCTION Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with PLP's financial statements and the accompanying notes. PLP's continuing business operations consist of its 41.5 percent joint venture ownership interest in IMC-Agrico. All amounts included in this discussion are shown at PLP's ownership interest. Management's Discussion and Analysis of Financial Condition and Results of Operations highlights the primary factors affecting changes in the operating results of PLP's continuing operations during the three year period, excluding the impact of certain special charges, discussed below. In 1999, PLP incurred special charges from continuing operations of $55.4 million, or $0.54 per unit, comprised of: (i) a $52.3 million, or $0.51 per unit, restructuring charge related to the Rightsizing Program; and (ii) a $3.1 million, or $0.03 per unit, charge related to additional asset write-offs. As a result of the special charges recorded in 1999, PLP expects to increase future annual earnings by an estimated $20.0 million, or $0.20 per unit. The increase in earnings is anticipated to result from rightsizing and cost reduction initiatives including headcount reductions. In 1998, PLP incurred special charges from continuing operations of $62.6 million, or $0.61 per unit, comprised of: (i) a $61.8 million, or $0.60 per unit, restructuring charge related to Project Profit; and (ii) $0.8 million, or $0.01 per unit, of other charges. As a result of Project Profit, PLP is on target to achieve a reduction in operating costs in excess of $41.5 million over the two-year period ending December 31, 2000, with $27.0 million realized in 1999. The reduction in costs resulted from the simplification of the business, shut down of high-cost operations, exit from low- margin businesses and headcount reductions. In 1997, PLP incurred special charges from continuing operations of $406.0 million, or $3.92 per unit, related to: (i) $384.5 million, or $3.71 per unit, for an impairment assessment of sulphur assets; and (ii) $21.5 million, or $0.21 per unit, related to the FTX Merger. All of these special charges significantly impacted the results of continuing operations of PLP and are referred to throughout Management's Discussion and Analysis of Financial Condition and Results of Operations. For additional detail on these charges, see Note 4, "Restructuring and Other Charges," in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. RESULTS OF OPERATIONS Overview 1999 Compared to 1998 Net sales of $592.0 million decreased 14 percent from net sales of $687.1 million in 1998. Gross margins for 1999 of $121.9 million, excluding special charges of $4.7 million, decreased from comparable 1998 margins of $179.8 million, excluding special charges of $8.0 million. Earnings from continuing operations in 1999 were $61.7 million, or $0.60 per unit, excluding the special charges of $55.4 million, or $0.54 per unit, discussed above. Earnings from continuing operations in 1998 were $116.1 million, or $1.12 per unit, excluding the special charges of $62.6 million, or $0.61 per unit, discussed above. Sales and earnings from continuing operations for 1999 reflected significantly reduced phosphate pricing and lower phosphate volumes. Partially offsetting the phosphate reductions were higher sales and earnings, driven by higher volumes and lower raw material costs, for Feed Ingredients. PLP incurred a loss in 1999 of $23.7 million, or $0.23 per unit, including: (i) the special charges of $55.4 million, or $0.54 per unit, discussed above; (ii) a loss from discontinued operations of $27.4 million, or $0.27 per unit; and (iii) a $2.6 million charge, or $0.02 per unit, for the cumulative effect of a change in accounting principle. PLP generated earnings in 1998 of $32.3 million, or $0.31 per unit, including: (i) the special charges of $62.6 million, or $0.61 per unit, discussed above; and (ii) a loss from discontinued operations of $21.2 million, or $0.20 per unit. 1998 Compared to 1997 Net sales of $687.1 million decreased 18 percent from net sales of $842.5 million in 1997. Gross margins for 1998 of $179.8 million, excluding special charges of $8.0 million, increased from comparable 1997 margins of $177.0 million, excluding a special charge of $384.5 million. Earnings from continuing operations in 1998 were $116.1 million, or $1.12 per unit, excluding the special charges of $62.6 million, or $0.61 per unit, discussed above. Earnings from continuing operations in 1997 were $82.5 million, or $0.80 per unit, excluding special charges of $406.0 million, or $3.92 per unit, discussed above. The decrease in sales relative to 1997 was primarily driven by the absence of PLP's sulphur business and its 58.3 percent interest in Main Pass 299 oil & gas operations (Main Pass), both of which were transferred to Freeport Sulphur Co. (FSC) as a result of the FTX Merger in December 1997. The increase in earnings from continuing operations, excluding special charges, was primarily a result of the absence of certain general and administrative expenses as a result of the FTX Merger. PLP generated earnings in 1998 of $32.3 million, or $0.31 per unit, including: (i) the special charges of $62.6 million, or $0.61 per unit, discussed above; and (ii) a loss from discontinued operations of $21.2 million, or $0.20 per unit. PLP incurred a loss in 1997 of $355.1 million, or $3.43 per unit, including: (i) the special charges of $406.0 million, or $3.92 per unit, discussed above; (ii) losses from discontinued operations of $17.1 million, or $0.17 per unit; and (iii) an extraordinary charge of $14.5 million, or $0.14 per unit, related to the early extinguishment of high-cost debt. IMC-Agrico 1999 Compared to 1998 IMC-Agrico's net sales of $592.0 million in 1999 decreased 14 percent from $687.1 million in 1998. Lower average sales realizations of concentrated phosphates, particularly DAP, unfavorably impacted net sales by $51.9 million. DAP prices decreased throughout 1999 to a low, as of December 31, 1999, of approximately $130 per short ton as a result of the depressed agricultural economy. Decreased shipments of concentrated phosphates unfavorably impacted net sales by an additional $45.5 million. The majority of the volume decline resulted from decreased shipments of DAP and GTSP. The decrease in domestic DAP and GTSP volumes was a result of lower agricultural commodity prices and the depressed agricultural economy. Internationally, decreased DAP volumes primarily resulted from reduced demand from lower crop purchases as a result of low grain prices and higher customer inventories. Partially offsetting these declines were improved volumes of animal feed ingredients. Gross margins in 1999 of $110.3 million, excluding special charges of $4.7 million, fell 34 percent from $168.2 million in 1998, excluding special charges of $8.0 million. The decrease was primarily a result of the decreased prices and volumes discussed above, partially offset by favorable raw material costs and savings realized from Project Profit. 1998 Compared to 1997 IMC-Agrico's net sales of $687.1 million in 1998 remained virtually unchanged from $683.8 million in 1997. Increased shipments of concentrated phosphates contributed an additional $23.9 million to net sales. The majority of the volume growth came from increased domestic shipments of DAP and GMAP, partially offset by decreased GTSP volumes. The increase in DAP and GMAP was primarily a result of a strong spring season, an increase in the number of supply contracts and spot sales to certain larger co- ops. The volume decrease in GTSP was primarily a result of the availability in the marketplace of aggressively priced imports. International sales volumes rose slightly compared to 1997 as increased shipments of GMAP and merchant acid were partially offset by decreased shipments of DAP. In addition, average sales realizations of concentrated phosphates, particularly DAP, favorably impacted net sales by $8.5 million. Net sales were also favorably impacted by $2.7 million due to higher domestic phosphate rock sales volumes. Gross margins of $168.2 million in 1998, excluding special charges of $8.0 million, climbed 18 percent from $142.1 million in 1997, primarily as a result of the increased volumes and prices discussed above as well as favorable raw material costs. Sulphur There were no sulphur sales in 1999 or 1998 as a result of the contribution of PLP's sulphur businesses to FSC in conjunction with the FTX Merger. Sulphur sales in 1997 were $129.1 million with negative margins of $4.4 million, excluding special charges of $384.5 million. Selling, General and Administrative Expenses Selling, general and administrative expenses were $27.4 million, $26.5 million and $53.2 million in 1999, 1998 and 1997, respectively, excluding special charges of $22.6 million in 1997. The decrease in 1998 as compared to 1997 was primarily a result of the absence of the sulphur operations and allocated FTX general and administrative expenses which were eliminated as a result of the FTX Merger. See Note 2, "Mergers," in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Special Charges Restructuring Charges During the fourth quarter of 1999, PLP implemented the Rightsizing Program which was designed to simplify and focus PLP's core businesses. The key components of the Rightsizing Program are: (i) the shutdown and permanent closure of the Nichols and Payne Creek facilities at IMC-Agrico resulting from an optimization program that will reduce rock and concentrate production costs through higher utilization rates at the lowest-cost facilities; and (ii) headcount reductions. In conjunction with the Rightsizing Program, PLP recorded a special charge of $52.3 million, or $0.51 per unit, in the fourth quarter of 1999. For more detail related to the Rightsizing Program, see Note 4, "Restructuring and Other Charges," in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. During the fourth quarter of 1998, PLP developed and began execution of Project Profit. Project Profit was comprised of four major initiatives: (i) the combination of certain activities within IMC's potash and phosphates business units in an effort to realize certain operating and staff function synergies; (ii) restructuring of the phosphate rock mining and concentrated phosphate production/distribution operations and processes in an effort to reduce costs; (iii) simplification of current business activities by eliminating businesses not deemed part of PLP's core competencies; and (iv) reduction of operational and corporate headcount. In conjunction with Project Profit, PLP recorded a special charge of $61.8 million, or $0.60 per unit, in the fourth quarter of 1998. For more detail related to Project Profit, see Note 4, "Restructuring and Other Charges," in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Other Charges During the fourth quarter of 1999, and in connection with the Rightsizing Program, PLP undertook a detailed review of its accounting records and valuation of various assets and liabilities. As a result, PLP recorded a special charge of $3.1 million, or $0.03 per unit, related to asset write-offs. This entire charge was included in Cost of goods sold. As a result of a review of its sulphur assets at September 30, 1997, PLP concluded that the carrying value of its Main Pass sulphur mine assets exceeded the undiscounted estimated future net cash flows, such that an impairment write-down of $375.5 million, or $3.63 per unit, was required. A similar analysis of the Culberson, Texas sulphur mine assets, based on a reassessment of recoverable reserves utilizing recent production history, also indicated an impairment write-down of $9.0 million, or $0.08 per unit, was required. Also, in connection with the FTX Merger, PLP recorded special charges of $21.5 million, or $0.21 per unit. Interest Expense The increase in interest expense in 1998 as compared to 1997 was due to higher average borrowings for 1998 as compared to 1997. These funds were utilized to fund oil and gas expenditures primarily related to the Exploration Program. CAPITAL RESOURCES AND LIQUIDITY PLP generates cash through distributions from its joint venture investment in IMC-Agrico and has sufficient borrowing capacity to meet its operating and discretionary spending requirements. Net cash provided by operating activities remained virtually unchanged as 1999 totaled $81.3 million versus $79.5 million for 1998. Net cash provided by investing activities for 1999 of $9.2 million increased from net cash used in investing activities for 1998 by $90.1 million. Capital expenditures decreased $42.4 million from the prior year primarily due to the exiting of the Exploration Program during the year. The dispositions of both the Exploration Program and PLP's investment in MMR resulted in proceeds of $44.8 million. Net cash used in financing activities for 1999 was $60.1 million which increased $54.9 million as compared to 1998. This increase was primarily the result of a $21.8 million increase in distributions to unitholders and higher net debt payments of $33.1 million. Both of these were primarily due to decreased Exploration Program funding requirements and the receipt of proceeds from the dispositions of both the Exploration Program and PLP's investment in MMR. CONTINGENCIES Reference is made to Note 9, "Commitments and Contingencies," of Notes to Financial Statements in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. ENVIRONMENTAL Reference is made to "Other Matters - Environmental, Health and Safety Matters," in Part I, Item 1, of this Annual Report on Form 10-K. YEAR 2000 DISCLOSURE PLP completed its Year 2000 readiness initiatives and did not experience any significant problems. PLP does not anticipate any significant adverse business effects related to this issue. PLP's share of cumulative costs of projects dedicated solely to Year 2000 remediation was approximately $1.0 million. RECENTLY ISSUED ACCOUNTING GUIDANCE PLP does not believe that Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," which PLP is required to adopt on January 1, 2001, will have a material impact on PLP's financial statements. FORWARD-LOOKING STATEMENTS All statements, other than statements of historical fact contained within this Form 10-K constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements include, but are not limited to, the following: general business and economic conditions and governmental policies affecting the agricultural industry in localities where PLP or its customers operate; weather conditions; the impact of competitive products; pressure on prices realized by PLP for its products; constraints on supplies of raw materials used in manufacturing certain of PLP's products; capacity constraints limiting the production of certain products; difficulties or delays in the development, production, testing and marketing of products; difficulties or delays in receiving required governmental and regulatory approvals; market acceptance issues, including the failure of products to generate anticipated sales levels; difficulties in integrating acquired businesses and in realizing related cost savings and other benefits; the effects of and change in trade, monetary, environmental and fiscal policies, laws and regulations; foreign exchange rates and fluctuations in those rates; the costs and effects of legal proceedings, including environmental, and administrative proceedings involving PLP; and other risk factors reported from time to time in PLP's Securities and Exchange Commission (SEC) reports. Item 7a. Item 7a. Quantitative and Qualitative Disclosures about Market Risk. PLP is exposed to the impact of interest rate changes on borrowings and the impact of fluctuations in the purchase price of natural gas, ammonia and sulphur consumed in operations, as well as changes in the market value of its financial instruments. PLP periodically enters into natural gas forward purchase contracts with maturities of typically one year or less in order to reduce the effects of changing raw material prices, but not for trading purposes. Gains and losses on these contracts are deferred until settlement and recorded as a component of underlying inventory costs when settled. The notional value of PLP's natural gas forward purchase contracts was $4.3 million and $3.3 million as of December 31, 1999 and 1998, respectively. The market value of these contracts is estimated based on the amount that PLP would receive or pay to terminate the contracts, and was not significantly different from the notional value at December 31, 1999 and 1998. The impact of the settlement of these contracts was immaterial to PLP in 1999, 1998 and 1997. PLP conducted sensitivity analyses of its derivatives and other financial instruments assuming the following: (i) a one percentage point adverse change in interest rates; and (ii) a ten percent adverse change in the purchase price of natural gas, ammonia and sulphur all from their levels at December 31, 1999. Holding all other variables constant, the hypothetical adverse changes would not materially affect PLP's financial position. These analyses did not consider the effects of the reduced level of economic activity that could exist in such an environment and certain other factors. Further, in the event of a change of such magnitude, management would likely take actions to further mitigate its exposure to possible changes. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analyses assume no changes in PLP's financial structure. Item 8. Item 8. Financial Statements and Supplementary Data. Page Report of Independent Auditors 20 Statement of Operations 21 Balance Sheet 22 Statement of Cash Flows 23 Statement of Partners' Capital (Deficit) 24 Notes to Financial Statements 25 REPORT OF INDEPENDENT AUDITORS To the Partners of Phosphate Resource Partners Limited Partnership: We have audited the accompanying balance sheet of Phosphate Resource Partners Limited Partnership (Partnership), a Delaware Limited Partnership, as of December 31, 1999 and 1998 and the related statements of operations, cash flows and partners' capital for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the General Partner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Partnership as of December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the financial statements, the Partnership changed its method of accounting for start-up activities in 1999 to conform with SOP 98-5, "Reporting on the Costs of Start-Up Activities." Ernst & Young LLP Chicago, Illinois January 31, 2000 PHOSPHATE RESOURCE PARTNERS LIMITED PARTNERSHIP Notes to Financial Statements (Dollars in millions, except per unit amounts) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Ownership The financial statements of PLP, a Delaware limited partnership, include all majority-owned subsidiaries. The investment in IMC-Agrico is reflected using the proportionate consolidation method. The activities of IMC-Agrico, 41.5 percent owned by PLP, include: (i) the mining and sale of phosphate rock; and (ii) the production, distribution and sale of concentrated phosphates, animal feed ingredients, and related products. Prior to its disposition in the fourth quarter of 1999, PLP's interest in the Exploration Program was proportionately consolidated at a rate of 56.4 percent of the exploration costs and 47.0 percent of the profits derived from oil and gas producing properties. Certain prior year amounts have been reclassified to conform to the current year presentation. As discussed in more detail in Note 5, "Discontinued Operations," the oil and gas operations have been presented as discontinued operations. Use of Estimates Management is required to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Revenue Recognition Revenue is recognized by PLP upon the transfer of title to the customer, which is generally at the time product is shipped. For certain export shipments, transfer of title occurs outside of the United States. Cash and Cash Equivalents PLP considers all highly liquid investments with an original maturity of three months or less to be cash equivalents which are reflected at their approximate fair value. IMC-Agrico's cash and cash equivalents are not available to PLP until a distribution is paid by IMC-Agrico. Concentration of Credit Risk Domestically, IMC-Agrico sells its products to manufacturers, distributors and retailers primarily in the midwestern and southeastern United States. Internationally, IMC-Agrico's products are sold primarily through a United States export association. No single customer or group of affiliated customers accounted for more than ten percent of PLP's net sales. Inventories Inventories are valued at the lower-of-cost-or-market (net realizable value). Cost for substantially all inventories is calculated on a cumulative annual-average basis. Property, Plant and Equipment Property (including mineral deposits), plant and equipment are carried at cost. Cost of significant assets includes capitalized interest incurred during the construction and development period. Expenditures for replacements and improvements are capitalized; maintenance and repair expenditures, except for repair and maintenance overhauls (Turnarounds), are charged to operations when incurred. Expenditures for Turnarounds are deferred when incurred and amortized into cost of goods sold on a straight-line basis, generally over an 18-month period. Turnarounds are large-scale maintenance projects that are performed regularly, usually every 18 to 24 months. Turnarounds are necessary to maintain the operating capacity and efficiency rates of the production plants. The deferred portion of Turnaround expenditures is classified in Other assets. Depreciation and depletion expenses for mining operations, including mineral deposits, are determined using the units-of-production method based on estimates of recoverable reserves. Other asset classes or groups are depreciated or amortized on a straight-line basis over their estimated useful lives as follows: buildings, 17 to 32 years; machinery and equipment, five to 32 years; and leasehold improvements, over the lesser of the remaining useful life of the asset or the remaining term of the lease. Using the methodology prescribed in SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," PLP reviews long-lived assets and any related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amounts of such assets may not be recoverable. Once an indication of a potential impairment exists, recoverability of the respective assets is determined by comparing the forecasted undiscounted net cash flows of the operation to which the assets relate, to the carrying amount, including associated intangible assets, of such operation. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Accrued Environmental Costs Through IMC-Agrico PLP produces and distributes crop and animal nutrients. These activities subject IMC-Agrico to an ever-evolving myriad of international, federal, state, provincial and local EHS laws, which regulate, or propose to regulate: (i) product content; (ii) use of products by both PLP and its customers; (iii) conduct of mining and production operations, including safety procedures used by employees; (iv) management and handling of raw materials; (v) air and water quality impacts by PLP's facilities; (vi) disposal of hazardous and solid wastes; and (vii) post-mining land reclamation. Compliance with these laws often requires PLP to incur costs. PLP has contingent environmental liabilities arising from three sources: facilities currently or formerly owned by PLP or its predecessors; facilities adjacent to currently or formerly owned facilities; and third-party Superfund sites. At facilities currently or formerly owned by PLP or its corporate predecessors, the historical use and handling of regulated chemical substances, crop and animal nutrients and additives have resulted in soil and groundwater contamination, sometimes requiring PLP to undertake or fund cleanup efforts. Of the environmental costs discussed above, the following environmental costs are charged to operating expense: fines, penalties and certain remedial actions to address violations of the law; remediation of properties that are currently or were formerly owned or operated by PLP, or its predecessors, when those properties do not contribute to current or future revenue generation; and liability for remediation of facilities adjacent to currently or formerly owned facilities or for third-party Superfund sites. Contingent environmental liabilities are recorded for environmental investigatory and non-capital remediation costs at identified sites when litigation has commenced or a claim or assessment has been asserted or is imminent and the likelihood of an unfavorable outcome is probable. PLP cannot determine the cost of any remedial action that ultimately may be required at unknown sites, sites currently under investigation, sites for which investigations have not been performed, or sites at which unanticipated conditions are discovered. Income Taxes PLP is not a taxable entity; therefore, no income taxes are reported in its financial statements. Derivatives PLP is exposed to the impact of interest rate changes on borrowings and the impact of fluctuations in the purchase price of natural gas, ammonia and sulphur consumed in operations, as well as changes in the market value of its financial instruments. PLP periodically enters into natural gas forward purchase contracts with maturities of typically one year or less in order to reduce the effects of changing raw materials prices, but not for trading purposes. Gains and losses on these contracts are deferred until settlement and recorded as a component of underlying inventory costs when settled. The notional value of PLP's natural gas forward purchase contracts was $4.3 million and $3.3 million as of December 31, 1999 and 1998, respectively. The market value of these contracts is estimated based on the amount that PLP would receive or pay to terminate the contracts, and was not significatly different from the notional amount as of December 31, 1999 and 1998, respectively. The impact of the settlement of these contracts was immaterial to PLP in 1999, 1998 and 1997. Adoption of SOP 98-5 In April 1998, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 98-5, "Reporting on the Costs of Start-Up Activities," which mandated that costs related to start-up activities be expensed as incurred, effective January 1, 1999. Prior to the adoption of SOP 98-5, PLP capitalized its start-up costs (i.e., pre-operating costs). PLP adopted the provisions of SOP 98-5 in its financial statements beginning January 1, 1999 and, accordingly, recorded a charge for the cumulative effect of an accounting change of $2.6 million, or $0.02 per unit, in order to expense start-up costs that had been previously capitalized. The future impact of SOP 98-5 is not expected to be material to PLP's operating results. Recently issued Accounting Standards PLP does not believe that SFAS No. 133, which PLP is required to adopt effective January 1, 2001, will have a material impact on PLP's financial statements. 2. MERGERS FTX In December 1997, FTX, the General Partner and owner of a 51.6 percent interest in PLP, merged into IMC, PLP's joint venture partner in IMC- Agrico. The FTX Merger resulted in the dissolution of FTX with IMC becoming the General Partner of PLP. In connection with the FTX Merger, PLP's sulphur business and certain oil and gas operations, including its 58.3 percent interest in Main Pass, together with IMC's 25.0 percent interest in Main Pass, were transferred to FSC, a newly formed public entity whose common stock was distributed pro rata to PLP's unitholders, including FTX. MMR In November 1998, McMoRan Oil & Gas Co. (MOXY) and FSC merged and became wholly-owned subsidiaries of a newly formed holding company, MMR (MMR Merger). MOXY stockholders received 0.2 MMR shares for each common share of MOXY held at the time of the MMR Merger which resulted in PLP owning 0.8 million shares, or approximately six percent, of outstanding MMR common stock. Subsequently, in the second quarter of 1999, PLP sold its entire investment in MMR stock. In connection with the sale, PLP received proceeds of $12.8 million and recorded a loss of $0.7 million. 3. DISTRIBUTIONS IMC-Agrico makes cash distributions to each partner based on formulas and sharing ratios as defined in the Partnership Agreement. For the year ended December 31, 1999, the total amount of cash generated for distribution by IMC-Agrico was $171.2 million, of which $56.8 million was distributed to PLP during the year and $14.0 million will be distributed to PLP in 2000. PLP's distributable cash is shared ratably by PLP's public unitholders and IMC, except that IMC will be entitled to receive unpaid cash distributions from previous quarters ($431.3 million unpaid as of December 31, 1999) from one-half of the quarterly distributable cash after the payment of $0.60 cents per unit to all PLP unitholders. 4. RESTRUCTURING AND OTHER CHARGES 1999 Restructuring Plan During the fourth quarter of 1999, PLP announced and began implementing the Rightsizing Program which was designed to simplify and focus PLP's core businesses. The key components of the Rightsizing Program are: (i) the shutdown and permanent closure of the Nichols and Payne Creek facilities of IMC-Agrico resulting from an optimization program that will reduce rock and concentrate production costs through higher utilization rates at the lowest-cost facilities; and (ii) headcount reductions. In conjunction with the Rightsizing Program, PLP recorded a special charge of $52.3 million, or $0.51 per unit, in the fourth quarter of 1999. The Rightsizing Program (shown below in tabular format) primarily related to the following: Asset Impairments The Rightsizing Program included the disposal of property, plant and equipment, as well as the write-down to fair value of assets as a result of the decision to close certain facilities. In order to determine the write-down of assets affected by the Rightsizing Program, and in accordance with SFAS No. 121, PLP performed an assessment of future cash flows and, accordingly, adjusted the assets to their appropriate fair values. The majority of the impairment occurred at PLP's Florida production facilities where property, plant and equipment was written down by approximately $16.1 million to reflect fair value. The phosphate mine and plant closures resulted from a facilities optimization program that will reduce rock and concentrate production costs through higher utilization rates at the lowest-cost facilities. The write-down of impaired assets primarily consisted of certain facilities and associated production equipment. Non-Employee Exit Costs As a result of the decision to permanently close certain PLP facilities described above, PLP recorded a charge of $18.7 million for closure costs. The closure costs included approximately $16.8 million for incremental environmental land reclamation of the surrounding mined-out areas with the remainder for demolition costs. PLP expects the demolition and closure activities to be essentially completed by the end of 2005. Other various non-employee exit costs totaled $0.5 million. Employee Headcount Reductions As part of the Rightsizing Program, headcount reductions were implemented throughout IMC-Agrico. The majority of these reductions were a result of the closing and/or exiting of production operations, as discussed above. Certain involuntary eliminations of positions, which were communicated prior to December 31, 1999, were necessary in order to achieve desired staffing levels. A total of 533 employees were terminated and had left IMC-Agrico by the end of December 31, 1999. PLP recorded a charge of $6.4 million for severance benefits related to these employee headcount reductions. Virtually all severance payments will be disbursed subsequent to December 31, 1999. As a result of the employee terminations necessitated by the Rightsizing Program, settlement, curtailment and special termination charges of $3.9 million were recorded in accordance with SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." The related liabilities have been classified in Other noncurrent liabilities. See Note 8, "Pensions and Other Postretirement Benefits." Inventories and Spare Parts of Exited Facilities The Rightsizing Program included a major reduction in production assets. This reduction was accomplished through the permanent shutdown of two phosphate facilities. Given the reduction in facilities and the resulting decrease in production, historical levels of spare parts inventory that had been maintained at these facilities were no longer necessary or warranted. Therefore, PLP recorded a charge of $5.1 million for the write-down of excess spare parts inventory which will be disposed. PLP recorded charges of approximately $1.6 million to reduce the carrying value of finished goods inventories on-hand to net realizable value at December 31, 1999, as a result of the facilities closures discussed above. Details of the restructuring charges were as follows: All restructuring charges have been recorded as a separate line item on the Statement of Operations, except for the finished goods inventory write-down of $1.6 million which was recorded in Cost of goods sold. 1998 Restructuring Charge During the fourth quarter of 1998, PLP developed and began execution of Project Profit. Project Profit was comprised of four major initiatives: (i) the combination of certain activities within IMC's potash and phosphate business units in an effort to realize certain operating and staff function synergies; (ii) restructuring of the phosphate rock mining and concentrated phosphate production/distribution operations and processes in an effort to reduce costs; (iii) simplification of the current business activities by eliminating businesses not deemed part of PLP's core competencies; and (iv) reduction of operational and administrative headcount. In conjunction with Project Profit, PLP recorded a special charge of $61.8 million, or $0.60 per unit, in the fourth quarter of 1998. Project Profit (shown below in tabular format) primarily related to the following: Asset impairments Project Profit included the removal of property, plant and equipment, as well as the write-down to fair value of those assets rendered unusable due to the decision to close certain facilities and forgo or abandon certain mineral properties. In order to determine the write- down of assets affected by Project Profit, and in accordance with SFAS No. 121, PLP performed an assessment of future cash flows and, accordingly, adjusted the assets to their appropriate fair values. The majority of the impairment occurred at PLP's Florida production facilities where property, plant and equipment was written down by approximately $20.3 million to fair value. PLP developed a new strategic mine plan (Mine Plan) which identified asset reductions, lower operating costs and optimal phosphate rock management as key drivers in the restructuring of operations. The write-down of impaired assets in connection with the Mine Plan primarily consisted of facilities, production equipment, operating supplies, land and mineral reserves. The $20.3 million in asset impairment charges included $5.5 million pertaining to assets which were utilized until their respective disposal dates, primarily within the first nine months of 1999. The estimated fair value of these assets, which was depreciated over their respective remaining periods of service, reflected estimated operating net cash flows until disposition. As of December 31, 1999, all of these assets have been sold or abandoned. Non-employee exit costs In accordance with the objective of the Mine Plan, to optimize phosphate rock management, PLP decided to permanently close a high-cost phosphate rock mine. As a result of this decision, PLP recorded a charge of $7.6 million for the demolition and other incremental costs of closure of the mine. The closure costs included approximately $6.4 million for incremental environmental land reclamation of the surrounding mined-out areas. The demolition and closure activities were still in process at the end of 1999 with an estimate of completion during 2001. PLP also decided to close certain production operations in connection with Project Profit, principally the uranium and urea operations of PLP. This decision was based on an analysis of the future outlook for these products, taking into consideration whether the operations were part of PLP's core businesses. These operations were determined to be non-core businesses and PLP recorded charges of approximately $5.3 million for demolition and/or closure, including environmental costs, of the uranium and urea production facilities. PLP expects the demolition and closure activities to be completed by the end of 2000. In connection with Project Profit, PLP decided to discontinue its transportation of ammonia from Louisiana to its phosphate operations in Florida. This decision was based on current market conditions which secured the availability of ammonia to PLP and which made the high-cost transportation of ammonia from Louisiana to Florida unnecessary. As a result, PLP recorded a charge of $5.5 million for the net present value of costs associated with permanently idling leased equipment used in the transportation of ammonia from Louisiana. Other various exit costs totaled $2.7 million. Employee headcount reductions As part of Project Profit, IMC-Agrico implemented headcount reductions. Certain of these reductions were a result of the closing and/or exiting of production operations, as discussed above. To facilitate headcount reductions, IMC-Agrico offered a voluntary retirement program for eligible employees. In addition, certain involuntary eliminations of positions, which were communicated prior to December 31, 1998, were necessary in order to achieve desired staffing levels. A total of 168 employees accepted the voluntary retirement plan by December 31, 1998, with 106 of those employees having left as of that date. At December 31, 1999, no voluntarily severed employees were remaining. Additionally, a total of 396 employees were involuntarily terminated and left PLP by the end of February 1999. PLP recorded a charge of $6.0 million for severance benefits related to these headcount reductions. Virtually all severance payments were disbursed prior to December 31, 1999 with the remaining payments to be disbursed during the first quarter of 2000. As a result of the employee terminations necessitated by Project Profit, settlement, curtailment and special termination charges of $3.6 million were recorded in accordance with SFAS No. 88. The related liabilities were classified in Other noncurrent liabilities. See Note 8, "Pensions and Other Postretirement Benefits." Inventories and spare parts of exited businesses PLP recorded charges of approximately $7.2 million to reduce the carrying value of finished goods inventories on-hand to net realizable value at December 31, 1998, as a result of the decision to exit certain businesses. Project Profit included a major reduction in production assets. The reduction was accomplished through the permanent shut-down of select mining facilities as well as a cut-back in concentrate facilities. Given the reduction in facilities and the resulting decrease in production, historical levels of spare parts inventory that had been maintained by PLP were no longer necessary or warranted. Therefore, PLP recorded a charge of $3.6 million for the write-off of spare parts inventory. Activity related to accruals for Project Profit in 1999 was as follows: All restructuring charges were recorded as a separate line item on the 1998 Statement of Operations, except for the finished goods inventory write-down of $7.2 million which was recorded in Cost of goods sold. Other Charges During the fourth quarter of 1999, and in connection with the Rightsizing Program, PLP undertook a detailed review of its accounting records and valuation of various assets and liabilities. As a result, PLP recorded a special charge of $3.1 million, or $0.03 per unit, related to asset write-offs. The entire charge was included in Cost of goods sold. 1997 Sulphur Assets Write-Down As a result of a review of its sulphur assets at September 30, 1997, PLP concluded that the carrying value of its Main Pass sulphur mine assets exceeded the undiscounted estimated future net cash flows, such that an impairment write-down of $375.5 million was required. A similar analysis of the Culberson, Texas sulphur mine assets, based on a reassessment of recoverable reserves utilizing recent production history, also indicated an impairment write-down of $9.0 million was required. 5. DISCONTINUED OPERATIONS In the fourth quarter of 1999, PLP decided to discontinue its oil and gas business which primarily consisted of its interests in the Exploration Program. PLP sold its interest in the Exploration Program for proceeds of $32.0 million. A loss on disposal of $22.4 million was recorded in the fourth quarter of 1999. The Statement of Operations has been restated to report the operating results of the oil and gas business as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations." For 1999 and 1998, the revenues from oil and gas operations were $7.0 million and $1.3 million, respectively. The exploration and development costs were accounted for using the successful efforts method of accounting. 6. DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS 7.FINANCING ARRANGEMENTS Long-term debt as of December 31 consisted of the following: In connection with the FTX Merger, PLP entered into two separate agreements with IMC (IMC Agreements). One agreement is a variable rate, based on LIBOR, 6.125% as of December 31, 1999, plus one percent, demand note for up to $200.0 million, while the other agreement is an 8.75 percent demand note for up to $150.0 million. Interest under the IMC Agreements is payable quarterly. IMC has no present intention of demanding payment on the IMC Agreements, therefore these notes have been classified as long-term. In June and August 1998, PLP, through its interest in IMC-Agrico, entered into two promissory notes payable to IMC for borrowings up to $27.0 million (Note Payable) and $21.7 million (Promissory Note), respectively. The Note Payable bears interest primarily based on the LIBOR rate. The Promissory Note bears a fixed rate of 6.75 percent with quarterly principal payments through December 2003. On December 31, 1999, the estimated fair value of long-term debt described above was approximately $15.0 million less than the carrying amount of such debt. The fair value was calculated in accordance with the requirements of SFAS No. 107, "Disclosures About the Fair Value of Financial Instruments," and was estimated by discounting the future cash flows using rates currently available to PLP for debt instruments with similar terms and remaining maturities. Scheduled maturities, excluding the IMC Agreements, are as follows: 2000 $ 4.3 2001 $ 4.4 2002 $ 4.2 2003 $ 3.9 2004 $ 5.7 Thereafter $ 224.1 8. PENSIONS AND OTHER POSTRETIREMENT BENEFITS Substantially all individuals who perform services for IMC-Agrico are employed by MP Co. This includes former employees of PLP and IMC who were transferred to MP Co. when IMC-Agrico was formed. As a result, on July 1, 1993, MP Co. established non-contributory pension plans (Plans) that cover substantially all of its employees who perform services for IMC-Agrico. Benefits are based on a combination of years of service and compensation levels, depending on the plan. Generally, contributions to the Plans are made to meet minimum funding requirements of the Employee Retirement Income Security Act of 1974. The expense related to such Plans is charged by MP Co. to IMC-Agrico. Certain employees whose pension benefits exceeded Internal Revenue Code limitations are covered by supplementary non-qualified, unfunded pension plans. The Plans' assets consist mainly of managed equity and fixed income security accounts. During 1997, MP Co. employees and certain IMC employees who provide services to IMC-Agrico and PLP, were given the option to remain in the current pension plan or transfer to a newly created defined contribution plan, effective January 1, 1998. As a result, under the provisions of SFAS No. 88, PLP recognized a $4.4 million curtailment loss for the year ended December 31, 1997. PLP provides certain health care benefit plans for certain retired employees. Prior to the FTX Merger, FTX and FM Services Company provided these benefits for retired employees. MP Co. also provides certain health care benefit plans for retired employees. Certain plans are contributory whereas certain other plans are non-contributory and contain certain other cost sharing features such as deductibles and coinsurance. The plans are unfunded. Employees are not vested and such benefits are subject to change. For those employees who provide services to IMC-Agrico but were included in health care benefit plans of IMC, the cost of providing such benefits is charged by IMC to MP Co., and in turn, to IMC-Agrico. Certain IMC employees also provide services to IMC-Agrico and PLP. Until January 1, 1999, such employees were covered by pension and postretirement health care benefit plans sponsored by IMC. The cost of providing such services, as well as the related pension expense, was charged to MP Co. and, in turn, to IMC-Agrico. Effective January 1, 1999, these employees are covered by pension and postretirement health care benefit plans sponsored by MP Co. PLP's share of pension expense for such employees totaled $2.3 million for 1999 of which $0.7 million represents curtailment and settlement loss; $2.3 million for 1998 of which $0.7 million represents curtailment and settlement loss; and $4.3 million for 1997 of which $2.3 million represents a curtailment loss. The following table sets forth pension and postretirement obligations for defined benefit plans, plan assets and benefit cost as of and for the years ended December 31 based on a September 30 measurement date: For measurement purposes, a 6.8 percent annual rate of increase in the per capita cost of covered pre-65 health care benefits was assumed for 1999 decreasing gradually to 4.7 percent in 2004 and thereafter; and a 7.1 percent annual rate of increase in the per capita cost of covered post-65 health care benefits was assumed for 1999 decreasing gradually to 5.0 percent in 2004 and thereafter. Amounts applicable to the pension plans with accumulated benefit obligations in excess of plan assets are as follows: The components of net pension and other benefits expense were: The assumed health care cost trend rate has a significant effect on the amounts reported. A one-percentage-point change in the assumed health care cost trend rate would have the following effects: MP Co. has defined contribution and pre-tax savings plans (MP Plans) for certain of its employees. The expense related to such MP Plans is charged by MP Co. to IMC-Agrico. PLP's expense for such MP Plans totaled $2.5 million, $2.9 million and $1.6 million for the years ended December 31, 1999, 1998 and 1997. In addition, MP Co. provides benefits such as workers' compensation and disability to certain former or inactive employees after employment but before retirement. The plans are unfunded. Employees are not vested and the plan benefits are subject to change. 9. COMMITMENTS AND CONTINGENCIES PLP purchases natural gas and ammonia from third parties under contracts extending in some cases, for multiple years. Purchases under these contracts are generally based on prevailing market prices. These contracts generally range from one to three years. PLP has entered into a third-party sulphur purchase commitment, the term of which is indefinite. Therefore, the dollar value of the sulphur commitments has been excluded from the schedule below after the year 2004. PLP leases various types of properties, including buildings and structures, railcars and various types of equipment through operating leases. Lease terms generally range from three to five years, although some have longer terms. Summarized below is a schedule of PLP's future minimum long-term purchase commitments and lease payments under non-cancelable operating leases as of December 31, 1999: PLP's rental expense for 1999, 1998 and 1997 was $9.2 million, $11.3 million and $9.5 million, respectively. PLP also sells phosphate rock and concentrated phosphates to customers and IMC under contracts extending in some cases for multiple years. Sales under these contracts, except for certain phosphate rock sales which are at prices based on PLP's cost of production, are generally at prevailing market prices. In November 1998, Phosphate Chemicals Export Association, Inc. (PhosChem), of which IMC-Agrico is a member, reached a two-year agreement through the year 2000 to supply DAP to the China National Chemicals Import and Export Corporation (Sinochem). This agreement provides Sinochem with an option to extend the agreement to December 31, 2002. Sinochem is a state company with government authority for the import of fertilizers into China. Under the contract's terms, Sinochem will receive monthly shipments at prices reflecting the market at the time of shipment. In November 1999, IMC-Agrico amended its phosphate rock sales agreement with U.S. Agri-Chemicals Corp., a wholly owned subsidiary of Sinochem. The new agreement provides for the sale of phosphate rock until 2024. FTX Merger Litigation In August 1997, five identical class action lawsuits were filed in Court by unitholders of PLP. Each case named the same defendants and broadly alleged that FTX and FMRP had breached fiduciary duties owed to the public unitholders of PLP. IMC was alleged to have aided and abetted these breaches of fiduciary duty. In November 1997, an amended class action complaint was filed with respect to all cases. The amended complaint named the same defendants and raised the same broad allegations. The defendants moved the Court to dismiss the amended complaint in November 1998, and the cases were dismissed in May 1999. In May 1998, the Plaintiffs filed the IMC Action in Court against the Director Defendants, and MMR, a former affiliate of FTX. The Plaintiffs alleged that the Director Defendants, as the directors of PLP's former General Partner FTX, owed duties of loyalty to PLP and its limited partnership unitholders. The Plaintiffs further alleged that the Director Defendants breached their duties by causing PLP to enter into a series of interrelated non-arm's-length transactions with MMR. The Plaintiffs also alleged that MMR knowingly aided and abetted and conspired with the Director Defendants to breach their fiduciary duties. On behalf of the PLP public unitholders, the Plaintiffs sought to reform or rescind the contracts that PLP entered into with MMR and to recoup the monies expended as a result of PLP's participation in those agreements. On November 10, 1999, the Plaintiffs and MMR announced a settlement of the IMC Action pursuant to which MMR agreed to purchase PLP's 47.0 percent interest in the Exploration Program, which includes three producing oil and gas fields plus an inventory of exploration prospects and leases, for a total of $32.0 million. In May 1998, Jacob Gottlieb filed the Gottlieb Action on behalf of himself and all other PLP unitholders against the Director Defendants, MMR and IMC asserting the same claims that IMC asserted in the IMC Action. Because IMC and PLP had already asserted these claims, in July 1998 IMC filed a motion to dismiss the Gottlieb Action. The Court has not set a briefing schedule for IMC's motion to dismiss, and the plaintiff has made no substantial activity in this case within the past year. IMC and PLP have recently been advised that the plaintiff intends to withdraw the complaint without prejudice. Pine Level Property Reserves In October 1996, PLP signed an agreement with Consolidated Minerals, Inc. (CMI) for the purchase of real property, Pine Level, containing approximately 100.0 million tons of phosphate rock reserves. In connection with the purchase, PLP has agreed to obtain all environmental, regulatory and related permits necessary to commence mining on the property. Within five years from the date of this agreement, PLP is required to provide notice to CMI regarding one of the following: (i) whether it has obtained the permits necessary to commence mining any part of the property; (ii) whether it wishes to extend the permitting period for an additional three years (Extension Option); or (iii) whether it wishes to decline to extend the permitting period. When the permits necessary to commence mining the property have been obtained, PLP is obligated to pay CMI its share of an initial royalty payment (Initial Royalty) of $28.9 million. In addition to the Initial Royalty, PLP is required to pay CMI a mining royalty on phosphate rock mined from the property to the extent the permits are obtained. PLP anticipates submitting permit applications by mid-2001. In the event that the permits are not obtained by October 2001, PLP presently intends to exercise the Extension Option, at a cost to PLP of $3.0 million (Extension Fee). This Extension Fee would be applied toward the Initial Royalty. Environmental Matters PLP's contingent environmental liability arises from three sources: facilities currently or formerly owned by PLP or its corporate predecessors; facilities adjacent to currently or formerly owned facilities; and third-party Superfund sites. At facilities currently or formerly owned by PLP or its corporate predecessors, the historical use and handling of regulated chemical substances, crop and animal nutrients and additives, or process tailings, have resulted in soil and groundwater contamination. Spills or other unintended releases of regulated substances have occurred previously at these facilities, and potentially could occur in the future, possibly requiring PLP to undertake or fund cleanup efforts. At some locations, PLP has agreed, pursuant to consent orders with the appropriate governmental agencies, to undertake certain investigations, which currently are in progress, to determine whether remedial action may be required to address contamination. At other locations, PLP has entered into consent orders with appropriate governmental agencies to perform required remedial activities that will address identified site conditions. In a limited number of cases, PLP's current or former operations also allegedly resulted in soil or groundwater contamination to neighboring off-site areas or third-party facilities. In some instances, PLP has agreed, pursuant to consent orders with appropriate governmental agencies, to undertake investigations, which currently are in progress, to determine whether remedial action may be required to address contamination. Four plaintiffs filed a class action lawsuit, Moore et al. vs. Agrico Chemical Company et al., which names Agrico Chemical Company, FTX, PLP and a number of unrelated defendants. The suit seeks unspecified compensation for alleged property damage, medical monitoring, remediation of an alleged public health hazard and other appropriate damages purportedly arising from operation of the neighboring fertilizer and crop protection chemical facilities in Lakeland, Florida. Agrico Chemical Company owned the Landia portion of these facilities for approximately 18 months during the mid-1970s. Because the litigation is in its early stages, management cannot determine the magnitude of any exposure to Agrico Chemical Company or PLP; however, Agrico Chemical Company and PLP intend to vigorously contest this action and to seek any indemnification to which it may be entitled. Concurrent with this litigation, the EPA has undertaken on-site and off-site investigations of these facilities to determine whether any remediation of existing contamination may be necessary. Pursuant to an indemnification agreement with Agrico Chemical Company and PLP, The Williams Companies have assumed responsibility for any costs that Agrico Chemical Company might incur for remediation as a result of the EPA's actions. Superfund, and equivalent state statutes, impose liability without regard to fault or to the legality of a party's conduct, on certain categories of persons that are considered to have contributed to the release of "hazardous substances" into the environment. Currently, PLP is involved or concluding involvement at less than ten Superfund or equivalent state sites. PLP believes that, pursuant to several indemnification agreements, it is entitled to at least partial, and in many instances complete, indemnification for the costs that may be expended by PLP to remedy environmental issues at certain facilities. These agreements address issues that resulted from activities occurring prior to PLP's acquisition of facilities or businesses from parties including: ARCO; Conoco; The Williams Companies; Kerr-McGee Inc.; and certain other private parties. PLP has already received and anticipates receiving amounts pursuant to the indemnification agreements for certain of its expenses incurred to date as well as any future anticipated expenses. Other Most of PLP's export sales of phosphate crop nutrients are marketed through a North American export association, PhosChem. As a member, PLP is, subject to certain conditions, contractually obligated to reimburse the export association for its pro rata share of any losses or other liabilities incurred. There were no such operating losses or other liabilities in 1999, 1998 and 1997. PLP also has certain other contingent liabilities with respect to litigation, claims and guarantees of debt obligations to third parties arising in the ordinary course of business. PLP does not believe that any of these contingent liabilities will have a material adverse impact on PLP's financial position, results of operations or liquidity. 10.OPERATING SEGMENTS PLP has one reportable segment, IMC-Agrico. In 1997, PLP had a second reportable segment, Sulphur, but this segment was spun off as a result of the FTX Merger. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. PLP evaluates performance based on operating earnings of the respective segments. The Notes to Financial Statements include detail related to discontinued operations and special charges and should be referred to when viewing the segment information herein. Segment information for the years 1999, 1998 and 1997 was as followsa: Financial information relating to PLP's operations by geographic area was as follows: Item 9. Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III. Item 10. Item 10.Directors and Executive Officers of the Registrant. As a limited partnership, PLP has no directors. IMC, the General Partner of PLP, performs comparable functions for PLP. PLP does not employ any executive officers; however, certain management functions are provided to PLP by executive officers and other employees of IMC. Section 16(a) Beneficial Ownership Reporting Compliance Because IMC is the General Partner of PLP, the directors of IMC and certain officers of IMC who perform policy-making functions for PLP are subject to the reporting requirements of Section 16 of the Exchange Act of 1934, as amended. Based solely upon a review of reports filed by such persons with the SEC pursuant to Section 16(a) and furnished to PLP, PLP believes that all such persons filed all reports required pursuant to Section 16(a) on a timely basis during 1999. Item 11. Item 11.Executive Compensation. PLP does not employ any executive officers and no compensation was provided by PLP to any executive officer for services rendered in any capacity in 1999. Prior to the FTX Merger, the services of executive officers of PLP were provided to PLP by FTX as provided in the PLP Agreement, for which PLP reimbursed FTX at its cost, including allocated overhead. Subsequent to the FTX Merger, IMC provides services to PLP as provided in the PLP Agreement, for which PLP reimburses IMC at its cost, including allocated overhead. Certain services provided by the General Partner are provided by executive officers and other employees of IMC. In accordance with the PLP Agreement, IMC is reimbursed on a monthly basis for expenses incurred on behalf of PLP. Reference is made to the information set forth in Part I, Item 1, "Business - Other Matters - Relationship between PLP and IMC," of this Annual Report on Form 10-K. Item 12. Item 12.Security Ownership of Certain Beneficial Owners and Management The following table contains certain information concerning the beneficial ownership of PLP units as of December 31, 1999 by each person known by PLP to be the beneficial owner of more than five percent of any class of PLP equity security, determined in accordance with Rule 13d-3 of the SEC and based on information furnished to PLP by each such person. Unless otherwise indicated, the securities shown are held with sole voting and investment power. Item 13. Item 13.Certain Relationships and Related Transactions. Reference is made to the information set forth in Part I, Item 1, "Business - Other Matters - Relationship between PLP and IMC" and Item 11, "Executive Compensation," of this Annual Report on Form 10- K. PART IV. Item 14. Item 14.Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)(1) Financial Statements. Reference is made to the Index to Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. (2) Financial Statement Schedules. Reference is made to the Index to Financial Statements Schedules appearing on page hereof. (3) Exhibits. Reference is made to the Exhibit Index beginning on page E-1 hereof. (b) Reports on Form 8-K. PLP filed a Current Report on Form 8-K for December 7, 1999, to report, under "Item 5, Other Events," the issuance of a press release on December 7, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PHOSPHATE RESOURCE PARTNERS LIMITED PARTNERSHIP By: IMC GLOBAL INC. Its Administrative Managing General Partner By: /s/ Douglas A. Pertz ----------------------------- Douglas A. Pertz Chief Executive Officer and President of IMC Global Inc. Date: March 30, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Title Date * Chairman and Director of IMC Global March 30, 2000 - --------------------- Inc. Joseph P. Sullivan /s/ Douglas A. Pertz Chief Executive Officer (principal March 30, 2000 - --------------------- executive officer), President Douglas A. Pertz (principal operating officer) and Director of IMC Global Inc. /s/ J.Bradford James Executive Vice President and Chief March 30, 2000 - --------------------- Financial Officer of IMC Global Inc. J.Bradford James (principal financial officer) /s/ Anne M. Scavone Vice President and Controller of IMC March 30, 2000 - --------------------- Global Inc. (principal accounting Anne M. Scavone officer) * Director of IMC Global Inc. March 30, 2000 - --------------------- Raymond F. Bentele * Director of IMC Global Inc. March 30, 2000 - --------------------- Rod F. Dammeyer * Director of IMC Global Inc. March 30, 2000 - --------------------- James M. Davidson * Director of IMC Global Inc. March 30, 2000 - --------------------- Harold H. MacKay * Director of IMC Global Inc. March 30, 2000 - --------------------- David B. Mathis * Director of IMC Global Inc. March 30, 2000 - --------------------- Donald F. Mazankowski * Director of IMC Global Inc. March 30, 2000 - --------------------- Richard L. Thomas * Director of IMC Global Inc. March 30, 2000 - --------------------- Pamela B. Strobel *By: /s/ Rose Marie Williams --------------------------- Rose Marie Williams Attorney-in-fact PHOSPHATE RESOURCE PARTNERS LIMITED PARTNERSHIP Exhibit Index Filed Incorporated with Herein by Electronic Exhibit No. Description Reference to Submission - ------------------------------------------------------------------------------- 3.i.(a) Amended and Restated Agreement of Exhibit B to the Limited Partnership of PLP dated as Prospectus dated of May 29, 1987 (PLP Partnership May 29, 1987 Agreement) among FTX, Freeport included in Phosphate Rock Company and Geysers Registration Geothermal Company, as general Statement No. 33- partners, and Freeport Minerals 13513, as amended Company (FMC), as general partner and attorney-in-fact for the limited partners, of PLP 3.i.(b) Amendment to the PLP Partnership Exhibit 3.2 to Agreement dated as of December 16, the Annual Report 1988 effected by FMC, as on Form 10-K for Administrative Managing General the Year Ended Partner, and FTX, as General Partner December 31, 1994* of PLP 3.i.(c) Amendment to the PLP Partnership Exhibit 19.2 to Agreement dated as of March 29, 1990 the Quarterly effected by FMC, as Administrative Report on Form Managing General Partner, and FTX, as 10-Q for the Managing General Partner, and FTX, as Quarterly Period Managing General Partner, of PLP Ended March 31, 1990* 3.i.(d) Amendment to the PLP Partnership Exhibit 19.3 to Agreement dated as of April 6, 1990 the Quarterly effected by FTX, as Administrative Report on Form 10- Managing General Partner of PLP Q for the Quarterly Period Ended March 31, 1990* 3.i.(e) Amendment to the PLP Partnership Exhibit 3.3 to Agreement dated as of January 27, the Annual Report 1992 between FTX, as Administrative on Form 10-K for Managing General Partner, and FMRP, the Year Ended as Managing General Partner, of PLP December 31, 1991* 3.i.(f) Amendment to the PLP Partnership Exhibit 3.4 to Agreement dated as of October 14, the Annual 1992 between FTX, as Administrative Report on Form Managing General Partner, and FMRP, 10-K for the Year as Managing General Partner, of PLP Ended December 31, 1992* 3.i.(g) Amended and Restated Certificate of Exhibit 3.3 to Limited Partnership of PLP dated June Registration 12, 1986 (PLP Partnership Statement No. 33- Certificate) 5561 3.i.(h) Amendment dated as of January 9, 1998 Exhibit 3.8 to effected by IMC, as Administrative the Annual Managing General Partner, and FMRP, Report on Form as Managing General Partner of PLP 10-K for the Year Ended December 31, 1997* 3.i.(i) Certificate of Amendment to the PLP Exhibit 3.6 to Partnership Certificate dated as of the Annual January 12, 1989 Report on Form 10-K for the Year Ended December 31, 1997* 3.i.(j) Certificate of Amendment to the PLP Exhibit 19.1 to Partnership Certificate dated as of the Quarterly December 29, 1989 Report on Form 10- Q for the Quarterly Period Ended March 31, 1990* 3.i.(k) Certificate of Amendment to the PLP Exhibit 19.4 to Partnership Certificate dated as of the Quarterly April 12, 1990 Report on Form 10-Q for the Quarterly Period Ended March 31, 1990* 3.i.(l) Certificate of Amendment to the PLP Exhibit 3.12 to Partnership Certificate dated as of the Annual Report January 9, 1998 on Form 10-K for the Year Ended December 31, 1998* 3.i.(m) Deposit Agreement dated as of June Exhibit 28.4 to 27, 1986 (Deposit Agreement) among the Current PLP, The Chase Manhattan Bank, N.A. Report on Form 8- (Chase) and Freeport Minerals Company K dated July 11, as attorney-in-fact of those limited 1986* partners and assignees holding depositary receipts for units of limited partnership interest in PLP 3.i.(n) Resignation dated December 26, 1991 Exhibit 4.5 to of Chase as Depositary under the the Annual Report Deposit Agreement and appointment on Form 10-K for dated December 27, 1991 of Mellon the Year Ended Bank, N.A. (Mellon) as successor December 31, 1991* Depositary, effective January 1, 1992 3.i.(o) Service Agreement dated as of January Exhibit 4.6 to 1, 1992 between PLP and Mellon the Annual Report pursuant to which Mellon serves as on Form 10-K for Depositary under the Deposit the Year Ended Agreement and Custodian under the December 31, 1991* Custodial Agreement 3.i.(p) Amendment to the Deposit Agreement Exhibit 4.4 to dated as of November 18, 1992 between the Annual Report PLP and Mellon on Form 10-K for the Year Ended December 31, 1992* 3.i.(q) Form of Depositary Receipt Exhibit 4.5 to the Annual Report on Form 10-K for the Year Ended December 31, 1992* 4.ii.(a) Form of Senior Indenture (Senior Exhibit 4.1 to Indenture) from PLP to Chemical Bank, the Current as Trustee. Report on Form 8- K dated February 13, 1996* 4.ii.(b) Form of Supplemental Indenture dated Exhibit 4.1 to February 14, 1996 from PLP to the Current Chemical Bank, as Trustee, to the Report on Form 8- Senior Indenture providing for the K dated February issuance of $150,000,000 aggregate 16, 1996* principal amount of 7% Senior Debentures due 2008 10.ii.(a) Amended and Restated Partnership Exhibit 10.3 to Agreement dated as of May 26, 1995 the Annual Report among IMC-Agrico GP Company, Agrico, on Form 10-K for Limited Partnership and IMC-Agrico MP the Year Ended Inc (Amended and Restated Partnership December 31, 1995* Agreement) 10.ii.(b) Amendment and Agreement dated as of Exhibit 10.1 to January 23, 1996 to the Amended and the Current Restated Partnership Agreement dated Report on Form 8-K May 26, 1995 by and among IMC-Agrico dated February MP, Inc., IMC Global Operations, Inc. 13, 1996* and IMC-Agrico Company 10.ii.(c) Amendment and Agreement dated as of Exhibit 10.5 to December 22, 1997 to the Amended and the Annual Report Restated Partnership Agreement dated on Form 10-K for May 26, 1995 by and among IMC-Agrico the Year Ended MP, Inc.; IMC Global Operations, December 31, 1998* Inc.; and IMC-Agrico Company 10.ii.(d) Amended and Restated Parent Agreement Exhibit 10.5 to dated as of May 26, 1995 among IMC the Annual Global Operations, Inc.; PLP; FTX; Report on Form and IMC-Agrico 10-K for the Year Ended December 31, 1995* 10.ii.(e) Promissory Demand Note between PLP, Exhibit 10.9 to as borrower, and IMC, as lender, the Annual Report dated December 22, 1997 in the on Form 10-K for principal sum of $200,000,000 the Year Ended December 31, 1997* 10.ii.(f) Promissory Demand Note between PLP, Exhibit 10.10 to as borrower, and IMC, as lender, the Annual Report dated December 22, 1997 in the on Form 10-K for principal sum of $150,000,000 the Year Ended December 31, 1997 21 Subsidiaries of the Registrant X 23 Consent of Ernst & Young LLP, X Independent Auditors 24 Powers of Attorney pursuant to which X this report has been signed on behalf of certain directors of IMC Global Inc. 27 PLP Financial Data Schedule X *SEC File No. 1-9164 INDEX TO FINANCIAL STATEMENT SCHEDULES The financial statement schedules listed below should be read in conjunction with such financial statements contained in PLP's 1999 Annual Report on Form 10-K. Page -------- I Condensed Financial Information of Registrant - II Valuation and Qualifying Accounts Schedules other than those listed above have been omitted since they are either not required, not applicable or the required information is included in the financial statements or notes thereto.

81362_1999.txt

81362_1999

1999

81362

Item 1. Business. General Description Quaker develops, produces, and markets a broad range of formulated chemical specialty products for various heavy industrial and manufacturing applications and, in addition, offers and markets chemical management services. Quaker's principal products and services include: (i) rolling lubricants (used by manufacturers of steel in the hot and cold rolling of steel and by manufacturers of aluminum in the cold rolling of aluminum); (ii) corrosion preventives (used by steel and metalworking customers to protect metal during manufacture, storage, and shipment); (iii) metal finishing compounds (used to prepare metal surfaces for special treatments such as galvanizing and tin plating and to prepare metal for further processing); (iv) machining and grinding compounds (used by metalworking customers in cutting, shaping, and grinding metal parts which require special treatment to enable them to tolerate the manufacturing process); (v) forming compounds (used to facilitate the drawing and extrusion of metal products); (vi) paper production products (used as defoamers, release agents, softeners, debonders, and dispersants); (vii) hydraulic fluids (used by steel, metalworking, and other customers to operate hydraulically activated equipment); (viii) products for the removal of hydrogen sulfide in various industrial applications; (ix) chemical milling maskants for the aerospace industry and temporary and permanent coatings for metal products; (x) construction products such as flexible sealants and protective coatings for various applications; and (xi) programs to provide chemical management services. A substantial portion of Quaker's sales worldwide are made directly through its own sales force with the balance being handled through distributors and agents. Quaker sales persons visit the plants of customers regularly and, through training and experience, identify production needs which can be resolved or alleviated either by adapting Quaker's existing products or by applying new formulations developed in Quaker's laboratories. In 1999, certain products were also sold in Canada and Korea by exclusive licensees under long-term royalty agreements. Generally, separate manufacturing facilities of a single customer are served by different sales personnel. The business of the Company and its operating results are subject to certain risks, of which the principal ones are referred to in the following subsections. Competition The chemical specialty industry is composed of a number of companies of similar size as well as companies larger and smaller than Quaker. Quaker cannot readily determine its precise position in every industry it serves. Based on information available to Quaker, however, it is estimated that Quaker holds a significant position (among a group in excess of 25 other suppliers) in the market for process fluids used in the production of hot and cold rolling of steel. Many competitors are in fewer and more specialized product classifications or provide different levels of technical services in terms of specific formulations for individual customers. Competition in the industry is based primarily on the ability to provide products which meet the needs of the customer and render technical services and laboratory assistance to customers and, to a lesser extent, on price. Major Customers and Markets During 1999, Quaker's five largest customers (each composed of multiple subsidiaries or divisions with semi-autonomous purchasing authority) accounted for approximately 14.0% of its consolidated net sales with the largest of these customers accounting for approximately 3.3% of consolidated net sales. Furthermore, a significant portion of Quaker's revenues are realized from the sale of process fluids to manufacturers of steel, automobiles, appliances, and durable goods, and, therefore, Quaker is subject to the same business cycles as those experienced by these manufacturers and their customers. Raw Materials Quaker uses over 500 raw materials, including mineral oils, fats and fat derivatives, ethylene derivatives, solvents, surface active agents, chlorinated paraffinic compounds, and a wide variety of organic and inorganic compounds. In 1999, only one raw material accounted for as much as 10% of the total cost of Quaker's raw material purchases. Many of the raw materials used by Quaker are "commodity" chemicals, and, therefore, Quaker's earnings can be affected by market changes in raw material prices. Quaker has multiple sources of supply for most materials, and management believes that the failure of any single supplier would not have a material adverse effect upon its business. Reference is made to disclosure contained in Item 7A of this Report. Patents and Trademarks Quaker has a limited number of patents and patent applications, including patents issued, applied for, or acquired in the United States and in various foreign countries, some of which may prove to be material to its business. Principal reliance is placed upon Quaker's proprietary formulae and the application of its skills and experience to meet customer needs. Quaker's products are identified by trademarks which are registered throughout its marketing area. Quaker makes little use of advertising but relies heavily upon its reputation in the markets which it serves. Research and Development--Laboratories Quaker's research and development laboratories are directed primarily toward applied research and development since the nature of Quaker's business requires continuing modification and improvement of formulations to provide chemical specialties to satisfy customer requirements. Incorporated by reference is the information contained under the caption "Research and Development Costs" appearing in Note 1 of Notes to Consolidated Financial Statements on page 22 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Quaker maintains quality control laboratory facilities in each of its manufacturing locations. In addition, Quaker maintains in Conshohocken, Pennsylvania, and Uithoorn, The Netherlands, laboratory facilities which are devoted primarily to applied research and development. Most of Quaker's subsidiaries and associated companies also have laboratory facilities. Although not as complete as the Conshohocken laboratories, these facilities are generally sufficient for the requirements of the customers being served. If problems are encountered which cannot be resolved by local laboratories, such problems may be referred to the corporate laboratory staff, which also defines and supervises corporate research projects. Approximately 152 persons, of whom 104 have B. S. degrees or advanced degrees, are employed in Quaker's laboratories. Number of Employees On December 31, 1999, Quaker's consolidated companies had 923 full-time employees of whom 396 were employed by the parent company and its U.S. subsidiaries and 527 were employed by its non-U.S. subsidiaries. Associated companies of Quaker (in which it owns 50% or less) employed 247 people on December 31, 1999. Product Classification Incorporated by reference is the information concerning product classification by markets served appearing in Note 11 of Notes to Consolidated Financial Statements on pages 28 and 29 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Non-U.S. Activities Incorporated by reference is the information concerning non-U.S. activities appearing in Note 11 of Notes to Consolidated Financial Statements on pages 28 and 29 of the Registrant's 1999 Annual Report to Shareholders and under the caption "General" of the Operations section of Management's Discussion and Analysis of Financial Condition and Results of Operations which appears on page 17 of the aforementioned Annual Report, the incorporated portions of which are included as Exhibit 13 to this Report. Since significant revenues and earnings are generated by its non-U.S. operations, Quaker's financial results are affected by currency fluctuations, particularly between the U.S. dollar, the Euro, the Dutch guilder, the Brazilian real, and other foreign currencies, and the impact of those currency fluctuations on the underlying economies. Reference is made to disclosure contained in Item 7A of this Report. Item 2. Item 2. Properties. Quaker's principal facilities in the United States are located in Conshohocken, Pennsylvania and Detroit, Michigan. Quaker's non-U.S. subsidiaries own facilities in Woodchester, England; Uithoorn, The Netherlands; Villeneuve, France; and Santa Perpetua de Mogoda, Spain; and Rio de Janeiro, Brazil and lease small sales facilities in other locations. All of these facilities are owned mortgage free. Financing for the Technical Center in Conshohocken, Pennsylvania was arranged through the use of industrial revenue and development bonds with an outstanding balance at December 31, 1999 of $5 million. Quaker's aforementioned facilities consist of various manufacturing, administrative, warehouse, and laboratory buildings. Substantially all of the buildings are of fire-resistant construction and are equipped with sprinkler systems. All facilities are primarily of masonry and/or steel construction and are adequate and suitable for Quaker's present operations. The Company has a program to identify needed capital improvements which will be implemented as management considers necessary or desirable. Most locations have various numbers of raw material storage tanks ranging from 7 to 66 having a capacity from 1,000 to 82,000 gallons each and processing or manufacturing vessels ranging in capacity from 15 to 16,000 gallons each. Manufacturing and warehouse facilities located in Conshohocken, Pennsylvania, were closed in 1996. In order to facilitate compliance with applicable federal, state, and local statutes and regulations relating to occupational health and safety and protection of the environment, the Company has an ongoing program of site assessment for the purpose of identifying capital expenditures or other actions that may be necessary to comply with such requirements. The program includes periodic inspections of each facility by Quaker and/or independent environmental experts, as well as ongoing inspections by on-site personnel. Such inspections are addressed to operational matters, record keeping, reporting requirements, and capital improvements. In 1999, capital expenditures directed solely or primarily to regulatory compliance amounted to approximately $1.7 million. Quaker's executive offices are located in a four-story building containing a total of approximately 47,000 square feet. A Technical Center containing approximately 28,700 square feet houses the laboratory facility. Both of these facilities are adjacent to Quaker's closed manufacturing facility in Conshohocken. Quaker's 50% or less owned non-U.S. associated companies own or lease a plant and/or sales facilities in various locations. Item 3. Item 3. Legal Proceedings. The Company is a party to proceedings, cases, and requests for information from, and negotiations with, various claimants and federal and state agencies relating to various matters including environmental matters, none of which is expected to result in monetary sanctions in an amount or in an award that would have a material adverse effect on the Company's results of operations or financial condition. For information concerning pending asbestos-related cases against a non-operating subsidiary and amounts accrued associated with certain environmental investigatory and noncapital remediation costs, refer to Note 13 of Notes to Consolidated Financial Statements which appears on page 30 in the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders during the last quarter of the period covered by this Report. Item 4(a). Executive Officers of the Registrant. Messrs. Bregolato, Ma, and Meijer have served as officers of the Registrant for more than the past five years. Prior to his election as President and Chief Executive Officer, effective October 2, 1995, Mr. Naples served as Chairman of the Board and Chief Executive Officer of Hunt Manufacturing Company until April 6, 1995, a position held for over five years. Mr. Naples was elected Chairman of the Board of the Registrant in 1997. Mr. Naples has been a Director of the Registrant since 1988. Prior to his election as an officer of the Registrant in July 1996, Mr. Virdone served as Industry Manager-Steel from 1994 to 1996. Prior to his election as an officer of the Registrant in November 1997, Mr. Geier was employed by Rhone-Poulenc Rorer Pharmaceuticals, Inc., where he held a variety of human resources positions. Prior to his election as an officer of the Registrant in March 1998, Mr. Bauer was employed by M. A. Hanna since 1992 and served as President of M. A. Hanna Color Division from 1996 to 1998 and President of PMS Consolidated from 1992 to 1995. Prior to his election as an officer of Registrant in November 1998, Mr. Barry was employed by Lyondell (formerly ARCO Chemical) where he held the position of Business Director for its Urethanes business throughout the Americas from 1997 to 1998 and where he also held a variety of finance and business positions from 1988 to 1997. Prior to his election as an officer of Registrant in March 1999, Mr. Clark was employed by Ciba Specialty Chemicals Corporation where he held the position of Vice President-Sales and Marketing, U.S. Pigments Division, from 1990 to 1998 and, in addition, was General Manager for one of its global pigment segments from 1996 to 1998. There is no family relationship between the Registrant and any of the Registrant's Executive Officers. Each officer is elected for a term of one year. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Incorporated by reference is the information appearing under the caption "Stock Market and Related Security Holder Matters" on page 34 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Item 6. Item 6. Selected Financial Data. Incorporated by reference is the information appearing under the caption "Eleven-Year Financial Information" on pages 32 and 33 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Incorporated by reference is the information appearing under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 16 and 17 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Quaker is exposed to the impact of interest rates, foreign currency fluctuations, and changes in commodity prices. Interest Rate Risk. Quaker's exposure to market rate risk for changes in interest rates relates primarily to its short and long-term debt. Most of Quaker's long-term debt has a fixed interest rate, while its short-term debt is negotiated at market rates which can be either fixed or variable. Incorporated by reference is the information in "Liquidity and Capital Resources" in Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 8 of the Notes to Consolidated Financial Statements on pages 16 and 26, respectively, of the Registrant's 1999 Annual Report to Shareholders, the incorporated portion of which is included as Exhibit 13 to this Report. Accordingly, if interest rates rise significantly, the cost of short-term debt to Quaker will increase. This can have a material adverse effect on Quaker depending on the extent of Quaker's short-term borrowings. As of December 31, 1999, Quaker had $331,000 in short-term borrowings. Foreign Exchange Risk. A significant portion of Quaker's revenues and earnings are generated by its non-U.S. operations of its foreign subsidiaries. Incorporated by reference is the information concerning Quaker's non-U.S. activities appearing in Note 11 of the Notes to Consolidated Financial Statements on pages 28 and 29 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portion of which is included as Exhibit 13 to this Report. All such subsidiaries use the local currency as their functional currency. Accordingly, Quaker's financial results are affected by risks typical of international business such as currency fluctuations, particularly between the U.S. dollar and the E.U. euro. As exchange rates vary, Quaker's results can be materially adversely affected. In the past, Quaker has used, on a limited basis, forward exchange contracts to hedge foreign currency transactions and foreign exchange options to reduce exposure to changes in foreign exchange rates. The amount of any gain or loss on these derivative financial instruments was immaterial, and there are no contracts or options outstanding at December 31, 1999. Incorporated by reference is the information concerning Quaker's Significant Accounting Policies appearing in Note 1 of the Notes to Consolidated Financial Statements on page 22 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portion of which is included as Exhibit 13 to this Report. Commodity Price Risk. Many of the raw materials used by Quaker are commodity chemicals, and, therefore, Quaker earnings can be materially adversely affected by market changes in raw material prices. In certain cases, Quaker has entered into fixed-price purchase contracts having a term of up to one year. These contracts provide for protection to Quaker if the price for the contracted raw materials rises, however, in certain limited circumstances, Quaker will not realize the benefit if such prices decline. Quaker has not been, nor is it currently a party to, any derivative financial instrument relative to commodities. Item 8. Item 8. Financial Statements and Supplementary Data. Incorporated by reference is the information appearing on pages 18 through 34 of the Registrant's 1999 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated by reference is the information beginning immediately following the caption "Election of Directors" to, but not including, the caption "Executive Compensation" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1999 (the "2000 Proxy Statement") and the information appearing in Item 4(a) on pages 6 and 7 of this Report. Section 16(a) Beneficial Ownership Reporting Compliance. Based solely on the Company's review of certain reports filed with the Securities and Exchange Commission pursuant to Section 16(a) of the Securities Exchange Act of 1934 (the "1934 Act"), as amended, and written representations of the Company's officers and directors, the Company believes that all reports required to be filed pursuant to the 1934 Act with respect to transactions in the Company's Common Stock through December 31, 1999 were filed on a timely basis. Item 11. Item 11. Executive Compensation. Incorporated by reference is the information beginning immediately following the caption "Executive Compensation" to, but not including, the caption "Compensation/Management Development Committee Report on Executive Compensation" contained in the Registrant's 2000 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference is the information beginning immediately following the caption "Security Ownership of Certain Beneficial Owners and Management" to, but not including, the caption "Election of Directors" contained in the Registrant's 2000 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. No information is required to be provided in response to this Item 13. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Exhibits and Financial Statement Schedules 1. Financial Statements The following is a list of the Financial Statements and related documents which have been incorporated by reference from the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1999, as set forth in Item 8: Consolidated Statement of Operations Consolidated Balance Sheet Consolidated Statement of Cash Flows Consolidated Statement of Shareholders' Equity Notes to Consolidated Financial Statements Management's Responsibility for Financial Reporting Report of Independent Accountants 2. Financial Statement Schedules All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of 50% or less owned companies have been omitted because none of the companies meets the criteria requiring inclusion of such statements. 3. Exhibits (numbered in accordance with Item 601 of Regulation S-K) 3(a)-- Amended and Restated Articles of Incorporation dated July 16, 1990. Incorporated by reference to Exhibit 3(a) as filed by Registrant with Form 10-K for the year 1996. 3(b)-- By-Laws as amended through May 6, 1998. Incorporated by reference to Exhibit 3(b) as filed by Registrant with Form 10-K for the year 1998. 4--Shareholder Rights Plan dated February 7, 1990. Incorporated by reference to Form 8-K as filed by the Registrant on February 20, 1990. 4(a)--Shareholder Rights Plan dated March 6, 2000. Incorporated by reference to Form 8-K as filed by the Registrant on March 7, 2000. 10(a)--Long-Term Performance Incentive Plan as approved May 5, 1993. Incorporated by reference to Exhibit 10(a) as filed by the Registrant with Form 10-K for the year 1993. 10(h)--Documents constituting employment contract by and be- tween Quaker Chemical Europe B.V. and M. C. J. Meijer dated January 1, 1991. Incorporated by reference to Exhibit 10(h) as filed by Registrant with Form 10-K for the year 1993. 10(i)--Employment Agreement by and between the Registrant and Ronald J. Naples dated August 14, 1995. Incorporated by reference to Exhibit 10(i) as filed by Registrant with Form 10-Q for the quarter ended September 30, 1995. 10(j)--Amendment to the Stock Option Agreement dated October 2, 1995 by and between the Registrant and Ronald J. Naples. Incorporated by reference to Exhibit 10(j) as filed by Registrant with Form 10-Q for the quarter ended September 30, 1995. 10(k)--Employment Agreement by and between Registrant and Jose Luiz Bregolato dated June 14, 1993. Incorporated by reference to Exhibit 10(k) as filed by Registrant with Form 10-K for the year 1995. 10(l)--Employment Agreement by and between Registrant and Daniel S. Ma dated May 18, 1993. Incorporated by reference to Exhibit 10(l) as filed by Registrant with Form 10-K for the year 1995. 10(o)--Amendment No. 1 to Employment Agreement dated January 1, 1997 by and between Registrant and Ronald J. Naples. Incorporated by reference to Exhibit 10(o) as filed by Registrant with Form 10-K for the year 1997. 10(p)--Amendment No. 1 to 1995 Naples Restricted Stock Plan and Agreement dated January 21, 1998 by and between Registrant and Ronald J. Naples. Incorporated by reference to Exhibit 10(p) as filed by Registrant with Form 10-K for the year 1997. 10(q)--Employment Agreement by and between Registrant and Joseph F. Virdone dated July 17, 1996. Incorporated by reference to Exhibit 10(q) as filed by Registrant with Form 10-K for the year 1997. 10(r)--Employment Agreement by and between Registrant and James A. Geier dated November 5, 1997. Incorporated by reference to Exhibit 10(r) as filed by Registrant with Form 10-K for the year 1997. 10(s)--Employment Agreement by and between Registrant and Joseph W. Bauer dated March 9, 1998. Incorporated by reference to Exhibit 10(s) as filed by Registrant with Form 10-K for the year 1997. 10(t)--Employment Agreement by and between Registrant and Ronald J. Naples dated March 11, 1999. Incorporated by reference to Exhibit 10(t) as filed by Registrant with Form 10-K for the year 1998. 10(u)--Employment Agreement by and between Registrant and Michael F. Barry dated November 30, 1998. Incorporated by reference to Exhibit 10(u) as filed by Registrant with Form 10-K for the year 1998. 10(v)--Employment Agreement by and between Registrant and Ian F. Clark dated March 15, 1999. Incorporated by reference to Exhibit 10(v) as filed by Registrant with Form 10-K for the year 1998. 10(w)--Change in Control Agreement by and between Registrant and Joseph W. Bauer dated February 1, 1999. Incorporated by reference to Exhibit 10(w) as filed by Registrant with Form 10-K for the year 1998. 10(x)--Change in Control Agreement by and between Registrant and Michael F. Barry dated November 30, 1998. Incorporated by reference to Exhibit 10(x) as filed by Registrant with Form 10-K for the year 1998. 10(y)--Change in Control Agreement by and between Registrant and Jose Luiz Bregolato dated January 6, 1999. Incorporated by reference to Exhibit 10(y) as filed by Registrant with Form 10-K for the year 1998. 10(z)--Change in Control Agreement by and between Registrant and James A. Geier dated January 15, 1999. Incorporated by reference to Exhibit 10(z) as filed by Registrant with Form 10-K for the year 1998. 10(aa)--Change in Control Agreement by and between Registrant and Daniel S. Ma dated January 15, 1999. Incorporated by reference to Exhibit 10(aa) as filed by Registrant with Form 10-K for the year 1998. 10(bb)--Change in Control Agreement by and between Registrant and Joseph F. Virdone dated December 21, 1998. Incorporated by reference to Exhibit 10(bb) as filed by Registrant with Form 10-K for the year 1998. 10(cc)--Change in Control Agreement by and between Registrant and Ian F. Clark dated March 15, 1999. Incorporated by reference to Exhibit 10(cc) as filed by Registrant with Form 10-K for the year 1998. 10(dd)--1999 Long-Term Performance Incentive Plan as approved May 12, 1999, effective January 1, 1999. 10(ee)--Employment Agreement by and between Registrant and Marcus C. J. Meijer dated September 28, 1999. 10(ff)--Deferred Compensation Plan as adopted by the Registrant dated December 17, 1999, effective July 1, 1997. 10(gg)--Supplemental Retirement Income Program adopted by the Registrant on November 6, 1984, as amended November 8, 1989. 13 -- Portions of the 1999 Annual Report to Shareholders incorporated by reference. 21 -- Subsidiaries and Affiliates of the Registrant. 23 -- Consent of Independent Accountants. 27 -- Financial Data Schedule. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Registrant during the last quarter of the period covered by this Report. (c) The exhibits required by Item 601 of Regulation S-K filed as part of this Report or incorporated herein by reference are listed in subparagraph (a)(3) of this Item 14. (d) The financial statement schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. QUAKER CHEMICAL CORPORATION --------------------------- Registrant Date: March 22, 2000 By: /s/ Ronald J. Naples --------------------------- Ronald J. Naples Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. EXHIBIT INDEX

850693_1999.txt

850693_1999

1999

850693

ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS Allergan, Inc. ("Allergan" or the "Company") is a leading provider of eye care and specialty pharmaceutical products throughout the world with products in the eye care pharmaceutical, ophthalmic surgical device, over-the-counter contact lens care, movement disorder, and dermatological markets. Its worldwide consolidated revenues are principally generated by prescription and non-prescription pharmaceutical products in the areas of ophthalmology and skin care, neurotoxins, intraocular lenses and other ophthalmic surgical products, and contact lens care products. Allergan was originally incorporated in California in 1948, became known as Allergan Corporation in 1950, and reincorporated in Delaware in 1977. In 1980, the Company was acquired by SmithKline Beecham plc (then known as "SmithKline Corporation" and herein "SmithKline"). The Company operated as a wholly-owned subsidiary of SmithKline from 1980 until 1989 when Allergan again became a stand-alone public company through a spin-off distribution by SmithKline. In November 1992, the Company sold its contact lens business in North and South America. In August 1993, the Company sold its contact lens business outside of the Americas. During 1994, the Company acquired the Ioptex Research worldwide intraocular lens product line. During 1995, the Company completed four acquisitions. In January 1995, the Company acquired Optical Micro Systems, Inc., a U.S.-based developer and manufacturer of phacoemulsification surgical equipment. In June 1995, the Company acquired Laboratorios Frumtost, S.A., a manufacturer of ophthalmic and other pharmaceutical products in Brazil. In August 1995, the Company purchased the assets of Herald Pharmacal, Inc., a U.S.-based developer and manufacturer of glycolic acid-based, aesthetic skin care products. In November 1995, the Company purchased the worldwide contact lens care product business of Pilkington Barnes Hind. Also in 1995, Allergan acquired 100% ownership interest in Santen-Allergan, its Japanese contact lens care joint venture. On December 9, 1999 the Company implemented a two-for-one stock split effected as a dividend to stockholders of record on November 18, 1999. All historical information contained in this report has been adjusted to reflect the 1999 stock split. ALLERGAN BUSINESSES The following table sets forth, for the periods indicated, the net sales from continuing operations for each of the Company's specialty therapeutics businesses and product lines: See Note 13 of Notes to Consolidated Financial Statements on pages A-39 to A-41 of the Company's Proxy Statement filed on March 16, 2000 for further information concerning foreign and domestic operations. SPECIALTY PHARMACEUTICAL BUSINESS Eye Care Pharmaceutical Product Line Allergan develops, manufactures and markets a broad range of prescription and non-prescription products designed to treat diseases and disorders of the eye, including glaucoma, inflammation, infection and allergy. In addition, the specialty over-the-counter product line consists of products designed to treat ocular surface disease, including artificial tears and ocular decongestants. The largest segment of the market for ophthalmic prescription drugs is for the treatment of glaucoma, a sight-threatening disease characterized by elevated intraocular pressure. Allergan's largest selling eye care pharmaceutical product is Alphagan(R) ophthalmic solution, which was approved by the United States Food and Drug Administration ("FDA") in September 1996 for the treatment of open-angle glaucoma and ocular hypertension. Sales of Alphagan(R) ophthalmic solution represented 4%, 9% and 12% of total Company sales in 1997, 1998 and 1999, respectively. The period of new chemical entity exclusivity in the United States for Alphagan(R) ophthalmic solution extends for five years from the date of approval. In March 1997, Alphagan(R) was also approved in the United Kingdom, and in October 1997, the Company received approval to market Alphagan(R) ophthalmic solution in 14 of the 15 member states of the European Union through the mutual recognition filing process. At the end of 1999, Alphagan(R) was approved in over 50 countries worldwide. In July 1998, the Company entered into an agreement with Santen Pharmaceutical Co., Ltd., granting Santen exclusive distribution rights for brimonidine (the compound marketed by Allergan under the Alphagan(R) brand name) in Japan. Under this agreement, Santen agreed to assume responsibility for future product development of brimonidine and for obtaining Ministry of Health approval in Japan. Allergan retained the option to co-promote or co-market brimonidine in Japan with Santen. The Company also markets Betagan(R) ophthalmic solution, a topical beta blocker used in the treatment of glaucoma, and Propine(R) ophthalmic solution, which is used alone or in combination with other drugs when initial drug therapy for glaucoma becomes inadequate. Patent protection for both products expired in the United States in 1991 and they both face generic competition from several companies including Bausch & Lomb and Alcon Laboratories, Inc. (a division of Nestle). In addition, the Company markets its own generic version of these two products. In December 1999, the FDA approved the marketing of Alocril(TM) ophthalmic solution for the treatment of itch associated with allergic conjunctivitis. In February 2000, the Company entered into an agreement with Dura Pharmaceuticals, Inc. to commercialize Alocril(TM) ophthalmic solution, with Allergan promoting to ophthalmologists and Dura promoting primarily to primary care practitioners and respiratory specialists. Allergan launched the product in March 2000. The Company also markets several leading ophthalmic products to treat ocular inflammation and infection. Pred Forte(R) and FML(R) Liquifilm(R) ophthalmic suspensions are leading products in the ocular corticosteroid inflammation market. Allergan's Acular(R)1 ophthalmic solution is indicated for the relief of itch associated with seasonal allergic conjunctivitis and for the treatment of postoperative inflammation in patients who have undergone cataract extraction. In November 1997, the Company received approval from the FDA to market Acular(R) PF, the first unit-dose, preservative-free topical nonsteroidal anti-inflammatory drug (NSAID) in the United States, for the reduction of ocular pain and photophobia following incisional refractive surgery. Allergan's major products in the anti-infective market are Ocuflox(R)/Oflox(R)/Exocin(R) ophthalmic solution, a fluroquinolone which treats bacterial conjunctivitis and corneal ulcers, Blephamide(R) ophthalmic suspension, a topical anti-inflammatory and anti-infective, and Polytrim(R) ophthalmic solution, a synthetic antimicrobial which treats surface ocular bacterial infections. Blephamide(R), Pred Forte(R) and Polytrim(R) ophthalmic solutions no longer have patent protection and face generic competition. In September 1999 Allergan entered into a multi-year agreement with McNeil Consumer Healthcare, a subsidiary of Johnson & Johnson, to commercialize Ocuflox(R) ophthalmic solution in the U.S. pediatric and selected general practitioner markets. Allergan has filed a new drug application with the FDA for Restasis(TM) ophthalmic emulsion for the treatment of chronic dry eye disease. An advisory committee to the FDA voted against recommending approval of the drug in July 1999, a decision that is not binding on the FDA. In August 1999, the FDA issued an "approvable letter" to the Company, indicating several points the Company must address before the application will be approved. The Company submitted a formal response to the FDA in the fourth quarter of 1999 and awaits the FDA's final determination. Also during the fourth quarter of 1999, the Company filed a Marketing Authorization Application for Restasis(TM) through the Mutual Recognition Process in Europe. In addition to its eye care pharmaceuticals, Allergan markets a variety of artificial tear products for various needs, under a range of brand names worldwide, led by the Refresh(R) brand. In the United States, the Refresh(R) brand includes Refresh Plus(R), the category unit dose leader, Refresh Tears(R), the leading multi-dose product, and Refresh P.M.(R), for overnight relief of dry eye. Allergan also markets Celluvisc(R) in the United States - -------- (1) Acular(R) is a registered trademark of and is licensed from its developer Syntex (U.S.A.) Inc. for severe dry eye. Other Allergan brands marketed around the world include the Lerin(R), Liquifilm Tears(R) and Lacri-Lube(R) S.O.P.(R) products. Skin Care Product Line Building upon its strength in marketing to medical specialties and taking advantage of synergies in research and development, Allergan's skin care business develops, manufactures and markets therapeutic as well as cosmetic skin care products, primarily in the United States. In June 1997, the Company received approval from the FDA to market Tazorac(R) (tazarotene topical gel) 0.05% and 0.1% (the trade name for Zorac(R) topical gel in the United States and Canada) for the treatment of plaque psoriasis and acne. In November 1999, the Company entered into an agreement with 3M Pharmaceuticals to co-promote Tazorac(R) gel in the U.S. dermatology market. Outside of the U.S., the Company entered into an agreement in February 1999 with Pierre Fabre Dermatologie, an affiliate of the private French company, Pierre Fabre, to commercialize tazarotene (Zorac(R)) in continental Europe and nearby territories. And, in April 1999 Allergan formed a marketing, sales and development partnership with Bioglan Pharma Plc to commercialize Zorac(R) gel in the United Kingdom, Ireland, Denmark, Sweden, Finland and other international markets, including certain countries in the Middle East and Africa. Azelex(R) cream for the topical treatment of mild to moderate inflammatory acne vulgaris was launched in the U.S. in December 1995 and has been well received in the market. The therapeutic product line also includes Elimite(R) cream for the treatment of scabies, and Gris-Peg(R) tablets, a systemic anti-fungal product. Patent protection for Elimite(R) cream in the United States has expired, and the product now faces generic competition. In 1999 the Company divested three older pharmaceutical products which were not being actively promoted: Naftin(R) gel, Erygel(R) topical gel and Erymax(R) topical solution. The Company also develops, manufactures and markets glycolic acid-based skin care products. In 1999 the Company divested its aesthetician salon and retail-based alpha hydroxy acid products as part of an initiative to focus on the M.D. Forte(R) line of products marketed to and dispensed by physicians. Botox(R)/Neuromuscular Allergan's Botox(R) (Botulinum Toxin Type A) Purified Neurotoxin Complex is used in the treatment of certain neuromuscular disorders which are characterized by involuntary muscle contractions or spasms. Sales of Botox(R) Purified Neurotoxin Complex represented 8%, 9.9% and 13% of total Company sales in 1997, 1998 and 1999, respectively. The Company markets Botox(R) Purified Neurotoxin Complex in the United States and in 66 other countries. The approved indications for Botox(R) in the United States are for the treatment of blepharospasm (the uncontrollable contraction of the eyelid muscles which can force the eye closed and result in functional blindness) and strabismus (misalignment of the eyes) in people 12 years of age and over. The Company is working to expand the approved indications for Botox(R) Purified Neurotoxin Complex in the United States. In 1998, the Company exercised its option to acquire the exclusive worldwide rights to U.S. and foreign patents for the use of botulinum toxin to treat migraine headaches, and the Company has filed an investigational new drug application with the FDA for the migraine headache indication for Botox(R). Clinical development for the migraine and tension headache indications are currently in Phase 2. In addition, the Company has orphan drug designations from the FDA for two indicated uses for Botox(R) Purified Neurotoxin Complex: cervical dystonia and juvenile cerebral palsy. The Company initiated Phase 3 clinical trials in 1999 in the United States for the juvenile cerebral palsy indication, and the Company sought supplemental approval for the cervical dystonia indication during 1999. If the Company gains approval for one or both uses before any other manufacturer of the same designated botulinum toxin serotype, the Company will be entitled to seven years of exclusive marketing rights in the United States for those uses. Botox(R) is also in Phase 3 clinical development in the United States for hyperfunctional facial lines (cosmetic brow furrows) and Phase 3 in the United States and Europe for low back pain associated with muscle spasm. The Company started Phase 3 clinical development for adult spasticity post-stroke in 1999. Outside of the United States, the Company is marketing Botox(R) Purified Neurotoxin Complex in 66 countries around the world. The Company continues to pursue expanded indications for Botox(R) outside of the U.S. Botox(R) Purified Neurotoxin Complex has been approved in 39 countries outside of the U.S. for the treatment of cervical dystonia and hemifacial spasm and in 31 countries outside of the U.S. for the treatment of lower limb spasticity in pediatric cerebral palsy patients, two years of age or older. In 1999, the Company received approval in Switzerland to market Botox(R) Purified Neurotoxin Complex for the treatment of upper limb spasticity associated with debilities occurring after a stroke. Subsequent filings throughout Europe for this indication are expected in 2000. In addition, in January 2000 the Company received regulatory approval in Japan for the hemifacial spasm indication. And, the Company has initiated a Phase 3 program in Europe for the treatment of axillary hyperhidrosis (excessive sweating). There are intrinsic uncertainties associated with Research & Development efforts and the regulatory process. There is no assurance that any of the research projects or pending drug marketing approval applications mentioned above will result in new approved indications for Botox(R) Purified Neurotoxin Complex. Delays or failures in one or more significant research projects and pending drug marketing approval applications could have a material adverse impact on the future results of the Company's Botox(R) business. The Company manufactures its own bulk toxin raw material necessary to produce Botox(R) Purified Neurotoxin Complex. The process to create bulk toxin is technically complicated and difficult. Any failure of the Company to maintain an adequate supply of bulk toxin could result in an interruption in the supply of Botox(R) Purified Neurotoxin Complex with a resulting decrease in sales of the product. MEDICAL DEVICES AND OTC PRODUCT LINES Ophthalmic Surgical Product Line Allergan's ophthalmic surgical business develops, manufactures and markets intraocular lenses ("IOLs"), surgically related pharmaceuticals, phacoemulsification equipment and other ophthalmic refractive surgical products. The largest segment of the surgical market is for the treatment of cataracts. Cataracts are a condition, usually age related, in which the natural lens of the eye becomes progressively clouded. This clouding obstructs the passage of light and can eventually lead to blindness. Most patients affected by cataracts can be surgically treated by removing the clouded lens and replacing it with an IOL. The Company currently offers a full line of products used in the performance of cataract surgery, including PMMA, silicone monofocal and multi-focal and an acrylic IOL. Sales of all models of the Company's IOLs represented 11%, 10% and 10% of total Company sales in 1997, 1998 and 1999, respectively. Intraocular lenses marketed by Allergan for small incision cataract surgery include the PhacoflexII(R)SI-30NB(R) foldable small incision IOL, introduced in April 1993, the SI-40NB(R) foldable small incision IOL, introduced in 1995, the PhacoflexII(R)SI-55NB(R), introduced in 1997, and the Sensar(R) IOL, which was introduced in Europe in 1998 and was approved for marketing in the United States in February 2000. Along with foldable IOLs, the Company also markets a series of insertion systems for each of its foldable lens models, referred to as The UnFolder(R) implantation systems. The systems assist the surgeon in achieving controlled release of the IOL in the smallest incisions. Small incision surgery is a less invasive procedure, and generally, smaller incisions lead to less induced astigmatism and faster visual recovery for the patient. The Array(R) multifocal IOL was approved for marketing in the United States in September 1997. It is also available in Brazil and several European countries including Germany, France and Italy. The Company believes that the Array(R) multifocal IOL will be viewed by ophthalmic surgeons and cataract patients as a significant improvement in IOL design, providing improved quality of life due to enhanced near vision. Small incision IOLs continue to grow in popularity along with increasing use of phacoemulsification, a method of cataract extraction that uses ultrasound waves to break the natural lens into small fragments that can be removed through a hollow needle. Phacoemulsification requires only a three to four millimeter incision, compared to incisions of up to 12 millimeters for other techniques. According to a 1997 survey of members of the American Society of Cataract and Refractive Surgery, phacoemulsification is currently utilized in more than 90% of cataract procedures in the United States. In 1993 Allergan introduced the Prestige(R) phacoemulsification machine. Prestige(R) makes small-incision cataract surgery easier than other phacoemulsification machines by using a sophisticated microprocessor that monitors vacuum and fluid in the eye. In January 1995, Allergan acquired Optical Micro Systems, Inc. ("OMS"). This acquisition, along with the acquisition of the Ioptex business in 1994, provided the Company with additional IOL and phacoemulsification equipment product offerings and proprietary technologies. The AMO(R)Diplomax(R) phacoemulsification machine, launched in the U.S. by the Company in November 1995, is the first OMS phaco-technology system introduced since the acquisition. In 1999, the Company launched the Sovereign(TM) phacoemulsification system, which offers advanced fluidics technology and enhanced power modulations. Allergan also markets AMO(R)Vitrax(R), a viscoelastic used to maintain the anterior chamber and protect endothelial cells during cataract surgery. And, in 1998, the Company became a distributor of BioLon(TM)2 viscoelastic in the United States under an agreement with Akorn, Inc. The Company has partnered with Allegiance Healthcare Corporation to provide custom surgical procedure packs to its U.S. customers and intends to offer this service in Europe in 2000. Contact Lens Care Product Line The Company has been doing business in the contact lens care market since 1960. On a worldwide basis, it develops, manufactures and markets a broad range of products for use with every available type of contact lens. These products include disinfecting solutions to destroy harmful microorganisms in and on the surface of contact lenses; daily cleaners to remove undesirable film and deposits from contact lenses; and enzymatic cleaners to remove protein deposits from contact lenses. In the area of disinfecting products, the Company offers products that can be used in both the hydrogen peroxide and convenient chemical systems. Allergan's leading hydrogen peroxide system products are the Oxysept 1Step(R)/UltraCare(R) hydrogen peroxide neutralizer/disinfection system, with a color indicator which turns the solution pink to indicate the disinfectant tablet has dissolved. Complete(R) brand Multi-Purpose solution is the Company's convenient, one-bottle chemical disinfection system for soft contact lenses. The Company currently markets Complete(R) brand Multi-Purpose solution worldwide, including Japan as of 1999. Complete(R) brand ComfortPLUS(TM) Multi-Purpose solution, the Company's latest product upgrade, contains a proprietary comfort formulation for longer, more comfortable contact lens wear. One-bottle systems, including the Company's product, continue to gain popularity with consumers. - ------------------ (2) BioLon(TM) is a trademark owned and licensed from Bio-Technology General Corporation. In November 1995, the Company acquired the worldwide contact lens care business of Pilkington Barnes Hind. Included in the acquisition was the Consept F(R) Cleaning and Disinfecting System, the first approved non-heat disinfection system for soft contact lenses in Japan. This acquisition significantly increased the Company's contact lens care product business in Japan. Sales of the Company's hydrogen peroxide disinfection systems represented 11%, 10% and 7% of total Company sales in 1997, 1998 and 1999, respectively. The Company's Contact Lens Care business continues to be impacted by trends in the contact lens and lens care marketplace, including technological and medical advances in surgical techniques for the correction of vision impairment. Cheaper one-bottle chemical disinfection systems have gained popularity among soft contact lens wearers instead of peroxide-based lens care products which have historically been Allergan's strongest family of lens care products. Also, the growing use and acceptance of daily contact lenses, along with the other factors above, could have the effect of reducing demand for lens care products generally. While the Company believes it has established appropriate marketing and sales plans to mitigate the impact of these trends upon its Contact Lens Care business, no assurance can be given in this regard. In 2000 Allergan is launching a new eye drop for contact lens wearers called Refresh Contacts(R) to help provide comfort and protection from dryness and irritation. EMPLOYEE RELATIONS At December 31, 1999, the Company employed 5,969 persons throughout the world, including 2,296 in the United States. None of the Company's U.S.-based employees are represented by unions. The Company considers that its relations with its employees are, in general, very good. INTERNATIONAL OPERATIONS The Company believes that international markets represent a significant opportunity for continued growth. International sales have represented approximately 57.2%, 53.8% and 51.9% of total sales for the years ended December 31, 1997, 1998, and 1999 respectively. Allergan believes that its well-established international market presence provides it with an advantage, enabling the Company to maximize the return on its investment in research, product development and manufacturing. Allergan established its first foreign subsidiary in 1964 and currently sells products in approximately 100 countries. Marketing activities are coordinated on a worldwide basis and resident management teams provide leadership and infrastructure for customer focused rapid introduction of new products in the local markets. SALES AND MARKETING Allergan maintains global marketing and regional sales organizations. Supplementing the sales efforts and promotional activities aimed at eye care professionals, as well as neurologists outside the U.S., who use, prescribe and recommend its products, Allergan has been focusing increasingly on managed care providers. In addition, Allergan advertises in professional journals and has an extensive direct mail program of descriptive product literature and scientific information to specialists in the ophthalmic, dermatological and movement disorder fields. The Company's specialty therapeutic products are sold to drug wholesalers, independent and chain drug stores, commercial optical chains, mass merchandisers, food stores, hospitals, ambulatory surgery centers and medical practitioners, including neurologists. At December 31, 1999, the Company employed approximately 1,400 sales representatives throughout the world. RESEARCH AND DEVELOPMENT The Company's global research and development efforts focus on eye care, skin care and neuromuscular products that are safe, effective, convenient and have an economic benefit. The Company's own research and development activities are supplemented by a commitment to identifying and obtaining new technologies through in-licensing, technological collaborations, joint ventures and acquisition efforts, including the establishment of research relationships with academic institutions and individual researchers. At December 31, 1999, there were, in the aggregate, over 930 people involved in the Company's research and development efforts. The Company's research and development expenditures for 1997, 1998, and 1999 were $131.2 million, $125.4 million, and $168.4 million respectively, excluding amounts spent by the Company on behalf of Allergan Ligand Retinoid Therapeutics, Inc. and Allergan Specialty Therapeutics, Inc. In April 1999, the Company announced plans for a $70 million expansion of its research and development facilities in Irvine, California, enabling the Company to hire approximately 300 new research scientists and other professionals by 2003. Research and development efforts for the ophthalmic pharmaceuticals business focus primarily on new therapeutic products for glaucoma, inflammation, dry eye and allergy and on new anti-infective pharmaceuticals for eye care. The Company is conducting research on new compounds that control intraocular pressure by either reducing the inflow or production, or improving the outflow, of aqueous humor. The Company is also conducting research and clinical trials on a class of compounds called hypotensive lipids. Unlike beta-blockers that decrease the inflow or production of aqueous humor, hypotensive lipids reduce intraocular pressure by improving its outflow. The Company is also developing Restatis(TM) cyclosporine ophthalmic emulsion for the treatment of moderate to severe dry eye. Research and development activities for the surgical business concentrate on improved cataract surgical systems, implantation instruments and methods, and new IOL materials and designs. Research and development efforts for neuromuscular disorders focus on expanding the uses for Botox(R) (Botulinum Toxin Type A) Purified Neurotoxin Complex to include treatment for cervical dystonia, juvenile cerebral palsy, spasticity, migraine and tension headache pain, back pain, brow furrow and hyperhidrosis. Research and development in the contact lens care business is aimed at systems that are effective and more convenient for patients to use, and thus lead to a higher rate of compliance with recommended lens care procedures. Improved compliance can enhance safety and extend the time a patient will be a contact lens wearer. The Company believes that continued development and commercialization of disinfection systems that are both easy-to-use and efficacious will be important for the future success of this part of the Company's business. From 1992 to 1994, the Company and Ligand Pharmaceuticals Incorporated ("Ligand") operated a joint venture for the purpose of performing certain research and development activities. In December 1994, Allergan and Ligand formed a new research and development company, Allergan Ligand Retinoid Therapeutics, Inc. ("ALRT") to function as the successor to the joint venture. In November 1997, pursuant to the exercise of its stock purchase option, Ligand acquired all of the stock of ALRT. At the same time, pursuant to the exercise of its asset purchase option, Allergan acquired an interest in one-half of all technologies, cash and other assets of ALRT. The initial agreements between Allergan and Ligand provided for a joint research, development and commercialization arrangement following such option exercises. In connection with the option exercises, Allergan and Ligand amended their agreements so that, among other things, ALRT compounds and development programs were divided between Allergan and Ligand, and each party received exclusive rights to ALRT technology for use with their respective compounds and programs, subject to certain royalty and milestone payment obligations. In 1997 the Company formed a new subsidiary, Allergan Specialty Therapeutics, Inc. ("ASTI"), to conduct research and development of potential pharmaceutical products based on the Company's retinoid and neuroprotective technologies. In March 1998, the Company distributed all ASTI Class A Common Stock to the Company's stockholders, who received one share of ASTI Class A Common Stock for each 20 shares of Allergan common stock held as of the record date. As the sole holder of ASTI's outstanding Class B Common Stock following the distribution and under the terms of ASTI's Restated Certificate of Incorporation, the Company has the option to repurchase all of the outstanding shares of ASTI Class A Common Stock under specified conditions. Under the terms of a technology license agreement and a license option agreement between the Company and ASTI, the Company has also granted certain technology licenses and agreed to make specified payments on sales of certain products in exchange for the payment by ASTI of a technology fee and the option to independently develop certain compounds funded by ASTI prior to the filing of an Investigational New Drug application with the FDA with respect thereto and to license any products and technology developed by ASTI. The Company will recognize the technology fee as revenue as it is earned and received. ASTI's technology and product research and development activities take place under a research and development agreement with the Company. The Company will recognize revenues and related costs as services are performed under such contracts. It is currently expected that substantially all of ASTI's funds will be directed toward continuing the research and development of products based on retinoid and neuroprotective technologies. In addition, ASTI may fund the research and development of pharmaceutical products in therapeutic categories of interest to the Company other than those based on retinoid and neuroprotective technologies, but that complement the Company's product pipeline or otherwise are believed to provide a potential commercialization opportunity for the Company. The Company has also entered into a series of collaboration agreements to further its research and development efforts: o In November 1996, the Company entered into a collaboration agreement with Cambridge NeuroScience, Inc. ("CNSI") to develop new treatments for glaucoma and other serious ophthalmic diseases. CNSI specializes in glutamate ion channel-blocker and sodium channel technology. In 1999, the Company extended this agreement to November 2000. o In September 1997, the Company entered into an exclusive collaboration agreement with ACADIA Pharmaceuticals Inc. (formerly Receptor Technologies) to identify receptor-selective compounds with respect to certain targets, develop receptor arrays and probes specific for G-protein coupled and other receptors and facilitate the establishment of drug discovery programs. o In July 1998, the Company entered into a multi-year research and development collaboration with the Parke-Davis Pharmaceutical Research Division of Warner-Lambert Company to identify, develop and commercialize up to two RXR subtype selective retinoid compounds for the treatment of metabolic diseases, including adult onset diabetes, insulin resistant syndromes and dyslipidemias. o In July 1998, the Company entered into an agreement with Santen Pharmaceutical Co., Ltd., whereby Santen assumed responsibility for future product development of brimonidine and for obtaining Japanese marketing approval in exchange for distribution rights in Japan. Brimonidine is a compound marketed by Allergan under the brand name Alphagan(R). o In June 1999, Allergan entered into a license agreement with XOMA Ltd. under which Allergan obtained exclusive rights to globally develop and commercialize XOMA's recombinant, bactericidal/permeability increasing protein in combination with other anti-infectives in products to treat ophthalmic infections. o In July 1999, the Company entered into a license and research collaboration agreement with ACADIA Pharmaceuticals Inc. to discover, develop and commercialize compounds for glaucoma based on receptor subtype-selective muscarinic lead compounds. o In October 1999, the Company announced an agreement with AXYS Advanced Technologies, Inc. to provide Allergan with a diverse compound screening library consisting of small molecule compounds and with technologies for reproducing and expanding the library chemistries. o In December 1999, the Company and Boehringer Ingelheim entered into a license for Allergan to develop and commercialize epinastine for the treatment of ocular allergies. The continuing introduction of new products supplied by the Company's research and development efforts and in-licensing opportunities is critical to the success of the Company. There is no assurance that any of the research projects or pending drug marketing approval applications will result in new products that the Company can commercialize. Delays or failures in one or more significant research projects and pending drug marketing approval applications could have a material adverse impact on the future operations of the Company. COMPETITION Allergan faces strong competition in all of its markets worldwide. Numerous companies are engaged in the development, manufacture and marketing of health care products competitive with those manufactured by Allergan. Major eye care competitors include Alcon Laboratories, Inc. (a subsidiary of Nestle), Bausch & Lomb and its acquired businesses, Chiron Vision and Storz Ophthalmics, CIBA Vision Ophthalmics (a division of Novartis), Merck & Co., Inc. and Pharmacia Ophthalmics (a subsidiary of Pharmacia & Upjohn). These competitors have equivalent or, in most cases, greater resources than Allergan. The Company's skin care business competes against a number of companies, including, among others, Bristol-Myers Squibb, Schering-Plough Corporation, Johnson & Johnson and Hoffman-La Roche Inc., which all have greater resources than Allergan. In the market for neurotoxins, the Company has one competitor in Europe, Asia and New Zealand, Beaufour Ipsen, and anticipates competition in the United States and Europe in 2000 from Athena Neurosciences, Inc., a subsidiary of Elan Corporation, PLC. In marketing its products to health care professionals, pharmacy benefits management companies, health care maintenance organizations, and various other national and regional health care providers and managed care entities, the Company competes primarily on the basis of product technology, value-added services and price. The Company believes that it competes favorably in its product markets. GOVERNMENT REGULATION Drugs, biologics and medical devices, including intraocular lenses (IOLs) and contact lens care products, are subject to regulation by the FDA, state agencies and, in varying degrees, by foreign health agencies. Government regulation of most of the Company's products generally requires extensive testing of new products and filing applications for approval by the FDA prior to sale in the United States and by some foreign health agencies prior to sale as well. The FDA and foreign health agencies review these applications and determine whether the product is safe and effective. The process of developing data to support a premarket application and governmental review is costly and takes many years to complete. In general, manufacturers of drugs, medical devices and biologicals are operating in an increasingly more rigorous regulatory environment than has been the case in previous years. The total cost of providing health care services has been and will continue to be subject to review by governmental agencies and legislative bodies in the major world markets, including the United States, which are faced with significant pressure to lower health care costs. In 1996, Congress examined the regulatory burdens imposed on drug and medical device manufacturers by the FDA in its product approval processes. In 1997, Congress enacted legislation intended to ameliorate those burdens. Among other things, the Food and Drug Administration Modernization Act of 1997 ("FDAMA") extends the Prescription Drug User Fee Act for another five years; expands access to investigational drugs; authorizes FDA to approve a new drug application on the basis of the results of one clinical trial, if the results are sufficient to establish effectiveness; provides incentives in the form of extended market exclusivity for companies who conduct qualified pediatric clinical studies; otherwise seeks to streamline and facilitate the drug approval process; permits the dissemination of scientific and medical information regarding a product's unapproved uses under specific circumstances; and expands FDAMA inspectional authority over non-prescription drugs. FDAMA also seeks to improve the regulation of medical devices. Much of FDAMA became effective in 1998, with implementation regulations effective in late 1998 and early 1999. The Company has not experienced material effects of FDAMA to date. Internationally, the regulation of drugs and medical devices is likewise becoming increasingly complex. In Europe, the Company's products are subject to extensive regulatory requirements. As in the United States, the marketing of medicinal products has for many years been subject to the granting of marketing authorizations by medicine agencies. Particular emphasis is also being placed on more sophisticated and faster procedures for reporting of adverse events to the competent authorities. Additionally, new rules have been introduced or are under discussion in several areas such as the recognition by the authorities in one Member State of the European Union ("EU") of the assessment and approval to market provided in another Member State and the harmonization of clinical research laws and labeling and patient package information, which collectively are expected to assist companies such as Allergan to bring products to market quickly once the first European approval is received. A new EU regulatory regime has been installed to cover medical devices. This regulatory process became mandatory in June 1998. It requires that medical devices may only be placed on the market if they do not compromise safety and health when properly installed, maintained and used in accordance with their intended purpose. National laws conforming to this EU legislation regulate the Company's IOLs and contact lens care products under the medical devices regulatory system rather than the more extensive system for medicinal products under which they were formerly regulated. The EU regulatory system for cosmetics, which covers many of the Company's skin care products, has been extended to include, among other aspects, formal maintenance of a technical file, a safety assessment, data on undesirable effects, good manufacturing practice and extended labeling requirements. In the United States, a significant percentage of the patients who receive the Company's IOLs are covered by the federal Medicare program. When a cataract extraction with IOL implantation is performed in an ambulatory surgery center ("ASC"), Medicare provides the ASC with a fixed facility fee which includes a $150 allowance to cover the cost of the IOL. When the procedure is performed in a hospital outpatient department, the hospital's reimbursement is determined using a complex formula that blends the hospital's costs with the $150 allowance paid to ASCs. In its effort to reduce Medicare expenditures, Congress may lower the IOL allowance below $150. The Medicare Technical Corrections Bill of 1994 directed the U.S. Health Care Financing Administration ("HCFA") to establish a system through which the agency would pay ASCs and hospitals a rate above $150 for "new technology IOLs." HCFA has issued final rules which implement this mandate. Allergan has filed for "new technology" status for the Array (R) multifocal IOL and the SI-40NB(R) and SI-55NB(R) monofocal IOLs. The Company's pharmaceutical products are not currently covered by Medicare, but proposals to amend Medicare coverage to include pharmaceuticals are currently in debate in the United States. Such coverage could impose price controls on the Company's products. If implemented, price controls could materially and adversely affect the Company's revenues and financial condition. The Company cannot predict the likelihood or pace of any significant legislative action in these areas, nor can it predict whether or in what form health care legislation being formulated by various governments will be passed. The Company also cannot predict exactly what effect such governmental measures would have if they were ultimately enacted into law. However, in general, the Company believes that such legislative activity will likely continue, and the adoption of such measures can be expected to have some impact on the Company's business. PATENTS, TRADEMARKS AND LICENSES Allergan owns, or is licensed under, numerous patents relating to its products, product uses and manufacturing processes. It has numerous patents issued in the United States and corresponding foreign patents issued in many of the major countries in which it does business. Allergan believes that its patents and licenses are important to its business, but that with the exception of those relating to Alphagan(R) ophthalmic solution and to hydrogen peroxide disinfection systems, no one patent or license is currently of material importance in relation to its overall sales. Allergan markets its products under various trademarks and considers these trademarks to be valuable because of their contribution to the market identification of the various products. ENVIRONMENTAL MATTERS The Company is subject to federal, state, local and foreign environmental laws and regulations. The Company believes that its operations comply in all material respects with applicable environmental laws and regulations in each country where the Company has a business presence. Although Allergan continues to make capital expenditures for environmental protection, it does not anticipate any significant expenditures in order to comply with such laws and regulations which would have a material impact on the Company's capital expenditures, earnings or competitive position. The Company is not aware of any pending litigation or significant financial obligations arising from current or past environmental practices that are likely to have a material adverse impact on the Company's financial position. There can be no assurance, however, that environmental problems relating to properties owned or operated by the Company will not develop in the future, and the Company cannot predict whether any such problems, if they were to develop, could require significant expenditures on the part of the Company. In addition, the Company is unable to predict what legislation or regulations may be adopted or enacted in the future with respect to environmental protection and waste disposal. CERTAIN FACTORS AND TRENDS AFFECTING ALLERGAN AND ITS BUSINESSES The Company believes that certain statements made by the Company in this report and in other reports and statements released by the Company constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, such as comments which express the Company's opinions about trends and factors which may impact future operating results. Disclosures which use words such as the Company "believes," "anticipates," "expects" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from expectations. Any such forward-looking statements, whether made in this report or elsewhere, should be considered in context with the various disclosures made by the Company about its businesses including, without limitation, the factors discussed below. o The pharmaceutical industry and other health care-related industries continue to experience consolidation, resulting in larger, more diversified companies with greater resources than the Company. Among other things, these larger companies can spread their research and development costs over much broader revenue bases than Allergan and can influence customer and distributor buying decisions. o Two of the Company's ophthalmic pharmaceutical products, Betagan(R) and Propine(R), are off patent in the U.S. and continue to face competition from generic versions of these compounds as well as from recently introduced new technology glaucoma products. Other significant products such as Elimite(R) cream, Blephamide(R) ophthalmic suspension and Pred-Forte(R) ophthalmic suspension are also off patent and may face similar generic competition. o The Company is currently the only manufacturer of an FDA-approved neurotoxin. The Company is aware, however, of another company seeking FDA approval of a neurotoxin. If such approval is granted, the Company's sales of Botox(R) Purified Neurotoxin Complex could be materially and negatively impacted. o The manufacturing process to create bulk toxin raw material necessary to produce Botox(R) Purified Neurotoxin Complex is technically complicated. Any failure of the Company to maintain an adequate supply of bulk toxin and finished product could result in an interruption in the supply of Botox(R) Purified Neurotoxin Complex with a resulting decrease in sales of the product. o The Company's Contact Lens Care business continues to be impacted by trends in the contact lens and lens care marketplace, including technological and medical advances in surgical techniques for the correction of vision impairment. Cheaper one-bottle chemical disinfection systems have gained popularity among soft contact lens wearers instead of peroxide-based lens care products which historically have been Allergan's strongest family of lens care products. Also, the growing use and acceptance of daily contact lenses, along with the other factors above, could have the effect of reducing demand for lens care products generally. While the Company believes it has established appropriate marketing and sales plans to mitigate the impact of these trends upon its Contact Lens Care business, no assurance can be given in this regard. o The Company has in the past been, and continues to be, subject to product liability claims. In addition, the Company has in the past and may in the future recall or issue field corrections related to its products due to manufacturing deficiencies, labeling errors or other safety or regulatory reasons. There can be no assurance that the Company will not experience material losses due to product liability claims or product recalls or corrections. o Sales of the Company's surgical and pharmaceutical products have been and are expected to continue to be impacted by continuing pricing pressures resulting from various government initiatives as well as from the purchasing and operational decisions made by managed care organizations. Failure of the Array(R) multifocal IOL to be designated as a "new technology IOL" by HCFA will adversely affect the Company's profit margin for the product. o A current political issue of debate in the United States is the propriety of expanding Medicare coverage to include pharmaceutical products. If measures to accomplish that coverage become law, and if these measures impose price controls on the Company's products, the Company's revenues and financial condition are likely to be materially and adversely affected. o The Company collects and pays a substantial portion of its sales and expenditures in currencies other than the U.S. dollar. Therefore, fluctuations in foreign currency exchange rates affect the Company's operating results. The Company can provide no assurance that future exchange rate movements will not have a material adverse effect on the Company's sales, gross profit or operating expenses. o The Company's business is also subject to other risks generally associated with doing business abroad, such as political unrest and changing economic conditions with countries where the Company's products are sold or manufactured. Management cannot provide assurances that it can successfully manage these risks or avoid their effects. o The Company sells its pharmaceutical products primarily through wholesalers. Wholesaler purchases may exceed customer demand, resulting in reduced wholesaler purchases in later quarters. The Company can give no assurances that wholesaler purchases will not decline as a result of this potential excess buying. o In past years, the Company has taken steps designed to improve its gross profit margin, including continued emphasis on new products as well as the closure of certain plants and other cost-cutting measures. In particular, the Company announced comprehensive plans in the third quarter of 1998 to streamline operations and reduce costs through global G&A restructuring and manufacturing consolidation. Whether these steps will succeed in improving gross profit margin depends in part on whether sales of new products will result in a more favorable mix of products, and on whether the anticipated cost savings can be achieved and sustained. o Future performance will be affected by the introduction of new products. The Company has allocated significant resources to the development and introduction of new products. The successful development, regulatory approval and market acceptance of the products cannot be assured. o There are intrinsic uncertainties associated with Research & Development efforts and the regulatory process both of which are discussed in greater details in the "Research and Development" and the "Government Regulation" sections, respectively, which are incorporated herein by reference. o In February 1999, the Financial Accounting Standards Board ("FASB") released a revised Exposure Draft of a Proposed Statement of Financial Accounting Standards - Consolidated Financial Statements: Purpose and Policy. If adopted as a SFAS, the terms of this Exposure Draft could require the Company to include the financial position and results of operation of Allergan Specialty Therapeutics, Inc. in its consolidated results. The Company continues to evaluate the effect of implementation of this proposed statement. By including the results of operations of ASTI, the Company's consolidated results of operations could be adversely affected. In addition, in 1999 the Emerging Issues Task Force ("EITF") of the FASB began deliberating Issue No. 99-16 relating to the appropriate methods of accounting for entities similar to ASTI. Certain alternatives under consideration by the EITF would require the Company to account for the activities of ASTI in the Company's Consolidated Financial Statements. ITEM 2. ITEM 2. PROPERTIES Allergan's operations are conducted in owned and leased facilities located throughout the world. The Company believes its present facilities are adequate for its current needs. Its headquarters and primary administrative and research facilities are located in Irvine, California. The Company has three additional facilities in California, two for raw material support (one leased and one owned) and one leased administrative facility. The Company owns one facility in Texas for manufacturing and warehousing, and the Company operates two facilities in Puerto Rico for manufacturing and warehousing. One of the Puerto Rico facilities is leased and the other is owned. As previously announced, the Company intends to close the facility that it owns in 2001. Outside of the United States and Puerto Rico, the Company owns and operates three manufacturing and warehousing facilities located in Brazil, Ireland and China. Other material facilities include one owned facility for administration and warehousing in Argentina; leased warehouse facilities in Mexico and Japan; leased administrative facilities in Australia, Brazil, Canada, France, Germany, Hong Kong, Ireland, Italy, Japan, Spain and the United Kingdom; and one leased facility in Japan used for administration and research and development. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in various litigation and claims arising in the ordinary course of business which Allergan considers to be normal in view of the size and nature of its business. Although the ultimate outcome of any pending litigation and claims cannot be precisely ascertained at this time, Allergan believes that any liability resulting from the aggregate amount of uninsured damages for outstanding lawsuits, investigations and claims will not have a material adverse effect on its consolidated financial position and results of operation. However, in view of the unpredictable nature of such matters, no assurances can be given in this regard. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company did not submit any matter during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. ITEM I-A. EXECUTIVE OFFICERS OF ALLERGAN, INC. The executive officers of the Company and their ages as of March 1, 2000 are as follows: Officers are appointed by and hold office at the pleasure of the Board of Directors. Mr. Pyott became President and Chief Executive Officer in January 1998. Previously, he was head of the Nutrition Division and a member of the executive committee of Novartis AG from 1995 until December 1997. From 1992 to 1995 Mr. Pyott was President and Chief Executive Officer of Sandoz Nutrition Corp., Minneapolis, Minnesota and General Manager of Sandoz Nutrition, Barcelona, Spain from 1990 to 1992. Prior to that Mr. Pyott held various positions within Sandoz Nutrition group from 1980. Mr. Ball has been Corporate Vice President and President, North America Region and Global Eye Rx Business since May 1998 and prior to that was Corporate Vice President and President, North America Region since April 1996. He joined the Company in 1995 as Senior Vice President, U.S. Eye Care after 12 years with Syntex Corporation, where he held a variety of positions including President, Syntex Inc. Canada and Senior Vice President, Syntex Laboratories. Mr. Brandt has been Corporate Vice President and Chief Financial Officer since May 1999. Prior to joining the Company, Mr. Brandt held various positions with the Boston Consulting Group ("BCG") from 1989, culminating in Vice President and Partner, and a senior member of the BCG Health Care practice. While at BCG, Mr. Brandt was involved in high level consulting engagements with top global pharmaceutical, managed care and medical device companies, focusing on corporate finance, shareholder value and post-merger integration. Mr. Brandt joined the Company in 1999. Mr. Fellows has been Corporate Vice President and President of the Asia Pacific Region since June 1997 and prior thereto, was Senior Vice President, U.S. Eye Care Marketing since June 1996. From 1993 to 1996, he was Senior Vice President, Therapeutics Strategic Marketing, and from 1991 until 1993, he was Vice President, Pharmaceuticals Strategic Marketing. Mr. Fellows joined the Company in 1980. Mr. Hindman has been Senior Vice President and Controller since January 2000 and prior thereto was Vice President, Financial Planning & Analysis since February 1997. Prior to that he served 12 years in a variety of positions at the Company, including Plant Controller, Director of Manufacturing Planning and Reporting, Director of Finance (Northwest Europe), and Assistant Corporate Controller. Mr. Hindman first joined the Company in 1984. Dr. Kaplan has been Corporate Vice President and President, Research and Development and Global BOTOX(R) since May 1998 and had been Corporate Vice President, Science and Technology since July 1996. From 1992 until 1996, he was Corporate Vice President, Research and Development. He had been Senior Vice President, Pharmaceutical Research and Development since 1991 and Senior Vice President, Research and Development since 1989. Dr. Kaplan first joined the Company in 1983. Dr. Lasezkay has been Corporate Vice President, Corporate Development since October 1998 and had been Vice President, Corporate Development since July 1996. He had been Assistant General Counsel of the Company since 1995 and Senior Counsel to the Company since 1989 when he first joined the Company. Mr. Marques has been Corporate Vice President and President, Latin America since October 1998. Prior to that he served 18 years with Alcon, where he held a variety of positions, including President, Alcon Laboratories do Brasil Ltda. from 1994 until 1998. Mr. Marques joined the Company in 1998. Mr. Mazzo has been Corporate Vice President and President, Europe/Africa/Middle East Region since April 1998 and in May 1998 he also assumed the duties of President of Global Lens Care Products. He had been Senior Vice President Eyecare/Rx Sales and Marketing, U.S. since June 1997 during which time he served as acting President Europe/Africa/Middle East Region from October - - December 1997. Prior to that he served 11 years in a variety of positions at the Company, including Director, Marketing (Canada), Vice President and Managing Director (Italy) and Senior Vice President Northern Europe. Mr. Mazzo first joined the Company in 1980. Ms. Schiavo has been Corporate Vice President, Worldwide Operations since 1992. She was Senior Vice President, Operations from 1991 and Vice President, Operations from 1989. Ms. Schiavo first joined the Company in 1980. Mr. Tunney is Corporate Vice President - Administration, General Counsel and Secretary of the Company. From 1991 through 1998 he was Corporate Vice President, General Counsel and Secretary and prior thereto was Senior Vice President, General Counsel and Secretary from 1989 through 1991. Mr. Tunney first joined SmithKline Beckman Corporation, the Company's former parent, in 1979. Mr. Yoder has been Senior Vice President from January 2000, prior to which he had been Senior Vice President and Controller from July 1996 and Vice President and Controller since joining the Company in 1990. Mr. Yoder will retire in June 2000. He is also the Chief Financial Officer of Allergan Specialty Therapeutics, Inc. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The section entitled "Market Prices of Common Stock and Dividends" on page A-47 of the Proxy Statement is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The table entitled "Selected Financial Data" on page A-47 of the Proxy Statement is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations for the Three-Year Period Ended December 31, 1999" on pages A-2 to A-17 of the Proxy Statement is incorporated herein by reference. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The section entitled "Quantitative and Qualitative Disclosures About Market Risk" on pages A-13 to A-16 of the Proxy Statement is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, including the notes thereto, included on pages A-18 to A-43 of the Proxy Statement, together with the sections entitled "Independent Auditors' Report" and "Quarterly Results (Unaudited)" of the Proxy Statement included on pages A-45 and A-46, respectively, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF ALLERGAN, INC. Information under this Item is included on pages 2-4 of the Proxy Statement in the section entitled "Election of Directors" and is incorporated herein by reference. Information with respect to executive officers is included on pages 16-18 of this Form 10-K. The information required by Item 405 of Regulation S-K is included on page 8 of the Proxy Statement under the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation," and the subsection entitled "Director Compensation" included in the Proxy Statement on pages 15-24 and pages 6-7, respectively, are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The common stock information in the section entitled "Security Ownership of Certain Beneficial Owners and Management" on pages 13-14 of the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The sections entitled "Other Matters" and "Compensation Committee Interlocks and Insider Participation" on pages 7-8 and page 23, respectively, of the Proxy Statement are incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Index to Financial Statements* All other schedules have been omitted for the reason that the required information is presented in financial statements or notes thereto, the amounts involved are not significant or the schedules are not applicable. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the last quarter of 1999. (c) Item 601 Exhibits Reference is made to the Index of Exhibits beginning at page S-3 of this report. (d) Other Financial Statements There are no financial statements required to be filed by Regulation S-X which are excluded from the Proxy Statement by Rule 14 a-3(b)(1). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 16, 2000 ALLERGAN, INC. By: /s/ DAVID E.I. PYOTT ---------------------------------- David E.I. Pyott President, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Date: March 16, 2000 By: /s/ DAVID E.I. PYOTT ---------------------------------- David E.I. Pyott President, Chief Executive Officer Date: February 17, 2000 By: /s/ ERIC K. BRANDT ---------------------------------- Eric K. Brandt Corporate Vice President and Chief Financial Officer (Principal Financial Officer) Date: March 16, 2000 By: /s/ DWIGHT J. YODER ---------------------------------- Dwight J. Yoder Senior Vice President (Principal Accounting Officer) Date: February 18, 2000 By: /s/ HERBERT W. BOYER ---------------------------------- Herbert W. Boyer, Ph.D., Chairman of the Board Date: March 16, 2000 By: /s/ RONALD M. CRESSWELL ---------------------------------- Ronald M. Cresswell, Director Date: February 28, 2000 By: /s/ HANDEL E. EVANS ---------------------------------- Handel E. Evans, Director Date: March 16, 2000 By: /s/ MICHAEL R. GALLAGHER ---------------------------------- Michael R. Gallagher, Director Date: March 16, 2000 By: /s/ WILLIAM R. GRANT ---------------------------------- William R. Grant, Director S-1 Date: March 16, 2000 By: /s/ GAVIN S. HERBERT ---------------------------------- Gavin S. Herbert, Director and Chairman Emeritus Date: March 16, 2000 By: /s/ LESTER J. KAPLAN ---------------------------------- Lester J. Kaplan, Ph.D., Director Date: March 16, 2000 By: /s/ KAREN R. OSAR ---------------------------------- Karen R. Osar, Director Date: March 16, 2000 By: /s/ LOUIS T. ROSSO ---------------------------------- Louis T. Rosso, Director Date: March 16, 2000 By: /s/ LEONARD D. SCHAEFFER ---------------------------------- Leonard D. Schaeffer, Director Date: March 16, 2000 By: /s/ HENRY WENDT ---------------------------------- Henry Wendt, Director S-2 INDEX OF EXHIBITS EXHIBIT NUMBER DESCRIPTION - ------ ----------- 3.1 Restated Certificate of Incorporation of the Company as filed with the State of Delaware on May 22, 1989 (incorporated by reference to Exhibit 3.1 to Registration Statement on Form S-1 No. 33-28855, filed May 24, 1989) 3.2 Bylaws of the Company (incorporated by reference to Exhibit 3 to the Company's Report on Form 10-Q for the Quarter ended June 30, 1995) 3.3 First Amendment to Allergan, Inc. Bylaws (incorporated by reference to Exhibit 3.1 to the Company's Report on Form 10-Q for the Quarter ended September 24, 1999) 4.1 Certificate of Designations of Series A Junior Participating Preferred Stock as filed with the State of Delaware on February 1, 2000 4.2 Rights Agreement, dated January 25, 2000, between Allergan, Inc. and First Chicago Trust Company of New York (incorporated by reference to Exhibit 4 to the Company's Current Report on Form 8-K filed on January 28, 2000) 10.1 Form of director and executive officer Indemnity Agreement (incorporated by reference to Exhibit 10.4 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1992)* 10.2 Allergan, Inc. 1989 Nonemployee Director Stock Plan, as amended and restated (incorporated by reference to Exhibit 10.1 to the Company's Report on Form 10-Q for the Quarter ended March 27, 1998)* 10.3 First Amendment to Allergan, Inc. 1989 Nonemployee Director Stock Plan, as amended and restated (incorporated by reference to Exhibit 10.9 to the Company's Current Report on Form 8-K filed on January 28, 2000)* 10.4 Allergan, Inc. Deferred Directors' Fee Program amended and restated as of November 15, 1999 (incorporated by reference to Exhibit 4 to Registration Statement on Form S-8 No. 333-94155, filed January 6, 2000)* S-3 INDEX OF EXHIBITS EXHIBIT NUMBER DESCRIPTION - ------ ----------- 10.5 Allergan, Inc. 1989 Incentive Compensation Plan, as amended and restated (incorporated by reference to Exhibit 10.4 to the Company's Current Report on Form 8-K filed on January 28, 2000)* 10.6 Restated Allergan, Inc. Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.1 to the Company's Report on Form 10-Q for the Quarter ended March 31, 1996) 10.7 First Amendment to Restated Allergan, Inc. Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.3 to the Company's Report on Form 10-Q for the Quarter ended June 30, 1996) 10.8 Second Amendment to Restated Allergan, Inc. Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.7 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997) 10.9 Third Amendment to the Restated Allergan, Inc. Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.4 to the Company's Report on Form 10-Q for the Quarter ended June 26, 1998) 10.10 Fourth Amendment to Restated Allergan, Inc. Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.6 to the Company's Report on Form 10-Q for the Quarter ended September 24, 1999) 10.11 Fifth Amendment to Restated Allergan, Inc. Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed on January 28, 2000) 10.12 Restated Allergan, Inc. Savings and Investment Plan (incorporated by reference to Exhibit 10.6 to the Company's Current Report on Form 8-K filed January 28, 2000) 10.13 First Amendment to the Allergan, Inc. Savings and Investment Plan (incorporated by reference to Exhibit 10.5 to the Company's Report on Form 10-Q for the Quarter ended September 24, 1999) 10.14 Second Amendment to the Allergan, Inc. Savings and Investment Plan (incorporated by reference to Exhibit 10.5 to the Company's Current Report on Form 8-K filed on January 28, 2000) 10.15 Form of Allergan change in control severance agreement (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on January 28, 2000)* S-4 INDEX OF EXHIBITS EXHIBIT NUMBER DESCRIPTION - ------ ----------- 10.16 $250,000,000 Credit Agreement dated as of December 22, 1993 and amended and restated as of May 10, 1996 among the Company, as Borrower and Guarantor, the Eligible Subsidiaries Referred to Therein, the Banks Listed Therein, Morgan Guaranty Trust Company of New York, as Agent and Bank of America National Trust and Savings Association, as Co-Agent (the "Credit Agreement") (incorporated by reference to Exhibit 10.7 to the Company's Report on Form 10-Q for the Quarter ended March 31, 1996) 10.17 Amendment No. 1 to the Credit Agreement (incorporated by reference to Exhibit 10.1 to the Company's Report on Form 10-Q for the Quarter ended June 26, 1998) 10.18 Restated Allergan, Inc. Pension Plan (incorporated by reference to Exhibit 10.3 to the Company's Report on Form 10-Q for the Quarter ended March 31, 1996) 10.19 First Amendment to the Allergan, Inc. Pension Plan (incorporated by reference to Exhibit 10.14 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997) 10.20 Second Amendment to the Allergan, Inc. Pension Plan (incorporated by reference to Exhibit 10.2 to the Company's Report on Form 10-Q for the Quarter ended June 26, 1998) 10.21 Third Amendment to the Allergan, Inc. Pension Plan (incorporated by reference to Exhibit 10.2 to the Company's Report on Form 10-Q for the Quarter ended September 24, 1999) 10.22 Fourth Amendment to the Allergan, Inc. Pension Plan (incorporated by reference to Exhibit 10.10 to the Company's Current Report on Form 8-K filed on January 28, 2000) 10.23 Restated Allergan, Inc. Supplemental Retirement Income Plan (incorporated by reference to Exhibit 10.5 to the Company's Report on Form 10-Q for the Quarter ended March 31, 1996)* 10.24 First Amendment to Allergan, Inc. Supplemental Retirement Income Plan (incorporated by reference to Exhibit 10.4 to the Company's Report on Form 10-Q for the Quarter ended September 24, 1999)* 10.25 Second Amendment to Allergan, Inc. Supplemental Retirement Income Plan (incorporated by reference to Exhibit 10.12 to the Company's Current Report on Form 8-K filed on January 28, 2000)* 10.26 Restated Allergan, Inc. Supplemental Executive Benefit Plan (incorporated by reference to Exhibit 10.6 to the Company's Report on Form 10-Q for the Quarter ended March 31, 1996)* S-5 INDEX OF EXHIBITS EXHIBIT NUMBER DESCRIPTION - ------ ----------- 10.27 First Amendment to Allergan, Inc. Supplemental Executive Benefit Plan (incorporated by reference to Exhibit 10.3 to the Company's Report on Form 10-Q for the Quarter ended September 24, 1999)* 10.28 Second Amendment to Allergan, Inc. Supplemental Executive Benefit Plan (incorporated by reference to Exhibit 10.11 to the Company's Current Report on Form 8-K filed on January 28, 2000)* 10.29 Allergan, Inc. Executive Bonus Plan (incorporated by reference to Exhibit C to the Company's Proxy Statement dated March 23, 1999, filed in definitive form on March 22, 1999) * 10.30 First Amendment to Allergan, Inc. Executive Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed on January 28, 2000)* 10.31 Allergan, Inc. 2000 Management Bonus Plan (incorporated by reference to Exhibit 10.8 to the Company's Current Report on Form 8-K filed on January 28, 2000)* 10.32 Distribution Agreement dated March 4, 1994 between Allergan, Inc. and Merrill Lynch & Co. and J.P. Morgan Securities Inc. (incorporated by reference to Exhibit 10.14 to the Company's Report on Form 10-K for the fiscal year ended December 31, 1993) 10.33 Allergan, Inc. Executive Deferred Compensation Plan amended and restated, effective January 1, 2000 (incorporated by reference to Exhibit 4 to Registration Statement on Form S-8 No. 333-94157, filed January 6, 2000)* 10.34 Allergan, Inc. Stock Price Incentive Plan (incorporated by reference to Exhibit 10.21 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997)* 10.35 Letter Agreement between Allergan, Inc. and William C. Shepherd dated September 27, 1997 (incorporated by reference to Exhibit 10.22 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997)* 10.36 Technology License Agreement dated as of March 6, 1998 among Allergan, Inc. and certain of its affiliates and Allergan Specialty Therapeutics, Inc. ("ASTI") (incorporated by reference to Exhibit 10.23 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997) 10.37 Research and Development Agreement dated as of March 6, 1998 between Allergan, Inc. and ASTI (incorporated by reference to Exhibit 10.2 to the Company's Report on Form 10-Q for the Quarter ended March 27, 1998) S-6 INDEX OF EXHIBITS EXHIBIT NUMBER DESCRIPTION - ------ ----------- 10.38 License Option Agreement dated as of March 6, 1998 between Allergan, Inc. and ASTI (incorporated by reference to Exhibit 10.25 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997) 10.39 Distribution Agreement dated as of March 6, 1998 between Allergan, Inc. and ASTI (incorporated by reference to Exhibit 10.26 to the Company's Report on Form 10-K for the Fiscal Year ended December 31, 1997) 21 List of Subsidiaries of the Company 23 Report and consent of KPMG LLP to the incorporation of their reports herein to Registration Statements Nos. 33-29527, 33-29528, 33-44770, 33-48908, 33-66874, 333-09091, 333-04859, 333-25891, 33-55061, 33-69746, 333-64559, and 333-70407, 333-94155 and 333-94157. 27 Financial Data Schedule - ---------- * Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. S-7 SCHEDULE II ALLERGAN, INC. VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 (IN MILLIONS) - ---------- (a) Provision charged to earnings. (b) Accounts written off. S-8

1071992_1999.txt

1071992_1999

1999

1071992

Item 1. Business. General Capital Bank Corporation (the "Company") is a bank holding company incorporated under the laws of North Carolina on August 10, 1998. The Company's primary function is to serve as the holding company for its wholly-owned subsidiary, Capital Bank. Capital Bank (the "Bank") was incorporated under the laws of the State of North Carolina on May 30, 1997, and commenced operations as a state-chartered banking corporation on June 20, 1997. The Bank is not a member of the Federal Reserve System and has no subsidiaries. At a special meeting of shareholders held on March 26, 1999, the shareholders of Capital Bank approved the reorganization of Capital Bank into Capital Bank Corporation. In the holding company reorganization, the shareholders of Capital Bank each received a right to one share of Company stock for each share of Capital Bank stock that they owned. Thus, the shareholders of Capital Bank before the holding company reorganization are now the shareholders of the Company. In addition, on March 31, 1999 the Company completed its acquisition of Home Savings Bank of Siler City SSB, Inc. in a stock-for-stock exchange in which the Company issued 1,181,038 shares of its Common Stock. On July 16, 1999, Home Savings Bank merged with Capital Bank to form one subsidiary under Capital Bank Corporation. Prior to the merger date, Home Savings Bank capitalized the holding company with an upstream dividend of $100,000. In conjunction with the merger, the common stock of Home Savings Bank was retired. As used in this report, the term "Company" refers to Capital Bank Corporation and its subsidiary, Capital Bank, after the holding company reorganization. As of December 31, 1999, the Company had assets of approximately $222.3 million, gross loans outstanding of approximately $159.3 million and deposits of approximately $163.2 million. The Company's corporate and main office is located at 4400 Falls of Neuse Road, Raleigh, North Carolina 27609, and its telephone number is (919) 878-3100. In addition to the main office, the Company has two branch offices in Cary, one in Siler City, and three in Sanford, North Carolina. The Bank is a locally-owned community bank engaged in the general commercial banking business in Wake, Chatham and Lee Counties, North Carolina. Wake County has a diversified economic base, comprised primarily of services, retail trade, government and manufacturing and includes the City of Raleigh, the state capital. Lee and Chatham Counties are significant centers for various industries, including agriculture, manufacturing, lumber and tobacco. The Bank offers a full range of banking services, including checking accounts, savings accounts, NOW accounts, money market accounts and certificates of deposit; loans for real estate, businesses, agriculture, personal uses, home improvement and automobiles; equity lines of credit; credit cards; individual retirement accounts; safe deposit boxes; bank money orders; electronic funds transfer services including wire transfers; traveler's checks; and free notary services to all Bank customers. In addition, the Bank provides automated teller machine access to its customers for cash withdrawals through nationwide ATM networks. At present, the Bank does not provide the services of a trust department. Recent Developments On January 21, 2000, the Company entered into a purchase and assumption agreement to acquire five branches that are being divested in connection with the merger of two other area financial institutions. Under this agreement, which is subject to regulatory approval, the Company will acquire the deposits, most of the loans and other assets of branches in Oxford (two locations), Warrenton, Seaboard and Woodland, North Carolina. Management expects each transaction to close in the second quarter of 2000. Lending Activities and Deposits Loan Types and Lending Policies. The Company makes a variety of loans, including loans secured by real estate, loans for commercial purposes and loans to individuals for personal and household purposes. There were no large concentrations of credit to any particular industry. The economic trends of the area served by the Company are influenced by the significant industries within the region. Consistent with the Company's emphasis on being a community-oriented financial institution, virtually all the Company's business activity is with customers located in the Cary, Siler City, Raleigh and Sanford areas. The ultimate collectibility of the Company's loan portfolio is susceptible to changes in the market conditions of this geographic region. The Company uses a centralized risk management process to insure uniform credit underwriting that adheres to bank policy. Lending policies are reviewed on a regular basis to confirm that the Company is prudent in setting its underwriting criteria. Credit risk is managed through a number of methods including loan grading of commercial loans, committee approval of larger loans, and class and purpose coding of loans. Management believes that early detection of credit problems through regular contact with the Company's clients coupled with consistent reviews of the borrowers' financial condition are important factors in overall credit risk management. The following table sets forth, as of December 31, 1999, the approximate composition of the Company's loan portfolio: Loan Type Amount Percentage --------- ------ ---------- (in thousands) Commercial............................... $104,572 65.5% Consumer................................. 11,444 7.2 Real Estate.............................. 31,533 19.8 Equity Lines............................. 12,008 7.5 ------ ------ Total........................ $159,557 100.0% ======== ====== Deposits. The majority of the Company's customers are individuals and small to medium-size businesses located in Wake, Chatham and Lee Counties, North Carolina and contiguous areas. The Company's deposits and loans are well diversified, with no material concentration in a single industry or group of related industries. The management of the Company does not believe that the deposits or the business of the Company in general are seasonal in nature. The deposits may, however, vary with local and national economic conditions but not enough, management believes, to have a material effect on planning and policy making. The Company attempts to control deposit flow through the pricing of deposits and promotional activities. Management believes that the Company's rates are competitive with those offered by other institutions in Cary, Sanford, Siler City and Raleigh. The following table sets forth the mix of depository accounts at the Company as a percentage of total deposits as of December 31, 1999: Non-interest bearing demand ..................... 6.7% Interest checking ............................... 6.8 Market rate investment .......................... 15.9 Savings ........................................ 3.1 Time deposits Under $100,000................................. 55.7 Equal to or over $100,000...................... 11.8 ------ 100.0 % Competition Commercial banking in North Carolina is extremely competitive in large part due to statewide branching. The Company competes in its market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of the Company's competitors have broader geographic markets and higher lending limits than the Company and are also able to provide more services and make greater use of media advertising. The enactment of legislation authorizing interstate banking has caused great increases in the size and financial resources of some of the Company's competitors. In addition, as a result of interstate banking, out-of-state commercial banks may acquire North Carolina banks and heighten the competition among banks in North Carolina. Despite the competition in its market area, the Company believes that it has certain competitive advantages that will distinguish it from its competition. The Company believes that its primary competitive advantages are its strong local identity and affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The Company offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The Company offers many personalized services and intends to attract customers by being responsive and sensitive to their individualized needs. The Company also relies on goodwill and referrals from shareholders and satisfied customers, as well as traditional media to attract new customers. To enhance a positive image in the community, the Company supports and participates in local events and its officers and directors serve on boards of local civic and charitable organizations. Employees At March 15, 2000, the Company employed 77 persons, of which 74 were full-time and 3 were part-time. None of its employees are represented by any collective bargaining unit. The Company considers relations with its employees to be good. Supervision and Regulation Holding companies, banks and many of their non-bank affiliates are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules and regulations affecting the Company and the Bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to the Company's or the Bank's business. Supervision, regulation and examination of the Company and the Bank by bank regulatory agencies is intended primarily for the protection of the Bank's depositors rather than holders of the Common Stock of the Company. Holding Company Regulation General. The Company is a holding company registered with the Federal Reserve under the Bank Holding Company Act of 1956 (the "BHCA"). As such, the Company and the Bank are subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The BHCA requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than five percent of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, (iii) acquiring all or substantially all of the assets of any bank or (iv) merging or consolidating with any other bank holding company. The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, conducting discount securities brokerage activities, performing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities. Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including the Company, provided the nature of the activity has been approved by the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it has reasonable cause to believe that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company. Recent Developments. On November 12, 1999, the President of the United States signed into law the Gramm-Leach-Bliley Act ("GLB"), which alters the regulatory framework for banking and other financial services companies. The GLB creates a new type of holding company called a "financial holding company." The new financial holding company structure allows banks, insurance companies, and securities firms to affiliate within a single entity, provided that the financial holding company satisfies and maintains certain new regulatory standards. Bank holding companies that meet these standards may elect to become financial holding companies, but if they remain bank holding companies, they are subject to the restrictions on their activities existing prior to the GLB, including those restrictions described above imposed by the BHCA. The Company has not elected to become a financial holding company, so it remains under essentially the same regulatory framework as it did before the enactment of the GLB. However, the financial holding company structure created by the GLB would allow insurance companies or securities firms operating under the financial holding company structure to acquire the Company, and, if the Company elects to become a financial holding company in the future, it could acquire insurance companies or securities firms. In addition to creating the more flexible financial holding company structure, GLB introduced several additional customer privacy protections that will apply to the Company and the Bank. Federal regulators have issued a draft of proposed privacy regulations implementing these protections for comment. Pursuant to the GLB's rulemaking provisions, regulations must be adopted by May 12, 2000, and institutions must begin privacy disclosures under the GLB within six months of adoption of such regulations. The GLB's privacy provisions require financial institutions to, among other things, (i) establish and annually disclose a privacy policy, (ii) give consumers the right to opt out of disclosures to nonaffiliated third parties, with certain exceptions, (iii) refuse to disclose consumer account information to third-party marketers and (iv) follow regulatory standards to protect the security and confidentiality of consumer information. Mergers and Acquisitions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "IBBEA") permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, prior to, or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the U.S. and no more than 30% of such deposits in any state (or such lesser or greater amount set by state law). In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997. The state of North Carolina has "opted in" to such legislation, effective June 22, 1995. In addition, a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. As a result of North Carolina's opt-in law, North Carolina law permits unrestricted interstate de novo branching. Additional Restrictions and Oversight. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are also prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries. The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve also regulates certain debt obligations, changes in control of bank holding companies and capital requirements. Under the provisions of the North Carolina law, the Company is registered with and subject to supervision by the North Carolina Commissioner of Banks (the "Commissioner"). Capital Requirements. The Federal Reserve has established risk-based capital guidelines for bank holding companies and state member banks. The minimum standard for the ratio of capital to risk-weighted assets (including certain off balance sheet obligations, such as standby letters of credit) is eight percent. At least half of this capital must consist of common equity, retained earnings and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less certain goodwill items ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist of mandatory convertible debt securities and a limited amount of other preferred stock, subordinated debt and loan loss reserves. In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts ("Leverage Ratio") equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent. The guidelines also provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, will be expected to maintain strong capital ratios substantially above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") will continue to consider a "tangible Tier 1 Leverage Ratio" (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised the Company of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to it. As of December 31, 1999, the Company had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 19.31%, 20.56% and 15.49%, respectively, all in excess of the minimum requirements. Bank Regulation The Bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the Commissioner and the Federal Reserve. The Federal Reserve and the Commissioner regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations, and other similar corporate actions, and to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The Federal Reserve and the Commissioner regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, issuances of securities, capital adequacy, loss reserves, and compliance with the Community Reinvestment Act of 1977 (the "CRA") as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are also subject to state usury laws and certain federal laws concerning interest rates. The deposit accounts of the Bank are insured by the Bank Insurance Fund (the "BIF") of the Federal Deposit Insurance Corporation (the "FDIC") up to a maximum of $100,000 per insured depositor. The FDIC issues regulations and conducts periodic examinations, requires the filing of reports and generally supervises the operations of its insured banks. This supervision and regulation is intended primarily for the protection of depositors. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies, and directives may be sanctioned for noncompliance. Civil and criminal proceedings may be instituted against any insured bank or any director, officer or employee of such bank for the violation of applicable laws and regulations, breaches of fiduciary duties or engaging in any unsafe or unsound practice. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose. Under the North Carolina corporation laws, the Company may not pay a dividend or distribution, if after giving it effect, the Company would not be able to pay its debts as they become due in the usual course of business or the Company's total assets would be less than its liabilities. In general, the Company's ability to pay cash dividends is dependent upon the amount of dividends paid by the Bank. The ability of the Bank to pay dividends to the Company is subject to statutory and regulatory restrictions on the payment of cash dividends, including the requirement under the North Carolina banking laws that cash dividends be paid only out of undivided profits and only if the bank has surplus of a specified level. The Federal Reserve also imposes limits on the Bank's payment of dividends. Like the Company, the Bank is required by federal regulations to maintain certain minimum capital levels. The levels required of the Bank are the same as required for the Corporation. At December 31, 1999, the Bank had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 19.31%, 20.56% and 15.49%, respectively, all in excess of the minimum requirements. The Bank is subject to insurance assessments imposed by the FDIC. Effective January 1, 1997, the FDIC adopted a risk-based assessment schedule providing for annual assessment rates ranging from 0 cents to 27 cents for every $100 in assessable deposits, applicable to institutions insured by both the BIF and the Savings Association Insurance Fund ("SAIF"). The actual assessment to be paid by each insured institution is based on the institution's assessment risk classification, which focuses on whether the institution is considered "well capitalized," "adequately capitalized" or "under capitalized," as such terms are defined in the applicable federal regulations. Within each of these three risk classifications, each institution will be assigned to one of three subgroups based on supervisory risk factors. In particular, regulators will assess supervisory risk based on whether the institution is financially sound with only a few minor weaknesses (Subgroup A), whether it has weaknesses which, if not corrected, could result in an increased risk of loss to the BIF (Subgroup B) or whether such weaknesses pose a substantial risk of loss to the BIF unless corrective action is taken (Subgroup C). The FDIC also is authorized to impose one or more special assessments in an amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the United States Treasury Department and, beginning in 1997, all banks are required to pay additional annual assessments at rates set by the Financing Corporation, which was established by the Competitive Equality Banking Act of 1987. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a "prompt corrective action" system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums. A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. Banks are also subject to the CRA, which requires the appropriate federal bank regulatory agency, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate-income neighborhoods. Each institution is assigned one of the following four ratings of its record in meeting community credit needs: "outstanding," "satisfactory," "needs to improve" or "substantial noncompliance." The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. Effective May 12, 2000, the GLB's "CRA Sunshine Requirements" call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements also must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require. This annual reporting requirement is effective for any agreements made after May 12, 2000. Monetary Policy and Economic Controls The Company and the Bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve Board, whose actions directly affect the money supply which, in turn, affects banks' lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve Board regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits. Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks' cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of the Bank or the Company. As a result, banks, including the Bank, face a significant challenge to maintain acceptable net interest margins. Executive Officers The executive officers of the Company are as follows: Name Age Position With Company - ---- --- --------------------- James A. Beck 47 President and Chief Executive Officer Allen T. Nelson, Jr. 50 Senior Vice President, Chief Financial Officer and Secretary Franklin G. Shell 41 Senior Vice President and Senior Credit Officer James A. Beck is currently President and Chief Executive Officer of the Company, a position he has held since the Company commenced operations. Mr. Beck served as Chairman, President and Chief Executive Officer of SouthTrust Bank of North Carolina, N.A. from January 1991 until June 1996 when it was merged into the SouthTrust Charlotte-based bank. Mr. Beck thereafter served as President and a director of the combined bank until January 1997, when he resigned to join the Company. Allen T. Nelson, Jr. has been employed by the Company since February 2, 1998, as its Chief Financial Officer and Secretary. From December 1993 through January 1998, Mr. Nelson served as the Senior Vice President and Chief Financial Officer for Jefferson Bankshares, Inc. and its principal subsidiary, Jefferson National Bank, both based in Charlottesville, Virginia. Franklin G. Shell has been employed with the Company since April 14, 1997, as its Senior Vice President and Senior Lending Officer. Prior thereto, from 1989, Mr. Shell was employed by the North Carolina-based bank, Branch Banking and Trust Company, serving as a commercial loan officer in its Raleigh, North Carolina office. Item 2. Item 2. Properties. The Company currently leases an aggregate of 5,700 square feet of office space located at 4400 Falls of Neuse Road, Raleigh, North Carolina for the Company's headquarters and main office pursuant to three lease agreements. These lease agreements expire on September 29, 2000, December 31, 2000, and December 31, 2000, respectively. In November 1999, the Company entered into a lease agreement for approximately 17,500 square feet, of which approximately 14,500 square feet is for the Company's principal offices and the remainder for a new branch office. The property is located at 4901 Glenwood Avenue, Raleigh, North Carolina. This lease is scheduled to begin on May 1, 2000 and has a ten-year term with two five-year renewal options. For the first twelve months, monthly rent for the branch bank space is $5,375 and for the office space is $20,954. The monthly rent is subject to annual cost of living increases after the first year. In June 1997, the Company opened a branch office at 129 South Steele Street, Sanford, North Carolina which it moved to 130 North Steele Street, Sanford, North Carolina in November 1997. The Company entered into a lease in October 1997 with Global House, Inc. for approximately 5,300 square feet for this branch office. This lease is for a ten-year term with monthly rent of $2,600 and has two five-year renewal options. In June 1997, the Company opened a branch office at 2800 Williams Street, Sanford, North Carolina. The Company entered into a lease with Buchanan Properties Joint Venture for approximately 1,800 square feet for this branch office. This lease was renewed in October, 1998 and extended for a five-year term with monthly rent of $850. On March 20, 1998, the Company opened a branch office located at 915 North Harrison Avenue, Cary, North Carolina. Formerly the site of a United Carolina Bank branch office (prior to that bank's acquisition by BB&T), the branch consists of approximately 1.14 acres of real property and a free-standing building of approximately 2,700 square feet which are owned by the Company. On September 8, 1998, the Company opened a branch office located at 1201 Kildaire Farm Road, Cary, North Carolina. The building, approximately 2,800 square feet, was purchased from another financial institution but the real property, which consists of approximately 1.14 acres, is leased under an arrangement with Triangle V III, Limited Partnership. The lease, which calls for monthly rent of $1,336, was assumed from the previous tenants and expires in December, 2004 with four five-year renewal options. On March 31, 1999, the Company completed the acquisition of Home Savings Bank of Siler City, Inc., SSB and converted the existing branch in that town, located at 300 East Raleigh Street, Siler City, North Carolina, into another Capital Bank branch. The branch consists of approximately 1.25 acres of real property and a free-standing building of approximately 7,400 square feet which are owned by the Company. On December 6, 1999, the Company opened a branch office located at 2222 Jefferson Davis Highway, Sanford, North Carolina. The branch, which was under construction for most of 1999, consists of approximately .73 acres of real property and a free-standing building of approximately 2,450 square feet which are owned by the Company. Item 3. Item 3. Legal Proceedings. There are no pending legal proceedings to which the Company is a party or of which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on the Company's business, operating results or financial condition. Item 4. Item 4. Submission of Matters To A Vote Of Security Holders. During the fourth quarter of the year ended December 31, 1999, there were no matters submitted to a vote of the Company's shareholders. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Information relating to the market for the Company's Common Stock is incorporated by reference from the inside back cover of the 1999 Annual Report to Shareholders of Capital Bank Corporation, filed as Exhibit 13 to this report. Information relating to dividends on the Company's Common Stock is incorporated by reference from the section entitled "Capital Resources" on page 11 of the 1999 Annual Report, filed as Exhibit 13 to this report, and from Note 11 in the Notes to Consolidated Financial Statements on page 11 of the 1999 Annual Report, filed as Exhibit 13 to this report. Recent Sales of Unregistered Securities. The Company did not sell any securities in the fiscal year ended December 31, 1999 which were not registered under the Securities Act of 1933, as amended, except that during such fiscal year the Company granted options to employees and directors to acquire an aggregate of 34,400 shares of its Common Stock at a weighted average exercise price of $11.16 per share pursuant to the Company's Stock Option Plans. Item 6. Item 6. Selected Financial Data. This information is incorporated by reference from the inside cover of the 1999 Annual Report, filed as Exhibit 13 to this report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. This information is incorporated by reference from pages 4 through 12 of the 1999 Annual Report, filed as Exhibit 13 to this report. Item 7A. Item 7A. Quantitative and Qualitative Disclosure About Market Risk This information is incorporated by reference from page 12 of the 1999 Annual Report, filed as Exhibit 13 to this report. Item 8. Item 8. Financial Statements and Supplementary Data. This information is incorporated by reference from pages 13 through 29 of the 1999 Annual Report, filed as Exhibit 13 to this report. Item 9. Item 9. Changes In and Disagreements With Accountants On Accounting and Financial Disclosure. None. PART III This Part incorporates certain information from the definitive proxy statement (the "2000 Proxy Statement") for the 2000 Annual Meeting of Shareholders of Capital Bank Corporation, as filed with the Securities and Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this Report on Form 10-K. Item 10. Item 10. Directors and Executive Officers of the Registrant. Information concerning the Company's executive officers is included under the caption "Executive Officers" on pages 11 through 12 of this report. Information concerning the Company's directors and filing of certain reports of beneficial ownership is incorporated by reference to the 2000 Proxy Statement. Item 11. Item 11. Executive Compensation. This information is incorporated by reference to the Company's definitive proxy statement, dated March 20,2000, as filed with the Securities and Exchange Commission. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. This information is incorporated by reference to the Company's definitive proxy statement, dated March 20,2000, as filed with the Securities and Exchange Commission. Item 13. Item 13. Certain Relationships and Related Transactions. This information is incorporated by reference to the Company's definitive proxy statement, dated March 20,2000, as filed with the Securities and Exchange Commission. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports On Form 8-K. (a)(1) Financial Statements. The following financial statements included in the 1999 Annual Report, filed as Exhibit 13 to this report, are incorporated by reference in Item 8 of this report: (a)(2) Financial Statement Schedules. All applicable financial statement schedules required under Regulation S-X and pursuant to Industry Guide 3 under the Securities Act of 1933 have been included in the Notes to the Financial Statements. (a)(3) Exhibits. The exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index immediately following the signature pages to this report. (b) Reports on Form 8-K. The Company filed no reports on Form 8-K in the fourth quarter of the year ended December 31, 1999. FORWARD-LOOKING STATEMENTS Information set forth in this Annual Report on Form 10-K contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which statements represent the Company's judgment concerning the future and are subject to risks and uncertainties that could cause the Company's actual operating results and financial position to differ materially from the forward looking statements. Such forward looking statements can be identified by the use of forward looking terminology such as "may," "will," "expect," "anticipate," "estimate," "believe," or "continue," or the negative thereof or other variations thereof or comparable terminology. The Company cautions that any such forward looking statements are further qualified by important factors that could cause the Company's actual operating results to differ materially from those in the forward looking statements, including without limitation, the Company's management of its growth, the risks associated with possible or completed acquisitions, competition within the industry, dependence on key personnel, government regulation and the other risk factors described in Exhibit 99 attached to this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in Raleigh, North Carolina, on the 16th day of March, 2000. CAPITAL BANK CORPORATION By: /s/ James A.Beck ----------------- James A. Beck President and Chief Executive Officer SIGNATURES AND POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints James A. Beck and Allen T. Nelson, Jr., and each of them, with full power to act without the other, his true and lawful attorneys-in-fact and agents, with full powers of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Federal Deposit Insurance Corporation, granting unto said attorneys-in-fact and agents full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully for all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated and on March 16, 2000. - -------------------------- 1 Incorporated by reference to the Company's Registration Statement on Form 14 filed with the SEC on October 19, 1998, as amended on November 10, 1998, December 21, 1998 and February 8, 1999. 2 Denotes a management contract or compensatory plan, contract or arrangement.

66960_1999.txt

66960_1999

1999

66960

ITEM 1. BUSINESS. ORGANIZATION AND HISTORY UtiliCorp United Inc. (the company, which may be referred to as we, us, or our) is a multinational energy solutions provider. We conduct business through the following business segments: - - NETWORK - includes our domestic and international network generation, distribution and transmission businesses, as well as our appliance repair/servicing businesses. International operations include activities in Australia, New Zealand and Canada. - - ENERGY MERCHANT - includes our domestic and international energy marketing and trading businesses; our natural gas gathering, processing and transportation company; and our 14 independent power projects. International operations are head-quartered in London, England. Prior to 1999, activity was limited to United Kingdom gas marketing and trading. In 1999, the business commenced expansion into other energy markets both within the United Kingdom and across Europe. New offices were opened in Spain, Germany and Norway. - - SERVICES - includes our investment in Quanta Services, Inc. (Quanta). Quanta is a provider of specialized construction services to electric utilities, telecommunications and cable television companies, and governmental entities. - - CORPORATE AND OTHER -includes the retained costs of the company that are not allocated to the business units, and prior to 1998, the net losses from our investments in Energy One, L. L. C. OUR STRATEGIC OBJECTIVES Our strategy is to be a world-class manager of energy delivery networks and production assets, and to be a leading energy merchant in the markets in which we compete. We believe that our globalized energy network and merchant strategies position us to compete effectively in a deregulated energy marketplace. THE FOLLOWING OBJECTIVES ARE THE TOOLS BY WHICH WE WILL IMPLEMENT OUR STRATEGIES: OBJECTIVE #1: WORLD CLASS MANAGER OF ENERGY NETWORK AND PRODUCTION ASSETS - - ACHIEVE OPERATIONAL EXCELLENCE by providing quality customer service through the delivery of an easy to use, safe, reliable product at a reasonable price, while earning a solid return for shareholders. - - CREATE ENERGY SOLUTIONS in an evolving utility industry by providing energy related products and services through existing sales channels supporting increased customer choice. - - DEVELOP PLATFORM FOR GROWTH by creating transferable models for customer service and operations that will bring added value for partnering opportunities. - - LEVERAGE MID-CONTINENT NATURAL GAS AND ELECTRIC SUPPLY MANAGEMENT CAPABILITIES by capitalizing on the opportunities being created with the transition of the utility industry into a competitive marketplace. - - ACQUIRE AND/OR REPOSITION NETWORK AND PRODUCTION ASSETS with targeted deployment of capital to new projects and businesses. OBJECTIVE #2: LEADING ENERGY MERCHANT - - DIVERSIFY RISK by expanding the commodity portfolio. - - EXPAND CONTROL OF MID-STREAM ASSETS to facilitate longer term complex transactions, provide earnings and balance sheet growth, and diversify the asset portfolio risk. - - INCREASE PRODUCT OFFERINGS to include new commodities, financing, and retail aggregator products. - - EXPAND CUSTOMER CHANNELS to include contacts at the Chief Executive Officer, Chief Financial Officer, and Senior Vice President level. - - LEVERAGING THE INFRASTRUCTURE to: 1) provide increased physical and financial risk clearing capability at the lowest cost possible per volumetric unit; 2) leverage systems, processes, and people into new markets; and 3) leverage the operational infrastructure through consolidation and partnering with other operators. OBJECTIVE #3: GLOBALIZE ENERGY NETWORK AND MERCHANT STRATEGIES - - ACQUIRE NETWORK, PRODUCTION, AND MERCHANT ENERGY ASSETS in current foreign markets, taking advantage of growing privatization and restructuring trends. - - MANAGE TO ACHIEVE OPERATIONAL EXCELLENCE; harvesting value and capital by partial sales of high performing businesses. - - DEVELOP MERCHANT BUSINESSES in locations where an existing network operation or relationship exists and the restructured utility environment provides favorable economic returns. - - LEVERAGE AND TRANSFER INFRASTRUCTURE, knowledge and people between foreign and U.S. operations. OUR COMPETITIVE STRENGTHS. We believe we have developed substantial competitive strengths that will enable us to continue to successfully execute our strategy and grow earnings. Our strengths include: - - An experienced management team whose compensation is directly tied to shareholder value. - - Low cost, non-nuclear domestic and international network businesses focused on superior customer service. - - Successful operation of competitive non-regulated business. - - Third largest energy position on a BTU basis. - - Proven risk management policies and procedures to limit exposure to commodity market positions. - - International operations in Australia, New Zealand, Europe and Canada from which we believe we have gained valuable experience in competitive markets. - - A proven track record of quickly and successfully integrating domestic and international mergers and acquisitions. - - A demonstrated ability to identify and react to new business opportunities. MERGERS, ACQUISITIONS & DIVESTITURES ST. JOSEPH LIGHT & POWER On March 4, 1999, St. Joseph Light & Power Company (SJL&P) agreed to merge with us. Under the agreement, SJL&P shareholders will receive $23.00 in UtiliCorp common shares for each SJL&P common share held. We will account for the transaction as a purchase. This transaction was approved by SJL&P shareholders on June 16, 1999, and is also subject to approval by various state and federal regulatory agencies. We and SJL&P filed a joint application with the Missouri Public Service Commission (MPSC) on October 19, 1999, requesting approval of the plans to merge in a transaction valued at approximately $270 million. We expect to close this transaction in the second half of 2000. NATURAL GAS STORAGE FACILITY On March 29, 1999, we agreed to purchase Western Gas Resources Storage Inc. The $100 million cash transaction increased our ownership and control of strategically located natural gas storage assets. The 2,200-acre subsurface facility in Katy, Texas has a storage capacity of 20 billion cubic feet. The purchase closed on May 3, 1999. AQUILA TENDER OFFER On May 7, 1999, approximately 3.4 million shares of Aquila Gas Pipeline Corporation (AQP) were tendered to us at $8.00. The 3.4 million shares together with the 24.0 million shares already held represented 93% of AQP's total shares outstanding. All remaining shares not tendered were converted in a "short-form" merger into a right to receive $8.00 per share. Upon completion of the short-form merger on May 14, 1999, AQP ceased being a publicly traded company and became wholly-owned by Aquila Energy Corporation (AEC). EMPIRE DISTRICT ELECTRIC COMPANY On May 10, 1999, The Empire District Electric Company (Empire) agreed to merge with us. Empire's shareholders approved the merger on September 3, 1999. Upon closing, they will be entitled to receive $29.50 for each share of Empire common stock held, payable in either cash or our common stock. The value of the merger consideration per share will decrease if our common stock is trading below $22 per share at closing and will increase if our common stock is trading above $26 per share at closing. The consideration paid to Empire shareholders, estimated to be $800 million, including the assumption of debt, is subject to certain conditions, such as cash and stock maximums, as well as certain regulatory approvals. We filed a joint application with the Missouri Public Service Commission on December 15, 1999, requesting approval of the plans to merge. We expect this merger to be completed by late 2000. SALE OF WEST VIRGINIA POWER DIVISION On September 9, 1999, we agreed to sell our West Virginia Power division to Allegheny Energy, Inc. for $75 million. The sale closed on December 31, 1999 and resulted in a fourth quarter gain of $4.5 million. In addition to the sale of West Virginia Power's electric and natural gas distribution assets, we entered into a separate agreement for Allegheny to purchase Appalachian Electric Heating, our heating and air conditioning service business in West Virginia. SALE OF RETAIL MARKETING In January 2000, we sold our retail gas marketing business for $14 million. We expect to record a gain in the first quarter of 2000. As a result of our assessment of retail competition possibilities, we have now exited all domestic retail energy activities until the market more fully develops. TRANSALTA ASSETS In February 2000, we agreed to acquire TransAlta Corporation's Alberta-based electricity distribution and retail assets for $450 million. The transaction includes 350,000 customers served by about 54,000 miles of low-voltage power distribution lines, and a 24-hour customer call center in Calgary. The transaction is subject to regulatory approvals in Canada and the United States and is expected to close in 2000. INITIAL PUBLIC OFFERING-UNITED ENERGY LIMITED In May 1998, United Energy Limited (UEL) sold 42% of its common stock to the Australian public. As a result, we recorded a $45.3 million gain. The partial sale to the public reduced our effective ownership of UEL to 29%. Concurrent with UEL's stock offerings, we bought an additional 5% in UEL from another company to bring our ownership to 34%. Prior to the common stock sale, UEL repaid us approximately $101 million for debt notes. The management agreement between UEL and UtiliCorp remains in place. MULTINET/IKON On March 12, 1999, we acquired, for $224 million, a 25.5% interest in Multinet/Ikon, a natural gas network and retailer in Victoria, Australia. QUANTA SERVICES, INC. On September 23, 1999, we invested $186 million in Quanta Services, Inc. (Quanta) preferred stock. The preferred stock is convertible into $6.2 million common shares based on a strike price of $30. This investment is accounted for by the equity method of accounting. We received a $7.6 million management and advisory fee from Quanta during 1999 which is reflected as equity earnings in the accompanying consolidated statement of income. In addition, we have purchased approximately $5.2 million shares of Quanta's common stock on the open market and in privately negotiated transactions. PULSE ENERGY On March 8, 2000, United Energy announced the formation of Pulse Energy, a joint venture in collaboration with Energy Partnership (Ikon Energy Pty Ltd), Shell Australia Ltd, and Woodside Energy Ltd. Pulse Energy will initially service more than one million Victoria, Australia customers with the aim of rapidly becoming a national energy player. The transaction is subject to banking and regulatory approvals. With much of the Australian retail energy market becoming contestable after 2000, Pulse Energy will provide Australia's first large-scale combination of electric and gas services and will have access to potentially 10 million energy customers in eastern Australia and southern Australia commencing January 2001. Effective ownership of Pulse Energy will comprise Shell (40%), United Energy (25%), Energy Partnership (25%) and Woodside (10%). NEW ZEALAND GAS DISTRIBUTION NETWORK On March 22, 2000, we expanded our presence in the New Zealand energy market by purchasing the natural gas distribution network and North Island contracting business of Orion New Zealand Limited for $US 268 million. Much of the gas service territory being acquired overlaps or borders UnitedNetworks' electric distribution areas, creating synergies between our gas and electric operations. Concurrent with the closing of this transaction, we will be pursuing the sale of a portion of our interests in the New Zealand holding company to a private equity investor. This should allow us to remove about $US 450 million of existing New Zealand debt from our balance sheet because of the change in our ownership interest. The debt expected to be incurred to complete the Orion transaction also will not be shown on our balance sheet. We expect our consolidated common equity ratio to immediately improve to an estimated 43% as a result of our reduced ownership. (This estimate assumes 70% conversion of our premium equity participating securities.) This transaction is conditional on UnitedNetworks' shareholder approval and the transaction has an effective date after April, 2000. The UnitedNetworks' shareholder meeting will be held in mid-April 2000. BUSINESS GROUP SUMMARY Segment information for the three years ended December 31, 1999 is incorporated by reference to pages 54 through 56 of our 1999 Annual Report to Shareholders. I. NETWORK ELECTRIC OPERATING STATISTICS The following table summarizes sales, volumes and customers for our North American electric network generation, transmission and distribution businesses. GAS OPERATING STATISTICS The following table summarizes sales, volumes and customers for our North American gas network businesses. REGULATION The following is a summary of our pending rate case activity. *ESTIMATED DATE OF REQUEST, AMOUNT NOT YET DETERMINED. In January 2000, we were ordered to reduce Kansas electric rates by $8.7 million. The order is currently being reconsidered by the commission based upon a request by the Company. A final order is expected by late March or early April. The Commission staff originally recommended a rate reduction of $19.9 million. ENVIRONMENTAL We are currently named as a potentially responsible party (PRP) at three PCB disposal sites. Our combined cleanup expenditures have been less than $1 million to date at these and other PCB disposal sites for which we have been named a PRP but have settled our liability. We anticipate that future expenditures on the three sites where we are currently named as a PRP will not be significant. We also own or once operated 29 former manufactured gas plants sites (MGP's) which may require some form of environmental remediation. As of December 31, 1999 we estimate cleanup costs on these identified sites to be $14.4 million (see Note 14 to the Consolidated Financial Statements for further discussion of this topic). In October 1998, the EPA published new air quality standards to further reduce the emission of NOx. These stricter standards will require us to install new equipment on our baseload coal units in Missouri that we estimate will cost $35 million. The new standards are under debate in the courts and our ultimate cost is therefore subject to change. The new standards as written are effective in May 2003. SEASONAL VARIATIONS OF BUSINESS Our network and independent power project businesses are weather-sensitive. We have both summer and winter peaking network assets to reduce dependence on a single peak season. The table below shows peak times for our North American network businesses. INTERNATIONAL NETWORK OPERATIONS Our international network operations are managed consistent with the strategies of our domestic network business segment. We manage our international business with local management that reports separately to the company. The contribution to earnings before interest and taxes from international network businesses was 31.4%, 31.6% and 17.5% of our total for the years ended December 31, 1999, 1998 and 1997, respectively. As of December 31, 1999, approximately $1,792.1 million of our total assets relate to our international network businesses. The following discussion briefly describes our international network businesses. AUSTRALIA We acquired an effective 49.9% ownership interest in United Energy Limited (UEL), an electric distribution utility serving 546,000 customers in the state of Victoria. As part of a management agreement between us and UEL, we manage the utility for a fee as well as participate in its earnings. In May 1998, UEL sold 42% of its common stock to the Australian public and as a result, we recorded a $45.3 million gain. The partial sale to the public reduced our effective ownership percentage to 29%. Concurrent with UEL's stock offerings, we bought an additional 5% in UEL from another company to bring our ownership to 34%. Prior to the common stock sale, UEL repaid approximately $101 million in debt notes owed to us. The management agreement between us and UEL remains in place. UEL distributes and sells electricity with a majority of its sales earned from the regulated distribution network business. The regulated distribution sales and connection charges for access to its distribution system will be reviewed by the Office of the Regulator-General(OGR), with new rates becoming effective January 1, 2001. The retail electric market in which UEL operates is being progressively opened to competition, with all customers becoming contestable by January 1, 2001. The following table shows the timing of electricity markets opening to competition in Victoria: In March 1999, we acquired a 25.5% interest in a gas distribution and retail business in Melbourne. The distribution business, Multinet, serves approximately 609,000 accounts, and the retail business, Ikon, serves approximately 520,000 customers. About 309,000 Multinet distribution customers are served by the Ikon retail business and approximately 280,000 Ikon customers are served electricity by United Energy. The gas business is managed by United Energy and pay UEL a fee for those services. Similar to electricity, retail gas customers in Victoria will all be able to select the retailer of their choice. The following table shows the timeline for the rollout of gas contestibility in Victoria: NEW ZEALAND Through a series of transactions in 1998, we acquired an additional 48% interest in Power New Zealand's common stock for approximately $245 million, increasing our ownership to 78.6%. Concurrent with this acquisition, we sold our 39.6% interest in WEL Energy Group, which we acquired in 1993 and bought out our 21% minority partner in our New Zealand subsidiary, UtiliCorp N.Z., Inc. In January 1999, an additional .2% interest was purchased from the Territorial Local Authorities. The Electricity Industry Reform Act of 1998 required all of New Zealand's integrated power companies have separate ownership of their lines (network) and energy (generation and retail) businesses effective April 1, 1999. Power New Zealand, with approximately 90% of its assets and earnings in the lines area, in November 1998, announced its intention to remain in the network business and to exit the energy business. It also agreed to purchase the Wellington-based lines assets of TransAlta New Zealand Ltd. and to sell to TransAlta its retail and generation businesses for net expenditure by Power New Zealand of $238 million. Because Power New Zealand's name transferred to TransAlta as part of the retail business TransAlta acquired, the network business became UnitedNetworks Limited on January 5, 1999. In November 1998, Power New Zealand agreed to purchase the electric line assets of neighboring power company TrustPower Limited for approximately $261 million. The assets became part of a greater network which includes parts of metropolitan Auckland and other areas in the central and southern regions of New Zealand's North Island. The TrustPower transaction closed January 31, 1999. Completion of the TransAlta and TrustPower transactions created the country's largest electricity distribution network, serving about 484,000 customers. CANADA We own West Kootenay Power Ltd.(WKP), a hydro-electric utility in British Columbia, Canada. WKP has four hydro-electric generation facilities with a capacity of 205 megawatts and 962 miles of transmission lines that serve approximately 135,000 direct and indirect customers in south central British Columbia. WKP generates about half of its power requirements and purchases the remaining requirements through power contracts. WKP is regulated by the British Columbia Utilities Commission. The Commission approved renewal of the incentive based rate setting mechanism for 2000. When first implemented in 1996, this mechanism was the first of its kind for electric utilities in Canada and was the result of a negotiated settlement with customers and regulators. The mechanism calls for sharing of savings between the customer and WKP if WKP performs over and above negotiated performance expectations. II. ENERGY MERCHANTS WHOLESALE ENERGY MARKETING Aquila's wholesale energy marketing business is conducted through various operating units, collectively referred to as Energy Marketing. Energy Marketing is a gas and power marketing company with a marketing, supply and transportation network consisting of relations with gas producers, local distribution companies, and end-users throughout the United States and Canada. Energy Marketing adds value for customers by leveraging its national position in financial deal structuring in gas and power marketing. It provides services such as complex fuel supply arrangements, energy management services and project development focused on control of mid-stream energy assets. For the five years ended December 31, 1999, Energy Marketing had marketing volumes of 9.9, 8.8, 5.7, 2.3, and 1.5 billion cubic feet a day (BCF/d), respectively. In 1995, Energy Marketing began selling electricity to wholesale customers, much as it markets natural gas. Aquila expects that the electricity marketing industry will continue to expand rapidly as liquidity and maturity increases. Aquila's wholesale power sales have grown from 129,000 megawatt hours (MWH) in 1995 to 236,500 million MWH in 1999, ranking it third among the nation's largest volume power marketers. Energy Marketing utilizes certain types of fixed-price contracts in connection with its natural gas and power marketing businesses. These include contracts that commit us to purchase or sell natural gas and other commodities at fixed prices in the future (i.e., fixed-price forward purchase and sales contracts), futures and options contracts traded on the NYMEX and swaps and other types of financial instruments traded in the over-the-counter financial markets. The availability and use of these types of contracts allows us to manage and hedge our contractual commitments, reduce our exposure relative to the volatility of cash market prices, take advantage of carefully selected arbitrage opportunities via open positions, protect our investment in natural gas storage inventories and provide price risk management services to our customers. We are also able to secure additional sources of energy or create additional markets for existing supply through the use of exchange for physical transactions allowed by NYMEX. We refer to our domestic and Canadian natural gas and electricity trading activities as price risk management activities. These are reflected in the accompanying financial statements using the mark-to-market method of accounting. Although we generally attempt to balance our fixed-price physical and financial purchase and sales contracts in terms of contract volumes and the timing of performance and delivery obligations, net open positions often exist or are established due to the origination of new transactions and our assessment of, and response to, changing market conditions. We will occasionally create a net open position or allow a net open position to continue when we believe, based upon competitive information gained from our energy marketing activities, that future price movements will be consistent with our net open position. When we have a net open position, we are exposed to fluctuating market prices. In addition to price risk movements, credit risk is also inherent in our risk management activities. Our trading and marketing business is also exposed to counterparty credit risk resulting from a counterparty not fulfilling its contractual obligations. Our credit policies with regard to our counterparties attempt to minimize overall credit risk. Our credit procedures include a thorough review of potential counterparties' financial condition, collateral requirements under certain circumstances, monitoring of net exposure to each counterparty and the use of standardized agreements which allow for the netting of positive and negative exposures associated with each counterparty. Our credit policy is monitored and administered by a function independent of the trading and marketing activities. GAS GATHERING AND PROCESSING Aquila Gas Pipeline (AQP) gathers and processes natural gas and natural gas liquids. AQP owns and operates a 3,133 mile intrastate gas transmission and gathering network and four processing plants that extract and sell natural gas liquids. Key operating statistics for AQP are presented in the table below. Aquila Energy and AQP own 35% of the capital stock of Oasis Pipe Line Company (Oasis) and have 280 MMcf/d of firm intrastate transportation capacity. The 600-mile Oasis pipeline system spans the state of Texas and links Aquila's gathering systems to the Waha, Texas hub and the Katy, Texas hub. In 1998, AQP entered into a joint venture ownership and operation agreement with a third party in the Austin Chalk area in Texas to gather and transport the natural gas produced from specified wells. The sales contract accounted for approximately 18% of AQP's total natural gas sales in 1999. INDEPENDENT POWER PROJECTS Aquila Energy participates in the ownership and operation of facilities in the independent and wholesale power generation market. Consistent with the company's overall strategy to minimize risk through diversification, Aquila Energy has invested in generation facilities which are geographically diverse and use a variety of fuels and proven technologies. Additionally, each project is a producer of competitively priced wholesale power in its geographic region and has a long-term market for its output. To date, Aquila Energy has made investments in 14 projects located in five states and Jamaica, with a total net ownership of approximately 255 MW of generating capacity. A description and listing of the power projects appears on page 15 of this report. We anticipate further expansion or investment in the independent power projects business through a newly formed entity focused on mid-stream energy assets. INTERNATIONAL ENERGY MERCHANT OPERATIONS Our international energy merchant operations are managed consistently with the strategies of our domestic energy merchant business segment. We manage our international business with local management that reports separately to the company. The contribution to earnings before interest and taxes from our international energy merchant businesses was 6.6%, (2.2%), and (1.2%) of our total for the years ended December 31, 1999, 1998 and 1997, respectively. As of December 31, 1999, approximately $618.3 million of our total assets relate to our international energy merchant businesses. The following discussion briefly describes our international energy merchant businesses. UNITED KINGDOM AND EUROPE We have been involved in UK gas markets since these markets to competition in the early 1990's. The UK gas markets have been fully opened to competition since 1998 and all end users, including residential households, are now free to select their gas supplier. Many new retail gas suppliers have entered the market with the implementation of full competition. Our UK business developed a strong position in the supply of gas transportation/shipping and balancing services to these new entrants to the gas markets. In 1999, the process of rationalizing and consolidation of the new entrants commenced. Our contract with a major customer was terminated at the end of the third quarter when it was acquired by another firm. As a result, the end consumers indirectly served by Aquila as of December 31, 1999 was approximately 790,000, a net decrease of 210,000 indirect customers since December 31, 1998. We expect the process of market rationalization to continue. Similar deregulation and the opening to competition has been completed in the UK electricity market. We obtained our UK Public Electricity Supply License in 1999, and we expect to obtain approval for our data processing systems in mid-year 2000. This is a further requirement to interface with and supply electricity to end consumers on the regulated local distribution networks. We expect the capability to provide a "dual fuel" service will counter the impact of rationalization and consolidation of retail gas and power suppliers. We commenced trading in the UK wholesale electricity market in October 1999. The European Union (EU) has agreed Gas and Electricity Directives which require all the member states of the EU to open their domestic gas and electricity markets to competition over a number of years. (Some member states, including United Kingdom, have already opened their markets to competition prior to the EU adopting these Directives.) Each member state is following the mandated timetable in different fashions with some countries progressing much faster than others. We have responded to these new opportunities by expanding our energy merchant activities into selected European countries. In 1999, we opened offices in Spain, Germany and Norway. We commenced trading in the Nordic Power market in November 1999. We anticipate business growth in these countries and throughout Europe as the process of deregulation and market opening develops. In June 1998, we paid $25.6 million to a third party to cancel two take-or-pay contracts and related guarantees effective April 1, 1998, that required us to take gas at significantly above-market prices until 2005. Between 1995 and 1997, we reserved $19.0 million against the estimated future losses on these contracts, resulting in a one time net settlement loss of $6.6 million. In July 1998, we lost a long-standing dispute with one of our previous suppliers related to a take-or-pay gas supply contract. We contended that the supplier did not make proper deliveries pursuant to the supply contract and further materially breached the contract. Accordingly, we began paying the supplier the prevailing market prices, which were lower than the contract price. The difference between the two prices accumulated to approximately $38.0 million, an amount we had previously recorded as a liability. A court ruling required us to pay this $38.0 million price difference along with interest of $6.8 million that accumulated from the date the contract invoices were due. This interest payment was recorded as a one-time loss. We are appealing the court's decision and are seeking recovery of the $44.8 million. III. SERVICES The services segment, appearing for the first time in our 1999 financial statements, consists of our investment in Quanta Services, Inc. (Quanta). Quanta is a provider of specialized construction services to electric utilities, telecommunications and cable television companies, and governmental entities. The contribution to earnings before interest and taxes from the services business group was 3.2% of our total for the year ended December 31, 1999. In September 1999, we invested $186 million in Quanta Preferred Stock. The stock is convertible into 6.2 million common shares based on a strike price of $30. We received $7.6 million in management and advisory fees from Quanta during 1999, which is included, along with $5.6 million of equity earnings, in Equity in earnings of investments and partnerships in the accompanying consolidated statement of income. In addition, we have purchased approximately 5.2 million shares of Quanta Common Stock on the open market and in privately negotiated transactions bringing our equity interest to 28%. We account for this investment using the equity method. IV. CORPORATE & OTHER COMPETITION DOMESTIC UTILITY OPERATIONS. Our domestic network businesses operate in a regulated environment. Industrial and large commercial customers largely have access to energy sources so some of the competitive pricing benefits have been transferred to these customers through open access tariffs relating to transmission lines and pipelines. Without federal legislation, competition at the retail level cannot form since the rules will be different in each state. Based on our assessment of retail competition possibilities, we have now exited all domestic retail activities, until the market more fully develops. ACCOUNTING IMPLICATIONS. We currently record the economic effects of regulation in accordance with the provisions of Statement of Financial Accounting Standards No. 71 (SFAS No.71), "Accounting for the Effect of Certain Types of Regulation". Accordingly, our rates will continue to be based on historical costs for the foreseeable future. If we discontinue applying SFAS No 71, we would make adjustments to the carrying value of our regulatory assets. Total net regulatory assets at December 31, 1999 were $96.8 million. COMPETITION IN AUSTRALIA. The State of Victoria is deregulating its electricity market in stages. Currently, customers with yearly usage above 160 megawatt-hours (industrial and large commercial customers) can choose their retail electricity suppliers. After January 1, 2001, all customers of United Energy Limited (UEL) will be able to choose their retail electricity suppliers. A majority of UEL's gross margin comes from distribution lines charges that would not be materially affected by this customer choice. REGULATION IN NEW ZEALAND. A concerted effort is currently under way to gain consensus for a regulatory system that is developed and administered by the utility industry. We fully support this movement. NORTH AMERICAN ENERGY MARKETING. Our energy marketing businesses operate in a fully competitive environment that rewards participants on price, service, and execution. Our energy marketing businesses compete for customers with the largest energy companies in North America. The industry is premised on large-volume sales with relatively low margins. Companies that operate in this industry must fully understand the price sensitivity and volatility of commodities. The public became more aware of some of the risks associated with this industry when a number of companies announced sudden losses resulting from the June 1998 price spike in electricity. We expect price volatility and events like price spikes to occur and we have risk control policies in place for dealing with such events. EUROPEAN ENERGY MARKETING. Our energy marketing business in Europe continues to build its capability to offer new products in gas, electric and other energy related areas. Trading of electricity in the United Kingdom began in October 1999, and trading in the Nordic Power Market began in November 1999. In the 1999 fourth quarter, we lost a major customer when it was bought by another firm. The resulting drop in indirect customers served in the U.K. is expected to be offset by our expansion on the European Continent. RICHARD C. GREEN, JR. (B.S., BUSINESS - SOUTHERN METHODIST UNIVERSITY) Rick joined our company in 1976 and held various financial and operating positions between 1976 and 1982. In 1982, Rick was appointed Executive Vice President at Missouri Public Service, the predecessor to UtiliCorp. Rick has served as Chairman of the Board of the company since 1989 and President and Chief Executive Officer for the period 1985 through 1996. ROBERT K. GREEN (B.S., ENGINEERING, PRINCETON UNIVERSITY; J.D. LAW, VANDERBILT UNIVERSITY) Bob joined our company in 1988 as Assistant Division Counsel and in 1989 was appointed to Division Counsel. Between 1989 and 1992, he held executive level positions at Missouri Public Service. In 1993, Bob was appointed Executive Vice President and in 1996 assumed additional duties as President. He also is the Chairman of United Energy Limited, a 34% owned foreign traded Australian company, UnitedNetworks Limited, a 78.8% owned foreign traded New Zealand company, and Aquila Energy Corporation. JAMES G. MILLER (B.S., ELECTRICAL ENGINEERING, M.B.A., MANAGEMENT, UNIVERSITY OF WISCONSIN) Jim joined our company in 1983 as President, Michigan Gas Utilities, a company acquired by us in 1989. In 1991, he was appointed President, WestPlains Energy and in 1995 was appointed Senior Vice President, Energy Delivery. Prior to joining UtiliCorp, he worked for Wisconsin Power and Light Company in various financial and operating capacities. KEITH G. STAMM (B.S., MECHANICAL ENGINEERING, UNIVERSITY OF MISSOURI AT COLUMBIA; M.B.A., FINANCE EMPHASIS, ROCKURST COLLEGE.) Keith joined our company in 1983 as a staff engineer at our Sibley Power Plant. Between 1985 and 1995, he held various operating positions. In 1995, Keith was promoted to Vice President, Energy Trading and in 1996, to Vice President and General Manager, Regulated Power. In 1997, Keith became Chief Executive Officer of United Energy Limited. In December 1999, he was named Chief Executive Officer, Aquila Energy Corporation and remains a Director of United Energy Limited. EDWARD K. MILLS (B.A., ENGLISH, UNIVERSITY OF TEXAS; M.B.A., FINANCE, RICE UNIVERSITY) Ed joined our company in 1993 as Director of Risk Management and Trading, Aquila Energy Corporation. In 1998, Ed was appointed President and Chief Operating Officer, Aquila Energy Corporation and in July 1998, was appointed Vice President of UtiliCorp. Prior to joining our company, Ed held executive and management positions at Fina Oil and Chemical Company, Texas Commerce Bank and Springer Holding Company. JON R. EMPSON (B.A., ECONOMICS, CARLETON COLLEGE, M.B.A., ECONOMICS, UNIVERSITY OF NEBRASKA AT OMAHA) Jon joined our company in 1986 as Vice President, Regulation, Finance and Administration. In 1993, he was appointed Senior Vice President, Gas Supply and Regulatory Services and in 1996 he was appointed Senior Vice President, Regulatory, Legislative and Environmental Services. Prior to joining UtiliCorp, Jon worked for a predecessor company in various executive and management positions for 7 years, held executive management positions at the Omaha Chamber of Commerce and Omaha Economic Development Council and worked as an economist with the Department of Housing and Urban Development. PETER S. LOWE (BACHELOR OF COMMERCE DEGREE AND MASTER OF BUSINESS DEGREE, UNIVERSITY OF MELBOURNE) Peter joined our company in June of 1999 as Vice President, Financial Management and Accounting Services. In January 2000, he was named Senior Vice President and Chief Financial Officer. Prior to joining our company, Peter was Chief Financial Officer/Group Manager of Business Services for United Energy Limited, a 34% owned foreign traded Australian Company. He has also served in a number of managerial and executive positions with Foster's Brewing Group Limited. SALLY C. MCELWREATH (B.A., SOCIAL SCIENCES; M.B.A., PUBLIC RELATIONS, PACE UNIVERSITY) Sally joined our company in 1994 as Senior Vice President, Corporate Communications. Previously, she was Vice President, Corporate Communications for MacMillan Inc. and for The Travel Channel; Director of Marketing Communications for Trans World Airways and Manager of Corporate Communications for United Airlines beginning in 1971. Prior to 1971, she held various positions with ARCO and Sinclair Oil Corporation. LEO E. MORTON (B.S., MECHANICAL ENGINEERING, TUSKEGEE UNIVERSITY; M.S. MANAGEMENT, MASSACHUSETTS INSTITUTE OF TECHNOLOGY) Leo joined our company in 1994 as Vice President, Performance Management. In 1996, he was appointed Senior Vice President, Human Resources and Operations Support and in March 2000, he was named Senior Vice President and Chief Administrative Officer of the company. Prior to working for us, Leo held executive and management positions in manufacturing and engineering for AT&T and Bell Laboritories beginning in 1973. DALE J. WOLF (B.S., BUSINESS ADMINISTRATION, FORT HAYS STATE UNIVERSITY; M.B.A., FINANCE, UNIVERSITY OF MISSOURI) Dale joined our company in 1962 as a staff accountant at Missouri Public Service. Between 1962 and 1972, he held various accounting and finance positions. In 1972, he was appointed Assistant Treasurer and in 1976, Treasurer. In 1984, he was promoted to Vice President and Treasurer for Missouri Public Service. When UtiliCorp was formed in 1985, Dale became its Vice President, Finance and Treasurer. In 1989, he also assumed the Corporate Secretary responsibilities. DONALD G. BACON (B.S., CIVIL ENGINEERING, UNIVERSITY OF ALBERTA) Don joined our company in 1993 as Chairman and Chief Executive Officer of West Kootenay Power. In 1997, he became Power New Zealand's Chief Executive Officer in addition to his responsibilities in Canada. In December 1999, Don was appointed Chief Executive Officer of United Energy Limited in Australia. Prior to Don's employment with us, he was Vice President, TransAlta Utilities Corporation in Canada. CHARLES K. DEMPSTER (B.S., CIVIL ENGINEERING, UNIVERSITY OF HOUSTON) Chuck joined our company in 1993 as President of Aquila Energy Corporation. In 1994, he was appointed Senior Vice President, Energy Resources. In 1995, Chuck became Chairman and Chief Executive Officer of Aquila Energy U.K., Inc. and in 1998, became Senior Vice President of our company and Chairman and Chief Executive Officer, Aquila Energy Corporation. Prior to joining us, Chuck was President, Reliance Pipeline Corporation between 1987 and 1993. Prior to 1987, Chuck held executive positions at NICOR and Enron. JEFFREY MICHNOWSKI (B.S., BUSINESS ADMINISTRATION, RUTGERS COLLEGE; M.B.A., BARUCH COLLEGE) Jeff joined our company in 1991 working in Aquila's Energy's U.S. Operations. While at Aquila, he held the positions of Risk Manager and Director and Vice President of Price-Risk Management. In 1998, Jeff was named Managing Director of Aquila Energy Limited, a London-based subsidiary of the company. ROBERT W. HOLZWARTH (B.S., TECHNICAL MANAGEMENT, DENVER TECHNICAL COLLEGE) Bob joined our company in 1993 as Vice President-Generation and Director-Power Production. In 1997, he was named Vice President and General Manager of Power Supply Services and in March 2000, Chief Executive Officer of our Canadian Network Operations. Prior to joining our company, Bob was general manager of power and water with the Ralph M. Parsons Company on assignment in Saudi Arabia. R. PAUL PERKINS (B.A., INTERNATIONAL RELATIONS, UNIVERSITY OF NORTH CAROLINA) Paul joined our company in 1994 as Vice President, Corporate Development. Paul's primary focus in Corporate Development was in international opportunities. In 1997, Paul was appointed Senior Vice President, Australasia. In June 1999, he was named Senior Vice President, International. Prior to joining UtiliCorp, he was a regional manager for WMX Technologies between 1992 and 1994 focusing on Latin America and the Caribbean. He worked for Texaco Inc. as a Division Manager, Supply and Trading for Latin America and West Africa between 1990 and 1992. Paul worked for Texaco between 1978 and 1990 in other international capacities. DANIEL W. WARNOCK (B.A., BUSINESS ADMINISTRATION, UNIVERSITY OF NEBRASKA AT OMAHA) Dan joined our company in 1988 as Manager of Regulatory Affairs at our Peoples Natural Gas Division. He then served as Senior Vice President of our Energy Supply Services in Omaha, Nebraska. In January 2000, Dan was named Chief Executive Officer at UnitedNetworks Limited, a 78.8% owned foreign traded New Zealand Company. UnitedNetworks Limited is New Zealand's largest electric distribution company. ITEM 2. ITEM 2. PROPERTIES. We own electric production, transmission and distribution systems and gas transmission and distribution systems throughout our service territories. We also own gas gathering, processing and pipeline systems. All network assets in Michigan are mortgaged pursuant to an Indenture of Mortgage and Deed of Trust dated July 1, 1951, as supplemented. Substantially all of our Canadian network plant is mortgaged under terms of a separate indenture. UTILITY FACILITIES Our electric generation plants, as of December 31, 1999, are as follows: The following table shows the overall fuel mix and generation capability for the past five years. At December 31, 1999, we had transmission and distribution lines as follows: At December 31, 1999, our gas utility operations had 2,170 miles of gas gathering and transmission pipelines and 17,978 miles of distribution mains and service lines located throughout its service territories. GAS PROCESSING AND GATHERING ASSETS AQP owned and/or operated 11 active natural gas pipeline systems with an aggregate length of approximately 3,133 miles. These pipelines do not form an interconnected system. Set forth below is information with respect to AQP's pipeline systems as of December 31, 1999: a) ALL MILEAGE, CAPACITY AND VOLUME INFORMATION IS APPROXIMATE. CAPACITY FIGURES ARE MANAGEMENT'S ESTIMATES BASED ON EXISTING FACILITIES WITHOUT REGARD TO THE PRESENT AVAILABILITY OF NATURAL GAS. b) GROSS GAS THROUGHPUT CAPACITY IS INCLUDED AT 100% WHILE NET AVERAGE GAS THROUGHPUT IS PRESENTED AT THE OUR PRESENT JOINT VENTURE OWNERSHIP INTEREST. c) EXCLUDES OFF-SYSTEM MARKETING SALES WITH AVERAGE DAILY VOLUMES OF 776 Mmcf/d SOLD FROM OTHER COMPANIES' FACILITIES. d) IN JULY 1999, AQUILA GAS SYSTEM SOLD THE ASSETS IN ITS MOORELAND SYSTEM. e) IN APRIL 1999, ASSETS WERE TRANSFERRED FROM AQUILA GAS SYSTEM TO FORM TRADERS CREEK PIPELINE. At December 31, 1999, we owned 35% of the capital stock of Oasis and the right to transport 280 MMcf/d of natural gas on Oasis' pipeline, plus the opportunity to utilize excess capacity on an interruptible basis. The Oasis pipeline is a 600-mile, 36-inch diameter natural gas pipeline which connects the Waha, Texas hub to the Katy, Texas hub. The Oasis pipeline has a 1 Bcf/d of throughput capacity. We use the equity method of accounting for this investment. At December 31, 1998, AQP owned and/or operated an interest in four natural gas processing plants listed. Set forth below is information with respect to AQP's processing plants as of December 31, 1999: a) ALL CAPACITY AND VOLUME INFORMATION IS APPROXIMATE. CAPACITY FIGURES ARE MANAGEMENT'S ESTIMATES BASED ON EXISTING FACILITIES WITHOUT REGARD TO THE PRESENT AVAILABILITY OF NATURAL GAS. b) VOLUMES FROM JOINT VENTURES HAVE BEEN INCLUDED AT THE PRESENT AQP OWNERSHIP INTEREST. c) THOUSANDS OF BARRELS PER DAY (MBbls/d). d) THIS PLANT IS OWNED AND OPERATED BY A THIRD PARTY FORM WHICH AQP RECEIVES A PORTION OF THE NGL'S PRODUCED FROM GAS AQP DELIVERS TO THE PLANT. THIS PLANT IS INCLUDED IN THIS SECTION FOR INFORMATIONAL PURPOSES TO SHOW THE GAS THROUGHPUT AND NGL'S PRODUCTION AQP RECEIVED UTILIZING THE ACCESS TO THIS PLANT. e) IN 1999, AQP ELECTED TO BYPASS THE KATY, TEXAS PLANT AND RECEIVE PAYMENT IN BTU VALUE DUE TO THE DEPRESSED NGL'S COMMODITY PRICES. The availability of natural gas reserves to AQP depends on their development in the area served by its pipelines and on AQP's ability to purchase gas currently sold to or transported through other pipelines. The development of additional gas reserves will be affected by many factors including the prices of natural gas and crude oil, exploration and development costs and the presence of natural gas reserves in the areas served by AQP's systems. INDEPENDENT POWER PROJECTS Information regarding the company's generating projects is set forth below. a) NOMINAL GROSS CAPACITY. b) INTEREST ACQUIRED IN JUNE 1989. c) INTEREST ACQUIRED IN DECEMBER 1988. d) INTEREST SOLD IN JANUARY 2000. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders in the fourth quarter of 1999. PART 2 ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The company's common stock (par $1) is listed on the New York, Pacific and Toronto stock exchanges under the symbol UCU. At December 31, 1999, the company had 40,317 common shareholders of record. Information relating to market prices of common stock and cash dividends on common stock is set forth in the table below. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The information required by this item is incorporated by reference to pages 25 through 37 in the company's 1999 Annual Report to Shareholders. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The information required by this item is incorporated by reference to pages 33 and 34 in the company's 1999 Annual Report to Shareholders. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this item is incorporated by reference to pages 38 through 58 of the company's 1999 Annual Report to Shareholders. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART 3 ITEMS 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY, EXECUTIVE COMPENSATION, SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, AND CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information regarding these items appear in our proxy statement and is hereby incorporated by reference in this Annual Report on Form 10-K. For information with respect to the executive officers of the company, see "Executive Officers of the Registrant" following Item 1 in Part 1 of this Form 10-K. PART 4 ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. The following documents are filed as part of this report: (a)(1) FINANCIAL STATEMENTS: * Incorporated by reference to pages 38 through 58 of the company's 1999 Annual Report to Shareholders. (a)(2) FINANCIAL STATEMENT SCHEDULE All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) LIST OF EXHIBITS * (a) The following exhibits relate to a management contract or compensatory plan or arrangement: * Incorporated by reference to the Index to Exhibits. REPORTS ON FORM 8-K (B) REPORTS ON FORM 8-K FOR THE QUARTER ENDED DECEMBER 31, 1999, WERE PREVIOUSLY REPORTED IN OUR FORM 10-Q FOR THE QUARTER ENDING SEPTEMBER 30, 1999. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors and Shareholders of UtiliCorp United Inc.: We have audited in accordance with auditing standards generally accepted in the United States, the consolidated financial statements for 1999, 1998, and 1997 described on page 58 of UtiliCorp United Inc.'s Annual Report to Shareholders, which is incorporated by reference in this Form 10-K, and have issued our report thereon dated February 1, 2000. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The Financial Statement Schedule listed in Item 14(a)2 is the responsibility of the company's management and is presented for the purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements, and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ ARTHUR ANDERSEN LLP Kansas City, Missouri February 1, 2000 UTILICORP UNITED INC. SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1999 (IN MILLIONS) UTILICORP UNITED INC. INDEX TO EXHIBITS *Exhibits marked with an asterisk are incorporated by reference as indicated pursuant to Rule 12(b)-23. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, there unto duly authorized. UTILICORP UNITED INC. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

350426_1999.txt

350426_1999

1999

350426

Item 1. -- "Business -- Product Markets and Major Customers". Prices for natural gas and, to a lesser extent, oil are subject to substantial seasonal fluctuations and prices for each are subject to substantial fluctuations as a result of numerous other factors. Since December 31, 1998, we have not filed any estimates of total proved net crude oil or natural gas reserves with any federal authority or agency other than the SEC. See Note 20 in our consolidated financial statements appearing elsewhere in this report for certain additional information concerning our proved reserves. PRODUCTIVE WELLS AND ACREAGE As of December 31, 1999, we had working interests in 1,811 gross (1,796 net) active oil wells. The following table sets forth certain information with respect to our developed and undeveloped acreage as of December 31, 1999. - ------------ (1) Developed acres are acres spaced or assigned to productive wells. (2) Undeveloped acres are acres on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas, regardless of whether such acreage contains proved reserves. (3) Less than 10% of total net undeveloped acres are covered by leases that expire from 2000 through 2003. (4) Does not include 9,000 acres covered by a farmout from Chevron, in which we own a 50% interest. (5) Does not include 29,000 gross (28,000 net) acres under a seismic option. DRILLING ACTIVITIES Certain information with regard to our drilling activities during the years ended December 31, 1999, 1998 and 1997 is set forth below: See Item 1. - "Business -- Acquisition and Exploitation" and -- "Productive Wells and Acreage" for additional information regarding exploitation activities, including waterflood patterns, workovers and recompletions. PRODUCTION AND SALES The following table presents certain information with respect to crude oil and natural gas production attributable to our properties, the revenue derived from the sale of such production, average sales prices received and average production costs during the three years ended December 31, 1999, 1998 and 1997. PAA PROPERTIES See description of PAA's properties under Item 1. -- "Business -- Midstream Activities". ITEM 3. ITEM 3. LEGAL PROCEEDINGS Texas Securities Litigation. On November 29, 1999, a class action lawsuit was filed in the United States District Court for the Southern District of Texas entitled Di Giacomo v. Plains All American Pipeline, et al. The suit alleged that Plains All American Pipeline, L.P. and certain of the general partner's officers and directors violated federal securities laws, primarily in connection with unauthorized trading by a former employee. An additional nineteen cases were filed in the Southern District of Texas, some of which name the general partner and us as additional defendants. Plaintiffs allege that the defendants are liable for securities fraud violations under Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934 and for making false registration statements under Sections 11 and 15 of the Securities Act of 1933. The court has consolidated all subsequently filed cases under the first filed action described above. Two unopposed motions are currently pending to appoint lead plaintiffs. These motions ask the court to appoint two distinct lead plaintiffs to represent two different plaintiff classes: (1) purchasers of our common stock and options and (2) purchasers of PAA's common units. Once lead plaintiffs have been appointed, the plaintiffs will file their consolidated amended complaints. No answer or responsive pleading is due until thirty days after a consolidated amended complaint is filed. Delaware Derivative Litigation. On December 3, 1999, two derivative lawsuits were filed in the Delaware Chancery Court, New Castle County, entitled Susser v. Plains All American Inc., et al and Senderowitz v. Plains All American Inc., et al. These suits, and three others which were filed in Delaware subsequently, named the general partner, its directors and certain of its officers as defendants, and allege that the defendants breached the fiduciary duties that they owed to Plains All American Pipeline, L.P. and its unitholders by failing to monitor properly the activities of its employees. The derivative complaints allege, among other things, that Plains All American Pipeline has been harmed due to the negligence or breach of loyalty of the officers and directors that are named in the lawsuits. These cases are currently in the process of being consolidated. No answer or responsive pleading is due until these cases have been consolidated and a consolidated complaint has been filed. We intend to vigorously defend the claims made in the Texas securities litigation and the Delaware derivative litigation. However, there can be no assurance that we will be successful in our defense or that these lawsuits will not have a material adverse effect on our financial position or results of operation. On July 9, 1987, Exxon Corporation ("Exxon") filed an interpleader action in the United States District Court for the Middle District of Florida, Exxon Corporation v. E. W. Adams, et al., Case Number 87-976-CIV-T-23-B. This action was filed by Exxon to interplead royalty funds as a result of a title controversy between certain mineral owners in a field in Florida. One group of mineral owners, John W. Hughes, et al. (the "Hughes Group"), filed a counterclaim against Exxon alleging fraud, conspiracy, conversion of funds, declaratory relief, federal and Florida RICO, breach of contract and accounting, as well as challenging the validity of certain oil and natural gas leases owned by Exxon, and seeking exemplary and treble damages. In March 1993, but effective November 1, 1992, Calumet Florida Inc. ("Calumet"), our wholly-owned subsidiary, acquired all of Exxon's leases in the field affected by this lawsuit. In order to address those counterclaims challenging the validity of certain oil and natural gas leases, which constitute approximately 10% of the land underlying this unitized field, Calumet filed a motion to join Exxon as plaintiff in the subject lawsuit, which was granted July 29, 1994. In August 1994, the Hughes Group amended its counterclaim to add Calumet as a counter-defendant. Exxon and Calumet filed a motion to dismiss the counterclaims. On March 22, 1996, the Court granted Exxon's and Calumet's motion to dismiss the counterclaims alleging fraud, conspiracy, and federal and Florida RICO violations and challenging the validity of certain of our oil and natural gas leases but denied such motion as to the counterclaim alleging conversion of funds. We have reached an agreement in principle to settle with the Hughes group. In consideration for full and final settlement, and dismissal with prejudice, we have agreed to pay to the Hughes group the total sum of $100,000. We and Exxon have filed motions for summary judgment with respect to the claims of the remaining parties. The court has not yet set a date for hearing of these motions. The trial date is currently scheduled in June 2000. We, in the ordinary course of business, are a claimant and/or a defendant in various other legal proceedings in which our exposure, individually and in the aggregate, is not considered material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders, through solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE COMPANY Information regarding our executive officers is presented below. All executive officers hold office until their successors are elected and qualified. Greg L. Armstrong, President and Chief Executive Officer Officer Since 1981 Mr. Armstrong, age 41, has been President, Chief Executive Officer and a director since 1992. He was President and Chief Operating Officer from October to December 1992, and Executive Vice President and Chief Financial Officer from June to October 1992. He was Senior Vice President and Chief Financial Officer from 1991 to June 1992, Vice President and Chief Financial Officer from 1984 to 1991, Corporate Secretary from 1981 to 1988, and Treasurer from 1984 to 1987. William C. Egg, Jr., Executive Vice President Officer Since 1984 Mr. Egg, age 48, has been Executive Vice President and Chief Operating Officer-Upstream since May 1998. He was Senior Vice President from 1991 to 1998. He was Vice President-Corporate Development from 1984 to 1991 and Special Assistant-Corporate Planning from 1982 to 1984. Cynthia A. Feeback, Vice President - Accounting Officer Since 1993 and Assistant Treasurer Ms. Feeback, age 42, has been Vice President and Assistant Treasurer since May 1999. She was Assistant Treasurer, Controller and Principal Accounting Officer of the Company from May 1998 to May 1999. She was Controller and Principal Accounting Officer from 1993 to 1998. She was Controller from 1990 to 1993 and Accounting Manager from 1988 to 1990. Jim G. Hester, Vice President - Business Development Officer Since 1999 and Acquisitions Mr. Hester, age 40, has been Vice President -- Business Development and Acquisitions since May 1999. He was Manager of Business Development and Acquisitions from 1997 to May 1999, Manager of Corporate Development from 1995 to 1997 and Manager of Special Projects from 1993 to 1995. He was Assistant Controller from 1991 to 1993, Accounting Manager from 1990 to 1991 and Revenue Accounting Supervisor from 1988 to 1990. Phillip D. Kramer, Executive Vice President, Chief Officer Since 1987 Financial Officer and Treasurer Mr. Kramer, age 44, has been Executive Vice President, Chief Financial Officer and Treasurer since May 1998. He was Senior Vice President and Chief Financial Officer from May 1997 to May 1998. He was Vice President and Chief Financial Officer from 1992 to 1997, Vice President and Treasurer from 1988 to 1992, Treasurer from 1987 to 1988, and Controller from 1983 to 1987. Michael R. Patterson, Vice President and General Counsel Officer Since 1985 Mr. Patterson, age 52, has been Vice President and General Counsel since 1985 and Corporate Secretary since 1988. Harry N. Pefanis, Executive Vice President Officer Since 1988 Mr. Pefanis, age 42, has been Executive Vice President-Midstream since May 1998. He was Senior Vice President from February 1996 to May 1998. He had been Vice President-Products Marketing since 1988. From 1987 to 1988 he was Manager of Products Marketing. From 1983 to 1987 he was Special Assistant for Corporate Planning. Mr. Pefanis is also President and Chief Operating Officer of Plains All American Inc. Mary O. Peters, Vice President - Administration and Officer Since 1991 Human Resources Ms. Peters, age 51, has been Vice President-Administration and Human Resources since 1991. She was Manager of Office Administration from 1984 to 1991. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Our common stock is listed and traded on the American Stock Exchange under the symbol "PLX". The number of stockholders of record of the common stock as of March 15, 2000 was 1,133. The following table sets forth the range of high and low closing sales prices for the common stock as reported on the American Stock Exchange Composite Tape for the periods indicated below. We have not paid cash dividends on shares of our common stock since our inception and do not anticipate paying any cash dividends on our common stock in the foreseeable future. In addition, we are restricted by provisions of the indentures governing the issue of $275.0 million 10.25% Senior Subordinated Notes Due 2006 (the "10.25% Notes") and prohibited by our $225.0 million revolving credit facility from paying dividends on our common stock. On December 14, 1999, we sold in a private placement 50,000 shares of our Series F Preferred Stock for $50.0 million. Each share of the Series F Preferred Stock has a stated value of $1,000 per share and bears a dividend of 10% per annum. Dividends are payable semi-annually in either cash or additional shares of Series F Preferred Stock at our option and are cumulative from the date of issue. Dividends paid in additional shares of Series F Preferred Stock are limited to an aggregate of six dividend periods. Each share of Series F Preferred Stock is convertible into 81.63 shares of common stock (an initial effective conversion price of $12.25 per share) and in certain circumstances may be converted at our option into common stock if the average trading price for any sixty-day trading period is equal to or greater than $21.60 per share. After December 15, 2003, the Series F Preferred Stock is redeemable at our option at 110% of stated value through December 15, 2004, and at declining amounts thereafter. If not previously redeemed or converted, the Series F Preferred Stock is required to be redeemed in 2007. On April 1, 1999, we paid a dividend on our Series E Preferred Stock for the period from October 1, 1998 through March 31, 1999. The dividend amount of approximately $4.1 million was paid by issuing 8,209 additional shares of the Series E Preferred Stock. On September 9, 1999, 3,408 shares of Series E Preferred Stock, including accrued dividends, were converted into 98,613 shares of common stock at a conversion price of $18.00 per share. On October 1, 1999, we paid a cash dividend of approximately $4.2 million on the Series E Preferred Stock for the period April 1, 1999 through September 30, 1999. On March 22, 2000, our Board of Directors declared cash dividends on our Series D Preferred Stock, Series F Preferred Stock and Series G Preferred Stock, all of which are payable on April 3, 2000 to holders of record on March 23, 2000. The dividend amount of $350,000 on the Series D Preferred Stock is for the period January 1, 2000 through March 31, 2000. The dividend amount of $1,475,000 on the Series F Preferred Stock is for the period December 15, 1999 (the date of original issuance) through March 31, 2000. The dividend amount of $4,219,000 for the Series G Preferred Stock is for the period October 1, 1999 through March 31, 2000. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) The following selected historical financial information was derived from, and is qualified by reference to our consolidated financial statements, including the notes thereto, appearing elsewhere in this report. The selected financial data should be read in conjunction with the consolidated financial statements, including the notes thereto, and "Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL We are an independent energy company that acquires, exploits, develops, explores and produces crude oil and natural gas. Through our majority ownership in PAA, we are also engaged in the midstream activities of marketing, transportation, terminalling and storage of crude oil. For financial statement purposes, the assets, liabilities and earnings of PAA are included in our consolidated financial statements, with the public unitholders' interest reflected as a minority interest. Our upstream crude oil and natural gas activities are focused in California in the Los Angeles Basin, the Arroyo Grande Field, and the Mt. Poso Field, offshore California in the Point Arguello Field, the Sunniland Trend of South Florida and the Illinois Basin in southern Illinois. Our midstream activities are concentrated in California, Texas, Oklahoma, Louisiana and the Gulf of Mexico. 1999 ACQUISITIONS On May 12, 1999, PAA completed the acquisition of Scurlock Permian LLC and certain other pipeline assets from Marathon Ashland Petroleum LLC. Including working capital adjustments and closing and financing costs, the cash purchase price was approximately $141.7 million. The assets, liabilities and results of operations of the Scurlock acquisition are included in our consolidated financial statements effective May 1, 1999. Scurlock, previously a wholly-owned subsidiary of Marathon Ashland Petroleum, is engaged in crude oil transportation, gathering and marketing, and owns approximately 2,300 miles of active pipeline, numerous storage terminals and a fleet of more than 250 trucks. On July 1, 1999, we acquired Chevron's interests in Point Arguello. The interests acquired include Chevron's 26% working interest in the Point Arguello Unit and associated onshore processing facilities, Chevron's right to participate in surrounding leases and certain fee acreage onshore. The acquisition, which was funded from our working capital, has an effective date of July 1, 1999. On July 15, 1999, PAA completed the acquisition of the West Texas gathering system from Chevron Pipe Line Company for approximately $36.0 million, including transaction costs. The assets acquired include approximately 450 miles of crude oil transmission mainlines, approximately 400 miles of associated gathering and lateral lines, and approximately 2.9 million barrels of tankage located along the system. UNAUTHORIZED TRADING LOSSES In November 1999, we discovered that a former employee of PAA had engaged in unauthorized trading activity, resulting in losses of approximately $162.0 million ($174.0 million, including estimated associated costs and legal expenses). Approximately $7.1 million of the unauthorized trading loss was recognized in 1998 and the remainder in 1999. As a result, we have restated our 1998 financial information. Normally, as PAA purchases crude oil, it establishes a margin by selling crude oil for physical delivery to third-party users or by entering into a future delivery obligation with respect to futures contracts. The employee in question violated PAA's policy of maintaining a position that is substantially balanced between crude oil purchases and sales or future delivery obligations. The unauthorized trading and associated losses resulted in a default of certain covenants under PAA's credit facilities and significant short-term cash and letter of credit requirements. See "Capital Resources, Liquidity and Financial Condition". RESULTS OF OPERATIONS For the year ended December 31, 1999, we reported a net loss of $25.3 million, or $2.05 per share on total revenue of $4.8 billion as compared to a net loss of $62.3 million, or $3.99 per share on total revenue of $1.3 billion in 1998. For the year ended December 31, 1997, we reported net income of $14.3 million or $0.85 per share ($0.77 per share diluted), on total revenue of $862.2 million. The net losses for the years ended December 31, 1999 and 1998 include the following nonrecurring items: . $166.4 million of unauthorized trading losses; . a $16.5 million gain on the segment of the All American Pipeline linefill that was sold in 1999; . a $9.8 million gain related to the sale of units by PAA; . restructuring expense of $1.4 million; and . an extraordinary loss of $0.5 million related to the early extinguishment of debt (net of minority interest and tax benefit). . $7.1 million of unauthorized trading losses; . a $109.0 million after-tax ($173.9 million pre-tax) reduction in carrying cost of oil and natural gas due to low crude oil prices at December 31, 1998; and . a $37.5 million after-tax ($60.8 million pre-tax) gain associated with the initial public offering of PAA. Excluding these nonrecurring items we would have reported net income of approximately $17.0 million and $8.4 million in 1999 and 1998, respectively. EBITDA increased 73% in 1999 to $139.1 million from the $80.3 million reported in 1998 and 103% from the $68.4 million reported in 1997. Cash flow from operations (net income before noncash items) was $70.4 million, $42.0 million and $46.2 million in 1999, 1998 and 1997, respectively. EBITDA and cash flow from operations also exclude the nonrecurring items discussed above. Net cash used in operating activities was $76.0 million for the year ended December 31, 1999, compared to net cash provided by operating activities of $37.6 million for 1998 and $30.3 million for 1997. Upstream Results The following table sets forth certain of our upstream operating information for the periods presented: Total oil equivalent production increased approximately 6% to an average of 23,400 BOE per day over the 1998 level of 22,100 BOE per day and 16% above the 1997 level of 20,200 BOE per day. The volume increase in 1999 is primarily associated with our ongoing acquisition and exploitation activities, offset somewhat by decreased production from certain of our other properties. The offshore California Point Arguello Unit, which we acquired from Chevron in July 1999, accounted for approximately 2,200 BOE per day of the increase. Net daily production from our onshore California properties increased to approximately 15,600 BOE per day in 1999, up 1,800 BOE per day, or 13% over 1998 and 39% over 1997. Excluding production from the Mt. Poso Field, which we acquired in December 1998, California production was up 6% from 1998. The increase in 1998 as compared to 1997 is partially attributable to the acquisition of the Arroyo Grande Field in the fourth quarter of 1997. Net daily production for our Gulf Coast properties averaged approximately 2,600 BOE per day in 1999, compared to 4,800 BOE per day in 1998 and 5,300 BOE per day in 1997. The Gulf Coast production decrease is due to mechanical downtime and the effects of natural decline. This is our most volatile area in terms of maintaining production levels. Net daily production in the Illinois Basin averaged 3,000 BOE per day during 1999, 3,500 BOE per day in 1998 and 3,600 BOE per day in 1997. Oil and natural gas revenues were $116.2 million in 1999, an increase of 13% over 1998 due to higher prices and increased production volumes. Oil and natural gas revenues decreased to $102.8 million in 1998 as compared to $109.4 million in 1997 due to decreased product prices which offset increased production volumes. Our average product price, which represents a combination of fixed and floating price sales arrangements and incorporates location and quality discounts from the benchmark NYMEX prices, averaged $13.61 per BOE in 1999, 7% higher than the price received in 1998 and 8% lower than the price received in 1997. The NYMEX benchmark WTI crude oil price averaged $19.25 per barrel in 1999, $14.43 per barrel in 1998, and $20.63 per barrel in 1997. Financial swap and collar arrangements and futures transactions that we entered into to hedge production are included in our average product prices. These transactions had the effect of decreasing the overall average price we received by $1.30 per BOE in 1999, increasing the price by $2.98 per BOE in 1998 and decreasing the price by $1.26 per BOE in 1997. We maintained hedges on approximately 63% of our crude oil production throughout 1999 at an average NYMEX WTI crude oil price of approximately $18.00 per barrel. We routinely hedge a portion of our crude oil production. See "-- Capital Resources, Liquidity and Financial Condition -- Changing Crude Oil and Natural Gas Prices" and Item 7a. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS We are exposed to various market risks, including volatility in crude oil commodity prices and interest rates. To manage our exposure, we monitor our inventory levels, current economic conditions and our expectations of future commodity prices and interest rates when making decisions with respect to risk management. We do not enter into derivative transactions for speculative trading purposes. Substantially all of our derivative contracts are exchanged or traded with major financial institutions and the risk of credit loss is considered remote. Commodity Price Risk. The fair value of outstanding derivative commodity instruments and the change in fair value that would be expected from a 10 percent adverse price change are shown in the table below (in millions): DECEMBER 31, --------------------------------------- 1999 1998 ------------------ ------------------ 10% 10% ADVERSE ADVERSE FAIR PRICE FAIR PRICE VALUE CHANGE VALUE CHANGE ------- --------- -------- -------- Crude Oil: Futures contracts $ - $(2.8) $ 1.8 $(0.3) Swaps and options contracts (21.9) (6.1) 16.9 (4.3) The fair values of the futures contracts are based on quoted market prices obtained from the NYMEX. The fair value of the swaps are estimated based on quoted prices from independent reporting services compared to the contract price of the swap and approximate the gain or loss that would have been realized if the contracts had been closed out at year end. All hedge positions offset physical positions exposed to the cash market; none of these offsetting physical positions are included in the above table. Price-risk sensitivities were calculated by assuming an across-the-board 10 percent adverse change in prices regardless of term or historical relationships between the contractual price of the instruments and the underlying commodity price. In the event of an actual 10 percent change in prompt month crude oil prices, the fair value of our derivative portfolio would typically change less than that shown in the table due to lower volatility in out-month prices. Interest Rate Risk. Our debt instruments are sensitive to market fluctuations in interest rates. The table below presents principal payments and the related weighted average interest rates by expected maturity dates for debt outstanding at December 31, 1999. Our variable rate debt bears interest at LIBOR plus the applicable margin. The average interest rates presented below are based upon rates in effect at December 31, 1999. The carrying value of variable rate bank debt approximates fair value as interest rates are variable, based on prevailing market rates. The fair value of fixed rate debt was based on quoted market prices based on trades of subordinated debt. The fair value of the Redeemable Preferred Stock approximates its liquidation value at December 31, 1999. At December 31, 1998, the carrying value of all variable rate bank debt and the Redeemable Preferred Stock of $184.7 million and $88.5 million, respectively, approximated the fair value and liquidation value, respectively, at that date. The carrying value and fair value of the fixed rate debt was $200.0 million and $202.0 million, respectively, at that date. Interest rate swaps and collars are used to hedge underlying debt obligations. These instruments hedge specific debt issuances and qualify for hedge accounting. The interest rate differential is reflected as an adjustment to interest expense over the life of the instruments. At December 31, 1999, we had interest rate swap and collar arrangements for an aggregate notional principal amount of $240.0 million, which positions had an aggregate value of approximately $1.0 million as of such date. These instruments are based on LIBOR margins and generally provide for a floor of 5% and a ceiling of 6.5% for $90.0 million of debt and a floor of 6% and a ceiling of 8% for $125.0 million of debt. In August 1999, we terminated our swap arrangements on an aggregate notional principal amount of $175.0 million and we received consideration in the amount of approximately $10.8 million. At December 31, 1998, we had interest rate swap arrangements for an aggregate notional principal amount of $200.0 million and would have been required to pay approximately $3.3 million to terminate the instruments at that date. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required here is included in the report as set forth in the "Index to Financial Statements" on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding our directors will be included in the proxy statement for the 2000 annual meeting of stockholders (the "Proxy Statement") to be filed within 120 days after December 31, 1999, and is incorporated herein by reference. Information with respect to our executive officers is presented in Part I, Item 4 of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation will be included in the Proxy Statement and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information, if any, regarding beneficial ownership of the common stock will be included in the Proxy Statement and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions will be included in the Proxy Statement and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) AND (2) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES See "Index to Consolidated Financial Statements" set forth on Page. (a) (3) EXHIBITS 2(a) Stock Purchase Agreement dated as of March 15, 1998, among Plains Resources Inc., Plains All American Inc. and Wingfoot Ventures Seven Inc. (incorporated by reference to Exhibit 2(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 3(a) Second Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995). 3(b) Bylaws of the Company, as amended to date (incorporated by reference to Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993). 3(c) Certificate of Designation, Preference and Rights of Series D Cumulative Convertible Preferred Stock (incorporated by reference to Exhibit 3(c) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997). *3(d) Certificate of Designation, Preference and Rights of Series F Cumulative Convertible Preferred Stock. *3(e) Certificate of Designation, Preference and Rights of Series G Cumulative Convertible Preferred Stock. 4 Indenture dated as of March 15, 1996, among the Company, the Subsidiary Guarantors named therein and Texas Commerce Bank National Association, as Trustee for the Company's 10 1/4% Senior Subordinated Notes due 2006, Series A and Series B (incorporated by reference to Exhibit 4(b) to the Company's Form S-3 (Registration No. 333-1851)). 4(a) Indenture dated as of July 21, 1997, among the Company, the Subsidiary Guarantors named therein and Texas Commerce Bank National Association, as Trustee for the Company's 10 1/4% Senior Subordinated Notes due 2006, Series C and Series D (incorporated by reference to Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997). 4(b) Specimen Common Stock Certificate (incorporated by reference to Exhibit 4 to the Company's Form S-1 Registration Statement (Reg. No. 33-33986)). 4(c) Purchase Agreement for Stock Warrant dated May 16, 1994, between Plains Resources Inc. and Legacy Resources, Co., L.P. (incorporated by reference to Exhibit 4(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1994). 4(d) Warrant dated November 12, 1997, to Shell Land & Energy Company for the purchase of 150,000 shares of Common Stock (incorporated by reference to Exhibit 4(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1997). 4(e) Indenture dated as of September 15, 1999, among Plains Resources Inc., the Subsidiary Guarantors named therein and Chase Bank of Texas, National Association, as Trustee (incorporated by reference to Exhibit 4(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999). 4(f) Registration Rights Agreement dated as of September 22, 1999, among Plains Resources Inc., the Subsidiary Guarantors named therein, J.P. Morgan Securities Inc. and First Union Capital Markets Corp. (incorporated by reference to Exhibit 4(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999). *4(g) Stock Purchase Agreement dated as of December 15, 1999, among Plains Resources Inc. and the purchasers named therein. *4(h) Amendment to Stock Purchase Agreement dated as of December 17, 1999, among Plains Resources Inc. and the purchasers named therein. **10(a) Employment Agreement dated as of March 1, 1993, between the Company and Greg L. Armstrong (incorporated by reference to Exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993). **10(b) The Company's 1991 Management Options (incorporated by reference to Exhibit 4.1 to the Company's Form S-8 Registration Statement (Reg. No. 33-43788)). **10(c) The Company's 1992 Stock Incentive Plan (incorporated by reference to Exhibit 4.3 to the Company's Form S-8 Registration Statement (Reg. No. 33-48610)). **10(d) The Company's Amended and Restated 401(k) Plan (incorporated by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). **10(e) The Company's 1996 Stock Incentive Plan (incorporated by reference to Exhibit 4 to the Company's Form S-8 Registration Statement (Reg. No. 333-06191)). **10(f) Stock Option Agreement dated August 27, 1996 between the Company and Greg L. Armstrong (incorporated by reference to Exhibit 10(l) to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). **10(g) Stock Option Agreement dated August 27, 1996 between the Company and William C. Egg Jr. (incorporated by reference to Exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). **10(h) First Amendment to the Company's 1992 Stock Incentive Plan (incorporated by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). **10(i) Second Amendment to the Company's 1992 Stock Incentive Plan (incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997). 10(j) Fourth Amended and Restated Credit Agreement dated May 22,1998, among the Company and ING (U.S.) Capital Corporation, et. al. (incorporated by reference to Exhibit 10(y) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998) **10(k) First Amendment to Plains Resources Inc. 1996 Stock Incentive Plan dated May 21, 1998 (incorporated by reference to Exhibit 10(z) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998) **10(l) Third Amendment to Plains Resources Inc. 1992 Stock Incentive Plan dated May 21, 1998 (incorporated by reference to Exhibit 10(aa) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998) 10(m) First Amendment to Fourth Amended and Restated Credit Agreement dated as of November 17, 1998, among the Company and ING (U.S.) Capital Corporation, et. al. (incorporated by reference to Exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998). 10(n) Second Amendment to Fourth Amended and Restated Credit Agreement dated as of March 15, 1999, among the Company and ING (U.S.) Capital Corporation, et. al. (incorporated by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998). **10(o) Employment Agreement dated as of November 23, 1998, between Harry N. Pefanis and the Company (incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998). 10(p) Purchase and Sale Agreement dated June 4, 1999, by and among the Company, Chevron U.S.A., Inc., and Chevron Pipe Line Company (incorporated by reference to Exhibit 10(h) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999). 10(q) Third Amendment to Fourth Amended and Restated Credit Agreement dated June 21, 1999, among the Company and ING (U.S.) Capital Corporation, et. al. (incorporated by reference to Exhibit 10(p) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999). 10(r) Second Amendment to Plains Resources 1996 Stock Incentive Plan dated May 20, 1999 (incorporated by reference to Exhibit 10(q) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999). 10(s) Fourth Amendment to Fourth Amended and Restated Credit Agreement dated September 15, 1999, among the Company and First Union National Bank, et al. (incorporated by reference to Exhibit 10(q) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999). *10(t) Fifth Amendment to Fourth Amended and Restated Credit Agreement dated December 1, 1999, among the Company and First Union National Bank, et al. *21 Subsidiaries of the Company. *23(a) Consent of PricewaterhouseCoopers LLP. *27(b) Financial Data Schedule for the year ended December 31, 1999. ________________________ * Filed herewith ** A management contract or compensation plan. (b) REPORTS ON FORM 8-K A Current Report on Form 8-K was filed on November 29, 1999, regarding the discovery of unauthorized trading activity by a former employee of PAA, which was expected to result in losses to PAA of approximately $160.0 million. A Current Report on Form 8-K was filed on December 1, 1999, regarding the execution of agreements with PAA's lenders to provide for a $300.0 million credit facility and the waiver of defaults under certain covenants in its credit facilities which resulted from its unauthorized trading losses, as well as the execution by us of commitment letters for the sale of up to $50.0 million of a new series of preferred stock, the proceeds of which would constitute a portion of the $114.0 million in debt financing which we agreed to provide to PAA. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PLAINS RESOURCES INC. Date: March 30, 2000 By: /s/ Phillip D. Kramer ------------------------------------------- Phillip D. Kramer, Executive Vice President and Chief Financial Officer (Principal Financial Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 30, 2000 By: /s/ Greg L. Armstrong --------------------------------------- Greg L. Armstrong, President, Chief Executive Officer and Director (Principal Executive Officer) Date: March 30, 2000 By: /s/ Jerry L. Dees --------------------------------------- Jerry L. Dees, Director Date: March 30, 2000 By: /s/ Tom H. Delimitros --------------------------------------- Tom H. Delimitros, Director Date: March 30, 2000 By: /s/ Cynthia A. Feeback --------------------------------------- Cynthia A. Feeback, Vice President - Accounting And Assistant Treasurer (Principal Accounting Officer) Date: March 30, 2000 By: /s/ William M. Hitchcock --------------------------------------- William M. Hitchcock, Director Date: March 30, 2000 By: /s/ Phillip D. Kramer --------------------------------------- Phillip D. Kramer, Executive Vice President and Chief Financial Officer (Principal Financial Officer) Date: March 30, 2000 By: /s/ Dan M. Krausse --------------------------------------- Dan M. Krausse, Chairman of the Board and Director Date: March 30, 2000 By: /s/ John H. Lollar --------------------------------------- John H. Lollar, Director Date: March 30, 2000 By: /s/ Robert V. Sinnott --------------------------------------- Robert V. Sinnott, Director Date: March 30, 2000 By: /s/ J. Taft Symonds --------------------------------------- J. Taft Symonds, Director Our annual report to stockholders for the year ended December 31, 1999, and the proxy statement relating to the annual meeting of stockholders will be furnished to stockholders subsequent to the filing of this annual report on Form 10-K. Such documents have not been mailed to stockholders as of the date of this report. PLAINS RESOURCES INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Plains Resources Inc. In our opinion, the consolidated financial statements listed in the accompanying index, after the restatement described in Note 3, present fairly, in all material respects, the financial position of Plains Resources Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Houston, Texas March 29, 2000 PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data) See notes to consolidated financial statements. PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except share data) See notes to consolidated financial statements. PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See notes to consolidated financial statements. PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN NON-REDEEMABLE PREFERRED STOCK, COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (in thousands) See notes to consolidated financial statements. PLAINS RESOURCES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- ORGANIZATION AND BASIS OF PRESENTATION Organization We are an independent energy company that acquires, exploits, develops, explores and produces crude oil and natural gas. Through our majority ownership in Plains All American Pipeline, L.P. ("PAA"), we are also engaged in the midstream activities of marketing, transportation, storage and terminalling of crude oil. Our upstream crude oil and natural gas activities are focused in California in the Los Angeles Basin, the Arroyo Grande Field, and the Mt. Poso Field, offshore California in the Point Arguello Field, the Sunniland Trend of South Florida and the Illinois Basin in southern Illinois. Our midstream activities are concentrated in California, Texas, Oklahoma, Louisiana and the Gulf of Mexico. Basis of Consolidation and Presentation The consolidated financial statements include the accounts of Plains Resources Inc., our wholly-owned subsidiaries and PAA in which we have an approximate 54% ownership interest, Plains All American Inc., one of our wholly owned subsidiaries, serves as PAA's sole general partner. For financial statement purposes, the assets, liabilities and earnings of PAA are included in our consolidated financial statements, with the public unitholders' interest reflected as a minority interest. All significant intercompany transactions have been eliminated. Certain reclassifications have been made to the prior year statements to conform to the current year presentation. NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates made by management include (1) crude oil and natural gas reserves (2) depreciation, depletion and amortization, including future abandonment costs, (3) income taxes and related valuation allowance and (4) accrued liabilities. Although management believes these estimates are reasonable, actual results could differ from these estimates. Cash and Cash Equivalents. Cash and cash equivalents consist of all demand deposits and funds invested in highly liquid instruments with original maturities of three months or less. Inventory. Crude oil inventory is carried at the lower of cost, as adjusted for deferred hedging gains and losses, or market value using an average cost method. Materials and supplies inventory is stated at the lower of cost or market with cost determined on a first-in, first-out method. Inventory at December 31, 1999 includes approximately $37.9 million of crude oil linefill which we began selling in November 1999 (see Note 6). Inventory consists of the following: DECEMBER 31, --------------------------- 1999 1998 ------- ------- (IN THOUSANDS) Crude oil $73,535 $37,702 Materials and supplies 4,814 4,818 ------- ------- $78,349 $42,520 ======= ======= Oil and Natural Gas Properties. We follow the full cost method of accounting whereby all costs associated with property acquisition, exploration, exploitation and development activities are capitalized. Such costs include internal general and administrative costs such as payroll and related benefits and costs directly attributable to employees engaged in acquisition, exploration, exploitation and development activities. General and administrative costs associated with production, operations, marketing and general corporate activities are expensed as incurred. These capitalized costs along with our estimate of future development and abandonment costs, net of salvage values and other considerations, are amortized to expense by the unit-of-production method using engineers' estimates of unrecovered proved oil and natural gas reserves. The costs of unproved properties are excluded from amortization until the properties are evaluated. Interest is capitalized on oil and natural gas properties not subject to amortization and in the process of development. Proceeds from the sale of oil and natural gas properties are accounted for as reductions to capitalized costs unless such sales involve a significant change in the relationship between costs and the estimated value of proved reserves, in which case a gain or loss is recognized. Unamortized costs of proved properties are subject to a ceiling which limits such costs to the present value of estimated future cash flows from proved oil and natural gas reserves of such properties reduced by future operating expenses, development expenditures and abandonment costs (net of salvage values), and estimated future income taxes thereon (the "Standardized Measure") (see Note 20). Crude Oil Pipeline, Gathering and Terminal Assets. Crude oil pipeline, gathering and terminal assets are recorded at cost. Depreciation is computed using the straight-line method over estimated useful lives as follows: . crude oil pipelines - 40 years; . crude oil pipeline facilities - 25 years; . crude oil terminal and storage facilities - 30 to 40 years; . trucking equipment, injection stations and other - 5 to 10 years; and Acquisitions and improvements are capitalized; maintenance and repairs are expensed as incurred. Other Property and Equipment. Other property and equipment is recorded at cost and consists primarily of office furniture and fixtures and computer hardware and software. Acquisitions, renewals, and betterments are capitalized; maintenance and repairs are expensed. Depreciation is provided using the straight-line method over estimated useful lives of three to seven years. Other Assets. Other assets consist of the following (in thousands): DECEMBER 31, ------------------- 1999 1998 ------- ------- (RESTATED) Pipeline linefill $ 17,633 $ 54,511 Deferred tax asset (See Note 11) 67,366 46,356 Land 8,853 8,853 Debt issue costs 35,101 18,668 Other 10,965 8,245 -------- -------- 139,918 136,633 Accumulated amortization (10,151) (4,987) -------- -------- $129,767 $131,646 ======== ======== Pipeline Linefill. Pipeline linefill is recorded at cost and consists of crude oil linefill used to pack a pipeline such that when an incremental barrel enters a pipeline it forces a barrel out at another location. After the sale of the linefill discussed below, we own approximately 1.2 million barrels of crude oil that is used to maintain the vast majority of our minimum operating linefill requirements. Proceeds from the sale and repurchase of pipeline linefill are reflected as cash flows from operating activities in the accompanying consolidated statements of cash flows. Proceeds from the sale of linefill in connection with the segment of the All American Pipeline that we sold are included in investing activities in the accompanying consolidated statements of cash flows (see Note 6). Costs incurred in connection with the issuance of long-term debt are capitalized and amortized using the straight-line method over the term of the related debt. Debt issue costs at December 31, 1999 include approximately $13.7 million paid in the fourth quarter of 1999 to amend PAA's credit facilities as a result of defaults caused by unauthorized trading losses (see Note 3). Federal and State Income Taxes. Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109"). SFAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using tax rates in effect for the year in which the differences are expected to reverse. Revenue Recognition. Gathering and marketing revenues are accrued at the time title to the product sold transfers to the purchaser, which typically occurs upon receipt of the product by the purchaser, and purchases are accrued at the time title to the product purchased transfers to us, which typically occurs upon our receipt of the product. Terminalling and storage revenues are recognized at the time service is performed. Revenues for the transportation of crude oil are recognized based upon regulated and non-regulated tariff rates and the related transported volumes. We recognize oil and gas revenue from our interests in producing wells as oil and gas is produced and sold from those wells. Hedging. We utilize various derivative instruments, for purposes other than trading, to hedge our exposure to price fluctuations on crude in storage and expected purchases, sales and transportation of crude oil. The derivative instruments consist primarily of futures and option contracts traded on the New York Mercantile Exchange and crude oil swap contracts entered into with financial institutions. We also utilize interest rate swaps and collars to manage the interest rate exposure on our long-term debt. These derivative instruments qualify for hedge accounting as they reduce the price risk of the underlying hedged item and are designated as a hedge at inception. Additionally, the derivatives result in financial impacts which are inversely correlated to those of the items being hedged. This correlation, generally in excess of 80%, (a measure of hedge effectiveness) is measured both at the inception of the hedge and on an ongoing basis. If correlation ceases to exist, we would discontinue hedge accounting and apply mark to market accounting. Gains and losses on the termination of hedging instruments are deferred and recognized in income as the impact of the hedged item is recorded. Unrealized changes in the market value of crude oil hedge contracts are not generally recognized in our statement of operations until the underlying hedged transaction occurs. The financial impacts of crude oil hedge contracts are included in our statements of operations as a component of revenues. Such financial impacts are offset by gains or losses realized in the physical market. Cash flows from crude oil hedging activities are included in operating activities in the accompanying statements of cash flows. Net deferred gains and losses on futures contracts, including closed futures contracts, entered into to hedge anticipated crude oil purchases and sales are included in current assets or current liabilities in the accompanying balance sheets. Deferred gains or losses from inventory hedges are included as part of the inventory costs and recognized when the related inventory is sold. Amounts paid or received from interest rate swaps and collars are charged or credited to interest expense and matched with the cash flows and interest expense of the long-term debt being hedged, resulting in an adjustment to the effective interest rate. Deferred gains of $10.1 million received upon the termination of an interest rate swap are included in other long-term liabilities and deferred credits in the accompanying balance sheet at December 31, 1999. Stock Options. We have elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related interpretations in accounting for our employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of options equals the fair value (market price) of the underlying stock on the date of grant. Sale of Units by a Subsidiary. When a subsidiary sells additional units to a third party, resulting in a change in our percentage ownership interest, we recognize a gain or loss in our consolidated statement of operations if the selling price per unit is more or less than our average carrying amount per unit. When we buy additional units from a subsidiary, resulting in a change in our percentage ownership interest, the difference between our cost and underlying equity in investee net assets is assigned first to identifiable tangible and intangible assets and to liabilities based on their fair values at the date of the change of interest; any unassigned difference is assigned to goodwill. Recent Accounting Pronouncements. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. For fair value hedge transactions in which we are hedging changes in an asset's, liability's, or firm commitment's fair value, changes in the fair value of the derivative instrument will generally be offset in the income statement by changes in the hedged item's fair value. For cash flow hedge transactions, in which we are hedging the variability of cash flows related to a variable-rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument will be reported in other comprehensive income. The gains and losses on the derivative instrument that are reported in other comprehensive income will be reclassified as earnings in the periods in which earnings are affected by the variability of the cash flows of the hedged item. This statement was amended by Statement of Financial Accounting Standards No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 ("SFAS 137") issued in June 1999. SFAS 137 defers the effective date of SFAS 133 to fiscal years beginning after June 15, 2000. We are required to adopt this statement beginning in 2001. We have not yet determined the effect that the adoption of SFAS 133 will have on our financial position or results of operations. NOTE 3 -- UNAUTHORIZED TRADING LOSSES AND RESTATED FINANCIAL STATEMENTS In November 1999, we discovered that a former employee of PAA had engaged in unauthorized trading activity, resulting in losses of approximately $162.0 million ($174.0 million, including estimated associated costs and legal expenses). A full investigation into the unauthorized trading activities by outside legal counsel and independent accountants and consultants determined that the vast majority of the losses occurred from March through November 1999, and the impact warranted a restatement of previously reported financial information for 1999 and 1998. Because the financial statements of PAA are consolidated with our financial statements, adverse effects on the financial statements of PAA directly affect our consolidated financial statements. As a result, we have restated our previously reported 1999 and 1998 results to reflect the losses incurred from these unauthorized trading activities. Approximately $7.1 million of the unauthorized trading losses were recognized in 1998 and the remainder in 1999. Normally, as it purchases crude oil, PAA establishes a margin by selling crude oil for physical delivery to third-party users or by entering into a future delivery obligation with respect to futures contracts. The employee in question violated PAA's policy of maintaining a position that is substantially balanced between crude oil purchases and sales or future delivery obligations. The unauthorized trading and associated losses resulted in a default of certain covenants under PAA's credit facilities and significant short-term cash and letter of credit requirements. Although one of our wholly-owned subsidiaries is the general partner of and owns 54% of PAA, the trading losses do not affect the operations or assets of our upstream business. The debt of PAA is nonrecourse to us. In addition, our indirect ownership in PAA does not collateralize any of our credit facilities. Our $225.0 million credit facility is collateralized by our oil and natural gas properties. In December 1999, PAA executed amended credit facilities and obtained default waivers from all of its lenders. The amended credit facilities: . waived defaults under covenants contained in the existing credit facilities; . increased availability under PAA's letter of credit and borrowing facility from $175.0 million in November 1999 to $295.0 million in December 1999, $315.0 million in January 2000, and thereafter decreasing to $239.0 million in February through April 2000, to $225.0 million in May and June 2000 and to $200.0 million in July 2000 through July 2001; . required the lenders' consent prior to the payment of distributions to unitholders; . prohibited contango inventory transactions subsequent to January 20, 2000; and . increased interest rates and fees under certain of the facilities. PAA paid approximately $13.7 million to its lenders in connection with the amended credit facilities. This amount was capitalized as debt issue costs and will be amortized over the remaining term of the amended facilities. In connection with the amendments, we loaned approximately $114.0 million to PAA. This subordinated debt is due not later than November 30, 2005. We financed the $114.0 million that we loaned PAA with: . the issuance of a new series of our 10% convertible preferred stock for proceeds of $50.0 million (see Note 8); . cash distributions of approximately $9.0 million made in November 1999 to PAA's general partner; and . $55.0 million of borrowings under our revolving credit facility. In the period immediately following the disclosure of the unauthorized trading losses, a significant number of PAA's suppliers and trading partners reduced or eliminated the open credit previously extended to PAA. Consequently, the amount of letters of credit PAA needed to support the level of its crude oil purchases then in effect increased significantly. In addition, the cost to PAA of obtaining letters of credit increased under the amended credit facility. In many instances PAA arranged for letters of credit to secure its obligations to purchase crude oil from its customers, which increased its letter of credit costs and decreased its unit margins. In other instances, primarily involving lower margin wellhead and bulk purchases, certain of its purchase contracts were terminated. The summarized restated results for the periods ended and financial position as of March 31, June 30, September 30, 1999 and December 31, 1998 are as follows (in thousands, except per shared data) (unaudited): The summarized previously reported results for the periods ended and financial position as of March 31, June 30, September 30, 1999 and December 31, 1998 are as follows (in thousands, except per share data) (unaudited): Below is the summarized restated and previously reported results for the three and nine months ending September 30, 1998. NOTE 4 -- PLAINS ALL AMERICAN PIPELINE, L.P. - FORMATION AND OFFERINGS Our midstream activities are conducted through PAA. PAA was formed in September of 1998 to acquire and operate the business and assets of our wholly- owned midstream subsidiaries. On November 23, 1998, PAA completed an initial public offering of 13,085,000 common units at $20.00 per unit, representing limited partner interests and received proceeds of approximately $244.7 million. Concurrently with the closing of the initial public offering, we were merged with certain of our midstream subsidiaries, and then sold the assets of these subsidiaries to PAA in exchange for $64.1 million and the assumption of $11.0 million of related indebtedness. At the same time, the general partner conveyed all of its interest in the All American Pipeline and the SJV Gathering System to PAA in exchange for: . 6,974,239 common units, 10,029,619 subordinated units and an aggregate 2% general partner interest; . the right to receive incentive distributions as defined in the partnership agreement; and . PAA's assumption of $175.0 million of indebtedness incurred by the general partner in connection with the acquisition of the All American Pipeline and the SJV Gathering System. In addition to the $64.1 million paid to us, PAA distributed approximately $177.6 million to the general partner and used approximately $3.0 million of the remaining proceeds to pay expenses incurred in connection with the offering. The general partner used $121.0 million of the cash distributed to it to retire the remaining indebtedness incurred in connection with the acquisition of the All American Pipeline and the SJV Gathering System and to pay other costs associated with the transactions. The general partner distributed the remaining $56.6 million to us, which we used to repay indebtedness and for other general corporate purposes. During 1998, we recognized a pre-tax gain of approximately $70.0 million (net of approximately $9.2 million in formation related expenses) in connection with the formation of PAA. The gain is the result of an increase in the book value of our equity in PAA to reflect our proportionate share of the underlying net assets of PAA due to the sale of units in the initial public offering. The formation related expenses consist primarily of amounts due to certain key employees in connection with the successful formation of PAA, debt prepayment penalties and legal fees. In May 1999, PAA sold to the general partner 1.3 million Class B common units of PAA for a total cash consideration of $25.0 million, or $19.25 per unit, the price equal to the market value of PAA's common units on May 12, 1999, in connection with the Scurlock acquisition (see Note 6). In October 1999, PAA completed a public offering of an additional 2,990,000 common units representing limited partner interests, at $18.00 per unit. Net proceeds to PAA from the offering, including our general partner contribution of $0.5 million, were approximately $51.3 million after deducting underwriters' discounts and commissions and offering expenses of approximately $3.1 million. These proceeds were used to reduce outstanding debt. We recognized a pre-tax gain of $9.8 million in connection with the offering as a result of an increase in the book value of our equity in PAA, as discussed above. NOTE 5 -- UPSTREAM ACQUISITIONS AND DISPOSITIONS On July 1, 1999, Arguello Inc., our wholly owned subsidiary, acquired Chevron's interests in Point Arguello. The interests acquired include Chevron's 26% working interest in the Point Arguello Unit, its 26% interest in various partnerships owning the associated transportation, processing and marketing infrastructure, and Chevron's right to participate in surrounding leases and certain fee acreage onshore. We assumed its 26% share of (1) plugging and abandoning all existing well bores, (2) removing conductors, (3) flushing hydrocarbons from all lines and vessels and (4) removing/abandoning all structures, fixtures and conditions created subsequent to closing. Chevron retained the obligation for all other abandonment costs, including but not limited to (1) removing, dismantling and disposing of the existing offshore platforms, (2) removing and disposing of all existing pipelines and (3) removing, dismantling, disposing and remediation of all existing onshore facilities. Arguello Inc. is the operator of record for the Point Arguello Unit and has entered into an outsourcing agreement with a unit of Torch Energy Advisors, Inc. for the conduct of certain field operations and other professional services. During 1998, we acquired the Mt. Poso field from Aera Energy LLC for approximately $7.7 million. The field is located approximately 27 miles north of Bakersfield, California, in Kern County. The field added approximately 8 million barrels of oil equivalent to our proved reserves at the acquisition date. In March 1997, we completed the acquisition of Chevron's interest in the Montebello field for $25.0 million, effective February 1, 1997. The assets acquired consist of a 100% working interest and a 99.2% net revenue interest in 55 producing oil wells and related facilities and also include approximately 450 acres of surface fee land. At the acquisition date, the Montebello Field, which is located approximately 15 miles from our existing California operations, was producing approximately 800 barrels of crude oil and 800 Mcf of natural gas per day and added approximately 23 million barrels of oil equivalent to our proved reserves. The acquisition was funded with proceeds from our revolving credit facility. In November 1997, we acquired a 100% working interest and a 97% net revenue interest in the Arroyo Grande Field in San Luis Obispo County, California, from subsidiaries of Shell Oil Company ("Shell"). The assets acquired include surface and development rights to approximately 1,000 acres included in the 1,500 acre unit. At the acquisition date, the Arroyo Grande Field was producing approximately 1,600 barrels of 14 degrees API gravity crude oil per day from 70 wells and added approximately 20 million barrels of oil equivalent to our proved reserves. The aggregate purchase price of $22.1 million for the Arroyo Grande field consisted of rights to a non-producing property interest conveyed to Shell, the issuance of 46,600 shares of Series D Preferred Stock with an aggregate stated value of $23.3 million and a 5-year warrant to purchase 150,000 shares of Common Stock at $25.00 per share. No proved reserves had been assigned to the rights to the property interest conveyed. During 1997, we sold certain non-strategic crude oil and natural gas properties located primarily in Louisiana for net proceeds of approximately $2.7 million. NOTE 6 -- MIDSTREAM ACQUISITIONS AND DISPOSITIONS Scurlock Acquisition On May 12, 1999, PAA completed the acquisition of Scurlock Permian LLC and certain other pipeline assets from Marathon Ashland Petroleum LLC. Including working capital adjustments and closing and financing costs, the cash purchase price was approximately $141.7 million. Scurlock, previously a wholly owned subsidiary of Marathon Ashland Petroleum, is engaged in crude oil transportation, gathering and marketing, and owns approximately 2,300 miles of active pipelines, numerous storage terminals and a fleet of more than 250 trucks. Its largest asset is an 800-mile pipeline and gathering system located in the Spraberry Trend in West Texas that extends into Andrews, Glasscock, Martin, Midland, Regan and Upton Counties, Texas. The assets we acquired also included approximately one million barrels of crude oil pipeline linefill. Financing for the Scurlock acquisition was provided through: . borrowings of approximately $92.0 million under Plains Scurlock's limited recourse bank facility with BankBoston, N.A.; . the sale to the general partner of 1.3 million Class B common units of PAA for a total cash consideration of $25.0 million, or $19.125 per unit, the price equal to the market value of PAA's common units on May 12, 1999; and . a $25.0 million draw under PAA's existing revolving credit agreement. The funds for the purchase of the Class B units by the general partner were provided by a capital contribution from us. We financed our capital contribution through our revolving credit facility. The purchase price allocation was based on preliminary estimates of fair value and is subject to adjustment as additional information becomes available and is evaluated. The purchase accounting entries include a $1.0 million accrual for estimated environmental remediation costs. Under the agreement for the sale of Scurlock by Marathon Ashland Petroleum to Plains Scurlock, Marathon Ashland Petroleum has agreed to indemnify and hold harmless Scurlock and Plains Scurlock for claims, liabilities and losses resulting from any act or omission attributable to Scurlock's business or properties occurring prior to the date of the closing of such sale to the extent the aggregate amount of such losses exceed $1.0 million; provided, however, that claims for such losses must individually exceed $25,000 and must be asserted by Scurlock against Marathon Ashland Petroleum on or before May 15, 2003. The assets, liabilities and results of operations of Scurlock are included in our consolidated financial statements effective May 1, 1999. The Scurlock acquisition has been accounted for using the purchase method of accounting and the purchase price was allocated in accordance with Accounting Principles Board Opinion No. 16, Business Combinations ("APB 16") as follows (in thousands): Crude oil pipeline, gathering and terminal assets $125,120 Other property and equipment 1,546 Pipeline linefill 16,057 Other assets (debt issue costs) 3,100 Other long-term liabilities (environmental accrual) (1,000) Net working capital items (3,090) -------- Cash paid $141,733 ======== Pro Forma Results for the Scurlock Acquisition The following unaudited pro forma data is presented to show pro forma revenues, net loss and basic and diluted net loss per share as if the Scurlock acquisition, which was effective May 1, 1999, had occurred on January 1, 1998 (in thousands, except per share data): YEAR ENDED DECEMBER 31, ---------------------- 1999 1998 --------- ---------- (RESTATED) Revenues $5,227,013 $2,529,558 ========== ========== Net loss $ (27,147) $ (69,682) ========== ========== Net loss per share available to common stockholders: Basic and diluted $ (2.15) $ (4.43) ========== ========== West Texas Gathering System Acquisition On July 15, 1999, Plains Scurlock Permian, L.P. completed the acquisition of a West Texas crude oil pipeline and gathering system from Chevron Pipe Line Company for approximately $36.0 million, including transaction costs. Our total acquisition cost was approximately $38.9 million including costs to address certain issues identified in the due diligence process. The principal assets acquired include approximately 450 miles of crude oil transmission mainlines, approximately 400 miles of associated gathering and lateral lines and approximately 2.9 million barrels of crude oil storage and terminalling capacity in Crane, Ector, Midland, Upton, Ward and Winkler Counties, Texas. Financing for the amounts paid at closing was provided by a draw under the term loan portion of the Plains Scurlock credit facility. Venice Terminal Acquisition On September 3, 1999, PAA completed the acquisition of a Louisiana crude oil terminal facility and associated pipeline system from Marathon Ashland Petroleum LLC for approximately $1.5 million. The principal assets acquired include approximately 300,000 barrels of crude oil storage and terminalling capacity and a six-mile crude oil transmission system near Venice, Louisiana. All American Pipeline Acquisition On July 30, 1998, Plains All American Inc., acquired all of the outstanding capital stock of the All American Pipeline Company, Celeron Gathering Corporation and Celeron Trading & Transportation Company (collectively the "Celeron Companies") from Wingfoot, a wholly-owned subsidiary of the Goodyear Tire and Rubber Company ("Goodyear") for approximately $400.0 million, including transaction costs. The principal assets of the entities acquired include the All American Pipeline and the SJV Gathering System, as well as other assets related to such operations. The acquisition was accounted for utilizing the purchase method of accounting with the assets, liabilities and results of operations included in our consolidated financial statements effective July 30, 1998. The acquisition was accounted for utilizing the purchase method of accounting and the purchase price was allocated in accordance with APB 16 as follows (in thousands): Financing for the acquisition was provided through a $325.0 million, limited recourse bank facility and an approximate $114.0 million capital contribution by us. Actual borrowings at closing were $300.0 million. All American Pipeline Linefill Sale and Asset Disposition We initiated the sale of approximately 5.2 million barrels of crude oil linefill from the All American Pipeline in November 1999. This sale was substantially completed in February 2000. The linefill was located in the segment of the All American Pipeline that extends from Emidio, California, to McCamey, Texas. Except for minor third party volumes, one of our subsidiaries has been the sole shipper on this segment of the pipeline since its predecessor acquired the line from Goodyear in July 1998. Proceeds from the sale of the linefill were approximately $100.0 million, net of associated costs, and were used for working capital purposes. We estimate that we will recognize a total gain of approximately $44.0 million in connection with the sale of linefill. As of December 31, 1999, we had delivered approximately 1.8 million barrels of linefill and recognized a gain of $16.5 million. The amount of crude oil linefill for sale at December 31, 1999 was $37.9 million and is included in inventory on the consolidated balance sheet. On March 24, 2000, we completed the sale of the above referenced segment of the All American Pipeline to a unit of El Paso Energy Corporation for total proceeds of $129.0 million. The proceeds from the sale were used to reduce PAA's outstanding debt. Our net proceeds are expected to be approximately $124.0 million, net of associated transaction costs and estimated costs to remove certain equipment. We estimate that we will recognize a gain of approximately $20.0 million in connection with the sale. During 1999, we reported gross margin of approximately $5.0 million from volumes transported on the segment of the line that was sold. NOTE 7 -- LONG-TERM DEBT AND CREDIT FACILITIES Short-term debt and current portion of long-term debt consists of the following (in thousands): Long-term debt consists of the following (in thousands): PLAINS RESOURCES LONG-TERM DEBT AND CREDIT FACILITIES Revolving Credit Facility We have a $225.0 million revolving credit facility with a group of banks. The revolving credit facility is guaranteed by all of our upstream subsidiaries and is collateralized by our upstream oil and natural gas properties and those of the guaranteeing subsidiaries and the stock of all upstream subsidiaries. The borrowing base under the revolving credit facility at December 31, 1999, is $225.0 million and is subject to redetermination from time to time by the lenders in good faith, in the exercise of the lenders' sole discretion, and in accordance with customary practices and standards in effect from time to time for crude oil and natural gas loans to borrowers similar to our company. Our borrowing base may be affected from time to time by the performance of our crude oil and natural gas properties and changes in crude oil and natural gas prices. We incur a commintment fee of 3/8% per annum on the unused portion of the borrowing base. The revolving credit facility, as amended, matures on July 1, 2001, at which time the remaining outstanding balance converts to a term loan which is repayable in sixteen equal quarterly installments commencing October 1, 2001, with a final maturity of July 1, 2005. The revolving credit facility bears interest, at our option of either LIBOR plus 1 3/8% or Base Rate (as defined therein). At December 31, 1999, letters of credit of $0.6 million and borrowings of approximately $137.3 million were outstanding under the revolving credit facility. The revolving credit facility contains covenants which, among other things, restrict the payment of cash dividends, limit the amount of consolidated debt, limit our ability to make certain loans and investments and provide that we must maintain a specified relationship between current assets and current liabilities. 10.25% Senior Subordinated Notes Due 2006 We have $275 million principal amount of 10.25% Senior Subordinated Notes Due 2006 outstanding which bear a coupon rate of 10.25% which at December 31, 1999 consists of (in thousands): Series A $ 500 Series B 149,500 Series C 50 Series D 49,950 Series E 75,000 -------- $275,000 ======== The Series A & B 10.25% Notes were issued in 1996 at 99.38% of par to yield 10.35%. The Series C & D 10.25% Notes were issued in 1997 at approximately 107% of par to yield a minimum yield to worst of 8.79%, or 9.03% to maturity. Proceeds from the sale of the Series C & D 10.25% Notes, net of offering costs, were approximately $53.0 million and were used to reduce the balance on our revolving credit facility. The Series E 10.25% Notes were issued in September 1999 pursuant to a Rule 144A private placement at approximately 101% of par to yield a minimum yield to worst of 9.97%. Proceeds from the sale of the Series E 10.25% Notes, net of offering costs, were approximately $74.6 million and were used to reduce the balance on our revolving credit facility. In connection with the sale of the Series E Notes, we agreed to offer to exchange 10.25% Senior Subordinated Notes due 2006, Series F for all of the Series E Notes. The Series F Notes will be substantially identical (including principal amount, interest rate, maturity and redemption rights) to the Series E Notes except for certain transfer restrictions relating to the Series E Notes. We also agreed to file a registration statement with the SEC with respect to this exchange offer and to use our best efforts to cause such registration statement to be declared effective by January 20, 2000. If such registration statement is not declared effective by such date, with respect to the first 90- day period thereafter, the interest rate on the Series E Notes increases by 0.50% per annum and will increase by an additional 0.50% per annum with respect to each subsequent 90-day period until the registration statement has been declared effective, up to a maximum increase of 2% per annum. While the registration statement has been filed, we will not request the SEC to declare it effective until after the filing of our 1999 Form 10-K. As a result, the interest rate on the Series E Notes has increased to 10.75% for the 90-day period following January 20, 2000. At such time as the registration statement is declared effective by the SEC, the interest rate will revert to 10.25% per annum. The 10.25% Notes are redeemable, at our option, on or after March 15, 2001 at 105.13% of the principal amount thereof, at decreasing prices thereafter prior to March 15, 2004, and thereafter at 100% of the principal amount thereof plus, in each case, accrued interest to the date of redemption. The Indenture contains covenants that include, but are not limited to, covenants that: (1) limit the incurrence of additional indebtedness; (2) limit certain investments; (3) limit restricted payments; (4) limit the disposition of assets; (5) limit the payment of dividends and other payment restrictions affecting subsidiaries; (6) limit transactions with affiliates; (7) limit the creation of liens; and (8) restrict mergers, consolidations and transfers of assets. In the event of a Change of Control and a corresponding Rating Decline, as both are defined in the Indenture, we will be required to make an offer to repurchase the 10.25% Notes at 101% of the principal amount thereof, plus accrued and unpaid interest to the date of the repurchase. The Series A-E Notes are unsecured general obligations and are subordinated in right of payment to all our existing and future senior indebtedness and are guaranteed by all of our upstream subsidiaries on a full, unconditional, joint and several basis. The Series A-E Notes are not guaranteed by PAA or any of our other midstream subsidiaries. PLAINS ALL AMERICAN PIPELINE L.P. CREDIT FACILITIES The discussion below relates to credit facilities of PAA, which are nonrecourse to us, but are included in our consolidated financial statements. In addition, our indirect ownership in PAA does not collateralize any of our credit facilities. PAA has a letter of credit and borrowing facility, the purpose of which is to provide standby letters of credit to support the purchase and exchange of crude oil for resale and borrowings primarily to finance crude oil inventory which has been hedged against future price risk or designated as working inventory. As a result of the unauthorized trading losses discovered in November 1999, the facility was in default of certain covenants, with those defaults being subsequently waived and the facility amended in December. As amended, the letter of credit facility has a sublimit for cash borrowings of $40.0 million at December 31, 1999, with decreasing amounts thereafter through April 30, 2000, at which time the sublimit is eliminated. The letter of credit and borrowing facility provides for an aggregate letter of credit availability of $295.0 million in December 1999, $315.0 million in January 2000, and thereafter decreasing to $239.0 million in February through April 2000, to $225.0 million in May and June 2000, and to $200.0 million in July 2000 through July 2001. Aggregate availability under the letter of credit facility for direct borrowings and letters of credit is limited to a borrowing base which is determined monthly based on certain of PAA's current assets and current liabilities, primarily accounts receivable and accounts payable related to the purchase and sale of crude oil. This facility is secured by a lien on substantially all of PAA's assets except the assets which secure the Plains Scurlock credit facility. At December 31, 1999, there were letters of credit of approximately $292.0 million and borrowings of $13.7 million outstanding under this facility. On December 30, 1999, PAA entered into a $65.0 million senior secured term credit facility to fund short-term working capital requirements resulting from the unauthorized trading losses. The facility was secured by a portion of the 5.2 million barrels of linefill that was sold and receivables from certain sales contracts applicable to the linefill. The facility had a maturity date of March 24, 2000 and was repaid with the proceeds from the sale of the linefill securing the facility. At December 31, 1999, there were borrowings of $45.0 million outstanding. Concurrently with the closing of PAA's initial public offering in November 1998, PAA entered into a $225.0 million bank credit agreement that includes a $175.0 million term loan facility and a $50.0 million revolving credit facility. As a result of the unauthorized trading losses discovered in November 1999, the facility was in default of certain covenants, with those defaults being subsequently waived and the facility amended in December. The bank credit agreement is secured by a lien on substantially all of PAA's assets except the assets which secure the Plains Scurlock credit facility. PAA may borrow up to $50.0 million under the revolving credit facility for acquisitions, capital improvements, working capital and general business purposes. At December 31, 1999, PAA had $175.0 million outstanding under the term loan facility, and $50.0 million outstanding under the revolving credit facility. The term loan facility matures in 2005, and no principal is scheduled for payment prior to maturity. The term loan facility may be prepaid at any time without penalty. The revolving credit facility expires in November 2000. The term loan and revolving credit facility bear interest at PAA's option at either the base rate, as defined, plus an applicable margin, or reserve adjusted LIBOR plus an applicable margin. PAA incurs a commitment fee on the unused portion of the revolving credit facility. Plains Scurlock, an operating partnership which is a subsidiary of PAA, has a bank credit agreement which consists of a five-year $82.6 million term loan facility and a three-year $35.0 million revolving credit facility. The Plains Scurlock bank credit agreement is nonrecourse to PAA, Plains Marketing, L.P. and All American Pipeline, L.P. and is secured by substantially all of the assets of Plains Scurlock Permian, L.P. and its subsidiaries, including the Scurlock assets and the West Texas gathering system. Borrowings under the term loan and under the revolving credit facility bear interest at LIBOR plus the applicable margin. A commitment fee equal to 0.5% per year is charged on the unused portion of the revolving credit facility. The revolving credit facility, which may be used for borrowings or letters of credit to support crude oil purchases, matures in May 2002. The term loan provides for principal amortization of $0.7 million annually beginning May 2000, with a final maturity in May 2004. As of December 31, 1999, letters of credit of approximately $29.5 million were outstanding under the revolver and borrowings of $82.6 million and $2.5 million were outstanding under the term loan and revolver, respectively. The term loan was reduced to $82.6 million from $126.6 million with proceeds from PAA's October 1999 public offering. All of PAA's credit facilities contain prohibitions on distributions on, or purchases or redemptions of, units if any default or event of default is continuing. In addition, PAA's facilities contain various covenants limiting its ability to: . incur indebtedness; . grant liens; . sell assets in excess of certain limitations; . engage in transactions with affiliates; . make investments; . enter into hedging contracts; and . enter into a merger, consolidation or sale of assets. Each of PAA's facilities treats a change of control as an event of default. In addition, the terms of PAA's letter of credit and borrowing facility and its bank credit agreement require lenders' consent prior to the payment of distributions to unitholders and require it to maintain: . a current ratio of 1.0 to 1.0, as defined in PAA's credit agreement; . a debt coverage ratio which is not greater than 5.0 to 1.0; . an interest coverage ratio which is not less than 3.0 to 1.0; . a fixed charge coverage ratio which is not less than 1.25 to 1.0; and . a debt to capital ratio of not greater than 0.60 to 1.0. The terms of the Plains Scurlock bank credit agreement require Plains Scurlock to maintain at the end of each quarter: . a debt coverage ratio of 6.0 to 1.0 from October 1, 1999 through June 30, 2000; 5.0 to 1.0 from July 1, 2000 through June 30, 2001; and 4.0 to 1.0 thereafter; and . an interest coverage ratio of 2.0 to 1.0 from October 1, 1999 through June 30, 2000 and 2.5 to 1.0 thereafter. In addition, the Plains Scurlock bank credit agreement contains limitations on the Plains Scurlock operating partnership's ability to make distributions to PAA if its indebtedness and current liabilities exceed certain levels as well as the amount of expansion capital it may expend. Maturities The aggregate amount of maturities of all long-term indebtedness for the next five years is: 2000 - $51.1 million, 2001 - $9.7 million, 2002 - $38.0 million, 2003 - $35.5 million and 2004 - $114.8 million. NOTE 8 - REDEEMABLE PREFERRED STOCK Series E and Series G Cumulative Convertible Preferred Stock On July 29, 1998, we sold in a private placement 170,000 shares of our Series E Cumulative Convertible Preferred Stock (the "Series E Preferred Stock") for $85.0 million. Each share of the Series E Preferred Stock has a stated value of $500 per share and bears a dividend of 9.5% per annum. Dividends are payable semi-annually in either cash or additional shares of Series E Preferred Stock at our option and are cumulative from the date of issue. Each share of Series E Preferred Stock is convertible into 27.78 shares of common stock (an initial effective conversion price of $18.00 per share) and in certain circumstances may be converted at our option into common stock if the average trading price for any thirty-day trading period is equal to or greater than $21.60 per share. The Series E Preferred Stock is redeemable at our option at 105% of stated value through December 31, 2003 and at par thereafter. If not previously redeemed or converted, the Series E Preferred Stock is required to be redeemed in 2012. Proceeds from the Series E preferred Stock were used to fund a portion of our capital contribution to Plains All American Inc. to acquire the Celeron Companies (see Note 6). On April 1, 1999, we paid a dividend on the Series E Preferred Stock for the period from October 1, 1998 through March 31, 1999. The dividend amount of approximately $4.1 million was paid by issuing 8,209 additional shares of the Series E Preferred Stock. On September 9, 1999, 3,408 shares of Series E Preferred Stock, including accrued dividends, were converted into 98,613 shares of common stock at a conversion price of $18.00 per share. On October 1, 1999, we paid a cash dividend of approximately $4.2 million on the Series E Preferred Stock for the period April 1, 1999 through September 30, 1999. In connection with the sale of the Series F Preferred Stock described below, we agreed with the purchasers of the Series F Preferred Stock (who were also holders of the Series E Preferred Stock), to reduce the conversion price of the Series E Preferred Stock from $18.00 to $15.00. This reduction of the conversion price of the Series E Preferred Stock was effected through an exchange of each outstanding share of Series E Preferred Stock for a share of a new Series G Preferred Stock. Other than the reduction of the conversion price, the terms of the Series G Preferred Stock are substantially identical to those of the Series E Preferred Stock. On March 22, our Board of Directors declared a cash dividend on our Series G Preferred Stock, which is payable on April 3, 2000 to holders of record on March 23, 2000. The dividend amount of $4,219,000 is for the period of October 1, 1999 through March 31, 2000. Series F Cumulative Convertible Preferred Stock On December 14, 1999, we sold in a private placement 50,000 shares of our Series F Cumulative Convertible Preferred Stock (the "Series F Preferred Stock") for $50.0 million. Each share of the Series F Preferred Stock has a stated value of $1,000 per share and bears a dividend of 10% per annum. Dividends are payable semi-annually in either cash or additional shares of Series F Preferred Stock at our option and are cumulative from the date of issue. Dividends paid in additional shares of Series F Preferred Stock are limited to an aggregate of six dividend periods. Each share of Series F Preferred Stock is convertible into 81.63 shares of common stock (an initial effective conversion price of $12.25 per share) and in certain circumstances may be converted at our option into common stock if the average trading price for any sixty-day trading period is equal to or greater than $21.60 per share. After December 15, 2003, the Series F Preferred Stock is redeemable at our option at 110% of stated value through December 15, 2004 and at declining amounts thereafter. If not previously redeemed or converted, the Series F Preferred Stock is required to be redeemed in 2007. Proceeds from the Series F Preferred Stock were advanced to PAA in connection with the unauthorized trading losses through the issuance of $114.0 million of subordinated debt, due not later than November 30, 2005 (see Note 3). On March 22, our Board of Directors declared a cash dividend on our Series F Preferred Stock, which is payable on April 3, 2000 to holders of record on March 23, 2000. The dividend amount of $1,475,000 is for the period December 15, 1999 (the date of original issuance) through March 31, 2000. NOTE 9 -- CAPITAL STOCK Common and Preferred Stock We have authorized capital stock consisting of 50 million shares of common stock, $0.10 par value, and 2 million shares of preferred stock, $1.00 par value. At December 31, 1999, there were 17.9 million shares of common stock issued and outstanding and 274,226 shares of preferred stock outstanding. Stock Warrants and Options At December 31, 1999, we had warrants outstanding which entitle the holders thereof to purchase an aggregate 251,350 shares of common stock. Per share exercise prices and expiration dates for the warrants are as follows: 101,350 shares at $7.50 expiring in 2000 and 150,000 shares at $25.00 expiring in 2002. We have various stock option plans for our employees and directors (see Note 15). Series D Cumulative Convertible Preferred Stock In November 1997, we issued 46,600 shares of Series D Cumulative Convertible Preferred Stock (the "Series D Preferred Stock"). The Series D Preferred Stock has an aggregate stated value of $23.3 million and is redeemable at our option at 140% of stated value. If not previously redeemed or converted, the Series D Preferred Stock will automatically convert into 932,000 shares of common stock in 2012. Each share of the Series D Preferred Stock has a stated value of $500 and is convertible into common stock at a ratio of $25.00 of stated value for each share of Common Stock to be issued. The Series D Preferred Stock was initially recorded at $20.5 million, a discount of $2.8 million from the stated value of $23.3 million. Commencing January 1, 2000, the Series D Preferred Stock will bear an annual dividend of $30.00 per share. Prior to this date, no dividends were accrued and the discount was amortized to retained earnings through December 31, 1999. On March 22, our Board of Directors declared a cash dividend on our Series D Preferred stock, which is payable on April 3, 2000 to holders of record on March 23, 2000. The dividend amount of $350,000 is for the period January 1, 2000 through March 31, 2000. NOTE 10 -- EARNINGS PER SHARE The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per share computations for income (loss) from continuing operations before extraordinary item for the years ended December 31, 1999, 1998 and 1997 (in thousands, except per share amounts): In 1999 and 1998, we recorded net losses and our options and warrants were not included in the computations of diluted earnings per share because their assumed conversion was antidilutive. In 1997 certain options and warrants to purchase shares of our common stock were not included in the computations of diluted earnings per share because the exercise prices were greater than the average market price of the common stock during the period of the calculations, resulting in antidilution. In addition, our preferred stock is convertible into common stock but was not included in the computation of diluted earnings per share in 1999, 1998 and 1997 because the effect was antidilutive. See Notes 9 and 15 for additional information concerning outstanding options and warrants. NOTE 11 -- INCOME TAXES Our deferred income tax assets and liabilities at December 31, 1999 and 1998, consist of the tax effect of income tax carryforwards and differences related to the timing of recognition of certain types of costs incurred in both our upstream and midstream activities as follows (in thousands): At December 31, 1999, we have a net deferred federal tax asset of $69.2 million. Management believes that it is more likely than not that it will generate taxable income sufficient to realize such asset based on certain tax planning strategies available to us. At December 31, 1999, we have carryforwards of approximately $229.3 million of regular tax NOLs, $7.0 million of statutory depletion, $1.4 million of alternative minimum tax credits and $0.3 million of enhanced oil recovery credits. At December 31, 1999, we had approximately $209.8 million of alternative minimum tax NOL carryforwards available as a deduction against future alternative minimum tax income. The NOL carryforwards expire from 2005 through 2019. Set forth below is a reconciliation between the income tax provision (benefit) computed at the United States statutory rate on income (loss) before income taxes and the income tax provision per the accompanying Consolidated Statements of Operations (in thousands): In accordance with certain provisions of the Tax Reform Act of 1986, a change of greater than 50% of our beneficial ownership within a three-year period (an "Ownership Change") will place an annual limitation on our ability to utilize our existing tax carryforwards. Under the Final Treasury Regulations issued by the Internal Revenue Service, we do not believe that an Ownership Change has occurred as of December 31, 1999. NOTE 12 -- EXTRAORDINARY ITEM For the year ended December 31, 1999, we recognized an extraordinary loss related to the early extinguishment of debt. The loss is related to the reduction of the Plains Scurlock term loan facility with proceeds from PAA's 1999 public offering and the restructuring of PAA's letter of credit and borrowing facility as a result of the unauthorized trading losses (see Note 3 and 7). NOTE 13 -- RELATED PARTY TRANSACTIONS Reimbursement of Expenses of the General Partner and Its Affiliates As the general partner for PAA, we have sole responsibility for conducting its business and managing its operations and we own all of the incentive distribution rights. Some of our senior executives who currently operate our business also manage the business of PAA. We do not receive any management fee or other compensation in connection with the management of their business, but we are reimbursed for all direct and indirect expenses incurred on their behalf. For the years ended December 31, 1999 and 1998, we were reimbursed approximately $44.7 million and $0.5 million, respectively, for direct and indirect expenses on their behalf. The reimbursed costs consist primarily of employee salaries and benefits. PAA does not employ any persons to manage its business. These functions are provided by the employees of the general partner and us. Crude Oil Marketing Agreement PAA is the exclusive marketer/purchaser for all of our equity crude oil production. The marketing agreement provides that PAA will purchase for resale at market prices all of our equity crude oil production for which they charge a fee of $0.20 per barrel. For the year ended December 31, 1999 and the period from November 23, 1998 to December 31, 1998, we were paid approximately $131.5 million and $4.1 million, respectively, for the purchase of crude oil under the agreement. Prior to the marketing agreement, PAA's predecessor marketed our crude oil production and that of our subsidiaries and our royalty owners. We were paid approximately $83.4 million and $101.2 million for the purchase of these products for the period from January 1, 1998 to November 22, 1998 and the year ended December 31, 1997, respectively. In management's opinion, such purchases were made at prevailing market prices. PAA's predecessor did not recognize a profit on the sale of the crude oil purchased from us. Financing In December 1999, we loaned to PAA $114.0 million. This subordinated debt is due not later than November 30, 2005 (see Note 3). To finance a portion of the purchase price of the Scurlock acquisition, we purchased 1.3 million Class B common units from PAA at $19.125 per unit, the market value of the common units on May 12, 1999 (see Note 6). Long-Term Incentive Plans We have adopted the Plains All American Inc. 1998 Long-Term Incentive Plan for employees and directors of the general partner and its affiliates who perform services for PAA. The Long-Term Incentive Plan consists of two components, a restricted unit plan and a unit option plan. The Long-Term Incentive Plan currently permits the grant of restricted units and unit options covering an aggregate of 975,000 common units. The plan is administered by the Compensation Committee of the general partner's board of directors. Restricted Unit Plan. A restricted unit is a "phantom" unit that entitles the grantee to receive a common unit upon the vesting of the phantom unit. As of March 15, 2000, an aggregate of approximately 500,000 restricted units have been authorized for grants to employees of the general partner, 170,000 of which have been granted with the remaining 330,000 to be granted in the near future. The Compensation Committee may, in the future, make additional grants under the plan to employees and directors containing such terms as the Compensation Committee shall determine. In general, restricted units granted to employees during the subordination period will vest only upon, and in the same proportions as, the conversion of the subordinated units to common units. Grants made to non-employee directors of the general partner will be eligible to vest prior to termination of the subordination period. Unit Option Plan. The Unit Option Plan currently permits the grant of options covering common units. No grants have been made under the Unit Option Plan to date. However, the Compensation Committee may, in the future, make grants under the plan to employees and directors containing such terms as the committee shall determine, provided that unit options have an exercise price equal to the fair market value of the units on the date of grant. Unit options granted during the subordination period will become exercisable automatically upon, and in the same proportions as, the conversion of the subordinated units to common units, unless a later vesting date is provided. Transaction Grant Agreements In addition to the grants made under the Restricted Unit Plan described above, the general partner, at no cost to PAA, agreed to transfer approximately 400,000 of its affiliates' common units (including distribution equivalent rights attributable to such units) to certain key employees of the general partner. A grant covering 50,000 of such common units was terminated in 1999. Generally, approximately 69,444 of the remaining common units vest in each of the years ending December 31, 1999, 2000 and 2001 if the operating surplus generated in such year equals or exceeds the amount necessary to pay the minimum quarterly distribution on all outstanding common units and the related distribution on the general partner interest. If a tranche of common units does not vest in a particular year, such common units will vest at the time the common unit arrearages for such year have been paid. In addition, approximately 47,224 of the remaining common units vest in each of the years ending December 31, 1999, 2000 and 2001 if the operating surplus generated in such year exceeds the amount necessary to pay the minimum quarterly distribution on all outstanding common units and subordinated units and the related distribution on the general partner interest. In 1999, approximately 69,444 of such common units vested and 47,224 of such common units remain unvested as no distribution on the subordinated units was made for the fourth quarter of 1999. Any common units remaining unvested shall vest upon, and in the same proportion as, the conversion of subordinated units to common units. Distribution equivalent rights are paid in cash at the time of the vesting of the associated common units. Notwithstanding the foregoing, all common units become vested if Plains All American Inc. is removed as general partner prior to January 1, 2002. We recognized noncash compensation expense of approximately $1.0 million for the year ended December 31, 1999 related to the transaction grants which vested in 1999 NOTE 14 -- RETIREMENT PLAN Effective June 1, 1996, our board of directors adopted a nonqualified retirement plan (the "Plan") for certain of our officers. Benefits under the Plan are based on salary at the time of adoption, vest over a 15-year period and are payable over a 15-year period commencing at age 60. The Plan is unfunded. Net pension expense for the years ended December 31, 1999, 1998 and 1997, is comprised of the following components (in thousands): The following schedule reconciles the status of the Plan with amounts reported in our balance sheet at December 31, 1999 and 1998 (in thousands): The weighted-average discount rate used in determining the projected benefit obligation was 7.8% and 6.5% for the years ended December 31, 1999 and 1998. NOTE 15 -- STOCK COMPENSATION PLANS Historically, we have used stock options as a long-term incentive for our employees, officers and directors under various stock option plans. The exercise price of options granted to employees is equal to or greater than the market price of the underlying stock on the date of grant. Accordingly, consistent with the provisions of APB 25, no compensation expense has been recognized in the accompanying financial statements. We have options outstanding under our 1996, 1992 and 1991 plans, under which a maximum of 3.5 million shares of common stock were reserved for issuance. Generally, terms of the options provide for an exercise price of not less than the market price of our stock on the date of the grant, a pro rata vesting period of two to four years and an exercise period of five to ten years. We have outstanding performance options to purchase a total of 500,000 shares of common stock which were granted to two executive officers. Terms of the options provide for an exercise price of $13.50, the market price on the date of grant, and an exercise period ending in August 2001. The performance options vest when the price of our common stock trades at or above $24.00 per share for any 20 trading days in any 30 consecutive trading day period or upon a change in control if certain conditions are met. A summary of the status of our stock options as of December 31, 1999, 1998, and 1997, and changes during the years ending on those dates are presented below: In October 1995, the Financial Accounting Standards Board issued SFAS 123 which established financial accounting and reporting standards for stock-based employee compensation. The pronouncement defines a fair value based method of accounting for an employee stock option or similar equity instrument. SFAS 123 also allows an entity to continue to measure compensation cost for those instruments using the intrinsic value-based method of accounting prescribed by APB 25. We have elected to follow APB 25 and related interpretations in accounting for our employee stock options because, as discussed below, the alternative fair value accounting provided for under SFAS 123 requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense has been recognized in the accompanying financial statements. We will recognize compensation expense under APB 25 in the future for the performance options described above, if certain conditions are met and the options vest. Pro forma information regarding net income (loss) and earnings per share is required by SFAS 123 and has been determined as if we had accounted for our employee stock options under the fair value method as provided therein. The fair value for the options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for grants in 1999, 1998 and 1997: risk-free interest rates of 5.1% for 1999, 5.6% for 1998 and 6.1% for 1997; a volatility factor of the expected market price of our common stock of .50 for 1999, .38 for 1998 and .42 for 1997; no expected dividends; and weighted-average expected option lives of 2.7 years in 1999, 2.7 years in 1998 and 2.6 years in 1997. The Black-Scholes option valuation model and other existing models were developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of and are highly sensitive to subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The pro forma information is not meant to be representative of the effects on reported net income (loss) for future years, because as provided by SFAS 123, the effects of awards granted before December 31, 1994, are not considered in the pro forma calculations. Set forth below is a summary of our net income (loss) before extraordinary item and earnings per share as reported and pro forma as if the fair value based method of accounting defined in SFAS 123 had been applied (in thousands, except per share data). The following table summarizes information about stock options outstanding at December 31, 1999 (share amounts in thousands): During 1999, 1998 and 1997, pursuant to board of directors' resolutions, we contributed approximately 65,000, 28,000 and 21,000 shares, respectively, of common stock at weighted average prices of $15.46, $16.21 and $15.22 per share, respectively, on behalf of participants in our 401(k) Savings Plan, representing our matching contribution for 50% of an employee's contribution. NOTE 16 -- COMMITMENTS, CONTINGENCIES AND INDUSTRY CONCENTRATION Commitments and Contingencies We lease certain real property, equipment and operating facilities under various operating leases. We also incur costs associated with leased land, rights-of-way, permits and regulatory fees whose contracts generally extend beyond one year but can be canceled at any time should they not be required for operations. Future non-cancelable commitments related to these items at December 31, 1999, are summarized below (in thousands): 2000 $8,093 2001 5,759 2002 2,257 2003 1,595 2004 1,506 Later years 2,245 Total expenses related to these commitments for the years ended December 31, 1999, 1998 and 1997 were $9.3 million, $1.6 million and $1.1 million, respectively. In connection with its crude oil marketing, PAA provides certain purchasers and transporters with irrevocable standby letters of credit to secure their obligation for the purchase of crude oil. Generally, these letters of credit are issued for up to seventy day periods and are terminated upon completion of each transaction. At December 31, 1999, PAA had outstanding letters of credit of approximately $321.5 million. Such letters of credit are secured by PAA's crude oil inventory and accounts receivable. (see Note 7). Under the amended terms of an asset purchase agreement between us and Chevron, commencing with the year beginning January 1, 2000, and each year thereafter, we are required to plug and abandon 20% of the then remaining inactive wells, which currently aggregate approximately 233. To the extent we elect not to plug and abandon the number of required wells, we are required to escrow an amount equal to the greater of $25,000 per well or the actual average plugging cost per well in order to provide for the future plugging and abandonment of such wells. In addition, we are required to expend a minimum of $600,000 per year in each of the ten years beginning January 1, 1996, and $300,000 per year in each of the succeeding five years to remediate oil contaminated soil from existing well sites, provided there are remaining sites to be remediated. In the event we do not expend the required amounts during a calendar year, we are required to contribute an amount equal to 125% of the actual shortfall to an escrow account. We may withdraw amounts from the escrow account to the extent we expend excess amounts in a future year. As of December 31, 1999, we have not been required to make contributions to an escrow account. Although we obtained environmental studies on our properties in California, the Sunniland Trend and the Illinois Basin and we believe that such properties have been operated in accordance with standard oil field practices, certain of the fields have been in operation for more than 90 years, and current or future local, state and federal environmental laws and regulations may require substantial expenditures to comply with such rules and regulations. In connection with the purchase of certain of our California properties, we received a limited indemnity from Chevron for certain conditions if they violate applicable local, state and federal environmental laws and regulations in effect on the date of such agreement. We believe that we do not have any material obligations for operations conducted prior to our acquisition of the properties from Chevron, other than our obligation to plug existing wells and those normally associated with customary oil field operations of similarly situated properties, there can be no assurance that current or future local, state or federal rules and regulations will not require us to spend material amounts to comply with such rules and regulations or that any portion of such amounts will be recoverable under the Chevron indemnity. Consistent with normal industry practices, substantially all of our crude oil and natural gas leases require that, upon termination of economic production, the working interest owners plug and abandon non-producing wellbores, remove tanks, production equipment and flow lines and restore the wellsite. We have estimated that the costs to perform these tasks is approximately $13.4 million, net of salvage value and other considerations. Such estimated costs are amortized to expense through the unit-of-production method as a component of accumulated depreciation, depletion and amortization. Results from operations for 1999, 1998 and 1997 include $0.5 million, $0.8 million and $0.6 million, respectively, of expense associated with these estimated future costs. For valuation and realization purposes of the affected crude oil and natural gas properties, these estimated future costs are also deducted from estimated future gross revenues to arrive at the estimated future net revenues and the Standardized Measure disclosed in Note 20. As is common within the industry, we have entered into various commitments and operating agreements related to the exploration and development of and production from proved crude oil and natural gas properties and the marketing, transportation, terminalling and storage of crude oil. It is management's belief that such commitments will be met without a material adverse effect on our financial position, results of operations or cash flows. Industry Concentration Financial instruments which potentially subject us to concentrations of credit risk consist principally of trade receivables. Our accounts receivable are primarily from purchasers of crude oil and natural gas products and shippers of crude oil. This industry concentration has the potential to impact our overall exposure to credit risk, either positively or negatively, in that the customers may be similarly affected by changes in economic, industry or other conditions. We generally require letters of credit for receivables from customers which are not considered investment grade, unless the credit risk can otherwise be reduced. The loss of an individual customer would not have a material adverse effect. There are a limited number of alternative methods of transportation for our production. Substantially all of our California crude oil and natural gas production and our Sunniland Trend crude oil production is transported by pipelines, trucks and barges owned by third parties. The inability or unwillingness of these parties to provide transportation services to us for a reasonable fee could result in our having to find transportation alternatives, increased transportation costs or involuntary curtailment of a significant portion of our crude oil and natural gas production which could have a negative impact on future results of operations or cash flows. NOTE 17 -- LITIGATION Texas Securities Litigation. On November 29, 1999, a class action lawsuit was filed in the United States District Court for the Southern District of Texas entitled Di Giacomo v. Plains All American Pipeline, et al. The suit alleged that Plains All American Pipeline, L.P. and certain of the general partner's officers and directors violated federal securities laws, primarily in connection with unauthorized trading by a former employee. An additional nineteen cases have been filed in the Southern District of Texas, some of which name the general partner and us as additional defendants. Plaintiffs allege that the defendants are liable for securities fraud violations under Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934 and for making false registration statements under Sections 11 and 15 of the Securities Act of 1933. The court has consolidated all subsequently filed cases under the first filed action described above. Two unopposed motions are currently pending to appoint lead plaintiffs. These motions ask the court to appoint two distinct lead plaintiffs to represent two different plaintiff classes: (1) purchasers of our common stock and options and (2) purchasers of PAA's common units. Once lead plaintiffs have been appointed, the plaintiffs will file their consolidated amended complaints. No answer or responsive pleading is due until thirty days after a consolidated amended complaint is filed. Delaware Derivative Litigation. On December 3, 1999, two derivative lawsuits were filed in the Delaware Chancery Court, New Castle County, entitled Susser v. Plains All American Inc., et al and Senderowitz v. Plains All American Inc., et al. These suits, and three others which were filed in Delaware subsequently, named the general partner, its directors and certain of its officers as defendants, and allege that the defendants breached the fiduciary duties that they owed to Plains All American Pipeline, L.P. and its unitholders by failing to monitor properly the activities of its employees. The derivative complaints allege, among other things, that Plains All American Pipeline has been harmed due to the negligence or breach of loyalty of the officers and directors that are named in the lawsuits. These cases are currently in the process of being consolidated. No answer or responsive pleading is due until these cases have been consolidated and a consolidated complaint has been filed. We intend to vigorously defend the claims made in the Texas securities litigation and the Delaware derivative litigation. However, there can be no assurance that we will be successful in our defense or that these lawsuits will not have a material adverse effect on our financial position or results of operation. On July 9, 1987, Exxon Corporation ("Exxon") filed an interpleader action in the United States District Court for the Middle District of Florida, Exxon Corporation v. E. W. Adams, et al., Case Number 87-976-CIV-T-23-B. This action was filed by Exxon to interplead royalty funds as a result of a title controversy between certain mineral owners in a field in Florida. One group of mineral owners, John W. Hughes, et al. (the "Hughes Group"), filed a counterclaim against Exxon alleging fraud, conspiracy, conversion of funds, declaratory relief, federal and Florida RICO, breach of contract and accounting, as well as challenging the validity of certain oil and natural gas leases owned by Exxon, and seeking exemplary and treble damages. In March 1993, but effective November 1, 1992, Calumet Florida, Inc. ("Calumet"), our wholly owned subsidiary, acquired all of Exxon's leases in the field affected by this lawsuit. In order to address those counterclaims challenging the validity of certain oil and natural gas leases, which constitute approximately 10% of the land underlying this unitized field, Calumet filed a motion to join Exxon as plaintiff in the subject lawsuit, which was granted July 29, 1994. In August 1994, the Hughes Group amended its counterclaim to add Calumet as a counter- defendant. Exxon and Calumet filed a motion to dismiss the counterclaims. On March 22, 1996, the Court granted Exxon's and Calumet's motion to dismiss the counterclaims alleging fraud, conspiracy, and federal and Florida RICO violations and challenging the validity of certain of our oil and natural gas leases but denied such motion as to the counterclaim alleging conversion of funds. We have reached an agreement in principle to settle with the Hughes Group. In consideration for full and final settlement, and dismissal with prejudice, we have agreed to pay to the Hughes Group the total sum of $100,000. We and Exxon have filed motions for summary judgment with respect to the claims of the remaining defendants. The court has not yet set a date for hearing of these motions. The trial date is currently scheduled in June 2000. We are a defendant, in the ordinary course of business, in various other legal proceedings in which our exposure, individually and in the aggregate, is not considered material to the accompanying financial statements. NOTE 18 -- FINANCIAL INSTRUMENTS Derivatives We utilize derivative financial instruments, as defined in Statement of Financial Accounting Standards No. 119, "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments" to hedge our exposure to price volatility on crude oil and do not use such instruments for speculative trading purposes. These arrangements expose us to credit risk (as to counterparties) and to risk of adverse price movements in certain cases where our purchases are less than expected. In the event of non-performance of a counterparty, we might be forced to acquire alternative hedging arrangements or be required to honor the underlying commitment at then-current market prices. In order to minimize credit risk relating to the non-performance of a counterparty, we enter into such contracts with counterparties that are considered investment grade, periodically review the financial condition of such counterparties and continually monitor the effectiveness of derivative financial instruments in achieving our objectives. In view of our criteria for selecting counterparties, our process for monitoring the financial strength of these counterparties and our experience to date in successfully completing these transactions, we believe that the risk of incurring significant financial statement loss due to the non- performance of counterparties to these transactions is minimal. We have entered into various arrangements to fix the NYMEX crude oil spot price for a significant portion of our crude oil production. On December 31, 1999, these arrangements provided for a NYMEX crude oil price for 18,500 barrels per day from January 1, 2000, through December 31, 2000, at an average floor price of approximately $16.00 per barrel. Approximately 10,000 barrels per day of the volumes hedged in 2000 will participate in price increases above the $16.00 per barrel floor price, subject to a ceiling limitation of $19.75 per barrel. Location and quality differentials attributable to our properties are not included in the foregoing prices. The agreements provide for monthly settlement based on the differential between the agreement price and the actual NYMEX crude oil price. Gains or losses are recognized in the month of related production and are included in crude oil and natural gas sales. At December 31, 1999, our hedging activities included crude oil futures contracts maturing in 2000 through 2002, covering approximately 7.4 million barrels of crude oil, including the portion of the linefill sold in January and February 2000. Since such contracts are designated as hedges and correlate to price movements of crude oil, any gains or losses resulting from market changes will be largely offset by losses or gains on our hedged inventory or anticipated purchases of crude oil. In addition, we have entered into swap agreements with various financial institutions to hedge the interest rate on an aggregate of $240 million of bank debt. These swaps are scheduled to terminate in 2001 and thereafter. Fair Value of Financial Instruments The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments ("SFAS 107"). The estimated fair value amounts have been determined using available market information and valuation methodologies described below. Considerable judgement is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. The carrying values of items comprising current assets and current liabilities approximate fair values due to the short-term maturities of these instruments. Crude oil futures contracts permit settlement by delivery of the crude oil and, therefore, are not financial instruments, as defined. The carrying amounts and fair values of our other financial instruments are as follows (in thousands): (1) These amounts represent the calculated difference between the NYMEX crude oil price and the hedge arrangements for future production from our properties as of December 31, 1999 and 1998. These hedges, and therefore the unrealized gains or losses, have been included in estimated future gross revenues to arrive at the estimated future net revenues and the Standardized Measure disclosed in Note 20. The carrying value of bank debt approximates its fair value as interest rates are variable, based on prevailing market rates. The fair value of subordinated debt was based on quoted market prices based on trades of subordinated debt. Other long-term debt was valued by discounting the future payments using our incremental borrowing rate. The fair value of the redeemable preferred stock is estimated to be its liquidation value at December 31, 1999 and 1998. The fair value of the interest rate swap and collar agreements is based on current termination values or quoted market prices of comparable contracts at December 31, 1999 and 1998. NOTE 19 -- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Selected cash payments and noncash activities were as follows (in thousands): NOTE 20 -- CRUDE OIL AND NATURAL GAS ACTIVITIES Our oil and natural gas acquisition, exploration, exploitation and development activities are conducted in the United States. The following table summarizes the costs incurred during the last three years (in thousands). Costs Incurred YEAR ENDED DECEMBER 31, ------------------------------- 1999 1998 1997 ------- -------- -------- Property acquisitions costs: Unproved properties $ 879 $ 6,266 $ 15,249 Proved properties 2,880 3,851 28,182 Exploration costs 4,101 1,657 1,730 Exploitation and development costs 65,119 89,161 82,217 ------- -------- -------- $72,979 $100,935 $127,378 ======= ======== ======== Capitalized Costs Under full cost accounting rules as prescribed by the Securities and Exchange Commission ("SEC"), unamortized costs of proved crude oil and natural gas properties are subject to a ceiling, which limits such costs to the Standardized Measure (as described below). At December 31, 1998, the capitalized costs of our proved crude oil and natural gas properties exceeded the Standardized Measure and we recorded a noncash, after tax charge to expense of $109.0 million ($173.9 million pre-tax). The following table presents the aggregate capitalized costs subject to amortization relating to our crude oil and natural gas acquisition, exploration, exploitation and development activities, and the aggregate related DD&A (in thousands). DECEMBER 31, -------------------- 1999 1998 --------- --------- Proved properties $ 671,928 $ 596,203 Accumulated DD&A (387,437) (369,260) --------- --------- $ 284,491 $ 226,943 ========= ========= The DD&A rate per equivalent unit of production excluding the writedown in 1998 was $2.13, $3.00 and $2.83 for the years ended December 31, 1999, 1998 and 1997, respectively. Costs Not Subject to Amortization The following table summarizes the categories of costs which comprise the amount of unproved properties not subject to amortization (in thousands). December 31, --------------------------------- 1999 1998 1997 ---------- ---------- ---------- Acquisition costs $ 42,261 $ 47,657 $ 41,652 Exploration costs 4,842 2,467 2,573 Capitalized interest 4,928 4,421 7,799 ---------- ---------- ---------- $ 52,031 $ 54,545 $ 52,024 ========== ========== ========== Unproved property costs not subject to amortization consist mainly of acquisition and lease costs and seismic data related to unproved areas. We will continue to evaluate these properties over the lease terms; however, the timing of the ultimate evaluation and disposition of a significant portion of the properties has not been determined. Costs associated with seismic data and all other costs will become subject to amortization as the prospects to which they relate are evaluated. Approximately 16%, 19% and 31% of the balance in unproved properties at December 31, 1999, related to additions made in 1999, 1998 and 1997, respectively. During 1999, 1998 and 1997, we capitalized $4.4 million, $3.7 million and $3.3 million, respectively, of interest related to the costs of unproved properties in the process of development. Supplemental Reserve Information (Unaudited) The following information summarizes our net proved reserves of crude oil (including condensate and natural gas liquids) and natural gas and the present values thereof for the three years ended December 31, 1999. The following reserve information is based upon reports of the independent petroleum consulting firms of H.J. Gruy and Company, Netherland Sewell & Associates, Inc., and Ryder Scott Company in 1999, 1998 and 1997 and in addition, in 1997 by System Technology Associates, Inc. The estimates are in accordance with regulations prescribed by the SEC. In management's opinion, the reserve estimates presented herein, in accordance with generally accepted engineering and evaluation principles consistently applied, are believed to be reasonable. However, there are numerous uncertainties inherent in estimating quantities and values of proved reserves and in projecting future rates of production and timing of development expenditures, including many factors beyond our control. Reserve engineering is a subjective process of estimating the recovery from underground accumulations of crude oil and natural gas that cannot be measured in an exact manner, and the accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. Because all reserve estimates are to some degree speculative, the quantities of crude oil and natural gas that are ultimately recovered, production and operating costs, the amount and timing of future development expenditures and future crude oil and natural gas sales prices may all differ from those assumed in these estimates. In addition, different reserve engineers may make different estimates of reserve quantities and cash flows based upon the same available data. Therefore, the Standardized Measure shown below represents estimates only and should not be construed as the current market value of the estimated crude oil and natural gas reserves attributable to our properties. In this regard, the information set forth in the following tables includes revisions of reserve estimates attributable to proved properties included in the preceding year's estimates. Such revisions reflect additional information from subsequent exploitation and development activities, production history of the properties involved and any adjustments in the projected economic life of such properties resulting from changes in product prices. Decreases in the prices of crude oil and natural gas have had, and could have in the future, an adverse effect on the carrying value of our proved reserves and our revenues, profitability and cash flow. Almost all of our reserve base (approximately 94% of year-end 1999 reserve volumes) is comprised of long-life crude oil properties that are sensitive to crude oil price volatility. The NYMEX market price of crude oil price at December 31, 1999, upon which proved reserve volumes, the estimated present value (discounted at 10%) of future net revenue from our proved crude oil and natural gas reserves (the "Present Value of Proved Reserves") and the Standardized Measure as of such date were based, was $25.60 per barrel. In comparison, the crude oil price at December 31, 1998, was $12.05 per barrel. Estimated Quantities of Crude Oil and Natural Gas Reserves (Unaudited) The following table sets forth certain data pertaining to our proved and proved developed reserves for the three years ended December 31, 1999 (in thousands). Standardized Measure of Discounted Future Net Cash Flows (Unaudited) The Standardized Measure of discounted future net cash flows relating to proved crude oil and natural gas reserves is presented below (in thousands): December 31, -------------------------------------- 1999 1998 1997 ----------- ---------- ----------- Future cash inflows $ 4,837,010 $1,102,863 $ 2,237,876 Future development costs (231,914) (117,924) (157,877) Future production expense (1,758,572) (546,091) (1,019,254) Future income tax expense (845,133) - (261,130) ----------- ---------- ----------- Future net cash flows 2,001,391 438,848 799,615 Discounted at 10% per year (1,073,591) (211,905) (387,792) ----------- ---------- ----------- Standardized measure of discounted future net cash flows $ 927,800 $ 226,943 $ 411,823 =========== ========== =========== The Standardized Measure of discounted future net cash flows (discounted at 10%) from production of proved reserves was developed as follows: 1. An estimate was made of the quantity of proved reserves and the future periods in which they are expected to be produced based on year-end economic conditions. 2. In accordance with SEC guidelines, the engineers' estimates of future net revenues from our proved properties and the present value thereof are made using crude oil and natural gas sales prices in effect as of the dates of such estimates and are held constant throughout the life of the properties, except where such guidelines permit alternate treatment, including the use of fixed and determinable contractual price escalations. The crude oil price at December 31, 1999 is based on the NYMEX crude oil price of $25.60 per barrel with variations therefrom based on location and grade of crude oil. We have entered into various fixed price and floating price collar arrangements to fix or limit the NYMEX crude oil price for a significant portion of our crude oil production. Arrangements in effect at December 31, 1999 are reflected in the reserve reports through the term of the arrangements (see Note 18). The overall average prices used in the reserve reports as of December 31, 1999, were $20.94 per barrel of crude oil, condensate and natural gas liquids and $2.77 per Mcf of natural gas. 3. The future gross revenue streams were reduced by estimated future operating costs (including production and ad valorem taxes) and future development and abandonment costs, all of which were based on current costs. 4. The reports reflect the pre-tax Present Value of Proved Reserves to be $1.2 billion, $226.9 million and $511.0 million at December 31, 1999, 1998 and 1997, respectively. SFAS No. 69 requires us to further reduce these estimates by an amount equal to the present value of estimated income taxes which might be payable by us in future years to arrive at the Standardized Measure. Future income taxes were calculated by applying the statutory federal income tax rate to pre-tax future net cash flows, net of the tax basis of the properties involved and utilization of available tax carryforwards. A large portion of our reserve base (approximately 94% of year-end 1999 reserve volumes) is comprised of long-life oil properties that are sensitive to crude oil price volatility. By comparison, using a normalized NYMEX crude oil price of $18.50 per barrel, results in a pre-tax Present Value of Proved Reserves of $664.7 million and estimated net proved reserves of 212.7 million barrels of oil equivalent. Such information is based upon reserve reports prepared by independent petroleum engineers, in accordance with the rules and regulations of the SEC, using a normalized crude oil price. The principal sources of changes in the Standardized Measure of the future net cash flows for the three years ended December 31, 1999, are as follows (in thousands): NOTE 21--QUARTERLY FINANCIAL DATA (UNAUDITED) The following table shows summary financial data for 1999 and 1998 (in thousands, except per share data): - ----------------- (1) As indicated in Note 3, quarterly results for 1999 and the fourth quarter of 1998 have been restated from amounts previously reported due to the unauthorized trading losses. (2) Excludes net gains of $9.8 million and $60.8 million related to PAA's unit offerings in 1999 and 1998, respectively, recorded upon the formation of PAA. NOTE 22--OPERATING SEGMENTS Our operations consist of three operating segments: (1) Upstream Operations - engages in the acquisition, exploitation, development, exploration and production of crude oil and natural gas and (2) Midstream Operations - engages in pipeline transportation, purchases and resales of crude oil at various points along the distribution chain and the leasing of certain terminalling and storage assets and (3) Corporate - reflects certain amounts that are not directly attributable to Upstream or Midstream Operations. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 1). We evaluate segment performance based on gross margin, gross profit and income before income taxes and extraordinary items. (a) Intersegment revenues and transfers were conducted on an arm's-length basis. (b) Gross margin is calculated as operating revenues less operating expenses. (c) Gross profit is calculated as operating revenues less operating expenses and general and administrative expenses. (d) Differences between segment totals and company totals represent the net gain of $60.8 million recorded upon the formation of PAA, which was not allocated to segments. The following table reconciles segment revenues to amounts reported in our financial statements: Customers accounting for more than 10% of total sales for the periods indicated are as follows: PERCENTAGE OF TOTAL SALES YEAR ENDED DECEMBER 31, ------------------------ CUSTOMER 1999 1998 1997 ------- ------ ------- Sempra Energy Trading Corporation 22% 27% 11% Koch Oil Company 18% 15% 27% PERCENTAGE OF OIL AND GAS SALES -------------------------------- Chevron 43% - - Tosco Refining Company 21% 50% - Conoco Inc. 12% Scurlock Permian LLC - 17% - Unocal Energy Trading, Inc. - - 52% Marathon Oil Company 17% - 23% Exxon Company U.S.A. - - 10% NOTE 23 -- CONSOLIDATING FINANCIAL STATEMENTS The following financial information presents consolidating financial statements which include: . the parent company only ("Parent"); . the guarantor subsidiaries on a combined basis ("Guarantor Subsidiaries"); . the nonguarantor subsidiaries on a combined basis ("Nonguarantor Subsidiaries"); . elimination entries necessary to consolidate the Parent, the Guarantor Subsidiaries and the Nonguarantor Subsidiaries; and . Plains Resources Inc. on a consolidated basis. These statements are presented because the Series A-E Notes discussed in Note 7 are not guaranteed by PAA and our consolidated financial statements include the accounts of PAA. PLAINS RESOURCES INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEET (in thousands) DECEMBER 31, 1999 PLAINS RESOURCES INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEET (restated) (in thousands) DECEMBER 31, 1998 PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATING STATEMENT OF OPERATIONS (in thousands) YEAR ENDED DECEMBER 31, 1999 PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATING STATEMENT OF OPERATIONS (restated) (in thousands) YEAR ENDED DECEMBER 31, 1998 PLAINS RESOURCES INC. AND SUBSIDIARIES CONSOLIDATING STATEMENT OF OPERATIONS (in thousands) YEAR ENDED DECEMBER 31, 1997 PLAINS RESOURCES INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS (in thousands) YEAR ENDED DECEMBER 31, 1999 PLAINS RESOURCES INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS (restated) (in thousands) YEAR ENDED DECEMBER 31, 1998 PLAINS RESOURCES INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS (unaudited) (in thousands) YEAR ENDED DECEMBER 31, 1997

1094068_1999.txt

1094068_1999

1999

1094068

Item 1. Business General We are a wholly-owned subsidiary of Petro Stopping Centers Holdings, L.P. ("Holdings"), incorporated July 6, 1999 for the sole purpose of serving as a co- issuer with Holdings for the issuance of 82,707 units each consisting of $1,000 principal amount at stated maturity of Holdings 15.0% senior discount notes due 2008 and 82,707 exchangeable Petro Warrant Holdings Corporation's warrants ("15% Notes"). Upon an exchange event, such as a change in control, IPO, or bankruptcy, the warrants will be exchanged, for no additional consideration, for 100% of the common stock of Petro Warrant Holdings Corporation, whose sole asset currently is approximately 10.0% of the common limited partnership interests in Holdings. The issuance also included notes issued to Chartwell Investments, Inc. of approximately $14,800,000 in accreted value, which were issued without warrants. The 15% Notes are recorded on the financial statements of Holdings. We have no employees, only nominal assets, have not and will not conduct any operations and, accordingly, have no statement of operations. Our financial statements are unaudited. In the opinion of management, the accompanying unaudited financial statements contain all necessary adjustments for fair presentation as of inception, July 6, 1999 through the year ended December 31, 1999. Holdings files with the Securities and Exchange Commission the reports required to be filed pursuant to the rules and regulations promulgated under the Securities Exchange Act of 1934. For information regarding Holdings and its business and financial results, reference is made to Holdings' Annual Report on Form 10-K for 1999, a copy of which is filed as Exhibit 99 to this report. Item 2. Item 2. Properties None Item 3. Item 3. Legal Proceedings None PART II Item 5. Item 5. Market of Registrant's Common Equity and Related Stockholder Matters We are a wholly-owned subsidiary of Holdings. Consequently, there is no established trading market for our equity. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Rate None Item 8. Item 8. Financial Statements and Supplementary Data PETRO HOLDINGS FINANCIAL CORPORATION UNAUDITED BALANCE SHEET (in thousands) December 31, -------- Assets Cash.............................................................. $ 1,000 -------- Total assets............................................. $ 1,000 ======== Stockholder's Equity Common stock, $.01 par value: 10,000 shares authorized; 2,500 shares issued and outstanding ........................... $ 25 Additional paid-in capital........................................ 975 -------- Total stockholder's equity .............................. $ 1,000 ======== See accompanying notes to unaudited financial statements PETRO HOLDINGS FINANCIAL CORPORATION UNAUDITED STATEMENT OF CASH FLOW (in thousands) See accompanying notes to unaudited financial statements PETRO HOLDINGS FINANCIAL CORPORATION NOTES TO UNAUDITED FINANCIAL STATEMENTS (1) Company Formation and Description of Business Company Formation Petro Holdings Financial Corporation (the "Company") is a wholly-owned subsidiary of Petro Stopping Centers Holdings, L.P. ("Holdings") and was incorporated July 6, 1999 for the sole purpose of serving as a co-issuer with Holdings for the issuance of 82,707 units each consisting of $1,000 principal amount at stated maturity of Holdings 15.0% senior discount notes due 2008 ("15% Notes") and 82,707 exchangeable Petro Warrant Holdings Corporation's warrants (the "Warrants"). Upon an exchange event, such as a change in control, IPO, or bankruptcy, the Warrants will be exchanged, for no additional consideration, for 100% of the common stock of Petro Warrant Holdings Corporation, whose sole asset currently is approximately 10.0% of the common limited partnership interests in Holdings. The issuance also included notes issued to Chartwell Investments, Inc. of approximately $14,800,000 in accreted value, which were issued without warrants. The 15% Notes and the notes issued to Chartwell Investments, Inc. are recorded on the financial statements of Holdings. (2) Summary of Significant Accounting Policies Basis of Presentation The Company has no employees, only nominal assets, has not and will not conduct any operations and, accordingly, has no statement of operations. At December 31, 1999 the Company's balance sheet consists only of common stock and additional paid-in capital in the amount of $1,000 and cash in the amount of $1,000. The accounts of the Company are included in the December 31, 1999 consolidated balance sheets of Holdings, which are included in Holding's Annual Report on Form 10-K for the year ended December 31, 1999, a copy of which is filed as Exhibit 99 to this report. In the opinion of management, the accompanying unaudited financial statements contain all necessary adjustments for fair presentation as of inception, July 6, 1999 through the year ended December 31, 1999. The Company meets all of the requirements of an Inactive Registrant as defined by Rule 3-11 of the Securities and Exchange Commission's Regulation S-X (the "Rule"). The Rule stipulates that if a registrant is inactive, the financial statements required for purposes of reports pursuant to the Securities Exchange Act of 1934 may be unaudited. (3) Stockholder's Equity The Company is a wholly-owned subsidiary of Holdings, which is the sole shareholder of the outstanding common stock of the Company. As the sole shareholder, Holdings holds all voting rights and privileges. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Forms 8-K The following documents are filed as a part of this report: Page ---- 1. Financial statements Balance Sheet 3 Statement of Cash Flows 4 The accounts of the Company are included in December 31, 1999 consolidated balance sheets of Holdings, which are included in Holding's Annual Report on Form 10-K for the year ended December 31, 1999, a copy of which is filed as Exhibit 99 to this Annual Report. 2. Financial statements schedule and supplementary information required to be submitted. None All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the financial statements or notes thereto. 3. Exhibits Incorporated herein by reference is a list of Exhibits contained in the Exhibit Index on Page 10 of this Annual Report. (b) Reports on Form 8-K: None SIGNATURES Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PETRO HOLDINGS FINANCIAL CORPORATION (Registrant) By: /s/ J.A. Cardwell, Sr. ------------------------------------------ (J.A. Cardwell Sr.) President and Director (Principal Executive Officer) March 29, 2000 Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons on behalf of Petro Holdings Financial Corporation and in the capacities and on the dates indicated. Signature Title Date - --------- ----- ---- /s/ J.A. Cardwell, Sr. President and Director March 29, 2000 - ---------------------------- (J.A. Cardwell, Sr.) (Principal Executive Officer) /s/ David A. Appleby Vice President of Finance and March 29, 2000 - ---------------------------- (David A. Appleby) Treasurer (Principal Financial Officer and Chief Accounting Officer) /s/ James A. Cardwell, Jr Director March 29, 2000 - ---------------------------- (James A. Cardwell, Jr) /s/ Larry J. Zine Director March 29, 2000 - ---------------------------- (Larry J. Zine) /s/ Kevin T. Weir Director March 29, 2000 - ---------------------------- (Kevin T. Weir) /s/ Robert Grussing IV Director March 29, 2000 - ---------------------------- (Robert Grussing IV) s/ Martha P. Boyd Director March 29, 2000 - ---------------------------- (Martha P. Boyd) /s/ David A. Parsons Director March 29, 2000 - ---------------------------- (David A. Parsons EXHIBIT INDEX Exhibit No. Exhibit Description 3.1(a) Certificate of Incorporation. 3.2(a) Bylaws. 23* Consent of Independent Public Accountants. 24.1 Power of Attorney (Included as part of the signature page of this Form 10-K). 27* Financial Data Schedule. 99* Petro Stopping Centers Holdings, L.P.'s Annual Report on Form 10-K for the year ended December 31, 1999, filed on March 29, 2000. * Filed herewith. (a) Incorporated by reference to Petro Stopping Centers Holdings, L.P.'s and Petro Holdings Financial Corporation's Registration Statement on Form S-4 (Registration No. 333-87371).

852203_1999.txt

852203_1999

1999

852203

Item 1. Business Company Overview Organization. CB Richard Ellis Services, Inc. ("CBRE Services") or (the "Company") is a holding company that conducts its operations primarily through approximately 75 direct and indirect operating subsidiaries. In the United States ("US") the Company's principal operating subsidiaries are CB Richard Ellis, Inc., L.J. Melody & Company ("L.J. Melody") and CB Richard Ellis Investors, L.L.C. ("CBRE Investors"). Outside of the US the Company's principal operating subsidiaries are CB Hillier Parker Limited ("HP") and approximately 25 direct and indirect subsidiaries of CB Commercial Limited (formerly known as REI Limited ("REI")) which operate in the United Kingdom ("UK") and CB Richard Ellis Limited which operates in Canada. The Company has operating subsidiaries in approximately 25 additional countries and cooperation agreements with independent firms in a number of additional countries. Approximately 78 percent of the Company's revenues are from the US and 22 percent from the rest of the world. Nature of Operations. The Company provides a full range of real estate services to commercial real estate tenants, owners and investors through approximately 250 offices worldwide including but not limited to the US, Argentina, Australia, Belgium, Brazil, Canada, Chile, Czech Republic, Denmark, France, Germany, Hong Kong, Hungary, India, Italy, the Netherlands, New Zealand, People's Republic of China, Portugal, Singapore, Spain, Sweden, Switzerland, Taiwan, Turkey and the UK. In July 1999, the Company undertook a reorganization to streamline its US operations which resulted in a change in its segment reporting from four to three segments. The Company's services under this new segmentation include (i) brokerage services whereby the Company facilitates the sale and lease of properties, transaction management and advisory services, and investment property transactions, including acquisitions and sales on behalf of investors ("Transaction Management"); (ii) capital market activities, including mortgage banking, brokerage and servicing, investment management and advisory services, real estate market research and valuation and appraisal services ("Financial Services"); and (iii) facilities management services to corporate real estate users, and property management and related services to owners ("Management Services"). The Company's diverse client base includes local, national and multinational corporations, financial institutions, pension funds and other tax exempt entities, local, state and national government entities, and individuals. While the Company provides Transaction Management and Management Services in most of its 250 offices, Financial Services are primarily provided in the US and the UK (except appraisal which is offered by most offices). A significant portion of the Company's revenue is seasonal. Historically, this seasonality has caused the Company's revenue, operating income and net income to be lower in the first two calendar quarters and higher in the third and fourth calendar quarters of each year. In addition, the Company's operations are directly affected by actual and perceived trends in various national and economic conditions, including interest rates, the availability of credit to finance commercial real estate transactions and the impact of tax laws. To date, the Company does not believe that general inflation has had a material impact upon its operations. Revenues, commissions and other variable costs related to revenues are primarily affected by real estate market supply and demand rather than general inflation. Recent Industry Trends Over the last several years, the commercial real estate industry has experienced a variety of changes, a number of which are structural in nature. The most important of these changes are discussed below. . Healthy Commercial Real Estate Markets. Coincident with the longer term structural shifts in the commercial real estate industry, commercial real estate markets in Australia, Europe and North America over the last several years have experienced increased activity in many product types and geographical market areas. This has been particularly true for the US in Arizona, California, Illinois, New England, New York, Texas and Washington D.C./Baltimore where the Company has a significant market presence and for Europe in France, the Netherlands, Spain and the UK. Office and industrial building occupancy levels have generally been rising, rental rates have been increasing and, correspondingly, property values have been rising. Capital in these markets has been disciplined so that space supply and demand for space has remained in equilibrium. In 1998 and the first three quarters of 1999 Asia had declining revenues. This decline appears to have reversed in the fourth quarter of 1999 as various Asian countries began to deal with their significant economic problems. The Company believes that while those problems are likely to continue into the year 2000 that in certain countries in Asia potential for profit exists. . Changing Composition and Needs of Investors in and Owners of Larger Commercial Real Estate Assets. Investors in and owners of larger commercial real estate assets have become increasingly institutional (including pension funds, life insurance companies, banks, property companies and in the US, publicly-held real estate investment trusts ("REIT")). Simultaneously, their investment and management needs have become increasingly multi-market due to the fact the commercial real estate properties in their portfolios are typically located in numerous geographic locations. With respect to institutions other than REITs, this change in the ownership characteristics and management requirements of institutional real estate investors and owners has fueled the demand for the growth of multi- service, nationally or internationally-oriented real estate service providers. As most REITs are internally managed and to date generally have outsourced only their brokerage service needs, their demand for the Company's other real estate services has been less than that of other institutional investors although a select group of small and medium-sized REITs showed some interest in 1999 in outsourcing property management services. The Company continues to believe that the REITs are a potential growth area if Wall Street puts a premium on growth in funds from operations which then causes REITs to elect to outsource various property management functions which can be performed more efficiently by broad-based management organizations like the Company. To date the Company has seen no material revenue from REIT outsourcing of property management due to expense containment although the Company currently manages multiple assets for several REITs and frequently originates mortgages and is engaged as exclusive leasing and sales agent for them. . Continuing Corporate Outsourcing Trend. Shareholder pressure for higher performance and return on equity within most publicly held corporations around the globe has heightened corporate management's awareness that corporate real estate assets are a major component of corporate net worth. Simultaneously, with competitive pressures encouraging greater focus on core businesses, companies have emphasized leaner staffing in non-core activities and, as a result, outsourced certain non-core activities to third parties. As a consequence, the demand for multi-discipline, multi- market global professional real estate service firms that provide integrated services capable of supplementing a corporate real estate department has increased significantly. The Company's unique, wholly owned global network provides access to Asian, European, North American and South American companies interested in outsourcing and provides a global network of very high quality services to companies throughout the world in the outsourcing process. As a result of its 1998 acquisitions, the Company has the ability to deliver commercial real estate and related services in every major world market. While corporate outsourcing is only a modest revenue source for the Company at this time the Company believes that the factors described above should accelerate the outsourcing trend. Acquisitions/Dispositions The Company does not presently intend to pursue a substantive acquisition strategy in 2000 but it will consider opportunistic acquisitions in its mortgage banking, brokerage and property management businesses. During 1999 the Company acquired four companies, including a brokerage company in Sweden, a brokerage company in Chile, a real estate consulting company in the US and a mortgage brokerage company in the US. The aggregate purchase price for these companies was approximately $13.8 million. During 1999 the Company sold five of its smaller non-strategic offices (Bakersfield and Fresno, California; Albuquerque, New Mexico; Reno, Nevada; and Salt Lake City, Utah) for a total of approximately $7 million received in cash and notes. It also sold an insurance operation which was used to help property management and other clients with complex insurance problems for $3 million in receivables. Because of the substantial non-cash goodwill and intangible amortization charges incurred by the Company in connection with acquisitions subject to purchase accounting and because of interest expense associated with cash acquisition financing, management anticipates that past acquisitions have and future acquisitions may adversely affect net income, especially in the first several years following the acquisition. This problem is compounded when, as in the case of the 1997 acquisition of Koll Real Estate Services ("Koll"), the amortization of goodwill must be deducted for financial reporting purposes but is not deductible for actual tax purposes with the result that the provision for taxes for financial reporting purposes will for some period of time be 50- 55% when the actual cash tax rate is 40-45%. In addition, during the first six months following an acquisition, the Company believes there are generally significant one-time costs relating to integrating information technology, accounting and management services and rationalizing personnel levels of the combined operation (costs which the Company intends to take as a single charge at the time of the acquisition to the maximum extent permissible). Management does not intend to pursue acquisitions unless they are accretive to income before interest expense and provision for amortization of goodwill and intangibles and to operating cash flows (excluding the costs of integration). The Company's Businesses Transaction Management Brokerage Services Including Investment Properties The Company and its predecessors have provided commercial real estate brokerage services since 1906 through the representation of buyers, sellers, landlords and tenants in connection with the sale and lease of office space, industrial buildings, retail properties, multi-family residential properties and unimproved land. Transaction Management includes investment property sales. Investment property sales are distinguished by the nature of the buyer (an investor rather than a user), by the size of the transaction (generally over $10 million) and by the team nature of the effort. On larger and more complex investment property sales assignments, the Company's financial consulting professionals provide sophisticated financial and analytical resources to the client, the marketing team and the investor. These services provide the client with in-depth analyses of transaction specific data as well as real estate market data. Investment property sales in 1999 were essentially flat due to slower than expected recovery from the 1998 capital markets liquidity crisis, a continued slowdown in REIT acquisitions of property and greater investor selectivity. In 1999, the Company generated revenues from its Transaction Management services of approximately $881.7 million representing approximately 32,159 completed transactions. In 1999, brokerage facilitated over 8,071 sale transactions with an aggregate estimated total consideration of approximately $28 billion and approximately 23,972 lease transactions involving aggregate rents, under the terms of leases facilitated, of approximately $19 billion. Transaction Management comprise the largest source of revenue for the Company and provides a foundation for growing the Company's other disciplines which make up its multi-discipline integrated commercial real estate services. The Company believes that its position in the brokerage services industry provides a competitive advantage for all of its lines of business by enabling them to leverage off brokerage's (i) international network of relationships with owners and users of commercial real estate, (ii) real-time knowledge of completed transactions and real estate market trends, and (iii) brand recognition in the brokerage area. Operations. At December 31, 1999 the Company employed approximately 1,800 brokerage professionals in Transaction Management in offices located in most of the largest Metropolitan Statistical Areas ("MSAs") in the US and approximately 920 brokerage professionals in the rest of the world. The Company maintains a decentralized approach to Transaction Management other than investment properties, bringing significant local knowledge and expertise to each assignment. Each local office draws upon the broad range of support services provided by the Company's other business groups around the world, including an international network of market research, client relationships and transaction referrals which the Company believes provides it with significant economies of scale over local, national and international competitors. While day-to-day operations are decentralized, most accounting and financial functions are centralized. In order to increase market share in secondary markets in the US which are not served by its wholly owned offices, the Company implemented a plan to establish "partnerships" with leading local firms in these markets. Through December 31, 1999, the Company had established such partnership-type arrangements in Bakersfield and Fresno, California; Ft. Wayne and South Bend, Indiana; Des Moines, Iowa; Louisville, Kentucky; East Lansing and Grand Rapids, Michigan; Reno, Nevada; Albuquerque, New Mexico; Albany, Buffalo, Rochester and Syracuse, New York; Toledo, Ohio; Charleston and Columbia, South Carolina; Memphis, Tennessee; El Paso, Texas; Salt Lake City, Utah; and Madison and Milwaukee, Wisconsin. A similar but less structured program exists in Europe where the Company has "Co-operation Agreements" in Ireland, Israel, Norway and Russia. In 1997, the Company contributed its brokerage and property management business in the New England area to a partnership along with Whittier Partners, a prominent New England real estate services firm. The Company also contributed cash because the assets it contributed were less valuable than the assets contributed by Whittier Partners. The Company and Whittier Partners each own 50% of the partnership. In 1998, the Company entered into a similar 50/50 joint venture in the Pittsburgh area which resulted in the formation of CB Richard Ellis Pittsburgh, L.P. The Company contributed $5.8 million to establish the Pittsburgh joint venture. In December of 1999 the Company sold five of its offices--Bakersfield and Fresno, California, Reno, Nevada, Albuquerque, New Mexico and Salt Lake City, Utah for a total of $7 million to various employees of the Company. The rationale for these sales was that while each of these locations is viable none of them are strategic to the Company nor interdependent with its other offices. Each of the sold offices joined the Company's Partners Program. The Company believes that these secondary market offices will perform at higher levels when owned by employees. The Company will evaluate the possibility of additional non- strategic office sales after the results of these sales can be assessed. Compensation. Under a typical brokerage services agreement, the Company is entitled to receive sale or lease commissions. Sale commissions, which are calculated as a percentage of sales price, are generally earned by the Company at the close of escrow. Sale commissions in the US typically range from approximately 1% to 6% with the rate of commission declining as the price of the property increases. In the case of large investment properties (over $20 million) the commission is generally less than 1%. Outside of the US commissions of 1% to 4% are typical. Lease commissions in the US are typically calculated either as a percentage of the minimum rent payable during the term of the lease or based upon the square footage of the leased premises, are generally earned by the Company at the commencement of a lease and are not contingent upon the tenant fulfilling the terms of the lease. In cases where a third-party brokerage firm is not involved, lease commissions earned by the Company for a new lease typically range between 2% and 6% of minimum rent payable under the lease depending upon the value of the lease. Outside of the US, the leasing commission is typically one month's rent or 10% of the first year's rent. For renewal of an existing lease, such fees are generally 50% of a new lease commission. In sales and leases where a third-party broker is involved, the Company must typically share 50% of the commission it would have otherwise received with the third-party broker. In the US, Canada and much of Australia, the Company's brokerage sales professionals will receive 40% to 60% of the Company's share of commissions before costs and expenses. In most other parts of the world, the Company's brokerage professionals receive a salary and a bonus, profit-share or small commission, which in the aggregate approximate 50% of the Company's share of commissions earned. Corporate Services The Company provides corporate services to major corporations around the world. Corporate services include assisting corporations in developing and executing integrated multiple-market real estate strategies. The Company's objective is to establish long-term relationships with corporations that require continuity in the delivery of high-quality, multi-market management services and strategic consulting services including acquisition and disposition services. Global competition, the focus on quality, "right-sizing" of corporate organizations and changes in management philosophy have all contributed to an increased interest in and reliance on outside third-party real estate service providers. Specifically, through contractual relationships, the Company assists major, multi-market companies in developing and executing real estate strategies as well as addressing specific occupancy objectives. Operations. Corporate Services coordinates the utilization of all the Company's various disciplines to deliver an integrated service to its clients over broad geographies. Essentially, corporate services expands a client's real estate department and supports most of the functions involved in a corporate real estate department. Corporate Services includes research and consulting, structured finance, facilities project management, lease administration, occupancy planning and transaction management. These services can be delivered as a bundled or unbundled basis in a single market or in multiple markets around the globe. These services are generally provided on a negotiated-fee basis. Compensation. A typical corporate services agreement gives the Company the right to execute some or all of the client's future sales and leasing transactions and to receive other fees on a negotiated basis. The commission rate with respect to such transactions frequently reflects a discount for the captive nature and large volume of the business. The Company is developing worldwide pricing to maximize integrated service delivery. Term. A typical corporate services agreement includes a stated term of at least one year and normally contains provisions for extension of the agreement. Financial Services Mortgage Banking The Company provides its mortgage origination and mortgage loan servicing almost entirely in the US through L.J. Melody, which was acquired in July 1996 and is based in Houston, Texas. The Company originated approximately $6 billion of mortgages in 1999 with more than 100 institutional lenders. As part of these origination activities, the Company has special conduit arrangements with Commercial Mortgage-Backed Securities ("CMBS") issuers who are affiliates of Bear Stearns, Citicorp, Deutsche Bank Securities, GE Capital, Heller Financial, J.P. Morgan, Lehman Brothers, Merrill Lynch & Co., NationsBank, and RFC Commercial which permit it to service the mortgage loans which it originates. Under these arrangements, the Company generally originates mortgages in its name, makes limited representations and warranties based upon representations made to it by the borrower or another party and immediately sells them into a conduit program without principal risk. The Company may originate mortgages into other conduit programs where it does not have servicing rights. The Company originates in its name (without principal risk) and services loans for Federal Home Loan Mortgage Corp. (Freddie Mac) and Federal National Mortgage Association (Fannie Mae). The Company is also a major mortgage originator for insurance companies and pension funds having originated mortgages in the names of insurance companies valued at approximately $2.9 billion in 1999. The Company has correspondent arrangements with various life insurance companies and pension funds which entitle it to originate loans in their names and subsequently service the mortgage loans it originates. At December 31, 1999, the Company serviced mortgage loan portfolios of approximately $13 billion. Operations. The Company employs approximately 100 mortgage banking professionals and a support and asset management staff of 200 people located in 30 offices in the US. The Company has no material mortgage banking operations outside of the US. The Company's mortgage loan originations take place throughout the US, with support from L.J. Melody's headquarters in Houston, Texas. The Company's mortgage loan servicing primarily is handled by L.J. Melody in Atlanta, Georgia; Minneapolis, Minnesota; Houston, Texas; and Seattle, Washington. Compensation. The Company typically receives origination fees, ranging from 0.5% for large insurance company and pension fund mortgage loans to 1.0% for most conduit and agency mortgage loans. In addition, the Company can earn special incentive fees from various conduit programs. In 1999, the Company received approximately $0.9 million from such incentives. In situations where the Company services the mortgage loans which it originates, it also receives a servicing fee between .03% and .25%, calculated as a percentage of the outstanding mortgage loan balance. These correspondent agreements generally contain an evergreen provision with respect to servicing which provides that the agreement remains in effect for an indefinite period, but enables the lender to terminate the agreement upon 30 days prior written notice, which the Company believes to be a customary industry termination provision. A majority of the Company's 1999 mortgage loan origination revenue was from agreements which entitled it to both originate and service mortgage loans. The Company also originates mortgage loans on behalf of conduits and insurance companies for whom it does not perform servicing. The Company's client relationships have historically been long term. The Company pays its mortgage banking professionals a combination of salary, commissions and incentive-based bonuses which typically average approximately 50% of the Company's loan origination fees. Investment Management Through its wholly owned subsidiary, CBRE Investors (CB Hillier Parker Investors in the UK), the Company sponsors real estate investment funds and programs targeted primarily for institutional investors. At December 31, 1999, assets under management were $8.4 billion representing an increase of 23.0% over the prior year. During 1999, CBRE Investors raised over $2.0 billion of equity from existing and new clients. CBRE Investors placed $1.6 billion in new investments on behalf of clients and sold $761.0 million of property from existing portfolios representing increases of 162.0% and 2.0% respectively over 1998. CBRE Investors has historically offered its investment management services in two formats: combined funds and separate managed accounts tailored to specific clients' needs. Separate accounts are typically non-discretionary and as of 1999 represented about 85% of total assets under management. Traditionally, the vast majority of investments were in unleveraged, low risk return strategies targeted at US and UK pension funds. With goals of increasing margins and assets under management, CBRE Investors adopted a business plan in 1998, which contains four principal elements. First, consistent with market demand, investment strategies have been broadened to include more "value added" activities, which have higher total return expectations. The higher return strategies are generally accompanied by co-investment by the Company and a dedicated team of employees. The team and the Company also share in the profits or "promote" from the venture. Capitalizing on the CBRE Investors global platform, strategies have also been expanded geographically with new investment programs created in Europe, Japan, and Southeast Asia. Second, CBRE Investors has shifted its primary new business focus from separate accounts to funds and joint ventures. The latter structures give the firm more control of assets, are more efficient to operate and generally have higher fees. The third element is to diversify CBRE Investors' clientele beyond pension funds. Over 60% of the firms' new clients in 1999 were non-pension funds including foundations, insurance companies, government investment funds, and bank sponsored funds. Building on the Company's global platform, over 60% of these new clients were located outside of the US. The fourth element of the growth strategy is to capitalize on the growing trend among institutional investors to outsource their real estate investment management functions. During the last two years CBRE Investors has assumed the investment management duties for portfolios totaling in excess of $1.5 billion. Operations. Operationally, each investment strategy is executed by a dedicated team with the requisite skill sets. At present time there are six dedicated teams. In the US, they are Fiduciary Services (low risk/return strategies), Strategic Partners, L.P. ("value added" fund), and Corporate Partners, LLC (corporate real estate strategies). Internationally they are CB Hillier Parker Investors (UK) (low risk/return strategies), CBRE Investors Asia ("value added"), and CBRE Investors Europe which will not begin to function until mid-2000. Each team's compensation is driven largely by the investment performance of its particular strategy/team. This organizational structure is designed to align the interests of team members with those of its investor clients/partners, determine accountability, and make performance the priority. Dedicated teams share resources such as accounting, financial controls, information technology, investor services and research. In addition to the research within the CB Richard Ellis platform, which focuses primarily on market conditions and forecasts, CBRE Investors has an in-house team of research professionals that focuses on investment strategy and underwriting. CBRE Investors has approximately 150 employees located in the Los Angeles headquarters and in regional offices in Boston, Frankfurt, London, Singapore and Tokyo. Compensation. Investment management fees can have up to three components. In chronological order, they are (i) acquisition fees, (ii) annual portfolio management fees and (iii) incentive fees or profit sharing. Each fund or account will have two or three of these components. Fees are typically higher for sponsoring funds or joint ventures than managing separate accounts. Acquisition and annual portfolio management fees usually range between .5-1.0% of purchase price in the US and Asia. In the UK annual fees on separate accounts are typically .05-.1% of asset value. Incentive fees usually range between 10-20% of profit in excess of an agreed upon threshold return. With respect to CBRE Investors' new funds in the US and all international investments, the Company also derives fees for ancillary services such as purchase and sale brokerage, mortgage origination, property management and leasing brokerage. Valuation and Appraisal Services The Company's valuation and appraisal services business delivers sophisticated commercial real estate valuations through a variety of products including market value appraisals, portfolio valuation, discounted cash flow analyses, litigation support, feasibility land use studies and fairness opinions. At December 31, 1999, the Company's appraisal staff had more than 475 professionals with approximately 50% of the staff holding professional designations. The business is operated internationally through 87 offices and its clients are generally corporate and institutional portfolio owners and lenders. In 1999, the Company performed more than 31,000 valuation and appraisal assignments. Approximately 130 of the Company's appraisal professionals were located in the US. During 1999, the Company developed an internet-based system for coordinating and delivering appraisals. The Company believes that this type of system is not currently in use by any competitor. The system became operational in early 2000. Real Estate Market Research Real estate market research services are provided by nearly 200 researchers worldwide in addition to 24 professionals in Boston, Massachusetts employed by CB Richard Ellis/Torto Wheaton Research, by 14 professionals in San Francisco, California employed by CB Richard Ellis/National Real Estate Index and by 27 professionals in London, England employed by CB Hillier Parker. Real estate research services are provided to the Company's multiple lines of business as well as sold to third-party clients and include (i) data collection and interpretation, (ii) econometric forecasting, and (iii) portfolio risk analysis for institutional clients within North American commercial real estate markets and selected markets in Asia, Europe and South America. The Company's publications and products provide real estate data for more than 60 of the largest MSAs in the US and are sold on a subscription basis to many of the largest portfolio managers, insurance companies and pension funds. The National Real Estate Index also compiles proprietary market research for 50 major urban areas nationwide, reporting benchmark market price and rent data for office, light industrial, retail, and apartment properties, and tracking the property portfolios of 150 of the largest REITs. Management Services Asset Services The Company provides value-added asset and related services for income- producing properties owned primarily by institutional investors and, at December 31, 1999, managed approximately 227 million square feet of commercial space in the US and 208 million square feet in the rest of the world. Asset services include maintenance, marketing and leasing services for investor-owned properties, including office, industrial, retail and multi- family residential properties. Additionally, the Company provides construction management services, which relate primarily to tenant improvements. The Company works closely with its clients to implement their specific goals and objectives, focusing on the enhancement of property values through maximization of cash flow. The Company markets its services primarily to long- term institutional owners of large commercial real estate assets. An asset services agreement puts the Company in a position to provide other services for the owner including refinancing, appraisal and lease and sales brokerage services. Operations. The Company employs approximately 1,195 individuals in its asset services business in the US and an estimated 1,227 individuals in its asset services business outside of the US. Most asset services are performed by management teams located on-site or in the vicinity of the properties they manage. This provides property owners and tenants with immediate and easily accessible service, enhancing client awareness of manager accountability. All personnel are trained and are encouraged to continue their education through both Company-sponsored and outside training. The Company provides each local office with centralized corporate resources including investments in computer software and hardware. Asset services personnel generally utilize state-of- the-art computer systems for accounting, marketing, and maintenance management. Compensation. Under a typical asset services agreement in the US, the Company will be entitled to receive management fees and lease commissions. Outside of the US, the management and leasing functions are generally separate, although the Company may do both. The management fee in most cases is based upon a formula which gives the Company either a certain amount per square foot managed or a specified percentage of the monthly gross rental income collected from tenants occupying the property under management. Where rent is used as the basis for the fee, the fee will fluctuate as building rents and occupancies increase and decrease. Some of these asset services agreements also include a stated minimum management fee. The Company is generally entitled to reimbursement for costs incurred that are directly attributable to management of the property. Reimbursable costs, which are not included in the Company's revenue, include the wages of on-site employees and, in most cases, the cost of field office rent, furniture, computers, supplies and utilities. The Company pays its asset services professionals a combination of salary and incentive-based bonuses. In the US, lease commissions, which are paid in addition to the management fee, are similar to those described for brokerage services. In the US, employees who provide leasing services for managed properties may be paid either commission or salary and incentive-based bonuses. In the rest of the world, individuals providing leasing services generally receive salary and incentive-based bonuses. Term. A typical asset services agreement contains an evergreen provision which provides that the agreement remains in effect for an indefinite period, but enables the property owner to terminate the agreement upon 30 days prior written notice, which the Company believes to be customary in the commercial real estate industry. Facilities Management The Company's facilities management unit specializes in the administration, management and maintenance of properties that are occupied by large corporations and institutions, such as corporate headquarters, regional offices, administrative offices and manufacturing and distribution facilities, as well as tenant representation, capital asset disposition, strategic real estate consulting and other ancillary services for corporate clients. At December 31, 1999, the Company had approximately 122 million square feet under facilities management. While most of the properties for which the Company provides facilities management are located within the US, the Company is providing such services in China, Italy, Norway, Sweden, and the UK for a total of approximately 2 million square feet and expects its facilities management business outside of the US to continue growing rapidly in 2000. However, outside the US, the facilities management business which involves significant up front infrastructure costs is not expected to be profitable before 2001. Operations. The Company's facilities management operations in the US are organized into three geographic regions in the Eastern, Western and Central areas, with each geographic region comprised of consulting, corporate services and team management professionals who provide corporate service clients with a broad array of financial, real estate, technological and general business skills. Facilities management teams are also in place in London and Singapore. In addition to providing a full range of corporate services in a contractual relationship, the facilities management group will respond to client requests generated by other Company business groups for significant, single-assignment acquisition, disposition and consulting assignments that may lead to long-term relationships. Compensation. Under a typical facilities management agreement, the Company is entitled to receive management fees and reimbursement for its costs (such as costs of wages of on-site employees, capital expenditures, field office rent, supplies and utilities) that are directly attributable to management of the facility. Payments for reimbursed expenses are set against those expenses and not included in revenue. Under certain facilities management agreements, the Company may also be entitled to an additional incentive fee which is paid if the Company meets certain performance criteria (such as a reduction in the cost of operating the facility) established in advance between the client and the Company. Information Technology The Company's goal in information technology is to provide worldwide capability to input, access and manipulate data for internal accounting and financial reporting, external or client accounting (primarily asset and facilities management and investment advisory services) and as a presentation and analytical business tool (including access to data and information by clients). The Company has adopted a PC/server enterprise platform based upon PeopleSoft and Vantif technology. The worldwide system is generally in place with respect to e-mail and was in place with respect to internal and external accounting by late 1999. As part of its information technology program the Company has adopted mandatory computer hardware and software standards. The Company's information technology group consists of approximately 161 employees, most of whom are located in the US. The Company has outsourced a significant part of its information technology requirements. The Internet The Company is pursuing a three-part strategy involving the internet that involves the development of investments in web-based applications in the following categories: (i) web applications that make the Company's internet processes more efficient; (ii) web applications that make the Company's client relationship more productive and efficient; and (iii) select equity and/or content investments in promising web-based commercial real estate entities. The Company believes the internet will be a net gain for the Company, eliminating some low value functions it currently earns fees for but at the same time greatly enhancing its service offering to its clients and assisting the Company in making its business more efficient. In addition, the cost of developing internet-based applications should create additional barriers to entry that will further differentiate the larger companies in the industry from smaller companies with less available capital for investment. Competition The market for the Transaction Management Business is both highly fragmented and competitive. Thousands of local commercial real estate brokerage firms and hundreds of regional commercial real estate brokerage firms have offices throughout the world. The Company believes that no more than two other major firms have the ability to compete internationally with the Company's brokerage, investment sales or corporate service businesses. Most of the Company's competitors in brokerage (and, to a significant extent, asset services) are local or regional firms that are substantially smaller than the Company on an overall basis, but in some cases may be larger locally. L.J. Melody competes (almost entirely in the US) with a large number of mortgage banking firms and institutional lenders as well as regional and national investment banking firms and insurance companies in providing its mortgage banking services. Appraisal services are provided by other international, national, local and regional appraisal firms and some international, national and regional accounting firms. CBRE Investors and HP investments have numerous competitors including other fund managers, investment banks and banks. The Company's management services business, located principally in the US and the UK, compete for the right to manage properties controlled by third parties. The competitor may be the owner of the property (who is trying to decide the efficiency of outsourcing) or another management services company. Increasing competition in recent years has resulted in having to provide additional services at lower rates, thereby eroding margins. In all of its business disciplines, the Company competes on the basis of the skill and quality of its personnel, the variety of services offered, the breadth of geographic coverage and the quality of its infrastructure, including technology. Employees At December 31, 1999, the Company had approximately 9,853 employees located in more than 33 countries. All of the Company's US and most of its international sales professionals are parties to contracts with the Company which subject them to the Company's rules and policies during their employment and limit their post-employment activities in terms of soliciting clients or employees of the Company. The Company believes that relations with its employees are good. Item 2. Item 2. Properties The Company sold its headquarters building in downtown Los Angeles, California, in September 1999 and its small office building in Phoenix, Arizona in October 1999, both at a minimal loss. The Los Angeles building was previously written down by $9.0 million to its estimated fair market value and reclassified as property held for sale which is included in other assets at December 31, 1998 in the accompanying consolidated balance sheets. The Company leases office space on terms that vary depending on the size and location of the office. The leases expire at various dates through 2014. For those leases that are not renewable, the Company believes there is adequate alternative office space available at acceptable rental rates to meet its needs, although rental rates in some markets may adversely affect the Company's profits in those markets. Item 3. Item 3. Legal Proceedings In December 1996, GMH Associates, Inc. ("GMH") filed a lawsuit against Prudential Realty Group ("Prudential") and the Company in Superior Court of Pennsylvania, Franklin County, alleging various contractual and tort claims against Prudential, the seller of a large office complex, and the Company, its agent in the sale, contending that Prudential breached its agreement to sell the property to GMH, breached its duty to negotiate in good faith, conspired with the Company to conceal from GMH that Prudential was negotiating to sell the property to another purchaser and that Prudential and the Company misrepresented that there were no other negotiations for the sale of the property. Following a non-jury trial, the court rendered a decision in favor of GMH and against Prudential and the Company, awarding GMH $20.3 million in compensatory damages, against Prudential and the Company jointly and severally, and $10.0 million in punitive damages, allocating the punitive damage award $7.0 million as against Prudential and $3.0 million as against the Company. Following the denial of motions by Prudential and the Company for a new trial, a judgment was entered on December 3, 1998. Prudential and the Company filed an appeal of the judgment. On March 3, 2000 the appellate court in Pennsylvania reversed all of the trial courts' decisions finding that liability was not supported on any theory claimed by GMH and directed that a judgement be entered in favor of the defendants including the Company. The plaintiff has filed an appeal with the Pennsylvania Supreme Court. In August 1993, a former commissioned sales person of the Company filed a lawsuit against the Company in the Superior Court of New Jersey, Bergen County, alleging gender discrimination and wrongful termination by the Company. On November 20, 1996, a jury returned a verdict against the Company, awarding $1.5 million in general damages and $5.0 million in punitive damages to the plaintiff. Subsequently, the trial court awarded the plaintiff $638,000 in attorneys' fees and costs. Following denial by the trial court of the Company's motions for new trial, reversal of the verdict and reduction of damages, the Company filed an appeal of the verdict and requested a reduction of damages. On March 9, 1999 the appellate court ruled in the Company's favor, reversed the trial court decision and ordered a new trial. On February 16, 2000 the Supreme Court of New Jersey reversed the decision of the appellate court, concluded that the general damage award in the trial court should be sustained and returned the case to the appellate court for a determination as to whether a new trial should be ordered on the issue of punitive damages. Based on available reserves, cash and anticipated cash flows, the Company believes that the ultimate outcome of this case will not have an impact on the Company's ability to carry on its operations. The Company is a party to a number of pending or threatened lawsuits arising out of, or incident to, its ordinary course of business. Based on available cash and anticipated cash flows, the Company believes that the ultimate outcome will not have an impact on the Company's ability to carry on its operations. Management believes that any liability to the Company that may result from disposition of these lawsuits will not have a material effect on the consolidated financial position or results of operations of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (1) The Company's common stock commenced trading on the New York Stock Exchange ("NYSE") on November 7, 1997 under the symbol "CBG." From November 26, 1996 through November 6, 1997, the Company's common stock traded on the Nasdaq Stock Market--National Market System ("NASDAQ--NMS") under the symbol "CBCG." Prior to that period, there was no established public trading market for the Company's common stock. The following table sets forth, for the periods indicated, the high and low sales price per share of the common stock on the NYSE. (2) At February 29, 2000, the Company had 925 record holders of its common stock. (3) In April 1999, the Company sold 140,833 shares of common stock to key executives of the Company under the Company's 1999 Equity Incentive Plan. The sale was made by private placement in reliance on the exemption from registration provisions provided for in Section 4(2) of the Securities Act of 1933, as amended. A registration statement will be filed for the plan which allows the shares to be sold freely once vested and paid for. (4) Since its incorporation in March 1989 the Company has not declared any cash dividends on its common stock. The Company's existing credit agreement restricts its ability to pay dividends on common stock. Item 6. Item 6. Selected Financial Data The following selected financial data has been derived from the consolidated financial statements. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related notes thereto included elsewhere in this Form 10-K. SELECTED CONSOLIDATED FINANCIAL INFORMATION (Dollars in thousands except share and per share data) - ------- (1) The results include the activities of Koll from August 28, 1997 to December 31, 1999, REI from April 17, 1998 to December 31, 1999 and HP from July 7, 1998 to December 31, 1999. (2) See Per Share Information in Note 12 of Notes to Consolidated Financial Statements. (3) EBITDA effectively removes the impact of certain non-cash and nonrecurring charges on income such as depreciation and the amortization of intangible assets relating to acquisitions, merger-related and other nonrecurring charges. Management believes that the presentation of EBITDA will enhance a reader's understanding of the Company's operating performance and ability to service debt as it provides a measure of cash generated (subject to the payment of interest and income taxes) that can be used by the Company to service its debt and for other required or discretionary purposes. Net cash that will be available to the Company for discretionary purposes represents remaining cash, after debt service and other cash requirements, such as capital expenditures, are deducted from EBITDA. EBITDA should not be considered as an alternative to (i) operating income determined in accordance with GAAP or (ii) operating cash flow determined in accordance with GAAP. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction The Company provides real estate services through approximately 250 offices worldwide including but not limited to the US, Argentina, Australia, Belgium, Brazil, Canada, Chile, Czech Republic, Denmark, France, Germany, Hong Kong, Hungary, India, Italy, the Netherlands, New Zealand, People's Republic of China, Portugal, Singapore, Spain, Sweden, Switzerland, Taiwan, Turkey and the UK. Over the course of the last five years, the Company, in recognition of a rapidly changing structural and economic environment, has changed from being almost exclusively a traditional US real estate broker to being a diversified global real estate services firm. The Company's Transaction Management is one of the largest such businesses in the US. As part of its strategic emphasis in developing a worldwide business, the Company has, since the beginning of 1995, completed multiple acquisitions, an $87.0 million public offering of common stock and a $175.0 million offering of senior subordinated notes. The Company is continually assessing acquisition opportunities as part of its growth strategy. Because of the substantial non- cash goodwill and intangible amortization charges incurred by the Company in connection with acquisitions subject to purchase accounting and because of interest expense associated with cash acquisition financing, management anticipates that past acquisitions have and future acquisitions may adversely affect net income, especially in the first several years following the acquisition. This problem is compounded when, as in the case of the 1997 acquisition of Koll Real Estate Services ("Koll"), the amortization of goodwill must be deducted for financial reporting purposes but is not deductible for actual tax purposes with the result that the provision for taxes for financial reporting purposes will for some period of time be 50-55% when the actual cash tax rate is 40-45%. In addition, during the first six months following an acquisition, the Company believes there are generally significant one-time costs relating to integrating information technology, accounting and management services and rationalizing personnel levels of the combined operation (costs which the Company intends to take as a single charge at the time of the acquisition to the maximum extent permissible). Management does not intend to pursue acquisitions unless they are accretive to income before interest expense and provision for amortization of goodwill and intangibles and to operating cash flows (excluding the costs of integration). Revenue from Transaction Management, which constitutes a substantial majority of the Company's revenue, is subject to economic cycles. However, the Company's significant size, geographic coverage, number of transactions and large continuing client base tend to minimize the impact of economic cycles on annual revenue and create what the Company believes is equivalent to a recurring stream of revenue. Approximately 53% of the costs and expenses associated with Transaction Management are directly correlated to revenue while approximately 20% of the costs and expenses of Management Services and Financial Services, are directly correlated to revenue. A significant portion of the Company's revenue is seasonal. Historically, this seasonality has caused the Company's revenue, operating income and net income to be lower in the first two calendar quarters and higher in the third and fourth calendar quarters of each year. In addition, the Company's operations are directly affected by actual and perceived trends in various national and economic conditions, including interest rates, the availability of credit to finance commercial real estate transactions and the impact of tax laws. To date, the Company does not believe that general inflation has had a material impact upon its operations. Revenues, commissions and other variable costs related to revenues are primarily affected by real estate market supply and demand rather than general inflation. Results of Operations The following table sets forth items derived from the Company's consolidated statements of operations for the years ended December 31, 1999, 1998, and 1997, presented in dollars and as a percentage of revenue. The Company's results have benefitted from its ability to take advantage of a growing US commercial real estate market and the generally rising occupancy and rental levels and property values, as well as from significant expansion into international markets. Since brokerage fees are typically based upon a percentage of transaction value, and property management fees are typically based upon a percentage of total rent collections, recent occupancy and rental rate increases at the property level have generated an increase in brokerage and property management fees to the Company. Year Ended December 31, 1999 Compared to Year Ended December 31, 1998 The Company reported a consolidated net income of $23.3 million, or $1.10 diluted earnings per share for the year ended December 31, 1999, on revenues of $1.213 billion compared to a consolidated net income of $24.6 million on revenues of $1.035 billion for the year ended December 31, 1998. However, including the $32.3 million deemed dividend resulting from the accounting treatment of the preferred stock repurchase, the 1998 net loss applicable to common stockholders was $7.7 million, or $0.38 diluted loss per share. To improve operating results the Company implemented in 1999 a reduction in force program which is expected to result in over $20 million in cost savings for the year 2000. The 1999 result includes proceeds from an insurance policy of $1.6 million, nonrecurring gains of $8.7 million from the sale of five non- strategic offices and a small insurance operation, and one-time charges of approximately $10.2 million, the majority of which were severance costs related to the Company's reduction in workforce. Revenues on a consolidated basis were $1.213 billion, an increase of $178.5 million or 17.3% for the year ended December 31, 1999, compared to the year ended December 31, 1998. The overall increase related to the continued improvement in the commercial real estate markets across the US as reflected in increases in lease transactions and the full contribution from REI and HP and various other 1998 acquisitions. Additionally, the Company continued to benefit from its global market presence by leveraging the ability to deliver comprehensive real estate services into new businesses. Commissions, fees and other incentives on a consolidated basis were $536.3 million, an increase of $77.8 million or 17.0% for the year ended December 31, 1999, compared to the year ended December 31, 1998. The increase in these costs is attributable to an increase in revenue and includes the impact of a new commission-based program which enables sales professionals to earn additional commission over a certain revenue threshold and full year contribution from REI and HP and various 1998 acquisitions. Operating, administrative and other on a consolidated basis was $559.4 million, an increase of $110.6 million or 24.6% for the year ended December 31, 1999, compared to the year ended December 31, 1998. As a percentage of revenue, operating, administrative and other were 46.1% for the year ended December 31, 1999 compared to 43.4% for the year ended December 31, 1998. The increase in amount and percentage is due to the acquisitions of REI and HP and higher operating expenses. Consolidated interest income was $1.9 million, a decrease of $1.1 million or 36.8% for the year ended December 31, 1999, as compared to the year ended December 31, 1998 due to a decrease in average cash balances during 1999. Consolidated interest expense was $39.4 million, an increase of $8.3 million or 26.8% for the year ended December 31, 1999, as compared to the year ended December 31, 1998. The increase resulted from the renewal of certain senior term loans at a higher borrowing rate and higher borrowing levels during 1999. Provision for income tax on a consolidated basis was $16.2 million for the year ended December 31, 1999, as compared to the provision for income tax of $25.9 million for the year ended December 31, 1998. The decrease is primarily due to the decrease in income before provision for income tax and the release of $6.3 million net operating loss ("NOL") valuation allowances as it became evident that it is more likely than not the Company would generate sufficient taxable income to utilize a portion of the Company's NOL from prior years, resulting in a decrease in the effective tax rate. In early 1998 the Company repurchased its outstanding preferred stock which triggered a limitation on the annual amount of NOL it can use to offset future US taxable income. This limitation does not affect the way taxes are reported for financial reporting purposes, but it will affect the timing of the actual amount of taxes paid on an annual basis. EBITDA was $117.4 million for the year ended December 31, 1999, as compared to $127.2 million for the year ended December 31, 1998. EBITDA effectively removes the impact of certain non-cash and nonrecurring charges on income such as depreciation, amortization of intangible assets relating to acquisitions and merger-related and other nonrecurring charges. Management believes that the presentation of EBITDA will enhance a reader's understanding of the Company's operating performance and ability to service debt as it provides a measure of cash generated (subject to the payment of interest and income taxes) that can be used by the Company to service its debt and for other required or discretionary purposes. Net cash that will be available to the Company for discretionary purposes represents remaining cash after debt service and other cash requirements, such as capital expenditures, are deducted from EBITDA. EBITDA should not be considered as an alternative to (i) operating income determined in accordance with GAAP or (ii) operating cash flow determined in accordance with GAAP. Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 The Company reported a consolidated net loss applicable to common stockholders of $7.7 million, or $0.38 diluted loss per share for the year ended December 31, 1998, on revenues of $1.035 billion, compared to a consolidated net earnings applicable to common stockholders of $20.4 million on revenues of $730.2 million for the year ended December 31, 1997. Excluding the deemed dividend of $32.3 million and merger-related and other nonrecurring charges of $16.6 million, and related tax effect, diluted earnings would have been $1.68 per share. Revenues on a consolidated basis were $1.035 billion, an increase of $304.3 million or 41.7% for the year ended December 31, 1998, compared to the year ended December 31, 1997. The overall increase reflected a continued improvement in the commercial real estate markets across the US, a full contribution from Koll and a partial contribution from REI and HP and various other 1998 acquisitions. This improvement reflected both the Company's position and increasing consumer confidence in the US and European economies and, in particular, real estate assets and improving real estate market liquidity. Additionally, the Company continued to benefit from its global market presence by leveraging the ability to deliver comprehensive real estate services into new businesses. However, revenues for the fourth quarter and 1998 as a whole were adversely affected by the liquidity problems in the global capital markets in general and the CMBS market in particular, which began in September of 1998. Commissions, fees and other incentives on a consolidated basis were $458.5 million, an increase of $94.1 million or 25.8% for the year ended December 31, 1998, compared to the year ended December 31, 1997. The increase in these costs is attributable to the increase in revenue since most of the Company's sales professionals are compensated based on revenue. As a percentage of revenue, commissions fees and other incentives were 44.3% for the year ended December 31, 1998, compared to 49.9% for the year ended December 31, 1997. The decrease as a percentage of revenue is primarily due to the acquisition of Koll, which has a higher percentage of base management fee revenue which has no related commission expense. Operating, administrative and other on a consolidated basis was $448.8 million, an increase of $173.0 million or 62.8% for the year ended December 31, 1998, compared to the year ended December 31, 1997. As a percentage of revenue, operating, administrative and other were 43.4% for the year ended December 31, 1998 compared to 37.8% for the year ended December 31, 1997. The increase in amount and percentage is primarily due to the building of an infrastructure in anticipation of improved market environment which was not fully realized in 1998 and the acquisition of Koll, REI and HP which have relatively higher fixed operating expenses. Due to the integration of Koll and the partial integration of REI and HP, operating, administrative and other as a percentage of revenue has increased, while commissions, fees and other incentives as a percentage of revenue has decreased. Merger-related and other nonrecurring charges were $16.6 million for the year ended December 31, 1998. These charges represent $3.8 million of costs associated with the integration of REI's operations and systems into the Company's, $3.8 million related to name change costs, and $9.0 million related to the write-down in the carrying value of the Company's headquarters building to its estimated fair market value. Consolidated interest income was $3.1 million, an increase of $0.5 million or 17.6% for the year ended December 31, 1998, as compared to the year ended December 31, 1997. Consolidated interest expense was $31.0 million, an increase of $15.3 million or 96.7% for the year ended December 31, 1998, as compared to the year ended December 31, 1997. The increase resulted from the issuance of senior subordinated notes and increased revolving credit facility borrowings which were used for the repurchase of the Company's preferred stock and to acquire businesses. Provision for income tax on a consolidated basis was $25.9 million for the year ended December 31, 1998, as compared to the provision for income tax of $20.6 million for the year ended December 31, 1997. The increase is attributable to increased earnings which include international earnings from various foreign jurisdictions. In early 1998 the Company repurchased its outstanding preferred stock which triggered a limitation on the annual amount of NOL it can use to offset future US taxable income. This limitation does not affect the way taxes are reported for financial reporting purposes, but it will affect the timing of the actual amount of taxes paid on an annual basis. The increase in the effective tax rate is primarily the result of additional nonamortizable goodwill from recent acquisitions and losses in certain foreign jurisdictions for which no tax benefit is received. EBITDA, excluding merger-related and other nonrecurring costs was $127.2 million for the year ended December 31, 1998, as compared to $90.1 million for the year ended December 31, 1997. EBITDA effectively removes the impact of certain non-cash and nonrecurring charges on income such as depreciation and the amortization of intangible assets relating to acquisitions, merger-related and other nonrecurring charges. Management believes that the presentation of EBITDA will enhance a reader's understanding of the Company's operating performance and ability to service debt as it provides a measure of cash generated (subject to the payment of interest and income taxes) that can be used by the Company to service its debt and for other required or discretionary purposes. Net cash that will be available to the Company for discretionary purposes that represents remaining cash after debt service and other cash requirements, such as capital expenditures, are deducted from EBITDA. EBITDA should not be considered as an alternative to (i) operating income determined in accordance with GAAP or (ii) operating cash flow determined in accordance with GAAP. Segment Operations The Company provides integrated real estate services through three global business segments. The three segments are Transaction Management, Financial Services and Management Services. The factors for determining the reportable segments were based on the type of service and client and the way the chief operating decision makers organize segments within the Company for making operating decisions and assessing performance. Each business segment requires and is responsible for executing a unique marketing and business strategy. Transaction Management consists of commercial property sales and leasing services, transaction management and advisory services, investment property services (acquisitions and sales on behalf of investors). Financial Services consists of mortgage loan origination and servicing through L.J. Melody, investment management and advisory services through CBRE Investors, capital markets activities, valuation and appraisal services and real estate market research. Management Services consists of facilities and property management and related services. In July 1999, the Company announced that it changed its segment reporting from four segments to three segments. Prior periods have been restated to conform to the new segmentation. The following tables summarize the revenue, cost and expenses, and operating income by operating segment for the years ended December 31, 1999, 1998 and 1997. - ------- (1) Revenue is allocated by material line of business specific to each segment. "Other" includes types of revenue that have not been broken out separately due to their immaterial balances and/or nonrecurring nature within each segment. Certain revenue types disclosed on the consolidated statements of operations may not be derived directly from amounts shown in this table. (2) Segment operating income excludes merger-related and other nonrecurring charges. Year Ended December 31, 1999 Compared to Year Ended December 31, 1998 Transaction Management Revenue increased by $118.7 million or 15.6% for the year ended December 31, 1999, compared to the year ended December 31, 1998, due to the continued improvement of the real estate market, mainly in brokerage leasing services and the full contribution of REI and HP and various other 1998 acquisitions. Commissions, fees and other incentives increased by $64.0 million or 15.8% for the year ended December 31, 1999, compared to the year ended December 31, 1998, primarily due to an increase in revenue and includes the impact of a new commission-based program which enables sales professionals to earn additional commission over a certain revenue threshold and full year contribution from REI and HP and various 1998 acquisitions. Operating, administrative, and other increased by $50.5 million or 19.2% for the year ended December 31, 1999, compared to the year ended December 31, 1998. The increase in the amount is primarily due to the increase in operating expenses and the inclusion of REI and HP and various other 1998 acquisitions. Depreciation and amortization increased by $4.5 million or 32.9% for the year ended December 31, 1999, as compared to the year ended December 31, 1998, primarily as a result of additional investments in hardware and software to support the increase in new business. Financial Services Revenue increased by $32.2 million or 22.2% for the year ended December 31, 1999, compared to the year ended December 31, 1998. The increase in revenue is primarily due to the appraisal and valuation services and other revenue which includes the full contribution from REI and HP and various other 1998 acquisitions. Commissions, fees and other incentives increased by $13.9 million or 33.6% for the year ended December 31, 1999, compared to the year ended December 31, 1998. The increase is primarily a result of the revenue increase. Operating, administrative, and other increased by $25.7 million or 30.0% for the year ended December 31, 1999, compared to the year ended December 31, 1998, primarily as a result of increased operating expenses and the integration of REI and HP and various other 1998 acquisitions. Depreciation and amortization increased by $1.7 million or 15.3% for the year ended December 31, 1999, as compared to the year ended December 31, 1998, primarily related to the additional investment in hardware and software to support the increase in new business and the acquisitions of REI and HP and various other 1998 acquisitions. Management Services Revenue increased by $27.6 million or 21.8% for the year ended December 31, 1999, compared to the year ended December 31, 1998, primarily due to growth in the facilities management businesses and the full contribution from REI and HP and various other 1998 acquisitions. Commissions, fees and other incentives decreased by $0.1 million or 1.2% for the year ended December 31, 1999, compared to the year ended December 31, 1998. Operating, administrative, and other increased $34.4 million or 34.3% for the year ended December 31, 1999, compared to the year ended December 31, 1998, primarily related to the acquisitions of REI and HP, higher operating expenses, and the investment in infrastructure to expand business. Depreciation and amortization increased by $2.1 million or 28.1% for the year ended December 31, 1999, as compared to the year ended December 31, 1998, primarily related to the acquisitions of REI and HP and various other 1998 acquisitions. Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 Transaction Management Revenue increased by $181.8 million or 31.3% for the year ended December 31, 1998, compared to the year ended December 31, 1997, due to the continued improvement of the real estate market primarily in brokerage sales and lease transactions, the full contribution of Koll and the partial contribution of REI and HP. Commissions, fees and other incentives increased by $79.7 million or 24.5% for the year ended December 31, 1998, compared to the year ended December 31, 1997, primarily due to increased revenues, which resulted in higher commission eligibility levels, and, thus, higher commissions. As a percentage of revenue, commissions, fees and other incentives were 53.1% for the year ended December 31, 1998 compared to 56.1% for the year ended December 31, 1997. The decrease in commissions, fees and other incentives as a percentage of revenue is primarily due to the integration of REI and HP which generally do not operate under a variable commission-based program. Operating, administrative, and other increased by $82.8 million or 46.1% for the year ended December 31, 1998, compared to the year ended December 31, 1997. The increase in the amount and percentage is primarily a result of additional personnel requirements, the acquisition of Koll, which has higher fixed operating expenses and the investment in infrastructure to expand business from the integration of REI and HP. Depreciation and amortization increased by $5.1 million or 58.8% for the year ended December 31, 1998, as compared to the year ended December 31, 1997, primarily as a result of additional investments in hardware and software to support the increase in new business and the acquisitions of Koll, REI and HP. Financial Services Revenue increased by $55.5 million or 61.8% for the year ended December 31, 1998, compared to the year ended December 31, 1997. The increase in revenue is primarily due to the full contribution of Koll, partial contribution of REI and HP and growth at the mortgage banking and valuations units. Commissions, fees and other incentives increased by $17.3 million or 71.5% for the year ended December 31, 1998, compared to the year ended December 31, 1997. The increase is primarily a result of the revenue increase and the resulting higher commission eligibility level in mortgage banking and valuation and appraisal services. Operating, administrative, and other increased by $30.0 million or 53.8% for the year ended December 31, 1998, compared to the year ended December 31, 1997, primarily as a result of business promotion expenses and additional personnel requirements, and the full integration of Koll and the partial integration of REI and HP. Depreciation and amortization increased by $4.3 million or 63.0% for the year ended December 31, 1998, as compared to the year ended December 31, 1997, primarily related to the additional investment in information systems hardware and software to support the increase in new business and the acquisitions of Koll, REI and HP. Management Services Revenue increased by $67.0 million or 112.9% for the year ended December 31, 1998, compared to the year ended December 31, 1997, primarily due to management's ability to achieve greater efficiency in operations and leverage the revenue base of Koll and other acquired companies. Commissions, fees and other incentives decreased by $3.0 million or 20.4% for the year ended December 31, 1998, compared to the year ended December 31, 1997, primarily because the base contract management fee revenues, which increased as a result of the acquisition of Koll, do not have corresponding commission expenses. Operating, administrative, and other increased $60.2 million or 150.1% for the year ended December 31, 1998, compared to the year ended December 31, 1997. The increase in amount and percentage is primarily due to the full integration of Koll and the partial integration of REI and HP. Depreciation and amortization increased by $4.8 million or 180.0% for the year ended December 31, 1998, compared to the year ended December 31, 1997, primarily related to the acquisitions of Koll and REI. Liquidity and Capital Resources The Company has historically financed its operations and non-acquisition related capital expenditures primarily with internally generated funds and borrowings under a revolving credit facility. The Company had net repayments of $7.0 million to the revolving credit facility, for the year ended December 31, 1999, due to the positive cash flows from operating activities. The Company's EBITDA was $117.4 million and $127.2 million for the years ended December 31, 1999 and 1998, respectively. Net cash provided by operating activities was $74.0 million for the year ended December 31, 1999, compared to $76.6 million for the year ended December 31, 1998. The change is primarily due to changes in components of operating assets and liabilities. Net cash used in investing activities was $26.8 million for the year ended December 31, 1999, compared to $223.5 million for the year ended December 31, 1998. The change is primarily due to a lower level of acquisition of businesses, the sale of various non-strategic offices and the inventoried property, and the absence in 1999 of the supplemental purchase price payments included in 1998 in connection with a 1995 acquisition. Net cash used in financing activities was $37.7 million for the year ended December 31, 1999, compared to $119.4 million provided by financing activities for the year ended December 31, 1998. The decrease primarily results from increases in repayments of the inventoried property loan, the revolving credit facility and other loans. At December 31, 1999, the Company had $361.1 million outstanding in total indebtedness, consisting primarily of acquisition debt. Annual aggregate maturities of total debt at December 31, 1999 are as follows: 2000--$5.3 million; 2001--$2.4 million; 2002--$3.3 million; 2003--$160.0 million; 2004-- $0.1 million; and $190.0 million thereafter. In May 1998, the Company amended its revolving credit facility with a group of banks to provide up to $400.0 million for five years, subject to mandatory reductions of $40.0 million, $80.0 million and $80.0 million on December 31, 1999, 2000 and 2001, respectively. Subsequently, in October 1999, the Company executed an amendment to the revolving credit facility, reducing the facility to $350.0 million, eliminating the mandatory reduction on December 31, 1999, and revising some of the restrictive covenants. The new amendment is also subject to mandatory reductions of the facility by $80.0 million and $70.0 million on December 31, 2000 and 2001, respectively. The amount outstanding under this facility was $160.0 million at December 31, 1999 which is included in the accompanying consolidated balance sheets. Interest rate alternatives include Bank of America's reference rate plus 1.00% and LIBOR plus 2.50%. The weighted average rate on amounts outstanding at December 31, 1999 was 8.45%. The revolving credit facility contains numerous restrictive covenants that, among other things, limit the Company's ability to incur or repay other indebtedness, make advances or loans to subsidiaries and other entities, make capital expenditures, incur liens, enter into mergers or effect other fundamental corporate transactions, sell its assets, or declare dividends. In addition, the Company is required to meet certain ratios relating to its adjusted net worth, level of indebtedness, fixed charges and interest coverage. The Company expects to have capital expenditures ranging from $15 million to $25 million in 2000. The Company expects to use net cash provided by operating activities for the next several years primarily to fund capital expenditures for computer related purchases, acquisitions, including earnout payments, and to make required principal payments under the Company's outstanding indebtedness. The Company believes that it can satisfy its non-acquisition obligations as well as working capital requirements from internally generated cash flow, borrowings under the amended revolving credit facility or any replacement credit facilities. Material future acquisitions, if any, that require cash will require new sources of capital such as an expansion of the amended revolving credit facility and raising money by issuing additional debt or equity. The Company anticipates that its existing sources of liquidity, including cash flow from operations, will be sufficient to meet the Company's anticipated non-acquisition cash requirements for the foreseeable future and in any event for at least the next twelve months. In connection with an on-going stock repurchase program, the Company purchased 396,200 shares of common stock for approximately $5.0 million in 1999 and 488,900 shares of common stock for approximately $8.9 million in 1998. Year 2000 Issues Prior to the Year 2000 rollover event, the Company evaluated all computing systems, application programs, information processing hardware and software, and telecommunications systems to determine their ability to function in the Year 2000. Based on this evaluation, the Company developed and implemented detailed plans for upgrades, conversions and/or replacements. The Company completed the conversions and testing in the fourth quarter of 1999. Throughout the weekend of December 31, 1999 through January 3, 2000, the Company conducted thorough testing of its core business applications and computing systems used for processing all lines of business to ensure a Y2K readiness. As of January 2000, all testing was completed and the Company returned to normal daily operations. To date, the Company has not experienced any Year 2000 related issues. The Company estimates that it has spent in total approximately $13.5 million to address the Y2K issues which includes replacing and upgrading the affected hardware and software. The Company does not track the cost and time that its own internal employees spent on the Y2K project. Euro Conversion Disclosure A majority of the European Union member countries converted to a common currency, the "Euro," on January 1, 1999. The existing legacy currencies of the participating countries will continue to be acceptable until January 1, 2002. The Company does not expect the introduction of the Euro to have a significant impact on its market or the manner in which it conducts business, and believes the related impact on the Company's financials is not material. Approximately 5% of the Company's 1999 business was transacted in the participating member countries. The Company is currently using both the Euro and legacy currencies to conduct business in these member countries. The Company is in the process of replacing or upgrading the various items of hardware and software to allow for dual-currency reporting during the transition period, and issues related but not limited to converting amounts and rounding. The Company anticipates these system upgrades will be fully functional prior to the end of the transition period. Recent Acquisitions During 1999, the Company acquired four companies with an aggregate purchase price of approximately $13.8 million. The two significant acquisitions were Eberhardt Company which was acquired in September 1999 through L.J. Melody for approximately $7 million and Profi Nordic which was acquired in February 1999 through CBRE Profi Acquisition Corp. (formerly Koll Tender III) for approximately $5.5 million. On October 20, 1998 the Company, through L.J. Melody, purchased Carey, Brumbaugh, Starman, Phillips, and Associates, Inc., a regional mortgage banking firm for approximately $5.6 million in cash and approximately $2.4 million in notes bearing interest at 9.0% with three annual payments which began in October 1999. Approximately $0.2 million of the $2.4 million notes was accounted for as deferred cash compensation to certain key executives. The acquisition was accounted for as a purchase. The purchase price has largely been allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. On October 1, 1998 the Company purchased the remaining ownership interests that it did not already own in the Richard Ellis Australia and New Zealand businesses. The costs for the remaining interest was $20.0 million in cash. Virtually all of the revenue of these locations is derived from brokerage and appraisal services. The acquisition was accounted for as a purchase. The purchase price has largely been allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives ranging up to 30 years. On September 22, 1998 the Company purchased the approximately 73.0% interest that it did not already own in CB Commercial Real Estate Group of Canada, Inc. The Company acquired the remaining interest for approximately $14.3 million in cash. The acquisition was accounted for as a purchase. The purchase price has been largely allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives ranging up to 30 years. On July 7, 1998 the Company acquired the business of Hillier, Parker, May and Rowden, now known as CB Hillier Parker Limited, a commercial property services partnership operating in the UK. The acquisition was accounted for as a purchase. The purchase price for HP included approximately $63.6 million in cash and $7.1 million in shares of the Company's common stock. In addition, the Company assumed a contingent payout plan for key HP employees with a potential payout over three years of approximately $13.9 million and assumed various annuity obligations of approximately $15.0 million. The purchase price has largely been allocated to goodwill which is amortized on a straight line basis over its estimated useful life of 30 years. On July 1, 1998 the Company increased its ownership percentage in CB Commercial/Arnheim & Neely, an existing partnership formed in September 1996, which then combined with the Galbreath Company Mid-Atlantic to form CB Richard Ellis/Pittsburgh, LP. The total purchase price of the Company's 50% interest in the combined enterprise is $5.7 million. On May 31, 1998 the Company acquired Mathews Click and Associates, a property sales, leasing, and management firm, for approximately $10.0 million in cash and potential supplemental payments of $1.9 million which are contingent upon operating results, payable to the sellers over a period of two years. The acquisition was accounted for as a purchase. The total purchase price including potential supplemental payments was allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. Effective May 1, 1998 the Company, through L.J. Melody, acquired Shoptaw- James, Inc., a regional mortgage banking firm, for approximately $6.3 million in cash and approximately $2.7 million in notes bearing interest at 9.0% with three annual payments which began in May 1999. The acquisition was accounted for as a purchase. Approximately $0.3 million of the $2.7 million notes are being accounted for as compensation over the term of the notes as the payment of these notes are contingent upon certain key executives' and producers' continued employment with the Company. The approximate $2.4 million of the $2.7 million is being accounted for as supplemental payments to the sellers over a period of three years. The purchase price and supplemental payments have largely been allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. On April 17, 1998 the Company purchased all of the outstanding shares of REI, an international commercial real estate services firm operating under the name Richard Ellis in major commercial real estate markets worldwide (excluding the UK). The acquisition was accounted for as a purchase. The purchase price has largely been allocated to goodwill, which is amortized on a straight line basis over an estimated useful life of 30 years. The purchase price for REI was approximately $104.8 million of which approximately $53.3 million was paid in cash and notes and approximately $51.5 million was paid in shares of the Company's common stock. In addition, the Company assumed approximately $14.4 million of long-term debt and minority interest. The Company incurred a one-time charge of $3.8 million associated with the integration of REI's operations and systems into the Company's. On February 1, 1998 the Company, through L.J. Melody, acquired all of the issued and outstanding stock of Cauble and Company of Carolina, a regional mortgage banking firm for approximately $2.2 million, including cash payments of approximately $1.8 million and a note payable of approximately $0.4 million bearing interest at 9.0% with principal payments starting in April 1998. The acquisition was accounted for as a purchase. The purchase price has largely been allocated to intangibles and goodwill, which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. On January 31, 1998 the Company, through L.J. Melody, acquired certain assets of North Coast Mortgage Company, a regional mortgage banking firm for cash payments of approximately $3.0 million and approximately $0.9 million in notes. Approximately $0.3 million of the $0.9 million notes have been accounted for as supplemental payments to the sellers and approximately $0.6 million as deferred compensation to certain key executives and producers payable in three annual installments which began in February 1999. The acquisition was accounted for as a purchase. The purchase price and supplemental payments have largely been allocated to intangibles and goodwill, which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. The $0.6 million of deferred cash compensation is being accounted for as compensation over the term of the agreements as the payment of the compensation is contingent upon certain key executives' and producers' continued employment with the Company. On August 28, 1997 the Company purchased Koll Real Estate Services through a merger. The acquisition was accounted for as a purchase and resulted in the issuance of equity valued at approximately $132.9 million and the assumption of debt and minority interest of approximately $57.4 million as of August 28, 1997. The initial purchase price, in excess of the net identifiable assets acquired, totaled $95.3 million, including $20.0 million relating to incentive fees on investments fund partnerships which is earned as assets within the funds are sold, is included, net of amortization, in goodwill and other intangible assets, respectively, in the accompanying consolidated balance sheets. Goodwill is being amortized on a straight line basis over an estimated useful life of 30 years. In the third quarter of 1997 the Company recorded the effects of a charge for merger- related costs of $11.2 million, which is included in total merger-related costs of $12.9 million. Litigation In December 1996, GMH Associates, Inc. ("GMH") filed a lawsuit against Prudential and the Company in Superior Court of Pennsylvania, Franklin County, alleging various contractual and tort claims against Prudential, the seller of a large office complex, and the Company, its agent in the sale, contending that Prudential breached its agreement to sell the property to GMH, breached its duty to negotiate in good faith, conspired with the Company to conceal from GMH that Prudential was negotiating to sell the property to another purchaser and that Prudential and the Company misrepresented that there were no other negotiations for the sale of the property. Following a non-jury trial, the court rendered a decision in favor of GMH and against Prudential and the Company, awarding GMH $20.3 million in compensatory damages, against Prudential and the Company jointly and severally, and $10.0 million in punitive damages, allocating the punitive damage award $7.0 million as against Prudential and $3.0 million as against the Company. Following the denial of motions by Prudential and the Company for a new trial, a judgment was entered on December 3, 1998. Prudential and the Company filed an appeal of the judgment. On March 3, 2000 the appellate court in Pennsylvania reversed all of the trial courts' decisions finding that liability was not supported on any theory claimed by GMH and directed that a judgement be entered in favor of the defendants including the Company. The plaintiff has filed an appeal with the Pennsylvania Supreme Court. In August 1993, a former commissioned sales person of the Company filed a lawsuit against the Company in the Superior Court of New Jersey, Bergen County, alleging gender discrimination and wrongful termination by the Company. On November 20, 1996, a jury returned a verdict against the Company, awarding $1.5 million in general damages and $5.0 million in punitive damages to the plaintiff. Subsequently, the trial court awarded the plaintiff $638,000 in attorneys' fees and costs. Following denial by the trial court of the Company's motions for new trial, reversal of the verdict and reduction of damages, the Company filed an appeal of the verdict and requested a reduction of damages. On March 9, 1999 the appellate court ruled in the Company's favor, reversed the trial court decision and ordered a new trial. On February 16, 2000 the Supreme Court of New Jersey reversed the decision of the appellate court, concluded that the general damage award in the trial court should be sustained and returned the case to the appellate court for a determination as to whether a new trial should be ordered on the issue of punitive damages. Based on available reserves, cash and anticipated cash flows, the Company believes that the ultimate outcome of this case will not have an impact on the Company's ability to carry on its operations. The Company is a party to a number of pending or threatened lawsuits arising out of, or incident to, its ordinary course of business. Based on available cash and anticipated cash flows, the Company believes that the ultimate outcome will not have an impact on the Company's ability to carry on its operations. Management believes that any liability to the Company that may result from disposition of these lawsuits will not have a material effect on the consolidated financial position or results of operations of the Company. Net Operating Losses The Company had federal income tax NOLs of approximately $57.4 million at December 31, 1999, corresponding to $20.1 million of the Company's $60.3 million in net deferred tax assets before valuation allowances, which expire in the years 2004 to 2008. The ability of the Company to utilize NOLs was limited in 1998 and will be in subsequent years as a result of the Company's 1996 public offering, the 1997 Koll acquisition and the 1998 repurchase of preferred stock which cumulatively caused a more than 50.0% change of ownership within a three year period. As a result of the limitation, the Company will be able to use approximately $26.0 million of its NOL in 1999 and in each subsequent year. The amount of NOLs is, in any event, subject to some uncertainty until the statute of limitation lapses. Segment Reporting In July 1999, the Company announced that it changed its segment reporting from four segments to three segments. Prior periods have been restated to conform to the new segmentation. New Accounting Pronouncements In 1999, the Company adopted Statement of Position 98-5, Reporting on the Costs of Start-up Activities, which requires costs of start-up activities and organization costs to be expensed as incurred. The adoption of this statement did not have a material impact on the Company's financial statements. In June 1999, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 137, Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133, which deferred the effective date of SFAS No. 133 for one year. SFAS No. 137 is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Company has not yet quantified the impacts of adopting SFAS No. 133 on its financial statements and has not determined the timing of or method of its adoption of SFAS No. 133. SFAS No. 133 is not anticipated to have any impact on earnings or other components of comprehensive income as the Company had no derivatives outstanding at December 31, 1999. The Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information during the quarter ended December 31, 1998. SFAS No. 131 requires the use of the "management approach" for segment reporting, which is based on the way the chief operating decision maker organizes segments within a company for making operating decisions and assessing performance. The adoption of this statement did not have a material impact on the Company's consolidated financial statements. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. Safe Harbor Statement Regarding Outlook and Other Forward-Looking Data Portions of the Annual Report, including Management's Discussion and Analysis, contain forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the Company's actual results and performance in future periods to be materially different from any future results or performance suggested in forward-looking statements in this release. Such forward-looking statements speak only as of the date of this report and the Company expressly disclaims any obligation to update or revise any forward-looking statements found herein to reflect any changes in Company expectations or results or any change in events. Factors that could cause results to differ materially include, but are not limited to: commercial real estate vacancy levels; employment conditions and their effect on vacancy rates; property values; rental rates; any general economic recession domestically or internationally; and general conditions of financial liquidity for real estate transactions. Report of Management The Company's management is responsible for the integrity of the financial data reported by the Company and its subsidiaries. Fulfilling this responsibility requires the preparation and presentation of consolidated financial statements in accordance with generally accepted accounting principles. Management uses internal accounting controls, corporate-wide policies and procedures and judgment so that such statements reflect fairly the consolidated financial position, results of operations and cash flows of the Company. Item 7A. Item 7A. Quantitative and Qualitative Disclosures About Market Risk The Company's exposure to market risk consists of foreign currency exchange rate fluctuations related to international operations and changes in interest rates on debt obligations. Following the REI and HP acquisitions, approximately 22% of the Company's business is transacted in currencies of foreign countries. The Company attempts to manage its exposure primarily by balancing monetary assets and liabilities, and maintaining cash positions only at levels necessary for operating purposes. While the Company's international results of operations as measured in dollars are subject to foreign exchange rate fluctuations, the related risk is not considered material. The Company routinely monitors its transaction exposure to currency rate changes, and enters into currency forward and option contracts to limit such exposure, as appropriate. Such contracts are usually short term in nature ranging from ten days to two months. Gains and losses on contracts are deferred until the transaction being hedged is finalized. In 1999, the Company did not enter into any derivative contracts. The Company does not engage in any speculative activities. The Company manages its interest expense by using a combination of fixed and variable rate debt. The Company utilizes sensitivity analyses to assess the potential effect of its variable rate debt. If interest rates were to increase by 80 basis points (approximately 10.0% of the Company's weighted-average variable rate at year-end), the net impact would be a decrease of $1.3 million on annual pre-tax income and cash flow. The Company's fixed and variable long- term debt at December 31, 1999 consisted of the following (dollars in thousands): - -------- (1) Includes Senior Subordinated Note. Based on dealer's quotes, the estimated fair value of the Company's $175.0 million Senior Subordinated Note is $155.3 million. Estimated fair values for other liabilities are not presented because the Company believes that they are not materially different from book value, primarily because the majority of the Company's remaining debt is based on variable rates that approximate terms that the Company could obtain at December 31, 1999. Item 8. Item 8. Financial Statements and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE All other schedules are omitted because either they are not applicable, not required or the information required is included in the Consolidated Financial Statements, including the notes thereto. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of CB Richard Ellis Services, Inc.: We have audited the accompanying consolidated balance sheets of CB Richard Ellis Services, Inc. (a Delaware corporation) as of December 31, 1999, and 1998, and the related consolidated statements of operations, stockholders' equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 1999. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CB Richard Ellis Services, Inc. as of December 31, 1999, and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to consolidated financial statements is presented for purposes of complying with the Securities and Exchange Commissions rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. Arthur Andersen LLP Los Angeles, California February 7, 2000 CB RICHARD ELLIS SERVICES, INC. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except share and per share data) The accompanying notes are an integral part of these consolidated financial statements. CB RICHARD ELLIS SERVICES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except share and per share data) The accompanying notes are an integral part of these consolidated financial statements. CB RICHARD ELLIS SERVICES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) The accompanying notes are an integral part of these consolidated financial statements. CB RICHARD ELLIS SERVICES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands) CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands) The accompanying notes are an integral part of these consolidated financial statements CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of CB Richard Ellis Services, Inc. ("CBRE Services" or "the Company") and its consolidated subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Cash and Cash Equivalents Cash and cash equivalents consist of cash and highly liquid investments with an original maturity of less than three months. Goodwill and Other Intangible Assets Net goodwill at December 31, 1999 consisted of $426.0 million related to the 1995 through 1999 acquisitions which is being amortized over an estimated useful life of 30 years and $19.0 million related to the Company's original acquisition in 1989 which is being amortized over an estimated useful life of 40 years. Net other intangible assets at December 31, 1999 included approximately $7.9 million of deferred financing costs and $49.6 million of intangibles stemming from the 1995 through 1999 acquisitions. These are amortized on a straight line basis over the estimated useful lives of the assets, ranging from 3 to 15 years. The Company periodically evaluates the recoverability of the carrying amount of goodwill and other intangible assets. In this assessment, the Company considers macro market conditions and trends in the Company's relative market position, its capital structure, lender relationships and the estimated undiscounted future cash flows associated with these assets. If any of the significant assumptions inherent in this assessment materially change due to market, economic and/or other factors, the recoverability is assessed based on the revised assumptions and resultant undiscounted cash flows. If such analysis indicates impairment, it would be recorded in the period such changes occur based on the fair value of the goodwill and other intangible assets. Income Recognition Real estate commissions on sales are recorded as income upon close of escrow or upon transfer of title. Real estate commissions on leases are generally recorded as income upon the earlier of date of occupancy or cash receipt unless significant future contingencies exist. Realty advisor incentive fees are recognized when earned under the provisions of the related advisory agreements. Other commissions and fees are recorded as income at the time the related services have been performed unless significant future contingencies exist. Foreign Currencies The currency effects of translating the financial statements of those non-US subsidiaries of the Company which operate in local currency environments are included in the "Accumulated other comprehensive income (loss) component of stockholders' equity. Gains and losses resulting from foreign currency transactions are included in results of operations and were not material in each of the three years in the period ended December 31, 1999. Comprehensive Income Comprehensive income consists of net income and other comprehensive income. Accumulated other comprehensive income (loss) consists of foreign currency translation adjustments. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Accounting for Transfers and Servicing The Company follows Statement of Financial Accounting Standards ("SFAS") No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments in accounting for loan sales and acquisition of servicing rights. Under SFAS No. 125, the Company is required to recognize, at fair value, financial and servicing assets it has acquired control over and related liabilities it has incurred and amortize them over the period of estimated net servicing income or loss. Write-off of the asset is required when control is surrendered. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities at the date of the financial statements and the reported amounts of certain revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that these estimates provide a reasonable basis for the fair presentation of its financial condition and results of operations. The most significant estimates with regard to these consolidated financial statements relate to deferred taxes and the useful life of goodwill. New Accounting Pronouncements In 1999, the Company adopted Statement of Position 98-5, Reporting on the Costs of Start-up Activities, which requires costs of start-up activities and organization costs to be expensed as incurred. The adoption of this statement did not have a material impact on the Company's financial statements. In June 1999, the Financial Accounting Standards Board ("FASB") issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities-- Deferral of the Effective Date of FASB Statement No. 133, which deferred the effective date of SFAS No. 133 for one year. SFAS No. 137 is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Company has not yet quantified the impacts of adopting SFAS No. 133 on its financial statements and has not determined the timing of or method of its adoption of SFAS No. 133. SFAS No. 133 is not anticipated to have any impact on earnings or other components of comprehensive income as the Company had no derivatives outstanding at December 31, 1999. The Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information during the quarter ended December 31, 1998. SFAS No. 131 requires the use of the "management approach" for segment reporting, which is based on the way the chief operating decision maker organizes segments within a company for making operating decisions and assessing performance. The adoption of this statement did not have a material impact on the Company's consolidated financial statements. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. Reclassifications Certain reclassifications, which do not have an effect on net income, have been made to the 1998 and 1997 financial statements to conform to the 1999 presentation. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 2. Acquisitions During 1999, the Company acquired four companies with an aggregate purchase price of approximately $13.8 million. The two significant acquisitions were Eberhardt Company which was acquired in September 1999 through L.J. Melody for approximately $7 million and Profi Nordic which was acquired in February 1999 through CBRE Profi Acquisition Corp. (formerly Koll Tender III) for approximately $5.5 million. On October 20, 1998 the Company, through L.J. Melody, purchased Carey, Brumbaugh, Starman, Phillips, and Associates, Inc., a regional mortgage banking firm for approximately $5.6 million in cash and approximately $2.4 million in notes bearing interest at 9.0% with three annual payments which began in October 1999. Approximately $0.2 million of the $2.4 million notes was accounted for as deferred cash compensation to certain key executives. The acquisition was accounted for as a purchase. The purchase price has largely been allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. On October 1, 1998 the Company purchased the remaining ownership interests that it did not already own in the Richard Ellis Australia and New Zealand businesses. The costs for the remaining interest was $20.0 million in cash. Virtually all of the revenue of these locations is derived from brokerage and appraisal services. The acquisition was accounted for as a purchase. The purchase price has largely been allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives ranging up to 30 years. On September 22, 1998 the Company purchased the approximately 73.0% interest that it did not already own in CB Commercial Real Estate Group of Canada, Inc. The Company acquired the remaining interest for approximately $14.3 million in cash. The acquisition was accounted for as a purchase. The purchase price has been largely allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives ranging up to 30 years. On July 7, 1998 the Company acquired the business of Hillier, Parker, May and Rowden, now known as CB Hillier Parker Limited ("HP"), a commercial property services partnership operating in the United Kingdom ("UK"). The acquisition was accounted for as a purchase. The purchase price for HP included approximately $63.6 million in cash and $7.1 million in shares of the Company's common stock. In addition, the Company assumed a contingent payout plan for key HP employees with a potential payout over three years of approximately $13.9 million and assumed various annuity obligations of approximately $15.0 million. The purchase price has largely been allocated to goodwill which is amortized on a straight line basis over its estimated useful life of 30 years. On July 1, 1998 the Company increased its ownership percentage in CB Commercial/Arnheim & Neely, an existing partnership formed in September 1996, which then combined with the Galbreath Company Mid-Atlantic to form CB Richard Ellis/Pittsburgh, LP. The total purchase price of the Company's 50% interest in the combined enterprise is $5.7 million. On May 31, 1998 the Company acquired Mathews Click and Associates, a property sales, leasing, and management firm, for approximately $10.0 million in cash and potential supplemental payments of $1.9 million which are contingent upon operating results, payable to the sellers over a period of two years. The acquisition was accounted for as a purchase. The total purchase price including potential supplemental payments was allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. Effective May 1, 1998 the Company, through L.J. Melody, acquired Shoptaw- James, Inc. ("Shoptaw-James"), a regional mortgage banking firm, for approximately $6.3 million in cash and approximately CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) $2.7 million in notes bearing interest at 9.0% with three annual payments which began in May 1999. The acquisition was accounted for as a purchase. Approximately $0.3 million of the $2.7 million notes are being accounted for as compensation over the term of the notes as the payment of these notes are contingent upon certain key executives' and producers' continued employment with the Company. The approximate $2.4 million of the $2.7 million is being accounted for as supplemental payments to the sellers over a period of three years. The purchase price and supplemental payments have largely been allocated to intangibles and goodwill which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. On April 17, 1998 the Company purchased all of the outstanding shares of CB Commercial Limited, formerly known as REI Limited ("REI"), an international commercial real estate services firm operating under the name Richard Ellis in major commercial real estate markets worldwide (excluding the UK). The acquisition was accounted for as a purchase. The purchase price has largely been allocated to goodwill, which is amortized on a straight line basis over an estimated useful life of 30 years. The purchase price for REI was approximately $104.8 million of which approximately $53.3 million was paid in cash and notes and approximately $51.5 million was paid in shares of the Company's common stock. In addition, the Company assumed approximately $14.4 million of long-term debt and minority interest. The Company incurred a one-time charge of $3.8 million associated with the integration of REI's operations and systems into the Company's. On February 1, 1998 the Company, through L.J. Melody, acquired all of the issued and outstanding stock of Cauble and Company of Carolina, a regional mortgage banking firm for approximately $2.2 million, including cash payments of approximately $1.8 million and a note payable of approximately $0.4 million bearing interest at 9.0% with principal payments starting in April 1998. The acquisition was accounted for as a purchase. The purchase price has been largely allocated to intangibles and goodwill, which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. On January 31, 1998 the Company, through L.J. Melody, acquired certain assets of North Coast Mortgage Company, a regional mortgage banking firm for cash payments of approximately $3.0 million and approximately $0.9 million in notes. Approximately $0.3 million of the $0.9 million notes have been accounted for as supplemental payments to the sellers and approximately $0.6 million as deferred compensation to certain key executives and producers payable in three annual installments which began in February 1999. The acquisition was accounted for as a purchase. The purchase price and supplemental payments have largely been allocated to intangibles and goodwill, which are amortized on a straight line basis over their estimated useful lives of 7 and 30 years, respectively. The $0.6 million of deferred cash compensation is being accounted for as compensation over the term of the agreements as the payment of the compensation is contingent upon certain key executives' and producers' continued employment with the Company. On August 28, 1997 the Company purchased Koll Real Estate Services ("Koll") through a merger. The acquisition was accounted for as a purchase and resulted in the issuance of equity valued at approximately $132.9 million and the assumption of debt and minority interest of approximately $57.4 million as of August 28, 1997. The initial purchase price, in excess of the net identifiable assets acquired, totaled $95.3 million, including $20.0 million relating to incentive fees on investments fund partnerships which is earned as assets within the funds are sold, and is included, net of amortization, in goodwill and other intangible assets, respectively, in the accompanying consolidated balance sheets. Goodwill is being amortized on a straight line basis over an estimated useful life of 30 years. In the third quarter of 1997 the Company recorded the effects of a charge for merger-related costs of $11.2 million, which is included in total merger-related costs of $12.9 million. The assets and liabilities of certain acquired companies, along with the related goodwill, intangibles and indebtedness, are reflected in the accompanying consolidated financial statements at December 31, 1999. The results of operations of the acquired companies are included in the consolidated results from the dates they were acquired. The unaudited pro forma results of operations of the Company for the year ended December 31, CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) and 1997, assuming the REI acquisition, and the Koll acquisition, had occurred on January 1, 1997, would have been as follows (amounts in thousands, except per share data): For the year ended December 31, 1998, net loss applicable to common stockholders includes a deemed dividend of $32.3 million on the repurchase of the Company's preferred stock. The pro forma results do not necessarily represent results which would have occurred if the acquisitions had taken place on the date assumed above, nor are they indicative of the results of future combined operations. The amounts are based upon certain assumptions and estimates, and do not reflect any benefit from economies which might be achieved from combined operations. Further, REI historical results for the first three months of 1998 include certain nonrecurring adjustments. 3. Other Current Assets In December 1999, the Company sold five non-strategic offices and a small insurance operation for a total of approximately $10 million. Other current assets include $9.2 million in receivables from the sales at December 31, 1999 in the accompanying consolidated balance sheets. 4. Property and Equipment Property and equipment is stated at cost and consists of the following (in thousands): The Company capitalizes expenditures that materially increase the life of the related assets and charges the cost of maintenance and repairs to expense. Upon sale or retirement, the capitalized costs and related accumulated depreciation or amortization are eliminated from the respective accounts, and the resulting gain or loss is included in operating income. Depreciation is computed primarily using the straight line method over estimated useful lives ranging from 3 to 10 years. Leasehold improvements are amortized over the term of the respective leases, excluding options to renew. Equipment under capital leases is depreciated over the related term of the leases. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The Company sold its headquarters building in downtown Los Angeles, California, in September 1999 and its small office building in Phoenix, Arizona in October 1999, both at a minimal loss. The Los Angeles building was previously written down by $9.0 million to its estimated fair market value and reclassified as property held for sale which is included in other assets at December 31, 1998 in the accompanying consolidated balance sheets. 5. Investments in and Advances to Unconsolidated Subsidiaries Investments in unconsolidated subsidiaries in which the Company does not have majority control are accounted for under the equity method. Investments in and advances to (from) unconsolidated subsidiaries as of December 31, 1999 and 1998 are as follows (in thousands): - -------- * Various interests with varying ownership rates. Unaudited combined condensed financial information for the entities accounted for using the equity method is as follows (in thousands): Condensed Statement of Operations Information: Condensed Balance Sheet Information: Equity interest in earnings (losses) of the unconsolidated subsidiaries of $7,528,000, $3,443,000 and $(113,000) for the years ended December 31, 1999, 1998 and 1997, respectively, have been included in "Operating, Administrative and Other" in the Consolidated Statements of Operations. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 6. Other Assets Included in other assets at December 31, 1999 in the consolidated balance sheets are $20.4 million invested in cash surrender value of insurance products and which function like mutual funds as an investment alternative for the Deferred Compensation Plan (see Note 7). Also included in other assets are $4.9 million of notes receivable from stock options exercised (see Note 10). At December 31, 1998, other assets included $5.3 million of notes receivable from stock options exercised, $8.0 million of property held for sale and $7.4 million of inventoried property which were sold in 1999. 7. Employee Benefit Plans Option Plans. In conjunction with the Shoptaw-James acquisition, options for 25,000 shares were granted with an exercise price representing a fair market value of $37.32 per share on the date of grant. On December 15, 1998 the option holders elected to change the exercise price to $20.00 per share, which was above market value on the date of election, and simultaneously reduce the number of shares by 20%. The options vest over five years at a rate of 20% per year, expiring in May 2008. Options for 20,000 shares were outstanding at December 31, 1999. In April 1998, in conjunction with the REI acquisition, the Company approved the assumption of the options outstanding under the REI Limited Stock Option Plan. These options for 46,115 shares of common stock were issued and exercised immediately at $14.95 per share in exchange for existing REI options. Also in conjunction with the REI acquisition, the Company granted options for 475,677 shares at an exercise price equal to fair market value at date of grant of $33.50 per share. On December 15, 1998 certain holders of a stock option grant elected to change the exercise price of their options to $20.00 per share, which was above market value on the date of election, and simultaneously reduce the number of shares by 20%. These options vest over three years at a rate of 33.33% per year, expiring in March 2009. Options for 499,286 shares were outstanding at December 31, 1999. In conjunction with the NCMC acquisition, options for 25,000 shares were granted with an exercise price representing the fair market value at date of grant of $32.50. On December 15, 1998, the option holders elected to change the exercise price to $20.00 per share, which was above market value on the date of election, and simultaneously reduce the number of shares by 20%. The options vest over five years at a rate of 20% per year, expiring in February 2008. Options for 20,000 shares were outstanding at December 31, 1999. A total of 700,000 shares of common stock have been reserved for issuance under the Company's 1997 Employee Stock Option Plan. On December 15, 1998, certain holders of stock option grants with an exercise price in excess of $20.00 per share elected to change the exercise price of their options to $20.00 per share, which was above market value on the date of election and simultaneously reduce the number of shares by 20%. During 1999, the Company granted options for 289,000 shares of common stock at an exercise price ranging from $14.25 to $16.38 per share. All options were granted at an exercise price equal to fair market value at date of grant. The vesting periods for these options range from approximately one to five years, expiring at various dates through 2009. Options for 647,160 shares were outstanding at December 31, 1999. In August 1997, in conjunction with the Koll acquisition, the Company approved the assumption of the options outstanding under the KMS Holding Company Amended 1994 Stock Option Plan (now known as the CBC Substitute Option Plan ("CBCSP")) and the Koll Acquisition Stock Option Plan ("KASOP"). Under the CBCSP, 407,087 stock options were issued with exercise prices ranging from $12.89 to $18.04 in exchange for existing Koll options. These options were immediately exercisable. At December 31, 1999, 158,072 options have been exercised and 249,015 options were outstanding. Under the KASOP, 550,000 stock options were issued to former senior executives of Koll who became employees or directors of the Company. These options have CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) exercise prices ranging from $14.25 to $36.75 per share and vesting periods ranging from immediate to three years, expiring at various dates through September 2009. Options for 300,000 shares were outstanding at December 31, 1999. A total of 90,750 shares of common stock have been reserved for issuance under the L.J. Melody Acquisition Stock Option Plan, which was adopted by the Board of Directors in September 1996 as part of the July 1996 acquisition of L.J. Melody. Options for all such shares have been issued at an exercise price of $10.00 per share and vest over a period of five years at the rate of 5% per quarter expiring in June 2006. Options for 90,750 shares of common stock were outstanding at December 31, 1999. A total of 600,000 shares of common stock have been reserved for issuance under the Company's 1991 Service Providers Stock Option Plan. In various years below market options were granted to certain directors as partial payment for director fees. On December 15, 1998 certain holders of stock option grants with an exercise price in excess of $20.00 per share elected to change the exercise price of their options to $20.00 per share, which was above market value on the date of election and simultaneously reduce the number of shares by 20%. During 1999, options for 87,000 shares were granted to certain directors and executive officers at an exercise price equal to fair market value at date of grant ranging from $14.25 to $18.13 per share. All options vest over one to five year periods, expiring at various dates through September 2009. Options for 569,178 shares were outstanding at December 31, 1999. A total of 1,000,000 shares of common stock have been reserved for issuance under the Company's 1990 Stock Option Plan. All options vest over one to four year periods, expiring at various dates through November 2006. During 1999 and 1998, options to purchase 58,000 shares and 668,250 shares of common stock were exercised, respectively. Options for 55,000 shares were outstanding at December 31, 1999. As allowed under the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, the Company has elected to follow Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its employee stock based compensation plans. Under this method the Company does not recognize compensation expense for options that were granted at or above the market price of the underlying stock on the date of grant. Had compensation expense been determined consistent with SFAS No. 123, the Company's net income and per share information would have been reduced to the following pro forma amounts (in thousands except per share data): Because the SFAS 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1999, 1998 and 1997, respectively: risk-free interest rates of 5.55%, 4.95% and 6.54% for the various plans. Expected volatility for 1999, 1998, and CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 1997, respectively, is 61.83%, 48.16% and 36.67%. Dividend yield is excluded from the calculation since it is the present intention of the Company to retain all earnings for future acquisitions. Expected life for 1999, 1998 and 1997 is 5.00, 5.00 and 5.15 years, respectively. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, the Company believes the Black-Scholes model does not necessarily provide a reliable single measure of the fair value of its employee stock options. A summary of the status of the Company's option plans at December 31, 1999, 1998, and 1997 and changes during the years then ended is presented in the table and narrative below: Significant option and warrant groups outstanding at December 31, 1999 and related weighted average price and life information is presented below: Stock Purchase Plans. The Company has restricted stock purchase plans covering certain key executives including senior management. A total of 500,000 and 550,000 shares of common stock have been reserved for issuance under the Company's 1999 and 1996 Equity Incentive Plans, respectively. The shares may be issued to senior executives for a purchase price equal to the greater of $18.00 and $10.00 per share or fair market value, CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) respectively. Under these plans, 140,833 and 506,286 shares were outstanding at December 31, 1999, respectively. The purchase price for these shares must be paid either in cash or by delivery of a full recourse promissory note. The related promissory notes are also included in the consolidated statements of stockholders' equity. Bonuses. The Company has bonus programs covering certain key employees, including senior management. Awards are based on the position and performance of the employee and the achievement of pre-established financial, operating and strategic objectives. The amounts charged to expense for bonuses were $44.3 million, $33.7 million, and $28.8 million for the years ended December 31, 1999, 1998, and 1997, respectively. Capital Accumulation Plan (the "Cap Plan"). The Cap Plan is a defined contribution profit sharing plan under Section 401(k) of the Internal Revenue Code and is the Company's only such plan. Under the Cap Plan, each participating employee may elect to defer a portion of his or her earnings and the Company may make additional contributions from the Company's current or accumulated net profits to the Cap Plan in such amounts as determined by the Board of Directors. The Company expensed, in connection with the Cap Plan, $1.6 million and $2.9 million for the years ended December 31, 1999 and 1997. No expense, in connection with the Cap Plan, was incurred for the year ended December 31, 1998. Deferred Compensation Plan (the "DCP"). In 1994 the Company implemented the DCP. Under the DCP, a select group of management and highly compensated employees can defer the payment of all or a portion of their compensation (including any bonus). The DCP permits participating employees to make an irrevocable election at the beginning of each year to receive amounts deferred at a future date either in cash, which is an unsecured long-term liability of the Company, or in newly issued shares of common stock of the Company which elections are recorded as additions to stockholders' equity. Effective May 1, 1999, the Company revised the DCP to add insurance products which function like mutual funds as an investment alternative and to fund the Company's obligation for deferrals invested in such insurance products. The Company received proceeds of approximately $1.6 million related to additional insurance products. For the twelve months ended December 31, 1999, approximately $31.4 million and $1.7 million were deferred in cash (including interest and capital appreciation) and stock, respectively. The accumulated deferrals net of disbursements at December 31, 1999, were approximately $47.2 million in cash (including interest and capital appreciation) and $11.7 million in stock of which $9.3 million are not yet issued for a total of $58.9 million, all of which was charged to expense in the period of deferral and classified as other long-term liabilities, except for stock which is included in stockholders' equity. Pension Plan. The Company, through the acquisition of HP, maintains a contributory defined benefit pension plan to provide retirement benefits to former HP employees participating in the plan. It is the Company's policy to fund the minimum annual contributions required by applicable regulations. Pension expense totaled $1,889,000 and $909,000 in 1999 and 1998, respectively. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following sets forth a reconciliation of benefit obligation, plan assets, plan's funded status and amounts recognized in the accompanying consolidated balance sheets: Weighted-average assumptions used in developing the projected benefit obligation were as follows: Net periodic pension cost consisted of the following: CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 8. Long-term Debt Long-term debt consists of the following (in thousands): Annual aggregate maturities of long-term debt at December 31, 1999 are as follows (in thousands): 2000-- $5,268; 2001--$2,360; 2002--$3,290; 2003-- $160,011; 2004--$109; and $190,045 thereafter. In May 1998, the Company amended its revolving credit facility with a group of banks to provide up to $400.0 million for five years, subject to mandatory reductions of $40.0 million, $80.0 million and $80.0 million on December 31, 1999, 2000 and 2001, respectively. Subsequently, in October 1999, the Company executed an amendment to the revolving credit facility, reducing the facility to $350.0 million, eliminating the mandatory reduction on December 31, 1999, and revising some of the restrictive covenants. The new amendment is also subject to mandatory reductions of the facility by $80.0 million and $70.0 million on December 31, 2000 and 2001, respectively. The amount outstanding under this facility was $160.0 million at December 31, 1999. Interest rate alternatives include Bank of America's reference rate plus 1.00% and LIBOR plus 2.50%. The weighted average rate on amounts outstanding at December 31, 1999 was 8.45%. The revolving credit facility contains numerous restrictive covenants that, among other things, limit the Company's ability to incur or repay other indebtedness, make advances or loans to subsidiaries and other entities, make capital expenditures, incur liens, enter into mergers or effect other fundamental corporate transactions, sell CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) its assets, or declare dividends. In addition, the Company is required to meet certain ratios relating to its adjusted net worth, level of indebtedness, fixed charges and interest coverage. In May 1998, the Company sold $175.0 million of 8.875% Senior Subordinated Notes ("Subordinated Notes") due on June 1, 2006. The Subordinated Notes are redeemable in whole or in part after June 1, 2002 at 104.438% of par on that date and at declining prices thereafter. On or before June 1, 2001, up to 35.0% of the issued amount may be redeemed at 108.875% of par plus accrued interest solely with the proceeds from an equity offering. The Company has a credit agreement with Chase Bank of Texas, National Association. The credit agreement provides for a revolving line of credit, which bears interest at 1.0% in excess of the yield equivalent (expressed as a percentage rate per annum) of the bank's cost of funds. The Company may borrow $20,000,000 under the line of credit until May 28, 2000, when the revolving line of credit expires. At December 31, 1999, the Company had no revolving line of credit principal outstanding. The Company has a credit agreement with Bank One Texas, National Association. The credit agreement provides for an investment line of credit, which bears interest at a varying rate per annum equal to the lesser of (a) the maximum nonusurious interest rate or (b) 0.35% for the equivalent amount for the monthly period. The Company may borrow $30,000,000 under the investment line of credit until July 31, 2000, when the investment line of credit expires. At December 31, 1999, the Company had no investment line-of- credit principal outstanding. In September 1999, with the acquisition of Eberhardt Company, the Company entered into a credit agreement with U.S. Bank National Association. The credit agreement provides for a revolving line of credit, which bears interest at 2.0% (fixed rate) per annum and a working capital facility in which interest will be paid at a rate equal to the floating LIBOR plus 2.125% per annum. The Company may borrow $8,500,000 under the revolving line of credit and $300,000 under the working capital facility until June 30, 2000, when the revolving line of credit and working capital facilities expire. At December 31, 1999, the Company had no revolving line of credit or working capital facility principal outstanding The Company has a credit agreement with Residential Funding Corporation (RFC). The credit agreement provides for a revolving line of credit, which bears interest at 1.25% per annum over LIBOR. The Company may borrow $50,000,000 under the revolving line of credit until August 31, 2000, when the revolving line of credit expires. At December 31, 1999, the Company had no revolving line of credit outstanding. 9. Commitments and Contingencies In December 1996, GMH Associates, Inc. ("GMH") filed a lawsuit against Prudential Realty Group ("Prudential") and the Company in Superior Court of Pennsylvania, Franklin County, alleging various contractual and tort claims against Prudential, the seller of a large office complex, and the Company, its agent in the sale, contending that Prudential breached its agreement to sell the property to GMH, breached its duty to negotiate in good faith, conspired with the Company to conceal from GMH that Prudential was negotiating to sell the property to another purchaser and that Prudential and the Company misrepresented that there were no other negotiations for the sale of the property. Following a non-jury trial, the court rendered a decision in favor of GMH and against Prudential and the Company, awarding GMH $20.3 million in compensatory damages, against Prudential and the Company jointly and severally, and $10.0 million in punitive damages, allocating the punitive damage award $7.0 million as against Prudential and $3.0 million as against the Company. Following the denial of motions by Prudential and the Company for a new trial, a judgment was entered on December 3, 1998. Prudential and the Company filed an appeal of the judgment. On March 3, 2000 the appellate court in Pennsylvania reversed all of the trial courts' decisions finding that liability was not supported on any theory CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) claimed by GMH and directed that a judgement be entered in favor of the defendants including the Company. The plaintiff has filed an appeal with the Pennsylvania Supreme Court. In August 1993, a former commissioned sales person of the Company filed a lawsuit against the Company in the Superior Court of New Jersey, Bergen County, alleging gender discrimination and wrongful termination by the Company. On November 20, 1996, a jury returned a verdict against the Company, awarding $1.5 million in general damages and $5.0 million in punitive damages to the plaintiff. Subsequently, the trial court awarded the plaintiff $638,000 in attorneys' fees and costs. Following denial by the trial court of the Company's motions for new trial, reversal of the verdict and reduction of damages, the Company filed an appeal of the verdict and requested a reduction of damages. On March 9, 1999 the appellate court ruled in the Company's favor, reversed the trial court decision and ordered a new trial. On February 16, 2000 the Supreme Court of New Jersey reversed the decision of the appellate court, concluded that the general damage award in the trial court should be sustained and returned the case to the appellate court for a determination as to whether a new trial should be ordered on the issue of punitive damages. Based on available reserves, cash and anticipated cash flows, the Company believes that the ultimate outcome of this case will not have an impact on the Company's ability to carry on its operations. The Company is a party to a number of pending or threatened lawsuits arising out of, or incident to, its ordinary course of business. Based on available cash and anticipated cash flows, the Company believes that the ultimate outcome will not have an impact on the Company's ability to carry on its operations. Management believes that any liability to the Company that may result from disposition of these lawsuits will not have a material effect on the consolidated financial position or results of operations of the Company. Future minimum rental commitments for noncancelable operating leases at December 31, 1999, are as follows (in thousands): 2000--$44,008; 2001-- $40,021; 2002--$32,426; 2003--$25,670; 2004--$18,987 and $100,555 thereafter. Future minimum lease commitments for noncancelable capital leases which are mainly computer leases with three-year commitments at December 31, 1999 are as follows (in thousands): 2000--$1,497; 2001--$1,243 and 2002--$669; 2003--$548; 2004--$ -- and $ -- thereafter. The interest portion of the lease payments totals approximately $0.9 million. Capital lease payments due within one year are classified as current liabilities. Substantially all leases require the Company to pay maintenance costs, insurance and property taxes, and generally may be renewed for five year periods. Total rental expense under noncancelable operating leases was $50.5 million, $32.4 million and $24.3 million for the years ended December 31, 1999, 1998 and 1997, respectively. During the year ended December 31, 1999, the Company entered into an agreement with Fannie Mae in which the Company agreed to fund the purchase of a $103.6 million loan portfolio from proceeds from its RFC line of credit, which was temporarily increased to $135.0 million. A 100% participation in this loan portfolio was subsequently sold to Fannie Mae with the Company retaining the credit risk on the first 2% of loss incurred on the underlying portfolio of commercial mortgage loans. The Company has collateralized its obligation to cover the first 2% of losses by pledging a letter of credit in the amount of $1.0 million to Fannie Mae. The Company has a participation agreement with RFC whereby RFC agrees to purchase a 99% participation interest in any eligible multifamily mortgage loans owned by the Company and outstanding at quarter-end. The participation agreement expires August 31, 2000. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 10. Stockholders' Equity In 1999, the Company issued 140,833 shares to certain key executives in connection with the 1999 Equity Incentive Plan and 58,000 shares in connection with stock option plans. In connection with an on-going stock repurchase program, the Company purchased 396,200 shares of common stock for approximately $5.0 million in 1999 and 488,900 shares of common stock for approximately $8.9 million in 1998. In October 1998, the Company offered all employees under the 1990 Stock Option Plan who hold options that expired in April 1999 a loan equal to 100% of the total exercise price plus 40% of the difference between the current market value of the shares and the exercise price. Loan proceeds were applied towards the total exercise price and payroll withholding taxes. The loans are evidenced by full recourse promissory notes having a maturity of five years at an interest rate of 6.0%. Interest is due annually, while the principal is due the earlier of five years or upon sale of the shares. The shares issued under this offering may not be sold until after 18 months from the date of issuance. A total of 415,000 shares were issued under this offering. The related promissory notes of $4.9 million and $5.3 million are included in other assets in the consolidated balance sheets at December 31, 1999 and 1998, respectively. In 1998, the Company issued 1,328,638 shares of common stock in the REI acquisition, 208,263 shares of common stock in the HP acquisition, 25,000 shares to a certain key employee in connection with the 1996 Equity Incentive Plan, 75,064 shares with a stated value of approximately $2.9 million to the Cap Plan for the year ended December 31, 1997 and 824,385 shares in connection with stock option plans. On January 27, 1998 the Company purchased all 4.0 million of its existing convertible preferred shares which could have been converted into approximately 2.56 million common shares, based on the Company's prevailing stock price on that date. The preferred shares carried a dividend requirement of $.35 per share per quarter. The total cost to purchase the preferred shares was $77.4 million, including $5.0 million of previously accrued dividends and certain stock options. The shares were originally issued in conjunction with the Company's acquisition by management in 1989. In August 1997 in conjunction with the Koll acquisition, the Company approved the issuance of 599,967 warrants. Of the outstanding warrants, 43,644 are attached to common stock obtainable under the CBC Substitute Option Plan and 556,323 are attached to shares of outstanding common stock. Each warrant is exercisable into one share of common stock at an exercise price of $30.00 (subject to adjustment) commencing on August 28, 2000 and expiring on August 27, 2004. At December 31, 1999, 599,967 warrants issued were outstanding. 11. Income Taxes The provisions for income taxes for the years ended December 31, 1999, 1998 and 1997 were computed in accordance with SFAS 109, the modified liability method of accounting for income taxes. The foreign currency translation adjustments included in accumulated other comprehensive income were net of an income tax (benefit) provision of $(458,000), $829,000 and $(175,000) in 1999, 1998 and 1997, respectively. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The tax provision (benefit) for the years ended December 31, 1999, 1998 and 1997 consisted of the following (in thousands): The following is a reconciliation, stated as a percentage of pre-tax income, of the US statutory federal income tax rate to the Company's effective tax rate on income from operations: CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Cumulative tax effects of temporary differences are shown below at December 31, 1999 and 1998 (in thousands): The Company had federal income tax NOLs of approximately $57.4 million at December 31, 1999, corresponding to $20.1 million of the Company's $60.3 million in net deferred tax assets before valuation allowances, which expire in the years 2004 to 2008. The ability of the Company to utilize NOLs was limited in 1998 and will be in subsequent years as a result of the Company's 1996 public offering, the 1997 Koll acquisition and the 1998 repurchase of preferred stock which cumulatively caused a more than 50.0% change of ownership within a three year period. As a result of the limitation, the Company will be able to use approximately $26.0 million of its NOL in 1999 and in each subsequent year. The amount of NOLs is, in any event, subject to some uncertainty until the statute of limitation lapses. A deferred US tax liability has not been provided on the unremitted earnings of foreign subsidiaries because it is the intent of the Company to permanently reinvest such earnings. Undistributed earnings of foreign subsidiaries, which have been or are intended to be permanently invested in accordance with APB No. 23, Accounting for Income Taxes--Special Areas, aggregated $11.0 million at December 31, 1999. 12. Per Share Information Basic earnings (loss) per share was computed by dividing net income (loss), less preferred dividend requirements as applicable, by the weighted average number of common shares outstanding during each period. The computation of diluted earnings (loss) per share further assumes the dilutive effect of stock options, stock warrants and, during periods when preferred stock was outstanding and was dilutive, the conversion of the preferred stock. When the Company is in a net loss position for a particular reporting period, the stock options and warrants outstanding are excluded as they are anti-dilutive. In January 1998 the Company repurchased all 4.0 million of its existing convertible preferred stock. The portion of the purchase price in excess of the carrying value represents the deemed dividend charge to net income applicable to common shareholders when computing basic and dilutive earnings (loss) per share for the year ended December 31, 1998. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following is a calculation of earnings (loss) per share for the years ended December 31 (in thousands, except share and per share data): The following items were not included in the computation of diluted earnings per share because their effect in the aggregate was anti-dilutive for the years ended December 31: 13. Fiduciary Funds The consolidated balance sheets do not include the net assets of escrow, agency and fiduciary funds, which amounted to $370.9 million and $201.6 million at December 31, 1999 and 1998, respectively. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 14. Disclosures About Fair Value of Financial Instruments Notes Receivable. The Company has determined that it is not practicable to estimate the fair value of the notes receivable amounting to $1.0 million and $1.7 million at December 31, 1999 and 1998, respectively, due to the cost involved in developing the information as such notes are not publicly traded. Based on dealer's quote, the estimated fair value of the Company's $175.0 million Senior Subordinated Note, as discussed in Note 8, is $155.3 million. Estimated fair values for the Revolving Credit Facilities and the remaining long-term debts are not presented because the Company believes that it is not materially different from book value, primarily because the majority of the Company's debt is based on variable rates. CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 15. Industry Segments In July 1999, the Company announced that it changed its segment reporting from four segments to three segments. Prior periods were restated to conform to the new segmentation. The three segments are Transaction Management, Financial Services and Management Services. The factors for determining the reportable segments were based on the type of service and client and on the way the chief operating decision makers organize segments within the Company for making operating decisions and assessing performance. Each business segment requires and is responsible for executing a unique marketing and business strategy. Transaction Management consists of commercial property sales and leasing services, transaction management and advisory services, investment property services (acquisitions and sales on behalf of investors). Financial Services consists of mortgage loan origination and servicing through L.J. Melody, investment management and advisory services through CB Richard Ellis Investors, L.L.C., capital markets activities, valuation and appraisal services and real estate market research. Management Services consists of facilities and property management and related services. The 1999 result includes proceeds from an insurance policy of $1.6 million, nonrecurring gains of $8.7 million from the sale of five non-strategic offices and a small insurance operation and one-time charges of approximately $10.2 million, the majority of which were severance costs related to the Company's reduction in workforce. The following tables summarize the revenue, cost and expenses, and operating income by operating segment for the years ended December 31, 1999, 1998 and 1997 (dollars in thousands). CB RICHARD ELLIS SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Identifiable assets by industry segment are those assets used in the Company operations in each segment. Corporate identified assets are principally made up of cash and cash equivalents, inventoried property, general prepaids and deferred taxes. Geographic Information Long-lived assets are principally made up of property, plant and equipment, property held for sale and inventoried property. CB RICHARD ELLIS SERVICES, INC. QUARTERLY RESULTS OF OPERATIONS AND OTHER FINANCIAL DATA (Unaudited) The following table sets forth the Company's unaudited quarterly results of operations. The unaudited quarterly information should be read in conjunction with the audited financial statements of the Company and the notes thereto. The operating results for any quarter are not necessarily indicative of the results for any future period. CB RICHARD ELLIS SERVICES, INC. SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS (Dollars in thousands) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information under the headings "Nomination and Election of Directors," "Directors and Nominees for Directors," "Committees and Meetings of the Board of Directors," "Management," "Certain Relationships and Related Transactions," and "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement for the Company's 2000 Annual Meeting of Stockholders to be filed by the Company with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the Company's fiscal year is incorporated herein by reference. Item 11. Item 11. Executive Compensation The information contained under the headings "Directors Fees and Executive Compensation" in the definitive Proxy Statement for the Company's 2000 Annual Meeting of Stockholders is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information contained under the heading "Principal Stockholders" in the definitive Proxy Statement for the Company's 2000 Annual Meeting of Stockholders is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information contained under the headings "Executive Compensation" and "Certain Relationships and Related Transactions" in the definitive Proxy Statement for the Company's 2000 Annual Meeting of Stockholders is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements See Index to Consolidated Financial Statements set forth on page 28. 2. Financial Statement Schedule See Index to Consolidated Financial Statements set forth on page 28. 3. Exhibits See Exhibit Index beginning on page 59 hereof. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CB RICHARD ELLIS SERVICES, INC. (Registrant) /s/ Raymond E. Wirta By: _________________________________ Raymond E. Wirta Chief Executive Officer Date: March 27, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. EXHIBIT INDEX EXHIBIT INDEX--(Continued) EXHIBIT INDEX--(Continued) EXHIBIT INDEX--(Continued) - -------- * Incorporated by reference + Management contract or compensatory plan required by Item 601 of Regulation S-K (b) Report on Form 8-K The registrant filed a Current Report on Form 8-K dated November 10, 1999 concerning the Company's press release announcing the results of operations for the three and nine months ended September 30, 1999 under the new segment reporting.

702902_1999.txt

702902_1999

1999

702902

Item 1. Business. - ------- History and Business - ---------------------- Harleysville National Corporation, a Pennsylvania corporation (the Corporation), was incorporated in June 1982. On January 1, 1983, the Corporation became the parent bank holding company of Harleysville National Bank and Trust Company (HNB), established in 1909, a wholly owned subsidiary of the Corporation. On February 13, 1991, the Corporation acquired all of the outstanding common stock of Citizens National Bank (CNB), established in 1903. On June 1, 1992, the Corporation acquired all of the outstanding stock of Summit Hill Trust Company (Summit Hill). On September 25, 1992, Summit Hill merged into CNB and is now operating as a branch office of CNB. On July 1, 1994 the Corporation acquired all of the outstanding stock of Security National Bank (SNB), established in 1988. On March 1, 1996, the Corporation acquired all of the outstanding common stock of Farmers & Merchants Bank ("F & M"). F & M was merged into CNB and is now operating as a branch office of CNB. On March 17, 1997, the HNC Financial Company was incorporated as a Delaware Corporation. HNC Financial Company's principal business function is to expand the investment opportunities of the Corporation. On January 20, 1999, the Corporation acquired all of the outstanding stock of Northern Lehigh Bancorp, Inc., parent company of Citizens National Bank of Slatington. The Corporation is primarily a bank holding company that provides financial services through its three bank subsidiaries. Since commencing operations, the Corporation's business has consisted primarily of managing HNB, CNB and SNB (collectively the Banks), and its principal source of income has been dividends paid by the Banks. The Corporation is registered as a bank holding company under the Bank Holding Company Act of 1956. The Banks are national banking associations under the supervision of the Office of the Comptroller of the Currency (the OCC). The Corporation and HNB's legal headquarters are located at 483 Main Street, Harleysville, Pennsylvania 19438. CNB's legal headquarters is located at 13-15 West Ridge Street, Lansford, Pennsylvania 18232. SNB's legal headquarters is located at One Security Plaza, Pottstown, Pennsylvania 19464. HNC Financial Company's legal headquarters is located at 300 Delaware Avenue, Suite 1704, Wilmington, Delaware 19801. In addition to historical information, this Form 10-K contains forward-looking statements. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of Harleysville National Corporation and its subsidiaries. When we use words such as "believes," "expects," "anticipates," or similar expressions, we are making forward-looking statements. Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that we incorporate by reference, could affect the future financial results of Harleysville National Corporation and its subsidiaries and could cause actual results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include the following: - - operating, legal and regulatory risks; - - economic, political and competitive forces affecting our banking, securities, asset management and credit services businesses; and - - the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful. As of December 31, 1999, the Corporation had total assets of $1,635,679,000, total shareholders' equity of $129,660,000 and total deposits of $1,231,265,000. The Banks engage in the full-service commercial banking and trust business, including accepting time and demand deposits, making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans and performing corporate pension and personal trust services. Their deposits are insured by the Federal Deposit Insurance Corporation to the extent provided by law. The Banks have 35 branch offices located in Montgomery, Bucks, Carbon, Wayne, Chester, Lehigh, Northampton and Schuylkill counties, Pennsylvania, 22 of which are owned by the Banks and 13 of which are leased from third parties. The Banks enjoy a stable base of core deposits and are leading community banks in their service areas. The Banks believe they have gained their position as a result of a customer-oriented philosophy and a strong commitment to service. Senior management has made the development of a sales orientation throughout the Banks one of their highest priorities and emphasizes this objective with extensive training and sales incentive programs that the Corporation believes are unusual for community banks. The Banks maintain close contact with the local business community to monitor commercial lending needs and believe they respond to customer requests quickly and with flexibility. Management believes these competitive strengths are reflected in the Corporation's results of operations. As of December 31, 1999, the Corporation and the Banks employed approximately 517 full-time equivalent employees. The Corporation provides a variety of employment benefits and considers its relationships with its employees to be satisfactory. Competition - ----------- The Banks compete actively with other eastern Pennsylvania financial institutions, many larger than the Banks, as well as with financial and non-financial institutions headquartered elsewhere. The Banks are generally competitive with all competing institutions in their service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts, interest rates charged on loans, and fees and charges for trust services. At December 31, 1999, HNB's legal lending limit to a single customer was $14,426,000 and CNB's and SNB's legal lending limits to a single customer were $3,246,000 and $1,441,000, respectively. Many of the institutions with which the Banks compete are able to lend significantly more than these amounts to a single customer. Supervision and Regulation - The Registrant - ------------------------------------------------ On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act of 1999, the Financial Services Modernization Act. The Financial Services Modernization Act repeals the two affiliation provisions of the Glass-Steagall Act: - - Section 20, which restricted the affiliation of Federal Reserve Member Banks with firms "engaged principally" in specified securities activities; and - - Section 32, which restricts officer, director or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities. In addition, the Financial Services Modernization Act also contains provisions that expressly preempt any state law insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company system to engage in a full range of financial activities through a new entity known as Financial Holding Company. "Financial activities" is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve, in consultation with the Secretary of Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Generally, the Financial Services Modernization Act: - - Repeals historical restrictions on, and eliminates many federal and state law barriers to, affiliations among banks, securities firms, insurance companies, and other financial service providers; - - Provides a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies; - - Broadens the activities that may be conducted by national banks, banking subsidiaries of bank holding companies, and their financial subsidiaries; - - Provides an enhanced framework for protecting the privacy of consumer information; - - Adopts a number of provisions related to the capitalization, membership, corporate governance and the other measures designed to modernize the Federal Home Loan Bank system; - - Modifies the laws governing the implementation of the Community Reinvestment Act; and - - Addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions. In order for the Corporation to take advantage of the ability to affiliate with other financial services providers, the Corporation must become a "Financial Holding Company" as permitted under an amendment to the Bank Holding Company Act. To become a Financial Holding Company, the Corporation would file a declaration with the Federal Reserve, electing to engage in activities permissible for Financial Holding Companies and certifying that it is eligible to do so because all of its insured depository institution subsidiaries are well-capitalized and well-managed. In addition, the Federal Reserve must determine that each insured depository institution subsidiary of the Corporation has at least a satisfactory CRA rating. The Corporation currently meets the requirements to make an election to become a Financial Holding Company. The Corporation's management has not determined at this time whether it will seek an election to become a Financial Holding Company. The Corporation is examining its strategic business plan to determine whether, based on market conditions, the relative financial conditions of the Corporation and its subsidiaries, regulatory requirements, general economic conditions, and other factors, the Corporation desires to utilize any of its expanded powers provided in the Financial Service Modernization Act. The Financial Services Modernization Act also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a Financial Holding Company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation. A national bank seeking to have a financial subsidiary, and each of its depository institution affiliates, must be "well-capitalized" and "well-managed." The total assets of all financial subsidiaries may not exceed the lesser of 45% of a bank's total assets or $50 billion. A national bank must exclude from its assets and equity all equity investments, including retained earnings, in a financial subsidiary. The assets of the subsidiary may not be consolidated with risk and protect the bank from such risks and potential liabilities. The Corporation and the Banks do not believe that the Financial Services Modernization Act will have a material adverse effect on our operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the company and the bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the company bank. From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, the business of the Corporation and the Banks. We cannot predict whether the legislation will be enacted or, if enacted, how the legislation would affect the business of the Corporation and the Banks. As a consequence of the extensive regulation of commercial banking activities in the United States, the Corporation's and the Banks' business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business. Except as specifically described above, management believes that the effect of the provisions of the aforementioned legislation on liquidity, capital resources and results of operations of the Corporation will be immaterial. Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation, which if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation's results of operations. Further, the business of the Corporation is also affected by the state of the financial services industry in general. As a result of legal and industry changes, management predicts that the industry will continue to experience an increase in consolidations and mergers as the financial services industry strives for greater cost efficiencies and market share. Management also expects increased diversification of financial products and services offered by the Banks and its competitors. Management believes that such consolidations and mergers, and diversification of products and services may enhance the Banks' competitive position. Pending Legislation - -------------------- Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation's results of operations. Effects of Inflation - ---------------------- Inflation has some impact on the Corporation's and the Banks' operating costs. Unlike many industrial companies, however, substantially all of the Banks' assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Corporation's and the Banks' performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services. Effect of Government Monetary Policies - ------------------------------------------ The earnings of the Corporation are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. An important function of the Federal Reserve is to regulate the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities and changes in reserve requirements against member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect rates charged on loans or paid for deposits. The Banks are members of the Federal Reserve and, therefore, the policies and regulations of the Federal Reserve have a significant effect on its deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Banks' operations in the future. The effect of such policies and regulations upon the future business and earnings of the Corporation and the Banks cannot be predicted. Environmental Regulations - -------------------------- There are several federal and state statutes which regulate the obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, a bank may be held liable under certain circumstances for the actions of its borrowers, or third parties, when such actions result in environmental problems on properties that collateralize loans held by the bank. Further, the liability has the potential to far exceed the original amount of a loan issued by the bank. Currently, neither the Corporation nor the Banks are a party to any pending legal proceeding pursuant to any environmental statute, nor are the Corporation and the Banks aware of any circumstances that may give rise to liability under any such statute. Supervision and Regulation - Banks - -------------------------------------- The operations of the Banks are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, to members of the Federal Reserve and to banks whose deposits are insured by the FDIC. The Banks' operations are also subject to regulations of the OCC, the Federal Reserve and the FDIC. The primary supervisory authority of the Banks is the OCC, who regularly examines the Banks. The OCC has authority to prevent a national bank from engaging in unsafe or unsound practices in conducting its business. Federal and state banking laws and regulations govern, among other things, the scope of a bank's business, the investments a bank may make, the reserves against deposits a bank must maintain, loans a bank makes and collateral it takes, the activities of a bank with respect to mergers and consolidations and the establishment of branches. As a subsidiary bank of a bank holding company, the Banks are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or its subsidiaries, or investments in the stock or other securities as collateral for loans. The Federal Reserve Act and Federal Reserve regulations also place certain limitations and reporting requirements on extensions of credit by a bank to principal shareholders of its parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulations may affect the terms upon which any person becoming a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship. Under the Federal Deposit Insurance Act, the OCC possesses the power to prohibit institutions regulated by it (such as the Banks) from engaging in any activity that would be an unsafe and unsound banking practice or would otherwise be in violation of the law. Under the Community Reinvestment Act of 1977, the OCC is required to assess the record of all financial institutions regulated by it to determine if these institutions are meeting the credit needs of the community, including low and moderate income neighborhoods, which they serve and to take this record into account in its evaluation of any application made by any of such institutions for, among other things, approval of a branch or other deposit facility, office relocation, a merger or an acquisition of bank shares. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 amended the CRA to require, among other things, that the OCC make publicly available the evaluation of a bank's record of meeting the credit needs of its entire community, including low and moderate income neighborhoods. This evaluation will include a descriptive rating like "outstanding", "satisfactory", "needs to improve" or "substantial noncompliance" and a statement describing the basis for the rating. These ratings are publicly disclosed. Under the Bank Secrecy Act, banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions of which a bank is aware in any one day that aggregate in excess of $10,000. Civil and criminal penalties are provided under the Bank Secrecy Act for failure to file a required report, for failure to supply information required by the Bank Secrecy Act or for filing a false or fraudulent report. The Federal Deposit Insurance Corporation Improvement Act of 1991 requires that institutions must be classified, based on their risk-based capital ratios into one of five defined categories, as illustrated below, well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. *3.0 for those banks having the highest available regulatory rating. In the event an institution's capital deteriorates to the undercapitalized category or below, FDICIA prescribes an increasing amount of regulatory intervention, including: the institution of a capital restoration plan and a guarantee of the plan by a parent institution; and the placement of a hold on increases in assets, number of branches or lines of business. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and, in critically undercapitalized situations, appointment of a receiver. For well capitalized institutions, FDICIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receives a less than satisfactory examination report rating for asset quality, management, earnings or liquidity. All but well capitalized institutions are prohibited from accepting brokered deposits without prior regulatory approval. Under FDICIA, financial institutions are subject to increased regulatory scrutiny and must comply with certain operational, managerial and compensation standards to be developed by Federal Reserve Board regulations. FDICIA also requires the regulators to issue new rules establishing certain minimum standards to which an institution must adhere including standards requiring a minimum ratio of classified assets to capital, minimum earnings necessary to absorb losses and minimum ratio of market value to book value for publicly held institutions. Additional regulations are required to be developed relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and excessive compensation, fees and benefits. Annual full-scope, on site regulatory examinations are required for all the FDIC-insured institutions except institutions with assets under $100 million which are well capitalized, well-managed and not subject to a recent change in control, in which case, the examination period is every 18 months. Banks with total assets of $500 million or more, as of the beginning of fiscal year 1993, are required to submit to their supervising federal and state banking agencies a publicly available annual audit report. The independent accountants of such bank are required to attest to the accuracy of management's report regarding the internal control structure of the bank. In addition, such banks also are required to have an independent audit committee composed of outside directors who are independent of management, to review with management and the independent accountants, the reports that must be submitted to the bank regulatory agencies. If the independent accountants resign or are dismissed, written notification must be given to the bank's supervising government banking agencies. These accounting and reporting reforms do not apply to an institution such as a bank with total assets at the beginning of its fiscal year of less than $500 million, such as CNB or SNB. FDICIA also requires that banking agencies reintroduce loan-to-value ratio regulations which were previously repealed by the 1982 Act. Loan-to-values limit the amount of money a financial institution may lend to a borrower, when the loan is secured by real estate, to no more than a percentage, set by regulation, of the value of the real estate. A separate subtitle within FDICIA, called the "Bank Enterprise Act of 1991", requires "truth-in-savings" on consumer deposit accounts so that consumers can make meaningful comparisons between the competing claims of banks with regard to deposit accounts and products. Under this provision, a bank is required to provide information to depositors concerning the terms of their deposit accounts, and in particular, to disclose the annual percentage yield. The operational cost of complying with the Truth-In-Savings law had no material impact on liquidity, capital resources or reported results of operations. While the overall impact of fully implementing all provisions of the FDICIA cannot be accurately calculated, Management believes that full implementation of the FDICIA had no material impact on liquidity, capital resources or reported results of operation in future periods. From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restriction on, the business of the Banks. It cannot be predicted whether any such legislation will be adopted or, if adopted, how such legislation would affect the business of the Banks. As a consequence of the extensive regulation of commercial banking activities in the United States, the Banks' business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business. Year 2000 - ---------- Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000 (Y2K). The Year 2000 issue affects virtually all companies and organizations. The Corporation did not experience problems associated with the Y2K issue and has not found Y2K problems with its related third parties, as of February 29, 2000. The Corporation's third parties include its vendors and commercial customers. The Corporation continues to monitor its own computer systems for Y2K problems and will continue to investigate any potential problems with its related third parties. The Corporation prepared a Y2K budget and has tracked expenses related to the Y2K issue. As of December 31, 1999, the Corporation expensed $381,000 and capitalized fixed assets of $116,000 during the last three years to address the Y2K issue. Statistical Data - ----------------- The information for this item is listed below and is incorporated by reference to pages 25 through 32 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999 which pages are included at Exhibit (13) to this Annual Report on Form 10-K. The following shows the carrying value of the Corporation's investment securities available for sale: There are no significant concentrations of securities (greater than 10% of shareholders' equity) in any individual security issuer. The maturity analysis of investment securities held to maturity, Including the weighted average yield for each category as of December 31, 1999, is as follows: The maturity analysis of securities available for sale, including the weighted average yield for Each category, as of December 31, 1999 is as follows: The following table details maturities and interest sensitivity of real estate, commercial and industrial, consumer loans and lease financing at December 31, 1999: The following table details those loans that were placed on nonaccrual status, were accounted for as troubled debt restructuring or were delinquent by 90 days or more and still accruing interest: The following table sets forth an allocation of the allowance for loan losses by category. The specific allocations in any particular category may be reallocated in the future to reflect then current conditions. Accordingly, management considers the entire allowance to be available to absorb losses in any category. The maturity distribution of certificates of deposit of $100,000 and over is as follows: NET INTEREST INCOME For analytical purposes, the following table reflects tax-equivalent net interest income in recognition of the income tax savings on tax-exempt items such as interest on municipal securities and tax-exempt loans. Adjustments are made using a statutory federal tax rate of 35%. The rate volume analysis set forth in the following table, which is computed on a tax-equivalent basis (tax rate of 35%), analyzes changes in net interest income for the last three years by their rate and volume components. Tax-equivalent net interest income was $64,335,000 for 1999, compared to $57,503,000 for 1998, an increase of $6,832,000, or 11.9%. This increase in tax-equivalent net interest income was primarily due to the net $7,824,000 increase related to volume, partially offset by a decrease related to interest rates of $992,000. Total interest income increased $13,467,000, primarily the result of higher volumes of loans and investment securities, in part offset by the lower loan rates experienced during 1999. Tax-equivalent interest income on loans grew 11.2% and tax-equivalent investment interest income increased 25.0%. The 1999 average loan and investment volumes increased 16.0% and 23.5% respectively. The Banks experienced growth throughout all loan portfolios. The increase in investment securities was due to both the funding of a $25,000,000 of a capital leverage program during 1999 and the planned growth of related to the increase in deposit funding. Total interest expense grew $6,635,000 during 1999 or 16.5%, compared to 1998. This growth was the result of increases in all interest-bearing liability categories. The volumes of savings deposits, time deposits and borrowings and other interest-bearing liabilities grew 12.5%, 10.0% and 97.3%, respectively. Borrowings and other interest-bearing liabilities include federal funds purchased, FHLB borrowings, securities sold under agreements to repurchase and U.S. Treasury notes. The increase in borrowings and other interest-bearing liabilities was due to both the growth in the capital leverage program and the loan portfolio during 1999. The 1998 tax-equivalent net interest income was $57,503,000, a $4,669,000 increase compared to $52,834,000 for 1997. This increase in tax-equivalent net interest income was primarily due to the $6,739,000 increase related to volumes, partially offset by the $2,070,000 decrease in net interest income related to rates. The growth in earning asset volumes was in investment securities and loans and the interest-bearing liabilities volume growth was due to increases in all categories. Item 2. Item 2. Properties. - -------------------- The principal executive offices of the Corporation and of HNB are located in Harleysville, Pennsylvania in a two-story office building owned by HNB, built in 1929. HNB also owns the buildings in which thirteen of its branches are located and leases space for the other ten branches from unaffiliated third parties under leases expiring at various times through 2036. The principal executive offices of CNB are located in Lansford, Pennsylvania in a two-story office building owned by CNB. Citizens also owns the buildings where its branches are located. The principal executive offices of SNB are located in Pottstown, Pennsylvania, in a building leased by SNB. SNB leases its East End and North End branches, and owns its Pottstown Center branch. HNC Investment Company leases an office in Wilmington, Delaware. In management's opinion, all of the above properties are in good condition and are adequate for the Registrant's and the Banks' purposes. Item 3. Item 3. Legal Proceedings. - ---------------------------- Management, based on consultation with the Corporation's legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its subsidiaries - Harleysville National Bank and Trust Company, The Citizens National Bank of Lansford, Security National Bank and HNC Financial Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation and the Banks by government authorities. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - --------------------------------------------------------------------- No matter was submitted during the fourth quarter of 1999 to a vote of holders of the Corporation's Common Stock. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Shareholder - -------------------------------------------------------------------------------- Matters. - -------- The information required by this Item is incorporated by reference to pages 8 and 20 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 6. Item 6. Selected Financial Data. - ------------------------------------ The information required by this Item is incorporated by reference to page 25 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. - -------------- The information required by this Item is incorporated by reference to pages 25 through 32 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 7.A. Quantitative and Qualitative Disclosure about Market Risk. - ---------------------------------------------------------------------------- The information required by this Item is incorporated by reference to pages 29 and 30 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 8. Item 8. Financial Statements and Supplementary Data. - --------------------------------------------------------- The information required by this Item is incorporated by reference to pages 8 through 24 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - -------------------------------------------------------------------------------- Financial Disclosure. - --------------------- None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. - ------------------------------------------------------------------- The information required by this Item with respect to the Corporation's directors is incorporated by reference to pages 6 through 9 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 11, 2000. Item 11. Item 11. Executive Compensation. - ---------------------------------- The information required by this Item is incorporated by reference to pages 10 through 15 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 11, 2000. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------------------------------------------------------------------------------- The information required by this Item is incorporated by reference to pages 6 through 7 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 11, 2000. Item 13. Item 13. Certain Relationships and Related Transactions. - ------------------------------------------------------------- The information required by this Item is incorporated by reference to page 20 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 11, 2000, and to page 17 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1999, which page is included at Exhibit (13) to this Annual Report on Form 10-K. Financial Statements Schedules are omitted because the required information is either not applicable, not required, or the information is included in the consolidated financial statements or notes thereto. *Refers to the respective page of the Annual Report to Shareholders. The Consolidated Financial Statements and Notes to Consolidated Financial Statements and Auditor's Report thereon on pages 8 to 24 of the Annual Report to Shareholders, are incorporated herein by reference and attached at Exhibit 13 to this Annual Report on Form 10-K. With the exception of the portions of such Annual Report specifically incorporated by reference in this Item and in Items 1, 5, 6, 7 and 8, such Annual Report shall not be deemed filed as part of this Annual Report on Form 10-K or otherwise subject to the liabilities of Section 18 of the Securities Exchange Act of 1934. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HARLEYSVILLE NATIONAL CORPORATION Date: March 3, 2000 By: /s/ Walter E. Daller, Jr. - ------------------------------------------------------------------------------- Walter E. Daller, Jr. President EXHIBIT INDEX - -------------- Exhibit - ----------------------------------------------------------------------------- (13) Excerpts from the Corporation's 1999 Annual Report to Shareholders (This excerpt includes only page 1 and pages 8 through 32, which are incorporated in this Report by reference.) (21) Subsidiaries of Registrant. (23) Consent of Grant Thornton LLP, Independent Certified Public Accountants. (99) Additional Exhibits. None.

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Item 2. Properties Not applicable on reliance of Relief Letters Item 3. Item 3. Legal Proceedings There were no legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of the Security Holders. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder matters There were twenty (20) participants in the DTC system holding positions in the Cede certificates. The following were Noteholders and Certificateholders of record as of the end of the reporting year. Salomon Brothers New Century Asset-Backed Floating Rate Certificates: Series 1999-NC1 Class A-1 Cede & Co. Series 1999-NC1 Class A-2 Cede & Co. Series 1999-NC1 Class M-1 Cede & Co. Series 1999-NC1 Class M-2 Cede & Co. Series 1999-NC1 Class M-3 Cede & Co. Series 1999-NC1 Class CE NC Residual II Corp Series 1999-NC1 Class P NC Residual II Corp Attn: Patti Dodge 18400 Von Karman, Suite 1000 Irvine, California 92612 There is no established public trading market for the notes. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures: Information required by Item 304 of Reg. S-K. There were no changes in and/or disagreements with Accountants on Accounting and Financial Disclosures. PART IV Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The Notes are represented by one or more notes registered in the name of of Cede & Co., the nominee of The Depository Trust Company. An investor holding Notes is not entitled to receive a certificate representing such Note, except in limited circumstances. Accordingly, Cede & Co. is the sole holder of Notes, which it holds on behalf of brokers, dealers, banks and other participants in the DTC system. Such participants may hold Notes for their own accounts or for the accounts of their customers. The address of Cede & Co. is: Cede & Co. c/o The Depository Trust Company Seven Hanover Square New York, New York 10004 There has not been, and there is not currently proposed, any transactions Itemor series or transactions, to which any of the Trust, the Registrant, the Trustee or the Servicer is a party with any Noteholder who, to the knowledge of the Registrant and Servicer, owns of record or beneficially more than five percent of the Notes. Item(a) 1. Not Applicable 2. Not Applicable 3. Exhibits 99.1 Annual Summary Statement 99.2 Annual Statement as to Compliance. 99.3 Annual Independent Public Accountant's Servicing Report. (b) Reports on Form 8-K The Registrant has filed Current Reports on Form 8-K with the Securities and Exchange Commision dated April 26, 1999; May 25, 1999; June 25, 1999, July 26, 1999, August 25, 1999; September 27, 1999, October 25, 1999, November 26, 1999, December 27, 1999. (c) See (a) 3 above (d) Not Applicable SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Salomon Brothers Mortgage Securities VII, INC. New Century Asset-Backed Floating Rate Certificates Series 1999-NC-1 /s/ Eve Kaplan, Vice President US Bank Date March 31, 2000 Exhibit Number EXHIBIT INDEX 99.1 99.2 Description 99.3 Annual Summary Statement Annual Statement of Compliance Report of Independent Accountants EXHIBIT 99.1 -- Summary of Aggregate Amounts or End of Year Amounts for the period ending December 31, 1999 Salomon Brothers Mortgage Securities VII, INC. New Century Asset-Backed Floating Rate Certificates Series 1999-NC-1 Summary of Aggregate Amounts or End of Year Amounts Pool Balance 281,615,627.40 Principal Collections 35,723,943.20 Realized Loss 0.00 Interest, Net of Fees Collections (1) 0.00 Master Servicer Fees 0.00 Trustee Fees 0.00 (1) Includes prepayment premium. Delinquency Percentage 6.10844% Delinquent Report Number Stated Principal Bal 30-59 days 75 5,597,078.57 60-89 days 15 897,240.09 90+ days 37 2,218,551.18 Foreclosures 121 8,276,410.13 Bankruptcies 60 4,372,424.54 REO Properties 1,437,681.98 Certificate Balance Interest Principal Class A-1 181,215,085.51 0.00 0.00 Class A-2 54,433,000.00 0.00 0.00 Class M-1 19,368,000.00 0.00 0.00 Class M-2 14,288,000.00 0.00 0.00 Class M-3 8,732,000.00 0.00 0.00 Class CE 9,525,824.99 0.00 Class P 100.00 0.00 To be supplied upon receipt by the Trustee EXHIBIT 99.2 -- Servicer's Annual Statement of Compliance To be supplied upon receipt by the Trustee EXHIBIT 99.3 -- Report of Independent Auditors

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ITEM 1. BUSINESS Novadigm, Inc. ("Novadigm" or the "Company") is a provider of technology solutions that efficiently and reliably deliver, update and maintain software and content across the extended enterprise. Novadigm has become an industry leader in reducing software ownership costs while at the same time reducing time-to-market for infrastructure and application deployment across any business-to-employee ("B2E"), business-to-business ("B2B") or business-to-consumer ("B2C") network -- from client/server to the Internet to public e-commerce terminals. Novadigm customers report software management savings of 80% or more and time-to-market improvement of 70% or more. Novadigm's suite of products share a common architecture and work seamlessly together as the only end-to-end solution that can reliably and scalably deploy and manage the full range of today's software and content. Novadigm's solution deploys and manages software and content as a self-installing, self-updating, self-repairing continuous flow, on a wide range of computing devices (fixed and mobile) over virtually any kind of network, from the core of the enterprise out to virtually any end-point of the extended enterprise. By managing this range of customer environments and business needs, Novadigm technology is a critical enabler of the evolving enterprise, optimizing companies' existing technology investments while facilitating their rapid migration from client/server-generation environments to the Internet generation. Novadigm's customers include Fortune 1000 companies in the financial services, insurance, transportation, telecommunications, healthcare, and utilities industries; government agencies; large independent software vendors; and information technology ("IT") service providers around the world. Because Novadigm's product suite is based on a common object-oriented platform and is seamlessly integrated, IT professionals can manage multiple locations and diverse environments with a single solution. Enterprise Desktop Manager(TM) ("EDM"), which is optimized for the enterprise, centrally manages the distribution, configuration, updating and maintenance of software and content across distributed PCs, servers, point-of-sale ("POS") devices and automated teller machines ("ATMs"); and the RADIA(TM) products ("Radia"), which are optimized for the Internet, provide automated updating and maintenance for subscribers' web-hosted applications and content. EDM and Radia use Novadigm's unique 'desired-state' management technology to automate the deployment and management of software and content across complex environments with reliability typically reported by customers as greater than 99%. In addition, our products use our patented component-level differencing technology as well as byte-level differencing, thereby deploying only the minimal software and content parts necessary for updates and corrections. This ensures minimal impact to networks and rapid application delivery across tens of thousands of devices. BACKGROUND Novadigm's software and computer-based content deployment and management solutions serve a number of related and overlapping markets that the continuing extension of the enterprise is drawing together. These markets incorporate numerous user communities, including corporate employees, remote/mobile users, customers, partners, suppliers, and customers of public e-commerce terminals such as ATMs and POS devices. This collection of markets is commonly characterized as Electronic Software Distribution ("ESD"), a large and rapidly growing segment of the systems management marketplace that arose in the early 1990s. The ESD market as a whole is expected by International Data Corporation to grow from $1.47 billion in 1998 to approximately $4 billion by the year 2003. ESD is generally used to describe a broad class of software tools that attempt to meet one or more of the business requirements to deploy infrastructure, business applications and personal productivity software within the enterprise and across the Internet. In the Internet space, emerging market segments which are often categorized within ESD include Internet Application Management and the Internet Services Management ("ISM") infrastructure market. ESD includes a wide range of technology solutions that focus on one or more types of software or content (such as operating systems, productivity tools, business-critical software, graphical documents, etc.), one or more kinds of networks (local area networks ("LANs"), wide area networks ("WANs"), virtual area networks ("VANs"), intranets, extranets or the Internet), and one or more audiences (such as in-house knowledge workers, remote/mobile workers, Internet users, etc.). As semi-automated tools based on older technologies, most ESD products are low-powered, platform-specific, specialized for a certain type of software or user environment, limited in scalability, and typically enforce standardization at the expense of user personalization. These approaches are often labor-intensive, error-prone and non-replicable (i.e., any changes in software, user configuration or environment require a great deal of manual rework). As a result, they cannot be scaled across large implementations, cannot deliver the application deployment speed required in the current business world, exact high implementation and operational costs, and, at enterprise scale, suffer a significant failure rate -- pegged at 75% by the GartnerGroup. What characterizes these solutions and their vendors competitively is the degree of usability, flexibility, level of automation, scalability, and reliability which they provide, and the range of software and content, computing devices, and environments that they can effectively manage. Novadigm believes that software and content management solutions that automate the 'end-to-end' process of discovering, tracking, configuring, deploying, updating, correcting and maintaining software and content across large-scale networks both inside and outside of corporate firewalls are fundamental to the future of software. These solutions must be fast, scalable, reliable and highly adaptable to each customer's individual applications, user audiences, and existing base of computing platforms and they must support the dynamic and rapidly changing requirements of the business. One of the key changes underway in the enterprise is its transformation from a firewall-enclosed environment into an extended enterprise that is reaching out to a rapidly growing population of remote/mobile users and -- via extranets, the Internet and e-commerce technologies -- is directly linking companies with suppliers and customers, wherever they may be. Because this transformation cannot be completed suddenly, given the complexity of the technology environments of most enterprises and their heavy investments in existing technologies, Novadigm also believes that flexible software and content management solutions that can provide an evolutionary bridge from existing to emerging technologies and environments is now a critical competitive factor in today's software-intensive enterprises. THE NOVADIGM SOLUTION Novadigm provides an enterprise-proven solution that can: - automate the deployment, updating and continuous maintenance of the full range of today's software and content, including shrink-wrapped and custom-built applications written in any language or composed of any type of distributed component, such as C++, Visual Basic, Common Object Request Broker Architecture ("CORBA"), etc., Y2K patches and virus protection files, operating systems, registry keys, icons, embedded links, digital information, graphics, and full motion video - across virtually any kind of enterprise network using a variety of protocols, including existing enterprise LANs, WANs, VANs, as well as intranets, extranets and the Internet, and a variety of authentication and security techniques - to the widest range of enterprise computing devices, including PCs, UNIX workstations, Macs, file, application and Web servers and ATMs/POS devices. Novadigm meets the requirements of today's extended enterprises for solutions that can manage their rapidly expanding scale, that can deliver the high level of reliability that e-commerce demands, and that can handle the heterogeneity of computing devices in use today, with flexible, scalable, highly reliable automated software and content management. Faster, more adaptable, more quickly implemented, and easier and more cost-effective to operate than conventional ESD tools and recent market entries, Novadigm's products allow IT professionals and service providers to effectively manage heterogeneous environments across any large-scale public and private network using existing service provider policies for automatically controlling the distribution and maintenance of software and content. The following are key attributes of Novadigm technology that distinguish it from other software management products: Reliable Desired-State Automation. Novadigm's pioneering 'desired-state' approach dynamically discovers the 'actual state' of each corporate user's, workgroup's, department's, or Internet-based consumer's software, configurations and content and compares this in real-time with its 'desired state.' If there is a difference between the two, Novadigm's patented differencing technology automatically determines the precise component-level changes that are required and sends only those changes to the user's computer. Adaptive Configuration Management. Novadigm's technology can automatically configure customized software packages and content for highly personalized user environments and install them as dictated by administrative policies or user preferences. As program versions and user environments and preferences change, the affected user's actual-state is automatically differenced and reconfigured to correspond to the desired-state of operation, thus eliminating the need for manual user or administrator involvement. Policy- and Subscription-Based Controls and Auditability. Novadigm's products use policy-based access models to allow IT administrators to efficiently and concisely define entitlements controlling the deployment of software to authorized users or subscribers. For example, within the enterprise, an IT administrator may implement a policy permitting access to certain financial databases only to a selected workgroup within an organization's finance department. In an e-commerce environment, subscribers would be automatically provided with software and content based on their entitlement in the customer database, without any additional activity required by an administrator. Subsequent changes to policies and entitlements cause software and content to be automatically installed, changed or de-installed for all affected users, again without any administrator intervention. This seamless integration between changing entitlements and automated fulfillment is essential to meeting the personalized needs of subscribers in large-scale enterprise and e-commerce environments. Scalability, Performance and Mobility. Novadigm's differencing processes calculate the precise changes needed by each device, assuring a minimum of network traffic and wait-time for bandwidth-constrained enterprise networks and remote/mobile and Internet users. Novadigm's distributed object infrastructure allows components to be "cached" at multiple locations and automatically provided to a user as needed, transparently and efficiently, using a combination of network protocols and offline media simultaneously to further optimize network performance. Rapid Deployment and Ease of Use. In addition to the shared architecture of Novadigm's product suite, the flexible nature of its distributed object technology, and the ease of defining desired state, Novadigm solutions include a variety of capabilities to ensure rapid deployment of complete software and content management solutions. Once installed, Novadigm's solutions can be operated by a very small group of administrators to rapidly deploy large numbers of software and content applications very quickly to tens of thousands of users. For example, customers have implemented and deployed EDM and large portfolios of applications to as many as 10,000 computers in one month. Novadigm believes that its technology and products establish a new standard for software and content management, and provide its customers with the most effective means for managing the next generation of B2E, B2B, and B2C applications and content, over both enterprise networks and the Internet. Novadigm's unique technology completely automates the deployment and ongoing change management requirements of distributed software and content, ensures the necessary scalability to support the high and growing numbers of servers, PCs, mobile laptops, ATMs and POS devices found in large organizations, and significantly reduces costs by eliminating manual installation and administration. These advancements result in faster deployments, lower total cost of ownership ("TCO"), and higher levels of personalization, reliability, scalability, and auditability -- key competitive factors for enterprises today and into the future. THE NOVADIGM STRATEGY Novadigm's objective is to maintain and expand its position as the leading provider of desired-state software and content management solutions for the extended enterprise. Key components of the Company's strategy include: Maintaining Technology Leadership. Novadigm believes that its unique "desired-state" management and patented "fractional differencing" technologies together with its end-to-end integrated product set and broad platform coverage distinguish its solutions from those of other vendors. The Company will continue to develop enhancements to existing products as well as new products that are responsive to the software and content management needs of organizations extending their Internet-based B2E, B2B and B2C networks. Increasing Market Share Leadership. Novadigm's current customer base is comprised of 240 large enterprise customers across major industries worldwide. The Company's strategy is to continue to increase its customer base and market share in the enterprise, Internet, mobile, and ATM/POS arenas by exploiting its competitive technology strengths, expanding its sales and partnering channels in the large enterprise marketplace, and developing additional selling channels to reach beyond the large enterprise market to small and medium enterprises, software publishers and services and content providers. Expanding Customer Relationships. Novadigm believes that its proven value in meeting the needs of its growing customer base, together with the broad range of software and content management capabilities in its integrated product line, positions it to be a provider of strategic enabling solutions to its customers as they extend their enterprise infrastructures to include Internet-based applications and services. Novadigm's strategy is to expand its relationships and licenses with existing customers by providing "plug-in" solutions which facilitate their rapid deployment of new Internet infrastructures and applications. TECHNOLOGY Novadigm's products share a common object-oriented architecture and 'desired-state' automation approach, implemented within a distributed management "engine" that automatically determines which software and content components are required for each individual user at the time of a configuration update. A key capability of this object-oriented architecture is that it can be easily extended by Novadigm, its customers, and partners, without programming, to manage any customer-defined or industry-standard software component (including C, C++, Visual Basic, Java, ActiveX, CORBA, Component object model, and JavaScript) or content format (such as registry directory, Hypertext mark-up language, Extensible mark-up language, multi-media, full motion video and animation). The benefit of this approach is that it enables Novadigm and its customers to quickly deploy emerging technologies and manage rapidly proliferating kinds of software across diverse and evolving platforms. Environment Discovery Process. A facility that dynamically audits managed computer environments on an on-demand or scheduled basis, creating inventory summaries of hardware and software contents for individual subscribers, workgroups, or departments. Policy/Entitlement Authentication/Authorization. A facility that dynamically authenticates a subscriber and determines the subscriber's entitlement to applications or services by one or more of a wide variety of characteristics such as userid, job function, department, geographic location, hardware configuration, subscription registration or customer database. Application Component Configuration. A facility that dynamically determines the current versions of application software or content components appropriate for each managed computer environment. Using this 'desired-state' engine, Novadigm's products can rapidly and precisely compute and compare the discovered actual state of each of these three dimensions with the personalized desired state of the managed computer's software and content. The resulting differences indicate without manual intervention what updates or changes are required, allowing components to be deployed and updated significantly faster, more efficiently, and with higher levels of reliability, adaptability and scalability than conventional non-desired-state ESD products. The engine itself is integrated within the entire Novadigm product suite as a shared set of "foundation" components which are installed in varying combinations in customer networks. These components consist of: Management Servers: Server-based components containing a distributed multi-domain object repository that synchronizes distributed objects -- application components, computer configurations, policy relationships -- across the network. This repository is configured with a variety of automated and graphical tools to include the packages, policies and configuration requirements necessary to automatically manage the transfer of objects to and from other Novadigm-managed servers and client computers. Multiple management servers may be deployed in "n-tier" configurations across enterprise and Internet networks as desired to support large numbers of users and large volumes of software and content, to optimize limited network connections, and to allow for distributed administration. Managed Clients: Lightweight components resident on managed computers that communicate with Novadigm's management servers to identify, obtain, install, repair and delete software or content. Operating as an extension of standard PC or Internet operating environments, the managed client automatically discovers current managed computer contents and synchronizes application versions with new or updated configurations residing on the management server. Administrators: Components resident on the administrator's desktop used to manage the object-repository and the engine. The administrator component contains a variety of graphical tools and utility programs used by customer administrators and technical staff to publish software and content components, specify policies and entitlements for users, and control the overall operation of the management servers and managed client components. These foundation components can be distributed across a variety of computing platforms: Communication between components is supported through a variety of protocols, including TCP/IP, SNA, IPX, and NetBIOS. A unique capability of Novadigm's object-oriented architecture is that it allows customers, systems integrators, outsourcers and application vendors to integrate their own custom development, systems management and desktop management tools into the Novadigm foundation infrastructure through the use of "Adapters" without requiring special application programming interfaces ("APIs") or third party vendor coding. Novadigm currently provides a variety of Adapters including: Network/Systems Management Frameworks. Novadigm's software and content management capabilities are integrated directly with the event, security and performance management environments of International Business Machines Corporation ("IBM")/Tivoli Systems Inc.'s ("Tivoli") TME10, Computer Associates International, Inc.'s ("Computer Associates") Unicenter, and Hewlett-Packard Company's ("Hewlett-Packard") OpenView. Security and Policy/Entitlement. Novadigm's policy management environment integrates with lightweight directory access protocol ("LDAP")-based directory servers, such as Microsoft Corporation's ("Microsoft") Active Directory, Novell Inc.'s ("Novell") NDS and other vendor LDAP servers, as well as with Microsoft's NT Domain Manager, IBM's RACF, Computer Associates ACF2 and Top Secret, and Oracle Corporation, ("Oracle"), Sybase, Inc. ("Sybase") and Microsoft SQL-based databases, to enable single source points of control for user authentication, access policies and subscriber entitlement. Problem/Help Desk Management. Novadigm's dynamic desktop configuration management facilities are integrated with problem management environments such as Remedy Corporation's AR system to integrate problem tracking and inventory discovery data. Custom-Built Application Management. Configuration management models for custom software developed in-house using Rational Software Corporation's PureAtria's ClearCase and Merant, Inc.'s PVCS are integrated directly into the distribution process, enabling changes in all phases of application development to be synchronized with deployment across pilot groups and throughout the entire enterprise once development is complete. PRODUCTS All Novadigm products are installed within customer environments upon the shared technology foundation. This facilitates seamless integration among individual products, sharing and reuse of software, content and policy/entitlement definitions among different audiences, and minimized use of machine, network and staff resources required to manage complex extended enterprise implementations. Novadigm products built upon the common foundation consist of: Enterprise Desktop Manager -- An "administrator managed" solution which enables IT organizations to centrally manage infrastructure, productivity and application software and content within enterprise WAN and LAN networks and across dialup/remote connections. Radia Application Manager -- A "provider managed" solution enabling enterprise and Internet application providers to deploy self-managing software to subscribers (employees, affiliates, partners and customers) over intranets, extranets and the Internet without subscriber or administrator involvement. Providers can select, install/deinstall and update their software and content automatically on a scheduled or just-in-time basis transparently to subscribers. Radia Software Manager -- A "subscriber managed" solution enabling self-service software and content management for knowledge workers within the extended enterprise, as well as to subscribers selecting software and content from Internet-based providers. Subscribers can select, install/deinstall and update their own elective software and content automatically or on-demand without provider involvement. Novadigm has announced its intention to deliver additional Radia products. The Company expects to release the Radia products, which are currently in various stages of customer testing, in the near future. Novadigm's future success will depend in large part on the Company's ability to develop and introduce new products that keep pace with technological developments, achieve market acceptance and respond to customer requirements that are constantly evolving. Any failure by the Company to anticipate or respond adequately to technological developments and customer requirements, or any significant delays in product development or introduction, could result in a loss of competitiveness and could materially and adversely affect the Company's operating results. There can be no assurance that any of the new products the Company plans to introduce will in fact be completed, or completed on time, or ultimately brought to market, or if brought to market, gain market acceptance. CUSTOMERS AND APPLICATIONS Novadigm's principal customers include medium to large enterprises with widely deployed and heterogeneous B2E, B2B and B2C networks. As of March 31, 1999, Novadigm's products had been licensed directly by the Company or through distributors to 240 customers worldwide. Novadigm supports the software management requirements of a wide range of industries, including banking, consumer products and services, financial services, government, insurance, Internet services, manufacturing, retail, technology, telecommunications, transportation, and utilities. Customers include AT&T Corp., Banca Commerciale Italiana, BMC Software, Inc., British Telecommunications plc, Electronic Data Systems, Limited, FMR Corp. (Fidelity Investments), Florists' Transworld Delivery, Inc. ("FTD"), The Gap, Inc., the Inland Revenue Service, J. Sainsbury PLC, KeySpan Corporation, Lockheed Martin Corporation, J.C. Bradford and Company, Metropolitan Life Insurance Company, NBA Properties, Inc. (the National Basketball Association), Northwest Airlines Corporation, The Prudential Insurance Company of America, Sony Corporation, Sybase, Telstra Corporation and Wells Fargo & Company. Novadigm's products manage a broad range of software and content for its customers, including business critical applications such as enterprise resource planning (ERP) software from SAP AG, The Baan Company, Oracle, and PeopleSoft, Inc. and sales force automation software from companies such as Siebel Systems, Inc.; content found on new e-commerce terminals such as ATMs and POS devices including full motion video and animation; personal productivity tools, browsers, virus checkers and utilities such as those from Microsoft, Netscape Communications Corp., Lotus Development Corporation, Network Associates, Inc. ("Network Associates") and Symantec Corporation; and just-in-time applications including applets, supply chain systems, and e-commerce sales interfaces for Web-based consumers. The Company's customers also use Novadigm's products to upgrade operating systems and/or migrate to new operating systems, as well as to deploy patches to help ensure existing software is Y2K-compliant or virus inoculated. During fiscal 1999, the Company had two customers which each accounted for over ten percent of the total revenues. Amdahl Corporation ("Amdahl"), an original equipment manufacturer ("OEM") and distributor of the Company's products (see "Sales and Marketing"), accounted for approximately 17% of total revenues for fiscal 1999 and Esoft, Ltd. ("Esoft"), a reseller, systems integrator and services provider in the United Kingdom ("UK"), accounted for approximately 12% of total revenues for fiscal 1999. SALES AND MARKETING Novadigm markets its software and services through its direct sales force and indirect channels comprised of OEMs, value added resellers ("VARs"), systems integrators, outsourcers and distributors, in North America, Europe, the Pacific Rim, South America, Middle East and Africa. Novadigm's North American and international sales activities, other than in Europe, the Middle East and Africa ("EMEA"), are managed from the Company's offices in Emeryville, California, Mahwah, New Jersey, and Chicago, Illinois; and sales activities for EMEA are managed from the Company's centers in Paris, France, Odiham, UK, and Hamburg and Munich, Germany. For fiscal 1999, revenues from direct and indirect sales accounted for 61% and 39%, respectively, of total revenues, and revenues from domestic and international sales accounted for 53% and 47%, respectively, of total revenues. Novadigm's direct sales activities have emphasized improvements in identifying and generating qualified prospective customer leads at the beginning phase of the sales cycle through concentrating on direct mail and teleprospecting activities. The leads generated from the telemarketing process are given to the Company's sales organization, which is divided into specialized teams of pre-sales specialists, account managers and post-sales service consultants that work together to provide an integrated selling approach to the customer. The Company's indirect channels are based on business arrangements with OEMs, VARs, systems integrators, outsourcers and distributors which are selected and trained by the Company to provide marketing, sales, post-sale support and services for the Company's products. These business arrangements are also useful to the Company in identifying product enhancements and developments that are responsive to customer and market requirements. The Company believes that it has been successful in minimizing marketing conflicts between its direct and indirect sales channels. Novadigm participates in the beta programs and partnering programs of the industry's market leaders, including Microsoft, Compaq Computer Corporation and Siebel Systems, Inc. With its relationship with Beyond.com Corporation, the Company is developing additional selling channels to reach beyond the large enterprise market to small and medium enterprises. Novadigm intends to continue to expand these technology, marketing and selling relationships. In June 1995, the Company entered into a seven-year, non-exclusive OEM and distribution agreement with Amdahl. Under the agreement, Amdahl may sublicense EDM throughout the world as part of its bundled solution and sublicense EDM stand-alone to a limited worldwide market. Novadigm agreed to provide limited technical support and training. The agreement required Amdahl to pay the Company a minimum royalty of $8 million in fiscal 1996; and $4 million in each of fiscal 1997 and fiscal 1998. The agreement was amended in March 1997, instead requiring Amdahl to pay $2 million in minimum royalties in each of fiscal 1997 and fiscal 1998; and minimum royalties of $3 million in each of fiscal 1999 and fiscal 2000. In the event of a change of control of the Company, the amended agreement allows Amdahl the right to terminate the agreement and recover unused guaranteed sublicense fees at the time of termination to the extent they were also outstanding on March 31, 1997. Amdahl renewed the agreement for fiscal 2000. There can be no assurance that Amdahl will extend this agreement in subsequent years. Novadigm to date has concentrated on establishing a market for its products in North America, Europe, Japan, South Africa, South America, Australia, Israel, Scandinavia, and Korea. Novadigm's marketing activities are designed to generate qualified leads and to supply sales channels with positioning, presentation materials, and product collateral to help generate and develop qualified customer prospects. Lead generation activities include seminars, trade shows, direct mailings, advertising and public relations activities. CUSTOMER SERVICE AND SUPPORT To facilitate implementation and integration of its products, Novadigm offers a range of support programs and services that complement its software and content management products. Novadigm provides all customers with telephone hotline, fax and e-mail access to its technical support staff, with additional support provided by the Company's OEMs, VARs, systems integrators, outsourcers, and distributors. Novadigm's technical support staff not only provides assistance in diagnosing problems, but works closely with customers to address systems implementation and integration issues and assists in increasing the efficiency of their enterprise systems. Novadigm also maintains a comprehensive solution-based web site of technical information on EDM and Radia. In addition, through the web site, Novadigm customers have the ability to download maintenance updates, submit problem reports and enhancements, and participate in a user discussion forum. Novadigm offers regional and on-site training programs covering object technologies and product implementation strategies to its customers, OEMs, VARs, systems integrators, outsourcers and distributors. Novadigm's professional services organization and a growing number of service providers are available to consult with customers on project planning and systems implementation and integration. Revenues from maintenance and services accounted for 35% of fiscal 1999 total revenues. PRODUCT DEVELOPMENT Since its inception, Novadigm has focused on, and made substantial investments in, product development. In fiscal 1999, Novadigm's total research and development expenses were approximately $4.9 million. To date, Novadigm has not capitalized any software development costs. Novadigm anticipates that it will continue to commit substantial resources to research and development, believing that its future success depends in large part on its ability to maintain and enhance the functionality of its current line of products and to develop and introduce new products that keep pace with technological developments, achieve market acceptance and respond to an ever-expanding range of customer requirements. The Company intends to enhance its existing product offerings and to introduce new products for the enterprise software and content management market. The Company's new product development effort is focused on products which address the unique requirements of the extended enterprise. In developing these new products and product enhancements, the Company makes extensive use of its own development tools and object-oriented technology. Although Novadigm expects to develop certain of its new products and product enhancements internally, the Company may acquire technology and/or products from third parties or consultants when considerations of time or cost dictate. If the next release of EDM, or any of the Radia products, or any potential new products and enhancements do not achieve market acceptance, or if for technological or other reasons the Company is unable to develop, introduce and sell its products in a timely manner, the Company's business, financial condition and results of operations will be materially and adversely affected. COMPETITION Competition in the software and content management market is diverse and rapidly changing. While a variety of vendors have offered some form of ESD, ISM or similar solutions with their offerings, the closest competitors of the Company today fall into three categories: Network/Systems Management Framework Vendors. These competitors include IBM/Tivoli and Computer Associates who offer conventional ESD tools as part of their enterprise frameworks. LAN/Desktop Management Suite Vendors. These competitors include vendors such as Microsoft, Intel Corporation and Network Associates, who offer workgroup-based conventional ESD tools as part of a LAN administration package. Internet ESD Vendors. These competitors (also known as ISM providers) include companies such as Marimba, Inc., and BackWeb Technologies Ltd. originally "push" technology companies that have redefined themselves to take advantage of the Internet services market. Mobile Management Suite Vendors. These competitors include Sterling Commerce, Inc. Novadigm believes that it competes effectively with all of these vendors in its target market on the basis of its broader product line for software and content management, patented fractional differencing technology, desired-state technological innovation, unique adaptive configuration functionality, higher product implementation success rates, and extensive customer support. Novadigm differentiates its products in the market based on results that have proven its products are capable of distributing and managing software and content faster, across larger and more diverse environments, with higher reliability and greater adaptability. However, there can be no assurance that the Company will be able to continue to compete effectively in the software management market or that its profitability or financial performance will not be adversely affected by increased competition. Many of Novadigm's competitors have longer operating histories, and many have significantly greater financial, technical, sales, marketing and other resources, as well as greater name recognition and larger customer installed bases. Moreover, there can be no assurance that either existing or new competitors will not develop products that are superior to the company's products or other technologies offering significant advantages over the Company's technology, which could have a material adverse effect on the Company's business, financial condition and results of operations. INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS In December 1996, Novadigm was issued a patent from the U.S. Patent Office for key components of its 'desired-state' management process used in the Company's software and content management products. There can be no assurance that the Company will develop additional proprietary technologies that are patentable, that any issued patent will provide the Company with any competitive advantages or will not be challenged by third parties, or that the patents of others will not have an adverse effect on the Company's ability to do business. Moreover, there can be no assurance that protective measures taken by the Company will prevent misappropriation of its proprietary technology, and such measures may not preclude competitors from developing products with features similar to those of the Company's products. Furthermore, effective copyright and trade secret protection may be limited or unavailable under the laws of certain foreign jurisdictions. The Company also relies on a combination of copyright and trademark laws, trade secrets, confidentiality procedures, contractual provisions and technical measures to protect its proprietary rights in its products. Although the Company believes that its products and trademarks do not infringe upon the proprietary rights of third parties, there can be no assurance that third parties will not assert infringement claims against the Company with respect to current or future products. Any such claims, whether with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require the Company to enter into royalty or license agreements, provided such agreements were available on reasonable terms or at all. Defense of any lawsuit or failure to obtain any required license could have a material, adverse effect on the Company's business, operating results and financial condition. The Company believes, however, that given the rapid pace of technological change in the industry, factors such as the technical expertise, knowledge and innovative skill of the Company's management and technical personnel, the Company's name recognition, the timeliness and quality of the support services it provides and its ability to offer frequent product enhancements and to develop, introduce and market new products are more significant in maintaining the Company's competitive technology leadership position. EMPLOYEES As of March 31, 1999, Novadigm had a total of 159 full-time employees, including 20 in customer support and services, 41 in product development, 72 in sales and marketing, 26 in general and administration. A total of 129 employees are based in the United States and 30 employees are based in Europe. None of the Company's employees are represented by a labor union. The Company has not experienced work stoppages and considers its relations with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT Novadigm's executive officers are as follows: Albion J. Fitzgerald co-founded Novadigm in February 1992, serving as Chairman since that time, and currently as Chief Executive Officer. Mr. Fitzgerald has previously served as Chief Technology Officer and President. In May 1990, Mr. Fitzgerald founded Fitzgerald Associates, Novadigm's predecessor, and served as the chief architect in the development of the desired-state management and fractional differencing technologies that are the basis of both EDM and Radia. Michael R. Carabetta joined Novadigm in February 1998 as President and Chief Operating Officer. From 1994 until joining Novadigm, Mr. Carabetta was Vice President and General Manager of the Amdahl Corporation. He was responsible for Amdahl's Open Enterprise Systems division and later responsible for the A+ software and services business unit. From 1983 to 1994, Mr. Carabetta was with Digital Equipment Corporation, serving first as Product Line Manager and later as Vice President, Financial & Cross Industry Applications. Robert B. Anderson joined Novadigm in June 1992 as Vice President, Chief Financial Officer, Secretary and as a director. He currently serves as Executive Vice President, Secretary and as a director. Joseph J. Fitzgerald co-founded Novadigm in February 1992. Since that time he has served as Director of Development, and as of June 1996, Vice President of Development. Mr. Fitzgerald is the brother of Albion Fitzgerald. Wallace D. Ruiz joined Novadigm in May 1995 as Vice President, Treasurer and Chief Financial Officer. From September 1993 until joining Novadigm, he was Vice President, Treasurer and Chief Financial Officer of Unisa Holdings, Inc., a designer, marketer, and retailer of women's fashion footwear. Mr. Ruiz is a certified public accountant. Mr. Ruiz is the brother-in-law of Albion Fitzgerald. ITEM 2. ITEM 2. PROPERTIES Novadigm's headquarters are located in Mahwah, New Jersey. Novadigm conducts its operations in North America principally out of leased facilities in Mahwah; Chicago; and Emeryville, California; and in Western Europe out of its facilities in Paris, France. The Company occupies approximately 30,223 square feet at its Mahwah facilities, which are used principally for product development, east coast sales, marketing and support, and general administration; and approximately 3,463 square feet at its California facilities, which are used principally for west coast sales, marketing and support. Novadigm's facilities in France are comprised of approximately 8,729 square feet and are used to support the Company's European operations. Novadigm also has sales and support offices in Odiham, UK; and Munich and Hamburg, Germany. The Company believes that its current facilities are adequate for its needs and will be adequate to meet its needs for the foreseeable future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On March 3, 1997, Novadigm sued Marimba, Inc. for infringement of the Company's U.S. Patent No. 5,581,764 (the "764 Patent") in the U.S. District Court for the Northern District of California. Novadigm alleges that Marimba's Castanet Software product infringes the "764 Patent." On May 2, 1997, Marimba filed an answer to Novadigm's complaint and a counterclaim, denying the Company's allegations and seeking a declaration that the "764 Patent" is invalid, not infringed, and unenforceable. Discovery in the case is nearing completion. Both parties have filed summary judgment motions, which are expected to be heard by the court in June, 1999. If the summary judgement motions do not dispose of the case, trial is presently scheduled for September 1999. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's stock has been traded on the Nasdaq National Market since the Company's initial public offering on July 13, 1995 under the Nasdaq symbol NVDM. The following table sets forth, for the periods indicated, the high and low sales prices for the Company's common stock as reported by Nasdaq: As of June 7, 1999, there were approximately 110 holders of record of the Company's common stock. The Company has never paid cash dividends on its common stock. The Company currently intends to retain earnings, if any, for use in its business and does not anticipate paying any cash dividends in the foreseeable future. In addition, the Company is prohibited from paying dividends under its revolving line of credit agreement. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements and Notes to Consolidated Financial Statements and other financial information included elsewhere in the report. NOVADIGM, INC. SELECTED CONSOLIDATED FINANCIAL DATA (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------- (1) Represents a non-recurring, non-cash compensation charge incurred upon the achievement of certain cash flow requirements under an escrow arrangement imposed on founder's shares in connection with the Company's public offering on the Vancouver Stock Exchange in September 1992. (2) See Note 10 of Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements which reflect the Company's current views with respect to future events and financial performance. Such forward-looking statements include, but are not limited to the last sentences of the first paragraph under "Revenue," the last sentences of "Cost of maintenance and services," "Sales and marketing," "Research and development" and "General and administrative," the statements under "Year 2000 compliance" and the last paragraph under "Liquidity and capital resources." These forward-looking statements are subject to certain risks and uncertainties, including those discussed under "Business Risks" below, that could cause actual results to differ materially from historical or anticipated results. OVERVIEW The Company designs, markets and supports technology solutions that efficiently and reliably deliver, update and maintain software and content across the extended enterprise. The Company's principal customers include medium to large organizations with widely deployed and heterogeneous B2E, B2B and B2C networks. The Company was incorporated in February 1992. Through September 1993, the Company's primary efforts were devoted to product development. In October 1993, Version 1.0 of EDM was released for general availability. Since its first release, the Company has continued to develop EDM by adding new features, applications and platforms. Version 2.0 of EDM was released in February 1994, Version 3.0 in June 1995, and Version 4.0 was released in October 1997. In November 1997, the Company released Radia Software Manager, an Internet-based software and content management solution and in November 1998, the Company announced the general availability of Radia Version 2.0 as well as the Radia Application Manager. The Company generates license revenues from licensing the rights to use its software products to end users and sublicense fees from resellers, including certain guaranteed sublicense fees. The Company also generates maintenance and service revenues from providing renewable support and software update rights services (maintenance) and from consulting and training activities performed for license customers. Revenues from perpetual software license agreements are recognized as revenue upon shipment of the software if there are no significant post-delivery obligations, payment is due within one year and collectibility is probable. If an acceptance period is required, revenues are recognized upon the earlier of customer acceptance or the expiration of the acceptance period. The Company enters into reseller arrangements that typically provide for sublicense fees payable to the Company based on a percent of the Company's list price. Reseller arrangements may include non-refundable payments in the form of guaranteed sublicense fees. Guaranteed sublicense fees from resellers are recognized as revenue upon shipment of the master copy of all software to which the guaranteed sublicense fees relate if there are no significant post-delivery obligations, the reseller is creditworthy and if the terms of the agreement are such that the payment obligation is not subject to price adjustment, is non-cancelable and non-refundable and due within 90 days. These guaranteed sublicense fees are applied against sublicense fees reported by the reseller in relicensing the Company's products to end-users. The Company recognized approximately $5.4 million in guaranteed sublicense fees under all such agreements in fiscal 1999, approximately $0.4 million in fiscal 1998, and approximately $3.9 million in fiscal 1997. At March 31, 1999, approximately 63% of all such guaranteed sublicense fees had been relicensed by the Company's resellers to end-users. Revenues for maintenance are recognized ratably over the term of the support period. If maintenance is included in a license agreement, such services are unbundled from the license fee at their fair market value based on the value established by independent sale of such maintenance to customers. Consulting revenues are primarily related to implementation services performed under separate service arrangements related to the installation of the Company's software products. Such services generally do not include customization or modification of the underlying software code. If included in a license agreement, such services are unbundled at their fair market value based on the value established by the independent sale of such services to customers. Revenues from consulting and training services are recognized as services are performed. ALL PERIOD REFERENCES IN THE DISCUSSION BELOW ARE TO FISCAL PERIODS OF THE COMPANY BASED ON ITS FISCAL YEAR ENDING MARCH 31. RESULTS OF OPERATIONS For the periods indicated, the following table sets forth the percentage of total revenues represented by the respective line items in the Company's statements of operations. REVENUES The Company generates revenues principally from licensing the rights to use its software products to end-users and from sublicense fees reported to the Company by resellers, including certain guaranteed sublicense fees. The Company also generates maintenance and service revenues from providing renewable support and software update rights services and from consulting and training activities performed for license customers. Maintenance and service revenues accounted for 45.9% of total revenues in 1997, 32.8% in 1998, and 35.3% in 1999, respectively. Though the Company expects maintenance and service revenues to increase in terms of absolute dollars in 2000 as compared to 1999, the Company expects maintenance and service revenues as a percentage of total revenues to decline in 2000 as a result of its emphasis on licensing activities. Total revenues were $22.4 million, $23.4 million, and $32.1 million in 1997, 1998, and 1999, respectively. Total revenues increased 4.5% in 1998 over 1997 and increased 37.0% in 1999 over 1998. License revenues were $12.1 million, $15.7 million, and $20.7 million in 1997, 1998 and 1999, respectively. License revenues increased 29.8% in 1998 over 1997 and increased 31.8% in 1999 over 1998. License revenues increased in both 1998 and 1999 over the previous years, respectively, due to improving market acceptance of the Company's products as a result of the release of new versions of EDM and Radia; the expansion of the direct sales force in North America and Europe; the reacquisition of distribution rights in the United Kingdom in 1997; the opening of a sales and support office in Germany in 1998; the expansion of the Company's international distributor channel to 13 countries; the establishment of numerous large enterprise reference accounts; and exploiting ATM, POS and mobile computing markets. Maintenance and service revenues were $10.3 million, $7.7 million, and $11.3 million in 1997, 1998 and 1999, respectively. Maintenance and service revenues declined 25.3% in 1998 compared to 1997 and increased 46.7% in 1999 over 1998. The decline in maintenance and service revenues in 1998 as compared to 1997 was primarily due to the expiration of the Company's agreement with IBM in March 1997 which provided $5.1 million in service revenues in 1997. The increase in maintenance and service revenues in 1999 over 1998 was due primarily to a 68.6% increase in maintenance revenues associated with licensing with 66 new customers in 1999 and due to an increase in the Company's maintenance prices during 1999. Consulting and training revenues increased 13.4% in 1999 over 1998 due to providing implementation and training services to new license customers. During 1999, two customers, Amdahl and Esoft accounted for approximately 17% and 12% of total revenues, respectively. During 1998, two customers, Amdahl and EDS, accounted for approximately 31% and 10% of total revenues, respectively. During 1997, two customers, IBM and Amdahl, accounted for approximately 23% and 16% of total revenues, respectively. The Company typically ships its products following a fully executed license agreement, and acceptance of a purchase order, and, as a result, has little or no backlog. OPERATING EXPENSES Cost of maintenance and services includes the direct costs of customer support and update rights, and the direct and indirect costs of providing training, technical support and consulting services to the Company's customers. Cost of maintenance and services consists primarily of payroll and benefits for field engineers and support personnel, travel and lodging expenses, third party consulting fees, and other related overhead. Cost of maintenance and services was $6.3 million, $7.0 million, and $4.4 million in 1997, 1998 and 1999, respectively. The cost of maintenance and services increased 11.1% in 1998 over 1997 and decreased 37.6% in 1999 as compared to 1998. The reason for the increase in 1998 over 1997 was due to higher staffing levels and an increased use of outside consultants. In March 1998, the Company reorganized the technical services department, reducing the personnel and the use of outside consultants. The Company expects the cost of maintenance and services to increase in 2000 both as a percentage of service revenues and in absolute dollars. Sales and marketing expenses consist primarily of salaries, related benefits, commissions, travel and other costs associated with the Company's sales and marketing efforts. Sales and marketing expenses were $17.1 million, $14.7 million, and $16.3 million in 1997, 1998 and 1999, respectively. Sales and marketing expenses declined 14.3% in 1998 as compared to 1997 and increased 10.9% in 1999 over 1998. The decrease in 1998 from 1997 was primarily the result of the restructuring program initiated in March 1997, which among other things included the closing of sales, support and marketing offices, revamping marketing programs and the reorganization of sales and marketing organizations. The increase in sales and marketing expenses in 1999 over 1998 was primarily due to the expansion of the European direct sales force as well as higher commission expense associated with the recording of higher revenue. The Company expects sales and marketing expenses to increase in 2000 compared to 1999 due to the sales programs put into place in 1999. Research and development expenses consist primarily of salaries, related benefits, consultant fees and other costs associated with the Company's research and development efforts. Research and development expenses were $6.2 million, $6.8 million, and $4.9 million in 1997, 1998 and 1999, respectively. Research and development expenses increased 10.2% in 1998 over 1997 and decreased 27.9% in 1999 as compared to 1998. The dollar increase in 1998 was due primarily to salary increases and the contracting of consultants to assist with the introduction and release of EDM version 4.0 and Radia. The decrease in research and development in 1999 as compared to 1998 was due primarily to a significant reduction in the use of outside consultants contracted in 1998 to assist in the development of EDM version 4.0 and Radia. The Company believes that a significant investment in research and development activities is essential to provide for the Company's future growth, particularly research and development relating to the Company's Internet activities. The Company anticipates that it will continue to invest resources to further enhance and develop its products, and anticipates growth in research and development expense in 2000. Under the provisions of Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed," software development costs are capitalized upon the establishment of technological feasibility, which the Company defines as establishment of a working model. Amounts which could have been capitalized under this statement were immaterial in all periods presented. Therefore, the Company has expensed all software development costs as incurred. General and administrative expenses consist primarily of salaries, related benefits, travel and fees for professional services such as consulting, legal, accounting and recruiting fees. General and administrative expenses were $5.0 million, $5.0 million, and $5.4 million in 1997, 1998 and 1999, respectively. General and administrative expenses remained unchanged in 1998 as compared to 1997 and increased 8.4% in 1999 over 1998. The increase in 1999 over 1998 is due primarily to higher compensation costs due to expanding Company's management and to higher legal fees associated with a patent infringement suit alleged by the Company. See Item 3. Legal Proceedings. The Company expects general and administrative expenses to increase in 2000. Restructuring charge. The Company implemented a restructuring program during the fourth quarter of 1997 to more closely align the Company's operating expenses with its revenue model, and recorded a charge of $1.8 million related to restructuring costs during this period. The program terminated or relocated 29 employees, principally in the sales and marketing departments, causing the closing of five regional sales offices and the Chicago-based marketing office, the restructuring of European operations, and the integration of North American channels marketing into the existing North American sales and services organization. The restructuring program was completed during 1998. INTEREST INCOME AND OTHER, NET. Interest income and other, net is comprised primarily of interest income earned on the Company's cash, cash equivalents and investments. Interest income was $1.6 million, $1.0 million, and $0.7 million in 1997, 1998 and 1999, respectively. Interest income and other, net declined 38.8% in 1998 as compared to 1997 and declined 32.0% in 1999 as compared to 1998. The decline of interest income and other, net in both 1998 and 1999 as compared to the previous year, respectively, is due primarily to lower average balances of cash and marketable securities in both years compared to the prior year average balances. INCOME TAXES. The Company recorded a provision for income taxes of approximately $59 thousand in 1997 primarily for federal and state alternative minimum taxes; an income tax benefit of $68 thousand in 1998 for state tax refunds; and a provision for income taxes of approximately $25 thousand in 1999 for federal and state alternative minimum taxes. As of March 31, 1999, the Company had net deferred tax assets of approximately $8.1 million. The Company has provided a full valuation allowance due to the uncertainty surrounding the timing of the realization of the net deferred tax assets. As of March 31, 1999, the Company had federal net operating loss carryforwards of approximately $15.4 million, which expire in various periods through 2013. The Company's ability to utilize the net operating loss carryforwards in future years may be limited in some circumstances, including significant changes in ownership interests, due to certain provisions of the Internal Revenue Code of 1986. YEAR 2000 COMPLIANCE The Year 2000 computer issue creates risks for the Company. If internal systems do no correctly recognize and process data information beyond the Year 1999, there could be an adverse impact on the company's operations. There are two other related issues which could also lead to incorrect calculations or failures: (1) some systems' programming assigns special meaning to certain dates, such as 9/9/99, and (2) the Year 2000 is a leap year. As used in this section, "Year 2000 capable" means that when used properly and in conformity with the product information provided by the company, and when used with Year 2000 capable computer systems, the product will accurately store, display, process, provide, and/or receive data from, into, and between the twentieth and twenty-first centuries, including leap year calculations, provided that all other technology used in combination with the Company's product properly exchanges the data with the Company's product. Internal Systems. To address these Year 2000 issues with its internal systems, the Company has initiated a program that is designed to deal with the Company's internal management information systems and its embedded systems (e.g. phones, and security systems). The program includes both assessment and remediation proceeding in parallel and the Company currently plans to have changes to those management and critical systems completed and tested by the third quarter of 1999. These activities are intended to encompass all major categories of systems used by the Company, including sales and financial systems and embedded systems. The program has completed its assessment phase, which identified a number of systems that had date dependencies. None of the systems are considered by the Company to be mission critical. 95% of the date dependencies have already been remediated. In almost all cases the fixes involved updating software or firmware. The unremediated date dependencies involve desktop workstations, and are expected to be fully remediated by the third quarter of 1999. Products. The Company has determined that the most recent versions of its products do not have any date dependencies that could give rise to Year 2000 capability problems. The Company plans to evaluate new products as they are developed. Because its products have no date dependencies that could give rise to Year 2000 capability problems, the Company does not believe it is legally responsible for cost incurred by customers related to ensuring their Year 2000 capability. Suppliers. The Company is also working with key suppliers of products and services to determine whether their operations and products are Year 2000 capable and to monitor their progress toward Year 2000 capability. The Company identified four vendors that could materially impact the Company's business if they experienced significant Year 2000 problems. These include the Company's electric power, local telephone, long distance and Internet service providers. The Company has obtained verbal assurances from each of these suppliers of services that they comply with industry standards for Year 2000 readiness. Costs. The Company is incurring various costs to provide customer support and customer satisfaction services regarding Year 2000 issues and it is anticipated that these expenditures will continue through 1999 and thereafter. The costs incurred to date related to the Company's Year 2000 assessment and remediation programs have not been material. The cost which will be incurred by the Company regarding the implementation of Year 2000 compliant internal information systems, answering and responding to customer requests related to Year 2000 issues, including both incremental spending and redeployed resources, is currently not expected to exceed $150,000. The total cost estimate does not include potential costs related to any customer or other claims or the cost of internal software and hardware replaced in the normal course of business. In some instances, the installation schedule of new software and hardware in the normal course of business is being accelerated to also afford a solution to Year 2000 capability issues. The total cost estimate is based on the current assessment of the projects and is subject to change as the project progress. Based on currently available information, management does not believe that the Year 2000 matters discussed above related to internal information technology or embedded systems of key suppliers' systems or products fold to customers will have material impact on the Company's financial condition or overall trends in results of operations. However, the Company cannot guarantee that the Year 2000 situation will not negatively impact the Company. In addition, the failure to ensure Year 2000 capability by a supplier or another third party could have a material adverse effect on the Company. The Company's Year 2000 compliance programs have been conducted internally, without the use independent verification or validation processes. These assessment and compliance programs have not caused the deferral by the Company of other information technology projects. The Company's most reasonably likely worst case Year 2000 scenario is that the Company experiences key service interruptions due to Year 2000 problems. The Company has addressed potential problem areas with internal systems and with suppliers and other third parties. It is expected that assessment, remediation and contingency planning activities will be ongoing throughout 1999 with the goal of appropriately resolving all material internal systems and third party issues. INFLATION The effects of inflation on the Company's financial position has not been significant to date. LIQUIDITY AND CAPITAL RESOURCES In 1997 and 1998, net cash used in operating activities was $9.1 million and $7.7 million, respectively, and was due primarily to the net loss in each year. Net cash provided by operating activities in 1999 was $1.6 million primarily as a result of net income and an increase in deferred revenue. The accounts receivable balance, net of the allowance for doubtful accounts increased $2.2 million to $8.6 million as of March 31, 1999. The increase in accounts receivable was primarily due to the higher revenues during 1999. As of March 31, 1999, the Company did not have any material commitments for capital expenditures. In July 1995, the Company completed a public offering in the United States of 2,875,000 shares of common stock (which included 500,000 shares sold by stockholders) at $15 per share, resulting in net proceeds to the Company of approximately $32.2 million, after offering costs. The Company received approximately $1.0 million and $0.4 million in 1997 and 1998, respectively, and paid approximately $0.6 million in 1999 from options exercised by optionees under the Company's stock option plans. In May 1996, the Board of Directors approved the repurchase of up to 500,000 shares of the Company's common stock. As of March 31, 1998, the Company had repurchased 500,000 shares, expending approximately $3.1 million. The repurchased shares have been accounted for as treasury stock and at March 31, 1999, all but 42,981 shares were used to fulfill commitments to optionees who had exercised options under the Company's stock option plan. In December 1994, the Company entered into an unsecured revolving line of credit agreement with a bank. The agreement has been renewed annually and at March 31, 1999 the available line of credit was $1.0 million, expiring in September 1999. Borrowings bear interest at the bank's reference rate (7.75% as of March 31, 1999). The agreement has a number of financial covenants which the Company is required to meet. The Company had no outstanding borrowings under the agreement as of March 31, 1999. Although it is difficult for the Company to predict future liquidity requirements with certainty, the Company believes that its existing cash and marketable securities balances, together with cash from operations and amounts available under the Company's revolving line of credit, will be adequate to finance its operations for at least the next twelve months. Although operating activities may provide cash in certain periods, to the extent the Company experiences growth in the future, the Company anticipates that its operating and investing activities may use cash. Consequently, any such future growth may require the Company to obtain additional equity or debt financing, which may not be available on commercially reasonable terms or which may be dilutive. BUSINESS RISKS History of Operating Losses. The Company has reported an operating loss for every quarter since its incorporation in February 1992 except for the four consecutive quarters of 1996 and the last three-quarters of 1999. There can be no assurance that the Company will be able to sustain profitability on a quarterly or annual basis in the future. Retention of Executives and Key Employees. The Company's future success depends upon the contributions of its executives and key employees. The inability to retain executives and certain key employees in research and development and sales and marketing could have a significant adverse affect on the Company's ability to develop new products and versions of its products and market and sell its products in the marketplace. The loss of the services of one or more of the Company's executives or key employees could have a material adverse effect on the Company's operating results. The Company also believes its future success will depend in large part upon its ability to attract and retain additional highly skilled personnel. Fluctuations in Quarterly Results; Seasonality. The Company's quarterly operating results have fluctuated in the past and are expected to fluctuate significantly in the future due to a number of factors, including, among others, the size and timing of customer orders, the timing and market acceptance of new products by the Company, the level and pricing of international sales, foreign currency exchange rates, changes in the level of operating expenses, technological advances and new product introductions by the Company's competitors and competitive conditions in the industry. Revenues received from individual customers of the Company vary significantly based on the size of the product installation. Customer orders for the Company's products have ranged from $25,000 to over $4 million, and have averaged several hundred thousand dollars. As a result, the Company's quarterly operating results are likely to be significantly affected by the number and size of customer orders the Company is able to obtain in any particular quarter. In addition, the sales cycle for the Company's products is lengthy and unpredictable, and may range from a few months to over a year, depending upon the interest of the prospective customer in the Company's products, the size of the order (which may involve a significant commitment of capital by the customer), the decision-making and acceptance procedures within the customer's organization, the complexity of implementation and other factors. The Company generally ships orders as received and as a result typically has little or no backlog. Quarterly revenues and operating results therefore depend upon the volume and timing of orders received during the quarter, which are difficult to forecast. Historically, the Company has recognized the substantial majority of its quarterly license revenues in the last weeks or week of each quarter. In addition, because the Company's expenditure levels for product development and other operating expenses are based in large part on anticipated revenues, a substantial portion of which are not typically generated until the end of each quarter, the timing and amount of revenues associated with orders have caused, and may continue to cause, significant variations in operating results from quarter to quarter. The Company's operating results are also expected to vary significantly due to seasonal trends. Historically, the Company has realized a greater percentage of its annual revenues in its fourth quarter, and a lower percentage in the first and second quarters. The Company believes that this seasonality is in part a result of efforts of the Company's direct sales personnel to meet annual sales quotas, and in part a result of lower international revenues in the summer months when many businesses in Europe experience lower sales. In addition, capital budgets of the Company's customers, which tend to concentrate spending activity at calendar year-end, have had, and may continue to have, a seasonal influence in the Company's quarterly operating results. The Company expects that its operating results will continue to fluctuate in the future as a result of these and other factors, and that seasonality may increase if the Company's efforts to expand its international sales are successful. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business -- Sales and Marketing." Rapid Technological Change and Introduction of New Products. The market for ESD products is characterized by rapid technological advances, changes in customer requirements and frequent new product introductions and enhancements. The Company's future success will depend in large part on the Company's ability to enhance its current products and to develop and introduce new products that keep pace with technological developments, achieve market acceptance and respond to customer requirements that are constantly evolving. Responding to rapid technological change and the need to develop and introduce new products to meet customers' expanding needs will require the Company to make substantial investments in research and product development. During 1999, among other research and development expenditures, the Company allocated research and development funding to the development of its most recent release of Radia, version 2.0, an integrated LDAP adapter, as well as enhancements to EDM. The Company intends to continue to allocate funding to these development projects throughout 2000. Any failure by the Company to anticipate or respond adequately to technological developments and customer requirements, and in particular advances in client/server enterprise hardware platforms, internet applications and platforms, operating systems and systems management applications, or any significant delays in product development or introduction, could result in a loss of competitiveness or could materially and adversely affect the Company's operating results. There can be no assurance that any product enhancements or new products developed by the Company will gain market acceptance. The failure to develop on a timely basis new products or product enhancements could cause customers to delay or refrain from purchasing the Company's existing products and thereby adversely affect the Company's operating results. If future releases of new products and enhancements do not achieve market acceptance, the Company's business, financial condition and results of operations will be materially and adversely affected. See "Business -- Products." Software products as complex as those offered by the Company may contain undetected errors or failures that, despite significant testing by the Company, are discovered only after a product has been installed and used by customers. Although the Company's business has not been materially and adversely affected by any such errors to date, there can be no assurance that errors will not be found in the Company's products in the future. Such errors could cause delays in product introductions and shipments, require design modifications, result in loss of or delay in market acceptance of the Company's products, or loss of existing customers, any of which could adversely affect the Company's business, financial condition and results of operation. Competition. Competition in the software and content management market is diverse and rapidly changing. While a variety of vendors have offered some form of ESD, ISM or similar solutions with their offerings, the current and prospective closest competitors of the Company today fall into three categories: Network/Systems Management Framework Vendors. These competitors include IBM/Tivoli and Computer Associates who offer conventional ESD tools as part of their enterprise frameworks. LAN/Desktop Management Suite Vendors. These competitors include vendors such as Microsoft, Intel Corporation and Network Associates, who offer workgroup-based conventional ESD tools as part of a LAN administration package. Internet ESD Vendors. These competitors (also known as ISM providers) include companies such as Marimba, Inc., and BackWeb Technologies Ltd. originally "push" technology companies that have redefined themselves to take advantage of the Internet services market. Mobile Management Suite Vendors. These competitors include Sterling Commerce, Inc. Novadigm believes that it competes effectively with all of these vendors in its target market on the basis of its broader product line for software and content management, patented fractional differencing technology, desired-state technological innovation, unique adaptive configuration functionality, higher product implementation success rates, and extensive customer support. Novadigm differentiates its products in the market based on results that have proven its products are capable of distributing and managing software and content faster, across larger and more diverse environments, with higher reliability and greater adaptability. Many of the Company's competitors have longer operating histories than the Company, and many may have significantly greater financial, technical, sales, marketing and other resources, as well as greater name recognition and larger installed customer bases. The Company's current and future competitors could introduce products with more features, greater functionality and lower prices than the Company's products. These competitors could also bundle existing or new products with other, more established products in order to compete with the Company. The Company's focus on software and content management products may be a disadvantage in competing with vendors that offer a broader range of products. Moreover, as the software and content management market develops, a number of companies with significantly greater resources than those of the Company could attempt to increase their presence in this market by acquiring or forming strategic alliances with competitors or business partners of the Company. There can be no assurance that the Company will be able to compete successfully or that competition will not have a material adverse effect on the Company's business, operating results or financial condition. See "Business -- Competition." Volatility. The market for the Company's common stock is highly volatile. The trading price of the Company's common stock has been and could in the future be subject to wide fluctuations in response to quarterly variations in operating and financial results, announcements of technological innovations or new products by the Company or its competitors, changes in prices of the Company's or its competitors' products and services, changes in product mix, change in the Company's revenue and revenue growth rates for the Company as a whole or for individual geographic areas, products or product categories, as well as other events or factors. Statements or changes in opinions, ratings, or earnings estimates made by brokerage firms or industry analysts relating to the market in which the Company does business or relating to the Company specifically have resulted, and could in the future result in, an immediate and adverse effect on the market price of the Company's common stock. In addition, the stock market has from time to time experienced extreme price and volume fluctuations which have particularly affected the market price for the securities of many high technology companies and which often have been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of the Company's common stock. Risks Related to International Revenues. In 1998 and 1999, approximately 46% and 47% of the Company's net revenues, respectively, were derived from its international operations. International revenues are a significant percentage of the Company's revenues and the Company plans to continue to develop international sales, primarily through its European operations. The Company's operations and financial results could be significantly affected by factors associated with international operations, such as changes in foreign currency exchange rates, uncertainties relative to regional economic circumstances, longer payment cycles, greater difficulty in accounts receivable collection, changes in regulatory requirements and product localization requirements, as well as by other factors associated with international activities. Customer Concentration. During 1999, two customers, Amdahl and Esoft accounted for approximately 17% and 12% of total revenues, respectively. During 1998, two customers, Amdahl and EDS, accounted for approximately 31% and 10% of total revenues, respectively. During 1997, two customers, IBM and Amdahl, accounted for approximately 23% and 16% of total revenues, respectively. In June 1995, the Company entered into a seven-year, non-exclusive OEM and distribution agreement with Amdahl. Under the agreement Amdahl can sublicense EDM throughout the world as part of their bundled solution and sublicense EDM stand-alone to a limited worldwide market. Novadigm agreed to provide limited technical support and training. The agreement required Amdahl to pay the Company $8 million in minimum royalties in 1996; and $4 million in minimum royalties in each of 1997 and 1998. The agreement was amended in March 1997, instead requiring Amdahl to pay $2 million in minimum royalties in each of 1997 and 1998; and minimum royalties of $3 million in each of 1999 and 2000. In the event of a change of control of the Company, the amended agreement allows Amdahl the right to terminate the agreement and recover unused guaranteed sublicense fees at the time of the termination, to the extent they were also outstanding at March 31, 1997. Though Amdahl renewed the agreement at the end of 1999, there can be no assurance that Amdahl will extend this agreement in subsequent years. Although the Company believes that its dependence on its relationship with Amdahl has become less significant over time as the Company expands the number of companies participating in its indirect marketing channels, the disruption of the Company's relationship with Amdahl could materially and adversely affect the Company's operating results and financial condition. Dependence on Proprietary Technology; Risks of Infringement. The success of the Company will be, heavily dependent upon proprietary technology. The Company relies primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which provide only limited protection. Despite precautions taken by the Company, it may be possible for unauthorized third parties to copy aspects of its current or future products or to obtain and use information that either regards as proprietary. In particular, the Company may provide its respective licensees with access to its proprietary information underlying its licensed applications. There can be no assurance that such means of protecting their proprietary rights will be adequate or that their competitors will not independently develop similar or superior technology. Policing unauthorized use of software is difficult and, while the Company is able to determine the extent to which piracy of its software products exists, software piracy can be expected to be a persistent problem. In addition, the laws of some foreign countries do not protect the proprietary rights of the Company to the same extent as do the laws of the United States. Litigation may be necessary in the future to enforce their intellectual property rights, to protect trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the business, results of operations, and financial condition of any or all of the Company. The Company is not aware that any of its software product offerings infringes the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement with respect to current or future products of the Company. The Company expects that software product developers will increasingly be subject to infringement claims as the number of products and competitors in their industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time consuming, result in costly litigation, cause product shipment delays, or require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on acceptable terms or at all, which could have a material adverse effect on the business, results of operations, and financial condition of the Company. Product Liability. The license agreements, which the Company enters with its customers typically, contain provisions designed to limit exposure to potential product liability claims. It is possible, however, that the limitation of liability provisions contained in such license agreements may not be effective under the laws of certain jurisdictions. Although the Company has not experienced any product liability claims to date, the sale and support of their products may entail the risk of such claims, and there can be no assurance that the Company will not be subject to such claims in the future. A product liability claim brought against the Company could have a material adverse effect on its respective businesses, results of operations, and financial condition. Year 2000 Implications. Many currently installed computer systems and software products are unable to distinguish 21st century dates from 20th century dates. Beginning in the year 2000, these date code fields will need to distinguish 21st century dates from 20th century dates, and, as a result, many companies' software and computer systems may need to be upgraded or replaced in order to comply with such "Year 2000" requirements. The Company is aware that some of its internal systems are not Year 2000 compliant and the Company is in the process of assessing the impact of replacing or upgrading these systems. The Company has on occasion warranted, and generally represents to its customers, that the newer version of its products, EDM version 4.0 and Radia are free from Year 2000 defects. There can be no assurance that the Company's products are Year 2000 compliant, or that the Company's products will not be integrated with, or otherwise interact with, non-compliant software. The foregoing could expose the Company to claims from its customers and result in the loss of or delay in market acceptance of the Company's products, increased service and warranty costs to the Company and payment by the Company of compensatory or other damages, any of which events could have a material adverse effect on the Company's business, operating results and financial condition. Although the Company believes that the cost to replace or upgrade its internal systems to be Year 2000 compliant will not have a material adverse effect on its business, the failure of any third-party systems to operate properly with regard to the Year 2000 and thereafter could have a material adverse effect on the Company's business, results of operations and financial condition. Furthermore, the purchasing patterns of potential customers may be affected by Year 2000 issues as companies expend significant resources to correct their current systems for Year 2000 compliance. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements and Supplementary Data of the Company required by this item are set forth at the pages indicated at Item 14(a). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this item concerning the Company's directors is incorporated by reference from the section captioned "Election of Directors" contained in the Company's Proxy Statement related to the Annual Meeting of Stockholders to be held September 17, 1999, to be filed by the Company with the Securities and Exchange Commission within 120 days of the end of the Company's fiscal year pursuant to General Instruction G(3) of Form 10-K (the "Proxy Statement"). The information required by this item concerning executive officers is set forth in Part I, Item 1 of this Report. The information required by this item concerning compliance with Section 16(a) of the Exchange Act is incorporated by reference from the section captioned "Compliance with Section 16(a) of the Exchange Act" contained in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference from the section captioned "Executive Compensation and Other Matters" contained in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference from the section captioned "Beneficial Security Ownership of Management and Certain Beneficial Owners" contained in the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference from the section captioned "Certain Relationships and Related Transactions" contained in the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this Form: 3. Exhibits - --------------- * Incorporated by reference to exhibits filed with Registrant's Registration Statement on Form S-1 (Reg. No. 33-92746) as declared effective by the Commission on July 13, 1995. ** Incorporated by reference to exhibits filed with Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1997. *** Incorporated by reference to exhibits filed with Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998. **** Incorporated by reference to exhibits filed with Registrant's Registration Statement on Form S-8 (file no. 333-67877). + Confidential treatment has been granted with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission. (b) Reports on Form 8-K: None. (c) Exhibits. See Item 14(a)(3) above. (d) Financial Statement Schedule. See Item 14(a)(2) above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NOVADIGM, INC. (Registrant) By /s/ WALLACE D. RUIZ ------------------------------------ Wallace D. Ruiz Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Date: June 29, 1999 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Wallace D. Ruiz, as his attorney-in-fact, with full power of substitution, for him in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission. SIGNATURES Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below on June 29, 1999 by the following persons on behalf of the Registrant and in the capacities and on the date indicated: NOVADIGM, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO NOVADIGM, INC.: We have audited the accompanying consolidated balance sheets of Novadigm, Inc. (a Delaware corporation) and subsidiaries as of March 31, 1999 and 1998, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity and cash flows for each of the three years in the period ended March 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Novadigm, Inc. and subsidiaries as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 1999 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying schedule listed in the index to financial statement schedules is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Roseland, New Jersey April 28, 1999 NOVADIGM, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA) ASSETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. NOVADIGM, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements. NOVADIGM, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements. NOVADIGM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements. NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1999 1. THE COMPANY Novadigm, Inc. (the "Company") was incorporated in Delaware in February 1992. The Company designs, markets and supports technology solutions that efficiently and reliably deliver, update and maintain software and content across the extended enterprise. The Company's principal customers include medium to large organizations with widely deployed and heterogeneous B2E, B2B and B2C networks. Prior to 1994, the Company's primary efforts related to completing the development of its software products, designing and implementing a marketing program and obtaining financing to support its operations. In September 1992, the Company completed a public offering of its common stock on the Vancouver Stock Exchange. During the second quarter of fiscal 1994, the Company commenced commercial sales of its products. In June 1994, March 1998 and June 1998, the Company established wholly owned subsidiaries in France, Germany and the United Kingdom, respectively, to act as sales and service offices to the European marketplace. In July 1995, the Company completed a public offering of its common stock on the Nasdaq National Market. The Company is subject to a number of risks, including a history of operating losses, dependence on key individuals, potential competition from larger and more established companies, customer concentration and the ability to penetrate the market with new products. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated. Translation of Foreign Currencies The functional currency of the Company's subsidiaries is its local currency. Accordingly, all assets and liabilities are translated into U.S. dollars at current exchange rates as of the respective balance sheet date. Revenue and expense items are translated at the average rates prevailing during the period. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that effect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. Revenues The Company recognizes revenue in accordance with the provisions of Statement of Position No. 97-2, "Software Revenue Recognition." The Company generates license revenues from licensing the rights to use its software products to end users and sublicense fees from resellers, including certain guaranteed sublicense fees. The Company also generates maintenance and service revenues from providing renewable support and software update rights services (maintenance) and from consulting and training activities performed for license customers. NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 Revenues from perpetual software license agreements are recognized upon shipment of the software if there are no significant post-delivery obligations, payment is due within one year and collectibility is probable. If an acceptance period is required, revenues are recognized upon the earlier of customer acceptance or the expiration of the acceptance period. The Company enters into reseller arrangements that typically provide for sublicense fees payable to the Company based on a percentage of the Company's list price. Reseller arrangements may include an initial non-refundable payment in the form of guaranteed sublicense fees. Guaranteed sublicense fees from resellers are recognized as revenue upon shipment of the master copy of all software to which the guaranteed sublicense fees relate if there are no significant post-delivery obligations, the reseller is creditworthy and if the terms of the agreement are such that the payment obligation is not subject to price adjustment, is non-cancelable and non-refundable and due within 90 days. These guaranteed sublicense fees are applied against sublicense fees reported by the reseller in relicensing the Company's products to end-users. The Company recognized $5.4 million, $0.4 million and $3.9 million in guaranteed sublicense fees under all such agreements in 1999, 1998 and 1997, respectively. At March 31, 1999, approximately 63% of all such guaranteed sublicense fees had been relicensed by the Company's resellers to end-users. Revenues for maintenance are recognized ratably over the term of the support period. If maintenance is included in a license agreement, such amounts are unbundled from the license fee at their fair market value based on the value established by independent sales of such maintenance to customers. Service revenues are primarily related to consulting services performed under separate service arrangements related to the installation and implementation of the Company's software products and the training of customer personnel. Such services generally do not include customization or modification of the underlying software code. If included in a license agreement, such services are unbundled at their fair market value based on the value established by the independent sale of such services to customers. Revenues from consulting and training services are recognized as services are performed. Cost of licenses consist of media and tapes on which the product is delivered. Such costs are not material and are included in research and development expenses in the accompanying consolidated statements of operations. Cost of maintenance and services includes the direct and indirect costs of providing technical support, consulting and training services to the Company's customers. Cost of maintenance and services consists primarily of payroll and benefits for field engineers and support personnel, other related overhead and third party consulting fees. Deferred revenue primarily relates to maintenance, consulting, and training services which have been paid by the customers prior to the performance of those services. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Concentrations of Credit Risk Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of temporary cash investments, marketable securities and accounts receivable. The Company has investment policies that restrict placement of these investments to financial institutions evaluated as highly creditworthy. The Company generally does not require collateral on trade accounts receivable as the Company's customer base consists of large, well-established companies and governmental entities. As of March 31, 1999 and 1998, approximately 23% and 46%, respectively, of accounts receivable are concentrated NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 with 2 customers who are large, well-established companies that the Company has determined are creditworthy. Marketable Securities In April 1994, the Company adopted the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). In accordance with SFAS 115, the Company's marketable securities which are composed of commercial paper, government and government-backed notes and corporate notes are classified as held-to-maturity. Held-to-maturity securities represent those securities that the Company has both a positive intent and ability to hold to maturity and are carried at amortized cost. Held-to maturity securities at March 31, 1999 (in thousands) of $13,412 were invested in commercial paper with a variety of large, well-established and highly rated companies. Proceeds from redemption of held-to-maturity securities were approximately $33.6 million in 1999. At March 31, 1999, approximately $3.5 million of held-to-maturity securities with original maturities of three months or less were included in cash and cash equivalents. Fair Value of Financial Instruments The carrying amounts of the Company's financial instruments, including cash and cash equivalents, accounts receivable and accounts payable approximate their fair values. Property and Equipment Property and equipment is stated at historical cost and consists of the following at March 31, (in thousands): Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the assets as follows: Long-Lived Assets The Company has adopted the provisions of Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-lived Assets" ("SFAS 121"). SFAS 121 requires, among other things, that an entity review its long-lived assets and certain related intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. As a NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 result of its review, the Company does not believe that any impairment currently exists related to its long-lived assets. Software Development Costs Under the provisions of Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed," software development costs are capitalized upon the establishment of technological feasibility, which the Company defines as establishment of a working model. Capitalized software development costs require a continuing assessment of their recoverability. This assessment requires considerable judgment by management with respect to various factors including, but not limited to, anticipated future gross product revenues, estimated economic lives and changes in software and hardware technology. Amounts which could have been capitalized under this statement, after consideration of the above factors, were immaterial to the Company's results of operations and financial position. Therefore, the Company has expensed all software development costs and included those costs in research and development expenses in the accompanying consolidated statements of operations. Earnings per Share In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128") which requires the presentation of basic earnings per share ("Basic EPS") and diluted earnings per share ("Diluted EPS"). Basic EPS is calculated by dividing income available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted EPS is calculated by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period adjusted to reflect potentially dilutive securities. In accordance with SFAS 128, the following table reconciles income and share amounts used to calculate basic earnings per share and diluted earnings per share. 3. REVOLVING LINE OF CREDIT AGREEMENT The Company entered into a $1.0 million unsecured revolving line of credit agreement with a bank, which expires in September 1999. Borrowings bear interest at the bank's reference rate (7.75% as of March 31, 1999). The agreement includes a provision that prohibits the Company from paying dividends and requires the Company to meet certain financial covenants. As of March 31, 1999, the Company had no outstanding borrowings under the agreement. NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 4. COMMITMENTS AND CONTINGENCIES The Company has various leases for its facilities under non-cancelable operating lease agreements. Rent expense incurred under these agreements in fiscal 1999, 1998 and 1997 was approximately $1,059, $928 and $659, respectively. During 1997, the Company entered into an amendment of the lease for its headquarters. Under the amendment, the Company extended the lease term for its original leased space and entered into a commitment for additional space. Future minimum commitments under all facility leases are as follows (in thousands): The Company is contingently liable with respect to lawsuits and other matters which arise in the normal course of business. Management believes that the outcome of such contingencies will not have a material adverse effect on the Company's financial position or results of operations. 5. COMMON STOCK In July of 1995, the Company completed a public offering in the United States of 2,875,000 shares of common stock (which included 500,000 shares sold by stockholders) at $15 per share, resulting in net proceeds to the Company of approximately $32.2 million after offering costs. The Company's shares trade on the Nasdaq National Market. In May of 1996, the Board of Directors approved the repurchase of up to 500,000 shares of the Company's common stock. As of March 31, 1998, the Company repurchased 500,000 shares, expending approximately $3.1 million. Approximately 369,000 and 90,000 of these shares were resold by the Company in fiscal 1999 and 1998, respectively for the exercise of stock options under the Company's stock option plan. 6. STOCK OPTIONS AND STOCK PURCHASE PLAN Under the Company's 1992 Stock Option Plan, as amended (the "Plan"), the Board of Directors may grant incentive and nonqualified stock options to employees, directors and consultants. Incentive options are granted at no less than fair market value at the date of grant based upon the price per share of the Company's stock on the Nasdaq National Market. Nonqualified options are granted at no less than 85% of fair market value at the date of grant. Option terms may not exceed five years and vesting is determined by the Board of Directors for each individual grant (generally four years). In June 1998, the Board of Directors approved an amendment to the Plan allowing for option terms of up to ten years, excluding options granted to officers and directors. The Plan will continue in effect until June 9, 2002, unless terminated sooner. During fiscal 1998, the shareholders approved an amendment to the Plan increasing the number of shares of common stock reserved for issuance under the Plan to 5,200,000 shares. NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 The following table summarizes the option activity (in thousands, except per share amounts): At March 31, 1999, 1,398,060 options are vested and exercisable and 4,187,072 shares of common stock are reserved for future issuance under the Plan. The weighted average exercise price of exercisable options at March 31, 1999 is $4.66 per share. During fiscal 1997, the Company canceled 1,945,000 options with prices ranging from $6.88 to $28.38 that had been granted prior to October 1996 and replaced them with 1,945,000 options at $5.25 each, which was the market price at the date of repricing. The effect of this transaction is treated as a cancellation of the old options and the grant of new options in accordance with the provisions of the Plan. The new options had the vesting period extended by three months. On May 17, 1995 the Board of Directors adopted the Company's Employee Stock Purchase Plan (the "Purchase Plan"), which was approved by the stockholders at the Company's annual meeting on November 17, 1995. A total of 1,000,000 shares of Common Stock was reserved for issuance under the Purchase Plan. The Purchase Plan covers substantially all employees in the United States. The participants' purchase price is the lower of 85% of the closing price on the first trading day of the six-month trade period or the last trade day of the period. Approximately 58,000 shares and 75,000 shares were purchased by employees under the Purchase Plan in fiscal 1999 and 1998, respectively. At March 31, 1999, the Company has reserved approximately 805,000 shares for future issuance. In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation", which establishes a fair value-based method of accounting for stock-based compensation plans and requires additional disclosures for those companies who elect not to adopt the new method of accounting. The Company adopted SFAS 123 in fiscal 1997 and in accordance with the provisions of SFAS 123, the Company applies APB Opinion 25 and related interpretations in accounting for its stock option and stock purchase plans. Had compensation cost for NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 these plans been determined consistent with SFAS 123, the Company's net loss and loss per share would have resulted in the following pro forma amounts indicated in the table below: Because the SFAS 123 method of accounting has not been applied to options granted prior to April 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. The weighted average fair values of options granted fiscal 1999, 1998 and 1997 were $2.81, $3.04 and $5.32, respectively. The options outstanding at March 31, 1999, have exercise prices between $2.45 and $8.25, with a weighted average exercise price of $4.54 and a weighted average remaining contractual life of 3.0 years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in fiscal 1999, 1998 and 1997: risk free interest rates ranged from 6.1% to 6.4%, expected dividend yields of 0%, expected lives of 5.0 years and expected volatility of 90%. 7. INCOME TAXES The Company accounts for income taxes pursuant to Statement of Financial Accounting Standards No. 109 ("SFAS 109") "Accounting for Income Taxes". SFAS 109 provides for an asset and liability approach to accounting for income taxes under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which taxes become payable. The components of the provision (benefit) for income taxes are as follows (in thousands): NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 The components of the net deferred tax asset at March 31, 1999 and 1998 are as follows (in thousands): As of March 31, 1999 the Company has net operating loss carryforwards for federal income tax reporting purposes of approximately $15.4 million. These carryforwards expire in various periods through 2013. The Company's ability to utilize the net operating loss carryforwards in future years may be limited in some circumstances, including significant changes in ownership interests, due to certain provisions of the Internal Revenue Code of 1986. The provision (benefit) for income taxes for the years ended March 31 differs from the statutory U.S. Federal income tax rate due to the following: 8. MAJOR CUSTOMERS During 1999, two customers, Amdahl and Esoft accounted for approximately 17% and 12% of total revenues, respectively. During 1998, two customers, Amdahl and EDS, accounted for approximately 31% and 10% of total revenues, respectively. During 1997, two customers, IBM and Amdahl, accounted for approximately 23% and 16% of total revenues, respectively. In June 1995, the Company entered into a seven-year, non-exclusive OEM and distribution agreement with Amdahl. Under the agreement, Amdahl can sublicense EDM throughout the world as part of its bundled solution and sublicense EDM stand-alone to a limited worldwide market. Novadigm agreed to provide limited technical support and training. The agreement required Amdahl to pay the Company $8 million in minimum royalties in fiscal 1996; and $4 million in minimum royalties in each of fiscal 1997 and fiscal 1998. The agreement was amended in March 1997, instead requiring Amdahl to pay $2 million in minimum royalties in each of fiscal 1997 and fiscal 1998; and minimum additional royalties of $3 million in each of fiscal 1999 and fiscal 2000. In the event of a change of control of the Company, the amended agreement allows Amdahl the right to terminate the agreement and recover unused guaranteed sublicense fees at the time of termination, to the extent they were also outstanding on March 31, 1997. Though Amdahl renewed the agreement at the end of 1999, there can be no assurance that Amdahl will extend this agreement in subsequent years. The Company recognized no guaranteed sublicense fees from Amdahl in 1999 and 1998, and $1.8 million in fiscal 1997. NOVADIGM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MARCH 31, 1999 9. INDUSTRY AND GEOGRAPHIC SEGMENT INFORMATION The Company has adopted the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 131, ("SFAS 131"), disclosures about segments of an enterprise and related information, effective for fiscal years beginning after December 31, 1997. SFAS 131 supersedes Statement of Financial Accounting Standards No. 14, ("SFAS 14"), Financial Reporting for Segments of a Business Enterprise. SFAS 131 changes current practice under SFAS 14 by establishing new standards to report information about operating segments in annual and interim financial statements based on the approach that management utilizes to organize the segments within the Company for management reporting and decision making. The Company's software products and related services are developed and marketed to support heterogeneous client/server and Internet computing environments for medium and large-scale enterprises. The Company markets its products and related services to customers in North America, Europe, the Pacific rim, Africa and South America. The Company's international revenue represents products shipped from the United States directly to end-users outside the Untied States. The Company does not sell products directly to its international subsidiaries. Revenue and long-lived-asset information by geographic area as of and for the year ended: 10. RESTRUCTURING CHARGE The Company recorded a $1.8 million restructuring charge in fiscal 1997 to reflect reorganization of the North American and European sales and marketing organizations. The significant provisions included in the restructuring charge (in thousands) were: The restructuring charge included severance for the termination of 29 employees, the costs to close and consolidate five regional sales offices and the Chicago-based marketing office, and the costs to realign distribution channels in Europe. As of March 31, 1997, no material payments had been made under the restructuring program. During fiscal 1998, the above restructuring charges were paid in full. NOVADIGM, INC. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) EXHIBIT INDEX - --------------- * Incorporated by reference to exhibits filed with Registrant's Registration Statement on Form S-1 (Reg. No. 33-92746) as declared effective by the Commission on July 13, 1995. ** Incorporated by reference to exhibits filed with Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1997. *** Incorporated by reference to exhibits filed with Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998. **** Incorporated by reference to exhibits filed with Registrant's Registration Statement on Form S-8 (file no. 333-67877). + Confidential treatment has been granted with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission.

106473_1999.txt

106473_1999

1999

106473

ITEM 1. BUSINESS GENERAL Roy F. Weston, Inc. (the Company) is an infrastructure redevelopment organization that provides integrated environmental engineering solutions to produce economic value for industrial and governmental clients. The Company's services include development of cost-effective technologies and solutions to environmental problems; selection of sites, assistance in obtaining governmental permits, and the preparation of specifications and designs for constructing remedial systems and facilities; and construction, startup and operation of facilities. These services are made available to clients through the Company's staff of professional and support personnel in offices worldwide. The Company assists its clients from the initial identification and definition of a problem, through the planning, evaluation and design stages, to the implementation of cost-effective, technologically feasible, and publicly acceptable solutions. Since its incorporation in 1957, the Company has been a pioneer in providing solutions to environmental, health and safety problems. As environmental concerns have grown in complexity and become the subject of heightened public awareness and extensive governmental regulation, the Company's strategy has been to build an organization with a high level of sophisticated professional skills and a broad range of scientific, technological and management resources. The Company uses a total systems approach that involves studying its clients' needs and providing cost-effective, customized solutions that address those needs. The Company's business strategy includes regular evaluation of opportunities to acquire, make investments in, or enter into joint ventures or other strategic alliances with, companies whose business complement the Company's business, some of which could be material. SERVICES The Company is pursuing infrastructure redevelopment as its primary market focus. Infrastructure involves physical resources - structures, facilities, plants and equipment, as well as land and other natural resources that are vital to the economic life of society. Redevelopment entails undoing the adverse environmental consequences of past development activities and restoring damaged resources to productive uses. Infrastructure redevelopment helps clients decide whether and how to make positive changes in the character or condition of their property. Infrastructure redevelopment is being pursued by the Company for a number of reasons. Demand for regulatory-driven environmental services, which are still a major source of business for the Company, has been declining. While the Company intends to maintain such services, it sees its long term opportunities in infrastructure redevelopment services where the market has been growing. The Company provides its services by combining its professional skills and technological resources in an integrated systems approach, which uses technical information and program management capabilities as well as cost control systems. The Company's service lines include infrastructure redevelopment, federal program management, and knowledge systems and solutions. Information about net revenues, segment profit (loss) and total assets for 1999 and 1998 is included in Note 16 to the Consolidated Financial Statements on page 34 of the Company's 1999 Annual Report to Shareholders and is incorporated herein by reference. INFRASTRUCTURE REDEVELOPMENT The Company's infrastructure redevelopment services involve the identification and characterization of a client's problems; the evaluation of alternative solutions; and the selection, design and development of a technologically feasible, cost-effective, and politically acceptable solution. The Company's trained professionals who provide these services are drawn from many different scientific and technological disciplines to assess the long-term effects and the risks associated with the environmental impact of clients' activities and products. In performing feasibility studies and environmental impact and risk assessments, the Company's professionals examine the relative effectiveness of various technological approaches for achieving permanent solutions and ensuring that additional environmental concerns are not created in the course of solving the primary problem. The Company applies its skills to all phases of environmental matters and related problems, including those relating to site remediation, redevelopment, and infrastructure operations support. SITE REMEDIATION. Site remediation services include site assessment, design, construction, treatment systems, and high-hazard remediation. Site assessments help clients avoid unnecessary litigation, reduce costs, and provide useable remediation plans. Design services provided include environmental systems, wastewater treatment, hazardous/toxic disposal facilities, and incinerators and landfills. Construction services include a full range of services required to develop and implement remedial action programs. Among such services are earthmoving, road construction, utility installation, and equipment erection. Treatment systems services focus on innovative technologies, including bioremediation, soil vapor extraction, soil and sediment washing, thermal desorption, composting/biodegradation of organics, and in situ recirculating well technology. High-hazard remediation services include unexploded ordnance cleanup, nuclear decontamination and demolition, chemical demilitarization, and radioactive waste site remediation. REDEVELOPMENT. Redevelopment services include impaired property redevelopment, ports and waterways, water and wastewater consulting and design, water and wastewater alternate delivery and contract operations, and municipal infrastructure support. Impaired property redevelopment comprises reuse analysis, preparation of risk management, plans and transfer of property. Ports and waterways services include environmental management solutions, navigation studies/dredged material management, treatment of contaminated sediments, and redevelopment of impaired marine properties. Water and wastewater consulting and design include negotiation of wastewater discharge permits, planning and design of wastewater treatment systems, and designing and implementing pollution prevention, monitoring, and compliance programs. Water and wastewater alternate delivery and contract services focus on design/build, facility ownership, and operations and maintenance of water and wastewater treatment facilities. Municipal infrastructure support services include those provided to airports, schools, landfills, and city planning and redevelopment. INFRASTRUCTURE OPERATIONS SUPPORT. Infrastructure operations support services include environmental management systems, permitting and compliance management, emissions testing, and health and safety program services. Environmental management systems comprise business management, strategic services, systems development, and outsourcing. Permitting and compliance management services are provided for air quality, solid and hazardous waste, health and safety, and natural resources. Emissions testing services include selecting samples and analyzing for pollutants using mobile equipment transported to the client's site. Health and safety program services include needs assessment, program evaluation and development, training, regulatory compliance, exposure monitoring, contractor oversight and information management. FEDERAL PROGRAMS MANAGEMENT Federal program management involves all phases of large-scale environmental, health and safety problems of government. The Company has the resources and technical abilities to accept overall responsibility for siting, evaluating, designing, implementing, and managing environmental programs, and to apply its diversified services, as appropriate, in an integrated systems approach. The Company provides the management systems and the direct involvement of its management to deal with the complexities of the underlying environmental problems, as well as the commitment of large numbers of personnel at geographically dispersed sites for extended time frames. The Company typically bids for contracts as the prime contractor and forms subcontractor teams in those instances where subcontractors provide expertise and staffing that enhance the Company's ability to obtain and perform contracts. Subcontractors may, from time to time, include certain competitors of the Company. KNOWLEDGE SYSTEMS AND SOLUTIONS Knowledge Systems and Solutions services include decision support systems, such as Geographic Information Systems, Facilities Management Systems, and Workflow Automation Systems to assist clients with managing geographically distributed assets (e.g., water utilities, gas transmission companies, etc.) The Company's data management services include records management, historical data loading and database software solutions tailored to environmental remedial investigation and feasibility studies. On-line products and services, such as Internet-based virtual communities, web-based project collaborative workspaces, and other sophisticated on-line products and services help clients more effectively collaborate, access information, and transact business over electronic networks. CUSTOMERS AND MARKETING The Company's marketing strategy emphasizes its ability to offer a broad range of specialized services designed to meet the needs of its clients in a timely and cost-efficient manner. The Company has the capability to undertake not only small tasks requiring a few professionals, but also management, staffing, design and implementation of major projects that may last for several years and involve many employees in several geographic locations. The Company's marketing efforts are directed from offices nationwide to three client sectors: the federal government; private industry; and state and local government. The Company's senior professionals are responsible for directing the execution of projects, monitoring quality assurance, and integrating the delivery of the Company's services. They also develop and maintain long-term working relationships with clients' management. The Company participates in industrial trade shows and technical conferences concerning environmental and health and safety issues, and sponsors related technical seminars. FEDERAL GOVERNMENT In the federal sector, the Company performs contracts for the U.S. Department of Defense (DOD), the U.S. Environmental Protection Agency (EPA) and the U.S. Department of Energy (DOE), as well as for other federal agencies. The Company develops comprehensive waste management and remediation programs at many priority sites throughout the country. The Company derived 54%, 56% and 56% of its consolidated gross revenues from the federal government for the years ended December 31, 1997, 1998 and 1999, respectively. Gross revenue percentages from the DOD, EPA and DOE for each of the fiscal years are as follows: PERCENTAGES OF CONSOLIDATED GROSS REVENUES FOR THE YEARS ENDED DECEMBER 31 The Company is a major provider of services to the federal government and thus is subject to audit with respect to costs and fees charged to the federal government. Revenues associated with federal overhead rates under government cost reimbursable contracts are adjusted when variances are determined on at least an annual basis. Provisions for losses on contracts are recorded when they are identified. As a result of its government contracting business, the Company is, has been, and may in the future be subject to audits and investigations by government agencies. In addition to potential damage to the Company's business reputation, the failure by the Company to comply with the terms of any of its government contracts could also result in fines, penalties or in the Company's suspension or debarment from future government contracts for a significant period of time. Such fines and penalties, or the Company's suspension or debarment could have a material adverse effect on the Company's business, particularly in light of its significance to the Company's consolidated revenues. PRIVATE INDUSTRY The Company provides a full range of services for industrial clients. Service to industrial clients provided 30%, 26% and 27% of the Company's gross revenues in 1997, 1998 and 1999, respectively. In addition to complying with regulatory requirements, companies are recognizing that the environmental impact must be considered from the inception of a product, throughout its use and final disposal. Corporate clients, which range from small business concerns to Fortune 100 companies, are offered a wide range of consulting, construction, remediation and redevelopment, and knowledge systems and solutions services. Market segments served include manufacturing, chemicals and allied products, petroleum, forest products, high technology, telecommunications, and utilities. STATE AND LOCAL GOVERNMENT The Company provides consulting and construction redevelopment services to many state and local governments and agencies. Services to state and local government clients provided 16%, 18% and 17% of the Company's gross revenues in 1997, 1998 and 1999, respectively. A growing number of cities, regional authorities, and state governments are instituting long-range programs to update essential facilities. Because these projects require comprehensive planning and engineering, they are expected to continue to be an important component of the Company's business. Typical projects include the design of water supply and wastewater systems; solid waste management; asbestos management; computer-based geographic mapping; and landfill design. COMPETITION The Company's markets are very competitive and require highly skilled, experienced technical and management personnel. Competition is based on, among other things, reputation, quality of service, price, expertise and local presence. In each of its specific service areas, the Company competes with many firms that are both larger and smaller than the Company, although the Company believes that no firm currently dominates any significant portion of those service areas. Many of the Company's competitors have greater financial resources than the Company. PATENTS AND TECHNOLOGY The Company owns six patents on certain remediation technologies and has filed additional patent applications. The Company also claims copyright and trade secret protection on certain of its computer software, publications and technologies. The Company does not believe that such patents and copyrights are a material factor in its business. BACKLOG The Company's net contract backlog (excluding estimated project expenses that are directly passed through to customers) was $67.5 million and $61.0 million at December 31, 1999 and 1998, respectively. Additionally, the Company derives revenues from open order contracts and from activities related to emergency response. As work assignments are approved and funded, the Company includes these amounts in its contract backlog. Some contracts are subject to cancellation by the customer, changes in scope of work, and delays in project startup, therefore, the amounts reflected in backlog may not all be realized as net revenues. The Company anticipates that the majority of its backlog will be realized in the current fiscal year. POTENTIAL LIABILITY AND INSURANCE A substantial portion of the Company's gross revenues is derived from work involving hazardous materials, toxic wastes, and other pollutants. Such efforts frequently entail significant risks of liability to the Company for environmental damage, personal injury, and fines and costs imposed by regulatory agencies. A substantial number of the Company's contracts require indemnification of a client for performance claims, damages or losses incurred during the performance of the Company's operations. The Company has been able to insure against most liabilities it incurs in connection with the conduct of its business. The Company has obtained coverage with commercial carriers to insure against pollution liability claims. Although this insurance covers many of the Company's environmental exposures, there are instances where project-specific pollution insurance policies are necessary. The Company will continue to evaluate exposures associated with each project to determine if additional coverage is necessary. The Company continues to be partially self-insured through its subsidiary, Cardinal Indemnity Company of North America (Cardinal), a wholly-owned insurance company. Cardinal provides professional liability and pollution coverage for deductible amounts under the Company's commercial insurance coverage. While the insurance carried by the Company may not be sufficient to cover all claims that may arise, and while insurance carriers may not continue to make coverage available to the Company, management believes it has provided an adequate level of insurance. The Company has also attempted to contractually protect itself through agreements with its clients to limit its liability, although the Company has not always been successful in obtaining such agreements. Most of the Company's contracts with EPA involving Superfund monies and some state contracts that employ federal Superfund appropriations contain provisions whereby the respective governmental agency agrees to indemnify the Company for third-party claims to the extent that such claims are not covered by insurance and appropriated funds are available, although the Company does not receive any assurance that any such appropriated funds will be made available. EPA has issued Final Response Action Contractor Indemnification Guidance (the Indemnification Guidance) applicable to contracts signed on or after October 16, 1986, the terms of which limit EPA's contractor indemnification under certain Superfund contracts retroactively to 1986, and prospectively, under certain circumstances. The Indemnification Guidance states that future contracts will not provide for indemnification unless EPA is unable to obtain responsible, competitive proposals without such an indemnification. The Company sometimes contracts with DOE to perform remedial work at various DOE facilities within the United States. On occasion, these contracts may involve the handling or other disposition of radioactive materials. In these contracts, DOE typically provides the Company with protection from potential third party claims arising out of "nuclear incidents," by including an indemnification clause authorized under the Price Anderson Act of 1988. The indemnity provides over $9 billion in "nuclear hazards" coverage. Congress is currently considering an extension of the Price Anderson Act, which will expire on August 1, 2002. The Company has also developed and implemented improvements to its quality assurance and health and safety programs. These programs establish certain minimum requirements for all project work and provide guidance for the development of quality assurance plans and health and safety plans on all projects. The objective of the quality assurance program is to provide assurance that project performance is of appropriate quality for the project requirements. The objective of the health and safety program is to protect project personnel from exposure to hazardous substances and situations. The scope of both programs includes the establishment of policy and procedures, staff training and operational review and audit. The Company and its employees are also subject to various state, local, and federal licenses, laws and regulations, and believes that it is in compliance with all material requirements. PERSONNEL As of December 31, 1999, the Company had approximately 1,650 employees, many of whom had advanced degrees in a variety of technical disciplines. Of these, 37 employees held doctorates, 381 held master's degrees, and 130 were registered professional engineers. The Company's ability to remain competitive depends on its ability to attract and retain qualified personnel. REGULATIONS Demand for the Company's services is affected by laws and regulations, the reauthorization, modification or elimination of which could significantly affect the Company's business. The reauthorization of several major federal environmental laws that have a significant impact on the work of the Company remains on the agenda of Congress. These include statutes that: - Protect the chemical, physical and biological integrity of water in the United States (such as the Clean Water Act of 1977 and associated state laws); - Regulate the handling of hazardous waste and mandate state oversight of solid waste (such as the Resource Conservation and Recovery Act of 1976 and associated state laws); - Regulate the identification, remediation and accountability for hazardous waste sites (such as the Superfund Amendments and Reauthorization Act of 1986 and associated state laws). In addition, administrative regulations mandated by the 1990 amendments to the Clean Air Act are likely to play a significant role in the Company's services to its industrial clients in the areas of emission and ambient air monitoring, air quality modeling and permitting, and assistance with compliance certification. In addition, new federal and state regulations are continually being considered which, if adopted, could materially impact the Company's business. The principal federal laws that affect the Company's business are: THE COMPREHENSIVE ENVIRONMENTAL RESPONSE, COMPENSATION, AND LIABILITY ACT OF 1980 (CERCLA OR SUPERFUND) AND SUPERFUND AMENDMENTS AND REAUTHORIZATION ACT (SARA) OF 1986: CERCLA addresses past waste disposal practices by providing means for identifying and remediating hazardous waste sites. The law authorizes EPA to compel responsible parties to remediate abandoned sites. Where initial enforcement actions would result in lengthy delays or where responsible parties cannot readily be identified, CERCLA authorizes funds for cleanups. Congress enacted SARA in 1986 to amend CERCLA and reauthorize Superfund. SARA strengthens EPA's authority to conduct short- and long-term enforcement and expands state involvement in the cleanup process. SARA also expands EPA's commitment to research and development, training, health assessments, and public participation. Sites considered to be most in need of remediation are ranked on EPA's National Priorities List (NPL). By March 2000, some 1,281 federal and nonfederal sites were listed or proposed for the NPL, and some 10,800 other hazardous waste sites remained on the CERCLA inventory of potential trouble spots. THE CLEAN WATER ACT (CWA): Amended in February 1987, the CWA authorized federal revolving loan funds through 1996 for construction grants and startup money to build wastewater treatment plants. Additional funds were appropriated for fiscal years 1997, 1998, 1999 and 2000. The Company believes that the CWA is accelerating the market for the municipal wastewater treatment plant design and construction services provided by the Company. Controls imposed by the CWA on toxic effluents also are stimulating industrial expenditures. THE RESOURCE CONSERVATION AND RECOVERY ACT OF 1976 (RCRA): RCRA controls the present and future management of newly generated hazardous wastes by mandating that private industry -- generators, transporters and disposers -- monitor and regulate their disposal of such wastes. As a result of the growing emphasis on the minimization of industrial process wastes, the increasing shortage of hazardous waste management facilities, and the considerable costs associated with disposal, RCRA will continue to be a key regulatory program. THE CLEAN AIR ACT (CAA) AND CLEAN AIR ACT AMENDMENTS (CAAA): The CAAA of 1990 charged EPA with promulgating more than 400 regulations and developing guidelines and procedures in the ensuing 10 years. The sweeping provisions of the CAAA are designed to diminish three major threats to the environment: acid rain, urban air pollution, and air toxic emissions. The revisions also establish a national permit program and a stronger enforcement program to make the CAA easier to monitor and ensure compliance. The CAA and the CAAA should continue to increase the Company's activities in emission and ambient air monitoring, air quality modeling, and permitting assistance to its industrial clients. Compliance certification, including the development and implementation of data management and reporting systems, should expand the Company's services to industry. The Company currently is pursuing business opportunities related to the restoration and development of environmentally impaired properties, sometimes referred to as "Brownfields." To the extent it does so as an investor or lender, it and other companies in this arena may be affected by the "Asset Conservation, Lender Liability and Deposit Insurance Protection Act of 1996." This federal law, and similar state laws, may limit to some degree the Company's potential liability under CERCLA, and RCRA (and State counterparts) as related to its brownfields work, should it ultimately need to take title to or obtain an ownership interest in the property in connection with efforts to recover on its loan or investment. The Company believes that in addition to services required by CERCLA, RCRA, CWA and CAA, other federal laws affect demand for the Company's services in the private and public sectors. These include the Safe Drinking Water Act, the National Environmental Policy Act, the Nuclear Waste Policy Act, the Toxic Substances Control Act, the Occupational Safety and Health Act, the Intermodal Surface Transportation and Efficiency Act, the Federal Facilities Compliance Act, and the Energy Policy Act. ITEM 2. ITEM 2. PROPERTIES The Company's principal offices are located on a 53-acre tract in West Whiteland Township, Chester County, Pennsylvania, in the suburbs of Philadelphia, and include five major buildings providing a total of approximately 150,000 square feet of space. The Company also leases an aggregate of approximately 469,000 square feet of office space in offices located in 24 states and the District of Columbia. Aggregate lease payments in 1999 were $15.5 million, of which $10.2 million were subject to direct reimbursement from projects. Approximately 87,000 square feet of such space has been subleased to third parties. These leases for office facilities are generally for 5 years or less. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is subject to certain claims and lawsuits in connection with work performed in the ordinary course of its business. In the opinion of management, such claims and lawsuits currently pending are either adequately covered by insurance or will not result in a material adverse effect on the financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information with respect to this item is incorporated by reference herein from the information in the Company's 1999 Annual Report to Shareholders in Notes 6 and 7 to the Consolidated Financial Statements on pages 25 to 26 and under the headings "Company Stock Listing" and "Stock History" on the inside back cover. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information with respect to this item is incorporated by reference herein from the information in the Company's 1999 Annual Report to Shareholders on page 15. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information with respect to this item is incorporated by reference herein from the information in the Company's 1999 Annual Report to Shareholders on pages 10 to 14. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not Applicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (a) Information with respect to this item is incorporated by reference herein from the information in the Company's 1999 Annual Report to Shareholders on pages 15 to 35. (b) Selected Quarterly Financial Data (Unaudited) are set forth in Note 18 to the Consolidated Financial Statements contained in the Company's 1999 Annual Report to Shareholders on page 35 and are incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS Information with respect to this item is set forth in the Company's definitive Proxy Statement, (the "Proxy Statement") to be filed with the Securities and Exchange Commission, for the Annual Meeting of Shareholders expected to be held on May 15, 2000, under the headings "Election of Directors", "Executive Management" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information with respect to this item is set forth in the Proxy Statement under the heading "Executive Management" and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information with respect to the ownership of securities of the Company is set forth in the Proxy Statement under the heading "Principal Shareholders" and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information with respect to certain transactions with management and others is set forth in the Proxy Statement under the headings "Executive Management - Compensation Committee Interlocks and Insider Participation" and "Executive Management - Other Relationships and Related Transactions" and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: 1. Consolidated Financial Statements: The information appearing in the Company's 1999 Annual Report to Shareholders as described in Item 8 is incorporated herein by reference. 2. Financial Statement Schedule: - Report of Independent Accountants - Schedule II - Valuation and Qualifying Accounts All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. With the exception of the consolidated financial statements and the independent accountants' report thereon listed in the above index, the information referred to in Items 5, 6, and 7, and the supplementary quarterly financial information referred to in Item 8, all of which are included in the 1999 Annual Report to Shareholders of Roy F. Weston, Inc. and incorporated by reference into this Annual Report on Form 10-K, the 1999 Annual Report to Shareholders is not to be deemed "filed" as part of this report. 3. Exhibits: The following exhibits are filed herewith unless otherwise indicated: EXHIBIT NO. DESCRIPTION 3.1 Articles of Incorporation of the Company. Incorporated by reference to Exhibit 3(a) to the Company's Registration Statement on Form S-1 (Registration No. 33-20834) ("No. 33-20834"). 3.2 Amended By-Laws of the Company. Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 4.1 Indenture between the Company and Mellon Bank, N.A. relating to the 7% Convertible Subordinated Debentures due April 15, 2002. Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-1 (Registration No. 33-13020) ("No. 33-13020"). 4.2 Trusteeship Transfer Agreement between PNC Bank, N. A., First Trust of New York, N.A. and the Company dated March 1, 1996, relating to the 7% Convertible Subordinated Debentures due April 15, 2002. Incorporated by reference to Exhibit 4.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. 10.1 Form of the Company's Retirement Supplement to Split Dollar Life Insurance Agreement. Incorporated by reference to Exhibit 10 (c) to the Company's Registration Statement on Form S-1 (Registration No. 33-5914) ("No. 33-5914"). 10.2 Form of the Company's Executive Supplemental Benefit Plan - Supplemental Retirement Agreement. Incorporated by reference to Exhibit 10(d) to No. 33-5914. 10.3 The Company's Stock-Based Incentive Compensation Plan. Incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 10.4 The Company's Retirement Income Restoration Plan, as amended. Incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 10.5 The Company's Director Stock Compensation Plan. Incorporated by reference to the Appendix to the Company's Proxy Statement for the 1999 Annual Meeting of Shareholders dated April 7, 1999. 10.6 Elective Deferred Compensation Agreement between William L. Robertson and the Company dated December 23, 1997. Incorporated by reference to Exhibit 10.20 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 10.7 Continuing Services/Retirement Agreement between Roy F. Weston and the Company dated July 19, 1997. Incorporated by reference to Exhibit 10.11 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997. 10.8 Stock Pooling Agreement among the Company and certain holders of the Company's Common Stock effective January 2, 1998. Incorporated by reference to Exhibit 10.29 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 10.9 Credit Agreement between the Company and Bank of America National Trust and Savings Association dated as of June 5, 1998. Incorporated by reference to Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998. EXHIBIT NO. DESCRIPTION 10.10 First Amendment to Credit Agreement between the Company and Bank of America National Trust and Savings Association dated August 14, 1998. Incorporated by reference to Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998. 10.11 Second Amendment to Credit Agreement between the Company and Bank of America National Trust and Savings Association dated as of October 15, 1998. 10.12 Third Amendment to Credit Agreement between the Company and Bank of America National Trust and Savings Association dated as of March 31, 1999. Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999. 10.13 Fourth Amendment and Waiver to Credit Agreement between the Company and Bank of America National Trust and Savings Association dated as of November 15, 1999. 10.14 Consulting Services Agreement between the Company and Katherine W. Swoyer effective July 1, 1998. Incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998. 10.15 Amended Employment Agreement between William L. Robertson and the Company dated as of March 20, 2000. 10.16 Amended Employment Agreement between Patrick G. McCann and the Company dated as of March 20, 2000. 10.17 Amended Employment Agreement between William G. Mecaughey and the Company dated as of March 20, 2000. 10.18 Investment and Partnering Agreement between Essential Technologies, Inc. and the Company effective December 21, 1999. 10.19 Master Services Agreement for Consulting Services between Infrastructure Revitalization Institute and the Company dated November 11, 1999. 10.20 Termination Agreement between International Corporate Travel Services and the Company dated May 28, 1998. Incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998. 11 Computation of Basic and Diluted Earnings (Loss) per Share. 13 The Company's 1999 Annual Report to Shareholders. 21 Subsidiaries of the Company. 23 Consent of Independent Accountants. 27 Financial Data Schedule. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the fourth quarter of 1999. Note: Any of the exhibits listed in the foregoing index not included with this Annual Report on Form 10-K may be obtained without charge by writing to Arnold P. Borish, Esq., Corporate Secretary, Roy F. Weston, Inc., 1400 Weston Way, P.O. Box 2653, West Chester, Pennsylvania 19380. REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors and Stockholders Roy F. Weston, Inc. Our report on the consolidated financial statements of Roy F. Weston, Inc. and Subsidiaries has been incorporated by reference in this Form 10-K from page 15 of the 1999 Annual Report to Shareholders of Roy F. Weston, Inc. and Subsidiaries. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in the index on page 12 of this Form 10-K. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. PRICEWATERHOUSECOOPERS, LLP February 3, 2000 ROY F. WESTON, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (THOUSANDS OF DOLLARS) SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, ROY F. WESTON, INC. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized: ROY F. WESTON, INC. By: s/WILLIAM L. ROBERTSON ------------------------------- William L. Robertson Date: March 27, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the dates indicated. NAME TITLE DATE s/WILLIAM L. ROBERTSON Chief Executive Officer and Director March 27, 2000 - ------------------------ (Principal Executive Officer) William L. Robertson s/PATRICK G. MCCANN President and March 27, 2000 - ------------------------ Chief Operating Officer Patrick G. McCann (Principal Operating Officer) s/WILLIAM G. MECAUGHEY Vice President and March 27, 2000 - ------------------------ Chief Financial Officer William G. Mecaughey (Principal Financial Officer) s/RICHARD L. ARMITAGE Director March 27, 2000 - ------------------------ Richard L. Armitage s/JESSE BROWN Director March 27, 2000 - ------------------------ Jesse Brown s/THOMAS E. CARROLL Director March 27, 2000 - ------------------------ Thomas E. Carroll s/THOMAS HARVEY Director March 27, 2000 - ------------------------ Thomas Harvey s/WAYNE F. HOSKING, JR. Director March 27, 2000 - ------------------------ Wayne F. Hosking, Jr. s/KATHERINE W. SWOYER Chairman and Director March 27, 2000 - ------------------------ Katherine W. Swoyer s/THOMAS M. SWOYER, JR. Director March 27, 2000 - ------------------------ Thomas M. Swoyer, Jr. s/A. FREDERICK THOMPSON Director March 27, 2000 - ------------------------ A. Frederick Thompson Director March 27, 2000 - ------------------------ Roy F. Weston s/JAMES H. WOLFE Director March 27, 2000 - ------------------------ James H. Wolfe

859368_1999.html

859368_1999

1999

859368

Item 1: Business The Company Medicis is the leading independent pharmaceutical company in the United States focusing primarily on the treatment of dermatological conditions. The Company offers prescription products and an over-the-counter (“OTC”) product, emphasizing the clinical effectiveness, quality, affordability and cosmetic elegance of its products. Medicis has achieved a leading position in branded products for the treatment of acne, acne-related conditions, dyschromias and hyperpigmentation disorders and also offers the leading OTC fade cream product in the United States. The Company has built its business through successfully introducing prescription products such as DYNACIN®(minocycline HCl) and TRIAZ® (benzoyl peroxide) for the treatment of acne, LUSTRA® (hydroquinone USP 4%) for the treatment of skin dyschromia associated with photoaging, as well as by marketing ESOTERICA®, an OTC fade cream product line. In addition, Medicis has acquired the dermatological assets LOPROX® (ciclopirox), TOPICORT® (desoximetasone) and A/ T/ S®(erythromycin) from Hoechst Marion Roussel, Inc. (“HMR”) and the LIDEX®(fluocinonide) and SYNALAR® (fluocinolone acetonide) corticosteroid product lines from Syntex USA Inc. (“Syntex”). The Company derives a majority of its revenue from sales of the DYNACIN®, TRIAZ® and LIDEX® products, the newly developed and expanded LUSTRA® line and the newly acquired LOPROX® and TOPICORT® products (the “Key Products”). Principal Products and Product Lines The Company currently offers products in the following areas of dermatology: acne, acne rosacea, fungal infections, psoriasis, eczema, hyperpigmentation, pediculosis and cosmesis (improvement in the texture and appearance of skin). The Company addresses these areas with a range of prescription products and an OTC product. Prescription Pharmaceuticals Prescription pharmaceuticals accounted for 77.0% of the Company’s net revenues in the fiscal year ended June 30, 1999 (“fiscal 1999”). The Company currently focuses its prescription pharmaceutical efforts primarily on treating acne, acne-related conditions, fungal infections, psoriasis and dyschromias of the skin. The Company’s principal branded pharmaceutical products are as follows: DYNACIN® is an oral, systemic antibiotic, available in 50-mg., 75-mg. and 100-mg. dosage forms, prescribed as an adjunctive therapy in the treatment of severe acne. DYNACIN® is the number one brand of minocycline for the treatment of severe acne. Acne-related conditions resulted in over 10 million visits to dermatologists in the United States in 1995. The most commonly prescribed systemic acne treatments are tetracycline and its derivatives, doxycycline and minocycline. Minocycline, the active ingredient in the DYNACIN® products, is widely prescribed for the treatment of acne for several reasons. It has a more convenient schedule of one or two doses per day as compared to other forms of tetracycline, which can require up to four doses per day. Other forms of tetracycline require ingestion on an empty stomach and may increase patient sensitivity to sunlight, creating a greater risk of sunburn. Moreover, the other forms of tetracycline, including doxycycline, often cause gastric irritation. In addition, resistance to several commonly used antibiotics, including erythromycin, clindamycin, doxycycline and tetracycline, by the primary bacterial organism responsible for acne has been documented. Studies suggest that bacterial resistance to erythromycin exceeds 50% and resistance to doxycycline and tetracycline exceeds 50%, while the bacteria showed virtually no resistance to minocycline. The Company believes the retail price of DYNACIN® products is approximately 30% lower than the average reported retail price of another branded minocycline product, Minocin®, while selling at approximately 25% to 30% higher than the average reported retail price of generic minocycline. DYNACIN® was launched in the second quarter of the fiscal year ended June 30, 1993 with 50-mg. and 100-mg. dosage forms available. The Company launched DYNACIN® in 75-mg. dosage form, currently the only 75-mg. minocycline product available on the market, in the fourth quarter of fiscal 1999. The Company has entered into a manufacturing and supply agreement with Schein Pharmaceutical, Inc. (“Schein”) for the supply of DYNACIN®products. TRIAZ® is an internally developed, patented, topical therapy prescribed for the treatment of all forms and varying degrees of acne, and is available as a gel or cleanser in two concentrations. The combined sales of topically applied prescription acne products were in excess of $500 million in the United States in 1996. TRIAZ® is currently the leading branded benzoyl peroxide product in dermatology. While other topical acne treatments including Cleocin-T® and Benzamycin® are generally effective, TRIAZ® offers advantages over each product, including improved stability, greater convenience of use, reduced cost and fewer side effects. The Company believes it can gain additional market share by focusing its promotional efforts on the benefits of TRIAZ® over Benzamycin®. For example, Benzamycin® requires refrigeration and mixing by a pharmacist and has a relatively short shelf life of three months. In contrast, TRIAZ® comes in a ready-mixed gel that does not require refrigeration and has a two-year shelf life. In addition, TRIAZ® is aesthetically pleasing and minimizes the extreme drying and scaling of skin. The Company believes the average reported retail price of TRIAZ® is less than that of either Cleocin-T® or Benzamycin®. TRIAZ® products are manufactured using the active ingredient benzoyl peroxide in a patented vehicle containing glycolic acid and zinc lactate. Studies conducted by third parties have shown that benzoyl peroxide is the most efficacious agent available for eradicating the bacteria that cause acne with no reported resistance. Glycolic acid is believed by the Company to enhance the effectiveness of benzoyl peroxide by exfoliating the outer layer of the skin and zinc lactate is believed by the Company to act to reduce the appearance of inflammation and irritation often associated with acne. TRIAZ® was developed by the Company and introduced in the second quarter of the fiscal year ended June 30, 1996. The Company has patents and certain licensed patent rights covering varying aspects of TRIAZ®. TRIAZ® products are manufactured to the Company’s specifications on a purchase order basis by West Pharmaceutical Services Lakewood, Inc. (“West”) and in accordance with a supply agreement with Contract Pharmaceuticals, Limited (“Contract Pharmaceuticals”). LIDEX® is a high-potency topical corticosteroid brand prescribed for the treatment of inflammatory and hyperproliferative skin diseases such as eczema, psoriasis, atopic dermatitis, poison ivy and other inflammatory skin conditions. Competing steroid brands in the high-potency category include Halog®, Elocon®, and Cyclocort®. LIDEX® was introduced more than 20 years ago and the Company believes it is among the most widely accepted, topical steroid treatments available. Topical corticosteroid treatments represented sales of approximately $480 million in 1996 in the United States. The active ingredient in LIDEX®, fluocinonide, works to alleviate inflammations of the skin by reducing swelling and pain, relieving itching and constricting blood vessels in the skin. The LIDEX® product line consists of various strengths and cosmetically elegant formulations, including gels, ointments, creams, solutions and emollient creams. This broad product line allows dermatologists to prescribe the most appropriate product based on the severity and location of a patient’s condition, as well as the thickness of a patient’s skin. With the exception of the LIDEX®-E Cream, the various forms of LIDEX® are preservative-free, and the active ingredient is fully dissolved in the vehicle of the medication, resulting in better absorption of the medication into the skin. The Company believes LIDEX® is priced comparably to other branded corticosteroid products, but significantly higher than the average reported retail price of generics containing fluocinonide. The Company acquired the rights to LIDEX® in the United States and Canada from Syntex in the third quarter of the fiscal year ended June 30, 1997 (“fiscal 1997”). The Company has a manufacturing and supply agreement with Patheon, Inc. (“Patheon”) for the production of LIDEX®. SYNALAR® is a mid- to low-potency topical corticosteroid brand prescribed for the treatment of less severe forms of inflammatory and hyperproliferative skin diseases such as eczema, psoriasis, poison ivy, atopic dermatitis and other inflammatory skin conditions. The active ingredient in SYNALAR®, fluocinolone acetonide, works to alleviate inflammations of the skin by reducing swelling and pain, relieving itching and constricting blood vessels in the skin. The SYNALAR® product line consists of various strengths and cosmetically elegant formulations, including ointments, creams, emollient creams and solutions. This flexibility allows dermatologists to prescribe the most appropriate product based upon the severity and location of a patient’s condition, as well as the thickness of a patient’s skin. Competing steroid brands in the mid- and low-potency categories include Aristocort®, Cutivate®, and Valisone®, SYNALAR® is priced comparably to other branded corticosteroid products but higher than the average reported price of generics containing fluocinolone acetonide. The Company has a manufacturing and supply agreement with Patheon for the production of SYNALAR®. LUSTRA® and LUSTRA-AF™ are internally developed, patented topical therapies prescribed for the treatment of ultra-violet induced skin discolorations and hyperpigmentation usually associated with the use of oral contraceptives, pregnancy, hormone replacement therapy, sun damage and superficial trauma. Both LUSTRA® and LUSTRA-AF™ contain 4% hydroquinone in a vehicle containing glycolic acid in an anti-oxidant complex. LUSTRA® is the leading prescription topical treatment for dyschromia and hyperpigmentation. In controlled clinical trials sponsored by the Company in 1998, LUSTRA® demonstrated a reduction in pigmented lesions in a two-week period with statistically significant performance over the competing brands Solaquin Forte® and Melanex®. In another clinical trial sponsored by the Company in 1997, LUSTRA® demonstrated a statistically significant reduction of sunburned skin cells when exposed to cumulative ultra-violet radiation as compared with no treatment. Such sunburned cells are a measure of ultra-violet induced skin damage. The Company started shipping LUSTRA® to wholesalers in February 1998. LUSTRA-AF™, a line extension of LUSTRA®, containing broad-spectrum UVA and UVB sunscreen agents, was introduced to the market in June 1999. LUSTRA® and LUSTRA-AF™ are manufactured in accordance with a manufacturing agreement with Contract Pharmaceuticals. LOPROX® cream 0.77% and lotion 0.77% are both broad-spectrum prescription antifungal agents indicated for the topical treatment of tinea pedis, tinea corporis, tinea cruris, tinea versicolor and cutaneous candidiasis. LOPROX® is the only hydroxypyridone antifungal agent available in the United States, and unlike other antifungals, does not effect sterol biosynthesis. LOPROX® works with a unique mode of action that has been shown to have fungistatic, fungicidal, sporicidal, enhanced penetration and anti-inflammatory properties and to be active against gram-negative and gram-positive bacteria. This unique mode of action makes LOPROX® an appropriate choice for topical treatment alone, or as concomitant treatment with an oral antifungal. For these reasons, the Company believes LOPROX® may be a better product to manage the often-complicated mix of organisms involved in tinea infections. In clinical trials, LOPROX® was shown to produce clinical improvement of 82% to 93% after a single week of treatment across the range of cutaneous mycoses. The Company believes it is among the lowest priced branded prescription topical antifungals. The United States market for topical antifungal pharmaceuticals reached $367.7 million in 1996. The overall market for antifungals in the United States is approximately $800 million annually. The most frequently prescribed topical antifungal products besides LOPROX® include Spectazole®, Nizoral®, Oxistat® and Lotrisone® (steroid/ antifungal combination). Patients suffering from fungal-related conditions have a variety of other prescription and OTC medications to choose from. LOPROX® was acquired from HMR in November 1998 and re-launched by Medicis in the third quarter of fiscal 1999. LOPROX® products are manufactured to the Company’s specifications and supplied by an agreement with HMR. TOPICORT® gel, cream, and ointment are Class II, high-potency corticosteroids indicated for topical use on corticosteroid-responsive inflammatory skin conditions, including psoriasis, contact dermatitis, seborrheic dermatitis, stasis dermatitis, rhus dermatitis, atopic dermatitis and more. The fourth product in the line is TOPICORT® LP cream, a Class III corticosteroid. Class II, or high-potency steroids, offer effective treatment without the risks commonly associated with super-potent, Class I products. Unlike Class I steroids, TOPICORT® has no dosing restrictions, and minimizes the hypothalamic-pituitary-adrenal (HPA) suppression commonly seen with Class I use. The Company believes TOPICORT® cream and gel have long been regarded as preferable to other available creams and gels because of their excellent cosmetic qualities. They do not contain propylene glycol (solvent), parabans (preservatives), or added fragrances that may cause irritation to sensitive-skin patients. Each of the TOPICORT® products currently come in 15- and 60-gram tubes. Topical corticosteroid treatments represent a significant portion of dermatological product sales, with estimated market sales of $500 million in 1998. The Company acquired the rights to TOPICORT® in the United States from HMR during the second quarter of fiscal 1999. The Company has a manufacturing and supply agreement with HMR for the production of TOPICORT®. NOVACET® is a topical cream prescribed for the treatment of acne rosacea, a chronic inflammatory skin disorder resembling acne and seborrheic dermatitis. The active ingredients in NOVACET® are sodium sulfacetamide and sulfur. Sales of products to treat acne rosacea in the United States in 1996 were approximately $50 million. NOVACET® was introduced by GenDerm Corporation (“GenDerm”) in 1993 and competes with other topical acne rosacea treatments such as Sulfacet-R®, MetroGel®, MetroCream® and generic treatments, as well as various forms of erythromycin, clindamycin and oral metronidazole, which also are used from time to time to treat acne rosacea. In a controlled clinical study sponsored by GenDerm, NOVACET® was shown to reduce the severity of redness and inflammation resulting from acne rosacea by 83% over an eight-week period. By week eight of the study, 98% of the patients in the study showed significant improvements in their condition. The Company believes NOVACET® is priced comparably to competing brands. The Company acquired NOVACET® in December 1997 when it acquired all the capital stock of GenDerm and assumed the marketing of this brand in the United States and Canada. The Company has a manufacturing and supply agreement with DPT Laboratories, Ltd. (“DPT”) for the production of NOVACET®. OVIDE® lotion 0.5% is a topical pediculicide indicated for the treatment of pediculus humanus capitis, or head lice, and their ova. Head lice products accounted for $170 million in sales in 1998 in the United States alone. Approximately 10 to 12 million Americans, mostly school-age children, are infested with head lice each year, and a growing body of evidence indicates significant levels of head lice that are resistant to currently available OTC treatments like NIX® and RID®. OVIDE® is a prescription alternative to the OTC treatments, offering both an excellent kill rate and ovicial activity. In addition, in controlled clinical studies, OVIDE® demonstrated residual activity with 90.4% of patients still lice-free 7 days after treatment. Until OVIDE®, the only prescription pediculicide available was lindane. Because of CNS toxicity potential, the FDA required a labeling change that recommends lindane’s use only for patients who have either failed to respond to adequate doses, or are intolerant of other approved therapies. Used as directed, OVIDE® provides safe and effective control of head lice and their ova. OVIDE® lotion is available in 2-ounce bottles. The Company introduced OVIDE® during the fourth quarter of fiscal 1999. OVIDE® is manufactured for the Company by West on a purchase order basis. Non-Prescription Product The Company’s OTC products (including those products that were divested in the third and fourth quarter of fiscal 1999) contract revenue and the physician-dispensed division accounted for 23.0% of the Company’s net revenue in fiscal 1999. The Company’s non-prescription product is as follows: ESOTERICA® is a line of topical creams used to treat minor skin discoloration conditions such as age spots, uneven skin tones, dark patches, blotches and freckles. ESOTERICA® is the leading fade cream line in the United States. ESOTERICA® is available in five formulations, consisting of four creams containing various concentrations of the active ingredient hydroquinone and a body lotion. Hydroquinone is the only agent proven to reduce hyperpigmentation and the only product legally sold in the United States for this purpose. Competing OTC products used to treat minor skin discoloration include Porcelana® and AMBI®, which are sold in a variety of creams, gels and lotions. The Company has a manufacturing agreement for the ESOTERICA®products with Contract Pharmaceuticals. Products in Development The Company has developed and obtained rights to certain pharmaceutical agents in various stages of development. The Company has a variety of products under development, ranging from existing product line extensions to new products to reformulations of existing products. Medicis’ strategy involves the rapid evaluation and formulation of new therapeutics by obtaining preclinical safety and efficacy data, when possible, followed by rapid safety and efficacy testing in humans. While development periods may vary, the Company generally selects products for internal development with the objective of proceeding from formulation to product launch within a two-year period. The Company directs the efforts of contract laboratory research facilities to perform formulation and research work on active ingredients, as well as to conduct preclinical studies and clinical trials. All products and technologies under development require significant commitments of personnel and financial resources. Several products require extensive clinical evaluation and premarketing clearance by the United Stated Food and Drug Administration (“FDA”) and comparable agencies in other countries prior to commercial sale. Certain of the products and technologies under development have been licensed from third parties. The failure of the Company to meet its obligations under one or more of these agreements could result in the termination of the Company’s rights under such agreements and other liabilities. In addition, the Company regularly reevaluates its product development efforts. On the basis of these reevaluations, the Company has, in the past, and may in the future, abandon development efforts for particular products. There can be no assurance that any product or technology under development will result in the successful introduction of any new product. The Company’s research and development costs for Company-sponsored and unreimbursed co-sponsored pharmaceutical projects for fiscal 1999, 1998 and 1997 were $3,396,000, $2,885,000 and $1,450,000, respectively. The Company has in the past supplemented, and may in the future supplement, its research and development efforts by entering into research and development agreements with other pharmaceutical companies to defray the cost of product development. In July 1997, the Company entered into an agreement with Abbott Laboratories (“Abbott”) for the development, manufacture and marketing of a branded dermatologic product. Abbott is responsible for the development and eventual manufacture of the product. The Company has agreed to pay certain development expenses estimated to be approximately $1,000,000. There can be no assurance that this collaboration will result in the successful introduction of any new product or technology or that the Company will continue the development of the product in the future. In December 1997, the Company acquired 100% of the common stock of GenDerm. The acquisition also included several in-process research and development projects. Although the Company intends to continue such development projects, there can be no assurance that any product or technology previously under development by GenDerm will result in the successful introduction of any new product, or that the Company will continue the development of any such projects in the future. In November 1998, the Company acquired the right to manufacture, market and sell the LOPROX®, TOPICORT® and A/ T/ S® products from HMR. The acquisition of these products also included several in-process research and development projects. Although the Company intends to continue such development projects, there can be no assurance that any technology previously under development by HMR will result in the successful introduction of any new line extensions, or that the Company will continue the development of any such projects in the future. Marketing and Sales The Company believes that its prescription pharmaceutical marketing and sales organization is one of the most productive in the dermatology sector. The Company’s marketing efforts are focused on assessing and meeting the needs of dermatologists and other specialties that treat conditions of the skin. The Company’s prescription sales team, consisting of 60 members at September 14, 1999, regularly calls on dermatologists, focusing on the approximately 3,200 dermatologists who are responsible for 80% of all prescriptions written by dermatologists in the United States. Additionally, the Company recently began calling on high-prescribing podiatrists. The Company has created an attractive incentive program based upon goals in market share growth and market share maintenance. The Company focuses on cultivating relationships of trust and confidence with the specialists themselves. In addition, the Company uses a variety of marketing techniques to promote its products including: sampling, journal advertising, promotional materials, specialty publications, rebate coupons, product guarantees, a leadership position in educational conferences and exposure of its products on the Internet. The Company’s OTC product is promoted to retailers and wholesalers by manufacturers’ representatives who also support a substantial number of products of other manufacturers. The Company also markets its OTC product through trade promotions, radio and print advertising, couponing and consumer awareness. Warehousing and Distribution The Company utilizes an independent national warehousing corporation to store and distribute its products from primarily two regional warehouses in Nevada and Georgia, as well as other warehouses in California and Maryland. Upon the receipt of a purchase order through electronic data input (“EDI”), phone, mail or facsimile, the order is processed into the Company’s inventory systems. An inventory picking sheet is then automatically placed via EDI to the most efficient warehouse location for shipment, usually within 24 hours, to the customer placing the order. Upon shipment, the warehouse sends back to the Company via EDI the necessary information to automatically process the invoice in a timely manner. Any delay or interruption in the process could have a material effect on the Company’s business, financial condition and results of operations. Customers The Company’s customers include the nation’s leading wholesale pharmaceutical distributors, such as McKesson HBOC, Inc. (“McKesson”), Bergen Brunswig Corporation (“Bergen Brunswig”), Cardinal Health, Inc. (“Cardinal”), Bindley Western Industries, Inc. (“Bindley”) and other major drug chains. During fiscal 1999, McKesson and Cardinal accounted for 18.0% and 14.1% respectively, of the Company’s revenues. During fiscal 1998, McKesson, Bergen Brunswig and Cardinal accounted for 16.9%, 13.2% and 12.6%, respectively, of the Company’s revenues. During fiscal 1997, McKesson, Cardinal and Bergen Brunswig accounted for 20.6%, 16.3% and 10.9%, respectively, of the Company’s revenues. The distribution network for pharmaceutical products has, in recent years, been subject to increasing consolidation. As a result, a few large wholesale distributors control a significant share of the market. In addition, the number of independent drug stores and small chains has decreased as retail consolidation has occurred. Further consolidation among, or any financial difficulties of, distributors or retailers could result in the combination or elimination of warehouses which may result in product returns to the Company, cause a reduction in the inventory levels of distributors and retailers, or otherwise result in reductions in purchases of the Company’s products, any of which could have a material adverse impact on the Company’s business, financial condition and results of operations. Additionally, the loss of, or deterioration in, any of these customer accounts could have a material adverse effect on the Company’s business, financial condition and results of operations. Manufacturing The Company currently contracts for all of its manufacturing needs and is required by the FDA to contract only with manufacturers that comply with current Good Manufacturing Practices (“cGMP”) regulations and other applicable laws and regulations. The Company typically enters into short-term manufacturing contracts with third-party manufacturers. Whether or not such contracts exist, there can be no assurance that the Company will be able to obtain adequate supplies of its products in a timely fashion, on acceptable terms, or at all. Schein manufactures the Company’s DYNACIN® products in compliance with the Company’s specifications and quality standards pursuant to a supply agreement. Under the agreement, Schein manufactures DYNACIN® for sale in the branded market exclusively for the Company, but may manufacture and sell minocycline for itself or others as a generic product. Schein currently manufactures minocycline for the generic market under its own label. The Company’s supply agreement expires in December 2003, but is subject to automatic renewal for successive two-year periods if neither party gives timely notice of termination. It may also be terminated by either party without cause upon twelve months notice to the other party. Schein may also terminate the exclusivity portion of the agreement if its profit margin on sales of DYNACIN® products falls below a specified level. The agreement also provides that the Company will purchase all of its requirements for minocycline from Schein but may purchase some of its requirements from another manufacturer if Schein fails to meet certain cost standards or fails to provide the Company with all of its requirements for two of four consecutive quarters. In addition, the Company may use alternative sources if Schein terminates the Company’s exclusive rights to purchase branded minocycline based upon the Company’s failure to meet the specified profit margins, as defined. Either party may terminate the agreement if one party cannot perform under the agreement for a period of three months or longer for certain reasons beyond its control. The Company believes that it has alternative sources of supply and that it would be able to use these alternative sources to preserve an adequate supply of DYNACIN®. However, the inability of Schein to fulfill the Company’s supply requirements for DYNACIN®, one of the Company’s largest-selling products, in a timely fashion, could have a material adverse effect on the Company’s business, financial condition and results of operations. The majority of the Company’s LIDEX® and SYNALAR® products are manufactured primarily by Patheon in accordance with a manufacturing and supply agreement assumed by the Company when it acquired the LIDEX® and SYNALAR® products. Under the terms of an agreement with the Company, F. Hoffman-La Roche, Ltd. supplies, at cost, active ingredients necessary for manufacturing the LIDEX® and SYNALAR® products. The Patheon manufacture and supply agreement expires in January 2000, however, the Company will extend this agreement through an automatic one year extension. The extension is available each year by contract unless either party gives timely notice of termination. The inability of Patheon to fulfill the Company’s supply requirements for LIDEX® and SYNALAR® in a timely fashion could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company’s LOPROX® and TOPICORT® products are manufactured by HMR in accordance with a supply agreement entered into by the Company in connection with the acquisition of LOPROX® and TOPICORT®. The HMR supply agreement expires in November 2001, but is subject to renewal. The inability of HMR to fulfill the Company’s supply requirements for LOPROX® and TOPICORT® in a timely fashion would have a material adverse effect on the Company’s business, financial condition and results of operation. The Company’s NOVACET® product is manufactured for distribution in the United States primarily by DPT and Patheon in accordance with manufacturing and supply agreements assumed by the Company when it acquired GenDerm. Under the agreement, the Company is required to purchase at least 90% of its annual sales requirements from DPT. The DPT manufacturing agreement expires in December 2003. Either party may terminate the agreement upon two-year notice by the Company and three-year notice by DPT. Such termination period becomes 60 days if either party fails to perform, without cure, its obligations under the DPT manufacturing agreement. The Company’s ESOTERICA®, LUSTRA®, LUSTRA-AF™ and TRIAZ® products are manufactured by Contract Pharmaceuticals pursuant to manufacturing agreements expiring in July 2001. The inability of Contract Pharmaceuticals to fulfill the Company’s supply requirements for these products could have a material adverse effect on the Company’s business, financial condition and results of operations. The remainder of the Company’s principal products are produced on a purchase order basis only; one LIDEX® product, a TRIAZ® product and the OVIDE® product are manufactured by West. Certain License and Royalty Agreements Pursuant to license agreements with third parties, the Company has acquired rights to manufacture, use or market certain of its products, as well as many of its other proposed products and technologies. Such agreements contain provisions requiring the Company to use its best efforts or otherwise exercise diligence in pursuing market development for such products in order to maintain the rights granted under the agreements and may be canceled upon the Company’s failure to perform its payment or other obligations. In addition, the Company has entered into agreements to license certain rights to manufacture, use and sell certain of its technologies outside the United States and Canada to various licensees. There can be no assurance that the Company will fulfill its obligations under its license agreements due to insufficient resources, lack of successful product development, lack of product acceptance or other reasons. The failure to satisfy the requirements of any such agreements may result in the loss of the Company’s rights under that agreement or under related agreements and other liabilities. The inability of the Company to continue to license these products or to license other necessary products for use with its products or substantial increases in royalty payments under third-party licenses could have a material adverse effect on the Company’s business, financial condition and results of operations. In addition, the effective implementation of the Company’s strategy depends upon the successful integration of these licensed products with the Company’s products. Therefore, any flaws or limitations of such licensed products may prevent or impair the Company’s ability to market and sell the Company’s products, delay new product introductions, and/or adversely affect the Company’s reputation. Such problems could have a material adverse effect on the Company’s business, financial condition and results of operations. In November 1998, the company entered into a license agreement with HMR. The license is for a term of three years with an option to purchase the products at the end of the term. The products licensed from HMR include LOPROX®, TOPICORT® and A/T/S®. Trademarks The Company believes that trademark protection is an important part of establishing product recognition. The Company owns more than 100 registered trademarks and trademark applications. United States federal registrations for trademarks remain in force for 10 years and may be renewed every 10 years after issuance, provided the mark is still being used in commerce. There can be no assurance that any such trademark or service mark registrations will afford the Company adequate protection, or that the Company will have the financial resources to enforce its rights under any such trademark or service mark registrations. The inability of the Company to protect its trademarks or service marks from infringement could result in the impairment of any goodwill, which may be developed in such trademarks or service marks. Moreover, the Company’s inability to use one or more of its trademarks or service marks, because of successful third-party claims to such marks, could have a material adverse effect on the Company’s business, financial condition and results of operations. From time to time, the Company receives communications from parties who allege that their trademark or service mark interests may be damaged either by the Company’s use of a particular trademark or service mark or its registration of such trademark or service mark, and, on occasion, the Company also sends such communications to third parties. In general, the Company seeks to resolve such conflicts before an actual opposition to registration or suit for infringement is filed. There can, however, be no assurance that such actions will not be filed or that, if filed, they will not have a material adverse effect upon the Company’s business, financial condition or results of operations. Patents and Proprietary Rights The Company is pursuing several United States patent applications. There can be no assurance that patents will be issued with respect to any of these applications. The Company has acquired rights under certain patents and patent applications from third-party licensors. The Company has obtained patents on some of its products directed to aspects of a compound, including a United States patent expiring in October 2015 covering various formulations of its TRIAZ® product line, and a United States patent expiring in August 2017 covering its LUSTRA® and LUSTRA-AF™ products. The Company has recently acquired from certain of its consultants and principals an assignment of their rights to certain United States patents or patent applications. Certain of such patents and patent applications may be subject to claims of rights by third parties by reason of existing relationships with the party who filed such patents or patent applications. There can be no assurance that the Company will be able to obtain any rights under such patents or patent applications as a result of such conflicting claims, or that any rights that the Company may obtain will be sufficient for the Company to market products that may be the subject of such patents or patent applications. The Company may be required to obtain licenses and/or pay royalties to obtain the rights it acquires under such patents or patent applications. There can be no assurance that the Company will be able to obtain rights under such patents or patent applications on terms acceptable to the Company, or at all. The Company believes that its success will depend in part on its ability to obtain and maintain patent protection for its own inventions, and to obtain and maintain adequate licenses for the use of patents licensed or sublicensed by third parties. There can be no assurance that any patent issued to, or licensed by, the Company will provide protection that has commercial significance. In this regard, the patent position of pharmaceutical compounds is particularly uncertain. There can be no assurance that challenges will not be instituted against the validity or enforceability of any patent owned by or licensed to the Company or, if instituted, that such challenges will not be successful. The cost of litigation to uphold the validity and prevent infringement of patents can be substantial and require a significant commitment of management’s time. Furthermore, there can be no assurance that others will not independently develop similar technologies or duplicate the technology owned by or licensed to the Company or design around the patented aspects of such technology. The Company only conducts complete searches to determine whether its products infringe upon any existing patents as it deems appropriate. There can be no assurance that the products and technologies the Company currently markets, or may seek to market in the future, will not infringe patents or other rights owned by others. The Company believes that obtaining foreign patents may be more difficult than obtaining domestic patents because of differences in patent laws, and therefore, recognizes that its patent position may be stronger in the United States than in Europe or elsewhere. In addition, the protection provided by foreign patents once they are obtained may be weaker than that provided by domestic patents. The Company relies and expects to continue to rely upon unpatented proprietary know-how and continuing technological innovation in the development and manufacture of many of its principal products. The Company’s policy is to require all its employees, consultants and advisors to enter into confidentiality agreements with the Company. There can be no assurance, however, that these agreements will provide meaningful protection for the Company’s trade secrets or proprietary know-how in the event of any unauthorized use or disclosure of such information. In addition, there can be no assurance that others will not obtain access to or independently develop similar or equivalent trade secrets or know-how. Competition The pharmaceutical industry is characterized by intense competition, rapid product development and technological change. Competition is intense among manufacturers of prescription pharmaceuticals, such as for the Company’s Key Products for the treatment of dermatological conditions, in the OTC market for ESOTERICA®, as well as other products, which the Company may develop and market in the future. Most of the Company’s competitors are large, well-established pharmaceutical, chemical, cosmetic or health care companies with considerably greater financial, marketing, sales and technical resources than those available to the Company. Additionally, many of the Company’s present and potential competitors have research and development capabilities that may allow such competitors to develop new or improved products that may compete with the Company’s product lines. The Company’s products could be rendered obsolete or made uneconomical by the development of new products to treat the conditions addressed by the Company’s products, technological advances affecting the cost of production, or marketing or pricing actions by one or more of the Company’s competitors. Each of the Company’s products competes for a share of the existing market with numerous products, that have become standard treatments recommended or prescribed by dermatologists. DYNACIN® competes with Minocin® a branded minocycline product marketed by American Home Products (“AHP”) and generic minocycline products marketed by Schein, Barr Laboratories, Inc. (“Barr Labs”) and ESI Lederle, Inc. Other oral antibiotics utilized for the treatment of acne include erythromycin, doxycycline and tetracycline marketed in branded and generic form by a variety of companies. LIDEX®, SYNALAR® and TOPICORT® compete with a number of corticosteroid brands in the super-, high-, mid-, and low-potency categories for the treatment of inflammatory and hyperproliferative skin conditions. Competing brands include Halog® and Ultravate®, marketed by Bristol-Myers Squibb Company (“Bristol-Myers”); Elocon® and Diprolene®, marketed by Schering-Plough Corporation (“Schering-Plough”); Cyclocort and Aristocort, marketed by Fujisawa Healthcare, Inc.; Temovate® and Cutivate®, marketed by Glaxo Wellcome, Inc. (“Glaxo Wellcome”); and Psorcon®, marketed by Dermik Laboratories, Inc. (“Dermik Labs”). The Company believes that TRIAZ® competes with Benzamycin®, marketed by Dermik Labs; Cleocin-T® and a generic topical clindamycin, marketed by Pharmacia & Upjohn Co, Inc. (“Pharmacia & Upjohn”); and Benzac®, marketed by Galderma Laboratories, Inc. (“Galderma”). The Company believes that LUSTRA® primarily competes with Solaquin Forte®, marketed by ICN Pharmaceuticals, Inc. and Melanex®, marketed by Neutrogena Dermatologics. ESOTERICA® primarily competes with Porcelana®, marketed by Schwarzkopf & Dep, Inc. and AMBI®, marketed by Kiwi Brands, a division of Sara Lee Brands Corporation. The Company believes that LOPROX® competes primarily with Lamisil®, marketed by Novartis Pharmaceuticals Corporation; Nizoral®, marketed by Janssen Pharmceutica, Inc; and Spectazole®, marketed by Ortho Dermatological. The Company believes that OVIDE® primarily competes with the OTC products NIX®, marketed by Warner-Lambert Consumer Healthcare and RID®, marketed by Pfizer, Inc. (“Pfizer”) and with generic products such as the prescription product lindane, marketed by various manufacturers. Several of the Company’s products, including DYNACIN® and LIDEX®, compete with generic (non-branded) pharmaceuticals, which claim to offer equivalent therapeutic benefits at a lower cost. In some cases, insurers and other third-party payors seek to encourage the use of generic products making branded products less attractive, from a cost perspective, to buyers. Government Regulation The manufacture and sale of cosmetics and drugs are subject to regulation principally by the FDA and state and local authorities in the United States, and by comparable agencies in certain foreign countries. The Federal Trade Commission (“FTC”) and state and local authorities regulate the advertising of OTC drugs and cosmetics. The Food and Drug Act and the regulations promulgated thereunder, and other federal and state statutes and regulations, govern, among other things, the testing, manufacture, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of the Company’s products. In general, products falling within the FDA’s definition of “new drugs” require premarketing clearance by the FDA. Products falling within the FDA’s definition of “cosmetics” or of “drugs” that are not “new drugs” and that are generally recognized as “safe and effective” do not require premarketing clearance. The steps required before a “new drug” may be marketed in the United States include (i) preclinical laboratory and animal testing, (ii) submission to the FDA of an Investigational New Drug (“IND”) application, which must become effective before clinical trials may commence, (iii) adequate and well-controlled clinical trials to establish the safety and efficacy of the drug, (iv) submission to the FDA of a New Drug Application (“NDA”) and (v) FDA approval of the NDA prior to any commercial sale or shipment of the drug. In addition to obtaining FDA approval for each product, each domestic drug-manufacturing establishment must be registered with, and approved by, the FDA. Drug product manufacturing establishments located in California also must be licensed by the State of California in compliance with separate regulatory requirements. Preclinical testing is generally conducted in laboratory animals to evaluate the potential safety and the efficacy of a drug. The results of these studies are submitted to the FDA as a part of an IND application, which must be approved before clinical trials in humans can begin. Typically, clinical evaluation involves a time consuming and costly three-phase process. In Phase I, clinical trials are conducted with a small number of subjects to determine the early safety profile, the pattern of drug distribution and metabolism. In Phase II, clinical trials are conducted with groups of patients afflicted with a specific disease to determine preliminary efficacy, optimal dosages and expanded evidence of safety. In Phase III, large-scale, multi-center, comparative trials are conducted with patients afflicted with a target disease to provide sufficient data to demonstrate the efficacy and safety required by the FDA. The FDA closely monitors the progress of each of the three phases of clinical trials and may, at its discretion, re-evaluate, alter, suspend or terminate the testing based upon the data that have been accumulated to that point and its assessment of the risk/benefit ratio to the patient. In general, FDA approval is required before a new drug product may be marketed in the United States. However, most OTC drugs are exempt from the FDA’s premarketing approval requirements. In 1972, the FDA instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness of OTC drug ingredients then in the market. Through this process, the FDA issues monographs that set forth the specific active ingredients, dosages, indications and labeling statements for OTC drug ingredients that the FDA will consider generally recognized as safe and effective and therefore not subject to premarket approval. OTC drug ingredients are classified by the FDA in one of three categories: Category I ingredients which are deemed “safe and effective for OTC use;” Category II ingredients which are deemed “not generally recognized as safe and effective for OTC use;” and Category III ingredients which are deemed “possibly safe and effective with studies ongoing.” Based upon the results of these ongoing studies, the FDA may reclassify all Category III ingredients as Category I or Category II ingredients. For certain categories of OTC drugs not yet subject to a final monograph, the FDA usually permits such drugs to continue to be marketed until a final monograph becomes effective, unless the drug will pose a potential health hazard to consumers. Drugs subject to final monographs, as well as drugs that are subject only to proposed monographs, are subject to various FDA regulations concerning, for example, cGMP, general and specific OTC labeling requirements, prohibitions against promotion for conditions other than those stated in the labeling, and requirement that OTC drugs contain only suitable inactive ingredients. OTC drug manufacturing facilities are subject to FDA inspection, and failure to comply with applicable regulatory requirements may lead to administrative or judicially imposed penalties. The active ingredient in DYNACIN® products, minocycline; LOPROX®, ciclopirox; TOPICORT®, desoximetasone; OVIDE® lotion, malathion; BUPHENYL™ powder and tablets, sodium phenylbutyrate; and LIDEX® and SYNALAR®, fluocinonide and fluocinolone acetonide, respectively, have been approved by the FDA under a NDA. The active ingredient in the TRIAZ® products has been classified as a Category III ingredient under a tentative final FDA monograph for OTC use in treatment of labeled conditions. The FDA has requested, and a task force of the Non-Prescription Drug Manufacturers Association (“NDMA”), a trade association of OTC drug manufacturers, has undertaken further studies to confirm that benzoyl peroxide, an active ingredient in the TRIAZ® products, is not a tumor promoter when tested in conjunction with UV light exposure. The TRIAZ® products, which the Company sells on a prescription basis, have the same ingredients at the same dosage levels as the OTC products. When the FDA issues the final monograph, the Company may be required by the FDA to sell TRIAZ® as an OTC drug unless the Company files an NDA covering such product. There can be no assurance as to the results of these studies or any FDA action to reclassify benzoyl peroxide. In addition, there can be no assurance that adverse test results would not result in withdrawal of TRIAZ® from marketing. An adverse decision by the FDA with respect to the safety of benzoyl peroxide could result in the assertion of product liability claims against the Company and could have a material adverse effect on the Company’s business, financial condition and results of operations. Certain ESOTERICA® and LUSTRA® products contain the active ingredient hydroquinone at a 2% and 4% concentration, respectively, currently a Category I ingredient. Independent expert dermatologists have formally expressed the view that hydroquinone at a 2% concentration is generally recognized as safe and effective for its intended use. In 1992, with the concurrence of the FDA, the industry initiated dermatological metabolism and toxicity studies to fully support hydroquinone’s continued Category I status. Notwithstanding the pendency or results of these tests, which may take up to three years to complete, the FDA may elect to classify hydroquinone as a Category III ingredient. The Company, in conjunction with the NDMA and other manufacturers, is responsible for 50% of the costs associated with these studies. An adverse decision by the FDA on the safety of hydroquinone could result in the assertion of product liability claims against the Company. Moreover, if hydroquinone is not maintained as a Category I or Category III ingredient, the Company would be required to cease marketing the ESOTERICA® and LUSTRA® products containing hydroquinone. An adverse decision by the FDA on the safety of hydroquinone could have a material adverse effect on the Company’s business, financial condition and results of operations. The ESOTERICA®, TRIAZ® and LUSTRA® products must meet the composition and labeling requirements established by the FDA for products containing their respective basic ingredients. The Company believes that compliance with those established standards avoids the requirement for premarketing clearance of these products. There can be no assurance that the FDA will not take a contrary position. NOVACET®, which contains the active ingredients sodium sulfacetamide and sulfur, is marketed under the FDA compliance policy entitled “Prescription Drugs Marketed with an NDA.” The Company believes that certain of its products, as they are promoted and intended by the Company for use, are exempt from being considered “new drugs” based upon the introduction date of their active ingredients and therefore do not require premarketing clearance. There can be no assurance that the FDA will not take a contrary position. If the FDA were to do so, the Company may be required to seek FDA approval for such products, market such products as OTC products or withdraw such products from the market. The Company believes that such products are subject to regulations governing product safety, use of ingredients, labeling and promotion and manufacturing methods. Clinical trials and the marketing and manufacturing of pharmaceutical products are subject to the rigorous testing and approval processes of the FDA and foreign regulatory authorities. The process of obtaining FDA and other required regulatory approvals is lengthy and expensive. There can be no assurance that the Company will be able to obtain the necessary approvals to conduct clinical trials or to manufacture and market such products, that all necessary clearances will be granted to the Company or its licensors for future products on a timely basis, or at all, or that FDA review or other actions will not cause delays adversely affecting the marketing and sale of the Company’s products. In addition, the testing and approval process with respect to certain new products, which the Company may develop or seek to introduce, is likely to take a substantial number of years and involve the expenditure of substantial resources. There can be no assurance that pharmaceutical products currently in development, or those products acquired or licensed by the Company, will be cleared for marketing by the FDA. Failure to obtain any necessary approvals or failure to comply with applicable regulatory requirements could have a material adverse effect on the Company’s business, financial condition and results of operations. Furthermore, future government regulation could prevent or delay regulatory approval of the Company’s products. There can be no assurance that any approval will be granted on a timely basis, or at all; that the FDA will not require post-marketing testing and surveillance to monitor the product and continued compliance with regulatory requirements; that the FDA will not require the submission of any lot of any product for inspection and will not restrict the release of any lot that does not comply with FDA standards; that the FDA will not otherwise order the suspension of manufacturing, recall or seizure of products; or that the FDA will not withdraw its marketing clearance of any product if compliance with regulatory standards is not maintained or if problems concerning safety or efficacy of the product are discovered following approval. From time to time, the FDA has issued correspondence to pharmaceutical companies, including the Company, alleging that certain advertising or promotional practices are false, misleading or deceptive. The Company seeks to resolve all such complaints without any further adverse action by the FDA and without incurring substantial expense. However, there can be no assurance that the Company will not receive such correspondence from the FDA in the future, or that, if such notices are received, they will not result in substantial cost or disruption, including fines and penalties, in material changes to the manner in which the Company promotes its products, in loss of sales of the Company’s products or other material adverse effects on the Company’s business, financial condition and results of operations. For both currently marketed and future products, failure to comply with the applicable regulatory requirements could, among other things, result in fines, suspensions of regulatory approvals, product recalls, operating restrictions, criminal prosecution, relabeling costs, delays in product distribution, marketing and sales, or seizure or cessation of manufacture of the products and the imposition of civil or criminal sanctions. There can be no assurance that the FDA or other regulatory agencies will not change its position with regard to the safety or effectiveness of the Company’s current or future products or that the FDA or other regulatory agencies will agree with the Company’s position regarding the regulatory status of its products. In the event that the FDA or other regulatory agencies takes a contrary position regarding any of the Company’s current or future products, the Company may be required to change its labeling or formulation or cease manufacturing and marketing such products. In addition, even prior to any formal regulatory action, the Company could decide voluntarily to cease distribution and sale or to recall any of its products if concern about the safety or efficacy of any of its products was to develop. Any such action could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company also will be subject to foreign regulatory authorities governing clinical trials and pharmaceutical sales if it seeks to market its products outside the United States. Whether or not FDA approval has been obtained, approval of a product by the comparable regulatory authorities of foreign countries must be obtained prior to the commencement of marketing of the product in those countries. The approval process varies from country to country and the time required may be longer or shorter than that required for FDA approval. There can be no assurance that any foreign regulatory agency will approve any product submitted for review by the Company. Third-Party Reimbursement The operating results of the Company will depend in part on the availability of adequate reimbursement for the Company’s products from third-party payors, such as government entities, private health insurers and managed care organizations. Third-party payors increasingly are seeking to negotiate the pricing of medical services and products and to promote the use of generic, non-branded pharmaceuticals through payor-based reimbursement policies designed to encourage their use. In some cases, third-party payors will pay or reimburse users or suppliers of a prescription drug product only a portion of the product purchase price. In the case of the Company’s prescription products, payment or reimbursement by third-party payors of only a portion of the cost of such products could make such products less attractive, from a cost perspective, to users, suppliers and prescribing physicians. There can be no assurance that reimbursement, if available, will be adequate. Moreover, certain of the Company’s products are not of a type generally eligible for third-party reimbursement. If government entities or other third-party payors do not provide adequate reimbursement levels for the Company’s products, or if those reimbursement policies increasingly favor the use of generic products, the Company’s business, financial condition and results of operations would be materially adversely affected. In addition, managed care initiatives to control costs have influenced primary-care physicians to refer fewer patients to dermatologists, resulting in a declining target market for the Company. Further reductions in referrals to dermatologists could have a material adverse effect upon the Company’s business, financial condition and results of operations. A number of legislative and regulatory proposals aimed at changing the U.S. health care system have been proposed in recent years. While the Company cannot predict whether any such proposals will be adopted, or the effect that any such proposal may have on its business, such proposals, if enacted, could have a material adverse effect on the Company’s business, financial condition and results of operations. Product Liability Insurance The Company faces an inherent risk of exposure to product liability claims in the event that the use of one or more of its products is alleged to have resulted in adverse effects. Such risk exists even with respect to those products that are manufactured in licensed and regulated facilities or that otherwise received regulatory approval for commercial sale. There can be no assurance that the Company will not be subject to significant product liability claims. The Company currently has product liability insurance in the amount of $50.0 million per claim and $50.0 million in the aggregate on a claims-made basis. Many of the Company’s customers require the Company to maintain product liability insurance coverage as a condition to their conducting business with the Company. As the loss of such insurance coverage could result in a loss of such customers, the Company intends to take all reasonable steps necessary to maintain such insurance coverage. There can be no assurance that insurance coverage will be available in the future on commercially reasonable terms, or at all, or that such insurance will be adequate to cover potential product liability claims. The loss of insurance coverage or the assertion of a product liability claim or claims could have a material adverse effect on the Company’s business, financial condition and results of operations. Employees As of June 30, 1999, the Company had 144 full-time employees. The Company believes its relationship with its employees is good. The Company intends to hire additional personnel as needed during the next 12 months. Additional Factors That May Affect Future Results Our disclosure and analysis in this report, in other reports that we file with the Securities and Exchange Commission, in our press releases and in public statements of our officers contain forward-looking statements. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current events. They use words such as “anticipate,” “estimate,” “expect,” “intend,” “plan,” “believe” and other words of similar meaning in connection with discussion of future operating or financial performance. These include statements relating to future actions, prospective products or product approvals, future performance or results of current and anticipated products, sales efforts, expenses, the outcome of contingencies such as legal proceedings and financial results. Forward-looking statements may turn out to be wrong. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many factors mentioned in this report - for example, governmental regulation and competition in our industry - will be important in determining future results. No forward-looking statement can be guaranteed, and actual results may vary materially from those anticipated in any forward-looking statement. We undertake no obligation to update any forward-looking statement. We provide the following discussion of risks and uncertainties relevant to our business. These are factors that we think could cause our actual results to differ materially from expected and historical results. Medicis could also be adversely affected by other factors besides those listed here. The following discussion is provided pursuant to the Private Securities Litigation Reform Act of 1995. We Rely on Others to Manufacture Our Products Currently, we contract out for all of our product manufacturing needs and do not manufacture any of our products. Typically, these manufacturing contracts are short-term. We are dependent upon renewing agreements with our existing manufacturers or finding replacement manufacturers to satisfy our requirements. As a result, we cannot be certain that manufacturing sources will continue to be available or that we can continue to out-source the manufacturing of our products on reasonable or acceptable terms. The underlying cost to Medicis for manufacturing our products is established in our agreements with these outside manufacturers. Because of the short-term nature of these agreements, our expenses for manufacturing are not fixed and could change from contract to contract. If the cost of production increases, our gross margins could be negatively impacted. In addition, we rely on outside manufacturers to provide us an adequate and reliable supply of our products on a timely basis. Any loss of a manufacturer or any difficulties which could arise in the manufacturing process could significantly affect our inventories and supply of products available for sale. In some cases, we do not have alternative sources of supply for our products. In the event our primary suppliers are unable to fulfill our requirements for any reason it could have a negative effect on our sales margins and market share, as well as our overall business and financial results. If we are unable to supply sufficient amounts of our products on a timely basis, our market share could decrease and, correspondingly, our profitability could decrease. We have entered into exclusive supply or manufacturing agreements for several of our largest-selling products, such as DYNACIN® and LIDEX®. Under these agreements, with certain exception, we must purchase most of our product supply from specific manufacturers. If any of these exclusive manufacturer or supplier relationships were terminated, we would be forced to find a replacement manufacturer or supplier. The FDA requires that all manufacturers used by pharmaceutical companies such as Medicis comply with the FDA’s regulations, including those cGMP regulations applicable to manufacturing processes. The cGMP validation of a new facility and the approval of that manufacturer for a new drug product may take a year or more before manufacture can begin at the facility. Delays in obtaining FDA validation of a replacement manufacturing facility could cause an interruption in the supply of our products. Although we have business interruption insurance covering the loss of income for up to 12 months, which may mitigate the harm to Medicis from the interruption of the manufacturing of our largest selling products caused by certain events, the loss of a manufacturer could still have a negative effect on our sales, margins and market share, as well as our overall business and financial results. Our Reliance on Third-Party Manufacturers and Suppliers Can Be Disruptive to Our Inventory Planning We and the manufacturers of our products rely on suppliers of raw materials used in the production of our products. Some of these materials are available from only one source and others may become available from only one source. Any disruption in the supply of raw materials or an increase in the cost of raw materials to our manufacturers could have a significant effect on their ability to supply us with our products. We try to maintain inventory levels that are no greater than necessary to meet our current projections. Any interruption in the supply of finished products could hinder our ability to timely distribute finished products. If we are unable to obtain adequate product supplies to satisfy our customers’ orders, we may lose those orders and our customers may cancel other orders and stock and sell competing products. This in turn could cause a loss of our market share and negatively affect our revenues. We cannot be certain that supply interruptions will not occur or that our inventory will always be adequate. Numerous factors could cause interruptions in the supply of our finished products including shortages in raw material required by our manufacturers, changes in our sources for manufacturing, our failure to timely locate and obtain replacement manufacturers as needed and conditions effecting the cost and availability of raw materials. The Growth of Managed Care Organizations and Other Third-Party Reimbursement Policies May Have an Adverse Effect on Our Pricing Policies and Our Margins Our operating results and business success depends in large part on the availability of adequate third-party payor reimbursement to patients for our prescription-brand products. These third-party payors include governmental entities (such as Medicaid), private health insurers and managed care organizations (“MCOs”). Over 70% of the U.S. population now participates in some version of managed care. Because of the size of the patient population covered by MCOs, marketing of prescription drugs to them and the pharmacy benefit managers (“PBMs”) that serve many of these organizations has become important to our business. MCOs and other third-party payors try to negotiate the pricing of medical services and products to control their costs. MCOs and PBMs typically develop formularies to reduce their cost for medications. Formularies can be based on the prices and therapeutic benefits of the available products. Due to their lower costs, generics are often favored. The breadth of the products covered by formularies varies considerably from one MCO to another, and many formularies include alternative and competitive products for treatment of particular medical conditions. Exclusion of a product from a formulary can lead to its sharply reduced usage in the MCO patient population. Payment or reimbursement of only a portion of the cost of our prescription products could make our products less attractive, from a net-cost perspective, to patients, suppliers and prescribing physicians. We cannot be certain that the reimbursement policies of these entities will be adequate for Medicis’ branded pharmaceutical products to compete on a price basis. If our products are not included within an adequate number of formularies or adequate reimbursement levels are not provided, or if those policies increasingly favor generic products, our market share and gross margins could be negatively affected, as could our overall business and financial condition. Some of our products are not of a type generally eligible for reimbursement. It is possible that products manufactured by others could address the same effects as our products and be subject to reimbursement. If this were the case, our products may be unable to compete on a price basis. Managed care initiatives to control costs have influenced primary-care physicians to refer fewer patients to dermatologists and other specialists. The result has been a declining market for dermatological products. Further reductions in these referrals could have a material adverse effect on the size of our potential market as well as our business, financial condition and results of operation. Our Continued Growth Depends on Acquisitions Medicis’ strategy for continued growth to a material extent involves the acquisition of new product lines or businesses. These acquisitions could be by acquiring other pharmaceutical companies, acquiring a portion of a company’s assets or product lines, or obtaining licenses or other rights to manufacture and distribute products. Currently, we intend to focus our acquisition, licensing and development efforts on skin care products, which has been our historical focus, and possibly on other specialty pharmaceutical niches. We cannot be certain that we will be able to identify suitable acquisition candidates or products or if any will be available at all. In addition, even if suitable acquisitions are identified, we may not be able to secure terms which are beneficial. Other pharmaceutical companies with greater financial, marketing and sales resources than we do also try to grow through these same acquisition and licensing strategies. Because of their greater resources, our competitors may be able to offer better terms for an acquisition than Medicis can offer or they may be able to demonstrate a greater ability than Medicis to market licensed products. Our Continued Growth Depends Upon Our Ability to Develop New Products Medicis has internally developed potential pharmaceutical compounds and agents; we also have acquired the rights to certain potential compounds and agents in various stages of development. We currently have a variety of new products in various stages of research and development and are working on possible improvements, extensions and reformulations of some existing products. These research and development activities, as well as the clinical testing and regulatory approval process, which must be completed before commercial quantities of these developments can be sold, will require significant commitments of personnel and financial resources. Delays in the research, development, testing or approval processes will cause a corresponding delay in revenue generation from those products. Regardless of whether they are ever released to the market, the expense of such processes will have already been incurred. We reevaluate our research and development efforts regularly to assess whether our efforts to develop a particular product or technology are progressing at a rate that justifies our continued expenditures. On the basis of these reevaluations, we have abandoned in the past, and may abandon in the future, our efforts on a particular product or technology. There can be no certainty that any product we are researching or developing will ever be successfully released to the market. If we fail to take a product or technology from the development stage to market on a timely basis, we may incur significant expenses without a near-term financial return. We have in the past, and may in the future, supplement our internal research and development by entering into research and development agreements with other pharmaceutical companies. We cannot be sure, however, that we will be able to locate adequate research partners or that supplemental research will be available on terms acceptable to us in the future. If Medicis is unable to enter into additional research partnership arrangements, we may incur additional costs to continue research and development internally or abandon certain projects. Our Business Strategy May Cause Fluctuating Operating Results Our operating results and financial condition may fluctuate from quarter to quarter and year to year depending upon the relative timing of events or uncertainties which may arise. For example, the following events or occurrences could cause fluctuations in our financial performance from period to period: • changes in the levels we spend to develop, acquire or license new product lines • changes in the amount we spend to promote our products • delays between our expenditures to acquire new product lines or businesses and the generation of revenues from those acquired products or businesses • changes in treatment practices of physicians that currently prescribe our products • changes in reimbursement policies of health plans and other similar health insurers, including changes that affect newly developed or newly acquired products • increases in the cost of raw materials used to manufacture our products • the development of new competitive products by others • the mix of products that we sell during any time period • our responses to price competition Fluctuations in Demand for Our Products Create Inventory Maintenance Uncertainties Medicis historically has experienced lower sales levels in the first quarter of our fiscal year (July 1 - September 30). In addition, we typically experience greater revenues and, correspondingly, greater income during the last month of each fiscal quarter. We try to match our expenditures for inventory with these historical fluctuations in demand. However, if these demand patterns change or we experience even a small delay in delivery of inventory, revenue could be deferred or even lost if products are unavailable to meet peak demand. A deferral of revenue to a later period, or the loss of revenue completely, could cause significant period-to-period fluctuations in our operating results, as a significant portion of our operating expenses are fixed in the short term. These fluctuations could result in our not meeting earnings expectations or result in operating losses for a particular period. Medicis Is Subject to Extensive Governmental Regulation Pharmaceutical companies are subject to heavy regulation by a number of national, state and local agencies. Of particular importance is the FDA in the United States. It has jurisdiction over all of our business and administers requirements covering testing, manufacture, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of our products. In addition, the FTC and state and local authorities regulate the advertising of OTC drugs and cosmetics. Failure to comply with applicable regulatory requirements could, among other things, result in fines; suspensions of regulatory approvals of products; product recalls; delays in product distribution, marketing and sale; and civil or criminal sanctions. Our prescription and OTC products receive FDA review regarding their safety and effectiveness. However, the FDA is permitted to revisit and change its prior determinations and we cannot be sure that the FDA will not change its position with regard to the safety or effectiveness of our products. If the FDA’s position changes, we may be required to change our labeling or formulations, or cease to manufacture and market the challenged products. Even prior to any formal regulatory action, we could voluntarily decide to cease distribution and sale or recall any of our products if concerns about the safety or effectiveness develop. Before marketing any drug that is considered a “new drug” by the FDA, the FDA must provide its premarketing approval of the product. All products which are considered “cosmetics” or drugs which are not “new drugs” and that generally are recognized as safe and effective for use by the FDA do not require the FDA’s premarketing approval. We believe that some of our products, as they are promoted and intended for use, are exempt from treatment as “new drugs” and are not subject to premarketing approval by the FDA. The FDA, however, could take a contrary position and we could be required to seek FDA approval of those products and the marketing of those products. We could also be required to withdraw those products from the market. In recent years, various legislative proposals have been offered in Congress and in some state legislatures that include major changes in the health care system. These proposals have included price or patient reimbursement constraints on medicines and restrictions on access to certain products. We cannot predict the outcome of such initiatives, and it is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting us. We Face Significant Competition Within Our Industry The pharmaceutical industry is highly competitive. Competition in our industry occurs on a variety of fronts, including developing and bringing new products to market before others, developing new technologies to improve existing products, developing new products to provide the same benefits as existing products at less cost and developing new products to provide benefits superior to those of existing products. Most of our competitors are large, well-established companies in the fields of pharmaceuticals, chemicals, cosmetics and health care. Our competitors include AHP, Warner Chilcott, Barr Labs, Schering-Plough, Bristol-Myers, Glaxo Wellcome, Galderma, Dermik Labs, Pharmacia & Upjohn and Pfizer. Many of these companies have greater resources than we do to devote to marketing, sales, research and development and acquisitions. As a result, they have a greater ability to undertake more extensive research and development, marketing and pricing policy programs. It is possible that our competitors may develop new or improved products to treat the same conditions as our products treat or make technological advances reducing their cost of production so that they may engage in price competition through aggressive pricing policies to secure a greater market share to our detriment. These competitors also may develop products which make our current or future products obsolete. Any of these events could have a significant negative impact on our business and financial results, including reductions in our market share and gross margins. Medicis sells and distributes both prescription brands and an OTC product. Each of these products competes with products produced by others to treat the same conditions. Several of our prescription products, including DYNACIN®, LIDEX®, SYNALAR® and TOPICORT®, compete with generic pharmaceuticals, which claim to offer equivalent benefit at a lower cost. In some cases, insurers and other health care payment organizations try to encourage the use of these less expensive generic brands through their prescription benefits coverages and reimbursement policies. These organizations may make the generic alternative more attractive to the patient by providing different amounts of reimbursement so that the net cost of the generic product to the patient is less than the net cost of our prescription brand product. Aggressive pricing policies by our generic product competitors and the prescription benefits policies of insurers could cause us to lose market share or force us to reduce our margins in response. Our Success Depends on the Management of Recent and Future Growth Medicis recently experienced a period of rapid growth from both acquisitions and internal expansion of our operations. This growth has placed significant demands on our human and financial resources. We must continue to improve our operational, financial and management information controls and systems and effectively motivate, train and manage our employees to properly manage this growth. Even if these steps are taken, we cannot be sure that our recent acquisitions will be assimilated successfully into our business operations. If we do not manage this growth effectively, maintain the quality of our products despite the demands on our resources and retain key personnel, our business could be negatively impacted. There are High Costs of Obtaining FDA and Other Regulatory Approvals The process of obtaining FDA and other regulatory approvals is lengthy and expensive. Clinical trials are required and the marketing and manufacturing of pharmaceutical products are subject to rigorous testing procedures. We may not be able to obtain FDA approval to conduct clinical trials or to manufacture and market any of the products we develop, acquire or license. Moreover, the costs to obtain approvals could be considerable and the failure to obtain or delays in obtaining an approval could have a significant negative effect on our business performance and financial results. Even if premarketing approval from the FDA is received, the FDA is authorized to impose post-marketing requirements such as: • testing and surveillance to monitor the product and its continued compliance with regulatory requirements • submitting products for inspection and, if any inspection reveals that the product is not in compliance, the prohibition of the sale of all products from the same lot • suspending manufacturing • recalling products • withdrawing marketing clearance In its regulation of advertising, the FDA from time to time issues correspondence to pharmaceutical companies alleging that some advertising or promotional practices are false, misleading or deceptive. The FDA has the power to impose a wide array of sanctions on companies for such advertising practices, and the receipt of correspondence from the FDA alleging these practices can result in the following: • incurring substantial expenses, including fines, penalties, legal fees and costs to comply with the FDA’s requirements • changes in the methods of marketing and selling products • taking FDA-mandated corrective action, which may include placing advertisements or sending letters to physicians rescinding previous advertisements or promotion • disruption in the distribution of products and loss of sales until compliance with the FDA’s position is obtained Dependence of Licenses from Others We have acquired the right to manufacture, use or market certain products, including our Key Products. We also expect to continue to obtain licenses for other products and technologies in the future. Our license agreements generally require us to develop a market for the licensed products. If we do not exert enough efforts to develop these markets, the licensors may be entitled to terminate these license agreements. We cannot be certain that we will fulfill all of our obligations under any particular license agreement for any variety of reasons, including insufficient resources to adequately develop and market a product, lack of market development despite our diligence and lack of product acceptance. Our failure to fulfill our obligations could result in the loss of our rights under a license agreement. Our inability to continue the distribution of any particular licensed product could have a material negative effect on our business, market share and profitability. Also, certain products we license are used in connection with other products we own or license. A loss of a license in such circumstances could materially harm our ability to market and distribute these other products. Our growth and acquisition strategy depends on the successful integration of licensed products with our existing products. Therefore, any loss, limitation or flaw in a licensed product could impair our ability to market and sell our products, delay new product development and introduction, and/or adversely affect our reputation. These problems, individually or together, could have a material adverse effect on our business and results of operation. Adequacy of Trademarks, Patents and Proprietary Rights We believe that the protection of our trademarks and service marks is an important factor in product recognition and in maintaining or increasing market share. If we do not adequately protect our rights in our various trademarks and service marks from infringement, any goodwill which has been developed in those marks could be lost or impaired. If the marks we use are found to infringe upon the trademark or service mark of another company, we could be forced to quit using those marks and, as a result, we could lose all the goodwill which has been developed in those marks and could be liable for damages caused by an infringement. We are pursuing several U. S. patent applications, although we cannot be sure that any of these patents will ever be issued. We also have acquired rights under certain patents and patent applications in connection with our licenses to distribute products and from the assignment rights to patents and patent applications from certain of our consultants and officers. These patents and patent applications may be subject to claims of rights by third parties. If there are conflicting claims to the same patent or patent application, we may not prevail and, even if we do have some rights in a patent or application, those rights may not be sufficient for the marketing and distribution of products covered by the patent or application. The patents and applications in which we have an interest may be challenged as to their validity or enforceability. Challenges may result in potentially significant harm to our business. The cost of responding to these challenges and the inherent costs to defend the validity of our patents, including the prosecution of infringements and the related litigation, could be substantial. Such litigation also could require a substantial commitment of management’s time. The ownership of a patent or an interest in a patent does not always provide significant protection. Others may independently develop similar technologies or design around the patented aspects of our technology. We only conduct patent searches to determine whether our products infringe upon any existing patents, when we think such searches are appropriate. As a result, the products and technologies we currently market, and those we may market in the future, may infringe on patents and other rights owned by others. If we are unsuccessful in any challenge to the marketing and sale of our products or technologies, we may be required to license the disputed rights, if the holder of those rights is willing, or to cease marketing the challenged products, or to modify our products to avoid infringing upon those rights. We also rely upon unpatented proprietary know-how and continuing technological innovation in developing and manufacturing many of our principal products. Medicis requires all of its employees, consultants and advisors to enter into confidentiality agreements prohibiting them from taking our proprietary information and technology. Nevertheless, these agreements may not provide meaningful protection of our trade secrets and proprietary know-how if they are used or disclosed. Despite all of the precautions we may take, people who are not parties to confidentiality agreements may obtain access to our trade secrets or know-how. In addition, others may independently develop similar or equivalent trade secrets or know-how. Product Liability Medicis is exposed to risks of product liability claims from allegations that our products resulted in adverse effects to the patient or others. These risks exist even with respect to those products that are approved for commercial sale by the FDA and manufactured in facilities licensed and regulated by the FDA. In addition to our desire to reduce the scope of our potential exposure to these types of claims, many of our customers require us to maintain product liability insurance as a condition of conducting business with us. We currently carry product liability insurance in the amount of $50.0 million per claim and $50.0 million in the aggregate on a claims-made basis. Nevertheless, this insurance may not be sufficient to cover all claims made against us. We also cannot be certain that our current coverage will continue to be available in the future on reasonable terms, if at all. If we are liable for any product liability claims in excess of our coverage or outside of our coverage, the cost and expense of such liability could severely damage our business, financial condition and profitability. Successful Integration of New Products Is Not Certain When we acquire or develop new products and product lines, we must be able to integrate those products and product lines into our systems for marketing, sales and distribution. If these products or product lines are not integrated successfully, the potential for growth is limited. The new products we acquire or develop could have channels of distribution, competition, price limitations or marketing acceptance different from our current products. As a result, we do not know whether we will be able to compete effectively and obtain market acceptance in any new product categories. After acquiring or developing a new product, we may need to significantly increase our sales force and incur additional marketing, distribution and other operational expenses. These additional expenses could negatively affect our gross margins and operating results. In addition, many of these expenses could be incurred prior to the actual distribution of new products. Because of this timing, if the new products are not accepted by the market or if they are not competitive with similar products distributed by others, the ultimate success of the acquisition or development could be substantially diminished. Item 2: Item 2: Properties The Company presently occupies approximately 29,000 square feet of office space, at an average annual expense of $433,000, under a lease agreement that expires in May 2005. The lease contains certain rent escalation clauses and, upon expiration, can be renewed for a period of five years. Rent expense was approximately $564,000, $350,000 and $203,000 for fiscal 1999, 1998 and 1997, respectively. The Company is currently evaluating its present office space in conjunction with its estimated personnel growth and is considering acquiring additional space, either at its existing location or, if not available, in another building within the Phoenix metropolitan area. Medicis Canada, Inc., a wholly owned subsidiary, presently leases approximately 7,500 square feet of office and warehouse space in St-Laurent, Quebec, Canada, under a lease agreement that expires in April 2000. Item 3: Item 3: Legal Proceedings The Company and certain of its subsidiaries are parties to actions and proceedings incident to their businesses, including certain litigation assumed in connection with the GenDerm acquisition. The Company believes liability in the event of final adverse determinations in any of these matters is either covered by the indemnification provided to the Company under the GenDerm acquisition agreement, insurance and/or established reserves, or, will not, in the aggregate, have a material adverse effect on the business, financial position or results of operations of the Company. There can be no assurance, however, that an adverse determination on any action or proceeding will not have a material adverse effect on the business, financial condition and results of operations of the Company, or that the Company will be able to realize the full amount of any indemnification obligation that any person may have to the Company under the GenDerm acquisition agreement. Item 4: Item 4: Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the security holders of the Company during the fourth quarter of fiscal 1999. PART II Item 5: Item 5: Market for Registrant’s Common Equity and Related Stockholder Matters The market for the Company’s Class A Common Stock is the New York Stock Exchange. Additional information required by this item is incorporated by reference from page 39 of the Company’s 1999 Annual Report to Shareholders. Item 6: Item 6: Selected Financial Data Historical financial information is incorporated by reference from the Selected Financial Data table on page 40 of the 1999 Annual Report to Shareholders. Item 7: Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations Information required by this item is incorporated by reference on pages 14-21 of the 1999 Annual Report to Shareholders. Item 7A: Item 7A: Quantitative and Qualitative Disclosures about Market Risk Information required by this item is incorporated by reference from the discussion under the heading Market Risk and Risk Management Policies on page 21 of the 1999 Annual Report to Shareholders. Item 8: Item 8: Financial Statements and Supplementary Data Information required by this item is incorporated by reference from the Independent Auditors Report found on page 22 and from the Consolidated Financial Statements and Supplementary Data on pages 23-40 of the 1999 Annual Report to Shareholders. Item 9: Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10: Item 10: Directors and Executive Officers of the Registrant Item 11: Item 11: Executive Compensation Item 12: Item 12: Security Ownership of Certain Beneficial Owners and Management Item 13: Item 13: Certain Relationships and Related Transactions The information called for by Items 10, 11, 12 and 13 are incorporated by reference to the Company’s definitive Proxy Statement for the 1999 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A. PART IV Item 14: Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K Item 14(a)(1): Financial Statements The following consolidated financial statements, related notes and independent auditors report, from the 1999 Annual Report to Shareholders, are incorporated by reference into item 8 of Part II of this report: Item 14 (a)(2): Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts S-1 The financial statement schedule should be read in conjunction with the consolidated financial statements. Financial Statement schedules not included in this Form 10-K have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Item 14 (a)(3): Exhibits Filed as Part of This Report (1) Incorporated by reference to the exhibit with the same number in the Registration Statement on Form S-1 of the Registrant, File No. 33-32918, filed with the SEC on January 16, (2) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1992, as amended, File No. 0-18443, previously filed with the SEC (3) Incorporated by reference to the exhibit with the same number in Amendment No. 2 to the Registration Statement on Form S-1 of the Company, File No. 33-34041, filed with the SEC on August 2, 1990 (4) Incorporated by reference to the exhibit with the same number in Registration Statement on Form S-1 of the Company, File No. 33-54276, filed with the SEC on June 11, 1993 (5) Incorporated by reference to Exhibit B to the Company’s definitive Proxy Statement for its 1992 Annual Meeting of Shareholders, File No. 0-18443, previously filed with the SEC. (6) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1993, File No. 0-18443, filed with the SEC on October 13, 1993 (7) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1995, File No. 0-18443, filed with the SEC on September 27, 1995 (8) Incorporated by reference to exhibit number 4.2 in the 1995 Form 10-K (9) Incorporated by reference to exhibit number 4.4 in the 1995 Form 10-K (10) Incorporated by reference to exhibit number 4.5 in the 1995 Form 10-K (11) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1996, File No. 0-18443, filed with the SEC on September 24, 1996 (12) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, File No. 0-18443, previously filed with the SEC (13) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 1996, File No. 0-18443, previously filed with the SEC (14) Incorporated by reference to the exhibit with the same number in the Company’s Current Report on Form 8-K filed with the SEC on December 15, 1997 (15) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 1998, File No. 0-18443, previously filed with the SEC (16) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 1999, File No. 0-18443, previously filed with the SEC (17) Filed herewith (b) Reports on Form 8-K During the fourth quarter of fiscal 1999, the Company filed the following reports on Form 8-K: (i) Current report on Form 8-K dated April 23, 1999 reporting under Item 5 that the Company acquired all the issued and outstanding common stock of Ucyclyd Pharma, Inc. (ii) Current report on form 8-K dated May 18, 1999 reporting under Item 5 that the Company’s Board of Directors adopted a resolution authorizing the plan to repurchase up to $75 million of the Company’s common stock. POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Jonah Shacknai and Mark A. Prygocki, Sr., or either of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and a all capacities, to sign any and all amendments to this Annual Report on Form 10-K and any documents related to this report and filed pursuant to the Securities and Exchange Act of 1934, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitute or substitutes may lawfully do or cause to be done by virtue hereof. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: September 28, 1999 MEDICIS PHARMACEUTICAL CORPORATION By: /s/ JONAH SHACKNAI Jonah Shacknai Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (1) Allowance related to acquisition of GenDerm. S-1 EXHIBIT INDEX (1) Incorporated by reference to the exhibit with the same number in the Registration Statement on Form S-1 of the Registrant, File No. 33-32918, filed with the SEC on January 16, (2) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1992, as amended, File No. 0-18443, previously filed with the SEC (3) Incorporated by reference to the exhibit with the same number in Amendment No. 2 to the Registration Statement on Form S-1 of the Company, File No. 33-34041, filed with the SEC on August 2, 1990 (4) Incorporated by reference to the exhibit with the same number in Registration Statement on Form S-1 of the Company, File No. 33-54276, filed with the SEC on June 11, 1993 (5) Incorporated by reference to Exhibit B to the Company’s definitive Proxy Statement for its 1992 Annual Meeting of Shareholders, File No. 0-18443, previously filed with the SEC. (6) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1993, File No. 0-18443, filed with the SEC on October 13, 1993 (7) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1995, File No. 0-18443, filed with the SEC on September 27, 1995 (8) Incorporated by reference to exhibit number 4.2 in the 1995 Form 10-K (9) Incorporated by reference to exhibit number 4.4 in the 1995 Form 10-K (10) Incorporated by reference to exhibit number 4.5 in the 1995 Form 10-K (11) Incorporated by reference to the exhibit with the same number in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1996, File No. 0-18443, filed with the SEC on September 24, 1996 (12) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, File No. 0-18443, previously filed with the SEC (13) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 1996, File No. 0-18443, previously filed with the SEC (14) Incorporated by reference to the exhibit with the same number in the Company’s Current Report on Form 8-K filed with the SEC on December 15, 1997 (15) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 1998, File No. 0-18443, previously filed with the SEC (16) Incorporated by reference to the exhibit with the same number in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 1999, File No. 0-18443, previously filed with the SEC (17) Filed herewith

741556_1999.txt

741556_1999

1999

741556

ITEM 1. BUSINESS General The Company was incorporated in Florida in June 1981 with the intended purpose of pursuing orders for products to be designed and manufactured for sale to the military engine generator set controls market, a segment with respect to which the Company's founders had acquired substantial experience. The Company currently designs, develops, manufactures and markets electronic control and measurement devices related to the distribution of electrical power and specializes in electrical safety products that prevent electrical fires and protect people from electrocution and serious injury from electrical shock. Such products include ground fault protective devices, fire prevention devices for fires caused by aging appliance and extension cords, controls for electrical power generating systems, transformers and magnetics. These products are used in providing safe and efficient utilization and controlled distribution of electricity and have consumer, commercial and governmental applications in the United States and throughout the world. Until the year ended March 31, 1989, a majority of the Company's revenues were derived from sales of military products. The Company believes that its successful design of ground fault devices for both personnel and equipment protection as well as meeting electrical safety requirements for personal care products, have formed the basis for the Company's success in the consumer/commercial, non-military markets. Net sales contributed by commercial and military products are as follows: Year Ended March 31 Commercial % Military % Total -------- ---------- ---- -------- ---- ---------- 1999 $ 13,929,177 81.4 $ 3,190,542 18.6 $ 17,119,719 1998 13,434,352 74.2 4,667,433 25.8 18,101,785 1997 12,803,181 85.3 2,200,413 14.7 15,003,594 1996 14,541,301 87.7 2,040,000 12.3 16,581,301 1995 18,095,134 86.4 2,840,423 13.6 20,935,557 Royalties from license agreements are as follows: Year Ended March 31 Royalties -------- --------- 1999 $ 91,295 1998 329,166 1997 381,977 1996 797,920 1995 837,399 The Company's backlog of unshipped orders at March 31, 1999 was approximately $2,000,000. This backlog consists of approximately 30% commercial product orders and approximately 70% military product orders, all of which is expected to ship within Fiscal Year 2000. Commercial Products and Markets Ground fault protective devices protect equipment and people against electrical faults which can occur between electrically "live" conductors and ground. These ground fault conditions can damage equipment, start fires, or seriously or fatally injure humans. Ground Fault Circuit Interrupters ("GFCI") and Appliance Leakage Circuit Interrupters ("ALCI") provide protection from dangerous electrical shock by sensing leakage of electricity and cutting off power. Equipment Leakage Current Interrupters ("ELCI") detect current leakage within equipment such as copy machines, printers and computers. GFCIs are currently available in three types: circuit breaker, receptacle and portable. The Company specializes in the portable types of these products. A ground fault is a condition where electric current finds an unintentional path to ground such as through the exposed metal parts of an appliance or tool. Faults occur because of damage that causes internal wiring to touch these exposed metal parts or because an appliance or tool gets wet. Upon such occurrence, the entire device can become as electrically alive as the power line to which it is attached. If a person is touching such a live device while grounded (by being in contact with the ground or, for example, a metal pipe, gas pipe, drain or any attached metal device), that person can be seriously or fatally injured by electric shock. Fuses or circuit breakers do not provide adequate protection against such shock, because the amount of current necessary to injure or kill a normal adult is far below the level of current required for a fuse to blow or a circuit breaker to trip. GFCIs constantly monitor electric current, and as long as the amount of current returning from the device is equal to the amount that is directed to the device, the GFCI performs no activities. Conversely, if there is less current coming back than there is flowing into the device, some portion must be taking a path through a foreign body, thereby creating a hazard. Upon recognizing that condition, the GFCI terminates the flow of electricity instantaneously. An ALCI is a device intended to be used in conjunction with an electrical appliance whose function is to interrupt both conductors of the electric circuit to a load when a fault current to ground exceeds 4 - 6 mA (milli- amperes) and is less than that required to operate the overcurrent protection device of the circuit. The ALCI is intended to be used only in a circuit that has a solidly grounded neutral conductor, and is not intended to be used in place of a GFCI in applications where the GFCI is required. ALCIs are considered "personnel protection" devices. This product is intended for portable and short-time use, and should be used only while attended; for example, with kitchen appliances, floor care products, hair dryers, and the like, which are connected to a power supply circuit by means of a flexible cord terminating in an attachment plug. An ELCI is a device intended to protect equipment from excessive electrical leakage current that could occur due to the breakdown of insulation between live and grounded parts which could cause fires and other damage. Xerox Corporation uses the Company's ELCI products to protect many of its business machines. The Company also has a unique versatile consumer ELCI product called the "Electra Shield" which, in addition to fire prevention capabilities, also provides three-mode surge suppression, power line filtering, and facsimile modem surge protection. This unique product offers multimedia protection for home and office personal computers, fax modems, TV and entertainment systems. Government and industry research into the major causes of fire has led to a search for new, cost-effective methods to prevent electrical fires. In response to this need, the Company developed and patented "Fire Shield", a product designed to prevent fires caused by damaged or aging appliance power supply cords and extension cords, which have been identified as a leading cause of electrical fires. On June 1, 1999, the Company announced major enhancements to its "Fire Shield" line of appliance power supply cords that will add a higher degree of safety against fire and electric shock for two wire appliances. These new capabilities have significant safety benefits to the consumer. These enhancements are based on feedback from the industry and from the staff of the United States Consumer Product Safety Commission ("CPSC") on the need to protect not only the power cord, but also the internal wiring of the appliance. According to the CPSC, these types of fires caused 149,900 residential structural fires involving electrical equipment, which resulted in 750 civilian deaths, more than 6,320 injuries and nearly $1.3 billion in property losses. The CPSC estimates were based on 1994 fire service reports. The National Electrical Code (the "Code") requires GFCIs for the protection of all receptacle outlets located outdoors, as well as in bathrooms, garages and other risk areas, and in new residences, hotels and public buildings. The Code is followed by most local government building codes. There is increasing effort by certain groups such as the National Electric Manufacturers Association and Consumer Products Safety Commission to require GFCI protection in other locations and applications. The Company presently focuses its marketing efforts in certain spot markets which have developed in response to Code imposed requirements. For example, in January 1989, high-pressure sprayer/washer manufacturers that desired Underwriter Laboratories ("UL") approval were required to include a GFCI and/or double-insulation protection on each electrically driven sprayer/ washer. Sales to this industry were severely impacted in Fiscal Year 1996 as the majority of the sprayer/washer manufacturers opted for the more cost effective double-insulated technology rather than GFCI technology. Effective January 1996, the double-insulation provision was eliminated from the National Electric Code, but until recently, UL had not updated its standard enforcing this change. Sales to this industry were approximately $4.5 million less in each of the Fiscal Years 1996, 1997, 1998 and 1999, compared to Fiscal Year 1995, due to the choice of sprayer/washer manufacturers not using the Company's GFCI products and due to the delay of UL enforcing on the industry the requirement for GFCI technology. The revised standard UL 1776 mandating the use of GFCIs on sprayer/washers has been issued, and the effective date for compliance is May 4, 2000. This action expands the Company's opportunity to sell into this important market again, but the Company has no certainty of returning back to its previous revenue level in this market. Another example is a Code requirement that became effective on January 1, 1991 that requires a protective device to be incorporated into hair dryers, curling irons and crimpers to protect users from possible electrocution. In response to this Code change, the Company developed a smaller GFCI plug that incorporates its patented GFCI/ALCI technology. Additionally, the Company developed an Immersion Detection Circuit Interrupter ("IDCI") that can also be used to protect users of these products. Also, Article 625 of the 1996 Edition of the National Electrical Code requires electric vehicle ("EV") charging systems to include a system that will protect people against serious electric shock in the event of a ground fault. The Company has shipped product to the majority of the major automobile manufacturers in support of their small EV production builds, and the Company is active with various standards and safety bodies, relating to the electric vehicle, on a worldwide basis. Sales for the Company's EV safety products remain relatively low due to the small number of electric vehicles produced. Improvements in battery technology, along with mandates from individual states for zero emission vehicles, are projected to make this a viable market in year 2003. The Company currently manufactures and markets various portable GFCI, ALCI and ELCI products, such as plug-in portable adapters, several extension cord models in various lengths, various modules for OEM customers, and variations of such products for voltage differences in both the United States and foreign markets. The Company has been issued several domestic and foreign patents on its portable GFCI which incorporate design features not available on any similar product known to the Company (see Patents, Licenses and Trademarks on page 9 for further information). The Company has entered into seven license agreements and three sales and marketing agreements concerning the portable GFCI, ALCI and ELCI. These agreements are with entities located in Australia, France, Italy, Japan, the United Kingdom and the United States and are for the purpose of market penetration in those areas where it would be difficult for the Company to compete on a direct basis. On February 16, 1999, the Company entered into a license agreement with Windmere-Durable Holdings, Inc. (the "Agreement"), which is filed herewith. Windmere-Durable Holdings, Inc. is a large Miami, Florida based manufacturer and distributor of a wide variety of, among other items, household appliances and portable personal care products utilizing electric current (e.g. washers and dryers, hair dryers and curlers, irons, food mixers and numerous other items), most of which are sold both domestically and internationally. Under the Agreement, Windmere-Durable was granted a non-exclusive license to manufacture, have manufactured, use and sell the Company's line of "Fire Shield" products in exchange for royalties. Military Products and Markets The Defense Logistics Agency established a program rating system for its suppliers in 1995, and since its inception and for the fourth straight year, the Company was honored as a Best Value Medalist for the highest rating Gold Category, which signifies the Company's commitment to military contract performance. The Company is currently a supplier of control equipment used in engine generator systems purchased by the United States military and its prime contractors. The term "control equipment" refers to the electrical controls used to control the electrical power output of the generating systems. In general, the controls monitor and regulate the operation of generator mobile electric generating system sets. Electric generating systems are basic to all branches of the military, and demand has remained relatively constant, unlike products utilized in armaments and missiles. Sales are made either directly to the government for support parts or to prime contractors for new electric generator sets which incorporate the Company's products. The Company is a qualified supplier for 37 control equipment products as required by the Department of Defense and is a supplier of the following types of control equipment, among others: protective relays and relay assemblies, instrumentation transducer controls, fault locating panel indicators, current transformer assemblies for current sensing control and instrumentation, motor operated circuit breaker assemblies and electrical load board and voltage change board assemblies. These products are primarily furnished for spare parts support for existent systems in the military inventory. In late 1989, the Company completed the redesign of the control equipment related to the Tactical Quiet Generator ("TQG") Systems program and provided prototype units to a prime contractor for testing, which was completed in the third fiscal quarter for the year ended March 31, 1992. Subsequently, the Company received production orders for these products from the U.S. Government's prime contractor in the approximate amount of $7,500,000 covering the time period from August 1992 to October 1994 and an additional $4,900,000 covering the time period August 1996 to July 1998. All deliveries have been completed under these contracts. The new contract that has been awarded by the U.S. Government for 5/10/15KW TQG Systems to the prime contractor is for a 10-year period with the last ordering period year being 2007. The Company has received initial production releases for this new contract, valued at $1.9 million, and shipments commenced in the 4th quarter of Fiscal Year 1999. The estimated value of the new 10-year contract for the Company for its 5/10/15KW control equipment is $8.2 million. As previously reported, the Company also received orders for approximately $6.3 million for the new 3KW military TQG Systems program. Assuming successful completion of First Article Testing and release of the production phase of the initial contract, shipments of approximately 4,200 3KW TQG control equipment are now estimated to begin in March 2000. The Company expects military sales to remain steady for Fiscal Year 2000 with potential strengthening in the fourth quarter to the extent that Shipments are made under the new 3KW TQ Program. The Company continues to furnish various types of electrical power monitors for military Naval shipboard requirements. The monitors are used on all classes of Naval surface vessels, such as minesweepers, destroyers guided missile cruisers and aircraft carriers in addition to other types of Naval vessels. The monitors are furnished for new vessel production, retrofit upgrades and existent vessels requiring spare support parts. The Company also supplies the military with electrical devices for control and monitoring of the on-board auxiliary power diesel electric generating system for the new C2v Armored Tactical Vehicle, Electronic Command Post System and the newly developed armored ambulances. These devices include A.C. power monitor assemblies (which provide system protection and status display on on-board computers), generator voltage regulators, power transformers, A.C. overcurrent and short circuit protection monitor assemblies and current sensing transformers. All of these products have met the high shock and vibration and endurance testing requirements during both highly accelerated stress screening tests and vehicle road testing at Aberdeen Proving Grounds. The Company is now receiving order releases for the initial low rate production phase for C2v vehicles. The Company's contracts with the U.S. Government are on a fixed-price bid basis. As with all fixed-price contracts, whether government or commercial, the Company may not be able to negotiate higher prices to cover losses should unexpected manufacturing costs occur. All government contracts contain a provision that allows for cancellation by the government "for convenience." However, the government must pay for costs incurred and a percentage of profits expected if a contract is so canceled. Contract disputes may arise which could result in a suspension of such contract or a reduction in the amounts claimed. Testing and Qualification A number of the Company's commercial products must be tested and approved by UL or an approved testing laboratory. UL publishes certain "Standards of Safety" which various types of products must meet and performs specific tests to ascertain whether a product meets the prescribed standards. If a product passes these tests, it receives UL approval. Once the Company's products have been initially tested and qualified by UL, they are subject to regular field checks and quarterly reviews and evaluations. UL may withdraw its approval for such products if they fail to pass these tests and if prompt corrective action is not taken. The Company's portable electrical safety products have received UL approval. In addition, certain of the Company's portable GFCI, ALCI and ELCI products have successfully undergone similar testing procedures conducted by comparable governmental testing facilities in Europe, Canada and Japan. The Company's military products are subject to testing and qualification standards imposed by the United States Government. The Company has established a quality control system which has been qualified by the United States Department of Defense to operate under the requirements of a particular specification (MIL-I-45208). To the extent the Company designs a product which it believes to meet those specifications, it submits the product to the responsible government testing laboratory. Upon issue of the qualification approval and source listing, the product is rarely subject to re-qualification; however, the military may disqualify a product if it is subject to frequent or excessive operational failures. Further, the current specifications and requirements could be changed at any time, which would require the Company to redesign its existing products or develop new products which would have to be submitted for testing and qualification prior to their approval for purchase by the military or its prime contractors. Certain contracts require witness testing and acceptance by government inspectors prior to shipment of the product. The Company's wholly owned foreign subsidiary, TRC/Honduras S.A. de C.V. is an ISO 9002 certified manufacturing facility. Design and Manufacturing The Company currently designs almost all of the products which it produces and generally will not undertake special design work for customers unless it receives a contract to produce the resulting products. The Company continues to work with foreign licensees to design products for foreign markets. A significant number of the Company's commercial and military electronic products are specialized in that they combine both electronic and magnetic features in design and production. The business of an electronics manufacturer, such as the Company, primarily involves assembly of component parts. The only products which the Company manufactures from raw materials are its transformers and magnetic products. The manufacture of such products primarily involves the winding of wire around magnetic steel cores. Recently, in an effort to lower cost by vertical integration, the Company also molds its own plastic parts for its commercial product lines at its off-shore manufacturing facility in Honduras. The remainder of the products which the Company manufactures are assembled from component parts produced by other manufacturers. On February 3, 1997, the Company's Board of Directors approved the incorporation of TRC Honduras, S.A. de C.V., a wholly owned subsidiary of Technology Research Corporation, for the purpose of manufacturing the Company's high-volume products. This decision was made in line with the Company's goal of always striving to improve quality, profit margins and customer satisfaction. TRC Honduras, S.A. de C.V. resides in a leased 42,000 square foot building located in ZIP San Jose, a free trade zone and industrial park, in San Pedro Sula, Honduras. The lease is for a term of five years with an option to extend the lease for another five years. The benefits of being located in a free trade zone include no Honduran duties on imported raw materials or equipment, no sales or export tax on exported finished product, a twenty year Honduran federal income tax holiday and a ten year Honduran municipal income tax holiday for the profits generated by the Honduran subsidiary, and various other benefits. The Company continues to manufacture its specialized military products and low-volume commercial products in its 43,000 square foot facility in Clearwater, Florida. Patents, Licenses, and Trademarks The Company's President, Mr. Legatti, has designed for the Company and the Company has been issued four U.S. patents and two British, Canadian, Italian and Australian patents with respect to its portable GFCIs that have features not presently available on any similar product known to the Company. Also, patents on the same device have been issued from France, Japan, Germany and three other countries. The patents will be valid for 20 years in the United States running from January 1986. Duration of patents in the other countries vary from 15 to 20 years. The Company licenses its technology for use by others in exchange for a royalty or product purchases. Licensees are located in Australia, France, Italy, Japan, the United Kingdom and the United States. Each licensee agrees to pay the Company a royalty or purchase product based on schedules set forth in the applicable agreement. The Company agrees to provide certain technical support and assistance to its licensees. The licensees have agreed to indemnify and hold the Company harmless against any liability associated with the manufacture and sale of products subject to the license agreement, including but not limited to defects in materials or workmanship. The Company has no other patents on or licensee agreements with respect to its products or technology, but has registered its TRC trademark with the U.S. Office of Patents and Trademarks. Marketing The Company's products are sold throughout the world, primarily through an expanded in-house sales force, licenses and sales and marketing agreements. Although the Company will continue to market existing and new products through these channels, the Company is looking for other viable channels through which to market its products. The Company relies significantly upon the marketing skills and experience, as well as the business experience, of the management of the Company in marketing its products. The Company complements its sales and marketing activity through the use of additional distributors and sales representative organizations. The Company's internal distribution division, TRC Distribution, is supported by 23 independent sales representatives who sell to 445 electrical, industrial and safety distributors. The Company also markets through OEMs that sell the Company's GFCI products under their own brand label. Additionally, the Company has exhibited its GFCI products at numerous trade shows which have resulted in new commercial markets, including the recreational vehicle industry and the appliance industry. The Company utilizes primarily foreign licenses and sales and marketing agreements to market its products internationally (see Patents, Licenses and Trademarks for further information). The Company's products have world-wide application, and the Company believes that international demand for these products will continue to contribute to the Company's growth. The Company offers its customers no specific product liability protection except with regards to those customers that are specifically named as "Broad Form Vendors" under its product liability coverage. The Company does extend protection to purchasers in the event there is a claimed patent infringement that pertains to the Company's portion of the final product. The Company also carries product and general liability insurance for protection in such cases. Major Customers and Exports Individual customers and aggregate exports which accounted for 10% or more of sales were: Year ended March 31 Customer 1999 1998 1997 -------- ---- ---- ---- Xerox Corporation $ 1,934,740 2,838,905 2,529,398 Noma Appliance & Electric, Inc. Noma Appliance, Inc. f/k/a Fleck Manufacturing, Inc. (a Xerox Corporation supplier) 1,623,904 1,666,516 1,776,424 Other Xerox suppliers 124,473 133,044 802,800 Fermont Division 1,397,211 2,817,079 1,434,422 --------- --------- --------- $ 5,080,328 7,455,544 6,543,044 Exports: ========= ========= ========= Canada $ 1,794,855 1,894,215 1,831,898 Far East 394,156 486,277 1,057,605 Europe 2,787,224 2,554,772 1,396,823 Mexico 711,067 979,187 736,992 Australia 117,754 218,530 150,760 South America 37,383 20,994 82,838 Middle East 2,067 3,397 5,324 --------- --------- --------- Total exports $ 5,844,506 6,157,372 5,262,240 ========= ========= ========= Overall, the Company's exports were down approximately 5% in Fiscal Year 1999, compared to the Company's prior fiscal year, due to Xerox Corporation and its suppliers whose sales were down from the previous fiscal year by approximately $1.0 million with the majority of the shortfall coming from the second half of the Company's fiscal year. Xerox and its suppliers accounted for approximately 22% of the Company's sales for Fiscal Year 1999, compared to approximately 26% for the prior fiscal year, and because they account for such a large percentage of the Company's sales, the loss of Xerox as a customer would have a material adverse effect on the Company's business. Excluding Xerox, exports to the Company's international OEM customers were stronger for Fiscal Year 1999 compared to the Company's prior fiscal year. The Company's military product sales are primarily to OEM prime contractors and secondarily to military procurement logistic agencies for field service support on previously shipped systems. In Fiscal Year 1999, military sales were approximately 19% of total sales, compared to 26% in the prior year. The decrease was primarily due to the level of sales with Fermont Division, the U.S. Government's prime contractor for the 5/10/15/30/60KW Tactical Quiet Generator Systems Program. (See MD&A discussion for more detail). Sales to Fermont Division were $1,397,211 in Fiscal Year 1999 compared to $2,817,079 in the prior fiscal year. The Company has no relationship with any of its customers except as a supplier of product. Competition The commercial and military business of the Company is highly competitive. In the commercial market, the Company has significant competition, except with respect to the "Fire Shield" products. The Company believes, however, that product knowledge, patented technology, ability to respond quickly to customer requirements, positive customer relations, price, technical background and industry experience are major competitive factors, and that it competes favorably with respect to these factors. In addition, the Company's patented GFCI technology utilizes, in certain adaptations, waterproofing, a retractable ground pin and "trip mechanism" techniques, each of which provides the Company, in the judgment of its management, with a current competitive advantage. In the military market, the Company's products must initially pass government specified tests. The Company must compete with other companies, some being larger and some smaller than the Company, acting as suppliers of similar products to prime government contractors. The Company believes that knowledge of the procurement process, engineering and technical support, price and delivery are major competitive factors in the military market. The Company believes that it has strength in all of these areas due to senior management's involvement in the government procurement process and experience in the design engineering requirements for military equipment. A substantial portion of spare part procurement is set aside for small business concerns, which are defined in general as entities with fewer than 1,000 employees. Because the Company is classified as a small business concern, it qualifies for such set aside procurements for which larger competitors are not qualified. The entry barriers to the military market are great because of the need, in most cases, for products to pass government tests and qualifications. Research, Development and Engineering The Company employs 18 persons in the Engineering Department, all of whom are engaged either full or part-time in research and development activities. This department is engaged in designing and developing new commercial and military products and improving existing products to meet the needs of the Company's customers. In connection with its efforts in developing the GFCI product, the Company believes that the increasing use of portable GFCI protection will provide new markets for the commercial marketplace, and accordingly, the Company has modified its GFCI designs to fit these markets and new applications. There can be no assurance, however, that the Company can maintain its sales levels in the commercial market in view of the possibility that an increased level of competition may develop. The Company spent $1,107,253 in Fiscal Year 1999, $1,223,422 in Fiscal Year 1998 and $1,147,630 in Fiscal Year 1997 on research, development and engineering activities. None of these activities were sponsored or financed by customers, and all are expensed as incurred. The Company anticipates spending levels to remain constant in the new fiscal year. Employees As of March 31, 1999, the Company employed 113 persons on a full time basis, and of that total, 70 employees were engaged in manufacturing operations, 18 in engineering, 15 in marketing and 10 in administration. The Company's subsidiary employed 405 persons on a full time basis as of March 31, 1999, and of that total, 400 employees were engaged in manufacturing operations and 5 in administration. None of the Company's employees are represented by a collective bargaining unit, and the Company considers its relations with employees to be stable. ITEM 2. ITEM 2. PROPERTIES The Company's executive offices and U.S. manufacturing facility are located on 4.7 acres of leased land in the St. Petersburg-Clearwater Airport Industrial Park. The lease, with options, extends for 40 years until 2021 and is subject to certain price escalation provisions every five years. This leased land is adequate to enable the Company to expand this facility to 60,000 square feet. The present facility provides a total of 43,000 square feet, including 10,000 square feet of offices and engineering areas, as well as 23,000 square feet of production areas and 10,000 square feet of warehouse space. In March 1997, the Company entered into a five year lease agreement with ZIP San Jose, an industrial park located in San Pedro Sula, Honduras, for a 42,000 square foot building in which the Company manufactures its high-volume products. The Company has the option of extending the lease another five years if it wishes. Lease payments began in May 1997 and continue through July 2002. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of the Company, the ultimate disposition of these matters will not have a material adverse effect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended March 31, 1999. Part II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The Company's shares of Common Stock are registered under 12(g) of the Securities Exchange Act of 1934 and are traded in the over-the-counter market utilizing the NASDAQ trading system, to which the Company gained admittance in December 1984, under the symbol "TRCI". In November 1995, NASDAQ approved the Company's application for listing on the National Market. The following tables set forth a range of high and low market prices for the Company's Common Stock for the fiscal years ended March 31, 1999, 1998 and 1997 as reported by the NASDAQ system. Market Price Cash Fiscal Year Ended High Low Dividends March 31, 1999: First Quarter ................. 2 1/2 1 1/16 $ - Second Quarter ................. 2 27/32 1 9/16 - Third Quarter ................. 2 15/16 - Fourth Quarter ................. 1 3/8 1 - ----- $ - March 31, 1998: First Quarter ................. 4 1/8 3 1/16 $ .06 Second Quarter ................. 4 1/2 3 9/16 .06 Third Quarter ................. 4 9/16 3 .06 Fourth Quarter ................. 3 7/16 1 15/16 - ----- $ .18 March 31, 1997: First Quarter ................. 6 1/4 4 1/2 $ .06 Second Quarter ................. 5 3/8 3 7/8 .06 Third Quarter ................. 4 5/8 4 .06 Fourth Quarter ................. 4 9/16 3 13/16 .06 ----- $ .24 As of May 28, 1999, the approximate number of the Company's shareholders was 530. This number does not include any adjustment for shareholders owning common stock in the Depository Trust name or otherwise in "Street" name, which the Company believes represents an additional 2,500 shareholders. The Company's authorized capital stock, as of May 28, 1999, consisted of 10,000,000 shares of authorized common stock, par value $.51, of which 5,455,756 shares were issued and outstanding. On March 16, 1998, the Company announced that its Board of Directors suspended its fourth quarter dividend. The Company's Board of Directors review the Company's dividend policy on a quarterly basis and make a determination at such time as to whether the Company will resume payment of a dividend based on the Company's cash and earnings position. The Company did not declare any dividends during Fiscal Year 1999 but did declare dividends of $.18 per share during Fiscal Year 1998 and $.24 per share during Fiscal Year 1997. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Year ended March 31: Operating revenues $ 17,211,014 18,430,951 15,385,571 17,379,221 21,772,956 Gross profit $ 4,078,461 4,836,280 4,747,997 5,895,687 5,246,105 Net income (loss) $ 15,892 (196,314) 566,658 2,038,785 1,867,957 Basic earnings per share $ - (.04) .11 .39 .36 Weighted average number of common shares outstanding 5,455,756 5,332,571 5,321,698 5,281,932 5,159,614 Diluted earnings per share $ - (.04) .10 .38 .35 Weighted average number of common and equivalent shares outstanding 5,476,134 5,332,571 5,441,620 5,404,885 5,339,953 Cash dividends declared $ - .18 .24 .24 - March 31: Working capital $ 6,899,677 6,875,679 9,651,145 10,931,740 10,089,672 Total assets $ 15,146,175 15,746,818 15,637,949 15,380,590 14,813,938 Current liabilities $ 3,521,949 4,243,200 2,903,154 1,867,678 2,119,000 Long-term debt $ 56,250 131,250 206,250 281,350 356,350 Total liabilities $ 3,578,199 4,374,450 3,109,404 2,149,028 2,475,350 Retained earnings $ 1,257,068 1,241,176 2,397,353 3,108,371 2,340,267 Total stockholders' equity $ 11,567,976 11,372,368 12,528,545 13,231,562 12,338,588 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Operating Results: Fiscal Years 1999 and 1998 Comparison The Company's operating revenues (net sales and royalties) for the fourth quarter ended March 31, 1999 were $4,276,183, compared to $4,415,303 reported in the same quarter last year, a decrease of approximately 3%. The Company lost $237,980 for the fourth quarter, compared to a loss of $466,204 for the same quarter last year, the difference primarily being an income tax benefit of $308,688, which was recorded in the current year's quarter. Basic and diluted earnings (loss) were $(.04) per share for the fourth quarter, compared to $(.09) per share for the same quarter last year. The loss in the fourth quarter was primarily due to revenue level, continued manufacturing inefficiencies and a physical inventory charge of approximately $250,000 recorded by the Company's off-shore manufacturing facility in Honduras. In March 1999, the Company replaced the General Manager of its Honduras operation. The Company's operating revenues (net sales and royalties) for the year ended March 31, 1999 were $17,211,014, compared to $18,430,951 reported in the same period last year, a decrease of approximately 7%. The Company earned $15,892 for the year, compared to a loss of $196,314, for the same period last year, and basic and diluted earnings were $.00 per share for the year, compared to basic and diluted earnings (loss) of $(.04) per share for the same period last year. The decline in revenues for the year ended March 31, 1999, as compared to the same period last year, was due to a decrease in military sales and royalties of $1,476,891 and $237,871, respectively. Total commercial sales were up $494,825 even though sales to Xerox Corporation, the Company's largest customer, were down $1,081,566 for the year. The Company's primary commercial distribution strategy of forming alliances with companies that have a significant market presence, for which the Company's products are used, contributed to the overall increase in commercial business. The result, excluding Xerox, was that the Company's international sales increased $337,503 and domestic sales increased $1,238,888 over the prior year. The Company is optimistic that this strategy will continue to produce growth in its domestic and international commercial business. The Company continues new product development for Xerox, and indications are sales to Xerox and its suppliers should increase in the second half of Fiscal Year 2000. The decrease in military sales for Fiscal Year 1999 was mainly due to the Company completing the previous contract related to the 5/10/15/30/60KW Tactical Quiet Generator ("TQG") Systems program. The new contract that has been awarded to the prime contractor by the U.S. Government for 5/10/15KW TQG Systems is for a 10-year period with the last ordering period year being 2007. The Company has received initial production releases for this new contract, valued at $1.9 million, and shipments commenced in the 4th quarter of Fiscal Year 1999. The estimated value of the new 10-year contract for the Company for its 5/10/15KW control equipment is $8.2 million. As previously reported, the Company also received orders for approximately $6.3 million for the new 3KW military TQG Program. Assuming successful completion of First Article Testing and release of the production phase of the initial contract, shipments of approximately 4,200 3KW TQG control devices are now estimated to begin in March 2000. The Company expects military sales to remain steady for Fiscal Year 2000 with potential strengthening in the fourth quarter to the extent that shipments are made under the new 3KW TQ Program. Royalty income was higher in Fiscal Year 1998 due to licensing fees of $135,000 from Yaskawa Control Company of Japan and a one-time final royalty payment of $100,000 from Windmere Corporation recorded in the first quarter of that year. The Company expects royalty income to remain constant over the coming year. The Company's Fiscal Year 1999 business plan called for a reduction in operating expenses of $800,000, and for the year ended March 31, 1999, the Company reduced its operating expenses by $988,544, compared to the prior year. The Company will continue this initiative in Fiscal Year 2000 in an effort to bring expense in line with revenue. The Company's gross profit margin was approximately 24% of net sales for Fiscal Year 1999 compared to 27% for the prior year. The difference was primarily due to weaker profit margins resulting from the price reduction to Xerox Corporation and manufacturing inefficiencies, inventory adjustments and the Company restructuring its manufacturing operations from a contract manufacturer in China to its wholly owned subsidiary in Honduras. The Company believes this restructuring will ultimately result in lower duty, freight and product costs thus positioning the Company to remain competitive in the future. Selling, general and administrative expenses for Fiscal Year 1999 were $3,150,830, compared to $4,023,205 for the prior year, a decrease of approximately 22%. Selling expenses were $1,766,018 for Fiscal Year 1999, compared to $2,710,774 for the prior year, a decrease of approximately 35%, reflecting lower group insurance and advertising costs. General and administrative expenses were $1,384,812 for Fiscal Year 1999, compared to $1,312,431 for the prior year, an increase of approximately 6%, reflecting higher professional fees and higher salary related expenses due to a greater number of employees in the department. Research, development and engineering expenses for Fiscal Year 1999 were $1,107,253, compared to $1,223,422 for the prior year, a decrease of approximately 9%, reflecting lower UL fees and lower salary related expenses due to fewer number of employees in the department. Interest expense, net of interest and sundry income, for Fiscal Year 1999 was $106,133, compared to $4,462 for the prior year, reflecting higher interest expense, due to the Company using its line of credit, and lower returns and average balances on the Company's cash investments. Income tax benefit for Fiscal Year 1999 was $210,352 and was based on the Company's U.S. loss of $523,114. Due to provisions in the Honduran tax code, the Company's wholly owned foreign subsidiary, TRC Honduras S.A. de C.V., benefits from a 20-year income tax holiday; therefore, no income tax expense was recorded on the profit of $328,653 recognized by the subsidiary. Fiscal Years 1998 and 1997 Comparison The Company's operating revenues (net sales and royalties) for the fiscal year ended March 31, 1998 ("Fiscal Year 1998") were $18,430,951, compared to $15,385,571 reported for the Company's fiscal year ended March 31, 1997 ("Fiscal Year 1997"), an increase of approximately 20%. The Company lost $196,314 for Fiscal Year 1998, compared to earning $566,658 for Fiscal Year 1997, and basic and diluted earnings were $(.04) per share for Fiscal Year 1998, compared to basic earnings of $.11 per share and diluted earnings of $.10 per share for Fiscal Year 1997. Common and equivalent shares outstanding were comparable from year to year. The Company's higher revenues for Fiscal Year 1998 were due to commercial sales increasing by $631,171 and military sales increasing by $2,467,020 over the prior year. The increase in commercial sales was primarily due to the level of business with the Company's international OEM customers while sales to the Company's domestic OEM customers were flat during Fiscal Year 1998. Sales to Xerox Corporation and its suppliers decreased by $343,969 primarily due to a price reduction which went into effect August 1, 1997. The increase in military sales was primarily due to the Company being in full production of the products related to the Tactical Quiet Generator Systems program. Royalty income was down, as expected, by $52,811 due to less royalties from Windmere Corporation. In April 1997, the Company agreed to accept a final payment of $100,000 from Windmere to license the Company's products with the understanding that no future royalties would be paid to the Company. On May 17, 1997, the Company granted an exclusive license to Yaskawa Control of Japan for the Company's full line of commercial electrical protection devices and the Company's protective devices for the electric vehicle charging systems. The Company received a licensing fee of $125,000 from Yaskawa Control in Fiscal Year 1998 which substantially offset the loss of royalty income from Windmere Corporation. Although the Company's revenues were higher for Fiscal Year 1998, compared to Fiscal Year 1997, net income decreased as a result of higher period expenses and lower gross margins. Higher period expenses were primarily due to the Company's special marketing programs, and lower gross margins were a result of manufacturing inefficiencies and inventory adjustments related to the Company restructuring its manufacturing operations from a contract manufacturer in China to its wholly owned subsidiary in Honduras(see next paragraph). The lower gross margins resulted from approximately $1,200,000 of additional manufacturing cost variances incurred for the Company to produce its products in Fiscal Year 1998, compared to the prior year, with the majority of these variances occurring in the third and fourth quarters. The Company's wholly owned subsidiary, TRC Honduras, S.A. de C.V., recorded a loss of $375,264 for Fiscal Year 1998. As part of the Company's on-going plan to produce its high-volume products at its Honduran subsidiary, the Company added six additional products to the production process in Honduras in the third quarter. Unfortunately, the manufacturing complexities associated with adding these additional products caused its subsidiary not to meet its production shipment plan for the third and fourth quarters, and the result was that additional product continued to be produced at the Company's Clearwater facility causing the use of temporary employees and heavy overtime as well as higher labor rates in order to meet customer delivery commitments. The Company's gross profit margin was approximately 27% of net sales for Fiscal Year 1998 compared to 32% for the prior year. The difference was primarily due to weaker profit margins resulting from the price reduction to Xerox Corporation and manufacturing inefficiencies, inventory adjustments and the Company restructuring its manufacturing operations from a contract manufacturer in China to its wholly owned subsidiary in Honduras. Selling, general and administrative expenses for Fiscal Year 1998 were $4,023,205, compared to $3,458,872 for the prior year, an increase of approximately 16%. Selling expenses were $2,710,774 for Fiscal Year 1998, compared to $2,257,128 for the prior year, an increase of approximately 20%, reflecting expenses related to the marketing of the "Fire Shield" products and the consumer marketing program. General and administrative expenses were $1,312,431, compared to $1,201,744 for the prior year, an increase of approximately 9%, reflecting the additional administration expenses of the Company's Honduran subsidiary. Research, development and engineering expenses for Fiscal Year 1998 were $1,223,422, compared to $1,147,630 for the prior year, an increase of approximately 7%, reflecting primarily higher salary expenses related to a a greater number of employees in the department. Interest expense, net of interest and sundry income, for Fiscal Year 1998 was $4,462, compared to interest and sundry income, net of interest expense, of $173,670 for the prior year, reflecting higher interest expense, due to the Company using its line of credit, and lower returns and average balances on the Company's short-term investments. Income tax expense for Fiscal Year 1998 was $110,671, compared to $130,484 in the prior year, which was based on U.S. income before income tax of $289,621 and $697,142, respectively. The Internal Revenue Code does not allow a tax benefit for losses on foreign subsidiaries, and no tax benefit is available in Honduras. For this reason, the Company did not record any tax benefit from the loss of $375,264 recorded by TRC Honduras S.A. de C.V., the Company's wholly owned foreign subsidiary. The actual tax rate for Fiscal Year 1997 was less than the expected tax rate, primarily due to the Company receiving a favorable ruling from the State of Florida regarding the apportionment of sales. Liquidity and Capital Resources As of March 31, 1999, the Company's cash and cash equivalents decreased to $1,653,952 from the March 31, 1998 total of $1,153,798 and short term investments of $1,033,902. The short term investments were comprised of U.S. Treasury Bills. On August 28, 1999, the Company expects to renew its commercial line of credit, which is currently $2,500,000, with its institutional lender for another year, maturing in August 2000. The Company continues to have the option of borrowing at the lender's prime rate of interest or the 30-day London Interbank Offering Rate (L.I.B.O.R.) plus 175 basis points. The Company also has available a Banker's Acceptance agreement which gives the Company the option of borrowing up to $750,000 under the line of credit with the interest rate being determined by the lender's International Division at the time of borrowing. The Company's debt from advances on its line of credit was $2,450,100 as of March 31, 1999. The Company's working capital increased by $23,998 to $6,899,677 at March 31, 1999, compared to $6,875,679 at March 31, 1998. The Company believes cash flow from operations, the available bank line, and its short term investments and current cash position will be sufficient to meet its working capital requirements for the immediate future. The mortgage payable to the Company's institutional lender as of March 31, 1999 was $131,250, compared to $206,250 at March 31, 1998, reflecting the Company's payments on principal for the twelve-month period. On March 16, 1998, the Company announced that its Board of Directors suspended its fourth quarter dividend. The Company's Board of Directors review the Company's dividend policy on a quarterly basis and make a determination at such time as to whether the Company will resume payment of a dividend based on the Company's cash and earnings position. The Company did not declare any dividends during Fiscal Year 1999 but did declare dividends of $.18 per share during Fiscal Year 1998 and $.24 per share during Fiscal Year 1997. Year 2000 Issues The Year 2000 issue is a result of certain microprocessors and computer programs that were designed using two digits rather than four to define the applicable year. Computer programs that have time sensitive software may recognize a date using "00" as the year 1900 rather that the year 2000. This could result in a system failure or miscalculation causing disruptions to operations including, among other things, a temporary inability to process transactions, send invoices or engage in similar activities. The Company is continually working to resolve the potential risks and concerns of the Year 2000 issues. The Company has made progress in assessing and implementing systems to be Year 2000 ready completing the conversion of its major business computer systems to be Year 2000 ready on January 1, 1999 at its U.S. facility and on July 4, 1998 at its Honduran facility. None of the Company's products are Year 2000 sensitive, so the total cost of the Year 2000 project has been minimal so far at approximately $10,000. The Company expensed all costs associated with these system changes as the costs were incurred, and they were funded through operating cash flows. Since the Company's major computer systems are already Year 2000 compliant, the Company does not foresee the need of a contingency plan for those minor systems that are not significant enough to disrupt the Company's business. The Company is also assessing the readiness of its significant suppliers, which if not Year 2000 ready, could have a material adverse effect on the Company's operations. The Company believes that if certain suppliers were not Year 2000 ready, then alternate arrangements could be made to alleviate any material impact on operations. Achieving Year 2000 compliance is dependent on many factors, some of which are not completely within the Company's control. There can be no assurances that the Company will be able to identify all aspects of its business that are subject to Year 2000 problems, specifically those related to suppliers that could have a material effect on the Company. As a contingency plan, the Company will maintain sufficient inventory of those parts with long lead times that are critical to the manufacturing process. NEW ACCOUNTING STANDARDS In 1999, the Company adopted SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting and presentation of comprehensive income and its components to a full set of financial statements. The Statement requires only additional disclosures in the financial statements; it does not affect the Company's financial position or results of operations. The Company has no components of comprehensive income, therefore the adoption of this standard did not have any effect on the consolidated financial statements. In June 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 which is effective for fiscal years beginning after December 15, 1997,changes the way public companies report information about segments of their business in their annual financial statements and requires them to report selected segment information in their quarterly reports issued to shareholders. The Company operates in a single segment of business. Therefore, there was no effect on the Company's consolidated financial statements from the adoption of SFAS 131. In 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair values. The Company will be required to adopt this standard for financial statements issued beginning the first quarter of fiscal year 2002. The Company has not historically had derivative financial instruments, therefore, the adoption of this standard is not expected to have any effect on the consolidated financial statements. Safe Harbor Statement The statements in this report that relate to future plans, expectations, events, performance and the like are forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995 and the Securities Exchange Act of 1934. Actual results or events could differ materially from those described in the forward-looking statements due to a variety of factors, including those set forth in the Company's reports on Form 10-K and 10-Q filed with the Securities and Exchange Commission. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Response to this item is submitted in a separate section of this report starting at Page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Part III of this Form 10-K is incorporated by reference from the registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on August 26, 1999. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) 1. Consolidated Financial Statements Page of Technology Research Corporation: Independent Auditors' Report .............................. Balance Sheets--March 31, 1999 and 1998 ................... Statements of Operations--Years Ended March 31, 1999, 1998, and 1997 .......................... Statements of Stockholders' Equity--Years Ended March 31, 1999, 1998, and 1997 .......................... Statements of Cash Flows--Years Ended March 31, 1999, 1998, and 1997 .......................... Notes to Financial Statements ............................. 2. The following Consolidated Financial Schedules for the years ended March 31, 1999, 1998, and 1997 are submitted herewith Schedule II--Valuation and Qualifying Accounts ............ All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits included herein: (See Next Page) (B) Reports on Form 8K No reports on Form 8K have been filed by the registrant during the last quarter of the fiscal year. INDEX TO EXHIBITS (Item 14(A)3) Exhibit (3) (a) Articles of Incorporation and By-Laws* (b) Certificate of Amendment to the Articles of Incorporation, dated September 24, 1990*** (c) Certificate of Amendment to the Articles of Incorporation, dated September 24, 1996*** (10) Material contracts: (a) License Agreement, dated as of January 1, 1985, between the Company and Societe BACO, a French corporation, granting BACO a non-exclusive right to manufacture the Company's GFCI products in France, and the non-exclusive right to sell GFCI products other than in North America.* (b) License Agreement between the Company and B & R Electrical Products, Ltd., an English corporation ("B & R") dated January 1, 1985, granting B & R a limited exclusive license to manufacture GFCI products within the United Kingdom and a non- exclusive license to market other such products other than in North America.* (c) License Agreement, dated as of January 8, 1987, between the Company and HPM INDUSTRIES PTY LTD, an Australian corporation ("HPM"), granting to HPM an exclusive license to manufacture and sell GFCI products in Australia, New Zealand, New Guinea, Papua and Fiji.* (f) Incentive Stock Option Plan, dated October 15, 1981.* (g) The 1993 Incentive Stock Option Plan, which was previously filed with and as part of the Registrant's Registration Statement on Form S-8 (No. 33-62397). (h) Non-Qualified Stock Option Agreements, dated as of various dates, between the Company and each of its current directors and officers, as well as two independent consultants, an independent entity which had provided the Company with certain technology rights and certain former directors.* (i) The 1993 Amended and Restated Non-Qualified Stock Option Plan, which was previously filed with and as part of the Registrant's Registration Statement on Form S-8 (No. 33-62379). (j) $600,000 Loan Agreement, dated January 8, 1993, between the Company and First Union National Bank of Florida.*** (k) $2,500,000 Revolving Credit Agreement, dated November 12, 1993, between the Company and First Union National Bank of Florida.*** (l) License Agreement, dated May 17, 1997, between the Company and Yaskawa Controls Company, Ltd., a Japanese company, granting Yaskawa an exclusive right to market and manufacture the Company's products developed for use in electrical vehicle charging systems.*** (m) Sales and Marketing Agreement, dated May 17, 1997, between the Company and Yaskawa Controls Company, Ltd., a Japanese company, granting Yaskawa exclusive sales and marketing rights to the Company's full line of commercial electrical protection devices, including "Fire Shield", "Shock Shield" and "Electra Shield".*** (n) License Agreement, dated February 16, 1999, between the Company and Windmere-Durable Holdings, Inc. granting Windmere-Durable a non-exclusive license to manufacture, have manufactured, use and sell the Company's line of "Fire Shield" products.***** (23) Consents of Experts and Counsel: (a) Consent of Independent Certified Public Accountants. ***** * Previously filed with and as part of the Registrant's Registration Statement on Form S-1 (No. 33-24647). ** Previously filed with and as a part of the Registrant's Registration Statement on Form S-1 (No. 33-31967). *** Previously filed with and as part of the Registrant's Annual Report on Form 10-K. **** Previously filed with and as part of the Registrant's Post-Effective Amendment No. 1 to Form S-1 (No. 33-31967) ***** Filed herewith. Independent Auditors' Report The Board of Directors and Stockholders Technology Research Corporation: We have audited the consolidated balance sheets of Technology Research Corporation and subsidiary as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statements schedule as listed in the accompanying index. These consolidated financial statements and financial statements schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Technology Research Corporation and subsidiary as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 1999, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP St. Petersburg, Florida April 30, 1999 TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Balance Sheets March 31, 1999 and 1998 Assets 1999 1998 Current assets: ---- ---- Cash and cash equivalents $ 1,653,952 1,153,798 Short-term investments (note 2) - 1,033,902 Accounts receivable, less allowance for doubtful accounts of $63,700 in 1999 and $64,700 in 1998 (note 6) 3,120,256 2,711,056 Income tax receivable 332,422 253,019 Inventories (notes 3 and 6) 4,724,182 5,325,409 Prepaid expenses and other current assets 75,804 235,595 Deferred income taxes (note 4) 515,010 406,100 ---------- ---------- Total current assets 10,421,626 11,118,879 ---------- ---------- Property, plant and equipment (notes 5 and 6) 9,806,134 9,033,808 Less accumulated depreciation 5,205,162 4,476,692 ---------- ---------- Net property, plant and equipment 4,600,972 4,557,116 ---------- ---------- Deferred income taxes (note 4) - 55,928 Other assets 123,577 14,895 ---------- ---------- 123,577 70,823 ---------- ---------- $ 15,146,175 15,746,818 ========== ========== Liabilities and Stockholders' Equity Current liabilities: Current installments of debt (note 6) $ 2,525,100 2,525,100 Trade accounts payable 649,252 1,216,624 Accrued expenses: Compensation 232,972 372,218 Other 99,012 83,645 Dividends payable 15,613 45,613 ---------- ---------- Total current liabilities 3,521,949 4,243,200 Debt, excluding current installments (note 6) 56,250 131,250 ---------- ---------- Total liabilities 3,578,199 4,374,450 ---------- ---------- Stockholders' equity (note 7): Common stock, $.51 par value. Authorized 10,000,000 shares; issued and outstanding 5,455,756 in 1999 and 5,332,571 in 1998 2,782,435 2,719,611 Additional paid-in capital 7,528,473 7,411,581 Retained earnings 1,257,068 1,241,176 ---------- ---------- Total stockholders' equity 11,567,976 11,372,368 ---------- ---------- Commitments and contingencies (notes 8, 10 and 11) $ 15,146,175 15,746,818 ========== ========== See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Statements of Operations Years ended March 31, 1999, 1998 and 1997 1999 1998 1997 Operating revenues: ---- ---- ---- Net sales (note 9) $ 17,119,719 18,101,785 15,003,594 Royalties 91,295 329,166 381,977 ---------- ---------- ---------- 17,211,014 18,430,951 15,385,571 ---------- ---------- ---------- Operating expenses: Cost of sales 13,041,258 13,265,505 10,255,597 Selling, general, and administrative 3,150,830 4,023,205 3,458,872 Research, development, and engineering 1,107,253 1,223,422 1,147,630 ---------- ---------- ---------- 17,299,341 18,512,132 14,862,099 ---------- ---------- ---------- Operating income (loss) (88,327) (81,181) 523,472 ---------- ---------- ---------- Other income (deductions): Interest and sundry income 84,211 131,727 206,944 Interest expense (193,902) (136,380) (33,274) Gain on foreign exchange 3,558 191 - ---------- ---------- ---------- (106,133) (4,462) 173,670 ---------- ---------- ---------- Income (loss) before income taxes (194,460) (85,643) 697,142 Income taxes expense (benefit) (note 4) (210,352) 110,671 130,484 ---------- ---------- ---------- Net income (loss) $ 15,892 (196,314) 566,658 ========== ========== ========== Basic earnings (loss) per share $ - (.04) .11 ========== ========== ========== Diluted earnings (loss) per share $ - (.04) .10 ========== ========== ========== Weighted average number of common and equivalent shares outstanding: Basic 5,455,756 5,332,571 5,321,698 Diluted 5,476,134 5,332,571 5,441,620 ========== ========== ========== See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Statements of Stockholders' Equity Years ended March 31, 1999, 1998 and 1997 Retained Additional earnings Total Common stock paid-in (accumulated stockholders' Shares Amount capital deficit) equity Balances at ------ ------ ------- ------- ------ March 31, 1996: 5,318,902 2,712,437 7,410,754 3,108,371 13,231,562 Exercise of stock options via exchange of 667 common shares and cash of $8,001 for 14,336 new common shares 13,669 7,174 827 - 8,001 Dividends - $.24 per share - - - (1,277,676) (1,277,676) Net income - - - 566,658 566,658 --------- --------- --------- --------- ---------- Balances at March 31, 1997: 5,332,571 2,719,611 7,411,581 2,397,353 12,528,545 Dividends - $.18 per share - - - (959,863) (959,863) Net loss - - - (196,314) (196,314) --------- --------- --------- --------- ---------- March 31, 1998: 5,332,571 $ 2,719,611 7,411,581 1,241,176 11,372,368 Exercise of stock options via exchange of 30,915 common shares and cash of $179,716 for 154,100 new common shares 123,185 62,824 72,524 - 135,348 Tax benefit related to exercise of employee stock options - - 44,368 - 44,368 Net income - - - 15,892 15,892 --------- --------- --------- --------- ---------- Balances at March 31, 1999: 5,455,571 $ 2,782,435 7,528,473 1,257,068 11,567,976 ========= ========= ========= ========= ========== See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended March 31, 1999, 1998 and 1997 1999 1998 1997 Cash flows from operating activities: ---- ---- ---- Net income (loss) $ 15,892 (196,314) 566,658 Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Accretion of interest (21,098) (114,825) (185,977) Allowance for doubtful accounts (1,000) (4,800) (14,500) Depreciation and amortization 733,906 622,219 494,292 Decrease (increase) in accounts receivable (408,200) (401,807) 317,203 Decrease (increase) in inventories 601,227 (182,641) 83,994 Decrease (increase) in prepaid expenses and other current assets 159,791 (56,623) (84,767) Increase in income taxes receivable (35,035) (74,889) (178,130) Decrease (increase) in deferred income taxes (52,982) 51,492 90,480 Decrease (increase) in other assets (114,118) 3,697 (23,505) Increase (decrease) in accounts payable (567,372) (390,492) 370,525 Increase (decrease) in accrued expenses (123,879) 159,314 76,514 --------- --------- --------- Net cash provided (used) by operating activities 187,132 (585,669) 1,512,787 --------- --------- --------- Cash flows from investing activities: Maturities of short-term investments 1,055,000 3,112,000 5,190,000 Purchases of short-term investments - (1,000,064) (3,950,338) Capital expenditures for property, plant and equipment (772,326) (2,216,397) (1,030,145) --------- --------- --------- Net cash provided (used) by investing activities 282,674 (104,461) 209,517 --------- --------- --------- Cash flows from financing activities: Net borrowings under line-of-credit agreement - 1,872,101 577,899 Principal payments on mortgage note payable (75,000) (75,000) (75,000) Proceeds from exercise of stock options 135,348 - 8,001 Dividends paid (30,000) (1,260,740) (1,267,238) --------- --------- --------- Net cash provided (used) by financing activities 30,348 536,361 (756,338) --------- --------- --------- Net increase (decrease) in cash and cash equivalents 500,154 (153,769) 965,966 Cash and cash equivalents at beginning of year 1,153,798 1,307,567 341,601 --------- --------- --------- Cash and cash equivalents at end of year $ 1,653,952 1,153,798 1,307,567 ========= ========= ========= Supplemental cash flow information: Cash paid for interest $ 193,902 136,380 33,274 ========= ========= ========= Cash paid (received) for income taxes $ (228,299) 134,068 219,125 ========= ========= ========= See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (1) Summary of Significant Accounting Policies (a) Description of Business Technology Research Corporation and subsidiary (the Company) is engaged in the design, development, manufacturing, and marketing of electronic control and measurement devices related to the distribution of electrical power and specializes in electrical safety products that prevent electrical fires and protect against electrocution and serious injury from electrical shock. The Company's corporate headquarters are located in Clearwater, Florida. During February 1997, the Company incorporated TRC Honduras, S.A. de C.V., a wholly- owned subsidiary, for the purpose of manufacturing the Company's high volume products in Honduras beginning in April 1997. The Company primarily sells its products to governmental entities and original equipment manufacturers involved in a variety of industries including business machinery and personal care appliances. The Company performs credit evaluations of all new customers and generally does not require collateral. Historically, the Company has experienced minimal losses related to receivables from individual customers or groups of customers in any particular industry or geographic area. The Company's customers are located throughout the world. See note 9 for further information on major customers. The Company also licenses its technology for use by others in exchange for a royalty or product purchases. Licensees are located in Australia, France, Italy, Japan, the United Kingdom and the United States. (b) Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates. (c) Foreign Currency Translation The U.S. dollar is the functional currency of the Honduran subsidiary. Foreign currency denominated assets and liabilities of this subsidiary are remeasured at the rates of exchange at the balance sheet date. Income and expense items are remeasured at average monthly rates of exchange. Gains and losses from foreign currency transactions of this subsidiary are included in operations. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (d) Financial Instruments The Company believes the book value of its financial instruments (short-term investments, accounts receivable, trade accounts payable, accrued expenses, dividends payable, income taxes receivable and payable and debt) approximate their fair value due to their short-term nature or with respect to debt, the interest rate appropriately reflects the credit risk. (e) Principles of Consolidation The consolidated financial statements include the financial statements of Technology Research Corporation and its wholly-owned subsidiary, TRC Honduras, S.A. de C.V. All significant intercompany balances and transactions have been eliminated in consolidation. (f) Cash Equivalents For purposes of the statements of cash flows, the Company considers all short- term investments purchased with a maturity of three months or less to be cash equivalents. There were no short-term investments considered cash equivalents at March 31, 1999 or 1998. (g) Short-Term Investments The Company considers all of its short-term investments to be "held-to-maturity," and therefore, are recorded at amortized cost. (h) Revenue Recognition Sales and cost of sales related to governmental contracts are recognized under the unit-of-delivery method, whereby sales and cost of sales are recorded as units are delivered. All other sales and cost of sales are recognized as product is shipped. The Company accrues minimum royalties due over the related royalty period. Royalties earned in excess of minimum royalties due are recognized as reported by the licensees. (i) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of The Company reviews long-lived assets and certain identifiable intangibles whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value, less costs to sell. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (j) Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. (k) Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets. (l) Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. (m) Stock-Based Compensation On April 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS 123 also allows entities to continue to apply the provisions of APB 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS 123 had been applied. The Company has elected to continue to apply the provisions of APB 25 and provide the pro forma disclosures of SFAS 123 (see note 7). (n) Earnings Per Share Basic earnings per share has been computed by dividing net income by the weighted average number of common shares outstanding. Common share equivalents included in the dilutive weighted average shares outstanding computation represent shares issuable upon assumed exercise of stock options which would have a dilutive effect in years where there are earnings. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (o) New Accounting Standards In 1999, the Company adopted SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting and presentation of comprehensive income and its components to a full set of financial statements. The Statement requires only additional disclosures in the financial statements; it does not affect the Company's financial position or results of operations. The Company has no components of comprehensive income; therefore the adoption of this standard did not have any effect on the consolidated financial statements. In June 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 which is effective for fiscal years beginning after December 15, 1997, changes the way public companies report information about segments of their business in their annual financial statements and requires them to report selected segment information in their quarterly reports issued to shareholders. The Company operates in a single segment of business; therefore, there was no effect on the Company's consolidated financial statements from the adoption of SFAS 131. In 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair values. The Company will be required to adopt this standard for financial statements issued beginning the first quarter of fiscal year 2002. The Company has not historically had derivative financial instruments; therefore, the adoption of this standard is not expected to have any effect on the consolidated financial statements. (2) Short-Term Investments The Company considers all of its investment securities to be held-to-maturity. These securities are all classified in short-term investments on the consolidated balance sheets and mature within one year. The amortized cost, gross unrealized holding gains, gross unrealized holding losses, and fair value for held-to-maturity securities at March 31, 1999 and 1998 were as follows: Gross unrealized Amortized holding Fair cost Gains Losses value ---- ----- ------ ----- March 31, 1999 - U.S. Treasury securities $ - - - - ========= ====== ====== ========= March 31, 1998 - U.S. Treasury securities $ 1,033,902 - - 1,033,902 ========= ====== ====== ========= The U.S. Treasury securities matured in August 1998 and the funds were transferred to a money market account which is included in cash and cash equivalents. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (3) Inventories Inventories at March 31, 1999 and 1998 consist of: 1999 1998 ---- ---- Raw materials $ 3,800,340 4,499,524 Work in process 242,683 387,170 Finished goods 681,159 438,715 --------- --------- $ 4,724,182 5,325,409 ========= ========= Approximately 29% and 27% of inventories were located in Honduras at March 31, 1999 and 1998 respectively. (4) Income Taxes The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at March 31, 1999 and 1998 are presented below: 1999 1998 ---- ---- Deferred tax assets: Accounts receivable, principally due to allowance for doubtful accounts $ 23,000 23,300 Inventories, principally due to valuation allowance for financial reporting purposes and additional costs inventoried for tax purposes 281,000 252,500 Accrued expenses, principally due to accrual for financial reporting purposes 47,000 65,600 Net operating loss carryforwards 214,000 182,000 Tax credit carryforwards 221,000 214,000 -------- -------- Total gross deferred tax assets 786,000 737,400 Less valuation allowance (187,000) (187,000) -------- -------- 559,000 550,400 -------- -------- Deferred tax liabilities: Property, plant and equipment, principally due to differences in depreciation (83,990) (88,372) -------- -------- Net deferred tax assets $ 515,010 462,028 ======== ======== TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Net deferred tax assets are included in the accompanying balance sheets at March 31, 1999 and 1998 as: 1999 1998 ---- ---- Deferred income taxes, current asset $ 515,010 406,100 Deferred income taxes, noncurrent asset - 55,928 -------- -------- $ 515,010 462,028 ======== ======== Management assesses the likelihood deferred tax assets will be realized which is dependent upon the generation of taxable income during the periods in which those temporary differences are deductible. Management considers historical taxable income, the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. In order to fully realize the deferred tax asset related to net operating loss and tax credit carryforwards, the Company will need to generate future taxable income of approximately $170,000 each year prior to the expiration of the net operating loss and tax credit carryforwards in 2003 and 2002, respectively. Based upon the level of historical taxable income and projections for future taxable income, management believes it will realize the benefits of these deductible differences, net of the existing valuation allowance at March 31, 1999. The valuation allowance at March 31, 1999 and 1998 relates to tax credit carryforwards which management expects will expire unused. At March 31, 1999, the Company has net operating loss carryforwards for Federal income tax purposes of approximately $306,000, which are available to offset future taxable income through 2003 and approximately $233,000 which are available to offset future taxable income through 2019. The Company also has available tax credit carryforwards for Federal income tax purposes of approximately $214,000, which are available to offset future Federal income taxes through 2002 and $7,000 of tax credit carryforwards which have no expiration date. As a result of an ownership change in 1989, the Internal Revenue Code limits the income tax benefit of $306,000 of net operating loss and $214,000 of tax credit carryforwards to approximately $65,000 each year. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Income tax expense (benefit) for the years ended March 31, 1999, 1998 and 1997 consists of: 1999 1998 1997 ---- ---- ---- Current: Federal $ (263,334) 59,179 156,748 State - - (116,744) -------- -------- --------- (263,334) 59,179 40,004 -------- -------- --------- Deferred: Federal 70,000 48,600 77,000 State (17,018) 2,892 13,480 -------- -------- --------- 52,982 51,492 90,480 -------- -------- --------- $ (210,352) 110,671 130,484 ======== ======== ========= Income tax expense (benefit) for the years ended March 31, 1999, 1998 and 1997 differs from the amounts computed by applying the Federal income tax rate of 34% to pretax income (loss) as a result of the following: 1999 1998 1997 ---- ---- ---- Computed expected tax (benefit) expense $ (66,000) (29,000) 237,000 Increase (reduction) in income taxes resulting from: Foreign activity for which no income tax has been provided (112,000) 128,000 - State income taxes, net of Federal income tax effect (8,000) 2,000 (68,000) Other (24,352) 9,671 (38,516) -------- -------- --------- $ (210,352) 110,671 130,484 ======== ======== ========= The operating results of the foreign manufacturing subsidiary are not subject to foreign tax since it is operating under a tax holiday for at least twenty years. The foreign operations resulted in income of $329,000 in 1999 and a loss of $375,000 in 1998. No income taxes have been provided on these results of operations. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (5) Property, Plant and equipment Property, plant and equipment at March 31, 1999 and 1998 consists of: Estimated 1999 1998 useful lives ---- ---- ------------ Building and improvements $ 1,516,676 1,512,205 20 years Machinery and equipment 8,289,458 7,521,603 5 - 15 years --------- --------- ------------ $ 9,806,134 9,033,808 ========= ========= Approximately 21% and 20% of property, plant and equipment is located in Honduras at March 31, 1999 and 1998, respectively. (6) Debt Debt at March 31, 1999 and 1998 consists of the following: 1999 1998 ---- ---- $2,500,000 line of credit; interest at LIBOR plus 175 and 200 basis points at March 31, 1999 and 1998, respectively, (6.687% and 7.69% at March 31, 1999 and 1998, respectively), payable monthly, due August 1999; secured by receivables, inventories and equipment (subject to provisions stated below) $ 2,450,100 2,450,100 First mortgage note payable; interest at LIBOR plus 175 and 200 basis points at March 31, 1999 and 1998, respectively, (6.687%and 7.69% at March 31, 1999 and 1998 respectively); due in monthly installments of $6,250, plus interest, matures December 2000; secured by operating facility 131,250 206,250 --------- --------- Total debt 2,581,350 2,656,350 Less current installments (2,525,100) (2,525,100) --------- ---------- Debt, excluding current installments $ 56,250 131,250 ========= ========== TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Borrowings under the line of credit are limited to 80% of eligible accounts receivable under 90 days, plus the lesser of 40% of eligible inventory or $450,000. The line of credit is secured by receivables, inventories, and property, plant and equipment, and requires the Company to maintain certain financial ratios and a minimum tangible net worth amount. The Company was in compliance with these covenants at March 31, 1999 and 1998. The aggregate maturities of long-term debt are: Year ending March 31, --------------------- 2000 $ 2,525,100 2001 56,250 --------- $ 2,581,350 ========= (7) Stock Options, Grants and Warrants The Company has two qualified incentive stock option plans, one performance- incentive stock option plan, and one nonqualified stock option plan (the Plans). Options granted under the Plans are granted to directors, officers and employees at fair value and expire ten years after the date of grant. Except for the Performance Plan, options granted under the Plans generally vest over three years. Options granted under the Performance Plan vest at the end of year ten but are subject to accelerated vesting if certain targets are met. Options may be exercised by payment of cash or with stock of the Company owned by the officer or employee. In November 1998, the Board of Directors approved a repricing of options under the qualified incentive stock option and nonqualified stock option plans. The options were repriced on November 19, 1998 based on the closing stock price on that date. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Option transactions and other information relating to the Plans for the three years ended March 31, 1999 are as follows: Qualified Performance Non- incentive incentive qualified Weighted stock stock stock average option option option exercise plans plan plan Total price ------- ------- ------- --------- -------- Outstanding at March 31, 1996 103,653 - 196,902 300,555 3.91 Granted 50,750 400,000 10,000 460,750 5.08 Exercised (6,002) - (8,334) (14,336) 0.75 Canceled (1,234) - - (1,234) 5.46 ------- ------- ------- --------- Outstanding at March 31, 1997 147,167 400,000 198,568 745,735 4.70 Granted 1,000 - 10,000 11,000 3.29 Canceled (14,020) - (2,000) (16,020) 5.29 ------- ------- ------- --------- Outstanding at March 31, 1998 134,147 400,000 206,568 740,715 4.32 Granted 141,911 - 46,134 188,045 1.57 Exercised - - (154,100) (154,100) 1.33 Canceled (134,147) - (52,468) (186,615) 5.08 ------- ------- ------- --------- Outstanding at March 31, 1999 141,911 400,000 46,134 588,045 3.99 ======= ======= ======= ========= Total number of options available under the plans 713,334 400,000 333,333 1,446,667 ======= ======= ======= ========= Exercisable at March 31, 1999 - - 23,334 23,334 1.63 ======= ======= ======= ========= Available for issue at March 31, 1999 13,645 - 28,674 42,319 ======= ======= ======= ========= The per share weighted average fair value of stock options granted during 1999, 1998 and 1997 was $1.15, $1.85 and $2.14, respectively, on the date of grant using the Black Scholes option pricing model, with the following assumptions: (1) risk free interest rate - 6.17% to 6.85%, (2) expected life - 6.5 to 10 years, (3) expected volatility - 72% to 75%, and (4) expected dividends - 5.1% to 5.8%. At March 31, 1999, the range of exercise prices and weighted average remaining contractual life of options outstanding and exercisable was as follows: Options Outstanding Options Exercisable - ------------------------------------------------- ---------------------------- Number Weighted average Weighted Number Weighted Range of outstanding remaining average exercisable average exercise as of contractual exercise as of exercise prices March 31, 1999 life price March 31, 1999 price - -------- -------------- -------------- --------- -------------- -------- $1.63 169,045 9.65 1.63 23,334 1.63 $1.06 19,000 10.01 1.06 - - $5.13 400,000 7.26 5.13 - - TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 The Company grants options at fair value and applies APB 25 in accounting for its Plans. Accordingly, no compensation cost has been recognized for stock options in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS 123, the Company's net income at March 31, 1999, 1998 and 1997 would have been reduced to the pro forma amounts indicated below: 1999 1998 1997 ---- ---- ---- Net income (loss): As reported $ 15,892 (196,314) 566,658 ========= ========= ========= Pro forma $ (70,343) (290,371) 476,123 ========= ========= ========= Income (loss) per common share: As reported $ - (.04) .10 ========= ========= ========= Pro forma $ (.01) (.05) .09 ========= ========= ========= Pro forma net income reflects only options granted in 1999, 1998, 1997 and 1996. Therefore, the full impact of calculating compensation costs for stock options under SFAS 123 is not reflected in the pro forma net income amounts presented above because compensation cost is reflected over the options' vesting period of three to ten years, and compensation costs for options granted prior to April 1, 1995 are not considered. The Company has also reserved 32,667 shares of its common stock for issuance to employees or prospective employees at the discretion of the Board of Directors of which 16,033 shares are available for future issue. There were no reserved shares issued during the years ended March 31, 1999, 1998 or 1997. (8) Leases The Company leases the land on which its operating facility is located. This operating lease is for a period of twenty years through 2001 with options to renew for two additional ten-year periods. The lease provides for rent adjustments every five years. The Company is responsible for payment of taxes, insurance, and maintenance. In the event the Company elects to terminate the lease, title to all structures on the land reverts to the lessor. The Company's subsidiary leases its operating facility in Honduras. This operating lease is for five years through the year 2002, with an option to renew for an additional five-year term. The Company also leases certain office equipment under long-term operating lease agreements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Future minimum lease payments under noncancelable operating leases as of March 31, 1999 are: Year ending March 31, --------------------- 2000 $ 244,834 2001 245,184 2002 205,690 2003 17,141 -------- Total minimum lease payments $ 712,849 ======== Rental expense for all operating leases was approximately $249,000 in 1999, $187,000 in 1998 and $80,000 in 1997. (9) Major Customers The Company operates in one business segment - the design, development, manufacture and marketing of electronic control and measurement devices for the distribution of electric power. The Company only reports sales and standard gross profit by market (commercial and military), no allocations of manufacturing variances and other costs of operations or assets are made to the market. Sales by market are: 1999 1998 1997 ---- ---- ---- Commercial $ 13,929,177 13,434,352 12,803,181 Military $ 3,190,542 4,667,433 2,200,413 ---------- ---------- ---------- $ 17,119,719 18,101,785 15,003,594 ========== ========== ========== Significant customers which accounted for 10% or more of sales in 1999, 1998 or 1997 and aggregate exports were: Year ended March 31 ------------------- Customer 1999 1998 1997 -------- ---- ---- ---- Xerox Corporation $ 1,934,740 2,838,905 2,529,398 Noma Appliance & Electric, Inc., f/k/a Fleck Manufacturing, Inc. (a Xerox Corporation supplier) 1,623,904 1,666,516 1,776,424 Other Xerox Corporation suppliers 124,473 133,044 802,800 Fermont Division 1,397,211 2,817,079 1,434,422 --------- --------- --------- $ 5,080,328 7,455,544 6,543,044 TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Year ended March 31 ------------------- Customer 1999 1998 1997 -------- ---- ---- ---- Exports: Canada $ 1,794,855 1,894,215 1,831,898 Far East 394,156 486,277 1,057,605 Europe 2,787,224 2,554,772 1,396,823 Mexico 711,067 979,187 736,992 Australia 117,754 218,530 150,760 South America 37,383 20,994 82,838 Middle East 2,067 3,397 5,324 --------- --------- --------- Total exports $ 5,844,506 6,157,372 5,262,240 ========= ========= ========= (10) Benefit Plan The Company's 401(k) plan covers all employees with one year of service who are at least twenty-one years old. The Company matches employee contributions dollar-for-dollar up to $300. Total Company contributions were approximately $25,000 in 1999, $29,000 in 1998 and $25,000 in 1997. (11) Litigation The Company is involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (12) Selected Quarterly Data (Unaudited) Information (unaudited) related to operating revenues, operating income, net income and earnings per share, by quarter, for the years ended March 31, 1999 and 1998 are: First Second Third Fourth quarter quarter quarter quarter ------- ------- ------- ------- Year ended March 31, 1999: Operating revenues $ 4,753,401 4,467,032 3,714,398 4,276,183 ========= ========= ========= ========= Gross profit $ 1,426,715 1,282,222 829,614 539,910 ========= ========= ========= ========= Operating income (loss) $ 410,425 160,780 (136,931) (522,601) ========= ========= ========= ========= Net income (loss) $ 239,862 84,010 (70,001) (237,979) ========= ========= ========= ========= Basic earnings per share $ .04 .02 (.02) (.04) ========= ========= ========= ========= Diluted earnings per share $ .04 .02 (.02) (.04) ========= ========= ========= ========= Year ended March 31, 1998: Operating revenues $ 4,811,585 4,545,950 4,658,113 4,415,303 ========= ========= ========= ========= Gross profit $ 1,488,247 1,336,956 1,140,074 871,003 ========= ========= ========= ========= Operating income (loss) $ 467,494 106,385 (145,509) (509,551) ========= ========= ========= ========= Net income (loss) $ 326,315 74,019 (130,444) (466,204) ========= ========= ========= ========= Basic earnings per share $ .06 .01 (.02) (.09) ========= ========= ========= ========= Diluted earnings per share $ .06 .01 (.02) (.09) ========= ========= ========= ========= The fourth quarter of the years ended March 31, 1999 and 1998 were adversely affected by an approximately $250,000 and $270,000, respectively, reduction in inventory as a result of the Company's physical inventory. It is not practicable to determine what, if any, other quarters are affected by this adjustment. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Schedule II Valuation and Qualifying Accounts Years ended March 31, 1999, 1998 and 1997 Additions ---------------------- Balances at Charged to Charged to Balances beginning costs and other at end of Description of period expenses accounts Deductions period ----------- ---------- ---------- ---------- ---------- --------- Allowance for doubtful accounts: Year ended March 31, 1999 $ 64,700 24,500 - 25,000 63,700 ======= ======= ======= ======= ======= Year ended March 31, 1998 $ 69,500 - - 4,800 64,700 ======= ======= ======= ======= ======= Year ended March 31, 1997 $ 84,000 - - 14,500 69,500 ======= ======= ======= ======= ======= SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TECHNOLOGY RESEARCH CORPORATION Dated: 6/11/1999 By: /s/ Robert S. Wiggins Robert S. Wiggins Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated: Signature Title Date Chairman, Chief Executive Officer, and Director (Principal Executive /s/ Robert S. Wiggins Officer) 6/11/1998 Robert S. Wiggins Vice President of Finance and Chief Financial Officer (Principal Financial /s/ Scott J. Loucks Officer) 6/11/1998 Scott J. Loucks /s/ Raymond H. Legatti President and Director 6/16/1999 Raymond H. Legatti Senior Vice President Government Operations and Marketing and /s/ Raymond B. Wood Director 6/22/1999 Raymond B. Wood /s/ Gerry Chastelet Director 6/18/1999 Gerry Chastelet /s/ Russell Cleveland Director 6/15/1999 Russell Cleveland /s/ Edmund F. Murphy, Jr. Director 6/21/1999 Edmund F. Murphy, Jr. /s/ Martin L. Poad Director 6/17/1999 Martin L. Poad ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) 1. Consolidated Financial Statements Page of Technology Research Corporation: Independent Auditors' Report .............................. Balance Sheets--March 31, 1999 and 1998 ................... Statements of Operations--Years Ended March 31, 1999, 1998, and 1997 .......................... Statements of Stockholders' Equity--Years Ended March 31, 1999, 1998, and 1997 .......................... Statements of Cash Flows--Years Ended March 31, 1999, 1998, and 1997 .......................... Notes to Financial Statements ............................. 2. The following Consolidated Financial Schedules for the years ended March 31, 1999, 1998, and 1997 are submitted herewith Schedule II--Valuation and Qualifying Accounts ............ All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits included herein: (See Next Page) (B) Reports on Form 8K No reports on Form 8K have been filed by the registrant during the last quarter of the fiscal year. INDEX TO EXHIBITS (Item 14(A)3) Exhibit (3) (a) Articles of Incorporation and By-Laws* (b) Certificate of Amendment to the Articles of Incorporation, dated September 24, 1990*** (c) Certificate of Amendment to the Articles of Incorporation, dated September 24, 1996*** (10) Material contracts: (a) License Agreement, dated as of January 1, 1985, between the Company and Societe BACO, a French corporation, granting BACO a non-exclusive right to manufacture the Company's GFCI products in France, and the non-exclusive right to sell GFCI products other than in North America.* (b) License Agreement between the Company and B & R Electrical Products, Ltd., an English corporation ("B & R") dated January 1, 1985, granting B & R a limited exclusive license to manufacture GFCI products within the United Kingdom and a non- exclusive license to market other such products other than in North America.* (c) License Agreement, dated as of January 8, 1987, between the Company and HPM INDUSTRIES PTY LTD, an Australian corporation ("HPM"), granting to HPM an exclusive license to manufacture and sell GFCI products in Australia, New Zealand, New Guinea, Papua and Fiji.* (f) Incentive Stock Option Plan, dated October 15, 1981.* (g) The 1993 Incentive Stock Option Plan, which was previously filed with and as part of the Registrant's Registration Statement on Form S-8 (No. 33-62397). (h) Non-Qualified Stock Option Agreements, dated as of various dates, between the Company and each of its current directors and officers, as well as two independent consultants, an independent entity which had provided the Company with certain technology rights and certain former directors.* (i) The 1993 Amended and Restated Non-Qualified Stock Option Plan, which was previously filed with and as part of the Registrant's Registration Statement on Form S-8 (No. 33-62379). (j) $600,000 Loan Agreement, dated January 8, 1993, between the Company and First Union National Bank of Florida.*** (k) $2,500,000 Revolving Credit Agreement, dated November 12, 1993, between the Company and First Union National Bank of Florida.*** (l) License Agreement, dated May 17, 1997, between the Company and Yaskawa Controls Company, Ltd., a Japanese company, granting Yaskawa an exclusive right to market and manufacture the Company's products developed for use in electrical vehicle charging systems.*** (m) Sales and Marketing Agreement, dated May 17, 1997, between the Company and Yaskawa Controls Company, Ltd., a Japanese company, granting Yaskawa exclusive sales and marketing rights to the Company's full line of commercial electrical protection devices, including "Fire Shield", "Shock Shield" and "Electra Shield".*** (n) License Agreement, dated February 16, 1999, between the Company and Windmere-Durable Holdings, Inc. granting Windmere-Durable a non-exclusive license to manufacture, have manufactured, use and sell the Company's line of "Fire Shield" products.***** (23) Consents of Experts and Counsel: (a) Consent of Independent Certified Public Accountants. ***** * Previously filed with and as part of the Registrant's Registration Statement on Form S-1 (No. 33-24647). ** Previously filed with and as a part of the Registrant's Registration Statement on Form S-1 (No. 33-31967). *** Previously filed with and as part of the Registrant's Annual Report on Form 10-K. **** Previously filed with and as part of the Registrant's Post-Effective Amendment No. 1 to Form S-1 (No. 33-31967) ***** Filed herewith. Independent Auditors' Report The Board of Directors and Stockholders Technology Research Corporation: We have audited the consolidated balance sheets of Technology Research Corporation and subsidiary as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statements schedule as listed in the accompanying index. These consolidated financial statements and financial statements schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Technology Research Corporation and subsidiary as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 1999, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP St. Petersburg, Florida April 30, 1999 TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Balance Sheets March 31, 1999 and 1998 Assets 1999 1998 Current assets: ---- ---- Cash and cash equivalents $ 1,653,952 1,153,798 Short-term investments (note 2) - 1,033,902 Accounts receivable, less allowance for doubtful accounts of $63,700 in 1999 and $64,700 in 1998 (note 6) 3,120,256 2,711,056 Income tax receivable 332,422 253,019 Inventories (notes 3 and 6) 4,724,182 5,325,409 Prepaid expenses and other current assets 75,804 235,595 Deferred income taxes (note 4) 515,010 406,100 ---------- ---------- Total current assets 10,421,626 11,118,879 ---------- ---------- Property, plant and equipment (notes 5 and 6) 9,806,134 9,033,808 Less accumulated depreciation 5,205,162 4,476,692 ---------- ---------- Net property, plant and equipment 4,600,972 4,557,116 ---------- ---------- Deferred income taxes (note 4) - 55,928 Other assets 123,577 14,895 ---------- ---------- 123,577 70,823 ---------- ---------- $ 15,146,175 15,746,818 ========== ========== Liabilities and Stockholders' Equity Current liabilities: Current installments of debt (note 6) $ 2,525,100 2,525,100 Trade accounts payable 649,252 1,216,624 Accrued expenses: Compensation 232,972 372,218 Other 99,012 83,645 Dividends payable 15,613 45,613 ---------- ---------- Total current liabilities 3,521,949 4,243,200 Debt, excluding current installments (note 6) 56,250 131,250 ---------- ---------- Total liabilities 3,578,199 4,374,450 ---------- ---------- Stockholders' equity (note 7): Common stock, $.51 par value. Authorized 10,000,000 shares; issued and outstanding 5,455,756 in 1999 and 5,332,571 in 1998 2,782,435 2,719,611 Additional paid-in capital 7,528,473 7,411,581 Retained earnings 1,257,068 1,241,176 ---------- ---------- Total stockholders' equity 11,567,976 11,372,368 ---------- ---------- Commitments and contingencies (notes 8, 10 and 11) $ 15,146,175 15,746,818 ========== ========== See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Statements of Operations Years ended March 31, 1999, 1998 and 1997 1999 1998 1997 Operating revenues: ---- ---- ---- Net sales (note 9) $ 17,119,719 18,101,785 15,003,594 Royalties 91,295 329,166 381,977 ---------- ---------- ---------- 17,211,014 18,430,951 15,385,571 ---------- ---------- ---------- Operating expenses: Cost of sales 13,041,258 13,265,505 10,255,597 Selling, general, and administrative 3,150,830 4,023,205 3,458,872 Research, development, and engineering 1,107,253 1,223,422 1,147,630 ---------- ---------- ---------- 17,299,341 18,512,132 14,862,099 ---------- ---------- ---------- Operating income (loss) (88,327) (81,181) 523,472 ---------- ---------- ---------- Other income (deductions): Interest and sundry income 84,211 131,727 206,944 Interest expense (193,902) (136,380) (33,274) Gain on foreign exchange 3,558 191 - ---------- ---------- ---------- (106,133) (4,462) 173,670 ---------- ---------- ---------- Income (loss) before income taxes (194,460) (85,643) 697,142 Income taxes expense (benefit) (note 4) (210,352) 110,671 130,484 ---------- ---------- ---------- Net income (loss) $ 15,892 (196,314) 566,658 ========== ========== ========== Basic earnings (loss) per share $ - (.04) .11 ========== ========== ========== Diluted earnings (loss) per share $ - (.04) .10 ========== ========== ========== Weighted average number of common and equivalent shares outstanding: Basic 5,455,756 5,332,571 5,321,698 Diluted 5,476,134 5,332,571 5,441,620 ========== ========== ========== See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Statements of Stockholders' Equity Years ended March 31, 1999, 1998 and 1997 Retained Additional earnings Total Common stock paid-in (accumulated stockholders' Shares Amount capital deficit) equity Balances at ------ ------ ------- ------- ------ March 31, 1996: 5,318,902 2,712,437 7,410,754 3,108,371 13,231,562 Exercise of stock options via exchange of 667 common shares and cash of $8,001 for 14,336 new common shares 13,669 7,174 827 - 8,001 Dividends - $.24 per share - - - (1,277,676) (1,277,676) Net income - - - 566,658 566,658 --------- --------- --------- --------- ---------- Balances at March 31, 1997: 5,332,571 2,719,611 7,411,581 2,397,353 12,528,545 Dividends - $.18 per share - - - (959,863) (959,863) Net loss - - - (196,314) (196,314) --------- --------- --------- --------- ---------- March 31, 1998: 5,332,571 $ 2,719,611 7,411,581 1,241,176 11,372,368 Exercise of stock options via exchange of 30,915 common shares and cash of $179,716 for 154,100 new common shares 123,185 62,824 72,524 - 135,348 Tax benefit related to exercise of employee stock options - - 44,368 - 44,368 Net income - - - 15,892 15,892 --------- --------- --------- --------- ---------- Balances at March 31, 1999: 5,455,571 $ 2,782,435 7,528,473 1,257,068 11,567,976 ========= ========= ========= ========= ========== See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended March 31, 1999, 1998 and 1997 1999 1998 1997 Cash flows from operating activities: ---- ---- ---- Net income (loss) $ 15,892 (196,314) 566,658 Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Accretion of interest (21,098) (114,825) (185,977) Allowance for doubtful accounts (1,000) (4,800) (14,500) Depreciation and amortization 733,906 622,219 494,292 Decrease (increase) in accounts receivable (408,200) (401,807) 317,203 Decrease (increase) in inventories 601,227 (182,641) 83,994 Decrease (increase) in prepaid expenses and other current assets 159,791 (56,623) (84,767) Increase in income taxes receivable (35,035) (74,889) (178,130) Decrease (increase) in deferred income taxes (52,982) 51,492 90,480 Decrease (increase) in other assets (114,118) 3,697 (23,505) Increase (decrease) in accounts payable (567,372) (390,492) 370,525 Increase (decrease) in accrued expenses (123,879) 159,314 76,514 --------- --------- --------- Net cash provided (used) by operating activities 187,132 (585,669) 1,512,787 --------- --------- --------- Cash flows from investing activities: Maturities of short-term investments 1,055,000 3,112,000 5,190,000 Purchases of short-term investments - (1,000,064) (3,950,338) Capital expenditures for property, plant and equipment (772,326) (2,216,397) (1,030,145) --------- --------- --------- Net cash provided (used) by investing activities 282,674 (104,461) 209,517 --------- --------- --------- Cash flows from financing activities: Net borrowings under line-of-credit agreement - 1,872,101 577,899 Principal payments on mortgage note payable (75,000) (75,000) (75,000) Proceeds from exercise of stock options 135,348 - 8,001 Dividends paid (30,000) (1,260,740) (1,267,238) --------- --------- --------- Net cash provided (used) by financing activities 30,348 536,361 (756,338) --------- --------- --------- Net increase (decrease) in cash and cash equivalents 500,154 (153,769) 965,966 Cash and cash equivalents at beginning of year 1,153,798 1,307,567 341,601 --------- --------- --------- Cash and cash equivalents at end of year $ 1,653,952 1,153,798 1,307,567 ========= ========= ========= Supplemental cash flow information: Cash paid for interest $ 193,902 136,380 33,274 ========= ========= ========= Cash paid (received) for income taxes $ (228,299) 134,068 219,125 ========= ========= ========= See accompanying notes to consolidated financial statements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (1) Summary of Significant Accounting Policies (a) Description of Business Technology Research Corporation and subsidiary (the Company) is engaged in the design, development, manufacturing, and marketing of electronic control and measurement devices related to the distribution of electrical power and specializes in electrical safety products that prevent electrical fires and protect against electrocution and serious injury from electrical shock. The Company's corporate headquarters are located in Clearwater, Florida. During February 1997, the Company incorporated TRC Honduras, S.A. de C.V., a wholly- owned subsidiary, for the purpose of manufacturing the Company's high volume products in Honduras beginning in April 1997. The Company primarily sells its products to governmental entities and original equipment manufacturers involved in a variety of industries including business machinery and personal care appliances. The Company performs credit evaluations of all new customers and generally does not require collateral. Historically, the Company has experienced minimal losses related to receivables from individual customers or groups of customers in any particular industry or geographic area. The Company's customers are located throughout the world. See note 9 for further information on major customers. The Company also licenses its technology for use by others in exchange for a royalty or product purchases. Licensees are located in Australia, France, Italy, Japan, the United Kingdom and the United States. (b) Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates. (c) Foreign Currency Translation The U.S. dollar is the functional currency of the Honduran subsidiary. Foreign currency denominated assets and liabilities of this subsidiary are remeasured at the rates of exchange at the balance sheet date. Income and expense items are remeasured at average monthly rates of exchange. Gains and losses from foreign currency transactions of this subsidiary are included in operations. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (d) Financial Instruments The Company believes the book value of its financial instruments (short-term investments, accounts receivable, trade accounts payable, accrued expenses, dividends payable, income taxes receivable and payable and debt) approximate their fair value due to their short-term nature or with respect to debt, the interest rate appropriately reflects the credit risk. (e) Principles of Consolidation The consolidated financial statements include the financial statements of Technology Research Corporation and its wholly-owned subsidiary, TRC Honduras, S.A. de C.V. All significant intercompany balances and transactions have been eliminated in consolidation. (f) Cash Equivalents For purposes of the statements of cash flows, the Company considers all short- term investments purchased with a maturity of three months or less to be cash equivalents. There were no short-term investments considered cash equivalents at March 31, 1999 or 1998. (g) Short-Term Investments The Company considers all of its short-term investments to be "held-to-maturity," and therefore, are recorded at amortized cost. (h) Revenue Recognition Sales and cost of sales related to governmental contracts are recognized under the unit-of-delivery method, whereby sales and cost of sales are recorded as units are delivered. All other sales and cost of sales are recognized as product is shipped. The Company accrues minimum royalties due over the related royalty period. Royalties earned in excess of minimum royalties due are recognized as reported by the licensees. (i) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of The Company reviews long-lived assets and certain identifiable intangibles whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value, less costs to sell. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (j) Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. (k) Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets. (l) Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. (m) Stock-Based Compensation On April 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS 123 also allows entities to continue to apply the provisions of APB 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS 123 had been applied. The Company has elected to continue to apply the provisions of APB 25 and provide the pro forma disclosures of SFAS 123 (see note 7). (n) Earnings Per Share Basic earnings per share has been computed by dividing net income by the weighted average number of common shares outstanding. Common share equivalents included in the dilutive weighted average shares outstanding computation represent shares issuable upon assumed exercise of stock options which would have a dilutive effect in years where there are earnings. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (o) New Accounting Standards In 1999, the Company adopted SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting and presentation of comprehensive income and its components to a full set of financial statements. The Statement requires only additional disclosures in the financial statements; it does not affect the Company's financial position or results of operations. The Company has no components of comprehensive income; therefore the adoption of this standard did not have any effect on the consolidated financial statements. In June 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 which is effective for fiscal years beginning after December 15, 1997, changes the way public companies report information about segments of their business in their annual financial statements and requires them to report selected segment information in their quarterly reports issued to shareholders. The Company operates in a single segment of business; therefore, there was no effect on the Company's consolidated financial statements from the adoption of SFAS 131. In 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair values. The Company will be required to adopt this standard for financial statements issued beginning the first quarter of fiscal year 2002. The Company has not historically had derivative financial instruments; therefore, the adoption of this standard is not expected to have any effect on the consolidated financial statements. (2) Short-Term Investments The Company considers all of its investment securities to be held-to-maturity. These securities are all classified in short-term investments on the consolidated balance sheets and mature within one year. The amortized cost, gross unrealized holding gains, gross unrealized holding losses, and fair value for held-to-maturity securities at March 31, 1999 and 1998 were as follows: Gross unrealized Amortized holding Fair cost Gains Losses value ---- ----- ------ ----- March 31, 1999 - U.S. Treasury securities $ - - - - ========= ====== ====== ========= March 31, 1998 - U.S. Treasury securities $ 1,033,902 - - 1,033,902 ========= ====== ====== ========= The U.S. Treasury securities matured in August 1998 and the funds were transferred to a money market account which is included in cash and cash equivalents. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (3) Inventories Inventories at March 31, 1999 and 1998 consist of: 1999 1998 ---- ---- Raw materials $ 3,800,340 4,499,524 Work in process 242,683 387,170 Finished goods 681,159 438,715 --------- --------- $ 4,724,182 5,325,409 ========= ========= Approximately 29% and 27% of inventories were located in Honduras at March 31, 1999 and 1998 respectively. (4) Income Taxes The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at March 31, 1999 and 1998 are presented below: 1999 1998 ---- ---- Deferred tax assets: Accounts receivable, principally due to allowance for doubtful accounts $ 23,000 23,300 Inventories, principally due to valuation allowance for financial reporting purposes and additional costs inventoried for tax purposes 281,000 252,500 Accrued expenses, principally due to accrual for financial reporting purposes 47,000 65,600 Net operating loss carryforwards 214,000 182,000 Tax credit carryforwards 221,000 214,000 -------- -------- Total gross deferred tax assets 786,000 737,400 Less valuation allowance (187,000) (187,000) -------- -------- 559,000 550,400 -------- -------- Deferred tax liabilities: Property, plant and equipment, principally due to differences in depreciation (83,990) (88,372) -------- -------- Net deferred tax assets $ 515,010 462,028 ======== ======== TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Net deferred tax assets are included in the accompanying balance sheets at March 31, 1999 and 1998 as: 1999 1998 ---- ---- Deferred income taxes, current asset $ 515,010 406,100 Deferred income taxes, noncurrent asset - 55,928 -------- -------- $ 515,010 462,028 ======== ======== Management assesses the likelihood deferred tax assets will be realized which is dependent upon the generation of taxable income during the periods in which those temporary differences are deductible. Management considers historical taxable income, the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. In order to fully realize the deferred tax asset related to net operating loss and tax credit carryforwards, the Company will need to generate future taxable income of approximately $170,000 each year prior to the expiration of the net operating loss and tax credit carryforwards in 2003 and 2002, respectively. Based upon the level of historical taxable income and projections for future taxable income, management believes it will realize the benefits of these deductible differences, net of the existing valuation allowance at March 31, 1999. The valuation allowance at March 31, 1999 and 1998 relates to tax credit carryforwards which management expects will expire unused. At March 31, 1999, the Company has net operating loss carryforwards for Federal income tax purposes of approximately $306,000, which are available to offset future taxable income through 2003 and approximately $233,000 which are available to offset future taxable income through 2019. The Company also has available tax credit carryforwards for Federal income tax purposes of approximately $214,000, which are available to offset future Federal income taxes through 2002 and $7,000 of tax credit carryforwards which have no expiration date. As a result of an ownership change in 1989, the Internal Revenue Code limits the income tax benefit of $306,000 of net operating loss and $214,000 of tax credit carryforwards to approximately $65,000 each year. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Income tax expense (benefit) for the years ended March 31, 1999, 1998 and 1997 consists of: 1999 1998 1997 ---- ---- ---- Current: Federal $ (263,334) 59,179 156,748 State - - (116,744) -------- -------- --------- (263,334) 59,179 40,004 -------- -------- --------- Deferred: Federal 70,000 48,600 77,000 State (17,018) 2,892 13,480 -------- -------- --------- 52,982 51,492 90,480 -------- -------- --------- $ (210,352) 110,671 130,484 ======== ======== ========= Income tax expense (benefit) for the years ended March 31, 1999, 1998 and 1997 differs from the amounts computed by applying the Federal income tax rate of 34% to pretax income (loss) as a result of the following: 1999 1998 1997 ---- ---- ---- Computed expected tax (benefit) expense $ (66,000) (29,000) 237,000 Increase (reduction) in income taxes resulting from: Foreign activity for which no income tax has been provided (112,000) 128,000 - State income taxes, net of Federal income tax effect (8,000) 2,000 (68,000) Other (24,352) 9,671 (38,516) -------- -------- --------- $ (210,352) 110,671 130,484 ======== ======== ========= The operating results of the foreign manufacturing subsidiary are not subject to foreign tax since it is operating under a tax holiday for at least twenty years. The foreign operations resulted in income of $329,000 in 1999 and a loss of $375,000 in 1998. No income taxes have been provided on these results of operations. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (5) Property, Plant and equipment Property, plant and equipment at March 31, 1999 and 1998 consists of: Estimated 1999 1998 useful lives ---- ---- ------------ Building and improvements $ 1,516,676 1,512,205 20 years Machinery and equipment 8,289,458 7,521,603 5 - 15 years --------- --------- ------------ $ 9,806,134 9,033,808 ========= ========= Approximately 21% and 20% of property, plant and equipment is located in Honduras at March 31, 1999 and 1998, respectively. (6) Debt Debt at March 31, 1999 and 1998 consists of the following: 1999 1998 ---- ---- $2,500,000 line of credit; interest at LIBOR plus 175 and 200 basis points at March 31, 1999 and 1998, respectively, (6.687% and 7.69% at March 31, 1999 and 1998, respectively), payable monthly, due August 1999; secured by receivables, inventories and equipment (subject to provisions stated below) $ 2,450,100 2,450,100 First mortgage note payable; interest at LIBOR plus 175 and 200 basis points at March 31, 1999 and 1998, respectively, (6.687%and 7.69% at March 31, 1999 and 1998 respectively); due in monthly installments of $6,250, plus interest, matures December 2000; secured by operating facility 131,250 206,250 --------- --------- Total debt 2,581,350 2,656,350 Less current installments (2,525,100) (2,525,100) --------- ---------- Debt, excluding current installments $ 56,250 131,250 ========= ========== TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Borrowings under the line of credit are limited to 80% of eligible accounts receivable under 90 days, plus the lesser of 40% of eligible inventory or $450,000. The line of credit is secured by receivables, inventories, and property, plant and equipment, and requires the Company to maintain certain financial ratios and a minimum tangible net worth amount. The Company was in compliance with these covenants at March 31, 1999 and 1998. The aggregate maturities of long-term debt are: Year ending March 31, --------------------- 2000 $ 2,525,100 2001 56,250 --------- $ 2,581,350 ========= (7) Stock Options, Grants and Warrants The Company has two qualified incentive stock option plans, one performance- incentive stock option plan, and one nonqualified stock option plan (the Plans). Options granted under the Plans are granted to directors, officers and employees at fair value and expire ten years after the date of grant. Except for the Performance Plan, options granted under the Plans generally vest over three years. Options granted under the Performance Plan vest at the end of year ten but are subject to accelerated vesting if certain targets are met. Options may be exercised by payment of cash or with stock of the Company owned by the officer or employee. In November 1998, the Board of Directors approved a repricing of options under the qualified incentive stock option and nonqualified stock option plans. The options were repriced on November 19, 1998 based on the closing stock price on that date. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Option transactions and other information relating to the Plans for the three years ended March 31, 1999 are as follows: Qualified Performance Non- incentive incentive qualified Weighted stock stock stock average option option option exercise plans plan plan Total price ------- ------- ------- --------- -------- Outstanding at March 31, 1996 103,653 - 196,902 300,555 3.91 Granted 50,750 400,000 10,000 460,750 5.08 Exercised (6,002) - (8,334) (14,336) 0.75 Canceled (1,234) - - (1,234) 5.46 ------- ------- ------- --------- Outstanding at March 31, 1997 147,167 400,000 198,568 745,735 4.70 Granted 1,000 - 10,000 11,000 3.29 Canceled (14,020) - (2,000) (16,020) 5.29 ------- ------- ------- --------- Outstanding at March 31, 1998 134,147 400,000 206,568 740,715 4.32 Granted 141,911 - 46,134 188,045 1.57 Exercised - - (154,100) (154,100) 1.33 Canceled (134,147) - (52,468) (186,615) 5.08 ------- ------- ------- --------- Outstanding at March 31, 1999 141,911 400,000 46,134 588,045 3.99 ======= ======= ======= ========= Total number of options available under the plans 713,334 400,000 333,333 1,446,667 ======= ======= ======= ========= Exercisable at March 31, 1999 - - 23,334 23,334 1.63 ======= ======= ======= ========= Available for issue at March 31, 1999 13,645 - 28,674 42,319 ======= ======= ======= ========= The per share weighted average fair value of stock options granted during 1999, 1998 and 1997 was $1.15, $1.85 and $2.14, respectively, on the date of grant using the Black Scholes option pricing model, with the following assumptions: (1) risk free interest rate - 6.17% to 6.85%, (2) expected life - 6.5 to 10 years, (3) expected volatility - 72% to 75%, and (4) expected dividends - 5.1% to 5.8%. At March 31, 1999, the range of exercise prices and weighted average remaining contractual life of options outstanding and exercisable was as follows: Options Outstanding Options Exercisable - ------------------------------------------------- ---------------------------- Number Weighted average Weighted Number Weighted Range of outstanding remaining average exercisable average exercise as of contractual exercise as of exercise prices March 31, 1999 life price March 31, 1999 price - -------- -------------- -------------- --------- -------------- -------- $1.63 169,045 9.65 1.63 23,334 1.63 $1.06 19,000 10.01 1.06 - - $5.13 400,000 7.26 5.13 - - TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 The Company grants options at fair value and applies APB 25 in accounting for its Plans. Accordingly, no compensation cost has been recognized for stock options in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS 123, the Company's net income at March 31, 1999, 1998 and 1997 would have been reduced to the pro forma amounts indicated below: 1999 1998 1997 ---- ---- ---- Net income (loss): As reported $ 15,892 (196,314) 566,658 ========= ========= ========= Pro forma $ (70,343) (290,371) 476,123 ========= ========= ========= Income (loss) per common share: As reported $ - (.04) .10 ========= ========= ========= Pro forma $ (.01) (.05) .09 ========= ========= ========= Pro forma net income reflects only options granted in 1999, 1998, 1997 and 1996. Therefore, the full impact of calculating compensation costs for stock options under SFAS 123 is not reflected in the pro forma net income amounts presented above because compensation cost is reflected over the options' vesting period of three to ten years, and compensation costs for options granted prior to April 1, 1995 are not considered. The Company has also reserved 32,667 shares of its common stock for issuance to employees or prospective employees at the discretion of the Board of Directors of which 16,033 shares are available for future issue. There were no reserved shares issued during the years ended March 31, 1999, 1998 or 1997. (8) Leases The Company leases the land on which its operating facility is located. This operating lease is for a period of twenty years through 2001 with options to renew for two additional ten-year periods. The lease provides for rent adjustments every five years. The Company is responsible for payment of taxes, insurance, and maintenance. In the event the Company elects to terminate the lease, title to all structures on the land reverts to the lessor. The Company's subsidiary leases its operating facility in Honduras. This operating lease is for five years through the year 2002, with an option to renew for an additional five-year term. The Company also leases certain office equipment under long-term operating lease agreements. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Future minimum lease payments under noncancelable operating leases as of March 31, 1999 are: Year ending March 31, --------------------- 2000 $ 244,834 2001 245,184 2002 205,690 2003 17,141 -------- Total minimum lease payments $ 712,849 ======== Rental expense for all operating leases was approximately $249,000 in 1999, $187,000 in 1998 and $80,000 in 1997. (9) Major Customers The Company operates in one business segment - the design, development, manufacture and marketing of electronic control and measurement devices for the distribution of electric power. The Company only reports sales and standard gross profit by market (commercial and military), no allocations of manufacturing variances and other costs of operations or assets are made to the market. Sales by market are: 1999 1998 1997 ---- ---- ---- Commercial $ 13,929,177 13,434,352 12,803,181 Military $ 3,190,542 4,667,433 2,200,413 ---------- ---------- ---------- $ 17,119,719 18,101,785 15,003,594 ========== ========== ========== Significant customers which accounted for 10% or more of sales in 1999, 1998 or 1997 and aggregate exports were: Year ended March 31 ------------------- Customer 1999 1998 1997 -------- ---- ---- ---- Xerox Corporation $ 1,934,740 2,838,905 2,529,398 Noma Appliance & Electric, Inc., f/k/a Fleck Manufacturing, Inc. (a Xerox Corporation supplier) 1,623,904 1,666,516 1,776,424 Other Xerox Corporation suppliers 124,473 133,044 802,800 Fermont Division 1,397,211 2,817,079 1,434,422 --------- --------- --------- $ 5,080,328 7,455,544 6,543,044 TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 Year ended March 31 ------------------- Customer 1999 1998 1997 -------- ---- ---- ---- Exports: Canada $ 1,794,855 1,894,215 1,831,898 Far East 394,156 486,277 1,057,605 Europe 2,787,224 2,554,772 1,396,823 Mexico 711,067 979,187 736,992 Australia 117,754 218,530 150,760 South America 37,383 20,994 82,838 Middle East 2,067 3,397 5,324 --------- --------- --------- Total exports $ 5,844,506 6,157,372 5,262,240 ========= ========= ========= (10) Benefit Plan The Company's 401(k) plan covers all employees with one year of service who are at least twenty-one years old. The Company matches employee contributions dollar-for-dollar up to $300. Total Company contributions were approximately $25,000 in 1999, $29,000 in 1998 and $25,000 in 1997. (11) Litigation The Company is involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements March 31, 1999, 1998 and 1997 (12) Selected Quarterly Data (Unaudited) Information (unaudited) related to operating revenues, operating income, net income and earnings per share, by quarter, for the years ended March 31, 1999 and 1998 are: First Second Third Fourth quarter quarter quarter quarter ------- ------- ------- ------- Year ended March 31, 1999: Operating revenues $ 4,753,401 4,467,032 3,714,398 4,276,183 ========= ========= ========= ========= Gross profit $ 1,426,715 1,282,222 829,614 539,910 ========= ========= ========= ========= Operating income (loss) $ 410,425 160,780 (136,931) (522,601) ========= ========= ========= ========= Net income (loss) $ 239,862 84,010 (70,001) (237,979) ========= ========= ========= ========= Basic earnings per share $ .04 .02 (.02) (.04) ========= ========= ========= ========= Diluted earnings per share $ .04 .02 (.02) (.04) ========= ========= ========= ========= Year ended March 31, 1998: Operating revenues $ 4,811,585 4,545,950 4,658,113 4,415,303 ========= ========= ========= ========= Gross profit $ 1,488,247 1,336,956 1,140,074 871,003 ========= ========= ========= ========= Operating income (loss) $ 467,494 106,385 (145,509) (509,551) ========= ========= ========= ========= Net income (loss) $ 326,315 74,019 (130,444) (466,204) ========= ========= ========= ========= Basic earnings per share $ .06 .01 (.02) (.09) ========= ========= ========= ========= Diluted earnings per share $ .06 .01 (.02) (.09) ========= ========= ========= ========= The fourth quarter of the years ended March 31, 1999 and 1998 were adversely affected by an approximately $250,000 and $270,000, respectively, reduction in inventory as a result of the Company's physical inventory. It is not practicable to determine what, if any, other quarters are affected by this adjustment. TECHNOLOGY RESEARCH CORPORATION AND SUBSIDIARY Schedule II Valuation and Qualifying Accounts Years ended March 31, 1999, 1998 and 1997 Additions ---------------------- Balances at Charged to Charged to Balances beginning costs and other at end of Description of period expenses accounts Deductions period ----------- ---------- ---------- ---------- ---------- --------- Allowance for doubtful accounts: Year ended March 31, 1999 $ 64,700 24,500 - 25,000 63,700 ======= ======= ======= ======= ======= Year ended March 31, 1998 $ 69,500 - - 4,800 64,700 ======= ======= ======= ======= ======= Year ended March 31, 1997 $ 84,000 - - 14,500 69,500 ======= ======= ======= ======= ======= SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TECHNOLOGY RESEARCH CORPORATION Dated: 6/11/1999 By: /s/ Robert S. Wiggins Robert S. Wiggins Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated: Signature Title Date Chairman, Chief Executive Officer, and Director (Principal Executive /s/ Robert S. Wiggins Officer) 6/11/1998 Robert S. Wiggins Vice President of Finance and Chief Financial Officer (Principal Financial /s/ Scott J. Loucks Officer) 6/11/1998 Scott J. Loucks /s/ Raymond H. Legatti President and Director 6/16/1999 Raymond H. Legatti Senior Vice President Government Operations and Marketing and /s/ Raymond B. Wood Director 6/22/1999 Raymond B. Wood /s/ Gerry Chastelet Director 6/18/1999 Gerry Chastelet /s/ Russell Cleveland Director 6/15/1999 Russell Cleveland /s/ Edmund F. Murphy, Jr. Director 6/21/1999 Edmund F. Murphy, Jr. /s/ Martin L. Poad Director 6/17/1999 Martin L. Poad

1082923_1999.txt

1082923_1999

1999

1082923

ITEM 1. BUSINESS Overview Stamps.com(TM) provides easy, convenient and cost-effective Internet mailing and shipping services to small businesses, large corporations, e- commerce vendors and individual consumers. We offer a one-stop service where customers can choose the best carrier for any transaction based on cost comparisons and delivery options. With Stamps.com's core mailing and shipping services, customers can use their existing PC/printer setup and Internet connection to select a carrier, print US postage or multi-carrier shipping labels, schedule a pick-up and track a package. Stamps.com was founded in September 1996 to investigate the feasibility of entering into the US Postal Service's Information Based Indicia Program and initiate the certification process for our Internet Postage service. In January 1998, we were incorporated in Delaware as StampMaster, Inc. and changed our name to Stamps.com Inc. in December 1998. We completed our initial public offering in June 1999 and our common stock is listed on the Nasdaq National Market under the symbol "STMP." In March 2000, we completed our acquisition of iShip.com(TM), a Washington corporation that was initially founded as MoveIt! Software, Inc. in May 1997 and changed its name to iShip.com, Inc. in May 1998. As a result of the acquisition, iShip.com is a wholly owned subsidiary of Stamps.com. Our principal executive offices are located at 3420 Ocean Park Boulevard, Suite 1040, Santa Monica, California 90405, and our telephone number is (310) 581-7200. Stamps.com Internet Mailing and Shipping Services Stamps.com Internet Postage(TM) Service. Our Internet Postage service is approved by the US Postal Service and enables users to print information-based indicia, or electronic stamps, over the Internet and directly onto envelopes, labels or business documents using ordinary laser or inkjet printers. Our service requires no additional hardware to purchase and print postage; the user's existing PC, printer and Internet setup are sufficient. Accessing our service is simple. Our free software can be downloaded from the Internet or installed from a free CD-ROM. After installing the software and completing a brief registration process, customers can purchase and print postage 24 hours a day, seven days a week from their PCs. Customers are charged a monthly convenience fee based on usage of our service. Our technology meets strict US government security standards and our service incorporates US Postal Service- mandated address verification features to enhance the efficiency of mail processing and delivery. In addition, our Internet Postage service is designed to interact with word processing, contact and address management, accounting and corporate applications to stamp letters, invoices, statements, checks and other business documents automatically. On October 22, 1999, we commercially launched our Internet Postage service. As of February 29, 2000, our customer base consisted of over 150,000 users who had downloaded our software and registered for our service. Shipping and Tracking Services. As a result of our acquisition of Bellevue, Washington-based iShip.com in March 2000, we have added Web-based technology that is designed to provide a complete one-stop shipping and tracking solution. Our shipping tools are designed to help consumers, small businesses and large corporations price, ship, track and manage shipments over the Internet. These services will enable a comparison of rates and services among multiple carriers, including Airborne Express, FedEx, UPS, the US Postal Service and Yellow Freight Systems. In addition, our multi-carrier shipping solution is designed to provide simplified functionality for consumers, a broader feature set for the small business, and extensive management tools for the large corporate enterprise user. iShip.com's core service is designed to enable shippers to: (a) select the optimal shipping solution every time they ship a package; (b) print shipping labels from their desktop laser jet printers or high-speed thermal printers; (c) track packages, including in- bound packages; (d) send and receive e-mail notifications of the status of shipped packages; (e) maintain a shipping log and history of packages shipped; (f) generate reports to help them better manage their shipping process; and (g) provide shipping data to the package carriers' back-end host systems. Non-Mailing and Shipping Services. In addition to our core mailing and shipping services, we continue to evaluate incremental revenue opportunities and derivative applications of our technology and plan to pursue and develop those opportunities with strategic partners and investors. For instance, we announced on November 16, 1999 the formation of a subsidiary, EncrypTix, Inc. to develop secure printing opportunities in the events, travel and financial services industries. In February 2000, we granted EncrypTix a license to our technology in those three specific fields of use. In addition, EncrypTix raised approximately $30 million in private financing from a group of financial and strategic investors that includes Vulcan Ventures, American Express Travel Related Services Company, Inc., Galileo International, GetThere.com, Inc., Loews Cineplex Entertainment Corporation, Mail Boxes Etc. USA, Inc., Mitsubishi International Corporation, Sabre, Inc., SunAmerica Investment Inc. and Tickets.com, Inc. As a result of the financing, we retain almost two-thirds of the economic interest and over 90% of the voting control of EncrypTix. EncrypTix provides highly secure, authenticated online printing technologies for the events, movie, travel and financial service industries. Utilizing many of the proprietary, Internet-based technologies developed by Stamps.com, EncrypTix will enable sellers and distributors of tickets and financial instruments to deliver value-bearing instruments such as tickets, vouchers, boarding passes, checks and gift certificates over the Internet through a customer's existing laser or inkjet printer. Similar to our Internet Postage service, no specialized hardware device is required for the EncrypTix service. Overview of Our Industry Growth of Internet Commerce The Internet has emerged as a significant global communications medium, enabling millions of people to share information and conduct business electronically. According to International Data Corporation, the number of Web users worldwide will grow from an estimated 142.2 million in 1998 to 502.4 million by 2003. In addition, International Data Corporation estimates that the percentage of Web users buying goods and services on the Internet will grow from 22% in December 1998 to 36% in December 2003. International Data Corporation further estimates that the total value of goods and services purchased over the Web will increase from approximately $50.4 billion in 1998 to approximately $1.3 trillion in 2003. Business-to-business commerce on the Internet is expected to contribute significantly to the future growth of Internet commerce. For example, International Data Corporation estimates that business-to-consumer commerce on the Internet will grow from approximately $14.9 billion in 1998 to approximately $177.7 billion in 2003 while business- to-business commerce on the Internet will grow from approximately $35.5 billion in 1998 to approximately $1.1 trillion in 2003. Growth in Internet Usage by Small Businesses The small office/home office and small business markets represent a large and growing customer segment. According to International Data Corporation, there were a combined 44.7 million small businesses and home offices in the United States in 1998, a number which International Data Corporation forecasts will grow to 57.6 million by 2002. For 1998, International Data Corporation reported that small businesses with less than 100 employees numbered 7.4 million, of which 77% had fewer than 10 employees. In addition, home offices numbered 37.3 million, of which 22.2 million were income-producing home offices, and the remainder were home offices used for corporate after-hours work or telecommuting. We believe that small businesses increasingly will rely on the functionality and pervasiveness of the Internet to reach and serve a large and global group of end users. The reduced cost of selling and marketing on the Internet, the ability to build and serve a large base of customers electronically and the potential for personalized low-cost customer interaction provide significant economic advantages. These overall benefits, combined with accessibility, have led to adoption of the Internet by small businesses and home offices. According to International Data Corporation, there will be 30.2 million US home offices accessing the Internet by 2002. According to Cyber Dialogue/FindSVP's 1999 US Small Business Internet Survey, 43% of businesses with fewer than 100 employees were estimated to be online in 1999. Of those small businesses that are currently online, 63% are already ordering products online and are spending an average of $171 monthly on postage. The Cyber Dialogue/FindSVP survey also found that 64% of online small businesses have employees who are online multiple times a day. This increased use of the Internet has resulted in small businesses becoming significant participants in the electronic commerce market. International Data Corporation estimates that small businesses accounted for $4.4 billion of electronic commerce in 1998 and will account for approximately $100.4 billion of electronic commerce activity in 2002. Traditional Postage Industry and the Emergence of Internet Postage According to the US Postal Service Annual Report, the total postage market was $62.8 billion in 1999, of which $38.9 billion was represented by first class, priority and express mail with the remainder consisting of other classes of mail including periodicals, bulk and international. The US Postal Service processed over 201 billion pieces of mail in 1998. Despite the growth in the use of e-mail, the total US postage market increased by 4.3% in 1999 from 1998. Despite this consistent growth in the postage market, the US Postal Service has experienced continued public demand for more convenient access to US Postal Service products and services; loss of revenue due to postal fraud; and strong competition from overnight delivery services and online transaction services. Recently, the General Accounting Office, in a report issued on October 21, 1999, stated that competition from alternatives such as online invoicing, bill payment and financial transactions could lead to declines in the U.S. Postal Service's First Class Mail volume in the next decade. Specifically, the report projects that First Class Mail will grow at an average annual rate of 1.8% in fiscal years 1999 to 2002 and then decline at an average annual rate of 2.5% in fiscal years 2003 to 2008. In addition, the Postal Service also forecasts Standard A mail, which is primarily advertising mail and includes letters, flats and parcels that are not sent by first-class mail or priority mail, to increase by an average annual rate of 5.3% in fiscal years 1999 through 2002 and to increase by an average annual rate of 3.3% in fiscal years 2003 through 2008. In response to these challenges, in 1995, the US Postal Service announced a program for its first new postage method since the approval of the postage meter in 1920. The Information Based Indicia Program is a ten-stage certification process for commercial release of Information Based Indicia products, or electronic postage, that can be purchased over the Internet and printed from a computer using ordinary laser or inkjet printers. Indicia are a new type of US Postal Service approved postage marks similar to stamps or metered postage. Information Based Indicia, which are essentially digital stamps, consist of a two dimensional bar code containing a digital signature that make each indicium unique. Through the Information Based Indicia Program, the US Postal Service is seeking to enhance user convenience with a new access channel for postage that allows users to print postage from their PCs 24 hours a day, seven days a week. The Information Based Indicia Program is intended to achieve the US Postal Service's security and revenue objectives by incorporating technological security features in each unique digitally-signed indicium and a secure postage accounting vault to provide greater revenue security. All Internet postage products, including any subsequent enhancements or additional implementation of a product, must complete US Postal Service testing and evaluation to ensure operational reliability, financial integrity and security to become certified for commercial distribution. Overall, the Information Based Indicia Program aims to provide improved, accurate mail processing and increased productivity, a result which is intended to reduce US Postal Service costs and postal fraud; increase service levels to under-served markets, including the rapidly growing small office/home office and other small business markets; and improve the US Postal Service's competitive position against overnight delivery services. The emergence of Internet postage though the US Postal Service's Information Based Indicia Program has created an attractive channel for the sale of postage, particularly to small office/home office and other small businesses. According to a 1997 US Postal Service survey of over 1,600 home offices, 98% of the respondents would likely use commercial software products to print postage directly from their computers, 88% of the respondents did not use a postage meter and 43% of the respondents purchased over $50 of postage per month. We believe that small businesses consider cost-effective mail generation, elimination of trips to the post office and the production of professional-looking mail as key components of an effective mailing system. Internet postage satisfies these requirements by providing 24 hours a day, seven day a week access to metered mail from the desktop. Furthermore, when considering the total cost of a traditional postage meter, including lease fees for both the meter and scale, meter resetting fees and special ink cartridges, small businesses pay a significant premium in addition to their normal postage expenditures for leasing a postage meter. Leasing a postage meter also requires space for additional hardware and the purchase of specialized materials and supplies. Meanwhile, small businesses that find leasing a postage meter uneconomical are still faced with the inconvenience of travelling to the post office, ATM or other locations to purchase stamps. Traditional Shipping Industry and the Emergence of Internet-Based Shipping By 2003, Forrester Research predicts that the number of residential packages shipped from online sales will top 2.1 billion per year. Forrester Research also projects that total residential package deliveries will grow from 2.98 million packages per day in 1999 to 6.53 million packages per day in 2003. International Data Corporation predicts a rise in the number of Internet users making purchases, from 31 million in 1998 to more than 183 million in 2003. With the growth in e-commerce activities, there is also increasing demand for package shipments relating to online commerce transactions in the business-to-consumer and business-to-business markets. We believe that technology will play an increasingly important role in creating efficiencies in package shipments. In addition, we believe that a major goal of package carriers is to capture shipping information electronically in order to reduce costs, increase accuracy, and speed tracking and billing. The Internet provides an ideal medium through which this information can be distributed and managed. The US Postal Service Certification Process for Our Internet Postage Service All Internet postage products must complete extensive US Postal Service testing and evaluation in the areas of operational reliability, financial integrity and security to become certified for commercial distribution. Each additional implementation of a particular product or function requires additional evaluation and approval by the US Postal Service prior to commercial delivery. The US Postal Service certification process for Internet postage is a standardized, ten-stage process concluding with commercial release. Each stage requires US Postal Service review and authorization to proceed to the next stage of the certification process. The US Postal Service has no published timeline or estimated time to complete each of the ten stages of the program. The most significant stage is the ninth stage, which requires a vendor to complete three phases of beta testing. In March 1997, we submitted our letter of intent to join the Information Based Indicia Program. From March 1997 through August 1998, we progressed through the first eight stages of the US Postal Service certification process. On August 24, 1998, the US Postal Service announced that we were approved for beta testing and our Internet Postage service became the first software-based postage solution approved by the US Postal Service for market testing. Between August 24, 1998 and August 9, 1999, we successfully completed the three-phase beta testing required by the US Postal Service's certification process. On August 9, 1999, we became the first software-based Internet postage solution approved for commercial release by the US Postal Service. On October 22, 1999, we launched our service. As of February 29, 2000, our customer base consisted of over 150,000 users who had downloaded our software and registered for our service. Our Strategic Business Units In March 2000, we announced that we had organized into three specialized strategic business units (SBUs) focused on the enterprise, e-commerce and small business market segments of our core mailing and shipping services. Enterprise Strategic Business Unit The Stamps.com Enterprise SBU will offer companies with more than 1,000 employees an Internet-based, multi-carrier mailing and shipping service. The Stamps.com enterprise service will allow corporations to centrally manage and control costs from mailing and shipping activities across multiple carriers and can be distributed to thousands of corporate desktops using only a Web browser. Employees can prepare packages for shipments, comparing rates and services among carriers that include the US Postal Service, UPS, FedEx, Airborne Express and Yellow Freight. Operations management can use centralized administration tools to define shipping procedures, approve carriers and rates, and set business rules to control shipping costs and quality. The service is based on the application service provider (ASP) deployment model and recurring, transaction-based revenue streams. E-Commerce Services Strategic Business Unit The Stamps.com E-commerce Services SBU addresses the growing shipping needs of e-tailers and other online businesses, including auctioneers. Through partnerships with premier auction Web sites, Stamps.com will provide mailing and shipping services available at the conclusion of any transaction on the Internet. These services will be embedded in auction Web sites, e-tailer "shopping carts" and other points-of-purchase on various Web sites, enabling buyers and sellers to select precise pricing and delivery terms from among a variety of carrier choices. Small Business Strategic Business Unit Stamps.com's traditional business, serving small businesses and consumers with our Internet Postage service, is now our Small Business SBU. This unit will continue to offer an Internet-based solution for printing US Postal Service-approved postage and expanded offerings of multi-carrier document and package shipping to small businesses and home offices. Stamps.com's Internet Postage service targets small businesses in need of a more efficient and cost- effective way to send letters, documents, parcels and packages. Our Strategic Distribution Partners Our objective is to achieve significant market penetration through relationships with strategic partners in each of the following categories: . Web portals, content sites and Internet service providers, including AOL; . independent software vendors, including Intuit and Microsoft; . PC, printer and other original equipment manufacturers, including IBM and Hewlett-Packard; . shipping services providers, including Mail Boxes, Etc., UPS, FedEx, Airborne Express and Yellow Freight; and . office/postal supplies vendors, including 3M and Office Depot. We believe we will benefit from these relationships by achieving positive brand association and a cost-effective means of customer acquisition. We believe our partners can utilize their relationships with us to derive additional revenue opportunities and provide more value-added services to their customers. Our current strategic partners include: Our Marketing and Sales We intend to establish a strong brand name by allocating significant resources to our marketing and distribution efforts. We distribute our Internet Postage software through our Web site and distribution partners. In addition, we will rely on traditional direct marketing tactics and several other channels to achieve distribution and branding of our mailing and shipping services, including: Web Sites. We intend to work with high traffic Web sites including portals, commerce and content sites, and other highly visible Internet sites. This channel will provide the opportunity for users to download our software and access our Internet Postage service or to access our Web-based shipping services. Affiliate Programs. We intend to utilize the traffic and customers of other online sites by offering revenue-sharing opportunities to affiliates that provide a link on their Web site to download our Internet Postage software and access our shipping and other related services. We can leverage our affiliates' abilities to offer new, value-added services and increase repeat visits to their site. Preloaded/Bundled Hardware and Services. We intend to take advantage of relationships with vendors of hardware products, including computers, printers and label makers, and with Internet service providers to offer our software and other services to buyers of their products. We can leverage our resellers' ability to promote new features on commodity, non-differentiated products and services. Embedded Software. We intend to seek further partnerships with software publishing companies. Software packages that would benefit from our current services would include word processing, contact and address management, accounting, billing and retail software. Postal and Packaging Supplies. We will target companies in the postal and packaging supplies industry, including manufacturers of envelopes, labels, checks, forms, digital scales and postage meters. Financial Services. We will seek distribution and co-branding opportunities with banks and brokerages by incorporating our mailing and shipping services into online banking and investing offered by financial service providers. Direct Sales. We will target corporate enterprise customers and specific large industries or vertical markets where distributed use of the mail and shipping services is prevalent, including insurance, travel and hospitality, financial services, law firms or other businesses where branch offices or agent organizational structures are common. We believe that significant benefits in the form of usability, convenience and cost savings to large corporate users may result from integrating our mailing and shipping services into the everyday work flow. Customer Retention Programs. We believe we can increase customer retention by offering a superior level of customer support and continually enhancing our service features to fully support all of our customers' mailing and shipping needs. We will continue to conduct both informal and formal market research to gain insight into what service enhancements are most important to both our current and prospective customers. In addition, we will build loyalty by offering exclusive savings to our customers through our existing partnerships and seeking online partnerships with points-based usage programs that reward our high revenue customers. Our Competition The market for Internet postage products and services is new and intensely competitive. The US Postal Service approved our software-based Internet postage service and E-Stamp Corporation's hardware-based Internet postage service for commercial release on August 9, 1999. At present, two other Internet postage vendors have hardware and software products available for beta testing. The following is a summary of our competitors in the Information Based Indicia Program, including the status of each competitor's product in the US Postal Service certification process: E-Stamp Corporation. E-Stamp is a developer and marketer of a hardware- based solution enabling users to generate postage transactions from their existing personal computers and printers. E-Stamp was the first company to gain US Postal Service approval for market testing of a hardware storage device identified as the Postal Security Device. The US Postal Service approved E- Stamp's PC Postal Security Device product for commercial release on August 9, 1999. On February 15, 2000, E-Stamp announced that it received approval from the US Postal Service to begin testing of a Web-based postage product. Neopost Industrie. Neopost is a large French postage company with a US presence in the traditional postage meter industry. Similar to E-Stamp, Neopost has developed an online postage product that requires a special purpose hardware device, and announced their approval for Phase I beta testing in September 1998. On March 29, 1999, Neopost announced that their software- based postage product was approved for Phase I beta testing. Both of these products entered Phase II beta testing in December 1999. Finally, Neopost has commercially available a specialty metering device that can be attached to a user's PC and allows a user to download postage to the device from the Internet. This specialty metering device is not regulated by the Information Based Indicia Program because it does not allow for the printing of postage from standard inkjet or laser printers. Pitney Bowes, Inc. Pitney Bowes is the current market leader in the traditional postage meter business and had approximately $4.4 billion in revenues in 1999. Pitney Bowes has developed a product similar to E-Stamp which requires the use of a specialized hardware device for postage transactions. In addition, Pitney Bowes has developed a software-based postage product. On December 15, 1999, Pitney Bowes announced that it had received approval from the US Postal Service to proceed to the third and final phase of beta testing for both its hardware and software products. Pitney Bowes is expected to commercially launch its software-based product as soon as the first quarter of 2000. In addition to competing with Internet postage vendors for market share of Internet postage sales, we will also compete with traditional postage methods including stamps and metered mail. While we believe our Internet Postage service provides benefits over traditional postage methods, we cannot be certain that Internet postage will be adopted by postage consumers on a commercial scale, if at all. These customers may continue to use traditional means to purchase postage, including purchasing postage from their local post office. Any failure by us or other Internet postage vendors to displace traditional postage methods would seriously impact our ability to compete with providers of traditional postage. We may also face competition from hardware-based products. Although, we believe our software-based solution is easier to use than hardware-based products, hardware-based products have some advantages. For example, our service requires a user to connect to the Internet each time the user prints postage, while the hardware-based solution allows users to download postage onto a storage device that is connected to the user's computer. If users of hardware-based products do not transition to a software-based solution, we could face continuing competition from this market. As a result of the iShip.com acquisition in March 2000, we also compete with companies that provide shipping solutions to businesses. Customers may continue using the direct services of the US Postal Service, UPS, FedEx and other major shippers, instead of adopting our online service. Alternatively, potential competitors with greater resources than us, like Pitney Bowes, may develop more successful Internet solutions. In addition, companies including TanData Corporation, GoShip.com, BITS, Inc./Intershipper.net, Kewill Systems, PackageNet and Virtan, Inc./SmartShip are competing in shipping services. We also face a significant risk that large shipping companies will collaborate in the development and operation of an online shipping system that could make our Web-based shipping service obsolete. Overall, we may not be able to maintain a competitive position against current or future competitors as they enter the markets in which we compete. This is particularly true with respect to competitors with greater financial, marketing, service, support, technical, intellectual property and other resources than us. Stamps.com's failure to maintain a competitive position within the market could seriously harm our business, financial condition and results of operations. For further discussion of the competitive risks and factors to be considering in making an investment in our common stock, see "Risk Factors--If we are unable to compete successfully, particularly against large, traditional providers of postage products like Pitney Bowes who enter the online postage and shipping markets, our revenues and operating results will suffer." Our Internet Postage Service Technology Our Internet Postage service is comprised of the following key components: System Architecture. Our servers are located in a high-security, off-site data center and operate with internally developed security software. These servers create the data used to generate information-based indicia. These servers also process postage purchases using secure technology that meets US Postal Service security requirements. Our service currently uses a Windows- based client application, which supports a variety of label and envelope options and a wide range of printers. In addition, our application employs an internally developed user authentication mechanism for additional security. Transaction Processing. Our transaction processing servers are a combination of secure, commercially available and internally-developed technologies that are designed to provide secure and reliable transactions. Our system implements hardware to meet government standards for security and data integrity. The performance and scalability of our Internet Postage system is designed to allow many users to process postage transactions through our Web site. Database Processing. Our database servers are designed and built with industry-leading database technologies and can be built to scale incrementally as needed. Our Web-Based Shipping Services Technology Our shipping services technology is comprised of the following key components: System Architecture. Our service is offered to customers via Internet browsers, and its server environment utilizes Microsoft Windows NT. The service is designed on a three-tier architecture comprised of customer, transactional and database technology layers. Transaction Processing. Our transaction processing servers include a combination of secure technologies that are designed to provide secure and reliable transactions. The performance and scalability of our Internet shipping system allow many users to process shipping transactions through our Web site. Our production servers are located in a high security, off-site data center, and our development and test data centers are located in our Bellevue, Washington facilities, allowing us to test releases in stages. Database Processing. Our database servers are designed and built with industry leading database technologies and can be built to scale incrementally as needed. Our Intellectual Property We rely on a combination of patent, trade secret, copyright and trademark laws and contractual restrictions to establish and to protect our intellectual property rights in products, services, know-how and information. We have three issued US patents and have filed 26 patent applications in the United States, and one international patent application. We have also applied to register a number of trademarks and service marks. We plan to apply for other patents in the future. Despite efforts to protect our intellectual property rights, we face substantial uncertainty regarding the impact that other parties' intellectual property positions will have on our markets. In particular, Pitney Bowes has sent formal comments to the US Postal Service asserting that intellectual property of Pitney Bowes related to postage metering and systems would be infringed by products meeting the requirements of the Information Based Indicia Program's specifications. Furthermore, in June 1999, Pitney Bowes filed two separate lawsuits in the United States District Court for the District of Delaware against both us and E-Stamp alleging infringement of Pitney Bowes patents. For a discussion of claims by Pitney Bowes and risks associated with intellectual property, please refer to "Risk Factors--Success by Pitney Bowes in its suit against us alleging patent infringement could prevent us from offering our Internet Postage service and severely harm our business or cause it to fail" and "Legal Proceedings." Employees As of December 31, 1999, we had 216 full-time employees, of which 58 were employed in research and development, 94 were employed in sales and marketing and 29 were employed in administrative positions. None of our employees are represented by a labor union, and we consider our employee relations to be good. Risk Factors You should carefully consider the following risks and the other information in this Report and our other filings with the SEC before you decide to invest in our company or to maintain or increase your investment. The risks and uncertainties described below are not the only ones facing Stamps.com. Additional risks and uncertainties may also adversely impact and impair our business. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment. This Report contains forward-looking statements based on the current expectations, assumptions, estimates and projections about Stamps.com and the Internet industry. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those discussed in these forward-looking statements as a result of certain factors, as more fully described in this section and elsewhere in this Report. Stamps.com does not undertake to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future. We face risks associated with our operations If we do not effectively manage the commercial release of our Internet mailing and shipping services, our business will be harmed. On August 9, 1999, our Internet Postage service was approved by the US Postal Service for commercial release. On October 22, 1999, we began to offer our Internet Postage service commercially. Our Internet shipping services have not yet been introduced on a commercial scale. We face numerous risks coincident with the introduction of our services. For example, our mailing and shipping services have not yet been subjected to the demands of widespread commercial use. We cannot be sure that our services will successfully process large numbers of user transactions. If we experience problems with the scalability or functionality of our services, our full commercial deployment could be delayed and our results of operations would be adversely impacted. The continued commercial roll-out of our Internet Postage service is dependent upon our service continuing to meet US Postal Service performance specifications and regulations. For example, our service must continue to perform according to US Postal Service specifications in order to receive additional license certificates necessary to add customers. Meanwhile, our Internet mailing and shipping services must meet the commercial demands of our customers, which are primarily expected to range from small businesses to large enterprises. We are currently conducting a national customer registration campaign, particularly for our Internet Postage service; however, we have very limited experience conducting marketing campaigns, and we may fail to generate significant interest. Additionally, we have limited experience selling our services to enterprise customers and cannot predict the length of enterprise sales cycles or implementation times for our services. On the other hand, if we experience extensive interest in our services, we may fail to meet the expectations of customers due to limited experience in operating our services and the strains this demand will place on our Web site, network infrastructure and systems. Our ability to obtain and retain customers depends on the attractiveness of our service to our customers and on our customer service capabilities. If we are unable at any time to address customer service issues adequately or to provide a satisfactory customer experience for current or potential customers, our business and reputation may be harmed. Success by Pitney Bowes in its suit against us alleging patent infringement could prevent us from offering our Internet Postage service and severely harm our business or cause it to fail. On June 16, 1999, Pitney Bowes filed a patent infringement lawsuit against us. The suit alleges that we are infringing two patents held by Pitney Bowes related to postage application systems and electronic indicia. The suit seeks treble damages, a preliminary and permanent injunction from further alleged infringement, attorneys' fees and other unspecified damages. We answered the complaint on August 6, 1999, denying the allegations of patent infringement and asserting a number of affirmative defenses. Pitney Bowes filed a similar complaint in early June 1999 against one of our competitors, E-Stamp Corporation, alleging infringement of seven Pitney Bowes patents. The outcome of the litigation that Pitney Bowes has brought against us is uncertain. Therefore, we can give no assurance that Pitney Bowes will not prevail in its suit against us. If Pitney Bowes prevails in its suit against us, we may be prevented from selling postage on the Internet. Alternatively, the Pitney Bowes suit could result in limitations on how we implement our service, delays and costs associated with redesigning our service and payments of license fees and other payments. Thus, if Pitney Bowes prevails in its suit against us, our business could be severely harmed or fail. In addition, the litigation could result in significant expenses and diversion of management time and other resources. On August 17, 1998, Pitney Bowes issued a press release stating that it holds dozens of US patents related to computer-based postage metering and that it intended to engage in discussions with other marketers of computer-based postal products to license Pitney Bowes technology. Prior to Pitney Bowes filing a lawsuit against us, we were in license discussions with Pitney Bowes. We intend to continue these discussions; however, we cannot predict whether these discussions will continue, the outcome of these discussions or the impact of Pitney Bowes' intellectual property claims on our business or the Internet postage market. If Pitney Bowes is able to prevail in its claims against us and if we do not enter into a license relationship with Pitney Bowes, our business could be impacted severely or fail. In addition, as described above, Pitney Bowes could obtain monetary and injunctive relief against us. The Internet postage and shipping markets are new and uncertain and our business may not develop. The markets for Internet postage and shipping have not developed, and their development is subject to substantial uncertainty. We cannot assure you that these markets will develop. We depend heavily on the commercial acceptance of our Internet Postage service. We cannot predict if our target customers will choose the Internet as a means of purchasing postage, or if customers will be willing to pay a fee to use our service, or if potential users will select our system over our competitors. Our target customers often have alternatives to the US Postal Service and shipping services, including online invoicing, bill payment and financial transactions. The General Accounting Office, in a report issued on October 21, 1999, stated that competition from these alternatives could lead to substantial declines in the US Postal Service's First Class Mail volume in the next decade. These trends could limit the market opportunity for our Internet Postage service. In addition, the US Postal Service could suspend, terminate or offer services which compete against Internet postage, any of which could stop or negatively impact the commercial adoption of our Internet Postage service. In addition, our acquisition of iShip.com in March 2000 represents our entry into the market for online shipping services. There can be no assurance that we will succeed in this business. The market for online shipping services is new and uncertain and may not develop. In addition, we have not released our shipping services on a commercial scale and we currently have no customers and no revenues attributable to our online shipping services. Our ability to obtain and retain customers will depend on the attractiveness of our service to our customers and on our customer service capabilities. If we experience significant system, customer service, security or other problems once we begin commercial operation of our shipping services, customers may stop using or refuse to try these and other services we offer. In addition, shippers may terminate or limit their relationships with us. The occurrence of these problems could have a material adverse effect on our business, financial condition or results of operations. The integration of our company and iShip.com will present significant challenges. We may not be able to realize the benefits we anticipate from the acquisition of iShip.com. As a result of our acquisition of iShip.com in March 2000, we face significant challenges in integrating organizations, operations, technology, product lines and services in a timely and efficient manner and in retaining key personnel and strategic partnerships of both companies. Cost synergies, revenue growth, technological development and other synergistic benefits may not materialize. Diversion of management attention, loss of management-level and other highly qualified employees, and an inability to integrate management, systems and operations of these two companies may all result from the acquisition. The failure to integrate our company and iShip.com successfully and to manage the challenges presented by the integration process may result in our company and iShip.com not achieving the anticipated potential benefits of the acquisition. Delays encountered in the transition process could have a material adverse effect upon the combined company. Further, the physical expansion in facilities that have occurred as a result of this acquisition may result in disruptions that seriously impair our business. In particular, we now have operations in multiple facilities in geographically distant areas. We are not experienced in managing facilities or operations in geographically distant areas. We have a history of losses and expect to incur losses in the future, and we may never achieve profitability. As of December 31, 1999, we had not generated any significant revenues and had a deficit accumulated during the development stage of $60.7 million. Our lack of revenues can be attributed primarily to the fact that our Internet Postage service had not been released commercially until October 22, 1999. Due to the need to establish our brand and service, we expect to incur increasing sales and marketing, research and development, and administrative expenses and therefore could continue to incur net losses for at least the next several years or longer. As a result, we will need to generate significant revenues to achieve and maintain profitability. Since inception, iShip.com did not generate any significant revenues and had an accumulated deficit of $10.6 million as of December 31, 1999. As a result of the iShip.com acquisition, we expect that our losses will increase even more significantly because of additional costs and expenses related to an increase in the number of employees; an increase in sales and marketing activities; additional facilities and infrastructure; and assimilation of operations and personnel. In connection with the iShip.com acquisition, we will record a significant amount of intangibles, the amortization of which will significantly and adversely affect our operating results. To the extent we do not generate sufficient cash flow to recover the amount of the investment recorded, the investment may be considered impaired and could be subject to an immediate write-down of up to the full amount of the investment. In this event, our net loss in any given period could be greater than anticipated and the market price of our stock could decline. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Our ability to generate gross margins generally assumes that if a market for our services develops, we must generate significant revenues from a large base of active customers. We currently charge our customers a fee to use our Internet Postage service. We have yet to determine how customers will be charged for our Internet shipping services. In order to attract customers, we may run special promotions and offer discounts on fees, postage and supplies. However, given the lack of an established or proven commercial market for our services, we cannot be sure that customers will be receptive to our fee structures. Even if we are able to establish a sizeable base of users, we still may not generate sufficient gross margins to become profitable. In addition, our ability to generate revenues or achieve profitability could be adversely affected by special promotions or changes to our pricing plans. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." If we cannot effectively manage our growth, our ability to provide services will suffer. Our reputation and ability to attract, serve and retain our customers depend upon the reliable performance of our Web site, network infrastructure and systems. We have a limited basis upon which to evaluate the capability of our systems to handle controlled or full commercial availability of our Internet Postage service or our online shipping services. We have recently expanded our operations significantly, and further expansion will be required to address the anticipated growth in our user base and market opportunities. To manage the expected growth of operations and personnel, we will need to improve existing and implement new systems, procedures and controls. In addition, we will need to expand, train and manage an increasing employee base. We will also need to expand our finance, administrative and operations staff. As a result of the iShip.com acquisition, we will need to assimilate substantially all of iShip.com's operations into our operations. We may not be able to manage our growth effectively. Our current expansion has and will continue to place a significant strain on our managerial, operational and financial resources. Our current and planned personnel, systems, procedures and controls may be inadequate to support our future operations. If we are unable to manage our growth effectively or experience disruptions during our expansion, our business will suffer and our financial condition and results of operations will be seriously affected. If we are unable to maintain and develop our strategic relationships and distribution arrangements, our Internet mailing and shipping services may not achieve commercial acceptance. We have established strategic relationships with a number of third parties. Our strategic relationships generally involve the promotion and distribution of our service through our partners' products, services and Web sites. Additionally, some of our relationships provide for the inclusion of our logo or promotional offers for our service in packaging and marketing materials utilized by our partners. In return for promoting our service, our partners may receive revenue-sharing opportunities. In order to achieve wide distribution of our service, we believe we must establish additional strategic relationships to market our service effectively. If one or more of our partners terminates or limits its relationship with us, our business could be severely harmed or fail. We have limited experience in establishing and maintaining strategic relationships and we may fail in our efforts to establish and maintain these relationships. Our current strategic relationships, including those established by iShip.com, have not yet resulted in significant revenues, primarily because we have only recently commercially released our Internet Postage service and our online shipping services have yet to be released on a commercial scale. As a result, our strategic partners may not view their relationships with us as significant or vital to their businesses and consequently, may not perform according to our expectations. We have little ability to control the efforts of our strategic partners and, even if we are successful in establishing strategic relationships, these relationships may not be successful. We face risks typical of early stage companies and of new and rapidly changing markets. You should consider our prospects in light of the risks and difficulties frequently encountered by early stage companies and those in new and rapidly evolving markets. These risks include, among other things, our (a) ability to meet and maintain government specifications for our Internet Postage service, specifically US Postal Service requirements; (b) complete dependence on Internet mailing and shipping services that currently do not have broad market acceptance; (c) need to expand our sales and support organizations; (d) ability to establish and promote our brand name; (e) ability to expand our operations to meet the commercial demand for our services; (f) development of and reliance on strategic and distribution relationships; (g) ability to prevent and respond quickly to service interruptions; (h) ability to minimize fraud and other security risks; and (i) ability to compete with companies with greater capital resources and brand awareness. If we do not achieve the brand recognition necessary to succeed in the Internet mailing and shipping markets, our business will suffer. We must quickly build our Stamps.com brand to gain market acceptance for our services. We believe it is imperative to our long term success that we obtain significant market share for our services before other competitors enter the Internet postage and shipping markets. We must make substantial expenditures on product development, strategic relationships and marketing initiatives in an effort to establish our brand awareness. In addition, we must devote significant resources to ensure that our users are provided with a high quality online experience supported by a high level of customer service. We cannot be certain that we will have sufficient resources to build our brand and realize commercial acceptance of our services. If we fail to gain market acceptance for our services, our business will suffer dramatically or may fail. System and online security failures could harm our business and operating results. Our services depend on the efficient and uninterrupted operation of our computer and communications hardware systems. In addition, we must provide a high level of security for the transactions we execute. We rely on internally-developed and third-party technology to provide secure transmission of postage and other confidential information. Any breach of these security measures would severely impact our business and reputation and would likely result in the loss of customers. Furthermore, if we are unable to provide adequate security, the US Postal Service could prohibit us from selling postage over the Internet. Our systems and operations are vulnerable to damage or interruption from a number of sources, including fire, flood, power loss, telecommunications failure, break-ins, earthquakes and similar events. We have entered into an Internet hosting agreement with Exodus Communications, Inc. to maintain our Internet postage servers at Exodus' data center in Southern California. Our operations depend on Exodus' ability to protect its and our systems in its data center against damage or interruption. Exodus does not guarantee that our Internet access will be uninterrupted, error-free or secure. Our servers are also vulnerable to computer viruses, physical, electrical or electronic break- ins and similar disruptions. We have experienced minor system interruptions in the past and may experience them again in the future. Any substantial interruptions in the future could result in the loss of data and could completely impair our ability to generate revenues from our service. We do have a business interruption plan that we continue to refine and update; however, we do not presently have a full disaster recovery plan in effect to cover loss of facilities and equipment. In addition, we do not have a "fail- over" site that mirrors our infrastructure to allow us to operate from a second location. We have business interruption insurance; however, we cannot be certain that our coverage will be sufficient to compensate us for losses that may occur as a result of business interruptions. A significant barrier to electronic commerce and communications is the secure transmission of confidential information over public networks. Anyone who is able to circumvent our security measures could misappropriate confidential information or cause interruptions in our operations. We may be required to expend significant capital and other resources to protect against potential security breaches or to alleviate problems caused by any breach. We rely on specialized technology, both within our own infrastructure and that provided by Exodus, to provide the security necessary for secure transmission of postage and other confidential information. Advances in computer capabilities, new discoveries in security technology, or other events or developments may result in a compromise or breach of the algorithms we use to protect customer transaction data. Should someone circumvent our security measures, our reputation, business, financial condition and results of operations could be seriously harmed. Security breaches could also expose us to a risk of loss or litigation and possible liability for failing to secure confidential customer information. As a result, we may be required to expend a significant amount of financial and other resources to protect against security breaches or to alleviate any problems that they may cause. If we do not expand our product and service offerings, our business may not grow. We may establish subsidiaries, enter into joint ventures or pursue the acquisition of new or complementary businesses, products or technologies in an effort to enter into new business areas, diversify our sources of revenue and expand our product and service offerings outside the Internet postage market. We have no commitments or agreements and are not currently engaged in discussions for any material acquisitions or investments. We continue to evaluate incremental revenue opportunities and derivative applications of our technology and may pursue and develop those opportunities with strategic partners and investors. To the extent we pursue new or complementary businesses, we may not be able to expand our service offerings and related operations in a cost-effective or timely manner. We may experience increased costs, delays and diversions of management's attention when integrating any new businesses or service. We may lose key personnel from our operations or those of any acquired business. Furthermore, any new business or service we launch that is not favorably received by users could damage our reputation and brand name in the Internet postage and shipping or other markets that we enter. We also cannot be certain that we will generate satisfactory revenues from any expanded services or products to offset related costs. Any expansion of our operations would also require significant additional expenses, and these efforts may strain our management, financial and operational resources. Additionally, future acquisitions may also result in potentially dilutive issuances of equity securities, the incurrence of additional debt, the assumption of known and unknown liabilities, and the amortization of expenses related to goodwill and other intangible assets, all of which could have a material adverse effect on our business, financial condition and operating results. New issuances of securities may also have rights, preferences and privileges senior to those of our common stock. Fluctuations in our operating results could cause our stock price to fall. Prior to our commercial launch on October 22, 1999, we had not generated any revenues from our operations. Accordingly, we have a limited basis upon which to predict future operating results. We expect that our revenues, margins and operating results will fluctuate significantly due to a variety of factors, many of which are outside of our control. These factors include: (a) the success of the commercial release of our Internet Postage and online shipping services; (b) the costs of defending ourselves in the Pitney Bowes litigation or against other intellectual property claims; (c) the costs of our marketing programs to establish and promote the Stamps.com brand name; (d) the demand for our Internet Postage and shipping services; (e) our ability to develop and maintain strategic distribution relationships; (f) the number, timing and significance of new products or services introduced by both us and our competitors; (g) our ability to develop, market and introduce new and enhanced services on a timely basis; (h) the level of service and price competition; (i) the increases in our operating expenses as we expand operations; and (j) general economic factors. Our cost of revenues includes costs for systems operations, customer service, Internet connection and security services; all of these costs will fluctuate depending upon the demand for our services. In addition, a substantial portion of our operating expenses is related to personnel costs, marketing programs and overhead, which cannot be adjusted quickly and are therefore relatively fixed in the short term. Our operating expense levels are based, in significant part, on our expectations of future revenues. If our expenses precede increased revenues, both gross margins and results of operations would be materially and adversely affected. Due to the foregoing factors and the other risks discussed in this annual report, you should not rely on period-to-period comparisons of our results of operations as an indication of future performance. It is possible that in some future periods our results of operations will be below the expectations of public market analysts and investors. In this event, the market price of our common stock is likely to decline. We rely on a relatively new management team and need additional personnel to grow our business. Our management team is relatively new. We hired our Chairman and Chief Executive Officer in October 1998, our President and Chief Operating Officer in October 1999 and our Chief Financial Officer in September 1998. We have also recently hired or intend to hire senior managers for our strategic business units. There can be no assurance that we will successfully assimilate our recently hired managers or that we can successfully locate, hire, assimilate and retain qualified key management personnel. Our business is largely dependent on the personal efforts and abilities of our senior management, including our Chairman and Chief Executive Officer, our President and Chief Operating Officer, and our Chief Financial Officer. Any of our officers or employees can terminate his or her employment relationship at any time. The loss of these key employees or our inability to attract or retain other qualified employees could have a material adverse effect on our results of operations and financial condition. Our future success depends on our ability to attract, retain and motivate highly skilled technical, managerial, marketing and customer service personnel. Also, our success will also depend on a successful integration of iShip.com's management with our senior management team. We plan to hire additional personnel in all areas of our business. Competition for qualified personnel is intense, particularly in the Internet and high technology industries. As a result, we may be unable to successfully attract, assimilate or retain qualified personnel. Further, we may be unable to retain the employees we currently employ or attract additional technical personnel. The failure to retain and attract the necessary personnel could seriously harm our business, financial condition and results of operations. Third party assertions of violations of their intellectual property rights could adversely affect our business. In addition to the Pitney Bowes claim described above, as is customary with technology companies, we may receive or become aware of correspondence claiming potential infringement of other parties' intellectual property rights. We could incur significant costs and diversion of management time and resources to defend claims against us regardless of their validity. We may not have adequate resources to defend against these claims and any associated costs and distractions could have a material adverse effect on our business, financial condition and results of operations. As an alternative to litigation, we may seek licenses for other parties' intellectual property rights. We may not be successful in obtaining all of the necessary licenses on commercially reasonable terms, if at all. Any loss resulting from intellectual property litigation could severely limit our operations, cause us to pay license fees, or prevent us from doing business. A failure to protect our own intellectual property could harm our competitive position. We rely on a combination of patent, trade secret, copyright and trademark laws and contractual restrictions to establish and protect our rights in our products, services, know-how and information. We have three issued US patents and have filed 26 patent applications in the United States, and one international patent application. We have also applied to register a number of trademarks and service marks. We plan to apply for other patents, trademarks and service marks in the future. We may not receive patents for any of our patent applications. Even if patents are issued to us, claims issued in these patents may not protect our technology. In addition, any of our patents, trademarks or service marks might be held invalid or unenforceable by a court. If our patents fail to protect our technology or our trademarks and service marks are successfully challenged, our competitive position could be harmed. Even if our patents are upheld or are not challenged, third parties may develop alternative technologies or products without infringing our patents. We generally enter into confidentiality agreements with our employees, consultants and other third parties to control and limit access and disclosure of our confidential information. These contractual arrangements or other steps taken to protect our intellectual property may not prove to be sufficient to prevent misappropriation of technology or deter independent third party development of similar technologies. Additionally, the laws of foreign countries may not protect our services or intellectual property rights to the same extent as do the laws of the United States. Our growth and operating results could be impaired if we are unable to meet our future capital requirements. We believe that our current cash balances will allow us to fund our operations through fiscal year 2001. However, we may require substantial working capital to fund our business and we may need to raise additional capital. We cannot be certain that additional funds will be available on satisfactory terms when needed, if at all. Our future capital needs depend on many factors, including market acceptance of our postage and shipping services; the level of promotion and advertising of our postage and shipping services; the level of our development efforts; rate of customer acquisition and retention of our postage and shipping services; and changes in technology. The various elements of our business and growth strategies, including our plans to support fully the commercial release of our service, our introduction of new products and services and our investments in infrastructure will require additional capital. If we are unable to raise additional necessary capital in the future, we may be required to curtail our operations significantly or obtain funding through the relinquishment of significant technology or markets. Also, raising additional equity capital would have a dilutive effect on existing stockholders. We could be required to register as an investment company and become subject to substantial regulation that would interfere with our ability to conduct our business. We invest in short-term instruments consistent with prudent cash management and not primarily for the purpose of achieving investment returns. This could result in our being treated as an investment company under the Investment Company Act of 1940 and therefore being required to register as an investment company under the Investment Company Act. The Investment Company Act requires the registration of companies which are engaged primarily in the business of investing, reinvesting or trading in securities or which are engaged in investing, reinvesting, owning, holding or trading in securities and over 40% of whose assets on an unconsolidated basis (other than government securities and cash) consist of investment securities. While we do not believe that we are engaged primarily in the business of investing, reinvesting or trading in securities, we may invest our cash and cash equivalents in government securities to the extent necessary to avoid having over 40% of our assets consist of investment securities. Government securities are defined as securities issued by the U.S. government and certain federal agencies. These securities generally yield lower rates of income than other short-term instruments in which we have invested to date. Accordingly, investing substantially all of our cash and cash equivalents in government securities could result in lower levels of interest income, which could cause our losses to increase. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure, management, operations, transactions with affiliated persons, if any, and other matters, incur substantial costs and experience a disruption of our business. Application of the provisions of the Investment Company Act to us would materially and adversely affect our business, prospects, financial condition and results of operations. If the software, hardware, computer technology and other systems and services we use are not Year 2000 compliant, our operations could suffer and we could lose customers. Many existing computer systems and software products are coded to accept only two digit entries in the date code field and cannot distinguish 21st century dates from 20th century dates. If these systems have not been properly corrected, there could be system failures or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in normal business activities. As a result, many companies' software and computer systems may need to be upgraded or replaced to become "Year 2000" compliant. In addition, despite the fact that many computer systems are currently processing 21st century dates correctly, these companies, including us, could experience latent Year 2000 problems. We use and depend on third party equipment and software that may not be Year 2000 compliant. If Year 2000 issues prevent our customers from accessing the Internet or our Web site, processing transactions or using their credit cards, our business will suffer. Any failure of our third party equipment, software or services to operate properly could require us to incur unanticipated expenses, which could seriously harm our business and operating results. We face risks associated with our market If we do not respond effectively to technological change, our services could become obsolete and our business will suffer. The development of our services and other technology entails significant technical and business risks. To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our online operations. The Internet and the electronic commerce industry are characterized by rapid technological change; changes in user and customer requirements and preferences; frequent new product and service introductions embodying new technologies; and the emergence of new industry standards and practices. The evolving nature of the Internet or the Internet postage and shipping markets could render our existing technology and systems obsolete. Our success will depend, in part, on our ability to license or acquire leading technologies useful in our business; enhance our existing services; develop new services or features and technology that address the increasingly sophisticated and varied needs of our current and prospective users; and respond to technological advances and emerging industry and regulatory standards and practices in a cost-effective and timely manner. Future advances in technology may not be beneficial to, or compatible with, our business. Furthermore, we may not be successful in using new technologies effectively or adapting our technology and systems to user requirements or emerging industry standards on a timely basis. Our ability to remain technologically competitive may require substantial expenditures and lead time. If we are unable to adapt in a timely manner to changing market conditions or user requirements, our business, financial condition and results of operations could be seriously harmed. If we are unable to compete successfully, particularly against large, traditional providers of postage products such as Pitney Bowes who enter the online postage and shipping markets, our revenues and operating results will suffer. The market for Internet postage products and services is new and we expect it to be intensely competitive. At present, E-Stamp has a hardware-based product commercially available and has announced that it begun testing a Web- based product through the Information Based Indicia Program. Pitney Bowes and Neopost Industrie are each seeking certification for both hardware and software products through the Information Based Indicia Program. Pitney Bowes and Neopost each have hardware products available for beta testing and Pitney Bowes is expected to commercially launch its software-based product as soon as the first quarter of 2000. If any of our competitors, including Pitney Bowes, provide the same or similar service as us, our operations could be adversely impacted. See "--Success by Pitney Bowes in its suit against us alleging patent infringement could prevent us from offering our Internet Postage service and severely harm our business or cause it to fail." Internet postage may not be adopted by customers. These customers may continue to use traditional means to purchase postage, including purchasing postage from their local post office. If Internet postage becomes a viable market, we may not be able to establish or maintain a competitive position against current or future competitors as they enter the market. Many of our competitors have longer operating histories, larger customer bases, greater brand recognition, greater financial, marketing, service, support, technical, intellectual property and other resources than us. As a result, our competitors may be able to devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing policies and devote substantially more resources to Web site and systems development than us. This increased competition may result in reduced operating margins, loss of market share and a diminished brand. We may from time to time make pricing, service or marketing decisions or acquisitions as a strategic response to changes in the competitive environment. These actions could result in reduced margins and seriously harm our business. If the market for Internet postage develops, we could face competitive pressures from new technologies or the expansion of existing technologies approved for use by the US Postal Service. We may also face competition from a number of indirect competitors that specialize in electronic commerce and other companies with substantial customer bases in the computer and other technical fields. Additionally, companies that control access to transactions through a network or Web browsers could also promote our competitors or charge us a substantial fee for inclusion. Our competitors may also be acquired by, receive investments from or enter into other commercial relationships with larger, better-established and better-financed companies as use of the Internet and other online services increases. In addition, changes in postal regulations could adversely affect our service and significantly impact our competitive position. We may be unable to compete successfully against current and future competitors, and the competitive pressures we face could seriously harm our business. As a result of the iShip.com acquisition in March 2000, we also compete with companies that provide shipping solutions to businesses. Customers may continue using the direct services of the US Postal Service, UPS and other major shippers, instead of adopting our online service. Alternatively, potential competitors with greater resources than iShip.com, like Pitney Bowes, may develop more successful Internet solutions. In addition, companies including TanData Corporation, GoShip.com, BITS, Inc./Intershipper.net, Kewill Systems, PackageNet and Virtan, Inc./SmartShip are competing in shipping services. We also face a significant risk that large shipping companies will collaborate in the development and operation of an online shipping system that could make our Internet shipping services obsolete. The success of our business will depend on the continued growth of the Internet and the acceptance by customers of the Internet as a means for purchasing postage and shipping services. Our success depends in part on widespread acceptance and use of the Internet as a way to purchase postage and shipping services. This practice is at an early stage of development, and market acceptance of Internet postage and shipping services is uncertain. We cannot predict the extent to which customers will be willing to shift their purchasing habits from traditional to online postage and/or shipping services. To be successful, our customers must accept and utilize electronic commerce to satisfy their product needs. Our future revenues and profits, if any, substantially depend upon the acceptance and use of the Internet and other online services as an effective medium of commerce by our target users. The Internet may not become a viable long-term commercial marketplace due to potentially inadequate development of the necessary network infrastructure or delayed development of enabling technologies and performance improvements. The commercial acceptance and use of the Internet may not continue to develop at historical rates. Our business, financial condition and results of operations would be seriously harmed if use of the Internet and other online services does not continue to increase or increases more slowly than expected; the infrastructure for the Internet and other online services does not effectively support future expansion of electronic commerce or our services; concerns over security and privacy inhibit the growth of the Internet; or the Internet and other online services do not become a viable commercial marketplace. US Postal Service regulation may cause disruptions or the discontinuance of our business. We are subject to continued US Postal Service scrutiny and other government regulations. The US Postal Service could change its certification requirements or specifications for Internet postage or revoke the approval of our service at any time. Any changes in requirements or specifications for Internet postage could adversely affect our pricing, cost of revenues, operating results and margins by increasing the cost of providing our Internet postage service. For example, the US Postal Service could decide to charge Internet postage vendors fees for the enrollment of each unique customer of the Internet postage product, which would be a cost that we would either absorb or pass through to customers. The US Postal Service could also decide that Internet postage should no longer be an approved postage service due to security concerns or other issues. Our business would suffer dramatically if we are unable to adapt our Internet Postage service to any new requirements or specifications or if the US Postal Service were to discontinue Internet postage as an approved postage method. Alternatively, the US Postal Service could introduce competitive programs or amend Internet postage requirements to make certification easier to obtain, which could lead to more competition from third parties or the US Postal Service itself. See "--If we are unable to compete successfully, particularly against large, traditional providers of postage products like Pitney Bowes who enter the online postage and shipping markets, our revenues and operating results will suffer." In addition, US Postal Service regulations may require that our personnel with access to postal information or resources receive security clearance prior to doing relevant work. We may experience delays or disruptions if our personnel cannot receive necessary security clearances in a timely manner, if at all. The regulations may limit our ability to hire qualified personnel. For example, sensitive clearance may only be provided to US citizens or aliens who are specifically approved to work on US Postal Service projects. Our operating results could be impaired if we or the Internet become subject to additional government regulation and legal uncertainties. With the exception of US Postal Service and Department of Commerce regulations, we are not currently subject to direct regulation by any domestic or foreign governmental agency, other than regulations applicable to businesses generally, and laws or regulations directly applicable to electronic commerce. However, due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet, relating to user privacy; pricing; content; copyrights; distribution; characteristics and quality of products and services; and export controls. The adoption of any additional laws or regulations may hinder the expansion of the Internet. A decline in the growth of the Internet could decrease demand for our products and services and increase our cost of doing business. Moreover, the applicability of existing laws to the Internet is uncertain with regard to many issues, including property ownership, export of specialized technology, sales tax, libel and personal privacy. Our business, financial condition and results of operations could be seriously harmed by any new legislation or regulation. The application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or the application of existing laws and regulations to the Internet and other online services could also harm our business. We offer our services in multiple states and plan to expand both domestically and internationally. These jurisdictions may claim that we are required to qualify to do business as a foreign corporation in each state or foreign country. Our failure to qualify as a foreign corporation in a jurisdiction where we are required to do so could subject us to taxes and penalties. Other states and foreign countries may also attempt to regulate our services or prosecute us for violations of their laws. Further, we might unintentionally violate the laws of foreign jurisdictions and those laws may be modified and new laws may be enacted in the future. If we market our services internationally, government regulation could disrupt our operations. One element of our strategy is to provide services in international markets. Our ability to provide our Internet Postage service in international markets would likely be subject to rigorous governmental approval and certification requirements similar to those imposed by the US Postal Service. For example, our Internet Postage service cannot currently be used for international mail because foreign postal authorities do not currently recognize information-based indicia postage. If foreign postal authorities accept postage generated by our service in the future, and if we obtain the necessary foreign certification or approvals, we would be subject to ongoing regulation by foreign governments and agencies. To date, efforts to create a certification process in Europe and other foreign markets are in a preliminary stage and these markets may not prove to be a viable opportunity for us. As a result, we cannot predict when, or if, international markets will become a viable source of revenues for a postage service similar to ours. Our ability to provide service in international markets may also be impacted by the export control laws of the United States. Our software technology makes us subject to stronger export controls, and may prevent us from being able to export our products and services. If we achieve significant international acceptance of our services, our business activities will be subject to a variety of potential risks, including the adoption of laws and regulatory requirements, political and economic conditions, difficulties protecting our intellectual property rights and actions by third parties that would restrict or eliminate our ability to do business in these jurisdictions. If we begin to transact business in foreign currencies, we will become subject to the risks attendant to transacting in foreign currencies, including the potential adverse effects of exchange rate fluctuations. Our charter documents could deter a takeover effort, which could inhibit your ability to receive an acquisition premium for your shares. The provisions of our Amended and Restated Certificate of Incorporation, Bylaws and Delaware law could make it difficult for a third party to acquire us, even it would be beneficial to our stockholders. In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which could prohibit or delay a merger or other takeover of our company, and discourage attempts to acquire us. Additional shares held by existing stockholders may be sold into the public market, which could cause our stock price to decline. Public sales of substantial amounts of common stock purchased in private financings prior to our initial public offering or upon the exercise of stock options or warrants could adversely affect the prevailing market price of our common stock. On December 22, 1999, upon the expiration of a lock-up entered into in connection with our initial public offering, an additional 2.1 million shares of our outstanding common stock were available for immediate sale. On February 7, 2000, a lock-up entered into in connection with our follow-on public offering expired for approximately 6.8 million shares of our outstanding common stock and, on March 6, 2000, the follow-on offering lock-up expired for all remaining shares subject to the lock-up. All of the shares subject to the lock-up were available for immediate sale, subject to the volume and other restrictions under Rule 144 of the Securities Act of 1933. Of these shares, approximately 22.5 million held by investment funds may be distributed by them from time to time to their investors. Upon distribution, those shares will be available for immediate sale. Sales of substantial amounts of common stock in the public market, or the perception that these sales could occur, could adversely affect the prevailing market price for our common stock and could impair our ability to raise capital through a public offering of equity securities. ITEM 2. ITEM 2. PROPERTIES Our corporate headquarters are located in a 90,000 square foot facility in Santa Monica, California under a lease expiring on May 31, 2004. We also have a 14,000 square foot facility in Irvine, California under a lease expiring in March 2004. Finally, we assumed a lease in the iShip.com acquisition for approximately 21,000 square feet in Bellevue, Washington expiring in August 2004 and have entered into a lease for 76,000 square feet in Bellevue, Washington which expires in March 2009. We believe that our current facilities and other facilities that will be available to us will be adequate to accommodate our needs for the foreseeable future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On June 16, 1999, Pitney Bowes sued us for alleged patent infringement in the United States District Court for the District of Delaware. The suit alleges that we are infringing two patents held by Pitney Bowes related to postage application systems and electronic indicia. The suit seeks treble damages, a preliminary and permanent injunction from further alleged infringement, attorneys' fees and other unspecified damages. We answered the complaint on August 6, 1999, denying the allegations of patent infringement and asserting a number of affirmative defenses. Pitney Bowes filed a similar complaint in early June 1999 against one of our competitors, E-Stamp Corporation, alleging infringement of seven Pitney Bowes patents. The outcome of the litigation that Pitney Bowes has brought against us is uncertain. Therefore, we can give no assurance that Pitney Bowes will not prevail in its suit against us. See "Risk Factors--Success by Pitney Bowes in its suit against us alleging patent infringement could prevent us from offering our Internet Postage service and severely harm our business or cause it to fail." On December 29, 1999, three individual plaintiffs filed a suit against us for alleged breach of oral contract, quantum meruit, fraud and negligent representation in the California Superior Court for the County of Los Angeles. The complaint was amended on January 28, 2000 to add Mohan Ananda, one of our directors, as a defendant and to remove one of the plaintiffs from the suit. The suit alleges that the plaintiffs were due cash consideration for securing a board member and investors for Stamps.com. The complaint seeks $13.3 million plus other unspecified compensatory damages, punitive and exemplary damages and attorneys' fees and costs incurred. We answered the complaint on March 8, 2000, denying the allegations and asserting a number of affirmative defenses. The outcome of this litigation is uncertain and we can give no assurance that the plaintiffs will not prevail. We are not currently involved in any other material legal proceedings, nor have we been involved in any such proceeding that has had or may have a significant effect on our company. We are not aware of any other material legal proceedings pending against us. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1999. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Market Information Our common stock has traded on The Nasdaq National Market under the symbol "STMP" since June 25, 1999. Prior to that time, there was no public market for our common stock. The following table sets forth the range of high and low closing sales prices reported on The Nasdaq National Market for our common stock for the periods indicated. Recent Share Prices The following table sets forth the closing sales prices per share of our common stock on The Nasdaq National Market on (i) December 31, 1999 and (ii) March 27, 2000. Holders As of March 27, 2000, there were 287 stockholders of record and approximately 48,468,899 shares of our common stock issued and outstanding. Dividend Policy We have never declared nor paid cash dividends on our capital stock. We currently intend to retain all available funds for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Recent Sales of Unregistered Securities We made the following unregistered sales of common stock during the quarter ended December 31, 1999: In October 1999, we entered into a common stock and warrant purchase agreement with AOL for the purchase of up to $11 million of common stock by AOL and the issuance of a warrant which allows AOL to purchase up to 50% of the number of shares of common stock issued to AOL. The warrant also allows for the purchase of additional shares of common stock (50% of the unexercised portion of the warrant) in the event we are unable to cure a material breach of the payment provisions of our marketing agreement with AOL. On October 29, 1999, we issued 178,638 shares of our common stock under the purchase agreement for $6.0 million in the aggregate, or $33.588 per share. On December 10, 1999, concurrent with the closing of our follow-on public offering, we issued an additional 148,862 shares of our common stock under the purchase agreement for $5.0 million in the aggregate, or $33.588 per share. In addition, AOL now holds a warrant to purchase 163,750 shares, or 50% of the total of 327,500 shares of common stock issued to AOL under the purchase agreement. The warrant may be exercised at any time on or before October 29, 2002, unless the term of exercisability is extended to compensate for any required regulatory filings. The foregoing transaction did not involve a public offering, and we believe that such transaction was exempt from the registration requirements of the Securities Act by virtue of Section 4(2) thereof or Regulation D promulgated thereunder. The recipient in such transaction represented its intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the share certificates and instruments issued in such transaction. All recipients had adequate access, through its existing and continuing relationships with us, to information about our company. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the "Selected Financial Data" and our financial statements and the related notes thereto. This discussion contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from historical results or anticipated results including those set forth in "Risk Factors" beginning on page 10 of this Report. Overview We offer a convenient, cost-effective and easy-to-use service for purchasing and printing postage over the Internet. On October 22, 1999, we commercially launched our Internet Postage service. To date, our operating activities have consisted primarily of efforts to promote our brand, build market awareness, attract new customers, recruit personnel, build operating infrastructure and develop our Web site and associated systems used to process customers' orders and payments. As of February 29, 2000, our customer base consisted of over 150,000 users who had downloaded our software and registered for our service. As a result of our acquisition of iShip.com in March 2000, we have added Web-based technology that is designed to provide a complete one-stop shipping and tracking solution. Our shipping tools are designed to help consumers, small businesses and large corporations price, ship, track and manage shipments over the Internet. These services will enable a comparison of rates and services among multiple carriers, including Airborne Express, FedEx, UPS, the US Postal Service and Yellow Freight Systems. For Internet Postage, we currently offer a single service plan to our users. Under this plan, a user purchases postage at cost and is charged a monthly convenience fee based upon how much postage he or she uses during the month. The current plan assesses a convenience fee of 10% of the value of postage printed during a month. The plan has a monthly minimum fee of $1.99 and a monthly maximum fee of $19.99. Convenience fees are calculated and charged at the end of a monthly billing cycle. Although we have established a single pricing plan, we may need to change our pricing plan given the lack of an established or proven commercial market for Internet postage. From time to time, we may offer special promotions to attract new customers. Currently, these promotions involve waiving or discounting convenience fees, discounts on supplies offered through Stamps.com's online store, or free postage. We cannot predict the impact of any promotion or pricing plan changes and our ability to generate revenues or achieve profitability could be adversely affected by special promotions or changes to pricing plans. Furthermore, given the lack of an established or proven commercial market, we are unable to quantify the total impact of these promotions on revenue and profitability. See "Risk Factors--We have a history of losses and expect to incur losses in the future and may never achieve profitability." For Internet-based shipping services, iShip.com recognized no revenues through December 31, 1999, as it had not yet commenced revenue-based operations. In April 1998, iShip.com began providing its Internet-based shipping services, including label printing and package tracking to users. Under an agreement with Mail Boxes Etc., we will receive service and transaction-based license fees from Mail Boxes Etc. and its participating franchisees. We currently provide free information regarding "zip-to-zip" shipping charges to eBay auction buyers and sellers, and it is contemplated that in the future eBay shippers will pay us a fee when they print shipping labels using our shipping services. To date, the iShip.com package tracking and pricing utilities have been offered at no charge to the user with the belief that offering these free basic services will increase the customer base. In addition, at the present time we offer at no charge to users a tool which allows prospective buyers on auction web sites to determine the cost of shipping a potential purchase, although in the future we intend to charge users for the use of a more fully-integrated shipping application for auction web sites. With the current limited use of these services and the lack of a commercial market for Internet-shipping services, we cannot be sure that these anticipated fees will be our ultimate pricing approach or that these fees will generate significant revenues, if at all. As a result, we cannot predict whether any contemplated pricing or fee structure will ever generate revenues or profits. See "Risk Factors--We have a history of losses and expect to incur losses in the future and may never achieve profitability." Some options and shares granted to our employees from January 9, 1998 (inception) through December 31, 1999 have been considered to be compensatory. Deferred compensation associated with such options and shares amounted to $12.0 million and $1.25 million for the fiscal years ended December 31, 1999 and 1998. Of these amounts, $5.7 million and $167,000 was charged to operations for the fiscal years ended December 31, 1999 and 1998. The balance of $7.4 million will be amortized over the vesting periods of the applicable options through the fiscal year ending December 31, 2003. In November 1999, we formed a subsidiary, EncrypTix, Inc. to develop secure printing opportunities in the events, travel and financial services industries. In February 2000, we granted EncrypTix a license to our technology in those three specific fields of use. In addition, EncrypTix raised approximately $30 million in private financing from a group of financial and strategic investors. EncrypTix will provide highly secure, authenticated online printing technologies for the events, movie, travel and financial service industries. Utilizing many of the proprietary, Internet-based technologies developed by Stamps.com, EncrypTix will enable sellers and distributors of tickets and financial instruments to deliver value-bearing instruments such as tickets, vouchers, boarding passes, checks and gift certificates over the Internet through a customer's existing laser or inkjet printer. Similar to our Internet Postage service, no specialized hardware device is required for the EncrypTix service. As a result of the February 2000 financing, we retain almost two- thirds of the economic interest and over 90% of the voting control of EncrypTix. For financial statement purposes, our interest in EncrypTix will be accounted for by consolidating its results with ours and recording a minority interest in profit, loss and equity. On March 7, 2000, we completed our acquisition of iShip.com. In connection with the acquisition, up to 8,000,000 shares of our common stock will be issued in exchange for all outstanding iShip.com capital stock, options and warrants. In addition, upon completion of the merger, we recorded a significant amount of intangibles, the amortization of which will significantly and adversely affect our operating results. The merger resulted in goodwill of approximately $230 million, which will be amortized over a four-year period. To the extent we do not generate sufficient cash flow to recover the amount of the investment recorded, the investment may be considered impaired and could be subject to an immediate write-down of up to the full amount of the investment. In this event, our net loss in any given period could be greater than anticipated. See "Risk Factors--We have a history of losses and expect to incur losses in the future, and we may never achieve profitability" and "--Fluctuations in our operating results could cause our stock price to fall." Results of Operations Sales and Marketing. Sales and marketing expenses principally consist of costs associated with strategic relationships, advertising and promotional expenditures, compensation and related expenses for personnel engaged in marketing and business development activities. Sales and marketing expenses for the year ended December 31, 1999 were approximately $35.2 million compared to $600,000 for the period from January 9, 1998 (inception) to December 31, 1998. We began the first phase of beta testing in August 1998 and therefore incurred minimal sales and marketing expenses during the period ended December 31, 1998. The increase in sales and marketing expenses is principally due to the marketing campaign and advertising of the launch of the Internet Postage solution in October 1999, as well as an increase in marketing personnel. We expect sales and marketing expenses to increase significantly as we fully roll- out our mailing and shipping services and continue to promote our brand and services through new strategic relationships and marketing campaigns. Research and Development. Research and development expenses principally consist of compensation for personnel involved in the development of the Internet Postage service and expenditures for consulting services and third- party software. Research and development expenses for the year ended December 31, 1999 were $7.4 million compared to $1.5 million for the period from January 9, 1998 (inception) to December 31, 1998. The increase is due to higher personnel and consulting costs and, to a lesser extent, other expenses associated with the ongoing development of the Internet Postage service. We believe that significant investments in research and development are required to remain competitive and expect to incur increasing research and development expenses. General and Administrative. General and administrative expenses principally consist of compensation and related costs for executive and administrative personnel, facility costs, fees for legal and other professional services, and amortization of deferred compensation. General and administrative expenses for the year ended December 31, 1999 were $14.3 million compared to $2.0 million for the period from January 9, 1998 (inception) to December 31, 1998. Of the $12.3 million increase, $5.5 million is due to amortization of deferred compensation. The remaining increase is principally due to increased headcount and the expansion of facilities related to the growth of the business, as well as to legal fees related to the Pitney Bowes patent infringement claim. We expect general and administrative expenses to increase as the business grows and to incur additional costs related to the Pitney Bowes patent infringement claim. Interest Income (Expense), Net. Interest income (expense), net consists of income from cash and cash equivalents net of interest expense related to financing obligations. Interest income (expense), net for the year ended December 31, 1999 was $2.5 million compared to $(16,000) for the period from January 9, 1998 (inception) to December 31, 1998. This increase is due to earnings on a higher average cash equivalent balance as a result of our initial public offering in June 1999 and our follow-on public offering in December 1999. Liquidity and Capital Resources As of December 31, 1999 and 1998, we had approximately $374.7 million and $3.5 million in cash and short-term investments, respectively. In June 1999, we completed our initial public offering in which the underwriters sold to the public 5,750,000 shares of common stock at $11.00 per share. The net proceeds from the offering were $10.23 per share, or $58.8 million in the aggregate. In December 1999, we completed a follow-on public offering in which the underwriters sold to the public 5,750,000 shares of common stock at $65.00 per share. Our net proceeds from the offering were $61.83 per share, or $355.5 million in the aggregate. We regularly invests excess funds in short-term money market funds and commercial paper and does not engage in hedging or speculative activities. In February 2000, our majority-owned subsidiary, EncrypTix, raised approximately $30.0 million in private financing from a group of financial and strategic investors. The proceeds of this financing will be used by EncrypTix for research and development, sales and marketing and general working capital purposes. In October 1999, we entered into a distribution and marketing agreement with AOL that will require aggregate payments of $56.0 million through April 2002. In addition, under this agreement, AOL purchased $6.0 million of common stock (178,638 shares at $33.588 per share) in October 1999 and purchased $5.0 million of common stock (148,862 shares at $33.588 per share) concurrent with the closing of our follow-on public offering. AOL also holds a three-year warrant to purchase up to an additional 163,750 shares at an exercise price of $33.588 per share. In May 1999, we entered into a facility lease agreement for the corporate headquarters with aggregate minimum lease payments of approximately $4.8 million through May 2004. We also entered into an agreement with Intuit/Quicken.com in May 1999, which requires aggregate payments by the Company of $3.3 million through 2000. Net cash used in operating activities was $67.5 million for the year ended December 31, 1999 compared to $3.1 million for the period from January 9, 1998 (inception) to December 31, 1998. The increase in net cash used in operating activities resulted primarily from increases in net loss. Net cash used in investing activities was $57.7 million for the year ended December 31, 1999 compared to $1.9 million for the period from January 9, 1998 (inception) to December 31, 1998. The increase in net cash used in investing activities resulted primarily from the purchase of short-term investments and increased capital expenditures for computer equipment, purchased software and office equipment. Net cash provided by financing activities was $450.1 million for the year ended December 31, 1999 compared to $6.9 million for the period from January 9, 1998 (inception) to December 31, 1998. The increase in net cash provided by financing activities resulted principally from the initial public offering in June 1999 and follow-on offering and December 1999. We anticipate that our current cash balances will be sufficient to fund our operations, including the acquired operations of iShip.com, through fiscal year 2001. However, we may require substantial working capital to fund our business and may need to raise additional capital. The Company cannot be certain that additional funds will be available on satisfactory terms when needed, if at all. See "Risk Factors--Our growth and operating results could be impaired if the Company is unable to meet future capital requirements." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Stamps.com's financial statements, schedules and supplementary data, as listed under Item 14, appear in a separate section of this Report beginning on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference from the information in our proxy statement for the 2000 Annual Meeting of Stockholders which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates. ITEM 11. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the information in our proxy statement for the 2000 Annual Meeting of Stockholders which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates. ITEM 12. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from the information in our proxy statement for the 2000 Annual Meeting of Stockholders which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates. PART IV. ITEM 13. ITEM 13. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this report. 1. Financial Statements. The following financial statements of Stamps.com are included in a separate section of this Annual Report on Form 10-K commencing on the pages referenced below: Stamps.com Consolidated Financial Statements iShip.com Financial Statements 2. Financial Statement Schedules. All financial statement schedules of Stamps.com have been omitted because they are not applicable, not required, or the information is included in the consolidated financial statements or notes thereto. 3. Exhibits. The following Exhibits are incorporated herein by reference or are filed with this report as indicated below: - -------- (1) Incorporated by reference to the Company's Form 8-K filed with the Securities and Exchange Commission (the "Commission") on October 29, 1999 (File No. 000-26427). (2) Incorporated by reference to the Company's Registration Statement on Form S-1 filed with the Commission (File No. 333-77025). (3) Incorporated by reference to the Company's Registration Statement on Form S-1 filed with the Commission (File No. 333-90115). (4) Incorporated by reference to the Company's Registration Statement on Form S-4 filed with the Commission (File No. 333-91377) (5) Filed with the Commission with this Annual Report on Form 10-K. + Confidential treatment requested and received as to certain portions. (b) Reports on Form 8-K: Report on Form 8-K, dated October 22, 1999, was originally filed on October 29, 1999 and amended on December 28, 1999 (Filing merger agreement and required financial statements for the iShip.com acquisition). REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Stamps.com Inc.: We have audited the accompanying consolidated balance sheets of Stamps.com Inc. (a Delaware corporation in the development stage) and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for the year ended December 31, 1999 and the period from January 9, 1998 (date of inception) through December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Stamps.com Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for the year ended December 31, 1999 and the period from January 9, 1998 (date of inception) through December 31, 1998 in conformity with accounting principles generally accepted in the United States. /s/ Arthur Andersen LLP Los Angeles, California January 19, 2000 STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED BALANCE SHEETS See accompanying notes. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) See accompanying notes. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Description of Business and Basis of Presentation Stamps.com Inc. (Stamps.com Inc. or the Company), incorporated in Delaware on January 9, 1998, offers a convenient, cost-effective and easy-to-use service for purchasing and printing postage over the Internet. Although the Company launched its Internet postage service on a national basis on October 22, 1999, it is considered a development stage enterprise, as there has not yet been significant revenues from this principal service. The Company is subject to the normal risks associated with a development stage enterprise in the technology industry and involved in e-commerce. These risks include, among others, the risks associated with product development, US Postal Service regulation, acceptance of the product by end users and the ability to raise additional capital to sustain operations. Principles of Consolidation The consolidated financial statements include the accounts of Stamps.com Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates and such differences may be material to the financial statements. Cash and Short-term Investments The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents. The Company's short-term investments are comprised of U.S. government obligations and public corporate debt securities with maturities of less than one year at the date of purchase. All short-term investments are classified as available for sale and are recorded at market using the specific identification method. Realized gains and losses are reflected in other income and expense while unrealized gains and losses, which to date have not been material, are included as a separate component of stockholder's equity (deficit). STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following table summarizes the Company's cash and short-term investments as of December 31 (in thousands): Fair Value of Financial Instruments Carrying amounts of certain of the Company's financial instruments, including cash and equivalents, accrued payroll, and other accrued liabilities, approximate fair value because of their short maturities. The fair values of investments are determined using quoted market prices for those securities or similar financial instruments. Concentration of Risk The Company's cash and short-term investment portfolio is diversified and consists primarily of investment grade securities. Investments are held with high-quality financial institutions, government and government agencies, and corporations, thereby reducing credit risk concentrations. Interest rate fluctuations impact the carrying value of the portfolio. Reclassifications Certain reclassifications have been made to prior periods to conform to current period presentations. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization are computed principally on a straight-line method over the shorter of the estimated useful life of the asset or the lease term, ranging from three to five years. Assets acquired under capitalized lease arrangements are recorded at the present value of the minimum lease payments. Amortization of assets capitalized under capital leases is computed using the straight-line method over the life of the asset or term of the lease, whichever is shorter. Expenditures for repairs and maintenance are charged to expense as incurred. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Property and equipment is comprised of the following at December 31 (in thousands): During 1999 and 1998, depreciation expense including the amortization on equipment under capital leases, was approximately $1,270,000 and $80,000, respectively. Other Assets Patents, trademarks and other intangibles are included in other assets in the accompanying balance sheets and are carried at cost less accumulated amortization. Amortization is calculated on a straight-line basis over the estimated useful lives of the assets, ranging from 5 to 15 years. Revenue Recognition Revenue from postage convenience fees is based on the amount of postage used by the customer and is recognized over the period that services are provided. Deferred revenue consists of annual prepaid fees billed in advance. Commissions from the sale of products by a third party vendor to our customer base are recognized as revenue when earned and collection is probable. Computation of Net Loss per Share Earnings per share are computed by dividing the net earnings available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing the net earnings for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares, representing incremental common shares issuable upon the exercise of stock options and warrants and upon conversion of convertible preferred stock, are excluded from the diluted earnings per share calculation as their effect is anti-dilutive. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following table sets forth the computation of basic and diluted earnings (loss) per share (in thousands, except per share amounts): Advertising Costs The Company generally expenses the costs of producing advertisements when the advertising first runs, and expenses the costs of communicating and placing the advertising in the period in which the advertising space or airtime is used. Internet advertising expenses are recognized based on specifics of the individual agreements. Under impression based agreements, advertising expense is recognized using the ratio of the number of impressions delivered over the total number of contracted impressions while agreements based on a period of time recognize advertising expense on the straight-line basis over the term of the contract. Income Taxes The Company accounts for income taxes in accordance with FASB 109, "Accounting for Income Taxes." Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statements and the tax basis of assets and liabilities using the enacted tax rate in effect for the years in which the differences are expected to reverse. Research and Development Costs Research and development costs are expensed as incurred. These costs primarily consist of salaries, development materials, supplies and applicable overhead expenses of personnel directly involved in the research and development of new technology and service offerings. Stock-Based Compensation SFAS No. 123, "Accounting for Stock-Based Compensation" (SFAS 123) encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic-value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Website Development Costs The Company developed and maintains its website. Costs associated with the website consist primarily of software purchased from third parties. The Company capitalizes costs of computer software obtained for internal use in web design and network operations. These capitalized costs are amortized based on their estimated useful life. Payroll and related costs are not capitalized, as the amounts are immaterial and principally relate to maintenance. Internal costs related to the development of website content are expensed as incurred. Recent Accounting Pronouncements Effective January 1, 1999, the Company adopted the provisions of Statement of Position No. 98-1, "Software for Internal Use", which provides guidance on accounting for the costs of computer software developed or obtained for internal use. 2. Legal Proceedings On June 16, 1999, Pitney Bowes filed a patent infringement lawsuit against the Company. The suit alleges that the Company is infringing two patents held by Pitney Bowes related to postage application systems and electronic indicia. The suit seeks treble damages, a preliminary and permanent injunction from further alleged infringement, attorneys' fees and other unspecified damages. The Company answered the complaint on August 6, 1999, denying the allegations of patent infringement and asserting a number of affirmative defenses. Pitney Bowes filed a similar complaint in early June 1999 against one of the Company's competitors, E-Stamp Corporation, alleging infringement of seven Pitney Bowes patents. The outcome of the litigation that Pitney Bowes has brought against the Company is uncertain. Therefore, the Company can give no assurance that Pitney Bowes will not prevail in its suit against the Company. If Pitney Bowes prevails in its claims against the Company, it may be prevented from selling postage on the Internet. Alternatively, the Pitney Bowes suit could result in limitations on how the Company implements its service, delays and costs associated with redesigning its service and payments of license fees and other payments. In addition, the litigation could result in significant expenses and diversion of management time and other resources. Thus, if Pitney Bowes prevails in its suit against the Company, its business could be severely harmed or fail. The company believes a reasonable possibility exists that a loss may be incurred. Due to the preliminary stage of this lawsuit, the Company cannot provide an estimate of possible loss or range at this time. On December 29, 1999, three individual plaintiffs filed a suit against the Company for alleged breach of oral contract, quantum meruit, fraud and negligent representation in the California Superior Court for the County of Los Angeles. The complaint was amended on January 28, 2000 to add one of the Company's directors as a defendant and to remove one of the plaintiffs from the suit. The suit alleges that the plaintiffs were due cash consideration for securing a board member and investors for the Company. The complaint seeks $13.3 million plus other unspecified compensatory damages, punitive and exemplary damages and attorneys' fees and costs incurred. The Company answered the complaint on March 8, 2000, denying the allegations and asserting a number of affirmative defenses. The outcome of this litigation is uncertain and the Company can give no assurance that the plaintiffs will not prevail. Due to the preliminary stage of this lawsuit, the Company cannot provide an estimate of possible loss or range at this time. 3. Line of Credit On May 1, 1998, the Company entered into a credit line agreement with a lender. The initial $300,000 borrowing base was increased to $1 million based on the Company's net equity balance, as defined, through STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) December 31, 1998. Borrowings bear interest at the lender's prime rate plus 1% (9.5% at December 31, 1999) and are collateralized by certain of the Company's assets. The credit line agreement matures on January 31, 2000. In connection with this indebtedness agreement, the Company issued a detachable warrant which permits the holder to purchase 7,050 shares of the Company's Common Stock for $.27 per share. The term of this warrant is for a period of seven years from the date of grant. The warrant was valued using the Black-Scholes pricing model. The compensation element will be recognized over the vesting period. 4. Income Taxes The provision for income taxes consists solely of minimum state taxes. The Company's effective tax rate differs from the statutory federal income tax rate primarily as a result of the establishment of a valuation allowance for the future benefits to be received from the net operating loss carryforwards and research tax credit carryforwards. The tax effect of temporary differences that give rise to a significant portion of the deferred tax assets and liabilities at December 31, 1999 and 1998 are presented below (in thousands). Because the Company is uncertain as to when and if it may realize its deferred tax assets, the Company has placed a valuation allowance against its otherwise recognizable deferred tax assets. The Company has a net operating loss carryforward of $46,392,000 and $55,023,000 for federal and state income tax purposes, respectively, at December 31, 1999, which can be carried forward to offset future taxable income. The Company also has available a tax credit carryforward at December 31, 1999 of $527,000, which can be carried forward to offset future taxable liabilities. The Company's federal net operating loss expires in 2018 and 2019, state net operating loss expires in 2007, and credits expire in 2018 and 2019. The Federal Tax Reform Act of 1986 and similar state tax laws contain provisions which may limit the net operating losses carryforwards to be used in any given year upon the occurrence of certain events, including a significant change in ownership interests. The provision for income taxes is comprised of (in thousands): STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Differences between the provision for income taxes and income taxes at the statutory federal income tax rate are as follows (in thousands): 5. Commitments Capital and Operating Leases The Company leases certain equipment under capital lease arrangements expiring on various dates through 2002. Included in property and equipment are the following assets held under capital lease at December 31 (in thousands): Following is a schedule of future minimum lease payments under capital leases and under operating leases that have initial or remaining noncancelable lease terms in excess of one year at December 31, 1999 (in thousands): Total rent expense for the year ended December 31, 1999 and 1998 was $751,000 and $109,000, respectively. The rent expense for fiscal year 1998 includes $23,000 paid to a stockholder/officer for rental of office space. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Advertising In October 1999, the Company entered into a three-year marketing and distribution agreement with America Online, Inc. ("AOL"). This partnership is an expansion of the existing agreement with AOL made in December 1998. Under the new agreement, the Company will be provided with a specific number of advertising impressions across several AOL brands featuring it as the exclusive provider of Internet postage services. Stamps.com software will also be included in AOL branded CD-ROMs for distribution. In consideration, the Company has committed to pay $56.0 million over the three-year term of the agreement. Of the $56.0 million total commitment, $18.5 million was paid in 1999 and $10.25 million, $16.25 million and $11 million will be paid in 2000, 2001 and 2002, respectively. Under the contract, the Company will receive internet impressions, distribution of the Company's software on AOL CD's and downloads of the Company's software on AOL partnership web sites. Expense related to impressions is recognized as the impressions are provided under the contract. Expense related to CD's and downloads will be recognized on a straight-line basis over the remaining contract period from the date the CD's and downloads are provided. In connection with the new AOL agreement, the Company issued 178,638 shares of common stock in October 1999 for $6.0 million in the aggregate, or $33.588 per share. In December 1999, the Company issued an additional 148,862 shares of common stock for $5.0 million in the aggregate, or $33.588 per share, pursuant to a warrant issued in October 1999. The total shares owned by AOL as a result of the transactions is 327,500. AOL presently holds unexercised warrants to purchase 163,750 shares at $33.588 per share from the original October issuance. The price per share issued to AOL in October 1999 was determined by taking the average of the closing prices of the Company's common stock over the 15 trading days preceding October 20, 1999. The fair value of the warrants issued were measured in October 1999. The estimated fair value of the warrants were determined using the Black-Scholes option pricing model. The issuance of these equity instruments resulted in a compensation element of $2.1 million. The $2.1 million will be recognized as expense over the 3 year contract period commencing in October 1999. In May 1999, the Company entered into a Sponsorship Agreement with Intuit Inc. (Intuit) that markets its Internet postage service on various Intuit internet sites and software. In exchange for this sponsorship, the Company is required to pay $3.3 million ($1.6 million in 1999 and $1.7 million in 2000). Additional payments may be required if this Sponsorship Agreement results in certain customer levels. The related expense will be recognized as the services are provided. 6. Related Party Transactions In October 1999, a director entered into a three-year consulting agreement with the Company to provide strategic planning services. In exchange for his consulting services, the director received an option to purchase 36,000 shares of common stock at $35.625 per share. A compensation element for these options will be recorded each month as the options vest, based on the Black-Scholes valuation method. In November 1999, this agreement was amended to provide that the director will receive consulting fees of $2,000 per day for any special projects on which the Company requires his services. In June 1999, the Company entered into a consulting services agreement with a director to provide us with strategic planning and business development advice, and other consulting services that the Company may request. In exchange for these services, the Company granted the director an option to purchase 10,000 shares of STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) common stock at an exercise price of $11.00 per share. During 1999, a compensation element of approximately $240,000 was calculated using the Black- Scholes valuation method for the options earned during the period. This agreement expired on October 1, 1999. In February 1999, a director entered into a three-year consulting agreement with the Company to provide marketing and strategic planning services. In exchange for his consulting services, the director will receive consulting fees of $120,000 per annum and an option to purchase 135,000 shares of common stock at $0.33 per share. During 1999, a compensation element of approximately $1.4 million was calculated using the Black-Scholes valuation model for the options earned during the period. This agreement was terminated in October 1999 upon the director's appointment as an officer of the Company. This change in status will result in a new measurement date for the remaining unvested options. The compensation expense resulting for the new measurement date will be recognized over the remaining vesting period. The Company paid $61,000 in March 1998 to Safeware Corporation for employee salary and patent prosecution expenses incurred to obtain a patent. These patent prosecution expenses consisted primarily of fees paid to patent counsel and fees paid to the US Patent and Trademark Office. A director of the Company is the majority shareholder in Safeware Corporation. The Company also reimbursed the director for approximately $20,000 for expenses incurred on its behalf. 7. Stockholders' Equity Stock Issuances In June 1999, the Company completed an initial public offering of 5,750,000 shares of its Common Stock, the net proceeds of which aggregated $57.8 million. Upon the closing of this offering, the Company repurchased 704,595 shares of Common Stock for $939,460 and converted all the Company's Redeemable Preferred Stock into an aggregate of 22,870,479 shares of Common Stock. In December 1999, the Company completed a follow-on public offering in which the underwriters sold to the public 5,750,000 shares of the Company's Common Stock. The Company's net proceeds from the offering were $354.1 million. Restricted Stock During 1998, the Company issued restricted stock to an employee and a director totaling 1,988,475 shares. Part of the purchase price included a full recourse note payable to the Company for $99,000. These shares vested one- fourth on May 30, 1999 and the remaining shares vest monthly over the subsequent thirty-six months. The Company issued these shares at prices which included approximately $650,000 of a compensation element. The $650,000 is being recognized as expense over the vesting periods and has been presented as a reduction of stockholders' equity (deficit) in the accompanying balance sheets. Common Stock In June 1999, the Board of Directors declared a stock dividend of 3 shares of Common Stock for every 2 shares of Common Stock then outstanding, an action which also resulted in an adjustment to the conversion ratio of the Series A, B and C redeemable preferred stock to a three-for-two basis. The stock dividend became effective on the date that the Company's initial public offering of Common Stock closed. Accordingly, the accompanying financial statements and footnotes have been restated to reflect the stock dividend. In addition the board changed the number of authorized shares of Common Stock and Preferred Stock to 95,000,000 and 5,000,000 shares, respectively. Prior to June 1999, the number of authorized shares of common stock and preferred stock was 40,000,000 shares and 15,500,000 shares, respectively. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Redeemable Preferred Stock In February 1999, the Board of Directors approved the sale of Series C Redeemable Preferred Stock and the Company issued 5,464,486 shares of its Series C Redeemable Preferred Stock at $5.49 per share. In February 1998, the Company issued 3,762,500 shares of its Series A Redeemable Preferred Stock at $0.40 per share and warrants to acquire 6,020,000 shares of the Company's Series B Redeemable Preferred Stock at $0.75 per share. In August and October 1998, 6,020,000 shares of Series B Redeemable Preferred Stock were issued under these warrants. In connection with the Company's Initial Public Offering in June 1999, all shares of Series A, B, and C Preferred Stock converted into 22,870,479 shares of Common Stock. Notes Receivable In connection with the issuance of Common Stock during the period, the Company exchanged shares with a fair value of $117,000 for notes receivable of the same amount. These notes receivable bear interest at 9% per annum and are payable in February 2003. 8. Employee Stock Plans Stock Incentive Plans The 1999 Stock Incentive Plan (the "1999 Plan") serves as the successor to the 1998 Stock Plan (the "Predecessor Plan). The 1999 Plan became effective in June 1999. At that time, all outstanding options under the Predecessor Plan were transferred to the 1999 Plan, and no further option grants can be made under the Predecessor Plan. All outstanding options under the Predecessor Plan continue to be governed by the terms and conditions of the existing option agreements for those grants, unless our compensation committee decides to extend one or more features of the 1999 Plan to those options. In October 1999, the Company's Board of Directors approved an increase of 2,500,000 shares to the number of shares eligible to be granted under the 1999 Plan from the initial authorization of 7,290,000 shares of the common stock. Upon stockholder approval of the increase, the total shares authorized for issuance under the 1999 will be 11,019,551, which amount includes an automatic annual increase to the share reserve of 3% of the Company's outstanding common shares on the last trading day in December. The increase on January 1, 2000 was 1,229,551 shares based on 40,985,054 shares outstanding on the last day of December 1999. In no event will this annual increase exceed 1,564,715 shares. In addition, no participant in the 1999 Plan may be granted stock options or direct stock issuances for more than 1,125,000 shares of common stock in total in any calendar year. Options granted under the 1999 Plan vest 25% per year, and the Board of Directors has the discretion with respect to vesting periods applicable to a particular grant. Each option granted has a 10 year contractual life. During 1999 and 1998, the Company issued options to purchase 5,001,454 and 2,347,471 shares of common stock, respectively, at prices which included approximately $11,995,000 of a compensation element in 1999 and $600,000 in 1998. The total of $12,595,000 is being recognized as expense over the vesting periods of the related options and has been presented as a reduction of stockholders' equity (deficit) in the accompanying balance sheets. The current year amortization of deferred compensation expense of $5,708,000 is included as a general and administrative expense. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) A summary of stock option activity is as follows (in thousands, except per share amounts): The following tables summarize information concerning outstanding and exercisable options at December 31, 1999 (in thousands, except number of years and per share amounts): SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123"), requires the Company to disclose pro forma information regarding option grants made to its employees. SFAS 123 specifies certain valuation techniques that produce estimated compensation charges that are included in the pro forma results below. These amounts have not been reflected in the Company's Consolidated Statement of Operations, because APB 25, "Accounting for Stock Issued to Employees," specifies that no compensation charge arises when the price of the employees' stock options equal the market value of the underlying stock at the grant date, as in the case of options granted to the Company's employees. SFAS 123 pro form numbers are as follows for December 31 (in thousands, except per share amounts and percentages): STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Under SFAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in management's opinion the existing models do not necessarily provide a reliable single measure of the fair value of the Company's options. Employee Stock Purchase Plan In June 1999, the Company's Board of Directors adopted an Employee Stock Purchase Plan ("the Purchase Plan") which allows eligible employees of the Company and eligible employees of the Company's participating subsidiaries to purchase shares of common stock, at semi-annual intervals, with their accumulated payroll deductions. Eligible participants may contribute up to 15% of cash earnings through payroll deductions, and the accumulated deductions will be applied to the purchase of shares on each semi-annual purchase date. The purchase price per share will be equal to 85% of the fair market value per share on the participant's entry date into the offering period or, if lower, 85% of the fair market value per share on the semi-annual purchase date. Upon adoption of the plan, 300,000 shares of common stock were reserved for issuance. This reserve will automatically increase on the first trading day in January each year, beginning in calendar year 2000, by an amount equal to 1% of the total number of outstanding shares of our common stock on the last trading day in December in the prior year. The increase on January 1, 2000 was 409,851 shares based on 40,985,054 shares outstanding on December 31, 1999. In no event will any annual increase exceed 521,571 shares. As of December 31, 1999, no shares have been issued under the Purchase Plan. Savings Plan During 1999, the Company implemented a savings plan for all eligible employees, which qualifies under Section 401(k) of the Internal Revenue Code. Participating employees may contribute up to 15% of their pretax salary, but not more than statutory limits. The Company matches 100% of the first 1.5% a participant contributes. 9. Events Subsequent to Date of Auditor's Report (Unaudited) Change in Subsidiary Ownership On February 17, 2000, the Company announced that it sold approximately 38% of EncrypTix, Inc., until then a wholly-owned subsidiary of the Company, in a private financing of approximately $30 million. STAMPS.COM INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) iShip.com Acquisition On March 7, 2000, the Company closed its acquisition of iShip.com, a development stage enterprise developing Internet-based shipping technology. In connection with the merger, up to 8 million shares will be exchanged for all outstanding stock, options and warrants of iShip.com. The acquisition will be accounted for using the purchase method of accounting. Accordingly, a portion of the purchase price will be allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values on the acquisition date. The company is currently in process of preparing the final purchase price allocation and determining the useful lives of the assets acquired. It is anticipated that the purchase will result in intangible assets of approximately $230 million. 10. Quarterly Information (unaudited) INDEPENDENT AUDITOR'S REPORT To the Stockholders iShip.com, Inc. We have audited the accompanying balance sheet of iShip.com, Inc. (a development stage company) as of December 31, 1998 and 1999, and the related statements of operations, stockholders' equity and cash flows for the period from inception (May 27, 1997) to December 31, 1997, the years ended December 31, 1998 and 1999 and the period from inception (May 27, 1997) to December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of iShip.com, Inc. as of December 31, 1998 and 1999, and the results of its operations and its cash flows for the period from inception (May 27, 1997) to December 31, 1997, the years ended December 31, 1998 and 1999 and for the period from inception (May 27, 1997) to December 31, 1999, in conformity with generally accepted accounting principles. /s/ Moss Adams LLP Seattle, Washington March 15, 2000 iSHIP.COM, INC. (A Development Stage Company) BALANCE SHEET DECEMBER 31, 1998 AND 1999 ASSETS See accompanying notes. iSHIP.COM, INC. (A Development Stage Company) STATEMENT OF OPERATIONS See accompanying notes. iSHIP.COM, INC. (A Development Stage Company) STATEMENT OF STOCKHOLDERS' EQUITY See accompanying notes. iSHIP.COM, INC. (A Development Stage Company) STATEMENT OF CASH FLOWS See accompanying notes. iSHIP.COM, INC. (A Development State Company) NOTES TO FINANCIAL STATEMENTS Note 1--Summary of Significant Accounting Policies Development Stage Operations--iShip.com, Inc. (the Company), a Washington corporation, was incorporated on May 27, 1997 under the name MoveIt! Software, Inc. On May 18, 1998, the Company changed its name to iShip.com, Inc. The Company's office is located in Bellevue, Washington. Since inception, the Company has been developing and marketing Internet applications that enable customers to price, ship, track and manage shipments over the Internet. In April 1998, the Company began providing its Internet- based shipping services to users. In April 1999, the Company entered into a five-year agreement with Mail Boxes Etc. to be the exclusive provider of an Internet-based retail package manifest system to its approximately 3,000 domestic retail centers. In October 1999, a beta version of this service was deployed in ten retail centers. In May 1999, the Company entered into a five- year agreement with eBay to provide shipping services to eBay auction customers. The first phase of this service launched on eBay in July 1999. Through December 31, 1999, the Company has offered its package tracking and pricing applications at no charge to the user. On March 7, 2000, the Company was acquired by Stamps.com, an Internet Postage service provider (See Note 10). Use of Estimates--The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Cash and Cash Equivalents--For the purposes of the statement of cash flows, cash and cash equivalents are defined as short-term, highly liquid investments that are readily convertible to cash and are so near maturity that fluctuations in interest rates lead to insignificant risk of changes in investment value. Fair Value of Financial Instruments--The Company's financial instruments, including cash, cash equivalents, and accounts payable are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. Long-term obligations are carried at cost, which approximates fair value due to the proximity of the implicit rates of these financial instruments and the prevailing market rates for similar instruments. Equipment and Leasehold Improvements--Equipment and leasehold improvements are stated at cost. The Company provides depreciation on the cost of its equipment using straight-line methods over estimated useful lives of three and five years. Amortization of leasehold improvements is extended over the term of the lease. Expenditures for repairs and maintenance are charged to expense as incurred. Impairment of Long-Lived Assets--The Company evaluates the recoverability of long-lived assets in accordance with "SFAS" No. 121, "Accounting for the Impairment of Long-Lived Assets to be Disposed of." SFAS No. 121 requires identification of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. To date, no such impairment has been indicated. Should there be an impairment in the future, the Company will measure the amount of the impairment based on the discounted future cash flows from the impaired assets. Research and Development Costs--Research and development costs are charged to expense as incurred. These costs primarily consist of salaries, development materials, supplies and applicable overhead expenses of personnel directly involved in the research and development of new technology. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) Website Development Costs--The Company developed and maintains its website. Costs associated with the website consist primarily of software purchased from third parties. Currently, the Company capitalized costs of computer software obtained for internal use in web design and network operations. These capitalized costs are amortized based on their useful life. Payroll and related costs are not capitalized, as the amounts are immaterial and principally related to maintenance. Costs related to development of website content are expensed as incurred. Advertising--The Company expenses advertising costs as incurred. No advertising costs were incurred during the period from inception (May 27, 1997) to December 31, 1999. Stock-Based Compensation--The Company accounts for stock-based compensation to employees using the intrinsic value method, whereby, compensation cost is recognized when the exercise price at the date of grant is less than the fair market value of the Company's common stock. The Company discloses the proforma effect of compensation cost based on the fair value method for determining compensation cost. Stock-based compensation awarded to non-employees is determined using the fair value method. Compensation cost is recognized over the service or vesting period. Risk Concentrations--Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash, cash equivalents and short-term investments. Cash, cash equivalents and short-term investments are deposited with high credit, quality financial institutions. Income Taxes--Income taxes are accounted for using an asset and liability approach, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities at the applicable enacted tax rates. Generally accepted accounting principles require a valuation allowance against deferred tax assets if, based on the weight of available evidence, it is more likely than not that some or all of its deferred tax assets will not be realized. Stock Split--On August 6, 1999 the Board of Directors approved a 2 for 1 split of the Company's Common and Preferred Stock and an increase in the number of authorized Common Stock shares to 60,000,000 and authorized Preferred Stock shares to 21,786,688. Accordingly, the share information in the accompanying financial statements and footnotes has been restated to reflect the stock split. Recent Accounting Pronouncements--In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivatives and Hedging Activities." SFAS 133 is effective for all fiscal quarters beginning with the quarter ending June 30, 1999. SFAS 133 establishes accounting and reporting standards of derivative instruments, including certain derivative instruments imbedded in other contracts, and for hedging activities. In July 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133," ("SFAS 137"). SFAS 137 deferred the effective date until the first fiscal quarter ended on or following June 30, 2000. The Company will adopt SFAS 133 in its quarter ending June 30, 2000 and does not expect such adoption to have a material impact on the Company's results of operations, financial position or cash flows. Note 2--Investment Securities Investment securities are classified as "available-for-sale" under generally accepted accounting principles. Available-for-sale securities are recorded at estimated fair value, with the net unrealized gain or loss included as a separate component of stockholders' equity, net of the related tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) At December 31, 1998, the Company had commercial paper with an amortized cost of $990,676, which approximated fair value and matured in 1999. Note 3--Equipment and Leasehold Improvements Equipment is recorded at cost and consists of the following at December 31: Included in equipment at December 31, 1999 is $3,276,612 held under capital lease with accumulated amortization of $139,594. At December 31, 1998 included in equipment is $186,125 held under capital lease with accumulated amortization of $77,552. Note 4--Notes Payable The Company has a Loan and Security Agreement with a bank for $2,950,000 of which $2.5 million is available for equipment purchases through February 19, 2000 and $450,000 is available through a revolving line maturing on August 19, 2000. Borrowings under the non-revolving equipment line of credit are payable in 30 equal monthly installments beginning in March 2000. Interest is payable monthly and accrues at the annual rate of the bank's prime rate plus 0.50%. Outstanding borrowings against the equipment line were $86,418 at December 31, 1998 and $2,054,067 at December 31, 1999. There were no outstanding borrowings under the revolving line at December 31, 1998 and 1999. In connection with the Loan and Security Agreement, the Company issued a Common Stock purchase warrant which permits the holder to purchase up to 10,000 shares of the Company's Common Stock at a purchase price of the lesser of $2.50 per share and the price per share received by the Company in the next round of financing. The warrant is exercisable only (i) after the Company's initial public offering, (ii) immediately prior to a change in control and (iii) with the written consent of the Company. The fair value of the purchase warrants has been estimated at $20,000 using the Black-Scholes option-pricing model. The Company capitalized the fair value, which is being amortized on a straight-line method over the repayment period. Required principal payments for years ending December 31 are as follows: Note 5--Deferred Officers' Compensation Three key officers of the Company deferred their salaries during the first nine months of development stage operations. The deferred compensation totaled $168,750 as of December 31, 1998. The deferred compensation was paid in 1999. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) Note 6--Capital Leases and Commitments The Company leases office space and certain leasehold improvements, office furniture, and computer equipment under various capital and operating leases through June 30, 2001. Future minimum lease payments required under non- cancelable capital and operating leases are as follows: Given the Company's development stage operations, only a portion of the standard lease payments, on certain agreements, are required in early months. The difference between the actual lease payments and the standard monthly payments are recorded as deferred rent payable. Total deferred rent was $50,845 as of December 31, 1998 and $111,859 as of December 31, 1999. Rental expense on operating leases totaled $15,753 in 1997, $277,584 in 1998, $538,669 in 1999 and $832,000 in the period from inception to December 31, 1999. The Company subleases a portion of the office space. Rental income from the sublease totaled $82,113 in 1998, $187,414 in 1999, and $269,527 for the period from inception to December 31, 1999. Subsequent to December 31, 1999, the Company entered into two non- cancelable operating lease agreement for additional office space. One lease has an initial term of 8 years with two renewal terms of five years each. The initial lease term will commence fifteen days following landlord's substantial completion of the building improvements. The estimated time period for commencement is in the first quarter of 2001. Base rent will be paid monthly based on an escalating rent schedule ranging from $23.00 per square foot in the initial year to $27.36 per square foot in the eighth year. The estimated rentable square feet are 75,510. The additional lease has a 24 month term with base rents paid monthly based on an escalating rent schedule ranging from $21.00 per square foot in the initial year to $22.00 per square foot in the second year. The estimated rentable square feet are 14,573. Note 7--Preferred Stock Transactions--The Company issued 1,600,000 shares in 1997 and 7,386,668 shares in 1998 of Series A Preferred Stock at $0.375 per share. The Company issued 10,133,334 shares of Series B Preferred Stock in 1999 at $0.75 per share. No direct costs were incurred in relation to the shares issued. Preference in Liquidation--In the event of voluntary or involuntary liquidation, distribution of assets, dissolution or winding-up of the Company before any distribution or payment to holders of the Company's common stock, the holders of Series A Preferred Stock are entitled to receive payment of $0.375 per outstanding share, and the holders of Series B Preferred Stock are entitled to receive payment of $0.75 per outstanding share. Dividends--Dividends payable to holders of preferred stock are at the discretion of the Company's Board of Directors. As of December 31, 1997, 1998 and 1999, no dividends had been declared. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) Conversion Rights--A holder of preferred stock, at the holder's option, has the right to convert shares of preferred stock into common stock on a one-for- one basis, subject to adjustment for stock splits and dilutive issuances. In addition, the preferred stock would automatically convert to common stock in the event of a change in control or the closing of an underwritten public offering that establishes a valuation of the Company of at least $75 million and results in gross proceeds of at least $15 million or upon the conversion of two-thirds of the shares of preferred stock originally issued. A change in control occurred as a result of the merger in March, 2000. Voting Rights--The holders of preferred stock are entitled to one vote for each share and are entitled to vote on all matters on which the holders of common stock have the right to vote. Stock Warrant--On April 27, 1999 the Company issued a warrant to a strategic partner for a maximum of 2,666,666 shares of the Company's Series B Preferred Stock at an exercise price of $1.50 per share. The actual number of shares purchasable under the warrant is equal to the quotient of the amount in excess of a specified dollar amount the Company receives in a specified one- year period pursuant to the agreement between the Company and this strategic partner divided by $0.75, and in any event may not exceed 2,666,666 shares. The specified one-year period begins on the earlier of March 1, 2000 and the date on which a certain threshold is reached pursuant to the agreement between the Company and this strategic partner. The warrant terminates on the earlier of April 27, 2004 and the consummation of a merger or acquisition of the Company occurring after the specified one-year period. The Company is valuing the warrant at its fair value, which at December 31, 1999 is zero. The fair value is determined using the Black-Scholes option-pricing model based on the lowest estimated number of shares of the Company's Series B Preferred Stock to be purchasable under the warrant. At April 27, 1999 and December 31, 1999, as no amounts have been received by the Company pursuant to the agreement, the lowest estimated number of shares to be purchasable under the warrant is zero, resulting in zero fair value. The fair value of the warrant will be adjusted, as events occur, until completion of performance. Costs resulting from the warrant, if any, will be recognized based on increases in the fair value of the warrant. Note 8--Stock Option Plan The Company has a stock option plan under which employees and consultants may be awarded incentive or nonstatutory stock options. The plan authorizes the grant of options for the purchase of up to 5,660,000 shares of common stock. In February 2000, the Board of Directors approved an increase of 500,000 shares to the option pool. Under the plan, the option exercise price for incentive stock options may not be less than the fair market value of the Company's common stock at the date of grant as determined by the Board of Directors, but for nonstatutory stock options may be less than the fair market value of the Company's common stock at the date of grant as determined by the Board of Directors. However, all option grants under the plan to 10% shareholders may not be less than 110% of fair market value of the Company's common stock at the date of grant as determined by the Board of Directors. Options expire no later than ten years from the grant date, and vesting is established at the time of grant provided that options shall become exercisable at the rate of at least 20% per year over five years. The Company has issued options to employees which, based on the intrinsic value method, include a compensation element of $184,500 in 1998, $9,095,436 in 1999, and $9,279,936 in the period from inception to December 31, 1999. The compensation element has been recorded as additional paid-in capital and deferred compensation and is being amortized to expense over the vesting periods of the related options. The Company has granted options to consultants with fair values at grant date of $2,623 in 1997, $13,362 in 1998, $523,193 in 1999 and $539,178 in the period from inception to December 31, 1999. The fair value of the options granted has been recorded as additional paid-in capital and deferred compensation expense and is being amortized to expense over the related service period. The fair value has been determined using the Black-Scholes option-pricing model with the following assumptions on the date of grant: 0% dividend yield, forfeiture rate and volatility, risk free rate of return of 4.47% and 6.18%, and expected life of five years. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) Stock option activity is as follows: The following summarizes options outstanding at December 31, 1999: Had the compensation cost for stock options been determined using the fair value method, the proforma net loss would have increased by $7,400 to $416,328 for the period from inception to December 31, 1997, by $5,700 to $1,888,492 for the year ended December 31, 1998, by $30,500 to $8,319,310 for the year ended December 31, 1999 and by $43,600 to $10,624,130 for the period from inception to December 31, 1999. The weighted average fair value of the options granted was estimated to be $.01 in the period from inception to December 31, 1997, $.027 in 1998 and $3.35 in 1999 using the Black-Scholes option-pricing model with the following assumptions on the date of grant: 0% dividend yield and volatility, 5% forfeitures per year, risk-free interest rate of 4.47% to 6.30%, expected lives of nine years. Note 9--Income Taxes At December 31, 1999, the Company has net operating loss carryforwards for federal income tax purposes of approximately $8,700,000 and research credit carryforwards of $288,900 available to offset future federal taxable income, if any. The net operating loss and research credit carryforwards generally expire in 2012 thru 2019. The Internal Revenue Code may limit the net operating loss carryforwards to be used in any given year upon the occurrence of certain events, including significant change in ownership interest. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) Deferred taxes are comprised of the following at December 31: A valuation allowance for the full amount of the net deferred tax asset has been recorded as realization in the near term is not reasonably assured. The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate of 34% to earnings before taxes due to the valuation allowance established for the current and prior year's net operating loss and nondeductible items. A reconciliation of the income tax benefit to the amounts computed by applying the federal statutory income tax rate to loss before income tax is as follows: Note 10--Merger Agreement and Subsequent Event In October 1999, the Company entered into a merger agreement with Stamps.com Inc. an enterprise developing an Internet-based postage service for end-users. On February 3, 2000, the Company obtained $2 million of subordinate bridge financing from Stamps.com Inc. On March 7, 2000, upon obtaining approval from the Company's shareholders and Stamps.com's stockholders, the merger was consummated. Under the terms of the merger agreement, the Company's preferred and common shareholders, warrant holders and option holders exchanged their securities in the Company for the equivalent of 8 million shares of Stamps.com common stock. Included in the 8 million shares to be received are amounts reserved for issuance under the terms of the outstanding stock options and warrants of the Company for which the holders received options and warrants for the purchase of Stamps.com common stock. The exercise price of the outstanding options and warrants was adjusted to reflect the share exchange ratio. Upon consummation of the merger the $2 million of bridge financing was converted to due to parent. iSHIP.COM, INC. (A Development Stage Company) NOTES TO FINANCIAL STATEMENTS--(Continued) The merger agreement reflects a change in control, which accelerated the vesting of options to purchase an estimate of 930,000 shares of the Company's common stock or one-third of all outstanding unvested options granted prior to October 21, 1999. The accelerated vesting will result in a compensation charge in March 2000 estimated to be $1.4 million. UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION On October 22, 1999, Stamps.com entered into a merger agreement to acquire iShip.com in exchange for up to 8,000,000 shares of Stamp.com's common stock. Stamps.com's management has prepared the following unaudited pro forma condensed combined financial information to give effect to this acquisition. The Unaudited Pro Forma Condensed Combined Statements of Operations for the period ended December 31, 1999 gives effect to the iShip.com acquisition as if it had taken place on January 1, 1999. The pro forma adjustments, which are based upon available information and certain assumptions that Stamps.com believes are reasonable in the circumstances, are applied to the historical financial statements of Stamps.com and iShip.com. The iShip.com acquisition will be accounted for using the purchase method of accounting. Stamps.com allocation of purchase price is based upon management's current estimates of the fair value of assets acquired and liabilities assumed in accordance with Accounting Principles Board No. 16. The purchase price allocations reflected in the accompanying unaudited pro forma condensed combined financial statements may be different from the final allocation of the purchase price due to the different periods of time used in the calculations and such differences may be material. The Company expects to complete a valuation and other procedures during the second quarter of 2000. As part of the merger agreement, 800,000 shares of the total 8,000,000 shares of Stamps.com common stock will be deposited into an escrow account immediately preceeding the close of this transaction. The escrow amount is intended to compensate Stamps.com for any inaccuracy or breach of any representation, warranty, covenant or agreement of iShip.com as contained in the merger agreement. The shares must remain in the escrow fund for a period of one year from the close of the acquisition. The parties are currently not aware of any inaccuracy or breach of any representation, warranty, covenant or agreement of iShip as contained in the merger agreement. The accompanying unaudited pro forma condensed combined financial information should be read in conjunction with the historical financial statements and the notes thereto for both Stamps.com and iShip.com, which are included elsewhere. The unaudited pro forma condensed combined financial information is provided for informational purposes only and does not purport to represent what Stamps.com's financial position or results of operations would actually have been had the iShip.com acquisition occurred on such dates or to project Stamps.com's results of operations or financial position for any future period. UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET AS OF DECEMBER 31, 1999 (Amounts in thousands) See notes to unaudited pro forma condensed combined financial information. UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1999 (Amounts in thousands, except per share data) See notes to unaudited pro forma condensed combined financial information. NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION The pro forma financial information gives effect to the following pro forma adjustments: The iShip.com merger will be accounted for using the purchase method of accounting. In connection with the acquisition, Stamps.com will issue up to 8 million shares of Common Stock in exchange for all of the outstanding shares of iShip.com capital stock, options and warrants. For purposes of these pro forma financial statements, the estimated purchase price is approximately $249.3 million based on $34.63 per share and the issuance of 7.2 million shares of common stock (8 million less the escrow amount of 800,000). The $34.63 per share amount is the average closing price of our Common Stock on the Nasdaq National Market for the 30 consecutive trading days ending on and including the third day prior to March 7, 2000 (closing date). The iShip.com shares were first converted to Stamps.com equivalent shares by taking the number of iShip.com shares over the total number of iShip.com shares multiplied by 7,200,000 to arrive at Stamps.com shares for each iShip.com share. This calculation has been made for purposes of these financial statements only and does not represent the final exchange ratio, which will be determined on the third trading day prior to the closing of the transaction. The purchase price was determined as follows (in thousands): The fair value of "shares" was calculated by taking the value of the Stamps.com shares ($34.63 per share) times the number of Stamps.com shares to be exchanged. With respect to stock options exchanged as part of the iShip.com merger, all vested and unvested iShip.com options exchanged for Stamps.com options are included as part of the purchase price based on their fair value. The fair value of the shares underlying options and warrants was calculated by taking the vested and unvested options and warrants to purchase Stamps.com shares (1,381,000 options) times the fair value of the stock ($34.63 per share). Proceeds to be received from the option holders upon exercise are estimated to be approximately $1.5 million based on the weighted average exercise price of $0.42 per outstanding option at December 31, 1999. The aggregate exercise price of the warrants is $5,000,000. These amounts are excluded from the fair value calculations. The pro forma financial information has been prepared on the basis of assumptions described in these notes and include assumptions relating to the allocation of the consideration paid for the assets and liabilities of iShip.com based on preliminary estimates of their fair value. The actual allocation of such consideration may differ from that reflected in the pro forma financial information after valuations and other procedures to be performed after the closing of the iShip.com acquisition. NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION--(Continued) Below is a table of the estimated acquisition cost, purchase price allocation and annual amortization of the intangible assets acquired (in thousands): Tangible assets of iShip.com acquired in the iShip.com merger principally include cash and fixed assets. Liabilities of iShip.com assumed in the iShip.com merger principally include accounts payable, accrued payroll and long-term debt. 2. The pro forma adjustment is for goodwill allocation of $232.07 million. 3. The pro forma adjustment is for deferred stock compensation associated with the unvested iShip.com stock options to acquire approximately 2 million shares of iShip.com common stock to be assumed by Stamps.com. 4. The pro forma adjustment to "shareholders' equity" reflects the elimination of iShip.com's shareholders' equity ($2.1 million) and the impact of the issuance of Stamps.com's common stock ($249.3 million) in connection with the iShip.com merger. 5. The pro forma adjustment is for amortization of deferred stock compensation associated with the unvested iShip.com stock options assumed by Stamps.com over the remaining vesting period of $3.8 million and amortization of goodwill of $58 million for the year ended December 31, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Santa Monica, State of California, on the 29th day of March, 2000. STAMPS.COM INC. By: /s/ John M. Payne ___________________________________ John M. Payne Chairman and Chief Executive Officer POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, the undersigned hereby constitute and appoint John M. Payne and John W. LaValle, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite or necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and on the dates indicated: - -------- (1) Incorporated by reference to the Company's Form 8-K filed with the Securities and Exchange Commission (the "Commission") on October 29, 1999 (File No. 000-26427). (2) Incorporated by reference to the Company's Registration Statement on Form S-1 filed with the Commission (File No. 333-77025). (3) Incorporated by reference to the Company's Registration Statement on Form S-1 filed with the Commission (File No. 333-90115). (4) Incorporated by reference to the Company's Registration Statement on Form S-4 filed with the Commission (File No. 333-91377) (5) Filed with the Commission with this Annual Report on Form 10-K. + Confidential treatment requested and received as to certain portions.

805268_1999.txt

805268_1999

1999

805268

ITEM 1. BUSINESS Boston Acoustics, Inc. (the "Company") engineers, manufactures and markets moderately-priced, high-quality audio systems for use in home audio and video entertainment systems, in after-market automotive audio systems and in multimedia computer environments. The Company believes that its products deliver better sound quality than other comparably priced audio systems. Most of the Company's products are assembled by the Company from purchased components, although certain automotive speakers are manufactured by others according to Company specifications. All of the Company's products and subassemblies, including those supplied by outside sources, have been designed by the Company's engineering department. Boston Acoustics' speakers are marketed nationwide through selected audio and audio-video specialty dealers and through distributors in many foreign countries. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- International Operations" which is included in the Company's 1999 Annual Report which is filed as Exhibit 13 hereto. The Company was organized as a Massachusetts corporation in 1979 by Andrew G. Kotsatos and former Chief Executive Officer, Francis L. Reed, who passed away in November 1996. Its principal executive offices and manufacturing facilities are located at 300 Jubilee Drive, Peabody, Massachusetts. PRODUCTS The Company has determined it has two reportable business industry segments: Core and original equipment manufacturer (OEM) and Multimedia. Prior to fiscal 1998, the Company operated as a single segment. The Company's reportable segments are strategic business units that sell the Company's products to distinct distribution channels. Both segments derive their revenues from the sale of audio systems. They are managed separately because each segment requires distinct selling and marketing strategies, as the class of customers within each segment is different. Each business segment has distinct product lines as discussed below. The Home Loudspeaker line consists of six bookshelf models currently ranging in price from $100 to $420 per pair, four floor-standing systems currently priced from $500 to $1600 per pair, two home theater subwoofer/satellite systems currently priced at $700 and $1000 per system, and three powered subwoofers priced at $400, $600 and $1200. Additional products for the home theater market include five different center-channel speakers currently ranging in price from $130 to $600 each and three diffuse-field surround speakers ranging in price from $200 to $500 per pair. The Company also produces magnetically shielded versions of most of its models and produces three indoor/outdoor speaker systems (Voyager-Registered Trademark-, Runabout-Registered Trademark- I, and Runabout II) currently priced from $200 to $400 per pair. The Company also produces a complete THX-Registered Trademark- Home Theater speaker system priced at $3,600 and the DigitalTheater-TM- 6000, a complete digital home theater sound system priced at $599.95. The Designer Series line is a collection of speaker systems engineered for flush mounting in the walls or ceilings of homes, businesses and recreational vehicles. There are eleven models in the Designer Series line with prices currently ranging from $130 to $500 per pair. The Automotive Series consists of 39 models of automotive speakers with prices currently ranging from $60 to $700 per pair. The automotive line includes high-quality full-range replacement speakers, sophisticated component systems, and subwoofers. The component systems permit flexible speaker placement and provide sound rivaling that of fine home speakers. The automotive line includes the CX Series, the 700 Series of plate speakers, the Boston Rally-TM- RC Series of component speakers, the Boston Rally RX Coaxial Series, the Boston Rally RS Subwoofers and Band-Pass enclosure systems, the Boston Rally RM Series, and the premium performance ProSeries Speaker Systems. The Multimedia category of products sold through the Company's retailers and via a direct Internet-based sales channel currently consists of three high performance powered subwoofer/satellite speaker systems for computing environments priced from $99.95 to $249.95 per system. The OEM sales of Multimedia speaker systems sold to Gateway, Inc. ("Gateway"), a leading global direct marketer of PC products, include the BA635 three-piece system, the Digital MediaTheater-TM- three-piece system, and the DigitalTheater-TM- 6000, a complete Dolby-Registered Trademark- Digital 5.1 Channel Home Theater System. NEW PRODUCTS In fiscal 1999, as in previous years, the Company introduced new systems for all of our markets. These new products, described below, supplemented or replaced certain products which in the Company's opinion had matured. The Company believes that its new product offerings will increase penetration in current markets, and help gain footholds in new markets. A highlight of fiscal 1999 was the Company's introduction of the DigitalTheater 6000. The DigitalTheater 6000 system is the first complete home theater sound system with 5.1 channel Dolby-Registered Trademark- Digital processing (the step beyond Dolby analog processing). It includes five sonically matched satellite speakers and a powered subwoofer, driven by a powerful six-channel amplifier. It is designed to utilize minimal space while producing superior sound quality. It has a suggested retail price of $599.95. In fiscal 1999, the Company added an important new model to its highly-regarded Lynnfield VR Series of floorstanding speakers. The new Lynnfield VR940, priced at $500 per pair, utilizes an innovative new bass driver designed and built by the Company that delivers exceptional performance from a sleek enclosure. The VR940 received an "Innovations '99" award for new product design and engineering excellence at the International Consumer Electronics Show in Las Vegas. The Company expanded its home theater speaker offerings with the introduction of the System8000. This system is a complete six-speaker package with front and rear satellites, a center channel speaker, and a 65-watt powered subwoofer. It features the Company's MagnaGuard-Registered Trademark- magnetic shielding and a DCD-TM- long excursion bass driver. The suggested retail price is $700 per system. The Company added two new models to its line of Compact Reference Series bookshelf speakers. The CR4 and CR5 are both smaller than a typical hardcover book, but offer smooth, wide-range sound. These new models are suited for use in small, high-quality music systems, as extension speakers or as an upgrade for speakers that are packaged with "shelf" audio systems. The CR4 and CR5 have suggested retail prices of $100 per pair and $150 per pair, respectively. The Company's new Digital MediaTheater-TM- desktop home theater system also debuted in fiscal 1999. Digital MediaTheater is a fully digital, self powered sound system for the personal computing environment. It uses Dolby Digital Decoding and Virtual Dolby to create a full 5.1 channel Dolby Digital sound experience for games, movies, music and other PC multimedia audio sources. The basic system includes two satellites and a hideaway subwoofer and has a suggested retail price of $299.95. Optional surround sound speakers are available for $50.00 a pair. In addition, the Company introduced the BA635 three-piece multimedia sound system. The system includes two diminutive desktop satellite speakers and a miniature hideaway subwoofer. It has quickly become one of the Company's best selling models. The suggested retail price is $99.95 per system. Introduced in fiscal 1999, the Company's new Designer Series DX Pro in-wall diffuse-field surround speaker is designed to be mounted flush with the wall surface. The DX Pro is designed to duplicate the performance of surround speakers in a movie theater, projecting sound along walls, ceilings, floors and other surfaces to provide a realistic three-dimensional sound field while remaining virtually invisible. DX Pro grilles and frames can be painted to match their surroundings. The suggested retail price is $500 per pair. In addition to the DX Pro, the Company added three additional new speakers to our popular Designer Series in fiscal 1999. Two of the new speakers are flush-mounted wall speakers--the Model 261, a 6 1/2-inch two way with a suggested retail price of $250per pair, and the Model 251, a 5 1/4-inch two way with a suggested retail price of $200 per pair. The third speaker, the Model 315, is a ceiling mounted speaker priced at $150 per pair and can be used to bring audio into hallways and small rooms, or to provide rear-channel surround in home theater systems. The Company also introduced in fiscal 1999, a completely new generation of its flagship ProSeries products for car audio enthusiasts. The ProSeries family is designed to handle high power without distortion and with accurate frequency response to produce detailed, clean sound. ProSeries components include woofers and distinctly small tweeters that can be mounted in a variety of places. These components can be installed in most stock factory locations without modifying car interiors, or in custom arrangements virtually anywhere in the vehicle. They have suggested retail prices ranging from $400 to $750 for the system. In addition to the ProSeries .5 component speakers, the Company also introduced completely redesigned 8-inch, 10-inch and 12-inch ProSeries .5 subwoofers for loud, undistorted bass sound in automotive environments and are priced from $220 to $300 each. In June 1996, the Company acquired the business of Snell-Registered Trademark- Acoustics ("Snell"), a manufacturer of high-quality speaker systems for traditional audio and home theater use. Snell specializes in creating furniture-quality speakers for discriminating customers. Snell's line of speakers includes products in four ranges - - compact speaker systems, floorstanding systems, in-wall speaker systems and THX home theater systems. Products range from $450 per pair for small bookshelf speakers, to $45,000 per system for a complete 7-speaker THX theater system with state-of-the-art digital room correction. ENGINEERING AND DEVELOPMENT The Company's engineering and development department is actively engaged in the development of new products and manufacturing processes, the improvement of existing products and the research of new materials for use in the Company's products. The Company designs all of its products and subassemblies, including those supplied by outside sources. The Company's engineering and development staff includes 59 full-time employees and three outside consultants. During fiscal years 1997, 1998 and 1999 the Company spent approximately, $3,187,000, $3,513,000 and $5,106,000, respectively, for engineering and development. MARKETING The Company employs 29 salespersons and retains 13 manufacturer's representatives who service the Company's dealer network. In addition, the Company retains the services of two freelance public relations consultants (one in the United States, one in Europe) to assist in the professional promotion of the Company and its products. Boston Acoustics' home audio, Designer Series (in wall/in ceiling models) and outdoor speaker products are distributed in the United States and Canada through approximately 551 selected audio or audio specialist retailers, some of whom have multiple outlets. The Company's car audio products are sold through approximately 332 similarly specialized retailers, some of whom also sell the Company's home audio products. The Company's dealers usually stock and sell a broad range of audio products including, in most cases, the Company's competitor's products. The Company seeks dealers who emphasize quality products and who are knowledgeable about the products they sell. The Company's Multimedia products are sold through an OEM agreement with Gateway, through the Company's retailers and via a direct Internet-based sales channel (www.bostondirect.com). During the fiscal year ended March 27, 1999 one customer accounted for 49% of net sales. Boston Acoustics' products are also exported to dealers in Canada and sold through exclusive distributors in over 50 foreign countries, primarily in Europe, Asia/Pacific and South/Central America. Export sales accounted for approximately 21% of net sales in fiscal 1997, 19% in fiscal 1998, and 14% in fiscal 1999. See also Note 7 to Consolidated Financial Statements incorporated herein by reference, pursuant to Part II, Item 8. The Company emphasizes the high performance-to-price ratio of its products in its advertising and promotion. Boston Acoustics believes that specialty retailers can be effective in introducing retail customers to the high dollar value of the Company's products. The Company directly supports its domestic dealers and international distributors via a cooperative advertising program, prepared advertisements, detailed product literature and point of purchase materials. The Company also regularly advertises in national specialist magazines including SOUND AND VISION, AUDIO, CAR AUDIO AND ELECTRONICS, CAR STEREO REVIEW, VIDEO, HOME THEATER and AUDIO VIDEO INTERNATIONAL. During fiscal 1999 the Company spent approximately $2,704,000 (2.3% of net sales) for advertising. COMPETITION The Company competes primarily on the basis of product performance, price and the strength of its dealer organization. The market for branded loudspeaker systems is served by many manufacturers, both foreign and domestic. Many products are available over a broad price range, and the market is highly fragmented and competitive. The Company distributes its products primarily through specialty retailers where it competes directly for space with other branded speaker manufacturers. Audio systems produced by many of the Company's competitors can be purchased by consumers through mass merchandisers, department stores, mail-order merchants, and catalogue showrooms. The Company believes it is more advantageous to distribute through specialty retailers who provide sales support and service to consumers. Boston Acoustics competes with a substantial number of branded speaker manufacturers, including Bose Corporation, Infinity and JBL (divisions of Harman International Industries), Advent (division of Recoton Corp.), Polk Audio, Inc., and Klipsch and Associates, Inc. Some of these competitors have greater technical and financial resources than the Company and may have broader brand recognition than Boston Acoustics. In addition to competition from branded loudspeaker manufacturers, the Company's products compete indirectly with single name "rack systems". Rack systems contain all the various components needed to form an audio system, and are sold by Sony, Pioneer, Technics, Yamaha and many others. Rack systems are generally sold through mass merchandisers and department stores, although many of the Company's dealers also sell rack systems. MANUFACTURING AND SUPPLIERS Most of the Company's products are assembled by the Company from components specially fabricated for the Company, although certain automotive speakers and multimedia audio systems are manufactured by others in certain foreign countries according to Company specifications. The Company purchases materials and component parts from approximately 274 suppliers located in the United States, Canada, Europe and the Far East. Although Boston Acoustics relies on single suppliers for certain parts, the Company could, if necessary, develop multiple sources of supply for these parts. The Company does not have long-term or exclusive purchase commitments. The Company does have a written agreement with one of its inventory suppliers, which accounted for more than 10% of the Company's purchases during fiscal year 1999. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--International Operations" which is included in the Company's 1999 Annual Report which is filed as Exhibit 13 hereto. SEASONALITY AND CONSUMER DISCRETION The home and automotive audio markets are both somewhat seasonal, with a majority of home speaker retail sales normally occurring in the period October through March and a majority of automotive speaker retail sales normally occurring in the period April through October. The Company's sales and earnings can also be affected by changes in the general economy since purchases of home entertainment and automotive audio products, including loudspeakers, are discretionary for consumers. PATENTS AND TRADEMARKS Boston Acoustics holds seven United States patents and numerous international patents, which relate to certain speaker technologies, assemblies and cabinet design. The Company also currently has several registered trademarks including Boston-Registered Trademark-, Boston Acoustics-Registered Trademark-, PowerVent-Registered Trademark-, Tempo-Registered Trademark-, Voyager-Registered Trademark-, and Runabout-Registered Trademark- . Trademarks used by the Snell subsidiary include Snell Acoustics, Snell Multimedia, Snell Music & Cinema and Room Ready-Registered Trademark-. The Company believes that its growth, competitive position and success in the marketplace are more dependent on its technical and marketing skills and expertise than upon the ownership of patent and trademark rights. There can be no assurance that any patent or trademark would ultimately be proven valid if challenged. SIGNIFICANT CUSTOMERS A significant portion of the Company's sales currently are to Gateway, Inc. ("Gateway") pursuant to a purchase agreement that extends through July 2, 1999. Since this purchase agreement with Gateway does not contain minimum or scheduled purchase requirements, purchase orders by Gateway may fluctuate significantly from quarter to quarter over the terms of the agreement. Although the Company expects Gateway to continue as a significant customer, the Company anticipates a decline in the quantity of products to be sold to Gateway in fiscal 2000. The loss of Gateway as a customer or any significant portion of orders from Gateway could have a material adverse affect on the Company's business, results of operation and financial condition. In addition, the Company also could be materially adversely affected by any substantial work stoppage or interruption of production at Gateway or if Gateway were to reduce or cease conducting operations. BACKLOG The Company currently has no significant backlog. The Company's policy is to maintain sufficient inventories of finished goods to fill all orders within two business days of receipt. WARRANTIES Boston Acoustics warrants its home speakers to be free from defects in materials and workmanship for a period of five years, its Designer Series speakers and its automotive speakers for one year and its multimedia audio speaker systems for a period of three years. During the years ended March 27, 1999, March 28, 1998 and March 29, 1997, warranty costs recorded by the Company were approximately $241,000, $193,000 and $232,000, respectively. EMPLOYEES As of June 24, 1999, the Company had 353 full-time employees who were engaged as follows: 219 in production and materials management; 59 in engineering and development; 49 in marketing and sales support; and 26 in administration. None of the Company's employees are represented by a collective bargaining agreement and the Company believes that its relations with its employees are satisfactory. EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning Andrew G. Kotsatos, who is Chairman of the Board, Chief Executive Officer and Treasurer of the Company, and Fred E. Faulkner, Jr., who is President and Chief Operating Officer of the Company, is incorporated herein by reference from the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held on August 10, 1999, under the headings "Proposal No. 1 -- Election of Directors" and "Board of Directors." Information concerning the Company's other executive officers as of June 24, 1999 is set forth below. Moses A. Gabbay has been Vice President - Engineering since joining the Company in 1981. Mr. Gabbay was previously Director of Engineering at Avid Corporation and an acoustic engineer for Teledyne Acoustic Research. Paul F. Reed was named Vice President - Administrative Services in May 1993. He has been with the Company since its inception in 1979. From production and shipping, Mr. Reed moved to sales in 1986 and, in 1989, became a Regional Sales Manager. He was named Director of Administrative Services in 1990. Debra A. Ricker-Rosato was named Vice President - Finance in May 1993. Prior to joining the Company in October 1986 as Controller, Ms. Ricker-Rosato was employed by Babco-Textron from 1975, a manufacturer of small aircraft engine components. Her last position with Babco-Textron was that of Assistant Controller. She holds an MSF degree from Bentley College. Robert L. Spaner was named Vice President - Sales in May 1993. He joined the Company in 1987 as a regional sales manager. In 1990 he became National Sales Manager. Mr. Spaner was formerly employed by Kloss Video as Western Regional Manager and worked six years in retail sales at Tweeter, Etc. Martin J. Harding was named Vice President - Marketing in November 1998. He joined the Company in 1996 as International sales manager. In 1997 he became Director of International Sales and Marketing. Mr. Harding previously held positions specializing in International sales and marketing with Casio, Celestion and NAD Electronics. Each executive officer is elected for a term scheduled to expire at the meeting of Directors following the Annual Meeting of Stockholders or until a successor is duly chosen and qualified. There are no arrangements or understandings pursuant to which any executive officer was or is to be selected for election or reelection. There are no family relationships among any Directors or executive officers, except that Paul F. Reed, an executive officer, and Lisa M. Mooney, a director, are brother and sister. ITEM 2. ITEM 2. PROPERTIES The Company owns its principal executive offices and manufacturing facilities which sits on 11 acres of land at 300 Jubilee Drive, Peabody, Massachusetts. Snell Acoustics ("Snell"), a subsidiary of the Company, leases all of the properties used in its business. Snell maintains its principal executive offices and manufacturing facilities at 143 Essex Street, Haverhill, Massachusetts. A total of 65,090 square feet of space is leased from an unrelated party under an operating lease which expires in September 1999. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings affecting the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of shareholders during the fourth quarter of fiscal 1999. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is incorporated by reference to the section entitled "Stock Market Activity" on page 21 in the Registrant's 1999 Annual Report to Stockholders, which is filed herewith as Exhibit 13. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is incorporated by reference to the section entitled "Selected Financial Data" on page 20 in the Registrant's 1999 Annual Report to Stockholders, which is filed herewith as Exhibit 13. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is incorporated by reference to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 6 through 10 in the Registrant's 1999 Annual Report to Stockholders, which is filed herewith as Exhibit 13. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is incorporated by reference to the section entitled "Quantitative and Qualitative Disclosures about Market Risk" on page 9 in the Registrant's 1999 Annual Report to Stockholders, which is filed herewith as Exhibit 13. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated by reference to the Consolidated Financial Statements at March 27, 1999 and notes thereto on pages 11 through 19 in the Registrant's 1999 Annual Report to Stockholders, which is filed herewith as Exhibit 13. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G (3) of Form 10-K and Instruction 3 to Item 401(b), the information required by this item concerning executive officers, including certain information incorporated herein by reference to the information appearing in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held on August 10, 1999 concerning Andrew G. Kotsatos, who is the Chairman of the Board, Chief Executive Officer and Treasurer of the Company, and Fred E. Faulkner, Jr., who is President and Chief Operating Officer of the Company, is set forth in Part I, Item 1, hereof, under the heading "Executive Officers of the Registrant". Information concerning Directors, including Messrs. Kotsatos and Faulkner, is incorporated by reference to the sections entitled "Proposal No. 1 -- Election of Directors", "Board of Directors" and "Compensation Interlocks and Insider Participation" in the Registrant's definitive Proxy Statement for its Annual Meeting of Stockholders to be held August 10, 1999. There is incorporated herein by reference to the discussion under "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held August 10, 1999 the information with respect to delinquent filings of reports pursuant to Section 16(a) of the Securities Exchange Act of 1934. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the sections entitled "Executive Compensation" in the Registrant's definitive Proxy Statement for its Annual Meeting of Stockholders to be held August 10, 1999. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the section entitled "Principal and Management Stockholders" in the Registrant's definitive Proxy Statement for its Annual Meeting of Stockholders to be held August 10, 1999. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the section entitled "Certain Relationships and Transactions" in the Registrant's definitive Proxy Statement for its Annual Meeting of Stockholders to be held August 10, 1999. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are included as part of this report: (1) FINANCIAL STATEMENTS The following consolidated financial statements are incorporated by reference to the Registrant's 1999 Annual Report to Stockholders: Report of Independent Public Accountants. Consolidated Balance Sheets as of March 28, 1998 and March 27, 1999. Consolidated Statements of Income for the three years ended March 27, 1999. Consolidated Statements of Shareholders' Equity for the three years ended March 27, 1999. Consolidated Statements of Cash Flows for the three years ended March 27, 1999. Notes to Consolidated Financial Statements. (2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules are filed as part of this report and should be read in conjunction with the consolidated financial statements: Report of Independent Public Accountants. Schedule II -- Valuation and Qualifying Account. Other financial schedules have been omitted because they are not required or because the required information is included in the Consolidated Financial Statements or notes thereto. (3) LISTING OF EXHIBITS * Indicates an exhibit which is filed herewith. + Indicates an exhibit which constitutes an executive compensation plan. # Indicates that portions of the exhibit have been omitted pursuant to an order granting a request for confidential treatment. ^ Indicates that portions of the exhibit have been omitted pursuant to a request for confidential treatment. - ------------------- (1) Incorporated by reference to the similarly numbered exhibits in Part II of File No. 33-9875. (2) Incorporated by reference to the similarly numbered exhibit in Item 14 of the Company's Annual Report on Form 10-K for the year ended March 27, 1993. (3) Incorporated by reference to the similarly numbered exhibit in Item 14 of the Company's Annual Report on Form 10-K for the fiscal year ended March 29, 1997. (4) Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for fiscal quarter ended June 28, 1997. (5) Incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 28, 1997. (6) Incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 28, 1997. (7) Incorporated by reference to Exhibit 10.A. to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended December 27, 1997. (8) Incorporated by reference to the similarly numbered exhibit in Item 14 of the Company's Annual Report on Form 10-K for the fiscal year ended March 30, 1996. (b) REPORTS ON FORM 8-K: No reports on Form 8-K were filed by the Registrant during the last quarter covered by this report, and no other such reports were filed subsequent to March 27, 1999 through the date of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Peabody, Commonwealth of Massachusetts, on the 29th day of June 1999. BOSTON ACOUSTICS, INC. (Registrant) BY: s/Andrew G. Kotsatos ----------------------------- Andrew G. Kotsatos Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

1064122_1999.txt

1064122_1999

1999

1064122

Item 1: BUSINESS General - -------- Scottish Annuity & Life Holdings, Ltd. ("Scottish Holdings", "we", "us", "our", or "the Company") completed its initial public offering ("IPO") on November 30, 1998. Scottish Holdings, and its wholly owned subsidiary, Scottish Annuity & Life Insurance Company (Cayman) Ltd. ("Scottish Insurance") were formed in 1998 as offshore companies principally to provide reinsurance of life and annuity products and to issue customized variable life insurance products to high net worth individuals and families. The Scottish Annuity Company (Cayman) Ltd. ("Scottish Annuity") , a Cayman Islands insurance company providing customized variable annuity products to high net worth individuals and families, was acquired by Scottish Holdings during 1999. Harbourton Reassurance, Inc. ("Harbourton"), a Delaware insurance company which is licensed in 15 states and admitted as a reinsurer in an additional 8 states, was also acquired during 1999 to provide us with a U.S. based platform to provide reinsurance products. We are in the process of changing Harbourton's name to Scottish Re (U.S.), Inc. In our reinsurance activities we seek to reinsure lines of business that are subject to significant reserve or capital requirements under regulatory and rating agency guidelines. We believe that, in response to heightened regulatory and rating agency scrutiny, insurers are increasingly seeking reinsurance as a means to improve earnings, risk-based capital or other financial ratios. We focus our reinsurance activities principally on accepting risk from U.S. insurers, although we also expect to target opportunities in the United Kingdom, Western Europe, Canada and Australia. In fiscal year 1999, our revenues from reinsurance activities were derived from the U.S. We provide both onshore and offshore solutions to primary insurers seeking non- traditional and traditional life reinsurance of annuity and life insurance business. Non-traditional reinsurance involves the transfer of investment risks associated with blocks of new and existing annuity type contracts, such as deferred annuities, payout annuities, funding agreements and similar contracts. Our traditional life reinsurance will focus on assuming risks associated with primary life insurance policies, both in force and new business. We expect to reinsure the following risks: (i) mortality and ancillary morbidity, (ii) investment, (iii) persistency, and (iv) expense. We will write reinsurance predominantly on a direct basis with primary life insurance companies, covering individual term life insurance policies, whole life insurance policies, universal life insurance policies, and joint and survivor insurance policies. We will limit our net liability on any one ordinary life risk up to $1.0 million. Through our variable products business, we are responding to what we believe are increasing demands of high net worth individuals and families for customized products for use as part of sophisticated estate planning strategies. For us, high net worth generally means individuals and families with a liquid net worth in excess of $10 million. We offer both variable universal life insurance policies and variable annuities. Variable life insurance offers a death benefit and a cash value component which is placed in a separate account and invested on behalf of the policyholder by a money manager. As a Cayman Islands insurance company, we have the flexibility to offer policies that permit the use of private independent money managers to manage the separate accounts and who utilize investment strategies not typically available in variable products issued to the general public. We will also seek to leverage our expertise with respect to variable life insurance products by offering structured life insurance products, such as corporate-owned life insurance, which target the deferred compensation market. Products Offered Reinsurance Reinsurance is an arrangement under which an insurance company, called the reinsurer, agrees to indemnify another insurance company, called the ceding company or cedent, for all or a portion of the insurance risks underwritten by the ceding company. It is standard industry practice for primary insurers to reinsure portions of their insurance risks with other insurance companies. This practice permits primary insurers to write insurance policies in amounts larger than they would be willing or able to retain. Reinsurers may also purchase reinsurance, or "retrocession" coverage, to limit their own risk exposure. We expect to assume risks from both primary insurers as well as reinsurers. We are focusing our reinsurance activities principally on the reinsurance of life insurance and annuity type products. For these products, we write reinsurance generally as coinsurance or modified coinsurance, whereby we assume all or a proportionate share of the liability for the reinsured business. Under coinsurance, ownership of the assets supporting the reserves is transferred to the reinsurer, whereas in modified coinsurance arrangements, the ceding company retains ownership of the assets supporting the reserves. Under a coinsurance or modified coinsurance arrangement, the reinsurer will generally share proportionately in all material risks inherent in the underlying policies. When we reinsure life insurance products, the reinsurance may also be structured on a yearly renewable term basis. Under the yearly renewable term structure, premium rates are generally adjusted annually based on the age and underwriting classification of each insured and the age of the policies and the reinsurer assumes only the mortality risk associated with the underlying policies. The reinsurer, under such treaties, agrees to indemnify the primary insurer for all or a portion of the risks associated with the underlying insurance policy in exchange for a reinsurance premium payable to the reinsurer. We may also enter into retrocessional reinsurance arrangements with other reinsurers, which operate in a manner similar to the underlying reinsurance treaty described above. Under retrocessional reinsurance arrangements, the reinsurer transfers a portion of the risk associated with the underlying insurance policy to the retrocessionaires. Each retrocessionaire in our current ordinary life pool reinsures a percentage of each risk that is retroceded to the pool. Each of the domestic participants in the pool is rated "A" or better by A.M. Best Company, Inc. ("A.M. Best"). Our reinsurance agreements will be written on an automatic treaty basis. The reinsurance may be solicited directly by us or through reinsurance intermediaries. An automatic treaty provides for a ceding company to cede contractually agreed-upon risks on specific blocks of business to a reinsurer. In addition, the reinsurance may be written on either: 1) a proportional basis under which a specified percentage of each risk in the reinsured class of risk is assumed by the reinsurer from the ceding company with the reinsurer receiving its proportion of the underlying premiums in proportion to such assumed risk; 2) or an excess of loss basis under which the reinsurer indemnifies the ceding company up to a contractually-specified amount for a portion of claims exceeding a specified retention amount in consideration of non- proportional premiums being paid. Variable Life Insurance and Annuities Variable life insurance and annuity products are "separate account" products under which the net premiums paid, after deducting expenses, including the costs of insurance, are placed in a separate account for the policyholder's benefit. Under Cayman Islands Law, assets held in a separate account are not subject to claims of the insurance company's general creditors. The cash values of this separate account are invested for the policyholder by a private independent money manager. Variable life insurance offers flexible premiums and a minimum death benefit in addition to providing a return linked to an underlying portfolio held in a separate account. Variable annuities provide tax-deferred growth of the contractholder's investment until earnings are withdrawn or periodic annuity payments begin. We do not provide any investment management or advisory services to any variable life policyholder. Our revenues earned from these policies consist of amounts assessed during the period against policyholders' separate account balances for mortality and expense fees and policy administration and surrender charges. Our variable life insurance and annuity contracts have no guaranteed rate of return on the cash values. The cash value varies based on the investment results on the policy's assets managed by the policy's private independent money manager. Marketing Under our marketing plan with respect to variable life insurance and annuity policies, we rely primarily on referrals by financial advisors, investment managers, private bankers, attorneys and other intermediaries in the U.S. to generate clients. None of these intermediaries represent us as agents or in any other capacity, nor do they receive any commissions or other remuneration from us for activities undertaken in the U.S. Our marketing plan with respect to our reinsurance business seeks to capitalize on the relationships developed by our executive officers and marketing staff with members of the actuarial profession and senior insurance company executives, at both primary insurers and other reinsurers. We target potential ceding insurers that we believe would benefit from our reinsurance products based on our analysis of publicly available information and other industry data. In addition, reinsurance transactions are often placed by reinsurance intermediaries, brokers and consultants. A significant component of our marketing program involves working with such third party marketers in an effort to maintain a high degree of visibility in the reinsurance marketplace. Underwriting Reinsurance The principal risk associated with our fixed annuity reinsurance activities is investment risk. Specifically, we are subject to the following: . asset value risk, which is the risk that invested assets supporting the reinsured business will decrease in value; . credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest; . reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than is necessary to match anticipated liabilities; and . disintermediation risk, which is the risk that we may have to sell assets at a loss to provide for policyholder withdrawals or to satisfy liabilities not otherwise properly matched. We may also be subject to mortality risk with respect to the fixed annuities we reinsure, although our exposure to such risk is expected to be generally immaterial as compared to the investment risk associated with these products. We may assume all of the liabilities under the fixed annuity contracts we reinsure, although, in certain circumstances, we may require the ceding company to retain a portion of such liabilities, typically not to exceed 10%. We also reinsure various forms of life insurance products, including universal, variable, term and whole life insurance. The primary risk under life insurance policies is mortality risk. Our Underwriting Guidelines with respect to reinsurance limit such risk to $1,000,000 per insured and we intend to reinsure, or retrocede, any liability for amounts in excess of $1,000,000 per insured in order to comply with such guidelines. Universal life insurance and similar interest-rate sensitive policies provide life insurance with adjustable rates of return based on applicable interest rates in effect from time to time. As a consequence, the risks reinsured by us may also include investment risks similar to those for fixed annuities. As with annuities, all life insurance policies are subject to surrender risk. Variable Life Insurance The principal risk associated with our variable life insurance policies is mortality risk. The death benefit provided by our variable life insurance policies varies based on the investment return of the underlying separate account of policy assets invested by the policy's private independent money manager. The difference between the value of the assets in the underlying separate account and the policy's stated death benefit, known as the "net amount at risk", represents a general liability. Fees are charged, based on the "net amount at risk", and increase with the age of the insured. In accordance with generally accepted accounting principles ("GAAP") no reserves are required other than the deposit liability as the Company fees are based on its expected mortality for the period charged. Mortality risk tends to be more stable when spread across large numbers of insureds. We expect that our variable life insurance policies, which provide substantial death benefits given expected initial premiums of at least $1.0 million for single premium policies and $500,000 for multiple premium policies, will be held by a relatively small number of high net worth policyholders. Consequently, our associated mortality risk exposure will be greater in the aggregate, and our probability of loss less predictable, than an insurer with a broader risk pool. Therefore, pursuant to our Underwriting Guidelines, we reinsure all of the mortality risk associated with our variable life insurance business. Our Underwriting Guidelines provide that any reinsurer to whom we cede business must have a financial strength rating of at least "A-" or higher from A.M. Best or an equivalent rating by another major rating agency. Investment Portfolio General We seek to generate attractive levels of investment income through a professionally managed investment portfolio. If we are unable to effectively manage our investment portfolio and the risks associated with such investments, our ability to support our variable life insurance and reinsurance businesses, and our results of operations and financial condition, will be adversely affected. Investment Guidelines Our investment activities are governed by the Investment Guidelines as approved by the Board of Directors. Our investment portfolio, excluding assets transferred and invested as part of any reinsurance transaction, principally consists of fixed income securities with a weighted average investment rating of "A". Although a fixed income security rated "A" by Standard & Poor's is somewhat susceptible to the adverse effects of changes in circumstances and economic conditions, however, the issuer's capacity to meet its financial commitment on the security is still strong. We do not invest in any fixed income securities in emerging markets or which are not rated by a major rating agency. The Investment Guidelines provide that we may purchase, among other things, securities issued by the United States government and its agencies and instrumentalities, securities issued by foreign governments if rated "A" or better by at least one major rating agency, certain asset backed securities, preferred stocks, mortgage backed securities and corporate debt securities (which may include convertible debt securities, but may not include payment-in- kind corporate securities), including fixed income securities that are rated below investment grade. The Investment Guidelines also provide that the fixed income investment portfolio may not be leveraged and that purchases of securities on margin and short sales may not be made without approval of the Board of Directors. We are exposed to two primary sources of investment risk on fixed income investments: credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest, and interest rate risk, relating to the market price and/or cash flow variability associated with changes in market interest rates. We seek to manage credit risk through industry and issuer diversification and asset allocation and interest rate risk through interest rate swaps and other hedging techniques. Our investments in fixed income securities that are rated below investment grade, are subject to greater risks than our investments in investment grade securities. The risk of loss of principal or interest through default is greater with lower-rated securities because they are usually unsecured and are often subordinated to an issuer's other obligations. Additionally, issuers of these securities frequently have higher debt levels which makes them more susceptible to adverse economic developments, individual corporate developments and rising interest rates could impair their ability to meet their financial commitments. Consequently, the market price of these securities may be quite volatile, and the risk of loss is greater. As a result, the Investment Guidelines provide that no more than 15% of our investment portfolio may be invested in fixed income securities that are rated below investment grade. We will manage the investment risks on the assets received from reinsurance transactions by matching anticipated payout patterns of the reinsurance liabilities. We invest such assets principally in fixed income and, to a lesser extent, equity securities. We may invest in foreign denominated securities to manage currency risk if the reinsurance transaction has a foreign currency component. We may also enter into interest rate swap and other hedging transactions in an effort to manage interest rate risks associated with such transactions. Although the total investment in derivatives may be substantial, any use of derivatives is expected to be incidental to our efforts to manage interest rate risk rather than a speculative investment. Any investment in equity securities (expected to be typically not more than 10% of the assets transferred to us in a reinsurance transaction) will be made in an effort to enhance our overall return on such assets. Investment Managers Our portfolio is managed by General Re-New England Asset Management, Inc. ("Gen Re") and Prudential Investment Corporation. Gen Re manages approximately 89% of our investment portfolio and Prudential Investment Corporation manages the balance. We expect that one or both of the Investment Managers will manage the investment of any assets transferred to us in any reinsurance transaction. Investment Oversight Our Board of Directors, from time to time, reviews our investment portfolio and the performance of our investment managers. The Board of Directors can approve exceptions to our Investment Guidelines and periodically reviews our Investment Guidelines in light of prevailing market conditions. The investment managers and our Investment Guidelines may be changed from time to time as a result of such reviews. Competition and Ratings The insurance and reinsurance industries are highly competitive. Most of the companies in such industries are significantly larger, and have operating histories and access to significantly greater financial and other resources than we do. Our variable products primarily compete with those issued by U.S. insurance companies. To the extent that our variable products provide for management of the underlying separate accounts by private independent money managers, our variable products compete with mutual funds and other investment or savings vehicles. We believe that the most important competitive factor affecting the marketability of our variable products is the degree to which these products meet customer expectations, in terms of low expenses, returns (after fees and expenses) and customer service. Competition in the reinsurance business is based on price, ratings, perceived financial strength and service. Because we currently rely on a small number of clients in both our variable products and reinsurance businesses and expect to continue to do so for the near future, such businesses are more susceptible to the adverse effects of competition. Insurance ratings are used by prospective purchasers of insurance policies as well as insurers and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers and reinsurers. In addition, a ceding company's own rating may be adversely affected by an unfavorable rating or the lack of a rating of its reinsurer. Duff & Phelps has assigned a rating of "A" and A.M. Best has assigned a Best Rating of "A-" (Excellent). These ratings have been assigned to Scottish Insurance and Harbourton. Duff & Phelps assigns an "A" rating to companies that it characterizes as having, in its opinion, high claims paying ability, average protection factors and an expectation of variability in risk over time due to economic or underwriting conditions. A.M. Best assigns an "A- " (Excellent) rating to companies that have, in its opinion, on balance, excellent financial strength, operating performance and market profile, as well as strong abilities to meet their ongoing obligations to policyholders. These ratings represent each rating agency's opinion of Scottish Insurance's and Harbourton's ability to meet its obligations to its policyholders. Scottish Annuity is unrated. Employees We currently employ forty-five full time employees. Regulation Cayman Islands Scottish Holdings is a holding company owning all of the outstanding Ordinary Shares of Scottish Insurance, Scottish Annuity, and Harbourton (through a Delaware holding company). Scottish Insurance and Scottish Annuity are subject to regulation as licensed insurance companies under Cayman Islands law. Scottish Insurance holds an unrestricted Class B insurance license under Cayman Islands Insurance Law and may therefore carry on an insurance business from the Cayman Islands, but may not engage in any Cayman Islands domestic insurance business. Scottish Annuity holds an unrestricted Class B license under Cayman Islands Insurance Law and may therefore carry on an insurance business from the Cayman Islands, but may not engage in any Cayman Islands domestic insurance business. Unless specifically exempted, a Cayman Islands insurance company must engage a licensed insurance manager operating in the Cayman Islands to provide insurance expertise and oversight. Scottish Insurance has been exempt from this requirement and Scottish Annuity has engaged International Risk Management (Cayman) Ltd. as its licensed insurance manager in the Cayman Islands. It is anticipated that Scottish Annuity will also be exempted from this requirement during 2000. In addition, under the Insurance Law, Cayman Islands insurance companies carrying on long term business (which includes the writing of life insurance policies) must hold all receipts in respect of its long-term business and earnings thereon in a separate long-term business fund. Payments from such long- term business fund may not be made directly or indirectly for any purpose other than those of the insurer's long-term business. Every Cayman Islands insurance company carrying on long-term business may establish any number of separate accounts in respect of premiums paid to it to provide (i) annuities on human life and (ii) contracts of insurance on human life, and such respective premiums shall be kept segregated one from the other and independent of all other funds of the Cayman Islands insurer, and, notwithstanding the provisions of any other written law to the contrary, are not chargeable with any liability arising from any other business of the insurer. The scope and the validity of the Cayman Islands law regarding separate accounts has not been tested in the courts of the Cayman Islands. United States and Other Jurisdictions Scottish Holdings, Scottish Insurance, and Scottish Annuity are not licensed to do business in any jurisdiction other than the Cayman Islands. The insurance laws of each state of the United States and of many foreign countries regulate the sale of insurance and reinsurance within their jurisdictions by alien insurers, such as Scottish Insurance and Scottish Annuity, that are not admitted to do business within such jurisdictions. With some exceptions, the sale of insurance within a jurisdiction where the insurer is not admitted to do business is prohibited. Scottish Insurance and Scottish Annuity conduct their insurance and reinsurance business through their executive offices in the Cayman Islands, and their personnel will not solicit, advertise, underwrite, settle claims or conduct other insurance or reinsurance activities in the United States or in any other jurisdiction where such activities are prohibited. All of Scottish Insurance's and Scottish Annuity's insurance, reinsurance, and annuity contracts are negotiated, executed, and issued, and all premiums will be received, at their offices in George Town, Grand Cayman or in such other offices outside the United States as Scottish Insurance or Scottish Annuity may establish or designate. Harbourton is a Delaware domestic life insurer. In total, Harbourton is licensed in 15 states and is also an authorized reinsurer in 8 additional states. As such, Harbourton is subject to individual state regulation and the requirements set forth by the National Association of Insurance Commissioners. Harbourton's principal office, which had been located in Aurora, Colorado prior to the acquisition by Scottish Holdings, has been relocated to Charlotte, North Carolina. Item 2: Item 2: PROPERTY We currently lease approximately 7,500 square feet of office space in George Town, Grand Cayman where our executive and principal offices are located. The base term of the lease is seven years. We also lease approximately 8,000 square feet of office space in Charlotte, North Carolina where Harbourton's principal offices are located. We also currently lease approximately 400 feet of office space in Denver, Colorado where Harbourton currently has temporary offices. Theses offices will be closed prior to July 2000. We believe that these properties are adequate to meet our needs for the foreseeable future. Item 3: Item 3: LEGAL PROCEEDINGS The Company is not currently involved in any litigation or arbitration. Item 4: Item 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS Scottish Holdings did not submit any matter to a vote of securities holders during the fourth quarter of the year covered by this Form 10-K. PART II Item 5: Item 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS A. Market for the Ordinary Shares The Ordinary Shares, par value $0.01 per share, of Scottish Holdings are quoted on the Nasdaq Stock Market National Market under the symbol "SCOT". The Ordinary Shares commenced trading on November 24, 1998. The high and low bid prices for the Ordinary Shares are shown below: As of March 24, 2000, Scottish Holdings had approximately twenty-six record holders of its Ordinary Shares. Approximately 14,180,250 Ordinary Shares are held in street name. Scottish Holdings did not pay any dividends in 1998. Cash dividends of $0.05 were paid each quarter by Scottish Holdings in 1999. Item 6: Item 6: SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the Consolidated Financial Statements, including the related notes, and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Item 7: Item 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General Scottish Holdings is an insurance holding company, and our principal assets include the ownership of Scottish Insurance, Harbourton and Scottish Annuity. Scottish Holdings was formed on May 12, 1998, and Scottish Insurance was formed on June 3, 1998, under the laws of the Cayman Islands. We commenced our insurance operations on November 30, 1998, immediately following our IPO. Harbourton was acquired effective as of September 30, 1999 and Scottish Annuity was acquired on December 31, 1999. Results of operations The following table summarizes our net income: *Date of incorporation Overview Our net income of $8,874,719 or $0.50 per share was driven by revenues from our investment portfolio and insurance administration fees. Our investment income in 1999 included $14,344,530 earned on our surplus and $9,723,710 earned in relation to our reinsurance activities. Comparisons to the prior period are not meaningful because of our limited period of operations after our November 1998 IPO. Investments Our investment portfolio is managed by two professional investment managers, Prudential Investment Corporation and Gen Re. Our investment guidelines are designed to diversify the portfolio to maximize investment income while minimizing risk. At December 31, 1999, the portfolio had an average quality rating of AA, an average duration of 2.98 years and an average book yield of 6.79%. At December 31, 1998, the portfolio had an average quality rating of AA+, an average duration of 3.67 years and an average book yield of 5.50%. Our fixed maturity portfolio increased from $178,520,719 to $546,806,744 principally as a result of the reinsurance transactions and acquisition of Harbourton. The duration of our portfolio was reduced from 3.67 years to 2.98 years as investments of short duration were acquired to match the duration of liabilities acquired through our reinsurance operations. The realized loss of $2,638,506 recorded for the year was due to portfolio restructuring. As at December 31, 1999 we had unrealized depreciation of $15.7 million, a result of the effect of the current interest rate environment on our fixed income portfolio. Insurance operations Our business consists of two lines of business, variable life insurance and annuities, and life and annuity reinsurance. Prior to the acquisition of Scottish Annuity, we provided a variety of insurance administration, accounting and other services to Scottish Annuity. During 1999, we wrote our first variable life insurance contracts and entered into several reinsurance treaties. The first treaty was a coinsurance transaction involving group long term disability claims for which we have established a reserve for policyholder benefits of approximately $104 million. This transaction involves a closed block of existing claims that were in effect as of June 1, 1999. The block consists of approximately 1,500 claimants who are receiving disability income payments. No additional claimants may be added. Further, our liability is limited to income benefit payments only and does not include any health, medical or other types of payments. Under our second reinsurance agreement, we contracted to reinsure up to $400 million of group funding agreement business. This transaction was structured so that reserves would be transferred in four separate $100 million tranches. Additionally, closing each tranch is subject to final approval by both parties. We closed on the two first tranches in July and August. Subsequently, in mutual agreement with the ceding company, we elected to delay taking down the third and fourth tranches. This decision does not reflect the quality of the reinsured business, but rather came as a result of adverse conditions in the overall market that were outside our control and that of the ceding company. As of December 31, 1999, we have not taken down the third and fourth tranches. As of year end, the business reinsured has perfomed as we had expected and, if market conditions permit, we will consider taking down the final two tranches. On October 15, 1999 we closed our acquisition of Harbourton. Harbourton provides us with a United States platform to write reinsurance business. Harbourton is licensed in 15 states and the District of Columbia and is an authorized reinsurer in an additional 8 states. Harbourton has approximately $83 million of annuity reinsurance in force as of year end 1999. Subsequent to year end, we have hired 26 reinsurance professionals to expand the reinsurance operations of Harbourton. While we expect to write short duration annuity reinsurance business in Harbourton, the principal focus of new business in Harbourton will be traditional life reinsurance. In addition, we are in the process of changing the name of Harbourton to "Scottish Re (U.S.), Inc.". We expect to have all required regulatory approvals for the name change by the end of the second quarter of 2000. In the fourth quarter we executed a letter of intent with Lincoln National Life Insurance Company, under which, beginning in February 2000, Scottish Insurance will reinsure a 50% share of the new fixed annuity business written by Lincoln and sold through financial institutions. The business, which is managed by First Penn-Pacific Life Insurance Company, is expected to generate $150 million of reinsurance reserves during 2000. The treaty has subsequently been executed, reinsuring business sold on or after February 15, 2000. However no assurance can be given that these expectations can be achieved. Effective December 31, 1999 we acquired ownership of Scottish Annuity, which has approximately $250 million of variable annuity business. We had previously provided insurance administration and accounting services to Scottish Annuity under an administration agreement. Outlook Our business consists of two lines of business, variable life insurance and annuity products, and annuity and life reinsuance. Both lines of business are designed to capitalize on our offshore location, which allows us to offer unique product features and competive pricing. During the past year, we entered into several reinsurance agreements and we are pricing and underwriting several more. In addition, the variable products business is beginning to grow more rapidly as we develop relationships with independent insurance brokers. Capital Resources and Liquidity At December 31, 1999, total capitalization was $218,661,081. In the third quarter we completed a stock repurchase program. At its conclusion, we had repurchased 2,529,700 shares for $24,999,234. On October 15, 1999 we completed our acquisition of Harbourton for $25,183,372. On December 31, 1999 we acquired Scottish Annuity for $11,601,464. We currently have no material commitments for capital expenditures and do not anticipate incurring material indebtedness other than letters of credit, which may be required in the ordinary course of our planned reinsurance business. During the year, we paid quarterly dividends of $928,822 or $0.05 per share, to the shareholders of record as at June 7, 1999 and September 6, 1999. We also paid $802,337 or $0.05 per share to shareholders of record as at December 6, 1999. We expect that our cash and investments, together with cash generated from our businesses, will provide sufficient sources of liquidity and capital to meet our needs for the next several years. In addition, we have access to a combined $70 million through available lines and letters of credit, none of which have been utilized to date. Year 2000 Risk Many computer programs used only two digits to identify a year in the date field prior to December 31, 1999. These programs, if not corrected, could have failed or created erroneous results by or at the year 2000. This "Year 2000" Issue was believed to affect virtually all companies and organizations, including us. Because most of our computer hardware and software is less than three years old, we believed that our exposure with respect to our own computer systems to Year 2000-related problems was not significant, and we encountered no Year 2000 related problems. We are continuing to monitor our systems and those of our primary suppliers of data. Changes in Accounting Standards The Financial Accounting Standards Board's Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities", was issued in June 1998 and requires adoption no later than fiscal quarters of fiscal years beginning after June 15, 2000. The new standard establishes accounting and reporting standards for derivative instruments. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. We have not yet completed our evaluation of the effect this standard will have on us. We do not currently own any securities that would be subject to this statement. Forward Looking Statements Some of the statements contained in this report are not historical facts and are forward-looking within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from the forward-looking statements. When used, the words "may," "will," "expect," "anticipate," "continue," "estimate," "project," "plan," "intend" and similar expressions identify forward-looking statements. These forward-looking statements involve risks and uncertainties including, but not limited to, the following: our ability to execute the business plan; changes in the general economic conditions including the performance of the financial markets and interest rates; changes in insurance regulations or taxes; changes in rating agency policy; the loss of key executives; trends in the insurance and reinsurance industries; government regulations; trends that may affect our financial condition or results of operations; and the declaration and payment of dividends. Potential investors are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties. Actual results may differ materially from those included within the forward-looking statements as a result of various factors. Factors that could cause or contribute to such differences include, but are not limited to, those described in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" and under the heading "Risk Factors of Investing in our Ordinary Shares" set forth below. We assume no obligation to update any forward-looking statement to reflect actual results or changes in or additions to the factors affecting such forward-looking statements. RISK FACTORS OF INVESTING IN OUR ORDINARY SHARES Investing in our Ordinary Shares involves a high degree of risk. Potential investors should consider carefully the following risk factors, in addition to the other information set forth in this Form 10-K, prior to investing in the Ordinary Shares. When used, the words "may," "will," "expect," "anticipate," "continue," "estimate," "project," "plan," "intend" and similar expressions identify forward-looking statements regarding among other things: (i) our business and growth plans; (ii) our relationship with third-party service providers and clients; (iii) trends in the insurance and reinsurance industries; (iv) government regulations; (v) trends that may affect our financial condition or results of operations; and (vi) the declaration and payment of dividends. Potential investors are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties. Actual results may differ materially from those included within the forward- looking statements as a result of various factors. Factors that could cause or contribute to such differences include, but are not limited to, those described below and under the heading "Management's Discussion and Analysis of Financial Condition and Plan of Operations" and elsewhere in this Form 10-K. Our Variable Life & Annuity Insurance Business Is Dependent Upon Referral Sources. We will not be successful in our variable life and annuity insurance business if we cannot get clients from referrals by financial advisors, investment managers, private bankers, attorneys and other intermediaries in the United States and elsewhere. Since Scottish Insurance and Scottish Annuity are not licensed or registered to do business in the U.S., these referral sources may not act as our agent, nor can they be compensated by us for any activities in the U.S. As a result, we cannot assure you that we will be able to effectively implement our insurance plans. We can, however, pay non-U.S. referral sources for activities undertaken outside the U.S. We expect to compensate referral sources based on a percentage of the revenue received from referrals. Subject to any regulatory limitations, we may provide referrals to persons or entities that provide referrals to us. We cannot assure you that we will receive a significant amount of referrals or, if so, that any referrals will result in actual sales of variable life and annuity insurance policies. Our Ability to Develop Our Reinsurance Business is Dependent Upon Building Relationships. We will not be successful in our non-traditional annuity and life reinsurance businesses if we cannot develop business primarily through relationships with reinsurance intermediaries, insurance consultants, members of the actuarial profession and senior insurance company executives. Our Reinsurance Business Targets a Competitive Market. The Scottish Insurance business plan for reinsurance activities provides that one of our principal targets is reinsuring blocks of in-force fixed annuities issued by insurers that are no longer actively writing these contracts or that want to lessen the reserve and capital requirements associated with these contracts. Another principal target is reinsuring new issues of fixed annuities. Reinsurance of new business can be used to increase capacity, lessen reserve and capital requirements, improve the competativeness of the product, improve the return to the insurance company, or some combination of the above. The Harbourton business plan primarily targets reinsurance of mortality risk associated with life insurance products issued by U.S. direct writers. While sales of life reinsurance have increased dramatically in recent years, the market is also well-established and competitive. As the business targets of both Scottish Insurance and Harbourton are addressed by several domestic and international reinsurers, we cannot be certain that it will meet our expectation. Our Ability to Develop Our Business Plan is Dependent Upon Maintaining Our Claims-Paying Ability Rating. Potential purchasers of insurance policies, insurers, reinsurers and insurance and reinsurance intermediaries use insurance ratings to assess the financial strength and quality of insurers and reinsurers. In addition, an unfavorable rating or the lack of a rating will adversely affect a company purchasing reinsurance. Although Duff & Phelps has assigned Scottish Insurance and Harbourton a claims-paying ability rating of "A" and A.M. Best has assigned both companies a rating of "A-" (Excellent), we cannot assure you that we will be able to maintain these ratings. If we are unable to maintain these ratings, we cannot assure you that we will be able to obtain similar claims-paying ability ratings from other major rating agencies. Changes in U.S. Tax Laws With Respect to Variable Annuities and Life Insurance Could Adversely Affect Our Product Sales The tax treatment afforded annuity and life insurance products (both variable and non-variable) by United States tax law is in many respects more favorable than the tax treatment of certain other investment alternatives, and is therefore a primary competitive feature of such products. Any material change in the current tax treatment of annuity or life insurance products, including the imposition of a "flat tax" or national sales tax in lieu of the current United States federal income tax structure, could adversely affect the market for variable annuities or life insurance products. In addition, elimination of the federal estate tax has been proposed from time to time. Were the federal estate tax to be eliminated, the sale of life insurance products could be adversely affected. The Clinton Administration's Fiscal Year 2000 Budget Proposal contains provisions that, if enacted into law, could adversely affect the sale of variable products. First, the Proposal would require the reporting of payments of more than $10,000 made to entities in "identified tax havens." It is not known if the Cayman Islands will be treated as an identified tax haven, but if so purchasers of variable policies issued by Scottish Insurance or Scottish Annuity will be required to provide certain information to the IRS. Second, the Proposal would require insurance companies to report to the IRS items of income and gain with respect to a "private separate account." Although the reporting requirements that would be imposed under this proposal would generally not apply to insurers that do not do business in the United States, the proposal indicates that the IRS might take the position that a United States taxpayer that is the owner of a variable contract that is based on a "private separate account" (i.e., the separate account supports only a small number of insurance or annuity contracts) will be treated as the owner of the assets held in the separate account for federal income tax purposes. Third, the Proposal would reduce or eliminate the tax advantages of "corporate-owned life insurance." Finally, the Proposal would eliminate the "Crummey" rule, pursuant to which certain gifts to trusts for the payment of life insurance premiums are treated as present interests that are eligible for the annual exclusion from the gift tax. The elimination of this rule would eliminate the primary and most efficient method of making premium payments by insurance trusts. Because we expect that insurance trusts will purchase our variable life insurance policies, or such policies will be contributed to trusts, to provide liquidity for estate taxes and to effect the transfer of assets from one generation to another, adoption of this proposal could adversely affect the sales of these policies, which could adversely affect our results of operation and our financial condition. In its most recent business plan, the IRS announced that it intends to issue guidance as to whether an annuity that is issued by an insurer that is not an "insurance company subject to tax under Subchapter L" (the provisions of the United States Internal Revenue Code that apply to insurance companies that do business in the United States) will be subject to the favorable tax treatment generally afforded annuity contracts, or instead will be treated as "debt instruments" that are not eligible for tax deferral. Were the IRS to adopt a rule or regulation treating annuities issued by Scottish Insurance or Scottish Annuity, which do not do business in the United States, as debt instruments, the market for such annuities could be adversely affected. Governmental Regulation Could Adversely Affect Our Business. Scottish Insurance and Scottish Annuity. Scottish Insurance and Scottish Annuity are licensed as unrestricted Class B insurers and are subject to regulation and supervision by the Cayman Islands Monetary Authority. They are not registered or licensed to do business in any jurisdiction in the United States or any other country. Generally, the sale of insurance within a jurisdiction where the insurer is not admitted to do business is prohibited. Under the operating guidelines, Scottish Insurance and Scottish Annuity do not operate in the United States or, to the extent prohibited, in any other country. We can give no assurance that inquiries or challenges to our insurance activities will not be raised in the future. Scottish Insurance's variable life insurance products have customized features that are not typically available from a company subject to those laws. If Scottish Insurance were to become subject to those laws, our business, results of operations and financial condition would likely be materially adversely affected. In the past, federal and state governments have proposed to regulate foreign insurers. While none of these proposals has been adopted, we cannot assure you that federal or state legislation will not be enacted subjecting our business to supervision and regulation in the United States. Our Reinsurance Business Could Be Adversely Affected By Uncertainties of Letters of Credit or Other Collateral Amounts. Because many jurisdictions do not allow insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless appropriate security measures are in place, we anticipate that our reinsurance clients will typically require us to post a letter of credit or provide other collateral through a funds withheld or trust arrangement. If we are unable to obtain a letter of credit facility on commercially acceptable terms or are unable to arrange for such other collateral, our ability to operate our reinsurance business will be severely limited. Our Products Carry With Them Inherent Insurance Industry Risks And Risks Specific to Our Business Plan. Life Reinsurance--Mortality Risk. The principal risk associated with our planned life reinsurance business is mortality risk. Harbourton will reinsure various forms of life insurance products including term life, universal life and traditional life insurance. Mortality risk typically is more stable when spread across large numbers of insureds. As our life reinsurance business grows, we will initially have a relatively small number of lives covered and as a result, our mortality risk exposure is likely to be larger, and our probability of loss less predictable, than an insurer with a larger risk pool. As a result, we cannot assure you that our actual mortality experience will be consistent with our pricing expectation. Mortality risk is also a factor in our variable life insurance product, however, currently we reinsure 100% of the mortality risk on all variable life policies. Fixed Annuity and Life Reinsurance--Investment Risk. The principal risk associated with our fixed annuity reinsurance activities is investment risk. Specifically, we are subject to the following risks: . the risk that invested assets supporting the reinsured business will decrease in value; . the credit risk that the continued ability of a given obligor to make timely payments of principal and interest; . the risk that interest rates will decline and funds reinvested will earn less than expected; and . the risk that we may have to sell assets at a loss to provide for policyholder withdrawals. Universal life insurance and similar policies sensitive to interest rates provide life insurance with adjustable rates of return based on applicable interest rates in effect from time to time. As a result, the risks with respect to reinsuring those kinds of policies may also include investment risks similar to those for fixed annuities. In addition, like annuities, life insurance policies and variable annuities are subject to surrender risk. Reinsurance Business--Ceding Insurer Risk. An additional risk associated with our reinsurance business is the risk that the ceding insurer will be unable to pay to us amounts due because of its own financial difficulties. We can give no assurance that the ceding insurers will be able to pay amounts due to us, which could have a material adverse effect on our business, results of operations or financial condition. In addition, we can give no assurance that the ceding companies will maintain appropriate interest crediting rates with respect to fixed annuities or interest rate-sensitive life insurance policies. Our Business is Dependent on Our Ability To Manage Risks In Our Investment Activities. Our fixed income investments are subject to the following two primary sources of investment risk: . credit risk, relating to the continued ability of a given obligor to make timely payments of principal and interest; and . interest rate risk, relating to the market price and/or cash flow variability associated with changes in market interest rates. We cannot assure you we will be able to effectively manage these risks. If we are unable to effectively manage these risks, our ability to support our planned variable insurance and reinsurance businesses, and our results of operations and financial condition, will be adversely affected. In addition, under our investment guidelines, we can invest up to 15% of our investment portfolio in below investment grade fixed income securities. While any investment carries some risk, the risks of investing in lower-rated securities are greater than the risks of investing in investment grade securities. In addition, we seek to invest the assets transferred to us to match our anticipated reinsurance liabilities. We expect to invest these assets in fixed income and, to a lesser extent, equity securities. We may invest in foreign denominated securities to manage currency risk if the coinsurance transaction involves foreign currency. We may also enter into interest rate swaps and other hedging transactions in an effort to manage interest rate risks. We can not assure you that we will successfully structure our investments so as to match our anticipated reinsurance liabilities. If our calculations are incorrect, or if we improperly structure our investments to match these liabilities, we could be forced to sell investments before they mature at a significant loss with the result that our assets may not be adequate to meet our needed reserves, which could adversely affect our business, results of operations and financial condition. Our Success May Be Affected by Foreign Currency Fluctuations. Our functional currency is the United States dollar. However, because a portion of our planned business, including premiums, may be in currencies other than United States dollars and because we may maintain a small portion of our investment portfolio in investments denominated in currencies other than United States dollars, we may have losses if we do not properly manage or otherwise hedge, our currency risks. We Have Limited Experience Competing With Established Companies in the Life Insurance and Reinsurance Industry. The life insurance and reinsurance industries are highly competitive and most of the companies in these industries are significantly larger, have operating histories and have access to significantly greater financial and other resources than we do. We have limited experience competing with these companies. Our Business Would Be Adversely Affected by the Imposition of or Increases in United States Taxes. As Cayman Islands companies, Scottish Insurance and Scottish Annuity, we operate in a manner so that we are not subject to United States tax, other than withholding tax on certain investment income from United States sources. However, the Internal Revenue Service could contend that we are conducting business in the United States. If the Internal Revenue Service were to prevail in that contention, we would be subject to United States tax at regular corporate rates on taxable income that is effectively connected with United States business plus an additional 30% "branch profits" tax on the income remaining after the regular tax, which could adversely affect our results of operation. Harbourton is a U.S. licensed insurance company and is therefore subject to United States tax at regular corporate tax rates on taxable income. Any increase in United States taxes on income in Harbourton could adversely affect our results of operation. Insurance and reinsurance premiums that will be paid to Scottish Insurance and Scottish Annuity will be subject to a U.S. excise tax to the extent the underlying risks are located in the United States. In addition, our investment income from United States sources could be subject to withholding tax. These taxes could be increased and other taxes could be imposed on our business, which could also adversely affect our results of operation. Owners of Our Ordinary Shares May in Certain Circumstances Be Exposed to Adverse Personal United States Tax Risks. Controlled Foreign Corporation Rules. Each "United States shareholder" of a "controlled foreign corporation" who owns shares in the controlled foreign corporation on the last day of its taxable year generally must include in his gross income for United States federal income tax purposes his pro-rata share of the controlled foreign corporation's "subpart F income," even if the subpart F income has not been distributed. For these purposes, any United States person who owns directly or indirectly 10% or more of our ordinary shares will be considered to be a "United States shareholder." In general, a foreign insurance company such as our subsidiary, Scottish Insurance, is treated as a controlled foreign corporation only if such "United States shareholders" collectively own more than 25% of the total combined voting power or total value of our stock for an uninterrupted period of 30 days or more during any year. We believe that, because of the anticipated dispersion of our share ownership among holders and because of the restrictions in our Articles of Association on transfer, issuance or repurchase of our ordinary shares, our shareholders will not be subject to treatment as "United States shareholders" of a controlled foreign corporation. In addition, because under the Articles of Association no single shareholder will be permitted to exercise 10% or more of our total combined voting power, our shareholders should not be viewed as "United States shareholders'" of a controlled foreign corporation for purposes of these rules. There can be no assurance, however, that these rules will not apply to our shareholders. Related Person Insurance Income Risks. If our related person insurance income, determined on a gross basis, were to equal or exceed 20% of our gross insurance income in any taxable year, and direct or indirect insureds and persons related to such insureds were directly or indirectly to own more than 20% of the voting power or value of our capital stock, a United States person who directly or indirectly owns our Ordinary Shares on the last day of the taxable year may be required to include in his income for United States federal income tax purposes the shareholder's pro-rata share of our related person insurance income for the taxable year, determined as if this income were distributed proportionately to the United States person at that date. Related person insurance income is generally underwriting premium and related investment income attributable to insurance or reinsurance policies where the direct or indirect insureds are United States shareholders or are related to United States shareholders of the insurance company issuing the policies. If we have related person insurance income, and all United States persons own 25% or more of the voting power or value of our shares, any shareholder who is a United States person who owns 10% or more of our shares and disposes of the shares would have any gain from the disposition generally treated as ordinary income to the extent of the shareholder's portion of our undistributed earnings and profits that were accumulated during the period that the shareholder owned the shares. The shareholder also will be required to follow certain reporting requirements, regardless of the amount of shares owned by the shareholder. These rules should not apply to sales of our shares because we are not directly engaged in the insurance business and because proposed United States Treasury regulations applicable to this situation appear to apply only in the case of shares of corporations that are directly engaged in the insurance business. We can give no assurances however, that the IRS will interpret the proposed regulations in this manner or that the proposed regulations will not be promulgated in final form in a manner that would cause these rules to apply to dispositions of Ordinary Shares. Passive Foreign Investment Company Risks. You will have adverse United States federal income tax consequences if we are deemed a "passive foreign investment company." In general, a foreign corporation is a passive foreign investment company if 75% or more of its income constitutes "passive income" or 50% or more of its assets produces passive income. "Passive income" generally includes interest, dividends and other investment income. However, "passive income" does not include income "derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business." This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent this income is attributable to financial reserves in excess of the reasonable needs of the insurance business. Because we intend to continue to be in the insurance business and do not intend to have financial reserves in excess of the reasonable needs of our insurance business, we do not expect to be a "passive foreign investment company." We can give no assurance, however, that the IRS or a court will agree in this view. Our Ability to Pay Dividends Is Dependent on the Success of Our Subsidiaries and Regulatory Constraints. We are a holding company engaged in the variable insurance and reinsurance business through our wholly owned subsidiaries, Scottish Insurance, Scottish Annuity, and Harbourton. Our principal source of income is dividends paid to us by our subsidiaries. The payment of dividends is at the discretion of our Board of Directors and depends largely on the ability of our subsidiaries to pay dividends to us. Scottish Insurance and Scottish Annuity are subject to Cayman Islands regulatory constraints which also affect their ability to pay dividends to us. Specifically, Scottish Insurance and Scottish Annuity must keep enough capital to support its variable insurance and reinsurance businesses and comply with restrictions under Cayman Islands insurance corporate law. Accordingly, there is no assurance that dividends will be declared or paid in the future. Our Articles of Association Contain Substantial Limitations on Ownership, Transfers and Voting Rights. Except as described below with respect to the purchase and sale of our shares on the Nasdaq National Market, our Articles of Association require our directors to decline to register any transfer of our shares if they believe that the transfer would result in a person (or any group of which such person is a member) beneficially owning, directly or indirectly, 10% or more of our outstanding shares. Similar restrictions apply to our issuance and repurchase of shares. The directors also may, in their absolute discretion, decline to register the transfer of any shares if they believe that the transfer may expose us, any subsidiary or shareholder or any person insured or reinsured or proposing to be insured or reinsured by us to adverse tax or regulatory treatment or if they believe that registration of the transfer under any federal or state securities law or under the laws of any other jurisdiction is required and the registration has not been done. A transferor of Ordinary Shares will be deemed to own the shares for dividend, voting and reporting purposes until a transfer of the shares has been registered on our Register of Members. We are authorized to request information from any holder or potential acquirer of our shares as necessary and may decline to register any transaction if we do not receive complete and accurate information. Our directors will not decline to register any transfer of our shares executed on the Nasdaq National Market. However, if any transfer results in the transferee (or any group) beneficially owning, directly or indirectly, 10% or more of any class of shares or causes our directors to have reason to believe that a transfer may expose us, any subsidiary or shareholder thereof or any person insured or reinsured or proposing to be insured or reinsured to adverse tax or regulatory treatment in any jurisdiction, under our Articles of Association, the directors have the power to deliver a notice to the transferee demanding that the transferee surrender to an agent, designated by the directors, certificates representing the shares and any dividends or distributions that the transferee has received as a result of owning the shares. A transferee who has resold the shares before receiving this notice will be required to transfer to the agent the proceeds of the sale, to the extent such proceeds exceed the amount that the transferee paid for such shares, together with any dividends or distributions that the transferee received from us. As soon as practicable after receiving the shares and any dividends or distributions that the transferee received, the agent will use its best efforts to sell the shares and any non-cash dividends or distributions to the extent tradeable as market securities in an arm's-length transaction on the Nasdaq National Market. After applying the proceeds from such sale toward reimbursing the transferee for the price paid for such shares, the agent will pay any remaining proceeds and any cash dividends and distributions to organizations described in Section 501(c)(3) of the Code that the directors designate. The proceeds of any such sale by the agent or the surrender of dividends or distributions will not inure to our benefit or the agent's benefit, but the amounts may be used to reimburse expenses incurred by the agent in performing its duties. In addition, the Articles of Association generally provide that any person (or any group) holding 10% or more of the total voting rights of all of our outstanding capital shares, will have the voting rights of its voting shares reduced so that the person (or group) may not exercise more than approximately 9.9% of the total voting rights. Because of the attribution provisions of the U.S. tax code and the rules of the Securities and Exchange Commission regarding determination of beneficial ownership, this requirement may have the effect of reducing the voting rights of a shareholder whether or not the shareholder directly holds of record 10% or more of the voting shares. The directors also have the authority to request from any shareholder certain information for the purpose of determining whether such shareholder's voting rights are to be reduced. If the shareholder fails to respond to the notice, or submits incomplete or inaccurate information, the directors (or their designee) have the discretion to disregard all votes attached to the shareholder's Ordinary Shares. Our Articles of Association and Cayman Islands Confidentiality Laws Have Anti- takeover Effects. Our Articles of Association contain provisions that make it more difficult to acquire control of us by means of a tender offer, open market purchase, a proxy fight or otherwise, including by reason of the limitation on transfers of Ordinary Shares and voting rights described above. While these provisions are designed to encourage persons seeking to acquire control to negotiate with our Board of Directors, they could have the effect of discouraging a potential purchaser from making a tender offer or otherwise attempting to obtain control. Cayman Islands law restricts disclosure of, among other things, shareholder lists. Accordingly, such laws may make the acquisition of control by means of a tender offer or proxy fight more difficult. Item 7A: Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our qualitative discussion about market risk is contained in the following sections: . Business--Underwriting; . Business--Investment Portfolio; . Management's Discussion and Analysis of Financial Condition and Results of Operations; . Risk Factors of Investing in Our Ordinary Shares--Our Products Carry With Them Inherent Industry Risks and Risks Specific to Our Business Plan; . Risk Factors of Investing in Our Ordinary Shares--Our Business is Dependent on Our Ability to Manage Risks in Our Investment Activities; and . Risk Factors of Investing in Our Ordinary Shares--Our Success May be Affected by Foreign Currency Fluctuations. Quantitative Market risk relates to those financial instruments that are sensitive to changes in interest rates, foreign exchange rates and equity price. Scottish Holdings' portfolio is principally composed of fixed maturity bond investments. These investments, by their nature, are subject to market value changes in relation to interest rate changes. Interest Rate Risk Scottish Holdings could incur losses on securities if it were required to liquidate during periods of volatile movements in interest rates. The Company attempts to mitigate its exposure to adverse interest rate movement through asset/liability duration matching exercises, and by staggering the maturities of its fixed income investments to assure sufficient liquidity to meet its obligations and to address reinvestment risk considerations. Sensitivity Anaylsis Scottish Holdings regularly conducts various analyses to gauge the financial impact of changes in interest rates on its financial condition. Quantitative Disclosure of Interest Rate Risk The following table represents a summary of the par values of the Company's financial investments at their expected maturity dates, the weighted average coupons by those maturity dates and the estimated fair value of those instruments for the period ended December 31, 1999. The expected maturity categories take into consideration par amortization (for mortgage backed securities), call features and sinking fund features. The estimated market value of available-for-sale securities is based on bid quotations from security dealers or on bid prices published in news quote services. December 31, 1999 market interest rates were used as discounting rates in the estimation of fair value. (Dollars in millions, except average interest rate) Item 8: Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this item is set forth in "Item 14: Exhibits, Financial Statements and Reports on Form 8-K". Item 9: Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There are no changes in or disagreements with accountants on accounting and financial disclosure for the fiscal year ended December 31, 1999. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information required by this item 10 will be set forth in the Company's Proxy Statement for its 2000 Annual Meeting of Shareholders (the "2000 Proxy Statement") under the captions "Proposal for Election of Directors," "Principal Shareholders and Management Ownership" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference. Item 11. Item 11. EXECUTIVE COMPENSATION The information required by this Item 11 will be set forth in the 2000 Proxy Statement under the captions "Management Compensation" and "Report on Executive Compensation" and is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 will be set forth in the 2000 Proxy Statement under the caption "Principal Shareholders and Management Ownership" and is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 will be set forth in the 2000 Proxy Statement under the caption "Certain Transactions" and is incorporated herein by reference. PART IV Item 14: Item 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: (1) Consolidated Financial Statements of Scottish Annuity & Life Holdings, Ltd.: Report of Management Report of Independent Auditors Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Comprehensive Loss Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (2) Consolidated Financial Statement Schedules All financial statement schedules are omitted because they are either not applicable or the required information is included in the balance sheet or notes thereto appearing elsewhere in this Registration Statement. (3) Exhibits Except as otherwise indicated, the following Exhibits are filed herewith and made a part hereof: Exhibit Number Description of Document - ------- ----------------------------------------------------------------- 3.1 Memorandum of Association of the Company (incorporated herein by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 3.2 Articles of Association of the Company (incorporated herein by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.1 Specimen Ordinary Share Certificate (incorporated herein by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.2 Form of Amended and Restated Class A Warrant (incorporated herein by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.3 Form of Amended and Restated Class B Warrant (incorporated herein by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.4 Form of Securities Purchase Agreement for the Class A Warrants (incorporated herein by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.5 Form of Warrant Purchase Agreement for the Class B Warrants (incorporated herein by reference to Exhibit 4.5 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.6 Form of Registration Rights Agreement for the Class A Warrants (incorporated herein by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.7 Form of Registration Rights Agreement for the Class B Warrants (incorporated herein by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.8 Form of Securities Purchase Agreement between the Company and the Shareholder Investors (incorporated herein by reference to Exhibit 4.10 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.9 Form of Registration Rights Agreement between the Company and the Shareholder Investors (incorporated herein by reference to Exhibit 4.11 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.10 Form of Securities Purchase Agreement between the Company and the Non-Shareholder Investors (incorporated herein by reference to Exhibit 4.12 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.11 Form of Registration Rights Agreement between the Company and the Non-Shareholder Investors (incorporated herein by reference to Exhibit 4.13 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.1 Employment Agreement dated June 18, 1998 between the Company and Michael C. French (incorporated herein by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.2 Second Amended and Restated 1998 Stock Option Plan effective October 22, 1998 (incorporated herein by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.3 Form of Stock Option Agreement in connection with 1998 Stock Option Plan (incorporated herein by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.4 Agreement dated June 30, 1998 between the Company and International Risk Management (Cayman) Ltd. (incorporated herein by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.5 Amended and Restated Insurance Administration, Services and Referral Agreement dated as of October 1, 1998 between the Company and The Scottish Annuity Company (Cayman) Ltd. (incorporated herein by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.6 Employment Agreement dated July 20, 1998 between the Company and Henryk Sulikowski (incorporated herein by reference to Exhibit 10.10 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.7 Form of Indemnification Agreement between the Company and each of its directors and officers (incorporated herein by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.8 Investment Management Agreement dated October 22, 1998 between the Company and Pacific Investment Management Company (incorporated herein by reference to Exhibit 10.13 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.9 Investment Management Agreement dated October 22, 1998 between the Company and General Re-New England Asset Management, Inc. (incorporated herein by reference to Exhibit 10.14 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.10 Agreement dated October 23, 1998 between the Company and Westport Partners (Bermuda), Ltd. (incorporated herein by reference to Exhibit 10.15 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.11 Investment Management Agreement dated October 22, 1998 between the Company and The Prudential Investment Corporation (incorporated herein by reference to Exhibit 10.16 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.12 Form of Omnibus Registration Rights Agreement (incorporated herein by reference to Exhibit 10.17 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.13 Investment Advisory Service between the Company and Prudential Securities Corporation (incorporated herein by reference to Exhibit 10.15 to the Company's Registration Statement on Form 10-K filed with the Securities Exchange Commission on March 30, 1999). 10.14 1999 Stock Option Plan. 10.15 Form of Stock Options Agreement in connection with 1999 Stock Option Plan. 10.16 Employment Agreement dated March 08, 2000 between the Company amd Scott E. Willkomm. 21.1 Subsidiaries of Registrant. 24.1 Powers of Attorney. 27.1 Financial Data Schedule. (b) Reports on Form 8-K (1) The Company filed a Report on Form 8-K on November 1, 1999 to report that the Company acquired, through a wholly owned subsidiary, all of the issued and outstanding shares of common stock of Harbourton Reassurance, Inc. (2) The Company filed a Report on Form 8-K/A on December 22, 1999 to file the financial statements of Harbourton Reassurance, Inc. and the Pro Forma Combined Condensed Financial Statements. Scottish Annuity & Life Holdings, Ltd. Consolidated Financial Statements For the Year Ended December 31, 1999 and the Period from May 12, 1998 (date of incorporation) to December 31, 1998 with Report of Independent Auditors Scottish Annuity & Life Holdings, Ltd. Report of Management Management of the Company has primary responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The consolidated financial statements included in this report were prepared in accordance with accounting principles generally accepted in the United States applied on a consistent basis. The consolidated financial statements include amounts that are based on management's best estimates and judgements. Management also prepared the other information presented in the annual report and is responsible for its accuracy and consistency with the consolidated financial statements. Management of the Company has established and maintains a system of internal controls designed to provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition and the prevention and detection of fraudulent financial reporting. The Company's consolidated financial statements have been audited by independent auditors. The independent auditors had unrestricted access to each member of management in conducting their audit. Management has made available to the independent auditors all of the Company's financial records and related data, as well as the minutes of shareholders' and directors' meetings. Management believes that all representations made to the independent auditors during their audits were valid and appropriate. The Audit Committee of the Board of Directors is comprised of certain directors who are neither employees nor officers of the Company. The Audit Committee meets periodically with management and independent auditors regarding independent audit scope, timing, results and to discuss other auditing and financial reporting matters. The independent auditors have direct access to and meet privately with the Audit Committee. Scott Willkomm President Bruce J. Crozier Senior Vice President and Chief Financial Officer Report of Independent Auditors To the Shareholders and Board of Directors Scottish Annuity & Life Holdings, Ltd. We have audited the accompanying consolidated balance sheets of Scottish Annuity & Life Holdings, Ltd. and subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of income, comprehensive loss, shareholders' equity, and cash flows for the year ended December 31, 1999 and for the period from May 12, 1998 (date of incorporation) through December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scottish Annuity & Life Holdings, Ltd. and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for the year ended December 31, 1999 and for the period from May 12, 1998 (date of incorporation) to December 31, 1998 in conformity with accounting principles generally accepted in the United States of America. /s/ Ernst & Young George Town, Grand Cayman British West Indies March 22, 2000 Scottish Annuity & Life Holdings, Ltd. Consolidated Balance Sheets (Stated in United States Dollars) See accompanying notes to consolidated financial statements Scottish Annuity & Life Holdings, Ltd. Consolidated Statements of Income (Stated in United States Dollars) * the period from May 12, 1998 (date of incorporation) to December 31, 1998 See accompanying notes to consolidated financial statements Scottish Annuity & Life Holdings, Ltd. Consolidated Statements of Comprehensive Loss (Stated in United States Dollars) * the period from May 12, 1998 (date of incorporation) to December 31, 1998 See accompanying notes to consolidated financial statements Scottish Annuity & Life Holdings, Ltd. Consolidated Statements of Shareholders' Equity (Stated in United States Dollars) * the period from May 12, 1998 (date of incorporation) to December 31, 1998 See accompanying notes to consolidated financial statements Scottish Annuity & Life Holdings, Ltd. Consolidated Statements of Cash Flows (Stated in United States Dollars) * the period from May 12, 1998 (date of incorporation) to December 31, 1998 See accompanying notes to consolidated financial statements Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements December 31, 1999 1. Organization, business, and basis of presentation Organization Scottish Annuity & Life Holdings, Ltd. ("Scottish Holdings") was incorporated as an exempted company with limited liability on May 12, 1998 under the laws of the Cayman Islands. Scottish Holdings has been organized to provide annuity contracts and insurance policies, as discussed below, through its wholly-owned subsidiaries, Scottish Annuity & Life Insurance Company (Cayman) Ltd. ("Scottish Insurance"), The Scottish Annuity Company (Cayman) Ltd. ("Scottish Annuity"), Scottish Holdings, Inc. ("SHI"), and Harbourton Reassurance, Inc. ("Harbourton") (collectively referred to as the "Company", and additionally referred to as "we", "our", and "us"). Prior to June 24, 1998, Scottish Holdings, Ltd. ("SHL"), a Cayman Islands company, owned all Ordinary Shares of Scottish Holdings. On July 8, 1998, Scottish Insurance received an unrestricted Class 'B' insurer's license under the insurance laws of the Cayman Islands. Scottish Holdings' initial public offering of its Ordinary Shares (the "IPO") was completed on November 30, 1998. Scottish Annuity was acquired by Scottish Holdings on December 31, 1999. The Company operates as an insurance company and engages in writing deferred variable annuities with a fixed annuity option with persons who are not resident in the Cayman Islands. Scottish Annuity also operates under the provision of an unrestricted Class `B' insurer's license under the insurance laws of the Cayman Islands. Scottish Holdings also acquired Harbourton (a U.S. based reinsurer) effective on September 30, 1999. Harbourton provides us with a United States platform to write insurance business. Harbourton is licensed in 15 states and the District of Columbia and is an authorized reinsurer in an additional 8 states. Business Our business activities currently consists of fee income from the administration of variable annuities for Scottish Annuity (prior to its acquistion) and includes life and annuity reinsurance and sales of variable life insurance policies. Variable life insurance is a separate account product where the net premium is placed in a separate account for the policyholder that is not subject to the claims of the Company's general creditors. Our product is targeted towards high net worth individuals or families generally worth more than $10 million. A private money manager manages the cash values. We do not provide any investment management or advisory services to any individual variable life policyholder. We also offer variable life insurance products to corporate customers in the form of corporate owned life insurance, bank owned life insurance, and trust-owned life insurance. These types of policies are primarily used in connection with certain deferred compensation and bonus plans for executives. We also offer variable life insurance policies under a group policy that is owned by an employer to fund employee benefits. Traditional reinsurance of life and annuity business is an arrangement under which an insurance company (the reinsurer) agrees to insure (assume risks of) another insurance company (the ceding company or cedent) for all or a portion of the insurance underwritten by the ceding company. Our reinsurance activities primarily focus on group and individual life and annuity type contracts. Basis of presentation Accounting Principles - Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") and all amounts are reported in United States dollars. We follow the accounting standards established by the Financial Accounting Standards Board and the American Institute of Certified Public Accountants. Consolidation - We consolidate our results and have eliminated all significant intercompany transactions. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 1. Organization, business, and basis of presentation (continued) Estimates, risks and uncertainties - The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported on the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Our most significant assumptions are for assumed reinsurance liabilities. We review and revise these estimates as appropriate. Any adjustments made to these estimates are reflected in the period the estimates are revised. 2. Summary of significant accounting policies As previously stated the consolidated financial statements are prepared in accordance with GAAP. The following are the significant accounting policies adopted by the Company: Investments - Fixed maturities are classified as available for sale, and accordingly, we carry these investments at fair values on our consolidated balance sheets. The cost of fixed maturities is adjusted for prepayments and the amortization of premiums and discounts. The unrealized appreciation (depreciation) is the difference between fair value and amortized cost and is recorded directly to equity with no impact to net income. The change in unrealized appreciation (depreciation) is included in accumulated other comprehensive loss, unrealized depreciation on investments. Short-term investments are carried at cost, which approximates fair value. Realized gains (losses) on securities are determined on a specific identification method which means that we track the cost of each security purchased so that we are able to identify and record a gain or loss when it is subsequently sold. In addition, declines in fair value that are determined to be other than temporary are included in realized gains (losses). Investment transactions are accounted for on a trade date basis. Interest is recorded on the accrual basis. Insurance administration fees - We collected insurance administration fees for the administration of a variable annuity book of business, which was written by Scottish Annuity. These fees are recognized ratably over the year based on the fair value of the underlying investments. (See note 11 for further discussion.) Due from brokers - Due from brokers includes amounts receivable from our brokers for investment transactions that have not settled at year end. Organizational and offering expenses - All formation and organization costs incurred have been expensed in the period ending December 31, 1998. All offering costs incurred in connection with the IPO, including certain amounts payable for investment banking and financial advisory services, have been deducted from the gross proceeds of the IPO. Cash and cash equivalents - Cash and cash equivalents include fixed deposits with an original maturity, when purchased, of three months or less. Cash and cash equivalents are recorded at face value, which approximates fair value. Policy revenues and related expenses - Our policy revenues are generated from reinsurance and variable life activities. The reinsurance revenues are derived from interest sensitive life products and traditional life reinsurance. The premium on interest sensitive products is reported as a deposit on the consolidated balance sheet with a corresponding liability. Revenues are reported periodically for the mortality, policy administration and surrender charges. The related policy benefits and claims expenses include benefit claims incurred in excess of deposits and interest credited to the policyholder for the period. The premiums from traditional reinsurance transactions are included in revenues over the premium paying period of the underlying policies. The related policy benefits and expenses are provided against the revenues to recognize profits over the estimated lives of the policies. Variable life insurance policies are also interest sensitive products and are reported like the reinsurance interest rate sensitive products except that the assets are reported in a separate account for the benefit of the policyholder. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 2. Summary of significant accounting policies (continued) Deferred policy acquisition costs - The costs of acquiring new business such as commissions, certain internal expenses related to policy issuance and underwriting departments, and certain variable selling expenses are capitalized and amortized in future periods. For variable life insurance and reinsurance of investment type fixed annuity contracts and reinsured variable annuity contracts, deferred policy acquisition costs will be amortized over the expected average life of the contracts as a constant percentage of the present value of estimated gross profits arising principally from investment results, mortality and expense margins, and surrender charges based on historical and anticipated future experience, which will be updated at the end of each accounting period. In computing amortization, interest will accrue to the unamortized balance of capitalized acquisition costs at the rate used to discount expected gross profits. The effect on the amortization of deferred policy acquisition costs of revisions to estimated gross profits will be reflected in earnings in the period such estimated gross profits are revised. For reinsured fixed immediate annuity policies and traditional life insurance contracts, deferred policy acquisition costs are charged to expense using assumptions consistent with those used in computing policy reserves. Assumptions as to anticipated premiums are estimated at the date of the policy issuance and are consistently applied during the life of the policies. Deviations from estimated experience are reflected in earnings in the period such deviations occur. For these policies, the amortization periods generally are for the estimated lives of the policies. When the liabilities for future policy benefits plus the present value of expected future gross premiums for a policy are insufficient to provide for expected future benefits and expenses for that policy, a premium deficiency reserve will be established by a charge to income. Present value of inforce business - The present value of the inforce business will be amortized over the expected life of the business at the time of acquisition. The amortization each year will be a function of the gross profits each year in relation to the total gross profits expected over the life of the business, discounted at the assumed net credit rate. Fixed assets and leasehold improvements - Fixed assets and leasehold improvements are recorded at cost and are depreciated over their estimated useful lives using the straight-line method. Policyholders' benefit liabilities - The liabilities for interest sensitive products equal the accumulated account values of the policies or contracts as of the valuation date. Liabilities for future benefits under traditional life insurance contracts reinsured are estimated using actuarial assumptions for mortality, morbidity, terminations, investment yields, and expenses applicable at the time the insurance contracts were entered into. Benefit liabilities for fixed annuities during the accumulation period equal their account values and, after annuitization equal the accumulated present value of expected future payments. Separate account assets and liabilities - Separate account investments are recorded at the net asset values of the underlying funds invested in plus separate cash and cash equivalent balances, less separate account fees payable to the Company. The funds in the separated accounts are not part of the Company's general funds and are not available to meet the general obligations of the Company. Separate account liabilities are the amounts set aside to pay the deferred variable annuities. They consist of the initial premiums paid after consideration of the net investment gains/losses attributable to each separate account, less fees and withdrawals. Separate account fees - Scottish Annuity charges separate account fees quarterly in advance. Such fees are recognized into income ratably. Separate account fees consist of Mortality, Expense and Distributions Risk Charges, Set-Up, and Maintenance and Supervisory Fees based on total assets in each contract holder's separate account. During 1996, Scottish Annuity ceased charging Maintenance and Supervisory Fees to substanially all contract holders and added an annual flat fee for contract administration. In addition, a contract holder may be charged a fee upon a partial or total surrender of the policy. Fair value of financial instruments - The fair value of the consolidated balance sheets which qualify as financial instruments under Statement of Financial Accounting Standards ("SFAS") No. 107 "Disclosure About Fair Value of Financial Instruments", approximates the carrying amount presented in the consolidated financial statements. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 2. Summary of significant accounting policies (continued) Accounting Standards - The Financial Accounting Standards Board has issued the following accounting standard that will affect us. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", was issued in June 1998 and requires adoption no later than fiscal quarters of fiscal years beginning after June 15, 2000. The new standard establishes accounting and reporting standards for derivative instruments. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency- denominated forecasted transaction. We have not yet completed our evaluation of the effect this standard will have on us. 3. Business Acquisitions SHI, a wholly owned subsidiary was formed on August 18, 1999, for the sole purpose of the purchase of Harbourton for a purchase price of $25,183,372. This transaction provides us with a United States platform to write insurance business. Harbourton is licensed in 15 states and the District of Columbia and is an authorized reinsurer in an additional 8 states. On December 31, 1999, Scottish Holdings entered into an agreement with SHL to purchase all the outstanding shares of Scottish Annuity. Scottish Holdings paid SHL $11,601,464, subject to adjustment for the value of its net assets per its year end audited financial statements. Scottish Annuity operates as a life insurance company and engages in writing deferred variable annuities with a fixed annuity option with persons who are not resident in the Cayman Islands. It does not provide any investment management or advisory services. The acquisitions described above were accounted for by the purchase method of accounting. In accordance with Accounting Principles Board ("APB") Opinion No. 16, "Business Combinations", the accompanying consolidated statements of income do not include any revenues or expenses related to these acquisitions prior to the respective closing dates. The following unaudited consolidated pro forma information utilizes our audited information for 1999 and 1998 and unaudited information for Scottish Annuity and Harbourton for the same periods. The proforma data assumes that both acquisitions had occurred on January 1, 1999 and May 12, 1998 respectively. * Date of incorporation These unaudited pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which would have actually resulted had the acquisitions been in effect on January 1, 1999 or May 12, 1998 or of future results of operations. 4. Information Concerning Business Segments We record segmental reporting in accordance with SFAS No.131 "Disclosures about Segments of an Enterprise and Related Information". The reportable lines of business offer different products and services. The Company's main lines of business are Reinsurance and Variable Products. Reinsurance and Variable Products activities have been defined in Note 1. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 4. Information Concerning Business Segments (continued) The segmental reporting for the lines of business is as follows: Our activities for the period ended December 31, 1998 were limited to investment income on capital and operating expenses not specifically allocated to a line of business and therefore, no comparative information has been provided. For 1999, the "Other" category includes investment income and realized losses on capital and operating expenses not specifically allocated to a line of business. Assets as of December 31, 1999 for the Reinsurance and Variable Products lines of business were $407,057,362 and $268,174,719, respectively. Assets of $181,402,406 were not specifically allocated to a line of business. Deferred acquisition costs for the Reinsurance line was $1,851,893 and for the Variable line was $67,635. Present value of inforce business for the Reinsurance line was $119,599 and for the Variable line was $10,500,000. Reserves for future policy benefits relate to the Reinsurance line of business. Segregated assets and liabilities relate to the Variable Products line of business. As of December 31, 1998, all assets and liabilities were not specifically allocated to a line of business. 5. Earnings per Ordinary Share We calculate earnings per ordinary share in accordance with SFAS No. 128 "Earnings per Share" (EPS). Basic EPS excludes the dilutive effect of options and warrants. Diluted EPS includes the dilutive effect of these securities under the treasury stock method. The weighted-average number of shares is determined by the number of days the shares have been outstanding over the accounting period. The dilutive impact of our warrants and options is not material and therefore, has no effect on EPS. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 5. Earnings per Ordinary Shares (continued) * the period from May 12, 1998 (date of incorporation) to December 31, 1998 At December 31, 1998, the Company had a relatively small number of shares outstanding from the date of incorporation through the initial public offering on November 30, 1998. As a result, the weighted average number of shares outstanding for the period ended December 31, 1998 and the related EPS are not meaningful, in the opinion of management. 6. Fixed Maturities The amortized cost, gross unrealized appreciation and depreciation, and estimated fair values of our fixed maturity investments are as follows: Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 6. Fixed Maturities (continued) The contractual maturities of the fixed maturities are as follows. Actual maturities may differ as a result of calls and prepayments. Gross gains and gross losses for the periods are as follows: * Date of incorporation At December 31, 1999 and 1998, investments owned by the Company for which no readily available market quotation exists were valued at $8,647,037 and $nil, respectively. Our investment manager obtains prices for these investments from a third party source. The realizable value of the securities may differ from the amount recorded in the consolidated balance sheets. 7. Present Value of Inforce Business Total amortization of the present value of inforce business was $ nil for the year ended December 31, 1999 and $ nil for the period ended December 31, 1998. Based on the amortization method and expected gross profits, the following chart provides the percentage of the present value of inforce business that we expect to amortize each year for the next 5 years: 8. Reserves Activity in the liability for unpaid claims and claim adjustment expense is summarized below. During the year, the Company reinsured a closed block of long-term disability claims. Our adjustment to reserves reflects changes in the estimates underlying the initial reserves and improvements in our case management. As of December 31, 1999, the unpaid claims and claim adjustment liability for these contracts is included in reserves for future policy benefits. We had no reserves for future policy benefits for the period ended December 31, 1998. The Company has entered into a reinsurance funding agreement that features put options for the ultimate insureds. If executed, these options would require the Company to repay liabilities within seven or thirty days. Total liabilities subject to the put options total $185,714,286. The Company holds marketable securities to meet these obligations. 9. Shareholders' Equity Effective June 24, 1998, SHL transferred to its shareholders all of its ordinary shares in Scottish Holdings by way of a distribution. On October 22, 1998, we paid nominal consideration and issued 900,000 Class A warrants to reacquire and cancel 1,100,000 of our issued and outstanding ordinary shares. On November 30, 1998, we closed our IPO of 16,750,000 ordinary shares for proceeds received net of underwriting discounts and commissions totaling $235,375,000. Simultaneous with the initial closing of the IPO, direct sales of 1,418,440 ordinary shares and 400,000 Class A warrants were made to Direct Investors for net proceeds of $20,000,000. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 9. Shareholders' Equity (continued) Common shares We are authorized to issue 100,000,000 ordinary shares of par value $0.01 each. At December 31, 1998, 18,568,440 ordinary shares were outstanding. In January 1999, 8,000 shares were issued as non-monetary compensation to an executive officer. On September 1, 1999, it was agreed by the directors of the Company to enter into a share repurchase program. This was completed November 2, 1999, resulting in 2,529,700 shares being repurchased for a total amount of $24,999,234. As at December 31, 1999, 16,046,740 ordinary shares were outstanding. Preferred shares We are authorized to issue 50,000,000 preferred shares of par value $0.01 each. At the balance sheet dates there were no preferred shares issued or outstanding. Warrants In connection with our initial capitalization, we issued Class A warrants to purchase an aggregate of 1,550,000 ordinary shares to related parties. The aggregate consideration of $100,000 paid for these warrants is reflected as additional paid-in-capital. The Class A warrants were issued on June 9, 1998 at the initial stage of the development of our business plan when the feasibility of proceeding with the offering was uncertain. The consideration paid for the Class A warrants was determined to be fair value in the judgement of management in light of such uncertainty. Effective September 3, 1998, the Class A warrant agreements were superseded by Amended and Restated Class A warrant agreements with no material impact on the operation of the agreements. The exercise price of the Class A warrants is $15 per share of the Company's ordinary shares. The Class A warrants become exercisable in equal amounts over a three-year period commencing on the first anniversary of the consummation of the Offering. The Class A warrants will expire on the tenth anniversary of the consummation of the Offering. We entered into Warrant Purchase Agreements whereby The Roman Arch Fund L.P. and The Roman Arch Fund II L.P. purchased an aggregate of 200,000 Class B warrants for an aggregate purchase price of $302,000 which is reflected as additional paid-in-capital. Class B Warrants are exercisable at $15 per ordinary share, in equal amounts over a three-year period commencing one year after the Offering and expire ten years after the consummation of the Offering. Management is of the view that the agreed sale price of the Class B Warrants represented fair value at the time of purchase. The Roman Arch Fund L.P. and the Roman Arch Fund II L.P. are each limited partnerships and affiliates of Prudential Securities Incorporated, one of the underwriters of the IPO, and make investments for the benefit of limited partners who are employees of Prudential Securities Incorporated. The Class B warrants were issued after our business plan underwent further development and we were in a position to proceed with the Offering. As a result, the Class B warrants were issued for greater consideration. Effective September 3, 1998, the Class B warrant agreements were superseded by Amended and Restated Class B warrant agreements with no material impact on the operation of the agreements. As of December 31, 1999, no Class A or Class B warrants have been executed. We have entered into an agreement with Westport Partners (Bermuda), Ltd. ("Westport"), a developer and administrator of insurance products for international insurance brokers, insurance companies and corporations, pursuant to which Westport will provide non-exclusive distribution services with respect to the Company's variable life insurance products. In addition, Westport may be retained to provide administration services for certain variable life insurance products that the Company issues. For its distribution activities, we are authorized to issue up to 750,000 Class C warrants to Westport at an exercise price equal to $15 per ordinary share. The warrants are issuable over a four-year period beginning on January 1, 2000 and on each anniversary thereafter in an amount to be determined by a formula, as defined, in the agreement. The Class C warrants, if issued, will be for a term expiring ten years from the date of the Offering. We apply the fair value method of SFAS Statement No. 123, "Accounting for Stock-Based Compensation," in accounting for these warrants. No Class C warrants had been issued as of December 31, 1999. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (Continued) 10. Stock Option Plan The Company has two stock option plans (the "1998 Plan" and the "1999 Plan") which allows us to grant non-statutory options, subject to certain restrictions, to certain eligible employees, non-employee Directors, advisors and consultants. The minimum exercise price of the options will be equal to the fair market value, as defined in the Plan, of our ordinary shares at the date of grant. The term of the options shall not be more than ten years from the date of grant. Unless otherwise provided in the option agreement, the options shall become exercisable in three equal annual installments, commencing on the first anniversary of the grant date. Option activity under the 1998 Plan is as follows: * Date of incorporation Option activity under the 1999 Plan is as follows: In addition to the Company's stock option plans, 750,000 options were authorized to be issued to new employees of our U.S. operations by the Board of Directors at an exercise price to be determined on the date of the grant. The term of the options shall be seven years from the date of grant. The options shall become exercisable in three equal annual installments, commencing on the first anniversary of the grant date. Of the 750,000 options authorized, 586,000 have been granted to new employees of our U.S. operations, pursuant to a resolution of the Board of Directors, at an exercise price equal to the fair market value of our ordinary shares at the date of the grant. The options that have been granted are reflected in the pro forma and outstanding options calculations below. Subsequent to year end, 300,000 options under the 1998 Plan were canceled and 400,000 options were granted to our President under the 1998 Plan. We have adopted the disclosure provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related Interpretations in accounting for employee stock options. Since the exercise price of the stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized. Pro forma information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if we accounted for the employee stock options under the fair value method of that Statement. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (continued) 10. Stock Option Plan (continued) The Binomial option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Our pro forma information follows: * Date of incorporation The fair value for the options was estimated at the date of grant using the Binomial option-pricing model with the following assumptions: The following table summarizes information concerning outstanding and exercisable options at December 31, 1999: The following table summarizes information concerning outstanding and exercisable options at December 31, 1998: As of December 31, 1999, options for 203,267 ordinary shares, exercisable at a price of $15 per share, have been granted to certain non-employee participants in the Plan (160,000 at December 31, 1998). The Company applies the fair value method of SFAS No. 123, in accounting for stock options granted to non-employees who provide services to the Company. Note 11: Pension Contributions The Company has a defined contribution retirement plan covering substantially all employees. Company contributions to the plan are two times the employee contribution. Employee contributions are defined by legislation in the Cayman Islands, and vary between 2% and 5% of salary. Amounts charged to operations under this plan were $114,759 for the year ended December 31, 1999 and $ nil for the period ended December 31, 1998. 12. Taxation There is presently no taxation imposed on income or capital gains by the Government of the Cayman Islands. If any taxation were to be enacted, Scottish Holdings and Scottish Insurance have been granted exemptions therefrom until 2018 and Scottish Annuity has been granted exemptions therefrom until 2014. These companies operate in a manner such that they will owe no United States tax other than premium excise taxes and withholding taxes on certain investment income. Both Harbourton and SHI are U.S. corporations and therefore are liable for Federal Income Tax. The valuation allowances for December 31, 1999 are related primarily to the tax benefit of the unrealized depreciation on securities and realized capital loss carryforwards of Harbourton. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (continued) 12. Taxation (continued) Undistributed earnings of the Company's foreign subsidiaries are considered to be indefinitely reinvested and, accordingly, no provision for U.S. federal withholding taxes has been provided thereon. Upon distribution of current or accumulated earnings and profits in the form of dividends or otherwise, the Company would be subject to U.S. withholding taxes at a 30% rate. At December 31, 1999, the Company has net operating loss carryforwards of approximately $3.3 million for income tax purposes that expire in years 2012 through 2014. The Company also has capital loss carryforwards of approximately $3.7 million for income tax purposes that expire in years 2002 through 2004. Those carryforwards resulted primarily from the Company's 1999 acquisition of Harbourton. For financial reporting purposes, a valuation allowance of approximately $1.2 million has been recognized to offset the deferred tax assets related to the capital loss carryforwards acquired. When realized, the tax benefit for those items will be applied to reduce intangible value related to the acquisition of Harbourton. Significant components of our deferred tax assets and liabilites are as follows: Deferred tax assets Net operating losses $ 1,126,031 Capital losses 1,258,717 Alternative minimum tax credits 20,083 Unrealized depreciation on investments 366,211 Accrued market discount 82,985 Negative proxy deferred acquisition costs 993,732 ------------ Total deferred tax assets 3,847,759 Valuation allowance (1,624,928) ------------ Deferred tax assets net of valuation allowance 2,222,831 Deferred tax liabilities: Reserves for future policy benefits 4,754 ------------ Total deferred tax liabilities 4,754 ------------ Net deferred tax asset $ 2,218,077 ============ For the year ended December 31, 1999 we have income tax benefits from operations as follows: Current tax benefit $ - Deferred tax benefit (41,386) ------------ Total tax benefit $ (41,386) ------------ Income tax expenses attributable to continuing operations differs from the amount of income tax expense that would result from applying the federal statutory rates to pretax income from operating due to the following: Pretax GAAP income at 34% $ 3,003,333 Income not subject to tax at 34% (3,095,668) Other 50,949 ------------ Tax benefit $ (41,386) ============ Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (continued) 13. Statutory Requirements and Dividend Restrictions Under The Insurance Law of the Cayman Islands, Scottish Insurance and Scottish Annuity must each maintain a minimum net capital worth of $240,000. Our ability to pay dividends depends on the ability of Scottish Insurance and Scottish Annuity pay dividends to Scottish Holdings. While we are not subject to any significant legal prohibitions on the payment of dividends, Scottish Insurance and Scottish Annuity will be subject to Cayman Islands regulatory constraints, which affect its ability to pay dividends. Scottish Insurance and Scottish Annuity are prohibited from declaring or paying a dividend if such payment would reduce their net capital worth below $240,000. 14. Related Parties Scottish Annuity agreement - Prior to our acquisition of Scottish Annuity, Scottish Insurance entered into an Insurance Administration, Services and Referral Agreement (the "Agreement") with Scottish Annuity effective October 1, 1998. Scottish Insurance provided Scottish Annuity with a variety of insurance administration, accounting and other services. Scottish Insurance received compensation equal to 0.50% per annum of the quarterly separate account value of each annuity contract issued by Scottish Annuity subject to a minimum of US$25,000 per year In addition, pursuant to this agreement (i) Scottish Annuity refrained from the direct or indirect offer or sale of any life insurance products and refered only to Scottish Insurance any opportunity or inquiry that it received to issue and sell any life insurance products, and (ii) Scottish Insurance refrained from the direct or indirect offer or sale of any variable annuity products and refered only to Scottish Annuity any opportunity or inquiry that it received to issue and sell any variable annuity products. The agreement remained in effect until December 31, 1999. Purchase of Scottish Annuity - On December 31, 1999 Scottish Holdings purchased all of the outstanding shares of Scottish Annuity from SHI. Our Chief Executive Officer and certain members of our board of directors own 95% of SHI. The purchase price paid was assessed for fairness by an independent party and therefore, management believes it represents a value that would have been reached at arms-length. DC Planning agreement - We entered into a consulting services agreement with DC Planning, an insurance consulting firm that develops life insurance products and acts as a consultant on insurance matters for high net worth families, trust companies and other fiduciaries. Under the terms of the agreement, DC Planning provided certain consulting services to the Company, including with respect to the development and implementation of its business plan. This agreement ceased with the death of Howard Shapiro who was the managing partner of DC Planning. 15. Credit Arrangements At December 31, 1999 the Company had in place a $50 million revolving line of credit with a U.S. bank. Under the agreement, the Company has the option to borrow at a predetermined interest rate of 40 basis points over LIBOR. The terms of the agreement expire on December 22, 2000 but are renewable with the agreement of both parties. Additionally, the Company has entered into a stand-by letter of credit agreement the terms of which allow the Company to issue letters of credit up to $25 million dollars. The terms of the stand-by letter of credit agreement expire July 13, 2000. In January, 2000, the amount available to the Company was reduced to $20 million to reflect the availability of credit under the revolving letter of credit. As of December 31, 1999 and 1998, the Company had not utilized either of the above credit facilities. Scottish Annuity & Life Holdings, Ltd. Notes to Consolidated Financial Statements (continued) 16. Quarterly Financial Data (Unaudited) Quarterly financial data for the year ended December 31, 1999 is as follows: Quarterly financial data for the period ended December 31, 1998 is as follows: SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SCOTTISH ANNUITY & LIFE HOLDINGS, LTD. By: /s/ Michael C. French -------------------------------- Michael C. French Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. * The undersigned, by signing his name hereto, does hereby sign this Annual Report on Form 10-K pursuant to the Powers of Attorney executed on behalf of the above-named officers and directors of the Registrant and contemporaneously filed herewith with the Securities and Exchange Commission. /s/ Michael C. French --------------------- Michael C. French Attorney-in-Fact EXHIBIT INDEX ------------- EXHIBIT SEQUENTIAL NUMBER PAGE NO. DESCRIPTION OF DOCUMENT - ---------- ----------------------- - -------------------------------------------------------------------------------- 3.1 Memorandum of Association of the Company (incorporated herein by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 3.2 Articles of Association of the Company (incorporated herein by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.1 Specimen Ordinary Share Certificate (incorporated herein by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.2 Form of Amended and Restated Class A Warrant (incorporated herein by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.3 Form of Amended and Restated Class B Warrant (incorporated herein by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.4 Form of Securities Purchase Agreement for the Class A Warrants (incorporated herein by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.5 Form of Warrant Purchase Agreement for the Class B Warrants (incorporated herein by reference to Exhibit 4.5 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.6 Form of Registration Rights Agreement for the Class A Warrants (incorporated herein by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.7 Form of Registration Rights Agreement for the Class B Warrants (incorporated herein by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.8 Form of Securities Purchase Agreement between the Company and the Shareholder Investors (incorporated herein by reference to Exhibit 4.10 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.9 Form of Registration Rights Agreement between the Company and the Shareholder Investors (incorporated herein by reference to Exhibit 4.11 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.10 Form of Securities Purchase Agreement between the Company and the Non-Shareholder Investors (incorporated herein by reference to Exhibit 4.12 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 4.11 Form of Registration Rights Agreement between the Company and the Non-Shareholder Investors (incorporated herein by reference to Exhibit 4.13 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.1 Employment Agreement dated June 18, 1998 between the Company and Michael C. French (incorporated herein by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.2 Second Amended and Restated 1998 Stock Option Plan effective October 22, 1998 (incorporated herein by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.3 Form of Stock Option Agreement in connection with 1998 Stock Option Plan (incorporated herein by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.4 Agreement dated June 30, 1998 between the Company and International Risk Management (Cayman) Ltd. (incorporated herein by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.5 Amended and Restated Insurance Administration, Services and Referral Agreement dated as of October 1, 1998 between the Company and The Scottish Annuity Company (Cayman) Ltd. (incorporated herein by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.6 Employment Agreement dated July 20, 1998 between the Company and Henryk Sulikowski (incorporated herein by reference to Exhibit 10.10 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.7 Form of Indemnification Agreement between the Company and each of its directors and officers (incorporated herein by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.8 Investment Management Agreement dated October 22, 1998 between the Company and Pacific Investment Management Company (incorporated herein by reference to Exhibit 10.13 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.9 Investment Management Agreement dated October 22, 1998 between the Company and General Re-New England Asset Management, Inc. (incorporated herein by reference to Exhibit 10.14 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.10 Agreement dated October 23, 1998 between the Company and Westport Partners (Bermuda), Ltd. (incorporated herein by reference to Exhibit 10.15 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.11 Investment Management Agreement dated October 22, 1998 between the Company and The Prudential Investment Corporation (incorporated herein by reference to Exhibit 10.16 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.12 Form of Omnibus Registration Rights Agreement (incorporated herein by reference to Exhibit 10.17 to the Company's Registration Statement on Form S-1 filed with the Securities Exchange Commission on June 19, 1998, as amended). 10.13 Investment Advisory Service between the Company and Prudential Securities Corporation (incorporated herein by reference to Exhibit 10.15 to the Company's Registration Statement on Form 10-K filed with the Securities Exchange Commission on March 30, 1999). 10.14 1999 Stock Option Plan. 10.15 Form of Stock Options Agreement in connection with 1999 Stock Option Plan. 10.16 Employment Agreement dated March 08, 2000 between the Company amd Scott E. Willkomm. 21.1 Subsidiaries of Registrant. 24.1 Powers of Attorney. 27.1 Financial Data Schedule.

949874_1999.txt

949874_1999

1999

949874

ITEM 1. BUSINESS. Young Innovations, Inc. (the "Company") develops, manufactures and markets supplies and equipment used by dentists and dental hygienists. The Company's product offering includes disposable and metal prophy angles, cups, brushes, handpieces and related components, panoramic x-ray machines and infection control products used in a dental office. The Company believes it is the leading manufacturer and distributor of prophylaxis angles and cups (used in teeth cleaning and polishing procedures) and panoramic X-ray equipment in the United States. The Company was incorporated in July 1995 to serve as the parent company for Young Dental Manufacturing I, LLC ("Young Dental", formerly Young Dental Manufacturing Company), and The Lorvic Corporation ("Lorvic"). Young Dental acquired Lorvic in May 1995, adding to Young Dental a new line of infection control products as well as chemical engineering and manufacturing expertise. In July 1996, the Company acquired Denticator International, Inc. ("Denticator") and its line of popular low-cost disposable prophylaxis angles to complement Young's premium-priced disposable angles. In February 1998, the Company acquired Panoramic Corporation ("Panoramic"), a leading manufacturer and marketer of X-ray equipment sold or rented to dental professionals in the United States. In April 1999, the Company acquired Athena Technology, LLC ("Athena", formerly Athena Technology, Inc.), which added a line of handpieces and related components to the Company's product line. Young Dental was founded in the early 1900's. As one of many small suppliers to the dental profession, Young Dental's strength was manufacturing consistently reliable dental products. As dentistry evolved, Young worked with practicing dentists and academics to identify clinical problems. Young Dental then used its engineering and manufacturing expertise to create solutions to those problems. The Company believes that decades of providing innovative products to meet the evolving needs of the dental profession have earned Young a strong reputation for quality, reliability and value. The Company markets its products in several international markets, including Europe, South America, Central America and the Pacific Rim. International sales represented less than 10% of the Company's total net sales in 1999. The Company is a Missouri corporation with its principal executive office located at 13705 Shoreline Court East, Earth City, Missouri 63045, in the St. Louis, Missouri metropolitan area; its telephone number is (314) 344-0010. PRODUCTS The Company primarily markets disposable and metal prophy angles, cups and brushes (collectively, "Prophy Products"), complementary preventive products, including pastes, fluorides and fluoride applicators, handpieces and related components as well as aspiration and infection control products and dental X-ray equipment. Prophy Products. The Company believes it manufactures and sells the broadest line of Prophy Products in the domestic professional dental products market. The Company is able to achieve its substantial share of the Prophy Product market by providing Prophy Products at both premium and popular prices. The Company generally prices its Young branded Prophy Products at premium levels and its Denticator branded Prophy Products at popular price levels. The Company's broad range of Prophy Products enables it to be a single-source supplier to its distributors. The Company's Prophy Products include several configurations of sealed metal autoclavable prophy angles and several disposable plastic prophy angles designed for single-use. Prophy Products consist of two components: an angle which is attached to and extends from a standard, low-speed dental handpiece and a rubber cup or brush which is attached to the angle and performs the cleaning function. During the prophylaxis process, the cup or brush is filled with abrasive paste, which is applied to the teeth as the prophy cup rotates. The dental professional polishes both the visible portion of the tooth and the subgingival portion (below the gum line). The prophy angle may be a disposable or a reusable instrument; prophy cups and brushes are sold as single-use items. Disposable prophy angles are sold as assembled units with a cup or brush already attached. The Company produces and markets a number of different disposable prophy angles, including both traditional right angle and contra angle configurations. Virtually all of the Company's metal prophy angles are sealed against penetration of matter from patients' mouths (thus reducing the risk of cross-contamination and damage to the prophy angle) and are designed for ease of maintenance. Because such metal prophy angles function optimally only when used with the Company's cups and brushes, most dentists who purchase the Company's metal prophy angles also purchase the Company's cups and brushes. Other Preventive Products. The Company's other preventive products include polishing pastes and powders, which are abrasive agents used for cleaning and polishing teeth; fluorides used in dental offices and at home to reduce cavities and tooth sensitivity; applicators used by dental professionals to apply fluoride to patients' teeth; and plaque disclosants, which are liquids or tablets that identify the presence of plaque when applied to tooth surfaces. The Company markets certain of its pastes, including fluoride products, in single-use containers, the demand for which has grown in response to infection control concerns. Infection Control Products. The Company's line of infection control products includes products such as indicator tape and tabs used to verify the effectiveness of a sterilizer; Nyclave wrap used to wrap instruments during sterilization so that sterility is maintained until use; barrier products used to wrap operatory knobs, handles and other devices that cannot be sterilized; and surgical milk and instrument care products used to inhibit corrosion, remove rust and lubricate hinged instruments in connection with the autoclave process. Autoclaving is the sterilization of instruments and equipment through the use of steam. X-Ray Products. The Company markets a line of dental X-ray equipment under the Panoramic brand name. Panoramic's PC 1000 X-ray machine produces a high quality image of the entire dental arch in one X-ray film. Panoramic's Laser 1000 cephalometric X-ray system allows analysis of the exact relationship of various anatomical reference points of the patient's anterior skull profile. General dentists and orthodontists use these calculations to locate and predict the movement of teeth in order to fit braces and other orthodontia. The device is used by oral surgeons to detect pathology and also to determine bone and teeth alignment before and after surgery. Handpieces and Accessories. The Company manufactures and markets a line of high-speed and low-speed handpieces. The Company also offers high-speed and low-speed handpiece repair services. High-speed handpieces, commonly referred to as dental drills, are used in a variety of operative and restorative dental procedures. Low-speed handpieces are used by dentists and dental hygienists in the teeth cleaning, or prophylaxis, procedure. Prophylaxis angles, such as the disposable or autoclavable prophylaxis angles sold by the Company, attach to a low-speed handpiece, which provides drive power for the angle. Low-speed handpieces are also used in certain operative and restorative dental procedures, though to a lesser extent than high-speed handpieces. The Company's handpieces are sold under the Athena and Champion brand names, as well as through private label agreements with certain dental distributors. Assisting and Other Products. The Company's assisting and other products include disposable aspiration products used to remove blood, saliva and other matter during dental procedures; cotton roll substitutes used to control saliva and moisture during dental procedures; matrix bands used for tooth restorations; rubber dam frames used to isolate teeth during dental procedures; and etching gels and bonding prep used to condition tooth surfaces for bonding. Private Label and OEM Products. In addition to branded products, the Company designs, develops and produces a limited number of proprietary private label and OEM products under contracts with dental distributors and other professional dental product manufacturers where the Company is able to use its expertise and excess manufacturing capacity. MARKETING AND DISTRIBUTION The Company markets its full line of products to dental professionals worldwide using a network of medical and dental product distributors. The Company actively supports its distributor relationships with Company sales personnel in the United States, independent sales representatives in Canada and exclusive sales representatives in 11 countries outside of North America. Until July 1997, the Company used independent non-exclusive sales representatives and a small number of Company employees for its marketing and sales efforts in the United States. In an effort to more efficiently market its products, the Company decided to switch from independent sales representatives to Company employees who focus on selling the Company's products exclusively. The Company also uses non-exclusive distributors to service markets in a number of other countries. All major distributors of dental products in North America sell the Company's products, including Henry Schein, Inc. and Patterson Dental Company which accounted for 17.7%, and 14.7%, respectively, of the Company's sales in 1999. The Company has no formal agreements with its distributors which generally purchase products from the Company by purchase order. The Company believes these arrangements are customary in the industry. In addition to marketing through distributors in the United States, the Company sells products directly to dental and dental hygiene schools, Veterans Administration healthcare facilities and United States military bases. The Company expends considerable effort educating its distributors about the quality, reliability and features of its products. The Company also advertises its products through industry publications and direct mail. To supplement its other marketing efforts, the Company provides product samples to dental professionals and exhibits its products at industry trade shows. In addition, the Company seeks to stimulate interest in its products by providing information and marketing materials to influential lecturers and prominent experts and consultants in the dental industry. Panoramic X-ray products are marketed in the United States and Canada directly to the end user, primarily by direct mail, trade shows and a limited amount of advertising in trade and professional journals. Panoramic also uses distributors to market its products in a number of other countries. PRODUCT DEVELOPMENT The Company's engineers and chemists are focused on developing innovative professional dental products and are actively involved in improving the Company's manufacturing processes. Frequently, these products are designed and developed in response to needs articulated to the Company by dental professionals. For example, the Company designed a contra disposable prophy angle to improve the ease with which dental professionals can reach and clean patients' teeth. The Company believes that the contra disposable prophy angle improves access to the oral cavity thereby reducing the risk of carpal tunnel syndrome by reducing the flexion of dental hygienists' wrists during prophy procedures. Additionally, many of the new products or product improvements developed by the Company are patented. MANUFACTURING AND SUPPLY The Company manufactures virtually all of its products and product components other than X-ray equipment. In May 1999, the Company acquired a one-third interest in International Assembly Inc. ("IAI"), a contract manufacturer located in Mexico that assembles a majority of the disposable prophy angles for Young Dental and Denticator. Prophy and Other Products. The Company uses a variety of state-of-the-art computer numerically controlled machining centers, injection molding machines and robotic assembly machines and continues to invest in new and more efficient equipment and production lines. The primary processes involved in manufacturing the Company's products consist of precision metal turning and milling, rubber molding, plastic injection molding, component parts assembling and finished goods packaging. Pastes, Liquids and Gels. The Company blends and mixes all of its pastes, liquids and gels at the Earth City and Brownsville facilities. The Company owns equipment used to form and dye-cut expanded polyethylene foam and to dye-cut extruded plastic into finished products and equipment used to package its products in a variety of container sizes, including prophy paste in unit-dose containers. X-Ray Equipment. Panoramic's X-ray equipment is manufactured and assembled by a contract manufacturer at Panoramic's premises in Fort Wayne, Indiana. The contract manufacturer supplies labor, purchases most components and performs administrative and logistical functions associated with the production of the machines. Panoramic owns all of the tooling, engineering documentation and assembly fixtures used in the process. Panoramic manufactures its own X-ray generators. Handpieces and Accessories. The Company uses a variety of state-of-the-art computer numerically controlled machines to manufacture a number of the components required to produce its high-speed and low-speed handpieces. Certain other handpiece component parts are sourced from a variety of OEMs. The Company assembles and provides repair services for its handpieces, and offers repair services for a number of other handpiece brands. Supply. The Company purchases a wide variety of raw materials, including bar steel, brass, rubber and plastic resins from numerous suppliers. The majority of the Company's purchases are commodities readily available at competitive prices. The Company also purchases certain of its products from other manufacturers for resale. COMPETITION The Company competes with manufacturers of both branded and private label dental products in each of the markets it serves. According to Strategic Dental Marketing, Inc., an independent market research firm, the Company had the largest domestic market share of distributor sales in Prophy Products during 1999, 1998 and 1997. The Company believes that dental professionals place major importance on the proven reliability of the Company's products and are generally not price-sensitive. Young Dental and Lorvic compete on the basis of the quality and reliability of their products as well as their reputations. As a result, Young Dental and Lorvic typically charge premium prices for their products. By contrast, Denticator and Panoramic's products are targeted to more price-sensitive dental service providers. Panoramic competes with seven competitors, six of which are foreign manufacturers. The markets for the Company's products are highly competitive. The Company believes that the principal competitive factors in all of its markets are product features, reliability, name recognition, established distribution network, customer service and, to a lesser extent, price. The relative speed with which the Company can develop, complete testing, obtain regulatory approval and sell commercial quantities of new products is also an important competitive factor. Some of the Company's competitors have greater financial, research, manufacturing and marketing resources than the Company and include DENTSPLY International, Inc., Oral-B Laboratories, Allegheny Teledyne Incorporated, StarDental, a division of DentalEZ Group, KaVo America, Siemens Dental Products, and Planmeca OY. EMPLOYEES As of December 31, 1999, the Company employed approximately 215 people, none of whom were covered by collective bargaining agreements. The Company believes that its relations with its employees are good. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company, their ages and their positions with the Company as of December 31, 1999 are set forth below. All officers serve at the pleasure of the Board of Directors. ITEM 2. ITEM 2. PROPERTIES. The Company's facilities are as follows: The Company believes that its facilities are generally in good condition and are adequate for its operations for the foreseeable future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries from time to time are parties to various legal proceedings arising out of their businesses. Management believes there are no such proceedings pending or threatened against the Company or its subsidiaries which, if determined adversely, would have a material adverse effect on the Company's business, financial condition, results of operations or cash flows. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Stock trades on the Nasdaq National Market under the symbol of "YDNT." The following table sets forth the high and low closing prices of the Common Stock as reported by the Nasdaq National Market during the last eight quarters. On February 25, 2000, there were approximately 31 holders of record of the Company's Common Stock. The Company has not paid cash dividends on its Common Stock since its inception. The Company currently intends to retain earnings for use in its business and, therefore, does not anticipate paying any cash dividends in the foreseeable future. Payment of cash dividends, if any, will be at the discretion of the Company's Board of Directors and will be dependent upon the earnings and financial condition of the Company and any other factors deemed relevant by the Board of Directors and will be subject to any applicable restrictions contained in the Company's then existing credit arrangements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table presents selected financial data of the Company. This historical data should be read in conjunction with the Consolidated Financial Statements and the related notes thereto in Item 8 and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL The Company develops, manufactures and markets supplies and equipment used by dentists and dental hygienists. The Company's product offering includes disposable and metal prophy angles, cups, brushes, handpieces and related components, panoramic x-ray machines and infection control products. The Company believes it is the leading manufacturer and distributor of prophylaxis angles and cups (used in teeth cleaning and polishing procedures) and panoramic X-ray equipment in the United States. The principal components of the Company's growth strategy are to continuously improve its operating efficiencies, to drive superior internal growth and to complete strategic acquisitions. In order to help fund the Company's strategy for growth, the Company completed an initial public offering of 2.3 million shares of its common stock in November 1997, resulting in net proceeds of $25.2 million. The Company used the proceeds to repay debt incurred with previous acquisitions and to fund future strategic acquisitions. On February 27, 1998, the Company acquired the assets of Panoramic for $13.9 million cash plus 62,500 shares of the Company's common stock and assumed approximately $3.9 million of Panoramic's liabilities, of which $2.6 million was repaid at closing. On April 2, 1999, the Company acquired the stock of Athena for $4.6 million in cash (subject to a purchase price adjustment) plus $430,000 in notes payable to the previous shareholders. Any purchase price adjustments are not expected to have a material negative impact on the financial condition of the Company. The results of operations for these acquisitions are included in the consolidated financial statements since the date of acquisition. The acquisitions were accounted for as purchase transactions. On May 17, 1999, the Company invested approximately $1.0 million in exchange for a one-third interest in International Assembly, Inc. (IAI). The Company has an option to purchase the remaining two-thirds interest in IAI or to sell its one-third interest back to IAI in early 2001. The investment is being accounted for under the equity method of accounting. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain items from the Company's statement of income expressed as a percentage of net sales. YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 Net Sales. Net sales increased $6.1 million, or 16.7%, to $42.7 million in 1999 from $36.6 million in 1998. The increase was primarily attributable to the inclusion of sales of Athena (acquired April 2, 1999) and a full year of Panoramic (acquired on February 27, 1998). The balance of the increase was due to higher sales of prophy products and x-ray machines during 1999 as compared to 1998 sales levels. Gross Profit. Gross profit increased $3.8 million, or 18.7%, to $23.9 million in 1999 from $20.1 million in 1998. Gross profit was favorably impacted by the acquisitions of Athena and Panoramic and by the increased prophy product sales. Gross margin increased to 55.9% of net sales in 1999 from 55.0% in 1998. This increase was attributable to improvements obtained from the transfer and consolidation of the majority of the manufacturing operations of the Denticator product line from California to Missouri. This benefit was partially offset by the inclusion of Athena sales and Panoramic for the full year, which typically carry lower margins. Selling, General, and Administrative Expenses ("SG&A"). SG&A expenses increased $1.6 million, or 14.8%, to $12.2 million in 1999 from $10.6 million in 1998 primarily due to the inclusion of expenses of Athena and a full year of Panoramic. As a percent of net sales, SG&A expenses decreased to 28.6% in 1999 from 29.0% in 1998. Income from Operations. Income from operations increased $2.2 million or 23.0%, to $11.7 million in 1999 from $9.5 million in 1998 as a result of the factors explained above. Interest Expense. Interest expense increased from $0 in 1998 to $105,000 in 1999. The increase was a result of interest on borrowings on the Company's revolving line of credit during 1999 as well as debt and capital leases associated with the acquisition of Athena. Other Income. Other income decreased $189,000 to $137,000 in 1999 from $326,000 in 1998 primarily due to less interest income and gains on the disposal of assets in 1998 as compared to 1999, as well as the inclusion of the Company's portion of the loss from its investment in IAI during 1999. Provision for Income Taxes. Provision for income taxes increased $800,000 in 1999 to $4.6 million from $3.8 million for 1998 primarily as a result of higher pre-tax income. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 Net Sales. Net sales increased $11.6 million, or 46.5%, to $36.6 million in 1998 from $25.0 million in 1997. The increase was primarily attributable to the inclusion of sales of Panoramic (acquired on February 27, 1998). The balance of the increase was due to higher sales of prophy products during 1998 as compared to 1997 sales levels. Gross Profit. Gross profit increased $5.2 million, or 35.5%, to $20.1 million in 1998 from $14.9 million in 1997. Gross profit was favorably impacted by the acquisition of Panoramic and by the increased prophy product sales. Gross margin decreased to 55.0% of net sales in 1998 from 59.5% in 1997. This decrease was due to the inclusion of lower margin sales of Panoramic products. The following factors also contributed to the decrease in the gross margin percentage: 1) the costs incurred in the transfer and consolidation of the majority of the manufacturing operations of the Denticator product line from California to Missouri, 2) the costs incurred in obtaining ISO certification for the Company's manufacturing facilities in Missouri and Texas, and 3) the costs incurred in obtaining European Conformity (CE) Mark approval for the Company's prophy products. Selling, General, and Administrative Expenses ("SG&A"). SG&A expenses increased $3.3 million, or 44.9%, to $10.6 million in 1998 from $7.3 million in 1997 primarily due to the inclusion of expenses of Panoramic. As a percent of net sales, SG&A expenses decreased to 29.0% in 1998 from 29.4% in 1997. Income from Operations. Income from operations increased $2.0 million or 26.3%, to $9.5 million in 1998 from $7.5 million in 1997 as a result of the factors explained above. Interest Expense. Interest expense decreased from $1.0 million in 1997 to $0 in 1998. The decrease was due to the retirement of all of the Company's bank debt with the net proceeds of the Company's initial public offering in November 1997. Other Expense (Income). Other expense (income) increased $186,000 to $(326,000) in 1998 from $(140,000) in 1997 primarily due to higher interest income and gains on the disposal of assets in 1998 as compared to 1997. Provision for Income Taxes. Provision for income taxes increased $1.3 million in 1998 to $3.8 million from $2.5 million for 1997 primarily as a result of higher pre-tax income. LIQUIDITY AND CAPITAL RESOURCES On May 17, 1999, the Company invested approximately $1.0 million in exchange for a one-third interest in IAI. The investment was principally financed through cash flows from operations. The Company has an option to purchase the remaining two-thirds interest in IAI or to sell its one-third interest back to IAI in early 2001. On April 2, 1999, the Company acquired Athena. The Company paid approximately $4.6 million in cash (subject to a purchase price adjustment) and issued approximately $430,000 in notes payable to the previous shareholders. Any purchase price adjustments are not expected to have a material negative impact on the financial condition of the Company. The cash portion of the purchase price was principally financed with cash flows from operations and borrowings on the Company's revolving line of credit. On February 27, 1998, the Company acquired the net assets of Panoramic. The Company paid approximately $13.9 million in cash plus $1.0 million (62,500 shares) of its common stock. The acquisition was principally financed with cash remaining from the net proceeds of the Company's initial public offering. Historically, the Company has financed its operations primarily through cash flow from operating activities and, to a lesser extent, through borrowings under its credit facilities. Net cash flow from operating activities was $8.9 million, $6.4 million, and $4.5 million for 1999, 1998 and 1997, respectively. Capital expenditures for property, plant and equipment were $1.5 million, $1.1 million, and $700,000 in 1999, 1998 and 1997, respectively. Consistent with the Company's historical capital expenditures, future capital expenditures are expected to include panoramic X-ray machines for rental, injection molding equipment, computer numeric controlled equipment and upgrades to production machinery and to the Company's information systems. During 1999, the Company borrowed $4.5 million under a credit arrangement for the acquisition of Athena and it's investment in IAI. The entire balance was re-paid during 1999. Management believes the Company has adequate liquidity and capital resources to meet its needs on a short and long-term basis. RECENT FINANCIAL ACCOUNTING STANDARDS BOARD STATEMENT In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which requires that all derivatives be recognized as either assets or liabilities in the statement of financial position at fair value. The Company is required to adopt this statement no later than the beginning of fiscal year 2000. The adoption of this statement is not expected to have an impact on operating results, statement of financial position or cash flows, as the Company does not currently invest in derivative instruments. YEAR 2000 ISSUE During 1999, the Company completed the process of preparing for the Year 2000 date change. To date, the Company has had no material Year 2000 failures. Although considered unlikely, unanticipated problems could still occur. The Company will continue to monitor all business processes, including third parties, through 2000, to address any issues and to ensure that all processes continue to function properly. Through 1999, the cost for the Year 2000 project was less than $100,000. We anticipate no material costs to be incurred in 2000 and beyond that are related to the Year 2000 project. The Company has a one-third interest in IAI, which has advised the Company that it had no material Year 2000 failures. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risk related to changes in interest rates. The value of financial instruments is subject to change as a result of movements in market rates and prices. Sensitivity analysis is one technique used to evaluate these impacts. Based upon a hypothetical 10% change in interest rates, the potential losses in future earnings, fair value and cash flows are not material. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Young Innovations, Inc.: We have audited the accompanying consolidated balance sheets of Young Innovations, Inc. (a Missouri corporation) and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Young Innovations, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. ARTHUR ANDERSEN LLP St. Louis, Missouri, February 2, 2000 YOUNG INNOVATIONS, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) The accompanying notes are an integral part of these balance sheets. YOUNG INNOVATIONS, INC. CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT SHARE DATA) The accompanying notes are an integral part of these statements. YOUNG INNOVATIONS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) The accompanying notes are an integral part of these statements. YOUNG INNOVATIONS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying notes are an integral part of these statements. YOUNG INNOVATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) 1. DESCRIPTION OF BUSINESS: Young Innovations, Inc. (the Company) develops, manufactures and markets supplies and equipment used by dentists and dental hygienists. The Company's product offering includes disposable and metal prophy angles, cups, brushes, handpieces and related components, panoramic x-ray machines and infection control products. The Company's manufacturing facilities are located in Missouri, California, Indiana and Texas. Export sales were less than 10% of total net sales for 1999, 1998 and 1997. Since the acquisition of Panoramic, the Company has two operating segments: preventative and diagnostic. The preventative segment produces disposable and metal prophy products. The diagnostic segment sells and rents dental x-ray equipment. Management believes it is appropriate to aggregate these operating segments into a single reportable segment. This aggregation is due to similarities in economic characteristics, customers, the nature of the products and the nature of the production processes. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Young Innovations, Inc. formed in July 1995 and its direct and indirect wholly owned subsidiaries, Young Dental Manufacturing I, LLC. (Young Dental, formerly Young Dental Manufacturing Company), The Lorvic Corporation (Lorvic), Denticator International, Inc. (Denticator), Young Acquisitions Company and Panoramic Rental Corp. (collectively, Panoramic), and Athena Technology, LLC. (Athena, formerly Athena Technology, Inc.). Panoramic is included since its acquisition on February 27, 1998, and Athena is included since its acquisition on April 2, 1999. All significant intercompany accounts and transactions are eliminated in consolidation. The preparation of these financial statements required the use of certain estimates by management in determining the Company's assets, liabilities, revenues and expenses. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all highly liquid investments with an initial maturity of three months or less. INVENTORIES Inventories are stated at the lower of cost (which includes material, labor and manufacturing overhead) or market. Cost is determined by the first-in, first-out (FIFO) method. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Expenditures for repairs and maintenance are charged to expense as incurred, and additions and improvements that significantly extend the lives of assets are capitalized. Upon disposition, cost and accumulated depreciation are eliminated from the related accounts and any gain or loss is reflected in the statement of income. The Company provides depreciation using the straight-line method over the estimated useful lives of the assets ranging from 3 to 39 years. OTHER ASSETS On May 17, 1999, the Company acquired a one-third interest in International Assembly, Inc., a Texas corporation (IAI). The Company paid approximately $1,050 in cash for this investment. The Company has an option to purchase the remaining two-thirds interest in IAI or to sell its one-third interest back to IAI in early 2001. The Company purchases certain services from IAI at amounts less than would be paid to unrelated parties. These services totaled $174 from May 17, 1999 through December 31, 1999. The investment was principally financed through cash flows from operations. The investment is being accounted for under the equity method of accounting. Equity income (using a 3 month lag) is recorded net, after reduction of goodwill amortized straight-line over 10 years. Goodwill of approximately $931 is based upon the excess of the amount paid for its interest in IAI over the fair value its portion of IAI's net assets at the date of the investment. The Company's share of losses for IAI is included in other expenses and totaled $80 for the period from May 17, 1999 to September 30, 1999. The Company's portion of IAI's loss for the fourth quarter 1999 is expected to be less than $60. Other assets also include costs related to patents issued to the Company and pending patent applications. Capitalized patent costs are amortized on a straight-line basis over the estimated useful lives of the patents, generally 17 years. INTANGIBLE ASSETS Intangible assets, consisting of goodwill, are stated at cost less accumulated amortization. Amortization is determined using the straight-line method over 40 years. LONG-LIVED ASSETS If facts and circumstances suggest that a long-lived asset may be impaired, the carrying value is reviewed. If this review indicates that the carrying value of the asset will not be recovered, as determined based on projected undiscounted cash flows related to the asset over its remaining life, the carrying value of the asset is reduced to its estimated fair value. ADVERTISING COSTS Advertising costs are expensed when incurred. RESEARCH AND DEVELOPMENT COSTS Research and development costs are expensed when incurred and totaled $802, $749 and $566 for 1999, 1998 and 1997, respectively. REVENUE RECOGNITION Revenue from the sale of products is recorded at the time of passage of title, generally when the products are shipped. EQUIPMENT RENTED TO OTHERS Since the acquisition of Panoramic in 1998, the Company owns x-ray equipment rented on a month-to-month basis to customers. Installation costs of the equipment are capitalized and amortized over four years. A liability for the removal costs of the equipment expected to be returned to the Company is included in accounts payable and accrued liabilities at December 31, 1999 and 1998. OTHER EXPENSE (INCOME) Other expense (income) includes the Company's portion of losses from its investment in IAI, interest income, sale of scrap, and other miscellaneous income and expense items, all of which are not directly related to the Company's primary business. In 1999, 1998 and 1997, interest income totaled $139, $216 and $121, respectively. INCOME TAXES The Company has accounted for income taxes under SFAS No. 109, an asset and liability approach to accounting and reporting for income taxes. Deferred income taxes are provided for temporary differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. SUPPLEMENTAL CASH FLOW INFORMATION Cash flows from operating activities include $4,014, $3,379 and $2,142 for the payment of federal and state income taxes and $105, $-0-, and $1,116 for the payment of interest during 1999, 1998 and 1997, respectively. The Company entered into a capital lease obligation during 1999 for $344. 3. ACQUISITIONS: On April 2, 1999, the Company acquired Athena. The Company paid $4,640 in cash (subject to a purchase price adjustment) and issued $430 in notes payable to the previous shareholders. Any purchase price adjustments are not expected to have a material negative impact on the financial condition of the Company. The cash portion of the purchase price was principally financed with cash flows from operations and borrowings on the Company's revolving line of credit. The acquisition was accounted for as a purchase transaction. The preliminary purchase price was allocated based upon estimates of fair values. This preliminary excess of purchase price over estimated fair value of net assets (goodwill) was $4,901 and is being amortized over 40 years. The results of operations for Athena are included in the consolidated financial statements since April 2, 1999. On February 27, 1998, the Company acquired the assets and assumed certain liabilities of Panoramic. The Company paid $13,875 in cash and issued $1,000 (62,500 shares) of common stock. The cash portion of the purchase price was principally financed with the net proceeds remaining from the Company's initial public offering. The acquisition was accounted for as a purchase transaction. The purchase price was allocated based upon estimates of fair value. The excess of purchase price over the estimated fair value of net assets acquired (goodwill) was $10,445 and is being amortized over 40 years. The results of operations for Panoramic are included in the consolidated financial statements since February 27, 1998. The following unaudited pro forma information presents a summary of consolidated results of operations of the Company and Panoramic as if the acquisition had occurred at the beginning of 1997, with pro forma adjustments to give effect to amortization of goodwill and certain other adjustments, together with related income tax effects. The unaudited pro forma information does not purport to be indicative of the results of operations had these transactions been completed as of the assumed dates or which may be obtained in the future. 4. CONCENTRATIONS OF CUSTOMERS: The Company generates trade accounts receivable in the normal course of business. The Company grants credit to distributors and customers throughout the world and generally does not require collateral to secure the accounts receivable. The Company's credit risk is concentrated among two distributors accounting for 29% and 41% of accounts receivable as of December 31, 1999 and 1998, respectively. 5. INVENTORIES: Inventories consist of the following: 6. PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment consist of the following: Machinery and equipment under capital lease and related accumulated depreciation was $794 and $121, respectively at December 31, 1999. 7. OTHER ASSETS: Other assets consist of the following: 8. INTANGIBLE ASSETS: Intangible assets consist of the following: Amortization of goodwill totaled $848, $698 and $475 for 1999, 1998 and 1997, respectively. 9. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES: Accounts payable and accrued liabilities consist of the following: 10. LONG-TERM DEBT AND CREDIT ARRANGEMENTS: At December 31, 1999 the Company had acquisition notes of $269 outstanding which consist of agreements with former Athena shareholders, which bear interest at 4.5%. These notes require monthly principal and interest payments and mature April 2, 2001. Capitalized lease obligations of $624 were also outstanding at December 31, 1999. In April 1999, the Company entered into a one-year revolving credit agreement, which provides a line of credit up to $5,000 at an interest rate of LIBOR + 1%. During 1999, the Company borrowed $4,500 from the line and repaid the entire balance. There were no amounts outstanding on this line as of December 31, 1999. Future maturities of long-term debt for the next five years are as follows: 11. COMMON STOCK: The Company completed an initial public offering of 2,300,000 shares of its common stock in November 1997, and the net proceeds to the Company, after deducting the underwriting discount and offering expenses, were $25,154. The Company used $13,180 of the proceeds to repay borrowings under its existing loan facility and invested the remaining proceeds in cash equivalents. In March 1999, the Company authorized the repurchase of up to 300,000 shares of its common stock. As of December 31, 1999, the Company had completed the repurchase of 277,500 shares for $3,323. The Company reissued 9,000 shares in conjunction with a stock option exercise for $107. 12. STOCK OPTIONS: The Company adopted the 1997 Stock Option Plan (the Plan) effective in November 1997 and amended the Plan in 1999. A total of 650,000 shares of Common Stock are reserved for issuance under this plan which is administered by the compensation committee of the Board of Directors (Compensation Committee). Participants in the Plan will be those employees whom the Compensation Committee may select from time to time and those nonemployee directors as the Company's Board of Directors may select from time to time. As of December 31, 1999, 622,800 options had been granted. A summary of the options outstanding and exercisable are as follows: As of January 1, 2000, 145,150 shares were exercisable with a range of exercise prices from $12.00 - $17.50 with a weighted average price of $13.06. The Compensation Committee of the Board of Directors establishes vesting schedules for each option issued under the Plan. Outstanding options generally vest over four years. The exercise price was equal to the fair value of the common stock at the date of grant. All options expire 10 years from the grant date. In accordance with SFAS No. 123, "Accounting for Stock-Based Compensation," the Company elected APB Opinion No. 25, "Accounting for Stock Issued to Employee," and related interpretations in accounting for the Plan. Accordingly, no compensation cost has been recognized for the Plan. Had compensation costs for the Plan been determined based upon the fair value of the options at the grant date consistent with the methodology prescribed under SFAS No. 123, the Company's net income and earnings per share would approximate the pro forma amounts below: The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: (i) dividend yield of 0%; (ii) expected volatility of 27.8%, 45.0% and 70% for 1999, 1998 and 1997, respectively; (iii) risk free interest rate of 6.4%, 5.3%, and 6.0% for 1999, 1998 and 1997, respectively; and (iv) expected life of 8.8 years for 1999 and 8.0 years for 1998 and 1997. The weighted average fair value of the options at the grant date was $7.47, $9.09 and $9.03 for 1999, 1998 and 1997, respectively. 13. EARNINGS PER SHARE: During 1997, the Company adopted Statement of Financial Accounting Standards No. 128, Earnings per Share. Basic earnings per share (Basic EPS) is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share (Diluted EPS) include the dilutive effect of stock options, if any, using the treasury stock method. For 1999, 1998 and 1997, the weighted average shares outstanding during the period of 6,565,621, 6,762,522 and 4,775,491, respectively, used for Basic EPS, was increased by the dilutive impact of stock options of 20,773, 42,104 and 6,993, respectively, for a total of 6,586,394, 6,804,626 and 4,782,484 shares, respectively, used for Diluted EPS. The Company retired substantially all of its outstanding indebtedness using a portion of the net proceeds from the sale of common stock. Assuming the Company's revolving line of credit and long-term borrowings were retired as of January 1, 1997, supplementary earnings per share would be $.80 for the year ended December 31, 1997, reflecting the elimination of interest expense, net of income taxes, of $628 for 1997. Supplementary earnings per share assumes 4,775,491 weighted average share outstanding for 1997 plus 1,150,000 shares, representing those shares of common stock sold at the initial public offering price, the application of the net proceeds therefrom sufficient to retire $12,400 of average outstanding borrowings for 1997. 14. QUARTERLY FINANCIAL DATA (UNAUDITED): 15. INCOME TAXES: The components of the provision for income taxes are as follows: The income tax provisions are different from the amount computed by applying the U.S. federal income tax rates to income before provision for income taxes. The reasons for these differences are as follows: Temporary differences that gave rise to deferred income tax assets and liabilities are as follows: Current deferred income tax assets of $1,100 and $663 are included in other current assets as of December 31, 1999 and 1998, respectively. 16. MAJOR CUSTOMERS: The percentage of net sales to major distributors to total net sales consist of the following: 17. SALES OF EQUIPMENT RENTED TO OTHERS: Panoramic periodically sells x-ray equipment that has been rented to customers in its normal course of business. The Company recognizes revenue for the proceeds of such sales and records as cost of goods sold the net book value of the equipment. Net sales of the equipment were $1,170 and $801 for 1999 and 1998, respectively and gross profit from the sales was $642 and $416 for 1999 and 1998, respectively. 18. EMPLOYEE BENEFITS: Young Dental has a nonqualified bonus plan under which 5% of base compensation is paid annually to full-time employees in Missouri, Texas and California who are at least 25 years of age and have at least three years of service with the Company. Compensation expense related to this plan totaled $122, $155, and $125 in 1999, 1998 and 1997, respectively. Young Dental also has a nonqualified profit sharing plan for its employees. Compensation expense related to this plan was $234, $218, and $189 in 1999, 1998 and 1997, respectively, and is based on the overall profitability of Young Dental. The Company is currently in the process of redesigning its bonus and profit sharing plans for Young Dental for the year 2000. In 1997, Denticator had a nonqualified profit sharing plan for certain employees in California. Compensation expense related to this plan was $87 in 1997. Panoramic has a defined contribution 401(k) plan covering substantially all full-time employees meeting service and age requirements. Contributions to the Plan can be made by an employee through deferred compensation and through a discretionary employer contribution. Compensation expense related to this plan was $26 for each of 1999 and 1998. Panoramic has nonqualified bonus and profit sharing plans covering substantially all employees. Contributions to the plan are based upon profitability and other performance measurements of Panoramic. Compensation expense related to these plans was $357 and $429 in 1999 and 1998, respectively. 19. RELATED-PARTY TRANSACTIONS: The Company leases a portion of its office space to and loans funds to, a corporation in which a principal stockholder of the Company has an equity interest. Rental and other income from such corporation totaled $10, $13 and $13 in 1999, 1998 and 1997, respectively. The Company sells products to, and pays for services from, a corporation in which a principal stockholder of the Company has an equity interest. Net sales to such corporation totaled $86, $54 and $98 in 1999, 1998 and 1997, respectively. Amounts paid for services totaled $3, $7 and $9 in 1999, 1998 and 1997, respectively. Since the acquisition of Panoramic in 1998, the Company provides administrative services for a corporation in which an officer of the Company has an equity interest. This corporation provides financing for certain purchasers of the Company's products. Net sales of the Company's products through financing arrangements with such corporation totaled $277 and $1,051 during 1999 and 1998. Net sales from such corporation totaled $18 and $16 in 1999 and 1998 and the accounts receivable from the corporation totaled $4 and $246 at December 31, 1999 and 1998. 20. CONTINGENCIES: The Company and its subsidiaries are from time to time parties to various legal proceedings arising out of their businesses. Management believes there are no such proceedings pending or threatened against the Company or its subsidiaries which, if determined adversely, would have a material adverse effect on the Company's business, financial condition, results of operations or cash flows. 21. ACCOUNTING STANDARD NOT YET IMPLEMENTED: In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which requires that all derivatives be recognized as either assets or liabilities in the statement of financial position at fair value. The adoption of SFAS 133 is not expected to have a material effect on the Company's financial position or results of operations, as the Company does not hold any derivative instruments. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. (a) Information concerning the Company's directors called for by this item will be included in the Company's definitive Proxy Statement prepared in connection with the 2000 Annual Meeting of Stockholders and is incorporated herein by reference. Such proxy statement will be filed with the Commission within 120 days after the close of the Company's fiscal year. (b) Reference is made to "Executive Officers of the Registrant" in Part I. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information concerning this item will be included under the captions "Executive Compensation" and "Options Grants" in the Company's definitive Proxy Statement prepared in connection with the 2000 Annual Meeting of Stockholders and is incorporated herein by reference. Such proxy statement will be filed with the Commission within 120 days after the close of the Company's fiscal year. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information concerning this item will be included under the caption "Securities Ownership of Management and Certain Beneficial Owners" in the Company's definitive Proxy Statement prepared in connection with the 2000 Annual Meeting of Stockholders and is incorporated herein by reference. Such proxy statement will be filed with the Commission within 120 days after the close of the Company's fiscal year. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information concerning this item will be included under the caption "Certain Relationships and Related Party Transactions" in the Company's definitive Proxy Statement prepared in connection with the 2000 Annual Meeting of Stockholders and is incorporated herein by reference. Such proxy statement will be filed with the Commission within 120 days after the close of the Company's fiscal year. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) Financial Statements -- Reference is made to Item 8 hereof. Consolidated Balance Sheets - December 31, 1999 and 1998. Consolidated Statements of Income - Years ended December 31, 1999, 1998 and 1997. Consolidated Statements of Stockholders' Equity - Years ended December 31, 1999, 1998, and 1997. Consolidated Statements of Cash Flows - Years ended December 31, 1999, 1998 and 1997. Notes to Consolidated Financial Statements - December 31, 1999. (a)(2) Financial Statement Schedule -- The following financial statement schedule of the Company is included for the years ended December 31, 1997, 1998 and 1999: Schedule II Valuation and Qualifying Accounts. All other financial statement schedules are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or the notes thereto. (a)(3) Exhibits -- See the Exhibit Index for the exhibits filed as a part of or incorporated by reference into this report. EXHIBIT NUMBER DESCRIPTION - ------ ----------- 3.1* Articles of Incorporation of Registrant and Statement of Correction 3.2* By-Laws of Registrant 10.1* Escrow Agreement dated May 4, 1995 among Young Dental Manufacturing Company, Chemical Venture Capital Associates, P. Jeffrey Leck, John F. Kirtley, Richard C. Nemanick, Lorvic Holdings, Inc. and Boatmen's Trust Company. 10.2* Contingent Payment Agreement dated as of May 4, 1995, by and between Young Dental Manufacturing Company, The Richard C. Nemanick Trust and Boatmen's Trust Company. 10.3* Young Dental Manufacturing Company Pension Bonus Plan dated as of April 12, 1983. 10.4* Young Dental Manufacturing Company Profit Sharing Plan dated as of January 1, 1987. 10.5*** 1997 Stock Option Plan of the Registrant, as amended. 10.6*** Employment Agreement dated October 1, 1999, by and between Young Innovations, Inc. and Alfred E. Brennan, Jr. (revised from agreement dated October 8, 1997) 10.7** Asset Purchase and Sale Agreement dated February 16, 1998 between Registrant and Panoramic Corporation. 10.8*** Employment Agreement dated July 6, 1999, by and between Young Innovations, Inc. and Arthur L. Herbst, Jr. 10.9*** Employment Agreement dated September 27, 1999, by and between Young Innovations, Inc. and Richard G. Richmond. 10.10*** Employment Agreement dated October 25, 1999, by and between Young Innovations, Inc. and Eric R. Stetzel. 21*** Subsidiaries of the Registrant 23*** Consent of Arthur Andersen LLP 24 Power of Attorney (included on Signature page) 27*** Financial Data Schedule - -------------------------------- * Filed as an Exhibit to Registrant's Registration Statement No. 333-34971 on Form S-1 and incorporated herein by reference. ** Filed as an Exhibit to Registrant's Current Report on Form 8-K filed on March 11, 1998 and incorporated herein by reference. *** Filed herewith. (b) Reports on Form 8-K, none. (c) See exhibits filed as part of or incorporated by reference in this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 20, 2000 YOUNG INNOVATIONS, INC. By: /s/ GEORGE E. RICHMOND ----------------------------------- George E. Richmond Chief Executive Officer Each person whose signature appears below constitutes and appoints George E. Richmond and Alfred E. Brennan his true and lawful attorneys-in-fact and agents, each acting alone, with full powers of substitution and re-substitution for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this report, and to file the same with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, each acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, each acting alone, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION - ------ ----------- 3.1* Articles of Incorporation of Registrant and Statement of Correction 3.2* By-Laws of Registrant 10.1* Escrow Agreement dated May 4, 1995 among Young Dental Manufacturing Company, Chemical Venture Capital Associates, P. Jeffrey Leck, John F. Kirtley, Richard C. Nemanick, Lorvic Holdings, Inc. and Boatmen's Trust Company. 10.2* Contingent Payment Agreement dated as of May 4, 1995, by and between Young Dental Manufacturing Company, The Richard C. Nemanick Trust and Boatmen's Trust Company. 10.3* Young Dental Manufacturing Company Pension Bonus Plan dated as of April 12, 1983. 10.4* Young Dental Manufacturing Company Profit Sharing Plan dated as of January 1, 1987. 10.5*** 1997 Stock Option Plan of the Registrant, as amended. 10.6*** Employment Agreement dated October 1, 1999, by and between Young Innovations, Inc. and Alfred E. Brennan, Jr. (revised from agreement dated October 8, 1997) 10.7** Asset Purchase and Sale Agreement dated February 16, 1998 between Registrant and Panoramic Corporation. 10.8*** Employment Agreement dated July 6, 1999, by and between Young Innovations, Inc. and Arthur L. Herbst, Jr. 10.9*** Employment Agreement dated September 27, 1999, by and between Young Innovations, Inc. and Richard G. Richmond. 10.10*** Employment Agreement dated October 25, 1999, by and between Young Innovations, Inc. and Eric R. Stetzel. 21*** Subsidiaries of the Registrant 23*** Consent of Arthur Andersen LLP 24 Power of Attorney (included on Signature page) 27*** Financial Data Schedule - -------------------------------- * Filed as an Exhibit to Registrant's Registration Statement No. 333-34971 on Form S-1 and incorporated herein by reference. ** Filed as an Exhibit to Registrant's Current Report on Form 8-K filed on March 11, 1998 and incorporated herein by reference. *** Filed herewith. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Young Innovations, Inc.: We have audited in accordance with auditing standards generally accepted in the United States, the consolidated financial statements of Young Innovations, Inc. and subsidiaries included in the Young Innovations, Inc. Form 10-K Annual Report and have issued our report thereon dated February 2, 2000. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. Schedule II included in this Form 10-K Annual Report is the responsibility of the Company's management and is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP St. Louis, Missouri February 2, 2000 YOUNG INNOVATIONS, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1997, 1998, and 1999 (IN THOUSANDS)

84748_1999.txt

84748_1999

1999

84748

Item 1. BUSINESS GENERAL Rogers Corporation (the Company), founded in 1832, is one of the oldest publicly traded U.S. companies in continuous operation. The Company has adapted its products over the years to meet changing market needs, moving from specialty paperboard to transformer boards for electrical insulation, and now predominantly to a range of specialty polymer composite materials for communications, imaging, computer, transportation, and consumer applications. New leadership in 1992 restructured the Company to focus on these materials based businesses -- circuit materials, high performance elastomers, and moldable composites. The Company's management, operations, sales and marketing, and technology development activities were redirected to efforts intended to grow the materials based businesses. In so doing, the Company takes advantage of its core competencies in polymers, fillers, and adhesion, and applies its related materials technologies to identified market needs. Materials based businesses were the core businesses responsible for the Company's strong growth in the 1960's and 1970's, and provided most of the Company's profits in the 1980's. During that time, the profits from the materials based businesses were often offset by substantial losses in the Company's former electronic components businesses, which are now divested. The materials based businesses are guided by clearly developed strategic business plans for profitable growth. The current focus is on worldwide markets for elastomeric materials and related components, high frequency and flexible circuit materials, moldable composite materials, and the electroluminescent lamp joint venture with 3M. BUSINESS SEGMENT FINANCIAL AND GEOGRAPHIC INFORMATION "Business Segment and Geographic Information" on pages 41-43 of the annual report to shareholders for the year ended January 3, 1999, is incorporated herein by reference. PRODUCTS Rogers Corporation manufactures and sells specialty polymer composite materials and components which it develops for growing markets and applications around the world. The Company has two business segments: Polymer Materials and Electronic Materials. The Company's products are based on its core technologies in polymers, fillers, and adhesion. Most products are proprietary, or incorporate proprietary technology in their development and processing, and are sold under the Company's valuable brand names. POLYMER MATERIALS Polymer Materials include high performance elastomer materials, elastomer components, and high performance thermoset moldable composites. The Company's Polymer Materials have characteristics that offer functional advantages in many market applications, and serve to differentiate the Company's products from competitors' materials and from other commonly available materials. Polymer Materials are sold to fabricators, molders, printers and original equipment manufacturers for applications in imaging, communications, computer, transportation, consumer and other markets. Trade names for the Company's Polymer Materials include: PORON(R) urethane foams used for making high performance gaskets and seals in vehicles, communications devices, computers and peripherals; PORON cushion insole materials for footwear and related products; PORON healthcare and medical materials for body cushioning, orthotic appliances, and artificial limbs; PORON silicone foams and sponges, used for making flame retardant gaskets and seals in aircraft, trains, cars and trucks; PORON silicone solids for shielding extreme temperature or flame; R/bak(R) compressible printing plate backing and mounting products for cushioning flexographic printing on packaging materials; NITROPHYL(R) floats for fill level sensing in fuel tanks, motors, and storage tanks; ENDUR(R) elastomer rollers and belts for document handling in copiers, computer printers, facsimile machines, mail sorting machines and automated teller machines; MPC(R) phenolic-based and RX(R) epoxy-based thermoset moldable composites for molding engine and transmission parts used in vehicles, and for molding commutator hubs, brush holders, and other high performance parts that insulate electrical activity in electric motors, appliances, and tools. In January 1999, the Company acquired portions of the moldable composite business of Cytec Fiberite, broadening the line of thermoset moldable phenolic and epoxy composites that it can offer customers for high performance applications. Acquired products include brake piston formulations for molding disk brakes, and toughened epoxy engineered composites for molding opto-electronics components. The Company's two joint ventures extend and complement the Company's worldwide businesses in Polymer Materials. The Rogers Inoac Corporation (RIC), a 50% owned joint venture with Japan-based Inoac Corporation, manufactures high performance PORON elastomer materials and ENDUR components in Mie and Nagoya, Japan. The Durel Corporation, a 50% owned joint venture with 3M, manufactures DUREL electroluminescent lamps in Chandler, Arizona. ELECTRONIC MATERIALS Electronic Materials include printed circuit board laminates for high frequency circuits, flexible printed circuit board laminates for high performance flexible circuits, polyester based industrial laminates, composite materials, and power distribution bus bars. The Company's Electronic Materials have characteristics that offer performance and other advantages in many market applications, and serve to differentiate the Company's products from competitors' products and from commonly available materials. Electronic Materials are sold principally to independent and captive printed circuit board manufacturers who convert the Company's laminates to custom printed circuits. The polymer based dielectric layers of the Company's high frequency circuit board laminates are proprietary materials that provide highly specialized electrical and mechanical properties. Trade names for the Company's high frequency printed circuit board materials include RO3000TM, RO4000TM, DUROID(R), RT/duroid(R), ULTRALAM(R), and TMM(R) laminates. All of these laminates are used for making circuitry that receives, transmits, and processes high frequency communications signals. Each laminate addresses specific needs and applications within the communications market. High frequency circuits are used throughout the equipment and devices that comprise all wireless communications systems, including for cellular communications, digital cellular communications, paging, direct broadcast television, global positioning, mobile radio communications, and radar. The flexible circuit materials that the Company manufactures are called R/flex(R) materials. They are mainly used to make interconnections for hard disk drives, portable computers, and miniaturized electronic devices. The performance characteristics of R/flex materials differentiate these laminates from commonly available flexible circuit materials. The adhesiveless flexible circuit materials that the Company sells to Hutchinson Technology Incorporated, for making TSA suspensions in magneto resistive hard disk drives, are called FLEX-I-MID(R) materials. FLEX-I-MID materials are manufactured by Mitsui Chemicals, Inc. of Japan, under a technology license from Rogers Corporation. Power distribution bus bars are manufactured by the Company under the MEKTRON(R) trade name. Bus bars are sold to manufacturers of high voltage electrical traction systems for use in mass transit and industrial applications, and to manufacturers of communication and computer equipment. Industrial laminates are manufactured by the Company under the Induflex(R) trade name. These polyester based laminates, with thin aluminum and copper cladding, are sold to telecommunications and data communication cable manufacturers for shielding electromagnetic and radio frequency interference, and to automotive component manufacturers for making flat, etched-foil heaters. The Company's nonwoven composite materials are manufactured for medical padding and bandaging, electrical and thermal insulation, and industrial pre-filtration applications. In October 1998, the Company acquired the dampening sleeve business of Imation, a former 3M business. These nonwoven composite roller covers, and related pressroom products, are consumable supplies used by the lithographic printing industry. BACKLOG Excluding joint venture activity, the backlog of firm orders for Polymer Materials was $15,092,000 at January 3, 1999 and $13,173,000 at December 28, 1997. The backlog of firm orders for Electronic Materials was $21,931,000 at January 3, 1999 and $21,585,000 at December 28, 1997. The amount of unfilled orders is reasonably stable throughout the year. RAW MATERIALS The manufacture of both Polymer and Electronic Materials requires a wide variety of purchased raw materials. Some of these raw materials are available only from limited sources of supply that, if discontinued, could interrupt production. When this has occurred in the past, the Company has purchased sufficient quantities of the particular raw material to sustain production until alternative materials and production processes could be qualified with customers. Management believes that similar responses would mitigate any raw material availability issues in the future. EMPLOYEES The Company employed an average of 553 people in the Polymer Materials operations and 568 people in the Electronic Materials operations during 1998. SEASONALITY In the Company's opinion, neither the Polymer Materials business nor the Electronics Materials business is seasonal. CUSTOMERS & MARKETING The Company's products were sold to approximately 2,300 customers worldwide in 1998. Sales to Hutchinson Technology Incorporated accounted for 13% of sales during 1998. Although the loss of all the sales made to any one of the Company's major customers would require a period of adjustment during which the business of a segment would be adversely affected, the Company believes that such adjustment could be made over a period of time. The Company also believes that its business relationships with the major customers within both its segments are generally favorable, and that it is in a good position to respond promptly to variations in customer requirements. However, the possibility exists of losing all the business of any major customer as to any product line. Likewise, the possibility exists of losing all the business of any single customer. The Company markets its full range of products throughout the United States and in most foreign markets. Over 85% of the Company's sales are sold through the Company's own domestic and foreign sales force, with the balance sold through independent agents and distributors. COMPETITION There are no firms that compete with the Company across its full range of product lines. However, each of the Company's products faces competition in each business segment in domestic and foreign markets. Competition comes from firms of all sizes and types, including those with substantially more resources than the Company. The Company's strategy is to offer technically advanced products that are price competitive in their markets, and to link the offerings with market knowledge and customer service. The Company believes this serves to differentiate the Company's products in many markets. RESEARCH & DEVELOPMENT The Company has many domestic and foreign patents and licenses and has additional patent applications on file related to both business segments. In some cases, the patents result in license royalties. The patents are of varying duration and provide some protection. Although the Company vigorously defends its patents, the Company believes that its patents have most value in combination with its equipment, technology, skills, and market position. The Company also owns a number of registered and unregistered trademarks which it believes to be of importance. During its fiscal year 1998, the Company spent $10,352,000 on research and development activities, compared with $9,608,000 in 1997, and $9,184,000 in 1996. These amounts include the cost of the corporate research and development effort in Rogers, Connecticut, which amounted to $7,452,000, $6,908,000, and $6,484,000 in 1998, 1997, and 1996, respectively. The balance was comprised of expenditures for product development and new process development activities in its operating units. ENVIRONMENTAL REGULATION During fiscal year 1998, the Company spent $930,000 on capital equipment necessary to comply with federal, state, and local environmental protection, health and safety regulations. Management estimates that 1999 expenditures needed for compliance with current environmental, health, and safety regulations will approximate $2,900,000 of which $1,600,000 has been accrued and $1,200,000 is expected to be capitalized. These capital expenditures will generally be depreciated on a straight-line basis over a period of from 5 to 10 years. EXECUTIVE OFFICERS OF THE REGISTRANT All officers hold office until the first meeting of the Board of Directors following the annual meeting of stockholders or until successors are elected. There are no family relationships between or among executive officers and directors of the Company. Served in Name, Age and Present Posi- Present Position Prior Business Experience in Past Five Years tion Since - ---------------- --------------------------------------------- ------------ Walter E. Boomer, General in the U.S. Marine Corps from June 1986 61, President and to August 1994; Senior Vice President and Chief Executive Chief Project Management Officer of McDermott Officer International, Inc. to February 1995; President of Babcock & Wilcox Power Generation Group and Executive Vice President of McDermott International, Inc. to October 1996. March 1997 Aarno A. Hassell, Vice President, Circuit Materials Group from 59, Vice President, January 1988 to August 1994. August 1994 Market Development Bruce G. Kosa, 59 Technical Director from August 1992 to October Vice President, 1994. October 1994 Technology Frank H. Roland, President of Halstead Industries, Inc. from 63, Vice June 1991 to January 1995; Vice President of President, RBX Corporation January 1995 to October 1996; Finance; Chief President of Rubatex Corporation April 1995 to Financial Officer; October 1996; President and Chief Executive and Secretary of RBX Corporation October 1996 to July 1998. Sept. 1998 John A. Richie, Director of Human Resources from July 1992 to 51, Vice October 1994. October 1994 President, Human Resources Robert D. Wachob, Vice President, Sales and Marketing from October 51, Senior Vice 1990 to May 1997. May 1997 President, Sales and Marketing Donald F. O'Leary, Assistant Controller from April 1982 to April 55, Corporate 1995. April 1995 Controller Executive Officer April 1996 Robert M. Soffer, 51 Treasurer and Assistant Secretary March 1987 Clerk February 1992 Item 2. Item 2. PROPERTIES The Company owns its properties, except as noted below. The Company considers that its properties are well-maintained, in good operating condition, and suitable for its current and anticipated business. Manufacturing capacity was added to the facilities located in Chandler, Arizona, Ghent, Belgium, and Woodstock, Connecticut, during 1998. Operating capacity can be increased by additional worker hours at these and at several of the Company's other locations. Also, adequate land is available for foreseeable future requirements at each of the Company's owned plants. Floor Space (Square Feet) Type of Facility Leased/Owned Polymer Materials Manchester, Connecticut 128,000 Manufacturing Owned 38,000 Warehouse Owned South Windham, Connecticut 88,000 Manufacturing Owned Woodstock, Connecticut 116,000 Manufacturing Owned Elk Grove Village, Illinois 93,000 Manufacturing Leased through 9/01 Electronic Materials Chandler, Arizona 112,000 Manufacturing Owned 11,000 Warehouse Owned Chandler, Arizona* 142,000 Manufacturing Facility Held for Sale Owned Rogers, Connecticut 290,000 Manufacturing Owned Ghent, Belgium Rogers NV 98,000 Manufacturing Owned Rogers Induflex NV 96,000 Manufacturing Owned Tokyo, Japan 2,000 Sales Office Leased through 8/99 Wanchai, Hong Kong 1,000 Sales Office Leased through 3/00 Taipei, Taiwan, R.O.C. 1,000 Sales Office Leased through 7/00 Corporate Rogers, Connecticut 116,000 Corporate Headquarters/ Research & Development Owned * The company is leasing this facility to the purchaser of the flexible interconnections business, which was sold in 1993. Item 3. Item 3. LEGAL PROCEEDINGS The Company is subject to federal, state, and local laws and regulations concerning the environment and is currently engaged in proceedings involving a number of sites under these laws, as a participant in a group of potentially responsible parties (PRPs). The Company is currently involved as a PRP in five cases involving waste disposal sites, all of which are Superfund sites. Several of these proceedings are at a preliminary stage and it is impossible to estimate the cost of remediation, the timing and extent of remedial action which may be required by governmental authorities, and the amount of liability, if any, of the Company alone or in relation to that of any other PRPs. The Company also has been seeking to identify insurance coverage with respect to several of these matters. Where it has been possible to make a reasonable estimate of the Company's liability, a provision has been established. Insurance proceeds have only been taken into account when they have been confirmed by or received from the insurance company. Actual costs to be incurred in future periods may vary from these estimates. Based on facts presently known to it, the Company does not believe that the outcome of these proceedings will have a material adverse effect on its financial position. In addition to the above proceedings, the Company has been actively working with the Connecticut Department of Environmental Protection (CT DEP) related to certain polychlorinated biphenyl (PCB) contamination in the soil beneath a section of cement flooring at its Woodstock, Connecticut facility. The Company has developed a remediation plan that has been approved by the CT DEP, and it is expected that removal of soil contamination will be completed in 1999. On the basis of estimates prepared by environmental engineers and consultants, the Company recorded a provision of approximately $900,000 in 1994, and based on updated estimates provided an additional $700,000 in 1997 and $600,000 in 1998 for costs related to this matter. During 1995, $300,000 was charged against this provision and $200,000 per year was charged in 1996, 1997 and 1998. Management believes, based on facts currently available, that the implementation of the aforementioned remediation will not have a material additional adverse impact on earnings. In this same matter the United States Environmental Protection Agency (EPA) has alleged that the Company improperly disposed of PCBs. An administrative law judge found the Company liable for this alleged disposal and assessed a penalty of approximately $300,000. The Company has reflected this fine in expense in 1998 but vigorously disputes the EPA allegations and has appealed the administrative law judge's findings and penalty assessment. The Company has not had any material recurring costs and capital expenditures relating to environmental matters, except as specifically described in the preceding statements. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information set forth under the caption "Capital Stock Market Prices" on page 45, under the caption "Restriction on Payment of Dividends" in Note G on page 33, and under the caption "Dividend Policy" in the "Management's Discussion and Analysis" on page 54 of the 1998 annual report to shareholders. At February 25, 1999, there were 1,060 shareholders of record. Item 6. Item 6. SELECTED FINANCIAL DATA Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information set forth under the caption "Selected Financial Data" on page 19 of the 1998 annual report to shareholders, but specifically excluding from said incorporation by reference the information contained therein and set forth under the subcaption "Other Data." Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information set forth under the caption "Management's Discussion and Analysis" on pages 46 through 56 of the 1998 annual report to shareholders. Item 7A. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information set forth under the caption "Market Risk" in the "Management's Discussion and Analysis" on page 53 of the 1998 annual report to shareholders. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information set forth on pages 20 through 44 and under the caption "Quarterly Results of Operations (Unaudited)" on page 45 of the 1998 annual report to shareholders. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information with respect to the Directors of the Registrant set forth under the caption "Nominees for Director" on page 2 of the Registrant's definitive proxy statement dated March 17, 1999, for its 1998 annual meeting of stockholders filed pursuant to Section 14(a) of the Act. Information with respect to Executive Officers of the Registrant is presented in Part I. Item 11. Item 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information set forth under the captions "Directors' Compensation" on page 5 and "Executive Compensation" on pages 6 through 13 of the Registrant's definitive proxy statement, dated March 17, 1999, for its 1999 annual meeting of stockholders filed pursuant to Section 14(a) of the Act. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information with respect to Security Ownership of Certain Beneficial Owners and Management set forth under the captions "Stock Ownership of Management" on page 3 and "Beneficial Ownership of More Than Five Percent of the Corporation's Stock" on page 4 of the Registrant's definitive proxy statement, dated March 17, 1999, for its 1999 annual meeting of stockholders filed pursuant to Section 14(a) of the Act. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G to Form 10-K, there is hereby incorporated by this reference the information with respect to certain relationships and related transactions included under the captions "Other Arrangements and Payments" and "Certain Relationships and Related Transactions" on page 14 of the Registrant's definitive proxy statement, dated March 17, 1999, for its 1999 annual meeting of stockholders filed pursuant to Section 14(a) of the Act. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) - The following consolidated financial statements of Rogers Corporation and Subsidiaries, included in the Annual Report of the Registrant to its shareholders for the fiscal year ended January 3, 1999, are incorporated by reference in Item 8: Consolidated Balance Sheets-January 3, 1999 and December 28, 1997 Consolidated Statements of Income -- Fiscal Years Ended January 3, 1999, December 28, 1997, and December 29, 1996 Consolidated Statement of Shareholders' Equity -- January 3, 1999, December 28, 1997, and December 29, 1996 Consolidated Statements of Cash Flows--Fiscal Years Ended January 3, 1999, December 28, 1997, and December 29, 1996 Notes to Consolidated Financial Statements-January 3, 1999 (2) - The following consolidated financial statement schedule of Rogers Corporation and consolidated subsidiaries is included in Item 14(d): Schedule II - Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (3) Exhibits (numbered in accordance with Item 601 of Regulation S-K): 3a Restated Articles of Organization, filed with the Secretary of State of the Commonwealth of Massachusetts on April 6, 1966, were filed as Exhibit 3a to the Registrant's Annual Report on Form 10-K for the fiscal year ended January 1, 1989 (the 1988 Form 10-K)*. 3b Articles of Amendment, filed with the Secretary of State of the Commonwealth of Massachusetts on August 10, 1966, were filed as Exhibit 3b to the 1988 Form 10-K*. 3c Articles of Merger of Parent and Subsidiary Corporations, filed with the Secretary of State of the Commonwealth of Massachusetts on December 29, 1975, were filed as Exhibit 3c to the 1988 Form 10-K*. 3d Articles of Amendment, filed with the Secretary of State of the Commonwealth of Massachusetts on March 29, 1979, were filed as Exhibit 3d to the 1988 Form 10-K*. 3e Articles of Amendment, filed with the Secretary of State of the Commonwealth of Massachusetts on March 29, 1979, were filed as Exhibit 3e to the 1988 Form 10-K*. 3f Articles of Amendment, filed with the Secretary of State of the Commonwealth of Massachusetts on April 2, 1982, were filed as Exhibit 3f to the 1988 Form 10-K*. 3g Articles of Merger of Parent and Subsidiary Corporations, filed with the Secretary of State of the Commonwealth of Massachusetts on December 31, 1984, were filed as Exhibit 3g to the 1988 Form 10-K*. 3h Articles of Amendment, filed with the Secretary of State of the Commonwealth of Massachusetts on April 6, 1988, were filed as Exhibit 3h to the 1988 Form 10-K*. 3i By-Laws of the Company as amended on March 28, 1991, September 10, 1991, and June 22, 1995 were filed as Exhibit 3i to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1995 (the 1995 Form 10-K)*. 3j Articles of Amendment, as filed with the Secretary of State of the Commonwealth of Massachusetts on May 24, 1994, were filed as Exhibit 3j to the 1995 Form 10-K*. 3k Articles of Amendment, as filed with the Secretary of State of the Commonwealth of Massachusetts on May 8, 1998 are filed herewith. 4a Certain Long-Term Debt Instruments, each representing indebtedness in an amount equal to less than 10 percent of the Registrant's total consolidated assets, have not been filed as exhibits to this Annual Report on Form 10-K. The Registrant hereby undertakes to file these instruments with the Commission upon request. 4b 1997 Shareholder Rights Plan was filed on Form 8-A dated March 24, 1997. The June 19, 1997 and July 7, 1997 amendments were filed on Form 8-A/A dated July 21, 1997*. 10a Rogers Corporation Incentive Stock Option Plan** (1979, as amended July 9, 1987 and October 23, 1996). The 1979 plan and the July 9, 1987 amendment were filed as Exhibit 10c to the Registrant's Annual Report on Form 10-K for the fiscal year ended January 3, 1988 (the 1987 Form 10-K). The October 23, 1996 amendment was filed as Exhibit 10a to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 29, 1996 (the 1996 Form 10-K)*. 10b Description of the Company's Life Insurance Program**, was filed as Exhibit K to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 28, 1980*. 10c Rogers Corporation Annual Incentive Compensation Plan** (as restated and amended on December 18, 1996) was filed as Exhibit 10c to the 1996 Form 10-K*. 10d Rogers Corporation 1988 Stock Option Plan** (as amended December 17, 1988, September 14, 1989, and October 23, 1996). The 1988 plan, the 1988 amendment, and the 1989 amendment were filed as Exhibit 10d to the Registrant's Annual Report on Form 10-K for the fiscal year ended January 1, 1995 (the 1994 Form 10-K)*. The 1996 amendment was filed as Exhibit 10d to the 1996 Form 10-K*. 10e Rogers Corporation 1990 Stock Option Plan** (as restated and amended on October 18, 1996), was filed as Registration Statement No. 333-14419 on Form S-8 dated October 18, 1996*. 10f Rogers Corporation Deferred Compensation Plan** (1983) was filed as Exhibit O to the Registrant's Annual Report on Form 10-K for the fiscal year ended January 1, 1984*. 10g Rogers Corporation Deferred Compensation Plan** (1986) was filed as Exhibit 10e to the 1987 Form 10-K*. 10h Rogers Corporation 1994 Stock Compensation Plan** (as restated and amended on December 6, 1996 and amended on December 18, 1997). The 1996 plan, as amended and restated on December 6, 1996, was filed as Exhibit 10h to the 1996 Form 10-K. The 1997 amendment was filed as Exhibit 10h to the 1997 Form 10-K*. 10i Rogers Corporation Voluntary Deferred Compensation Plan for Non-Employee Directors** (1994, as amended December 26, 1995 and December 27, 1996). The 1994 plan, the December 26, 1995 and December 27, 1996 amendments were filed as Exhibit 10i to the 1994 Form 10-K, 1995 Form 10-K, and 1996 Form 10-K, respectively*. 10j Rogers Corporation Voluntary Deferred Compensation Plan for Key Employees** (1993, as amended on October 18, 1994, December 22, 1994, December 21, 1995, December 22, 1995, and April 16, 1996). The 1993 plan and the 1994 amendments were filed as Exhibit 10j to the 1994 Form 10-K. The 1995 and 1996 amendments were filed as Exhibit 10j to the 1995 Form 10-K and 1996 Form 10-K, respectively*. 10k Rogers Corporation Long-Term Enhancement Plan for Senior Executives of Rogers Corporation** dated December 18, 1997. 10l Rogers Corporation 1998 Stock Incentive Plan** was filed as Registration Statement No. 333-50901 on April 24, 1998*. 13 Portions of the Rogers Corporation 1998 Annual Report to Shareholders which are specifically incorporated by reference in this Annual Report on Form 10-K. 21 Subsidiaries of the Registrant. 23 Consent of Independent Auditors. 27.1 Financial Data Schedule. * In accordance with Rule 12b-23 and Rule 12b-32 under the Securities Exchange Act of 1934, as amended, reference is made to the documents previously filed with the Securities and Exchange Commission, which documents are hereby incorporated by reference. ** Management Contract. (b) No reports on Form 8-K were filed during the three months ended January 3, 1999. (c) Exhibits - The response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedule SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS ROGERS CORPORATION AND CONSOLIDATED SUBSIDIARIES (Dollars in Thousands) Additions Balance Balance at Charged to Charged at End Beginning Costs and to Other Other of Description of Period Expenses Accounts Deductions Period Year ended Jan. 3,1999: Deducted from asset accounts: Net realizable value allowance for assets held for sale $ 492 $ -- $ -- $ -- $ 492 Year ended Dec. 28, 1997: Deducted from asset accounts: Net realizable value allowance for assets held for sale $ 492 $ -- $ -- $ -- $ 492 Year ended Dec. 29, 1996: Deducted from asset accounts: Net realizable value allowance for assets held for sale $ 2,032 $ -- $ -- $ 1,540* $ 492 * Allowance applicable to assets sold during 1996 at approximate book value. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ROGERS CORPORATION (Registrant) Date: March 25, 1999 By /s/FRANK H. ROLAND Frank H. Roland Vice President, Finance; Chief Financial Officer; and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 23, 1999, by the following persons on behalf of the Registrant and in the capacities indicated. By /s/WALTER E. BOOMER President (Principal Executive Officer) Walter E. Boomer and Director By /s/LEONID V. AZAROFF Director Leonid V. Azaroff By /s/LEONARD M. BAKER Director Leonard M. Baker By /s/HARRY H. BIRKENRUTH Director Harry H. Birkenruth By /s/EDWARD L. DIEFENTHAL Director Edward L. Diefenthal By /s/MILDRED S. DRESSELHAUS Director Mildred S. Dresselhaus By /s/DONALD J. HARPER Director Donald J. Harper By /s/GREGORY B. HOWEY Director Gregory B. Howey By /s/LEONARD R. JASKOL Director Leonard R. Jaskol By /s/WILLIAM E. MITCHELL Director William E. Mitchell EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT Percentage of Voting Jurisdiction Securities of Incorporation Company Owned or Organization Rogers L-K Corp. 100% Delaware Rogers Japan, Inc. 100% Delaware Rogers Southeast Asia, Inc. 100% Delaware Rogers Taiwan, Inc. 100% Delaware TL Properties, Inc. 100% Arizona World Properties, Inc. 100% Illinois Rogers Export Sales Corporation 100% Barbados Rogers Induflex N.V. 100% Belgium Rogers N.V. 100% Belgium Rogers GmbH 100% Germany Rogers (UK) LTD. 100% England Rogers S.A. 100% France * Rogers Inoac Corporation 50% Japan * Durel Corporation 50% Delaware *These entities are unconsolidated joint ventures and accordingly are not consolidated in the consolidated financial statements of Rogers Corporation. EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Annual Report (Form 10-K) of Rogers Corporation of our report dated February 22, 1999, included in the 1998 Annual Report to Shareholders of Rogers Corporation. Our audits also included the financial statement schedules of Rogers Corporation listed in Item 14(a). This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set form therein. We also consent to the incorporation by reference in Registration Statements (Forms S-8 Nos. 2-84992, 33-15119, 33-21121, 33-38219, 33-64314, 33-44087, 33-53353, 333-14419, and 333-42545, 333-50901 and Form S-3 No. 33-53369) pertaining to various stock option and employee savings plans, and stock grants, of Rogers Corporation of our report dated February 2, 1999, with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedule included in this Annual Report (Form 10-K) of Rogers Corporation. ERNST & YOUNG LLP Providence, Rhode Island March 23, 1999 The Commonwealth of Massachusetts William Francis Galvin Secretary of the Commonwealth One Ashburton Place, Boston, Massachusetts 02108-1512 ARTICLES OF AMENDMENT (General Laws, Chapter 156B, Section 72) We, Walter E. Boomer, President ---------------- and Robert M. Soffer, Treasurer ---------------- of Rogers Corporation ------------------ (Exact name of corporation) located at c/o Abrams, Roberts & Klickstein, 265 Franklin Street, Boston, MA 02110 ---------------------------------------------------------------- - ----- (Street address of corporation in Massachusetts) certify that these Articles of Amendment affecting articles numbered: - --- (Number those articles 1, 2, 3, 4, 5 and/or 6 being amended) of the Articles of Organization were duly adopted at a meeting held on April 23, 1998, by vote of: 6,423,290 shares of Capital Stock, $1.00 per share par value of 7,591,730 - --------- ------------------------------------------------------ shares outstanding, (type, class & series, if any) being at least a majority of each type, class or series outstanding and' entitled to vote thereon: The Commonwealth of Massachusetts Articles of Amendment (General Laws, Chapter 156B, Section 72) I hereby approve the within Articles of Amendment and, the filing fee in the amount of $25,000 having been paid, said articles are deemed to have been filed with me this 8th day of May, 1998. Effective date: /s/ William Francis Galvin Secretary of the Commonwealth TO BE FILLED IN BY CORPORATION Photocopy of document to be sent to: Steven R. London, Esquire Brown, Rudnick, Freed & Gesmer, P.C. One Financial Center Boston, MA 02110 The foregoing amendment(s) will become effective when these Articles of Amendment are filed in accordance with General Laws, Chapter 156B, Section 6 unless these articles specify, in accordance with the vote adopting the amendment, a later effective date not more than thirty days after such filing, in which event the amendment will become effective on such later date. Later effective date: SIGNED UNDER THE PENALTIES OF PERJURY, this 23rd day of April, 1998. /s/ Walter E. Boomer, President /s/ Robert M. Soffer, Clerk To change the number of shares and the par value (if any) of any type, class or series of stock which the corporation is authorized to issue, fill in the following: The total presently authorized is: WITHOUT PAR VALUE STOCKS WITH PAR VALUE STOCKS TYPE NUMBER OF SHARES TYPE NUMBER OF SHARES PAR VALUE Common: Common: Capital 25,000,000 $1.00 Preferred: Preferred: Change the total authorized to: WITHOUT PAR VALUE STOCKS WITH PAR VALUE STOCKS TYPE NUMBER OF SHARES TYPE NUMBER OF SHARES PAR VALUE Common: Common: Capital 50,000,000 $1.00 Preferred: Preferred: SELECTED FINANCIAL DATA (Dollars in Thousands, Except per Share Amounts) - ---------- 1998 1997 1996 1995 1994 -------- -------- -------- -------- -------- SALES AND INCOME - ---------- Net Sales $216,574 $189,652 $141,476 $140,293 $133,866 Income Before Income Taxes 19,126 22,005 17,657 15,390 10,712 Net Income 13,771 16,500 13,949 13,081 10,134 PER SHARE DATA - ---------- Basic 1.81 2.21 1.92 1.84 1.50 Diluted 1.74 2.10 1.83 1.69 1.41 Book Value 14.47 12.51 10.43 8.42 6.41 FINANCIAL POSITION (YEAR-END) - ---------- Current Assets 74,322 79,483 62,725 55,766 47,720 Current Liabilities 32,305 33,983 24,637 24,412 23,016 Ratio of Current Assets to Current Liabilities 2.3 to 1 2.3 to 1 2.5 to 1 2.3 to 1 2.1 to 1 Cash, Cash Equivalents, and Marketable Securities 9,849 21,555 19,631 14,676 13,851 Working Capital 42,017 45,500 38,088 31,354 24,704 Property, Plant and Equipment - Net 74,811 52,201 36,614 36,473 34,061 Total Assets 176,174 158,440 119,227 102,516 89,443 Long-Term Debt less Current Maturities 13,687 13,660 3,600 4,200 6,675 Shareholders' Equity 110,231 94,378 77,212 60,098 45,125 Long-Term Debt as a Percentage of Shareholders' Equity 12% 14% 5% 7% 15% OTHER DATA - ---------- Depreciation and Amortization 8,439 6,614 5,781 5,738 6,680 Research and Development Expenses 10,352 9,608 9,184 9,320 9,230 Capital Expenditures 28,965 17,739 6,326 8,853 4,648 Number of Employees (Average) 1,122 993 854 928 977 Net Sales per Employee 193 191 166 151 137 Number of Shares Outstanding at Year-End 7,617,666 7,543,699 7,405,961 7,135,090 7,045,270 CONSOLIDATED STATEMENTS OF INCOME - ---------- (Dollars in Thousands, Except Per Share 1998 1997 1996 Amounts) (53 weeks) (52 weeks) (52 weeks) ---------- ---------- ---------- Net Sales $ 216,574 $ 189,652 $ 141,476 Cost of Sales 158,509 133,653 97,279 Selling and Administrative Expenses 28,073 26,061 21,285 Research and Development Expenses 10,352 9,608 9,184 --------- --------- --------- Total Costs and Expenses 196,934 169,322 127,748 --------- --------- --------- Operating Income 19,640 20,330 13,728 Other Income less Other Charges (981) 1,108 3,415 Interest Income, Net 467 567 514 --------- --------- --------- Income Before Income Taxes 19,126 22,005 17,657 Income Taxes 5,355 5,505 3,708 --------- --------- --------- Net Income $ 13,771 $ 16,500 $ 13,949 ========= ========= ========= Net Income Per Share (Notes A & I): Basic $ 1.81 $ 2.21 $ 1.92 --------- --------- --------- Diluted $ 1.74 $ 2.10 $ 1.83 --------- --------- --------- Shares Used in Computing (Notes A & I): Basic 7,601,235 7,474,992 7,283,625 --------- --------- --------- Diluted 7,899,913 7,863,084 7,627,184 ========= ========= ========= - ---------- The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED BALANCE SHEETS - ---------- January 3, December 28, (Dollars in Thousands) 1999 1997 ---------- ---------- ASSETS - ---------- Current Assets: Cash and Cash Equivalents $ 9,593 $ 18,791 Marketable Securities 256 2,764 Accounts Receivable, Net 32,590 28,658 Inventories: Raw Materials 10,392 10,262 In-Process and Finished 12,637 12,446 Less LIFO Reserve (272) (1,123) --------- --------- Total Inventories 22,757 21,585 Current Deferred Income Taxes 3,481 1,936 Assets Held for Sale, Net of Valuation Reserves of $492 in each year (Note B) 5,158 5,158 Other Current Assets 487 591 --------- --------- Total Current Assets 74,322 79,483 --------- --------- Property, Plant and Equipment, Net of Accumulated Depreciation of $69,051 and $63,855 74,811 52,201 Investment in Unconsolidated Joint Venture 5,467 5,373 Pension Asset 4,606 4,731 Goodwill and Other Intangible Assets 14,935 14,500 Other Assets 2,033 2,152 --------- --------- Total Assets $ 176,174 $ 158,440 ========= ========= January 3, December 28, (Dollars in Thousands) 1999 1997 ---------- ---------- LIABILITIES AND SHAREHOLDERS' EQUITY - ---------- Current Liabilities: Accounts Payable $ 17,766 $ 16,771 Current Maturities of Long-Term Debt 600 600 Accrued Employee Benefits and Compensation 6,577 8,098 Accrued Income Taxes Payable 1,059 3,628 Taxes, Other than Federal and Foreign Income 1,038 839 Other Accrued Liabilities 5,265 4,047 --------- --------- Total Current Liabilities 32,305 33,983 --------- --------- Long-Term Debt, less Current Maturities 13,687 13,660 Noncurrent Deferred Income Taxes 5,938 2,311 Noncurrent Pension Liability 3,703 3,900 Noncurrent Retiree Health Care and Life Insurance Benefits 6,268 6,277 Other Long-Term Liabilities 4,042 3,931 Shareholders' Equity: Capital Stock, $1 Par Value (Notes A & I): Authorized Shares 50,000,000; Issued Shares 7,630,466 and 7,543,699 7,630 7,544 Additional Paid-In Capital 33,323 31,097 Treasury Stock (12,800 shares) (Note A) (423) -- Accumulated Other Comprehensive Income, Net of Tax (Note I) 1,348 1,155 Retained Earnings 68,353 54,582 --------- --------- Total Shareholders' Equity 110,231 94,378 --------- --------- Total Liabilities and Shareholders' Equity $ 176,174 $ 158,440 ========= ========= - ---------- The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY - ---------- Capital Accumulated Total (Dollars in Thousands, Stock Additional Other Share- Except Capital Stock (Number Paid-in Retained Comprehensive holders' Amounts) of Shares) Capital Earnings Income Equity ------------------------------------------------------ Balance at December 31, 1995 7,135,090 $ 26,286 $ 24,133 $ 2,544 $ 60,098 ------------------------------------------------------ Comprehensive Income: Net Income for 1996 13,949 13,949 Other Comprehensive Income (511) (511) -------- Total Comprehensive Income 13,438 Stock Options Exercised 70,854 656 727 Stock Issued to Directors 3,661 92 96 Shares Reacquired and Cancelled (3,644) (106) (110) Warrants Exercised 200,000 2,500 2,700 Tax Benefit on Stock Options Exercised 263 263 ------------------------------------------------------ Balance at December 29, 1996 7,405,961 $ 29,691 $ 38,082 $ 2,033 $ 77,212 ------------------------------------------------------- Comprehensive Income: Net Income for 1997 16,500 16,500 Other Comprehensive Income (878) (878) -------- Total Comprehensive Income 15,622 Stock Options Exercised 138,076 1,298 1,436 Stock Issued to Directors 2,506 92 95 Shares Reacquired and Cancelled (2,844) (103) (106) Tax Benefit on Stock Options Exercised 119 119 ------------------------------------------------------ Balance at December 28, 1997 7,543,699 $ 31,097 $ 54,582 $ 1,155 $ 94,378 ------------------------------------------------------ Comprehensive Income: Net Income for 1998 13,771 13,771 Other Comprehensive Income 193 193 -------- Total Comprehensive Income 13,964 Stock Options Exercised 90,167 884 974 Stock Issued to Directors 10,966 352 363 Shares Reacquired and Cancelled (14,366) (589) (604) Tax Benefit on Stock Options Exercised 1,579 1,579 Treasury Stock Acquisitions (12,800 Shares) (423) ------------------------------------------------------ Balance at January 3, 1999 7,630,466 $ 33,323 $ 68,353 $ 1,348 $110,231 ====================================================== The dollar amount of the capital stock ($1 par value) is equal to the indicated number of shares. - ---------- The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands) CASH FLOWS PROVIDED BY (USED IN) OPERATING 1998 1997 1996 ACTIVITIES: (53 weeks) (52 weeks) (52 weeks) ---------------------------------- - ---------- Net Income $ 13,771 $ 16,500 $ 13,949 Adjustments to Reconcile Net Income to Cash Provided by Operating Activities: Depreciation and Amortization 8,439 6,614 5,781 (Benefit) Expense for Deferred Income Taxes 2,009 2,543 (1,439) Equity in Undistributed (Income) of Unconsolidated Joint Ventures, Net (414) (635) (1,555) (Gain) Loss on Disposition of Assets 249 52 (10) Noncurrent Pension and Postretirement Benefits (58) 1,610 1,482 Other, Net (524) (783) 202 Changes in Operating Assets and Liabilities Excluding Effects of Acquisition and Disposition of Assets: Accounts Receivable (3,984) (6,683) (2,173) Inventories (912) (6,515) (2,000) Prepaid Expenses 124 (161) 3 Accounts Payable and Accrued Expenses (2,775) 6,414 46 ---------------------------------- Net Cash Provided by Operating Activities 15,925 18,956 14,286 CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES: - ---------- Capital Expenditures (28,965) (17,739) (6,326) Proceeds from Sale of Business -- -- 2,567 Acquisition of Businesses (1,500) (11,589) (9,690) Proceeds from Sale of Property, Plant and Equipment 100 59 946 Proceeds from Sale of Marketable Securities 2,508 -- 609 Purchase of Marketable Securities -- (1,808) -- Investment in Unconsolidated Joint Ventures and Affiliates 333 386 490 ---------------------------------- Net Cash Used in Investing Activities (27,524) (30,691) (11,404) CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES: - ---------- Proceeds from Short- and Long-Term Borrowings 736 12,259 -- Repayments of Debt Principal (603) (2,100) (600) Acquisition of Treasury Stock (423) -- -- Proceeds from Sale of Capital Stock 2,313 1,544 3,427 ---------------------------------- Net Cash Provided by Financing Activities 2,023 11,703 2,827 Effect of Exchange Rate Changes on Cash 378 148 (145) ---------------------------------- Net Increase (Decrease) in Cash and Cash Equivalents (9,198) 116 5,564 Cash and Cash Equivalents at Beginning of Year 18,791 18,675 13,111 ---------------------------------- Cash and Cash Equivalents at End of Year $ 9,593 $ 18,791 $ 18,675 ================================== - ---------- The accompanying notes are an integral part of the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------- NOTE A-ACCOUNTING POLICIES - ---------- ORGANIZATION: - ---------- Rogers Corporation manufactures specialty materials, which it sells to targeted markets around the world. In 1998 Rogers had two business segments which were about equal in size based on sales and assets. Polymer Materials included high performance elastomer materials and components, and moldable composite materials. Polymer Materials were sold principally to manufacturers in the imaging, transportation, consumer, communications, and computer markets. Electronic Materials included circuit board laminates for high frequency printed circuits, flexible circuit board laminates for interconnections, industrial laminates for shielding of electromagnetic interference, and bus bars for power distribution. Electronic Materials were sold principally to printed circuit board manufacturers and equipment manufacturers for applications in the computer, communications, transportation, and consumer markets. PRINCIPLES OF CONSOLIDATION: - ---------- The consolidated financial statements include the accounts of Rogers Corporation and its wholly-owned subsidiaries (the Company), after elimination of significant intercompany accounts and transactions. CASH EQUIVALENTS: - ---------- Cash equivalents include commercial paper and U.S. government and federal agency securities with an original maturity of three months or less. These investments are stated at cost, which approximates market value. MARKETABLE SECURITIES: - ---------- The Company's marketable securities are classified as available-for- sale and are reported at fair value (based on quoted market prices) on the Company's consolidated balance sheet. Marketable securities are comprised of commercial paper, U.S. treasury notes, and corporate bonds. Unrealized gains and losses on such securities are reflected, net of tax, in shareholders' equity. INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES: - ---------- The Company accounts for its investments in and advances to unconsolidated joint ventures, both of which are 50% owned, using the equity method. RELATED PARTY TRANSACTIONS: - ---------- Sales to unconsolidated joint ventures are made on terms similar to those prevailing with unrelated customers. However, payment terms for amounts owed by the joint ventures may be extended. FOREIGN CURRENCY TRANSLATION: - ---------- All balance sheet accounts of foreign subsidiaries are translated at rates of exchange in effect at each year-end, and income statement items are translated at the average exchange rates for the year. Resulting translation adjustments are made directly to a separate component of shareholders' equity. Currency transaction adjustments are reported as income or expense. INVENTORIES: - ---------- Inventories are valued at the lower of cost or market. Certain inventories, amounting to $7,965,000 at January 3, 1999, and $6,028,000 at December 28, 1997, or 35% and 28% of total Company inventories in the respective periods, are valued at the lower of cost, determined by the last-in, first-out (LIFO) method, or market. The cost of the remaining portion of the inventories was determined principally on the basis of standard costs, which approximate actual first-in, first-out (FIFO) costs. PROPERTY, PLANT AND EQUIPMENT: - ---------- Property, plant and equipment is stated on the basis of cost, including capitalized interest. For financial reporting purposes, provisions for depreciation are calculated on a straight-line basis over the following estimated useful lives of the assets: Years ------------------------------------- Buildings 30 -- 45 Building improvements 10 -- 25 Machinery and equipment 5 -- 15 Office equipment 3 -- 10 INTANGIBLE ASSETS: - ---------- Goodwill, representing the excess of the cost over the net tangible and identifiable assets of acquired businesses, is stated at cost. Goodwill is being amortized on a straight-line method over periods ranging from 10-40 years. Amortization charges to operations amounted to $453,000 in 1998 and $258,000 in 1997. When events and circumstances so indicate, all long-term assets are assessed for recoverability based upon cash flow forecasts. Based on its most recent analysis, the Company believes that no material impairment of goodwill exists at January 3, 1999. Purchased patents and licensed technology are capitalized and amortized on a straight-line basis over their estimated useful lives, generally from 2 to 17 years. PENSIONS AND OTHER POSTRETIREMENT BENEFIT PLANS: - ---------- The Company adopted Statement of Financial Accounting Standards (FAS No. 132), "Employers' Disclosures about Pensions and Other Postretirement Benefits," in 1998. The provisions of FAS No. 132 revise employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of these plans. It standardizes the disclosure requirements for pensions and other postretirement benefits to the extent practicable. INCOME TAXES: - ---------- The Company recognizes income taxes under the liability method. No provision is made for U.S. income taxes on the undistributed earnings of consolidated foreign subsidiaries because such earnings are substantially reinvested in those companies for an indefinite period. Provision for the tax consequences of distributions, if any, from consolidated foreign subsidiaries is recorded in the year the distribution is declared. REVENUE RECOGNITION: - ---------- Revenue is recognized when goods are shipped. NET INCOME PER SHARE: - ---------- The following table sets forth the computation of basic and diluted earnings per share: (Dollars in Thousands, Except Per Share 1998 1997 1996 Amounts) ---------------------------------- Numerator: Net income $ 13,771 $ 16,500 $ 13,949 Denominator: Denominator for basic earnings per share - weighted average shares 7,601,235 7,474,992 7,283,625 Effect of stock options 298,678 388,092 343,559 ---------------------------------- Denominator for diluted earnings per share - adjusted weighted-average shares and assumed conversions 7,899,913 7,863,084 7,627,184 ================================== Basic earnings per share $ 1.81 $ 2.21 $ 1.92 ================================== Diluted earnings per share $ 1.74 $ 2.10 $ 1.83 ================================== USE OF ESTIMATES: - ---------- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. TREASURY STOCK: - ---------- From time to time the Company's Board of Directors authorizes the repurchase, at management's discretion, of shares of the Company's capital stock. The most recent authorization was approved on April 23, 1998 and provided for the repurchase of up to an aggregate of $2.0 million in market value of such stock. On June 17, 1998, the Board of Directors adopted a policy that stated that all such subsequently repurchased stock be maintained as authorized and issued, but not outstanding shares (i.e., Treasury Shares) until transferred pursuant to authority previously or subsequently granted by the Board of Directors. Currently, Treasury Stock totals 12,800 shares and is shown at cost on the balance sheet as a reduction of Shareholders' Equity. NOTE B-ACQUISITIONS AND DIVESTITURES - ---------- IMATION SLEEVES BUSINESS ACQUISITION: - ---------- Effective September 30, 1998, the Company acquired a line of printing pressroom products from Imation Corp., formerly a business of 3M Corporation, for $2.25 million, of which $.75 million is due in March 1999. The acquisition included a line of dampening and ductor sleeves used in lithographic printing, along with related manufacturing assets and intellectual property rights. This acquisition was accounted for as a purchase and, accordingly, results are included in the Company's consolidated financial statements since the date of acquisition. ROGERS INDUFLEX N.V. ACQUISITION: - ---------- The Company acquired UCB Induflex N.V. of Ghent, Belgium from UCB S.A. on September 30, 1997. Induflex, which is now known as Rogers Induflex N.V., manufactures thin aluminum and copper laminates for shielding electromagnetic and radio frequency interference, primarily in telecommunication and data communication applications. The purchase included the business and its Ghent, Belgium facility. For financial statement purposes, the acquisition was accounted for as a purchase and, accordingly, Rogers Induflex N.V.'s results are included in the Company's consolidated financial statements since the date of acquisition. The aggregate purchase price of approximately $11.3 million, which included costs of acquisition, has been allocated to the assets of the Company based on their respective fair market values. The excess of the purchase price over assets acquired (Goodwill) approximated $6.1 million and is being amortized over 40 years. The majority of the purchase price was funded through a new Multi- Currency Revolving Credit Agreement with Fleet National Bank, although at the time the Company could have drawn down its cash position to make the purchase. The Company borrowed 390.2 million Belgian francs ($10.8 million) in September 1997, which is payable in full on or before September 19, 2002. BISCO ACQUISITION: - ---------- Effective January 1, 1997, the Company completed the acquisition of the Bisco Products silicone foam materials business based in the Chicago area, from a wholly-owned subsidiary of Dow Corning Corporation for approximately $11.0 million. The acquisition included machinery and equipment and other fixed assets; inventories of supplies, merchandise, materials, and products; intellectual property rights; books, records and computer software; and all unfilled customer orders. The Company did not acquire the cash and accounts receivable of the Seller and did not assume the liabilities of the Seller. The acquisition was accounted for as a purchase in 1997, and the results for the entire fiscal year were included in the Company's consolidated financial statements. Goodwill approximated $8.5 million and is being amortized over 40 years. PRO FORMA RESULTS (UNAUDITED): - ---------- The following unaudited pro forma consolidated results of operations have been prepared as if the acquisitions of Rogers Induflex N.V. and of the dampening sleeve business from Imation Corp. had occurred as of the beginning of fiscal 1997: (Dollars in Thousands, Except Per Share Pro Forma Years Amounts (Unaudited) --------------------- 1998 1997 --------------------- Net sales $ 223,782 $ 205,608 Net income 14,610 17,843 Net income per share: Basic $ 1.92 $ 2.39 Diluted $ 1.85 $ 2.27 The pro forma consolidated results do not purport to be indicative of results that would have occurred had the acquisitions been in effect for the period presented, nor do they purport to be indicative of the results that will be obtained in the future. ASSETS HELD FOR SALE: - ---------- At January 3, 1999, assets held for sale at estimated net realizable value were $5.2 million, consisting of the land and building being leased to the buyer of the Company's divested flexible interconnections business. NOTE C-PROPERTY, PLANT AND EQUIPMENT - ---------- January 3, December 28, (Dollars in Thousands) 1999 1997 ---------- ---------- Land $ 1,605 $ 1,426 Buildings and improvements 42,088 35,217 Machinery and equipment 76,142 63,129 Office equipment 7,915 7,766 Installations in process 16,112 8,518 ---------- ---------- 143,862 116,056 Accumulated depreciation (69,051) (63,855) ---------- ---------- $ 74,811 $ 52,201 ========== ========== Depreciation expense was $8,029,000 in 1998, $6,169,000 in 1997, and $5,752,000 in 1996. Interest costs incurred during the years 1998, 1997, and 1996 were $1,781,000, $1,033,000, and $765,000, respectively, of which $894,000 in 1998, $251,000 in 1997, and $116,000 in 1996 were capitalized as part of the cost of plant and equipment additions. NOTE D-SUMMARIZED FINANCIAL INFORMATION OF UNCONSOLIDATED JOINT VENTURES AND RELATED PARTY TRANSACTIONS - ---------- The tables shown below summarize combined financial information of the Company's unconsolidated joint ventures which are accounted for by the equity method. Amounts presented include the financial information reported by Rogers Inoac Corporation, located in Japan, and Durel Corporation, located in Arizona, both of which are Polymer Materials ventures. Each of these ventures is 50% owned by the Company. The difference between the Company's investment in unconsolidated joint ventures and its one-half interest in the underlying shareholders' equity of the joint ventures is due primarily to the following factors: 1) The Company's major initial contribution to each venture was technology which was valued differently by the joint venture than it was on the Company's books; 2) one of the joint ventures has a negative retained earnings balance; and 3) translation of foreign currency at current rates differs from that at historical rates. This also results in a difference between the Company's recorded income from unconsolidated joint ventures and a 50% share of the income of those joint ventures. January 3, December 28, (Dollars in Thousands) 1999 1997 ---------- ---------- Current Assets $ 19,691 $ 21,062 Noncurrent Assets 12,171 13,339 Current Liabilities 6,758 9,903 Noncurrent Liabilities 12,468 12,247 Shareholders' Equity 12,636 12,251 Year Ended ---------------------------------------- January 3, December 28, December 29, (Dollars in Thousands) 1999 1997 1996 ---------- ---------- ---------- Net Sales $ 58,570 $ 64,265 $ 64,850 Gross Profit 18,530 21,234 22,058 Net Income 718 971 3,995 Note that in the tables above, Rogers Inoac Corporation is reported as of October 31 for the respective years. Sales to unconsolidated joint ventures amounted to $275,000 in 1998, $659,000 in 1997, and $710,000 in 1996. At January 3, 1999, the Company had indirectly guaranteed 50% of a loan entered into by one of the unconsolidated joint ventures. The Company's proportionate share of the outstanding principal under this guarantee was $5,000,000 at January 3, 1999 and $4,750,000 at December 28, 1997. The Company believes that the unconsolidated joint venture will be able to meet its obligations under this financing arrangement and accordingly no payments will be required and no losses will be incurred under this guarantee. Equity income from unconsolidated joint ventures is included in other income less other charges on the consolidated statements of operations. NOTE E-PENSIONS AND OTHER POSTRETIREMENT BENEFIT PLANS - ---------- PENSIONS: - ---------- The Company has two qualified noncontributory defined benefit pension plans covering substantially all U.S. employees. The Company also has established a nonqualified unfunded noncontributory defined benefit pension plan to restore certain retirement benefits that might otherwise be lost due to limitations imposed by federal law on qualified pension plans. In addition, the Company sponsors three unfunded defined benefit health care and life insurance plans for retirees. The following provides a reconciliation of benefit obligations, plan assets, and funded status of the plans: Other Pension Benefits Postretirement Benefits (Dollars in Thousands) 1998 1997 1998 1997 --------- --------- --------- --------- Components of net periodic benefits cost: Service cost $ 1,569 $ 1,408 $ 304 $ 267 Interest cost 3,791 3,627 354 341 Expected return on plan assets (5,346) (4,507) -- -- Amortizations and deferrals 417 467 (75) (97) Amortization of transition asset (335) (335) -- -- --------- --------- --------- --------- Net periodic benefit costs $ 96 $ 660 $ 583 $ 511 ========= ========= ========= ========= Change in plan assets: Fair value of plan assets January 1 $ 57,860 $ 48,516 $ -- $ -- Actual return on plan assets 2,559 10,104 -- -- Employer contributions 87 1,253 492 476 Benefit payments (2,295) (2,013) (492) (476) --------- --------- --------- --------- Fair value of plan assets December 31 $ 58,211 $ 57,860 $ -- $ -- ========= ========= ========= ========= Change in benefit obligation: Benefit obligation at January 1 $ 54,814 $ 50,920 $ 4,910 $ 4,875 Service cost 1,569 1,408 304 267 Interest cost 3,791 3,627 354 341 Actuarial return on plan assets 5,669 872 212 (97) Benefit payments (2,295) (2,013) (492) (476) --------- --------- --------- --------- Benefit obligation at December 31 $ 63,548 $ 54,814 $ 5,288 $ 4,910 ========= ========= ========= ========= Reconciliation of funded status: Funded status $ (5,337) $ 3,046 $ (5,288) $ (4,910) Unrecognized net gain/ (loss) 5,941 (2,441) (1,580) (1,867) Unrecognized prior service cost 2,079 2,421 -- -- Unrecognized transition (asset) (1,712) (2,047) -- -- --------- --------- --------- --------- Prepaid/(accrued) benefit cost at December 31 $ 971 $ 979 $ (6,868) $ (6,777) ========= ========= ========= ========= Assumptions as of December 31: Discount rate 6.75% 7.00% 6.75% 7.00% Rate of compensation increase 4.00% 4.50% -- -- The expected long-term rates of investment return were assumed to be 9.00% for the pension plan covering unionized hourly employees and 9.50% for the other pension plan in each year presented. The Company has one nonqualified unfunded pension plan with accumulated benefit obligations in excess of plan assets. Amounts applicable to this plan are: 1998 1997 --------- --------- Projected benefit obligation $ 1,281 $ 1,089 Accumulated benefit obligation 1,015 705 Fair value of plan assets -- -- OTHER POSTRETIREMENT BENEFITS: - ---------- The assumed health care cost trend rate of increase is 4.5% for 1999, 5.5% for 1998 and 6.5% for 1997. It is expected to continue at 4.5% after 1999. The health care cost trend rate assumption has the following effect on the amounts reported: increasing the assumed health care cost trend rates by one percentage point for each future year would increase the accumulated postretirement benefit obligation as of the beginning of 1999 by $374,000 and the aggregate of service cost and interest cost components of net periodic postretirement benefit cost for fiscal 1998 by $64,000; decreasing the assumed rates by one percentage point would decrease the accumulated postretirement benefit obligation at the beginning of 1999 by $338,000 and the aggregate of service cost and interest cost components of net periodic postretirement benefit cost for fiscal 1998 by $57,000. NOTE F-EMPLOYEE SAVINGS AND INVESTMENT PLAN - ---------- The Rogers Employee Savings and Investment Plan (RESIP) meets the requirements contained in Section 401(k) of the Internal Revenue Code. All regular U.S. employees with at least one month of service are eligible to participate. The plan is designed to encourage the Company's U.S. employees to save for retirement. Contributions to the plan as well as earnings thereon benefit from tax deferral. Participating employees generally may contribute up to 18% of their salaries and wages. An employee's elective pretax contribution for which a tax deferral is available is limited to the maximum allowed under the Internal Revenue Code. To further encourage employee savings, the Company matched employee contributions up to 5% of a participant's deferred eligible annual compensation subject to IRS limitations, at a rate of 50% in 1998, for all participants other than those in collective bargaining units. The Company matched employee contributions up to 4% of a participant's deferred eligible annual compensation subject to IRS limitations, at a rate of 50% in 1997 and 1996, for all participants other than those in collective bargaining units. In 1998, 100% of the Company's contribution was invested in Company stock. In 1997 and 1996, one-half of the Company's contribution was invested in Company stock and the other half was invested at the employee's discretion. RESIP related expense amounted to $697,000 in 1998, $654,000 in 1997, and $427,000 in 1996, including Company matching contributions of $686,000, $501,000, and $415,000, respectively. NOTE G-DEBT - ---------- LONG-TERM DEBT: - ---------- In 1988 the Company borrowed $6,000,000 at 10.6%. Principal repayments of $600,000 per year began in 1994 and are scheduled to continue until 2003. At January 3, 1999, $3,000,000 of this debt was still outstanding ($3,600,000 at December 28, 1997). In general, interest rates are lower today than they were in 1988 and this, in conjunction with the reduced number of years remaining on the loan, result in an estimated market value for this debt of approximately $3,130,000. Subject to certain loan agreement limitations, the Company has the right to prepay this loan in whole or in part, but the Company has not yet chosen to do so because of the prepayment penalty. In September 1997 the Company cancelled its $5.0 million unsecured revolving credit agreement with Fleet National Bank and replaced it with an unsecured multi-currency revolving credit agreement, also with Fleet. Under the new arrangement, the Company can borrow up to $15.0 million, or the equivalent in Belgian francs and/or Japanese yen. Amounts borrowed under this agreement are to be paid in full by September 19, 2002. The Company borrowed 390,207,039 Belgian francs (the equivalent of $11,290,000 as of January 3, 1999 and of $10,660,000 as of December 28, 1997) under the new arrangement to facilitate the Rogers Induflex N.V. acquisition in Belgium. Under the arrangement, the ongoing facility fee varies from 17.5 to 30 basis points of the maximum amount that can be borrowed. The rate of interest charged on outstanding loans can, at the Company's option and subject to certain restrictions, be based on the prime rate, or at rates from 45 to 65 basis points over either London Interbank Offered Rate (LIBOR) quoted in U.S. dollars or Japanese yen, or Belgian Interbank Offered Rate (BIBOR) quoted in Belgian francs. The spreads over LIBOR and BIBOR and the level of facility fees are based on a measure of the Company's financial strength. The borrowing at year-end was denominated in Belgian francs and the interest rate on the loan was 3.85% as of January 3, 1999. The carrying value of this debt approximates fair value as of January 3, 1999. The loan agreements contain restrictive covenants primarily related to working capital, leverage, and net worth. The Company is in compliance with these covenants. MATURITIES: - ---------- Required long-term debt principal repayments due during the years after 1998 are: 1999-2001, $600,000 each year; 2002, $11,890,000; 2003, $600,000. INTEREST PAID: - ---------- Interest paid during the years 1998, 1997, and 1996, was $1,362,000, $1,003,000, and $935,000, respectively. RESTRICTION ON PAYMENT OF DIVIDENDS: - ---------- Under the most restrictive covenant of the loan agreements, $35,150,000 of retained earnings was available at January 3, 1999, for cash dividends. NOTE H-INCOME TAXES - ---------- Consolidated income before income taxes consists of: (Dollars in Thousands) 1998 1997 1996 ------------------------------------ Domestic $ 14,756 $ 18,168 $ 17,114 Foreign 4,370 3,837 543 ------------------------------------ $ 19,126 $ 22,005 $ 17,657 ==================================== The income tax expense (benefit) in the consolidated statements of income consists of: (Dollars in Thousands) Current Deferred Total ------------------------------------ 1998: Federal $ 2,276 $ 1,322 $ 3,598 Foreign 1,066 687 1,753 State 4 -- 4 ------------------------------------ $ 3,346 $ 2,009 $ 5,355 ==================================== 1997: Federal $ 2,477 $ 1,548 $ 4,025 Foreign 447 995 1,442 State 38 -- 38 ------------------------------------ $ 2,962 $ 2,543 $ 5,505 ==================================== 1996: Federal $ 4,872 $ (1,481) $ 3,391 Foreign 53 42 95 State 222 -- 222 ------------------------------------ $ 5,147 $ (1,439) $ 3,708 ==================================== Deferred tax assets and liabilities as of January 3, 1999 and December 28, 1997, respectively, are comprised of the following: (Dollars in Thousands) January 3, December 28, 1999 1997 ---------- ---------- Deferred tax assets: Accruals not currently deductible for tax purposes: Accrued employee benefits and compensation $ 1,533 $ 1,433 Accrued postretirement benefits 2,020 1,977 Other accrued liabilities and reserves 1,346 754 Net investments in joint ventures 2,547 2,794 Tax credit carryforwards -- 70 Other 107 165 --------- --------- Total deferred tax assets 7,553 7,193 Less deferred tax asset valuation allowance 3,327 3,327 --------- --------- Net deferred tax assets 4,226 3,866 --------- --------- Deferred tax liabilities: Depreciation and amortization 6,683 4,241 --------- --------- Total deferred tax liabilities 6,683 4,241 --------- --------- Net deferred tax asset (liability) $ (2,457) $ (375) ========= ========= Income tax expense differs from the amount computed by applying the U.S. statutory federal income tax rate to income before income tax expense. The reasons for this difference are as follows: (Dollars in Thousands) 1998 1997 1996 -------------------------------- Tax expense at statutory rate $ 6,694 $ 7,702 $ 6,180 Net U.S. tax (foreign tax credit) on foreign earnings (326) (745) 314 General business credits (400) (500) (375) Nontaxable foreign sales income (421) (392) (280) State income taxes, net of federal benefit 3 25 144 Net deferred tax benefits utilized in the current year: Employee benefits and compensation -- -- 111 Other net temporary differences -- -- (200) Net deferred tax benefits to be used in future years -- -- (2,114) Other (195) (585) (72) -------------------------------- Income tax expense $ 5,355 $ 5,505 $ 3,708 ================================ The deferred tax asset valuation allowance remained unchanged for 1998 and 1997. The valuation allowance decreased by $3,425,000 during 1996. The 1996 decrease resulted primarily from the recognition for financial reporting purposes in 1996 of tax credit carryforwards which the Company utilized for tax purposes in 1996 and 1997. Undistributed foreign earnings, before available tax credits and deductions, amounted to $8,601,000 at January 3, 1999, $5,984,000 at December 28, 1997, and $3,589,000 at December 29, 1996. Income taxes paid were $4,442,000, $3,090,000, and $2,554,000, in 1998, 1997, and 1996, respectively. NOTE I-SHAREHOLDERS' EQUITY AND STOCK OPTIONS - ---------- As of January 1, 1998 the Company adopted Statement of Financial Accounting Standards No. 130 (FAS No. 130), "Reporting Comprehensive Income". FAS No. 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of this statement had no impact on the Company's net income or shareholders' equity. FAS No. 130 requires unrealized gains or losses on the Company's available-for-sale securities, foreign currency translation adjustments, and changes in certain minimum pension liabilities, which prior to adoption were reported separately in shareholders' equity, to be included in other comprehensive income. Prior year financial statements have been reclassified to conform to the requirements of FAS No. 130. Components of Other Comprehensive Income (Loss) consist of the following: (Dollars in Thousands) 1998 1997 1996 ------------------------------ Foreign currency translation adjustments $ 112 $ (875) $ (509) Change in unrealized gains (losses) on marketable securities 3 (3) (2) Change in minimum pension liability 78 -- -- Income tax benefit -- -- -- ------------------------------ Other comprehensive income (loss) $ 193 $ (878) $ (511) ============================== Reclassification adjustments in each year are immaterial. Accumulated balances related to each component of Other Comprehensive Income (Loss) are as follows: (Dollars in Thousands) 1/3/99 12/28/97 ---------------------- Foreign currency translation adjustments $ 1,272 $ 1,160 Unrealized loss on marketable securities (2) (5) Change in minimum pension liability 78 -- ---------------------- Accumulated balance $ 1,348 $ 1,155 ====================== In 1988, shareholders approved the 1988 Stock Option Plan including the reservation of 380,000 shares of capital stock for the granting of stock options. Incentive stock options and nonqualified stock options may be granted to officers and other key employees. Additionally, nonqualified stock options can be granted to directors. Incentive stock option grants must be at a price no less than the fair market value of the capital stock as of the date of grant. Nonqualified stock options for officers and other key employees must be granted at a price equal to at least 50% of the fair market value of the capital stock as of the date of grant. To date, all options granted to officers and other key employees under the plan have been at a price equal to the fair market value of the capital stock as of the date of grant. Under certain conditions, non-employee directors were able to receive nonqualified stock options at a discounted exercise price in lieu of a corresponding amount of directors' fees pursuant to the 1988 plan. Currently existing options issued under the plan are exercisable within a period of ten years from the date of grant. In the future, only nonqualified stock options may be granted pursuant to this plan. In 1990, the Company adopted another stock option plan which only permits the granting of nonqualified stock options. Options for a total of 1,370,000 shares have been authorized for issuance under this 1990 plan. In 1994, shareholders approved the 1994 Stock Compensation Plan including the reservation of 500,000 shares of capital stock for stock option grants and stock grants. The plan permits the granting of incentive stock options and nonqualified stock options to officers and other key employees. Additionally, until the approval of the 1998 Stock Incentive Plan (described below), this plan required that the retainer fee for non-employee directors be paid semi-annually in shares of the Company's capital stock with the number of shares of stock granted based on its then fair market value. Stock options also were granted to non-employee directors twice a year. The number of shares in each six-month non-employee director stock option grant was determined by dividing $6,750 (half of the annual director retainer fee at the time the plan was established) by the fair market value of a share of the Company's capital stock as of the date of grant. Nonqualified stock options for officers and other key employees must be granted at a price equal to at least 85% of the fair market value of the capital stock as of the date of grant. To date, virtually all options granted under this plan have been at an exercise price equal to the fair market value of the capital stock as of the date of grant. Currently existing stock options issued under this plan are exercisable within a period of ten years from date of grant. In 1998, shareholders approved the 1998 Stock Incentive Plan including the reservation of 750,000 shares of capital stock for stock option grants and stock grants. The plan permits the granting of incentive stock options and nonqualified stock options to officers and other key employees. Additionally, the plan requires that the retainer fee for non-employee directors be paid semi-annually in shares of the Company's capital stock with the number of shares of stock granted based on its then fair market value. Each non-employee director also receives a 500 share stock option grant twice a year. The exercise price for such non-employee director stock option grants is equal to the then fair market value of a share of capital stock. Nonqualified stock options for officers and other key employees must be granted at a price equal to at least 85% of the fair market value of the capital stock as of the date of grant. To date, all options granted under this plan have been at an exercise price equal to the fair market value of the capital stock as of the date of grant. In general, regular stock options granted to officers and employees have ten-year terms and become exercisable in one-third increments beginning on the second anniversary of the grant date. Non-employee director options granted under the 1988 plan became exercisable on the first anniversary of the date of grant, while options to such individuals granted pursuant to the 1994 plan became exercisable six months and one day after the date of grant. Options granted to non- employee directors pursuant to the 1998 Stock Incentive Plan are immediately exercisable. The options outstanding on January 3, 1999 expire on various dates, beginning March 8, 1999 and ending on December 15, 2008. Shares of capital stock reserved for possible future issuance are as follows: January 3, December 28, 1999 1997 ----------- ----------- Shareholder Rights Plan 10,209,263 9,726,696 Stock options 2,435,711 2,020,606 Rogers Employee Savings and Investment Plan 84,522 84,522 Long-Term Enhancement Plan 68,242 75,000 Stock to be issued in lieu of deferred directors' fees 3,122 2,869 ----------- ----------- Total 12,800,860 11,909,693 =========== =========== The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123 (FAS No. 123), "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized in the financial statements for the stock option plans. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards in 1998, 1997, and 1996 consistent with the provisions of FAS No. 123, the Company's net earnings and earnings per share would have been reduced to the pro forma amounts indicated below: (Dollars in Thousands, Except Per Share Amounts) 1998 1997 1996 ------------------------------------------- Net income As Reported $13,771 $16,500 $13,949 Pro Forma 12,440 15,678 13,551 ------------------------------------------- Basic earnings per share As Reported $ 1.81 $ 2.21 $ 1.92 Pro Forma 1.64 2.10 1.86 ------------------------------------------- Diluted earnings per share As Reported $ 1.74 $ 2.10 $ 1.83 Pro Forma 1.56 1.99 1.78 ------------------------------------------- The effects on pro forma net income and earnings per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reported net income for future years due to such things as the vesting period of the stock options and the potential for issuance of additional stock options in future years. An average vesting period of 36 months was used for the assumption regarding stock options issued in 1998, 1997, and 1996. Options usually become exercisable in one-third increments beginning on the second anniversary of the grant date. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants: 1998 1997 1996 ---------------------------------- Risk-free interest rate 4.65% 5.7% 6.0% Dividend yield 0% 0% 0% Volatility factor 30.6% 28.2% 30.5% Weighted-average expected life 5.5 years 5.3 years 4.7 years A summary of the status of the Company's stock option program at year-end 1998, 1997, and 1996, and changes during the years ended on those dates is presented below: ----------------------------------------------------------- 1998 1997 1996 ----------------------------------------------------------- Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Stock Options Shares Price Shares Price Shares Price ----------------------------------------------------------- Outstanding at beginning of year 1,130,183 $20.54 1,063,277 $15.26 995,437 $13.35 Granted 160,418 25.15 205,050 41.11 143,061 26.04 Exercised (90,167) 10.79 (138,076) 10.40 (72,354) 10.26 Cancelled (10,111) 30.32 (68) 47.90 (2,400) 19.55 Expired -- -- -- -- (467) 8.38 ----------------------------------------------------------- Outstanding at end of year 1,190,323 21.81 1,130,183 20.54 1,063,277 15.26 =========================================================== Options exercisable at end of year 692,067 604,198 533,480 =========================================================== Weighted-average fair value of options granted during year $9.36 $15.30 $9.52 =========================================================== The following table summarizes information about stock options outstanding at January 3, 1999: --------------------------------------------------------------- Options Outstanding Options Exercisable --------------------------------------------------------------- Weighted- Average Weighted- Weighted- Range of Number Remaining Average Number Average Exercise Outstanding Contractual Exercise Exercisable Exercise Prices at 01/03/99 Life in Years Price at 01/03/99 Price -------------------------------------------------------------- $7 to $22 524,426 4.3 $11.75 524,426 $11.75 $23 to $45 665,897 8.3 29.74 167,641 24.50 -------------------------------------------------------------- $7 to $45 1,190,323 6.5 $21.81 692,067 $14.84 ============================================================== NOTE J-COMMITMENTS AND CONTINGENCIES - ---------- LEASES: - ---------- The Company's principal noncancellable operating lease obligations are for building space and vehicles. The leases generally provide that the Company pay maintenance costs. The lease periods range from one to five years and include purchase or renewal provisions at the Company's option. The Company also has leases that are cancellable with minimal notice. Lease expense was $975,000 in 1998, $951,000 in 1997, and $581,000 in 1996. Future minimum lease payments under noncancellable operating leases at January 3, 1999, aggregate $3,978,000. Of this amount, annual minimum payments are $805,000, $600,000, $484,000, $400,000, and $369,000 for years 1999 through 2003, respectively. PURCHASE COMMITMENTS: - ---------- At January 3, 1999, the Company had committed to capital expenditures of approximately $1.3 million, to be used primarily for the construction of facilities and related machinery and equipment. CONTINGENCIES: - ---------- The Company is subject to federal, state, and local laws and regulations concerning the environment and is currently engaged in proceedings involving a number of sites under these laws, as a participant in a group of potentially responsible parties (PRPs). The Company is currently involved as a PRP in five cases involving waste disposal sites, all of which are Superfund sites. Several of these proceedings are at a preliminary stage and it is impossible to estimate the cost of remediation, the timing and extent of remedial action which may be required by governmental authorities, and the amount of liability, if any, of the Company alone or in relation to that of any other PRPs. The Company also has been seeking to identify insurance coverage with respect to several of these matters. Where it has been possible to make a reasonable estimate of the Company's liability, a provision has been established. Insurance proceeds have only been taken into account when they have been confirmed by or received from the insurance company. Actual costs to be incurred in future periods may vary from these estimates. Based on facts presently known to it, the Company does not believe that the outcome of these proceedings will have a material adverse effect on its financial position. In addition to the above proceedings, the Company has been actively working with the Connecticut Department of Environmental Protection (CT DEP) related to certain polychlorinated biphenyl (PCB) contamination in the soil beneath a section of cement flooring at its Woodstock, Connecticut facility. The Company has developed a remediation plan which has been approved by the CT DEP, and it is expected that removal of soil contamination will be completed in 1999. On the basis of estimates prepared by environmental engineers and consultants, the Company recorded a provision of approximately $900,000 in 1994, and based on updated estimates provided an additional $700,000 in 1997 and $600,000 in 1998 for costs related to this matter. During 1995, $300,000 was charged against this provision and $200,000 per year was charged in 1996, 1997 and 1998. Management believes, based on facts currently available, that the implementation of the aforementioned remediation will not have a material additional adverse impact on earnings. In this same matter the United States Environmental Protection Agency (EPA) has alleged that the Company improperly disposed of PCBs. An administrative law judge found the Company liable for this alleged disposal and assessed a penalty of approximately $300,000. The Company has reflected this fine in expense in 1998 but vigorously disputes the EPA allegations and has appealed the administrative law judge's findings and penalty assessment. In addition to the environmental issues, the nature and scope of the Company's business bring it in regular contact with the general public and a variety of businesses and government agencies. Such activities inherently subject the Company to the possibility of litigation which is defended and handled in the ordinary course of business. The Company has established accruals for matters for which management considers a loss to be probable and reasonably estimable. It is the opinion of management that facts known at the present time do not indicate that such litigation, after taking into account insurance coverage and the aforementioned accruals, will have a material adverse effect on the financial position of the Company. NOTE K-BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION - ---------- The Company has adopted Statement of Financial Accounting Standards (FAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information" in 1998 which changes the way the Company reports information about its operating segments. The information for 1997 and 1996 has been restated from the prior year's presentation in order to conform to the presentation required by FAS No. 131. The Company's nine business units and two joint ventures have separate management teams and infrastructures that in most cases offer different products and services. The business units and joint ventures have been aggregated into two reportable segments, Polymer Materials, and Electronic Materials. Polymer Materials: This segment consists of four business units and two joint ventures. The products produced by these operations consist primarily of high performance elastomer foams and proprietary reinforced plastics that are engineered to perform to predetermined specifications where combinations of properties are needed to satisfy rigorous electrical, mechanical, and environmental requirements. The products, which can be in the form of either materials or components, are sold worldwide and for the most part are sold to fabricators and original equipment manufacturers. Electronic Materials: This segment consists of five business units. The products produced by these operations consist primarily of laminate materials and power distribution components used in electronics equipment for transmitting, receiving, and controlling electrical signals. These products tend to be proprietary materials which provide highly specialized electrical and mechanical properties to meet the demands imposed by increasing speed, complexity, and power of analog, digital, and microwave equipment. These materials are fabricated, coated and/or customized as necessary to meet customer demands and are sold worldwide. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on operating income of the respective business units. The principal operations of the Company are located in the United States and Europe. The Company markets its products throughout the United States and sells in foreign markets directly, through distributors and agents, and through its 50% owned joint venture in Japan. In 1998, approximately 53% of total sales were to the electronics industry and one customer accounted for approximately 13% of total sales. Approximately 18% of the Company's sales of products manufactured by U.S. divisions were made to customers located in foreign countries. This includes sales to Europe of 11%, sales to Asia of 4%, and sales to Canada of 2%. At January 3, 1999, the electronics industry accounted for approximately 66% of, and one customer accounted for approximately 20% of, total accounts receivable due from customers. Accounts receivable due from customers located within the United States accounted for 83% of the total accounts receivable owed to the Company at the end of 1998. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. Receivables are generally due within 30 days. Credit losses relating to customers have been minimal and have been within management's expectations. Inter-segment and inter-area sales, which are generally priced with reference to costs or prevailing market prices, are not material in relation to consolidated net sales and have been eliminated from the sales data reported in the following tables. BUSINESS SEGMENT INFORMATION Polymer Electronic (Dollars in Thousands) Materials Materials Other Total -------------------------------------------- 1998: Net sales $ 102,450 $ 114,124 $ 216,574 Operating income 10,682 8,958 19,640 Total assets 72,155 90,689 $ 13,330 176,174 Capital expenditures 9,284 19,681 28,965 Depreciation 4,200 3,829 8,029 ============================================ 1997: Net sales $ 98,853 $ 90,799 $ 189,652 Operating income 8,850 11,480 20,330 Total assets 65,251 69,698 $ 23,491 158,440 Capital expenditures 9,857 7,882 17,739 Depreciation 3,820 2,349 6,169 ============================================ 1996: Net sales $ 79,867 $ 61,609 $ 141,476 Operating income 7,485 6,243 13,728 Total assets 53,123 43,666 $ 22,438 119,227 Capital expenditures 3,286 3,040 6,326 Depreciation 3,080 2,672 5,752 ============================================ Information relating to the Company's operations by geographic area are as follows: Europe United (primarily (Dollars in Thousands) States Belgium) Total -------------------------------------------- 1998: Net sales $ 173,694 $ 42,880 $ 216,574 Long-lived assets 72,874 18,905 91,779 ============================================ 1997: Net sales $ 160,116 $ 29,536 $ 189,652 Long-lived assets 54,823 14,030 68,853 ============================================ 1996: Net sales $ 121,973 $ 19,503 $ 141,476 Long-lived assets 43,917 3,759 47,676 ============================================ Net sales are attributed to the business unit making the sale. Long- lived assets are attributed to the location of the asset. The net assets of wholly-owned foreign subsidiaries were $16,609,000 at January 3, 1999, and $13,118,000 at December 28, 1997. Net income of these foreign subsidiaries was $2,631,000 in 1998, $2,409,000 in 1997, and $462,000 in 1996, including net currency transaction gains (losses) of $62,000 in 1998, $180,000 in 1997, and ($23,000) in 1996. REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS - ---------- Board of Directors and Shareholders Rogers Corporation - ---------- We have audited the accompanying consolidated balance sheets of Rogers Corporation and subsidiaries as of January 3, 1999 and December 28, 1997, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three fiscal years in the period ended January 3, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Rogers Corporation and subsidiaries at January 3, 1999 and December 28, 1997, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended January 3, 1999, in conformity with generally accepted accounting principles. ERNST & YOUNG LLP Providence, Rhode Island February 2, 1999 QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) - ---------- (Dollars in Thousands, Except Per Share Amounts) Basic Diluted Net Manufacturing Net Net Income Net Income Quarter Sales Profit Income Per Share Per Share - --------------------------------------------------------------------------- 1998 Fourth $ 53,553 $ 15,928 $ 3,998 $ .51 $ .51 Third 51,319 12,910 2,693 .36 .34 Second 53,389 13,147 2,621 .35 .33 First 58,313 16,080 4,459 .59 .56 - --------------------------------------------------------------------------- 1997 Fourth $ 51,772 $ 14,927 $ 4,017 $ .53 $ .50 Third 47,752 14,393 4,338 .58 .55 Second 45,788 13,605 4,105 .55 .53 First 44,340 13,074 4,040 .54 .52 - ---------------------------------------------------------------------------- CAPITAL STOCK MARKET PRICES - ---------- The Company's capital stock is traded on the American and Pacific Stock Exchanges. The following table sets forth the composite high and low closing prices during each quarter of the last two years on a per share basis. 1998 1997 - -------------------------------------------------------------------- Quarter High Low High Low - -------------------------------------------------------------------- Fourth $ 29-7/8 $ 22-7/16 $ 46-1/2 $ 35-7/8 Third 33-3/4 21-3/8 44 33-1/4 Second 46-1/2 30-1/8 35-7/8 27 First 41-1/2 37 28-1/2 25-3/4 - -------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS CONSOLIDATED SALES AND OPERATIONS - 1998 TO 1997 Net sales of $216.6 million in 1998 were 14% higher than the previous year. Combined Sales, which include one-half of the sales of the Company's two unconsolidated joint ventures totaled $245.3 million, up 11% from 1997. Several of the Company's major product groups achieved record sales in 1998 mainly as the result of unit volume increases. A majority of the year-to- year volume increase came from sales of a customized FLEX-I-MID material to Hutchinson Technology Incorporated and from sales by Induflex, the European flexible laminates business Rogers acquired at the end of September 1997. The 1998 sales increase was achieved despite a severely overbuilt market in hard disk drives that peaked in 1997 causing customers to draw down inventories through most of 1998. This resulted in a major customer losing nearly one-third of its business in 1998, an event that affected the Company's sales and profitability during the second and third quarters. The Company's strategy continues to emphasize growth by developing current markets, particularly through the introduction of new products, and by means of acquisitions. In 1998 Rogers committed to a market-driven process for product development called Concurrent Product Development (CPD). CPD adds discipline to the process of bringing new products to market, forcing hard decisions relative to the commitment of people and resources. It should help the Company more effectively bring to market new products that have the properties customers need, and that the Company can manufacture. Effective September 30, 1998, the Company acquired a line of printing pressroom products from Imation Corp., formerly a business of 3M Corporation. This dampening sleeve business is integral to the water transfer and inking of many types of offset presses in use throughout the world. This acquisition complements the Company's existing line of R/bak compressible plate mounting materials for flexography and will permit better utilization of the Rogers, Connecticut facility. Net Income was $13.8 million or $1.74 per share on a diluted basis in 1998 compared with $2.10 per share in 1997. Basic earnings per share were $1.81 in 1998 and $2.21 in 1997. Before-tax profits declined 13% from $22.0 million in 1997 to $19.1 million in 1998. The effective tax rates were 28% and 25% in 1998 and 1997, respectively. The decrease in both before-tax profits and net income primarily can be attributed to the severe downturn in sales in 1998 of R/flex flexible circuit materials manufactured by the Company. The widely reported overbuilding by hard disk drive manufacturers coupled with the 32% reduction of sales to a major customer, the largest producer of flexible circuits in the United States, resulted in dramatic sales and profit reductions in this product group. Durel Corporation, the Company's 50% owned joint venture with 3M in electroluminescent lamps, is in the midst of a challenging transition to convert its processes to manufacture smaller, more complex pieces at higher volumes for the wireless communications market. In addition, Durel has significant business in Asia, and has suffered from the decline in the Asian economy, the strong U.S. dollar, and increasing competition causing customers to demand steep price reductions. Also, profits continue to be negatively impacted by costs related to the patent infringement suit brought by Durel in 1995 against Osram Sylvania. It now appears that this long-delayed court case will go to trial in 1999. Rogers Inoac Corporation (RIC), the Company's 50% owned joint venture with Inoac Corporation of Japan, has been negatively impacted by the loss of disk drive business and the poor economic conditions in Japan and Southeast Asia. While sales in local currency in 1998 decreased 10%, currency rate changes caused sales measured in U.S. dollars to decrease 20%. On the positive side, RIC is positioning itself to broaden its product offerings in Asia. This includes ongoing participation with Rogers Corporation in a major marketing success of 1998, the incorporation of significant volumes of PORON materials into the products of one of the world's largest sports-shoe companies. The Company's manufacturing profit was 27% in 1998 and 30% in 1997. This decrease was primarily due to the lower profit margins earned on resale of the specialty FLEX-I-MID material to Hutchinson Technology Incorporated (HTI), the world leader in suspension assemblies for hard disk drives. This material is manufactured by Mitsui Chemicals, Inc. under a technology license from the Company. The doubling of sales of this material to HTI during the year resulted in a 3 percentage point decrease in consolidated manufacturing profit. Selling and administrative expense increased in total dollars but decreased as a percentage of net sales to 13% in 1998 from 14% in 1997. The increase in dollars primarily reflects steps taken to strengthen the internal organization and to improve information systems. Research and development expense totaled $10.4 million in 1998 compared with $9.6 million in 1997. Greater R&D emphasis continues to be given to the development of product platforms resulting in the creation of product families, combined with increased resources applied to improving process capability to achieve lower cost and better controlled manufacturing operations. Major development activities in circuit materials included process and product improvements to the RO3000 and RO4000 high frequency circuit board materials which are designed for use in high volume, low cost commercial wireless communication applications. These activities included the development of a bondply addition to the RO4000 family that will allow multi- layer circuit boards to be made using RO4000 laminates. Flexible circuit materials development efforts focused on the introduction of a new epoxy based adhesive system, R/flex Crystal, and on manufacturing improvements designed to significantly improve the dimensional stability of all R/flex laminates. PORON materials development activities included commercialization of several new formulations for industrial and footware applications; in addition, new thinner adhesive-backed R/bak tapes were developed for the flexographic printing market. Molding materials development continued to emphasize tougher, more dimensionally stable materials for small electrical motor commutators. Net interest income decreased $100,000 from 1997 to 1998. This decrease is primarily due to the lower interest income earned as a result of the significant decrease in cash and marketable securities. Other income less other charges reflected a net income amount of $1.1 million in 1997 and a net expense amount of $1.0 million in 1998. This $2.1 million negative impact on earnings was caused primarily by a $600,000 decrease in royalties and income from joint ventures, a $700,000 change in gains/(losses) from disposal of assets, and $400,000 of additional environmental costs in 1998. The Company is subject to federal, state, and local laws and regulations concerning the environment and is currently engaged in proceedings involving a number of sites under these laws, as a participant in a group of potentially responsible parties (PRPs). The Company is currently involved as a PRP in five cases involving waste disposal sites, all of which are Superfund sites. Several of these proceedings are at a preliminary stage and it is impossible to estimate the cost of remediation, the timing and extent of remedial action which may be required by governmental authorities, and the amount of liability, if any, of the Company alone or in relation to that of any other PRPs. The Company also has been seeking to identify insurance coverage with respect to several of these matters. Where it has been possible to make a reasonable estimate of the Company's liability, a provision has been established. Insurance proceeds have only been taken into account when they have been confirmed by or received from the insurance company. Actual costs to be incurred in future periods may vary from these estimates. Based on facts presently known to it, the Company does not believe that the outcome of these proceedings will have a material adverse effect on its financial position. In addition to the above proceedings, the Company has been actively working with the Connecticut Department of Environmental Protection (CT DEP) related to certain polychlorinated biphenyl (PCB) contamination in the soil beneath a section of cement flooring at its Woodstock, Connecticut facility. The Company has developed a remediation plan which has been approved by the CT DEP, and it is expected that removal of soil contamination will be completed in 1999. On the basis of estimates prepared by environmental engineers and consultants, the Company recorded a provision of approximately $900,000 in 1994, and based on updated estimates provided an additional $700,000 in 1997 and $600,000 in 1998 for costs related to this matter. During 1995, $300,000 was charged against this provision and $200,000 per year was charged in 1996, 1997 and 1998. Management believes, based on facts currently available, that the implementation of the aforementioned remediation will not have a material additional adverse impact on earnings. In this same matter the United States Environmental Protection Agency (EPA) has alleged that the Company improperly disposed of PCBs. An administrative law judge found the Company liable for this alleged disposal and assessed a penalty of approximately $300,000. The Company has reflected this fine in expense in 1998 but vigorously disputes the EPA allegations and has appealed the administrative law judge's findings and penalty assessment. The Company has not had any material recurring costs and capital expenditures relating to environmental matters, except as specifically described in the preceding statements. CONSOLIDATED SALES AND OPERATIONS - 1997 TO 1996 Net sales were $189.7 million for 1997, 34% higher than those reported in 1996. Combined Sales, which include 50% of the sales of the Company's two unconsolidated joint ventures, were $220.9 million, up 27% over 1996. For the fiscal year ended December 28, 1997, each of the Company's divisions recorded sales gains, mainly the result of unit volume increases. The Company's strategy is to achieve growth by developing current markets and by means of acquisitions. In 1997 many opportunities for RO3000 and RO4000 high frequency laminates were realized in wireless communications. The growing application of a custom adhesiveless laminate into the suspension assemblies of Hutchinson Technology Incorporated (HTI), the world's leading supplier of suspension assemblies for hard disk drives, was another major growth area. This represented the first year of full-scale commercialization of this technology. Mitsui Chemicals, Inc. manufactures these laminates in Japan under a technology license from the Company. The Company also strengthened its position in the dynamic wireless communication market with the reformulation of PORON urethane foam materials. Effective January 1, 1997, the Company completed the acquisition of the Bisco Products silicone foam materials business, based in the Chicago area, from a wholly-owned subsidiary of Dow Corning Corporation for approximately $11 million. This acquisition enhanced the Company's position as a leading supplier of high performance foam materials. It broadened the product range and provided a strong foothold in Europe's commercial aerospace industry. On September 30, 1997, the Company completed the acquisition of Induflex, located in Ghent, Belgium, the existing headquarters of the Company's European operations, from manufacturer UCB S.A. The company, now known as Rogers Induflex N.V., manufactures laminates for shielding of electromagnetic and radio frequency interference. During 1997, significant efforts were expended in the integration of the Bisco and Induflex acquisitions into the Company. Full year before-tax profits rose 25% to a record $22.0 million in 1997, while after-tax profits improved 18% to $16.5 million, also a record. Basic earnings per share for the year were $2.21, up from $1.92 in 1996. Diluted earnings per share for the year were $2.10, up from $1.83 in 1996. Significantly higher sales, and operating income growth exceeding the rate of sales increase, were the major contributing factors to the improvement in before-tax income. After-tax profits reflect a 25% tax rate in 1997 and a 21% tax rate in 1996. Durel Corporation continued to make the transition from automotive to wireless communication applications. Durel sales decreased very slightly from 1996 with several large manufacturing programs being replaced by new projects in a start-up phase. Profits were negatively impacted due to inventory adjustments by a major customer in the fourth quarter and by increased costs related to the patent infringement lawsuit brought by Durel to protect its proprietary technology. Rogers Inoac Corporation further developed new low-airflow PORON material grades for disk-drive cover gaskets. While sales in local currency in 1997 increased 7%, currency rate changes caused sales measured in U.S. dollars to decrease 3%. The Company's manufacturing profit was 30% of sales in 1997 and 31% in 1996. The decrease from 1996 to 1997 reflects the integration costs related to the acquisitions of the Bisco Materials Unit and Rogers Induflex N.V., and the lower profit margins on a custom adhesive laminate sold to HTI. It also reflected a decline in average sales price per square foot for laminates as the microwave business continued to shift to lower-priced higher volume wireless communication applications. Selling and administrative expense increased in total dollars, but decreased as a percentage of net sales to 14% in 1997 from 15% in 1996. Research and development expense totaled $9.6 million in 1997 compared to $9.2 million in 1996. Overall, greater R&D emphasis was given to the development of product platforms from which families of products result, rather than individual, less related products. This emphasis is intended to provide greater leverage for growth. Increased corporate resources were also applied to improving process capability to achieve lower costs and better controlled manufacturing operations. Major development activities in Electronic Materials included process and product improvements to the RO3000 and RO4000 high frequency circuit board materials, which are designed for use in high volume, low cost commercial wireless communication applications. The development of these products and their extensions represented the Company's most significant commitment of technology resources in 1997. In flexible circuit materials, development efforts focused on improved adhesives. During the year, Polymer Materials activity included the commercialization of a controlled response PORON urethane material for the foot comfort market, as well as improvements to a variety of other PORON materials for industrial and printing applications. A new ENDUR component formulation was developed to provide improved friction properties and longevity in document transport applications. Finally, higher strength phenolic composites were developed for demanding applications in automotive powertrains and electric motors. The Company's core technical capabilities in polymers, fillers and adhesion continued to improve with these specialized technologies now applied to immediate as well as longer term development tasks. Net interest income for 1997 increased slightly from 1996. Interest earned increased because of a higher level of cash equivalents and marketable securities; however, this income was partially offset by interest expense paid on debt incurred in September 1997 for the Induflex acquisition. Average debt outstanding during 1997 was $7.0 million, compared with $4.5 million for 1996. Other income less other charges decreased to $1.1 million for 1997 from $3.4 million for 1996. Lower royalty income and lower joint venture income were the major contributors to this decrease. SEGMENT SALES AND OPERATIONS Sales in the Polymer Materials business segment increased 4%, 24%, and 7%, in 1998, 1997, and 1996, respectively. The increase from 1997 to 1998 was led by a record sales performance in the Elastomer Components Unit. A new application for nitrophyl floats for fuel level sensing in propane tanks contributed to this sales growth. The moldable composites business was bolstered by increasing sales to Europe and by the addition of a major new U.S. customer for electrical commutator materials. The major expansion completed in 1997 is now effectively supporting the growth of moldable composites in Europe and in the United States. The addition of the Bisco Materials Unit accounted for one-half of the increase from 1996 to 1997. Also in 1997 elastomer components sales far exceeded figures from the previous year. The Polymer Materials business segment generated operating income of $10.7 million in 1998, $8.9 million in 1997, and $7.5 million in 1996. Benefits related to the acquisition of the dampening sleeves business in September 1998, and significantly lower bonus expenses for the year 1998 were the primary contributors to the improved 1998 income levels. For 1997 elastomer components profits were substantially higher than 1996, a result of improved manufacturing performance made possible by enhancements in automation that allowed the unit to fabricate products more cost competitively for industry leaders in document handling. Revenues from the Electronic Materials business segment increased 26% in 1998, 47% in 1997, and 3% in 1996. The addition of a full year of Induflex sales in 1998 accounted for 36% of the increase. Continuing growth of sales of FLEX-I-MID material to HTI more than offset the decline in sales of flexible circuit materials manufactured in Chandler, Arizona. Production and sale of high frequency circuit materials continued an upward trend in 1998. This was made possible by the completion and startup of the new manufacturing facility in Arizona. This facility not only increases the Company's capacity to make high frequency laminates, but now the Company is able to manufacture rather than purchase a critical material used in this product line. Also in 1998, Rogers N.V., a European manufacturing facility, strengthened its position in bus bars, used as power distribution components for trains and mass transit systems, as well as in cellular base stations. Already the market leader in Germany and Scandinavia, the Company made significant inroads toward gaining market share in England and France. In 1997 the majority of high frequency laminate sales occurred in the communications market with particularly healthy growth taking place in the RO3000 and RO4000 laminate product lines. Unit volume increased 50% in 1997, while dollar sales increased by more than 33%. Sales figures in 1997 also increased due to the continuing growth in sales of FLEX-I-MID materials to HTI for hard disk drives. European sales of high frequency circuit materials grew in 1997 with the proliferation of cellular base stations throughout Europe. Electronic Materials operating income was $9.0 million in 1998, $11.5 million in 1997 and $6.2 million in 1996. The decline in sales of flexible circuit materials manufactured in Chandler, Arizona, is the primary reason for the drop in operating income in 1998. Profits from Rogers N.V. sales of bus bars and flexible circuit materials grew significantly in 1997. Sales made through Rogers N.V. stated in local currencies increased 20% in 1998, 42% in 1997, and 8% in 1996. When translated into U.S. dollars these changes became gains of 18%, 30%, and 5% in 1998, 1997, and 1996, respectively. Over the past several years, the Company has intensified its sales and marketing activities in Europe. This effort is now paying off handsomely with sales of almost all product lines in Europe increasing in 1998. Sales of high frequency circuit materials and sales of Endur components were very strong in 1997. BACKLOG The Company's backlog of firm orders was $38.5 million at January 3, 1999, and $34.8 million at December 28, 1997. The increase is due primarily to the higher level of sales. SOURCES OF LIQUIDITY AND CAPITAL Net cash provided by operating activities amounted to $15.9 million in 1998, $19.0 million in 1997, and $14.3 million in 1996. The major reason for the decrease in 1998 is the lower level of income in that year. Primary factors contributing to the year-to-year increase from 1996 to 1997 include increased earnings, a benefit from deferred taxes, and a higher level of accounts payable and accrued expenses. Capital expenditures totaled $29.0 million in 1998, $17.7 million in 1997, and $6.3 million in 1996. In terms of capacity in 1998, the Company has built new production facilities and expanded production lines in the United States and Europe. In addition to the multi-million dollar expansion at the Microwave Materials Division in Chandler, Arizona, a new production line was built at the Poron Materials Unit in Woodstock, Connecticut. Also, in Ghent, Belgium, installation of the microwave laminates product line is virtually completed with manufacturing scheduled to begin in the first quarter of 1999. Capital spending was exceeded by cash generated from the Company's operating activities in both 1997 and 1996. In 1998 capital expenditures exceeded cash generated from operating activities by $13.0 million and more than accounted for the $11.7 million reduction in cash and marketable securities during 1998. For 1999, it is anticipated that capital spending will approximate $15.0 million and that this will be financed by internally generated funds. In September 1997 the Company canceled its $5.0 million unsecured revolving credit agreement with Fleet National Bank and replaced it with an unsecured multi-currency revolving credit agreement, also with Fleet. Under the new arrangement, the Company can borrow up to $15.0 million, or the equivalent in Belgian francs and/or Japanese yen. Amounts borrowed under this agreement are to be paid in full by September 19, 2002. The Company borrowed 390,207,039 Belgian francs (the equivalent of $11,290,000 as of January 3, 1999) under the new arrangement to facilitate the Rogers Induflex N.V. acquisition in Belgium. Under the arrangement, the ongoing facility fee varies from 17.5 to 30 basis points of the maximum amount that can be borrowed. The rate of interest charged on outstanding loans can, at the Company's option and subject to certain restrictions, be based on the prime rate, or at rates from 45 to 65 basis points over either London Interbank Offered Rate (LIBOR) quoted in U.S. dollars or Japanese yen, or Belgian Interbank Offered Rate (BIBOR) quoted in Belgian francs. The spreads over LIBOR and BIBOR and the level of facility fees is based on a measure of the Company's financial strength. The borrowing at year-end was denominated in Belgian francs and the interest rate on the loan at that time was 3.85%. The carrying value of this debt approximates fair value as of January 3, 1999. Included in the provisions of the Company's long-term loan agreements are restrictions on the Company and its subsidiaries with respect to additional borrowings, loans to others except for subsidiaries, payment of dividends, transactions in capital stock, asset acquisitions and dispositions, and lease commitments. These agreements also impose financial covenants requiring the Company to maintain certain levels of working capital and net worth, and specified leverage ratios. Management believes that in the near term, internally generated funds plus available lines of credit will be sufficient to meet the needs of the business. The Company continually reviews and assesses its lending relationships. MARKET RISK The Company is exposed to market risk from changes in interest rates and foreign exchange rates. The Company does not use derivative instruments for trading purposes. The Company monitors foreign exchange and interest rate risks and manages such risks on specific transactions. The risk management process primarily uses analytical techniques and sensitivity analysis. The Company has fixed rate debt obligations and obligations where the interest rate, although not fixed, is relatively low compared to the prime interest rate. An increase in interest rates would not significantly increase interest expense due to the current makeup of the Company's debt obligations. Because of the size and structure of these obligations, a 100 basis point increase in the prime interest rate would not result in a material change in the Company's interest expense or in the fair value of the debt obligations. The fair value of the Company's investment portfolio or the related interest income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the size and short-term nature of the Company's investment portfolio and the relative insignificance of interest income to consolidated pretax income, respectively. The Company's largest foreign currency exposure is against the Belgian franc, primarily because of its investments in its ongoing operations in Belgium. Exposure to variability in currency exchange rates is mitigated, when possible, through the use of natural hedges, whereby purchases and sales in the same foreign currency and with similar maturity dates offset one another. The Company also has a borrowing arrangement under which the Company has borrowed 390 million Belgian francs which is to be paid in full by September 19, 2002. This arrangement functions as a natural hedge against its other Belgian franc exposure. Additionally, the Company can initiate hedging activities by entering into foreign exchange forward contracts with third parties when the use of natural hedges is not possible. Relative to foreign currency exposures existing at January 3, 1999, a 10% unfavorable movement in the Belgian franc exchange rate would not significantly affect consolidated operating results, financial position or cash flows. In addition to the direct effects of changes in exchange rates, such changes typically affect the volume of sales or the foreign currency sales prices as competitors' products become more or less attractive. The Company's sensitivity analysis does not factor in a potential change in sales levels or local currency selling prices. YEAR 2000 The year 2000 issue is the result of computer programs using two digits rather than four to define the applicable year. Such software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in systems failures or miscalculations leading to disruptions in a company's activities and operations. If a company, its significant customers, or suppliers fail to make necessary modifications and conversions on a timely basis, the year 2000 issue could have a material adverse effect on a company's operations. The Company is conducting a review of its systems and operations, including systems currently being implemented, to identify computer hardware, software, and process control systems that do not properly recognize dates after December 31, 1999, including those linked to third party systems. The Company is now in the process of reprogramming or replacing hardware, software, and process control systems as necessary to ensure compliance with year 2000 requirements. The Company is confident that its own internal systems are year 2000 compliant or planned upgrades will be in place. The Company has also initiated communications, primarily in the form of questionnaires, with third parties whose computer systems' functionality could directly impact the operations of the Company. The costs of the Company's year 2000 compliance efforts are being funded with cash flows from operations and are being expensed as incurred. In total these costs are not expected to be substantially different from the normal, recurring costs that are incurred for systems development and implementation. Although the Company is not aware of any material operational issues or costs associated with preparing its internal systems for the year 2000, there can be no assurance that the Company will not experience serious unanticipated negative consequences and/or material costs caused by undetected errors or defects in the technology used in its internal operating systems which are composed predominantly of third party software and hardware technology. Non-compliance by any of the Company's major distributors, suppliers, customers, vendors, or financial organizations could result in business disruptions that could have a material adverse effect on the Company's results of operations, liquidity and financial condition. The Company will develop a contingency plan based on its assessment of significant third party compliance. The goal of the contingency plan will be to minimize the Company's exposure to work slowdowns or business disruptions and any adverse effects on the Company's results of operations. DIVIDEND POLICY In 1992, the Board of Directors voted to discontinue cash dividends. At present, the Company expects to maintain a policy of emphasizing longer-term growth of capital rather than immediate dividend income. FORWARD-LOOKING INFORMATION Certain statements in this Management's Discussion and Analysis section and in other parts of this annual report may constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors which may cause the actual results or performance of the Company to be materially different from any future results or performance expressed or implied by such forward-looking statements. Such risks include changing business, economic, and political conditions both in the United States and in foreign countries; uncertainties and expenses associated with litigation and changes in laws, regulations, and policies of governmental entities; increasing competition; changes in product mix; the development of new products and manufacturing processes and the inherent risks associated with such efforts; changes in the availability and cost of raw materials; fluctuations in foreign currency exchange rates; any difficulties in integrating acquired businesses into the Company's operations; and the pace of technological change. Additional information about certain factors that could cause actual results to differ from such forward-looking statements include the following: The hard disk drive market for personal computers is characterized by volatility in demand, rapid technological change, significant pricing pressures and short lead times. Since the Company manufactures and sells its own circuit materials to meet the needs of this market, the Company's results may be affected by these factors. The Company also sells FLEX-I-MID circuit materials in the U.S. and Europe through an arrangement with Mitsui Chemicals, Inc. which produces this material in Japan under a technology license from the Company. In this case, the Company has no direct control over the manufacturing process, delivery dates or the impact of foreign exchange rates on its sale of FLEX-I-MID circuit materials. The wireless communications market is characterized by frequent new product introductions, evolving industry standards, rapid changes in product and process technologies, price competition and many new potential applications. The RO4000 laminates and other circuit materials that the Company manufactures and sells to this market are relatively new. To be successful in this area, the Company must be able to consistently manufacture and supply high frequency circuit materials that meet the demanding expectations of customers for quality, performance and reliability at competitive prices. The timely introduction by the Company of such new products could be affected by engineering or other development program slippages and problems in effectively and efficiently ramping up production to meet customer needs. While the personal computer industry and the wireless communications industry have in the past experienced overall growth, these industries historically have been characterized by wide fluctuations in product supply and demand. From time to time, the industries have experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. These downturns have been characterized by diminished product demand, production over-capacity and subsequent accelerated price erosion. The Company's business may in the future be materially and adversely affected by downturns. The Company's future results depend upon its ability to continue to develop new products and improve its product and process technologies. The Company's success in this effort will depend upon the Company's ability to anticipate market requirements in its product development efforts, the acceptance and continued commercial success of the end user products for which the Company's products have been designed, and the ability to adapt to technological changes and to support established and emerging industry standards. The Company has been actively working with the Connecticut Department of Environmental Protection related to certain polychlorinated biphenyl contamination in the soil beneath a small section of cement flooring at its Woodstock, Connecticut facility. The Company has developed a remediation plan, which has been approved by the Connecticut Department of Environmental Protection, and it is expected that removal of soil contamination will be completed in 1999. While the Company believes that the implementation of the remediation activities will not have a material adverse impact on the Company's results, there can be no assurance that unanticipated costs will not arise. In addition, the Company is currently engaged in proceedings involving a number of Superfund sites, as a participant in a group of potentially responsible parties. The Company's estimation of environmental liabilities is based on an evaluation of currently available information with respect to each individual situation, including existing technology, presently enacted laws and regulations and the Company's experience in the addressing of such environmental matters. While current regulations impose potential joint and several liability upon each named party at any Superfund site, the Company's contribution for cleanup is expected to be limited due to the number of other potentially responsible parties, and the Company's share of the volume contributions of alleged waste to the sites, which the Company believes is de minimis. However, there can be no assurances that the Company's estimates will not be disputed or that any ultimate liability concerning these sites will not have a material adverse effect on the Company. The level of anticipated 1999 capital expenditures could differ significantly from the forecasted amount due to a number of factors, including but not limited to changes in design, differences between the anticipated and actual delivery dates for new machinery and equipment, problems with the installation and start-up of such machinery and equipment, delays in the construction or modifications of buildings and delays caused by the need to address other business priorities. The Company from time to time must procure certain raw materials from single or limited sources which involves certain risks, including vulnerability to price increases and the quality of the material. In addition, the inability of the Company to obtain these materials in required quantities could result in significant delays or reductions in its own product shipments. When such problems have occurred in the past, the Company has been able to purchase sufficient quantities of the particular raw material to sustain production until alternative materials and production processes could be requalified with customers. However, any inability of the Company to obtain timely deliveries of materials of acceptable quantity or quality, or a significant increase in the prices of materials, could materially and adversely affect the Company's operating results. The Company's international sales involve a number of inherent risks, including imposition of governmental controls, currency exchange fluctuations, potential insolvency of international customers, reduced protection for intellectual property rights in some areas, the impact of recessions in foreign countries, political instability and generally longer receivables collection periods, as well as tariffs and other trade barriers. There can be no assurance that these factors will not have an adverse effect on the Company's future international sales, and consequently, on the Company's business, operating results and financial condition. The Company is in the process of reprogramming or replacing hardware, software, and process control systems to address year 2000 compliance issues. Although the Company is not aware of any material operational issues or costs associated with preparing its internal systems for the year 2000, there can be no assurance that the Company will not experience serious unanticipated negative consequences and/or material costs caused by undetected errors or defects in the technology used in its internal operating systems which are composed predominantly of third party software and hardware technology. The Company has also initiated communications, primarily in the form of questionnaires, with third parties, including vendors, suppliers, and major customers whose computer systems' functionality could directly impact the operations of the Company. Third party non-compliance with year 2000 issues could have a material adverse effect on the Company's operations.

77808_1999.txt

77808_1999

1999

77808

ITEM 1. BUSINESS. GENERAL The Petrie Stores Liquidating Trust (the "Liquidating Trust") is the successor to Petrie Stores Corporation, a New York corporation that was dissolved effective February 5, 1997 ("Petrie"). Since January 24, 1995, Petrie (and from January 22, 1996, the Liquidating Trust) has been in liquidation pursuant to Petrie's shareholder-approved Plan of Liquidation and Dissolution (the "Plan of Liquidation"). Prior to December 9, 1994, the date on which Petrie sold its retail operations (as more fully described below), Petrie and its subsidiaries operated a chain of retail stores that specialized in the sale of women's apparel. During its fiscal year ended January 28, 1995, Petrie undertook a reorganization of its operations in order to separate its investment in Toys "R" Us, Inc. ("Toys 'R' Us") from its retail operations and distribute its shares of Toys "R" Us common stock, par value $.01 per share ("Toys Common Stock"), to Petrie's shareholders without the incurrence of any significant federal income tax by Petrie or its shareholders. In connection with such reorganization, on December 9, 1994, Petrie completed the sale (the "Sale") to PS Stores Acquisition Corp. ("PS Stores") of all of the stock of Petrie's former subsidiary, Petrie Retail, Inc. ("Petrie Retail"), which then owned all of Petrie's retail operations, for $190 million in cash plus the assumption of certain of Petrie's liabilities. The Sale was consummated pursuant to a Stock Purchase Agreement, dated as of August 23, 1994 and amended as of November 3, 1994, between Petrie and WP Investors, Inc., an affiliate of E.M. Warburg, Pincus & Co., Inc. (the "Retail Operations Stock Purchase Agreement"). On January 24, 1995, Petrie exchanged (the "Exchange") with Toys "R" Us 39,853,403 shares of Toys Common Stock held by Petrie, plus $165 million in cash derived from the Sale, for 42,076,420 shares of Toys Common Stock, pursuant to an Acquisition Agreement, dated as of April 20, 1994 and amended as of May 10, 1994, between Petrie and Toys "R" Us (the "Toys Acquisition Agreement"). The Toys Acquisition Agreement had required, among other things, that Petrie sell its retail operations prior to the consummation of the Exchange and that, following the Exchange, Petrie liquidate and dissolve and distribute to its shareholders all of its remaining assets, less an adequate provision for Petrie's actual and contingent liabilities. Since January 24, 1995, the date on which Petrie's shareholders approved the Plan of Liquidation, Petrie (and its successor, the Liquidating Trust) (i) placed 3,493,450 shares of Toys Common Stock into an escrow account to provide for the payment of Petrie's contingent liabilities pursuant to the terms of the Toys Acquisition Agreement, the Retail Operations Stock Purchase Agreement and other agreements with Toys "R" Us and/or PS Stores (which escrow account terminated in accordance with its terms on January 24, 2000); (ii) made two liquidating distributions to Petrie shareholders of an aggregate of 31,410,144 shares of Toys Common Stock; (iii) made one liquidating distribution to unit holders of the Liquidating Trust of approximately $78.5 million in cash and 1,688,576 shares of Toys Common Stock; (iv) sold an aggregate of 6,977,700 shares of Toys Common Stock; and (v) delivered 2,000,000 shares of Toys Common Stock to Canadian Imperial Bank of Commerce in exchange for a cash payment of approximately $61.4 million in connection with the settlement of the transactions contemplated by the Master Agreement (as defined below). As a result of the foregoing transactions, the Liquidating Trust no longer holds any shares of Toys Common Stock. Petrie had also placed 3,200,082 shares of Toys Common Stock in a collateral account (the "Collateral Account") pursuant to the terms of an Amended and Restated Cash Collateral and Pledge Agreement, dated as of December 9, 1994 and amended as of January 24, 1995, among Petrie, PS Stores, certain subsidiaries of PS Stores, and Custodial Trust Company, as Collateral Agent (the "Amended and Restated Cash Collateral Agreement"). On December 19, 1995, the Amended and Restated Cash Collateral Agreement was further amended and restated and, pursuant thereto, the 3,200,082 shares of Toys Common Stock held in the Collateral Account were released to Petrie in exchange for Petrie's deposit of $67.5 million in U.S. Treasury obligations in the Collateral Account. In connection with the settlement of a dispute with the Internal Revenue Service (the "IRS"), approximately $32 million in U.S. Treasury obligations held in the Collateral Account were transferred to the Liquidating Trust on May 20, 1997. Pursuant to a stipulation and release approved by the bankruptcy court in Petrie Retail's bankruptcy case (discussed below), an additional $32 million in U.S. Treasury obligations held in the Collateral Account were transferred to the Liquidating Trust on November 10, 1999. The Liquidating Trust is currently required to maintain approximately $5.5 million in the Collateral Account. The U.S. Treasury obligations held in the Collateral Account pursuant to the Amended and Restated Cash Collateral Agreement secure the obligation of the Liquidating Trust, as successor to Petrie, to indemnify PS Stores for certain liabilities relating to Petrie Retail's withdrawal from a multiemployer pension plan. See Item 7 and Notes to Financial Statements. The Liquidating Trust had entered into a Master Agreement (based on the International Swaps and Derivatives Association Form), dated as of November 19, 1997 (the "Master Agreement"), with Canadian Imperial Bank of Commerce ("CIBC"), to protect the Liquidating Trust against certain investment risks associated with 2,000,000 shares of the Toys Common Stock held by the Liquidating Trust. Pursuant to the Master Agreement, if on December 3, 1999, the price of Toys Common Stock were below $30.7264 (the "Put Price"), CIBC would have been obligated to pay the Liquidating Trust the difference between the Put Price and the then prevailing price of Toys Common Stock, multiplied by 2,000,000. The Master Agreement provided that the Liquidating Trust had the right to elect to receive the entire Put Price (in lieu of receiving the difference between the Put Price and the prevailing price of Toys Common Stock) by delivering to CIBC the 2,000,000 shares of Toys Common Stock subject to the Master Agreement. On November 29, 1999, the Liquidating Trust and CIBC agreed to terminate the Master Agreement prior to the Master Agreement's scheduled termination date of December 3, 1999. In connection with such termination, the Liquidating Trust delivered to CIBC the 2,000,000 shares of Toys "R" Us, Inc. common stock which were subject to the Master Agreement in exchange for a cash payment of approximately $61.4 million. The Liquidating Trust was established pursuant to an Agreement and Declaration of Trust, dated as of December 6, 1995, between Petrie and the trustees named therein (the "Liquidating Trust Agreement"). Pursuant to the Liquidating Trust Agreement, on January 22, 1996 (the "Succession Date"), Petrie transferred its assets (then consisting of approximately $131 million in cash and cash equivalents and 5,055,576 shares of Toys Common Stock) to, and its remaining fixed and contingent liabilities were assumed by (the "Succession"), the Liquidating Trust. Each holder of Petrie common stock, par value $1.00 per share ("Petrie Common Stock"), as of the close of business on the Succession Date, became the holder of one unit of beneficial interest in the Liquidating Trust for each share of Petrie Common Stock owned by such shareholder. Certificates representing shares of Petrie Common Stock were automatically deemed to represent a corresponding number of units of beneficial interest. The Liquidating Trust's activities are limited to winding up Petrie's affairs in furtherance of the Plan of Liquidation. The Liquidating Trust was established to enable Petrie to liquidate prior to fully winding up its affairs, in accordance with the terms of a private letter ruling received by Petrie from the IRS on November 15, 1994. The Liquidating Trust Agreement prohibits the Liquidating Trustees from entering into or engaging in any trade or business on behalf of the Liquidating Trust or its unit holders and from receiving any property, making any distribution, satisfying or discharging any claims, expenses, charges, liabilities or obligations or otherwise taking any action which, in any case, is inconsistent with Petrie's complete liquidation (as such term is used in and interpreted under Sections 368(a)(1)(C) and (a)(2)(G) of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder). The Liquidating Trust is a complete pass-through entity for federal income tax purposes and, accordingly, is not subject to federal income tax. Instead, each holder of units of beneficial interest in the Liquidating Trust is required to take into account, in accordance with such holder's method of accounting, his pro rata share of the Liquidating Trust's items of income, gain, loss, deduction or credit, regardless of the amount or timing of distributions to such holder. The principal executive offices of the Liquidating Trust are located at 201 Route 17, Suite 300, Rutherford, New Jersey 07070 (telephone (201) 635-9637). EMPLOYEES The Liquidating Trust has two part-time employees, Stephanie R. Joseph and H. Bartlett Brown. Ms. Joseph serves as Manager and Chief Executive Officer of the Liquidating Trust. Mr. Brown serves as Assistant Manager and Chief Financial Officer of the Liquidating Trust. ITEM 2. ITEM 2. PROPERTIES. Other than the Liquidating Trust's principal executive offices, the Liquidating Trust neither owns nor leases any real property. As successor to Petrie, the Liquidating Trust is a guarantor of certain leases for which Petrie Retail or an affiliate thereof has assumed liability. See Item 7 and Notes to Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Aventura Malls Venture et al. v. Petrie Stores Corporation et al. As previously disclosed, on February 7, 1996, a complaint was filed in New York State Supreme Court against Petrie, the Liquidating Trust and the Liquidating Trustees by five landlords and certain of their affiliates seeking declaratory relief and unspecified damages for breach of contract and fraud with respect to 146 store leases. The complaint alleged that the Liquidating Trust, as successor to Petrie, had liability as a guarantor of certain of these leases, notwithstanding Petrie's receipt from these landlords of releases with respect to substantially all of the purported lease guarantees. On December 2, 1996, the plaintiffs served an amended complaint, which sought damages only against Petrie and the Liquidating Trust, added a claim for negligent misrepresentation and reduced to 135 the number of store leases subject to the action. On April 7, 1997, the trial court dismissed the plaintiffs' claims for fraud and negligent misrepresentation with respect to the releases of the guarantees. On November 10, 1997, the plaintiffs appealed the decision of the trial court. On April 21, 1998, the trial court's decision was upheld on appeal. On December 28, 1999, the Liquidating Trust paid the plaintiffs $2.4 million in settlement of their remaining claims against the Liquidating Trust and received a full release from all claims, without any recognition of wrongdoing or liability with respect to the claims asserted. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS. UNITS OF BENEFICIAL INTEREST Since January 23, 1996, the units of beneficial interest have been quoted on the OTC Bulletin Board under the symbol "PSTLS." The high and low closing prices per unit of beneficial interest are shown below: As of March 27, 2000, the most recent practicable date prior to the printing of this report, there were approximately 2,829 holders of record of units of beneficial interest of the Liquidating Trust. On February 11, 2000, the Liquidating Trust distributed to its unit holders a total of $78,525,357 in cash and its remaining 1,688,576 shares of Toys Common Stock, or $1.50 in cash and approximately 0.03225536 of a share of Toys Common Stock for each unit held of record at the close of business on January 31, 2000. Prior thereto, the Liquidating Trust had not made a liquidating distribution since its establishment on January 22, 1996. The Liquidating Trustees will consider additional distributions of cash to unit holders when the status of the Liquidating Trust's remaining contingent liabilities is further clarified. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Set forth below are selected consolidated financial data of the Liquidating Trust as of and for the years ended December 31, 1999, 1998 and 1997 and the periods ended December 31, 1996 and January 22, 1996. A liquidation basis of accounting was implemented for all periods presented. - ------------------ (1) Total assets at January 22, 1996 reflect Petrie's first and second liquidating distributions of 26,175,109 shares (including 1,391 shares of Toys Common Stock distributed to certain former shareholders of Winkelman Stores Incorporated (a former subsidiary of Petrie) in respect of their interests in the first distribution) on March 24, 1995 and 5,235,035 shares of Toys Common Stock on August 15, 1995, and the sales of (a) 610,700 shares of Toys Common Stock on May 26, 1995, (b) an aggregate of 3,000,000 shares of Toys Common Stock on October 25 and 26, 1995 and (c) an aggregate of 2,000,000 shares of Toys Common Stock from December 28, 1995 through January 4, 1996. (2) Corporate overhead charges during the years ended December 31, 1999, December 31, 1998 and December 31, 1997 and the periods ended December 31, 1996 and January 22, 1996 relate primarily to accruals for costs and expenses related to Petrie Retail's bankruptcy. During the year ended December 31, 1999, corporate overhead includes $2.0 million relating to an accrual in respect of the settlement of the Aventura Malls Venture action described above, which amount was partially offset by a reduction in the accrual for lease liabilities of approximately $800,000 following the settlement and release of claims asserted by certain other landlords. During the year ended December 31, 1999, corporate overhead also included professional fees and approximately $898,000 in income related to refunds received for retrospective insurance premiums, taxes paid on behalf of Petrie Retail and bankruptcy settlement payments. During the year ended December 31, 1998, the Liquidating Trust's total accrual for lease liabilities was reduced by approximately $2.0 million following the settlement and release of claims asserted by landlords, which reduction was offset by $2.3 million in accruals relating to other liabilities relating to Petrie Retail's bankruptcy. For the year ended December 31, 1997 and the periods ended December 31, 1996 and January 22, 1996, such overhead includes $18 million, $22 million and $15 million, respectively, relating to the liability of the Liquidating Trust, as successor to Petrie, as a guarantor of certain leases for which Petrie Retail or one of its affiliates has assumed liability and $3 million, $4 million and $5 million, respectively, relating to certain other liabilities related to Petrie Retail's bankruptcy. Corporate overhead also consists of other costs and expenses related to the liquidation and dissolution of Petrie, including, but not limited to, legal fees, real estate advisory fees, insurance, salaries for the Liquidating Trust's two part-time employees, trustee fees, accounting fees, transfer agent fees and printing and related expenses. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read in conjunction with the Financial Statements and the Notes thereto of the Liquidating Trust, as successor to Petrie. As previously disclosed, Petrie sold its retail operations to PS Stores on December 9, 1994, and on January 24, 1995 (the date on which Petrie's shareholders approved the Plan of Liquidation), Petrie commenced its liquidation. As a result, effective January 28, 1995, Petrie changed its basis of accounting from a going-concern basis to a liquidation basis. During all periods since such date, the Liquidating Trust's activities have been limited to continuing Petrie's liquidation in furtherance of the Plan of Liquidation. For financial statement purposes, the Liquidating Trust is deemed to be the successor to Petrie, and the results of operations of Petrie are presented in the financial statements of the Liquidating Trust. Beginning with the period ended December 31, 1996, the Liquidating Trust adopted the calendar year as its fiscal year. RESULTS OF OPERATIONS Year Ended December 31, 1999 Compared to the Year Ended December 31, 1998 The Liquidating Trust's net income for the year ended December 31, 1999 was $2,229,000, as compared to a net loss of $27,912,000 for the year ended December 31, 1998. In applying a liquidation basis of accounting, the Liquidating Trust, as successor to Petrie, has given effect in its results of operations to fluctuations in the market price of the Toys Common Stock held by it during the years ended December 31, 1999 and December 31, 1998. The market price per share of Toys Common Stock fluctuated during the year ended December 31, 1999 as follows: The Liquidating Trust has recorded a net realized gain of $1,530,000 and an unrealized loss of $3,745,000 on the Toys Common Stock for the year ended December 31, 1999 as compared to an unrealized loss of $31,228,000 for the year ended December 31, 1998. At various times between April 28, 1999 and May 7, 1999, the Liquidating Trust sold an aggregate of 367,000 shares of Toys Common Stock for approximately $8.5 million and on November 29, 1999 delivered 2,000,000 shares of Toys Common Stock in exchange for a cash payment of approximately $61.4 million, resulting in the net realized gain of $1,530,000 described above. For the year ended December 31, 1999, the Liquidating Trust, as successor to Petrie, incurred corporate overhead of $2,259,000 as compared to $3,710,000 for the year ended December 31, 1998. The Liquidating Trust's corporate overhead generally consists of costs and expenses related to the liquidation and dissolution of Petrie, including, but not limited to, costs and expenses that the Liquidating Trust incurred as a result of Petrie Retail's failure to perform its obligations in connection with its bankruptcy filing, legal fees, real estate advisory fees, salaries for the Liquidating Trust's two part-time employees, trustee fees, accounting fees, transfer agent fees and printing and related expenses. During the year ended December 31, 1999, corporate overhead included lower professional fees and approximately $898,000 in income related to refunds received for retrospective insurance premiums, taxes paid on behalf of Petrie Retail and bankruptcy settlement payments. During the year ended December 31, 1999, corporate overhead includes $2.0 million relating to an accrual in respect of the settlement of the Aventura Malls Venture action described above, which amount was partially offset by a reduction in the accrual for lease liabilities of approximately $800,000 following the settlement and release of claims asserted by certain other landlords. During the year ended December 31, 1999, the Liquidating Trust, as successor to Petrie, earned $6,703,000 in investment income, as compared to $7,165,000 earned during the year ended December 31, 1998. The decrease in investment income earned during the year ended December 31, 1999 is due to lower prevailing interest rates. Year Ended December 31, 1998 Compared to the Year Ended December 31, 1997 The Liquidating Trust's net loss for the year ended December 31, 1998 was $27,912,000, as compared to a net loss of $10,704,000 for the year ended December 31, 1997. In applying a liquidation basis of accounting, the Liquidating Trust, as successor to Petrie, has given effect in its results of operations to fluctuations in the market price of the Toys Common Stock held by it during the years ended December 31, 1998 and December 31, 1997. The market price per share of Toys Common Stock fluctuated during the year ended December 31, 1998 as follows: The Liquidating Trust recorded an unrealized loss on the Toys Common Stock for the year ended December 31, 1998 of $31,228,000, as compared to an unrealized gain of $6,336,000 for the year ended December 31, 1997. In addition, at various times between January 23, 1997 and February 5, 1997, the Liquidating Trust sold an aggregate of 1,000,000 shares of Toys Common Stock for approximately $25.5 million. The Liquidating Trust realized a loss with respect to such sale of approximately $4,375,000 for the year ended December 31, 1997. For the year ended December 31, 1998, the Liquidating Trust, as successor to Petrie, incurred corporate overhead of $3,710,000 as compared to $24,717,000 for the year ended December 31, 1997. The Liquidating Trust's corporate overhead generally consists of costs and expenses related to the liquidation and dissolution of Petrie, including, but not limited to, costs and expenses that the Liquidating Trust incurred as a result of Petrie Retail's failure to perform its obligations in connection with its bankruptcy filing, legal fees, real estate advisory fees, salaries for the Liquidating Trust's two part-time employees, trustee fees, accounting fees, transfer agent fees and printing and related expenses. During the year ended December 31, 1998, the Liquidating Trust's total accrual for lease liabilities was reduced by approximately $2.0 million following the settlement and release of claims asserted by landlords, which reduction was offset by the Liquidating Trust's accrual of $2.3 million for other liabilities relating to Petrie Retail's bankruptcy. Included in corporate overhead for the year ended December 31, 1997 are accruals of approximately $18 million relating to the liability of the Liquidating Trust, as successor to Petrie, as a guarantor of certain leases under which Petrie Retail or one of its affiliates has failed to perform and an amount in respect of retrospective insurance premium adjustments of which approximately $1.5 million was paid in 1997. See Notes to Financial Statements. During the year ended December 31, 1998, the Liquidating Trust, as successor to Petrie, earned $7,165,000 in investment income, as compared to $8,164,000 earned during the year ended December 31, 1997. The decrease in investment income earned during the year ended December 31, 1998 is due to a reduced amount of funds available for investment and lower prevailing interest rates. LIQUIDITY AND CAPITAL RESOURCES General As previously disclosed, approximately $5.5 million in U.S. Treasury obligations is required to be held by the Liquidating Trust in the Collateral Account to secure the Liquidating Trust's obligation to indemnify PS Stores for certain liabilities relating to Petrie Retail's withdrawal from a multiemployer pension plan. The assets of the Liquidating Trust are subject to the terms of a letter agreement dated as of January 24, 1995 (the "Side Letter Agreement"), pursuant to which Petrie agreed with Toys "R" Us that Petrie would retain, either individually or in combination, (i) cash in an amount of at least $177.5 million (the "Reserved Amount") or (ii) shares of Toys Common Stock having a market value (using the per share price on January 20, 1995) of at least twice the Reserved Amount, to secure the payment of Petrie's contingent liabilities. In connection with the distribution of $78,525,357 in cash and 1,688,576 shares of Toys Common Stock by the Liquidating Trust on February 11, 2000, the Liquidating Trust provided Toys "R" Us with prior notice of the proposed distribution and Toys "R" Us agreed that it did not object to such distribution. Pursuant to the terms of the Side Letter Agreement, the Liquidating Trust is required to provide similar notice to Toys "R" Us prior to making any additional distributions. The Liquidating Trust had entered into the Master Agreement with CIBC to protect the Liquidating Trust against certain investment risks associated with 2,000,000 shares of Toys Common Stock held by the Liquidating Trust. Pursuant to the Master Agreement, if on December 3, 1999, the price of Toys Common Stock were below $30.7264 (the "Put Price"), CIBC would have been obligated to pay the Liquidating Trust the difference between the Put Price and the then prevailing price of Toys Common Stock, multiplied by 2,000,000. The Master Agreement provided that the Liquidating Trust had the right to elect to receive the entire Put Price (in lieu of receiving the difference between the Put Price and the prevailing price of Toys Common Stock) by delivering to CIBC the 2,000,000 shares of Toys Common Stock subject to the Master Agreement. On November 29, 1999, the Liquidating Trust and CIBC agreed to terminate the Master Agreement prior to the Master Agreement's scheduled termination date of December 3, 1999. In connection with such termination, the Liquidating Trust delivered to CIBC the 2,000,000 shares of Toys "R" Us, Inc. common stock which were subject to the Master Agreement in exchange for a cash payment of approximately $61.4 million. As of March 27, 2000, the Liquidating Trust had approximately $121 million in cash, cash equivalents and investments in U.S. Treasury obligations (including those held in the Collateral Account). The Liquidating Trust believes that it has sufficient liquid funds available to satisfy the foreseeable liabilities of the Liquidating Trust (including, without limitation, costs and expenses related to the administration of the Liquidating Trust such as legal fees, real estate advisory fees, insurance, salaries for the Liquidating Trust's two part-time employees, trustee fees, accounting fees, transfer agent fees and printing and related expenses). Contingent Liabilities As successor to Petrie, the Liquidating Trust has certain contingent liabilities with respect to existing or potential claims, lawsuits and other proceedings, which primarily relate to (i) guarantees of certain retail store leases, expiring at various times through 2011 for which Petrie Retail or an affiliate thereof assumed liability, and certain other liabilities that were assumed by Petrie Retail (but as to which Petrie's liability has not been released) in connection with the Sale (collectively, the "Assumed Obligations") to the extent that Petrie Retail or its successor fails to perform; and (ii) Petrie's agreement with Petrie Retail to indemnify it for certain liabilities relating to the funding of, and Petrie Retail's withdrawal from, the United Auto Workers District 65 Security Plan Pension Fund (the "Multiemployer Plan"). The Liquidating Trust accrues liabilities when it is probable that future costs will be incurred and when such costs can be reasonably estimated. Such accruals are based on developments to date, the Liquidating Trust's estimates of the outcome of these matters and its experience (including that of its predecessor, Petrie) in contesting, litigating and settling matters. At December 31, 1999 and December 31, 1998, the Liquidating Trust, as successor to Petrie, had accrued approximately $36 million and $39 million, respectively, for contingent liabilities. As the scope of these liabilities becomes better defined, there may be changes in the estimates of future costs, which could have a material effect on the Liquidating Trust's financial condition, liquidity and future ability to make liquidating distributions. Petrie Retail's Bankruptcy. On October 12, 1995, Petrie Retail filed a voluntary petition for reorganization relief under Chapter 11 of the United States Bankruptcy Code with the U.S. Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). In connection with its filing for bankruptcy protection, Petrie Retail failed to perform or make payments with respect to certain of the Assumed Obligations, including, but not limited to, Assumed Obligations relating to store leases for which Petrie Retail or an affiliate thereof had assumed liability, state and federal taxes, employment agreements, insurance premiums and certain other claims and contractual obligations. Accordingly, the Liquidating Trust has been and may continue to be required to make payments in respect of certain of the Assumed Obligations. On December 23, 1997, the Liquidating Trust filed over 110 claims in the Bankruptcy Court against Petrie Retail and certain of its affiliates with respect to an aggregate of approximately $14 million in payments which had then been made by the Liquidating Trust as a result of the failure by Petrie Retail or an affiliate thereof to perform or pay certain of the Assumed Obligations. The Liquidating Trust subsequently amended these claims such that it asserted fixed claims representing a total of approximately $16.9 million against Petrie Retail's estate. The Liquidating Trust also filed approximately 600 additional claims in the Bankruptcy Court against Petrie Retail and certain of its affiliates with respect to payments which the Liquidating Trust may in the future be required to make as a result of the failure by Petrie Retail or its affiliates to perform or pay Assumed Obligations. On March 9, 2000, the distribution company (the "Distribution Company") designated by the Petrie Retail Plan (as defined below) moved for Bankruptcy Court approval of a stipulation of settlement with the Liquidating Trust. Pursuant to the proposed settlement, the Liquidating Trust and the Distribution Company would settle their disputes regarding the claims that the Liquidating Trust filed against Petrie Retail by (i) allowing the Liquidating Trust a single unsecured claim against Petrie Retail in the amount of $15.3 million, subject to certain adjustments, (ii) releasing to the Liquidating Trust the $5.5 million held in the Collateral Account by June 30, 2000, unless the Distribution Company pays $10 million or more to the Multiemployer Plan prior to that date, and (iii) exchanging mutual releases. A hearing on the motion to approve the settlement is scheduled for April 12, 2000. There can be no assurance that the Bankruptcy Court will approve the settlement. Moreover, even if the settlement is approved, there can be no assurance as to the timing of the payment of claims against the reorganized Petrie Retail entity or the amount of the payments, if any, that the reorganized Petrie Retail entity will make to creditors asserting unsecured claims. Accordingly, no amounts have been accrued as receivables for potential reimbursement or recoveries from the reorganized Petrie Retail entity. On April 10, 1998, PS Stores, the parent of Petrie Retail, filed a voluntary petition for reorganization relief under Chapter 11 of the United States Bankruptcy Code with the Bankruptcy Court. On August 7, 1998, the Liquidating Trust filed claims in the Bankruptcy Court against PS Stores substantially similar to those filed against Petrie Retail. On December 8, 1998, the Bankruptcy Court confirmed the proposed plan of reorganization for Petrie Retail (the "Petrie Retail Plan"), which modified the plan of reorganization filed by Petrie Retail and Warburg Pincus Ventures, L.P. ("Warburg") with the Bankruptcy Court on August 6, 1998, as amended. Under the confirmed Petrie Retail Plan, Petrie Retail sold substantially all of its remaining operating assets to Urban Acquisition Corp., an affiliate of Urban Brands, Inc., a retailer that operates under the Ashley Stewart trade name, for $52.25 million, and retained 13 of its store leases, for which Warburg was required to contribute $12 million to the bankruptcy estate, assume $3.1 million of Petrie Retail's executive severance obligations and waive approximately $3.8 million in fees and expenses allegedly owed to it under Petrie Retail's debtor-in-possession financing arrangement. On December 8, 1998, the Bankruptcy Court confirmed PS Stores' proposed plan of reorganization. In August 1999, pursuant to a settlement approved by the Bankruptcy Court, the Liquidating Trust received a payment in the amount of $0.2 million from PS Stores' bankruptcy estate. Store Leases. As described above, in December 1998, Petrie Retail disposed of substantially all its remaining operations and store leases as part of the Petrie Retail Plan. Of the roughly 1600 stores that Petrie Retail operated prior to filing its bankruptcy petition in October 1995, (i) 722 leases were rejected, (ii) 615 leases were assigned to third party retailers, including (A) 410 leases which were part of Petrie Retail's former G&G Shops Inc. division and were included in the sale of such division to an investor group led by Pegasus Partners, L.P. and certain executives of such division, (B) 85 leases which were sold to Urban Acquisition Corp. as part of the Petrie Retail Plan and (C) 120 leases which were not part of Petrie Retail's former G&G Shops Inc. division and which were sold to third party retailers other than Urban Acquisition Corp., (iii) 13 leases were retained by the reorganized Petrie Retail entity for stores which are currently managed by Urban Acquisition Corp. and which Urban Acquisition Corp. has the right to purchase at a later date and (iv) approximately 250 leases expired or were terminated by mutual landlord and tenant consent. In addition, an affiliate of the Liquidating Trust's real estate advisor has assumed Petrie Retail's former headquarters lease at 150 Meadowlands Parkway in Secaucus, New Jersey, which lease is guaranteed by the Liquidating Trust. The Liquidating Trust's real estate advisor has sublet a portion of the former headquarters space and is seeking to sublet the remainder of the space in an effort to mitigate the Liquidating Trust's liability under this lease, although no assurance can be given that such efforts will be successful. After taking into account settlements and releases obtained from landlords, the Liquidating Trust, as successor to Petrie, remains the guarantor of 168 of the retail leases and the headquarters lease described above. The Liquidating Trust's theoretical exposure relating to these leases, without giving effect to any present value discount and assuming the landlord in each case is unable to mitigate its damages, would be approximately $46 million. Such exposure includes (i) approximately $30 million in potential liability related to 73 of the rejected store leases described above and 43 of the leases which have expired or were terminated by mutual landlord and tenant consent described above, which amount is included in the Liquidating Trust's accrued expenses and other liabilities at December 31, 1999, (ii) approximately $2 million in potential liability relating to the headquarters lease, which amount is included in the Liquidating Trust's accrued expenses and other liabilities at December 31, 1999, and (iii) approximately $14 million in potential liability related to 51 of the store leases which were either assigned to third party retailers or are still held by the successor of Petrie Retail. Of the $16 million in potential liability related to the assigned leases, the leases that are still held by the successor of Petrie Retail and the headquarters lease, approximately $4 million is due in 2000 and approximately $12 million is due thereafter. As previously disclosed, landlords under leases relating to 135 stores operated by Petrie Retail or an affiliate thereof alleged in a complaint that the Liquidating Trust, as successor to Petrie, had liability as a guarantor of certain leases notwithstanding Petrie's receipt from these landlords of releases of guarantees with respect to substantially all of such leases. On December 28, 1999, the Liquidating Trust paid the plaintiffs $2.4 million in settlement of their remaining claims against the Liquidating Trust and received a full release from all claims, without any recognition of wrongdoing or liability with respect to the claims asserted. The Liquidating Trust's lease exposure calculations reflect the estimated sum of all base rent and additional rent (such as taxes and common area charges) due under a lease through the end of the current lease term, but do not reflect potential penalties, interest and other charges to which a landlord may be entitled. Such additional charges (which may in part be unenforceable) are not expected to materially increase the Liquidating Trust's lease guarantee liability. A significant number of leases discussed above under which a landlord might claim that the Liquidating Trust, as successor to Petrie, has liability as a lease guarantor either expressly contain mitigation provisions or relate to property in states that imply such provisions as a matter of law. Mitigation generally requires, among other things, that a landlord of a closed store seek to reduce its damages, including by attempting to locate a new tenant. Employment Agreements. As previously disclosed, on October 23, 1995, Petrie Retail notified three former executives of Petrie that, as a result of Petrie Retail's bankruptcy filing, Petrie Retail would no longer honor its obligations under the employment agreements each executive had entered into with Petrie which had been assumed by Petrie Retail in connection with the sale of the retail operations. On April 25, 1996, the Liquidating Trust entered into settlement agreements with two of the former executives and on January 27, 1997 entered into a settlement agreement with the estate of the third executive. Pursuant to such settlement agreements, the Liquidating Trust agreed to pay each substantially all the amounts due under respective agreements with Petrie. The total cost of these settlements to the Liquidating Trust was approximately $3.2 million, of which approximately $440,000 (relating to certain unfunded pension obligations) remained unpaid and was included in the Liquidating Trust's accrued expenses and other liabilities at December 31, 1999. Multiemployer Plan. As previously disclosed, effective January 31, 1995, Petrie Retail withdrew from the Multiemployer Plan. Due to the Multiemployer Plan's underfunded status, Petrie Retail and its affiliates incurred withdrawal liability under the Employee Retirement Income Security Act of 1974, as amended. By letter dated May 30, 1996, the Multiemployer Plan initially assessed withdrawal liability against Petrie Retail in the amount of approximately $9.4 million plus interest, to be paid in quarterly installments of approximately $317,000 commencing August 1, 1996 through and including August 1, 2006, with a final payment of approximately $18,000 due November 1, 2006. In addition, the Multiemployer Plan initially assessed liability against Petrie Retail of approximately $2 million attributable to the Multiemployer Plan's failure to meet certain Internal Revenue Code minimum funding standards, which amount was payable on August 1, 1996. In December 1998, the Multiemployer Plan also submitted amended proofs of claim indicating that, among other entities, PS Stores and Petrie Retail were indebted to the Multiemployer Plan in the aggregate amount of approximately $17.3 million, consisting of withdrawal liability of $4.7 million, funding deficiencies of $1.4 million and an additional $11.2 million as a result of a mass withdrawal by contributing employers from the Multiemployer Plan. To the knowledge of the Liquidating Trust, Petrie Retail never made any payments with respect to such liabilities. Pursuant to the Retail Operations Stock Purchase Agreement, Petrie Retail and its affiliates are responsible for payment of the first $10 million in withdrawal and related liabilities and are entitled to be reimbursed by the Liquidating Trust, as successor to Petrie, for 75% of the next $50 million paid by Petrie Retail and its affiliates in respect of such liabilities. It is unclear what effect, if any, Petrie Retail's or PS Stores' bankruptcy filings may have upon the timing and amount of any payments the Liquidating Trust may be required to make under the Retail Operations Stock Purchase Agreement with respect to the Multiemployer Plan, but in no event will the Liquidating Trust's maximum contractual liability be increased as a result of Petrie Retail's or PS Stores' bankruptcy filings. On or about September 25, 1998, the Internal Revenue Service issued an examination report asserting that "Petrie Stores, Inc." is liable for excise taxes and penalties of approximately $192,000 relating to the Multiemployer Plan's funding deficiencies for the three plan years ended January 31, 1993, 1994 and 1995. On January 24, 2000, the Liquidating Trust paid the Internal Revenue Service approximately $59,000 in full settlement of the alleged liability. The Liquidating Trust believes, based on the most recently available information, that appropriate accruals have been established in the accompanying financial statements to provide for any losses that may be incurred with respect to the aforementioned contingencies. Year 2000 The Liquidating Trust's principal information technology software package is compliant with respect to year 2000 issues. In addition, according to information provided to the Liquidating Trust by Petrie Retail and its successor, the computer systems of Petrie Retail's successor are year 2000 compliant. Based on the foregoing, the Liquidating Trust believes that year 2000 issues have not resulted, and are not expected to result, in the imposition of material costs on the Liquidating Trust. If, however, all year 2000 issues have not been properly identified or effectively remedied, there can be no assurance that year 2000 issues will not have a material adverse effect on the Liquidating Trust. Additionally, there can be no assurance that the impact of year 2000 issues on other entities will not have a material adverse effect on the Liquidating Trust. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Except for historical matters, the matters discussed in this Form 10-K are forward-looking statements that involve risks and uncertainties. Forward-looking statements include, but are not limited to, statements relating to the Liquidating Trust's contingent liabilities contained above in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes to Financial Statements. The Liquidating Trust wishes to caution readers that in addition to factors that may be described elsewhere in this Form 10-K, the following important factors, among others, could cause the Liquidating Trust's assets and liabilities to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Liquidating Trust, and could materially affect the Liquidating Trust's financial condition, liquidity and future ability to make liquidating distributions: (1) A decision by Petrie Retail's successor to close additional stores for which the Liquidating Trust, as successor to Petrie, has liability as a guarantor; (2) Other actions by Petrie Retail's successor which cause the default of obligations assumed by Petrie Retail in connection with the Sale for which the Liquidating Trust, as successor to Petrie, may be deemed to have liability; (3) A decision by a court that the Liquidating Trust, as successor to Petrie, has liability as a guarantor of certain leases notwithstanding Petrie's receipt from the landlords thereof of releases of guarantees with respect to such leases; (4) An adverse material change in general economic conditions and the interest rate environment; (5) The effects of, and changes in, laws and regulations and other activities of federal and local governments, agencies and similar organizations; (6) The costs and other effects of other legal and administrative cases and proceedings, settlements and claims relating to the Liquidating Trust's contingent liabilities; and (7) The failure of the Liquidating Trust, Petrie Retail's successor or other third parties on whom the Liquidating Trust's financial condition and results of operations are dependent to properly identify and effectively remedy on a timely basis all year 2000 issues affecting their operations. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Liquidating Trust invests its available cash in short-term United States Treasury Obligations. Although the rate of interest paid on short-term United States Treasury Obligations may fluctuate over time based on changes in the general level of U.S. interest rates, each of such investments is made at a fixed interest rate over the duration of the investment and each has a maturity of less than 365 days. In addition, the Liquidating Trust Agreement prohibits the Liquidating Trust from making certain investments with a maturity of greater than one year and certain other investments that could expose the Liquidating Trust to market risk. The Liquidating Trust believes that its exposure to market risk fluctuations for its investments is not material as of December 31, 1999. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See pages through annexed hereto. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. LIQUIDATING TRUSTEES AND EXECUTIVE OFFICERS The following table shows, as of March 27, 2000, the Liquidating Trustees and the Liquidating Trust's executive officers, their respective ages, the year each person became a Liquidating Trustee or officer of the Liquidating Trust and all positions currently held with the Liquidating Trust by each such person: Biographical information concerning the Liquidating Trustees and the Liquidating Trust's executive officers is provided below. Stephanie R. Joseph became Secretary and Principal Legal Officer of Petrie in February 1995 and Manager, Chief Executive Officer and Liquidating Trustee of the Liquidating Trust in December 1995. She is the founder and President of The Directors' Network Inc., a corporate consulting firm that prepares directors for their boardroom responsibilities, since March 1994. From May 1984 until June 1992, she was employed as the Associate General Counsel of American Express Company. H. Bartlett Brown became Treasurer, Chief Financial Officer and Principal Accounting Officer of Petrie in February 1995 and Assistant Manager and Chief Financial Officer of the Liquidating Trust in December 1995. Mr. Brown is a tax consultant. He was a partner in Ernst & Young LLP, an accounting firm, from October 1970 until September 1994. Joseph H. Flom became a Liquidating Trustee in December 1995. He has been a partner in Skadden, Arps, Slate, Meagher & Flom LLP, a law firm and counsel to Petrie, the Liquidating Trust and the Estate of Milton Petrie, for more than the past five years. Mr. Flom is a director of The Warnaco Group, Inc.; Chairman of the Board of Trustees of the Woodrow Wilson International Center for Scholars; a director of United Way of New York City; a director of the American-Israel Friendship League; and a trustee of the New York University Medical Center. Bernard Petrie became both a director of Petrie and a Liquidating Trustee in December 1995. He is an attorney and has been self-employed for more than the past five years. Laurence A. Tisch became a Liquidating Trustee in December 1995. Since January 1999, Mr. Tisch has been the Co-Chairman of the Board of Loews Corporation, a diversified holding company. From October 1994 to January 1999, Mr. Tisch was the Co-Chairman and Co-Chief Executive Officer of Loews Corporation. From May 1960 to October 1994, Mr. Tisch was the Chairman of the Board and Chief Executive Officer of Loews Corporation. Since March 1990, he has also been the Chief Executive Officer and a director of CNA Financial Corp., an insurance and financial services company and a publicly-held subsidiary of Loews Corporation. From January 1987 to November 1995, Mr. Tisch was Chairman of the Board, President and Chief Executive Officer of CBS Inc., a television and radio network. Mr. Tisch is a director of Loews Corporation; a director of Automatic Data Processing, Inc., a provider of payroll and other data processing services; a director of Bulova Corporation, a watch manufacturer and a publicly-held subsidiary of Loews Corporation; a director of Federated Department Stores, Inc., an operator of department stores; a trustee of the New York Public Library; a trustee of the Metropolitan Museum of Art; and a director of United Jewish Appeal. Raymond S. Troubh became a Liquidating Trustee and Chairman of the Board of Liquidating Trustees in December 1995. Mr. Troubh served as Treasurer of Petrie from December 9, 1994 to February 7, 1995. He is a financial consultant, a former governor of the American Stock Exchange and a former general partner of Lazard Freres & Co., an investment banking firm. Mr. Troubh is a director of ARIAD Pharmaceuticals, Inc., a pharmaceutical company; Diamond Offshore Drilling, Inc., an offshore drilling company; Foundation Health Systems, Inc., a healthcare company; General American Investors Company, an investment and advisory company; Gentiva Health Services, Inc. a healthcare company; Olsten Corporation, a temporary personnel and healthcare services company; Starwood Hotels & Resorts, a hotel and gaming company; WHX Corporation, a holding company; and Triarc Companies, Inc., a diversified holding company. Mr. Troubh also serves as trustee of the MicroCap Liquidating Trust, a liquidating trust that holds the assets of The MicroCap Fund, Inc., an investment company. MEETINGS AND STANDING COMMITTEES The Liquidating Trustees met five times during the year ended December 31, 1999. During such period, the Liquidating Trustees had no committees. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. GENERAL The following table sets forth the total annual compensation paid by the Liquidating Trust to its Manager and Chief Executive Officer, who is the only executive officer of the Liquidating Trust whose compensation exceeded $100,000: SUMMARY COMPENSATION TABLE - ------------------ (1) Ms. Joseph receives $45,000 per fiscal year for her service as a Liquidating Trustee. COMPENSATION OF LIQUIDATING TRUSTEES Liquidating Trustees are compensated for their service as Liquidating Trustees in the amount of $30,000 per fiscal year, with the exception of Raymond S. Troubh and Stephanie R. Joseph, who are each compensated $45,000 per fiscal year for their service as Liquidating Trustees. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION During the year ended December 31, 1999, the Liquidating Trustees did not have a compensation committee, and each of the Liquidating Trustees other than Stephanie R. Joseph participated in deliberations of the Liquidating Trustees concerning executive officer compensation. During the year ended December 31, 1999, no executive officer of the Liquidating Trust served as a member of the compensation committee (or other board committee performing equivalent functions, or in the absence of any such committee, the entire board of directors) of another entity, one of whose executive officers served as a Liquidating Trustee. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Units of Beneficial Interest The following table sets forth certain information with respect to (i) the only persons who, to the best knowledge of the Liquidating Trust, are the beneficial owners of more than five percent of the outstanding units of beneficial interest of the Liquidating Trust and (ii) the number of units of beneficial interest of the Liquidating Trust owned by each of the Liquidating Trustees, the officers of the Liquidating Trust and the Liquidating Trustees and officers as a group. - ------------------ * Less than one percent of the outstanding units of beneficial interest. (1) Based on information contained in the Statement on Schedule 13D filed by the Estate of Milton Petrie (the "Estate") with the Securities and Exchange Commission on January 31, 1996. Mr. Flom, Hilda K. Gerstein, Jerome A. Manning, Bernard Petrie, Carroll Petrie, Dorothy Stern Ross, Mr. Tisch and David Zack serve as the executors of the Estate. The executors of the Estate share equally the power to dispose of, and to vote, the units of beneficial interest held by the Estate. Messrs. Flom, Petrie and Tisch disclaim beneficial ownership of the units of beneficial interest held by the Estate. (2) Based on information contained in Amendment No. 4 to the Statement on Schedule 13G filed by HBK Investments L.P. and HBK Finance L.P. with the Securities and Exchange Commission on February 2, 2000. (3) Based on information contained in Amendment No. 4 to the Statement on Schedule 13G filed by T. Rowe Price Associates, Inc. ("Price Associates") with the Securities and Exchange Commission on February 14, 2000. These securities are owned by various individual and institutional investors which Price Associates serves as investment adviser with power to direct investments and sole power to vote the securities. For (Footnotes continued on next page) (Footnotes continued from previous page) purposes of the reporting requirements of the Securities Exchange Act of 1934, as amended, Price Associates is deemed to be a beneficial owner of such securities. Price Associates has, however, expressly disclaimed that it is, in fact, the beneficial owner of such securities. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Skadden, Arps, Slate, Meagher & Flom LLP serves as legal counsel to the Liquidating Trust and the Estate of Milton Petrie, which owns approximately 53.7% of the Liquidating Trust's outstanding units of beneficial interest, and has provided services to each during the year ended December 31, 1999. Joseph H. Flom, a Liquidating Trustee and an executor of the Estate of Milton Petrie, is a partner in Skadden, Arps, Slate, Meagher & Flom LLP. The Liquidating Trust maintains directors' and officers' liability insurance provided by Continental Casualty Company, an affiliate of CNA Financial Corp. Laurence A. Tisch, a Liquidating Trustee and an executor of the Estate of Milton Petrie, is Chairman of the Board of CNA Financial Corp. Messrs. Flom, Petrie and Tisch are executors of the Estate of Milton Petrie and are entitled to executors' commissions. Mr. Petrie is also a beneficiary of the Estate of Milton Petrie. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1), (2) List of Financial Statements. See Index to Financial Statements at page. (a)(3) List of Exhibits. (b) Reports on Form 8-K Current Report on Form 8-K, filed on December 1, 1999, reporting the termination of the Master Agreement. Current Report on Form 8-K, filed on December 28, 1999, reporting the settlement of the Aventura Malls Venture litigation. Current Report on Form 8-K, filed on January 21, 2000, reporting the distribution of $78,525,357 in cash and 1,688,576 shares of Toys Common Stock to be made by the Liquidating Trust to unit holders on February 11, 2000. (c) See Item 14(a)(3) above. The Liquidating Trust will furnish to any holder of units of beneficial interest of the Liquidating Trust, upon written request, any exhibit listed in response to Item 14(a)(3) upon payment by such holder of the Liquidating Trust's reasonable expenses in furnishing any such exhibit. (d) See Item 14(a)(2) above. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. PETRIE STORES LIQUIDATING TRUST By: /s/ Stephanie R. Joseph ---------------------------------- Stephanie R. Joseph Manager and Chief Executive Officer Dated: March 30, 2000 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. PETRIE STORES LIQUIDATING TRUST REPORT OF INDEPENDENT AUDITORS Board of Trustees and Holders of Units of Beneficial Interest Petrie Stores Liquidating Trust We have audited the accompanying statements of net assets in liquidation of the Petrie Stores Liquidating Trust (successor to Petrie Stores Corporation and its former subsidiaries) as of December 31, 1999 and December 31, 1998, and the related statements of changes in net assets in liquidation for each of three years in the period ended December 31, 1999. These financial statements are the responsibility of the management of the Petrie Stores Liquidating Trust. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the net assets in liquidation of the Petrie Stores Liquidating Trust (successor to Petrie Stores Corporation and its former subsidiaries) as of December 31, 1999 and December 31, 1998 and the changes in net assets in liquidation for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. ERNST & YOUNG LLP MetroPark, New Jersey March 20, 2000 PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) STATEMENTS OF NET ASSETS IN LIQUIDATION (IN THOUSANDS) See accompanying notes. PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) STATEMENTS OF CHANGES IN NET ASSETS IN LIQUIDATION (IN THOUSANDS, EXCEPT PER UNIT AMOUNTS) PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1999 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The Petrie Stores Liquidating Trust (the "Liquidating Trust") is the successor to Petrie Stores Corporation ("Petrie"). Prior to December 9, 1994, Petrie operated a chain of retail stores that specialized in women's apparel and were located throughout the United States (including Puerto Rico and the U.S. Virgin Islands). At Petrie's Annual Meeting, held on December 6, 1994, Petrie's shareholders approved the sale of Petrie's retail operations (the "Sale"). At Petrie's Reconvened Annual Meeting, held on January 24, 1995, Petrie's shareholders approved (i) an exchange of shares of Toys "R" Us, Inc. ("Toys 'R' Us") common stock ("Toys Common Stock") with Toys "R" Us (Note 2) and (ii) the liquidation and dissolution of Petrie pursuant to a plan of liquidation and dissolution (the "Plan of Liquidation"). Pursuant to the Plan of Liquidation and the Agreement and Declaration of Trust, dated as of December 6, 1995 (the "Liquidating Trust Agreement"), between Petrie and the trustees named therein (the "Liquidating Trustees"), effective as of the close of business on January 22, 1996 (the "Succession Date"), Petrie transferred its remaining assets (then consisting of approximately $131 million in cash and cash equivalents and 5,055,576 shares of Toys Common Stock) to, and its remaining fixed and contingent liabilities were assumed by (the "Succession"), the Liquidating Trust. The assets of the Liquidating Trust are subject to various contingent liabilities, the status of which is presently unclear (Note 4), as well as the terms of a letter agreement with Toys "R" Us (Note 2) pursuant to which the Liquidating Trust is required to provide notice to Toys "R" Us prior to making any future liquidating distributions. Since the Succession Date, Petrie has been preparing for its dissolution. On November 6, 1996, Petrie filed Articles of Dissolution with the Secretary of State of the State of New York. Effective February 5, 1997, Petrie was dissolved. Beginning with the period ended December 31, 1996, the Liquidating Trust has adopted the calendar year as its fiscal year. A liquidation basis of accounting was implemented as of January 28, 1995. The statements of net assets in liquidation at December 31, 1999 and December 31, 1998 do not distinguish between current and long-term balances as would be reflected if such statements had been prepared on a going-concern basis. Principles of Consolidation In December 1994, as part of the reorganization of Petrie's retail operations in connection with their sale, all of Petrie's former subsidiaries with retail operations were transferred to Petrie Retail, Inc., then a wholly owned subsidiary of Petrie ("Petrie Retail"), and all of the shares of Toys Common Stock held by Petrie's former subsidiaries were transferred to Petrie. Thereafter, Petrie Retail was sold to PS Stores Acquisition Corp. (hereafter, including its subsidiaries and affiliates unless the context requires otherwise, "PS Stores"). Cash Equivalents Cash equivalents consist of highly liquid investments of less than 90 days' maturity from the date of purchase. These investments are carried at cost plus accrued interest, which approximates fair market value. Investments in U.S. Treasury Obligations Investments in U.S. Treasury obligations are carried at fair market value and unrealized gains or losses thereon are recognized in the statement of changes in net assets in liquidation. Income Taxes The Liquidating Trust is a complete pass-through entity for federal income tax purposes and, accordingly, is not itself subject to federal income tax. Instead, for federal income tax purposes, each Petrie shareholder (i) is deemed to have received on the Succession Date, and therefore own, a pro rata share of the assets transferred by Petrie to the Liquidating Trust, subject to a pro rata share of Petrie's liabilities assumed by the Liquidating Trust, and (ii) is subject to the same federal income tax consequences with respect to the receipt, ownership or PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES --(CONTINUED) disposition of such assets as if such shareholder had directly received, owned or disposed of such assets, subject to such liabilities. Earnings Per Unit Earnings per unit have been computed based on the weighted average number of units outstanding. Since there are no dilutive securities outstanding for any of the periods presented, basic and diluted earnings per unit are the same. Concentration of Credit Risk Certain financial instruments potentially subject the Liquidating Trust to concentrations of credit risk. These financial instruments consist primarily of temporary cash investments and U.S. Treasury obligations. The Liquidating Trust places its temporary cash investments with high credit quality financial institutions to limit its credit exposure. The Liquidating Trust also has an investment in Toys "R" Us Common Stock. See Note 2 for a discussion of credit risk associated with the Liquidating Trust's investment in Common Stock. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 2. INVESTMENTS IN COMMON STOCK The Liquidating Trust's investments in common stock at December 31, 1999 and 1998 consist of 1,688,576 and 4,055,576 shares, respectively, of Toys "R" Us, which operates a chain of specialty retail stores principally engaged in the sale of toys and children's clothing in the United States and abroad. At December 31, 1999, the 1,688,576 shares are carried at market value. At December 31, 1998, 2,055,576 shares are carried at market value and 2,000,000 shares are carried at the Put Price (as defined below). On January 24, 1995, pursuant to the terms of an Acquisition Agreement dated as of April 20, 1994, and amended as of May 10, 1994 (the "Toys Acquisition Agreement"), between Petrie and Toys "R" Us, Petrie exchanged (the "Exchange") with Toys "R" Us all of its shares of Toys Common Stock (39,853,403 shares), plus $165 million in cash, for 42,076,420 shares of Toys Common Stock (approximately 15.0% of the outstanding Toys Common Stock at January 28, 1995). Simultaneously with the closing of the Exchange, Petrie placed 3,493,450 shares of Toys Common Stock into an escrow account (the "Escrow Account") pursuant to the terms of an escrow agreement, dated as of January 24, 1995, between Petrie and Custodial Trust Company, as Escrow Agent (the "Escrow Agreement"). The shares of Toys Common Stock were placed into the Escrow Account pursuant to the Escrow Agreement to provide for the payment of certain obligations of the Liquidating Trust, as successor to Petrie, to Toys "R" Us arising (i) under (x) the Toys Acquisition Agreement, (y) the Seller Indemnification Agreement, dated as of December 9, 1994, among Petrie, Toys "R" Us, Petrie Retail, PS Stores, and certain subsidiaries of PS Stores, and (z) the Retail Operations Stock Purchase Agreement, dated as of August 23, 1994 and amended on November 3, 1994 (the "Retail Operations Stock Purchase Agreement"), between Petrie and PS Stores, and (ii) otherwise. The Escrow Account terminated in accordance with its terms on January 24, 2000. The assets of the Liquidating Trust are subject to the terms of a letter agreement, dated as of January 24, 1995, pursuant to which Petrie agreed with Toys "R" Us that Petrie will retain, either individually or in combination, (i) cash in an amount of at least $177.5 million (the "Reserved Amount") or (ii) shares of Toys Common Stock having a market value (using the per share price on January 20, 1995) of at least twice the Reserved Amount, to secure the payment of Petrie's contingent liabilities (Note 4). In connection with the PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 2. INVESTMENTS IN COMMON STOCK--(CONTINUED) distribution of $78,525,357 in cash and 1,688,576 shares of Toys Common Stock by the Liquidating Trust on February 11, 2000, the Liquidating Trust provided Toys "R" Us with prior notice of the proposed distribution and Toys "R" Us agreed that it did not object to such distribution. Pursuant to the terms of the letter agreement, the Liquidating Trust is required to provide similar notice to Toys "R" Us prior to making any additional distributions. Petrie had also placed 3,200,082 shares of Toys Common Stock in a collateral account (the "Collateral Account") pursuant to the terms of an Amended and Restated Cash Collateral and Pledge Agreement, dated as of December 9, 1994 and amended as of January 24, 1995, among Petrie, PS Stores, certain subsidiaries of PS Stores, and Custodial Trust Company, as Collateral Agent (the "Amended and Restated Cash Collateral Agreement"). On December 19, 1995, the Amended and Restated Cash Collateral Agreement was further amended and restated and, pursuant thereto, the 3,200,082 shares of Toys Common Stock held in the Collateral Account were released to Petrie in exchange for Petrie's deposit of $67.5 million in U.S. Treasury obligations in the Collateral Account. In connection with the settlement of a dispute with the Internal Revenue Service (the "IRS"), approximately $32 million in U.S. Treasury obligations held in the Collateral Account were transferred to the Liquidating Trust on May 20, 1997. Pursuant to a stipulation and release approved by the bankruptcy court in Petrie Retail's bankruptcy case (discussed below), an additional $32 million in U.S. Treasury obligations held in the Collateral Account were transferred to the Liquidating Trust on November 10, 1999. The Liquidating Trust is currently required to maintain approximately $5.5 million in the Collateral Account. The U.S. Treasury obligations held in the Collateral Account pursuant to the Amended and Restated Cash Collateral Agreement secure the payment of certain obligations of the Liquidating Trust, as successor to Petrie, to PS Stores arising under (i) the Retail Operations Stock Purchase Agreement and (ii) the Cross-Indemnification and Procedure Agreement, dated as of December 9, 1994, between Petrie and PS Stores (Note 4). The Liquidating Trust had also entered into a Master Agreement (based on the International Swaps and Derivatives Association Form), dated as of November 19, 1997 (the "Master Agreement"), with CIBC, to protect the Liquidating Trust against certain investment risks associated with 2,000,000 of the shares of Toys Common Stock held by the Liquidating Trust. Pursuant to the Master Agreement, if on December 3, 1999, the price of Toys Common Stock was below $30.7264 (the "Put Price"), CIBC would have been obligated to pay the Liquidating Trust the difference between the Put Price and the then prevailing price of Toys Common Stock, multiplied by 2,000,000. In addition, under the Master Agreement, the Liquidating Trust had the right to elect to receive the entire Put Price (in lieu of receiving the difference between the Put Price and the prevailing price of Toys Common Stock) by delivering to CIBC the 2,000,000 shares of Toys Common Stock subject to the Master Agreement. On November 29, 1999, the Liquidating Trust and CIBC agreed to terminate the Master Agreement prior to the Master Agreement's scheduled termination date of December 3, 1999. In connection with such termination, the Liquidating Trust delivered to CIBC the 2,000,000 shares of Toys Common Stock which were subject to the Master Agreement in exchange for a cash payment of approximately $61.4 million. In accordance with the Plan of Liquidation, Petrie made an initial liquidating distribution on March 24, 1995 of 26,173,718 shares of Toys Common Stock (market value on March 24, 1995 of approximately $644.5 million). Petrie subsequently distributed 1,391 shares of Toys Common Stock to certain former shareholders of Winkelman Stores Incorporated (a former subsidiary of Petrie) in respect of their interests in the March 24, 1995 distribution. On August 15, 1995, Petrie made a second liquidating distribution of 5,235,035 shares of Toys Common Stock (market value on August 15, 1995 of approximately $139.4 million). At various times during the period ended January 22, 1996, Petrie sold an aggregate of 5,610,700 shares of Toys Common Stock for approximately $126.9 million in proceeds. Between January 23, 1997 and February 5, 1997, the Liquidating Trust sold an aggregate of 1,000,000 shares of Toys Common Stock for approximately $25.5 million in proceeds. During 1999, in addition to the 2,000,000 shares of Toys Common Stock delivered to PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 2. INVESTMENTS IN COMMON STOCK--(CONTINUED) CIBC in exchange for a cash payment of approximately $61.4 million as discussed above, the Liquidating Trust sold an aggregate of 367,000 shares of Toys Common Stock for approximately $8.5 million in proceeds. In November 1994, Petrie received a favorable private letter ruling from the IRS to the effect that the Exchange and the subsequent distribution of Toys Common Stock to Petrie's shareholders would qualify as a tax-free reorganization under the Internal Revenue Code of 1986, as amended. The ruling further provided that Petrie would not recognize any gain on these transactions. On February 11, 2000, the Liquidating Trust distributed a total of $78,525,357 in cash and 1,688,576 shares of Toys "R" Us common stock. 3. INCOME TAXES As a result of the Succession, Petrie ceased to be a taxable entity. Subsequent to January 22, 1996, the Liquidating Trust, as successor to Petrie, is a complete pass-through entity for federal income taxes and, accordingly, is not itself subject to federal income tax. During the year ended December 31, 1997, $4,066,000 in income tax refunds, plus interest thereon, were released to the Liquidating Trust from escrow in offset of certain claims that the Liquidating Trust had against Petrie Retail relating to Petrie Retail's failure to perform certain of the obligations that it assumed in connection with the Sale. The income tax refunds were released from escrow following the previously disclosed settlement of an action commenced by Petrie Retail in the Bankruptcy Court to recover income tax refunds received by the Liquidating Trust in respect of taxes paid by Petrie prior to the Sale. Pursuant to the settlement, approved by the Bankruptcy Court on June 25, 1997, the Liquidating Trust reserved the right to assert future claims against Petrie Retail to the extent that such claims relate to amounts in excess of the amounts offset in the settlement. Additionally, Petrie Retail and the Liquidating Trust agreed to share equally in the proceeds of any similar tax refunds received in the future. 4. COMMITMENTS AND CONTINGENCIES As successor to Petrie, the Liquidating Trust has certain contingent liabilities with respect to existing or potential claims, lawsuits and other proceedings, which primarily relate to (i) guarantees of certain retail store leases, expiring at various times through 2011 for which Petrie Retail or an affiliate thereof assumed liability, and certain other liabilities that were assumed by Petrie Retail (but as to which Petrie's liability has not been released) in connection with the Sale (collectively, the "Assumed Obligations") to the extent that Petrie Retail or its successor fails to perform; and (ii) Petrie's agreement with Petrie Retail to indemnify it for certain liabilities relating to the funding of, and Petrie Retail's withdrawal from, the United Auto Workers District 65 Security Plan Pension Fund (the "Multiemployer Plan"). The Liquidating Trust accrues liabilities when it is probable that future costs will be incurred and when such costs can be reasonably estimated. Such accruals are based on developments to date, the Liquidating Trust's estimates of the outcome of these matters and its experience (including that of its predecessor, Petrie) in contesting, litigating and settling matters. At December 31, 1999 and December 31, 1998, the Liquidating Trust, as successor to Petrie, had accrued approximately $36 million and $39 million, respectively, for contingent liabilities. As the scope of these liabilities becomes better defined, there may be changes in the estimates of future costs, which could have a material effect on the Liquidating Trust's financial condition, liquidity and future ability to make liquidating distributions. Petrie Retail's Bankruptcy. On October 12, 1995, Petrie Retail filed a voluntary petition for reorganization relief under Chapter 11 of the United States Bankruptcy Code with the U.S. Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). In connection with its filing for bankruptcy protection, Petrie Retail failed to perform or make payments with respect to certain of the Assumed Obligations, including, but not limited to, Assumed Obligations relating to store leases for which Petrie Retail or an affiliate thereof had assumed liability, state and federal taxes, employment agreements, insurance premiums and certain other claims PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 4. COMMITMENTS AND CONTINGENCIES--(CONTINUED) and contractual obligations. Accordingly, the Liquidating Trust has been and may continue to be required to make payments in respect of certain of the Assumed Obligations. On December 23, 1997, the Liquidating Trust filed over 110 claims in the Bankruptcy Court against Petrie Retail and certain of its affiliates with respect to an aggregate of approximately $14 million in payments which had then been made by the Liquidating Trust as a result of the failure by Petrie Retail or an affiliate thereof to perform or pay certain of the Assumed Obligations. The Liquidating Trust subsequently amended these claims such that it asserted fixed claims representing a total of approximately $16.9 million against Petrie Retail's estate. The Liquidating Trust also filed approximately 600 additional claims in the Bankruptcy Court against Petrie Retail and certain of its affiliates with respect to payments which the Liquidating Trust may in the future be required to make as a result of the failure by Petrie Retail or its affiliates to perform or pay Assumed Obligations. On March 9, 2000, the distribution company (the "Distribution Company") designated by the Petrie Retail Plan (as defined below) moved for Bankruptcy Court approval of a stipulation of settlement with the Liquidating Trust. Pursuant to the proposed settlement, the Liquidating Trust and Distribution Company would settle their disputes regarding the claims that the Liquidating Trust filed against Petrie Retail by (i) allowing the Liquidating Trust a single unsecured claim against Petrie Retail in the amount of $15.3 million, subject to certain adjustments, (ii) releasing to the Liquidating Trust the $5.5 million held in the Collateral Account by June 30, 2000, unless the Distribution Company pays $10 million or more to the Multiemployer Plan prior to that date, and (iii) exchanging mutual releases. A hearing on the motion to approve the settlement is scheduled for April 12, 2000. There can be no assurance that the Bankruptcy Court will approve the settlement. Moreover, even if the settlement is approved, there can be no assurance as to the timing of the payment of claims against the reorganized Petrie Retail entity or the amount of the payments, if any, that the reorganized Petrie Retail entity will make to creditors asserting unsecured claims. Accordingly, no amounts have been accrued as receivables for potential reimbursement or recoveries from the reorganized Petrie Retail entity. On April 10, 1998, PS Stores, the parent of Petrie Retail, filed a voluntary petition for reorganization relief under Chapter 11 of the United States Bankruptcy Code with the Bankruptcy Court. On August 7, 1998, the Liquidating Trust filed claims in the Bankruptcy Court against PS Stores substantially similar to those filed against Petrie Retail. On December 8, 1998, the Bankruptcy Court confirmed the proposed plan of reorganization for Petrie Retail (the "Petrie Retail Plan"), which modified the plan of reorganization filed by Petrie Retail and Warburg Pincus Ventures, L.P. ("Warburg") with the Bankruptcy Court on August 6, 1998, as amended. Under the confirmed Petrie Retail Plan, Petrie Retail sold substantially all of its remaining operating assets to Urban Acquisition Corp., an affiliate of Urban Brands, Inc., a retailer that operates under the Ashley Stewart trade name, for $52.25 million, and retained 13 of its store leases, for which Warburg was required to contribute $12 million to the bankruptcy estate, assume $3.1 million of Petrie Retail's executive severance obligations and waive approximately $3.8 million in fees and expenses allegedly owed to it under Petrie Retail's debtor-in-possession financing arrangement. On December 8, 1998, the Bankruptcy Court confirmed PS Stores' proposed plan of reorganization. In August 1999, pursuant to a settlement approved by the Bankruptcy Court, the Liquidating Trust received a payment in the amount of $0.2 million from PS Stores' bankruptcy estate. Store Leases. As described above, in December 1998, Petrie Retail disposed of substantially all its remaining operations and store leases as part of the Petrie Retail Plan. Of the roughly 1600 stores that Petrie Retail operated prior to filing its bankruptcy petition in October 1995, (i) 722 leases were rejected, (ii) 615 leases were assigned to third party retailers, including (A) 410 leases which were part of Petrie Retail's former G&G Shops Inc. division and were included in the sale of such division to an investor group led by Pegasus Partners, L.P. and certain executives of such division, (B) 85 leases which were sold to Urban Acquisition Corp. as part of PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 4. COMMITMENTS AND CONTINGENCIES--(CONTINUED) the Petrie Retail Plan and (C) 120 leases which were not part of Petrie Retail's former G&G Shops Inc. division and which were sold to third party retailers other than Urban Acquisition Corp., (iii) 13 leases were retained by the reorganized Petrie Retail entity for stores which are currently managed by Urban Acquisition Corp. and which Urban Acquisition Corp. has the right to purchase at a later date and (iv) approximately 250 leases expired or were terminated by mutual landlord and tenant consent. In addition, an affiliate of the Liquidating Trust's real estate advisor has assumed Petrie Retail's former headquarters lease at 150 Meadowlands Parkway in Secaucus, New Jersey, which lease is guaranteed by the Liquidating Trust. The Liquidating Trust's real estate advisor has sublet a portion of the former headquarters space and is seeking to sublet the remainder of the space in an effort to mitigate the Liquidating Trust's liability under this lease, although no assurance can be given that such efforts will be successful. After taking into account settlements and releases obtained from landlords, the Liquidating Trust, as successor to Petrie, remains the guarantor of 168 of the retail leases and the headquarters lease described above. The Liquidating Trust's theoretical exposure relating to these leases, without giving effect to any present value discount and assuming the landlord in each case is unable to mitigate its damages, would be approximately $46 million. Such exposure includes (i) approximately $30 million in potential liability related to 73 of the rejected store leases described above and 43 of the leases which have expired or were terminated by mutual landlord and tenant consent described above, which amount is included in the Liquidating Trust's accrued expenses and other liabilities at December 31, 1999, (ii) approximately $2 million in potential liability relating to the headquarters lease, which amount is included in the Liquidating Trust's accrued expenses and other liabilities at December 31, 1999, and (iii) approximately $14 million in potential liability related to 51 of the store leases which were either assigned to third party retailers or are still held by the successor of Petrie Retail. Of the $16 million in potential liability related to the assigned leases, the leases that are still held by the successor of Petrie Retail and the headquarters lease, approximately $4 million is due in 2000 and approximately $12 million is due thereafter. As previously disclosed, landlords under leases relating to 135 stores operated by Petrie Retail or an affiliate thereof alleged in a complaint that the Liquidating Trust, as successor to Petrie, had liability as a guarantor of certain leases notwithstanding Petrie's receipt from these landlords of releases of guarantees with respect to substantially all of such leases. On December 28, 1999, the Liquidating Trust paid the plaintiffs $2.4 million in settlement of their remaining claims against the Liquidating Trust and received a full release from all claims, without any recognition of wrongdoing or liability with respect to the claims asserted. The Liquidating Trust's lease exposure calculations reflect the estimated sum of all base rent and additional rent (such as taxes and common area charges) due under a lease through the end of the current lease term, but do not reflect potential penalties, interest and other charges to which a landlord may be entitled. Such additional charges (which may in part be unenforceable) are not expected to materially increase the Liquidating Trust's lease guarantee liability. A significant number of leases discussed above under which a landlord might claim that the Liquidating Trust, as successor to Petrie, has liability as a lease guarantor either expressly contain mitigation provisions or relate to property in states that imply such provisions as a matter of law. Mitigation generally requires, among other things, that a landlord of a closed store seek to reduce its damages, including by attempting to locate a new tenant. Employment Agreements. As previously disclosed, on October 23, 1995, Petrie Retail notified three former executives of Petrie that, as a result of Petrie Retail's bankruptcy filing, Petrie Retail would no longer honor its obligations under the employment agreements each executive had entered into with Petrie which had been assumed by Petrie Retail in connection with the sale of the retail operations. On April 25, 1996, the Liquidating Trust entered into settlement agreements with two of the former executives and on January 27, 1997 entered into PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 4. COMMITMENTS AND CONTINGENCIES--(CONTINUED) a settlement agreement with the estate of the third executive. Pursuant to such settlement agreements, the Liquidating Trust agreed to pay each substantially all the amounts due under respective agreements with Petrie. The total cost of these settlements to the Liquidating Trust was approximately $3.2 million, of which approximately $440,000 (relating to certain unfunded pension obligations) remained unpaid and was included in the Liquidating Trust's accrued expenses and other liabilities at December 31, 1999. Multiemployer Plan. As previously disclosed, effective January 31, 1995, Petrie Retail withdrew from the Multiemployer Plan. Due to the Multiemployer Plan's underfunded status, Petrie Retail and its affiliates incurred withdrawal liability under the Employee Retirement Income Security Act of 1974, as amended. By letter dated May 30, 1996, the Multiemployer Plan initially assessed withdrawal liability against Petrie Retail in the amount of approximately $9.4 million plus interest, to be paid in quarterly installments of approximately $317,000 commencing August 1, 1996 through and including August 1, 2006, with a final payment of approximately $18,000 due November 1, 2006. In addition, the Multiemployer Plan initially assessed liability against Petrie Retail of approximately $2 million attributable to the Multiemployer Plan's failure to meet certain Internal Revenue Code minimum funding standards, which amount was payable on August 1, 1996. In December 1998, the Multiemployer Plan also submitted amended proofs of claim indicating that, among other entities, PS Stores and Petrie Retail were indebted to the Multiemployer Plan in the aggregate amount of approximately $17.3 million, consisting of withdrawal liability of $4.7 million, funding deficiencies of $1.4 million and an additional $11.2 million as a result of a mass withdrawal by contributing employers from the Multiemployer Plan. To the knowledge of the Liquidating Trust, Petrie Retail never made any payments with respect to such liabilities. Pursuant to the Retail Operations Stock Purchase Agreement, Petrie Retail and its affiliates are responsible for payment of the first $10 million in withdrawal and related liabilities and are entitled to be reimbursed by the Liquidating Trust, as successor to Petrie, for 75% of the next $50 million paid by Petrie Retail and its affiliates in respect of such liabilities. It is unclear what effect, if any, Petrie Retail's or PS Stores' bankruptcy filings may have upon the timing and amount of any payments the Liquidating Trust may be required to make under the Retail Operations Stock Purchase Agreement with respect to the Multiemployer Plan, but in no event will the Liquidating Trust's maximum contractual liability be increased as a result of Petrie Retail's or PS Stores' bankruptcy filings. On or about September 25, 1998, the Internal Revenue Service issued an examination report asserting that "Petrie Stores, Inc." is liable for excise taxes and penalties of approximately $192,000 relating to the Multiemployer Plan's funding deficiencies for the three plan years ended January 31, 1993, 1994 and 1995. On January 24, 2000, the Liquidating Trust paid the Internal Revenue Service approximately $59,000 in full settlement of the alleged liability. The Liquidating Trust believes, based on the most recently available information, that appropriate accruals have been established in the accompanying financial statements to provide for any losses that may be incurred with respect to the aforementioned contingencies. PETRIE STORES LIQUIDATING TRUST (SUCCESSOR TO PETRIE STORES CORPORATION) NOTES TO FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1999 5. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for the years ended December 31, 1999 and December 31, 1998 are as follows: - ------------------ (1) The first quarter of the year ended December 31, 1999 includes an unrealized gain related to an increase in the market value of Toys Common Stock of $3,854,000 and a reduction in the Liquidating Trust's accrual for lease liabilities of $400,000, following the settlement and release of claims asserted by certain landlords. (2) The second quarter of the year ended December 31, 1999 includes an unrealized gain related to an increase in the market value of Toys Common Stock of $4,738,000, realized gains of $1,572,000 related to sales of Toys Common Stock, a reduction in the Liquidating Trust's accrual for lease liabilities of $200,000 following the settlement and release of claims asserted by certain landlords and $720,000 in income related to refunds received for retrospective insurance premiums and taxes paid on behalf of Petrie Retail. (3) The third quarter of the year ended December 31, 1999 includes an unrealized loss related to a decrease in the market value of Toys Common Stock of $9,604,000 partially offset by a reduction in the Liquidating Trust's accrual for lease liabilities of $200,000 following the settlement and release of claims asserted by certain landlords and the receipt of $178,000 of bankruptcy settlement payments. (4) The fourth quarter of the year ended December 31, 1999 includes an unrealized loss of $1,161,000 related to a decrease in the market value of Toys Common Stock, a realized loss of $42,000 in connection with delivering 2,000,000 shares of Toys Common Stock and the accrual of an additional $2 million in respect of the settlement of the Aventura Malls Venture litigation. (5) The first quarter of the year ended December 31, 1998 includes an unrealized loss related to a decrease in the market value of Toys Common Stock of $4,120,000 and additional accruals of $2.0 million for contingent guarantee liabilities related to store leases with respect to which Petrie Retail failed to perform its obligations. (6) The second and third quarters of the year ended December 31, 1998 include unrealized losses related to decreases in the market value of Toys Common Stock of $13,747,000 and $14,903,000, respectively, offset by reductions in the Liquidating Trust's accrual for lease liabilities of $3.0 million and $600,000, respectively, following the settlement and release of claims asserted by certain landlords. (7) The fourth quarter of the year ended December 31, 1998 includes an unrealized gain related to an increase in the market value of Toys Common Stock of $1,542,000 and a reduction in the Liquidating Trust's accrual for lease liabilities of $400,000 following the settlement and release of claims asserted by certain landlords.

1007254_1999.txt

1007254_1999

1999

1007254

ITEM 1. BUSINESS The World Financial Network Credit Card Master Trust (the "Trust") was formed pursuant to a Pooling and Servicing Agreement dated as of January 17, 1996, and amended and restated as of September 17, 1999, (the "Pooling Agreement") between World Financial Network National Bank (the "Bank"), as transferor (the "Transferor") and as servicer (the "Servicer"), and the Harris Trust and Savings Bank, as trustee (the "Trustee"). The Bank sold to the Trust approximately $1.83 billion of credit card receivables arising in a portfolio of consumer open end credit card accounts (the "Trust Portfolio"). The Trust Portfolio includes the private label credit card programs of a number of national retail and catalogue entities. The Trust has issued four series of certificates - Series 1996-A, Series 1996-B, Series 1996-VFC, and Series 1999-A. The Series 1996-A Class A, Series 1996-A Class B, Series 1996-B Class A, Series 1996-B Class B and Series 1999-A Class A have been distributed to the public. The Series 1996-A Class D, and Series 1996-B Class D certificates are held by the Transferor and Servicer, World Financial Network National Bank. The Series 1996-VFC and Series 1999-A, Class B certificates have been privately placed. Each outstanding Series includes one or more classes of certificates as well as certain Collateral Interests. The Transferor is required under the Pooling Agreement to maintain a minimum 4% interest in the Trust Portfolio (6% November through January) (the "Transferor's Interest"). The Bank services the receivables pursuant to the Pooling Agreement and is compensated for acting as the servicer. ITEM 2. ITEM 2. PROPERTIES There is nothing to report with regard to this item. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There is nothing to report with regard to this item. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There is nothing to report with regard to this item. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS To the knowledge of the Bank and the Trust, there is an over the counter market in the Trust's Series 1996-A, Class A and Class B, Series 1996-B, Class A and Class B, and Series 1999-A, Class A Certificates, although the frequency of transactions varies substantially over time. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data has been omitted since the required information is included in the financial statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Trust was formed January 17, 1996 pursuant to the Pooling and Servicing Agreement, as amended and restated as of September 17, 1999, between World Financial Network National Bank, as seller (the "Seller"), Transferor and Servicer and The Harris Trust and Savings Bank, as trustee (the "Trustee"). The Seller sold to the Trust approximately $1.83 billion of receivables arising from certain proprietary credit card programs. The Trust has sold four series of certificates representing an undivided interest in the Trust Portfolio. In addition, the Trust has sold certain Collateral Interests in the Trust Portfolio. The Transferor is required under the Pooling Agreement to maintain a minimum 4% interest in the Trust Portfolio (6% November through January). The following series of certificates have been issued by the Trust as of December 31, 1999 (dollars in thousands): The Series 1996-A, Class A and Class B and Series 1996-B, Class A and Class B certificates have been distributed to the public under prospectuses dated April 9, 1996. The Series 1999-A, Class A certificates have been distributed to the public under a prospectus dated September 3, 1999. The Bank is the originator of the receivables and continues to service the receivables for the Trust and receives a fee for providing such servicing. Under the Pooling Agreement, new receivables generated under the specified proprietary credit card programs are required to be sold to the Trust on a daily basis. If there are insufficient new receivables to maintain the required minimum receivable level in the Trust, principal collections are retained by the Trust for the benefit of the certificateholders or until new receivables are available for purchase. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. To manage our direct risk from market interest rates, we actively monitor the interest rates to minimize the impact that changes in interest rates have on the fair value of assets, net income and cash flow. To achieve this objective, we manage our exposure to fluctuations in market interest rates through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. In addition, we have entered into derivative financial instruments, interest rate swaps, to mitigate our interest rate risk and to effectively lock the interest rate on a portion of our variable rate debt. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT To the World Financial Network Credit Card Master Trust We have audited the accompanying statements of assets and liabilities arising from cash transactions of the World Financial Network Credit Card Master Trust (the "Trust") as of December 31, 1999 and 1998, and the related statements of distributable income arising from cash transactions for the year ended December 31, 1999 and the eleven month period ended December 31, 1998. These financial statements are the responsibility of the management of the Trust. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements were prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities arising from cash transactions of the Trust as of December 31, 1999 and 1998, and its distributable income arising from cash transactions for the respective periods stated above on the basis of accounting described in Note 1. By: /s/ Deloitte & Touche LLP ----------------------------------- Deloitte & Touche LLP Columbus, Ohio March 1, 2000 WORLD FINANCIAL NETWORK CREDIT CARD MASTER TRUST - ------------------------------------------------------------------------------ STATEMENTS OF ASSETS AND LIABILITIES ARISING FROM CASH TRANSACTIONS (in thousands of dollars) See accompanying Notes to Financial Statements. WORLD FINANCIAL NETWORK CREDIT CARD MASTER TRUST - ------------------------------------------------------------------------------ STATEMENTS OF DISTRIBUTABLE INCOME ARISING FROM CASH TRANSACTIONS (in thousands of dollars) See accompanying Notes to Financial Statements. WORLD FINANCIAL NETWORK CREDIT CARD MASTER TRUST NOTES TO FINANCIAL STATEMENTS - ----------------------------- NOTE 1. General Information and Accounting Policies The World Financial Network Credit Card Master Trust (the "Trust") was formed pursuant to a Pooling and Servicing Agreement, dated as of January 17,1996, and amended and restated as of September 17, 1999, (the "Pooling Agreement") between World Financial Network National Bank (the "Bank"), as transferor (the "Transferor") and as servicer (the "Servicer") of receivables (the "Receivables") arising in a portfolio of consumer open end credit card accounts (the "Trust Portfolio") and the Harris Trust and Savings Bank, as trustee (the "Trustee"). The Trust Portfolio includes the private label credit card programs of a number of national retail and catalogue entities. The Bank services the receivables pursuant to the Pooling Agreement and is compensated for acting as the Servicer. In order to facilitate its servicing functions and minimize administrative burdens and expenses, the Bank retains physical possession of the documents relating to the receivables as custodian for the Trustee. The Trust has no employees. During 1998, the Trust changed its year end to December 31. Prior to that change the Trust used a fifty-two/fifty-three week fiscal year that ended on the Saturday closest to January 31. The financial statements of the Trust are prepared on a cash basis of accounting which differs from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. The statement of assets and liabilities arising from cash transactions as of December 31, 1999 reflects the amounts to be distributed on January 15, 2000, which represents the distribution of income received by the Trust for the period December 1 through December 31, 1999. NOTE 2. Sale of Certificates The Trust may issue from time to time asset-backed certificates in one or more Series, which will consist of one or more classes of certificates, representing an undivided ownership interest in the Receivables. As of December 31, 1999 the Trust had issued the following certificates, representing the indicated undivided interest in the Trust Portfolio: The Series 1996-A, Class A and Class B and Series 1996-B Class A and Class B certificates were distributed to the public pursuant to a Prospectus dated April 9, 1996 and the Series 1999-A, Class A certificates were distributed to the public pursuant to a Prospectus dated September 3, 1999. The Series 1996-A, Class D and Series 1996-B, Class D certificates are held by the Transferor and Servicer, World Financial Network National Bank. The Series 1999-A, Class B certificates were privately placed and the Series 1996-VFC class of certificates has been retained by three conduit banks. Collectively, holders of all Series are referred to as "Certificateholders." In addition, certain Collateral Interests were issued by the Trust, representing a 10.7% interest in the Trust Portfolio. Such Collateral Interests are held by four banks at December 31, 1999 (the "Collateral Interestholders"). The Transferor is required to maintain a minimum 4% (6% November through January) interest in the Trust Portfolio (the "Transferor's Interest"). The rights of the Collateral Interestholders to receive distributions are subordinate to the rights of the Class A, B and D Certificateholders and the Transferor's Interest. NOTE 3. Principal and Interest Payment Collections of principal are used by the Trust to purchase new charge card receivables on a daily basis. Collections of finance charges, which includes late fees, non-sufficient funds check fees and recoveries of amounts previously written-off, are used to pay interest to the Certificateholders, pay servicing fees and to purchase new charge card receivables equal to amounts written-off during the month. Excess finance charge collections, if any, are distributed to the Servicer. The distribution date is the 15th day of each month (or, if such day is not a business day, the next following business day). NOTE 4. Federal Income Taxes The Trust is not taxable as a corporation for Federal income tax purposes. Accordingly, no provision for income taxes is reflected in the accompanying financial statements. NOTE 5. Supplementary Financial Data (unaudited) The following is a summary of quarterly (the quarter ending December 31, 1998 consists of two months) distributable income arising from cash transactions (in thousands of dollars): NOTE 6: Fair Value of Financial Instruments The fair value of the Trust's credit card receivables approximate their carrying value due to the short maturity and average interest rates that approximate current market rates. The fair value of the asset-backed certificates is estimated to be $2,144,464,035 (carrying value of $2,116,932,959) as of December 31, 1999 and $1,471,239,882 (carrying value of $1,444,368,476) as of December 31, 1998, based on quoted market prices or current market rates for similar securities with similar remaining maturities and interest rates. (See also Note 7) NOTE 7: INTEREST SWAPS In September 1999, the Trust entered into two interest rate swap agreements with JP Morgan Company ("Morgan") with a notional amount of $525 million. The interest rate swaps effectively change the Trust's interest rate exposure on $473.4 million and $51.6 million of securitized acounts receivable to a fixed rate of approximately 6.40% and 6.41% respectively. The notional amount of swaps, $525 million as of December 31, 1999 will decrease with a corresponding decrease of the related securitized receivables. The fair value of the interest rate swaps was estimated based on the monies the Trust would receive if they terminated the agreements. ITEM 9. ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There is nothing to report with regard to this item. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There is nothing to report with regard to this item. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There is nothing to report with regard to this item. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is nothing to report with regard to this item. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is nothing to report with regard to this item. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a) Listed below are the documents filed as part of this report: Ommitted b) Reports on Form 8-K: The following current reports on Form 8-K were filed for the fourth quarter of 1999: c) Omitted d) Omitted SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Bank, on behalf of the Trust, has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: World Financial Network Credit Card Master Trust World Financial Network National Bank, as Servicer Date: 3/31/00 By: /s/ Daniel T. Groomes -------------- -------------------------- Daniel T. Groomes President

43362_1999.txt

43362_1999

1999

43362

Item 1. BUSINESS GENERAL Great Lakes Chemical Corporation is a Delaware corporation incorporated in 1933, having its principal executive offices in Indianapolis, Indiana. The Company is organized into four global business units: Polymer Additives, Performance Chemicals, Water Treatment and Energy Services and Products. In 1999, the Company took several steps towards achieving higher growth and productivity including: - - expanding its growth platforms by acquiring NSC Technologies and FMC's Process Additives Division which strengthen product offerings in Polymer Additives, Performance Chemicals and Water Treatment; - - completing, in July 1999, the sale of $400 million of 7% notes, due 2009, which were used to fund the acquisitions and repay a portion of the commercial paper outstanding; - - recognizing certain asset impairments in Polymer Additives, Energy Services and Products' and Corporate that will increase the Company's focus on its core specialty chemicals businesses and position these operations to achieve higher growth and profitability; - - announcing its plan to sell up to 50% of OSCA, Inc. an oil field services subsidiary in an initial public offering scheduled for the first half of 2000. Unless otherwise indicated, the information herein refers to the continuing business of the Company. The Review of Operations on pages 14 through 17 of the 1999 Annual Report to Stockholders is incorporated herein by reference. The term "Great Lakes" as used herein means Great Lakes Chemical Corporation and its Subsidiaries unless the context indicates otherwise. PRODUCTS AND SERVICES The following is a list of the principal products and services provided by Great Lakes: POLYMER ADDITIVES PERFORMANCE CHEMICALS WATER TREATMENT WATER TREATMENT (CONTINUED) ENERGY SERVICES AND PRODUCTS BUSINESS RISKS Great Lakes Chemical Corporation is including the following cautionary statement in this Annual Report of Form 10-K to make applicable and take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 with respect to any forward-looking statement made by, or on behalf of, the Company. The factors identified in this cautionary statement are important factors (but do not necessarily constitute all important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company. Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, the Company cautions that, while it believes such assumptions or bases to be reasonable and makes them in good faith, assumed facts or bases almost always vary from actual results, and the differences between assumed facts or bases and actual results can be material, depending upon the circumstances. Where, in any forward-looking statement, the Company, or its management, expresses an expectation or belief as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will result or be achieved or accomplished. Taking into account the foregoing, certain factors, including but not limited to, those listed below may cause actual results to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company. Economic factors over which the Company has no control, including changes in inflation, tax rates, interest rates and foreign currency exchange rates. Competitive factors such as pricing pressures on key products and the cost and availability of key raw materials. Governmental factors including laws and regulations and judicial decisions related to the production or use of key products such as bromine and bromine derivatives. The difficulties and uncertainties inherent in new product development. New product candidates that appear promising in development may fail to reach the market because of safety concerns, inability to obtain necessary regulatory approvals, difficulty or excessive costs to manufacture, or infringements of the patents or intellectual property rights of others. Legal factors, including unanticipated litigation of product liability claims, antitrust litigation; environmental matters, and patent disputes with competitors which could preclude commercialization of products or negatively affect the profitability of existing products. Inability to obtain existing levels of product liability insurance or denial of insurance coverage following a major product liability claim. Changes in tax laws, including future changes in tax laws related to the remittance of foreign earnings or investments in foreign countries with favorable tax rates. Changes in accounting standards promulgated by the Financial Accounting Standards Board, the Securities and Exchange Commission, and the American Institute of Certified Public Accountants which are adverse to the Company. Internal factors such as changes in business strategies and the impact of cost control efforts and business combinations. Loss of brine leases or inability to produce the bromide ion in required quantities due to depletion of resources or other causes beyond the Company's control. 1999 DEVELOPMENTS The Review of Operations on pages 14 through 17 of the 1999 Annual Report to Stockholders is incorporated herein by reference. Raw Materials The sources of essential raw materials for bromine are the brine from company-owned wells in Arkansas and a sea water extraction plant in Europe. The Arkansas properties are located atop the Smackover lime deposits, which constitute a vast underground sea of bromine-rich brine. The area between ElDorado and Magnolia, Arkansas, (located about 35 miles west of ElDorado) provides the best known geological location for bromine production and both major domestic bromine manufacturers are located there. Based on projected production rates, the Company's brine reserves are estimated to be adequate for the foreseeable future. Other materials used in the chemical processes are obtained from outside suppliers through purchase contracts. Supplies of these materials are believed to be adequate for the Company's future operations International Operations Great Lakes has significant presence in foreign markets, principally Western Europe and Asia. Approximately one third of the Company's assets and sales are outside the United States. The geographic segment data contained in Note 15: "Segment Information" of the Notes to Consolidated Financial Statements on page 38 and 39 of the 1999 Annual Report to Stockholders is incorporated herein by reference. Customers and Distribution During the last three years, no single customer accounted for more than 10% of Great Lakes' total consolidated sales. The Company has no material contracts or subcontracts with government agencies. A major portion of the Company's sales are sold to industrial or commercial users for use in the production of other products. Some products, such as recreational water treatment chemicals and supplies, are sold to a large number of retail pool stores, mass merchandisers and distributors. Some export sales are marketed through distributors and brokers. The Company's business does not normally reflect any material backlog of orders at year-end. Competition Great Lakes is in competition with businesses producing the same or similar products as well as businesses producing products intended for similar use. There is one other major bromine producer in the United States which competes with the Company in varying degrees, depending on the product involved, with respect to the sale of bromine and bromine derivatives. There is also one major overseas manufacturer of bromine and brominated products which competes with the Company in the United States and elsewhere. There are several small producers in the U.S. and overseas which are competitors in several individual products. In addition, there are numerous manufacturers of alternatives that compete with the Company. In polymer stabilizers, the Company competes with a significantly larger supplier across this entire product line and with a number of smaller companies in individual product areas. The Company competes with several manufacturers and distributors of swimming pool and spa chemicals. Principal methods of competition are price, product quality and purity, technical services and ability to deliver promptly. The Company is able to move quickly in providing new products to meet identified market demands, and believes its production costs are among the lowest in the world. These factors, combined with high technical skills, allow the Company to compete effectively. Seasonality and Working Capital The products which the Company sells to the agricultural and swimming pool markets exhibit some seasonality which is reflected in relatively higher sales and profits in the first half of each year. Seasonality results in the need to build inventories for rapid delivery at certain times of the year. The pool product season is strongest during the first six months, requiring a build-up of inventory at the beginning of the year. Except for certain arrangements with distributors and dealers of swimming pool and spa products, customers are not permitted to return unsold material at the end of a season. Extended credit terms are granted only in cases where the Company chooses to do so to meet competition. The effect of the above items on working capital requirements is not material. Research and Development and Patents Research and development expenditures are included in Note 14: "Research and Development Expenses" of the Notes to Consolidated Financial Statements on page 38 of the 1999 Annual Report to Stockholders and is incorporated herein by reference. The Company holds no patents, licenses, franchises or concessions which are essential to its operations. Environmental and Toxic Substances Control The Company recognizes its responsibility for the sound environmental management of its businesses and operations. In addressing this responsibility, the Company's domestic chemical manufacturing operations subscribe to the comprehensive environmental stewardship program developed by the Chemical Manufacturers Association known as Responsible Care. The Company is in material compliance with all environmental laws and regulations to which it is subject. Employees The Company has approximately 5,800 employees. Item 2. Item 2. PROPERTIES Great Lakes has plants at 14 locations in 9 states and 20 plants in 10 foreign countries. Most principal plants are owned. Listed under Item 1 above in a table captioned Products and Services are the principal locations at which products are manufactured, distributed or marketed. The Company leases warehouses, distribution centers and space for offices throughout the world. All of the Company's facilities are in good repair, suitable for the Company's businesses, and have sufficient space to meet present marketing demands at an efficient operating level. Item 3. Item 3. LEGAL PROCEEDINGS There are no material pending legal proceedings involving the Company, its subsidiaries or any of its properties. Furthermore, no director, officer or affiliate of the Company, or any associate of any director or officer is involved, or has a material interest in, any proceeding which would have a material adverse effect on the Company. Item 103 of Regulation S-K requires disclosure of administrative or judicial proceedings arising under any federal, state or local provisions dealing with protection of the environment, if the monetary sanctions might exceed $100,000. There are currently no such proceedings. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the quarter ended December 31, 1999. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS As of March 20, 2000, there were approximately 2,700 registered holders of Great Lakes Common Stock. Additional information is contained in the 1999 Annual Report to Stockholders under the captions "Stock Price Data" and "Cash Dividends Paid" on page 41, all of which are incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA This information is contained in the 1999 Annual Report to Stockholders under the caption "Financial Review" on page 18, and is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 19 through 25 of the 1999 Annual Report to Stockholders is incorporated herein by reference. Item 7a. Item 7a. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK This information is included in the "Market Risks" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 24 of the 1999 Annual Report to Stockholders, and is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements, together with the report thereon of Ernst & Young LLP dated February 18, 2000, appearing on pages 26 through 40 and the "Quarterly Results of Operations" on page 41 of the 1999 Annual Report to Stockholders, are incorporated herein by reference. Item 9. Item 9. DISAGREEMENT OF ACCOUNTING AND FINANCIAL DISCLOSURE No change of auditors or disagreements on accounting methods have occurred which would require disclosure hereunder. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Executive Officers Information with respect to directors of the Company is contained under the heading "Proposal One: Election of Directors" in the Great Lakes' Proxy Statement relating to the 2000 Annual Meeting of Stockholders expected to be filed on March 27, 2000, which is incorporated herein by reference. Item 11. Item 11. EXECUTIVE COMPENSATION The information under the heading "Executive Compensation and Other Information" in the 2000 Proxy Statement is incorporated by reference in this report. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the heading "Security Ownership of Certain Beneficial Owners and Management" in the 2000 Proxy Statement is incorporated by reference in this report. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the heading "Compensation Committee Interlocks and Insider Participation" in the 2000 Proxy Statement is incorporated by reference in this report. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements The following Consolidated Financial Statements of Great Lakes Chemical Corporation and Subsidiaries and related notes thereto, together with the report thereon of Ernst & Young LLP dated, February 18, 2000 appearing on pages 26 through 40 of the 1999 Annual Report to Stockholders, are incorporated by reference in Item 8: Consolidated Balance Sheets - December 31, 1999 and 1998 Consolidated Statements of Income - Years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows - Years ended December 31, 1999, 1998 and 1997 Consolidated Statements of Stockholders' Equity - Years ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements (a)(2) Financial Statement Schedules The following additional information is filed as part of this report and should be read in conjunction with the 1999 financial statements. Schedule II - Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore, have been omitted. (a)(3) Exhibits: Exhibit No. 23 is included herewith. Exhibits No. 3ii, 10ii, 10iii, 10v, 10ix, 10xvi, 10xvii, 13 and 27 are included herewith as part of the electronic filing. (b) Reports on Form 8-K (c) Exhibits The response to this section of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedules The response to this section of Item 14 is submitted as a separate section of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SCHEDULE II GREAT LAKES CHEMICAL CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1999 (A) Uncollectible accounts receivable written off, net of recoveries and foreign currency translation. (B) Foreign currency translation.

732718_1999.txt

732718_1999

1999

732718

ITEM 1. BUSINESS GENERAL MediaOne Group, Inc. ("MediaOne Group" or the "Company") is incorporated under the laws of the State of Delaware and has its principal executive offices at 188 Inverness Drive West, Englewood, Colorado 80112, telephone number (303) 858-3000. MediaOne Group (NYSE: UMG) is one of the world's largest broadband communications companies. For 1999, the businesses of MediaOne Group produced $7.8 billion in proportionate revenue. (Financial information concerning MediaOne Group's operations is set forth in the Consolidated Financial Statements and Notes thereto, which begin on page 46.) At December 31, 1999, MediaOne Group and its subsidiaries employed a total of 15,196 people. Prior to June 12, 1998, MediaOne Group was known as "U S WEST, Inc." On June 12, 1998, U S WEST, Inc. (the "Old U S WEST") separated its businesses into two independent public companies (the "Separation"). Until the Separation, U S WEST, Inc. conducted its businesses through two groups: U S WEST Media Group and U S WEST Communications Group. Upon the Separation, the Old U S WEST was renamed "MediaOne Group, Inc." and retained the multimedia businesses of U S WEST Media Group, except for U S WEST Dex, Inc., the domestic telephone directory business, which became aligned with U S WEST Communications Group. The telecommunications businesses of U S WEST Communications Group, along with the domestic telephone directory business of U S WEST Dex, became an independent public company and retained the "U S WEST, Inc." name. RECENT DEVELOPMENT On May 6, 1999 the Board of Directors of MediaOne Group approved a merger agreement that provides for the merger of MediaOne Group with and into Meteor Acquisition Inc., a wholly owned subsidiary of AT&T Corp. The merger will join AT&T, a worldwide communications leader, with MediaOne Group, a leader in the broadband communications industry, to create the leading carrier of end-to-end communications services for consumers and businesses. We believe that the combined company will be well-positioned to create and provide nationally branded broadband services and to service new markets and exploit business opportunities. OPERATIONS MediaOne Group is one of the largest broadband communications operators in the United States. Among its investments, MediaOne Group holds a 25.51% interest in Time Warner Entertainment Company, L.P. ("TWE"), a provider of cable programming, filmed entertainment and broadband communications services that is the second largest cable television system operator in the United States. BROADBAND COMMUNICATIONS--MEDIAONE NETWORKS. As of December 31, 1999, MediaOne Group's cable television systems passed approximately 8.6 million homes and provided service to approximately 5.0 million cable subscribers. MediaOne Group's systems are organized into six operating regions, including large clusters in Atlanta, Massachusetts, California, Chicago, Florida, Detroit and Minneapolis/ St. Paul. MediaOne Group believes that its operating scale in key markets generates significant benefits, including operating efficiencies, and enhances its ability to develop and deploy new broadband technologies and services. MediaOne Group's cable services are marketed under the "MediaOne" brand and are operated by its wholly owned subsidiary, MediaOne of Delaware, Inc. ("MediaOne"). MediaOne Group's cable systems offer customers various levels (or "tiers") of cable programming services consisting of broadcast television signals available off-the-air in any locality, televisions signals from so-called "super stations" originating in distant cities (such as WGN), various satellite-delivered non-broadcast channels (such as CNN, MTV, USA Network, ESPN, the Discovery Channel and Nickelodeon), displays of information featuring news, weather, stock and financial market reports and programming originated locally by the systems (such as public, governmental and educational access channels). MediaOne Group's systems also provide premium programming service to their customers for an extra monthly charge. These premium programming services include HBO, Cinemax, Showtime, The Movie Channel, Encore and regional sports networks. Customers generally pay initial connection charges and fixed monthly fees for a tier of programming services and additional fixed monthly fees for premium programming services. MediaOne Group also offers pay-per-view programming of movies and special events for an additional per-program charge. MediaOne Group's systems have channel capacity and addressability that are among the highest in the cable industry. MediaOne Group's systems are located primarily in suburban communities adjacent to major metropolitan markets and in mid-sized cities that generally are densely populated and geographically diverse. MediaOne Group believes that its technologically advanced broadband networks and the demographic profile of its subscriber base, coupled with its effective marketing, have been essential to its ability to sustain total monthly revenue per basic subscriber that is among the highest in the cable industry. MediaOne Group believes that the geographic diversity of its system clusters reduces its exposure to economic, competitive or regulatory factors of any particular region. MediaOne Group is upgrading its cable systems to create broadband hybrid fiber-coax ("HFC") networks. These HFC networks will provide increased channel capacity for the delivery of additional cable programming and facilitate the delivery of additional services, such as telephony services, enhanced video services, and high speed Internet access services. MediaOne Group is selectively upgrading its systems and expects that it will have nearly 90% of its systems upgraded by the end of 2000. BROADBAND COMMUNICATIONS--TIME WARNER CABLE. MediaOne Group owns a 25.51% priority capital and residual equity interest in TWE. The remaining interests in TWE are owned by Time Warner, Inc. ("TWX"). TWE is engaged in the cable programming, filmed entertainment and broadband communications businesses. TWE, through Time Warner Cable, its cable division, is the second-largest cable television system operator in the United States. Time Warner Cable offers cable programming services over its networks similar to those offered by MediaOne Group under the MediaOne brand. Like MediaOne Group, Time Warner Cable is upgrading its cable systems to provide increased channel capacity and to facilitate the delivery of additional services. In order to avoid disputes as to whether the AT&T merger would violate the non-competition provisions of the TWE partnership agreement, on August 3, 1999, MediaOne Group sent a notice of termination to TWE which terminated these non-competition provisions as to MediaOne Group. The non-competition provisions continue to apply to TWX. Delivery of the notice of termination permitted TWE to terminate most of MediaOne Group's management rights in TWE, which it did on August 4, 1999. Most of these rights would have terminated in any event upon the change of control of MediaOne Group in the merger. The delivery of the termination notice and the resulting termination of management rights is irrevocable, however, even if the merger does not occur. The loss of these management rights may have a material adverse effect on the value of MediaOne Group's interest in TWE. Notwithstanding the notice of termination, MediaOne Group retains certain rights under the partnership agreement, including the right to approve such matters as a merger of TWE, TWE's entrance into new lines of business and the issuance of new partnership interest. REGULATION. The products and services of MediaOne Group are subject to varying degrees of regulation. Under the Telecommunications Act of 1996 (the "Telecommunications Act"), the regulation of all but basic service tier cable and equipment and installation rates was discontinued effective March 31, 1999. However, as described below, the rate regulation for cable systems covered by MediaOne's social contract with the Federal Communications Commissions ("FCC") remain subject to rate regulations until the social contract expires on December 31, 2000. The Telecommunications Act also eliminated certain cross-ownership restrictions among cable operations, broadcasters and multipoint multichannel distribution services ("MMDS") operations, and removed barriers to competition with local exchange carriers ("LECs"). The social contract (as amended) is a six-year agreement covering most of MediaOne's franchises. As part of the social contract, the Company agreed to, among other things, invest at least $1.7 billion in domestic system rebuilds and upgrades through the year 2000 to expand channel capacity and improve system reliability and picture quality. As of December 31, 1998, the investment commitment had been met. However, the Company must still upgrade all systems covered by the social contract to a minimum of 550MHz, with at least half being upgraded to 750 MHz. As of the end of 1998, 70% of customers in systems covered by the social contract were served by systems with a channel capacity of 550 MHz or greater, and 47% were served by 750 MHz systems. On October 8, 1999, the FCC revised its rules on the number of cable subscribers that a company may reach and the method to identify cable ownership interests that would be attributable to a company. The revised rules maintained the original ruling that a cable operator may not own systems that reach more than 30% of United States homes. The calculation of the number of United States homes reached was modified, however, to include those households that subscribe to broadcast satellite and other multi-channel video programming distributors, effectively increasing the number of subscribers that a cable operator may serve. The FCC has voluntarily stayed the ownership rules pending the outcome of a court challenge to the original ownership rules. The Company believes that these new rules will not prevent the closing of the AT&T merger. Cable television systems are also subject to local regulation, typically imposed through the franchising process. Local officials may be involved in the initial franchise selection, system design and construction, safety, rate regulation, customer service standards, billing practices, community-related programming and services, franchise renewal and imposition of franchise fees. Currently, seven local franchise authorities, representing less than three percent of the Company's subscribers, are attempting to require MediaOne Group to allow unaffiliated Internet service providers ("ISPs") to connect to the cable network for the purpose of transmitting information between the ISP's customers and the Internet. MediaOne Group believes that local governments, including franchising authorities, lack authority to force cable companies to provide network access to other ISPs and will vigorously defend against any such forced access mandates. In June 1998, the FCC issued formal rules providing for the retail sale of set-top television boxes which integrate security and non-security functions. On January 1, 2005, cable companies will no longer be permitted to sell or lease new integrated boxes to their subscribers. In addition, cable companies must provide subscribers with related security modules that plug into set-top boxes that are purchased from consumer electronics retailers by July 1, 2000. In February 1999, MediaOne Group partnered with various manufacturers of digital set-top boxes in order to provide an open conditional access system, which would be compliant with domestic OpenCable-TM-specifications. In May 1999, the FCC issued an interpretation of these rules which clarified that the segregation requirements applied to digital and hybrid digital/analog boxes only. COMPETITION. MediaOne Group's cable television systems generally compete for viewer attention with other providers of video programming, including direct broadcast satellite ("DBS") systems, MMDS systems, local multipoint distribution services systems, satellite master antenna television ("SMATV") systems and other cable companies providing services in areas where MediaOne Group operates. In addition, certain LECs, including regional Bell operating companies ("RBOCs"), are beginning to offer video programming in competition with MediaOne Group's cable services. In the past, federal cross-ownership restrictions have limited entry by LECs into the cable television business. The Telecommunications Act has eliminated many of these barriers, thereby enhancing the ability of LECs to provide video programming in competition with MediaOne Group. The extent of such competition in any franchise area is dependent, in part, upon the quality, variety and price of the programming provided by these services. Many of these competitive services are generally not subject to the same local government regulation that affects cable television. The cable television services offered by MediaOne Group also face competition for viewers and advertising from other communications and entertainment media, including off-air television broadcasting services, movie theaters, video tape rentals and live sporting events. The competition faced by MediaOne Group's cable systems may increase in the future with the development and growth of new technologies. As MediaOne Group begins to offer additional services over its HFC networks, MediaOne Group will face additional competition. MediaOne Group's high speed Internet access and telephony services face competition from other providers, including regional bell operating companies, LECs, inter-exchange carriers ("IXCs"), ISPs and other providers of local exchange and on-line services. The degree of competition will be dependent upon the state and federal regulations concerning entry, interconnection requirements and the degree of unbundling of the LECs' networks. Competition will be based upon price, service quality, breadth of services offered and, to a lesser extent, on price. ITEM 2. ITEM 2. PROPERTIES. MediaOne Group's principal physical assets consist of cable television operating plant and equipment, including signal receiving, encoding and decoding devices, headends and distribution systems and customer house drop equipment for each of its cable television systems. The signal receiving apparatus typically includes a tower, antenna, ancillary electronic equipment and earth stations for reception of satellite signals. Headends, consisting of related electronic equipment necessary for the reception, amplification and modulation of signals, are located near the receiving devices. The physical components of cable television systems require maintenance and periodic upgrading to keep pace with technological changes. MediaOne Group owns or leases parcels of real property for signal reception sites (antenna towers and headends), microwave facilities and business offices in each of its market areas and owns most of its service vehicles. MediaOne Group believes that its properties, both owned and leased and taken as a whole, are in good operating condition and are suitable and adequate for MediaOne group's business operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. MediaOne Group, Inc. and its subsidiaries are subject to claims and proceedings arising in the ordinary course of business. While complete assurance cannot be given as to the outcome of any contingent liabilities, in the opinion of MediaOne Group, any financial impact to which MediaOne Group and its subsidiaries are subject is not expected to be material in amount to MediaOne Group's operating results or its financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. At a Special Meeting of Shareholders held in Englewood, Colorado on October 21, 1999, the shareholders voted as follows to approve the adoption of an Agreement and Plan of Merger among MediaOne Group, Inc., AT&T and Meteor Acquisition Inc., a wholly owned subsidiary of AT&T, (the "Merger Agreement") by which MediaOne Group, Inc. would be merged into Meteor Acquisition, Inc.: EXECUTIVE OFFICERS OF MEDIAONE GROUP, INC. Pursuant to General Instructions G(3), the following information is included as an additional item in Part I: - ------------------------ (1) Mr. Ames is also President and Chief Executive Officer of MediaOne International, Inc. (2) In connection with the Separation, Mr. Lillis became the President, Chief Executive Officer and Chairman of MediaOne Group, Inc. Mr. Lillis was previously President and Chief Executive Officer of the U S WEST Media Group. (3) Ms. Peters is also President and Chief Executive Officer of MediaOne. Executive Officers are not elected for a fixed term of office, but serve at the discretion of the Board of Directors. With the exception of Ms. Peters, who joined One 2 One in 1996, each of the above executive officers has held a managerial position with Old U S WEST or an affiliate of Old U S WEST since at least 1988. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required by this item is included in Note 26, Quarterly Financial Data, on page 98. The US markets for trading in MediaOne Group common stock are the New York Stock Exchange and the Pacific Stock Exchange. As of January 31, 2000, MediaOne Group common stock was held by approximately 500,254 registered shareholders. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Reference is made to the information set forth on pages 11 through 12. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Reference is made to the information set forth on pages 13 through 43. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. Reference is made to the information set forth on pages 35 and 36. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Reference is made to the information set forth on pages 46 through 100. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by this item with respect to executive officers is set forth in Part I, page 5, under the caption "Executive Officers of MediaOne Group, Inc." The information required by this item with respect to Directors is included in the MediaOne Group definitive Proxy Statement relating to the Annual Meeting of Stockholders held on June 4, 1999 (the "Annual Proxy Statement") under "Election of Directors" and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is included in the Annual Proxy Statement under "Election of Directors" and "Executive Compensation" and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is included in the Annual Proxy Statement under "Stock Ownership" and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not applicable. PART IV ITEM 14. ITEM 14. FINANCIAL STATEMENT SCHEDULES, REPORTS ON FORM 8-K AND EXHIBITS. (a) Documents filed as part of this report: Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. (b) Reports on Form 8-K: (c) Exhibits: Exhibits identified in parentheses below are on file with the Securities and Exchange Commission ("SEC") and are incorporated herein by reference. All other exhibits are provided as part of this electronic submission. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Englewood, State of Colorado, on March 23, 2000. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. MEDIAONE GROUP, INC. FINANCIAL HIGHLIGHTS - -------------------------- (1) On June 12, 1998, U S WEST, Inc. ("Old U S WEST") separated its businesses into two independent public companies (the "Separation"). Prior to the Separation, Old U S WEST conducted its businesses through two groups: U S WEST Media Group ("Media Group") and U S WEST Communications Group ("Communications Group"). Upon the Separation, Old U S WEST was renamed MediaOne Group, Inc. ("MediaOne Group" or the "Company") and retained the businesses of Media Group, except for U S WEST Dex, Inc. ("Dex"), the domestic directory business. The telecommunications businesses of Communications Group became an independent public company and retained the "U S WEST, Inc." name ("New U S WEST"). In addition, Dex was aligned with New U S WEST. MediaOne Group has accounted for the distribution to shareowners of New U S WEST as a discontinuance of the businesses comprising New U S WEST. 1998 income from discontinued operations includes a gain on Separation of $24,461 ($40.25 per share of MediaOne Group Stock). See Note 25--Discontinued Operations--to the Consolidated Financial Statements. (2) 1999, 1998, 1997 and 1996 sales and other revenues include $2,384, $2,191, $2,070 and $252, respectively, related to Continental Cablevision, Inc. ("Continental") which was acquired by MediaOne Group on November 15, 1996 (the "Continental Acquisition"). In addition, 1998, 1997, 1996 and 1995 sales and other revenues include $361, $1,428, $1,183, and $941, respectively, related to the domestic wireless operations which were sold on April 6, 1998. (3) 1999 income from continuing operations includes a net gain of $1,530 ($2.50 per share of MediaOne Group Stock) related to an investment in AirTouch Communications, Inc. stock, net gains of $314 and $4,084 ($0.51 and $6.68 per share of MediaOne Group Stock, respectively) on the sale of domestic and international investments, respectively, a net charge of $1,688 ($2.76 per share of MediaOne Group Stock) for merger related activity, net loss from operations of $117 ($0.19 per share of MediaOne Group Stock) related to Continental, and a net charge MEDIAONE GROUP, INC. FINANCIAL HIGHLIGHTS of $30 ($0.05 per share of MediaOne Group Stock) related to the PrimeStar investment. 1998 income from continuing operations includes a net gain of $2,257 ($3.71 per share of MediaOne Group Stock) on the sale of the domestic wireless businesses, net gains of $44 ($0.08 per share of MediaOne Group Stock) on the sales of various domestic investments, net income of $20 ($0.04 per share of MediaOne Group Stock) related to the domestic wireless businesses, net loss from operations of $384 ($0.63 per share of MediaOne Group Stock) related to Continental, and a net loss of $100 ($0.16 per share of MediaOne Group Stock) related to the PrimeStar investment. 1997 income from continuing operations includes net gains of $249 ($0.41 per share of MediaOne Group Stock) on the sales of various domestic and international investments, net income of $83 ($0.13 per share of MediaOne Group Stock) related to the domestic wireless businesses and net loss from operations of $356 ($0.59 per share of MediaOne Group Stock) related to Continental. 1996 income from continuing operations includes net income of $96 ($0.19 per share of MediaOne Group Stock) related to the domestic wireless businesses, net loss from operations of $71 ($0.15 per share of MediaOne Group Stock) related to Continental and a charge of $19 ($0.04 per share of MediaOne Group Stock) related to the sale of MediaOne Group's cable television interests in Norway, Sweden and Hungary. 1995 income from continuing operations includes a gain of $95 ($0.20 per share of MediaOne Group Stock) from the merger of Telewest Communications plc with SBC CableComms (UK), net income of $58 ($0.12 per share of MediaOne Group Stock) related to the domestic wireless businesses and costs of $9 ($0.02 per share of MediaOne Group Stock) associated with the Recapitalization Plan discussed in footnote 9 below. (4) 1999 net income was increased by an extraordinary gain of $17 ($0.03 per share of MediaOne Group Stock) for the early extinguishment of debt. 1998 net income was reduced by an extraordinary item of $333 ($0.55 per share of MediaOne Group Stock) for the early extinguishment of debt in conjunction with the Separation. 1995 net income was reduced by an extraordinary item of $4 ($0.01 per share of MediaOne Group Stock) for the early extinguishment of debt. (5) Debt at December 31, 1999, 1998, 1997 and 1996 includes debt related to the Continental Acquisition. Debt for years prior to 1998 excludes the capital assets segment which had been discontinued and held for sale, and the discontinued operations of New U S WEST which were distributed to shareowners effective June 12, 1998. Capital expenditures exclude the discontinued operations of New U S WEST, but include the capital assets segment in 1999. (6) Includes Company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely Company-guaranteed subordinated debentures ("Preferred Securities") of $1,060 at December 31, 1999, $1,061 at December 31, 1998, $1,080 at December 31, 1997 and 1996, and $600 at December 31, 1995; preferred stock subject to mandatory redemption of $50 at December 31, 1999, $100 at December 31, 1998 and 1997, and $51 at December 31, 1996 and 1995; and minority interest in Centaur Funding of $1,113 at December 31, 1999 and $1,099 at December 31, 1998. (7) MediaOne Group considers earnings before interest, taxes, depreciation, amortization and other ("EBITDA") an important indicator of the operational strength and performance of its businesses. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of MediaOne Group's businesses, or as an alternative to cash flows from operating activities as a measure of liquidity, in each case determined in accordance with generally accepted accounting principles ("GAAP"). (8) Proportionate results represent the relative weight of the Company's ownership in each of its respective domestic and international equity ventures, combined with its consolidated results. Proportionate information is not intended to replace financial and operating data prepared in accordance with GAAP since proportionate results depart materially from GAAP. However, MediaOne Group believes that proportionate financial and operating data facilitate the understanding and assessment of its results. Proportionate EBITDA excludes domestic wireless EBITDA of $114, $398, $307 and $226 for 1998, 1997, 1996 and 1995, respectively. (9) Effective with the Separation on June 12, 1998, each outstanding common share of Media Group stock remains outstanding and represents one share of MediaOne Group common stock ("MediaOne Group Stock"). In addition, all shares of Communications Group stock were canceled. See Note 17--Earnings Per Share--to the Consolidated Financial Statements--for a discussion of Communications Group stock earnings per share. The average common shares of MediaOne Group Stock outstanding for the year ended December 31, 1996 include 150,615,000 shares issued in connection with the Continental Acquisition. Effective November 1, 1995, each share of common stock of Old U S WEST was converted into one share each of Communications Group stock and Media Group stock (the "Recapitalization Plan"). Earnings per common share and dividends per common share for 1995 have been presented on a pro forma basis to reflect the two classes of stock as if they had been outstanding since January 1, 1995. MEDIAONE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) Some of the information presented in or in connection with this report constitutes "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Although the Company believes that its expectations are based on reasonable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results will not differ materially from its expectations. Factors that could cause actual results to differ from expectations include: (i) greater than anticipated competition from new entrants into the cable and wireless communications markets, and from direct broadcast satellite systems, (ii) changes in demand for the Company's products and services, (iii) regulatory changes affecting the cable and telecommunications industries, (iv) a change in economic conditions in the various markets served by MediaOne Group's operations, including international markets, that could adversely affect the level of demand for cable, wireless or other services offered by the Company, (v) greater than anticipated competitive activity requiring new pricing for services, (vi) higher than anticipated start-up costs associated with new business opportunities, (vii) higher than anticipated employee levels, capital expenditures, and operating expenses, (viii) consumer acceptance of broadband services, including telephony and data services, and wireless services, (ix) increases in fraudulent activity with respect to broadband and wireless services, or (x) delays in the development of anticipated technologies, or the failure of such technologies to perform according to expectations. AT&T MERGER On May 6, 1999, MediaOne Group, Inc. ("MediaOne Group" or the "Company") entered into an agreement with AT&T Corp. ("AT&T") to merge its operations with those of AT&T, and terminated the merger agreement previously entered into with Comcast Corporation ("Comcast"). On October 21, 1999, MediaOne Group's shareowners approved the merger with AT&T. The transaction is expected to close in the second quarter of 2000, subject to legal and regulatory approval. See Note 1--Business Overview--to the Consolidated Financial Statements for a detailed discussion of the AT&T / MediaOne Group merger. BUSINESS DESCRIPTION MediaOne Group is a diversified global broadband communications company having the capability to offer video, high speed Internet access and telephone services simultaneously over its broadband network. Domestically, the Company serves approximately 5.0 million cable customers and passes 8.6 million homes. MediaOne Group's cable systems include large clusters in Atlanta, Massachusetts, California, Chicago, Florida, Detroit and Minneapolis/St. Paul. The cable systems offer customers various levels of cable programming services, including premium programming services such as HBO, Cinemax, Showtime, The Movie Channel and Encore, as well as pay-per-view movies and special events. The domestic cable and broadband operations of the Company are managed by MediaOne of Delaware, Inc. ("MediaOne"), a subsidiary of MediaOne Group. The Company's high speed Internet access service is available in 14 areas nationwide, providing its customers with a continuous, direct link to the Internet over the Company's broadband network. Telephone service is available in seven metro areas providing clearer and more cost-effective telephone service to its customers. In addition to its domestic cable operations, the Company also holds significant domestic cable and broadband investments including an investment in Time Warner Entertainment Company L.P. ("TWE" or "Time Warner Entertainment"), the second largest provider of cable television services in the United States, and interests in programming that include E! Entertainment Television and New England Cable News. MediaOne Group also holds an interest in a joint venture with Time Warner, Inc., ("Time Warner"), TWE, Time Warner Entertainment-Advance/Newhouse Partnership, Microsoft Corporation ("Microsoft") and Compaq Computer Corporation to provide high speed Internet access services under the "RoadRunner" brand name (the "RoadRunner Joint Venture"). Internationally, the Company holds interests in various cable and broadband, and wireless properties. During 1999, as a result of the anticipated merger with AT&T, MediaOne Group formalized a plan to sell its international broadband and wireless investments. In conjunction with the AT&T merger, the Company sold its investments in Mercury Personal Communications ("One 2 One"), Cable Plus, a.s. and A2000. In addition, the Company entered into definitive agreements to sell its interest in Telewest Communications plc ("Telewest") to Microsoft, and its interests in most of its Central European wireless ventures, including Polska Telefonia Cyfrowa, Westel 900, Westel Radiotelefon, and Russian Telecommunications Development Corporation. See Note 7--Net Investment in International Ventures--and Note 23--Subsequent Events--to the Consolidated Financial Statements. THE SEPARATION Prior to June 12, 1998, MediaOne Group was known as "U S WEST, Inc." ("Old U S WEST"). On June 12, 1998, Old U S WEST separated its businesses into two independent public companies (the "Separation"). Until the Separation, Old U S WEST conducted its businesses through two groups: U S WEST Media Group (the "Media Group") and U S WEST Communications Group (the "Communications Group"). Upon the Separation, Old U S WEST was renamed "MediaOne Group, Inc." and retained the multimedia businesses of Media Group, except for U S WEST Dex, Inc. ("Dex"), the domestic directory business. The telecommunications businesses of the Communications Group became an independent public company and retained the "U S WEST, Inc." name ("New U S WEST"), and Dex was aligned with New U S WEST (the "Dex Alignment"). See Note 1--Business Overview--to the Consolidated Financial Statements. The Company accounted for the distribution of New U S WEST stock to the Communications Group stockholders, and to the Media Group stockholders for the Dex Alignment, as a discontinuance of the businesses comprising New U S WEST. Because the distribution was non pro-rata, as compared with the businesses previously attributed to Old U S WEST's two classes of stock, the distribution was accounted for at fair value and resulted in a gain of $24,461, or $40.25 basic earnings per share of MediaOne Group common stock ("MediaOne Group Stock"), net of $114 of Separation costs (net of tax benefits of $37). See Note 25--Discontinued Operations--to the Consolidated Financial Statements. In conjunction with the Separation, MediaOne Group refinanced substantially all of the indebtedness issued or guaranteed by Old U S WEST through a combination of tender offers, prepayments and consent solicitations (the "Refinancing"). Long-term debt outstanding of $4.9 billion was redeemed, resulting in an extraordinary loss of $333, net of tax benefits of $209, or $0.55 basic loss per MediaOne Group Stock. The loss was the result of refinancing costs, including the difference between the market and face value of the debt redeemed and a charge for unamortized debt issuance costs. See Note 10--Debt--to the Consolidated Financial Statements. OTHER On September 2, 1999, holders of the Company's Series C Cumulative Redeemable Preferred Stock (the "Series C Preferred Stock") exercised options to receive common shares of Financial Security Assurance Holdings Ltd. ("FSA") held by the Company. As a result of the exercise of the FSA options, the Series C Preferred Stock was effectively redeemed, resulting in an after tax charge to equity of $28 (net of $18 of tax benefits) or $(0.04) basic loss per share of MediaOne Group Stock. See Note 15--Preferred Stock Subject to Mandatory Redemption--to the Consolidated Financial Statements. On June 1, 1999, the Company redeemed the 11.0 percent senior subordinated debentures of MediaOne with a carrying value of $345. The debt extinguishment resulted in an after tax gain of $17 (net of income tax expense of $11), or $0.03 basic earnings per share of MediaOne Group Stock, primarily related to the write-off of excess debt premiums. The gain is reflected as an extraordinary item in the Consolidated Statements of Operations. The following discussion is based on MediaOne Group's Consolidated Financial Statements prepared in accordance with generally accepted accounting principles ("GAAP"). RESULTS OF OPERATIONS--CONTINUING OPERATIONS--1999 COMPARED WITH 1998 - ------------------------ (1) Represents the operations of the domestic wireless businesses which were sold to AirTouch Communications, Inc. ("AirTouch") effective 4/6/98. - ------------------------ (1) Businesses were sold in April 1998. The table above normalizes for significant one-time items that aid in the comparability of the Company's performance year over year. Routine acquisitions and dispositions are normalized within the revenues and operating income discussions which follow. The decrease in normalized loss from continuing operations during 1999 was primarily a result of decreased equity losses in unconsolidated ventures, increased interest and dividend income in 1999, and the loss recognized in 1998 related to an interest rate swap on the Company's investment in AirTouch preferred stock. The decrease was partially offset by minority interest expense in Centaur Funding as a result of the securities' issuance in December 1998. SALES AND OTHER REVENUES - ------------------------ (1) 1998 amounts have been reclassified to conform with the current year presentation. (2) Businesses were sold in April 1998. MediaOne Group sales and other revenues decreased during 1999 primarily as a result of the sale of the domestic wireless businesses in April, 1998, partially offset by growth in domestic cable and broadband revenues. Normalized for acquisitions and dispositions, total revenues increased $238, or 9.7 percent, during 1999, due primarily to growth in domestic cable and broadband revenues. DOMESTIC CABLE AND BROADBAND - ------------------------ (1) 1998 amounts have been reclassified to conform with the current year presentation. Domestic cable and broadband revenues increased during 1999 due primarily to increased video and new products revenues, partially offset by the lack of PrimeStar, Inc. ("PrimeStar") direct broadcast services ("DBS") revenues in 1999. Normalized for the one-time effects of cable system acquisitions and dispositions, total domestic cable and broadband revenues increased 10.9 percent during 1999. BASIC CABLE. Basic cable services revenues increased during 1999 due primarily to a five percent increase in revenue per average cable subscriber and increased basic subscribers. At December 31, 1999, basic cable subscribers were 4,993,000, an increase of 1.7 percent compared with the same period in 1998, normalized for the effects of cable system acquisitions and dispositions. The increase in revenue per subscriber is the result of expanded channel offerings, repackaging of services and increased rates. PREMIUM. Premium service revenues increased during 1999 due primarily to improved premium service customer growth as a result of the launch of "NexTV" in September 1998, partially offset by discounting of premium service packages. NexTV is a repackaging of the Company's premium services into related premium channels. At December 31, 1999, premium units were 4,392,000, an increase of 7.1 percent compared with the same period in 1998, normalized for the effects of cable system acquisitions and dispositions. At December 31, 1999, digital subscribers totaled 56,000 and digital market-ready homes were 1,482,000, encompassing six digital markets. Market-ready homes are those potential customers which are connected to the broadband network and which could be provided and billed for service. Digital NexTV services are available in Atlanta, Boston, Cleveland, Detroit, Pompano, Florida, and Richmond, Virginia. PAY-PER-VIEW. Pay-per-view revenues increased during 1999 due primarily to the offering of various major sporting events in 1999 compared with one major sporting event in 1998. In addition, growth in digital subscribers during 1999, providing higher impulse pay-per-view capability, has resulted in greater movie and other product purchases. During 1999, purchases of pay-per-view movies and other products have increased 10 percent on a normalized basis. ADVERTISING. Advertising revenues increased during 1999 primarily as a result of growth in local and national advertising sales as compared with the same period in 1998. EQUIPMENT AND INSTALLATION. Equipment and installation revenues increased in 1999 due primarily to subscribers upgrading converter boxes, slightly offset by free installation programs offered during the second quarter of 1999. OTHER. Other revenues include revenues received for guides and miscellaneous revenues, offset by franchise fee payments. VIDEO. Video revenue per average cable subscriber was $43.08 per month for the year-ended December 31, 1999, an increase of 6.8 percent, compared with $40.33 for the same period in 1998. Adjusted for the one-time effects of cable system acquisitions and dispositions, video revenue per average cable subscriber increased 6.5 percent during 1999 as a result of increased rates and expanded channel offerings, as well as growth in advertising and pay-per-view revenues. Video revenues increased 7.9 percent during 1999, normalized for the one-time effects of cable system acquisitions and dispositions. NEW PRODUCTS. New products revenues increased during 1999 due primarily to customer growth in high speed Internet access services, as well as the launch of residential telephone services during 1998 and 1999. Normalized for dispositions, new products revenues increased $75, or 192.3 percent, during 1999 compared with new products revenues of $39 in 1998. At December 31, 1999, MediaOne Group had approximately 220,000 high speed Internet customers compared with 84,000 customers for the same period in 1998. High speed Internet access services were available to 5,333,000 market-ready homes at December 31, 1999, compared with 3,535,000 for the same period in 1998. High speed Internet access services are available in 14 metro areas in the following states: California, Florida, Georgia, Illinois, Massachusetts, Michigan, Minnesota, New Hampshire, Ohio and Virginia. During the second quarter of 1999, the Company completed the transition of its high speed Internet customers to the "RoadRunner" brand name. In addition, as per the agreement to the RoadRunner Joint Venture, the responsibility for the maintenance of the Internet network, the development of national content and the provisioning of technical customer support will now be provided by the joint venture. At December 31, 1999, MediaOne Group had approximately 66,000 residential telephone customers with 88,000 telephone lines, compared with 11,000 residential telephone customers with 13,000 telephone lines as of the same period in 1998. Residential telephone services were available to 1,671,000 market-ready homes as of December 31, 1999, compared with approximately 530,000 market-ready homes for the same period in 1998. Residential telephone services were available in seven metro areas within the states of California, Florida, Georgia, Massachusetts, Virginia, and Michigan, which was launched in April 1999. Effective March 31, 1999, MediaOne Group sold its investments in Continental Fiber Technologies, Inc. and Alternet of Virginia, Inc., providers of business telephony services, (the "CLEC Businesses"). During 1998, these businesses contributed telephony revenues of $14 and operating losses of $3 which have been included as part of new products revenues and domestic cable and broadband operating loss. PRIMESTAR. Subsequent to April 1, 1998, MediaOne Group no longer reflects PrimeStar DBS services revenues as it contributed its PrimeStar subscribers and certain related assets to PrimeStar (the "PrimeStar Contribution"). See Note 3--Domestic Acquisitions, Dispositions and Other--to the Consolidated Financial Statements. INTERNATIONAL. International revenues represent the consolidated operations of Cable Plus a.s. ("Cable Plus"), a cable operator in the Czech Republic. Effective April 1, 1999, the Company no longer consolidated the operations of Cable Plus as the entity was held for sale, and subsequently sold in October 1999. See Note 7--Net Investment in International Ventures--to the Consolidated Financial Statements. CORPORATE AND OTHER. Corporate and other revenues decreased during 1999 due to adjustments associated with the discontinuance of insurance policies on cellular phones. DOMESTIC WIRELESS. On April 6, 1998, MediaOne Group sold its domestic wireless businesses to AirTouch. See Note 4--Investment in Vodafone Group/AirTouch Communications--to the Consolidated Financial Statements. OPERATING INCOME (LOSS) - ------------------------ (1) 1998 amounts have been reclassified to conform with the current year presentation. (2) Businesses were sold in April 1998. During 1999, MediaOne Group's operating loss increased due primarily to the sale of its domestic wireless businesses in 1998. Also contributing were increased depreciation and amortization charges on the continuing upgrade of the Company's domestic cable networks, partially offset by operating income from the capital assets segment. MediaOne Group's earnings before interest, taxes, depreciation, amortization and other ("EBITDA") for 1999 were $877, compared with $943 during the same period in 1998. Excluding the effect of the domestic wireless operations, EBITDA would have been $795 in 1998, resulting in a 10.3 percent increase in EBITDA during 1999. MediaOne Group considers EBITDA an important indicator of the operational strength and performance of its businesses. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of MediaOne Group's businesses, or as an alternative to cash flows from operating activities as a measure of liquidity, in each case determined in accordance with GAAP. DOMESTIC CABLE AND BROADBAND. Domestic cable and broadband operating losses increased during 1999 due primarily to greater depreciation and amortization expense on the continuing upgrade of the Company's cable networks, as well as a one-time $25 depreciation and amortization charge related to the deferral of a cable system trade with Tele-Communications, Inc., now owned by AT&T, (the "TCI trade") until such time as the merger of MediaOne Group with AT&T is completed. Depreciation and amortization expense on the TCI trade properties had been suspended during 1998 pending the disposition of these properties. Partially offsetting the increase in depreciation expense was the suspension in 1999 of $50 in depreciation and amortization expense related to cable systems held for sale during the year, and a one-time charge of $28 in the first quarter of 1998 for depreciation and amortization expense suspended in 1997 on cable systems held for sale, which were subsequently retained. During 1999, EBITDA for domestic cable and broadband operations was $980, an increase of $39, or 4.1 percent, compared with $941 in 1998. Revenue increases of $219, or 8.9 percent, exceeded increased programming costs of $85, or 14.8 percent, and increased operating, general and administrative costs of $95, or 10.0 percent. Of those amounts, the PrimeStar Contribution provided revenue decreases of $34 and cost decreases of $30, including $14 of programming costs, to total domestic cable and broadband EBITDA for the period. Normalized for the one-time effects of cable system acquisitions and dispositions, domestic cable and broadband EBITDA increased $47, or 5.0 percent, during 1999 compared with normalized EBITDA of $933 for 1998. Video EBITDA was $1,034 for 1999, an increase of $39, or 3.9 percent, compared with $995 during 1998. Normalizing for acquisitions and dispositions, video EBITDA increased $40, or 4.0 percent, compared with normalized video EBITDA of $994 for 1998. New products EBITDA was a loss of $(54) in 1999, a decrease in losses of $4, or 6.9 percent, compared with an EBITDA loss of $(58) in 1998. New products revenue increases of $64, or 128.0 percent, were offset by new products costs increases of $60, or 55.6 percent, primarily for the offering of residential telephone services. Normalizing for dispositions, new products EBITDA loss decreased $7, or 11.5 percent during 1999, compared with an EBITDA loss of $(61) for the same period in 1998. Programming costs were $660 for 1999, an increase of $85, or 14.8 percent, over 1998. Excluding programming costs related to PrimeStar DBS services, programming costs increased 17.6 percent. The normalized increase was primarily a result of programmer rate increases, expanded channel offerings and growth in subscribers, as well as fees paid in 1999 to the RoadRunner Joint Venture to provide high speed Internet access services to MediaOne Group's customers. Operating, general and administrative costs were $1,046 during 1999, an increase of $95, or 10.0 percent, over 1998. Increases in operating, general and administrative costs were primarily a function of adding customer service employees; spending on marketing and advertising to deploy new products and to drive subscriber growth; and spending on specific initiatives to improve the operations of the Company. During 1999, MediaOne Group incurred initiatives costs of $53 to improve reporting and billing systems, consolidate and build-out call centers, and create customer databases to serve customers more effectively, and Year 2000 incremental remediation costs of $18. Total initiatives spending and Year 2000 incremental costs increased $43 during 1999, compared with total costs of $28 in 1998. INTERNATIONAL. International operating losses represent the consolidated operations of Cable Plus and Russian Telecommunications Development Corporation ("RTDC"), a Russian venture which holds various wireless investments. Effective April 1, 1999, MediaOne Group no longer consolidates RTDC's results as the entity is held for sale. CORPORATE AND OTHER. Corporate and other operating losses have decreased during 1999 due to operating income from the capital assets segment and decreased international overhead costs. INTEREST EXPENSE AND OTHER INTEREST EXPENSE. Interest expense decreased during 1999 due primarily to the assumption by New U S WEST of $3.9 billion of debt related to the Dex Alignment, the refinancing in 1998 which resulted in lower interest rate commercial paper outstanding, the assumption in 1998 of $1,350 in debt by AirTouch as a result of the sale of the Company's domestic wireless businesses to AirTouch, and various debt redemptions and maturities in 1999 totaling approximately $600. The reduction in interest expense was partially offset by the issuance in 1999 of $1.7 billion of private placement debt, the $1.5 billion note to AT&T, and $1.1 billion of debt exchangeable into Vodafone ADRs, and the issuance in the third quarter of 1998 of $1.7 billion of debt exchangeable into AirTouch common stock. MediaOne Group's weighted average borrowing cost was 6.2 percent in 1999, compared with 7.28 percent in 1998. EQUITY LOSSES IN UNCONSOLIDATED VENTURES. Equity losses during 1999 decreased due primarily to greater earnings of $212 from domestic ventures, partially offset by increased losses of $51 from international ventures. Effective April 1, 1999, equity losses from international ventures include the results of operations of Cable Plus and RTDC as these investments are no longer consolidated with the Company's results of operations. In addition, during fourth-quarter 1999, equity method accounting was suspended on the Company's investments in India and Russia as these investments had been reduced below zero as a result of the recognition of equity losses and debt guarantees. Equity earnings from domestic ventures have increased due to one-time gains recognized by TWE during 1999, and the absence of losses from the investment in PrimeCo Personal Communications, L.P. ("PrimeCo") as it was sold to AirTouch in April 1998. Equity losses from international ventures increased due primarily to greater equity losses from Telewest, partially offset by improved results from the international wireless ventures. As of April 1, 1999, MediaOne Group suspended recording equity losses for the RoadRunner Joint Venture as its investment had been reduced to zero and the Company had no future funding commitments to the venture. Unrecognized equity losses during 1999 related to the RoadRunner Joint Venture totaled approximately $50. GAINS (LOSSES) ON INVESTMENTS SALES OF DOMESTIC INVESTMENTS. During 1999, gains on the sales and redemptions of domestic investments included the following gains: (a) $383 ($235 after tax) on the exchange of Time Warner and Cox Communications ("Cox") cable systems, and various other cable systems, (b) $50 ($31 after tax) on the exercise of an option for FSA shares held by the Company, (c) $44 ($27 after tax) on the sale of the CLEC Businesses, (d) $21 ($14 after tax) on the redemption of FSA shares for debt exchangeable into common stock ("DECS"), and (e) $12 ($7 after tax) on the sales of miscellaneous assets from the capital assets group. During 1998, MediaOne Group sold: (a) shares of Sportsline USA, Inc. resulting in a pretax gain of $12 ($8 after tax), (b) a cable programming investment resulting in a pretax gain of $17 ($10 after tax), (c) various domestic cable investments resulting in a pretax gain of $16 ($10 after tax), and (d) miscellaneous items resulting in a pretax gain of $9 ($6 after tax). SALES AND EXIT COSTS OF INTERNATIONAL INVESTMENTS--NET. During 1999, MediaOne Group sold its international investments in: (a) One 2 One for a pretax gain of $6,012 ($3,711 after tax), (b) A2000 for a pretax gain of $154 ($94 after tax), (c) shares of Cable and Wireless Optus Limited ("Optus") for a pretax gain of $155 ($95 after tax), (d) Cable Plus for a pretax gain of $74 ($45 after tax), (e) Telenet for a pretax gain of $44 ($27 after tax), and (f) various other international investments resulting in a pretax gain of $29 ($14 after tax). In addition, during the fourth quarter of 1999, the Company recorded a pretax gain of $157 ($97 after tax) related to the dilution of its investment in Telewest as a result of a Telewest share offering, and during the second quarter of 1999, the Company recorded a charge of $43 ($28 after tax) related to its plan to exit its international investments. See Note 7--Net Investment in International Ventures--to the Consolidated Financial Statements. During 1998, MediaOne Group sold shares of Optus and miscellaneous items resulting in a pretax gain of $16 ($10 after tax). EXCHANGE OF AIRTOUCH INVESTMENT. During June 1999, AirTouch merged its operations into Vodafone Group Public Limited Company ("Vodafone"), which resulted in MediaOne Group's investment in AirTouch being exchanged and modified into an investment in Vodafone. The transaction resulted in a net pretax gain of $2,482 ($1,530 after tax) to the Company. See Note 4--Investment in Vodafone Group/ AirTouch Communications--to the Consolidated Financial Statements. PRIMESTAR INVESTMENT. During 1999, MediaOne Group recorded a pretax loss of $49 ($30 after tax) related to PrimeStar funding obligations. During the fourth quarter of 1998, MediaOne Group recorded a charge of $163 ($100 after tax) to reduce the carrying amount of its investment in PrimeStar. See Note 3--Domestic Acquisitions, Dispositions and Other--to the Consolidated Financial Statements. MINORITY INTEREST EXPENSE IN CENTAUR FUNDING. Minority interest expense in Centaur Funding represents dividends and accretion on the three series of preferred shares (the "Preference Shares") issued in December 1998 by Centaur Funding Corporation ("Centaur"), a special purpose entity consolidated by MediaOne Group, for gross proceeds of $1.1 billion. During 1999, minority interest expense in Centaur also includes a $21 extraordinary dividend paid by Centaur to its Series B and Series C Preference Shares holders to mirror the extraordinary dividend paid by AirTouch in August 1999 as a result of the Vodafone merger. The dividend was paid since the Series B and Series C Preference Shares are referenced to the AirTouch preferred shares; dividend or redemption activity of the AirTouch preferred shares requires a similar action of the Series B and Series C Preference Shares. GUARANTEED MINORITY INTEREST EXPENSE. Guaranteed minority interest expense has increased during 1999 due primarily to the exchange of MediaOne Group's 7.96 and 8.25 percent Company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely Company-guaranteed subordinated debentures ("Preferred Securities") for 9.30 and 9.50 percent Preferred Securities in mid-June 1998, and the issuance in October 1998 of $500 face value of 9.04 percent Preferred Securities. The Preferred Securities were exchanged in conjunction with the Separation. MERGER COSTS. As a result of the Company's anticipated merger with AT&T, MediaOne Group incurred total pretax merger costs of $1,810 ($1,688 after tax) during 1999. The majority of such costs consisted of a charge of $1,500 to terminate the Company's previous merger agreement with Comcast. The remaining costs represented employee bonuses paid in accordance with the AT&T merger agreement, as well as change in control payments triggered as a result of the shareowners' approval to merge with AT&T, and miscellaneous legal and advisory fees. OTHER INCOME--NET. Other income during 1999 increased primarily due to income earned on cash balances resulting from asset sales and debt issuances during the period, the recognition of $62 of income in 1999 for a fee paid by Optus to the Company as a result of having met certain performance measures, and the recognition in 1998 of a $70 loss related to an interest rate swap agreement associated with the AirTouch preferred stock. In addition, other income increased due to dividend income from the Company's investment in AirTouch preferred stock, partially offset by increased foreign exchange transaction losses associated with loans to international ventures and the conclusion of TWE management fees in 1998. PROVISION FOR INCOME TAXES FOR CONTINUING OPERATIONS The increase in the 1999 effective tax rate is primarily a result of merger costs, gains on the sales of investments and the loss on the PrimeStar investment. Excluding merger costs, the effective tax rate would have been 39.0 percent in 1999. The effective tax rate for 1998 would have been 32.8 percent excluding the gain on the sale of the domestic wireless businesses. The increase in the adjusted effective tax rate during 1999 was due to the Company recording pretax income during the year, as opposed to a pretax loss during 1998. RESULTS OF OPERATIONS--CONTINUING OPERATIONS--1998 COMPARED WITH 1997 - ------------------------ (1) Operations were sold in April 1998. - ------------------------ (1) Operations were sold in April 1998. The decrease in normalized loss from continuing operations was primarily a result of decreased equity losses generated by unconsolidated international ventures and decreased interest expense due to lower debt levels at MediaOne Group. The table above normalizes for significant one-time items that aid in the comparability of the Company's performance year over year. Routine acquisitions and dispositions are normalized within the discussions of revenues and operating income which follow. SALES AND OTHER REVENUES(1) - ------------------------ (1) Amounts have been reclassified to conform with the current year presentation. (2) Includes wholly-owned international directories which were sold in the latter part of 1997 (3) Operations were sold in April 1998. MediaOne Group sales and other revenues decreased during 1998 primarily as a result of the sales of the domestic wireless businesses in April 1998, and the wholly-owned international directories businesses during the latter part of 1997. Normalized for acquisitions and dispositions, total revenues increased 10.7 percent during 1998, due primarily to increases from the domestic cable and broadband operations. DOMESTIC CABLE AND BROADBAND - ------------------------ (1) Amounts have been reclassified to conform with the current year presentation. Domestic cable and broadband revenues increased during 1998 due primarily to increased video revenues, partially offset by the lack of PrimeStar DBS revenues in the last three quarters of 1998. Normalized for the one-time effects of cable system acquisitions and dispositions, a change in classification of late fee revenues, and the discontinuance of PrimeStar DBS revenues, total domestic cable and broadband revenues increased 10.6 percent during 1998. BASIC CABLE. Basic cable services revenues increased during 1998 due primarily to a 9.5 percent increase in revenue per average cable subscriber and increased basic subscribers. At December 31, 1998, basic cable subscribers were 4,965,000, an increase of 1.0 percent compared with the same period in 1997, normalized for the effects of cable system acquisitions and dispositions. The increase in revenue per subscriber is the result of expanded channel offerings, repackaging of services and increased rates. PREMIUM. Premium service revenues decreased during 1998 due primarily to discounting of premium service packages, movements of certain premium service packages to basic, and a migration of customers to lower priced premium service packages. In an effort to improve premium service revenues, the Company repackaged its premium services and launched "NexTV" in September 1998, a packaging program which clusters related premium channels. At December 31, 1998, premium units were 4,176,000, an increase of 3.6 percent compared with the same period in 1997, normalized for the effects of cable system acquisitions and dispositions. PAY-PER-VIEW. Pay-per-view revenues decreased during 1998 due to a lack of major sporting events in 1998 as compared with 1997. The decline was slightly offset by increased revenues on movies. ADVERTISING. Advertising revenues increased during 1998 as a result of expanded channel capacity, growth in local and national advertising sales, and increased rates. EQUIPMENT AND INSTALLATION. Equipment and installation revenues increased in 1998 due primarily to subscribers upgrading converter boxes. OTHER. The decrease in other revenues during 1998 is due primarily to the classification of late fee revenues in 1998; late fee revenues were reflected in "other revenues" during 1997, whereas in 1998 these revenues are classified as an offset to "selling, general and administrative expenses." VIDEO. Video revenue per average cable subscriber was $40.33 per month for the year-ended December 31, 1998, an increase of 6.8 percent, compared with $37.76 for the same period in 1997. Adjusted for the one-time effects of cable system acquisitions and dispositions and a change in classification of late fee revenues, video revenue per average cable subscriber increased 7.8 percent during 1998. Video revenue per average cable subscriber has increased as a result of expanded channel offerings, repackaging of services and increased rates. Video revenues increased 9.4 percent during 1998, normalized for the one-time effects of cable system acquisitions and dispositions, and for the change in classification of late fee revenues. NEW PRODUCTS. New products revenues increased during 1998 due primarily to the launch and customer growth of high speed Internet access services in new markets, and growth in business dedicated telephony services. At December 31, 1998, MediaOne Group had approximately 84,000 high speed Internet customers compared with 21,000 high speed Internet customers for the same period in 1997. High speed Internet access was available to over 3 million market-ready homes. On June 15, 1998, MediaOne Group formed the RoadRunner Joint Venture with Time Warner, TWE and Time Warner Entertainment-Advance/Newhouse Partnership to deliver high speed Internet access services under the "RoadRunner" brand name. The joint venture is responsible for maintaining connections to the Internet, providing technical customer support and developing national content. The parties to the joint venture operate their respective high speed Internet access businesses and are responsible for their respective customers' billing and customer service issues. Accordingly, MediaOne Group continues to reflect high speed Internet access services revenues in its consolidated results, as well as a service fee payable to the RoadRunner Joint Venture for services provided. MediaOne Group began offering residential telephone services during 1998. As of December 31, 1998, residential telephone services were available to approximately 530,000 market-ready homes. PRIMESTAR. Subsequent to April 1, 1998, MediaOne Group no longer reflects PrimeStar DBS services revenues as it contributed its PrimeStar subscribers and certain related assets to PrimeStar. INTERNATIONAL. International revenues represent the consolidated operations of Cable Plus. Such operations were sold in 1999. CORPORATE AND OTHER. The decrease in corporate and other revenues during 1998 was due to the sale of the Company's wholly-owned international directory operations in the United Kingdom and Poland in June and October 1997, respectively. DOMESTIC WIRELESS. On April 6, 1998, MediaOne Group sold its domestic wireless businesses to AirTouch. OPERATING INCOME (LOSS)(1) - ------------------------ (1) Amounts have been reclassified to conform with the current year presentation (2) Includes wholly-owned international directories which were sold in the latter part of 1997. (3) Businesses were sold in April 1998. During 1998, MediaOne Group's operating income decreased $269 to a loss of $239, primarily a result of selling the domestic wireless businesses in April 1998. Excluding the effects of the domestic wireless businesses, operating income has decreased primarily as a result of greater depreciation and amortization expenses from the domestic cable and broadband operations, partially offset by decreased operating losses from the wholly-owned international directories operations which were sold in 1997. MediaOne Group's EBITDA for 1998 was $943, compared with $1,287 during the same period in 1997. Excluding the effect of the domestic wireless operations, EBITDA would have been $795 in 1998, compared with $754 in the same period of 1997. MediaOne Group considers EBITDA an important indicator of the operational strength and performance of its businesses. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of MediaOne Group's businesses, or as an alternative to cash flows from operating activities as a measure of liquidity, in each case determined in accordance with GAAP. DOMESTIC CABLE AND BROADBAND. Domestic cable and broadband operating losses increased during 1998 due primarily to increased depreciation and amortization expense. As MediaOne Group continues to upgrade its cable networks, depreciation expense will continue to increase. During the first quarter of 1998, there was a one-time increase to depreciation and amortization expense of $28 related to the termination of the sale of cable systems in Minnesota. Depreciation and amortization expense had been suspended on these systems in 1997 while they were held for sale. This increase was offset by a reduction to depreciation and amortization expense of $29 for systems held for sale during 1998. During 1998, EBITDA for domestic cable and broadband operations was $941, an increase of $11, or 1.2 percent, compared with $930 in 1997. Revenue increases of $144, or 6.2 percent, exceeded increased programming costs of $50, or 9.5 percent, and increased operating, general and administrative costs of $83, or 9.6 percent. Of those amounts, the PrimeStar Contribution provided revenue decreases of $75 and cost decreases of $63, including $25 of programming costs, to total domestic cable and broadband EBITDA for the period. Normalized for the one-time effects of cable system acquisitions and dispositions, domestic cable and broadband EBITDA increased 2.2 percent. Video EBITDA was $995 for 1998, an increase of $47, or 5.0 percent, compared with $948 during 1997. Normalizing for acquisitions and dispositions, and excluding Year 2000 implementation costs of $13 during 1998, video EBITDA was $1,008 for 1998, an increase of $57, or 6.0 percent, compared with 1997. New Products EBITDA losses were $(58), an increase in losses of $(24), or 70.6 percent, compared with EBITDA losses of $(34) in 1997. New Products revenue increases of $30 were more than offset by New Products costs increases of $54 during the period. Programming costs were $575 for 1998, an increase of $50, or 9.5 percent, over 1997. Excluding programming costs related to PrimeStar DBS services, programming costs increased 15.7 percent. The normalized increase was primarily a result of greater programming costs per subscriber as a result of rate increases, expanded channel offerings and growth in subscribers. Operating, general and administrative costs were $951 during 1998, an increase of $83, or 9.6 percent, over 1997. Increases in operating, general and administrative costs were primarily a function of increases in employee costs due to improvements in customer service, marketing and advertising costs associated with the deployment of new products, such as high speed Internet access and residential telephone services, as well as NexTV, and spending on initiatives to improve the operations of the Company. These cost increases were partially offset by decreased costs related to the PrimeStar Contribution. During 1998, MediaOne Group incurred costs of $15 to improve reporting and billing systems, and to create customer databases to serve customers more effectively, and costs of $13 for incremental Year 2000 implementation costs, for a total of $28. INTERNATIONAL. The decrease in international operating losses was primarily the result of increased revenues and decreased operating expenses of the broadband operations, due primarily to efficiency gains and reduced headcount. CORPORATE AND OTHER. The decrease in corporate and other operating losses during 1998 is due to a $30 charge in 1997 for management changes and moving costs related to relocating MediaOne's operations from Boston to Denver, and a decrease of $11 during 1998 due to the sales in 1997 of the wholly-owned international directories operations. The decrease was partially offset by increased corporate overhead costs during 1998. INTEREST EXPENSE AND OTHER INTEREST EXPENSE. Interest expense decreased during 1998 due primarily to the June 12, 1998 assumption by New U S WEST of $3.9 billion of debt related to the Dex Alignment, the Refinancing which resulted in lower interest rate commercial paper outstanding, and the assumption of $1,350 in debt by AirTouch as a result of the sale of the Company's domestic wireless businesses to AirTouch. The reduction in interest expense was partially offset by the third-quarter 1998 issuance of $1,686 of debt exchangeable into AirTouch common stock and a charge of $16 related to the termination of various interest rate swap agreements. The swap agreements were terminated since the long term debt underlying the instruments was refinanced at the time of the Separation. MediaOne Group's weighted average borrowing cost was 7.28 percent in 1998, compared with 6.95 percent in 1997. EQUITY LOSSES IN UNCONSOLIDATED VENTURES. Equity losses decreased during 1998 due predominantly to a $200 charge in 1997 to write down the carrying value of the investment in Malaysia to its fair value of zero and to recognize probable funding commitments in connection with a shareholder support agreement related to the investment in Indonesia. In addition, during 1998, the Company suspended equity method accounting for the Company's investments in Malaysia and Indonesia, compared with equity losses recognized in 1997 of $71 and $46, respectively. Also contributing to the decrease in equity losses during 1998 were overall improvements from the international wireless investments and the absence of losses from the investment in PrimeCo, which was sold to AirTouch on April 6, 1998. GAINS (LOSSES) ON INVESTMENTS SALES OF DOMESTIC INVESTMENTS. During 1998, MediaOne Group sold: (a) shares of Sportsline USA, Inc. resulting in a pretax gain of $12 ($8 after tax), (b) a cable programming investment resulting in a pretax gain of $17 ($10 after tax), (c) various domestic cable investments resulting in a pretax gain of $16 ($10 after tax) and (d) miscellaneous items resulting in a pretax gain of $9 ($6 after tax). During 1997, the Company sold shares of Teleport Communications Group, Inc. ("TCG") for a pretax gain of $162 ($96 after tax), and shares of Time Warner for a pretax gain of $44 ($25 after tax). SALES OF INTERNATIONAL INVESTMENTS. During 1998, MediaOne Group sold shares of Optus, resulting in a pretax gain of $9 ($6 after tax), and a miscellaneous item, resulting in a pretax gain of $7 ($4 after tax). During 1997, the Company sold (a) its 90 percent interest in Fintelco, S.A. ("Fintelco") for a pretax gain of $135 ($80 after tax), (b) its five percent interest in a French wireless venture for a pretax gain of $51 ($31 after tax), and (c) U S WEST Polska, its wholly owned directory operation in Poland, for a pretax gain of $29 ($17 after tax). SALE OF DOMESTIC WIRELESS INVESTMENT. On April 6, 1998, MediaOne Group sold its domestic wireless businesses to AirTouch. Consideration for the sale consisted of (i) debt reduction of $1,350, (ii) the issuance to MediaOne Group of $1,650 in liquidation preference of dividend bearing AirTouch preferred stock (fair value of $1,493), and (iii) the issuance to MediaOne Group of 59,314,000 shares of AirTouch common stock. The transaction resulted in a pretax gain of $3,869, ($2,257 after tax). The Company's investment in AirTouch stock was exchanged for Vodafone shares plus cash in June 1999, as a result of the merger of Vodafone and AirTouch. See Note 4--Investment in Vodafone Group/AirTouch Communications--to the Consolidated Financial Statements. PRIMESTAR INVESTMENT. During the fourth quarter of 1998, MediaOne Group recorded a charge of $163 ($100 after tax) to reduce the carrying amount of its investment in PrimeStar. In December 1998, PrimeStar management provided a business plan to its board of directors, of which MediaOne Group is a part. Additionally, in early 1999, PrimeStar announced that it was selling its DBS medium-power business and assets to Hughes Electronics Corporation ("Hughes"). Based on the review of PrimeStar's business plan and on the anticipated sale to Hughes, MediaOne Group believed that it would not receive proceeds on the sale of its investment in PrimeStar, and therefore, reduced the carrying amount of its investment to zero. See Note 3--Domestic Acquisitions, Dispositions and Other--to the Consolidated Financial Statements. GUARANTEED MINORITY INTEREST EXPENSE. Guaranteed minority interest expense decreased $21 during 1998 due primarily to the cash redemption on June 12, 1998, of $301 face value of 7.96 Preferred Securities and $237 face value of 8.25 percent Preferred Securities. The decrease was partially offset by the issuance in October 1998 of $500 face value of 9.04 percent Preferred Securities. OTHER INCOME--NET. Other income during 1998 was favorably impacted by decreased foreign exchange transaction losses of $51, dividend income of $66 earned on the AirTouch preferred stock received in connection with the sale of its domestic wireless operations to AirTouch, and the lack of minority interest expense of $37 from the domestic wireless operations due to the sale of these operations. Such improvements were partially offset by a $50 loss related to an interest rate swap agreement associated with the AirTouch preferred stock and a related $20 loss for the purchase of a new interest rate option. See Note 4--Investment in Vodafone Group/AirTouch Communications--to the Consolidated Financial Statements. (PROVISION) BENEFIT FROM INCOME TAXES FOR CONTINUING OPERATIONS The increase in the effective tax rate is primarily a result of the gain on the sale of the domestic wireless businesses. Excluding the gain on the sale of the domestic wireless businesses, the effective tax rate would have been 32.8 percent. LIQUIDITY AND CAPITAL RESOURCES OPERATING ACTIVITIES Cash provided by operating activities decreased during 1999 due to merger costs paid during 1999 and the lack of operating cash from the domestic wireless operations which were sold in April 1998. Partially offsetting the decrease was the receipt of $365 of net income tax benefits in 1999, primarily for the carryback of the 1998 taxable loss to the 1996 consolidated tax return, and the receipt of $12 in international dividends from Westel Radiotelefon and Westel 900, the Company's European wireless investments in Hungary. Cash provided by operating activities decreased during 1998 due primarily to the sale of the domestic wireless operations in April 1998, as well as the payment of interest and Separation costs during the year. Partially offsetting the decrease in cash provided by operating activities were increased tax receipts of $85 from the Communications Group, the receipt of $51 in international dividends, primarily from Westel Radiotelefon and Westel 900, and the receipt of $40 in dividends from the AirTouch preferred stock. MediaOne Group expects that cash from operations will not be adequate to fund expected cash requirements in 2000. Additional funding will come from cash on hand and asset sales. INVESTING ACTIVITIES Total capital expenditures at MediaOne Group were $1,983, $1,726 and $1,522 during 1999, 1998 and 1997, respectively. The majority of capital expenditures were devoted to upgrading the domestic cable network and preparing for the provision of new and enhanced products and services. In 2000, capital expenditures are expected to range between $1.3 billion and $1.5 billion, primarily for the domestic cable and broadband business. During 1999, the Company invested $130 in international ventures, net of a $19 return of capital from a wireless investment in the United Kingdom. The remaining investments made in 1999 were primarily capital contributions and shareholder loans to cable investments in Belgium, the Netherlands, Poland, Japan, and Singapore, as well as wireless ventures in India and Indonesia. During 1998, the Company invested $583, net of a $45 return of capital from a wireless investment in the United Kingdom. Included in this amount was a total investment in Telewest of $525, made up of (a) $131 as a result of the Company's participation in a rights offering by Telewest in connection with that company's acquisition of General Cable, and (b) $394 by purchasing an additional 175 million Telewest shares from another Telewest shareholder. The remaining international investments made during 1998 were capital contributions to its cable investments in Belgium, the Netherlands, Japan and Singapore. For 1997, the Company invested $334 in international ventures in Belgium, India, Indonesia and Japan, and the purchase of an additional 40 percent interest in Fintelco. The total investment in Fintelco was subsequently sold in October 1997. The Company anticipates that investments in international ventures will approximate $30 in 2000 to fund the continued expansion in the Slovak Republic and India. Subsequent to year-end, MediaOne Group entered into an agreement to sell its Japanese cable and telephony investment. As part of the sale proceeds, the Company will be reimbursed for any capital contributions made after June 30, 1999, which totaled $41 as of December 31, 1999. During 1999, 1998 and 1997, the Company invested $104, $108 and $249, respectively, in domestic ventures, including $55 funded in 1999 related to the Company's funding obligations of PrimeStar. The remaining investments in domestic ventures for 1999 related to investments in various Internet content service providers. For investments made in 1998 and 1997, $64 and $213, respectively, related to contributions to PrimeCo for network build activity. PrimeCo was sold to AirTouch on April 6, 1998. MediaOne Group anticipates that the RoadRunner Joint Venture will require investor funding in 2000. As the Company suspended recording equity losses for the RoadRunner Joint Venture in April 1999, any capital contributions made by the Company to the joint venture will be expensed, up to the amount of unrecorded equity losses which approximate $50 as of December 31, 1999. MediaOne Group purchased various domestic cable systems and investments in 1998 totaling $92. Such purchases included a cable system in Michigan for $57 which serves approximately 31,000 cable subscribers. During the first quarter of 1997, the Company paid the cash portion of the Continental Acquisition consideration of $1,150 to the Continental shareowners. During 1999, MediaOne Group sold various investments resulting in net proceeds of $6,507 comprised of the following: In addition, in 1999, MediaOne Group received cash proceeds of $534 upon the exchange of its investment in AirTouch common stock for Vodafone ADRs and $9.00 per share cash proceeds. MediaOne Group also received $16 on the maturity of an option for FSA shares held by the Company, $11 on investment maturities, and net proceeds of $5 from various asset transactions, net of payments of $9 made to TWE and Cox Communications on the swap of cable systems. During 1998, MediaOne Group sold various investments resulting in net proceeds of $241, comprised of the following: (a) net proceeds of $77 related to the PrimeStar Contribution, (b) various cable systems for net proceeds of $50, (c) residual shares in Enhance Financial Services Group, Inc., and shares of SportsLine USA, Inc. and Optus for total net proceeds of $46, (d) a cable programming investment for net proceeds of $38, and (e) miscellaneous investments for net proceeds of $30. In addition, MediaOne Group paid a net amount of $164 related to other activities as follows: (a) paid $215 related to the settlement of an interest rate swap agreement and the purchase of a related put option, (b) received proceeds of $71 on the sale of a note receivable, (c) restricted $26 of cash related to Centaur, and (d) received $6 for miscellaneous asset sales. Throughout 1997, the Company monetized nonstrategic assets, including various domestic and international investments. Such asset sales generated total proceeds of $2,058. Proceeds from sales of international investments totaled $887, domestic investments totaled $931, assets held for sale totaled $231, and disposals of property, plant and equipment totaled $9. International sales consisted of: (a) a five percent interest in a French wireless venture for proceeds of $81, (b) a 90 percent interest in Fintelco for proceeds of $641, (c) Thomson Directories, the directory operation in the United Kingdom, and U S WEST Polska, the directory operation in Poland, for net proceeds of $121 and $27, respectively, and (d) other miscellaneous international investment sales for proceeds of $17. Domestic sales were comprised of the sale of shares of TCG, for net proceeds of $678, shares of Time Warner, for net proceeds of $220, and miscellaneous asset sales, for proceeds of $33. FINANCING ACTIVITIES DEBT AND OTHER FINANCING ACTIVITY Total debt at December 31, 1999 was $10,179, an increase of $4,757 compared with December 31, 1998. The increase in debt outstanding was due primarily to new debt issuances totaling $2.8 billion, and non-cash transactions made up of the issuance of a $1.5 billion note payable to AT&T for the funding of the Comcast merger termination fee and a $1.4 billion increase in the fair market value of certain debt issued in 1998 whose redemption value is derived from the underlying shares' fair market value. Debt increases during the period were partially offset by debt maturities and redemptions totaling approximately $600. The remaining change in debt outstanding was due primarily to the repayment of commercial paper using the income tax refund received and proceeds generated by asset sales. See Note 10--Debt--to the Consolidated Financial Statements. In November 1999, MediaOne Group issued 26 million of 7.0 percent exchangeable notes (the "1999 Exchangeable Notes") with a total face value of $1,129, for net proceeds of $1,098. The 1999 Exchangeable Notes mature on November 15, 2002, and are mandatorily redeemable into cash and/or Vodafone American Depository Receipts ("ADRs"). Proceeds from the debt offering were invested in short term instruments, to be used for general corporate purposes. On September 23, 1999, MediaOne SPC VI ("MediaOne SPC VI"), a wholly-owned subsidiary of MediaOne Group, issued $717 of floating rate debt at 3-month LIBOR plus 0.5 percent and paid $216 to fix and pre-fund interest payments on the debt (the "Zero Coupon Swap"). The floating rate debt matures in equal quarterly installments beginning in the second quarter of 2003 and ending in the fourth quarter of 2005. Net proceeds from the debt offering were invested in short term instruments, to be used for general corporate purposes. On June 3, 1999, MediaOne SPC IV ("MediaOne SPC IV"), a wholly-owned subsidiary of MediaOne Group, issued $1,128 of floating rate debt at 3-month LIBOR plus 0.5 percent and paid $321 for a Zero Coupon Swap to fix and pre-fund interest payments on the debt. The floating rate debt matures in equal quarterly installments beginning in the second quarter of 2003 and ending in the second quarter of 2005. Net proceeds from the debt offering were used for general corporate purposes. As a result of the Vodafone merger, $105 of the debt issued by MediaOne SPC IV was repaid in August 1999 using the $9.00 per share cash proceeds received on the exchange of AirTouch common stock into Vodafone ADRs. On June 1, 1999, MediaOne Group redeemed 11.0 percent senior subordinated debentures with a carrying value of $345, including a debt premium of $45. The debt extinguishment resulted in an extraordinary gain of $17 (net of income tax expense of $11). In addition, the Company redeemed a third-party note for its carrying value of $12. MediaOne Group financed the redemptions with cash on hand. On May 15, 1999, DECS originally issued in 1996 matured and were redeemed for FSA shares held by the Company. The redemption resulted in a pretax gain of $21 ($14 after tax). On December 15, 1998, Centaur issued the Preference Shares for total net proceeds of $1,099, net of issuance costs of $31. Dividend and redemption payments on certain of the Preference Shares may only be made to the extent Vodafone pays dividends or redeems its outstanding preferred shares held by the Company. See Note 13--Minority Interest in Centaur Funding--to the Consolidated Financial Statements. Proceeds from the issuance of the Preference Shares were loaned to a subsidiary of the Company and used for general corporate purposes. In October 1998, MediaOne Group issued $500 of 9.04 percent Preferred Securities for net proceeds of $484. The proceeds from the issuance were used to redeem outstanding commercial paper and for general corporate purposes. MediaOne Group guarantees the payment of interest and redemption amounts to holders of the Preferred Securities. During August and September, 1998, MediaOne Group issued approximately $1,686 of 6.25 percent exchangeable notes (the "1998 Exchangeable Notes") for net proceeds of $1,642. The notes mature on August 15, 2001, and are mandatorily redeemable at MediaOne Group's option into cash and/or AirTouch common stock. As a result of the Vodafone merger in June 1999, the terms of the 1998 Exchangeable Notes were modified so that the redemption value of the notes is based on Vodafone ADRs rather than AirTouch common stock. The number of Vodafone ADRs to be exchanged for each 1998 Exchangeable Note and/or the cash equivalent varies based upon the fair value of Vodafone ADRs. In December 1998, MediaOne Group also redeemed DECS originally issued in 1995. Such DECS were redeemed with shares of Enhance Financial Services Group, Inc., held by the Company. On June 12, 1998, MediaOne Group tendered $4.9 billion notional amount of long term debt. Also on June 12, 1998, MediaOne Group tendered for cash $301 face value of the 7.96 percent Preferred Securities and $237 face value of the 8.25 percent Preferred Securities originally issued in 1995 and 1996, respectively. The cash redemption amount of $5.5 billion for the long term debt and $582 for the Preferred Securities was financed with floating-rate commercial paper with a weighted average interest rate of 5.85 percent. In addition, in accordance with the terms of the Separation Agreement, New U S WEST funded to MediaOne Group $3.9 billion related to the Dex Alignment. Such funds were used to repay a portion of the commercial paper issued in connection with the Refinancing. During 1997, the Company redeemed its zero coupon subordinated notes, which had a recorded value of $268. In addition, MediaOne redeemed a 10.625 percent senior subordinated note with a recorded value of $110, including a premium of $10. The Company financed both redemptions with floating-rate commercial paper. In June 1997, the Company acquired cable systems serving approximately 40,000 subscribers in Michigan for cash of $25 and the issuance of approximately $50 in liquidation value of Old U S WEST Series E Preferred Stock (the "Series E Preferred Stock"). Effective with the Separation, the Series E Preferred Stock remains outstanding and represents shares of Series E Preferred Stock of MediaOne Group. The Series E Preferred Stock is redeemable at the Company's option beginning five years from the date of issuance. The stockholders have the right to elect cash upon redemption, or to convert their shares into MediaOne Group Stock based on a predetermined formula. MEDIAONE GROUP CREDIT RATINGS The following table provides credit ratings for MediaOne Group, primarily debt issued by MediaOne Group Funding, Inc., the financing subsidiary of MediaOne Group, and MediaOne. The credit ratings are all investment grade. MediaOne Group does not guarantee the outstanding senior and subordinated debt of MediaOne. - ------------------------ (1) In February 1999, Standard & Poor's announced a methodology change for the rating of Preferred Securities and other similar instruments which is reflected above. This change is not a credit event. MediaOne Group's senior unsecured debt and MediaOne's senior debt were placed on credit watch with positive implications as a result of the Company's anticipated merger with AT&T. The Centaur preferred shares Series B and Series C were placed on credit watch for a possible downgrade by Standard & Poor's as a result of Vodafone's acquisition plans. DIVIDENDS The Company paid dividends on the Communications Stock totaling $519 and $992 in 1998 and 1997, respectively. MediaOne Group no longer pays dividends on the Communications Stock as it has been canceled effective June 12, 1998, as a result of the Separation. CASH FROM DISCONTINUED OPERATIONS Cash from discontinued operations was $4,953 in 1998 through the date of the Separation, and $1,091 in 1997. Such amounts consisted primarily of fundings to MediaOne Group for common dividends paid to Communications Stock shareowners, dividends paid by Dex to MediaOne Group, proceeds from the issuance of Communications Stock, and debt fundings and repayments between MediaOne Group and New U S WEST. Also included in the 1998 amounts were the $3.9 billion of debt assumed by New U S WEST in connection with the Dex Alignment, as well as $152 of net costs reimbursed to MediaOne Group as a result of the Separation and the Refinancing. The $3.9 billion payment by New U S WEST was used by MediaOne Group to repay commercial paper issued in the Refinancing. OTHER FINANCING ACTIVITIES COMMITMENTS AND DEBT GUARANTEES. At December 31, 1999, MediaOne Group's international commitments and debt guarantees totaled approximately $330. This amount includes approximately $50 of outstanding debt guarantees assumed by MediaOne Group upon its acquisition of additional ownership interests in TITUS Communications Corporation, a broadband network operation in Japan, and Chofu Cable Television, a cable operation in Japan. As a result of an investment sale in 1999, an international subsidiary of the Company has been released as a guarantor of approximately $880 in debt. During 1999 and 2000, MediaOne Group entered into agreements to sell various international investments, and subsequent to 1999, certain other international investments were sold. Upon completion of the sales of these investments in the year 2000, the Company's international commitments and debt guarantees will be reduced by approximately $250. MediaOne Group's domestic commitments and debt guarantees at December 31, 1999 totaled approximately $180. This amount reflects the Company's release on a $75 letter of credit for PrimeStar as a result of PrimeStar's closing on the sale of its medium-powered business. The Company remains a guarantor for PrimeStar on a $25 letter of credit, which is included in the above total. DEBT FACILITIES. MediaOne Group maintains 364-day and 5-year revolving bank credit facilities totaling $2.0 billion to support its commercial paper program and to provide financing, all of which were available as of December 31, 1999. SHELF REGISTRATIONS. Under a registration statement filed with the Securities and Exchange Commission as of October 8, 1999, MediaOne Group is permitted to issue up to approximately $3.9 billion of new debt securities. SHARE REPURCHASE. On August 7, 1998, the Board of Directors of MediaOne Group authorized the repurchase of up to 25 million shares of the Company's common stock. The shares may be repurchased over the next three years, dependent on market and financial conditions. During 1999 and 1998, MediaOne Group purchased and placed into treasury approximately 830,000 and 8,682,000 shares of MediaOne Group Stock for a total costs basis of $46 and $352, respectively. From January 1, 2000 through February 29, 2000, the Company purchased 7,379,900 shares of MediaOne Group Stock for a total cost basis of $428. Prior to the Separation, Old U S WEST purchased and placed into treasury $31 of Communications Stock. All outstanding shares of Communications Stock held as treasury stock by Old U S WEST were canceled as of the Separation date. PREFERRED STOCK REDEMPTIONS. Effective November 15, 1999, MediaOne Group called for redemption the outstanding shares of the Company's 4.5 percent Series D Convertible Preferred Stock (the "Series D Preferred Stock"). The Company issued a total of 39,576,000 shares of MediaOne Group Stock in exchange for 19,997,525 shares of Series D Preferred Stock. See Note 16--Shareowners' Equity--to the Consolidated Financial Statements. On September 2, 1999, the Series C Preferred Stock holders exercised options to receive common shares of FSA held by the Company. As a result of the exercise of this option, the Series C Preferred Stock was effectively redeemed. See Note 15--Preferred Stock Subject to Mandatory Redemption--to the Consolidated Financial Statements. RISK MANAGEMENT MediaOne Group is exposed to market risks arising from changes in interest rates, foreign exchange rates and equity prices. Derivative financial instruments are used to selectively manage these risks. MediaOne Group does not use derivative financial instruments for trading purposes. INTEREST RATE RISK MANAGEMENT. MediaOne Group is exposed to interest rate risk from its cash and cash equivalents balances, investments in AirTouch preferred stock and other debt securities, and debt issued by the Company. A 10 percent decline in the December 31, 1999 weighted average interest rates affecting the Company's investments, partially offset by the AT&T note, the Series A Preference Shares and other miscellaneous floating rate debt for which the Company is liable, would result in an approximate $20 decline in net income. Conversely, a 10 percent increase in the December 31, 1999 weighted average interest rates would result in an approximate $20 increase in net income. The change in the Company's exposure to interest rate risk is due primarily to the large cash and cash equivalents balance at December 31, 1999 as compared with the balance in 1998, partially offset by the AT&T note. FOREIGN EXCHANGE RISK MANAGEMENT. MediaOne Group selectively enters into forward and option contracts to manage the market risks associated with fluctuations in foreign exchange rates after considering offsetting foreign exposures among international operations. The use of forward and option contracts allows MediaOne Group to fix or cap the cost of firm foreign investment commitments, the amount of foreign currency proceeds from sales of foreign investments, the repayment of foreign currency denominated receivables and the repatriation of dividends. The market values of foreign exchange positions, including hedging instruments, are continuously monitored and compared with predetermined levels of acceptable risk. All foreign exchange contracts have maturities of one year or less. As of December 31, 1999, the Company had no foreign exchange contracts outstanding. MediaOne Group is exposed to foreign exchange risk associated with its cash deposits, and a cost method investment denominated in British Pounds. A hypothetical 10 percent adverse change in the British Pound exchange rate as compared with the U. S. dollar would reduce the market value of the cash deposits and investment by approximately $20 as of December 31, 1999. The reduction in the Company's exposure to foreign currency risk on financial instruments as of December 31, 1999 as compared to the same period in 1998 is primarily due to the sale of MediaOne Group's investments in One 2 One and Cable Plus, offset by an increase in the value of the Company's cost method investment. EQUITY-PRICE RISK MANAGEMENT. MediaOne Group is exposed to market risks associated with equity security prices related to its investments in marketable equity securities. On a selective basis, MediaOne Group enters into option contracts and exchangeable debt instruments to manage risks associated with fluctuations in equity security prices. The table below presents the approximate impact of hypothetical movements in the equity security prices related to MediaOne Group's combined position in marketable equity securities and derivative contracts. The hypothetical change in stock prices movements is based upon the historical trading volatility of the stocks. The change in the Company's exposure to equity price risk as of December 31, 1999 is primarily due to the higher value of the Vodafone shares, partially offset by the Exchangeable Notes and the Collars, and the receipt of Time Warner Telecom shares from the TWE partnership. The changes in interest rates, foreign exchange rates and equity security prices are based on hypothetical movements in future market rates and are not necessarily indicative of actual results that may occur. Future gains and losses will be affected by actual changes in interest rates, foreign exchange rates, equity security prices, and changes in derivative financial instruments employed during the year. COMPETITIVE AND REGULATORY ENVIRONMENT CABLE AND BROADBAND--DOMESTIC REGULATORY. The Company's products and services are subject to varying degrees of regulation. The Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") provided for the regulation of rates for certain tiered video services and for equipment and installation charges. Under the Telecommunications Act of 1996 (the "Telecommunications Act"), the regulation of all but basic service tier cable and equipment and installation rates was discontinued effective March 31, 1999 for the cable industry. The Telecommunications Act also eliminated certain cross-ownership restrictions among cable operations, broadcasters and multi-point multi-channel distributions services ("MMDS") operations and removed barriers to competition with local exchange carriers ("LECs"). Rates in the Company's systems covered by its Social Contract with the Federal Communications Commission (the "FCC") remain subject to rate regulation until the Social Contract expires on December 31, 2000. The Social Contract, as amended, is a six-year agreement covering most of the Company's franchises. As part of the Social Contract, the Company agreed to, among other things, invest at least $1.7 billion in domestic system rebuilds and upgrades through the year 2000 to expand channel capacity and improve system reliability and picture quality. The investment commitment was met as of the end of 1998, and 70 percent of systems covered by the Social Contract had been upgraded to a minimum of 550 MHz and 47 percent had been upgraded to 750 MHz. The Company is continuing its efforts to upgrade systems covered by the Social Contract to a minimum of 550 MHz and has substantially completed the upgrade to 750 MHz of at least half of the systems covered by the Social Contract. On October 8, 1999, the FCC revised its rules on the number of cable subscribers that a company may reach and the method to identify cable ownership interests that would be attributable to a company. The revised rules maintained the original ruling that a cable operator may not own systems that reach more than 30 percent of United States homes. The calculation of the number of United States homes reached was modified, however, to include those households that subscribe to broadcast satellite and other multi-channel video programming distributors, effectively increasing the number of subscribers that a cable operator may serve. The FCC has voluntarily stayed the ownership rules pending the outcome of a court challenge to the original ownership rules. The Company believes that these new rules will not prevent the closing of the AT&T merger. Cable television systems are also subject to local regulation, typically imposed through the franchising process. Local officials may be involved in the initial franchise selection, franchise service area, construction standards, safety, rate regulation of the lowest tier of service and equipment and installation rates, customer service standards, billing practices, community-related programming and services, franchise renewal, and imposition of franchise fees. Currently, seven local franchise authorities, representing less than three percent of the Company's subscribers, are attempting to require MediaOne Group to allow unaffiliated Internet service providers ("ISPs") to connect to the cable network for the purpose of transmitting information between the ISPs' customers and the Internet. MediaOne Group believes that local governments, including franchising authorities, lack authority to force cable companies to provide network access to other ISPs and will vigorously defend against any such forced access mandates. In June 1998, the FCC issued formal rules providing for the retail sale of set-top television boxes which integrate security and non-security functions. On January 1, 2005, cable companies will no longer be permitted to sell or lease new integrated boxes to their subscribers. In addition, cable companies must provide subscribers with related security modules that plug into set-top boxes that are purchased from consumer electronics retailers by July 1, 2000. In February 1999, MediaOne Group partnered with various manufacturers of digital set-top boxes in order to provide an open conditional access system, which would be compliant with domestic OpenCable-TM- specifications. In May 1999, the FCC issued an interpretation of the above rules which clarified that the segregation requirements applied to digital and hybrid digital/ analog boxes only. COMPETITION. MediaOne Group's cable television systems generally compete with other providers of video programming for viewer attention and advertising dollars. Competitors include service providers such as television broadcasters, DBS, MMDS, local multi-point distribution services ("LMDS"), satellite master antenna service ("SMATV"), video tape rentals stores, movie theaters and live sporting events. In addition, as a result of the Telecommunications Act, certain LECs, including Regional Bell Operating Companies ("RBOCs"), are beginning to offer video programming in competition with the Company's cable services. The competition faced by the Company's cable systems is likely to increase in the future with the development and growth of new technologies. As MediaOne Group continues to offer additional services over its hybrid fiber-coax ("HFC") networks, MediaOne Group will face additional competition. Both the high speed Internet access and telephone services offered by MediaOne Group will face competition from other providers, including RBOCs and other incumbent LECs, interexchange carriers ("IXCs"), ISPs and other providers of local exchange and on-line services. The degree of competition will be dependent upon the state and federal regulations concerning entry, interconnection requirements and the degree of unbundling of the incumbent LECs' networks. Competition will be based upon product, service quality, breadth of services offered, and to a lesser extent on price. In November 1999, Congress passed the Satellite Home Viewer Improvement Act of 1999, which was signed by the President. This law allows DBS carriers to retransmit local television channels to their subscribers, making DBS much more competitive with cable systems. Such retransmission will require consent of the local channel owners after May 30, 2000. INTERNATIONAL The Company's international broadband and wireless communications businesses also face significant competition in their respective markets. Competition is based upon price, geographic coverage and the quality of the services offered. CONTINGENCIES During 1998, certain cable subsidiaries of the Company in Florida, Michigan, and Ohio were named as defendants in various class action lawsuits challenging such subsidiaries' policies for charging late payment fees when customers fail to pay for subscriber services in a timely manner. MediaOne Group does not anticipate that these lawsuits will have a material impact on the Company's results of operations. YEAR 2000 READINESS The statements made herein relating to the Year 2000 are designated as Year 2000 Readiness Disclosures for purposes of the Year 2000 Information and Readiness Disclosure Act. At the date of this filing, the Company has experienced no material Year 2000 failures and, to MediaOne Group's knowledge, neither have any of its key vendors, suppliers or customers. MediaOne Group incurred approximately $52 of costs to implement its Year 2000 compliance program through the fourth quarter of 1999, of which $6 represented capitalized expenditures. Of the total costs incurred, approximately $45 were incremental to MediaOne Group. The funding of these costs was managed by the Company through its liquidity and capital resources plan. FUTURE IMPLEMENTATION OF NEW ACCOUNTING STANDARDS In June 1999, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133--An Amendment of SFAS No. 133," which deferred the effective date of SFAS No. 133 until fiscal years beginning after June 15, 2000. As a result, the Company will adopt SFAS No. 133 in the year 2001. SFAS No. 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. Among other things, the statement requires that an entity recognize all derivative instruments on the balance sheet as either assets or liabilities, and to account for those instruments at fair value. The Company is evaluating the impact of SFAS No. 133. On December 3, 1999, the SEC issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements." SAB No. 101 summarizes the SEC's views on the application of GAAP to revenue recognition. The Company has reviewed SAB No. 101 and believes it is in compliance with the SEC's interpretation of revenue recognition. OUTLOOK The outlook section contains "forward looking information" within the meaning of the Private Securities Litigation Reform Act of 1995. Although MediaOne Group believes that its expectations are based on reasonable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results will not differ materially from its expectations. For a detailed listing of factors that could cause actual results to differ from the Company's expectations, see the "Safe Harbor Language" on page 13, incorporated herein by reference. DOMESTIC CABLE AND BROADBAND BUSINESS The following expectations are based on the cable systems held as of December 31, 1999, and could be impacted by cable system acquisitions, dispositions or trades, as well as the AT&T merger. CONSOLIDATED REVENUES. The Company expects total revenue growth in the low teens during 2000. Total revenue includes video, high speed Internet access, telephone and other services. Revenue growth will be driven by the following: (i) Subscriber growth--As of year-end 2000, subscriber growth is expected to range between 1.5 and 1.7 percent, on a comparable basis. (ii) Digital video subscribers growth--By year-end 2000, the Company anticipates having 300,000 digital subscribers. (iii) High speed Internet access subscribers growth--By year-end 2000, the Company anticipates doubling its high speed Internet access customers to approximately 400,000 customers. (iv) Telephone customers growth--The digital telephone customer base is expected to more than double by year-end 2000, to 150,000 digital telephone subscribers. CONSOLIDATED EBITDA. EBITDA growth is expected to be in the low to mid teens in 2000, aided in part by high speed Internet access services which is expected to be EBITDA positive during 2000, and decreased EBITDA losses from telephone services. * * * * * * * * MediaOne Group from time to time engages in preliminary discussions regarding restructurings, dispositions and other similar transactions. Any such transaction may include, among other things, the transfer of certain assets, businesses or interests, or the incurrence or assumption of indebtedness, and could be material to the financial condition and results of operations of the Company. There is no assurance that any such discussions will result in the consummation of any such transaction. SELECTED PROPORTIONATE FINANCIAL DATA The following table reflects the significant entities included in MediaOne Group's Consolidated Financial Statements and the percent ownership by industry segment. The proportionate financial and operating data for these entities are summarized in the proportionate data tables that follow. (1) During fourth-quarter 1999, the Company no longer includes the operations of RTDC and BPL Cellular Limited in proportionate results to reflect the suspension of their equity losses in consolidated results. SELECTED PROPORTIONATE FINANCIAL DATA (CONTINUED) PROPORTIONATE RESULT OF OPERATIONS--1999 COMPARED WITH 1998 The following table and discussion is not required by GAAP or intended to replace the Consolidated Financial Statements prepared in accordance with GAAP. It is presented supplementally because MediaOne Group believes that proportionate financial and operating data facilitate the understanding and assessment of its Consolidated Financial Statements. The table does not reflect financial data of the capital assets segment. The financial information included below departs materially from GAAP because it aggregates the revenues and operating income of entities not controlled by MediaOne Group with those of the consolidated operations of MediaOne Group. - ------------------------ (1) 1998 amounts have been reclassified to conform with the current year presentation. (2) The proportionate results are based on MediaOne Group's 25.51 percent pro rata priority and residual equity interests in reported TWE results. The reported TWE results are prepared in accordance with GAAP and have not been adjusted to report TWE's results on a proportionate basis. (3) Primarily includes international directories. (4) Amounts exclude proportionate revenues for the domestic wireless operations of $354 and proportionate EBITDA of $114 for 1998. (5) Proportionate EBITDA represents MediaOne Group's equity interest in the entities multiplied by the entity's EBITDA. As such, proportionate EBITDA does not represent cash available to MediaOne Group. SELECTED PROPORTIONATE FINANCIAL DATA (CONTINUED) PROPORTIONATE RESULTS OF OPERATIONS--1999 COMPARED WITH 1998 - ------------------------ (1) The proportionate statistics exclude MediaOne Group's 25.51 percent pro rata priority and residual equity interests in reported TWE results. Normalized for the one-time effects of acquisitions, dispositions and other asset transactions, proportionate revenues increased $905, or 13.2 percent, and EBITDA increased $277, or 15.2 percent. DOMESTIC CABLE AND BROADBAND. During 1999, normalized for the one-time effects of cable system acquisitions and dispositions, proportionate revenues increased $569, or 10.4 percent. This is a result of increases in subscribers and revenue per subscriber mainly due to expanded channel offerings, repackaging of services and increased rates. Normalized for the one-time effects of cable system acquisitions and dispositions, proportionate EBITDA increased $125, or 7.4 percent. This increase is primarily a result of higher revenues, partially offset by higher programming fees, increased personnel costs related to customer service initiatives and costs associated with the deployment of high speed data services. Proportionate EBITDA related to TWE operations increased 77.1 percent. TWE's results benefited from improved cable, programming and filmed entertainment operations, and gains realized by asset sales. INTERNATIONAL. During 1999, normalized for asset dispositions, international cable and broadband proportionate revenues increased $80, or 18.9 percent, due primarily to customer growth at Telewest, and normalized proportionate international wireless revenues increased $361, or 26.7 percent, due to the 73.2 percent increase in the international wireless subscriber base to 1,183,000, on a comparable basis. The digital wireless operations in Hungary, the Czech and Slovak Republics, and Poland contributed significantly to the increase. During the same period, normalized international cable and broadband proportionate EBITDA increased $31, or 81.6 percent, primarily due to a decrease in MediaOne Group international staff costs and improved operations at Telewest. Normalized international wireless proportionate EBITDA increased $106, or 59.9 percent, due to the increase in the international wireless subscriber base. Proportionate international cable subscribers totaled 432,000 at December 31, 1999, a 15.5 percent increase over last year on a comparable basis. Telewest's cable television subscribers increased 10.5 percent over last year on a comparable basis. SELECTED PROPORTIONATE FINANCIAL DATA (CONTINUED) PROPORTIONATE RESULTS OF OPERATIONS--1999 COMPARED WITH 1998 CORPORATE AND OTHER. Corporate and other reflects corporate operations and the results of the international directories operations located in South America. During 1999, corporate proportionate revenues decreased $24, to a loss of $(4), primarily due to adjustments associated with the discontinuance of insurance policies on cellular phones, and other proportionate revenues decreased $54 due to the sale of the South American international directories operations in June 1999. Corporate EBITDA losses decreased $10, or 14.5 percent, to a loss of $(59) primarily due to decreased costs. Other EBITDA losses decreased $5, to a loss of $(4), due primarily to the sale of the South American international directories operations. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareowners of MediaOne Group, Inc.: We have audited the accompanying Consolidated Balance Sheets of MediaOne Group, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1999 and 1998, and the related Consolidated Statements of Operations, Shareowners' Equity and Cash Flows for each of the three years in the period ended December 31, 1999. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and this schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of MediaOne Group, Inc. and subsidiaries as of December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule appearing on page S-1 of this Form 10-K is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Denver, Colorado, February 28, 2000. REPORT OF MANAGEMENT The Consolidated Financial Statements of MediaOne Group have been prepared in conformity with generally accepted accounting principles applied on a consistent basis. The integrity and objectivity of information in these financial statements, including estimates and judgments, are the responsibility of management, as is all other financial information included in this report. MediaOne Group maintains a system of internal accounting controls designed to provide reasonable assurance as to the integrity and reliability of financial statements, the safeguarding of assets and the prevention and detection of material errors or fraudulent financial reporting. Monitoring of such systems includes an internal audit program designed to objectively assess the effectiveness of internal controls and recommend improvements therein. Limitations exist in any system of internal accounting controls based upon the recognition that the cost of the system should not exceed the benefits derived. MediaOne Group believes that the Company's system does provide reasonable assurance that transactions are executed in accordance with management's general or specific authorizations and is adequate to accomplish the stated objectives. The independent certified public accountants, whose report is included herein, were engaged to express an opinion on our Consolidated Financial Statements. Their opinion is based on procedures performed in accordance with generally accepted auditing standards, including examining, on a test basis, evidence supporting the amounts and disclosures in the Consolidated Financial Statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. In an attempt to assure objectivity, the financial information contained in this report is subject to review by the Audit Committee of the Board of Directors. The Audit Committee is composed of outside directors who meet regularly with management, internal auditors and independent auditors to review financial reporting matters, the scope of audit activities and the resolution of audit findings. Charles M. Lillis PRESIDENT AND CHIEF EXECUTIVE OFFICER Richard A. Post EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER February 28, 2000 MEDIAONE GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS - ------------------------ (1) In 1998 the Company distributed $25,345 as a dividend to New U S WEST stockholders upon the Separation representing the fair value of the businesses comprising New U S WEST. The accompanying notes are an integral part of the Consolidated Financial Statements. MEDIAONE GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED) - ------------------------ (1) For additional earnings per share information of MediaOne Group Stock and earnings per share information of Communications Stock, see Note 17--Earnings Per Share--to the Consolidated Financial Statements. (2) Amounts represent the operations of U S WEST Dex, Inc., which were discontinued as of June 12, 1998. (3) Amounts may not add due to rounding of components. The accompanying notes are an integral part of the Consolidated Financial Statements. MEDIAONE GROUP, INC. CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of the Consolidated Financial Statements. MEDIAONE GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the Consolidated Financial Statements. MEDIAONE GROUP, INC. CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY The accompanying notes are an integral part of the Consolidated Financial Statements. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) NOTE 1: BUSINESS OVERVIEW MediaOne Group, Inc. ("MediaOne Group" or the "Company") is a diversified global broadband communications company with domestic operations incorporating large clusters in Atlanta, Massachusetts, California, Chicago, Florida, Detroit, and Minneapolis/St. Paul, having the capability to offer video, high speed Internet access and telephone services simultaneously over its broadband network. Among its domestic investments, MediaOne Group owns an investment in Time Warner Entertainment Company, L.P. ("TWE" or "Time Warner Entertainment"), which provides cable programming, filmed entertainment and broadband communications services, and is the second largest cable television system operator in the United States. The Company also owns an interest in a joint venture to provide high speed Internet access services under the "RoadRunner" brand name (the "RoadRunner Joint Venture"). Internationally, the Company owns various investments in international broadband and wireless ventures. As a result of the anticipated merger with AT&T Corp. ("AT&T") described below, MediaOne Group formalized a plan during 1999 to sell its international broadband and wireless investments, and, as a result, these investments are classified as held for sale on the Consolidated Balance Sheets. See Note 7--Net Investment In International Ventures--to the Consolidated Financial Statements. AT&T MERGER On May 6, 1999, MediaOne Group entered into an agreement with AT&T to merge its operations with those of AT&T, and terminated the merger agreement previously entered into with Comcast Corporation ("Comcast"). On October 21, 1999, MediaOne Group's shareowners approved the merger with AT&T. The transaction is expected to close in the second quarter of 2000, subject to legal and regulatory approval. Under the terms of the AT&T definitive merger agreement, MediaOne Group shareowners will have the right to receive, for each share of MediaOne Group common stock ("MediaOne Group Stock"), (i) 1.4912 shares of AT&T common stock, (ii) $85.00 in cash, or (iii) .95 of a share of AT&T common stock and cash of $30.85. Since AT&T has agreed to pay a set amount of AT&T common stock in the merger, MediaOne Group shareowners who elect to receive all AT&T common stock or all cash may be subject to proration in the event that the common stock to be issued is over or under subscribed. With respect to MediaOne Group shareowners who receive AT&T common stock, if the volume-weighted average sale price of the AT&T common stock for the 20 trading days ending three trading days prior to the effective date of the merger (the "AT&T Price") is between $51.30 and $57.00 per share, an additional amount in cash will be paid so that the total value of the AT&T common stock (based on the AT&T Price) and cash received per share of MediaOne Group Stock will be $85.00. If the AT&T Price is less than $51.30 per share, the additional cash payment will be made based on an assumed AT&T Price of $51.30 per share, and the total value of cash and AT&T common stock (based on the AT&T Price) received per share of MediaOne Group Stock will be less than $85.00. If the AT&T Price is above $57.00 per share, the total value of cash and AT&T common stock (based on the AT&T Price) received per share of MediaOne Group Stock will be more than $85.00. If a shareowner chooses the AT&T stock plus cash election, the maximum additional cash payment would be $5.42 per share of MediaOne Group Stock. If a shareowner chooses the AT&T stock election, the maximum additional cash payment would be $8.50 per share of MediaOne Group Stock. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1: BUSINESS OVERVIEW (CONTINUED) In order to avoid disputes as to whether the AT&T merger would violate the non-competition provisions of the TWE partnership agreement, on August 3, 1999, MediaOne Group sent a notice of termination to TWE which terminated these non-competition provisions as to MediaOne Group. See Note 6--Investment in Time Warner Entertainment--to the Consolidated Financial Statements. In addition, Time Warner, Inc. ("Time Warner") has expressed its view that, absent Time Warner's consent, completion of the AT&T merger will violate the TWE partnership agreement unless AT&T and MediaOne Group delay completion of the merger at least until August 3, 2000, one year following delivery of the termination notice. While AT&T and MediaOne Group disagree with this view, if Time Warner's view prevails and if Time Warner does not consent to an earlier closing, AT&T and MediaOne Group may have to delay completing the merger to August 3, 2000. Any such delay could delay the ability to realize the expected financial and operating benefits of the merger. During 1999, MediaOne Group incurred total pretax merger costs of $1,810, comprised primarily of the $1.5 billion fee paid to Comcast to terminate the Company's merger agreement with Comcast as outlined in the Comcast merger agreement. The fee was funded by AT&T on the Company's behalf and AT&T received in exchange a note payable from MediaOne Group. See Note 10--Debt--to the Consolidated Financial Statements. Merger costs also included $310 of costs related to employee bonuses paid in accordance with the AT&T merger agreement, as well as change of control payments made to select employees which were triggered as a result of the shareowners' approval to merge with AT&T, and miscellaneous legal and advisory fees. THE SEPARATION Prior to June 12, 1998, MediaOne Group was known as "U S WEST, Inc." ("Old U S WEST"). On June 12, 1998, Old U S WEST separated its businesses into two independent public companies (the "Separation"). Until the Separation, Old U S WEST conducted its businesses through two groups: U S WEST Media Group (the "Media Group") and U S WEST Communications Group (the "Communications Group"). Upon Separation, Old U S WEST was renamed "MediaOne Group, Inc." and retained the multimedia businesses of Media Group, except for U S WEST Dex, Inc. ("Dex"), the domestic directory business. The telecommunications businesses of the Communications Group became an independent public company and retained the "U S WEST, Inc." name ("New U S WEST"). In addition, Dex was aligned with New U S WEST (the "Dex Alignment"). The Separation was consummated pursuant to the terms of a separation agreement between MediaOne Group and New U S WEST (the "Separation Agreement"). The Company accounted for the distribution of New U S WEST stock to the Communications Group stockholders, and to the Media Group stockholders for the Dex Alignment, as a discontinuance of the businesses comprising New U S WEST. See Note 25--Discontinued Operations--to the Consolidated Financial Statements. Prior to the Separation, Old U S WEST had outstanding two separate classes of common stock which reflected the performance of its two groups. The performance of Media Group was reflected by the U S WEST Media Group common stock (the "Media Stock") and the performance of the Communications Group was reflected by the U S WEST Communications Group common stock (the "Communications Stock"). Upon Separation, and in accordance with the Separation Agreement, each outstanding share of Media Stock remains outstanding and represents one share of MediaOne Group Stock. Each issued and outstanding share of Communications Stock was redeemed for one share of New U S WEST common stock. See Note 16--Shareowners' Equity--to the Consolidated Financial Statements. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1: BUSINESS OVERVIEW (CONTINUED) In connection with the Dex Alignment, (i) each holder of Media Stock received as a dividend .02731 shares of New U S WEST common stock for each share of Media Stock held (the "Dex Dividend"), and (ii) $3.9 billion of Old U S WEST debt was refinanced by New U S WEST. In connection with the Separation, MediaOne Group refinanced substantially all of the indebtedness issued or guaranteed by Old U S WEST through a combination of tender offers, prepayments and consent solicitations (the "Refinancing"). On June 12, 1998, $4.9 billion notional medium and long-term debt was redeemed for a total cash redemption amount of $5.5 billion. MediaOne Group extinguished the debt by issuing commercial paper at a weighted-average interest rate of 5.85 percent. In accordance with the Separation Agreement, New U S WEST funded to MediaOne Group $3.9 billion related to the Dex Alignment. The Company used the funds to repay a portion of the amount of commercial paper issued in connection with the Refinancing. Debt extinguishment costs related to the Refinancing totaled $333 (net of income tax benefits of $209) and are reflected in the Consolidated Statements of Operations as an extraordinary item. In addition to refinancing costs, such costs included the difference between the market and face value of the debt redeemed and a charge for unamortized debt issuance costs. MediaOne Group financed the debt extinguishment costs by issuing commercial paper, net of a $140 reimbursement by New U S WEST for shared costs. Remaining commercial paper issued in connection with the Refinancing was subsequently repaid with proceeds generated from a debt offering in August 1998. See Note 10--Debt--to the Consolidated Financial Statements. NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries. Effective January 1, 1999 for the Consolidated Statements of Operations, and December 31, 1998 for the Consolidated Balance Sheets, the Consolidated Financial Statements include the activity of the capital assets segment. Prior to this time, the capital assets segment had been reported as a net investment in assets held for sale. See Note 24--Net Investment In Assets Held For Sale--to the Consolidated Financial Statements. All significant intercompany amounts and transactions within continuing operations have been eliminated. Investments in less than majority-owned ventures not held for sale are generally accounted for using the equity method. Certain reclassifications within the Consolidated Financial Statements have been made to conform to the current year presentation. USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS. Cash and cash equivalents include highly liquid investments with original maturities of three months or less that are readily convertible into cash and are not subject to significant risk from fluctuations in interest rates. PROPERTY, PLANT AND EQUIPMENT. The investment in property, plant and equipment, including construction materials, is carried at cost less accumulated depreciation. Additions, replacements and substantial betterments are capitalized. Costs for normal repair and maintenance of property, plant and equipment are expensed as incurred. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) MediaOne of Delaware, Inc. ("MediaOne"), the domestic cable and broadband subsidiary of the Company, provides for depreciation of certain property, plant and equipment using various straight-line group methods and remaining economic lives. When depreciable property, plant and equipment accounted for on the group methods is retired, the original cost less the net salvage value is generally charged to depreciation. The Company's remaining assets are depreciated using the straight-line method. Gains or losses on disposal are included in income. The Company depreciates buildings between 10 to 35 years, cable distribution systems between 3 to 15 years, and general purpose computers and other between 3 to 20 years. Interest related to qualifying construction projects, including construction projects of equity method investees, is capitalized and reflected as a reduction of interest expense. Amounts capitalized were $16, $19 and $36 for the years ended 1999, 1998 and 1997, respectively. COMPUTER SOFTWARE. On January 1, 1999, the Company adopted Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." SOP 98-1 requires that certain costs of internal use software, whether purchased or developed internally, be capitalized and amortized over the estimated useful life of the software. Capitalized software costs are amortized over periods ranging up to 5 years. All other computer software costs not meeting the criteria of SOP 98-1 are expensed. At December 31, 1999 and 1998, capitalized computer software of $147 and $89, respectively, are recorded as a component of property, plant and equipment. MediaOne amortized capitalized computer software costs of $42, $13 and $10 in 1999, 1998 and 1997, respectively. INTANGIBLE ASSETS. Intangible assets are recorded when the cost of acquired companies exceeds the fair value of their net tangible assets. The costs of identified intangible assets and goodwill are amortized by the straight-line method over periods ranging from 5 to 25 years. These assets are evaluated for impairment with other related assets, using the methodology as prescribed by Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." INVESTMENTS IN DEBT AND EQUITY SECURITIES. Debt and marketable equity securities are classified as available for sale and are carried at fair market value with unrealized gains and losses included in equity as a component of other comprehensive income. FOREIGN CURRENCY TRANSLATION. Assets and liabilities of international subsidiaries and investments are translated at year-end exchange rates, and income statement items are translated at average exchange rates for the year. Resulting translation adjustments are included in equity as a component of other comprehensive income. Gains and losses resulting from foreign currency transactions are included in income. FINANCIAL INSTRUMENTS. Synthetic instrument accounting is used for interest rate swaps if the index, maturity, and amount of the instrument match the terms of the underlying debt. Net interest accrued is recognized over the life of the instruments as an adjustment to interest expense and is a component of cash provided by operating activities. Any gain or loss on the termination of an instrument that qualifies for synthetic instrument accounting would be deferred and amortized over the remaining life of the original instrument. Deferral accounting is used for foreign currency forward and purchased option contracts which qualify for and are designated as hedges of firm equity investment commitments and for forward and purchased MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) option contracts which qualify as hedges of future debt issues or investments in debt and equity securities. To qualify for deferral accounting, the contracts must have a high inverse correlation to the exposure being hedged, and reduce the risk or volatility associated with changes in foreign exchange rates, interest rates, or equity prices. Qualified foreign exchange contracts are carried at market value with gains and losses recorded in equity until sale of the investment. Qualified interest rate contracts are associated with the related debt and amortized as yield adjustments. Qualified interest rate and equity contracts associated with investments in debt or equity securities are carried at market value, with gains and losses recorded to the associated investment account. Any gain or loss on the termination of a contract that qualifies for deferral accounting would be deferred and accounted for with the underlying transaction being hedged. If a contract does not maintain the required correlation with the hedged item, deferral accounting is terminated and a gain or loss is recognized in the Consolidated Statement of Operations for the difference between the change in the fair value of the contract and the change in the fair value of the hedged item. Market value accounting is used for derivative contracts which do not qualify for synthetic instrument or hedge accounting. Market value accounting is also used for foreign exchange contracts designated as hedges of foreign denominated receivables and payables. These contracts are carried at market value in other assets or liabilities with gains and losses recorded as other income or expense. The Company does not enter into derivative financial instruments for trading purposes. STOCK OPTIONS. MediaOne Group accounts for its stock incentive plans in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." The Company also follows the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." See Note 18--Stock Incentive Plans--to the Consolidated Financial Statements. REVENUE RECOGNITION. Cable television, local telephone and high speed Internet access services are generally billed monthly in advance, and revenues are recognized the following month when services are provided. Revenues derived from other cable television services, including pay-per-view and advertising, are recognized as the service is provided. Installation revenue is recognized as the service is provided, to the extent of direct selling costs, in accordance with SFAS No. 51, "Financial Reporting by Cable Television Companies." On December 3, 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements." SAB No. 101 summarizes the SEC's views on the application of GAAP to revenue recognition. The Company has reviewed SAB No. 101 and believes that it is in compliance with the SEC's interpretation of revenue recognition. ADVERTISING COSTS. Costs related to advertising are expensed as incurred. Advertising expense was $75, $114 and $206 in 1999, 1998 and 1997, respectively. INCOME TAXES. The provision for income taxes consists of an amount for taxes currently payable or receivable and an amount for tax consequences deferred to future periods. EARNINGS PER COMMON SHARE. MediaOne Group computes basic and diluted earnings per common share in accordance with SFAS No. 128, "Earnings Per Share." See Note 17--Earnings Per Share--to the Consolidated Financial Statements. Unless otherwise indicated, all per share amounts in the notes to the Consolidated Financial Statements are computed based on basic weighted average common shares outstanding. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) NEW ACCOUNTING STANDARDS. On January 1, 1999, MediaOne Group adopted SOP 98-5, "Reporting on the Costs of Start-Up Activities." SOP 98-5 required, among other things, that the costs related to start-up activities of a new entity, facility, product or service be expensed. Adoption of SOP 98-5 did not have a material impact on the financial position or results of operations of the Company. FUTURE IMPLEMENTATION OF NEW ACCOUNTING STANDARDS. In June 1999, the Financial Accounting Standards Board issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133--An Amendment of SFAS No. 133," which deferred the effective date of SFAS No. 133 until fiscal years beginning after June 15, 2000. As a result, the Company will adopt SFAS No. 133 in the year 2001. SFAS No. 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. Among other things, the statement requires that an entity recognize all derivative instruments on the balance sheet as either assets or liabilities, and to account for those instruments at fair value. The Company is evaluating the impact of SFAS No. 133. NOTE 3: DOMESTIC ACQUISITIONS, DISPOSITIONS AND OTHER CABLE SYSTEMS. During third quarter of 1999, MediaOne Group, Time Warner Cable, a division of Time Warner and TWE, and Cox Communications, Inc., ("Cox") completed the exchange of certain cable systems previously announced. Effective July 31, 1999, MediaOne Group exchanged cable systems in Ohio and Maine, serving approximately 280,000 subscribers, for Time Warner Cable cable systems in Massachusetts and New Hampshire, serving approximately 240,000 subscribers, and $40 in cash. Effective August 31, 1999, MediaOne Group exchanged cable systems in California, serving approximately 67,000 subscribers, and $39 in cash for Time Warner Cable cable systems in Georgia, serving approximately 72,000 subscribers; and MediaOne Group cable systems in Connecticut and Rhode Island, serving approximately 51,000 subscribers, and cash of $10 for Cox cable systems in Massachusetts, serving approximately 54,000 subscribers. As a result of the cable system trades with Time Warner Cable and Cox, MediaOne Group recognized a pretax gain of $368 ($226 after tax). The pretax gain is net of a $26 deferred gain related to a cable system traded with TWE, of which MediaOne Group owns a 25.51 percent interest. The deferred gain will be amortized to earnings over 15 years. MediaOne Group accounted for the cable systems acquired in the trades under the purchase method of accounting. The excess of the purchase price over the fair market value of net tangible assets acquired totaled $435 and will be amortized over 25 years. The purchase price allocation is based on preliminary information and may be modified upon the receipt of final asset appraisals. On October 13, 1998, MediaOne Group and Tele-Communications, Inc. ("TCI") signed a definitive agreement to exchange certain of MediaOne Group's cable television systems in Illinois and Michigan for certain of TCI's cable television systems in South Florida and California (the "TCI trade"). In March 1999, TCI was acquired by AT&T. Effective on June 1, 1999, due to the proposed merger of MediaOne Group with AT&T, the companies deferred closing on the TCI trade until the merger with AT&T is completed. If the merger with AT&T does not occur, the TCI trade will take place as planned. In the meantime, the Company's cable systems in Illinois and Michigan will continue to be owned by MediaOne Group, but will be managed by AT&T, and the AT&T cable systems in South Florida and California will remain under both the ownership and management of AT&T. As a result of the deferral of the TCI trade, the Company MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3: DOMESTIC ACQUISITIONS, DISPOSITIONS AND OTHER (CONTINUED) recorded a $25 one-time depreciation and amortization charge to catch-up for depreciation and amortization expense suspended in the fourth quarter of 1998. Depreciation and amortization expense was suspended on these properties while they were held for sale. During the first quarter of 1999, MediaOne Group sold its cable television systems in Reno, Nevada and Mammoth and June Lake, California for total proceeds of $32, resulting in a pretax gain of $14. The cable systems served approximately 10,000 and 7,000 subscribers, respectively. In December 1998, the Company acquired Time Warner's cable systems in the cities of Dearborn and Wayne, Michigan for $57. The systems serve approximately 31,000 subscribers. In addition, during 1998, MediaOne Group sold various cable television systems in California, Idaho, Iowa and Washington, serving approximately 33,000 subscribers, for total proceeds of $50. ROADRUNNER JOINT VENTURE. On June 15, 1998, MediaOne Group formed the RoadRunner Joint Venture with Time Warner, TWE and Time Warner Entertainment-Advance/Newhouse Partnership ("TWE/AN") to deliver high speed Internet access services. The parties to the joint venture contributed certain of their respective high speed Internet access assets into the RoadRunner Joint Venture in exchange for common equity interests of approximately 31.4 percent for MediaOne Group, 10.7 percent for Time Warner, 25.0 percent for TWE and 32.9 percent for TWE/AN. Taking into account MediaOne Group's ownership in TWE, the Company would hold a 43.2 percent proportionate ownership in the venture. In addition, Microsoft Corporation and Compaq Computer Corporation each contributed $212.5 million for a respective 10 percent preferred equity investment in the RoadRunner Joint Venture. The preferred shares are convertible into a combined 20 percent common equity interest in the RoadRunner Joint Venture. MediaOne Group provides high speed Internet access services under the "RoadRunner" brand name. Assuming the conversion of the preferred shares and taking into account MediaOne Group's ownership in TWE, MediaOne Group would hold a proportionate diluted common equity interest in the RoadRunner Joint Venture of approximately 34.6 percent. MediaOne Group accounts for its investment in the RoadRunner Joint Venture under the equity method of accounting. As of April 1, 1999, MediaOne Group suspended recording equity losses for the RoadRunner Joint Venture as its investment had been reduced to zero and the Company had no future funding commitments to the venture. Unrecognized equity losses for the joint venture during 1999 totaled approximately $50. The RoadRunner Joint Venture is responsible for maintaining connections to the Internet, providing technical customer support and developing national content. The parties to the joint venture operate their respective high speed Internet access businesses and are responsible for their respective customers' billing and customer service issues. Accordingly, MediaOne Group continues to reflect high speed Internet access service revenues in its consolidated results, as well as a service fee payable to the RoadRunner Joint Venture for services provided. OTHER. Effective on March 31, 1999, MediaOne Group sold its investments in Continental Fiber Technologies, Inc. and Alternet of Virginia, Inc., providers of business telephony services in Jacksonville, Florida and Richmond, Virginia, respectively, for net proceeds of $82. The sale resulted in a pretax gain of $44. In addition, the capital assets group sold various leveraged leases for net proceeds of $64 and a pretax gain of $12. PRIMESTAR. Prior to April 1, 1998, the Company held a 10.4 percent interest in PrimeStar Partners, L.P. ("Old PrimeStar"). In addition, MediaOne Group distributed PrimeStar direct broadcast MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3: DOMESTIC ACQUISITIONS, DISPOSITIONS AND OTHER (CONTINUED) satellite ("DBS") services to subscribers in its service areas and, as a result, reflected consolidated operating results with respect to such subscribers. On April 1, 1998, the Company contributed its interest in Old PrimeStar, as well as its PrimeStar subscribers and certain related assets, to PrimeStar, Inc. ("PrimeStar"), a newly formed entity, in exchange for an approximate 10 percent interest in PrimeStar and $77 in cash (the "PrimeStar Contribution"). In December 1998, PrimeStar management provided a business plan to its board of directors, of which MediaOne Group is a part. Additionally, in January 1999, Hughes Electronics Corporation ("Hughes") entered into an agreement to purchase PrimeStar's DBS assets. Based on its review of PrimeStar's business plan and on the anticipated sale to Hughes, the Company believed it would not receive proceeds on the sale of its investment in PrimeStar. As a result, MediaOne Group recorded a charge of $163 ($100 after tax) to reduce the carrying amount of its investment in PrimeStar to zero as of December 31, 1998. On March 31, 1999, certain PrimeStar shareholders, including MediaOne Group, signed a separate funding agreement to cover various operation and transition costs of the PrimeStar DBS medium-power business. On April 28, 1999, PrimeStar received required consents from lenders and closed the DBS medium-power business sale. As a result of these transactions, MediaOne Group was released as guarantor on a $75 letter of credit for PrimeStar. The Company remains a guarantor for PrimeStar on a $25 letter of credit. During 1999, MediaOne Group funded $55 in connection with the PrimeStar funding agreement, of which $49 ($30 after tax) was expensed in 1999. NOTE 4: INVESTMENT IN VODAFONE GROUP / AIRTOUCH COMMUNICATIONS AIRTOUCH TRANSACTION. On April 6, 1998, MediaOne Group sold its domestic wireless businesses to AirTouch Communications, Inc. ("AirTouch") in exchange for (i) debt assumption of $1,350, (ii) the issuance to MediaOne Group of $1,650 in liquidation preference of 5.143 percent dividend bearing AirTouch preferred stock (fair value of $1,493), and (iii) the issuance to MediaOne Group of 59,314,000 shares of AirTouch common stock. The domestic wireless businesses included cellular communication services provided to 2.6 million customers in 12 western and midwestern states and a 25 percent interest in PrimeCo Personal Communications, L.P. ("PrimeCo"). The transaction resulted in a pretax gain of $3,869 ($2,257 after tax). VODAFONE/AIRTOUCH MERGER. Effective on June 30, 1999, AirTouch merged its operations into a subsidiary of Vodafone Group Public Limited Company ("Vodafone"). Under the terms of the Vodafone merger, each share of AirTouch common stock was converted into $9.00 in cash plus 1/2 of a Vodafone American Depository Receipt ("ADR"). The AirTouch preferred stock, consisting of 825,000 shares each of AirTouch 5.143 percent Class D Cumulative Preferred Stock, Series 1998, (the "Class D ATI Shares") and 5.143 percent Class E Cumulative Preferred Stock, Series 1998, (the "Class E ATI Shares" and together with the Class D ATI Shares, the "ATI Shares"), remained outstanding as preferred shares of AirTouch, a subsidiary of Vodafone, with the following modifications: (a) the early redemption option on the Class D ATI Shares was eliminated, (b) the maturity date on the Class E ATI Shares was extended to April 1, 2020, and (c) an extraordinary dividend of $25.00 per share, or a total of $21, was paid on August 16, 1999 on each Class E ATI Share. MediaOne Group recognized a pretax gain of $2,482 ($1,530 after tax) on the exchange and modification of its AirTouch common and preferred shares into Vodafone ADRs and preferred shares, and received $534 in cash related to its investment in AirTouch common stock. The pretax gain was the result of the difference between the cost basis and fair market value of the investment in AirTouch as of the MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4: INVESTMENT IN VODAFONE GROUP / AIRTOUCH COMMUNICATIONS (CONTINUED) effective date. MediaOne Group accounts for its investment in Vodafone under the cost method of accounting, as available for sale securities. In October 1999, Vodafone executed a five for one stock split of its Vodafone ADRs. References to Vodafone shares prior to the stock split will be referred to in the Notes to the Consolidated Financial Statements as "pre-split." On a consolidated basis as of December 31, 1999, MediaOne Group held a total of approximately 148,284,000 Vodafone ADRs. VODAFONE COLLAR. During May and September 1999, the Company contributed 11,662,000 shares of AirTouch common stock to MediaOne SPC IV ("MediaOne SPC IV"), and 3,600,000 pre-split shares of its investment in Vodafone ADRs to MediaOne SPC VI ("MediaOne SPC VI"), both wholly-owned subsidiaries of MediaOne Group. MediaOne SPC IV subsequently entered into a series of purchased and written options (the "SPC IV Collar") on its AirTouch common shares and issued $1,128 in debt. MediaOne SPC VI also entered into a series of purchased and written options (the "SPC VI Collar" and together with the SPC IV Collar, the "Collars") on its Vodafone ADRs and issued $717 in debt. See Note 10--Debt--to the Consolidated Financial Statements. Upon the Vodafone merger in June 1999, the SPC IV Collar was automatically transferred to Vodafone ADRs and the put and call prices were adjusted accordingly. As of December 31, 1999, MediaOne SPC IV holds approximately 29,154,000 Vodafone ADRs and MediaOne SPC VI holds approximately 18,000,000 Vodafone ADRs. The Collars have been designated and are effective as a hedge of the market risk associated with the Company's investment in Vodafone ADRs. The Collars are therefore carried at intrinsic value with gains or losses recorded in equity as a component of other comprehensive income together with any change in the fair value of the Vodafone ADRs. As of December 31, 1999, the Company recorded a loss in equity of $19 related to the Collars. At expiration of the SPC IV Collar, the Company will receive cash if the market value of a Vodafone ADR is less than approximately $34.00 per share, effectively eliminating downside risk on the stock below $34.00. Conversely, if the market value of a Vodafone ADR is greater than approximately $49.00 per share, the Company will be required to pay cash which will be offset by the corresponding increase in the value of the Vodafone ADRs. The SPC IV Collar expires quarterly, in equal installments, starting in the second quarter of 2003 and ending in the second quarter of 2005. At expiration of the SPC VI Collar, the Company will receive cash if the market value of a Vodafone ADR is less than approximately $40.00 per share, effectively eliminating downside risk on the stock below $40.00 per share. Conversely, if the market value of a Vodafone ADR is greater than approximately $58.00 per share, the Company will be required to pay cash which will be offset by the corresponding increase in the value of the Vodafone ADRs. The SPC VI Collar expires quarterly, in equal installments, starting in the second quarter of 2003 and ending in the fourth quarter of 2005. MediaOne Group intends to use proceeds from the sale of the Vodafone ADRs to fund any cash obligations related to the Collars. AIRTOUCH INTEREST RATE SWAP AGREEMENT. Prior to the Vodafone merger, MediaOne Group accounted for its investment in AirTouch stock under the cost method of accounting, as available for sale securities. The AirTouch preferred stock was reported at fair value on the Consolidated Balance Sheet, in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." To minimize MediaOne Group's exposure to fluctuations in the fair value of the AirTouch preferred stock, the Company entered into an interest rate swap agreement in April 1998 and an interest rate option MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4: INVESTMENT IN VODAFONE GROUP / AIRTOUCH COMMUNICATIONS (CONTINUED) agreement in October 1998. The interest rate swap agreement matured in October 1998, and the interest rate option agreement in December 1998. During September 1998, the change in the value of the AirTouch preferred stock and interest rate swap did not achieve the required correlation to continue deferral accounting. Consequently, the Company recognized a net loss of $31 (net of income tax benefits of $19) in other income for the change in the fair value of the AirTouch preferred stock not offset by the fair value of the interest rate swap agreement, in accordance with SFAS No. 80, "Accounting for Futures Contracts." In addition, the Company recorded a charge of $12 (net of income tax benefits of $8) for the purchase of the interest rate option offset by a gain on the portion of the interest rate option associated with the issuance of Company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely Company-guaranteed subordinated debentures ("Preferred Securities"). The gain on the interest rate option associated with the Preferred Securities was $6 (net of income tax expense of $4). NOTE 5: OPERATING SEGMENTS The Company reports on its operating segments in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." Operating segments are components of an enterprise for which separate financial information is available and which is evaluated regularly by the Company's chief operating decision maker, or decision making group, in deciding how to allocate resources and assess performance. Operating segments are managed separately and represent strategic business units that offer different products and serve different markets. The Company's reportable segments include: (1) domestic cable and broadband, (2) international services, and (3) other. The domestic cable and broadband segment is comprised of MediaOne and Multimedia Ventures. MediaOne consists of cable television properties serving 5.0 million domestic subscribers and passing 8.6 million domestic homes. Multimedia Ventures includes the Company's equity interest in Time Warner Entertainment. The international services segment includes the cable and broadband and wireless communications operations located abroad, in addition to international corporate overhead. Other includes the discontinued operations of New U S WEST, capital assets (which was held for sale until December 31, 1998), investments in domestic interactive services, the domestic wireless business (which was sold in April 1998 in conjunction with the AirTouch Transaction), the international directories operations (of which the wholly owned operations in the United Kingdom and Poland were sold in 1997), and corporate overhead. MediaOne Group believes that proportionate financial data facilitates the understanding and assessment of its results. Therefore, "Sales and Other Revenues" for each segment is presented on a proportionate basis. Proportionate results reflect the relative weight of MediaOne Group's ownership in each of its respective domestic and international equity ventures together with the consolidated results of its subsidiaries. In addition, the Company believes earnings before interest, taxes, depreciation, amortization and other ("EBITDA") is an important indicator of the operating performance of its businesses. As such, EBITDA is also presented, on a proportionate basis, for each segment. The computation of EBITDA excludes gains on asset sales, equity losses, guaranteed minority interest expense, and restructuring charges. Adjustments made to "Sales and Other Revenues" and EBITDA to arrive at proportionate results are reversed in the column labeled "Eliminations and Adjustments," in conformance with SFAS No. 131, so that in total, "Sales and Other Revenues" and EBITDA reflect consolidated results. All other line items presented in the tables reflect consolidated results. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5: OPERATING SEGMENTS (CONTINUED) Consolidated results for the operating segments reflect the accounting policies described in Note 2--Summary of Significant Accounting Policies--to the Consolidated Financial Statements. Intersegment sales and transfers are accounted for at fair value as if the sales were to third parties. For proportionate results, the ventures' management determines its accounting policies. Industry segment financial information follows: - ------------------------ (1) Multimedia Ventures includes MediaOne Group's 25.51 percent equity interest in TWE, as well as domestic cable overheads. The reported TWE results are prepared in accordance with GAAP and have not been adjusted to report TWE's investments accounted for under the equity method on a proportionate basis. (2) EBITDA should not be considered an alternative to operating or net income as an indicator of the performance of MediaOne Group's businesses, or as an alternative to cash flows from operating activities as a measure of liquidity, in each case determined in accordance with GAAP. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5: OPERATING SEGMENTS (CONTINUED) A portion of general and administrative costs, including executive management, legal, tax, accounting and auditing, treasury, strategic planning and public policy services, are directly assigned to the Company's subsidiaries based on actual utilization or are allocated based on operating expenses, number of employees, external revenues, average capital and/or average equity. Total assets are those assets and investments that are used in, or pertain to, each segment's operations. The "Other" column includes primarily cash; debt and equity securities; net assets of discontinued operations and net investment in assets held for sale for the capital assets segment in 1997; the domestic wireless businesses; investments in domestic interactive services; and other corporate assets. The following table presents a geographic breakout for proportionate revenues and EBITDA and a reconciliation to consolidated amounts: NOTE 6: INVESTMENT IN TIME WARNER ENTERTAINMENT On September 15, 1993, the Company acquired 25.51 percent pro-rata priority capital and residual equity interests ("equity interests") in Time Warner Entertainment for an aggregate purchase price of $2.553 billion. The remaining interest in TWE is owned by Time Warner. TWE owns and operates substantially all of the entertainment assets previously owned by Time Warner, consisting primarily of its filmed entertainment, programming-HBO and cable television businesses. In order to avoid disputes as to whether the AT&T merger would violate the non-competition provisions of the TWE partnership agreement, on August 3, 1999, MediaOne Group sent a notice of termination to TWE which terminated these non-competition provisions as to MediaOne Group. The non-competition provisions continue to apply to Time Warner. Delivery of the notice of termination permitted TWE to terminate most of MediaOne Group's management rights in TWE, which it did on August 4, 1999. Most of these rights would have terminated in any event upon the change of control of MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6: INVESTMENT IN TIME WARNER ENTERTAINMENT (CONTINUED) MediaOne Group in the merger. The delivery of the termination notice and the resulting termination of management rights is irrevocable, however, even if the merger does not occur. The loss of these management rights may have a material adverse effect on the value of MediaOne Group's interest in TWE. Notwithstanding the notice of termination, MediaOne Group retains certain rights under the partnership agreement, including the right to approve such matters as a merger of TWE, TWE's entrance into new lines of business and the issuance of new partnership interests. The Company has an option to increase its pro-rata priority capital and residual equity interests in TWE from 25.51 percent up to 31.84 percent depending upon cable operating performance. The option is exercisable, in whole or in part, between January 1, 1999 and May 31, 2005, for an aggregate cash exercise price ranging from $1.25 billion to $1.8 billion, depending upon the year of exercise. Either TWE or the Company may elect that the exercise price for the option be paid with partnership interests rather than cash. Pursuant to the TWE Partnership Agreement, there are four levels of capital. From the most to least senior, the capital accounts are: senior preferred (held by the general partners); A preferred priority capital (held pro rata by the general and limited partners); B preferred priority capital (held by the general partners); and residual equity capital (held pro rata by the general and limited partners). Of the $2.553 billion contributed by the Company, $1.658 billion represents a preferred priority capital and $895 represents residual equity capital. The TWE Partnership Agreement provides for special allocations of income and distributions of partnership capital. Partnership income, to the extent earned, is allocated as follows: (1) to the partners so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership was taxed as a corporation ("special tax allocations"); (2) to the partners' preferred capital accounts in order of priority described above, at various rates of return ranging from 8 percent to 13.25 percent; and (3) to the partners' residual equity capital accounts according to their residual partnership interests. To the extent partnership income is insufficient to satisfy all special allocations in a particular accounting period, the unearned portion is carried over until satisfied out of future partnership income. Partnership losses generally are allocated in reverse order, first to eliminate prior allocations of partnership income, except senior preferred and special tax income, next to reduce initial capital amounts, other than senior preferred, then to reduce the senior preferred account, and finally, to eliminate special tax allocations. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6: INVESTMENT IN TIME WARNER ENTERTAINMENT (CONTINUED) A summary of the contributed capital and priority capital rates of return follows: - ------------------------ (a) Represents the estimated fair value of net assets contributed as of formation of TWE, excluding partnership income or loss allocated thereto. (b) Cumulative priority capital is not necessarily indicative of the fair value of the underlying priority capital interests. (c) Net of $2,100 of cumulative cash distributions received by Time Warner. (d) To the extent income allocations are concurrently distributed, the priority capital rates of return on the A preferred capital and the B preferred capital are 11% and 11.25%, respectively. Cash distributions are required to be made to the partners to permit them to pay income taxes at statutory rates based on their allocable taxable income from TWE ("Tax Distributions"). The aggregate amount of such Tax Distributions is computed generally by reference to the taxes that TWE would have been required to pay if it were a corporation. Tax Distributions are paid to the partners on a current basis. For distributions other than those related to taxes or the senior preferred, the TWE Partnership Agreement requires certain cash distribution thresholds be met to the limited partners before the general partners receive their full share of distributions. No cash distributions have been made to the Company. The Company accounts for its investment in TWE under the equity method of accounting. The excess of fair market value over the book value of total partnership net assets implied by the Company's initial investment was $5.7 billion. This excess is being amortized on a straight-line basis over 25 years. The Company's recorded share of TWE operating results represents allocated TWE net income adjusted for the amortization of the excess of fair market value over the book value of the partnership net assets. As a result of this amortization and the special income allocations described above, the Company's recorded pretax share of TWE's operating results before extraordinary item was $170, $7 and $11 in 1999, 1998 and 1997, respectively. The Company's 1999 recorded pretax share of TWE's operating results is net of a $21 deferred gain on the exchange of cable systems with MediaOne Group. MediaOne Group will amortize the gain to income over the next 15 years. As consideration for its expertise and participation in the cable operations of TWE, the Company earned a management fee of $130 over five years, ending in September 1998. The fee was payable over a four-year period beginning in 1995, and final payment was received in September 1998. Management fees of $18 and $26 were recorded to other income in 1998 and 1997. In addition, MediaOne purchases cable television programming from TWE and Time Warner at market prices. These services totaled $171, $168 and $110 in 1999, 1998 and 1997, respectively. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6: INVESTMENT IN TIME WARNER ENTERTAINMENT (CONTINUED) Summarized financial information for TWE is presented below: - ------------------------ (1) Includes depreciation and amortization of $1,364, $1,436 and $1,370, in 1999, 1998 and 1997, respectively. (2) Operating expenses for 1999 include a net pretax gain of approximately $215 related to the early termination of a long-term distribution agreement with Metro-Goldwyn-Mayer, Inc., a net pretax gain of $97 related to the sale of an interest in CanalSatellite, and a one-time non-cash pretax charge of $106 relating to certain Warner Bros.' retail stores. Operating expenses are also reflected net of $2,119, $90 and $200 of net pretax gains related to the sale or exchange of certain cable television systems in 1999, 1998 and 1997, respectively. (3) Includes corporate services of $73 in 1999, and $72 in each of 1998 and 1997, and minority interest expense of $422, $264 and $305 in 1999, 1998 and 1997, respectively. (4) 1998 interest and other expense includes a charge of approximately $210 principally to reduce the carrying value of TWE's interest in PrimeStar. 1997 interest and other expense includes a gain of approximately $250 related to the sale of TWE's interest in E! Entertainment Television, Inc. - ------------------------ (1) Includes cash of $517 and $87 at December 31, 1999 and 1998, respectively. (2) Includes a loan receivable from Time Warner of $400 at December 31, 1998. (3) Contributed capital is based on the estimated fair value of the net assets that each partner contributed to the partnership. The aggregate of such amounts is significantly higher than TWE's partners' capital as reflected in this Summarized Financial Position, which is based on the historical cost of the contributed net assets. TIME WARNER TELECOM. On July 14, 1998, MediaOne Group received an 18.85 percent ownership interest in Time Warner Telecom, Inc. ("TW Telecom") as a result of TWE, TWE-A/N and Time Warner MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6: INVESTMENT IN TIME WARNER ENTERTAINMENT (CONTINUED) contributing the assets and liabilities of the Time Warner competitive local exchange business (the "Time Warner Telecom Business") into a newly formed entity. The Time Warner Telecom Business had been jointly operated by the parties to provide telephony services to business customers in their respective cable markets. TWE and TWE-A/N distributed their ownership interest in TW Telecom on a pro rata basis to Time Warner, MediaOne Group and Advance/Newhouse. Since the investment in TW Telecom resulted from a distribution by TWE, MediaOne Group's investment balance in TWE was reduced in 1998 by $48, the book value of the TW Telecom investment attributable to MediaOne Group. In May 1999, TW Telecom completed an initial public offering of its common stock. As of December 31, 1999, TW Telecom shares had a fair market value of $49.94 per share, resulting in the Company recording $716 of gross unrealized gains on its investment. MediaOne Group accounts for its investment in TW Telecom under the cost method of accounting, as available for sale securities, and includes the investment in "Other Assets" in the Consolidated Balance Sheet. NOTE 7: NET INVESTMENT IN INTERNATIONAL VENTURES As a result of the anticipated merger with AT&T, MediaOne Group formalized a plan during 1999 to sell its international broadband and wireless investments, including its international consolidated entities, Cable Plus a.s. ("Cable Plus"), a cable operator in the Czech Republic, and Russian Telecommunications Development Corporation ("RTDC"), a Russian venture that holds various wireless investments. The carrying value of the net investments in international ventures are reflected as "net investments in international ventures held for sale" on the Consolidated Balance Sheet for 1999. In addition, during 1999, the results of operations of Cable Plus and RTDC are no longer consolidated with MediaOne Group's results but are rather reflected as part of "equity losses in unconsolidated ventures" in the Consolidated Statements of Operations. As a result of the decision to exit its international businesses, the Company recorded a $43 charge ($28 after tax) during 1999. The exit charge includes employee severance and foreign income tax settlement costs of $33 for 122 people, and lease termination, relocation and other costs of $10. The charge is reflected as a component of "gains on investments--sales and exit costs of international investments--net" in the Consolidated Statement of Operations. During 1999, the Company paid $6 related to this charge and 44 people left under the exit plan. COMBINED FINANCIAL RESULTS OF INTERNATIONAL EQUITY INVESTMENTS. The following table reflects summarized combined financial information for the Company's investments in international ventures accounted for on the equity method. For 1999, the information presented excludes a portion of the fourth-quarter 1999 activity related to the Company's investments in BPL Cellular Limited ("BPL Cellular") in India and RTDC since MediaOne Group suspended equity method accounting for these investments as the investments had been reduced below zero due to the recognition of equity losses and debt guarantees. Any suspended equity losses on these investments will need to be recognized to the extent MediaOne Group funds additional amounts to these ventures in the future. For 1999 and 1998, the information presented excludes activity related to the Company's investments in Binariang SDN BHD in Malaysia and PT ARIAWEST International ("ARIAWEST") in Indonesia. Both investments were determined to be MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7: NET INVESTMENT IN INTERNATIONAL VENTURES (CONTINUED) impaired at the end of 1997 and the Company terminated or suspended equity method accounting on these investments in 1998. INVESTMENT DISPOSITIONS, ANNOUNCED AGREEMENTS AND OTHER ONE 2 ONE. On October 1, 1999, MediaOne Group sold its 50 percent ownership in Mercury Personal Communications ("One 2 One"), a wireless operation in the United Kingdom, to Deutsche Telekom for $5.7 billion, including approximately $190 for the repayment of shareholder loans owed to the Company. In connection with the sale of One 2 One, the Company entered into put options to minimize its exposure to declines in the exchange rate on the British Pound, for a cost of approximately $75. In September 1999, the Company unwound certain of the put options and entered into forward contracts related to the British Pound. The put options and forward contracts expired in October 1999. The cost of the put options and the settlement value on the forward contract was included in the calculation of the gain on the sale of One 2 One. The sale resulted in a pretax gain of $6,012 ($3,711 after tax). TELEWEST. On October 4, 1999, the Company signed an agreement to sell its interest in Telewest Communications plc ("Telewest"), a cable and telecommunications provider in the United Kingdom, to Microsoft Corporation ("Microsoft") for approximately 30 million shares of Microsoft common stock with a value of approximately $3.7 billion as of December 31, 1999. The terms and conditions of the sale are subject to certain approvals. The sale is expected to occur in 2000. In the fourth quarter of 1999, the Company entered into an agreement with Microsoft whereby the Company has the option to sell its Flextech plc ("Flextech") shares to Microsoft at a fixed price. As of December 31, 1999, MediaOne Group owned approximately 10,519,000 Flextech shares. During the fourth quarter of 1999, Telewest notified its shareholders of its intention to raise cash through a rights offering and use the proceeds to fund the acquisition of the remaining 50 percent of Cable MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7: NET INVESTMENT IN INTERNATIONAL VENTURES (CONTINUED) London plc. MediaOne Group's interest in Telewest was diluted to 27.2 percent as the Company did not participate in the rights offering. The Company recorded a pretax gain of $157 ($97 after tax) to recognize the increase in the value of its interest in Telewest. At December 31, 1999 and 1998, the Company's interest in Telewest, which is the only equity method investment for which a quoted market price is available, had a market value of $3,527 and $1,803, respectively. On September 1, 1998, Telewest acquired General Cable plc ("General Cable"), a cable provider in the United Kingdom, for approximately $1.1 billion in stock and cash. Telewest raised cash for the acquisition through a rights offering to its existing shareholders, including MediaOne Group. MediaOne Group purchased 85 million new Telewest shares at a cost of $131. In addition, the Company recorded a gain in equity of $39, net of deferred taxes of $25, related to Telewest's acquisition of General Cable. On November 10, 1998, MediaOne Group purchased an additional 175 million Telewest shares from Southwestern Bell International Holdings at a price of $2.25 per share, or $394. At December 31, 1998, the Company held a 29.9 percent interest in Telewest. A2000. On September 3, 1999, United Pan-Europe Communications N.V. ("UPC") purchased MediaOne Group's interests in A2000, a cable operator located in the Netherlands, for proceeds of $229, including $14 for the repayment of shareholder loans and receivables owed to the Company. The sale resulted in a pretax gain of $154 ($94 after tax). CABLE PLUS. On October 27, 1999, the Company sold its interest in Cable Plus to UPC for proceeds of $150. The sale resulted in a pretax gain of $74 ($45 after tax). CENTRAL EUROPEAN WIRELESS. On October 22, 1999, MediaOne Group agreed to sell its interests in most of its Central European wireless ventures for $2 billion. These ventures include Polska Telefonia Cyfrowa, a wireless operator located in Poland, Westel 900 and Westel Radiotelefon, wireless operators located in Hungary, and RTDC. This transaction is expected to close in early 2000. In July 1998, Westel 900 repurchased shares of its stock. This repurchase resulted in an increase in MediaOne Group's interest in Westel 900 to 49.0 percent from 46.6 percent. LISTEL. On June 2, 1999, the Company sold its interest in Listel, a South American directories operation, to BellSouth Corporation, for proceeds of $55 and a pretax gain of $20 ($9 after tax). LYONNAISE. On September 8, 1999, the Company sold its interest in Lyonnaise Communications, a cable operator in France, for proceeds of $22, which resulted in a pretax gain of $10 ($6 after tax). OPTUS SHARES. During the first half of 1999, the Company disposed of its remaining investment in shares of Cable & Wireless Optus Limited ("Optus"), for net proceeds of $164 and a gain of $155 ($95 after tax). MediaOne Group had received 13.6 million shares of Optus in the first quarter of 1999 as a result of having met certain performance measures at Optus and purchased 5.6 million additional Optus shares related to the Company's anti-dilution rights. In addition, MediaOne Group had received 50 million Optus shares in November 1998 when it converted a note with Optus into Optus shares. The Company also acquired 24.2 million Optus shares, related to MediaOne Group's anti-dilution rights, in 1998 for $30. Such shares were subsequently sold in 1998 for $39, realizing a gain of $9 ($6 after tax). MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7: NET INVESTMENT IN INTERNATIONAL VENTURES (CONTINUED) In addition, during 1999, MediaOne Group recognized a $62 commission fee from Optus in income. The Company earned the fee as a result of Optus having met certain performance measures. TELENET. On November 19, 1999, MediaOne Group sold its interest in Telenet, a cable operator located in Belgium, to the remaining shareholders of Telenet for proceeds of $98, resulting in a gain of $44 ($27 after tax). In connection with the sale of Telenet, the Company entered into put options to minimize its exposure to declines in the exchange rate on Euro Dollars, for a cost of approximately $3. The cost of the put options was included in the calculation of the gain on the sale of Telenet. If within one year of MediaOne Group's sale to the Telenet shareholders this interest is subsequently sold, the Company is entitled to receive approximately 62 percent of the difference between the new transaction price and MediaOne Group's sale price. WATCHMARK. On July 16, 1999, MediaOne Group sold WatchMark, a wholly owned wireless network management software operation, to Lucent Technologies for proceeds of $7, resulting in a pretax loss of $1. TITUS AND CHOFU. During the second and third quarters of 1999, the Company increased its ownership in TITUS Communication Corporation ("TITUS"), a broadband network operation in Japan, and Chofu Cable Television ("Chofu"), a cable operation in Japan. As part of the acquisition, MediaOne Group assumed outstanding debt guarantees totaling approximately $50. During fourth quarter 1999, the Company made additional capital contributions, further increasing MediaOne Group's investment in TITUS to a total interest of 60 percent. As of December 31, 1999, MediaOne Group's interest in Chofu was 33.3 percent. Subsequent to year-end 1999, the Company entered into an agreement to sell its interests in TITUS and Chofu. See Note 23--Subsequent Events--to the Consolidated Financial Statements. ARIAWEST. On May 13, 1999, ARIAWEST reached an agreement to restructure its debt into a non-recourse debt facility. MediaOne Group will evaluate any probable funding obligations as they arise. OTHER. In 1997, MediaOne Group recorded a charge related to its investment in ARIAWEST for probable funding commitments. During fourth-quarter 1999, the Company redesignated $37 of this charge to RTDC for RTDC's debt guarantees and accounts receivable. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7: NET INVESTMENT IN INTERNATIONAL VENTURES (CONTINUED) The Company's key equity method investments in international ventures follow: - ------------------------ (1) MediaOne Group sold its 50 percent investment in a South American directory operation in June 1999. (2) MediaOne Group sold its interest in these investments during 1999. (3) Investments are held by RTDC, owned 66.5 percent by the Company. (4) The Company suspended equity method accounting for RTDC and BPL Cellular in the fourth quarter of 1999. At December 31, 1999 and 1998, the difference between the carrying amount and the Company's interest in the underlying equity of its international ventures was approximately $250 and $160, respectively. FOREIGN CURRENCY TRANSACTIONS. The Company selectively enters into forward and purchased option contracts to manage the market risks associated with fluctuations in foreign exchange rates after considering offsetting foreign exposures among international operations. The use of forward and purchased option contracts allows the Company to fix or cap the cost of firm foreign investment commitments, the amount of foreign currency proceeds from sales of foreign investments, the repayment of foreign currency denominated receivables and the repatriation of dividends. All foreign exchange contracts have maturities of one year or less. The use of such contracts was limited in 1999 and 1998. There were no foreign exchange contracts outstanding as of December 31, 1999 and December 31, 1998. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7: NET INVESTMENT IN INTERNATIONAL VENTURES (CONTINUED) Forward contracts were selectively used to hedge foreign denominated proceeds from the sale of foreign investments and foreign denominated receivables during 1999 and 1998. Foreign currency pretax hedging losses of $1 was included in each of 1999 and 1998. The counterparties to these contracts are major financial institutions. The Company is exposed to credit loss in the event of nonperformance by these counterparties. The Company does not have significant exposure to an individual counterparty and does not anticipate nonperformance by any counterparty. For the years ended 1999, 1998 and 1997, the Company recorded foreign currency transaction pretax losses of $4, pretax gains of $13, and pretax losses of $40, respectively. NOTE 8: PROPERTY, PLANT AND EQUIPMENT The composition of property, plant and equipment follows: Depreciation expense was $729, $657 and $727 for the years ended 1999, 1998 and 1997, respectively. NOTE 9: INTANGIBLE ASSETS The composition of intangible assets follows: Amortization expense for 1999, 1998 and 1997 was $519, $525 and $530, respectively. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10: DEBT SHORT-TERM DEBT The components of short-term debt follow: MediaOne Group maintains 365-day and 5-year revolving bank credit facilities totaling $2.0 billion to support its commercial paper program and to provide financing, all of which were available as of December 31, 1999. The weighted average interest rate on commercial paper was 6.09 percent at December 31, 1998. SHORT-TERM DEBT ISSUANCE. As a result of the termination of the Comcast merger, AT&T funded the $1.5 billion termination fee to Comcast on behalf of MediaOne Group, and MediaOne Group issued a note payable to AT&T. The AT&T note bears interest at 3-month LIBOR plus 0.15 percent and matures on December 31, 2000. The note is due on demand at any time following consummation of the merger between the Company and AT&T. SHORT-TERM DEBT MATURITIES. On May 15, 1999, $254 of Debt Exchangeable for Common Stock ("DECS") matured. In accordance with the terms of the original debt issuance, the DECS were redeemed for shares of Financial Security Assurance Holdings Ltd. ("FSA") held by the Company, resulting in a pretax gain of $21 ($14 after tax). On December 15, 1998, $130 of DECS matured and were redeemed for shares of Enhance Financial Services Group, Inc. ("Enhance") held by MediaOne Group, in accordance with the terms of the original debt issuance. In addition, the Company settled an option issued in 1997 for the purchase of MediaOne Group's residual shares of Enhance common stock at the DECS' maturity resulting in a pretax gain of $9. As a result of both transactions, the Company has disposed of its ownership in shares of Enhance. In connection with the sale of the domestic wireless businesses in April 1998, AirTouch assumed $1,350 of short-term debt from MediaOne Group. LONG-TERM DEBT EXCHANGEABLE NOTES. During 1999 and 1998, the Company issued debt mandatorily redeemable at MediaOne Group's option into (i) Vodafone ADRs held by MediaOne Group, (ii) the cash equivalent, or (iii) a combination of cash and Vodafone ADRs, (the "Exchangeable Notes"). The maturity value of the Exchangeable Notes varies based upon the fair market value of a Vodafone ADR. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10: DEBT (CONTINUED) Following is a summary of the Exchangeable Notes outstanding: - ------------------------ (1) As a result of the exchange of two shares of AirTouch common stock for one Vodafone ADR, and the five for one split of Vodafone ADRs, the redemption value of the 1998 Exchangeable Notes is now based on 72,500,000 Vodafone ADRs. (2) As a result of the exchange of AirTouch common stock for Vodafone ADRs and $9.00 cash proceeds per share, the cost basis for the 1998 Exchangeable Notes was revised as shown. Debt proceeds were used by the Company to reduce outstanding commercial paper and for general corporate purposes. The redemption formula for the 1999 Exchangeable Notes is as follows: (a) If the fair market value of a Vodafone ADR is greater than or equal to $51.2563, each 1999 Exchangeable Note is equivalent to 0.8475 of a Vodafone ADR; (b) If the fair market value of a Vodafone ADR is less than or equal to $43.4375, each 1999 Exchangeable Note is equivalent to one Vodafone ADR; or (c) If the fair market value of a Vodafone ADR is less than $51.2563 but greater than $43.4375 per share, each 1999 Exchangeable Note is equivalent to a fraction of a Vodafone ADR equal to (i) the issuance price per 1999 Exchangeable Note of $43.4375 divided by (ii) the fair market value of one Vodafone ADR. Upon issuance of the 1998 Exchangeable Notes, their maturity value was based on the fair market value of AirTouch common stock. As a result of the Vodafone merger in June 1999, the terms of the 1998 Exchangeable Notes were modified so that the maturity value of the debt would be based on the fair market value of Vodafone ADRs. The redemption formula was also modified for the five for one Vodafone stock split. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10: DEBT (CONTINUED) The number of Vodafone ADRs to be exchanged at maturity for each 1998 Exchangeable Note, and/or the cash equivalent, will be based upon a redemption value of $9.00 in cash plus 2 1/2 times the fair market value of a Vodafone ADR (the "Maturity Price"), as follows: (a) If the Maturity Price is greater than or equal to $71.75 per share, each 1998 Exchangeable Note is equivalent to .8101 of the Maturity Price; (b) If the Maturity Price is less than or equal to $58.125 per share, each 1998 Exchangeable Note is equivalent to the Maturity Price; or (c) If the Maturity Price is less than $71.75 per share but greater than $58.125 per share, each 1998 Exchangeable Note is equivalent to $58.125. The Exchangeable Notes are being accounted for as indexed debt instruments since the maturity value of the Exchangeable Notes is dependent upon the fair market value of the underlying Vodafone ADRs. For the 1999 debt issuance, the Company has eliminated the market risk on a decline in value of Vodafone ADRs below $43.4375 per share on 26,000,000 of the 148,284,000 Vodafone ADRs held by the Company. Conversely, MediaOne Group would be entitled to 15.25 percent of the fair market value in excess of $51.2563 per Vodafone ADR on 26,000,000 Vodafone ADRs. For the 1998 debt issuance, the Company has eliminated the market risk on a decline in value of Vodafone ADRs below $19.65 per share on 72,500,000 of the 148,284,000 Vodafone ADRs held by the Company. Conversely, MediaOne Group would be entitled to approximately 19 percent of the fair market value in excess of $25.10 per share on 72,500,000 Vodafone ADRs. At December 31, 1999, the Vodafone ADRs had a fair market value of $49.50 per share. Since the Vodafone ADRs are a cost method investment being accounted for as "available for sale" securities under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," changes in the maturity value of the Exchangeable Notes are being recorded in equity as unrealized gains or losses. The Exchangeable Notes are unsecured obligations of MediaOne Group, ranking equally in right of payment with all other unsecured and unsubordinated obligations of MediaOne Group. FLOATING RATE DEBT. On June 3, 1999 and September 23, 1999, MediaOne SPC IV and MediaOne SPC VI issued approximately $1,128 and $717 of floating rate debt, respectively, at 3-month LIBOR plus 0.5 percent. MediaOne SPC IV and MediaOne SPC VI also paid $321 and $216, respectively, to fix and pre-fund interest payments on approximately $1.1 billion and $700 notional amount of their respective debt through interest swap agreements (the "Zero Coupon Swap"). The MediaOne SPC IV debt and corresponding Zero Coupon Swap mature in equal quarterly installments beginning in the second quarter of 2003 and ending in the second quarter of 2005. The MediaOne SPC VI debt and corresponding Zero Coupon Swap mature in equal quarterly installments beginning in the second quarter of 2003 and ending in the fourth quarter of 2005. The Company has therefore deferred the costs of the Zero Coupon Swaps and will amortize the costs as adjustments of interest expense associated with the respective floating rate debt. As a result of the amortization and payments received under the Zero Coupon Swap, the Company expects to have a fixed effective interest rate of 5.91 percent on the MediaOne SPC IV debt and 6.02 percent on the MediaOne SPC VI debt. In August 1999, MediaOne SPC IV redeemed approximately $105 of its floating rate debt for face value. The debt was redeemed with the cash proceeds received in June 1999 from the exchange of the Company's investment in AirTouch common stock for Vodafone ADRs. In addition, the Company received MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10: DEBT (CONTINUED) proceeds of $30 upon the termination of the corresponding portion of the Zero Coupon Swap which had a carrying value of approximately $29. The assets of MediaOne SPC IV, which are primarily the 29,154,000 Vodafone ADRs, are not available to pay the creditors of any member of the Company except the creditors of MediaOne SPC IV. The assets of MediaOne SPC VI, which are primarily the 18,000,000 Vodafone ADRs, are not available to pay the creditors of any member of the Company except the creditors of MediaOne SPC VI. LONG-TERM DEBT REDEMPTIONS. On June 1, 1999, the Company redeemed the 11.0 percent senior subordinated debentures of MediaOne with a carrying value of $345. The debt extinguishment resulted in an after tax gain of $17 (net of income tax expense of $11) primarily related to the write-off of excess debt premiums. The gain is reflected as an extraordinary item in the Consolidated Statement of Operations. MediaOne Group also redeemed a third-party note for its carrying value of $12. MediaOne Group financed the redemptions with cash on hand. OTHER. In conjunction with the Refinancing in 1998, MediaOne Group assumed from Old U S WEST $351 of medium and long-term debt securities which remained outstanding after the Refinancing. The debt securities had already been allocated to MediaOne Group's operations prior to the Separation. Since the capital assets segment is no longer accounted for as "held for sale," its results are reflected in the Company's Consolidated Balance Sheets. At December 31, 1999 and 1998, the Company's consolidated debt balances included $150 and $155 of long-term debt associated with the capital assets segment, respectively. Long-term debt of the capital assets segment primarily represents non recourse loans issued in September 1997 by MediaOne Financial Services, Inc. ("Financial Services"), a subsidiary of the Company and a member of the capital assets segment, which are securitized by certain finance receivables of Financial Services. The loans bear interest at an average rate of 6.9 percent and mature in April, 2009. MediaOne Group's long-term debt components are as follows: Senior unsecured notes and debentures totaling $2.0 billion as of December 31, 1999 were assumed by the Company in connection with its acquisition of Continental Cablevision, Inc. ("Continental") in 1996, and are not guaranteed by the Company. These notes and debentures limit MediaOne's ability to, among other things, pay dividends, create liens, incur additional debt, dispose of property, investments and leases, and require certain minimum ratios of cash flow to debt and cash flow to related fixed charges. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10: DEBT (CONTINUED) Interest rates and maturities of long-term debt at December 31, 1999 follow: Interest payments, net of amounts capitalized, were $404, $709 and $572 for 1999, 1998 and 1997, respectively, of which $16, $33 and $47, respectively, related to the capital assets segment. INTEREST RATE RISK MANAGEMENT The objective of an interest rate risk management program is to minimize the total cost of debt over time and the interest rate variability. This is achieved through the use of interest rate swaps, which adjust the ratio of fixed- to variable-rate debt. Under an interest rate swap, the Company agrees with another party to exchange interest payments at specified intervals over a defined term. Interest payments are calculated by reference to the notional amount based on the fixed- and variable-rate terms of the swap agreements. Apart from the Zero Coupon Swaps discussed above, MediaOne Group had no other swaps or interest rate contracts outstanding as of December 31, 1999. During fourth-quarter 1996, the Company purchased $1.5 billion notional of put options on U. S. Treasury Bonds to protect against an increase in interest rates in conjunction with the 1997 refinancing of debt assumed from Continental. The contracts closed in January 1997 and a gain of $5 was deferred. The gain was recognized in 1998 in conjunction with the Refinancing as part of the loss on debt extinguishment. NOTE 11: FAIR VALUES OF FINANCIAL INSTRUMENTS Fair values of cash equivalents, other current amounts receivable and payable, and short-term debt approximate carrying values due to their short-term nature. The carrying values of mandatorily redeemable preferred stock and long-term receivables approximate the fair values based on quoted market prices or discounted future cash flows. The carrying values of foreign exchange contracts approximate the fair values based on estimated amounts the Company would receive or pay to terminate such agreements. It is not practicable to estimate the fair value of financial guarantees because there are no quoted market prices for similar transactions. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11: FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED) The fair values of interest rate swaps are based on estimated amounts the Company would receive or pay to terminate such agreements taking into account current interest rates and creditworthiness of the counterparties. The fair values of the Zero Coupon Swaps are based on discounting future cash flows using current interest rates. The fair values of the Collars are calculated using an option valuation model that includes dividends, volatility, price of underlying instrument and interest rates. The fair values of long-term debt and Preferred Securities and minority interest in Centaur Funding are based on quoted market prices where available or, if not available, are based on discounting future cash flows using current interest rates. The unamortized cost and estimated market value of debt and equity securities follow: - ------------------------ (1) Gross unrealized losses on equity securities represent the fair market value of the Collars, which have a zero cost basis. Investments in debt and equity securities are classified as available for sale and are carried at market value. Debt and equity securities primarily represent Vodafone ADRs and preferred stock during 1999, and AirTouch preferred and common securities during 1998. The AirTouch shares were received in April 1998 as a result of the sale of the Company's domestic wireless businesses to AirTouch. Net unrealized gains and losses on marketable securities are included in comprehensive income as a component of equity. The market value of these securities is based on quoted market prices where available or, if not available, is based on discounting future cash flows using current interest rates. As of December 31, 1999, contractual maturities of investments in debt securities held by MediaOne Group were as follows: $72 less than one year, $66 from one to 5 years, and $1,405 greater than 5 years MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11: FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED) through 2026. Investments in debt securities may not be held to their contractual maturities as the Company may sell these securities in response to liquidity needs and changes in interest rates. NOTE 12: LEASING ARRANGEMENTS The Company has entered into operating leases for office facilities, equipment and real estate. Rent expense under operating leases was $43, $56 and $74 in 1999, 1998 and 1997, respectively. Future minimum lease payments as of December 31, 1999, under noncancelable operating leases follow: NOTE 13: MINORITY INTEREST IN CENTAUR FUNDING On December 15, 1998, Centaur Funding Corporation ("Centaur"), a special purpose entity consolidated by MediaOne Group, issued three series of preferred shares to external investors (the "Preference Shares") as well as $25 of common securities. The Company owns all of the outstanding common securities, representing a 9.9 percent voting interest in Centaur. Centaur was formed for the principal purpose of raising capital through the issuance of the Preference Shares. The net proceeds from the issuance of the Preference Shares were loaned to MediaOne SPC II, LLC ("MediaOne SPC II"), a subsidiary of MediaOne Group (the "MediaOne SPC II Notes"). Principal and interest payments on the MediaOne SPC II Notes are expected to be Centaur's principal source of funds to make dividend and redemption payments on the Preference Shares. In addition, the dividend payments and certain redemption payments on the Preference Shares will be determined by reference to the dividend and redemption activity of the ATI Shares. See Note 4--Investment in Vodafone Group/AirTouch Communications--to the Consolidated Financial Statements. The ATI Shares are owned by MediaOne SPC II. Payments on the Preference Shares are neither guaranteed nor secured by MediaOne Group. The sole assets of Centaur are the MediaOne SPC II Notes and the proceeds from the sale of the common securities, which may be invested in certain eligible investments as outlined in Centaur's articles of incorporation. The ATI Shares, 75 percent of the outstanding common stock of MediaOne International Holdings, Inc., (the "International Stock"), and a certain intercompany note receivable from MediaOne of Colorado, a wholly owned subsidiary of the Company, to MediaOne SPC II and certain other assets are properties of MediaOne SPC II and are not available to pay creditors of any member of the Company, other than creditors of MediaOne SPC II. The International Stock owned by MediaOne SPC II may be transferred or dividended by MediaOne SPC II to another member of MediaOne Group if such transfer or dividend is in compliance with certain covenants and limitations. MediaOne SPC II is a limited liability company, the membership interest of which is owned by MediaOne SPC I LLC ("MediaOne SPC I"), a wholly owned subsidiary of the Company. That membership interest is the property of MediaOne SPC I MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13: MINORITY INTEREST IN CENTAUR FUNDING (CONTINUED) and is not available to pay creditors of any member of MediaOne Group, other than creditors of MediaOne SPC I. The three series of Centaur Preference Shares are as follows: - ------------------------ (1) Maturity dates of the Series B and Series C Preference Shares are referenced to the ATI Shares. The Auction Market Preference Shares, Series A (the "Series A Preference Shares") have a liquidation value of two hundred and fifty thousand dollars per share, and were recorded at their liquidation value less issuance costs of $3. Dividends on the Series A Preference Shares are payable quarterly as and when declared by Centaur's Board of Directors out of funds legally available. The 9.08 percent Cumulative Preference Shares, Series B (the "Series B Preference Shares") have a liquidation value of one thousand dollars per share, and were recorded at their liquidation value less issuance costs of $25. Dividends on the Series B Preference Shares are payable quarterly in arrears when declared by Centaur's Board of Directors out of funds legally available. In addition, dividends may be declared and paid only to the extent that dividends have been declared and paid on the ATI Shares. The Preference Shares, Series C (the "Series C Preference Shares") have a liquidation value of one thousand dollars per share at maturity, and were recorded at their fair value of $96 less issuance costs of $3. The value of the Series C Preference Shares will be accreted to reach its liquidation value upon maturity. Certain redemption payments on the Series B and Series C Preference Shares will be determined by reference to the redemption of the ATI Shares. On May 13, 1999, as a result of the Vodafone merger, Centaur mailed notices to the holders of the Series B and Series C Preference Shares that described the manner in which the terms of the Series B and Series C Preference Shares would be deemed modified to reflect the changes to the ATI Shares, pursuant to the Articles of Association of Centaur, without any action of the holders of such shares. The revised redemption schedule was modified so that the maturity date on the Class E ATI Shares is now April 1, 2020. The Class E ATI Shares represent 50 percent of the ATI Shares. Consequently, if Vodafone redeems all of the Class E ATI Shares, Centaur must redeem 50 percent of the outstanding Series B and Series C Preference Shares. In addition, all of the Class D ATI Shares mature on April 21, 2020. If Vodafone redeems all of the Class D ATI Shares, then Centaur would be obligated to redeem the same percentage of the Series B and Series C Preference Shares. See Note 4--Investment in Vodafone Group/AirTouch Communications--to the Consolidated Financial Statements. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13: MINORITY INTEREST IN CENTAUR FUNDING (CONTINUED) The $21 extraordinary dividend payment on the Class E ATI Shares was allocated to the Series B and Series C Preference Shares on a pro-rata basis based on the liquidation value of the Series B Preference Shares and on the accreted value of the Series C Preference Shares as of June 30, 1999, and is reflected as "minority interest expense in Centaur Funding" in the Consolidated Statements of Operations. The amount allocated to the Series B Preference Shares was reflected as a one-time extraordinary dividend and was paid to the holders in August 1999 following the payment in August 1999 on the Class E ATI Shares. The amount allocated to the Series C Preference Shares was reflected as an increase in Centaur's obligation upon maturity. The Series A, Series B and Series C Preference Shares are recorded as "Minority interest in Centaur Funding" on the Consolidated Balance Sheets of the Company. The Series B Preference Shares rank equally with the Series C Preference Shares as to redemption payments and upon liquidation, and the Series B and Series C Preference Shares rank senior to the Series A Preference Shares and the common shares of Centaur as to redemption payments and upon liquidation. The Series B Preference Shares rank senior to the Series A Preference Shares and the common shares with respect to dividend payments. Centaur may only pay a dividend to its common shareholder when its assets, including the MediaOne SPC II Notes, exceed the liquidation preference and accumulated and unpaid dividends on the Series B and Series C Preference Shares by $28 after paying the common dividends, and when it has a cash balance, including qualified investments, in excess of $28 after paying the common dividend. At December 31, 1999 and 1998, Centaur held $27 and $26, respectively, in cash for its exclusive use. Since Centaur's cash management options are limited to non-affiliated, risk-free investments, and it is restricted from loaning up to $28 in cash to MediaOne Group and its subsidiaries, Centaur's cash balance is not included in the Company's cash and cash equivalents balance. Instead, Centaur's cash balance has been classified in the Consolidated Balance Sheets of the Company as a component of "Other Assets." NOTE 14: COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY COMPANY--GUARANTEED SUBORDINATED DEBENTURES The following table summarizes the Preferred Securities outstanding as of December 31, 1999: MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 14: COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY COMPANY--GUARANTEED SUBORDINATED DEBENTURES (CONTINUED) THE EXCHANGE OFFER On June 12, 1998, MediaOne Group tendered for cash or exchange all of the outstanding Preferred Securities (the "Exchange Offer"). At that time, the Company had outstanding $600 face value of 7.96 percent Preferred Securities of Old U S WEST Financing I ("Financing I"), a subsidiary of Old U S WEST, and $480 face value of 8.25 percent Preferred Securities of Old U S WEST Financing II ("Financing II"), a subsidiary of Old U S WEST. Of the total outstanding, $301 face value of 7.96 percent Preferred Securities and $237 face value of 8.25 percent Preferred Securities were redeemed for cash. The cash redemption amount of $570 was financed by issuing commercial paper at a weighted average interest rate of 5.85 percent, which was subsequently repaid with net proceeds from the 1998 Exchangeable Notes issuance. See Note 10--Debt--to the Consolidated Financial Statements. In addition, $266 face value of 7.96 percent Preferred Securities of Financing I were exchanged for $274 fair value of 9.30 percent Preferred Securities issued by MediaOne Finance Trust I ("Finance I"), a subsidiary of MediaOne Group, and $213 face value of 8.25 percent Preferred Securities of Financing II were exchanged for $224 fair value of 9.50 percent Preferred Securities issued by MediaOne Finance Trust II ("Finance II"), a subsidiary of MediaOne Group. The Preferred Securities of Finance I and Finance II were recorded upon issuance at fair value of $25.75 and $26.30 per security, respectively. Finance I and Finance II also issued $9 and $7, respectively, of common securities which are held by MediaOne Group. With the exception of the dividend rates, the terms and maturity of the Finance I and Finance II Preferred Securities are substantially the same as those of the Financing I and Financing II Preferred Securities. The Preferred Securities of Financing I and Financing II which were neither redeemed for cash nor exchanged for new Preferred Securities remain outstanding and their respective common securities were retained by MediaOne Group. As a result of the Exchange Offer, MediaOne Group recorded a charge to equity of $53, (net of tax benefits of $28). Such charge represented redemption costs, including the difference between the face and market value of the securities, and a charge for unamortized issuance costs. Also included was a charge of $19 related to market value premiums on the exchanged securities. On October 23, 1998, MediaOne Finance Trust III ("Finance III"), a subsidiary of MediaOne Group, issued $500 of 9.04 percent Preferred Securities and $15 of common securities. The common securities are held by MediaOne Group. Total proceeds from the issuance of the Preferred Securities and the common securities of Financing I and Financing II (the "Old Trusts"), and Finance I, Finance II and Finance III, (the "New Trusts", and collectively with the Old Trusts, "the Trusts"), were used to purchase Subordinated Deferrable Interest Notes (the "Subordinated Debt Securities") from MediaOne Group Funding, Inc. ("MediaOne Funding"), a wholly owned subsidiary of MediaOne Group, the obligations under which are fully and unconditionally guaranteed by MediaOne Group (the "Debt Guarantees"). The Subordinated Debt Securities have the same interest rate and maturity date as the Preferred Securities to which they relate. The sole assets of the Trusts are and will be the Subordinated Debt Securities and the Debt Guarantees. In the Exchange Offer, the Subordinated Debt Securities that relate to the remaining outstanding Preferred Securities of the Old Trusts were assumed by MediaOne Group and the related Debt Guarantees were extinguished. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 14: COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY COMPANY--GUARANTEED SUBORDINATED DEBENTURES (CONTINUED) MediaOne Group has guaranteed the payment of interest and redemption amounts to holders of the Preferred Securities when the Trusts have funds available for such payments (the "Payment Guarantee") as well as the Company's and MediaOne Funding's undertaking to pay all of the costs, expenses and other obligations (the "Expense Undertaking") of the Old Trusts and the New Trusts, respectively. The Payment Guarantee and the Expense Undertaking, including MediaOne Group's guarantee with respect thereto, considered together with MediaOne Funding's obligations under the indenture and Subordinated Debt Securities and MediaOne Group's obligations under the indenture, declaration and Debt Guarantees, constitute a full and unconditional guarantee by MediaOne Group of the Trusts' obligations under the Preferred Securities. The interest and other payment dates on the Subordinated Debt Securities are the same as the distribution and other payment dates on the Preferred Securities. Under certain circumstances, the Subordinated Debt Securities may be distributed to the holders of Preferred Securities and common securities in liquidation of the Trusts. All of the Subordinated Debt Securities are redeemable by the Company or MediaOne Funding at a redemption price of $25.00 per security, plus accrued and unpaid interest. If the Company or MediaOne Funding redeems the Subordinated Debt Securities, the Trusts are required to concurrently redeem their respective Preferred Securities at $25.00 per share plus accrued and unpaid distributions. The 9.30 percent and the 7.96 percent Subordinated Debt Securities are redeemable in whole or in part at any time on or after September 11, 2000. The 9.50 percent and the 8.25 percent Subordinated Debt Securities are redeemable in whole or in part at any time on or after October 29, 2001. The 9.04 percent Subordinated Debt Securities are redeemable in whole or in part at any time on or after October 28, 2003. NOTE 15: PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION SERIES E PREFERRED STOCK. On June 30, 1997, Old U S WEST acquired cable systems serving approximately 40,000 subscribers in Michigan for cash of $25 and the issuance of 996,562 shares of Old U S WEST Series E Preferred Stock (the "Series E Preferred Stock") with a fair value of $50. Dividends are payable quarterly at the annual rate of 6.34 percent. The Series E Preferred Stock was recorded at fair value of $50.00 per share at June 30, 1997, which was equal to its liquidation value. Effective with the Separation, the Old U S WEST Series E Preferred Stock remains outstanding and represents shares of MediaOne Group Series E Preferred Stock. Upon redemption, the preferred stockholders may elect to receive cash or convert their Series E Preferred Stock into MediaOne Group Stock. Cash redemption is equal to the Series E Preferred Stock's liquidation value of $50.00 per share, plus accrued dividends. The number of shares of MediaOne Group Stock to be received upon conversion is based on a formula of $47.50 per share divided by the then current market price of MediaOne Group Stock. The conversion rate is subject to adjustment by the Company under certain circumstances. The Series E Preferred Stock ranks senior to MediaOne Group's common stock, and is subordinated to any senior debt and the Preferred Securities. The Series E Preferred Stock is redeemable as follows: (a) the Company may call for redemption all or any part of the Series E Preferred Stock beginning on June 30, 2002; (b) on a yearly basis beginning August 1, 2007, and continuing through August 1, 2016, the Company will redeem 49,704 shares of Series E Preferred Stock, and on June 30, 2017, all of the remaining outstanding shares of Series E Preferred Stock; or (c) all of the outstanding Series E Preferred Stock shall be redeemed upon the occurrence of certain MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 15: PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION (CONTINUED) events, including the dissolution or sale of all or substantially all of MediaOne Group. Pursuant to the AT&T merger agreement, each share of the Company's Series E Preferred Stock will be converted into one share of a newly created AT&T series E preferred stock with substantially the same rights as the MediaOne Group Series E Preferred Stock. SERIES C PREFERRED STOCK. On September 2, 1994, Old U S WEST issued to Fund American Enterprises Holdings Inc. 50,000 shares of a class of 7 percent Series C Cumulative Redeemable Preferred Stock (the "Series C Preferred Stock") for a total of $50. Beginning on September 2, 1999, MediaOne Group had the option to redeem the Series C Preferred Stock for one thousand dollars per share plus unpaid dividends and a redemption premium. On September 2, 1999, holders of the Series C Preferred Stock exercised options to receive common shares of Financial Security Assurance Holdings Ltd. ("FSA") held by the Company with a fair market value of $96. As a result of the exercise of the FSA options, the Series C Preferred Stock was effectively redeemed, resulting in an after tax charge to equity of $28 (net of tax benefits of $18). The Company also recognized a pretax gain in income of $50 ($31 after tax) based upon the difference in the fair market value and carrying value of the FSA shares surrendered. The Company did not have to pay a redemption premium since the Series C Preferred Stock holders exercised the option to receive FSA shares. NOTE 16: SHAREOWNERS' EQUITY SERIES D PREFERRED STOCK. On October 1, 1999, MediaOne Group issued redemption notices to its 4.5 percent, 20 year, Series D Preferred Stock (the "Series D Preferred Stock") holders indicating that, effective on November 15, 1999, Series D Preferred Stock holders would receive .744 of a share of MediaOne Group Stock per share of Series D Preferred Stock. The redemption formula was based on the Series D Preferred Stock liquidation value of $50.00 per share, divided by 95 percent of the average of the daily closing price of MediaOne Group Stock for the ten consecutive trading days ending on November 10, 1999. The Series D Preferred Stock holders also had the option to convert their shares prior to November 15, 1999 at a ratio of 1.98052 shares of MediaOne Group Stock per share of Series D Preferred Stock, which a majority did. A total of 39,576,000 shares of MediaOne Group Stock were issued in exchange for the Company's Series D Preferred Stock. The 19,999,478 shares of Series D Preferred Stock were originally issued on November 15, 1996, to shareowners of Continental as partial consideration for the purchase of Continental. COMMON STOCK. Other activity for 1999 represents $121 of tax benefits on stock option exercises, an $11 gain on the exercise of a call option on MediaOne Group Stock, and $10 of miscellaneous costs. For 1998, other activity includes $44 of tax benefits on stock option exercises, a $39 gain related to the acquisition of General Cable by Telewest, a $39 gain on the exercise of a call option on shares of the Company's stock, and miscellaneous activity of $25. SHARE REPURCHASE. On August 7, 1998, the Board of Directors of MediaOne Group authorized the repurchase of up to 25 million shares of the Company's common stock over the next three years, dependent on market and financial conditions. During 1999, MediaOne Group purchased and placed into treasury 830,000 shares of MediaOne Group Stock at an average purchase price of $56.06 per share, or a total cost basis of $46. In addition, MediaOne Group issued 6,483,000 common shares out of treasury to execute the conversion of Series D Preferred Stock into common stock. The treasury shares had an average cost of $41.80 per share, for a total cost basis of $271. During 1998 and 1997, MediaOne Group purchased MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16: SHAREOWNERS' EQUITY (CONTINUED) and placed into treasury approximately 8,682,000 and 2,838,000 shares of MediaOne Group Stock at an average purchase price per share of $40.51 and $18.71, for a total cost basis of $352 and $53, respectively. Prior to the Separation, Old U S WEST purchased and placed into treasury $31 of Communications Stock. All outstanding shares of Communications Stock held as treasury stock by Old U S WEST were canceled as of the Separation date. OTHER. As a result of the Separation the distribution of New U S WEST was accounted for at fair value, resulting in a reduction in 1998 of $24,924 to retained earnings and $421 to common stock, representing the fair value of the businesses comprising New U S WEST previously held by Old U S WEST. Following is a roll-forward of share activity during the three years ended December 31, 1999: COMPREHENSIVE INCOME. MediaOne Group discloses comprehensive income in accordance with the provisions of SFAS No. 130, "Reporting Comprehensive Income." Comprehensive income includes net income and other non-owner changes to equity not included in net income, such as foreign currency translation and unrealized gains or losses on debt and equity securities. The majority of the unrealized gains on debt and equity securities during 1999 relate to the Company's investment in Vodafone ADRs and preferred stock, totaling $852 (net of deferred taxes of $542), as well as $466 (net of deferred taxes of $251) in unrealized gains on its investment in TW Telecom which offered its shares in an initial public offering in May 1999. In addition, prior to the exchange of AirTouch shares into Vodafone shares during June 1999, MediaOne Group had recorded gains of $1,302 (net of deferred taxes of $817) on its investment in AirTouch. Of the total reclassifications in 1999, $1,302 (net of deferred taxes of $817) relate to gains realized upon the exchange and modification of AirTouch MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16: SHAREOWNERS' EQUITY (CONTINUED) common and preferred stock for Vodafone ADRs and preferred stock, and $26 (net of deferred taxes of $16) relate to foreign currency translation adjustments on the sale of various international investments during the year. Of the total net unrealized gains on debt and equity securities during 1998, $826 (net of deferred taxes of $530), relate to the Company's investment in AirTouch common and preferred stock. During 1998, MediaOne Group recorded an unrealized gain of $147 related to its investment in AirTouch preferred stock. This unrealized gain was fully offset by a loss on an interest rate swap agreement which was designed to minimize the Company's exposure to fluctuations in the fair value of the AirTouch preferred stock as a result of interest rate changes. The following table presents the components of other comprehensive income and their related tax impacts. It also presents reclassification adjustments related to gains realized on the sale of debt and equity securities, and international investments. EMPLOYEE STOCK OWNERSHIP PLAN. MediaOne Group sponsors a defined contribution savings plan for substantially all employees of MediaOne Group, except for foreign national employees. The Company matches a percentage of eligible employee contributions with shares of MediaOne Group Stock. Participants are fully vested in the Company match contribution. The Company recognizes expense based on the cash payments method. During 1999, 1998 and 1997, MediaOne Group's contributions to the plan were $20, $8 and $9, respectively. During 1998 and 1997, MediaOne Group maintained a Leveraged Employee Stock Ownership Plan ("LESOP"). Shares in the LESOP were used to fund Company match contributions as principal and interest were paid on the debt. Borrowings associated with the LESOP, which were unconditionally guaranteed by Old U S WEST, were included in the Consolidated Balance Sheets of the Company and corresponding amounts were recorded as reductions to shareowners' equity. The borrowings were repaid in May 1998, in connection with the Separation. At December 31, 1998, there were no remaining shares of MediaOne Group Stock to be allocated. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16: SHAREOWNERS' EQUITY (CONTINUED) SHAREHOLDER RIGHTS PLAN. The Board of Directors has adopted a shareholder rights plan which, in the event of a takeover attempt, would entitle existing shareowners to certain preferential rights. The rights expire on April 6, 2009, and are redeemable by MediaOne Group at any time prior to the date they would become effective. NOTE 17: EARNINGS PER SHARE The following table reflects the computation of basic and diluted earnings (loss) per share for MediaOne Group Stock, in accordance with the provisions of SFAS No. 128, "Earnings Per Share." Earnings per share information is also reflected for Communications Stock during 1998 and 1997 since the stock was outstanding at that time. Dilutive securities represent the incremental weighted average shares from potential share issuances associated with MediaOne Group stock options in 1999 and 1998, and Communications Group stock options in 1998, as well as the pro rated conversion in 1999 and the assumed conversion in 1998 of the convertible Series D Preferred Stock for MediaOne Group Stock. Diluted earnings (loss) and related per share amounts for 1997 do not include potential share issuances associated with stock options and the convertible Series D Preferred Stock since the effect would have been antidilutive on the loss from continuing operations. The calculation of diluted shares for 1999 did not include stock options for approximately 3,310,000 potential share issuances since the effect would have been antidilutive. - ------------------------ (1) Represents the operations of Dex, which were discontinued on June 12, 1998. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 17: EARNINGS PER SHARE (CONTINUED) - ------------------------ (1) Represents the operations of Dex, which were discontinued on June 12, 1998. (2) The Communications Stock was canceled on June 12, 1998, effective with the Separation. (3) Represents the operations of the Communications Group, which were discontinued on June 12, 1998, and included with New U S WEST. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 18: STOCK INCENTIVE PLANS MediaOne Group maintains stock incentive plans for executives, other employees and nonemployees, primarily members of the Board of Directors. The Amended MediaOne Group 1994 Stock Plan (the "Plan") is administered by the Human Resources Committee of the Board of Directors with respect to officers, executive officers and outside directors, and by a special committee with respect to all other eligible employees and eligible nonemployees. As of December 31, 1999, the maximum aggregate number of shares of MediaOne Group Stock that could have been granted in any calendar year for all purposes under the Plan was one percent of the shares outstanding (excluding shares held in treasury) on the first day of such calendar year. In the event that fewer than the full aggregate number of shares available for issuance in any calendar year were issued in any such year, the shares not issued may be added to the shares available for issuance in any subsequent year or years. Options granted vest over periods up to three years and may be exercised no later than 10 years after the grant date. The compensation cost that has been included in income in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees," was $12, $26 and zero in 1999, 1998 and 1997, respectively, all of which related to modifications of stock option terms. MediaOne Group has adopted the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," but continues to account for the Plan under APB Opinion No. 25. Had compensation cost for the Plan been determined consistent with the fair value based accounting method under SFAS No. 123, the pro forma net income and earnings per share for both the MediaOne Group Stock and Communications Stock would have been the following. The fair value based method of accounting for stock-based compensation plans under SFAS No. 123 recognizes the value of options granted as compensation cost over the options' vesting period and has not been applied to options granted prior to January 1, 1995. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 18: STOCK INCENTIVE PLANS (CONTINUED) Following are the weighted-average assumptions used in connection with the Black-Scholes option-pricing model to estimate the fair value of options granted during 1999, 1998 and 1997: Data for outstanding options under the Plan is summarized as follows: MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 18: STOCK INCENTIVE PLANS (CONTINUED) The number of exercisable options under the Plan and the weighted-average exercise prices follow: The following table summarizes the status of outstanding and exercisable options under the Plan at December 31, 1999. The total options outstanding represent 4.6 percent of the MediaOne Group common shares outstanding. A total of 13,076,747, 6,088,849 and 8,733,782 MediaOne Group Stock options were granted in 1999, 1998 and 1997, respectively. A total of 9,491,642 Communications Stock options were granted in 1997. The modified MediaOne Group Stock options were not significant in 1999 and 1998, and the Communications Stock options were not significant in 1997. The exercise price for the majority of the MediaOne Group Stock options granted in 1999, as well as all of the 1998 and 1997 MediaOne Group and Communications Stock grants, excluding modified options, equals the market price on the grant date. Approximately 8,213,000 and 4,046,000 shares of MediaOne Group Stock were available for grant under the plans in effect at December 31, 1999 and 1998, respectively. Approximately 36,598,000 shares of MediaOne Group Stock were authorized but unissued under the Plan at December 31, 1999. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 19: EMPLOYEE BENEFITS MEDIAONE GROUP PLANS The MediaOne Group defined benefit pension plan covers substantially all of its employees, except for foreign national employees. Management benefits are based on a final pay formula. MediaOne Group uses the projected unit credit method for the determination of pension cost for financial reporting and funding purposes. MediaOne Group's policy is to fund amounts required under the Employee Retirement Income Security Act of 1974; no funding was required in 1999, 1998 nor 1997. MediaOne Group also sponsors a nonqualified pension plan which pays supplemental pension benefits to key executives in addition to amounts received under the MediaOne Group pension plan. The obligation and annual expense for this plan are included in the 1999 and 1998 pension detail below. MediaOne Group provides certain health care and life insurance benefits to retired employees. MediaOne Group uses the projected unit credit method for the determination of postretirement medical and life costs for financial reporting purposes. Net periodic benefit costs for pension benefits were $9 in 1999 and $3 in 1998, and $2 in each of 1999 and 1998 for other postretirement benefits. Below is a reconciliation of the change in the fair value of the plan assets for the pension and postretirement plans for 1999 and 1998: - ------------------------ (1) Pension assets include MediaOne Group stock of $1 for 1998. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 19: EMPLOYEE BENEFITS (CONTINUED) Below is a reconciliation of the change in the benefit obligation for the pension and postretirement plans for 1999 and 1998: The following table represents the funded status of the pension and postretirement plans at December 31, 1999 and 1998: The actuarial assumptions used to account for the plans are as follows: A one percent change in the assumed healthcare cost trend rate would have increased the accumulated postretirement benefit obligation by $3 in 1999 and by $4 in 1998, and decreased it by $3 in each of 1999 and 1998. The impact on service and interest cost components would not have been material. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 19: EMPLOYEE BENEFITS (CONTINUED) OLD U S WEST PLANS Prior to the Separation, MediaOne Group participated in the employee benefits plans sponsored by Old U S WEST. Since both MediaOne Group and New U S WEST belonged to a single pension and postretirement plan, assets were not segregated until Separation. Pension and postretirement benefit costs were allocated to MediaOne Group based on the ratio of MediaOne Group's service cost to total service cost. MediaOne Group's share of the net pension credit for 1997 was $(3). MediaOne Group's share of the net postretirement costs for 1997 was $4. NOTE 20: INCOME TAXES The components of the provision (benefit) for income taxes follow: The Company received $365 for income taxes in 1999, and paid $24 and $636 for income taxes in 1998 and 1997, respectively, inclusive of the discontinued operations of New U S WEST and the capital assets segment. Income taxes paid for the discontinued operations of New U S WEST, through the Separation date of June 12, 1998, were $379 and $906 in 1998 and 1997, respectively. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 20: INCOME TAXES (CONTINUED) The effective tax rate differs from the statutory tax rate as follows: The components of the net deferred tax liability follow: In connection with the acquisition of Continental in November 1996, the Company acquired operating loss carryforwards of approximately $217 for federal income tax purposes, expiring in various years through 2011. The Company also acquired investment tax credit carryforwards of approximately $41, expiring in various years through 2005. Due to potential use limitations, a valuation allowance of $269 has been MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 20: INCOME TAXES (CONTINUED) established for the carryforwards and for a deferred tax asset associated with an investment. If the realization of the carryforwards or deferred tax asset becomes more likely than not in future periods, any reduction in the valuation allowance will be allocated to reduce goodwill and acquired intangible assets. The current portion of the deferred tax asset was $69 and $74 at December 31, 1999 and 1998, respectively, resulting primarily from compensation-related items and other accrued expenses. Foreign operations contributed pretax income of $6,284 during 1999, and pretax losses of $336 and $604 during 1998 and 1997, respectively. NOTE 21: CAPITAL ASSETS The accounts of the capital assets segment are reflected in the Company's Consolidated Balance Sheets for 1999 and 1998, and in the Consolidated Statements of Operations for 1999. Prior to this time, the capital assets segment was considered a discontinued operation and, in accordance with GAAP, was accounted for as a "net investment in assets held for sale." See Note 24--Net Investment in Assets Held for Sale--to the Consolidated Financial Statements. The remaining assets of the capital assets segment primarily represent long term lease finance receivables which will be run-off. These receivables are reflected in "Other Assets" in the Consolidated Balance Sheets. Finance receivables primarily consist of contractual obligations under long-term leases with maturity dates ranging from 2000 to 2016 that MediaOne Group intends to run off. Certain leases contain renewal options and buyout provisions. These long-term leases consist mostly of leveraged leases related to aircraft and power plants. For leveraged leases, the cost of the assets leased is financed primarily through nonrecourse debt which is netted against the related lease receivable. The components of finance receivables follow: - ------------------------ (1) Includes allowance for credit losses of $13 in each of 1999 and 1998. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET CREDIT RISK--FINANCIAL GUARANTEES MediaOne Group retained certain risks in asset-backed obligations related to the commercial real estate portfolio. As of December 31, 1999, the principal amounts insured on asset-backed obligations was $267 for maturity terms up to five years. As of December 31, 1998, the principal amounts insured on asset- backed obligations were $146 that mature within five years and $138 for maturity terms ranging from 5 to 10 years, for a total principal amount insured of $284. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 21: CAPITAL ASSETS (CONTINUED) Concentrations of collateral associated with insured asset-backed obligations follow: ADDITIONAL FINANCIAL INFORMATION Information for Financial Services, a member of the capital assets segment, follows: NOTE 22: COMMITMENTS AND CONTINGENCIES MediaOne Group's commitments and debt guarantees totaled approximately $330 for its international investments and $180 for its domestic investments as of December 31, 1999. During 1999, certain cable subsidiaries of the Company in Florida, Michigan, and Ohio were named as defendants in various class action lawsuits challenging such subsidiaries' policies for charging late payment fees when customers fail to pay for subscriber services in a timely manner. The Company anticipates that these lawsuits will not have a material impact on its results of operations. NOTE 23: SUBSEQUENT EVENTS On January 28, 2000, MediaOne Group signed an agreement to sell its Japanese cable and telephony investments for $225 plus the repayment of capital contributions made to the Japanese ventures after June 30, 1999. At December 31, 1999, the Company had made capital contributions of $41 that would be subject to repayment at the closing of the sale. MediaOne Group will also be released from guarantees given to support debt at certain of the Japanese ventures. At December 31, 1999, the amount of these debt guarantees totaled $132. On February 7, 2000, the Company signed a definitive agreement to sell its equity interest in the Trip.com, an online travel services company, to Galileo International, Inc., for cash and stock valued at approximately $70. This sale is subject to regulatory approvals. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 23: SUBSEQUENT EVENTS (CONTINUED) On February 15, 2000, MediaOne Group sold its 25 percent interest in Singapore Cablevision ("Singapore") to Singapore Technologies for $218. As a result of the sale, MediaOne Group's commitments disclosed in Note 22--Commitments and Contingencies--to the Consolidated Financial Statements were reduced by $47. NOTE 24: NET INVESTMENT IN ASSETS HELD FOR SALE As of December 31, 1998, the disposal of assets held for sale of the capital assets segment was substantially completed. Therefore, the accounts of the capital assets segment are reflected in the Company's Consolidated Balance Sheets for 1999 and 1998, and in the Consolidated Statements of Operations for 1999. See Note 21--Capital Assets--to the Consolidated Financial Statements for the continuing operations. Prior to this time, the capital assets segment had been accounted for in accordance with SAB No. 93, issued by the SEC, which required discontinued operations not disposed of within one year of the measurement date to be accounted for prospectively in continuing operations as a "net investment in assets held for sale." The remaining assets of the capital assets segment primarily represent long term lease finance receivables. MediaOne Real Estate, Inc. ("Real Estate") sold various assets during 1998, and 1997 for proceeds of $182, and $88, respectively. The sales proceeds were in line with estimates. Proceeds from sales were primarily used to repay related debt. As of December 31, 1998, the Company had substantially completed the liquidation of this portfolio. Building sales and operating revenues of the capital assets segment were $208 and $116 in 1998 and 1997, respectively. During 1998 and 1997, income or losses from the capital assets segment were deferred and included within the reserve for assets held for sale. NOTE 25: DISCONTINUED OPERATIONS In accordance with APB Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," the Consolidated Financial Statements for 1998 and 1997 reflect New U S WEST as a discontinued operation. Revenues and expenses, and the cash flows of New U S WEST have been separately classified in the Consolidated Statements of Operations and Statements of Cash Flows. The Company has accounted for the distribution of New U S WEST common stock to the holders of Communications Stock, and to the holders of MediaOne Group Stock for the Dex Alignment as a discontinuance of the businesses comprising New U S WEST. The measurement date for discontinued operations accounting purposes is June 4, 1998, the date upon which Old U S WEST's shareowners approved the Separation. Because the distribution was non pro-rata, as compared with the businesses previously attributed to Old U S WEST's two classes of shareowners, it was accounted for at fair value. The distribution resulted in a gain of $24,461, net of $114 of Separation costs (net of tax benefits of $37). Separation costs included cash payments under severance agreements of $45 and financial advisory, legal, MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 25: DISCONTINUED OPERATIONS (CONTINUED) registration fee, printing and mailing costs. Separation costs also included a one-time payment to terminate the sale of the Minnesota cable systems. NOTE 26: QUARTERLY FINANCIAL DATA (UNAUDITED) - ------------------------ (1) Sales and other revenues include revenues related to the domestic wireless operations of $341 and $20 for the first and second quarters of 1998, respectively. The domestic wireless operations were sold on April 6, 1998. (2) Income from discontinued operations includes $87 and $72 related to Dex, and $347 and $241 related to the Communications Group for the first and second quarters of 1998, respectively. MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 26: QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED) First-quarter 1999 net loss includes a gain of $76 ($0.13 per share of MediaOne Group Stock) related to the sale of Optus shares, a gain of $43 ($0.07 per share of MediaOne Group Stock) related to the sale of domestic cable systems and investments, a charge of $40 ($0.07 per share of MediaOne Group Stock) related to the Company's investment in PrimeStar, and a charge of $15 ($0.03 per share of MediaOne Group Stock) for merger costs incurred by the Company. Second-quarter 1999 net loss includes a gain of $1,530 ($2.52 per share of MediaOne Group Stock) related to the exchange of the Company's investment in AirTouch stock, a net gain of $14 ($0.02 per share of MediaOne Group Stock) related to the sale of domestic investments, a charge of $3 (no per share impact) on the sale and exit costs of international investments, a charge of $1,497 ($2.47 per share of MediaOne Group Stock) for the Comcast termination fee and other merger related costs incurred by the Company, and a charge of $13 ($0.02 per share of MediaOne Group Stock) for an extraordinary dividend paid to the Centaur Preference Shares holders as a result of the Vodafone/AirTouch merger. Third-quarter 1999 net income includes a gain of $257 ($0.42 per share of MediaOne Group Stock) related to the sale of domestic cable systems and investments, a net gain of $102 ($0.17 per share of MediaOne Group Stock) related to the sale of international investments, and a charge of $9 ($0.01 per share of MediaOne Group Stock) for other merger related costs. Fourth-quarter 1999 net income includes a gain of $3,909 ($6.20 per share of MediaOne Group Stock) related to the sale of international investments, a net charge of $167 ($0.26 per share of MediaOne Group Stock) for merger related activity, and income of $10 ($0.02 per share of MediaOne Group Stock) related to the Company's investment in PrimeStar. First-quarter 1998 net income includes net income of $15 ($0.03 per share of MediaOne Group Stock) related to the domestic wireless businesses and a gain of $10 ($0.02 per share of MediaOne Group Stock) related to the sale of a domestic cable programming investment. Second-quarter 1998 net income includes a gain of $24,461 ($40.16 per share of MediaOne Group Stock) related to the Separation, a gain of $2,257 ($3.71 per share of MediaOne Group Stock) related to the sale of MediaOne Group's domestic wireless businesses, gains of $14 ($0.02 per share of MediaOne Group Stock) related to various domestic investment sales, net income of $5 ($0.01 per share of MediaOne Group Stock) related to the domestic MEDIAONE GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 26: QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED) wireless businesses, and a charge of $333 ($0.55 per share of MediaOne Group Stock) for the early extinguishment of debt. Third-quarter 1998 net income includes gains of $2 (no per share impact) on sales of miscellaneous domestic cable systems and a charge of $25 ($0.04 per share of MediaOne Group Stock) related to an interest rate swap agreement which did not qualify for deferral accounting. Fourth-quarter 1998 net income includes gains of $8 ($0.01 per share of MediaOne Group Stock) related to sales of various domestic investments, gains of $10 ($0.02 per share of MediaOne Group Stock) related to sales of various international investments, a charge of $100 ($0.16 per share of MediaOne Group Stock) related to a write-down to zero of the Company's investment in PrimeStar, and a charge of $18 ($0.03 per share of MediaOne Group Stock) related to the termination of an interest rate swap agreement and the purchase of an interest rate option. - ------------------------ (1) The Communications Stock was canceled on June 12, 1998, effective with the Separation.

902279_1999.txt

902279_1999

1999

902279

ITEM 1. BUSINESS THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 WITH RESPECT TO THE FINANCIAL CONDITION, RESULTS OF OPERATIONS AND BUSINESS OF THE COMPANY, INCLUDING STATEMENTS UNDER THE CAPTIONS "BUSINESS" AND "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." THESE FORWARD-LOOKING STATEMENTS INVOLVE CERTAIN RISKS AND UNCERTAINTIES. NO ASSURANCE CAN BE GIVEN THAT ANY OF SUCH MATTERS WILL BE REALIZED. FACTORS THAT MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE CONTEMPLATED BY SUCH FORWARD-LOOKING STATEMENTS INCLUDE, AMONG OTHERS: (1) BANKRUPTCY COURT ACTIONS OR PROCEEDINGS RELATED TO THE BANKRUPTCY OF LFI AND ITS SUBSIDIARIES; (2) COMPETITIVE PRESSURE IN LFI'S INDUSTRY; (3) GENERAL ECONOMIC CONDITIONS; (4) CHANGES IN THE FINANCIAL MARKETS AFFECTING LFI'S FINANCIAL STRUCTURE AND LFI'S COST OF CAPITAL AND BORROWED MONEY; (5) INVENTORY RISKS DUE TO CHANGES IN MARKET DEMAND OR LFI'S BUSINESS STRATEGIES; (6) CHANGES IN EFFECTIVE TAX RATES; (7) YEAR 2000 RISKS; AND (8) THE UNCERTAINTIES INHERENT IN LFI'S OPERATIONS. LFI HAS NO DUTY UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 TO UPDATE THE FORWARD-LOOKING STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K. CHAPTER 11 FILING On September 5, 1997 (the "Petition Date"), Levitz Furniture Incorporated, a Delaware corporation ("LFI" or the "Company"), and 11 of its subsidiaries (collectively, the "Debtors"), including, Levitz Furniture Corporation, a Florida corporation and wholly-owned subsidiary of LFI ("Levitz"), filed voluntary petitions for relief under Chapter 11, Title 11 of the United States Code (the "Bankruptcy Code") with the United States Bankruptcy Court for the District of Delaware, Wilmington, Delaware (the "Court") under Case No. 97-1842(MFW). Pursuant to Sections 1107 and 1108 of the Bankruptcy Code, LFI, as debtor and debtor-in-possession, has continued to manage and operate its assets and businesses pending the confirmation of a reorganization plan or plans and subject to the supervision and orders of the Court. Because LFI is operating as debtor-in-possession under Chapter 11 of the Bankruptcy Code, the existing directors and officers of LFI continue to manage the operations of LFI subject to the supervision and orders of the Court. On July 7 1999, the Debtors filed a "Disclosure Statement" and a "Joint Plan of Reorganization" ("Plan of Reorganization" or "Plan"), pursuant to Section 1125 of the Bankruptcy Code with the Court. The Disclosure Statement sets forth certain information regarding, among other things, significant events that have occurred during the Debtors' Chapter 11 cases and the anticipated organization, operation and financings of "Reorganized Levitz". The Disclosure Statement describes the Plan of Reorganization, certain effects of Plan confirmation, certain risk factors associated with securities to be issued under the Plan, and the manner in which distribution will be made under the Plan. In addition, the Disclosure Statement discusses the confirmation process and the voting procedures that holders of claims in impaired classes must follow for their votes to be counted. The Plan of Reorganization sets forth certain information, among other things, the classification and treatment of claims and interests, means for implementation of the Plan, acceptance or rejection of the Plan and effect of rejection by one or more classes of claims or interests, provisions for governing distributions, the treatment of executory contracts and leases, conditions precedent to confirmation of the Plan and the occurrence of the effective date of the Plan. The Plan of Reorganization provides, among other things, that as of the Plan effective date: (1) All holders of an allowed administrative and priority tax claim are unimpaired and unclassified, are not entitled to vote on the Plan and will receive cash or such other treatment as to which LFI and such creditor shall have agreed in writing. (2) All holders of an allowed other priority claim (Class 1), setoff claim (Class 2) and miscellaneous secured claim (Class 3) are unimpaired, are deemed to have accepted the Plan and, therefore not entitled to vote on the Plan and will receive cash or setoff or reinstatement or such other treatment as to which LFI and such creditor shall have agreed in writing. (3) All holders of a small unsecured claim (less than $1,000, Class 4) are impaired and are entitled to vote on the Plan and shall receive in cash 25% of the allowed amount of the claim. (4) All holders of an allowed general unsecured claim (Class 5) are impaired, are entitled to vote on the Plan and shall receive their pro rata share of the new common stock distribution of "Reorganized Levitz". (5) All holders of an allowed subordinated claim (Class 6) are impaired, are deemed to have rejected the Plan and, therefore, not entitled to vote on the Plan, and shall not receive or retain any property or interest in property on account of their subordinated claim. (6) All intercompany claims (Class 7) shall be cancelled, and their holders shall not receive or retain any property or interest in property on account of their intercompany claims. (7) All holders of Interests (the rights of any current or former holder or owner of "old equity securities" authorized and issued prior to the Plan confirmation date, Class 8) are impaired, are deemed to have rejected the Plan and, therefore, are not entitled to vote on the Plan. All Interests shall be cancelled and the Interest holders shall not receive or retain any property or interest in property on account of their Interests. Although the Plan of Reorganization provides for the Debtors' emergence from bankruptcy, there can be no assurances given that the Plan will be confirmed by the Court, or that such Plan will be consummated. At this time, it is not possible to predict the outcome of the Debtors' Chapter 11 cases or their effect on the Debtors' business. Reference is made to Item 7 - "Management's Discussion and Analysis of Results of Operations and Financial Condition" and the Report of Independent Public Accountants included on page 32 which indicates the substantial doubt about LFI's ability to continue as a going concern. THE COMPANY LFI was incorporated in Delaware in 1984 under the name LFC Holding Corporation for the purpose of acquiring Levitz Furniture Corporation. LFI changed its name to Levitz Furniture Incorporated in 1993. LFI's only material asset is the common stock of Levitz Furniture Corporation and it conducts no business other than holding the common stock of Levitz Furniture Corporation. The principal executive offices of LFI are located at 7887 North Federal Highway, Boca Raton, FL 33487-1613, and its telephone number is (561) 994-6006. Levitz Furniture Corporation (which together with its subsidiaries are collectively referred to as "Levitz"), was organized in 1965 as a Florida corporation, is the successor to a business originally commenced in 1910 and was acquired by LFI in 1985. Levitz is one of the largest specialty retailers of furniture in the United States with, as of June 8, 1999, a chain of 64 stores serviced by 21 warehouses located in major metropolitan areas in 13 states. Levitz pioneered the warehouse-showroom concept by opening the first warehouse-showroom in 1963 in Allentown, Pennsylvania. Levitz stores generated revenues of $653.1 million in the year ended March 31, 1999 ("Fiscal 1999"). Management believes the Levitz name to be one of the most recognized in furniture retailing. Levitz stores offer a wide selection primarily of brand-name furniture and accessories including living room, bedroom, dining room, kitchen and occasional furniture and bedding. Some of the well known, nationally advertised brands offered by Levitz stores include Ashley, Bassett, Benchcraft, Berkline, Douglas, Klaussner, Lane, Lea Industries, Rowe, Sealy, Simmons, Stanley, and Universal. Levitz does not manufacture any of the merchandise sold in its stores but instead devotes all of its resources to the retail sale of furniture. Levitz has experienced declining profitability and cash flows over the past several fiscal years. Reference is made to "Restructuring Activities" and Item 7 - - "Management's Discussion and Analysis of Results of Operations and Financial Condition" for a discussion of action taken with an intent to restore profitable operations. BUSINESS STRATEGY Levitz's retailing concept targets value-conscious consumers by offering: -- broad selections of furniture and accessories; -- nationally advertised brands; -- competitive prices; and -- immediate availability of merchandise. Levitz offers one of America's largest selection of quality brand name furniture at guaranteed low prices. The Company's large stores facilitate the display of a broad selection of furniture and accessories. Levitz's sales volumes create a key channel of distribution for its principal vendors. Management has developed strong partnerships with these principal vendors from whom it purchases large quantities of quality merchandise, often at substantial savings. This buying power enables Levitz to price its merchandise very competitively. MERCHANDISING Levitz targets value-conscious consumers between 18 and 44 years of age with a family income between $45,000 and $65,000 per year. Its customers seek moderately priced merchandise to upper moderately priced merchandise, appreciate style and recognize value. Levitz offers a wide array of choices to the value-conscious consumer. The large product selection is an inducement for consumers to purchase at Levitz and differentiates Levitz from its competitors. The merchandise sales mix among product line groupings for Fiscal 1999 was upholstery/seating 44.1%, bedroom 20.0%, occasional 11.1%, dining room (formal and casual) 12.3%, bedding 9.9%, and other 2.6%. Percentage breakdowns have been relatively consistent for the past several years. To attract consumers who prefer more customized merchandise, Levitz can special order fabrics on upholstered products from a wide variety of preselected patterns ("Choices Program"). Moreover, Levitz has enhanced its special order leather program, which allows customers to receive their merchandise generally within four weeks of purchase. During Fiscal 1999 the Choices Program represented approximately 9.7% of upholstery sales for continuing stores. ADVERTISING AND PROMOTION Levitz retains independent advertising firms for creative and production services in connection with its print, radio and television advertisements. For Fiscal 1999, Levitz's advertising expenditures amounted to $93.4 million or 14.3% of net sales, as compared to $108.1 million or 13.3% of net sales, for Fiscal 1998. Advertising expenditures include promotional finance fees of $28.4 million and $27.2 million in Fiscal 1999 and 1998, respectively. Levitz's advertising seeks to attract a broader customer segment and emphasize the difference between shopping at Levitz and at other stores. Levitz continues to promote its stores through newspaper inserts and circulars distributed through the mail ("Preprints"). These Preprint promotions reflect (i) the great styles offered at Levitz, (ii) the wide array of choices, (iii) Levitz's low prices and (iv) fast delivery. CUSTOMER SERVICE Levitz is committed to providing high-quality customer service in all phases of its business, including instant store credit and prompt delivery. Levitz offers its customers instant credit at the time of purchase using point-of-sale terminals on the showroom floors. In the case of any damaged or defective merchandise Levitz will repair or replace the item or, if impracticable to repair or replace, will offer a refund to the customer. Management believes its commitment to customer service has contributed to the substantial percentage of repeat purchases by Levitz's customers. STORE OPERATIONS STORES Each of Levitz's sixty-four stores feature selling space of 18,000 to 112,000 square feet. Merchandise is typically displayed in model room settings of which approximately 240 to 330 are located in each facility containing 50,000 or more square feet of selling space. Smaller facilities feature approximately 110 to 230 model room settings. Levitz's customers typically have the option to receive their merchandise at the store immediately upon purchase or within a few days or to have their merchandise delivered to their homes for a modest delivery charge. Levitz's stores are typically located within easy access of expressway interchanges or major highways and have adjacent parking facilities. Levitz opened one new store in May 1999 and relocated one store in November 1998. Levitz expects to relocate one additional store in Fiscal 2000. See "Properties" for information regarding the locations of Levitz's stores. Levitz's retail facilities are generally open Monday through Saturday from 10:00 a.m. to 9:00 p.m., and on Sundays from 12:00 noon to 6:00 p.m. SALES SUPPORT CENTERS Levitz's twenty-one Sales Support Centers (formerly known as warehouses) provide the selling support for all sixty-four stores. The support provided includes the warehousing of merchandise, customer service, data processing, inventory control and delivery. Each Sales Support Center is currently attached to a store and is in close proximity to other detached stores that it services. CUSTOMER CREDIT POLICIES Levitz sells its merchandise either for cash, or through bank credit cards and a private label credit card program. During Fiscal 1999 and 1998, approximately 48% and 40%, respectively, of sales at Levitz's facilities were for cash (including bank credit cards), and approximately 52% and 60%, respectively, of sales were under customer credit plans. The availability of a "private label" credit-financing program is critical to Levitz's business. Private label credit supports marketing programs and offers a convenient way for Levitz customers to spread over time the cost of furniture purchases. Levitz's private label credit card program is offered under an agreement with Household Bank (SB), N.A. ("Household"). Under the program, Household approves the credit application and pays Levitz for the sale. Levitz pays Household a fee for servicing the accounts and an amount intended to compensate Household for its invested capital. Levitz receives all income and pays all expenses relating to the financing of the portfolio. Levitz is also responsible for any bad debts associated with the portfolio up to 15% of average outstanding receivables in any contract year. Any amounts in excess of 15% are to be shared equally by Levitz and Household. In the event Household denies credit approval to a customer, Levitz endeavors to obtain credit approval from other third-party finance companies. Under such arrangements, Levitz sells the sale transaction to the finance company for a discount and on a non-recourse basis. VENDOR PARTNERSHIPS/INVENTORY Management has established strong partnerships with its principal vendors to review new merchandise and plan promotions and marketing strategies, as well as manage inventory levels. Substantially all manufacturers have cooperative advertising budgets with Levitz. Electronic data interchange ("EDI") is an important aspect of these partnerships. Ninety-eight manufacturers currently participate in Levitz's EDI system which enables manufacturers to plan and produce goods more efficiently while making it possible for Levitz to maintain an in-stock position with less inventory. The EDI system includes the daily electronic transmission of purchase orders and bar code data to vendors and returned receipt of acknowledgements of the purchase orders from vendors. The acknowledgement authenticates, among other things, price, items and expected shipment date. The use of EDI combined with the newly implemented demand forecasting and inventory replenishment system will streamline the merchandise re-ordering process and allow Levitz to be in a better in-stock position with less inventory investment. During May 1999, 96.0% of all furniture purchases were made through the EDI system, as compared to 98.1% for the same month of the prior year. Levitz has six vendors that send invoices through EDI. This process is integrated with the accounts payable system. Levitz intends to continue working with vendors to increase the number of vendors that use EDI for invoices and also to introduce additional EDI features such as advance ship notices which are expected to enhance relations and improve efficiencies for the Company. Levitz currently purchases merchandise from over 247 independent manufacturers. For Fiscal 1999, Levitz's top ten vendors accounted for 50.3% of purchases. Levitz has no long-term contractual commitments with any of its manufacturers, and with the exception of the disruption caused by its 1997 Chapter 11 filing, has had no difficulty in the past in obtaining merchandise for sale. Levitz is concentrating its vendor relations on key vendors, which account for approximately eighty percent of net sales. These enhanced relationships involve regular assessment reports and periodic strategy planning meetings. MANAGEMENT INFORMATION SYSTEMS Levitz maintains an IBM AS/400 computer in each Sales Support Center to track all inventory and sales activity for the stores that the Sales Support Center services. When merchandise arrives at the Sales Support Center, it has been or is immediately bar coded, enabling scanning by hand-held readers. This information is directly loaded into the AS/400 thereby eliminating clerical errors, increasing available inventory for sale and minimizing inventory shrinkage. The sales floors in all stores are equipped with on-line point-of-sale terminals enabling sales persons to access inventory status, reserve inventory, schedule delivery and begin the credit approval process for customers. All data is transmitted to corporate headquarters each night. Management at corporate headquarters and at the store level monitor inventory composition, age and condition. Levitz is developing a radio-frequency ("RF") system to track all merchandise movement in and out of its stores and Sales Support Centers. All furniture movement will be scanned and updated immediately in the inventory files. The initial test system will be implemented in Fiscal 2000. COMPETITION The home furnishings industry is a highly competitive and fragmented market with sales for furniture, bedding and decorative accessories by furniture stores in the United States estimated at $37.6 billion in 1998. According to a leading industry publication, the nation's 100 largest furniture retailers accounted for approximately 48.0% of all furniture sales by furniture stores in the United States in 1998. According to the same publication, in 1998 Levitz represented 1.6% of total domestic furniture sales, and was the fifth largest specialty retailer of furniture in the United States. Levitz's competition varies significantly according to geographic areas. Levitz's principal competitors consist of local independent specialty furniture retailers. Levitz also competes with national and regional specialty furniture retailers, general merchandisers, internet and "800" number based retailers and, in certain limited categories, wholesale clubs. In the future Levitz may have increasing competition from other major retail operations, some of which may have greater financial and other resources than Levitz and may derive revenues from sales of products other than household furnishings. EMPLOYEES As of March 31, 1999, Levitz had 2,993 employees, of whom 946 were engaged in sales, 333 in merchandising and display, 779 in warehouse and maintenance functions and 935 in office and administrative work. As of March 31, 1999, 2,322 of Levitz's employees were full-time and 671 were part-time. Sales personnel are paid primarily on a commission basis. Levitz's store managers and key marketing, distribution and operations personnel may receive, in addition to their base salaries, bonus compensation based upon achieving planned sales and operating performance for the location or locations for which the employee has responsibility. Certain of Levitz's national staff personnel, including officers, may receive bonuses based upon favorable operating results during the fiscal year. Levitz maintains one facility in the state of Washington which its sales employees are covered by a collective bargaining agreement with a local of the United Food and Commercial Workers Union ("UFCW"). This collective bargaining agreement expires in December 2000. Levitz maintains two facilities in New Jersey in which all non-management employees are represented by an affiliate of the Teamsters Union. The Union was certified as bargaining agent for the employees in August 1998. The parties are engaged in contract negotiations with that union. In 1995, Levitz withdrew recognition of a UFCW local as bargaining agent for the employees at a facility in California. That decision was upheld by the NLRB Regional Director and the local has appealed the matter to the NLRB. In the past, a number of petitions were received from various unions, including affiliates of the UFCW and the Teamsters Union, for organization of some or all of the employees in certain other of Levitz's facilities. Except as noted above, none of these petitions or other union activities has resulted in a current collective bargaining agreement. Levitz has not experienced a material work stoppage due to union activity in the past 10 years. Levitz expects that union efforts to organize the employees at its facilities will continue from time to time, but cannot predict what effect these activities may have on Levitz's business operations, employee relations or income from operations. Although nationwide organizational campaigns may be instituted by one or more unions, all union activities to date have been confined to the local or regional level. RESTRUCTURING ACTIVITIES Since the Petition Date, management of the Company and its advisors in the bankruptcy proceedings have conducted an extensive analysis of business operations with the objective of making the changes necessary to improve operating performance. Levitz has devised a comprehensive strategy to focus and increase its presence in its most productive markets, streamline its warehousing and delivery systems, and improve its internal operations and selling functions. The major restructuring initiatives that have been implemented or are currently underway include the following: FOCUS ON MARKETS WITH STRONG COMPETITIVE POSITIONING Management has studied each of the market areas in which Levitz stores operate. This study compared the operating performance of Levitz's stores against key competitors in each market. Levitz determined that a key determinant of the ability of Levitz to profitably compete was for Levitz to be one of the dominant furniture retailers, in terms of number of stores and sales revenues, within each geographic market. The conclusion was based upon the significant advertising and promotional expenses required to operate in the furniture retail business and the ability to leverage fixed expenses across a greater sales base within each market. Accordingly, management decided to close selected markets in which Levitz did not have sufficient market presence and to refocus those assets into other core markets by opening new stores or by remodeling existing stores. Levitz has closed a total of sixty-six stores since the Petition Date, enabling it to concentrate resources on the remaining core stores, primarily in the Northeast and on the West Coast. As part of their efforts to increase market share and to improve profitability, Levitz plans to relocate selected existing stores and to open additional stores over the next three to five years within core markets, dependent on general business conditions and Levitz's ability to finance the openings. DISTRIBUTION SYSTEM RATIONALIZATION Levitz is implementing a "warehouse rationalization program," aimed at limiting the number of warehouses serving each market. This initiative should provide the following benefits: (i) reduced in-bound freight costs; (ii) reduced warehouse operating costs; (iii) lower inventory investments; (iv) improved merchandise in-stock position; (v) better ability to clear discontinued merchandise; and (vi) overall logistics simplification. In addition, the warehouse rationalization program may provide Levitz the opportunity to relocate certain existing stores into more favorable retail locations. The warehouse rationalization program is being implemented in several phases. The first phase, begun in June 1998 with the closure of the warehouse facility in the Paramus, New Jersey store was completed in June 1999. Also, during this time, 14 other warehouse facilities were shut down and the distribution and warehousing activities for attached stores were transferred to other warehouse-showroom stores within the same or adjacent markets. At the completion of this initial phase, Levitz is operating 64 stores, which are supported by twenty-one warehouse facilities (Sales Support Centers). Levitz is analyzing the opportunity to further improve its logistic practices through the introduction of regional distribution centers in future years. It is believed such a program would provide significant savings related to in-bound freight expense, lower the required inventory investment levels and also create the opportunity to introduce further economies in merchandise buying practices. IMPROVED SALES FORCE STAFFING AND MANAGEMENT TECHNIQUES Levitz has implemented several initiatives to improve the performance of its sales force, including: (i) hiring additional sales people at its ongoing stores since the Petition Date, increasing the number of sales people (net of terminations); (ii) reorganizing the field management structure to provide for more frequent and detailed store visits; (iii) installing sophisticated sales force performance measurement tools designed to identify "best practices" within the stores and to set benchmarks for performance; and (iv) testing various sales force compensation structures. CREATION OF NEW STORE PROTOTYPES Levitz has created a new store design prototype which features a "race-track" floor layout, as compared to the traditional "alley" design, and a more open, brighter feeling store environment with higher ceilings and more lighting. To date, the prototype has been implemented in a remodeling of the store in King of Prussia, Pennsylvania and at a relocated store in Phoenix, Arizona. The performance of these stores has improved significantly as compared to periods immediately before the implementation of the new prototype design. In addition, in May 1999 Levitz opened a new store in Valencia, California with this new design. Levitz intends to introduce additional stores in the new prototype layout over the next several years, either as new stores or as remodels of existing stores. Levitz's ability to complete such plans may be subject to Court approval and is dependent on general business conditions and the ability to finance the required capital expenditures. MORE FOCUSED VENDOR RELATIONSHIPS Since the Petition Date, Levitz has undertaken a comprehensive review of their merchandise vendor structure and have determined to significantly reduce the number of vendors that they deal with and increase the strength of their remaining vendor relationships. As part of a more focused relationship with ongoing vendors, Levitz is exploring opportunities to: (i) increase frequency and shorten lead times for deliveries; (ii) improve operational and financial performance of the vendor-merchant relationship for both parties; (iii) develop special promotions and financing opportunities; and (iv) improve dating. IMPROVED INVENTORY PLANNING SYSTEMS Levitz has added specialized employees and dedicated software systems designed to increase the ability to forecast inventory levels and purchasing requirements and to allocate inventory to stores so as to improve the in-stock levels at the stores. The ability to better plan inventory provides Levitz significant advantages in the following ways: (i) by improving in-stock position, fewer opportunities are missed to generate sales when a customer wants to purchase an item but it is unavailable; (ii) by giving vendors more lead time on expected purchases, Levitz can realize cost savings because of the more orderly production schedules the vendors can run; and (iii) tighter controls on inventory allow Levitz to operate with a lower inventory investment in the stores and to transition out of discontinued items with lower mark-downs. MERCHANDISING ASSORTMENT PLANNING Levitz is employing new planning techniques to evaluate the appropriateness of current merchandise assortment. Every category of merchandise is being evaluated to ensure the assortment achieves the desired breadth of selection considering quality, style and price and local market differentiation. The assortment plans will incorporate consideration of the availability options to be provided to customers. Vendors will be selected based on their capability to most efficiently support the vendor assortment programs. IMPROVED ADVERTISING PROGRAMS Levitz has adopted a longer time horizon into planning advertising campaigns in order to better integrate merchandising planning and marketing efforts. New themes have been developed and a "new look" adopted to improve the clarity of the message to the customer on why to shop at Levitz, and Levitz has hired a new advertising agency. Research is being conducted to better understand customer profiles in markets where stores are located. This research will impact the merchandise assortment, pricing and methods Levitz will use to communicate with customers from market to market. ITEM 2. ITEM 2. PROPERTIES On June 8, 1999, Levitz operated 64 retail stores, and 21 Sales Support Centers located in major metropolitan areas in 13 states, with a concentration in California. The following table sets forth the number of retail facilities owned or leased by Levitz on June 8, 1999: OWNED LEASED ----- ------ Stores with attached Sales Support Centers................ 1 20 Stores that are detached or freestanding.................. -- 43 On June 8, 1999, these facilities contained a total of approximately 7,000,000 square feet, including approximately 3,100,000 square feet of selling space. Levitz also leases a 45,000 square feet facility for its corporate offices in Boca Raton, Florida and owns a 35,000 square foot facility in Pottstown, Pennsylvania which is used for accounting offices. The following sets forth, as of June 8, 1999, the retail premises operated by Levitz: - ---------- (1) The column refers to stores with attached Sales Support Centers ("WS") or to detached or freestanding stores ("ST"). (2) The Los Angeles, CA property is part of the collateral for borrowings under the DIP Facility and is pending an agreement of sale. (3) The remaining terms of the leases range from 16 months to 39 years, including renewal options. Lease payments are either fixed or fixed minimums coupled with contingent rentals based on the Consumer Price Index or a percentage of net sales. (4) Subject to Unitary Lease described in Note 19 to the consolidated financial statements. In addition to the above properties, as of June 8, 1999 Levitz had available for disposition nine owned and nineteen leased properties formerly operated as retail stores. As part of its "warehouse rationalization program", the Company has completed the closing of its warehouses in Dedham, MA, Danvers, MA, Paramus, NJ, Garden City, NY, Northridge, CA, Minneapolis, MN, San Bernardino, CA, Cherry Hill, NJ, South San Francisco, CA, Hartford, CT, Redondo Beach CA, Lynwood, WA, Allentown, PA, Concord, CA and Modesto CA. ITEM 3. ITEM 3. LEGAL PROCEEDINGS CHAPTER 11 FILING On September 5, 1997, LFI and 11 of its subsidiaries, including Levitz, filed voluntary petitions for relief under the Bankruptcy Code, Chapter 11, Title 11 of the United States Code, with the United States Bankruptcy Court for the District of Delaware, Wilmington, Delaware 19801 under Case No. 97-1842(MFW). Under section 362 of the Bankruptcy Code, during a Chapter 11 case, creditors and other parties in interest may not, without Court approval: (i) commence or continue judicial, administrative or other proceedings against the Debtors that were or could have been commenced prior to commencement of the Chapter 11 case, or recover a claim that arose prior to commencement of the case; (ii) enforce any pre-petition judgments against the Debtors; (iii) take any action to obtain possession of or exercise control over property of the Debtors or their estates; (iv) create, perfect or enforce any lien against the property of the Debtors; (v) collect, assess or recover claims against the Debtors that arose before the commencement of the case; or (vi) set off any debt owing to the Debtors that arose prior to the commencement of the case against a claim of such creditor or party in interest against the Debtors that arose before the commencement of the case. Although the Debtors are authorized to operate their businesses and manage their properties as debtors-in-possession, they may not engage in transactions outside of the ordinary course of business without complying with the notice and hearing provisions of the Bankruptcy Code and obtaining Court approval. As debtors-in-possession, the Debtors have the right, subject to Court approval and certain other limitations, to assume or reject executory, pre-petition contracts and unexpired leases. In this context, "assumption" requires the Debtors to perform their obligations and cure all existing defaults under the assumed contract or lease and "rejection" means that the Debtors are relieved from their obligations to perform further under the rejected contract or lease, but are subject to a claim for damages for the breach thereof subject to certain limitations contained in the Bankruptcy Code. Any damages resulting from rejection are treated as general unsecured claims in the reorganization cases. Under the Bankruptcy Code, a creditor's claim is treated as secured only to the extent of the value of such creditor's collateral, and the balance of such creditor's claim is treated as unsecured. Generally, unsecured and undersecured debt does not accrue interest after the Petition Date. Pre-petition claims that were contingent or unliquidated at the commencement of the Chapter 11 cases are generally allowable against the Debtors in amounts to be fixed by the Court or otherwise agreed upon. These claims, including, without limitation, those which arise in connection with the rejection of executory contracts and leases, are expected to be substantial. The Debtors have established reserves approximating what the Debtors believe will be its liability under these claims. The Court fixed August 10, 1998 as the last date by which most creditors of the Debtors could file proofs of claim for claims that arose prior to the Petition Date. PLAN OF REORGANIZATION PROCEDURES For 120 days after the date of the filing of a voluntary Chapter 11 petition, a debtor has the exclusive right to propose and file a reorganization plan with the Court and an additional 60 days within which to solicit acceptances to any plan so filed (the "Exclusive Period"). The Court may increase or decrease the Exclusive Period for cause shown, and as long as the Exclusive Period continues, no other party may file a reorganization plan. The Debtors currently retain the exclusive right to propose and solicit acceptances of a plan or plans of reorganization until September 30, 1999. If Levitz fails to obtain acceptance of such plan from impaired classes of creditors during the exclusive solicitation period, any party in interest, including a creditor, an equity security holder or a committee of creditors, may file a reorganization plan for such Chapter 11 debtor. Inherent in a successful plan of reorganization is a capital structure which permits the Debtors to generate sufficient cash flow after reorganization to meet its restructured obligations and fund the current obligations of the Debtors. Under the Bankruptcy Code, the rights and treatment of pre-petition creditors and stockholders may be substantially altered. At this time it is not possible to predict the outcome of the Chapter 11 case, in general, or the effects of the Chapter 11 case on the business of the Debtors or on the interests of creditors. On July 7 1999, the Debtors filed a "Disclosure Statement" and a "Joint Plan of Reorganization" ("Plan of Reorganization" or "Plan"), pursuant to Section 1125 of the Bankruptcy Code with the Court. The Disclosure Statement sets forth certain information regarding, among other things, significant events that have occurred during the Debtors' Chapter 11 cases and the anticipated organization, operation and financings of "Reorganized Levitz". The Disclosure Statement describes the Plan of Reorganization, certain effects of Plan confirmation, certain risk factors associated with securities to be issued under the Plan, and the manner in which distribution will be made under the Plan. In addition, the Disclosure Statement discusses the confirmation process and the voting procedures that holders of claims in impaired classes must follow for their votes to be counted. The Plan of Reorganization sets forth certain information, among other things, the classification and treatment of claims and interests, means for implementation of the Plan, acceptance or rejection of the Plan and effect of rejection by one or more classes of claims or interests, provisions for governing distributions, the treatment of executory contracts and leases, conditions precedent to confirmation of the Plan and the occurrence of the effective date of the Plan. The Plan of Reorganization provides, among other things, that as of the Plan effective date: (1) All holders of an allowed administrative and priority tax claim are unimpaired and unclassified, are not entitled to vote on the Plan and will receive cash or such other treatment as to which LFI and such creditor shall have agreed in writing. (2) All holders of an allowed other priority claim (Class 1), setoff claim (Class 2) and miscellaneous secured claim (Class 3) are unimpaired, are deemed to have accepted the Plan and, therefore not entitled to vote on the Plan and will receive cash or setoff or reinstatement or such other treatment as to which LFI and such creditor shall have agreed in writing. (3) All holders of a small unsecured claim (less than $1,000, Class 4) are impaired and are entitled to vote on the Plan and shall receive in cash 25% of the allowed amount of the claim. (4) All holders of an allowed general unsecured claim (Class 5) are impaired, are entitled to vote on the Plan and shall receive their pro rata share of the new common stock distribution of "Reorganized Levitz". (5) All holders of an allowed subordinated claim (Class 6) are impaired, are deemed to have rejected the Plan and, therefore, not entitled to vote on the Plan, and shall not receive or retain any property or interest in property on account of their subordinated claim. (6) All intercompany claims (Class 7) shall be cancelled, and their holders shall not receive or retain any property or interest in property on account of their intercompany claims. (7) All holders of Interests (the rights of any current or former holder or owner of "old equity securities" authorized and issued prior to the Plan confirmation date, Class 8) are impaired, are deemed to have rejected the Plan and, therefore, are not entitled to vote on the Plan. All Interests shall be cancelled and the Interest holders shall not receive or retain any property or interest in property on account of their Interests. Generally, after a plan has been filed with the Court, it will be sent, with a disclosure statement approved by the Court following a hearing, to members of all classes of impaired creditors for acceptance or rejection. Following acceptance or rejection of any such plan by impaired classes of creditors, the Court, after notice and a hearing, would consider whether to confirm the plan. Among other things, to confirm a plan the Court is required to find that (i) each impaired class of creditors and equity security holders will, pursuant to the plan, receive at least as much as the class would have received in a liquidation of the debtor and (ii) confirmation of the plan is not likely to be followed by the liquidation or need for further financial reorganization of the debtor or any successor to the debtor, unless the plan proposes such liquidation or reorganization. To confirm a plan, the Court generally is also required to find that each impaired class of creditors has accepted the plan by the requisite vote. If any impaired class of creditors does not accept a plan but all of the other requirements of the Bankruptcy Code are met, the proponent of the plan may invoke the so-called "cram down" provisions of the Bankruptcy Code. Under these provisions, the Court may confirm a plan notwithstanding the non-acceptance of the plan by an impaired class of creditors if certain requirements of the Bankruptcy Code are met, including that (i) at least one impaired class of claims has accepted the plan, (ii) the plan "does not discriminate unfairly" and (iii) the plan "is fair and equitable with respect to each class of claims or interests that is impaired under, and has not accepted, the plan." As used by the Bankruptcy Code, the phrases "discriminate unfairly" and "fair and equitable" have meanings unique to bankruptcy law. OTHER LEGAL PROCEEDINGS In the ordinary course of business, Levitz is party to various legal actions which it believes are routine in nature and incidental to the operation of its business. In the opinion of management, the outcome of the proceedings to which Levitz is currently party will not have a material adverse effect upon its operations or financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Prior to September 24, 1997, LFI's Common Stock was traded on the New York Stock Exchange ("NYSE"). Effective at the opening of the trading session on December 3, 1997, the NYSE formally removed from listing and registration the Common Stock of LFI pursuant to an Order, dated December 2, 1997, of the Securities and Exchange Commission granting the application for removal by the NYSE. As of June 8, 1999, there were 738 holders of record of Voting Common Stock and 7 holders of record of Non-Voting Common Stock. LFI has not paid dividends on any class of its Common Stock since 1987 and does not intend to pay dividends in the foreseeable future. LFI's only material asset is the common stock of Levitz and, therefore, its ability to pay cash dividends, interest and principal is dependent upon dividends and other payments from Levitz. LFI's ability to obtain cash from Levitz is restricted by the Bankruptcy Court, the DIP Facility, the indentures relating to Levitz's outstanding indebtedness and Florida law. The Plan of Reorganization as filed with the Bankruptcy Court on July 7, 1999 provides that all holders of equity securities and/or interests shall not be entitled to, and shall not, receive any property or interest in property on account of such equity or equity interest. The range of high and low sales prices for LFI's Common Stock as reported in the New York Stock Exchange Composite Index through September 24, 1997 and as reported by the OTC Bulletin Board (OTCBB), which is a regulated quotation service, for each quarterly period after September 24, 1997 within the two most recent fiscal years, is as follows: QUARTER ENDED HIGH LOW ------------- ---- ----- June 30, 1997 $3.000 $1.438 September 24, 1997 1.688 0.219 September 30, 1997 0.516 0.391 December 31, 1997 0.250 0.234 March 31, 1998 0.359 0.344 June 30, 1998 0.470 0.440 September 30, 1998 0.260 0.250 December 31, 1998 0.210 0.188 March 31, 1999 0.210 0.190 The Company has insufficient information to determine the accuracy of the quotations after September 24, 1997. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data has been derived from, and should be read in conjunction with, the Consolidated Financial Statements of LFI and the Notes thereto included elsewhere in this document. The only material asset of LFI is the common stock of Levitz, and it conducts no business other than holding the common stock of Levitz. See Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion should be read in conjunction with the "Selected Financial Data" and the Consolidated Financial Statements and Notes thereto appearing elsewhere in this document. GENERAL On September 5, 1997, the Debtors filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code and are presently operating their business as debtors-in-possession subject to the jurisdiction of the United States Bankruptcy Court for the District of Delaware. For further discussion of Chapter 11 proceedings, see "Item 1. Business-Chapter 11 Filing", "Item 3. Legal Proceedings" and Note 1 to Notes to Consolidated Financial Statements. The Company's consolidated financial statements have been prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities and commitments in the normal course of business. The Chapter 11 filing, related circumstances and the losses from operations, raise substantial doubt about the Company's ability to continue as a going concern. The appropriateness of reporting on the going concern basis is dependent upon, among other things, confirmation of a plan of reorganization, future profitable operations, and the ability to generate sufficient cash from operations and financing sources to meet obligations (see "Liquidity and Capital Resources" and Note 1 to "Notes to Consolidated Financial Statements"). As a result of the filing and related circumstances, however, such realization of assets and liquidation of liabilities is subject to significant uncertainty. While under the protection of Chapter 11, the Debtors may sell or otherwise dispose of assets, and liquidate or settle liabilities, for amounts other than those reflected in the accompanying consolidated financial statements. Further, a plan of reorganization could materially change the amounts reported in the accompanying consolidated financial statements. The consolidated financial statements do not include any adjustments relating to the recoverability of the value of recorded asset amounts or the amounts and classification of liabilities that might be necessary as a consequence of a plan of reorganization. Comparable store sales have declined 0.1%, 6.4% and 1.3% for the last three fiscal years ended March 31, 1999, 1998 and 1997, respectively. Comparable store sales increased 1.9% in April 1999 and decreased 2.2% and 0.9% in May and June 1999, respectively. Operating loss was $22.0 million in Fiscal 1999 and $32.2 million in Fiscal 1998. In Fiscal 1997 operating income was $16.0 million. The following table sets forth LFI's results of operations expressed as a percentage of net sales for the periods indicated: PERCENT OF NET SALES ------------------------------ YEARS ENDED MARCH 31, ------------------------------ 1999 1998 1997 ------ ------ ------ Net sales 100.0 % 100.0 % 100.0 % Cost of sales 57.6 57.5 56.6 ------ ------ ------ Gross profit 42.4 42.5 43.4 Selling, general and administrative expenses 43.0 41.5 37.9 Unusual operating expenses -- 2.0 -- Charge for store closings -- -- 0.9 Depreciation and amortization 2.7 3.0 2.9 Interest expense, net 4.5 4.9 5.9 Reorganization items 6.6 6.8 -- ------ ------ ------ Loss before income taxes (14.4) (15.7) (4.2) Income tax benefit -- 4.9 1.5 ------ ------ ------ Loss before extraordinary items (14.4) (10.8) (2.7) Extraordinary items -- (0.7) (0.2) ------ ------ ------ Net loss (14.4) (11.5) (2.9) ====== ====== ====== Comparable store sales decrease (1) (0.1)% (6.4)% (1.3)% ====== ====== ====== - -------------- (1) Comparable store sales are calculated by excluding the net sales of a store for any full month of one period if the store was not open during the same full month of the prior period. COMPARISON OF OPERATIONS FOR FISCAL 1999 TO FISCAL 1998 Net sales for Fiscal 1999 decreased to $653.1 million or 19.7% from $812.9 million for Fiscal 1998. Comparable store sales for Fiscal 1999 declined 0.1% from Fiscal 1998. Levitz closed forty-two stores during Fiscal 1999. The comparable store sales decreased 2.5% and 5.4% in the first and third quarter of Fiscal 1999, respectively. Comparable store sales increased 8.7% and 0.3% in the second and forth quarter of Fiscal 1999, respectively. The decrease in comparable store sales for the first quarter of Fiscal 1999 is primarily attributed to the announcement of fifteen store closings at the end of June 1999. The increase in comparable store sales for the second quarter of Fiscal 1999 is primarily due to the filing of a Chapter 11 petition in the same quarter of the previous year. The decrease in comparable store sales for the third quarter of Fiscal 1999 was impacted by the resumption of normal shipments during the third quarter of Fiscal 1998 which transferred sales that would have normally been recorded in the second quarter of Fiscal 1998 to the third quarter of Fiscal 1998. Gross profit for Fiscal 1999 was $276.8 million, or 42.4% of net sales, as compared to $345.4 million, or 42.5% of net sales, for Fiscal 1998. Gross profit for Fiscal 1999 includes a write-down of $4.8 million for excess, discontinued and damaged inventory in continuing stores of which $0.9 million of the reserve remained at March 31, 1999. Excluding the effect of the inventory write-down, gross profit as a percentage of net sales would have been 42.5%. Selling, general and administrative (SG&A) expenses decreased by $56.5 million or 16.8% to $280.8 million in Fiscal 1999 from $337.3 million in Fiscal 1998. The dollar decrease in SG&A expenses is primarily due to the reduction in costs attributable to the closing of forty-two stores during Fiscal 1999. The increase in SG&A in Fiscal 1999 as a percentage of net sales to 43.0% from 41.5% is due to an increase in advertising expense of 1.0%, an increase in salaries and related expenses and benefits of 0.8% as offset by an increase in the service fee income of 0.3% under Levitz's private-label credit card program. During Fiscal 1998, LFI incurred unusual operating expenses of $1.3 million under the provisions of an employment agreement due to the termination of an officer. Additionally, LFI recorded a $5.9 million write-off of the future service revenue receivable under the GECC Agreement when Levitz was required to account for the transfer of assets under the GECC Agreement as a secured borrowing with a pledge of collateral rather than as a sale for financial reporting purposes. During the fourth quarter of Fiscal 1998, the Company reviewed certain discontinued and/or slow moving inventory items which did not complement the new merchandise assortment. In an effort to accelerate the liquidation of these items, the Company reduced their selling prices. Included in unusual operating expenses is a $6.1 million charge reflecting the Company's adjustment to record this inventory at its estimated net realizable value. The Company also wrote off goodwill in the amount of $2.8 million. Depreciation and amortization expenses decreased to $17.9 million in Fiscal 1999 from $24.1 million in Fiscal 1998. The decrease is primarily attributable to the suspension of depreciation on assets of the closed stores. At the same time, the assets were written down to their net realizable value. Interest expense for Fiscal 1999 decreased to $29.5 million or 4.5% of net sales from $39.6 million or 4.9% of net sales for Fiscal 1998. Interest on pre-petition unsecured obligations has not been accrued after the Petition Date except that interest expense continues to be recorded on capital lease obligations. Contractual interest expense of $23.1 million and $13.3 million was not recorded on certain pre-petition debt for Fiscal 1999 and the period from September 5, 1997 through March 31, 1998. Reorganization items represent the costs to restructure the Company during the Chapter 11 proceedings. The following costs are included for Fiscal 1999 and 1998 (dollars in millions): 1999 1998 ------- ------- Store closings $ 42.3 $ 23.4 Loss on sale of John M. Smyth Company assets -- 22.7 Gain on sale of property held for resale (5.9) -- Deferred finance fees and other -- 2.5 Professional fees 6.6 6.9 ------- ------- $ 43.0 $ 55.5 ======= ======= Store closing charges include the write-down of assets to their net realizable value, severance pay and continuing expenses. During Fiscal 1998, LFI incurred an after-tax extraordinary loss of $5.8 million due to the write-off of deferred financing fees related to the previous bank credit agreements. As a result of the aforementioned factors, the net loss was $94.4 million or 14.4% of net sales for Fiscal 1999 as compared to $93.4 million or 11.5% of net sales for Fiscal 1998. COMPARISON OF OPERATIONS FOR FISCAL 1998 TO FISCAL 1997 Net sales for Fiscal 1998 decreased to $812.9 million or 13.7% from $941.9 million for Fiscal 1997. Comparable store sales for Fiscal 1998 declined 6.4% from Fiscal 1997. Levitz attempted to address the decrease in comparable store sales declines by (i) changing its merchandise lineup, (ii) making a concerted effort to liquidate older, discontinued merchandise, (iii) shifting its focus in advertising expenditures by media outlet to those deemed most effective, and (iv) closing certain underperforming stores to enable it to focus efforts and resources on key markets. In addition to the comparable store sales decline experienced during Fiscal 1998, the Company closed 24 under-performing stores. Gross profit for Fiscal 1998 was $345.4 million, or 42.5% of net sales, as compared to $408.3 million, or 43.4% of net sales, for fiscal 1997. The decrease in gross profit percentage of net sales is attributable to the increase in items sold at lower margins that were deleted from the merchandise assortment. Selling, general and administrative (SG&A) expenses decreased by $19.7 million or 5.5% to $337.3 million in Fiscal 1998 from $357.0 million in Fiscal 1997. The dollar decrease in SG&A expenses is primarily attributable to the reduction in costs attributable to the disposal of 24 stores during 1998. During Fiscal 1998, LFI incurred unusual operating expenses of $1.3 million under the provisions of an employment agreement due to the termination of an officer. Additionally, LFI recorded a $5.9 million write-off of the future service revenue receivable under the GECC Agreement when Levitz was required to account for the transfer of assets under the GECC Agreement as a secured borrowing with a pledge of collateral rather than as a sale for financial reporting purposes. During the fourth quarter of Fiscal 1998, the Company reviewed certain discontinued and/or slow moving inventory items which did not complement the new merchandise assortment. In an effort to accelerate the liquidation of these items, the Company reduced their selling prices. Included in unusual operating expenses is a $6.1 million charge reflecting the Company's adjustment to record this inventory at its estimated net realizable value. The Company also wrote off goodwill in the amount of $2.8 million. Depreciation and amortization expenses decreased to $24.1 million in Fiscal 1998 from $27.0 million in Fiscal 1997. The decrease is primarily attributable to the retirement of depreciable assets related to closed stores and the writeoff of all goodwill. Interest expense for Fiscal 1998 decreased to $39.6 million or 4.9% of net sales from $55.5 million or 5.9% of net sales for Fiscal 1997. Interest on prepetition unsecured obligations was not accrued after the Petition Date except that interest expense continues to be recorded on capital lease obligations. Contractual interest expense of $13.3 million was not recorded on certain prepetition debt for the period from September 5, 1997 through March 31, 1998. During Fiscal 1998, LFI recorded reorganization related expenses of $55.5 million which included $33.6 million for 24 store closings, $15.0 million for the acceleration of goodwill amortization and $6.9 million for professional services provided to LFI and the Creditors' Committee. In Fiscal 1997, Levitz closed five satellite stores which resulted in a pre-tax charge for store closings of $8.3 million. The charge includes the reduction of the carrying value of the store assets to their estimated fair value net of selling expenses as well as reserves for future rental payments under operating lease agreements. During Fiscal 1998 and 1997, LFI incurred after-tax extraordinary losses of $5.8 million and $2.0 million respectively due to the write-off of deferred financing fees related to the previous bank credit agreements. As a result of the aforementioned factors, net loss was $93.4 million or 11.5% of net sales for Fiscal 1998 as compared to $27.6 million or 2.9% of net sales for Fiscal 1997. SEASONALITY AND INFLATION Management does not believe that seasonal variation has a significant impact on its business. LFI has generally been able to pass along any price increases relating to inflation. Accordingly, the effect of inflation, if any, on LFI's results of operations has been minor. LIQUIDITY AND CAPITAL RESOURCES Cash Flows LFI's only material asset is the common stock of Levitz and, therefore, its ability to pay cash dividends, interest and principal, is dependent upon dividends and other payments from Levitz. LFI's ability to obtain cash from Levitz is restricted by the Bankruptcy Court, the DIP Facility (as defined below), the indentures relating to Levitz's outstanding indebtedness and Florida law. LFI's only outstanding obligations are $8.7 million of Senior Deferred Coupon Debentures due June 15, 2002 which includes accrued interest through September 4, 1997, that are currently classified as liabilities subject to compromise. Levitz's primary sources of liquidity are cash flows from operations (including the proceeds from customer credit obligations under the private-label credit card program by Household), trade credit and borrowings under the DIP Facility. During Fiscal 1999, cash flow used in operating activities before changes in operating assets and liabilities was $46.7 million. Cash used in operating activities for the months of June 1998 and December 1998 was $22.0 million or 47.1% of the total cash used. Both months were affected by the recording of cash reserves for store closings of $12.6 million. This was favorably offset by corresponding increase in cash provided by the change in operating assets and liabilities. Cash flows provided by changes in operating assets and liabilities was $45.6 million for Fiscal 1999. Changes in operating assets and liabilities were favorably impacted by the decrease in inventory of $46.1 million and reduction in receivables of $3.6 million primarily due to the closing of forty-two stores. The increase of accrued expenses of $10.8 million also favorably impacted operating assets and liabilities. This was due primarily to the change in payment terms for promotional discount fees under the Merchant Agreement with Household as compared to the GECC Agreement. This was offset by reductions in other accrued expenses and liabilities associated with store closings. Changes in operating assets and liabilities were unfavorably impacted by reductions of $14.9 million in trade payables and other current assets, also due primarily to the store closings. Net cash used in financing activities amounted to $14.2 million in Fiscal 1999, and includes net repayments under the DIP Facilities of $4.2 million, principal payments on long-term debt and capital lease obligations of $2.4 million and a decrease in the cash overdraft position of $7.6 million which is reflective of the decrease in inventory levels and the timing of payments. Net cash used in financing activities amounted to $19.5 million in Fiscal 1998 and included net repayments under the credit facilities of $1.4 million, principal payments on long-term debt and capital lease obligations of $11.7 million, a decrease in cash overdraft position of $3.1 million and payment of deferred financing fees for the DIP Facility of $3.2 million. Cash provided by investing activities for Fiscal 1999 includes the proceeds from the sale of eight previously closed stores. Proceeds in Fiscal 1998 include asset sales of the JMS stores, the Company's Boca Raton headquarters, and other closed facilities. All of these proceeds were applied as repayments to the DIP Facilities as required by the agreement. Levitz's capital expenditures (other than for capitalized leases) totaled approximately $7.8 million, $14.1 million and $11.0 million during Fiscal 1999, 1998 and 1997, respectively. Capital expenditures during Fiscal 1999 were for existing store improvements and equipment and the opening of one new store in May 1999. Management plans to spend approximately $7.0 million for capital expenditures in Fiscal 2000 of which approximately $2.9 million is for maintenance of existing facilities. Levitz expects to relocate one additional store in Fiscal 2000. Debt LFI and substantially all of its subsidiaries, as debtors-in-possession, are parties to a Postpetition Credit Agreement dated as of September 5, 1997 (the "DIP Facility") with BT Commercial Corporation ("BTCC") as agent. The DIP Facility was approved by the Court and included an initial commitment of $260.0 million that was comprised of revolving notes of $223.6 million and a term note of $36.4 million. Letter of Credit obligations under the revolver portion of the DIP Facility are limited to $25.0 million. The DIP Facility is intended to provide LFI with the cash and liquidity to conduct its operations and pay for merchandise shipments at normal levels during the course of the Chapter 11 proceedings. In September 1998, the DIP Facility was amended to include, among other things, a new term loan in the principal amount of $22.0 million under a second term note. The proceeds from the second term note were used to pay down the revolver portion of the DIP Facility. In December 1998, the Company obtained a waiver to the DIP Facility eliminating the minimum EBITDA requirements through March 31, 1999. In March 1999, the DIP Facility was amended to include, among other things: (1) The availability of an additional $10.0 million loan ("Overadvance Term Loan") from a third party which would be drawn if the borrowing base availability declined to $12.0 million. If drawn, the proceeds from the Overadvance Term Loan would be used to reduce borrowings under the revolver portion of the DIP Facility. (2) Set minimum EBITDA requirements for April 1999 and restrict capital expenditures through May 1999. (3) Extend the DIP Facility expiration date to June 7, 1999. In May 1999, the DIP Facility was amended to include, among other things: (1) An extension of the DIP Facility expiration date to December 31, 1999. (2) A consent to the repayment of the term notes from the net proceeds of the Sale-Leaseback Transaction. (3) The establishment of the fixed asset sublimit under the borrowing base calculation at $36.0 million, which is reduced by scheduled reductions upon disposition of specific properties and for the total elimination of the fixed asset sublimit by September 1, 1999. (4) A reduction in the total commitment under the DIP Facility to $125.0 million. (5) Minimum EBITDA requirements for June and September 1999. The May 1999 amendment was subject to the closing of the Sale-Leaseback Transaction described in Note 19 to the consolidated financial statements. On June 8, 1999, when the Sale-Leaseback Transaction was closed, the term notes of $58.4 million that accrued interest at sixteen percent were paid in full. On July 7, 1999, when the Bulk Sale Transaction was closed, net proceeds of $18.1 million were used to pay down the revolver portion of the DIP Facility. As a result of the transaction, the fixed asset sublimit was reduced to approximately $17.1 million by the amount of the net proceeds. After the closing of the Bulk Sale Transaction on July 7, 1999, the total outstanding borrowings under the DIP Facility were approximately $74.6 million and the excess availability was approximately $18.2 million. See Note 19 to the consolidated financial statements for a description of the Bulk Sale Transaction. The Company is in negotiations with its lenders to amend the DIP Facility to include, among other things, a reduction in the EBITDA requirements for June and September 1999 and the extension of the fixed asset sublimit expiration date to September 30, 1999. No assurances can be given that such amendment will be successfully negotiated. Levitz is aggressively marketing for sale additional properties. At the current time there are fourteen properties under agreement of sale, letters of intent or other types of offers estimated to be $34.3 million of gross proceeds. No assurances can be given that a sufficient number of these transactions will close prior to the expiration of the fixed asset sublimit on September 30, 1999. Based on facts and circumstances at that time, Levitz may have to request an extension of the fixed asset sublimit expiration date or obtain additional financing. No assurances can be given that an extension of the expiration date would be granted or that additional financing could be obtained. Loans made under the revolving notes bear interest, at Levitz's option, at a rate equal to either Bankers Trust Company's prime lending rate plus 1.50% or BTCC's LIBOR rate plus 3.75%. The term note bore interest at 16%. Levitz is required to pay an unused line fee of 0.50%, and a letter of credit fee of 2.0%. Levitz paid financing fees of $3.2 million on the closing date. These financing fees have been deferred and were amortized over the original life of the DIP Facility. Levitz is exposed to market risk as a result of the terms of the DIP Facility which requires the Company to pay a variable interest rate based on the fluctuation of Bankers Trust Company's prime lending rate. The change in annual cash flow and earnings resulting from a 1% increase or decrease in interest rates based on outstanding borrowings at July 7, 1999 would be approximately $0.7 million assuming other variables remained constant. The maximum borrowings, excluding the term commitments, under the DIP Facility are limited to 85% of eligible accounts receivable, 75% of eligible inventory (as defined in the DIP Facility) and a fixed asset sublimit which is permanently reduced as the proceeds from the sale of fixed assets and leasehold interests are received. Qualification of accounts receivable and inventory items as "eligible" is subject to unilateral change at the discretion of the lenders. The DIP Facility is secured by substantially all of the assets of Levitz and its subsidiaries and a perfected pledge of stock of all Levitz's subsidiaries. The DIP Facility contains restrictive covenants including, among other things, the maintenance of minimum earnings before interest, taxes, depreciation and amortization as defined (EBITDA), limitations on the incurrence of additional indebtedness, liens, contingent obligations, sales of assets, and a prohibition on paying dividends. The lenders under the DIP Facility have a super-priority administrative expense claim against the estate of the Debtors. In connection with the Plan of Reorganization, LFI expects to obtain a post-confirmation financing commitment before December 31, 1999, which would be an asset based revolving credit facility having substantially the same advance rate as the DIP Facility. LFI will seek a commitment in an amount sufficient to execute the Plan of Reorganization. There can be no assurances given that such a commitment will be obtained. All mortgages have been classified as current due to the Sale-Leaseback Transaction and Bulk Sale Transaction as described in Note 19 to the consolidated financial statements. All mortgages have been paid from the proceeds of both transactions. The Company is currently in default of the senior notes, senior deferred coupon debentures, and senior subordinated notes, all of which are unsecured and have been classified as liabilities subject to compromise. On September 4, 1998 Levitz and its operating subsidiaries entered into an agreement ("Merchant Agreement") with Household Bank (SB), N.A. ("Household") whereby Household would provide financing to individual consumers purchasing merchandise from Levitz ("Private-Label Credit Card Program"). The Court approved the Merchant Agreement and granted a first priority and security interest and lien to Household on certain reserves retained or accumulated by Household, totaling $6.1 million at March 31, 1999, and gave administrative expense status to substantially all obligations of Levitz arising under the Merchant Agreement. Also on September 4, 1998, General Electric Capital Corporation ("GECC") and Levitz terminated the Second Amended and Restated Account Purchase and Credit Card Agreement (the "GECC Agreement") which was replaced by the Merchant Agreement. Levitz and GECC jointly released each other from substantially all obligations under the GECC Agreement. At the same time GECC sold the majority of the portfolio under the GECC Agreement, approximately $561.0 million, to Household. The Company determined that the transfer of the GECC portfolio to Household qualified for sale treatment under Financial Accounting Standards Board, Statement of Accounting Standards No. 125, "Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities". Accordingly, the Receivable under Account Purchase Agreement and the offsetting Obligation Under Account Purchase Agreement were removed from the consolidated condensed balance sheets. At March 31, 1999, Household's portfolio balance was $549.8 million. The portfolio balance includes Levitz customer purchases through Household as well as customer accounts transferred to Household from GECC. Levitz recorded income from both the Merchant Agreement and the GECC Agreement of $13.2 million, $7.9 million and $12.8 million, respectively for the years ended March 31, 1999, 1998 and 1997. The decrease in recorded income for the period ended March 31, 1998 was due to the write-off of $5.9 million in future revenue service fees under the GECC Agreement as explained in Note 7 to the consolidated financial statements. Levitz is exposed to market risk under the terms of the Household Agreement. Levitz may pay a fee or may receive income, based upon the relationship among the interest earned on the portfolio, the amount of the servicing fee, the cost of capital, promotional discount fees and credit losses. Levitz is obligated for all credit losses under the portfolio, including the GECC portfolio transferred to Household, up to a maximum of 15% of average outstanding receivables and for 50% of all credit losses above 15%. Levitz is also required under the Merchant Agreement to fund a merchant risk reserve of 2.5% for the first year and 3.5% thereafter of all amounts financed up to a stipulated dollar amount. A one percent increase or decrease in the finance charge to customers or the cost of capital or the credit loss rate would increase or decrease the annual income from the portfolio by $3.5 million to $5.5 million. GOING CONCERN The Company believes that cash on hand, amounts available under the DIP Facility, as amended, and funds from operations will enable the Company to meet its current liquidity and capital expenditures requirements. On July 7 1999, the Debtors filed a "Disclosure Statement" and a "Joint Plan of Reorganization" ("Plan of Reorganization" or "Plan"), pursuant to Section 1125 of the Bankruptcy Code with the Court. The Disclosure Statement sets forth certain information regarding, among other things, significant events that have occurred during the Debtors' Chapter 11 cases and the anticipated organization, operation and financings of "Reorganized Levitz". The Disclosure Statement describes the Plan of Reorganization, certain effects of Plan confirmation, certain risk factors associated with securities to be issued under the Plan, and the manner in which distribution will be made under the Plan. In addition, the Disclosure Statement discusses the confirmation process and the voting procedures that holders of claims in impaired classes must follow for their votes to be counted. The Plan of Reorganization sets forth certain information, among other things, the classification and treatment of claims and interests, means for implementation of the Plan, acceptance or rejection of the Plan and effect of rejection by one or more classes of claims or interests, provisions for governing distributions, the treatment of executory contracts and leases, conditions precedent to confirmation of the Plan and the occurrence of the effective date of the Plan. The Plan of Reorganization provides, among other things, that as of the Plan effective date: (1) All holders of an allowed administrative and priority tax claim are unimpaired and unclassified, are not entitled to vote on the Plan and will receive cash or such other treatment as to which LFI and such creditor shall have agreed in writing. (2) All holders of an allowed other priority claim (Class 1), setoff claim (Class 2) and miscellaneous secured claim (Class 3) are unimpaired, are deemed to have accepted the Plan and, therefore not entitled to vote on the Plan and will receive cash or setoff or reinstatement or such other treatment as to which LFI and such creditor shall have agreed in writing. (3) All holders of a small unsecured claim (less than $1,000, Class 4) are impaired and are entitled to vote on the Plan and shall receive in cash 25% of the allowed amount of the claim. (4) All holders of an allowed general unsecured claim (Class 5) are impaired, are entitled to vote on the Plan and shall receive their pro rata share of the new common stock distribution of "Reorganized Levitz". (5) All holders of an allowed subordinated claim (Class 6) are impaired, are deemed to have rejected the Plan and, therefore, not entitled to vote on the Plan, and shall not receive or retain any property or interest in property on account of their subordinated claim. (6) All intercompany claims (Class 7) shall be cancelled, and their holders shall not receive or retain any property or interest in property on account of their intercompany claims. (7) All holders of Interests (the rights of any current or former holder or owner of "old equity securities" authorized and issued prior to the Plan confirmation date, Class 8) are impaired, are deemed to have rejected the Plan and, therefore, are not entitled to vote on the Plan. All Interests shall be cancelled and the Interest holders shall not receive or retain any property or interest in property on account of their Interests. In connection with the Plan of Reorganization, LFI expects to obtain a post-confirmation financing commitment before December 31, 1999, which would be an asset based revolving credit facility having substantially the same advance rate as the DIP Facility. LFI will seek a commitment in an amount sufficient to execute the Plan of Reorganization. There can be no assurances given that such a commitment will be obtained. Although the Plan of Reorganization provides for the Debtors' emergence from bankruptcy, there can be no assurances given that the Plan will be confirmed by the Court, or that such Plan will be consummated. Inherent in a successful plan of reorganization is a capital structure that permits the Company to generate sufficient cash flow after reorganization to meet its restructured obligations and fund the current obligations of the Company. Under the Bankruptcy Code, the rights and treatment of pre-petition creditors and stockholders may be substantially altered. At this time it is not possible to predict the outcome of the Chapter 11 case, in general, or the effects of such case on the business of the Company or on the interests of creditors and stockholders. YEAR 2000 LFI recognizes the need to ensure its operations will not be adversely impacted by Year 2000 technology failures. Software failures due to processing errors potentially arising from calculations using the Year 2000 date are a known risk. During Fiscal 1998, management established a team to oversee the Company's Year 2000 date conversion project. The project is composed of the following stages: 1) assessment of the problem; 2) prioritization of systems; 3) remediation activities; and 4) compliance testing. A plan of corrective action using both internal and external resources to enhance or replace the system for Year 2000 compliance has been implemented. Internal resources consist of permanent employees of the Company's Information Systems department, whereas external resources are composed of contract programming personnel that are directed by the Company's management. The majority of the financial and operating systems have been completed through remediation and are in the compliance testing stage. Since the project's beginning in Fiscal 1998, the Company has incurred approximately $1.4 million in expenses, excluding in-house salaries, wages and benefits, for hardware and software and $0.2 million for maintenance and development of operational systems to alleviate potential Year 2000 problems. The remaining expenditures are expected to be approximately $0.6 million. Purchased hardware, software and the costs of implementation are capitalized and amortized over their useful lives while other costs of remediation associated with the Year 2000 project are being expensed as incurred. The remaining cost of the Company's Year 2000 project and the dates on which the Company plans to complete the Year 2000 compliance program are based on management's current estimates, which are derived utilizing numerous assumptions. Such assumptions include, but are not limited to, the continued availability of certain resources and the readiness of third-parties through their own remediation plans. These assumptions are inherently uncertain and actual events could differ significantly from those anticipated. The Company is also communicating with vendors, financial institutions and others with which it does business to coordinate Year 2000 conversion. There can be no assurance, however, that the systems of these other companies will be converted in a timely manner, or that any such failure to convert by another company would not have an adverse effect on the Company's systems and operations. Management believes the Year 2000 compliance issue is being addressed properly by the Company to prevent any material adverse operational or financial impacts. However, if such enhancements are not completed in a timely manner, the Year 2000 issue may have a material adverse impact on the operations of the Company. The Company is currently assessing the consequences of its Year 2000 project not being completed on schedule or its remediation efforts not being successful. Management is developing contingency plans to mitigate the effects of problems experienced by the Company, key vendors or service providers related to the Year 2000. Contingency plans may include the purchase of additional levels of inventory as a precaution based on the Company's expected needs. Management expects to complete its Year 2000 contingency planning during the second quarter of Fiscal 2000. INCOME TAXES LFI has a Federal cumulative net operating loss ("NOL") carry-forward of $163.4 million as of March 31, 1999. LFI has recorded a full valuation allowance against the NOL for the fiscal year ended March 31, 1999. In prior years, LFI had recorded a deferred tax asset (benefit) for its cumulative NOL as of the fiscal year ended March 31, 1998. LFI has always provided a full valuation allowance against state net operating losses. The cumulative NOL net benefit at March 31, 1999 was $24.7 million. The Sale-Leaseback Transaction and Bulk Sale Transaction as described in Note 19 to the consolidated financial statements are estimated to utilize approximately $15.9 million of the cumulative NOL net benefit. The remaining cumulative NOL net benefit of $8.8 million is supported by deferred tax credits that are projected to turn during the carry-forward periods. LFI will continue its current practice of providing a valuation allowance against future net operating losses pending a change in financial condition. Limitations may be placed on the realization of these NOL's when LFI emerges from bankruptcy. 1999 1998 1997 ---- ---- ---- Effective Tax Rate -- 31.2% 35.2% The effective tax benefit decreased from 35.2% in Fiscal 1997 to 31.2% in Fiscal 1998 due to permanent differences arising from the write-off of goodwill and for non-deductible expenses. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGE ---- Report of Independent Public Accountants................................. 32 Consolidated Balance Sheets.............................................. 34 Consolidated Statements of Operations.................................... 35 Consolidated Statements of Stockholders' Deficit......................... 36 Consolidated Statements of Cash Flows.................................... 37 Notes to Consolidated Financial Statements............................... 38 Consolidated Financial Statement Schedule (Item 14(a))................... 80 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Levitz Furniture Incorporated: We have audited the accompanying consolidated balance sheets of Levitz Furniture Incorporated (a Delaware corporation) and subsidiaries, debtor-in-possession (the "Company") as of March 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' deficit and cash flows for each of the three years in the period ended March 31, 1999. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Levitz Furniture Incorporated and subsidiaries as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 1999, in conformity with generally accepted accounting principles. As discussed in Note 1, on September 5, 1997 the Company filed a voluntary petition for reorganization under Chapter 11 of the Federal Bankruptcy Code. The accompanying consolidated financial statements do not purport to reflect or provide for the consequences of the bankruptcy proceedings. In particular, such consolidated financial statements do not purport to show (a) as to assets, their realizable value on a liquidation basis or their availability to satisfy liabilities; (b) as to prepetition liabilities, the amounts that may be allowed and priority thereof; (c) as to stockholder accounts, the effect of any changes that may be made in the capitalization of the Company; or (d) as to operations, the effect of any changes that may be made in the business. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The Chapter 11 filing was the result of violation of certain debt covenants, recurring losses, deterioration of vendor support, and cash flow deficiencies. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Although the Company is currently operating as a debtor-in-possession under the jurisdiction of the bankruptcy court, the continuation of the business as a going concern is contingent upon, among other things, the ability to formulate a plan of reorganization which will gain approval of the creditors and confirmation by the bankruptcy court, success of future operations, the ability to obtain financing and the ability to recover the carrying amount of assets and/or the amount and classification of liabilities. Management's plans in regard to these matters are described in Note 1. The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS (CONTINUED) Our audit was made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed in the index to the consolidated financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in our audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole, considering the matter discussed in the preceding paragraph. ARTHUR ANDERSEN LLP Philadelphia, Pa. July 8, 1999 LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except share data) The accompanying notes are an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except share data) The accompanying notes are an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT (Dollars in thousands, except share data) The accompanying notes are an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) The accompanying notes are an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1999 1. CHAPTER 11 PROCEEDINGS AND BASIS OF FINANCIAL STATEMENTS PRESENTATION: On September 5, 1997 (the "Petition Date"), Levitz Furniture Incorporated, a Delaware corporation ("LFI"), and 11 of its subsidiaries (collectively, the "Debtors"), including, Levitz Furniture Corporation, a Florida corporation and wholly-owned subsidiary of LFI ("Levitz"), filed voluntary petitions for relief under Chapter 11, Title 11 of the United States Code (the "Bankruptcy Code") with the United States Bankruptcy Court (the "Court") for the District of Delaware, Wilmington, Delaware under Case No. 97-1842(MFW). Pursuant to Sections 1107 and 1108 of the Bankruptcy Code, LFI, as debtor and debtor-in-possession, has continued to manage and operate its assets and businesses pending the confirmation of a reorganization plan or plans and subject to the supervision and orders of the Court. Because LFI is operating as debtor-in-possession under Chapter 11 of the Bankruptcy Code, the existing directors and officers of LFI continue to manage the operations of LFI subject to the supervision and orders of the Court. Certain subsidiaries were not included in the Chapter 11 filings. These subsidiaries are inactive and the results of their operations and financial position are not material to the consolidated financial statements. On July 7 1999, the Debtors filed a "Disclosure Statement" and a "Joint Plan of Reorganization" ("Plan of Reorganization" or "Plan"), pursuant to Section 1125 of the Bankruptcy Code with the Court. The Disclosure Statement sets forth certain information regarding, among other things, significant events that have occurred during the Debtors' Chapter 11 cases and the anticipated organization, operation and financings of "Reorganized Levitz". The Disclosure Statement describes the Plan of Reorganization, certain effects of Plan confirmation, certain risk factors associated with securities to be issued under the Plan, and the manner in which distribution will be made under the Plan. In addition, the Disclosure Statement discusses the confirmation process and the voting procedures that holders of claims in impaired classes must follow for their votes to be counted. The Plan of Reorganization sets forth certain information, among other things, the classification and treatment of claims and interests, means for implementation of the Plan, acceptance or rejection of the Plan and effect of rejection by one or more classes of claims or interests, provisions for governing distributions, the treatment of executory contracts and leases, conditions precedent to confirmation of the Plan and the occurrence of the effective date of the Plan. The Plan of Reorganization provides, among other things, that as of the Plan effective date: (1) All holders of an allowed administrative and priority tax claim are unimpaired and unclassified, are not entitled to vote on the Plan and will receive cash or such other treatment as to which LFI and such creditor shall have agreed in writing. (2) All holders of an allowed other priority claim (Class 1), setoff claim (Class 2) and miscellaneous secured claim (Class 3) are unimpaired, are deemed to have accepted the Plan and, therefore not entitled to vote on the Plan and will receive cash or setoff or reinstatement or such other treatment as to which LFI and such creditor shall have agreed in writing. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 (3) All holders of a small unsecured claim (less than $1,000, Class 4) are impaired and are entitled to vote on the Plan and shall receive in cash 25% of the allowed amount of the claim. (4) All holders of an allowed general unsecured claim (Class 5) are impaired, are entitled to vote on the Plan and shall receive their pro rata share of the new common stock distribution of "Reorganized Levitz". (5) All holders of an allowed subordinated claim (Class 6) are impaired, are deemed to have rejected the Plan and, therefore, not entitled to vote on the Plan, and shall not receive or retain any property or interest in property on account of their subordinated claim. (6) All intercompany claims (Class 7) shall be cancelled, and their holders shall not receive or retain any property or interest in property on account of their intercompany claims. (7) All holders of Interests (the rights of any current or former holder or owner of "old equity securities" authorized and issued prior to the Plan confirmation date, Class 8) are impaired, are deemed to have rejected the Plan and, therefore, are not entitled to vote on the Plan. All Interests shall be cancelled and the Interest holders shall not receive or retain any property or interest in property on account of their Interests. Although the Plan of Reorganization provides for the Debtors' emergence from bankruptcy, there can be no assurances given that the Plan will be confirmed by the Court, or that such Plan will be consummated. The exclusivity period to prepare a plan of reorganization will expire on September 30, 1999. After the expiration of the exclusivity period, creditors will have the right to propose alternative plans of reorganization. The consolidated financial statements have been presented in accordance with the American Institute of Certified Public Accountants Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" (SOP 90-7) and have been prepared in accordance with generally accepted accounting principles applicable to a going concern, which principles, except as otherwise disclosed, assume that assets will be realized and liabilities will be discharged in the ordinary course of business. As a result of the Chapter 11 cases and circumstances relating to this event, including LFI's debt structure, its recurring losses, and current economic conditions, such realization of assets and liquidation of liabilities are subject to significant uncertainty. While under the protection of Chapter 11, the Company may sell or otherwise dispose of assets, and liquidate or settle liabilities, for amounts other than those reflected in the financial statements. Additionally, the amounts reported on the consolidated balance sheet could materially change because of changes in business strategies and the effects of any proposed plan of reorganization. The appropriateness of using the going concern basis is dependent upon, among other things, confirmation of a plan of reorganization, future profitable operations, the ability to comply with the terms of the DIP Facility and the ability to generate sufficient cash from operations and financing arrangements to meet obligations. In the Chapter 11 cases, substantially all unsecured liabilities as of the Petition Date are subject to compromise or other treatment under a plan of reorganization which must be confirmed by the Bankruptcy Court LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 after submission to any required vote by affected parties. For financial reporting purposes, those liabilities and obligations whose treatment and satisfaction is dependent on the outcome of the Chapter 11 cases have been segregated and classified as liabilities subject to compromise under reorganization proceedings in the consolidated balance sheets. Generally, all actions to enforce or otherwise effect repayment of pre-Chapter 11 liabilities as well as all pending litigation against the Debtors are stayed while the Debtors continue their business operations as debtors-in-possession. Unaudited schedules have been filed by the Debtors with the Court setting forth the assets and liabilities of the Debtors as of the Petition Date as reflected in the Debtor's accounting records. LFI has notified all known claimants subject to the August 10, 1998 bar date of their need to file a proof of claim with the Court. A bar date is the date by which claims against LFI must be filed if the claimants wish to receive any distribution in the Chapter 11 cases. Differences between amounts shown by the Debtors and claims filed by creditors are being investigated and will be either amicably resolved or adjudicated before the Court. The ultimate amount of and settlement terms for such liabilities are subject to an approved plan of reorganization and accordingly are not presently determinable. Under the Bankruptcy Code, the Debtors may elect to assume or reject real estate leases, employment contracts, personal property leases, service contracts and other prepetition executory contracts, subject to Court approval. Claims for damages resulting from the rejection of real estate leases and other executory contracts will be subject to separate bar dates. The Debtors have not reviewed all real estate leases for assumption or rejection. As of March 31, 1999, the Debtors had rejected leases for 17 store locations, reached agreement with the landlord on one store location to terminate without liability and assumed and assigned leases on three store locations without liability. The Court has extended the time for which the Debtors may assume or reject unexpired leases of nonresidential real property to August 24, 1999. The liabilities subject to compromise include a reserve for an estimated amount that may be claimed by lessors for the stores that have been closed through March 31, 1999. The Debtors will continue to analyze their real estate leases and executory contracts and may assume or reject additional leases and contracts. Such rejections could result in additional liabilities subject to compromise. 2. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: DESCRIPTION OF BUSINESS Levitz Furniture Incorporated (LFI), a Delaware Corporation, was incorporated in December 1984 for the purpose of acquiring Levitz Furniture Corporation (which together with its subsidiaries are collectively referred to as "Levitz"). Levitz is a specialty retailer of furniture with a chain of 64 stores and 21 sales support centers located in major metropolitan areas in 13 states. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of LFI and its wholly-owned subsidiaries. All material intercompany accounts and transactions are eliminated in consolidation. REVENUE RECOGNITION POLICY Levitz recognizes revenue at the time a sales order is written and the following conditions are met: the merchandise is in stock and is available for sale; for a credit sale, the credit is unconditionally approved; and for items requested to be delivered by a customer, a firm delivery date is set, and a minimum down payment is received. CASH, CASH EQUIVALENTS AND CASH OVERDRAFTS All highly liquid debt instruments purchased with original maturities of three months or less are considered to be cash equivalents. Cash overdrafts include checks outstanding that do not have the right of offset with cash and cash equivalents. The carrying value approximates fair value because of the short maturity of those instruments. INVENTORIES Inventories of furniture and accessories are stated at the lower of cost or market. In December 1998, the Company reviewed certain discontinued and/or slower moving inventory as well as damaged inventory items. Included in cost of sales is a $4.8 million charge reflecting the Company's adjustment to record this inventory at its estimated net realizable value. Cost is determined using the last-in, first-out (LIFO) method. Inventories valued on the LIFO cost method were approximately $8.8 million and $11.9 million lower than first-in, first-out (FIFO) costs at March 31, 1999 and 1998, respectively. See additional discussion in Note 7 to the consolidated financial statements. During the year ended March 31, 1999, there was a significant reduction in inventories as a result of the sale of inventory to third-party liquidators upon the closing of forty-two facilities. The reduction in inventory caused the liquidation of prior year LIFO layers. The liquidation of prior year layers at prior year prices reduced the LIFO reserve and cost of sales by $3.9 million more than would have resulted if the liquidation of the layers were measured at current year prices. PROPERTY AND EQUIPMENT, DEPRECIATION AND AMORTIZATION Property and equipment purchased by LFI are stated at cost. Capital leases are recorded at the lower of the present value of the future minimum lease obligations or fair market value of the property. Depreciation is provided substantially by the straight-line method over the estimated useful lives of the related assets. The estimated useful lives range from 10 to 40 years for buildings, building improvements and leasehold improvements, and 2 to 20 years for store, warehouse and transportation equipment. Fully depreciated assets are written off against accumulated depreciation. Capital leases are depreciated over their initial terms which generally range from 15 to 40 years. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 PROPERTY HELD FOR DISPOSAL Property held for disposal represents the net book value or net realizable value of land, buildings, leasehold improvements and leasehold interests associated with closed facilities. Property held for disposal was $32.5 million and $17.8 million at March 31, 1999 and 1998, respectively and is classified in other assets. INTANGIBLE LEASEHOLD INTERESTS Intangible leasehold interests represent the value associated with renewal terms of capital leases and original and renewal terms of operating leases acquired by LFI at rents below market value. Intangible leasehold interests are amortized by the straight-line method over the original and renewal terms of the related leases. Accumulated amortization related to intangible leasehold interests was $9.1 million and $12.3 million as of March 31, 1999 and 1998, respectively. LONG-LIVED ASSETS In Fiscal 1997, the Company adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS No. 121"). This statement requires recognition of impairment losses for long-lived assets whenever events or changes in circumstances result in the carrying amount of the assets exceeding the sum of the expected future undiscounted cash flows associated with such assets. The measurement of the impairment losses to be recognized is based on the difference between the fair values and the carrying amounts of the assets. SFAS No. 121 also requires any long-lived assets held for sale be reported at the lower of carrying amount or the fair value less selling cost. The adoption of this statement resulted in a $2.4 million charge during Fiscal 1997. GOODWILL Goodwill was written-off during the fiscal year ended March 31, 1998 due to the sale of substantially all the assets of John M. Smyth Company (JMS) on January 9, 1998 and the impaired financial condition of LFI. JMS was a wholly-owned subsidiary of Levitz. Prior to the write-off, goodwill was being amortized on a straight-line basis over forty years. INCOME TAXES LFI accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in LFI's financial statements or tax returns. In estimating future tax consequences, LFI generally considers all expected future events other than enactment of changes in the tax laws or rates. The income tax benefit generated as a result of the net loss during the year ended March 31, 1999 was fully offset by a valuation allowance. DEFERRED FINANCING FEES Deferred financing fees represent costs associated with obtaining financing arrangements. These fees were amortized over the original terms of the related debt. Accumulated amortization of the DIP LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 financing fees was $1.1 million at March 31, 1998. Net deferred financing costs as of the Petition Date of $8.4 million and $2.5 million for the senior secured facilities and for the various unsecured-debt obligations were written off during the fiscal year ended March 31, 1998 as an extraordinary item and as reorganization items, respectively. ADVERTISING EXPENSES LFI expenses all advertising costs the first time the advertising takes place including direct-response advertising. Advertising expense for fiscal years ended March 31, 1999, 1998 and 1997 was $93.4 million, $108.1 million and $102.1 million, respectively. Advertising expenditures include promotional financing fees of $28.4 million, $27.2 million and $28.3 million for fiscal years ended March 31, 1999, 1998 and 1997, respectively. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. See Note 1 regarding proceedings under Chapter 11. SELF INSURANCE LFI is generally self-insured up to a maximum of $0.2 million to $0.3 million for losses and liabilities related to worker's compensation, health and welfare claims and comprehensive general, product and vehicle liability. Losses are accrued based upon LFI's estimates of the aggregate liability for claims incurred using certain actuarial assumptions followed in the insurance industry and based on LFI's experience. STOCK-BASED COMPENSATION The Company follows Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), which provides for a fair value based method of accounting for grants of equity instruments to employees or suppliers in return for goods or services. As permitted under SFAS No. 123, the Company has elected to continue to account for compensation costs under the provisions prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." The Company has included pro forma disclosures of net loss and loss per share in Note 14 to the consolidated financial statements as if the fair value based method had been applied in measuring compensation cost. EARNINGS PER SHARE Shares outstanding from the issuance of options, warrants and restricted stock was 6,178,740, 7,293,737 and 7,811,987 for the years ended March 31, 1999, 1998 and 1997, respectively. Even though a portion of these shares may have a dilutive affect on earnings per share, all had an antidilutive impact on the Company's loss from continuing operations, and therefore, have no impact on the Company's earnings per share calculation. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 RECLASSIFICATIONS Effective March 31, 1999, LFI elected to reclassify certain revenues in its consolidated statements of operations. As a result, net sales, and selling, general and administrative ("SG&A") expenses have been restated for the fiscal years ended March 31, 1999, 1998 and 1997. LFI now reflects delivery income and miscellaneous revenue in SG&A expenses. Previously, these revenues were included in net sales. The effect of this reclassification was to reduce net sales and SG&A expenses by $19.8 million, $23.9 million and $25.0 million for the fiscal years ended March 31, 1999, 1998 and 1997, respectively. Certain other amounts in prior years' consolidated financial statements have been reclassified to conform to the current year's presentation. 3. CONSOLIDATED STATEMENTS OF CASH FLOWS: Supplemental disclosures of cash flow information (dollars in thousands): 1999 1998 1997 -------- -------- -------- Cash paid/(received) during the year for: Interest $ 26,152 $ 37,853 $ 49,678 Income tax (refunds), net 36 (2,417) (6,985) Non-cash activities: Warrants issued -- -- 600 LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 4. DEBT: Outstanding balances under debt arrangements are as follows (dollars in thousands): LFI and substantially all of its subsidiaries, as debtors-in-possession, are parties to a Postpetition Credit Agreement dated as of September 5, 1997 (the "DIP Facility") with BT Commercial Corporation ("BTCC") as agent. The DIP Facility was approved by the Court and included an initial commitment of $260.0 million that was comprised of revolving notes of $223.6 million and a term note of $36.4 million. Letter of Credit obligations under the revolver portion of the DIP Facility are limited to $25.0 million. The DIP Facility is intended to provide LFI with the cash and liquidity to conduct its operations and pay for merchandise shipments at normal levels during the course of the Chapter 11 proceedings. In September 1998, the DIP Facility was amended to include, among other things, a new term loan in the principal amount of $22.0 million under a second term note. The proceeds from the second term note were used to pay down the revolver portion of the DIP Facility. In December 1998, the Company obtained a waiver to the DIP Facility eliminating the minimum EBITDA requirements through March 31, 1999. In March 1999, the DIP Facility was amended to include, among other things: (1) The availability of an additional $10.0 million loan ("Overadvance Term Loan") from a third party which would be drawn if the borrowing base availability declined to $12.0 million. If drawn, the proceeds from the Overadvance Term Loan would be used to reduce borrowings under the revolver portion of the DIP Facility. (2) Set minimum EBITDA requirements for April 1999 and restrict capital expenditures through May 1999. (3) Extend the DIP Facility expiration date to June 7, 1999. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 In May 1999, the DIP Facility was amended to include, among other things: (1) An extension of the DIP Facility expiration date to December 31, 1999. (2) A consent to the repayment of the term notes from the net proceeds of the Sale-Leaseback Transaction. (3) The establishment of the fixed asset sublimit under the borrowing base calculation at $36.0 million, which is reduced by scheduled reductions upon disposition of specific properties and for the total elimination of the fixed asset sublimit by September 1, 1999. (4) A reduction in the total commitment under the DIP Facility to $125.0 million. (5) Minimum EBITDA requirements for June and September 1999. The May 1999 amendment was subject to the closing of the Sale-Leaseback Transaction described in Note 19 to the consolidated financial statements. On June 8, 1999, when the Sale-Leaseback Transaction was closed, the term notes of $58.4 million that accrued interest at sixteen percent were paid in full. On July 7, 1999, when the Bulk Sale Transaction was closed, net proceeds of $18.1 million were used to pay down the revolver portion of the DIP Facility. As a result of the transaction, the fixed asset sublimit was reduced to approximately $17.1 million. After the closing of the Bulk Sale Transaction on July 7, 1999, the total outstanding borrowings under the DIP Facility were approximately $74.6 million and the excess availability was approximately $18.2 million. See Note 19 to the consolidated financial statements for a description of the Bulk Sale Transaction. The Company is in negotiations with its lenders to amend the DIP Facility to include, among other things, a reduction in the EBITDA requirements for June and September 1999 and the extension of the fixed asset sublimit expiration date to September 30, 1999. No assurances can be given that such amendment will be successfully negotiated. Levitz is aggressively marketing for sale additional properties. At the current time there are fourteen properties under agreement of sale, letters of intent or other types of offers estimated to be $34.3 million of gross proceeds. No assurances can be given that a sufficient number of these transactions will close prior to the expiration of the fixed asset sublimit on September 30, 1999. Based on facts and circumstances at that time, Levitz may have to request an extension of the fixed asset sublimit expiration date or obtain additional financing. No assurances can be given that an extension of the expiration date would be granted or that additional financing could be obtained. Loans made under the revolving notes bear interest, at Levitz's option, at a rate equal to either Bankers Trust Company's prime lending rate plus 1.50% or BTCC's LIBOR rate plus 3.75%. The term note bore interest at 16%. Levitz is required to pay an unused line fee of 0.50%, and a letter of credit fee of 2.0%. Levitz paid financing fees of $3.2 million on the closing date. These financing fees have been deferred and were amortized over the original life of the DIP Facility. Levitz is exposed to market risk as a result of the terms of the DIP Facility which requires the Company to pay a variable interest rate LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 based on the fluctuation of Bankers Trust Company's prime lending rate. The change in annual cash flow and earnings resulting from a 1% increase or decrease in interest rates based on outstanding borrowing at July 7, 1999 would be approximately $0.7 million assuming other variables remained constant. The maximum borrowings, excluding the term commitments, under the DIP Facility are limited to 85% of eligible accounts receivable, 75% of eligible inventory (as defined in the DIP Facility) and a fixed asset sublimit which is permanently reduced as the proceeds from the sale of fixed assets and leasehold interests are received. Qualification of accounts receivable and inventory items as "eligible" is subject to unilateral change at the discretion of the lenders. The DIP Facility is secured by substantially all of the assets of Levitz and its subsidiaries and a perfected pledge of stock of all Levitz's subsidiaries. The DIP Facility contains restrictive covenants including, among other things, the maintenance of minimum earnings before interest, taxes, depreciation and amortization as defined (EBITDA), limitations on the incurrence of additional indebtedness, liens, contingent obligations, sales of assets, and a prohibition on paying dividends. The lenders under the DIP Facility have a super-priority administrative expense claim against the estate of the Debtors. In connection with the Plan of Reorganization, LFI expects to obtain a post-confirmation financing commitment before December 31, 1999, which would be an asset based revolving credit facility having substantially the same advance rate as the DIP Facility. LFI will seek a commitment in an amount sufficient to execute the Plan of Reorganization. There can be no assurances given that such a commitment will be obtained. All mortgages have been classified as current due to the Sale-Leaseback Transaction and Bulk Sale Transaction as described in Note 19 to the consolidated financial statements. All mortgages have been paid from the proceeds of both transactions. The Company is currently in default of the senior notes, senior deferred coupon debentures, and senior subordinated notes, all of which are unsecured and have been classified as liabilities subject to compromise. 5. LIABILITIES SUBJECT TO COMPROMISE: The principal categories of obligations classified as liabilities subject to compromise under reorganization proceedings are identified below. The amounts below in total vary significantly from the stated amount of proofs of claim that were filed by the bar date set by the Court of August 10, 1998. The difference between claim amounts scheduled by the Debtors and the claim amounts filed by creditors are being investigated and will be either amicably resolved or adjudicated before the Court. The amounts in total will be subject to future adjustment depending on Court action, further developments with respect to potential disputed claims, determination as to the value of any collateral securing claims, or other events. Additional claims may arise from the rejection of additional real estate leases and executory contracts by the Debtors. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 MARCH 31, (DOLLARS IN LIABILITIES SUBJECT TO COMPROMISE THOUSANDS) --------------------------------- ---------- Accounts payable, trade $ 38,520 Accrued expenses 15,205 13.375% Senior Notes due 10/15/98 96,031 (1) 9.625% Senior Subordinated Notes due 7/15/03 101,337 (1) Senior Deferred Coupon Debentures due 6/15/02 8,716 (1) Reserve for lease rejection claims 20,054 Executive retirement and employment agreements 16,144 General liability claims 736 Reserve for previous store closings 1,353 Common area maintenance 262 Real estate taxes 2,414 Personal property taxes 554 -------- $301,326 ======== (1) Includes accrued interest at September 4, 1997. As a result of the Chapter 11 filing, no principal or interest payments will be made on most prepetition debt without Court approval or until a plan of reorganization providing for the repayment terms has been confirmed by the Court and becomes effective. Interest on prepetition unsecured obligations has not been accrued after the Petition Date except that interest expense and principal payments will continue to be recorded on capital lease obligations unless the leases are rejected by the Debtors. If a capital lease is rejected the obligation will be limited to the lease rejection claim. Contractual interest expense of $23.1 million and $13.3 million was not recorded on certain prepetition debt for the fiscal year ended March 31, 1999 and for the period from September 5, 1997 through March 31, 1998. 6. REORGANIZATION ITEMS: During Fiscal 1999 and 1998 the Company initiated a series of actions under its reorganization proceedings to improve its performance, which included store closures and dispositions, and incurred professional fees in connection with the Bankruptcy proceedings. These reorganization items aggregated, after-tax, $43.0 million or $1.43 per share and $38.2 million or $1.28 per share, for the fiscal years ended March 31, 1999 and 1998, respectively. In Fiscal 1999, LFI closed forty-two stores in under-performing or non-strategic markets. Fifteen stores were closed in June 1998 and twenty-seven stores were closed in January 1999. In addition to the store closings, certain support functions were or are being eliminated over a period of time and fifteen warehouses, as part of the "Warehouse Rationalization Program", were closed where another warehouse in the same or adjacent market could service the store. The pre-tax charge for store and warehouse closings and the elimination of certain support functions was $42.3 million which included non-cash charges of $17.8 LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 million for the write-down of assets to their net realizable values net of capital lease obligations of $14.7 million, $7.6 million loss on the sale of inventory to liquidators and anticipated lease rejection claims of $4.3 million. Cash charges include severance pay of $3.3 million and continuing expenses of $9.3 million. At March 31, 1999 approximately $5.3 million of these reserves remained which provides for the estimated continuing expenses of the facilities until they are sold. During Fiscal 1999, LFI recognized $5.9 million in gains on the sale of eight previously closed stores. The gains were recorded as reorganizational items. During October, 1997, the Court approved a motion for Levitz to close eighteen stores in under-performing markets. The Company recorded a pre-tax charge of $23.8 million associated with the closing of these stores. The charge included non-cash items for the write-down of property, capital lease assets, furniture and fixtures to their net realizable values of $18.9 million, the loss on sale of inventory through liquidation in the amount $1.5 million and the write-down of other assets in the amount of $0.8 million. Cash items include severance pay of $1.6 million and continuing expenses of $1.0 million. Additional non-cash reorganization items written off at the same time included acceleration of goodwill amortization of $4.7 million and deferred financing fees of $2.5 million. As of March 31, 1999 approximately $0.2 million of this closing reserve remained. On January 9, 1998, Levitz sold substantially all of the assets of the John M. Smyth Company ("JMS"), a wholly-owned subsidiary of Levitz, which then operated five store locations in the Chicago, Illinois vicinity. The gross proceeds from the sale, which includes reimbursed amounts, were approximately $35.6 million. The proceeds were used to pay mortgages, accounts payable, accrued liabilities and reduce borrowings under the DIP Facilities. In December 1997, Levitz incurred a charge of $18.0 million on the sale and closing of the JMS facilities. The charge included non-cash items for loss on sale of property and equipment of $5.0 million, acceleration of goodwill amortization of $10.3 million, lease rejection claims of $1.6 million and write-off of other assets of $0.2 million. The charge included cash items of $0.3 million for severance pay and $0.6 million for continuing expenses. At March 31, 1999 approximately $0.1 million of this closing reserve remained. Net sales and operating income (loss) (exclusive of certain central office expense allocations and prior to interest expense, income taxes and reorganization items) from the forty-two stores closed in Fiscal 1999, the twenty-four stores closed or disposed of during Fiscal 1998 and the five stores closed during Fiscal 1997 (see Note 8) were (in 000's): 1999 1998 1997 --------- --------- --------- Net sales $ 138,257 $ 299,073 $ 389,232 Operating income (loss) (2,879) (24,044) 10,239 Professional fees include accounting, legal and consulting services provided to LFI and the Creditors' Committee which, subject to Court approval, are required to be paid by LFI while it is in Chapter 11. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 Fees accrued for these services totaled $6.6 million and $6.9 million in Fiscal 1999 and 1998, respectively. 7. UNUSUAL OPERATING EXPENSES: During Fiscal 1998, upon the resignation of an officer, LFI accrued severance costs (i.e., future payroll and employee benefit) of $1.3 million under the provisions of an employment agreement. Additionally, LFI recorded a $5.9 million write-off of the future service revenue receivable under the GECC Agreement when Levitz was required to account for the transfer of assets under the GECC Agreement as a secured borrowing with a pledge of collateral rather than as a sale for financial reporting purposes. The charges increased net loss by $5.0 million or $0.17 per share. During the fourth quarter of Fiscal 1998, the Company reviewed certain discontinued and/or slow moving inventory items that did not complement the new merchandise assortment. In an effort to accelerate the liquidation of these items, the Company reduced their selling prices. Included in unusual operating expenses is a $6.1 million charge reflecting the Company's adjustment to record this inventory at its estimated net realizable value. The Company also wrote off goodwill in the amount of $2.8 million. The charges increased net loss by $6.1 million or $0.20 per share. 8. STORE CLOSING AND RESTRUCTURING EXPENSE: In the fiscal year ended March 31, 1997, management developed a plan to close five stores. The stores were closed on October 31, 1996. The plan resulted in a pre-tax charge for store closings of $8.3 million. The charge includes the reduction of the carrying value of the store assets to their estimated realizable value net of selling expenses as well as reserves for future rental payments under operating lease agreements. Included in the store closing charge is a $2.4 million charge from the adoption of SFAS No. 121 effective April 1, 1996 for one of the closed stores. The charge increased net loss by $5.4 million or $0.18 per share. 9. EXTRAORDINARY ITEMS: On September 5, 1997, LFI incurred a before-tax extraordinary loss of $8.4 million on the write-off of deferred financing fees related to the termination of the previous credit facilities. The after-tax loss was $5.8 million or $0.19 per share. In the period ended December 31, 1996, LFI incurred a before-tax extraordinary loss of $3.1 million on the write-off of deferred financing fees related to the termination of the previous bank credit agreement, the after-tax loss was $2.0 million or $0.07 per share. 10. LEASING ARRANGEMENTS: Levitz leases its facilities generally under non-cancelable leases for original terms ranging from 10 to 40 years. Most leases contain renewal options and some include options to purchase the properties. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 The following is an analysis of property under capital leases by major classes (dollars in thousands): 1999 1998 -------- -------- Land, buildings and improvements $ 60,913 $177,192 Equipment -- 1,152 -------- -------- 60,913 178,344 Less- Accumulated amortization 27,610 85,623 -------- -------- $ 33,303 $ 92,721 ======== ======== Amortization expense relating to property under capital leases for the years ended March 31, 1999, 1998 and 1997 was $6.0 million, $8.3 million and $9.5 million, respectively. Minimum annual rentals on continuing stores at March 31, 1999 (net of sublease income to be received) for the five years subsequent to March 31, 1999 and in the aggregate are as follows (dollars in thousands): CAPITAL OPERATING YEAR LEASES (1) LEASES (2) ---- ----------------------------- 2000 $4,212 $ 24,430 2001 4,095 25,156 2002 4,007 24,240 2003 4,007 23,435 2004 4,007 21,307 Thereafter 72,075 248,720 ----------- -------------- Total minimum lease payments 92,403 $367,288 ============== Less - Amount representing interest 62,417 ----------- Present value of net minimum payments under capital leases 29,986 Less - Current portion of continuing leases 618 ----------- $29,368 =========== (1) Minimum annual rentals for capital leases have been reduced for those leases included in the Sale-Leaseback Transaction described in Note 19 to the consolidated financial statements. Capital leases included in the Sale-Leaseback Transactions were determined to be treated as operating leases in accordance with SFAS No. 13, "Accounting for Leases". Consequently, the total capital lease obligations of $9.1 million for those leases has been classified as current liabilities at March 31, 1999 as this obligation will be retired upon closing of the Sale-Leaseback Transaction and the future minimum annual rentals for those leases are included with operating leases. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 (2) Minimum annual rentals of operating leases include rentals for those capital leases included in the Sale-Leaseback Transaction and the Unitary Lease Agreement as described in Note 19 to the consolidated financial statements. The minimum annual rentals for the Unitary Lease Agreement are as follows (dollars in thousands): OPERATING YEAR LEASES ---------------- -------------- 2000 $ 5,889 2001 7,235 2002 7,235 2003 7,235 2004 7,235 Thereafter 118,386 ------------- $ 153,215 ============= Rent expense includes minimum rentals on operating leases, contingent payments based on either the Consumer Price Index or a percentage of sales for both capital and operating leases and amortization of intangible leasehold interests. Rent expense consists of the following (dollars in thousands): 1999 1998 1997 -------- -------- -------- Rent expense $ 18,630 $ 23,835 $ 24,567 Sublease income (810) (519) (888) -------- -------- -------- Rent expense, net $ 17,820 $ 23,316 $ 23,679 ======== ======== ======== Some rental agreements contain escalation provisions that may require higher future rent payments. Rent expense incurred under rental agreements that contain fixed escalation clauses is recognized on a straight-line basis over the life of the lease. 11. PRIVATE-LABEL CREDIT CARD PROGRAM: On September 4, 1998 Levitz and its operating subsidiaries entered into an agreement ("Merchant Agreement") with Household Bank (SB), N.A. ("Household") whereby Household would provide financing to individual consumers purchasing merchandise from Levitz ("Private-Label Credit Card Program"). The Court approved the Merchant Agreement and granted a first priority and security interest and lien to Household on certain reserves retained or accumulated by Household, totaling $6.1 million at March 31, 1999, and gave administrative expense status to substantially all obligations of Levitz arising under the Merchant Agreement. Also on September 4, 1998, General Electric Capital Corporation ("GECC") and Levitz terminated the Second Amended and Restated Account Purchase and Credit Card Agreement (the "GECC Agreement") which was replaced by the Merchant Agreement. Levitz and GECC jointly released each other from substantially all obligations under the GECC Agreement. At the LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 same time GECC sold the majority of the portfolio under the GECC Agreement, approximately $561.0 million, to Household. The Company determined that the transfer of the GECC portfolio to Household qualified for sale treatment under Financial Accounting Standards Board, Statement of Accounting Standards No. 125, "Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities". Accordingly, the Receivable under Account Purchase Agreement and the offsetting Obligation under Account Purchase Agreement were removed from the consolidated balance sheets. At March 31, 1999, Household's portfolio balance was $549.8 million. The portfolio balance includes Levitz customer purchases through Household as well as customer accounts sold to Household by GECC. Levitz recorded income from both the Merchant Agreement and the GECC Agreement of $13.2 million, $7.9 million and $12.8 million, respectively for the years ended March 31, 1999, 1998 and 1997. Levitz is exposed to market risk under the terms of the Household Agreement. Levitz may pay a fee or may receive income, based upon the relationship among the interest earned on the portfolio, the amount of the servicing fee, the cost of capital, promotional discount fees and credit losses. Levitz is obligated for all credit losses under the portfolio, including the GECC portfolio transferred to Household, up to a maximum of 15% of average outstanding receivables and for 50% of all credit losses above 15%. Levitz is also required under the Merchant Agreement to fund a merchant risk reserve of 2.5% for the first year and 3.5% thereafter of all amounts financed up to a stipulated dollar amount. A one percent increase or decrease in the finance charge to customers or the cost of capital or the credit loss rate would increase or decrease the annual income from the portfolio by $3.5 million to $5.5 million. Included in the consolidated balance sheets for the years ended March 31, are (dollars in thousands): (1) The net receivable/payable represents amounts due from or owed to Household on the settlement of portfolio earnings from the previous month and customer accounts that were submitted to Household for purchase. In Fiscal 1998, the amount was due to GECC. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 (2) The merchant risk reserve is the amounts paid to Household in case the Merchant Agreement is terminated or Levitz would discontinue operations. The cash can be returned to Levitz if a letter of credit is posted or Levitz emerges from bankruptcy and meets certain financial covenants. The amount is included in other long-term assets on the consolidated balance sheets. (3) The promotional discount accrual represents the estimated interest that will be charged back to Levitz for those customers that are likely to take advantage of a "no-interest" finance promotion at their time of purchase. Levitz is required to make payments of the estimated amount on a monthly basis. Under the GECC Agreement these amounts were paid in advance. This accrual is included in accrued liabilities and other expenses on the consolidated balance sheets. In addition to the above, Levitz has funded a credit loss reserve of $33.9 million through the monthly settlement of portfolio earnings as of March 31, 1999 which is not on the consolidated balance sheets. 12. INCOME TAXES: LFI has a Federal cumulative net operating loss ("NOL") carry-forward of $163.4 as of the fiscal year ended March 31, 1999. LFI has recorded a full valuation allowance against the NOL for the fiscal year ended March 31, 1999. In prior years, LFI had recorded a deferred tax asset (benefit) for its cumulative NOL as of the fiscal year ended March 31, 1998. LFI has always provided a full valuation allowance against state net operating losses. The cumulative NOL net benefit at March 31, 1999 was $24.7 million. The Sale-Leaseback Transaction and Bulk Sale Transaction as described in Note 19 to the consolidated financial statements are estimated to utilize approximately $15.9 million of the cumulative NOL net benefit. The remaining cumulative NOL net benefit of $8.8 million is supported by deferred tax credits that are projected to turn during the carry-forward periods. LFI will continue its current practice of providing a valuation allowance against future net operating losses pending a change in financial condition. Limitations may be placed on the realization of these NOL's when LFI emerges from bankruptcy. Federal NOL carry-forwards are available through Fiscal 2019. The benefit for income taxes was allocated as follows (dollars in thousands): 1999 1998 1997 -------- -------- -------- Loss before extraordinary items $ -- $(39,687) $(13,921) Extraordinary items -- (2,630) (1,090) -------- -------- -------- $ -- $(42,317) $(15,011) ======== ======== ======== LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 The components of the benefit for income taxes applicable to loss before extraordinary items is (dollars in thousands): 1999 1998 1997 -------- -------- -------- Current: Federal $ -- $ -- $ (1,275) State 52 57 13 -------- -------- -------- 52 57 (1,262) -------- -------- -------- Deferred: Federal -- (35,249) (11,137) State (52) (4,495) (1,522) -------- -------- -------- (52) (39,744) (12,659) -------- -------- -------- $ -- $(39,687) $(13,921) ======== ======== ======== A reconciliation of the statutory benefit for income taxes on loss before extraordinary items to the actual tax benefit is as follows (dollars in thousands): 1999 1998 1997 -------- -------- -------- Computed income tax benefit at Federal statutory rate $(33,056) $(44,544) $(13,393) State and local income tax benefit, net of federal income tax (5,676) (7,108) (3,676) Permanent differences 2,938 6,797 182 Federal valuation allowance 31,388 1,072 -- State valuation allowance 7,198 4,223 2,680 Other (2,792) (127) 286 -------- -------- -------- $ -- $(39,687) $(13,921) ======== ======== ======== LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 Components of the deferred income tax assets and liabilities are (dollars in thousands): 13. EMPLOYEE BENEFIT PLANS: Levitz has a non-contributory, defined benefit plan (the Pension Plan). In March 1996, Levitz amended the Pension Plan to exclude future benefit accruals for credited service and annual earnings after March 31, 1996 and also excluded any associate from becoming a participant in the plan after January 1, 1996 (Pension Curtailment). Pension benefits are based on length of service and final average compensation as of the Pension Curtailment date and are integrated with Social Security. The maximum pension benefit per individual is limited to $130,000 per year. Plan assets consist primarily of marketable equity and debt securities and cash equivalents. Levitz's funding policy is to make the minimum annual contributions required by applicable regulations. Certain officers of Levitz are participants in an unfunded non-contributory supplemental executive retirement plan (SERP) and a life insurance plan. The SERP provides supplemental retirement, disability and/or death benefits. Retirement and disability benefits are equal to 4.0% of the highest consecutive five-year average of salary plus bonus paid for each year of service, limited to a maximum of 60% of compensation or $0.3 million on an indexed basis. Death benefits are equal to 3% per year of service to a maximum of 45% of such compensation. Benefits are subject to a dollar-for-dollar reduction for benefits paid under the Pension Plan, Social Security and certain other LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 specified pension plan payments. The liability for the SERP and insurance plan is included in liabilities subject to compromise. The table below reconciles the funded status of the plans with the amounts recognized in the consolidated balance sheets (dollars in thousands): (1) Included in settlements above for Fiscal 1999 are obligations related to inactive employees which are included in liabilities subject to compromise. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 The tables below list the weighted average assumptions and the components of periodic (benefit) costs (dollars in thousands): ASSOCIATES SAVINGS PLAN Levitz has savings plans which were adopted under Section 401(k) of the Internal Revenue Code. Under the provisions of the Associates Savings Plans, substantially all employees who meet the age and service requirements of the plan are entitled to defer a certain percentage of their compensation. Levitz contributed to the fund 30% of the first 6% beginning January 1, 1999 and 20% of the first 6% beginning January 1, 1998 and 1997 subject to certain limitations. Such matching contributions of $0.6 million, $0.8 million and $0.9 million were made by Levitz for the years ended March 31, 1999, 1998 and 1997, respectively. 14. CAPITAL STOCK, STOCK OPTION PLANS, RIGHTS AND STOCK WARRANTS: COMMON STOCK As of March 31, 1999 LFI had 30,320,628 shares of Common Stock issued and 30,071,621 shares outstanding. 26,565,234 shares were voting stock and 3,573,662 shares were non-voting stock. The Plan of Reorganization filed by the Company on July 7, 1999 does not provide for any distribution to existing stockholders. RESTRICTED STOCK LFI contracted to issue 700,000 shares of restricted stock to certain key employees during the fiscal year ended March 31, 1996. These shares of restricted stock were issued in the fiscal year ended March 31, 1997. The total market value at the effective date of grant was recorded as deferred compensation, a separate component of stockholders' deficit. The deferred compensation was charged to selling, general and administrative expenses over the three-year vesting period. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 STOCK OPTIONS In May 1993, LFI adopted an Executive Long-Term Incentive Plan (Plan), which provides for incentive awards to include the issuance of stock options. The Plan provides that the stock option price shall not be less than the fair market value of the shares on the date of grant and that no portion of the options may be exercised beyond ten years from that date. Options are exercisable in various increments starting one year from date of grant. LFI accounts for these plans under APB Opinion No. 25, "Accounting for Stock Issued to Employees", under which no compensation expense is recognized because the exercise price of stock options granted equals the market price of the underlying stock on the date of grant. Had compensation costs for these plans been determined consistent with FASB Statement No. 123, LFI's net loss and net loss per common share would have been adjusted to the following pro forma amounts (dollars in thousands, except per share data): 1999 1998 1997 -------- -------- -------- Net loss As reported ($94,444) ($93,387) ($27,586) Pro forma (94,586) (94,291) (29,332) Net loss per common share As reported $3.15 ($3.12) ($0.93) Pro forma (3.15) (3.15) (0.98) Because the FASB Statement No. 123 method of accounting has not been applied to options granted prior to April 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. The fair value of each option granted is estimated at the date of grant using the Black-Scholes option pricing model. The following weighted-average assumptions were used for grants in the fiscal years ended March 31: 1999 1998 1997 ----------- ---------- ----------- Risk free interest rates 0.00% 6.30% 6.61% Expected life (in years) 0 6 6 Expected volatility 0.00% 64.77% 71.22% Expected dividends None None None LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 EMPLOYEE STOCK OPTIONS Employee Stock Option Plans are summarized as follows: The following table summarizes information concerning outstanding and exercisable employee options at March 31, 1999: On November 25, 1996, LFI repriced 284,000 shares of stock options previously granted with option prices ranging from $9.06 to $12.31 to the market value of the stock on November 25, 1996 of $3.63. All other conditions of the stock options remained the same. The repricing is included as a cancellation and new grant of options during 1997 in the above table. On August 20, 1996 at the Annual Stockholders Meeting, the stockholders approved an amendment to the Plan to increase the number of shares of Common Stock authorized for issuance thereunder to 2,881,031 shares and to limit the maximum number of shares granted to any participant to 500,000 shares in each fiscal year. DIRECTORS STOCK OPTIONS In addition, LFI has adopted a Non-qualified Non-Employee Directors Stock Option Plan. The Plan provides that the stock option price shall not be less than the fair market value of the shares on the date of grant and that no portion of the options may be exercised beyond ten years from the date of grant. Options are exercisable in various increments starting one year from date of grant. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 Directors' Option Plans are summarized as follows: The following table summarizes information concerning outstanding and exercisable director's options at March 31, 1999: RIGHTS In May 1993, the Board of Directors adopted a Rights Agreement which declared a dividend distribution of one Right for each outstanding share of LFI's Common Stock effective with the close of the Offering. Each Right entitles the registered holder to purchase from LFI one one-hundredth of a share of Series A Junior Participating Preferred Stock at a purchase price of $50 per share. The Rights are exercisable at specified number of days following (i) a public announcement that a person or group of persons has acquired or obtained the right to acquire beneficial ownership of 15% or more of LFI's outstanding Common Stock or (ii) the commencement of a tender offer or exchange offer that would result in persons acquiring 15% or more of LFI's outstanding Common Stock. LFI has reserved 1,000,000 shares, $1 par value, of Series A Junior Participating Preferred Stock for issuance upon exercise of the Rights. The Rights may be redeemed by LFI, subject to the approval of the Board of Directors, for $0.01 per Right in accordance with the provisions of the Rights Agreement. If the Rights are not redeemed, the holder of the Rights may purchase stock of LFI (or in certain circumstances, stock of an acquiring person) for approximately half its value. The Rights will expire on July 2, 2003, unless redeemed earlier by LFI. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 STOCK WARRANTS In March 1996, LFI issued warrants to purchase 283,972 shares of LFI Common Stock at an exercise price equal to $3.89 per share as part of an exchange offer in which Levitz issued $91.6 million aggregate principal amount of 13.375% Senior Notes due October 15, 1998 for $91.6 million principal amount of 12.375% Senior Notes due April 15, 1997. The warrants were revalued at $0.7 million which was being amortized as interest expense over the life of the 13.375% Senior Notes until the Petition Date. The warrants expire on March 25, 2001. In July 1996, LFI issued warrants to purchase up to 5,000,000 shares of LFI Common Stock, subject to downward adjustments if certain targeted stock prices of LFI were not achieved and other anti-dilution provisions. The exercise price as of June 19, 1998 was $0.01 per share. The warrants were issued as part of a refinancing in July 1996. The warrants were valued at $0.6 million and were amortized as interest expense over the original life of the DIP Facility which replaced the previous financing. The warrants expire on July 1, 2001. 15. ACCRUED EXPENSES AND OTHER LIABILITIES (DOLLARS IN THOUSANDS): 1999 1998 ------- ------- Payroll $ 9,394 $12,510 Payroll and sales taxes 4,843 4,547 Real estate taxes 3,238 2,809 Interest 2,615 1,687 Promotional discount accrual 21,460 3,127 Workers Compensation 6,708 7,663 Other 25,721 23,504 ------- ------- $73,979 $55,847 ======= ======= 16. COMMITMENTS AND CONTINGENCIES: As a result of the bankruptcy filing, the initiation of litigation against the Debtors involving matters arising prior to the filing for bankruptcy is stayed. Such stay may be lifted by the Bankruptcy Court in appropriate circumstances. Levitz has employment agreements with seven officers. Each of these agreements is for an initial term of eighteen months and will be automatically renewed for an additional twelve months unless either party gives prior written notice of intent to terminate the agreement. The agreements provide that if the officer is terminated by Levitz other than for Cause (as defined in the agreements) or disability or by the officer for Good Reason (as defined in the agreements), Levitz must continue to pay such officer's base salary for eighteen months and, for certain of the officers, would be required to credit such officer with three years of additional service and age for purposes of Levitz's SERP. In the event of such termination following a Change in Control (as defined in the agreements), Levitz must pay such officer a lump sum amount equal to one and one-half times his or her annual base salary. Each agreement also contains certain non-competition provisions. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 LFI is subject to a number of lawsuits, investigations and claims arising out of the normal conduct of its business, including those relating to government regulations, general and product liability and employee relations. Although there are a number of actions pending against LFI as of March 31, 1999, in the opinion of Management such actions as currently known would not have a material effect on the financial position of LFI. 17. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED): The following is a summary of LFI's unaudited quarterly results of operations for the years ended March 31, 1999 and 1998: (1) See Note 6 to consolidated financial statements. (2) See Notes 1, 5, 6 and 7 to consolidated financial statements. (3) See Note 9 to consolidated financial statements. LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 18. FAIR VALUE OF FINANCIAL INSTRUMENTS: The carrying amounts and fair values of LFI's financial instruments at March 31, 1999 and 1998, were as follows (dollars in thousands): The carrying amounts of cash and cash equivalents approximate fair value because of the short maturity of these instruments. The fair value of LFI's long-term debt, including current maturities, is estimated based on the quoted market prices for the same or similar issues. The contract amount of the letter of credit approximates its fair value. The fair value of the Company's liabilities subject to compromise are not presently determinable as a result of the Chapter 11 proceedings. 19. SUBSEQUENT EVENTS: On June 8, 1999, Levitz sold 11 owned properties and leasehold interests and/or rights on 11 leased properties for gross proceeds of $67.3 million ("Contract of Sale"). Net proceeds, which excludes closing costs, of $67.1 million were used to pay-off existing mortgages and related accrued interest, default interest and other fees of $7.6 million; the term notes under the DIP Facility including accrued interest, extension fees and other fees of $59.2 million and cure costs relating to pre-petition liabilities of $0.3 million. The aggregate carrying value of these properties of $72.2 million was classified as property under agreement of sale at March 31, 1999. Capital lease obligations relating to these properties were $9.1 million as of March 31, 1999 which were classified as current. The gain on the sale of owned property and leasehold interests of approximately $2.2 million, subject to further adjustment, will be amortized over the initial term of the "Unitary Lease Agreement" as described below. As part of the Contract of Sale, the purchaser escrowed an additional $1.0 million to be paid to Levitz on January 1, 2000 subject to Levitz's emergence from bankruptcy by December 31, 1999. In addition, the Contract of Sale places certain limitations on Levitz incurring new unsecured debt following the approval of a plan of reorganization. At the same time, Levitz entered into a Unitary Lease Agreement to lease back all of the owned property as well as the property where the leasehold interest was sold ("Sale-Leaseback Transaction"). The Unitary Lease Agreement is for an initial term of twenty years with three additional option periods of five years each. Rent is payable monthly, in advance, calculated at 10.75% of the gross proceeds for the first five LEVITZ FURNITURE INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) MARCH 31, 1999 years of the initial term with incremental increases of 5% after each five year period of the initial terms and all option periods. The Unitary Lease requires Levitz to assume all obligations for payments and lease terms under the original leases ("the Overleases"). The Unitary Lease allows Levitz to exercise a right to vacate or surrender all or a portion of the lease space of the properties by giving notice on or before the two year anniversary of the Unitary Lease Agreement and vacating within three years. In some instances, there is also a requirement that Levitz must vacate the warehouse portion and/or the showroom portion of some of the properties by specified dates. Levitz would receive a pro rata reduction in the Unitary Lease rent at the time it vacates the entire property and would be released of all payment obligations for the Overlease in the instances described above. The cash effect for the first twelve month period as the result of the Sale-Leaseback Transaction is approximately (dollars in thousands): Decrease in interest on term notes $ 9,337 Decrease in mortgage payments 1,196 Increase in rent payments (7,235) ---------- Total cash effect $ 3,298 ========== On July 7, 1999, Levitz sold five owned properties and leasehold interests/rights in six properties, all of which locations had previously been closed. The gross proceeds from the transaction were $19.8 million (the "Bulk Sale Transaction"). Net proceeds of approximately $19.4 million, excluding closing costs, were used to pay-off existing mortgages and accrued interest of $0.6 million, cure costs relating to pre-petition liabilities of $0.3 million, proration of real estate taxes and other costs of $0.4 million and to pay down the revolver portion of the DIP Facility of approximately $18.1 million. The Bulk Sale Transaction relieved Levitz of all lease obligations for the leased properties. The aggregate carrying value of these properties of $20.3 million was classified as property under agreement of sale at March 31, 1999. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The following table sets forth, as of June 8, 1999, the name, age, position at LFI and Levitz and principal occupation or employment for the past five years, of the directors and executive officers of LFI and Levitz. Each of such persons is a citizen of the United States. None of the directors or executive officers is related to each other. The Board of Directors of LFI is divided into three classes serving staggered three-year terms. The terms of office of Messrs. Harrell, Leadbetter and Moelis have expired in prior years; however, because the Company did not hold an Annual Meeting of Stockholders since 1996, such directors continue in office until their successors are elected. The term of office of Mr. Reiling expires in 1999. Directors who are employees of LFI or Levitz do not receive any compensation for serving on the Board of Directors of either LFI or Levitz. Directors who are not employees of LFI or Levitz receive $15,000 in compensation annually. Audit and Compensation Committee members receive $1,000 for each committee meeting attended and each committee chairman receives an additional $5,000 per year for serving as chairman. Pursuant to the Company's Non-Employee Directors' Stock Option Plan, following the Company's Annual Meeting of Stockholders, each director who is not an employee of the Company receives an annual grant of an option to purchase 2,000 shares of the Company's Common Stock. Such directors may also elect to receive options to purchase shares of the Company's Common Stock in lieu of their yearly retainer fee. The exercise price of all options granted pursuant to this plan will be set at the average of the high and low prices of the Common Stock on the date of grant. The term of each option is ten years from date of grant. Annual grant options are exercisable as to one-third of the shares subject to the option on each of the first, second and third anniversary of the grant. Elective grant options are exercisable six months after the grant. LFI has entered into indemnification agreements with each of its officers and directors. The indemnification agreements provide that LFI shall indemnify the officers and directors to the fullest extent permitted by law against any and all expenses, judgments, fines, penalties and settlement amounts paid or incurred in any threatened, pending or completed action, suit or proceeding related to their service as a director, officer, employee, agent or fiduciary of LFI with another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise when they are serving at the request of LFI. LFI's Restated Certificate of Incorporation also provides for certain indemnification rights. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following summary compensation table sets forth information regarding the annual and long-term compensation awarded or earned for each of the last three fiscal years to those persons who were, for the fiscal year ended March 31, 1999, the Chief Executive Officer and the four other most highly compensated executive officers. Mr. Grund was not employed by the Company prior to the 1999 fiscal year and Mr. McCreery was not employed by the Company prior to the 1998 fiscal year. Accordingly, no information is set forth with respect to these individuals for the prior year(s). - ------------- (1) Included in this column for the fiscal year ended March 31, 1999 are matching contributions paid pursuant to Levitz's Associates' Savings Plan to Messrs. Bozic, McCreery, Zimmer, Mazzoni and Masullo in the amounts of $735, $634, $2,271, $2,256, and $2,047, respectively, and the dollar value attributable to life insurance premiums paid on behalf of Messrs. Grund, Bozic, Homler, McCreery, Zimmer, Mazzoni and Masullo in the amounts of $5,147, $35,631, $6,191, $5,438, $3,199, $3,386 and $5,732, respectively. (2) Pursuant to the terms of his employment agreement with the Company, Mr. Grund received a guaranteed bonus of $100,000 for the fiscal year ended March 31, 1999 plus a $100,000 signing bonus. (3) Represents relocation expenses paid by the Company. (4) Includes $80,772 of payments for termination of employment agreement. (5) Pursuant to the terms of his employment agreement with the Company, Mr. Homler received a guaranteed bonus of $70,000 for the fiscal year ended March 31, 1998 plus a $25,000 signing bonus. (6) Represents perquisites and other personal benefits of which $33,500 is attributable to relocation expenses. (7) Pursuant to the terms of his employment agreement with the Company, Mr. McCreery received a guaranteed bonus of $50,000 for the fiscal year ended March 31, 1999 and $50,000 signing bonus for fiscal year ended March 31, 1998. OPTION GRANTS IN THE LAST FISCAL YEAR There were no grants of stock options in the fiscal year ended March 31, 1999. AGGREGATE OPTIONS EXERCISED IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES None of the officers exercised any options in the fiscal year ended March 31, 1999. The following table provides information on the number of options held by the executive officers named in the Summary Compensation Table. Messrs. Grund, Bozic, Homler and McCreery hold no options. LEVITZ RETIREMENT PLANS Certain officers (a total of seven persons) are participants in the Levitz Furniture Corporation Employees Retirement Plan (the "Retirement Plan") and the Levitz Furniture Corporation Supplemental Executive Retirement Plan (the "Supplemental Plan"). After March 31, 1996 no additional benefits accrue under the Retirement Plan. Retirement and disability benefits pursuant to the Supplemental Plan are equal to 4% of the highest five-year average of salary plus bonus for each year of service to a maximum of 15 years of service. The retirement benefit of a participant who terminates service prior to age 65 is, except under certain circumstances, subject to reduction. Benefits are subject to a dollar-for-dollar reduction for similar benefits paid under the Retirement Plan, pension plans of other employers and Social Security. Retirement and disability benefits under the Supplemental Plan are limited to a 1999 maximum of $491,577 per year, to be increased annually by the average increase in annual salary for Supplemental Plan participants. The following table shows annual benefits payable (before offsets) under the Supplemental Plan and the Retirement Plan to participants at age 65 in specified years of service and remuneration classes: Pension Plan Table YEARS OF SERVICE(2) -------------------------------------------- REMUNERATION(1) 10 15 OR MORE AT AGE 65 --------------- -------------- -------------------- $200,000 $80,000 $120,000 300,000 120,000 180,000 400,000 160,000 240,000 500,000 200,000 300,000 600,000 240,000 360,000 - -------------- (1) For the fiscal year ended March 31, 1999, remuneration equaled the amount listed for each executive officer under "Annual Compensation" in the Summary Compensation Table. (2) As of March 31, 1999, Messrs. Grund and McCreery had less than two years of service and the remaining listed executive officers had more than 15 years of service under the Supplemental Plan. EMPLOYMENT AGREEMENTS Levitz has employment agreements with each of the named executive officers listed in the Summary Compensation Table on page 68. Each of these agreements is for an initial term of eighteen months and will be automatically renewed for an additional twelve months unless either party gives prior written notice of intent to terminate the agreement. The agreements provide that if the officer is terminated by Levitz other than for Cause (as defined in the agreements) or disability or by the officer for Good Reason (as defined in the agreements), Levitz must continue to pay such officer's base salary for eighteen months and, for certain of the officers, would be required to credit such officer with three years of additional service and age for purposes of Levitz's Supplemental Plan. In the event of such termination following a Change in Control (as defined in the agreements), Levitz must pay such officer a lump sum amount equal to one and one-half times his or her annual base salary. Each agreement also contains certain non-competition provisions. In the event of termination at their current salary, the current executive officers listed in the Summary Compensation Table would receive the following total compensation pursuant to the above-described employment agreements: Mr. Grund, $637,572, Mr. McCreery, $450,060, Mr. Zimmer, $292,500, Mr. Mazzoni, $277,524 and Mr. Masullo, $262,548. These amounts assume payments for 18 months at current salaries. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT PRINCIPAL STOCKHOLDERS As of June 8, 1999, the Common Stock was held of record by 745 stockholders. The following table sets forth certain information concerning the beneficial ownership of Common Stock by each stockholder who is known by the Company to own beneficially in excess of 5% of the outstanding Common Stock, by each director, by the executive officers named in the Summary Compensation Table above, and by all directors and executive officers as a group, as of the Record Date. Except as otherwise indicated, all persons listed below have (i) sole voting power and investment power with respect to their shares of Common Stock, except to the extent that authority is shared by spouses under applicable law, and (ii) record and beneficial ownership with respect to their shares of Common Stock. * Less than 1.0% (1) Includes Voting Common Stock and Non-Voting Common Stock. The Non-Voting Common Stock is identical to the Voting Common Stock in all respects, except that the Non-Voting Common Stock is non-voting and is convertible into Voting Common Stock. On June 8, 1999, there were 26,497,959 shares of Voting Common Stock and 3,573,662 shares of Non-Voting Common Stock outstanding, which were held by 738 and 7 holders of record, respectively. (2) Represents warrants to purchase 5,000,000 shares of Common Stock. (3) CSCL is an indirect wholly-owned subsidiary of Citicorp. Of these shares 3,484,888 are Non-Voting Common Stock. (4) Includes beneficial ownership of 6,000 shares which may be acquired within 60 days pursuant to stock option grants. (5) Includes beneficial ownership of 17,247 shares which may be acquired within 60 days pursuant to stock option grants. (6) Consists solely of beneficial ownership of shares which may be acquired within 60 days pursuant to stock option grants. (7) Includes beneficial ownership of 17,247 shares which may be acquired within 60 days pursuant to stock option grants. Also includes 2,250 shares held in trust for members of Mr. Reiling's family. Mr. Reiling disclaims beneficial ownership of such shares held by members of his family. (8) Includes beneficial ownership of 75,000 shares which may be acquired within 60 days pursuant to stock option grants. (9) Includes beneficial ownership of 206,143 shares which may be acquired within 60 days pursuant to stock option grants and other shares as to which beneficial ownership is disclaimed. (10) Includes beneficial ownership of 236,250 shares which may be acquired within 60 days pursuant to stock option grants and other shares as to which beneficial ownership is disclaimed. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Directors who are employees of the Company or Levitz do not receive any compensation for serving on the Board of Directors of either the Company or Levitz. Directors who are not employees of the Company or Levitz receive $15,000 in compensation annually. Audit and Compensation Committee members receive $1,000 for each committee meeting attended and each committee chairman receives an additional $5,000 per year for serving as chairman. Pursuant to the Company's Non-Employee Directors' Stock Option Plan, each director who is not an employee of the Company, following the Company's Annual Meeting of Stockholders, receives an annual grant of an option to purchase 2,000 shares of the Company's Common Stock. Such directors may also elect to receive options to purchase shares of the Company's Common Stock in lieu of their yearly retainer fee. The exercise price of all options granted pursuant to this plan will be set at the average of the high and low prices of the Common Stock on the New York Stock Exchange on the date of grant. The term of each option is ten years from date of grant. Annual grant options are exercisable as to one-third of the shares subject to the option on each of the first, second and third anniversary of the grant. Elective grant options are exercisable six months after the grant. Court Square Capital, Ltd. owns 19.2% of the Company's Common Stock. Court Square Capital, Ltd. also owns the capital stock of Furniture Comfort Corporation, which, in the ordinary course of business, sold $31.3 million of merchandise to Levitz in Fiscal 1999. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES & REPORTS ON FORM 8-K (a) FINANCIAL STATEMENTS The financial statements filed as part of this report are listed on the Index to Consolidated Financial Statements on page 31. FINANCIAL STATEMENT SCHEDULES INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES SCHEDULES PAGE ---- Schedule I - Condensed Financial Information of Registrant . . . . . . 80 All other schedules have been omitted because the required information is shown in the Consolidated Financial Statements or Notes thereto or they are not applicable. (b) REPORT ON FORM 8-K On February 17, 1999 the registrant filed a Report on Form 8-K reporting under Item 5. Other Events disclosing a letter to its vendors concerning the status of the registrant's Chapter 11 Bankruptcy Proceeding. On July 2, 1999 the registrant filed a Report on Form 8-K reporting under Item 5. Other Events disclosing the sale of eleven owned parcels of real property and leasehold interests on twelve leased properties and the execution of a Unitary Lease to lease the properties back ("Sale-Leaseback Transaction"). The Sale-Leaseback Transaction was consummated on June 8, 1999. (c) EXHIBITS See Page 76 for Index to Exhibits. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. LEVITZ FURNITURE INCORPORATED Date: July 12, 1999 By: /s/ EDWARD L. GRUND -------------------------------- Edward L. Grund Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. INDEX TO EXHIBITS (NUMBERED IN ACCORDANCE WITH ITEM 601 OF REGULATION S-K) EXHIBIT NO. DESCRIPTION OF EXHIBITS - ------- ----------------------- 3.01 Form of Restated Certificate of Incorporation of the Company. (1) 3.02 Form of By-Laws of the Company. (1) 3.03 Certificate of Incorporation of Levitz. (2) 3.04 By-Laws of Levitz. (2) 4.01 Form of Stockholder Rights Plan, including exhibits. (1) 10.02 Form of Indemnification Agreement. (1) 10.04 Amendment to Shareholders Agreement dated as of May 14, 1993. (1) 10.05 Senior Deferred Coupon Debenture Indenture dated as of December 1, 1992 between the Company and First Bank National Association, as Trustee. (1) 10.06 Form of Senior Deferred Coupon Debenture (included as Exhibit A to 10.05 above). (1) 10.07 First Supplemental Indenture dated as of April 21, 1993, relating to the Debenture Indenture. (1) 10.08 Second Supplemental Indenture, dated as of June 16, 1993, relating to the Debenture Indenture. (1) 10.10 Shareholders Agreement, dated as of December 23, 1986 between the Company and the Investors. (3) 10.11 Form of Agreement of Indemnification dated March 5, 1985 between Levitz and certain directors of Levitz Furniture Corporation. (3) 10.14 Supplemental Executive Retirement Plan of Levitz dated April, 1995. (4) 10.15 Levitz Bonus Plan. (4) 10.16 13-3/8% Senior Note Indenture, dated as of March 1, 1996, between Levitz Furniture Corporation and American Bank National Association, as Trustee. (4) 10.17 Form of 13-3/8% Senior Note (included as Exhibit A to 10.16 above). (4) 10.18 First Supplemental Indenture, dated as of May 29, 1996, to the 13-3/8% Senior Note Indenture, dated as of March 1, 1996 between Levitz Furniture Corporation and American Bank National Association, as Trustee. (4) 10.19 Warrant Agreement, dated as of March 25, 1996, by and between the Company and American Stock Transfer & Trust Company, as Agent.(7) 10.20 Form of Warrant, dated March 25, 1996 (included as Exhibit A to Exhibit 10.19 above). (4) 10.22 Warrant Certificate, dated as of July 1, 1996, by and between the Company and Apollo Investment Fund III, L.P. (4) 10.23 Warrant Certificate, dated as of July 1, 1996, by and between the Company and Apollo Overseas Partners III, L.P. (4) 10.24 Warrant Certificate, dated as of July 1, 1996, by and between the Company and Apollo (U.K.) Partners III, L.P. (4) 10.25 Registration Rights Agreement, dated as of July 1, 1996, by and among the Company, Apollo Investment Fund III, L.P., Apollo Overseas Partners III, L.P., Apollo (U.K.) Partners II, L.P. and Court Square Capital Limited. (4) 10.26 $150,000,000 Credit Agreement, dated as of July 1, 1996, among Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., John M. Smyth Company, each of the lenders from time to time parties thereto, Apollo Investment Fund III, L.P., Apollo Overseas Partners III, L.P., Apollo U.K. Partners III, L.P. and BT Commercial Corporation, as agent. (4) EXHIBIT NO. DESCRIPTION OF EXHIBITS - ------- ----------------------- 10.27 $40,000,000 Credit Agreement, dated as of July 1, 1996, among Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., John M. Smyth Company, each of the lenders from time to time parties thereto, Apollo Investment Fund III, L.P., Apollo Overseas Partners III, L.P., Apollo U.K. Partners III, L.P. and BT Commercial Corporation, as agent. (4) 10.28 Intercreditor and Collateral Agency Agreement, dated as of July 1, 1996, among Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., John M. Smyth Company, BT Commercial Corporation and the lenders named therein. (4) 10.29 Intercreditor Agreement, dated as of July 1, 1996, among Levitz Furniture Corporation, General Electric Capital Corporation, BT Commercial Corporation and the lenders named therein. (4) 10.30 Revolving Note, dated July 1, 1996, by and among BT Commercial Corporation, Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., and John M. Smyth Company. (4) 10.31 Term Note, dated July 1, 1996, by and among Apollo (UK) Partners III, L.P. and Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., and John M. Smyth Company. (4) 10.32 Term Note, dated July 1, 1996, by and among Apollo Overseas Partners III, L.P. and Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., and John M. Smyth Company. (4) 10.33 Term Note, dated July 1, 1996, by and among Apollo Investment Fund III, L.P. and Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., and John M. Smyth Company. (4) 10.34 Note, dated July 1, 1996, by and among BT Commercial Corporation and Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., and John M. Smyth Company. (4) 10.35 Security Agreement, dated as of July 1, 1996, by Levitz Furniture Corporation, Levitz Furniture Company of the Midwest, Inc., Levitz Furniture Company of the Pacific, Inc., Levitz Furniture Company of Washington, Inc., and John M. Smyth Company in favor of BT Commercial Corporation. (4) 10.36 Pledge Agreement, dated as of July 1, 1996, by and between Levitz Furniture Corporation and BT Commercial Corporation. (4) 10.37 Amendment No. 1 dated as of December 6, 1996 to the Credit Agreements dated as of July 1, 1996 among Levitz Furniture Corporation, et al. and BT Commercial Corporation, as Agent. (5) 10.39 Amendment No. 2 dated as of December 16, 1996 to the Credit Agreements dated as of July 1, 1996 among Levitz Furniture Corporation, et al. and BT Commercial Corporation, as Agent. (6) 10.40 Amendment No. 3 dated as of June 13, 1997 to the Credit Agreements dated as of July 1, 1996 among Levitz Furniture Corporation, et al. and BT Commercial Corporation, as Agent. (7) EXHIBIT NO. DESCRIPTION OF EXHIBITS - ------- ----------------------- 10.41 Amendment No. 4 dated as of June 30, 1997 to the Credit Agreements dated as of July 1, 1996 among Levitz Furniture Corporation et al. and BT Commercial Corporation, as Agent. (7) 10.44 Amendment No. 5 dated as of July 25, 1997 to the Credit Agreements among Levitz Furniture Corporation, et al. and BT Commercial Corporation, as agent. (8) 10.45 $260,000,000 Postpetition Credit Agreement among Levitz Furniture Incorporated, Levitz Furniture Corporation and certain other subsidiaries and certain financial institutions, with Levitz Furniture Corporation, as LFC Funds Administrator and, BT Commercial Corporation, as Agent, dated as of September 5, 1997. (9) 10.46 Second Amended and Restated Account Purchase and Credit Card Program Agreement by and among Levitz Furniture Corporation, certain other subsidiaries and General Electric Capital Corporation, dated September 5, 1997. (9) 10.47 Amendment No. 1 dated as of October 7, 1997 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (10) 10.48 Amendment No. 1 dated as of October 7, 1997 to the Second Amended and Restated Account Purchase and Credit Card Agreement among Levitz Furniture Corporation, et al. and General Electric Capital Corporation. (10) 10.49 Amendment No. 2, dated as of December 30, 1997 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (11) 10.50 Amendment No. 3 dated as of February 23, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (12) 10.51 Amendment No. 4 dated as of February 20, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (12) 10.52 Amendment No. 5 dated as of May 14, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (12) 10.53 Amendment No. 6 dated as of June 23, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (12) 10.54 Form of Employment Agreement by and among Levitz Furniture Corporation and Edward L. Grund dated as of June 1, 1998. (12) 10.55 Form of Employment Agreement between Levitz and certain officers. (12) 10.56 Merchant Agreement among Levitz Furniture Corporation and certain other subsidiaries and Household Bank (SB) N.A., dated September 4, 1998. (13) 10.57 Amendment No. 7 dated as of September 4, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (13) 10.58 Amendment No. 8 dated as of September 18, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (13) 10.59 Waiver dated as of December 31, 1998 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. (14) 10.60 Amendment No. 9 dated as of March 5, 1999 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. 10.61 Amendment No. 10 dated as of May 14, 1999 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. 10.62 Contract of Sale by and among Levitz Furniture Corporation and certain other subsidiaries and Klaff Realty, LP, Lubert-Adler Capital Real Estate Fund II, L.P., Lubert-Adler Real Estate Fund II, L.P. and Lubert-Adler Parallel Fund II, L.P., dated as of April 20, 1999. (15) 10.63 First Amendment to Contract of Sale by and among Levitz Furniture Corporation and certain subsidiaries and the various purchasers set forth therein, dated as of June 8, 1999. (15) 10.64 Unitary Lease by and among Levitz Furniture Corporation and certain other subsidiaries and the various purchasers set forth therein, dated as of June 8, 1999. (15) 21.01 Wholly Owned Subsidiaries of Levitz Furniture Incorporated. 27 Financial Data Schedule. - ------------------ (1) Incorporated by reference from the Company's and Levitz's Registration Statement Nos. 33-61534 and 33-61534-01 on Form S-1 filed April 23, 1993. (2) Incorporated by reference from Levitz's Registration Statement No. 33-1325 on Form S-1 declared effective on August 13, 1986. (3) Incorporated by reference from Levitz's Registration Statement No. 33-12639 on Form S-1 declared effective on May 12, 1987. (4) Incorporated by reference from Levitz Furniture Incorporated's Form 10-K for the fiscal year ended March 31, 1996. (5) Incorporated by reference to Form 8-K filed December 6, 1996. (6) Incorporated by reference from Levitz Furniture Incorporated's quarterly report on Form 10-Q for the quarter ended December 31, 1996. (7) Incorporated by reference from Levitz Furniture Incorporated's Annual Report on Form 10-K for the year ended March 31, 1997. (8) Incorporated by reference from Levitz Furniture Incorporated's quarterly report on Form 10-Q for the quarter ended June 30, 1997. (9) Incorporated by reference to Form 8-K filed September 12, 1997. (10) Incorporated by reference from Levitz Furniture Incorporated's quarterly report on Form 10-Q for the quarter ended September 30, 1997. (11) Incorporated by reference from Levitz Furniture Incorporated's quarterly report on Form 10-Q for the quarter ended December 31, 1997. (12) Incorporated by reference from Levitz Furniture Incorporated's Annual Report on Form 10-K for the year ended March 31, 1998. (13) Incorporated by reference from Levitz Furniture Incorporated's quarterly report on Form 10-Q for the quarter ended September 30, 1998. (14) Incorporated by reference from Levitz Furniture Incorporated's quarterly report on Form 10-Q for the quarter ended December 31, 1998. (15) Incorporated by reference to Form 8-K filed July 2, 1999. LEVITZ FURNITURE INCORPORATED SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS (Dollars in thousands, except share data) The accompanying note is an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF OPERATIONS (Dollars in thousands, except share data) The accompanying note is an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS (Dollars in thousands, except share data) The accompanying note is an integral part of these financial statements. LEVITZ FURNITURE INCORPORATED SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTE TO FINANCIAL STATEMENTS MARCH 31, 1999 1. These statements should be read in conjunction with LFI's Consolidated Financial Statements and Notes thereto as described in the index listed in Item 8. EXHIBIT INDEX EXHIBIT DESCRIPTION - ------- ----------- 10.60 Amendment No. 9 dated as of March 5, 1999 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. 10.61 Amendment No. 10 dated as of May 14, 1999 to the Postpetition Credit Agreement among Levitz Furniture Incorporated, et al. and BT Commercial Corporation, as agent. 21.01 Wholly Owned Subsidiaries of Levitz Furniture Incorporated. 27 Financial Data Schedule.

65011_1999.txt

65011_1999

1999

65011

Item 1. Business General - ------- Meredith Corporation was founded in 1902 by Edwin Thomas Meredith and incorporated in Iowa in 1905. Since its beginnings in agricultural publishing, the company has expanded to include mass audience and special interest publications designed to serve the home and family market. In 1948, Meredith entered the television broadcasting business. The company now owns and operates television stations in locations across the continental United States. These publishing and broadcasting businesses and associated trademarks have been the core of Meredith's success. The company has two business segments: publishing and broadcasting. The publishing segment includes magazine and book publishing, brand licensing, integrated marketing and other related operations. Prior to fiscal 1999, the publishing segment also included the residential real estate franchising operations that were sold effective July 1, 1998. The broadcasting segment includes the operations of 12 network-affiliated television stations and syndicated television program marketing and development. In previously reported fiscal years, the company's segments included the cable television segment. The cable television segment was classified as a discontinued operation in fiscal 1996 and the sale of all cable television operations was finalized in fiscal 1997. Virtually all of the company's revenues are generated and assets reside within the United States. There are no material intersegment transactions. The company's largest source of revenues is magazine and television advertising. Television advertising tends to be seasonal in nature with higher revenues traditionally reported in the second and fourth fiscal quarters, and cyclical increases during certain periods, such as key political elections and network coverage of major events like the Olympic Games. Trademarks (e.g. Better Homes and Gardens, Ladies' Home Journal) are very important to the company's publishing segment. Local recognition of television station call letters is important in maintaining audience shares in the broadcasting segment. Name recognition and the public image of these trademarks are vital to both ongoing operations and the introduction of new businesses. Accordingly, the company aggressively defends it trademarks. - 2 - The company did not have any material expenses for research and development during any of the past three fiscal years. There is no material effect on capital expenditures, earnings or the competitive position of the company regarding compliance with federal, state and local provisions relating to the discharge of materials into the environment and to the protection of the environment. The company had 2,642 employees at June 30, 1999 (including 176 part-time employees). Business Developments - --------------------- On March 1, 1999, the company acquired the net assets of WGNX-TV, the CBS affiliate serving the Atlanta market. As part of the transaction, Meredith purchased the assets of KCPQ-TV, a FOX affiliate serving the Seattle market, for $380 million from Kelly Television Company. The assets of KCPQ-TV were then transferred to Tribune Company in exchange for the assets of WGNX-TV and $10 million. As a result, the net cost of the acquisition of WGNX-TV was approximately $370 million. Effective July 1, 1998, the company sold the net assets of the Better Homes and Gardens Real Estate Service to GMAC Home Services, Inc., a subsidiary of GMAC Financial Services. In a separate transaction, Meredith and GMAC Home Services entered into a licensing agreement that authorizes GMAC Home Services to use the Better Homes and Gardens trademark in connection with residential real estate marketing for a period not to exceed 10 years. This allows GMAC Home Services a reasonable time to transition the business to its own brand. The information required by this item regarding financial information about industry segments is set forth on pages to of this Form 10-K and is incorporated herein by reference. Description of Business - ----------------------- PUBLISHING - ---------- Years ended June 30 1999 1998 1997 ------------------------------------------------------------------- (In thousands) Publishing revenues $774,031 $769,197 $698,790 ======== ======== ======== Publishing operating profit $119,581 $101,145 $ 82,768 ======== ======== ======== Publishing represented 75 percent of the company's consolidated revenues and 62 percent of consolidated operating profit before unallocated corporate expenses in fiscal 1999. - 3 - Magazine - -------- Magazine operations account for approximately 90 percent of the revenues and operating profit of the publishing segment. Meredith currently publishes 20 subscription magazines that appeal primarily to consumers in the home and family market. Key advertising and circulation information for major subscription titles is as follows: June 30 Title Frequency Rate Base Ad Pages ------------------------------------------------------------------- Better Homes and Gardens - Home service Fiscal 1999 Monthly 7,600,000 1,946 Fiscal 1998 Monthly 7,600,000 1,911 Ladies' Home Journal - Women's service Fiscal 1999 Monthly 4,500,000 1,397 Fiscal 1998 Monthly 4,500,000 1,516 Country Home - Home decorating Fiscal 1999 8x/year* 1,000,000 701 Fiscal 1998 Bimonthly 1,000,000 642 Midwest Living - Regional travel and lifestyle Fiscal 1999 Bimonthly 815,000 628 Fiscal 1998 Bimonthly 815,000 608 Traditional Home - Home decorating Fiscal 1999 Bimonthly 800,000 645 Fiscal 1998 Bimonthly 775,000 573 WOOD - Woodworking projects and techniques Fiscal 1999 9x/year 600,000 460 Fiscal 1998 9x/year 600,000 416 Crayola Kids - Kids' reading, crafts and games Fiscal 1999 Bimonthly 550,000 350 Fiscal 1998 Bimonthly 500,000 284 Family Money - Personal finance Fiscal 1999 Bimonthly* 500,000 227 Fiscal 1998 Quarterly 625,000 193 Successful Farming - Farm information Fiscal 1999 12x/year 475,000 661 Fiscal 1998 12x/year 475,000 700 MORE - Women's service (age 40+) Fiscal 1999 Bimonthly 400,000 384 Fiscal 1998 1 special issue n/a n/a Golf for Women - Golf instruction and information Fiscal 1999 Bimonthly 370,000 413 Fiscal 1998 Bimonthly** 360,000 530 - 4 - * Increase in frequency effective in calendar 1999, resulting in 7 issues of Country Home and 5 issues of Family Money being published in fiscal 1999. ** Fiscal 1998 included seven issues versus six in fiscal 1999 due to a change in an issue on-sale date. Rate base is the circulation guaranteed to advertisers. Actual circulation often exceeds rate base, and is tracked by the Audit Bureau of Circulation, which issues periodic statements for audited magazines. Ad pages are as reported to Publisher's Information Bureau, Agricom, or if unreported, as calculated by the publisher using a similar methodology. Better Homes and Gardens magazine, the company's flagship, accounts for a significant percentage of revenues and operating profit of the company and the publishing segment. Meredith also has a 50 percent interest in a monthly Australian edition of Better Homes and Gardens magazine. Other subscription magazines published by the company are Country Gardens, Cross Stitch & Needlework, Decorative Woodcrafts, Crafts & Decorating Showcase, American Patchwork & Quilting, Renovation Style, Decorating, Do It Yourself Ideas for Your Home & Garden, and Deck & Landscape. All subscription magazines, except Successful Farming, are also sold on newsstands. Successful Farming is available only by subscription to qualified farm families. The company also publishes a group of Special Interest Publications, primarily under the Better Homes and Gardens name, that are typically sold only on newsstands. These titles are issued from one to four times annually. More than 100 issues were published in fiscal 1999 in categories including decorating, do-it-yourself, home plans, crafts, gardening, holidays and cooking. The company also publishes the American Park Network visitor guides and travel guides for certain states and cities. Meredith Integrated Marketing offers advertisers and other external clients integrated strategies that combine all of Meredith's custom capabilities. Fiscal 1999 clients included Nestle USA, Inc., Lutheran Brotherhood, The IAMS Company, The Home Depot U.S.A., Inc., The Sherwin-Williams Company and Florida Department of Citrus, among others. Country America magazine, which was jointly owned by Meredith Corporation (80 percent owner), Group W Satellite Communications and Opryland U.S.A., Inc., was discontinued in November 1998. Crayola Kids magazine and the Crayola Kids line of books are published under a license from Binney & Smith Properties, Inc., makers of Crayola crayons. The company pays Binney & Smith royalties for use of the Crayola trademark. Family Money magazine reduced its rate base from 625,000 to 500,000 effective with the March/April 1999 issue. This reduction in rate base reflected the decision by Metropolitan Life Insurance Company to discontinue its program of purchasing customized subscriptions to Family Money. Management is currently reviewing other options for partnerships or affiliations for the magazine. MORE magazine increased its rate base to 500,000 effective with the July/August 1999 issue. Effective with the February 2000 issue, Ladies' Home Journal will lower its rate base to 4.1 million. - 5 - Several of the company's magazines have established Web sites on the internet. In addition, Meredith has entered into an alliance with America Online that makes content from several of the company's Web sites available through online services within the AOL network. None of these ventures is currently a material source of revenues or operating profit. Advertising - ----------- Years ended June 30 1999 1998 1997 ---------------------------------------------------------------------- (In thousands) Advertising revenues $359,123 $350,158 $311,161 ======== ======== ======== Advertising revenues are generated primarily from sales to clients engaged in consumer marketing. Many of the company's larger magazines offer advertisers different regional and demographic editions which contain the same basic editorial material but permit advertisers to concentrate their advertising in specific markets or to target specific audiences. The company sells two primary types of magazine advertising: display and direct-response. Advertisements are either run-of-press (printed along with the editorial portions of the magazine) or inserts (preprinted forms). Most of the company's advertising pages and revenues are derived from run-of-press display advertising. Meredith has a group sales staff specializing in advertising sales across titles. Circulation - ----------- Years ended June 30 1999 1998 1997 ---------------------------------------------------------------------- (In thousands) Circulation revenues $273,621 $271,004 $257,222 ======== ======== ======== Subscription revenues, the largest source of circulation revenues, are generated through direct-mail solicitation, agencies, insert cards and other means. Newsstand sales also are important sources of circulation revenues for most magazines. Magazine wholesalers have the right to receive credit from the company for magazines returned to them by retailers. Other - ----- Years ended June 30 1999 1998 1997 ---------------------------------------------------------------------- (In thousands) Other revenues $141,287 $148,035 $130,407 ======== ======== ======== - 6 - Magazine operations also realize revenues from the sale of ancillary products and services. The company publishes and markets a line of approximately 300 consumer home and family service books. The line includes books published under the Better Homes and Gardens trademark as well as books published under contract for Ortho and The Home Depot. They are sold through retail book and specialty stores, mass merchandisers and other means. Fifty-nine new or revised titles were published during fiscal 1999. Meredith has licensed Wal-Mart Stores, Inc., to sell Better Homes and Gardens branded products in its garden centers nationwide. The company receives an annual trademark license fee for sales of licensed products offered exclusively in Wal-Mart stores. In addition, Meredith has licensed GMAC Home Services, Inc., to use the Better Homes and Gardens trademark in connection with residential real estate marketing for an annual fee. Also, Meredith has licensed Global Vacation Group, Inc., to sell vacation packages to selected destinations under the Better Homes and Gardens name. The Better Homes and Gardens Real Estate Service is a national residential real estate franchise and marketing service. As noted in the Business Developments section of this report, the net assets of the Better Homes and Gardens Real Estate Service were sold in July 1998. In fiscal 1998 and prior years, the primary revenue sources of the real estate operations were franchise fees (based on a percentage of each member's gross commission income on residential housing sales) and the sale of marketing programs and materials to members and affiliates. Production and Delivery - ----------------------- The major raw materials essential to this segment are coated publication and book-grade papers. Meredith supplies all of the paper for its magazine production and most of the paper for its book production. The company's major paper suppliers lowered prices on certain types of paper during fiscal 1999 resulting in lower average paper prices for the fiscal year. The price of paper is driven by overall market conditions and, therefore, is difficult to predict. However, at this time, management anticipates that if prices rise over the next year, the increases will be moderate. The company has contractual agreements with major paper manufacturers to ensure adequate supplies of paper for planned publishing requirements. The company has printing contracts for all of its magazine titles. Its two largest titles, Better Homes and Gardens and Ladies' Home Journal, are printed under long-term contracts with a major United States printer. The company's largest magazine printing contract has been renewed and the company has entered into new contracts with several other major printers. These new contracts are expected to result in lower unit costs in fiscal 2000 and beyond. All of the company's published books are manufactured by outside printers. Book manufacturing contracts are generally on a title-by-title basis. Postage is also a significant expense to this segment due to the large volume of magazine and subscription promotion mailings. The publishing operations continually seek the most economical and effective methods for mail delivery. - 7 - Accordingly, certain cost-saving measures, such as pre-sorting and drop- shipping to central postal centers, are utilized. The U.S. Postal Service enacted rate changes in January 1999 that increased mailing costs an average of 4.6 percent for magazine publishers taken as a whole. Meredith's effective increase was less than the average because of the company's efficient mailing processes. Paper, printing and postage costs accounted for approximately 40 percent of the publishing segment's fiscal 1999 operating costs. Fulfillment services for the company's magazine operations are being consolidated with one external provider. This change is expected to result in improved customer service and marketing capabilities. National newsstand distribution services are also provided by an unrelated third party under a multi-year agreement. Competition - ----------- Publishing is a highly competitive business. The company's magazines, books, and related publishing products and services compete with other mass media and many other types of leisure-time activities. Overall competitive factors in this segment include price, editorial quality and customer service. Competition for advertising dollars in magazine operations is primarily based on advertising rates, reader response to advertisers' products and services and effectiveness of sales teams. Better Homes and Gardens and Ladies' Home Journal compete for readers and advertising dollars primarily in the women's service magazine category. Both are part of a group known as the "Seven Sisters," which also includes Family Circle, Good Housekeeping, McCall's, Redbook and Woman's Day magazines, published by other companies. In fiscal 1999, the combined advertising revenue market share of Better Homes and Gardens and Ladies' Home Journal magazines totaled 40 percent. Their share exceeded that of each of the three other publishers included in the Seven Sisters. BROADCASTING - ------------ Years ended June 30 1999 1998 1997 ---------------------------------------------------------------------- (In thousands) Broadcasting advertising revenues $254,277 $229,871 $148,517 ======== ======== ======== Broadcasting total revenues $262,091 $240,730 $156,428 ======== ======== ======== Broadcasting operating profit $ 72,347 $ 74,532 $ 55,744 ======== ======== ======== Broadcasting represented 25 percent of the company's consolidated revenues and 38 percent of consolidated operating profit before unallocated corporate expenses in fiscal 1999. Broadcasting results include the effects of the acquisitions of WGNX-TV in March 1999; WFSB-TV in September 1997; and KPDX-TV, KFXO-LP and WHNS-TV in July 1997. - 8 - Station, Channel, Market, Network DMA Expiration Average Commercial Affiliation, TV Homes National Date of FCC Audience TV Stations Frequency(1) in DMA Rank(2) License Share(3) in Market(4) - ----------------- --------- -------- ----------- -------- ---------- WGNX-TV, Ch. 46 1,722,000 10 4-1-2005 8.0% 3 VHF Atlanta, Ga. 6 UHF (CBS) UHF KPHO-TV, Ch. 5 1,343,000 17 10-1-2006 11.0% 5 VHF Phoenix, Ariz. 4 UHF (CBS) VHF WOFL-TV, Ch. 35 1,072,000 22 2-1-2005 7.0% 3 VHF Orlando/Daytona Beach/Melbourne, Fla. 4 UHF (FOX) UHF KPDX-TV, Ch. 49 994,000 23 2-1-2007 9.3% 4 VHF Portland, Ore. 2 UHF (FOX) UHF WFSB-TV, Ch. 3 910,000 27 4-1-2007 15.3% 2 VHF Hartford/New Haven, Conn. 5 UHF (CBS) VHF WSMV-TV, Ch. 4 812,000 30 8-1-2005 15.3% 3 VHF Nashville, Tenn. 4 UHF (NBC) VHF KCTV, Ch. 5 802,000 33 2-1-2006 16.0% 3 VHF Kansas City, Mo. 5 UHF (CBS) VHF WHNS-TV, Ch. 21 740,000 35 12-1-2004 6.3% 3 VHF Greenville, S.C./Spartanburg, S.C./Asheville, N.C. 3 UHF (FOX) UHF KVVU-TV, Ch. 5 497,000 56 10-1-2006 7.8% 4 VHF Las Vegas, Nev. 4 UHF (FOX) VHF WNEM-TV, Ch. 5 445,000 64 10-1-2005 17.3% 2 VHF Flint/Saginaw/Bay City, Mich. 2 UHF (CBS) VHF WOGX-TV, Ch. 51 103,000 165 2-1-2005 9.5% 3 UHF Ocala/Gainesville, Fla. (FOX) UHF KFXO-LP, Ch. 39 40,000 200 2-1-2007 8.0% 2 UHF Bend, Ore. (FOX) UHF - 9 - (1) VHF (very high frequency) stations transmit on channels 2 through 13; UHF(ultra high frequency) stations transmit on channels above 13. Technical factors and area topography determine the market served by a television station. (2) Designated Market Area (DMA), as defined by A.C. Nielsen Company (Nielsen), is an exclusive geographic area consisting of all counties in which local stations receive a preponderance of total viewing hours. The national rank is the Nielsen 1998-99 DMA ranking based on estimated television households. (3) Average audience share represents the estimated percentage of households using television tuned to the station. The percentages shown reflect the average Nielsen ratings share for the May 1998, July 1998, November 1998, and February 1999 measurement periods from 9 a.m. to midnight daily. (4) The number of commercial television stations reported is from BIA's "Investing in Series, 1999 Television Market Report" dated February 1999. The company's station and all other stations reporting revenues are included. Public television stations are not included. Operations - ---------- Advertising is the principal source of revenues for the broadcasting segment. The stations sell commercial time to both local/regional and national advertisers. Rates for spot advertising are influenced primarily by the market size and audience demographics for programming. Most national advertising is sold by national advertising representative firms. Local/regional advertising revenues are generated by sales staff at each station's location. All of the company's television stations are network affiliates and as such receive programming and, in some instances, cash compensation from their respective national network. In exchange, much of the advertising time during this programming is sold by the network. In some cases, network compensation is partially offset by payments to the network for certain programming costs such as professional football. Affiliation with a national network has an important influence on a station's revenues. The audience share drawn by a network's programming affects a station's advertising rates. The company's television stations' network contracts are typically for terms of five or more years and historically the company's relations with the networks have been good. Local news programming is an important source of revenues to television stations, as more than 25 percent of a market's total revenues typically come from news. Over the next two years, the company's stations plan to add about 40 additional hours of news programming per week. This 25 percent increase will be led by Meredith's stations in Atlanta and Las Vegas. In addition, the company's FOX affiliates in Greenville, Portland and Orlando will double the amount of local news they currently provide. All of the company's television stations have established Web sites on the Internet. In addition to marketing these Web sites locally, the company is planning to aggregate online activity and sell the total reach to national clients. None of these ventures is currently a material source of revenues or operating profit. - 10 - Competition - ----------- Meredith television stations compete directly for advertising dollars and programming in each of their markets with other television stations and cable television providers. Other mass media providers such as newspapers, radio and the internet also provide competition for market advertising dollars and for entertainment and news information. Ownership consolidation continues to occur in the television broadcast industry which may increase local market competition for syndicated programming. In addition, the Telecommunication Act of 1996 (1996 Act) is expected to increase competition over the next several years in part due to the ability of new video service providers (e.g. telephone companies) to enter the industry. The company cannot predict the effects of these actions on the future results of the company's broadcasting operations. Regulation - ---------- Television broadcasting operations are subject to regulation by the Federal Communications Commission (FCC) under the Communications Act of 1934, as amended (Communications Act). Under the Communications Act, the FCC performs many regulatory functions including granting of station licenses and determining regulations and policies which affect the ownership, operation, programming and employment practices of broadcast stations. The FCC must approve all television licenses and therefore compliance with FCC regulations is essential to the operation of this segment. The maximum term of broadcast licenses is eight years. Management is not aware of any reason why its television station licenses would not be renewed by the FCC. The Communications Act also prohibits the assignment of a broadcast license or the transfer of control of a broadcast licensee without prior FCC approval. The 1996 Act allows broadcast companies to own an unlimited number of television stations as long as the combined service areas of such stations do not include more than 35 percent of U.S. television households. In August 1999, the FCC issued regulations permitting the ownership of two stations in a market under certain circumstances. As of June 30, 1999, the company's household coverage is approximately 7.2 percent (based on the FCC method of calculation which includes 50 percent of the market size for UHF stations owned). Congressional legislation and FCC rules are subject to change and these groups may adopt regulations that could affect future operations and profitability of the company's broadcasting segment. In April 1997, the FCC announced rules for the implementation of digital television (DTV) service. Under these rules, all broadcasters who, as of April 3, 1997, held a license to operate a full-power television station or a construction permit for such a station will be assigned, for an eight-year transition period, a second channel on which to initially provide separate DTV programming or simulcast its analog programming. Stations must construct their DTV facilities and be on the air with a digital signal according to a schedule set by the FCC based on the type of station and the size of the market in which it is located. According to these rules, the company's Atlanta broadcast television station was required to begin transmission of digital programming by May 1, 1999. Under previous ownership, the station voluntarily committed to begin DTV transmission by November 1, 1998, along with other top 10 market stations, and subsequently met the accelerated schedule. Four of the company's broadcast television stations (those in Phoenix, Orlando, Portland and Hartford/New Haven) will be required to begin transmission of digital programming by November 1999. Most of the - 11 - company's remaining stations must follow suit by May 2002. At the end of the transition period, analog television transmissions will cease, and DTV channels may be reassigned. The FCC hopes to complete the full transition to DTV by 2006. The Commission has announced that it will review the progress of DTV every two years and make adjustments to the 2006 target date, if necessary. The impact of these rulings to the company are uncertain. However, digital conversion is expected to require capital expenditures of approximately $2 million per station beginning in fiscal 1999 to transmit a digital signal and comply with current DTV requirements. The information given in this section is not intended to be a complete listing of all regulatory provisions currently in effect. The company cannot predict what changes to current legislation will be adopted or determine what impact any changes could have on its television broadcasting operations. DISCONTINUED OPERATION - ---------------------- On October 25, 1996, the company, through its cable venture, Meredith/New Heritage Partnership, sold the venture's 73 percent ownership interest in Meredith/New Heritage Strategic Partners, L.P. to a subsidiary of its minority partner, Continental Cablevision, Inc. (See Note 2 to Consolidated Financial Statements on page of this Form 10-K for financial and other information related to the discontinued cable operation.) EXECUTIVE OFFICERS OF THE REGISTRANT (AS OF AUGUST 30, 1999) - ------------------------------------------------------------ Name Age Title Since - ------------------- --- ----------------------------------- ----- William T. Kerr 58 Chairman and Chief Executive Officer 1991 Christopher M. Little 58 President - Publishing Group 1994 John P. Loughlin 42 President - Broadcasting Group 1997 Leo R. Armatis 61 Vice President - Corporate Relations 1995 Stephen M. Lacy 45 Vice President - Chief Financial Officer 1998 John S. Zieser 40 Vice President - General Counsel and Secretary 1999 Executive officers are elected to one-year terms of office each November. Mr. Kerr is a director of the company. The company has employed all present executive officers except Mr. Lacy and Mr. Zieser for at least five years. Mr. Lacy became vice president-chief financial officer on February 3, 1998. In July 1999, the company announced that Mr. Lacy will become a Publishing Group vice president as part of an executive development plan. The move will take place when a successor is named. Prior to joining Meredith, Mr. Lacy had been, successively, vice president-chief financial officer, executive vice president, and president of Johnson & Higgins/Kirke-Van Orsdel, a company that provides outsourced administrative services for employee benefit plans of Fortune 1000 companies, from 1992 until the time he joined Meredith. Mr. Zieser became vice president-general counsel and secretary on January 18, 1999. Prior to joining Meredith, Mr. Zieser had been group president of First Data Merchant Services Corporation (FDMS), a leading provider of merchant processing and information services at the point of sale and over the Internet. Mr. Zieser joined FDMS in 1993 as legal counsel and was subsequently promoted to associate general counsel prior to his appointment to other senior management positions. - 12 - Item 2. Item 2. Properties Meredith Corporation headquarters are located at 1716 and 1615 Locust Street, Des Moines, Iowa. The company owns these buildings and is the sole user. Meredith also owns an office building located at 1912 Grand Avenue in Des Moines. Meredith employees occupy a portion of the facility and approximately one-third of the space in that building is being leased to an outside party. The publishing segment operates mainly from the Des Moines offices and from leased facilities at 125 Park Avenue, New York, New York. The New York facility is used primarily as an advertising sales office for all Meredith magazines and headquarters for Ladies' Home Journal and Golf for Women magazines. The publishing segment also maintains ad sales offices, which are leased, in Chicago, San Francisco, Los Angeles, Detroit and several other cities. These offices are adequate for their intended use. The broadcasting segment operates from offices in the following locations: Atlanta, Ga.; Phoenix, Ariz.; Orlando, Fla.; Portland, Ore.; Hartford, Conn.; Nashville, Tenn.; Kansas City, Mo.; Greenville, S.C.; Asheville, N.C.; Las Vegas, Nev.; Flint, Mich.; Saginaw, Mich.; Ocala, Fla.; Gainesville, Fla.; and Bend, Ore. All of these properties, except those noted, are owned by the company and are adequate for their intended use. The properties in Asheville, Flint, Gainesville and Bend are leased and are currently adequate for their intended use. The leased properties in Atlanta and Portland do not allow room for expansion of newsroom facilities. Therefore, the company has purchased or plans to purchase land in both the Atlanta and Portland areas and plans to construct new facilities to accommodate growth. Construction has begun on the Portland facility and it is expected to be completed in calendar year 2000. Construction of the Atlanta facility is expected to begin during fiscal year 2000 and be completed in calendar year 2001. Each of the broadcast stations also maintains an owned or leased transmitter site. Item 3. Item 3. Legal Proceedings There are various legal proceedings pending against the company arising from the ordinary course of business. In the opinion of management, liabilities, if any, arising from existing litigation and claims would not have a material effect on the company's earnings, financial position or liquidity. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters have been submitted to a vote of stockholders since the company's last annual meeting held on November 9, 1998. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The principal market for trading the company's common stock is the New York Stock Exchange (trading symbol MDP). There is no separate public trading market for the company's class B stock, which is convertible share-for-share at any time into common stock. Holders of both classes of stock receive equal dividends per share. - 13 - The range of trading prices for the company's common stock and the dividends paid during each quarter of the past two fiscal years are presented below. High Low Dividends ------- ------- --------- Fiscal 1999 First Quarter $48.50 $28.56 $ .070 Second Quarter 40.00 26.69 .070 Third Quarter 40.25 30.87 .075 Fourth Quarter 38.00 30.62 .075 Fiscal 1998 First Quarter $33.62 $26.75 $ .065 Second Quarter 36.94 29.25 .065 Third Quarter 44.44 34.62 .070 Fourth Quarter 46.94 38.37 .070 Stock of the company became publicly traded in 1946, and quarterly dividends have been paid continuously since 1947. It is anticipated that comparable dividends will continue to be paid in the future. On July 30, 1999, there were approximately 1,900 holders of record of the company's common stock and 1,300 holders of record of class B stock. Item 6. Item 6. Selected Financial Data The information required by this Item is set forth on pages and of this Form 10-K and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required by this Item is set forth on pages through of this Form 10-K and is incorporated herein by reference. Item 7a. Item 7a. Quantitative and Qualitative Disclosures About Market Risk The information required by this Item is set forth on pages and of this Form 10-K and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The information required by this Item is set forth on pages through of this Form 10-K and is incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None. - 14 - PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information required by this Item is set forth in Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on November 8, 1999, under the caption "Election of Directors" and in Part I of this Form 10-K on page 12 under the caption "Executive Officers of the Registrant" and is incorporated herein by reference. Item 11. Item 11. Executive Compensation The information required by this Item is set forth in Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on November 8, 1999, under the captions "Report of the Compensation/Nominating Committee on Executive Compensation" and "Retirement Programs and Employment Agreements" and in the last three paragraphs under the caption "Board Committees" and is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item is set forth in Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on November 8, 1999, under the caption "Security Ownership of Certain Beneficial Owners and Management" and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this Item is set forth in Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on November 8, 1999, in the last paragraph under the caption "Board Committees" and is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K The following consolidated financial statements listed under (a) 1. and the financial statement schedule listed under (a) 2. of the company and its subsidiaries are filed as part of this report as set forth on the Index at page. (a) 1. Financial Statements: Consolidated Statements of Earnings for the years ended June 30, 1999, 1998 and 1997 Consolidated Balance Sheets as of June 30, 1999 and 1998 Consolidated Statements of Stockholders' Equity for the years ended June 30, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the years ended June 30, 1999, 1998 and 1997 Notes to Consolidated Financial Statements Independent Auditors' Report - 15 - (a) 2. Financial Statement Schedule as of or for each of the years ended June 30, 1999, 1998 and 1997: Schedule II - Valuation and Qualifying Accounts All other Schedules have been omitted for the reason that the items required by such schedules are not present in the consolidated financial statements, are covered in the consolidated financial statements or notes thereto, or are not significant in amount. (a) 3. Exhibits. Certain of the exhibits to this Form 10-K are incorporated herein by reference, as specified: (See index to attached exhibits on page E-1 of this Form 10-K.) 3.1 The company's Restated Articles of Incorporation, as amended, are incorporated herein by reference to Exhibit 3.1 to the company's Quarterly Report on Form 10-Q for the period ended March 31, 1996. 3.2 The Restated Bylaws, as amended, are incorporated herein by reference to Exhibit 3 to the company's Quarterly Report on Form 10-Q for the period ended September 30, 1997. 4.1 Note Purchase Agreement dated March 1, 1999 among Meredith Corporation, as issuer and seller, and named purchasers is incorporated herein by reference to Exhibit 4.1 to the company's Current Report on Form 8-K dated March 1, 1999. 4.2 Credit Agreement dated December 10, 1998, among Meredith Corporation, and certain banks specified therein, for whom Wachovia Bank, N.A. is acting as Agent, is incorporated herein by reference to Exhibit 2 to the company's Quarterly Report on Form 10-Q for the period ended December 31, 1998. 4.3 Credit Agreement dated July 1, 1997, among Meredith Corporation and a group of banks with Wachovia Bank, N.A. as Agent is incorporated herein by reference to Exhibit 4 to the company's Current Report on Form 8-K dated July 1, 1997. 10.1 Amendment to the Meredith Corporation 1990 Restricted Stock Plan for Non-Employee Directors. 10.2 Agreement dated February 25, 1999, between Meredith Corporation and William T. Kerr regarding conversion of restricted stock award shares into stock equivalents. 10.3 Meredith Corporation 1972 Management Incentive Plan. 10.4 Kelly Television Co. Agreement and Plan of Merger among Kelly Television Co., J. S. Kelly L.L.C., G. G. Kelly L.L.C., Robert E. Kelly, Meredith Corporation and KCPQ Acquisition Corp. dated as of August 21, 1998, is incorporated herein by reference to exhibit 2.1 to the company's Quarterly Report on Form 10-Q for the period ended September 30, 1998. - 16 - 10.5 Asset Exchange Agreement dated August 21, 1998, among Tribune Broadcasting Company, WGNX Inc., Meredith Corporation and KCPQ Acquisition Corp., with respect to KCPQ (TV), Seattle, Washington and WGNX (TV), Atlanta, Georgia, is incorporated herein by reference to Exhibit 2.2 to the company's Quarterly Report on Form 10-Q for the period ended September 30, 1998. 10.6 Employment Agreement dated February 2, 1998, between Meredith Corporation and E. T. Meredith III is incorporated herein by reference to Exhibit 10 to the company's Quarterly Report on Form 10-Q for the period ended March 31, 1998. 10.7 Employment agreement dated November 11, 1996, between Meredith Corporation and William T. Kerr is incorporated herein by reference to Exhibit 10.1 to the company's Quarterly Report on Form 10-Q for the period ended December 31, 1996. 10.8 Meredith Corporation 1990 Restricted Stock Plan for Non-Employee Directors, as amended, is incorporated herein by reference to Exhibit 10.1 to the company's Quarterly Report on Form 10-Q for the period ended September 30, 1996. 10.9 Meredith Corporation 1993 Stock Option Plan for Non-Employee Directors, as amended, is incorporated herein by reference to Exhibit 10.2 to the company's Quarterly Report on Form 10-Q for the period ended September 30, 1996. 10.10 Meredith Corporation Deferred Compensation Plan, dated as of November 8, 1993, is incorporated herein by reference to Exhibit 10 to the company's Quarterly Report on Form 10-Q for the period ending December 31, 1993. 10.11 1992 Meredith Corporation Stock Incentive Plan effective August 12, 1992, is incorporated herein by reference to Exhibit 10b to the company's Annual Report on Form 10-K for the year ended June 30, 1992. Amendment to the aforementioned agreement is incorporated herein by reference to Exhibit 10.3 to the company's Quarterly Report on Form 10-Q for the period ended September 30, 1996. 10.12 Meredith Corporation 1996 Stock Incentive Plan effective August 14, 1996, is incorporated herein by reference to Exhibit A to the company's Proxy Statement for the Annual Meeting of Shareholders on November 11, 1996. 10.13 Employment contract by and between Meredith Corporation and Jack D. Rehm as of July 1, 1992, is incorporated herein by reference to Exhibit 10c to the company's Annual Report on Form 10-K for the year ended June 30, 1992. Amendment to the aforementioned agreement is incorporated herein by reference to Exhibit 10.2 to the company's Quarterly Report on Form 10-Q for the period ended December 31, 1996. 10.14 Indemnification Agreement in the form entered into between the company and its officers and directors is incorporated herein by reference to Exhibit 10 to the company's Quarterly Report on Form 10-Q for the period ending December 31, 1988. - 17 - 10.15 Severance Agreement in the form entered into between the company and its officers is incorporated herein by reference to Exhibit 10 to the company's Annual Report on Form 10-K for the fiscal year ending June 30, 1986. 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors 27.1 Financial Data Schedule 27.2 Restated Financial Data Schedule for June 30, 1998 (b) Reports on Form 8-K During the fourth quarter of fiscal 1999, the company filed on May 14, 1999 a Form 8-K/A-1 dated March 1, 1999 to file under Item 7 the financial statements of businesses acquired and pro forma financial information related to the acquisition of WGNX-TV. The acquisition of WGNX-TV was reported on Form 8-K on March 15, 1999 under Item 2. - 18 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MEREDITH CORPORATION /s/ John S. Zieser ------------------------------- John S. Zieser, Vice President- General Counsel and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ Stephen M. Lacy /s/ William T. Kerr - --------------------------------- -------------------------------- Stephen M. Lacy, Vice President- William T. Kerr, Chairman of the Chief Financial Officer (Principal Board, Chief Executive Officer and Accounting and Financial Officer) Director (Principal Executive Officer) /s/ E. T. Meredith III /s/ Herbert M. Baum - --------------------------------- -------------------------------- E. T. Meredith III Herbert M. Baum, Chairman of the Executive Director Committee and Director /s/ Mary Sue Coleman /s/ Frederick B. Henry - --------------------------------- -------------------------------- Mary Sue Coleman, Director Frederick B. Henry, Director /s/ Joel W. Johnson /s/ Robert E. Lee - --------------------------------- -------------------------------- Joel W. Johnson, Director Robert E. Lee, Director /s/ Richard S. Levitt /s/ Philip A. Marineau - --------------------------------- -------------------------------- Richard S. Levitt, Director Philip A. Marineau, Director /s/ Nicholas L. Reding /s/ Jack D. Rehm - --------------------------------- -------------------------------- Nicholas L. Reding, Director Jack D. Rehm, Director /s/ Barbara Uehling Charlton ---------------------------------- Barbara Uehling Charlton, Director Each of the above signatures is affixed as of September 17, 1999. - 19 - Index to Consolidated Financial Statements, Financial Schedules and Other Financial Information Page ---- Selected Financial Data F- 2 Management's Discussion and Analysis of Financial Condition and Results of Operations F- 4 Quantitative and Qualitative Disclosures about Market Risk Consolidated Financial Statements: Balance Sheets Statements of Earnings Statements of Cash Flows Statements of Stockholders' Equity Notes (including supplementary financial information) Independent Auditors' Report Report of Management Financial Statement Schedule: Schedule II - Valuation and Qualifying Accounts Selected Financial Data Meredith Corporation and Subsidiaries Years Ended June 30 1999 1998 1997 1996 1995 - ------------------------------------------------------------------------------- (In thousands except per share) Results of operations: Total revenues.............. $1,036,122 $1,009,927 $855,218 $867,137 $829,401 ========== ========== ======== ======== ======== Earnings from continuing operations................. $ 89,657 $ 79,858 $ 67,592 $ 54,657 $ 44,198 Discontinued operation...... -- -- 27,693 (717) (4,353) Cumulative effect of change in accounting principle.... -- -- -- -- (46,160) ---------- ---------- -------- -------- -------- Net earnings (loss)......... $ 89,657 $ 79,858 $ 95,285 $53,940 $ (6,315) ========== ========== ======== ======== ======== Basic earnings per share: Earnings from continuing operations................. $ 1.72 $ 1.51 $ 1.26 $ 1.00 $ 0.81 Discontinued operation...... -- -- 0.52 (0.02) (0.07) Cumulative effect of change in accounting principle.... -- -- -- -- (0.86) ---------- ---------- -------- -------- -------- Net earnings(loss) per share $ 1.72 $ 1.51 $ 1.78 $ 0.98 $ (0.12) ========== ========== ======== ======== ======== Diluted earnings per share: Earnings from continuing operations................. $ 1.67 $ 1.46 $ 1.22 $ 0.97 $ 0.79 Discontinued operation...... -- -- 0.50 (0.01) (0.07) Cumulative effect of change in accounting principle.... -- -- -- -- (0.83) ---------- ---------- -------- -------- -------- Net earnings(loss) per share $ 1.67 $ 1.46 $ 1.72 $ 0.96 $ (0.11) ========== ========== ======== ======== ======== Dividends paid per share.... $ 0.29 $ 0.27 $ 0.24 $ 0.21 $ 0.19 ========== ========== ======== ======== ======== Financial position at June 30: Total assets................ $1,423,396 $1,065,989 $760,433 $733,692 $743,796 ========== ========== ======== ======== ======== Long-term obligations....... $ 564,573 $ 244,607 $ 17,032 $ 71,482 $102,259 ========== ========== ======== ======== ======== General: Prior years are reclassified to conform with the current-year presentation. Significant acquisitions occurred in March 1999 with the acquisition of WGNX-TV; in September 1997 with the acquisition of WFSB-TV; in July 1997 with the purchase of KPDX-TV, WHNS-TV and KFXO-LP; and in January 1995 with the purchase of WSMV-TV. Per-share amounts have been adjusted to reflect two-for-one stock splits in March 1997 and March 1995. Long-term obligations include the current and long-term amounts of broadcast rights payable and company debt associated with continuing operations. Earnings from continuing operations: Fiscal 1999 included a gain of $1.4 million, or 3 cents per diluted share, from the sale of the real estate operations. Fiscal 1996 included a gain of $5.9 million, or 6 cents per diluted share, from the sale of three book clubs. Fiscal 1995 included interest income of $8.6 million, or 8 cents per diluted share, from the IRS for the settlement of the company's 1986 through 1990 tax years. Discontinued operations: The cable segment was classified as a discontinued operation effective September 30, 1995. Fiscal 1997 included a post-tax gain of $27.7 million, or 50 cents per diluted share, from the disposition of the company's remaining interest in cable television. Fiscal 1996 reflected cable net losses through the measurement date of September 30, 1995. Fiscal 1995 included a post-tax gain of $1.1 million, or 2 cents per diluted share, from the disposition of a cable property. Changes in accounting principles: Fiscal 1995 reflected the adoption of Practice Bulletin 13, "Direct- Response Advertising and Probable Future Benefits." Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion presents the key factors that have affected the company's business over the last three years. This commentary should be read in conjunction with the company's consolidated financial statements and the 5-year selected financial data presented elsewhere in this annual report. All per-share amounts refer to diluted earnings per share and are computed on a post-tax basis. This section and other areas of this annual report contain, and management's public commentary from time to time may contain, certain forward-looking statements that are subject to risks and uncertainties. The words "expect," "anticipate," "believe," "likely," "will," and similar expressions generally identify forward-looking statements. These statements are based on management's current knowledge and estimates of factors affecting the company's operations. Readers are cautioned not to place undue reliance on such forward- looking information as actual results may differ materially from those currently anticipated. Factors that could adversely affect future results include, but are not limited to: downturns in national and/or local economies; a softening of the domestic advertising market; increased consolidation among major advertisers or other events depressing the level of advertising spending; the unexpected loss of one or more major clients; changes in consumer reading, purchasing and/or television viewing patterns; unanticipated increases in paper, postage, printing or syndicated programming costs; changes in television network affiliation agreements; technological developments affecting products or methods of distribution such as the internet or e-commerce; potential adverse effects of unresolved Year 2000 issues; changes in government regulations affecting the company's industries; unexpected changes in interest rates; and any acquisitions and/or dispositions. Significant Events Fiscal 1999 - ----------- On March 1, 1999, the company acquired the net assets of WGNX-TV, the CBS affiliate serving the Atlanta market. As part of the transaction, Meredith purchased the assets of KCPQ-TV, a FOX affiliate serving the Seattle market, for $380 million from Kelly Television Company. The assets of KCPQ-TV were then transferred to Tribune Company in exchange for the assets of WGNX-TV and $10 million. As a result, the net cost of WGNX-TV was approximately $370 million. Effective July 1, 1998, Meredith sold the net assets of the Better Homes and Gardens Real Estate Service to GMAC Home Services, Inc. The sale resulted in a net gain of $1.4 million, or 3 cents per share. In a separate transaction, Meredith and GMAC Home Services entered into a licensing agreement that authorizes GMAC Home Services to use the Better Homes and Gardens trademark in connection with residential real estate marketing for a period not to exceed 10 years. GMAC Home Services will pay Meredith an annual license fee for the use of the trademark. Fiscal 1998 - ----------- On July 1, 1997, Meredith purchased the net assets of three television stations affiliated with the FOX television network from First Media Television, L.P. (First Media) for $216 million. Those stations are: KPDX-TV (Portland, Ore.); KFXO-LP (Bend, Ore. - a low-power station); and WHNS-TV (Greenville, S.C./Spartanburg, S.C./Asheville, N.C.). On September 4, 1997, Meredith acquired and then exchanged the net assets of the fourth First Media station, WCPX-TV in Orlando, for WFSB-TV, a CBS network-affiliated television station serving the Hartford/New Haven, Conn. market. WFSB-TV was acquired from Post- Newsweek Stations, Inc., through an exchange of assets plus a $60 million cash payment to Meredith. The result was a net cost to the company of $159 million for WFSB-TV. Fiscal 1997 - ----------- In October 1996, the company sold its ownership interests in cable television systems. The Meredith/New Heritage Partnership, of which the company indirectly owned 96 percent, sold its 73 percent ownership interest in Meredith/New Heritage Strategic Partners, L.P., to a subsidiary of Continental Cablevision, Inc. The total value of the systems was $262.5 million. Meredith Corporation received $116 million in cash (after payment of debt and taxes) and recorded a net gain of $27.7 million, or 50 cents per share. The cable segment was classified as discontinued on September 30, 1995. Results of Operations Years ended June 30 1999 Change 1998 Change 1997 ---------------------------------------------------------------------------- (In millions except per share) Total revenues............. $1,036.1 3 % $1,009.9 18 % $ 855.2 ======== ======== ======= Income from operations..... $ 171.1 12 % $ 152.5 33 % $ 114.7 ======== ======== ======= Earnings before nonrecurring items....... $ 88.2 10 % $ 79.9 18 % $ 67.6 ======== ======== ======= Earnings from continuing operations.... $ 89.7 12 % $ 79.9 18 % $ 67.6 ======== ======== ======= Net earnings............... $ 89.7 12 % $ 79.9 (16)% $ 95.3 ======== ======== ======= Diluted earnings per share: Earnings before nonrecurring items....... $ 1.64 12 % $ 1.46 20 % $ 1.22 ======== ======== ======= Earnings from continuing operations.... $ 1.67 14 % $ 1.46 20 % $ 1.22 ======== ======== ======= Net earnings............... $ 1.67 14 % $ 1.46 (15)% $ 1.72 ======== ======== ======= Fiscal 1999 compared to 1998 - Net earnings of $89.7 million, or $1.67 per share, were recorded in fiscal 1999 compared to net earnings of $79.9 million, or $1.46 per share, in fiscal 1998. Fiscal 1999 net earnings included a post- tax gain of $1.4 million, or 3 cents per share, from the disposition of the Better Homes and Gardens Real Estate Service. Excluding that gain, earnings per share increased 12 percent on the strength of record operating profit from the publishing segment. Increased interest expense resulting from debt incurred to finance the acquisition of WGNX-Atlanta partially offset the operating improvement. Overall, management estimates that the acquisition of WGNX-Atlanta diluted earnings per share by 8 cents per share in fiscal 1999. This estimate includes the after-tax effects of the station's operating profit after amortization of acquired intangibles and interest expense on debt incurred to finance the acquisition. Management had previously estimated fiscal 2000 dilution to be in the mid-teens on a per share basis. Based on a two-month delay in closing the acquisition and accelerated spending on news expansion, fiscal 2000 dilution could be higher than previously estimated. Fiscal 1999 revenues increased 3 percent, reflecting the acquisition of WGNX- Atlanta and growth of ongoing operations. Adjusting for the impacts of the real estate sale, the WGNX-Atlanta acquisition, the closing of Country America magazine and the fiscal 1998 first quarter acquisition of WFSB-Hartford/New Haven, revenues increased 4 percent. Increased advertising, circulation and integrated marketing revenues were the primary factors in the growth. Operating costs and expenses increased approximately 1 percent as a result of the acquisition of WGNX-Atlanta, a full year of operating costs and expenses at WFSB-Hartford/New Haven, the write-down of certain broadcast rights to net realizable value, growth in the amount of integrated marketing business, and increased investment in television programming and news expense. These increased expenses were partially offset by the absence of costs from the real estate operation, lower magazine production costs and lower average paper prices. Compensation costs increased as a result of the television station acquisitions, expanded local news programming at three television stations and normal merit increases. Depreciation and amortization increased in total and as a percentage of revenues primarily from the acquisition of WGNX-Atlanta. The operating profit margin rose from 15.1 percent of revenues in fiscal 1998 to 16.5 percent in fiscal 1999. Net interest expense increased to $21.3 million in fiscal 1999 versus expense of $13.4 million in the prior year, primarily from debt incurred to finance the acquisition of WGNX-Atlanta. The company's effective tax rate was 41.1 percent in fiscal 1999 compared with 42.6 percent in the prior year. The decline reflected lower effective state tax rates and the diminished impact of nondeductible items because of increased earnings. The weighted-average number of shares outstanding declined slightly in fiscal 1999 primarily from company share repurchases. Fiscal 1998 compared to 1997 - Earnings per share from continuing operations increased 20 percent as both the publishing and broadcasting segments reported higher operating profits. Increased interest expense resulting from debt incurred to finance the broadcasting acquisitions partially offset the operating improvements. Net earnings per share declined 15 percent as the prior year included a gain of $27.7 million, or 50 cents per share, from the sale of the discontinued cable operation. The weighted-average diluted number of shares outstanding decreased 2 percent in fiscal 1998. Fiscal 1998 revenues increased 18 percent, reflecting the broadcasting acquisitions and increased publishing revenues. On a comparable basis excluding the newly acquired stations, revenues increased approximately 10 percent. Operating costs increased due to the broadcasting acquisitions, growth in existing magazine titles and custom publishing volumes, and increased investment in newer magazine titles and television programming. Magazine paper expense increased due to a higher average cost per ton and an increase in paper usage. Compensation costs increased as a result of the acquisitions, staff growth for new magazine ventures and the start of local news at three television stations, and normal merit increases. The operating profit margin rose from 13.4 percent of revenues in fiscal 1997 to 15.1 percent in fiscal 1998. The improvement reflected a higher publishing segment margin due to increased advertising revenues and the addition of the four television stations. (The broadcasting segment is the company's highest margin business.) Depreciation and amortization increased in total, and as a percentage of revenues, from the acquisitions of the television stations. Debt incurred to finance the broadcasting acquisitions resulted in net interest expense of $13.4 million in fiscal 1998 versus net interest income of $3.8 million in fiscal 1997. Overall, management estimates that the broadcasting acquisitions were slightly accretive to earnings per share in fiscal 1998. This estimate includes the after-tax effects of the stations' operating profits after amortization of intangibles, interest expense on debt and estimated interest income forgone from cash available for investment. The company's effective tax rate was 42.6 percent in fiscal 1998 compared with 42.9 percent in fiscal 1997. Publishing - ---------- The publishing segment includes magazine and book publishing, brand licensing, integrated marketing and other related operations. Years ended June 30 1999 Change 1998 Change 1997 ---------------------------------------------------------------------------- (In millions) Revenues --------- Advertising.................. $359.1 3 % $350.2 13 % $311.2 Circulation.................. 273.6 1 % 271.0 5 % 257.2 Other........................ 141.3 (5)% 148.0 14 % 130.4 ------ ------ ------ Total revenues............... $774.0 1 % $769.2 10 % $698.8 ====== ====== ====== Operating profit............. $119.6 18 % $101.1 22 % $ 82.8 ====== ====== ====== Fiscal 1999 compared to 1998 - Publishing revenue growth was affected by the sale of the real estate operations, effective July 1, 1998, and the mid-year closing of Country America magazine. Excluding the impact of those items, revenues increased 5 percent compared to the prior year. Magazine advertising revenues grew 3 percent reflecting additional advertising pages and higher average revenues per page at most titles. Advertising categories reporting strong growth in fiscal 1999 included pharmaceutical, travel and household furnishings and appliances. The company's largest circulation title, Better Homes and Gardens magazine, reported solid advertising revenue gains, as did Country Home, Traditional Home, Midwest Living, Crayola Kids, Better Homes and Gardens Family Money and MORE magazines. The increases at Country Home, Family Money and MORE magazines reflect additional issues in fiscal 1999 compared to the prior year. This growth in advertising revenue was partially offset by lower advertising revenues at Ladies' Home Journal, Successful Farming and American Park Network resulting from fewer advertising pages. Traditional Home, Crayola Kids, and Golf for Women magazines increased their rate bases during fiscal 1999. Family Money reduced its rate base effective with the March/April 1999 issue. This reflected the decision by Metropolitan Life Insurance Company to discontinue its program of purchasing customized subscriptions to Family Money. Management is currently reviewing other options for partnerships or affiliations for the magazine. MORE magazine increased its rate base to 500,000 effective with the July/August 1999 issue. Effective with the February 2000 issue Ladies' Home Journal will lower its rate base to 4.1 million. Circulation revenues increased slightly in fiscal 1999. Excluding the impact of the closing of Country America magazine, circulation revenues increased 3 percent primarily from the rollout of MORE magazine. Other publishing revenues declined as a result of the sale of the real estate operations. Excluding the effect of that sale, other publishing revenues grew 14 percent because of increased sales in the integrated marketing and consumer book businesses. Publishing operating profit increased 18 percent to a record level in fiscal 1999. The improvement reflected higher magazine advertising revenues, lower production costs and lower average paper prices. Fiscal 1999 results were led by Better Homes and Gardens magazine. Traditional Home, Country Home, Midwest Living and Crayola Kids magazines, as well as Meredith Integrated Marketing, also posted strong operating profit increases. Investment spending for the current year test of Better Homes and Gardens Hometown Cooking magazine was less than the spending in fiscal 1998 for the launch of MORE magazine. In addition, fiscal 1999 results were affected by costs for the closing of Country America magazine and a favorable settlement related to the discontinuation of a direct marketing alliance. Paper, printing and postage costs account for approximately 40 percent of the publishing segment's operating costs. Total paper expense grew slightly as increased usage more than offset lower average prices. At June 30, 1999, paper prices had declined in the mid-single digits on a percentage basis from a year earlier. Paper prices are driven by overall market conditions and, therefore, are difficult to predict. However, at this time, management anticipates that if prices rise over the next year, the increases will be moderate. The U.S. Postal Service enacted rate changes in January 1999 that increased mailing costs an average of 4.6 percent for magazine publishers taken as a whole. Meredith's effective increase was less than the average because of the company's efficient mailing processes. The company's largest magazine printing contract has been renewed and the company has entered into new contracts with several other major printers. These new contracts are expected to result in lower unit costs in fiscal 2000 and beyond. Fiscal 1998 compared to 1997 - Total revenues increased 10 percent, reflecting increases in all major categories. The growth in magazine advertising revenues reflected additional advertising pages at most titles and higher average revenues per page. Advertising categories reporting strong growth in fiscal 1998 included the endemic home/building and food categories, as well as pharmaceuticals and financial services. The company's two largest circulation titles, Better Homes and Gardens and Ladies' Home Journal magazines, both reported strong advertising revenue gains, as did Country Home, Traditional Home, Successful Farming, Golf for Women and Crayola Kids magazines. Increased advertising revenues from the Better Homes and Gardens Special Interest Publications, the American Park Network visitor guides and the start- up of Better Homes and Gardens Family Money magazine also contributed. Increased newsstand sales of the Better Homes and Gardens Special Interest Publications and other special and custom issues, and increased subscription revenues led to the increase in magazine circulation revenues. Subscription revenue gains resulted from new titles and higher average prices for several existing titles. Consumer book revenues rose, reflecting increased sales volumes of custom books developed for The Home Depot, books sold under the Ortho agreement and the Better Homes and Gardens annuals. Increased custom publishing revenues, both from higher volumes with existing customers and new business, as well as higher transaction fee revenues from the real estate franchise operations, contributed to the increase in other publishing revenues. Publishing operating profit increased 22 percent in fiscal 1998. The improvement was largely a result of increased operating profit from higher magazine publishing advertising revenues. Favorable circulation results, due to the aforementioned revenue increases, and an increased contribution from the company's custom publishing activities also were factors. In addition, fiscal 1997 publishing operating profit was reduced by a one-time charge related to a joint publishing venture. Fiscal 1998 operating results included investment spending related to the launch of MORE magazine aimed at women over age 40. MORE was introduced as a bimonthly subscription magazine in the fall of 1998. Higher sales volumes led to increased operating profit from book publishing. Operating profit from the real estate franchise business also increased due to higher transaction fee revenues. Licensing revenues and operating profit were lower in fiscal 1998 primarily as a result of a one-time favorable audit adjustment to revenues received from the company's garden licensing agreement with Wal-Mart Stores, Inc., in fiscal 1997. The company renewed this agreement for an additional five-year period effective in January 1998. Paper, printing and postage costs account for approximately 40 percent of the publishing segment's operating costs. Total paper expenses increased nearly 10 percent due to higher average prices and an increase in usage. At June 30, 1998, paper prices were more than 10 percent higher than a year earlier. Broadcasting - ------------ The broadcasting segment includes the operation of network-affiliated television stations and syndicated television program marketing and development. Years ended June 30 1999 Change 1998 Change 1997 ---------------------------------------------------------------------------- (In millions) Revenues -------- Advertising.................. $254.3 11 % $229.9 55 % $148.5 Other........................ 7.8 (28)% 10.8 37 % 7.9 ------ ------ ------ Total revenues............... $262.1 9 % $240.7 54 % $156.4 ====== ====== ====== Operating profit............. $ 72.3 (3)% $ 74.5 34 % $ 55.7 ====== ====== ====== Fiscal 1999 compared to 1998 - Revenues increased 9 percent in fiscal 1999, including the impact of the March 1999 acquisition of WGNX-Atlanta. Excluding that impact and the effect of the September 1997 acquisition of WFSB- Hartford/New Haven, revenues increased 3 percent. The growth reflected moderate increases in local advertising revenues and the addition of political advertising revenues for the November 1998 elections. These increases were partially offset by the absence of advertising related to the 1998 Winter Olympics at the company's CBS affiliates; lower General Motors advertising, primarily in the fiscal first quarter due to the GM labor dispute; and weak advertising sales nationwide in the fiscal fourth quarter. Fiscal year revenue changes among the stations were mixed. The strongest gains were at the company's FOX affiliates, KPDX-Portland, KVVU-Las Vegas and WOFL- Orlando. The Las Vegas and Orlando stations benefited from the introduction of local news programming late in fiscal 1998, while the increase at Portland reflected strong ratings growth resulting from investments in programming. Lower advertising revenues were reported at most of the company's CBS affiliates primarily because of the aforementioned Olympic revenues in fiscal 1998. In addition, WHNS-Greenville, S.C./Spartanburg, S.C./Asheville, N.C. reported lower advertising revenues primarily due to weak local economic factors. Broadcasting operating profit declined to $72.3 million in fiscal 1999 compared to operating profit of $74.5 million in the prior year. The decline was primarily the result of a write-down of approximately $5 million of certain broadcast rights to estimated net realizable value. The write-down was largely related to the weak ratings performance of "The Roseanne Show". Several of the company's stations have programming contracts for the show through September 2000. Excluding this charge, operating profits increased slightly, reflecting higher advertising revenues, lower investment spending for television program development and the addition of WGNX-Atlanta. However, investments in programming for the television stations, including local news expansion, and sales, marketing and research activities, affected the profit growth. The company plans to continue expanding the amount of local news produced over the next 18 months by approximately 25 percent. In April 1999, the company was notified that the FOX Television Network (FOX) planned to change financial arrangements with its affiliates. In June, the company signed an agreement that is slightly more favorable to its FOX- affiliated stations than the original proposal. The new contract took effect in July 1999. The company believes this will not have a material adverse impact on fiscal 2000 financial results. Fiscal 1998 compared to 1997 - Revenues increased 54 percent in fiscal 1998, principally as a result of the first quarter acquisitions of KPDX-Portland, Ore.; KFXO-Bend, Ore. (a low-power station); WHNS-Greenville, S.C./Spartanburg, S.C./Asheville, N.C.; and WFSB-Hartford/New Haven, Conn. Excluding revenues of the newly acquired stations, the percentage increase in comparable revenues was in the mid-single digits despite an approximate $4 million decline in political advertising revenues due to the off year. On a comparable basis, the percentage increase in local/regional advertising revenues was in the mid-teens due to strong demand and higher spot rates. Most stations reported double- digit percentage advertising revenue growth. National advertising revenues increased slightly on a comparable basis, reflecting only modest growth or declines in all markets except KPHO-Phoenix. WOFL-Orlando and WSMV-Nashville registered the largest declines in national revenues. The decline at WSMV- Nashville primarily resulted from incremental revenues in fiscal 1997 related to the NBC network's coverage of the 1996 Summer Olympic Games. WOFL-Orlando was affected by declines in telecommunications, theme park and automotive advertising in the Orlando market. Including the newly acquired stations, operating profit increased 34 percent from fiscal 1997. The operating profit margin declined from 36 percent to 31 percent, primarily due to increased amortization of intangibles resulting from the acquisitions. On a comparable basis, the percentage increase in operating profit was in the mid-single digits and profit margins improved slightly compared to fiscal 1997. Four of the seven comparable stations reported higher operating profits. WOFL-Orlando reported the most significant decline in operating profit, primarily from lower advertising revenues. Costs related to the start of local news programming on March 1, 1998, also contributed. Local news programming was also introduced at WOGX-Ocala/Gainesville on that date and at KVVU-Las Vegas, beginning June 1, 1998. After the acquisition of three of the First Media stations on July 1, 1997, the company entered into new 10-year affiliation agreements with the FOX network for all of Meredith's FOX affiliates, including the three new stations. Discontinued Operation - ---------------------- In October 1996, the company sold its ownership interests in cable television operations and recorded a gain of $27.7 million, or 50 cents per share, from the sale. The gain was net of taxes and deferred cable losses from September 30, 1995, until the effective date of sale. The cable segment was classified as a discontinued operation on September 30, 1995. See Note 2 for further information on the discontinued operation. Liquidity and Capital Resources Years ended June 30 1999 Change 1998 Change 1997 ---------------------------------------------------------------------------- (In millions) Earnings from continuing operations.... $ 89.7 12 % $ 79.9 18 % $ 67.6 ======= ======= ======= Cash flows from operations. $ 134.7 7 % $ 125.6 28 % $ 98.4 ======= ======= ======= Cash flows from investing.. $(386.5) (4)% $(372.7) nm $ 45.7 ======= ======= ======= Cash flows from financing.. $ 257.9 45 % $ 177.5 nm $ (83.5) ======= ======= ======= Net cash flows............. $ 6.1 nm $ (69.5) nm $ 60.7 ======= ======= ======= EBITDA..................... $ 215.2 14 % $ 189.3 38 % $ 137.7 ======= ======= ======= nm - not meaningful Cash and cash equivalents increased by $6.1 million in fiscal 1999 compared to a decrease of $69.5 million in the prior year. The change reflected a higher level of debt funding for the television station acquisition in the current year compared to the debt financing of acquisitions in the prior year. Cash provided by operating activities increased because of higher operating cash flows (earnings plus depreciation and amortization), including the addition of cash flows from the Atlanta television station. Also contributing to the increase were changes in working capital items that resulted primarily from the prior-year television station acquisitions. These increases in cash provided by operations were partially offset by changes in deferred income taxes, reflecting a tax-basis market-value adjustment related to accounts receivable in the prior-year period. The acquisition of WGNX-Atlanta resulted in substantial increases in certain balance sheet items including: accounts receivable; broadcast rights; property, plant and equipment; goodwill and other intangibles; and broadcast rights payable. EBITDA is defined as earnings from continuing operations before interest, taxes, depreciation and amortization. EBITDA is often used to analyze and compare companies on the basis of operating performance and cash flow. Fiscal 1999 EBITDA increased 14 percent from fiscal 1998. EBITDA is not adjusted for all noncash expenses or for working capital, capital expenditures and other investment requirements. EBITDA should not be considered in isolation or as a substitute for measures of performance prepared in accordance with generally accepted accounting principles. At June 30, 1999, long-term debt outstanding totaled $530 million. This debt has been incurred over the last two fiscal years in connection with the acquisitions of five television stations. The company has two variable-rate bank credit facilities with total outstanding debt of $330 million at June 30, 1999. Interest rates are based on applicable margins plus, at the company's option, either LIBOR or the higher of the overnight federal funds rate plus 0.5 percent or the bank's prime rate. In addition, at June 30, 1999, the company has $200 million outstanding of fixed-rate unsecured senior notes issued to five insurance companies. Interest rates on the notes range from 6.51 percent to 6.65 percent. Principal payments on the debt due in succeeding fiscal years are: Years ended June 30 ------------------- (In millions) 2000............ $ 45.0 2001............ 50.0 2002............ 35.0 2003............ 100.0 2004............ 100.0 Later years..... 200.0 ------ Total........... $530.0 ====== Funds for payments of interest and principal on the debt are expected to be provided by cash generated by future operating activities. The weighted- average interest rate on debt outstanding at June 30, 1999, was approximately 6.5 percent. These debt agreements include certain financial covenants related to debt levels and coverage ratios. As of June 30, 1999, the company was in compliance with all debt covenants. Meredith uses interest rate swap contracts to manage interest cost and risk associated with possible increases in variable interest rates. Under these contracts, Meredith pays fixed rates of interest while receiving floating rates of interest based on three-month LIBOR. These contracts effectively fix the base interest rate on a substantial portion of the variable-rate credit facilities, although the applicable margins vary based on the company's debt- to-EBITDA ratio. The notional amount covered by the contracts was $273 million at June 30, 1999. The swap contracts expire on June 28, 2002, and the notional amount varies over the terms of the contracts. The company is exposed to credit-related losses in the event of nonperformance by counterparties to the contracts. Management does not expect any counterparties to fail to meet their obligations, given their strong creditworthiness. At June 30, 1999, Meredith had available credit totaling $160 million, including $150 million under a revolving credit facility. Any amounts borrowed under this agreement are due and payable on May 31, 2002. In fiscal 1999, the company spent $43.9 million to repurchase an aggregate of approximately 1.1 million shares of Meredith Corporation common stock at then current market prices. This compares with fiscal 1998 spending of $31.2 million for the repurchase of approximately 900,000 shares. The company expects to continue to repurchase shares from time to time in the foreseeable future, subject to market conditions. In fiscal 1998, the company entered into a put option agreement to repurchase up to 598,000 common shares at market prices, subject to certain restrictions and discounts. In July 1998, 270,000 shares were repurchased under this agreement. The agreement expired in February 1999 with no further activity. Meredith entered into similar put option agreements effective August 1, 1998, to repurchase up to 1.6 million common shares over the following 24 months. As of June 30, 1999, 77,000 shares had been repurchased under these agreements. These put option agreements were entered into in order to provide an orderly process for the planned liquidation of blocks of Meredith stock by certain trusts of the Bohen family, nonaffiliate descendants of the company's founder. As of June 30, 1999, approximately 1.9 million shares could be repurchased under existing authorizations by the board of directors. The status of this program is reviewed at each quarterly board of directors meeting. Dividends paid in fiscal 1999 were $15.1 million, or 29 cents per share, compared with $14.3 million, or 27 cents per share, in fiscal 1998. On February 1, 1999, the board of directors increased the quarterly dividend by 7 percent, or one-half cent per share, to 7.5 cents per share effective with the dividend payable on March 15, 1999. On an annual basis, this increase will result in the payment of approximately $1 million in additional dividends, based on the current number of shares outstanding. The board of directors also approved a dividend reinvestment plan, effective May 31, 1999. Expenditures for property, plant and equipment were $25.7 million in fiscal 1999 compared to $46.2 million in fiscal 1998. The decrease primarily reflected the completion of a new office building and related improvements in Des Moines in fiscal 1998. Fiscal 1998 spending included $23 million for this project. Significant spending in fiscal 1999 included the purchase of land and initial construction costs for a new broadcasting facility for KPDX-Portland, expenditures for the initial implementation of digital television technology at five stations, and expenditures for broadcast news equipment primarily related to the introduction or expansion of local news programming. The broadcasting segment expects to spend approximately $60 million over the next three fiscal years for the initial transition to digital technology, and for new and remodeled facilities and other costs associated with the introduction, expansion or improvement of news programming. This spending includes the completion of the KPDX-Portland facility and the purchase of land and construction of a new broadcasting facility for WGNX-Atlanta. Construction in Atlanta is expected to begin in fiscal 2000 and be completed in calendar year 2001. Also, Meredith has a commitment to spend approximately $13 million over the next two years for replacement aircraft. The company has no other material commitments for capital expenditures. Funds for capital expenditures are expected to be provided by cash from operating activities or, if necessary, borrowings under credit agreements. At this time, management expects that cash on hand, internally generated cash flow and debt from credit agreements will provide funds for any additional operating and recurring cash needs (e.g., working capital, cash dividends) for the foreseeable future. Year 2000 - ---------- The Year 2000 issue, common to most companies, concerns the inability of information and noninformation systems to recognize and process date-sensitive information because of the use of only the last two digits to refer to a year. This problem could affect information systems (software and hardware) and other equipment that relies on microprocessors. Management completed a company-wide evaluation of this impact on its computer systems, applications and other date- sensitive equipment. Systems and equipment that were not Year 2000 compliant were identified and substantially all remediation efforts and testing of systems/equipment were completed by June 30, 1999. The company also is in the process of monitoring the progress of material third parties (vendors and suppliers) in their efforts to become Year 2000 compliant. Those third parties include, but are not limited to: magazine and book printers, paper suppliers, magazine fulfillment providers, the U. S. Postal Service, television networks, other television programming suppliers, mainframe computer services suppliers, financial institutions and utilities. One area of particular concern is the company's and material third parties' dependence on power and telecommunications services and the limited availability of alternative sources. The company has sought compliance information with respect to vendors and suppliers through the use of surveys, industry groups, peer reviews and vendor Web sites. Management then followed up to obtain more detailed information regarding the Year 2000 efforts of material third parties. Most of these material third parties have been cooperative and are supplying Year 2000 project-related information. The company continues to pursue additional information from material third parties where needed and from those not responding. Through June 30, 1999, the company has spent approximately $2.7 million to address Year 2000 issues. Total costs to address Year 2000 issues are currently estimated not to exceed $5 million and consist primarily of costs for the remediation of internal systems and broadcasting equipment. Funds for these costs are expected to be provided by the operating cash flows of the company. The majority of the internal system remediation efforts relate to staff costs of on-staff systems engineers and, therefore, are not incremental costs. Meredith Corporation could be faced with severe consequences if Year 2000 issues are not identified and resolved in a timely manner by the company and material third parties. A worst-case scenario would result in the short-term inability of the company to produce and distribute magazines or broadcast television programming because of unresolved Year 2000 issues. This would result in lost revenues; however, the amount would be dependent on the length and nature of the disruption, which cannot be predicted or estimated. In light of the possible consequences, the company is devoting the resources needed to address Year 2000 issues in a timely manner. Management has contracted with an outside consultant to monitor the progress of Meredith's Year 2000 efforts and provide update reports to the audit committee of the board of directors at each quarterly meeting. While management expects successful resolution of Year 2000 issues, there can be no guarantee that all Year 2000 issues will be identified and resolved by Meredith, material third parties, on which Meredith relies, will address all Year 2000 issues on a timely basis or that failure to successfully address all issues would not have an adverse effect on Meredith. Meredith has developed contingency plans in case business interruptions occur. Initial contingency plans were substantially complete at June 30, 1999. Meredith will continue to develop, review, test and revise contingency plans, as more information becomes available. Quantitative and Qualitative Disclosures about Market Risk Market Risk - ----------- The market risk inherent in the company's financial instruments subject to such risks is the potential market value loss arising from adverse changes in interest rates and/or the potential effect of increases in the market price of company common stock on the company's liquidity. All of the company's financial instruments subject to market risk are held for purposes other than trading. Interest Rate Swap Contracts - ---------------------------- The company uses interest rate swap contracts to reduce exposure to interest rate fluctuations on its debt. At June 30, 1999, the company had interest rate swap contracts that effectively converted a substantial portion of its outstanding bank debt from floating interest rates to a fixed interest rate. Since interest rates on the majority of the debt are effectively fixed, changes in interest rates would have little impact on future interest expense related to this debt. Therefore, there is no material earnings or liquidity risk associated with the interest rate swap agreements. The fair market value of the interest rate swaps is the estimated amount, based on discounted cash flows, the company would pay or receive to terminate the swap contracts. A 10 percent decrease in interest rates would result in a $2.1 million cost to terminate the swap agreements compared to the current benefit of $1.4 million at June 30, 1999. Put Option Agreements - --------------------- At June 30, 1999, the company had put option agreements outstanding to repurchase up to 1.5 million common shares. These agreements require the company to buy these shares at market prices subject to certain terms and conditions. The risk to the company of an increase in share price is from a liquidity perspective. Based on the June 30, 1999 closing price, a 10 percent increase in share price would cause the potential repurchase cost for these put options to increase by $5.3 million. This calculation is based on a sudden increase in share price and all outstanding put options exercised at that price. Broadcast Rights Payable - ------------------------ The company enters into contracts for broadcast rights to air on its television stations. These contracts are generally on a market-by-market basis and subject to terms and conditions of the seller of the broadcast rights. Generally, these rights are sold to the highest bidder in each market and the process is very competitive. There are no earnings or liquidity risks associated with broadcast rights payable. Fair market values are determined using discounted cash flows. At June 30, 1999, a 10 percent decrease in interest rates would result in a $1.3 million increase in the fair market value of the available and unavailable broadcast rights payable. Financial Statements and Supplementary Data Consolidated Balance Sheets Meredith Corporation and Subsidiaries Assets June 30 1999 1998 - ------------------------------------------------------------------------------- (In thousands) Current assets: Cash and cash equivalents........................ $ 11,029 $ 4,953 Accounts receivable (net of allowances of $12,010 in 1999 and $12,119 in 1998)........................... 138,723 138,036 Inventories...................................... 33,511 34,765 Subscription acquisition costs................... 41,396 47,070 Broadcast rights................................. 14,644 14,809 Other current assets............................. 16,872 7,168 ---------- ---------- Total current assets............................... 256,175 246,801 Property, plant and equipment Land............................................. 11,141 11,141 Buildings and improvements....................... 89,807 86,095 Machinery and equipment.......................... 171,576 156,280 Leasehold improvements........................... 7,846 7,540 Construction in progress......................... 13,940 6,432 ---------- ---------- Total property, plant and equipment................ 294,310 267,488 Less accumulated depreciation.................... (134,554) (116,407) ---------- ---------- Net property, plant and equipment.................. 159,756 151,081 ---------- ---------- Subscription acquisition costs..................... 31,182 36,941 Other assets....................................... 39,478 33,808 Goodwill and other intangibles (at original cost less accumulated amortization of $120,445 in 1999 and $97,716 in 1998)............ 936,805 597,358 ---------- ---------- Total assets....................................... $1,423,396 $1,065,989 ========== ========== See accompanying Notes to Consolidated Financial Statements. Liabilities and Stockholders' Equity June 30 1999 1998 - ------------------------------------------------------------------------------- (In thousands except share data) Current liabilities: Current portion of long-term debt................ $ 45,000 $ 40,000 Current portion of long-term broadcast rights payable................................. 21,123 18,934 Accounts payable................................. 55,018 63,171 Accruals: Compensation and benefits...................... 34,596 31,730 Distribution expenses.......................... 17,429 17,517 Other taxes and expenses....................... 35,204 33,528 ---------- ---------- Total accruals..................................... 87,229 82,775 Unearned subscription revenues..................... 135,745 141,989 ---------- ---------- Total current liabilities.......................... 344,115 346,869 Long-term debt..................................... 485,000 175,000 Unearned subscription revenues..................... 90,276 95,603 Deferred income taxes.............................. 33,578 20,822 Other noncurrent liabilities....................... 57,122 49,682 ---------- ---------- Total liabilities.................................. 1,010,091 687,976 ---------- ---------- Temporary equity: Put option agreements Common stock, outstanding, 1,535,140 shares in 1999 and 597,878 shares in 1998........................ 53,147 28,063 ---------- ---------- Stockholders' equity: Series preferred stock, par value $1 per share Authorized 5,000,000 shares; none issued........ -- -- Common stock, par value $1 per share Authorized 80,000,000 shares; issued and outstanding 39,220,509 shares in 1999 (excluding 27,362,776 shares held in treasury) and 40,996,510 shares in 1998 (excluding 26,274,767 shares held in treasury)............. 39,220 40,996 Class B stock, par value $1 per share, convertible to common stock Authorized 15,000,000 shares; issued and outstanding 11,063,708 shares in 1999 and 11,279,881 shares in 1998....................... 11,064 11,280 Retained earnings.................................. 312,553 301,201 Accumulated other comprehensive loss............... (625) (1,177) Unearned compensation.............................. (2,054) (2,350) ---------- ---------- Total stockholders' equity......................... 360,158 349,950 ---------- ---------- Total liabilities and stockholders' equity......... $1,423,396 $1,065,989 ========== ========== See accompanying Notes to Consolidated Financial Statements. Consolidated Statements of Earnings Meredith Corporation and Subsidiaries Years ended June 30 1999 1998 1997 - -------------------------------------------------------------------------- (In thousands except per share) Revenues: Advertising........................ $ 613,400 $ 580,029 $ 459,678 Circulation........................ 273,621 271,004 257,222 All other.......................... 149,101 158,894 138,318 ---------- ---------- ---------- Total revenues....................... 1,036,122 1,009,927 855,218 ---------- ---------- ---------- Operating costs and expenses: Production, distribution and edit.. 427,556 408,560 339,895 Selling, general & administrative.. 393,396 412,026 377,655 Depreciation and amortization...... 44,083 36,840 22,997 ---------- ---------- ---------- Total operating costs and expenses... 865,035 857,426 740,547 ---------- ---------- ---------- Income from operations............... 171,087 152,501 114,671 Gain from disposition................ 2,375 -- -- Interest income...................... 710 1,278 5,010 Interest expense..................... (21,997) (14,665) (1,254) ---------- ---------- ---------- Earnings from continuing operations before income taxes................ 152,175 139,114 118,427 Income taxes......................... 62,518 59,256 50,835 ---------- ---------- ---------- Earnings from continuing operations.. 89,657 79,858 67,592 Discontinued operation: Gain from disposition.............. -- -- 27,693 ---------- ---------- ---------- Net earnings......................... $ 89,657 $ 79,858 $ 95,285 ========== ========== ========== Basic earnings per share: Earnings from continuing operations.. $ 1.72 $ 1.51 $ 1.26 Discontinued operation............... -- -- 0.52 ---------- ---------- ---------- Net earnings per share............... $ 1.72 $ 1.51 $ 1.78 ========== ========== ========== Basic average shares outstanding..... 52,188 52,945 53,566 ========== ========== ========== Diluted earnings per share: Earnings from continuing operations.. $ 1.67 $ 1.46 $ 1.22 Discontinued operation............... -- -- 0.50 ---------- ---------- ---------- Net earnings per share............... $ 1.67 $ 1.46 $ 1.72 ========== ========== ========== Diluted average shares outstanding... 53,761 54,603 55,522 ========== ========== ========== See accompanying Notes to Consolidated Financial Statements. Consolidated Statements of Cash Flows Meredith Corporation and Subsidiaries Years ended June 30 1999 1998 1997 - ------------------------------------------------------------------------------- (In thousands) Cash flows from operating activities: Net earnings................................... $ 89,657 $ 79,858 $ 95,285 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization.................. 44,083 36,840 22,997 Amortization of broadcast rights............... 38,529 27,677 17,388 Payments for broadcast rights.................. (33,601) (28,269) (18,184) Gain from disposition, net of taxes............ (1,425) -- -- Gain from discontinued operation............... -- -- (27,693) Changes in assets and liabilities: Accounts receivable.......................... 387 (44,641) (518) Inventories.................................. 900 (4,492) 912 Supplies and prepayments..................... (743) 2,972 (1,360) Subscription acquisition costs............... 11,433 8,136 3,485 Accounts payable............................. (7,273) 14,865 6,221 Accruals..................................... 5,143 16,797 (6,073) Unearned subscription revenues............... (11,571) (3,393) 2,773 Deferred income taxes........................ 2,179 11,269 (1,871) Other noncurrent liabilities................. (3,022) 7,960 5,087 -------- -------- -------- Net cash provided by operating activities........ 134,676 125,579 98,449 -------- -------- -------- Cash flows from investing activities: Purchases of marketable securities............. -- -- (50,557) Redemptions of marketable securities........... -- 50,371 -- Proceeds from dispositions..................... 9,922 -- 123,275 Acquisitions of businesses..................... (372,186) (375,000) -- Additions to property, plant, and equipment.... (25,691) (46,181) (23,299) Changes in investments and other............... 1,426 (1,858) (3,678) -------- -------- -------- Net cash (used) provided by investing activities. (386,529) (372,668) 45,741 -------- -------- -------- Cash flows from financing activities: Long-term debt incurred........................ 400,000 270,000 -- Repayment of long-term debt.................... (85,000) (55,000) (50,000) Debt acquisition costs......................... (1,342) (195) -- Proceeds from common stock issued.............. 2,560 8,386 6,142 Purchases of company stock..................... (43,852) (31,194) (29,268) Dividends paid................................. (15,129) (14,286) (12,839) Other.......................................... 692 (167) 2,472 -------- -------- -------- Net cash provided (used) by financing activities. 257,929 177,544 (83,493) -------- -------- -------- Net increase (decrease) in cash and cash equivalents................................ 6,076 (69,545) 60,697 Cash and cash equivalents at beginning of year... 4,953 74,498 13,801 -------- -------- -------- Cash and cash equivalents at end of year......... $ 11,029 $ 4,953 $ 74,498 ======== ======== ======== Supplemental disclosures of cash flow information: Cash paid Interest....................................... $ 15,394 $ 15,301 $ 1,818 ======== ======== ======== Income taxes................................... $ 58,341 $ 28,339 $ 66,105 ======== ======== ======== Noncash transactions Broadcast rights financed by contracts payable. $ 36,171 $ 14,778 $ 13,734 ======== ======== ======== Tax benefit related to stock options........... $ 1,577 $ 8,275 $ 3,574 ======== ======== ======== See accompanying Notes to Consolidated Financial Statements. Consolidated Statements of Stockholders' Equity Meredith Corporation and Subsidiaries Accum Add'l Other Unearned Common Class B Paid-in Retained Comp. Compensa- (In thousands) Stock Stock Capital Earnings Inc(Loss) tion Total - ------------------------------------------------------------------------------- Balance at June 30, 1996 $20,380 $6,569 -- $236,903 $( 48) $(2,288) $261,516 - ------------------------------------------------------------------------------- Comprehensive income: Net earnings -- -- -- 95,285 -- -- 95,285 Other comprehen- sive loss, net -- -- -- -- (233) -- (233) ------ Total comp income 95,052 Stock issued under various incentive plans, net of forfeitures 596 -- 7,066 -- -- (1,527) 6,135 Purchases of company stock (1,237) -- (11,874) (16,157) -- -- (29,268) Conversion of class B to common stock 803 (803) -- -- -- -- -- Two-for-one stock split in March 1997 20,380 6,569 -- (26,949) -- -- -- Dividends paid, 24 cents per share Common stock -- -- -- (9,784) -- -- (9,784) Class B stock -- -- -- (3,055) -- -- (3,055) Restricted stock amortized to operations -- -- 674 -- -- 1,245 1,919 Tax benefit from incentive plans -- -- 3,574 -- -- -- 3,574 Other -- -- 560 -- -- -- 560 - ------------------------------------------------------------------------------- Balance at June 30, 1997 $40,922 $12,335 -- $276,243 $(281) $(2,570) $326,649 - ------------------------------------------------------------------------------- Consolidated Statements of Stockholders' Equity - Continued Meredith Corporation and Subsidiaries Accum Add'l Other Unearned Common Class B Paid-in Retained Comp. Compensa- (In thousands) Stock Stock Capital Earnings Inc(Loss) tion Total - ------------------------------------------------------------------------------- Balance at June 30, 1997 $40,922 $12,335 -- $276,243 $(281) $(2,570) $326,649 - ------------------------------------------------------------------------------- Comprehensive income: Net earnings -- -- -- 79,858 -- -- 79,858 Other comprehen- sive loss, net -- -- -- -- (896) -- (896) ------ Total comp income 78,962 Stock issued under various incentive plans, net of forfeitures 516 -- 8,615 -- -- (745) 8,386 Purchases of company stock (899) -- (17,146) (13,149) -- -- (31,194) Reclassification of put option agreement (598) -- -- (27,465) -- -- (28,063) Conversion of class B to common stock 1,055 (1,055) -- -- -- -- -- Dividends paid, 27 cents per share Common stock -- -- -- (11,126) -- -- (11,126) Class B stock -- -- -- (3,160) -- -- (3,160) Restricted stock amortized to operations -- -- 256 -- -- 965 1,221 Tax benefit from incentive plans -- -- 8,275 -- -- -- 8,275 - ------------------------------------------------------------------------------- Balance at June 30, 1998 $40,996 $11,280 -- $301,201 $(1,177) $(2,350) $349,950 - ------------------------------------------------------------------------------- Consolidated Statements of Stockholders' Equity - Continued Meredith Corporation and Subsidiaries Accum Add'l Other Unearned Common Class B Paid-in Retained Comp. Compensa- (In thousands) Stock Stock Capital Earnings Inc(Loss) tion Total - ------------------------------------------------------------------------------- Balance at June 30, 1998 $40,996 $11,280 -- $301,201 $(1,177) $(2,350) $349,950 - ------------------------------------------------------------------------------- Comprehensive income: Net earnings -- -- -- 89,657 -- -- 89,657 Other comprehen- sive income, net -- -- -- -- 552 -- 552 ------ Total comp income 90,209 Stock issued under various incentive plans, net of forfeitures 66 -- 2,125 -- -- (664) 1,527 Purchases of company stock (1,115) (6) (3,702) (39,029) -- -- (43,852) Reclassification of put option agreement (937) -- -- (24,147) -- -- (25,084) Conversion of class B to common stock 210 (210) -- -- -- -- -- Dividends paid, 29 cents per share Common stock -- -- -- (11,893) -- -- (11,893) Class B stock -- -- -- (3,236) -- -- (3,236) Restricted stock amortized to operations -- -- -- -- -- 960 960 Tax benefit from incentive plans -- -- 1,577 -- -- -- 1,577 - ------------------------------------------------------------------------------- Balance at June 30, 1999 $39,220 $11,064 -- $312,553 $ (625) $(2,054) $360,158 - ------------------------------------------------------------------------------- See accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Meredith Corporation and Subsidiaries 1. Organization and Summary of Significant Accounting Policies a. Nature of operations Meredith Corporation is a diversified media company primarily focused on the home and family marketplace. The company's principal businesses are magazine publishing and television broadcasting. Operating profits of the publishing and broadcasting segments were 62 percent and 38 percent, respectively, of total operating profit before unallocated corporate expense in fiscal 1999. Magazine operations accounted for approximately 90 percent of the revenues and operating profit of the publishing segment, which also includes book publishing, brand licensing, residential real estate franchising, integrated marketing and other related operations. The residential real estate operations were sold in July 1998. Better Homes and Gardens is the most significant trademark to the publishing segment and is used extensively in its operations. The company's television broadcasting operations include 12 network-affiliated television stations. Meredith's operations are diversified geographically within the United States, and the company has a broad customer base. Advertising and magazine circulation revenues accounted for 59 percent and 26 percent, respectively, of the company's revenues in fiscal 1999. Revenues and operating results can be affected by changes in the demand for advertising and/or consumer demand for the company's products. National and local economic conditions largely affect the overall industry levels of advertising revenues. Magazine circulation revenues are generally affected by national and/or regional economic conditions and competition from other forms of media. b. Principles of consolidation The consolidated financial statements include the accounts of Meredith Corporation and its majority-owned subsidiaries. On March 1, 1999, the net assets of WGNX-TV, a CBS affiliate serving the Atlanta market, were acquired. Its results of operations are included in the company's fiscal 1999 financial statements from the acquisition date. There are no significant intercompany transactions. c. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates. d. Cash and cash equivalents All cash and short-term investments with original maturities of three months or less are considered cash and cash equivalents, since they are readily convertible to cash. These short-term investments are stated at cost which approximates fair value. e. Marketable securities No marketable securities were owned at any time during fiscal 1999 or at June 30, 1998. Marketable securities at June 30, 1997, were classified as available-for-sale and consisted of short-term debt securities issued by the U.S. Treasury. Proceeds from sales and maturities of securities were $50.4 million during fiscal 1998. Realized gains and losses were not material. The costs used to compute realized gains and losses were determined by specific identification. f. Inventories Paper inventories are stated at cost, which is not in excess of market value, using the last-in first-out (LIFO) method. All other inventories are stated at the lower of cost (first-in first-out, or average) or market. g. Subscription acquisition costs Subscription acquisition costs primarily represent magazine direct-mail agency commissions. These costs are deferred and amortized over the related subscription term, typically one or two years. h. Property, plant and equipment Property, plant and equipment are stated at cost. Costs of replacements and major improvements are capitalized, and maintenance and repairs are charged to operations as incurred. Depreciation expense is provided primarily by the straight-line method over the estimated useful lives of the assets: five to 45 years for buildings and improvements, and three to 20 years for machinery and equipment. The costs of leasehold improvements are amortized over the lesser of the useful lives or the terms of the respective leases. Depreciation and amortization of property, plant and equipment was $21.4 million in fiscal 1999 ($17.8 million in fiscal 1998 and $12.4 million in fiscal 1997). i. Broadcast rights Broadcast rights and the liabilities for future payments are reflected in the consolidated financial statements when programs become available for broadcast. These rights are valued at the lower of cost or estimated net realizable value and are generally charged to operations on an accelerated basis over the contract period. Amortization of these rights is included in production, distribution and editorial expenses. Any reduction in unamortized costs to net realizable value is included in amortization of broadcast rights in the accompanying Consolidated Financial Statements. Fiscal 1999 results include expense of approximately $5 million for such reductions in unamortized costs. These expenses were not material in fiscal 1998 or 1997. j. Goodwill and other intangibles Goodwill and other intangibles represent the excess of the purchase price over the estimated fair values of net tangible assets acquired in the purchases of businesses. The values of identifiable intangibles have been determined by independent appraisals. The unamortized portion of intangible assets primarily consisted of television Federal Communications Commission (FCC) licenses ($440.4 million and $263.8 million at June 30, 1999 and 1998), goodwill ($270.4 million and $170.1 million at June 30, 1999 and 1998), and television network affiliation agreements ($208.4 million and $143.3 million at June 30, 1999 and 1998). Virtually all of these assets were acquired after October 31, 1970, and are being amortized by the straight-line method over the following periods: 40 years for television FCC licenses; 20 to 40 years for goodwill; and 15 to 40 years for network affiliation agreements. The company evaluates the recoverability of its intangible assets as current events or circumstances warrant to determine whether adjustments are needed to carrying values. Such evaluation may be based on projected income and cash flows on an undiscounted basis from the underlying business or from operations of related businesses. Other economic and market variables also are considered in any evaluation. k. Derivative financial instruments All interest rate swap agreements are held for purposes other than trading, and are accounted for by the accrual method. Amounts due to or from counterparties are recorded as adjustments to interest expense in the periods in which they accrue. The fair market value of put options outstanding is reclassified from stockholders' equity to the temporary equity classification titled, "Put option agreements." Adjustments to the fair market value resulting from changes in the stock price of the company's common shares result in adjustments between equity and temporary equity, with no effect on earnings. l. Revenues Advertising revenues are recognized when the advertisements are published or aired. Magazine advertising revenues totaled $359.1 million in fiscal 1999 ($350.2 million in fiscal 1998 and $311.2 million in fiscal 1997). Broadcasting advertising revenues were $254.3 million in fiscal 1999 ($229.9 million in fiscal 1998 and $148.5 million in fiscal 1997). Revenues from magazine subscriptions are deferred and recognized proportionately as products are delivered to subscribers. Revenues from magazines sold on the newsstand and books are recognized at shipment, net of provisions for returns. m. Advertising expenses Total advertising expenses included in the Consolidated Statements of Earnings were $76.2 million in fiscal 1999, $74.8 million in fiscal 1998 and $71.8 million in fiscal 1997. The majority of the company's advertising expenses relate to direct-mail costs for magazine subscription acquisition efforts. These costs are expensed as incurred. n. Stock-based compensation The company accounts for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees." The company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." o. Income Taxes The company accounts for certain income and expense items differently for financial reporting purposes than for income tax reporting purposes. Deferred income taxes are provided in recognition of these temporary differences. p. Earnings per share Basic earnings per share (EPS) is computed using the weighted average number of actual common shares outstanding during the period. Diluted EPS reflects the potential dilution that would occur from the exercise of common stock options outstanding and the issuance of other stock equivalents. The following table presents the calculations of EPS from continuing operations: Years ended June 30 1999 1998 1997 - ------------------------------------------------------------------------- (In thousands except per share) Earnings from continuing operations...... $89,657 $79,858 $67,592 ======= ======= ======= Basic average shares outstanding......... 52,188 52,945 53,566 Dilutive effect of stock options and equivalents........................ 1,573 1,658 1,956 ------- ------- ------- Diluted average shares outstanding....... 53,761 54,603 55,522 ======= ======= ======= Basic EPS from continuing operations..... $ 1.72 $ 1.51 $ 1.26 ======= ======= ======= Diluted EPS from continuing operations... $ 1.67 $ 1.46 $ 1.22 ======= ======= ======= Antidilutive options excluded from the above calculations totaled 705,000 options at June 30, 1999 (with a weighted average exercise price of $40.11), 5,000 options at June 30, 1998 (with a weighted average exercise price of $42.87) and 517,000 options at June 30, 1997 (with a weighted average exercise price of $27.45). q. Other Certain prior-year financial information has been reclassified or restated to conform to the fiscal 1999 financial statement presentation. The company adopted SFAS No. 130, "Reporting Comprehensive Income," SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," and SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," effective July 1, 1998. These statements require revised and/or additional disclosures but did not have a material effect on the results of operations or financial position of the company. 2. Discontinued Operation On October 25, 1996, the Meredith/New Heritage partnership (MNH Partnership), of which the company indirectly owned 96 percent, completed the sale of its 73 percent ownership interest in Meredith/New Heritage Strategic Partners, L.P. (Strategic Partners), to Continental Cablevision of Minnesota Subsidiary Corporation, an affiliate of MNH Partnership's minority partner, Continental Cablevision of Minnesota, Inc. Strategic Partners owned and operated cable television systems with approximately 127,000 subscribers in the Minneapolis/St. Paul area. The total value of the cable television systems was $262.5 million based on estimated future cash flows. Strategic Partners' debt of $84.3 million was retired. Meredith Corporation's share of the proceeds after the debt payment and taxes was $116 million. The company recorded a gain of $27.7 million, or 50 cents per share, from the sale. The gain was net of income tax expense of $8.8 million and deferred operating losses of $0.2 million. The deferred operating losses represented cable operating results after the measurement date of September 30, 1995. Those financial results included revenues of $52.9 million, income from operations of $5.9 million and a net loss of $0.2 million (including income tax expense of $89,000). Cable operating results in fiscal 1997 included revenues of $13.4 million, income from operations of $1.6 million and a net profit of $0.2 million (including an income tax benefit of $40,000). Interest expense reflected in the results of the discontinued cable operation was specifically attributable to the cable operation and the related debt was nonrecourse to Meredith Corporation. 3. Acquisitions and Dispositions On March 1, 1999, the company acquired the net assets of WGNX-TV, the CBS affiliate serving the Atlanta market. As part of the transaction, Meredith purchased the assets of KCPQ-TV, a FOX affiliate serving the Seattle market, for $380 million from Kelly Television Company. The assets of KCPQ-TV were then transferred to Tribune Company in exchange for the assets of WGNX-TV and $10 million. As a result, the net cost of WGNX-TV was approximately $370 million. On July 1, 1997, Meredith purchased the net assets of three television stations affiliated with the FOX television network from First Media Television, L.P. (First Media) for $216 million. Those stations are: KPDX-TV (Portland, Ore.); KFXO-LP (Bend, Ore. - a low-power station); and WHNS-TV (Greenville, S.C./Spartanburg, S.C./Asheville, N.C.). Meredith had also agreed to acquire WCPX-TV, a CBS network-affiliated television station serving the Orlando, Fla. market, from First Media. However, the company already owned WOFL-TV, a FOX network-affiliated television station serving the Orlando market. FCC regulations at that time prohibited the ownership of more than one television station in a market. Therefore, Meredith transferred the net assets of WCPX-TV to Post-Newsweek Stations, Inc. (Post-Newsweek), in exchange for the net assets of WFSB-TV, a CBS network- affiliated television station serving the Hartford/New Haven, Conn., market. Post-Newsweek is a wholly owned subsidiary of the Washington Post Company. The acquisition of WCPX-TV and the subsequent exchange for WFSB-TV were completed on September 4, 1997, at a net cost of $159 million. All of the above acquisitions were accounted for as asset purchases, and accordingly, the operations of the acquired properties have been included in the company's consolidated operating results from their respective acquisition dates. The costs of the acquisitions were allocated on the bases of the estimated fair market values of the assets acquired and liabilities assumed. These purchase price allocations included the following intangibles: FCC licenses of $185.0 million in 1999 and $212.4 million in 1998, network affiliation agreements of $70.0 million in 1999 and $90.7 million in 1998, and goodwill of $107.5 million in 1999 and $40.1 million in 1998. These intangibles are being amortized over periods ranging from 15 to 40 years. The acquisitions also included property, plant and equipment and broadcast program rights and the related payables. (See Note 5 for information on the debt incurred to finance these acquisitions.) Pro forma results of operations as if the acquisitions had occurred at the beginning of each period presented are as follows: Years ended June 30 1999 1998 - ------------------------------------------------------------------ (In thousands except per share) Total revenues.......................... $1,057,280 $1,050,383 ========== ========== Net earnings............................ $ 81,151 $ 69,850 ========== ========== Basic earnings per share................ $ 1.55 $ 1.32 ========== ========== Diluted earnings per share.............. $ 1.51 $ 1.28 ========== ========== Effective July 1, 1998, the company sold the net assets of the Better Homes and Gardens Real Estate Service to GMAC Home Services, Inc., a subsidiary of GMAC Financial Services. Fiscal 1999 earnings include an after-tax gain of $1.4 million, or 3 cents per diluted share, from the sale, which closed on July 27, 1998. See Note 2 for information regarding the disposition of the discontinued cable segment in fiscal 1997. 4. Inventories Inventories consist of paper stock, books and editorial content. Of net inventory values shown, approximate portions determined using the LIFO method were 46 percent at June 30, 1999, and 58 percent at June 30, 1998. LIFO inventory (income) expense included in the Consolidated Statements of Earnings was ($2.0) million in fiscal 1999, $1.4 million in fiscal 1998 and ($6.0) million in fiscal 1997. June 30 1999 1998 - --------------------------------------------------------------------------- (In thousands) Raw materials..................................... $17,686 $24,777 Work in process................................... 16,569 13,286 Finished goods.................................... 5,965 5,446 ------- ------- 40,220 43,509 Reserve for LIFO cost valuation................... (6,709) (8,744) ------- ------- Inventories....................................... $33,511 $34,765 ======= ======= 5. Long-term Debt The company has variable rate unsecured credit agreements consisting of a $210 million amortizing term loan (of which $130 million remains outstanding at June 30, 1999), a $200 million amortizing term loan entered into on December 10, 1998, and a $150 million revolving credit facility. Any amounts borrowed under the revolving credit facility are due and payable on May 31, 2002. Interest rates under the variable rate credit facilities are based on applicable margins plus, at the company's option, either LIBOR or the higher of the overnight federal funds rate plus 0.5 percent or the bank's prime rate. The revolving credit facility also allows for a money market interest rate option. On March 1, 1999, the company issued to five insurance companies $200 million in fixed rate unsecured senior notes maturing in fiscal years 2005 and 2006. Long-term debt consisted of the following: June 30 1999 1998 - --------------------------------------------------------------------------- (In thousands) Variable rate credit facilities: Revolving credit facility of $150 million due 5/31/2002................... $ -- $ 30,000 Amortizing term loan of $210 million due 5/31/2002................................ 130,000 185,000 Amortizing term loan of $200 million due 5/1/2004................................. 200,000 -- Private placement notes: 6.51% senior notes, due 3/1/2005............... 75,000 -- 6.57% senior notes, due 9/1/2005............... 50,000 -- 6.65% senior notes, due 3/1/2006............... 75,000 -- -------- -------- Total long-term debt.............................. 530,000 215,000 Current portion of long-term debt................. (45,000) (40,000) -------- -------- Total long-term debt (less current portion)....... $ 485,000 $ 175,000 ======== ======== Principal payments on the debt due in succeeding fiscal years are: Years ended June 30 ------------------- (In thousands) 2000............................. $ 45,000 2001............................. 50,000 2002............................. 35,000 2003............................. 100,000 2004............................. 100,000 Later years...................... 200,000 -------- Total long-term debt............. $530,000 ======== The debt agreements include certain financial covenants related to debt levels and coverage ratios. As of June 30, 1999, the company was in compliance with all debt covenants. Meredith uses interest rate swap contracts to manage interest cost and risk associated with possible increases in variable interest rates. The company amended its existing swap contracts effective December 31, 1998 and entered into two new swap contracts with effective dates of March 31, 1999. Under the contracts, Meredith pays fixed rates of interest while receiving floating rates of interest based on three month LIBOR. These contracts effectively fix the base interest rate on the variable rate credit facilities, although the applicable margins vary based on the company's debt-to-EBITDA ratio. These contracts are held for purposes other than trading. The notional amount covered by the contracts was $273 million at June 30, 1999. The average notional amount of indebtedness outstanding under the contracts for fiscal years 2000 through 2002 is as follows: $305 million, $223 million and $93 million, respectively. The company is exposed to credit related losses in the event of nonperformance by the counterparties to the interest rate swap contracts. Management does not expect any counterparties to fail to meet their obligations given their creditworthiness. The weighted-average interest rate on debt outstanding at June 30, 1999, was approximately 6.5 percent. Interest expense related to long term debt totaled $21.5 million in fiscal 1999, $14.3 million (excluding $1.3 million in capitalized interest) in fiscal 1998, and $0.9 million in fiscal 1997 (excluding $92,000 in capitalized interest). At June 30, 1999 Meredith had available credit totaling $160 million, including $150 million under the aforementioned revolving credit facility. 6. Fair Values of Financial Instruments Carrying amounts and estimated fair values of financial instruments are as follows: June 30 1999 1998 - -------------------------------------------------------------------------- Carrying Fair Carrying Fair Amount Value Amount Value - -------------------------------------------------------------------------- (In thousands) Assets (Liabilities): Broadcast rights payable. $ (34,573) $ (32,419) $ (29,607) $ (28,058) ========= ========= ========= ========= Long-term debt........... $(530,000) $(516,927) $(215,000) $(215,000) ========= ========= ========= ========= Interest rate swaps...... $ -- $ 1,375 $ -- $ (3,059) ========= ========= ========= ========= Fair values were determined as follows: Broadcast rights payable: Discounted cash flows. Long-term debt: Discounted cash flows using borrowing rates currently available for debt with similar terms and maturities. Interest rate swaps: Estimated amount the company would pay or receive to terminate the swap agreements. The carrying amounts reported on the Consolidated Balance Sheets at June 30, 1999 and 1998, for all other financial instruments, including the put option agreements classified as temporary equity, approximate their respective fair values due to the short-term nature of these instruments. Fair value estimates are made at a specific point in time based on relevant market and financial instrument information. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect these estimates. 7. Income taxes Income tax expense attributable to earnings from continuing operations consists of: Years ended June 30 1999 1998 1997 - ----------------------------------------------------------------------------- (In thousands) Currently payable: Federal.................................. $50,880 $39,921 $45,596 State.................................... 9,459 8,066 10,684 ------- ------- ------- 60,339 47,987 56,280 ------- ------- ------- Deferred: Federal.................................. 1,765 9,128 (4,356) State.................................... 414 2,141 (1,089) ------- ------- ------- 2,179 11,269 (5,445) ------- ------- ------- Total.................................. $62,518 $59,256 $50,835 ======= ======= ======= In fiscal 1997, $8.8 million of income tax expense was allocated to the discontinued operation resulting in total income tax expense of $59.6 million. The differences between the effective tax rates and the statutory U.S. federal income tax rate are as follows: Years ended June 30 1999 1998 1997 - ---------------------------------------------------------------------------- U.S. statutory tax rate...................... 35.0% 35.0% 35.0% State income taxes, less federal income tax benefits............ 4.2 4.8 5.3 Goodwill amortization........................ 0.9 1.1 1.2 Other........................................ 1.0 1.7 1.4 ----- ----- ---- Effective income tax rate ................. 41.1% 42.6% 42.9% ===== ===== ===== The tax effects of temporary differences that gave rise to the deferred income tax assets and liabilities are as follows: June 30 1999 1998 - ----------------------------------------------------------------- (In thousands) Deferred tax assets: Accounts receivable allowances and return reserves..................... $ 13,998 $ 10,632 Compensation and benefits................. 19,490 22,369 Expenses deductible for taxes in different years than accrued............ 18,265 13,891 All other assets.......................... 71 4,866 ------- ------- Total deferred tax assets................... 51,824 51,758 ------- ------- Deferred tax liabilities: Subscription acquisition costs............ 23,372 26,334 Accumulated depreciation and amortization. 31,569 19,485 Gains from dispositions................... 7,484 8,020 Carrying value of accounts receivable..... 9,133 12,011 Expenses deductible for taxes in different years than accrued............ 4,291 4,322 All other liabilities..................... 558 3,206 ------- ------- Total deferred tax liabilities.............. 76,407 73,378 ------- ------- Net deferred tax liability.................. $ 24,583 $21,620 ======= ======= The current portions of deferred tax assets and liabilities are included in "other current assets" and "other taxes and expenses," respectively, in the Consolidated Balance Sheets. 8. Pension and Postretirement Benefit Plans Effective July 1, 1998, the company adopted Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." This statement requires revised disclosures; however, it had no effect on the financial position or results of operations of the company. Pension Plans - ------------- The company has noncontributory pension plans covering substantially all employees. Assets held in the plans are a mix of noncompany equity and debt securities. The following table summarizes the pension benefit activity for fiscal 1999 and fiscal 1998: Years ended June 30 1999 1998 - ------------------------------------------------------------------------ (In thousands) Change in benefit obligation: Benefit obligation, beginning of year......... $ 67,418 $ 67,517 Service cost.................................. 4,204 3,642 Interest cost................................. 4,789 5,247 Plan amendments............................... 771 -- Actuarial loss (gain)......................... (197) 5,668 Benefits paid (including lump sums)........... (14,827) (14,656) -------- --------- Benefit obligation, end of year............... $ 62,158 $ 67,418 ======== ========= Change in plan assets: Fair value of plan assets, beginning of year.. $ 82,447 $ 63,860 Actual return on plan assets.................. 1,052 27,116 Employer contributions........................ 1,499 6,127 Benefits paid (including lump sums)........... (14,827) (14,656) -------- -------- Fair value of plan assets, end of year........ $ 70,171 $ 82,447 ======== ======== Funded status, end of year.................... $ 8,013 $ 15,029 Unrecognized actuarial loss (gain)............ (13,379) (23,763) Unrecognized prior service cost............... 2,104 1,766 Unrecognized net transition obligation........ 1,460 1,817 Contributions between measurement date and fiscal year end......................... 19 148 -------- -------- Net recognized amount, end of year............ $ (1,783) $ (5,003) ======== ======== Consolidated Balance Sheets: Prepaid benefit cost.......................... $ 4,958 $ 838 Accrued benefit liability..................... (6,741) ( 5,841) Additional minimum liability.................. (2,421) ( 2,955) Intangible asset.............................. 2,012 2,382 Accumulated other comprehensive income........ 409 573 -------- -------- Net recognized amount, end of year............ $ (1,783) $( 5,003) ======== ======== June 30 1999 1998 1997 - ---------------------------------------------------------------------------- Weighted-average assumptions: Discount rate (before retirement)............. 7.00% 7.00% 7.75% ====== ====== ====== Discount rate (after retirement).............. 6.25% 6.25% 6.25% ====== ====== ====== Expected return on plan assets................ 8.25% 8.25% 8.25% ====== ====== ====== Rate of compensation increase................. 5.00% 6.00% 6.00% ====== ====== ====== Years ended June 30 1999 1998 1997 - ----------------------------------------------------------------------------- (In thousands) Components of net periodic pension cost: Service cost.................................. $ 4,204 $3,642 $3,650 Interest cost................................. 4,789 5,247 5,017 Expected return on plan assets................ (6,554) (5,041) (4,991) Prior service cost amortization .............. 434 379 380 Actuarial loss (gain) amortization............ (1,454) (397) (216) Transition amount amortization................ 356 356 376 Settlement gain............................... (3,624) (2,448) -- Curtailment loss.............................. -- 213 -- ------- ------ ------ Net periodic pension cost..................... $(1,849) $1,951 $4,216 ======= ====== ====== The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $11.4 million, $8.9 million and $0.2 million, respectively, as of June 30, 1999 and $11.3 million, $8.4 million and $46,000, respectively as of June 30, 1998. Postretirement Benefit Plans - ---------------------------- The company sponsors defined health care and life insurance plans that provide benefits to eligible retirees. The company funds a small portion of its postretirement benefits through a 401(h) account. All assets are held in noncompany equity securities. The following table summarizes the postretirement benefit activity for fiscal 1999 and 1998: Years ended June 30 1999 1998 - --------------------------------------------------------------------------- (In thousands) Change in benefit obligation: Benefit obligation, beginning of year.............. $ 14,758 $ 14,126 Service cost....................................... 679 479 Interest cost...................................... 1,041 1,086 Participant contributions.......................... 190 154 Actuarial loss (gain).............................. (1,276) (206) Benefits paid ..................................... (1,314) (881) -------- -------- Benefit obligation, end of year.................... $ 14,078 $ 14,758 ======== ======== Change in plan assets: Fair value of plan assets, beginning of year....... $ 1,244 $ 927 Actual return on plan assets....................... 41 317 Employer contributions............................. 773 727 Participant contributions.......................... 190 154 Benefits paid...................................... (1,314) (881) -------- -------- Fair value of plan assets, end of year............. $ 934 $ 1,244 ======== ======== Funded status, end of year......................... $(13,144) $(13,514) Unrecognized actuarial loss (gain)................. (670) 558 Unrecognized prior service cost.................... (2,444) (2,643) -------- -------- Accrued benefit liability, end of year............. $(16,258) $(15,599) ======== ======== June 30 1999 1998 1997 - ------------------------------------------------------------------------------ Weighted-average assumptions: Discount rate.................................... 7.00% 7.00% 7.75% ===== ===== ===== Expected return on plan assets................... 8.25% 8.25% 8.25% ===== ===== ===== Rate of compensation increase.................... 5.00% 6.00% 6.00% ===== ===== ===== The assumed health care cost trend rate used in measuring the postretirement benefit obligation was 9 percent for pre-age 65 benefits (6 percent for post- age 65 benefits) decreasing to 5.75 percent in 2003 (5.75 percent in 2000 for post-age 65 benefits) and thereafter. Years ended June 30 1999 1998 1997 - ------------------------------------------------------------------------------ (In thousands) Components of net periodic postretirement benefit cost: Service cost..................................... $ 679 $ 479 $ 445 Interest cost.................................... 1,041 1,086 1,077 Expected return on assets........................ (101) (72) (55) Prior service cost amortization.................. (200) (200) (200) Actuarial loss (gain) amortization............... -- -- 76 ------ ------ ------ Net periodic postretirement benefit cost......... $1,419 $1,293 $1,343 ====== ====== ====== Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in the assumed health care cost trend rates would have the following effects: One-Percentage- One-Percentage- Year ended June 30, 1999 Point Increase Point Decrease - ------------------------------------------------------------------------------- (In thousands) Effect on total of service and interest cost components....................... $ 130 $ (110) ======= ======= Effect on postretirement benefit obligation...... $ 709 $ (619) ======= ======= 9. Capital Stock The company has two classes of common stock outstanding, common and class B. Holders of both classes of common stock receive equal dividends per share. Class B stock, which has 10 votes per share, is not transferable as class B stock except to family members of the holder or certain other related entities. At any time, class B stock is convertible, share for share, into common stock with one vote per share. Class B stock transferred to persons or entities not entitled to receive it as class B stock will automatically be converted and issued as common stock to the transferee. The principal market for trading the company's common stock is the New York Stock Exchange (trading symbol MDP). No separate public trading market for the company's class B stock exists. From time to time, the company's board of directors has authorized the repurchase of shares of the company's common stock on the open market. Repurchases under these authorizations were as follows: Years ended June 30 1999 1998 1997 - ------------------------------------------------------------------- (In thousands) Number of shares...................... 1,121 899 1,237 ======= ======= ======= Cost at market value.................. $43,852 $31,194 $29,268 ======= ======= ======= In fiscal 1998, the company entered into a put option agreement with certain trusts of the Bohen family, nonaffiliate descendants of the company's founder, to repurchase up to 598,000 shares at market prices, subject to certain restrictions and discounts. In July 1998, 270,000 shares were repurchased under this agreement. The agreement expired in February 1999 with no further activity. Meredith Corporation entered into similar put option agreements effective August 1, 1998, to repurchase up to 1.6 million common shares at market prices over the next 24 months subject to certain restrictions and discounts. As of June 30, 1999, 77,000 shares had been repurchased under these agreements. The market value of the shares subject to put option agreements has been reclassified from stockholders' equity to the temporary equity classification titled, "Put option agreements," at June 30, 1999 and 1998. As of June 30, 1999, approximately 1.9 million shares could be repurchased under existing authorizations by the board of directors. 10. Common Stock and Stock Option Plans Savings and Investment Plan - --------------------------- The company maintains a 401(k) Savings and Investment Plan which permits eligible employees to contribute funds on a pre-tax basis. The plan provides for employee contributions of up to 12.0 percent of eligible compensation. Beginning January 1, 1998, the company matched 100 percent of the first 3 percent and 50 percent of the next 2 percent of employee contributions. Previously, the company matched 75 percent of the first 5 percent contributed. In recognition of all employees' contributions to the company's record financial performance in fiscal 1997, a special one-time additional company match of 25 cents per regularly matched $1 was charged against fiscal 1997 earnings. The 401(k) Savings and Investment Plan allows employees to choose among various investment options, including the company's common stock. Company contribution expense under this plan totaled $4.3 million in fiscal 1999, $3.7 million in fiscal 1998, and $4.6 million in fiscal 1997. Restricted Stock and Stock Equivalent Plans - ------------------------------------------- The company has awarded common stock and/or common stock equivalents to eligible key employees under a stock incentive plan and to nonemployee directors under a restricted stock plan. All plans have restriction periods tied primarily to employment and/or service. In addition, certain awards are granted based on specified levels of company stock ownership. The awards are recorded at market value on the date of the grant as unearned compensation. The initial values of the grants are amortized over the restriction periods, net of forfeitures. The number of stock units and annual expense information follows: Years ended June 30 1999 1998 1997 - ----------------------------------------------------------------------- (In thousands except per share) Number of stock units awarded............... 18 32 71 ====== ====== ====== Average market price of stock units awarded. $37.53 $35.94 $21.94 ====== ====== ====== Stock units outstanding..................... 228 319 592 ====== ====== ====== Annual expense, net......................... $ 960 $1,221 $1,919 ====== ====== ====== In fiscal 1997, the company discontinued the pension plan for active nonemployee members of its board of directors. On November 11, 1996, the pension benefit for each of these directors was determined and converted to common stock equivalents at the market price on that date. Approximately 20,000 stock equivalents were established. Stock Option Plans - ------------------ Under the company's stock incentive plan, nonqualified stock options may be granted to certain employees to purchase shares of common stock at prices not less than market prices at the dates of grant. All options granted under these plans expire at the end of 10 years. Most of these option grants vest one- third each year over a three-year period. Others have "cliff-type" vesting after either three- or five-year periods. Some of the options granted in fiscal 1998 are tied to attaining specified earnings per share and return on equity goals for the three years ended June 30, 2000. If these goals are met, the options become fully vested three years from the date of grant. The vesting of some of these options can accelerate based on the achievement of certain financial goals. The company also has a nonqualified stock option plan for nonemployee directors. Options vest either 40, 30, and 30 percent in each successive year or one-third each year over a three-year period. No options can be issued under this plan after July 31, 2003, and options expire 10 years after issuance. A summary of stock option activity and weighted average exercise prices follows: Years ended June 30 1999 1998 1997 - --------------------- ---------------- ---------------- ---------------- Exercise Exercise Exercise Options Price Options Price Options Price - ------------------------------------------------------------------------------- (Options in thousands) Outstanding, beginning of year....... 5,328 $18.63 4,704 $15.32 3,571 $11.27 Granted at market price... 593 $40.82 1,029 $30.74 1,280 $21.64 Granted at price exceeding market........ -- $ -- -- $ -- 233 $29.21 Exercised................. (87) $17.94 (385) $10.10 (380) $ 7.10 Forfeited................. (51) $32.12 (20) $28.41 -- -- ----- ------ ----- ------ ----- ------ Outstanding, end of year.. 5,783 $20.79 5,328 $18.63 4,704 $15.32 ===== ====== ===== ====== ===== ====== Exercisable, end of year.. 3,474 $14.53 2,795 $12.25 2,182 $10.50 ===== ====== ===== ====== ===== ====== Fair value of options granted: At market price...... $13.43 $ 9.40 $ 6.74 ====== ====== ====== Above market price... $ -- $ -- $ 5.14 ====== ====== ====== A summary of stock options outstanding and exercisable as of June 30, 1999, follows: Options outstanding Options exercisable ------------------------ --------------------- Weighted Weighted Weighted average average average Range of Number remaining exercise Number exercise exercise prices outstanding life (years) price exercisable price - ---------------------------------------------------------------------------- (Options in thousands) $ 6.61 - $11.56 1,982 4.43 $10.02 1,982 $10.02 $11.67 - $20.31 1,552 6.65 $18.59 1,129 $17.96 $20.94 - $32.54 1,544 7.59 $28.01 330 $27.62 $34.78 - $42.88 705 9.07 $40.11 33 $36.60 ----- ----- ------ ----- ------ 5,783 6.43 $20.79 3,474 $14.53 ===== ===== ====== ===== ====== The maximum number of shares reserved for use in all company restricted stock, stock equivalent and stock incentive plans totals approximately 10.6 million. The total number of restricted and equivalent stock shares and stock options which have been awarded under these plans as of June 30, 1999, is approximately 7.3 million. No stock options have expired to date. The company accounts for stock options in accordance with APB No. 25 and therefore no compensation cost related to options has been recognized in the Consolidated Statements of Earnings. Had compensation cost for the company's stock-based compensation plans been determined consistent with the fair value method of SFAS No. 123, the company's net earnings and earnings per share would have been as follows: Years ended June 30 1999 1998 1997 - ----------------------------------------------------------------------- (In thousands except per share) Net earnings as reported................. $89,657 $79,858 $95,285 ======= ======= ======= Pro forma net earnings................... $84,692 $75,900 $93,046 ======= ======= ======= Basic earnings per share as reported..... $ 1.72 $ 1.51 $ 1.78 ======= ======= ======= Pro forma basic earnings per share....... $ 1.62 $ 1.43 $ 1.74 ======= ======= ======= Diluted earnings per share as reported... $ 1.67 $ 1.46 $ 1.72 ======= ======= ======= Pro forma diluted earnings per share..... $ 1.57 $ 1.39 $ 1.68 ======= ======= ======= For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting periods. Options vest over a period of several years and additional awards are generally made each year. Pro forma disclosures do not reflect compensation expense for options granted prior to fiscal 1996. Therefore, the full effect of applying SFAS No. 123 for providing pro forma disclosures is first evident in fiscal 1999. In addition, valuations are based on highly subjective assumptions about the future, including stock price volatility and exercise patterns. The company used the Black-Scholes option pricing model to determine the fair value of grants made. The following assumptions were applied in determining the pro forma compensation cost: Years ended June 30 1999 1998 1997 - ----------------------------------------------------------------------- Risk-free interest rate.................. 5.91% 5.61% 6.42% ====== ====== ====== Expected dividend yield.................. 0.75% 1.00% 1.13% ====== ====== ====== Expected option life..................... 6.3 yrs 6.4 yrs 6.8 yrs ====== ====== ====== Expected stock price volatility.......... 21.00% 20.00% 17.00% ====== ====== ====== 11. Commitments and Contingent Liabilities The company occupies certain facilities and sales offices and uses certain equipment under lease agreements. Rental expense for such leases was $6.0 million in 1999 ($5.6 million in 1998 and $4.4 million in 1997). Minimum rental commitments at June 30, 1999, under all noncancellable operating leases due in succeeding fiscal years are: Years ended June 30 ------------------------------------------------------ (In thousands) 2000....................................... $ 4,534 2001....................................... 4,242 2002....................................... 3,409 2003....................................... 3,445 2004....................................... 3,539 Later years................................ 27,590 ------- Total amounts payable...................... $ 46,759 ======== Most of the future lease payments relate to the lease of office facilities in New York City through December 31, 2011. In the normal course of business, leases that expire are generally renewed or replaced by leases on similar property. The company has recorded commitments for broadcast rights payable due in future fiscal years. The company also is obligated to make payments under contracts for broadcast rights not currently available for use, and therefore not included in the consolidated financial statements, in the amount of $81.1 million at June 30, 1999 ($60.9 million at June 30, 1998). The fair values of these commitments for unavailable broadcast rights were $69.1 million and $54.1 million at June 30, 1999 and 1998, respectively. The broadcast rights payments due in succeeding fiscal years are: Recorded Unavailable Years ended June 30 Commitments Rights -------------------------------------------------------------- (In thousands) 2000............................ $ 21,123 $ 14,695 2001............................ 10,559 18,817 2002............................ 2,159 16,892 2003............................ 116 11,112 Later years..................... 616 19,571 -------- -------- Total amounts payable........... $ 34,573 $ 81,087 ======== ======== Meredith Corporation also may have commitments related to put option agreements. See Note 9. The broadcasting segment expects to spend approximately $60 million over the next three fiscal years for new and remodeled facilities, the initial transition to digital technology and other costs associated with the introduction, expansion or improvement of news programming. Meredith also has a commitment to spend approximately $13 million for replacement aircraft over the next two years. The company is involved in certain litigation and claims arising in the normal course of business. In the opinion of management, liabilities, if any, arising from existing litigation and claims will not have a material effect on the company's earnings, financial position or liquidity. 12. Other Comprehensive Income Effective July 1, 1998, Meredith adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income includes net earnings as well as items of other comprehensive income. The following table summarizes the items of other comprehensive income (loss) and the accumulated other comprehensive income (loss) balances: Foreign Minimum Accumulated Currency Pension Other Translation Liability Comprehensive Adjustments Adjustments Income(Loss) - ----------------------------------------------------------------------------- (In thousands) - ----------------------------------------------------------------------------- Balance at June 30, 1996........... $ -- $ (48) $ (48) - ----------------------------------------------------------------------------- Current year adjustments, pre-tax.. -- (388) (388) Tax benefit........................ -- 155 155 ------ ------ ------ Other comprehensive loss........... -- (233) (233) - ----------------------------------------------------------------------------- Balance at June 30, 1997........... $ -- $ (281) $ (281) - ----------------------------------------------------------------------------- Current year adjustments, pre-tax.. (1,388) (105) (1,493) Tax benefit........................ 555 42 597 ------ ------ ------ Other comprehensive loss........... (833) (63) (896) - ----------------------------------------------------------------------------- Balance at June 30, 1998........... $ (833) $ (344) $(1,177) - ----------------------------------------------------------------------------- Current year adjustments, pre-tax.. 754 164 918 Tax expense........................ (301) (65) (366) ------ ------ ------ Other comprehensive income......... 453 99 552 - ----------------------------------------------------------------------------- Balance at June 30, 1999........... $ (380) $ (245) $ (625) ============================================================================= 13. Financial Information about Industry Segments Effective July 1, 1998, Meredith adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement replaces the industry segment concept previously used with a management approach to reporting segment information. Prior-years information has been restated to conform to the current-year presentation. Meredith Corporation is a diversified media company primarily focused on the home and family marketplace. Based on products and services, the company has established two reportable segments: publishing and broadcasting. The publishing segment includes magazine and book publishing, brand licensing, integrated marketing and other related operations. In fiscal 1998 and 1997, the publishing segment also included the residential real estate franchising operations that were sold effective July 1, 1998. The broadcasting segment includes the operations of 12 network-affiliated television stations and syndicated television program marketing and development. The broadcasting segment information includes the effects of the acquisitions of WGNX-TV in March 1999; WFSB-TV in September 1997; and KPDX-TV, KFXO-LP and WHNS-TV in July 1997. Virtually all of the company's revenues are generated and assets reside within the United States. There are no material intersegment transactions. Operating profit for segment reporting is revenues less operating costs and does not include gains from dispositions, interest income and expense, or unallocated corporate expense. Segment operating costs include allocations of certain centrally incurred costs such as employee benefits, occupancy, information systems, accounting services, internal legal staff and human resources administration expenses. These costs are allocated based on actual usage or other appropriate methods, primarily number of employees. A significant noncash item, other than depreciation and amortization of fixed and intangible assets, is the amortization of broadcast rights in the broadcasting segment, totaling $38.5 million in fiscal 1999, $27.7 million in fiscal 1998 and $17.4 million in fiscal 1997. EBITDA is defined as earnings from continuing operations before interest, taxes, depreciation and amortization. EBITDA is often used to analyze and compare companies on the basis of operating performance and cash flow. EBITDA is not adjusted for all noncash expenses or for working capital, capital expenditures and other investment requirements. EBITDA should not be considered in isolation or as a substitute for measures of performance prepared in accordance with generally accepted accounting principles. Segment assets include intangible, fixed and all other noncash assets identified with each segment. Jointly used assets such as office buildings and information services and technology equipment are allocated to the segments by appropriate methods, primarily number of employees. Unallocated corporate assets consist primarily of cash and cash items, assets allocated to or identified with corporate staff departments and other miscellaneous assets not assigned to one of the segments. At June 30, 1997, unallocated corporate assets included approximately $125 million in cash and marketable securities and construction-in-progress costs for the expansion of corporate headquarters. At June 30, 1998, the cash had been invested in television station acquisitions. Construction costs of the completed facility were allocated, primarily to the publishing segment, by the number of Des Moines-based employees. Unallocated corporate capital expenditures included spending for the construction of the corporate headquarters expansion and related improvements in Des Moines in fiscal 1998 and 1997. Expenditures for long-lived assets other than capital expenditures included the acquisitions of one television station in fiscal 1999 and four television stations in fiscal 1998. These acquisitions resulted in broadcasting segment additions to intangible assets of $362.5 million in fiscal 1999 and $343.7 million in fiscal 1998 and additions to fixed assets of $6.4 million in fiscal 1999 and $33.9 million in fiscal 1998. Years ended June 30 1999 1998 1997 - ------------------------------------------------------------------------------ (In thousands) Revenues Publishing....................... $ 774,031 $ 769,197 $ 698,790 Broadcasting..................... 262,091 240,730 156,428 ---------- ---------- --------- Total revenues................... $1,036,122 $1,009,927 $ 855,218 ========== ========== ========= Operating profit Publishing....................... $ 119,581 $ 101,145 $ 82,768 Broadcasting..................... 72,347 74,532 55,744 Unallocated corporate expense.... (20,841) (23,176) (23,841) --------- --------- --------- Income from operations........... $ 171,087 $ 152,501 $ 114,671 ========== ========== ========= Depreciation/amortization Publishing....................... $ 11,368 $ 10,103 $ 9,665 Broadcasting..................... 30,735 24,924 12,102 Unallocated corporate............ 1,980 1,813 1,230 ---------- ---------- --------- Total depreciation/amortization.. $ 44,083 $ 36,840 $ 22,997 ========== ========== ========= EBITDA Publishing....................... $ 130,949 $ 111,248 $ 92,433 Broadcasting..................... 103,082 99,456 67,846 Unallocated corporate............ (18,861) (21,363) (22,611) ---------- ---------- --------- Total EBITDA..................... $ 215,170 $ 189,341 $ 137,668 ========== ========== ========= Assets Publishing....................... $ 317,297 $ 349,783 $ 304,051 Broadcasting..................... 1,039,745 675,409 273,981 Unallocated corporate............ 66,354 40,797 182,401 ---------- ---------- --------- Total assets..................... $1,423,396 $1,065,989 $ 760,433 ========== ========== ========= Capital expenditures Publishing....................... $ 1,417 $ 2,932 $ 1,947 Broadcasting..................... 16,470 13,945 4,391 Unallocated corporate............ 7,804 29,304 16,961 ---------- ---------- --------- Total capital expenditures....... $ 25,691 $ 46,181 $ 23,299 ========== ========== ========= 14. Selected Quarterly Financial Data (unaudited) First Second Third Fourth Year ended June 30, 1999 Quarter Quarter Quarter Quarter Total - ------------------------------------------------------------------------------ (In thousands except per share) Revenues Publishing................. $190,816 $182,858 $202,071 $198,286 $ 774,031 Broadcasting............... 55,021 72,066 63,050 71,954 262,091 -------- -------- -------- -------- ---------- Total revenues............. $245,837 $254,924 $265,121 $270,240 $1,036,122 ======== ======== ======== ======== ========== Operating profit Publishing................. $ 24,819 $ 26,762 $ 37,020 $ 30,980 $ 119,581 Broadcasting............... 13,060 25,915 14,728 18,644 72,347 Unallocated corporate exp.. (3,974) (4,874) (8,518) (3,475) (20,841) -------- -------- -------- -------- ---------- Income from operations..... $ 33,905 $ 47,803 $ 43,230 $ 46,149 $ 171,087 ======== ======== ======== ======== ========== Net earnings............... $ 18,811 $ 25,423 $ 22,087 $ 23,336 $ 89,657 ======== ======== ======== ======== ========== Basic earnings per share... $ 0.36 $ 0.48 $ 0.43 $ 0.45 $ 1.72 ======== ======== ======== ======== ========== Diluted earnings per share. $ 0.35 $ 0.47 $ 0.41 $ 0.44 $ 1.67 ======== ======== ======== ======== ========== Dividends per share........ $ 0.070 $ 0.070 $ 0.075 $ 0.075 $ 0.29 ======== ======== ======== ======== ========== Stock price per share: High...................... $ 48.50 $ 40.00 $ 40.25 $ 38.00 ======== ======== ======== ======== Low....................... $ 28.56 $ 26.69 $ 30.87 $ 30.62 ======== ======== ======== ======== First Second Third Fourth Year ended June 30, 1998 Quarter Quarter Quarter Quarter Total - ------------------------------------------------------------------------------ (In thousands except per share) Revenues Publishing................. $180,750 $182,352 $203,062 $203,033 $ 769,197 Broadcasting............... 50,149 66,532 57,124 66,925 240,730 -------- -------- -------- -------- ---------- Total revenues............. $230,899 $248,884 $260,186 $269,958 $1,009,927 ======== ======== ======== ======== ========== Operating profit Publishing................. $ 19,449 $ 22,630 $ 33,563 $ 25,503 $ 101,145 Broadcasting............... 14,521 25,218 13,407 21,386 74,532 Unallocated corporate exp.. (5,541) (4,983) (8,335) (4,317) (23,176) -------- -------- -------- -------- ---------- Income from operations..... $ 28,429 $ 42,865 $ 38,635 $ 42,572 $ 152,501 ======== ======== ======== ======== ========== Net earnings............... $ 15,091 $ 22,332 $ 20,115 $ 22,320 $ 79,858 ======== ======== ======== ======== ========== Basic earnings per share... $ 0.29 $ 0.42 $ 0.38 $ 0.42 $ 1.51 ======== ======== ======== ======== ========== Diluted earnings per share. $ 0.27 $ 0.40 $ 0.37 $ 0.42 $ 1.46 ======== ======== ======== ======== ========== Dividends per share........ $ 0.065 $ 0.065 $ 0.070 $ 0.070 $ 0.27 ======== ======== ======== ======== ========== Stock price per share: High..................... $ 33.62 $ 36.94 $ 44.44 $ 46.94 ======== ======== ======== ======== Low...................... $ 26.75 $ 29.25 $ 34.62 $ 38.37 ======== ======== ======== ======== Fiscal 1999 - ----------- Financial results include the operations of WGNX-TV from its acquisition date of March 1, 1999 (Note 3). First quarter results include a gain from the disposition of the Better Homes and Gardens Real Estate Service. Fiscal 1998 - ----------- Financial results include the operations of the following television stations from their respective acquisition dates: KPDX-TV, WHNS-TV, and KFXO-TV on July 1, 1997; and WFSB-TV on September 4, 1997 (Note 3). INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Meredith Corporation: We have audited the accompanying consolidated balance sheets of Meredith Corporation and subsidiaries as of June 30, 1999 and 1998, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the years in the three-year period ended June 30, 1999. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedule, as listed in Part IV, Item 14 (a) 2 herein. These consolidated financial statements and financial statement schedule are the responsibility of the company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Meredith Corporation and subsidiaries as of June 30, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP KPMG LLP Des Moines, Iowa July 30, 1999 REPORT OF MANAGEMENT To the Shareholders of Meredith Corporation: Meredith management is responsible for the preparation, integrity and objectivity of the financial information included in this annual report to shareholders. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include amounts based on management's informed judgments and estimates. To meet management's responsibility for financial reporting, the company's internal control systems and accounting procedures are designed to provide reasonable assurance as to the reliability of financial records. In addition, the internal audit staff monitors and reports on compliance with company policies, procedures and internal control systems. The consolidated financial statements have been audited by independent auditors. In accordance with generally accepted auditing standards, the independent auditors conducted a review of the company's internal accounting controls and performed tests and other procedures necessary to determine an opinion on the fairness of the company's consolidated financial statements. The independent auditors were given unrestricted access to all financial records and related information, including all board of directors' and board committees' minutes. The audit committee of the board of directors, which consists of five independent directors, meets with the independent auditors, management and internal auditors to review accounting, auditing and financial reporting matters. To ensure complete independence, the independent auditors have direct access to the audit committee, with or without the presence of management representatives. /s/ Stephen M. Lacy Stephen M. Lacy Vice President - Chief Financial Officer Schedule II MEREDITH CORPORATION AND SUBSIDIARIES Valuation and Qualifying Accounts Years ended June 30, 1999, 1998 and 1997 (in thousands) Year ended June 30, 1999 --------------------------------------------------- Additions ------------------- Balance at Charged to Charged Balance beginning costs and to other at end of Description of period expenses accounts Deductions period - --------------------------- ---------- ---------- -------- ---------- --------- Those reserves which are deducted in the consolidated financial statements from Receivables: Reserve for doubtful $ 7,489 $ 2,832 $ - $ 3,406 $ 6,915 accounts Reserve for returns 4,630 8,977 - 8,512 5,095 ------- ------- ---- ------- ------- $12,119 $11,809 $ - $11,918 $12,010 ======= ======= ==== ======= ======= Year ended June 30, 1998 --------------------------------------------------- Additions ------------------- Balance at Charged to Charged Balance beginning costs and to other at end of Description of period expenses accounts Deductions period - --------------------------- ---------- ---------- -------- ---------- --------- Those reserves which are deducted in the consolidated financial statements from Receivables: Reserve for doubtful $10,298 $ 3,948 $ - $ 6,757 $ 7,489 accounts Reserve for returns 3,923 6,395 - 5,688 4,630 ------- ------- ---- ------- ------- $14,221 $10,343 $ - $12,445 $12,119 ======= ======= ==== ======= ======= Year ended June 30, 1997 --------------------------------------------------- Additions ------------------- Balance at Charged to Charged Balance beginning costs and to other at end of Description of period expenses accounts Deductions period - --------------------------- ---------- ---------- -------- ---------- --------- Those reserves which are deducted in the consolidated financial statements from Receivables: Reserve for doubtful $ 8,351 $ 7,721 $ - $ 5,774 $10,298 accounts Reserve for returns 5,153 5,918 - 7,148 3,923 ------- ------- ---- ------- ------- $13,504 $13,639 $ - $12,922 $14,221 ======= ======= ==== ======= ======= Index to Exhibits Exhibit Number Item ------- ---------------------------------------------------- 10.1 Amendment to the Meredith Corporation 1990 Restricted Stock Plan for Non-Employee Directors. 10.2 Agreement dated February 25, 1999, between Meredith Corporation and William T. Kerr regarding conversion of restricted stock award shares into stock equivalents. 10.3 Meredith Corporation 1972 Management Incentive Plan 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors 27.1 Financial Data Schedule 27.2 Restated Financial Data Schedule for June 30, 1998 E-1

1085321_1999.txt

1085321_1999

1999

1085321

ITEM 1. BUSINESS GENERAL Muzak LLC (the "Company") is the leading provider of business music programming in the United States based on market share. Together with its independent franchisees, the Company serves an installed base of approximately 300,000 business locations nationwide. The Company and its independent franchisees also sell, install and maintain electronic equipment related to the Company's business. The Company's nationwide network divides the country into 168 territories, of which 50 are served by the Company's owned operations, and the remaining 118 are served by the Company's independent franchisees. The independent franchisees have exclusive licenses to sell the Company's products and to use the Company's trademarks in their territories. The Company is a wholly owned subsidiary of Muzak Holdings LLC (the "Parent"), previously known as ACN Holdings, LLC. As of December 31, 1999, ABRY Partners, LLC and its respective affiliates collectively own approximately 68% of the voting interests in the Parent. All of the operating activities are conducted through the Company and its subsidiaries. The Company's customers typically enter into a noncancelable five-year contract that renews automatically for at least one five-year term unless specifically terminated at the initial contract expiration date. The average length of service per customer is approximately 12 years. The Company typically makes an initial one-time installation investment per location, in exchange for recurring monthly fees. For music clients generated by the independent franchisees, the Company receives a net monthly royalty fee for each client location in exchange for music programming. The Company does not incur a capital outlay for a new client location generated by a independent franchisee. DEVELOPMENTS ACQUISITIONS The Company was formed on August 28, 1998 as ACN Operating LLC and in October 1998 changed its name to Audio Communications Network, LLC ("ACN"). On October 7, 1998 ACN acquired the independent franchisees in the Baltimore, Charlotte, Hillsborough, Kansas City, St. Louis, Jacksonville, Phoenix, and Fresno areas from Audio Communications Network, Inc. (the "Predecessor Company"). On March 18, 1999, Muzak Limited Partnership ("Old Muzak") merged with and into ACN. At the time of the merger, ACN changed its name to Muzak LLC. Under the terms of the agreement, the Company paid total consideration of $274.2 million, which is comprised of the following: $125.5 million cash consideration, $114.9 million consideration in the tender offer and consent solicitation for the 10% Senior Notes due 2003 of Old Muzak, $15.9 million for debt repayment of Old Muzak outstanding obligations and assumed $17.9 million of other obligations. In addition, at the time of the merger, the Company repaid $42.4 million ACN borrowed from ABRY Broadcast Partners in October 1998 in connection with the acquisition of the Company's independent franchisees from the Predecessor Company. In 1999, prior to the merger, the Company made the following acquisitions: o On January 15, 1999, the Company acquired all of the outstanding stock of Business Sound, Inc. for approximately $4.1 million which included 3,661 Class A units of the Parent. Business Sound was the Company's independent franchisee for the New Orleans, Louisiana and Mobile, Alabama areas. o On February 24, 1999, the Company acquired all of the outstanding stock of Electro Systems for approximately $0.7 million, which included 650 Class A units of the Parent, and assumed certain non-recourse debt. Electro Systems was the Company's independent franchisee located in Panama City, Florida. The Company made thirteen acquisitions between the merger of Old Muzak and ACN on March 18, 1999 and December 31, 1999. The table below provides information regarding these acquisitions (in millions, except for number of Parent units). - --------- (1) Total Purchase Price includes 13,535 Class A units of the Parent. (2) The Parent acquired Capstar Broadcasting Corporation's ("Capstar") independent franchisees located in Atlanta, Albany, and Macon, Georgia, Ft Myers, Florida and Omaha Nebraska. The total consideration was accounted for as an equity contribution to the Company. The purchase price includes 2,385 Class A units of the Parent. (3) Total purchase price includes 100 Class A units of the Parent. (4) The Company paid $3.1 million of the purchase price of Mountain West Audio as of December 31, 1999. In February 2000, the Company paid the remaining purchase price, which included 456 Class A units of the Parent. (5) The purchase price does not include transaction costs. FINANCING DEVELOPMENTS From July 1, 1999 through November 24, 1999, the Company issued 15% junior subordinated unsecured notes (the "ABRY Notes") to MEM Holdings, LLC in an aggregate amount of $30.0 million. MEM Holdings is a holdings company that owns 68% of the voting interests in the Parent. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. On July 14, 1999, the Company increased its borrowings under the Term Loan B of the Senior Credit Facility by $30.0 million, for a total amount borrowed under Term Loan B of $135.0 million. In January 2000, the Company entered into an indenture for up to $50.0 million Senior Subordinated Floating Rate Notes (the "Floating Rate Notes"). The Floating Rate Notes will be available for drawdowns until July 31, 2000. As of March 29, 2000, $25.0 million of the Floating Rate Notes were outstanding. Proceeds from the issuance of Floating Rate Notes will be used to fund acquisitions. PRODUCTS The Company's core product is Audio Architecture, and complementary products include Audio marketing and Video Architecture. The Company believes that the products assist customers in strengthening their brand images and enhancing the experiences of their customers. Audio Architecture is the art of creating business music programming designed to enhance a client's brand image. The Company has an in-house staff of audio architects that analyzes a variety of music to develop and maintain 60 core music programs in 10 genres that appeal to a wide range of tastes. Programs include current top-of-the-charts hits to jazz, classic rock, urban, country, Latin, classical music and others. The Company's audio architects update the music programs on a daily basis, incorporating the continuous release of new music recordings and drawing from the Company's extensive music library. In designing the music programs, the audio architects use proprietary computer software that allows them to efficiently access the extensive library, avoid repeated songs and manage tempo and music variety to provide customers with high quality, seamlessly arranged programs. As a complement to Audio Architecture, the Company's marketing on hold creates customized music and messages that allow customers' telephone systems to deliver targeted music and messaging during their customers time on hold. The Company has the in-house capability to write, edit, produce and duplicate messages. The Company's fully integrated sound studios and editing and tape duplication facilities provide flexibility in responding to client's needs. Video Architecture is video programming designed to enhance the brand personality of the Company's customers by entertaining, informing and captivating their customers. The Company has a library of video programs from which customer specific programming is produced. The Company's net sales of Audio Architecture, Audio marketing and Video Architecture were $65.4 million, $8.6 million, and $2.2 million, respectively in 1999. In connection with the sale of Audio Architecture, Audio marketing, and Video Architecture products, the Company sells and leases various audio and video system-related products, principally sound systems. As part of a typical music programming contract, the Company provides music receiving or playback equipment to its customers. The Company's music clients generally purchase or lease audio equipment that supplements the music receiving or playback equipment. The Company also sells, installs, and maintains non-music related equipment, such as intercom, paging and drive-thru systems. CUSTOMERS The Company provides its products to numerous types of businesses including specialty retailers, restaurants, department stores, supermarkets, drug stores, financial institutions, hotels, golf clubs, health and fitness centers, business offices, manufacturing facilities, and medical centers. During 1999, none of the Company's customers represented more than 2% of revenues, and less than 2% of revenues were for services provided to customers located outside of the United States. However, the Company has 16 independent franchisees located outside the United States that serve areas in Canada, Mexico, Bermuda, Japan, Indonesia, New Zealand, Europe, and Peru. NATIONWIDE AFFILIATE NETWORK The Company has a nationwide network that divides the country into 168 affiliate territories, of which 50 are served by the Company's owned operations and the remaining 118 are served by the Company's independent franchisees. The Company's owned operations generally operate in the larger and the more populated territories. The Company's business relationships with its independent franchisees are governed by independent affiliate agreements that have ten-year renewable terms. In exchange for the exclusive right to offer and sell the Company's products, the independent franchisees pay a monthly fee based on the number of businesses within its territory. In addition, the Company also receives a royalty or a wholesale fee depending on the type of product sold. DISTRIBUTION SYSTEMS The Company transmits its offerings through various mediums including direct broadcast satellite transmission, local broadcast transmission, audio and videotapes and compact discs. During 1999, the Company served its customer locations through the following means: approximately 61% through direct broadcast satellite transmission, approximately 29% through local broadcast technology, and approximately 10% through on-premises tapes or compact discs. The Company's transmissions via direct broadcast satellite to customers are primarily from transponders leased from Microspace and EchoStar Satellite Corporation ("EchoStar"). Microspace provides the Company with facilities for uplink transmission of medium-powered direct broadcast satellite signals to the transponders. Microspace, in turn, leases its transponder capacity on satellites operated by third parties. The term of the Company's principal transponder lease with Microspace is projected to end in 2005. The Company also furnishes music channels to commercial and residential subscribers over EchoStar's satellite system. The Company furnishes 60 music channels to commercial subscribers and 30 music channels to residential subscribers over EchoStar's satellite system. Pursuant to the agreements with EchoStar, EchoStar pays the Company a programming fee for each of its residential subscribers and pays the Company's independent franchisees a commission for sales made by EchoStar or its agents to commercial subscribers in an affiliate's territory. The Company pays EchoStar a fee for uplink transmission of music channels to its customers and rents space at EchoStar's Cheyenne, Wyoming uplink facility. The Company also pays EchoStar a royalty and combined access fees on music programs sold by the Company which are distributed by EchoStar to commercial subscribers. EchoStar has the right to cancel its distribution of the 30 music programs to residential subscribers at any time upon 60 days notice. Upon such cancellation, EchoStar must pay the Company the depreciated book value of its capital investment in equipment to support the residential music channels and continue to provide 2.4 megahertz of transponder capacity for use in serving commercial subscribers. In such event, the Company would only be able to provide 30 music programs and would need to lease other transponder space in order to continue providing the other 30 music programs. The Company would also lose the programming fee generated by EchoStar's residential subscribers. The Company's agreements with EchoStar are projected to end in 2010. During the first quarter of 2000, EchoStar approached the Company and expressed a desire to reassess the business terms that pertain to EchoStar's distribution of the residential music channels. The Company and EchoStar are in the process of negotiating an understanding in which the programming fees earned by the Company and paid by EchoStar in connection with the residential music channels may be eliminated in consideration for a long-term supply agreement with respect to satellite services. The Company expects to conclude negotiations prior to the third quarter of 2000. COMPETITION The Company competes with many local, regional, national and international providers of business music and business services. National competitors include AEI Music Network, Inc., DMX, Inc. and Music Choice. Local and regional competitors are typically smaller entities that target businesses with few locations. Some of the Company's competitors may have substantially greater financial, technical, personnel or other resources than the Company. There are numerous methods by which our existing and future competitors deliver programming, including various forms of DBS services, wireless cable, fiber optic cable, digital compression over existing telephone lines, advance television broadcast channels, Digital Audio Radio Service ("DARS"), and the Internet. The Company may not be able to compete successfully with existing or potential new competitors, maintain or increase current market share, compete effectively with competitors that adopt new delivery methods and technologies, or keep pace with discoveries or improvements in the communications, media and entertainment industries such that existing technologies or delivery systems on which the Company relies will not become obsolete. In addition, the terms of the Company's debt impose operational and financial restrictions that may inhibit the Company's ability to compete. The Company principally competes on the basis of service, the quality and variety of music programs, versatility and flexibility, the availability of non-music services and, to a lesser extent, price. Even though the Company is seldom the lowest-priced provider of business music in a territory, the Company believes it can compete effectively on all these bases due to widespread recognition of the MUZAK(R) trademark, the Company's nationwide network, the quality and variety of music programming, the talent of the Company's audio architects and the Company's multiple delivery systems. SALES AND MARKETING The Company employs a direct sales process in marketing products, which is focused on securing new client contracts and renewing existing contracts. Customer agreements typically have a non-cancelable term of five years and renew automatically for at least one additional five-year term unless specifically terminated at the initial contract expiration date. Repeat clients comprise the core of the account base. The Company has local, national, and regional sales forces. Local account executives typically focus on customers that have fewer than 50 locations. MUSIC LICENSES The Company licenses rights to rerecord and distribute music from a variety of sources and pays royalties to songwriters and publishers through contracts negotiated with performing rights societies such as the American Society of Composers, Authors and Publishers ("ASCAP"), Broadcast Music, Inc. ("BMI"), and the Society of European Stage Authors and Composers ("SESAC"). The industry-wide agreement between business music providers and BMI expired in December 1993. Since this time the Company has been operating under an interim agreement pursuant to which the Company has continued to pay royalties at the 1993 rates. Business music providers and BMI have been negotiating the terms of a new agreement. The industry wide agreement between business music providers and ASCAP expired in May 1999. Negotiations between ASCAP and the Company began in June 1999, and the Company has continued to pay ASCAP royalties at the 1999 rates. In 1999, the Company paid approximately $4.1 million in royalties to ASCAP and BMI. The Company is involved in a rate court proceeding, initiated by BMI in Federal Court in New York. At issue are the music license fees payable by the Company and its owned operations as well as licensed independent franchisees to BMI. The period from which such "reasonable" license fees are payable covers the period January 1, 1994 to December 31, 1999, and likely several years thereafter. BMI contends that those fee levels understate reasonable fee levels by as much as 100%. The Company vigorously contests BMI's assessment. The eventual court ruling setting final fees for the period covered will require retroactive adjustment, upward or downward, likely back to January 1, 1994, and possibly will also entail payment of pre-judgment interest. Discovery in the proceeding has commenced and is not yet completed. A trial date has not been set. GOVERNMENT REGULATION The Company is subject to governmental regulation by the United States and the governments of other countries in which it provides services. The Company provides music services in a few areas in the United States through 928 to 960 megahertz frequencies licensed by the Federal Communications Commission ("FCC"). Additionally, the FCC licenses the frequencies used by satellites on which the Company transmits direct broadcast satellite services in the United States. If the FCC or any other person revokes or refuses to extend any of these licenses, the Company would be required to seek alternative transmission facilities. Laws, regulations and policy, or changes therein, in other countries could also adversely affect the Company's existing services or restrict the growth of its business in these countries. EMPLOYEES As of December 31, 1999, the Company had 1,286 full-time and 38 part-time employees. Approximately 100 of the technical and service personnel are covered by eight union contracts, all of which are with the International Brotherhood of Electrical Workers. All of the contracts, with the exception of one, expire on dates ranging from October 31, 2000 to January 31, 2003. One of the International Brotherhood of Electrical Workers contracts that covers less than 10 employees expired on February 28, 2000 and the Company is in the process of negotiating a replacement agreement. Management believes that the Company's relations with its employees and with the unions that represent them are generally good. ITEM 2. ITEM 2. PROPERTIES The Company's headquarters are located in Charlotte, North Carolina and consist of approximately 10,000 square feet. As of December 31, 1999, the Company also occupied approximately 80,000 square feet in Seattle, Washington which served as Old Muzak's headquarters. In order to achieve operational efficiencies and consolidate geographically disbursed business units, the Company decided to relocate its headquarters to Fort Mill, South Carolina and has entered into a lease which obligates the landlord to construct a 100,000 square foot facility in Fort Mill, South Carolina which will accommodate the Company's headquarters, the Charlotte owned operation, and several of its other divisions. The facility is currently under construction and is expected to be completed during the third quarter of 2000. The Company has approximately 55 local sales offices in various locations, office and satellite uplink facilities in Raleigh, North Carolina and Cheyenne, Wyoming and warehouses in various locations. Approximately 95% of the total square footage of these facilities is leased and the remainder is owned. In January 2000, the Company entered into a lease for approximately 29,000 square feet to accommodate additional headquarter employees on a temporary basis in Charlotte, North Carolina. The Company believes that its facilities are sufficient to meet existing needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is subject to various proceedings in the ordinary course of business. Except as described below, management believes that such proceedings are routine in nature and incidental to the conduct of its business, and that none of such proceedings, if determined adversely to the Company, would have a material adverse effect on the consolidated financial condition or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company is a wholly owned subsidiary of the Parent. The Parent does not have an established public trading market for its equity securities. The equity securities of the Parent are held by MEM Holdings LLC, CBC Acquisition Company, Inc., and by current or former management. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. The Company's bank agreement, the indentures with respect to the Senior Subordinated and Floating Rate Notes of the Company, and the indenture with respect to the Parent's Senior Discount Notes restrict the ability of the Company and the Parent to make dividends and distributions in respect of their equity. During 1999, the Parent issued its membership units in the following transactions: o In January, the Parent issued 3,661 Class A Units to MEM Holdings LLC in connection with the Company's acquisition of Business Sound. o In February, the Parent issued 650 Class A Units to MEM Holdings LLC in connection with the Company's acquisition of Electro Systems. o In March, the Parent issued: o 17,836.88 Class A Units to MEM Holdings LLC, 850 Class A Units to management, and 2,876.334 Class B-4 Units to Music Holdings Corp. in connection with the Muzak, L.P. merger; o 13,535.432 Class A Units to Capstar Broadcasting Corporation in connection with the acquisition of the Georgia and Florida Capstar franchisees; o 3,037.63 Class A Units to holders of Class A Units at such time as a yield on such Class A Units; o 101.25 Class A Units to management holders of Class A Units as a yield on the Class A Units held at such time; and o 1,154.885 Class A Units, 2,484 Class B-1 Units, 2,501 Class B-2 Units, 2,515 Class B-3 Units and 25.883 Class B-4 Units to members of management. o In May, the Parent issued 2,385.483 Class A Units to Capstar Broadcasting Corporation and 0.886 Class B-4 Units to management and 98.51 B-4 units to Music Holdings Corp. in connection with the acquisition of the Omaha Capstar franchisee. o In November, the Parent issued 25 Class A Units to management and issued 100 Class A units to the principal shareholder of Audio Environments, Inc. and Background Music Broadcasters, Inc. in connection with this acquisition on November 1, 1999. o In November, Capstar Broadcasting Corporation transferred 15,920.915 Class A units to CBC Acquisition Company, Inc. All of such issuances were deemed exempt from registration under the Securities Act by virtue of Section 4(2) thereof, as transactions not involving a public offering. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Set forth below is Selected Financial Data for Muzak LLC ("the Company") for the period from October 7, 1998 to December 31, 1998 and for the year ended December 31, 1999 and for Audio Communications Network, Inc. (the "Predecessor Company") for the fiscal year ended December 31, 1997 and for the period from January 1, 1998 to October 6, 1998. As discussed above in "Item 1. Business", on October 7, 1998 ACN acquired Audio Communications Inc. ACN had no operations until it acquired Audio Communications Inc. in October 1998. In connection with the merger with Old Muzak on March 18, 1999, ACN changed its name to Muzak LLC. - --------- (1) EBITDA represents earnings before deductions for net interest expense, income taxes, depreciation, and amortization. EBITDA does not represent and should not be considered as an alternative to net income or cash flow from operations as determined by generally accepted accounting principles. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Company is the leading provider of business music programming in the United States. Together with its independent franchisees, the Company serves an installed base of approximately 300,000 business locations nationwide. The Company and its independent franchisees also sell, install and maintain electronic equipment related to the Company's business. The Company was formed on August 28, 1998 as ACN Operating LLC and in October of 1998 changed its name to Audio Communications Network, LLC ("ACN"). On October 7, 1998 ACN acquired the independent franchisees in the Baltimore, Charlotte, Hillsborough, Kansas City, St. Louis, Jacksonville, Phoenix, and Fresno areas from Audio Communications Network, Inc. (the "Predecessor Company"). On March 18, 1999, Muzak Limited Partnership ("Old Muzak") merged with and into ACN. At the time of the merger, ACN changed its name to Muzak LLC. Under the terms of the agreement, the Company paid total consideration of $274.2 million, which consisted of the following: $125.5 million cash consideration, $114.9 million consideration in the tender offer and consent solicitation for the 10% Senior Notes due 2003 of Old Muzak, $15.9 million for debt repayment of Old Muzak outstanding obligations and assumed $17.9 million of other obligations. In addition, at the time of the merger, the Company repaid $42.4 million ACN borrowed from ABRY Broadcast Partners in October 1998 in connection with the acquisition of the Company's independent franchisees from the Predecessor Company. Since the merger, the Company and the Parent have acquired thirteen businesses for total consideration of $73.9 million, which included 16,476 Class A units of the Parent, including the acquisition of Capstar Broadcasting Corporation's ("Capstar") Atlanta, Albany, and Macon Georgia and Ft.Myers Florida independent franchisees on March 18, 1999. In 1999, prior to the merger, the Company made the following acquisitions: o On January 15, 1999, the Company acquired all of the outstanding stock of Business Sound, Inc. for approximately $4.1 million, which included 3,661 Class A units of the Parent. Business Sound was the Company's independent franchisee for the New Orleans, Louisiana and Mobile, Alabama areas. o On February 24, 1999, the Company acquired all of the outstanding stock of Electro Systems for approximately $0.7 million, which included 650 Class A units of the Parent, and assumed certain non-recourse debt of $2.4 million. Electro Systems was the Company's independent franchisee located in Panama City, Florida. The Company made thirteen acquisitions between the merger of Old Muzak and ACN on March 18, 1999 and December 31, 1999. The table below provides information regarding these acquisitions (in millions, except for number of Parent units). - --------- (1) Total purchase price included 13,535 Class A units of the Parent. (2) The Parent acquired Capstar Broadcasting Corporation's ("Capstar") independent franchisees located in Atlanta, Albany, and Macon, Georgia, Ft Myers, Florida and Omaha, Nebraska. The total consideration was accounted for as an equity contribution to the Company and included 2,385 Class A units of the Parent. (3) Total purchase price included 100 Class A units of the Parent. (4) The Company paid $3.1 million of the purchase price of Mountain West Audio as of December 31, 1999. In February 2000, the Company paid the remaining purchase price, which included 456 Class A units of the Parent. (5) The purchase price does not include transaction costs. RECENT DEVELOPMENTS ADDITIONAL FINANCING In January 2000, the Company entered into an indenture for up to $50.0 million Senior Subordinated Floating Rate Notes (the "Floating Rate Notes"). The Floating Rate Notes are available to be drawn up to $50.0 million in increments of no less than $2.5 million to fund acquisitions. The Floating Rate Notes will be available for drawdowns until July 31, 2000. Commitments on all amounts undrawn under the Floating Rate Notes by July 31, 2000 will expire and will be ineligible for future draw downs. The Floating Rate Notes may be redeemed at 100% if redeemed before July 31, 2000 and at 101.50% if redeemed August 1, 2000 through October 31, 2000. If the Company does not redeem the Floating Rate Notes by November 1, 2000, the Floating Rate Notes will automatically convert into fixed-rate permanent notes due March 2009. As of March 29, 2000, $25.0 million of the Floating Rate Notes were outstanding. Also, in February 2000, the Company received approximately $10.6 million in equity contributions from its members. The proceeds of the equity contributions will be used to make repayments on the revolving loan (as defined below) and to fund acquisitions and for general corporate purposes. ACQUISITIONS On February 2, 2000, the Company acquired certain of the net assets of Quincy Broadcasting Company, a Delaware corporation, for approximately $0.4 million. Quincy Broadcasting Company was the Company's independent franchisee located in Quincy, Illinois. On February 2, 2000, the Company acquired certain of the assets and assumed certain obligations of General Communications Corporation ("On Hold America"), an Indiana corporation, for approximately $0.9 million. On Hold America was an audio marketing business serving areas primarily in Indiana, Georgia, Florida, and Ohio. On February 2, 2000, the Company acquired certain of the assets and certain obligations of Texas Sound Co. Ltd for approximately $0.4 million. Texas Sound Co. Ltd was a provider of business music and audio marketing services. On February 24, 2000, the Company acquired Telephone Audio Productions, Inc., ("Sold on Hold Communications"), a Texas corporation, for approximately $3.7 million. Sold on Hold Communications was an audio marketing and messaging business serving various markets in the United States. On March 24, 2000, the Company acquired the stock of Vortex Sound Communications Company, Inc., ("Vortex") for approximately $9.2 million, which included 802 Class A units of the Parent. Vortex was the Company's independent franchisee located in Washington, DC. REVENUES AND EXPENSES The Company derives the majority of its revenues from the sale of business music products. The core product is AUDIO ARCHITECTURE and its two complementary products are AUDIO MARKETING and VIDEO ARCHITECTURE. These revenues are generated by clients, who pay monthly subscription fees under noncancelable five year contracts. The Company also derives revenues from the sale and lease of audio system-related products, principally sound systems and intercoms, to business music clients and other clients. In addition, the Company sells electronic equipment, such as proprietary tape playback equipment and other audio and video equipment to franchisees to support the sale of business music services. Installation, service and repair revenues consist principally of revenues from the installation of sound systems and other equipment that is not expressly part of a business music contract, such as paging, security and drive-through systems. These revenues also include revenue from the installation, service and repair of equipment installed under a business music contract. Music contract installation revenues are deferred and recognized over the term of the respective contracts. The cost of revenues for business services consists primarily of broadcast delivery, programming and licensing associated with providing music and other business programming to a client or a franchisee. The cost of revenues for equipment represents the purchase cost plus handling, shipping and warranty expenses. The cost of revenues for installation, service and repair consists primarily of service and repair labor and labor for installation that is not associated with new client locations. Installation costs associated with new client locations are capitalized and charged to depreciation expense over the estimated life of the clients' contract. The Company's customers typically enter into a noncancelable five-year contract that renews automatically for at least one five-year term unless specifically terminated at the initial contract expiration date. The average length of service per customer is approximately 12 years. The Company typically makes an initial one-time installation investment per location, in exchange for recurring monthly fees. For music clients generated by the independent franchisees, the Company receives a net monthly royalty fee for each client location in exchange for music programming. The Company does not incur a capital outlay for a new client location generated by a independent franchisee. The business music industry remains highly fragmented, with numerous independent operators. The Company plans to pursue acquisitions of in market competitors and of its independent franchisees. Through acquisitions, the Company expects to realize cost savings by eliminating duplicative programming, distribution, sales and marketing, and technical and other general administrative expenses The business music industry is influenced by the recording industry, performing rights societies, government regulations, technological advancements, satellite capabilities, and competition. The Company must license rights to rerecord and distribute music and is reliant on third parties for satellite capabilities. Selling, general and administrative expenses include salaries, benefits, commissions, travel, marketing materials, training and occupancy costs associated with staffing and operating local and national sales offices. These expenses also include personnel and other costs in connection with the Company's headquarters functions. Sales commissions are capitalized and charged as selling, general and administrative expense over the typical contract term of five years. If a client contract is terminated early, the unamortized sales commission is typically recovered from the salesperson. RESULTS OF OPERATIONS Set forth below are discussions of the results of operations for Muzak LLC, ACN, Old Muzak and the Predecessor Company for the periods indicated. ACN had no operations until it acquired the Predecessor Company in October 1998. ACN changed its name to Muzak LLC in connection with its merger with Old Muzak. The fiscal year ended December 31, 1999 includes operating results of ACN for the period from January 1, 1999 to March 17, 1999, and for Muzak LLC for the period March 18, 1999 to December 31, 1999. MUZAK LLC -- FISCAL YEAR ENDED DECEMBER 31, 1999 The Company did not compare the results for the year ended December 31, 1999 to the prior period as the prior period does not include a full year of operations and the Company made numerous material acquisitions during 1999. As a result, the comparison of 1999 to the period October 7, 1998 to December 31, 1998 is not meaningful. REVENUES. Revenues totaled $130.0 million for the year ended December 31, 1999, comprised of $92.1 million business music revenues and $37.9 million equipment and related services. Business music revenues and equipment and related revenues from the acquisitions subsequent to the merger of ACN, Old Muzak, and Capstar were $5.0 million and $1.0 million, respectively. GROSS PROFIT. Gross profit was $81.7 million, and 62.8% as a percentage of revenues for the year ended December 31, 1999. The general increase in gross margin over the quarters during 1999 is due to growth in higher margin business services as well as the acquisition of competitors and independent franchisees business music contracts. Gross profit for the acquisitions subsequent to the merger of ACN, Old Muzak, and Capstar was $3.2 million. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general, and administrative expenses were $42.5 million, comprised of $16.5 million of sales and marketing expenses and $26.0 million of general and administrative expenses. Duplicative facilities and expenses related to integrating acquisitions resulted in an increase in selling, general, and administrative expenses during 1999. As a percentage of total revenues, selling, general and administrative expenses were 32.7% for the year ended December 31, 1999. DEPRECIATION AND AMORTIZATION EXPENSES. Depreciation and amortization was $36.5 million for the year ended December 31, 1999. Amortization expense generally increased in the quarters throughout 1999 due to the intangibles related to the acquisitions of competitors' and independent franchisees business music contracts during 1999. INTEREST EXPENSE. Interest expense, net of interest income, was $24.9 million for the year ended December 31, 1999. Interest expense was comprised primarily of expenses related to the Senior Notes and to the Senior Credit facility. INCOME TAX BENEFIT. Income tax benefit was $0.4 million for the year ended December 31, 1999 and related to the Company's corporate subsidiaries. The Company is a limited liability company and is treated as a partnership for income tax purposes. MUZAK LLC -- PERIOD FROM OCTOBER 7, 1998 TO DECEMBER 31, 1998 Revenues totaled $5.9 million for the period ended December 31, 1998, comprised primarily of business music revenues. For the same period, cost of sales totaled $2.6 million, resulting in a gross profit margin of 56.8%. Total selling, general, and administrative expenses for the period totaled $1.8 million, comprised principally of salary, benefits, and overhead expenses. PREDECESSOR COMPANY -- AUDIO COMMUNICATIONS NETWORK INC. -- PERIOD FROM JANUARY 1, 1998 TO OCTOBER 6, 1998 COMPARED TO THE NINE MONTH PERIOD ENDED SEPTEMBER 30, 1997 REVENUES. Total revenues increased 60.2% from $11.8 million in 1997 to $18.9 million in 1998, primarily as a result of the impact of a reverse acquisition which occurred in May 1997, as well as the growth in business music revenues and equipment sales and related services GROSS PROFIT. Total gross profit increased 35.0% from $8.0 million in 1997 to $10.7 million in 1998. The Predecessor Company's gross margin in 1998 was 56.7%. Such gross margin is not comparable to the prior period as a result of a reverse acquisition in 1997. The 1998 gross margin was negatively impacted by approximately 3.0% or $0.6 million resulting from one-time charges related to the Galaxy IV satellite failure. SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES. Selling, general, and administrative expenses increased 84.7% from $3.9 million in 1997 to $7.2 million in 1998. Such increase was primarily the result of the impact of a reverse acquisition in 1997, the growth in business music revenues and equipment sales and related services and approximately $0.8 million being incurred in 1998 pertaining to transaction costs related to the sale of Audio Communications Network Inc. in October 1998. OLD MUZAK -- YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, REVENUES. Total revenues increased 9.4% from $91.2 million in 1997 to $99.7 million in 1998 principally as a result of an 11.1% increase in music and other business services revenues and a 6.1% increase in equipment sales and related services. Music and other business services revenues increased due to an increase in the number of broadcast music subscribers, sales growth and the acquisition of competitors' business music contracts, together with an increase in the royalties paid by independent franchisees resulting from growth in the broadcast music subscribers in the franchise network. Royalties and other fees from independent franchisees and international distributors included in broadcast music revenues accounted for $8.9 million or 8.9% of Old Muzak's revenues in 1998, compared with $8.8 million or 9.6% of Old Muzak's revenues in 1997. The continued decrease in the surcharges assessed to independent franchisees for satellite transmission costs was offset by increased growth in royalties related to new subscriber billing. Equipment and installation revenues increased 4.7% and 8.7%, respectively due to the expansion of national accounts. GROSS PROFIT. Total gross profit increased 13.4% from $50.5 million in 1997 to $57.2 million in 1998. As a percentage of total revenues, gross profit increased from 55.4% in 1997 to 57.4% in 1998. The improvement in gross profit percentage in 1998 was due to growth of higher margin business services, such as broadcast music, audio marketing, and on-premise music. The improvement in gross profit was partially offset by approximately $1.5 million of one-time charges related to the Galaxy IV satellite failure. On May 19, 1998, services on the Galaxy IV satellite were permanently lost when the satellite ceased communicating to uplink stations throughout the United States. SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased 3.2% from $33.3 million in 1997 to $34.3 million in 1998. As a percentage of total revenues, selling, general and administrative expense decreased from 36.5% in 1997 to 34.4% in 1998. Selling and marketing expenses increased 3.0% from $13.8 million in 1997 to $14.2 million in 1998, principally due to an increase in commissions paid as a result of increased levels of sales of business products. General and administrative costs increased 3.3% from $19.5 million in 1997 to $20.1 million in 1998, primarily due to transaction costs related to the merger. NON-CASH INCENTIVE COMPENSATION. Non-cash incentive compensation increased from $0.2 million in 1997 to $2.2 million in 1998. This increase is primarily due to the meeting of performance criteria for options issued combined with the increase in value of Old Muzak. DEPRECIATION EXPENSE. Depreciation expense decreased 8.6% from $10.7 million in 1997 to $9.7 million in 1998, principally as a result of a reduction of depreciation expense for assets that were fully depreciated in 1997 related to the acquisition of Old Muzak in September 1992. AMORTIZATION EXPENSE. Amortization expense increased 18.1% from $10.0 million in 1997 to $11.8 million in 1998. The increase in amortization expense was due to an increase in intangibles related to the increased investment in the expanded customer base and acquisitions of competitor's business music contracts in 1997 and 1998. INTEREST EXPENSE. Total interest expense increased 4.4% from $10.8 million in 1997 to $11.2 million in 1998. The increase in interest expense in 1998 compared to 1997 is related to the increase in the average outstanding debt during the year. Old Muzak's total interest-bearing debt increased from $101.0 million to $118.4 million at December 31, 1997 and 1998, respectively. LIQUIDITY AND CAPITAL RESOURCES The Company had cash and cash equivalents totaling $2.3 million and $1.3 million at December 31, 1999 and 1998, respectively. The Company had $10.0 million of borrowing availability under its credit agreements as of December 31, 1999. Availability under the revolving credit facility has been reduced by outstanding letters of credit of $0.3 million. SOURCES AND USES OF FUNDS The Company's principal sources of funds are cash generated from continuing operations, borrowings under the Senior Credit Facility, Floating Rate Notes and proceeds from equity contributions. The Company's strategic plan is to pursue opportunities to acquire music contract portfolios of competitors and to review acquisitions of independent franchisees if they become available. However, the Company may require additional debt or equity financing to complete additional acquisitions. In February 2000, the Company received equity contributions totaling $10.6 million from its members. The proceeds were used to pay down the revolving loan and to fund acquisitions. Net cash used by continuing operating activities of the Company was $2.3 million for 1999. The Company's principal uses of funds from operating activities and borrowings for the next several years are expected to fund acquisitions, interest and principal payments on its indebtedness, net working capital increases and capital expenditures. At December 31, 1999, the Company has total outstanding indebtedness of $338.1 million (excluding approximately $0.3 million of outstanding letters of credit) at an average interest rate of 9.6%. Of the total outstanding indebtedness, $305.3 million relates to the Senior Credit Facility and the Senior Notes. Proceeds from the Senior Credit Facility, the Senior Notes, and the Senior Discount Notes were used to pay merger consideration consisting of $125.5 million in cash to the partners of Old Muzak, approximately $114.9. million consideration in the tender offer and consent solicitation for the 10% Senior Notes due 2003 of Old Muzak together with accrued interest, $15.9 million for debt repayment of Old Muzak obligations, approximately $42.4 million of borrowings by Audio Communications Network under ABRY Broadcast Partners III subordinated note, merger consideration for Capstar Broadcasting Corporation, and to pay fees and expenses in connection with the foregoing. CAPITAL EXPENDITURES The Company's business generally requires capital for the installation of equipment for new business music clients. The Company currently anticipates that its capital expenditures for fiscal 2000 will be in the range of $ 24.0 million to $ 29.0 million, a portion of which may be financed through leasing. As of December 31, 1999, the Company had approximately $5.2 million in outstanding capital expenditure commitments. Of the total, approximately $3.8 million in commitments are related to the construction of the Company's new headquarters facility in Fort Mill, South Carolina. In addition, during 2000, the Company will continue to pursue a business strategy that includes selective acquisitions. SENIOR CREDIT FACILITY In March 1999, the Company entered into a new senior credit facility ("Senior Credit Facility") consisting of: (i) a term loan facility in the amount of $30.0 million payable in semi-annual installments until final maturity on December 31, 2005 ("Term Loan A"); (ii) a term loan facility in the amount of $105.0 million payable in semi-annual installments until final maturity on December 31, 2006 ("Term Loan B")(together with Term Loan A, the "Term Loans"); and (iii) a revolving loan (the "Revolving Loan") in an aggregate principal amount of up to $35.0 million terminating on December 31, 2005. In July 1999, the Company amended the Senior Credit Facility which increased the principal amount of Term Loan B by $30.0 million to $135.0 million. In October 1999, the Company amended the Senior Credit Facility to enable a related party to make a subordinated loan to the Company in the aggregate principal amount of $20.0 million and to permit the Company to issue additional senior subordinated notes and the Parent to issue preferred stock if certain covenants are met by the Company. The Senior Credit Facility, which is guaranteed by the Parent, the Company, and certain of its domestic subsidiaries, contains restrictive covenants including maintenance of interest and leverage ratios and various other restrictive covenants which are customary for such facilities. In addition, the Company is generally prohibited from incurring additional indebtedness, incurring liens, paying dividends or making other restricted payments, consummating asset sales, entering into transactions with affiliates, merging or consolidating with any other person or selling assigning, transferring, leasing, conveying, or otherwise disposing of assets. These conditions were satisfied as of December 31, 1999. Such limitations, together with the Company's highly leveraged nature could limit the Company's corporate and operating activities in the future, including the implementation of future acquisitions. FLOATING RATE NOTES In January 2000, the Company entered into an indenture for up to $50.0 million Senior Subordinated Floating Rate Notes (the "Floating Rate Notes"). The Floating Rate Notes will be available for drawdowns until July 31, 2000. Commitments on all amounts undrawn under the Floating Rate Notes by July 31, 2000 will expire and will be ineligible for future drawdowns. The Floating Rate Notes may be redeemed at 100% if redeemed before July 31, 2000 and at 101.50% if redeemed August 1, 2000 through October 31, 2000. If the Company does not redeem the Floating Rate Notes by November 1, 2000, the Floating Rate Notes will automatically convert into fixed-rate permanent notes due March 2009. As of March 29, 2000, $25.0 million of the Floating Rate Notes were outstanding. Proceeds from the Floating Facility will be used to fund acquisitions. SENIOR SUBORDINATED NOTES On March 18, 1999, the Company together with its wholly owned subsidiary, Muzak Finance Corp., co-issued $115.0 million in principal amount of Senior Subordinated Notes ("Senior Notes") which mature on March 15, 2009. Interest is payable semi-annually, in arrears, on March 15 and September 15 of each year, commencing on September 15, 1999. The Senior Notes are general unsecured obligations of the Company and Muzak Finance and are subordinated in right of payment to all existing and future Senior Indebtedness of the Company and Muzak Finance. The Senior Notes are guaranteed by the Parent, the Company, MLP Environmental Music, LLC, Business Sound, Inc., BI Acquisition LLC, Audio Environments, Inc., Background Music Broadcasters, Inc., and Muzak Capital Corporation. The indenture governing the Senior Notes generally prohibits the Company from making certain payments such as dividends and distributions of their capital stock; repurchases or redemptions of their capital stock, and investments (other than permitted investments) unless certain conditions are met by the Company. Before March 15, 2002, the issuers may redeem up to 35% of the aggregate principal amount of the Notes originally issued under the indenture at a redemption price of 109.875% of the aggregate principal amount so redeemed, plus accrued and unpaid interest to the redemption date, with the net proceeds of one or more equity offerings if certain conditions are met. After March 15, 2004, the issuers may redeem all or part of the Senior Notes at a redemption price equal to 104.938% of the principal amount, which redemption price declines to 100% of the principal amount in 2007. SENIOR DISCOUNT NOTES On March 18, 1999, the Parent together with its wholly owned subsidiary Muzak Holdings Finance Corp., co-issued $75.0 million in principal amount at maturity or $39.9 million in accreted value on the issue date, of 13% Senior Discount Notes (the "Senior Discount Notes") due 2010. Cash interest on the Senior Discount Notes does not accrue and is not payable prior to March 15, 2004. The Senior Discount Notes were issued at a substantial discount from their principal amount at maturity. Until March 15, 2004, the Senior Discount Notes will accrete in value such that the accreted value on March 15, 2004 will equal the principal amount at maturity of the Senior Discount Notes. From and after March 15, 2004, interest on the Senior Discount Notes will accrue at a rate of 13% per annum. Interest will be payable semi-annually in arrears on each March 15 and September 15, commencing September 15, 2004, to holders of record of the Senior Discount Notes at the close of business on the immediately preceding March 1 and September 1. The Senior Discount Notes are general unsecured obligations of the Parent and Muzak Holdings Finance Corp and effectively subordinated in right of payment to all existing and future Senior Indebtedness of the Company and Muzak Finance Corp. The Parent is a holding company for the Company and its subsidiaries, with no material operations of its own and only limited assets. Muzak Holdings Finance has no operations and substantially no assets. Accordingly, the Parent is dependent upon the distribution of the earnings of its subsidiaries to service its debt obligations. The indenture governing the Senior Discount Notes generally prohibits the Parent and its restricted subsidiaries from making certain payments such as dividends and distributions of their capital stock; repurchases or redemptions of their capital stock, and investments (other than permitted investments) unless certain conditions are met by the Parent and its restricted subsidiaries. Before March 15, 2002, the issuers may redeem up to 35% of the aggregate principal amount of the Senior Discount Notes originally issued under the indenture at a redemption price of 113% of the aggregate principal amount so redeemed, plus accrued and unpaid interest to the redemption date, with the net proceeds of one or more equity offerings if certain conditions are met. After March 15, 2004, the issuers may redeem all or part of the Senior Discount Notes at a redemption price equal to 106.5% of the principal amount which redemption price declines to 100% of the principal amount in 2007. RELATED PARTY DEBT From July 1, 1999 through November 24, 1999, the Company borrowed an aggregate amount of $30.0 million from MEM Holdings LLC in the form of Junior Subordinated Unsecured Notes (the "ABRY Notes"). The ABRY Notes mature on June 30, 2007, at which time principal and accrued interest are due. Interest accrues at 15% per annum; any accrued interest not paid as of March 31, June 30, September 30 or December 31 will bear interest at 15% per annum until such interest is paid or extinguished. The ABRY Notes are junior and subordinate to payments for the Senior Credit Facility and the Senior Notes. Proceeds from the ABRY Notes were used to fund operations and acquisitions. INTEREST RATE EXPOSURE Indebtedness under the Term Loan A and the revolving loans bears interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (which is the highest of prime rate and the Federal Funds Rate plus .5%) plus a margin ranging from 1.00% to 2.00% or (ii) the offered rates for Eurodollar deposits ("LIBOR") of one, two, three, or six months, as selected by the Company, plus a margin ranging from 2.0% to 3.0%. Margins, which are subject to adjustment based on the changes in the Company's ratio of consolidated total debt to EBITDA (i.e., earnings before interest, taxes, interest, depreciation, amortization and other non cash charges) were 2.0% in the case of Alternate Base Rate and 3.0% in the case of LIBOR as of December 31, 1999. Indebtedness under the Term Loan B bears interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (as described above) plus a margin of 2.5% or (ii) LIBOR of one, two, three, or six months, as selected by the Company plus a margin of 3.5%. Commitment fees range from .375% to .625%. Indebtedness under the Floating Rate Notes bears interest at a per annum rate equal to (i) three month LIBOR plus a margin of 5.0% until July 31, 2000 (ii) at three month LIBOR plus a margin of 7.5% for the period beginning August 1, 2000 through October 31, 2000 and (iii) for the period from November 1, 2000 through maturity, at a fixed rate based on the greater of (a) three month LIBOR plus 7.5% and (b) the yield on the Company's Senior Notes plus 2.5%. Interest on the Senior Notes accrues at a rate of 9.875% per annum. Until March 15, 2004, the Senior Discount Notes will accrete in value such that the accreted value on March 15, 2004 will equal the principal amount at maturity of the Senior Discount Notes. From and after March 15, 2004, interest on the Senior Discount Notes will accrue at a rate of 13% per annum. Cash interest paid was $14.1 million, $2 thousand, $2.9 million, and $2.2 million, for the fiscal year ended December 31, 1999, the period from October 7, 1998 through December 31, 1998, the period from January 1, 1998 through October 6, 1998, and for the fiscal year ended December 31, 1997, respectively. Due to the variable interest rates under the Senior Credit Facility, the Company is sensitive to changes in interest rates. Accordingly, during April 1999, the Company entered into a four year interest rate swap agreement in which the Company effectively exchanged $100.0 million of floating rate debt at three month LIBOR for 5.59% fixed rate debt. The Company terminated this agreement on January 28, 2000 and received approximately $4.4 million for this agreement. On January 28, 2000, the Company entered into a new interest rate swap agreement in which the Company effectively exchanged $100.0 million of floating rate debt at three month Libor for 7.042% fixed rate debt. The interest rate swap agreement terminates on April 19, 2002. Based on amounts outstanding at December 31, 1999, a .5% increase in each of LIBOR and the Alternate Base Rate (6.19% and 8.5% respectively, at December 31, 1999) would impact interest costs by approximately $0.9 million annually on the Senior Credit Facility. DEBT MATURITIES The current maturities of long-term debt primarily consist of the current portion of the Senior Credit Facility and other miscellaneous debt. The maturities of long-term debt of the Company's operations during 2000, 2001, 2002, 2003, and 2004 are $4.2 million, $5.2 million, $6.7 million, $7.8 million, $26.3 million, respectively. The Senior Notes mature in March 2009. In addition, the Senior Credit Facility provides for mandatory prepayments with net cash proceeds of certain asset sales, net cash proceeds of permitted debt issuances, net cash proceeds from insurance recovery and condemnation events, and beginning December 31, 2000 the Senior Credit Facility requires annual excess cash repayments. The indentures governing the Senior Notes and the Senior Discount Notes provide that in the event of certain asset dispositions, the Company and the Parent must apply net proceeds first to repay Senior Indebtedness. To the extent the net proceeds have not been applied within 360 days from the asset disposition to an investment in capital expenditures or other long term tangible assets used in the business, and to the extent the remaining net proceeds exceed $10.0 million, the Company must make an offer to purchase outstanding Senior Notes at 100% of their principal amount plus accrued interest. To the extent there are excess funds after the purchase of the Senior Notes, the Parent must make an offer to purchase outstanding Senior Discount Notes at 100% of the accreted value. The Company and the Parent must also make an offer to purchase outstanding Senior Notes and the Senior Discount Notes at 101% of their principal amount plus accrued and unpaid interest if a Change in Control of the Company occurs. Subject to compliance with the Senior Credit facility, the Floating Rate Notes will be mandatory redeemable with the proceeds of any securities issuances or incurrences of indebtedness at any time on or prior to October 31, 2000. If the Company does not redeem the Floating Rate Notes by November 1, 2000, the Floating Rate Notes will automatically convert into fixed-rate permanent notes due March 15, 2009. IMPACT OF YEAR 2000 COMPLIANCE The Company's program to address the Year 2000 issue consisted of (i) assessing the state of Year 2000 readiness of its systems and third parties upon which it relies (ii) replacing the primary computer system at headquarters and owned operations, (iii) testing these systems, and (iv) contingency planning. The Company did not experience any significant disruption as a result of the Year 2000 issue. Costs related to the Year 2000 issue were approximately $1.0 million and were funded through operating cash flows. The Company completed its assessment of its Year 2000 risks related to significant relationships with its critical third party suppliers and customers. Despite these efforts, the Company can provide no assurance that all third parties compliance plans were successfully completed in a timely manner, although it is not aware of any problems which would significantly impact its operations. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE EXPOSURE The Company's exposure to market risk for changes in interest rates relates primarily to the Company's long-term debt obligations. The interest rate exposure for the Company's variable rate debt obligations is currently indexed to LIBOR of one, two, or three months as selected by the Company, or the Alternate Base Rate. The Company uses interest rate swap agreements to modify its exposure to interest rate movements and to reduce borrowing rates. The table below provides information about the Company's debt obligations and interest rate protection agreement. For debt obligations, the table presents principal cash flows and related weighted average interest rates by expected maturity dates. For interest rate protection agreements, the table presents notional amounts and weighted average interest rates by expected (contractual) maturity dates. Weighted average variable interest rates are based on implied LIBOR in the yield curve at the reporting date. The principal cash flows are in thousands. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See the Consolidated Financial Statements of Muzak LLC included herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Muzak LLC (the "Company") is wholly owned subsidiary of Muzak Holdings LLC (the "Parent"). The Parent is a limited liability company whose affairs are governed by a Board of Directors. The following table sets forth information about the directors of the Parent and the executive officers of the Company as of December 31, 1999 and their ages as of December 31, 1999. Each of the directors identified below is currently a director of the Parent, has served as a director of the Parent since March 1999 and is serving a one-year term. The election of directors is subject to the terms of the Members Agreement and Securityholders Agreement and are described below under the heading "Certain Relationships and Related Transactions." The following sets forth biographical information with respect to the directors of the Parent and executive officers of the Company. WILLIAM A. BOYD is a director, has been the Chief Executive Officer of the Company since March 1999 and was the Chief Executive Officer of Old Muzak from 1997 to March 1999, Chairman of the Board of Music Holdings Corporation, the general partner of the managing general partner of Old Muzak, from 1997 to March 1999 and was a director of Music Holdings Corporation from 1996 to March 1999. From 1995 to 1996, Mr. Boyd was a private investor. From 1982 to 1995, Mr. Boyd was owner and president of SunCom Communications, the largest independent franchisee of Old Muzak. Mr. Boyd was President of the franchise organization from 1994 to 1995 and from 1986 to 1987. Mr. Boyd was also President of Old Muzak's Owned Affiliate division in 1987. Prior to owning a franchise, Mr. Boyd held various positions with Old Muzak. Mr. Boyd is the father of Robert T. Boyd, Vice President of Finance for Owned Operations. STEVEN K. RANDALL has been an Executive Vice President of the Company since November 1999. Prior to November 1999, Mr. Randall was the owner and President of MountainWest Audio Inc., an independent franchisee of the Company. He served in this capacity from 1979 until joining the Company in November 1999. While he was the owner of Mountainwest Audio, Mr. Randall served on the President's Advisory Board and the National Sales Committee for the Company. While serving as President of MountainWest Audio, he was an officer and board member of the franchise organization. BRAD D. BODENMAN has been Chief Financial Officer and Treasurer of the Company since March 1999 and was the Chief Financial Officer of Old Muzak from 1998 to March 1999. Mr. Bodenman served as Old Muzak's Vice President, Finance and Administration from 1997 to 1998, as its Controller from 1996 to 1997, as its Director of Finance from 1994 to 1996, as an Accounting Manager from 1991 to 1994, and Accounting Supervisor from 1990 to 1991 and as Senior Accountant from 1989 to 1990. Prior to joining Old Muzak, he served as a senior accountant at Price Waterhouse. Subsequent to December 31, 1999, Mr. Bodenman resigned his position as Chief Financial Officer of the Company and Parent effective April 30, 2000. STEVEN M. TRACY has served as Senior Vice President, Owned Operations of the Company since March 1999 and was the Senior Vice President, Owned Operations of Old Muzak from 1998 to March 1999. From 1997 to 1998, Mr. Tracy was Old Muzak's Vice President, Owned Operations, Western Region. Prior to 1997, Mr. Tracy served as a Regional Director from 1994 to 1997, General Manager from 1988 to 1994 and Vice President/General Manager for Old Muzak from 1986 to 1988. MICHAEL F. ZENDAN II has been the Company's Vice President and General Counsel since October 1999. From 1996 to October 1999, Mr. Zendan was Assistant General Counsel (Aerospace) and Assistant Secretary for Coltec Industries Inc, and was Assistant General Counsel (Industrial) for Coltec Industries Inc from 1994-1996, and served as Attorney and Senior Attorney for Coltec Industries Inc from 1992-1994. From 1988-1992, he served as an Associate at Pepe & Hazard. PENI GARBER is a principal and Secretary of ABRY Partners. She joined ABRY Partners in 1990 from Price Waterhouse, where she served as Senior Accountant in the Audit Division from 1985 to 1990. Ms. Garber is presently a director or the equivalent of Nexstar Broadcasting Group LLC, Network Music Holdings LLC, Quorum Broadcast Holdings Inc. Ms. Garber graduated summa cum laude from Bryant College. DAVID W. UNGER is a founder and managing Partner of Avalon Equity Partners. From May 1997 to March 1999, he was Executive Vice President of Audio Communications Network. Prior to May 1997, he was chairman of Suncom Communications, LLC, an independent franchisee of the Company. ROYCE G. YUDKOFF is the President and managing Partner of ABRY Partners. Prior to joining ABRY Partners, Mr. Yudkoff was affiliated with Bain & Company an international management consulting firm. At Bain, where he was Partner from 1985 through 1988, he shared significant responsibility for the firm's media practice. Mr. Yudkoff is presently a director or the equivalent of various companies including Quorum Broadcast Holdings Inc., Nexstar Broadcasting Group LLC, Metrocall, Inc. and Pinnacle Towers Inc. Mr. Yudkoff graduated as a Baker Scholar from the Harvard Business School and is an honors graduate of Dartmouth College. R. STEVEN HICKS. Mr. Hicks became a director of AMFM and was elected Vice Chairman of AMFM and President and Chief Executive Officer of the AMFM New Media Group in March 1999. Mr. Hicks has served as a director of AMFM since August 1999. Mr. Hicks served as President, Chief Executive Officer and a director of Capstar Broadcasting from June 1997 to July 1999. Mr. Hicks has also served as Chairman of the Board of Capstar Broadcasting from June to September 1997. Prior to joining Capstar, Mr. Hicks served as Chairman of the Board and Chief Executive Officer of Gulfstar Communications, Inc. from July 1987 to January 1997 and as president and Chief Executive Officer of SFX Broadcasting, Inc. ("SFX") from November 1993 to May 1996. Mr. Hicks is a 33-year veteran of the radio broadcasting industry. D. GEOFFREY ARMSTRONG. Mr. Armstrong was elected Executive Vice President and Chief Financial Officer of AMFM in March 1999. Mr. Armstrong served as Executive Vice President and Chief Operating Officer of Capstar Broadcasting from July 1998 to March 1999, and served as Director of Capstar Broadcasting from July 1998 to July 1999. Mr. Armstrong served as the Chief Operating officer and an Executive Vice president of SFX from November 1996 to May 1998 and served as a director of SFX from 1993 to 1998. Mr. Armstrong became the Chief Officer of SFX in June 1996 and served as the Chief Financial Officer and Treasurer of SFX from 1992 until March 1995. Mr. Armstrong currently serves as a director of SFX Entertainment, Inc. ANDREW BANKS is Chairman of ABRY Holdings, Inc. Previously, Mr. Banks was affiliated with Bain & Company, an international management consulting firm. At Bain, where he was a partner from 1986 until 1988, he shared significant responsibility for the firm's media practice. Mr. Banks is presently a director or the equivalent of Pinnacle Towers, Inc. Mr. Banks is a graduate of the Harvard Law School, a Rhodes Scholar holding a Master's degree from Oxford University and a graduate of the University of Florida. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Company was formed on August 28, 1998 as ACN Operating LLC and in October of 1998 changed its name to Audio Communications Network, LLC ("ACN"). On March 18, 1999, Muzak Limited Partnership ("Old Muzak") merged with and into ACN. At the time of the merger, ACN changed its name to Muzak LLC ("the Company"). The following table sets forth information concerning the compensation of the Company's Chief Executive officer and each of the Company's four most highly compensated executive officers, at December 31, 1999, for services in all capacities to the Company. Each of the executive officers listed below were not employees of the Company until the merger, and therefore, except as otherwise indicated, the following table includes compensation only for the period from March 18, 1999 to December 31, 1999. SUMMARY COMPENSATION TABLE - --------- (1) Consists of contributions by the Company to a defined contribution 401(k) plan. (2) Bonus amount includes $358,000 of retention bonus in connection with the merger. Other Annual Compensation consists of a housing allowance of $30,000 and a car allowance of $5,000. Aggregate restricted stock holdings were 1,924 shares, with a value on December 31, 1999 of $27,417. One fifth of the restricted stock award vested on March 18, 2000. The remainder is to vest in four additional installments of 384.8 shares each on March 18, 2001, March 18, 2002, March 18, 2003 and March 18, 2004. (3) Mr. Saldarini's employment with the Company terminated upon his retirement on December 31, 1999. Bonus amount includes $358,000 of retention bonus in connection with the merger. Other Annual Compenstaion consists of a housing allowance of $25,000 and a car allowance of $5,000. Aggregated restricted stock holdings were 526 shares, with a value on December 31, 1999 of $7,495. In connnection with Mr. Saldarini's change in employment status, the Parent repurchased the restricted stock in February 2000. (4) Joined the Company November 1, 1999. (5) Other Annual Compensation consists of a car allowance of $5,000. Aggregated restricted stock holdings were 439 shares, with a value on December 31, 1999 of $6,256. One fifth of the restricted stock award vested on March 18, 2000. The remainder is to vest in four additional installments of 87.8 shares each on March 18, 2001, March 18, 2002, March 18, 2003, and March 18, 2004. (6) Mr. Bodenman's aggregated restricted stock holdings were 351 shares, with a value on December 31, 1999 of $5,002. One fifth of the restricted stock award vested on March 18, 2000. The remainder is to vest in four additional installments of 70.2 shares each on March 18, 2001, March 18, 2002, March 18, 2003, and March 18, 2004. (7) Joined the Company on October 18, 1999. MANAGEMENT EMPLOYMENT AGREEMENTS Concurrently with the consummation of the merger on March 18, 1999 of Old Muzak with and into Audio Communications Network, the Company entered into an employment agreement with Mr. W. Boyd. After the merger, the Company entered into employment agreements with Steven M. Tracy and Brad D. Bodenman, the terms of which are the same in all material respects. The terms of these agreements are described below. WILLIAM A. BOYD. Pursuant to the employment agreement dated as of March 18, 1999 by and among Mr. Boyd, the Company and the Parent, the Company agreed to employ Mr. Boyd as President and Chief Executive Officer until his resignation, death, disability or termination of employment. Under the employment agreement, Mr. Boyd is: o Required to devote substantially all of his business time to the Company, o Entitled to a minimum base salary of $0.3 million, with annual increase by the consumer price index of the preceding year, o Eligible for a bonus, as determined by the Board of Directors of the Parent, up to $0.15 million with annual increases by the consumer price index of the preceding year, o Prohibited from competing with the Company during the term of his employment period and for a period of twelve months thereafter, and o Prohibited from disclosing any confidential information gained during his employment period. If the Company terminates Mr. Boyd's employment without "cause," Mr. Boyd will be entitled to receive his base salary for a period of one year thereafter. OTHER EXECUTIVE OFFICERS. Steven M. Tracy, Brad D. Bodenman, Steven K. Randall and the Company are parties to employment agreements the terms of which are the same in all material respects. Each agreement may be terminated at any time by either party. Under the agreements, the executive is: o Entitled to compensation in accordance with the Company's employee compensation plan, which may be amended by the Company at any time, o Prohibited from competing with the Company during the term of employment and for 18 months thereafter, and o Prohibited from disclosing any confidential information gained during the executive's employment period. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Parent owns all of the membership units of the Company. The following table sets forth information regarding the beneficial ownership of the Class A units of the Parent, which are the only outstanding membership interests in the Parent with voting rights, as of March 29, 2000, by: o Holders having beneficial ownership of more than 5% of the voting equity interest of the Parent, o Each director of the Parent o Each of the Company's executive officers shown in the summary compensation table, and o All directors and executive officers as a group. - --------- * Less than 1% (a) "Beneficial ownership" generally means any person who, directly or indirectly, has or shares voting or investment power with respect to a security or has the right to acquire such power within 60 days. Unless otherwise indicated, the Company believes that each holder has sole voting and investment power with regard to the equity interests listed as beneficially owned. (b) Mr. Yudkoff is the sole owner of the equity interests of ABRY Holdings III, Inc., the general partner of ABRY Equity Investors, L.P., the general partner of ABRY Broadcast Partners III. Mr. Yudkoff is also the sole owner of ABRY Holdings, Inc., the general partner of ABRY Capital, L.P., which is the general partner of ABRY Broadcast Partners II. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. As a result, Mr. Yudkoff may be deemed to beneficially own the shares owned by MEM Holdings. The address of Mr. Yudkoff is the address of MEM Holdings and ABRY Partners. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS INVESTOR SECURITIES PURCHASE AGREEMENT David W. Unger, ABRY Broadcast Partners III and the Parent are parties to an Investor Securities Purchase Agreement dated as of October 6, 1998, pursuant to which the Parent sold to investors, and investors purchased from the Parent, Class A units of the Parent. The investors are entitled to indemnification in some circumstances to the extent the Parent is determined to have breached representations, warranties or agreements contained in the Investor Securities Purchase Agreement. The Management Securities Repurchase Agreement between Mr. Unger and the Parent was terminated in August 1999. MEMBERS AGREEMENT The Parent, MEM Holdings, Joseph Koff, Mr. Unger, CMS Co-Investment Subpartnership, CMS Diversified Partners, L.P., Music Holdings Corp. and Stephen F. Jones are parties to an Amended and Restated Members Agreement dated as of March 18, 1999. Pursuant to the Members Agreement, MEM Holdings, Mr. Koff, Mr. Unger and Music Holdings Corp. have agreed to vote their equity interests in the Parent to elect Mr. Unger to the Board of Directors of the Parent. The Members Agreement also contains: o "co-sale" rights exercisable in the event of specified sales by ABRY Broadcast Partners III, o "drag along" sale rights exercisable by the Board of Directors of the Parent and holders of a majority of the then class A Units, in the event of an Approved Company Sale (as defined in the Members Agreement), o preemptive rights and o restrictions on transfers of membership interests by Mr. Koff, Mr. Unger, Music Holdings Corp, and its permitted transferees. The voting, co-sale, drag along and transfer restrictions will terminate upon consummation of the first to occur of a Qualified Public Offering, as defined in the Members Agreement, or an Approved Company Sale. SECURITYHOLDERS AGREEMENT The Parent, MEM Holdings, and CBC Acquisition Company, Inc. are parties to a Securityholders Agreement dated as of March 18, 1999. Pursuant to the Securityholders Agreement, MEM Holdings and CBC Acquisition Company, Inc. have agreed to vote their equity interests in the Parent to establish the composition of the Board of Directors of the Parent and to elect Steven Hicks as the Chairman. The Securityholders Agreement also contains: o "co-sale" rights exercisable in the event of specified sales by MEM Holdings or CBC Acquisition Company, Inc., respectively, o "drag along" rights exercisable by the Board of Directors of the parent and holders of a majority of the then class A units, in the event of an Approved Company Sale, as defined in the Securityholders Agreement, o preemptive rights, and o any transfer by MEM Holdings is subject to a right to first offer by CBC Acquisition Company, Inc., and vice versa. The voting restrictions will terminate upon an Approved Company Sale. The drag along and the transfer restrictions will terminate upon the consummation of the first to occur of a Qualified Public Offering, as defined in the Securityholders Agreement, or an Approved Company Sale. The co-sale rights will terminate upon the consummation of the first to occur of an initial public offering by the Parent or an Approved Company Sale. REGISTRATION AGREEMENT The Parent, MEM Holdings, Mr. Koff, Mr. Unger, Music Holdings Corp., CMS Co-Investment Subpartnership, CMS Diversified Partners, L.P. and CBC Acquisition Company, Inc. are parties to an Amended and Restated Registration Agreement. Pursuant to this Registration Agreement, the holders of majority of the ABRY Registrable Securities, as defined in the Registration Agreement, may request a demand registration under the Securities Act of all or any portion of the ABRY Registrable Securities: o on Form S-1 or any similar long-form registration, o on Form S-2 or S-3 or any similar short-form registration, if available, and o on any applicable form pursuant to Rule 415 under the Securities Act. In accordance with the Registration Agreement, the holders of a majority of CBC Acquisition Company, Inc. Registrable Securities, as defined in the Registration Agreement, may request a demand registration under the Securities Act of all or any portion of the Capstar Registrable Securities on Form S-1 or any similar long-form registration and on Form S-2 or S-3 or any similar short-form registration. In addition, all holders of Registrable Securities, as defined in the registration Agreement, will have unlimited "piggyback" registration rights, which entitle them to include their registrable equity securities in registrations of securities by the Parent, subject to the satisfaction of specified conditions. The Parent is responsible for all expenses incident to its performance under the Registration Agreement, including without limitation all registration and filing fees, fees and expenses of compliance with securities or blue sky laws, printing expenses, fees of counsel for the Parent and the holders of registrable securities and all independent certified public accountants and underwriters. ABRY PARTNERS MANAGEMENT AND CONSULTING SERVICES AGREEMENT Pursuant to a Management Agreement between ABRY Partners and the Company dated October 6, 1998, ABRY Partners is entitled to a management fee when, and if, it provides advisory and management consulting services to the Company and based on the amount invested by ABRY partners and its affiliates in the Company. The Company anticipates that any such management fee, if incurred, would be $0.3 million per annum payable quarterly in arrears plus reimbursable expenses, adjusted as follows. The Management Agreement provides that beginning in 1999, any applicable management fee should be multiplied by 1.05 raised to the power obtained by subtracting 1998 from the number of the calendar year. Either ABRY Partners or the Company, with the approval of the Board of Directors of the Parent, may terminate the management Agreement by prior written notice to the other. ABRY BROADCAST PARTNER'S III'S SUBORDINATED NOTE In connection with the acquisition of the Company's franchises from Audio Communications Network, Inc. ("Predecesser Company") ACN borrowed approximately $40.8 million from ABRY Broadcast Partners III under ABRY Broadcast Partners III's subordinated note. During 1998, no interest payments were made on ABRY Broadcast Partners III's subordinated note and interest accrued at 9% per annum. The Company repaid $41.7 million outstanding under ABRY III's subordinated note at the time of the merger and converted $0.7 million into voting units of the Parent. With the proceeds of the note, ABRY made a capital contribution of $17.9 million to the Parent. INTERCOMPANY LOANS In connection with the acquisition of the Company's franchisees from the Predecessor Company, ACN borrowed $17.6 million from the Parent. On October 9, 1998, ACN borrowed $0.9 million from the Parent to provide working capital and for acquisitions. On November 25, 1998, ACN borrowed an additional $0.2 million for acquisitions. Each of these loans bore interest at market rates and did not require scheduled cash payments. On December 4, 1998, the Parent converted these loans of $18.7 million plus accrued interest of approximately $0.1 million into membership units of ACN. RELATED PARTY DEBT From July 1, 1999 through November 24, 1999, the Company borrowed an aggregate amount of $30.0 million from MEM Holdings LLC in the form of Junior subordinated unsecured notes (the "ABRY Notes"). MEM Holdings is a holdings company that owns 68% of the voting interests in the Parent. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. The ABRY Notes mature on June 30, 2007, at which time principal and accrued interest are due. Interest accrues at 15% per annum; any accrued interest not paid as of March 31, June 30, September 30 or December 31 with bear interest at 15% per annum until such interest is paid or extinguished. The ABRY Notes are junior and subordinate to payments for the Senior Credit Facility and the Senior Notes. At any time, the ABRY Notes, with the exception of the $3.0 million note, may be converted into class A units of the Parent. If the ABRY notes, with the exception of the $3.0 million note, have not been repaid in full as of May 2001, the ABRY notes will automatically be converted into class A units of the Parent. FAMILY RELATIONSHIPS William Boyd, the Company's Chief Executive Officer, is the father of Robert Boyd, the Company's Vice President, of Finance for Owned Operations. Robert Boyd earned over $60,000 during 1999. TRANSACTIONS WITH MANAGEMENT AND OTHERS As a result of the consummation of the merger between Old Muzak and ACN, the executive management of Old Muzak liquidated their stock options. Mr. Willliam Boyd, Mr. Steven Tracy, Mr. Charles Saldarini, and Mr. Brad Bodenman received $2.8 million, $84 thousand, $1.4 million, and $45 thousand, respectively upon the liquidation of their stock options. In addition, Mr. Steven Tracy, Mr. Charles Saldarini, and Mr. Brad Bodenman received $0.2 million, $0.5 million, and $0.2 million, respectively, which represented consideration for partnership units of Old Muzak. CERTAIN BUSINESS RELATIONSHIPS The Company's Charlotte Owned Operation leased facilities from WRA Associates during 1999. William A. Boyd is the managing partner of WRA Associates. Other Partners include William Boyd, Robert Boyd, and Andy Boyd, all of whom are sons of William A. Boyd. Payments to WRA Associates for these facilities aggregated $86,095 during 1999. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements: (2) Financial Schedules: All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because they are not required, are inapplicable, or the information is included in the Consolidated Financial Statements or the Notes thereto. (a) (3) Exhibits: - --------- * Management contract or compensatory plan or arrangement. (1) Incorporated by reference to the Company's Registration Statement on Form S-4, File No. 333-78571. (2) Incorporated by reference to the Parent's Registration Statement on Form S-4, File No. 333-78573. (3) Incorporated by reference to the Company's Report on Form 10-Q for the fiscal quarter ended September 30, 1999. (b) Reports on Form 8-K. (c) During the last quarter of the fiscal year for which this report on Form 10-K was filed, the Company filed no reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrants have duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized., on the 30th day of March 2000. MUZAK FINANCE CORP. MUZAK LLC By: -------------------------------------- NAME: WILLIAM A. BOYD TITLE: PRESIDENT AND CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Muzak LLC: In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 25 related to Muzak LLC present fairly, in all material respects, the financial position of Muzak LLC and its subsidiaries (the "Company"), formally known as Audio Communications Network, LLC, at December 31, 1999 and 1998, and the results of their operations and their cash flows for the year ended December 31, 1999 and for the period from October 7, 1998 to December 31, 1998, in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 14(a)(2) on page 25, present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers LLP Charlotte, North Carolina March 24, 2000 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors Muzak LLC In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 25 related to Audio Communications Network, Inc. ("ACN" or "Predecessor Company") present fairly, in all material respects, the results of their operations and their cash flows for the period from January 1, 1998 to October 6, 1998 in conformity with generally accepted accounting principles in the United States. These financial statements are the responsibility of ACN's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. /s/ PRICEWATERHOUSECOOPERS LLP February 19, 1999 Charlotte, North Carolina REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors of Muzak LLC: We have audited the accompanying consolidated statements of operations, stockholders' equity, and cash flows of Audio Communications Network, Inc. and its subsidiaries (the "Predecessor Company") for the year ended December 31, 1997. These financial statements are the responsibility of the Predecessor Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of the Predecessor Company for the year ended December 31, 1997 in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP Orlando, Florida March 31, 1998 ITEM 1. FINANCIAL STATEMENTS MUZAK LLC CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK LLC CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS) The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK LLC CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK LLC CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND MEMBER'S INTEREST (IN THOUSANDS, EXCEPT FOR UNITS) PREDECESSOR COMPANY, INC: - -------------------------------------------------------------------------------- MUZAK LLC: The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION -- Muzak LLC ("the Company"), a Delaware limited liability company, was formed on August 28, 1998 as ACN Operating LLC and in October 1998 changed its name to Audio Communications Network, LLC ("ACN"). On October 7, 1998 ACN commenced operations with its acquisition of the independent franchisees in the Baltimore, Charlotte, Hillsborough, Kansas City, St. Louis, Jacksonville, Phoenix, and Fresno areas from Audio Communications Network, Inc. (the "Predecessor Company"). On March 18, 1999, Muzak Limited Partnership ("Old Muzak") merged with and into ACN. At the time of the merger, ACN changed its name to Muzak LLC. The Company is a wholly owned subsidiary of Muzak Holdings LLC (the "Parent"), previously known as ACN Holdings, LLC. As of December 31, 1999, ABRY Partners, LLC. and its respective affiliates collectively own approximately 68% of the beneficial interests in the Parents voting interests. All of the operating activities are conducted through the Company and its subsidiaries. The Company derives the majority of its revenues from the sale of business music products. The core porduct is AUDIO ARCHITECTURE and its two complementary products are AUDIO MARKETING and VIDEO IMAGING. These revenues are generated by clients, who pay monthly subscription fees under noncancelable five year contracts. The Company also derives revenues from the sale and lease of audio system-related products, principally sound systems and intercoms, to business music clients and other clients. In addition, the Company sells electronic equipment, such as proprietary tape playback equipment and other audio and video equipment to franchisees to support the sale of business music services. Installation, service and repair revenues consist principally of revenues from the installation of sound systems and other equipment that is not expressly part of a business music contract, such as paging, security and drive-through systems. These revenues also include revenue from the installation, service and repair of equipment installed under a business music contract. Music contract installation revenues are deferred and recognized over the term of the respective contracts. BASIS OF PRESENTATION -- The consolidated financial statements include the accounts of the Company and its subsidiaries; Muzak Capital Corporation, Muzak Finance Corporation, Business Sound Inc., Electro Systems Corporation, BI Acquisition LLC, MLP Environmental Music, LLC, Audio Environments, Inc, and Background Music Broadcasters, Inc. All significant intercompany items have been eliminated in consolidation. Certain prior year items have been reclassified to conform with the fiscal 1999 presentation. The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financials statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS -- Cash and cash equivalents include all cash balances and highly liquid investments with an original maturity of three months or less. INVENTORIES -- Inventories consist primarily of electronic equipment and are valued at the lower of cost or market, but not in excess of net realizable value. Cost is determined on the first-in, first-out basis. PROPERTY AND EQUIPMENT -- Property and equipment are stated at cost. Depreciation is computed on a straight-line basis over the estimated useful lives of the assets, ranging from 3 to 30 years. Sound and music equipment installed at customer premises under contracts to provide music programming services is transferred from inventory to property and equipment at cost plus an allocation of installation costs and is amortized over 5 years. Impairment losses are recognized if recorded values exceed undiscounted future cash flows, by reducing them to estimated fair value. No impairment losses were recognized by the Company or the Predecessor Company for the periods presented. INTANGIBLE ASSETS -- Goodwill, the excess of the purchase price over the fair value of net assets of businesses acquired, is amortized over twenty years using the straight-line method. Income producing contracts are amortized using the straight-line method over periods ranging from 8-14 years. Management evaluates the recoverability of intangibles by comparing MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) recorded values to the undiscounted future cash flows that can be generated by such assets. Impairment losses are recognized if recorded values exceed undiscounted future cash flows, by reducing them to estimated fair value. No impairment losses were recognized by the Company for the periods presented. INCOME TAXES -- The Company is a Limited Liability Company that is treated as a partnership for income tax purposes. No provision for income taxes is required by the Company as its income and expenses are taxable to or deductible by its members. The Company's corporate subsidiaries are subject to income taxes and account for deferred income taxes under the liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. REVENUE RECOGNITION -- Revenues from music services are recognized on a straight-line basis over the term of the customer contracts in the period services are provided. Revenues for equipment sales and related installation are recognized upon delivery or installation. Contracts are typically for a five-year non-cancelable period with renewal options for an additional five years. Fees received for services to franchisees are recognized as revenues in the month services are provided. SUBSCRIBER ACQUISITION COSTS -- Subscriber acquisition costs are direct sales commissions incurred in connection with acquiring new subscribers, which are amortized as a component of selling, general, and administrative expenses over the life of the customer contract or five years, whichever is shorter, on a straight-line basis. If a customer contract terminates early, the unamortized subscriber acquisition costs is typically recovered from the salesperson. Subscriber acquisition costs are included in deferred charges and other assets, net. ADVANCE BILLINGS -- The Company invoices certain customers in advance for contracted music and other business services. Amounts invoiced in advance of the service period are deferred when invoiced and recognized as revenue in the period earned. CONCENTRATION OF CREDIT RISK -- Concentrations of credit risk with respect to trade accounts receivable are limited as the Company sells its products to customers in diviersified industries thorughout the United States. The Company performs ongoing credit evaluations of its customers' financial condition and maintains allowances for potential credit losses. Actual losses have been within management's expectations and estimates. 2. ACQUISITIONS On October 7, 1998, the Company acquired certain assets and liabilities of ACN for $66.8 million. The acquisition was accounted for using the purchase method of accounting. Accordingly, the consideration paid was allocated based on the estimated fair market value of the net assets acquired. The excess of the consideration paid over the estimated fair market value of the net assets acquired approximated $17.0 million and is being using the straight amortized using the straight-line method over 20 years. In order to complete the acquisition of ACN, the Company received a $8.4 million capital contribution from the Parent, and issued notes payable to a related party and the Parent of $40.8 million (see Note 6) and $17.6 million, respectively. On December 4, 1998, the Parent converted the $17.6 million note payable along with additional noted issued during the period of October 7, 1998 through December 31, 1998 which approximated $1.0 million, plus accrued interest of $0.1 million, into membership interests. As discussed in Note 1, on March 18, 1999 Old Muzak merged with and into ACN. Under the terms of the agreement, the Company paid total consideration of $274.2 million, which is comprised of the following: $125.5 million cash consideration, $114.9 million consideration in the tender offer and consent solicitation for the 10% Senior Notes due 2003 of Old Muzak, $15.9 million for debt repayment of Old Muzak outstanding obligations and assumed $17.9 million of other obligations. In addition, at the time of the merger, the Company repaid $41.7 million borrowed from ABRY Broadcast Partners by ACN in October 1998 in connection with the acquisition of the Company's independent franchisees from the Predecessor Company and converted $0.7 million into voting units of the Parent. In 1999, the Company made the following acquisitions: MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2. ACQUISITIONS -- (CONTINUED) o On January 15, 1999, the Company acquired all of the outstanding stock of Business Sound, Inc. for approximately $4.1 million, which included 3,661 Class A units of the Parent. Business Sound was the Company's independent franchisee for the New Orleans, Louisiana and Mobile, Alabama areas. o On February 24, 1999, the Company acquired all of the outstanding stock of Electro Systems for approximately $0.7 million, which included 650 Class A units of the Parent, and assumed certain nonrecourse debt of $2.4 million. Electro Systems was the Company's independent franchise located in Panama City, Florida. The Company made thirteen acquisitions between the merger on March 18, 1999 and December 31, 1999. The table below provides information regarding these acquisitions (in millions, except for number of Parent units). - --------- (1) Total purchase price included 13,535 Class A units of the Parent. (2) The Parent acquired Capstar Broadcasting Corporation's ("Capstar") independent franchisees located in Atlanta, Albany, and Macon, Georgia, Ft Myers, Florida and Omaha Nebraska. The total consideration was accounted for as an equity contribution to the Company and included 2,385 Class A units of the Parent. (3) Total purchase price included 100 Class A units of the Parent. (4) The Company paid $3.1 million of the purchase price of Mountain West Audio as of December 31, 1999. In February 2000, the Company paid the remaining purchase price, which included 456 Class A units of the Parent. (5) The purchase price does not include transaction costs. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2. ACQUISITIONS -- (CONTINUED) The results of operations of the acquired companies are included in the Company's consolidated statement of operations for the periods in which they were owned by the Company. The acquisitions were accounted for under the purchase method of accounting. Accordingly, the consideration was allocated to the net assets acquired based on the fair market values at the date of acquisition as determined through the use of an independent appraisal. The excess of purchase price for each acquisition over the estimated fair value of the tangible and identifiable intangible assets acquired approximated $127.9 million and is being amortized over a period of twenty years on a straight-line basis. The following presents the unaudited pro forma results assuming that the acquisitions discussed above and financings (see Note 6) had occurred as of the beginning of fiscal 1999 and 1998. These pro forma results are not necessarily indicative of the results that will occur in future periods (in thousands). 3. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands): Depreciation of property and equipment was $17.6 million, $0.8 million, $1.9 million, and $1.4 million for year ended December 31, 1999, the period from October 7, 1998 to December 31, 1998, for the period from January 1, 1998 to October 6, 1998, and for the year ended December 31, 1997, respectively. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 4. INTANGIBLE ASSETS Intangible assets consist of the following (in thousands): Amortization of intangible assets was $18.8 million, $0.8 million, $2.5 million, and $2.6 million for the year ended December 31, 1999, the period from October 7, 1998 to December 31, 1998, for the period from January 1, 1998 to October 6, 1998, and for the year ended December 31, 1997, respectively. 5. ACCRUED EXPENSES Accrued expenses are summarized below (in thousands): - --------- Additional purchase price for Mountain West Audio, Inc. was paid in February 2000. 6. DEBT Debt obligations consist of the following (in thousands): MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. DEBT -- (CONTINUED) SENIOR CREDIT FACILITY In March 1999, the Company entered into a new senior credit facility ("Senior Credit Facility") consisting of: (i) a term loan facility in the amount of $30.0 million payable in semi-annual installments until final maturity on December 31, 2005 ("Term Loan A") ; (ii) a term loan facility in the amount of $105.0 million payable in semi-annual installments until final maturity on December 31, 2006 ("Term Loan B")(together with Term Loan A , the "Term Loans"); and (iii) a revolving loan (the "Revolving Loan") in an aggregate principal amount of up to $35.0 million terminating on December 31, 2005. In July 1999, the Company amended the Senior Credit Facility which increased the principal amount of the Term Loan B by $30.0 million to $135.0 million. In October 1999, the Company amended the Senior Credit Facility to enable a related party to make a subordinated loan to the Company in the aggregate principal amount of $20.0 million and to permit the Company to issue additional senior subordinated notes and the Parent to issue preferred stock if certain covenants are met by the Company. The Senior Credit Facility, which is guaranteed by the Parent, the Company, and certain of its domestic subsidiaries contains restrictive covenants including maintenance of interest and leverage ratios and various other restrictive covenants which are customary for such facilities. In addition, the Company is generally prohibited from incurring additional indebtedness, incurring liens, paying dividends or making other restricted payments, consummating asset sales, entering into transactions with affiliates, merging or consolidating with any other person or selling assigning, transferring, leasing, conveying, or otherwise disposing of assets. These conditions were satisfied as of December 31, 1999. Indebtedness under the Term Loan A and the Revolving Loans bear interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (which is the highest of prime rate and the Federal Funds Rate plus .5%) plus a margin ranging from 1.00% to 2.00% or (ii) the offered rates for Eurodollar deposits ("LIBOR") of one, two, three, or six months, as selected by the Company, plus a margin ranging from 2.0%to 3.0%. Margins, which are subject to adjustment based on the changes in the Company's ratio of consolidated total debt to EBITDA (i.e., earnings before interest, taxes, interest, depreciation, amortization and other non cash charges) were 2.0% in the case of Alternate Base Rate and 3.0% in the case of LIBOR as of December 31, 1999. Indebtedness under the Term Loan B bears interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (as described above) plus a margin of 2.5% or (ii) LIBOR of one, two, three, or six months, as selected by the Company plus a margin of 3.5%. The weighted average rate of interest on the Senior Credit Facility at December 31, 1999 was 9.01%. SENIOR NOTES On March 18, 1999, the Company together with its wholly owned subsidiary, Muzak Finance Corp., co-issued $115.0 million in principal amount of 9 7/8% Senior Subordinated Notes ("Senior Notes") which mature on March 15, 2009. Interest is payable semi-annually, in arrears, on March 15 and September 15 of each year. The Senior Notes are general unsecured obligations of the Company and Muzak Finance and are subordinated in right of payment to all existing and future Senior Indebtedness of the Company and Muzak Finance. The Senior Notes are guaranteed by the Parent, MLP Environmental Music, LLC, Business Sound, Inc., BI Acquisition LLC, Audio Environments, Inc., Background Music Broadcasters, Inc., and Muzak Capital Corporation. The indenture governing the Senior Notes prohibits the Company from making certain payments such as dividends and distributions of their capital stock; repurchases or redemptions of their capital stock, and investments (other than permitted investments) unless certain conditions are met by the Company. Before March 15, 2002, the issuers may redeem up to 35% of the aggregate principal amount of the Notes originally issued under the indenture at a redemption price of 109.875% of the aggregate principal amount so redeemed, plus accrued and unpaid interest to the redemption date, with the net proceeds of one or more equity offerings if certain conditions are met. After March 15, 2004, the issuers may redeem all or part of the Notes at a redemption price equal to 104.938% of the principal which redemption price declines to 100% of the principal amount in 2007. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. DEBT -- (CONTINUED) RELATED PARTY NOTES From July 1, 1999 through November 24, 1999, the Company borrowed an aggregate amount of $30.0 million, from MEM Holdings LLC in the form of Junior Subordinated Unsecured Notes (the "ABRY Notes"). MEM Holdings is a company that owns 68% of the voting interests in the Parent. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. The ABRY Notes mature on June 30, 2007, at which time principal and accrued interest are due. Interest accrues at 15% per annum; any accrued interest not paid as of March 31, June 30, September 30 or December 31 will bear interest at 15% per annum until such interest is paid or extinguished. The ABRY Notes are junior and subordinate to payments for the Senior Credit Facility, and the Senior Notes. At any time, all of the ABRY Notes, with the exception of the $3.0 million note may be converted into class A units of the Parent. If the ABRY Notes with the exception of the $3.0 million note, have not been repaid in full as of May, 2001, the ABRY Notes will automatically be converted into class A units of the Parent. Proceeds from the ABRY Notes were used to fund operations and acquisitions. In order to complete the acquisition of the Predecessor Company, the Company issued Notes payable to a related party for $40.8 million in 1998. The Company repaid $41.7 million outstanding under this note at the time of the merger and converted $0.7 million into Class A units the Parent. OTHER DEBT In connection with the purchase of ElectroSystems on February 24, 1999, the Company assumed several promissory notes, totaling $2.4 million as of the acquisition date. All of the notes, with the exception of one, bear interest at 9.887% and mature in November 2016. The Company is required to make interest only payments on a monthly basis through October 2006, and principal and interest payments for the remainder of the term. The Note terms are the same for all but one of the notes. This note bears interest at 8% with principal and interest payments due monthly until maturity in October 2006. See Note 14 for a description of additional debt incurred by the Company after December 31, 1999. ANNUAL MATURITIES Annual maturities of long-term debt obligations are as follows (in thousands): Total interest paid by the Company on all indebtedness was $14.1 million, $2.0 thousand, $2.9 million, and $2.2 million for the year ended December 31, 1999, the period from October 7, 1998 through December 31, 1998, for the period from January 1, 1998 through October 6, 1998 and the year ended December 31, 1997, respectively. INTEREST RATE PROTECTION PROGRAMS During April 1999, the Company entered into a four year interest rate swap agreement in which the Company effectively exchanged $100.0 million of floating rate debt at three month Libor for 5.59% fixed rate debt. This agreement is designated as a hedge of interest rates, and the differential to be paid or received on the swap is accrued as an adjustment to interest expense as interest rates change. The Company is exposed to credit loss in the event of nonperformance by the other party to the swap agreement. However, the Company does not anticipate nonperformance by the counterparty. The effect of this interest rate protection agreement on the operating results of the Company was to increase interest expense by $67 thousand in fiscal 1999. The Company terminated this agreement on January 28, 2000 and received approximately $4.4 million for this agreement. The proceeds will be recorded an as adjustment to interest expense. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. DEBT -- (CONTINUED) On January 28, 2000, the Company entered into a new interest rate swap agreement in which the Company effectively exchanged $100.0 million of floating rate debt at three month Libor for 7.042% fixed rate debt. The interest rate swap agreement terminates on April 19, 2002. Payments received, if any, as a result of this agreement are accrued as an adjustment to interest expense. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Company's debt as of December 31, 1999 and December 31, 1998 were $334.5 million and $42.7 million, respectively. The fair value of the Senior Notes is based upon quoted market price. The fair value of the other long-term debt of the Company approximates the carrying value. The fair value of the interest rate swap agreement was approximately $4.4 million as of December 31, 1999. The fair values of interest rate swaps are obtained from dealer quotes which represents the estimated amount the Company would receive or pay to terminate agreements taking into consideration current interest rates and creditworthiness of the counterparties. 7. LEASE COMMITMENTS The Company is the lessee under various long-term operating and capital leases for machinery, equipment, buildings, and vehicles for periods ranging from 2 years to 10 years. The Company has also entered into various agreements to lease transponders to transmit music programs via direct broadcast satellite. The majority of these leases contain renewal provisions. At December 31, 1999, future minimum lease payments under operating and capital leases as follows (in thousands): Rental expense under operating leases was $6.3 million, $94 thousand, $0.2 million, and $0.7 million for the year ended December 31, 1999, for the period from October 7, 1998 through December 31, 1998, for the period from January 1, 1998 through October 6, 1998, and for the year ended December 31, 1997, respectively. 8. EMPLOYEE BENEFIT PLANS During 1999, the Company maintained two defined contribution plans. Substantially all employees are covered under a plan whereby eligible employees may contribute up to 14% of their compensation per year, subject to certain tax law restrictions. The Company has the option to make a matching contribution up to a maximum of 100% of the first 3% and 50% of the next 3%, up to 6% of the total base salary contributed by the employee each year. Participants are immediately vested in their contributions as well as the employer's contributions. Certain other employees are covered under a plan whereby employees may contribute up to 15% of pre-tax pay and employer contributions are discretionary. Participants are immediately vested in their contributions and become fully vested in employer contributions after the third year of service with the Company. Plan expense was $0.8 million, $55 thousand, $23 thousand, and $32 thousand for the year ended December 31, 1999, for the period from October 7, 1998 to December 31, 1998, the period from January 1, 1998 to October 6, 1998 and the year ended December 31, 1997, respectively. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. INCOME TAXES The provision (benefit) for income taxes is as follows (in thousands): The Company's effective tax rate differs from the statutory federal tax rate for the following reasons: The components of the net deferred tax asset (liability) at December 31 are as follows (in thousands): 10. RELATED PARTY TRANSACTIONS During October 1998, the Company entered into a Management Agreement with ABRY Partners which provides that the Company will pay a management fee as defined in the Management Agreement. There were no fees incurred under the agreement during 1999 and for the period from October 7, 1998 to December 31, 1998. Either the Company or ABRY Partners, with the approval of the Board of Directors of the Parent, may terminate the Management Agreement by prior written notice to the other. During fiscal 1999, the Company borrowed $30.0 million from MEM Holdings under junior subordinated notes. See Note 7 for a description of this related party note. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. MUZAK FINANCE CORP. Muzak Finance Corp. had no operating activities during the twelve months ended December 31, 1999 12. COMMITMENTS AND CONTINGENCIES LITIGATION The Company is involved in various claims and lawsuits arising out of the normal conduct of its business. Although the ultimate outcome of these legal proceedings cannot be predicted with certainty, the management of the Company believes that the resulting liability, if any, will not have a material effect upon the Company's consolidated financial statements or liquidity. OTHER COMMITMENTS As of December 31, 1999, the Company's operations has approximately $5.2 million in outstanding capital expenditure commitments. The Company, as discussed in Note 7 above, is the lessee under various operating and capital leases for equipment, vehicles, satellite capacity, and buildings. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): (IN THOUSANDS) The quarterly data below is based on the Company's fiscal periods. In the first quarter of 1999, the Company misreported a $0.7 million extraordinary gain on the extinguishment of debt related to the conversion of certain related party debt and associated interest and goodwill by the same amount related to the Old Muzak acquisition. The effect of the adjustment was to eliminate the extraordinary gain and reduce goodwill by $.7 million for quarter ended March 31, 1999. The Company's operations are not subject to significant seasonal influences. 14. SUBSEQUENT EVENTS (UNAUDITED) In January 2000, the Company entered into an indenture for up to $50.0 million Senior Subordinated Floating Rate Notes (the "Floating Rate Notes"). The Floating Rate Notes are available to be drawn up to $50.0 million in increments of no less than $2.5 million to fund acquisitions. The Floating Rate Notes will be available for drawdowns until July 31, 2000. Commitments on all amounts undrawn under the Floating Rate Notes by July 31, 2000 will expire and will be ineligible for future draw downs. The Floating Rate Notes may be redeemed at 100% if redeemed before July 31, 2000 and at 101.50% if redeemed August 1, 2000 through October 31, 2000. If the Company does not redeem the Floating Rate Notes by November 1, 2000, the Floating Rate Notes will automatically convert into fixed-rate permanent notes due March 2009. As of March 29, 2000, $25.0 million of the Floating Rate Notes were outstanding. MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 14. SUBSEQUENT EVENTS (UNAUDITED) -- (CONTINUED) On February 2, 2000, the Company acquired certain of the net assets of Quincy Broadcasting Company, a Delaware corporation, for approximately $0.4 million. Quincy Broadcasting Company was the Company's independent franchisee located in Quincy, Illinois. On February 2, 2000, the Company acquired certain of the assets and assumed certain obligations of General Communications Corporation ("On Hold America"), an Indiana corporation, for approximately $0.9 million. On Hold America was an audio marketing business serving areas primarily in Indiana, Georgia, Florida, and Ohio. On February 2, 2000, the Company acquired certain of the assets and certain obligations of Texas Sound Co. Ltd for approximately $0.4 million. Texas Sound Co. Ltd was a provider of business music and audio marketing services. On February 24, 2000, the Company acquired Telephone Audio Productions, Inc., ("Sold on Hold Communications"), a Texas corporation, for approximately $3.7 million. Sold on Hold Communications was an audio marketing and messaging business serving various markets in the United States. On March 24, 2000, the Company acquired the stock of Vortex Sound Communications Company, Inc., ("Vortex") for approximately $8.4 million in cash consideration and 802 units of the Parent. Vortex, was the Company's independent franchisee located in Washington, DC. The following presents the unaudited pro forma results of the Company for the year ended December 31, 1999, as if the acquisitions and financings, including those discussed above in subsequent events, occurred on January 1, 1999. These unaudited pro forma results are not necessarily indicative of the results that will occur in future periods (in thousands). REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Muzak Holdings LLC: In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 25 related to Muzak Holdings LLC present fairly, in all material respects, the financial position of Muzak Holdings LLC and its subsidiaries (the "Company"), formally known as ACN Holdings, LLC, at December 31, 1999 and 1998, and the results of their operations and their cash flows for the year ended December 31, 1999 and for the period from October 7, 1998 to December 31, 1998, in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 14(a)(2) on page 25, present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers LLP Charlotte, North Carolina March 24, 2000 ITEM 1. FINANCIAL STATEMENTS MUZAK HOLDINGS LLC CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK HOLDINGS LLC CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS) The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK HOLDINGS LLC CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK HOLDINGS LLC CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND MEMBERS' INTEREST (IN THOUSANDS, EXCEPT FOR UNITS) PREDECESSOR COMPANY, INC: - -------------------------------------------------------------------------------- MUZAK HOLDINGS LLC: - -------------------------------------------------------------------------------- MUZAK HOLDINGS The Notes to Consolidated Financial Statements are an integral part of these consolidated financial statements. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION -- Muzak Holdings LLC ("the Company"), formerly known as ACN Holdings, LLC, was formed in September 1998 pursuant to the laws of Delaware. Muzak LLC, a wholly owned subsidiary of the Company, owns and operates franchises. Muzak LLC began its operations on October 7, 1998 with the acquisition of the independent franchisees in the Baltimore, Charlotte, Hillsborough, Kansas City, St. Louis, Jacksonville, Phoenix, and Fresno areas from Audio Communications Network, Inc. (the "Predecessor Company"). On March 18, 1999, Muzak Limited Partnership ("Old Muzak") merged with and into ACN. At the time of the merger, ACN changed its name to Muzak LLC. The Company is a wholly owned subsidiary of Muzak Holdings LLC (the "Parent"), previously known as ACN Holdings, LLC. As of December 31, 1999, ABRY Partners, LLC. and its respective affiliates collectively own approximately 68% of the beneficial interests in the Company's voting interests. All of the operating activities are conducted through the Company and its subsidiaries. The Company derives the majority of its revenues from the sale of business music products. The core porduct is AUDIO ARCHITECTURE and its two complementary products are AUDIO MARKETING and VIDEO IMAGING. These revenues are generated by clients, who pay monthly subscription fees under noncancelable five year contracts. The Company also derives revenues from the sale and lease of audio system-related products, principally sound systems and intercoms, to business music clients and other clients. In addition, the Company sells electronic equipment, such as proprietary tape playback equipment and other audio and video equipment to franchisees to support the sale of business music services. Installation, service and repair revenues consist principally of revenues from the installation of sound systems and other equipment that is not expressly part of a business music contract, such as paging, security and drive-through systems. These revenues also include revenue from the installation, service and repair of equipment installed under a business music contract. Music contract installation revenues are deferred and recognized over the term of the respective contracts. BASIS OF PRESENTATION -- The consolidated financial statements include the accounts of the Company and its subsidiaries; Muzak Capital Corporation, Muzak Finance Corporation, Business Sound Inc., Electro Systems Corporation, BI Acquisition LLC, MLP Environmental Music, LLC, Audio Environments, Inc, and Background Music Broadcasters, Inc. All significant intercompany items have been eliminated in consolidation. Certain prior year items have been reclassified to conform with the fiscal 1999 presentation. The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financials statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS -- Cash and cash equivalents include all cash balances and highly liquid investments with an original maturity of three months or less. INVENTORIES -- Inventories consist primarily of electronic equipment and are valued at the lower of cost or market, but not in excess of net realizable value. Cost is determined on the first-in, first-out basis. PROPERTY AND EQUIPMENT -- Property and equipment are stated at cost. Depreciation is computed on a straight-line basis over the estimated useful lives of the assets, ranging from 3 to 30 years. Sound and music equipment installed at customer premises under contracts to provide music programming services is transferred from inventory to property and equipment at cost plus an allocation of installation costs and is amortized over 5 years. Impairment losses are recognized if recorded values exceed undiscounted future cash flows, by reducing them to estimated fair value. No impairment losses were recognized by the Company or the Predecessor Company for the periods presented. INTANGIBLE ASSETS -- Goodwill, the excess of the purchase price over the fair value of net assets of businesses acquired, is amortized over twenty years using the straight-line method. Income producing contracts are amortized using the straight-line method over periods ranging from 8-14 years. Management evaluates the recoverability of intangibles by comparing MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) recorded values to the undiscounted future cash flows that can be generated by such assets. Impairment losses are recognized if recorded values exceed undiscounted future cash flows, by reducing them to estimated fair value. No impairment losses were recognized by the Company for the periods presented. INCOME TAXES -- The Company is a Limited Liability Company that is treated as a partnership for income tax purposes. No provision for income taxes is required by the Company as its income and expenses are taxable to or deductible by its members. The Company's corporate subsidiaries are subject to income taxes and account for deferred income taxes under the liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. REVENUE RECOGNITION -- Revenues from music services are recognized on a straight-line basis over the term of the customer contracts in the period services are provided. Revenues for equipment sales and related installation are recognized upon delivery or installation. Contracts are typically for a five-year non-cancelable period with renewal options for an additional five years. Fees received for services to franchisees are recognized as revenues in the month services are provided. SUBSCRIBER ACQUISITION COSTS -- Subscriber acquisition costs are direct sales commissions incurred in connection with acquiring new subscribers, which are amortized as a component of selling, general, and administrative expenses over the life of the customer contract or five years, whichever is shorter, on a straight-line basis. If a customer contract terminates early, the unamortized subscriber acquisition costs is typically recovered from the salesperson. Subscriber acquisition costs are included in deferred charges and other assets, net. ADVANCE BILLINGS -- The Company invoices certain customers in advance for contracted music and other business services. Amounts invoiced in advance of the service period are deferred when invoiced and recognized as revenue in the period earned. CONCENTRATION OF CREDIT RISK -- Concentrations of credit risk with respect to trade accounts receivable are limited as the Company sells its products to customers in diviersified industries thorughout the United States. The Company performs ongoing credit evaluations of its customers' financial condition and maintains allowances for potential credit losses. Actual losses have been within management's expectations and estimates. 2. ACQUISITIONS On October 7, 1998, the Company acquired certain assets and liabilities of ACN for $66.8 million. The acquisition was accounted for using the purchase method of accounting. Accordingly, the consideration paid was allocated based on the estimated fair market value of the net assets acquired. The excess of the consideration paid over the estimated fair market value of the net assets acquired approximated $17.0 million and is being using the straight amortized using the straight-line method over 20 years. In order to complete the acquisition of ACN, the Company received a $8.4 million capital contribution from the Parent, and issued notes payable to a related party and the Parent of $40.8 million (see Note 6) and $17.6 million, respectively. On December 4, 1998, the Parent converted the $17.6 million note payable along with additional noted issued during the period of October 7, 1998 through December 31, 1998 which approximated $1.0 million, plus accrued interest of $0.1 million, into membership interests. As discussed in Note 1, on March 18, 1999 Old Muzak merged with and into ACN. Under the terms of the agreement, the Company paid total consideration of $274.2 million, which is comprised of the following: $125.5 million cash consideration, $114.9 million consideration in the tender offer and consent solicitation for the 10% Senior Notes due 2003 of Old Muzak, $15.9 million for debt repayment of Old Muzak outstanding obligations and assumed $17.9 million of other obligations. In addition, at the time of the merger, the Company repaid $41.7 million borrowed from ABRY Broadcast Partners by ACN in October 1998 in connection with the acquisition of the Company's independent franchisees from the Predecessor Company and converted $0.7 million into voting units of the Parent. In 1999, the Company made the following acquisitions: MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2. ACQUISITIONS -- (CONTINUED) o On January 15, 1999, the Company acquired all of the outstanding stock of Business Sound, Inc. for approximately $4.1 million, which included 3,661 Class A units of the Parent. Business Sound was the Company's independent franchisee for the New Orleans, Louisiana and Mobile, Alabama areas. o On February 24, 1999, the Company acquired all of the outstanding stock of Electro Systems for approximately $0.7 million, which included 650 Class A units of the Parent, and assumed certain nonrecourse debt. Electro Systems was the Company's independent franchise located in Panama City, Florida. The Company made thirteen acquisitions between the merger on March 18, 1999 and December 31, 1999. The table below provides information regarding these acquisitions (in millions, except for number of Parent units). - --------- (1) Total purchase price included 13,535 Class A units of the Parent. (2) The Parent acquired Capstar Broadcasting Corporation's ("Capstar") independent franchisees located in Atlanta, Albany, and Macon, Georgia, Ft Myers, Florida and Omaha Nebraska. The total consideration was accounted for as an equity contribution to the Company and included 2,385 Class A units of the Parent. (3) Total purchase price included 100 Class A units of the Parent. (4) The Company paid $3.1 million of the purchase price of Mountain West Audio as of December 31, 1999. In February 2000, the Company paid the remaining purchase price, which included 456 Class A units of the Parent. (5) The purchase price does not include transaction costs. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2. ACQUISITIONS -- (CONTINUED) The results of operations of the acquired companies are included in the Company's consolidated statement of operations for the periods in which they were owned by the Company. The acquisitions were accounted for under the purchase method of accounting. Accordingly, the consideration was allocated to the net assets acquired based on the fair market values at the date of acquisition as determined through the use of an independent appraisal. The excess of purchase price for each acquisition over the estimated fair value of the tangible and identifiable intangible assets acquired approximated $127.9 million and is being amortized over a period of twenty years on a straight-line basis. The following presents the unaudited pro forma results assuming that the acquisitions discussed above and financings (see Note 6) had occurred as of the beginning of fiscal 1999 and 1998. These pro forma results are not necessarily indicative of the results that will occur in future periods (in thousands). 3. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands): Depreciation of property and equipment was $17.6 million, $0.8 million, $1.9 million, and $1.4 million for year ended December 31, 1999, the period from October 7, 1998 to December 31, 1998, for the period from January 1, 1998 to October 6, 1998, and for the year ended December 31, 1997, respectively. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 4. INTANGIBLE ASSETS Intangible assets consist of the following (in thousands): Amortization of intangible assets was $18.8 million, $0.8 million, $2.5 million, and $2.6 million for the year ended December 31, 1999, the period from October 7, 1998 to December 31, 1998, for the period from January 1, 1998 to October 6, 1998, and for the year ended December 31, 1997, respectively. 5. ACCRUED EXPENSES Accrued expenses are summarized below (in thousands): - --------- Additional purchase price for Mountain West Audio, Inc. was paid in February 2000. 6. DEBT Debt obligations consist of the following (in thousands): MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. DEBT -- (CONTINUED) SENIOR CREDIT FACILITY In March 1999, the Company entered into a new senior credit facility ("Senior Credit Facility") consisting of: (i) a term loan facility in the amount of $30.0 million payable in semi-annual installments until final maturity on December 31, 2005 ("Term Loan A") ; (ii) a term loan facility in the amount of $105.0 million payable in semi-annual installments until final maturity on December 31, 2006 ("Term Loan B")(together with Term Loan A , the "Term Loans"); and (iii) a revolving loan (the "Revolving Loan") in an aggregate principal amount of up to $35.0 million terminating on December 31, 2005. In July 1999, the Company amended the Senior Credit Facility which increased the principal amount of the Term Loan B by $30.0 million to $135.0 million. In October 1999, the Company amended the Senior Credit Facility to enable a related party to make a subordinated loan to the Company in the aggregate principal amount of $20.0 million and to permit the Company to issue additional senior subordinated notes and the Parent to issue preferred stock if certain covenants are met by the Company. The Senior Credit Facility, which is guaranteed by the Parent, the Company, and certain of its domestic subsidiaries contains restrictive covenants including maintenance of interest and leverage ratios and various other restrictive covenants which are customary for such facilities. In addition, the Company is generally prohibited from incurring additional indebtedness, incurring liens, paying dividends or making other restricted payments, consummating asset sales, entering into transactions with affiliates, merging or consolidating with any other person or selling assigning, transferring, leasing, conveying, or otherwise disposing of assets. These conditions were satisfied as of December 31, 1999. Indebtedness under the Term Loan A and the Revolving Loans bear interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (which is the highest of prime rate and the Federal Funds Rate plus .5%) plus a margin ranging from 1.00% to 2.00% or (ii) the offered rates for Eurodollar deposits ("LIBOR") of one, two, three, or six months, as selected by the Company, plus a margin ranging from 2.0%to 3.0%. Margins, which are subject to adjustment based on the changes in the Company's ratio of consolidated total debt to EBITDA (i.e., earnings before interest, taxes, interest, depreciation, amortization and other non cash charges) were 2.0% in the case of Alternate Base Rate and 3.0% in the case of LIBOR as of December 31, 1999. Indebtedness under the Term Loan B bears interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (as described above) plus a margin of 2.5% or (ii) LIBOR of one, two, three, or six months, as selected by the Company plus a margin of 3.5%. The weighted average rate of interest on the Senior Credit Facility at December 31, 1999 was 9.01%. SENIOR NOTES On March 18, 1999, the Company together with its wholly owned subsidiary, Muzak Finance Corp., co-issued $115.0 million in principal amount of 9 7/8% Senior Subordinated Notes ("Senior Notes") which mature on March 15, 2009. Interest is payable semi-annually, in arrears, on March 15 and September 15 of each year. The Senior Notes are general unsecured obligations of the Company and Muzak Finance and are subordinated in right of payment to all existing and future Senior Indebtedness of the Company and Muzak Finance. The Senior Notes are guaranteed by the Parent, MLP Environmental Music, LLC, Business Sound, Inc., BI Acquisition LLC, Audio Environments, Inc., Background Music Broadcasters, Inc., and Muzak Capital Corporation. The indenture governing the Senior Notes prohibits the Company from making certain payments such as dividends and distributions of their capital stock; repurchases or redemptions of their capital stock, and investments (other than permitted investments) unless certain conditions are met by the Company. Before March 15, 2002, the issuers may redeem up to 35% of the aggregate principal amount of the Notes originally issued under the indenture at a redemption price of 109.875% of the aggregate principal amount so redeemed, plus accrued and unpaid interest to the redemption date, with the net proceeds of one or more equity offerings if certain conditions are met. After March 15, 2004, the issuers may redeem all or part of the Notes at a redemption price equal to 104.938% of the principal which redemption price declines to 100% of the principal amount in 2007. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. DEBT -- (CONTINUED) RELATED PARTY NOTES From July 1, 1999 through November 24, 1999, the Company borrowed an aggregate amount of $30.0 million, from MEM Holdings LLC in the form of Junior Subordinated Unsecured Notes (the "ABRY Notes"). MEM Holdings is a company that owns 68% of the voting interests in the Parent. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. The ABRY Notes mature on June 30, 2007, at which time principal and accrued interest are due. Interest accrues at 15% per annum; any accrued interest not paid as of March 31, June 30, September 30 or December 31 will bear interest at 15% per annum until such interest is paid or extinguished. The ABRY Notes are junior and subordinate to payments for the Senior Credit Facility, and the Senior Notes. At any time, all of the ABRY Notes, with the exception of the $3.0 million note may be converted into class A units of the Parent. If the ABRY Notes with the exception of the $3.0 million note, have not been repaid in full as of May, 2001, the ABRY Notes will automatically be converted into class A units of the Parent. Proceeds from the ABRY Notes were used to fund operations and acquisitions. In order to complete the acquisition of the Predecessor Company, the Company issued Notes payable to a related party for $40.8 million in 1998. The Company repaid $41.7 million outstanding under this note at the time of the merger and converted $0.7 million into Class A units the Parent. OTHER DEBT In connection with the purchase of ElectroSystems on February 24, 1999, the Company assumed several promissory notes, totaling $2.4 million as of the acquisition date. All of the notes, with the exception of one, bear interest at 9.887% and mature in November 2016. The Company is required to make interest only payments on a monthly basis through October 2006, and principal and interest payments for the remainder of the term. The Note terms are the same for all but one of the notes. This note bears interest at 8% with principal and interest payments due monthly until maturity in October 2006. See Note 15 for a description of additional debt incurred by the Company after December 31, 1999. ANNUAL MATURITIES Annual maturities of long-term debt obligations are as follows (in thousands): Total interest paid by the Company on all indebtedness was $14.1 million, $2.0 thousand, $2.9 million, and $2.2 million for the year ended December 31, 1999, the period from October 7, 1998 through December 31, 1998, for the period from January 1, 1998 through October 6, 1998 and the year ended December 31, 1997, respectively. INTEREST RATE PROTECTION PROGRAMS During April 1999, the Company entered into a four year interest rate swap agreement in which the Company effectively exchanged $100.0 million of floating rate debt at three month Libor for 5.59% fixed rate debt. This agreement is designated as a hedge of interest rates, and the differential to be paid or received on the swap is accrued as an adjustment to interest expense as interest rates change. The Company is exposed to credit loss in the event of nonperformance by the other party to the swap agreement. However, the Company does not anticipate nonperformance by the counterparty. The effect of this interest rate protection agreement on the operating results of the Company was to increase interest expense by $67 thousand in fiscal 1999. The Company terminated this agreement on January 28, 2000 and received approximately $4.4 million for this agreement. The proceeds will be recorded an as adjustment to interest expense. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. DEBT -- (CONTINUED) On January 28, 2000, the Company entered into a new interest rate swap agreement in which the Company effectively exchanged $100.0 million of floating rate debt at three month Libor for 7.042% fixed rate debt. The interest rate swap agreement terminates on April 19, 2002. Payments received, if any, as a result of this agreement are accrued as an adjustment to interest expense. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Company's debt as of December 31, 1999 and December 31, 1998 were $334.5 million and $42.7 million, respectively. The fair value of the Senior Notes is based upon quoted market price. The fair value of the other long-term debt of the Company approximates the carrying value. The fair value of the interest rate swap agreement was approximately $4.4 million as of December 31, 1999. The fair values of interest rate swaps are obtained from dealer quotes which represents the estimated amount the Company would receive or pay to terminate agreements taking into consideration current interest rates and creditworthiness of the counterparties. 7. LEASE COMMITMENTS The Company is the lessee under various long-term operating and capital leases for machinery, equipment, buildings, and vehicles for periods ranging from 2 years to 10 years. The Company has also entered into various agreements to lease transponders to transmit music programs via direct broadcast satellite. The majority of these leases contain renewal provisions. At December 31, 1999, future minimum lease payments under operating and capital leases as follows (in thousands): Rental expense under operating leases was $6.3 million, $94 thousand, $0.2 million, and $0.7 million for the year ended December 31, 1999, for the period from October 7, 1998 through December 31, 1998, for the period from January 1, 1998 through October 6, 1998, and for the year ended December 31, 1997, respectively. 8. EMPLOYEE BENEFIT PLANS During 1999, the Company maintained two defined contribution plans. Substantially all employees are covered under a plan whereby eligible employees may contribute up to 14% of their compensation per year, subject to certain tax law restrictions. The Company has the option to make a matching contribution up to a maximum of 100% of the first 3% and 50% of the next 3%, up to 6% of the total base salary contributed by the employee each year. Participants are immediately vested in their contributions as well as the employer's contributions. Certain other employees are covered under a plan whereby employees may contribute up to 15% of pre-tax pay and employer contributions are discretionary. Participants are immediately vested in their contributions and become fully vested in employer contributions after the third year of service with the Company. Plan expense was $0.8 million, $55 thousand, $23 thousand, and $32 thousand for the year ended December 31, 1999, for the period from October 7, 1998 to December 31, 1998, the period from January 1, 1998 to October 6, 1998 and the year ended December 31, 1997, respectively. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. MEMBER'S INTEREST The Company has authorized two classes of equity units: class A units ("Class A Units") and class B units ("Class B Units")(collectively, the "Units"). Each class of units represents a fractional part of the membership interests of the Company. VOTING UNITS Each class A unit is entitled to voting rights equal to the percentage such unit represents of the aggregate number of outstanding class A units. Each class A unit accrues a preferred return (the "ACN Holdings Preferred Return") annually on the original issue price ("the "Capital Value") of each voting unit at a rate of 15% per annum. The Company can not pay distributions, other than tax distributions, in respect of other classes of securities, including distributions made in connection with a liquidation, until the Capital Value and accrued ACN Holdings Preferred Return in respect of each voting unit is paid to each holder (such distributions being the "Priority Distributions"). In addition to these Priority Distributions, each holder of these voting units is also entitled to participate in distributions payable to the residual common equity interests of the Company (the "Last Priority Distributions"). NON VOTING UNITS The class B units are non-voting equity interests in the Company which are divided into four subclasses, Class B-1 units, Class B-2 units, Class B-3 units, and Class B-4 units. Each holder of class B units is entitled to participate in Last Priority Distributions, if any, provided that Priority Distributions on all voting interests have been paid in full. The Company is authorized to issue class B-5 units, however no B-5 units are outstanding as of December 31, 1999. The class B-1 units, B-2 units, and B-3 units have a vesting period of five years, and the class B-4 units vest immediately upon issuance. Upon a change in control, as defined, all of these units become fully vested and exercisable. As of December 31, 1999 and 1998, the Company had 2,410 and 804 B-1 units outstanding, respectively. As of December 31, 1999 and 1998, the Company had 2,429 and 806 B-2 units outstanding, respectively. As of December 31, 1999 and 1998, the Company had 2,441 and 804 B-3 units outstanding, respectively. As of December 31, 1999, the Company had 3,002 B-4 units outstanding, with a value of $2.8 million. There were no B-4 units outstanding as of December 31, 1998. 10. INCOME TAXES The provision (benefit) for income taxes is as follows (in thousands): MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10. INCOME TAXES -- (CONTINUED) The Company's effective tax rate differs from the statutory federal tax rate for the following reasons: The components of the net deferred tax asset (liability) at December 31 are as follows (in thousands): 11. RELATED PARTY TRANSACTIONS During October 1998, the Company entered into a Management Agreement with ABRY Partners which provides that the Company will pay a management fee as defined in the Management Agreement. There were no fees incurred under the agreement during 1999 and for the period from October 7, 1998 to December 31, 1998. Either the Company or ABRY Partners, with the approval of the Board of Directors of the Parent, may terminate the Management Agreement by prior written notice to the other. During fiscal 1999, the Company borrowed $30.0 million from MEM Holdings under junior subordinated notes. See Note 7 for a description of this related party note. 12. MUZAK FINANCE CORP. Muzak Finance Corp. had no operating activities during the twelve months ended December 31, 1999 13. COMMITMENTS AND CONTINGENCIES LITIGATION The Company is involved in a rate court proceeding, initiated by Broadcast Music, Inc. ("BMI"), in Federal Court in New York. At issue are the music license fees payable by the Company and its owned and operated as well as licensed independent franchisees, to a music performing licensing organization, BMI, in respect of their commercial music services. The period from which such "reasonable" license fees are payable covers the period January 1, 1994 to December 31, 1999, and likely several years thereafter. The Company has been paying license fees to date at interim levels reflecting the final rates in place under the last negotiated license, which expired at the end of 1993. BMI contends that those fee levels understate reasonable fee levels by as much as 100%. The Company vigorously contests BMI's assessment. The eventual court ruling setting final fees for the period covered will require retroactive adjustment, upward or downward, likely back to January 1 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 13. COMMITMENTS AND CONTINGENCIES -- (CONTINUED) 1994, and possibly will also entail payment of pre-judgment interest. Discovery in the proceeding has commenced and is not yet completed. A trial date has not been set. In addition to the BMI proceeding discussed above, the Company is involved in various claims and lawsuits arising out of the normal conduct of its business. Although the ultimate outcome of these legal proceedings cannot be predicted with certainty, the management of the Company believes that the resulting liability, if any, will not have a material effect upon the Company's consolidated financial statements or liquidity. OTHER CONTINGENCIES The Company transmits its offerings through various mediums including direct broadcast satellite transmission, local broadcast transmission, audio and videotapes and compact discs. The Company's transmissions via direct broadcast satellite to customers are primarily from transponders leased from Microspace and EchoStar Satellite Corporation ("EchoStar"). The Company also furnishes music channels to commercial and residential subscribers over EchoStar's satellite system. The Company furnishes 60 music channels to commercial subscribers and 30 music channels to residential subscribers over EchoStar's satellite system. Pursuant to the agreements with EchoStar, EchoStar pays the Company a programming fee for each of its residential subscribers and pays the Company's independent franchisees a commission for sales made by EchoStar or its agents to commercial subscribers in an affiliate's territory. The Company pays EchoStar a fee for uplink transmission of music channels to its customers and rents space at EchoStar's Cheyenne, Wyoming uplink facility. The Company also pays EchoStar a royalty and combined access fees on music programs sold which are distributed by EchoStar to commercial subscribers. EchoStar has the right to cancel its distribution of the 30 music programs to residential subscribers at any time upon 60 days notice. Upon such cancellation, EchoStar must pay the Company the depreciated book value of its capital investment in equipment to support the residential music channels and continue to provide 2.4 megahertz of transponder capacity for our use in serving commercial subscribers. In such event, the Company would only be able to provide 30 music programs and would need to lease other transponder space in order to continue providing the other 30 music programs. The Company would also lose the programming fee generated by EchoStar's residential subscribers. During the first quarter of 2000, EchoStar approached the Company and expressed a desire to reassess the business terms that pertain to EchoStar's distribution of the residential music channels. The Company and EchoStar are in the process of re-evaluating their relationship and negotiating an understanding in which the programming fees earned by the Company and paid by EchoStar in connection with the residential music channels may be eliminated in consideration for a long-term supply agreement with respect to satellite services. The Company expects to conclude negotiations prior to the third quarter of 2000. OTHER COMMITMENTS As of December 31, 1999, the Company's operations has approximately $5.2 million in outstanding capital expenditure commitments. The Company, as discussed in Note 7 above, is the lessee under various operating and capital leases for equipment, vehicles, satellite capacity, and buildings. 14. QUARTERLY FINANCIAL DATA (UNAUDITED): (IN THOUSANDS) The quarterly data below is based on the Company's fiscal periods. MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 14. QUARTERLY FINANCIAL DATA (UNAUDITED): (IN THOUSANDS) -- (CONTINUED) In the first quarter of 1999, the Company misreported a $0.7 million extraordinary gain on the extinguishment of debt related to the conversion of certain related party debt and associated interest and goodwill by the same amount related to the Old Muzak acquisition. The effect of the adjustment was to eliminate the extraordinary gain and reduce goodwill by $.7 million. The Company's operations are not subject to significant seasonal influences. 15. SUBSEQUENT EVENTS (UNAUDITED) In January 2000, the Company entered into an indenture for up to $50.0 million Senior Subordinated Floating Rate Notes (the "Floating Rate Notes"). The Floating Rate Notes are available to be drawn up to $50.0 million in increments of no less than $2.5 million to fund acquisitions. The Floating Rate Notes will be available for drawdowns until July 31, 2000. Commitments on all amounts undrawn under the Floating Rate Notes by July 31, 2000 will expire and will be ineligible for future draw downs. The Floating Rate Notes may be redeemed at 100% if redeemed before July 31, 2000 and at 101.50% if redeemed August 1, 2000 through October 31, 2000. If the Company does not redeem the Floating Rate Notes by November 1, 2000, the Floating Rate Notes will automatically convert into fixed-rate permanent notes due March 2009. As of March 29, 2000, $25.0 million of the Floating Rate Notes were outstanding. On February 2, 2000, the Company acquired certain of the net assets of Quincy Broadcasting Company, a Delaware corporation, for approximately $0.4 million. Quincy Broadcasting Company was the Company's independent franchisee located in Quincy, Illinois. On February 2, 2000, the Company acquired certain of the assets and assumed certain obligations of General Communications Corporation ("On Hold America"), an Indiana corporation, for approximately $0.9 million. On Hold America was an audio marketing business serving areas primarily in Indiana, Georgia, Florida, and Ohio. On February 2, 2000, the Company acquired certain of the assets and certain obligations of Texas Sound Co. Ltd for approximately $0.4 million. Texas Sound Co. Ltd was a provider of business music and audio marketing services. On February 24, 2000, the Company acquired Telephone Audio Productions, Inc., ("Sold on Hold Communications"), a Texas corporation, for approximately $3.7 million. Sold on Hold Communications was an audio marketing and messaging business serving various markets in the United States. On March 24, 2000, the Company acquired the stock of Vortex Sound Communications Company, Inc., ("Vortex") for approximately $8.4 million in cash consideration and 802 units of the Parent. Vortex, was the Company's independent franchisee located in Washington, DC. The following presents the unaudited pro forma results of the Company for the year ended December 31, 1999, as if the acquisitions and financings, including those discussed above in subsequent events, occurred on January 1, 1999. These unaudited pro forma results are not necessarily indicative of the results that will occur in future periods (in thousands).

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Item 1. Business Introduction NEXTLINK Communications, Inc., NEXTLINK or the Company, is a Delaware corporation, which, through its predecessor entities, was formed on September 16, 1994. The Company was originally organized as NEXTLINK Communications, L.L.C., a Washington limited liability company. On January 31, 1997, NEXTLINK Communications, L.L.C. merged into NEXTLINK Communications, Inc., a Washington corporation, which on June 4, 1998 reincorporated in Delaware under the same name. NEXTLINK’s principal executive and administrative offices currently are located at 1505 Farm Credit Drive, McLean, Virginia 22102, and its telephone number is (703) 547-2000. Overview Since 1996, NEXTLINK has provided high-quality telecommunications services to the rapidly growing business market. We believe that increasing usage of both telephone service and newer data and information services will continue to increase demand for telecommunications capacity, or bandwidth, and for new telecommunications services and applications. To serve our customers’ broad and expanding telecommunications needs, we have assembled a unique collection of high-bandwidth, local and national network assets. We intend to integrate these assets with advanced communications technologies and services in order to become one of the nation’s leading providers of a comprehensive array of communications services. To accomplish this: • we have built 31 high-bandwidth, or broadband, local networks in 19 states, generally located in the central business districts of the cities we serve, and we are continuing to build additional networks; • we have become the nation’s largest holder of broadband fixed wireless spectrum, with Federal Communications Commission, or FCC, licenses covering 95% of the population of the 30 largest U.S. cities, which we will use to extend the reach of our networks to additional customers; and • we have acquired, through a joint venture known as INTERNEXT, rights to use unlit fiber optic strands, known as dark fiber, and an empty conduit in a national broadband network now being built to traverse over 16,000 miles and to connect more than 50 cities in the United States and Canada, including most of the major metropolitan markets that our current and planned local networks serve. By acquiring “dark” fiber rather than leasing “lit” fiber capacity, we have retained control over decisions on where and how to deploy existing or new generations of optical transmission equipment to enhance our network’s capacity and performance. We currently offer our customers a variety of voice services and high-speed Internet access. As our networks become increasingly optimized for data transmission and through our pending acquisition of Concentric Network Corporation, we plan to expand our Internet access business and offer additional data services, such as Internet web hosting, support for e-commerce, virtual private network services and other customized data communications services. By web hosting, we mean support for customers’ web sites at our central offices, running either on their computers or on ours. In addition, through our NEXTLINK Interactive subsidiary, we currently provide a number of voice response, speech recognition and e-commerce services. We plan to build on our existing expertise in customized information and automated order fulfillment to serve clients with e-commerce businesses, that is, businesses conducting high volume retail transactions over the Internet. We are now operating 31 broadband local networks in 49 cities. We are currently building additional networks, and plan to have operational networks in most of the 30 largest U.S. cities by the end of 2000. We have been successful in attracting customers in the markets that we serve. We provided nearly 428,000 business telephone lines to our customers as of December 31, 1999, of which more than 78,000 were installed in the fourth quarter of 1999. Our local and national networks employ fiber optic technology, which uses light waves to transmit signals over cables consisting of many glass fiber strands. Fiber optic strands have enough capacity to carry tens of thousands times more traffic than traditionally-configured copper wire. Rings of our fiber optic cables typically encircle a city’s central business district and connect to our central offices. These central offices contain the switches and routers that direct calls and data traffic to their destinations, and have space to house the additional equipment necessary for future telecommunications services. Wherever we can, we build and own these local networks ourselves. We believe that owning our own network assets will enable us to deliver higher quality and new services at a lower cost, which we expect will increase our operating margins. Our goal is to provide our customers with complete voice and data network solutions for all of their communications needs, using our own fiber, switches and other facilities to the greatest extent possible. Today, however, we frequently lease the existing copper telephone wires from the dominant local telephone company to make the physical connection for the short distance between our customers and our fiber optic networks. Congress and our industry refer to this dominant local carrier as the incumbent local exchange carrier, or the incumbent carrier. To reduce our reliance on connections leased from the incumbent carrier, we intend to increase the number of customers connected directly to our networks. In some cases, we will construct a new fiber optic extension from our network to the customer’s premises. In other cases, using our fixed wireless spectrum, we will deploy a high-bandwidth wireless connection between an antenna on the roof of the customer’s premises and an antenna attached to our fiber rings. These wireless connections offer high-quality broadband capacity and, in many cases, cost less than fiber to install. We expect to deploy wireless direct connections to our networks in 25 markets by the end of 2000. We are also deploying a technology called Digital Subscriber Line, or DSL, to meet the high bandwidth needs of those customers whose connection to our network remains over copper wire. DSL technology increases the effective capacity of existing copper telephone wires. We are installing our own DSL equipment to provide these services ourselves, and we also resell another provider’s DSL services. Our networks support a variety of communications technologies. This permits us to offer customers a set of technology options to meet their changing needs, and introduce new technologies as they become available. For example, we have begun to install Internet Protocol, or IP, routers, which will enable us to carry Internet traffic more efficiently and to provide more data services. We also have been installing Asynchronous Transfer Mode, or ATM, routers and switches in our local networks, which will enable us to meet the demands of large, high-volume customers. We anticipate that future IP technologies will enable the high-bandwidth, end-to-end national network we are building to carry data, voice and video. Such a network should also enable us to offer our customers entirely new classes of IP services. To serve our customers’ present needs and to take advantage of the future opportunities that technological advances may bring, we intend to remain flexible in our technology choices. Business Strategy Our goal is to provide integrated, end-to-end solutions for all of our customers’ communications needs over our own network. We plan to deliver these solutions primarily through equipment and networks we own or control and, therefore, continue to be a facilities-based carrier. The key components of our strategy to achieve this goal are to: • Build Broadband Local Networks. We build high-bandwidth local networks using fiber optic cable bundles, which are capable of carrying high volumes of data, voice, video and Internet traffic as well as other high-bandwidth services. In our newer markets, we install as many as 400 fiber strands in each network, with built-in capacity for future growth. We plan to have completed broadband local networks in most of the nation’s 30 largest cities by the end of 2000. • Increase Direct Customer Connections. We generally build our networks in the central business districts of our markets to permit direct connections to a high percentage of the area’s commercial buildings at a lower capital cost. For buildings where direct fiber connections to our networks are not economic, we will use our fixed wireless spectrum to make broadband direct connections where appropriate. • Create an Integrated, End-To-End, Facilities-Based National Network. We will use our interest in a 16,000 mile, national fiber optic network to offer end-to-end communications services over our own facilities, rather than lines leased from others. By owning these high-speed facilities rather than leasing “lit” fiber capacity, we will be able to upgrade our system as new generations of optical transmission equipment become available. This will allow us to maximize the capacity and enhance the performance of our network as needed to meet our customers’ current and future broadband data and other communication needs, rather than relying on the owner of leased lines to make those upgrades. • Deploy New Technology Optimized for IP. We are installing high-capacity IP routers and switches, wavelength division multiplexing technology, and the latest fiber optic technology in our network to further increase its capacity to meet our customers’ growing data needs. We believe that future IP technologies will enable our network to carry all types of communications traffic, including data, voice and video services. • Introduce New Internet Services. In addition to our current offering of high-speed Internet access, we plan to offer customers secure, robust web hosting services at our central offices, and provide extensive back-office support for their e-commerce operations. We expect to substantially accelerate the deployment of data services as a result of our pending acquisition of Concentric. • Build on Our Customer Base, Staff and Systems to Succeed in the Data Services Market. We will combine the strategies and skills we have developed competing successfully in the local exchange market with the proven skills of Concentric to compete in the expanding data services market. These include a focus on the business customer, close attention to customer care, and effective, reliable back-office systems. • Expand Our Targeted Customer Base. Historically, our targeted customer base has consisted primarily of small and medium-sized businesses. As our capabilities expand through the completion of INTERNEXT’s national fiber optic network, the addition of data service capabilities, including enhancements of those capabilities resulting from the Concentric acquisition, and the addition of ATM and IP technology to our networks, we plan to expand our targeted customers to include larger national customers that can benefit from our unique “end-to-end” broadband capabilities. • Attract Experienced Management at All Key Levels. We have attracted a highly qualified senior management team at our headquarters and throughout our field operations. Experienced telecommunications and technology industry executives will lead the implementation of our integrated telecommunications strategy. We expect to benefit from the skills and experience of the seasoned executive, technical and marketing personnel who will be joining us when the Concentric acquisition is completed. 1999 Transactions and Developments Local Fiber Optic Network Development. We launched service in 10 major metropolitan markets in 1999, each of which includes one or more fiber optic rings each consisting of up to 432 fiber optic strands. These market launches included San Diego, Seattle and Washington, D.C. during the first half of 1999, Newark, Detroit and Houston during the third quarter of 1999, and Phoenix, Boston, St. Louis and Sacramento in the fourth quarter of 1999. In September 1999, we also connected two additional markets to our South Bay fiber ring in the San Francisco area by launching service in Mountain View and Santa Clara, California. Acquisition of Fixed Wireless Spectrum. In 1999, we acquired licenses for broadband fixed wireless spectrum for local multi-point distribution services, or LMDS, in order to expand on our ability to directly connect customers to our network. We are now the largest owner of LMDS spectrum in the United States holding 82 licenses covering approximately 95 percent of the top 30 United States markets, and have entered into agreements to acquire additional licenses. These pending and completed transactions include the following: • WNP Communications. In April 1999, we acquired WNP Communications, Inc., which owned licenses for 1,150 MHz of LMDS spectrum, or A block LMDS licenses, in 39 cities and one license for 150 MHz of LMDS spectrum, or B block LMDS license, in one city. The purchase price was $698.2 million, of which $157.7 million was paid in cash to the FCC for license fees, including interest. The remainder was paid to stockholders of WNP, and consisted of $190.1 million in cash and 11,431,662 shares of NEXTLINK Class A common stock. • NEXTBAND. In June 1999, we acquired from Nextel Communications Inc. its 50% interest in NEXTBAND, a joint venture formed in January 1998 by us and Nextel. As a result, we now own all of NEXTBAND, which holds A and B block LMDS licenses in 42 markets throughout the United States. The purchase price for Nextel’s interest was $137.7 million in cash, and was determined based on a formula derived from the purchase price paid in the WNP acquisition. • SPEEDUS.com. In July 1999, we purchased a license for 150 MHz of LMDS spectrum held by SPEEDUS.com, Inc. in the five boroughs that comprise New York City and 2,000,000 shares of SPEEDUS.com common stock for a total of $40.0 million. SPEEDUS.com is a facilities based high-speed Internet service provider. • HighSpeed. In November 1999, we announced a strategic partnership with HighSpeed.Com, L.L.C. in which we will acquire a 15% equity interest in HighSpeed and a license for 300 MHz of LMDS spectrum in Denver, Colorado. In addition to the Denver LMDS license, HighSpeed holds LMDS licenses covering areas where approximately 12 million people live or work in seven western states. We have agreed to pay $18.7 million to HighSpeed.Com in exchange for the 15% interest and the LMDS spectrum. We expect this transaction to close in the second quarter of 2000. Field Testing of Fixed Wireless Technology. In September 1999, we began field testing LMDS technology with several customers in the Los Angeles and Dallas areas. For the year prior to that, we had been testing broadband wireless equipment in our Plano, Texas research lab. Field testing gives us the opportunity to test wireless point-to-multipoint and point-to-point equipment from several vendors in several operating environments. In our field tests, we used a point-to-multi-point wireless hub site to connect customers directly to our Los Angeles-area and Dallas fiber networks. Although point-to-point equipment has performed to our standards, we believe that improvements in the price, features, and functionality of the point-to-multi-point equipment must be made before we undertake a broader commercial launch of services using this technology. Our vendors have advised us that these improvements will be incorporated in their second generation equipment, which is expected to be available later this year. In January 2000, we completed our field tests and made commercial broadband wireless services available using the point-to-point equipment to a limited group of customers in Los Angeles and Dallas. We have announced commencement of lab testing of the second generation point-to-multi-point equipment that we plan to deploy throughout our networks this year. We plan to deploy service using fixed wireless technology in 25 markets by the end of 2000 as an alternative to fiber to connect customers directly to our fiber optic networks. Construction of National Network. In December 1999, the first segment of the intercity national fiber optic network being constructed for INTERNEXT was completed. This segment consisted of most of the network connecting Dallas, Houston, Austin and San Antonio, Texas, the remainder of which is now substantially complete. We expect the construction of the remainder of the fiber backbone in the network to be substantially completed in segments during 2000 and 2001. In January 2000, we entered into an agreement with Eagle River Investments, LLC to acquire the 50% interest in INTERNEXT that we do not currently own, which we expect to close in the second quarter of 2000. Equity and Debt Financings. In 1999, we completed public offerings of our Class A common stock, 10 3/4% Senior Notes due 2009 and 12 1/4% Senior Discount Notes due 2009, and private offerings of 10 1/2% Senior Notes due 2009 and 12 1/8% Senior Discount Notes due 2009, with aggregate net proceeds of approximately $1,940.7 million dollars. • Common Stock Offering. On June 1, 1999, we completed the sale of 15,200,000 shares of Class A common stock at $38.00 per share. Of the total shares sold, NEXTLINK offered 8,464,100 shares and certain stockholders who previously owned interests in WNP offered 6,735,900 shares. Gross proceeds from the shares offered by NEXTLINK totaled $321.6 million, which yielded proceeds net of underwriting discounts, advisory fees and estimated expenses of approximately $310.5 million. • Offering of 10 3/4% Senior Notes due 2009 and 12 1/4% Senior Discount Notes due 2009. Concurrent with our June 1, 1999 common stock offering, we completed the sale of $675.0 million of 10 3/4% Senior Notes due 2009 and $588.9 million in principal amount at maturity of 12 1/4% Senior Discount Notes due 2009. From these sales, we received net proceeds of approximately $979.5 million. • Private Offerings of 10 1/2% Senior Notes due 2009 and 12 1/8% Senior Discount Notes due 2009. On November 17, 1999, we completed the sale of $400.0 million of 10 1/2% Senior Notes due 2009 and $455.0 million in principal amount at maturity of 12 1/8% Senior Discount Notes due 2009. From these sales, we received net proceeds of approximately $639.6 million. In accordance with the terms under which the notes were issued, we are in the process of registering an exchange offer with the Securities and Exchange Commission, in which we will offer holders of these notes the opportunity to exchange the unregistered notes originally issued for registered notes with identical terms and conditions. Investment by Forstmann Little & Co. In December 1999, several Forstmann Little & Co. investment funds agreed to invest $850.0 million in NEXTLINK in exchange for newly-created convertible preferred stock of NEXTLINK, to be used to expand our networks and services, introduce new technologies and fund our business plan. The investment closed in January 2000. Pursuant to the terms of the preferred stock, Nicholas C. Forstmann and Sandra J. Horbach, both general partners at Forstmann Little, joined NEXTLINK’s Board of Directors in January 2000. Acquisition of Canadian Fixed Wireless Spectrum. In December 1999, our NEXTLINK International subsidiary joined a venture, Wispra Networks, Inc., with TD Capital Group, a leading Canadian private equity investor in the communications and media industry, and Wispra Inc., a previous participant in Canada’s broadband wireless marketplace. In December, Wispra Networks was named the provisional winner of six fixed broadband wireless 24 GHz spectrum licenses, following an auction of the licenses by Industry Canada, covering areas in which approximately 14.3 million people live or work, including Toronto, Montreal, Vancouver, Ottawa, Edmonton, Calgary and surrounding areas. Wispra Networks has paid a total of approximately Cdn. $74 million for 400 MHz of spectrum in the six market areas. Wispra Networks anticipates that Industry Canada will officially issue the licenses for the spectrum in 2000. Wispra was founded to provide broadband telecommunications services in Canada using emerging wireless telecommunications technologies. Post Year-End Transactions and Developments Agreement to Acquire Concentric Network Corporation. In January 2000, we agreed to acquire Concentric Network Corporation, a provider of high-speed DSL, web hosting, e-commerce, and other Internet services. As a combined company, we will be able to offer a complete, single source communications solution to our customers by combing our voice and data products with the full array of products from Concentric’s Internet business, data center, and application service provider services. In this transaction, both NEXTLINK and Concentric will merge into a newly-formed company, to be renamed NEXTLINK Communications, Inc., which will assume all of our and Concentric’s outstanding debt obligations. In the transaction, each outstanding share of our Class A common stock and Class B common stock would be converted into one share of Class A common stock or Class B common stock, as applicable, of the corporation surviving the merger, which stock will be substantially identical to our Class A and Class B common stock. In addition, each outstanding share of Concentric common stock would be converted into 0.495 of a share of Class A common stock of the surviving corporation, unless the trading price of our Class A common stock at the effective time is less than or equal to $90.91, in which case each outstanding share would be converted into $45.00 of Class A common stock of the surviving corporation (based on the trading price of our Class A common stock prior to the effective time). If at the effective time our average stock price is less than $69.23, each outstanding share of Concentric common stock would covert into 0.650 of a share of Class A common stock of the surviving corporation. The transaction is subject to approval of the Concentric stockholders and other customary closing conditions, and is expected to close in the second quarter of 2000. Acquisition of INTERNEXT Interest. In January 2000, as part of the reorganization of NEXTLINK under which we will acquire Concentric Network Corporation, we entered into an agreement with Eagle River Investments, LLC, to acquire the 50% interest of INTERNEXT, L.L.C. that we do not currently own. NEXTLINK and Eagle River formed INTERNEXT to hold our interests in the national network. The purchase price for Eagle River’s interest is approximately 3.4 million shares of the Class A common stock of the corporation surviving the reorganization. As a result of this acquisition, which is expected to be consummated in the second quarter of 2000, we will own the entire interest in this 16,000 mile, 50 city national broadband network. The closing of this transaction is not conditioned on the closing of the Concentric acquisition. Secured Credit Facility. On February 3, 2000, we entered into a $1.0 billion senior secured credit facility underwritten by a syndicate of banks and other financial institutions. The credit facility consists of a $387.5 million tranche A term loan facility, a $225.0 million tranche B term loan facility and a $387.5 million revolving credit facility. We have borrowed $375.0 million under this facility. The security of the credit facility consists of the assets purchased using the proceeds thereof, the stock of certain of our direct subsidiaries, all assets of NEXTLINK and, to the extent of $125.0 million of guaranteed debt, all assets of certain of our subsidiaries. Both the revolving credit facility and the tranche A term loan facility mature on December 31, 2006, and the tranche B term loan facility matures on June 30, 2007. The maturity date for each of the facilities may be accelerated to October 31, 2005 unless we have refinanced our $350.0 million 12 1/2% Senior Notes due 2006 by April 15, 2005. We also are required to repay the facilities in full upon the occurrence of a change of control. Amounts drawn under the revolving credit facility and the term loans bear interest, at our option, at the alternate base rate or reserve-adjusted London Interbank Offered Rate (LIBOR) plus, in each case, applicable margins. The credit agreement contains customary events of default and covenants restricting and limiting our ability to engage in certain activities, including but not limited to: • limitations on indebtedness, guarantee obligations and the incurrence of liens, • restrictions on sale lease back transactions, consolidations, mergers, liquidations, dissolutions, leases, certain sales of assets, transactions with affiliates and investments, • restrictions on issuance of preferred stock, dividends and distributions on capital stock and other similar distributions, and • restrictions on optional payments and modifications of other debt instruments, changes in fiscal year, and changes in lines of business. Two-for-One Stock Split. In February 2000, our Board of Directors declared a two-for-one stock split of our common stock, to be paid on June 15, 2000 in the form of a stock dividend. The split is subject to stockholder approval of a proposed increase in the number of shares of our common stock authorized for issuance. This proposal will be considered and voted on at our May 24, 2000 annual meeting of stockholders. Industry and Market Overview Prior to 1984, AT&T Corp. dominated both the local exchange and long distance marketplace by owning the operating entities that provided both local exchange and long distance services to most of the U.S. population. While the court-ordered breakup of AT&T established the conditions for competition in the long distance services market in 1984, the market for local exchange services has been, until recently, virtually closed to competition and has largely been dominated by regulated monopolies. To foster competition in the long distance market, AT&T’s divested local exchange businesses, the Regional Bell Operating Companies, or RBOCs, were prohibited from providing long distance services to customers in their home markets. We believe that a similarly critical event occurred in 1996 with the passage of the Telecommunications Act of 1996, or the Telecom Act. Before passage of this law, in most locations throughout the United States, the incumbent carrier operated a virtual monopoly in the provision of most local exchange services. However, just as competition slowly emerged in the long distance business prior to the mandated breakup of AT&T, competitive opportunities also have slowly emerged over the last 10 years at the local exchange level. We believe that the Telecom Act provided the opportunity to accelerate the development of competition at the local level by, among other things, requiring the incumbent carriers to cooperate with competitors’ entry into the local exchange market. These provisions include: • Interconnection-provides competitors the right to connect to the incumbent carriers’ networks at any technically feasible point and to obtain access to its rights-of-way; • Unbundling of the Local Network-allows competitors to purchase and utilize components of the incumbent carriers’ network selectively; • Reciprocal Compensation-establishes the framework for pricing between a competitor and the incumbent carrier for use of each other’s networks; and • Number Portability-allows incumbent carrier customers to retain their current telephone numbers when they switch to a competitor. The Telecom Act and the subsequent rules issued by the FCC governing competition, as well as pro-competitive policies already developed by state regulatory commissions, have caused fundamental changes in the structure of the local exchange markets. These developments created opportunities for new entrants into the local exchange market to capture a portion of the incumbent carrier’s dominant, and historically monopoly controlled, market share of local services. The development of switched local service competition, however, is still in its early stages. Industry sources estimate that in 1998 the total revenues from local and long distance telecommunications services were approximately $210 billion, of which approximately $105 billion were derived from local exchange services and approximately $105 billion from long distance services. Based on FCC information, total revenues for local and long distance services grew at a compounded annual rate of approximately 5.4% between 1992 and 1998. In addition to traditional local and long distance voice services, telecommunication services have been growing at an accelerated pace because of increased data telecommunications, such as Internet usage. As technology advances, we believe the demand for broadband capacity and additional business and consumer telecommunications services will increase. The emergence of the Internet and the widespread adoption of IP as a data transmission standard in the 1990s, combined with deregulation of the telecommunications industry and advances in telecommunications technology, have significantly increased the attractiveness of providing data communication applications and services over public networks. At the same time, growth in client/server computing, multimedia personal computers and online computing services and the proliferation of networking technologies have resulted in a large and growing group of people who are accustomed to using networked computers for a variety of purposes, including email, electronic file transfers, online computing and electronic financial transactions. These trends have led businesses increasingly to explore opportunities to provide IP-based applications and services within their organization, and to customers and business partners outside the enterprise. The ubiquitous nature and relatively low cost of the Internet have resulted in its widespread usage for certain applications, most notably Web access and email. However, usage of the Internet for business applications has been impeded by the limited security and unreliable performance inherent in the structure and management of the Internet. In addition, transmission delays make the Internet less appealing for these emerging applications. Although private networks are capable of offering lower and more stable transmission delays, providers of these emerging applications also desire a network that will offer their customers full access to the Internet. As a result, these businesses and applications providers require a network that combines the best features of the Internet, such as openness, ease of access and low cost made possible by the IP standard, with the advantages of a private network, such as high security, low/fixed latency and customized features. Industry analysts expect the market size for both value-added IP data networking services and Internet access to grow rapidly as businesses and consumers increase their use of the Internet, intranets and privately managed IP networks. According to industry analyst Forrester Research, Inc., the Internet services market will grow from $2.8 billion in 1998 to $56.6 billion in 2003. Forrester Research predicts that access revenue will comprise nearly $42.0 billion of the 2003 market and hosting services revenue will comprise the remainder. NEXTLINK’s Networks We have built, and are continuing to build, fiber optic networks with robust capacity in urban centers across the country. Our IP-optimized national network will connect these local networks to one another. Our fiber optic and wireless customer connections will complete our goal of becoming an end-to-end, facilities-based provider of broadband communications services. Local Fiber Optic Networks The core of each of our local networks is a ring of fiber optic cable in a city’s central business district that connects to our central offices. These facilities contain the switches and routers that direct data and voice traffic to their destinations, and also have the space to house the additional equipment necessary for future telecommunications services. We are now operating 31 broadband local networks in 49 cities, having launched networks in 10 major metropolitan markets in 1999 and having connected two additional markets to our South Bay Area network. Based on our recent successes in operating and expanding our existing networks, as well as new opportunities in other markets, we are pursuing an aggressive growth plan. We are currently building additional local networks, and plan to have operational networks in most of the 30 largest U.S. cities by the end of 2000. The following table provides information on the markets in which we have launched bundled switched local and long distance services. We build high capacity networks using a backbone density ranging between 72 and 432 strands of fiber optic cable. Fiber optic cables have the capacity, or bandwidth, to carry tens of thousands times the amount of traffic as traditionally-configured copper wire. We believe that installing high-count fiber strands will allow us to offer a higher volume of broadband and voice services without incurring significant additional construction costs. To enhance our ability to connect customers directly to our networks, we design them to serve both core downtown areas and other metropolitan and suburban areas where business development supports the capital required for the network build. Our customer base has been growing rapidly, as the following table of access lines installed on our networks illustrates: National Network We are creating a single, end-to-end network by linking our local networks to one another through the use of a national fiber optic backbone network currently being constructed by Level 3 Communications for INTERNEXT. When complete, we will be able to utilize this network to offer our customers integrated, end-to-end telecommunications services over facilities we control. By owning these high-speed “dark” fiber facilities rather than leasing “lit” fiber capacity from others, we have retained control over decisions on where and how to deploy existing or new generations of optical transmission equipment. This will allow us to maximize the capacity and enhance the performance of our network as needed to meet our customers’ current and future broadband data and other communications needs, rather than relying on the owners of leased lines to make those upgrades. This national network is planned to cover more than 16,000 route miles with six or more conduits and connect 50 cities in the United States and Canada. INTERNEXT L.L.C., a joint venture managed by us and currently owned 50% each by us and Eagle River, has entered into a cost sharing agreement with Level 3 with respect to this network. Under this agreement, INTERNEXT has: • an exclusive interest in 24 “dark” fibers in a shared, filled conduit throughout this network; • an exclusive interest in one empty conduit, through which we expect to be able to pull up to 432 fiber optic strands; and • the right to 25% of the “dark” fibers pulled by Level 3 through the sixth and any additional conduits in the network. We expect the construction of the fiber backbone in the national network to be substantially completed in years 2000 and 2001. We have entered into an agreement to acquire from Eagle River the 50% interest that we did not own of INTERNEXT. As a result of this acquisition, which is expected to close in the second quarter of 2000, we will have complete control over this national network. Although this acquisition is part of the transition in which we will acquire Concentric, the two closings are not conditioned on one another. Connecting Customers to Our Networks We intend to reduce our reliance on customer connections leased from the incumbent carrier by increasing the number of customers connected directly to our networks. We believe that by deploying direct connections to our customers, rather than connecting through the incumbent carriers’ facilities, we will be better positioned to meet our customers’ communications requirements. Direct customer connections enhance our ability to: • ensure technological support for high-bandwidth communications; • manage and control the quality of services used by our customers; • meet the varying bandwidth needs of our customers; and • achieve better operating margins. By designing and deploying high capacity local networks, we maximize the number of customers that can be connected directly to our networks with fiber strands that we own or using our LMDS spectrum. By having both fiber and LMDS spectrum at our disposal, we can directly connect customers to our network using the most cost efficient means. In those instances where it is not cost effective or feasible to directly connect customers to our networks using fiber or fixed wireless technology, we can connect them by leasing the incumbent carriers’ facilities, and meet their high bandwidth needs by deploying DSL technology where available. Fiber Optics. In cases where expected revenues justify the cost, we will construct a new fiber optic extension from our network to the customer’s premises. Whether it is economic to construct a fiber optic extension depends, among other things, on: • the existing and potential revenue base located in the building in question; • the building location relative to our network, and • local permitting requirements. Even if we initially determine that it is not economic to construct a fiber connection to a building, we will continually reexamine the costs and benefits of a fiber connection and may at a later date determine that construction of one is justified. Making a direct fiber optic connection for a customer who is a tenant in an office building requires installation of in-building cabling through the building’s risers from the customer’s office to our fiber in the street. Space in building risers for fiber optic cables is limited, and in some office buildings, particularly the premier buildings in the largest markets, competition among carriers to gain access to this space is intense. Moreover, increasingly the owners of these buildings are seeking to impose fees or other revenue sharing arrangements as a condition of access. Broadband Wireless Spectrum. In cases where construction of a fiber optic connection is not economic, we plan to deploy a high-bandwidth wireless connection between an antenna on the roof of the customer’s premises and an antenna attached to our fiber rings. These wireless connections offer high-quality broadband capacity and, in many cases, cost less to install than fiber connections. In January 2000, we announced completion of our first generation broadband wireless field tests and the availability of commercial broadband wireless services to a limited group of customers in Los Angeles and Dallas. We also announced commencement of lab testing of the second generation point-to-multi-point equipment that we plan to deploy throughout our networks this year and that we will purchase broadband, point-to-multi-point access equipment from Nortel Networks on a non-exclusive basis. We expect to deploy wireless direct connections to our networks in 25 markets by the end of 2000. Through a series of auction bids and acquisitions, we have become the largest holder of broadband fixed wireless spectrum in North America. We hold licenses to 1,150 to 1,300 MHz of LMDS spectrum in 52 cities, covering areas where 95% of the population of the 30 largest U.S. cities live or work. Our licenses also include 150 MHz of LMDS spectrum in 13 smaller cities and 300 MHz of spectrum in the five boroughs that comprise New York City. In addition, we have entered into an agreement to acquire 300 MHz of spectrum in Denver, Colorado. We believe that, for many locations, broadband wireless connections from customer buildings to our local fiber optic networks will offer a lower cost solution for providing high-quality broadband services than fiber or copper connections. The following table provides information on the markets in which we hold LMDS licenses. (1) Pending closing of the transaction with HighSpeed.Com. (2) For the five boroughs comprising New York City, we hold licenses for 300 MHz of spectrum. For the remainder of the New York Basic Trading Area, we hold licenses for 1,300 MHz of spectrum. In order to obtain the necessary access to install our LMDS equipment and connect our intended customers, we must secure roof and other building access rights, including access to conduits and wiring from the owners of each building or other structure on which we propose to install our equipment, and may need to obtain construction, zoning, franchise or other governmental permits. DSL Technology. We are also currently deploying DSL technology to meet the high-bandwidth needs of those customers located less than three miles from the incumbent carrier’s central office and whose customer connection remains over copper wire. DSL technology reduces the bottleneck in the transport of information, particularly for data services, by increasing the data carrying capacity of copper telephone lines. We believe that, for many locations, existing copper connections using DSL technology from customer buildings to our local fiber optic networks will offer a lower cost solution for providing high-quality broadband services than fiber or LMDS connections. We have arrangements with incumbent carriers with respect to more than 247 of their central offices that enable us to make direct connections to each business or resident connected to that central office over leased lines. These arrangements are known in our industry as collocations. We have introduced our own DSL equipment and services at many of our collocation sites, and plan to introduce DSL equipment and services at other collocation sites, to provide our customers with increased data carrying capacity. Technology The wires, cables and spectrum that comprise the physical layer of our networks can support a variety of communications technologies. We seek to offer customers a set of technology options to meet their changing needs, and introduce new technologies as necessary. Specifically, we believe that a service platform based on Internet Protocol, or IP, will provide us with significant future opportunities, because it will enable data, voice and video to be carried inexpensively over our end-to-end, facilities-based network. We have, therefore, begun to supplement our current data and voice switching technology with IP and ATM equipment. These technologies will enable us to offer our customers additional services, such as high-speed Internet access, Internet web hosting, e-commerce and other Internet services. Because they are more efficient, IP and ATM technology increase the effective capacity of networks for these types of applications, and in the future may become the preferred technology for voice calls and faxes as well. Circuit Switching vs. Packet Switching There are two widely used switching technologies in currently deployed communications networks: circuit-switching systems and packet-switching systems. Circuit switch-based communications systems, which currently dominate the public telephone network, establish a dedicated channel for each communication (such as a telephone call for voice or fax), maintain the channel for the duration of the call, and disconnect the channel at the conclusion of the call. Packet switch-based communications systems, which format the information to be transmitted into a series of shorter digital messages called “packets,” are the preferred means of data transmission. Each packet consists of a portion of the complete message plus the addressing information to identify the destination and return address. A key feature that distinguishes Internet architecture from the public telephone network is that on the packet-switched Internet, a single dedicated channel between communication points is not required. Packet switch-based systems offer several advantages over circuit switch-based systems, particularly the ability to commingle packets from several communications sources together simultaneously onto a single channel. For most communications, particularly those with bursts of information followed by periods of “silence,” the ability to commingle packets provides for superior network utilization and efficiency, resulting in more information being transmitted through a given communication channel. IP technology, an open protocol that allows unrelated computer networks to exchange data, is the technological basis of the Internet. The Internet’s explosive growth in recent years has focused intensive efforts worldwide on developing IP-based networks and applications. In contrast to protocols like ATM, which was the product of elaborate negotiations between the world’s monopoly telephone companies, IP is an open standard, subject to continuous improvement. We believe that a form of IP-based switching will eventually replace both ATM and circuit switched technologies, and will be the foundation of integrated networks that treat all transmissions - including voice, fax and video - simply as forms of data transmission. Current implementations of IP technology over the Internet lack the necessary quality of service to support real-time applications like voice and fax at commercially acceptable quality levels. We fully expect that a combination of increased bandwidth and improved technology will correct these deficiencies. We are in the process of constructing IP points of presence in all of our major markets using high-capacity IP routers. We have launched points of presence in eight of our markets, through which we offer Internet-related services, and plan to launch and acquire, through the Concentric acquisition, additional points of presence in 2000. We currently connect these points of presence with leased backbone facilities. On completion, our national network will serve as our IP backbone. We believe that the IP deployment currently under way on our network will enable us to implement new services based on current IP technology, and position us to adopt future IP technology implementations as they evolve to support fully integrated communications networks. We anticipate remaining flexible in our use of technology, however, so that as underlying communications technology changes, we will have the ability to take advantage of and implement these new technologies. To enhance the capacity of our networks, we are incorporating wavelength division multiplexing technology, which increases the capacity of an optical fiber by simultaneously operating at more than one wavelength, thereby allowing the transmission of multiple signals through the same fiber at different wavelengths. To further enhance our network’s capacity, we also are using the latest in fiber technology. In our national network, we are deploying a new generation of fiber that allows for faster transmission of traffic with less dispersion than previous generations, which can enhance the speed and capacity of the national network. LMDS Wireless Technology LMDS is a fixed broadband service that the license holder may use to provide high-speed data transfer, wireless local telephone service, wireless transmission of telephone calls in bulk quantity, video broadcasting and videoconferencing, in any combination. This spectrum is not suitable for mobile telephones, but can transmit voice, data or video signals from one fixed antenna to many others. As the word “local” in the local multipoint distribution service name implies, the radio links provided using LMDS frequencies are of limited distance, typically of a few miles or less, due to the degradation of these high-frequency signals over greater distances. A wireless connection typically consists of paired antennas that we anticipate will be placed at a distance of up to 2.5 miles from one another with a direct, unobstructed line of sight. The antennas are typically installed on rooftops, towers or windows. Point-to-multipoint technology allows a single hub site antenna to be used to form multiple paths with antennas located on numerous customer buildings. As few as four hub site antennas can provide telecommunications connections to buildings in all directions that have line of sight visibility. Wireless local loop technology typically utilizes millimeter wave transmissions having narrow beam width, reducing the potential for channel interference and allowing dense deployment and channel re-use. This means that, like cellular telephone systems, LMDS sites can be split into sectors in order to increase the available capacity. The large amount of capacity in each channel permits the simultaneous use of multiple voice and data applications. LMDS and other wireless broadband services require a direct line of sight between two antennas comprising a link and are subject to distance and rain attenuation. We expect that the average coverage radius of a base station will be up to approximately 2.5 miles, depending on local conditions, and we expect that our base stations will utilize power control to increase signal strength where necessary to mitigate the effects of rain attenuation. In areas of heavy rainfall, transmission links will be engineered for shorter distances and greater power to maintain transmission quality. This reduction of path link distances to maintain transmission quality requires more closely spaced transceivers and, therefore, tends to increase the cost of service coverage. Due to line of sight limitations, we currently plan to install our transceivers and antennas on the rooftops of buildings. Line of sight and distance limitations generally do not present problems in urban areas, provided that suitable roof rights can be obtained, due to the existence of unobstructed structures from which to transmit and the concentration of customers within a limited area. Line of sight and distance limitations in non-urban areas can arise due to lack of structures with sufficient height to clear local obstructions. We may have to plan to construct intermediate links or use other means to resolve these line of sight and distance issues. These limitations may render point-to-multipoint links uneconomic in certain locations. Applications and Services Voice Applications and Services In each market in which we operate, we currently offer the telephone services listed below, at prices generally determined and implemented locally in each market. These prices are generally 10% to 15% lower than the pricing for comparable local services from the incumbent carrier. Our service offerings include: • standard dial tone, including touch tone dialing, 911 and operator assisted calling; • multi-trunk services, including direct inward dialing, or DID, and direct outward dialing, or DOD; • long distance service, including 1+, 800/888 and operator services; • voice messaging with personalized greetings, send, transfer, reply and remote retrieval capabilities; and • directory listings and assistance. In each of our operational markets, we have negotiated and entered into interconnection agreements with the incumbent carrier, and implemented permanent local number portability, which allows customers to retain their telephone numbers when changing telephone service providers. Additionally, in each of our markets we offer the following services to long distance carriers and high volume customers, which our customers use as both primary and back-up circuits: • special access circuits that connect end users to long distance carriers; • special access circuits that connect long distance carriers’ facilities to one another; and • private line circuits that connect several facilities owned by the same end user. Historically, our targeted customer base has consisted of primarily small and medium-sized businesses. As our capabilities expand through the completion of INTERNEXT’s national fiber optic network, the addition of data service capabilities, including enhancements of those capabilities resulting from the Concentric acquisition, and the addition of IP technology to our networks, we plan to expand our targeted customers to include larger national customers that can benefit from our unique end-to-end broadband capabilities. Data Applications and Services In the eight markets in which we have launched IP points of presence, we offer Internet access services. We will offer Internet access services in all of our markets as we launch additional points of presence this year or acquire them in the Concentric acquisition. We offer these services on a stand-alone basis and bundled with local and long distance telephone service. We intend to configure the central offices of our network backbone with electrical and environmental controls and 24-hour maintenance and technical support, which will provide an attractive location for our customers to locate their larger computers (which are known as servers) or from which they can run important applications on servers that we will maintain. This will enable us to offer: • Web Hosting: support for customers’ websites, including design, maintenance and telecommunications services; • Server Hosting: collocation of customers’ servers in our central offices; • Application Hosting: running our customers’ enterprise-wide applications at our central offices and distributing them as needed over our network to ensure uniformity, reduce costs and implement upgrades on a continuous and immediate basis; and • E-Commerce Support: support for high-volume purchases over the Internet, including system design, order fulfillment and network security. In December 1999, we launched Internet access services as an Internet service provider, or ISP, in eight markets. We expect that our acquisition of Concentric will significantly accelerate implementation of our data services strategy and, in particular will significantly enhance our ability to market Internet access services utilizing Concentric’s status as an ISP with significant peering arrangements. Concentric provides high speed Internet access, virtual private networks and web hosting services principally to small to medium-sized enterprises. We also plan to combine the capabilities of our national network with the mass-market e-commerce expertise we have developed through NEXTLINK Interactive to offer customers a broad range of services to their e-commerce activities, including telecommunications, web-site design, order fulfillment and enhancement of back-office systems. Other Businesses NEXTLINK Interactive Through our NEXTLINK Interactive subsidiary, we develop systems for clients that enable those clients’ consumers to order products and services, receive information, seek assistance, and a host of other capabilities via the Internet, through a call center or within a physical store location. NEXTLINK Interactive’s systems enable its clients to seamlessly integrate sales and customer service functions across their Internet site, call center and physical store, thereby creating a uniform experience for its clients’ customers regardless of how a customer chooses to interact with the NEXTLINK Interactive client. NEXTLINK Interactive builds, operates, maintains and hosts customized Internet and telephony-based third-party software applications and technologies that are integrated with its clients’ existing or desired operational and business systems. It hosts these applications in data centers and deploys them to the client across a network, thereby alleviating the client’s need to purchase, own, install, or maintain these applications. Clients pay for the use of these customized solutions through a combination of “upfront” payments for installation and system integration and recurring fees based on transaction volume. Examples of solutions that NEXTLINK Interactive has developed and operated for its clients include: • Automated cross channel purchasing and customer service; • Applications that identify and supply consumers with information that directs them to the closest retail location or dealer; • Applications that configure and prices a product or service for a consumer; and • Subscription or metered based service delivery. Examples of key technologies and capabilities include: • Hardware and software integration expertise; • E-commerce application development; • Interactive Voice Response (IVR) and natural language speech recognition development; • Call center solutions development and integration; • Handheld and kiosk application development; and • Application management and hosting. Significantly, in February 2000, NEXTLINK Interactive announced that it entered into an agreement to develop one of the largest installations in the world of interactive voice response and natural language speech recognition applications for Federal Express Corp. NEXTLINK Interactive’s service offerings currently are not integrated with NEXTLINK’s telecommunications networks and services. We, however, plan to use these service offerings as a means to expand the relationship with NEXTLINK Interactive’s customers to include utilization of telecommunications services on our network. For financial information regarding NEXTLINK Interactive’s operations, see note 16 to our consolidated financial statements regarding reportable segments. Shared Tenant Services Through our NEXTLINK One subsidiary (formerly known as Start Technologies) acquired in November 1997, we provide shared tenant services. Shared tenant services are telecommunications management services provided to groups of small and medium-sized businesses located in the same office building. This service enables businesses too small to justify hiring their own telecommunications managers to benefit from the efficiencies, including volume discounts, normally available only to larger enterprises. NEXTLINK One installs an advanced telecommunications system throughout each building it serves, leasing space for on-site sales and service, and offers tenants products and services such as telephones, voice mail, local calling lines, discounted long distance and high speed Internet connections, all on a single, detailed invoice. Sales and Customer Care Overview We use a two-pronged sales strategy, one directed to the sale of local, long distance, and high-speed Internet access services and the other to enhanced communications services. Historically, our primary sales efforts have focused on selling switched local and long distance to small and medium-sized businesses and professional groups with fewer than 50 business lines. Our market research indicates that these customers prefer a single source for all of their telecommunications requirements, including products, billing, installation, maintenance, and customer service. Using direct sales efforts, we offer bundled local and long distance services that are generally priced at a 10% to 15% discount from the incumbent carrier. By bundling local and long distance services, we believe we provide our customers a level of convenience that has been generally unavailable since the break-up of AT&T. In some of our markets, we also target high concentrations of business customers in multi-tenant commercial office buildings in major metropolitan areas. This allows these business customers to benefit from voice and data services offered through our on-site facilities and technical staff. We market our enhanced communications services nationally through a separate direct sales force. In addition, we employ a national sales team to market services to long distance carriers and large commercial users. As our capabilities expand through the completion of INTERNEXT’s national fiber optic network, the addition of data service capabilities, including enhancements of those capabilities resulting from the Concentric acquisition and the addition of IP technology to our networks, we plan to expand our targeted customers to include larger national customers that can benefit from our unique end-to-end broadband capabilities. Sales Force We have established a highly motivated and experienced direct sales force and customer care organization that is designed to establish a direct and personal relationship with our customers. We seek to recruit salespeople with strong sales backgrounds, including salespeople from long distance companies, telecommunications equipment manufacturers, network systems integrators and the incumbent carriers. We have expanded our sales force from 319 salespeople at December 31, 1998 to 707 salespeople at December 31, 1999. Salespeople are given incentives through a commission structure that generally targets 40-50% of a salesperson’s compensation to be based on performance. Concentric pursues a multi-tiered sales strategy consisting of third party distribution channels, inbound and outbound telesales, value-added resellers, original equipment manufacturers and a direct sales force. After closing the Concentric acquisition, we plan to leverage these distribution channels as a means to complement our direct sales force approach. Customer Care We augment our direct sales approach with customer care and support from locally based customer care representatives. We have structured our customer care organization so that each customer has a single customer care point of contact who is responsible for solving problems and responding to customer inquiries. We have expanded our customer care organization from 256 customer care employees at December 31, 1998 to 321 employees at December 31, 1999. Our goal is to provide a customer care group that has the ability and resources to respond to and resolve customer problems as they arise. We believe that customer care representatives are most effective if they are based in the communities in which we offer services, which also allows, among other things, the opportunity for the representatives to visit the customer’s location. Regulatory Overview Overview The Telecom Act, which substantially revised the Communications Act of 1934, established the regulatory framework for the introduction of competition for local telecommunications services throughout the United States by new competitive entrants such as NEXTLINK. Prior to the passage of the Telecom Act, states typically granted an exclusive franchise in each local service area to a single dominant carrier - often a former subsidiary of AT&T, known as a Regional Bell Operating Company, or RBOC - which owned and operated the entire local exchange network. The RBOCs, following some recent consolidation, now consist of the following companies: BellSouth, Bell Atlantic, U S WEST (which has agreed to merge with Qwest Communications International, Inc.), and SBC Communications. Among other things, the Telecom Act preempts state or local governments from prohibiting any entity from providing telecommunications service, which had the effect of eliminating prohibitions on entry found in almost half of the states at the time the Telecom Act was enacted. The Telecom Act requires incumbent carriers to interconnect their facilities with those of their competitors, including NEXTLINK. This interconnection obligation permits our customers to exchange telecommunications traffic with the customers of other carriers, including the incumbent carrier. This ability to interconnect with incumbent carriers and the preemption of state and local prohibitions on entry are essential to our ability to be a full service provider of telecommunications services. At the same time, the Telecom Act preserved state and local jurisdiction over many aspects of local telephone service, and, as a result, we are subject to varying degrees of federal, state and local regulation. Consequently, federal, state and local regulation, and other legislative and judicial initiatives relating to the telecommunications industry, could significantly affect our business. Federal Regulation Although the FCC exercises jurisdiction over our communication facilities and services, we are not currently required to obtain FCC authorization for the installation, acquisition or operation of our wireline network facilities. We are, however, required to hold and have obtained FCC authorizations for the operation of our fixed wireless LMDS facilities. Unlike incumbent carriers, we are not currently subject to price cap or rate of return regulation, which leaves us freer to set our own pricing policies. The FCC does require us to file interstate tariffs on an ongoing basis for interstate access, rates charged among carriers for access to their networks, and domestic and international long distance service. An FCC order that could have exempted us from any requirement to file tariffs for interstate access and domestic long distance service has been stayed pending further judicial review, and, as a result, we currently file tariffs for these services. The following table summarizes the interconnection rights granted by the Telecom Act that are most important for full local competition and our belief as to the effect of the requirements, if properly implemented. Issue Definition Effect Interconnection Efficient network interconnection to transfer calls back and forth between incumbent carriers and competitive networks (including 911, 0+, directory assistance, etc.) Allows the customers of NEXTLINK and other competitors to exchange traffic with customers connected to other networks Local Loop Unbundling Allows competitors to selectively gain access to incumbent carriers’ facilities and wires which connect the incumbent carriers’ central offices with customer premises Reduces the capital costs of NEXTLINK and other competitors to serve customers not directly connected to their networks Reciprocal Compensation Mandates reciprocal compensation for local traffic exchange between incumbent carriers and NEXTLINK and other competitors Improves NEXTLINK’s and other competitors’ margins for local service Number Portability Allows customers to change local carriers without changing numbers Allows customers to switch to NEXTLINK’s and other competitor’s local service without changing phone numbers Access to Phone Numbers Mandates assignment of new telephone numbers to NEXTLINK’s and other competitors’ customers Allows NEXTLINK and other competitors to provide telephone numbers to new customers on the same basis as the incumbent carrier In January 1999, the U.S. Supreme Court upheld key provisions of the FCC rules implementing the Telecom Act, in a decision that was generally favorable to competitive telephone companies such as NEXTLINK. In finding that the FCC has general jurisdiction to implement the Telecom Act’s local competition provisions, the Supreme Court confirmed the FCC’s role in establishing national telecommunications policy, and thereby created certainty regarding the rules governing local competition going forward. Although the rights established in the Telecom Act are a necessary prerequisite to the introduction of full local competition, they must be properly implemented to permit competitive telephone companies like NEXTLINK to complete effectively with the incumbent carriers. Discussed below are several FCC and court proceedings relating to the application of certain FCC rules and policies that are significant to our operations. Unbundling of Incumbent Network Elements. In the January 1999 Supreme Court decision discussed above, the Court affirmed the FCC’s interpretation of matters related to unbundling of incumbent carriers’ network elements. It held that the FCC correctly interpreted the meaning of the term “network element”, which defines the parts of an incumbent carrier’s operations that may be subject to the “unbundling” requirement of the Telecom Act. The Court, however, also held that the FCC did not correctly determine which network elements must be unbundled and made available to competitive telephone companies such as NEXTLINK. In November 1999, the FCC released its order addressing the deficiencies in the FCC’s original ruling cited by the Supreme Court. The order is generally viewed as favorable to NEXTLINK and other competitive carriers because it ensures that incumbent carriers will be required to continue to make available those network elements, including unbundled loops, that are crucial to our ability to provide local and other services. It states that incumbent carriers must provide access to the following unbundled network elements: • loops, including loops used to provide high-capacity and advanced telecommunications services, which allows competitors to access all of the features, functions and capabilities of the transmission facilities owned by the incumbent carrier between its central office and the customer’s location; • network interface devices, which permits competitors to connect their facilities with the telephone wiring inside the customer’s location; • local circuit switching (except for larger business customers in major urban markets), which allows competitors to access all of the features, functions and capabilities of the incumbent carrier’s switch; • dedicated and shared transport, which allows competitors to utilize transmission facilities owned by the incumbent carrier between customer locations and the incumbent carrier’s switches or between the incumbent carrier’s switch locations; • signaling and call-related databases, which competitors use to correctly route and bill calls; and • operations support systems, which permit competitors to submit orders to the incumbent for unbundled network elements and for provisioning, repair and maintenance services. In addition, incumbent carriers must provide access to combinations of elements if they are currently combined in the networks, but the FCC did not address whether an incumbent carrier must combine network elements that are not already combined in the network because that issue is pending before the Eighth Circuit Court of Appeals. The FCC declined, except in limited circumstances, to require incumbents to unbundle the facilities used to provide high-speed Internet access and other data services. In addition, the FCC did not require incumbents to provide competitive carriers with access to operator and directory assistance services. These aspects of the order are not expected to have a material adverse effect on our operations. The Supreme Court’s decision did not address or resolve the incumbent carriers’ challenge to the FCC’s forward-looking pricing methodology for unbundling network elements. The incumbent carriers have challenged this methodology before the Eighth Circuit Court of Appeals, claiming that the pricing procedure should take into account historical costs. If the incumbent carriers succeed in this contention, we would be required to pay more to purchase network elements, which could increase our cost of doing business. Regulation of the RBOC’s Ability to Provide Long Distance Service. The FCC has primary jurisdiction over the implementation of Section 271 of the Telecom Act, which provides that the RBOCs cannot combine in-region long distance services with the local services they offer until they have demonstrated that: • they have entered into an approved interconnection agreement with a facilities-based competitive telephone company or that no such competitive telephone company has requested interconnection as of a statutorily determined deadline, • they have satisfied a 14-element checklist designed to ensure that the RBOC is offering access and interconnection to all local exchange carriers on competitive terms, and • the FCC has determined that allowing the RBOC to offer in-region, long distance services is consistent with the public interest, convenience and necessity. In December 1999, Bell Atlantic became the first RBOC to win Section 271 authority when the FCC approved its application to provide long distance services in the State of New York. SBC Communications has pending an application filed with the FCC in January 2000 for Section 271 authority to enter the long distance market in Texas. The FCC is expected to rule on this application in April 2000. In addition, several applications are currently pending before state commissions and it is expected that these applications plus several new applications are likely to be filed with the FCC in the near future. We cannot predict if any of these applications will be approved or when such approval is likely to occur. Approval could have an adverse affect on our ability to compete if it is not accompanied by safeguards to ensure that the RBOC continues to comply with the market-opening requirements of Section 271 or if it is granted prematurely before the RBOC has completely satisfied the market-opening requirements. For example, the FCC recently fined Bell Atlantic after concluding that widespread systems problems have hindered many of its customers from switching telephone service to Bell Atlantic’s competitors. Provision of Advanced Telecommunications Services. Rules promulgated under the Telecom Act restrict the RBOCs’ ability to provide advanced telecommunications services, such as data and DSL services. In August 1998, the FCC denied the request of various RBOCs that the FCC waive enforcement of these restrictions, but the agency also initiated a proceeding, which is still pending, to determine whether to relax some of the restrictions. Certain of the RBOCs also have filed tariffs for the provision of advanced services, such as DSL, that are based upon an assumption that these services are outside the purview of the Telecom Act under certain circumstances. The FCC has allowed these tariffs to go into effect and has determined that the RBOCs’ treatment of these services is lawful. This decision may have the effect of allowing RBOCs to provide terms, conditions and pricing to their own affiliates that provide data services that are better than those made available to unaffiliated competitors. Universal Service. In 1997, the FCC established a significantly expanded federal telecommunications subsidy regime known as “universal service.” For example, the FCC established new subsidies for services provided to qualifying schools and libraries and rural health care providers, and expanded existing subsidies to low income consumers. Most telecommunications companies, including NEXTLINK, must pay for these programs based on its share of certain defined telecommunications revenues. In a 1999 decision, the Fifth Circuit Court of Appeals issued a ruling that had the net effect of somewhat lowering our contribution of revenues to universal service. We cannot be sure that legislation or FCC rulemaking will not increase the size of our subsidy payments or the scope of the subsidy program. Access Charge Reform. Long distance carriers pay local carriers, including NEXTLINK, interstate access charges for both originating and terminating the interstate calls of long distance customers on the local carriers’ networks. Historically, the RBOCs set access charges higher than cost and justified this pricing to regulators as a subsidy to the cost of providing local telephone service to higher cost customers. With the establishment of an explicit universal service subsidy mechanism, however, the FCC is under increasing pressure to revise the current access charge regime to bring the charges closer to the cost of providing access. In response, the FCC has initiated a proceeding to consider whether competitors’ access charges should be regulated and a request by AT&T that competitors’ access rates be set through negotiation rather than tariffing. The method selected and the timing of a FCC decision to lower access charge levels or an FCC decision requiring that competitors’ access rates be set through negotiation rather than tariffing may reduce access charge revenue that we receive from long distance carriers. Although an FCC decision lowering access charges may reduce our access charge revenues, we do not expect that such a reduction would have a material impact on our total revenues or financial position. Regulation of Business Combinations. The FCC, along with the Department of Justice and state commissions, has jurisdiction over business combinations involving telecommunications companies. The FCC has reviewed a number of recent and proposed combinations to determine whether the combination would undermine the market-opening incentives of the Telecom Act by permitting the combined company to expand its operations without opening its local markets to competition or have other anti-competitive effects on the telecommunications and Internet access markets. For example, the FCC conditioned its approval of the recent Ameritech and SBC Communications combination on the parties’ agreement to a series of safeguards intended to neutralize any adverse affect on competitors. In addition, the FCC approved the Qwest and US West combination, subject to Qwest’s divestiture of long distance customers in US West territory. We cannot predict whether these conditions will be effective, nor can we predict whether the FCC will impose similar conditions should it approve future business combinations currently under consideration by the FCC, including the proposed mergers of GTE with Bell Atlantic and MCI WorldCom with Sprint. State Regulation State regulatory commissions retain jurisdiction over our facilities and services to the extent they are used to provide intrastate communications. We expect that we will be subject to direct state regulation in most, if not all, states in which we operate in the future. Many states require certification before a company can provide intrastate communications services. We are certified in all states where we have operations and certification is required. We cannot be sure that we will retain such certifications or that we will receive authorization for markets in which we expect to operate in the future. Most states require us to file tariffs or price lists setting forth the terms, conditions and prices for services that are classified as intrastate. In some states, our tariff can list a range of prices for particular services. In other states, prices can be set on an individual customer basis. We are not subject to price cap or to rate of return regulation in any state in which we currently provide service. Under the regulatory arrangement contemplated by the Telecom Act, state authorities continue to regulate matters related to universal service, public safety and welfare, quality of service and consumer rights. All of these regulations, however, must be competitively neutral and consistent with the Telecom Act, which generally prohibits state regulation that has the effect of prohibiting us from providing telecommunications services in any particular state. State commissions also enforce some of the Telecom Act’s local competition provisions, including those governing the arbitration of interconnection disputes between the incumbent carriers and competitive telephone companies. Local Government Regulation In certain locations, we must obtain local franchises, licenses or other operating rights and street opening and construction permits to install, expand and operate our fiber-optic networks. In some of the areas where we provide network services, our subsidiaries pay license or franchise fees based on a percentage of gross revenues or on a per linear foot basis. Cities that do not currently impose fees might seek to impose them in the future, and after the expiration of existing franchises, fees could increase. Under the Telecom Act, state and local governments retain the right to manage the public rights-of-way and to require fair and reasonable compensation from telecommunications providers, on a competitively neutral and nondiscriminatory basis, for use of public rights-of-way. As noted above, these activities must be consistent with the Telecom Act, and may not have the effect of prohibiting us from providing telecommunications services in any particular local jurisdiction. If an existing franchise or license agreements were terminated prior to its expiration date and we were forced to remove our fiber from the streets or abandon our network in place, our operations in that area would cease, which could have a material adverse effect on our business as a whole. We believe that the provisions of the Telecom Act barring state and local requirements that prohibit or have the effect of prohibiting any entity from providing telecommunications service should be construed to limit any such action. Although none of our existing franchise or license agreements have been terminated, and we have received no threat of such a termination, there can be no assurance that one or more local authorities will not attempt to take such action. Nor is it clear that we would prevail in any judicial or regulatory proceeding to resolve such a dispute. Environmental Regulation Our switch site and customer premise locations are equipped with back-up power sources in the event of an electrical failure. Each of our switch site locations has battery and diesel fuel powered back-up generators, and we use batteries to back-up some of our customer premise equipment. Federal, state and local environmental laws require that we notify certain authorities of the location of hazardous materials and that we implement spill prevention plans. During 1999, we instituted a program, retained environmental consultants, and worked with federal and state environmental regulators to bring us into compliance with these laws and regulations. The cost related to those efforts are not expected to be material. We believe that we currently are in compliance with these requirements in all material respects. Canadian Regulation Wispra Networks, as the provisional winner of fixed broadband wireless spectrum licenses in Canada’s recent spectrum auction, will be subject to regulation by Industry Canada, which regulates wireless licensees, and the Canadian Radio-television and Telecommunications Commission, known as CRTC, which regulates local, interexchange and international telecommunications carriers operating in Canada. To be eligible to hold wireless licenses or to operate as a Canadian competitive local exchange carrier, an entity must be Canadian-owned and controlled and incorporated under the laws of Canada. Although Wispra expects that its applications to hold its wireless licenses and for competitive carrier status ultimately will be approved, it cannot predict whether that approval will be conditioned upon changes to the joint venture between NEXTLINK International and its Canadian partners that are adverse to our interests. Wispra must also secure licenses from the cities in its markets to occupy the municipal rights of way. Wispra has no assurance that these licenses will be granted, or that if they are granted that they are on terms and conditions favorable to Wispra. Like in the United States, incumbent carriers in Canada must provide competitive carriers with interconnection, including collocation in their central offices and access to unbundled network elements. There, however, are significant differences between the Canadian and the United States regulatory structures. In many cases, the Canadian regulations are less favorable for competitive carriers than those applicable in the United States. In addition, Canadian regulation promotes the ownership and control of Canadian telecommunications carriers by Canadians and restricts the voting rights and equity participation of non-Canadian investors like us in ventures like Wispra. Competition The regulatory environment in which we operate is changing rapidly. The passage of the Telecom Act combined with other actions by the FCC and state regulatory authorities continues to promote competition in the provision of telecommunications services. Incumbent Carriers In each market we serve, we face, and expect to continue to face, significant competition from the incumbent carriers, which currently dominate the local telecommunications markets. We compete with the incumbent carriers in our markets for local exchange services on the basis of product offerings, reliability, state-of-the-art technology, price, route diversity, ease of ordering and customer service. However, the incumbent carriers have long-standing relationships with their customers and provide those customers with various transmission and switching services that we, in many cases, do not currently offer. Current competition for telecommunications services is based primarily on quality, capacity and reliability of network facilities, customer service, response to customer needs, service features and price, and is not based on any proprietary technology. Because our fiber optic networks have been recently installed compared to those of the incumbent carriers, our networks’ dual path architectures and state-of-the-art technology may provide us with cost, capacity, and service quality advantages over some existing incumbent carrier networks. Other Competitors We also face, and expect to continue to face, competition for local telecommunications services from other competitors and potential competitors. In addition to the incumbent carriers, competitors and potential competitors offering or capable of offering switched local and long distance services include long distance carriers such as AT&T, MCI WorldCom, Inc. and Sprint Corporation (which has agreed to merge with MCI WorldCom), cable television companies the largest of which have merged or agreed to merge with AT&T and America Online, Inc., electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end users, as well as other new entrants such as Qwest, Level 3, McLeodUSA Incorporated, Winstar Communications, Inc. and Teligent, Inc. We also compete with long distance carriers in the provision of long distance services. Although the long distance market is dominated by three major competitors, AT&T, MCI WorldCom, and Sprint, hundreds of other companies, such as Qwest, also compete in the long distance marketplace. In addition, we will compete with the RBOCs for the provision of long distance service as they receive FCC authority to offer such service. Many of our existing and potential competitors have financial, personnel and other resources, including name recognition, significantly greater than ours. Data Service Competitors Whether or not the Concentric acquisition closes, we will face competition from at least four groups of companies for Internet access and other data services, and the following are examples of the key competitors in these groups: • Telecommunications companies: AT&T, MCI WorldCom, Sprint, Qwest, Level 3 Communications, the incumbent carriers; • Online service providers: America Online, Inc., CompuServe Corporation, MSN, the Microsoft Network, Prodigy Communications Corporation; • Internet service providers: BBN Corporation, a subsidiary of GTE, EarthLink Network, Inc., MindSpring Enterprises, Inc., PSINet Inc., Verio Inc., other national and regional providers; and • Web hosting providers: AboveNet Communications, Exodus Communications. Additional groups of competitors include cable companies and DSL providers, including Covad Communications Group, Inc. and Rhythms Netconnections, Inc. Many of these competitors have greater market presence, engineering and marketing capabilities, and financial, technological and personnel resources than those available to us, even if the Concentric acquisition closes. Other Business Competitors Our enhanced communications service offerings are also subject to competition. For example, there are several competitors that offer interactive voice response services similar to those offered by NEXTLINK Interactive, such as Call Interactive and West Teleservices Corporation, which we believe focus their sales efforts on large volume interactive voice response service users. Additionally, many of the long distance competitors discussed above have their own enhanced services products that compete with those offered by NEXTLINK Interactive. Our shared tenant services business competes with a number of companies offering similar services, including Allied Riser Communications Corporation, OnSite Access and Cypress Communications. Employees As of December 31, 1999, we employed approximately 3,500 people, including full-time and part-time employees. We consider our employee relations to be good. None of our employees is covered by a collective bargaining agreement. Risk Factors Risks Related to Liquidity and Financial Resources We have a history of increasing net losses and negative cash flow from operations and may not be able to satisfy our cash needs from operations For each period since inception, we have incurred substantial and increasing net losses and negative cash flow from operations. For 1999, we posted a net loss attributable to common stockholders of approximately $627.9 million and showed negative cash flow from operations of approximately $358.9 million. Our accumulated deficit was approximately $1,217.5 million at December 31, 1999. We expect that losses and negative cash flow from operations will continue over the next several years. Our existing operations do not currently, and are not expected to in the near future to, generate cash flows from which we can make interest payments on our outstanding notes, make dividend payments on our outstanding preferred stock or fund continuing operations and planned capital expenditures. We cannot know when, if ever, net cash generated by our internal business operations will support our growth and continued operations. If we are unable to generate cash flow in the future sufficient to cover our fixed charges and are unable to raise sufficient funds from other sources, we may be required to: • refinance all or a portion of our existing debt and redeemable preferred stock; or • sell all or a portion of our assets. We have substantial existing debt and we will incur substantial additional debt As of December 31, 1999, we had outstanding nine issues of senior notes totaling $3,733.3 million in principal amount, approximately $4.1 million in miscellaneous debt obligations of our subsidiaries, and two series of redeemable preferred stock. These preferred stock series include 8,324,796 shares of 14% exchangeable preferred stock, with a liquidation preference of $50 per share, and 4,000,000 shares of 6 1/2% cumulative convertible preferred stock, with a liquidation preference of $50 per share. Since December 31, 1999, we have obtained a $1,000.0 million credit facility, of which $375.0 million has been drawn, and have issued two additional series of preferred stock in connection with the Forstmann Little investment. These preferred stock issuances included 584,375 shares of Series C cumulative convertible participating preferred stock and 265,625 shares of Series D convertible participating preferred stock, both with a liquidation preference of $1,000 per share. At December 31, 1999 Concentric’s total liabilities (including current portion) was $214.8 million, including its 12 3/4% Senior Notes due 2007, which has an aggregate principal amount of $150.0 million. Concentric also has outstanding 187,205 shares of preferred stock with dividends which accrue at the rate of 13 1/2% per year which, prior to June 1, 2003, are payable in additional shares of preferred stock at Concentric’s option, and which are redeemable at $1,000 per share, and 50,000 shares of preferred stock with dividends which accrue at the rate of 7% per year, redeemable at $1,000 per share. The indentures under which our notes have been issued, and our credit facility, permit us to incur substantial additional debt. We fully expect to draw down the remaining $625 million available under our credit facility and borrow substantial additional funds in the next several years. This additional indebtedness, together with any indebtedness we assume in connection with the Concentric acquisition, will further increase the risk of a default unless we can establish an adequate revenue base and generate sufficient cash flow to repay our indebtedness. We cannot assure you that we will ever establish an adequate revenue base to produce an operating profit or generate adequate positive cash flow to provide future capital expenditures and repayment of debt. We do not have sufficient additional financing commitments to meet our long term needs and, if we are not successful in raising additional capital, we will not be able to build and maintain our business Building our business will require substantial additional capital spending. Our capital spending plans have increased substantially over time, as our strategy has evolved and our planned networks have grown larger and more robust. We will need to raise additional capital because our anticipated future capital requirements exceed the $1,881.8 million in cash and marketable securities we had on hand as of December 31, 1999, the $850.0 million that we received in January 2000 in connection with the Forstmann Little investment, the $375.0 million that we received in February 2000 in connection with our credit facility, and the $625.0 million currently available under our credit facility, our only current commitment for additional financing. If we fail to raise sufficient capital, we may be required to delay or abandon some of our planned future expansion or expenditures, which could have a material adverse effect on our growth and our ability to compete in the telecommunications services industry and generate profits for stockholders, and could even result in a payment default on our existing debt. Under the terms of the indenture governing Concentric’s 12 3/4% Senior Notes due 2007, and the terms of its 13 1/2% Series B Senior Redeemable Exchangeable Preferred Stock, upon completion of the Concentric acquisition we will be required to offer to repurchase those outstanding senior notes and shares of preferred stock at a purchase price equal to 101% of the principal amount of the senior notes and 101% of the liquidation preference of the shares of the preferred stock. As of December 31, 1999, the total principal amount of the senior notes and the liquidation preference of the shares of preferred stock outstanding was approximately $338.7 million. If we were required to utilize available cash to fund repurchase of all or a significant amount of Concentric’s senior notes and preferred stock, it would reduce the amount of funds available to implement our business plan. The covenants in our indentures and credit facility restrict our financial and operational flexibility, which could have an adverse affect on our results of operations The indentures under which our senior notes have been issued and our credit facility contains covenants that restrict, among other things, our ability to borrow money, make particular types of investments or other restricted payments, sell assets or merge or consolidate. Our credit facility also requires us to maintain specified financial ratios. If we fail to comply with these covenants or meet these financial ratios, the noteholders or the lenders under our credit facility could declare a default and demand immediate repayment. Unless we cure any such default, they could seek a judgment and attempt to seize our assets to satisfy the debt to them. The security for our credit facility consists of all of the assets purchased with the proceeds thereof, the stock of certain of our direct subsidiaries, all assets of NEXTLINK and, to the extent of $125 million of guaranteed debt, all assets of certain of our subsidiaries. In addition, a default under any of these obligations could adversely affect our rights under other commercial agreements. Our existing debt obligations and outstanding redeemable preferred stock also could affect our financial and operational flexibility, as follows: • they may impair our ability to obtain additional financing in the future; • they will require that a substantial portion of our cash flow from operations and financing activities be dedicated to the payment of interest on debt and dividends on preferred stock, which will reduce the funds available for other purposes; • they may limit our flexibility in planning for or reacting to changes in market conditions; and • they may cause us to be more vulnerable in the event of a downturn in our business. Risks Related to Network Development If we cannot quickly and efficiently install our hardware, we will be unable to generate revenue Each of our networks consists of many different pieces of hardware, including switches, routers, fiber optic cables, electronics and combination radio transmitter/receivers, known as transceivers, and associated equipment, which are difficult to install. If we cannot install this hardware quickly, the time in which customers can be connected to our network and we can begin to generate revenue from our network will be delayed. You should be aware that the construction of our national fiber optic network is not under our control, but is under the control of Level 3 Communications. If Level 3 fails to complete its network on time or if it fails to perform as specified, our strategy of linking our local networks to one another and creating an end-to-end national network will be delayed. IP technology has not yet been perfected for full service networks like ours We plan to rely on IP technology as the basis for our planned end-to-end network. Although IP technology is used throughout the Internet, its extension to support other telecommunications applications, such as voice and video, has not yet been perfected, and IP technology currently has several deficiencies, including poor reliability and quality. Integrating these technologies into our network may prove difficult and may be subject to delays. We cannot assure you that these improvements will become available in a timely fashion or at reasonable cost, if at all, or that the technology choices we make will prove to be cost effective and correct. We may not be able to connect our network to the incumbent carrier’s network or obtain Internet peering arrangements on favorable terms We require interconnection agreements with the incumbent carrier to connect our customers to the public telephone network. We cannot assure you that we will be able to negotiate or renegotiate interconnection agreements in all of our markets on favorable terms. If we fail to consummate the Concentric merger for any reason, we will require peering arrangements with other ISPs, particularly the large, national ISPs, to implement our planned expansion of data services including Internet access services. Peering arrangements are agreements among Internet backbone providers to exchange data traffic. Depending on the relative size of the carriers involved, these exchanges may be made without settlement charge. Although we anticipate that we would be able to enter into the agreements necessary to become an ISP, the terms and conditions of these peering agreements are becoming more restrictive as Internet service becomes increasingly commercialized, and we cannot be sure that these peering arrangements would be on favorable terms. Physical space limitations in office buildings and landlord demands for fees or revenue sharing could limit our ability to connect customers directly to our networks and reduce our operating margins Connecting a customer who is a tenant in an office building directly to our network requires installation of in-building cabling through the building’s risers from the customer’s office to our fiber in the street or our antenna on the roof. In some office buildings, particularly the premier buildings in the largest markets, the risers are already close to their maximum physical capacity due to the entry of other competitive carriers into the market. Moreover, the owners of these buildings are increasingly requiring competitive telecommunications service providers like NEXTLINK to pay fees or otherwise share revenue as a condition of access. We have not been required to pay these fees in the smaller markets we have served in the past, but may be required to do so to penetrate larger markets, which would reduce our operating margins. In addition, some major office building owners have equity interests in, or joint ventures with, companies offering broadband communications services over fiber optic networks and may have an incentive to encourage their tenants to choose those companies’ services over ours or to grant those companies more favorable terms for installation of in-building cabling. Our deployment of wireless first mile connections could be delayed by a lack of acceptable equipment and by installation risks Our LMDS broadband wireless spectrum is a newly-authorized service, and equipment vendors are only beginning to offer radios, transceivers and related equipment designed to work at these frequencies. Recently completed field testing revealed that improvements in the price, features and functionality of the point-to-multi-point equipment must be made before we undertake a broader commercial launch of services using this technology. Although our vendors have advised us that these improvements will be incorporated in their second generation equipment, this equipment is still in development. We cannot be certain that commercial quantities of equipment meeting our standards will be available in time to meet our development schedule. LMDS direct connections require us to obtain access to rooftops from building owners and to satisfy local construction and zoning rules for antennas and transmitters. The need to obtain these authorizations could be an additional source of cost and delay. We cannot accurately predict the total cost of our wireless first mile deployment Although we have selected one vendor from which we will purchase LMDS equipment, because our fixed wireless deployment strategy contemplates utilizing a number of equipment vendors, we do not know precisely how much the equipment we will need will cost. Installation costs are expected to vary greatly, depending on the particular characteristics of the locations to be served. After initial installation, we expect to incur additional costs to reconfigure, redeploy and upgrade our wireless direct connections as technologies improve. It is expensive and difficult to switch new customers to our network, and provisioning bottlenecks with the incumbent carrier can slow the new customer connection process It is expensive and difficult for us to switch a new customer to our network because: • a potential customer faces switching costs if it decides to become our customer, and • we require cooperation from the incumbent carrier in instances where there is no direct connection between the customer and our network. Our principal competitors, the incumbent carriers, are already established providers of local telephone services to all or virtually all telephone subscribers within their respective service areas. Their physical connections from their premises to those of their customers are expensive and difficult to duplicate. To complete the new customer provisioning process, we rely on the incumbent carrier to process certain information. The incumbent carriers have a financial interest in retaining their customers, which could reduce their willingness to cooperate with our new customer provisioning requests. If we lose key personnel and qualified technical staff, our ability to manage the day-to-day aspects of our complex network will be weakened We believe that a critical component for our success will be the attraction and retention of qualified professional and technical personnel. There is intense competition for qualified personnel in our business with the technical and other skill sets that we seek. The loss of the services of our senior executive management team or other key personnel, or the inability to attract additional qualified personnel, could cause us to make less successful strategic decisions, which could hinder the introduction of new services or the entry into new markets. We could also be less prepared for technological or marketing problems, which could reduce our ability to serve our customers and lower the quality of our services. We may not be able to attract, develop, motivate and retain experienced and innovative personnel. In addition, we must also develop and retain a large and sophisticated sales force, particularly in connection with our plan to target larger national customers. If we fail to do so, there will be an adverse effect on our ability to generate revenue and, consequently, our operating cash flow. Risks Related to Competition and Our Industry We face competition in local markets from other carriers, putting downward pressure on prices We face competition in each of our markets principally with the incumbent carrier in that market, but also from recent and potential market entrants, including long distance carriers seeking to enter, reenter or expand entry into the local exchange marketplace, such as AT&T, MCI WorldCom and Sprint (which has agreed to merge with MCI WorldCom). This competition places downward pressure on prices for local telephone service and data services, which can adversely affect our operating results. In addition, we expect competition from other companies, such as cable television companies, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end-users. We cannot assure you that we will be able to compete effectively with these industry participants. We face competition in long distance markets, putting downward pressure on prices We also face intense competition from long distance carriers in the provision of long distance services, which places downward pressure on prices for long distance services, including both voice and data services, and makes it difficult for us to achieve positive operating cash flow. Although the long distance market is dominated by three major competitors, AT&T, MCI WorldCom and Sprint (which has agreed to merge with MCI WorldCom), hundreds of other companies, such as Qwest, also compete in the long distance marketplace. We also anticipate that the incumbent carriers will be competing in the long distance market in the near future. We cannot assure you that we will be able to effectively compete with any of these industry participants. We face competition in creating a national broadband network Several of our competitors, such as AT&T, MCI WorldCom, Qwest, Level 3, IXC and Williams, are creating end-to-end broadband networks that would compete directly with the network we are building. In addition, other competitors have the ability to do so as well. We cannot assure you that we will be able to successfully compete with these service providers. We face competition for data services Competitors for data services consist of online service providers, Internet service providers and Web hosting providers. New competitors continue to enter this market and include large computer hardware, software, media and other technology and telecommunications companies, including the incumbent carriers. Certain telecommunications companies and online services providers are currently offering or have announced plans to offer Internet or online services or to expand their network services. Certain companies, including America Online, BBN, PSINet and Verio, have also obtained or expanded their Internet access products and services. Many of these competitors have superior resources, which may place us at a cost and price disadvantage Many of our current and potential competitors have market presence, engineering, technical and marketing capabilities and financial, personnel and other resources substantially greater than those of NEXTLINK. As a result, some of our competitors can raise capital at a lower cost than we can, and they may be able to develop and expand their communications and network infrastructures more quickly, adapt more swiftly to new or emerging technologies and changes in customer requirements, take advantage of acquisition and other opportunities more readily, and devote greater resources to the marketing and sale of their products and services than we can. Also, our competitors’ greater brand name recognition may require us to price our services at lower levels in order to win business. Finally, our competitors’ cost advantages give them the ability to reduce their prices for an extended period of time if they so choose. The technologies we use may become obsolete, which would limit our ability to compete effectively The telecommunications industry is subject to rapid and significant changes in technology. If we do not replace or upgrade technology and equipment that becomes obsolete, we will be unable to compete effectively because we will not be able to meet the expectations of our customers. The following technologies and equipment that we use or will use are subject to obsolescence: wireline and wireless transmission technologies, circuit and packet switching technologies, multiplexing technologies and data transmission technologies, including the DSL, ATM and IP technologies. In addition, we cannot assure you that the technologies in which we choose to invest will lead to successful implementation of our business plan. Additionally, the markets for data and Internet-related services are characterized by rapidly changing technology, evolving industry standards, changes in customer needs, emerging competition and frequent new product and service introductions. The future success of our data services business will depend, in part, on our ability to accomplish the following in a timely and cost-effective manner: • effectively use leading technologies; • continue to develop technical expertise; • enhance current networking services; • develop new services that meet changing customer needs; and • influence and respond to emerging industry standards and other technological changes. Our pursuit of necessary technological advances may require substantial time and expense. We may be required to pay patent licensing fees, which will divert funds which could be used for other purposes From time to time, we receive requests to consider licensing certain patents held by third parties that may have bearing on our interactive voice response, other enhanced, or data services. Should we be required to pay license fees in the future, such payments, if substantial, could have a material adverse effect on our results of operations. Our company and industry are highly regulated, imposing substantial compliance costs and restricting our ability to compete in our target markets We are subject to varying degrees of federal, state and local regulation. This regulation imposes substantial compliance costs on us. It also restricts our ability to compete. For example, in each state in which we desire to offer our services, we are required to obtain authorization from the appropriate state commission. We cannot assure you that we will receive authorization for markets or services to be launched in the future. For further discussion regarding regulatory matters and risks related thereto, see “Business - Regulatory Overview”. The requirement that we obtain permits and rights-of-way increases our cost of doing business In order for us to acquire and develop our fiber networks, we must obtain local franchises and other permits, as well as rights-of-way and fiber capacity from entities such as incumbent carriers and other utilities, railroads, long distance companies, state highway authorities, local governments and transit authorities. You should be aware that the process of obtaining these permits and rights-of-way increases our cost of doing business. We cannot assure you that we will be able to maintain our existing franchises, permits and rights-of-way that we need to implement our business. Nor can we assure you that we will be able to obtain and maintain the other franchises, permits and rights that we require. A sustained and material failure to obtain or maintain these rights could materially adversely affect our business in the affected metropolitan area. Risks Related to Growth, Development of Data Services and the Concentric Acquisition Continued rapid growth of our network, services and subscribers could be slowed if we cannot manage this growth We have rapidly expanded and developed our network, services and subscribers, and expect to continue to do so. This has placed and will continue to place significant demands on our management, operational and financial systems and procedures and controls. We may not be able to manage our anticipated growth effectively, which would harm our business, results of operations and financial condition. Further expansion and development will depend on a number of factors, including: • technological developments; • our ability to hire, train and retain qualified personnel in a competitive labor market; • availability of rights-of-way, building access and antenna sites; • development of customer billing, order processing and network management systems that are capable of serving our growing customer base; • cooperation of the existing local telephone companies; • regulatory and governmental developments; and • existence of strategic alliances or relationships. We will need to continue to improve our operational and financial systems and our procedures and controls as we grow. We must also develop, train and manage our employees. Our ability to succeed in the data services market is uncertain Our ability to succeed in the data services market depends to a large extent on our ability to build a tailored, value-added network services business. Our ability to do so is subject to the following risks: • the data services markets are relatively new, and current and future competitors are likely to introduce competing services or products which may result in market saturation; • certain critical issues concerning commercial use of tailored, value-added services and Internet services, including, among others, security, reliability, ease and cost of access, and quality of service, remain unresolved and may impact the growth of such services; • the market for data services may fail to grow or grow more slowly than anticipated; • reliability, quality or compatibility problems with new enterprise service offerings which we may introduce could significantly delay or hinder market acceptance and could divert technical and other resources; • our inability to obtain sufficient quantities of sole- or limited-source components required to provide data services or to develop alternative sources, if required, could result in delays and increased costs in expanding, and overburdening of, our network infrastructure; • suppliers may not provide us with products or components that comply with Internet standards or that inter-operate with other products or components used in our network infrastructure; • capacity constraints that adversely affect the system performance if demand for data services were to increase faster than projected or were to exceed current forecasts; • our ability to respond to changing customer requirements or evolving industry trends; • the failure of any link in the delivery chain, including the networks with which we may establish public or private peering arrangements or private transit; • the market for tailored value-added network services is extremely competitive, and we expect that competition will intensify in the future; • increased price and other competition due to Internet industry consolidation; • interruptions in service due to a natural disaster, such as an earthquake, or other unanticipated problem; and • liability for information disseminated through our network. If the Concentric acquisition closes, we could face these risks sooner, and the magnitude of such risks could be greater, than if we fully implemented our data services strategy organically. The Concentric acquisition remains subject to Concentric stockholder approval and other conditions If Concentric stockholders fail to approve our proposed acquisition, or if that transaction fails to close for any other reason, our data strategy will likely take longer than if we combined with Concentric and our entry into the data services and web hosting business will be delayed. As a consequence, our business will not expand as rapidly in this significant, rapidly growing area of the telecommunications market. If the Concentric acquisition closes we will face challenges integrating our business with theirs, and difficulties in the integration process may prevent the benefits of the merger from being realized The Concentric acquisition will be the largest acquisition we have made to date. As a result of the differing nature of Concentric’s and NEXTLINK’s operations, it may be difficult to quickly integrate the products, services, technologies, research and development activities, administration, sales and marketing and other operations of the two companies. Integration difficulties may disrupt the combined company’s business and could prevent the achievement of the potential benefits of the merger. The difficulties, costs and delays involved in integrating Concentric and NEXTLINK, which could be substantial, may include: • Distracting management and other key personnel, particularly sales and marketing personnel and senior engineers involved in network deployment, from the business of the combined company; • Failure to integrate complex technology, product lines and development plans and the difficulty of maintaining uniform standards, controls, procedures and policies; • Potential incompatibility of business cultures; • Costs and delays in implementing common systems and procedures, particularly in integrating different information systems; • Inability to retain and integrate key management, technical, sales and customer support personnel; • Disruptions in the combined sales forces that may result in a loss of current customers or the inability to close sales with potential customers; • The additional financial resources that may be needed to fund combined operations; • Incorporating acquired technology or businesses into service offerings to maximize the combined company’s financial and strategic position; and • Impairment of relationships with employees and customers as a result of changes in management. If we cannot quickly and efficiently integrate Concentric’s personnel, products and services with our own following the closing, we will not enjoy the full benefits we anticipate from the transaction. Concentric officers and employees have valuable knowledge of the data services and web hosting business that would be difficult to replace if we do not retain the services of a substantial portion of them. We face risks associated with international expansion We have begun to expand into Canadian markets, and through the Concentric acquisition we would acquire a subsidiary in the United Kingdom. We may in the future expand into other international markets, either through acquisition of businesses or assets, organic development, or a combination thereof. The following risks are inherent in doing business on an international level: • unexpected changes in regulatory requirements; • export restrictions; • export controls relating to encryption technology; • tariffs and other trade barriers; • difficulties in staffing and managing foreign operations; • longer payment cycles; • problems in collecting accounts receivable; • political instability; • fluctuations in currency exchange rates; • seasonal reductions in business activity during the summer months in Europe and certain other parts of the world; and • potentially adverse tax consequences that could adversely impact the success of our international operations. We cannot assure you that one or more of such factors will not have a material adverse effect on our future international operations. Other Risks Craig O. McCaw, who controls approximately 55% of the voting power of NEXTLINK, may have interests which are adverse to your interests Craig O. McCaw, primarily through his majority ownership and control of Eagle River Investments, L.L.C., currently controls approximately 55% of NEXTLINK’s total voting power, and holds proxies that are likely to continue to assure that Mr. McCaw will hold a majority of that voting power. Because Mr. McCaw has the ability to control the direction and future operations of NEXTLINK and has interests in other companies that may compete with NEXTLINK, he may make decisions which are adverse to your interests and the interests of other NEXTLINK security holders. Mr. McCaw effectively controls a decision whether a change of control of NEXTLINK will occur. Moreover, Delaware corporate law could make it more difficult for a third party to acquire control of us, even if a change of control could be beneficial to you. We do not plan on paying any dividends on our common stock We do not anticipate paying any dividends for the foreseeable future. Our credit facility and the indentures governing our senior notes restrict our ability to pay cash dividends. Forward-Looking Statements Our forward-looking statements are subject to a variety of factors that could cause actual results to differ significantly from current beliefs Some statements and information contained in this report are not historical facts, but are “forward-looking statements”, as such term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “plans,” “may,” “will,” “would,” “could,” “should,” or “anticipates” or the negative of these words or other variations of these words or other comparable words, or by discussions of strategy that involve risks and uncertainties. Such forward-looking statements include, but are not limited to, statements regarding: • market development, the number of markets we expect to serve, and the expected number of addressable business lines in such markets; • network development, including those with respect to IP and ATM network and facilities development and deployment, broadband fixed wireless technology, testing and installation, high speed technologies such as DSL, and matters relevant to our national network; • liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness; and • statements with respect to the Concentric acquisition and its effects. All such forward-looking statements are qualified by the inherent risks and uncertainties surrounding expectations generally, and also may materially differ from our actual experience involving any one or more of these matters and subject areas. The operation and results of our business also may be subject to the effect of other risks and uncertainties in addition to the relevant qualifying factors identified in the above “Risk Factors” section and elsewhere in this report, including, but not limited to: • general economic conditions in the geographic areas that we are targeting for communications services; • the ability to achieve and maintain market penetration and average per access line revenue levels sufficient to provide financial viability to our business; • access to sufficient debt or equity capital to meet our operating and financing needs; • the quality and price of similar or comparable communications services offered or to be offered by our competitors; and • future telecommunications-related legislation or regulatory actions. NEXTLINK Capital, Inc. NEXTLINK Capital, Inc. is a Washington corporation and a wholly-owned subsidiary of NEXTLINK Communications. NEXTLINK Capital was formed for the sole purpose of obtaining financing from external sources when NEXTLINK Communications was a limited liability company. It is a joint obligor with NEXTLINK Communications on the 12 1/2% Senior Notes due 2006. NEXTLINK Capital has had no operations to date. Item 2. Item 2. Properties We own or lease, in our operating territories, telephone property which includes: fiber optic backbone and distribution network facilities; point-to-point distribution capacity; central office switching equipment; connecting lines between customers’ premises and the central offices; and customer premise equipment. Our central office switching equipment includes electronic switches and peripheral equipment. The fiber optic backbone and distribution network and connecting lines include aerial and underground cable, conduit, and poles and wires. These facilities are located on public streets and highways or on privately-owned land. We have permission to use these lands pursuant to consent or lease, permit, easement, or other agreements. We, and our subsidiaries, lease facilities for our and their administrative and sales offices, central switching offices network nodes and warehouse space. The various leases expire in years ranging from 2000 to 2008. Most have renewal options. We recently relocated our headquarters to McLean, Virginia, where we are currently leasing 9,500 square feet of office space on an interim basis. We have entered into a lease for approximately 212,000 square feet of space located in Reston, Virginia, which will serve as our permanent headquarters beginning in the third quarter of 2000. We still maintain some operation in the 45,000 square feet in Bellevue, Washington, leased for our former headquarters. Additional office space and equipment rooms will be leased as the Company’s operations and networks are expanded and as new networks are constructed. Item 3. Item 3. Legal Proceedings We are not currently a party to any legal proceedings, other than regulatory and other proceedings that are in the normal course of its business. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the quarter ended December 31, 1999. Effective October 19, 1999, our Board of Directors approved amendments to the NEXTLINK Communications, Inc. Stock Option Plan to authorize an additional 5,000,000 shares of our Class A common stock to be issued under the plan, increasing the maximum number of shares authorized for issuance under the plan to 41,000,000, adjusted for NEXTLINK’s 100% stock dividend paid in August 1999. The amendment also provided that the maximum number of shares of Class A stock with respect to which options may be granted to any individual in any calendar year is limited to the maximum number of shares authorized under the plan. These amendments also were approved by one of our stockholders, Eagle River, which, as of October 19, 1999, held 37,743,574 shares of our Class B common stock, representing shares with a majority of the total number of votes attributable to all shares of outstanding common stock. Our common stock is the only outstanding class of capital stock of NEXTLINK entitled to vote on this matter. Eagle River approved the Board’s action by a written consent in lieu of stockholder meetings dated October 19, 1999, pursuant to Section 228(a) of the Delaware General Corporation Law. Because we are a corporation organized under the laws of the State of Delaware, our stockholders may take action by written consent without a meeting. The Board did not solicit any proxies or consents from any other stockholders in connection with this action. The amendments became effective on or about December 12, 1999, 20 days after the date on which we mailed the information statement to stockholders of NEXTLINK in accordance with rules of the Securities and Exchange Commission. Executive Officers of the Registrant The following table sets forth the names, ages and positions of NEXTLINK’s executive officers. Their respective backgrounds are described following the table. Name Age Title Daniel F. Akerson Chairman, Chief Executive Officer Nathaniel A. Davis President and Chief Operating Officer Steven W. Hooper Executive Vice President Wayne M. Perry Executive Vice President Gary D. Begeman Senior Vice President, General Counsel and Secretary Doug L. Carter Senior Vice President, Chief Technology Officer Nancy B. Gofus Senior Vice President, Chief Marketing Officer Mark S. Gunning Senior Vice President, Chief Financial Officer Charles W. Sackley Senior Vice President, National Accounts Sales and Marketing R. Gerard Salemme Senior Vice President, Regulatory and Legislative Affairs Scott G. Macleod Vice President, Chief Corporate Development Officer Dennis O’Connell President, North Region Michael Ruley President, West Region Daniel F. Akerson. Mr. Akerson has served as our Chairman of the Board of Directors and Chief Executive Officer since joining NEXTLINK in September 1999. Since March 1996, he has been the Chairman of the Board of Directors of Nextel Communications, Inc. From March 1996 to July 1999, he was Chief Executive Officer of Nextel. From 1993 until March 1996, Mr. Akerson served as a general partner of Forstmann Little & Co., a private investment firm. While serving as a general partner of Forstmann Little, Mr. Akerson also held the positions of Chairman of the Board and Chief Executive Officer of General Instrument Corporation, a technology company acquired by Forstmann Little. From 1983 to 1993, Mr. Akerson held various senior management positions with MCI Communications Corporation, including president and chief operating officer. In addition, Mr. Akerson is a member of Eagle River and he currently serves as a director of the American Express Company, America OnLine, Inc., and Nextel International, Inc., a substantially wholly owned subsidiary of Nextel. Nathaniel A. Davis. Mr. Davis has served as our President and Chief Operating Officer since joining NEXTLINK in January 2000. In February 2000, he was elected to serve on our Board of Directors. From October 1998 to January 2000, Mr. Davis served as Vice President of Technical Services for Nextel. From November 1996 to September 1998, Mr. Davis was Chief Financial Officer of U.S. Operations at MCI. From January 1994 to October 1996, he was Chief Operating Officer of MCImetro, a subsidiary of MCI. From July 1992 to December 1993, Mr. Davis was Senior Vice President of Access Services for MCI. Mr. Davis currently serves as a director of Mutual of America Capital Management Corporation and XM Satellite Radio, Inc. Steven W. Hooper. Mr. Hooper has been an Executive Vice President of NEXTLINK since February 2000. From September 1999 to February 2000, he was our Vice Chairman - Strategic Development and served as a member of our Board of Directors. From March 1999 to September 1999, Mr. Hooper was our Chief Executive Officer. From July 1997 to September 1999, he was our Chairman of the Board of Directors. From January 1998 to July 1999, he was Co-Chief Executive Officer with Craig O. McCaw of Teledesic Corporation, a satellite telecommunications company. From January 1995 to June 1997, Mr. Hooper was President and Chief Executive Officer of AT&T Wireless Services, Inc. From January 1993 to January 1995, he served as Chief Financial Officer of AT&T Wireless Services. Wayne M. Perry. Mr. Perry has been an Executive Vice President of NEXTLINK since February 2000. From June 1997 to February 2000, he was a Vice Chairman of NEXTLINK. From July 1997 to March 1999, Mr. Perry was Chief Executive Officer of NEXTLINK. From September 1994 to July 1997, he was a Vice Chairman of AT&T Wireless Services, Inc. From December 1985 to June 1989, served as President McCaw Cellular and, from June 1989 to September 1994, he served as Vice Chairman of the Board of McCaw Cellular. Gary D. Begeman. Mr. Begeman has served as our Senior Vice President, General Counsel and Secretary since November 1999. From May 1997 to November 1999, he was Deputy General Counsel of Nextel, and from August 1999 to November 1999, he also was a Vice President of Nextel. From January 1992 to May 1997, Mr. Begeman was a partner of the law firm Jones, Day, Reavis & Pogue, specializing in corporate and securities law and mergers and acquisitions. Doug L. Carter. Mr. Carter has served as our Senior Vice President, Chief Technology Officer since May 1999. From July 1998 to May 1999, he was our Senior Vice President, Technology. From February 1998 to November 1998, Mr. Carter also was the Vice President, Technology of Teledesic. From June 1996 to January 1998, he was Senior Vice President, Network Operations of AT&T Wireless Services and from June 1995 to May 1996, he was AT&T Wireless’ Vice President, Network Operations. From January 1987 to May 1995, Mr. Carter was Director, Technology of McCaw Cellular. Nancy B. Gofus. Ms. Gofus has served as our Senior Vice President, Chief Marketing Officer since January 2000. From March 1999 to December 1999, she was the Chief Operating Officer of Concert Management Services, Inc., which previously was a wholly-owned subsidiary of British Telecom and is a global provider of managed telecommunications services. From March 1995 to March 1998, Ms. Gofus was Concert’s Senior Vice President of Marketing. Mark S. Gunning. Mr. Gunning has served as our Senior Vice President, Chief Financial Officer since March 2000. From August 1996 to November 1999, he was Chief Financial Officer of Primco Personal Communications, a wireless telecommunications company. From March 1988 to November 1999, Mr. Gunning held various positions in finance with Airtouch Communications, a wireless telecommunications company, which owned 50% of Primco, including Vice President from 1996 to 1999. Charles W. Sackley. Mr. Sackley has served as our Senior Vice President, National Accounts Sales and Marketing since February 2000. From May 1999 to February 2000, he was Senior Vice President, Sales and Marketing for Wireless Facilities, Inc. and, from February 1998 to May 1999, he was Wireless Facilities’ Vice President, Sales and Business Development. From May 1997 to January 1998, Mr. Sackley was Executive Director of Marketing - Americas for Broadband Networks, Inc. From 1995 to 1997, he was Senior Director - Intelligent Network Operations of the Cellular Infrastructure Group of Motorola Inc. and, from 1993 to 1995, he was the Cellular Infrastructure Group’s Director - Switching and Intelligent Network Operations. R. Gerard Salemme. Mr. Salemme has served as our Senior Vice President, Regulatory and Legislative Affairs since January 2000. From March 1998 to January 2000, he served as our Senior Vice President, External Affairs and Industry Relations. From July 1997 to March 1998, he was our Vice President, External Affairs and Industry Relations. From December 1994 to July 1997, Mr. Salemme was Vice President, Government Affairs at AT&T Corp. From 1991 to 1994, Mr. Salemme was Senior Vice President, External Affairs at McCaw Cellular. Scott G. Macleod. Mr. Macleod has been our Vice President, Chief Corporate Development Officer since May, 1999. From January 1992 to May 1999, he was an investment banker with Merrill Lynch & Co., in its telecommunications group. While Mr. Macleod was with Merrill Lynch, he was a Vice President from 1993 to 1995, a director in 1996, and a managing director from 1997 to May 1999. Dennis O’Connell. Mr. O’Connell has been our President, North Region since January 2000. From April 1998 to January 2000, he was the President of our Northeast Region and, from June 1999 to January 2000, he was also our President, North American Operations. From June 1995 to March 1998, Mr. O’Connell was President of the Northeast Region for AT&T Wireless. From January 1992 to May 1995, Mr. O’Connell was the New York Vice President of Operations for AT&T Wireless. Michael S. Ruley. Mr. Ruley has been our President, West Region since June 1999. From April 1998 to June 1999, he was the President of our Southwest Region. Mr. Ruley has over 15 years of experience in the telecommunications field. From June 1996 to April 1998, Mr. Ruley held various positions at TCG, including Regional Vice President of the Pacific Bell Territory and Vice President and General Manager of both the San Francisco and Colorado markets. From March 1993 to June 1996, Mr. Ruley was the Director of New Business Development for BPI Communications, a Colorado based telecommunications and technology company. Mr. Ruley has also managed District Sales for Librex Computer Express in Colorado; and was Vice-President of Sales and Marketing for Integrated Management Systems of Denver, Colorado. PART II Item 5. Item 5. Market for Registrants’ Common Stock and Related Stockholder Matters Market Information NEXTLINK’s Class A common stock is traded on the NASDAQ National Market under the symbol “NXLK”. The following table shows, for the periods indicated, the high and low bid prices for our Class A common stock as reported by the NASDAQ National Market tier of The NASDAQ Stock Market. The prices below have been adjusted for the two-for-one stock split effected August 27, 1999. There is no public trading market for our Class B common stock or NEXTLINK Capital’s common equity. NEXTLINK Capital is a wholly owned subsidiary of ours, formed for the sole purpose of obtaining financing from external sources. As of March 15, 2000, the approximate number of shareholders of our Class A and Class B common stock was approximately 44,000 and nine, respectively. NEXTLINK is the sole holder of record of NEXTLINK Capital’s common stock. Use of Proceeds The initial public offering (IPO) of our Class A common stock took place in October 1997 (File No. 333-32001). The net proceeds we received from the offering totaled approximately $226.8 million. As of December 31, 1999, proceeds from the IPO remain available for future network build out and working capital requirements. We have raised additional funding from debt and additional equity offerings in 1998 and 1999. The proceeds from these recent offerings have been applied first in funding the expansion of our network and other working capital requirements. Dividends Neither we nor NEXTLINK Capital have declared a cash dividend on any of our respective common stock. Covenants in our credit facility and the indentures pursuant to which our and NEXTLINK Capital’s Senior Notes have been issued restrict our ability to pay cash dividends on our capital stock. Sales of Unregistered Securities On November 17, 1999, we completed the issuance and sale in a private placement transaction of $400.0 million of 10 1/2% Senior Notes due 2009 and $455.0 million in principal amount at stated maturity of 12 1/8% Senior Discount Notes due 2009. The Senior Notes were sold at 100% of their principal amount, yielding $400.0 million in gross proceeds. The Senior Discount Notes were sold at 55.257% of their principal amount at maturity, yielding gross proceeds of approximately $251.4 million. Goldman, Sachs & Co., Salomon Smith Barney Inc., Credit Suisse First Boston Corporation, TD Securities (USA) Inc., Barclays Capital Inc., Chase Securities Inc., Banc of America Securities LLC, BancBoston Robertson Stephens Inc., Deutsche Bank Securities Inc., J.P. Morgan Securities Inc. and PNC Capital Markets, Inc. acted as initial purchasers and received approximately $11.6 million in fees in connection with the sale of the notes. The offer and sale of the notes was exempt from the registration requirements of the Securities Act of 1933, as amended, because each initial purchaser offered and sold the notes in the United States only to qualified institutional buyers in reliance on Rule 144A under the Securities Act and outside the United States only to non-U.S. persons in offshore transactions in reliance on Regulation S under the Securities Act. Item 6. Item 6. Selected Financial Data (1) The net loss per share data above has been adjusted for the stock splits effected in 1999 and in prior periods. (2) EBITDA represents net loss before interest expense, interest income, depreciation, amortization and deferred compensation expense, and has been adjusted to exclude the non-recurring restructuring charge recorded in the fourth quarter of 1999. EBITDA is commonly used to analyze companies on the basis of operating performance, leverage and liquidity. While EBITDA should not be construed as a substitute for operating income or a better measure of liquidity than cash flow from operating activities, which are determined in accordance with generally accepted accounting principles, it is included herein to provide additional information with respect to our ability to meet future debt service, capital expenditure and working capital requirements. Item 7. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-looking and Cautionary Statements Some of the statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations may be deemed to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, as discussed further elsewhere in this report and in our public filings with the Securities and Exchange Commission. Overview Since 1996, we have provided high-quality telecommunications services to the rapidly growing business market. We believe that increasing usage of both telephone service and newer data and information services will continue to increase demand for telecommunications capacity, or bandwidth, and for new telecommunications services and applications. To serve our customers’ expanding telecommunications needs, we have assembled a unique collection of high-bandwidth local and national network assets. We intend to integrate these assets with advanced communications technologies and services in order to become one of the nation’s leading providers of a comprehensive array of communications services and applications. To accomplish this: • We have built 31 high-bandwidth or broadband local networks in 19 states, generally located in the central business districts of the cities we serve, and we continue to build additional networks; • We have become the nation’s largest holder of broadband fixed wireless spectrum with FCC licenses covering 95% of the population of the 30 largest U.S. cities, which we will use to extend the reach of our networks to additional customers; and • We have acquired, through a joint venture known as INTERNEXT, rights to use unlit fiber optic strands, known as dark fiber, and an empty conduit in a national broadband network now being built to traverse over 16,000 miles and to connect more than 50 cities in the United States and Canada, including all of the largest cities that our current and planned local networks serve. By acquiring “dark” fiber rather than leasing “lit” fiber capacity, we have retained control over decisions on where and how to deploy existing or new generations of optical transmission equipment to enhance our network’s capacity and performance. We currently offer our customers a variety of voice services and high-speed Internet access. As our networks become increasingly optimized for data transmission and through our pending acquisition of Concentric Network Corporation (Concentric), we plan to expand our Internet access business and offer additional data services, such as Internet web hosting, support for e-commerce, virtual private network services and other customized data communications services. In addition, through our NEXTLINK Interactive subsidiary, we currently provide a number of voice response, speech recognition, and e-commerce services. We plan to build on our existing expertise in customized information and automated order fulfillment to serve clients with e-commerce businesses, that is, businesses conducting high volume retail transactions over the Internet. We currently operate 31 broadband local networks in 49 cities. We launched services in San Diego, Seattle and Washington D.C. during the first half of 1999, in Newark, Detroit and Houston during the third quarter of 1999, and, most recently, in Phoenix, Boston, St. Louis and Sacramento. We are currently building additional local networks, and plan to have operational networks in most of the 30 largest U.S. cities by the end of 2000. Our goal is to provide customers with complete voice and data network solutions for all of their communications needs, using our own fiber, switches and other facilities to the greatest extent possible. To reduce reliance on the physical connection for the short distance between our customers and our fiber optic networks, which are, in most instances, leased from the dominant carrier, we intend to increase the number of customers connected directly to our networks. In some cases, using our fixed wireless spectrum, we will construct a new fiber optic extension from our network to the customer’s premises. In other cases, we will deploy a high-bandwidth wireless connection between an antenna on the roof of the customer’s premises and an antenna attached to our fiber rings. These fixed wireless connections offer high-quality broadband capacity and, in most cases, will cost less than fiber to install. In December 1999, we completed our first generation broadband wireless field testing and announced the availability of commercial services to a limited group of customers in Los Angeles and Dallas. We continue to evaluate vendors for participation in our planned commercial rollout of broadband wireless service in 25 markets scheduled for the end of 2000. We are also deploying a technology called Digital Subscriber Line, or DSL, to meet the high bandwidth needs of those customers whose connection to our network remains over copper wire. DSL technology increases the effective capacity of existing copper telephone wires. We are installing our own DSL equipment to provide these services ourselves, and we also resell another provider’s DSL services. Our networks support a variety of communications technologies, which permit us to offer our customers a set of technology options to meet their changing needs, and introduce new technologies, as they become available. For example, we have begun to install Internet Protocol (IP) routers, which will enable us to carry Internet traffic more efficiently and to provide more data services. We also have been installing Asynchronous Transfer Mode (ATM) routers and switches in our local network, which will enable us to meet the demands of large, high volume customers. We anticipate that future IP technologies will enable the high-bandwidth, end-to-end national network we are building to carry data, voice and video. Such a network should also enable us to offer our customers entirely new classes of IP services. To serve our customers’ present needs and to take advantage of future opportunities that technological advances may bring, we intend to remain flexible with respect to technology choices. The table provides selected key operational data: (1) The operating data include 100% of the statistics of the Las Vegas network, which we manage and in which we have a 40% membership interest. (2) Route miles refer to the number of miles of the telecommunications path in which we own or lease the fiber optic cables that are installed. (3) Fiber miles refer to the number of route miles installed along a telecommunications path, multiplied by our estimate of the number of fibers along that path. (4) Represents buildings physically connected to our networks, excluding those connected by unbundled dominant local exchange carrier facilities. (5) Represents buildings connected to our networks through leased or unbundled dominant carrier facilities. (6) Represents the number of access lines in service, including those lines that are provided through resale of Centrex services, for which we are billing services. We serviced 1,463 resold access lines as of December 31, 1999. An access line is defined as a telephone connection between our facilities and a customer purchasing local telephone services. This connection does not include so-called access line equivalents (ALEs), and is a one-for-one relationship with no multipliers used for trunk ratios, except for those trunks over which we provide primary rate interface (PRI) service is provided, which are counted as 23 access lines. Concentric Acquisition In January 2000, we agreed to acquire Concentric, a provider of high-speed DSL, web hosting, e-commerce and other Internet services. As a combined company, we will be able to offer a complete, single source communications solution to our customers by combining our voice and data products with the full array of products from Concentric’s Internet business, data center, and application service provider (ASP) services. In this transaction, both the Company and Concentric will merge into a newly-formed company, to be renamed NEXTLINK Communications, Inc., which will succeed to both companies’ assets and businesses and will assume all of NEXTLINK’s and Concentric’s outstanding debt obligations and other liabilities. In the transaction, each outstanding share of our Class A common stock and Class B common stock would be converted into one share of Class A common stock or Class B common stock, as applicable, of the corporation surviving this merger, which stock will be substantially identical to our Class A and Class B common stock. In addition, each outstanding share of Concentric common stock would be converted into 0.495 of a share of Class A common stock of the surviving corporation, unless the trading price of our Class A common stock at the effective time is less than or equal to $90.91, in which case each outstanding share would be converted into $45.00 of Class A common stock of the surviving corporation (based on the trading price of our Class A common stock prior to the effective time). If at the effective time our average stock price is less than $69.23, each outstanding share of Concentric common stock would convert into 0.650 of a share of the Class A common stock of the surviving corporation. This transaction is intended to be tax-free to our shareholders and Concentric’s shareholders and has been unanimously approved by both our and Concentric’s boards of directors, but remains subject to approval by Concentric stockholders. Eagle River, the majority holder of our voting power, has agreed to approve the transaction. The parties have obtained the consent of Concentric’s bond and preferred stock holders to certain amendments to those securities that are necessary to complete this transaction. The transaction is subject to customary closing conditions and is expected to close during the second quarter of 2000. The merger will be accounted for under the purchase method of accounting. Results of Operations Revenue grew 96% to $274.3 million in 1999, from $139.7 million in 1998. In 1998, revenue increased 143% to $139.7 million from $57.6 million in 1997. Revenue reported consisted of the following components (dollars in thousands): Core services revenue, consisting of bundled local and long distance, as well as dedicated services, grew 183% to $217.1 million from $76.7 million in 1998. In 1998, core services revenue grew 277% from $20.3 million in 1997. This revenue growth corresponded to an increase in customer access lines installed, which was driven by growth in our existing markets, as well as expansion into new markets. During 1999, access lines in service grew 146% to 428,035 as of December 31, 1999 from 174,182 at December 31, 1998. At December 31, 1997 access lines in service totaled 50,131. Our quarterly customer access line installation rate grew 97% to 78,881 in the fourth quarter of 1999 from 40,075 in the same quarter of 1998. Through our NEXTLINK One subsidiary, we provide shared tenant services, including telecommunications management services, to groups of small and medium-sized businesses located in the same office building. This service enables businesses too small to justify hiring their own telecommunications managers to benefit from the efficiencies, including volume discounts, normally only available to larger enterprises. We acquired our NEXTLINK One subsidiary (formerly Start Technologies Corporation) in the fourth quarter of 1997; therefore, 1998 was the first full year of shared tenant services revenue recognized. Revenue from our stand-alone long distance telephone services declined in 1999 from 1998, primarily due the conversion of those customers onto our local networks, as we began servicing those customers with our bundled local and long distance services. We expect this trend to continue in future periods both in absolute terms and as a percentage of revenue. In 1998, revenue from this source increased due to the acquisition of Chadwick Telecommunications Corporation, a switch-based long distance service reseller, in the fourth quarter of 1997. Enhanced revenue consists primarily of interactive voice response (IVR) services provided by our NEXTLINK Interactive subsidiary. IVR is a platform that allows a consumer to dial into a computer-based system using a toll-free number and a touch-tone phone and access a variety of information by following a customized menu. Simultaneously, a profile of the caller is left behind for either our use or the use of our customer. The table below provides expenses by classification and as a percentage of revenue: Operating expenses consist of costs directly related to providing facilities-based network and enhanced communications services and also includes salaries, benefits and related costs of operations and engineering personnel. Operating expenses increased 79% in 1999 to $221.7 million versus $123.7 million in 1998. In 1998, operating expenses increased 129% from $54.0 million in 1997. The increase in both years was attributable to increased network costs related to provisioning higher volumes of local, long distance and enhanced communications services, an increase in employees and an increase in other related costs primarily to expand our switched local and long distance service businesses in existing and planned markets. To a lesser extent, the acquisitions of Start and Chadwick in the fourth quarter of 1997 also contributed to the increase in operating costs in 1998 over those in 1997. We expect operating expenses to continue to increase in future periods in connection with our growth and expansion plans. Selling, general and administrative (SG&A) expenses include salaries and related personnel costs, facilities expenses, sales and marketing, information systems costs, consulting and legal costs and equity in loss of affiliated companies. SG&A expenses increased 70% in 1999 to $266.9 million from $156.9 million in 1998. In 1998, SG&A increased 107% from $75.7 million in 1997. Consistent with the cost drivers of our operating expenses, the increases in SG&A in both periods was primarily due to increases in employees and other costs associated with the expansion of our switched local and long distance service businesses in existing and planned markets. In the fourth quarter of 1999, we recorded a $30.9 million non-recurring restructuring charge for costs associated with relocating our Bellevue, Washington headquarters to Northern Virginia. Approximately $28.0 million of the charge resulted from non-cash stock option compensation charges that arose from accelerated vesting on certain employee options associated with their severance. Deferred compensation expense was recorded in connection with our Equity Option Plan until April 1997, and in connection with our Stock Option Plan, which replaced the Equity Option Plan, subsequent to April 1997. The stock options granted under the Equity Option Plan were considered compensatory. All options outstanding under the Equity Option Plan were re-granted under the Stock Option Plan with terms and conditions substantially the same as under the Equity Option Plan. As such, we continue to record deferred compensation expense for those compensatory stock options issued and for compensatory stock options issued subsequent to the Stock Option Plan inception date. Compensation expense is recognized over the vesting periods of the options based on the excess of the fair value of the stock options at the date of grant over the exercise price. Depreciation expense increased 104% in 1999 to $93.1 million from $45.6 million in 1998. In 1998, depreciation expense increased 142% from $18.9 million in 1997. The increase in both years was primarily due to placement in service of additional telecommunications network assets, including switches, fiber optic cable, and network electronics and related equipment. As we expand our networks and install additional switches and related equipment and other network technology, depreciation expense is expected to continue to increase. Amortization of intangible assets increased in 1998 over 1997 primarily as a result of the Start and Chadwick acquisitions in the fourth quarter of 1997. In 1999, interest expense increased 96% to $283.1 million from $144.6 million in 1998. In 1998, interest expense increased 165% from $54.5 million in 1997. The increase in both years was due to an increase in our average outstanding indebtedness. Interest expense will increase in future periods in conjunction with an increase in our average outstanding indebtedness. For more information, see “Liquidity and Capital Resources.” A portion of interest costs is capitalized as part of the construction cost of our communications networks. Capitalized interest was $9.9 million in 1999, $4.3 million in 1998, and $1.8 million in 1997. Interest income increased 26% in 1999 to $91 million from $72.4 million in 1998. In 1998, interest income increased 157% from $28.1 million in 1997. The increases in both years corresponded to the increase in our average cash and investment balances. Liquidity and Capital Resources Our business is capital-intensive and, as such, has required and will continue to require substantial capital investment. We build high capacity networks with broad market coverage, a strategy that initially increases our level of capital expenditures and operating losses and requires us to make a substantial portion of our capital investments before we realize any revenue from them. These capital expenditures, together with the associated early operating expenses, will continue to result in negative cash flow unless and until we are able to establish an adequate customer base. We believe, however, that over the long term this strategy will enhance our financial performance by increasing the traffic flow over our networks. Capital Uses During 1999, we used $358.9 million in cash for operating activities, compared to $174.5 million used in 1998 and $97.3 million used in 1997. The increase was primarily due to a substantial increase in our activities associated with the continued development and expansion of switched local and long distance service operations. Accounts receivable increased 123% during 1999, primarily due to the increase in revenue in the same period. Increases in accounts payable and accured liabilities were proportional with the increase in operating costs and selling, general, and administrative expenses. In addition, during 1999, we invested an additional $1,127.1 million in property and equipment, and acquisitions of telecommunications assets, including a $515.6 million investment in fixed wireless licenses. During 1999, we acquired a number of licenses to broadband fixed wireless spectrum. We plan to use our fixed wireless licenses to extend the reach of our fiber networks and to connect additional customers directly to our fiber networks. Deploying the technologies associated with this strategy will require additional capital expenditures. The transactions completed included the following: • In April 1999, we acquired WNP Communications, Inc. for $698.2 million. Of this amount, we paid $157.7 million to the FCC for license fees, including interest. We paid the remainder of the purchase price, consisting of $190.1 million in cash and 11,431,662 shares of Class A common stock, to the stockholders of WNP. In this transaction, we acquired licenses for 1,150 MHz of local multi-point distribution services (LMDS) spectrum (A block LMDS licenses) in 39 cities and one license for 150 MHz of LMDS spectrum (B block LMDS license) in one city. • In June 1999, we acquired from Nextel Communications Inc. (Nextel) its 50% interest in NEXTBAND, a joint venture we formed with Nextel in January 1998, for $137.7 million in cash. NEXTBAND owns LMDS licenses in 42 markets throughout the U.S. The purchase price was determined based on a formula derived in conjunction with our acquisition of WNP. In July 1998, we formed INTERNEXT L.L.C., which is currently beneficially owned 50% each by us and Eagle River Investments, LLC. INTERNEXT entered into an agreement with Level 3 Communications, Inc., which is constructing a fiber optic network that is expected to cover more than 16,000 route miles with six or more conduits and connect 50 cities in the United States and Canada. Pursuant to this agreement, INTERNEXT will receive an exclusive interest in 24 “dark” fibers in a shared, filled conduit, one empty conduit and the right to 25% of the fibers pulled through the sixth and any additional conduits in the network. INTERNEXT will pay $700.0 million in exchange for these rights, the majority of which will be payable as segments of the network are completed and accepted, which is expected to occur substantially during 2000 and 2001. As of December 31 1999, INTERNEXT had paid $47.6 million to Level 3 of which $19.8 million was paid in 1999. In January 2000, we entered into an agreement with Eagle River to purchase the 50% interest that we did not own of INTERNEXT. The purchase price for Eagle River’s interest is approximately 3.4 million shares of the Class A common stock of the corporation surviving the Concentric acquisition. As a result of this acquisition, which is expected to be consummated in the second quarter of 2000, we will have complete control over this national broadband network. We expect to make substantial capital expenditures in 2000 and beyond relating to our existing and planned network development and operations. These expenditures include: • the purchase and installation of switches, routers, servers and other data-related equipment and related electronics in existing networks and in networks to be constructed or acquired in new or adjacent markets; • the purchase and installation of fiber optic cable and electronics to expand existing networks and develop new networks, including the connection of new buildings; • the development of our comprehensive information technology platform; • the purchase and installation of equipment associated with the deployment of LMDS using our LMDS spectrum; • funding of the commitments to build our national network, and related expenses we expect to incur in building our national network; • the purchase and installation of equipment associated with deployment of DSL services; and • the funding of operating losses and working capital. Our strategic plan also calls for expansion into additional market areas. This expansion will require significant additional capital for: • potential acquisitions of businesses or assets; • design, development and construction of new networks; and • the funding of operating losses and working capital during the start-up phase of each market. In addition, our proposed acquisition of Concentric may result in additional capital uses. Specifically, under the terms of the indenture governing Concentric’s 12 3/4% Senior Notes due 2007 and the terms of Concentric’s 13 1/2% Series B Senior Redeemable Exchangeable Preferred Stock, upon completion of the Concentric transaction we will be required to offer to repurchase those outstanding senior notes and shares of preferred stock at a purchase price equal to 101% of the principal amount of the senior notes and 101% of the liquidation preference of the shares of the preferred stock. As of December 31, 1999, the total principal amount of the Concentric senior notes and the liquidation preference of the shares of Concentric preferred stock outstanding were approximately $338.7 million. If we were required to utilize available cash to fund repurchase of all or a significant amount of Concentric’s senior notes and preferred stock, it would reduce the amount of funds available to implement our business plan. Based on the current and historical trading prices of Concentric’s senior notes and preferred stock, we do not expect that the holders of these notes and preferred stock will tender them for repurchase. However, if there is a significant adverse change in the market for these securities or an adverse change with respect to either of us or Concentric, it is likely that some or all of the Concentric senior notes and preferred stock will be tendered in the repurchase offer. Capital Resources 1999 Financing Activities. In November 1999, we sold $400.0 million of 10 1/2% Senior Notes and $455.0 million in principal amount at stated maturity of 12 1/8% Senior Discount Notes both due December 1, 2009. The transaction generated proceeds, net of discounts, commissions, advisory fees and expenses, totaling approximately $639.6 million. Interest payments on the 10 1/2% Notes are due semi-annually, beginning June 1, 2000. The 12 1/8% Notes were issued at a discount from their principal amount to generate aggregate gross proceeds of approximately $251.4 million. The 12 1/8% Notes accrete at a rate of 12 1/8% compounded semi-annually, to an aggregate principal amount of $455.0 million by December 1, 2004. No cash interest will accrue on the 12 1/8% Notes until December 1, 2004. Interest will become payable in cash semi-annually beginning June 1, 2005. We have the option to redeem both the 10 1/2% Notes and the 12 1/8% Notes, in whole or in part, beginning December 1, 2004 at established redemption prices that decline to 100% of the stated principal amount thereof by December 1, 2007. In June 1999, we completed the sale of $675.0 million of 10 3/4% Senior Notes and $588.9 million in principal amount at stated maturity of 12 1/4% Senior Discount Notes, both due June 1, 2009. The transaction generated proceeds, net of discounts, underwriting commissions, advisory fees and expenses, totaling approximately $979.5 million. Interest payments on the 10 3/4% Notes due 2009 are due semi-annually, beginning December 1, 1999. The 12 1/4% Notes were issued at a discount from their principal amount to generate aggregate gross proceeds of approximately $325.0 million. The 12 1/4% Notes accrete at a rate of 12 1/4% compounded semi-annually, to an aggregate principal amount of approximately $588.9 million by June 1, 2004. No cash interest will accrue on the 12 1/4% Notes until June 1, 2004. Interest will become payable in cash semi-annually beginning December 1, 2004. We have the option to redeem both the 10 3/4% Notes and the 12 1/4% Notes, in whole or in part, beginning June 1, 2004 at established redemption prices that decline to 100% of the stated principal amount thereof by June 1, 2007. Our operating flexibility with respect to certain business matters is, and will continue to be, limited by covenants associated with our outstanding indebteness and preferred stock. Among other things, these covenants limit our ability to incur additional indebtedness, create liens upon assets, apply the proceeds from the disposal of assets, make dividend payments and other distributions on capital stock and redeem capital stock. We are required to use the proceeds from the sale of certain series of our senior notes solely to fund 80% of the expenditures for the construction, improvement and acquisition of new and existing networks and services and direct and indirect investments in certain joint ventures, by covenants in the indentures under which these and other of our notes were issued. We expect to fund the remainder of these costs with the proceeds of other offerings. These covenants may adversely affect our ability to finance our future operations or capital needs or to engage in other business activities that may be in our interest. In June 1999, we completed the sale of 15,200,000 shares of Class A common stock at $38.00 per share, 8,464,100 shares of which we offered and 6,735,900 shares of which were offered by certain stockholders that previously owned interests in WNP. Gross proceeds from the offering totaled $321.6 million, and our proceeds, net of underwriting discounts, advisory fees and expenses, aggregated approximately $310.5 million. At December 31, 1999 we had $150.6 million of comprehensive income generated from net unrealized holding gains and losses on our equity investments in marketable securities. These investments were classified as available-for-sale in accordance with Statement Financial Accounting Standard 115, “Accounting For Certain Investments in Debt and Equity Securities.” In the first quarter of 2000, we sold a portion of these investments realizing most of this gain, including the impact of subsequent changes in fair market value. Secured Credit Facility. In February 2000, we entered into a $1.0 billion Senior Secured Credit Facility with various lenders, and certain of our subsidiaries, as guarantors. The security for the facility consists of all of the assets purchased with the proceeds thereof, the stock of certain of our subsidiaries, all assets of NEXTLINK and, to the extent of $125.0 million of guaranteed debt, all assets of certain of our subsidiaries. A portion of the facility is available to provide working capital and for other general corporate purposes with the remainder available to provide financing for the construction, acquisition or improvement of telecommunication assets. The facility consists of a $387.5 million multi-draw term loan A, a $225.0 million term loan B, and a $387.5 million revolving credit facility. In addition, the facility may be increased by up to an additional $1.0 billion under certain circumstances. At closing, we borrowed $150.0 million of the term loan A and the entire $225.0 million of the term loan B. The revolving credit facility and the term loan A mature on December 31, 2006, and the term loan B matures on June 30, 2007. The maturity date for each of the facilities may be accelerated to October 31, 2005 unless we have refinanced our $350.0 million 12 1/2% Senior Notes by April 15, 2005. Amounts drawn under the revolving credit facility and the term loans are expected to bear interest, at our option, at the alternate base rate or reserve-adjusted London Interbank Offered Rate (LIBOR) plus, in each case, applicable margins. Forstmann Little Investment. In December 1999, several Forstmann Little & Co. investment funds agreed to invest $850.0 million in NEXTLINK, to be used to expand our networks and services, introduce new technologies and fund our business plan. The investment closed in January 2000. In the transaction, the investors acquired shares of two series of convertible preferred stock that together are convertible into Class A common stock at a conversion price of $63.25 per share and provide for a 3.75% dividend payable quarterly. Under the agreement, the holders may convert the preferred stock into Class A common stock at any time after January 20, 2001, and we may redeem the preferred stock at any time after the later of January 20, 2005 and the date we have redeemed our 12 1/2% Notes in full. The preferred stock is redeemable at the option of the holders during the 180-day period commencing January 20, 2010. Liquidity Assessment We believe that the net proceeds from the Forstmann Little investment together with the amounts borrowed and available under the secured credit facility, cash and marketable securities on hand and cash generated from operations, will provide sufficient funds for us to expand our business as planned and to fund operating losses until the latter half of 2001. However, the amount of future funding requirements will depend on a number of factors, including the success of our business, the dates at which we further expand our network, the types of services we offer, staffing levels, acquisitions and customer growth, as well as other factors that are not within our control, including the obligation to fund the repurchase offer obligation with respect to Concentric’s senior notes and preferred shares that will be triggered upon completion of the Concentric transaction, competitive conditions, government regulatory developments and capital costs. In the event our plan or assumptions change or prove to be inaccurate, or available borrowings under the secured credit facility, cash and investments on hand and cash generated from operations prove to be insufficient to fund our growth in the manner and at the rate currently anticipated, we may be required to delay or abandon some or all of our development and expansion plans or we may be required to seek additional sources of financing earlier than currently anticipated. In the event we are required to seek additional financing, there can be no assurance that such financing will be available on acceptable terms or at all. Impact of Year 2000 Prior to January 1, 2000, considerable concern was raised as to Year 2000 readiness of computer systems. The Year 2000 concerns arose because certain older computer systems and applications were written to define a given year with abbreviated dates using the last two digits in a year rather than the entire four digits. As a result, when computer systems attempt to process dates both before and after January 1, 2000, two digit year fields may create processing ambiguities that can cause errors and system failures. For example, systems and applications may have time-sensitive software that recognize an abbreviated year “00” as the year 1900 rather than the year 2000. There was concern as to whether these errors or failures would have limited effects, or whether the effects would be widespread, depending on the computer chip, system, or software, and its location and function. We experienced no significant problems arising from the Year 2000 concerns and, to date, no year 2000-related claims have been made against us. We continue to monitor for date-related impacts. State of Readiness We had adopted a formal Year 2000 plan, the purpose of which was to develop and perform reasonable steps intended to prevent our critical operational functions from being impaired due to the Year 2000 problem. We engaged outside consultants to aid in formulating and implementing the plan. Prior to December 31, 1999 our assessments, which included testing and vendor confirmations, indicated that our major operational support systems, including our billing, order management, network management, and financial systems were Year 2000 ready. Costs to Address Year 2000 Issues We have not incurred material historical costs for Year 2000 awareness, inventory, assessment, analysis, conversion, or contingency planning. We currently do not anticipate any future costs for these purposes. Year 2000 Risk Factors and Contingency Plans In the unlikely event that a post Year 2000 date-related incident does occur, our contingency plans developed prior to December 31, 1999 would be implemented. Item 7A. Item 7A. Quantitative and Qualitative Disclosure About Market Risk We currently have instruments sensitive to market risks relating to exposure to changing interest rates. As disclosed in Notes 8 and 9 to the consolidated financial statements, we had $3,733.3 million in fixed rate debt and $612.3 million in fixed rate redeemable preferred stock as of December 31, 1999. We do not have significant cash flow exposure to changing interest rates on our long term debt and redeemable preferred stock because the interest rates are fixed. However, the estimated fair values of the fixed-rate debt and redeemable preferred stock are subject to market risk. We also maintain an investment portfolio consisting of U.S. government and other securities with an average maturity of less than one year. These securities are classified as “available for sale”. If interest rates were to increase or decrease immediately, it could have a material impact on the fair value of these financial instruments. However, changes in interest rates would not likely have a material impact on interest earned on our investment portfolio. We do not currently hedge these interest rate exposures. We have in the past hedged certain equity securities available-for-sale to reduce our risk of exposure to declines in the market price of such securities. Presented below is an analysis of our financial instruments, as of December 31, 1999, that are sensitive to changes in interest rates. The model demonstrates the change in fair value of the instruments calculated for an instantaneous parallel shift in interest rates, plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS (in millions). The sensitivity analysis provides only a limited, point-in-time view of the market risk sensitivity of certain of our financial instruments. The actual impact of market interest rate and price changes on the financial instruments may differ significantly from those shown in the sensitivity analysis. Item 8. Item 8. Financial Statements and Supplementary Data Our consolidated financial statements are filed under this Item, beginning on page of this Report, and NEXTLINK Capital’s balance sheet is filed under this Item, beginning on Page of this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information required herein regarding directors is incorporated herein by reference from the definitive Proxy Statement for NEXTLINK’s 2000 Annual Meeting, which is scheduled to be filed on or before April 29, 2000, under the caption “Election of Directors”. The information required herein regarding executive officers required is set forth in Part I hereof under the heading “Executive Officers of the Registrant”, which information is incorporated herein by reference. The information required by this item regarding compliance with Section 16(a) of the Securities and Exchange Act of 1934 by NEXTLINK’s directors and executive officers, and holders of ten percent of a registered class of NEXTLINK’s equity securities is incorporated herein by reference from the definitive Proxy Statement for NEXTLINK’s 2000 Annual Meeting which is scheduled to be filed on or before April 29, 2000, under the caption “Other Information-Section 16(a) Beneficial Ownership Reporting Compliance”. Item 11. Item 11. Executive Compensation The information required by this item regarding compensation of executive officers and directors is incorporated herein by reference from the definitive Proxy Statement for NEXTLINK’s 2000 Annual Meeting, which is scheduled to be filed on or before April 29, 2000, under the captions “Director Compensation” and “Executive Compensation”. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is incorporated herein by reference from the definitive Proxy Statement for NEXTLINK’s 2000 Annual Meeting, which is scheduled to be filed on or before April 29, 2000, under the caption “NEXTLINK Common Stock Ownership”. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this item is incorporated herein by reference from the definitive Proxy Statement for NEXTLINK’s 2000 Annual Meeting, which is scheduled to be filed on or before April 29, 2000, under the caption “Certain Relationships and Related Transactions.” PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. and 2. Financial Statements and Schedules: (3) List of Exhibits - Refer to Exhibit Index, which is incorporated herein by reference. (b) Reports on Form 8-K: (1) Current Report on Form 8-K dated November 17, 1999, reporting under Item 5 certain completed and proposed financings of NEXTLINK Communications, Inc. (2) Current Report on Form 8-K dated December 7, 1999, reporting under Item 5 that NEXTLINK Communications, Inc. had entered into certain financing and other agreements. (3) Current Report on Form 8-K dated January 11, 2000, reporting under Item 5 that NEXTLINK Communications, Inc. had entered into an Agreement and Plan of Merger and Share Exchange Agreement with Concentric Network Corporation and Eagle River Investments, L.L.C. (4) Current Report on Form 8-K dated January 24, 2000, reporting under Item 5 the closing of the previously announced $850 million investment by Forstmann Little & Co. in NEXTLINK Communications, Inc. (5) Current Report on Form 8-K dated January 24, 2000, reporting under Item 5 certain details regarding the Concentric acquisition and the closing of the previously announced $1 billion credit facility with various lenders, Goldman Sachs Credit Partners L.P., as syndication agent, Toronto Dominion (Texas), Inc., as administrative agent, Barclays Bank PLC, and The Chase Manhattan Bank, as co-documentation agents and Goldman Sachs Credit Partners L.P., and TD Securities (USA) Inc., as joint lead arrangers, and certain subsidiaries of NEXTLINK, as guarantors. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrants have duly caused this report to be signed on their behalf by their undersigned thereunto duly authorized. NEXTLINK Communications, Inc. Date: March 29, 2000 By: /s/ DANIEL F. AKERSON Daniel F. Akerson Chief Executive Officer Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 29, 2000 by the following persons on behalf of the Registrants and in the capacities indicated: Name Title /s/ DANIEL F. AKERSON Daniel F. Akerson Chief Executive Officer (Principal Executive Officer) Chairman of the Board of Directors /s/ MARK S. GUNNING Mark S. Gunning Senior Vice President, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) /s/ JOSEPH L. COLE Joseph L. Cole Director /s/ NATHANIEL A. DAVIS Nathaniel A. Davis Director /s/ NICHOLAS C. FORSTMANN Nicholas C. Forstmann Director William A. Hoglund Director /s/ SANDRA J. HORBACH Sandra J. Horbach Director /s/ NICOLAS KAUSER Nicolas Kauser Director Craig O. McCaw Director Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrants have duly caused this report to be signed on their behalf by their undersigned thereunto duly authorized. NEXTLINK Capital, Inc. Date: March 29, 2000 By: /s/ DANIEL F. AKERSON Daniel F. Akerson Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 29, 2000 by the following persons on behalf of the Registrants and in the capacities indicated: Name Title /s/ DANIEL F. AKERSON Daniel F. Akerson Chief Executive Officer (Principal Executive Officer) /s/ MARK S. GUNNING Mark S. Gunning Senior Vice President, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) /s/ GARY D. BEGEMAN Gary D. Begeman Director EXHIBIT INDEX 2.1 - Agreement and Plan of Merger and Share Exchange Agreement, dated January 9, 2000, by and among Concentric Network Corporation, NEXTLINK Communications, Inc., Eagle River Investments, L.L.C. and NM Acquisition Corp. (Incorporated herein by reference to exhibit 10.1 filed with the current report on Form 8-K filed on January 11, 2000) 3.1.1 - Certificate of Incorporation of NEXTLINK Communications, Inc. (Incorporated herein by reference to exhibit 3.1 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 3.1.2 - Certificate of Amendment of Certificate of Incorporation of NEXTLINK Communications, Inc., dated August 25, 1999 (Incorporated herein by reference to exhibit 3.2 filed with the quarterly report on Form 10-Q for the quarterly period ended September 30, 1999 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 3.1.3 - Certificate of Designation of the Powers, Preferences and Relative, Participating, Optional and Other Special Rights of 14% Senior Exchangeable Redeemable Preferred Shares and Qualifications, Limitations and Restrictions Thereof (Incorporated herein by reference to the exhibit 4.2 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 3.1.4 - Certificate of Designation of Powers, Preferences and Relative, Participating, Optional and Other Special Rights of 6 1/2% Cumulative Convertible Preferred Stock and Qualifications, Limitations and Restrictions Thereof (Incorporated herein by reference to exhibit 4.8 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 3.1.5 - Certificate of Designation of Powers, Preferences and Relative, Participating, Optional and Other Special Rights of Series C Cumulative Convertible Participating Preferred Stock and Qualifications, Limitations and Restrictions Thereof 3.1.6 - Certificate of Designation of the Powers, Preferences and Relative, Participating, Optional and Other Special Rights of Series D Convertible Participating Preferred Stock and Qualifications, Limitations and Restrictions Thereof 3.2 - By-laws of NEXTLINK Communications, Inc. (Incorporated herein by reference to exhibit 3.2 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 3.3 - Articles of Incorporation of NEXTLINK Capital, Inc. (Incorporated herein by reference to exhibit 3.3 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, L.L.C. (the predecessor of NEXTLINK Communications, Inc.) and NEXTLINK Capital, Inc. (Commission File No. 333-4603)) 3.4 - By-laws of NEXTLINK Capital, Inc. (Incorporated herein by reference to exhibit 3.4 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, L.L.C. (the predecessor of NEXTLINK Communications, Inc.) and NEXTLINK Capital, Inc. (Commission File No. 333-4603)) 4.1.1 - Form of stock certificate of 14% Senior Exchangeable Redeemable Preferred Shares (Incorporated herein by reference to exhibit 4.4 filed with the Annual Report on Form 10-KSB for the year ended December 31, 1996 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 4.1.2 - Form of stock certificate of Class A common stock (Incorporated herein by reference to exhibit 4.4 filed with the Registration Statement on Form S-1 of NEXTLINK Communications, Inc. (Commission File No. 333-32001)) 4.1.3 - Form of stock certificate of 6 1/2% Cumulative Convertible Preferred Stock 4.1.4 - Form of stock certificate of Series C Cumulative Convertible Participating Preferred Stock 4.1.5 - Form of stock certificate of Series D Convertible Participating Preferred Stock 4.2.1 - Indenture, dated as of April 25, 1996, by and among NEXTLINK Communications, Inc., NEXTLINK Capital, Inc. and United States Trust Company of New York, as Trustee, relating to 12 1/2% Senior Notes due April 15, 2006, including form of global note (Incorporated herein by reference to exhibit 4.1 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, L.L.C. (the predecessor of NEXTLINK Communications, Inc.) and NEXTLINK Capital, Inc. (Commission File No. 333-4603)) 4.2.2 - First Supplemental Indenture, dated as of January 31, 1997, by and among NEXTLINK Communications, Inc., NEXTLINK Communications, L.L.C., NEXTLINK Capital, Inc. and United States Trust Company of New York, as Trustee (Incorporated herein by reference to exhibit 4.6 filed with the Annual Report on Form 10-KSB for the year ended December 31, 1996 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 4.2.3 - Second Supplemental Indenture, dated June 3, 1998, amending Indenture dated April 25, 1996, by and among NEXTLINK Communications, Inc., NEXTLINK Capital, Inc. and United States Trust Company of New York, as Trustee (Incorporated herein by reference to exhibit 4.10 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 4.3.1 - Indenture dated September 25, 1997 between United States Trust Company, as Trustee and NEXTLINK Communications, Inc., relating to the 9 5/8% Senior Notes due 2007 (Incorporated herein by reference to exhibit 4.7 filed with the Registration Statement on Form S-3 of NEXTLINK Communications, Inc. (Commission File No. 333-77577)) 4.3.2 - First Supplemental Indenture, dated June 3, 1998, amending Indenture dated September 25, 1997, by and between NEXTLINK Communications, Inc. and United States Trust Company of New York, as Trustee (Incorporated herein by reference to exhibit 4.11 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 4.4.1 - Indenture, dated March 3, 1998, between United States Trust Company, as Trustee and NEXTLINK Communications, Inc., relating to the 9% Senior Notes due 2008 (Incorporated herein by reference to exhibit 4.7 filed with the Annual Report on Form 10-KSB for the year ended December 31, 1997 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 4.4.2 - First Supplemental Indenture, dated June 3, 1998, amending Indenture dated March 3, 1998, by and between NEXTLINK Communications, Inc. and United States Trust Company of New York, as Trustee (Incorporated herein by reference to exhibit 4.12 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 4.5.1 - Indenture, dated April 1, 1998, between United States Trust Company, as Trustee and NEXTLINK Communications, Inc., relating to the 9.45% Senior Discount Notes due 2008 (Incorporated herein by reference to exhibit 4.9 filed with the quarterly report on Form 10-Q for the quarterly period ended March 31, 1998 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 4.5.2 - First Supplemental Indenture, dated June 3, 1998, amending Indenture dated April 1, 1998, by and between NEXTLINK Communications, Inc. and United States Trust Company of New York, as Trustee (Incorporated herein by reference to exhibit 4.13 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 4.6 - Indenture, dated November 12, 1998, by and among NEXTLINK Communications, Inc. and United States Trust Company of New York, as trustee relating to the 10 3/4% Senior Notes due 2008 (Incorporated herein by reference to exhibit 4.1 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-71749)) 4.7 - Indenture, dated June 1, 1999, by and among NEXTLINK Communications, Inc. and United States Trust Company of New York, as Trustee, relating to the 10 3/4% Senior Notes due 2009 (Incorporated herein by reference to exhibit 4.16 filed with the quarterly report on Form 10-Q for the quarterly period ended September 30, 1999 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 4.8 - Indenture, dated June 1, 1999, by and among NEXTLINK Communications Inc. and United States Trust Company of Texas, as Trustee, related to the 12 1/4% Senior Discount Notes due 2009 (Incorporated herein by reference to exhibit 4.17 filed with the quarterly report on Form 10-Q for the quarterly period ended September 30, 1999 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 4.9 - Indenture, dated November 17, 1999, by and among NEXTLINK Communications, Inc. and United States Trust Company of New York, as Trustee, relating to the 10 1/2% Senior Notes due 2009 (Incorporated herein by reference to exhibit 4.1(i) filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-30388)) 4.10 - Indenture, dated November 17, 1999, by and among NEXTLINK Communications, Inc. and United States Trust Company of Texas, as Trustee, relating to the 12 1/8% Senior Discount Notes due 2009 (Incorporated herein by reference to exhibit 4.1(ii) filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-30388)) 10.1 - Stock Option Plan of NEXTLINK Communications, Inc. as amended 10.2 - Employee Stock Purchase Plan of NEXTLINK Communications, Inc. (Incorporated herein by reference to exhibit 10.2 filed with the Registration Statement on Form S-4 of NEXTLINK Communications, Inc. (Commission File No. 333-53975)) 10.3 - NEXTLINK Communications, Inc. Change of Control Retention Bonus and Severance Pay Plan 10.4 - Registration Rights Agreement, dated as of January 15, 1997, between NEXTLINK Communications, Inc. and the signatories listed therein (Incorporated herein by reference to exhibit 10.4 filed with the Annual Report on Form 10-KSB for the year ended December 31, 1996 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 10.5 - Registration Rights Agreement, dated as of November 4, 1997, between NEXTLINK Communications, Inc. and Wendy P. McCaw 10.6 - Registration Right Agreement, dated as of June 30, 1999, between NEXTLINK Communications, Inc. and Craig O. McCaw 10.7 - Registration Rights Agreement dated as of January 20, 2000, between NEXTLINK Communications, Inc. and the purchasers listed on the signature pages thereto, relating to Class A common stock issuable upon conversion of Series C and D convertible preferred stock 10.8 - Registration Rights Agreement, dated January 14, 1999, between NEXTLINK Communications, Inc. and the Holders referred to therein. (Incorporated herein by reference to exhibit 10.2 filed with the current report on Form 8-K filed on January 19, 1999) 10.9 - Employment Agreement, effective September 21, 1999, by and between Daniel Akerson and NEXTLINK Communications, Inc. (Incorporated herein by reference to exhibit 10.11 filed with the quarterly report on Form 10-Q for the quarterly period ended September 30, 1999 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 10.10 - Letter agreement, dated June 9, 1998, between NEXTLINK Communications, Inc. and Jan Loichle 10.11 - Employment Agreement, dated as of January 3, 2000, by and between Nathaniel A. Davis and NEXTLINK Communications, Inc. 10.12 - Fiber Lease and Innerduct Use Agreement, dated February 23, 1998, by and between NEXTLINK Communications, Inc. and Metromedia Fiber Network, Inc. (Incorporated herein by reference to exhibit 10.5 filed with the Annual Report on Form 10-KSB for the year ended December 31, 1997 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 10.13 - Amendment No. 1 to Fiber Lease and Innerduct Use Agreement, dated March 4, 1998, by and between NEXTLINK Communications, Inc. and Metromedia Fiber Network, Inc. (Incorporated herein by reference to exhibit 10.6 filed with the Annual Report on Form 10-KSB for the year ended December 31, 1997 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 10.14 - Cost sharing and IRU Agreement, dated July 18, 1998, between Level 3 Communications, LLC and INTERNEXT LLC. (Incorporated herein by reference to exhibit 10.8 filed with the quarterly report on Form 10-Q for the quarterly period ended September 30, 1998 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 10.15 - Guaranty Agreement, dated July 18, 1998, between NEXTLINK Communications, Inc. and Level 3 Communications, LLC. (Incorporated herein by reference to exhibit 10.7 filed with the quarterly report on Form 10-Q for the quarterly period ended September 30, 1998 of NEXTLINK Communications, Inc. and NEXTLINK Capital, Inc.) 10.16 - Credit and Guaranty Agreement, dated as of February 3, 2000, among NEXTLINK Communications, Inc., certain subsidiaries of NEXTLINK Communications, Inc., as guarantors, various lenders, Goldman Sachs Credit Partners L.P., as syndication agent, Toronto Dominion (Texas), Inc., as administrative agent, Barclays Bank PLC, and The Chase Manhattan Bank, as co-documentation agents and Goldman Sachs Credit Partners L.P., and TD Securities (USA) Inc., as joint lead arrangers (Incorporated herein by reference to exhibit 10.1 filed with the current report on Form 8-K filed on February 16, 2000) - Subsidiaries of the Registrant - Consent of Independent Public Accountants - Financial Data Schedule REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of NEXTLINK Communications, Inc.: We have audited the accompanying consolidated balance sheets of NEXTLINK Communications, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, shareholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of NEXTLINK Communications, Inc. and subsidiaries as of December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. /s/ ARTHUR ANDERSEN LLP Seattle, Washington February 14, 2000 NEXTLINK Communications, Inc. Consolidated Balance Sheets (Dollars in thousands, except share and per share amounts) See accompanying notes to consolidated financial statements. NEXTLINK Communications, Inc. Consolidated Statements of Operations (Dollars in thousands, except share and per share amounts) See accompanying notes to consolidated financial statements. NEXTLINK Communications, Inc. Consolidated Statements of Shareholders’ Equity (Deficit) (Dollars in thousands) [Additional columns below] [Continued from above table, first column(s) repeated] See accompanying notes to consolidated financial statements. NEXTLINK Communications, Inc. Consolidated Statements of Cash Flows (Dollars in thousands) See accompanying notes to consolidated financial statements. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements December 31, 1999, 1998 and 1997 1. ORGANIZATION AND DESCRIPTION OF BUSINESS The consolidated financial statements include the accounts of NEXTLINK Communications, Inc., a Delaware corporation, and its majority-owned subsidiaries (collectively referred to as the Company). The Company, through predecessor entities, was formed in September 1994 and, through its subsidiaries, provides competitive local, long distance and enhanced telecommunications services in selected markets in the United States. The Company is a majority-owned subsidiary of Eagle River Investments, LLC (Eagle River). As the competitive local telecommunications service business is a capital intensive business, the Company’s operations are subject to significant risks and uncertainties including competitive, financial, developmental, operational, growth and expansion, technological, regulatory, and other risks associated with developing the Company’s business. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The Company’s financial statements include 100% of the assets, liabilities and results of operations of subsidiaries in which the Company has a controlling interest. All significant inter-company accounts and transactions have been eliminated. Cash and Cash Equivalents The Company considers all highly liquid investments with maturities of three months or less at the time of purchase to be cash equivalents. Marketable Securities Investments in marketable securities are classified as available-for-sale and are reported at fair value in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The fair values are based on quoted market prices. Unrealized gains and losses on marketable securities are reported as a separate component of comprehensive income, if significant. The Company’s marketable securities consist of U.S. government and other securities with original maturities beyond three months. Pledged Securities As of December 31, 1999, the Company had pledged $40.0 million in marketable securities as collateral against certain hedge options. The Company had entered into a hedge transaction during 1999 to reduce its risk of significant market declines on certain highly volatile equity securities. The hedge was closed out in early 2000. As of December 31, 1998, the Company had pledged $20.5 million in U.S. government securities to be used to satisfy interest payment obligations on its 12 1/2% Senior Notes due 2006. In connection with the sale of 12 1/2% Senior Notes, a portion of the net proceeds was used to purchase a portfolio consisting of U.S. government securities, which matured at dates sufficient to provide for interest payments in full on the 12 1/2% Senior Notes through April 15, 1999. All of such pledged securities were used for such interest payments with remaining amounts released to the Company. The pledged securities are stated at cost, adjusted for premium amortization and accrued interest. The fair value of the pledged securities approximates the carrying value. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) Property and Equipment Property and equipment are stated at cost and depreciated on a straight-line basis over the estimated useful lives of the assets. Direct costs of construction are capitalized, including $9.9 million, $4.3 million, and $1.8 million of interest costs related to construction during 1999, 1998 and 1997, respectively. Estimated useful lives of property and equipment are as follows: Telecommunications networks 5-20 years Office equipment, furniture and other 3-5 years Leasehold improvements the lesser of the estimated useful lives or the terms of the leases Investment in Fixed Wireless Licenses Investment in fixed wireless licenses consists of direct and indirect costs to acquire fixed wireless license rights. Such costs will be amortized using the straight-line method over 20 years commencing when the license is placed into use, or when commercial service using fixed wireless technology is deployed in the license’s geographic area. Other Assets Other assets consist primarily of intangible assets including costs allocated in acquisitions to customer bases, software and related intellectual property, and goodwill. Such costs are amortized using the straight-line method over the estimated useful lives of the assets as follows: Customer bases 5 years Software and related intellectual property 5 years Goodwill 15-20 years The Company periodically evaluates the recoverability of goodwill based upon projected undiscounted cash flows and operating income or other valuation techniques. Costs incurred in connection with securing the Company’s debt facilities, including underwriting and advisory fees and other such costs, are deferred and included in other assets, and are amortized over the term of the financing using the straight-line method. Other assets also includes investments in entities in which the Company has less than a majority interest but can exercise significant influence. The Company uses the equity method to account for such investments. Under the equity method, investments originally recorded at cost, are adjusted to recognize the Company’s share of net earnings or losses of the affiliates as they occur, rather than as dividends or other distributions received, limited to the extent of the Company’s investment in, advances to and guarantees for the investees. Investments in publicly traded equity securities are marked to market in accordance with SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities.” Investments in entities in which the Company has no significant influence are accounted for under the cost method and included in other assets. Income Taxes The Company accounts for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes”, which requires that deferred income taxes be determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of the enacted tax laws. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) Revenue Recognition The Company recognizes revenue on telecommunications and enhanced communications services in the period that services are provided. Net Loss Per Share Net loss per share has been computed in accordance with SFAS No. 128, “Earnings Per Share.” Accordingly, net loss per share amounts are based on the weighted average number of common shares outstanding during each period. Pursuant to the Securities and Exchange Commission Staff Accounting Bulletin No. 98, nominal issuances of shares and common stock equivalents during the twelve-month period preceding the Company’s initial public offering in September 1997 have been included as if such shares were outstanding for all periods presented. All other common share equivalents are excluded from the calculation of net loss per share due to their antidilutive effect. Therefore, the weighted average number of common shares outstanding for basic and dilutive net loss per share calculations are equal for all periods presented. Stock-Based Compensation As allowed by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company has chosen to account for compensation cost associated with its stock option plans in accordance with Accounting Principles Bulletin Opinion No. 25 adopting the disclosure-only provisions of SFAS 123. Accordingly, the excess, if any, of the market value of the common stock over the exercise price of the option on the date of grant is recorded as expense ratably over the vesting period. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of trade receivables. The Company’s trade receivables are geographically dispersed and include customers in many different industries. Management believes that any risk of loss is significantly reduced due to the diversity of its customers and geographic sales areas. The Company continually evaluates the creditworthiness of its customers; however, it generally does not require collateral. The Company’s allowance for doubtful accounts is based on historical trends, current market conditions and other relevant factors. Use of Estimates The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Reclassifications Certain reclassifications have been made to prior period amounts in order to conform to the current year presentation. Accounting Changes Comprehensive Income Under SFAS No. 130 “Reporting Comprehensive Income,” the Company is required to report comprehensive income, which includes the Company’s net income, as well as changes in equity from other sources. In the Company’s case, the other changes in equity included in comprehensive income comprise unrealized gains and losses on available-for-sale investments. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) Segment Information In the first quarter of 1998, the Company adopted SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information.” SFAS No. 131 supersedes SFAS No. 14 “Financial Reporting for Segments of a Business Enterprise.” Under the new standard the Company uses the “management” approach to reporting its segments. Under the management approach, the internal organization that is used by management for making operating decisions and assessing performance is the basis for designating the Company’s segments. New Accounting Pronouncements In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” which establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The standard was initially proposed to be effective for all fiscal quarters of all fiscal years beginning after June 15, 1999, however the FASB issued SFAS 137 “Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133”, and the effective date of this SFAS has been deferred until issuance by the FASB. Management believes that the adoption of SFAS 133 will not materially impact the Company’s financial position. In January 2000, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 101, “Revenue Recognition,” that will be effective for the Company’s year ending December 31, 2000. The bulletin provides guidance for applying Generally Accepted Accounting Principles to revenue recognition, presentation, and disclosure in financial statements filed with the SEC. Management believes that the bulletin will not materially impact the Company’s financial position. 3. ACQUISITIONS In April 1999, the Company acquired WNP Communications, Inc (WNP), for a total of $698.2 million. Of this amount the Company paid $157.7 million to the FCC in license fees, including interest. The remainder of the purchase price, consisting of $190.1 million in cash and 11,431,662 shares of Class A common stock, was paid to the stockholders of WNP. In this transaction, the Company acquired 39 A block local multi-point distribution services, or LMDS, wireless licenses and one B block LMDS wireless license. At the time of the acquisition, WNP was a holding company for the fixed wireless licenses and did not have any operations. In June 1999, the Company acquired from Nextel Communications Inc. (Nextel) its 50% interest in NEXTBAND, a joint venture formed between the Company and Nextel in January 1998, for $137.7 million in cash. NEXTBAND owns LMDS licenses in 42 markets throughout the U.S. The purchase price was determined based on a formula derived in conjunction with the acquisition of WNP. In July 1998, the Company formed INTERNEXT L.L.C., which is beneficially owned 50% each by the Company and Eagle River. INTERNEXT entered into an agreement with Level 3 Communications, Inc. Level 3 is constructing a fiber optic network that is expected to cover more than 16,000 route miles with six or more conduits and connect 50 cities in the United States and Canada. Pursuant to this agreement, INTERNEXT will receive an exclusive interest in 24 “dark” fibers in a shared, filled conduit, one empty conduit and the right to 25% of the fibers pulled through the sixth and any additional conduits in the network. INTERNEXT will pay $700 million in exchange for these rights, the majority of which will be payable as segments of the network are completed and accepted, substantially all of which is expected to occur during 2000 and 2001. As of December 31, 1999, INTERNEXT had paid $47.6 million to Level 3 of which $19.8 million was paid in 1999. The investment is recorded in Other Assets. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) In November 1997, the Company acquired all of the outstanding shares of Start Technologies Corporation (Start), a shared tenant services provider offering local and long distance services, Internet access and customer premise equipment management in Texas and Arizona. The Company paid consideration for the transaction consisting of $20.0 million in cash, 882,672 shares of Class A common stock, and the assumption of approximately $5.3 million in liabilities. In October 1997, the Company acquired all of the outstanding shares of Chadwick Telecommunications Corporation, a switch-based long distance reseller in central Pennsylvania, through a merger transaction between Chadwick and a wholly owned subsidiary of the Company. The purchase price consisted of a $5.0 million promissory note paid in January 1998, issuance of 1,028,604 and 578,588 shares of Class A common stock in 1997 and March 2000, respectively, and the repayment of long-term debt and other liabilities totaling $6.6 million. The Company also has agreed to issue an additional 96,432 shares of Class A common stock in the event that certain performance goals are achieved by March 31, 2002. 4. MARKETABLE SECURITIES Of the marketable securities outstanding as of December 31, 1999, $532.9 million matures within one year. The remainder matures in less than two years. As of December 31, 1999, the Company’s marketable securities were recorded at fair value. As of December 31, 1998, such securities were recorded at amortized cost which approximated fair value. The Company’s marketable securities consisted of the following (in thousands): 5. PROPERTY AND EQUIPMENT Property and equipment consisted of the following components (in thousands): In February 1998, the Company entered into a 20-year capital lease for exclusive rights to multiple fibers and innerducts throughout New York, New Jersey, Connecticut, Pennsylvania, Delaware, Maryland and Washington D.C. The Company paid $97.0 million in the transaction, of which $5.0 million was paid for rights-of-way. Of the purchase price, $80.3 million was placed into escrow pending completion and delivery of segments of the network route to the Company. The payment was recorded as a long-term asset, and is NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) reclassified as property and equipment as portions of the network are completed. As of December 31, 1999, $25.2 million has been released from escrow for delivery of portions of the network. The Company has the option to renew the lease for two additional 10 year terms. 6. OTHER ASSETS Other assets consisted of the following components (in thousands): 7. OTHER ACCRUED LIABILITIES Other accrued liabilities consisted of the following components (in thousands) NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) 8. LONG-TERM DEBT Long-term debt consisted of the following components (in thousands): On November 17, 1999, the Company completed the sale of $400.0 million of 10 1/2% Senior Notes and $455.0 million in principal amount at stated maturity of 12 1/8% Senior Discount Notes, both due 2009. The Company received proceeds, net of discounts, commissions, advisory fees and expenses totaling approximately $639.6 million. Interest payments on the 10 1/2% Notes are due semi-annually beginning June 1, 2000. The 12 1/8% Notes were issued at a discount from their principal amount to generate aggregate gross proceeds of approximately $251.4 million. The 12 1/8% Notes accrete at a rate of 12 1/8% compounded semi-annually, to an aggregate principal amount of $455 million by December 1, 2004. No cash interest will accrue on the 12 1/8% Notes until December 1, 2004. Interest will become payable in cash semi-annually beginning June 1 2005. The Company has the option to redeem the 10 1/2% Notes and the 12 1/8% Notes, in whole or in part, beginning December 1, 2004 at established redemption prices that decline to 100% of the stated principal amount thereof by December 1, 2007. On June 1, 1999, the Company completed the sale of $675.0 million of 10 3/4% Senior Notes and $588.9 million in principal amount at stated maturity of 12 1/4% Senior Discount Notes, both due June 1, 2009. The Company received proceeds, net of discounts, underwriting commissions, advisory fees and expenses, totaling approximately $979.5 million. Interest payments on the 10 3/4% Notes due 2009 are due semi-annually beginning December 1, 1999. The 12 1/4% Notes were issued at a discount from their principal amount to generate aggregate gross proceeds of $325.0 million. The 12 1/4% Notes accrete at a rate of 12 1/4% compounded semi-annually, to an aggregate principal amount of approximately $588.9 million by June 1, 2004. No cash interest will accrue on the 12 1/4% Notes until June 1, 2004. Interest will become payable in cash semi-annually beginning December 1, 2004. The Company has the option to redeem the 10 3/4% Notes due 2009 and the 12 1/4% Notes, in whole or in part, beginning June 1, 2004 at established redemption prices that decline to 100% of the stated principal amount thereof by June 1, 2007. On November 12, 1998, the Company completed the sale of $500.0 million of 10 3/4% Senior Notes due November 15, 2008. The Company received proceeds from the sale, net of commissions, advisory fees and expenses, totaling approximately $488.5 million. Interest payments on the notes are due semi-annually. The 10 3/4% Notes due 2008 are redeemable at the option of the Company, in whole or in part, beginning November 15, 2003 at established redemption prices, that decline to 100% of the stated principal amount thereof by November 12, 2006. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) On April 1, 1998, the Company completed the sale of $637.0 million in principal amount at stated maturity of 9.45% Senior Discount Notes due April 15, 2008. The 9.45% Notes were issued at a discount from their principal amount to generate aggregate gross proceeds of approximately $400.0 million. The Company received proceeds, net of discounts, commissions, advisory fees and expenses, totaling approximately $390.9 million. The 9.45% Notes accrete at a rate of 9.45% compounded semi-annually, to an aggregate principal amount of approximately $637.0 million by April 15, 2003. No cash interest will accrue on the 9.45% Notes until April 15, 2003. Interest will become payable in cash semi-annually beginning on October 15, 2003. The 9.45% Notes are redeemable at the option of the Company, in whole or in part, beginning April 15, 2003 at established redemption prices, that decline to 100% of the stated principal amount thereof by April 1, 2006. On March 3, 1998, the Company completed the sale of $335.0 million of 9% Senior Notes due March 15, 2008. The Company received proceeds from the sale, net of discounts, commissions, advisory fees and expenses, of approximately $326.5 million. Interest payments on the 9% Senior Notes are due semi-annually. The 9% Senior Notes are redeemable at the option of the Company, in whole or in part, beginning March 15, 2003 at established redemption prices that decline to 100% of the stated principal amount thereof by March 3, 2006. On October 1, 1997, the Company completed the sale of $400.0 million in principal amount of 9 5/8% Senior Notes due October 1, 2007. The Company received proceeds from the sale, net of underwriting commissions, advisory fees and expenses, totaling approximately $388.5 million. Interest payments on the 9 5/8% Notes are due semi-annually. The 9 5/8% Notes are redeemable at the option of the Company, in whole or in part, at any time on or after October 1, 2002 at established redemption prices, that decline to 100% of the stated principal amount thereof by October 1, 2005. On April 25, 1996, the Company completed the sale of $350.0 million in principal amount of 12 1/2% Senior Notes due April 15, 2006. The Company received proceeds from the sale, net of commissions, advisory fees and expenses totaling approximately $340.2 million. The Company used $117.7 million of the proceeds to purchase U.S. government securities, representing funds sufficient to provide for payment in full of interest on the 12 1/2% Senior Notes through April 15, 1999 and $32.2 million to repay advances and accrued interest from Eagle River. Interest payments on the 12 1/2% Senior Notes are due semi-annually. The 12 1/2% Senior Notes are redeemable at the option of the Company, in whole or in part, at any time on or after April 15, 2001 at established redemption prices that decline to 100% of the stated principal amount thereof by April 15, 2004. The indentures pursuant to which all of the Company’s Senior Notes and Senior Discount Notes have been issued contain covenants that, among other things, limit the ability of the Company and its subsidiaries to incur additional indebtedness, issue stock in subsidiaries, pay dividends or make other distributions, repurchase equity interests or subordinated indebtedness, engage in sale and leaseback transactions, create certain liens, enter into certain transactions with affiliates, sell assets of the Company and its subsidiaries, and enter into certain mergers and consolidations. In addition, the Company is required to use the net proceeds from the sale of certain sales of senior notes and senior discount notes to fund 80% of the expenditures for the construction, improvement and acquisition of new and existing networks and services and direct and indirect investments in certain joint ventures to fund similar expenditures. Prior to the application of all such proceeds, the Company may invest them in marketable securities. In the event of a change in control of the Company as defined in the indentures, holders of the Notes will have the right to require the Company to purchase their Notes, in whole or in part, at a price equal to 101% of the stated principal amount thereof, plus accrued and unpaid interest, if any, thereon to the date of purchase. The Notes are senior unsecured obligations of the Company, and are subordinated to all current and future indebtedness of the Company’s subsidiaries, including trade payables. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) 9. REDEEMABLE PREFERRED STOCK On March 31, 1998, the Company completed the sale of 4,000,000 shares of 6 1/2% cumulative convertible preferred stock (6 1/2% Preferred Stock) with a liquidation preference of $50 per share. The sale generated gross proceeds to the Company of $200.0 million, and proceeds net of commissions, advisory fees and expenses of approximately $193.8 million. Each share of 6 1/2% Preferred Stock is convertible, at the option of the holder, into 2.29 shares of the Company’s Class A common stock (subject to adjustments in certain circumstances). The Company may cause such conversion rights to expire if the closing price of the Class A common stock exceeds 120% of an implied conversion price (as defined) for 20 days in a 30 consecutive day trading period after April 15, 2001 and through April 15, 2006. Dividends on the 6 1/2% Preferred Stock accrue from March 31, 1998 and are payable in cash quarterly, at an annual rate of 6 1/2% of the liquidation preference thereof. The Company is required to redeem all of the 6 1/2% Preferred Stock outstanding on March 31, 2010 at a redemption price equal to 100% of the liquidation preference thereof, plus accumulated and unpaid dividends to the date of redemption. As of December 31, 1999, the implied fair value of the Company’s 6 1/2% Preferred Stock is $777.0 million based on the market price of the Company’s Class A common stock into which the preferred stock converts. Terms, including conversion features, vary based on market conditions at the time the security is issued. Accordingly, management believes that this value may not reflect the proceeds the Company would obtain if it issued convertible preferred stock today. On January 31, 1997, the Company completed the sale of 5.7 million units consisting of (i) 14% senior exchangeable redeemable preferred shares (14% Preferred Shares), liquidation preference $50 per share, and (ii) contingent warrants to acquire in the aggregate 5% of each class of outstanding junior shares (as defined) of the Company on a fully diluted basis as of February 1, 1998. The sale generated gross proceeds to the Company of $285.0 million, and proceeds net of commissions, advisory fees and expenses of approximately $274.0 million. The contingent warrants expired unexercised as of the date of the Company’s initial public offering of Class A common stock. Dividends on the 14% Preferred Shares accrue from January 31, 1997 and are payable quarterly, at an annual rate of 14% of the liquidation preference thereof. Dividends may be paid, at the Company’s option, on any dividend payment date occurring on or prior to February 1, 2002, either in cash or by issuing additional 14% Preferred Shares with an aggregate liquidation preference equal to the amount of such dividends. The Company is required to redeem all of the 14% Preferred Shares outstanding on February 1, 2009 at a redemption price equal to 100% of the liquidation preference thereof, plus accumulated and unpaid dividends to the date of redemption. Management believes that, as of December 31, 1999, the carrying value of the 14% Preferred Shares approximated its fair market value. Subject to certain conditions, the 14% Preferred Shares are exchangeable in whole, but not in part, at the option of the Company, on any dividend payment date, for the 14% senior subordinated notes (Senior Subordinated Notes) due February 1, 2009 of the Company. All terms and conditions (other than interest, ranking and maturity) of the Senior Subordinated Notes would be substantially the same as those of the Company’s outstanding 12 1/2% Senior Notes. The terms of the 14% Preferred Stock limit the ability of the Company to incur additional indebtedness and issue additional preferred stock. In the event of a change of control, as defined by the terms of the 14% Preferred Stock, holders of the 14% Preferred Stock will have the right to require the Company to purchase their shares, in whole or in part, at a price equal to 101% of the $50 liquidation preference thereof, plus accumulated and unpaid dividends, if any, thereon at the date of purchase. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) 10. INCOME TAXES Components of deferred tax assets and liabilities were as follows (in thousands): The net change in the valuation allowance for the years ended December 31, 1999, 1998 and 1997 was an increase of $128.7 million, $114.9 million and $34.1 million, respectively. As of December 31, 1999, the Company had net operating loss carryforwards of approximately $916.8 million, of which $119.3 million, $178.9 million and $618.6 million expire in 2012, 2018 and 2019 respectively. A reconciliation of the Company’s effective income tax rate and the U.S. federal tax rate is as follows: 11. SHAREHOLDERS’ EQUITY (DEFICIT) In August 1999, the Company effected a two-for-one stock split of the issued and outstanding shares of Class A and Class B common stock, in the form of a stock dividend. In August 1997, the Company effected a 0.441336-for-1 reverse stock split of the issued and outstanding shares of Class A and Class B common stock. The accompanying consolidated financial statements and the related notes herein have been adjusted retroactively to reflect both the reverse stock split and the two-for-one stock split. In June 1999, the Company completed the sale of 15,200,000 shares of Class A common stock at $38.00 per share, 8,464,100 of which were offered by the Company and 6,735,900 of which were offered by certain shareholders that previously owned interests in WNP. Gross proceeds from the offering totaled $321.6 million, and proceeds to the Company, net of underwriting discounts, advisory fees and expenses, totaled approximately $310.5 million. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) In October 1997, the Company completed an initial public offering (IPO) of 24,000,000 shares of Class A common stock at a price of $8.50 per share. In addition, the underwriters of the IPO exercised an option to purchase 4,560,000 additional shares of Class A common stock at the same price per share. Gross proceeds from the IPO totaled approximately $242.8 million, and proceeds to the Company, net of underwriting discounts, advisory fees and expenses, totaled approximately $226.8 million. Since January 31, 1997, the Company has had two classes of common stock outstanding, Class A common stock and Class B common stock. The Company’s Class A common stock and Class B common stock are identical in dividend and liquidation rights, and vote together as a single class on all matters, except as otherwise required by applicable law, with the Class A shareholders entitled to cast one vote per share, and the Class B shareholders entitled to cast 10 votes per share. 12. NET LOSS PER SHARE Shares used in the computation of net loss per share amounts were calculated as follows: 13. STOCK COMPENSATION ARRANGEMENTS Effective July 1, 1998, the Company adopted the Employee Stock Purchase Plan, or the Purchase Plan. Under the Purchase Plan, the Company has authorized the issuance of 6,000,000 Class A common shares, which allows eligible employees of the Company to purchase common shares of the Company at 85% of the simple average of the fair value of the common stock on the first and the last trading day of each month. Employees who own 5% or more of the voting rights of the Company’s outstanding common shares may not participate in the Purchase Plan. Employees purchased 124,716 and 111,934 shares of Class A Common Stock under the Purchase Plan during 1999 and 1998, respectively. The Company also maintains the NEXTLINK Communications, Inc. Stock Option Plan (the Plan) to provide a performance incentive for certain officers, employees and individuals or companies who provide services to the Company. The Plan provides for the granting of qualified and non-qualified stock options. The Company has reserved 41,000,000 shares of Class A common stock for issuance under the Plan. The options become exercisable over vesting periods of up to four years and expire no later than 10 years after the date of grant. The exercise price of qualified stock options granted under the Plan may not be less than the fair market value of the common shares on the date of grant. The exercise price of non-qualified stock options granted under the Plan may be greater or less than the fair market value of the common stock on the date of grant, as determined at the discretion of the Board of Directors. Stock options granted at prices below fair market value at the date of grant are considered compensatory, and compensation expense is deferred and recognized ratably over the option vesting period based on the excess of the fair market value of the stock at the date of grant over the exercise price of the option. The Company recorded approximately $12.9 million, $4.9 million and $2.3 million of deferred compensation expense related to the Plan for the years ended December 31, 1999, 1998, and 1997, respectively. Additionally, $28.0 million of the Company’s 1999 restructuring charge associated with the relocation of the NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) Company’s headquarters from Bellevue, Washington to Northern Virginia arose due to accelerated vesting of employee options in conjunction with severance arrangements for approximately 125 employees. The Company has adopted the disclosure-only provisions of SFAS 123. Had compensation costs been recognized based on the fair value at the date of grant for options awarded under the Plan and the Equity Option Plan, the pro forma amounts of the Company’s net loss and net loss per share for the years ended December 31, 1999, 1998 and 1997 would have been as follows (in thousands, except per share amounts): The fair value of each option grant was estimated using the Black-Scholes option-pricing model assuming no dividend yield and the following weighted average assumptions: The weighted average fair value of options granted during 1999, 1998 and 1997 was $24.27, $15.71, and $5.94, respectively. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) Information with respect to the Plan and the Equity Option Plan is as follows: At December 31, 1999 there were approximately 7 million shares of Class A common stock shares available for future issuances. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) 14. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Supplemental disclosure of the Company’s cash flow information is as follows (in thousands): 15. LEASES The Company is leasing premises under various operating leases which, in addition to rental payments, require payments for insurance, maintenance, property taxes and other executory costs related to the leases. The lease agreements have various expiration dates and renewal options through 2028. Future minimum lease commitments required under operating leases that have an initial or remaining noncancelable lease term in excess of one year at December 31, 1999 were as follows (in thousands): Rent expense totaled approximately $28.0 million, $13.3 million and $6.4 million in 1999, 1998 and 1997, respectively. 16. OPERATING SEGMENTS Reportable Segments The Company has two reportable segments as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”: a switched telecommunication services segment and an Interactive Voice Response, or IVR service segment. The switched telecommunications services segment is the Company’s largest segment and includes operations relating to the Company’s bundled local and long distance switched services, dedicated services, and long distance services. These services have similar network operations and technology requirements and are sold through identical sales channels to a targeted customer NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) base. Therefore, the Company manages these services as a single segment that is divided into geographic profit centers, or markets, within the United States. The Company’s IVR services manages an IVR platform that allows a consumer to dial into a computer-based system using a toll-free number and a touch-tone phone and, by following a customized menu, access a variety of information. Simultaneously, a profile of the caller is left behind for either the Company’s or its customers’ use. The Company manages its IVR operations as a separate segment due to differences in technology requirements, sales and marketing strategy, and targeted customer base. The accounting policies followed by these segments are consistent with those described in Note 2. There are no significant inter-segment transactions. The Company does not allocate overhead expenses generated by its headquarters to individual segments. The Company’s IVR segment contributed the following percentages to the Company’s total: Products and Services The Company groups its products and services offered by its switched telecommunications services segment into core services, (comprised of bundled local and long distance as well as dedicated services) shared tenant services, long distance telephone services and enhanced services. Revenues from the IVR services segment services are included in the enhanced services product group. The revenues generated by the Company’s products and services were as follows (in thousands): NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) 17. SELECTED QUARTERLY DATA (Unaudited) Summarized quarterly financial information for the year was as follows (in thousands, except per share amounts): Since there are changes in the weighted average number of shares outstanding each quarter, the sum of net loss per share by quarter may not equal the total net loss per share for the applicable year. 18. RELATED PARTY TRANSACTIONS In June 1999, the Company acquired the assets of NEXTLINK, Inc., a company owned by Craig O. McCaw, the Company’s largest and controlling shareholder, through a merger transaction. NEXTLINK, Inc., owned approximately 1% minority interests in 10 of the Company’s subsidiaries. The Company issued 537,806 shares of Class B common stock in exchange for the minority interests. As part of this transaction, Mr. McCaw also received 532,932 shares of the Company’s Class B common stock, the number of shares of Class B common stock previously owned by NEXTLINK, Inc. The transaction was accounted for as a purchase of minority interests between entities under common control and, as such, the minority interests were recorded at NEXTLINK, Inc.’s historical cost. 19. SUBSEQUENT EVENTS Senior Secured Credit Facility In February 2000, the Company entered into a $1.0 billion secured credit facility. The facility is comprised of a $387.5 million senior secured multi-draw term loan A, a $225.0 million senior secured term loan B, and a $387.5 million revolving credit facility. At closing, the Company borrowed $150.0 million and $225.0 million of the term loan A and term loan B, respectively. The security for the Senior Secured Credit Facility consists of all of the assets purchased with the proceeds of the Senior Secured Credit Facility, the stock of certain of the Company’s direct subsidiaries, all assets of the Company and up to $125.0 million of guaranteed debt, all assets of certain of the Company’s subsidiaries. Amounts drawn under the Senior Secured Credit Facility will bear interest, at the option of the Company, at an alternate base rate or reserve-adjusted LIBOR plus, in each case, applicable margins. NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) Initially, the applicable margins for the term loan A and the revolving credit facility are 175 basis points over the alternate base rate and 275 basis points over LIBOR. After June 30, 2003, the applicable margins for the term loan A and the revolving credit facility range from 62 1/2 to 150 basis points over the alternate base rate and from 162 1/2 to 250 basis points over LIBOR, based on the ratio of the Company’s consolidated total debt to annualized consolidated EBITDA. The applicable margin for the term loan B is fixed at 250 basis points over the alternate base rate and 350 basis points over LIBOR. Specific rates are determined by actual borrowings under each facility. Interest on the term loans A and the revolving credit facility is payable on the earlier of the last day of each interest period, or each successive date three months after the first day of such interest period. The term loan A and the revolving credit facility mature on December 31, 2006, and the term loan B matures on June 30, 2007. In each case, the maturity dates are subject to acceleration to October 31, 2005 if the Company has not refinanced its 12 1/2% Senior Notes due 2006 by April 15, 2005. The term loans A and B and the revolving credit facility provide for automatic and permanent quarterly reductions of the amount available for borrowing under those facilities, beginning on March 31, 2004. The term loan B contains nominal amortization provisions beginning March 31, 2004 until maturity. The Senior Secured Credit Facility contains certain covenants, which, among other things, limit additional indebtedness, certain investments and other transactions, and dividend payments. Preferred Stock In December 1999, several Forstmann Little & Co. investment funds agreed to invest $850.0 million in NEXTLINK, to be used to expand its networks and services, introduce new technologies and fund its business plan. The investment closed in January 2000. In the transaction, the investors acquired shares of two series of convertible preferred stock that together are convertible into the Company’s Class A common stock at a conversion price of $63.25 per share and provide for a 3.75% dividend payable quarterly. The holders may convert the preferred stock into Class A common stock at any time after January 20, 2001, and the Company may redeem the preferred stock at any time after later of January 20, 2005 and the date when the Company has redeemed its 12 1/2% Notes in full. Holders of the preferred stock will also have the option of requiring redemption of the preferred stock during the 180-day period commencing January 20, 2010. Concentric Acquisition In January 2000, the Company agreed to acquire Concentric Network Corporation, a provider of high-speed digital subscriber lines (DSL), web hosting, e-commerce and other Internet services. In this transaction, both the Company and Concentric will merge into a newly-formed company, to be renamed NEXTLINK Communications, Inc., which will succeed to both companies assets and businesses and will assume all their outstanding debt obligations and other liabilities. In the transaction, each outstanding share of the Company’s Class A common stock and Class B common stock would be converted into one share of Class A common stock or Class B common stock, as applicable, of the corporation surviving this merger, which stock will be substantially identical to the Company’s Class A and Class B common stock. In addition, each share of Concentric common stock would be converted into 0.495 of a share of Class A common stock of the surviving corporation, unless the trading price of the Company’s common stock at the effective time is less than or equal to $90.91, in which case each outstanding share would be converted into $45.00 in Class A common stock of the surviving corporation (based on the trading price of our Class A common stock prior to the effective time). If the Company’s average stock price is less than $69.23, each outstanding share of Concentric common stock would convert into 0.650 of a share of the Class A common stock of the surviving corporation. This transaction is intended to be tax-free to the Company’s and Concentric’s shareholders and has been unanimously approved by both the Company’s and Concentric’s boards of directors, but remains subject to NEXTLINK Communications, Inc. Notes to Consolidated Financial Statements - (Continued) approval by Concentric’s stockholders. Eagle River, the holder of the majority of the Company’s voting power, has agreed to approve the transaction. The parties have obtained the consent of Concentric’s bond and preferred stock holders to certain amendments to those securities that are necessary to complete this transaction. The transaction is subject to customary closing conditions and is expected to close during the second quarter of 2000. The merger will be accounted under the purchase method of accounting. INTERNEXT Acquisition In January 2000, the Company agreed to acquire Eagle River’s 50% interest in INTERNEXT, L.L.C. in exchange for approximately 3.4 million shares of Class A common stock of the corporation surviving the reorganization. The acquisition, which is expected to close in the second quarter of 2000, will give the Company exclusive rights to “dark” fiber and empty conduits in the 16,000 mile, 50 city national broadband network that Level 3 is currently constructing. As this is a reorganization of entities under common control, Eagle River’s 50% interest in INTERNEXT will be recorded by the Company at Eagle River’s historical cost. Although this acquisition part of the reorganization in connection with the Concentric acquisition, closing is not conditioned on the closing of the Concentric acquisition. 2000 Stock Split In February 2000, the Company announced a two-for-one stock split, to be effected in the form of a stock dividend, effective for stockholders of record on June 1, 2000, and payable on June 15, 2000. The split is subject to stockholder approval of a proposed increase in the number of shares of the Company’s common stock authorized for issuance. This proposal will be considered and voted on at the Company’s May 24, 2000 annual meeting of stockholders. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To NEXTLINK Capital, Inc.: We have audited the accompanying balance sheets of NEXTLINK Capital, Inc. (a Washington Corporation) as of December 31, 1999 and 1998. These balance sheets are the responsibility of the Company’s management. Our responsibility is to express an opinion on these balance sheets based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the balance sheets are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the balance sheets. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the balance sheets referred to above present fairly, in all material respects, the financial position of NEXTLINK Capital, Inc. as of December 31, 1999 and 1998, in conformity with accounting principles generally accepted in the United States. /s/ ARTHUR ANDERSEN LLP Seattle, Washington February 14, 2000 NEXTLINK Capital, Inc. Balance Sheets NEXTLINK Capital, Inc. Note to Balance Sheets December 31, 1999 and 1998 1. Description NEXTLINK Capital, Inc. (NEXTLINK Capital) is a Washington corporation and a wholly owned subsidiary of NEXTLINK Communications, Inc. (NEXTLINK). NEXTLINK Capital was formed for the sole purpose of obtaining financing from external sources and is a joint obligor on the 12 1/2% Senior Notes due April 15, 2006 of NEXTLINK. NEXTLINK Capital was initially funded with a $100 contribution from NEXTLINK and has had no operations to date. NEXTLINK Capital’s sole source and repayment for the 12 1/2% Senior Notes will be from the operations of NEXTLINK. Therefore, these balance sheets should be read in conjunction with the consolidated financial statements of NEXTLINK.

1083058_1999.txt

1083058_1999

1999

1083058

882288_1999.txt

882288_1999

1999

882288

ITEM 1. DESCRIPTION OF BUSINESS For more detailed information about the Registrant's business, see "Business of the Partnership" in the Registrant's Prospectus as supplemented. (a) General Development of Business The Registrant is a California Limited Partnership formed on October 30, 1991 to purchase, own, operate, lease, and sell equipment used in the containerized cargo shipping industry. The Registrant commenced offering units representing limited partnership interests (Units) to the public on April 30, 1992 in accordance with its Registration Statement and ceased to offer such Units as of April 30, 1994. The Registrant raised a total of $136,918,060 from the offering and invested a substantial portion of the money raised in equipment. The Registrant has since engaged in leasing this and other equipment in the international shipping industry. See Item 10 herein for a description of the Registrant's General Partners. See Item 7 herein for a description of current market conditions affecting the Registrant's business. (b) Financial Information About Industry Segments Inapplicable. (c) Narrative Description of Business (c)(1)(i) A container leasing company generally, and the Registrant specifically, is an operating business comparable to a rental car business. A customer can lease a car from a bank leasing department for a monthly charge which represents the cost of the car, plus interest, amortized over the term of the lease; or the customer can rent the same car from a rental car company at a much higher daily lease rate. The customer is willing to pay the higher daily rate for the convenience and value-added features provided by the rental car company, the most important of which is the ability to pick up the car where it is most convenient, use it for the desired period of time, and then drop it off at a location convenient to the customer. Rental car companies compete with one another on the basis of lease rates, availability of cars, and the provision of additional services. They generate revenues by maintaining the highest lease rates and the highest utilization factors that market conditions will allow, and by augmenting this income with proceeds from sales of insurance, drop-off fees, and other special charges. A large percentage of lease revenues earned by car rental companies are generated under corporate rate agreements wherein, for a stated period of time, employees of a participating corporation can rent cars at specific terms, conditions and rental rates. Container leasing companies and the Registrant operate in a similar manner by owning a worldwide fleet of new and used transportation containers and leasing these containers to international shipping companies hauling various types of goods among numerous trade routes. All lessees pay a daily rental rate and in certain markets may pay special handling fees and/or drop-off charges. In addition to these fees and charges, a lessee must either provide physical damage and liability insurance or purchase a damage waiver from the Registrant, in which case the Registrant agrees to pay the cost of repairing any physical damage to containers caused by lessees. Container leasing companies compete with one another on the basis of lease rates, availability of equipment and services provided. To ensure the availability of equipment to its customers, container leasing companies and the Registrant may pay to reposition containers from low demand locations to higher demand locations. By maintaining the highest lease rates and the highest equipment utilization factors allowed by market conditions, the Registrant attempts to generate revenue and profit. The majority of the Registrant's equipment is leased under master leases, which are comparable to the corporate rate agreements used by rental car companies. The master leases provide that the lessee, for a specified period of time, may rent containers at specific terms, conditions and rental rates. Although the terms of the master lease governing each container under lease do not vary, the number of containers in use can vary from time to time within the term of the master lease. The terms and conditions of the master lease provide that the lessee pays a daily rental rate for the entire time the container is in his possession (whether or not he is actively using it), is responsible for any damage, and must insure the container against liabilities. For a more detailed discussion of the leases for the Registrant's equipment, see "Leasing Policy" under "Business of the Partnership" in the Registrant's Prospectus as supplemented. The Registrant also sells containers in the course of its business as opportunities arise, at the end of the container's useful life or if market and economic considerations indicated that a sale would be beneficial. See "Business of the Partnership" in Registrant's Prospectus, as supplemented. (c)(1)(ii) Inapplicable. (c)(1)(iii) Inapplicable. (c)(1)(iv) Inapplicable. (c)(1)(v) Inapplicable. (c)(1)(vi) Inapplicable. (c)(1)(vii) No single lessee generated lease revenue for the years ended December 31, 1999, 1998 and 1997 which was 10% or more of the total revenue of the Registrant. (c)(1)(viii) Inapplicable. (c)(1)(ix) Inapplicable. (c)(1)(x) There are approximately 80 container leasing companies of which the top ten control approximately 91% of the total equipment held by all container leasing companies. The top two container leasing companies combined control approximately 36% of the total equipment held by all container leasing companies. Textainer Equipment Management Limited, an Associate General Partner of the Registrant and the manager of its marine container equipment, is the third largest container leasing company and manages approximately 13% of the equipment held by all container leasing companies. The customers for leased containers are primarily international shipping lines. The Registrant alone is not a material participant in the worldwide container leasing market. The principal methods of competition are price, availability and the provision of worldwide service to the international shipping community. Competition in the container leasing market has increased over the past few years. Since 1996, shipping alliances and other operational consolidations among shipping lines have allowed shipping lines to begin operating with fewer containers, thereby decreasing the demand for leased containers. Furthermore, primarily as a result of lower new container prices and low interest rates, shipping lines now own, rather than lease, a higher percentage of containers. The decrease in demand from shipping lines, along with the entry of new leasing company competitors offering low container rental rates, has increased competition among container lessors such as the Registrant. (c)(1)(xi) Inapplicable. (c)(1)(xii) Inapplicable. (c)(1)(xiii) The Registrant has no employees. Textainer Financial Services Corporation (TFS), the Managing General Partner of the Registrant, is responsible for the overall management of the business of the Registrant and at December 31, 1999 had 4 employees. Textainer Equipment Management Limited (TEM), an Associate General Partner, is responsible for the management of the leasing operations of the Registrant and at December 31, 1999 had a total of 164 employees. (d) Financial Information about Foreign and Domestic Operations and Export Sales. The Registrant is involved in the leasing of shipping containers to international shipping companies for use in world trade and approximately 15%, 21% and 15% of the Registrant's rental revenue during the years ended December 31, 1999, 1998 and 1997, respectively, was derived from operations sourced or terminated domestically. These percentages do not reflect the proportion of the Partnership's income from operations generated domestically or in domestic waterways. Substantially all of the Partnership's income from operations is derived from assets employed in foreign operations. See "Business of the Partnership", and for a discussion of the risks of leasing containers for use in world trade, "Risk Factors" in the Registrant's Prospectus, as supplemented. ITEM 2. ITEM 2. PROPERTIES As of December 31, 1999, the Registrant owned the following types and quantities of equipment: 20-foot standard dry freight containers 11,929 40-foot standard dry freight containers 14,670 40-foot high cube dry freight containers 6,277 ------ 32,876 ====== During December 1999, approximately 77% of these containers were on lease to international shipping companies, and the balance were being stored at container manufacturers' locations and at a large number of storage depots located worldwide. At December 31, 1999 less than 1% of the Partnership's equipment had been identified as being for sale. For information about the Registrant's property, see "Business of the Partnership" and "Risk Factors" in the Registrant's Prospectus, as supplemented. See also Item 7, "Results of Operations" regarding current, and possible future, write-downs of some of the Registrant's property. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Registrant is not subject to any legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS Inapplicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ITEM 201: (a) Market Information. (a)(1)(i) The Registrant's limited partnership Units are not publicly traded and there is no established trading market for such Units. The Registrant has a program whereby limited partners may redeem Units for a specified redemption price. The program operates only when the Managing General Partner determines, among other matters, that payment for redeemed units will not impair the capital or operations of the Registrant. (a)(1)(ii) Inapplicable. (a)(1)(iii) Inapplicable. (a)(1)(iv) Inapplicable. (a)(1)(v) Inapplicable. (a)(2) Inapplicable. (b) Holders. (b)(1) As of January 1, 2000, there were 8,108 holders of record of limited partnership interests in the Registrant. (b)(2) Inapplicable. (c) Dividends. Inapplicable. For details of the distributions which are made monthly by the Registrant to its limited partners, see Item 6 ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Amounts in thousands except for unit and per unit amounts) The Financial Statements contain information that will assist in evaluating the financial condition of the Partnership for the years ended December 31, 1999, 1998 and 1997. Please refer to the Financial Statements and Notes thereto in connection with the following discussion. Liquidity and Capital Resources From May 1, 1992 until April 30, 1994, the Partnership offered limited partnership interests to the public. The Partnership received its minimum subscription amount of $5,000 on June 11, 1992 and on April 30, 1994 the Partnership had received a total subscription amount of $136,918. From time to time, the Partnership redeems units from limited partners for a specified redemption value, which is set by formula. Up to 2% of the Partnership's outstanding units may be redeemed each year, although the 2% limit may be exceeded at the Managing General Partner's discretion. All redemptions are subject to the Managing General Partner's good faith determination that payment for the redeemed units will not (i) cause the Partnership to be taxed as a corporation, (ii) impair the capital or operations of the Partnership, or (iii) impair the ability of the Partnership to pay distributions in accordance with its distribution policy. During the year ended December 31, 1999, the Partnership redeemed 3,288 units for a total dollar amount of $34. The Partnership used cash flow from operations to pay for the redeemed units. The Partnership invests working capital, cash flow from operations prior to its distribution to the partners and proceeds from container sales that have not been used to purchase containers in short-term, liquid investments. The Partnership's cash is affected by cash provided by or used in operating, investing and financing activities. These activities are discussed in detail below. Limited partners are currently receiving monthly distributions in an annualized amount equal to 7% of their original investment. During the year ended December 31, 1999, the Partnership declared cash distributions to limited partners pertaining to the period from December 1998 through November 1999, in the amount of $11,437. On a cash basis, $9,304 of these distributions were from current year operating activities and the remainder was from cash provided by previous years' operations that had not been distributed or used to purchase containers or redeem units. On a GAAP basis, $10,990 of these distributions was a return of capital and the balance was from net earnings. At December 31, 1999, the Partnership had no commitments to purchase containers. Net cash provided by operating activities for the years ended December 31, 1999 and 1998 was $9,338 and $13,675, respectively. The decrease of $4,337, or 32%, was primarily attributable to the decrease in net earnings, adjusted for non-cash transactions and fluctuations in accounts receivable, excluding write-offs, offset by fluctuations in due from affiliates, net. Net earnings, adjusted for non-cash transactions, decreased primarily due to the decline in rental income, which is discussed more fully in "Results of Operations". The decrease in accounts receivable of $341 for the year ended December 31, 1999 was primarily due to the decrease in rental income, offset by an increase in the average collection period of accounts receivable. The decrease in accounts receivable, excluding write-offs, of $942 for the comparable period in 1998 was primarily due to the decrease in the average collection period of accounts receivable. The increases in due from affiliate, net, resulted from timing differences in the payment of expenses and fees and the remittance of net rental revenues. For the year ended December 31, 1999, net cash provided by investing activities (the purchase and sale of containers) was $2,474 compared to $1,797 for the year ended December 31, 1998. Net cash provided by investing activities increased $677 due to the Partnership having sold more containers during the year ended December 31, 1999 than in 1998, partially offset by the Partnership having purchased more containers during the year ended December 31, 1999 than in 1998. The increase in proceeds from container sales during 1999 was due to the Partnership continuing to sell containers located in low demand locations as discussed below in "Results of Operations", offset by lower average sales prices received on the container sales. The sales prices received on these container sales decreased as a result of current market conditions, which have adversely affected the value of used containers. Until conditions improve in these low demand locations, the Partnership plans to continue to sell some of its containers located there. The Partnership sells containers when (i) a container reaches the end of its useful life or (ii) an analysis indicates that the sale is warranted based on existing market conditions and the container's age, location and condition. The increase in container purchases from 1998 to 1999 was due to the increase in cash available for equipment purchases as a result of increased container sales. Proceeds from container sales will fluctuate based on the number of containers sold and the actual price received on the sale. Consistent with its investment objectives, the Partnership intends to continue to reinvest available cash from operations, after distribution and redemptions, and all or a significant amount of the proceeds from container sales in additional containers. However, the number of additional containers purchased is not likely to equal the number of containers sold, as new container prices are likely to be greater than the average sales price of containers sold. Market conditions have had an adverse effect on the average sales price recently realized from container sales and on the amount of cash provided by operations that is available for additional container purchases. These factors have contributed to a lower than anticipated reinvestment in containers. The rate of reinvestment is also affected by distributions and redemptions, which are determined by the General Partners in accordance with the Partnership Agreement. Market conditions are discussed more fully under "Results of Operations". A slower rate of reinvestment will, over time, affect the size of the Partnership's container fleet. Results of Operations The Partnership's income from operations, which consists primarily of rental income, container depreciation, direct container expenses, management fees, and reimbursement of administrative expenses was directly related to the size of the container fleet during the years ended December 31, 1999, 1998 and 1997, as well as certain other factors as discussed below. The following is a summary of the container fleet (in units) available for lease during those periods: 1999 1998 1997 ---- ---- ---- Beginning container fleet............... 34,661 36,409 35,931 Ending container fleet.................. 32,876 34,661 36,409 Average container fleet................. 33,769 35,535 36,170 The decline in the average container fleet of 5% from the year ended December 31, 1998 to the year ended December 31, 1999 was due to the Partnership having sold more containers than it purchased since December 31, 1998. Although some of the sales proceeds were used to purchase additional containers, fewer containers were bought than sold, resulting in the net decrease in the size of the container fleet. The Partnership plans to use the remaining sales proceeds for future container purchases. As noted above, when containers are sold, sales proceeds are not likely to be sufficient to replace all of the containers sold. This trend, which is expected to continue, has contributed to a slower rate of reinvestment than had been expected by the General Partners. Other factors related to this trend are discussed above under "Liquidity and Capital Resources." Rental income and direct container expenses are also affected by the utilization of the container fleet, which was 71%, 79% and 80% on average during the years ended December 31, 1999, 1998 and 1997, respectively. In addition, rental income is affected by daily rental rates. The following is a comparative analysis of the results of operations for the years ended December 31, 1999, 1998 and 1997. The Partnership's income from operations for the years ended December 31, 1999 and 1998 was $831 and $5,616, respectively, on rental income of $17,256 and $21,505, respectively. The decrease in rental income of $4,249, or 20%, from the year ended December 31, 1998 to the year ended December 31, 1999 was attributable to decreases in container rental income and other rental income which is discussed below. Income from container rentals, the major component of total revenue, decreased $3,521, or 19%, primarily due to the decreases in the average on-hire utilization of 10%, the average container fleet of 5% and average rental rates of 4%. The Partnership's income from operations for the years ended December 31, 1998 and 1997 was comparable at $5,616 and $5,454, respectively, on rental income of $21,505 and $21,297, respectively. The increase in rental income of $208, or 1%, from the year ended December 31, 1997 to the same period in 1998 was primarily attributable to an increase in other rental income which is discussed below. Income from container rentals decreased $758, or 4%, primarily due to the decreases in the average container fleet of 2%, average rental rates of 3% and average on-hire utilization of 1%. Since 1996, the container leasing industry has been adversely affected by lower demand for leased containers, increased competition and a trade imbalance, which have resulted in declining utilization and rental rates and increased costs. Demand for leased containers decreased due to changes in the business of shipping line customers as a result of (i) over-capacity resulting from the additions of new, larger ships to the existing container ship fleet at a rate in excess of the growth rate in containerized cargo trade; (ii) shipping line alliances and other operational consolidations that have allowed shipping lines to operate with fewer containers; and (iii) shipping lines purchasing containers to take advantage of low prices and favorable interest rates. The entry of new leasing company competitors offering low container rental rates to shipping lines resulted in downward pressure on rental rates, and caused leasing companies to offer higher leasing incentives and other discounts to shipping lines. The decline in the purchase price of new containers during this period and excess industry capacity have also caused additional downward pressure on rental rates. The weakening of many Asian currencies in 1998 resulted in a significant increase in exports from Asia to North America and Europe and a corresponding decrease in imports into Asia from North America and Europe. This trade imbalance created a weak demand for containers in North America and Europe and a strong demand for containers in Asia, which resulted in a decline in leasing incentives in Asia, but contributed to a further decline in average utilization and rental rates for the fleet managed by TEM. This imbalance has also resulted in an unusually high build-up of containers in lower demand locations. To alleviate the container build-up, the Partnership has repositioned newer containers to higher demand locations. However, as a result of this effort, the Partnership has incurred increased direct container expenses during 1998 and 1999. In addition to repositioning containers, the Partnership has sold certain containers located in lower demand locations. The decision to sell these containers was based on the current expectation that the economic benefit of selling these containers is greater than the estimated economic benefit of continuing to own these containers. The majority of the containers sold during 1998 and 1999 were older containers as the expected economic benefit of continuing to own these containers was significantly less than that of newer containers, primarily due to their shorter remaining marine life, the cost to reposition containers and shipping lines' preference for leasing newer containers. Once the decision had been made to sell certain containers during 1998 and 1999, the Partnership wrote down the value of these specifically identified containers to their estimated fair value, which was based on recent sales prices. Due to unanticipated declines in container sales prices, the actual sales prices received on some containers during 1999 were lower than the estimates used for the write-down, resulting in the Partnership incurring losses upon the sale of some of these containers. The Partnership recorded additional write-downs during 1999 on previously written down containers and on containers subsequently identified for sale. Until market conditions improve, the Partnership may incur further write-downs and/or losses on the sale of such containers. Should the decline in economic value of continuing to own such containers turn out to be permanent, the Partnership may be required to increase its depreciation rate or write-down the value for some or all of its container rental equipment. Although average utilization during the year ended December 31, 1999 was lower than the comparable period in 1998 for the reasons discussed above, utilization has been steadily improving during the second half of 1999 and has remained stable into the beginning of 2000. This improvement in utilization was due to slight improvements in demand for leased containers and the trade imbalance primarily as a result of the improvement in certain Asian economies and a related increase in exports out of Europe. Although the General Partners do not foresee material changes in existing market conditions for the near term, they are cautiously optimistic that the current level of utilization might be maintained during 2000. However, the General Partners caution that utilization, lease rates and container sale prices could also decline, adversely affecting the Partnership's operating results. Substantially all of the Partnership's rental income was generated from the leasing of the Partnership's containers under short-term operating leases. The balance of other rental income consists of other lease-related items, primarily income from charges to lessees for dropping off containers in surplus locations less credits granted to lessees for leasing containers from surplus locations (location income), income from charges to lessees for handling related to leasing and returning containers (handling income) and income from charges to lessees for a Damage Protection Plan (DPP). For the year ended December 31, 1999, the total of these other rental income items was $2,085, a decrease of $728 from the year ended December 31, 1998. This decrease was primarily due to decreases in location and handling income of $638 and $107, respectively. Location income decreased primarily due to a decrease in charges to lessees for dropping off containers in certain locations and an increase in credits given to lessees for picking up containers from certain locations. These decreases and increases were in the lessees' favor and were driven by the market conditions discussed above. Handling income decreased due to a decrease in the average handling price charged per container, offset by an increase in container movement. For the year ended December 31, 1998, the total of these other rental income items was $2,813, an increase of $966 from the year ended December 31, 1997. This increase was primarily due to an increase in location income of $1,093, offset by a decrease in handling income of $175. Location income increased primarily due to a decrease in credits given to lessees for picking up containers from certain locations. Handling income decreased primarily due to a decrease in container movement. Direct container expenses increased $816, or 17%, from the year ended December 31, 1998 to same period in 1999. The increase was primarily due to increases in storage and DPP expenses of $513 and $443, respectively. Storage expense increased primarily due to the decrease in average utilization. DPP expense increased due to an increase in the average repair cost per DPP container and an increase in the number of containers covered under DPP. Direct container expenses increased $446, or 10%, from the year ended December 31, 1997 to the year ended December 31, 1998. The increase was primarily due to an increase in repositioning expense of $577 offset by a decrease in handling expense of $108. Repositioning expense increased primarily due to an increase in the number of containers being transported from low demand locations to higher demand locations at a higher average cost per container. Handling expense decreased primarily due to the decrease in container movement. Bad debt expense (benefit) was $364, ($265) and $280 for the years ended December 31, 1999, 1998 and 1997, respectively. The effect of insurance proceeds received during 1998 relating to certain receivables against which reserves had been recorded in 1994 and 1995, as well as from the resolution of payment issues with one lessee during 1998, were primarily responsible for the benefit recorded in 1998 and, therefore, the fluctuation in bad debt expense (benefit) between the periods. Depreciation expense decreased $395, or 5%, and $74, or 1%, from the years ended December 31, 1998 to 1999 and December 31, 1997 to 1998, respectively. These decreases were due to the decline in the average fleet size. New container prices have been declining since 1995, and the cost of new containers at year-end 1998 and during 1999, was significantly less than the cost of containers purchased in prior years. The Partnership evaluated the recoverability of the recorded amount of container rental equipment at December 31, 1998 and 1999, and determined that a reduction to the carrying value of the containers held for continued use was not required, but that a write-down in value of certain containers identified for sale was required. The Partnership wrote down the value of these containers to their estimated fair value, which was based on recent sales prices less cost of sell. During the fourth quarter of 1998, the Partnership recorded a write-down of $457 on 844 containers identified for sale. During the year ended December 31, 1999, the Partnership recorded additional write-downs of $475 on previously written down containers and on 746 containers subsequently identified for sale. The Partnership sold 1,499 previously written down containers for a loss of $193. The Partnership incurred losses on the sale of some containers previously written down as the actual sales prices received on these containers were lower than the estimates used for the write-downs, primarily due to unexpected declines in container sale prices. Additionally, the Partnership incurred losses of $204 on the sale of containers that had not been written-down. If more containers are subsequently identified as for sale or if container sales prices continue to decline, the Partnership may incur additional write-downs on containers and/or may incur losses on the sale of containers. Management fees to affiliates decreased $293, or 15%, from the year ended December 31, 1998 to the year ended December 31, 1999 due to decreases in both incentive and equipment management fees. The decrease in equipment management fees resulted primarily from the decrease in rental income, upon which the management fee is primarily based. These fees were approximately 7% of rental income for both periods. Incentive management fees, which are based on the Partnership's limited and general partner distribution percentage and partners' capital, decreased primarily due to the decreases in the limited partner distribution percentage from 9% to 8% of partners' capital in July 1999 and 8% to 7% of partners' capital in October 1999. Management fees to affiliates decreased $49, or 2%, from the year ended December 31, 1997 to the year ended December 31, 1998 due to decreases in both incentive and equipment management fees. Equipment management fees decreased as a result of the decrease in rental income and due to an adjustment resulting from the write-off of receivables for two lessees. Incentive management fees decreased primarily due to the decrease in the limited partner distribution percentage from 9.5% to 9% of partners' capital, effective January 1, 1998. General and administrative costs to affiliates decreased $251, or 22% and $154, or 12%, from the years ended December 31, 1998 to 1999 and December 31, 1997 to 1998, respectively. These decreases were due to a decrease in the allocation of overhead costs from TEM, as the Partnership represented a smaller portion of the total fleet managed by TEM and due to lower costs allocated by TFS. Other expense decreased $341, or 56%, for the year ended December 31, 1998 to the year ended December 31, 1999 primarily due to a decrease in the loss on sale of containers. Although the Partnership continued to sell containers in low demand locations at lower average sales prices, as a result of market conditions, it incurred fewer losses during 1999 than 1998 primarily due to the write-down of certain containers recorded during 1998 and 1999. Other expense increased from income of $296 for the year ended December 31, 1997 to an expense of $605 for the year ended December 31, 1998. The increase was primarily due to the fluctuation of gain/loss on sale of containers from a gain of $230 for the year ended December 31, 1997 to a loss of $700 for the year ended December 31, 1998. The loss on sale of containers was primarily due to the Partnership selling containers located in low demand locations at lower average sales prices, as a result of current market conditions. Net earnings per limited partnership unit decreased from $0.72 to $0.07, and from $0.82 to $0.72 from the years ended December 31, 1998 to 1999 and from December 31, 1997 to 1998, respectively. These decreases reflect the decreases in net earnings allocated to limited partners from $4,881 to $447 from the year ended December 31, 1998 to 1999 and from $5,614 to $4,881 from December 31, 1997 to 1998. The allocation of net earnings for the years ended December 31, 1999, 1998 and 1997 included a special allocation of gross income of $114, $80 and $78, respectively, to the General Partners in accordance with the Partnership Agreement. Although substantially all of the Partnership's income from operations is derived from assets employed in foreign operations, virtually all of this income is denominated in United States dollars. The Partnership's customers are international shipping lines, which transport goods on international trade routes. The domicile of the lessee is not indicative of where the lessee is transporting the containers. The Partnership's business risk in its foreign operations lies with the creditworthiness of the lessees, and the Partnership's ability to keep its containers under lease, rather than the geographic location of the containers or the domicile of the lessees. The containers are generally operated on the international high seas rather than on domestic waterways. The containers are subject to the risk of war or other political, economic or social occurrence where the containers are used, which may result in the loss of containers, which, in turn, may have a material impact on the Partnership's results of operations and financial condition. The General Partners are not aware of any conditions as of December 31, 1999, which would result in such a risk materializing. Other risks of the Partnership's leasing operations include competition, the cost of repositioning containers after they come off-lease, the risk of an uninsured loss, increases in maintenance expenses or other costs of operating the containers, and the effect of world trade, industry trends and/or general business and economic cycles on the Partnership's operations. See "Risk Factors" in the Partnership's Prospectus, as supplemented, for additional information on risks of the Partnership's business. Effect of Date Crossing to Year 2000 There has been no material effect on the Partnership's financial condition and results of operations as a result of problems arising from computer systems' abilities to process dates beyond January 1, 2000. The General Partners do not currently expect any such problems to arise within their own computer systems. The likelihood that a failure in a third party's system would occur and have a significant adverse effect on the Partnership's operations seems increasingly remote, but no assurance can be given that, due to unforeseen circumstances, such an event could not occur. Therefore, the Partnership's contingency plan remains in place; that is, the General Partners continue to remain capable of switching temporarily to manual operations in the event of a computer system's failure. There can be no assurance, however, that switching to manual operations would prevent all adverse effects of any future year 2000 problem. Forward Looking Statements The foregoing includes forward-looking statements and predictions about possible or future events, results of operations and financial condition. These statements and predictions may prove to be inaccurate, because of the assumptions made by the Partnership or the General Partners or the actual development of future events. No assurance can be given that any of these forward-looking statements or predictions will ultimately prove to be correct or even substantially correct. The risks and uncertainties in these forward-looking statements include, but are not limited to, changes in demand for leased containers, changes in global business conditions and their effect on world trade, future modifications in the way in which the Partnership's lessees conduct their business or of the profitability of their business, increases or decreases in new container prices or the availability of financing therefor, alterations in the costs of maintaining and repairing used containers, increases in competition, changes in the Partnership's ability to maintain insurance for its containers and its operations, the effects of political conditions on worldwide shipping and demand for global trade or of other general business and economic cycles on the Partnership, as well as other risks detailed herein and from time to time in the Partnership's filings with the Securities and Exchange Commission. The Partnership does not undertake any obligation to update forward-looking statements. ITEM 7A. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Inapplicable. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Attached pages 13 to 25 Independent Auditors' Report The Partners Textainer Equipment Income Fund IV, L.P.: We have audited the accompanying balance sheets of Textainer Equipment Income Fund IV, L.P. (a California limited partnership) as of December 31, 1999 and 1998, the related statements of earnings, partners' capital and cash flows for each of the years in the three-year period ended December 31, 1999. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Textainer Equipment Income Fund IV, L.P. as of December 31, 1999 and 1998, and the results of its operations, its partners' capital and its cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles. KPMG LLP San Francisco, California February 18, 2000 TEXTAINER EQUIPMENT INCOME FUND IV, L.P. (a California Limited Partnership) Notes to Financial Statements Years ended December 31, 1999, 1998 and 1997 (Amounts in thousands except for unit and per unit amounts) - -------------------------------------------------------------------------------- Note 1. Summary of Significant Accounting Policies (a) Nature of Operations Textainer Equipment Income Fund IV, L.P. (TEIF IV or the Partnership), a California limited partnership, with a maximum life of 20 years, was formed on October 30, 1991. The Partnership was formed to engage in the business of owning, leasing and selling both new and used equipment related to the international containerized cargo shipping industry, including, but not limited to, containers, trailers and other container-related equipment. TEIF IV offered units representing limited partnership interests (Units) to the public until April 30, 1994, the close of the offering period, when a total of 6,845,903 Units had been purchased for a total of $136,918. Textainer Financial Services Corporation (TFS) is the managing general partner of the Partnership and is a wholly-owned subsidiary of Textainer Capital Corporation (TCC). Textainer Equipment Management Limited (TEM) and Textainer Limited (TL) are associate general partners of the Partnership. The managing general partner and the associate general partners are collectively referred to as the General Partners and are commonly owned by Textainer Group Holdings Limited (TGH). The General Partners also act in this capacity for other limited partnerships. Prior to its liquidation in October 1998, Textainer Acquisition Services Limited (TAS), a former affiliate of the General Partners, performed services related to the acquisition of containers outside the United States on behalf of the Partnership. Effective November 1998, these services are being performed by TEM. The General Partners manage and control the affairs of the Partnership. (b) Basis of Accounting The Partnership utilizes the accrual method of accounting. Revenue is recorded when earned according to the terms of the container rental contracts. These contracts are classified as operating leases or direct finance leases if they so qualify under Statement of Financial Accounting Standards No. 13: "Accounting for Leases". Substantially all of the Partnership's rental income was generated from the leasing of the Partnership's containers under short-term operating leases. (c) Use of Estimates Certain estimates and assumptions were made by the Partnership's management that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. (d) Fair Value of Financial Instruments In accordance with Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the Partnership calculates the fair value of financial instruments and includes this additional information in the notes to the financial statements when the fair value is different than the book value of those financial instruments. At December 31, 1999 and 1998, the fair value of the Partnership's financial instruments approximates the related book value of such instruments. (e) Container Rental Equipment Container rental equipment is recorded at the cost of the assets purchased, which includes acquisition fees, less depreciation charged. Depreciation of new containers is computed using the straight-line method over an estimated useful life of 12 years to a 28% salvage value. Used containers are depreciated based upon their estimated remaining useful life at the date of acquisition (from 2 to 11 years). When assets are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the equipment accounts and any resulting gain or loss is recognized in income for the period. In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of" (SFAS 121), the Partnership periodically compares the carrying value of the containers to expected future cash flows for the purpose of assessing the recoverability of the recorded amounts. If the carrying value exceeds expected future cash flows, the assets are written down to estimated fair value. In addition, containers identified for disposal are recorded at the lower of carrying amount or fair value less cost to sell. New container prices have been declining since 1995, and the cost of new containers at year-end 1998 and during 1999, was significantly less than the cost of containers purchased in prior years. The Partnership has evaluated the recoverability of the recorded amount of container rental equipment at December 31, 1997 and determined that a reduction to the carrying value of containers was not required. During the years ended December 31, 1998 and 1999, the Partnership determined that a reduction to the carrying value of the containers held for continued use was not required, but that a write-down in value of certain containers identified for sale was required. The Partnership wrote down the value of these containers to their estimated fair value, which was based on recent sales prices less cost to sell. During the fourth quarter of 1998, the Partnership recorded a write-down of $457 on 844 containers identified for sale. During the year ended December 31, 1999, the Partnership recorded additional write-downs of $475 on previously written down containers and on 746 containers subsequently identified for sale. The Partnership sold 1,499 previously written down containers for a loss of $193. The Partnership incurred losses on the sale of some containers previously written down as the actual sales prices received on these containers were lower than the estimates used for the write-downs, primarily due to unexpected declines in container sales prices. Additionally, the Partnership incurred losses of $204 on the sale of containers that had not been written-down. If more containers are subsequently identified as for sale or if container sales prices continue to decline, the Partnership may incur additional write-downs on containers and/or may incur losses on the sale of containers. The Partnership will continue to evaluate the recoverability of the recorded amounts of container rental equipment and cautions that a write-down of container rental equipment and/or an increase in its depreciation rate may be required in future periods for some or all of its container rental equipment. (f) Nature of Income from Operations Although substantially all of the Partnership's income from operations is derived from assets employed in foreign operations, virtually all of this income is denominated in United States dollars. The Partnership's customers are international shipping lines that transport goods on international trade routes. The domicile of the lessee is not indicative of where the lessee is transporting the containers. The Partnership's business risk in its foreign operations lies with the creditworthiness of the lessees rather than the geographic location of the containers or the domicile of the lessees. No single lessee accounted for more than 10% of the Partnership's revenues for the years ended December 31, 1999, 1998 and 1997. (g) Allocation of Net Earnings and Partnership Distributions In accordance with the Partnership Agreement, sections 3.08 through 3.12, net earnings or losses and distributions are generally allocated 1% to the General Partners and 99% to the Limited Partners. If the allocation of distributions exceeds the allocation of net earnings and creates a deficit in a General Partner's capital account, the Partnership Agreement provides for a special allocation of gross income equal to the amount of the deficit. Actual cash distributions to the Limited Partners differ from the allocated net earnings as presented in these financial statements because cash distributions are based on cash available for distribution. Cash distributions are paid to the general and limited partners on a monthly basis in accordance with the provisions of the Partnership Agreement. Some limited partners have elected to have their distributions paid quarterly. The Partnership has recorded deferred distributions of $127 and $175 at December 31, 1999 and 1998, respectively. (h) Income Taxes The Partnership is not subject to income taxes. Accordingly, no provision for income taxes has been made. The Partnership files federal and state information returns only. Taxable income or loss is reportable by the individual partners. (i) Organization Costs Organization costs which resulted from the formation of the Partnership were capitalized and amortized on a straight-line basis over five years. These costs were fully amortized in 1997. (j) Acquisition Fees In accordance with the Partnership Agreement, acquisition fees equal to 5% of the container purchase price were paid to TEM beginning in November 1998 and TAS through October 1998. These fees are capitalized as part of the cost of the containers. (k) Recovery Costs The Partnership accrues an estimate for recovery costs as a result of defaults under its leases that it expects to incur, which are in excess of estimated insurance proceeds. At December 31, 1999 and 1998, the amounts accrued were $186 and $128, respectively. (l) Damage Protection Plan The Partnership offers a Damage Protection Plan (DPP) to lessees of its containers. Under the terms of DPP, the Partnership earns additional revenues on a daily basis and, in return, has agreed to bear certain repair costs. It is the Partnership's policy to recognize revenue when earned and provide a reserve sufficient to cover the Partnership's obligation for estimated future repair costs. DPP expenses are included in direct container expenses in the Statements of Earnings and the related reserve at December 31, 1999 and 1998, was $544 and $374, respectively. (m) Warranty Claims During 1996 and 1995, the Partnership settled warranty claims against two container manufacturers. The Partnership is amortizing the settlement amounts over the remaining estimated useful lives of the applicable containers (ten years), reducing maintenance and repair costs over that time. At December 31, 1999 and 1998, the unamortized portion of the settlement amount was $415 and $476, respectively. (n) Limited Partners' Per Unit Share of Net Earnings and Distributions Limited partners' per unit share of both net earnings and distributions were computed using the weighted average number of units outstanding during the years ended December 31, 1999, 1998 and 1997, which were 6,793,790, 6,819,646, and 6,827,168, respectively. (o) Redemptions The following redemption offerings were consummated by the Partnership during the years ended December 31, 1999, 1998 and 1997: The redemption price is fixed by formula. (p) Reclassifications Certain reclassifications, not affecting net earnings, have been made to prior year amounts in order to conform with the 1999 financial statement presentation. Note 2. Transactions with Affiliates As part of the operation of the Partnership, the Partnership is to pay to the General Partners, or TAS prior to its liquidation, an acquisition fee, an equipment management fee, an incentive management fee and an equipment liquidation fee. These fees are for various services provided in connection with the administration and management of the Partnership. The Partnership capitalized $73, $47, and $165 of container acquisition fees as part of container rental equipment costs during the years ended December 31, 1999, 1998 and 1997, respectively. The Partnership incurred $472, $517, and $546 of incentive management fees during each of the three years ended December 31, 1999, 1998 and 1997, respectively. No equipment liquidation fees were incurred during these periods. The Partnership's containers are managed by TEM. In its role as manager, TEM has authority to acquire, hold, manage, lease, sell and dispose of the containers. TEM holds, for the payment of direct operating expenses, a reserve of cash that has been collected from leasing operations; such cash is included in due from affiliates, net, at December 31, 1999 and 1998. Subject to certain reductions, TEM receives a monthly equipment management fee equal to 7% of gross lease revenues attributable to operating leases and 2% of gross lease revenues attributable to full payout net leases. For the years ended December 31, 1999, 1998 and 1997, equipment management fees totaled $1,206, $1,454, and $1,474, respectively. The Partnership's containers are leased by TEM to third party lessees on operating master leases, spot leases, term leases and full payout net leases. The majority of the Partnership's leases are operating leases with limited terms and no purchase option. Certain indirect general and administrative costs such as salaries, employee benefits, taxes and insurance are incurred in performing administrative services necessary to the operation of the Partnership. These costs are incurred and paid by TEM and TFS. Total general and administrative costs allocated to the Partnership were as follows: 1999 1998 1997 ---- ---- ---- Salaries $ 508 $ 631 $ 717 Other 405 533 601 --- ----- ----- Total general and administrative costs $ 913 $ 1,164 $ 1,318 === ===== ===== TEM allocates these general and administrative costs based on the ratio of the Partnership's interest in the managed containers to the total container fleet managed by TEM during the period. TFS allocates these costs based on the ratio of the Partnership's containers to the total container fleet of all limited partnerships managed by TFS. The General Partners allocated the following general and administrative costs to the Partnership: 1999 1998 1997 ---- ---- ---- TEM $816 $1,054 $1,166 TFS 97 110 152 --- ----- ----- Total general and administrative costs $913 $1,164 $1,318 === ===== ===== The General Partners, or TAS through October 1998, may acquire containers in their own name and hold title on a temporary basis for the purpose of facilitating the acquisition of such containers for the Partnership. The containers may then be resold to the Partnership on an all-cash basis at a price equal to the actual cost, as defined in the Partnership Agreement. In addition, the General Partners and, prior to its liquidation, TAS are entitled to an acquisition fee for any containers resold to the Partnership. At December 31, 1999 and 1998, due from affiliates, net, is comprised of: 1999 1998 ---- ---- Due from affiliates: Due from TEM........................... $ 784 $ 1,197 ------ ----- Due to affiliates: Due to TL.............................. 1 1 Due to TCC............................. 15 8 Due to TFS............................. 38 44 ------ ----- 54 53 ------ ----- Due from affiliates, net $ 730 $ 1,144 ====== ===== These amounts receivable from and payable to affiliates were incurred in the ordinary course of business between the Partnership and its affiliates and represent timing differences in the accrual and payment of expenses and fees described above or in the accrual and remittance of net rental revenues from TEM. It is the policy of the Partnership and the General Partners to charge interest on amounts due to the General Partners which are outstanding for more than one month, to the extent such balances relate to loans for container purchases. Interest is charged at a rate not greater than the General Partners' or affiliates' own cost of funds. The Partnership incurred $13 and $10 of interest expense on amounts due to the General Partners in the years ended December 31, 1998 and 1997, respectively. There was no interest expense incurred on amounts due to the General Partners during the year ended December 31, 1999. Note 3. Rentals under Operating Leases The following are the future minimum rent receivables under cancelable long-term operating leases at December 31, 1999. Although the leases are generally cancelable at the end of each twelve-month period with a penalty, the following schedule assumes that the leases will not be terminated. Year ending December 31, 2000.................................................... $1,214 2001.................................................... 438 2002.................................................... 298 2003.................................................... 39 2004.................................................... 15 ----- Total minimum future rentals receivable................ . $2,004 ===== Note 4. Income Taxes At December 31, 1999, 1998 and 1997, there were temporary differences of $60,380, $65,020, and $57,135, respectively, between the financial statement carrying value of certain assets and liabilities and the federal income tax basis of such assets and liabilities. The reconciliation of net income for financial statement purposes to net income for federal income tax purposes for the years ended December 31, 1999, 1998 and 1997 is as follows: Note 5. Accounts Receivable Write-Off During 1998, the Partnership wrote-off $561 of delinquent receivables from two lessees against which reserves were recorded in 1994 and 1995. During the year ended December 31, 1999, there were no such write-offs. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. There have been none. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Registrant has no officers or directors. As described in the Prospectus, the Registrant's three original general partners were TCC, TEM and Textainer Inc. (TI), which comprised the original Textainer Group. Effective October 1, 1993, the Textainer Group restructured its organization by forming a new holding company, Textainer Group Holdings Limited (TGH), and the shareholders of the underlying companies which include the General Partners accepted shares in TGH in exchange for their shares in the individual companies. Textainer Financial Services Corporation (TFS) is the Managing General Partner of the Partnership (prior to its name change on April 4, 1994, TFS was known as Textainer Capital Corporation). TFS is a wholly-owned subsidiary of Textainer Capital Corporation (TCC) (prior to its name change on April 4, 1994, TCC was known as Textainer (Delaware) Inc.). Textainer Equipment Management Limited (TEM) is an Associate General Partner of the Partnership. TI was an Associate General Partner of the Partnership through September 30, 1993 when it was replaced in that capacity by Textainer Limited (TL), pursuant to the corporate restructuring effective October 1, 1993, which caused TFS, TEM and TL to fall under the common ownership of TGH. Pursuant to this restructuring, TI transferred substantially all of its assets including all of its rights and duties as Associate General Partner to TL. This transfer was effective from October 1, 1993. The end result was that TFS now serves as the Managing General Partner and TEM and TL now serve as the Associate General Partners. The Managing General Partner and Associate General Partners are collectively referred to as the General Partners and are wholly-owned or substantially-owned subsidiaries of TGH. The General Partners also act in this capacity for other limited partnerships. Prior to its liquidation in October 1998, Textainer Acquisition Services Limited (TAS) was an affiliate of the General Partners and performed services related to the acquisition of equipment outside the United States on behalf of the Partnership. Effective November 1998, these services are performed by TEM. TFS, as the Managing General Partner, is responsible for managing the administration and operation of the Registrant, and for the formulation and administration of investment policies. TEM, an Associate General Partner, manages all aspects of the operation of the Registrant's equipment. TL, an Associate General Partner, owns a fleet of container rental equipment which is managed by TEM. TL provides advice to the Partnership regarding negotiations with financial institutions, manufacturers and equipment owners, and regarding the terms upon which particular items of equipment are acquired. Section 16(a) Beneficial Ownership Reporting Compliance. Section 16(a) of the Securities Exchange Act of 1934 requires the Partnership's General Partners, policy-making officials and persons who beneficially own more than ten percent of the Units to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Copies of these reports must also be furnished to the Partnership. Based solely on a review of the copies of such forms furnished to the Partnership or on written representations that no forms were required to be filed, the Partnership believes that with respect to its most recent fiscal year ended December 31, 1999, all Section 16(a) filing requirements were complied with. No member of management, or beneficial owner owned more than 10 percent of any interest in the Partnership. None of the individuals subject to section 16(a) failed to file or filed late any reports of transactions in the Units. The directors and executive officers of the General Partners are as follows: Neil I. Jowell is Director and Chairman of TGH, TEM, TL, TCC and TFS and a member of the Investment Advisory Committee (see "Committees" below). He has served on the Board of Trencor Ltd. since 1966 and as Chairman since 1973. He is also a director of Mobile Industries, Ltd. (1969 to present), an affiliate of Trencor, and a non-executive director of Forward Corporation Ltd. (1993 to present). Trencor is a publicly traded diversified industrial group listed on the Johannesburg Stock Exchange. Its business is the leasing, owning, managing and financing of marine cargo containers worldwide and the manufacture and export of containers for international markets. In South Africa, it is engaged in manufacturing, trading and exports of general commodities. Trencor also has an interest in Forward Corporation Ltd., a publicly traded holding company listed on the Johannesburg Stock Exchange. It has interests in industrial and consumer businesses operating in South Africa and abroad. Mr. Jowell became affiliated with the General Partners and its affiliates when Trencor became, through its beneficial ownership in two controlled companies, a major shareholder of the Textainer Group in 1992. Mr. Jowell has over 36 years' experience in the transportation industry. He holds an M.B.A. degree from Columbia University and Bachelor of Commerce and L.L.B. degrees from the University of Cape Town. John A. Maccarone is President, CEO and Director of TGH, TEM, TL, TCC and TFS. In this capacity he is responsible for overseeing the management of and coordinating the activities of Textainer's worldwide fleet of marine cargo containers and the activities of TCC and TFS. Additionally, he is Chairman of the Equipment Investment Committee, the Credit Committee and the Investment Advisory Committee (see "Committees", below). Mr. Maccarone was instrumental in co-founding Intermodal Equipment Associates (IEA), a marine container leasing company based in San Francisco, and held a variety of executive positions with IEA from 1979 until 1987, when he joined the Textainer Group. Mr. Maccarone was previously a Director of Marketing for Trans Ocean Leasing Corporation in Hong Kong with responsibility for all leasing activities in Southeast Asia. From 1969 to 1977, Mr. Maccarone was a marketing representative for IBM Corporation. He holds a Bachelor of Science degree in Engineering Management from Boston University and an M.B.A. from Loyola University of Chicago. James E. Hoelter is a director of TGH, TEM, TL, TCC and TFS. In addition, Mr. Hoelter is a member of the Equipment Investment Committee and the Investment Advisory Committee (see "Committees", below). Mr. Hoelter was the President and Chief Executive Officer of TGH and TL from 1993 to 1998 and currently serves as a consultant to Trencor (1999 to present). Prior to joining the Textainer Group in 1987, Mr. Hoelter was president of IEA. Mr. Hoelter co-founded IEA in 1978 with Mr. Maccarone and was president from inception until 1987. From 1976 to 1978, Mr. Hoelter was vice president for Trans Ocean Ltd., San Francisco, a marine container leasing company, where he was responsible for North America. From 1971 to 1976, he worked for Itel Corporation, San Francisco, where he was director of financial leasing for the container division. Mr. Hoelter received his B.B.A. in finance from the University of Wisconsin, where he is an emeritus member of its Business School's Dean's Advisory Board, and his M.B.A. from the Harvard Graduate School of Business Administration. Alex M. Brown is a director of TGH, TEM, TL, TCC and TFS. Additionally, he is a member of the Equipment Investment Committee and the Investment Advisory Committee (see "Committees", below). Among other directorships, Mr. Brown is a director of Trencor Ltd. (1996 to present) and Forward Corporation (1997 to present). Both companies are publicly traded and listed on the Johannesburg Stock Exchange. Mr. Brown became affiliated with the Textainer Group in April 1986. From 1987 until 1993, he was President and Chief Executive Officer of Textainer, Inc. and the Chairman of the Textainer Group. Mr. Brown was the managing director of Cross County Leasing in England from 1984 until it was acquired by Textainer in 1986. From 1993 to 1997, Mr. Brown was Chief Executive Officer of AAF, a company affiliated with Trencor Ltd. Mr. Brown was also Chairman of WACO International Corporation, based in Cleveland, Ohio until 1997. Harold J. Samson is a director of TGH and TL and is a member of the Investment Advisory Committee (see "Committees", below). Mr. Samson served as a consultant to various securities firms from 1981 to 1989. From 1974 to 1981 he was Executive Vice President of Foster & Marshall, Inc., a New York Stock Exchange member firm based in Seattle. Mr. Samson was a director of IEA from 1979 to 1981. From 1957 to 1984 he served as Chief Financial Officer in several New Yor Stock Exchange member firms. Mr. Samson holds a B.S. in Business Administration from the University of California, Berkeley and is a California Certified Public Accountant. Philip K. Brewer was President of TCC and TFS from January 1, 1998 to December 31, 1998 until his appointment as Senior Vice President - Asset Management Group. As President of TCC, Mr. Brewer was responsible for overseeing the management of, and coordinating the activities of TCC and TFS. As Senior Vice President, he is responsible for optimizing the capital structure of and identifying new sources of finance for Textainer, as well as overseeing the management of and coordinating the activities of Textainer's risk management, logistics and the resale divisions. Mr. Brewer is a member of the Equipment Investment Committee, the Credit Committee and was a member of the Investment Advisory Committee through December 31, 1998 (see "Committees" below). Prior to joining Textainer in 1996, as Senior Vice President - Capital Markets for TGH and TL, Mr. Brewer worked at Bankers Trust from 1990 to 1996, starting as a Vice President in Corporate Finance and ending as Managing Director and Country Manager for Indonesia; from 1989 to 1990, he was Vice President in Corporate Finance at Jarding Fleming; from 1987 to 1989, he was Capital Markets Advisor to the United States Agency for International Development; and from 1984 to 1987 he was an Associate with Drexel Burnham Lambert in New York. Mr. Brewer holds an M.B.A. in Finance from the Graduate School of Business at Columbia University, and a B.A. in Economics and Political Science from Colgate University. Robert D. Pedersen is Senior Vice-President - Leasing Group and a Director of TEM, responsible for worldwide sales and marketing related activities and operations. Mr. Pedersen is a member of the Equipment Investment Committee and the Credit Committee (see "Committees" below). He joined Textainer in 1991 as Regional Vice President for the Americas Region. Mr. Pedersen has extensive experience in the industry having held a variety of positions with Klinge Cool, a manufacturer of refrigerated container cooling units (from 1989 to 1991), where he was worldwide sales and marketing director, XTRA, a container lessor (from 1985 to 1988) and Maersk Line, a container shipping line (from 1978 to 1984). Mr. Pedersen is a graduate of the A.P. Moller shipping and transportation program and the Merkonom Business School in Copenhagen, majoring in Company Organization. Ernest J. Furtado is Senior Vice President, CFO and Secretary of TGH, TEM, TL, TCC and TFS and a Director of TCC and TFS, in which capacity he is responsible for all accounting, financial management, and reporting functions for TGH, TEM, TL, TCC and TFS. Additionally, he is a member of the Investment Advisory Committee for which he serves as Secretary, the Equipment Investment Committee and the Credit Committee (see "Committees", below). Prior to these positions, he held a number of accounting and financial management positions at Textainer, of increasing responsibility. Prior to joining Textainer in May 1991, Mr. Furtado was Controller for Itel Instant Space and manager of accounting for Itel Containers International Corporation, both in San Francisco, from 1984 to 1991. Mr. Furtado's earlier business affiliations include serving as audit manager for Wells Fargo Bank and as senior accountant with John F. Forbes & Co., both in San Francisco. He is a Certified Public Accountant and holds a B.S. in business administration from the University of California at Berkeley and an M.B.A. in information systems from Golden Gate University. Wolfgang Geyer is based in Hamburg, Germany and is Regional Vice President - Europe, responsible for coordinating all leasing activities in this area of operation. Mr. Geyer joined Textainer in 1993 and was the Marketing Director in Hamburg through July 1997. From 1991 to 1993, Mr. Geyer most recently was the Senior Vice President for Clou Container Leasing, responsible for its worldwide leasing activities. Mr. Geyer spent the remainder of his leasing career, 1975 through 1991, with Itel Container, during which time he held numerous positions in both operations and marketing within the company. Mak Wing Sing is based in Singapore and is the Regional Vice President - - South Asia, responsible for container leasing activities in North/Central People's Republic of China, Hong Kong, South China (PRC), and Southeast Asia. Mr. Mak most recently was the Regional Manager, Southeast Asia, for Trans Ocean Leasing, working there from 1994 to 1996. From 1987 to 1994, Mr. Mak worked with Tiphook as their Regional General Manager, and with OOCL from 1976 to 1987 in a variety of positions, most recently as their Logistics Operations Manager. Masanori Sagara is based in Yokohama, Japan and is the Regional Vice President - North Asia, responsible for container leasing activities in Japan, Korea, and Taiwan. Mr. Sagara joined Textainer in 1990 and was the company's Marketing Director in Japan through 1996. From 1987 to 1990, he was the Marketing Manager at IEA. Mr. Sagara's other experience in the container leasing business includes marketing management at Genstar from 1984 to 1987 and various container operations positions with Thoresen & Company from 1979 to 1984. Mr. Sagara holds a Bachelor of Science degree in Economics from Aoyama Bakuin University. John A. Lore is based in Hackensack, New Jersey and is the Regional Vice President - Americas, responsible for container leasing activities in North/South America, Australia/New Zealand, Africa, the Middle East and Persian Gulf. Prior to joining Textainer in 1999, Mr. Lore was the America's Vice President for Xtra International Limited from 1996 to 1999 and Area Director from 1990 to 1996. He has held various positions within the container leasing industry since 1978. Mr. Lore holds a B.B.A. in Marketing Management from Baruch College and an M.B.A. in Executive Management from St. John's University. Stefan Mackula is Vice President - Equipment Resale, responsible for coordinating the worldwide sale of equipment into secondary markets. Mr. Mackula also served as Vice President - Marketing from 1989 to 1991 where he was responsible for coordinating all leasing activities in Europe, Africa, and the Middle East. Mr. Mackula joined Textainer in 1983 as Leasing Manager for the United Kingdom. Prior to joining Textainer, Mr. Mackula held, beginning in 1972, a variety of positions in the international container shipping industry. Anthony C. Sowry is Vice President - Corporate Operations and Acquisitions. He is also a member of the Equipment Investment Committee and the Credit Committee (see "Committees", below). Mr. Sowry supervises all international container operations and maintenance and technical functions for the fleets under Textainer's management. In addition, he is responsible for the acquisition of all new and used containers for the Textainer Group. He began his affiliation with Textainer in 1982, when he served as Fleet Quality Control Manager for Textainer Inc. until 1988. From 1980 to 1982, he was operations manager for Trans Container Services in London; and from 1978 to 1982, he was a technical representative for Trans Ocean Leasing, also in London. He received his B.A. degree in business management from the London School of Business. Mr. Sowry is a member of the Technical Committee of the International Institute of Container Lessors and a certified container inspector. Richard G. Murphy is Vice President, Risk Management, responsible for all credit and risk management functions. He also supervises the administrative aspects of equipment acquisitions. He is a member of and acts as secretary to the Equipment Investment and Credit Committees (see "Committees", below). He previously served as TEM's Director of Credit and Risk Management from 1989 to 1991 and as Controller from 1988 to 1989. Prior to the takeover of the management of the Interocean Leasing Ltd. fleet by TEM in 1988, Mr. Murphy held various positions in the accounting and financial areas with that company from 1980, acting as Chief Financial Officer from 1984 to 1988. Prior to 1980, he held various positions with firms of public accountants in the U.K. Mr. Murphy is an Associate of the Institute of Chartered Accountants in England and Wales and holds a Bachelor of Commerce degree from the National University of Ireland. Janet S. Ruggero is Vice President, Administration and Marketing Services. Ms. Ruggero is responsible for the tracking and billing of fleets under TEM management, including direct responsibility for ensuring that all data is input in an accurate and timely fashion. She assists the marketing and operations departments by providing statistical reports and analyses and serves on the Credit Committee (see "Committees", below). Prior to joining Textainer in 1986, Ms. Ruggero held various positions with Gelco CTI over the course of 15 years, the last one as Director of Marketing and Administration for the North American Regional office in New York City. She has a B.A. in education from Cumberland College. Jens W. Palludan is based in Hackensack, New Jersey and is the Regional Vice President - Logistics Division, responsible for coordinating container logistics. He joined Textainer in 1993 as Regional Vice President - Americas/Africa/Australia, responsible for coordinating all leasing activities in North and South America, Africa and Australia/New Zealand. Mr. Palludan spent his career from 1969 through 1992 with Maersk Line of Copenhagen, Denmark in a variety of key management positions in both Denmark and overseas. Mr. Palludan's most recent position at Maersk was that of General Manager, Equipment and Terminals, where he was responsible for the entire managed fleet. Mr. Palludan holds an M.B.A. from the Centre European D'Education Permanente, Fontainebleau, France. Sheikh Isam K. Kabbani is a director of TGH and TL. He is Chairman and principal stockholder of the IKK Group, Jeddah, Saudi Arabia, a manufacturing and trading group which is active both in Saudi Arabia and internationally. In 1959 Sheikh Isam Kabbani joined the Saudi Arabian Ministry of Foreign Affairs, and in 1960 moved to the Ministry of Petroleum for a period of ten years. During this time he was seconded to the Organization of Petroleum Exporting Countries (OPEC). After a period as Chief Economist of OPEC, in 1967 he became the Saudi Arabian member of OPEC's Board of Governors. In 1970 he left the ministry of Petroleum to establish his own business, the National Marketing Group, which has been his principal business activity for the past 18 years. Sheikh Kabbani holds a B.A. degree from Swarthmore College, Pennsylvania, and an M.A. degree in Economics and International Relations from Columbia University. James A. C. Owens is a director of TGH and TL. Mr. Owens has been associated with the Textainer Group since 1980. In 1983 he was appointed to the Board of Textainer Inc., and served as President of Textainer Inc. from 1984 to 1987. From 1987 to 1998, Mr. Owens served as an alternate director on the Boards of TI, TGH and TL. Apart from his association with the Textainer Group, Mr. Owens has been involved in insurance and financial brokerage companies and captive insurance companies. He is a member of a number of Boards of Directors. Mr. Owens holds a Bachelor of Commerce degree from the University of South Africa. S. Arthur Morris is a director of TGH, TEM and TL. He is a founding partner in the firm of Morris and Kempe, Chartered Accountants (1962-1977) and currently functions as a correspondent member of a number of international accounting firms through his firm Arthur Morris and Company (1977 to date). He is also President and director of Continental Management Limited (1977 to date). Continental Management Limited is a Bermuda corporation that provides corporate representation, administration and management services and corporate and individual trust administration services. Mr. Morris has over 30 years experience in public accounting and serves on numerous business and charitable organizations in the Cayman Islands and Turks and Caicos Islands. Mr. Morris became a director of TL and TGH in 1993, and TEM in 1994. Dudley R. Cottingham is Assistant Secretary, Vice President and a director of TGH, TEM and TL. He is a partner with Arthur Morris and Company (1977 to date) and a Vice President and director of Continental Management Limited (1978 to date), both in the Cayman Islands and Turks and Caicos Islands. Continental Management Limited is a Bermuda corporation that provides corporate representation, administration and management services and corporate and individual trust administration services. Mr. Cottingham has over 20 years experience in public accounting with responsibility for a variety of international and local clients. Mr. Cottingham became a director of TL and TGH in 1993, and TEM in 1994. Nadine Forsman is the Controller of TCC and TFS. Additionally, she is a member of the Investment Advisory Committee and Equipment Investment Committee (See "Committees" below). As controller of TCC and TFS, she is responsible for accounting, financial management and reporting functions for TCC and TFS as well as overseeing all communications with the Limited Partners and as such, supervises personnel in performing these functions. Prior to joining Textainer in August 1996, Ms. Forsman was employed by KPMG LLP, holding various positions, the most recent of which was manager, from 1990 to 1996. Ms. Forsman holds a B.S. in Accounting and Finance from San Francisco State University and holds a general securities license and a financial and operations principal securities license. Committees The Managing General Partner has established the following three committees to facilitate decisions involving credit and organizational matters, negotiations, documentation, management and final disposition of equipment for the Partnership and for other programs organized by the Textainer Group: Equipment Investment Committee. The Equipment Investment Committee will review the equipment leasing operations of the Partnership on a regular basis with emphasis on matters involving equipment purchases, the equipment mix in the Partnership's portfolio, equipment remarketing issues, and decisions regarding ultimate disposition of equipment. The members of the committee are John A. Maccarone (Chairman), James E. Hoelter, Anthony C. Sowry, Richard G. Murphy (Secretary), Alex M. Brown, Philip K. Brewer, Robert D. Pedersen, Ernest J. Furtado and Nadine Forsman. Credit Committee. The Credit Committee will establish credit limits for every lessee and potential lessee of equipment and periodically review these limits. In setting such limits, the Credit Committee will consider such factors as customer trade routes, country, political risk, operational history, credit references, credit agency analyses, financial statements, and other information. The members of the Credit Committee are John A. Maccarone (Chairman), Richard G. Murphy (Secretary), Janet S. Ruggero, Anthony C. Sowry, Philip K. Brewer, Ernest J. Furtado and Robert D. Pedersen. Investment Advisory Committee. The Investment Advisory Committee will review investor program operations on at least a quarterly basis, emphasizing matters related to cash distributions to investors, cash flow management, portfolio management, and liquidation. The Investment Advisory Committee is organized with a view to applying an interdisciplinary approach, involving management, financial, legal and marketing expertise, to the analysis of investor program operations. The members of the Investment Advisory Committee are John A. Maccarone (Chairman), James E. Hoelter, Ernest J. Furtado (Secretary), Nadine Forsman, Harold J. Samson, Alex M. Brown and Neil I. Jowell. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Registrant has no executive officers and does not reimburse TFS, TEM or TL for the remuneration payable to their executive officers. For information regarding reimbursements made by the Registrant to the General Partners, see note 2 of the Financial Statements in Item 8. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security Ownership of Certain Beneficial Owners There is no person or "Group" who is known to the Registrant to be the beneficial owner of more than five percent of the outstanding units of limited partnership interest in the Registrant. (b) Security Ownership of Management As of January 1, 2000: Number Name of Beneficial Owner Of Units % All Units --------- ----------- James E. Hoelter....................... 10,995 0.1618% John A. Maccarone...................... 5,500 0.0810% ------ ------- Officers and Management as a Group.......................... 16,495 0.2428% ====== ======= (c) Changes in control. Inapplicable. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Amounts in thousands) (a) Transactions with Management and Others. At December 31, 1999 and 1998, due from affiliates, net, is comprised of: 1999 1998 ---- ---- Due from affiliates: Due from TEM............................ $ 784 $1,197 ----- ----- Due to affiliates: Due to TL............................... 1 1 Due to TCC.............................. 15 8 Due to TFS.............................. 38 44 ----- ----- 54 53 ----- ----- Due from affiliates, net $ 730 $1,144 ===== ===== These amounts receivable from and payable to affiliates were incurred in the ordinary course of business between the Partnership and its affiliates and represent timing differences in the accrual and payment of expenses and fees described above or in the accrual and remittance of net rental revenues from TEM. It is the policy of the Partnership and the General Partners to charge interest on amounts due to the General Partners which are outstanding for more than one month, to the extent such balances relate to loans for container purchases. Interest is charged at a rate not greater than the General Partners' or affiliates' own cost of funds. The Partnership incurred $13 and $10 of interest expense on amounts due to the General Partners in the years ended December 31, 1998 and 1997, respectively. There was no interest expense incurred on amounts due to the General Partners during the year ended December 31, 1999. In addition, the Registrant paid or will pay the following amounts to the General Partners and TAS: Acquisition fees in connection with the purchase of containers on behalf of the Registrant: 1999 1998 1997 ---- ---- ---- TAS.................... $ - $ 31 $ 165 TEM.................... 73 16 - ----- ------ ------ Total.................. $ 73 $ 47 $ 165 ====== ====== ====== Management fees in connection with the operations of the Registrant: 1999 1998 1997 ---- ------ ---- TEM.................... $ 1,310 $ 1,568 $ 1,594 TFS.................... 368 403 426 ------ ------ ------ Total.................. $ 1,678 $ 1,971 $ 2,020 ====== ====== ====== Reimbursement for administrative costs in connection with of the operations of the Registrant: 1999 1998 1997 ---- ---- ---- TEM.................... $ 816 $ 1,054 $ 1,166 TFS.................... 97 110 152 ----- ----- ----- Total.................. $ 913 $ 1,164 $ 1,318 ===== ===== ===== (b) Certain Business Relationships. Inapplicable. (c) Indebtedness of Management Inapplicable. (d) Transactions with Promoters Inapplicable. See the "Management" and "Compensation of General Partners and Affiliates" sections of the Registrant's Prospectus, as supplemented, and the Notes to the Financial Statements in Item 8. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Audited financial statements of the Registrant for the year ended December 31, 1999 are contained in Item 8 of this Report. 2. Financial Statement Schedules. (i) Independent Auditors' Report on Supplementary Schedule. (ii) Schedule II - Valuation and Qualifying Accounts. 3. Exhibits Incorporated by reference. (i) The Registrant's Prospectus as contained in Pre-Effective Amendment No. 2 to the Registrant's Registration Statement (No. 33-44687), as filed with the Commission April 10, 1992, as supplemented by Post-Effective Amendment No. 3 filed with the Commission under Section 8(c) of the Securities Act of 1993 on May 25, 1993, and as supplemented by Supplement No. 8 as filed under Rule 424(b) of the Securities Act of 1933 on March 1, 1994. (ii) The Registrant's limited partnership agreement, Exhibit A to the Prospectus. (b) During the year ended 1999, no reports on Form 8-K have been filed by the Registrant. Independent Auditors' Report on Supplementary Schedule The Partners Textainer Equipment Income Fund IV, L.P.: Under the date of February 18, 2000, we reported on the balance sheets of Textainer Equipment Income Fund IV, L.P. (the Partnership) as of December 31, 1999 and 1998, and the related statements of earnings, partners' capital and cash flows for each of the years in the three-year period ended December 31, 1999, which are included in the 1999 annual report on Form 10-K. In connection with our audits of the aforementioned financial statements, we also audited the related financial statement schedule as listed in Item 14. This financial statement schedule is the responsibility of the Partnership's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP San Francisco, California February 18, 2000 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TEXTAINER EQUIPMENT INCOME FUND IV, L.P. A California Limited Partnership By Textainer Financial Services Corporation The Managing General Partner By__________________________ Ernest J. Furtado Senior Vice President Date: March 28, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Textainer Financial Services Corporation, the Managing General Partner of the Registrant, in the capacities and on the dates indicated: SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TEXTAINER EQUIPMENT INCOME FUND IV, L.P. A California Limited Partnership By Textainer Financial Services Corporation The Managing General Partner By /s/Ernest J. Furtado ________________________________ Ernest J. Furtado Senior Vice President Date: March 28, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Textainer Financial Services Corporation, the Managing General Partner of the Registrant, in the capacities and on the dates indicated: